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26172_1993.txt

26172_1993

1993

26172

ITEM 1. BUSINESS ~~~~~~~ ~~~~~~~~ OVERVIEW ~~~~~~~~ Cummins Engine Company, Inc. ("Cummins" or "the Company") is a leading worldwide designer and manufacturer of fuel-efficient diesel engines and related products. Engines ranging from 76 to 2,000 horsepower serve a wide variety of equipment in Cummins' key markets: heavy-duty truck, midrange truck, power generation, bus and light commercial vehicles, industrial products, government and marine. In addition, Cummins produces strategic components and subsystems critical to the engine, including filters, turbochargers and electronic control systems. Cummins sells its products to original equipment manufacturers ("OEMs"), distributors and other customers worldwide and conducts manufacturing, sales, distribution and service activities in most areas of the world. In 1993, approximately 56 percent of net sales were made in the United States. Major international markets include the United Kingdom and Europe (14 percent of net sales); Asia, the Far East and Australia (13 percent of net sales); and Mexico and South America (8 percent of net sales). Cummins' growing presence in international markets and its significant investment in emissions technology have created opportunities for cooperative arrangements with vertically integrated manufacturers worldwide. In addition to agreements with major US equipment manufacturers, Cummins recently developed alliances with Scania of Sweden to develop a fuel system for heavy-duty diesel engines; with Tata Engineering and Locomotive Company ("TELCO") of India to manufacture Cummins B Series engines for TELCO trucks; and with Komatsu of Japan to produce Cummins B Series engines in Japan and to adapt for production high-horsepower Komatsu-designed engines in the United States. BUSINESS MARKETS ~~~~~~~~~~~~~~~~ Heavy-duty Truck ~~~~~~~~~~~~~~~~ The Company has a complete product line of 8-, 10-, 11- and 14-litre diesel engines that range from 260 to 500 horsepower serving the heavy-duty truck market. Cummins' heavy-duty diesel engines are offered as standard or optional power by most major heavy-duty truck manufacturers in North America. The seven largest US heavy-duty truck OEMs produced approximately 98 percent of the heavy-duty trucks sold in North America in 1993. The loss of certain of these customers could have an adverse effect on the Company's business. The Company's largest customer for heavy-duty truck engines in 1993 was Navistar International Corporation, which represented 7.5 percent of the Company's 1993 net sales. In 1993, the Company accounted for 62.7 percent of Navistar's heavy-duty engine purchases. In the heavy-duty truck market, the Company competes with independent engine manufacturers as well as truck producers who manufacture diesel engines for their own products. Certain of these integrated manufacturers also are customers of the Company. In North America, the Company's primary competitors in the heavy-duty truck engine market are Caterpillar, Inc., Detroit Diesel Corporation and Mack Trucks, Inc. The Company's principal competitors in international markets vary from country to country, with local manufacturers generally predominant in each geographic market. Other diesel engine manufacturers in international markets include Mercedes Benz, AB Volvo, Renault Vehicles Industriels, Iveco Diesel Engines, Hino Motors, Ltd., Mitsubishi Heavy Industries, Ltd., Isuzu Motors, Ltd., DAF Group N.V. and SAAB-Scania A.B. The North American heavy-duty truck market is affected significantly by the overall level of economic activity. In 1993, North American heavy-duty truck production grew by 34 percent from the previous year's level. Production was 174,000 trucks in 1993 compared to 130,000 in 1992 and 96,000 in 1991. The Company's share of the North American heavy-duty truck engine market was 35 percent in 1993, which was significantly higher than its nearest competitor. The Company's share of the North American heavy-duty truck engine market was 37 percent in 1992 and 38 percent in 1991. While the European truck market continued at depressed levels during 1993, the UK market began to recover, producing at total of 13,300 units, compared to 10,000 in 1992. Cummins' share of the UK market was approximately 14 percent in 1993. The Mexican heavy-duty truck market declined approximately 18 percent in 1993, from 7,900 units in 1992 to 6,500 units in 1993, due primarily to high interest rates and restrictive economic policies imposed by the Mexican government to reduce inflation. The Company's share of this market was nearly 80 percent in 1993. Midrange Truck ~~~~~~~~~~~~~~ The Company has a product line of diesel engines ranging from 160 to 300 horsepower serving midrange and intercity delivery truck customers. The Company entered the North American midrange diesel engine truck market in 1990. Production of medium-duty trucks in North America grew 5 percent in 1993 from 105,000 units in 1992 to 110,000 units in 1993. The Company's share of the market in 1993 was 30 percent, a major factor of which was sales to Ford Motor Company. In 1993, Ford completed its introduction of the Company's B and C Series engines as exclusive diesel power in its medium-duty truck line. Ford was the Company's largest customer for midrange engines for this market in 1993, representing approximately 5 percent of the Company's net sales. The Company also sells its B and C Series engines and engine components outside North America to midrange truck markets in Asia, Europe and South America. Cummins and TELCO, India's largest truck manufacturer, formed a joint venture in 1993 to manufacture B Series engines in India for TELCO vehicles. Cummins engines will be phased into these vehicles beginning in 1994, with production to begin at the joint venture's plant in 1995. In the midrange truck market, the Company competes with independent engine manufacturers as well as truck producers who manufacture diesel engines for their own products. Certain of these integrated manufacturers also are customers of the Company. Primary engine competitors in the midrange truck market in North America are Navistar International Corporation and Caterpillar, Inc. The Company's principal competitors in international markets vary from country to country, with local manufacturers generally predominant in each geographic market. Other diesel engine manufacturers in international markets include Mercedes Benz, AB Volvo, Renault Vehicles Industriels, Iveco Diesel Engines, Hino-Motors Ltd., Mitsubishi Heavy Industries, Ltd., Isuzu Motors, Ltd., DAF Group N.V., SAAB-Scania A.B., Perkins Engines Ltd., and Nissan. Power Generation ~~~~~~~~~~~~~~~~ In 1993, power generation continued to represent over 20 percent of the Company's net sales. Products include the complete line of Cummins' engines, Onan's gasoline engines, generator sets and switches and Newage alternators. These products serve the stationary power, mobile and alternator markets. In stationary power, Onan's industrial business and Cummins' G-drive groups provide electrical and engine power generation products and services to essentially all major markets worldwide. The product line is the broadest in the industry, ranging from 5 to 1500 kW. In the mobile business, Onan is a leading supplier of power generation sets for the recreational vehicle market in the United States. As part of a Department of Energy contract, Onan recently was selected to develop a 35 kW auxiliary power unit for passenger hybrid electric vehicles. Bus and Light Commercial Vehicles ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ This market includes Cummins-powered pickup trucks, school buses, urban transit buses, delivery trucks and recreational vehicles. In 1993, sales increased almost 20 percent over the 1992 level. Chrysler, which offers the Cummins B Series engines in its Dodge Ram pickup truck, was the Company's largest customer for midrange engines in this market, representing 5.4 percent of the Company's net sales in 1993. Cummins' share of the US transit bus market was 40 percent in 1993, due in part to the introduction of the C Series engines and Cummins' natural gas L10 engine. Cummins' natural gas engine was the first natural gas fueled heavy-duty engine certified by the California Air Resources Board. In 1993, sales of engines for school buses, recreational vehicles and light commercial vehicles, including delivery trucks and panel vans, also were strong. In these markets, the Company also competes with both independent manufacturers of diesel engines and vehicle producers who manufacture diesel engines for their own products. Primary manufacturers of diesel engines for the bus and light commercial truck markets are Detroit Diesel Corporation, General Motors Corporation, Navistar International Corporation, Perkins Engines Ltd., MAN, AB Volvo, Mercedes Benz and SAAB-Scania A.B. Industrial Products ~~~~~~~~~~~~~~~~~~~ Cummins' engines power more than 3,000 models of equipment for the construction, logging, mining, agricultural, petroleum and rail markets. Worldwide sales of Cummins products to this market increased approximately 3 percent in 1993, compared to 1992. The increase in sales was primarily in international markets. Industrial markets are recovering modestly in the United States. Cummins introduced the B Series engine at 200 horsepower in 1993. It was the first engine to be introduced to the marketplace which meets the stringent 1996 California off-highway emissions regulations. In 1993, Cummins and Komatsu formed joint ventures to produce Cummins' B Series engines in Japan and Komatsu's 30-litre engine in the United States. Production at both joint venture sites is expected to commence in 1996. Government ~~~~~~~~~~ Cummins sells engines for a variety of military and civilian applications. Government sales continued to decline in 1993 from a peak of $236 million in 1991. The Company believes that this market may decline further due to reductions in US military expenditures. Cummins Military Systems Co. ("CMSC"), which specialized in rebuilt military vehicles, was one of two bidders competing for a production contract to remanufacture up to 10,000 US Army 2-1/2 ton trucks. CMSC was unsuccessful in its bid and, as a result, the Company has closed CMSC and will dispose of its assets. Marine ~~~~~~ Product applications span 76 to 1,400 horsepower for recreational, commercial and military markets. In 1993, marine sales were approximately 6 percent higher than in 1992, with Asia representing the most rapidly growing market for these products. Fleetguard, Holset and Cummins Electronics ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Sales of filters, turbochargers and electronic systems represented approximately 11 percent of the Company's sales in 1993, compared to approximately 12 percent in 1992 and 1991. Effective at the beginning of the third quarter of 1993, the Company transferred its 80-percent interest in McCord Heat Transfer Corp., to Behr America Holding, Inc., for a 35-percent interest in Behr America Holding, Inc., a company that also holds all of the North American operations of Julius F. Behr of Germany. The Company's minority interest in Behr America Holding, Inc., has been reported as an unconsolidated company since the third quarter of 1993. Fleetguard is a leading manufacturer of products for the North American heavy-duty filter industry. Its products also are produced and sold in international markets, including Europe, Mexico, India, Australia and the Far East. Holset's products also are sold worldwide. In 1993, Holset introduced a new viscous damper and coupling design, as well as an air compressor for the heavy-duty market. In 1993, Holset also completed the acquisition of Kompressorenbau Bannewitz GmbH near Dresden, Germany, which produces turbochargers for high-horsepower diesel engines. Cummins Electronics provides controls for Cummins' engines and on- board business information and specialized electronics systems for Cummins' customers. BUSINESS OPERATIONS ~~~~~~~~~~~~~~~~~~~ Research and Development ~~~~~~~~~~~~~~~~~~~~~~~~ Cummins conducts an extensive research and engineering program to achieve product improvements, innovations and cost reductions, as well as to satisfy legislated emissions requirements. As disclosed in Note 1 to the Consolidated Financial Statements, research and development expenditures approximated $158 million in 1993, $129 million in 1992 and $99 million in 1991. Sales and Distribution ~~~~~~~~~~~~~~~~~~~~~~ While the Company has several supply contracts for its products in on- and off-highway markets, much of its business is done on open purchase orders. These purchase orders usually may be canceled on reasonable notice without cancellation charges. Therefore, while incoming orders generally are indicative of anticipated future demand, the actual demand for the Company's products may change at any time. The Company's products compete on a number of factors, including price, delivery, quality, warranty and service. Cummins believes that its continued focus on cost, quality and delivery, its extensive technical investment, its full product line and customer-led service and support programs are key elements of its competitive position. The Company's major markets typically experience modest seasonal declines in production during the third quarter of the year, which has an effect on the demand for Cummins' products during that quarter of each year. Cummins warrants its engines, subject to proper use and maintenance, against defects in factory workmanship or materials for either a specified time period or mileage or hours of use. Warranty periods vary by engine family and market segment and are subject to competitive pressures. Cummins sells engines, parts and related products through distributorships worldwide. The Company believes its distribution system is an important part of its marketing strategy and competitive position. Most of its North American distributors are independently owned and operated. The Company has agreements with each of these distributors, which typically are for a term of three years, subject to certain termination provisions. Upon termination or expiration of the agreement, the Company is obligated to purchase various assets of the distributorship. Through an arrangement with Citicorp Dealer Finance, a unit of Citicorp North America, the Company also guarantees certain financing obligations of some of these distributors. There are approximately 5,700 locations in North America, primarily owned and operated by OEMs or their dealers, at which Cummins-trained service personnel and parts are available to maintain and repair Cummins engines. The Company's parts distribution centers are located strategically throughout the world. Supply ~~~~~~ The Company machines many of the components used in its engines, including blocks, heads, rods, turbochargers, crankshafts and fuel systems. Cummins has adequate sources of supply of raw materials and components required for its operations. International ~~~~~~~~~~~~~ Cummins sells its products to major international firms outside North America by exports directly from the United States and shipments from foreign facilities (operated through subsidiaries, affiliates, joint ventures or licensees) which manufacture and/or assemble Cummins' products. The Company's international operations are subject to risks such as currency controls and fluctuations, import restrictions and changes in national governments and policies. The Company has entered into license agreements that provide for the manufacture and sale of licensed engines and engine components for use in certain territories prescribed in the respective agreements. In addition, licensees produce engines and engine components which are available to help meet demand for Cummins' products in the rest of the world. The paragraph under Item 1, "Overview", on page 2 on international markets and operations is incorporated herein by reference. Employment ~~~~~~~~~~ At December 31, 1993, Cummins employed 23,600 persons worldwide, approximately 10,200 of whom are represented by various unions. The Company has labor agreements covering employees in North America, South America and the United Kingdom. In 1993, members of the Diesel Workers Union in Southern Indiana approved an 11-year contract. Production workers at Atlas, Inc., in Fostoria, Ohio, and office and technical workers in Southern Indiana also ratified 3-year contracts during 1993. ENVIRONMENTAL COMPLIANCE ~~~~~~~~~~~~~~~~~~~~~~~~~ Product Environmental Compliance ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Cummins' engines are subject to extensive statutory and regulatory requirements that directly or indirectly impose standards with respect to emissions and noise. Cummins' products comply with emissions standards that the US Environmental Protection Agency ("EPA") and California Air Resources Board ("CARB") have established for emissions for on-highway diesel engines produced through 1994. Cummins' ability to comply with these and future emissions standards is an essential element in maintaining its leadership position in the North American heavy-duty truck and other automotive markets, as well as in supplying other markets. The Company will make significant capital and research expenditures to comply with these standards. Failure to comply could result in adverse effects on future financial results. Cummins has completed successfully the certification of its 1994 on- highway products, which include both midrange and heavy-duty engines. All of these products underwent extensive laboratory and field testing prior to their release. Emissions Averaging, Banking and Trading regulations were promulgated by the EPA in July 1990. By selling 1991, 1992 and 1993 model year engines with emissions levels below applicable standards and by introducing several of the Company's 1994 configurations early, Cummins generated both nitric oxide and particulate matter credits. Certain of the Company's 1994 products which do not meet 1994 emissions standards will be sold by using these emissions credits. The next major change in emissions requirements for heavy-duty diesel engines occurs in 1998, when the nitric oxide standard is lowered from 5.0 to 4.0 g/bhp-hr. Design and development activity toward meeting this standard is well underway. In 1996, the particulate matter standard for engines used in urban buses changes from 0.07 to 0.05 g/bhp-hr. Contained in the environmental regulations are several means for the EPA to ensure and verify compliance with emissions standards. Two of the principal means are tests of new engines as they come off the assembly line, referred to as selective enforcement audits ("SEA"), and tests of field engines, commonly called in-use compliance tests. The SEA provisions have been used by the EPA to verify the compliance of heavy-duty engines for several years. In 1993, three such audit tests were performed on Cummins engines, all of which passed. The failure of an SEA could result in cessation of production of the noncompliant engines and the recall of engines produced prior to the audit. In the product development process, Cummins anticipates SEA requirements when it sets emissions design targets. No Cummins engines were chosen for in-use compliance testing in 1993. It is anticipated that the EPA will increase the in-use test rate in 1994 and subsequent years, raising the probability that one or more of the Company's engines will be selected. As with SEA testing, if an in-use test is failed, an engine recall may be necessary. Cummins believes that its engines meet the EPA's in-use criteria. In November, 1990, the Clean Air Act Amendments of 1990 were signed into law. These amendments include special provisions for certain truck fleets in nonattainment metropolitan areas and instruct the EPA to consider regulating emissions from engines used in mobile off- highway applications. The EPA completed the mandated study of these sources and concluded that regulations are required. Promulgation of the final rule is anticipated to occur in the second quarter of 1994. Effective in 1995, CARB has promulgated new emissions standards for vehicles from 8,500 to 14,000 pounds gross vehicle weight. Cummins' B Series engines compete in this category. Design and development activity toward meeting these standards is well underway. In January 1992, CARB promulgated regulations for mobile off-highway applications that use engines rated at or above 175 horsepower. The effective date of the first tier of regulations is January 1, 1996. The Company expects that its products will comply with these regulations before the effective date. More stringent emissions standards also are being adopted in international markets, including Europe and Japan. Given the Company's experience in meeting US emissions standards, it believes that it is well positioned to take advantage of opportunities in these markets as the need for emissions-control capability grows. There are several Federal and state regulations which encourage and, in some cases, mandate the use of alternatively fueled heavy-duty engines. The Company currently offers a natural gas fueled version of its L10 engine and has several development programs underway to expand its alternatively fueled product offering. Vehicles and certain industrial equipment in which diesel engines are installed must meet Federal noise standards. The Company believes that applications in which its engines are now installed meet these noise standards and that future installations also will be in compliance. Other Environmental Statutes and Regulations ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ With respect to environmental statutes and regulations applicable to the plants and operations of the Company and its subsidiaries, Cummins believes it is in compliance in all material aspects with applicable laws and regulations. During the last five years, expenditures for environmental control facilities and environmental remediation projects at the Company's operating facilities in the United States have not been a major portion of annual capital outlays and are not expected to be material in 1994. The Company or its subsidiaries have been identified as potentially responsible parties ("PRPs") pursuant to the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, as amended or similar state laws, at a number of waste disposal sites. Under such laws, PRPs typically are jointly and severally liable for any investigation and remediation costs incurred with respect to such sites. The Company's ultimate responsibility, therefore, could be greater than the share of waste contributed by the Company would otherwise indicate. While the Company is unable at this time to determine the aggregate cost of remediation at these sites or the Company's ultimate liability with respect thereto, the Company has attempted to analyze its proportionate and actual liability by analyzing the amounts of hazardous materials contributed by the Company to such sites, the estimated costs, the number and identities of other PRPs and the level of insurance coverage. The Company has entered into administrative agreements at certain of these sites to perform remedial actions. Onan Corporation, a subsidiary of the Company, has entered into an administrative agreement to participate in remediation of the Waste Disposal Engineering landfill in Andover, Minnesota, along with 28 other PRPs. The cost of remediation at this site is estimated to range from $10 million to $15 million, of which Onan expects to contribute approximately $600,000, which has been reserved fully. The parties to the remediation agreement are in the process of seeking contributions from third parties, which may reduce Onan's proportionate share of the remediation costs. Onan also has entered into an administrative agreement for the Oak Grove Sanitary Landfill in Oak Grove Township, Minnesota. The estimated cost to remediate this site is approximately $6 million. Onan has agreed to contribute $127,000 to cover its share of the cost of remediation. Onan is in the process of seeking insurance reimbursement (which is being contested by the insurers) and contributions from other PRPs, which could reduce this amount. At the Old City Landfill in Columbus, Indiana, the Company and two other PRPs have entered into a Consent Order with the Indiana Department of Environmental Management to implement the Record of Decision issued by EPA in 1992. The cost to implement the Consent Order is estimated to be approximately $300,000 based upon current conditions at the site. The Company's share of this expense will be approximately 50 percent. At the Purity Oil Site located in Fresno, California, a subsidiary of the Company has been identified as a PRP and is one of several PRPs who have been issued an order by EPA to undertake remedial action at the site. The Company's subsidiary has contributed $150,000 toward the first phase of remedial action at the site. While the subsidiary's liability for future expenditures has not been determined, the Company estimates that its percentage contribution of hazardous waste to the site was less than 1 percent. It is unclear whether the Company's share of future remediation cost will be based upon its proportionate share of waste contributed to the site. The costs of future remediation have not yet been determined but are likely to exceed the cost of the first phase of remedial action. As a result, the Company's share of such future expenses is likely to exceed amounts spent to date at this site. The Company believes that it has adequate reserves to cover its share of future expenses at each of these sites. With respect to other sites at which the Company or its subsidiaries have been named as PRPs, the Company cannot estimate reasonably the future remediation costs. At several sites, the remedial action to be implemented has not been determined for the site or the Company has been named only recently as a PRP. In addition, the Company presently is contesting any liability at several of these sites. Based upon the Company's prior experiences at similar sites, however, the aggregate future cost of all PRPs to remediate these sites is likely to be significant. While the Company believes that it has good defenses at several of these sites, that its percentage contribution at other sites is likely to be de minimis and that other PRPs will bear most of the future remediation costs, the Company's ultimate responsibility will be based on many factors outside the Company's control and, therefore, could be material in the event that the Company becomes obligated to pay a significant portion of those expenses. Based upon information presently available, the Company believes that such liability is unlikely and that its actual and proportionate costs of participating in the remediation of these sites will not be material. ITEM 2. ITEM 2. PROPERTIES ~~~~~~~ ~~~~~~~~~~ Cummins' worldwide manufacturing facilities occupy approximately 13 million square feet, including approximately 5 million square feet outside the United States. Principal engine manufacturing facilities in the United States include the Company's plants in Southern Indiana and Jamestown, New York, as well as an engine plant in Rocky Mount, North Carolina, which is operated in partnership with J I Case. Countries of manufacture outside of the United States include England, Scotland, Brazil, Mexico, France, Spain, Australia and Germany. In addition, engines and engine components are manufactured by joint ventures or independent licensees at plants in China, India, Japan, Pakistan, South Korea and Turkey. Cummins believes that all of its plants have been maintained adequately, are in good operating condition and are suitable for its current needs through productive utilization of the facilities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ~~~~~~~ ~~~~~~~~~~~~~~~~~ The information appearing in Note 15 to the Consolidated Financial Statements is incorporated herein by reference. On April 5, 1990, Raphael Warkel and Alan J. Stransky filed a complaint in the US District Court for the Southern District of Indiana against the Company, all of its then-current directors and one past director. The complaint purported to be brought as a class action on behalf of persons who purchased the Company's common stock between May 1, 1989 and September 21, 1989. The complaint alleged that the Company and the other defendants violated Section 10(b) and Section 20 of the Securities Exchange Act of 1934 by failing to disclose material financial information concerning the Company in an effort to "artificially inflate" the market price of the Company's common stock. The complaint sought compensatory damages of unspecified amount, costs and attorneys' fees. All defendants answered denying the substantive allegations of the complaint. The plaintiffs moved for class certification, which motion was opposed by the defendants. On November 30, 1992, the court granted defendants' motion for judgment on the pleading and dismissed the complaint. The court held that the complaint failed to state a claim for relief under the Federal securities laws. The court gave the plaintiffs 30 days to file an amended complaint. On December 29, 1992, plaintiffs filed an amended complaint against the same defendants. The amended complaint, which alleges the Company and other defendants violated Section 10(b) and Section 20 of the Securities Exchange Act by failing to disclose material financial information concerning the Company in an effort to "artificially inflate" the market price of the Company's common stock, is also brought as a class action and seeks compensatory damages of unspecified amount, costs and attorneys' fees. On March 3, 1993, defendants moved to dismiss the amended complaint. On September 13, 1993, the court dismissed the claims of plaintiff Stransky with prejudice. The court also dismissed the claims of plaintiff Warkel except for a claim based on an allegedly false and misleading press release issued by the Company in July 1989. Warkel was given until December 13, 1993 to file an amended complaint, which time has passed and no amended complaint has been filed. Plaintiff Stransky has moved the court for reconsideration of the order dismissing his claims, which motion remains pending. Defendants believe the remaining allegations in the amended complaint are without merit and intend to defend the action vigorously. The material in Item 1 "Other Environmental Statutes and Regulations" is incorporated herein by reference. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS ~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ None. PART II ~~~~~~~ ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ The Company's common stock is listed on the New York Stock Exchange and the Pacific Stock Exchange under the symbol "CUM". On October 12, 1993, the Board of Directors authorized a two-for-one stock split of the common stock, which was effected by a stock dividend payable to holders of record on October 25, 1993. The following table sets forth, for the calendar quarters shown, the range of high and low composite prices of the common stock on the New York Stock Exchange and the cash dividends declared on the common stock. The information in the table has been adjusted to give effect to the stock split. High Low Dividends Declared ~~~~~~~ ~~~~~~~ ~~~~~~~~~~~~~~~~~~ ~~~~ First quarter $48 3/4 $37 3/8 $.025 Second quarter 49 5/16 38 1/2 .025 Third quarter 45 39 .025 Fourth quarter 54 3/8 38 7/8 .125 ~~~~ First quarter $33 $26 5/8 $.025 Second quarter 38 3/8 28 3/8 .025 Third quarter 35 7/8 30 5/16 .025 Fourth quarter 40 7/16 29 11/16 .025 During the fourth quarter of 1993, the Board of Directors of the Company increased the common stock dividend from $.025 to $.125 per quarter. The declaration and payment of future dividends by the Board of Directors of the Company will be dependent upon the Company's earnings and financial condition, economic and market conditions and other factors deemed relevant by the Board of Directors. At December 31, 1993, the approximate number of holders of record of the Company's common stock was 4,400. Certain of the Company's loan indentures and agreements contain provisions which permit the holders to require the Company to repurchase the obligations upon a change of control of the Company, as defined in the applicable debt instruments. As more fully described in Note 13 to the Consolidated Financial Statements, which information is incorporated herein by reference, the Company has a Shareholders' Rights Plan. The Company's bylaws provide that Cummins is not subject to the provisions of the Indiana Control Share Act. However, Cummins is governed by certain other laws of the State of Indiana applicable to transactions involving a potential change of control of the Company. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (Dollars in Millions, except per share amounts) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 1990 1989 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Net sales $4,247.9 $3,749.2 $3,405.5 $3,461.8 $3,519.5 Earnings (loss) before extraordinary items & cumulative effect of accounting changes 182.6 67.1 (65.6) (165.1) (6.1) Net earnings (loss) 177.1 (189.5) (14.1) (137.7) (6.1) Primary earnings (loss) per common share: Before extraordinary items & cumulative effect of accounting changes 4.95 1.77 (2.48) ( 7.23) (.76) Net 4.79 ( 6.01) ( .75) ( 6.13) (.76) Fully diluted earnings (loss) per common share: Before extraordinary items & cumulative effect of accounting changes 4.77 1.77 (2.48) ( 7.23) (.76) Net 4.63 ( 6.01) ( .75) ( 6.13) (.76) Cash dividends per common share .20 .10 .35 1.10 1.10 Total assets 2,390.6 2,230.5 2,041.2 2,086.3 2,030.8 Long-term debt and redeemable preferred stock 189.6 412.4 443.2 411.4 473.7 All pre-share data have been restated to give effect to the October 1993 two-for-one stock split. In December 1993, the Company sold 2.6 million shares of its common stock in a public offering and used a portion of the proceeds to redeem $77.2 in principal amount of the Company's outstanding 9-3/4 percent sinking fund debentures. This early extinguishment of debt resulted in an extraordinary charge of $5.5. In 1992, the Company sold 4.6 million shares of its common stock in a public offering and used a portion of the proceeds to extinguish $71.1 of debt of Consolidated Diesel Company, an unconsolidated, 50-percent owned partnership, $8.2 of the Company's 8-7/8 percent sinking fund debentures and $11.4 of a 15-percent note payable to an insurance company. These early extinguishments of debt resulted in an extraordinary charge of $5.5. In 1992, the Company's results also included a charge of $251.1 for the cumulative effect of changes in accounting as prescribed by SFAS Nos. 106, 109 and 112 related to accounting of retirees' health care and life insurance benefits, income taxes and postemployment benefits. The Company's results for 1991 included a credit of $51.5 for the cumulative effect of changes in accounting to include in inventory certain production-related costs previously charged directly to expense and to adopt a modified units-of-production depreciation method for substantially all engine production equipment. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Dollars in Millions, unless otherwise stated) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ OVERVIEW ~~~~~~~~ Cummins recorded net sales of $4,248 in 1993, the highest level in the Company's history. This was 13 percent higher than in 1992 and 25 percent higher than in 1991. The increase in sales during 1993 was primarily attributable to higher sales of midrange engines worldwide and the strong North American heavy-duty truck market. The Company continued to achieve improvements in its financial results in 1993, generating net earnings of $177.1, or $4.79 per share, due to the increase in sales, continued cost-improvement measures and operating efficiencies, and the ability to reduce a portion of its tax valuation allowance. Effective January 1, 1992, the Company adopted three new accounting rules, which resulted in a one-time, non-cash, after-tax charge of $251.1. This resulted in a net loss of $189.5, or $6.01 per share, in 1992. In both 1993 and 1992, the Company recorded extraordinary charges of $5.5 related to early retirement of debt. The Company reported a net loss of $14.1 in 1991, including a credit of $51.5 for the cumulative effect of changes in accounting for inventory and depreciation. RESULTS OF OPERATIONS ~~~~~~~~~~~~~~~~~~~~~ The percentage relationship between net sales and other elements of the Company's Consolidated Statement of Operations for each of the last three years was: Percent of Net Sales 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~ ~~~~~ ~~~~~ ~~~~~ Net sales 100.0 100.0 100.0 Cost of goods sold 75.6 77.5 81.5 ~~~~~ ~~~~~ ~~~~~ Gross profit 24.4 22.5 18.5 Selling & administrative expenses 13.6 14.2 13.9 Research & engineering expenses 4.9 4.8 4.3 Interest expense .9 1.1 1.2 Other expenses .2 .4 .4 ~~~~ ~~~~ ~~~~ Earnings (loss) before income taxes 4.8 2.0 (1.3) Provision for income taxes .5 .2 .5 Minority interest - - .1 ~~~~ ~~~~ ~~~~~ Earnings (loss) before extraordinary items & cumulative effect of accounting changes 4.3 1.8 (1.9) Extraordinary items ( .1) ( .1) - Cumulative effect of accounting changes - (6.7) 1.5 ~~~~~ ~~~~~ ~~~~~ Net earnings (loss) 4.2 (5.0) ( .4) ~~~~~ ~~~~~ ~~~~~ Sales by Market ~~~~~~~~~~~~~~~ The Company's sales for each of its key markets during the last three years were: 1993 1992 1991 ~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~~~ Dollars Percent Dollars Percent Dollars Percent ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ Heavy-duty truck 1,230 29 1,081 29 940 28 Midrange truck 482 11 221 6 69 2 Power generation 963 23 914 24 813 24 Bus & light commercial vehicles 498 12 423 11 417 12 Industrial products 438 10 425 11 450 13 Government 109 3 173 5 236 7 Marine 68 1 64 2 61 2 Fleetguard, Holset and Cummins Electronics (a) 460 11 448 12 420 12 ~~~~~ ~~ ~~~~~ ~~ ~~~~~ ~~ Net sales 4,248 100 3,749 100 3,406 100 ~~~~~ ~~~ ~~~~~ ~~~ ~~~~~ ~~~ (a) Included sales of McCord prior to the third quarter of 1993. Sales to the heavy-duty truck market in 1993 were 14 percent higher than in 1992 and 31 percent higher than the 1991 level. The increase in sales since 1991 has been due to increasing demand for engines in the North American heavy-duty truck market. In 1993, the Company's heavy-duty engine shipments in this market increased approximately 30 percent over 1992 and were more than double the 1991 level. The Company continued to lead this market with a 35-percent market share in 1993. The Company's market share was 37 percent in 1992 and 38 percent in 1991. Heavy-duty truck engine shipments in international markets in 1993 were approximately 10 percent lower than in 1992 but 5 percent above the 1991 level. While markets in the United Kingdom are showing signs of emerging from recessionary levels, no significant recovery is apparent in European markets. The Company's operations in Brazil were moderately profitable due to cost reductions and operating efficiencies that resulted in their lowering the break-even point. Even though there have been signs that the Brazilian truck market is recovering, uncertainty continues to exist in this market due to inflationary and other economic pressures. The heavy-duty truck market in Mexico also remains depressed due to the tightening of credit, which has limited the ability of fleets to purchase new trucks. Sales to the midrange truck market have more than doubled since 1991. In 1993, the Company completed the first full year of a contract with Ford Motor Company to provide exclusive diesel power for Ford's medium-duty trucks. While some customers made advance purchases of midrange engines at the end of 1993, the current level of demand indicates continued growth in this market. Power generation sales of $963 in 1993 increased 5 percent over the 1992 level and were 18 percent higher than in 1991. During 1993, power generation sales continued to benefit from strong demand for industrial generator sets in international markets, particularly in China where sales were double the 1992 level. The Company also benefited from an increase in demand for generator sets for recreational vehicles in 1993 over 1992. In the bus and light commercial vehicle market, the Company's sales were approximately 18 percent higher than in both 1992 and 1991. Engine shipments for the bus market in North America were significantly higher than prior year's levels. The Company's sales to this market also benefited in 1993 from continued strong demand for midrange engines for Chrysler's Dodge Ram pickup truck. Sales to industrial markets in 1993 were essentially level with those of the two prior years, although sales of engine parts and components, primarily to China and Turkey, increased significantly. Engine shipments to construction and agricultural markets in North America also showed modest gains in 1993; however, there was no improvement in shipments for logging or mining markets, which continue at low levels. Government sales continue to be lower than prior years' levels due primarily to the reduction in US government expenditures. Sales have declined from 1991 peak of 7 percent of the Company's net sales to 5 percent of net sales in 1992 and 3 percent of net sales in 1993. The Company believes this market may decline further due to reductions in US military expenditures. Sales for the marine business continued to increase but represented less than 2 percent of the Company's net sales in the three years' reporting periods. Engine shipments for all markets in 1993 were 263,000, compared to 222,000 in 1992 and 200,600 in 1991. Shipments by engine family for the comparative periods were: 1993 1992 1991 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Midrange engines 167,900 139,800 129,700 Heavy-duty engines 86,500 73,900 62,800 High-horsepower engines 8,600 8,300 8,100 ~~~~~~~ ~~~~~~~ ~~~~~~~ Total engine shipments 263,000 222,000 200,600 ~~~~~~~ ~~~~~~~ ~~~~~~~ Sales of filters, turbochargers and electronic systems increased from the 1992 level and were approximately 10 percent higher than in 1991. These businesses have benefited from an increase in sales for both the midrange and heavy-duty engine markets in North America. European markets for these products remained at depressed levels. Prior to the third quarter of 1993, sales of McCord Heat Transfer Co., were reported in this business market. Effective at the beginning of the third quarter of 1993, the Company transferred its 80-percent interest in McCord to Behr America Holding, Inc., for a 35-percent interest in Behr America Holding, Inc. The Company's minority interest in Behr America Holding, Inc., has been reported as an unconsolidated company since the transfer. Gross Profit ~~~~~~~~~~~~ The Company's gross profit percentage increased to 24.4 percent of net sales in 1993 from 22.5 percent in 1992 and 18.5 percent in 1991. The Company continued to benefit from improved margins across all of its engine families during 1993. The key factor contributing to the improved margin in 1993 was the increase in demand for the Company's products, which represented approximately 50 percent of the increase in gross profit. Other factors included the effects of cost- improvement measures implemented since 1991 to improve production systems and throughput time, engine and parts pricing actions subsequent to the first quarter of 1992, and lower costs associated with product coverage programs. The cost of product coverage programs, which includes both warranty and extended coverage, improved to 2.1 percent of net sales in 1993, compared to 2.4 percent in 1992 and 3.8 percent in 1991. Improvements included reduced warranty rates for engines sold in 1993 and adjustments to reduce the product coverage liability for engines previously placed in service. In 1993, members of the Diesel Workers Union in Southern Indiana approved an 11-year contract. The contract provided for a team-based work system designed to increase flexibility, employee involvement and efficiency in exchange for improved pension and health care benefits for future retirees. Based upon the composition of age and service of the labor force, the increased expense associated with prior service of these employees will be recognized during the early years of the contract. In 1991, the Company's margin contribution was low due to a decline in sales of heavy-duty engines, as well as higher costs related to introduction of the 1991 product line, which incorporated electronic controls for the first time. Operating Expenses ~~~~~~~~~~~~~~~~~~ Selling and administrative expenses were $579.2 in 1993, compared to $532.5 in 1992 and $472.3 in 1991. The increase in these expenditures in 1993 was primarily attributable to variable operating expenses to support the higher sales volumes. Research and engineering expenses were $209.6 in 1993, compared to $179.5 in 1992 and $147.0 in 1991. The increase in 1993 of 17 percent compared to 1992 and 43 percent compared to 1991 was due to continued expenditures for fuel systems development, electronic systems and future technology developments. Other Expenses ~~~~~~~~~~~~~~ Interest expense of $36.3 in 1993 was $4.7 lower than in 1992 and $6.2 lower than in 1991 due to the Company's early retirement and redemption of debt obligations during 1993 and 1992 and an overall decline in interest rates. In 1993, the decrease in other expense of $6.3 compared to 1992 and $5.9 compared to 1991 was due to a reduction in interest expense as a result of debt retirement at Consolidated Diesel Company, an unconsolidated 50-percent owned partnership, in the fourth quarter of 1992. This was offset partially by lower income from unconsolidated companies. Provision for Income Taxes ~~~~~~~~~~~~~~~~~~~~~~~~~~ As described in Note 9 to the Consolidated Financial Statements, the Company reduced its valuation allowance for tax benefit carryforwards during 1993 and 1992. The tax provision also included a one-time credit of $4.4 in 1993 as a result of the Omnibus Budget Reconciliation Act of 1993. In 1991, Cummins' effective tax rate varied from the US statutory rate because of operating losses for which no tax benefit was recorded and the recognition of foreign and state taxes. Extraordinary Items ~~~~~~~~~~~~~~~~~~~ As disclosed in Note 7 to the Consolidated Financial Statements, the Company extinguished certain indebtedness in 1993 and 1992 that resulted in an extraordinary charge of $5.5 in each year. Accounting Changes ~~~~~~~~~~~~~~~~~~ As disclosed more fully in Note 1 to the Consolidated Financial Statements, in 1992, the Company changed its method of accounting for retirees' health care and life insurance benefits, postemployment benefits and income taxes, all of which were required by new accounting rules released by the Financial Accounting Standards Board. In 1991, the Company changed its method of accounting for inventory and depreciation. FINANCIAL CONDITION AN CASH FLOW ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ During 1993, the Company's financial position improved significantly. Shareholders' investment increased from $501.1 at year-end 1992 to $821.1 at December 31, 1993. The improvement in financial position was the result of the issuance of 2.6 million shares of common stock, which produced net proceeds of $124.5, the conversion by holders of $48.5 of convertible debt into 1.0 million shares of common stock and the generation of net earnings of $177.1 during the year. In addition, the proceeds from the common stock offering and net cash flow from operations were applied to reduce the Company's indebtedness from $488.0 at December 31, 1992 to $235.6 at December 31, 1993, a 52- percent decrease. The combination of the significantly strengthened equity position and reduced debt level lowered the Company's debt-to- capital ratio from 49.3 percent at December 31, 1992 to 22.3 percent at December 31, 1993. At December 31, 1993, "Other liabilities" in the Consolidated Statement of Financial Position increased $86.8 compared to December 31, 1992. This increase reflects the minimum liability related to improved pension benefits that were granted in 1993 for prior service of employees covered by collectively bargained pension plans. An intangible asset of $68.1 was recorded in "Intangibles, deferred taxes and deferred charges" related to this liability. Key elements of the Consolidated Statement of Cash Flows were: 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ Net cash provided by (used for): Operating activities $285.6 $197.7 $106.7 Investing activities (148.8) (296.5) (136.3) Financing activities (113.5) 104.9 2.2 Effect of exchange rate changes on cash ( .2) ( 3.4) ( 1.1) ~~~~~~~ ~~~~~~~ ~~~~~~~ Net change in cash and cash equivalents $ 23.1 $ 2.7 $ 28.5) ~~~~~~ ~~~~~~ ~~~~~~~ Net cash flow from operating and investing activities totaled $136.8 in 1993, compared to a net cash outflow of $98.8 in 1992 and $29.6 in 1991. The cash outflow in 1992 included $65.1 to acquire the remaining 36-percent interest in Onan Corporation and a capital contribution of $71.1 to Consolidated Diesel Company to retire indebtedness. Capital expenditures during 1993 increased to $174.2 compared to $139.3 in 1992 and $123.9 in 1991. The increase in 1993 was related to investments for new product introductions and fuel systems. The Company expects that capital expenditures will increase in 1994 to fund continued investments in these areas. The Company also expects to make investments in 1994 in joint ventures announced during 1993, including the joint venture with TELCO to produce midrange engines in India for TELCO vehicles and with Komatsu to produce midrange engines in Japan and high-horsepower engines in the United States. During the fourth quarter of 1993, the Company split its common stock on a two-for-one basis through the declaration of a stock dividend. Concurrently, the common stock dividend was increased from 2.5 cents per share per quarter, on a post-split basis, to 12.5 cents per share. Cash at year-end 1993 was $77.3, an increase of $23.1 above the 1992 year-end level. In addition, the Company had no borrowings outstanding on its $300 revolving credit agreement at December 31, 1993. In 1993, the term of this credit facility was extended to 1997. On January 24, 1994, the Company announced that its outstanding Convertible Exchangeable Preference Stock, which had a face value of $112.2 at December 31, 1993, would be redeemed on February 23, 1994 at a price of $51.05 per depositary share, plus accrued dividends. Holders of the stock elected to convert their shares into 2.9 million shares of common stock. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA ~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ See index to Financial Statements and Schedules on page 25. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ None. PART III ~~~~~~~~ ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ The information appearing under the caption "Election of Directors" of the Company's definitive Proxy Statement, dated March 4, 1994, for the Annual Meeting of the Shareholders to be held on April 5, 1994 (hereinafter the "Proxy Statement") is incorporated by reference in partial answer to this item. The executive officers of the Company at December 31, 1993 are set forth below. The Chairman of the Board and President are elected annually by the Board of Directors at the Board's first meeting following the Annual Meeting of the Shareholders. Other officers hold office for such period as the Board of Directors or Chairman of the Board may prescribe. Present Position & Business Experience During Name Age Last 5 Years ~~~~~~~~~~~~~~ ~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ M. E. Chesnut 47 Vice President - Quality & Organizational Effectiveness (1992 to present), Vice President- Human Resources & Organizational Effectiveness (1989-1992) C. R. Cordaro 44 Group Vice President - Marketing (1990 to present), Vice President - Automotive Marketing (1988 to 1990) J. K. Edwards 49 Vice President - International (1989 to present) R. L. Fealy 42 Vice President - Treasurer (1988 to present) P. B. Hamilton 47 Vice President & Chief Financial Officer (1988 to present) J. A. Henderson 59 President & Chief Operating Officer (1977 to present) M. D. Jones 47 Vice President - Aftermarket Group (1989 to present) F. J. Loughrey 44 Group Vice President - Worldwide Operations (1990 to present), Vice President - Heavy-Duty Engines (1988 to 1990) J. McLachlan 61 Vice President - Corporate Controller (1991 to present), Vice President - Engine Business Controller (1989-1991) G. D. Nelson 53 Vice President - Alternate Fueled Products (1993 to present), Vice President - Research & Development & Chief Technical Officer (1984 to 1993) H. B. Schacht 59 Chairman of the Board of Directors and Chief Executive Officer (1977 to present) T. M. Solso 47 Executive Vice President - Operations (1992 to present), Vice President & General Manager Engine Business (1988 to 1992) R. B. Stoner-Jr. 47 Vice President - Cummins Power Generation Group and President - Onan Corporation (1992 to present), Managing Director - Holset (1986-1992) S. L. Zeller 37 Vice President - Law & External Affairs & Corporate Secretary (1992 to present), Vice President - General Counsel & Secretary (1990 to 1992), Vice President - General Counsel (1989 to 1990) ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~ The information appearing under the following captions in the Company's Proxy Statement is hereby incorporated by reference: "The Board of Directors and Its Committees", "Executive Compensation -- Compensation Tables and Other Information" (including the tables and information contained at pages 16 to 18 of the Proxy Statement), "Executive Compensation -- Change of Control Arrangements" and "Executive Compensation -- Compensation Committee Interlocks and Insider Participation". Except as otherwise specifically incorporated by reference, the Proxy Statement is not to be deemed filed as part of this report. The Company has adopted various benefit and compensation plans covering officers and other key employees under which certain benefits become payable upon a change of control of the Company. Cummins also has adopted an employee retention program covering approximately 350 employees of the Company and its subsidiaries, which provides for the payment of severance benefits in the event of termination of employment following a change of control of Cummins. The Company and its subsidiaries also have severance programs for other exempt employees of the Company whose employment is terminated following a change of control of the Company. Certain of the pension plans covering employees of the Company provide, upon a change of control of Cummins, that excess plan assets become dedicated solely to fund benefits for plan participants. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ A discussion of the security ownership of certain beneficial owners and management appearing under the captions "Principal Security Ownership", "Election of Directors" and "Executive Compensation -- Security Ownership of Management" in the Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ The information appearing under the captions "The Board of Directors and Its Committees", "Executive Compensation - Compensation Committee Interlocks and Insider Participation" and "Other Transactions and Agreements with Directors, Officers and Certain Shareholders" in the Proxy Statement is incorporated herein by reference. Reference is made to the information on related parties appearing in Note 4 to the Consolidated Financial Statements. PART IV ~~~~~~~ ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K ~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Documents filed as a part of this report: 1. See Index to Financial Statements and Schedules on page 25 for a list of the financial statements and schedules filed as a part of this report. 2. See Exhibit Index on page 59 for a list of the exhibits filed or incorporated herein as a part of this report. No reports on Form 8-K were filed during the fourth quarter of 1993. (page INDEX TO FINANCIAL STATEMENTS AND SCHEDULES ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Page ~~~~ Management's Responsibility for Financial Statements 26 Report of the Independent Public Accountants 27 Consolidated Statement of Operations 28 Consolidated Statement of Financial Position 29 Consolidated Statement of Cash Flows 31 Consolidated Statement of Shareholders' Investment 33 Notes to Consolidated Financial Statements 35 Quarterly Financial Data 51 Property, Plant and Equipment 52 Accumulated Depreciation of Property, Plant & Equipment 53 Valuation and Qualifying Accounts 54 Short-term Borrowings 55 Supplementary Income Statement Information 56 (page) MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Management is responsible for the preparation of the Company's consolidated financial statements and all related information appearing in this Form 10-K. The statements and notes have been prepared in conformity with generally accepted accounting principles and include some amounts which are estimates based upon currently available information and management's judgment of current conditions and circumstances. The Company engaged Arthur Andersen & Company, independent public accountants, to examine the consolidated financial statements. Their report appears on page 27. To provide reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition and that accounting records are reliable for preparing financial statements, management maintains a system of accounting and controls, including an internal audit program. The system of accounting and controls is improved and modified in response to changes in business conditions and operations and to recommendations made by the independent public accountants and the internal auditors. The Board of Directors has an Audit Committee whose members are not employees of the Company. The committee met four times in 1993 with management, internal auditors and representatives of the Company's independent public accountants to review the Company's program of internal controls, audit plans and results and the recommendations of the internal and external auditors and management's responses to those recommendations. (page) REPORT OF THE INDEPENDENT PUBLIC ACCOUNTANTS ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ To the Shareholders and Board of Directors of Cummins Engine Company, Inc.: We have audited the accompanying consolidated statement of financial position of Cummins Engine Company, Inc., (an Indiana corporation) and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and shareholders' investment for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly in all material respects, the financial position of Cummins Engine Company, Inc., and subsidiaries as of December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As explained in Note 1 to the financial statements, effective January 1, 1992, the Company changed its method of accounting for the cost of retirees' health care and life insurance benefits, postemployment benefits and income taxes. Also, as disclosed in Note 1, effective January 1, 1991, the Company changed its method of accounting for inventory and depreciation. Our audits were made for the purpose of forming an opinion on the consolidated statements taken as a whole. The schedules listed under Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied to the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. Arthur Andersen & Co. Chicago, Illinois, January 26, 1994. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (Dollars in Millions, except per share amounts) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ NET SALES $4,247.9 $3,749.2 $3,405.5 Cost of goods sold 3,211.0 2,906.7 2,776.7 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Gross profit 1,036.9 842.5 628.8 Selling & administrative expenses 579.2 532.5 472.3 Research & engineering expenses 209.6 179.5 147.0 Interest expense 36.3 41.0 42.5 Other expenses 6.8 13.1 12.7 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Earnings (loss) before income taxes 205.0 76.4 (45.7) Provision for income taxes 22.3 8.9 16.9 Minority interest .1 .4 3.0 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~ EARNINGS (LOSS) BEFORE EXTRAORDINARY ITEMS AND CUMULATIVE EFFECT OF ACCOUNTING CHANGES 182.6 67.1 (65.6) Extraordinary items (Note 7) (5.5) (5.5) - Cumulative effect of accounting changes (Note 1) - (251.1) 51.5 ~~~~~~~~~ ~~~~~~~~~ ~~~~~~~~~ NET EARNINGS (LOSS) 177.1 (189.5) (14.1) Preference stock dividends 8.0 8.0 8.0 ~~~~~~~~ ~~~~~~~~~ ~~~~~~~~~ EARNINGS (LOSS) AVAILABLE FOR COMMON SHARES $ 169.1 $ (197.5) $ (22.1) ~~~~~~~~ ~~~~~~~~~ ~~~~~~~~~ ~~~~~~~~ ~~~~~~~~~ ~~~~~~~~~ Primary earnings (loss) per common share: Before extraordinary items and cumulative effect of accounting changes $ 4.95 $ 1.77 $ (2.48) Net 4.79 (6.01) (.75) Fully diluted earnings (loss) per common share: Before extraordinary items and cumulative effect of accounting changes $ 4.77 $ 1.77 $ (2.48) Net 4.63 (6.01) ( .75) The accompanying notes are an integral part of this statement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENT OF FINANCIAL POSITION (Millions, except per share amounts) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ December 31, 1993 1992 ~~~~~~~~ ~~~~~~~~ ASSETS CURRENT ASSETS: Cash and cash equivalents $ 77.3 $ 54.2 Receivables less allowances of $9.5 & $11.8 426.3 372.7 Inventories 440.2 440.4 Other current assets 127.9 128.3 ~~~~~~~~ ~~~~~~~~ 1,071.7 995.6 ~~~~~~~~ ~~~~~~~~ INVESTMENTS AND OTHER ASSETS: Investments in and advances to unconsolidated companies 101.9 146.2 Other assets 88.8 71.7 ~~~~~~~~ ~~~~~~~~ 190.7 217.9 PROPERTY, PLANT AND EQUIPMENT: ~~~~~~~~ ~~~~~~~~ Land and buildings 357.9 351.9 Machinery, equipment and fixtures 1,689.9 1,680.7 Construction in progress 132.7 89.7 ~~~~~~~~ ~~~~~~~~ 2,180.5 2,122.3 Less accumulated depreciation 1,222.3 1,193.6 ~~~~~~~~ ~~~~~~~~ 958.2 928.7 ~~~~~~~~ ~~~~~~~~ INTANGIBLES, DEFERRED TAXES & DEFERRED CHARGES 170.0 88.3 ~~~~~~~~ ~~~~~~~~ TOTAL ASSETS $2,390.6 $2,230.5 ~~~~~~~~ ~~~~~~~~ LIABILITIES AND SHAREHOLDERS' INVESTMENT CURRENT LIABILITIES: Loans payable $ 13.4 $ 50.5 Current maturities of long-term debt 32.6 25.1 Accounts payable 267.5 255.3 Accrued salaries and wages 78.1 71.4 Accrued product coverage & marketing expenses 123.5 139.9 Income taxes payable 21.2 11.5 Other accrued expenses 164.0 170.5 ~~~~~~~~ ~~~~~~~~ 700.3 724.2 ~~~~~~~~ ~~~~~~~~ LONG-TERM DEBT 189.6 412.4 ~~~~~~~~ ~~~~~~~~ OTHER LIABILITIES 679.6 592.8 ~~~~~~~~ ~~~~~~~~ SHAREHOLDERS' INVESTMENT: Convertible preference stock, no par value, .2 shares outstanding 112.2 114.9 Common stock, $2.50 par value, 40.6 & 36.5 shares issued 101.5 91.3 Additional contributed capital 822.8 654.4 Retained earnings (deficit) 4.1 (146.1) Common stock in treasury, at cost, 2.1 shares ( 67.3) ( 67.3) Unearned ESOP compensation ( 59.3) ( 63.5) Cumulative translation adjustments ( 92.9) ( 82.6) ~~~~~~~~~ ~~~~~~~~~ 821.1 501.1 ~~~~~~~~~ ~~~~~~~~~ TOTAL LIABILITIES & SHAREHOLDERS' INVESTMENT $2,390.6 $2,230.5 ~~~~~~~~~ ~~~~~~~~ The accompanying notes are an integral part of this statement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~~~~ ~~~~~~~~ ~~~~~~~~ CASH FLOWS FROM OPERATING ACTIVITIES: Net earnings (loss) $ 177.1 $(189.5) $( 14.1) ~~~~~~~ ~~~~~~~~ ~~~~~~~~ Adjustments to reconcile net earnings (loss) to net cash from operating activities: Depreciation and amortization 125.1 122.5 127.2 Extraordinary items & cumulative effect of accounting changes 5.5 256.6 ( 51.5) Accounts receivable ( 59.4) ( 30.9) 5.3 Inventories .9 ( 18.8) 31.1 Accounts payable and accrued expenses 6.6 14.1 ( 10.8) Other 29.8 43.7 19.5 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Total adjustments 108.5 387.2 120.8 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Net cash provided by operating activities 285.6 197.7 106.7 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ CASH FLOWS FROM INVESTING ACTIVITIES: Property, plant and equipment: Additions (174.2) (139.3) (123.9) Disposals 12.0 22.9 2.2 Acquisition of new business activities 3.4 ( 66.8) - Net cash proceeds from the disposition of certain business activities - 1.9 19.0 Investments in and advances to affiliates and unconsolidated companies 10.0 (115.2) ( 33.6) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Net cash used for investing activities (148.8) (296.5) (136.3) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from borrowings 56.5 112.3 48.4 Payments on borrowings (247.5) (128.3) ( 26.2) Net borrowings under credit agreements ( 25.5) 16.2 ( .6) Net proceeds from common stock issuances 124.5 126.1 - Payments of dividends ( 15.0) ( 11.3) ( 18.4) Other ( 6.5) ( 10.1) ( 1.0) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ Net cash (used for) provided by financing activities (113.5) 104.9 2.2 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ EFFECT OF EXCHANGE RATE CHANGES ON CASH ( .2) ( 3.4) ( 1.1) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~ NET CHANGE IN CASH AND CASH EQUIVALENTS 23.1 2.7 ( 28.5) Cash & cash equivalents at beginning of year 54.2 51.5 80.0 ~~~~~~~ ~~~~~~~ ~~~~~~~ CASH & CASH EQUIVALENTS AT END OF YEAR $ 77.3 $ 54.2 $ 51.5 ~~~~~~~ ~~~~~~~ ~~~~~~~ Cash payments during the year for: Interest $ 39.5 $ 41.5 $ 40.6 Income taxes 18.1 20.6 26.8 The accompanying notes are an integral part of this statement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' INVESTMENT (Millions, except per share amounts) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ CONVERTIBLE PREFERENCE STOCK, no par value, 1.0 shares authorized (.2 shares): Beginning balance $114.9 $114.9 $114.9 Converted to common stock ( 2.7) - - ~~~~~~ ~~~~~~ ~~~~~~ Ending balance 112.2 114.9 114.9 ~~~~~~ ~~~~~~ ~~~~~~ COMMON STOCK, $2.50 par value, 50.0 shares authorized: Beginning balance (36.5, 31.8 & 31.8 shares) 91.3 79.4 79.4 Retired (.2, .2 and .1 shares) ( .6) ( .6) ( .1) Issued in public offerings (2.6 & 4.6 shares) 6.6 11.5 - Conversion of LYONs and preference stock (1.1 shares) 2.8 - - Other (.6, .3 and .1 shares) 1.4 1.0 .1 ~~~~~~ ~~~~~~ ~~~~~~ Ending balance (40.6, 36.5 & 31.8 shares) 101.5 91.3 79.4 ~~~~~~ ~~~~~~ ~~~~~~ ADDITIONAL CONTRIBUTED CAPITAL: Beginning balance 654.4 537.5 533.0 Retired ( 9.9) ( 7.3) ( 1.1) Issued in public offerings 117.9 114.6 - Conversion of LYONs & preference stock 48.0 - - Other 12.4 9.6 5.6 ~~~~~~ ~~~~~~ ~~~~~~ Ending balance 822.8 654.4 537.5 ~~~~~~ ~~~~~~ ~~~~~~ RETAINED EARNINGS (DEFICIT): Beginning balance (146.1) 48.0 82.0 Net earnings (loss) for the year 177.1 (189.5) (14.1) Cash dividends declared: Convertible preference stock ( 8.0) ( 8.0) ( 8.0) Common stock ( 7.0) ( 3.3) (10.4) Additional minimum liability for pensions ( 11.9) 6.7 ( 1.5) ~~~~~~~ ~~~~~~~ ~~~~~~~ Ending balance 4.1 (146.1) 48.0 ~~~~~~~ ~~~~~~~ ~~~~~~~ COMMON STOCK IN TREASURY, at cost (2.1 (shares) ( 67.3) ( 67.3) (67.3) ~~~~~~~ ~~~~~~~ ~~~~~~~ UNEARNED ESOP COMPENSATION: Beginning balance ( 63.5) ( 67.9) (72.2) Shares allocated to participants 4.2 4.4 4.3 ~~~~~~~ ~~~~~~~ ~~~~~~~ Ending balance ( 59.3) ( 63.5) (67.9) ~~~~~~~ ~~~~~~~ ~~~~~~~ CUMULATIVE TRANSLATION ADJUSTMENTS: Beginning balance ( 82.6) ( 20.8) ( .5) Adjustments ( 10.3) ( 61.8) (20.3) ~~~~~~ ~~~~~~ ~~~~~~ Ending balance ( 92.9) ( 82.6) (20.8) ~~~~~~~ ~~~~~~~ ~~~~~~~ SHAREHOLDERS' INVESTMENT $821.1 $501.1 $623.8 ~~~~~~~ ~~~~~~~ ~~~~~~~ The accompanying notes are an integral part of this statement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Millions, unless otherwise stated) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ NOTE 1. SUMMARY OF ACCOUNTING POLICIES: Principles of Consolidation: The consolidated financial statements include the accounts of Cummins Engine Company, Inc., and its majority-owned subsidiaries. Affiliated companies in which Cummins does not have a controlling interest or in which control is expected to be temporary are accounted for using the equity method. Stock Split: On October 12, 1993, the Company announced a two-for-one common stock split that was distributed on November 11, 1993 to shareholders of record on October 25, 1993. All references to the number of shares issued or outstanding and to per-share information have been adjusted to reflect the stock split on a retroactive basis. Foreign Currency: The Company uses the local currency as the functional currency for its significant manufacturing operations outside the United States, except those in Brazil and Mexico for which it uses the US dollar. At operations which use the local currency as the functional currency, results are translated into US dollars using average exchange rates for the year, while assets and liabilities are translated into US dollars using year-end exchange rates. The resulting translation adjustments are recorded in a separate component of shareholders' investment. Gains and losses from foreign currency transactions are included in net earnings. The financial statements of operations in Brazil and Mexico are translated into US dollars using both current and historical exchange rates, with the resulting translation adjustments reflected in net earnings. The Company enters into forward exchange contracts to hedge the effects of fluctuation currency rates on certain assets and liabilities, such as accounts receivable and payable, that are denominated in foreign currencies. The contracts typically provide for the exchange of different currencies at specified future dates and rates. The gain or loss due to the difference between the forward exchange rates of the contracts and current rates offsets in whole or in part the loss or gain on the assets or liabilities being hedged. Cash Equivalents: Cash equivalents are investments that are readily convertible to known amounts of cash and have original maturities of three months or less. Inventories: The company accounts for substantially all of its US heavy-duty and high-horsepower engine and engine parts inventories on the last-in, first-out (LIFO) cost method. All other inventories are valued at the lower of first-in, first-out (FIFO) cost or net realizable value. LIFO inventories were $144.9 at December 31, 1993 and $147.8 at December 31, 1992. The current cost of these inventories was $49.8 higher than LIFO cost at December 31, 1993 and $52.9 higher than LIFO cost at December 31, 1992. During 1993, 1992 and 1991, certain of the Company's LIFO inventory investment was reduced, resulting in the liquidation of low-cost LIFO inventory layers. The effect of the LIFO liquidation was to reduce cost of goods sold by $2.0 in 1993, $1.4 in 1992 and $6.3 in 1991. Inventory values include the combined costs of purchased materials, labor and manufacturing overhead. Effective January 1, 1991, the Company recognized a credit of $25.0 as a result of a change in accounting to include in inventory certain production-related costs previously charged directly to expense. The Company's operations are integrated vertically, which makes it impracticable to distinguish between raw material and work-in-process on a consolidated basis. At December 31, 1993 and 1992, the FIFO value of finished goods, which represented products available for shipment to the Company's customers, approximated $273 and $251, respectively. Futures Contracts and Interest Rate Swaps: The Company has entered into forward exchange and commodity futures contracts which are accounted for as hedges. The gains or losses on forward exchange contracts are reflected in earnings concurrently with the hedged items while gains or losses on commodity futures contracts are charged or credited to earnings when the contracts are settled. The Company also has entered into interest rate swap agreements that have the effect of fixing interest rates on certain of the Company's floating rate indebtedness. The net difference to be paid or received on the interest rate swaps is charged or credited to interest expense as interest rates change. Property, Plant and Equipment: Property, plant and equipment are recorded at cost. Effective January 1, 1991, the Company changed its accounting for depreciation of substantially all engine production equipment to a modified units-of-production method, which is based upon units produced subject to a minimum level. The cumulative effect of this change in accounting was a credit of $26.5 in 1991. Depreciation of all other equipment is computed using the straight- line method for financial reporting purposes. The estimated service lives to compute depreciation range from 20 to 40 years for buildings and 3 to 20 years for machinery, equipment and fixtures. Where appropriate, the Company uses accelerated depreciation methods for tax purposes. Maintenance and repair costs are charged to earnings as incurred. Technical Investment: Expenditures associated with research and development of new products and major improvements to existing products, as well as engineering expenditures during early production and ongoing efforts to improve existing products, are charged to earnings as incurred, net of contract reimbursements: 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ Research & engineering expenses $209.6 $179.5 $147.0 Reimbursements 28.8 36.9 28.6 Other technical spending 38.1 31.0 33.1 ~~~~~~ ~~~~~~ ~~~~~~ Technical investment expenditures $276.5 $247.4 $208.7 ~~~~~~ ~~~~~~ ~~~~~~ Included above in research and engineering expenses are research and development costs approximating $158 in 1993, $129 in 1992 and $99 in 1991. Product Coverage Programs: Estimated costs of warranty and extended coverage are charged to earnings at the time the Company sells its products. Retirement and Postemployment Benefits: The Company charges the cost of all retirement benefits to earnings during employees' active service as a form of deferred compensation. The change in accounting from a cash basis to this policy for health care and life insurance, effective January 1, 1992, resulted in an after-tax charge of $228.6 for prior service. This change resulted in an incremental annual expense of $11.4, net of taxes, during 1992. The cost of postemployment benefits, such as long-term disability, is charged to earnings at the time employees leave active service. The cumulative effect of the change to this accounting from a cash basis, effective January 1, 1992, was $22.5, net of taxes. This change resulted in an incremental expense of $3.2, net of taxes, in 1992. Income Tax Accounting: Deferred tax assets and liabilities are recognized for the future tax effects of temporary differences between the financial statement basis and the tax basis of assets and liabilities. Future tax benefits of tax loss and tax credit carryforwards also are recognized as deferred tax assets. Deferred tax assets are offset by a valuation allowance to the extent the Company concludes there is uncertainty as to their ultimate realization. Earnings (Loss) Per Common Share: Primary earnings per share of common stock are computed by subtracting preference stock dividend requirements from net earnings (loss) and dividing that amount by the weighted average number of common shares outstanding during each year. The weighted average number of shares, which includes the exercise of certain stock options granted to employees, was 35.3 million in 1993, 32.9 million in 1992 and 29.7 million in 1991. Fully diluted earnings per share are computed by dividing net earnings (loss) by the weighted average number of shares assuming the exercise of stock options and the conversion of debt and preference stock to common stock. NOTE 2. SUBSEQUENT EVENT: On January 24, 1994, the Company announced that its outstanding Convertible Exchangeable Preference Stock, which had a face value of $112.2 at December 31, 1993, would be redeemed on February 23, 1994 at a price of $51.05 per depositary share, plus accrued dividends. Holders of the stock elected to convert their shares into 2.9 million shares of common stock. Had the stock conversion and cash redemption occurred on January 1, 1993, pro forma net earnings per share would have approximated $4.63 in 1993. NOTE 3. ACQUISITION: On June 15, 1992, the Company acquired for $64 in cash the remaining 36 percent of Onan Corporation from Hawker Siddeley Overseas Investments Limited, a UK company. Cummins had owned the majority interest in Onan since 1986. The acquisition was accounted for as a purchase. Had the acquisition occurred as of January 1, 1991, the pro forma net loss per share for 1992 would have approximated $6.00 and the pro forma net loss per share for 1991 would have approximated 63 cents. Such pro forma per share information is not necessarily indicative of what the results of operations would have been had the acquisition actually occurred earlier, nor is it indicative of what may occur in the future. NOTE 4. RELATED PARTIES: In 1990, Ford Motor Company and Tenneco Inc., each purchased from Cummins 3.2 million shares of the Company's common stock. The shares were purchased pursuant to separate investment agreements between Cummins and the investors. Both Ford and Tenneco have agreed to certain voting, standstill and other provisions and each has the right to designate a representative to the Company's Board of Directors. The Company also entered into an option agreement with Ford pursuant to which Ford has the right, exercisable until 1996, to purchase up to 2.96 million additional shares of the Company's common stock at a price equal to 120 percent of the market price of the common stock for the 30 trading days prior to the exercise of the option but for no less than $31.25 per share. In December 1993, Tenneco transferred the shares of Cummins common stock it held to a trust that funds pension plans sponsored by Tenneco. The shares will continue to be subject to the terms of the investment agreement, and the trust has agreed to assume all of Tenneco's rights and obligations under such agreement. Cummins' sales of diesel engines and parts and related products to Ford approximated $343 in 1993, $182 in 1992 and $56 in 1991. In addition, Cummins' purchases of gasoline engines and parts from Ford approximated $4 in 1993 and $3 in both 1992 and 1991. At December 31, 1993 and 1992, the Company had accounts receivable outstanding of approximately $27 and $20, respectively, with Ford. Cummins and J I Case, a subsidiary of Tenneco Inc., are partners in the manufacture of midrange diesel engines at Consolidated Diesel Company. In 1993, 1992 and 1991, Cummins' sales of heavy-duty midrange diesel engines, components, service parts and related products and services to J I Case and other subsidiaries of Tenneco approximated $43, $52 and $61, respectively. Cummins' purchases from J I Case approximated $1 in both 1993 and 1992 and $7 in 1991. At both December 31, 1993 and 1992, the Company had accounts receivable outstanding of $6 with subsidiaries of Tenneco. NOTE 5. SALE OF RECEIVABLES: The Company has an agreement to sell, without recourse, up to $110.0 of eligible trade receivables. The amount of receivables outstanding was $108.0 under this agreement at December 31, 1993 and $100.0 at December 31, 1992. As collections reduce previously sold receivables, new receivables customarily are sold up to the $110.0 level. NOTE 6. INVESTMENTS IN UNCONSOLIDATED COMPANIES: December 31, Location Ownership 1993 1992 ~~~~~~~~~~~~~ ~~~~~~~~~ ~~~~~~ ~~~~~~ Consolidated Diesel Company United States 50% $ 50.9 $100.1 Kirloskar Cummins Limited India 50% 16.9 17.3 Behr America Holding, Inc. United States 35% 12.1 - Other investments Various Various 22.0 28.8 ~~~~~~ ~~~~~~ $101.9 $146.2 ~~~~~~ ~~~~~~ Included above in other investments at December 31, 1993 and 1992 were $18.5 and $21.8, respectively, related to temporarily owned distributorships. Cummins' sales to temporarily owned distributorships approximated $57 in 1993, $49 in 1992 and $143 in 1991. Summary financial information for Consolidated Diesel Company, Kirloskar Cummins Limited, Behr America Holding, Inc., and other 50-percent or less owned companies follows: Earnings Statement Data 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~ Net sales $746.4 $695.9 $733.1 Earnings before extraordinary item 3.4 14.4 12.4 Earnings 3.4 6.4 12.4 Cummins' share of earnings .4 3.4 6.4 December 31, Balance Sheet Data 1993 1992 ~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ Current assets $151.4 $178.1 Noncurrent assets 207.0 220.6 Current liabilities (127.0) (111.2) Noncurrent liabilities ( 38.2) ( 41.9) ~~~~~~~ ~~~~~~~ Net assets $193.2 $245.6 ~~~~~~ ~~~~~~ Cummins' share of net assets $ 82.7 $123.4 ~~~~~~ ~~~~~~ NOTE 7. LONG-TERM DEBT: December 31, 1993 1992 ~~~~~~ ~~~~~~ Senior debt: 9.74%-10.65% medium-term notes, due 1993 to 1998 $126.2 $136.2 9-3/4% sinking fund debentures, due 1998 to 2016 - 77.2 8.76% guaranteed notes of ESOP Trust, due 1998 70.7 71.8 9.45% note payable to insurance company, due through 1999 - 18.6 3.875%-10.4% notes payable to banks due through 1998 8.0 63.4 Mortgage, capitalized leases and other notes, due through 2005 17.3 25.1 Subordinated debt: LYONs - 45.2 ~~~~~~ ~~~~~~ Total indebtedness 222.2 437.5 Less current maturities 32.6 25.1 ~~~~~~ ~~~~~~ Long-term debt $189.6 $412.4 ~~~~~~ ~~~~~~ Aggregate maturities of long-term debt for the five years subsequent to December 31, 1993 are $32.6, $36.3, $41.5, $23.7 and $16.7. In December 1993, the Company sold 2.6 million shares of its common stock in a public offering for $49 per share. A portion of the proceeds was used to redeem $77.2 in principal amount of the Company's outstanding 9-3/4 percent sinking fund debentures. This early extinguishment of debt resulted in an extraordinary charge of $5.5. The Company also called for redemption of all the outstanding LYONs. Holders submitted 112,808 LYONs with an accreted value of $48.5 for conversion into 1.0 million shares of common stock, and the remaining were redeemed for $.2. Had the stock issuance, debt repayments and conversion of LYONs occurred as of January 1, 1993, pro forma net earnings per share would have approximated $4.65 in 1993. In April 1992, the Company sold 4.6 million shares of its common stock in a public offering for $28.50 per share. A portion of the net proceeds was used at the time of the issuance to repay borrowings under the Company's revolving credit agreement. During the fourth quarter of 1992, the Company extinguished $71.1 of debt of Consolidated Diesel Company, an unconsolidated, 50-percent owned partnership, $8.2 of the Company's 8-7/8 percent sinking fund debentures and $11.4 of a 15-percent note payable to an insurance company. These early extinguishments of debt resulted in an extraordinary charge of $5.5. Had the stock issuance and debt repayments occurred as of January 1, 1992, the pro forma net loss per share would have approximated $5.80 in 1992. The Company maintains a $300 revolving credit agreement, under which there were no outstanding borrowings at December 31, 1993. At December 31, 1992, there were $90.0 outstanding borrowings under the revolving credit agreement. In 1993, the term of the revolving credit agreement was extended to 1997. The Company also maintains other domestic and international credit lines with approximately $170 available at December 31, 1993. The Company has guaranteed the outstanding borrowings of its ESOP Trust. The ESOP was established for certain of the Company's domestic salaried employees who participate in the qualified benefit savings plans. The Company's cash contributions to the ESOP Trust, together with the dividends accumulated on the common stock held by the ESOP Trust, are used to pay interest and principal due on the notes. Cash contributions and dividends to the ESOP Trust approximated $7 in 1993 and 1992 to fund its principal payment of $1 and interest payment of $6. The Company's compensation expense was $10.0 in 1993, $10.3 in 1992 and $9.9 in 1991. The unearned compensation, which is reflected as a reduction to shareholders' investment, represents the historical cost of the ESOP Trust's shares of common stock that have not yet been allocated to participants. Based on borrowing rates currently available to the Company for bank loans and similar terms and average maturities, the fair value of total indebtedness approximated $237 at December 31, 1993 and $436 at December 31, 1992. NOTE 8. OTHER LIABILITIES: December 31, 1993 1992 ~~~~~~ ~~~~~~ Accrued retirement & postemployment benefits $521.8 $436.4 Accrued product coverage & marketing expenses 90.5 102.9 Deferred taxes 17.3 9.3 Accrued compensation expenses 5.6 4.3 Other 44.4 39.9 ~~~~~~ ~~~~~~ Other liabilities $679.6 $592.8 ~~~~~~ ~~~~~~ NOTE 9. INCOME TAXES: Income Tax Provision 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~ ~~~~~ ~~~~~ ~~~~~ Current: US federal and state $ 4.7 $ 1.8 $(4.2) Foreign 19.1 15.6 23.6 ~~~~~ ~~~~~ ~~~~~ 23.8 17.4 19.4 ~~~~~ ~~~~~ ~~~~~ Deferred: US federal and state (12.3) (8.5) (1.9) Foreign 10.8 - ( .6) ~~~~~~ ~~~~~~ ~~~~~~ ( 1.5) (8.5) (2.5) ~~~~~~ ~~~~~~ ~~~~~~ Income tax provision $22.3 $ 8.9 $16.9 ~~~~~~ ~~~~~~ ~~~~~~ Prior to 1992, losses at the Company's operations in the United States and United Kingdom had eliminated the need for virtually all deferred income taxes. Effective January 1, 1992, the Company adopted an asset and liability approach to income tax accounting. At the same time, the Company recorded substantial obligations for retirement and other postemployment benefits that are tax deductible only on a cash basis. The tax benefit of the future tax deduction represented by these accruals is recognized as a deferred asset along with the effect of all other temporary differences between the tax basis and financial statement basis of assets and liabilities. Deferred income taxes also reflect the value of the tax benefit carryforwards and an offsetting valuation allowance. December 31, Net Deferred Tax Asset 1993 1992 ~~~~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ Tax effects of future tax deductible differences related to: Accrued health care, life insurance & postemployment benefits $174.0 $161.6 Other accrued employee benefit expenses 29.9 31.1 Accrued product coverage & marketing expenses 63.4 67.3 Other net deductible differences 19.3 9.7 Tax effects of future taxable differences related to: Accelerated tax depreciation & other tax over book deductions related to US plant & equipment (114.1) (107.9) Net UK taxable differences related primarily to plant and equipment ( 10.2) - Miscellaneous net foreign taxable differences ( 1.3) ( .7) ~~~~~~~ ~~~~~~~ Net tax effects of temporary differences 161.0 161.1 ~~~~~~~ ~~~~~~~ Tax effects of carryforward benefits: US federal net operating loss carryforwards, expiring 2006 to 2007 18.7 58.6 US federal foreign tax credits, expiring 1998 4.7 - US federal general business tax credits, expiring 1996 to 2008 71.6 58.4 US federal minimum tax credits with no expiration 7.1 3.1 UK net tax benefit carryforwards with no expiration - 4.1 ~~~~~~ ~~~~~~~ Tax effects of carryforwards 102.1 124.2 ~~~~~~ ~~~~~~~ Tax effects of temporary differences & carryforwards 263.1 285.3 Less valuation allowance (100.7) (124.4) ~~~~~~~ ~~~~~~~ Net deferred tax asset $162.4 $160.9 ~~~~~~~ ~~~~~~~ Classified in the Consolidated Statement of Financial Position as: Current assets $ 89.2 $ 96.4 Noncurrent assets 90.5 73.8 Noncurrent liabilities ( 17.3) ( 9.3) ~~~~~~~ ~~~~~~~ Net deferred tax asset $162.4 $160.9 ~~~~~~~ ~~~~~~~ While the company believes all tax assets ultimately will be realized, such realization is dependent upon future earnings in specific tax jurisdictions. Dependent upon the level of profitability, the Company's net operating loss carryforwards may be utilized but replaced with foreign tax credit carryforwards, which have a shorter life and significant limitations on utilization. The Company's other carryforwards also have significant usage limitations which can be overcome only by generating earnings at considerably higher levels than have been generated in all but the most recent two years. The Company, therefore, has recorded a full valuation allowance against those tax assets which represent carryforwards of tax benefits because of previous unprofitable operations. While the need for this valuation allowance is subject to periodic review, it is expected that the allowance will be reduced and the tax benefits of the carryforwards will thereby be recorded in future operations as a reduction of income tax expense as the carryforwards actually are realized by future earnings. Such reductions in the valuation allowance and realizations of carryforwards amounted to $41.5 in 1993 and $17.4 in 1992. The Omnibus Budget Reconciliation Act ("OBRA") of 1993 retroactively extended the research tax credit from its 1992 expiration date through June 30, 1995. Research tax credits of $6.1 for 1992 and an estimated $8.0 for 1993 have increased both the general business credit carryforwards and the offsetting valuation allowance disclosed above as of December 31, 1993. Earnings (loss) before income taxes and differences between the effective tax rate at US federal income tax rate were: 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ Earnings (loss) before income taxes: Domestic $110.7 $(36.4) $(142.7) Foreign 94.3 112.8 97.0 ~~~~~~ ~~~~~~~ ~~~~~~~~ $205.0 $ 76.4 $( 45.7) ~~~~~~ ~~~~~~ ~~~~~~~~ Tax (benefit) at US statutory tax rate $ 71.8 $ 25.9 $( 15.5) Increase in the value of net US deferred tax assets as a result of the OBRA change in the tax rate from 34% to 35% ( 4.4) - - Utilization of net operating loss and tax credit carryforwards from prior years (41.5) (17.4) - Current year operating losses & tax credits for which no benefit has been recognized - - 31.7 Other ( 3.6) .4 .7 ~~~~~~~ ~~~~~~ ~~~~~~~ Income tax provision $ 22.3 $ 8.9 $ 16.9 ~~~~~~~ ~~~~~~ ~~~~~~~ NOTE 10. OPERATING LEASES: Certain of the Company's manufacturing plants, warehouses and offices are leased facilities. The Company also leases automobiles and manufacturing and office equipment. Most of these leases require fixed rental payments, expire over the next 10 years and can be renewed or replaced with similar leases. Rental expense under these leases in 1993, 1992 and 1991 was $50.8, $45.3 and $44.0, respectively. Future minimum payments for operating leases with original terms of more than one year are $28.7 in 1994, $22.8 in 1995, $17.6 in 1996, $16.1 in 1997, $14.5 in 1998 and $114.4 thereafter. NOTE 11. RETIREMENT PLANS: The Company and its subsidiaries have several contributory and noncontributory pension plans covering substantially all employees. Benefits for salaried plans generally are based upon the employee's compensation during the three to five years preceding retirement. Under the hourly plans, benefits generally are based upon various monthly amounts for each year of credited service. It is the Company's policy to make contributions to these plans sufficient to meet the funding requirements of applicable laws and regulations, plus such additional amounts, if any, as the Company deems appropriate. Plan assets consist principally of equity securities and corporate and Government fixed-income obligations. Net Periodic Pension Cost 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~ Service cost for benefits earned during the year $ 30.9 $ 28.7 $ 28.2 Interest cost on projected benefit obligation 80.7 78.1 82.1 Return on plan assets: Actual (202.5) (79.6) (235.4) Deferred gain (loss) 99.5 (26.2) 135.0 Amortization of transition asset ( 9.2) ( 9.6) ( 9.6) Other amortization, net 2.4 ( 2.2) 3.1 ~~~~~~~~ ~~~~~~~ ~~~~~~~ Net periodic pension cost (credit) $ 1.8 $(10.8) $ 3.4 ~~~~~~~~ ~~~~~~~ ~~~~~~~ Funded Status Overfunded Underfunded Combined ~~~~~~~~~~~~~ ~~~~~~~~~~ ~~~~~~~~~~~ ~~~~~~~~ ~~~~ Actuarial present value of: Vested benefit obligation $(569.2) $(425.5) $( 994.7) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Accumulated benefit obligation $(642.3) $(522.8) $(1,165.1) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Projected benefit obligation $(736.0) $(539.8) $(1,275.8) Plan assets at fair value 780.8 401.2 1,182.0 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Excess of assets over (under) projected benefit obligation 44.8 (138.6) ( 93.8) Unrecognized net experience loss 17.6 3.1 20.7 Unrecognized prior service cost 22.7 98.5 121.2 Additional minimum liability - ( 87.7) ( 87.7) Unamortized transition asset ( 36.1) ( 11.5) ( 47.6) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Accrued pension asset (liability) $ 49.0 $(136.2) $( 87.2) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ ~~~~ Actuarial present value of: Vested benefit obligation $(358.5) $(393.0) $ (751.5) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Accumulated benefit obligation $(414.2) $(480.7) $ (894.9) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Projected benefit obligation $(468.6) $(529.8) $ (998.4) Plan assets at fair value 542.4 481.1 1,023.5 ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Excess of assets over (under) projected benefit obligation 73.8 ( 48.7) 25.1 Unrecognized net experience gain ( 23.1) ( 28.1) ( 51.2) Unrecognized prior service cost 9.7 66.8 76.5 Additional minimum liability - ( 4.3) ( 4.3) Unamortized transition asset ( 32.8) ( 24.2) ( 57.0) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ Accrued pension asset (liability) $ 27.6 $( 38.5) $ ( 10.9) ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~ In 1993, the projected benefit obligation was determined using weighted average discount rates ranging from 6.75 percent for the US plans to 8 percent for the international plans and in 1992 rates ranging from 8 percent to 9 percent, respectively. The assumed long- term rates of compensation increase for salaried plans approximated expected inflation in both 1993 and 1992. The long-term rates of return on assets were assumed to be 9.25 percent in 1993 and 9.6 percent in 1992 for the US plans and 10 percent in 1993 and 11 percent in 1992 for the international plans. The Company has a non-qualified excess benefit plan that provides certain employees with defined retirement benefits in excess of qualified plan limits imposed by US tax law. In addition, the Company has a supplementary life insurance plan that provides officers and other key employees with term life protection during their active employment and supplemental retirement benefits upon retirement. The cost of these plans was $3.6 in 1993, $3.2 in 1992 and $2.7 in 1991. At December 31, 1993 and 1992, the accrued pension liability for these plans was $18.7 and $15.9, respectively. In addition to the pension plans, the Company provides certain health care and life insurance benefits to eligible retirees and their dependents. The plans are contributory, with retirees' contributions adjusted annually, and contain other cost-sharing features, such as deductibles, coinsurance and spousal contributions. The general policy is to fund these benefits as claims and premiums are incurred. In 1992, Cummins adopted a new accounting rule for these benefits and chose to recognize immediately the unfunded liability for prior service. Prior to 1992, the cost of benefits for eligible retirees and their dependents was included in costs as funded and totaled $13.6 in 1991. Net Periodic Cost 1993 1992 ~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ Service cost for benefits earned during the year $ 5.7 $ 5.2 Interest cost on benefit obligation 29.5 29.7 Other (.1) - ~~~~~~~ ~~~~~~ Net periodic cost $ 35.1 $ 34.9 ~~~~~~~ ~~~~~~ Funded Status ~~~~~~~~~~~~~ Actuarial present value of accumulated benefit obligation for: Retirees $210.0 $241.7 Employees eligible to retire 102.1 55.6 Other active plan participants 191.7 99.9 Unrecognized prior service cost (24.5) - Unrecognized net experience loss (69.2) (1.9) ~~~~~~~ ~~~~~~~ Accrued benefit liability $410.1 $395.3 ~~~~~~~ ~~~~~~~ The weighted average discount rate used in determining the accumulated benefit obligation was 6.75 percent in 1993 and 8 percent in 1992. The trend rate for medical benefits provided prior to Medicare eligibility is 15.5 percent, grading down to an ultimate rate of 4.5 percent by 2006. For medical benefits provided after Medicare eligibility, the trend rate is 8 percent, grading down to an ultimate rate of 4.5 percent by 1997. The health care cost trend rate assumption has a significant effect on the determination of the accumulated benefit obligation. For example, increasing the rate by 1 percent would increase the accumulated benefit obligation by $29 and net periodic cost by $2. NOTE 12. EMPLOYEE STOCK PLANS: The Company has various stock incentive plans under which officers and other eligible employees may be awarded stock options, stock appreciation rights and restricted stock during the next 10 years. Under the provisions of the plans, up to 1 percent of the Company's outstanding shares of common stock on December 31 of the preceding year is available for issuance under the plans each year. At December 31, 1993, there were 439,820 shares of common stock available for grant under the plans. There were 78,220 options exercisable under the plans at December 31, 1993. Number of Shares Option Price per Share ~~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~ Outstanding options at 12/31/91 261,360 $15.94 to $38.91 Granted 4,900 $30.94 to $35.28 Exercised (67,260) $15.94 to $31.38 Canceled or expired ( 3,740) $20.88 to $30.72 ~~~~~~~~ Outstanding options at 12/31/92 195,260 $15.94 to $38.91 Granted 456,150 $37.41 to $52.56 Exercised (123,740) $15.94 to $40.25 Canceled or expired ( 2,600) $24.20 to $31.63 ~~~~~~~~~ Outstanding options at 12/31/93 525,070 $15.94 to $52.56 ~~~~~~~~ NOTE 13. SHAREHOLDERS' RIGHTS PLAN: The Company has a Shareholders' Rights Plan which it first adopted in 1986. The Rights Plan provides that each share of the Company's common stock has associated with it a stock purchase right. The Rights Plan becomes operative when a person or entity acquires 15 percent of the Company's common stock or commences a tender offer to purchase 20 percent or more of the Company's common stock without the approval of the Company's Board of Directors. In the event a person or entity acquires 15 percent of the Company's common stock, each right, except for the acquiring person's rights, can be exercised to purchase $400 worth of the Company's common stock for $200. In addition, for a period of 10 days after such acquisition, the Board of Directors can exchange such right for a new right which permits the holders to purchase one share of the Company's common stock for $1 per share. If a person or entity commences a tender offer to purchase 20 percent or more of the Company's common stock, unless the Board of Directors redeems the rights within 10 days of the event, each right can be exercised to purchase one share for $200. If the person or entity becomes an acquiring person, the provisions noted above apply. The Rights Plan also allows holders of the rights to purchase shares of the acquiring person's stock at a discount if the Company is acquired or 50 percent of the assets or earnings power of the Company is transferred to an acquiring person. NOTE 14. SEGMENTS OF THE BUSINESS: The Company operates in a single industry segment -- designing, manufacturing and marketing diesel engines and related products. Manufacturing, marketing and technical operations are maintained in major areas of the world. Summary financial information is listed below for each geographic area. Earnings (loss) for each area may not be a meaningful representation of each area's contribution to consolidated operating results because of significant sales of products between and among the Company's various domestic and foreign operations. UK/ All Corp. Items & US Europe Other Eliminations Combined 1993 ~~~~~~ ~~~~~~ ~~~~~ ~~~~~~~~~~~~ ~~~~~~~~ ~~~~ Net sales: To customers in the area $2,374 $590 $439 $ - $3,403 To customers outside the area 589 251 5 - 845 Intergeographic transfers 317 149 84 (550) - ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Total $3,280 $990 $528 $(550) $4,248 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Earnings (loss) before income taxes $ 140 $ 89 $ 19 $( 43) $ 205 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Identifiable assets $1,487 $407 $340 $ 157 $2,391 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ ~~~~ Net sales: To customers in the area $1,996 $616 $418 $ - $3,030 To customers outside the area 508 209 2 - 719 Intergeographic transfers 273 129 69 (471) - ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Total $2,777 $954 $489 $(471) $3,749 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Earnings (loss) before income taxes $ 32 $ 93 $ 5 $( 54) $ 76 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Identifiable assets $1,432 $404 $322 $ 72 $2,230 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ ~~~~ Net sales: To customers in the area $1,946 $568 $427 $ - $2,941 To customers outside the area 276 188 1 - 465 Intergeographic transfers 250 117 80 (447) - ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Total $2,472 $873 $508 $(447) $3,406 ~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~ Earnings (loss) before income taxes $ (74) $ 62 $ 21 $( 55) $ (46) ~~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~~ Identifiable assets $1,148 $462 $322 $ 109 $2,041 ~~~~~~~ ~~~~ ~~~~ ~~~~~~ ~~~~~~~ Total sales for each geographic area are classified by manufacturing source and include sales to customers within and outside the area and intergeographic transfers. Transfer prices for sales between the Company's various operating units generally are at arm's length, based upon business conditions, distribution costs and other costs which are expected to be incurred in producing and marketing products. Corporate items include interest and other income and expense. Identifiable assets are those resources associated with the operations in each area. Corporate assets are principally cash and investments. The Company generally sells its products on open account under credit terms customary to the region of distribution. The Company performs ongoing credit evaluations of its customers and generally does not require collateral to secure its customers' receivables. Net Sales by Marketing Territory 1993 1992 1991 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~ United States $2,389 $2,016 $1,955 United Kingdom/Europe 600 629 582 Asia/Far East/Australia 559 455 340 Mexico/South America 330 355 290 Canada 257 187 161 Africa/Middle East 113 107 78 ~~~~~~ ~~~~~~ ~~~~~~ Net sales $4,248 $3,749 $3,406 ~~~~~~ ~~~~~~ ~~~~~~ NOTE 15. GUARANTEES, COMMITMENTS AND CONTINGENT LIABILITIES: In connection with the disposition of certain products and operations in 1989, the Company sold substantially all of the loan and lease portfolios of its former finance subsidiary. Under the terms of the sale, the purchaser has recourse to Cummins should certain amounts of the loans or leases prove to be uncollectible. At December 31, 1993, the loan and lease portfolios amounted to $14.3. Accounts receivable that have been sold with recourse amounted to $26.5 at December 31, 1993. At December 31, 1993, the Company was a party to interest rate swap agreements, maturing in 1994 and having an aggregate notional amount of $12.0. The Company had $258.3 of foreign exchange contracts outstanding at December 31, 1993. The foreign exchange contracts mature through 1995 and are denominated primarily in UK sterling, Japanese yen and European currencies. The Company had a currency swap with a notional amount of $202.6 at December 31, 1993, which matures in 1994. Commodity futures contracts of $5.2 were outstanding at December 31, 1993. These contracts mature through 1995. At December 31, 1993, commitments under outstanding letters of credit, guarantees and contingencies approximated $100. Cummins and its subsidiaries are defendants in a number of pending legal actions, including actions relating to use and performance of the Company's products. The Company carries product liability insurance covering significant claims for damages involving personal injury and property damage. The Company also has been identified as a potentially responsible party at several waste disposal sites under US and related state environmental statutes and regulations. The Company denies liability with respect to many of these legal actions and environmental proceedings and vigorously is defending such actions or proceedings. The Company has established reserves for its expected future liability in such actions and proceedings when the nature and extent of such liability can be estimated reasonably based upon presently available information. In the event the Company is determined to be liable for damages in connection with such actions and proceedings, the unreserved and uninsured portion of such liability is not expected to be material. NOTE 16. QUARTERLY FINANCIAL DATA (unaudited): First Second Third Fourth Full 1993 Quarter Quarter Quarter Quarter Year ~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~ ~~~~~~~~ Net sales $1,048.4 $1,093.4 $988.3 $1,117.8 $4,247.9 Gross profit 251.0 260.6 239.4 285.9 1,036.9 Earnings before the extraordinary item 41.1 48.2 40.7 52.6 182.6 Net earnings 41.1 48.2 40.7 47.1 177.1 Primary earnings per common share: Before the extra- ordinary item $ 1.12 $ 1.32 $ 1.11 $ 1.42 $ 4.95 Net 1.12 1.32 1.11 1.26 4.79 Fully diluted earnings per common share: Before the extra- ordinary item 1.07 1.25 1.06 1.36 4.77 Net 1.07 1.25 1.06 1.22 4.63 ~~~~ Net sales $ 881.3 $ 948.1 $903.6 $1,016.2 $3,749.2 Gross profit 190.4 211.7 202.7 237.7 842.5 Earnings before the extraordinary item & cumulative effect of accounting changes 5.0 18.8 13.8 29.5 67.1 Net earnings (loss) (246.1) 18.8 13.8 24.0 (189.5) Primary & fully diluted earnings (loss) per common share: Before the extra- ordinary item & cumulative effect of accounting changes $ .10 $ .50 $ .34 $ .79 $ 1.77 Net (8.33) .50 .34 .63 (6.01) Net earnings in the third quarter of 1993 included a one-time tax credit of $4.4 resulting from the OBRA. As disclosed in Note 7, net earnings in the fourth quarter of 1993 and 1992 included extraordinary charges of $5.5 related to early extinguishments of debt. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (Dollars in Million) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Balance Retirements Balance Jan. 1 Adds. or Sales Other Dec. 31 ~~~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~ Land and buildings $ 351.9 $ 8.3 $ 5.5 $ 3.2 $ 357.9 Machinery, equipment and fixtures 1,680.7 46.4 109.5 72.3 1,689.9 Construction in progress 89.7 129.0 2.0 (84.0) 132.7 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $2,122.3 $183.7 $117.0 $( 8.5) $2,180.5 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ ~~~~ Land and buildings $ 354.3 $ 1.4 $ .4 $( 3.4) $ 351.9 Machinery, equipment and fixtures 1,666.8 38.4 56.9 32.4 1,680.7 Construction in progress 89.9 100.8 .4 (99.6) 89.7 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $2,110.0 $140.6 $ 57.7 $(70.6) $2,122.3 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ ~~~~ Land and buildings $ 330.7 $ 19.5 $ 2.5 $ 6.6 $ 354.3 Machinery, equipment and fixtures 1,588.9 34.1 44.9 88.7 1,666.8 Construction in progress 107.7 88.6 2.3 (105.1) 88.9 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~~~~~ Total $2,027.3 $142.2 $ 49.7 $( 9.8) $2,110.0 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ The net change in "Other" primarily represents translation adjustments per SFAS No. 52. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Balance Retirements Balance Jan. 1 Adds. or Sales Other Dec. 31 ~~~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~~~ ~~~~~~~~ ~~~~ Buildings $ 156.8 $ 11.9 $ 2.5 $( 1.9) $ 164.3 Machinery, equipment and fixtures 1,036.8 110.0 86.5 ( 2.3) 1,058.0 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $1,193,6 $121.9 $ 89.0 $( 4.2) $1,222.3 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ ~~~~ Buildings $ 149.1 $ 11.9 $ .1 $( 4.1) $ 156.8 Machinery, equipment and fixtures 1,007.9 108.5 52.2 (27.4) 1,036.8 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $1,157.0 $120.4 $ 52.3 $(31.5) $1,193.6 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ ~~~~ Buildings $ 139.2 $ 11.7 $ 1.3 $( .5) $ 149.1 Machinery, equipment and fixtures 966.9 113.3 42.0 ( 30.3) 1,007.9 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ Total $1,106.1 $125.0 $ 43.3 $(30.8) $1,157.0 ~~~~~~~~ ~~~~~~ ~~~~~~ ~~~~~~~ ~~~~~~~~ The net change in "Other" primarily represents translation adjustments per SFAS No. 52. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~ ~~~~ ~~~~ Allowance for Doubtful Accounts: ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Balance beginning of period $11.8 $14.4 $14.6 Additions: Provisions 4.9 1.8 2.8 Recoveries and translation adjustments .1 (.1) .7 Deductions: Write-offs 7.3 4.3 3.7 ~~~~ ~~~~ ~~~~ Balance end of period $ 9.5 $11.8 $14.4 ~~~~~ ~~~~~ ~~~~~ Tax Valuation Allowance: ~~~~~~~~~~~~~~~~~~~~~~~~ Balance beginning of period $124.4 Additions to offset increases in deferred tax assets related to: Tax benefit carryforwards recognized as assets upon the initial January 1, 1992 adoption of SFAS No. 109 - $139.9 Additional general business tax credits for 1992 and 1993 research tax credits generated 14.1 - Increase in the value of net operating tax carryforwards as a result of the OBRA tax rate increase 1.7 - Reduction in the utilization of net operating loss carryforwards due to extraordinary charges for early extinguishment of debt 1.9 1.9 Deductions to reflect reductions in deferred tax assets related to actual utilization of tax benefit carryforwards (41.5) (17.4) Other .1 - ~~~~~~ ~~~~~~ $100.7 $124.4 ~~~~~~ ~~~~~~ (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE IX SHORT-TERM BORROWINGS (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ At Year-end During the Year ~~~~~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Average Average Interest Maximum Average Interest Borrowed Rate Outstanding Outstanding Rate ~~~~~~~~ ~~~~~~~~ ~~~~~~~~~~~ ~~~~~~~~~~~ ~~~~~~~~ ~~~~ Domestic $ - - $40.0 $25.9 4.0% Foreign 13.4 18.4% 42.2 11.6 11.5% ~~~~~ ~~~~~ ~~~~~ Total $13.4 $82.2 $37.5 ~~~~~ ~~~~~ ~~~~~ ~~~~ Domestic $40.0 4.8% $61.0 $38.9 4.4% Foreign 10.5 11.9% 12.5 17.7 13.0% ~~~~~ ~~~~~ ~~~~~ Total $50.5 $73.5 $56.6 ~~~~~ ~~~~~ ~~~~~ ~~~~ Domestic $10.0 6.4% $35.3 $26.6 6.5% Foreign 11.3 12.3% 17.7 15.0 12.7% ~~~~~ ~~~~~ ~~~~~ Total $21.3 $53.0 $41.6 ~~~~~ ~~~~~ ~~~~~ Average outstanding borrowings during the year were calculated for each entity based on the sum of daily outstanding balances divided by 365 days, or using the average monthly balances. Average interest rates during the year were calculated by dividing related interest expense for the year by average outstanding borrowings. Short-term borrowings are payable to banks and include amounts outstanding under various formal and informal credit arrangements including certain amounts where related interest rates are subsidized to promote trade exports. The Company also maintains a $300 revolving credit agreement available for short- and/or long-term borrowings with banks. At December 31, 1993, there were no outstanding borrowings under this agreement. At December 31, 1992, the Company had $40.0 outstanding short-term borrowings and $50.0 outstanding long-term borrowings under this agreement. At December 31, 1991, the Company had $20.0 of outstanding long-term borrowings under this agreement. (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION (Dollars in Millions) ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1993 1992 1991 ~~~~~~ ~~~~~~ ~~~~~~ Maintenance and repairs $145.0 $125.1 $118.7 Depreciation & amortization of intangibles $125.1 $122.5 $127.2 (page) SIGNATURES ~~~~~~~~~~ Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CUMMINS ENGINE COMPANY, INC. By /s/Peter B. Hamilton By /s/John McLachlan ~~~~~~~~~~~~~~~~~~~~ ~~~~~~~~~~~~~~~~~ P. B. Hamilton J. McLachlan Vice President & Chief Vice President - Corporate Financial Officer Controller (Principal (Principal Financial Accounting Officer) Officer) 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. Signatures Title Date ~~~~~~~~~~ ~~~~~ ~~~~ Director & Chairman of the Board 3/4/94 * of Directors & Chief Executive ~~~~~~~~~~~~~~~~~~~~~ Officer (Principal Executive Officer) (H. B. Schacht) * Director and President & Chief 3/4/94 ~~~~~~~~~~~~~~~~~~~~~ Operating Officer (J. A. Henderson) * 3/4/94 ~~~~~~~~~~~~~~~~~~~~~ Director (H. Brown) * ~~~~~~~~~~~~~~~~~~~~~ Director 3/4/94 (R. J. Darnall) * ~~~~~~~~~~~~~~~~~~~~~ Director 3/4/94 (J. D. Donaldson) * ~~~~~~~~~~~~~~~~~~~~~ Director 2/24/94 (W. Y. Elisha) * ~~~~~~~~~~~~~~~~~~~~~ Director 2/22/94 (H. H. Gray) ~~~~~~~~~~~~~~~~~~~~~ Director (D. G. Mead) * ~~~~~~~~~~~~~~~~~~~~~ Director 3/4/94 (J. I. Miller) * ~~~~~~~~~~~~~~~~~~~~~ Director 2/22/94 (W. I. Miller) * ~~~~~~~~~~~~~~~~~~~~~ Director 3/4/94 (D. S. Perkins) ~~~~~~~~~~~~~~~~~~~~~ Director (W. D. Ruckelshaus) * ~~~~~~~~~~~~~~~~~~~~~ Director 2/22/94 (F. A. Thomas) * 3/4/94 ~~~~~~~~~~~~~~~~~~~~~ Director (J. L. Wilson) By /s/Steven L. Zeller ~~~~~~~~~~~~~~~~~~~ Steven L. Zeller Attorney-in-fact (page) CUMMINS ENGINE COMPANY, INC., AND SUBSIDIARIES EXHIBIT INDEX ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 3(a) Restated Articles of Incorporation of Cummins Engine Company, Inc., as amended (incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended October 1, 1989 and by reference to Form 8-K, dated July 16, 1990). 3(b) By-laws, as amended and restated, of the Company (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988 and by reference to Quarterly Report on Form 10-Q for the quarter ended April 2, 1980). 4(b) Revolving Credit Agreement dated as of June 4, 1993, among Cummins Engine Company, Inc., certain banks, Chemical Bank as Administrative Agent and Morgan Guaranty Trust Company of New York as Co-Agent (incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended July 4, 1993). 4(c) Rights Agreement, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1989, by reference to Form 8-K, dated July 26, 1990, by reference to Form 8, dated November 6, 1990, by reference to Form 8-A12B/A, dated November 1, 1993, and by reference to Form 8-A12B/A, dated January 12, 1994). 10(a) Target Bonus Plan (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1992). 10(b) Five-Year Performance Plan, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(c) Key Employee Stock Investment Plan, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(d) Supplemental Life Insurance and Deferred Income Program, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(e) Financial Counseling Program, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1983). 10(f) 1986 Stock Option Plan (incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended March 30, 1986). 10(g) Deferred Compensation Plan for Non-Employee Directors, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(h) Key Executive Compensation Protection Plan (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(i) Excess Benefit Retirement Plan, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(j) Performance Share Plan, as amended (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988). 10(k) Restated Sponsors Agreement between Case Corporation and Cummins Engine Company, Inc., dated December 7, 1990, together with the Restated Partnership Agreement between Case Engine Holding Company, Inc., and Cummins Engine Holding Company, Inc., dated December 7, 1990 (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1990). 10(l) Retirement Plan for Non-Employee Directors of Cummins Engine Company, Inc., (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1989). 10(m) Stock Unit Appreciation Plan (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1990). 10(n) Investment Agreement between Ford Motor Company and Cummins Engine Company, Inc., dated July 16, 1990 (incorporated by reference to Form 8-K, dated July 26, 1990). 10(o) Investment Agreement between Tenneco Inc., and Cummins Engine Company, Inc., dated July 16, 1990 (incorporated by reference to Form 8-K, dated July 26, 1990). 10(p) Investment Agreement between Kubota Corporation and Cummins Engine Company, Inc., dated July 16, 1990 (incorporated by reference to Form 8-K, dated July 26, 1990). 10(q) Three Year Performance Plan (incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1992). 10(r) Consulting Arrangement with Harold Brown (incorporated by reference to the description thereof provided in the Company's definitive Proxy Statement, dated March 4, 1994). 10(s) 1992 Stock Incentive Plan (incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended April 4, 1993). 11 Schedule of Computation of Per Share Earnings for each of the three years ended December 31, 1993 (filed herewith). 21 Subsidiaries of the Registrant (filed herewith). 23 Consent of Arthur Andersen & Co. (filed herewith). 24 Powers of Attorney (filed herewith).

106535_1993.txt

106535_1993

1993

106535

Item 1. Business - ----------------------------------------------------------------------------- DESCRIPTION OF THE BUSINESS OF THE COMPANY Weyerhaeuser Company (the company) was incorporated in the state of Washington in January 1900, as Weyerhaeuser Timber Company. It is principally engaged in growing and harvesting of timber and the manufacture, distribution and sale of forest products, real estate development and construction, and financial services. Its principal business segments include timberlands and wood products, pulp and paper products, real estate, and financial services. A description of each of these business segments follows. Timberlands and Wood Products The company owns approximately 5.5 million acres of commercial forestland in the United States (50% in the South and 50% in the Pacific Northwest), most of it highly productive and located extremely well to serve both domestic and international markets. The company has, additionally, long-term license arrangements in Canada covering approximately 17.8 million acres (of which 14 million acres are considered to be productive forestland). The combined total timber inventory on these U.S. and Canadian lands is approximately 245 million cunits (a cunit is 100 cubic feet of solid wood), of which approximately 75% is softwood species. The relationship between cubic measurement and the quantity of end products that may be produced from timber varies according to the species, size and quality of timber, and will change through time as the mix of these variables changes. To sustain the timber supply from its fee timberland, the company is engaged in extensive planting, suppression of nonmerchantable species, precommercial and commercial thinning and fertilization and operational pruning, all of which increase the yield from its fee timberland acreage. Weyerhaeuser Company and Subsidiaries Part I Item 1. Business - Continued - ----------------------------------------------------------------------------- The company's wood products businesses produce and sell softwood lumber, plywood and veneer; composite panels; oriented strand board; hardboard; hardwood lumber and plywood; doors; treated products; logs; chips and timber. These products are sold primarily through the company's own sales organizations. Building materials are sold to wholesalers, retailers and industrial users. Sales by volumes by major product class are as follows (millions): Selected product prices: Weyerhaeuser Company and Subsidiaries Part I Item 1. Business - Continued - ----------------------------------------------------------------------------- Pulp and Paper Products The company's pulp and paper products businesses include: Pulp, which manufactures chemical wood pulp for world markets; Newsprint, which manufactures newsprint at the company's North Pacific Paper Corporation mill and markets it to West Coast and Japanese newspaper publishers; Paper, which manufactures and markets a range of both coated and uncoated fine papers through paper merchants and printers; Containerboard Packaging, which manufactures linerboard and corrugating medium, which is primarily used in the production of corrugated shipping containers and manufactures and markets corrugated shipping containers for industrial and agricultural packaging; Paperboard, which manufactures bleached paperboard that is used for production of liquid containers and is marketed to West Coast and Pacific Rim customers; Recycling, which operates an extensive wastepaper collection system and markets it to company mills and worldwide customers; Chemicals, which produces chlorine, caustic and tall oil, which are used principally by the company's pulp and paper operations; and Personal Care Products, which manufactures disposable diapers sold under the private-label brands of many of North America's largest retailers (this business was sold in February 1993 through an initial public offering of stock). Sales volumes by major product class are as follows (thousands): Selected product prices (per ton): Weyerhaeuser Company and Subsidiaries Part I Item 1. Business - Continued - ----------------------------------------------------------------------------- Real Estate The company, through its real estate subsidiary, Weyerhaeuser Real Estate Company, is a builder/developer of for-sale housing and apartments, develops commercial and residential lots for sale to users and other builders, builds commercial buildings for sale to institutional investors, and is an investor in joint ventures and limited partnerships. Volumes sold: Financial Services The company, through its financial services subsidiary, Weyerhaeuser Financial Services, Inc., is involved in a range of financial services. The principal operating unit is Weyerhaeuser Mortgage Company, which has origination offices in 12 states, with a servicing portfolio of $8.4 billion covering approximately 112,000 loans throughout the country. Mortgages are resold in the secondary market through mortgage-backed securities to financial institutions and investors. Through its insurance services organization, it also offers a broad line of property, life and disability insurance. GNA Corporation, a subsidiary that specialized in the sale of life insurance annuities and mutual funds to the customers of financial institutions, was sold in April 1993. Republic Federal Savings & Loan Association, a subsidiary that operated in Southern California through 1991, was dissolved in 1992. Volume information (millions): Weyerhaeuser Company and Subsidiaries Part I Item 2. Item 2. Properties - ----------------------------------------------------------------------------- Timberlands and Wood Products Facilities and annual production are summarized by major product class as follows (millions): Principal manufacturing facilities are located as follows: Softwood lumber and plywood Hardwood doors Alabama, Arkansas, Georgia, Idaho, Wisconsin Mississippi, North Carolina, Oklahoma, Oregon, Composite panels Washington, and Georgia, North Carolina, Alberta, British Columbia, and Oregon and Wisconsin Saskatchewan, Canada Oriented strand board Hardwood lumber Michigan, North Carolina, Arkansas, Oklahoma, Pennsylvania, and Alberta, Canada Washington, and Wisconsin Hardboard Oregon Weyerhaeuser Company and Subsidiaries Part I Item 2. Properties - Continued - ------------------------------------------------------------------------------ Pulp and Paper Products Facilities and annual production are summarized by major product class as follows (thousands): Principal manufacturing facilities are located as follows: Pulp Containerboard Georgia, Mississippi, North North Carolina, Oklahoma, Carolina, Washington, and Oregon, and Washington Alberta, British Columbia, and Saskatchewan, Canada Packaging Arizona, California, Florida, Newsprint Georgia, Hawaii, Illinois, Washington Indiana, Iowa, Kentucky, Maine, Michigan, Minnesota, Paper Mississippi, Missouri, Nebraska, Mississippi, North Carolina, New Jersey, New York, North Washington, Wisconsin, and Carolina, Ohio, Oregon, Saskatchewan, Canada Tennessee, Texas, Virginia, Washington, and Wisconsin Paperboard Washington Recycling California, Colorado, Iowa, Kansas, Maryland, North Carolina, Oklahoma, Oregon, Texas, Virginia, Washington, and British Columbia, Canada Chemicals Georgia, Mississippi, North Carolina, Oklahoma, Washington, and Saskatchewan, Canada Weyerhaeuser Company and Subsidiaries Part I Item 2. Properties - Continued - ----------------------------------------------------------------------------- Real Estate Principal operations are located as follows: Weyerhaeuser Company and Subsidiaries Part I Item 2. Properties - Continued - ----------------------------------------------------------------------------- Financial Services Principal operations are located as follows: Weyerhaeuser Company and Subsidiaries Part I Item 3. Item 3. Legal Proceedings - ------------------------------------------------------------------------------ Trial began in May 1992 in a federal income tax refund case that the company filed in July 1989 in the United States Claims Court. The complaint seeks a refund of federal income taxes that the company contends it overpaid in 1977 through 1983. The alleged overpayments are the result of the disallowance of certain timber casualty losses and certain deductions claimed by the company arising from export transactions. The refund sought was approximately $29 million, plus statutory interest from the dates of the alleged overpayments. The company has reached an agreement with the United States Department of Justice to settle the portion of the case relating to export transactions. That settlement has been approved by the Joint Committee on Taxation of the U.S. Congress. The tax refund remaining in dispute is approximately $9 million plus statutory interest from the dates of the alleged overpayments. The court has not entered a decision on the remaining issue. On March 6, 1992, the company filed a complaint in the Superior Court for King County, Washington against a number of insurance companies. The complaint seeks a declaratory judgment that the insurance companies named as defendants are obligated under the terms and conditions of the policies sold by them to the company to defend the company and to pay, on the company's behalf, certain claims asserted against the company. The claims relate to alleged environmental damage to third-party sites and to some of the company's own property to which allegedly toxic material was delivered or on which allegedly toxic material was placed in the past. Since December 1992, the company has agreed to settlements with six of the defendants. In July 1993, the trial court dismissed fourteen of the thirty-five sites named in the complaint. Appeal of those dismissals was heard by the Washington State Supreme Court on February 22, 1994. Trial on two sites is scheduled for October 1994. In April 1991, the United States Environmental Protection Agency (EPA) issued an amended complaint adding the company as an additional defendant in an administrative proceeding under the Toxic Substances Control Act (TSCA). The proceeding seeks penalties of $171,000 from all defendants with respect to alleged improper storage and record keeping between 1980 and 1989 for certain transformers which contained polychlorinated biphenyls. The transformers, which the company sold in 1980, were located at the company's former hardboard siding mill in Doswell, Virginia. The company is currently negotiating with the EPA to settle the matter with no admission of liability or penalties. In April 1992, the Georgia Department of Natural Resources, Environmental Protection Division issued a Notice of Violation to the company's Adel, Georgia particleboard plant citing violations of particulate emission standards. A consent order was entered into on September 18, 1992 assessing a $35,000 penalty and a stipulated penalty of $100 per day until the facility is in full compliance with particulate emission requirements. The Consent Order sets a compliance deadline of January 31, 1994. The Consent Order also requires that the company demonstrate that the facility is in compliance with regulations under the Prevention of Significant Deterioration (PSD) regulations under the Clean Air Act. The company has submitted compliance data and is awaiting the State's concurrence that it satisfies the consent order requirements. The company has undertaken a review of all its wood products facilities for compliance with the PSD regulations and has disclosed PSD compliance issues to certain state agencies and the EPA. The company and the State of Mississippi Department of Environmental Quality (DEQ) have entered into a consent agreement concerning PSD regulations at two company facilities in Mississippi involving penalties of $170,000. The State of Alabama has issued a compliance order with penalties totaling $100,000 for noncompliance with PSD regulations at the company's Millport facility. The company and North Carolina's Division of Environmental Management have entered into a consent agreement for its Elkin, North Carolina facility involving penalties of $140,000 and are currently negotiating a separate consent agreement for its Moncure, North Carolina facility involving penalties of $140,000. The company has signed a consent agreement including penalties of $140,000 relating to PSD issues at the company's Wright City, Oklahoma facility with the State of Oklahoma Department of Environmental Quality. The company is negotiating a consent agreement with the State of Arkansas concerning PSD related issues for two facilities in that state involving $375,000 in total penalties for both facilities. Region V of the EPA has issued a Notice of Violation for permit violations at the company's Grayling, Michigan facility. The company is negotiating settlement of those alleged permit violations and other PSD related issues with the Michigan Department of Natural Resources and the EPA that may involve penalties of up to $416,000. In September 1992, the EPA issued a Section 114 Request for Information concerning PSD compliance at the company's oriented strand board and medium density fiberboard mills. In June 1993, the EPA issued a similar Section 114 request for the company's plywood and particleboard mills. The company is also undertaking a review of its pulp and paper facilities for PSD compliance. Weyerhaeuser Company and Subsidiaries Part I Item 3. Legal Proceedings - Continued - ------------------------------------------------------------------------------ On April 9, 1993, the company entered into a Stipulated Final Order (SFO) with the Oregon Department of Environmental Quality for alleged air emissions in excess of permit levels and PSD noncompliance at the company's North Bend, Oregon containerboard facility. The SFO establishes a compliance schedule for installing control technology. A supplemental SFO assessed upfront penalties of $247,000 and penalties of $500 per day until compliance is demonstrated. The SFO requires demonstrated compliance by December 1993 and a historical evaluation of the facility's PSD status. The company has submitted a plant site PSD review to the state and is awaiting its review. In August 1992, the EPA issued an administrative complaint for the assessment of $215,000 in civil penalties against the company's Longview, Washington facility. The penalties are based upon alleged violations of the record keeping and storage provisions of the polychlorinated biphenyls rules contained in the TSCA. The company and the EPA settled the complaint for a maximum penalty of $118,150, 50% of which was paid when the settlement was signed. Payment of the remaining 50% was deferred and will be eliminated based on the expenditure of more than $118,150 by the company to dispose of PCB contaminated transformers at Longview during 1993. On November 2, 1992, an action was filed against the company in the Circuit Court for the First Judicial District of Hinds County, Mississippi on behalf of a purported class of riparian property owners in Mississippi and Alabama whose properties are located on the Tennessee Tombigbee Waterway, Aliceville Lake, Cedar Creek and the Magoway Creek. The complaint seeks $1 billion in compensatory and punitive damages for diminution in property value, personal injuries and mental anguish allegedly resulting from the discharge of purported hazardous substances, including dioxins and furans, by the company's pulp and paper mill in Columbus, Mississippi and the alleged fraudulent concealments of such discharge. The complaint also seeks an injunction prohibiting future releases and the removal of hazardous substances allegedly released in the past. On August 20, 1993, a companion action was filed in Green County, Alabama on behalf of a similar purported class of riparian owners with essentially the same claims as the Mississippi case. The action was removed to the Federal District Court for the Northern District of Alabama, which subsequently remanded the case to state court. Trial began in January 1994 in the United States District Court for the District of Alaska of claims filed against Weyerhaeuser by two corporations with which Weyerhaeuser had entered into financing arrangements, a marketing agreement, and a technical assistance agreement. The plaintiffs claim that Weyerhaeuser breached contractual and common law duties by allegedly failing to adequately market and ship the plaintiffs' products, misrepresenting its marketing and shipping capabilities, and acting to further its interests at the plaintiffs' expense. The plaintiffs in the First Amended Complaint, filed in May 1992, seek an unstated amount of damages described as more than $50 million in compensatory damages plus not less than $75 million in punitive damages. The claim for punitive damages has been dismissed by the trial court. The company is also a party to various proceedings relating to the clean up of hazardous waste sites under the Comprehensive Environmental Response Compensation and Liability Act, commonly known as "Superfund," and similar state laws. The Environmental Protection Agency and/or various state agencies have notified the company that it may be a potentially responsible party with respect to other hazardous waste sites as to which no proceedings have been instituted against the company. The company is also a party to other legal proceedings generally incidental to its business. Although the final outcome of any legal proceeding is subject to a great many variables and cannot be predicted with any degree of certainty, the company presently believes that any ultimate liability resulting from the legal proceedings discussed herein, or all of them combined, would not have a material effect on the company's financial position. Weyerhaeuser Company and Subsidiaries Part III Item 10. Directors and Executive Officers of the Registrant - ---------------------------------------------------------------------------- Part IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K - ----------------------------------------------------------------------------- Financial Statements Weyerhaeuser Company and Subsidiaries 1 Financial Statement Schedules Schedule V - Property and Equipment Schedule VI - Allowance for Depreciation and Amortization of Property and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short-term Borrowings Schedule X - Supplementary Income Statement Information Exhibits Exhibit 3 - Articles of Incorporation and Bylaws Exhibit 10 - Material Contracts (a) Agreement with N. E. Johnson (b) Agreement with W. R. Corbin Exhibit 11 - Statement Re: Computation of Per Share Earnings (incorporated by reference to page 52 of the 1993 Weyerhaeuser Company Annual Report) Exhibit 13 - Portions of the 1993 Weyerhaeuser Company Annual Report specifically incorporated by reference herein Exhibit 22 - Subsidiaries of the Registrant Exhibit 24 - Consents of Experts and Counsel Reports on Form 8-K The registrant has not filed a report on Form 8-K during the last fiscal quarter of the period for which this Form 10-K is filed. 1 Incorporated in Part II, Item 8

315213_1993.txt

315213_1993

1993

315213

ITEM 1. BUSINESS OVERVIEW Robert Half International Inc. (the "Company"), a Delaware corporation, primarily operates the nation's largest staffing services organization specializing in the accounting, financial, tax and banking fields. The Company operates through offices in the United States, Canada, the United Kingdom, Belgium and France, offering permanent and temporary personnel services under the names ROBERT HALF-R-and ACCOUNTEMPS-R-, respectively. Currently, the Company operates 153 offices and an additional 7 offices are operated by independent franchisees. The Company also places high-end office and administrative professionals (under the name OFFICETEAM-R-). ACCOUNTING, FINANCIAL, TAX AND BANKING SERVICES The Company provides skilled personnel to virtually all industries for a wide range of accounting, financial, tax, banking and data processing positions. The Company's office network maintains an interoffice referral system which enables the offices to cooperate in fulfilling a client's permanent and temporary employment requirements. The ROBERT HALF permanent placement services complement the ACCOUNTEMPS temporary staffing services by providing customers the ability to obtain both temporary and permanent employees from one source and by attracting applicants for permanent positions who are often willing to accept temporary positions during their search for permanent employment. The ACCOUNTEMPS temporary services division offers customers a reliable and economical means of dealing with uneven or peak work loads caused by such predictable events as vacations, taking inventories, tax work, month-end activities and special projects and such unpredictable events as illnesses and emergencies. Businesses increasingly view the use of temporary employees as a means of controlling personnel costs and converting such costs from fixed to variable. The cost and inconvenience to clients of hiring and firing permanent employees are eliminated by the use of ACCOUNTEMPS temporaries. The temporary workers are employees of ACCOUNTEMPS and are paid by ACCOUNTEMPS only when working on customer assignments. The customer pays a fixed rate only for hours worked. ACCOUNTEMPS clients may fill their permanent employment needs by using an ACCOUNTEMPS employee on a trial basis and, if so desired, "converting" the temporary position to a permanent position. The client typically pays a one-time fee for such conversions. The Company offers permanent placement services through its office network under the name ROBERT HALF. The Company's ROBERT HALF division specializes in placing accounting, financial, tax, banking and data processing personnel. Fees for successful permanent placements are paid only by the employer and are generally a percentage of the new employee's annual compensation. No fee for permanent placement services is charged to employment candidates. OTHER ACTIVITIES The Company's OFFICETEAM division places temporary and permanent high-end office and administrative personnel, ranging from word processors to office managers. OFFICETEAM operates in much the same fashion as the ACCOUNTEMPS and ROBERT HALF divisions. The Company has a small operation involving only a limited number of offices which places temporary and permanent employees in paralegal, legal administrative and legal secretarial positions (operating under the name THE AFFILIATES-R-). ORGANIZATION Management of the Company's offices is coordinated from its headquarters in Menlo Park, California. Office managers are responsible for most activities of their offices, including sales, local advertising and marketing and recruitment. The Company's headquarters provides support and centralized services to Company-owned offices in the administrative, marketing, accounting, training and legal areas, particularly as it relates to the standardization of the operating procedures of Company-owned offices. MARKETING AND RECRUITING The Company markets its services to clients as well as employment candidates. Local marketing and recruiting are generally conducted by each office or related group of offices. Advertising directed to clients and employment candidates consists primarily of yellow pages advertisements, classified advertisements and radio. Direct marketing through mail and telephone solicitation also constitutes a significant portion of the Company's total advertising. National advertising conducted by the Company consists primarily of print advertisements in national newspapers, magazines and certain trade journals. The Company also conducts public relations activities designed to enhance public recognition of the Company and its services. Local employees are encouraged to be active in civic organizations and industry and trade groups. The Company owns many trademarks, service marks and tradenames, including the "ROBERT HALF", "ACCOUNTEMPS" and "OFFICETEAM" marks, which are registered in the United States and in a number of foreign countries. COMPETITION The Company faces competition in its efforts to attract clients as well as high-quality specialized employment candidates. The permanent placement business is highly competitive, with a number of firms offering services similar to those provided by the Company, mostly on a regional or local basis. The temporary services industry is also highly competitive. There are several large nationwide operations, some of which have greater resources than the Company. In many areas the local companies are the strongest competitors. The most significant competitive factors in the permanent placement and temporary personnel service markets are price and the reliability of service, both of which are often a function of the availability and quality of personnel. Customers and employment candidates may use more than one permanent or temporary personnel services company. EMPLOYEES The Company and its subsidiaries presently employ approximately 1,150 regular full-time employees. The Company's offices employed approximately 59,000 different temporary employees on assignments during 1993. The ACCOUNTEMPS and OFFICETEAM temporary employees are the Company's employees for all purposes while they are working on assignments. The Company pays the related costs of employment, such as workers' compensation insurance, state and federal unemployment taxes, social security and certain fringe benefits. The Company provides voluntary health insurance coverage to interested temporary employees. FRANCHISING The Company is not currently seeking to grant additional franchises or to grant licenses for the operation of ROBERT HALF or ACCOUNTEMPS offices. However, the Company is exploring the possibility of using joint ventures or licensing arrangements as a means of expanding its operations. The Company believes its relationships with its independently-owned franchisees are good. Franchisees operate their businesses autonomously, subject to the requirements of the franchise agreements. The franchise agreements authorize franchisees to establish one or more ROBERT HALF and ACCOUNTEMPS offices within designated geographic areas. The agreements provide for monthly payments of royalties to the Company based on the franchisee's cash collections and are generally for a term of twenty years, renewable at the franchisee's option. OTHER INFORMATION The Company's current business constitutes a single business segment. (See Item 8. Financial Statements and Supplementary Data for financial information about the Company.) The Company is not dependent upon a single customer or a limited number of customers. The Company's operations are generally more active in the first and fourth quarters of a calendar year. Order backlog is not a material aspect of the Company's business and no material portion of the Company's business is subject to government contracts. The Company does not have any material expenditures for research and development. Compliance with federal, state or local environmental protection laws has no material effect on the capital expenditures, earnings or competitive position of the Company. Information about foreign operations is contained in Note N of Notes to Consolidated Financial Statements in Item 8. The Company does not have export sales. ITEM 2. ITEM 2. PROPERTIES The Company's headquarters is located in Menlo Park, California. Placement activities are conducted through 153 offices located in the United States, Canada, the United Kingdom, Belgium and France. All of the offices are leased. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any material pending legal proceedings other than routine litigation incidental to its business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of the Company's security holders during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is listed for trading on the New York Stock Exchange under the symbol "RHI". On February 28, 1994, there were 1,337 holders of record of the Common Stock. Following is a list by fiscal quarters of the sales prices of the stock as quoted on the New York Stock Exchange: No cash dividends were paid in 1993 or 1992. The Company, as it deems appropriate, may continue to retain all earnings for use in its business or may consider paying a dividend in the future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Following is a table of selected financial data of the Company of the last five years: ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 Temporary services revenues increased 40% during 1993, including the revenues generated from the Company's OfficeTeam division, which was started in 1991 to provide highly-skilled office and administrative personnel. Permanent placement revenues increased 30% during the year ended December 31, 1993. The positive revenue comparisons reflect strong demand for the Company's specialized personnel services. Net service revenues grew at a slower rate in 1992 compared to 1991, primarily as a result of the general economic recession. Temporary services revenues increased 9% while Robert Half division revenues decreased 21%. Gross margin as a percentage of revenues declined 1% between 1993 and 1992 and equaled 39% of revenue in 1993. In 1992, gross margin equaled 40% of revenue and in 1991, gross margin was 44% of revenue. The percentage declines related principally to a lower mix of the higher permanent placement gross margins and higher unemployment insurance costs associated with the temporary services divisions. Selling, general and administrative expenses were $88 million during 1993 compared to $72 million in 1992 and $73 million in 1991. Selling, general and administrative expenses as a percentage of revenues was 29% in 1993, compared to 33% in 1992 and 35% in 1991. The percentage declines were attributable to revenue growth coupled with the Company's continued cost containment. Amortization of intangible assets increased from 1991 to 1993 due to the acquisitions in each of those years of additional personnel services operations. Interest expense for the years ended December 31, 1993 and 1992 decreased 7% and 35%, respectively, over the comparable prior periods due to the reduction in outstanding indebtedness in both years and declining interest rates in the year ending December 31, 1992. The provision for income taxes was 46% in 1993, as compared to 45% in 1992 and 49% in 1991. The 1993 increase reflects the effect of the 1% increase in the federal corporate income tax rate as a result of the 1993 Tax Act. Because of the increase in pre-tax book income, the effect of the non-deductible intangible amortization on the effective tax rate was reduced in 1993 as compared to 1992. The 1992 reduction relative to 1991 was due primarily to a one-time benefit in the fourth quarter of 1992 for the resolution of tax accounting issues related to previous acquisitions. The Financial Accounting Standards Board issued a new standard on accounting for income taxes, which the Company was required to adopt on January 1, 1993. The cumulative effect of the adoption of the accounting method prescribed by the new standard was immaterial. LIQUIDITY AND CAPITAL RESOURCES The change in the Company's liquidity during the past three years is the net effect of funds generated by operations and the funds used for the personnel services acquisitions, principal payments on outstanding notes payable, and the securities repurchase program. The Company's Board of Directors previously authorized the repurchase, on the open market or in privately-negotiated transactions, of up to 3.25 million shares of the Company's common stock or the equivalent amount of Convertible Debentures or other common stock equivalents. The Company has repurchased approximately 3.1 million shares of the Company's common stock or common stock equivalents. See Note F to the Consolidated Financial Statements. Repurchases of the securities have been funded with cash generated from operations and the bank line of credit. On December 10, 1993, substantially all of its outstanding convertible subordinated debentures were converted into common stock of the Company. See Note E to the Consolidated Financial Statements. The Company's working capital requirements consist primarily of the financing of accounts receivable. While there can be no assurances in this regard, the Company expects that internally generated cash plus the bank revolving line of credit will be sufficient to support the working capital needs of the Company's offices, the Company's fixed payments and other long-term obligations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ROBERT HALF INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (IN THOUSANDS, EXCEPT SHARE AMOUNTS) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. ROBERT HALF INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. ROBERT HALF INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. ROBERT HALF INTERNATIONAL INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION. The Consolidated Financial Statements include the accounts of Robert Half International Inc. (the "Company") and its subsidiaries, all of which are wholly-owned. The Company is a Delaware corporation. All significant intercompany balances have been eliminated. Certain reclassifications have been made to the 1992 and 1991 financial statements to conform to the 1993 presentation. REVENUE RECOGNITION. Temporary services revenues are recognized when the services are rendered by the Company's temporary employees. Permanent placement revenues are recognized when employment candidates accept offers of permanent employment. Reserves are established to estimate losses due to placed candidates not remaining in employment for the Company's guarantee period, typically 90 days. FOREIGN CURRENCY TRANSLATION. Foreign income statement items are translated at the monthly average exchange rates prevailing during the period. Foreign balance sheets are translated at the current exchange rates at the end of the period, and the related translation adjustments are recorded as part of Stockholders' Equity. Gains and losses resulting from foreign currency transactions are included in the Consolidated Statements of Income. CASH AND CASH EQUIVALENTS. For purposes of the Consolidated Statements of Cash Flows, the Company classifies all highly-liquid investments with a maturity of three months or less as cash equivalents. INTANGIBLE ASSETS. Intangible assets represent the cost of acquired companies in excess of the fair market value of their net tangible assets at acquisition date, and are being amortized on a straight-line basis over a period of 40 years. INCOME TAXES. Effective January 1, 1993, the Company adopted Financial Accounting Standards No. 109, Accounting for Income Taxes (FAS 109). Under FAS 109, deferred taxes are computed based on the difference between the financial statement and income tax bases of assets and liabilities using the enacted marginal tax rate. As permitted under the provisions of FAS 109, the Company elected not to restate prior years and has determined that the cumulative effect of implementation was immaterial. NOTE B -- ACQUISITIONS In July 1986, the Company acquired all of the outstanding stock of Robert Half Incorporated, the franchisor of the Accountemps and Robert Half operations. Subsequently, in 57 separate transactions the Company acquired all of the outstanding stock of certain corporations operating Accountemps and Robert Half franchised offices in the United States, the United Kingdom and Canada as well as other personnel services businesses. The Company has paid approximately $185 million in cash, stock, notes and other indebtedness in these acquisitions, excluding transaction costs and cash acquired. These acquisitions were accounted for as purchases, and the excess of cost over the fair market value of the net tangible assets acquired is being amortized over 40 years using the straight-line method. Results of operations of the acquired companies are included in the Consolidated Statements of Income from the dates of acquisition. The acquisitions made during 1993 and 1992 had no material impact on the pro forma results of operations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE C -- NOTES PAYABLE AND OTHER INDEBTEDNESS The Company issued promissory notes as well as other forms of indebtedness in connection with certain acquisitions. These are due in varying installments, carry varying interest rates and in aggregate amount to $2,440,000 at December 31, 1993, and $3,510,000 at December 31, 1992. At December 31, 1993, $1.5 million of the notes were secured by standby letters of credit (see Note D). The following table shows the schedule of maturities for notes payable and other indebtedness at December 31, 1993 (in thousands): At December 31, 1993, all of the notes carried fixed rates of interest ranging from 8.0% to 13.3%. The weighted average interest rate for the above was approximately 11.1% and 8.5% for the years ended December 31, 1993 and 1992, respectively. As part of a Restructuring in 1987, a newly formed corporation, BF Enterprises, Inc., assumed the obligation for certain subordinated debentures issued by a predecessor of the Company. At December 31, 1993, the Company remains contingently liable for $11.3 million of these subordinated debentures, payment of $9.5 million of which has been provided for by the issuance of letters of credit to the trustee for the debentures by BF Enterprises, Inc. Additionally, pursuant to a pledge and security agreement entered into at the time of Restructuring, BF Enterprises, Inc., has agreed to pledge to the Company collateral (consisting of real estate, marketable securities and bank letters of credit) if the net worth of BF Enterprises, Inc., falls below certain minimum levels. NOTE D -- BANK LOAN (REVOLVING CREDIT) On November 1, 1993, the Company replaced the then existing unsecured credit facility. The new credit facility provides a line of credit of up to $80,000,000, which is available to fund the Company's general business and working capital needs, including acquisitions and the purchase of the Company's common stock, and to cover the issuance of debt support standby letters of credit up to $15,000,000. As of December 31, 1993, the Company had borrowed $30,300,000 on the line of credit, and had used $2,780,000 in debt support standby letters of credit. Of the $30,300,000 outstanding balance at December 31, 1993, $29,000,000 carried an interest rate tied to Eurodollar rates plus 1.25% and $1,300,000 carried an interest rate at prime. There is a commitment fee on the unused portion of the entire credit facility of .25%. The loan is subject to certain financial covenants which also affect the interest rates charged. The credit facility has the following scheduled reduction in availability (in thousands): The final maturity date for the credit facility is August 31, 2000. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE D -- BANK LOAN (REVOLVING CREDIT) (CONTINUED) As of December 31, 1992, the Company had borrowed $35,600,000 of the borrowing facility in place at that time and had used $2,700,000 in debt support standby letters of credit. Of the $35,600,000 outstanding loan balance at December 31, 1992, $25,000,000 carried an interest rate tied to Eurodollar rates plus 1.25% and the remaining balance of $10,600,000 carried an interest rate at prime. NOTE E -- CONVERTIBLE SUBORDINATED DEBENTURES On August 6, 1987, the Company issued $74,750,000 principal amount of the Convertible Subordinated Debentures (the "Convertible Debentures"). Prior to 1993, all but $22,745,000 of the Convertible Debentures were repurchased by the Company pursuant to its repurchase program (see Note F). The Convertible Debentures were unsecured obligations of the Company with an original maturity date of August 1, 2012. Interest was payable semi-annually as of February 1 and August 1 of each year to the registered holders as of the preceding January 15 and July 15, respectively. The Convertible Debentures were redeemable at the Company's option at any time on or after August 1, 1990, at declining redemption prices. In December 1993, the Company called for redemption all of its then outstanding Convertible Debentures. Holders of $22,440,000 in principal amount elected to convert their debentures into 1.02 million shares of common stock at the conversion price of $22.00 per share. The remaining $305,000 in principal amount of Convertible Debentures were redeemed at 102.9% of their principal amount plus accrued interest. NOTE F -- SECURITIES REPURCHASE PROGRAM The Company was previously authorized by its Board of Directors to repurchase up to a total of 3.25 million shares of the Company's common stock, or the equivalent amount of Convertible Debentures or other common stock equivalents from time to time on the open market or in privately negotiated transactions. As of December 31, 1993, 3.1 million equivalent shares have been repurchased. There were no repurchases under the program during 1993. During 1992, the Company purchased 15,230 shares of common stock. In 1991, the Company repurchased $1 million face amount of Convertible Debentures and purchased 3,457 shares of common stock for an aggregate of approximately 49,000 shares or share equivalents. These repurchases were financed with internally generated cash and the revolving line of credit. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE G -- INCOME TAXES The provisions for income taxes for the three years ended December 31, 1993 consisted of the following (in thousands): The income taxes shown above varied from the statutory federal income tax rates for these periods as follows: The deferred portion of the tax provisions consisted of the following (in thousands): During the fourth quarter of 1992, the Company recorded a one-time benefit of $400,000 for the resolution of certain tax accounting issues related to previous acquisitions. The deferred income tax liability shown on the balance sheet is comprised of the following (in thousands): No valuation allowances against deferred tax assets were required at December 31, 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE G -- INCOME TAXES (CONTINUED) The components of the net deferred income tax liability at December 31, 1993 were as follows (in thousands): NOTE H -- EMPLOYEE BENEFIT PLANS Under a retirement plan covering one current and one former executive officer of the Company, monthly benefits are payable equal to 25% of the participant's base compensation as defined, increased by an inflation formula. The plan was amended effective May 31, 1992 to provide a fixed supplemental benefit for the current employee during the first 15 years after retirement. The current employee forfeited long-term incentive awards of equal value in exchange for this amendment. The plan was also amended effective May 21, 1991 for the current employee to increase the percentage of base compensation to 30% increasing thereafter by 3% for each year of service beyond the age of 50, up to a maximum of 66%. During 1993, the Company changed its discount rate assumption from 8% to 6%. The effect of both plan amendments and the discount rate change are being amortized over the employee's expected future service period of 15 years and will increase after-tax expense by approximately $76,000 per year. The employee can require the Company to discharge its liability at defined intervals by purchasing annuities. At December 31, 1992 a liability of $1,124,000 was established to cover the estimated unfunded cost of these benefits. This amount was increased to $1,721,000 at December 31, 1993. Pre-tax pension costs for these plans were $188,000, $131,000, and $72,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These charges were computed using certain assumptions regarding salary increases, retirement age and life expectancy. NOTE I -- COMMITMENTS AND CONTINGENCIES Rental expense, primarily for office premises, amounted to $8,457,000, $8,042,000 and $7,616,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The approximate minimum rental commitments for 1994 and thereafter under non-cancelable leases in effect at December 31, 1993, are as follows (in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE J -- STOCK PLANS Under various stock plans, officers, employees and outside directors may receive grants of restricted stock or options to purchase common stock. Grants are made at the discretion of the Compensation Committee of the Board of Directors. Grants usually vest over four years. Options granted under the plans have exercise prices ranging from 85% to 100% of the fair market value of the Company's common stock at the date of grant, consist of both incentive stock options and nonstatutory stock options under the Internal Revenue Code, and generally have a term of ten years. Recipients of restricted stock do not pay any cash consideration to the Company for the shares, have the right to vote all shares subject to such grant, and receive all dividends with respect to such shares, whether or not the shares have vested. As of December 31, 1993 the total number of available grants under the plans (consisting of either restricted stock or options) was 396,054. The following table reflects activity under all stock plans from January 1, 1991 through December 31, 1993 and the exercise prices: As of December 31, 1993, an aggregate of 615,965 restricted common stock or options to purchase common stock were vested. NOTE K -- PREFERRED SHARE PURCHASE RIGHTS On July 23, 1990, the Board of Directors declared a dividend distribution of one Preferred Share Purchase Right (the "Rights") on each outstanding share of the Company's common stock. The Rights will be exercisable only if a person or group becomes an Acquiring Person (as such term is defined in the Right's Agreement) or announces a tender offer the consummation of which would result in a person or group becoming an Acquiring Person. Each Right will entitle stockholders to buy one one-hundredth of a share of a new series of junior participating preferred stock at an exercise price of $65 (subject to adjustment) upon certain events. Effective October 28, 1993, Acquiring Person means any person or group of affiliated or associated persons who shall be the beneficial owner of 15% or more of the common stock of the Company then outstanding, but does not include the only shareholder (and affiliates and associates thereof) known by the Company to have beneficial ownership on October 28, 1993, in excess of 15% of the then outstanding common stock, provided that NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE K -- PREFERRED SHARE PURCHASE RIGHTS (CONTINUED) such exclusion terminates immediately in the event that such shareholder (or any such affiliate or associate) increases its beneficial ownership of common stock other than pursuant to certain specified transactions. If, after the Rights become exercisable, the Company is acquired in a merger or other business combination transaction, or sells 50% or more of its assets or earnings power, each Right will entitle its holder to purchase, at the Right's then-current exercise price, a number of the acquiring company's common shares having a market value at the time of twice the Right's exercise price. In addition, if a person or group becomes an Acquiring Person otherwise than pursuant to a cash tender offer for all shares in which such person or group increases its stake to 85% of the outstanding shares of common stock, each Right will entitle its holder (other than such person or members of such group) to purchase, at the Right's then-current exercise price, a number of the Company's common shares (or cash, other securities or property) having a market value of twice the Right's exercise price. At any time after a person or group becomes an Acquiring Person and prior to an acquisition by such person or group of 50% or more of the common stock, the Board of Directors may exchange the Rights (other than Rights owned by such person or group), in whole or in part, at an exchange ratio of one share of common stock (or one one-hundredth of a share of the new series of junior participating preferred stock) per Right. At any time prior to ten days after a person or group becomes an Acquiring Person, the Rights are redeemable for one cent per Right at the option of the Board of Directors. The dividend distribution was made on August 8, 1990, payable to stockholders of record on that date. The Rights will expire on July 23, 2000. NOTE L -- INCOME PER SHARE Income per fully diluted share has been computed using the weighted average number of shares of fully diluted common stock and common stock equivalents outstanding during each period (12,630,000, 12,003,000 and 11,637,000 shares for the years ending December 31, 1993, 1992 and 1991, respectively). An assumed conversion of the Convertible Debentures was not dilutive to income per share in 1993 (see Note E), 1992 or 1991. NOTE M -- QUARTERLY FINANCIAL DATA (UNAUDITED) The following tabulation shows certain quarterly financial data for 1993 and 1992 (in thousands, except per share amounts): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE N -- SEGMENT REPORTING Information about the Company's operations in different geographic locations for the three fiscal years ended in December 1993, is shown below. The Company's areas of operations outside of the United States include Canada, the United Kingdom, Belgium and France. Revenues represent total net revenues from the respective geographic areas. Operating income is net revenues less operating costs and expenses pertaining to specific geographic areas. Foreign operating income reflects charges for U.S. management fees and amortization of intangibles of $917,000, $854,000 and $650,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Domestic operating income reflects charges for amortization of intangibles of $3,841,000, $3,606,000 and $3,564,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Identifiable assets are those assets used in the geographic areas and are reflected after elimination of intercompany balances. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE STOCKHOLDERS AND THE BOARD OF DIRECTORS OF ROBERT HALF INTERNATIONAL INC.: We have audited the accompanying consolidated statements of financial position of Robert Half International Inc. (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Robert Half International Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN & CO. San Francisco, California January 28, 1994 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III The information required by Items 10 through 13 of Part III is incorporated by reference from the registrant's Proxy Statement, under the captions "NOMINATION AND ELECTION OF DIRECTORS," "BENEFICIAL STOCK OWNERSHIP," "COMPENSATION OF DIRECTORS," "COMPENSATION OF EXECUTIVE OFFICERS" AND "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION AND CERTAIN TRANSACTIONS," which Proxy Statement will be mailed to stockholders in connection with the registrant's annual meeting of stockholders which is scheduled to be held in May 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) 1. FINANCIAL STATEMENTS The following consolidated financial statements of the Company and its subsidiaries are included in Item 8 of this report: Consolidated statements of financial position at December 31, 1993 and 1992. Consolidated statements of income for the years ended December 31, 1993, 1992 and 1991. Consolidated statements of stockholders' equity for the years ended December 31, 1993, 1992 and 1991. Consolidated statements of cash flows for the years ended December 31, 1993, 1992 and 1991. Notes to consolidated financial statements. Report of independent public accountants. Selected quarterly financial data for the years ended December 31, 1993 and 1992 are set forth in Note M - Quarterly Financial Data (Unaudited) included in Item 8 of this report. 2. FINANCIAL STATEMENT SCHEDULES Report of independent public accountants on supporting schedules. II - Amounts receivable from related parties X - Supplementary income statement information Schedules I, III, IV, V, VI, VII, VIII, IX, XI, XII and XIII have been omitted as they are inapplicable. 3. EXHIBITS (b) Reports on Form 8-K The Registrant did not file any reports on Form 8-K during the fiscal quarter ending December 31, 1993. 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. ROBERT HALF INTERNATIONAL INC. (Registrant) Date: March 22, 1994 By: _______/S/_M. KEITH WADDELL_______ M. Keith Waddell Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) 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. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and the Board of Directors of Robert Half International Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Robert Half International Inc. and subsidiaries included in this Form 10-K, and have issued our report thereon dated January 28, 1994. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. San Francisco, California January 28, 1994 S-1 ROBERT HALF INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 S-2 ROBERT HALF INTERNATIONAL INC. AND SUBSIDIARIES SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 S-3 INDEX TO EXHIBITS Sequentially Exhibit Numbered No. Exhibit Page ------- ------------------------------------ ---- 3.1 Restated Certificate of Incorporation, incorporated by reference to Exhibit 3.1 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. 3.2 By-Laws. 4.1 Indenture dated as of October 1, 1972, as amended, between IDS Realty Trust and First National Bank of Minneapolis, incorporated by reference to Exhibits 6(t) and 6(v) to the Form S-14 Registration Statement of the Registrant (formerly known as Boothe Interim Corporation) filed with the Securities and Exchange Commission on December 31, 1979. 4.2 Restated Certificate of Incorporation of Registrant (filed as Exhibit 3.1). 4.3 Rights Agreement, dated as of July 23, 1990, between the Registrant and Manufacturers Hanover Trust Company of California, incorporated by reference to (i) Exhibit 1 to the Registrant's Registration Statement on Form 8-A for its Preferred Share Purchase Rights, which Registration Statement was filed with the Commission on July 30, 1990, (ii) Exhibit 19.1 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 1990 and (iii) Exhibit 3 to Registrant's Form 8-A/A Amendment No. 2 filed on December 2, 1993. 10.1 Credit Agreement dated as of November 1, 1993, among the Registrant, NationsBank of North Carolina, N.A. and Bank of America National Trust and Savings Association, incorporated by reference to Exhibit 10 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 1993. 10.2 Reorganization and Distribution Agreement between the Registrant and BF Enterprises, Inc., incorporated by reference to Exhibit 10.9 to Registrant's Registration Statement on Form S-1 (No. 33-15171). 10.3 Agreement of Assignment and Assumption of Rights and Obligations under the Indenture between the Registrant and BF Enterprises, Inc., incorporated by reference to Exhibit 10.10 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. 10.4 Assumption of Obligations and Liabilities between the Registrant and BF Enterprises, Inc., incorporated by reference to Exhibit 10.11 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987. 10.5 Pledge and Security Agreement between the Registrant and BF Enterprises, Inc., incorporated by reference to Exhibit 10.10 to Registrant's Registration Statement on Form S-1 (No. 33-15171). 10.6 Tax Sharing Agreement between the Registrant and BF Enterprises, Inc., incorporated by reference to Exhibit 10.11 to Registrant's Registration Statement on Form S-1 (No. 33-15171). *10.7 Employment Agreement dated as of October 2, 1985, between the Registrant and Harold M. Messmer, Jr. The Eighth Amendment to such agreement is filed with this Annual Report on Form 10-K for the fiscal year ended December 31, 1993. The original agreement and the first seven amendments thereto are incorporated by reference to (i) Exhibit 10.(c) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985, (ii) Exhibit 10.2(b) to Registrant's Registration Statement on Form S-1 (No. 33-15171), (iii) Exhibit 10.2(c) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, (iv) Exhibit 10.2(d) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, (v) Exhibit 28.1 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1990, (vi) Exhibit 10.8 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991 and (vii) Exhibit 10.1 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1993. *10.8 Key Executive Retirement Plan - Level II, incorporated by reference to Exhibit 10.(f) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985 and Exhibit 19.2 to Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 1991. *10.9 Key Executive Retirement Plan - Level II Agreement between the Registrant and Harold M. Messmer, Jr. The Sixth Amendment to such agreement is filed with this Annual Report on form 10- K for the fiscal year ended December 31, 1992. The original agreement and the first five amendments thereto are incorporated by reference to (i) Exhibit 10.5 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, (ii) Exhibit 19.3 to Registrant's Quarterly Report on Form 10- Q for the fiscal quarter ended June 30, 1991, (iii) Exhibit 10.10 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, and (iv) Exhibit 10.2 to the Registrant's Quarterly Report on Form 10- Q for the fiscal quarter ended June 30, 1993. *10.10 1985 Stock Option Plan, as amended, incorporated by reference to Exhibit 10.7 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988. *10.11 Non-Employee Directors' Option Plan, incorporated by reference to Exhibit 10.(j) to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986. *10.12 Outside Directors' Option Plan, incorporated by reference to Exhibit 10.21 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. *10.13 1989 Restricted Stock Plan, as amended, incorporated by reference to Exhibit 10.14 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. *10.14 StockPlus Plan, as amended, incorporated by reference to Exhibit 10.15 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. *10.15 1993 Incentive Plan, as amended. *10.16 Deferred Compensation Plan, incorporated by reference to Exhibit 10.24 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. *10.17 Annual Performance Bonus Plan. *10.18 Form of Severance Agreement, incorporated by reference to (i) Exhibit 10.26 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989 and (ii) Exhibit 19.2 to the Registrant's Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 1990. *10.19 Form of Indemnification Agreement for Directors of the Registrant. The form of agreement is incorporated by reference to Exhibit 10.27 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. Filed herewith is a schedule listing the names of the individuals with whom the agreement has been executed and the date of execution. *10.20 Form of Indemnification Agreement for Executive Officers of Registrant, incorporated by reference to Exhibit 10.28 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. 11 Statement re computation of per share earnings. 21 Subsidiaries of the Registrant. 23 Accountants' Consent. _____ * Management contract or compensatory plan required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K.

814046_1993.txt

814046_1993

1993

814046

ITEM 1. BUSINESS All references to "Notes" are to Notes to Consolidated Financial Statements contained in this report. The registrant, Arvida/JMB Partners, L.P. (the "Partnership"), is a limited partnership formed in 1987 and currently governed under the Revised Uniform Limited Partnership Act of the State of Delaware. The Partnership was formed to own and develop substantially all of the assets of Arvida Corporation (the "Seller"), a subsidiary of The Walt Disney Company, which were acquired by the Partnership from the Seller on September 10, 1987. On September 16, 1987, the Partnership commenced an offering to the public of up to $400,000,000 in Limited Partnership Interests and assignee interests therein ("Interests") pursuant to a Registration Statement on Form S-1 under the Securities Act of 1933 (No. 33-14091). A total of 400,000 Interests were sold to the public (at an offering price of $1,000 per Interest before discounts) and the holders of 400,000 Interests were admitted to the Partnership in October 1987. The offering terminated October 31, 1987. In addition, a holder (an affiliate of the dealer-manager of the public offering) of 4,000 Interests was admitted to the Partnership in October 1987. Subsequent to admittance to the Partnership, no holder of Interests (a "Limited Partner" or "Holder") has made any additional capital contribution. The Limited Partners of the Partnership generally share in their portion of the benefits of ownership of the Partnership's real property investments and other assets according to the number of Interests held. Pursuant to the Partnership Agreement, the Partnership may continue in existence until December 31, 2087; however, the General Partner shall elect to pursue one of the following courses of action: (i) to cause the Interests to be listed on a national exchange or on the National Association of Securities Dealers Automated Quotation System at any time on or prior to the date ten years from the termination date of the offering of Interests; (ii) to purchase, or cause one of its affiliates to purchase, ten years from the termination of the offering of Interests, all of the Interests at their then appraised fair market value (as determined by an independent nationally recognized investment banking firm or real estate advisory company); or (iii) to commence a liquidation phase ten years from the termination of the offering of Interests in which all of the Partnership's remaining assets will be sold prior to the end of the fifteenth year from the termination of the offering. The assets of the Partnership consist principally of interests in land which is in the process of being developed into master-planned residential communities (the "Communities") and, to a lesser extent, commercial and industrial properties; mortgage notes and accounts receivable; certain management and other service contracts; construction, brokerage and other support businesses; real estate assets held for investment; certain club and recreational facilities; and certain cable television businesses serving certain of its Communities. The Partnership is principally engaged in the development of comprehensively planned resort and primary home Communities containing a diversified product mix designed for the middle and upper income segments of the various markets in which the Partnership operates. The Partnership sells individual residential lots and parcels of partially developed and undeveloped land. The third-party builders and developers to whom the Partnership sells homesites and land parcels are generally smaller local builders who require project specific financing for their developments and whose operations are more susceptible to fluctuations in the availability of financing. In addition, within the Communities, the Partnership constructs, or causes to be constructed, a variety of products, including single-family homes, townhouses and condominiums to be developed for sale, as well as related commercial and recreational facilities. The Communities are located primarily throughout the State of Florida, with Communities also located near Atlanta, Georgia; Highlands, North Carolina and in Orange County, California. Additional undeveloped properties owned by the Partnership in or near its Communities are being considered for development as commercial, office and industrial properties. The Partnership also owns or manages certain club and recreational facilities within certain of its Communities. Certain assets located in Florida were acquired by the Partnership from the Seller by purchasing a 99.9% interest in a joint venture partnership in which the General Partner acquired the remaining joint venture partnership interest. In addition, other assets are owned by various partnerships, the interests of which are held by certain indirect subsidiaries of the Partnership and by the Partnership. Arvida Company ("Arvida"), an affiliate of the General Partner, provides certain development and management supervisory personnel to the Partnership for the supervision of all of its projects and operations, subject, in each case, to the overall control of the General Partner on behalf of the Partnership. The Partnership, directly or through certain subsidiaries, provides development and management services to the home ownership associations within the Communities. Two of the Partnership's Communities currently offer cable television systems to certain of their residents, which systems are owned and operated by entities owned by the Partnership. The business of the Partnership is cyclical in nature and certain aspects of the development of Community projects are to some degree seasonal. The Partnership does not expect that such seasonality will have a material impact on its business. A presentation of information about industry segments, geographic regions or raw materials is not applicable and would not be material to an understanding of the Partnership's business taken as a whole. The Communities are in various stages of development. The remaining estimated build-out time for the Communities ranges from one year to 11 years. The Partnership generally follows the practice with respect to Communities of (i) developing an overall master plan for the Community, (ii) creating a unifying architectural theme that is consistent with the Community's master plan, (iii) offering a variety of recreational facilities, (iv) imposing architectural standards and other property restrictions on residents and third-party developers, in order to enhance the long-term value of the Community, (v) establishing property owners' associations to maintain compliance with architectural, landscaping and other requirements and to provide for ownership and maintenance of certain facilities, and/or (vi) operating and controlling access to golf, tennis and other recreational facilities. The Partnership's development approach, individually or by joint venture, is intended to enhance the value of real estate in successive phases. The first step in the development of a property is to design a Community master plan that addresses the appropriate land uses and product mix, including residential, recreational and, where appropriate, commercial and industrial uses. The Partnership then seeks to obtain the necessary regulatory and environmental approvals for the development of the Community in accordance with the master plan. This approval process is a major factor in determining the viability and prospects for profitability of the Partnership's development projects. The first phase in the regulatory approval process will usually consist of obtaining the proper zoning approvals for the intended development. The Partnership must also comply with state and local laws governing large planned developments which may vary from state to state and community to community. In Florida, for example, land development is subject to the Florida Local Government Comprehensive Planning and Land Development Regulation Act, as administered by the State and implemented by regional, county and municipal authorities. In addition, prior to or contemporaneously with zoning approval, the Partnership, if subject to the applicable filing requirements, must obtain "Development of Regional Impact" ("DRI") approval from the applicable local governmental agency after review and recommendations from the appropriate regional planning agency, with oversight by the Florida State Department of Community Affairs. With the exception of approximately 2,460 acres of Weston (Weston's Increment III), the Partnership has received DRI approval on all of its Florida Properties. Application with respect to Weston's Increment III DRI approval has been filed and is being processed in the ordinary course of business. Receipt of DRI approval is a prerequisite to obtaining zoning, platting, building permits or other approvals required to begin development or construction. Obtaining such approvals can involve substantial periods of time and expense and may result in the loss of desired densities, and approvals may need to be resubmitted if there is any subsequent deviation in current approved plans. The process may also require committing land for public use and payment of substantial impact fees. In addition, state laws generally provide further that a parcel of land cannot be subdivided into distinct segments without having a plat filed and finalized with the local or municipal authority, which will, in general, require the approval of various local agencies, such as environmental and public works departments. In addition, the Partnership must secure the actual permits for development from applicable Federal (e.g., the Army Corps of Engineers and/or the Environmental Protection Agency with respect to coastal and wetlands developments, including dredging of waterways) and state or local agencies, including construction, dredging, grading, tree removal and water management and drainage district permits. The Partnership may, in the process of obtaining such permits or approvals for platting or construction activities, incur delays or additional expenses; however, such permits and approvals are customarily obtained to permit development. Failure to obtain or maintain necessary approvals, or rejection of submitted plans, would result in an inability to develop the Community as originally planned and would cause the Partnership to reformulate development plans for resubmission, which might result in a failure to increase, or a loss of, market value of the property. The foregoing discussion and the discussion which follows are also generally applicable to the Partnership's commercial and industrial developments. Upon receipt of all approvals and permits required to be obtained by the Partnership for a specific Community, other than actual approvals or permits for final platting and/or construction activities, the Partnership applies for the permits and other approvals necessary to undertake the construction of infrastructure, including roads, water and sewer lines and amenities such as lakes, clubhouses, golf courses, tennis courts and swimming pools. These expenditures for infrastructure and amenities are generally significant and are usually required early in the development of a Community project, although the Partnership will attempt, to the extent feasible, to develop Communities in a phased manner. See Note 12 for further discussion regarding Tax Increment Financing Entities and their involvement with infrastructure improvements. Certain of the Florida Communities described below have applied for and have been designated as a Planned Unit Development ("PUD") by the local zoning authority (usually the governing body of the municipality or the county in which the Community is or will be located). Designation as a PUD generally establishes permitted densities (i.e., the number of residential units which may be constructed) with respect to the land covered thereby and, upon receipt, enables the developer to proceed in an orderly, planned fashion. Generally, such PUD approvals permit flexibility between single-unit and multi-unit products since the developer can plan Communities in either fashion as long as permitted densities are not exceeded. As a consequence, developments with PUD status are able to meet changing demand patterns in housing through such flexibility. It should be noted that some of the Communities, while not having received PUD approval, have obtained the necessary zoning approvals to create a planned community development with many of the benefits of PUD approval such as density shifting. In developing the infrastructure and amenities of its Communities and building its own housing products, the Partnership may function as a general contractor although it may also from time to time hire firms for general contracting work. The Partnership generally follows the practice of hiring subcontractors, architects, engineers and other professionals on a project-by- project basis rather than maintaining in-house capabilities, principally to be able to select the subcontractors and consultants it believes are most suitable for a particular development project and to control fixed overhead costs. The Partnership maintains, through a wholly-owned affiliate, a staff to perform certain construction work, to supervise construction and to perform routine maintenance and minor repair work. Although the General Partner does not expect the Partnership to be faced with any significant material or labor shortages, the construction industry in general has from time to time experienced serious difficulties in obtaining certain construction materials and in having available a sufficiently large and adequately trained work force. The Partnership's strategy includes the ownership and development of certain commercial and industrial property not located in a Partnership Community. In addition, certain of the Partnership's Communities contain acreage zoned for commercial use, although, except for the Weston Community, such acreage is generally not substantial. On both of such types of properties, the Partnership, individually or with a joint venture partner, may build shopping centers, office buildings and other commercial buildings and may sell land to be so developed. Certain of the Communities and operations are owned by the Partnership jointly with third parties. Such investments by the Partnership are generally in partnerships or ventures which own and operate a particular property in which the Partnership or an affiliate (either alone or with an affiliate of the General Partner) has an interest. The principal assets in which interests have been acquired by the Partnership are described in more detail under Item 2 ITEM 2. PROPERTIES The principal assets being developed or managed by the Partnership are described below. The acreage amounts set forth herein are approximations of the gross acreage of the Communities or other properties referred to or described and are not necessarily indicative of the net developable acreage currently owned by the Partnership or its joint ventures. All of the Partnership's properties are subject to mortgages to secure the repayment of the Partnership's indebtedness as discussed in detail in Note 8. (a) Palm Beach County, Florida The Partnership owns property in Broken Sound, a 970-acre Community located in Boca Raton. The Community offers a wide range of residential products built by the Partnership or third-party builders and is in its final stage of development. (b) Broward County, Florida The Partnership owns property in Weston, a 7,500-acre Community in its mid stage of development. The Community offers a complete range of housing products built by the Partnership or third-party builders, as well as tennis, swim and fitness facilities, a golf course and an equestrian center. In addition, the Partnership owns commercial properties, most of which are currently undeveloped, located in the Weston Community. Reference is made to Note 12 for a discussion of the Partnership's use of certain tax-exempt financing in connection with the development of the Weston Community. (c) Sarasota / Tampa, Florida The Partnership owns property in the Longboat Key Club, a Community on Longboat Key which is a barrier island on Florida's west coast, approximately four miles from downtown Sarasota and seven miles from Sarasota/Bradenton airport. The Community is in its late stage of development. The Partnership also owns property in a Community in the Tampa area known as River Hills Country Club which is a 1,200-acre Community in its mid stage of development. The Partnership owned an interest in The Oaks Community in Sarasota, Florida. The Partnership sold its interest in The Oaks during 1993. Reference is made to Note 8 for a discussion of the sale of the Partnership's interest in The Oaks property and the repayment of the mortgage loan secured by such property. (d) Jacksonville, Florida The Partnership owns property in two Communities in Ponte Vedra Beach, Florida, twenty-five miles from downtown Jacksonville, known as Sawgrass Country Club and The Players Club at Sawgrass. These Communities are in their final stages of development. The Partnership also owns property in a 730-acre Community known as the Jacksonville Golf and Country Club which is in its mid stage of development. (e) Atlanta, Georgia The Partnership owns properties in the Atlanta, Georgia area known as Water's Edge and Dockside, which are in their mid and final stages of development, respectively. (f) Highlands, North Carolina The Partnership owns a 600-acre Community near Highlands, North Carolina known as The Cullasaja Club. The Community is in its mid stage of development. At December 31, 1991, the Partnership owned a 50% joint venture interest in this Community; however, during 1992, the Partnership purchased its joint venture partner's 50% interest in the Community. Reference is made to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 7 for further discussion of this joint venture. (g) Other The Partnership also owns a 20% joint venture interest in a 4,000-acre Community, known as Coto de Caza, located in Southern Orange County, California. The Community is in its mid stage of development. At December 31, 1991, the Partnership was the managing partner and owned a 50% joint venture interest in the Community; however, during 1992 the Partnership's joint venture partner was reallocated an additional 30% interest in the venture and assumed the role of managing partner in exchange for funding the venture's future cash requirements. Reference is made to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 7 for further discussion of this joint venture. The Partnership also has joint venture interests in Mizner Court and Mizner Tower, located in Mizner Village, which consisted of 335 luxury condominium units in Palm Beach County, Florida, all of which were sold as of December 31, 1991. The Partnership also owns land zoned for commercial use in or near its Communities in Jacksonville, Boca Raton, Atlanta, Georgia and in its Weston Community. The Partnership also owns, either directly or through joint venture interests, various commercial and industrial sites and buildings in Sarasota, Tampa, Ocala, Pompano Beach and Palm Beach County, Florida which are not located in its residential Communities. At December 31, 1993, the joint venture with property in Pompano Beach was encumbered by mortgages in the aggregate principal amount of approximately $4 million. Reference is made to Note 11 for further discussion of this venture and its related indebtedness. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Partnership is involved in an Environmental Protection Agency (EPA) administrative enforcement proceeding with regard to the Partnership's Water's Edge property. The EPA has asserted that a dam built to create a lake at the Community during the time the property was owned by the Seller was in violation of Section 404 of the Clean Water Act in that certain wetlands areas had been filled. Pursuant to a Consent Agreement and Order entered into with the EPA, the Partnership acquired certain land (at a cost of approximately $400,000) for which it has developed and implemented a plan of mitigation for the wetlands lost. In accordance with certain provisions of the Consent Agreement and Order, the Partnership must provide the EPA with periodic reports regarding the status of the mitigation plan. An agreement in principle has been reached to settle the dispute between the parties pursuant to which the EPA has agreed to assess a civil penalty of $125,000. The Partnership cannot assure that the settlement agreement in fact will be consummated. The Partnership is actively pursuing indemnification from the Seller for the total costs that will ultimately be incurred to resolve this issue. There can be no assurance that the Partnership will be reimbursed by the Seller. The Partnership has been named as a defendant in a number of homeowner lawsuits, each of which has been filed in the Circuit Court of the 11th Judicial District for Dade County, Florida. Each of these suits allegedly in part arises out of or relates to Hurricane Andrew, which resulted in damage to, among other things, the Country Walk development in South Florida on August 24, 1992. A number of the homeowner lawsuits were brought by various plaintiffs in their individual capacity and other homeowner lawsuits were brought as purported class actions. In general, the complaints in the homeowner lawsuits allege that the various plaintiffs and plaintiff classes purchased and owned homes and/or condominiums located in the Country Walk development and that the damage or destruction suffered by such homes and/or condominiums as a result of Hurricane Andrew was beyond what should have been reasonably expected. The allegations further suggest that the damage caused by Hurricane Andrew was a result of the defendants' alleged defective design, construction, inspection and/or other improper conduct in connection with development, construction and sale of such homes and/or condominiums; that such misconduct on the part of the defendants constituted, among other things, violations of various building code provisions and breaches of express and implied warranties of merchant- ability and habitability, or constituted intentional tort, negligence, misrepresentation or fraudulent concealment, and caused personal injury. In addition, there are allegations of latent defects that were uncovered by Hurricane Andrew. The complaints allege that the Partnership is liable to the named plaintiffs and plaintiff classes either as a result of the Partnership's own acts of misconduct and/or as a result of the Partnership's purchase of the assets of the Seller and the stock of three of the Seller's subsidiaries in 1987 and the Partnership's subsequent marketing, management and development of the Country Walk development. The various named plaintiffs and purported plaintiff classes seek compensatory damages in varying and, in some cases, unspecified amounts, and other relief, including, in some of the actions, injunctive relief and/or punitive damages. The Partnership intends to vigorously defend itself in these lawsuits. In connection with its purchase of assets, including certain assets relating to the Country Walk development from the Seller, then a wholly-owned subsidiary of The Walt Disney Company ("Disney"), in September 1987, the Partnership obtained indemnification by Disney for certain liabilities relating to facts or circumstances arising or occurring prior to the closing of the Partnership's purchase of the assets. Over 80% of the Arvida-built homes in Country Walk were built prior to the Partnership's ownership of the Community. The Partnership has tendered each of the above-described lawsuits to Disney for defense and indemnification in whole or in part pursuant to the Partnership's indemnification rights. Where appropriate, the Partnership has also tendered these lawsuits to its various insurance carriers for defense and coverage. The Partnership is unable to determine at this time to what extent damages in these lawsuits, if any, against the Partnership, as well as the Partnership's cost of investigating and defending the lawsuits, will ultimately be recoverable by the Partnership either pursuant to its rights of indemnification by Disney or under contracts of insurance. The Partnership has negotiated the terms of a class action settlement with opposing counsel in one of the pending homeowners' lawsuits, which has the potential for resolving substantial portions of the pending homeowners' lawsuits which have been filed. On June 3, 1993, the Circuit Court of Dade County entered an order preliminarily finding that the Partnership's proposed class action settlement agreement, as revised, was within the range of what appeared to be a fair and adequate settlement of the claims filed by single- family homeowners and condominium owners at Country Walk. On August 10, 1993, the court issued a final order approving the class action settlement. The settlement, which is designed to resolve claims arising in connection with estate and patio homes and condominiums sold by the Partnership after September 10, 1987, is structured to compensate residents for losses not covered by insurance. Settlement amounts payable are a function of the type of unit involved and the claimant's proof regarding the adequacy of insurance proceeds. Settlement class members representing 188 units in Country Walk have accepted the settlement. Those who affirmatively rejected the offer may continue to litigate against the Partnership. The Partnership currently believes that the class action settlement may cost approximately $2.5 million. The settlement is being funded by one of the Partnership's insurers, subject to a reservation of rights. The amount of money, if any, which the insurance company may recover from the Partnership pursuant to its reservation of rights is uncertain. On February 24, 1994, the Partnership was dismissed from the pending class action homeowner lawsuits pursuant to the class action settlement. In addition, the Partnership has been informed that Disney and an insurer have reached agreements to settle five of the individual homeowner actions which were tendered by the Partnership to Disney ("Disney Settlements"). These Disney Settlements will be funded without any contribution from the Partnership. The Partnership can give no assurance that the Disney settlements will be finalized. As noted above, those homeowners who affirmatively rejected the offer of settlement may continue to litigate. The Partnership is currently a defendant in eleven lawsuits brought by condominium and patio homeowners, all of whom have declined to accept the terms of the class action settlement. These lawsuits, involving nineteen named individuals, are pending in the Circuit Court of Dade County. In these lawsuits, plaintiffs allege a variety of claims involving, among other things, breach of warranty, negligence and building code violations. The Partnership intends to vigorously defend itself in these matters. The Partnership has resolved a claim for construction related damages brought by the Villages of Country Walk Homeowners' Association, Inc., among others. Two of the Partnership's insurance carriers funded a settlement in the amount of $2,740,000 to resolve claims related to the construction of the common elements of the condominium units at Country Walk. One of the insurance carriers has issued a reservation of rights in connection with these claims and the extent to which that insurance company may ultimately recover any of these proceeds from the Partnership is unknown. On April 19, 1993, a subrogation claim entitled Village Homes At Country Walk Master Maintenance Association, Inc. v. Arvida Corporation et al., was filed in the 11th Judicial Circuit for Dade County. Plaintiffs filed this suit for the use and benefit of American Reliance Insurance Company ("American Reliance"). Plaintiffs seek to recover damages and pre- and post-judgment interest in connection with $10,873,000 American Reliance has allegedly paid to its insureds living in condominium units at Country Walk in the wake of Hurricane Andrew. Disney is also a defendant in this suit. On July 1, 1993, a subrogation lawsuit entitled Prudential Property and Casualty Company v. Arvida/JMB Partners, et al., was filed in the 11th Judicial Circuit for Dade County. Plaintiff seeks to recover damages, costs, and interest in connection with $16,679,622 Prudential allegedly paid to its insureds living in Country Walk at the time of Hurricane Andrew. Disney is also a defendant in this suit. On July 15, 1993, a subrogation lawsuit entitled Allstate Insurance Company v. Arvida/JMB Partners, et al., was filed in the 11th Judicial Circuit for Dade County. Plaintiff seeks to recover damages, costs, and interest in connection with $18,540,196 Allstate allegedly paid to its insureds living in Country Walk at the time of Hurricane Andrew. Disney is also a defendant in this suit. The Partnership settled a threatened subrogation action by State Farm Insurance Company. The settlement was funded by one of the Partnership's insurance carriers subject to a reservation of rights. The amount of money the insurance carrier may seek to recover from the Partnership for this and any other settlements it has funded is uncertain. The Partnership is a defendant in and anticipates other subrogation claims by insurance companies which have allegedly paid policy benefits to Country Walk residents. The Partnership intends to defend itself vigorously in all such matters. On October 13, 1993, a lawsuit captioned Berry v. Merril (sic) Lynch, Pierce Fenner & Smith, J&B Arvida Limited Partnership (sic) and Does 1 through 100, was filed in the Superior Court of the State of California in and for the County of San Diego, Case No. 669709. The lawsuit was purportedly filed as a class action on behalf of the named plaintiffs and all other persons or entities in the State of California who bought or acquired, directly or indirectly, limited partnership interests ("Interests") in the Partnership from September 1, 1987 through the present. The complaint in the action alleges, among other things, that the defendants made misrepresentations and concealed various facts, breached fiduciary duties, and violated the covenant of good faith in connection with the sale of Interests in the Partnership. The complaint further alleges that such conduct violated California state law relating to fraud, breach of fiduciary duty, willful suppression of facts, and breach of the covenant of good faith. Plaintiffs, on behalf of themselves and the purported plaintiff class, seek unspecified compensatory damages, consequential damages, punitive and exemplary damages, interest, costs of the suit, and such other relief as the court may order. The Partnership believes that the lawsuit is without merit and intends to vigorously defend itself. Other than as described above, the Partnership is not subject to any material pending legal proceedings, other than ordinary routine litigation incidental to the business of the Partnership. Reference is made to Note 2 regarding certain other litigation involving the Partnership. Reference is also made to Note 11 for a discussion of certain claims by Merrill Lynch for indemnification by the Partnership and the General Partner against losses and expenses that may be suffered by Merrill Lynch relating to claims for arbitration asserted against it by certain investors in the Partnership. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during 1992 and 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE PARTNERSHIP'S LIMITED PARTNERSHIP INTERESTS AND RELATED SECURITY HOLDER MATTERS As of December 31, 1993, there were 27,001 record Holders of Interests of the Partnership. There is no public market for Interests, and it is not anticipated that a public market for Interests will develop. Upon request, the General Partner may provide information relating to a prospective transfer of Interests to an investor desiring to transfer his Interests. The price to be paid for the Interests, as well as any other economic aspects of the transaction, will be subject to negotiation by the investor. However, there are restrictions governing the transferability of these Interests as described in "Transferability of Partnership Interests" on pages A-31 to A-33 of the Partnership Agreement and limitations on the rights of assignees of Holders of Interests as described in Sections 3 and 4 of the Assignment Agreement which are hereby incorporated by reference to Exhibits 3 and 4.0, respectively, of the Partnership's Report on Form 10-K dated March 29, 1993 (File No. 0-16976). Reference is made to Item 1. Business for a discussion of the election to be made by the General Partner with respect to causing a listing of Interests on a national exchange, purchasing or causing an affiliate to purchase all of the Interests at their then appraised fair market value, or commencing a liquidation of all of the Partnership's assets. Reference is made to Item 6. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993 and 1992, the Partnership had cash and cash equivalents of approximately $18,907,000 and $7,634,000, respectively. Such funds were available for debt service, working capital requirements and distributions to partners. The favorable variance in cash and cash equivalents at December 31, 1993 as compared to 1992 is due to an increase in cash generated from operating activities due primarily to an overall increase in sales activity, as well as an increase in net cash proceeds received from the Partnership's joint ventures in 1993 as compared to 1992. The source of both short-term and long-term future liquidity is expected to be derived primarily from the sale of housing units, homesites and land parcels and through the Partnership's credit facilities, which are discussed below. In October 1992, the Partnership and its lenders executed a binding agreement to restructure the Partnership's credit facility. The new facility consists of a term loan in the amount of $126,805,195, a revolving line of credit facility up to $45 million, an income property term loan of $20 million and a $15 million letter of credit facility. The term loan, the revolving line of credit and the letter of credit facility are secured by recorded mortgages and security interests on all otherwise unencumbered tangible assets of the Partnership as well as an assignment of all mortgages receivable, equity memberships, certain joint venture interests or proceeds from joint ventures, and cash balances (with the exception of deposits held in escrow). The income property term loan is secured by the recorded first mortgages on a mixed-use center and an office building in Boca Raton, Florida. All of the notes under the new facility are cross-collateralized and cross-defaulted. The Partnership made the required principal repayments under the new term loan agreement of $8 million and $10 million in February 1993 and March 1994, respectively. Principal repayments of $10 million are due in each of the years 1995 and 1996, and the remaining balance outstanding is due in 1997. In addition, the new term loan agreement provides for additional principal repayments based upon a specified percentage of available cash flow and upon the sale of certain assets. For the year ended December 31, 1993, the Partnership made additional term loan payments totalling approximately $10.5 million. Under the new income property term loan, monthly principal and interest payments are required to be paid on a 25-year amortization schedule with the remaining balance outstanding due in July 1994. The revolving line of credit and the letter of credit facility also mature in July 1994. The Partnership is in the process of negotiating a renewal of its credit facilities. Although the Partnership is hopeful these renewals will be obtained, there can be no assurance that such will occur or that the terms, amounts and restrictions of the renewed credit facilities will be similar to those under the Partnership's existing facilities. As of December 31, 1993, all available term loan proceeds had been borrowed, however, $45 million was available under the revolving line of credit facility, subject to certain loan covenant restrictions. Reference is made to Note 8 for further discussion of the Partnership's credit facility. The facility contains significant restrictions with respect to the payment of distributions to partners, the maintenance of certain loan-to-value ratios, the use of proceeds from the sale of the Partnership's assets, and advances to the Partnership's joint ventures. Other than the uncertainty surrounding the funding of any required joint venture advances, which require the lenders' approval, and subject to the successful renewal of the Partnership's credit facilities as discussed above, the Partnership believes that the current and expected future liquidity and capital resources of the Partnership, including its restructured bank credit facilities, generally should be adequate to fund currently expected short and long-term capital requirements for development and other costs of operations. During November 1993, the Partnership received a commitment from a lender for a $24 million revolving construction line of credit for the first building and certain amenities within the Partnership's new condominium project on Longboat Key, Florida known as Grand Bay. This line of credit was subsequently executed on January 14, 1994. The line of credit bears interest at the lender's prime rate plus 3/4% and matures January 14, 1996. See Note 15 for further discussion regarding this line of credit. A statement of cash flows is required under generally accepted accounting principles that classifies cash receipts and disbursements according to whether they result from operating, investing or financing activities as those terms are defined in Statement of Financial Accounting Standards No. 95. On a cumulative basis, the Partnership has paid distributions from operating, investing and financing activities. At December 31, 1991, the Partnership owned a 50% joint venture interest in the Cullasaja Community. The operations of the venture require periodic cash advances from the partners. Since the fourth quarter of 1990, the Partnership has funded the cash deficits of the venture in their entirety. As a result, during July 1992, the Partnership purchased its joint venture partner's 50% interest in the Community. The Partnership was not required to make any cash payment to the joint venture partner for its interest. Instead, the purchase price of such interest is in the form of subordinated non- recourse promissory notes (the "Notes"), the payment of which is solely contingent upon the ultimate net cash flow generated by the venture. The Notes are subordinated to the repayment of the outstanding first mortgage loan and certain advances, plus accrued interest thereon, made to the venture by the partners. To the extent the Partnership has funded 100% of the venture's cash deficits in the past or advances new funds, the repayment of such advances, plus accrued interest thereon, is senior to the repayment of funds previously advanced by both partners. A portion of the cash flow remaining after payment of all senior indebtedness is to be applied annually against the principal and interest (at 10% per annum) owed on the Notes. This agreement was pursued as a more favorable alternative to the remedies included in the previously existing joint venture agreement for situations in which the partners advance unequal funds to the venture. As a result of this transaction, the Partnership changed from the equity method of accounting to the consolidated method of accounting for the joint venture effective January 1, 1992, resulting in a net increase in the Partnership's balance sheet of approximately $12.1 million at that date. Certain of the Partnership's property within the Cullasaja Community is encumbered by a mortgage note with an outstanding balance of approximately $5.4 million at December 31, 1993. The note has a maturity date of March 1, 1994 and bears interest at prime (6% at December 31, 1993) plus 1.25% per annum, payable monthly. The Partnership is currently seeking an extension of this loan. However, there can be no assurance that the Partnership can obtain an extension. The Partnership is required to make repayments on the note in accordance with a homesite lot release provision of $72,750 per lot at closing. The note is collateralized by a first mortgage on certain real estate inventories and 12.5% of the outstanding balance is guaranteed by the Partnership. The Coto de Caza joint venture had utilized the maximum amount available under its operating line of credit and had been seeking alternative financing sources to fund the significant additional cash necessary to continue development of the project and to fund other joint venture operating costs. In the interim, the Partnership and its joint venture partner had each advanced approximately $3.1 million, net of reimbursements, to the joint venture during 1991 and an additional $1.0 million during the first five months of 1992. Given the weak market conditions in Orange County, California and the continued lack of development financing available from traditional lending sources, it was unlikely that the joint venture would be able to secure additional financing in the near term. The Partnership's joint venture partner was willing to continue to advance funds to meet the venture's operating needs. The Partnership determined that it was in its best long-term interest to utilize its capital for the development of its other properties rather than commit additional funds for the development of the Coto de Caza Community. As a result, the venture partner has funded the venture's cash deficits in their entirety since June 1, 1992. As an alternative to advancing funds for the venture's future capital requirements, the Partnership and its joint venture partner amended the joint venture agreement, effective September 15, 1992, and reallocated ownership interests. In exchange for funding the venture's future operating needs, the venture partner was reallocated an additional 30% interest in the venture, and assumed the role of managing general partner. As such, the venture partner has control over the future operations of the Community, including the timing and extent of its development. The Partnership retains a 20% limited partnership interest and is entitled to receive distributions from net cash flow, after repayment of third party loans and advances made by the venture partners, up to an amount agreed upon by the Partnership and its joint venture partner. Certain specified costs and liabilities incurred prior to the reallocation will continue to be shared equally by the Partnership and its joint venture partner. This agreement was pursued as a more favorable alternative to the provisions included in the existing joint venture agreement for reallocation of partnership interests should both partners not advance equal funds to the venture. As a result of the Partnership's decrease in its ownership interest, and its joint venture partner's control over the future operations of the Community, commencing on September 15, 1992, the Partnership accounts for its share of the operations of the Coto de Caza joint venture in accordance with the cost method of accounting. During 1992, the Partnership sold 60% of its interest in two land parcels located in the Weston Community to unaffiliated third-party purchasers. Subsequent to these transactions, the Partnership and the purchasers each contributed their interests in these land parcels to two joint ventures which were established for the purpose of constructing housing products within Weston. The Partnership entered into development management agreements with these joint ventures. Pursuant to the terms of these agreements, the Partnership has agreed to fund all development and construction costs, as well as certain overheads, incurred on behalf of the joint ventures' projects. Amounts funded are to be reimbursed by the joint ventures from sales revenues generated by each joint venture. Amounts advanced by the Partnership to each respective joint venture earn interest at 8.5% for the first year and prime (6.0% at December 31, 1993) plus 2% per annum thereafter. During the first quarter of 1993, one of the joint ventures obtained project specific financing in the amount of $4,950,000 to fund its development and construction activities. In accordance with the provisions of this financing agreement, as of December 31, 1993, the Partnership had been reimbursed the majority of amounts previously advanced to the joint venture. As a result of this financing arrangement, the Partnership does not anticipate the need for future advances to this venture. Due to significant sales activity, amounts previously advanced to the Partnership's other joint venture were reimbursed in full as of December 31, 1993. These reimbursements are the primary reasons for the decrease in investments in and advances to joint ventures on the accompanying consolidated balance sheets from December 31, 1992 to December 31, 1993. Also contributing to the decrease in investments in and advances to joint ventures on the accompanying consolidated balance sheets at December 31, 1993 as compared to December 31, 1992 is the receipt of distributions from these joint ventures in the amount of $2.6 million, as well as $0.8 million and $0.3 million of distributions from the Mizner Tower and Mizner Court joint ventures, respectively. In anticipation of its future development plans, the Partnership is currently in the process of obtaining permits for development of Increment III of its Weston Community, portions of which are environmentally sensitive areas and are subject to protection as wetlands. The time involved to complete this process, which involves the approvals of the Army Corps of Engineers, the Environmental Protection Agency and comparable state and local regulatory agencies, is expected to be lengthy. It is anticipated that certain costs of mitigation will be incurred in conjunction with obtaining the necessary permits, the amount and extent of which are unknown at this time. The Partnership had previously gone through a similar process and was successful in obtaining approvals for Increment II of the Weston Community. Although there can be no assurance, given the Partnership's prior experience and discussions to date with the appropriate agencies, the Partnership is hopeful that a compromise will ultimately be reached that will adequately address the concerns of the environmental agencies, while allowing the Partnership to continue its development plans for Increment III of Weston. In June 1993, the Partnership executed an agreement with Equitable South Florida Venture ("Equitable"), the successor in interest to Tishman Speyer/Equitable South Florida Venture, the original purchaser of approximately 390 acres of land in Increment III of the Partnership's Weston Community, whereby, in exchange for $5.0 million, the Partnership repurchased approximately 330 acres of the land and Equitable agreed to relieve the Partnership of the obligations under certain provisions of the Sale and Purchase Agreement dated December 15, 1983, which were assumed by the Partnership in connection with the purchase of the assets of Arvida Corporation in September 1987. Of the agreed upon price of $5 million, $2.5 million was paid at the execution of the agreement and the balance of $2.5 million will be paid in equal annual installments of $500,000 together with interest thereon at 8% per annum beginning May 1994. The unpaid principal balance is secured by a mortgage on certain real estate located in the Weston Community. As part of its efforts to obtain the appropriate development permits discussed in the preceding paragraph, the Partnership has included this land as part of its proposed mitigation plan for the development of Increment III of its Weston Community. The Partnership owned an 80% general partnership interest in The Oaks Community located near Sarasota, Florida. During the fourth quarter of 1991, the Partnership's joint venture partner failed to make capital contributions required to fund ongoing operations and pursuant to the joint venture agreement, was in default of the agreement. The Partnership executed an agreement in August 1993 with its joint venture partner, CIS Oaks, Ltd., ("CIS"), whereby CIS assigned its 20% interest in The Oaks to the Partnership, thereby vesting 100% control of the assets of the joint venture in the Partnership. Certain of the assets of The Oaks joint venture were encumbered by two mortgage loans. A $12,492,200 loan was scheduled to mature in January 1997 and a $3,260,000 loan was scheduled to mature in December 1993. The joint venture had guaranteed $2.7 million of the loans, and the guaranteed amount was with recourse to the Partnership. The joint venture was in default under the terms of these loan agreements as a result of its failure to make principal payments of approximately $1.3 million in January 1993 to release the minimum number of homesite lots as required under these agreements and its failure to pay interest commencing with a payment due in April 1993. The Partnership was able to reach an agreement with its lenders to pay off the existing mortgage loans at a substantial discount from face value. On September 3, 1993, the Partnership paid the joint venture's lenders $6.7 million in full satisfaction of the outstanding mortgage loans, accrued interest and guaranty. This transaction contributed to the decrease in notes and mortgages payable at December 31, 1993 as compared to December 31, 1992 and is the cause of the approximate $9.5 million extraordinary gain on the early extinguishment of debt for the year ended December 31, 1993. The Partnership also sold its remaining land holdings in The Oaks Community and its interest in The Oaks Club, an equity club, to an unaffiliated third-party purchaser for $5.8 million. This sale transaction occurred simultaneously with the repayment of the loans and satisfaction of the mortgages, as discussed above. These transactions are the cause of various changes in the Consolidated Balance Sheets at December 31, 1993 as compared to December 31, 1992. In light of the Partnership's guarantee under the loan agreement of $2.7 million of the outstanding mortgage loans, as well as other factors, these transactions were pursued as the least costly alternative available to the Partnership. These transactions resulted in a minimal net gain for Federal income tax purposes. During the first quarter of 1993, the Partnership reached a settlement agreement with its joint venture partner in a property located in Ocala, Florida, whereby in exchange for its partner's 50% interest in the venture, the Partnership agreed to dismiss a lawsuit previously filed against its venture partner for failure to perform in accordance with the terms of a $1,600,000 note which had been issued to the Partnership by the joint venture. This agreement was pursued as a more favorable remedy to other alternatives available to the Partnership. As a result of this transaction, the Partnership changed from the equity method of accounting to the consolidated method of accounting for the joint venture effective March 1, 1993. This consolidation contributes to the decrease in mortgages receivable at December 31, 1993 as compared to December 31, 1992. During October 1993, the Partnership closed on the sale of its Oak Bridge Club near Jacksonville, Florida to an unaffiliated third party for approximately $3.2 million. This is the primary cause for the decrease in property and equipment in the Consolidated Balance Sheets at December 31, 1993 as compared to December 31, 1992. Reference is made to Note 11 regarding the Partnership's financial guarantees pursuant to the terms of a loan agreement for a commercial/industrial joint venture in Pompano Beach, Florida in which the Partnership owns a 50% interest. The Partnership also has certain continuing obligations relative to this joint venture as referred to in such Note. Reference is made to Item 3. Legal Proceedings of this annual report for a discussion of several lawsuits, in which the Partnership is a defendant, allegedly arising out of or relating to Hurricane Andrew and certain property damage allegedly suffered by the plaintiffs at a previously developed community known as Country Walk. During 1991, the Partnership obtained project specific financing in the amount of $7 million on a retail shopping plaza located in the Partnership's Weston Community. Subsequent to this transaction, the Partnership contributed the assets and related indebtedness associated with the plaza to a joint venture and sold a 21% interest in the venture to an unaffiliated third-party. In July 1991, the Partnership converted the Weston Hills Country Club (the "Club") from an equity to a non-equity membership plan in an effort to increase membership and usage of the Club and stimulate sales momentum within the Community. In addition, during 1991 the Partnership closed on the sale of a land parcel in its Broken Sound Community to an unaffiliated third-party builder in conjunction with the repurchase of a land parcel in the Partnership's Weston Community from the same builder. This transaction will alter the timing and amount of expected future revenues. The Partnership's obligations under bonds and standby letters of credit have decreased approximately $13.9 million since December 31, 1992 primarily due to decreased development and construction activity at the Partnership's Broken Sound Community and the release of obligations related to the land repurchased by the Partnership in its Weston Community, as discussed above. The Partnership has been advised by Merrill Lynch that Merrill Lynch has been named a defendant in actions pending in the Eleventh and Seventeenth Judicial Circuit Courts in Dade and Broward Counties, Florida to compel arbitration of claims brought by certain investors of the Partnership representing approximately 4% of the total Interests outstanding. Merrill Lynch has asked the Partnership and its General Partner to confirm an obligation of the Partnership and its General Partner to indemnify Merrill Lynch in these claims against all loss, liability, claim, damage and expense, including without limitation attorney's fees and expenses, under the terms of a certain Agency Agreement dated September 15, 1987 ("Agency Agreement") with the Partnership relating to the sale of Interests in the Partnership through Merrill Lynch on behalf of the Partnership. The Partnership is unable to determine at this time the ultimate investment of investors who have filed arbitration claims as to which Merrill Lynch might seek indemnification in the future. At this time, and based upon the information presently available about the arbitration statements of claims filed by some of these investors, the Partnership and its General Partner believe that they have meritorious defenses to demands for indemnification made by Merrill Lynch and intend to vigorously pursue such defenses. In the event Merrill Lynch is entitled to indemnification of its attorney's fees and expenses or other losses and expenses, these amount may prove to be material. RESULTS OF OPERATIONS The results of operations for the years ended December 31, 1993, 1992 and 1991 are primarily attributable to the development and sale or operation of the Partnership's assets. See Note 1 for a discussion regarding the recognition of profit from sales of real estate. Housing revenues are generated from the sale of homes within the Partnership's Communities. Housing revenues increased significantly for the year ended December 31, 1993 as compared to 1992 due primarily to increased sales activity at the Partnership's Weston, Broken Sound and Jacksonville Golf & Country Club Communities as well as the completion and close-out of the Partnership's Marina Bay condominium project on Longboat Key, Florida. In an effort to capture additional market share in Broward County, Florida, the Partnership introduced several new value-oriented products in Weston in late 1992 and early 1993. The success of these products contributed to the increased closings in Weston and the overall increase in revenues for the year ended December 31, 1993 as compared to 1992. Revenues increased at Broken Sound and Jacksonville Golf & Country Club due to new products introduced in late 1992 which had their initial closings in 1993. Housing revenues increased for the year ended December 31, 1992 as compared to 1991 due primarily to an increase in sales activity at the Partnership's Broken Sound and River Hills Communities. The increase in revenues at Broken Sound is due to the sale of a new product line first offered in 1992, as well as an increase during 1992, as compared to 1991, in sales volume of another housing product offered at the Community. The increase in activity at the River Hills Community was due primarily to the broader market appeal of the Partnership's new lower-priced, value-oriented products. Approximately 63% of 1993's housing revenues were generated during the fourth quarter. This substantial increase in revenues was due primarily to an increase in the demand for housing product in Weston combined with the introduction of several new value oriented products in this Community earlier in the year. Also contributing to the increase in revenues during the fourth quarter of 1993 was the completion and close-out of all of the units in the final phase of the Partnership's Marina Bay condominium project on Long Boat Key, Florida in November and December 1993. The gross operating profit from housing sales increased for the year ended December 31, 1993 as compared to 1992 due primarily to the mix of product sold at the Partnership's Weston and Broken Sound Communities. The increase in gross operating profits is also attributable to higher profit margins recognized from the final phase of Marina Bay on Longboat Key, Florida. These closings generated increased revenues due to the desirable location of the final building. Revenues from the sale of homesites include amounts earned from the sale of developed lots within the Partnership's Communities. Revenues from the sale of homesites increased for the year ended December 31, 1993 as compared to the same period in 1992 due to the initial closing of lots in several homesite projects introduced early in 1993 in the Weston Hills Country Club section of the Partnership's Weston Community. Also contributing to the favorable variance was the closing of the remaining lots held for sale by the Partnership on Longboat Key, Florida during September 1993. This favorable variance was partially offset by decreased revenues at the Partnership's Broken Sound Community due to the close-out of the final homesites in that Community in 1992. Revenues from homesite sales activities were higher for the year ended December 31, 1992 as compared to 1991 due primarily to an increase in closings at the Partnership's Weston and River Hills Communities. The increased activity was primarily attributable to the introduction of several new products within these Communities in 1992. This favorable volume variance was partially offset by decreased closing activity associated with certain product lines which were substantially or completely sold out in 1991, as well as decreased closing activity at one of the Partnership's Atlanta Communities. In an effort to stimulate sales activity at one of the Atlanta Communities, the Partnership is offering lower-priced homesites more consistent with market demand. Land and property revenues are generated from the sale of developed and undeveloped residential or commercial land tracts, as well as the sale of equity memberships in the clubs within the Partnership's Boca Raton, Florida Community, as well as its Communities near Jacksonville, Florida and Highlands, North Carolina. Revenues from land and property sales increased for the year ended December 31, 1993 primarily as a result of the sale of the remaining real estate and equity memberships at the Partnership's Oaks Community. See further discussion regarding this transaction in Liquidity and Capital Resources, above. In addition, the Partnership closed on the sale of the Oak Bridge Club near Jacksonville, Florida to an unaffiliated third-party purchaser in October 1993. The sale of this club also contributed to the increase in land and property revenues for 1993 as compared to 1992. The increase in the gross operating profit from land and property sales in 1993 as compared to 1992 is due primarily to the recognition of deferred revenues in 1993 for sales, primarily at Broken Sound and Weston, which previously did not meet the criteria for revenue recognition in accordance with generally accepted accounting principles ("GAAP"). This increase was partially offset, however, by the sale of the remaining real estate and equity memberships at the Partnership's Oaks Community. Certain sales transactions which closed in previous periods but did not meet the criteria for revenue recognition remain deferred at December 31, 1993, and profit will be recognized in future periods as these sales become eligible for revenue recognition in accordance with GAAP. Land and property revenues decreased for the year ended December 31, 1992 as compared to 1991. Land and property revenues in 1992 resulted primarily from the sale of a 17-acre single family residential parcel located in the Partnership's Weston Community, the sale of 60% of the Partnership's interest in two residential land parcels also located in the Weston Community, and the sale of approximately 21 acres of undeveloped residential land located in the Partnership's Broken Sound Community. Certain of these residential sales transactions legally closed in 1992 but were not eligible for accounting profit recognition during the year due to certain contract provisions. However, certain amounts which had been deferred in previous years became eligible for profit recognition in 1992 and are included in 1992 land and property revenues. Sales of undeveloped commercial tracts in 1992 include approximately four acres located in Palm Beach County, Florida, and approximately nine acres located on Longboat Key, Florida. Land and property revenues for the year ended December 31, 1991 resulted primarily from the sale of a 28-acre multi-family residential parcel and a 16-acre single family residential parcel in Palm Beach County, Florida, as well as an 18-acre multi- family residential parcel located in one of the Partnership's Jacksonville Communities. Revenues from the sale of equity memberships decreased in 1992 as compared to 1991 due primarily to the inclusion in 1991 of profits related to the sales of Broken Sound equity memberships which had previously been deferred for accounting purposes. The recognition of these deferred profits in 1991 is the primary cause for the decrease in the net margin from land and property sales in 1992 as compared to 1991. Costs of revenues pertaining to the Partnership's housing sales reflect the cost of the acquired assets as well as development and construction expenditures, certain capitalized overhead costs, capitalized interest and marketing and disposition costs. The costs related to the Partnership's homesite sales reflect the cost of the acquired assets, related development expenditures, certain capitalized overhead costs, capitalized interest and disposition costs. Land and property costs reflect the cost of the acquired assets, certain development costs and related disposition costs as well as the costs associated with the sale of equity memberships. Operating properties represents activity from the Partnership's club and hotel operations, commercial properties and certain other operating assets. Revenues generated by the Partnership's operating properties increased for the year ended December 31, 1993 as compared to 1992 primarily as a result of an increase in membership activity at the Partnership's club facilities in Weston resulting from the overall increase in home sales activity within that Community. In addition, revenues from the Partnership's cable operations in Broken Sound and Weston increased during the year ended December 31, 1993 as compared to 1992 resulting from an increase in the number of cable subscribers within those Communities as well as a change in the cable rate structure. The decrease in the negative net margins for 1993 as compared to 1992 is due primarily to cost reductions implemented at the Partnership's club and hotel operations coupled with an overall increase in revenues from these operations. The Partnership continues to evaluate the operations of its club and hotel facilities and institute additional cost controls as deemed appropriate. The decrease in the negative margins generated from operating properties for the year ended December 31, 1992 as compared to 1991 was primarily the result of increased operating revenues combined with reductions in certain overheads and other operating costs at the Partnership's hotel operation and at several of the Partnership's clubs and commercial and retail operating properties. These favorable variances are partially offset, however, by the inclusion of the funding of deficits for the Cullasaja Club during 1992 resulting from the consolidation of the assets of the Cullasaja Joint Venture, as discussed above in Liquidity and Capital Resources. Contributing to the improvement in the 1992 net margins as compared to 1991 was the inclusion in 1991 of certain costs associated with the conversion of the Weston Hills Country Club from an equity to a non-equity club. Brokerage and other operations represents activity from the resale of real estate inside and outside the Partnership's Communities, activity from the sale of builders' homes within the Partnership's Communities, proceeds from the Partnership's property management activities as well as fees earned from various management agreements with joint ventures. The increase in revenues and the corresponding increase in the gross operating profit from brokerage and other operations for the year ended December 31, 1993 as compared to 1992 was attributable to an increase in the volume of resale activity, primarily in the Sarasota, Broward County and Palm Beach County, Florida areas, as well as a decrease in the related cost of revenues resulting from a reduction in commissions paid due to a modification of the Partnership's brokerage commission structure. The increase in revenues and gross operating profit from brokerage and other operations at December 31, 1992 as compared to 1991 is due primarily to an increase in commissions earned by the Partnership from the sale of builder units, primarily at the Partnership's Weston and Broken Sound Communities, as well as the reduction of commissions associated with the sale of these units. Also contributing to the improved margins is the increase in the volume of resale activity in the Weston Community as well as the Jacksonville and Palm Beach County areas. Selling, general and administrative expenses include all marketing costs, with the exception of those costs capitalized in conjunction with the construction of housing units, and project and general administrative costs. These expenses are net of the marketing fees earned from third-party builders. Selling, general and administrative expenses were significantly lower for the year ended December 31, 1993 as compared to 1992. The significant reductions in selling, general and administrative costs during the past three years are attributable to the implementation of a series of overhead reductions including the consolidation of certain administrative functions, a reduction in the number of employees and other employee-related expenditures, the implementation of more cost-effective marketing programs, as well as an overall reduction of other administrative expenses. The favorable variance in selling, general and administrative expenses for the year ended December 31, 1993 as compared to 1992 is also due in part to an increase in marketing fees earned by the Partnership as a result of the increase in builder unit closings. Management will continue to evaluate the operations of the Partnership and institute additional cost controls as deemed necessary to maximize the Partnership's profits in the future. Charges to the carrying value of real estate inventories and other assets represent adjustments to the book values of the Partnership's projects based upon the analysis of each projects' estimated selling price in the ordinary course of business less estimated costs of completion, holding and disposal as compared to its recorded book value. At December 31, 1992, the Partnership recorded charges to the inventory carrying values of certain residential and commercial properties totalling approximately $12.2 million to reflect their estimated net realizable values as determined by management's evaluation of these properties. These charges include approximately $7.4 million to reduce the carrying values of the Partnership's Water's Edge and Dockside Communities located near Atlanta, Georgia and $1.8 million to reduce the carrying value of its River Hills Community in Tampa, Florida. These Communities had been experiencing slower sales absorptions than anticipated due to the pricing of current products not being in line with current market demand. The charges to the inventory carrying values result from the Partnership's plans to offer lower-priced homesite and housing products in these Communities which are more consistent with market demand. The Partnership did reduce the price of homesites in the Water's Edge and Dockside Communities as planned; however, during 1993, the Partnership experienced no significant increase in sales absorptions in these Communities. Recent market studies indicate that the housing product offered for sale by third-party builders in Water's Edge and Dockside continues to be priced higher than market, and further reductions of housing sales prices are warranted. Therefore, during the second quarter of 1993, the Partnership recorded an additional charge totalling approximately $4.9 million to the inventory carrying value of the Water's Edge and Dockside Communities to reflect the adverse impact of these additional reductions in housing prices on future anticipated lot values. In light of the circumstances surrounding The Oaks joint venture as discussed in Liquidity and Capital Resources above, the Partnership, as a matter of prudent accounting practice, recorded a charge to the carrying value of real estate inventories and equity memberships of approximately $2.3 million and $1.0 million, respectively, in the fourth quarter of 1992 to properly reflect the estimated market value of The Oaks property in its current state of development assuming a bulk sale of the entire property under present market conditions. The balance of the charges to reduce real estate inventories at December 31, 1992, totalling approximately $0.7 million, were recorded to reflect the then current market value of several parcels of undeveloped commercial real estate. In the fourth quarter of 1992, the Partnership recorded an approximate $3.4 million charge to the net book value of property and equipment to reflect the reduction in the values of a 29,000 square foot office building located in Palm Beach County, Florida and the golf and country club facility at the Partnership's River Hills Community. The value of the golf and country club facility at River Hills had been adversely impacted by the introduction of new lower-priced products within the Community, which are more in line with market demand, as well as overall economic conditions and the competition from other club facilities within the Tampa, Florida area. The Partnership owns interests in a number of commercial joint ventures located throughout Florida. Due to a significant decline in the demand for undeveloped commercial real estate in the markets in which these properties are located, in 1992 the respective joint ventures recorded charges to the carrying values of their real estate inventories of approximately $7.4 million to reflect their estimated net realizable values. The amenities within the Partnership's Jacksonville Golf and Country Club and Broken Sound Communities are conveyed to homeowners through the sale of equity memberships. The sales of memberships in Jacksonville Golf and Country Club have been adversely impacted during the past several years by the introduction of lower-priced products within the Community in response to market conditions as well as competition from other club facilities located in the Jacksonville area. At Broken Sound, the higher-priced equity memberships had experienced a slowdown in absorptions due primarily to the overall slowdown in the economy and the low levels of consumer confidence. As a result of the above, in 1992 the Partnership recorded charges to the carrying value of its equity memberships at Jacksonville Golf and Country Club and Broken Sound of approximately $2.2 million and $1.0 million, respectively. In addition, equity memberships also included a $1.0 million reduction in the value of The Oaks country club's equity memberships as discussed above. Charges to the carrying value of real estate inventories and other assets during 1991 consisted of a charge to income of approximately $1.4 million to reduce the carrying value of the Partnership's interest in a commercial joint venture located in Tampa, Florida. Also included in 1991, was an approximate $0.7 million charge to the carrying value of housing product offered for sale in the Partnership's River Hills Community due to the decision to replace a higher-priced product line with a new lower-priced product more in line with market demand. In addition, the Partnership reduced the carrying value of an undeveloped land parcel held for sale in Jacksonville, Florida. Interest income decreased for the year ended December 31, 1993 as compared to 1992 primarily due to an overall decrease in the average amounts invested in short-term instruments during 1993 as compared to 1992. Interest income decreased in 1992 in comparison to 1991 primarily as a result of the Partnership's purchase of its venture partner's interest in the Cullasaja Joint Venture and the resulting consolidation of the venture's operations. Interest income at December 31, 1991 includes interest earned on advances previously made by the Partnership to the joint venture. Also contributing to the decrease in interest income is the Partnership's decision to reserve interest income accrued on advances to the Coto de Caza Joint Venture. Reference is made to the Liquidity and Capital Resources section above for further discussion concerning the Partnership's ownership interest in the Coto de Caza joint venture. Equity in earnings of unconsolidated joint ventures increased for the year ended December 31, 1993 as compared to the same periods in 1992 due to the change from the equity to the cost method of accounting for the Partnership's investment in the Coto de Caza joint venture, which resulted in the Partnership no longer recording its ownership share of the loss from the Coto de Caza venture's operations. See Liquidity and Capital Resources above for further discussion of the change in ownership of the Coto de Caza joint venture. The increase was also attributable to the earnings generated from the two joint ventures formed during the second half of 1992 for the purpose of constructing homes within the Partnership's Weston Community. See Liquidity and Capital Resources above and Notes 1 and 7 for further discussion regarding these joint venture interests. The increase in equity in losses of unconsolidated ventures in 1992 in comparison to 1991 is due primarily to the Partnership's ownership interest in the Coto de Caza joint venture. Increased operating losses were generated by the Coto de Caza joint venture primarily due to the expensing of costs that previously qualified for capitalization. In addition, interest income earned by the joint venture decreased in comparison to 1991 due to the sale of the venture's mortgage portfolio in the fourth quarter of 1991. The increase in losses during 1992 is also attributable to the Partnership's ownership interest in a commercial joint venture located in Ocala, Florida. This venture's 1991 results of operations included profits from land sale activity, while no land sales occurred for this venture in 1992. These unfavorable variances were partially offset by the Partnership's interest in the Cullasaja joint venture's losses no longer being included in equity in losses of unconsolidated ventures due to the purchase in 1992 of the joint venture partner's interest in the venture. The results of operations for Cullasaja since that purchase have been consolidated in the accompanying Consolidated Statement of Operations. Interest and real estate taxes decreased for the year ended December 31, 1993 as compared to 1992 due to an overall decrease in the Partnership's average debt balance outstanding and an increase in the amount of real estate inventories which meet the requirements for capitalization of these costs. Nationwide housing starts and total nationwide single-family permits for 1993 increased 7.1 %* and 10.3%**, respectively from 1992. Trends in housing permits for the major markets in which the Partnership's properties are located are shown below. % CHANGE FROM ------------------------------------------ HOUSING PERMITS (SINGLE FAMILY)** 1992-1993 1991-1992 1990-1991 1989-1990 ------------------ --------- --------- --------- --------- Florida Markets: West Palm Beach (includes Boca Raton). +9.4% +22.6% -7.5% -47.7% Miami - Ft. Lauderdale . +27.4% +34.8% -14.9% -30.4% Jacksonville . . . . . . +4.2% +13.9% -1.3% -10.2% Tampa Bay. . . . . . . . +6.4% +23.9% -0.2% -27.5% Atlanta, Georgia . . . . . +14.1% +26.0% +4.9% -6.3% Orange County, California. +24.0% -0.3% -16.8% -57.3% * Source: "Housing Market Statistics" (February 1994) a publication of the National Association of Home Builders ** Source: "U.S. Housing Markets" (February 2, 1994, February 5, 1993, February 4, 1992, and February 1, 1992) a publication of Lomas Mortgage USA For the year ended December 31, 1993, the Partnership (including its consolidated ventures and its unconsolidated ventures accounted for under the equity method) closed on the sale of 626 housing units, 752 homesite lots, approximately 50 acres of developed and undeveloped residential or commercial/industrial land tracts as well as the sales of The Oak Bridge Club and the remaining real estate and equity memberships at The Oaks Community. This compares to sales closings in 1992 of 320 housing units, 639 homesite lots and approximately 91 acres of developed and undeveloped residential or commercial/industrial land tracts. Sales closings in 1991 were for 273 housing units, 594 homesite lots and 107 acres of developed and undeveloped land tracts. Outstanding contracts ("backlog") as of December 31, 1993 were for 521 housing units, 127 homesites and approximately 47 acres of developed and undeveloped land tracts. This compares to a backlog as of December 31, 1992 of 270 housing units, 86 homesites and 6 acres of developed and undeveloped land tracts. The backlog as of December 31, 1991 was for 96 housing units, 28 homesites and approximately 34 acres of developed and undeveloped land tracts. The increasing trend in backlog as compared to prior years is indicative of the improvement in sales activity seen at many of the Partnership's Communities. As a result of management's efforts to broaden the appeal of the Partnership's Communities through the introduction of new housing products, the implementation of a series of cost reductions as well as the upward trends in housing activity that the nation as well as the markets in which the Partnership's properties are located have been experiencing, the Partnership was able to generate significant cash flow before debt service during 1993. The Partnership utilized this excess cash flow to make scheduled and accelerated principal repayments on its outstanding debt, as required under the terms of the credit facility agreement, and to increase its cash reserves. Furthermore, in February 1994, the Partnership made a distribution of $2,565,433 to its Limited Partners ($6.35 per Interest) and $142,523 to the General Partner and Associate Limited Partners, collectively. As mentioned above, the Partnership's income property term loan, revolving line of credit and letter of credit facility are due for renewal in July 1994. Although the Partnership is hopeful these renewals will be obtained, there can be no assurance that such will occur or that the terms, amounts and restrictions of the renewed credit facilities will be similar to those under the Partnership's existing facilities. As a result, the Partnership will not be able to assess whether or not cash distributions to partners can be made for 1994 until the end of 1994 when the final operating results for the year as well as the terms and conditions of a new credit facility are known. INFLATION Although the relatively low rates of inflation in recent years generally have not had a material effect on the Community development business, inflation in future periods can adversely affect the development of Communities generally because of its impact on interest rates. High interest rates not only increase the cost of borrowed funds to developers, but also have a significant effect on the affordability of permanent mortgage financing to prospective purchasers. In addition, any increased costs of materials and labor resulting from high rates of inflation may, in certain circumstances, be passed through to purchasers of real properties through increases in sales prices, although such increases may reduce sales volume. If such cost increases are not passed through to purchasers, there could be a negative impact on the ultimate margins realized by the Partnership. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES INDEX Reports of Independent Accountants Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Partners' Capital Accounts (Deficit) for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements SCHEDULE Supplementary Statements of Operations Information . . . . . . . . X SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or immaterial, or the information is presented in the consolidated financial statements or related notes. Report of Independent Accountants To the Partners of Arvida/JMB Partners, L.P. In our opinion, the consolidated financial statements listed in the index appearing under Item 14 (a) (1) and (2) present fairly, in all material respects, the financial position of Arivda/JMB Partners, L.P. (a limited partnership) and its subsidiaries at December 31, 1992, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1992, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Partnership's management; our responsibility is to express and opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. We have not audited the consolidated financial statements of Arvida/JMB Partners, L.P. and its subsidiaries for any period subsequent to December 31, 1992. PRICE WATERHOUSE Miami, Florida March 23, 1993 REPORT OF INDEPENDENT ACCOUNTANTS To the Partners of ARVIDA/JMB PARTNERS, L.P. We have audited the accompanying consolidated balance sheet of Arvida/JMB Partners, L.P. and Consolidated Ventures as of December 31, 1993, and the related consolidated statements of operations, changes in partners' capital accounts (deficit), and cash flows for the year then ended. Our audit also included the 1993 financial statement schedule listed in the Index at Item 8. These financial statements and schedule are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Arvida/JMB Partners, L.P. and Consolidated Ventures at December 31, 1993, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with generally accepted accounting principles. Also, in our opinion, the related 1993 financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. ERNST & YOUNG Miami, Florida March 15, 1994 ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) BASIS OF ACCOUNTING Principles of Consolidation The consolidated financial statements include the accounts of Arvida/JMB Partners, L.P. (the "Partnership") and its consolidated ventures (Note 7). All material intercompany balances and transactions have been eliminated in consolidation. The equity method of accounting has been applied in the accompanying consolidated financial statements with respect to those investments where the Partnership's ownership interest is 50% or less, with the exception of the Partnership's investment in the Coto de Caza Joint Venture which is accounted for in accordance with the cost method of accounting, effective September 15, 1992 (Note 7). Recognition of Profit from Sales of Real Estate For sales of real estate, profit is recognized in full when the collecta- bility of the sales price is reasonably assured and the earnings process is virtually complete. When the sale does not meet the requirements for recognition of income, profit is deferred until such requirements are met. For sales of residential units, profit is recognized at the time of closing or if certain criteria are met, on the percentage-of-completion method. Real Estate Inventories and Cost of Real Estate Revenues Real estate inventories are carried at cost, including capitalized interest and property taxes, but not in excess of the net realizable value determined by the evaluation of individual projects. Management's evaluation of net realizable value is based on each projects' estimated selling price in the ordinary course of business less estimated costs of completion, holding and disposal. These estimates are reviewed periodically and compared to each project's recorded book value. Adjustments to book value, as they become necessary, are reported in the period in which they become known. The total cost of land, land development and common costs are apportioned among the projects on the relative sales value method. Costs pertaining to the Partnership's housing, homesite, and land and property revenues reflect the cost of the acquired assets as well as development costs, construction costs, capitalized interest, capitalized real estate taxes and capitalized overheads. Certain marketing costs relating to housing projects, including exhibits and displays, and certain planning and other predevelopment activities, excluding normal period expenses, are capitalized and charged to housing cost of revenues as related units are closed. A warranty reserve is provided as residential units are closed. This reserve is reduced by the cost of subsequent work performed. Capitalized Interest and Real Estate Taxes Interest and real estate taxes incurred are capitalized to qualifying assets, principally real estate inventories. Such capitalized interest and real estate taxes are charged to cost of revenues as sales of real estate inventories are recognized. Interest, including the amortization of loan fees, of $14,786,169, $17,424,850 and $16,621,042 was incurred for the years ended December 31, 1993, 1992 and 1991, respectively, of which $7,738,179, $4,470,150 and $2,939,326 was capitalized for the years ended December 31, 1993, 1992 and 1991, respectively. Interest payments, including amounts capitalized, of $15,125,383, $15,415,266 and $17,537,916 were made for the years ended December 31, 1993, 1992 and 1991, respectively. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Real estate taxes of $8,870,693, $9,099,508 and $7,623,857 were incurred for the years ended December 31, 1993, 1992 and 1991, respectively, of which $3,179,099, $2,026,309 and $1,072,410 were capitalized for the years ended December 31, 1993, 1992 and 1991, respectively. Real estate tax payments of $8,733,910, $10,301,400 and $7,217,145 were made for the years ended December 31, 1993, 1992 and 1991, respectively. The preceding analysis of real estate taxes does not include real estate taxes incurred or paid with respect to the Partnership's club facilities and operating properties as these taxes are included in cost of revenues for operating properties. Property and Equipment and Other Assets Property and equipment are carried at cost less accumulated depreciation and are depreciated on the straight-line method over the estimated useful lives of the assets which range from two to forty years. Expenditures for maintenance and repairs are charged to expense as incurred. Costs of major renewals and improvements which extend useful lives are capitalized. Other assets are amortized on the straight-line method, which approximates the interest method, over the useful lives of the assets which range from one to five years. Amortization of debt discounts (1992 and 1991 only) and other assets, excluding loan fees, of approximately $247,400, $1,074,000 and $1,289,100 was incurred for the years ended December 31, 1993, 1992 and 1991, respectively. Amortization of loan fees, which is included in interest expense, of approximately $587,500, $343,800 and $0 was incurred for the years ended December 31, 1993, 1992 and 1991, respectively. Investments in and Advances to Joint Ventures, Net In general, the equity method of accounting has been applied in the accompanying consolidated financial statements with respect to those investments for which the Partnership does not have majority control and where the Partnership's ownership interest is 50% or less. The cost method of accounting has been applied in the accompanying consolidated financial statements with respect to the Coto de Caza joint venture, effective September 15, 1992, as a result of the Partnership's decrease in its ownership interest and its joint venture partner's control over the future operations of the Community. The cost method of accounting is used when a limited partner has virtually no influence over venture operations and financial policies. Under the cost method, income is generally recorded only to the extent of distributions received. Reference is made to Note 7 for further discussion of this joint venture. Investments in joint ventures are carried at the Partnership's proportionate share of the ventures' assets (not in excess of their net realizable value determined by evaluation of individual projects), net of their related liabilities and adjusted for any basis differences. Basis differences result from the purchase of interests at values which differ from the recorded cost of the Partnership's proportionate share of the joint ventures' net assets. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership periodically advances funds to certain of its joint ventures in which it holds ownership interests when deemed necessary and economically justifiable. Such advances are generally interest bearing and are payable to the Partnership from amounts earned through joint venture operations. Equity Memberships The amenities within certain of the Partnership's Boca Raton and Jacksonville, Florida Communities, as well as its Community near Highlands, North Carolina are sold to the respective homeowners through the sale of equity memberships. The amounts recorded as equity memberships in the accompanying Consolidated Balance Sheets represent the accumulation of costs incurred in constructing clubhouses, golf courses, tennis courts and various other related assets, less amounts allocated to memberships sold not in excess of their net realizable value determined by evaluations of individual amenities. Equity membership revenues and related cost of revenues are included in land and property in the Consolidated Statements of Operations. Partnership Records The Partnership's records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying consolidated financial statements have been prepared from such records after making appropriate adjustments where applicable to reflect the Partnership's accounts in accordance with generally accepted accounting principles ("GAAP") and to consolidate the accounts of the ventures as described above. The net effect of these items is summarized as follows: Reference is made to Note 14 for further discussion of the allocation of profits and losses to the General Partner, Associated Limited Partners and Limited Partners. The net income (loss) per Limited Partnership Interest is based upon the number of Limited Partnership Interests outstanding at the end of each period (404,005). ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Reclassifications During 1992, the Partnership evaluated the presentation and classification of information in its consolidated financial statements, the usefulness of such information and its conformity with the financial statements of other real estate developers and builders. As a result of this evaluation, the Partnership restructured the presentation of financial information in its Consolidated Statements of Operations. Such reclassifications are reflected in the accompanying Consolidated Statements of Operations and the Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. Certain reclassifications have also been made to the 1991 Consolidated Statement of Cash Flows to conform with the 1992 presentation. Management believes that these reclassifications have resulted in a more informative presentation of the Partnership's financial information. Certain reclassifications have also been made to the 1992 and 1991 financial statements to conform to the 1993 presentation. Income Taxes No provision for state or Federal income taxes has been made as the liability for such taxes is that of the partners rather than the Partnership. However, in certain instances, the Partnership has been required under applicable state law to remit directly to the state tax authorities amounts representing withholding on applicable taxable income allocated to partners. (2) INVESTMENT PROPERTIES The Partnership's assets consist principally of interests in land which is in the process of being developed into master-planned residential Communities (the "Communities") and, to a lesser extent, commercial properties; mortgage notes and accounts receivable; management and other service contracts; construction, brokerage and other support activities; real estate assets held for investment; club and recreational facilities; and cable television businesses serving certain of its Communities. On August 27, 1991, the General Partner, on behalf of the Partnership, initiated a lawsuit in the Circuit Court of Cook County (County Department, Chancery Division), Illinois against The Walt Disney Company ("Disney"). The litigation arises out of the Partnership's acquisition of substantially all of the real estate and other assets of Arvida Corporation, a subsidiary of Disney, in September 1987. In the complaint filed on its behalf, the Partnership alleges that under the terms of the contract with Disney for the acquisition, the purchase price of the assets was to be reduced by the amount of certain payments made prior to the closing (the "Closing") of the transaction out of funds of Arvida Corporation in order to satisfy certain obligations that were not assumed by the Partnership. The complaint also alleges that the contract entitles the Partnership to (i) reimbursement by Disney for amounts advanced by the Partnership to pay certain other claimed obligations of Arvida Corporation, including certain post-Closing adjustments, in connection with the acquisition and (ii) indemnification by Disney for additional costs and expenses incurred by the Partnership subsequent to the Closing in order to remedy certain environmental conditions that existed prior to the Closing. The complaint further alleges that the Partnership has made various demands on Disney for payment of these amounts and that Disney has refused to make such payments. The Partnership seeks declaratory judgments that the Partnership is entitled to a purchase price reduction from Disney and ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED reimbursement or indemnification by Disney for amounts advanced or costs and expenses incurred by the Partnership for certain obligations of Arvida Corporation, together with interest on all such amounts and costs. During the second quarter of 1992, the Partnership received approximately $0.8 million in settlement of portions of this claim. There is no assurance as to what amounts, if any, the Partnership will recover as a result of the litigation with regard to the remaining open issues under the initially filed complaint. During July 1993, Disney filed an answer denying the substantive allegations of the Partnership's complaint and raising various affirmative defenses. The Partnership believes Disney's defenses are without merit and will continue to pursue its claims. In addition, Disney has filed a three count counterclaim in which it seeks among other things: a complete accounting of liabilities allegedly assumed but not discharged by the Partnership to ascertain whether certain funds, not to exceed $2.9 million, are due Disney in accordance with the purchase agreement; an unspecified amount of damages exceeding $500,000 allegedly representing workers compensation and warranty payments made by Disney, which Disney alleges are obligations of the Partnership; an accounting for funds disbursed from a claims pool in the amount of $3,000,000 established by the parties; and attorney fees and costs. The Partnership believes it has meritorious defenses to these counterclaims and will defend itself vigorously against them. (3) CASH, CASH EQUIVALENTS AND RESTRICTED CASH At December 31, 1993 and 1992, cash and cash equivalents primarily consisted of U.S. Government obligations with original maturities of three months or less, money market demand accounts and repurchase agreements, the cost of which approximated market value. Cash and cash equivalents include treasury bills with original maturities of three months or less of approximately $3,900,000 and $0 at December 31, 1993 or 1992. Included in restricted cash are amounts restricted under various escrow agreements. Credit risk associated with cash, cash equivalents and restricted cash is considered low due to the high quality of the financial institutions in which these assets are held. (4) MORTGAGES RECEIVABLE Mortgages receivable generally range in maturity from 1 to 3 years, certain of which are collateralized by liens on the property sold and bear interest with stated rates up to 10% per annum. All mortgages receivable with below market rates are discounted at the market rate prevailing at the date of issue or purchase. The resulting effective interest rates on mortgages receivable range from approximately 11% to 14% per annum. The outstanding principal balances of mortgages receivable at December 31, 1993 and 1992 are summarized as follows: 1993 1992 ----------- ------------ Total gross mortgages receivable . . . . $3,958,649 6,838,848 Unamortized discount and valuation allowances . . . . . . . . . (1,017,688) (1,101,517) ---------- ---------- Mortgages receivable, net . . . . . $2,940,961 5,737,331 ========== ========== ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (5) REAL ESTATE INVENTORIES Real estate inventories at December 31, 1993 and 1992 are summarized as follows: 1993 1992 ------------ ------------ Land held for future development or sale . . . . . . . . . . . . . . . . . $ 24,259,509 30,459,094 Community development inventory: Work in progress and land improvements. . . . . . . . . . 137,048,514 133,507,511 Completed inventory. . . . . . . . . . 27,371,129 25,682,648 ------------ ----------- Real estate inventories . . . . . . $188,679,152 189,649,253 ============ =========== Real estate inventories at December 31, 1992 include charges to the inventory carrying values of certain residential and commercial properties totalling approximately $12.2 million to reflect their estimated net realizable values as determined by management's evaluation of these properties. These charges include approximately $9.2 million to reduce the carrying values of the Partnership's Water's Edge and Dockside Communities located near Atlanta, Georgia and its River Hills Community in Tampa, Florida. These Communities had been experiencing slower sales absorptions than anticipated due to the pricing of products not being in line with market demand. The charges to the inventory carrying values resulted from the Partnership's plans to offer lower-priced homesite and housing products in these Communities which are more consistent with market demand. The Partnership did reduce the price of homesites in the Water's Edge and Dockside Communities as planned; however, during 1993, the Partnership experienced no significant increase in sales absorptions in these Communities. Recent market studies indicate further reductions of housing sales prices in these communities are warranted. Therefore, real estate inventories at December 31, 1993 include an additional charge totalling approximately $4.9 million to the inventory carrying value of the Water's Edge and Dockside Communities to reflect the adverse impact of these additional reductions in housing prices on future anticipated lot values. Also included in real estate inventories at December 31, 1992, is a charge of approximately $2.3 million to reduce the carrying value of real estate inventories at The Oaks to properly reflect the estimated market value of the property assuming a bulk sale of the entire property. The balance of the charges to reduce real estate inventories, of approximately $0.7 million, was recorded to reflect the then current market value of several parcels of undeveloped commercial real estate. See Note 8 for discussion regarding the Partnership's sale of its remaining land holdings in The Oaks Community during 1993. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (6) PROPERTY AND EQUIPMENT Property and equipment at December 31, 1993 and 1992 are summarized as follows: 1993 1992 ------------ ------------ Land . . . . . . . . . . . . . . . . . $ 6,566,045 6,560,828 Land improvements. . . . . . . . . . . 18,214,258 19,388,725 Buildings. . . . . . . . . . . . . . . 51,166,841 50,098,289 Equipment and furniture. . . . . . . . 19,024,112 18,225,992 Construction in progress . . . . . . . 1,281,936 873,411 ------------ ------------ Total . . . . . . . . . . . . . . 96,253,192 95,147,245 Accumulated depreciation. . . . . (29,263,615) (25,074,779) ------------ ------------ Property and equipment, net . . . $ 66,989,577 70,072,466 ============ ============ In the fourth quarter of 1992, the Partnership recorded an approximate $3.4 million charge to the net book value of property and equipment to reflect reductions in the values of a 29,000 square foot office building located in Palm Beach County, Florida and a golf and country club facility at the Partnership's River Hills Community. The value of the golf and country club facility at River Hills had been adversely impacted by the introduction of new lower-priced products within the Community as well as overall economic conditions and the competition from other club facilities within the Tampa, Florida area. Depreciation expense of approximately $5,397,200, $6,132,700 and $5,783,600 was incurred for the years ended December 31, 1993, 1992 and 1991, respectively. (7) INVESTMENTS IN AND ADVANCES TO JOINT VENTURES, NET The Partnership has numerous investments in real estate joint ventures with ownership interests ranging from 20% to 50%. The Partnership's joint venture interests accounted for under the equity method are as follows: ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED LOCATION OF NAME OF VENTURE % OF OWNERSHIP PROPERTY - --------------- -------------- ------------ Arvida Boose Joint Venture 50 Florida Arvida Corporate Park Associates 50 Florida Arvida Pompano Associates Joint Venture 50 Florida H.A.E. Joint Venture 33-1/3 Florida Mizner Court Associates Joint Venture 50 Florida Mizner Tower Associates Joint Venture 50 Florida Ocala 202 Joint Ventures 50 Florida Tampa 301 Associates Joint Venture 50 Florida Windmill Lake Estates Associates Joint Venture 50 Florida Arvida/RBG I Joint Venture 40 Florida Arvida/RBG II Joint Venture 40 Florida The following is combined summary information of joint ventures accounted for under the equity method. The 1993 and 1992 summary information presented below is not comparable to the 1991 information due to the consolidation of the Cullasaja Joint Venture effective January 1, 1992 and the application of the cost method of accounting, effective September 15, 1992, for the Partnership's ownership interest in the Coto de Caza joint venture. The 1993 summary information presented is not comparable to the 1992 and 1991 information due to the consolidation of AOK Group effective March 1, 1993. See further discussion below regarding the Partnership's accounting for these joint venture interests. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership's share of net income (loss) is based upon its ownership interest in numerous investments in joint ventures which are accounted for in accordance with the equity method of accounting. Equity in earnings (losses) of unconsolidated ventures represents the Partnership's share of net income (loss) and reflects a component of purchase price adjustments included in the Partnership's basis, which are generally being amortized in relation to the cost of revenues of the underlying real estate assets. Equity in earnings (losses) of unconsolidated ventures may also include adjustments to carrying values of the investments as deemed necessary to reflect such investments at their appropriate net realizable values. These factors contribute to the differential in the Partnership's proportionate share of the net income (loss) of the joint ventures and its equity in earnings (losses) of unconsolidated ventures as well as to the basis differential between the Partnership's investments in joint ventures and its equity in underlying net assets, as shown above. Due to a significant decline in the demand for undeveloped commercial real estate in the markets in which the Partnership's joint venture properties are located, the respective joint ventures recorded charges to the carrying values of their real estate inventories of approximately $7.4 million in 1992 to reflect their estimated net realizable values. Equity in earnings (losses) of unconsolidated joint ventures for the year ended December 31, 1991 includes a charge to income of approximately $1.4 million to reduce the carrying value of the Partnership's interest in a commercial joint venture located in Tampa, Florida. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. In addition, under certain circumstances, either pursuant to the joint venture agreements or due to the Partnership's obligations as a general partner, the Partnership may be required to make additional cash advances or contributions to certain of the ventures. At December 31, 1991, the Partnership owned a 50% joint venture interest in the Cullasaja Community. Certain of the venture's property is encumbered by a mortgage. The principal balance outstanding on this note at December 31, 1993 and 1992 was approximately $5,412,000 and $6,649,000, respectively. The note matures on March 1, 1994 and bears interest at a rate of prime (6% at December 31, 1993) plus 1.25% per annum which is payable monthly. The Partnership is required to make repayments on the note in accordance with a homesite lot release provision of $72,750 per lot at closing. The Partnership is currently seeking an extension of this loan. However, there can be no assurance that the Partnership can obtain an extension. The operations of the venture required periodic cash advances from the partners. Since the fourth quarter of 1990, the Partnership has funded the venture's cash deficits in their entirety. As a result, during July 1992, the Partnership reached an agreement to purchase its joint venture partner's 50% interest in the Community. The Partnership was not required to make any cash payment to the joint venture partner for its interest. Instead, the purchase price of such interest is in the form of subordinated non-recourse promissory notes (the "Notes"), the payment of which is solely contingent upon the ultimate net cash flow generated by the joint venture. The Notes are subordinated to the repayment of the outstanding first mortgage loan and certain advances, plus accrued interest thereon, made to the venture by the partners. To the extent the Partnership has funded 100% of the venture's cash deficits in the ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED past or advances new funds, the repayment of such advances, plus accrued interest thereon, is senior to the repayment of funds previously advanced by both partners. A portion of the cash flow remaining after payment of all senior indebtedness is to be applied annually against the principal and interest (at 10% per annum) owed on the Notes. This agreement was pursued as a more favorable alternative to the remedies included in the previously existing joint venture agreement for situations in which the partners advance unequal funds to the venture. As a result of this transaction, the Partnership has changed from the equity method of accounting to the consolidated method of accounting for the joint venture effective January 1, 1992. The consolidation and the issuance of the Notes described above yielded an increase in the Partnership's total assets of approximately $12.1 million. The Coto de Caza joint venture had utilized the maximum amount available under its operating line of credit and had been seeking alternative financing sources to fund the significant additional cash necessary to continue development of the project and to fund the venture's other operating costs. In the interim, the Partnership and its joint venture partner had each advanced, net of reimbursements, approximately $3.1 million to the venture during 1991 and an additional $1.0 million during the first five months of 1992. Interest earned, at 10% per annum, during 1991 had been paid in full as of December 31, 1991. Interest earned during 1993 and 1992 totalling approximately $803,000 was unpaid as of December 31, 1993. Due to the reallocation of the Partnership's interest in the Coto de Caza joint venture effective September 15, 1992, the Partnership has provided an allowance for doubtful accounts with regard to the interest earned and unpaid at December 31, 1993 on advances previously made by the Partnership. Given the weak market conditions in Orange County, California and the continued lack of development financing available from traditional lending sources, it was unlikely that the joint venture would be able to secure additional financing in the near term. The joint venture partner was willing to continue to advance funds to meet the venture's operating needs. Given the finite amount of available capital, the Partnership determined that it was in its best long- term interest to utilize that capital for the development of its other properties rather than commit additional funds for the development of the Coto de Caza Community. As a result, the venture partner has funded the venture's cash deficits in their entirety since June 1, 1992. As an alternative to funding future capital requirements, the Partnership and its joint venture partner agreed to amend the joint venture agreement and reallocate ownership interests. In exchange for funding the venture's future operating needs, the venture partner was reallocated an additional 30% interest in the venture, and assumed the role of managing general partner. As such, the venture partner has control over the future operations of the Community, including the timing and extent of its development. The Partnership retains a 20% limited partnership interest and is entitled to receive distributions from net cash flow, after repayment of third party loans and advances made by the venture partners, up to an amount agreed upon by the Partnership and its joint venture partner. Certain specified costs and liabilities incurred prior to the reallocation will continue to be shared equally by the Partnership and its joint venture partner. This agreement was pursued as a more favorable alternative to the provisions included in the previously existing joint venture agreement for reallocation of partnership interests should both partners not advance equal funds to the venture. As a result of the Partnership's decrease in its ownership interest, and its joint venture partner's control over the future operations of the Community, commencing on September 15, 1992, the Partnership accounts for its share of the operations of the Coto de Caza joint venture in accordance with the cost method of accounting. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED During 1992 the Partnership sold 60% of its interest in two land parcels located in its Weston Community to unaffiliated third-party purchasers. Subsequent to these transactions, the Partnership and the purchasers each contributed their interests in these land parcels to joint ventures established for the purpose of developing housing products within Weston. The Partnership entered into development management agreements with these joint ventures. Pursuant to the terms of these agreements, the Partnership agreed to fund all development and construction costs, as well as certain overheads, incurred on behalf of the joint venture projects. Amounts funded are reimbursed by the joint ventures from sales revenues generated by each joint venture. Amounts advanced by the Partnership to each respective joint venture earn interest at 8.5% for the first year and prime plus 2% per annum thereafter. During the first quarter of 1993, one of the joint ventures obtained third-party, project specific financing in the amount of $4,950,000 to fund its development and construction activities. In accordance with the provisions of this financing agreement, as of December 31, 1993, the Partnership had been reimbursed the majority of amounts previously advanced to the joint venture. As a result of this financing arrangement, the Partnership does not anticipate the need for future advances to this venture. Due to significant sales activity, amounts previously advanced to the Partnership's other joint venture were reimbursed in full during 1993. During the first quarter of 1993, the Partnership reached a settlement agreement with AOK Group, its joint venture partner in a property located in Ocala, Florida, whereby in exchange for its joint venture partner's 50% interest in the venture, the Partnership agreed to dismiss a lawsuit previously filed against its joint venture partner for failure to perform in accordance with the terms of a $1,600,000 note which had been issued to the Partnership by the joint venture. This agreement was pursued as a more favorable remedy to other alternatives available to the Partnership. As a result of this transaction, the Partnership has changed from the equity method of accounting to the consolidated method of accounting for the joint venture effective March 1, 1993. This transaction resulted in an increase in the Partnership's total assets of approximately $324,000. The Partnership incurs certain general and administrative expenses, including insurance premiums, which are paid by the Partnership on behalf of the joint ventures in which it holds interests. The Partnership receives reimbursements from the joint ventures for such costs. For the year ended December 31, 1993, the Partnership was entitled to receive approximately $343,000 from certain of the joint ventures in which it holds interests. At December 31, 1993, approximately $64,000 was owed to the Partnership, of which approximately $27,000 was received as of March 15, 1994. (8) NOTES AND MORTGAGES PAYABLE Notes and mortgages payable at December 31, 1993 and 1992 are summarized as follows: 1993 1992 ------------ ------------ Term loan credit facility of $126,805,195 bearing interest at approximately 5.6% and 6.5% per annum at December 31, 1993 and 1992, respectively (A). . . . . . . $108,262,248 126,805,195 Income property term loan of $20,000,000, bearing interest at approximately 5.6% and 6.0% per annum at December 31, 1993 and 1992, respectively (A). . . . . . . 18,933,328 19,733,332 ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 1993 1992 ------------ ------------ Revolving line of credit of $45,000,000 (A) . . . . . . . . . . . . . . . . . . -- -- Other notes and mortgages payable (B). . 20,575,416 34,397,645 ------------ ------------ Total. . . . . . . . . . . . . $147,770,992 180,936,172 ============ ============ (A) At December 31, 1991, the Partnership had an agreement with two commercial banks permitting the Partnership to borrow up to $225 million under various credit facilities consisting of a term loan originally totalling $150 million and a revolving credit line of up to $75 million. In addition, the Partnership had a letter of credit agreement up to $20 million. Although the Partnership's term loan was not scheduled to mature until February 1998, the lenders required the Partnership to restructure its entire credit facility as part of the extension of the revolving line of credit facility which originally matured on January 15, 1992. The Partnership and its lenders finalized an agreement in October of 1992 for a new facility. The new facility consists of a term loan in the amount of $126,805,195, a revolving line of credit facility up to $45 million, an income property term loan of $20 million, and a $15 million letter of credit facility. The term loan, the revolving line of credit and the letter of credit facility are secured by recorded mortgages on all otherwise unencumbered real property assets of the Partnership as well as an assignment of all mortgages receivables, equity memberships, certain joint venture interests or joint venture proceeds and cash balances (with the exception of deposits held in escrow). The income property term loan is secured by the recorded first mortgages on a mixed-use center and an office building in Boca Raton, Florida. All of the notes under the new facility are cross-collateralized and cross-defaulted. The term loan, the revolving line of credit and the income property term loan bear interest based, at the Partnership's option, on one of the lender's prime rate plus 1% or on the relevant London Inter-Bank Offering Rate (LIBOR) plus 2.25% per annum. At December 31, 1993, $75 million of the Partnership's outstanding credit facility was under two interest rate swap arrangements. For the year ended December 31, 1993, the effective interest rate for the combined term loan, income property term loan and revolving line of credit facility was approximately 9.3% per annum. This rate includes the effect of the interest rate swap agreements, one of which matured in February 1994 and the other of which will mature in October 1994. In addition, the Partnership was required to pay the lenders certain commitment and administration fees as well as all closing costs relating to these borrowings. Under the term loan agreement, the Partnership made the first scheduled principal repayments of $8 million in February 1993 and $10 million in March 1994. Principal repayments of $10 million are due in each of the years 1995 and 1996, and the remaining balance outstanding is due in July 1997. In addition, the term loan agreement provides for additional principal repayments based upon a specified percentage of available cash flow and upon the sale of certain assets. For the year ended December 31, 1993, the Partnership made additional term loan payments totalling approximately $10.5 million. Under the income property term loan, monthly principal and interest payments are required to be paid on a 25-year amortization schedule with the remaining balance outstanding due in July 1994. The revolving line of credit and letter of credit facility also mature in July 1994. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership is in the process of negotiating a renewal of its credit facilities. Although the Partnership is hopeful these renewals will be obtained, there can be no assurance that such will occur or that the terms, amounts and restrictions of the renewed credit facilities will be similar to those under the Partnership's existing facilities. The credit agreement contains significant restrictions with respect to the payment of distributions to partners, the maintenance of certain loan-to-value ratios, the use of proceeds from the sale of the Partnership's assets and advances to the Partnership's joint ventures. As of March 15, 1994, all of the term loan proceeds had been borrowed with a remaining balance of $92,360,145, and $0, $18,733,327 and $11,868,393 were outstanding on the revolving line of credit facility, the income property term loan and the letter of credit facility, respectively. Loan fees incurred in connection with the restructuring of the Partnership's credit facility have been capitalized and are being amortized over the lives of the loans included in the credit facility using the straight-line method, which approximates the interest method. (B) Other notes and mortgages payable are collateralized by certain real estate inventories, property and equipment and certain investments with a net book value of approximately $22 million at December 31, 1993. These notes and mortgage notes have a weighted average annual effective interest rate of approximately 7.2% and 7.5% at December 31, 1993 and 1992, respectively, and mature in varying amounts through 2017. The Partnership owned an 80% general partnership interest in The Oaks Community located near Sarasota, Florida. The Partnership's joint venture partner was in default under the terms of the joint venture agreement due to its failure to make capital contributions to fund ongoing operations. In August 1993, the Partnership's joint venture partner assigned its 20% interest in The Oaks to the Partnership thereby vesting 100% control of the joint venture assets in the Partnership. Certain of the assets of The Oaks joint venture were encumbered by two mortgage loans. A $12,492,200 loan was scheduled to mature in January 1997 and a $3,260,000 loan was scheduled to mature in December 1993. The joint venture had guaranteed $2.7 million of the loans, and the guaranteed amount was with recourse to the Partnership. The joint venture was in default under the terms of these loan agreements as a result of its failure to make principal payments of approximately $1.3 million in January 1993 to release the minimum number of homesite lots as required under these agreements and its failure to pay interest commencing with a payment due in April 1993. The Partnership was able to reach an agreement with the lenders to pay off the existing mortgage loans at a substantial discount from face value. On September 3, 1993, the Partnership paid the joint venture's lenders $6.7 million in full satisfaction of the outstanding mortgage loans, accrued interest and guaranty. This transaction contributes to the decrease in notes and mortgages payable at December 31, 1993 as compared to December 31, 1992 and is the cause of the approximate $9.5 million extraordinary gain on the early extinguishment of debt as of December 31, 1993. The joint venture also sold its remaining land holdings in The Oaks Community and its interest in The Oaks Club to an unaffiliated third party purchaser for $5.8 million simultaneously with the repayment of the loans and satisfaction of the mortgages. These transactions are the cause of various ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED changes in the consolidated balance sheets at December 31, 1993 as compared to December 31, 1992. In light of the Partnership's guarantee under the loan agreement of $2.7 million of the outstanding mortgage loans, as well as other factors, the above transactions were pursued as the least costly alternative available to the Partnership. These transactions resulted in a minimal net gain for Federal income tax purposes. In anticipation of the above circumstances, the Partnership, as a matter of prudent accounting practice, recorded a charge to the carrying value of real estate inventories and equity memberships of approximately $2.3 million and $1.0 million, respectively, in the fourth quarter of 1992 to properly reflect the estimated market value of the property in its then current state of development assuming a bulk sale of the entire property. Following is a schedule of the maturities of the notes and mortgages payable at December 31, 1993. 1994 . . . . . . . . . . . . . . . $ 37,184,325 1995 . . . . . . . . . . . . . . . 10,665,714 1996 . . . . . . . . . . . . . . . 17,374,705 1997 . . . . . . . . . . . . . . . 78,762,248 1998 . . . . . . . . . . . . . . . 500,000 Thereafter . . . . . . . . . . . . 3,284,000 ------------ Total notes and mortgages payable. . . . . . $147,770,992 ============ (9) EQUITY MEMBERSHIPS Equity memberships represent the accumulation of costs incurred in constructing club houses, golf courses, tennis courts and various other related assets, less amounts allocated to memberships sold, not in excess of their net realizable values determined by evaluation of individual amenities. These amenities are conveyed to homeowners through the sale of equity memberships. The sale of memberships in Jacksonville Golf and Country Club has been adversely impacted during the past several years by the introduction of lower-priced products within the Community as well as the competition from other club facilities located in the Jacksonville area. At Broken Sound, the higher-priced equity memberships have experienced a slowdown in absorptions due primarily to the overall slowdown in the economy and the low levels of consumer confidence. As a result of the above, in 1992, the Partnership recorded charges to the carrying value of its equity memberships at Jacksonville Golf and Country Club and Broken Sound of approximately $2.2 million and $1.0 million, respectively. In addition, equity memberships for the year ended December 31, 1992 also include a $1.0 million reduction in the value of The Oaks Country Club's equity memberships as discussed further in Note 8. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership receives reimbursements from or reimburses affiliates of the General Partner for certain general and administrative costs including, and without limitation, salary and salary-related costs relating to work performed by employees of the Partnership and certain out-of-pocket expenditures incurred on behalf of such affiliates. For the year ended December 31, 1993, the total of such costs incurred by the Partnership on behalf of these affiliates totalled approximately $171,000. Approximately $24,700 was outstanding at December 31, 1993, of which approximately $4,400 was received as of March 15, 1994. This amount does not bear interest and is expected to be paid in future periods. For the year ended December 31, 1992, the Partnership was entitled to receive reimbursements of approximately $129,000. In accordance with the Partnership Agreement, the General Partner and Associate Limited Partners have deferred a portion of their distributions of net cash flow from the Partnership totaling approximately $810,000 as of December 31, 1993. This amount does not bear interest and is expected to be paid in future periods subject to certain restrictions contained in the Partnership's credit facility. Arvida Company ("Arvida"), pursuant to an agreement with the Partnership, provides development, construction, management and other personnel and services to the Partnership for all of its projects and operations. Pursuant to such agreement, the Partnership shall reimburse Arvida for all of its out-of-pocket expenditures (including salary and salary-related costs), subject to certain limitations. The total of such costs for the years ended December 31, 1993 and 1992 was approximately $6,686,100 and $6,622,800, respectively, of which approximately $80,000 was unpaid as of December 31, 1993 and all of which was paid as of March 15, 1994. The Partnership and Arvida/JMB Partners, L.P.-II (a publicly-held limited partnership affiliated with the General Partner) each employ project related and administrative personnel who perform services on behalf of both partnerships. In addition, certain out-of-pocket expenditures related to such services and other general and administrative costs, including certain insurance premiums, are incurred and allocated to each partnership as appropriate. The Partnership receives reimbursements from or reimburses Arvida/JMB Partners, L.P.-II for such costs (including salary and salary- related costs). For the year ended December 31, 1993, the Partnership was entitled to receive approximately $2,497,400 from Arvida/JMB Partners, L.P.- II. At December 31, 1993, approximately $26,100 was outstanding, all of which was received as of March 15, 1994. In addition, for the year ended December 31, 1993, the Partnership was obligated to reimburse Arvida/JMB Partners, L.P.-II approximately $1,234,300, all of which was paid as of December 31, 1993. The net reimbursements paid to the Partnership for the year ended December 31, 1992 was approximately $236,000. The Partnership pays for certain general and administrative costs, including insurance premiums, on behalf of its affiliated clubs, homeowners associations and maintenance associations. The Partnership receives reimbursements from the affiliates for such costs. For the year ended December 31, 1993, the Partnership was entitled to receive approximately $366,400 from its affiliates. At December 31, 1993, approximately $116,700 was owed to the Partnership, of which approximately $23,000 was received as of March 15, 1994. The amount reimbursed to the Partnership for the year ended December 31, 1992 was approximately $2,327,200. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (11) COMMITMENTS AND CONTINGENCIES As security for performance of certain development obligations, the Partnership is contingently liable under standby letters of credit and bonds for approximately $11,651,000 and $11,146,000, respectively, at December 31, 1993. As of December 31, 1992, the Partnership was contingently liable under standby letters of credit and bonds for approximately $18,438,000 and $18,293,000, respectively. In addition, certain joint ventures in which the Partnership holds an interest are also contingently liable under bonds for approximately $1,089,000 and $1,180,000 at December 31, 1993 and 1992, respectively. The Partnership leases certain building space for its management offices, sales offices and other facilities, as well as certain equipment. The building and equipment leases expire over the next 2 to 11 years. Minimum future rental commitments under non-cancelable operating leases having a remaining term in excess of one year as of December 31, 1993 are as follows: 1994 . . . . . . . . . . . $1,287,841 1995 . . . . . . . . . . . 1,130,218 1996 . . . . . . . . . . . 855,780 1997 . . . . . . . . . . . 228,167 1998 . . . . . . . . . . . 150,437 Thereafter . . . . . . . . 283,835 ---------- $3,936,278 ========== Rental expense of $2,786,710, $2,320,028 and $2,865,680 was incurred for the years ended December 31, 1993, 1992 and 1991, respectively. The Partnership is named a defendant in a number of homeowner lawsuits, certain of which purported to be class actions, that allegedly in part arose out of or related to Hurricane Andrew, which on August 24, 1992 resulted in damage to a former community development known as Country Walk. The homeowner lawsuits allege, among other things, that the damage suffered by the plaintiffs' homes and/or condominiums within Country Walk was beyond what could reasonably be expected from the hurricane and/or was a result of the defendants' alleged defective design, construction, inspection and/or other improper conduct in connection with the development, construction and sales of such homes and condominiums, including alleged building code violations. The various plaintiffs seek varying and, in some cases, unspecified amounts of compensatory damages and other relief. In certain of the lawsuits injunctive relief and/or punitive damages are sought. The Partnership intends to vigorously defend itself in these lawsuits. The various lawsuits arising out of or relating to Hurricane Andrew allege that the Partnership is liable, among other reasons, as a result of its own alleged acts of misconduct or as a result of the Partnership's assumption of Arvida Corporation's liabilities in connection with the Partnership's purchase of Arvida Corporation's assets from the Walt Disney Company ("Disney") in 1987, which included certain assets related to the Country Walk development. Pursuant to the agreement to purchase such assets, the Partnership obtained indemnification by Disney for certain liabilities relating to facts or circumstances arising or occurring prior to the closing of the Partnership's purchase of the assets. Over 80% of the Arvida-built homes in Country Walk were built prior to the Partnership's ownership of the ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Community. Where appropriate, the Partnership has tendered or will tender each of the above-described lawsuits to Disney for defense and indemnification in whole or in part pursuant to the Partnership's indemnification rights. Where appropriate, the Partnership is also tendering these lawsuits to its various insurance carriers for defense and coverage. The Partnership is unable to determine at this time to what extent damages in these lawsuits, if any, against the Partnership, as well as the Partnership's cost of investigating and defending the lawsuits, will ultimately be recoverable by the Partnership either pursuant to its rights of indemnification by Disney or under contracts of insurance. The Partnership has negotiated the terms of a class action settlement with opposing counsel in one of the pending homeowners' lawsuits which has the potential for resolving substantial portions of the pending homeowners' lawsuits which have been filed. On June 3, 1993, the Circuit Court of Dade County entered an order preliminarily finding that the Partnership's proposed class action settlement agreement, as revised, was within the range of what appeared to be a fair and adequate settlement of the claims filed by single- family homeowners and condominium owners at Country Walk. On August 10, 1993, the court issued a final order approving the class action settlement. The settlement, which is designed to resolve claims arising in connection with estate and patio homes and condominiums sold by the Partnership after September 10, 1987, is structured to compensate residents for losses not covered by insurance. Settlement amounts payable are a function of the type of unit involved and the claimant's proof regarding the adequacy of insurance proceeds. Homeowners of 188 units of Country Walk have accepted the settlement. Those who affirmatively rejected the offer may continue to litigate against the Partnership. The Partnership currently believes that the class action settlement may cost approximately $2.5 million. The settlement is being funded by one of the Partnership's insurers, subject to a reservation of rights. The amount of money, if any, which the insurance company may recover from the Partnership pursuant to its reservation of rights is uncertain. Due to this uncertainty, the accompanying consolidated balance sheets do not reflect an accrual for such costs. On February 24, 1994, the Partnership was dismissed from the pending class action lawsuits pursuant to the class action settlement. In addition, the Partnership has been informed that Disney and an insurer have reached agreements to settle five of the individual homeowners actions which were tendered by the Partnership to Disney. These Disney Settlements will be funded without any contribution from the Partnership. The Partnership can give no assurance that the Disney settlements will be finalized. As noted above, those homeowners who affirmatively rejected the offer of settlement may continue to litigate. The Partnership is currently a defendant in eleven lawsuits brought by condominium and patio home owners, all of whom have declined to accept the terms of the class action settlement. These lawsuits, involving nineteen named individuals, are pending in the Circuit Court of Dade County. In these lawsuits, plaintiffs allege a variety of claims involving, among other things, breach of warranty, negligence and building code violations. The Partnership intends to vigorously defend itself in these matters. On April 19, 1993, a subrogation claim entitled Village Homes at Country Walk Master Maintenance Association, Inc. v. Arvida Corporation et al., was filed in the 11th Judicial Circuit for Dade County. Plaintiffs filed this suit for the use and benefit of American Reliance Insurance Company ("American Reliance"). Plaintiffs seek to recover damages and pre- and post-judgment interest in connection with $10,873,000 American Reliance has allegedly paid to its insureds living in condominium units at Country Walk in the wake of Hurricane Andrew. Disney is also a defendant in this suit. On July 1, 1993, a subrogation lawsuit entitled Prudential Property and Casualty Company v. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Arvida/JMB Partners, et al., was filed in the 11th Judicial Circuit for Dade County. Plaintiff seeks to recover damages, costs, and interest in connection with $16,679,622 Prudential allegedly paid to its insureds living in Country Walk at the time of Hurricane Andrew. Disney is also a defendant in this suit. On July 15, 1993, a subrogation lawsuit entitled Allstate Insurance Company v. Arvida/JMB Partners, et al., was filed in the 11th Judicial Circuit for Dade County. Plaintiff seeks to recover damages, costs, and interest in connection with $18,540,196 Allstate allegedly paid to its insureds living in Country Walk at the time of Hurricane Andrew. Disney is also a defendant in this suit. The Partnership settled a threatened subrogation action by State Farm Insurance Company. The settlement was funded by one of the Partnerships insurance carriers subject to a reservation of rights. The amount of money the insurance carrier may seek to recover from the Partnership for this and any other settlements it has funded is uncertain. The Partnership is a defendant in and anticipates other subrogation claims by insurance companies which have allegedly paid policy benefits to Country Walk residents. The Partnership intends to defend itself vigorously in all such matters. The Partnership has resolved a claim for construction related damages brought by the Villages of Country Walk Homeowners' Association, Inc., among others. Two of the Partnership's insurance carriers funded a settlement in the amount of $2,740,000 to resolve claims related to the construction of the common elements of the condominium units at Country Walk. One of the insurance carriers has issued a reservation of rights in connection with these claims and the extent to which that insurance company may ultimately recover any of these proceeds from the Partnership is unknown. Therefore, the accompanying consolidated balance sheets do not reflect an accrual for such costs. The Partnership is involved in an Environmental Protection Agency (EPA) administrative enforcement proceeding with regard to the Partnership's Water's Edge property. The EPA has asserted that a dam built to create a lake at the Community during the time the property was owned by Arvida Corporation was in violation of Section 404 of the Clean Water Act in that certain wetland areas had been filled. Pursuant to a Consent Agreement and Order entered into with the EPA, the Partnership acquired certain land (at a cost of approximately $400,000) for which it has developed and implemented a plan of mitigation for the wetlands lost. In accordance with certain provisions of the Consent Agreement and Order, the Partnership must provide the EPA with periodic reports regarding the status of the mitigation plan. An agreement in principle has been reached to settle the dispute between the parties pursuant to which the EPA has agreed to assess a civil penalty of $125,000. The Partnership is actively pursuing indemnification from Disney for the total costs that will ultimately be incurred to resolve this issue. There can be no assurance that the Partnership will be reimbursed by Disney. On October 13, 1993, a lawsuit captioned Berry v. Merril (sic) Lynch, Pierce Fenner & Smith, J&B Arvida Limited Partnership (sic) and Does 1 through 100, was filed in the Superior Court of the State of California in and for the County of San Diego, Case No. 669709. The lawsuit was purportedly filed as a class action on behalf of the named plaintiffs and all other persons or entities in the State of California who bought or acquired, directly or indirectly, limited partnership interests ("Interests") in the Partnership from September 1, 1987 through the present. The complaint in the action alleges, among other things, that the defendants made misrepresentations and concealed various facts, breached fiduciary duties, and violated the covenant of good faith in connection with the sale of Interests in the Partnership. The complaint further alleges that such conduct violated California state law ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED relating to fraud, breach of fiduciary duty, willful suppression of facts, and breach of the covenant of good faith. Plaintiffs, on behalf of themselves and the purported plaintiff class, seek unspecified compensatory damages, consequential damages, punitive and exemplary damages, interest, costs of the suit, and such other relief as the court may order. The Partnership believes that the lawsuit is without merit and intends to vigorously defend itself. In addition, the Partnership has been advised by Merrill Lynch that Merrill Lynch has been named a defendant in actions pending in the Eleventh and Seventeenth Judicial Circuit Courts in Dade and Broward Counties, Florida to compel arbitration of claims brought by certain investors of the Partnership representing approximately 4% of the total Interests outstanding. Merrill Lynch has asked the Partnership and its General Partner to confirm an obligation of the Partnership and its General Partner to indemnify Merrill Lynch in these claims against all loss, liability, claim, damage and expense, including without limitation attorneys' fees and expenses, under the terms of a certain Agency Agreement dated September 15, 1987 ("Agency Agreement") with the Partnership relating to the sale of Interests in the Partnership through Merrill Lynch on behalf of the Partnership. In the actions to compel arbitration, the claimants have advised Merrill Lynch that they will seek to file demands for arbitration and claims for unspecified damages against Merrill Lynch based on Merrill Lynch's alleged violation of applicable state and/or federal securities laws and alleged violations of the rules of the National Association of Securities Dealers, Inc., together with pendent state law claims. The Agency Agreement generally provides that the Partnership and its General Partner shall indemnify Merrill Lynch against losses occasioned by an actual or alleged misstatements or omission of material facts in the Partnership's offering materials used in connection with the sale of Interests and suffered by Merrill Lynch in performing its duties under the Agency Agreement, under certain specified conditions. The Agency Agreement also generally provides, under certain conditions, that Merrill Lynch shall indemnify the Partnership and its General Partner for losses suffered by the Partnership and occasioned by certain specified conduct by Merrill Lynch in the course of Merrill Lynch's solicitation of subscriptions for Interests. The Partnership is unable to determine at this time the ultimate investment of investors who have filed arbitration claims as to which Merrill Lynch might seek indemnification in the future. At this time, and based upon the information presently available about the arbitration statements of claims filed by some of these investors, the Partnership and its General Partner believe that they have meritorious defenses to demands for indemnification made by Merrill Lynch and intend to vigorously pursue such defenses. In the event Merrill Lynch is entitled to indemnification of its attorney's fees and expenses or other losses and expenses, these amounts may prove to be material. The Partnership is also a defendant in several actions brought against it arising in the normal course of business. It is the belief of the General Partner, based on knowledge of facts and advice of counsel, that the claims made against the Partnership in such actions will not result in any material adverse effect on the Partnership's consolidated financial position or results of operations. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The Partnership owns a 50% joint venture interest in 31 acres located within a 209-acre commercial/industrial park in Pompano Beach, Florida. The joint venture's property is encumbered by a mortgage loan in the principal amount of approximately $4 million as of December 31, 1993. As the Partnership believes the economics of the project do not warrant making additional cash investments or providing further financial guarantees, it was determined in 1991 that the least costly alternative for the venture would be to convey the land to the lender and to make certain cash payments to the lender in connection with the existing guarantees under the venture loan agreement. During April 1992, the Partnership and its joint venture partner each tendered payment in the amount of approximately $3.1 million for their respective shares of the guarantee payment and certain other holding costs to the lender, the majority of which reduced the outstanding mortgage loan to the current balance. Title to the property was not conveyed at that time pending resolution of certain general development obligations of the venture and certain environmental issues. The Partnership has been negotiating with the lender regarding the scope of the development work required to be done and does not anticipate the associated costs to be significant. With respect to the environmental issues, the previous owner remains obligated to undertake the clean up pursuant to, among other things, a surviving obligation under the purchase and sale agreement. During January 1994, the Florida Department of Environmental Protection approved the first phase of a three phase environmental clean-up program. However, no substantial clean-up has occurred to date. If the previous owner is unable to fulfill its obligations as they relate to this environmental issue, the resolution of the environmental issue and its related costs may become an obligation of the venture and ultimately the Partnership. Should this occur, the Partnership does not anticipate the cost of this clean-up to be material to its operations. The lender has recently asserted the mortgage loan is with recourse to the joint venture partners as a result of the partners' failure to perform in accordance with the terms of the loan agreement. The Partnership believes this claim is without merit and will vigorously defend itself against this allegation. The transfer of title, when fully consummated, will not have a significant impact on the Partnership's operations for financial reporting purposes due to the prior payment of the financial guarantees and certain holding costs. However, the Partnership will recognize a loss for Federal income tax purposes. In anticipation of its future development plans, the Partnership is currently in the process of obtaining permits for development of Increment III of its Weston Community, portions of which are environmentally sensitive areas that may be subject to protection as wetlands. The time involved to complete this process, which involves the approvals of the Army Corps of Engineers, the Environmental Protection Agency and other regulatory agencies, is expected to be lengthy. It is anticipated that certain costs of mitigation will be incurred in conjunction with obtaining the necessary permits, the amount and extent of which are unknown at this time. The Partnership had previously gone through a similar process and was successful in obtaining the approvals for Increment II of the Weston Community. Although there can be no assurance, given the Partnership's prior experience and discussions to date with the appropriate agencies, the Partnership is hopeful that a compromise will ultimately be reached that will adequately address the concerns of the environmental agencies, while allowing the Partnership to continue its development plans for Weston's Increment III. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED In June 1993, the Partnership reached an agreement with Equitable South Florida Venture ("Equitable"), the successor in interest to Tishman Speyer/Equitable South Florida Venture, the original purchaser of approximately 390 acres of land in Increment III in the Partnership's Weston Community, whereby, in exchange for $5.0 million, the Partnership repurchased approximately 330 acres of the land and Equitable agreed to relieve the Partnership of the obligations under certain provisions of the Sale and Purchase Agreement dated December 15, 1983 which were assumed by the Partnership in connection with the purchase of the assets of Arvida Corporation in September 1987. Of the agreed upon price of $5 million, $2.5 million was paid at closing and the balance of $2.5 million will be paid in equal annual installments of $500,000 together with interest thereon of 8% per annum beginning May 1994. The unpaid principal balance will be secured by a mortgage on certain real estate located in the Partnership's Weston Community. As part of its efforts to obtain the appropriate development permits discussed in the preceding paragraph, the Partnership has included this land as part of its proposed mitigation plan for the development of Increment III of its Weston Community. The Partnership may be responsible for funding certain other ancillary activities for related entities in the ordinary course of business which the Partnership does not currently believe will have any material effect on its consolidated financial position or results of operations. (12) TAX INCREMENT FINANCING ENTITIES In connection with the development of the Partnership's Weston Community, which is in the mid stage of development, bond financing is utilized to construct certain on-site and off-site infrastructure improvements, including major roadways, lakes, other waterways and pump stations, which the Partnership would otherwise be obligated to finance and construct as a condition to obtain certain approvals for the project. This bond financing is obtained by The Indian Trace Community Development District ("District"), a local government district operating in accordance with Chapter 190 of the Florida Statutes. Under this program, the Partnership is not obligated directly to repay the bonds. Rather, the bonds are expected to be fully serviced by special assessment taxes levied on the property, which effectively collateralizes the obligation to pay such assessments. While the owner of the property, the Partnership is responsible to pay the special assessment taxes until land parcels are sold. At such point, the liability for the assessments related to parcels sold will be borne by the purchasers through a tax assessment on their property. These special assessment taxes are designed to cover debt service on the bonds, including principal and interest payments, as well as the operating and maintenance budgets of the District. The use of this type of bond financing is a common practice for major land developers in South Florida. The District issued $64,660,000 of variable rate bonds in November 1989 and $31,305,000 of variable rate bonds in July 1991. These bonds mature in various years commencing in May 1991 through May 2011. At December 31, 1993, the amount of bonds issued and outstanding totalled $89,950,000. For the twelve months ended December 31, 1993, the Partnership paid special assessments related to these bonds of approximately $5.2 million. In order to take advantage of historically low interest rates and reduce the exposure of variable rate debt, the District is pursuing a new bond issuance. If successful, the proceeds from this offering will be used to refund 1989 and 1991 bonds currently outstanding. ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (13) STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 107 ("SFAS 107") - DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS 107 requires entities with total assets exceeding $150 million for fiscal years ending after December 15, 1992 to disclose the SFAS 107 values of all financial assets and liabilities for which it is practicable to estimate. Value is defined in SFAS 107 as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Partnership believes the carrying amount of its financial instruments (excluding its interest rate swap agreements) approximates SFAS 107 value. The SFAS 107 value of the Partnership's interest rate swap agreements were obtained from dealer quotes. These values represent the estimated amounts the Partnership would be obligated to pay to terminate the agreements, taking into account current interest rates. The notional amounts, the carrying amounts, and SFAS 107 values for the Partnership's interest rate swap agreements are as follows: At December 31, 1993 --------------------------------- Notional Carrying SFAS 107 Amount Amount (1) Value ---------- ---------- ---------- Interest Rate Swap Agreements: In a net payable position. . . $50,000,000 $1,018,902 $1,306,410 In a net payable position. . . 25,000,000 240,838 1,229,232 (1) The amounts shown under "carrying amount" represent interest expense accruals arising from these unrecognized financial instruments. (14) PARTNERSHIP AGREEMENT Pursuant to the terms of the Partnership Agreement (and subject to Section 4.2 which allocates Profits, as defined, to the General Partner and Associate Limited Partners), profits or losses of the Partnership will be allocated as follows: (i) profits will be allocated such that the General Partner and the Associate Limited Partners will be allocated profits equal to the amount of cash flow distributed to them for such fiscal period with the remainder allocated to the Limited Partners, except that in all events, the General Partner shall be allocated at least 1% of profits and (ii) losses will be allocated 1% to the General Partner, 1% to the Associate Limited Partners and 98% to the Limited Partners. In the event profits to be allocated in any given year do not equal or exceed cash distributed to the General Partner and the Associate Limited Partners for such year, the allocation of profits will be as follows: The General Partner and the Associate Limited Partners will be allocated profits equal to the amount of cash flow distributed to them for such year. The Limited Partners will be allocated losses such that the sum of amounts allocated to the General Partner, Associate Limited Partners, and Limited Partners equals the profit for the given year. Section 4.2F of the Partnership Agreement requires the allocation of Profits (as defined) to the General Partner and Associate Limited Partners in order to take account of a current or anticipated reduction in the Partnership's indebtedness and certain other circumstances. In accordance with Section 4.2F of the Partnership Agreement, for financial reporting and Federal income tax purposes for the year ended December 31, 1992, the General ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Partner and Associate Limited Partners received allocations of Profits in addition to their respective allocations, pursuant to the other allocation provisions of the Partnership Agreement, of the Partnership's loss, as adjusted for such allocation of Profits. The amount of Profits, net of such loss, allocated to the General Partner and Associate Limited Partner, collectively, for tax and financial reporting purposes for 1992 was approximately $9,230,000 and $20,836,000, respectively. In future periods in which the Partnership incurs a loss, the General Partner and Associate Limited Partners may be allocated Profits pursuant to Section 4.2F equivalent to the amount of loss (as adjusted for such allocation of Profits), if any, allocable to them for financial reporting and Federal income tax purposes. For the year ended December 31, 1993, the Partnership had net income for financial reporting and Federal income tax purposes, however, no cash distributions were made during 1993. In accordance with Section 4.2A of the Partnership Agreement, the amount of net income allocated, collectively, to the General and Associate Limited Partners for tax and financial reporting purposes was approximately $19,000 and $293,000, respectively. In general, and subject to certain limitations, the distribution of Cash Flow (as defined) after the initial admission date is allocated 90% to the Holders of Interests and 10% to the General Partner and the Associate Limited Partners (collectively) until the Holders of Interests have received cumulative distributions of Cash Flow equal to a 10% per annum return (non- compounded) on their Adjusted Capital Investments (as defined) plus the return of their Capital Investments; provided, however, that 4.7369% of the 10% amount otherwise distributable to the General Partner and Associate Limited Partners (collectively) will be deferred, and such amount will be paid to the Holders of Interests, until the Holders of Interests receive Cash Flow distributions equal to a cumulative, non-compounded amount of 12% per annum of their Capital Investments (as defined). This deferral provision is in place until the Holders of Interests receive total cash distributions equal to their Capital Investments. Any deferred amounts owed to the General Partner and Associate Limited Partners (collectively) will be distributable to them out of Cash Flow otherwise distributable to the Holders of Interests at such time as such Holders have received a 12% per annum cumulative, non-compounded return on their Capital Investments (as defined) or in any event, to the extent of one-half of Cash Flow otherwise distributable to the Holders of Interests at such time as they have received total distributions of Cash Flow equal to their Capital Investments (as defined). Thereafter, all distributions of Cash Flow will be made 85% to the Holders of Interests and 15% to the General Partner and the Associate Limited Partners (collectively); provided, however, that the General Partner and the Associate Limited Partners (collectively) shall be entitled to receive an additional share of Cash Flow otherwise distributable to the Holders of Interests equal to the lesser of an amount equal to 2% of the cumulative gross selling prices of any interests in real property of the Partnership (subject to certain limitations) or 13% of the aggregate distributions of Cash Flow to all parties pursuant to this sentence. (15) Subsequent Events (a) During February 1994, the Partnership paid a distribution of $2,565,433 to the Limited Partners ($6.35 per Interest) and $142,523 to the General Partner and Associate Limited Partners, collectively. (b) During November 1993, the Partnership received a commitment from a lender for a $24 million revolving construction line of credit for the first building and certain amenities within the Partnership's new condominium project on Longboat Key, Florida known as Grand Bay. This note was subsequently executed on January 14, 1994 and bears interest at the lender's prime rate plus 3/4%, payable monthly. In addition, the Partnership is required to make repayments on the note in accordance with release provisions as set forth in the credit agreement, with any remaining outstanding principal ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONCLUDED balance payable at maturity on January 14, 1996. The note is secured by a recorded first mortgage on certain real and personal property in Sarasota County, Florida. As of March 15, 1994, approximately $2.6 million was outstanding under this note. The Grand Bay project is planned to consist of six condominium buildings on 24 acres and will offer certain amenities including a recreation facility with a community pool and two tennis courts. The Partnership intends to obtain additional lines of credit prior to the construction of each of the remaining five buildings at Grand Bay. These buildings are planned to be constructed over the next five years with the final building expected to be completed in 1998. SCHEDULE X ARVIDA/JMB PARTNERS, L.P. (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES SUPPLEMENTARY STATEMENTS OF OPERATIONS INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Depreciation and amortization . . . . . $6,232,092 7,550,386 7,072,673 Repairs and maintenance. . . . . . 2,623,072 2,328,918 1,673,475 Property taxes, net of amounts capitalized. . . . . . 6,925,925 8,220,342 7,353,574 Advertising costs. . . . 5,051,175 5,240,007 7,561,712 ----------- ----------- ----------- $20,832,264 23,339,653 23,661,434 =========== =========== =========== ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On November 30, 1993, the General Partner of the Partnership approved the engagement of Ernst & Young as the Partnership's independent auditors for the fiscal year ending December 31, 1993 to replace the firm of Price Waterhouse who were dismissed as auditors of the Partnership effective November 30, 1993. The reports of Price Waterhouse on the Partnership's consolidated financial statements for the year ended December 31, 1992 and 1991 did not contain an adverse opinion or a disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope, or accounting principles. In connection with the audits of the Partnership's financial statements for the above-mentioned years and in the subsequent interim period, there were no disagreements with Price Waterhouse on any matters of accounting principles or practices, financial statement disclosure, or auditing scope and procedures which, if not resolved to the satisfaction of Price Waterhouse would have caused Price Waterhouse to make reference to the matter in their report. The change in accountants was previously reported in the Partnership's Report on Form 8-K dated December 8, 1993, a copy of which is filed as Exhibit 99.2 to this report, describing the change in the Partnership's independent auditors. There were no changes or disagreements with auditors during 1992. PART III ITEM 10. ITEM 10. DIRECTOR AND EXECUTIVE OFFICERS OF THE REGISTRANT The General Partner of the Partnership is Arvida/JMB Managers, Inc., a Delaware corporation, all of whose outstanding shares of stock are owned by JMB Holdings Corporation, an Illinois corporation, 75% of the outstanding shares of which are owned by JMB Realty Corporation ("JMB"), a Delaware corporation, and the remaining 25% of which are owned by 900 Partner Investments, an Illinois general partnership whose partners include certain officers and directors of JMB and its affiliates. Arvida/JMB Managers, Inc. was substituted as general partner of the Partnership as a result of a merger on March 30, 1990 of an affiliated corporation that was the then general partner of the Partnership into Arvida/JMB Managers, Inc., which, as the surviving corporation of such merger, continues as General Partner. All references herein to "General Partner" include Arvida/JMB Managers, Inc. and its predecessor, as appropriate. The General Partner has responsibility for all aspects of the Partnership's operations. Arvida/JMB Associates, an Illinois general partnership, of which certain officers and affiliates of JMB are partners and Arvida/JMB Limited Partnership, an Illinois limited partnership, of which Arvida/JMB Associates is the general partner, are the Associate Limited Partners of the Partnership. Various relationships of the Partnership to the General Partner and its affiliates are described under the caption "Conflicts of Interest" at pages 21-24 of the Prospectus, which description is hereby incorporated herein by reference to Exhibit 28.1 of the Partnership's Report on Form 10-K dated March 29, 1993 (File No. 0-16976). The director, executive officers and certain other officers of the General Partner of the Partnership are as follows: SERVED IN NAME OFFICE OFFICE SINCE ---- ------ ------------ Judd D. Malkin Chairman 04/08/87 Neil G. Bluhm President 04/08/87 Roger E. Hall Vice President 04/09/87 Ernest M. Miller, Jr. Vice President 04/09/87 H. Rigel Barber Vice President 04/08/87 Ira J. Schulman Vice President 04/09/87 Gailen J. Hull Vice President 04/09/87 Howard Kogen Vice President and Treasurer 04/08/87 Gary Nickele Vice President, General Counsel 04/08/87 and Director 12/18/90 Vincent P. Donahue, Jr. Vice President 04/09/87 James D. Motta Vice President 04/09/87 John Garrity Vice President 02/01/91 John Grab Vice President 04/09/87 There is no family relationship among any of the foregoing director or officers. The foregoing director has been elected to serve a one-year term until the annual meeting of the General Partner to be held on June 7, 1994. All of the foregoing officers have been elected to serve one-year terms until the first meeting of the Board of Directors held after the annual meeting of the General Partner to be held on June 7, 1994. There are no arrangements or understandings between or among any of said director or officers and any other person pursuant to which any director or officer was selected as such. The foregoing director and certain of the officers are also officers and/or directors of various affiliated companies, including JMB, which is the corporate general partner of Carlyle Real Estate Limited Partnership-VII ("Carlyle-VII"), Carlyle Real Estate Limited Partnership-IX ("Carlyle-IX"), Carlyle Real Estate Limited Partnership-X ("Carlyle-X"), Carlyle Real Estate Limited Partnership-XI ("Carlyle-XI"), Carlyle Real Estate Limited Partner- ship-XII ("Carlyle-XII"), Carlyle Real Estate Limited Partnership-XIII ("Carlyle-XIII"), Carlyle Real Estate Limited Partnership-XIV ("Carlyle-XIV"), Carlyle Real Estate Limited Partnership-XV ("Carlyle-XV"), Carlyle Real Estate Limited Partnership-XVI ("Carlyle-XVI"), Carlyle Real Estate Limited Partnership-XVII ("Carlyle-XVII"), JMB Mortgage Partners, Ltd. ("Mortgage Partners"), JMB Mortgage Partners, Ltd.-II ("Mortgage Partners-II"), JMB Mortgage Partners, Ltd.-III ("Mortgage Partners-III"), JMB Mortgage Partners, Ltd.-IV ("Mortgage Partners-IV"), Carlyle Income Plus, Ltd. ("Carlyle Income Plus") and Carlyle Income Plus, Ltd.-II ("Carlyle Income Plus-II") and the managing general partner of JMB Income Properties, Ltd.-IV ("JMB Income-IV"), JMB Income Properties, Ltd.-V ("JMB Income-V"), JMB Income Properties, Ltd.-VI ("JMB Income-VI"), JMB Income Properties, Ltd.-VII ("JMB Income-VII"), JMB Income Properties, Ltd.-VIII ("JMB Income-VIII"), JMB Income Properties, Ltd.-IX ("JMB Income-IX"), JMB Income Properties, Ltd.-X ("JMB Income-X"), JMB Income Properties, Ltd.-XI ("JMB Income-XI"), JMB Income Properties, Ltd.-XII ("JMB Income-XII") and JMB Income Properties, Ltd.-XIII ("JMB-XIII"). Most of the foregoing director and officers are also officers and/or directors of various affiliated companies of JMB including Arvida/JMB Managers-II, Inc. (the general partner of Arvida/JMB Partners, L.P.-II ("Arvida-II") and Income Growth Managers, Inc. (the corporate general partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG")). The director and most of such officers are also partners, directly or indirectly, of certain partnerships (the "Associate Partnerships") which are associate general partners in the following real estate limited partnerships: Carlyle-VII, Carlyle-IX, Carlyle-X, Carlyle-XI, Carlyle-XII, Carlyle-XIII, Carlyle-XIV, Carlyle-XV, Carlyle-XVI, Carlyle-XVII, JMB Income-VI, JMB-VII, JMB Income-VIII, JMB Income-IX, JMB Income-X, JMB Income-XI, JMB Income-XII, JMB Income-XIII, Mortgage Partners, Mortgage Partners-II, Mortgage Partners-III, Mortgage Partners-IV, Carlyle Income Plus, Carlyle Income Plus-II and IDS/BIG. The following director and officers are partners, indirectly through other partnerships, of one of the Associate Limited Partners of the Partnership and of the Associate Limited Partner of Arvida-II. The business experience during the past five years of the director and such officers of the Corporate General Partner of the Partnership in addition to that described above is as follows: Judd D. Malkin (age 56) is Chairman of the Board of JMB, an officer and/or director of various JMB affiliates and a partner, directly or indirectly, of the Associate Partnerships. He is also an individual general partner of JMB Income Properties-IV and JMB Income Properties-V. Mr. Malkin has been associated with JMB since October, 1969. He is a Certified Public Accountant. Neil G. Bluhm (age 56) is President and a director of JMB and an officer and/or director of various JMB affiliates and a partner, directly or indirectly, of the Associate Partnerships. He is also an individual general partner of JMB Income Properties-IV and JMB Income Properties-V. Mr. Bluhm has been associated with JMB since August, 1970. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Roger E. Hall (age 62) is Chairman of Arvida. Prior thereto, he was President-Arvida (September, 1987 to January, 1989). Ernest M. Miller, Jr. (age 51) is President and Chief Executive Officer of Arvida. Prior thereto, he was Executive Vice President and Chief Financial Officer of Arvida (September, 1987 to February, 1989). From February, 1984, Mr. Miller has been Chairman of Wilson Miller Capital Corp., a real estate investment and consulting business. H. Rigel Barber (age 45) is Chief Executive Officer and Executive Vice President of JMB, an officer of various JMB affiliates and a partner of various Associate Partnerships. Mr. Barber has been associated with JMB since March, 1982. He received a J.D. Degree from the Northwestern Law School and is a member of the Bar of the State of Illinois. Ira J. Schulman (age 42) is Executive Vice President of JMB, an officer of various JMB affiliates and a partner, directly or indirectly, of various Associate Partnerships. He holds a Masters Degree in Business Administration from the University of Pittsburgh. Gailen J. Hull (age 46) is a Senior Vice President of JMB, an officer of various JMB affiliates and a partner, directly or indirectly, of various Associate Partnerships. Mr. Hull has been associated with JMB since March, 1982. He holds a Masters degree in Business Administration from Northern Illinois University and is a Certified Public Accountant. Howard Kogen (age 58) is Senior Vice President and Treasurer of JMB, an officer of various JMB affiliates and a partner, directly or indirectly, of various Associate Partnerships. Mr. Kogen has been associated with JMB since March, 1973. He is a Certified Public Accountant. Gary Nickele (age 41) is Executive Vice President, Secretary and General Counsel of JMB, an officer of various JMB affiliates and a partner, directly or indirectly, of various Associate Partnerships. Mr. Nickele has been associated with JMB since February, 1984. He holds a J.D. degree from the University of Michigan Law School and is a member of the Bar of the State of Illinois. Vincent P. Donahue Jr. (age 40) is Vice President of Finance and Chief Financial Officer of Arvida. Prior thereto, he was Vice President- Acquisitions of Arvida from October, 1987 to October, 1990. James D. Motta (age 37) is President-Community Development Division of Arvida. Prior thereto, he was President-Southeast Division of Arvida (July, 1992 to July, 1993), President-South Florida Division of Arvida (January, 1989 to July, 1992) and Vice President and General Manager--Boca Raton of Arvida (September, 1987 to January, 1989). John R. Grab (age 37) is Vice President and General Manager - Club/Hotel Operations. Prior thereto, he was Vice President and Project General Manager - - Weston Hills (October 1990 to October 1993), Vice President and Project General Manager - Jacksonville Golf & Country Club (June 1988 to October 1990), and Vice President of Finance - North Florida Division (September 1987 to June 1988). Previously, he was employed by Arvida Corporation, which he joined in December 1981, and was Vice President - Finance and Accounting with Arvida Hospitality Management, Inc. (October 1986 to September 1987). He is a Certified Public Accountant. He received his B.S. in Accounting from St. Leo College. John M. Garrity (age 47) is Vice President and General Manager - Arvida Homes, with Arvida Company. Prior thereto, he was Vice President of Construction - Arvida Homes (December 1992 to March 1993) and Vice President and Project General Manager - Weston (February 1991 to December 1992). Previously, he was President of The Key Company (September 1988 to February 1991), and Vice President and Market Manager - Tampa (March 1981 to August 1988). He holds a Masters degree in Business Administration from the University of North Carolina. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The officers and the director of the General Partner receive no current or proposed direct remuneration in such capacities from the Partnership. The General Partner and the Associate Limited Partners are entitled to receive a share of cash distributions, when and as cash distributions are made to the Limited Partners, and a share of profits or losses as described under the caption "Cash Distributions and Allocations of Profit and Losses" at pages 61 to 64 of the Prospectus and at pages A-9 to A-16 of the Partnership Agreement, which description incorporated herein by reference to Exhibits 28.1 and 3., respectively, to the Partnership's Report for December 31, 1992 on Form 10-K dated March 29, 193 (File No. 0-16976). Reference is also made to Notes 1 and 14 for a description of such distributions and allocations. The General Partner and the Associate Limited Partners did not receive any cash distributions in 1993. Under certain circumstances they will be entitled to approximately $810,000 which was deferred in 1990. Such payment is subject to certain restrictions contained in the Partnership Agreement and the Partnership's credit facility. Pursuant to the Partnership Agreement, the General Partner and Associate Limited Partners were allocated profits for tax purposes for 1993 of approximately $19,280. Reference is made to Note 14 for further discussion of this allocation. The Partnership is permitted to engage in various transactions involving the General Partner and its affiliates, as described under the captions "Management of the Partnership" at pages 56 to 59, "Conflicts of Interest" at pages 21-24 of the Prospectus and "Rights, Powers and Duties of the General Partner" at pages A-16 to A-28 of the Partnership Agreement, which descriptions are hereby incorporated herein by reference to Exhibits 28.1 and 3., respectively, to the Partnership's Report for December 31, 1992 on Form 10-K dated March 29, 1993 (File No. 0-16976). The relationships of the General Partner (and its director and executive officers and certain other officers) and its affiliates to the Partnership are set forth above in Item 10. Arvida may be reimbursed fully for all of its out-of-pocket expenditures (including salary and salary-related expenses) incurred while supervising the development and management of the Partnership's properties and other operations, subject to the limitation that such reimbursement may not exceed 5% of the aggregate gross revenues from the business of the Partnership. In 1993, such expenses were approximately $6,686,100, of which approximately $80,000 was unpaid as of December 31, 1993. The Partnership and Arvida/JMB Partners, L.P.-II (a publicly-held limited partnership affiliated with the General Partner) each employ project related and administrative personnel who perform services on behalf of both partnerships. In addition, certain out-of-pocket expenditures related to such services and other general and administrative expenses, including certain insurance premiums, are incurred and allocated to each partnership as appropriate. The Partnership receives reimbursements from or reimburses Arvida/JMB Partners, L.P.-II for such costs (including salary and salary- related expenses). The Partnership was entitled to receive approximately $2,497,400 from Arvida/JMB Partners, L.P.-II for such costs and services incurred in 1993, approximately $26,100 of which was outstanding as of December 31, 1993. In addition, the Partnership was obligated to reimburse Arvida/JMB Partners, L.P.-II approximately $1,234,300 for the year ended December 31, 1993, all of which was paid at December 31, 1993. JMB Insurance Agency, Inc., an affiliate of the General Partner, earned and received insurance brokerage commissions in 1993 of approximately $288,000 in connection with providing insurance coverage for certain of the properties of the Partnership, all of which were paid as of December 31, 1993. Such commissions are at rates set by insurance companies for the classes of coverage provided. The General Partner of the Partnership or its affiliates are entitled to property management fees and may be reimbursed for their direct expenses or out-of-pocket expenses relating to the administration of the Partnership and the acquisition, development, ownership, supervision, and operation of the Partnership assets. In 1993, the General Partner of the Partnership or its affiliates were due reimbursement for such direct or out-of-pocket expenses and property management fees in the amount of approximately $173,600, approximately $165,200 of which was paid as of December 31, 1993. Additionally, the General Partner and its affiliates are entitled to reimbursements for legal and accounting services. Such costs for 1993 were approximately $93,700, none of which was paid as of December 31, 1993. The Partnership was also entitled to receive reimbursements from affiliates of the General Partner for certain general and administrative expenses including, and without limitation, salary and salary-related expenses relating to work performed by employees of the Partnership and certain out-of- pocket expenditures incurred on behalf of such affiliates. The Partnership was owed approximately $171,000 for such costs and services incurred in 1993, approximately $146,300 of which was received as of December 31, 1993. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) No person or group is known by the Partnership to own beneficially more than 5% of the outstanding Interests of the Partnership. (b) The General Partner and its officers and directors own the following Interests of the Partnership: NAME OF AMOUNT AND NATURE BENEFICIAL OF BENEFICIAL PERCENT TITLE OF CLASS OWNER OWNERSHIP OF CLASS - -------------- ---------- ----------------- -------- Limited Partnership General Partner 125 Interests Less Interests and its officers than 1% and director as a group - --------------- No officer or director of the General Partner of the Partnership possesses a right to acquire beneficial ownership of Interests of the Partnership. All of the outstanding shares of the General Partner of the Partnership are owned by affiliates of its officers and director as set forth above in Item 10. (c) There exists no arrangement, known to the Partnership, the operation of which may at a subsequent date result in a change in control of the Partnership. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the General Partner, affiliates or their management other than those described in Items 10, 11 and 12 above. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements. (See Index to Financial Statements filed with this annual report on Form 10-K). 2. Exhibits. 3. Amended and Restated Agreement of Limited Partnership.** 4.0 Assignment Agreement by and among the General Partner, the Initial Limited Partner and the Partnership.** 4.1 Amended and Restated Credit Agreement dated October 7, 1992, among Arvida/JMB Partners, L.P., Arvida/JMB Partners, Southeast Florida Holdings, Inc., Center Office Partners, Center Retail Partners, Center Hotel Limited Partnership, Weston Hills Country Club Limited Partnership and Chemical Bank and Nationsbank of Florida, N.A. is herein incorporated by reference to Exhibit No. 4.4 to the Partnership's Report on Form 10Q (File number 0-16976) dated November 11, 1992. 4.2 Security Agreement dated as of October 7, 1992 made by Arvida/JMB Partners, L.P., Arvida/JMB Partners, Southeast Florida Holdings, Inc., Center Office Partners, Center Retail Partners, Center Hotel Limited Partnership and Weston Hills Country Club Limited Partnership (as "grantors") in favor of Chemical Bank and Nationsbank of Florida, N.A. (as "lenders") is herein incorporated by reference to Exhibit No. 4.5 the Partnership's Report on Form 10Q (File number 0-16976) dated November 11, 1992. 4.3 Pledge Agreement dated as of October 7, 1992 among Arvida/JMB Partners, L.P., Arvida/JMB Partners, Southeast Florida Holdings, Inc., Center Office Partners, Center Retail Partners, Center Hotel Limited Partnership and Weston Hills Country Club Limited Partnership (as "pledgors") and Chemical Bank and Nationsbank of Florida, N.A. (as "lenders") is herein incorporated by reference to Exhibit No. 4.6 the Partnership's Report on Form 10Q (File number 0-16976) dated November 11, 1992. 4.4 Various mortgages and other security interests dated October 7, 1992 related to the assets of Arvida/JMB Partners, Center Office Partners, Center Retail Partners, Center Hotel Limited Partnership, Weston Hills Country Club Limited Partnership which secure loans under the Amended and Restated Credit Agreement referred to in Exhibit 4.1 are herein incorporated by reference to Exhibit No. 4.7 the Partnership's Report on Form 10Q (File number 0-16976) dated November 11, 1992. 4.7. $24,000,000 Consolidated Revolving Promissory Note dated January 14, 1994 by and between Arvida Grand Bay Limited Partnership-I, Arvida Grand Bay Limited Partnership-II, Arvida Grand Bay Limited Partnership-III, Arvida Grand Bay Limited Partnership-IV, Arvida Grand Bay Limited Partnership-V and Arvida Grand Bay Limited Partnership-VI and Barnett Bank of Broward County, N.A. is filed herewith. 4.8. Amended and Restated Mortgage and Security Agreement dated January 14, 1994 by and between Arvida Grand Bay Limited Partnership-I, Arvida Grand Bay Limited Partnership-II, Arvida Grand Bay Limited Partnership-III, Arvida Grand Bay Limited Partnership-IV, Arvida Grand Bay Limited Partnership-V, Arvida Grand Bay Limited Partnership-VI and Arvida Grand Bay Properties, Inc. and Barnett Bank of Broward County, N.A. is filed herewith. 4.9. Construction Loan Agreement dated January 14, 1994 by and between Arvida Grand Bay Limited Partnership-I and Arvida Grand Bay Properties, Inc. and Barnett Bank of Broward County, N.A. is filed herewith. 10.1. Agreement between the Partnership and The Walt Disney Company dated January 29, 1987 is hereby incorporated by reference to Exhibit 10.2 to the Partnership's Registration Statement on Form S-1 (File No. 33-14091) under the Securities Act of 1933 filed on May 7, 1987. 10.2. Management, Advisory and Supervisory Agreement is hereby incorporated by reference to Exhibit 10.2 to the Partnership's Form 10- K (File No. 0-16976) dated March 27, 1991. 10.3. Letter Agreement, dated as of September 10, 1987, between the Partnership and The Walt Disney Company, together with exhibits and related documents.* 10.4. Joint Venture Agreement dated as of September 10, 1987, of Arvida/JMB Partners, a Florida general partnership. * 21. Subsidiaries of the Registrant. 99.1. Pages 21-24, 56-59, 61-64, A-9 to A-28, A-31 to A-33, and B-2 of the Partnership dated September 16, 1987 (relating to SEC Registration Statement File No. 33-14091).* 99.2. The Registrant's Form 8-K Report (File No. 0-16976) dated December 6, 1993 is incorporated by reference. * Previously filed with the Securities and Exchange Commission as Exhibits 10.4 and 10.5, respectively, to the Partnership's Registration Statement (as amended) on Form S-1 (File No. 33-14091) under the Securities Act of 1933 filed on September 11, 1987 and incorporated herein by reference. ** Previously filed with the Securities and Exchange Commission as Exhibits 3 and 4, respectively, to the Partnership's Form 10-K Report (File No. 0-16976) filed on March 27, 1990 and hereby incorporated herein by reference. The Partnership agrees to furnish to the Securities and Exchange Commission upon request a copy of each instrument with respect to long-term indebtedness of the Partnership and its consolidated subsidiaries, the authorized principal amount of which is 10% or less than the total assets of the Partnership and its subsidiaries on a consolidated basis. (b) Reports on Form 8-K The Partnership's report dated December 6, 1993 describing the change in the Partnership's independent auditors for the year ended December 31, 1993. No financial statements were required to be filed therewith. No annual report or proxy material for the fiscal year 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ARVIDA/JMB PARTNERS, L.P. BY: Arvida/JMB Managers, Inc. (The General Partner) GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date: March 25, 1994 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. BY: Arvida/JMB Managers, Inc. (The General Partner) NEIL G. BLUHM By: Neil G. Bluhm, President (Principal Executive Officer) Date: March 25, 1994 JUDD D. MALKIN By: Judd D. Malkin, Chairman (Principal Financial Officer) Date: March 25, 1994 GARY NICKELE By: Gary Nickele, Vice President and Director Date: March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Vice President (Principal Accounting Officer) Date: March 25, 1994

353524_1993.txt

353524_1993

1993

353524

ITEM 1. BUSINESS: The principal business of IBM Credit Corporation (the Company) is financing. All the outstanding capital stock of the Company is owned by International Business Machines Corporation (IBM), a New York corporation. The Company finances the purchase and lease of IBM products and related products and services by customers of IBM in the U.S. The Company also engages in other financings, some of which are related and some of which are unrelated to the business of IBM. Pursuant to a Support Agreement between IBM and the Company, IBM has agreed to retain 100 percent of the voting capital stock of the Company, unless required to dispose of any or all such shares of stock pursuant to a court decree or order of any governmental authority which, in the opinion of counsel to IBM, may not be successfully challenged. IBM has also agreed to cause the Company to have a tangible net worth of at least $1.00 at all times. ITEM 2. ITEM 2. PROPERTIES: The Company's principal executive offices in Stamford, Connecticut, comprise approximately 154,000 square feet of office space. The Company occupies this space under an arrangement with IBM, which is the master tenant of this property under long-term leases. ITEM 3. ITEM 3. LEGAL PROCEEDINGS: None material. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS: Omitted pursuant to General Instruction J. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS: All shares of the Company's capital stock are owned by IBM and accordingly there is no market for such stock. The Company paid dividends of $325,000,000 and $50,000,000 to IBM in 1993 and 1992, respectively. Dividends are paid as declared by the Board of Directors of the Company. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS: OVERVIEW The Company originated financing for $9.3 billion of equipment, software and services during 1993. Net earnings for 1993 were $220.2 million, yielding a return on average equity of 19.1 percent. During the fourth quarter of 1993, the Company sold $1.4 billion of capital equipment and working capital financing receivables (financing receivables) realizing an aftertax gain of $12.9 million, as described throughout this discussion and analysis. In addition, during 1993, a charge of $23.9 million was recorded to reflect the effect of an increase in the federal income tax rate from 34 percent to 35 percent. The effect of the new tax rate was required to be recognized in accordance with Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes." In the 1993 second quarter, responding to the decline in IBM shipments and the resulting lower level of IBM Credit capital equipment financing originated, the Company initiated actions to reduce its infrastructure, including specific actions to reduce its workforce. These actions reduced future expenses and brought resources in line with current market conditions. To recognize the cost of these actions, aftertax restructuring charges of $6.4 million were recorded in 1993. FINANCING ORIGINATED For the year ended December 31, 1993, the Company originated financing for $9.3 billion of equipment, software and services, an increase of 8 percent from 1992. Capital equipment financing for end users decreased by 22 percent to $3.4 billion. The decrease in capital equipment financing originated is primarily the result of fewer IBM shipments in 1993 compared with 1992, together with a decline in the proportion of IBM products and services financed by the Company. Working capital financing for dealers and remarketers of information industry products increased by 39 percent to $5.9 billion. This improvement reflects increased shipments of IBM's personal computer and workstation products throughout 1993, as well as the development of IBM Credit's efforts to provide working capital financing that meets the full range of financing requirements of IBM authorized resellers. Capital equipment financings for end users is comprised of purchases of $1,733.8 million of information handling systems products from International Business Machines Corporation (IBM), financing originated of installment receivables of $165.1 million, other financing, primarily for IBM software and services of $277.5 million, installment and lease financing for state and local government customers of $294.2 million for the account of IBM, and other financing of $919.7 million for equipment and services including maintenance, remarketing transactions, sale leaseback transactions, as well as selected complementary non-IBM equipment which meets IBM customers' total solution requirements. The purchases of $1,733.8 million from IBM consisted of $1,306.3 million for capital leases and $427.5 million for operating leases. REMARKETING ACTIVITIES In addition to originating new financing, the Company remarkets used IBM equipment. This equipment is primarily sourced from the termination of existing lease transactions and is generally remarketed through retail channels in cooperation with the IBM sales force. The equipment is leased to end users or sold outright. These transactions may be with existing lessees or, when equipment is returned, with a new customer. At December 31, 1993, the investment in remarketed equipment on capital and operating leases totaled $619.8 million, an increase of 40.3 percent from the 1992 year-end investment of $441.9 million. Included in remarketing activities are income from leases and gross profit on equipment sales, net of the reduction in income to recognize the writedown in residual values of certain leased equipment. These remarketing contributions amounted to $103.1 million for the year ended December 31, 1993, down from $118.9 million for the year ended December 31, 1992. ASSETS Total assets were $10.0 billion at December 31, 1993, compared with $11.5 billion at December 31, 1992. The decrease reflects the securitization and sale of $1.4 billion of financing receivables during the fourth quarter of 1993, proceeds of which were used to reduce total debt, as well as the decrease in capital equipment financing originated in 1993, offset in part by an increase in working capital financing originated. Total financing receivables serviced by the Company as of December 31, 1993 were $11.1 billion, compared with $11.3 billion at December 31, 1992. Total financing receivables serviced include those financing receivables securitized and sold in the fourth quarter of 1993 ($1,371.0 million), capital and operating leases ($6,363.0 million in 1993, $7,814.0 million in 1992), loans receivable ($1,038.0 million in 1993, $1,416.0 million in 1992), and working capital financing receivables ($1,426.0 million in 1993, $1,138.0 million in 1992), as well as state and local government installment and lease financing receivables of IBM ($868.0 million in 1993, $950.0 million in 1992). Approximately 85 percent of the Company's total assets at December 31, 1993, related to the financing of IBM products and services. LIABILITIES AND STOCKHOLDER'S EQUITY The assets of the business were financed with $6,507.5 million of debt at December 31, 1993. Total debt, which includes short-term and long-term debt, decreased by $1,297.6 million during 1993. This decrease was primarily the result of applying proceeds from the sale of financing receivables during the fourth quarter of 1993 to reduce commercial paper and retire long-term debt. The proceeds were also used for general Corporate purposes, including dividends to IBM. At December 31, 1993, the Company had available $1.9 billion of a shelf registration with the Securities and Exchange Commission. This shelf registration allows the Company to quickly access domestic financial markets. In addition, a subsidiary of the Company had available $750.0 million of a separate shelf registration for asset backed securities. The Company also has a commercial paper program, a medium-term note program, and the IBM money market program. The Company is an authorized borrower of up to $1.0 billion under a $10.0 billion IBM Global Credit Facility, and has a liquidity agreement with IBM for $500.0 million. Back up lines of credit in the amount of $1.6 billion were terminated when the IBM Global Credit Facility was put in place; they had not been drawn upon. The Company also has the option, as approved by the Board of Directors on July 29, 1993, to sell, assign, pledge, or transfer up to an additional $2.6 billion of assets to third parties through December 31, 1994. These financing sources along with the Company's internally generated cash, medium-term note and commercial paper programs provide the flexibility to the Company to grow its lease and loan portfolio, service debt, and fund working capital. Due to IBM Corporation and affiliates decreased by $144.2 million to $1,259.5 million at December 31, 1993 from $1,403.7 million at December 31, 1992. This reduction was primarily attributable to the lower volume of capital equipment purchased from IBM in the fourth quarter of 1993, compared with the fourth quarter of 1992, offset by a net increase in working capital financing receivables purchased in the fourth quarter of 1993 compared with the 1992 fourth quarter. Amounts due to IBM Corporation and affiliates represent trade payables arising from purchases of equipment for term leases and installment receivables, working capital financing receivables for dealers and remarketers, and software license fees, with payment terms comparable to those offered to other IBM customers. Also included in due to IBM Corporation and affiliates is income taxes currently payable under the intercompany tax allocation agreement. Total stockholder's equity at December 31, 1993 was $1,150.7 million, down $104.8 million from year-end 1992. The change in stockholder's equity reflects payments of $325.0 million in dividends to IBM, and net earnings of $220.2 million. At December 31, 1993, the Company's debt to equity ratio was 5.7:1, compared with 6.2:1 at December 31, 1992. :hp3.TOTAL CASH PROVIDED BEFORE DIVIDENDS:EHP3. Total cash provided before dividends was $336.3 million for 1993, compared with $125.1 million for 1992. Cash and cash equivalents at December 31, 1993, totaled $609.9 million, an increase of $11.3 million compared with the balance at December 31, 1992. Total cash provided before dividends reflects $1,631.7 million of cash provided by operating and investing activities, reduced by $1,295.4 million of cash used in financing activities, before dividends. INCOME FROM LEASES Income from leases decreased by 14 percent to $573.4 million in 1993, from $667.0 million in 1992. This decline is the result of a decrease in capital equipment financing originated throughout 1993, together with lower yields associated with declining market interest rates. Income from leases includes lease income resulting from remarketing transactions. For the year ended December 31, 1993, this income amounted to $71.6 million, which is comparable to 1992. On a periodic basis, the Company reassesses the future residual value of its portfolio of leases. In accordance with generally accepted account- ing principles, anticipated increases in specific future residual values may not be recognized before realization and are thus a source of potential future profits. Anticipated decreases in specific future residual values, considered to be other than temporary, must be recognized currently. A review of the Company's $775.0 million residual value portfolio at December 31, 1993 indicated that the overall estimated future value of the portfolio continues to be greater than the value currently recorded, but declines in the future residual value of certain leased equipment were identified. To recognize these declines, the Company recorded a $32.0 million reduction to income from leases for 1993, compared with $20.0 million in 1992. INCOME FROM LOANS Income from loans decreased by 28 percent to $112.3 million in 1993 from $155.6 million in 1992. This decline is the result of a reduction in the loan portfolio and lower yields associated with declining market interest rates. INCOME FROM WORKING CAPITAL FINANCING Income from working capital financing increased 29 percent to $104.3 million in 1993, compared with $80.6 million in 1992. This increase is primarily due to growth in the size of the average working capital financing receivables outstanding during 1993, compared with 1992. The growth reflects increased amounts of IBM's personal computer and workstation products, which the Company financed throughout 1993, as well as an increase in the volume of financing provided for non-IBM products for IBM authorized resellers. EQUIPMENT SALES Equipment sales increased by 13 percent to $840.9 million in 1993, compared with $743.3 million in 1992. Included in these amounts is revenue from outright sales and sales-type leases of Company-owned equipment with either existing lessees or, when equipment is returned, with other customers. Gross profit on equipment sales amounted to $63.6 million for 1993, compared with $66.9 million for 1992. The gross profit margin declined to 7.6 percent in 1993 from 9.0 percent in 1992. This lower margin reflects a $20.0 million charge to recognize the decline in current market value for 3390 Model 2 Direct Access Storage Device equipment sold or leased under sales-type leases during the third and fourth quarters of 1993 or inventoried at December 31, 1993. The decline in current market value of this equipment was the result of a temporary excess supply in the used equipment markets. Gross profit margin on other products continues to be within the range of management's expectations. OTHER INCOME Other income increased by 20 percent to $139.5 million in 1993 from $116.0 million in 1992. Included in other income is a pretax gain on the sale of financing receivables of $21.0 million, net of related expenses. The sale of financing receivables generally accelerates the recognition of finance income and can result in a current period gain or loss. The amount of such gain or loss is dependent on a number of factors and may create a degree of volatility in earnings depending on the type of receivables sold, the structure of the transaction, and prevailing financial market conditions. The Company continues to service the financing receivables sold and earns a fee which is included in other income. Also included in other income is interest income earned on cash and cash equivalents, as well as fees for managing IBM's state and local government installment and lease financing receivable portfolio. The increase in other income is the result of growth in interest income and the gain on the sale of financing receivables, partially offset by a decrease in fees earned from managing IBM's state and local government installment and lease financing receivable portfolio. TOTAL FINANCE AND OTHER INCOME Total finance and other income increased to $1,770.4 million in 1993 from $1,762.5 million in 1992. The increase is due to growth in income from working capital financing, other income, and equipment sales, partially offset by reductions in income from leases and loans. INTEREST EXPENSE Interest expense declined as the Company's total debt decreased. In addition, the Company continued to benefit from lower market interest rates, partially offset by an increased cost of funding due to debt downgradings throughout 1993. Interest expense decreased by 18 percent to $365.7 million in 1993, compared with $445.8 million in 1992. The Company's overall average cost of debt decreased to 5.0 percent in 1993, from 5.9 percent in 1992. SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES Selling, general, and administrative expenses decreased one percent to $185.5 million in 1993, from $186.9 million in 1992. The decrease is due to the Company's continuing efforts to manage expenses. PROVISION FOR RECEIVABLE LOSSES The Company's portfolio of capital equipment leases and loans is predominantly with investment grade customers. The Company generally takes a security interest in any underlying equipment financed. The portfolio is diversified by geography, industry, and individual unaffiliated customer. Working capital financing receivables are secured by the underlying inventory and accounts receivable financed. At December 31, 1993, the allowance for receivable losses approximated 1.5 percent of the Company's portfolio of leases and loans, compared with approximately 1.7 percent at December 31, 1992. The provision for receivable losses decreased to $38.0 million in 1993 from $102.6 million in 1992. This decrease reflects the reduction in the amount of capital equipment financed, and an economic environment that continues to improve. Additionally, the Company continues to effectively manage credit risk and contain losses. These efforts resulted in the 1993 recovery of $11.0 million of losses previously recorded in 1991 and 1992 to reflect the then estimated loss associated with a major bankruptcy, along with other recoveries throughout 1993. INCOME TAXES The effective tax rate in 1993 was 44.0 percent, compared with 37.5 percent in 1992. The increase in the effective tax rate reflects the enactment of the Omnibus Budget Reconciliation Act of 1993 (the Act) during the third quarter of 1993. The Act increased the U.S. corporate income tax rate from 34 percent to 35 percent, retroactive to January 1, 1993. The tax rate increase resulted in a $23.9 million charge for 1993; $20.1 million related to previously provided deferred taxes, and $3.8 million in current taxes. The Company expects its effective tax rate to approximate the statutory federal and state income tax rates in future years. NET EARNINGS Net earnings were $220.2 million for the year ended December 31, 1993, compared with $219.3 million for 1992. Excluding the additional income tax expense, the restructuring charges, and the gain on the sale of financing receivables, net earnings would have been $237.6 million for 1993, an increase of 8.3 percent compared with 1992. RETURN ON AVERAGE EQUITY The 1993 results yielded a return on average equity of 19.1 percent, compared with 19.0 percent in 1992. Without the specific items mentioned in the preceding paragraph, the return on average equity would have been 20.3 percent. NEW ACCOUNTING STANDARDS In November 1992, the Financial Accounting Standards Board (FASB) issued SFAS 112, "Employer's Accounting for Postemployment Benefits," which established new accounting principles for the cost of benefits provided to former or inactive employees after employment but before retirement. IBM and IBM Credit elected early adoption of SFAS 112 as of January 1, 1993. The impact of adoption did not materially impact the results of the Company's operations. In May 1993, the FASB issued SFAS 114, "Accounting by Creditors for Impairment of a Loan," which amends SFAS 5, "Accounting for Contingencies," and SFAS 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings." Under SFAS 114, creditors should evaluate the collectibility of both contractual interest and principal of all receivables when assessing the need for a loss accrual. Additionally, SFAS 114 requires creditors to measure all loans that are restructured in a troubled debt restructuring involving a modification of terms to reflect the time value of money. This statement is effective for fiscal years beginning after December 15, 1994. In May 1993, the FASB issued SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities," which prescribes the accounting for debt and equity securities held as assets. This statement is effective for fiscal years beginning after December 15, 1993. It is expected that the implementation of standards 114 and 115 will not result in a material charge to the results of operations in the year of adoption. CLOSING DISCUSSIONS In the 1993 second quarter, the Company initiated actions to reduce its infrastructure, including specific actions to reduce its workforce. To recognize the cost of these actions, aftertax restructuring charges of $6.4 million were recorded. If our assumptions with regard to market conditions prove correct, then the Company's resources will be sufficient to enable it to carry out its mission of supporting customers in their acquisition of IBM products and services by providing competitive financing, and contributing to the growth and stability of IBM earnings. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA: Report of Independent Accountants February 16, 1994 To the Stockholder and Board of Directors of IBM Credit Corporation In our opinion, the accompanying consolidated financial statements listed in the index appearing under Item 14(a) 1. and 2. on pages 33 and 34 present fairly, in all material respects, the financial position of IBM Credit Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion thereon based on our audits. We conducted our audits in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether such statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. Price Waterhouse Stamford, CT IBM CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation: The consolidated financial statements include the accounts of IBM Credit Corporation (the Company) and those of its subsidiaries which are more than 50 percent owned. Investments in partnerships in which the Company has typically a 20 percent ownership are accounted for using the equity method. Cash and Cash Equivalents: Time deposits with original maturities generally of three months or less are included in cash and cash equivalents. Cash paid for interest was $366.2 million, $504.1 million, and $580.3 million for 1993, 1992 and 1991, respectively. Finance Income Recognition: Income attributable to direct financing leases and loans receivable is initially recorded as unearned income and subsequently recognized as finance income at level rates of return over the term of the leases or receivables. Income recognized from leveraged leases includes the amortization of unearned finance income and deferred investment and other tax credits over the term of the leases, at level rates of return, during periods when the net investment balance is positive. Equipment on Operating Lease: Equipment is depreciated on a straight-line basis to its estimated residual value over the lease term. Equipment Sales Income Recognition: Revenue from equipment sales to existing lessees is recognized at the effective date a purchase provision is exercised. Revenue from sales to parties other than the existing lessee is recognized when title transfers. Allowance for Receivable Losses: The allowance for receivable losses is determined on the basis of actual collection experience and estimated future collectibility of the related assets. Income Taxes: The application of the intercompany tax allocation agreement (the Agreement) between the Company and its parent company, IBM, was mutually clarified during the first quarter of 1993. The Agreement now aligns the settlement of federal and state tax benefits/and or obligations with the Company's provision for income taxes determined on a separate company basis. The Company is part of the IBM consolidated federal tax return, and files separate state tax returns in selected states. Included in due to IBM Corporation and affiliates at December 31, 1993 and 1992, respectively, is $263.8 million and $5.3 million of current income taxes payable as determined in accordance with the intercompany tax allocation agreement. Cash paid for income taxes in 1993, 1992, and 1991, was $120.6 million, $7.8 million, and $5.5 million, respectively. RELATIONSHIP WITH IBM: Pursuant to a Support Agreement between IBM and the Company, IBM has agreed to retain 100% of the voting capital stock of the Company, unless required to dispose of any or all such shares of stock pursuant to a court decree or order of any governmental authority which in the opinion of counsel to IBM, may not be successfully challenged. IBM has also agreed to cause the Company to have a tangible net worth of at least $1.00 at all times. The Support Agreement provides that it shall not be deemed to constitute a direct or indirect guarantee of IBM to any party of the payment of the principal of, or interest on, any indebtedness, liability or obligation of the Company. The Support Agreement may not be modified, amended or terminated while there is outstanding any debt of the Company, unless all holders of such debt have consented in writing. IBM provides collection, administration and other services and products for the Company and is reimbursed for the cost of these services and products. The Company is compensated for services performed for IBM, primarily for management of IBM's state and local government installment receivable portfolio, the fees for which are reflected in other income. Additionally, the Company is compensated for the tax benefits resulting from tax deferrals generated through January 1, 1993, by leasing transactions, and the fees are included in other income. An operating agreement with IBM provides that installment receivables, which include finance charges, may be purchased by the Company at a mutually agreed-upon price. The Company is reimbursed by IBM for any price adjustments and concessions which reduce the amount of receivables previously purchased by the Company. The operating agreement with IBM also provides that IBM will offer term leases of the Company to creditworthy potential lessees. IBM's sales price of the equipment to the Company will be at the purchase price payable by the lessee, unless otherwise agreed to. The Company has an agreement with IBM which provides that losses on receivables arising from purchases of IBM equipment by IBM and Lexmark dealers and remarketers in excess of 2.25 percent of the average aggregate monthly receivable balance for any given year will be reimbursed to the Company by IBM. The Company has not received any payments from IBM as a result of this agreement. The Company has a liquidity agreement with IBM International Financing, N.V. (IIF), whereby the Company has agreed to advance funds to IIF, as an enhancement to IIF's ability to carry out business. The amount of the advances is not to exceed the greater of $500.0 million or 5 percent of the Company's total assets. To support this arrangement, the Company entered into a backup agreement with IBM, whereby IBM has agreed to advance funds to the Company, in amounts not to exceed the greater of $500.0 million or 5 percent of the Company's total assets, if at any time the Company requires such funds to satisfy its agreement with IIF. The Company has neither received nor made any advances with respect to these liquidity agreements as of December 31, 1993. From time to time, the Company has provided IBM and its affiliates with funds at prevailing interest rates. NET INVESTMENT IN CAPITAL LEASES: The Company's capital lease portfolio includes direct financing and leveraged leases. Direct financing leases consist principally of IBM information handling equipment with terms generally from three to five years. The components of the net investment in direct financing leases at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Minimum lease payments receivable . . . . $4,500,304 $6,413,253 Estimated unguaranteed residual values. . 366,356 449,055 Deferred initial direct costs . . . . . . 30,932 39,242 Unearned income . . . . . . . . . . . . . (622,410) (996,129) Allowance for receivable losses . . . . . (47,398) (74,548) __________ __________ $4,227,784 $5,830,873 ========== ========== The scheduled maturities of minimum lease payments outstanding at December 31, 1993, expressed as a percentage of the total, are as follows: ______ Due within 12 months. . . . . . . . . . . . . . . . 36.6% 13 to 24 months . . . . . . . . . . . . . . . . . . 31.7 25 to 36 months . . . . . . . . . . . . . . . . . . 21.0 37 to 48 months . . . . . . . . . . . . . . . . . . 8.2 After 48 months . . . . . . . . . . . . . . . . . . 2.5 ______ 100.0% ====== The reconciliation of the direct financing lease allowance for receivable losses is as follows: (Dollars in thousands) 1993 1992 1991 _______ _______ _______ Beginning of year. . . . . . . . . . . . $74,548 $42,089 $23,667 Additions . . . . . . . . . . . . . . . 24,793 66,665 66,131 Accounts written off (net of recoveries) (45,336) (34,206) (47,709) Transfers to allowance for losses on receivables sold . . . . . . . . (6,607) - - ________ _______ ________ End of year. . . . . . . . . . . . . . . $47,398 $74,548 $42,089 ======== ======= ======== Included in the net investment in capital leases is $335.0 million of seller interest relating to the securitization of such leases. Leveraged lease investments include coal-fired electric generating facilities, commercial aircraft and other non-IBM manufactured equipment. Leveraged leases have remaining terms ranging from two to twenty-five years. The components of the net investment in leveraged leases at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 ________ ________ Net rents receivable. . . . . . . . . . $273,183 $243,931 Estimated unguaranteed residual values. 40,752 77,209 Unearned and deferred income. . . . . . (97,222) (89,854) Allowance for losses. . . . . . . . . . (7,240) (24,890) ________ ________ Investment in leveraged leases. . . . . 209,473 206,396 Less: Deferred income taxes. . . . . . (234,805) (229,166) ________ ________ Net investment in leveraged leases. . . $(25,332) $(22,770) ======== ======== During 1993, the net investment in leveraged leases was reduced primarily from the restructuring of certain leveraged leases, writeoffs of transactions that were previously reserved, and the increase in the federal income tax rate from 34 percent to 35 percent. EQUIPMENT ON OPERATING LEASE: Operating leases consist principally of IBM information handling equipment with terms generally from two to four years. The components of equipment on operating lease at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Cost. . . . . . . . . . . . . . . . . . . $2,853,672 $2,826,381 Accumulated depreciation. . . . . . . . . (1,100,551) (1,049,805) __________ __________ $1,753,121 $1,776,576 ========== ========== Minimum future rentals were approximately $1,538.7 million at December 31, 1993. The scheduled maturities of the minimum future rentals expressed as a percentage of total rentals, are as follows: ______ Due within 12 months. . . . . . . . . . . . . . . . 38.5% 13 to 24 months . . . . . . . . . . . . . . . . . . 27.4 25 to 36 months . . . . . . . . . . . . . . . . . . 19.0 37 to 48 months . . . . . . . . . . . . . . . . . . 11.4 After 48 months . . . . . . . . . . . . . . . . . . 3.7 ______ 100.0% ====== LOANS RECEIVABLE: Loans receivable include installment receivables which are principally financings of customer purchases of IBM information handling products. Also included are other financings, comprised primarily of IBM software and services. The components of loans receivable at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Loans receivable . . . . . . . . . . $1,255,557 $1,702,068 Unearned income. . . . . . . . . . . (160,189) (215,845) Allowance for receivable losses. . . (57,504) (69,971) __________ __________ $1,037,864 $1,416,252 ========== ========== The scheduled maturities of loans receivable outstanding at December 31, 1993, expressed as a percentage of the total, are as follows: ______ Due within 12 months . . . . . . . . . . . . . . . 37.9% 13 to 24 months. . . . . . . . . . . . . . . . . . 28.9 25 to 36 months. . . . . . . . . . . . . . . . . . 19.1 37 to 48 months. . . . . . . . . . . . . . . . . . 10.6 49 to 60 months. . . . . . . . . . . . . . . . . . 3.5 ______ 100.0% ====== Included in loans receivable is $94.9 million and $99.6 million at December 31, 1993 and 1992, respectively, that is due from the Company's term lease partnerships. Such loans are secured by the general pool of leases in the partnerships. Also included in loans receivable is $37.5 million of seller interest relating to the securitization of such loans. The following is a reconciliation of the loans receivable allowance for receivable losses: (Dollars in thousands) 1993 1992 1991 _______ _______ _______ Beginning of year. . . . . . . . . . . . $69,971 $59,031 $53,150 Additions. . . . . . . . . . . . . . . . 13,460 34,634 53,596 Accounts written off (net of recoveries) (16,585) (23,694) (47,715) Transfers to allowance for losses on receivables sold . . . . . . . . (9,342) - - _______ _______ _______ End of year. . . . . . . . . . . . . . . $57,504 $69,971 $59,031 ======= ======= ======= WORKING CAPITAL FINANCING RECEIVABLES: Working capital financing receivables arise primarily from secured inventory and accounts receivable financing for IBM and Lexmark dealers and remarketers. Inventory financing includes the financing of the purchase by these dealers and remarketers of information handling products. Payment terms for inventory secured financing are typically less than 45 days. Accounts receivable financing includes the financing of trade accounts receivable for these dealers and remarketers. Payment terms for accounts receivable secured financing typically range from 30 days to 180 days. The components of working capital financing receivables at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Working capital financing receivables $1,440,079 $1,147,103 Allowance for receivable losses . . . (14,298) (8,972) __________ __________ $1,425,781 $1,138,131 ========== ========== The following is a reconciliation of the working capital financing receivables allowance for receivable losses: (Dollars in thousands) 1993 1992 1991 _______ _______ _______ Beginning of year. . . . . . . . . . . $ 8,972 $ 7,914 $11,847 Additions. . . . . . . . . . . . . . . 6,528 2,866 873 Accounts written off (net of recoveries) (1,202) (1,808) ( 4,806) _______ _______ _______ End of year. . . . . . . . . . . . . . $14,298 $ 8,972 $ 7,914 ======= ======= ======= Included in working capital financing receivables is $381.2 million of seller interest relating to the securitization of such receivables. Additionally, the Company has approved but unused $1.2 billion of working capital financing credit lines available to customers at December 31, 1993. INVESTMENTS AND OTHER ASSETS: The components of investments and other assets at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 ________ ________ Receivables from customers . . . . . . . . . $177,167 $279,389 Receivables from affiliates . . . . . . . . . 171,188 43,307 Remarketing inventory . . . . . . . . . . . . 92,681 85,485 Investments in partnerships . . . . . . . . . 8,158 17,122 Other assets . . . . . . . . . . . . . . . . 82,543 59,179 ________ ________ $531,737 $484,482 ======== ======== DUE AND DEFERRED FROM RECEIVABLE SALES: The Company began selling financing receivables to investors subject to limited recourse provisions during the fourth quarter of 1993. The Company's interest in excess servicing cash flows, subordinated interests in trusts, cash deposits and other related amounts are restricted assets and subject to limited recourse provisions. The following summarizes the amounts included in due and deferred from receivable sales: December 31, ____________ (Dollars in thousands) Excess servicing $ 26,355 Subordinated interests in trusts 172,970 Receivables from investors 45,786 Cash deposits held by trustee 16,730 Less: Allowance for estimated credit losses on receivables sold (15,949) _________ $245,892 ========= Gains and losses from the sale of financing receivables are recognized in the period in which the sale occurs. Provisions for expected credit losses are provided during the periods in which the receivables were originated, and, as such, the gain or loss is not usually required to be adjusted for expected credit losses. The gain on the sale of receivables is included in other income, and amounted to $21.0 million for the year ended December 31, 1993. The provision for credit losses relating to such sales amounted to $16.4 million. SHORT-TERM DEBT: The components of short-term debt at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Commercial paper. . . . . . . . . . . . . . . $1,641,473 $3,409,184 Current maturities of long-term debt . . . . 1,399,687 845,297 IBM Money Market Account notes. . . . . . . . 359,874 530,917 Other short-term debt . . . . . . . . . . . . 826,690 613,632 __________ __________ $4,227,724 $5,399,030 ========== ========== Other short-term debt includes notes having maturities between nine and twelve months offered through the Company's medium-term note program. :hp3.LONG-TERM DEBT::EHP3. The components of long-term debt at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ ___________ 8.3 % notes due November 1993 . . . . . . . $ - $ 400,000 7.2 % notes due February 1994. . . . . . . 300,000 300,000 6.125 % notes due November 1994 . . . . . . 500,000 500,000 8 % Dual currency notes due September 1995(1) - 120,200 Medium-term notes with original maturities after one year at rates averaging 5.3% through 2008 . . . . 2,778,277 1,829,311 Other debt . . . . . . . . . . . . . . . . 99,000 99,000 __________ __________ 3,677,277 3,248,511 Net unamortized premiums and discounts . . 2,206 2,857 __________ __________ 3,679,483 3,251,368 Less: Current maturities. . . . . . . . . 1,399,687 845,297 __________ __________ $2,279,796 $2,406,071 ========== ========== (1) Called in September 1993. Premiums and discounts have the effect of modifying the stated rate of interest on long-term debt offerings. Annual maturity of long-term debt at December 31, 1993 is as follows: (Dollars in thousands) 1994 . . . . . . . . . . . . . . . . . . . $1,399,687 1995 . . . . . . . . . . . . . . . . . . . 1,305,101 1996 . . . . . . . . . . . . . . . . . . . 374,455 1997 . . . . . . . . . . . . . . . . . . . 93,625 1998 . . . . . . . . . . . . . . . . . . . 463,409 1999 and thereafter . . . . . . . . . . . 41,000 __________ $3,677,277 ========== SFAS 105, "Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk," requires certain disclosure about financial instruments with off-balance sheet risk. The following summary of contract or notional (face) amounts outstanding merely provides an indication of the extent of the Company's involvement in such instruments. The Company does not anticipate any material adverse effect on its financial position resulting from its involvement in these instruments, nor does it anticipate nonperformance by any of its counterparties. (Dollars in thousands) December 31, December 31, 1993 1992 _________ _________ Interest rate swap agreements $2,283,374 $1,489,000 Currency exchange agreements $ 197,197 $ 320,000 SFAS 105 also requires the disclosure of information about significant geographic, business, or other concentrations of credit risk for all financial instruments. The Company originates financing for customers in a variety of industries and throughout the United States. The Company does not have any significant geographic or industry concentrations of credit risk. RATIO OF EARNINGS TO FIXED CHARGES: The ratio of earnings to fixed charges calculated in accordance with applicable Securities and Exchange Commission requirements was 2.07, 1.78 and 1.58 for the years ended December 31, 1993, 1992, and 1991, respectively. RELATED COMPANY TRANSACTIONS: IBM charged the Company $97.8 million, $94.0 million and $84.3 million in 1993, 1992 and 1991, respectively, representing costs for various loans receivable and lease services, employee benefit plans, facilities rental and staff support. The Company has received compensation for services and benefits provided to IBM. The fees received relate to the management of IBM's portfolio of state and local government installment receivables and to tax benefits produced by the Company relating to leasing transactions. The latter fees are based on potential savings recognized by IBM as a result of the deferral of income taxes and are calculated at prevailing market interest rates. The Company received fees of $65.9 million, $89.0 million and $111.5 million in 1993, 1992 and 1991, respectively, for these services and benefits which are included in other income. In 1993, these fees are primarily for the management of IBM's portfolio of state and local government installment receivables. Amounts due to IBM and affiliates are for software, services, purchases of receivables and purchases of equipment for term leases, with payment terms comparable to those offered to other IBM customers, as well as current income taxes payable. At December 31, 1993 and 1992, amounts due to IBM were $1,259.5 million and $1,403.7 million, respectively. Interest income of $.9 million, $6.0 million and $5.6 million was earned from loans to IBM and affiliates in 1993, 1992 and 1991, respectively. The Company provides capital equipment financing at market rates to IBM and affiliated companies for both IBM and non-IBM products. The Company originated $456.4 million and $449.4 million of such financing during 1993 and 1992, respectively. At December 31, 1993 and 1992, approximately $1,100.0 million and $700.0 million, respectively, of such financings are included in the lease and loan portfolio. The Company entered into a financing agreement in 1989 with a partnership in which IBM is an equity partner. The Company guarantees the interest and principal obligation of the commercial paper issued by the partnership for a fee. The total amount of commercial paper committed to be guaranteed amounts to $325.0 million. As of December 31, 1993, the partnership had $296.0 million par value of commercial paper and accrued interest outstanding. The term of the agreement extends through June, 1994. At December 31, 1993, the Company has deposited a total of $15.9 million into restricted accounts. Of this restricted amount, $9.4 million has been deposited to collateralize both a $5.9 million surety bond provided by the IBM Credit Insurance Company, a wholly owned subsidiary of the Company, and a $3.5 million limited guarantee provided by the Company. Additionally, $5.7 million of this restricted amount has been deposited as a requirement under a loan agreement entered into by the Company, and $.8 million is held as security deposits received from customers. The cash on deposit related to the surety bond, the limited guarantee, and the loan agreement was delivered in connection with certain tax-exempt grantor trusts comprised of pools of IBM state and local government installment receivables. The Company also has deposited an additional $2.2 million into restricted accounts at December 31, 1993 as required by the pooling and servicing agreement for selected tax-exempt grantor trusts. This amount relates to daily cash collections deposited with the trustee. The trustee of each grantor trust is entitled to draw upon the amounts in the restricted account set aside for such particular trust in the event of non-performance, defaults or other losses relating to such installment receivables. PROVISION FOR INCOME TAXES: The components of the provision for income taxes are as follows: (Dollars in thousands) 1993 1992 1991 _________ ________ ________ Federal: Current . . . . . . . . . $ 30,612 $(137,455) $ 304,939 Deferred. . . . . . . . . 116,494 245,071 (202,333) _________ ________ ________ 147,106 107,616 102,606 _________ ________ ________ State and local: Current . . . . . . . . . 47,353 (18,853) 20,860 Deferred. . . . . . . . . (21,287) 42,799 1,392 _________ ________ ________ 26,066 23,946 22,252 _________ ________ ________ Total provision . . . . . $173,172 $131,562 $124,858 ========= ======== ======== The Company implemented SFAS 109 in 1992. This statement replaced the previous accounting standard for income taxes, SFAS 96, which the Company adopted in 1988. Both SFAS 96 and SFAS 109 require the use of the liability method for recording deferred taxes. The implementation of SFAS 109 had no impact on the Company's financial statements other than to require the disclosure of the significant components of deferred taxes which are as follows: (Dollars in thousands) 1993 1992 _________ _________ Deferred tax assets (liabilities): Provision for receivable losses $ 85,174 $ 89,820 State and local taxes 21,722 37,950 Lease income and depreciation (923,624) (847,568) Other 5,445 3,627 _________ _________ Deferred income taxes $(811,283) $(716,171) ========= ========= The provision for income taxes varied from the U.S. federal statutory income tax rate as follows: 1993 1992 1991 ______ ______ ______ Federal statutory rate. . . . . . . . 35.0% 34.0% 34.0% Federal tax rate increase (1) . . . . 5.1 - - State and local taxes, net of federal tax benefits . . . . . . 4.2 4.6 4.5 Other, net . . . . . . . . . . . . . (.3) (1.1) (0.1) ______ ______ ______ Effective income tax rate . . . . . 44.0% 37.5% 38.4% ====== ====== ====== (1) On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 (the Act) was enacted. The Act increased the U.S. corporate income tax rate from 34 percent to 35 percent, retroactive to January 1, 1993. SFAS 109, "Accounting for Income Taxes," requires that the income effects on deferred taxes of enacted changes in tax laws are to be recognized in the period of enactment. Consequently, the Company's deferred income tax liability has been adjusted to reflect the new tax rate, and federal tax expense for the current year has been calculated using the new rate. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS: In 1992, the Company implemented SFAS 107, "Disclosures about Fair Value of Financial Instruments." This statement requires the disclosure of estimated fair values for all financial instruments for which it is practical to estimate fair value. Fair value is a very subjective and imprecise measurement that is based on numerous estimates and assumptions which require substantial judge- ment and may only be valid at a particular point in time. As such, fair value can only represent a very general approximation of possible value which may never actually be realized. The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practicable to estimate. In accordance with SFAS 107, fair value disclosure is not required for lease contracts. Cash and cash equivalents: The carrying amount approximates fair value due to the short maturity of these instruments. Loans receivable: The fair value is estimated by discounting the future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings with the same remaining maturities. Working capital financing receivables: The carrying amount approximates fair value due to the short maturity of most of these instruments. Due and deferred from receivable sales: The carrying amount approximates fair value. Short-term debt: For the majority of these instruments, the carrying amount approximates fair value due to their short maturity. Long-term debt and current maturities of long-term debt: The fair value of these instruments is based on replacement cost or quoted market prices for the same issues. Replacement cost is the cost to issue a similar instrument with similar maturity and credit risk. Interest rate swaps and currency exchange agreements: The fair value of these instruments has been estimated as the amount the Company would receive or pay to terminate the agreements, taking into consideration current interest and currency exchange rates. Financial guarantees: The fair value of financial guarantees is estimated as the amount that would be paid if the Company had to settle the obligation. The estimated fair values of the Company's financial instruments are summarized as follows: At December 31, 1993 (Dollars in thousands) Carrying Estimated Amount Fair Value __________ __________ Financial assets: Cash and cash equivalents $ 609,891 $ 609,891 Loans receivable $1,037,864 $1,122,139 Working capital financing receivables $1,425,781 $1,425,781 Due and deferred from receivable sales $ 245,892 $ 245,892 Financial liabilities: Short-term debt (excluding current maturities of long-term debt) $2,828,037 $2,828,594 Long-term debt and current maturities of long-term debt $3,679,483 $3,665,268 Off-balance-sheet instruments: Interest rate swaps and currency exchange agreements - $ 54,400 Financial guarantees - $ 18,382 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS:(cont.) At December 31, 1992 (Dollars in thousands) Carrying Estimated Amount Fair Value __________ __________ Financial assets: Cash and cash equivalents $ 598,557 $ 598,557 Loans receivable $1,416,252 $1,467,444 Working capital financing receivables $1,138,131 $1,138,131 Financial liabilities: Short-term debt (excluding current maturities of long-term debt) $4,553,733 $4,562,590 Long-term debt and current maturities of long-term debt $3,251,368 $3,301,283 Off-balance-sheet instruments: Interest rate swaps and currency exchange agreements - $ 30,530 Financial guarantees - $ 22,900 Selected Quarterly Financial Data: (Unaudited) (Dollars in thousands) Finance and Other Interest Net Income Expense Earnings ____ First Quarter . . . . . . . $ 405,657 $ 93,931 $ 58,251 Second Quarter. . . . . . . 382,620 91,576 50,590 Third Quarter . . . . . . . 460,029 94,237 37,706 Fourth Quarter. . . . . . . 522,124 85,931 73,673 __________ __________ __________ $1,770,430 $ 365,675 $ 220,220 ========== ========== ========== ____ First Quarter . . . . . . . $ 409,856 $ 125,542 $ 58,102 Second Quarter. . . . . . . 464,654 116,870 52,738 Third Quarter . . . . . . . 457,450 106,331 55,851 Fourth Quarter. . . . . . . 430,570 97,073 52,579 __________ __________ __________ $1,762,530 $ 445,816 $ 219,270 ========== ========== ========== SUBSEQUENT EVENT: On January 28, 1994, the Company's Board of Directors approved a $150.0 million dividend payable to IBM on February 28, 1994. ITEM 9. CHANGES in and DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING and FINANCIAL DISCLOSURE: None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT: Omitted pursuant to General Instruction J. ITEM 11. EXECUTIVE COMPENSATION: Omitted pursuant to General Instruction J. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT: Omitted pursuant to General Instruction J. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS: Omitted pursuant to General Instruction J. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K: (a) The following documents are filed as part of this report: 1. Consolidated Financial Statements included in Part II of this report: Report of Independent Accountants (page 12). Consolidated Statement of Financial Position at December 31, 1993 and 1992 (page 13). Consolidated Statement of Earnings and Retained Earnings for the years ended December 31, 1993, 1992 and 1991 (page 14). Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 (page 15). Notes to Consolidated Financial Statements (pages 16 through 32). 2. Financial statement schedules required to be filed by Item 8 of this Form: Page Schedule Number ____ _______________ 36 IX -- Short-Term Borrowings All other schedules are omitted because of the absence of the conditions under which they are required or because the information is disclosed in the financial statements or the notes thereto. 3. Exhibits required to be filed by Item 601 of Regulation S-K: Included in this Form 10-K: Exhibit Number _______ I. Agreement to furnish information defining the rights of debt holders. II. Statement re computation of ratios. III. Consent of Experts and Counsel. IV. Power of attorney of James J. Forese. V. Power of attorney of John W. Thompson. Not included in this Form 10-K: The Certificate of Incorporation of IBM Credit Corporation is filed pursuant to Quarterly report on Form 10Q for the Quarterly period ended June 30, 1993 on August 10, 1993, and is hereby incorporated by reference. The By-Laws of IBM Credit Corporation is filed pursuant to Quarterly report on Form 10Q for the Quarterly period ended September 30, 1993 on November 10, 1993 and is hereby incorporated by reference. The Support Agreement dated as of April 15, 1981, between the Company and IBM is filed with Form SE dated March 26, 1987, and is hereby incorporated by reference. Powers of Attorney of Bob E. Dies, Takeshi Gotoh, and John J. Higgins. (b) Reports on Form 8-K: There were no 8-K reports filed during the last quarter of 1993. [SIGNATURE] 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. IBM CREDIT CORPORATION (Registrant) By: /s/James J. Forese __________________ (James J. Forese) (Chairman) Date: March 15, 1994 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 March 15, 1994 Signature Title _________ _____ _James J Forese ______ ______________________ (James J. Forese)* Chairman _Melvin Kyle Grosz____ ______________________ (Melvin Kyle Grosz) Vice President and Assistant General Manager, Finance and Risk Management _Richard J. Obetz_____ ______________________ (Richard J. Obetz) Controller ] ] ] Bob E. Dies* Director ] ] /s/ Melvin Kyle Grosz Takeshi Gotoh* Director ]By: _________________ ] (Melvin Kyle Grosz) John J. Higgins* Director ] Attorney-in-fact ] John W. Thompson* Director ] ] ] ] ] * A majority of the Board of Directors EXHIBIT INDEX _____________ Reference Number Exhibit Number per Item 601 of in This Regulation S-K Description of Exhibits Form 10-K ________________ _______________________ _____________ (3) Certificate of Incorporation and By-Laws. The certificate of incorporation of IBM Credit Corporation is filed pursuant to Form 10Q for the Quarterly period ended June 30, 1993 on August 10, 1993, and is hereby incorporated by reference. The By-Laws of IBM Credit Corporation are file pursuant to Quarterly report on Form 10Q for the Quarterly period ended September 30, 1993 on November 10, 1993 and are hereby incorporated by reference. (4) (a) Instruments Defining the Rights of Security Holders. An agreement to furnish to the Securities I and Exchange Commission on request, a copy of instruments defining the rights of debt holders. (4) (b) Indenture dated as of January 15, 1989 filed electronically as Exhibit No. 4 to Amendment No. 1 to Form S-3 on April 3, 1989, and hereby incorporated by reference. (9) Voting Trust Agreement Not applicable (10) Material Contracts. The Support Agreement dated as of April 15, 1981, between the Company and IBM is filed with Form SE dated March 26, 1987, and is hereby incorporated by reference. EXHIBIT INDEX _____________ (continued) Reference Number Exhibit Number per Item 601 of in This Regulation S-K Description of Exhibits Form 10-K ________________ _______________________ _____________ (11) Statement re computation of per share Not earnings applicable (12) Statement re computation of ratios II (18) Letter re change in accounting principles Not applicable (19) Previously unfiled documents Not applicable (22) Subsidiaries of the registrant Omitted (23) Published report regarding matters Not submitted to vote of security holders applicable (24) Consent of experts and counsel III (25) (a) Power of attorney of Bob E. Dies is filed on Form SE dated March 3, 1989, and is hereby incorporated by reference. (25) (b) Power of attorney of Takeshi Gotoh is filed on Form SE dated September 17, 1990 and is hereby incorporated by reference. (25) (c) Power of attorney of John J. Higgins is filed on Form SE dated April 16, 1991, and is hereby incorporated by reference. (25) (d) Power of attorney of James J. Forese IV (25) (e) Power of attorney of John W. Thompson V (28) Additional exhibits Not applicable (29) Information from reports furnished to Not state insurance regulatory authorities applicable Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS: OVERVIEW The Company originated financing for $9.3 billion of equipment, software and services during 1993. Net earnings for 1993 were $220.2 million, yielding a return on average equity of 19.1 percent. During the fourth quarter of 1993, the Company sold $1.4 billion of capital equipment and working capital financing receivables (financing receivables) realizing an aftertax gain of $12.9 million, as described throughout this discussion and analysis. In addition, during 1993, a charge of $23.9 million was recorded to reflect the effect of an increase in the federal income tax rate from 34 percent to 35 percent. The effect of the new tax rate was required to be recognized in accordance with Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes." In the 1993 second quarter, responding to the decline in IBM shipments and the resulting lower level of IBM Credit capital equipment financing originated, the Company initiated actions to reduce its infrastructure, including specific actions to reduce its workforce. These actions reduced future expenses and brought resources in line with current market conditions. To recognize the cost of these actions, aftertax restructuring charges of $6.4 million were recorded in 1993. FINANCING ORIGINATED For the year ended December 31, 1993, the Company originated financing for $9.3 billion of equipment, software and services, an increase of 8 percent from 1992. Capital equipment financing for end users decreased by 22 percent to $3.4 billion. The decrease in capital equipment financing originated is primarily the result of fewer IBM shipments in 1993 compared with 1992, together with a decline in the proportion of IBM products and services financed by the Company. Working capital financing for dealers and remarketers of information industry products increased by 39 percent to $5.9 billion. This improvement reflects increased shipments of IBM's personal computer and workstation products throughout 1993, as well as the development of IBM Credit's efforts to provide working capital financing that meets the full range of financing requirements of IBM authorized resellers. Capital equipment financings for end users is comprised of purchases of $1,733.8 million of information handling systems products from International Business Machines Corporation (IBM), financing originated of installment receivables of $165.1 million, other financing, primarily for IBM software and services of $277.5 million, installment and lease financing for state and local government customers of $294.2 million for the account of IBM, and other financing of $919.7 million for equipment and services including maintenance, remarketing transactions, sale leaseback transactions, as well as selected complementary non-IBM equipment which meets IBM customers' total solution requirements. The purchases of $1,733.8 million from IBM consisted of $1,306.3 million for capital leases and $427.5 million for operating leases. REMARKETING ACTIVITIES In addition to originating new financing, the Company remarkets used IBM equipment. This equipment is primarily sourced from the termination of existing lease transactions and is generally remarketed through retail channels in cooperation with the IBM sales force. The equipment is leased to end users or sold outright. These transactions may be with existing lessees or, when equipment is returned, with a new customer. At December 31, 1993, the investment in remarketed equipment on capital and operating leases totaled $619.8 million, an increase of 40.3 percent from the 1992 year-end investment of $441.9 million. Included in remarketing activities are income from leases and gross profit on equipment sales, net of the reduction in income to recognize the writedown in residual values of certain leased equipment. These remarketing contributions amounted to $103.1 million for the year ended December 31, 1993, down from $118.9 million for the year ended December 31, 1992. ASSETS Total assets were $10.0 billion at December 31, 1993, compared with $11.5 billion at December 31, 1992. The decrease reflects the securitization and sale of $1.4 billion of financing receivables during the fourth quarter of 1993, proceeds of which were used to reduce total debt, as well as the decrease in capital equipment financing originated in 1993, offset in part by an increase in working capital financing originated. Total financing receivables serviced by the Company as of December 31, 1993 were $11.1 billion, compared with $11.3 billion at December 31, 1992. Total financing receivables serviced include those financing receivables securitized and sold in the fourth quarter of 1993 ($1,371.0 million), capital and operating leases ($6,363.0 million in 1993, $7,814.0 million in 1992), loans receivable ($1,038.0 million in 1993, $1,416.0 million in 1992), and working capital financing receivables ($1,426.0 million in 1993, $1,138.0 million in 1992), as well as state and local government installment and lease financing receivables of IBM ($868.0 million in 1993, $950.0 million in 1992). Approximately 85 percent of the Company's total assets at December 31, 1993, related to the financing of IBM products and services. LIABILITIES AND STOCKHOLDER'S EQUITY The assets of the business were financed with $6,507.5 million of debt at December 31, 1993. Total debt, which includes short-term and long-term debt, decreased by $1,297.6 million during 1993. This decrease was primarily the result of applying proceeds from the sale of financing receivables during the fourth quarter of 1993 to reduce commercial paper and retire long-term debt. The proceeds were also used for general Corporate purposes, including dividends to IBM. At December 31, 1993, the Company had available $1.9 billion of a shelf registration with the Securities and Exchange Commission. This shelf registration allows the Company to quickly access domestic financial markets. In addition, a subsidiary of the Company had available $750.0 million of a separate shelf registration for asset backed securities. The Company also has a commercial paper program, a medium-term note program, and the IBM money market program. The Company is an authorized borrower of up to $1.0 billion under a $10.0 billion IBM Global Credit Facility, and has a liquidity agreement with IBM for $500.0 million. Back up lines of credit in the amount of $1.6 billion were terminated when the IBM Global Credit Facility was put in place; they had not been drawn upon. The Company also has the option, as approved by the Board of Directors on July 29, 1993, to sell, assign, pledge, or transfer up to an additional $2.6 billion of assets to third parties through December 31, 1994. These financing sources along with the Company's internally generated cash, medium-term note and commercial paper programs provide the flexibility to the Company to grow its lease and loan portfolio, service debt, and fund working capital. Due to IBM Corporation and affiliates decreased by $144.2 million to $1,259.5 million at December 31, 1993 from $1,403.7 million at December 31, 1992. This reduction was primarily attributable to the lower volume of capital equipment purchased from IBM in the fourth quarter of 1993, compared with the fourth quarter of 1992, offset by a net increase in working capital financing receivables purchased in the fourth quarter of 1993 compared with the 1992 fourth quarter. Amounts due to IBM Corporation and affiliates represent trade payables arising from purchases of equipment for term leases and installment receivables, working capital financing receivables for dealers and remarketers, and software license fees, with payment terms comparable to those offered to other IBM customers. Also included in due to IBM Corporation and affiliates is income taxes currently payable under the intercompany tax allocation agreement. Total stockholder's equity at December 31, 1993 was $1,150.7 million, down $104.8 million from year-end 1992. The change in stockholder's equity reflects payments of $325.0 million in dividends to IBM, and net earnings of $220.2 million. At December 31, 1993, the Company's debt to equity ratio was 5.7:1, compared with 6.2:1 at December 31, 1992. :hp3.TOTAL CASH PROVIDED BEFORE DIVIDENDS:EHP3. Total cash provided before dividends was $336.3 million for 1993, compared with $125.1 million for 1992. Cash and cash equivalents at December 31, 1993, totaled $609.9 million, an increase of $11.3 million compared with the balance at December 31, 1992. Total cash provided before dividends reflects $1,631.7 million of cash provided by operating and investing activities, reduced by $1,295.4 million of cash used in financing activities, before dividends. INCOME FROM LEASES Income from leases decreased by 14 percent to $573.4 million in 1993, from $667.0 million in 1992. This decline is the result of a decrease in capital equipment financing originated throughout 1993, together with lower yields associated with declining market interest rates. Income from leases includes lease income resulting from remarketing transactions. For the year ended December 31, 1993, this income amounted to $71.6 million, which is comparable to 1992. On a periodic basis, the Company reassesses the future residual value of its portfolio of leases. In accordance with generally accepted account- ing principles, anticipated increases in specific future residual values may not be recognized before realization and are thus a source of potential future profits. Anticipated decreases in specific future residual values, considered to be other than temporary, must be recognized currently. A review of the Company's $775.0 million residual value portfolio at December 31, 1993 indicated that the overall estimated future value of the portfolio continues to be greater than the value currently recorded, but declines in the future residual value of certain leased equipment were identified. To recognize these declines, the Company recorded a $32.0 million reduction to income from leases for 1993, compared with $20.0 million in 1992. INCOME FROM LOANS Income from loans decreased by 28 percent to $112.3 million in 1993 from $155.6 million in 1992. This decline is the result of a reduction in the loan portfolio and lower yields associated with declining market interest rates. INCOME FROM WORKING CAPITAL FINANCING Income from working capital financing increased 29 percent to $104.3 million in 1993, compared with $80.6 million in 1992. This increase is primarily due to growth in the size of the average working capital financing receivables outstanding during 1993, compared with 1992. The growth reflects increased amounts of IBM's personal computer and workstation products, which the Company financed throughout 1993, as well as an increase in the volume of financing provided for non-IBM products for IBM authorized resellers. EQUIPMENT SALES Equipment sales increased by 13 percent to $840.9 million in 1993, compared with $743.3 million in 1992. Included in these amounts is revenue from outright sales and sales-type leases of Company-owned equipment with either existing lessees or, when equipment is returned, with other customers. Gross profit on equipment sales amounted to $63.6 million for 1993, compared with $66.9 million for 1992. The gross profit margin declined to 7.6 percent in 1993 from 9.0 percent in 1992. This lower margin reflects a $20.0 million charge to recognize the decline in current market value for 3390 Model 2 Direct Access Storage Device equipment sold or leased under sales-type leases during the third and fourth quarters of 1993 or inventoried at December 31, 1993. The decline in current market value of this equipment was the result of a temporary excess supply in the used equipment markets. Gross profit margin on other products continues to be within the range of management's expectations. OTHER INCOME Other income increased by 20 percent to $139.5 million in 1993 from $116.0 million in 1992. Included in other income is a pretax gain on the sale of financing receivables of $21.0 million, net of related expenses. The sale of financing receivables generally accelerates the recognition of finance income and can result in a current period gain or loss. The amount of such gain or loss is dependent on a number of factors and may create a degree of volatility in earnings depending on the type of receivables sold, the structure of the transaction, and prevailing financial market conditions. The Company continues to service the financing receivables sold and earns a fee which is included in other income. Also included in other income is interest income earned on cash and cash equivalents, as well as fees for managing IBM's state and local government installment and lease financing receivable portfolio. The increase in other income is the result of growth in interest income and the gain on the sale of financing receivables, partially offset by a decrease in fees earned from managing IBM's state and local government installment and lease financing receivable portfolio. TOTAL FINANCE AND OTHER INCOME Total finance and other income increased to $1,770.4 million in 1993 from $1,762.5 million in 1992. The increase is due to growth in income from working capital financing, other income, and equipment sales, partially offset by reductions in income from leases and loans. INTEREST EXPENSE Interest expense declined as the Company's total debt decreased. In addition, the Company continued to benefit from lower market interest rates, partially offset by an increased cost of funding due to debt downgradings throughout 1993. Interest expense decreased by 18 percent to $365.7 million in 1993, compared with $445.8 million in 1992. The Company's overall average cost of debt decreased to 5.0 percent in 1993, from 5.9 percent in 1992. SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES Selling, general, and administrative expenses decreased one percent to $185.5 million in 1993, from $186.9 million in 1992. The decrease is due to the Company's continuing efforts to manage expenses. PROVISION FOR RECEIVABLE LOSSES The Company's portfolio of capital equipment leases and loans is predominantly with investment grade customers. The Company generally takes a security interest in any underlying equipment financed. The portfolio is diversified by geography, industry, and individual unaffiliated customer. Working capital financing receivables are secured by the underlying inventory and accounts receivable financed. At December 31, 1993, the allowance for receivable losses approximated 1.5 percent of the Company's portfolio of leases and loans, compared with approximately 1.7 percent at December 31, 1992. The provision for receivable losses decreased to $38.0 million in 1993 from $102.6 million in 1992. This decrease reflects the reduction in the amount of capital equipment financed, and an economic environment that continues to improve. Additionally, the Company continues to effectively manage credit risk and contain losses. These efforts resulted in the 1993 recovery of $11.0 million of losses previously recorded in 1991 and 1992 to reflect the then estimated loss associated with a major bankruptcy, along with other recoveries throughout 1993. INCOME TAXES The effective tax rate in 1993 was 44.0 percent, compared with 37.5 percent in 1992. The increase in the effective tax rate reflects the enactment of the Omnibus Budget Reconciliation Act of 1993 (the Act) during the third quarter of 1993. The Act increased the U.S. corporate income tax rate from 34 percent to 35 percent, retroactive to January 1, 1993. The tax rate increase resulted in a $23.9 million charge for 1993; $20.1 million related to previously provided deferred taxes, and $3.8 million in current taxes. The Company expects its effective tax rate to approximate the statutory federal and state income tax rates in future years. NET EARNINGS Net earnings were $220.2 million for the year ended December 31, 1993, compared with $219.3 million for 1992. Excluding the additional income tax expense, the restructuring charges, and the gain on the sale of financing receivables, net earnings would have been $237.6 million for 1993, an increase of 8.3 percent compared with 1992. RETURN ON AVERAGE EQUITY The 1993 results yielded a return on average equity of 19.1 percent, compared with 19.0 percent in 1992. Without the specific items mentioned in the preceding paragraph, the return on average equity would have been 20.3 percent. NEW ACCOUNTING STANDARDS In November 1992, the Financial Accounting Standards Board (FASB) issued SFAS 112, "Employer's Accounting for Postemployment Benefits," which established new accounting principles for the cost of benefits provided to former or inactive employees after employment but before retirement. IBM and IBM Credit elected early adoption of SFAS 112 as of January 1, 1993. The impact of adoption did not materially impact the results of the Company's operations. In May 1993, the FASB issued SFAS 114, "Accounting by Creditors for Impairment of a Loan," which amends SFAS 5, "Accounting for Contingencies," and SFAS 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings." Under SFAS 114, creditors should evaluate the collectibility of both contractual interest and principal of all receivables when assessing the need for a loss accrual. Additionally, SFAS 114 requires creditors to measure all loans that are restructured in a troubled debt restructuring involving a modification of terms to reflect the time value of money. This statement is effective for fiscal years beginning after December 15, 1994. In May 1993, the FASB issued SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities," which prescribes the accounting for debt and equity securities held as assets. This statement is effective for fiscal years beginning after December 15, 1993. It is expected that the implementation of standards 114 and 115 will not result in a material charge to the results of operations in the year of adoption. CLOSING DISCUSSIONS In the 1993 second quarter, the Company initiated actions to reduce its infrastructure, including specific actions to reduce its workforce. To recognize the cost of these actions, aftertax restructuring charges of $6.4 million were recorded. If our assumptions with regard to market conditions prove correct, then the Company's resources will be sufficient to enable it to carry out its mission of supporting customers in their acquisition of IBM products and services by providing competitive financing, and contributing to the growth and stability of IBM earnings. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA: Report of Independent Accountants February 16, 1994 To the Stockholder and Board of Directors of IBM Credit Corporation In our opinion, the accompanying consolidated financial statements listed in the index appearing under Item 14(a) 1. and 2. on pages 33 and 34 present fairly, in all material respects, the financial position of IBM Credit Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion thereon based on our audits. We conducted our audits in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether such statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. Price Waterhouse Stamford, CT IBM CREDIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation: The consolidated financial statements include the accounts of IBM Credit Corporation (the Company) and those of its subsidiaries which are more than 50 percent owned. Investments in partnerships in which the Company has typically a 20 percent ownership are accounted for using the equity method. Cash and Cash Equivalents: Time deposits with original maturities generally of three months or less are included in cash and cash equivalents. Cash paid for interest was $366.2 million, $504.1 million, and $580.3 million for 1993, 1992 and 1991, respectively. Finance Income Recognition: Income attributable to direct financing leases and loans receivable is initially recorded as unearned income and subsequently recognized as finance income at level rates of return over the term of the leases or receivables. Income recognized from leveraged leases includes the amortization of unearned finance income and deferred investment and other tax credits over the term of the leases, at level rates of return, during periods when the net investment balance is positive. Equipment on Operating Lease: Equipment is depreciated on a straight-line basis to its estimated residual value over the lease term. Equipment Sales Income Recognition: Revenue from equipment sales to existing lessees is recognized at the effective date a purchase provision is exercised. Revenue from sales to parties other than the existing lessee is recognized when title transfers. Allowance for Receivable Losses: The allowance for receivable losses is determined on the basis of actual collection experience and estimated future collectibility of the related assets. Income Taxes: The application of the intercompany tax allocation agreement (the Agreement) between the Company and its parent company, IBM, was mutually clarified during the first quarter of 1993. The Agreement now aligns the settlement of federal and state tax benefits/and or obligations with the Company's provision for income taxes determined on a separate company basis. The Company is part of the IBM consolidated federal tax return, and files separate state tax returns in selected states. Included in due to IBM Corporation and affiliates at December 31, 1993 and 1992, respectively, is $263.8 million and $5.3 million of current income taxes payable as determined in accordance with the intercompany tax allocation agreement. Cash paid for income taxes in 1993, 1992, and 1991, was $120.6 million, $7.8 million, and $5.5 million, respectively. RELATIONSHIP WITH IBM: Pursuant to a Support Agreement between IBM and the Company, IBM has agreed to retain 100% of the voting capital stock of the Company, unless required to dispose of any or all such shares of stock pursuant to a court decree or order of any governmental authority which in the opinion of counsel to IBM, may not be successfully challenged. IBM has also agreed to cause the Company to have a tangible net worth of at least $1.00 at all times. The Support Agreement provides that it shall not be deemed to constitute a direct or indirect guarantee of IBM to any party of the payment of the principal of, or interest on, any indebtedness, liability or obligation of the Company. The Support Agreement may not be modified, amended or terminated while there is outstanding any debt of the Company, unless all holders of such debt have consented in writing. IBM provides collection, administration and other services and products for the Company and is reimbursed for the cost of these services and products. The Company is compensated for services performed for IBM, primarily for management of IBM's state and local government installment receivable portfolio, the fees for which are reflected in other income. Additionally, the Company is compensated for the tax benefits resulting from tax deferrals generated through January 1, 1993, by leasing transactions, and the fees are included in other income. An operating agreement with IBM provides that installment receivables, which include finance charges, may be purchased by the Company at a mutually agreed-upon price. The Company is reimbursed by IBM for any price adjustments and concessions which reduce the amount of receivables previously purchased by the Company. The operating agreement with IBM also provides that IBM will offer term leases of the Company to creditworthy potential lessees. IBM's sales price of the equipment to the Company will be at the purchase price payable by the lessee, unless otherwise agreed to. The Company has an agreement with IBM which provides that losses on receivables arising from purchases of IBM equipment by IBM and Lexmark dealers and remarketers in excess of 2.25 percent of the average aggregate monthly receivable balance for any given year will be reimbursed to the Company by IBM. The Company has not received any payments from IBM as a result of this agreement. The Company has a liquidity agreement with IBM International Financing, N.V. (IIF), whereby the Company has agreed to advance funds to IIF, as an enhancement to IIF's ability to carry out business. The amount of the advances is not to exceed the greater of $500.0 million or 5 percent of the Company's total assets. To support this arrangement, the Company entered into a backup agreement with IBM, whereby IBM has agreed to advance funds to the Company, in amounts not to exceed the greater of $500.0 million or 5 percent of the Company's total assets, if at any time the Company requires such funds to satisfy its agreement with IIF. The Company has neither received nor made any advances with respect to these liquidity agreements as of December 31, 1993. From time to time, the Company has provided IBM and its affiliates with funds at prevailing interest rates. NET INVESTMENT IN CAPITAL LEASES: The Company's capital lease portfolio includes direct financing and leveraged leases. Direct financing leases consist principally of IBM information handling equipment with terms generally from three to five years. The components of the net investment in direct financing leases at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Minimum lease payments receivable . . . . $4,500,304 $6,413,253 Estimated unguaranteed residual values. . 366,356 449,055 Deferred initial direct costs . . . . . . 30,932 39,242 Unearned income . . . . . . . . . . . . . (622,410) (996,129) Allowance for receivable losses . . . . . (47,398) (74,548) __________ __________ $4,227,784 $5,830,873 ========== ========== The scheduled maturities of minimum lease payments outstanding at December 31, 1993, expressed as a percentage of the total, are as follows: ______ Due within 12 months. . . . . . . . . . . . . . . . 36.6% 13 to 24 months . . . . . . . . . . . . . . . . . . 31.7 25 to 36 months . . . . . . . . . . . . . . . . . . 21.0 37 to 48 months . . . . . . . . . . . . . . . . . . 8.2 After 48 months . . . . . . . . . . . . . . . . . . 2.5 ______ 100.0% ====== The reconciliation of the direct financing lease allowance for receivable losses is as follows: (Dollars in thousands) 1993 1992 1991 _______ _______ _______ Beginning of year. . . . . . . . . . . . $74,548 $42,089 $23,667 Additions . . . . . . . . . . . . . . . 24,793 66,665 66,131 Accounts written off (net of recoveries) (45,336) (34,206) (47,709) Transfers to allowance for losses on receivables sold . . . . . . . . (6,607) - - ________ _______ ________ End of year. . . . . . . . . . . . . . . $47,398 $74,548 $42,089 ======== ======= ======== Included in the net investment in capital leases is $335.0 million of seller interest relating to the securitization of such leases. Leveraged lease investments include coal-fired electric generating facilities, commercial aircraft and other non-IBM manufactured equipment. Leveraged leases have remaining terms ranging from two to twenty-five years. The components of the net investment in leveraged leases at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 ________ ________ Net rents receivable. . . . . . . . . . $273,183 $243,931 Estimated unguaranteed residual values. 40,752 77,209 Unearned and deferred income. . . . . . (97,222) (89,854) Allowance for losses. . . . . . . . . . (7,240) (24,890) ________ ________ Investment in leveraged leases. . . . . 209,473 206,396 Less: Deferred income taxes. . . . . . (234,805) (229,166) ________ ________ Net investment in leveraged leases. . . $(25,332) $(22,770) ======== ======== During 1993, the net investment in leveraged leases was reduced primarily from the restructuring of certain leveraged leases, writeoffs of transactions that were previously reserved, and the increase in the federal income tax rate from 34 percent to 35 percent. EQUIPMENT ON OPERATING LEASE: Operating leases consist principally of IBM information handling equipment with terms generally from two to four years. The components of equipment on operating lease at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Cost. . . . . . . . . . . . . . . . . . . $2,853,672 $2,826,381 Accumulated depreciation. . . . . . . . . (1,100,551) (1,049,805) __________ __________ $1,753,121 $1,776,576 ========== ========== Minimum future rentals were approximately $1,538.7 million at December 31, 1993. The scheduled maturities of the minimum future rentals expressed as a percentage of total rentals, are as follows: ______ Due within 12 months. . . . . . . . . . . . . . . . 38.5% 13 to 24 months . . . . . . . . . . . . . . . . . . 27.4 25 to 36 months . . . . . . . . . . . . . . . . . . 19.0 37 to 48 months . . . . . . . . . . . . . . . . . . 11.4 After 48 months . . . . . . . . . . . . . . . . . . 3.7 ______ 100.0% ====== LOANS RECEIVABLE: Loans receivable include installment receivables which are principally financings of customer purchases of IBM information handling products. Also included are other financings, comprised primarily of IBM software and services. The components of loans receivable at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Loans receivable . . . . . . . . . . $1,255,557 $1,702,068 Unearned income. . . . . . . . . . . (160,189) (215,845) Allowance for receivable losses. . . (57,504) (69,971) __________ __________ $1,037,864 $1,416,252 ========== ========== The scheduled maturities of loans receivable outstanding at December 31, 1993, expressed as a percentage of the total, are as follows: ______ Due within 12 months . . . . . . . . . . . . . . . 37.9% 13 to 24 months. . . . . . . . . . . . . . . . . . 28.9 25 to 36 months. . . . . . . . . . . . . . . . . . 19.1 37 to 48 months. . . . . . . . . . . . . . . . . . 10.6 49 to 60 months. . . . . . . . . . . . . . . . . . 3.5 ______ 100.0% ====== Included in loans receivable is $94.9 million and $99.6 million at December 31, 1993 and 1992, respectively, that is due from the Company's term lease partnerships. Such loans are secured by the general pool of leases in the partnerships. Also included in loans receivable is $37.5 million of seller interest relating to the securitization of such loans. The following is a reconciliation of the loans receivable allowance for receivable losses: (Dollars in thousands) 1993 1992 1991 _______ _______ _______ Beginning of year. . . . . . . . . . . . $69,971 $59,031 $53,150 Additions. . . . . . . . . . . . . . . . 13,460 34,634 53,596 Accounts written off (net of recoveries) (16,585) (23,694) (47,715) Transfers to allowance for losses on receivables sold . . . . . . . . (9,342) - - _______ _______ _______ End of year. . . . . . . . . . . . . . . $57,504 $69,971 $59,031 ======= ======= ======= WORKING CAPITAL FINANCING RECEIVABLES: Working capital financing receivables arise primarily from secured inventory and accounts receivable financing for IBM and Lexmark dealers and remarketers. Inventory financing includes the financing of the purchase by these dealers and remarketers of information handling products. Payment terms for inventory secured financing are typically less than 45 days. Accounts receivable financing includes the financing of trade accounts receivable for these dealers and remarketers. Payment terms for accounts receivable secured financing typically range from 30 days to 180 days. The components of working capital financing receivables at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Working capital financing receivables $1,440,079 $1,147,103 Allowance for receivable losses . . . (14,298) (8,972) __________ __________ $1,425,781 $1,138,131 ========== ========== The following is a reconciliation of the working capital financing receivables allowance for receivable losses: (Dollars in thousands) 1993 1992 1991 _______ _______ _______ Beginning of year. . . . . . . . . . . $ 8,972 $ 7,914 $11,847 Additions. . . . . . . . . . . . . . . 6,528 2,866 873 Accounts written off (net of recoveries) (1,202) (1,808) ( 4,806) _______ _______ _______ End of year. . . . . . . . . . . . . . $14,298 $ 8,972 $ 7,914 ======= ======= ======= Included in working capital financing receivables is $381.2 million of seller interest relating to the securitization of such receivables. Additionally, the Company has approved but unused $1.2 billion of working capital financing credit lines available to customers at December 31, 1993. INVESTMENTS AND OTHER ASSETS: The components of investments and other assets at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 ________ ________ Receivables from customers . . . . . . . . . $177,167 $279,389 Receivables from affiliates . . . . . . . . . 171,188 43,307 Remarketing inventory . . . . . . . . . . . . 92,681 85,485 Investments in partnerships . . . . . . . . . 8,158 17,122 Other assets . . . . . . . . . . . . . . . . 82,543 59,179 ________ ________ $531,737 $484,482 ======== ======== DUE AND DEFERRED FROM RECEIVABLE SALES: The Company began selling financing receivables to investors subject to limited recourse provisions during the fourth quarter of 1993. The Company's interest in excess servicing cash flows, subordinated interests in trusts, cash deposits and other related amounts are restricted assets and subject to limited recourse provisions. The following summarizes the amounts included in due and deferred from receivable sales: December 31, ____________ (Dollars in thousands) Excess servicing $ 26,355 Subordinated interests in trusts 172,970 Receivables from investors 45,786 Cash deposits held by trustee 16,730 Less: Allowance for estimated credit losses on receivables sold (15,949) _________ $245,892 ========= Gains and losses from the sale of financing receivables are recognized in the period in which the sale occurs. Provisions for expected credit losses are provided during the periods in which the receivables were originated, and, as such, the gain or loss is not usually required to be adjusted for expected credit losses. The gain on the sale of receivables is included in other income, and amounted to $21.0 million for the year ended December 31, 1993. The provision for credit losses relating to such sales amounted to $16.4 million. SHORT-TERM DEBT: The components of short-term debt at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ __________ Commercial paper. . . . . . . . . . . . . . . $1,641,473 $3,409,184 Current maturities of long-term debt . . . . 1,399,687 845,297 IBM Money Market Account notes. . . . . . . . 359,874 530,917 Other short-term debt . . . . . . . . . . . . 826,690 613,632 __________ __________ $4,227,724 $5,399,030 ========== ========== Other short-term debt includes notes having maturities between nine and twelve months offered through the Company's medium-term note program. :hp3.LONG-TERM DEBT::EHP3. The components of long-term debt at December 31, 1993 and 1992 are as follows: (Dollars in thousands) 1993 1992 __________ ___________ 8.3 % notes due November 1993 . . . . . . . $ - $ 400,000 7.2 % notes due February 1994. . . . . . . 300,000 300,000 6.125 % notes due November 1994 . . . . . . 500,000 500,000 8 % Dual currency notes due September 1995(1) - 120,200 Medium-term notes with original maturities after one year at rates averaging 5.3% through 2008 . . . . 2,778,277 1,829,311 Other debt . . . . . . . . . . . . . . . . 99,000 99,000 __________ __________ 3,677,277 3,248,511 Net unamortized premiums and discounts . . 2,206 2,857 __________ __________ 3,679,483 3,251,368 Less: Current maturities. . . . . . . . . 1,399,687 845,297 __________ __________ $2,279,796 $2,406,071 ========== ========== (1) Called in September 1993. Premiums and discounts have the effect of modifying the stated rate of interest on long-term debt offerings. Annual maturity of long-term debt at December 31, 1993 is as follows: (Dollars in thousands) 1994 . . . . . . . . . . . . . . . . . . . $1,399,687 1995 . . . . . . . . . . . . . . . . . . . 1,305,101 1996 . . . . . . . . . . . . . . . . . . . 374,455 1997 . . . . . . . . . . . . . . . . . . . 93,625 1998 . . . . . . . . . . . . . . . . . . . 463,409 1999 and thereafter . . . . . . . . . . . 41,000 __________ $3,677,277 ========== SFAS 105, "Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk," requires certain disclosure about financial instruments with off-balance sheet risk. The following summary of contract or notional (face) amounts outstanding merely provides an indication of the extent of the Company's involvement in such instruments. The Company does not anticipate any material adverse effect on its financial position resulting from its involvement in these instruments, nor does it anticipate nonperformance by any of its counterparties. (Dollars in thousands) December 31, December 31, 1993 1992 _________ _________ Interest rate swap agreements $2,283,374 $1,489,000 Currency exchange agreements $ 197,197 $ 320,000 SFAS 105 also requires the disclosure of information about significant geographic, business, or other concentrations of credit risk for all financial instruments. The Company originates financing for customers in a variety of industries and throughout the United States. The Company does not have any significant geographic or industry concentrations of credit risk. RATIO OF EARNINGS TO FIXED CHARGES: The ratio of earnings to fixed charges calculated in accordance with applicable Securities and Exchange Commission requirements was 2.07, 1.78 and 1.58 for the years ended December 31, 1993, 1992, and 1991, respectively. RELATED COMPANY TRANSACTIONS: IBM charged the Company $97.8 million, $94.0 million and $84.3 million in 1993, 1992 and 1991, respectively, representing costs for various loans receivable and lease services, employee benefit plans, facilities rental and staff support. The Company has received compensation for services and benefits provided to IBM. The fees received relate to the management of IBM's portfolio of state and local government installment receivables and to tax benefits produced by the Company relating to leasing transactions. The latter fees are based on potential savings recognized by IBM as a result of the deferral of income taxes and are calculated at prevailing market interest rates. The Company received fees of $65.9 million, $89.0 million and $111.5 million in 1993, 1992 and 1991, respectively, for these services and benefits which are included in other income. In 1993, these fees are primarily for the management of IBM's portfolio of state and local government installment receivables. Amounts due to IBM and affiliates are for software, services, purchases of receivables and purchases of equipment for term leases, with payment terms comparable to those offered to other IBM customers, as well as current income taxes payable. At December 31, 1993 and 1992, amounts due to IBM were $1,259.5 million and $1,403.7 million, respectively. Interest income of $.9 million, $6.0 million and $5.6 million was earned from loans to IBM and affiliates in 1993, 1992 and 1991, respectively. The Company provides capital equipment financing at market rates to IBM and affiliated companies for both IBM and non-IBM products. The Company originated $456.4 million and $449.4 million of such financing during 1993 and 1992, respectively. At December 31, 1993 and 1992, approximately $1,100.0 million and $700.0 million, respectively, of such financings are included in the lease and loan portfolio. The Company entered into a financing agreement in 1989 with a partnership in which IBM is an equity partner. The Company guarantees the interest and principal obligation of the commercial paper issued by the partnership for a fee. The total amount of commercial paper committed to be guaranteed amounts to $325.0 million. As of December 31, 1993, the partnership had $296.0 million par value of commercial paper and accrued interest outstanding. The term of the agreement extends through June, 1994. At December 31, 1993, the Company has deposited a total of $15.9 million into restricted accounts. Of this restricted amount, $9.4 million has been deposited to collateralize both a $5.9 million surety bond provided by the IBM Credit Insurance Company, a wholly owned subsidiary of the Company, and a $3.5 million limited guarantee provided by the Company. Additionally, $5.7 million of this restricted amount has been deposited as a requirement under a loan agreement entered into by the Company, and $.8 million is held as security deposits received from customers. The cash on deposit related to the surety bond, the limited guarantee, and the loan agreement was delivered in connection with certain tax-exempt grantor trusts comprised of pools of IBM state and local government installment receivables. The Company also has deposited an additional $2.2 million into restricted accounts at December 31, 1993 as required by the pooling and servicing agreement for selected tax-exempt grantor trusts. This amount relates to daily cash collections deposited with the trustee. The trustee of each grantor trust is entitled to draw upon the amounts in the restricted account set aside for such particular trust in the event of non-performance, defaults or other losses relating to such installment receivables. PROVISION FOR INCOME TAXES: The components of the provision for income taxes are as follows: (Dollars in thousands) 1993 1992 1991 _________ ________ ________ Federal: Current . . . . . . . . . $ 30,612 $(137,455) $ 304,939 Deferred. . . . . . . . . 116,494 245,071 (202,333) _________ ________ ________ 147,106 107,616 102,606 _________ ________ ________ State and local: Current . . . . . . . . . 47,353 (18,853) 20,860 Deferred. . . . . . . . . (21,287) 42,799 1,392 _________ ________ ________ 26,066 23,946 22,252 _________ ________ ________ Total provision . . . . . $173,172 $131,562 $124,858 ========= ======== ======== The Company implemented SFAS 109 in 1992. This statement replaced the previous accounting standard for income taxes, SFAS 96, which the Company adopted in 1988. Both SFAS 96 and SFAS 109 require the use of the liability method for recording deferred taxes. The implementation of SFAS 109 had no impact on the Company's financial statements other than to require the disclosure of the significant components of deferred taxes which are as follows: (Dollars in thousands) 1993 1992 _________ _________ Deferred tax assets (liabilities): Provision for receivable losses $ 85,174 $ 89,820 State and local taxes 21,722 37,950 Lease income and depreciation (923,624) (847,568) Other 5,445 3,627 _________ _________ Deferred income taxes $(811,283) $(716,171) ========= ========= The provision for income taxes varied from the U.S. federal statutory income tax rate as follows: 1993 1992 1991 ______ ______ ______ Federal statutory rate. . . . . . . . 35.0% 34.0% 34.0% Federal tax rate increase (1) . . . . 5.1 - - State and local taxes, net of federal tax benefits . . . . . . 4.2 4.6 4.5 Other, net . . . . . . . . . . . . . (.3) (1.1) (0.1) ______ ______ ______ Effective income tax rate . . . . . 44.0% 37.5% 38.4% ====== ====== ====== (1) On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 (the Act) was enacted. The Act increased the U.S. corporate income tax rate from 34 percent to 35 percent, retroactive to January 1, 1993. SFAS 109, "Accounting for Income Taxes," requires that the income effects on deferred taxes of enacted changes in tax laws are to be recognized in the period of enactment. Consequently, the Company's deferred income tax liability has been adjusted to reflect the new tax rate, and federal tax expense for the current year has been calculated using the new rate. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS: In 1992, the Company implemented SFAS 107, "Disclosures about Fair Value of Financial Instruments." This statement requires the disclosure of estimated fair values for all financial instruments for which it is practical to estimate fair value. Fair value is a very subjective and imprecise measurement that is based on numerous estimates and assumptions which require substantial judge- ment and may only be valid at a particular point in time. As such, fair value can only represent a very general approximation of possible value which may never actually be realized. The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practicable to estimate. In accordance with SFAS 107, fair value disclosure is not required for lease contracts. Cash and cash equivalents: The carrying amount approximates fair value due to the short maturity of these instruments. Loans receivable: The fair value is estimated by discounting the future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings with the same remaining maturities. Working capital financing receivables: The carrying amount approximates fair value due to the short maturity of most of these instruments. Due and deferred from receivable sales: The carrying amount approximates fair value. Short-term debt: For the majority of these instruments, the carrying amount approximates fair value due to their short maturity. Long-term debt and current maturities of long-term debt: The fair value of these instruments is based on replacement cost or quoted market prices for the same issues. Replacement cost is the cost to issue a similar instrument with similar maturity and credit risk. Interest rate swaps and currency exchange agreements: The fair value of these instruments has been estimated as the amount the Company would receive or pay to terminate the agreements, taking into consideration current interest and currency exchange rates. Financial guarantees: The fair value of financial guarantees is estimated as the amount that would be paid if the Company had to settle the obligation. The estimated fair values of the Company's financial instruments are summarized as follows: At December 31, 1993 (Dollars in thousands) Carrying Estimated Amount Fair Value __________ __________ Financial assets: Cash and cash equivalents $ 609,891 $ 609,891 Loans receivable $1,037,864 $1,122,139 Working capital financing receivables $1,425,781 $1,425,781 Due and deferred from receivable sales $ 245,892 $ 245,892 Financial liabilities: Short-term debt (excluding current maturities of long-term debt) $2,828,037 $2,828,594 Long-term debt and current maturities of long-term debt $3,679,483 $3,665,268 Off-balance-sheet instruments: Interest rate swaps and currency exchange agreements - $ 54,400 Financial guarantees - $ 18,382 DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS:(cont.) At December 31, 1992 (Dollars in thousands) Carrying Estimated Amount Fair Value __________ __________ Financial assets: Cash and cash equivalents $ 598,557 $ 598,557 Loans receivable $1,416,252 $1,467,444 Working capital financing receivables $1,138,131 $1,138,131 Financial liabilities: Short-term debt (excluding current maturities of long-term debt) $4,553,733 $4,562,590 Long-term debt and current maturities of long-term debt $3,251,368 $3,301,283 Off-balance-sheet instruments: Interest rate swaps and currency exchange agreements - $ 30,530 Financial guarantees - $ 22,900 Selected Quarterly Financial Data: (Unaudited) (Dollars in thousands) Finance and Other Interest Net Income Expense Earnings ____ First Quarter . . . . . . . $ 405,657 $ 93,931 $ 58,251 Second Quarter. . . . . . . 382,620 91,576 50,590 Third Quarter . . . . . . . 460,029 94,237 37,706 Fourth Quarter. . . . . . . 522,124 85,931 73,673 __________ __________ __________ $1,770,430 $ 365,675 $ 220,220 ========== ========== ========== ____ First Quarter . . . . . . . $ 409,856 $ 125,542 $ 58,102 Second Quarter. . . . . . . 464,654 116,870 52,738 Third Quarter . . . . . . . 457,450 106,331 55,851 Fourth Quarter. . . . . . . 430,570 97,073 52,579 __________ __________ __________ $1,762,530 $ 445,816 $ 219,270 ========== ========== ========== SUBSEQUENT EVENT: On January 28, 1994, the Company's Board of Directors approved a $150.0 million dividend payable to IBM on February 28, 1994. ITEM 9. ITEM 9. CHANGES in and DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING and FINANCIAL DISCLOSURE: None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT: Omitted pursuant to General Instruction J. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION: Omitted pursuant to General Instruction J. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT: Omitted pursuant to General Instruction J. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS: Omitted pursuant to General Instruction J. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K: (a) The following documents are filed as part of this report: 1. Consolidated Financial Statements included in Part II of this report: Report of Independent Accountants (page 12). Consolidated Statement of Financial Position at December 31, 1993 and 1992 (page 13). Consolidated Statement of Earnings and Retained Earnings for the years ended December 31, 1993, 1992 and 1991 (page 14). Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 (page 15). Notes to Consolidated Financial Statements (pages 16 through 32). 2. Financial statement schedules required to be filed by Item 8 of this Form: Page Schedule Number ____ _______________ 36 IX -- Short-Term Borrowings All other schedules are omitted because of the absence of the conditions under which they are required or because the information is disclosed in the financial statements or the notes thereto. 3. Exhibits required to be filed by Item 601 of Regulation S-K: Included in this Form 10-K: Exhibit Number _______ I. Agreement to furnish information defining the rights of debt holders. II. Statement re computation of ratios. III. Consent of Experts and Counsel. IV. Power of attorney of James J. Forese. V. Power of attorney of John W. Thompson. Not included in this Form 10-K: The Certificate of Incorporation of IBM Credit Corporation is filed pursuant to Quarterly report on Form 10Q for the Quarterly period ended June 30, 1993 on August 10, 1993, and is hereby incorporated by reference. The By-Laws of IBM Credit Corporation is filed pursuant to Quarterly report on Form 10Q for the Quarterly period ended September 30, 1993 on November 10, 1993 and is hereby incorporated by reference. The Support Agreement dated as of April 15, 1981, between the Company and IBM is filed with Form SE dated March 26, 1987, and is hereby incorporated by reference. Powers of Attorney of Bob E. Dies, Takeshi Gotoh, and John J. Higgins. (b) Reports on Form 8-K: There were no 8-K reports filed during the last quarter of 1993. [SIGNATURE] 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. IBM CREDIT CORPORATION (Registrant) By: /s/James J. Forese __________________ (James J. Forese) (Chairman) Date: March 15, 1994 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 March 15, 1994 Signature Title _________ _____ _James J Forese ______ ______________________ (James J. Forese)* Chairman _Melvin Kyle Grosz____ ______________________ (Melvin Kyle Grosz) Vice President and Assistant General Manager, Finance and Risk Management _Richard J. Obetz_____ ______________________ (Richard J. Obetz) Controller ] ] ] Bob E. Dies* Director ] ] /s/ Melvin Kyle Grosz Takeshi Gotoh* Director ]By: _________________ ] (Melvin Kyle Grosz) John J. Higgins* Director ] Attorney-in-fact ] John W. Thompson* Director ] ] ] ] ] * A majority of the Board of Directors EXHIBIT INDEX _____________ Reference Number Exhibit Number per Item 601 of in This Regulation S-K Description of Exhibits Form 10-K ________________ _______________________ _____________ (3) Certificate of Incorporation and By-Laws. The certificate of incorporation of IBM Credit Corporation is filed pursuant to Form 10Q for the Quarterly period ended June 30, 1993 on August 10, 1993, and is hereby incorporated by reference. The By-Laws of IBM Credit Corporation are file pursuant to Quarterly report on Form 10Q for the Quarterly period ended September 30, 1993 on November 10, 1993 and are hereby incorporated by reference. (4) (a) Instruments Defining the Rights of Security Holders. An agreement to furnish to the Securities I and Exchange Commission on request, a copy of instruments defining the rights of debt holders. (4) (b) Indenture dated as of January 15, 1989 filed electronically as Exhibit No. 4 to Amendment No. 1 to Form S-3 on April 3, 1989, and hereby incorporated by reference. (9) Voting Trust Agreement Not applicable (10) Material Contracts. The Support Agreement dated as of April 15, 1981, between the Company and IBM is filed with Form SE dated March 26, 1987, and is hereby incorporated by reference. EXHIBIT INDEX _____________ (continued) Reference Number Exhibit Number per Item 601 of in This Regulation S-K Description of Exhibits Form 10-K ________________ _______________________ _____________ (11) Statement re computation of per share Not earnings applicable (12) Statement re computation of ratios II (18) Letter re change in accounting principles Not applicable (19) Previously unfiled documents Not applicable (22) Subsidiaries of the registrant Omitted (23) Published report regarding matters Not submitted to vote of security holders applicable (24) Consent of experts and counsel III (25) (a) Power of attorney of Bob E. Dies is filed on Form SE dated March 3, 1989, and is hereby incorporated by reference. (25) (b) Power of attorney of Takeshi Gotoh is filed on Form SE dated September 17, 1990 and is hereby incorporated by reference. (25) (c) Power of attorney of John J. Higgins is filed on Form SE dated April 16, 1991, and is hereby incorporated by reference. (25) (d) Power of attorney of James J. Forese IV (25) (e) Power of attorney of John W. Thompson V (28) Additional exhibits Not applicable (29) Information from reports furnished to Not state insurance regulatory authorities applicable

702165_1993.txt

702165_1993

1993

702165

Item 1. Business. - ------ -------- and Item 2. Item 2. Properties. - ------ ---------- GENERAL. Norfolk Southern Corporation (Norfolk Southern) was incorporated on July 23, 1980, under the laws of the Commonwealth of Virginia. On June l, 1982, Norfolk Southern acquired control of two major operating railroads, Norfolk and Western Railway Company (NW) and Southern Railway Company (Southern). In accordance with an Agreement of Merger and Reorganization dated as of July 31, 1980, and related Plans of Merger, and the approval of the transaction by the Interstate Commerce Commission (ICC), each issued share of NW's common stock was converted into one share of Norfolk Southern Common Stock and each issued share of Southern common stock was converted into 1.9 shares of Norfolk Southern Common Stock. The outstanding shares of Southern's preferred stock remained outstanding without change. Effective December 31, 1990, Norfolk Southern transferred all the common stock of NW to Southern, and Southern's name was changed to Norfolk Southern Railway Company (Norfolk Southern Railway). As of February 28, 1994, all the common stock of NW (100 percent voting control) is owned by Norfolk Southern Railway, and all the common stock of Norfolk Southern Railway and 7.1 percent of its preferred stock (resulting in 94.3 percent voting control) are owned directly by Norfolk Southern. On June 21, 1985, Norfolk Southern acquired control of North American Van Lines, Inc. and its subsidiaries (NAVL), a diversified motor carrier. In accordance with an Acquisition Agreement dated May 2, 1984, and the approval of the transaction by the ICC, Norfolk Southern acquired all the issued and outstanding common stock of NAVL from PepsiCo, Inc. During 1993, NAVL underwent a restructuring (see discussion on page 7 and in Note 3 of Notes to Consolidated Financial Statements on page 74) designed to enhance its opportunities to return to profitability. Unless indicated otherwise, Norfolk Southern and its subsidiaries are referred to collectively as NS. STOCK PURCHASE PROGRAMS. Norfolk Southern announced on November 24, 1987, that its Board of Directors had authorized the purchase of up to 20 million shares of Norfolk Southern's common stock through the end of 1990. This program was completed in November 1989. On October 24, 1989, the Board of Directors authorized the purchase of up to an additional 45 million shares of common stock. Purchases under these programs initially were made with internally generated cash. Beginning in May 1990, some purchases were financed with proceeds from the sale of short-term notes pursuant to the commercial paper program discussed below. On January 29, 1992, Norfolk Southern announced that, primarily related to issues surrounding the 1991 special charge (see Note 15 of Notes to Consolidated Financial Statements on page 85), the purchase program would continue, but at a slower pace and over a longer authorized period with purchases dependent on market conditions, the economy, cash needs and alternative investment opportunities. As of December 31, 1993, 33.6 million shares had been purchased pursuant to the current program resulting in a total of 53.6 million shares purchased and retired since 1987 at a cost of approximately $2.2 billion. If all 45 million shares are purchased under the current program, the number of outstanding shares of common stock will have been reduced by about one third since 1987. Purchases are made in regular brokerage transactions on the open market at prevailing market prices and otherwise in accordance with Securities and Exchange Commission regulations. In June 1989, Norfolk Southern announced that it intended to purchase up to 250,000 shares of Norfolk Southern Railway's $2.60 Cumulative Preferred Stock, Series A, during the subsequent two-year period. In May 1991, Norfolk Southern extended the previously announced stock purchase program through 1993. In March 1994, Norfolk Southern announced that it would continue purchasing up to 250,000 shares of the stock through 1996. From June 2, 1989, through December 31, 1993, Norfolk Southern had purchased 77,626 shares of the preferred stock at a total cost of approximately $2.67 million. COMMERCIAL PAPER PROGRAM AND DEBT ISSUANCE. In May 1990, Norfolk Southern established a commercial paper program principally to finance the purchase and retirement of its common stock. Commercial paper debt is due within one year, but a portion has been classified as long-term because Norfolk Southern has the ability and intends to refinance its commercial paper on a long-term basis, either by issuing additional commercial paper (supported by a revolving credit agreement) or by replacing commercial paper notes with long-term debt. The original $350 million credit agreement was replaced effective June 9, 1992, by a credit agreement expiring June 9, 1995, having a credit limit of $400 million. The agreement provides for interest on borrowings at prevailing short-term rates and contains customary financial covenants, including principally a minimum tangible net worth requirement of $3 billion and a restriction on the creation or assumption of certain liens. Norfolk Southern intends to replace the current credit agreement with a new agreement during the first half of 1994. It is expected that the new credit agreement will have a term of five years, a credit limit of $500 million and covenants similar to those included in the current agreement. In January 1991, Norfolk Southern filed with the Securities and Exchange Commission a shelf registration statement on Form S-3 covering the issuance of up to $750 million principal amount of unsecured debt securities. On March 13, 1991, Norfolk Southern issued and sold $250 million principal amount of its 9 percent Notes due March 1, 2021 (9% Notes). The 9% Notes are not redeemable prior to maturity and are not entitled to any sinking fund. Proceeds from the sale of the 9% Notes were used to purchase and retire shares of Norfolk Southern Common Stock and to retire short-term commercial paper debt issued to fund previous share purchases. On February 26, 1992, Norfolk Southern issued and sold $250 million principal amount of its 7-7/8 percent Notes due February 15, 2004 (7-7/8% Notes). The 7-7/8% Notes are not redeemable prior to maturity and are not entitled to any sinking fund. Proceeds from the sale of the 7-7/8% Notes were used to purchase and retire shares of Norfolk Southern Common Stock and to retire short-term commercial paper debt. RAILROAD OPERATIONS. As of December 31, 1993, NS' railroads operated 14,589 miles of road in the states of Alabama, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maryland, Michigan, Mississippi, Missouri, New York, North Carolina, Ohio, Pennsylvania, South Carolina, Tennessee, Virginia and West Virginia, and the Province of Ontario, Canada. Of this total, 12,761 miles are owned, 677 miles are leased and 1,151 miles are operated under trackage rights. Of the operated mileage, 11,870 miles are main line and 2,719 miles are branch line. In addition, NS' railroads operate approximately 11,266 miles of passing, industrial, yard and side tracks. NS' railroads have major leased lines in North Carolina and between Cincinnati, Oh., and Chattanooga, Tn. The North Carolina leases, covering approximately 300 miles, expire at the end of 1994, and NS' railroads are discussing possible renewals with the lessor. If these leases are not renewed, NS' railroads could be required to continue using the lines subject to conditions prescribed by the ICC or they might find it necessary ultimately to operate over an alternate route or routes. It is not expected that the resolution of this matter, whether resulting in renewal of the leases, continued use of the leased lines under prescribed conditions or operation over one or more alternate routes, will have a material effect on NS' consolidated financial position. The Cincinnati-Chattanooga lease, covering about 335 miles, expires in 2026, subject to an option to extend the lease for an additional 25 years at terms to be agreed upon. NS' lines carry raw materials, intermediate products and finished goods primarily in the Southeast and Midwest and to and from the rest of the United States and parts of Canada. These lines also transport overseas freight through several Atlantic and Gulf Coast ports. Atlantic ports served by NS include: Norfolk, Va.; Morehead City, N.C.; Charleston, S.C.; Savannah and Brunswick, Ga.; and Jacksonville, Fl. Gulf Coast ports served include: Mobile, Al., and New Orleans, La. The lines of NS' railroads reach most of the larger industrial and trading centers of the Southeast and Midwest, with the exception of those in central and southern Florida. Atlanta, Birmingham, New Orleans, Memphis, St. Louis, Kansas City (Missouri), Chicago, Detroit, Cincinnati, Buffalo, Norfolk, Charleston, Savannah and Jacksonville are among the leading centers originating and terminating freight traffic on the system. In addition to serving other established centers, its lines reach many industries, mines (in western Virginia, eastern Kentucky and southern West Virginia) and businesses located in smaller communities in its service area. The traffic corridors carrying the heaviest volumes of freight include those from the Appalachian coal fields of Virginia, West Virginia and Kentucky to Norfolk and Sandusky, Oh.; Buffalo to Chicago and Kansas City; Chicago to Jacksonville (via Cincinnati, Chattanooga and Atlanta); and Washington, D.C./Hagerstown, Md., to New Orleans (via Atlanta and Birmingham). Buffalo, Chicago, Hagerstown, Jacksonville, Kansas City, Memphis, New Orleans and St. Louis are major gateways for interterritorial system traffic. MOTOR CARRIER OPERATIONS. NAVL's principal transportation activity is the domestic, irregular route common and contract carriage of used household goods and special commodities between points in the United States. NAVL also operates as an intrastate carrier of property in 17 states. Prior to its restructuring in 1993, NAVL's domestic motor carrier business was organized into three primary divisions: Relocation Services (RS) specializing in residential relocation of household goods; High Value Products (HVP) specializing in office and industrial relocations and transporting exhibits; and Commercial Transport (CT) specializing in the transportation of truckload shipments of general commodities. In 1993, NAVL underwent a restructuring involving termination of the CT Division and sale of the operations of Tran-Star, Inc. (Tran-Star), NAVL's refrigerated trucking subsidiary. In 1993, NAVL discontinued CT's operations, transferred some parts of CT's business to other divisions and began selling CT's assets that are not needed in NAVL's other operations. The sale of Tran-Star's operations was completed on December 31, 1993. During 1993, the RS and HVP divisions conducted operations through agents at 707 locations in the United States. Agents are local moving and storage companies that provide NAVL with such services as solicitation, packing and warehousing in connection with the movement of household goods and specialized products. NAVL's domestic operations are expected to be conducted principally through the RS and HVP divisions in 1994 and thereafter. Customized Logistics Services (CLS) was established in 1993 as an operating unit of the HVP Division. CLS' business is to focus NAVL's resources to respond to a variety of customer needs for integrated logistics services. The services include emergency parts order fulfillment, time definite transportation, and returns and merchandise recycling services. NAVL's foreign operations are conducted through the RS and HVP Divisions and through foreign subsidiaries, including North American Van Lines Canada, Ltd. The latter subsidiary provides motor carrier service for the transportation of used household goods and specialized commodities between most points in Canada through a network of approximately 182 agent locations. NAVL's international operations consist primarily of forwarding used household goods to and from the United States and between foreign countries through a network of approximately 350 foreign agents and representatives. NAVL's international operations are structured to align them with the services provided by its domestic operating divisions. All international household goods operations and related subsidiaries in Alaska, Canada and Panama are assigned to the RS Division. The remaining international operations, which include subsidiaries in the United States, Germany and the United Kingdom, are involved in the transportation of selected general and specialized commodities and are assigned to the HVP Division. The RS Division successfully completed its negotiations in the first quarter of 1992 to form a joint venture company known as UTS Europe Holding BV (UTS). The new entity, which is headquartered in Amsterdam, Netherlands, has been handling intra-European movement of household goods since March 1, 1992. NAVL has a 40 percent interest in UTS which is comprised of approximately 70 individual shareholders in 65 locations throughout Europe. To date, national and regional organizations have been formed under the UTS banner in Germany and the Netherlands (founding members), with an 8 percent and 5 percent interest in UTS, respectively. In addition, the United Kingdom (8 percent interest in UTS), Belgium (5 percent interest) and the Scandinavian countries (5 percent interest) have also formed under the UTS banner. TRIPLE CROWN OPERATIONS. Until April 1993, Norfolk Southern's intermodal subsidiary, Triple Crown Services, Inc. (TCS), offered intermodal service using RoadRailer (Registered Trademark) (RT) equipment and domestic containers. RoadRailer(RT) units are enclosed vans which can be pulled over highways in tractor- trailer configuration and over the rails by locomotives. On April 1, 1993, the business, name and operations of TCS were transferred to Triple Crown Services Company (TCSC), a partnership formed by subsidiaries of Norfolk Southern and Consolidated Rail Corporation (CR). RoadRailer(RT) equipment owned or leased by TCS (which was renamed TCS Leasing, Inc.) is operated by TCSC. Because NS indirectly owns only 50 percent of TCSC (an affiliate of CR also owns 50 percent), the revenues of TCSC are not consolidated with the results of NS. TCSC offers door-to-door intermodal service using RoadRailer(RT) equipment and domestic containers in the corridors previously served by TCS, as well as service to the New York and New Jersey markets via CR. Major traffic corridors include those between New York and Chicago, Chicago and Atlanta and Atlanta and New York. TRANSPORTATION OPERATING REVENUES. NS' total transportation operating revenues were $4.5 billion in 1993. These revenues were received for the transportation of revenue freight: 262.3 million tons by rail and 3.2 million tons by motor carrier. Of the rail tonnage, approximately 210.4 million tons originated on line, approximately 222.8 million tons terminated on line (including 177.1 million tons of local traffic -- originating and terminating on line) and approximately 6.2 million tons was overhead traffic (neither originating nor terminating on line). Revenue and revenue ton mile (one ton of freight moved one mile) contributions by principal transportation operating revenue sources for the period 1989 through 1993 are set forth in the following table: COAL TRAFFIC - The commodity group moving in largest tonnage volume over NS' railroads is coal, coke and iron ore, most of which is bituminous coal. NS' railroads originated 112.1 million tons of coal, coke and iron ore in 1993 and handled a total of 118.0 million tons. Originated tonnage decreased 5 percent from 118.0 million tons in 1992, and total tons handled decreased 5 percent from 124.4 million tons. Revenues from coal, coke and iron ore, which accounted for 27 percent of NS' total transportation operating revenues and 36 percent of total revenue ton miles in 1993, were $1.21 billion, a decrease of 6 percent from $1.30 billion in 1992. The following table shows total coal tonnage originated on NS' lines, received from connections and handled for the five years ended December 31, 1993: Of the 109.8 million tons of coal originating on NS railroad lines in 1993, the approximate breakdown is as follows: 37.9 million tons from West Virginia, 37.6 million tons came from Virginia, 22.9 million tons from Kentucky, 7.6 million tons from Alabama, 1.7 million tons from Tennessee, 1.1 million tons from Illinois, and 1.0 million tons from Indiana. Of this NS-origin coal, approximately 25.3 million tons moved for export, principally through NS pier facilities at Norfolk (Lamberts Point), Va.; 20.1 million tons moved to domestic and Canadian steel industries; 55.6 million tons of steam coal moved to electric utilities; and 8.8 million tons moved to other industrial and miscellaneous users. NS' railroads moved 9.7 million tons of originated coal to various docks on the Ohio River for further movement by barge and 5.1 million tons to various Lake Erie ports. Other than coal moving for export, virtually all coal tonnage handled by NS' railroads was terminated in states situated east of the Mississippi River. Total NS coal tonnage handled through all system ports in 1993 was 42.4 million. Of this total, 65 percent moved through the pier facilities at Lamberts Point. In 1993, total tonnage handled at Lamberts Point, including coastwise traffic, was 27.6 million tons, a 20 percent decrease from the 34.7 million tons handled in 1992. The quantities of NS coal handled for export only through Lamberts Point for the five years ended December 31, 1993, were as follows: The recession in Europe and high stockpiles of coal overseas continued to affect NS' railroads' export coal shipments in 1993, as did the UMWA strike at several mines served by NS. Domestic coal was essentially flat, compared with 1992, although the market for utility coals increased slightly because of the hot weather in our service region and continued spot tonnage purchases. Increased shipments to steel producers were attributed to strike-related problems encountered by suppliers served by other carriers; the industrial market stayed even with the previous year. MERCHANDISE RAIL TRAFFIC - The merchandise traffic group consists of Intermodal and five major commodity groupings (Paper/Forest; Chemicals; Automotive; Agriculture; and Metals/Construction). Total NS railroad merchandise revenues increased in 1993 to $2.41 billion, a 2 percent increase over 1992. Railroad merchandise carloads handled in 1993 were 2.82 million, compared with 2.66 million handled in 1992, an increase of 6 percent. Intermodal results reflect the effect of the formation, in April 1993, of Triple Crown Services Company (TCSC), a partnership between NS and Conrail subsidiaries (see also page 8). This partnership provides RoadRailer(RT) and domestic container services previously offered by a wholly owned NS subsidiary. Because NS owns only 50 percent of TCSC, its revenues are not consolidated, and NS' 1993 intermodal revenues include only revenues for rail service provided by NS to the partnership. Excluding this partnership effect, intermodal revenues would have increased 10 percent, and merchandise revenues would have increased 5 percent. In 1993, 97.8 million tons of merchandise freight, or approximately 68 percent of total rail merchandise tonnage handled by NS, originated on line. The balance of NS' railroad merchandise traffic was received from connecting carriers (mostly railroads, with some intermodal, water and highway as well), usually at interterritorial gateways. The principal interchange points for NS- received traffic included Chicago, Memphis, New Orleans, Cincinnati, Kansas City, Detroit, Hagerstown, St. Louis/East St. Louis, and Louisville. The economy improved in 1993, but the pace of recovery was still below the average of post-war recoveries. All merchandise commodity groups showed improvement over 1992. The biggest gains were in Intermodal, up $34.1 million (adjusted for the effect of the TCSC partnership with Conrail); Automotive, up $28.0 million; Metals/ Construction, up $19.8 million and Agriculture, up $18.3 million. There were smaller gains in Paper/Forest and Chemicals. PAPER/FOREST traffic (including paper, paperboard, wood pulp, pulpwood, wood chips, lumber, kaolin clay and waste paper) accounted for 11 percent of NS' total transportation operating revenues and 13 percent of total revenue ton miles during 1993. Compared with 1992, Paper/Forest revenues increased 1 percent and revenue ton miles increased 3 percent. Weak domestic and overseas demand for paper depressed NS shipments for much of the year. Lumber, however, posted a 4 percent gain in revenue due to a strong recovery in housing construction. Moderate growth, somewhat higher than industry production, is expected over the next few years due to growth in market share. CHEMICALS traffic (including petroleum products, plastics, fertilizers, nonmetallic minerals, sulfur, chloral-alkali chemicals, rubber, miscellaneous chemicals and waste/hazardous chemicals) accounted for 11 percent of NS' total transportation operating revenues and 13 percent of total revenue ton miles during 1993. Compared with 1992, NS' total revenue for chemicals was up 0.3 percent and revenue ton miles increased 3 percent. The lower gain in revenue was due to a change in the mix of traffic. Gains in general chemicals and plastics were offset by weakness in movements of export fertilizer due to sluggish conditions overseas. Stronger growth is expected in 1994 and beyond, paced by additional rail-truck distribution facilities for bulk chemicals. While environmental concerns could adversely affect production of pesticides and chlorine, increased environmental awareness is likely to have a positive impact on movements of recyclables, hazardous wastes and alternative fuels such as ethanol. AUTOMOTIVE traffic (including motor vehicles, vehicle parts, miscellaneous transportation and ordnance, and tires) accounted for 10 percent of NS' total transportation operating revenues and 4 percent of revenue ton miles during 1993. Compared with 1992, NS Automotive revenues increased 7 percent and revenue ton miles increased 14 percent. The gain was due to strong demand for vehicles produced at plants served by NS. NS' largest customer, Ford Motor Company, produced the top-selling automobile and truck in 1993. In addition, NS benefited from a full year of production at the Ford/Nissan plant located near Avon Lake, Oh. Successful marketing efforts, such as an innovative program with GM for just-in-time movement of auto parts, also contributed to the gain. Further growth in Automotive is expected in 1994 and beyond, as U.S. automotive production is anticipated to increase for the next few years. Within this growing market, NS will pursue innovative marketing programs and aggressive industrial development. From 1994 to 1997, operations will begin at three new or expanded automotive assembly plants located on NS--the second Toyota Plant at Georgetown, Ky., in 1994; BMW at Greer, S.C., in 1995; and Mercedes- Benz at Tuscaloosa, Al., in 1997. The retooling of GM's Wentzville, Mo., and Doraville, Ga., plants for van production should also increase traffic. AGRICULTURE traffic (including grains and soybeans, feed and feed ingredients, sweeteners, beverages, consumer products, and various other agricultural and food commodities) accounted for 7 percent of NS' total transportation operating revenues and 12 percent of total revenue ton miles during 1993. Compared with 1992, agricultural revenues increased 6 percent and revenue ton miles increased 8 percent. In the early part of the year, NS benefited from a record harvest, that continued well into 1993. During the summer, the flood in the Midwest diverted traffic to rail that formerly moved by barge. In the fall, good crop conditions in NS' sourcing areas and poor conditions elsewhere produced strong NS traffic gains. Although the special conditions present during 1993 are not likely to recur in 1994, a small increase in agriculture revenue is expected, driven by growth in poultry production in the Southeast, a prime NS feed grain market. METALS/CONSTRUCTION traffic (including aluminum ore, iron and steel, aluminum products, scrap metal, machinery, sand and gravel, cement, brick, miscellaneous construction, and nonhazardous waste) accounted for 7 percent of NS' total transportation operating revenues and 9 percent of total revenue ton miles during 1993. Compared with 1992, NS' total revenues for Metals/Construction were up 7 percent and revenue ton miles were up 13 percent. Most of the revenue gain was in shipments of iron and steel, where strong industry production and new plants located on NS' lines boosted revenue $10 million. Shipments of construction commodities were also strong due to a recovery in housing. Further gains are expected over the next few years. NS has initiatives under way intended to win back truck business in aluminum, and several new movements of municipal solid waste are expected. INTERMODAL traffic (including trailers, containers, and Triple Crown) accounted for 8 percent of NS' total transportation operating revenues and 11 percent of total revenue ton miles during 1993. Compared with 1992, intermodal revenues increased 9 percent, and revenue ton miles increased 9 percent. Intermodal growth in 1993 was led by a 21 percent increase in Triple Crown activity due to strong automotive shipments and expansion of service to the Northeast through the partnership with Conrail. Container revenues were up 6 percent, a smaller increase than previous years due to less international traffic caused by the continuing recession in Europe and Japan. Trailer revenue was up 11 percent, boosted by gains from haulage arrangements with truckload carriers. Strong growth is expected in 1994 and for the next several years. TCSC should continue to grow as service is expanded to additional markets. Container growth is expected to improve as recoveries overseas produce steady growth in international shipments. Trailer business also is expected to grow, as leading truckload carriers, such as Schneider National and J.B. Hunt, use rail for the long-haul portion of their shipments. OTHER INTERMODAL primarily consists of drayage from or to rail points and is exclusively related to Triple Crown activity (see discussion of new partnership on page 12). The figures shown for 1993 reflect the results of NS' wholly owned subsidiary which performed RoadRailer(RT) services only for the first three months of 1993 (up to the inception of the TCSC partnership). MOTOR CARRIER TRAFFIC - NAVL's traffic volume decreased during 1993; total revenues from operations were $714.2 million, down 13.9 percent from 1992, including a 16.2 percent decrease resulting from NAVL's restructuring. NAVL's expenses decreased 11.5 percent in 1993, also resulting from the restructuring. NAVL's domestic motor carrier operations are conducted primarily through its RS and HVP divisions. In 1993, total domestic shipments for these divisions, including the CT Division through June 25, 1993, numbered 550,207, down 12.8 percent from 1992, resulting from the restructuring. Further comments about each division follow. Domestic shipments of used household goods transported by the RS Division fall into three market categories. Approximately 50 percent of the domestic shipment volume comes from the sale of moving services to individual consumers. Another 35 percent comes from corporations and other businesses that pay for the relocation of their employees. The remaining 15 percent is derived from military, government and other sources. Total domestic RS Division shipments in 1993 represented 21 percent of the NAVL domestic motor carrier shipments transported by the three primary divisions. Total domestic revenues from this division were down 2 percent, compared with 1992, and represented 38 percent of total revenues from operations. The HVP Division specializes in providing transportation services in less-than-truckload (LTL) and truckload (TL) quantities to manufacturers of sensitive products. These products are divided into the following categories: office furniture and equipment, exhibits and displays, electronic equipment, industrial machinery, commercial relocation, LTL furniture and selected general commodities. Total HVP Division shipments transported in 1993, including TL and LTL, represented 43 percent of the NAVL domestic motor carrier shipments transported by the three primary divisions. Revenues from this division were up 15 percent from 1992 levels and represented 33 percent of total revenues from operations. The operations of the CT Division were discontinued in 1993. Total CT Division shipments transported in 1993 represented 36 percent of NAVL's total domestic motor carrier shipments transported for the entire year by the three primary divisions. Revenues from this division were down 50 percent from 1992 levels and represented 19 percent of total revenues from operations. FOREIGN OPERATIONS include NAVL's Canadian subsidiary, North American Van Lines Canada, Ltd., as well as operating subsidiaries in England, Germany and Panama. Foreign operations involving the transportation of household goods and selected general and specialized commodities generated revenues of $69.5 million in 1993, down 10 percent from 1992. Revenues from foreign operations represented 10 percent of NAVL's total revenue. RAIL OPERATING STATISTICS. The following table sets forth certain statistics relating to NS' railroad operations during the periods indicated: FREIGHT RATES. In the pricing of freight services, NS' railroads continued in 1993 to increase reliance on private contracts which, coupled with traffic that has been exempted from regulation by the ICC (e.g., boxcar and intermodal traffic), presently account for over 80 percent of freight operating revenues. Thus, a major portion of NS' railroads' freight business is not economically regulated by the government. In general, market forces have been substituted for government regulation and now are the primary determinant of rail service prices. In 1993, the ICC found NS' railroads "revenue adequate" based on results for the year 1992. A railroad is "revenue adequate" under the Interstate Commerce Act when its return on net investment exceeds the rail industry's cost of capital. The condition of "revenue adequacy" determines whether a railroad can take advantage of a provision in the Interstate Commerce Act allowing freedom to increase regulated rates by a specific percentage. However, with the decreasing importance of regulated tariff traffic to NS' railroads, the ICC's "revenue adequacy" findings have less impact than formerly. Pricing and service flexibility afforded by the Motor Carrier Act of 1980 and the Household Goods Transportation Act of 1980 has resulted in NAVL's increased emphasis on innovative pricing action in order to remain competitive. Since 1980, NAVL has increasingly operated as a contract carrier. As of December 31, 1993, domestic contract carriage agreements accounted for the following percentage of shipments: RS Division, 31.9 percent and HVP Division, 72.7 percent; the CT Division was discontinued in June of 1993. PASSENGER OPERATIONS. Regularly scheduled passenger operations on NS' lines consist of Amtrak trains operating between Alexandria and New Orleans, and between Charlotte and Selma, N.C. Former Amtrak operations between East St. Louis and Centralia, Il., were discontinued by Amtrak November 3, 1993. Commuter trains continued operations on the NS line between Manassas and Alexandria under contract with two transportation commissions of the Commonwealth of Virginia, providing for reimbursement of related expenses incurred by NS. During 1993, a lease of the Chicago to Manhattan, Il., line to the Commuter Rail Division of the Regional Transportation Authority of Northeast Illinois replaced a purchase of service agreement by which NS had provided commuter rail service for the Authority. OTHER RAILWAY OPERATIONS. Revenues from switching, demurrage and miscellaneous services amounted to $121.5 million, or approximately 3 percent of total transportation operating revenues, during 1993 and $121.7 million, or approximately 3 percent of total transportation operating revenues, in 1992. NONCARRIER OPERATIONS. Norfolk Southern's noncarrier subsidiaries engage principally in the acquisition and subsequent leasing of coal, oil, gas and timberlands, the development of commercial real estate and the leasing or sale of rail property and equipment. In 1993, no such noncarrier subsidiary or industry segment grouping of noncarrier subsidiaries met the requirements for a reportable business segment set forth in Statement of Financial Accounting Standards No. 14. In January 1994, certain Norfolk Southern subsidiaries purchased rights with respect to an estimated 210 million recoverable tons of coal located primarily in eastern Kentucky and southern West Virginia. The cash purchase price for the acquisition was $71 million. These coal reserves have been leased to various producers who are to operate and mine the properties under long-term leases providing royalty income to NS. The average age of the freight car fleet at December 31, 1993, was 20.8 years. During 1993, NS retired 5,576 freight cars. As of December 31, 1993, the average age of the locomotive fleet was 14.6 years. During 1993, NS retired 37 locomotives, the average age of which was 24.7 years. Since 1989, NS has rebodied over 14,000 coal cars. As a result, the remaining serviceability of the freight car fleet is greater than is indicated by the percentage of freight cars built in earlier years. NS continues freight car and locomotive maintenance programs to ensure the highest standards of safety, reliability, customer satisfaction and equipment marketability. In recent years, as illustrated in the table below, the bad order ratio has risen or remained fairly stable primarily due to the storage of certain types of cars which are not in high demand. Funds were not spent to repair cars for which present and future customers' needs could be adequately met without such repair programs. Also, NS' own standards of what constitutes a "serviceable" car have risen, and NS continues a rational disposition program for underutilized, unserviceable and overage cars. TRACKAGE - All NS trackage is standard gauge, and the rail in approximately 95 percent of the main line trackage (including first, second, third and branch main tracks, all excluding trackage rights) is heavyweight rail ranging from 90 to 155 pounds per yard. Of the 23,512 miles of track maintained by NS as of December 31, 1993, 15,621 were laid with welded rail. The density of traffic on NS running tracks (main line trackage plus passing tracks) during 1993 was as follows: MICROWAVE SYSTEM - The NS microwave system, consisting of 6,584 radio path miles, 374 active stations and 7 passive repeater stations, provides communication services between Norfolk, Buffalo, Detroit, Fort Wayne, Chicago, Kansas City, St. Louis, Washington, D.C., Atlanta, New Orleans, Jacksonville, Memphis, Cincinnati and most operating locations between these cities. The microwave system provides approximately 2,152,600 individual voice channel miles of circuits, and NS began a conversion of the system from analog to digital technology in 1993. Conversion is under way on all microwave facilities between St. Louis, Mo., and Danville, Ky.; the process is also under way between Roanoke and Norfolk, Va. The microwave communication system is used principally for voice communications, VHF radio control circuits, data and facsimile transmissions, traffic control operations, AEI data transmissions, and relay of intelligence from defective equipment detectors. Extension of microwave communications to low density or operations support facilities is accomplished via microwave interface to buried fiber-optic or copper cables. TRAFFIC CONTROL - Of a total of 13,438 road miles operated by NS, excluding trackage rights over foreign lines, 5,274 road miles are governed by centralized traffic control systems and 2,734 road miles are equipped for automatic block system operation. COMPUTERS - Data processing facilities connect the yards, terminals, transportation offices, rolling stock repair points, sales offices and other key locations on NS to the central computer complex in Atlanta, Ga. System operating and traffic data are compiled and stored to provide customers with information on their shipments throughout the system. Data processing facilities are capable of providing current information on the location of every train and each car on line, as well as related waybill and other train and car movement data. Additionally, this facility affords substantial capacity for, and is utilized to assist management in the performance of, a wide variety of functions and services, including payroll, car and revenue accounting, billing, material management activities and controls, and special studies. OTHER - NS has extensive facilities for support of railroad operations, including freight depots, car construction shops, maintenance shops, office buildings, and signals and communications facilities. MOTOR CARRIER PROPERTY. REAL ESTATE - NAVL owns and leases real estate in support of its operations. Principal real estate holdings include NAVL's headquarters complex and warehouse and vehicle maintenance facilities in Fort Wayne, Indiana, vehicle maintenance facilities in Fontana, California, and terminal facilities in Grand Rapids, Michigan, and Great Falls, Montana. NAVL also leases facilities throughout the United States for sales offices, maintenance facilities and for warehouse, terminal and distribution center operations. EQUIPMENT - NAVL relies extensively on independent contractors (owner-operators) who supply the power equipment (tractors) used to pull NAVL trailers. Agents also provide a substantial portion of NAVL's equipment needs, particularly for the transportation of household goods, by furnishing tractors and trailers on either a permanent or an intermittent lease basis. As of December 31, 1993, agents and owner-operators together supplied 4,280 tractors, representing 71 percent of the U.S. power equipment operated in NAVL service. Also as of December 31, 1993, NAVL owned 6,981 trailer units, representing 73 percent of the U.S. trailer fleet in NAVL service. The remaining 27 percent was provided mainly by agents and owner-operators. Agents also provided 1,145 straight trucks, or 97 percent of such units in NAVL service. NAVL has an extensive program for the repair and maintenance of its trailer equipment. In 1993, work orders on approximately 18,574 trailers were completed at NAVL's facility in Fort Wayne. As of December 31, 1993, the average age of trailer equipment in the NAVL fleet was 6.7 years. COMPUTERS - NAVL relies extensively on data processing facilities for shipment planning and dispatch functions as well as shipment tracing. Data processing capabilities are also utilized in revenue processing functions, driver and agent account settlement activity, and internal accounting and record keeping service. In 1993, NAVL continued implementation of WORLDTRAC(Trademark), a satellite-based mobile communications and position-reporting system. The system allows NAVL, through computers installed in cabs, to communicate instantaneously with fleet drivers while enroute to optimize customer service and to insure customer retention. The ability to locate a driver and communicate instantly has resulted in improved equipment utilization. As of December 31, 1993, satellite units were in place on approximately 1,710 tractors throughout the NAVL fleet. This is a substantial decrease from 1992 due to the discontinuation of the CT Division's operations. ENCUMBRANCES. A substantial portion of NS' properties is subject to liens securing, as of December 31, 1993 and 1992, approximately $125.9 million and $148.5 million of mortgage debt, respectively. In addition, certain equipment is subject to the prior lien of equipment financing obligations amounting to approximately $551.4 million as of December 31, 1993, and $593.7 million at December 31, 1992. Many of the tractors utilized in NAVL service are purchased by NAVL from manufacturers and resold to agents and owner-operators under a NAVL-sponsored financing program. At December 31, 1993, NAVL had $27.1 million in such tractor contracts receivable. This program allows NAVL to generate the funds necessary to purchase the tractors and to resell them under favorable financing terms. The equipment is sold under conditional sales contracts with the agents and owner- operators. CAPITAL EXPENDITURES. During the five calendar years ended December 31, 1993, NS' capital expenditures for road, equipment and other property were as follows: NS' capital spending and maintenance programs are and have been designed to assure the Corporation's ability to provide safe, efficient and reliable transportation services. For 1994, NS is planning $634 million of capital spending, of which $627 million will be for railway projects and $7 million for motor carrier property. NS anticipates new equipment financing of approximately $72 million in 1994. Looking further ahead, rail capital spending is likely to increase moderately over the next few years. The proposed construction of a $100 million coal ground storage facility in Isle of Wight County, Va., may affect capital spending in future years. However, because of delays in the permitting process and reduced demand for export coal, any significant spending on this project is not expected until after 1994. In addition to boosting capacity, this new facility should further increase the efficiency of coal transportation service and reduce the need for new coal hopper cars. A substantial portion of future capital spending is expected to be funded through internally generated cash, although debt financing will continue as the primary funding source for equipment acquisitions. In January 1994, NS spent $71 million for coal reserves (see discussion on page 18). ENVIRONMENTAL MATTERS. Compliance with federal, state and local laws and regulations relating to the protection of the environment is a principal NS goal. To date, such compliance has not affected materially NS' capital additions, earnings, liquidity or competitive position. Costs for environmental protection for 1993 were approximately $32.9 million, of which $28.9 million were operating expenses and $4.0 million were capitalized. Such NS expenditures historically have been associated with the cleanup of real estate used for operating and nonoperating purposes, solid/hazardous waste handling and disposal, water pollution control, asbestos removal projects and removal/remediation work related to underground tanks. To promote achievement of NS' environmental objectives and to assure continuous improvement in its programs, environmental engineers perform ongoing analyses of all identified sites, and -- after consulting with counsel -- any necessary adjustments to initial liability estimates are recorded (and expensed or capitalized, as appropriate). Evaluations of other sites are ongoing. NS also has established an Environmental Policy Council, composed of senior managers, to prescribe and direct its environmental initiatives and undertake environmental awareness programs through which NS employees will receive training. Certain NS rail subsidiaries have received notices from the Environmental Protection Agency that they are potentially responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) which generally imposes joint and several liability for cleanup costs. State agencies also have notified certain NS rail subsidiaries that they may be potentially responsible for environmental damages, and in several instances they have agreed voluntarily to initiate cleanup. For CERCLA sites and all other known environmental incidents where loss or liability is probable, NS has recorded an estimated liability. The amount of that liability, which includes estimated costs of remediation (and any associated restoration) on a site-by-site basis, is expected to be paid over several years. Although the estimated liability usually is expensed in the year it is recorded, certain expenditures relating to real estate development projects have been capitalized. Claims, if any, against third parties for recovery of remediation costs incurred by NS are reflected as receivables in the balance sheet and not netted against the associated NS liability. Estimates of a company's potential financial exposure even for known environmental claims or incidents are necessarily imprecise because of the widely varying costs of available remediation techniques, the difficulty of determining in advance the nature and extent of contamination and each potential participant's share of an estimated loss, and evolving statutory and regulatory standards governing liability. The risk of incurring environmental liability -- for acts and omissions, both past and current -- is inherent in railroad operations. Moreover, some of the commodities, particularly those classified as hazardous materials, in NS' traffic mix can pose special risks, which NS and its subsidiaries work diligently to minimize. In addition, several NS subsidiaries have land holdings that may be leased (and operated by others) or held for sale. Because certain conditions may exist on these properties for which NS ultimately may bear some financial responsibility, there can be no assurance that NS will not incur liabilities or costs, the amount and materiality of which, to a single accounting period or in the aggregate, cannot be estimated reliably now, related to environmental problems that are latent or undiscovered. However, based on its assessments of the facts and circumstances now known and after consulting with its legal counsel, Management believes that it has recorded appropriate estimates of liability for those environmental matters of which NS is aware. At year end, a grand jury investigation was under way regarding possible violations of certain environmental statutes in 1989 at Moberly Yard, Moberly, Mo. A more detailed report of this incident, including information concerning its resolution since year end, is set forth under the heading "Item 3. Item 3. Legal Proceedings - ------ ----------------- New Orleans, Louisiana - Tank Car Fire. A number of lawsuits have been filed as a result of a tank car fire which occurred in New Orleans, La., on September 9, 1987, and resulted in the evacuation of many residents of the surrounding area. Plaintiffs allege that they were injured and sustained other economic loss when a chemical called butadiene leaked from a tank car under the control of either CSX Transportation, Inc., or New Orleans Terminal Company (a subsidiary of Norfolk Southern Railway) or both. In addition to the rail defendants, defendants in one or more of the suits include the City of New Orleans, the owner of the tank car (General American Transportation Corporation), the loader of the tank car (GATX Terminals Corporation), and the shipper (Mitsui & Co. (USA Inc.)). The suits, which are pending in the Civil District Court for the parish of Orleans, seek damages ranging from $10,000 to $20,000,000,000. Management, after consulting with its legal counsel, is of the opinion that ultimate liability will not materially affect the consolidated financial position of NS. This matter has been reported previously by Norfolk Southern in Part II, Item 1, of its Form 10-Q Reports for the quarters ending September 30, 1987, and March 31, 1990; and in Part I, Item 3, of its Form 10-K Annual Reports for 1987, 1988, 1989, 1990, 1991 and 1992. Moberly, Missouri - Burial of Paint and Solvent. On or about May 16 and May 23, 1991, respectively, certain employees and NW were served with subpoenas duces tecum requiring production of various documents and information, all related to a federal grand jury's investigation of possible violations of certain environmental statutes in 1989 at Moberly Yard, Moberly, Mo. A search warrant also was served on NW at Moberly, and various company records were seized. A second subpoena duces tecum was served on September 19, 1991, concerning the relationship between Norfolk Southern Corporation and NW. The investigation resulted from employees' having buried containers of paint and one container of solvent. NW management first learned of the incident in June 1990 from the Missouri Department of Natural Resources ("DNR"). Promptly thereafter, NW initiated appropriate remediation efforts and notified the National Response Center. The burial of paint and solvent violated long-standing NW policy and instructions. NW cooperated fully with the DNR; at year end 1993, the grand jury's investigation was continuing. The paint and paint cans (along with the single drum which contained a solvent and appears not to have leaked) and any associated contaminated dirt have been excavated and properly disposed of under the DNR's direction. On February 23, 1994, NW settled this matter with the federal and state governments by pleading guilty to a single violation of the federal Resource Conservation and Recovery Act and by making or committing to make penalty and restitution payments of up to $4,400,000. Of that amount, $1.7 million is to purchase equipment for state environmental enforcement purposes and, in line with NW's suggestion, $1.0 million is for the Katy Trail State Park which was damaged severely in the 1993 Missouri River flood. In addition, NW made certain commitments with respect to an organization-wide environmental awareness program. Management believes the February 23 settlements conclude this matter and expects to make no further reports about it. This matter has been reported previously by Norfolk Southern in Part II, Item 1, of its Form 10-Q Report for the quarter ending June 30, 1991, and in Part I, Item 3, of its Form 10-K Annual Reports for 1991 and 1992. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------ ---------------------------------------------------- There were no matters submitted to a vote of security holders during the fourth quarter of 1993. Executive Officers of the Registrant. - ------------------------------------- Norfolk Southern's officers are elected annually by the Board of Directors at its first meeting held after the annual meeting of stockholders, and they hold office until their successors are elected. There are no family relationships among the officers, nor any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. The following table sets forth certain information, as of March 1, 1994, relating to these officers: Business Experience during Name, Age, Present Position past 5 Years - --------------------------- ------------------------------------ David R. Goode, 53, Present position since September Chairman, President and 1992. Served as President from Chief Executive Officer October 1991 to September 1992, Executive Vice President- Administration from January to October 1991 and prior thereto as Vice President-Taxation. John R. Turbyfill, 62, Present position since June 1993. Vice Chairman Served prior thereto as Executive Vice President-Finance. R. Alan Brogan, 53, Executive Present position since December Vice President-Transportation 1992. Served as Vice President- Logistics and President-North Quality Management from April American Van Lines, Inc. 1991 to December 1992, Vice President-Material Management and Property Services from July 1990 to April 1991, and prior thereto as Vice President-Material Management. Paul R. Rudder, 61, Present position since March Executive Vice President- 1990. Served as Senior Vice Operations President-Operations from October 1989 to March 1990, and prior thereto as Vice President- Engineering. John S. Shannon, 63, Executive Present position since June 1982. Vice President-Law Thomas C. Sheller, 63, Present position since October Executive Vice President- 1991. Served prior thereto as Administration Vice President-Personnel and Labor Relations. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- ------------------------------------ D. Henry Watts, 62, Executive Present position since July 1986. Vice President-Marketing Henry C. Wolf, 51, Executive Present position since June 1993. Vice President-Finance Served as Vice President-Taxation from January 1991 to June 1993, and prior thereto as Assistant Vice President-Tax Counsel. Stephen C. Tobias, 49, Senior Present position since October Vice President-Operations 1993. Served as Vice President- Strategic Planning from December 1992 to October 1993, Vice President-Transportation from October 1989 to December 1992, and prior thereto as General Manager-Western Lines. William B. Bales, 59, Vice Present position since August 1993. President-Coal Marketing Served prior thereto as Vice President-Coal and Ore Traffic. James C. Bishop, Jr., 57, Present position since August Vice President-Law 1989. Served prior thereto as Senior General Solicitor. John F. Corcoran, 53, Vice- Present position since March 1992. President-Public Affairs Served prior thereto as Assistant Vice President-Public Affairs. Thomas L. Finkbiner, 41, Present position since August 1993. Vice President-Intermodal Served as Senior Assistant Vice President-International and Intermodal from April to August 1993, and prior thereto as Assistant Vice President- International and Intermodal. James L. Granum, 57, Vice- Present position since March 1992. President-Public Affairs Served prior thereto as Assistant Vice President-Public Affairs. James A. Hixon, 40, Vice Present position since June 1993. President-Taxation Served as Assistant Vice President-Tax Counsel from January 1991 to June 1993, and prior thereto as General Tax Attorney. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- ------------------------------------ Harold C. Mauney, Jr., 55, Present position since December Vice President-Quality 1992. Served as Assistant Vice Management President-Quality Management from April 1991 to December 1992, and prior thereto as General Manager- Intermodal Transportation Services. Donald W. Mayberry, 50, Present position since October 1987. Vice President-Mechanical James W. McClellan, 54, Vice Present position since October President-Strategic Planning 1993. Served as Assistant Vice President-Corporate Planning from March 1992 to October 1993, and prior thereto as Director- Corporate Development. Kathryn B. McQuade, 37, Present position since December Vice President-Internal Audit 1992. Served as Director-Income Tax Administration from May 1991 to December 1992, and prior thereto as Director-Federal Income Tax Administration. Charles W. Moorman, 42, Vice Present position since October President-Information 1993. Served as Vice President- Technology Employee Relations from December 1992 to October 1993, Vice President-Personnel and Labor Relations from February to December 1992, Assistant Vice President-Stations, Terminals and Transportation Planning from March 1991 to February 1992, Senior Director Transportation Planning from March 1990 to March 1991, and prior thereto as Director, Transportation Planning. Phillip R. Ogden, 53, Vice Present position since December President-Engineering 1992. Served as Assistant Vice President-Maintenance from November 1990 to December 1992, Chief Engineer-Line Maintenance North from February 1989 to November 1990, and prior thereto as Chief Engineer-Program Maintenance. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- ------------------------------------ L. I. Prillaman, Jr., 50, Present position since December Vice President-Properties 1992. Served as Vice President and Controller from May 1988 to December 1992 and prior thereto as Vice President-Accounting. Magda A. Ratajski, 43, Vice Present position since July 1984. President-Public Relations John P. Rathbone, 42, Vice Present position since December President and Controller 1992. Served as Assistant Vice President-Internal Audit from January 1990 to December 1992, and prior thereto as Director- Internal Audit. William J. Romig, 49, Vice Present position since April 1992. President and Treasurer Served prior thereto as Assistant Vice President-Finance. Donald W. Seale, 41, Vice Present position since August 1993. President-Merchandise Served as Assistant Vice Marketing President-Sales and Service from May 1992 to August 1993, Director- Metals, Waste and Construction from March 1990 to May 1992, and prior thereto as Director- Marketing Development. Powell F. Sigmon, 54, Vice Present position since October President-Safety, Environ- 1993. Served as Assistant Vice mental and Research President-Mechanical (Car) from Development January 1991 to October 1993, and prior thereto as General Manager- Mechanical Facilities. Donald E. Middleton, 63, Present position since June 1982. Corporate Secretary PART II Item 5. Item 5. Market for Registrant's Common Stock and Related - ------- ------------------------------------------------ Stockholder Matters. ------------------- NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES STOCK PRICE AND DIVIDEND INFORMATION The common stock of Norfolk Southern Corporation, owned by 51,884 stockholders of record as of December 31, 1993, is traded on the New York Stock Exchange with the symbol NSC. The following table shows the high and low sales prices and dividends per share, by quarter, for 1993 and 1992. Item 6. Item 6. Selected Financial Data. - ------- ----------------------- Item 6. Selected Financial Data. (continued) - ------- ----------------------- Item 6. Selected Financial Data. (continued) - ------- ----------------------- Item 6. Selected Financial Data. (continued) - ------- ----------------------- Item 7. Item 7. Management's Discussion and Analysis of Financial - ------- ------------------------------------------------- Condition and Results of Operations. ----------------------------------- See pages 48 - 61 for "Management's Discussion and Analysis of Financial Condition and Results of Operations." Item 8. Item 8. Financial Statements and Supplementary Data. - ------- ------------------------------------------- Item 8. Financial Statements and Supplementary Data. (continued) - ------- ------------------------------------------- The Index to Financial Statement Schedules appears in Item 14 on page 42. The financial statements and related documents for Norfolk Southern Corporation and Subsidiaries are as follows: Index to Financial Statements: Page ----------------------------- ---- Consolidated Statements of Income Years ended December 31, 1993, 1992 and 1991 62-63 Consolidated Balance Sheets As of December 31, 1993 and 1992 64 Consolidated Statements of Cash Flows Years ended December 31, 1993, 1992 and 1991 65-66 Consolidated Statements of Changes in Stockholders' Equity Years ended December 31, 1993, 1992 and 1991 67 Notes to Consolidated Financial Statements 68-87 Independent Auditors' Report 88 Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting - ------- ----------------------------------------------------------- and Financial Disclosure. ------------------------ None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. - ------- -------------------------------------------------- Item 11. Item 11. Executive Compensation. - ------- ---------------------- Item 12. Item 12. Security Ownership of Certain Beneficial Owners - ------- ----------------------------------------------- and Management. -------------- and Item 13. Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- In accordance with General Instruction G(3), the information called for by Part III is incorporated herein by reference from Norfolk Southern's definitive Proxy Statement, to be dated April 4, 1994, for the Norfolk Southern Annual Meeting of Stockholders to be held on May 12, 1994, which definitive Proxy Statement will be filed electronically with the Commission pursuant to Regulation 14A. The information regarding executive officers called for by Item 401 of Regulation S-K is included in Part I beginning on page 30 under "Executive Officers of the Registrant." PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. -------- (a) The following documents are filed as part of this report: 1. Financial Statement Schedules: The following consolidated financial statement schedules should be read in connection with the consolidated financial statements: Index to Consolidated Financial Statement Schedules Page --------------------------------------------------- ---- Schedule V - Property, Plant and Equipment 89 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 90 Schedule VII - Guarantees of Securities of Other Issuers 91 Schedule VIII - Valuation and Qualifying Accounts 92-93 Schedule IX - Short-Term Borrowings 94 Schedule X - Supplementary Income Statement Information 95 Schedules other than those listed above are omitted for the reasons that they are not required, are not applicable or the information is included in the consolidated financial statements or related notes. 2. Exhibits Exhibit Number Description - ------- ------------------------------------------------- 3 Articles of Incorporation and Bylaws - 3(a) The Restated Articles of Incorporation of Norfolk Southern are incorporated herein by reference from Exhibit 1 of Norfolk Southern's Form 10-Q report for the quarter ended September 30, 1989. 3(b) The Bylaws of Norfolk Southern, as last amended January 25, 1994, are incorporated herein by reference from Exhibit 4 of Norfolk Southern's Registration Statement on Form S-8, filed electronically on January 26, 1994. Item 14. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. (continued) -------- Exhibit Number Description - ------- ------------------------------------------------- 4 Instruments Defining the Rights of Security Holders, Including Indentures - In accordance with Item 601(b)(4)(iii) of Regulation S-K, copies of instruments of Norfolk Southern and its subsidiaries with respect to the rights of holders of long-term debt are not filed herewith, or incorporated by reference, but will be furnished to the Commission upon request. 10 Material Contracts - (a) The Agreement of Merger and Reorganization dated as of July 31, 1980, among NWS Enterprises, Inc. (name changed to Norfolk Southern Corporation by Certificate of Amendment issued by the State Corporation Commission of Virginia on November 2, 1981), NW, Norfolk and Western Railroad Company of Virginia, Southern Railway Company (name changed to Norfolk Southern Railway Company by Certificate of Amendment issued by the State Corporation Commission of Virginia as of December 31, 1990), and Southern Railroad Company of Virginia and the related Plans of Merger (Exhibits B and C to the Agreement) are incorporated herein by reference from Appendix A to NW's and Southern's definitive Proxy Statements dated October 1, 1980, for NW's and Southern's Special Meetings of Stockholders held on November 7, 1980. (b) The lease between The Cincinnati, New Orleans and Texas Pacific Railway Company, a subsidiary of Norfolk Southern Railway, as lessee, and the Trustees of the Cincinnati Southern Railway, as lessor, dated as of October 11, 1881, is incorporated herein by reference from Exhibit 5 of Southern's 1980 Annual Report on Form 10-K. The Supplementary Agreement to the lease, dated as of January 1, 1987, is incorporated herein by reference from Exhibit 10(b) of Southern's 1987 Annual Report on Form 10-K. Item 14. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. (continued) -------- Exhibit Number Description - ------- ------------------------------------------------- (c) The lease between The North Carolina Railroad Company, as lessor, and Norfolk Southern Railway, as lessee, dated as of January 1, 1896, is incorporated herein by reference from Exhibit 6 of Southern's 1980 Annual Report on Form 10-K. (d) The lease between Atlantic and North Carolina Railroad Company (The North Carolina Railroad Company, successor by merger, September 29, 1989), as lessor, and Atlantic and East Carolina Railway Company, a subsidiary of Norfolk Southern Railway, as lessee, dated as of April 20, 1939, is incorporated herein by reference from Exhibit 7 of Southern's 1980 Annual Report on Form 10-K. Management Compensation Plans ----------------------------- (e) The Norfolk Southern Corporation Management Incentive Plan is incorporated herein by reference from Exhibit 10(h) of Norfolk Southern's 1987 Annual Report on Form 10-K. (f) The Norfolk Southern Corporation Long-Term Incentive Plan is incorporated herein by reference from Appendix A to Norfolk Southern's definitive Proxy Statement dated April 3, 1989, for the Norfolk Southern Annual Meeting of Stockholders held May 11, 1989. (g) A copy of the Norfolk Southern Corporation Officers' Deferred Compensation Plan as amended effective January 1, 1994. (h) A copy of the Directors' Deferred Fee Plan of Norfolk Southern Corporation as amended effective January 1, 1994. (i) The Norfolk Southern Corporation Directors' Restricted Stock Plan effective January 26, 1994, is incorporated herein by reference from Exhibit 99 to Norfolk Southern's Form S-8 filed electronically on January 26, 1994. Item 14. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. (continued) -------- Exhibit Number Description - ------- ------------------------------------------------- (j) The Excess Benefit Plan of Norfolk Southern Corporation and Participating Subsidiary Companies is incorporated herein by reference from Exhibit 10(k) of Norfolk Southern's 1988 Annual Report on Form 10-K. (k) The Directors' Pension Plan of Norfolk Southern Corporation is incorporated herein by reference from Exhibit 10(l) of Norfolk Southern's 1989 Annual Report on Form 10-K. 11 Computation of Earnings Per Share 12 Computation of Ratio of Earnings to Fixed Charges 21 Subsidiaries of the Registrant. 23 Consents of Experts and Counsel - Consent of Independent Auditors. (b) Reports on Form 8-K. No reports on Form 8-K were filed for the three months ended December 31, 1993. (c) Exhibits. The Exhibits required by Item 601 of Regulation S-K as listed in Item 14(a)2 are filed herewith or incorporated herein by reference. (d) Financial Statement Schedules. Financial statement schedules and separate financial statements specified by this Item are included in Item 14(a)1 or are otherwise not required or are not applicable. POWER OF ATTORNEY ----------------- Each person whose signature appears below under "SIGNATURES" hereby authorizes Henry C. Wolf and John S. Shannon, or either of them, to execute in the name of each such person, and to file, any amendment to this report and hereby appoints Henry C. Wolf and John S. Shannon, or either of them, as attorneys-in-fact to sign on his or her behalf, individually and in each capacity stated below, and to file, any and all amendments to this report. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Norfolk Southern Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 22nd day of March, 1994. NORFOLK SOUTHERN CORPORATION By /s/ David R. Goode ----------------------------------------- (David R. Goode, Chairman, President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on this 22nd day of March, 1994, by the following persons on behalf of Norfolk Southern Corporation and in the capacities indicated. Signature Title --------- ----- /s/ David R. Goode - ------------------------------ Chairman, President and Chief (David R. Goode) Executive Officer and Director (Principal Executive Officer) /s/ Henry C. Wolf - ------------------------------ Executive Vice President-Finance (Henry C. Wolf) (Principal Financial Officer) /s/ John P. Rathbone - ------------------------------ Vice President and Controller (John P. Rathbone) (Principal Accounting Officer) /s/ Gerald L. Baliles - ------------------------------ Director (Gerald L. Baliles) Signature Title --------- ----- /s/ Gene R. Carter - ------------------------------ Director (Gene R. Carter) /s/ L. E. Coleman - ------------------------------ Director (L. E. Coleman) - ------------------------------ Director (William J. Crowe, Jr.) /s/ T. Marshall Hahn, Jr. - ------------------------------ Director (T. Marshall Hahn, Jr.) /s/ Landon Hilliard - ------------------------------ Director (Landon Hilliard) /s/ E. B. Leisenring, Jr. - ------------------------------ Director (E. B. Leisenring, Jr.) /s/ Arnold B. McKinnon - ------------------------------ Director (Arnold B. McKinnon) /s/ Robert E. McNair - ------------------------------ Director (Robert E. McNair) /s/ Jane Margaret O'Brien - ------------------------------ Director (Jane Margaret O'Brien) /s/ Harold W. Pote - ------------------------------ Director (Harold W. Pote) (ITEM 7) NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes beginning on page 62 and the Ten-Year Financial Review on page 35. The Condensed Summary provides a brief overview of results of operations, and the text beginning under "Results of Operations" is a more detailed analytical discussion. CONDENSED SUMMARY OF RESULTS OF OPERATIONS 1993 Compared with 1992 - ----------------------- Net income was $772.0 million in 1993, a substantial increase over the $557.7 million reported in 1992. Earnings per share were $5.54 compared with $3.94 in 1992. Results for 1993 were significantly affected by required accounting changes (see Note 1 on page 68) and by an increase in the federal income tax rate (see Note 2 on page 70). Excluding the impact of the accounting changes and the federal tax rate increase related to prior years, 1993 earnings would have been $594.9 million, or $4.27 per share, a $37.2 million, or 7%, increase over 1992. Total transportation operating revenues decreased 3%, compared with 1992. Railway operating revenues declined 1%, primarily as a result of lower coal traffic levels and a reduced share of certain intermodal revenues after formation of a partnership with Consolidated Rail Corporation (Conrail). Motor carrier operating revenues declined 14%, due to a restructuring of NAVL (see Note 3 on page 74), which resulted in the disposition of two of its businesses. Total transportation operating expenses declined 3%, largely a result of the restructuring of NAVL. Nonoperating income reflected in the Consolidated Statements of Income as "Other income-net" rose $39.0 million due principally to gains from property and stock sales (see Note 4 on page 74). 1992 Compared with 1991 - ----------------------- Net income was $557.7 million in 1992, a significant increase over the $29.7 million reported in 1991. Earnings per share were $3.94, compared with $0.20 in 1991. Earnings in 1991 were adversely affected by a $680 million special charge. Excluding the impact of the special charge in 1991, 1992 earnings increased by $30.3 million, or 6%, compared with 1991. Total transportation operating revenues were up 3%, compared with 1991; railway operating revenues were up 3% despite a decline in coal traffic, and motor carrier operating revenues increased 4%. Total railway operating expenses were down less than half of 1%, compared with 1991 (excluding the special charge). Motor carrier operating expenses increased 9% and resulted in an operating loss of $39.7 million. Nonoperating income declined $33.5 million, reflecting lower interest income on less cash available to invest, lower interest rates and reduced gains on investment-related transactions (see Note 4 on page 74). Interest expense on debt was up 9% due to new debt issues (see Note 8 on page 76). RESULTS OF OPERATIONS Railway Operating Revenues - -------------------------- Railway operating revenues were $3.75 billion in 1993, compared with $3.78 billion in 1992 and $3.65 billion in 1991. The following table presents a three-year comparison of revenues by market group and reflects (in Intermodal) the effect of the formation in April 1993 of Triple Crown Services Company (TCSC), a partnership between NS and Conrail subsidiaries. This partnership provides RoadRailer(RT) and domestic container services previously offered by a wholly owned NS subsidiary. Because NS owns only 50% of TCSC, its revenues are not consolidated, and NS' intermodal revenues include only revenues for rail service provided by NS to the partnership. Excluding this partnership effect, intermodal revenues would have increased 10%, and total railway operating revenues would have increased 1%. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Most NS rail traffic, particularly coal traffic, moves under contractually negotiated rates as opposed to the typically higher regulated tariff rates. In 1993, 91% of NS origin coal moved under contract, compared with 88% in 1992 and 90% in 1991. Traffic volume increased for all market groups except coal. The large reduction in revenue per unit/mix was due principally to the effect of the TCSC partnership described above. The remaining reduction in the average revenue per car was largely due to new business that was short- haul and lowered the overall average. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations COAL (which includes coke and iron ore) traffic volume in 1993 decreased 6%, and revenues, which represented 32% of total railway operating revenues, were down 6% from 1992. Coal accounted for about 97% of this market group's volume, and 95% of coal shipments originated on NS' lines. As shown in the following table, small tonnage gains in utility and steel coal were more than offset by declines in export coal, down 22%, compared with 1992. The export coal market continues to be weak. The recession in Europe deepened as the year progressed. Additionally, stockpiles remain at high levels in the United Kingdom, and two Italian coal-fired generating stations that closed in 1992 remained closed for all of 1993. The UMWA strike, which was settled in December 1993, also had an adverse effect on the export market, as some U.S. producers deferred export shipments to take advantage of higher domestic spot market prices. Although the strike was not widespread at mines served by NS, it idled four operations that are heavily oriented toward export shipments. NS' export coal business is expected to remain somewhat depressed in 1994. Expanded coal output and export capacity by foreign producers may make this market very competitive, especially for steam coal. Export coal opportunities for NS are expected to continue to be greatest in Europe, and moderate growth is expected over the next five-year period. In contrast to the export market, domestic coal remained steady. Extended periods of warmer-than-usual temperatures in the Southeast resulted in increased business for a number of utility customers. NS was able to provide coal service to some whose customary carriers were adversely affected by flooding in the Midwest and the UMWA strike. NS continued to do well in domestic steel markets, especially in the Midwest. While total volumes in the domestic steel market remained relatively flat, compared with 1992, NS was able to increase its market share. The outlook for domestic NS coal traffic remains promising. New movements of western coal to an eastern utility began late in 1993 and are expected to reach 3 million tons in 1994 and to grow to nearly 7 million tons annually in the next few years. Changes in emissions regulations for sulfur dioxide included in the Clean Air Act Amendments of 1990 may increase NS utility traffic. Coal volume in 1992 decreased 2%, compared with 1991, and revenues were down 3% from 1991. Traffic volume in 1991 represented NS' second best year since the 1982 consolidation. As shown in the table above, NS had mixed results in 1992 in the four basic coal market segments it serves. The largest decline in coal tonnage was in export coal, down 8%, compared with 1991. Beginning in 1992, the European economies slumped badly, reducing demand for U.S. coal in both steel and electricity production. Domestic utility tonnages showed the second greatest decline, 2% below 1991, reflecting weakness in the overall economy and unusually mild weather in NS' service region. On the positive side, coal traffic to domestic steel companies in 1992 showed improvement. Compared with 1991, tonnage increased 15%, and NS increased its market share. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations MERCHANDISE TRAFFIC volume in 1993 increased 6%, and revenues (excluding, for comparative purposes, the effect of the TCSC partnership with Conrail) increased by $104.6 million, or 5%, compared with 1992. Merchandise carloads handled in 1993 were 2.8 million, compared with 2.7 million in 1992. Despite the slow economic recovery, all six market groups comprising merchandise traffic showed revenue improvement over 1992. The largest gains were in intermodal, up $34.1 million, or 10% (excluding the TCSC effect); automotive, up $28.0 million, or 7%; and metals/construction, up $19.8 million, or 7%. PAPER/FOREST traffic was about even with 1992, and revenues increased 1%. Weak domestic and overseas demand for paper depressed NS' shipments for much of the year. Lumber, however, posted a solid 4% revenue gain due to a strong recovery in housing construction. Moderate growth, somewhat higher than industry production, is expected over the next few years due to growth in market share. CHEMICALS traffic rose 4% over 1992; however, revenues increased less than 1% due to a change in the mix of traffic. There were solid gains in general chemicals and plastics, but this was offset by weakness in movements of export fertilizer due to sluggish conditions overseas. Stronger growth is expected in 1994 and beyond, paced by additional rail- truck distribution facilities for bulk chemicals. While environmental concerns could adversely affect production of pesticides and chlorine, increased environmental awareness is likely to have a positive impact on movements of recyclables, hazardous wastes and alternative fuels such as ethanol. AUTOMOTIVE traffic rose 8%, and revenues increased 7%, compared with 1992. The gain was due to strong demand for vehicles produced at plants served by NS. NS' largest customer, Ford Motor Company, produced the top- selling automobile and truck in 1993. In addition, NS benefited from a full year of production at the Ford/Nissan plant located near Avon Lake, Oh. Successful marketing efforts, such as an innovative program with GM for just-in-time movement of auto parts, also contributed to the higher traffic levels. Further growth in automotive traffic is expected in 1994 and beyond, as U.S. automotive production is anticipated to increase for the next few years. From 1994 to 1997, operations will begin at three new or expanded automotive assembly plants located on NS' lines: the second Toyota plant at Georgetown, Ky., in 1994; BMW at Greer, S.C., in 1995; and Mercedes-Benz at Tuscaloosa, Al., in 1997. The retooling of GM's Wentzville, Mo., and Doraville, Ga., plants for van production should also increase traffic. AGRICULTURE traffic rose 4%, and revenues increased 6%, compared with 1992. In the early part of the year, NS benefited from a record harvest that continued well into 1993. During the summer, the flood in the Midwest diverted traffic to rail that formerly moved by barge. In the fall, good crop conditions in NS' sourcing areas and poor conditions elsewhere produced strong NS traffic gains. Although the special conditions present during 1993 are not likely to recur in 1994, a small increase in agriculture revenues is expected, driven by growth in poultry production in the Southeast, a prime NS feed grain market. METALS/CONSTRUCTION traffic rose 9%, and revenues increased 7%, compared with 1992. Most of the revenue gain was in shipments of iron and steel; strong industry production and new plants located on NS' lines boosted revenue $10 million. Shipments of construction commodities were also strong due to a recovery in housing. Further gains are expected over the next few years, as NS has initiatives under way intended to win back truck business in aluminum, and several new movements of municipal solid waste are expected. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations INTERMODAL traffic rose 9%, and revenues (adjusted for the effect of the TCSC partnership) increased 10%, compared with 1992. Intermodal revenue growth in 1993 was led by a 21% increase in Triple Crown(RT) activity due to strong automotive shipments and expansion of service to the Northeast. Container revenues were up 6%, a smaller increase than previous years, reflecting reduced international traffic caused by continuing recessions in Europe and Japan. Trailer revenues were up 11%, boosted by gains from haulage arrangements with truckload carriers. Strong growth in intermodal traffic is expected in 1994 and for the next several years. TCSC should continue to grow as it expands to serve additional markets. Container traffic is expected to improve as recoveries overseas produce steady growth in international shipments. Trailer business also is expected to grow, as leading truckload carriers, such as Schneider National and J.B. Hunt, use rail for the long-haul portion of their shipments. During 1992, all six merchandise market groups showed improvement over 1991. Traffic volume increased 6% and revenues increased $159.4 million, or 7%. The largest revenue increases were in the automotive group, up $75.6 million, or 23%, over a weak 1991. The intermodal group was up $28.3 million, or 7%, over 1991, and the paper/forest and chemicals groups each reported 5% revenue gains. The growth in the automotive group was the result of a national rise in automobile production, especially increased production of popular models at plants which NS serves. All segments of intermodal traffic showed growth during 1992. Triple Crown(RT) (now TCSC), the fastest growing segment, which accounted for 24% of intermodal traffic, began a new domestic container service in the eastern part of the NS system, in addition to its RoadRailer(RT) business. Paper/forest revenues improved as the result of increased housing starts and greater paper production. Chemical revenues were higher because of a general recovery in chemical production over the recessionary levels of 1991. Transportation Operating Expenses - --------------------------------- Transportation operating expenses decreased 3% in 1993, compared with 1992, and decreased 14% in 1992, compared with 1991. Included in 1993's expenses was a $50.3 million charge for restructuring NAVL's operations (see motor carrier discussion on page 55). Included in 1991's expenses was a $680.0 million special charge discussed below. Excluding the 1993 restructuring charge and the 1991 special charge, transportation operating expenses decreased 5% in 1993, compared with 1992, and increased 2% in 1992, compared with 1991. SPECIAL CHARGE IN 1991 (see Note 15 on page 85): By the end of 1991, after several years of negotiations and a brief nationwide strike, new rail labor agreements were in place that allowed NS to begin operating trains with reduced crew sizes. The agreements also provide for future crew size reductions. To achieve the reductions in employment and other labor savings permitted by the new agreement, NS recorded a special charge that included $450 million to cover the cost of future separation payments, protective payments and amounts to buy out productivity funds. The special charge, which totalled $680 million, also included $187 million to write down the goodwill portion of NS' investment in NAVL and a $43 million write-down of certain properties to be sold or abandoned. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations The following table compares, on a year-to-year basis, railway operating expenses summarized by major classifications. The special charge also is summarized, as well as comparative railway operating expenses, excluding the special charge. The narrative expense analysis presented in the following paragraphs focuses on the major factors contributing to changes in railway operating expenses, excluding the effects of the 1991 special charge discussed above and in Note 15 on page 85. COMPENSATION AND BENEFITS, which includes salaries, wages and fringe benefits, represents about half of total railway operating expenses and increased 1% in 1993, compared with 1992, and declined 2% in 1992, compared with 1991. The higher expenses in 1993 were mainly due to accruals for postretirement and postemployment benefits which were previously accounted for on a pay-as-you-go basis (see "Required Accounting Changes" in Note 1 on page 68) and higher costs for stock- based compensation plans. A voluntary early retirement program was completed in 1993, which resulted in a $42.4 million charge in compensation and benefits expense (see Note 11 on page 80). Also in 1993, a $46 million credit was recorded in compensation and benefits, reflecting a partial reversal of the 1991 special charge (see Note 15 on page 85). Labor expenses were favorably affected by a lower average train crew size, which was 2.6 in 1993, a moderate decline compared with 1992. The lower expenses in 1992, compared with 1991, were mainly due to savings associated with reduced train crew sizes. The average train crew size in 1992 was 2.7 compared with 3.5 in 1991. MATERIALS, SERVICES AND RENTS consists of items used for maintenance of road (rail line and related structures) and equipment (locomotives and freight cars); equipment rents representing the cost to NS of using freight equipment owned by other railroads or private owners, less the rent paid to NS for the use of its equipment; and the cost of services purchased from outside contractors, including the net costs of operating joint (or leased) facilities with other railroads. This category had the largest decrease in 1993, compared with 1992, down 6%, but was up 10% in 1992, compared with 1991. The decrease in 1993 was largely due to the absence of certain expenses which, NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations subsequent to March 31, 1993, were incurred by TCSC (see discussion on page 48). The increase in 1992 largely was a result of that year's greatly expanded equipment maintenance program. Also contributing to the 1992 increase were higher roadway maintenance activity, increased gross ton miles, and accruals related to a lease with Canadian National Railway. DEPRECIATION expense (see Note 1 "Properties" on page 68 for NS' depreciation policy) was up 7% in 1993, compared with 1992, and up 5% in 1992, compared with 1991. The increases in both periods were due to property additions, reflecting substantial levels of capital spending during the three-year period ended December 31, 1993. DIESEL FUEL costs declined 2% in 1993, compared with 1992, and declined 5% in 1992, compared with 1991. NS consumes substantial quantities of diesel fuel; therefore, changes in price per gallon or consumption have a significant impact on the cost of providing transportation services. The lower costs in 1993 were due to a lower price per gallon, offset in part by a 2% increase in consumption related to the 3% increase in gross ton miles. Expenses declined in 1992, compared with 1991, mainly due to a lower price per gallon offset partially by increased consumption. CASUALTIES AND OTHER CLAIMS (which includes insurance costs, estimates of costs related to personal injury, property damage and environmental- related costs) declined 2% in 1993, compared with 1992, and decreased 22% in 1992, compared with 1991. By far the largest component, personal injury expenses, which relate primarily to the cost of on-the-job employee injuries, has shown favorable trends since 1990, reflecting both success in reducing accidental employee injuries and effective claims handling. Unfortunately, the favorable trend in accidental injury claims has been more than offset by increased costs of nonaccidental "occupational" claims. The rail industry remains uniquely susceptible to both accidental injury and occupational claims because of an outmoded law, the Federal Employers' Liability Act (FELA), originally passed in 1908 and applicable only to railroads. This law provides the sole basis for compensating railroad employees who sustain job-related injuries. Under the FELA, claimants unable to reach an agreement with the railroad concerning compensation may file a civil suit to recover damages. In most cases, a jury must then determine whether the claimant is entitled to any damages and, if so, the amount. The system produces results that are unpredictable, inconsistent and frequently unfair, at a cost to the rail industry that is two or three times greater than the no-fault workers' compensation systems to which nonrail competitors are universally subject. The railroads have been unsuccessful so far in efforts to persuade Congress to replace the FELA with a no-fault workers' compensation act. OTHER expenses decreased 3% in 1993, compared with 1992, and 7% in 1992, compared with 1991. These decreases were largely the result of favorable settlements of issues related to property and other state taxes. The NS railway operating ratio (the percentage of railway operating revenues consumed by railway operating expenses) continues to be the best among the major railroads in the United States. NS will continue to pursue cost-containment efforts to assure that its rail subsidiaries are operated efficiently. The operating ratios for past six years were as follows: NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Other Income-Net - ---------------- Nonoperating income increased $39.0 million, or 40%, in 1993, compared with 1992, but decreased $33.5 million, or 26%, in 1992, compared with 1991 (see Note 4 on page 74). The 1993 increase principally arose from gains on stock and property sales. The 1992 decline was a result of an absence of stock sales in 1992, coupled with a decline in interest income due to lower cash and short-term investments balances and lower rates. Interest Expense on Debt - ------------------------ Interest expense on debt decreased 10%, compared with 1992, due principally to lower levels of equipment debt and lower interest rates on NS' commercial paper. Interest expense increased 9% from 1991 to 1992 mainly as a result of an additional $250 million of notes issued under NS' shelf registration statement and new equipment debt (see Note 8 on page 76). MOTOR CARRIER RESULTS Motor Carrier operations resulted in a loss of $54.9 million in 1993, compared with a loss of $39.7 million in 1992 and income of $0.2 million in 1991. Despite significant turnaround efforts, NAVL's persistently poor performance in its general commodities operations led to a decision to restructure its operations in 1993, which resulted in the disposition of two of its businesses. The Commercial Transport Division (CT), a truckload carrier, was liquidated, and Tran-Star (TS), a refrigerated carrier, was sold. A restructuring charge of $50.3 million was recorded in 1993, reflecting costs to discontinue these businesses, including projected operating losses during the phase-out period, as well as labor, equipment and facility-related costs. The large operating loss reported in 1993 was almost entirely attributable to the restructuring charge. However, results of the two remaining divisions produced an operating profit of $14.4 million in 1993. Contributing principally to the loss in 1992 were actuarially determined increases in reserves for casualty claims and workers' compensation, which added $27 million to operating expenses, and accruals for litigation. The following table presents a three-year comparison of revenues by principal operations. Prior year amounts have been reclassified to reflect the transfer of a subsidiary from the RS Division to the HVP Division. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations RS' revenues depend on four primary segments of household goods' transportation: corporate national accounts, interstate C.O.D. movements, military and international relocations. RS' 1993 revenues were even with 1992, and increased 1% in 1992, compared with 1991. Revenues in 1993 were adversely affected by a decline in domestic military volume and fewer Canadian shipments. These decreases were offset largely by a modest rate increase and gains in the international household relocation segment. The increase in 1992 revenues was due to modest rate increases and some improvement in domestic household goods shipments. The continued downsizing of U.S. corporations and changes in policy relative to military staffing levels are likely to result in ongoing pressure on this division's operating revenues. HVP's main line of business is transporting office products and other sensitive equipment, as well as exhibits and displays. The division also is capitalizing on its specialized handling expertise to generate new revenues in the Customized Logistics Services (CLS) segment. HVP's revenues increased 8% in 1993, compared with 1992, and in 1992, compared with 1991. The increase in 1993 was due to the award of a significant logistics contract by IBM, and also to the expansion of air freight services into several new markets. The increase in 1992 was the result of additional interstate transportation activity reflecting some improvement in the demand for office products and an increase in revenues from European subsidiary operations. HVP may benefit from a continued increase in demand for office products; however, a trend toward smaller shipment sizes will subject this operation to increasing competition from LTL (less than truckload) carriers. Significant future revenue growth in the CLS segment is possible as more shippers look to carriers like NAVL to provide logistics expertise to reduce their overall shipping and handling costs. CT's and TS' revenues for 1993 are reflected only through June 30, 1993. A decision to discontinue these businesses was made, and accordingly, results subsequent to June were charged to the reserve established for the restructuring. Motor carrier operating expenses as a percentage of revenues were 108%, 105% and 100%, respectively, in 1993, 1992 and 1991. Overall, the negative operating ratio was caused by the losses sustained in the truckload operations, which more than offset the positive results of RS and HVP. The high operating ratio in 1993 was primarily due to the restructuring charge and in 1992 to increased reserves for casualty claims, litigation and workers' compensation. NAVL's continuing operations (excluding CT and TS) achieved a 97% operating ratio in 1993, as compared to 102% in 1992 and 96% in 1991. Excluding insurance reserve adjustments, the 1992 operating ratio would have been 99%. Due to deregulation and overcapacity in the industry, motor carriers will continue to face vigorous competition that will keep profits at a modest level. For RS, contract carriage and volume discount programs dominate the corporate relocation segment, and guaranteed price options are common in the individual consumer segment. Contract carriage agreements also are utilized by HVP to meet customers' service and price requirements. However, given the elimination of unprofitable businesses, NAVL is now positioned to compete in these markets, as well as to expand where opportunities such as providing customized logistics solutions present themselves. Income Taxes - ------------ Income tax expense in 1993 was $349.9 million for an effective rate of 38.9%, compared with an effective rate of 36.3% in 1992 and 36.0% in 1991, excluding the special charge. Income tax expense in 1993 was accrued under SFAS 109, rather than under the prior accounting rules (see Note 1 on page 68). Absent the federal income tax rate increase imposed by the Revenue Reconciliation Act of 1993, income tax expense in 1993 would have been $295.8 million for an effective rate of 32.9%. This low effective rate was partly due to tax benefits related to the motor carrier restructuring (see Note 3 on page 74). Current income tax expense increased from $253.5 million in 1992 to $293.7 million in 1993, primarily due to tax payments made in anticipation of Revenue Agent Reports for the 1988-1989 federal income tax audit. Deferred tax expense for 1993, compared to 1992, decreased primarily for the same reason. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Current and deferred tax expenses for 1991 were affected significantly by the special charge. Much of the tax benefit resulting from this charge was not deductible in 1991 and therefore was recorded as a deferred tax benefit. Excluding the payment discussed above and the federal tax rate increase, the portion of the special charge that reversed in 1993 and 1992, combined with property-related adjustments, including depreciation, were the principal causes for the increase in deferred tax expense over the 1991 level. As a result of changes in tax law that limit or defer the timing of deductions and recent tax rate increases, NS expects current taxes to remain high in relation to pretax earnings (see Note 2 on page 70 for the components of income tax expense). Required Accounting Changes - --------------------------- Effective January 1, 1993, NS adopted required accounting for postretirement benefits other than pensions, postemployment benefits and income taxes (see Note 1 on page 68 for a discussion of these accounting changes). The net cumulative effect of these noncash adjustments increased 1993's net income by $223.3 million, or $1.60 per share. The balance sheet effects of these accrual adjustments are reflected primarily in "Other liabilities" for the postretirement and postemployment benefits and in "Deferred income taxes" for the income tax accounting change. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES FINANCIAL CONDITION refers to the assets, liabilities and stockholders' equity of an organization, including the value of those individual elements in relation to each other. Generally, financial condition is evaluated at a point in time using an organization's balance sheet (see page 64). LIQUIDITY refers to the ability of an organization to generate adequate amounts of cash, principally from operating results or through borrowing power (based on net income or financial condition), to meet its short-term and long-term cash requirements. CAPITAL RESOURCES refers to the ability of an organization to attract investors through the sale of either debt or equity (stock) securities. CASH PROVIDED BY OPERATING ACTIVITIES, which is NS' principal source of liquidity, declined 9% in 1993, compared with 1992, but was up 26% in 1992, compared with 1991. These fluctuations were primarily due to the timing of income tax payments. In 1993, tax payments were $139.9 million higher than in 1992, due to payments related to the 1988-1989 federal income tax audit, higher 1993 earnings and the fact that 1992's tax payments were low. In 1992, tax payments were $74.1 million less than 1991, primarily due to the higher tax payments in 1991 related to the federal income tax audit for 1986 and 1987, and to estimated tax payments in 1991 utilized in 1992. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Implementation of the labor portion of the 1991 special charge also contributed to the fluctuations in cash provided by operations. In 1993, only $36.1 million was used for labor costs related to the special charge, compared with $134.7 million in 1992 and $108.0 million in 1991. The decline in 1993 was partly due to the failure to reach agreement on terms for certain further labor savings. This situation also led to a partial reversal of the 1991 special charge (see discussion in Note 15 on page 85). Looking ahead, the labor portion of the special charge is expected to continue to require the use of cash to achieve productivity gains permitted by the agreements, although at a level somewhat lower than previously anticipated. NS regards this cash outflow as an investment because, in view of the high cost of labor and fringe benefits, these payments are expected to produce significant future labor savings. It is estimated that NS' labor-related payments will be reduced by about $150 million per year upon full implementation of the new labor agreements. Since the NS consolidation in 1982, cash provided by operating activities has been sufficient to fund dividend requirements, debt repayments and a significant portion of capital spending (see Consolidated Statements of Cash Flows on page 65). CASH USED FOR INVESTING ACTIVITIES declined 30% in 1993, compared with 1992, but was up 24% in 1992, compared with 1991. A combination of higher proceeds from property and investment sales and reduced capital spending yielded the improvement in 1993. Increased capital spending and the absence of investment sales caused the 1992 over 1991 increase. Although the high level of property and stock sales that occurred in 1993 is not expected to continue, efforts to hold down capital spending will be ongoing as NS seeks to maximize utilization of all its assets. In this connection, NS continues to review its route network to identify areas where efficiency can be enhanced by coordinated agreements with other railroads, or through sale or abandonment. The following table summarizes capital spending over the last five years, as well as track maintenance statistics and the average ages of railway equipment. The average age of locomotives retired during 1993 was 24.7 years. In recent years, NS has rebodied over 14,000 coal cars and plans to continue that program at the rate of about 3,000 cars per year for the next several years. This process, performed at NS' Roanoke Car Shop, converts hopper cars into high-capacity steel gondolas or hoppers. As a result, the remaining serviceability of the freight car fleet is greater than indicated by the increasing average age of the freight car fleet. Construction of two surge silos at the coal transloading facility in Norfolk was completed in 1993. The silos, which have a total capacity of 8,150 tons, allow for continuous dumping which reduces operating costs and loading time. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations For 1994, NS is planning $634 million of capital spending, of which $627 million will be for railway projects and $7 million for motor carrier property. NS anticipates new equipment financing of approximately $72 million in 1994. NS also plans to spend approximately $70 million for coal reserves located in the Lincoln, Mingo and Logan counties of West Virginia and in the Floyd, Johnson and Martin counties of Kentucky. This acquisition should add approximately 210 million tons of high-volatile, low-sulfur steam coal to NS' holdings. Looking further ahead, the restructuring of NAVL, which was completed in 1993, is expected to reduce the level of capital spending for motor carrier property. Rail capital spending is likely to increase moderately over the next few years. The proposed construction of a $100 million coal ground storage facility in Isle of Wight County, Va., may affect capital spending in future years. However, because of delays in the permitting process and reduced demand for export coal, any significant spending on this project is not expected until after 1994. In addition to adding capacity, this new facility should further increase the efficiency of coal transportation service and reduce the need for new coal hopper cars. A substantial portion of future capital spending is expected to be funded through internally generated cash, although debt financing will continue as the primary funding source for equipment acquisitions. Investments (see Note 5 on page 75) decreased $122.6 million in 1993, compared with 1992. This decline reflects a $220 million reclassification to "Other current assets" for the cash surrender value of certain corporate owned life insurance (COLI), which is expected to be borrowed in April 1994, and accounts for the increase in working capital. Absent this reclassification, "Investments" would have increased almost $100 million, principally reflecting premium payments on COLI, which increase the cash surrender value of the underlying insurance policies. CASH USED FOR FINANCING ACTIVITIES increased 32% in 1993, compared with 1992, but had declined 27% in 1992, compared with 1991. The 1993 increase was principally a result of lower borrowing, making it the first year in the past 5 years to produce a net reduction in debt. Debt activity over the past five years was as follows: Debt requirements for 1994 are expected to remain moderate partly because another source of cash, borrowing on the cash surrender value of COLI, will satisfy some of 1994's cash requirements (see Note 5 on page 75 regarding COLI). The decline in cash used for financing activities in 1992, compared with 1991, principally was due to purchases of fewer shares of NS stock. Cash spent in recent years to purchase and retire stock amounted to $2.2 billion, of which $138.1 million, $177.2 million and $635.3 million was spent in 1993, 1992 and 1991, respectively (see Note 14 on page 85 for details of the stock purchase programs). Before 1991 and during 1993, a significant portion of this total spending was from cash reserves, whereas 1991 and 1992 purchases were funded largely through issuance of debt. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations ENVIRONMENTAL MATTERS NS is subject to various jurisdictions' environmental laws and regulations. Certain NS rail subsidiaries have received notices from the Environmental Protection Agency that they are potentially responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), which generally imposes joint and several liability for cleanup costs. State agencies also have notified certain NS rail subsidiaries that they may be potentially responsible for environmental damages, and in several instances they have agreed voluntarily to initiate cleanup. For CERCLA sites and all other known environmental incidents where loss or liability is probable, NS has recorded an estimated liability. The amount of that liability, which includes estimated costs of remediation (and any associated restoration) on a site-by-site basis, is expected to be paid over several years. Claims, if any, against third parties for recovery of remediation costs incurred by NS are reflected as receivables in the balance sheet and are not netted against the associated NS liability. Environmental engineers perform ongoing analyses of all identified sites, and--after consulting with counsel--any necessary adjustments to initial liability estimates are recorded. NS also has established an Environmental Policy Council, composed of senior managers, to prescribe and direct its environmental initiatives. Estimates of a company's potential financial exposure even for known environmental claims or incidents are necessarily imprecise because of the widely varying costs of available remediation techniques, the difficulty of determining in advance the nature and extent of contamination and each potential participant's share of an estimated loss and evolving statutory and regulatory standards governing liability. The risk of incurring environmental liability--for acts and omissions, both past and current--is inherent in railroad operations. Moreover, some of the commodities, particularly those classified as hazardous materials, in NS' traffic mix can pose special risks that NS and its subsidiaries work diligently to minimize. In addition, several NS subsidiaries have land holdings that may be leased (and operated by others) or held for sale. Because certain conditions may exist on these properties for which NS ultimately may bear some financial responsibility, there can be no assurance that NS will not incur liabilities or costs, the amount and materiality of which, to a single accounting period or in the aggregate, cannot be estimated reliably now, related to environmental problems that are latent or undiscovered. However, based on its assessments of the facts and circumstances now known and after consulting with its legal counsel, Management believes that it has recorded appropriate estimates of liability for those environmental matters of which the Corporation is aware. INFLATION Generally accepted accounting principles require the use of historical costs in preparing financial statements. This approach disregards the effects of inflation on the replacement cost of property and equipment. NS, a capital-intensive company, has approximately $12.8 billion invested in such assets. The replacement costs of these assets, as well as the related depreciation expense, would be substantially greater than the amounts reported on the basis of historical costs. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations RAIL INDUSTRY TRENDS NS and other railroads are continuing to seek opportunities to share traffic routes and facilities, furthering the goals of providing seamless service to customers, making railroads more competitive with trucks and maximizing efficiency of the respective railroads. NS is responding to concerns regarding the emission of coal dust from in- transit coal trains. Testing is under way of various methods of controlling such emissions. However, at this time final results of the testing and estimated costs that may be incurred to implement the conclusions resulting therefrom are not available. NS and the rail industry are continuing their efforts to replace the FELA with a no-fault workers' compensation system, which we strongly believe to be fairer both to the rail industry and to its employees. (Continued) (Continued) NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements The following notes are an integral part of the consolidated financial statements. 1. Summary of Significant Accounting Policies Principles of Consolidation - --------------------------- The consolidated financial statements include Norfolk Southern Corporation (Norfolk Southern) and its majority-owned and controlled subsidiaries (collectively NS). The major subsidiaries are Norfolk Southern Railway Company and North American Van Lines, Inc. (NAVL). All significant intercompany balances and transactions have been eliminated in consolidation. Cash Equivalents - ---------------- Cash equivalents are highly liquid investments purchased three months or less from maturity. The carrying value approximates fair value because of the short maturity of these investments. Materials and Supplies - ---------------------- Materials and supplies, which consist mainly of fuel oil and items for maintenance of property and equipment, are stated at average cost. The cost of materials and supplies expected to be used in capital additions or improvements is included in properties. Properties - ---------- Properties are stated principally at cost and are depreciated using group depreciation. Rail is primarily depreciated on the basis of use measured by gross ton miles. The effect of this method is to write off these assets over 42 years on average. Other properties are depreciated generally using the straight-line method over estimated service lives at annual rates that range from 1% to 25%. The overall depreciation rate averaged 2.7% for roadway and 4.6% for equipment. NS capitalizes interest on major capital projects during the period of their construction. Maintenance expense is recognized when repairs are performed. When properties other than land are sold or retired in the ordinary course of business, the cost of the assets less the sale proceeds or salvage is charged to accumulated depreciation rather than recognized through income. Gains and losses on disposal of land, which is a nondepreciable asset, are included in other income. Revenue Recognition - ------------------- Revenue is recognized proportionally as a shipment moves from origin to destination. Earnings Per Share - ------------------ Earnings per share are computed by dividing net income by the weighted average number of common shares outstanding during the respective periods. Recent decreases in the number of shares outstanding are the result of the stock purchase program described in Note 14. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies (continued) Balance Sheet Classification - ---------------------------- Beginning with 1991, the balance sheet classification of certain revenue-related balances appears on an actual (net) basis rather than an estimated (gross) basis due to the earlier availability of certain settlement data with other railroads. This modification, which had no income statement effect, resulted in large offsetting declines in accounts receivable and accounts payable as illustrated in the Statement of Cash Flows for 1991. Required Accounting Changes - --------------------------- Effective January 1, 1993, NS adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106), and Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS 112). SFAS 106 requires NS to accrue the cost of specified health care and death benefits over an employee's active service period rather than, as was the previously prevailing practice, accounting for such expenses on a pay-as-you-go basis. SFAS 112 requires corporations to recognize the cost of benefits payable to former or inactive employees after employment but before retirement on an accrual basis. For NS, such postemployment benefits consist principally of benefit obligations related to participants in the long-term disability plan. NS recognized the effects of these changes in accounting on the immediate recognition basis. The cumulative effects on years prior to 1993 of adopting SFAS 106 and SFAS 112 increased pretax expenses $360.2 million ($223.8 million after-tax), and $31.8 million ($19.7 million after-tax), respectively (see Note 12). The impact on 1993 expenses is not material. The pro forma effects of applying SFAS 106 and SFAS 112 on individual prior years is not presented, as the effect on each separate year also is not material. Also effective January 1, 1993, NS adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). SFAS 109 requires a change from the deferred method of accounting for income taxes to the asset and liability method of accounting for income taxes. Under the asset and liability method, 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 laws and tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Under the deferred method, which applied for 1992 and prior years, deferred income taxes were recognized for income and expense items that were reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation, and deferred taxes were not adjusted for subsequent changes in tax rates. The cumulative effect on years prior to 1993 of adopting SFAS 109 increased net income by $466.8 million (see also Note 2). The effect on net income and earnings per share as a result of implementing the accounting changes was to increase net income and earnings per share by $223.3 million and $1.60 per share, respectively. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 2. Income Taxes Federal Income Tax Rate Increase - -------------------------------- In August 1993, Congress enacted the Revenue Reconciliation Act of 1993, which increased the federal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. The tax rate increase had two components which, as required by SFAS 109, were recognized in 1993's earnings. The first component relates to the increased income tax rate's effect on 1993's earnings, which increased the provision for income taxes and reduced net income by $7.9 million, or $0.06 per share. The second component increased the provision for the net deferred tax liability in the Consolidated Balance Sheet, which reduced net income by $46.2 million, or $0.33 per share. Excluding the one-time noncash charge of $0.33 per share, 1993's earnings per share before accounting changes would have been $4.27. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 2. Income Taxes (continued) Deferred Income Tax Expense - --------------------------- Some income and expense items are reported differently for financial reporting and income tax purposes. Provisions for deferred income taxes were made in recognition of these differences in accordance with APB Opinion No. 11 for years prior to 1993, and SFAS 109 for 1993 (see Note 1 for an explanation of this required accounting change). NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 2. Income Taxes (continued) NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 2. Income Taxes (continued) Except for amounts for which a valuation allowance is provided, Management believes the other deferred tax assets will be realized. The valuation allowance for deferred tax assets as of January 1, 1993, was $9.8 million. The net change in the total valuation allowance for the year ended December 31, 1993, was an increase of $1.1 million. Internal Revenue Service (IRS) Reviews - -------------------------------------- Consolidated federal income tax returns have been examined and Revenue Agent Reports have been received for all years up to and including 1989. The consolidated federal income tax returns for 1990 through 1992 are being audited by the IRS. Management believes that adequate provision has been made for any additional taxes and interest thereon that might arise as a result of these examinations. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 3. Motor Carrier Restructuring On June 25, 1993, NS announced a plan to restructure its motor carrier subsidiary by seeking buyers for the truckload freight portion of North American Van Lines, Inc. (NAVL) which consisted of the Commercial Transport Division (CT), a nationwide truckload carrier, and Tran-Star (TS), a refrigerated carrier. In recent years, these businesses contributed about one third of NAVL's revenues but, primarily due to CT, produced operating losses. As a result of the restructuring, NS recorded a $50.3 million pretax ($32.3 million after-tax) charge and recognized an additional tax benefit of $36.8 million. The estimated costs of this restructuring included projected operating losses during the phase-out period, as well as labor, equipment and facility related costs. Accordingly, results of operations for these businesses are excluded from the Statement of Income after June 30, 1993. On December 31, 1993, NS completed a sale of TS' operations. The proceeds from this sale are reflected in "Investment sales and other" in the Consolidated Statement of Cash Flows. Most of the assets and liabilities of the CT Division were liquidated or transferred to other NAVL divisions. CT's assets remaining at December 31, 1993, are expected to be disposed of within the first six months of 1994 and, accordingly, have been classified in the Consolidated Balance Sheet in "Other current assets." NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements Corporate Owned Life Insurance - ------------------------------ The cash surrender value of certain corporate owned life insurance amounting to approximately $220 million, which is expected to be borrowed in April 1994, has been reclassified in the Consolidated Balance Sheet from "Investments" to "Other current assets." Fair Values - ----------- At December 31, 1993, the fair value of investments approximated $217 million. The fair values of marketable securities were based on quoted market prices. At December 31, 1993 and 1992, the market value of marketable equity securities was $14.5 million and $45.5 million, respectively. The fair values of stock in nonmarketable securities were estimated based on the underlying net assets. For the remaining investments, consisting principally of corporate owned life insurance, the carrying value approximates fair value. Investment Write-Downs in 1991 - ------------------------------ In 1991, NS recorded a $20 million pretax ($13.2 million after-tax) loss to write off its remaining investment in a bank that declared bankruptcy. This write-down, as well as investment sales transactions, are reflected in "Other income-net" in the Consolidated Statements of Income (see Note 4). Investment write-downs (which are noncash transactions) are not included in the Consolidated Statements of Cash Flows. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 6. Properties (continued) Noncash Property Transactions Excluded from the Consolidated Statements - ----------------------------------------------------------------------- of Cash Flows - ------------- Additions to "Other property" in 1991 included $66.6 million for assets acquired from a real estate partnership in which an NS subsidiary owns an equity interest. Of this transaction, $54 million was noncash and relates to amounts invested in or advanced to that partnership which previously had been classified in "Investments." Capitalized Interest - -------------------- Total interest cost incurred on debt for 1993, 1992 and 1991 was $120.2 million, $126.9 million and $117.3 million, respectively, of which $21.6 million, $17.9 million and $17.6 million was capitalized. 8. Debt Commercial Paper Program - ------------------------ In 1990, a commercial paper program was initiated principally to finance the purchase and retirement of common stock (see Note 14). As of December 31, 1993 and 1992, NS had $521.8 million and $520.5 million, respectively, of notes outstanding under this program. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 8. Debt (continued) Commercial paper debt is due within one year, but a portion has been classified as long-term because NS has the ability and intends to refinance its commercial paper on a long-term basis, either by issuing additional commercial paper (supported by a revolving credit agreement) or by replacing the commercial paper notes with long-term debt. The credit agreement, which is effective through June 9, 1995, has a $400 million credit limit. A portion of the commercial paper outstanding, to the extent of the revolving credit limit, is classified as long-term debt. The credit agreement provides for interest at prevailing short-term rates and contains customary financial covenants, including principally a minimum tangible net worth requirement of $3 billion. Debt Registration - ----------------- In February 1992, NS issued and sold $250 million principal amount of its 7-7/8% notes due February 15, 2004. In March 1991, NS issued and sold $250 million principal amount of its 9% notes due March 1, 2021. These notes were issued under a shelf registration statement on Form S-3 filed in 1991 with the Securities and Exchange Commission covering the issuance of unsecured debt securities in an aggregate principal amount of up to $750 million. Proceeds from the sale of these notes were used to purchase and retire shares of NS common stock (see Note 14), to retire short-term commercial paper debt issued to fund previous share purchases and for general corporate purposes. These notes are not redeemable prior to maturity and are not entitled to any sinking fund. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 8. Debt (continued) A substantial portion of NS' properties and certain investments in affiliated companies are pledged as collateral for much of the secured debt. Fair Values - ----------- The carrying value of short-term debt approximates fair value. The fair value of long-term debt, including current maturities, approximated $1.74 billion at December 31, 1993. The fair values of debt were estimated based on quoted market prices or discounted cash flows using current interest rates for debt with similar terms, company rating and remaining maturity. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 9. Lease Commitments Among NS' leased properties are approximately 300 miles of road in North Carolina. The leases expire in 1994, and NS is discussing renewals with the lessor (see also page 6). NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 11. Pension Plans Norfolk Southern and certain subsidiaries have defined benefit pension plans which principally cover salaried employees. Pension benefits are based primarily on years of creditable service with NS and compensation rates near retirement. Contributions to the plans are made on the basis of not less than the minimum funding standards set forth in the Employee Retirement Income Security Act of 1974, as amended. Assets in the plans consist mainly of common stocks. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 11. Pension Plans (continued) Early Retirement Program - ------------------------ During 1993, NS completed a voluntary early retirement program for salaried employees that resulted in a $42.4 million charge in compensation and benefits expense. The principal benefit for those who participated in the program was enhanced pension benefits which are reflected in the accumulated benefit obligation at December 31, 1993. Transfer of Pension Plan Assets - ------------------------------- During 1991, the NS Retirement Plan was amended to establish a Section 401(h) account for the purpose of transferring a portion of pension plan assets in excess of the projected actuarial liability to fund current- year medical payments for retirees. In December 1993, 1992 and 1991, $13 million, $15 million and $14.5 million, respectively, were transferred from this account to reimburse NS for such payments. NS contributed equal amounts to a Voluntary Employee Beneficiary Association account in those years to fund future medical costs for retirees (see Note 12). 401(k) Plan - ----------- Norfolk Southern and certain subsidiaries provide a 401(k) savings plan for salaried employees. Under the plan, NS matches a portion of the employee contributions, subject to applicable limitations. NS' expenses under this plan were $5.2 million, $4.9 million and $4.5 million in 1993, 1992 and 1991, respectively. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 12. Postretirement Benefits Other Than Pensions Norfolk Southern and certain subsidiaries provide specified health care and death benefits to eligible retired employees, principally salaried employees. Under the present plans, which may be amended or terminated at NS' option, a defined percentage of health care expenses is covered, reduced by any deductibles, co-payments, Medicare payments and, in some cases, coverage provided by other group insurance policies. The cost of such health care coverage to a retiree may be determined, in part, by the retiree's years of creditable service with NS prior to retirement. Death benefits are determined based on various factors, including, in some cases, salary at time of retirement. NS continues to fund benefit costs principally on a pay-as-you-go basis. However, in 1991, NS established a Voluntary Employee Beneficiary Association (VEBA) account to fund a portion of the cost of future health care benefits for retirees. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 12. Postretirement Benefits Other Than Pensions (continued) For measurement purposes, a 12% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1993; the rate was assumed to decrease gradually to an ultimate rate of 6% for 2005 and remain at that level thereafter. The health care cost trend rate has a significant effect on the amounts reported in the financial statements. To illustrate, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by about $55.8 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year 1993 by about $5.1 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.25%. A 6% salary increase assumption was used for death benefits based on salary at the time of retirement. The VEBA trust holding the plan assets is not expected to be subject to federal income taxes as the assets are invested entirely in trust- owned life insurance. The long-term rate of return on plan assets, as determined by the growth in cash surrender value of the life insurance policies, is expected to be 9%. Under collective bargaining agreements, NS and certain subsidiaries participate in a multi-employer benefit plan, which provides certain postretirement health care and life insurance benefits to eligible union employees. Premiums under this plan are expensed as incurred and amounted to $6.4 million, $6.2 million and $6.2 million in 1993, 1992 and 1991, respectively. 13. Long-Term Incentive Plan Under the stockholder-approved Long-Term Incentive Plan, a disinterested committee of the Board of Directors may grant stock options, stock appreciation rights (SARs), and performance share units (PSUs), up to a maximum 11,675,000 shares of Norfolk Southern common stock. Grants of SARs and PSUs result in charges to earnings while grants of stock options currently have no effect on earnings. Options may be granted for a term not to exceed 10 years but may not be exercised prior to the first anniversary date of grant. Options are exercisable at the fair market value of Norfolk Southern stock on the date of grant. SARs were granted on a one-for-one basis in tandem with certain of the stock option shares. Upon the exercise of an SAR, the optionee receives in common stock or cash or both (as determined by the committee administering the plan) the amount by which the fair market value of common stock on the exercise date exceeds the option price. Exercise of an SAR or option cancels any related option/SAR. During 1991, the Securities and Exchange Commission issued new regulations under Section 16(b) of the Securities Exchange Act of 1934. In view of these new regulations, plan participants surrendered, without cash or other consideration, all outstanding SARs granted after 1988. Consistent with the new regulations and the surrender of post-1988 SARs, future grants of SARs are not anticipated at this time. SARs outstanding as of each year end were as follows: 95,852 in 1993; 133,659 in 1992; and 203,728 in 1991. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 13. Long-Term Incentive Plan (continued) Performance Share Units - ----------------------- Performance share units, which were added to this plan by a 1989 amendment, entitle participants to earn shares of common stock at the end of a three-year performance cycle based upon achievement of certain predetermined corporate performance goals. PSU grants totaled 186,000 in 1991; 196,000 in 1992; and 160,500 in 1993. Shares earned and issued may be subject to share retention agreements and held by NS for up to 5 years. The plan also permits the payment, in cash or in stock, of dividend equivalents on shares of common stock covered by options and PSUs granted after January 1, 1989, commensurate with dividends paid on common stock. Tax absorption payments, in an amount estimated to equal the federal and state income taxes applicable to shares of common stock issued subject to a share retention agreement, also are authorized. Dividend equivalents and tax absorption payments, if made, result in charges to earnings. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 14. Stock Purchase Programs Since 1987, the Board of Directors has authorized the purchase and retirement of up to 65 million shares of common stock. Purchases under the programs initially were made with internally generated cash. Beginning in May 1990, some purchases were financed with proceeds from the sale of commercial paper notes. In March 1991, $250 million of long- term notes were issued in part to repay a portion of the commercial paper notes, as well as to provide funds for additional purchases. An additional $250 million of long-term notes were issued in February 1992 (see Note 8 for debt details). On January 29, 1992, NS announced that, for reasons primarily related to issues surrounding the 1991 special charge (see Note 15), the purchase program would continue, but at a slower pace and over a longer authorized period, with actual purchases dependent on market conditions, the economy, cash needs and alternative investment opportunities. The recent decreases in the average number of outstanding common shares, as disclosed in the Ten-Year Financial Review on page 36, are the results of these purchase programs. Since the first purchases in December 1987 and through December 31, 1993, NS has purchased and retired 53,615,800 shares of its common stock under these programs at a cost of $2.2 billion. 15. Special Charge in 1991 and Subsequent Partial Reversal in 1993 Included in 1991 results was a $680 million special charge for labor force reductions and asset write-downs. The special charge reduced net income by $498 million, or $3.37 per share. The principal components of the special charge were as follows: Labor - ----- Significant new labor agreements were reached late in 1991 following a Presidential Emergency Board's recommendations that railroads be permitted to modify long-standing unproductive work rules. The principal feature of the new agreements concerned a change in crew consist (the required number of crew members on a train) from four to two members to be implemented over a five-year period across most of NS' system. Surplus employees whose positions were eliminated as a result of the restructured crew size are entitled to protective pay and may be offered voluntary separation incentives. Related to crew-consist changes, separate agreements were reached concerning the buyout of certain productivity funds (payments to train service employees whenever a train operates with a reduced crew). The labor portion of the special charge amounted to $450 million and represented the estimated costs of achieving the productivity gains provided by these new agreements. Goodwill - -------- In 1985, NS acquired all the common stock of NAVL for $369 million. The transaction was accounted for as a purchase and included $211 million representing cost in excess of net assets acquired (goodwill). The price NS paid for NAVL was based on an evaluation of its earning power. Generally, earnings since acquisition were much lower than anticipated. In 1991, NS evaluated the carrying value of its investment in NAVL and concluded that the goodwill portion of its investment was not recoverable primarily because of reduced profit margins resulting from intense competition in the motor carrier industry. As a result of this determination, NS recorded a $187 million noncash charge against 1991 earnings (with no related tax benefit) representing the unamortized balance of its investment in NAVL's goodwill. See also Note 3 regarding NAVL's restructuring in 1993. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 15. Special Charge in 1991 and Subsequent Partial Reversal in 1993 (continued) Property - -------- The property portion of the special charge, which amounted to $43 million, was for marginally productive railroad property and motor carrier equipment assets that were scheduled for sale or abandonment. Special Charge Reversal - ----------------------- Based on NS' success in eliminating reserve board positions in 1992 and 1993, and on events occurring in the third quarter of 1993, the accrual included in the 1991 special charge related to labor was reduced by $46 million and was reflected as a credit in compensation and benefits expense. The principal factor contributing to the reversal was that, in 1993, agreement on terms for certain further labor savings could not be reached. Accordingly, it became apparent that a surplus existed in the labor portion of the provision established in the 1991 special charge. 16. Contingencies Lawsuits - -------- Norfolk Southern and certain subsidiaries are defendants in numerous lawsuits relating principally to railroad operations. While the final outcome of these lawsuits cannot be predicted with certainty, it is the opinion of Management, after consulting with its legal counsel, that ultimate liability will not materially affect the consolidated financial position of NS. Debt Guarantees - --------------- As of December 31, 1993, certain Norfolk Southern subsidiaries are contingently liable as guarantors with respect to $37 million of indebtedness of related entities. Environmental Matters - --------------------- NS is subject to various jurisdictions' environmental laws and regulations. Certain NS rail subsidiaries have received notices from the Environmental Protection Agency that they are potentially responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), which generally imposes joint and several liability for cleanup costs. State agencies also have notified certain NS rail subsidiaries that they may be potentially responsible for environmental damages, and in several instances they have agreed voluntarily to initiate cleanup. For CERCLA sites and all other known environmental incidents where loss or liability is probable, NS has recorded an estimated liability. The amount of that liability, which includes estimated costs of remediation (and any associated restoration) on a site-by-site basis, is expected to be paid over several years. Claims, if any, against third parties for recovery of remediation costs incurred by NS are reflected as receivables in the balance sheet and are not netted against the associated NS liability. Environmental engineers perform ongoing analyses of all identified sites, and--after consulting with counsel--any necessary adjustments to initial liability estimates are recorded. NS also has established an Environmental Policy Council, composed of senior managers, to prescribe and direct its environmental initiatives. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 16. Contingencies (continued) Estimates of a company's potential financial exposure even for known environmental claims or incidents are necessarily imprecise because of the widely varying costs of available remediation techniques, the difficulty of determining in advance the nature and extent of contamination and each potential participant's share of an estimated loss, and evolving statutory and regulatory standards governing liability. The risk of incurring environmental liability--for acts and omissions, both past and current--is inherent in railroad operations. Moreover, some of the commodities, particularly those classified as hazardous materials, in NS' traffic mix can pose special risks that NS and its subsidiaries work diligently to minimize. In addition, several NS subsidiaries have land holdings that may be leased (and operated by others) or held for sale. Because certain conditions may exist on these properties for which NS ultimately may bear some financial responsibility, there can be no assurance that NS will not incur liabilities or costs, the amount and materiality of which, to a single accounting period or in the aggregate, cannot be estimated reliably now, related to environmental problems that are latent or undiscovered. However, based on its assessments of the facts and circumstances now known and after consulting with its legal counsel, Management believes that it has recorded appropriate estimates of liability for those environmental matters of which the Corporation is aware. INDEPENDENT AUDITORS' REPORT The Stockholders and Board of Directors Norfolk Southern Corporation: We have audited the consolidated financial statements of Norfolk Southern Corporation and subsidiaries as listed in Item 8. In connection with our audits of the consolidated financial statements, we also have audited the consolidated financial statement schedules as listed in Item 14(a)1. These consolidated financial statements and consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Norfolk Southern Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 1, the Company changed its methods of accounting in 1993 by adopting the provisions of the Financial Accounting Standards Board's Statement 109, Accounting for Income Taxes; Statement 106, Employers' Accounting for Postretirement Benefits Other Than Pensions; and Statement 112, Employers' Accounting for Postemployment Benefits. /s/ KPMG Peat Marwick Norfolk, Virginia January 25, 1994 (continued) EXHIBIT INDEX ------------- Electronic Submission Exhibit Number Description Page Number - ---------- ----------------------------------------- ----------- 10.g Norfolk Southern Corporation Officers' Deferred Compensation Plan as amended effective January 1, 1994. 97-106 10.h Directors' Deferred Fee Plan of Norfolk Southern Corporation as amended effective January 1, 1994. 107-112 11 Computation of Earnings Per Share. 113-116 12 Computation of Ratio of Earnings to Fixed Charges. 117 21 Subsidiaries of Norfolk Southern. 118-120 23 Consent of Independent Auditors. 121

706166_1993.txt

706166_1993

1993

706166

Item 1. Business. Carolina Freight Corporation is a freight transportation holding company whose primary subsidiaries are Carolina Freight Carriers Corporation ("Carolina"), Red Arrow Freight Lines, Inc. ("Red Arrow"), G.I. Trucking Company ("G.I."), Cardinal Freight Carriers, Inc. ("Cardinal"), The Complete Logistics Company, Inc. ("CLC"), and Innovative Logistics Incorporated ("ILI"). The consolidated revenue of the Corporation ranks it among the ten largest motor carriers of general freight in the United States. Through its subsidiary carriers, Carolina Freight Corporation serves all of the 50 largest Standard Metropolitan Statistical Areas of the United States. In addition to their independent operations, Carolina, G.I. and Red Arrow use rail carriers to provide intermodal transportation between their areas of operation. Subsidiaries of Carolina Freight Corporation presently provide services for customers in over 130 countries in North America, Africa, Australia, New Zealand, South America, Central America, Eastern and Western Europe, the Middle East, Asia and throughout the Pacific Rim and the Caribbean Sea. The Corporation`s consolidated insurance subsidiary, Motor Carrier Insurance, Ltd., a Bermuda company, provides cargo, public liability and workers' compensation insurance coverage, under reinsurance agreements, to the Corporation's operating subsidiaries. The Corporation's principal offices are located at North Carolina Highway No. 150 East, Cherryville, North Carolina 28021, and its telephone number is 704/435-6811. On December 31, 1993, the Corporation had 11,174 total employees. Unless the context requires otherwise, reference to the Corporation in this report shall mean Carolina Freight Corporation and its subsidiaries. CAROLINA FREIGHT CARRIERS Carolina Freight Carriers is an over-the-road motor carrier which began operations in 1932 as Beam Trucking Company. The company has its headquarters in Cherryville, North Carolina and operates as a transporter of general commodities primarily within a 32 state region of the eastern half of the United States. Its major service area is connected with the territories of G.I. and Red Arrow through an intermodal partnership with those companies. Carolina`s major traffic lanes are between points in the South and Northeast, the South and Midwest, the Midwest and the Northeast, and within the South. Carolina is authorized by the Interstate Commerce Commission ("ICC") to serve all points in the contiguous United States. Carolina handles broadly diversified traffic including textile products, plastics, foodstuffs, pharmaceuticals, chemicals, auto parts, construction materials and hardware. The only commodity accounting for more than 10% of revenue in 1993 was textiles (cloth, dry goods, fabrics, clothing, fibers, yarn) which accounted for approximately 10.8%. During 1993, no single customer accounted for more than 4% of revenue, and the largest ten customers accounted for less than 18% of revenue. During 1993, 91% of revenue was derived from less-than-truckload ("LTL") shipments (shipments weighing less than 10,000 pounds). EQUIPMENT AND PROPERTY. Carolina owns all of its revenue equipment except equipment used in connection with intermodal operations. At December 31, 1993, Carolina owned 3,093 tractors, 10,846 trailers, 78 trucks, and operated 171 service centers consisting of 154 terminals (98 owned and 56 leased) and 17 agencies. In addition to the operation of major vehicle maintenance facilities at the six major breakbulk terminals in Carolina's system - Atlanta, Chicago, Carlisle (Pa.), Cherryville, Cincinnati, and Toledo - - there are similar maintenance facilities at various terminals throughout the Carolina system. G.I. TRUCKING COMPANY G.I. is headquartered in La Mirada, California and provides over-the-road freight transportation services to shippers and receivers in California, Oregon, Washington, Idaho, Utah, Nevada, Colorado, New Mexico, Texas and Arizona. Service is provided to and from Hawaii. The major service area of G.I. is connected with the territories of Carolina and Red Arrow through an intermodal partnership with those companies. Founded in 1946, G.I. was acquired by Carolina Freight Corporation in October 1983. At December 31, 1993, G.I. owned 424 tractors, 1,586 trailers, 16 trucks, and operated 44 service centers consisting of 24 terminals (14 owned and 10 leased) and 20 agencies. RED ARROW FREIGHT LINES, INC. Red Arrow`s executive offices are in Dallas, Texas and administrative services are performed in corporate offices in Cherryville, North Carolina. It is an over-the-road motor carrier which transports general commodities in Texas, Kansas, Arkansas, Louisiana and Oklahoma. The major service area of Red Arrow is connected with the territories of G.I. and Carolina through an intermodal partnership with those companies. Red Arrow was founded in 1928 and acquired by Carolina Freight Corporation in January 1984. At December 31, 1993, Red Arrow owned 191 tractors, 179 trailers, 3 trucks, and operated 15 service centers consisting of 11 terminals (4 owned and 7 leased) and 4 agencies. CARDINAL FREIGHT CARRIERS, INC. Cardinal was established in 1980. It is an irregular route motor carrier with authority to serve all points in the United States, although its services are presently confined to serving customers east of the Mississippi River. Cardinal specializes in the transportation of truckload freight. Its general office is in Concord, North Carolina. At December 31, 1993, Cardinal owned 130 tractors and 744 trailers and operated 217 leased tractors. THE COMPLETE LOGISTICS COMPANY, INC. CLC is a full service equipment and driver leasing company, owning 124 tractors, 284 trailers, and 67 trucks as of December 31, 1993. CLC was formerly the leasing division of G.I. Trucking Company and is headquartered in Buena Park, California. INNOVATIVE LOGISTICS INCORPORATED ILI is a third party logistics firm based in Fort Mill, South Carolina and provides transportation-related services such as intermodal shipping, rate negotiation, and warehousing. The international division, with offices in Charleston, South Carolina, and Houston, Texas, provides NVOCC service to most foreign locations. CAPITAL EXPENDITURES Capital expenditures in 1993 net of dispositions were $15.8 million. Revenue and service equipment purchases were $17.3 million. Land and terminal expenditures were $4.7 million. Other capital expenditures totaled $7.3 million. The proceeds from dispositions totaled $13.5 million which included the sale of terminal facilities in Atlanta, Cincinnati, Austin, Houston, and San Antonio. MANAGEMENT CHANGES James D. Carlton became president of Carolina Freight Carriers in June 1993. In December 1993, Braxton Vick, who previously served as Executive Vice President of Corporate Services, was promoted to Executive Vice President of Corporate Planning and Development. In addition, John L. Fraley, Jr., a veteran of Carolina Freight Carriers, and James R. Hertwig, former president of a major intermodal company, were elected vice presidents of the Company. In January 1993, Philip G. Deely, who formerly served as a distribution executive for a large shipper, was named President of Innovative Logistics Incorporated. Item 2. Item 2. Properties. The Corporation, through its subsidiaries, owns and operates 117 terminal facilities in 26 states. At December 31, 1993, these properties had a net book value of $132.5 million. In addition, the Corporation leases 71 real properties under leases for terms of generally one to ten years. These properties are used as offices, terminals, warehouses and vehicle maintenance facilities. The Corporation, through its subsidiaries, transports freight, using both over-the-road and local tractors, trailers and trucks. This revenue equipment is virtually all owned by the respective subsidiary, though minor amounts are leased both with and without drivers. At December 31, 1993, the value of revenue equipment, less accumulated depreciation, totaled $87.8 million and consisted of 4,179 tractors, 13,639 trailers and 164 trucks. In addition, service vehicles, data processing equipment, furniture and fixtures, and leasehold improvements had a net book value of $26.1 million. Item 3. Item 3. Legal Proceedings. (a) There are not now pending any material legal proceedings, other than ordinary routine litigation incident to the Corporation's business, to which the Corporation or any of its subsidiaries is a party or to which any of their respective properties is subject. During 1993, no material litigation or governmental proceeding was instituted or pending against the Corporation or any of its subsidiaries arising from any alleged violation of any emission control standards or other environmental regulations. (b) No material legal proceedings were terminated in the fourth quarter of 1993. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted during the fourth quarter of 1993 to a vote of security holders, through the solicitation of proxies or otherwise. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. The registrant's common stock is traded on the New York and Pacific Stock Exchanges (Symbol - CAO). The range of market values and amounts of dividends paid during the last two years are shown in the following table: As of December 31, 1993, there were 2,642 record holders of the Corporation's Common Stock. The Corporation has paid quarterly cash dividends on its Common Stock since 1963. The Board of Directors suspended payment of common share dividends on January 10, 1994. Future dividends will depend upon the Corporation's earnings, its financial condition and other relevant factors. A debt agreement places certain restrictions on the payment of cash dividends by Carolina Freight Corporation, the parent company. Under the agreement, future dividends of the Corporation are limited to approximately $3.7 million plus 50% of earnings, as defined, after December 31, 1993. Item 6. Item 6. Selected Financial Data. The selected financial data for the past five years appears on pages 18 and 19 of the registrant's annual report to shareholders for the year ended December 31, 1993 and is incorporated by reference to the extent of the respective columns of financial data for the years 1989 through 1993. Item 7. Item 7. Management`s Discussion and Analysis of Results of Operations and Financial Condition. Management`s Review appearing on pages 20 through 23 of the annual report to shareholders for the year ended December 31, 1993 is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The consolidated financial statements including the Report of Independent Public Accountants, appearing on pages 24 through 37, in the annual report to shareholders for the year ended December 31, 1993 are incorporated herein by reference. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure. None. PART III The information called for by Part III is incorporated by reference from registrant's definitive proxy statement. Disclosures concerning delinquent filings under Section 16(A) of the Securities Exchange Act of 1934 can be found in the Company's 1994 Proxy Statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as a part of this report: 1. Financial Statements - The following information appearing in the annual report to shareholders for year ended December 31, 1993 is incorporated by reference: 2. Financial Statement Schedules Schedule No. Schedule Name ------------ ------------- III. Condensed Financial Information - Parent Company Only V. Property, Plant and Equipment VI. Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment VIII. Valuation and Qualifying Accounts X. Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable. 3. Exhibits 3(a) Articles of Incorporation of Carolina Freight Corporation (as amended up to May 16, 1988). Incorporated by reference to Exhibit 3(a) on Form 10-K for the year ended December 31, 1988, File No. 1-8441. (i) Articles of Amendment of Carolina Freight Corporation. Incorporated by reference to Exhibit 3(a)(i) on Form 10-K for the year ended December 31, 1989, File No. 1-8441. 3(b) Amended and Restated Bylaws of Carolina Freight Corporation. Incorporated by reference to Exhibit 3(b) on Form 10-Q for the quarter ended September 8, 1990, File No. 1-8441. 3(c) Amended and Restated Charter of Carolina Freight Carriers Corporation. Incorporated by reference to Exhibit 3(b) on Form 10-K for the year ended December 31, 1985, File No. 1-8441. 4 6 1/4% Convertible Subordinated Debentures Due 2011 - all documents in connection with Company's registration statement on Form S-3, File No. 33-4742 in 1986 are incorporated by reference. 10(a) Consulting Services Agreement between Carolina Freight Corporation and K. G. Younger. Incorporated by reference to Exhibit 10(b) on Form 10-K for the year ended December 31, 1990, File No. 1-8441. 10(b) Employment Contract Agreement between Carolina Freight Corporation and Lary R. Scott dated March 22, 1993. 10(c) Employment Contract Agreement between Carolina Freight Corporation and Palmer E. Huffstetler dated March 22, 1993. 10(d) Carolina Freight Corporation Employee Savings and Protection Plan (as amended through October 1, 1991). Incorporated by reference to Exhibit 10(c) on Form 10-K for the year ended December 31, 1991, File No. 1-8441. 10(e) The Complete Logistics Company Employee Savings and Profit Sharing Plan, October 1, 1993. 10(f) Carolina Freight Corporation Employees' Pension Plan (as restated January 1, 1985). Incorporated by reference to Exhibit 10(d) on Form 10-K for the year ended December 31, 1985, File No. 1-8441. (i) 1989 Amendments to Carolina Freight Corporation Employees' Pension Plan. Incorporated by reference to Exhibit 10(c) (i) on Form 10-K for the year ended December 31, 1989, File No. 1-8441. (ii) 1992 Amendment to Carolina Freight Corporation Employees' Pension Plan. Incorporated by reference to Exhibit 10(d) (ii) on Form 10-K for the year ended December 31, 1992, File No. 1-8441. 10(g) G. I. Trucking Company Employees Retirement Plan as amended and restated effective July 1, 1992. Incorporated by reference to Exhibit 10(e) on Form 10-K for the year ended December 31, 1992, File No. 1-8441. 10(h) G. I. Trucking Company Freight Handlers Retirement Plan as amended and restated effective July 1, 1992. Incorporated by reference to Exhibit 10(f) on Form 10-K for the year ended December 31, 1992, File No. 1-8441. 10(i) Group Annuity Contract No. IN 15150 between G.I. Trucking Company and Connecticut General Life Insurance Company. Incorporated by reference to Exhibit 10(h) on Form 10-K for the year ended December 31, 1985, File No. 1-8441. 10(j) Stock Option Plans: (i) 1984 Incentive Stock Option Plan of Carolina Freight Corporation and 1984 Incentive Stock Option Agreement. Incorporated by reference to Exhibit 10(d) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (ii) Amendment to 1984 Incentive Stock Option Plan of Carolina Freight Corporation. Incorporated by reference to Exhibit 10(h)(ii) on Form 10-K for the year ended December 31, 1987, File No. 1-8441. (iii) Amendments to 1975, 1980 and 1984 Stock Option Plans. Incorporated by reference to Exhibit 10(h)(iii) on Form 10-K for the year ended December 31, 1988, File No. 1-8441. (iv) 1988 Incentive Stock Option Plan of Carolina Freight Corporation and 1988 Incentive Stock Option Agreement. Incorporated by reference to Exhibit 10(h)(iv) on Form 10-K for the year ended December 31, 1988, File No. 1-8441. (v) Amendments to 1980, 1984 and 1988 Incentive Stock Option Plans of Carolina Freight Corporation. Incorporated by reference to Exhibit 10(h)(v) on Form 10-K for the year ended December 31, 1989, File No. 1-8441. (vi) 1989 Incentive Stock Option Plan of Carolina Freight Corporation and 1989 Incentive Stock Option Agreement. Incorporated by reference to Exhibit 10(h)(vi) on Form 10-K for the year ended December 31, 1989, File No. 1-8441. 10(k) Revolving Credit and Term Loan Agreement between Carolina Freight Carriers Corporation and Citibank, N.A. dated December 1, 1990. Incorporated by reference to Exhibit 10(i) on Form 10-K for the year ended December 31, 1990, File No. 1-8441. (i) First Amendment to Revolving Credit and Term Loan Agreement dated December 31, 1991. Incorporated by reference to Exhibit 10(i) on Form 10-K for the year ended December 31, 1991, File No. 1-8441. (ii) Second Amendment to Revolving Credit and Term Loan Agreement dated October 5, 1992. Incorporated by reference to Exhibit 10(i)(ii) on Form 10-K for the year ended December 31, 1992, File No. 1-8441. 10(l) Guaranty Agreement between Carolina Freight Corporation and Citibank, N.A. dated December 1, 1990. Incorporated by reference to Exhibit 10(j) on Form 10-K for the year ended December 31, 1990, File No. 1-8441. (i) First Amendment to Guaranty Agreement dated October 5, 1992. Incorporated by reference to Exhibit 10(j)(i) on Form 10-K for the year ended December 31, 1992, File No. 1-8441. 10(m) Carolina Freight Trade Receivables Master Trust Pooling and Servicing Agreement dated December 1, 1993. 10(n) Executive Benefit Plan Agreements: (i) Executive Benefit Plan Agreements of All Officers and Directors of Carolina Freight Corporation. Incorporated by reference to Exhibit 10(j) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (ii) Salary Deferral Plan of Officers and Directors of Carolina Freight Corporation. Incorporated by reference to Exhibit 10(r)(ii) on Form 10-K for the year ended December 31, 1986, File No. 1-8441. (iii) Amendment Number One to Deferred Compensation Agreement of All Directors of Carolina Freight Corporation. Incorporated by reference to Exhibit 10(p)(iii) on Form 10-K for the year ended December 31, 1987, File No. 1-8441. (iv) Amendment Number One to Deferred Compensation Agreement of All Officers of Carolina Freight Corporation. Incorporated by reference to Exhibit 10(p)(iv) for the year ended December 31, 1987, File No. 1-8441. (v) Amended Executive Supplemental Benefit Plan. Incorporated by reference to Exhibit 10(p)(v) on Form 10-K for the year ended December 31, 1988, File No. 1-8441. (vi) Representative sample of individual contracts signed by participants in the 1990 Salary Deferral Plan for Officers and Directors. The total amount deferred by the executive officers, as a group, in 1991 can be found on page 7 of the Company's 1992 Proxy Statement. The total amount deferred in 1991 by the directors, as a group, was $37,000. Incorporated by reference to Exhibit 10(v)(vi) on Form 10-K for the year ended December 31, 1991, File 1-8441. 10(o) Form of Indemnification Agreement between Carolina Freight Corporation and Its Board of Directors and Schedule Identifying Documents Omitted. Incorporated by reference to Exhibit 10(q) on Form 10-K for the year ended December 31, 1987, File No. 1-8441. 10(p) Form of Severance Pay Agreement between Carolina Freight Corporation and Its Officers and Schedule Identifying Documents Omitted. Incorporated by reference to Exhibit 10(r) on Form 10-K for the year ended December 31, 1987, File No. 1-8441. 10(q) Loan Agreements in connection with the following industrial revenue bond financings of Carolina Freight Carriers Corporation: (i) Howard County, Maryland dated September 1, 1981. Incorporated by reference to Exhibit 10(k)(i) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (ii) City of Rockford, Illinois dated October 1, 1981. Incorporated by reference to Exhibit 10(k)(ii) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (iii) New Jersey Economic Development (Jersey City) dated January 1, 1982. Incorporated by reference to Exhibit 10(k)(iii) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (iv) Village of Forest View, Illinois dated November 1, 1982. Incorporated by reference to Exhibit 10(k)(iv) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (v) County of Cuyahoga, Ohio dated August 29, 1983. Incorporated by reference to Exhibit 10(k)(vi) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (vi) Mortgage Note and Mortgage dated December 9, 1983 of Berks County Development Authority. Incorporated by reference to Exhibit 10(k)(vii) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (vii) City of Hayward, California and Summit Companies, Inc. Incorporated by reference to Exhibit 10(k)(viii) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (viii) County of Lucas, Ohio dated May 1, 1984. Incorporated by reference to Exhibit 10(k)(ix) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (ix) Michigan Job Development Authority dated October 1, 1984. Incorporated by reference to Exhibit 10(k)(x) on Form 10-K for the year ended December 31, 1984, File No. 1-8441. (x) Cumberland County, Pa. Industrial Development Authority Mortgage dated October 1, 1985, and Promissory Note dated October 17, 1985. Incorporated by reference to Exhibit 10(s)(xii) on Form 10-K for the year ended December 31, 1985, File No. 1-8441. (xi) Dade County, Florida, Industrial Development Authority, Installment Purchase Contract, dated December 1, 1985. Incorporated by reference to Exhibit 10(s)(xiv) on Form 10-K for the year ended December 31, 1985, File No. 1-8441. (xii) City of Memphis and County of Shelby, Tennessee, Industrial Development Board dated October 1, 1986. Incorporated by reference to Exhibit 10(s)(xv) on Form 10-K for the year ended December 31, 1986, File No. 1-8441. (xiii) New Jersey Economic Development Authority, Variable Rate Demand Economic Development Bond dated February 22, 1990. Incorporated by reference to Exhibit 10(v)(xiv) on Form 10-K for the year ended December 31, 1990, File No. 1-8441. (xiv) Carolina Freight Tax-Exempt Bond Grantor Trust dated May 23, 1990. Incorporated by reference to Exhibit 10(v)(xv) on Form 10-K for the year ended December 31, 1990, File No. 1-8441. 10(r) Grantor Trust Agreement. Incorporated by reference to Exhibit 10(w) on Form 10-K for the year ended December 31, 1989, File No. 1-8441. 11 Computation of Earnings Per Common Share. 13 1993 Annual Report to Shareholders. 21 List of subsidiaries of Carolina Freight Corporation. 23 Consent of Independent Public Accountants. (b) Reports on Form 8-K filed in the fourth quarter, 1993: None CAROLINA FREIGHT CORPORATION SCHEDULE III - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY FOR THE YEARS ENDED DECEMBER 31, 1993 AND 1992 CONDENSED BALANCE SHEETS 1993 1992 Assets ------------ ------------ Current Assets: Cash and temporary cash investments $ 131,611 $ 161,683 Prepayments 102,618 77,496 Other Assets 1,587,202 1,563,837 ------------ ------------ Total current assets $ 1,821,431 $ 1,803,016 ------------ ------------ Other Assets: Investment in subsidiaries 196,569,010 146,153,266 Advances to subsidiaries 24,660,076 41,569,976 Other 1,256,711 1,135,542 ------------ ------------ Total other assets 222,485,797 188,858,784 ------------ ------------ Total Assets $224,307,228 $190,661,800 ============ ============ Liabilities and Stockholders' Equity Current Liabilities: Accounts payable $ 149,455 $ 149,148 Other payables and accrued liabilities 726,566 702,791 ------------ ------------ Total current liabilities 876,021 851,939 ------------ ------------ Advances from subsidiaries 51,508,967 12,325,769 ------------ ------------ Long-Term Debt: 6.25% Convertible Subordinated Debentures 49,994,000 49,994,000 Other long-term debt 601,980 518,545 ------------ ------------ Total long-term debt 50,595,980 50,512,545 ------------ ------------ Deferred Income Taxes (286,352) (203,434) ------------ ------------ Stockholders' Equity: Preferred stock 2,211,200 2,211,200 Common stock 3,280,836 3,280,836 Paid-in capital 44,349,110 44,349,110 Retained earnings 71,771,466 77,333,835 ------------ ------------ Total stockholders' equity 121,612,612 127,174,981 ------------ ------------ Total liabilities and stockholders' equity $224,307,228 $190,661,800 ============ ============ CAROLINA FREIGHT CORPORATION SCHEDULE III - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CONDENSED STATEMENTS OF EARNINGS CAROLINA FREIGHT CORPORATION SCHEDULE III - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CONDENSED STATEMENTS OF CASH FLOWS CAROLINA FREIGHT CORPORATION SCHEDULE III - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 NOTES TO CONDENSED FINANCIAL STATEMENTS (1) These unaudited condensed financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations, although the company believes that the disclosures made are adequate to make the information presented not misleading. (2) The revolving credit agreements of Carolina Freight Carrier Corporation, the 9.4% note agreement and certain industrial bonds of the operating subsidiaries totaling $11,196,000 are guaranteed as to principal and interest payments by Carolina Freight Corporation. (3) See Notes to Consolidated Financial Statements for additional disclosures. CAROLINA FREIGHT CORPORATION SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (1) $(297,827) adjustment of capitalized computer lease of 1991. CAROLINA FREIGHT CORPORATION SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (1) Depreciation of $132,478 relating to non-operating assets was also charged to expense. (2) Depreciation of $242,268 relating to non-operating assets was also charged to expense. (3) $(84,653) adjustment of capitalized computer lease of 1991. (4) Depreciation of $175,073 relating to non-operating assets was also charged to expense. CAROLINA FREIGHT CORPORATION SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (1) Uncollectible accounts written off net of bad debt recoveries. (2) $20,033 applicable to customer and interline receivables and $5,161,569 applicable to other receivables as a result of the sale of receivables explained in the Notes to Consolidated Financial Statements. (3) $2,629,186 applicable to customer and interline receivables and $2,353,267 applicable to other receivables as a result of the sale of receivables explained in the Notes to Consolidated Financial Statements. (4) $2,423,239 applicable to customer and interline receivables and $2,139,476 applicable to other receivables as a result of the sale of receivables explained in the Notes to Consolidated Financial Statements. CAROLINA FREIGHT CORPORATION SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The following amounts have been charged directly to income during the three years ended December 31: 1993 1992 1991 ----------- ----------- ----------- Maintenance and repairs $39,522,704 $35,523,797 $34,500,352 Taxes, other than payroll and income taxes: $30,083,353 $28,267,184 $26,367,215 Fuel (included above) $17,730,666 $16,304,608 $15,706,506 Amortization of operating rights, royalties and advertising expenses have been omitted since they are not required under the related instruction. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Carolina Freight Corporation: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in Carolina Freight Corporation's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 31, 1994 (except with respect to the matter discussed in the subsequent event footnote, as to which the date is March 17, 1994). Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in item 14(a)(2) are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. Charlotte, North Carolina, January 31, 1994 (except with respect to the matter discussed in the subsequent event footnote, as to which the date is March 17, 1994). 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, on the 28th day of March, 1993. CAROLINA FREIGHT CORPORATION (Registrant) /s/ Lary R. Scott By: ____________________________ Lary R. Scott Chief Executive Officer 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 indicated on the 28th day of March, 1993. EXHIBIT INDEX

36510_1993.txt

36510_1993

1993

36510

ITEM 1. BUSINESS First Maryland Bancorp (the "Corporation") is a Maryland corporation incorporated in 1973 and is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). At December 31, 1993, the Corporation had consolidated total assets of $9.5 billion, total deposits of $6.8 billion, and total stockholders' equity of $976.8 million. Its principal subsidiaries are The First National Bank of Maryland ("First National"), First Omni Bank, N.A. ("First Omni") and The York Bank and Trust Company ("York Bank"). These banks provide comprehensive corporate, commercial, correspondent and retail banking services and personal and corporate trust services which include lending, depository and related financial services to individuals, businesses, governmental units and financial institutions primarily in Maryland and the adjacent states. The assets of these banks at December 31, 1993 accounted for approximately 95% of the Corporation's consolidated total assets and the banks contributed approximately 91%, 95% and 94% to the consolidated net income of the Corporation for each of the three years ended December 31, 1993, 1992 and 1991, respectively. First National, the Corporation's largest subsidiary, is a national banking association chartered under the laws of the United States. It commenced operations in Baltimore, Maryland on July 10, 1865 and is the successor to a Maryland banking institution founded in 1806. At December 31, 1993, First National was the second largest commercial bank headquartered in Maryland in terms of assets, loans and deposits, with assets of $7.5 billion, net loans of $3.7 billion, and deposits of $6.1 billion. Its assets at such date comprised 79% of the consolidated assets of the Corporation. Including its main office, First National operates 177 banking facilities in Maryland, including 146 full service offices, and loan production offices in Washington, D.C. and York, Pennsylvania. It conducts international activities at its Baltimore headquarters, a Cayman Islands branch and a representative office in London, and maintains correspondant relationships with more than 75 foreign banks. It offers investment, foreign exchange and securities brokerage services, operates a brokerage subsidiary and acts as investment adviser to the ARK Funds, a family of proprietary mutual funds. York Bank was acquired by the Corporation on December 31, 1991. It is a Pennsylvania chartered commercial bank organized in 1960 as the product of a consolidation of two banks chartered in 1810 and 1890. With assets of $1.1 billion, net loans of $683.4 million, deposits of $894.4 million at December 31, 1993 and 21 offices in south central Pennsylvania, it is the largest banking institution headquartered in York County, Pennsylvania, a market contiguous to First National's principal market. First Omni is a national banking subsidiary of the Corporation headquartered in Millsboro, Delaware and conducts retail bankcard services for the Corporation. It offers Mastercard (R) and VISA (R) bankcards both directly and as agent for other banks. At December 31, 1993 it managed bankcard receivables of $692.7 million (including $165.0 million of securitized bankcard receivables). The Corporation operates various other subsidiaries, including First National Mortgage Corporation, a mortgage banking company which originates, sells and services residential mortgage loans through its network of 11 offices in Maryland, Pennsylvania and Virginia; First National Bank of Maryland, D.C. ("First D.C."), a national bank with its office in the District of Columbia, First Maryland Leasecorp, a commercial finance company specializing in equipment financing and First Maryland Mortgage Corporation, a commercial real estate lender. Allied Irish Banks, p.l.c. ("AIB") is an Irish banking corporation whose stock is traded on the Dublin, London and New York Stock Exchanges. In December 1983, AIB acquired 43% of the outstanding shares of the Corporation. On March 21, 1989, AIB increased its investment to 100% of the Corporation, thereby furthering its strategic objective of increasing the geographic diversification of its investments and operations. AIB is a registered bank holding company under the Bank Holding Company Act and AIB is the largest banking corporation organized under the laws of Ireland, based upon total assets at December 31, 1993. Based upon United States generally accepted accounting principles at December 31, 1993, AIB and its subsidiaries (collectively, "AIB Group") had total assets of approximately $29.8 billion. AIB Group provides a diverse range of banking, financial and related services principally in Ireland, the United States and the United Kingdom. COMPETITION The market for banking and bank-related services is highly competitive. The Corporation and its subsidiaries compete with other providers of financial services such as other bank holding companies, commercial and savings banks, savings and loan associations, credit unions, money market and other mutual funds, mortgage companies, insurance companies, and a growing list of other local, regional and national institutions which offer financial services. Mergers between financial institutions within Maryland and in neighboring states have added competitive pressure. Competition is expected to intensify as a consequence of interstate banking laws now in effect or that may be in effect in the future. The Corporation and its subsidiaries compete by offering quality products and convenient services at competitive prices. In order to maintain and enhance its competitive position, the Corporation regularly reviews various acquisition prospects and periodically engages in discussions regarding such possible acquisitions. SUPERVISION AND REGULATION The information contained in this section summarizes portions of the applicable laws and regulations relating to the supervision and regulation of the Corporation and its subsidiaries. These summaries do not purport to be complete, and they are qualified in their entirety by reference to the particular statutes and regulations described. Bank Holding Company Regulation The Corporation, as a bank holding company registered under the Bank Holding Company Act, is required to file with the Federal Reserve Board an annual report and such additional information as the Federal Reserve Board may require, and is subject to regular examinations by the staff of the Federal Reserve Bank of Richmond. The Bank Holding Company Act requires that a bank holding company obtain the prior approval of the Federal Reserve Board before it may acquire substantially all the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition, it will own or control, directly or indirectly, more than 5% of the voting shares of such bank. Under existing Federal and state laws, the Federal Reserve Board may not approve the acquisition by the Corporation of any bank located outside the State of Maryland unless such an acquisition is specifically authorized by the statutory law of the state in which such bank is located. Most states have authorized interstate banking acquisitions by bank holding companies on one or more of the following bases: a regional reciprocal basis, a national reciprocal basis or an unrestricted basis. Subject to applicable Federal and state approval procedures and registration requirements, the Corporation may, consistent with the Bank Holding Company Act, acquire banks in Maryland, Pennsylvania, Virginia, West Virginia and the District of Columbia and most of the southeastern states. In addition to restricting banking acquisitions, the Bank Holding Company Act generally prohibits a bank holding company from engaging in non-banking activities or acquiring direct or indirect control of voting shares of any company engaged in such activities. The Bank Holding Company Act limits the activities which may be engaged in by the Corporation and its subsidiaries to those of banking and the management of banking organizations, and to non- banking activities which the Federal Reserve Board may find, by order or regulation, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The approval of the Federal Reserve Board is required prior to engaging in non-banking activities. The Banks First National, First Omni, and First D.C. (the "National Banks" and together with York Bank, the "Banks"), as national banking associations, are subject to the supervision of, and regulation and examination by the Comptroller. York Bank, a Pennsylvania state chartered bank, is supervised, regulated and examined by the Pennsylvania Department of Banking and the FDIC. Deposits, reserves, investments, loans, consumer law compliance, issuance of securities, payment of dividends, mergers and consolidations, electronic funds transfers, management practices, and other aspects of the Banks' operations are subject to regulation. The approval of the appropriate bank regulatory authority is required for the establishment of additional branch offices by any of the Banks, subject to applicable state law restrictions. All of the National Banks are members of the Federal Reserve System, and the deposits of all the Banks are insured by the FDIC. Some of the aspects of the lending and deposit business of the Banks which are subject to regulation by the Federal Reserve Board or the FDIC include disclosure requirements in connection with personal and mortgage loans, interest on deposits and reserve requirements. In addition, the Banks are subject to numerous federal, state and local laws and regulations which set forth specific restrictions and procedural requirements with respect to the extension of credit, credit practices, the disclosure of credit terms and discrimination in credit transactions. The Banks are subject to restrictions under federal law which limit the transfer of funds by the Banks to the Corporation and its non-banking subsidiaries, whether in the form of loans, extensions of credit, investments or asset purchases. Such transfers by any Bank to the Corporation or any of its non-banking subsidiaries are limited in amount to 10% of such Bank's capital and surplus and, with respect to the Corporation and all such non-banking subsidiaries, to an aggregate of 20% of such Bank's capital and surplus. Furthermore, such loans and extensions of credit are required to be secured in specified amounts. As a result of the enactment of the Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA") on August 9, 1989, a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989 in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. "Default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a "default" is likely to occur in the absence of regulatory assistance. As a consequence of the extensive regulation of the commercial banking business in the United States, the business of the Banks is particularly susceptible to changes in Federal and state legislation and regulations which may increase the cost of doing business. Dividends The Corporation is a legal entity separate and distinct from the Banks and its other subsidiaries, although the principal source of the Corporation's cash revenues is dividends from the Banks. Various Federal (and in the case of York Bank, state) laws and regulations limit the amount of dividends the Banks can pay to the Corporation without regulatory approval. The approval of the Comptroller is required for any dividend by a national bank if the total of all dividends declared by such bank in any calendar year would exceed the total of its net profits, as defined by the Comptroller, for that year combined with its retained net profits for the preceding two years less any required transfers to surplus or a fund for the retirement of any preferred stock. Additionally, national bank subsidiaries may not declare dividends in excess of net profits on hand, after deducting the amount by which the principal amount of all loans on which interest is past due for a period of six months or more exceeds the reserve for credit losses. In addition, the "prompt corrective action" provisions of FDICIA prohibit the payment of dividends by a bank if the payment would cause the bank to become "undercapitalized." Under the first and currently more restrictive of the foregoing dividend limitations, at January 1, 1994, approximately $29.2 million of retained earnings of the National Banks was available to pay dividends to the Corporation. Pursuant to Pennsylvania law, York Bank may pay dividends only out of accumulated net earnings and may not pay a dividend if any transfer of net earnings to surplus is required. In addition, in December 1991, the Board of Directors of York Bank adopted resolutions at the direction of the Pennsylvania Department of Banking and the FDIC which prohibit any payment of dividends that would reduce York Bank's ratio of tier 1 capital to total assets (leverage ratio) below 6% and provide for the reduction of the ratio of classified assets less the allowance for credit losses to tier 1 capital. At December 31, 1993, York Bank's tier 1 capital ratio as a percent of total assets (leverage ratio) was 9.4%. The Federal Reserve Board and the Comptroller also have issued guidelines that require bank holding companies and national banks to evaluate continuously the level of cash dividends in relation to the organization's net income, capital needs, asset quality and overall financial condition. The Comptroller also has authority under the Financial Institutions Supervisory Act to prohibit national banks from engaging in what, in the Comptroller's opinion, constitutes an unsafe or unsound practice. The payment of a dividend by a bank could, depending upon the financial condition of such bank and other factors, be construed by the Comptroller to be such an unsafe or unsound practice. The Comptroller has stated that a dividend by a national bank should bear a direct correlation to the level of the bank's current and expected earnings stream, the bank's need to maintain an adequate capital base and the marketplace's perception of the bank and should not be governed by the financing needs of the bank's parent corporation. As a result, notwithstanding the level of dividends which could be declared without regulatory approval by the Banks as set forth in the preceding paragraph, the level of dividends from the Banks to the Corporation in 1994 is not expected to exceed the earnings of the Banks. If the ability to pay dividends to the Corporation were to become restricted, the Corporation would need to rely on alternative means of raising funds to satisfy its requirements. Such alternative means might include, but would not be restricted to, non-bank subsidiary dividends, asset sales or other capital market transactions. Under Federal Reserve Board policy, the Corporation is expected to act as a source of financial strength to the Banks and to commit resources to support the Banks in circumstances where it might not do so absent such policy. In addition, any capital loans by the Corporation to any of the Banks would also be subordinate in right of payment to deposits and to certain other indebtedness of such Bank. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank at a certain level will be assumed by the bankruptcy trustee and entitled to a priority of payment. Capital Requirements The Federal Reserve Board has adopted risk-based capital guidelines for bank holding companies. As of December 31, 1993, the minimum ratio of capital to risk-adjusted assets (including certain off-balance sheet items, such as standby letters of credit) was 8%. At least half of the total capital must be comprised of common equity, retained earnings and a limited amount of perpetual preferred stock, after subtracting goodwill and certain other adjustments ("Tier 1 capital"). The remainder may consist of perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, other preferred stock and a limited amount of loan loss reserves ("Tier 2 capital"). The maximum amount of supplementary capital elements that qualifies as Tier 2 capital is limited to 100% of Tier 1 capital net of goodwill. The Federal Reserve Board also has adopted a minimum leverage ratio (Tier 1 capital to average total assets) of 3% for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. The rule indicates that the minimum leverage ratio should be at least 1.0% to 2.0% higher for holding companies that do not have the highest rating or that are undertaking major expansion programs. The Corporation's national and state chartered banking subsidiaries are subject to similar risk-based and leverage capital requirements adopted by the Comptroller and the FDIC, respectively. On December 31, 1993, the Corporation had a Tier 1 capital to risk adjusted assets ratio of 12.88%, a total (Tier 1 plus Tier 2) capital ratio of 16.62%, and a leverage ratio of 9.60%. Failure to meet the capital guidelines could subject a banking institution to a variety of enforcement remedies available to federal regulatory authorities, including the termination of deposit insurance by the FDIC, and the appointment of a conservator or receiver by the appropriate federal regulatory authority. In September 1993, the federal bank regulatory agencies issued proposed revisions to their capital adequacy guidelines which provide for consideration of interest rate risk in the overall determination of a bank's minimum capital requirement. The intended effect of the proposal would be to ensure that banking institutions effectively measure and monitor their interest rate risk and that they maintain adequate capital for the risk. Under the proposal, an institution's exposure to interest rate risk would be measured using either a supervisory model, developed by the federal bank regulatory agencies, or the bank's own internal model. Measured exposure to interest rate risk that exceeds more than a prescribed supervisory threshold would require additional capital. The Corporation does not believe that the proposed revisions, if adopted, would have an adverse effect on the Corporation. FDICIA On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted. Among other things, FDICIA provides increased funding for the Bank Insurance Fund ("BIF") of the FDIC and provides for expanded regulation of depository institutions and their affiliates, including parent holding companies. The following is a brief summary of certain provisions of FDICIA. Pursuant to FDICIA, the Federal Reserve Board, the Comptroller and the FDIC have adopted regulations, effective December 19, 1992, setting forth a five- tier scheme for measuring the capital adequacy of the financial institutions they supervise. Under the regulations (commonly referred to as the "prompt corrective action" rules), an institution is placed in one of the following capital categories: (i) well capitalized (an institution that has a total risk- based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6% and a leverage ratio of at least 5%); (ii) adequately capitalized (an institution that has a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a leverage ratio of at least 4%); (iii) undercapitalized (an institution that has a total risk-based capital ratio of under 8% or a Tier 1 risk-based ratio under 4% or a leverage ratio under 4%); (iv) significantly undercapitalized (an institution that has a total risk-based capital ratio of under 6% or a Tier 1 risk-based capital ratio under 3% or a leverage ratio under 3%); and (v) critically undercapitalized (an institution that has a ratio of tangible equity to total assets of 2% or less). The regulations permit the appropriate Federal banking regulator to downgrade an institution to the next lower category if the regulator determines (i) after notice and opportunity for hearing or response, that the institution is in an unsafe or unsound condition or (ii) that the institution has received (and not corrected) a less-than-satisfactory rating for any of the categories of asset quality, management, earnings or liquidity in its most recent exam. Supervisory actions by the appropriate Federal banking regulator depend upon an institution's classification within the five categories. All institutions are generally prohibited from declaring any dividends, making any other capital distribution, or paying a management fee to any controlling person, if such payment would cause the institution to become undercapitalized. Additional supervisory actions are mandated for an institution falling into one of the three "undercapitalized" categories, with the severity of supervisory action increasing at greater levels of capital deficiency. For example, critically undercapitalized institutions are, among other things, restricted from making any principal or interest payments on subordinated debt without prior approval of their appropriate Federal banking regulator, and are generally subject to the appointment of a conservator or receiver. The regulations apply only to banks and not to bank holding companies, such as the Corporation; however, the Federal Reserve Board is authorized to take appropriate action at the holding company level based on the undercapitalized status of such holding company's subsidiary banking institutions. In certain instances relating to an undercapitalized banking institution, the bank holding company is required to guarantee the performance of the undercapitalized subsidiary and may be liable for civil money damages for failure to fulfill its commitments on such guarantee. As of December 31, 1993, each of the Banks met the requirements of a "well-capitalized" institution. The FDIC issued a rule, effective June 16, 1992, regarding the ability of depository institutions to accept brokered deposits. Under the rule, (i) an "undercapitalized" institution is prohibited from accepting, renewing or rolling over brokered deposits, (ii) an "adequately capitalized" institution must obtain a waiver from the FDIC before accepting, renewing or rolling over brokered deposits and (iii) a "well capitalized" institution may accept, renew or roll over brokered deposits without restriction. In addition, both "undercapitalized" and "adequately capitalized" institutions are subject to restrictions on the rates of interest they may pay on deposits. The definitions of "well capitalized", "adequately capitalized", and "undercapitalized" conform to the definitions utilized in the "prompt corrective action" rules described above. The FDIC has also issued regulations implementing, effective for the semi- annual assessment period commencing January 1, 1993, a system of risk-based FDIC-insurance premiums. Under this system, each depository institution is assigned to one of nine risk classifications based upon certain capital and supervisory measures and, depending upon its classification, will be assessed premiums ranging from 23 basis points to 31 basis points per $100 of domestic deposits. To date, implementation of this system has not had a material effect on the Corporation's income. Effective August 10, 1993, the Federal Deposit Insurance Act was amended to provide that, in the liquidation or other resolution by any receiver of a bank insured by the FDIC, the claims of depositors have priority over the general claims of other creditors. Hence, in the event of the liquidation or other resolution of a banking subsidiary of the Corporation, the general claims of the Corporation as creditor of such banking subsidiary would be subordinate to the claims of the depositors of such banking subsidiary, even if the claims of the Corporation were not by their terms so subordinated. In addition, this statute may, in certain circumstances, increase the costs to the Banks of obtaining funds through nondeposit liabilities. MONETARY POLICY The Corporation's subsidiaries, and thus the Corporation, are affected by monetary policies of regulatory authorities, including the Federal Reserve Board, which regulate the national money supply in order to mitigate recessionary and inflationary pressures. Among the techniques of monetary policy available to the Federal Reserve Board are engaging in open market transactions in U.S. Government securities, changing the discount rate on bank borrowing, and changing reserve requirements against bank deposits. These techniques are used in varying combinations to influence the overall growth and distribution of bank loans, investments, and deposits. Their use may also affect interest rates charged on loans or paid on deposits. The effect of governmental monetary policies on the earnings of the Corporation cannot be predicted. EMPLOYEES As of December 31, 1993, the Corporation employed approximately 4,585 full- time equivalent employees. Management of the Corporation considers relations with its employees to be satisfactory. ITEM 2. ITEM 2. PROPERTIES The following describes the location and general character of the principal offices and other materially important physical properties of the Corporation and its subsidiaries. The Corporation is a major tenant in a building located at 25 South Charles Street, Baltimore, Maryland, occupying approximately 66% of the 330,000 square feet of office space available in the building, and will continue to be the major tenant of the building under a lease expiring in 1997, with a renewal option to the year 2002. During 1993, the annual rental for the space, less amounts received on subleases to others, was $5.1 million. The Corporation is the sole tenant at First Center (formerly the Paca Pratt Building) located at 110 South Paca Street, Baltimore, Maryland. The building contains 267,000 square feet of office space and houses certain lending, staff, and operations functions of the Corporation. The current lease term expires on December 31, 2011. During 1993, the annual rental for the space was $2.6 million. The Corporation is a limited partner with a 0.2% operating interest and a 50% residual interest in the limited partnership which owns the building. The Corporation also owns First Bank Center located at Mitchell Street, Millsboro, Delaware. The building, acquired in 1981, contains approximately 300,000 square feet of space, sits on approximately 60 acres of land, and houses certain retail operations functions of First National together with the branch and bankcard functions of First Omni. In addition to the above office space, the Corporation owns and leases office space in various other office buildings located in Maryland, New York, Pennsylvania, Virginia and the District of Columbia. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Corporation and its subsidiaries are defendants in various matters of litigation generally incidental to their respective businesses. In the opinion of Management, based on its review with counsel of the development of these matters to date, disposition of all pending litigation will not materially affect the consolidated financial position or results of operations of the Corporation and its subsidiaries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Corporation became a wholly owned subsidiary of Allied Irish on March 21, 1989 and, as a result, the Corporation's common stock is no longer listed or traded on any securities exchanges. The Corporation's 7.875% Noncumulative Preferred Stock, Series A was issued on December 13, 1993 and is listed on the New York Stock Exchange. The transfer agent and registrar for the Preferred Stock is First National. As of March 23, 1994 there were 970 registered holders of the Preferred Stock. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data is derived from the audited financial statements of the Corporation. It should be read in conjunction with the detailed information and financial statements of the Corporation included elsewhere herein. Since the acquisition of York Bank occurred on December 31, 1991, the Consolidated Summary of Operations and the Consolidated Average Balances for the year ended December 31, 1991 do not include amounts for York Bank; however, the capital and loan quality ratios shown below at December 31, 1991 reflect the acquisition of York Bank. - -------- (1) The Board of Governors of the Federal Reserve System (the "Federal Reserve Board") guidelines for risk-based capital requirements applicable to all bank holding companies require the minimum ratios of Tier 1 and total capital to risk-adjusted assets to be 4% and 8%, respectively. The Federal Reserve Board's minimum leverage guidelines require all bank holding companies to maintain a ratio of Tier 1 capital to total average quarterly assets of at least 4%. The Tier 1, total capital, and leverage ratios for prior periods have been restated to reflect the cumulative effect on prior years of retroactively applying Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." (2) Net interest margin is the ratio of net interest income on a fully tax equivalent basis to average earning assets. (3) Nonperforming assets include nonaccrual loans, restructured loans, and collateral on loans to which the Corporation has taken title. (4) Ratios for prior periods have been restated to reflect the reclassification of certain loans previously classified as in-substance foreclosures, consistent with a policy change adopted by the federal regulatory agencies. (5) Restated to reflect the cumulative effect on prior years of retroactively applying Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" to January 1, 1990. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following analysis of the Corporation's financial condition and results of operations as of and for the years ended December 31, 1993, 1992 and 1991 should be read in conjunction with the Consolidated Financial Statements of the Corporation and statistical data presented elsewhere herein. The Corporation acquired all of the issued and outstanding capital stock of York Bank on December 31, 1991. Since the acquisition took place on December 31, 1991, the Consolidated Statement of Income and Consolidated Average Balances of the Corporation for the year ended December 31, 1991 do not reflect the results of operations or the average balances of York Bank. EARNINGS SUMMARY The Corporation's net income for the year ended December 31, 1993 was $113.9 million, compared to $92.5 million for the year ended December 31, 1992, an increase of $21.4 million (23.1%). The major factors contributing to the increase in net income were increases in net interest income and noninterest income combined with a decrease in the provision for credit losses. The Corporation's net income for the year ended December 31, 1992 was $92.5 million, compared to $75.1 million for the year ended December 31, 1991. An increase in net interest income and a decrease in the provision for credit losses were the primary reasons for the $17.4 million (23.2%) increase in net income when 1992 is compared to 1991. Analysis of Return on Average Assets NET INTEREST INCOME Net interest income, the largest component of the Corporation's earnings, is the difference between the interest and yield-related fee income generated by earning assets and the expense associated with funding those assets. As such, net interest income represents pretax profits from the Corporation's lending, investing and funding activities. When net interest income is presented on a fully tax equivalent basis, interest income from tax exempt earning assets is increased by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the statutory Federal income tax rate of 35% for 1993 and 34% for 1992 and 1991. An analysis of fully tax equivalent net interest income, interest rate spreads and net interest margins is shown in the following two tables. Net Interest Income, Interest Rate Spread and Net Interest Margin on Average Earning Assets (Tax Equivalent Basis) - ------- (1) Interest rate spread is the difference between the ratio of interest income to average earning assets and the ratio of interest expense to average interest bearing liabilities. (2) Net interest margin is the difference between the ratio of interest income to average earning assets and the ratio of interest expense to average earning assets. Average earning assets were $8.5 billion for the year ended December 31, 1993, an increase of $305.2 million over average earning assets of $8.2 billion for the year ended December 31, 1992. This increase is primarily attributable to an increase in investment securities. Investment securities represented 33.8% of total earning assets for the year ended December 31, 1993 compared to 28.7% for the year ended December 31, 1992. The net interest margin for the year ended December 31, 1993 was 4.64% compared to 4.58% for the year ended December 31, 1992. Positively impacting net interest income and the net interest margin in 1993 was a $254.1 million increase in interest free sources of funds. This increase was primarily due to a $209.6 million increase in average noninterest bearing demand deposits. The net interest margin peaked in the first quarter of 1993 at 4.76%, but declined to 4.64%, 4.62% and 4.54% in the second, third and fourth quarters of 1993, respectively, reflecting the compression of the yield curve, the sale of higher yielding assets and reinvestment in lower yielding assets and the offering of promotional rates on certain retail products in 1993. Average earning assets were $8.2 billion for the year ended December 31, 1992, an increase of $1.1 billion over average earning assets of $7.1 billion for the year ended December 31, 1991. This increase was due to the addition of the average earning assets of York Bank which were $1.2 billion for the year ended December 31, 1992. Investment securities represented 28.7% of total earning assets for the year ended December 31, 1992 compared to 20.7% for the year ended December 31, 1991. The interest rate spread and net interest margin both improved in 1992 when compared to 1991. This improvement can be attributed to the interest rate environment in 1992. Interest rates declined in 1992 when compared to 1991. These declines benefited the Corporation because the balance sheet was structured to take advantage of these market changes. The net result was that interest expense decreased at a faster rate than interest income resulting in an improvement in the net interest spread and net interest margin in 1992. Net Interest Income Analysis (Tax Equivalent Basis) - -------- (1) The rate/volume change is allocated between volume change and rate change using the ratio each of the components bears to the absolute value of their total. Variances are computed on a line-by-line basis and are non-additive. Fully tax equivalent net interest income is affected by changes in the mix and volume of earning assets and interest bearing liabilities, market interest rates, the volume of noninterest bearing liabilities available to support earning assets, and the statutory Federal income tax rate. As the table above indicates, net interest income on a tax equivalent basis increased $19.3 million (5.2%) when the year ended December 31, 1993 is compared to the year ended December 31, 1992. An increase in the volume of earning assets, primarily due to the purchase of investment securities, resulted in the $14.1 million net interest income volume variance. The $5.2 million positive rate variance is due to a six basis point favorable variance in the net interest margin when the year ended December 31, 1993 is compared to the year ended December 31, 1992. Average interest bearing deposits decreased $322.2 million when 1993 is compared to 1992 resulting in the negative volume variance in domestic deposits. The decrease in deposits included a $210.2 million decrease in large denomination time deposits resulting from a decision to use other sources of short-term funding. This is evidenced by the positive volume variance under Federal funds sold and other short-term borrowings. Net interest income on a tax equivalent basis increased $61.3 million (19.5%) when the year ended December 31, 1992 is compared to the year ended December 31, 1991. The positive volume variance was caused by the addition of the earning assets and interest bearing liabilities of York Bank. The net interest income of York Bank, adjusted for the funding costs associated with the acquisition, resulted in approximately $34.5 million (11.0%) of the increase in tax equivalent net interest income in 1992. The remaining $26.8 million (8.5%) increase in net interest income was the result of a favorable interest rate environment in 1992. The net interest margin improved in 1992 when compared to 1991 resulting in a positive rate variance when 1992 is compared to 1991. The following table provides additional information on the Corporation's average balances, interest yields and rates, and net interest margin for the years ended December 31, 1993, 1992 and 1991. Average Balances, Interest Yields and Rates, and Net Interest Margin (Tax Equivalent Basis) - ------- (1) Interest on loans to and obligations of public entities is not subject to Federal income tax. In order to make pre-tax yields comparable to taxable loans and investments a tax equivalent adjustment is used based on a 35% Federal tax rate for 1993 and a 34% Federal tax rate for 1992 and 1991. (2) Nonaccrual loans are included under the appropriate loan categories as earning assets. (3) Includes overdrafts excluded from average loan balances for yield purposes. (4) Includes current portion of long-term debt in 1992 and 1991. (5) Net interest spread is the difference between the ratio of interest income to average earning assets and the ratio of interest expense to average interest bearing liabilities. (6) Net interest margin is the difference between the ratio of interest income to average earning assets and the ratio of interest expense to average earning assets. (7) These categories, coupled with the average balances related to $90 million in short-term borrowings from Allied Irish in 1992 and 1991 and the average balances related to $60 million in long-term debt in 1991 comprise foreign activities. The aggregate of the following categories did not exceed 10% of average total deposits: foreign banks, foreign governments and official institutions, other foreign demand deposits and other foreign savings and time deposits. (8) Restated to reflect the cumulative effect on prior years of retroactively applying Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" to January 1, 1990. PROVISION FOR CREDIT LOSSES The provision for credit losses was $45.3 million in 1993, down $12.8 million (22.1%) from the $58.1 million provision for 1992. The reduction was primarily attributable to an $8.9 million decline in bankcard provisions due to more favorable charge-off experience, and a $3.8 million decrease in York Bank's provisions due to lower loan volumes and an overall improvement in credit quality. Partially offsetting these declines was a $5.4 million increase in the Corporation's manufactured housing subsidiary's provisions resulting from a deterioration in credit quality. The 1992 provision for credit losses was $58.1 million which was down $11.4 million (16.4%) from the $69.5 million provision for 1991. Excluding York Bank's provision of $10.7 million, the provision decreased $22.1 million (31.8%). The decrease was due to lower levels of problem loans and an improvement in bankcard charge-off experience in 1992. NONINTEREST INCOME The following table presents the components of noninterest income for the years ended December 31, 1993, 1992 and 1991, and a year to year comparison expressed in terms of percent changes. Noninterest Income * Amounts excluding York Bank. The Corporation's noninterest income for the year ended December 31, 1993 was $233.4 million, a $35.3 million (17.8%) increase over noninterest income for the year ended December 31, 1992. Service charges on deposit accounts increased $4.5 million (6.5%) due to a higher level of corporate noninterest bearing demand deposits and pricing increases. Servicing income on securitized assets decreased $1.4 million (4.8%) due to a decline in securitized manufactured housing loans. Trust fees increased $619,000 (3.3%) primarily due to increased transaction volumes and advisory fees on new mutual fund products. Investment securities gains increased $13.8 million (223.8%). Investment securities sales are discussed in detail under "Investment Portfolio". Mortgage banking income increased $9.1 million (54.7%) due to increased origination volumes and improvements in the market pricing of mortgage and loan servicing sales relative to 1992. Bankcard charges and fees decreased $715,000 (3.7%) due to lower loan volumes in 1993. Customer service fees increased $1.3 million (14.4%) primarily due to a higher level of mortgage placement fees and commercial loan forbearance fees. Other noninterest income was $30.6 million in 1993 compared to $22.2 million in 1992. The primary reasons for the $8.5 million (38.3%) increase in other noninterest income were a $2.8 million increase in leasing residual gains, a $2.4 million recovery of interest on Argentine loans previously charged off, a $2.3 million increase in foreign exchange and trading income, a $794,000 increase in gains on the sale of fixed assets, a $583,000 increase in gains on the sale of other real estate, a $532,000 casualty loss recovery, and a $461,000 gain on the sale of a branch. These increases in other noninterest income were offset by a $2.9 million gain on the sale of $130.2 million in residential mortgages in 1992. The Corporation's noninterest income for the year ended December 31, 1992 excluding York Bank, was $186.1 million, a $5.6 million (3.1%) increase over the noninterest income for 1991. Service charges on deposit accounts increased $5.4 million (9.1%) due to an increased volume of corporate deposits and higher fees on retail savings accounts. Servicing income from securitized assets increased $6.2 million (27.3%) reflecting a full year of income on asset securitizations which took place in the first and third quarter of 1991. The $1.1 million (8.3%) increase in trust fees for 1992 was primarily due to higher volumes. Investment security gains decreased $5.3 million (46.4%) in 1992 compared to 1991. Investment securities sales are discussed in detail under "Investment Portfolio". Mortgage banking income increased $5.6 million (51.0%) due to increased mortgage origination fees resulting from increased loan volume. Bankcard charges and fees decreased $3.8 million (16.4%) due to decreased bankcard demand. Investment banking income increased $1.8 million (25.0%) primarily due to brokerage and mutual fund fees. Other noninterest income was $19.3 million in 1992 compared to $25.1 million in 1991. The primary reason for the $5.8 million (23.1%) decrease in other noninterest income was a $4.2 million decrease in trading account profits. NONINTEREST EXPENSE The following table presents the components of noninterest expense for the years ended December 31, 1993, 1992 and 1991 and a year to year comparison expressed in terms of percent changes. Noninterest Expense * Amounts excluding York Bank The Corporation's noninterest expenses for the year ended December 31, 1993 were $394.7 million, a $32.9 million (9.1%) increase over the noninterest expenses for the year ended December 31, 1992. Salaries and wages increased $10.4 million (6.7%) primarily due to merit and promotional increases and increases in commissions. The increase in salaries and wages included $2.1 million in severance expense resulting from the reengineering of back office support functions and the discontinuation of the Corporation's manufactured housing financing subsidiary. Other personnel costs increased $6.8 million (20.1%) primarily due to increased employee retirement plan expenses resulting from lower returns on retirement plan assets, lower discount rates and reduced employee turnover. In addition, the implementation of Statement of Financial Accounting Standards No. 106, "Employers Accounting For Postretirement Benefits Other Than Pensions", resulted in a $2.6 million increase in other personnel costs in 1993. Occupancy costs increased $1.3 million (4.4%) due to property rent expense associated with new facilities and scheduled rent increases on existing facilities. Equipment costs increased $2.0 million (7.7%) primarily due to an increase in depreciation expense associated with computer hardware and software purchases. Lending and collection expenses increased $2.2 million (19.7%) with the most significant increases in bankcard fraud losses ($692,000) and outside appraisal expenses ($543,000). Professional fees increased $4.5 million (52.5%) primarily due to consulting fees associated with major system conversions. Advertising and public relations expense increased $1.6 million (16.6%) due to increased advertising budgets in 1993. Other real estate expenses decreased $2.6 million (27.7%) due to a $335,000 decrease in provisions for losses on other real estate and a $2.3 million decrease in expenses associated with other real estate properties. Other noninterest expenses were $55.2 million in 1993 compared to $49.1 million in 1992. The primary reasons for the $6.1 million (12.4%) increase in other noninterest expenses were a $3.4 million increase in the amortization of bankcard premiums, a $2.1 million increase in personal property expense due to an increase in the capitalization threshold in 1993 and the upgrading of computer workstations throughout the Corporation this year, an $803,000 increase in printing and supplies expenses primarily due to printing costs incurred for a bankcard solicitation program, and a $600,000 accrual for discontinued operations at the Corporation's manufactured housing subsidiary. Offsetting these increases in noninterest expense was a $1.8 million write-off of a subsidiary bank's unamortized goodwill balance in 1992. The Corporation's noninterest expenses for the year ended December 31, 1992 excluding York Bank, were $324.4 million, a $20.4 million (6.7%) increase over the noninterest expense for 1991. Salaries and wages rose $10.5 million (8.0%) primarily due to incentive compensation increases associated with higher mortgage banking revenues and merit increases. The $3.8 million (14.3%) increase in other personnel costs was related to increases in payroll taxes, health care costs, and deferred benefit expenses. Net occupancy costs and equipment costs increased $268,000 (1.0%) and $350,000 (1.6%) respectively, for 1992. Other operating expenses increased $5.4 million (5.6%) in 1992 when compared to 1991. This increase was attributable to a $1.7 million (26.4%) increase in other real estate expense in 1992. The $1.1 million (8.8%) increase in examinations and assessments expense was principally the result of a full year of expense related to the deposit insurance rate increase in July of 1991. The increase in professional fees of $1.7 million (27.8%) was largely attributable to increased legal fees and consulting work for systems conversions. The $1.1 million (13.5%) increase in advertising and public relations was due to normal increases in advertising budgets. All other expenses increased $366,000 (0.9%) due primarily to a $1.8 million write-off of a subsidiary bank's unamortized goodwill balance in September of 1992. In addition, decreased transaction volume reduced the bankcard processing fees by $1.2 million (15.3%) for 1992. INCOME TAXES The Corporation's effective tax rate on earnings in 1993 was 35.6% compared to 34.7% in 1992 and 31.8% in 1991. The increase in the effective tax rate in 1993 was due to an increase in the statutory tax rate from 34% to 35% and a decrease in tax-exempt income as a proportion of income before income taxes. The net effect of these and other lesser factors and the increase in pre-tax income accounted for the tax provision increase of $13.6 million in 1993. Additional information related to income taxation is presented in Note 14 of the Notes to Consolidated Financial Statements of the Corporation. PROSPECTIVE ACCOUNTING CHANGES New and prospective accounting changes relating to accounting for postemployment benefits and the accounting for loan impairment are discussed below. Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits"--In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." Statement 112 establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement. This Statement is effective for fiscal years beginning after December 15, 1993. The adoption of Statement 112 is not expected to have a material effect on the financial statements of the Corporation. Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan"--In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan." Statement 114 applies to loans that are considered impaired, where it is probable that the creditor will not collect all principal and interest payments according to the loan's contractual terms. Under Statement 114, impaired loans must be measured at the present value of the loan's expected future cash flows discounted at the loan's effective interest rate, observable market price of the loan, or fair value of the collateral. If the measure of an impaired loan is less than the recorded investment, a valuation allowance must be established through a corresponding charge to the provision for credit losses. The Statement is effective for fiscal years beginning after December 15, 1994. The impact that adoption of Statement 114 will have on the financial statements is currently under review, but is not expected to have a material effect on the financial statements of the Corporation. QUARTERLY SUMMARY The following table presents a summary of earnings by quarter for the years ended December 31, 1993 and 1992: Summary of Quarterly Earnings - -------- (1) Restated to reflect the reclassification of in-substance foreclosures provisions, consistent with a policy change adopted by the federal regulatory agencies. LIQUIDITY Liquidity is the ability of the Corporation to meet a demand for funds, such as deposit outflows, net new loan requests and other corporate funding requirements. Liquidity can be obtained either through the maturity or sale of assets or the issuance of liabilities at acceptable costs within an acceptable period of time. The liquidity of the Corporation is enhanced by asset and liability management policies. The Funds Management Policy Committee is responsible for setting general guidelines regarding the Corporation's sources and uses of funds, asset and liability sensitivity, and interest margins, pursuant to the Corporation's Funds Management Policy approved by the Board of Directors. The Committee's goals foster the stable generation of increased net interest income without sacrificing credit quality, jeopardizing capital or adversely impacting liquidity. The Corporation maintains a level of asset and liability liquidity based on an internal assessment of its ability to meet obligations under both normal and adverse conditions. The Corporation experienced high levels of liquidity during 1993. The ratio of liquid assets to total assets at December 31, 1993 was 26.8%. Liquid assets are defined as vault cash, balances with the Federal Reserve Banks of Richmond and Philadelphia, unencumbered investment securities (including held-to- maturity investment securities), assets available for immediate borrowing from the Federal Reserve Banks of Richmond and Philadelphia and money market assets. Additionally, the Corporation measures liquidity by calculating the ratio of its liquid assets to credit sensitive liabilities. Credit sensitive liabilities are defined as wholesale liabilities where the credit rating of the Corporation would have a significant impact on the Corporation's ability to roll over maturing liabilities. At December 31, 1993, the ratio of liquid assets to credit sensitive liabilities was 212.2%. The Corporation expects the high level of liquidity to continue during 1994. ASSET/LIABILITY MANAGEMENT Asset and liability management is a process that involves the development and implementation of strategies to maximize net interest margin while minimizing the earnings risk associated with changing interest rates. The Funds Management Policy Committee has responsibility for the overall management of the Corporation's asset and liability position, pursuant to the Corporation's Funds Management Policy approved by the Board of Directors. The Committee manages the Corporation's asset and liability position within the constraints of maintaining capital adequacy, liquidity and safety. Management of the interest rate risk of the Corporation is effected through adjustments to the size and duration of the available-for-sale investment portfolio, the duration of purchased funds and other borrowings, and through the use of interest rate derivatives such as interest rate swaps, interest rate caps and floors and financial futures. The use of derivatives augments the Corporation's management of interest rate risk, liquidity risk, basis risk, and also assists customers in the management of their interest rate risk. Interest rate derivatives are used by the Corporation to lengthen or shorten the duration of its liabilities, extend the duration of its assets, or reduce the basis risk between rate resets on sources of funds and rate resets on uses of funds. Interest rate derivatives allow the Corporation to issue liabilities based on customers' or market requirements and swap these liabilities to maturities or indices suitable to the needs of the Corporation. The Corporation's interest rate derivatives portfolio at December 31, 1993 is shown in the following table. Derivatives Portfolio The market value of the derivatives portfolio as of December 31, 1993 was $3,234,000. Measurement of the Corporation's sensitivity to changing interest rates is accomplished primarily through an earnings simulation model. Throughout 1993, the Corporation maintained a balance sheet that would benefit from falling interest rates. This liability sensitive position remained at December 31, 1993. As previously mentioned, the Corporation uses simulation techniques to measure the potential impact of interest rate changes on earnings. The simulation model associates projected changes in balance sheet activity with underlying repricing frequency to determine the effects of interest rate movements on the Corporation's net interest margin. The simulation models are adjusted and executed monthly. At December 31, 1993, the simulation results under a ^ 200 basis point change in interest rates reflected projected changes in the Corporation's net interest margin which were considered acceptable and within the Corporation's guidelines for managing interest rate risk. The maximum interest rate risk acceptable to the Corporation would place at risk 10% of stockholders' equity given the immediate and sustained ^ 200 basis point change in interest rates of which no more than one-third of that risk may be exposed in any one year. The net interest rate sensitivity of the Corporation at December 31, 1993 is illustrated in the following table. This information is presented for six different time periods reflecting the balances of assets and liabilities with rates that are subject to change, any rate sensitive off-balance sheet contracts and data regarding funds which are not sensitive to interest rates. As indicated in the following table, the Corporation is liability sensitive in the near term and becomes asset sensitive over the long term. The table shows the sensitivity of the balance sheet at one point in time and is not necessarily indicative of the position on other dates. Interest Rate Sensitivity * Includes investment securities available-for-sale. In developing the classifications used for the preceding table, it was necessary to make certain assumptions and approximations in assigning assets and liabilities to the different maturity categories. These assumptions have been developed by Management over a period of time and reflect its best assessment of current conditions. These assumptions are continuously reviewed since they are subject to factors brought about by the development of new products and changes in consumer behavior patterns. INVESTMENT PORTFOLIO The Corporation adopted the provisions of Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" ("FAS 115") on December 31, 1993. Pursuant to the requirements of FAS 115, investment securities may be held in one of three separate portfolios. When the Corporation has the intent and ability to hold a security to maturity, it will be held in the held-to-maturity ("HTM") portfolio. Such securities are recorded at cost, net of amortization of premium and accretion of discount. At December 31, 1993, the book value of the HTM portfolio was $1.7 billion. If and when the Corporation intends to hold a security for an indefinite time period, or intends to use a security to manage the interest rate risk of the balance sheet, those securities will be held in the available-for-sale ("AFS") portfolio. The AFS portfolio is marked-to-market on a monthly basis. Changes in the fair value of the AFS portfolio are excluded from earnings and reported in a separate component of equity, net of taxes. At December 31, 1993, the book value of the AFS portfolio was $1.3 billion, approximately $43.6 million above the amortized cost of the portfolio. Lastly, investment securities purchased for very short time horizons with the intent to benefit from changes in market rate or price are held in the trading account. This portfolio is carried at market value which was $53.3 million on December 31, 1993. Changes in the market value of the trading account are recorded in the income statement. Prior to the adoption of FAS 115, investment securities purchased for a shorter time horizon or to manage the interest rate risk of the balance sheet were classified as held-for-possible-sale. This portfolio was carried at the lower of cost or market value. The AFS and HTM investment portfolios are comprised of four basic types of securities: U.S. Treasury and U.S. agency securities ("U.S. Treasury and Agency"), mortgage-backed obligations of Federal agencies ("MBS's"), collateralized mortgage obligations ("CMO's"), and obligations of states and political subdivisions ("Municipals"). The book value of other investment securities accounted for only 1.3% of the book value of the total portfolio at December 31, 1993. The securities of no single issuer other than the U.S. Government and related agencies exceeded 10% of stockholders' equity at December 31, 1993. Substantially all of the Municipals are rated A or higher by Moody's Investors Service, Inc. and approximately 58% are rated AAA. Investment securities classified as other securities are generally unrated. At December 31, 1993, the book value of the total investment portfolio (both AFS and HTM in 1993) was $3.0 billion compared with $2.6 billion at December 31, 1992. The portfolio size increased from 29.8% of total assets at December 31, 1992 to 31.7% at December 31, 1993. This increase in the overall investment portfolio was prompted by continued lackluster lending activity, by weak macro- economic growth and excellent investment opportunities precipitated by the shape of the yield curve. Available-for-Sale Investment Portfolio The AFS portfolio is managed from a total return perspective. As such, securities will often be sold out of the AFS portfolio when management deems that a greater return can be earned in another type of security (including cash) or that the interest rate risk in the balance sheet is not appropriate for the prevailing micro- and macro-economic climate. All of the Corporation's 15-year MBS's, selected CMO's, municipal obligations, adjustable rate MBS's and floating rate CMO's are held in the AFS portfolio. The cash flows of the 15-yr MBS's were deemed too uncertain relative to the current micro- and macro-economic conditions facing the Corporation. They were, therefore, placed in the AFS portfolio. Occasionally, CMO's have been purchased to manage the interest rate risk of the Corporation. Because these CMO's might be sold, they have been placed in the AFS portfolio. The floating rate CMO's and adjustable rate MBS's, though interest rate insensitive, have long average lives that make it less likely that the Corporation will hold them to maturity. Municipals are held in the AFS portfolio because they might be sold in response to a change in the tax position of the Corporation. The following table sets forth the amortized cost and book value of the available-for-sale securities owned by the Corporation. Available-for-Sale Investment Portfolio - -------- (1) The book value of investment securities classified as available-for-sale is equal to fair value. (2) Issues of the Federal Home Loan Mortgage Corporation or the Federal National Mortgage Corporation included in the amortized cost and book values presented totaled $122.8 million and $126.6 million, respectively. At December 31, 1993, the book value of the Corporation's AFS investment portfolio was approximately $43.6 million above the amortized cost of the portfolio. Gross unrealized gains on AFS debt securities of $39.2 million far exceeded gross unrealized losses of $2.3 million at year end. More specifically, the net unrealized gain at December 31, 1993 on MBS's was $13.7 million, on CMO's $3.8 million, and on municipals $19.4 million. Gross unrealized gains on AFS equity securities were $6.7 million at December 31, 1993. On December 31, 1992, the Corporation's entire investment portfolio (prior to AFS/HTM split) had a market value of $62.6 million above its book value. The following table shows the maturity distribution of the available-for-sale investment portfolio of the Corporation at December 31, 1993 based upon amortized cost. Maturity of Available-for-Sale Investment Portfolio - -------- (1) The maturity distribution is based upon a constant prepayment rate of 20% for adjustable rate MBS's and fixed and floating rate CMO's. The following table reflects the approximate weighted average tax equivalent yield (at an assumed Federal tax rate of 35%) of the available-for-sale investment portfolio at December 31, 1993 based upon amortized cost. Available-for-Sale Investment Portfolio (Tax Equivalent Yields) - -------- (1) Computation of weighted average tax equivalent yields includes $97.9 million of floating rate MBS's and $36.4 million of floating rate CMO's. Held-to-Maturity Investment Portfolio The HTM portfolio is managed from an interest income perspective. Therefore, security sales and transfers from the HTM portfolio will be very infrequent. Occasionally, the Corporation will "clean up" the portfolio by selling its holdings of MBS's and CMO's that have paid down at least 85% of the purchased principal and are thus too small to efficiently administer. Also, unanticipated changes in tax law or regulatory capital standards could precipitate a sale. Securities could also be sold if there were a deterioration in the financial condition of the issuer of a security, if the security (after it is held one year) is within three months of maturity, or if the Corporation is involved in a major business combination or disposition. Securities will not be sold out of the HTM portfolio in response to changes in loan demand, interest rates, or prepayment speeds. Likewise, the Corporation will not use securities in the HTM portfolio to manage the interest rate risk of the Corporation. Treasuries have very stable cash flows, minimum credit risk, and utilize no capital on the margin. They are therefore an excellent offset to the duration of the Corporation's liabilities. MBS balloon securities have relatively stable cash flows due to the balloon structure, utilize only a small amount of capital and also have minimum credit risk. In general, CMO's are bought to offset core liabilities and capital of the Corporation. These CMO's are held in the HTM portfolio. Like MBS balloons, the HTM CMO's have only slightly less stable cash flows than Treasuries with low capital requirements and minimum credit risk. Coupled with a high interest spread over Treasuries, these short-duration, stable CMO's were best suited for the HTM portfolio. The following table sets forth the book value of the held-to-maturity securities owned by the Corporation. Held-To-Maturity Investment Portfolio - -------- (1) At December 31, 1993, 1992 and 1991, $450.4 million, $538.6 million and $250.9 million of CMO's, respectively, were issues of the Federal Home Loan Mortgage Corporation or the Federal National Mortgage Corporation. The following table shows the maturity distribution of the held-to-maturity securities owned by the Corporation: Maturity of Held-to-Maturity Investment Portfolio - -------- (1) The maturity distribution is based upon constant prepayment rates of 48% for 7 year MBS's, 20% for 15 year MBS's and 20% for CMO's. The following table reflects the approximate weighted average tax-equivalent yield (at an assumed Federal tax rate of 35%) on held-to-maturity investment securities at December 31,1993. Held-to-Maturity Investment Portfolio (Tax Equivalent Yields) At December 31, 1993, the market value of the Corporation's HTM investment portfolio was approximately $21.8 million above the amortized cost (book value) of the portfolio. Gross unrealized gains on HTM debt securities of $24.6 million far exceeded gross unrealized losses of $2.8 million at year end. More specifically, the net unrealized gain at December 31, 1993 on Treasuries was $18.5 million, on MBS's $2.8 million, and on CMO's $477,000. Investment Securities Sales Proceeds from the sale of investment securities during 1993 amounted to $711.1 million resulting in pretax gains of $19.9 million. This compares to realized gains of $6.2 million on $470.0 million of sales in 1992 and gains of $15.4 million on $526.8 million of security sales in 1991. In March and April of 1993, high coupon MBS's totaling approximately $280.8 million were sold from the held-for-possible-sale portfolio generating gains of $14.9 million. In May and June of 1993, an additional $408.7 million in Treasury notes were sold from the held-for-possible-sale portfolio generating gains of $4.2 million. High coupon MBS's were sold to manage prepayment risk and Treasuries were sold to manage the duration risk of the portfolio. The proceeds from the sale of these securities were used to purchase lower coupon mortgage-backed securities, shorter duration MBS balloons, shorter duration Treasuries, adjustable-rate mortgage pass-thrus, and short duration, stable, CMO's with more certain cash flows. There were no material sales of securities held in the HTM portfolio in 1993. CREDIT RISK MANAGEMENT Credit approval policies for the Corporation are designed to provide an effective and timely response to loan requests and to ensure the maintenance of a sound loan portfolio. The Corporation manages credit risk and the credit approval process by adhering to written policies which generally specify underwriting standards by industry and in some cases limit credit exposure by industry, country or product type. All such policies are reviewed and approved annually by the Board of Directors. The Banks each establish individual loan authority levels based on the specific job responsibilities of their officers. The Banks also have loan committees which approve credit exposure above individual loan authorities. Larger credit exposures are reviewed by executive committees appointed by the Boards of Directors of the Banks. The Loan Review function, which reports independently to the Board of Directors' Audit Committee, annually reviews all lending units in the Corporation. It also maintains a continuous review of the loan portfolio to ensure the accuracy of risk ratings, to verify the identification of problem credits, to provide executive management with an independent and objective evaluation of the quality of the portfolio, and to assist the Board of Directors in evaluating the adequacy of the allowance for credit losses. The internal review function is further enhanced through examinations by independent auditors and regulators. LOAN PORTFOLIO The following table sets forth the composition of the loan portfolio by type of loan and the percentage of loans by category. Composition of the Loan Portfolio The following table displays the contractual maturities and interest rate sensitivities of the loans of the Corporation at December 31, 1993. The Corporation's experience indicates that certain of the loans will be renewed, rescheduled, or repaid prior to scheduled maturity. Accordingly, the table should not be regarded as a forecast of future cash collections. Contractual Loan Maturities - -------- (1) Includes demand loans, loans having no stated schedule of repayments or maturity, and overdrafts. (2) The variable interest rate loans generally fluctuate according to a formula based on prime rate. COMMERCIAL LOANS Commercial loans represent 31.3% of the Corporation's total loans and leases at December 31, 1993 and include short and medium term loans, revolving credit arrangements, lines of credit, asset based lending and equipment lending. The commercial loan portfolio is segregated by market sector as well as geographic regions. The primary segmentation divides the commercial loan portfolio into three market sectors, Multinational, Middle Market and Small Business. The organizational components of the Multinational Group (46.7% of total outstandings) are, the National Division calling on large Fortune 500 companies often with a significant presence in the Maryland marketplace, the Maryland Division which services similar sized companies headquartered in Maryland and its contiguous states, and the Financial Institutions Division which calls on financial intermediaries within Maryland and throughout the country. In addition, the Multinational Group includes several specialized lending functions, the most significant of which are Healthcare, Communications, Transportation, Commercial Leasing and Asset Based lending. The Corporation's Middle Market customers (approximately 40.3% of outstandings) are generally those in the Maryland marketplace with sales volumes of $5 to $100 million, while the Corporation's Small Business customers (13.0% of outstandings) have sales volumes of less than $5 million. Both Middle Market and Small Business lending activities are directed through the Corporation's regional structure and utilize the Corporation's market presence and branch organization to develop market opportunities. Middle Market and Small Business lending deals with the full range of business organizations and employs other specialized lending groups within the Corporation as needed. The majority of the Corporation's commercial lending is in the Maryland market, with 65.1% of the Corporation's commercial loans made in the Maryland marketplace. The Corporation's commercial loan portfolio decreased $122.8 million or 7.0% from December 31,1992 to December 31,1993. General economic uncertainty plagued many of the Corporation's market sectors, and business owners remained cautious. As economic stagnation continued in 1993, the Corporation saw very little capital expansion planned by customers. In addition to monitoring exposure based on market segment, the Corporation monitors exposure based on industry classifications and establishes exposure limits that are reviewed by the Board of Directors. Loan Portfolio Distribution by Industry Classification - -------- (1) Includes exposure to hospitals and nursing care facilities, both commercial loans and real estate loans (2) Includes loans and leases for vessel, commercial aircraft and railroad equipment financing The loans in the Communications portfolio are to companies and systems located throughout the United States. The Communications Industry group is broken down into four distinctly independent industries. Cable television represents 43.9% of total outstanding with Wireless representing 31.4%, Publishing and Newspapers, 18.5% and Broadcasting, 6.2%. With the exception of Wireless, these are mature industries with most loans representing the purchase and/or expansion of existing companies and systems. Wireless is a rapidly emerging industry with many of the loans representing the establishment of relatively new systems. Most of the loans to the Communications Industries are multibank facilities. COMMERCIAL REAL ESTATE The Corporation's commercial real estate outstandings were $1.2 billion at December 31, 1993, representing 23.9% of total loans, an increase of $2.4 million from December 31, 1992. While the absolute levels of the portfolio outstandings did not change appreciably, the product mix continued to shift to a greater concentration in commercial mortgages. This change is attributed to completed construction properties converting to permanent commercial mortgages as well as the scarcity of viable new construction business. The Corporation's commercial real estate loan portfolio represents loans secured primarily by real property, other than loans secured by mortgages on 1- 4 family residential properties. Commercial real estate would include the loan categories presented in the following table. Commercial Real Estate Outstandings The commercial real estate portfolio is well diversified by project type and geographic location as illustrated in the following two tables. At December 31, 1993, office buildings comprised the largest portion of the commercial real estate portfolio representing 26.9% of total loans outstanding and other real estate owned. Industrial warehouse and other commercial properties at 16.2% and retail properties at 14.3% also comprise a significant portion of the commercial real estate portfolio. Loans Secured by Real Estate and Other Assets Owned by Property Type As the following table indicates, 64.8% of the aggregate commercial real estate portfolio at December 31, 1993, was secured by properties in Maryland, 15.3% in Pennsylvania, and 6.5% in Virginia. Consistent with the Corporation's strategy to lend on real estate in its primary markets, only 7.7% of the Corporation's commercial real estate was secured by properties outside the Mid- Atlantic marketplace. Loans Secured by Real Estate and Other Assets Owned by Geographic Region The real estate downturn in the Mid-Atlantic marketplace put severe pressure on the portfolio during the past 3 1/2 years. It would appear, however, that market conditions began to improve in the second half of 1993 and that gradual improvement can be expected going forward in particular property types and sub- markets. The Corporation's commercial real estate portfolio quality has exhibited marked improvement throughout 1993. The commencement of stabilization in the marketplace along with the workout efforts and restructuring of 1991-1992 helped to produce 1993's positive results. At the same time, new high quality loans were recorded. Non-accrual loans declined 38.1% to $48.3 million and owned real estate was reduced by 14.7% to $19.0 million. See Nonperforming Assets section for further discussion. REAL ESTATE, CONSTRUCTION The Corporation's construction lending portfolio decreased $43.1 million in 1993, reflecting the continued unfavorable markets for new development and portfolio adjustments to move completed projects into permanent financing. Lenders and developers continue their retrenchment as the unfavorable economic climate has remained. There is minimal real estate construction growth forecasted for the near term, although the Corporation continues to solicit the few high quality loan opportunities available in the marketplace to offset the expected continuing run-off. Real estate construction outstandings include land acquisition and development loans, and building construction loans. The most recent assessment of real estate construction outstandings indicated that 90% of construction loan projects were at least "shell complete" (the building is essentially complete except for tenant specific interior improvements on unleased space) and approximately 92% of land loan projects were fully developed. As a result, at December 31, 1993, there was minimal building and land construction risk associated with the Corporation's real estate construction outstandings. Leasing risk within the portfolio is also modest as buildings are on average 91% leased or preleased. REAL ESTATE MORTGAGE, COMMERCIAL The Corporation's commercial mortgage portfolio increased $45.5 million in 1993, reflecting the transfer of completed projects into permanent financing and the ability of the Corporation to record selective new loans. Approximately $394.6 million (41.2%) of the outstandings are owner-occupied, for which repayment is primarily dependent on the operation of the owners' businesses. The Corporation intends to continue to actively solicit this business to support its emphasis as a relationship lender for regional companies. The remaining $563.0 million are investment property mortgages which are generally dependent on the operation, sale, or refinancing of the collateral. With new construction activity diminished, the Corporation will continue to selectively provide acquisition and refinancing loans. REAL ESTATE MORTGAGE, RESIDENTIAL The Corporation originates residential mortgage loans primarily for sale in the secondary market. New residential mortgage loan originations are primarily financed through the Corporation's mortgage banking subsidiary, First National Mortgage Corporation, and are limited to Maryland, Washington, D.C., Virginia, Delaware, Pennsylvania and West Virginia. This market has generally shown growth in per capita income, a relatively low unemployment rate, a diversified and stable economic base and, despite recent local economic weakness, charge- offs have been negligible. Substantially all loans originated by the mortgage banking subsidiary are classified as loans held-for-sale on the consolidated statements of condition of the Corporation. New originations retained for the Corporation's residential real estate mortgage portfolio consist primarily of low-income housing, non-convertible Jumbo ARMS and residential construction loans. Residential mortgages retained in the portfolio at December 31, 1993 increased $115.4 million from December 31, 1992 primarily as a result of the success of the non-convertible Jumbo ARM product. RETAIL The Corporation provides a wide range of retail loan products including installment and other personal loans, home improvement loans, home equity loans, automobile and other personal property consumer financings. The recent economic recession created higher unemployment, which combined with higher levels of personal debt, put consumers under increasing pressure to meet their obligations. These pressures have resulted in rising rates of personal bankruptcies and consumer loan defaults. Despite these negative trends, the Corporation's delinquency and net charge-off experience with retail loan products has been generally better than industry averages due to stricter underwriting standards and collection procedures. When compared to December 31, 1992, retail loans at December 31, 1993 decreased $55.6 million. This decrease is largely due to the sale of $57.3 million in manufactured housing receivables in the fourth quarter of 1993 and the Corporation's decision to phase out indirect automobile and boat lending. Retail loan demand is currently weak and is not expected to improve in the short term. BANKCARD The Corporation through its subsidiary, First Omni, offers both VISA(R) and MasterCard(R). Outstanding bankcard receivables increased to $527.7 million at December 31, 1993 from $494.9 million at December 31, 1992 largely due to direct solicitation efforts in 1993. First Omni will continue to increase the portfolio by increasing the level of direct solicitation efforts and by pursuing the purchase of small portfolios as opportunities arise. All delinquent bankcard accounts are charged off when they reach 180 days past due. Also, all accounts held by account holders who become deceased or file bankruptcy are charged off the month that advice of death or bankruptcy is received. LEASES RECEIVABLE Leases receivable include retail automobile, small equipment and general equipment leasing portfolios. Leases receivable increased to $211.8 million at December 31, 1993 from $206.3 million at December 31, 1992. The general equipment leasing portfolio represents approximately 84.3% of total lease receivables with an emphasis on transportation equipment. The primary market for direct sales calling efforts on customers and targeted prospects is the Mid-Atlantic region. Other regions comprise a secondary market for direct sales calling but with a greater reliance on outside referral sources. Competition includes banks, as well as non-bank, independent and captive finance and leasing companies and income funds. FOREIGN Loans to foreign banks increased $1.8 million during 1993. This increase was due to refinancing of Letters of Credit in the Latin American portfolio. Foreign commercial and industrial loans were $186.5 million at December 31, 1993, an increase of $35.5 million when compared to December 31, 1992. Commercial and industrial loan exposure consists of maritime industry exposure (76%), non-maritime Latin American (21%) and European (3%) exposure. The maritime portfolio is widely diversified, both geographically and by asset type and is secured by first mortgages/liens. All of the $19.7 million in government and official institution exposure was in Latin America. Government and official institutions are central, state, provincial and local governments in foreign countries and their ministries, departments and agencies. The economies of virtually all Latin American countries where the Corporation has exposure continued to evidence a steady trend of improvement in 1993. Lower inflation, improving trade balances, and healthy reserve positions to fund trade deficits characterized most of those economies where the Corporation has exposure. Latin American outstandings continue to represent a higher level of risk than other foreign obligations and are identified as the only foreign obligations where balance of payment uncertainties and/or liquidity pressures might adversely impact the timely repayment of debt. Most of the Corporation's Latin American exposure lies in Mexico where economic indicators demonstrated continued improvement. The bulk of the Mexican exposure is tied to trade facilities extended to key private sector multinationals. Lower inflation, a stable currency, a balanced federal budget, the passage of NAFTA, and continued inflow of foreign funds for both direct and portfolio investment are positive trends mitigated only by the country's continuing trade deficit. The latter is tied largely to capital and intermediate goods imports to finance the modernization of the private sector economy and is believed to be manageable. ASSET QUALITY Economic Environment The economic recession and deteriorating conditions in the commercial real estate market that were prevalent in most of the United States during the past several years had an adverse effect on the Corporation's primary markets in the period 1990 through 1992. These conditions, combined with increased regulatory scrutiny of financial institutions, created a less stable economic and regulatory environment for all financial institutions. More recently, however, generally improving economic and market conditions have contributed to a reduction in the financial difficulties faced by some of the Corporation's borrowers. Although further deterioration in the commercial real estate and real estate construction markets is possible without a more pronounced pick up in the pace of the economy in Maryland and adjacent states, the most severe problems appear to be receding. The Corporation anticipates modest near term improvement in general economic conditions, and expects that these trends, and their effect on asset quality, will be positive in 1994. NONPERFORMING ASSETS Nonperforming assets totaled $135.4 million at December 31, 1993, a decrease of $64.3 million (32.2%) when compared to $199.7 million in nonperforming assets at December 31, 1992. The decrease in nonperforming assets was due to a combination of factors. Among the most significant factors were a slow down in the number of new nonaccrual loans, pay downs, other real estate owned sales, loans reclassified to accrual status and charge-offs. The loans reclassified to accrual status included loans reclassified through the troubled debt restructuring process as well as through the process discussed in the following paragraph. At this time, the Corporation does not anticipate significant new nonaccruals in 1994, and expects that the overall level of nonperforming assets will continue to decline. Loans are placed on nonaccrual status when interest or principal has been in default for 90 days or more, and the loan is not both well secured and in the process of collection; payment in full of interest or principal is not expected; or the loan is on a cash basis because of deterioration in the financial position of the borrower. A loan remains on nonaccrual status until it is either current as to payment of principal or interest with the borrower demonstrating the ability to pay and remain current, or it meets revised regulatory guidance on returning to accrual status even though the loan has not been brought fully current. Under these circumstances two criteria must be met: (1) all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within a reasonable period, and (2) there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms involving payments of cash or cash equivalents. Restructured loans are "troubled debt restructurings" as defined in Statement of Financial Accounting Standards No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings." Nonaccrual loans would not be included in troubled debt restructurings. Other real estate and other assets owned represent collateral on loans to which the Corporation has taken title. This property, which is held for resale, is carried at fair market value minus estimated costs to sell. Consistent with regulatory guidance on the reporting of in-substance foreclosures and the recently issued (but not yet adopted) Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," the Corporation no longer reports loans as in-substance foreclosures unless the Corporation has possession of the collateral. For collateral dependent real estate loans where the Corporation has not taken title, loss recognition through a charge to the allowance for credit losses is based on the fair value (as defined in paragraph 13 of FAS 15) of the collateral if foreclosure is probable with the loan remaining in the loan category. The following table sets forth nonperforming assets and accruing loans which are 90 days or more past due as to principal or interest payments on the dates indicated. Nonperforming Assets - -------- (1) Includes $1,793,000 in commercial loans classified as held-for-sale at December 31, 1993. (2) Includes $2,308,000 in commercial mortgages classified as held-for-sale at December 31, 1993. The following table details the gross interest income that would have been received during the year ended December 31, 1993 on nonaccrual loans had such loans been current in accordance with their original terms throughout the year and the interest income on such loans actually included in income for the year. At December 31, 1993, the Corporation was monitoring loans totaling $30.9 million not classified as nonaccrual, restructured or past due loans. These loans demonstrate characteristics which may result in classification as such in the future. There were no other interest bearing assets, other than loans, at December 31, 1993 which were classifiable as nonaccrual, restructured, past due or potential problem assets. PROVISION AND ALLOWANCE FOR CREDIT LOSSES The allowance for credit losses (the "Allowance") is created by direct charges against income (provision for credit losses). The amount of the Allowance equals the cumulative total of the provisions made from time to time, reduced by credit charge-offs, and increased by recoveries of credits previously charged off. In addition, the Allowance will increase by the allowance for credit losses of portfolios acquired and will be reduced by the allowance for credit losses associated with portfolios sold. It is the policy of the Corporation to comply fully with OCC Banking Circular 201 (Revised) and the supplementary Interagency Policy Statement on the Allowance for Loan and Lease Losses released December 21, 1993. The Corporation maintains an Allowance sufficient to absorb all estimated inherent losses in the loan and lease portfolio. Inherent losses are losses that meet the criteria in Statement of Financial Accounting Standards No. 5 for recognition of charges to income. This requires the determination that it is probable that an asset has been impaired. All outstanding loans, leases and legally binding commitments to lend are considered in evaluating the adequacy of the Allowance. In addition, a provision for inherent losses arising from off-balance sheet commitments such as standby letters of credit are included in the Allowance. The Allowance does not provide for inherent losses stemming from uncollectible interest because Corporation policy requires all accrued but unpaid interest to be reversed once a loan is placed on nonaccrual status. All loans classified doubtful and all nonaccrual loans classified substandard are analyzed individually to determine specific reserves. All other loans and leases are segmented into pools based on their risk ratings. Reserve allocation for these pools is based upon historical loss experience. The methodologies used for determining historical loss rate factors include actual loss experience over a period of years, loss migration analysis, or a combination of the two. In addition, the historical loss percentage for each pool is adjusted to reflect current conditions. Among the factors considered are the levels and trends in delinquencies and nonaccruals; trends in volumes and terms of loans; effects of any changes in lending policies and procedures; the experience, ability and depth of the lending management and staff; national and local economic trends and conditions; and concentrations of credit. The Corporation's Loan Review Group reports independently to the Board of Directors' Audit Committee. This unit's responsibility is to maintain a continuous review of the loan portfolio to ensure the accuracy of risk ratings, to verify the identification of problem credits, to provide executive management with an independent and objective evaluation of the quality of the portfolio and to assist the Board of Directors in evaluating the adequacy of the Allowance. In the retail loan and residential loan areas, this review is conducted primarily by a retail loan review staff which monitors performance trends. Formal reviews are supported by management information systems which are designed to identify accounts which deviate from established lending policies. In other lending areas, a team of loan review officers systematically inspects the credit files to identify potential credit problems. The review process as detailed above is used by the Corporation in forming its conclusion that the Allowance is adequate at December 31, 1993. The following table details certain information relating to the Allowance and credit losses of the Corporation for the five years ended December 31, 1993. See also Note 7 of the Notes to Consolidated Financial Statements of the Corporation. Analysis of the Allowance for Credit Losses The following table provides an allocation of the Allowance to the respective loan classifications. The Corporation does not believe that the Allowance can be fragmented by category with any precision. The allocation of the Allowance is based on a consideration of all of the factors discussed above which are used to determine the Allowance as a whole. Since all of those factors are subject to change, the allocation of the Allowance detailed below is not necessarily indicative of future losses or future allocations. The Allowance at December 31, 1993 is available to absorb losses occurring in any category of loans. Allocation of the Allowance for Credit Losses DEPOSITS The table below provides information on the average amount of and rates paid on the deposit categories indicated for the years ended December 31, 1993, 1992 and 1991. The aggregated amount of foreign deposits did not exceed 10% of average total deposits. The majority of deposits in the foreign banking office were in amounts in excess of $100,000. Average Deposits and Average Rates Paid The following table details the maturity of domestic deposits of $100,000 or more on December 31, 1993. Maturity Distribution of Certificates of Deposit and Other Time Deposits in Amounts of $100,000 or More SHORT-TERM BORROWINGS To the extent that deposits are not adequate to fund customer loan demand in the Banks, or to the extent that long-term borrowings are inadequate to fund loan demand of other subsidiaries of the Corporation, liquidity needs can be met in the short-term funds markets. The Corporation utilizes many sources to meet these short-term needs. The following table provides information with respect to each of these sources over the three years ended December 31, 1993. Short-term Borrowings Short-term borrowings include master demand notes of the Corporation. This product is an unsecured obligation of the Corporation which was developed to meet the overnight investment needs of the Corporation's cash management customers. Under the masternote program, investable customer balances are swept daily into demand notes. The proceeds of these notes are used to provide short- term funding to the Corporation's nonbank subsidiaries with any excess funds invested in short-term liquid assets. Outstanding master demand note balances are determined by the investable balances of the Corporation's sweep account customers. STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY The following table shows the changes in the Corporation's stockholders' equity for the years ended December 31, 1993, 1992 and 1991. Changes in Stockholders' Equity The Corporation's stockholders' equity was $976.8 million at December 31, 1993 compared to $694.2 million at December 31, 1992. The $282.6 million (40.7%) increase in stockholders' equity is primarily due to $113.9 million of net income in 1993 and the issuance of 6,000,000 shares of noncumulative preferred stock in December of 1993. Preferred stock was issued to the public at a price of $150 million with total proceeds to the Corporation of $144.8 million after deducting underwriting discounts and other issuance costs. In addition, stockholders' equity increased $26.6 million in 1993 due to net unrealized gains on investment securities available-for-sale resulting from the implementation of FAS 115 on December 31, 1993. The primary source of growth in stockholder's equity in 1992 and 1991 was the net income of the Corporation. Stockholders' equity has been restated for all years presented to reflect the cumulative effect on prior years of retroactively applying Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." The Corporation's regulatory capital and regulatory capital ratios presented in the following table have also been restated to reflect this change. The following table details the Corporation's capital components and ratios at December 31, 1993, 1992 and 1991 based upon the capital requirements of regulatory agencies discussed under "Business--Supervision and Regulation." Tier 1 and total capital increased $256.3 million and $256.9 million, respectively, when December 31, 1993 is compared to December 31, 1992 due to $113.9 million in net income in 1993 and the issuance of preferred stock in 1993. Significant transactions affecting regulatory capital in 1992 included the issuance of $100 million in qualifying long-term debt in May of 1992 and the call of $50 million in long-term debt in April of 1992. Capital Components - -------- (1) The Tier 1, total capital and leverage ratios have been restated to reflect the cumulative effect on prior years of retroactively applying statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FIRST MARYLAND BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME See accompanying notes to consolidated financial statements FIRST MARYLAND BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CONDITION See accompanying notes to consolidated financial statements FIRST MARYLAND BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY See accompanying notes to consolidated financial statements FIRST MARYLAND BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of First Maryland Bancorp and subsidiaries (the "Corporation") conform to generally accepted accounting principles. The following is a description of the more significant of these policies: Business--The Corporation is a wholly owned subsidiary of Allied Irish Banks, p.l.c. and provides a full range of banking services through its banking subsidiaries, The First National Bank of Maryland, First Omni Bank, N.A., and The First National Bank of Maryland, D.C. (collectively the "National Banks") and The York Bank and Trust Company (collectively with the National Banks, the "Banks"). Other subsidiaries of the Corporation are primarily engaged in consumer banking, construction lending, and equipment, consumer, and commercial financing. The Corporation's primary market area is the Baltimore/Washington marketplace which encompasses all of Maryland, Washington, D.C., Northern Virginia and Southern Pennsylvania. The Corporation is subject to the regulations of certain Federal agencies and undergoes periodic examinations by those regulatory agencies. Basis of Presentation--The consolidated financial statements include the Corporation and its subsidiaries, principally The First National Bank of Maryland ("First National"), The York Bank and Trust Company ("York Bank") and First Omni Bank, N.A. ("First Omni"). All significant intercompany transactions have been eliminated. In preparing the financial statements, Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of condition and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for credit losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for credit losses and real estate owned, Management obtains independent appraisals for significant properties. Management believes that the allowances for losses on loans and real estate owned are adequate. While Management uses available information to recognize losses on loans and real estate owned, future additions to the allowances may be necessary based on changes in economic conditions, particularly in the Mid- Atlantic region of the United States. In addition, as an integral part of their examination process, various regulatory agencies periodically review the Corporation's allowance for losses on loans and real estate owned. Such agencies may require the Corporation to recognize additions to the allowances based on their judgments about information available to them at the time of their examination. Foreign Currency Transactions--Foreign currency amounts, including those related to foreign branches, are remeasured into the functional currency (the U.S. dollar) generally at relevant exchange rates. Aggregate transaction gains and losses are included in other income and other expense and are not material to the financial statements. Money Market Investments--Money market investments are stated at cost, which approximates market value except for trading account securities which are carried at market value. Adjustments to market and trading account gains and losses are classified as other income in the accompanying consolidated statements of income. Securities--At December 31, 1993, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires the classification of securities into one of three categories: trading, available- for-sale, or held-to-maturity. At the time of purchase, management determines the appropriate designation for debt securities and reassesses the classification periodically. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Trading account securities are purchased with the intent to earn a profit by trading or selling the security. These securities are stated at market value. Adjustments to the carrying value are reported in other noninterest income. Securities not classified as held-to-maturity or trading are classified as available-for-sale. Available-for-sale securities are stated at fair value, with unrealized gains or losses, net of tax, reported as a separate component of stockholders' equity. Held-to-maturity securities are purchased with the ability and intent to hold them to maturity and are, therefore, carried at cost adjusted for amortization of premium and accretion of discount. Amortization and accretion of discounts and premiums associated with securities classified as held-to-maturity or available-for-sale are computed on the straight-line basis adjusted for expected prepayment experience, which does not differ significantly from the level yield method. Gains and losses, and declines in value judged to be other than temporary, are included as part of noninterest income. The cost of securities sold is determined based on the specific identification method. Loans Held-For-Sale--Loans held-for-sale are stated at the lower of aggregate cost or market. Financial Interest Rate Instruments--The Corporation enters into financial interest rate instruments, primarily interest rate swaps, to manage its interest rate sensitivity and to generate fee income. Transactions designated as hedges of specific assets or liabilities are recorded as yield adjustments to the income or expense of the underlying assets or liabilities. Transactions hedging overall interest rate sensitivity or open positions are recorded using mark-to-market accounting. Income generated from matched transactions where the Corporation is acting as a financial intermediary is recorded as noninterest fee income. Income on Loans Receivable--Loans are stated at the amount of unpaid principal, reduced by unearned income and an allowance for credit losses. The net asset amounts for leased equipment also reflect both related estimated residual values and unearned investment tax credits to the extent such amounts are taken into income as yield adjustments over the lives of the related leases. Discounts on discounted loans and interest on other loans are generally recognized as income on the level yield method (interest method). Commitment and origination fees are generally recognized as income over the commitment and loan periods, respectively. Loans are placed on nonaccrual status when in the opinion of Management the collection of additional interest is unlikely or a specific loan meets the criteria for nonaccrual status established by regulatory authorities. A loan remains on nonaccrual status until the loan is current as to payment of both principal and interest with the borrower demonstrating the ability to pay and remain current, or it meets revised regulatory guidance on returning to accrual status even though the loan has not been brought fully current. Premises and Equipment--Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are charged to operating expenses. Depreciation generally is computed on the straight line basis over the estimated useful lives of the assets. Leasehold improvements are amortized over the lesser of the term of the respective leases or the lives of the assets. Maintenance and repairs are expensed as incurred. The costs of replacing structural parts of major units are considered individually and are expensed or capitalized as the facts dictate. Depreciation and amortization amounts are adjusted, if appropriate, at the time an asset is retired. Leases are accounted for as operating leases since none which meet the criteria for capitalization would have a material effect if capitalized. Income Taxes--Effective January 1, 1993, the Corporation adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" and has restated prior years' retained earnings to reflect the cumulative effect of the change in the method of accounting for income taxes. Under the asset and liability method of SFAS No. 109, 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 FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized as income in the period that includes the enactment date. The Corporation files a consolidated federal income tax return. Deferred income taxes are provided on certain transactions which are reported in the financial statements in different years than for income tax purposes. The principal items are the provision for credit losses, income from lease financing, interest and fee income on loans, securities transactions, deferred compensation and restricted stock. Accumulated deferred taxes resulting from these timing differences are included in the aggregate in other assets to the extent realizable or accrued taxes and other liabilities in the consolidated statements of condition. Investment tax credits on lease financing transactions are deferred and taken into income as yield adjustments over the lives of the related leases. Other Real Estate and Assets--Other real estate and other assets owned represent property acquired through foreclosure or deeded to the Corporation in lieu of foreclosure on loans on which borrowers have defaulted as to the payment of principal and interest. Other real estate and assets, at the time of foreclosure, are recorded at the asset's fair value. Any write-downs at the date of acquisition are charged to the allowance for credit losses. Subsequent write downs to reflect declines in fair value minus the estimated costs to sell are charged to operating expenses through the establishment of a valuation allowance. Any improvement in fair value is reflected by a decrease to the valuation allowance and a credit to income. Expenses incurred in maintaining assets are included in other operating expenses. Trust Assets--Property held in fiduciary or agency capacities for First National's and York Bank's customers is not included in the consolidated statements of condition since such assets are not assets of the banks. Statement of Cash Flows--For purposes of reporting cash flows, cash equivalents include cash and due from banks and interest bearing deposits in other banks of $406,000, $20,100,000 and $7,812,000 at December 31, 1993, 1992 and 1991, respectively, which are included in money market investments in the consolidated statements of condition. Servicing Income From Securitized Assets--Servicing income from securitized assets represents the financial spread (between finance charges and other charges earned on such assets and the pass-through rate due to investors) retained as seller/servicer reduced by estimated credit losses chargeable against such spread. Reclassifications--Certain amounts in the 1991 and 1992 consolidated financial statements have been reclassified to conform with the 1993 presentation. Consistent with regulatory guidance on the reporting of in- substance foreclosures and the recently issued (but not yet adopted) Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," the Corporation no longer reports loans as in-substance foreclosures unless the Corporation has possession of the collateral. In- substance foreclosures and the related valuation allowances were reclassified to the loan portfolio and the allowance for credit losses, respectively, in the 1992 consolidated statement of condition. In addition, provisions for in- substance foreclosures previously reported as other real estate expense were reclassified to the provision for credit losses in the 1992 and 1991 consolidated statements of income. 2. ACQUISITION OF THE YORK BANK AND TRUST COMPANY On December 31, 1991, the Corporation purchased all of the issued and outstanding common stock of The York Bank and Trust Company, based in York, Pennsylvania, for a cash price of $129 million. The fair value of the assets acquired and liabilities assumed totaled $1.4 billion and $1.3 billion, respectively. The transaction was accounted for as a purchase. Goodwill of $37.3 million was acquired and is being amortized FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) over 15 years on a straight-line basis. York Bank is a Pennsylvania chartered commercial bank with 21 full service offices in south central Pennsylvania. The results of operations of York Bank are not included in the consolidated statement of income for the year ended December 31, 1991. The unaudited pro forma information presented in the following table has been prepared based on the historical results of the Corporation combined with York Bank. The information has been combined to present the results of operations as if the acquisition had occurred at the beginning of 1991. The pro forma results are not necessarily indicative of the results which would have actually been obtained if the acquisition had been consummated in the past nor is it indicative of the results that may be attained in the future. - -------- (1) Total revenue includes net interest income and noninterest income 3. MONEY MARKET INVESTMENTS Money market investments at December 31, 1993 and 1992 included the following: FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 4. INVESTMENT SECURITIES As discussed in Note 1, the Corporation adopted SFAS No. 115 effective December 31, 1993. Prior to December 31, 1993, the Corporation classified securities as held-for-possible-sale and investment securities. Held-for- possible-sale securities were carried at the lower of cost or fair value and investment securities were carried at amortized cost. The following is a comparison of the book value and market value of held-to- maturity securities in the consolidated investment portfolio: The book and market values of held-to-maturity securities at December 31, 1993 are as follows: The book and market values of held-to-maturity securities at December 31, 1992 are as follows: FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The book and market values of held-to-maturity debt securities at December 31, 1993 by contractual maturity are shown in the following table. Expected maturities will differ from contractual maturities because many issuers have the right to call or prepay obligations with or without call or prepayment penalties. The following is a comparison of the amortized cost and book value of available-for-sale securities in the consolidated investment portfolio: - -------- (1) The book value of investment securities classified as available-for-sale is equal to fair value. The amortized cost and book values of available-for-sale securities at December 31, 1993 are as follows: The amortized cost and book values of available-for-sale debt securities at December 31, 1993 by contractual maturity are shown in the following table. Expected maturities will differ from contractual maturities because many issuers have the right to call or prepay obligations with or without call or prepayment penalties. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Proceeds from the sale of investment securities were $711,058,000, $470,028,000 and $526,779,000 during 1993, 1992 and 1991, respectively. Gross gains and losses realized on the sale of investment securities were as follows: Investment securities from the consolidated investment portfolio with a book value of $788,522,000 at December 31, 1993 and $725,836,000 at December 31, 1992 were pledged to secure public funds, trust deposits, repurchase agreements and funds transactions and for other purposes required by law. 5. LEASES RECEIVABLE The investment in leases at December 31, 1993 and 1992 consisted of the following: Minimum lease payments receivable at December 31, 1993 are due as follows: 6. SIGNIFICANT CONCENTRATIONS OF CREDIT RISK The majority of the Corporation's loan activity is with customers within the Maryland marketplace and as such its performance will be influenced by the economy of this region. The loan portfolio is diversified with no single industry or customer comprising a significant portion of the total portfolio. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 7. ALLOWANCE FOR CREDIT LOSSES The provision for credit losses is determined by analyzing the status of individual loans, reviewing historical loss experience and reviewing the delinquency of principal and interest payments where pertinent. Management believes that all uncollectible amounts have been charged off and that the allowance is adequate to cover possible future charge-offs. A summary of the activity in the allowance for the three years ended December 31, 1993 follows: 8. PREMISES AND EQUIPMENT Components of premises and equipment at December 31, 1993 and 1992 were as follows: Depreciation and amortization on premises and equipment charged to operations amounted to $18,020,000 in 1993, $16,555,000 in 1992, and $14,070,000 in 1991. 9. FUNDS SOLD AND PURCHASED AND REPURCHASE AGREEMENTS Federal funds generally represent one-day transactions, a large portion of which arise because of the Corporation's market activity in Federal funds for correspondent banks and other customers. Securities sold or purchased under agreements to resell or repurchase are secured by U.S. Treasury and U.S. Government agency securities and mature within three months. At December 31, 1993, securities purchased under agreements to resell amounted to $21,829,813. All securities purchased were delivered either directly to the Corporation or to an agent for safekeeping. The aggregate market value of all securities purchased under agreements to resell did not exceed 10% of total assets and the amount at risk with any individual counterparty or group of related counterparties did not exceed 10% of total stockholders' equity. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) At December 31, 1993, securities sold under agreements to repurchase amounted to $402,590,381. The aggregate market value of all securities sold under agreements to repurchase did not exceed 10% of total assets and the amount at risk with any individual counterparty or group of related counterparties did not exceed 10% of total stockholders' equity. 10. OTHER BORROWED FUNDS, SHORT-TERM Following is a summary of short-term borrowings exclusive of Federal funds purchased and securities sold under agreements to repurchase at December 31, 1993 and 1992: At December 31, 1993, the Corporation had available lines of credit with third-party banks aggregating $100,000,000 to support commercial paper borrowings for which a fee is generally paid in lieu of compensating balances. Investment securities with a book value of $131,363,846 were pledged to secure the Treasury tax and loan notes at December 31, 1993. The Banks are required to maintain reserves, included in cash and due from banks, with the Federal Reserve Bank against their deposits. Average reserve balances maintained during 1993 and 1992 were $57,563,950 and $60,920,000, respectively. 11. LONG-TERM DEBT Following is a summary of the long-term debt of the Corporation at December 31, 1993 and 1992 which is all unsecured: FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) All of the notes other than the 10.375% Subordinated Capital Notes and the 8.375% Subordinated Notes are senior indebtedness. There is no provision in any of the Notes or related indentures for a sinking fund. Several of the notes or related indentures also prohibit the sale, transfer, or disposal of any capital stock of the Corporation. The 10.375% Subordinated Capital Notes mature August 1, 1999 with interest payable semiannually and at maturity and will be exchanged for Common Stock of the Corporation having a market value equal to the principal amount of the Notes, except to the extent that the Corporation, at its option, elects to pay in cash the principal amount of the Notes, in whole or in part, from amounts representing proceeds of other issuances of securities qualifying as capital, designated for such purpose. The 9.15% Notes mature June 1, 1996 with interest payable semiannually and are not redeemable except under certain conditions. The notes contain various financial covenants, including tangible net worth requirements and the maintenance of indebtedness ratios. The Corporation was in compliance with the financial covenants at December 31, 1993. The 8.68% Notes mature January 31, 1997 with interest payable semiannually and are not redeemable prior to maturity. The 8.67% Notes mature March 20, 1997 with interest payable semiannually and are not redeemable prior to maturity. The 8.375% Subordinated Notes mature May 15, 2002, with interest payable semiannually and are not redeemable prior to maturity. 12. EMPLOYEE BENEFIT PLANS The Corporation sponsors three defined benefit pension plans. The largest plan covers substantially all employees of the Corporation and its subsidiaries; the two smaller plans provide supplemental benefits to certain key employees. Benefits under the plans are generally based on age, years of service and compensation levels. Net periodic pension costs totaled $10,209,000 in 1993, $6,204,000 in 1992, and $4,198,000 in 1991. The following tables set forth the combined financial status of the plans for 1993 and 1992, and the composition of net periodic pension costs for 1993, 1992 and 1991. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Included in accrued pension costs and netted against retained earnings in 1993, 1992 and 1991 are accruals of $2,078,000, $1,005,000, and $1,114,000, respectively. The adjustments were made to reflect the excess of the unfunded accumulated benefit obligation (the excess of the accumulated benefit obligations over the fair value of plan assets) over the existing unrecognized prior service costs for one of the supplemental plans. The 1993 weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 6.68% and 5.50%, respectively. The expected long-term rate of return on assets was 8.00% in 1993. For 1992, the rates were 7.50%, 5.50% and 9.00%, respectively. The Corporation sponsors defined benefit postretirement plans that provide medical and life insurance coverage to eligible employees and dependents based on age and length of service. Medical coverage options are the same as those available to active employees. The cost of plan coverage for retirees and their qualifying dependents is based upon a credit system that combines age and years of service. Substantially all employees become eligible for these benefits when they retire. Benefits are provided through an insurance company whose premiums are based on the benefits paid during the year. In 1993, the Corporation adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and elected to amortize the transition obligation of $19.8 million on a straight-line basis over a period of twenty years. Postretirement benefit costs for 1992 and 1991 were recorded on a cash basis and represented the cost of annual insurance premiums which were approximately $749,000 in 1992 and $875,000 in 1991. Postretirement benefit costs increased to $3.7 million in 1993 as a result of the adoption of SFAS No. 106. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table sets forth the plan's funded status and amounts recognized in the Corporation's Consolidated Statement of Condition. The assumptions used in developing the present value of the postretirement benefit obligation were as follows: The resulting net periodic postretirement benefit cost consisted of the following components: The weighted average annual assumed rate of increase in the per capita cost of covered benefits is 13.5% for 1994 and is assumed to decrease gradually to 5.5% in the year 2002 and remain at that level thereafter. This health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by one percentage point would increase the accumulated post retirement benefit obligation at December 31, 1993 by $1,315,000, and the aggregate of the service and interest cost components of net periodic postretirement benefit costs for 1993 by $113,000. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 13. OTHER INCOME AND OTHER OPERATING EXPENSES The following table summarizes the more significant elements of these accounts for the three years ended December 31, 1993: 14. INCOME TAXES As discussed in Note 1, the Corporation adopted SFAS No. 109 retroactive to January 1, 1990. The cumulative effect of this change was to decrease retained earnings as of December 31, 1990 by $5.2 million. There was no effect on net income, effective tax rates or components of income tax expense for any periods subsequent to December 31, 1990. SFAS 109 requires an asset and liability approach for accounting for income taxes. Its objective is to recognize the amount of taxes payable or refundable in the current year, and deferred tax assets and liabilities for future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases. The measurement of tax assets and liabilities is based on enacted tax laws. Deferred tax assets are reduced, if necessary, by the amount of such benefits that are not expected to be realized based on available evidence. The following is an analysis of income tax amounts included in the consolidated statements of condition at December 31, 1993 and 1992: FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The components of income tax expense for the three years ended December 31, 1993 are as follows: Foreign income taxes represent taxes on interest received from foreign borrowers and foreign dividends received. The reconciliation of the statutory Federal income tax rate to the effective tax rate for the three years ended December 31, 1993 follows: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and 1992 are presented below: FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Federal income tax returns have been examined by the Internal Revenue Service through December 31, 1989 and adequate provision has been made for all liabilities for Federal and other income taxes as of December 31, 1993. The composition of the 1993 income tax liability and provision between current and deferred portions is subject to final determination based on the 1993 consolidated Federal income tax return. The foregoing liability and provision amounts for 1992 have been reclassified to reflect the final determinations made with respect to the 1992 federal income tax return. 15. LEASE COMMITMENTS The Corporation occupies various office facilities under lease arrangements virtually all of which are operating leases. Rental expense under these leases, net of subleases, was $16,469,000 in 1993, $17,471,000 in 1992, and $15,906,000 in 1991. Rental expense under equipment lease arrangements, all of which are considered short-term commitments, was $2,731,000 in 1993, $2,525,000 in 1992, and $2,366,000 in 1991. The following is a summary of the annual noncancellable long-term commitments, net of subleases: The lease amounts represent minimum rentals not adjusted for property tax and operating expenses which the Corporation may be obligated to pay. Such amounts are insignificant in relation to the minimum obligations. It is expected that in the normal course of business, leases that expire will be renewed or replaced by leases on other properties; thus, it is anticipated that future annual minimum lease commitments will not be less than the rental expense for 1993. 16. REGULATORY REQUIREMENTS AND RESTRICTIONS Regulations of the Comptroller place a limitation on the amount of dividends that a national bank may pay to its shareholders without prior approval. Based on these limitations, the amount available for dividends in 1993 to the Corporation by the National Banks will be the National Banks' net profits in 1993 plus the total amount available for dividends at January 1, 1994 of approximately $29.2 million. The Comptroller also has the authority to prohibit a national bank from paying dividends if the Comptroller deems such payment to be an unsafe or unsound banking practice. In December 1991, the Board of Directors of York Bank adopted resolutions at the direction of the Pennsylvania Department of Banking and the FDIC which prohibit any payment of dividends that would reduce York Bank's ratio of tier 1 capital to total assets (leverage ratio) below 6% and provide for the reduction of the ratio of classified assets less the allowance for credit losses to tier 1 capital. At December 31, 1993 York Bank's tier 1 capital ratio as a percent of total assets (leverage ratio) was 9.4%. Current Federal Reserve regulations place certain restrictions on "covered transactions" (which includes loans and purchases of assets) by banks with their nonbank affiliates. The amount of covered transactions that a bank may have is limited to 10% with any one nonbank affiliate and to 20% in aggregate of the bank's capital stock, surplus and undivided profits (net assets) after adding back the allowance for loan and lease losses. Covered transactions must be on terms and conditions consistent with safe and sound banking practices, and banks are precluded from purchasing low quality assets from affiliates, with very limited FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) exceptions. Furthermore, certain covered transactions are required to be secured by collateral having a market value equal to 100% or more of the amount of the transaction depending on the type of collateral. Based on these limitations, there was approximately $145.3 million available for covered transactions between the banks and their nonbank affiliates at December 31, 1993. 17. OFF-BALANCE SHEET ITEMS, COMMITMENTS AND CONTINGENT LIABILITIES The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of customers and to manage the Corporation's exposure to fluctuations in interest rates. These financial instruments include unfunded commitments to extend credit, standby, commercial and similar letters of credit, commitments to sell securities, foreign exhange contracts, futures, forward and option contracts and interest rate contracts. When viewed in terms of the maximum exposure, these instruments involve, in varying degrees, exposure to credit and interest rate risk in excess of the amount recognized in the consolidated statements of condition. The contract or notional amount represents the extent of the Corporation's involvement in any particular class of instrument. The Corporation's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for unfunded commitments to extend credit and commercial, standby and other letters of credit is represented by the contractual amounts of those instruments. The Corporation follows the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. For interest rate caps, floors, and swap transactions, futures and forward contracts, and options written, the contract and notional amounts do not represent exposure to credit loss. The Corporation controls the credit risk of these instruments through adherence to credit approvals, risk control limits and monitoring procedures. The Corporation evaluates each customer's credit worthiness on a case by case basis and requires collateral to support financial instruments when it is deemed necessary. The amount of collateral obtained upon extension of credit is based on Management's evaluation of the counterparty. Collateral held varies but may include deposits held in financial institutions, U.S. Treasury securities, other marketable securities, income producing commercial properties, accounts receivable, property, plant and equipment, and inventory. Financial instruments whose contract amounts represent potential credit risk at December 31, 1993 and 1992 are shown below: FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The notional values of financial instruments whose contract or notional amounts do not represent potential credit risk at December 31, 1993 and 1992 are shown below: Specific discussion of these instruments along with the attendant risks, credit concentrations and collateral policies is as follows: Commitments to Extend Credit--These are legally binding contracts to lend to a customer as long as there is no violation of any condition established in the contract. Commitments usually have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. At December 31, 1993, binding commitments to extend credit by category were as follows: Standby, Commercial and Similar Letters of Credit--These instruments are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support the performance of products, services and contractual obligations or to support public and private borrowing arrangements, including commercial paper transactions, bond financing and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Risks associated with standby letters of credit are reduced by participations to third parties. At December 31, 1993 and 1992, $2,500,000 and $1,000,000, respectively, of standby letters of credit had been participated to others. Securities Lent--These are the Corporation's securities and customers' securities held by the Corporation which are lent to third parties. The Corporation obtains collateral, with a market value exceeding 100 percent of the contract amount, for all securities lent which is used to indemnify the Corporation and customers against possible losses resulting from third party defaults. Interest Rate Swaps--These transactions generally involve the exchange of fixed and floating rate payment obligations without the exchange of the underlying principal amounts. Swaps are used as part of the Corporation's asset and liability management. In addition, interest rate swap activity may arise when the FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Corporation acts as an intermediary in arranging interest rate swap transactions for customers. The Corporation typically becomes a principal in the exchange of interest payments between the parties and, therefore, is exposed to loss should one party default. The Corporation minimizes credit risk by performing normal credit reviews on its swap customers and minimizes its exposure to interest rate risk inherent in interest rate swaps by entering into offsetting swap positions or other instruments that essentially counterbalance each other. Entering into interest rate swap agreements involves not only the risk of dealing with counterparties and their ability to meet the terms of the contracts but also the interest rate risk associated with unmatched positions. Notional principal amounts often are used to express the volume of these transactions, but the amounts potentially subject to credit risk are much smaller. These amounts are derived by estimating the cost, on a present value basis, of replacing at current market rates all those outstanding agreements for which the Corporation would incur a loss in replacing the contract. At December 31, 1993 and 1992, the amounts at risk totaled $11,853,000 and $19,321,000, respectively. Options--Included in option contracts purchased are optional commitments to deliver mortgage loans to various investors in the amount of $22,000,000 and $28,500,000 at December 31, 1993 and 1992, respectively. Interest Rate Caps and Floors--These instruments are written by the Corporation to transfer, modify or reduce its customers' or its own interest rate exposure. Credit risk and interest rate risk are managed through the oversight procedures applied to other interest rate contracts, as well as through the purchase of offsetting cap and floor positions. The present value of caps and floors in a profitable position, which represents the credit risk on these instruments totaled $99,000 and $632,000 at December 31, 1993 and 1992, respectively. At December 31, 1993 and 1992, the Corporation had purchased $73,260,000 and $199,591,000 in notional principal amount interest rate caps and floors as offsetting positions to interest rate caps and floors written and $165,000,000 notional principal amount interest rate caps to hedge the interest rate risk associated with bankcard asset securitizations. Commitments to Purchase and Sell Securities, Futures and Forward Contracts-- These instruments are contracts for delayed delivery of securities or money market instruments in which the seller agrees to make delivery at a specified future date of a specified instrument, at a specified price or yield. Risks arise in these transactions through the possible inability of one of the counterparties to meet the terms of the contracts and from movements in interest rates or securities values. Included in forward contracts sold are mandatory commitments to deliver mortgage loans to various investors in the amounts of $305,557,000 and $178,512,000 at December 31, 1993 and 1992, respectively, which are used to hedge the price risk associated with residential mortgages held-for-sale. Commitments to Purchase and Sell Foreign Exchange--As with commitments to sell securities, these future type agreements represent contractual obligations to purchase and sell foreign exchange at some future price. The potential risks associated with these obligations arise from fluctuations in foreign exchange rates, as well as the potential inability of the counterparty to perform under the contract. These risks are mitigated by offsetting sell positions as well as standard limiting and monitoring procedures. The exposure to loss on forward transactions can be estimated by calculating the cost to replace all profitable contracts outstanding. At December 31, 1993 and 1992, the Corporation's estimates of its exposure were $4,310,000 and $4,496,000, respectively. Securitized Assets--At the end of 1990 and during 1991 and 1992, the Corporation's subsidiaries securitized and sold manufactured housing and credit card receivables in amounts aggregating $496.0 million. The Corporation's subsidiaries continue to service the accounts for servicing fees which are comprised of the financial spread less estimated credit losses. Credit recourse is generally limited to future servicing income and certain balances maintained in trust for the benefit of investors. No gains or losses were recorded in connection with the sales. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Corporation and its subsidiaries are defendants in various matters of litigation generally incidental to their respective businesses. In the opinion of management, based on its review with counsel of these matters to date, disposition of all matters will not materially affect the consolidated financial position or results of operations of the Corporation and its subsidiaries. 18. RELATED PARTY TRANSACTIONS The Corporation has granted loans to certain of its executive officers, directors, principal holders of equity securities, and their associates (defined generally, as general partners of noncorporate entities, beneficial owners of at least 10% of equity securities of corporate borrowers, and members of their immediate families). Such loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than the normal risk of collectibility. The aggregate dollar amount of these loans, exclusive of loans not exceeding $60,000 in the aggregate to any one person, was $29,893,000 and $41,513,000 at December 31, 1993 and 1992, respectively. During 1993, $78,096,000 of new loans were made and repayments and other reductions totaled $89,716,000. At December 31, 1993, none of the loans outstanding were classified as nonaccrual, restructured or potential problem loans. Following the termination of the Corporation's Long Term Incentive Plan on March 21, 1989, the Corporation adopted its 1989 Long-Term Incentive Plan and Trust (the "1989 Plan"). The 1989 Plan provides for the award to key employees who contribute to the continued growth, development and financial success of the Corporation of up to 7 million Ordinary shares IR25p each of Allied Irish ("Common Stock") (or the equivalent thereof in Common Stock ADRs) and 200,000 Non-Cumulative Preference Share ADRs of Allied Irish ("Preferred Stock") (together the "Restricted Stock"). Awards are made to participants, without payment of consideration by the participant, in the form of Restricted Stock purchased by the Corporation in the open market and held in trust under the 1989 Plan until the expiration of the relevant restriction period. During 1993, 1991 and 1989 awards were made under the 1989 Plan aggregating the equivalent of 2,035,680, 1,986,954 and 1,834,700 shares of Common Stock and 57,470, 70,361 and 50,704 shares of Preferred Stock, respectively, and expenses relative to this plan totaled $4,051,000, $2,942,000 and $4,022,000 in 1993, 1992 and 1991, respectively. The awards are subject to a restriction period of at least three years. 19. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments ("Statement 107"), requires that the Corporation disclose estimated fair values for financial instruments. Fair value estimates, methods, and assumptions are set forth below for the Corporation's financial instruments. Cash and due from banks The carrying amounts for cash and due from banks reported on the consolidated statements of condition approximates fair value due to the short maturity of these instruments. Money market investments Money market investments include interest bearing deposits in other banks, trading account securities, Federal funds sold, and securities purchased under agreements to resell. Fair values were determined as follows: Interest bearing deposits in other banks--The fair value of interest bearing deposits in other banks was determined by discounting the cash flows associated with these instruments using an appropriate discount FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) rate. Current middle market rates for deposits with similar characteristics to the financial instrument being valued were obtained from offshore eurodollar dealers and used as discount rates. Trading account securities--The fair values for the Corporation's trading account securities are based on quoted market prices and trading account securities are recognized on the consolidated statements of condition at fair value. Federal funds sold--The carrying amount of federal funds sold reported on the consolidated statement of condition approximates fair value due to the overnight maturity of these instruments. Securities purchased under agreements to resell--The fair value of securities purchased under agreements to resell was determined by discounting the cash flows associated with these instruments using an appropriate discount rate. Market rates for financial instruments with similar characteristics to the financial instrument being valued were used as the discount rate. Market rates were based on an average of quotes obtained from several securities dealers. The carrying values and fair values of money market investments consisted of the following at December 31, 1993 and 1992: Investment securities The fair value of investment securities is based on bid prices received from an external pricing service or bid quotations received from external securities dealers. The carrying amounts and fair values of investment securities is presented in Note 4 of the Notes to the Consolidated Financial Statements. The available- for-sale securities are carried at fair value. Loans Loans were segmented into portfolios with similar financial characteristics, such as commercial, commercial real estate, residential mortgage, retail, bankcard and foreign loans. Each loan category was further segmented by fixed and adjustable rate interest terms and by performing and nonperforming categories. Taxable fixed rate loans were valued separately from tax exempt loans. Commercial real estate was further segmented between investment and owner occupied properties. The fair value of fixed rate performing loans except residential mortgages was calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan portfolio. The estimated maturity was based on the Corporation's historical experience with repayments for each loan classification modified, as required, by an estimate of the effect of current economic and lending conditions. Adjustable rate loans were considered to be at fair value if there had not been any significant deterioration in the credit risk of the borrower. Adjustable FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) rate loans which had deteriorated in credit quality since their origination date were further discounted to reflect a reduction in fair value. Residential mortgages were valued based on quoted market prices for comparable mortgage- backed securities. The fair value for significant nonperforming loans was determined by reducing the book value of nonperforming loans by the specific loan loss reserves established for these loans. Specific reserves were established by using appraisals, available market information and specific borrower information. The fair value estimate for bankcard receivables is based on the value of existing loans at December 31, 1993 and 1992. This estimate does not include the value that relates to estimated cash flows from new loans generated from existing cardholders over the remaining life of the portfolio. Recent portfolio sales indicate that if this additional value had been considered, the fair value estimate for bankcard receivables would have increased by approximately 10% of the carrying amount of the receivables. The fair value of LDC loans was based on market quotes where available and, where not available, on quoted market prices of LDC debt with similar characteristics with appropriate adjustments if necessary. The carrying amounts and fair values of loans receivable consisted of the following at December 31, 1993 and 1992: The majority of the loans held-for-sale at December 31, 1993 and 1992 were residential mortgages. The carrying amount and fair value of loans held-for- sale at December 31, 1993 and 1992 were as follows: Accrued interest receivable The carrying amount of accrued interest receivable approximates its fair value. Deposits Under Statement 107, the fair value of deposits with no stated maturity, such as noninterest bearing demand deposits, interest bearing demand deposits and money market and savings accounts, is equal to the FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) amount payable on demand as of December 31, 1993 and 1992. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate for retail certificates of deposits was estimated using the rate currently offered for deposits of similar remaining maturities. The discount rate for large denomination time deposits which includes commercial, brokered, public funds and negotiable CD's and deposit notes was determined by using quotations from pricing services or obtaining quotes from securities dealers depending on the type of deposit being valued. The carrying amounts and fair values of deposits consisted of the following at December 31, 1993 and 1992: Federal funds purchased and securities sold under repurchase agreements Federal funds purchased--The carrying amount of Federal funds purchased approximates its fair value due to the overnight maturities of these financial instruments. Securities sold under agreements to repurchase--The fair value of securities sold under agreements to repurchase was determined by discounting the cash flows associated with these instruments using an appropriate discount rate. Market rates for financial instruments with similar characteristics to the financial instrument being valued were used as the discount rate. Market rates were based on an average of quotes obtained from several securities dealers. In the case of dollar roll repurchase agreements which are unique instruments with no quoted market rates, market values were estimated using an equivalent maturity repurchase agreement market rate. The carrying amounts and fair values of federal funds purchased and securities sold under repurchase agreements consisted of the following at December 31, 1993 and 1992: Other borrowed funds, short term The master demand notes of the Corporation and the Treasury tax and loan balances reprice daily. The carrying amount of these financial instruments approximates fair value. The book value of other short-term borrowings also approximates its fair value. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Long-term debt The fair value of long-term debt was calculated by discounting the cash flows associated with these instruments using appropriate discount rates. Market rates for financial instruments with equivalent credit risk characteristics and equivalent maturities were obtained from investment bankers and used as discount rates in the valuation model. The carrying amount and fair values of long-term borrowings consisted of the following at December 31, 1993 and 1992: Accrued interest payable The carrying amount of accrued interest payable approximates its market value. Interest rate swaps agreements, interest rate caps and floors, foreign exchange options contracts and swaptions The fair value of interest rate swaps, interest rate caps and floors, foreign exchange options contracts and swaptions is obtained from dealer quotes. These values represent the estimated amount the Corporation would receive or pay to terminate the contracts or agreements, taking into account current interest rates and, when appropriate, the credit worthiness of the counterparties. The notional amount, and estimated fair value for interest rate swaps, interest rate caps and floors, foreign exchange options contracts and swaptions at December 31, 1993 and 1992 consisted of the following: Commitments to extend credit and standby letters of credit The Corporation's commercial loan, commercial mortgage and construction mortgage commitments to extend credit move with market rates, therefore, they are not subject to interest rate risk. A significant portion of the Corporation's commercial loan and commercial mortgage commitment fees are determined retrospectively and are recognized as service fee income on the fee determination date. It was not considered practicable to develop fair value disclosures for loan commitments due to the difficulty involved in estimating future commitment fees when the fee determination date is at the end of the determination period. Fee income recognized as noninterest income totaled $2.3 million and $1.9 million for the years ended December 31, 1993 and 1992, respectively. The Corporation had $38,431,000 and $24,569,000 of residential mortgage commitments outstanding at December 31, 1993 and 1992 with estimated fair values of $1,245,000 and $620,000, respectively. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Corporation uses a variety of billing methods for its outstanding standby and commercial letters of credit. Fees may be billed in advance or in arrears on an annual, quarterly or monthly basis. It was not considered practicable to perform a fair value calculation on standby and commercial letters of credit because each customer relationship would have to be separately evaluated. The majority of the Corporation's standby and commercial letters of credit would have a positive fair value due to the unbilled and unrecognized fee income associated with these off-balance sheet commitments. At December 31, 1993 and 1992, deferred commissions on standby and commercial letters of credit totaled $811,000 and $602,000, respectively. Total fee income on standby and commercial letters of credit was $4.9 million and $4.4 million for the years ended December 31, 1993 and 1992. Limitations Fair value estimates are made at a specific point in time, based on relevant market information and information about financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Corporation's financial instruments, fair value estimates are based on judgements regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgement and therefore cannot be determined with precision. Changes in assumptions could significantly affect estimates. Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities not considered financial instruments. FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 20. CONDENSED PARENT COMPANY FINANCIAL INFORMATION Following is condensed financial information of First Maryland Bancorp (parent company only): CONDENSED STATEMENTS OF INCOME FIRST MARYLAND BANCORP FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED) CONDENSED STATEMENTS OF CONDITION FIRST MARYLAND BANCORP FIRST MARYLAND BANCORP AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED) CONDENSED STATEMENTS OF CASH FLOWS FIRST MARYLAND BANCORP - -------- (1) Cash and cash equivalents include those amounts under the captions "Cash and due from banks" and "Interest bearing deposits in other banks" on the condensed statements of condition. There were no unconsolidated subsidiaries or 50% or less owned persons accounted for by the equity method for the three years ended December 31, 1993. MANAGEMENT'S REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of First Maryland Bancorp has prepared and is responsible for the accompanying financial statements, together with the financial data and other information presented in this annual report on Form 10-K. Management believes that the financial statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances to reflect the substance of events and transactions that should be included. The financial statements include amounts that are based on Management's best estimates and judgments. Management maintains and depends upon an internal accounting control system designed to provide reasonable assurance that transactions are executed in accordance with Management's authorization, that financial records are reliable as the basis for the preparation of all financial statements, and that the Corporation's assets are safeguarded. The design and implementation of all systems of internal control are based on judgments required to evaluate the costs and controls in relation to the expected benefits and to determine the appropriate balance between these costs and benefits. The Corporation maintains an internal audit program to monitor compliance with the system of internal accounting control. The audit committee of the Board of Directors, comprised solely of outside directors, meets at least quarterly with the independent public accountants, KPMG Peat Marwick, management and internal auditors to review accounting, auditing and financial reporting matters. The independent public accountants and internal auditors each meet privately with the committee, without management present, to discuss the results of their audit work and their evaluations of the adequacy of internal controls and the quality of financial reporting. The financial statements in this annual report on Form 10-K have been examined by the Corporation's independent public accountants for the purpose of expressing an opinion as to the fair presentation of the financial statements. Their independent professional opinion on the Corporation's financial statements is presented on the following page. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders First Maryland Bancorp: We have audited the accompanying consolidated statements of condition of First Maryland Bancorp and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Maryland Bancorp and subsidiaries at December 31, 1993 and 1992 and the results of their operations and cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 1 and 12, the Corporation adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities" effective December 31, 1993; SFAS No. 109, "Accounting for Income Taxes" retroactive to January 1, 1990; and SFAS No. 106, "Employers' Accounting for Postretirement Benefits other than Pensions" effective in 1993. KPMG Peat Marwick Baltimore, Maryland February 10, 1994 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable PART III Items 10-13 of this Annual Report will be filed by amendment. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements: See Item 8. 2. Financial Statement Schedules: None. 3. Exhibits: (3.1) Articles of Incorporation and Bylaws. (Incorporated by reference to Exhibits 3.1 and 3.2 to the Form SE containing Exhibits to the Corporation's Registration Statement on Form S-1 filed March 13, 1992.) (3.2) Articles Supplementary creating the 7.875% Noncumulative Preferred Stock, Series A (Incorporated by reference to Exhibit 3 of the Corporation's Registration Statement on Form S-3 filed November 16, 1993, File No. 33-51065.) (4.1) The Corporation agrees to furnish to the Securities and Exchange Commission upon request a copy of each instrument defining the rights of holders of long-term debt of the Corporation and its consolidated subsidiaries. (4.2) Form of Preferred Stock Certificate (Incorporated by reference to Exhibit 4 of the Corporation's Registration Statement on Form S-3 filed November 16, 1993, File No. 33-51065.) (10) Material contracts. (Incorporated by reference to Exhibits 10.1 through 10.19 to the Form SE containing Exhibits to the Corpora- tion's Registration Statement on Form S-1 filed March 13, 1992.) (24) Power of Attorney. (b) Reports on Form 8-K There were no current reports on Form 8-K filed during the quarter ended December 31, 1993. 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. First Maryland Bancorp /s/ Charles W. Cole, Jr. By __________________________________ (CHARLES W. COLE, JR., PRESIDENT AND CHIEF EXECUTIVE OFFICER) PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE CAPACITIES AND ON THE DATE INDICATED. PRINCIPAL EXECUTIVE OFFICER: /s/ Charles W. Cole, Jr. President and Chief March 30, 1994 - ------------------------------------- Executive Officer (CHARLES W. COLE, JR.) PRINCIPAL FINANCIAL OFFICER: /s/ Robert W. Schaefer Executive Vice March 30, 1994 - ------------------------------------- President (ROBERT W. SCHAEFER) PRINCIPAL ACCOUNTING OFFICER: /s/ James A. Smith Senior Vice March 30, 1994 - ------------------------------------- President (JAMES A. SMITH) MAJORITY OF THE BOARD OF DIRECTORS: Benjamin L. Brown, Jeremiah E. Casey, Charles W. Cole, Jr., J. Owen Cole, Edward A. Crooke, John F. Dealy, Mathias J. DeVito, Rhoda M. Dorsey, Jerome W. Geckle, Frank A. Gunther, Jr., Curran W. Harvey, Jr., Margaret M. Heckler, Kevin J. Kelly, Henry J. Knott, Jr., Thomas P. Mulcahy, William M. Passano, Jr., Robert I. Schattner and Brian V. Wilson. /s/ Robert W. Schaefer Attorney-in-Fact March 30, 1994 By _________________________________ (ROBERT W. SCHAEFER)

810578_1993.txt

810578_1993

1993

810578

ITEM 1. BUSINESS GENERAL St. Paul Bancorp, Inc. (the "Company") was incorporated under the laws of the State of Delaware in February 1987 by authorization of the Board of Directors of St. Paul Federal Bank For Savings ("St. Paul Federal" or the "Bank") for the purpose of becoming the holding company of St. Paul Federal upon the Bank's conversion from federal mutual to federal stock form. As a Delaware corporation, the Company is authorized to engage in any activity permitted by the Delaware General Corporation Law. The Company is presently conducting business as a non-diversified unitary thrift holding company. The holding company structure allows the Board of Directors greater flexibility to diversify and expand its business activities, through newly formed subsidiaries or through acquisitions of insured depository institutions and other companies. See "Regulation -- Thrift Holding Company Regulation." At present, the primary business of the Company is the business of St. Paul Federal, a federally chartered stock savings bank. St. Paul Federal is a consumer oriented retail financial institution, operating 50 banking offices throughout the Chicago, Illinois metropolitan area, including 15 "in-store" full-service offices located in OMNI(R) grocery superstores. The in-store banking offices provide the Bank access to an expanded retail customer base. Through each of its banking offices, the Bank attracts retail deposits from the general public in the neighborhoods and surrounding suburbs of metropolitan Chicago with high levels of home ownership and favorable savings patterns. Deposit accounts in the Bank are insured by the Federal Deposit Insurance Corporation ("FDIC"). The Bank focuses its current lending activities on the origination and purchase of mortgages secured by 1-4 family residential properties and the purchase of mortgage-backed securities ("MBS"). In addition to originating loans its local market area, the Bank utilizes a correspondent loan program to originate 1-4 family loans in the states of Illinois, Wisconsin, Indiana, Michigan, and Ohio. The Bank also offers a variety of consumer loan products. The Bank's focus on retail operations includes significant diversification of income sources beyond net interest income. The Bank has approximately 146,000 checking accounts, which generate significant fee income. The Bank engages in mortgage banking activities and operates approximately 174 automated teller machines ("ATMs") throughout the Chicago metropolitan area. In 1994, the Bank plans to originate mortgage loans secured by 5 to 35 unit apartment buildings located in the Chicago metropolitan area. Management has targeted the origination of $50 million of loans under this new multi-family lending program in 1994. On February 23, 1993, the Company acquired Elm Financial Services, Inc., the holding company for Elmhurst Federal Savings Bank, an FDIC insured savings bank (the "Elm Acquisition"). The acquisition of Elm Financial added 8 offices to the Bank's branch network and significantly expanded the Bank's presence in eastern Du Page County, Illinois. For further discussion see "Acquisition Activities" in Management's Discussion and Analysis and "NOTE Y -Acquisition of Elm Financial" to the Consolidated Financial Statements contained in the 1993 annual report to shareholders filed as an exhibit hereto. The Bank is a member of the Federal Home Loan Bank ("FHLB") System. The Bank is subject to comprehensive examination, supervision and regulation by the Office of Thrift Supervision (the "OTS") and the FDIC. The Bank is also regulated by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). Regulation of the Bank by the FDIC, the OTS and the Federal Reserve Board is intended primarily for the protection of depositors. See "Regulation." The Bank controls three principal subsidiaries: Investment Network, Inc., which engages in the discount brokerage business; St. Paul Service, Inc. ("SPSI"), which operates an insurance brokerage business; and Managed Properties, Inc., which manages foreclosed real estate. During 1991, the Company established a second wholly-owned subsidiary, Annuity Network, Inc. ("ANI"), which began operations on November 1, 1991. The business activity of ANI is the sale of annuity products. Prior to the incorporation of ANI, annuity products had been sold by SPSI, a subsidiary of the Bank. The earnings and cash flows of ANI are affected by the revenue lease sharing arrangement with SPSI which was entered into on June 30, 1993. This agreement was designed to compensate SPSI for providing ANI access to its customers. While the agreement impacts the earnings and cash flows of the two companies, it has no impact on the consolidated results of operations. During 1993, the Company acquired St. Paul Financial Development Corporation ("St. Paul Financial") from the Bank at its fair market value. St. Paul Financial primarily engages in single family real estate development in the Chicago metropolitan area. The Company's executive offices are located at 6700 West North Avenue, Chicago, Illinois 60635, telephone (312) 622-5000. Financial information contained in this Form 10-K concerning the Company is presented on a consolidated basis with its subsidiaries, unless otherwise indicated. See page 21 of Management's Discussion and Analysis contained in the 1993 annual report to shareholders filed as an exhibit hereto for an overview of the Bank's investing and financing activities. MARKET AREA St. Paul Federal is based in Chicago, Illinois, the third largest metropolitan area in the United States. Based on total assets of $3.7 billion at December 31, 1993, St. Paul Federal was the largest independent savings institution headquartered in Illinois. The Bank's deposits are primarily derived from the areas where its 50 banking offices are located. The Bank does not actively solicit deposits outside the Chicago metropolitan area and does not use brokers to obtain deposits. St. Paul Federal strives for the betterment of the greater Chicago area and particularly those communities and neighborhoods it serves directly. The Bank attempts to serve the credit needs of the communities where its offices are located. In fulfilling the credit needs in its principal lending communities, the Bank funded over $1.7 billion in 1-4 family residential mortgage loans in the metropolitan area from 1989 through 1993. See "Liquidity" and "Credit" in Management's Discussion and Analysis and "NOTE W - Concentration of Credit Risk" to the Consolidated Financial Statements contained in the 1993 annual report to shareholders filed as an exhibit hereto and "Multi-Family and Commercial Real Estate Loans" below, for a discussion of asset origination and purchases beyond the Chicago area market. INVESTMENTS Federally chartered savings banks have authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, certain certificates of deposit at insured depository institutions, certain bankers' acceptances and Federal funds. Subject to various restrictions, federally chartered savings institutions may also invest a portion of their assets in commercial paper and corporate debt securities and in mutual funds whose assets conform to the investments that a federally chartered savings institution is otherwise authorized to make directly. Historically, the Bank has limited its investments to United States Treasury obligations, securities of various federal agencies, and federal funds. The Bank is required to maintain liquid assets at minimum levels which vary from time to time. St. Paul Federal's liquid investments primarily include United States government and agency securities and federal funds sold. See "Liquidity" in Management's Discussion and Analysis, and "NOTE B - Cash and Cash Equivalents," "NOTE C - Marketable-Debt Securities," and "NOTE K - Federal Home Loan Bank Stock" contained in the 1993 annual report to shareholders filed as an exhibit hereto. See "Regulation" following. The Bank's investment policy allows the Bank to deal only with primary government securities dealers. The Bank's policy permits investment in corporate bonds of at least "AA" or equivalent rating but limits investments to no more than $5.0 million in bonds of any one corporate issuer. The policy permits investments in United States Treasury and government securities with terms up to five years, negotiable certificates of deposit, bankers' acceptances, commercial paper with terms up to nine months, and federal funds with terms of no more than one year. The amount of the Bank's investments in term federal funds, negotiable certificates of deposit and commercial paper are limited by Bank policy based on a specified percentage of liquidity. The Bank places overnight federal funds with large commercial banks in the United States, based upon periodic review of the financial condition of these institutions. Based upon the results of this review, the Bank limits investments in overnight federal funds with these financial institutions at predetermined levels, approved by the Board of Directors. The following table sets forth the carrying amounts of investment securities on a consolidated basis at December 31: Of the $390.6 million of investment securities at December 31, 1993, $269.7 million at a weighted average rate of 3.16% will mature within one year and $120.8 million at a weighted average rate of 4.38% will mature between one and five years. Trading Account. Prior to 1994, the Bank maintained a trading account which was used to buy and sell specifically identified assets for market gains. Beginning in 1994, the Bank discontinued these trading account activities in order to focus more attention on other investment activities. The Bank had no securities in its trading portfolio at December 31, 1993, 1992 and 1991. See "RESULTS OF OPERATIONS - COMPARISON OF YEARS ENDED DECEMBER 31, 1993 AND 1992. Other Income" in Management's Discussion and Analysis in the 1993 annual report to shareholders filed as an exhibit hereto for a discussion of the classification of MBS originated through mortgage banking operations as trading account assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 65, "Accounting for Certain Mortgage Banking Activities," as amended by SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." MORTGAGE-BACKED SECURITIES The Bank purchases and holds for investment MBS which are backed by 1-4 family mortgage loans. The MBS portfolio includes both purchased securities and swapped mortgages that are held as long-term investments. This portfolio includes both fixed- and adjustable-rate securities backed by the Federal Home Loan Mortgage Corporation ("FHLMC"), Federal National Mortgage Association ("FNMA"), and Government National Mortgage Association ("GNMA") as well as privately issued securities. MBS qualify as mortgage loans for income tax purposes (see "Regulation - Taxation"). See "Liquidity" in "Management's Discussion and Analysis," contained in the 1993 annual report to shareholders filed as an exhibit hereto, for discussion of other attributes of MBS. The following table summarizes MBS portfolio held for investment at December 31, 1989 through 1993 (dollars in thousands): Of the $733.6 million of MBS held at December 31, 1993, $10.6 million at a weighted average rate of 5.82% is contractually scheduled to mature within one year, $50.3 million at a weighted average rate of 5.85% is contractually scheduled to mature in one to five years, $85.4 million at a weighted average rate of 5.90% is contractually scheduled to mature in five to ten years, and $587.3 million at a weighted average rate of 5.92% is contractually scheduled to mature after 10 years. The Bank purchases MBS issues of government sponsored enterprises (i.e. FNMA, FHLMC, GNMA) or private labels rated at least "AA" by a major rating agency. If, subsequent to purchase, a security is downgraded below "AA" by a nationally recognized rating agency, the Bank reevaluates the credit worthiness of the security to determine whether it should be sold. See "NOTE A - - Summary of Significant Accounting Policies" contained in the 1993 annual report to shareholders filed as an exhibit hereto. St. Paul Federal also acquires MBS under matched funding arrangements whereby the Bank can enhance its net interest income with profitable spread opportunities and low costs of execution and servicing. The Bank also owns MBS that relate to 1-4 family mortgages originated by St. Paul Federal that were swapped with FNMA or FHLMC for their government sponsored agency certificates. As of December 31, 1993, 16.5% of the Bank's MBS were acquired as a result of such swaps. All of the MBS created through the securitization of 1-4 family loans during 1993 and 1992 were sold during each of the respective years. See "Sale of Mortgages and MBS" following. The following table summarizes MBS purchases for the years ending December 31, 1989 through 1993 (dollars in thousands): * Less than one percent. LENDING 1-4 Family Mortgage Loans. At December 31, 1993, St. Paul Federal held in its loan portfolio $1.1 billion of first mortgage loans secured by 1-4 family residential housing, or 95.2% of its total 1-4 family mortgages. The remaining 4.8% of 1-4 family mortgage loans held in portfolio as of December 31, 1993 represented junior mortgages. The Bank's loans are predominately "conventional" loans, i.e., loans that are not insured by the Federal Housing Administration ("FHA") or guaranteed by the Veterans Administration ("VA"). As of December 31, 1993, the Bank's 1-4 family mortgage loan portfolio was comprised of $1.0 billion of individual loans originated by St. Paul Federal (including loans acquired from Elm Financial) and $177.7 million of loans purchased from other institutions. Purchased loans have included mortgages with servicing retained and with servicing released. Also, purchased mortgage servicing rights have been acquired. During 1993, the Bank originated adjustable-rate mortgage loans ("ARMs"), ARMs with initial fixed-interest rate periods of 3-5 years and fixed rate mortgage loans. All ARM loans (including those loans with initial fixed-interest rate periods ranging from 3-5 years) fully amortize over a 30 year period and have interest rate and payment adjustments made at regular intervals based on various rate indices. During 1993, the majority of ARMs originated were tied to the national cost of funds, the 11th district cost of funds, or the one-year constant maturity treasury bill. Fixed rate loans were originated for 10-, 15- and 30 year periods. The 15 and 30 year fixed-rate mortgage loans fully amortize at their maturity while the 10-year fixed-rate mortgage loan requires both monthly amortization based upon a 30-year amortization schedule and a balloon payment upon maturity. In the past, the Bank also originated a 7 year balloon mortgage, which provided for monthly amortization based upon a 30-year amortization period. Although the Bank currently does not originate this product, $39.2 million of these mortgages were held at December 31, 1993. Generally, the Bank's policy is to sell conforming 15 and 30 year fixed rate loans in the secondary market. See "Sales of Mortgages and Mortgage Backed Securities" discussion following. The Bank achieved record origination volumes in 1993 due to record mortgage refinancings caused by the lowest mortgage rates in over twenty years. The Bank originated $172.2 million of ARMs, $151.8 million of ARMs with initial fixed-interest rate periods of 3-5 years, and $211.6 million of fixed-rate loans in 1993. See Management's Discussion and Analysis - "Credit" and "Results of Operations - Comparison of Years Ended December 31, 1993 and 1992" contained in the 1993 annual report to shareholders filed as an exhibit hereto. At December 31, 1993, 63% of the Bank's 1-4 family loan portfolio was comprised of adjustable rate loans (including ARMs with initial fixed-interest rate periods of 3-5 years) and 37% of the portfolio was comprised of fixed rate loans. Of the adjustable rate products held in the Bank's portfolio, the majority reprice based upon one of the following three indices: the national cost of funds, the 11th district cost of funds, or the one year constant maturity treasury bills. Original repricing intervals range from one month to five years, with the majority of the adjustable rate mortgage loans repricing on an annual basis. The weighted average lifetime caps on the Bank's adjustable rate 1-4 family mortgage loans at December 31, 1993 approximated 13%. At December 31, 1993, $112.5 million of 1-4 family loans were at their weighted average floor rate of 8.24%. This weighted average floor was 158 basis points higher than the fully-indexed loan rate at December 31, 1993. The Bank's primary method of originating 1-4 family mortgages is through applications taken in its retail branches and servicing departments. Demand for 1-4 family loans is created through both advertisement and promotion and referrals from builders and real estate brokers. The Bank's secondary method of originating 1-4 family mortgages is through loan correspondents (mortgage brokers and other financial institutions) primarily located in Illinois. In addition, the Bank has developed correspondent lending relationships to originate loans in selected areas of surrounding states, which include Wisconsin, Indiana, southwest Michigan, and Ohio. During 1993, $110.8 million of 1-4 family mortgage loans were originated through correspondents in Illinois and $66.0 million of mortgage loans were originated through brokers in surrounding states. At December 31, 1993, $203.1 million of the Bank's 1-4 family mortgage loan portfolio had been originated through Illinois brokers and $97.8 million had been originated through brokers in surrounding states. The Bank's loan approval process assesses both the prospective borrower's ability to repay and the adequacy of the property as collateral for the loan requested. Detailed residential loan applications are submitted to salaried, full-time employees of the Bank with designated credit approval dollar limits. Where the loan approval exceeds an employee's authority, the credit is reviewed by increasingly higher levels of management. The Bank generally requires that borrowers obtain mortgage insurance on the portion of the loan which exceeds 80% of the value of the real estate and improvements. St. Paul Federal does not fund conventional mortgage loans which exceed 95% of the value of the real estate securing the loan. St. Paul Federal's mortgage lending is subject to prescribed loan origination procedures which are based upon the standards of the FNMA, FHLMC and other institutional investors. Property appraisals on the real estate collateral securing St. Paul Federal's 1-4 family mortgage loans are made by staff appraisers and by independent appraisers approved by the Bank's Board of Directors. Appraisals of 1-4 family properties by independent appraisers are reviewed by the Bank's staff appraisers. Loan packages received from correspondents are underwritten before disbursement in accordance with the same guidelines the Bank applies to its direct originations. Appraisals are obtained from approved appraisers and are subject to further evaluation by outside consultants or by the Bank's own Appraisal Department. The Bank obtains title insurance policies on first mortgage real estate loans. Borrowers also must obtain hazard insurance prior to closing and, when required by the United States Department of Housing and Urban Development, flood insurance. Borrowers may be required to advance funds to a mortgage escrow account from which the Bank makes disbursements for items such as real estate taxes, hazard insurance premiums and mortgage insurance premiums as they become due. Mortgage loans funded by St. Paul Federal include a "due-on-sale" clause, which is a provision giving the Bank the right to declare a loan immediately due and payable in the event, among other things, that the borrower sells or otherwise disposes of the real property subject to the mortgage and the loan is not repaid. Due-on-sale clauses are an important means of speeding the repayment of low interest-rate loans in high interest-rate environments. It is St. Paul Federal's policy to actively enforce such clauses. The average life of the Bank's one-to-four family loans varies from year to year with changes in interest rates but has generally ranged from six to nine years. The Bank also accesses the secondary market to purchase 1-4 family mortgage loans to supplement its loan originations. Under the Bank's 1-4 family loan acquisition program, St. Paul Federal emphasizes adjustable rate, first mortgages that are also owner occupied. The Bank reviews the reputation of each of the sellers, and servicers if applicable, and generally uses sampling methods to evaluate the quality of the seller's underwriting. In addition, depending on the representations and warranties obtained and other factors, the Bank may review each loan presented in a pool prior to purchase. The Bank only purchases whole loans that meet its established underwriting and pricing requirements. Purchases of 1-4 family mortgage loans have been minimal in recent years. See Management's Discussion and Analysis - "Credit" contained in the 1993 annual report to shareholders filed as an exhibit hereto. Multi-Family and Commercial Real Estate Loans. At December 31,1993, the Bank had approximately $1.14 billion in multi-family commercial real-estate and land loans outstanding, constituting 48.5% of the Bank's loan portfolio, which were originated through a "Nationwide" lending program.(a) Of this amount, $1.06 - ------------------------------- (a) The Bank also originated multi-family and commercial real estate loans prior to the establishment of the Nationwide lending program. The remaining loan balance for these assets was assets was $4.8 million at December 31, 1993. Also, the Bank acquired 82 multi-family and commercial real estate loans totaling $29.3 million during 1993 as part of the Elm Financial acquisition. billion represented multi-family loans, $73.0 million represented commercial real estate loans, and $10.3 million represented land loans. For a discussion of geographic concentration risk associated with the Nationwide lending program, see "NOTE W - Concentration of Credit Risk" to the Consolidated Financial Statements and "Credit" in Management's Discussion and Analysis contained in the 1993 annual report to shareholders filed as an exhibit hereto. Since 1990, the Bank's only multi-family or commercial lending activity outside of the Chicago metropolitan area has been limited to financing arrangements provided to facilitate real estate owned ("REO") sales or to reacquire loans that had been sold with recourse provisions. See "NOTE U - Financial Instruments With Off- Balance Sheet Credit Risk" to the audited financial statements contained in the 1993 annual report to shareholders filed as an exhibit hereto. At the time of originations, all of the properties securing the loans that were originated under the "Nationwide" lending program were inspected by the Bank's loan underwriters. The Bank obtained appraisals of each property in accordance with federal regulations. Appraisals used in connection with underwriting were performed by independent appraisers who were members of the American Institute of Real Estate Appraisers (MAI) and were approved by the Bank's Board Of Directors. The Bank's original underwriting policy for multi-family and commercial loans required debt service coverage ratios of 1.10:1, using the midpoint of the interest rate ceilings and floors. Appraisals performed by independent appraisers during original underwriting indicated loan-to-value ratios for the Bank's multi-family and commercial loans that ranged from 25% to 86% with an average loan-to-value ratio of 71.5% at the time of origination. To minimize the risks involved in originating these loans, Management considered, among other things, the creditworthiness of borrowers (although most of the Nationwide loans have been without recourse against the borrowers), the location of the real estate, the condition and occupancy levels of the real estate collateral, as well as the competitive marketplace and operating results of the property. To ensure that the loan documents complied with applicable state laws, all transactions were reviewed and closed by local law firms. Most of the loans were referred to the Bank by mortgage brokerage firms. Referring mortgage brokers were paid by the borrowers. All multi-family and commercial real estate loans were approved by the loan committee of the board of directors. Any loan of $5.0 million or more was reviewed and approved by the entire Board of Directors. The Bank has implemented new credit administration procedures for its Nationwide loans in recent years. The credit administration procedures require annual inspections of the real estate serving as collateral for such loans (or more frequent if the Bank deems warranted) and an analysis of the borrowers' operating statements. Also, each Nationwide loan is assigned to a portfolio administrator who has responsibility to monitor and analyze specific geographic areas of the country. The Bank's credit administration procedures require preparation and maintenance of comprehensive credit analyses on all Nationwide loans. Independent appraisals are obtained in accordance with federal regulations or as deemed warranted by Management. The Bank's multi-family loans are secured by apartment buildings and complexes. These loans range in amount from $20,000 to $26.6 million, and the apartment complexes securing the loans contain from five to 600 units. Borrowers are individuals or partnerships with substantial experience in real estate investment and generally, the loans were made on a non-recourse basis. Loan proceeds have been used to purchase the collateral or to refinance existing loans from other financial institutions. Of the multi-family and commercial real estate loans, 91.1% were first mortgage liens and 8.9% were second mortgages as of December 31, 1993. Second mortgages were underwritten on the basis of the total outstanding indebtedness, including the senior mortgages. The Bank holds sixty commercial real estate loans which are either secured by office buildings, shopping centers, or industrial buildings. The total amount of such loans outstanding at December 31, 1993 was $73.0 million or 3.1.% of the Bank's total loan portfolio. The loans ranged in principal amount from $32,000 to $7.9 million as of December 31, 1993. These loans have been made under similar terms and underwriting criteria as the Bank's multi-family loans. Multi-family and commercial real estate loans have been made for up to fifteen-year terms, in most cases with only interest payable during the first five years. Amortization of principal on multi-family and commercial loans generally begins in the sixth year and is based on a 25-year amortization schedule. As of December 31, 1993, approximately 75% or $858.4 million of the Multi-Family, Commercial Real Estate and Commercial Land portfolio is in its amortization term. Prepayment is permitted without penalty in most cases. The initial interest rate generally has been fixed from 8% to 13.5%, depending on the prevailing rates at the time the loan was originated, for initial periods ranging from three months to one year. Following such initial period, the interest rate typically adjusts either quarterly or semiannually, although annual or monthly adjustments have been established in certain instances. Adjustments are made to a level that is a percentage above a specified index. As of December 31, 1993, approximately 90.9% of the Bank's multi-family and commercial mortgage loan portfolio contains adjustable-rate mortgages that reprice based on a variety of indices including: the FHLB National Cost Of Funds Index, the FHLB 11th District Cost Of Funds Index, the U.S. Treasury Bill Index, and the Prime Rate. Interest rate ceilings and floors have been established on the multi-family and commercial loans and, except for loans tied to the Treasury Bill Index, the loans typically do not contain limits on the interest-rate adjustments that may occur in any one adjustment period. The remaining 9.1% of the Bank's multi-family and commercial mortgage loans portfolio contain fixed interest rates. At December 31, 1993, $781.7 million, or approximately 81.8%, of Nationwide multi-family and commercial loans were at their weighted average floor rate of 8.05%. This weighted average floor was 174 basis points higher than the fully-indexed loan rate at December 31, 1993. The majority of these loans reprice quarterly and are adjusted to the FHLB National Cost Of Funds Index or the 11th District Cost Of Funds Index. See "Interest Rate Risk" in Management's Discussion and Analysis contained in the 1993 annual report to shareholders filed as an exhibit hereto. In certain other instances, the mortgage notes permit the deferral of interest payments (i.e.., negative amortization) in the event that the applicable interest rate increases above a specified percentage, during the first five years of the loan. In 1993, there were no instances of negative amortization due to market interest rates declining throughout the year. Such deferrals are not permitted to exceed 10% of the original loan amount. At December 31, 1993, total negative amortization on the Nationwide portfolio recorded as income was $204,000. The Bank plans to originate loans secured by existing 5-35 unit apartment buildings located in the six county Chicago metropolitan area in 1994. Site inspections and environmental questionnaires will be performed for every property, with a full Phase I environmental investigation and report required for all properties securing loans in excess of $1.0 million. The Bank's internal Commercial Real Estate Review Committee will approve all loan applications. Applications for loans in excess of $1.0 million will also be approved by the Loan Committee of the Board of Directors. The loans originated under this 5-35 unit loan program will be administered under the existing multi-family and commercial Loan Servicing Department of the Bank. Management hopes to originate $50 million of loans under this new program in 1994. See Management's Discussion and Analysis "Credit" contained in the 1993 annual report to shareholders for a discussion of underwriting standards for these loans. The Bank encounters certain environmental risks in its lending activities. Under federal and state environmental laws, lenders may become liable for the costs of cleaning up hazardous materials found on security properties. Certain states may also impose liens with higher priorities than first mortgages on properties to recover funds used in such efforts. Although the foregoing environmental risks are more usually associated with industrial and commercial loans, environmental risks may be substantial for residential lenders, like St. Paul Federal, since environmental contamination may render the security property unsuitable for residential use. In addition, the value of residential properties may become substantially diminished by contamination of nearby properties. In accordance with the guidelines of FNMA and FHLMC, appraisals for 1-4 family homes on which the Bank lends include comment on environmental influences and conditions. St. Paul Federal attempted to control its exposure to environmental risks with respect to multi-family, commercial and land loans originated under the Nationwide lending program by utilizing one or more of the following techniques: requiring borrowers to agree not to cause or permit the storage, disposal or presence of hazardous substances; by training its lending personnel to recognize the signs of environmental problems when they inspect properties; by requiring borrowers to represent and warrant that properties securing loans do not contain hazardous waste, asbestos or other such substances; by requiring borrowers to indemnify St. Paul Federal, with personal recourse, against environmental losses; by obtaining reports from consulting engineers on all loans to facilitate the sale of real estate owned or secured by non-residential properties and on 5-35 unit residential properties or where the loan exceeds $1 million; and by obtaining further environmental reviews and tests where indicated by information obtained from borrowers or from property inspections or otherwise. No assurance can be given, however, that the value of properties securing loans in the Bank's portfolio will not be adversely affected by the presence of hazardous materials or that future changes in federal or state laws will not increase St. Paul Federal's exposure to liability for environmental cleanup. Consumer Loans. Federal regulations permit federally chartered savings institutions to make secured and unsecured consumer loans up to 30% of the institution's total assets. In addition, a federal savings institution has lending authority above the 30% limitation for certain consumer loans, such as home equity loans (loans secured by equity in the borrower's residence but not necessarily for the purpose of improvement), property improvement loans and deposit account secured loans. At December 31, 1993, the Bank's consumer loans totaled $19.7 million, or 0.53% of assets. St. Paul Federal originates automobile loans, home improvement loans, education loans, and personal loans that are made to depositors on the security of their deposit accounts. The Bank also offers credit card services through an agency agreement with another financial institution. Beginning in 1993, the Bank no longer owns credit card loans. Loans Held For Investment The following table summarizes loans receivable portfolio held for investment at December 31, 1989 through 1993 (dollars in thousands): Loan Origination and Purchases The following tables sets forth loan origination and purchases for the years ended December 31, 1989 through 1993 (dollars in thousands). Scheduled Loan Principal Repayments The following table sets forth as of December 31, 1993 information regarding the dollar amount of loans receivable maturing in the Bank's portfolio, including assets held for sale, based on either their contractual terms to the maturity or scheduled principal amortization. Loan Repricing The following table sets forth certain information at December 31, 1993 regarding the dollar amount of loans receivable maturing in the Bank's portfolio, including assets held for sale, based on their scheduled principal amortization, maturity or scheduled interest-rate repricing. See Management Discussion and Analysis "Interest Rate Risk" and "GAP Table" following. - ----------------- (a) 1993, 1992 and 1991 primarily includes loans to facilitate the sale of foreclosed real estate assets and repurchases of assets under recourse arrangements. The following table sets forth as of December 31, 1993 the dollar amount of loans receivable in the Bank's portfolio due after December 31, 1994 categorized by either fixed interest rates or floating and adjustable interest rates. Sales of Mortgages and MBS. While the Bank seeks adjustable-rate loans for its own portfolio, most fixed-rate loans are originated with terms that permit their sale in the secondary market. St. Paul Federal participates in secondary market activities by selling whole loans and participations in loans to FNMA, FHLMC and various other institutional investors. This practice enables the Bank to satisfy the demand for such loans in its local communities, to meet asset and liability objectives of Management and to develop a source of fee income through loan servicing. In 1993, 1992, and 1991, the Bank arranged for "swap" transactions with FNMA and FHLMC which involved the exchange of - ---------------------------- (a) Subject to limit of rate caps and floors. (b) Includes $235.4 million of 1-4 family adjustable-rate mortgage loans that have initial fixed interest rate terms of three- to five-years and $20.6 million of renegotiable rate mortgages which adjust every three or five years. Also includes $64.6 million in five-, seven- and ten-year multi-family loans which adjust after their respective initial terms, and which are matched to FHL Bank advances having identical terms. approximately $146.4 million, $208.6 million and $86.9 million, respectively, of fixed-rate mortgage loans held for sale for MBS, which were subsequently sold. As the Bank commits to fund fixed-rate 1-4 family loans, it typically secures commitments, approximately sixty days in advance, to securitize and sell such loans into the secondary market. The amounts of the commitments to sell are based on the Bank's estimates of the fixed-rate loans it will fund given then-current interest rates, anticipated rate movements and the Bank's asset/liability needs. In general, loans are sold without recourse and servicing is retained by the Bank. The Bank's Credit Review Department in 1994 has begun to perform quality control in-house for agencies purchasing single family loans. Previously, the Bank relied upon the use of consultants to perform these procedures. See "NOTE U - Financial Instruments With Off-Balance Sheet Credit Risk" in the 1993 annual report to shareholders filed as an exhibit hereto for a discussion of loans sold with recourse and forward loan sale commitments. The following table summarizes mortgage servicing statistics at December 31, 1989 through 1993 (dollars in thousands): The following table summarizes loans held-for-sale as of December 31, 1989 through 1993 (dollars in thousands): CREDIT See Management's Discussion and Analysis and Management's Discussion and Analysis "Credit" contained in the 1993 annual report to shareholders filed as an exhibit hereto for a discussion of credit issues affecting the Company. At December 31, 1993, the Bank's non-performing assets totaled $49.6 million compared to $48.4 million at December 31, 1992. Non-performing multi-family and commercial real estate assets totaled $32.9 million (a) at year end 1993 compared to $32.0 million at December 31, 1992. Of the $32.9 million of non-performing multi-family and commercial real estate assets, $16.5 million represented real estate or real estate collateral located in the state of California. In - ------------------------ (a) including $2.4 million of land loans. comparison, $17.8 million of the non-performing multi-family and commercial real estate assets represented real estate or real estate collateral located in the state of California at December 31, 1992. The following are descriptions of individual non-performing assets as of December 31, 1993 in which the Company's carrying amount exceeded $3.0 million: - A $10.2 million first mortgage loan (210 days delinquent) secured by a 435 unit apartment building located in Kent, Washington. The Bank's net carrying amount of the loan is only $6.0 million since a portion of the ownership interest in the loan was sold without recourse to other institutions and $1.1 million of charge-offs have been recorded. At December 31, 1993, the Bank classified this asset as in-substance foreclosed real estate. This property was removed from bankruptcy during the first quarter of 1994 and the Bank anticipates completing foreclosure during the second quarter of 1994. The Bank had begun to make disbursements for capital improvements to the properties which may total $1 million in the aggregate. The Bank will be reimbursed on a pro-rata basis by the investing participants for all disbursements made for this property. - A $5.0 million, 176 unit apartment building located in Riverside, California. The Bank is currently marketing the property. To date, no charge-offs have been recorded against this loan. - A $3.4 million first mortgage loan (90 days delinquent) secured by a 128 unit apartment building located in Madison, Wisconsin. The property was removed from bankruptcy during the first quarter of 1994 and the Bank anticipates completing foreclosure during the second quarter of 1994. During 1993, approximately $1.9 million of charge-offs were recorded on this loan. - A $3.0 million first mortgage loan (60 days delinquent) secured by a 100 unit apartment building located in Colton, California. The property is currently in bankruptcy and the Bank anticipates completing foreclosure during the second quarter of 1994. During 1993, the Bank recorded a $500,000 charge-off on the loan and, at December 31, 1993, approximately $50,000 of the loan was classified as "loss" for which the Bank provided a specific valuation allowance. See Management's Discussion and Analysis "Credit" and "NOTE W - Concentration of Credit Risk" to the consolidated financial statements contained in the 1993 annual report to shareholders filed as an exhibit hereto for additional discussion of non-performing assets. The Bank had an aggregate recorded investment in troubled-debt restructurings of $15.6 million at December 31, 1993 compared to $25.0 million at December 31, 1992. The $15.6 million of troubled-debt restructurings represent first mortgage loans secured by three multi-family apartment buildings located in the state of Washington which are owned by the same borrower. The Bank has entered into an agreement with the borrower concerning the restructuring of these loans. The properties have undergone substantial construction rehabilitation to rectify building defects. A substantial insurance settlement was reached between the developer and its insurance agencies, which funded some of the new construction costs. The rehabilitation project was completed during 1993. The Bank in 1984 purchased a participation with an original face amount of $10 million in an approximately $970 million amortizing note issued by certain partnerships, the general partner of each of which is an affiliate of Olympia and York Developments Limited. At December 31, 1993, the Bank's net carrying amount in the loan was $8.0 million, net of the $1.5 million portion of the loan that the Bank classifies as loss and against which the Bank provides a specific valuation. In addition, the Bank has allocated $930,000 of its general valuation allowance for potential losses on this loan. The note is secured by three large office buildings located in New York City, one of which is currently being prepared for sale. While there has not been a bankruptcy of the borrowers, the fact that they are engaged in the commercial real estate development, ownership, and management business throughout the United States, the fact that commercial real estate values in New York City have been declining for sometime, and the fact that affiliates of the borrowers have gone through bankruptcy or similar proceedings in the United Kingdom and Canada or otherwise have experienced debt payment problems have caused the Bank to view the note as a potential non-performing loan. Because current and anticipated cash flows from the property provide sufficient anticipated debt service coverage to make scheduled interest and principal payments on the note through May 31, 1994, at the very earliest, the note is currently treated as performing by the Bank. However, a higher than normal risk exists that such note could become non-performing in the future, unless a restructure currently under negotiation is agreed to. The Bank is a member of a noteholders steering committee that actively monitors the performance of the borrower under the loan documents, including the occurrence and continuance of any defaults, continually assesses the situation, and considers asset management alternatives with respect to such notes. See "NOTE A - Summary of Significant Accounting Policies" contained in the 1993 annual report shareholders filed as an exhibit hereto for a discussion of the Bank's policy for placing loans on a non-accrual status. The following table sets forth certain information regarding non-accrual loans and troubled debt restructurings at the dates indicated. The reversal of interest on non-accrual loans resulted in a reduction in interest income of $2.8 million, $1.7 million, and $3.3 million in 1993, 1992 and 1991, respectively. Interest on delinquent 1-4 family loans that was not collected but was accrued as income because their loan-to-value ratio was less than 80%, totaled $400,000, $425,000, and $539,000 at December 31, 1993, 1992 and 1991, respectively. See "NOTE E - Loans Receivable" to the Consolidated Financial Statements contained in the 1993 annual report to shareholders filed as an exhibit hereto, for SFAS #15," Accounting by Debtors and Creditors for Troubled Debt Restructurings" disclosure related to modified loan interest. The following table sets forth information on delinquent loans for which the Bank has accrued interest income. The Bank's Credit Review Department evaluates the risk ratings of all multi-family, commercial and 1-4 family mortgage assets on a 9-class scale and, in 1994, will begin to risk rate home equity and other consumer loans. The thirty-two factors in the multi-family and commercial rating system are evaluated under one of the five categories following: property management, financial risks, operating risks, the competitiveness of the marketplace and the condition of the collateral. The 1-4 family rating system uses a matrix with 9 risk factors, heavily weighted toward borrower creditworthiness. The Bank risk rates all geographic areas in which it does business both in-state and out-of-state, and attempts to detect and report on early warning signs of potentially troubled loans. In addition, credit review creates reports on geographic and other concentrations on a bi-monthly basis, reviews all multi-family credits for upgrade and downgrade, develops "early warning systems" to identify credits for downgrade prior to the normal review cycle and develops profiles of potentially troubled loans. Management has integrated the regulatory classification system for problem assets, which requires that such assets be classified as "substandard," "doubtful" or "loss" into its credit rating system. The Bank believes the credit rating system results in loan classifications consistent with applicable regulatory standards. Under the regulations, an asset is considered "substandard" if inadequately protected by the current net worth and paying capacity of the obligor or by the collateral pledged, if any. Assets will also be classified "substandard" if characterized by the "distinct possibility" that the insured institution will sustain "some loss" if the deficiencies are not corrected. Assets so classified must have a well defined weakness or weaknesses. Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard" with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions and values, "highly questionable and improbable." Assets classified "loss" are those considered "uncollectible" and of such little value that their continuance as assets is not warranted. The Bank charges-off or provides a specific valuation allowance to assets classified as loss. See "Credit" in "Management's Discussion and Analysis" contained in the 1993 annual report to shareholders filed as an exhibit hereto. The Bank's credit review function also evaluates off-balance sheet credit risk using the Bank's credit rating system and the Bank includes these credits in its loss reserve methodology. At December 31, 1993 the Bank had total classified assets, including off-balance sheet items, of $255.0 million compared to $249.1 million at December 31, 1992. The following table details the components of substandard assets at December 31, 1993 and 1992: Assets classified as doubtful totaled $4.0 million at December 31, 1993 compared to $4.3 million at December 31, 1992. Assets classified as loss totaled $6.1 million at December 31, 1993 and $4.0 million at December 31, 1992. Of total classified assets at December 31, 1993, $228.4 million or 89.6% represented Nationwide assets, of which $153.3 million (or 60.1% of total classified assets) consisted of California multi-family assets(a). See "Credit" in Management's Discussion and Analysis contained in the 1993 annual report to shareholders filed as an exhibit hereto. Of the $228.4 million of classified multi-family assets, $26.5 million were multi-family loans sold with recourse (i.e. off-balance sheet credit risk) which were performing in accordance with the mortgage notes but were deemed classified pursuant to the Bank's credit rating system. Also included in substandard assets were $153.5 million of loans held - ----------------- a Also includes a $7.9 million commercial real-estate loan. in the Bank's portfolio which were performing in accordance with the mortgage notes, but were deemed classified pursuant to the Bank's credit rating system. St. Paul Federal has submitted a plan to the OTS to maintain the ratio of classified assets to tangible capital and general loan loss reserves at less than 70%. As of December 31, 1993, the Bank's ratio of classified assets to tangible capital and general valuation allowances was 65.3%, considerably lower than the ratio reported at December 31, 1992 of 79.1%. See "Regulation -- Safety and Soundness Regulations" for additional discussion. The following is a summary of activity in the accumulated provision for loan and REO losses for the periods indicated. See also "NOTE F - Accumulated Provision for Loan Losses" and "NOTE I - Foreclosed Real Estate" to the Consolidated Financial Statements contained in the 1993 annual report to shareholders filed as an exhibit hereto. The following table presents an allocation of St. Paul Federal's accumulated provisions for loan and REO losses as of the dates indicated: As of December 31, 1993, St. Paul's GVA for loans and REO was $42.4 million, compared to $47.1 million reported at December 31, 1992. Although the actual content of the GVA differs between institutions, St. Paul Federal's GVA represents that part of the accumulated loss provisions for loans and REO in excess of asset balances classified as loss for regulatory reporting. In addition to the GVA, the Bank had $5.0 million of specific reserves on loans at December 31, 1993 compared to specific reserves of $2.7 million on loans and $1.3 million on REO at December 31, 1992. See "NOTE A - Summary of Significant Accounting Policies" and "Credit" in Management's Discussion and Analysis contained in the 1993 annual report to shareholders filed as an exhibit hereto. The following table summarizes net mortgage loan and REO charge-offs by state for the year ended December 31, 1993: - ---------------- (a) Also includes commercial real estate and land loans. See "NOTE E - Loans Receivable" contained in the 1993 annual report to shareholders filed as an exhibit hereto. The following table summarizes net mortgage loan and REO charge-offs by state for the year ended December 31, 1992: The following table summarizes cumulative net mortgage loan and REO charge-offs by state from 1982(b) through December 31, 1993: See "Management's Discussion and Analysis - Credit and - Results of Operations - Provision for Loan Losses," "NOTE E - Loans Receivable," "NOTE F - -Accumulated Provision for Loan Losses," "NOTE I - Foreclosed Real Estate," "NOTE W - Concentration of Credit Risk," and "NOTE U - Financial Instruments - -------------------------- (a) Also includes commercial real estate and land loans. See "NOTE E - Loans Receivable" contained in the 1993 annual report to shareholders filed as an exhibit hereto. (b) The Bank began its nationwide multi-family and commercial real estate lending program during 1982; however, the first loss experienced on loans originated through this lending program did not occur until 1986. With Off-Balance Sheet Credit Risk" contained in the 1993 annual report to the shareholders filed as an exhibit hereto. SOURCES OF FUNDS See "Liquidity" in Management's Discussion and Analysis contained in the 1993 annual report to shareholders filed as an exhibit hereto, for a discussion of the Bank's sources of funds. Deposits. St. Paul Federal offers a variety of checking, savings, and time deposit accounts having a wide range of interest rates and terms. Average balances of and rates paid on such deposits at December 31, 1993 and 1992 are set forth in "NOTE N - Deposits" to the Consolidated Financial Statements contained in the 1993 annual report to shareholders filed as an exhibit hereto. Interest rates on all deposit accounts are reviewed at weekly meetings of the Bank's Liability Pricing Committee, which is comprised of certain managers of the Bank. The Bank attempts to control the flow of funds in its deposit accounts according to its need for funds and the cost of alternative sources of funds. St. Paul Federal controls the flow of funds primarily by the pricing of deposits to take advantage of opportunities for profitable investment of the funds. In connection with an ongoing review of the Bank's deposit product composition and fee schedule, the Bank initiated a new checking account campaign in the first quarter of 1992. The Bank pays interest rates comparable to those paid on deposits by other insured-depository institutions in its market area. Interest rate increases are also influenced by the Bank's liquidity needs and by competitive factors. See "Liquidity" and "Results of Operations-Comparison of Years Ended December 31, 1993 and 1992" in Management's Discussion and Analysis contained in the 1993 annual report to shareholders filed as an exhibit hereto. Many of the checking account products offered by the Bank bear interest. Checking accounts are assessed fees of varying amounts, depending upon the product type, the balance maintained in the account and the number of monthly transactions executed on the account. Each of the checking accounts have access to an electronic banking system using an ATM card. Over 1,800 banking locations are available in the Chicago metropolitan area (65,000 locations worldwide) through a shared electronic network of ATMs. In addition to checking accounts offered to retail bank customers, the Bank also offers a commercial checking account product. The Bank offers several types of passbook and statement savings accounts. Some of these accounts feature electronic banking access using an ATM card. The rate paid on savings accounts is reviewed on a quarterly basis. As of December 31, 1993, passbook and statement accounts earned 2.42% interest. The Bank also offers a money market account which is an insured investment account that pays market rates with no withdrawal penalty. The Bank also issues fixed and variable rate certificates of deposit ("CDs") of varying maturities. Short-term CDs with maturities of three months can be opened for $500 or more and six-month CDs can be opened for $2,000 or more. The variable-rate CDs have a maturity of eighteen-months and the interest rate earned on the accounts changes weekly throughout the eighteen-month term. There is a substantial penalty for early withdrawal on all CDs offered by the Bank. St. Paul Federal's deposit base at December 31, 1993 included $1.8 billion of CDs with a weighted average rate of 4.75%. Of these CDs, approximately $1.1 billion will mature during the twelve months ending December 31, 1994. The Bank will seek to retain these deposits to the extent consistent with its long-term objective of maintaining positive interest rate spreads. See "Borrowings" discussion following. Depending upon interest rates existing at the time such CDs mature, the Bank's cost of funds may be significantly affected by the rollover of these funds. The following table presents the amount of the Bank's time deposits in amounts of $100,000 or more at December 31, 1993 maturing during the periods indicated. The following table summarizes the average balance and rate paid on deposits during the three years ended December 31, 1993, 1992, and 1991 (dollars in thousands): Individual retirement accounts can be opened using the passbook savings account or any of the CD accounts described above. Borrowings. The following table presents certain information regarding short-term borrowings. For a description of the general terms of such borrowings see "NOTE O - FHL Bank Advances" and "NOTE P - Other Borrowings" to the Consolidated Financial Statements contained in the 1993 annual report to shareholders filed as an exhibit hereto. As a member of the FHLB System, the FHLB of Chicago generally is allowed to extend credit to St. Paul Federal through advances and letters of credit up to 20% of St. Paul Federal's total assets. As of December 31, 1993, the Bank also had approximately $925.0 million of unused credit lines available to borrow under agreements to repurchase. In February 1993, the Company issued $34.5 million of subordinated notes. The Company used the proceeds for general corporate purposes, including the acquisition of St. Paul Financial from St. Paul Federal on June 30, 1993. See "Liquidity" in Management's Discussion and Analysis contained in the 1993 annual report to shareholders filed as an exhibit hereto. Asset/Liability Management See "Interest Rate Risk" section of Management's Discussion and Analysis to the Consolidated Financial Statements contained in the 1993 annual report to shareholders filed as an exhibit hereto. The GAP Table, set forth on the following page, identifies the projected maturity/repricing structure of the Company's interest-earning assets and interest-bearing liabilities at December 31, 1993. The GAP Table does not use the contractual maturities of certain categories of assets and liabilities. Because prepayments of loans and withdrawals of deposits are determined by changing economic circumstances and customer behavior, adjustments to contractual terms were needed to obtain a more accurate measure of the repricing of certain asset and liability categories. See Note A to the GAP Table appearing on the following page. Management also must adhere to interest-rate risk exposure limits established in June 1990 by the Board of Directors in compliance with Thrift Bulletin ("TB") 13. TB 13 requires that Management measure and report to the Board of Directors the effect that immediate increases and decreases of 100, 200, 300 and 400 basis points in market rates have upon net interest income and market value of portfolio equity. GAP TABLE(a) - ------------------ (a) The mortgage loan repricing/maturity projections were based upon principal repayment percentages in excess of the contractual amortization schedule of the underlying mortgages. Multi-family mortgages were estimated to be prepaid at a rate of approximately 5% per year; adjustable-rate mortgage loans on 1-4 family residences and loan securities were estimated to prepay at a rate of 18% per year; fixed-rate loans and loan securities were estimated to prepay at a rate of 20% per year. Checking accounts were estimated to be withdrawn at rates between 15% and 21% per year depending on the age of the accounts. Regular savings accounts were estimated to be withdrawn at rates between 15% and 26% per year. Except for multi-family loans, the prepayment and withdrawal assumptions included in the Asset/Liability Repricing Schedule applied the most recently available quarterly national interest rate risk assumptions distributed by the OTS. The Bank assumed a prepayment percentage of 5% instead of the 12% suggested by the OTS because of current market conditions and the nature of the Bank's multi-family portfolio. (b) Includes investment in FHLB Stock and other stock. (c) Excludes borrowings by the employee stock ownership plan. SERVICE CORPORATION ACTIVITIES The Bank has six wholly owned subsidiaries; St. Paul Service, Inc. ("St. Paul Service"), St. Paul Securities, Inc., Managed Properties, Inc., Community Finance Corporation, EFS Service Corporation and EFS/San Diego Service Corporation. These subsidiaries are incorporated in the state of Illinois. St. Paul Service is an insurance agency providing a variety of insurance coverage including homeowners, automobile, life, disability income, special multi-peril, commercial automobile, dwelling, fire and allied lines, liability, bonds, workers compensation, and group health plans. The Bank Credit Review Department risk rates all annuity insurance companies with which it does business or is contemplating doing business. The Bank offers discount brokerage services directly to its customers through Investment Network, Inc, a wholly owned subsidiary of St. Paul Securities, Inc. Investment Network, Inc., provides a full line of investment brokerage services through 52 of the Bank's branches and employs 15 registered principals and 91 registered representatives. As a registered broker/dealer the company is subject to regulation under the Securities Exchange Act of 1934. The Bank Credit Review Department risk rates all broker-dealers and mutual fund seller companies with which it does business or is contemplating doing business. Managed Properties, Inc. is engaged in the management of real estate acquired by the Bank through foreclosure of multi-family and commercial real estate loans. Community Finance Corporation holds investments in a general partnership which acquires limited partnership interests in low income building development projects to help comply with the Community Reinvestment Act. EFS Service Corporation, a subsidiary acquired from Elm Financial, was established to, from time to time, participate in real estate joint venture activities. EFS/San Diego Service Corporation, a subsidiary acquired from Elm Financial, owns assets which are leased to others. At December 31, 1993, the total amount the Bank was authorized to invest in subsidiary service corporations, not including amounts authorized for investment in conforming loans, was 2% of its total assets, or approximately $74.1 million. At that date, the Bank's direct investment (consisting of capital stock and nonconforming loans) in its service corporations was $14.6 million. During 1991, the Company established ANI whose business consists of the sale of annuity products. Prior to the incorporation of ANI, annuity products had been sold by St. Paul Service. During 1993, ANI and St. Paul Service executed a percentage lease revenue sharing arrangement whereby ANI pays St. Paul Service a portion of its commission on the sale of annuity products for use of St. Paul Service's facilities and access to its customers. On June 30, 1993, the Company purchased St. Paul Financial Development Corporation ("Development Corporation") from the Bank. The purchase price of the transaction was $9.2 million and represented the fair market value of the Development Corporation at that date (as determined by an independent valuation). EMPLOYEES At December 31, 1993 St. Paul Federal had 1,046 full-time equivalent employees. The 1,046 consists of 917 full-time employees and 246 part-time employees and 81 reserve employees. The St. Paul Federal employee benefit program includes, among other benefits, an educational assistance program to encourage ongoing employee development. In 1993, 84 employees were involved in undergraduate, graduate and management certificate programs. In addition, 190 employees have become Illinois Life Producers Representatives and 91 employees have become registered with the National Association of Securities Dealers, Inc. ("NASD"), with 91 becoming registered securities representatives of the Bank's discount brokerage subsidiary and 21 becoming registered agents for the Bank. In connection with the Elm acquisition, in which the Bank acquired 8 full-service branch facilities, the Bank added 73 full time equivalents, consisting of 60 full-time employees and 13 part-time employees. COMPETITION St. Paul Federal experiences substantial competition in attracting and retaining deposit accounts and in making mortgage and other loans. The primary factors in competing for deposit accounts are interest rates, the quality and range of financial services offered, convenience of office locations and office hours. Competition for deposit accounts comes primarily from other federally insured depository institutions such as other savings institutions, commercial banks and credit unions, money market funds and other investment alternatives. Additional competition for deposits comes from various types of corporate and government borrowers and insurance companies. The primary factors in competing for loans are interest rates, loan origination fees, customer relationships, reputation, market presence and the quality and range of lending services offered. Competition for origination of first mortgage loans comes primarily from mortgage brokers, other savings institutions, mortgage banking firms, commercial banks, insurance companies and real estate investment trusts. The OTS's statement of policy on branching by federally chartered savings institutions generally permits nationwide branching. However, nationwide branching is not permitted to the extent that it would result in formation of a multiple savings and loan holding company controlling savings institutions in more than one state. Generally, the formation of multi-state, multiple savings and loan holding companies is prohibited unless one of three exemptions exists. The first exemption authorizes a savings and loan holding company or any of its savings institution subsidiaries to acquire an institution or operate branches in another state following a supervisory acquisition. The second exemption relates to grandfathered branching rights and the third exemption relates to specific approvals under the law of the state in which the acquired institution or branches are located. Additionally, OTS regulations allow a federal savings institution to establish, in any state in which the institution has its home or branch office, agency offices which only service and originate (but do not approve) loans and contracts, manage or sell real estate owned by the institution or engage in such other activities (other than accepting payments on savings accounts or approving loans) as may be approved by the OTS. St. Paul Federal's market area is experiencing increased competition from the acquisition of local financial institutions by out-of-state commercial banks. In addition, recent changes in Illinois branch banking laws may make Illinois savings institutions more attractive acquisition candidates for out-of-state commercial banks. Usury Limitations. Federal legislation has permanently pre-empted all state interest ceilings applicable to residential first mortgage loans unless the state legislature acted to override the pre-emption by April 1, 1983. The Illinois State Legislature did not act to override the federal pre-emption. At present, Illinois law imposes no ceiling on interest rates for residential real estate loans, including junior mortgage loans. Additionally, federal law permits federally insured savings institutions to charge the highest rate permitted to lenders in Illinois. The Illinois State Legislature has allowed state banks to charge any interest rate on any type of loan, and thus, there are effectively no ceilings on the interest rates which a federal savings bank may charge on a loan in Illinois. Other states in which St. Paul Federal acquires loans through its correspondent lending program have varying laws concerning usury. Management believes that all loans acquired by the Bank in other states are in compliance with applicable usury limitations. REGULATION GENERAL The Company, as a savings institution holding company (a "thrift holding company"), and St. Paul Federal, as a federally chartered savings bank, are subject to extensive regulation, supervision and examination by the OTS as their primary federal regulator. The Bank also is subject to regulation, supervision and examination by the FDIC and as to certain matters by the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). In recent years there have been a significant number of changes in the manner in which insured depository institutions and their holding companies are regulated. Such changes have imposed additional regulatory restrictions on the operations of insured depository institutions and their holding companies. In particular, regulatory capital requirements for insured depository institutions have increased significantly. The Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDICIA") requires the bank regulatory agencies to impose certain sanctions on insured depository institutions which fail to meet minimum capital requirements. In addition, the deposit premiums paid by insured depository institutions have increased significantly in recent years and will most likely increase in the future. THRIFT HOLDING COMPANY REGULATION General. Under the Home Owners' Loan Act (the "HOLA"), the Company, as a thrift holding company, is subject to regulation, supervision and examination by, and the reporting requirements of, the Director of the OTS. The HOLA permits, subject to a number of conditions, the acquisition by a thrift holding company, such as the Company, of control of another savings institution or thrift holding company with prior written approval of the Director of the OTS, including in certain situations an acquisition that would result in the creation of a multiple thrift holding company controlling savings institutions located in more than one state. No director, officer, or controlling shareholder of the Company may, except with the prior approval of the Director of the OTS, acquire control of any savings institution which is not a subsidiary of the Company. Restrictions relating to service as an officer or director of an unaffiliated holding company or savings institution are applicable to the directors and officers of the Company and its savings institution subsidiaries under the Depository Institutions Management Interlocks Act. Under HOLA, transactions engaged in by a savings institution or one of its subsidiaries with affiliates of the savings institution generally are subject to the affiliate transaction restrictions contained in Sections 23A and 23B of the Federal Reserve Act. Section 23A of the Federal Reserve Act imposes both quantitative and qualitative restrictions on transactions with an affiliate, while Section 23B of the Federal Reserve Act requires, among other things that all transactions with affiliates be on terms substantially the same, and at least as favorable, as the terms that would apply to, or would be offered in, a comparable transaction with an unaffiliated party. Exemptions from, and waivers of, the provisions of Sections 23A and 23B of the Federal Reserve Act may be granted only by the Federal Reserve Board. HOLA contains certain other restrictions on loans and extension of credit to affiliates, and authorizes the Director of the OTS to impose additional restrictions on transactions with affiliates if the Director determines such restrictions are necessary to ensure the safety and soundness of any savings institution. Current OTS regulations are similar to Sections 23A and 23B of the Federal Reserve Act. As a unitary savings institution holding company (i.e., a holding company with only one savings institution subsidiary), the Company is not currently subject to any additional statutory or regulatory restrictions on the types of activities in which it and its non-savings institution subsidiaries may engage, provided that St. Paul Federal continues to qualify as a qualified thrift lender ("QTL"). If, however, the Company were to acquire control of another savings institution (other than in a supervisory transaction or by merger or consolidation with St. Paul Federal) or if St. Paul Federal were to fail to maintain its status as a QTL, (see "Regulation - Savings Institution Regulation - Qualified Thrift Lender Requirement"), the Company and its subsidiaries, other than its savings institution subsidiary or subsidiaries, would become subject to restrictions on the activities permitted to them. SAVINGS INSTITUTION REGULATION General. St. Paul Federal is subject to supervision and regulation by the Director of the OTS. Under OTS regulations, St. Paul Federal is required to obtain an annual audit by an independent accountant and to be examined periodically by the Director of the OTS. St. Paul Federal is subject to assessments by the OTS and FDIC to cover the costs of such examinations. The OTS may revalue assets of the Bank, based upon appraisals, and require the establishment of specific reserves in amounts equal to the difference between such revaluation and the book value of the assets. The Director is authorized to promulgate regulations to ensure the safe and sound operation of savings institutions and may impose various requirements and restrictions on the activities of savings institutions. Additionally, under the FDICIA, the OTS has recently proposed safety and soundness regulations relating to (i) internal controls, information systems, and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset growth; and (vi) compensation and benefit standards for officers, directors, employees and principal shareholders. The HOLA requires that all regulations and policies of the Director of the OTS for the safe and sound operation of savings institutions are to be no less stringent than those established by the Office of the Comptroller the Currency (the "OCC") for national banks. The Bank, as a member of the SAIF, also is subject to regulation and supervision by the FDIC, in its capacity as administrator of the SAIF, to ensure the safety and soundness of the SAIF. See "-- Insurance of Deposits." Effective July 21, 1993, the Bank's Supervisory Agreement entered into with the OTS in July 1990 was terminated. In connection with such termination, the Bank indicated to the OTS that it has no immediate plans to re-enter the multi-family lending business on a nationwide basis and remains committed to reduce the level of the Bank's classified assets as well as to reduce multi-family and commercial loan concentrations outside the State of Illinois. Capital Requirements. Under OTS regulations, savings institutions must maintain (i) "core capital" in an amount of not less than 3% of total assets, (ii) "tangible capital" in an amount not less than 1.5% of total assets and (iii) a level of risk-based capital equal to 8% of risk- weighted assets. Capital requirements higher than the generally applicable minimum requirement may be established for a particular savings institution if the OTS determines that the institution's capital is or may become inadequate in view of the particular circumstances. Individual minimum capital requirements may be appropriate where the savings institution is receiving special supervisory attention, has a high degree of exposure to interest rate risk, or poses other safety or soundness concerns. Capital standards established by the OTS for savings institutions must generally be no less stringent than those applicable to national banks. Under OTS regulations, the term "core capital" generally includes common stockholders' equity, noncumulative perpetual preferred stock and related surplus, and minority interests in the equity accounts of consolidated subsidiaries less unidentifiable intangible assets (other than certain amounts of supervisory goodwill) and certain investments in subsidiaries plus 90% of the fair market value of readily marketable purchased mortgage servicing rights ("PMSRs") (subject to certain conditions). "Tangible capital" is core capital minus intangible assets and certain investments in subsidiaries, provided, however, that savings institutions may include 90% of the fair market value of readily marketable PMSRs as tangible capital (subject to certain conditions, including any limitations imposed by the FDIC on the maximum percentage of the tangible capital requirement that may be satisfied with such servicing rights). In establishing risk-based capital requirements for savings institutions, the Director of the OTS may deviate from the risk-based capital standards applicable to national banks to reflect interest-rate risk or other risks so long as such deviations, in the aggregate, do not result in a materially lower risk-based capital requirement for savings institutions than would be required under the national bank standards. In determining total risk-weighted assets for purposes of the risk-based requirement, (i) each off-balance sheet asset must be converted to its on-balance sheet credit equivalent amount by multiplying the face amount of each such item by a credit conversion factor ranging from 0% to 100% (depending upon the nature of the asset), (ii) the credit equivalent amount of each off-balance sheet asset and each on-balance sheet asset must be multiplied by a risk factor ranging from 0% to 200% (again depending upon the nature of the asset) and (iii) the resulting amounts are added together and constitute total risk-weighted assets. Total capital, for purposes of the risk-based capital requirement, equals the sum of core capital plus supplementary capital (which, as defined, includes the sum of, among other items, perpetual preferred stock not counted as core capital, limited life preferred stock, subordinated debt, and general loan and lease loss allowances up to 1.25% of risk-weighted assets) less certain deductions. The amount of supplementary capital that may be counted towards satisfaction of the total capital requirement may not exceed 100% of core capital, and OTS regulations require the maintenance of a minimum ratio of core capital to total risk-weighted assets of 4%. At December 31, 1993, the Bank met all applicable OTS capital requirements on a fully phased-in basis and continues to have capital in excess of OTS regulatory capital requirements on a fully phased-in basis. See "NOTE R - - Stockholders' Equity" contained in the 1993 annual report to shareholders filed as an exhibit hereto for the Bank's regulatory capital levels at December 31, 1993. Under an OCC rule, all national banks must maintain "core" or "Tier 1" capital of at least 3% of total assets. The rule further provides that a national bank operating at or near the 3% capital level is expected to have well-diversified risks, including no undue interest rate risk exposure; excellent control systems; good earnings; high asset quality; high liquidity; well-managed on and off-balance sheet activities; and in general be considered a strong banking organization with a composite 1 rating under the CAMEL rating system for banks. For all but the most highly rated banks meeting the above conditions, the minimum leverage requirement will be 4% to 5% of total assets. The OTS is required to issue capital standards that are no less stringent than those applicable to national banks. The OTS has issued notice of a proposed regulation that would require all but the most highly rated savings institutions to maintain a minimum leverage ratio (defined as the ratio of core capital to total assets) of between 4% and 5%. In August 1993, the OTS issued new regulations, effective January 1, 1994, which add an interest-rate risk component to the risk-based capital requirement. Under the new regulation, an institution is considered to have excess interest-rate risk if, based upon a 200 basis point change in market interest rates, the market value of an institution's capital changes by more than 2%. This new requirement is not expected to have any material effect on the Bank's ability to meet the risk-based capital requirement. The OTS is required to revise its risk-based capital standards to ensure that its standards provide adequately for concentration of credit risk, risk from non-traditional activities and actual performance and expected risk of loss on multi-family mortgages. Further increases in capital requirements are possible in future periods. Capital requirements higher than the generally applicable minimum requirement may be established for a particular savings institution if the OTS determines that the institution's capital was or may become inadequate in view of its particular circumstances. Individual minimum capital requirements may be appropriate where the savings institution is receiving special supervisory attention, has a high degree of exposure to interest rate risk, or poses other safety or soundness concerns. No such requirements have been established for the Bank. Prompt Corrective Action. Pursuant to FDICIA, the federal banking agencies are required to establish, by regulation, for each capital measure, the levels at which an insured institution is well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, and to take prompt corrective action with respect to insured institutions which fall below minimum capital standards. The degree of regulatory intervention mandated by FDICIA is tied to an insured institution's capital category, with increasing scrutiny and more stringent restrictions being imposed as an institution's capital declines. Any insured depository institution which falls below the minimum capital standards must submit a capital restoration plan. FDICIA requires any company that controls an undercapitalized savings institution, in connection with the submission of a capital restoration plan by the savings institution, to guarantee that the institution will comply with the plan and to provide appropriate assurances of performance. The aggregate liability of any such controlling company under such guaranty is limited to the lesser of (i) 5% of the savings institution's assets at the time it became undercapitalized; or (ii) the amount necessary to bring the savings institution into capital compliance at the time the institution fails to comply with the terms of its capital plan. If St. Paul Federal were to become undercapitalized, the Company would be required to provide such a guarantee. Pursuant to the FDICIA provisions, undercapitalized institutions are precluded from increasing their assets, acquiring other institutions, establishing additional branches, or engaging in new lines of business without an approved capital plan and an agency determination that such actions are consistent with the plan. Savings institutions that are significantly undercapitalized may be required to take one or more of the following actions: (i) raise additional capital so that the institution will be adequately capitalized; (ii) be acquired by, or combined with, another institution if grounds exist for appointing a receiver; (iii) refrain from affiliate transactions; (iv) limit the amount of interest paid on deposits to the prevailing rates of interest in the region where the institution is located; (v) further restrict asset growth; (vi) hold a new election for directors, dismiss any director or senior executive officer who held office for more than 180 days immediately before the institution became undercapitalized, or employ qualified senior executive officers; (vii) stop accepting deposits from correspondent depository institutions; and (viii) divest or liquidate any subsidiary which the OTS determines poses a significant risk to the institution. Any company which controls a significantly undercapitalized savings institution may be required to: (i) divest or liquidate any affiliate other than an insured depository institution; (ii) divest the institution if the OTS determines that divestiture would improve the institution's financial condition and future prospects; and (iii) if such company is a bank holding company, refrain from making any capital distribution without the prior approval of the Federal Reserve Board. Critically undercapitalized institutions are subject to additional restrictions. No later than 90 days after a savings institution becomes critically undercapitalized, the Director of the OTS is required to appoint a conservator or receiver for the institution, unless the Director determines, with the concurrence of the FDIC, that other action would better achieve the purpose of FDICIA. The Director must make periodic redeterminations that the alternative action continues to be justified no less frequently than every 90 days. The Director is required to appoint a receiver if the institution remains critically undercapitalized nine months later, unless the institution is in compliance with an approved capital plan and the OTS and FDIC certify that the institution is viable. Under prompt corrective action regulations adopted by the OTS, an institution will be considered (i) "well capitalized" if the institution has a total risk-based capital ratio of 10% or greater, a Tier 1 or core capital to risk-weighted assets ratio of 6% or greater, and a leverage ratio of 5% or greater (provided that the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure); (ii) "adequately capitalized" if the institution has a total risk-based capital ratio of 8% or greater, a Tier 1 or core capital to risk-weighted assets ratio of 4% or greater, and a leverage ratio of 4% or greater (3% or greater if the institution is rated composite 1 in its most recent report of examination); (iii) "undercapitalized" if the institution has a total risk-based capital ratio that is less than 8%, a Tier 1 or core capital to risk-weighted assets ratio of less than 4%, or a leverage ratio that is less than 4% (3% if the institution is rated composite 1 in its most recent report of examination); (iv) "significantly undercapitalized" if the institution has a total risk-based capital ratio that is less than 6%, a Tier 1 or core capital to risk-weighted assets ratio that is less than 3%, or a leverage ratio that is less than 3%; and (v) "critically undercapitalized" if the institution has a ratio of tangible equity to total assets that is less than or equal to 2%. The regulation also permits the OTS to determine that a savings institution should be classified in a lower category based on other information, such as the institution's examination report, after written notice. Under the OTS's prompt corrective action regulations, at December 31, 1993, St. Paul Federal qualified as a well capitalized institution based on its capital ratios as of such date. FDICIA prohibits any depository institution that is not well capitalized from accepting deposits through a deposit broker. Previously, only troubled institutions were prohibited from accepting brokered deposits. The FDIC may allow adequately capitalized institutions that apply for a waiver to accept brokered deposits. Institutions that receive a waiver are subject to limits on the rates of interest they may pay on brokered deposits. FDICIA also prohibits undercapitalized institutions from offering rates of interest on insured deposits that significantly exceed the prevailing rate in their normal market area or the area in which the deposits would otherwise be accepted. Safety and Soundness Regulations. Under FDICIA, the OTS is required to prescribe safety and soundness regulations relating to (i) internal controls, information systems, and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset growth; and (vi) compensation and benefit standards for officers, directors, employees and principal shareholders. In November 1993, the OTS, along with the other federal banking agencies, published revised proposed regulations for the purpose of implementing this provision of FDICIA. As proposed, savings institutions, such as St. Paul Federal, would be required, among other things, to maintain a ratio of classified assets to total risk-based capital and allowances for loan losses not eligible for inclusion in risk-based capital that is no greater than 1.0. At December 31, 1993, St. Paul Federal had a ratio of classified assets to total risk-based capital and ineligible allowances of 65.6%. The proposed regulations also would impose safety and soundness standards on holding companies such as the Company. Under the proposed regulations, an institution or holding not meeting one or more of the safety and soundness standards would be required to file a compliance plan with the appropriate federal banking agency. In the event that an institution or holding company fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan within the time allowed by the agency, the institution or holding company would be required to correct the deficiency and the appropriate federal agency would also be authorized to: (1) restrict asset growth; (2) require the institution or holding company to increase its ratio of tangible equity to assets; (3) restrict the rates of interest that the institution may pay; or (4) take any other action that would better carry out the purpose of the corrective action. Until adopted in final form, the Company is unable to predict the precise effect of these regulations on the Company or the Bank. Qualified Thrift Lender Requirement. In order for St. Paul Federal to exercise the powers granted to a federally chartered savings bank and maintain full access to FHLB advances, it must meet the definition of a QTL. A savings institution will be a QTL if the savings institution's qualified thrift investments continue to equal or exceed 65% of the institution's portfolio assets on a monthly average basis in nine out of every 12 months. Subject to certain exceptions, qualified thrift investments generally consist of housing related loans and investments, certain obligations of federal instrumentalities and certain groups of assets, such as consumer loans, to a limited extent. The term "portfolio assets" means the savings institution's total assets minus goodwill and other intangible assets, the value of property used by the savings institution to conduct its business, and liquid assets held by the savings institution in an amount up to 20% of its total assets. OTS regulations provide that any savings institution that fails to meet the definition of a QTL must either convert to a bank charter, other than a savings bank charter, or limit its future investments and activities (including branching and payments of dividends) to those permitted for both savings institutions and national banks. Additionally, any such savings institution that does not convert to a bank charter will be ineligible to receive further FHLB advances and beginning three years after the loss of QTL status, will be required to repay all outstanding FHLB advances and dispose of or discontinue any preexisting investment or activities not permitted for both savings institutions and national banks. Further, within one year of the loss of QTL status, the holding company of a savings institution that does not convert to a bank charter must register as a bank holding company and will be subject to all statutes applicable to bank holding companies. St. Paul Federal is a QTL under the current test, having investments in qualified thrift investments in excess of required limits. Liquidity. Under applicable federal regulations, savings institutions are required to maintain an average daily balance of liquid assets (including cash, certain time deposits, certain bankers' acceptances, certain corporate debt securities and highly rated commercial paper, securities of certain mutual funds and specified United States government, state or federal agency obligations) equal to a monthly average of not less than a specified percentage of the average daily balance of the savings institution's net withdrawable deposits plus short-term borrowings. Under the HOLA, this liquidity requirement may be changed from time to time by the Director of the OTS to any amount within the range of 4% to 10% depending upon economic conditions and the deposit flows of member institutions, and currently is 5%. Savings institutions are also required to maintain an average daily balance of short-term liquid assets at a specified percentage (currently 1%) of the total of the average daily balance of its net withdrawable deposits and short-term borrowings. The Bank is in compliance with these liquidity requirements. Loans to One Borrower Limitations. The HOLA generally requires savings institutions to comply with the loans to one borrower limitations applicable to national banks. National banks generally may make loans to a single borrower in amounts up to 15% of their unimpaired capital and surplus, plus an additional 10% of capital and surplus for loans secured by readily marketable collateral. FIRREA provides exceptions under which a savings institution may make loans to one borrower in excess of the generally applicable national bank limits. Under the HOLA, savings institution may make loans to one borrower in excess of such limits under one of the following circumstances: (i) for any purpose, in any amount not to exceed $500,000; (ii) to develop domestic residential housing units, in an amount not to exceed the lesser of $30 million or 30% of the savings institution's unimpaired capital and unimpaired surplus, provided other conditions are satisfied; or (iii) to finance the sale of real property acquired in satisfaction of debts previously contracted in good faith in amounts up to 50% of the savings institution's unimpaired capital and unimpaired surplus. However, the OTS has modified the third standard by limiting loans to one borrower to finance the sale of real property acquired in satisfaction of debts to 15% of unimpaired capital and surplus. That rule provides, however, that purchase money mortgages received by a savings institution to finance the sale of such real property do not constitute "loans" (provided the savings institution is not placed in a more detrimental position holding the note than holding the real estate) and, therefore, are not subject to the loans to one borrower limitations. The Bank does not have any loans to any one borrower in violation of these regulations. Commercial Real Estate Loans. HOLA limits the aggregate amount of commercial (i.e. non-residential) real estate loans that a federal savings institution may make to an amount not in excess of 400% of the savings institution's capital. The Bank has no loans in excess of this limit. Limitation on Capital Distributions. Applicable rules and regulations of the OTS impose limitations on capital distributions by savings institutions such as the Bank. Within these limitations, certain "safe harbor" capital distributions are permitted, subject to providing the OTS at least 30 days' advance notice. The safe harbor amount is based upon an institution's regulatory capital level. Savings institutions which have capital in excess of all fully phased-in capital requirements before and after the proposed capital distribution ("Tier 1 Institutions") may make capital distributions during a calendar year up to the greater of (i) 100% of net income to date during the calendar year, plus the amount that would reduce by one-half its "surplus capital ratio" (the excess capital over its fully phased-in capital requirements) at the beginning of the calendar year, or (ii) 75% of its net income over the most recent four-quarter period. Institutions which meet minimum regulatory capital requirements, but not fully phased-in requirements, before or after a proposed capital distribution ("Tier 2 Institutions"), may make distributions of up to 75% of net income over the most recent four-quarter period. Savings institutions that do not meet minimum regulatory capital requirement prior to or after the proposed capital distribution ("Tier 3 Institutions") may not make any capital distributions without prior approval of the OTS Savings institutions may apply to the OTS to make capital distributions in excess of the safe harbor amount. The OTS also may prohibit a proposed capital distribution by an institution if the OTS determines that such distribution would constitute an unsafe or unsound practice. The Bank currently has capital in excess of fully phased-in requirements such that it meets the Tier 1 institutions criteria. See "Regulation - Savings Institution Regulation -General." FDICIA prohibits an insured depository institution from declaring any dividend, making any other capital distribution, or paying a management fee to a controlling person if, following the distribution or payment, the institution would be classified as undercapitalized, significantly undercapitalized or critically undercapitalized. The OTS had indicated that it intends to review its existing capital distribution regulations to determine whether amendments are necessary based on FDICIA. In the interim, the OTS has indicated that it intends for the permissibility of capital distributions to be determined by the prompt corrective action regulations recently adopted under FDICIA. A savings institution permitted to make a capital contribution under the prompt corrective action regulation may do so only if the amount and type would also be permitted under the OTS's existing capital distribution regulation. Limitation on Equity Risk Investments. The Bank is generally prohibited from investing directly in equity securities and real estate (other than that used for offices and related facilities or acquired through, or in lieu of, foreclosure or on which a contract purchaser has defaulted). In addition, existing regulations limit the aggregate investment by savings institutions in certain equity risk investments, including equity securities, real estate, service corporations and operating subsidiaries and loans for the purchase of land and construction loans made after February 27, 1987 on non-residential properties with loan-to-value ratios exceeding 80%. The Bank is in compliance with the requirements of the equity risk investment limitations. Activities of Subsidiaries. FIRREA requires a savings institution seeking to establish a new subsidiary, acquire control of an existing company (after which it would be a subsidiary), or conduct a new activity through a subsidiary, to provide 30 days' prior notice to the FDIC and the Director of the OTS and conduct any activities of the subsidiary in accordance with regulations and orders of the Director of the OTS. The Director of the OTS has the power to require a savings institution to divest any subsidiary or terminate any activity conducted by a subsidiary that the Director of the OTS determines is a serious threat to the financial safety, soundness or stability of such savings institution or is otherwise inconsistent with sound banking practices. Insurance of Deposits. Federal deposit insurance is required for all federally chartered savings institutions. Savings institutions' deposits are insured to a maximum of $100,000 for each insured depositor by the SAIF. As a SAIF-insured institution, St. Paul Federal is subject to regulation and supervision by the FDIC, to the extent deemed necessary by the FDIC to ensure the safety and soundness of the SAIF. The FDIC is entitled to have access to reports of examination of St. Paul Federal made by the Director of the OTS and all reports of condition filed by St. Paul Federal with the Director of the OTS, and may require the Bank to file such additional reports as the FDIC determines to be advisable for insurance purposes. The FDIC may determine by regulation or order that any specific activity poses a serious threat to the SAIF and that no SAIF member may engage in the activity directly. The FDIC is also authorized to issue and enforce such regulations or orders as it deems necessary to prevent actions of savings institutions that pose a serious threat to SAIF. Under the FDICIA, the FDIC was required to promulgate regulations establishing a risk-based assessment system. Furthermore, effective January 1, 1998, the FDIC is required to set SAIF semiannual assessment rates in an amount sufficient to increase the reserve ratio of the SAIF to 1.25% of insured deposits over no more than a 15-year period. The FDICIA also gives the FDIC the authority to establish a higher reserve ratio. As part of the risk-based deposit insurance system, the deposit insurance assessment rate was increased from .23% of an institution's assessed deposits for 1992 to an assessment rate within the range of .23% to .31% for all SAIF members, depending on the assessment risk classification assigned to each institution, effective January 1, 1993. Each SAIF member is assigned to one of three capital groups: "well capitalized," "adequately capitalized," or "less than adequately capitalized." Such terms are defined in the same manner as under the OTS's prompt corrective action regulation (discussed above), except that "less than adequately capitalized" includes any institution that is not well capitalized or adequately capitalized. Within each capital group, institutions are assigned to one of three supervisory subgroups -- "healthy" (institutions that are financially sound with only a few minor weaknesses), "supervisory concern" (institutions with weaknesses which, if not corrected, could result in significant deterioration of the institution and increased risk to SAIF) or "substantial supervisory concern" (institutions that pose a substantial probability of loss to SAIF unless corrective action is taken). The FDIC places each institution into one of nine assessment risk classifications based on the institution's capital group and supervisory subgroup classification. As a result of implementation of the risk-based deposit insurance system, the Bank's federal deposit insurance premiums for 1993 increased by approximately $1.8 million over such premiums paid during 1992. FDIC premiums in 1994 should be approximately $1.0 million lower in 1994 as a result of lower premiums assessed to the Bank. During the five-year period ending on August 9, 1994, savings institutions are precluded from engaging in any transaction which would result in a conversion from SAIF to Bank Insurance Fund ("BIF") insurance (subject to certain exceptions for limited branch sales and supervisory transactions). FDICIA expands the list of permitted conversion transactions that may be effected during the five-year moratorium. Under FDICIA, BIF and SAIF insured institutions may merge, consolidate or engage in asset transfer and liability assumption transactions. The resulting institution will continue to be subject to BIF and SAIF assessments in relation to that portion of its combined deposit base which is attributable to the deposit base of its respective predecessor BIF and SAIF institutions. After August 9, 1994, the resulting institution may apply to the FDIC to convert all of its deposits to either insurance fund upon payment of the then applicable entrance and exit fees for each fund. Insurance of deposits may be terminated by the FDIC after notice and hearing, upon a finding by the FDIC that the savings institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, rule, regulation, order or condition imposed by, or written agreement with, the FDIC. Additionally, if insurance termination proceedings are initiated against a savings institution, the FDIC may temporarily suspend insurance on new deposits received by an institution under certain circumstances. The Bank is not aware of any activity or condition which could result in a termination of its deposit insurance. FEDERAL HOME LOAN BANK SYSTEM The Federal Home Loan Bank System consists of 12 regional FHLBs, each subject to supervision and regulation by the Federal Housing Finance Board (the "FHFB"). The FHLBs provide a central credit facility for member savings institutions. St. Paul Federal, as a member of the FHLB of Chicago, is required to own shares of capital stock in the FHLB of Chicago in an amount at least equal to 1% of the aggregate principal amount of unpaid residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year, or 1/20 of its advances (borrowings) from the FHLB, whichever is greater. St. Paul Federal is in compliance with this requirement. The maximum amount which the FHLB of Chicago will advance fluctuates from time to time in accordance with changes in policies of the FHFB and the FHLB of Chicago, and the maximum amount generally is reduced by borrowings from any other source. In addition, the amount of FHLB advances that a savings institution may obtain will be restricted in the event the institution fails to constitute a QTL. See "Regulation-- Qualified Thrift Lender Requirement." FEDERAL RESERVE SYSTEM The Federal Reserve Board has adopted regulations that require savings institutions to maintain nonearning reserves of 3% on the first $46.8 million and 10% on the remaining balance of net transaction accounts (primarily checking accounts). St. Paul Federal is in compliance with these requirements. These reserves may be used to satisfy liquidity requirements imposed by the Director of the OTS. Because required reserves must be maintained in the form of cash or a noninterest-bearing account at a Federal Reserve bank, the effect of this reserve requirement is to reduce the amount of the institution's interest-earning assets. Savings institutions also have the authority to borrow from the Federal Reserve "discount window." Federal Reserve Board regulations, however, require savings institutions to exhaust all FHLB sources before borrowing from a Federal Reserve bank. TAXATION Federal. The Bank and the Company file a calendar tax year consolidated federal income tax return and report their income and expenses using the accrual method of accounting. Savings institutions are generally taxed in the same manner as other corporations. Unlike other corporations, however, qualifying savings institutions such as St. Paul Federal that meet certain definitional tests relating to the nature of their supervision, income, assets and business operations are allowed to establish reserves for bad debts for both "qualifying" and "non-qualifying loans" each tax year and are permitted to deduct additions to the reserve on "qualifying real property loans" using the more favorable of the following two alternative methods: (i) a method based on the institution's actual loss experience (the "experience method") or (ii) a method based on a specified percentage of an institution's taxable income (the "percentage of taxable income method"). "Qualifying real property loans" are, in general, loans secured by interests in improved real property. The addition to the reserve for nonqualifying loans must be computed under the experience method. St. Paul Federal (except for 1989, 1992 and 1993, in which the experience method was used) generally computes the addition to its reserve for losses on qualifying real property loans using the percentage of taxable income method. Under this method a qualifying institution generally may deduct 8% of its separate taxable income after certain adjustments, subject to the limitations discussed below. Under the experience method, a savings institution is permitted to compute its addition to its reserve for loss in an amount equal to the greater of the amount necessary to increase its reserve to (i) an amount determined by multiplying the ratio of its total loan losses sustained during the current and preceding five years to the sum of its loans outstanding at the close of each of those six years by the loans outstanding at the end of the current year or (ii) the balance of its reserve as of the end of the last tax year beginning before 1988. The amount of the bad debt deduction that a savings institution may claim with respect to additions to its reserve for bad debts is subject to certain limitations. First, the deduction may be eliminated entirely (regardless of the method of computation) if at least 60% of the savings institution's assets do not fall within certain designated categories. Second, the bad debt deduction attributable to "qualifying real property loans" cannot exceed the greater of (i) the amount deductible under the experience method or (ii) the amount which, when added to the bad debt deduction for nonqualifying loans, equals the amount by which 12% of the sum of the total deposits and the advance payments by borrowers for taxes and insurance at the end of the taxable year exceeds the sum of the surplus, undivided profits, and reserves at the beginning of the taxable year. Third, the amount of the bad debt deduction attributable to qualifying real property loans computed using the percentage of taxable income method is permitted only to the extent that the institution's reserve for losses on qualifying real property loans at the close of the taxable year, taking into account the addition to the reserve for that taxable year, does not exceed 6% of such loans outstanding at such time. Fourth, the amount of the percentage of taxable income bad debt deduction is reduced, but not below zero, by the amount of the addition to reserves for losses on nonqualifying loans for the taxable year. Finally, a savings institution that computes its bad debt deduction using the percentage of taxable income method and files its federal income tax return as part of a consolidated group, as St. Paul Federal does, is required to reduce proportionately its bad debt deduction for losses attributable to activities of nonsavings institution members of the consolidated group that are "functionally related" to the savings institution member. (The savings institution member is permitted, however, to proportionately increase its bad debt deduction in subsequent years to recover any such reduction to the extent the nonsavings institution members realize income in future years from their "functionally related" activities.) St. Paul Federal does not expect that the amount of its otherwise allowable bad debt deductions will be reduced as a result of these limitations for the foreseeable future. As of December 31, 1993, St. Paul Federal's tax bad debt reserves totaled approximately $51.1 million. To the extent that (i) St. Paul Federal's reserve for losses on qualifying real property loans plus its supplemental reserve for losses on loans exceeds the amount that would have been allowed under the experience method and (ii) St. Paul Federal makes distributions to the Company that are considered to result in withdrawals from this excess bad debt reserve, then the amounts withdrawn will be included in the Bank's taxable income. The amount considered to be withdrawn by a distribution will be the amount of the distribution plus the amount necessary to pay the tax with respect to the withdrawal. Dividends paid out of St. Paul Federal's current or accumulated earnings and profits as calculated for federal income tax purposes, however, will not be considered to result in withdrawals from its bad debt reserves. Distributions in excess of St. Paul Federal's current and accumulated earnings and profits, distributions in redemption of stock, and distributions in partial or complete liquidation of St. Paul Federal will be considered to result in withdrawals from its bad debt reserves. Savings institutions, such as St. Paul Federal, are also entitled to limited special tax treatment with respect to the deductibility of interest expense relating to certain tax-exempt obligations and the carryback and carryforward periods for certain net operating losses. Savings institutions are entitled to deduct 100% of their interest expense allocable to the purchase or carrying of tax exempt obligations acquired before 1983. The deduction is reduced to 80% with respect to obligations acquired after 1982. For taxable years ending after 1986, however, the Tax Reform Act of 1986 (the "Tax Act") eliminates the deduction entirely for obligations purchased after August 7, 1986 (except for certain issues by small municipal issuers). St. Paul Federal does not own any obligations that are exempt for federal income tax purposes. Savings institutions are subject to the same carryover rules as regular corporations (i.e., they are able to carry net operating losses back for only three years but forward for 15 years) for losses incurred in the tax years beginning after 1986. Depending on the composition of its items of income and expense, a savings institution may be subject to the alternative minimum tax. For tax years beginning after 1986, a thrift institution must pay an alternative minimum tax equal to the amount (if any) by which 20% of alternative minimum taxable income ("AMTI"), as reduced by an exemption varying with AMTI, exceeds the regular tax due. AMTI equals regular taxable income increased or decreased by certain adjustments and increased by certain tax preferences, including depreciation deductions in excess of that allowable for alternative minimum tax purposes, tax-exempt interest on most private activity bonds issued after August 7, 1986 (reduced by any related interest expense disallowed for regular tax purposes), the amount of the bad debt reserve deduction claimed in excess of the deduction based on the experience method and, for tax years after 1989, 75% of the excess of adjusted current earnings over AMTI. AMTI may be reduced only up to 90% by alternative minimum tax net operating loss carryovers. The payment of alternative minimum tax will give rise to a minimum tax credit which will be available with an indefinite carryforward period, to reduce the federal income taxes of the institution in future years (but not below the level of alternative minimum tax arising in each of the carryforward years). St. Paul Federal has been audited or its books have been closed without audit by the Internal Revenue Service (the "IRS") with respect to tax returns filed through December 31, 1989. State. The State of Illinois imposes a corporate income tax of 4.8% and a replacement tax of 2.5% on the Illinois net taxable income of savings banks. For tax years beginning after June 30, 1993, the corporate income tax rate will be 4.4%. Illinois taxable income is substantially similar to federal taxable income with certain adjustments (including the addition of interest income on state and municipal obligations and the exclusion of interest on United States Treasury obligations). In 1993, 1992, and 1991, the exclusion of income on United States Treasury obligations had the effect of reducing significantly the Illinois taxable income of St. Paul Federal. St. Paul Federal has been audited or its books have been closed without audit by the Illinois Department of Revenue with respect to tax returns filed through 1990. No outstanding deficiencies in tax payments have been proposed or assessed by Illinois or other state taxing authorities. See Management's Discussion and Analysis - "Comparison of Years Ended December 31, 1993 and 1992 - Income Taxes" and "Comparison of Years Ended December 31, 1992 and 1991 - Income Taxes" and "NOTE Q - Income Taxes" contained in the Company's 1993 annual report to shareholders filed as an exhibit hereto. Item 2. Item 2. Properties The Company neither owns nor leases any real property. For the present, it uses the premises, equipment and furniture of St. Paul Federal without direct payment of any rental fees to St. Paul Federal. As of December 31, 1993, St. Paul Federal has 50 banking offices located throughout the greater Chicago metropolitan area. All branch locations, except three drive-up facilities, are full-service offices and provide a full range of banking services. Fifteen of the branches are located in OMNI(R) food stores in the Chicago area with at least one additional store scheduled to be opened in 1994. St. Paul Federal supplies its own data processing facilities. The primary internal data processing equipment at St. Paul Federal consists of desk-top and teller terminals which are both leased and owned and mainframe hardware components and ATMs which are owned. At December 31, 1993, the equipment owned had a net book value of approximately $9.3 million. ATMs are located at all of the Bank's offices. The Bank also has installed ATMs at 116 locations which are not St. Paul offices. The following table sets forth certain information concerning the home office and each branch of the Bank at December 31, 1993. Additionally, the Bank owns five administrative buildings, one of which is utilized by three of its service corporations, and leases administrative office space in a nearby office complex. The aggregate net book value of St. Paul Federal's banking and administrative offices owned and the net book value of leasehold improvements at the offices leased at December 31, 1993 was approximately $22.8 million. The amount of annual lease expenses is not considered material. Management believes that all of these properties are in good condition. Item 3. Item 3. LEGAL PROCEEDINGS As of December 31, 1993, there were no material pending legal proceedings to which the Company, St. Paul Federal or any of St. Paul Federal's subsidiaries was a party or of which any of their property was subject. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year ended December 31, 1993, no matters were submitted to a vote of security holders through a solicitation of proxies or otherwise. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information as to the principal market on which the Company's common stock is traded, the approximate number of holders of record as of December 31, 1993, and the Company's dividend record, and the high and low sales prices for each fiscal quarter is incorporated herein by reference from the inside back cover of the Company's 1993 Annual Report to Shareholders filed as an exhibit hereto. As of the close of business on March 18, 1994, St. Paul Bancorp stock price was $18 1/2. Under Delaware law, the Company may pay dividends out of surplus or, in the event there is no surplus, out of net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Dividends may not be paid out of net profits, however, if the capital of the Company has been diminished to an amount less than the aggregate amount of capital represented by all classes of preferred stock. Dividends and other distributions of the Company's stock are subject to restrictions agreed upon by the Company in connection with the issuance of $34.5 million of subordinated notes in February, 1993 - See "NOTE R- Stockholders' Equity" in the 1993 Annual Report to Shareholders filed as an exhibit hereto. There are various restrictions on the ability of the Bank to pay dividends to the Company. See Item 1. -- "Regulation -- Savings Institutions" and "NOTE R - Stockholders' Equity" and Management's Discussion and Analysis "Capital" incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA Selected consolidated financial data for the five years ended December 31, 1993, consisting of data captioned "Five Year Summary" on page 18 of the 1993 Annual Report to Shareholders filed as an exhibit hereto, is incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Management's Discussion and Analysis" on pages 19 to 37 of the Company's 1993 Annual Report to Shareholders filed as an exhibit hereto is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Statements of Financial Condition of the Company and its subsidiaries as of December 31, 1993 and 1992, and the related Consolidated Statements of Income, Stockholders' Equity and Cash Flows for each of the years in the three-year period ended December 31, 1993, together with the related notes and the report of Ernst & Young, independent auditors are incorporated herein by reference from pages 38 to 63 of the Company's 1993 Annual Report to Shareholders filed as an exhibit hereto. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information with respect to non-director officers of the Company, all of whom also currently hold positions with the Bank: The principal occupation or business experience during the past five years of each non-director officer of the Company is set forth below. Robert N. Parke, Senior Vice President--Finance and Chief Financial Officer, joined the Bank in 1977. He was elected Treasurer in 1978 and promoted to his present position in 1981. Prior to joining St. Paul Federal, Mr. Parke, a Certified Public Accountant, was with the firm of Ernst and Young and specialized in the audit of the real estate, savings and loan and mortgage banking industries. Mr. Parke is a member of the American Institute of Certified Public Accountants and the Financial Managers Society, Inc. He is a former member of The Savings and Loan Associations Committee of the American Institute of Certified Public Accountants and is the past chairman of the Finance Industry Accounting Committee of the Financial Managers Society. Mr. Parke holds an undergraduate degree from Knox College and a graduate degree from the Amos Tuck Graduate School of Business at Dartmouth College. Thomas J. Rinella, Senior Vice President--Marketing and Community Lending, has responsibility for administration of the Bank's marketing, public relations, residential mortgage originations, and consumer lending activities. Mr. Rinella joined the Bank in 1968 as a Loan Officer. Subsequently, he has held positions in the Bank as a Systems Analyst, Loan Department Manager, Human Resources Director, and Marketing Director. He was promoted to Senior Vice President in 1980 and assumed his present position in 1987. Mr. Rinella serves on the Board of Directors of Cash Station, Inc., Community Investment Corp., and the Savings and Loan Network, Inc. He also serves on the Business Advisory Council of the College of Business Administration, University of Illinois at Chicago and the Board of Trustees and Executive Committee of the Illinois Council on Economic Education. He holds an undergraduate degree from the University of Illinois at Chicago and an MBA from DePaul University. Clifford M. Sladnick, Senior Vice President--General Counsel and Corporate Secretary, joined the Bank in 1990 as First Vice President, Corporate Secretary, and Securities Counsel. He was appointed General Counsel in December 1990 and was promoted to Senior Vice President in July, 1991. Prior to joining the Bank, he was a partner in the corporate department of the law firm of McDermott, Will & Emery. Mr. Sladnick is also a Certified Public Accountant. He holds a degree in accounting from the University of Illinois and a juris doctor degree from the College of Law at the University of Illinois. Mr. Sladnick is on the Board of Directors of the Montessori School in Niles, Illinois. Information regarding the directors of the Company is omitted from this Report as the Company intends to file a definitive proxy statement not later than 120 days after the end of the fiscal year covered by this Report, and the information to be included therein is incorporated herein by reference. Item 11. Item 11. OFFICER AND DIRECTOR COMPENSATION Information regarding compensation of officers and directors is omitted from this Report as the Company intends to file a definitive proxy statement not later than 120 days after the end of the fiscal year covered by this Report, and the information included therein is incorporated herein by reference. Not withstanding anything to the contrary set forth herein, the Report of the Organizational Planning and Stock Option Committees on Executive Compensation and the Corporate Performance Graph contained in the proxy statement shall not be incorporated by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this Item is omitted from this Report as the Company intends to file a definitive proxy statement not later than 120 days after the end of the fiscal year covered by this Report, and the information to be included therein is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions is omitted from this Report as the Company intends to file a definitive proxy statement not later than 120 days after the end of the fiscal year covered by this Report, and the information included therein is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) The following consolidated financial statements of the Registrant and its subsidiaries included in the Annual Report to Shareholders for the year ended December 31, 1993, are incorporated herein by reference in Item 8. The remaining information appearing in the Annual Report to Shareholders is not deemed to be filed as part of this Report, except as expressly provided herein. Consolidated Statements of Financial Condition - December 31, 1993 and 1992. Consolidated Statements of Stockholders' Equity - Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Income - Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991. Notes to the Consolidated Financial Statements. (a)(2) Not applicable. (a)(3) The following exhibits are either filed as part of this Report or are incorporated herein by reference: Exhibit No. 3. Certificate of Incorporation and By-laws. * Management contract or compensatory plan or arrangement required to be filed as an exhibit. Exhibit No. 13. 1993 Annual Report to Shareholders. Management's Discussion and Analysis and the audited financial statements, including footnotes, contained in the 1993 Annual Report to Shareholders is attached as an exhibit to this Report. Portions of the Annual Report to Shareholders have been incorporated herein by reference into this Form 10-K. Exhibit No. 21. Subsidiaries of the Registrant. A list of the Company's and St. Paul Federal's subsidiaries is included as an exhibit to this report. Exhibit No. 23. Consent of Ernst & Young. (b) The Company filed a current report on Form 8-K on December 6, 1993 relating to the announcement by St. Paul Bancorp of a three-for-two stock split issued to shareholders on January 4, 1994. (c) Exhibits to this Form 10-K are either filed as part of this Report or are incorporated herein by reference. (d) Not Applicable. SIGNATURES Pursuant to the requirements of Section 13 and 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. St. Paul Bancorp, Inc. -------------------------- Registrant By: /s/ Joseph C. Scully -------------------------- Joseph C. Scully Chairman of the Board March 30, 1994 -------------------------- Date 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. By: /s/ Joseph C. Scully March 30, 1994 - ------------------------------------------------- -------------- Joseph C. Scully Date Chairman of the Board and Chief Executive Officer By: /s/ Patrick J. Agnew March 30, 1994 - ------------------------------------------------- -------------- Patrick J. Agnew Date President and Chief Operating Officer By: /s/ William A. Anderson March 30, 1994 - ------------------------------------------------- -------------- William A. Anderson Date Director By: /s/ John W. Croghan March 30, 1994 - ------------------------------------------------- -------------- John W. Croghan Date Director By: /s/ Alan J. Fredian March 30, 1994 - ------------------------------------------------- -------------- Alan J. Fredian Date Director By: /s/ Kenneth J. James March 30, 1994 - ------------------------------------------------- -------------- Kenneth J. James Date Director By: /s/ Jean C. Murray March 30, 1994 - ------------------------------------------------- -------------- Jean C. Murray Date Director By: /s/ Michael R. Notaro March 30, 1994 - ------------------------------------------------- -------------- Michael R. Notaro Date Director By: /s/ John J. Viera March 30, 1994 - ------------------------------------------------- -------------- John J. Viera Date Director By: /s/ James B. Wood March 30, 1994 - ------------------------------------------------- -------------- James B. Wood Date Director By: /s/ Robert N. Parke March 30, 1994 - ------------------------------------------------- -------------- Robert N. Parke Date Senior Vice President and Treasurer (Principal Financial Officer) By: /s/ Paul J. Devitt March 30, 1994 - ------------------------------------------------- -------------- Paul J. Devitt Date First Vice President and Controller (Principal Accounting Officer) * Management contract or compensatory plan or arrangement required to be filed as an exhibit.

716039_1993.txt

716039_1993

1993

716039

ITEM 3 - LEGAL PROCEEDINGS ( 1 ) The company may face potentially significant financial exposure from possible civil penalty citations, claims and lawsuits regarding environmental matters. These matters include, for example, properties requiring presently undeterminable amounts of cleanup efforts and expenses, soil or water contamination, and claims for personal injuries allegedly caused by exposure to toxic materials manufactured or used by the company. Within this category, there are various sites for which the company could be liable, either alone or in some proportionate amount with other defendants, for civil penalties, claims and lawsuits: The present state of the law which imposes joint and several liability on defendants, the potentially large number of claimants for any given site or exposure, the uncertainty attendant to the possible award of punitive damages, the imprecise and conflicting engineering evaluations and estimates of proper cleanup methods and costs, and the recent judicial recognition of new causes of action, all contribute to the practical impossibility of making any reasonable estimate of the company's potential liability for most of these environmental matters. The company is usually just one of several companies cited as a potentially responsible party. Although potential aggregate monetary damages might be substantial, Unocal's share of any liability is likely to be relatively small. Settlements and costs incurred in those matters that have previously been resolved have not been materially significant to the company's operating results or financial position. Except for specific sites discussed later, the company does not believe that the ultimate share of its liability at the above sites or other presently unknown sites will be material to its financial condition. Even though unlikely, an adverse decision awarding punitive damages to numerous plaintiffs or imposing joint and several liability for the cleanup obligations of other equally responsible parties, however, could have a material effect on the company's financial condition. Also, if liabilities are aggregated and assumed to occur in a single fiscal year, they could be material to the company's operating results. ( 2 ) In the Exxon Valdez litigation, Alyeska and its owners, including ------------ Unocal Pipeline company, have reached a settlement for $98 million with the remaining private plaintiffs in the litigation. The settlement will resolve all outstanding private damage claims against Alyeska and its owner companies as a result of the spill. The settlement was approved by both the state and federal courts overseeing the litigation. Unocal's share of the settlement amount is about $1.3 million. Exxon has filed appeals seeking to enjoin Alyeska's settlement for the private damage claims. The parties have settled the remaining claims of the State of Alaska in State ----- of Alaska v. Exxon, et al., No. A92-175, U.S.D.C. Alaska (originally filed in - -------------------------- Superior Court, Third Judicial District, No. 89-6852) and the United States in United States of America v. Exxon, et al., No. A91-082, U.S.D.C. Alaska, without - ----------------------------------------- admitting liability. The defendants agreed to pay $31.7 million to settle the lawsuits, of which Unocal Pipeline company's share is $600,086. ( 3 ) The judgment against the company in Angelina Hardwood Lumber Company -------------------------------- v. Prairie Producing Co., Cause No. 24, 654-91-01, in the District Court of - ------------------------ Angelina County, Texas, is still on appeal. The judgment holds the company liable for approximately $23.5 million in compensatory damages, $50 million in punitive damages, and $5.5 million in prejudgment interest and attorneys' fees. This case involves complicated factual and legal questions regarding a title dispute to natural gas producing properties in Louisiana. The company firmly believes that the judgment in this case is not justified and that a successful outcome on appeal is reasonably likely. ( 4 ) On March 15, 1994, the company entered a plea of no contest to three misdemeanor counts of a criminal complaint: a) California Water Code S 13272 - failure to report the discharge of petroleum product to State waters; b) California Water Code SS 13376 and 13387 (a) (1) - negligent failure to report the discharge of petroleum product to navigable waters; and c) California Fish and Game Code S 5650 - deposit of petroleum product where it could pass into State waters. (People v. Unocal Corporation, et al., DA #930004569, San Luis ------------------------------------- Obispo Country Municipal Court, State of California). All remaining charges against the company and six of its current and former employees were dismissed. The charges concern the failure to report contamination in the Guadalupe Oil Field that may have occurred at various times in the 1960s, 1970s and 1980s. The company agreed to pay $1.5 million in restitution and civil penalties. Most of the monetary sanctions were paid under a Stipulation for Judgment and Judgment Pursuant to Business & Professions Code 17200, et seq. in the case for civil penalties (People v. Unocal Corporation, CV 75157, Superior Court of the ------------------------------ State of California, County of San Luis Obispo). Under the terms of a three-year probation, the company must investigate and remediate the hydrocarbon contamination at the Guadalupe Oil Field to the satisfaction of the lead regulatory agency and also undertake a program of mandatory education and training concerning environmental regulations for its employees. A civil suit seeking various forms of penalties and restitution was filed on March 23, 1994 (People v. Union Oil Company of California, Superior Court of ------------------------------------------- San Luis Obispo County, Civil No. 75194) by the California Attorney General on behalf of the Department of Fish and Game, the Regional Water Quality Control Board, and the Department of Toxic Substances Control. The complaint alleges several categories of violations, namely, discharge into marine and state waters, failure to report discharge, destruction of natural resources, failure to warn and exposure to known carcinogens (benzene/toluene), public nuisance, unauthorized disposal of hazardous waste, and labeling violations for "recycled" diluent material. Injunctive relief and civil penalties are demanded for the various claimed violations as well as prejudgment and postjudgment interest, costs, and reasonable attorney fees. Cleanup and remediation of the Field are continuing. The ultimate cost of that effort and the outcome of civil litigation are presently undetermined. In the opinion of management, however, the likely financial outcome of this event and the ensuing litigation could be substantial but will not result in any loss which would materially affect the company's financial position or operations. ( 5 ) In the McColl dumpsite litigation, the defendants have reached a partial tentative settlement of $18 million of claims for past costs by the EPA. The company's share of the settlement is 18.75%, and the settlement is awaiting final language and judicial approval, U.S.A., et al. v. Shell Oil company, et ----------------------------------------- al., CV-91-0589 RKJ (EX), United States District Court, Central District of - --- California. Still remaining is the EPA determination on the parameters of the final remedy at the site. The defendants' counterclaims also remain. Predesign and design of the proposed remedial solution (soft material solidification) continues as the result of an agreed order. ( 6 ) The company was cited by the EPA as one of 14 respondents to an Administrative Order issued under Section 106 of CERCLA ("Superfund") regarding the Gulf Coast Vacuum Site in Abbeville, Louisiana, which is an abandoned oil and gas exploration and production waste site. Under this Order, the company is required to conduct an "interim remedial action" at the Gulf Coast Site in accordance with a Statement of Work and an earlier Record of Decision. Compliance with the Order was completed in December, 1993. A consent decree signed by the parties for performance of the final remediation was entered with the EPA and is awaiting judicial approval. The company's share of the estimated $16.4 million final remediation costs is 11 percent. ( 7 ) The company is still defending the EPA Region 9 administrative order issued under Section 106(a) of CERCLA requiring the company and eight other companies to conduct a prescribed Remedial Design and Remedial Action to address groundwater contamination at the Purity Oil Sales Superfund Site near Fresno, California. A consent order to perform the Remedial Design for the soils remedy has been negotiated. Execution of the remedy covered by the design will be negotiated later. ( 8 ) A final settlement was made with the City of Heath, Ohio, in 1993 in the lawsuit filed by the City against the company and Ashland Petroleum concerning an Ashland terminal, an alleged source of pollution which was formerly a company refinery until sold to Ashland in 1970. In related matters, the joint investigation of pollution which may be related to the terminal/refinery site, as required by a consent order, is now complete. Negotiations are pending with the state over further required actions which will define the scope of the company's future liability at the Heath site. The allegations against the company in all of the above matters have been denied. Although management does not believe that an award of punitive or treble damages is justified in any of these cases, any award of substantial punitive or treble damages, however remotely possible, could have a material effect upon the company's operating results or financial condition. The company believes that its challenges to notices of environmental violations will be upheld or will result in a significant reduction in the amount of penalties sought. The company has or is in the process of instituting remedial measures necessary to avoid similar future incidents. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - NONE EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below are the executive officers of Unocal Corporation as of March 1, 1994. PART II ITEM 5 ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Prices in the foregoing table are from the New York Stock Exchange Composite Transactions listing. On March 15, 1994, the high price per share was $27-3/8 and the low price per share was $27-1/8. Unocal common stock is listed for trading on the New York, Pacific and Chicago stock exchanges in the United States, and on the Basel, Geneva and Zurich stock exchanges in Switzerland. As of March 15, 1994, the approximate number of holders of record of Unocal common stock was 41,208, and the number of shares outstanding was 241,841,427. Unocal's quarterly dividend rate declared has been $.20 per common share since the third quarter of 1993. The previous quarterly dividend rate was $.175 per share since the third quarter of 1989. The company has paid a quarterly dividend for 78 consecutive years. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA - see page 56. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONSOLIDATED RESULTS Unocal's net earnings for 1993 were $213 million, compared with $220 million in 1992 and $73 million in 1991. Earnings for the three years included the following special items: Excluding the effect of accounting changes and other special items, net earnings were $347 million in 1993, $234 million in 1992 and $117 million in 1991. The significant improvement in 1993 operating earnings reflected higher domestic natural gas prices and production, improved West Coast refining and marketing margins, lower worldwide exploration expenses and lower interest expense. In addition, the company benefited from continued cost reductions as a result of its 1992 restructuring efforts. These favorable factors were partially offset by lower crude oil prices. In 1993, the company completed the sale of its geothermal operations in the Imperial Valley of California and its national auto/truckstop system. Major asset sales in 1992 included the company's retail chemical distribution and polymers businesses. Comparing 1992 results with 1991, the increase was mainly due to improved margins for refined products, higher natural gas sales prices and volumes, and lower domestic exploration costs. Partially offsetting these positive factors were lower crude oil production and reduced earnings from chemical operations. REVENUES Consolidated revenues continued to decline in 1993, down by $1.7 billion from 1992 and $2.6 billion from 1991. This trend reflects the company's divestments in recent years and the phase-out of its marketing operations in the southeastern United States. The decrease in 1993 also reflects lower crude oil prices. Divestments planned for 1994 are not expected to have a significant effect on revenues. COSTS AND OTHER DEDUCTIONS Crude oil and product purchases, operating expense, and selling, administrative and general expense totaled $5.4 billion in 1993, compared with $7.0 billion in 1992 and $7.8 billion in 1991. The decline was mainly the result of business divestments and the phase-out of Southeastern marketing operations. Lower crude purchase costs and cost reduction efforts also contributed to the decrease. Administrative and general expense in 1992 included a $55 million charge related to the company's restructuring efforts. Dry hole and exploration expenses declined in 1993 reflecting highly focused worldwide exploration activities. Lower interest expense in 1993 was mainly due to the debt reduction efforts in late 1992. OIL AND GAS EXPLORATION AND PRODUCTION The results for all three years reflected continued improvement in the U.S. natural gas market. The company's average sales price for domestic natural gas was $1.97 per thousand cubic feet, up from $1.74 in 1992 and $1.66 in 1991. Domestic daily natural gas production in 1993 was up two percent from 1992 and six percent from 1991. The results also reflected continued decreases in exploration expenses and other cost reductions. While these gains were significant, they were partially offset by a decrease in crude oil prices and lower crude oil production due to natural decline and lost production resulting from property sales. The company's average worldwide sales prices of crude oil were $14.21 per barrel in 1993, $15.99 in 1992 and $16.50 in 1991. Special items for 1993 consisted primarily of gains from the sale of nonstrategic properties; for 1992, a $44 million deferred income tax benefit related to foreign exploration expenses; and for 1991, a $24 million earnings benefit from natural gas contract settlements. REFINING, MARKETING AND TRANSPORTATION The company's West Coast refining and marketing margins continued to improve in 1993. Although selling prices for refined products were lower than a year ago, the impact was more than offset by lower crude oil and product purchase costs. The phase-out of the company's Southeastern retail operations in late 1991 also had a favorable impact on 1993 results. Comparing 1992 results with 1991, the significant increase in earnings before special items was principally due to improved margins in West Coast operations, including the benefits from the integration of the Los Angeles Refinery with the Carson Plant, and strong earnings from the company's UNO-VEN joint venture in the Midwest. Special items for 1993 principally included charges for asset write-offs which were partially offset by gains from various asset sales. Special items for 1992 reflected charges related to restructuring and a write-down of surplus equipment; and for 1991, a gain from the sale of refined product inventories in the Southeastern market. CHEMICALS Net earnings for this segment were $42 million in 1993, $23 million in 1992 and $47 million in 1991. The lower 1992 earnings were principally caused by residual expenses associated with the retail chemical distribution and polymers manufacturing businesses that were sold in early 1992. These businesses posted a small loss in 1991. With the sale of its retail agricultural business in 1993, this segment's primary sources of income are derived from its manufacturing of nitrogen-based fertilizer and petroleum cokes. Higher earnings were recorded for the petroleum coke operations in 1993. GEOTHERMAL Geothermal energy earnings in 1993 were $46 million, which included a $19 million gain from the sale of the Imperial Valley operations. Net earnings were $38 million in 1992 and $37 million in 1991, including Imperial Valley operating earnings of $19 million in 1992 and $18 million in 1991. Geothermal steam production in Indonesia is scheduled to come on stream in the second quarter of 1994. CORPORATE AND OTHER Corporate expense includes general corporate overhead and other unallocated items. Other operations include the results of shale oil, mineral and real estate businesses. The 1993 results continued to reflect the favorable impact of discontinuing the company's shale oil and molybdenum operations. The company also recorded higher earnings from its lanthanide operations. Net interest expense represents interest income and expense, net of capitalized interest. The decrease in 1993 reflects the full-year impact of more than $1 billion reduction in debt in 1992. Interest expense is expected to be slightly lower in 1994 due to refinancing a portion of debt at lower interest rates, and continued debt reduction. Special items for all three years primarily include provisions for litigation. The 1992 and 1991 amounts included asset write-downs of $6 million and $67 million, respectively. The 1993 amount did not include any asset write- downs. FINANCIAL CONDITION Cash flow from operating activities, including working capital changes, was $1,100 million in 1993, $1,157 million in 1992 and $1,043 million in 1991. Cash generated from operations was up $302 million in 1993, but this was more than offset by working capital changes, payments for legal and tax settlements, and an adjustment for a 1992 crude oil forward sale. During 1993, the company generated $586 million in pretax proceeds from various asset sales, compared with $469 million in 1992 and $132 million in 1991. The 1993 proceeds included $205 million from the sale of geothermal Imperial Valley assets, $172 million from the sale of the company's national auto/truckstop system, and $106 million from the sale of various oil and gas properties. The 1993 operating cash flow and proceeds from asset sales totaled $1,686 million, which provided sufficient cash for capital spending, dividend payments and a $176 million reduction in debt. Consolidated working capital was $382 million at year-end 1993, which included $114 million of refundable income taxes expected to be received in 1994. In February 1994 the company issued $200 million of 6-3/8% notes due 2004. Proceeds will be used to retire certain notes due in early 1994. For 1994, the company expects cash generated from operations and asset sales, including the tax refunds, to be sufficient to finance its operating requirements, capital spending and dividend payments. CAPITAL EXPENDITURE Capital expenditures increased significantly in 1993 from the prior year as more cash was spent on worldwide oil and gas activities. The 1993 spending on domestic oil and gas exploration and production was up by 54 percent compared with 1992, primarily reflecting the first year of a three-year accelerated drilling program to produce proved undeveloped reserves in the United States. The increase in foreign spending was due to the continued development of offshore gas fields in Thailand and a new oil field in the Netherlands. The $236 million spent on refining, marketing and transportation operations during 1993 primarily reflected refinery upgrades to meet environmental requirements and the addition of units to increase production of higher value products. Capital spending on geothermal energy projects in 1993 primarily included expenditures in Indonesia for development and exploration. The increase in other capital expenditures from 1992 reflected environmental remediation of properties held for sale by the Real Estate Division. The $1.46 billion capital budget for 1994 is based on West Texas Intermediate spot market crude oil price of $18 per barrel. In light of current crude prices, capital spending will be kept in line with spot market prices of $15 to $16 per barrel at least for the first six months. If crude prices remain below $15 per barrel, spending should be about the same as in 1993. Approximately $911 million, or 63 percent of the 1994 plan, is directed toward the company's worldwide petroleum exploration and production. The company plans to spend $521 million on exploration and production of crude oil and natural gas resources in the U.S., down slightly from $562 million in 1993. The major focus will be on Louisiana and the Gulf of Mexico, Alaska's Cook Inlet, California and the Permian Basin in west Texas. The spending plan includes $49 million for projects near existing operations that are classified as exploratory but have potential for rapid development. Capital spending for foreign petroleum exploration and production is expected to total $390 million, an 18 percent increase from $330 million in 1993. The 1994 budget includes continued development of natural gas reserves offshore Thailand and field development work in Indonesia and the Netherlands. This budget includes $34 million for exploration work in Indonesia, most of which is recoverable under the company's production sharing contract with Pertamina, Indonesia's state-owned oil company. Refining, marketing and transportation capital spending is budgeted at $388 million, up from $236 million in 1993. This includes more than $290 million for refinery projects, including modifications required to manufacture reformulated gasoline. Approximately $40 million is dedicated to the upgrade of marketing facilities. Planned capital spending for geothermal energy totals $73 million, compared with $53 million last year. The higher spending reflects increased development work on geothermal projects on the island of Java and exploratory drilling on the island of Sumatra in Indonesia. ENVIRONMENTAL MATTERS In 1993, the company spent approximately $368 million for environmental protection and for compliance with federal, state and local laws and provisions regulating the discharge of materials into the environment. Of this amount $133 million was for capital expenditures and $235 million was recorded as expense. The amount charged to earnings includes expenditures to remediate past contamination and for Unocal's operating, maintenance and administrative costs to maintain environmental compliance. Estimated 1994 expenditures for environmental-related costs are $296 million in capital and $242 million in expense. The increase in capital is primarily due to expenditures for refinery projects to produce reformulated gasoline mandated by government agencies. The Air Quality Management Plan for the Los Angeles Basin, as adopted, and the Clean Air Act Amendments could, by the year 2000, significantly and adversely affect all of the company's petroleum operations in the Los Angeles area, including its refining operations located near the Los Angeles harbor and in Carson. The company believes it can continue to meet the requirements of existing laws and regulations, although changes in operating procedures and the acquisition of additional pollution control facilities may be necessary. The company is subject to federal, state and local environmental laws and regulations, including the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, and the Resource Conservation and Recovery Act (RCRA). Under these laws, the company is subject to possible obligations to remove or mitigate the environmental effects of the disposal or release of certain chemical and petroleum substances at various sites. Corrective investigations and actions pursuant to RCRA are being performed at the San Francisco Refinery, Beaumont facility, Los Angeles Refinery-Carson Plant and Molycorp Inc. Mountain Pass Plant. The company also must guarantee future closure and post-closure costs of its RCRA permitted facilities. The company believes that these obligations are not likely to have an adverse material effect on the company's operating results or financial condition. The company is a defendant in several lawsuits, as are most other companies within our industry, brought by government agencies seeking to impose cleanup liability for environmental contamination. The company has been notified that it may be a potentially responsible party (PRP) by the federal EPA at 67 sites and may share liability at certain of these sites. Various state agencies, private parties, and the company itself have identified other sites that may require investigation or remediation. Unocal does not consider the number of sites for which it has been named a PRP as a relevant measure of liability. The company is usually just one of several companies designated as a PRP. For example, all but a small percentage of the 67 sites mentioned above are sites where the company has denied liability to the EPA, and/or which are still under investigation, and/or which the company estimates it has one percent or less of any potential liability. The company is uncertain as to its involvement in many of the sites and is unable to estimate with any certainty the potential loss that may arise from environmental liabilities. The solvency of other parties and disputes regarding responsibilities may also impact the company's ultimate liability. Settlements and costs incurred in matters that have been resolved have not been materially significant to the company's operating results or financial condition. Management believes that Unocal's costs will not vary proportionally from those of our competitors. For sites where it is probable that future costs will be incurred, and such costs can be reasonably estimated, reserves have been recorded in the consolidated balance sheet. At December 31, 1993, the company's environmental reserve for those sites was $87 million, which represents the company's estimate of the future liability for these costs. In addition, the company has accrued $432 million for the future costs to abandon and remove wells and production facilities. Future changes in technology, government regulations and practices, will affect the company's ultimate liability for environmental remediation and abandonment costs. On March 4, 1994, Unocal announced that if negotiations with the land owner permit the company to do so, it will permanently cease production at its Guadalupe Oil Field (central coast of California). The company will continue to concentrate on the cleanup of a diesel-like additive formerly used to help produce the heavy crude oil. The field is currently producing 170 barrels of oil per day. The field has been under study for some time to determine the extent of the underground contamination. Although the cleanup cost has not been determined, such cost is not expected to have a material effect on the company's operating results or financial condition See Note 16 to the consolidated financial statements for information on contingent liabilities relating to environmental matters. OUTLOOK The 1994 outlook for the petroleum industry is uncertain since financial results are sensitive to product prices. Negative factors affecting crude prices include current oversupply, the possible re-entry of Iraq into the world oil markets and OPEC's strategy of defending its market share. Demand for natural gas is expected to remain strong. On the West Coast, the sluggish economy continues to affect demand for refined products. The company's current operating strategy is to increase cash flow from operations by increasing resource production and emphasizing cost control in all areas. Over the next three years, the company expects to increase natural gas production by about 25 percent and crude oil production about 14 percent. The centerpiece of this effort is the accelerated development drilling program in North America launched during 1993. The 1994 capital budget includes approximately 535 wells, with 410 in North America. However, lower than expected oil prices at the beginning of 1994, has caused the company to slow down development of crude oil and focus more on natural gas development. This shift and reduction in capital may delay achievement of the production goal for crude oil. Unocal also continues to seek a role in the development of vast oil and gas resources in the Caspian Sea. Negotiations are ongoing with Azerbaijan and the international consortium of oil companies of which Unocal is a member. The company's refining and marketing operations will continue to focus on improving refining efficiencies and strengthening its Western marketing. Unocal expects to spend approximately $210 million in 1994 and $175 million in 1995, in capital, to modify its refineries in order to produce reformulated gasoline that will meet specifications mandated by the California Air Resources Board and the 1990 Federal Clean Air Act Amendments. The company has made significant progress toward debt reduction and asset sales goals established in April 1992. Total debt was reduced in 1993 by $176 million, which brings the total debt reduction to 80 percent of the $1.5 billion five-year target. The company is also 80 percent of the way toward meeting its two-year goal of generating $700 million in after-tax proceeds from asset sales. Toward this goal, at year-end 1993, the company had realized proceeds of $560 million from asset sales. The company will continue to work toward the debt reduction and asset sales targets. Total debt is expected to be reduced by an additional $50 million in 1994. Planned asset sales in 1994 are expected to generate more than $200 million in after-tax proceeds. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES All other financial statement schedules have been omitted as they are not applicable, not material or the required information is included in the financial statements or notes thereto. REPORT ON MANAGEMENT'S RESPONSIBILITIES TO THE STOCKHOLDERS OF UNOCAL CORPORATION: Unocal's management is responsible for the integrity and objectivity of the financial information contained in this Annual Report. The financial statements included in this report have been prepared in accordance with generally accepted accounting principles and, where necessary, reflect the informed judgments and estimates of management. The financial statements have been audited by the independent accounting firm of Coopers & Lybrand. Management has made available to Coopers & Lybrand all of the company's financial records and related data, minutes of the company's executive committee meetings and directors' meetings and all internal audit reports. The independent accountants conduct a review of internal accounting controls to the extent required by generally accepted auditing standards and perform such tests and procedures as they deem necessary to arrive at an opinion of the fairness of the financial statements presented herein. Management maintains and is responsible for systems of internal accounting controls designed to provide reasonable assurance that the company's assets are properly safeguarded, transactions are executed in accordance with management's authorization and the books and records of the company accurately reflect all transactions. The systems of internal accounting controls are supported by written policies and procedures and by an appropriate segregation of responsibilities and duties. The company maintains an extensive internal auditing program that independently assesses the effectiveness of these internal controls with written reports and recommendations issued to the appropriate levels of management. Management believes that the existing systems of internal controls are achieving the objectives discussed herein. Unocal assessed its internal control systems in relation to criteria for effective internal control over financial reporting following the Treadway Commission's Committee of Sponsoring Organizations "Internal Control - Integrated Framework." Based on this assessment, Unocal believes that, as of December 31, 1993, its systems of internal controls over financial reporting met those criteria. Unocal's Accounting, Auditing and Ethics Committee, consisting solely of directors who are not employees of Unocal, is responsible for: reviewing the company's financial reporting, accounting and internal control practices; recommending the selection of independent accountants (which in turn are approved by the Board of Directors and annually ratified by the stockholders); monitoring compliance with applicable laws and company policies; and initiating special investigations as deemed necessary. The independent accountants and the internal auditors have full and free access to the Accounting, Auditing and Ethics Committee and meet with it, with and without the presence of management, to discuss all appropriate matters. February 14, 1994 REPORT OF INDEPENDENT ACCOUNTANTS TO THE STOCKHOLDERS OF UNOCAL CORPORATION: We have audited the accompanying consolidated balance sheet of Unocal Corporation and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, cash flows and stockholders' equity for each of the three years in the period ended December 31, 1993 and the related financial statement schedules. These financial statements and financial statement schedules are the responsibility of Unocal Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above, which appear on pages 29 through 51 of this Annual Report on Form 10-K, present fairly, in all material respects, the consolidated financial position of Unocal Corporation and its subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes 1 and 12 to the consolidated financial statements, Unocal Corporation and its subsidiaries changed their method of accounting for income taxes in 1992 and for postretirement benefits other than pensions and for postemployment benefits in 1993. /s/ COOPERS & LYBRAND COOPERS & LYBRAND Los Angeles, California February 14, 1994 CONSOLIDATED EARNINGS UNOCAL CORPORATION See Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEET UNOCAL CORPORATION The company follows the successful efforts method of accounting for its oil and gas activities. See Notes to Consolidated Financial Statements. CONSOLIDATED CASH FLOWS UNOCAL CORPORATION See Notes to Consolidated Financial Statements. CONSOLIDATED STOCKHOLDERS' EQUITY UNOCAL CORPORATION See Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation For the purpose of this report, Unocal Corporation (Unocal) and its consolidated subsidiary, Union Oil Company of California (Union Oil) and its consolidated subsidiaries, will be referred to as the company. The consolidated financial statements of the company include the accounts of subsidiaries more than 50 percent owned. Investments in affiliates owned 50 percent or less are accounted for by the equity method. Under the equity method, the investments are stated at cost plus the company's equity in undistributed earnings after acquisition. Income taxes estimated to be payable when earnings are distributed are included in deferred income taxes. Inventories Inventories are valued at lower of cost or market. The cost of crude oil, refined products and chemicals inventories is determined using the last-in, first-out (LIFO) method. The cost of other inventories is determined by using various methods. Cost elements primarily consist of raw materials and production expenses. Capitalized Leased Properties Facilities and lands leased by the company under firm, long-term obligations are capitalized as assets and depreciated in the same manner as owned properties. Future minimum rental payments are discounted to present value using the company's incremental borrowing rate in effect at the time of leasing and such value is recorded as a liability. Earnings are charged for depreciation of the facilities and the imputed interest on the rental obligations in lieu of actual rental payments. Oil and Gas Exploration and Development Costs The company follows the successful efforts method of accounting for its oil and gas activities. Acquisition costs of exploratory acreage are capitalized. Full amortization of the nonproductive portion of such costs is provided over the shorter of the exploratory period or the lease holding period. Costs of successful leases are transferred to proved properties. Exploratory drilling costs are initially capitalized. If exploratory wells are determined to be commercially unsuccessful, the related costs are expensed. Geological and geophysical costs for exploration and leasehold rentals for unproved properties are expensed. Development costs of proved properties are capitalized. Depreciation, Depletion and Amortization Depreciation, depletion and amortization related to proved oil and gas properties and estimated future abandonment and removal costs for offshore production platforms are calculated at unit of production rates based upon estimated proved recoverable reserves. Depreciation of other properties is generally on a straight-line method using various rates based on estimated useful lives. Maintenance and Repairs Expenditures for maintenance and repairs are expensed. In general, improvements are charged to the respective property accounts and such accounts are relieved of the original cost of property replaced. Retirement and Disposal of Properties Upon retirement of facilities depreciated on an individual basis, remaining book values are charged to current depreciation expense. For facilities depreciated on a group basis, remaining book values are charged to accumulated allowances. Gains or losses on sales of properties are included in current earnings. Income Taxes Effective January 1, 1992, the company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." This statement superseded SFAS 96, which the company adopted in 1988. SFAS 109 continues to require the use of the liability method for reporting income taxes in which current or deferred tax liabilities or assets are recorded in accordance with enacted tax laws and rates. Under this method, the amount of deferred tax liabilities or assets at the end of each period is determined using the tax rate expected to be in effect when taxes are actually paid or recovered. SFAS 109 changed, among other things, the recognition criteria for deferred tax assets. Future tax benefits are recognized to the extent that realization of such benefits is more likely than not. Upon adoption, the company was able to record certain deferred foreign income tax benefits not previously recognized. The favorable cumulative effect of this accounting change for the periods prior to January 1, 1992, was $24 million. Deferred income taxes are provided for the estimated income tax effect of temporary differences between financial and tax bases in assets and liabilities. Deferred tax assets are also provided for certain tax credit carryforwards. A valuation allowance to reduce deferred tax assets will be established if appropriate. See Note 8 for the principal temporary differences and unused tax credits. Foreign Currency Translation Foreign exchange gains and losses as a result of translating a foreign entity's financial statements from its functional currency into U.S. dollars are included as a separate component of stockholders' equity. The functional currency for all foreign operations, except Canada, is the U.S. dollar. Gains or losses incurred on currency transactions in other than a country's functional currency are included in net earnings. Environmental Costs Environmental expenditures are expensed or capitalized in accordance with generally accepted accounting principles. Expenditures that relate to existing conditions caused by past operations and have no future economic benefit are expensed. Liabilities are recognized for those superfund sites and facilities previously owned by the company where it is probable that the company is obligated for environmental expenditures, and the amounts can be reasonably estimated. The timing of liability recognition generally coincides with the formulation and commitment to an appropriate plan of action. Environmental liabilities are not discounted or reduced by possible recoveries from third parties. However, accrued liabilities reflect anticipated allocation of liabilities among settling participants in multi-party sites. Environmental remediation costs required for properties held for sale are capitalized. A valuation allowance will be established if the aggregate book value of those properties including capitalized remediation costs exceed net realizable value. See Notes 6 and 16 for additional environmental information. Other Earnings per share of common stock are based on earnings less preferred stock dividend requirements, divided by the weighted average shares of common stock outstanding during each period. Interest is capitalized on major construction and development projects as part of the cost of the asset. Certain items in prior year financial statements have been reclassified to conform to the 1993 classification. NOTE 2 - RESTRUCTURING COSTS In 1992, as part of its efforts to improve cash flow and operating results, the company underwent work force reductions and operational changes. Voluntary retirement and severance packages were accepted by 1,145 employees. A $55 million provision, net of reduced pension obligations, was included in administrative and general expenses. NOTE 3 - WRITE-DOWNS OF ASSETS Earnings in 1993 included a pretax charge of $19 million for the write-off of refining projects, primarily due to the cancellation of a portion of work associated with the reformulated fuels program at the company's Los Angeles Refinery. In 1992, the company recorded a pretax charge of $50 million for the write- down of its interest in a Canadian partnership and various assets that were shut down or sold. In 1991, the company recorded several write-downs of assets. Pretax charges to earnings included $73 million for the Los Angeles Refinery due to the suspension of the hydrotreater project as a result of the company's purchase of a major portion of the Shell Oil Company's refinery in Carson, California. Also included were $25 million for nitric acid and urea ammonium nitrate manufacturing plants in West Sacramento, California, due to the reduction in scope of an expansion project, and $8 million for certain mineral assets. NOTE 4 - DISPOSITIONS OF ASSETS In 1993, the sale of the company's geothermal assets in the Imperial Valley of California and other geothermal exploration leases resulted in a $40 million pretax gain on proceeds of $218 million. An $11 million pretax gain on proceeds of $172 million was recorded from the sale of the company's national auto/truckstop system. In addition, various oil and gas properties were sold which generated total proceeds of $106 million with a pretax gain of $42 million. The company also sold its retail agricultural businesses with a pretax loss of $1 million on proceeds of $31 million. In 1992, the company recorded a pretax loss of $1 million on the sales of its retail chemical distribution and polymer businesses, and Southeast marketing terminals. The total proceeds from the sales of these businesses, net of certain related costs, were approximately $250 million. In addition, the company realized a pretax gain of $53 million and proceeds of approximately $158 million from the sale of various oil and gas properties in North America and the Netherlands. NOTE 5 - CASH FLOW INFORMATION The company considers cash equivalents to be all highly liquid investments purchased with a maturity of three months or less. All income taxes paid are included in determining cash flows from operating activities. As a result, income taxes expected to be paid on the taxable income from the sales of assets are not included in cash flows from investing activities. In the consolidated statement of cash flows for 1993, other changes related to operations principally included $106 million of payments for Alaska tax and geothermal energy sales contract settlements. Also included was a cash flow reduction of $125 million relating to the settlement of crude oil forward sales contracts, for which revenue was recognized in 1993, but cash was received in 1992. The consolidated statement of cash flows for 1992 excluded the effect of noncash activities related to the merger of Unocal Exploration Corporation into Union Oil (see Note 17). The effect on the balance sheet was to increase properties, deferred income taxes and stockholders' equity by $173 million, $64 million and $142 million, respectively, and to decrease minority interest liability by $33 million. NOTE 6 - OTHER FINANCIAL INFORMATION Consolidated earnings include the following: In addition, social security and unemployment insurance taxes, which are charged to earnings and included with salaries and wages, totaled $44 million in 1993, $48 million in 1992 and $49 million in 1991. NOTE 8 - INCOME TAXES Unocal files a consolidated federal income tax return that includes essentially all U.S. subsidiaries. The components of pretax earnings and the provision for income taxes are as follows: Due to an operating loss carryback in 1993, the company expects a $114 million income tax refund in 1994. The following table is a reconciliation of income taxes at the federal statutory income tax rates to income taxes as reported in the Consolidated Earnings Statement. The significant components of deferred income tax assets and liabilities included in the Consolidated Balance Sheet as of December 31, 1993 and 1992 are as follows: The above net deferred income tax liabilities are classified in the Consolidated Balance Sheet as follows: No deferred U.S. income tax liability has been recognized on the undistributed earnings of foreign subsidiaries or affiliates that have been retained for reinvestment. If distributed, no additional U.S. tax is expected due to the availability of foreign tax credits. Such undistributed earnings for tax purposes, excluding previously taxed earnings, are estimated at $955 million as of December 31, 1993. At year-end 1993, the company had $60 million of unused foreign tax credits with various expiration dates through 1997. No deferred tax asset for these foreign tax credits is recognized for financial statement purposes. The federal alternative minimum tax credits are available to offset future U.S. federal income taxes on an indefinite basis. In addition, the company has approximately $28 million of business tax credit carryforwards that will expire between 2001 and 2008. NOTE 9 - INVENTORIES Current cost of inventories exceeded the LIFO inventory value included above by $147 million and $176 million at December 31, 1993 and 1992, respectively. The LIFO profits included in earnings were insignificant in 1993 and 1992 while 1991 earnings included $90 million due to the sale of the company's southeastern U.S. marketing inventory. NOTE 10 - PROPERTIES AND CAPITALIZED LEASES Investments in owned and capitalized leased properties at December 31, 1993 and 1992 are set forth below. Total accumulated depreciation, depletion and amortization was $11,667 million and $11,579 million at December 31, 1993 and 1992, respectively. Capitalized leased properties principally consist of service stations and petroleum facilities. Capital leases have expiration dates ranging from 1994 to 2009, and include purchase options and favorable renewal options. * Includes mineral and real estate assets. NOTE 11 - RETIREMENT PLANS The company and its subsidiaries have several non-contributory retirement plans covering substantially all employees. Plan benefits are primarily based on years of service and employees' compensation near retirement. All U.S. plans are administered by corporate trustees. There was no company contribution to any of the U.S. plans during the years 1991 through 1993 as plan assets substantially exceeded the pension obligations. At year-end 1993, plan assets principally consist of equity securities, U.S. government and agency issues, corporate bonds and cash. Employees of certain foreign subsidiaries of the company are covered by separate plans. Total costs for all foreign plans were insignificant for each period. Pension costs for the funded U.S. plans include the following components: The 1992 net gain from partial settlement of obligation was the result of the voluntary retirement and severance packages accepted by employees and those employees who left the company due to the sale of business units in 1992. The following table sets forth the plans' funded status and amounts recognized in the Consolidated Balance Sheet at December 31, 1993 and 1992: The assumed rates used to measure the projected benefit obligation and the expected earnings on plan assets were as follows: The amount of benefits which can be covered by the funded plans described above are limited by the Employee Retirement Security Act of 1974 and the Internal Revenue Code. Therefore, the company has an unfunded supplemental retirement plan designed to maintain benefits for all employees at the plan formula level. The amounts expensed for this plan were $2 million, $23 million and $1 million in 1993, 1992 and 1991, respectively. The 1992 amount included a one-time charge of $21 million as a result of the company's restructuring program. The accumulated obligation recognized in the Consolidated Balance Sheet at December 31, 1993 was $19 million. NOTE 12 - POSTRETIREMENT AND POSTEMPLOYMENT BENEFIT PLANS The company's medical plan provides health care benefits for eligible employees and retired employees. Employees may become eligible for postretirement benefits if they reach the normal retirement age while working for the company. The plan is contributory and the benefits are subject to deductibles and co-payments. Effective January 1, 1993, the company adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This new accounting standard requires the company to recognize its obligation to provide postretirement health care benefits and to accrue such costs rather than recording them on a cash basis. The actuarial present value of the accumulated postretirement health care obligation existing at January 1, 1993 was recognized in the Consolidated Earnings Statement as a cumulative effect of an accounting change, resulting in a charge to the first quarter 1993 earnings of $192 million before tax ($121 million after tax or 50 cents per common share). The following table sets forth the postretirement benefit obligation recognized in the Consolidated Balance Sheet at December 31, 1993: Net periodic postretirement benefits cost includes the following components: The pay-as-you-go cost for postretirement medical benefits was $13 million each in 1992 and 1991. The accumulated postretirement benefit obligation at December 31, 1993 was determined using a discount rate of 7.25 percent. The health care cost trend rates used in measuring the 1993 benefit obligations were 9 percent for under age 65 and 7 percent for age 65 and over, gradually decreasing to 5 percent by the year 2001 and remaining at that level thereafter. The rates are subject to change in the future. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, an increase in the assumed health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $20 million and net periodic benefits cost by $3 million. The company also adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," effective January 1, 1993. This statement requires the company to recognize its obligation to provide benefits, such as workers' compensation and disabled employees' medical care, to former or inactive employees after employment but before retirement. The charge to earnings for the cumulative effect of the company's unfunded obligation prior to 1993 was $14 million before tax ($9 million after tax or 4 cents per common share). The accumulated postemployment benefit obligation was $17 million as of December 31, 1993. NOTE 13 - LONG-TERM DEBT AND CREDIT AGREEMENTS The following table summarizes the company's long-term debt: * Weighted average interest rate at December 31, 1993. At December 31, 1993, the commercial paper borrowings and the two notes due 1994 were classified as long-term debt. The company has both the ability and intent to refinance these borrowings on a long-term basis through existing lines of credit. The current portion of long-term debt at year-end 1993 represents the net amount of debt expected to be reduced in 1994. The amounts of long-term debt maturing in 1995, 1996, 1997 and 1998 are $282 million, $318 million, $303 million and $300 million, respectively. During 1993, the company prepaid in full $120 million of 8-5/8% Debentures due 2006, $23 million of 6-5/8% Debentures due 1998 and $65 million of 7-1/4% Pollution Control Bonds due 1997. The redemption premium on the retired debentures and bonds totaled $3 million and $1 million, respectively. In addition, the company retired $250 million of 9% notes and paid down the $250 million loan under the Bank Credit Agreement. The debt repayments were funded with the issuance of commercial paper and cash on hand. The company borrowed $41 million under a revolving credit facility that was established in 1993 for the purpose of funding its oil and gas development program in the Netherlands. Also, a $250 million revolving credit facility was established in December 1993 for the same purpose in Thailand. Both facilities require a fee of 1/4 of 1 % on the total commitments. The Bank Credit Agreement provides a revolving credit of $1.2 billion through 1996 at interest rates based on London Interbank Offered Rates. This agreement is available for general corporate purposes, including the support of commercial paper issued by Union Oil. At December 31, 1993, the company had available undrawn commitments of $1.2 billion. The company pays a facility fee of 1/4 of 1% on the total commitments. The company also has reimbursement agreements with a major bank providing for the reimbursement of amounts drawn under irrevocable direct-pay letters of credit issued by such bank for the payment of $23 million on certain industrial development revenue bonds issued in 1988. The company pays a facility fee of .525% on these outstanding letters of credit. The company has other letters of credit for approximately $142 million. The majority are maintained for operational needs. NOTE 14 - LEASE RENTAL OBLIGATIONS Future minimum rental payments for capitalized leased properties and for operating leases having initial or remaining noncancelable lease terms in excess of one year are as follows: * The current portion of these obligations amounted to $2 million. There were no material contingent rentals applicable to capital leases. Net operating rental expense included in consolidated earnings is as follows: NOTE 15 - FINANCIAL INSTRUMENTS FAIR VALUE The company had $205 million in cash and cash equivalents at year-end 1993, which approximates fair value because of the short maturity of these investments. The estimated fair value of the company's long-term debt, including currency and interest rate swaps, was $3.8 billion at year-end 1993. This fair value was estimated based upon the discounted amount of future cash outflows using the rates offered to the company for debt of the same remaining maturities. OFF-BALANCE-SHEET RISK The company is a party to financial instruments with off-balance-sheet risk in the normal course of business to reduce its exposure to fluctuations in interest and currency exchange rates and petroleum-related prices. These financial instruments include interest rate and currency swaps and forward currency and futures contracts, which involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the financial statements. The company believes that the actual exposure to loss is minimal and immaterial. As of December 31, 1993, the company had no financial instruments with significant off-balance-sheet risk. CONCENTRATIONS OF CREDIT RISK Financial instruments that potentially subject the company to concentrations of credit risk consist primarily of temporary cash investments and trade receivables. The company places its temporary cash investments with high credit quality financial institutions and, by policy, limits the amount of credit exposure to any one financial institution. Concentrations of credit risks with respect to trade receivables are limited because there are a large number of customers in the company's customer base spread across many industries and geographic areas. As of December 31, 1993, the company had no significant concentrations of credit risk. NOTE 16 - CONTINGENT LIABILITIES The company has certain contingent liabilities with respect to existing or potential claims, lawsuits and other proceedings, including those involving environmental, tax and other matters. Management is of the opinion, based on developments to date, that such contingencies are not likely to have a material effect on the company's financial condition (including stockholders' equity, liquidity and capital resources). Although unlikely, substantial adverse decisions could have a material effect on the company's financial condition. Also, if liabilities are aggregated and assumed to occur in a single fiscal year, they could be material to the company's operating results; the likelihood of such occurrences is considered remote. The company may face potentially significant financial exposure from possible claims and lawsuits regarding environmental matters. These matters include, for example, designation of the company as a "potentially responsible party" under the federal Comprehensive Environmental Response, Compensation, and Liability Act; properties requiring presently undeterminable amounts of cleanup efforts and expenses; soil or water contamination; and claims for personal injuries allegedly caused by exposure to toxic materials manufactured or used by the company. The present state of the law which imposes joint and several liability on defendants, the potentially large number of claimants for any given site or exposure, the uncertainty attendant to the possible award of punitive damages, the imprecise and conflicting engineering evaluations and estimates of proper cleanup methods and costs, the uncertainty of potential recovery from third parties and the recent judicial recognition of new causes of action, all contribute to the practical impossibility of making any reasonable estimate of the company's potential liability for most of these environmental matters. The company is usually just one of several companies cited as a potentially responsible party. Settlements and costs incurred in those matters that have been resolved have not been materially significant to the company's operating results or financial condition, and the company does not believe that future similar liability will be material to its financial condition. Even though unlikely, a substantial adverse decision awarding punitive damages to several plaintiffs or imposing several liability for the cleanup obligations of other equally responsible parties, however, could have a significant effect on the company's financial condition. Also, if liabilities are aggregated and assumed to occur in a single fiscal year, they could be material to Unocal's operating results; the likelihood of such occurrences is considered remote. The company also has certain other contingent liabilities with respect to litigation, claims and contractual agreements arising in the ordinary course of business. In the opinion of management, such contingent liabilities are not likely to result in any loss that would materially affect the company's operating results or financial condition. However, they could have a material effect on the company's operating results in a given quarter or year when such matters are resolved; the likelihood of such occurrence is considered remote. NOTE 17 - CAPITAL STOCK COMMON STOCK In 1992, Unocal Exploration Corporation (UXC), a majority owned subsidiary of Unocal, merged with and into Union Oil. Each outstanding share of UXC common stock held by the public was converted upon the merger. The company issued approximately 5 million shares of its common stock in exchange for 10 million shares of UXC common stock. At December 31, 1993, approximately 16.7 million shares were reserved for the conversion of preferred stock and 7.8 million shares were reserved for management incentive program awards. Under the incentive program, restricted shares are issued to key employees and outside directors. These awards generally require continuation of service with Unocal during the restriction period. The common shares outstanding at year-end 1993 included approximately 1.1 million shares of restricted stock. PREFERRED STOCK The company has 100,000,000 shares of preferred stock with a par value of $0.10 per share authorized. In July 1992, the company issued 10,250,000 shares of $3.50 convertible preferred stock. The convertible preferred stock is redeemable after July 15, 1996, in whole or in part, at the option of the company, at redemption prices declining to $50 per share in and after the year 2002. The convertible preferred stock has a liquidation value of $50 per share and is convertible at the option of the holder into common stock of the company at a conversion price of $30.75 per share, subject to adjustment in certain events. Dividends on the preferred stock at an annual rate of $3.50 per share are cumulative and are payable quarterly in arrears, when and as declared by Unocal's Board of Directors. Holders of the preferred stock have no voting rights. However, there are certain exceptions including the right to elect two additional directors if the equivalent of six quarterly dividends payable on the preferred stock are in default. STOCKHOLDER RIGHTS PLAN In January 1990, the Board of Directors of Unocal (the Board) adopted a stockholder rights plan (The Rights Plan) and declared a dividend of one preferred stock purchase right (Right) for each share of common stock outstanding. The Board also authorized the issuance of one Right for each common share issued after February 12, 1990, and prior to the earlier of the date on which the rights become exercisable, the redemption date, or the expiration date. The board has designated 3,000,000 shares of preferred stock as Series A Junior Participating Cumulative Preferred Stock (Series A Preferred Stock) in connection with The Rights Plan. The Rights Plan provides that, in the event any person becomes the beneficial owner of 15 percent or more of the outstanding common shares, each Right (other than a Right held by the 15 percent stockholder) will be exercisable, on and after the close of business on the tenth business day following such event, to purchase units of Series A Preferred Stock (each consisting of one one-hundredth of a share) having a market value equal to two times the then-current exercise price (initially $75). The Rights Plan further provides that if, on or after the occurrence of such event, the company is merged into any other corporation or 50 percent or more of the company's assets or earning power are sold, each Right (other than a Right held by the 15 percent stockholder) will be exercised to purchase shares of the acquiring corporation having a market value equal to two times the exercise price. The Rights expire on January 29, 2000, unless previously redeemed by the Board. The Rights do not have voting or dividend rights and, until they become exercisable, have no diluting effect on the earnings of the company. As of December 31, 1993, none of the Series A Preferred Stock had been issued nor had the Rights become exercisable. NOTE 18 - STOCK OPTION PLANS Under the company's Long-Term Incentive Plans of 1991 and 1985, stock options are granted to executives and key employees to purchase shares of the company's common stock. The option price per share will not be less than the fair market value of a share of common stock on the date granted. No options will be exercisable more than 10 years after the date of grant. Restrictions may be imposed for a period of five years on certain shares acquired through exercise of options granted after 1990. The following is a summary of stock option transactions for 1991, 1992 and 1993: Under the Long-Term Incentive Plan of 1991, there were 7,745,536 shares available at year-end 1993 for stock option awards as well as other awards. No additional shares will be granted under the 1985 Plan. NOTE 19 - SEGMENT AND GEOGRAPHIC DATA The company is engaged principally in petroleum, chemical and geothermal operations. Petroleum involves the exploration, production, transportation and sale of crude oil and natural gas; and the manufacture, transportation and marketing of petroleum products. Chemicals involves the manufacture, purchase, transportation and marketing of chemicals for agricultural and industrial uses. Geothermal involves the exploration, production and sale of geothermal resources. Other business activities currently include the production and marketing of lanthanides and niobium, and real estate development and sales. The company's shale oil and molybdenum operations were suspended in 1991. Financial data by business segment and geographic area of operation are shown on the following two pages. Intersegment revenue eliminations in business segment data are mainly transfers from exploration and production operations to refining, marketing and transportation operations, and in geographic areas of operations essentially represent transfers from foreign countries to the United States. Intersegment sales prices approximate market prices. NOTE 20 - INVESTMENTS IN AFFILIATES Investments in affiliated companies accounted for by the equity method were $389 million, $387 million and $377 million at December 31, 1993, 1992 and 1991, respectively. Dividends or cash distributions received from these affiliates were $80 million, $74 million and $62 million for the same years, respectively. These affiliated companies are primarily engaged in pipeline ventures, refining and marketing operations, and the manufacture of needle coke. The excess of the company's investments in Colonial Pipeline Company and West Texas Gulf Pipeline Company over its share in the related underlying equity in net assets is being amortized on a straight-line basis over a period of 40 years. The remaining unamortized balance at December 31, 1993 was $113 million. The company has a 50% interest in The UNO-VEN Company (UNO-VEN), a refining and marketing joint venture in the midwestern United States. The company's share of the underlying equity in the net assets of UNO-VEN over the carrying value of its investment is amortized on a straight-line basis over a period of 25 years. The remaining unamortized balance at December 31, 1993 was $63 million. Summarized financial information for these equity investees is shown below. * Reflects a significant provision for a tariff settlement and associated interest costs recorded by Kuparuk Pipeline Company, of which Unocal's share is five percent. BUSINESS SEGMENT DATA BUSINESS SEGMENT DATA (CONTINUED) (a) 1990 excludes the Prairie acquisition valued at approximately $340 million. (b) Includes asset write-downs as described in the footnotes (g) and (h) on the previous page. 1990 includes a $127 million write-down of molybdenum assets. OIL AND GAS FINANCIAL DATA RESULTS OF OPERATIONS Results of operations of oil and gas exploration and production activities are shown below. Sales revenues are net of royalty and net profits interests. Other revenues primarily include gains on sales of oil and gas properties, natural gas contract settlements and miscellaneous rental income. Production costs include lifting costs and taxes other than income. Other operating expenses primarily include administrative and general expense. Exploration expenses consist of geological and geophysical costs, leasehold rentals and dry hole costs. Income tax expense is based on the tax effects arising from the operations. Results of operations do not include general corporate overhead and interest costs. COSTS INCURRED Costs incurred in oil and gas property acquisition, exploration and development activities, either capitalized or charged to expense, are shown below. Data for the company's capitalized costs related to petroleum production and exploration activities are presented in Note 10. AVERAGE SALES PRICE AND PRODUCTION COSTS PER UNIT (UNAUDITED) The average sales price is based on sales revenues and volumes attributable to net working interest production. The average production costs per barrel presented below are based on equivalent petroleum barrels, including natural gas converted at a ratio of 5.3 MCF to one barrel of oil which represents the energy content of the wet gas. OIL AND GAS RESERVE DATA (UNAUDITED) Estimates of physical quantities of oil and gas reserves, determined by company engineers, for the years 1993, 1992 and 1991 are as shown below. As defined by the Securities and Exchange Commission, proved oil and gas reserves are the estimated quantities of crude oil, natural gas and natural gas liquids that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Accordingly, these estimates do not include probable or possible reserves. Estimated oil and gas reserves are based on available reservoir data and are subject to future revision. Proved reserve quantities exclude royalties owned by others but include net profits type agreements on a gross basis. Natural gas reserves are reported on a wet-gas basis, which include natural gas liquids reserves. For informational purposes, natural gas liquids reserves in the U.S. were 95, 97 and 103 million barrels at December 31, 1993, 1992 and 1991, respectively. Foreign natural gas liquids reserves were insignificant for the above periods. The domestic reserve quantities for natural gas liquids are on a leasehold basis and are derived from the natural gas reserves by applying a national average shrinkage factor obtained from the Department of Energy published statistics. (a) Includes 10 million barrels acquired through exchanges of property. (b) Includes the sale of 8 million barrels of future production under forward contracts and 10 million barrels due to exchanges of properties. (c) Includes the sale of 7 million barrels of future production under forward contracts. (d) Excludes 8 million barrels produced in 1992 but sold under forward contracts in 1991. (e) Excludes 7 million barrels produced in 1993 but sold under forward contracts in 1992. OIL AND GAS RESERVE DATA (UNAUDITED) (CONTINUED) (a) Includes 8 BCF acquired through exchanges of properties. (b) Includes dispositions of 12 BCF due to exchanges of properties. PRESENT VALUE OF FUTURE NET CASH FLOW RELATED TO PROVED OIL AND GAS RESERVES (UNAUDITED) The present value of future net cash flows from proved oil and gas reserves for the years 1993, 1992 and 1991 are presented below. Revenues are based on estimated production of proved reserves from existing and planned facilities and on average prices of oil and gas at year-end. Development and production costs related to future production are based on year-end cost levels and assume continuation of existing economic conditions. Income tax expense is computed by applying the appropriate year-end statutory tax rates to pretax future cash flows less recovery of the tax basis of proved properties, and reduced by applicable tax credits. The company cautions readers that the data on the present value of future net cash flow of oil and gas reserves are based on many subjective judgments and assumptions. Different, but equally valid, assumptions and judgments could lead to significantly different results. Additionally, estimates of physical quantities of oil and gas reserves, future rates of production and related prices and costs for such production are subject to extensive revisions and a high degree of variability as a result of economic and political changes. Any subsequent price changes will alter the results and the indicated present value of oil and gas reserves. It is the opinion of the company that this data can be highly misleading and may not be indicative of the value of underground oil and gas reserves. (a) Includes dismantlement and abandonment costs. (b) The average crude oil prices per barrel at year end used in this calculation are as follows: 1993 $10.08 $14.96 $11.78 1992 14.70 18.97 16.44 1991 13.96 19.91 17.09 CHANGES IN PRESENT VALUE OF FUTURE NET CASH FLOW (UNAUDITED) (a) Purchases of reserves were valued at $39 million, $56 million and $168 million in 1993, 1992 and 1991, respectively. Sales of reserves, including the sale of future production, were valued at $91 million, $175 million and $210 million for the same years, respectively. (b) Excludes the 1992 sale of future production for which income was recognized in 1993 but cash was received in 1992. (c) Excludes the 1991 sale of future production for which income was recognized in 1992 but cash was received in 1991. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (a) The fourth quarters of 1993 and 1992 exclude $16 million and $27 million for asset write-downs, respectively. (b) The first quarters of 1993 and 1992 include a charge of $130 million and a gain of $24 million for the cumulative effect of accounting changes, respectively. SELECTED FINANCIAL DATA (a) Net earnings for 1993 and 1992 include a charge of $130 million ($.54 per share) and a gain of $24 million ($.10 per share) for the cumulative effect of accounting changes, respectively. (b) Employee benefits are net of pension income recognized in accordance with current accounting standards for pension costs. 1993 also includes the accrued postretirement medical benefits cost under new accounting standards . ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE: None ---------------------------------- PART III The information required by Items 10 through 12 (except for information regarding the company's executive officers) is incorporated by reference from Unocal's Proxy Statement for its 1994 Annual Meeting of Stockholders, File No. 1-8483, as indicated below. ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding the Directors of the Registrant and the Executive Officers of the Registrant can be found on pages 3 through 5 of the 1994 Proxy Statement and page 18 of this Annual Report on Form 10-K, respectively. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION See pages 12 through 15 of the 1994 Proxy Statement. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See pages 7 and 16 of the 1994 Proxy Statement. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS: Not required. ---------------------------------- PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial statements, financial statement schedules and exhibits filed as part of this annual report: (1) Financial Statements: See Item 8 on page 26 of this Annual Report on Form 10-K (2) Financial Statement Schedules: See Item 8 on page 26 of this Annual Report on Form 10-K (3) Exhibits The Exhibit Index on page 64 of this Annual Report on Form 10-K lists the exhibits that are filed as part of this report. (b) Five Reports on Form 8-K were filed: (1) Filed December 8, 1993, Unocal announced the May 1, 1994, retirement of Richard J. Stegemeier, the Chief Executive Officer of the company. (2) Filed January 12, 1994, the settlement of a lawsuit with MESA Petroleum was announced. (3) Filed January 31, 1994, Unocal's 1993 4th Quarter and Year-end earnings were announced. (4) Filed March 2, 1994, the company announced a change in its bylaws which reduces the number of directors from 14 to 12, effective April 25, 1994. (5) Filed March 24, 1994, a civil lawsuit concerning the Guadalupe oil field was announced. 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. UNOCAL CORPORATION (Registrant) Date: March 28, 1994 By THOMAS B. SLEEMAN --------------------------------- Thomas B. Sleeman Senior Vice President and Chief Financial Officer 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 indicated on March 28, 1994. UNOCAL CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (MILLIONS OF DOLLARS) - ------------------ (a) Includes minerals, oil shale and real estate properties (b) Includes dry hole costs and land relinquishments. (c) Includes land relinquishments. (d) Consists mainly of intersegment transfers and foreign currency translation adjustments. UNOCAL CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (MILLIONS OF DOLLARS) - --------------------------- (a) Includes minerals, oil shale and real estate properties (b) Includes dry hole costs and land relinquishments. (c) Includes land relinquishments. (d) Consists mainly of intersegment transfers, foreign currency translation adjustments, and the effect of the UXC merger. UNOCAL CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (MILLIONS OF DOLLARS) - ------------------------ (a) Includes minerals, oil shale and real estate properties (b) Includes dry hole costs and land relinquishments. (c) Includes land relinquishments. (d) Consists mainly of intersegment transfers and foreign currency translation adjustments. UNOCAL CORPORATION AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (MILLIONS OF DOLLARS) - --------------------------------- (a) Represents receivables written off, net of recoveries, reinstatements, and losses sustained. UNOCAL CORPORATION EXHIBIT INDEX

773915_1993.txt

773915_1993

1993

773915

Item 1. Business Damson/Birtcher Realty Income Fund-II, Limited Partnership (the "Partnership") was formed on September 13, 1985, under the laws of the State of Delaware. The General Partner of the Partnership is Birtcher/Liquidity Properties, a general partnership, consisting of LF Special Fund I, L.P., a California limited partnership, and Birtcher Investors, a California limited partnership. The Partnership is engaged in the business of acquiring and operating existing income-producing office buildings, research and development facilities, shopping centers and other commercial or industrial properties as specified in its prospectus (Commission File No. 2-99421) dated September 27, 1985, as amended. See Item 2 Item 2. PROPERTIES SEE NOTES TO TABLE ON THE FOLLOWING PAGE. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 2. PROPERTIES (Cont'd.) NOTES TO TABLE ON THE PRECEDING PAGE (1) The purchase price does not include an allocable share of acquisition fees of $2,629,000 paid to the General Partner. Also, for certain properties, the purchase price has been reduced by cash received at acquisition under rental agreements for non-occupied space. (2) An interest in Cooper Village was acquired by the Partnership through a general partnership, Cooper Village Partners ("CV Partners") consisting of the Partnership and Real Estate Income Partners III, Limited Partnership, an affiliated limited partnership. At December 31, 1993, the Partnership had a 58% interest in CV Partners. (See Note 3 to financial statements in Item 8 for a further discussion of the Partnership's interest in CV Partners.) The amounts shown herein for approximate purchase price and net rentable square feet represent 58% of the respective amounts for CV Partners. Item 3. Item 3. LEGAL PROCEEDINGS The Partnership is not a party to any pending legal proceedings, other than ordinary routine litigation incidental to its business. It is the General Partner's belief that the outcome of these proceedings will not be material to the business or financial condition of the Partnership. NASD Matter. In a matter not directly involving the Partnership or its General Partner, in 1991, the National Association of Securities Dealers, Inc. (the "Association") Business Conduct Committee for the Northern District of California initiated a complaint against a broker-dealer affiliate of LF Special Fund I, L.P. (a general partner of the General Partner of the Partnership), alleging violations of the Association's Rules of Fair Practice. Specifically, the complaint alleged that the affiliate (1) bought and sold limited partnership units (but not interests in the Partnership) in the secondary market, from or to unaffiliated parties, subject to mark-ups or mark-downs in excess of the Association's guidelines and (ii) failed to disclose the amount or existence of such mark-ups and mark-downs to buyers and sellers of limited partnership units. Brent Donaldson and Richard Wollack, executive officers of LF Special Fund I, L.P., were also named as respondents in the complaint in their capacities as principals of the affiliate. The complaint was settled as of January 3, 1992 on the following terms: the Association made findings, which were neither admitted nor denied, of violations by the affiliate and Mr. Donaldson of the Association's guidelines with respect to mark-ups or mark-downs, and of the failure by the affiliate (but not Mr. Donaldson) to disclose the amount of such mark-ups or mark-downs. Both allegations were dismissed as to Mr. Wollack. The settlement further provided that the affiliate would be censured and fined $125,000 and that Mr. Donaldson would be censured and fined $7,500. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S LIMITED PARTNERSHIP INTERESTS AND RELATED SECURITY HOLDER MATTERS There is no public market for the limited partnership interests and a market is not expected to develop as such limited partnership interests are not publicly traded or freely transferable. As of February 28, 1994, the number of holders of the Partnership's interests is as follows: General Partner 1 Limited Partners 7,186 ----- 7,187 ===== The Partnership makes quarterly cash distributions to its partners out of distributable cash pursuant to the Partnership's Agreement of Limited Partnership. Distributable cash is generally paid 99% to the Limited Partners and 1% to the General Partner. The Partnership has paid the following quarterly cash distributions to its Limited Partners: The Limited Partners and the General Partner are entitled to receive quarterly cash distributions, as available, in the future. Item 6. Item 6. SELECTED FINANCIAL DATA DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 6. SELECTED FINANCIAL DATA (Cont'd.) Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Capital Resources and Liquidity The Partnership completed its acquisition program in December 1988 and is principally engaged in the operation of its properties. The Partnership intends to hold its properties as long-term investments, although properties may be sold at any time, depending upon the General Partner's judgment of the anticipated remaining economic benefits of continued ownership. That notwithstanding, the Information Statement, dated May 5, 1993, as described below, mandates that the General Partner shall seek a vote of the Limited Partner's no later than December 31, 1996, regarding prompt liquidation of the Partnership in the event that properties with appraised values as of January 1993 which constituted at least one-half of the aggregate appraised values of all Partnership properties as of January 1993, are not sold or under contract for sale by the end of 1996. Working capital is and will be principally provided from the operation of the Partnership's properties and the working capital reserve established for the properties. The Partnership may incur mortgage indebtedness relating to such properties by borrowing funds primarily to fund capital improvements or to obtain financing proceeds for distribution to the partners. Distributions for the year ended December 31, 1993, represent net cash flow from operations of the Partnership's properties and interest earned on the temporary investment of working capital, reduced by current year capital reserve requirements. Future cash distributions will be made principally to the extent of cash flow attributable to the operations of the Partnership's properties after capital reserve requirements. See Item 5 for a description of the Partnership's distribution history. Certain of the Partnership's properties are not fully leased. The Partnership is actively marketing the vacant space in these properties, subject to the competitive environment in each of the market areas. To the extent the Partnership is not successful in maintaining or increasing occupancy levels at these properties, the Partnership's future cash flow and distributions may be reduced. On June 24, 1993, the Partnership completed its solicitation of written consents from its Limited Partners. A majority in interest of the Partnership's Limited Partners approved each of the proposals contained in the Information Statement, dated May 5, 1993. Those proposals have been implemented by amending the Partnership Agreement as contemplated by the Information Statement. The amendments include, among other things, the future payment of asset management and leasing fees to the General Partner and the elimination of the General Partner's residual interest and deferred leasing fees that were previously subordinated to return of the Limited Partners' 9% Preferential Return. See Item 8, Note 4 to the financial statements for discussion of fees paid to the General Partner for the year ended December 31, 1993. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Cont'd.) Results of Operations Year Ended December 31, 1993 The increase in rental income for the year ended December 31, 1993, as compared to 1992, was attributable to several factors. At Kennedy, the expansion of two existing tenants (encompassing an aggregate 7,406 square feet), resulted in an increase in occupancy rate and an aggregate increase in rental income of $106,000. In addition, bad debt charge-offs of $72,000 were recorded in 1992, as a result of two tenant bankruptcies at Kennedy Corporate Center and Lakeland Industrial Park. These charge-offs had the effect of lowering 1992 revenue as compared to 1993. The aforementioned increases were partially offset by a decrease in rental income at Atrium Place, which resulted from the property's decrease in aggregate occupancy during 1993. The decreased occupancy (currently 45%) reduced rental income by $130,000, when compared to 1992. Interest income resulted from the temporary investment of Partnership working capital. The decrease for the year ended December 31, 1993, as compared to 1992, was attributable to a reduced level of average working capital and a lower rate-of-return on short-term investments. The decrease in operating expenses for the year ended December 31, 1993, as compared to 1992, was primarily attributable to the decrease in legal and professional services relating to a tenant dispute and real estate tax appeals at Creekridge and Kennedy Corporate Center. The aforementioned decreases were partially offset by an increase in utilities, cleaning and HVAC repairs at Lakeland Industrial Park. The decrease in real estate taxes for the year ended December 31, 1993, as compared to 1992, was primarily attributable to a lower tax assessment at Atrium and Kennedy Corporate Center. The aforementioned decreases were partially offset by an increase in real estate tax expense at Creekridge. The increase was as a result of a $134,000 tax refund in 1992, which had the effect of lowering 1992 tax expense. The decreases in depreciation expenses for the year ended December 31, 1993, as compared to 1992, were a result of a $3,850,000 adjustment to the carrying value of real estate assets during 1992. As part of this adjustment, the depreciable bases (buildings and improvements) of Atrium Place, Creekridge and Kennedy were reduced in December 1992, by $236,000, $2,822,000 and $370,000, respectively, with the remaining adjustment of $422,000 allocated to land. General and administrative expenses for the year ended December 31, 1993 included charges of 423,000 from the General Partner and its affiliates for services rendered in connection with administering the affairs of the Partnership and operating the Partnership's properties. Also included in general and administrative expenses are direct charges of $414,000 relating to audit and tax preparation fees, annual appraisal fees, legal fees, insurance, costs incurred in providing information to the limited partners and other miscellaneous costs. The increase in general and administrative expenses for the year ended December 31, 1993, as compared to 1992, was primarily attributable to the payment of asset management fees ($232,000) to the General Partner and its affiliates pursuant to the amended Partnership Agreement. In addition, legal and professional services, printing, postage and mailing expenses increased as a result of the Partnership's solicitation of the limited partners for the Information Statement. The General Partner elected to terminate the Partnership's Property Management DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Cont'd.) Results of Operations (Cont'd.) Year Ended December 31, 1993 (Cont'd.) Agreement with Glenborough Management Corporation ("Glenborough") effective November 1, 1993. On that date, the General Partner caused the Partnership to enter a new property management agreement with Birtcher Properties, an affiliate of the General Partner. Pursuant to the Partnership Management Agreement, Birtcher Properties will act as the Partnership's exclusive agent to operate, rent, manage and maintain the Partnership's properties. In its capacity as property manager for the Partnership's properties, Birtcher Properties will perform substantially the same services that Glenborough performed during the previous two-year period at fees similar to (and not larger than) the fees it used to pay Glenborough, plus certain costs associated with property management, as before. The contract is terminable upon a minimum of 60 days' written notice by either party. As before, the General Partner will continue to oversee the day-to-day management of the Partnership. Year Ended December 31, 1992 The decrease in rental income for the year ended December 31, 1992, as compared to 1991, was attributable to several factors. At Lakeland, three substantial tenants downsized and consolidated their operations at another site. The lost tenancy resulted in a net decrease to rental income of $312,000 for 1992. In addition, operating expense recoveries declined at Atrium Place by $92,000 due to the reconciliation of 1991 recoveries, a reduced real estate tax assessment and lower operating expenses incurred during 1992. The aforementioned decreases were partially offset by the substantial increase in occupancy from 44%, in September 1991, to the current level of 70% at Creekridge Center in Bloomington, Minnesota. The increase in occupancy at Creekridge Center resulted in $216,000 of additional rental income for 1992. Interest income resulted from the temporary investment of Partnership working capital. The decrease for 1992 as compared to 1991, was attributable to a lower rate-of-return on short-term investments. The decrease in operating expenses for the year ended December 31, 1992, as compared to 1991, was primarily attributable to an overall decrease in property management fees and related on-site expenses incurred during 1992. In addition, maintenance and repair expenses were lower at Iomega and Atrium Place in 1992. The aforementioned expense reductions were partially offset by increased legal fees incurred during 1992, as a result of tenant business failures, rent abatement, rental relief requests and bankruptcies associated with the national economic downturn. The decrease in real estate taxes for the year ended December 31, 1992, as compared to 1991, was attributable to a successful tax appeal at Creekridge, which resulted in a $134,000 tax refund in 1992. The overall decrease was partially offset by increased tax assessments for Kennedy Corporate Center, Iomega and Ladera II Shopping Center during 1992. General and administrative expenses for the year ended December 31, 1992, included charges of $224,000 from the General Partner and its affiliates for services rendered in connection with administering the affairs of the Partnership and operating the Partnership's properties. Also included in general and administrative expenses were direct charges of $298,000 relating to audit fees, tax preparation fees, legal fees, appraisal fees, business plans, insurance, costs incurred in providing information to the Limited Partners and other Item DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Cont'd.) Results of Operations (Cont'd.) Year Ended December 31, 1992 (Cont'd.) miscellaneous costs. The decrease in general and administrative expenses for the year ended December 31, 1992, as compared to 1991, was primarily attributable to the payment of the $311,000 of previously deferred property management fees to an affiliate of the General Partner in 1991. Investments in real estate reflect an adjustment to the carrying value of real estate assets of $3,850,000 for the year ended December 31, 1992. In May 1992, the General Partner obtained appraisals of the Partnership's properties from a qualified independent appraiser. Based upon these appraisals, management's intention to hold these real estate assets and current and anticipated market conditions, management estimated that three of the Partnership's properties, Atrium Place Office Building ($275,000), Creekridge Center ($3,150,000) and Kennedy Corporate Center-I ($425,000) have each experienced a permanent impairment of value as compared to their respective carrying values. Year Ended December 31, 1991 The decrease in rental income for the year ended December 31, 1991, as compared to 1990, was primarily attributable to the reduced occupancy at Creekridge. In June 1990, Delta Dental Corporation was allowed to contract its office space (originally 42,303 square feet) in exchange for a lease buyout in the amount of $121,000 and a five-year lease extension of the remaining 26,043 square feet it occupied. The effect of Delta Dental's contraction was minimal for 1990, as a result of the lease buyout, however, the effect on 1991 rental income was a decrease of approximately $237,000. In addition, Springboard Software vacated upon its lease expiration in December 1990 (7,799 square feet) and First Union Mortgage (3,152 square feet) closed its Minneapolis office in April 1991. The impact on rental income amounted to respective reductions of approximately $106,000 and $41,000 for the year ended December 31, 1991. The aforementioned decreases at Creekridge were partially offset by scheduled Consumer Price Index increases at the Iomega/Northpointe Business Center. Interest income resulted from the temporary investment of Partnership working capital. The decrease for the year ended December 31, 1991, as compared to 1990, was attributable to reduced working capital reserve levels and a lower rate-of-return on short-term investments. The increase in operating expenses for the year ended December 31, 1991, as compared to 1990, was primarily attributable to higher miscellaneous building operating expenses during 1991. The decrease in real estate taxes for the year ended December 31, 1991, as compared to 1990, was primarily attributable to a $68,000 real estate tax refund at Creekridge, which occurred during the fourth quarter of 1991. The overall decrease was partially offset by increases in tax rates at Atrium and Kennedy. General and administrative expenses for the year ended December 31, 1991, included charges of $207,000 from the General Partner and its affiliates for services rendered in connection with administering the affairs of the Partnership and operating the Partnership's properties. Also included in general and administrative expenses were direct charges of $315,000 relating to audit fees, tax preparation fees, appraisal fees, insurance, costs incurred in providing information to the Limited Partners and other miscellaneous costs. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Cont'd.) Results of Operations (Cont'd.) Year Ended December 31, 1991 (Cont'd.) The increase in general and administrative expenses for the year ended December 31, 1991, as compared to 1990, was primarily attributable to the payment of the $311,000 of previously deferred property management fees due to an affiliate of the General Partner. In addition, legal fees and other professional services were incurred during 1991 in connection with the Partnership's strategic review. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS, SCHEDULES AND SUPPLEMENTAL INFORMATION Information required by other schedules called for under Regulation S-X is either not applicable or is included in the financial statements. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP INDEPENDENT AUDITORS' REPORT To Birtcher/Liquidity Properties, as General Partner of Damson/Birtcher Realty Income Fund-II, Limited Partnership: We have audited the financial statements of Damson/Birtcher Realty Income Fund-II, Limited Partnership as listed in the accompanying index. In connection with our audits of the financial statements, we also have audited the financial statement schedule as listed in the accompanying index. These financial statements and the financial statement schedule are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Damson/Birtcher Realty Income Fund-II, Limited Partnership as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG Peat Marwick Orange County, California January 24, 1994, except as to Note 8, which is as of February 28, 1994 DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP BALANCE SHEETS The accompanying notes are an integral part of these financial statements. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these financial statements. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP STATEMENTS OF CHANGES IN PARTNERS' CAPITAL The accompanying notes are an integral part of these financial statements. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these financial statements. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (1) Organization and Operations Damson/Birtcher Realty Income Fund-II, Limited Partnership (the "Partnership") is a limited partnership formed on September 13, 1985, under the laws of the State of Delaware for the purpose of acquiring and operating income-producing retail, commercial and industrial properties. The General Partner of the Partnership is Birtcher/Liquidity Properties, a general partnership consisting of LF Special Fund I, L.P. ("LF-I"), a California limited partnership and Birtcher Investors, a California limited partnership. Birtcher Investors, or its affiliates, provides day-to-day administration, supervision and management of the Partnership and its properties. In January 1993, the General Partner filed an information statement with the Securities and Exchange Commission seeking consent of the Limited Partners to amend the Partnership Agreement. On June 24, 1993, the Partnership completed its solicitation of written consent from its Limited Partners. A majority in interest of the Partnership's Limited Partners approved each of the proposals contained in the Information Statements, dated May 5, 1993. Those proposals have been implemented by the Partnership as contemplated by the Information Statement as amendments to the Partnership Agreement, and are reflected in these financial statements as such. The amendment modifies the Partnership Agreement to eliminate the General Partner's 10% subordinated interest in distributions of Distributable Cash (net cash from operations) and to reduce its subordinated interest in such distributions from 10% currently to 1%. The amendment also modifies the Partnership Agreement to eliminate the General Partner's 10% subordinated interest in Sale or Financing Proceeds (net cash from sale or financing of Partnership property) and to reduce its subordinated interest in such proceeds from 15% currently to 1%. In lieu thereof, the Partnership Agreement now provides for the Partnership's payment to the General Partner of an annual asset management fee equal initially to .75% of the aggregate appraised value of the Partnership's properties. The portfolio was appraised at an aggregate value of approximately $34,965,000 which includes the Partnership's interest in Cooper Village Partners which was appraised at $4,060,000 as of January 1, 1993. The factor used to calculate the annual asset management fee will be reduced by .10% (e.g., from .75% in 1996 to .65% in 1997) each year beginning after December 31, 1996. The amendment modifies the Partnership Agreement to eliminate the subordination provisions with respect to future property disposition fees payable under that section and authorizes payment to the General Partner and its affiliates of the foregoing property disposition fees as earned. The fees will not be subordinated to the return to the Limited Partners Preferred Return and Adjusted Invested Capital or any other amount. The disposition fees will be paid to the General Partner or its affiliates in an amount equal to 50% of the competitive real estate brokerage commission that would be charged by unaffiliated third parties providing comparable services in the area in which a property is located, but in no event more than three percent of the gross sale price of the property, and is to be reduced by the amount by which any brokerage or similar commissions paid to any unaffiliated third parties in connection with the sale of the property exceed three percent of the gross sale price. This amount is not payable, unless and to the extent that the sale price of the property in question, net of any other brokerage commissions (but not other costs of sale), exceeds the appraised value of the property as of January 1, 1993. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Cont'd.) (1) Organization and Operations (Cont'd.) The amendment states that the Partnership is no longer authorized to pay the General Partner or its affiliates any insurance commission or any property financing fees. No such commission or fees have been paid or accrued by the Partnership since its inception. The amendment modifies the provisions of the Partnership Agreement regarding allocations of Partnership income, gain and other tax items between the General Partner and the Limited Partners primarily to conform to the changes in the General Partner's interest in distributions of Distributable Cash and Sale or Financing Proceeds effected by the amendment. It is not anticipated that the adoption and implementation of the amendment will have any material adverse effect on future allocations of income, gain, loss or other tax items to the Limited Partners. However, if any of the Partnership's properties are sold for a gain, a special allocation to the General Partner would have the effect of reducing the amount of Sale or Financing Proceeds otherwise distributable to the Limited Partners and correspondingly increasing the amount of such distributions to be retained by the General Partner. The amount of such distributions to be affected would be approximately equal to any deficit balance in the General Partner's capital account in the Partnership at the time of the allocation. The Limited Partners have certain priorities in the allocation of cash distributions by the Partnership. Out of each distribution of net cash, the Limited Partners generally have certain preferential rights to receive payments that, together with all previous payments to them, would provide an overall 9% per annum (cumulative non-compounded) return (a "9% Preferential Return") on their investment in the Partnership. Any distributions not equaling this 9% Preferential Return in any quarter are to be made up in subsequent periods if and to the extent distributable cash is available. Distributable cash from operations is paid out each quarter in the following manner: 99% to the Limited Partners and 1% to the General Partner. These payments are made each quarter to the extent that there is sufficient distributable cash available. Sale or financing proceeds are to be distributed, to the extent available, as follows: (i) to the Limited Partners until all cash distributions to them amount to a 9% Preferential Return on their investment cumulatively from the date of their admission to the Partnership, (ii) then to the Limited Partners in an amount equal to their investment; and (iii) the remainder, 99% to Limited Partners and 1% to the General Partner. The unpaid 9% Preferential Return to the limited partners' aggregates $18,142,000 as of December 31, 1993. Income or loss for financial statement purposes is allocated 99% to the Limited Partners and 1% to the General Partner. The amendment modifies the Partnership Agreement so as to restrict the Partnership from entering into a future "Reorganization Transaction" (as defined in the Amendment) sponsored by the General Partner or any of its affiliates unless such transaction is approved by a "supermajority" of at least 80% in interest of the Limited Partners and the General Partner. The amendment also prohibits the modification of this restriction on Reorganization Transactions without the approval of at least 80% in interest of the Limited Partners. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Cont'd.) (1) Organization and Operations (Cont'd.) The Partnership's original investment objectives contemplated that it would hold its properties for a period of at least five years, with decisions about the actual timing of property sales or other dispositions to be left to the General Partner's discretion based on the anticipated remaining economic benefits of continued ownership and other factors. Although the current market for real estate is depressed, the General Partner is committed to selling the Partnership's properties as soon asreasonably practicable. To that end, the amendment mandates that the General Partner seek a vote of the Limited Partners no later than December 31, 1996 regarding the prompt liquidation of the Partnership in the event that properties with appraised values as of January 1993 which constituted at least one- half of the aggregate appraised value of all Partnership properties as of January 1993 are not sold or under contract for sale by the end of 1996. In conjunction with the vote, the General Partner will provide an analysis and recommendation regarding the advisability of liquidating the Partnership. (2) Summary of Significant Accounting Policies Carrying Value of Real Estate Provision is made for impairment loss if the General Partner determines that the loss is other than temporary. In 1992, the General Partner obtained third party appraisals on the Partnership's properties as required by the Partnership Agreement. These appraisals indicated that certain of the Partnership's properties had market values below their then-current net book value. Management estimated that Atrium Place, Creekridge Center and Kennedy Corporate Center-I each experienced an impairment to their value, as compared to their respective carrying values at December 31, 1992. This determination was based upon the independent appraisals provided in May 1992, and management's interpretation of then-current and anticipated market conditions for these respective properties. The aggregate adjustment resulting from management's estimate amounted to $3,850,000. At December 31, 1993, the General Partner estimated that no additional adjustment was required. Cash and Cash Equivalents The Partnership invests its excess cash balances in short-term investments (cash equivalents). These investments are stated at cost, which approximates market, and consist of money market, certificates of deposit and other non-equity-type cash investments. Cash equivalents outstanding at December 31, 1993 and 1992, totaled $926,000 and $941,000, respectively. Cash equivalents are defined as temporary non-equity investments with original maturities of three months or less, which can be readily converted into cash and are not subject to changes in market value. Depreciation Depreciation expense is computed using the straight-line method. Rates used in the determination of depreciation are based upon the following estimated useful lives: DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Cont'd.) (2) Summary of Significant Accounting Policies (Cont'd.) Depreciation (Cont'd.) Maintenance and repairs are charged to expense when incurred. Maintenance and repairs aggregated $138,000, $139,000 and $129,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Revenue Recognition Rental income pertaining to operating lease agreements which specify scheduled rent increases or free rent periods, is recognized on a straight-line basis over the period of the related lease agreement. Rental concessions treated as rental income during the years ended December 31, 1993, 1992 and 1991 amounted to $48,000, $76,000 and $76,000, respectively. Income Taxes Income taxes are not levied at the Partnership level, but rather on the individual partners; therefore, no provision or liability for Federal and State income taxes has been reflected in the accompanying financial statements. The tax returns, the qualification of the Partnership as such for tax purposes, and the amount of the Partnership's income or loss are subject to examination by Federal and State taxing authorities. If such examinations result in changes with respect to the Partnership's qualification or in changes to the Partnership's income or loss, the tax liability of the Partners could be changed accordingly. Following are the Partnership's assets and liabilities as determined in accordance with generally accepted accounting principles ("GAAP") and for federal income tax reporting purposes at December 31: Following are the differences between the financial statements and tax return income: DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Cont'd) (2) Summary of Significant Accounting Policies (Cont'd.) Significant Customers Rental income from Iomega Corporation totaled $1,196,000 in 1993, $1,196,000 in 1992 and $1,140,000 in 1991, or approximately 29%, 30% and 28%, respectively, of the Partnership's total rental income. Rental income from Delta Dental Corporation totaled $629,000 in 1993, $645,000 in 1992, $615,000 in 1991, or approximately 15%, 16% and 15%, respectively, of the Partnership's total rental income. Earnings Per Unit The Partnership Agreement does not designate investment interests in units. All investment interests are calculated on a "percent of Partnership" basis, in part to accommodate reduced rates on sales commissions for subscriptions in excess of certain specified amounts. A Limited Partner who was charged a reduced sales commission or no sales commission was credited with proportionately larger Invested Capital and therefore had a disproportionately greater interest in the capital and revenues of the Partnership than a Limited Partner who paid commissions at a higher rate. As a result, the Partnership has no set unit value as all accounting, investor reporting and tax information is based upon each investor's relative percentage of Invested Capital. Accordingly, earnings or loss per unit is not presented in the accompanying financial statements. Investment in Cooper Village The Partnership uses the equity method of accounting to account for its investment in Cooper Village Partners inasmuch as control of Cooper Village Partners is shared jointly between the Partnership and Real Estate Income Partners III, Limited Partnership. The accounting policies of Cooper Village Partners are consistent with those of the Partnership. Reclassifications Certain reclassifications have been made to conform prior year amounts to the 1993 presentation. (3) Investment in Cooper Village Partners During 1987 and 1988, Cooper Village Partners ("CV Partners"), a California general partnership consisting of the Partnership and Real Estate Income Partners III, Limited Partnership, an affiliated limited partnership ("Fund III"), acquired Cooper Village. In connection therewith, the Partnership and Fund-III contributed capital contributions of $5,937,000 (58%) and $4,300,000 (42%), respectively, and share in the profits, losses and distributions of CV Partners in proportion to their respective ownership interests. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Cont'd.) (3) Investment in Cooper Village Partners (Cont'd.) Condensed summary financial information for CV Partners is presented below. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Cont'd.) (4) Transactions with Affiliates The Partnership has no employees and, accordingly, the General Partner and its affiliates perform services on behalf of the Partnership in connection with administering the affairs of the Partnership. The General Partner and affiliates are reimbursed for their general and administrative costs actually incurred and associated with services performed on behalf of the Partnership. For the years ended December 31, 1993, 1992 and 1991, the Partnership was charged with approximately $150,000, $165,000 and $156,000, respectively, of such expenses. An affiliate of the General Partner provided property management services with respect to the Partnership's properties through October 31, 1991. Subsequent to that date, the Partnership contracted with an unaffiliated third party to perform these services. On November 1, 1993, the General Partner elected to terminate the Partnership's property management agreements with this unaffiliated third party. On that date, the General Partner entered into new property management agreements with Birtcher Properties, an affiliate of the General Partner. The new contracts encompass terms at least as favorable to the Partnership as the terminated contracts with the unaffiliated third party and are terminable by the Partnership upon 60 days' written notice to Birtcher Properties. Fees paid to the General Partner's affiliate for property management services in 1993 and 1991 were not to exceed 6% of the gross receipts from the properties under management, provided that leasing services were performed, otherwise not to exceed 3%. Such fees amounted to approximately $29,000 in 1993 and $116,000 in 1991. Additionally in 1991, the Partnership paid $311,000 of previously deferred leasing fees related to leasing services that the General Partner had elected to defer from the inception of the Partnership through 1990. Such fees paid on a current basis amounted to $41,000, $59,000 and $51,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Those fees have been recorded in general and administrative expenses in the accompanying statements of operations for the years ended December 31, 1993, 1992 and 1991. As reimbursement of costs for on-site property management personnel and other related costs, an affiliate of the General Partner received $19,000 in 1993 and $99,000 in 1991. The amended Partnership Agreement provides for the Partnership's payment to the General Partner of an annual asset management fee equal to .75% of the aggregate appraised value of the Partnership's properties as determined by independent appraisal undertaken in January of each year. Such fees for the year ended December 31, 1993, amounted to $232,000. In addition to the aforementioned, the General Partner was also paid $30,000, related to the Partnership's portion (58%) of asset management fees for Cooper Village Partners for the year ended December 31, 1993. (5) Commitments and Contingencies Litigation The Partnership is not a party to any pending legal proceedings other than ordinary routine litigation incidental to its business. It is the General Partner's belief that the outcome of these proceedings will not be material to the business or financial condition of the Partnership. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO FINANCIAL STATEMENTS (Cont'd.) (5) Commitments and Contingencies (Cont'd.) Future Minimum Annual Rentals The Partnership has determined that all leases which had been executed as of December 31, 1993, are properly classified as operating leases for financial reporting purposes. Future minimum annual rental income to be received under such leases as of December 31, 1993, is as follows: Certain of these leases also provide for, among other things: tenant reimbursements to the Partnership of certain operating expenses; payments of additional rents in amounts equal to a set percentage of the tenant's annual revenue in excess of specified levels; and escalations in annual rents based upon the Consumer Price Index. (6) Accounts Payable and Accrued Liabilities Accounts payable and accrued liabilities consist of the following: (7) Allowance for Doubtful Accounts (8) Subsequent Event On February 28, 1994, the Partnership made an aggregate cash distribution of $358,000 to its limited partners. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP SCHEDULE XI REAL ESTATE AND ACCUMULATED DEPRECIATION AS OF DECEMBER 31, 1993 (AMOUNTS IN THOUSANDS) NOTE: Columns B and G are either none or are not applicable. See notes to table on following page. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO SCHEDULE XI (a) For a description of the properties, see "Item 2. Properties." This schedule does not include the investment in Cooper Village Partners which is accounted for under the equity method of accounting. (b) Investments in real estate reflect the adjustment to the carrying value of real estate assets of $3,850,000 for the year ended December 31, 1992. In May 1992, the General Partner obtained appraisals of the Partnership's properties from a qualified independent appraiser. Based upon these appraisals, management's intention to hold these real estate assets and current and anticipated market conditions, management has estimated that three of the Partnership's properties, Atrium Place Office Building ($275,000), Creekridge Center, ($3,150,000) and Kennedy Corporate Center-I ($425,000) have each experienced a permanent impairment of value as compared to their respective carrying values. The aggregate cost of land, buildings and improvements for Federal income tax purposes (unaudited) was $40,457,000 as of December 31, 1993. The differences between the aggregate cost of land, buildings and improvements for tax reporting purposes as compared to financial reporting purposes are primarily attributable to: 1) amounts received under rental agreements for non-occupied space, which were recorded as income for tax reporting purposes but were recorded as a reduction of the corresponding property basis for financial reporting purposes, and; 2) the adjustment to the carrying value of real estate which was recorded as a reduction of the corresponding property basis for financial statement purposes and has no effect for tax reporting purposes. (c) The initial cost to the Partnership includes acquisition fees paid to the General Partner. (d) RECONCILIATION OF REAL ESTATE DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP NOTES TO SCHEDULE XI (Cont'd.) RECONCILIATION OF ACCUMULATED DEPRECIATION (e) Depreciation expense is computed based upon the following estimated useful lives: DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Partnership and the General Partner have no directors or executive officers. The General Partner of the Partnership is Birtcher/Liquidity Properties, a California general partnership of which Birtcher Investors, a California limited partnership, and LF Special Fund I, L.P., a California limited partnership, are the general partners. Under the terms of the Partnership Agreement, Birtcher Investors is responsible for the day-to-day management of the Partnership's assets. The general partner of LF Special Fund I, L.P., is Liquidity Fund Asset Management, Inc., a California corporation affiliated with Liquidity Financial Group, L.P. The principals and officers of Liquidity Fund Asset Management, Inc. are as follows: Richard G. Wollack, Chairman of the Board Brent R. Donaldson, President Deborah M. Richard, Chief Financial Officer The general partner of Birtcher Investors is Birtcher Investments, a California general partnership. Birtcher Investments' general partner is Birtcher Limited, a California limited partnership and its general partner is BREICORP, a California corporation. The principals and relevant officers of BREICORP are as follows: Ronald E. Birtcher, Co-Chairman of the Board Arthur B. Birtcher, Co-Chairman of the Board Robert M. Anderson, Executive Director Item 11. Item 11. EXECUTIVE COMPENSATION The following table sets forth the fees, compensation and other expense reimbursements paid to the General Partner and its affiliates in all capacities for each fiscal year in the three-year period ended December 31, 1993. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 11. EXECUTIVE COMPENSATION (Cont'd.) ______________ (1) The General Partner did not provide property management services to the Partnership's properties from November 1, 1991 through October 31, 1993 and, consequently, the General Partner did not receive any similar compensation during the fiscal year ended December 31, 1992. (2) Additionally in 1991, the Partnership paid $311,000 of previously deferred property management fees related to leasing services that the General Partner had elected to defer from the inception of the Partnership through 1990. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT As of January 31, 1994, there was no entity or individual holding more than 5% of the limited partnership interests of the Registrant. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information concerning transactions to which the Registrant was or is to be a party in which the General Partner or its affiliates had or are to have a direct or indirect interest, see Notes 1, 3, 4 and 8 to the Financial Statements in Item 8, which information is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a) 1. and 2. Financial Statements and Financial Statements Schedules: See accompanying Index to Financial Statements, Schedules and Supplemental Information to Item 8, which information is incorporated herein by reference. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Cont'd.) 3. Exhibits: Articles of Incorporation and Bylaws (a) Agreement of Limited Partnership incorporated by reference to Exhibit No. 3.1 to the Partnership's registration statement on Form S-11 (Commission File No. 2-99421), dated August 5, 1985, as filed under the Securities Act of 1933. 10. Material Contracts (a) Form of Property Management Agreement between Birtcher Properties and the Registrant incorporated by reference to Exhibit No. 10.1 of the Partnership's registration statement on Form S-11 (Commission File No. 2-99421), as filed September 24, 1985, under the Securities Act of 1933. (SUPERSEDED) (b) Letter of Intent regarding Purchase and Sale of Real Property (Cooper Village, Phase I) dated September 3, 1987, by and between Arizona Building and Development, the Wolfswinkel Group and Birtcher Realty Corporation incorporated by reference to Exhibit 19(a) of the Partnership's Quarterly Report on Form 10-Q for the quarter ended September 30, 1987. (c) Agreement of Purchase and Sale of Real Property (Cooper Village, Phase I) dated November 13, 1987, by and between Broadway Village Partners and Birtcher Acquisition Corporation incorporated by reference to Form 8-K, as filed December 30, 1987. (d) Agreement of General Partnership, dated December 15, 1987, by and between Damson/Birtcher Realty Income Fund-II, Limited Partnership and Real Estate Income Partners III, Limited Partnership incorporated by reference to Form 8-K, as filed December 30, 1987. (e) Property Management Agreement dated October 24, 1991,between Glenborough Management Corporation and the Registrant for Atrium Place, Creekridge Center, Iomega/Northpointe Business Center, Kennedy Corporate Center I, Ladera II Shopping Center and Lakeland Industrial Park. Incorporated by reference to Exhibit 1 of the Partnership's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991. (SUPERSEDED) DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Cont'd.) (f) Property Management Agreement dated October 24, 1991, between Glenborough Management Corporation and Cooper Village Partners for Cooper Village Shopping Center. Incorporated by reference to Exhibit 2 of the Partnership's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991. (SUPERSEDED) (g) Agreement for Partnership Administrative Services dated October 24, 1991, between Glenborough Management Corporation and the Registrant for the services described therein. Incorporated by reference to Exhibit 3 of the Partnership's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991. (SUPERSEDED) (h) Property Management Agreement, dated October 29, 1993, between Birtcher Properties and the Registrant for Atrium Place, Creekridge Center, Iomega Business Center, Kennedy Corporate Center-I, Ladera-II Shopping Center, and Lakeland Industrial Park. Incorporated by reference to Exhibit 1 of the Partnership's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. (i) Property Management Agreement, dated October 29, 1993, between Birtcher Properties and Cooper Village Partners for Cooper Village Shopping Center. Incorporated by reference to Exhibit 2 of the Partnership Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. b) Reports on Form 8-K: Report on Form 8-K, dated July 2, 1993, regarding the approval of a majority in interest of the Limited Partners of each of the proposals included in the Information Statement, dated May 5, 1993, is herein incorporated by reference. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP 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. DAMSON/BIRTCHER REALTY INCOME FUND-II, LIMITED PARTNERSHIP By: BIRTCHER/LIQUIDITY By: BIRTCHER INVESTORS, PROPERTIES a California limited partnership (General Partner) By: BIRTCHER INVESTMENTS, a California general partnership, General Partner of Birtcher Investors By: BIRTCHER LIMITED, a California limited partnership, General Partner of Birtcher Investments By: BREICORP, a California corporation, formerly known as Birtcher Real Estate Inc., General Partner of Birtcher Limited Date: March 30, 1994 By: /s/Robert M. Anderson --------------------- Robert M. Anderson Executive Director BREICORP By: LF Special Fund I, L.P., a California limited partnership By: Liquidity Fund Asset Management, Inc., a California corporation, General Partner of LF Special Fund I, L.P. Date: March 30, 1994 By: /s/ Brent R. Donaldson ---------------------- Brent R. Donaldson President Liquidity Fund Asset Management, Inc. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Birtcher/Liquidity Properties (General Partner of the Registrant) and in the capacities and on the dates indicated.

60512_1993.txt

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ITEM 3. LEGAL PROCEEDINGS. Information presented in Note 15 under the heading "Notes to Consolidated Financial Statements" in the Company's Annual Report to Shareholders for 1993 (page 24 of Exhibit 13 filed herewith) is incorporated herein by reference. See also "Environmental Matters." ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. EXECUTIVE OFFICERS OF THE REGISTRANT NAME AGE POSITIONS _________________________________________________________________ H. Leighton Steward (59) Chairman of the Board, President and Chief Executive Officer since 1989. Richard A. Bachmann (49) Director since 1989. Executive Vice President, Finance and Administration and Chief Financial Officer since 1985. John F. Greene (53) Director since 1989. Executive Vice President, Exploration and Production since 1985. Jerry D. Carlisle (48) Vice President and Controller since 1984. Robert J. Chebul (46) Vice President since July, 1991. Held various managerial positions, including District Manager from 1988 to 1991. E. J. Leidner, Jr. (57) Vice President since 1986. John O. Lyles (48) Vice President since 1992. Vice President and Treasurer from 1984 to 1992. Joel M. Wilkinson (58) Vice President since 1988. John A. Williams (49) Vice President since 1988. Frederick J. Plaeger, II (40) General Counsel and Corporate Secretary since 1992. Corporate Secretary and Senior Counsel from 1989 to 1992. Partner in the law firm of Milling, Benson, Woodward, Hillyer, Pierson and Miller from 1985 to 1989. Louis A. Raspino (42) Treasurer since 1992. Assistant Treasurer from 1984 to 1992. Each officer holds office until the first meeting of the Board of Directors following the annual meeting of shareholders and until his successor shall have been elected and qualified, or until he shall have resigned or been removed as provided in the LL&E By- Laws. No family relationship exists between any of the above listed executive officers or between any such executive officer and any Director of LL&E. PART II Index Page Number __________________________________________________________________ 25 Item 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information presented under the caption "Capital Stock, Dividends and Other Market Data" in the Company's Annual Report to Shareholders for 1993 (page 35 of Exhibit 13 filed herewith) and information presented under the caption "Market Price and Dividend Data" in the Company's Annual Report to Shareholders for 1993 (page 49 of Exhibit 13 filed herewith) are incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Information presented under the caption "Selected Financial Data" in the Company's Annual Report to Shareholders for 1993 (page 48 of Exhibit 13 filed herewith) is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Information presented under the heading "Financial Review" in the Company's Annual Report to Shareholders for 1993 (under the heading "Management's Discussion and Analysis" on page 29 of Exhibit 13 filed herewith) is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of The Louisiana Land and Exploration Company and Subsidiaries, together with the report thereon of KPMG Peat Marwick dated February 9, 1994, and the supplementary data referred to in Item 14(a)(1) hereof, which are contained in the Company's Annual Report to Shareholders for 1993 (Exhibit 13 filed herewith), are incorporated herein by reference. The report of KPMG Peat Marwick covering the aforementioned consolidated financial statements refers to the adoption of the methods of accounting for income taxes and postretirement benefits other than pensions prescribed by Statement of Financial Accounting Standards Nos. 109 and 106, respectively. The consolidated financial statements of MaraLou Netherlands Partnership and Subsidiary (a 50%-owned affiliate accounted for under the equity method), together with the report thereon of KPMG Peat Marwick dated January 28, 1994, as referred to in Item 14(a)(1) hereof, are included herein and filed herewith. The report of KPMG Peat Marwick covering the aforementioned consolidated financial statements refers to the adoption of the method of accounting for income taxes prescribed by Statement of Financial Accounting Standard No. 109. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III Index Page Number __________________________________________________________________ 27 Item 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information relating to directors of the Registrant will be contained in the definitive Proxy Statement for its Annual Meeting of Stockholders to be held on May 12, 1994, which the Registrant will file pursuant to Regulation 14A not later than 120 days after December 31, 1993, and such information is incorporated herein by reference in accordance with General Instruction G(3) of Form 10-K. Information relating to executive officers of the Registrant appears at page 23 of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information relating to the compensation of the Registrant's executive officers and directors will be contained in the definitive Proxy Statement referred to above in "Item 10. Directors and Executive Officers of the Registrant," and such information is incorporated herein by reference in accordance with General Instruction G(3) of Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information relating to beneficial ownership of securities will be contained in the definitive Proxy Statement referred to above in "Item 10. Directors and Executive Officers of the Registrant," and such information is incorporated herein by reference in accordance with General Instruction G(3) of Form 10-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information relating to transactions with management and others and certain business relationships regarding directors will be contained in the definitive Proxy Statement referred to above in "Item 10. Directors and Executive Officers of the Registrant," and such information is incorporated herein by reference in accordance with General Instruction G(3) of Form 10-K. PART IV Index Page Number __________________________________________________________________ Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. 29 (a)(1) Financial Statements and Supplementary Data 49 Independent Auditors' Report 50 (a)(2) Financial Statement Schedules: 50 Schedule V - Property, Plant and Equipment 51 Schedule VI - Accumulated Depletion, Depreciation and Amortization 52 Schedule X - Supplementary Earnings Statement Information All other schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. 53 (a)(3) Index to Exhibits 56 (b) Reports on Form 8-K 57 Signatures THE LOUISIANA LAND AND EXPLORATION COMPANY AND SUBSIDIARIES Financial Statements and Supplementary Data (Item 14 (a)(1)) The following financial statements and supplementary data included in the Company's Annual Report to Shareholders for 1993 are incorporated herein by reference in response to Item 8: Page in Exhibit 13 filed herewith Financial Statements: Consolidated Balance Sheets 3 Consolidated Statements of Earnings (Loss) 4 Consolidated Statements of Stockholders' Equity 5 Consolidated Statements of Cash Flows 6 Notes to Consolidated Financial Statements 7 Report of Management 26 Independent Auditors' Report 27 Unaudited Supplemental Data: Data on Oil and Gas Activities 36 Quarterly Data 50 The following financial statements of 50% or Less Owned Persons required by Regulation S-X, Rule 3-09, are included herein and filed herewith in response to Item 8: Page herein MaraLou Netherlands Partnership and its wholly-owned consolidated subsidiary, CLAM Petroleum Company: Independent Auditors' Report 31 Consolidated Balance Sheets 32 Consolidated Statements of Income 33 Consolidated Statements of Partners' Capital 34 Consolidated Statements of Cash Flows 36 Notes to Consolidated Financial Statements 38 MARALOU NETHERLANDS PARTNERSHIP AND SUBSIDIARY CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (WITH INDEPENDENT AUDITORS' REPORT THEREON) Independent Auditors' Report The Partners MaraLou Netherlands Partnership: We have audited the accompanying consolidated balance sheets of MaraLou Netherlands Partnership and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of income, partners' capital, and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MaraLou Netherlands Partnership and subsidiary as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in note 4 to the consolidated financial statements, the Partnership adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" in 1993. /s/ KPMG Peat Marwick KPMG Peat Marwick Houston, Texas January 28, 1994 (Continued) (Continued) MARALOU NETHERLANDS PARTNERSHIP Notes to Consolidated Financial Statements December 31, 1993, 1992 and 1991 1. Organization and summary of significant accounting policies Organization and ownership: MaraLou Netherlands Partnership (MaraLou), a Texas general partnership, was formed on March 27, 1985 by LL&E (Netherlands), Inc. (LL&E Netherlands) and Marathon Petroleum Netherlands, Ltd. (Marathon Netherlands) for the purpose of owning their interests in CLAM Petroleum Company (CLAM) and for the purpose of purchasing the outstanding shares of CLAM held by Netherlands-Cities Services, Inc. On March 27, 1985 both partners agreed to contribute their respective ten thousand shares of CLAM to MaraLou. These shares were transferred to MaraLou on June 21, 1985. The remaining shares held by Netherlands-Cities Services, Inc. were acquired by MaraLou for $85,381,881 on March 29, 1985. The acquisition has been accounted for using the purchase method of accounting effective January 1, 1985. On December 6, 1991 an agreement was concluded whereby LL&E Netherlands Petroleum Company, an affiliated company to LL&E Netherlands - both of which are wholly owned subsidiaries of Louisiana Land and Exploration Company, contributed Netherlands North Sea license interests and other assets valued at $11,629,000 for five hundred newly issued shares of CLAM stock. For financial reporting purposes, the contribution made by LL&E Netherlands Petroleum Company in excess of its calculated minority interest is reflected in Partners' capital as an addition to the LL&E Netherlands capital balance. MaraLou made a cash contribution of $11,629,000 for an additional five hundred newly issued shares of CLAM stock. The contributed cash is to be used to develop the North Sea license interest contributed by LL&E Netherlands Petroleum Company. MaraLou subsequently sold all of its newly issued shares of CLAM stock to Marathon Netherlands, a partner in MaraLou, which purchased the shares with a note valued at $11,629,000, on which $6,000,000 was paid in 1991 and $6,000,000, inclusive of interest, was paid in 1992. These newly issued shares of CLAM stock have been pledged as security for MaraLou and CLAM's revolving credit agreement (see Note 6). CLAM Petroleum Company, a Delaware Corporation, was formed in October 1975 by LL&E Netherlands, Marathon Netherlands and Netherlands-Cities Service, Inc. (stockholders) for the purpose of owning their interest in certain licenses and agreements covering hydrocarbon operations in The Netherlands and for the purpose of entering into agreements with lending institutions to finance such interest. Effective May 24, 1976 the stockholders assigned their interests and obligations under the licenses and related agreements to CLAM. CLAM has no operations outside the oil and gas industry or in areas other than The Netherlands North Sea. The financial statements reflect the consolidation of CLAM Petroleum Company (the Company) with MaraLou for the period from January 1, 1985. The financial statements also reflect the interests and earnings of the minority shareholders, LL&E Netherlands Petroleum Company and Marathon Netherlands. Currently, MaraLou has no interests other than in the operation of CLAM. Cash equivalents: Cash equivalents of $11,133,745, $18,721,023 and $23,638,318 at December 31, 1993, 1992 and 1991 respectively, consist of Eurodollar and Euroguilder investments. For purposes of the statements of cash flows, MaraLou considers all highly liquid debt instruments with original maturities of three months or less to be cash equivalents. Joint venture agreements: CLAM, together with unrelated parties, has interests in certain prospecting and production licenses and related operating agreements which provide for the joint conduct of seismic, geological, exploration and development activities on the continental shelf of The Netherlands. The accompanying financial statements include CLAM's share of operations as reported to it by the operator of the joint venture. The amounts reported by the operator of the joint venture are subject to an annual audit by the non-operators. The audit for the year 1992 has been conducted with the non-operators awaiting the operator's initial response to the audit report. Petroleum exploration and development costs: CLAM follows the successful efforts method of accounting for oil and gas properties. Exploration expenses, including geological and geophysical costs, prospecting costs, carrying costs and exploratory dry hole costs are charged against income as incurred. The acquisition costs of unproved properties are capitalized with appropriate provision for impairment based upon periodic assessments of such properties. All development costs, including development dry hole costs, are capitalized. Capitalized costs are adjusted annually for cash adjustments relating to changes in CLAM's share in gas reserve estimates (see Note 7). Depletion, amortization and depreciation: Depletion is provided under the unit-of-production method based upon estimates of proved developed reserves. Depreciation is based on estimated useful life. Reserve determinations are management's best estimates and generally are related to economic and operating conditions. Depletion and depreciation rates are adjusted for future estimated salvage values. CLAM property, plant and equipment retirements: Upon sale or retirement of property, plant and equipment, the cost and related accumulated depletion, amortization and depreciation are eliminated from the accounts and the gain or loss is reflected in income. CLAM platform abandonment amortization: Platform abandonment amortization is provided under the unit- of-production method based upon estimates of proved-developed reserves. Amortization rates are adjusted for future estimated abandonment costs. Platform abandonment amortization is charged to operating expense. 2. Related party transactions CLAM transactions with related parties consisted of charges for geological, geophysical and administrative services rendered by an affiliate under two service contracts and administrative services rendered by another affilate. Such charges were approximately $2,512,536, $2,530,608 and $2,267,479 for 1993, 1992 and 1991, respectively. Salaries and related social charges included therein amounted to $1,685,046, $1,858,876 and $1,512,633 for 1993, 1992 and 1991, respectively. MaraLou transactions with related parties consisted of charges for administrative services rendered by an affiliate amounting to $55,800, $58,200 and $57,600 in 1993, 1992 and 1991, respectively. 3. Property, plant and equipment Changes in property, plant and equipment for the years ended December 31, 1993, 1992 and 1991 are as follows (in thousands of U.S. dollars): 4. Federal and foreign income taxes MaraLou is a partnership and, therefore, does not pay income taxes. Since CLAM (wholly owned by MaraLou) is a corporation, income taxes included in the accompanying consolidated financial statements have been determined utilizing applicable domestic and foreign tax rates. The FASB has issued Statement of Financial Accounting Standard (SFAS) No. 109, "Accounting for Income Taxes" which superseded SFAS No. 96. "Accounting for Income Taxes." The adoption of SFAS 109 caused an additional deferred income tax liability of $6,003,589 as of January 1, 1993, which has been recorded as a cumulative effect of change in accounting principle. Prior year consolidated financial statements have not been adjusted and are based on SFAS No. 96. SFAS 109 requires a change from the deferred method of accounting for income taxes to the asset and liability method. Under the new method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates applicable to those years in which the temporary differences between financial statement carrying amounts and tax bases are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period when the change is enacted. Under the deferred method of accounting for income taxes which was applied in 1992 and prior years, deferred income taxes applicable to each year's net temporary differences were provided based on the tax rates in effect during that year and no adjustments were made to the deferred income tax liability amounts for subsequent changes in tax rates. Dutch investment incentive premiums (WIR) are credited to foreign income tax in the year in which they are claimed. CLAM incurred WIR premium expense of $60,331 and $371,771 in 1993 and 1992, respectively. Details of federal and foreign income taxes (in thousands of U.S. dollars) are as follows: Total income tax expense differed from the amounts computed by applying the U.S. Federal income tax rate of 35 and 34 percent for 1993 and 1992, respectively, to income before income taxes of CLAM as a result of the following (in thousands of U.S. dollars): Temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that give rise to significant portions of the deferred tax assets and liabilities at December 31, 1993 and 1992 relate to the following (in thousands of U.S. dollars): The Company's 1993 and 1992 current tax liability was determined on a regular tax basis. The amount of unused foreign tax credit carryforward available on an alternative minimum tax (AMT) basis was $23,354,336 at December 31, 1993. The carryforward expires $5,660,000 in 1994, $5,417,000 in 1995, $5,117,000 in 1996, $3,355,000 in 1997 and $3,805,000 in 1998. The Company did not pay any AMT in 1992 or 1993. 5. CLAM foreign currency translation adjustment As of January 1, 1983 CLAM adopted Statement of Financial Accounting Standards No. 52, "Foreign Currency Translation" (SFAS No. 52), under which the functional currency is deemed to be the Dutch guilder. Effective January 1, 1987 CLAM changed its functional currency from the Dutch guilder to the U.S. dollar. The change was precipitated by the significant effect on CLAM's operation of a new dollar-driven gas sales contract which was effective January 1, 1987 and the Tax Reform Act of 1986. In accordance with SFAS No 52 there is no restatement of prior years' financial statements and the translated amounts for nonmonetary assets as of December 31, 1986 have become the accounting basis for those assets in the year of the change. 6. Debt On July 25, 1985 MaraLou and CLAM entered into a revolving credit agreement, which was amended and restated as of June 19, 1992, with a syndicate of major international banks to fund the purchase by MaraLou of CLAM shares previously owned by Netherlands-Cities Service, Inc. and to provide working capital for CLAM. The banks' total commitment as of December 31, 1993 and December 31, 1992 was $110,000,000. Interest is paid, at the borrower's option, based on the prime rate, the London Interbank Offered Rate (LIBOR), or an adjusted CD rate. A contractual margin is added to LIBOR and CD based borrowings. The all-in interest rates for CLAM for December 31, 1993 and December 31, 1992 were 3.9375% and 4.125%, respectively. During the revolving credit period, the borrowers are obligated to pay a commitment fee of 1/4% on the unused committed portion of the facility. All of the CLAM common stock held by MaraLou has been pledged as security for the facility. In addition, under certain circumstances MaraLou can exercise an option to purchase the shares held by LL&E Netherlands Petroleum Company and Marathon Petroleum Netherlands, Ltd. for a nominal amount. The option agreement has been assigned to the banks as security for the facility. The credit agreement permits CLAM and MaraLou to incur total debt up to an agreed borrowing base which at December 31, 1993 and December 31, 1992 was $145,000,000. The agreement provides that the borrowing base is reduced periodically over the term of the facilty which is currently scheduled to expire on January 1, 2000. The borrowing base and the scheduled reductions may be adjusted based on a redetermination of the net present value of the projections of certain cash flows included in an Engineering Report prepared by petroleum engineers. The outstanding balances for MaraLou and CLAM, respectively, were $-0- and $87,800,000, at December 31, 1993 of which $-0- was due within one year. The outstanding balances for MaraLou and CLAM, respectively, were $-0- and $97,800,000 at December 31, 1992. At December 31, 1993, the required reductions to the borrowing base in each of the next five years are $-0- in 1994, $-0- in 1995, $-0- in 1996, $19,800,000 in 1997, $30,000,000 in 1998 and $38,000,000 thereafter. CLAM has an unsecured combined short-term loan and overdraft facility of Dfl. 80,000,000 ($41,152,263 at year-end exchange rate). On December 31, 1993 and December 31, 1992 the outstanding balances relating to this facility were $-0-. Interest rates are determined at the time borrowings are made. 7. Annual evaluation of gas reserves Under the provisions of the Joint Development Operating Agreement to which CLAM is a party, an annual estimate of gas reserves is to be made and agreed upon by the Area Management Committee. Based upon such estimate, each participant's investment in the area properties, as defined, is to be adjusted so that a participant's investment is in proportion to its interest in the remaining reserves. Adjustments to the investments are made in cash in the year following the date the reserve revision is agreed upon. In 1992, the Area Management Committee agreed to freeze each participant's interest through 1994, at the level agreed upon in 1992. A new gas reserve estimate will be agreed upon in 1995. 8. Reserves of oil and gas (unaudited) CLAM's share of proven gas reserves at January 1, 1994 and 1993 are 317,737 MMCF and 343,432 MMCF, respectively. 9. Major customer CLAM has one major customer from which it derives 98% of its sales revenue. CLAM was required under its production license to offer its production first to this customer, which is partially owned by The Netherlands government. Unitization and natural gas sales agreements were executed July 29, 1987 for the K12 - K15 "B" structure. CLAM is a K15 Block participant, however this property is operated by a K12 Block participant. This gas is also sold to the major customer. 10. Net profits interest agreement CLAM entered into an agreement dated November 1, 1981 which requires CLAM to pay a portion of its net profits ("net profits interest") to an unrelated party in exchange for a 7-1/2% participation interest in certain blocks. The "net profits interest" is equal to one twenty-fourth (1/24) of CLAM's revenues from the contract area, after various deductions, as defined in the agreement. 11. Issuance of production licenses In March 1990, a production license was granted by the Minister of Economics Affairs of the Netherlands covering the L12a and L12b/L15b blocks. As a result, the Dutch Government, through Energie Beheer Nederland (EBN) (a Dutch company wholly-owned by the Dutch Government) exercised its option to participate 40% in the L12a block and 50% in the L12b/L15b block. CLAM was subsequently reimbursed $10,628,572 during 1990, all of which was included in income because there were costs associated with these blocks which had been written-off in prior years. Components of the reimbursement were: Exploration well cost (previously written off as dry wells) $ 5,595,076 Exploration administrative expense 1,818,220 Interest 3,215,276 Total reimbursement $10,628,572 In 1991, it was determined that the portion of the above noted reimbursement allocable to trapping unit L12-FC, within blocks L12b/l15b, would be refunded to EBN as production on this trapping unit is not expected to commence within the 48-month requirement stipulated by the contractual agreement with EBN (the Agreement). The refundable amount, which CLAM expects to repay in 1994, was recorded as a long-term receivable of $3.6 million, interest expense of $1.5 million and an accrued liability of $5.1 million. The Agreement calls for EBN to reimburse the funds to CLAM net of interest upon first production from trapping unit L12-FC, which is expected to occur in 1997. In 1992, it was determined that the portion of the above noted reimbursement allocable to trapping units L12-FA and L12-FB, within blocks L12a and L12b/L15b, would be refunded to EBN as production on these trapping units are not expected to commence within the 48-month requirement stipulated by the Agreement. The refundable amount for L12-FA and L12-FB, which CLAM expects to repay in 1994, was recorded as a long-term receivable of $0.5 and $1.6 million, respectively, interest expense $0.2 million and $0.6 million, respectively and an accrued liability of $0.7 million and $2.2 million respectively. The Agreement calls for EBN to reimburse the respective funds to CLAM net of interest upon first production from trapping units L12-FA and L12-FB, which is expected to occur in 2000 and 1998, respectively. 12. Disclosures about fair value of financial instruments Cash and Cash Equivalents, Receivables, Due from Operator of Joint Venture, Due to Affiliated Company, Accounts Payable, and Due to Operator of Joint Venture - The carrying amount approximates fair value because of the short maturity of these instruments. Long-Term Receivable - The estimated fair value of the Company's long-term receivable is as follows (in thousands of U.S. Dollars): At December 31, 1992 Carrying Estimated Amount Fair Value Long-term receivable $5,620 $3,681 The fair value of the long-term receivable was based on discounted cash flows. Long-Term Debt Due to Banks - The carrying amount approximates fair value because of the variable rate of interest associated with this debt. Independent Auditors' Report The Board of Directors and Stockholders The Louisiana Land and Exploration Company: Under date of February 9, 1994, we reported on the consolidated balance sheets of The Louisiana Land and Exploration Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings (loss), stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the Annual Report to Shareholders for 1993. As discussed in Notes 11 and 12 to the consolidated financial statements, the Company adopted the methods of accounting for income taxes and postretirement benefits other than pensions prescribed by Statements of Financial Accounting Standards Nos. 109 and 106, respectively. These consolidated financial statements and our report thereon are incorporated by reference in the Annual Report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement Schedules V, VI and X. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG Peat Marwick KPMG Peat Marwick New Orleans, Louisiana February 9, 1994 THE LOUISIANA LAND AND EXPLORATION COMPANY AND SUBSIDIARIES Index to Exhibits (Item 14(a)(3)) The following Exhibits have been filed with the Securities and Exchange Commission: Exhibit 2.1 Stock Purchase Agreement, dated as of July 18, 1993, between NERCO, Inc. and The Louisiana Land and Exploration Company (excluding the schedules thereto, which will be made available to the Securities and Exchange Commission upon request). (Incorporated by reference to Exhibit 2.1 to the Registrant's Current Report on Form 8-K dated September 2, 1993, as amended, Commission File No. 1-959.). Exhibit 2.2 Sale and Purchase Agreement, dated as of August 19, 1993, between British Gas Exploration and Production Limited and LL&E (U.K.) Inc. (excluding the schedules thereto, which will be made available to the Securities and Exchange Commission upon request). (Incorporated by reference to Exhibit 2.2 to the Registrant's Current Report on Form 8-K dated September 2, 1993, as amended, Commission File No. 1-959.). Exhibit 2.3 Amendment, dated October 12, 1993, to Sale and Purchase Agreement in Exhibit 2.2 herein. Exhibit 3(a) Certificate of Incorporation (Incorporated by reference to Exhibit 1-3(a) to the Registrant's Registration Statement No. 2-45541 on Form S-1); Articles Supplementary pursuant to Section 3- 603(d)(4) of the Maryland General Corporation Law (Incorporated by reference to Exhibit 3(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1983 - Commission File No. 1-959); Articles of Amendment of Charter dated May 30, 1985 (Incorporated by reference to Exhibit 3(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985 - Commission File No. 1-959.); Articles of Amendment of Charter dated May 12, 1988 (Incorporated by reference to Exhibit 3(c) to the Registrant's Form 8 dated April 24, 1989 - Commission File No. 1-959.). Exhibit 3(b) By-Laws (Incorporated by reference to Exhibit (1) to the Registrant's Current Report on Form 8-K dated October 1, 1989 - Commission File No. 1- 959.). (continued) THE LOUISIANA LAND AND EXPLORATION COMPANY AND SUBSIDIARIES Index to Exhibits (continued) (Item 14(a)(3)) Exhibit 4(a) Rights Agreement dated as of May 25, 1986 among the Registrant and The Bank of New York (as Rights Agent) - (Incorporated by reference to Exhibit 4(a) to the Registrant's Current Report on Form 8-K dated May 25, 1986 - Commission File No. 1-959.). Exhibit 4(b) Indenture dated as of June 15, 1992 among the Registrant and Texas Commerce Bank National Association (as Trustee) (Incorporated by reference to Exhibit 4.1 to the Registrant's Registration Statement No. 33-50991 on Form S-3, as amended.). Exhibit 10(a) Form of Termination Agreement with Senior Management Personnel (Incorporated by reference to Exhibit 10(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1982 - Commission File No. 1-959.). Exhibit 10(b) The Louisiana Land and Exploration Company 1982 Stock Option Plan as adopted (Incorporated by reference to Exhibit A to the Registrant's definitive Proxy Statement dated March 26, 1982) and the amendment thereto dated December 8, 1982 (Incorporated by reference to Exhibit 10(c) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1982 - Commission File No. 1-959.). Exhibit 10(c) The Louisiana Land and Exploration Company 1988 Long-Term Stock Incentive Plan as amended (Incorporated by reference to Exhibit A to the Registrant's definitive Proxy Statement dated March 22, 1993). Exhibit 10(d) Deferred Compensation Plan for Directors (Incorporated by reference to Exhibit 10(d) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1982 - Commission File No. 1-959.). Exhibit 10(e) Pension Agreement, dated November 10, 1988 (Incorporated by reference to Exhibit 10(f) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988 - Commission File No. 1-959.). (continued) THE LOUISIANA LAND AND EXPLORATION COMPANY AND SUBSIDIARIES Index to Exhibits (continued) (Item 14(a)(3)) Exhibit 10(f) The Louisiana Land and Exploration Company 1990 Stock Option Plan for Non-Employee Directors as adopted (Incorporated by reference to Exhibit A to the Registrant's definitive Proxy Statement dated March 26, 1990). Exhibit 10(g) Form of The Louisiana Land and Exploration Company Deferred Compensation Arrangement for Selected Key Employees (Incorporated by reference to Exhibit 10(i) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 - Commission File No. 1-959.). Exhibit 10(h) Retirement Plan for Directors of The Louisiana Land and Exploration Company dated March 1, 1987 (Incorporated by reference to Exhibit 10(j) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 - Commission File No. 1-959.). Exhibit 10(i) The LL&E Special Termination Benefit Plan (Incorporated by reference to Exhibit 10(j) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 - Commission File No. 1-959.). Exhibit 10(j) The LL&E Supplemental Excess Plan (Incorporated by reference to Exhibit 10(k) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 - Commission File No. 1-959.). Exhibit 10(k) Form of Compensatory Benefits Agreement (Incorporated by reference to Exhibit 10(l) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 - Commission File No. 1-959.). Exhibit 10(l) Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1993 among the Registrant, the Banks listed therein, Morgan Guaranty Trust Company of New York, as Agent, and Texas Commerce Bank National Association and NationsBank of Texas, N.A., as Co-Agents (Incorporated by reference to Exhibit 10 to the Registrant's Registration Statement No. 33-50161 on Form S-3, as amended.). (continued) THE LOUISIANA LAND AND EXPLORATION COMPANY AND SUBSIDIARIES Index to Exhibits (continued) (Item 14(a)(3)) Exhibit 11 Computation of Primary and Fully Diluted Earnings (Loss) Per Share - Years Ended December 31, 1993, 1992 and 1991. Exhibit 13 Annual Report to Shareholders for 1993. Exhibit 21 Subsidiaries of the Registrant. Exhibit 23 Consent of Experts. Exhibit 24 Powers of Attorney. Certain debt instruments have not been filed. The Company agrees to furnish a copy of such agreement(s) to the Commission upon request. Reports on Form 8-K Quarter Ended December 31, 1993 (Item 14(b)) A Current Report on Form 8-K was filed on September 2, 1993, Items 5 and 7 of which were amended on Form 8-K/A filed on October 7, 1993. A Current Report on Form 8-K dated October 29, 1993 was filed containing the press release relating to the unaudited financial results for the Registrant's fiscal quarter ended September 30, 1993. 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. THE LOUISIANA LAND AND EXPLORATION COMPANY (Registrant) Date: February 18, 1994 By /s/ Frederick J. Plaeger, II __________________________________ Frederick J. Plaeger, II General Counsel and Corporate Secretary 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. Date: February 18, 1994 *H. Leighton Steward _____________________________________ H. Leighton Steward Director, Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer) Date: February 18, 1994 *Leland C. Adams _____________________________________ Leland C. Adams Director Date: February 18, 1994 *Richard A. Bachmann _____________________________________ Richard A. Bachmann Director, Executive Vice President, Finance and Administration (Principal Financial Officer) Date: February 18, 1994 *John F. Greene _____________________________________ John F. Greene Director, Executive Vice President, Exploration and Production Date: February 18, 1994 *Eamon M. Kelly _____________________________________ Eamon M. Kelly Director Date: February 18, 1994 *Victor A. Rice _____________________________________ Victor A. Rice Director Date: February 18, 1994 *Orin R. Smith _____________________________________ Orin R. Smith Director Date: February 18, 1994 *Arthur R. Taylor _____________________________________ Arthur R. Taylor Director Date: February 18, 1994 *W. R. Timken, Jr. _____________________________________ W. R. Timken, Jr. Director Date: February 18, 1994 *Carlisle A.H. Trost _____________________________________ Carlisle A.H. Trost Director Date: February 18, 1994 *E. L. Williamson _____________________________________ E. L. Williamson Director Date: February 18, 1994 *Jerry D. Carlisle _____________________________________ Jerry D. Carlisle Vice President and Controller (Principal Accounting Officer) */s/ Frederick J. Plaeger, II _________________________________________ Frederick J. Plaeger, II General Counsel and Corporate Secretary (As attorney-in-fact for each of the persons indicated) ________________________________________________________________ ________________________________________________________________ SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 __________________________ FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 __________________________ THE LOUISIANA LAND AND EXPLORATION COMPANY (Exact name of registrant as specified in its charter) EXHIBITS ________________________________________________________________ ________________________________________________________________ THE LOUISIANA LAND AND EXPLORATION COMPANY AND SUBSIDIARIES Index to Exhibits (Item 14(a)(3)) The following Exhibits have been filed with the Securities and Exchange Commission: Exhibit 2.1 Stock Purchase Agreement, dated as of July 18, 1993, between NERCO, Inc. and The Louisiana Land and Exploration Company (excluding the schedules thereto, which will be made available to the Securities and Exchange Commission upon request). (Incorporated by reference to Exhibit 2.1 to the Registrant's Current Report on Form 8-K dated September 2, 1993, as amended, Commission File No. 1-959.). Exhibit 2.2 Sale and Purchase Agreement, dated as of August 19, 1993, between British Gas Exploration and Production Limited and LL&E (U.K.) Inc. (excluding the schedules thereto, which will be made available to the Securities and Exchange Commission upon request). (Incorporated by reference to Exhibit 2.2 to the Registrant's Current Report on Form 8-K dated September 2, 1993, as amended, Commission File No. 1-959.). Exhibit 2.3 Amendment, dated October 12, 1993, to Sale and Purchase Agreement in Exhibit 2.2 herein. Exhibit 3(a) Certificate of Incorporation (Incorporated by reference to Exhibit 1-3(a) to the Registrant's Registration Statement No. 2-45541 on Form S-1); Articles Supplementary pursuant to Section 3- 603(d)(4) of the Maryland General Corporation Law (Incorporated by reference to Exhibit 3(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1983 - Commission File No. 1-959); Articles of Amendment of Charter dated May 30, 1985 (Incorporated by reference to Exhibit 3(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985 - Commission File No. 1-959.); Articles of Amendment of Charter dated May 12, 1988 (Incorporated by reference to Exhibit 3(c) to the Registrant's Form 8 dated April 24, 1989 - Commission File No. 1-959.). Exhibit 3(b) By-Laws (Incorporated by reference to Exhibit (1) to the Registrant's Current Report on Form 8-K dated October 1, 1989 - Commission File No. 1- 959.). (continued) THE LOUISIANA LAND AND EXPLORATION COMPANY AND SUBSIDIARIES Index to Exhibits (continued) (Item 14(a)(3)) Exhibit 4(a) Rights Agreement dated as of May 25, 1986 among the Registrant and The Bank of New York (as Rights Agent) - (Incorporated by reference to Exhibit 4(a) to the Registrant's Current Report on Form 8-K dated May 25, 1986 - Commission File No. 1-959.). Exhibit 4(b) Indenture dated as of June 15, 1992 among the Registrant and Texas Commerce Bank National Association (as Trustee) (Incorporated by reference to Exhibit 4.1 to the Registrant's Registration Statement No. 33-50991 on Form S-3, as amended.). Exhibit 10(a) Form of Termination Agreement with Senior Management Personnel (Incorporated by reference to Exhibit 10(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1982 - Commission File No. 1-959.). Exhibit 10(b) The Louisiana Land and Exploration Company 1982 Stock Option Plan as adopted (Incorporated by reference to Exhibit A to the Registrant's definitive Proxy Statement dated March 26, 1982) and the amendment thereto dated December 8, 1982 (Incorporated by reference to Exhibit 10(c) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1982 - Commission File No. 1-959.). Exhibit 10(c) The Louisiana Land and Exploration Company 1988 Long-Term Stock Incentive Plan as amended (Incorporated by reference to Exhibit A to the Registrant's definitive Proxy Statement dated March 22, 1993). Exhibit 10(d) Deferred Compensation Plan for Directors (Incorporated by reference to Exhibit 10(d) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1982 - Commission File No. 1-959.). Exhibit 10(e) Pension Agreement, dated November 10, 1988 (Incorporated by reference to Exhibit 10(f) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988 - Commission File No. 1-959.). (continued) THE LOUISIANA LAND AND EXPLORATION COMPANY AND SUBSIDIARIES Index to Exhibits (continued) (Item 14(a)(3)) Exhibit 10(f) The Louisiana Land and Exploration Company 1990 Stock Option Plan for Non-Employee Directors as adopted (Incorporated by reference to Exhibit A to the Registrant's definitive Proxy Statement dated March 26, 1990). Exhibit 10(g) Form of The Louisiana Land and Exploration Company Deferred Compensation Arrangement for Selected Key Employees (Incorporated by reference to Exhibit 10(i) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 - Commission File No. 1-959.). Exhibit 10(h) Retirement Plan for Directors of The Louisiana Land and Exploration Company dated March 1, 1987 (Incorporated by reference to Exhibit 10(j) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990 - Commission File No. 1-959.). Exhibit 10(i) The LL&E Special Termination Benefit Plan (Incorporated by reference to Exhibit 10(j) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 - Commission File No. 1-959.). Exhibit 10(j) The LL&E Supplemental Excess Plan (Incorporated by reference to Exhibit 10(k) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 - Commission File No. 1-959.). Exhibit 10(k) Form of Compensatory Benefits Agreement (Incorporated by reference to Exhibit 10(l) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 - Commission File No. 1-959.). Exhibit 10(l) Amended and Restated Revolving Credit and Term Loan Agreement dated as of September 22, 1993 among the Registrant, the Banks listed therein, Morgan Guaranty Trust Company of New York, as Agent, and Texas Commerce Bank National Association and NationsBank of Texas, N.A., as Co-Agents (Incorporated by reference to Exhibit 10 to the Registrant's Registration Statement No. 33-50161 on Form S-3, as amended.). (continued) THE LOUISIANA LAND AND EXPLORATION COMPANY AND SUBSIDIARIES Index to Exhibits (continued) (Item 14(a)(3)) Exhibit 11 Computation of Primary and Fully Diluted Earnings (Loss) Per Share - Years Ended December 31, 1993, 1992 and 1991. Exhibit 13 Annual Report to Shareholders for 1993. Exhibit 21 Subsidiaries of the Registrant. Exhibit 23 Consent of Experts. Exhibit 24 Powers of Attorney. Certain debt instruments have not been filed. The Company agrees to furnish a copy of such agreement(s) to the Commission upon request. EXHIBIT 2.3 Exhibit 2.3 AMENDMENT TO SALE AND PURCHASE AGREEMENT THIS AGREEMENT is made on the 12th day of October, 1993 BETWEEN:- (1) BRITISH GAS EXPLORATION AND PRODUCTION LIMITED (registered in England under number 902239) whose registered office is at Rivermill House, 152 Grosvenor Road, London SW1V 3JL (the "Seller"); (2) LL&E (U.K.) INC. whose principal place of business is at LL&E House, 40A Dover Street, London W1X 3RB ("LL&E"); and (3) MURPHY PETROLEUM LIMITED (registered in England under number 811102) whose registered office is at Winston House, Dollis Park, Finchley, London N3 1HZ ("Murphy"). WHEREAS: (A) By a sale and purchase agreement dated 12th August, 1993 between the Seller and LL&E (the "SPA"), the Seller agreed to sell to LL&E, subject to certain conditions contained in the SPA, certain Assets (as defined in the SPA) referable to a fourteen percent interest under the Operating Agreement (as defined in the SPA). (B) LL&E and Murphy have requested the Seller to suspend the SPA for the time being to enable the Seller to sell to Murphy that portion of the Assets referable to a two point seven four percent. (2.74%) interest under the Operating Agreement (the "Murphy interest") and to LL&E that portion of the Assets referable to an eleven point two six percent. (11.26%) interest under the Operating Agreement (the "LL&E interest") and the Seller has agreed, subject to and on the terms and conditions of this Agreement, so to suspend the SPA. (C) It is the intention of the parties that the Seller be in no worse position as a result of entering into this Agreement than if it had proceeded with the SPA in the form entered into by it with LL&E on 12th August, 1993. (D) All relevant pre-emption rights pursuant to the Operating Agreement in respect of the transactions contemplated in this Agreement have been waived. IN CONSIDERATION of the mutual promises and undertakings herein contained on the part of the parties hereto IT IS AGREED as follows: 1. Definitions In this Agreement terms and expressions defined in either the LL&E Agreement or the Murphy Agreement, as appropriate, shall, unless the context otherwise requires, bear the same meanings herein. 2. Undertaking 2.1 LL&E and Murphy acknowledge and are aware that the Seller, in entering into this Agreement, is relying on the following undertaking. LL&E and Murphy hereby undertake for themselves or either of them that as a result of the Seller entering into this Agreement they will put the Seller fully and effectively into a position which is no worse than it would have been in had it proceeded with the SPA with LL&E, such undertaking to include without limitation payment of all costs (including legal costs), charges and expenses whatsoever which are necessarily suffered or incurred by the Seller in relation to the enforcement of this Agreement, the LL&E Agreement or the Murphy Agreement (each as defined below) or any related or subsequent agreement (including those referred to as Further Documentation in the LL&E Agreement and the Murphy Agreement). The Seller shall not be entitled to make a claim under this undertaking unless it has first served on LL&E and Murphy written notice of the matter complained of within 30 days of becoming aware of the same (giving such outline details as shall then be reasonably practicable). 2.2 The undertaking contained in clause 2.1 above shall expire twenty four (24) months after the later of the Completion Dates (as revised pursuant to this Agreement, if appropriate) save in respect of claims made prior to such expiry date, such claims to be pursued with reasonable expedition. 2.3 Murphy shall not be obligated under the undertaking contained in clause 2.1 above for the failure of LL&E to complete the sale and purchase under the LL&E Agreement, save and to the extent that such failure is caused or contributed to by a breach by Murphy of its obligations under clause 6.4 below. 2.4 LL&E shall not be obligated under the undertaking contained in clause 2.1 above for the failure of Murphy to complete the sale and purchase under the Murphy Agreement, save and to the extent that such failure is caused or contributed to by a breach by LL&E of its obligations under clause 6.4 below. 3. SPA 3.1 The SPA shall not be terminated by the execution of this Agreement but shall be suspended and it shall remain suspended until either (a) the Seller is to enforce its rights under the SPA in accordance with clause 6.2.1, 6.2.2 or 6.3.1 below (whereupon it shall come into full force and effect again) or (b) Completion (except a Completion which is deemed not to have occurred pursuant to the provisions of clause 6 below) occurs of either the LL&E Agreement or the Murphy Agreement (whereupon the SPA shall terminate automatically). Neither the Seller nor LL&E shall have any obligations to each other or to any other person under the SPA while it so suspended. 3.2 During such period as the SPA is not in full force and effect (being when it is either suspended or terminated the provisions of Parts 1 and 2 of the Schedule hereto shall apply as agreements in place of the SPA as provided in clauses 4 and 5 below. 4. LL&E Agreement In respect of the sale to LL&E there shall be in effect an agreement on the terms as set out in Part 1 of the Schedule hereto, and the provisions applying to that Schedule shall be called the "LL&E Agreement". 5. Murphy Agreement In respect of the sale to Murphy there shall be in effect an agreement on the terms as set out in Part 2 of the Schedule hereto, and the provisions applying to that Schedule shall be called the "Murphy Agreement". 6. Completion 6.1 Completion of each of the LL&E Agreement and the Murphy Agreement (each and "Agreement" and together the "Agreement") will take place simultaneously and, notwithstanding anything in each of the Agreements, Completion of each Agreement shall, except as provided below, be dependent upon Completion of the other save only for the provisions of this clause. Upon each of the LL&E Agreement and the Murphy Agreement being completed in all respects subject only to the inter-dependence provision in this clause, this clause shall automatically fall away and Completion of each of the Agreements shall be deemed to have occurred. If, but for the provisions of this clause, and except as provided below, one of the Agreements would have been completed but not the other, the first such Agreement shall be deemed not to have been completed, all documents which may have been executed as a part of such Completion shall be null and void and any amounts transferred to the Seller shall be returned immediately without interest. 6.2 The exceptions referred to in clause 6.1 above are: 6.2.1 If LL&E has not for whatsoever reason completed the sale and purchase under the LL&E Agreement (ignoring, for this purpose, the inter-dependence provision in clause 6.1 above) but, save for such provision, Murphy would have completed the Murphy Agreement, any amounts transferred to the Seller shall be returned immediately without interest and the Seller shall have the option exercisable within 7 days following the date when Murphy would have completed the Murphy Agreement (ignoring for this purpose the inter-dependence provision in clause 6.1 above) by notice in writing to the parties hereto either: (a) to declare that the inter- dependence provision in clause 6.1 above is waived and that the sale and purchase under the Murphy Agreement is to be completed, or (b) to declare that the inter-dependence provision in clause 6.1 above is not waived. If the Seller does not give a notice within 7 days exercising either option (a) or (b) above, it shall at the expiry of such 7 day period be deemed to have exercised option (b). If the Seller exercises option (a) above, the Murphy Agreement shall be completed (the "revised Completion Date"), as soon as the relevant Further Documentation is available and shall contain such amendments as are reasonably necessary to reflect that Completion of only one Agreement is taking place, and on the revised Completion Date Murphy shall transfer to the Seller all amounts due under the Murphy Agreement (save that the Completion Date for the purposes of clause 3.2.3 of the Murphy Agreement shall be the actual date of Completion), the Seller shall be entitled to enforce its rights against LL&E under the LL&E Agreement and the SPA shall terminate. If the Seller exercises or is deemed to have exercised option (b) above, this Agreement shall be deemed to have rescinded and the Seller shall be entitled to enforce its rights against LL&E under the SPA. For the avoidance of doubt, LL&E and Murphy shall upon such deemed rescission be released from the undertaking given by them under clause 2.1 above. 6.2.2 If Murphy has not for whatsoever reason completed the sale and purchase under the Murphy Agreement (ignoring, for this purpose, the inter-dependence provision in clause 6.1 above) but, save for such provision, LL&E would have completed the sale and purchase under the LL&E Agreement, any amounts transferred to the Seller shall be returned immediately without interest and the Seller shall have the option exercisable within 7 days following the date when LL&E would have completed the LL&E Agreement (ignoring for this purpose the inter- dependence provision in clause 6.1 above) by notice in writing to the parties hereto either: (a) to declare that the inter-dependence provision in clause 6.1 above is waived and that the sale and purchase under the LL&E Agreement is to be completed, or (b) to declare that the inter- dependence provision in clause 6.1 above is not waived. If the Seller does not give a notice within 7 days exercising either option (a) or (b) above, it shall at the expiry of such 7 day period be deemed to have exercised option (b). If the Seller exercises option (a) above, the LL&E Agreement shall be completed (the "revised Completion Date"), as soon as the relevant Further Documentation is available and shall contain such amendments as are reasonably necessary to reflect that Completion of only one Agreement is taking place, and on the revised Completion Date LL&E shall transfer to the Seller all amounts due under the LL&E Agreement (save that the Completion Date for the purposes of clause 3.2.3 of the LL&E Agreement shall be the actual date of Completion), the Seller shall be entitled to enforce its rights against Murphy under the Murphy Agreement and the SPA shall terminate. If the Seller exercises or is deemed to have exercised option (b) above, this Agreement shall be deemed to have been rescinded and the Seller shall be entitled to enforce its rights against LL&E under the SPA. For the avoidance of doubt, LL&E and Murphy shall upon such deemed rescission be released from the undertaking given by them under clause 2.1 above. 6.3 If Completion has not taken place under either the Murphy Agreement or the LL&E Agreement by 1st December 1993 (or such later date as the parties may agree in writing) the Seller shall have the option exercisable by written notice to the parties hereto or either: 6.3.1 rescinding this Agreement and enforcing the Seller's rights against LL&E under the SPA and for the avoidance of doubt LL&E and Murphy shall thereupon be released from the undertaking given by them under clause 3.1 above; or 6.3.2 enforcing its rights against LL&E under the LL&E Agreement and against Murphy under the Murphy Agreement. 6.4 Each of the parties shall use reasonable endeavors with all due despatch to procure the satisfaction of the conditions necessary for Completion to be achieved including the obtaining of any amended version of the Further Documents. 7. Notices 7.1 Any notice or other document to be served under or in connection with this Agreement may be delivered or sent by first class recorded delivery post or telex or facsimile process to the party to be served at his address, to his telex or facsimile number appearing below or at such other address or to such other number as he may have notified to the other parties in accordance with this clause. British Gas Exploration Address: 100 Thames Valley Park Drive and Production Limited Reading Barks RG6 1PT Fax No: 0434 292100 Telex: 846231 Attention: Dr. Y. O. Barton LL&E (U.K.) Inc. Address: LL&E House 48A Dover Street London W1X 3RB Fax No: 071 499 0677 Telex: 267436 Attention: Dr. J. A. Williams Murphy Petroleum Limited Address: Winston House Dollis Park London N3 1HZ Fax No: 081 349 4443 Telex: 21970 Attention: Managing Director 7.2 Any notice or document shall be deemed to have been served: 7.2.1 if delivered, at the time of delivery; or 7.2.2 if posted, at 10:00 a.m. on the second business day after it was put into the post; or 7.2.3 if sent by telex or facsimile process, at the expiration of two hours after the time of despatch, if despatched before 3:00 p.m. on any business day, and in any other case at 10:00 a.m. on the business day following the date of despatch. 7.3 In proving service of a notice or document it shall be sufficient to prove that delivery was made or that the envelope containing the notice or document was properly addressed and posted as a prepaid first class recorded delivery letter or that the telex or facsimile message was properly addressed and despatched as the case may be. 7.4 For the purposes of this paragraph, a business day is a day other than a Saturday or statutory holiday on which banks are or, as the context may require, were generally open for business in England and New York. 8. Counterpart Execution This Agreement may be executed in any number of counterparts, all of which taken together shall constitute one and the same agreement and any party may enter into this agreement by executing a counterpart. 9. Supremacy if any conflict or inconsistency arises between provisions in the body of this Agreement and those contained in Parts 1 and 2 of the Schedule hereto or the SPA, then the provisions in the body of this Agreement shall prevail. 10. Proper Law This Agreement shall be governed by and construed in accordance with English law. The parties hereto submit to the exclusive jurisdiction of the English courts. IN WITNESS whereof the parties hereto have executed this Agreement the day and year first above written. Signed by J. G. REID ) for and on behalf of ) BRITISH GAS EXPLORATION ) J. G. REID AND PRODUCTION LIMITED ) Signed by B. WRATHMELL ) for and on behalf of ) LL&E (U.K.) INC. ) B. WRATHMELL Signed by I. IQBAL ) for and on behalf of ) MURPHY PETROLEUM LIMITED) I. IQBAL EXHIBIT 11 EXHIBIT 13 EXHIBIT 13 1993 ANNUAL REPORT TO SHAREHOLDERS (INCORPORATED BY REFERENCE INTO ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993) _________________________________________________________________ FINANCIAL REPORT: Page herein Consolidated Balance Sheets 3 Consolidated Statements of Earnings (Loss) 4 Consolidated Statements of Stockholders' Equity 5 Consolidated Statements of Cash Flows 6 Notes to Consolidated Financial Statements 7 Report of Management 26 Independent Auditors' Report 27 Unaudited Supplemental Data 28 _________________________________________________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Louisiana Land and Exploration Company and Subsidiaries December 31, 1993, 1992 and 1991 _________________________________________________________________ 1. Summary of Significant Accounting Policies a. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. Investments in affiliates are accounted for under the equity method. Certain amounts have been reclassified to conform to the current period's presentation. b. Petroleum Operations The Company uses the successful efforts method of accounting for its oil and gas operations. The costs of unproved leaseholds are capitalized pending the results of exploration efforts. Significant unproved leasehold costs are assessed periodically, on a property-by-property basis, and a loss is recognized to the extent, if any, that the cost of the property has been impaired. The costs of individually insignificant unproved leaseholds estimated to be nonproductive are amortized over estimated holding periods based on historical experience. Exploratory dry holes and geological and geophysical charges are expensed. Depletion of proved leaseholds and amortization and depreciation of the costs of all development and successful exploratory drilling are provided by the unit-of- production method based upon estimates of proved and proved-developed oil and gas reserves, respectively, for each property. The estimated costs of dismantling and abandoning offshore and significant onshore facilities are provided currently using the unit-of-production method; such costs for other onshore facilities are insignificant and are expensed as incurred. The costs of refining and processing equipment and facilities are depreciated on a straight-line basis over their estimated useful lives. The Company uses the entitlement method for recording natural gas sales revenues. Under the entitlement method of accounting, revenue is recorded based on the Company's net working interest in field production. Deliveries of natural gas in excess of the Company's working interest are recorded as liabilities while under- deliveries are recorded as receivables. Such amounts are immaterial. The Company's anticipated purchases and sales of crude oil and refined petroleum products and its committed foreign currency expenditures may be hedged against market risks through the use of forward/futures contracts. The gains and losses on these contracts are recognized upon the expiration of the contract and are included in the valuation of the anticipated transactions being hedged. A default by a counterparty to a contract would expose the Company to market risks for the quantity of the contract. There is no material risk to the Company as a result of these contracts and the Company does not anticipate nonperformance by any of the counterparties. c. Functional Currency The foreign exploration and production operations of the Company's subsidiaries and its foreign affiliate, CLAM Petroleum Company, are considered an extension of the parent company's operations. The assets, liabilities and operations of these companies are therefore measured using the United States dollar as the functional currency. As a result, foreign currency translation/transaction adjustments (which were not material) are included in net earnings. d. Income Taxes The Company and its domestic subsidiaries file a consolidated federal income tax return. The Company adopted, effective January 1, 1988, Statement of Financial Accounting Standards No. 96 ("SFAS No. 96") - "Accounting For Income Taxes". Under the liability method specified by SFAS No. 96, the deferred tax liability is determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by existing tax rates which are presumed to be in effect when these differences reverse. Deferred tax expense is the result of changes in the liability for deferred taxes. In February 1992, Statement of Financial Accounting Standards No. 109 ("SFAS No. 109") - "Accounting for Income Taxes" was issued. SFAS No. 109 supersedes SFAS No. 96. SFAS No. 109 was adopted effective as of January 1, 1993. The Company applied the provisions of the SFAS No. 109 without restating prior years' financial statements. For the Company, the most significant change in SFAS No. 109 as compared to SFAS No. 96 is that deferred tax assets will now be recognized and measured based on the likelihood of realization of a tax benefit in future years. Under SFAS No. 109, deferred tax assets are initially recognized for differences between the financial statement carrying amounts and tax bases of assets and liabilities that will result in future deductible amounts and operating loss and tax credit carryforwards. A valuation allowance would then be established to reduce that deferred tax asset if it is more likely than not that the related tax benefits will not be realized. Under SFAS No. 96, the recognition of deferred tax benefits was limited to benefits that would offset deferred tax liabilities and benefits that could be realized through carryback to recover taxes paid for the current year or prior years. e. Earnings (Loss) Per Share Primary earnings (loss) per share are calculated on the weighted average number of shares outstanding during each period for capital stock and, when dilutive, capital stock equivalents, which assumes exercise of stock options. Fully diluted earnings (loss) per share are calculated on the same basis, but also assumes conversion, when dilutive, of the convertible subordinated debentures for the period outstanding prior to the call for redemption on September 25, 1992, and elimination of the related interest expense, net of income taxes. 2. 1993 Acquisitions and Dispositions In September 1993, the Company completed the acquisition of all of the issued and outstanding common stock of NERCO Oil & Gas, Inc. ("NERCO") for a cash purchase price of approximately $354 million plus associated expenses. The acquisition was financed initially through the credit facility discussed in Note 8. The cost of the acquisition was allocated under the purchase method of accounting based on the fair value of the assets acquired and liabilities assumed. The results of NERCO's operations were consolidated with the Company's effective October 1, 1993. Pro forma combined results of operations of the Company and NERCO, including appropriate purchase accounting adjustments for the years ending December 31, 1993 and 1992, as though the acquisition had taken place on January 1 of the respective years, are as follows: In December 1993, the Company acquired an 11.26% working interest in Block 16/17 in the U.K. North Sea ("T-Block") from British Gas Exploration and Production Limited for approximately $187 million in cash. The purchase was financed initially through the credit facility discussed in Note 8. Initial production from T-Block came onstream in late 1993 and had an insignificant impact on results of operations. In December 1993, the Company completed the sale of certain oil and gas producing properties, undeveloped acreage and seismic data located in southern Alberta, Canada for approximately $42.8 million resulting in a gain, net of associated expenses, of approximately $23.5 million (before income taxes of $10.3 million). The properties sold generated revenues of $12.1 million and $15.3 million and pretax earnings of $1.2 million and $1.6 million in 1993 and 1992, respectively. 3. Cash Flows All of the Company's cash investments are highly liquid short-term debt instruments and are considered to be cash equivalents. These cash investments are carried in the accompanying balance sheets at cost plus accrued interest, which approximates fair value. Cash flows related to hedging activities through forward/futures contracts are classified in the same categories as that from the items being hedged. In 1992, the Company acquired certain proved properties for approximately $36 million and incurred a short-term liability which was outstanding at year end, the settlement of which is included in 1993 cash flows from investing activities. 4. Restructuring and Other Nonrecurring Charges/Credits In 1992, the Company recorded a charge of $52.4 million (before income tax benefits of approximately $17.8 million) against earnings to provide for the restructuring of its oil and gas operations. This charge included provisions for estimated losses on the disposition of selected domestic properties of $47.6 million (both developed and undeveloped) and costs associated with staff retirements, reductions and related transition expenses of $4.8 million. The Company completed the sale of substantially all of the selected properties for a purchase price of $48.1 million. In addition, during 1992 the Company reduced its litigation accrual for the State of Louisiana gas royalty claim by $25 million (before an income tax charge of $8.5 million). See Note 15. 5. Inventories At December 31, 1993, the LIFO cost of refinery inventories exceeded their current market values which resulted in a non-cash charge to earnings of $6.5 million (before income tax benefits of $2.3 million) which is included in "Refinery Cost of Sales and Operating Expenses" in the accompanying Consolidated Statements of Earnings (Loss). The Company's equity in earnings of affiliates, which is included in "Other Revenues" in the accompanying Consolidated Statements of Earnings (Loss), amounted to $2.4 million, $6.9 million and $15 million in 1993, 1992 and 1991, respectively. Cash dividends received from MaraLou/CLAM in 1993, 1992 and 1991 totaled $10 million, $7.5 million and $18.5 million, respectively. The consolidated financial position of MaraLou and its wholly owned subsidiary, CLAM, as of December 31, 1993 and 1992 and the results of their operations for each of the years in the three-year period ended December 31, 1993 are summarized below. MaraLou applied the provisions of SFAS No. 109 as of January 1, 1993 without restating prior years' financial statements. Upon adoption, MaraLou recorded a non-cash charge to earnings of $6 million ($3 million net to the Company's interest). The common stock of CLAM is pledged as collateral under a revolving credit agreement between MaraLou and a group of banks. The credit agreement is nonrecourse to the partners of MaraLou. 7. Property, Plant and Equipment 8. Long-term Debt The fair value of the Company's long-term debt as of December 31, 1993 is estimated to be approximately $744 million based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar maturities. Debt maturities for the next five years follows. To finance the aforementioned NERCO and T-Block acquisitions (see Note 2), refinance certain existing indebtedness and fund general corporate activities, the Company entered into a $790 million credit facility with a syndicate of banks in September 1993. Commitments under the agreement originally consisted of (i) a $540 million Revolving Credit Facility and (ii) a $250 million Term Loan Facility (which was utilized and repaid and is no longer available to the Company). The Revolving Credit Facility was subsequently reduced to $450 million and will be reduced by approximately $24 million quarterly from June 1994 through September 1999. Amounts outstanding under the Revolving Credit Facility bear interest at fluctuating rates subject to certain options chosen in advance by the Company. Borrowings under the Revolving Credit Facility and the Term Loan Facility during 1993 were at an average interest rates of 5%. A commitment fee of 1/4% is charged on the unused portion of the facility. Bank fees and other costs associated with this facility totaled $8.1 million of which $6.7 million was charged to interest and debt expenses in the fourth quarter of 1993. The balance will be written off during the first quarter of 1994, at which time the Company intends to renegotiate the facility. In June 1992, the Company registered under the Securities and Exchange Commission's shelf registration rules $300 million of senior unsecured debt securities to be issued from time to time on terms to be then determined. In June 1992, the Company sold $100 million of 8-1/4% Notes due 2002. In April 1993, the Company completed its second $100 million public offering of debt securities under the existing shelf registration filed in 1992 with the issuance of 7-5/8% Debentures due 2013. In November 1993, the Company registered up to $500 million of senior unsecured debt securities under the Securities and Exchange Commission's shelf registration rules, which included the $100 million available under the shelf registration filed in 1992. In December 1993, the Company completed a $200 million public offering with the issuance of 7.65% Debentures due 2023. The Company's $20 million Loan Agreement, the $15 million balance of which was repaid in December 1993, was with a group of banks in the form of a revolving credit loan. The interest rate varied with time and market conditions and was determined by the banks subject to certain options chosen in advance by the Company. A commitment fee of 1/4% was charged on the unused portion of the loan during the revolving credit period. Borrowings under this agreement during 1993 and 1992 were at average interest rates of 4% and 4.5%, respectively. In November 1987, the Company created a leveraged employee stock ownership plan (ESOP) within an existing employee savings plan. To fund the ESOP, in 1987 and 1988 the Company borrowed $10.2 million and $14 million, respectively, from a bank (unsecured) and loaned the proceeds to the ESOP. The ESOP then used the proceeds to acquire shares of the Company's capital stock (374,678 in 1987; 461,690 in 1988) at average market prices of $27.125 and $30.25, respectively. The capital stock issued was taken from the Company's treasury at a cost of $30 per share; the differences between treasury stock cost and value were recorded in additional paid-in capital. The loans to the ESOP are on substantially the same terms and conditions as the Company's bank loans and, in addition, are secured by the Company's capital stock owned by the ESOP. The ESOP will repay the loans (plus interest) with the proceeds from the Company's monthly contributions and quarterly dividends paid on the capital stock. The Company's bank loans will be similarly repaid monthly through 1995. The interest rates vary with time and market conditions and are determined by the bank subject to certain options chosen in advance by the Company. The average interest rates for both loans in 1993 and 1992 were 3.1% and 3.7%, respectively. During 1993, the average monthly balance of commercial paper notes outstanding was $38.8 million; the maximum amount outstanding during that period was $94 million. Commercial paper borrowings during 1993 and 1992 were at average interest rates of 3.3% and 4.3%, respectively. The Company's commercial paper program was supported by a $100 million revolving line of credit, which required a commitment fee of 1/4% per annum. No borrowings were made under the line of credit. As of September 1993, the commercial paper program is supported by the unused portion of the aforementioned Revolving Credit Facility. In September 1992, the Company announced the call for early retirement of the 8-1/2% Convertible Subordinated Debentures due September 2000. The redemption completed at a price of 101.66% of principal and the premium, along with unamortized discount, resulted in an extraordinary loss of $5.6 million, after income tax benefits of $2.8 million. The Term Loan with banks, which was retired in January 1994, bore interest at 8.92% (discounted to yield 10.7%), was unsecured and was payable in July 1994. The balance has been excluded from current liabilities as the Company refinanced the balance due on a long-term basis utilizing the Revolving Credit Facility. The early retirement was completed at a price of 102.4% of principal and the premium, along with unamortized discount, resulted in an extraordinary loss of $3.3 million, after income tax benefits of $1.7 million. 9. Interest and Debt Expenses For the years ended December 31, 1993, 1992 and 1991, interest costs incurred, which were essentially the same as interest payments, were $47 million, $37.5 million and $39.5 million, respectively, of which $18.7 million, $12.9 million and $22.6 million, respectively, were capitalized as part of the cost of property, plant and equipment. In 1992 and 1993, the Company participated in interest rate swaps (which were to terminate in 1994 and 1996, respectively) having a notional principal amount totaling $200 million. Under the agreements, the Company received an annual fixed rate and paid a variable rate based on the six-month London Interbank Offering Rate. The rates payable were recalculated in June and December of each year and the amounts received/paid were credited/charged to interest expense. In September 1993, the Company terminated both agreements and deferred a gain of approximately $3.6 million which will be recognized over the remaining terms of the respective agreements as reductions of interest expense. 10. Foreign Currency Contracts The Company hedges its committed British pound expenditures in the U.K. North Sea through the purchase of forward contracts. At December 31, 1993, forward contracts outstanding totaled $24.6 million. The fair value of these contracts, which represents the Company's cost to offset its forward position, is estimated to be approximately $1 million as of December 31, 1993. 11. Income Taxes As explained in Note 1(d), the Company adopted SFAS No. 109 effective January 1, 1993. Upon adoption, the Company recorded a non-cash credit to earnings of $13.7 million which represented the recognition of deferred tax assets existing at December 31, 1992. With the enactment of the Budget Reconciliation Act of 1993, the Federal statutory corporate income tax rate was increased from 34% to 35% retroactive to January 1, 1993. As a result, the Company increased its deferred income tax liabilities as of January 1, 1993 with a non-cash charge to income tax expense of $3 million. The components of earnings (loss) before income taxes were taxed under the following jurisdictions: Components of income tax expense (benefit) are as follows: Tax expense (benefit) differs from the amounts computed by applying the U.S. Federal tax rate (1993 - 35%; 1992-91 - 34%) to earnings (loss) before income tax. The reasons for the differences are as follows: As a result of the prospective adoption of SFAS No. 109 effective January 1, 1993, the following additional disclosures are presented as of and for the year ended December 31, 1993. Total income tax expense (benefit) was allocated as follows: The significant components of deferred income tax expense attributable to income from continuing operations are as follows: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows: The net change in the valuation allowance for the year ended December 31, 1993 was an increase of $3 million. This change was made to provide for uncertainties surrounding the realization of certain foreign tax credit carryforwards. The remaining balance of the deferred tax assets should be realized through future operating results and the reversal of taxable temporary differences. Deferred tax expense (benefit) included the following components, the disclosure of which was prescribed by the now-superseded SFAS No. 96: For the years ended December 31, 1993, 1992 and 1991, the Company's net cash payments (refunds) of income taxes totaled $7.1 million, $(.6) million and $6.5 million, respectively. At December 31, 1993 the Company has foreign tax credit carryforwards for Federal income tax purposes of $10.2 million which are available through 1998 to offset future Federal income taxes, if any. The Company also has alternative minimum tax credit carryforwards of $5.2 million which are available to reduce Federal regular income taxes, if any, over an indefinite period. 12. Retirement Benefits The Company has a noncontributory defined benefit pension plan covering all eligible employees, with benefits based on years of service and the employee's highest three-year average monthly earnings. The Company's funding policy is intended to provide for both benefits attributed to service to-date and for those expected to be earned in the future. Plan assets consist primarily of stocks, bonds and short-term cash investments. Since the spin-off of the pension plan of a discontinued subsidiary in 1985 and the contribution of excess assets remaining after purchasing annuities for affected employees, the pension plan did not require funding through the year ended December 31,1992. A minimum amount of funding was required in 1993. As a result of an early retirement incentive program and a reduction in force in 1992, benefit obligations of $4.2 million were settled from plan assets, including $1.1 million of early retirement incentive costs included in the restructuring charge described in Note 4. The settlement of the pension obligations related to the restructuring program resulted in a loss of $.3 million, which was also included in the restructuring charge. The following tables set forth the plan's funded status and amounts recognized in the statements of financial position and results of operations at December 31: The Company has postretirement medical and dental care plans for all eligible retirees and their dependents with eligibility based on age and years of service upon retirement. The Company also maintains a Medicare Part B reimbursement plan and life insurance coverage for a closed group of retirees of a former subsidiary for which estimated benefits of approximately $4.7 million were accrued at December 31, 1992. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS No. 106) - "Employers' Accounting for Postretirement Benefits Other than Pensions", which changed the Company's practice of accounting for postretirement benefits on a pay-as-you-go (cash) basis by requiring accrual, during the years that the employee renders the necessary service, of the expected cost of providing those benefits to an employee and the employee's beneficiaries and covered dependents. Upon adoption, the Company recorded a transition liability of approximately $20.5 million ($13.5 million after income taxes) as a one-time, non-cash charge against earnings. The postretirement benefit plans are unfunded and the Company continues to fund claims on a cash basis. The following tables set forth the amounts recognized in the statements of financial position and results of operations. Assumptions utilized to measure the accumulated postretirement obligation at December 31, and January 1, 1993 were: discount rates of 7.25% and 8.5%, respectively; health care cost trend rates of 14% declining over 10 years to 5% and 6%, respectively, and held constant thereafter. A 1% increase in the assumed trend rates would have resulted in increases in the accumulated postretirement benefit obligation at December 31, and January 1, 1993 of $2.6 million and $2.1 million, respectively; the aggregate of service cost and interest cost for the year ended December 31, 1993 would have increased by $.4 million. 13. Capital Stock, Options and Rights In November 1993, the Company completed a public offering of 4.4 million shares of capital stock at a price of $44.625 per share. The capital stock was taken from the Company's treasury at an average cost of $33.125 per share. The excess of net proceeds over the cost of treasury stock issued was credited to additional paid- in-capital. The net proceeds of the offering, after underwriting commissions and expenses, were approximately $188.8 million. In May 1988, the 1988 Long-term Stock Incentive Plan (1988 Plan) was approved by the shareholders to replace the 1982 Stock Option Plan (1982 Plan). Under the 1988 Plan, as amended, the Company may grant to officers and key employees stock options, stock appreciation rights, performance shares, performance units, restricted stock or restricted stock units for up to 2.8 million shares (plus the 22,274 shares not awarded under the 1982 Plan) of the Company's capital stock. As prescribed by both Plans, stock options are exercisable at the market price on the date of the grant, generally over a two-year period at the rate of 50% each year commencing on the first anniversary of the date of grant; all options expire ten years from the date of grant. In 1993 and 1992, options for 277,700 shares and 600,400 shares were granted, respectively. The restricted stock and performance shares awarded under the 1988 Plan entitle the grantee to the rights of a shareholder, including the right to receive dividends and to vote such shares, but the shares are restricted as to sale, transfer or encumbrance. Restricted stock is issued to the grantee over varying periods after a one-year waiting period has expired. In 1993, awards were granted for 34,250 shares of restricted stock. In 1992, no awards were granted. The performance cycle consists of a three-year period, beginning with the year of grant, at the end of which certain performance goals must be attained by the Company for the unrestricted performance shares to be issued to the grantee. Awards granted in 1993 and 1992 for performance shares amounted to 18,900 shares and 26,600 shares, respectively. Performance shares issued in 1993 and 1992 amounted to 15,257 shares and 19,000 shares, respectively. Restricted stock and performance share awards are "compensatory" awards and the Company accrued compensation expense of $.7 million, $1 million and $.8 million in 1993, 1992 and 1991, respectively. In May 1990, the 1990 Stock Option Plan for Non-Employee Directors (1990 Plan) was approved by the shareholders, under which the Company will grant stock options to non-employee directors for up to 150,000 shares of the Company's capital stock. As prescribed by the 1990 Plan, the options are exercisable at the market price at the date of grant over a two-year period at the rate of 50% each year commencing on the first anniversary of the date of grant; all options expire ten years from the date of grant. Awards for 20,000 shares were granted in both 1993 and 1992. At December 31, 1993, 1,254,638 shares of capital stock were reserved for future grants under all Plans. Total grants outstanding under the Plans and the changes therein for the periods indicated follows. In 1986, the Company's Board of Directors declared a dividend to shareholders consisting of one Capital Stock Purchase Right on each outstanding share of capital stock. A Right will also be issued with each share of capital stock that becomes outstanding prior to the time the Rights become exercisable or expire. If a person or group acquires beneficial ownership of 20% or more, or announces a tender offer that would result in beneficial ownership of 20% or more, of the shares of outstanding capital stock, the Rights become exercisable ten days thereafter and each Right will entitle its holder to purchase one share of capital stock for $90. If the Company is acquired in a business combination transaction, each Right not owned by the 20% holder will entitle its holder to purchase, for $90, common shares of the acquiring company having a market value of $180. Alternatively, if a 20% holder were to acquire the Company by means of a reverse merger in which the Company and its capital stock survive or were to engage in certain "self- dealing" transactions, or if a person or group were to acquire 30% or more of the outstanding capital stock (other than pursuant to a cash offer for all shares), each Right not owned by the acquiring person would entitle its holder to purchase, for $90, capital stock of the Company having a market value of $180. Each Right can be redeemed by the Company for $.05, subject to the occurrence of certain events and other restrictions, and expires in 1996. These Rights may cause substantial ownership dilution to a person or group who attempts to acquire the Company without approval of the Company's Board of Directors. The Rights should not interfere with a business combination transaction that has been approved by the Board of Directors. The table below sets forth estimates of the domestic sulphur reserves attributable to the interests of the Company as of December 31: _________________________________________________________________ Standardized Measure of Discounted Future Net Cash Flows and Changes Therein Relating to Proved Oil and Gas Reserves The following supplemental data on the Company's oil and gas activities were prepared in accordance with the Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards No. 69 - "Disclosures About Oil and Gas Producing Activities." Estimated future net cash flows are determined by: (1) applying the respective year-end oil and gas prices to the Company's estimates of future production of proved reserves; (2) deducting estimates of the future costs of development and production of proved reserves based on the assumed continuation of the cost levels and economic conditions existing at the respective year-end; and (3) deducting estimates of future income taxes based on the respective year-end and future statutory tax rates. Present value is determined using the FASB-prescribed discount rate of 10% per annum. Although the information presented is based on the Company's best estimates of the required data, the methods and assumptions used in preparing the data were those prescribed by the FASB. Although unrealistic, they were specified in order to achieve uniformity in assumptions and to provide for the use of reasonably objective data. It is important to note here that this information is neither fair market value nor the present value of future cash flows and it does not reflect changes in oil and gas prices experienced since the respective year-end. It is primarily a tool designed by the FASB to allow for a reasonable comparison of oil and gas reserves and changes therein through the use of a standardized method. Accordingly, the Company cautions that this data should not be used for other than its intended purpose. EXHIBIT 21 EXHIBIT 23 Exhibit 23 The Board of Directors The Louisiana Land and Exploration Company: We consent to incorporation by reference in Registration Statements No. 2-79097, No. 2-98948, No. 33-22108, No. 33-22338 and No. 33-37814 on Form S-8, No. 33-48339 and No. 33-50991 on Form S-3 and No. 33-6593 on Form S-4 of The Louisiana Land and Exploration Company of our reports dated February 9, 1994, relating to the consolidated balance sheets of The Louisiana Land and Exploration Company and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of earnings (loss), stockholders' equity, and cash flows and related schedules for each of the years in the three-year period ended December 31, 1993 which reports appear or are incorporated by reference in the December 31, 1993 annual report on Form 10-K of The Louisiana Land and Exploration Company. Our reports refer to the adoption of the methods of accounting for income taxes and postretirement benefits other than pensions prescribed by Statement of Financial Accounting Standards Nos. 109 and 106, respectively. We also consent to incorporation by reference in the previously referred to Registration Statements of our report dated January 28, 1994, relating to the consolidated balance sheets of MaraLou Netherlands Partnership and subsidiary as of December 31, 1993 and 1992 and the related consolidated statements of income, partners' capital, and cash flows for each of the years in the three-year period ended December 31, 1993 which report appears in the December 31, 1993 annual report on Form 10-K of The Louisiana Land and Exploration Company. Our report refers to the adoption of the method of accounting for income taxes prescribed by Statement of Financial Accounting Standard No. 109. /s/ KPMG Peat Marwick KPMG PEAT MARWICK New Orleans, Louisiana February 18, 1994 EXHIBIT 24 THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director and the principal executive officer of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director and the principal executive officer of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ H. Leighton Steward _____________________________ H. Leighton Steward THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ Leland C. Adams _____________________________ Leland C. Adams THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director and the principal financial officer of The Louisiana Land and Exploration Company hereby appoints Frederick J. Plaeger, II and Jerry D. Carlisle his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director and the principal financial officer of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ Richard A. Bachmann _____________________________ Richard A. Bachmann THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ John F. Greene _____________________________ John F. Greene THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ Eamon M. Kelly _____________________________ Eamon M. Kelly THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ Victor A. Rice _____________________________ Victor A. Rice THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ Orin R. Smith _____________________________ Orin R. Smith THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ Arthur R. Taylor _____________________________ Arthur R. Taylor THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ W. R. Timken, Jr. _____________________________ W. R. Timken, Jr. THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ Carlisle A.H. Trost _____________________________ Carlisle A.H. Trost THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as a director of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann, Frederick J. Plaeger, II and Jerry D. Carlisle and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as a director of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ E. L. Williamson _____________________________ E. L. Williamson THE LOUISIANA LAND AND EXPLORATION COMPANY POWER OF ATTORNEY WHEREAS, The Louisiana Land and Exploration Company intends to file with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, an Annual Report on Form 10-K; NOW, THEREFORE, the undersigned in his capacity as the principal accounting officer of The Louisiana Land and Exploration Company hereby appoints Richard A. Bachmann and Frederick J. Plaeger, II and each of them severally, his true and lawful attorneys or attorney with power to act with or without the other and with full power of substitution and resubstitution, to execute in his name, place, and stead, in his capacity as the principal accounting officer of The Louisiana Land and Exploration Company, said Annual Report on Form 10-K and any and all amendments thereto and all instruments necessary or incidental in connection therewith, and to file or cause to be filed the same with the Securities and Exchange Commission. Each of said attorneys shall have full power and authority to do and perform in the name and on behalf of the undersigned, in any and all capacities, every act whatsoever necessary or desirable to be done in the premises, as fully to all intents and purposes as the undersigned might or could do in person. The undersigned hereby ratifies and approves the acts of said attorneys and each of them. IN WITNESS WHEREOF, the undersigned has executed this instrument this 18th day of February, 1994. /s/ Jerry D. Carlisle _____________________________ Jerry D. Carlisle [TYPE] COVER THE LOUISIANA LAND AND EXPLORATION COMPANY 909 Poydras Street New Orleans, LA 70112 February 22, 1994 Securities and Exchange Commission Washington, D.C. 20549 Gentlemen: Pursuant to the requirements of the Securities Exchange Act of 1934, we are transmitting herewith the attached Annual Report on Form 10-K for the fiscal year ended December 31, 1993. Sincerely, THE LOUISIANA LAND AND EXPLORATION COMPANY s/Frederick J. Plaeger, II Frederick J. Plaeger, II General Counsel and Corporate Secretary

37076_1993.txt

37076_1993

1993

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ITEM 1. BUSINESS GENERAL Firstar Corporation is a registered bank holding company incorporated in Wisconsin in 1929. Firstar Corporation ("Firstar") is the largest bank holding company headquartered in Wisconsin. Firstar's 17 bank subsidiaries in Wisconsin had total assets of $9.3 billion at December 31, 1993. Its eleven Iowa banks, four Illinois banks and one Minnesota bank had total assets of approximately $2.6 billion, $944 million and $1.1 billion, respectively, as of December 31, 1993. Firstar has one bank in Phoenix, Arizona with total assets of $99 million. Firstar's principal subsidiary, Firstar Bank Milwaukee, N.A., had total assets of $5.5 billion which represented 40 percent of Firstar's consolidated assets at December 31, 1993, and is the largest commercial bank in Wisconsin. Firstar provides banking services throughout Wisconsin and Iowa and in the Chicago, Minneapolis-St. Paul and Phoenix metropolitan areas. Its Wisconsin bank subsidiaries operate in 113 locations, with offices in eight of the ten largest metropolitan population centers of the state, including 46 offices in the Milwaukee metropolitan area. Its Iowa bank subsidiaries operate in 42 locations; its Illinois bank subsidiaries in 15 locations; its Minnesota bank subsidiary in 25 locations; its Arizona bank in three locations; and a trust subsidiary in Florida in two locations. Firstar's bank subsidiaries provide a broad range of financial services for companies based in Wisconsin, Iowa, Illinois and Minnesota, national business organizations, governmental entities and individuals. These commercial and consumer banking activities include accepting demand, time and savings deposits; making both secured and unsecured business and personal loans; and issuing and servicing credit cards. The bank subsidiaries also engage in correspondent banking and provide trust and investment services to individual and corporate customers. Firstar Bank Milwaukee, N.A., Firstar Bank Cedar Rapids, N.A. and Firstar Bank Madison, N.A. also conduct international banking services consisting of foreign trade financing, issuance and confirmation of letters of credit, funds collection and foreign exchange transactions. Nonbank subsidiaries provide retail brokerage services, trust and investment management services, residential mortgage banking activities, title insurance, business insurance, consumer and credit related insurance, and corporate computer and operational services. At December 31, 1993, Firstar and its subsidiaries employed 7,323 full-time and 2,345 part-time employees, of which approximately 926 full-time employees are represented by a union under a collective bargaining agreement that expires on August 31, 1996. Management considers its relations with its employees to be good. COMPETITION Banking and bank-related services is a highly competitive business. Firstar's subsidiaries compete primarily in Wisconsin and the Midwestern United States. Firstar and its subsidiaries have numerous competitors, some of which are larger and have greater financial resources. Firstar competes with other commercial banks and financial intermediaries, such as savings banks, savings and loan associations, credit unions, mortgage companies, leasing companies and a variety of financial services and advisory companies located throughout the country. SUPERVISION Firstar's business activities as a bank holding company are regulated by the Federal Reserve Board under the Bank Holding Company Act of 1956 which imposes various requirements and restrictions on its operations. The activities of Firstar and those of its banking and nonbanking subsidiaries are limited to the business of banking and activities closely related or incidental to banking. The business of banking is highly regulated, and there are various requirements and restrictions in the laws of the United States and the states in which the subsidiary banks operate including the requirement to maintain reserves against deposits and adequate capital to support their operations, restrictions on the nature and amount of loans which may be made by the banks, restrictions relating to investment (including loans to and investments in affiliates), branching and other activities of the banks. Firstar's subsidiary banks with a national charter are supervised and examined by the Comptroller of the Currency. The subsidiary banks with a state charter are supervised and examined by their respective state banking agency and either by the Federal Reserve if a member bank of the Federal Reserve or by the FDIC if a nonmember. All of the Firstar subsidiary banks are also subject to examination by the Federal Deposit Insurance Corporation. In recent years Congress has enacted significant legislation which has substantially changed the federal deposit insurance system and the regulatory environment in which depository institutions and their holding companies operate. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), the Comprehensive Thrift and Bank Fraud Prosecution and Taxpayer Recovery Act of 1990 and the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") have significantly increased the enforcement powers of the federal regulatory agencies having supervisory authority over Firstar and its subsidiaries. Certain parts of such legislation, most notably those which increase deposit insurance assessments and authorize further increases to recapitalize the bank deposit insurance fund, increase the cost of doing business for depository institutions and their holding companies. FIRREA also provides that all commonly controlled FDIC insured depository institutions may be held liable for any loss incurred by the FDIC resulting from a failure of, or any assistance given by the FDIC, to any of such commonly controlled institutions. Federal regulatory agencies have implemented provisions of FDICIA with respect to taking prompt corrective action when a depository institution's capital falls to certain levels. Under the new rules, five capital categories have been established which range from "critically undercapitalized" to "well capitalized". Failure of a depository institution to maintain a capital level within the top two categories will result in specific actions from the federal regulatory agencies. These actions could include the inability to pay dividends, restricting new business activity, prohibiting bank acquisitions, asset growth limitations and other restrictions on a case by case basis. In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy. Changes to such monetary policies have had a significant effect on operating results of financial institutions in the past and are expected to have such an effect in the future; however, the effect of possible future changes in such policies on the business and operations of Firstar cannot be determined. EXECUTIVE OFFICERS OF THE REGISTRANT The following is a list of all the executive officers (14) of Firstar as of December 31, 1993. All of these officers are elected annually by their respective boards of directors. All of the officers have been employed by Firstar and/or one or more of its subsidiaries during the past five years, except Messrs. Stowe and Schoenke, who were previously employed by other banking companies and joined Firstar as executive officers in 1989 and 1990, respectively. There are no family relationships between any of the executive officers. ITEM 2. ITEM 2. PROPERTIES On December 31, 1993, Firstar had 200 banking locations, of which 147 were owned and 53 were leased. All of these offices are considered by management to be well maintained and adequate for the purpose intended. See Note 7 of the Notes to Consolidated Financial Statements included under Item 8 of this document for further information on properties. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Firstar and its subsidiaries are subject to various legal actions and proceedings in the normal course of business, some of which involve substantial claims for compensatory or punitive damages. Although litigation is subject to many uncertainties and the ultimate exposure with respect to these matters cannot be ascertained, management does not believe that the final outcome will have a material adverse effect on the financial condition of Firstar. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS See Item 6 ITEM 6. SELECTED FINANCIAL DATA - -------------------------------------------------------------------------------- ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS HIGHLIGHTS Firstar reported record earnings in 1993 of $204.3 million, a 23.1% improvement over the $166.0 million earned in 1992. On a per common share basis, 1993 net income increased 20.2% to $3.15 from $2.62 earned in 1992. In 1991, net income was $134.3 million or $2.14 per common share. Firstar has seen successive quarterly improvements in net income for the past twelve quarters. Earnings as measured as a percent of average common equity increased to 18.61% in 1993, compared to 17.43% in 1992 and 15.85% in 1991. This performance level places Firstar within the top 25% of bank holding companies in its peer group during each of the past three years. This group currently consists of the 29 companies with assets ranging from $10 billion to $25 billion. Return on average assets has shown similar improvement with the return reaching 1.59% in 1993 compared with 1.36% in 1992 and 1.16% in 1991. Table 1 highlights the major factors affecting the changes in earnings during the last two years. Continued improvement in both net interest revenue and other operating revenue were key factors in the earnings improvement during both years. Also of benefit was a lower loan loss provision resulting from lower net charge-offs and reduced nonperforming assets. Operating expenses, while increasing, were reduced relative to gross revenues resulting in further improvement in Firstar's efficiency ratio. TABLE 1 CHANGE IN NET INCOME PER COMMON SHARE - -------- Calculation based upon shares outstanding in each year. The net interest margin remained near record levels in 1993, declining modestly from the 1992 high of 5.27% to 5.21% in 1993. During 1991 the margin was 5.00%. Other operating revenue has shown a 13.8% improvement over 1992, led by increased trust and investment management fees along with gains from the mortgage banking business. This growth in fee related revenue follows a similar 10.4% rise in 1992. Continued emphasis has been placed on cost control and operational efficiencies. Operating expenses rose by 5.4% in 1993 and 8.2% in 1992. Further improvements in asset quality were achieved in 1993. Nonperforming assets were reduced to $64.9 million at December 31, 1993, compared with $88.8 million and $108.5 million at the end of 1992 and 1991 respectively. Nonperforming assets now represent .72% of total loans and other real estate. As a point of comparison, the median of Firstar's peer group is approximately twice as high. Within this peer group, Firstar ranks third by this measure of asset quality. Stockholders' equity was $1.16 billion at the end of 1993. Capital strength, by all measures, remains strong. Firstar's capital ratios are in the top quartile of its peer group and it has the highest capital rating by its regulatory agency. NET INTEREST REVENUE Net interest revenue, which comprises interest and loan-related fees less interest expense, is the principal source of earnings for Firstar. Net interest revenue is affected by a number of factors including the level, pricing and maturity of earning assets and interest-bearing liabilities, interest rate fluctuations and asset quality. Net interest margin is net interest revenue expressed as a percentage of average earning assets. To permit comparisons, net interest revenue and margin in the accompanying discussion and tables have been adjusted to show tax-exempt income, such as interest on municipal securities and loans, on a taxable-equivalent basis. Table 2 shows the components of net interest revenue, net income and net interest margin for 1993 and the two prior years. TABLE 2 CONDENSED INCOME STATEMENTS--TAXABLE-EQUIVALENT BASIS Net interest revenue increased 4.7% to $597.4 million during 1993, which compares with a 10.6% increase in 1992. The growth in both years benefited from higher average earning asset balances. During 1993 the positive effect of increased average earning asset balances was partially offset by the decline in the net interest margin. In 1992, however, the increased margin contributed significantly to the improved net interest revenue. Net interest margin for the current year was 5.21% compared with 5.27% in 1992 and 5.00% in 1991. The margin declined modestly in 1993 but nonetheless remains strong relative to earlier years. Rates paid on interest bearing liabilities adjust to general market changes more rapidly than rates on loans and investments, thus increasing Firstar's interest rate spreads. This spread, which is the difference between the earning asset rate and the rate paid on interest bearing liabilities, widened by .06%, or 6 basis points, in 1993 compared to 44 basis points in 1992. A general movement by customers from time certificates of deposit to lower rate savings and interest bearing transaction accounts during the past two years has aided the interest rate spread. Offsetting the benefit of wider spreads was the lower contribution of interest- free funds supporting earning assets. While the level of earning assets funded by noninterest-bearing liabilities increased to 21.8% in 1993 from 20.4% in 1992 and 17.4% in 1991, the lower interest rates reduced the earnings contribution of these funds. This factor reduced the net interest margin by 12 basis points in 1993 and 17 basis points during 1992. Foregone interest on nonperforming loans and other real estate reduced net interest revenue by $4.6 million in 1993, $8.3 million in 1992 and $13.2 million in 1991. This resulted in a corresponding reduction in net interest margin of .03% in 1993 and .05% in 1992 and .11% in 1991. The lower impact is a reflection of Firstar's reduced level of nonperforming assets. Table 3 shows the components of interest revenue and expense along with changes related to volumes and rates. Total interest revenue on a taxable- equivalent basis declined by 3.6% to $896.3 million in 1993. This resulted from lower overall interest rates, which was partially offset by the 5.7% increase in average earning assets. The rate received on earning assets declined from 8.58% in 1992 to 7.82% in 1993. Likewise, the 5.1% decline in interest revenue during 1992 was attributable to lower interest rates, despite increases in average earning assets. The rate on all earning assets declined from 9.86% in 1991 to 8.58% in 1992. During this three-year period the prime rate dropped from a high of 10% to the current 6% level. TABLE 3 ANALYSIS OF INTEREST REVENUE AND EXPENSE - -------- Calculations are computed on a taxable-equivalent basis using a tax rate of 35% in 1993 and 34% in 1992 and 1991. The change attributable to both volume and rate has been allocated proportionately to the changes due to volume and rate. Total interest expense was $298.9 million in 1993, a reduction of 16.8% from 1992. The interest rates on liabilities, declining from 4.16% in 1992 to 3.34% in 1993, produced the lower expense. During 1992 interest expense declined by 28.3% similarly due to reduced interest rates paid, dropping from 5.88% in 1991 to 4.16% in 1992. OTHER OPERATING REVENUE Total other operating revenue amounted to $342.3 million, an increase of $41.5 million or 13.8% from 1992. The comparable growth during 1992 was 10.4%. This growth reflects the continuing effort to emphasize non-interest revenue. This focus provides several benefits to Firstar. Much of Firstar's fee revenue is not subject to the fluctuations that are inherent in the interest rate cycle. Firstar's broad customer base provides opportunities for expanded revenues as the marketplace looks to financial institutions for services beyond traditional lending and deposit activities. Table 4 shows the composition of other operating revenue. TABLE 4 ANALYSIS OF OTHER OPERATING REVENUE Other operating revenue now represents 36% of Firstar's revenue. An industry measure of fee revenue prominence is the ratio of this revenue stream to average assets. During 1993 this ratio was 2.66% compared to 2.46% in 1992 and 2.33% in 1991. These figures place Firstar fifth among the 29 banking organizations with total assets of $10 billion to $25 billion. Trust and investment management fees are the single largest source of fee revenue, contributing $110.2 million, nearly a third of other operating revenue. This level represents a 14.9% growth in revenue in 1993 which in turn followed an 18.7% rise in the previous year. This pattern of growth was the result of the development of new business and increased market value of assets. Expanded services are being offered through Firstar's banking network. Additional marketing efforts are also being directed to institutional investors beyond the Midwest. The introduction of fourteen proprietary mutual funds and the serving as custodian/transfer agent for 160 publicly registered mutual funds have enhanced trust revenues. Trust assets under management increased by 8.3% during 1993 to $14.8 billion at the end of the year. Additional assets held in custody accounts rose by 22.1% to $39.3 billion. Revenue from service charges on deposit accounts increased 11.7% in 1993 to a level of $74.1 million, which follows a similar increase in 1992. This growth resulted from an increase in deposits, along with the repricing of certain account charges. Another factor was the impact of the lower rate environment on business accounts, which receive a rate credit for deposit balances in lieu of cash payments. Additional service charge fees were collected as a result of lower rate credits to these accounts in both years. Credit card service revenues are the third largest source of fee revenue totaling $53.3 million during 1993, which was a 2.8% increase over 1992. During 1992, credit card revenue declined by 5.0%. Increased competition from other card issuers and some consumer anxiety about economic conditions have reversed previous growth trends. The favorable introduction of new credit card products and growth in merchant fee activity have been encouraging trends. Firstar services 600,000 active card holders, has 32,500 merchant accounts and provides credit card programs to more than 780 financial institutions. This customer base, which covers the Upper Midwest and includes Wisconsin, Iowa, Illinois, Minnesota, Upper Michigan and the Dakotas, provides a market for the sale and expansion of other financial products. Revenue from mortgage banking activities increased substantially during 1993, up 105% to $26.8 million. This income represents mortgage servicing fees, loan origination fees and gains on loan sales into the secondary market. Historically low interest rates fueled a refinancing boom. Loan originations totaled $1.3 billion in 1993 and total loans serviced for others were $2.0 billion at the end of the year. Firstar has expanded its mortgage banking activities during the last two years through coordinated marketing efforts within Firstar's banking network. Data processing fee income declined 11.5% in 1993 after remaining essentially level during the prior two years. A shrinking customer base due to continuing bank consolidations through mergers or acquisitions and conversions by smaller community banks to in-house data processing systems have acted to reduce revenues. Intense price competition has also occurred due to the shrinking market for sales and has affected revenue levels through pricing changes and some loss of customers. The past two years saw continued growth in insurance activity, with a 23.3% increase in 1993 compared with 10.4% during 1992. This line of business generates revenue from the sale of annuities and insurance products and represents an important element in Firstar's strategy to continually expand fee revenue. Brokerage revenue increased by 42.1% during 1993 to $8.7 million. This follows a 1992 increase of 103.7%. This rapid growth reflects the expanded marketing effort throughout the Firstar banking system and favorable market conditions. The remaining sources of other operating revenue derive from a wide range of services and collectively increased by 3.9% in 1993 and 1.7% during 1992, excluding the effect of $2 million of nonrecurring revenue in 1993. OTHER OPERATING EXPENSES Total operating expense increased by 5.4% to $587.7 million in 1993 compared with an increase of 8.2% in 1992. Information on the components of other operating expense is shown in Table 5. TABLE 5 ANALYSIS OF OTHER OPERATING EXPENSE Personnel costs, which include salaries and fringe benefits, are the largest component of operating expenses, representing more than half of operating costs. This expense rose by 10.2% in 1993 compared with 7.8% in 1992. Salaries rose by 8.2% in 1993 and 7.3% in 1992. In addition to normal merit increases, the staffing level has risen from 7,709 full-time equivalent employees at December 31, 1991 to 8,246 at year-end 1992 and 8,608 at year-end 1993. Approximately half of this staffing growth was attributable to bank acquisitions. Employee benefit costs rose by 19.8% in 1993 after increasing by 10.3% in 1992. Firstar adopted Statement of Financial Accounting Standards No. 106, "Accounting for Postretirement Benefits Other Than Pensions" in 1993. The statement requires employers to recognize postretirement benefits on an accrual basis over employee service periods, as contrasted to the expensed-as-incurred method of accounting. Excluding the impact of Statement No. 106, which increased costs by $7.0 million, employee benefit costs rose by 5.7% during 1993. The Financial Accounting Standards Board also issued Statement No. 112, "Employers' Accounting for Postemployment Benefits", which is effective in 1994. The statement requires employers to recognize benefits provided to former employees after employment but before retirement. These postemployment benefits include salary continuation, severance benefits and benefit continuation. The statement will not affect Firstar's current accounting practice with respect to these payments. Net occupancy expense increased by 9.7% in 1993 and 5.1% in 1992. The addition of new banks and costs associated with office closings/restructuring have affected the increase in 1993 and 1992. Office closing/restructuring charges added $2.2 million, $1.5 million and $3.3 million to expense in 1993, 1992 and 1991, respectively. Equipment expense declined by 1.2% after increasing by 14.7% in 1992. Firstar has invested in upgraded central data processing equipment as a result of the growth of Firstar through bank acquisitions and strong growth of fee service businesses. Ensuring that Firstar data processing capabilities are up-to-date is critical to deliver quality services in a cost-effective manner to customers. Business development costs rose by 4.4% in 1993 and 10.4% in 1992. Increased marketing and advertising expenses associated with expansion into new markets, office consolidation programs and changing bank names caused the rise in expenses. FDIC insurance is an uncontrollable cost, with the premium established by the federal regulatory agency. This expense has more than tripled since 1989. The FDIC set new premium schedules in 1993 which specified varying premium amounts based upon capitalization levels and soundness criteria. Firstar's capital strength has permitted payments at the lowest rate levels. The amortization of intangibles includes amounts associated with goodwill, core deposit intangibles and purchased mortgage loan servicing rights. During 1993 and 1992 additional amortization of mortgage servicing rights was taken due to the high volume of the underlying mortgage loans which were refinanced. Expense associated with the amortization of mortgage servicing rights was $5.2 million in 1993, $8.3 million in 1992 and $1.6 million in 1991. The remaining unamortized mortgage loan service rights were $2.4 million at the end of 1993. Expenses associated with foreclosed real estate were further reduced during 1993, decreasing to $2.1 million from $4.3 million in 1992 and $10.5 million in 1991. Included in these expenses are costs associated with the loss on sale and reduction in the book value of the properties of $.8 million in 1993, $1.3 million in 1992 and $8.3 million in 1991. The remaining costs represent the net expense of operating the properties. All other expenses include a wide range of items and remained level in 1993 and increased by 6.5% in 1992. A measure of the success in managing operating expense is expressed in the ratio of expense to revenue and is referred to as the efficiency ratio. The objective is to reduce this ratio through revenue growth, cost control or a combination of both. This ratio was 62.6% in 1993, 64.0% in 1992 and 65.5% in 1991 and places Firstar above the median level of its peer companies. Firstar continues to seek ways to improve its efficiency. PROVISIONS FOR LOAN LOSSES The provision for loan losses is used to cover actual loan losses and to adjust the size of the reserve relative to the amount and quality of loans. In determining the adequacy of the reserve, management considers the financial strength of borrowers, loan collateral, current and anticipated economic conditions and other factors. The 1993 provision for loan losses was $24.6 million, compared with $44.8 million in 1992 and $50.3 million in 1991. The reduced level of nonperforming assets and lower net charge-offs have permitted Firstar to reduce its provision for loan losses. INCOME TAXES Income tax expense was $93.7 million in 1993, compared to $71.5 million in 1992 and $53.0 million in 1991. The effective tax rate was 31.4% in 1993, 30.1% in 1992 and 28.3% in 1991. The effective tax rate rose in 1993 due to a 1% increase in the federal corporate tax rate. Additionally, in both 1993 and 1992, a lower level of tax-exempt municipal interest income served to increase the effective tax rate. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". Statement No. 109 changes the method of accounting for income taxes from the deferral method to the asset and liability approach. Under previous rules, the tax effects of timing differences between financial reporting and taxable income were deferred. Under Statement No. 109, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Enacted tax rates expected to apply to taxable income in years in which those temporary differences are expected to be recovered or settled are used. Firstar adopted Statement No. 109 in 1993. The cumulative effect on earnings of adoption resulted in an increase to earnings of $2.3 million and is reported as a component of the provision for income taxes. BALANCE SHEET ANALYSIS Changes in the balance sheet of a financial institution reflect both the forces of the marketplace and the company's response to these conditions. Firstar's strategy in managing balance sheet growth is based upon the goals of enhancing soundness and providing a broad range of services for customers. Total assets at the end of 1993 reached $13.8 billion, an increase of $625 million or 4.7% over a year earlier. Average total assets for 1993 were $12.9 billion, an increase of 5.6% over 1992. Table 6 shows the geographic distribution of Firstar's banking assets. Firstar has expanded beyond its Wisconsin base through select acquisitions. Assets outside of Wisconsin now represent 36% of consolidated assets. Firstar's acquisition activity will focus on attractive markets in the upper Midwest that will complement the existing Firstar banking network. The combination of internal growth and acquisitions provides new opportunities to build and diversify Firstar's earnings within an economically stable region. TABLE 6 SUBSIDIARY AVERAGE ASSETS LOANS AND INVESTMENTS Earning assets, shown in Table 7, averaged $11.5 billion, an increase of $620 million, or 5.7% over 1992. Loans, the largest category of earning assets, represented 72.7% of earning assets as compared to 70.4% in 1992. On average, loans totaled $8.3 billion, an increase of $698 million or 9.1% over 1992. Excluding the impact of loans added through bank acquisitions, average loans grew by 5.1%. TABLE 7 AVERAGE EARNING ASSETS - ----------- *Comparable data not available Commercial loans, which account for 59% of the loan portfolio, increased by $417 million, or 9.2% on average, to $4.9 billion during 1993. Excluding bank acquisitions which occurred during the past two years, commercial loans have increased by 7.0%. This represents a significant change from 1992 where internally generated loan growth was just over 1%. The Wisconsin banks have experienced commercial loan growth of over 9% during 1993 while the Iowa banks' commercial loans rose by 4%. Consumer loans averaged $3.4 billion, an increase of $281 million, or 9.0% over 1992. Acquisitions added $212 million of this increase. Consumer loans rose by 2.3% excluding this factor. The level of credit card loans outstanding has declined during the last two years. Average balances were 3.8% lower in 1993 compared to 1992 which in turn was 8.0% lower than 1991. This trend is in part due to increased competitive pressures from new card issuers. Also a factor has been consumers' reluctance to increase personal debt combined with the opportunity afforded consumers to convert unsecured consumer debt to home equity secured loans at a much lower interest rate. Short-term investments, which include interest-bearing deposits with banks, trading account securities, and federal funds sold and resale agreements, averaged $198 million in 1993, a decrease of $162 million, or 45.0%, from a year earlier. This decrease in part funded the increased loan demand. Investment securities represent 26% of earning assets. They averaged $2.9 billion during 1993, an increase of $84 million, or 3.0% over 1992. Tables 8 and 9 show the maturity range and changing mix of the investment portfolio. The average maturity of the portfolio was 2.2 years at the end of 1993. Current low interest rates do not make it advantageous to purchase longer maturity securities. TABLE 8 MATURITY RANGE AND AVERAGE YIELD OF INVESTMENT SECURITIES - ----------- Rates are calculated on a taxable-equivalent basis using a tax rate of 35%. The maturity information on mortgage-backed obligations is based on anticipated payments. The Financial Accounting Standards Board issued in 1993, Statement No. 115 "Accounting for Certain Investments in Debt and Equity Securities". This statement established categories of investment securities which include held to maturity and available for sale. The latter securities are carried at market value and the former at amortized cost. Firstar adopted Statement No. 115 as of December 31, 1993. Firstar reviewed its investment policy and goals in conjunction with the statement and has classified its entire portfolio as to be held to maturity. Future purchases of securities may be classified as available for sale. TABLE 9 INVESTMENT SECURITIES FUND SOURCES Average fund sources, consisting of deposits and borrowed funds, increased by $532 million, or 4.9%, to $11.5 billion in 1993. Total deposits averaged $10.5 billion, an increase of $416 million, or 4.1% over 1992. Bank acquisitions accounted for the deposit growth. A change in the mix of deposits has occurred as customers have moved deposits to passbook and demand accounts to maintain liquidity. A future consequence of this movement of deposits may be an increased sensitivity to rising interest rates if these deposits flow back to term certificates or nonbank investment alternatives. The changing relationships of fund sources are shown in Table 10. TABLE 10 AVERAGE FUND SOURCES Core deposits, which include transaction accounts and consumer deposits, are Firstar's predominant and most stable source of funds. These deposits equaled $9.6 billion, an increase of $439 million, or 4.8% over 1992. Core deposits represent 84% of average fund sources. Firstar's expanding member bank network allows it to attract core deposits from its many markets. Commercial deposits were reduced by $22 million on average which was offset by increased levels of short-term borrowed funds which rose by $130 million. The net increase in non-core deposit funds was used to meet the increased loan demand of Firstar's customers. CREDIT RISK MANAGEMENT Since the mid-1980's, credit management has been refined through procedural and personnel changes. Emphasis on credit quality standards and diversification of risk have been key strategies. The benefits of this program are seen in the significant reductions in nonperforming assets and overall credit quality achieved during the past several years. During this period nonperforming assets as a percentage of loans and other real estate have declined from 1.87% in 1990 to .72% at the end of 1993. Put in perspective of Firstar's peer group of banks, this placed Firstar near the top 10% for asset quality. Nonperforming assets consist of loans that are not accruing interest, loans with renegotiated credit terms and collateral acquired in settlement of nonperforming loans. The composition of these assets is shown in Table 11. These nonperforming assets totaled $64.9 million at December 31, 1993 and represented .72% of Firstar's $9.0 billion of loans and other real estate. This is a $23.9 million, or 27%, reduction from a year earlier. TABLE 11 NONPERFORMING ASSETS AND PAST DUE LOANS - -------- *Nonperforming loans which were included in other real estate under "in substance foreclosure" accounting rules were $10.5 million, $10.5 million, and $5.0 million at December 31, 1992, 1991 and 1990, respectively. Such "in substance foreclosed" loans were reclassified to loans in 1993. Commercial real estate related nonperforming assets totaled $36.4 million at the end of 1993, a reduction of 33% from a year earlier. These nonperforming assets represented 1.86% of their respective loan category. Firstar experienced an increase in real estate related nonperforming assets several years ago, although to a much lesser extent than many other financial institutions. These assets reached a high of $93.7 million at the end of 1990. As can be seen, significant progress has been made in reducing this category of nonperforming assets. The remaining commercial loan portfolio had a nonperforming asset ratio of .66%, down from .89% a year earlier. This is reflective of the overall financial strength of Firstar's commercial borrowers. Nonperforming consumer loans have also declined from previously higher levels. At year-end 1993, they represented a very minimal .17% of outstandings. While further reductions of nonperforming assets may not be likely, the attainment of this low level is an indication of Firstar's overall high asset quality. It is Firstar's goal to remain within the top 25% of its peer group in asset quality measures. Loans ninety days or more past due on December 31, 1993, totaled $21.8 million, compared with $20.6 million a year earlier. These loans are on a full accrual basis and are judged by management to be collectible in full. In addition, Firstar had $23 million of loans at December 31, 1993, on which interest is accruing, but, because of existing economic conditions or circumstances of the borrower, doubts exist as to the ability of the borrower to comply with the present loan terms. While these loans are identified as requiring additional monitoring, they do not necessarily represent future nonperforming assets. Additional indicators of asset quality can be found in the geographic distribution, industry diversification and type of lending represented in the loan portfolio. Credit policies have been changed over the past several years to reduce vulnerability to potential adverse economic trends. Marketing efforts have been directed to Firstar's primary market segments which are consumer, small business and middle market customers in communities where Firstar banks are located. This emphasis on smaller, locally based credits brings with it a diversified group of customers without any significant industry concentration. Firstar does not participate in any significant syndicated lending or highly leveraged transactions. Commercial real estate lending includes construction loans, income property loans and other commercial loans where real estate is involved as collateral. Midwestern real estate did not experience the rapid price appreciation that occurred in other areas, spurring over-investment in development projects and subsequent collapse of demand. Consequently, the earlier recessionary economy has not put as much pressure on some of Firstar's borrowers. Policy limits control this type of lending. Approximately sixty percent of these loans represent owner-occupied commercial properties. The remaining portion involves loans to developers and investors. The average loan size in the developer portion of the portfolio was $260,000 and reflects the regional focus and customer diversification of the portfolio. The reserve for loan losses is reviewed and adjusted quarterly, subject to evaluation of economic conditions and expectations, historical experience and the risk rating of individual loans. Table 12 shows the activity affecting the reserve for loan losses for the last five years. The reserve totaled $174.9 million at the end of 1993, compared with $168.5 million a year earlier. Total net charge-offs of $20.7 million represented .25% of average loans during 1993, a reduction of 37.6% from 1992. This places Firstar among the lowest charge-off levels in its peer group. This compares with charge-offs of $33.1 million or .43% of loans during 1992 and $34.3 million or a .47% charge- off level during 1991. Not included in these charge-off totals, but nevertheless associated with the credit loss, were additional writedowns or losses on other real estate of $.8 million in 1993, $1.3 million in 1992 and $8.3 million in 1991. As a regional financial institution, Firstar lends to a diversified group of Midwestern borrowers and, to a much lesser degree, to national companies with Midwest operations. Net charge-offs in this commercial segment of the portfolio were $6.1 million in 1993, or .20% of average loans. This compares with $11.8 million of net charge-offs in 1992, representing .42% of loans. This level of charge-offs is significantly lower than prior years and again, is reflective of the economic strength of the marketplace and Firstar's lending policies. Commercial real estate loans net charge-offs also declined in 1993 and represented a nominal .03% of outstandings. This level compares with .16% in 1992 and the high of .78% during 1990. The loan charge-off levels within this category result from both the improved economy and earlier periods' recognition of losses by Firstar. Future charge-off levels should not differ significantly from Firstar's overall non-real estate commercial lending experience. TABLE 12 RESERVE FOR LOAN LOSSES Consumer lending includes loans to individuals in communities served by Firstar's banks. These loans include both open-ended credit arrangements subject to an overall limit per customer, such as credit card and home equity loans, and closed-end loans subject to specific contractual payment schedules, such as installment loans and residential mortgages. Consumer net charge-offs were $14.6 million in 1993, compared with $19.1 million in 1992 and $24.4 million in 1991. The net charge-offs of .43% in 1993 compares with .61% and .84% in 1992 and 1991, respectively. Credit card net charge-offs have declined from 2.90% in 1991 to 2.17% during 1993 reflecting both lower charge-offs and higher recovery rates. This progressive reduction in consumer charge-off levels reinforces the conclusion about the economic strength of Firstar's marketplace. Consumer net charge-offs for 1993 are, in fact, at a seven year low. Consumer charge-offs are expected to remain at or near this level. TABLE 13 COMPOSITION OF LOANS - ----------- *Comparable data not available The Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan", which is effective in 1995. The statement establishes procedures for determining the appropriate reserve for loan losses for loans deemed impaired. The calculation of reserve levels would be based upon the discounted present value of expected cash flows received from the debtor or other measures of value such as market prices or collateral values. The adoption of this statement should not have any significant impact on the current level of the reserve for loan losses or operating results. LIQUIDITY AND INTEREST RATE RISK MANAGEMENT Two objectives of Firstar's asset and liability management strategy include the maintenance of appropriate liquidity and management of interest rate risk. Liquidity management aligns sources and uses of funds to meet the cash flow requirements of customers and Firstar. Interest rate risk management seeks to generate growth in net interest revenue and manage exposure to risks associated with interest rate movements and provide for acceptable and predictable results. Although conceptually distinct, liquidity and interest rate sensitivity must be managed together since action taken with respect to one often influences the other. The scheduled maturity of loans can provide a source of asset liquidity. Table 14 shows the range of loan maturities as of December 31, 1993. Short- term investments, such as federal funds, repurchase agreements and interest- bearing deposits, are another source of liquidity. These investments stood at $287 million at the end of 1993. The investment securities portfolio provides liquidity through scheduled maturities, as shown in Table 8, and the ability to use these securities in borrowing transactions. TABLE 14 MATURITY DISTRIBUTION OF LOANS - -------- Of the above loans due after one year, $3,903,916,000 have predetermined interest rates and $1,636,845,000 have floating or adjustable interest rates. TABLE 15 MATURITY RANGE OF TIME DEPOSITS The requirement for liquidity is diminished by the predominance of core deposits, which account for 84% of Firstar's fund sources. Stable core deposits do not require significant amounts of liquidity to meet the net withdrawal demands of customers on a short or intermediate term basis. Other sources of liquidity are short-term borrowed funds and commercial time deposits, which totaled $2.1 billion at the end of 1993 and consist primarily of funds from customers who use other Firstar services. Firstar's ability to refinance maturing amounts and, when necessary, increase this funding base is a significant factor in its liquidity management. The absolute level and volatility of interest rates can have a significant impact on earnings. The objective of interest risk management is to identify and manage the sensitivity of net interest revenue to changing interest rates. Firstar's Asset-Liability Committee has established a guideline which limits to 5% the amount of earnings that may be placed at risk over the next twelve months if interest rates move unexpectedly within certain ranges. To ensure compliance with these risk limits, the committee regularly monitors the level of sensitivity. At the end of 1993 Firstar's forecast for 1994 net interest revenue indicated that its position was well within this limit. Firstar uses simulation modeling as the primary tool in measuring interest rate risk and managing interest rate sensitivity. Simulation modeling incorporates the dynamics of changing balance sheet mix, interest rate movements and the related impact on net interest revenue. This simulation testing is done over a one-year and two-year time horizon. The simulation model is supplemented with a more traditional tool used in the banking industry for measurement of interest rate risk known as the gap analysis. This measures the difference between assets and liabilities repricing or maturing within specified time periods. The gap analysis does however, have some limitations such as not reflecting degree of rate sensitivity in a given financial instrument. A positive gap indicates that there are more rate sensitive assets than rate sensitive liabilities repricing within a given time frame. A positive gap would generally imply a favorable impact on net income in periods of rising rates. Conversely, a negative gap indicates a liability sensitive position. Table 16 shows Firstar's interest sensitivity under a traditional gap approach. TABLE 16 ASSET AND LIABILITY INTEREST SENSITIVITY DECEMBER 31, 1993 Interest rate sensitivity can be managed by adjusting the mix of assets and liabilities. Where this is not practical or cost effective, off-balance sheet instruments can be utilized. Firstar uses interest rate swaps, caps and floors in this process. The use of these instruments allows Firstar to change interest rate sensitivity while retaining the ability to offer products that satisfy customer needs. Interest rate instruments have been used to alter the rate characteristics of both loans and deposits. Table 17 shows information on interest rate risk management instruments in effect at the end of 1993. The notional amount of these agreements was $1.3 billion. Additionally, Firstar has $1.3 billion of interest rate instruments for which it serves as an intermediary for customers. Notional principal amounts are the basis for the exchange of interest payments. Under a typical interest rate swap agreement, one party pays a fixed rate of interest on a notional amount to a second party, which in turn pays the first party a variable rate of interest on the same notional amount. Interest rate caps and floors require one party to pay another party if a variable interest rate is above or below a preset level. The net cash flow exchanged in these transactions increased net interest margin by five basis points in 1993. These off balance sheet transactions were constructed as hedges of existing balance sheet items and, to the extent that the hedges were effective, they served to offset reductions in the net interest margin associated with the hedged balances. Firstar's simulation modeling indicated a modest vulnerability to 1994's net interest margin if interest rates would decline from current levels. The interest rate instruments in effect at year-end 1993 were constructed to contribute approximately seven basis points to net interest margin in a low rate scenario. The low rate scenario assumed a reduction of the prime interest rate from the current 6% level to 4.75% by the end of the year. The modeling indicates that this contribution from interest rate instruments will decline as rates increase. This reduced impact however, would be offset by wider spreads between earning asset rates and deposit rates. Therefore, a gradual increase in interest rates should not adversely impact Firstar's net interest revenue. TABLE 17 INTEREST RATE RISK MANAGEMENT INSTRUMENTS DECEMBER 31, 1993 - -------- (1) Rate paid varies primarily with the three month LIBOR rate (2) Rate received varies primarily with the Federal funds rate (3) Rate received includes a fixed spread over three month LIBOR with limitations on periodic increases (4) Receipt of payments start if the three month LIBOR rate exceeds a weighted average rate of 3.92% (5) Receipt of payments start if the three month LIBOR rate is below a weighted average rate of 4.67% CAPITAL Total stockholders' equity increased 10.3% to $1.16 billion as of December 31, 1993. Stockholders' equity represented 8.38% of total assets at the end of 1993 compared to 7.96% a year earlier. Firstar redeemed its adjustable rate preferred stock at the end of 1993 at a price of $103 per share, or $51.5 million. This action removed a higher cost equity component. Dividends paid to common stockholders totaled $63.7 million, or $1.00 per share, a 25% increase over 1992. This represented a 32% payout of net income for 1993. It is Firstar's target to maintain a dividend payout level approximately equal to the median of its peer group. Bank regulatory agencies have established capital adequacy standards which are used extensively in their monitoring and control of the industry. These standards relate capital to level of risk by assigning different weightings to assets and certain off-balance sheet activity. Capital is measured by two risk- based ratios: Tier I capital and total capital, which includes Tier II capital. The rules require that companies have minimum ratios of 4% and 8% for Tier I and total capital, respectively. As of December 31, 1993, Firstar had Tier I capital of 11.08% and total capital of 13.18%, significantly exceeding regulatory minimum standards. The components of these capital levels are shown in Table 18. Additionally, a Tier I leverage ratio is also used by bank regulators as another measure of capital strength. This ratio compares Tier I capital to total reported assets reduced by goodwill. The regulatory minimum level of this ratio is 3%, and it acts as a constraint on the degree to which a company can leverage its equity base. Firstar's Tier I leverage ratio was 8.30% at December 31, 1993. The Federal Deposit Insurance Corporation Improvement Act of 1991 provided additional guidance that considers capital levels and other factors. The guidelines established five supervisory groupings of capital adequacy. Firstar is considered "well capitalized" which is the highest group. Maintaining a strong capital position is important to Firstar's long-term strategies which emphasize soundness, profitability and growth. Higher capital levels contribute to overall financial soundness as a cushion against cyclical economic trends which can effect the banking industry. Strong capital levels also will permit future growth through both internal asset generation and bank acquisitions. TABLE 18 CAPITAL COMPONENTS AND RATIOS ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FIRSTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS - ----------- The average balances are not covered by the Independent Auditors' Report. See accompanying notes to consolidated financial statements. FIRSTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME See accompanying notes to consolidated financial statements. FIRSTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY See accompanying notes to consolidated financial statements. FIRSTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements. FIRSTAR CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The significant accounting policies of Firstar Corporation and its subsidiaries are summarized as follows: Principles of consolidation--The consolidated financial statements include the accounts of Firstar and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Results of operations of companies purchased are included from the date of acquisition. Financial statements have been restated to include companies acquired under pooling of interests when material. Certain prior year amounts have been reclassified to conform to current year classifications. Securities--Purchases of investment securities are made with the intent and ability to hold them to maturity and are carried at cost, adjusted for amortization of premium and accretion of discount using a level yield method. Gains or losses on sales of investment securities are computed on the basis of specific identification of the adjusted cost of each security. Securities to be held for indefinite periods of time and not intended to be held to maturity or on a long-term basis are classified as available for sale and carried at market value. Securities held for indefinite periods of time may include securities that management intends to use as part of its asset/liability management strategy or have been acquired in business acquisitions and are designated to be sold. Trading account securities are carried at market. Valuation adjustments are included in other revenue in the consolidated statements of income. Loans--Loans, which include lease financing receivables, are stated at the principal amount. Interest is accrued on all loans not discounted by applying the interest rate to the amount outstanding. On discounted loans, income is recognized on a basis which results in approximately level rates of return over the term of the loans. Loan origination and commitment fees and certain direct loan origination costs are being deferred where material and the net amount amortized as an adjustment of the related loans' yield. These amounts are being amortized over the contractual life of the related loans. Where it is not reasonable to expect that income will be realized, accrual of income ceases and these loans are placed on a "cash basis" for purposes of income recognition. Loans upon which foreclosure action is commenced or for which borrowers have begun bankruptcy proceedings are reviewed individually as to continuation of interest accrual. Mortgage loans held for sale are carried at the lower of aggregate cost or market, after consideration of related loan sale commitments. Reserve for loan losses--The reserve for loan losses is maintained at a level adequate to provide for potential loan losses through charges to operating expense. The reserve is based upon a continuing review of loans which includes consideration of actual net loan loss experience, changes in the size and character of the loan portfolio, identification of problem situations which may affect the borrowers' ability to repay and evaluation of current economic conditions. Loan losses are recognized through charges to the reserve. Installment and credit card loan losses are charged to the reserve based upon fixed delinquency periods. All other loans are evaluated individually and charged to the reserve to the extent that outstanding principal balances are deemed uncollectible. Any subsequent recoveries are added to the reserve. Other real estate--Other real estate, the balance of which is included in other assets, includes primarily properties acquired through loan foreclosure proceedings or acceptance of deeds in lieu of foreclosure. These properties are recorded at the lower of the carrying value of the related loans or the fair market value of the real estate acquired less the estimated costs to sell the real estate. Initial valuation adjustments, if any, are charged against the reserve for loans losses. Subsequent revaluations of the properties, which indicate reduced value, are recognized through charges to operations. Revenues and expenditures related to holding and operating these properties are included in other operating expense. Bank premises and equipment--Bank premises and equipment are stated at cost less depreciation, which has been accumulated on the straight-line basis. Intangible assets--Intangible assets attributable to the value of core deposits and goodwill acquired are included in other assets and are amortized over fifteen to twenty-five years, on a straight-line basis. The value of mortgage servicing rights acquired is amortized in relation to the servicing revenue expected to be earned. Income taxes--Firstar and its subsidiaries file a consolidated federal income tax return. The effect of items of income and expense that are recognized for financial reporting purposes in periods other than those in which they are recognized for tax purposes are reflected as a current or deferred tax asset or liability based on current tax laws. Accordingly, income taxes provided in the consolidated statements of income include charges or credits for deferred income taxes related to temporary differences. Foreign currency translation--Monetary assets and liabilities recorded in foreign currencies are translated at the rate of exchange in effect at each year-end. Income statement items are translated monthly using the average rate for the month. Exchange adjustments, including gain or loss on forward exchange contracts, are charged or credited to income currently. Cash and cash equivalents--For purposes of the consolidated statements of cash flows, cash and cash equivalents are considered to include the balance sheet caption cash and due from banks. Interest rate swaps and other agreements--Firstar enters into interest rate swaps and other agreements to manage its interest rate exposure and to serve as a financial intermediary for matched transactions. Transactions designated as hedges of assets or liabilities are recorded using the accrual method and settlements are classified as interest income or expense in the consolidated statements of income according to the type of earning assets or interest bearing liability that the agreement hedges. Fee income from matched transactions for which Firstar serves as a financial intermediary is recognized over the lives of the related agreements and is classified as other income in the consolidated statements of income. Income per common share--Net income per common share is based on the weighted average number of shares of common stock outstanding during each year, after giving effect to common stock splits and the amortization of restricted stock. The weighted average shares were 63,747,000 in 1993, 61,879,000 in 1992 and 60,998,000 in 1991. For calculation purposes, earnings are reduced by preferred stock dividends. Common stock equivalents are not significant in any year presented. NOTE 2. MERGERS AND ACQUISITIONS The following table summarizes completed acquisitions: The effect of the four 1993 and 1992 bank acquisitions, accounted for as pooling of interests, was not material to prior years' reported operating results and, accordingly, previously reported results have not been restated. In 1994 Firstar announced a merger agreement with First Southeast Banking Corp., a $423 million bank holding company in Lake Geneva, WI. The transaction will be accounted for as a pooling of interests with the issuance of 1,807,577 shares of Firstar common stock. NOTE 3. INTANGIBLE ASSETS Intangible assets, net of accumulated amortization, are summarized as follows: Firstar recorded additional amortization of mortgage servicing rights in the amount of $3,088,000 in 1993 and $6,500,000 in 1992 due to increased prepayment rates on serviced loans. NOTE 4. INVESTMENT SECURITIES The amortized cost and approximate market values of investment securities are as follows: The amortized cost and approximate market value of investment securities at December 31, 1993, by contractual maturity, are shown below. Maturities of mortgage backed obligations were estimated based on anticipated payments. Securities held for sale at December 31, 1992 were $21.0 million. Gross gains of $232,000, $1,106,000 and $1,644,000 and gross losses of $50,000, $125,000 and $25,000 were realized on investment securities sales in 1993, 1992 and 1991, respectively. The amortized cost of investment securities pledged to secure public or trust deposits, securities sold under repurchase agreements and for other purposes as required or permitted by law was $712,696,000 at December 31, 1993 and $598,983,000 at December 31, 1992. The Financial Accounting Standards Board issued Statement No. 115 "Accounting for Certain Investments in Debt and Equity Securities". This statement established categories of investment securities that include securities that are held to maturity and securities that are available for sale. Firstar adopted Statement No. 115 on December 31, 1993. None of Firstar's current investment portfolio is classified as available for sale. NOTE 5. LOANS The composition of loans, including lease financing receivables, is summarized below. Loans are presented net of unearned discount which amounted to $10,938,000 and $15,432,000 at December 31, 1993 and 1992, respectively. Commercial loans pledged to secure public deposits were $15,444,000 on December 31, 1993 and $21,676,000 on December 31, 1992. Firstar serviced $2,045 million, $1,672 million and $1,407 million of mortgage loans for other investors as of December 31, 1993, 1992 and 1991, respectively. Residential mortgage loans held for resale were $229,250,000 and $177,107,000 on December 31, 1993 and 1992, respectively. Loans on which income is recognized only as cash payments are received or is accrued at less than the original contract rate are summarized below. Nonperforming loans which were classified as "in substance foreclosure" and included in other real estate were $10.5 million at both December 31, 1992 and 1991. Such "in substance foreclosed" loans were reclassified to loans in 1993. The Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan", which is effective in 1995. The statement establishes procedures for determining the appropriate reserve for loan losses for loans deemed impaired. The calculation of reserve levels would be based upon the discounted present value of expected cash flows received from the debtor or other measures of value such as market prices or collateral values. The adoption of this statement should not have any significant impact on the current level of the reserve for loan losses or operating results. NOTE 7. BANK PREMISES AND EQUIPMENT Bank premises and equipment are summarized as follows: Depreciation charged to other operating expense amounted to $34,385,000, $33,418,000 and $31,252,000 in 1993, 1992 and 1991, respectively. Rental expense for bank premises and equipment amounted to $30,079,000, $28,843,000 and $26,896,000 in 1993, 1992 and 1991, respectively. Contingent rentals and sublease rental income amounts were not significant. Occupancy expense is net of amortization of a total of $68 million of pre-tax deferred gain on a building sale which is being amortized through 1997, at which time the related leaseback expires. This amortization was $6,312,000 in 1993, 1992, and 1991. Firstar and its subsidiaries are obligated under noncancellable operating leases for various bank premises and equipment. These leases expire intermittently over the years through 2034. The minimum rental commitments under noncancellable leases for the next five years are shown below. NOTE 8. SHORT-TERM BORROWED FUNDS Short-term borrowed funds are summarized as follows: Federal funds purchased, which totaled $675 million at December 31, 1993, generally represent one-day borrowings obtained primarily from financial institutions in Firstar's marketplace in conjunction with their customer correspondent relationships with the subsidiary banks. Securities sold under repurchase agreements, which totaled $357 million at December 31, 1993, represent borrowings maturing within one year that are secured by U.S. Treasury and federal agency securities. Other short-term borrowed funds comprise primarily treasury, tax and loan notes. NOTE 9. LONG-TERM DEBT Long-term debt is summarized as follows: Firstar issued $100,000,000 of 10 1/4% notes under an indenture dated as of May 1, 1988. The notes, which are subordinated to all unsubordinated indebtedness of Firstar for borrowed money, are unsecured and mature May 1, 1998. The indenture contains a provision which restricts the disposition of or subjecting to lien any common stock of certain subsidiaries. Firstar issued $50,000,000 of 10% notes under an indenture dated as of June 1, 1986. The notes are unsecured and mature June 1, 1996. The indenture contains a provision which restricts the disposition of or subjecting to lien any common stock of certain subsidiaries. The convertible notes matured in 1993 and were converted into 502,959 shares of Firstar common stock. The Federal Home Loan Bank advances were repaid in 1993. Other debt at December 31, 1993 includes debentures of $757,000 which bear interest at 12% and mature in 1994 and notes of $2,706,000 which bear interest at 11.50% and mature in 1996. Long-term debt has aggregate maturities for the five years 1994 through 1998 as follows: $832,000 in 1994, $75,000 in 1995, $46,906,000 in 1996 and $78,462,000 in 1998. Firstar has repurchased portions of the 10 1/4% and 10% notes and incurred losses of $57,000, $605,000, $943,000 in 1993, 1992 and 1991, respectively. NOTE 10. STOCKHOLDERS' EQUITY The authorized and outstanding shares of Firstar are as follows: In June 1986 Firstar issued 500,000 shares of adjustable rate cumulative preferred stock, series B. Firstar Corporation redeemed all of its series B preferred stock on December 29, 1993 at $103 per share plus accrued dividends. Dividends deducted from net income for purposes of determining net income applicable to common stockholders were $3,266,000 in 1993, $3,747,000 in 1992, and $4,054,000 in 1991. In January 1989 Firstar adopted a shareholder rights plan. Under the rights plan each share of common stock entitles its holder to one-half right. Under certain conditions, each right entitles the holder to purchase one one- hundredth of a share of series C preferred stock at a price of $85, subject to adjustment. The rights will only be exercisable if a person or group has acquired, or announced an intention to acquire, 20% or more of the outstanding shares of Firstar common stock. Under certain circumstances, including the existence of a 20% acquiring party, each holder of a right, other than the acquiring party, will be entitled to purchase at the exercise price Firstar common shares having a market value of two times the exercise price. In the event of the acquisition of Firstar by another company subsequent to a party acquiring 20% or more of Firstar common stock, each holder of a right is entitled to receive the acquiring company's common shares having a market value of two times the exercise price. The rights may be redeemed at a price of $.01 per right prior to the existence of a 20% acquiring party, and thereafter, may be exchanged for one common share per right prior to the existence of a 50% acquiring party. The rights will expire on January 19, 1999. The rights do not have voting or dividend rights and until they become exercisable, have no dilutive effect on the earnings of Firstar. Under the rights plan, the Board of Directors of Firstar may reduce the thresholds applicable to the rights from 20% to not less than 10%. Preferred shares, when issued, rank prior to common shares both as to dividends and liquidation but have no general voting rights. The series C preferred stock, none of which is outstanding, is entitled to 100 votes per share and other rights such that the value of a one one-hundredth interest in a series C preferred share should approximate the value of one common share. In conjunction with long-term incentive plans, 30,235 shares of restricted common stock are being held in escrow for executive officers as of December 31, 1993. The shares cannot be sold prior to the end of a three-year period and are subject to adjustment in accordance with the terms of the award. NOTE 11. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS Firstar has an incentive stock plan that provides for a maximum grant of 2,600,000 stock options, stock appreciation rights and/or shares of stock. The options expire ten years and one month after the date of grant. The following table summarizes option activity under these plans: At December 31, 1993, options to acquire 797,884 shares were exercisable. In 1994 options to acquire 368,900 shares of common stock at $30.88 to $31.25 per share were issued. Under stock appreciation rights plans, rights were granted to certain officers of Firstar and its subsidiaries. The rights entitled holders to receive shares of Firstar common stock and cash pursuant to a formula based upon the market performance of the stock. All remaining rights matured in 1992. Firstar accrued as compensation expense a percentage of net market appreciation based on the number of years from origination. Compensation amounting to $182,000 and $1,761,000 was recognized by Firstar in accordance with this method in 1992 and 1991, respectively. No additional rights will be awarded under these plans. NOTE 12. OTHER OPERATING REVENUE AND EXPENSE A summary of other operating revenue is as follows: NOTE 13. EMPLOYEE BENEFIT PLANS Firstar and its subsidiaries have non-contributory defined benefit pension plans covering substantially all employees. The benefits are based upon years of service and the employee's compensation during the last five years of employment. The funding policy is to contribute annually the minimum amount necessary to satisfy federal minimum funding standards. Plan assets are primarily invested in listed stocks and U.S. Treasury and federal agency securities. The table below summarizes data relative to the plans. Firstar has a profit sharing plan under which eligible employees can participate by contributing a portion of their salary for investment in one or more trust funds. Contributions are made to the account of each participant based upon profitability or at the discretion of the board of directors. Amounts expensed in connection with this plan were $9,667,000 in 1993, $8,539,000 in 1992 and $7,167,000 in 1991. In addition to pension benefits, certain health care benefits are made available to active and retired employees. Firstar adopted Statement of Financial Accounting Standards No. 106, "Accounting for Postretirement Benefits Other Than Pensions" in 1993. The statement requires employers to recognize postretirement benefits on an accrual basis over employee service periods as contrasted with the expensed-as- incurred method of accounting. The implementation of this statement resulted in a net increase of $7.0 million in annual costs in 1993. The table below summarizes data relative to this benefit program. The program is unfunded and the transition obligation is being amortized over 20 years. For measurement purposes, a 12% annual rate of increase in the per capita cost of covered health care benefits was assumed, decreasing to 7% by 2008 and remaining at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement accumulated benefit obligation by $11,915,000 and the aggregate of the service and interest cost components of net postretirement benefit cost by $1,785,000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.75%. NOTE 14. INCOME TAXES Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes", was issued by the Financial Accounting Standards Board in February 1992 and adopted by Firstar on January 1, 1993. Statement 109 requires a change from the income statement approach under APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of Statement 109, deferred income taxes 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 those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. The taxes applicable to net income were as follows: Income tax expense differed from the amount computed by applying the federal statutory rate of 35% in 1993 and 34% in 1992 and 1991 to income before taxes as a result of the following: The significant components of deferred income tax expense are as follows: For the years ended December 31, 1992 and 1991, deferred income tax benefits of $10,061,000 and $5,526,000, respectively, resulted from timing differences in the recognition of income and expense for income tax and financial reporting purposes. The sources and tax effects of those timing differences are presented below: The significant components of the net deferred tax asset were as follows: The valuation allowance for deferred tax assets as of January 1, 1993 was $13,991,000. The net change in the valuation allowance for the year ended December 31, 1993 was an increase of $195,000. The valuation allowance has been recognized primarily to offset deferred tax assets related to state net operating loss carryforwards of subsidiaries totaling approximately $156,000,000 which expire at various times within the next 15 years. If realized, the tax benefit for these items will reduce current tax expense for that period. Other assets include net deferred income tax charges of $76,477,000 at December 31, 1993 and $61,315,000 at December 31, 1992. NOTE 15. COMMITMENTS AND CONTINGENT LIABILITIES Firstar is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, commitments to sell mortgages, contracts to buy or sell securities and foreign currency, mortgage loans sold with recourse, interest rate caps and floors written and interest rate swaps. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement Firstar has in particular classes of financial instruments. Firstar's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, commitments to sell mortgages, contracts to buy or sell investment securities and foreign currency, mortgage loans sold with recourse and standby letters of credit is represented by the contractual notional amount of those instruments. Firstar uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Firstar evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management's credit evaluation of the party. For interest rate caps, floors and swap transactions, the contract or notional amounts do not represent exposure to credit loss. Firstar controls the credit risk of its interest rate agreements through credit approvals, limits and monitoring procedures. A summary of significant off-balance sheet financial agreements at December 31, 1993 and 1992 follows: Commitments to extend credit are agreements to lend to a customer as long as there is not a violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Credit card commitments are unsecured agreements to extend credit. Such commitments are reviewed periodically, at which time the commitments may be maintained, increased, decreased or canceled depending upon evaluation of the customer's credit worthiness and other considerations. Standby and commercial letters of credit are conditional commitments issued by Firstar to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Firstar originates and sells residential mortgage loans as a part of various mortgage-backed security programs sponsored by United States government agencies or government-sponsored agencies, such as the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association and the Government National Mortgage Association. These sales are often subject to certain recourse provisions in the event of default by the borrower. Other financial instruments include agreements to purchase or sell investment securities and agreements to purchase or sell foreign currency. Firstar enters into both mandatory and optional commitments to sell groups of residential mortgage loans that it originates or purchases as part of its mortgage banking activities. Firstar commits to sell the loans at specified prices in a future period typically within 90 days. The risk associated with these commitments consists primarily of loans not closing in sufficient volumes and at appropriate yields to meet the sale commitments. Firstar enters into interest rate swaps, caps, and floors to hedge its own interest rate risk and to act as an intermediary on behalf of its customers. Under a typical swap agreement, one party pays a fixed rate of interest on a notional amount to a second party who in turn pays a variable rate of interest on the same notional amount. Credit risk associated with interest rate swaps is dependent upon the ability of the counterparty to perform its payment obligation under the agreement. Firstar performs normal credit reviews on its swap counterparties. Where Firstar acts as an intermediary for customers, it enters into positions that essentially offset one another. Firstar and its subsidiaries are subject to various legal actions and proceedings in the normal course of business, some of which involve substantial claims for compensatory or punitive damages. Although litigation is subject to many uncertainties and the ultimate exposure with respect to these matters cannot be ascertained, management does not believe that the final outcome will have a material adverse effect on the financial condition of Firstar. NOTE 16. REGULATORY RESTRICTIONS ON SUBSIDIARY DIVIDENDS AND CASH Federal regulations require Firstar to maintain as reserves, minimum cash balances based on deposit levels at subsidiary banks. Cash balances restricted from usage due to these requirements were $267 million and $238 million at December 31, 1993 and 1992, respectively. Firstar's subsidiary banks are restricted by regulation as to the amount of funds which can be transferred to the parent in the form of loans and dividends. As of December 31, 1993, $117 million could be loaned to Firstar by the subsidiary banks subject to strict collateral requirements, and $216 million could be paid to Firstar by the subsidiary banks in the form of dividends. In addition each subsidiary bank could pay dividends to Firstar in an amount which approximates Firstar's equity in their 1994 net income. The payment of dividends by any subsidiary bank may also be affected by other factors beyond this regulatory limitation, such as maintenance of adequate capital for such subsidiary bank. NOTE 17. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments", requires that Firstar disclose estimated fair values for its financial instruments. Fair value estimates were based on relevant market data and information about the various financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time Firstar's entire holdings of a particular financial instrument. Because no market exists for a significant portion of Firstar's financial instruments, fair value estimates are based on judgements regarding current economic conditions, risk characteristics of various financial instruments, future expected loss experience and other factors. These estimates are subjective and involve uncertainties and matters of significant judgement and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on and off balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities which are not considered financial instruments. Significant assets that are not considered financial instruments include goodwill, core deposit intangibles, certain customer relationships and fixed assets. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered. Fair value estimates, methods and assumptions are set forth below for Firstar's financial instruments. Cash and short-term investments--The carrying amounts for short-term investments (which include interest-bearing deposits with banks, federal funds sold and resale agreements) approximate fair value because they mature in 90 days or less and do not represent unanticipated credit concerns. Investment and trading account securities--Estimated fair value for investment and trading account securities is based on quoted market prices. The fair value of certain small issues and municipal securities which are not readily available through market quotations is assumed to equal carrying value as these securities generally have short terms. These securities do not represent a significant portion of the portfolio. Loans--Fair values were estimated for loans with similar financial characteristics. The commercial loan portfolio was separated into credit risk categories by variable and fixed rate loans. The fair value of performing loans, except for internally criticized commercial and lease financing loans, was calculated by discounting cash flows using an estimated discount rate that reflects current market rates, the type of loan, credit risk inherent in the loan category and repricing characteristics. Fair value for criticized commercial loans was calculated by reducing the carrying value by an amount that reflects the estimated principal loss. This loss was based on internal credit analysis of specific borrowers taking into consideration past loan loss experience and trends in loan quality. For lease financing loans, carrying value was considered to approximate fair value. The fair value of credit card loans was estimated using the net present value method. Credit card portfolios are not actively traded and the discount rate used reflects an estimated rate of return based on the credit quality of the portfolio. This estimate does not include the value that relates to estimated cash flows from new loans generated from existing cardholders over the remaining life of the portfolio. For residential mortgages, fair value was estimated by discounting cash flows adjusted for anticipated prepayments using discount rates based on current market rates for similar loans. Deposits--The fair value of deposits with no stated maturity, such as interest bearing and non-interest bearing demand, savings and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows using current market rates for similar types of deposits. Borrowed funds--The carrying value of short-term borrowed funds approximate fair value as they are payable within three months or less. The estimated fair value of long-term debt is based on broker quotations, when available. Debt for which quoted prices were not available was valued using cash flows discounted at a current market rate for similar types of debt. Off-balance sheet items--The fair value of interest rate swap agreements is based on the present value of the swap using dealer quotes. Fair values for caps and floors were obtained using an option pricing model which reflects industry pricing standards. These values represent the estimated amount Firstar would receive or pay to terminate the contracts or agreements taking into account current interest rates and market volatility. The fair value of these agreements were $1 million and $3 million at December 31, 1993 and 1992, respectively. The fair value of commitments to extend credit and standby letters of credit was estimated using fees currently charged to enter into similar agreements. The fair value of credit card lines is based on cardholder fees currently being charged. The estimated fair value for commitments to extend credit, standby letters of credit and credit card lines at December 31, 1993 and 1992 were $15 million and $17 million, respectively. The estimated fair value of Firstar's financial instruments is summarized as follows: NOTE 18. PARENT CORPORATION CONDENSED FINANCIAL STATEMENTS BALANCE SHEETS STATEMENTS OF INCOME NOTE 18. PARENT CORPORATION CONDENSED FINANCIAL STATEMENTS (CONTINUED) STATEMENTS OF CASH FLOWS LOGO INDEPENDENT AUDITORS' REPORT The Board of Directors Firstar Corporation: We have audited the accompanying consolidated balance sheets of Firstar Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Firstar Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in notes 13, 14 and 4 to the consolidated financial statements, Firstar Corporation adopted the provisions of Statement of Financial Accounting Standards Nos. 106, 109 and 115, respectively, in 1993. LOGO KPMG PEAT MARWICK Milwaukee, Wisconsin January 20, 1994 FIRSTAR CORPORATION AND SUBSIDIARIES SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED) FIRSTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME AND FINANCIAL RATIOS FIRSTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED AVERAGE BALANCE SHEETS, NET INTEREST REVENUE AND RATE ANALYSIS - ------ Interest and rates are calculated on a taxable equivalent basis, using a tax rate of 35% in 1993 and 34% in 1992, 1991, 1990 and 1989. The rate calculations include the effect of certain loans on which income is recognized only as cash payments are received or is accrued at less than the original contract rate. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Notice of the 1994 Annual Meeting and Proxy Statement filed pursuant to Regulation 14A is incorporated herein by reference. The executive officers of Firstar Corporation are listed under Item 1 of this document. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Notice of the 1994 Annual Meeting and Proxy Statement filed pursuant to Regulation 14A is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Notice of the 1994 Annual Meeting and Proxy Statement filed pursuant to Regulation 14A is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Notice of the 1994 Annual Meeting and Proxy Statement filed pursuant to Regulation 14A is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A)1. FINANCIAL STATEMENTS The following financial statements of Firstar Corporation are filed as a part of this document underItem 8. Financial Statements and Supplementary Data. Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Independent Auditors' Report (A)2. FINANCIAL STATEMENT SCHEDULES All financial statement schedules have been included in the consolidated financial statements or are either not applicable or not significant. (A)3. EXHIBITS A copy of the exhibits listed herein can be obtained by writing to Mr. William H. Risch, Senior Vice President-Finance and Treasurer, Firstar Corporation, P.O. Box 532, Milwaukee, Wisconsin 53201. *Executive Compensation Plans (B) No reports on Form 8-K were filed during the fourth quarter of 1993. 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. FIRSTAR CORPORATION LOGO ------------------------------------- Roger L. Fitzsimonds March 18, 1994 Chairman and Chief Executive Officer Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated. March 18, 1994 LOGO - ------------------------------------- Roger L. Fitzsimonds Chairman, Chief Executive Officer and director March 18, 1994 - ------------------------------------- LOGO John A. Becker President, Chief Operating Officer and director March 18, 1994 LOGO - ------------------------------------- William H. Risch Senior Vice President-Finance and Treasurer (principal finance and accounting officer) DIRECTORS Michael E. Batten* John H. Hendee, Jr.* George W. Mead George M. Chester, Jr.* Jerry M. Hiegel* II* Roger H. Derusha* Joe Hladky* Guy A. Osborn* James L. Forbes* James H. Keyes* Judith D. Pyle* Holmes Foster* Sheldon B. Lubar* Clifford V. Joseph F. Heil, Jr.* Daniel F. McKeithan, Jr.* Smith, Jr.* William W. Wirtz* March 18, 1994 LOGO *By__________________________________ William H. Risch Attorney-in-Fact

912025_1993.txt

912025_1993

1993

912025

ITEM 1. BUSINESS. General Development of Business EQK Green Acres Trust (the 'Trust' or the 'Company'), a Delaware business trust, was formed pursuant to a Certificate of Trust dated September 8, 1993. The Trust has an indefinite life and intends to elect real estate investment trust ('REIT') status under the Internal Revenue Code of 1986, as amended. Under the Internal Revenue Code, a real estate investment trust that meets applicable requirements is not subject to Federal income tax on that portion of its taxable income that is distributed to its shareholders. The principal executive offices of the Trust are located at Suite 800, One Tower Bridge, W. Conshohocken, Pennsylvania 19428, and the telephone number is (215) 941-2933. On February 28, 1994, EQK Green Acres, L.P. (the 'Partnership') merged with and into Green Acres Mall Corp., a wholly-owned subsidiary of the Trust (the 'Merger'). Prior to February 28, 1994, the Trust did not have significant operations. The Partnership was a Delaware limited partnership formed pursuant to a certificate of limited partnership dated June 30, 1986. Equitable Realty Portfolio Management, Inc. ('ERPM', successor in interest to EQK Partners), which is wholly owned by Equitable Real Estate Investment Management, Inc. ('Equitable Real Estate'), itself an indirect wholly owned subsidiary of The Equitable Life Assurance Society of the United States ('Equitable'), acted as the advisor (the 'Advisor') to the Partnership. The Partnership had been formed to acquire and operate Green Acres Mall (the 'Mall'), a regional shopping mall located in Nassau County, Long Island, New York. In 1991, the Partnership completed the conversion of a leased industrial building, located adjacent to the Property, into a convenience shopping center known as the Plaza at Green Acres (the 'Plaza'). The Mall and the Plaza are referred to collectively as the 'Property' and are described below and under Item 2. ITEM 2. PROPERTIES General. Green Acres Mall is a one-level and two-level T-shaped enclosed regional shopping mall, which together with 14 free-standing outparcel buildings and a convenience center known as the Plaza at Green Acres, is located on a site of approximately 100 acres. Adjacent to the Mall parking area are parcels owned by unaffiliated parties consisting of soon-to-be opened Home Depot and Caldor stores which are not part of the Property and in which the Company has not acquired any interest. The total building area of the Property is allocated as shown in the table below. - ------------------ (a) The improvements constituting the Sears department and auto accessory stores (aggregating 144,537 gross leasable square feet) are owned by Sears pursuant to ground leases of the land underlying such improvements. The Company has acquired title to such land, but will not acquire title to such improvements until such ground leases have terminated. Gross leasable area information contained herein includes the gross leasable area of such improvements. (b) Anchor tenant square footage includes approximately 51,421 square feet of separately leased storage space. (c) Includes stores leased to Kids 'R' Us, The Wiz, Red Lobster and Home Federal Savings Bank, among others. Does not include five outparcel buildings which are owned by the respective tenants subject to ground leases from the Company of the land underlying such stores. The Company is a lessee in a long-term lease for a ten-acre site adjacent to the Property on which there is situated a 170,000 square foot retail facility. The lease provides for an initial term of 30 years with three six-year option terms for a total term of up to 48 years. This building was converted in 1991 into the Plaza, a convenience center which initially contained a supermarket (Waldbaum, Inc., a division of The Great Atlantic and Pacific Tea Company, Inc.), a home improvement center (Pergament Home Improvement Center) and several small retail shops. In January 1993, the Company terminated its lease with Pergament and entered into a new lease agreement covering Pergament's space and all but one of the Plaza's small store spaces with Kmart Corporation. The convenience center began operations in September 1991. In April 1993, the Company completed the acquisition of an adjacent industrial tract (the 'Bulova Parcel') through a subsidiary partnership and entered into a lease/purchase agreement for this real estate with Home Depot. Pursuant to the lease/purchase agreement, Home Depot paid $9,500,000 to the Company, a portion of which was used to complete the purchase of the Bulova Parcel. As a result of the completion in 1993 of specified environmental work, the lease/purchase agreement obligated Home Depot to take title to the Bulova Parcel. In connection with this lease/purchase agreement, the Company recognized a gain on sale of real estate of $440,000 during 1993. During the first quarter of 1994, the Company completed the sale to Home Depot of an approximate two acre parking lot tract adjacent to the Bulova Parcel. The proceeds from the sale were $1,500,000, resulting in a 1994 gain on sale of real estate of approximately $800,000. Development History. The Property opened in 1958 as a single-level, open-air mall. The Mall was enclosed and climate-controlled in 1970. An extensive renovation, expansion and remerchandising program carried out in 1982-1983 included the following: (i) the addition of the Sears store and Auto Service Center, and a new two-level mall connecting the Sears store with the existing one-level mall; (ii) construction of a new three-level parking structure adjacent to the Sears store; and (iii) renovation of the existing one-level mall area and the J.C. Penney store. The outparcel buildings were not renovated in connection with this program. A renovation program for the interior of the Mall was completed during 1991-1992. The program included new tile flooring throughout the common areas, intensified lighting, new seating areas, and decorative columns and other features in a new color scheme. The food court was also renovated. Management has not yet determined whether to proceed with a previously planned expansion of the Mall that was suspended in 1992 for the lack of financing. The expansion will be accomplished only if its net effect on operations is expected to be positive and, in any event, actual construction would not be expected to commence prior to 1997. Remerchandising Program. In anticipation of the 1993-1996 lease expirations, the Company has under way a remerchandising campaign, the primary goal of which is to alter the tenant mix to appeal to a broader cross-section of the market while achieving increased revenues. Management estimates that approximately 95% of tenants whose leases expire between 1993 and 1996 are paying below market rents. The Company is negotiating with a group of prominent national retailers that Management believes will further enhance the overall financial stability of the Mall while maintaining the Mall's distinctive character associated with successful local and regional tenants. Over 50% of the Mall (excluding department stores) is leased to national retailers, including such major chains as The Limited (The Limited, Express, Victoria's Secret, and Bath & Body Works), The Gap, Footlocker, Mothercare, Edison Brothers (5-7-9, Coda, The Wild Pair), Melville (Kay-Bee Toy & Hobby, Fan Club), Waldenbooks and Radio Shack. Several national retailers have expressed interest in both expanding their current divisional presence as well as bringing new divisions into the Mall. By developing a leasing plan that takes advantage of upcoming lease rollovers, the Company expects to accommodate the requests of the larger national retailers, while at the same time meeting the space needs of smaller regional and local tenants. Management believes the remerchandising program will address consumers' needs for a diversified retail mix, thus strengthening the Mall's overall competitive position. Management estimates that the program will be completed by early 1995 and that the cost of tenant allowances required for the program will be approximately $3.5 million, approximately $1.8 million of which has already been expended. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. None. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. On December 23, 1993, the Trust and the Partnership issued a written Consent Solicitation Statement/Prospectus to the Partnership's Unitholders of record as of December 6, 1993. The Prospectus solicited the consent of Unitholders to a conversion of the Partnership with and into the Trust, a real estate investment trust, pursuant to a merger of the Partnership into a wholly-owned subsidiary of the Trust ('Proposal 1') and an amendment to the Amended and Restated Agreement of Limited Partnership of EQK Green Acres, L.P. (the 'Partnership Agreement') so as to permit the acquisition of additional real estate investments ('Proposal 2') . On February 28, 1994, the conversion of the Partnership with and into the Trust and the amendment to the Partnership Agreement were approved by a majority of the Partnership's Unitholders. The final tabulation of votes cast was as follows: - ------------------ (1) Represents the percentage of votes cast. The total votes cast, 6,860,879, represents 67.4% of total Units outstanding. For a detailed description of this matter, reference is made to the Registration Statement of the Partnership and the Trust on Form S-4 (Registration No. 33-68664), declared effective by the Securities and Exchange Commission on December 17, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Shares of Beneficial Interest are traded on the New York Stock Exchange (symbol EGA). The Company is listed in the stock tables as 'EQK Green.' As of March 1, 1994, the record number of Common Shareholders was 1,663. Although the Company does not know the exact number of beneficial holders the Company's Common Shares of Beneficial Interest, it believes the number exceeds 5,900. The Company's Common Shares of Beneficial Interest began trading on the New York Stock Exchange on March 1, 1994. The following table presents cash distributions and the high and low prices of the predecessor Partnership's Units based on The New York Stock Exchange daily composite transactions. - ------------------ (a) On January 25, 1994, a distribution of $.2750 per Common Share was declared with a record date of March 31, 1994 and a payment date of May 15, 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. - ------------------ (a) The distribution for the first quarter of 1990 of $.3225 was declared on December 8, 1989. Such amount was accrued as a distribution in the 1989 financial statements but is reflected as a 1990 distribution in the table above. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This discussion should be read in conjunction with the Consolidated Financial Statements and accompanying Notes to Consolidated Financial Statements. FINANCIAL CONDITION MERGER TRANSACTION On February 28, 1994, EQK Green Acres, L.P. (the 'Partnership') merged with and into Green Acres Mall Corp., a wholly-owned subsidiary of EQK Green Acres Trust (the 'Trust'). The Trust and the Partnership are collectively referred to herein as the 'Company.' See Item 1 and Note 1 to the consolidated financial statements for a discussion of the Company's common shares (the 'Common Shares') issued in connection with this merger (the 'Merger'). The issuance of 10,277,469 Common Shares to the Unitholders and the General Partners on account of their respective percentage interests in the Partnership represents a reorganization of entities under common control and, accordingly, was accounted for in a manner similar to a pooling of interests. The financial statements of the Partnership and the Trust have been combined at historical cost retroactive to January 1, 1991. The issuance of these Common Shares has been reflected as of this date at the amount of the Unitholders' and General Partners' original contributions to the Partnership. The issuance of Common Shares to the Special General Partner on account of its residual interest in the Partnership and to Equitable Realty Portfolio Management, Inc. (the 'Advisor') will be reflected in the Company's consolidated financial statements as of February 28, 1994 and March 30, 1994, respectively. The issuance of Common Shares to the Special General Partner will increase the Company's carrying value of land and buildings and improvements by $3,024,000 and $13,347,000, respectively, representing the value of the Special General Partner's residual interest in accordance with the allocation methodology utilized by the Partnership in connection with the Merger. Annual depreciation expense will increase by approximately $342,000 as a result of the increase in the basis of the Mall. The issuance of Common Shares to the Advisor will be reflected as a charge to earnings during the first quarter of 1994 in the approximate amount of $3,843,000. In connection with the Merger, the Company recognized as an expense nonrecurring legal, accounting, and printing costs aggregating approximately $1,250,000. CASH FLOWS FROM OPERATING, INVESTING, AND FINANCING ACTIVITIES Cash flows from operating activities for 1993 and 1992 were $6,649,000 and $13,719,000, respectively. The 1993 results, and the related decline from 1992, are principally attributable to payments in 1993 of $1,951,000 and $2,684,000 for 1992 real estate taxes and deferred advisory and property management fees, respectively, and the payments of $1,123,000 for interest on the collateralized floating rate notes (the 'Floating Rate Notes'), $686,000 for deferred leasing costs, and $382,000 for Merger costs. During 1992, the Company's net cash provided by operating activities decreased by $1,131,000 compared to 1991. The primary cause of this decrease was the payment of $2,203,000 in 1992 for certain advisory and property management fees attributable to 1991. In 1991, the payment of these fees had been deferred, resulting in a nonrecurring cash flow benefit in that year. Offsetting this benefit in 1991 was the nonrecurrence of certain real estate taxes collected in 1990 attributable to the one-time acceleration of the billing of such taxes to tenants, and higher interest costs. Cash flows from investing activities increased by $6,713,000 in 1993 over the prior year, primarily due to the receipt of proceeds from the April 1993 transfer of an adjacent industrial tract (the 'Bulova Parcel') to Home Depot. Pursuant to a lease/purchase agreement, Home Depot paid $9,500,000 to the Company, a portion of which was used to complete the purchase of the Bulova Parcel. In connection with this lease/purchase agreement, the Company recognized a gain on sale of real estate of $440,000 during 1993. Subsequent to December 31, 1993, the Company's restricted cash balance of $500,000 was released from escrow. During 1992, net cash used in investing activities by the Company increased $193,000 compared to 1991. The Company's capital expenditures for 1992 included payments of $1,884,000 related to the acquisition of the Bulova Parcel, predevelopment costs of $1,110,000 related to the deferred mall expansion project and tenant allowance and other capital items. In 1991, the Company completed a $2,700,000 interior renovation, and spent an additional $2,100,000 in developing the Plaza. Cash flows used in financing activities for 1993 and 1992 were $8,753,000 and $8,220,000, respectively. The increase in cash used in financing activities is primarily attributable to the refinancing activities in August 1993 in which the net proceeds from the issuance of the Floating Rate Notes were used to purchase a zero coupon mortgage note (the 'Zero Note') and to repay $16,500,000 in second mortgage financing. During 1992, the Company's net cash used in financing activities increased $300,000 compared to 1991. The increase was due to a decline in net additional borrowings substantially offset by lower distributions paid to Common Shareholders. The Company believes that Funds from Operations represents an indicator of its ability to make cash distributions. Funds from Operations is defined as net income before depreciation, amortization of financing and other deferred expenses, and gains or losses on sales of assets. Management believes that Funds from Operations is the most significant factor in determining the amount of cash distributions, although Funds from Operations does not represent net income or cash flows from operating activities as defined by generally accepted accounting principles and is not necessarily indicative of cash available to fund all cash flow needs. Furthermore, Funds from Operations should not be considered as an alternative to net income as an indicator of the Company's operating performance or to cash flows from operating activities as a measure of liquidity. As indicated in the Consolidated Statements of Cash Flows, the Company experienced an unfavorable trend in cash provided by operating activities over the periods presented. However, the trend in Funds from Operations, which is not affected by temporary changes in working capital, has not been as unfavorable. The following table sets forth Funds from Operations and cash provided by operating activities of the Company for the periods indicated: The decrease of $1,152,000 in Funds from Operations for 1993 compared to 1992 is attributable to the 1993 incurrence of currently payable interest expense on the Floating Rate Notes and payments of Merger expenses of $1,824,000 and $1,250,000, respectively, offset by the nonrecurrence of a $1,439,000 write-off of capitalized predevelopment costs in 1992. The decline of $1,479,000 in Funds from Operations for 1992 compared to 1991 is also attributable to this 1992 write-off. DEBT REFINANCING On August 19, 1993, the Company, through a wholly-owned subsidiary, issued the Floating Rate Notes in an aggregate principal amount of $118,000,000. The Floating Rate Notes are secured by a first mortgage on substantially all of the real property comprising Green Acres Mall and a first leasehold mortgage on the Plaza. The early extinguishment of the Zero Note, as described above, resulted in an extraordinary charge of $6,373,000. The remainder of the proceeds from the Floating Rate Notes was used to purchase an interest rate cap and to pay mortgage recording taxes and other costs incurred in connection with the refinancing. The entire principal amount of the Floating Rate Notes is due on their maturity date, August 19, 1998. The Floating Rate Notes have a floating interest rate equal to 78 basis points in excess of the three-month LIBOR. The interest rate on this debt, which is subject to quarterly reset, was 4.28% at December 31, 1993. Payments of interest expense will be funded from cash flows from operations supplemented, as necessary, by borrowings under the revolving credit facility described below. Amortization of the deferred financing costs, approximating $1,161,000 per annum, will result in an additional charge (non-cash) to interest expense. As a result of an interest rate cap agreement also entered into on August 19, 1993, the effective interest rate of the Floating Rate Notes will not exceed 9% per annum. The mortgage and indenture relating to the Floating Rate Notes limit additional indebtedness that may be incurred by Green Acres Mall Corp., but not by the Trust. Those agreements also contain certain other covenants which, among other matters, effectively subordinate distributions from Green Acres Mall Corp. to the debt service requirements of the Floating Rate Notes. On August 19, 1993, the Partnership also obtained an 18 month unsecured revolving credit facility in the amount of $3,400,000 which bears interest at 1% over the lender's prime rate (effective interest rate of 7.00% at December 31, 1993). At December 31, 1993, $1,800,000 was outstanding. The Floating Rate Notes' mortgage agreement places certain limitations on the Company's ability to borrow under the line of credit agreement. At December 31, 1993, limitations related to future capital expenditures reduced the Company's available borrowing capacity to approximately $1,150,000. In February 1994, the Company borrowed an additional $900,000 under this credit facility. The Company anticipates that it will refinance the revolving credit facility prior to the expiration of such facility. The Company also anticipates that it will refinance the Floating Rate Notes at maturity in August 1998. Given the substantial equity the Partnership has in the Property (the principal amount of the Floating Rate Notes represents less than 50% of the Property's estimated fair value at December 31, 1993), Management anticipates that it will have considerable flexibility in obtaining such refinancing. However, at this time, Management has not identified any specific sources of such refinancing. In connection with the issuance of the Floating Rate Notes, interest expense is expected to decline significantly after 1993. Although the refinancing program will result in substantial interest savings, interest will be payable currently rather than accrued and, as a result, cash flow available for distributions will be reflective of such expenditures. DIVIDENDS The Company's current quarterly dividend rate of $.275 per Common Share represents an annual dividend rate of $1.10 per Common Share. The issuance of Common Shares to the Special General Partner and the Advisor will reduce the cash available per Common Share for distribution to the former Unitholders of the Partnership. However, the Special General Partner and the Advisor have agreed that all distributions received by them prior to May 1995 on account of the Common Shares issued in respect of the Special General Partner's residual interest in the Partnership and the termination of the agreement with the Advisor will be reinvested through a distribution reinvestment plan in newly issued Common Shares. As a result, the issuance of such Common Shares to the Special General Partner and Advisor will not affect cash flow available for distribution to the former Unitholders of the Partnership until after May 1995. Management anticipates that annual distributions on account of 1994 operations will be $1.10 per Common Share. The Company expects that an increase in Funds from Operations (before interest) will offset the effect of paying interest on the Floating Rate Notes on a current basis in 1994 and through maturity. The anticipated growth in Funds from Operations in 1994 reflects cost reductions resulting from the termination of the Advisory Agreement, net of costs associated with the Company's planned acquisitions program, and an increase in rental revenues. The Company also received, during the first quarter of 1994, $1,500,000 from the sale of two acres of property to Home Depot, which supplements Funds from Operations available for distribution. During 1994, the Company anticipates that its capital expenditures will be approximately $2,900,000 which it intends to fund from borrowings. The Company is currently pursuing an extension of its existing line of credit, although there can be no assurance that it will receive such an extension. Should it be unable to fund capital expenditures from borrowings, or should there be a shortfall in budgeted revenue growth or an unanticipated increase in interest expense, the Company's ability to maintain distributions at $1.10 per Common Share could be adversely affected. Commencing in May 1995, the Special General Partner and the Advisor will be entitled to receive cash distributions on their Common Shares. Consequently, in addition to the aforementioned growth in Funds from Operations required in 1994, Funds from Operations in 1995 must increase an additional $1,950,000 to maintain the current distribution rate of $1.10 per Common Share for 1995 and future years. Based on the information presently available, Management believes that stipulated rent increases from existing tenants, additional income from new tenants, renewal of expiring leases at higher market rents and increases in percentage rents will increase Funds from Operations by an amount sufficient to sustain the current dividend level in 1995, although there is no assurance as to this. Further, it is anticipated that capital expenditure requirements will decline significantly in 1995 due to the completion of the remerchandising program and the resulting reduction in future tenant allowances. The Company intends to acquire additional real estate investments. Financing for any such investments would be sought through any combination of public or private debt and/or equity financing (including possibly financing provided in whole or in part by sellers) determined by the Company to be advisable at the time. It is premature to seek such financing and there can be no assurance that any such financing could be obtained on favorable terms or at all. RESULTS OF OPERATIONS COMPARISON OF 1993, 1992, AND 1991 The Company reported a net loss of $5,223,000 ($.51 per Common Share) in 1993, compared with a net loss of $163,000 ($.02 per Common Share) in 1992 and net income of $2,511,000 ($.24 per Common Share) in 1991. The 1993 results were impacted by the recognition of an extraordinary loss of $6,373,000 ($.62 per Common Share) from the early retirement of the Zero Note. The extraordinary loss was comprised principally of prepayment penalties and the write-off of deferred financing costs. Earnings in 1993 also declined as a result of the recognition of $1,250,000 of Merger costs. The earnings decline in 1993 was partially offset by the $440,000 gain on sale of real estate and a decrease in interest expense from 1992. The 1992 results were impacted by the writeoff of predevelopment costs. In June 1992, the Company announced its decision to defer a planned expansion of the Mall due to its inability to secure financing for this project. It is uncertain when, or if, the expansion program will be resumed. Accordingly, capitalized costs related to the predevelopment phase of the expansion, totaling $1,439,000, were written off. The earnings decline in 1992 over 1991 was also affected by higher interest expense in 1992, partially offset by an increase in revenues from rental operations. The trend in earnings is more fully described in the discussion of revenues and expenses that follows. Revenues from rental operations in 1993 decreased modestly from the prior year. The decline in 1993 revenues of $106,000 was attributable to a $334,000 decline in Plaza revenues, primarily related to the buildout of the new Kmart discount store, partially offset by higher Mall revenues attributable to specialty leasing of space to temporary tenants. In January 1993, the Company replaced Pergament Home Improvement Center, Inc. ('Pergament'), one of the Plaza's anchor tenants, and all but one of the Plaza's small store spaces, with a new Kmart discount store. In connection with the lease termination, the Partnership paid $450,000 to Pergament on July 1, 1993. The Company also paid a $150,000 fee to the Advisor in connection with the securing of Kmart as a new anchor tenant. This change in Plaza tenants is expected to generate an additional $350,000 of income from rental operations on an annualized basis compared to the income generated from the Plaza in 1992. Revenues from rental operations in 1992 increased from 1991 by $3,061,000 or 18%. Approximately one-half of the revenue increase was attributable to the operation of the Plaza, which was open for its first full year of business in 1992. In addition, the 1992 minimum rent from mall tenants increased due to improved occupancy, percentage rents increased due to higher tenant sales levels and other income increased due to an expanded temporary leasing program. Net operating expenses increased in 1993 to $2,059,000 from $1,779,000 in 1992 and $195,000 in 1991. This $280,000 increase in 1993 is primarily attributable to increases in net real estate taxes and food court costs of $147,000 and $119,000, respectively. The increase in net operating expenses in 1992 over 1991 is due to an increase in the expenses of the Plaza, which was in its first full year of operations, and increases in net operating expenses associated with common area maintenance and real estate taxes of $485,000 and $522,000, respectively. Included in net operating expenses are property management fees of $786,000, $785,000, and $697,000 for 1993, 1992, and 1991, respectively, attributable to the related agreement with Compass Retail, Inc. ("Compass"). In connection with the Merger, the agreement with Compass was amended and restated to extend its termination date by two years to August 31, 1998, and to limit Compass' scope of responsibilities primarily to accounting and financial services currently provided in connection with the operations of the Property. Compass' compensation will be reduced from 4% to 2% of net rental and service income collected from tenants. Operating expense increases attributable to inflation generally do not have a significant effect on the Company's income from rental operations as substantially all operating expenses are reimbursed by tenants in accordance with the terms of their leases. Advisory fees have declined to $1,625,000 in 1993 from $1,709,000 in 1992 and $1,931,000 in 1991. The advisory fee was comprised of an annual base fee of $250,000 and an annual subordinated incentive advisory fee of $1,250,000 which increased in proportion to the amount by which aggregate distributions of operating cash flow to Unitholders exceed a ten percent return on the Unitholder's Adjusted Capital Contributions (as defined in the Partnership Agreement). Decreases in operating cash flows over the three year period account for the reductions in the advisory fees. The advisory agreement will terminate on March 30, 1994, upon the expiration of a 30-day transition period agreement. The provision for doubtful accounts was $424,000 in 1993, $809,000 in 1992 and $505,000 in 1991. The 1992 provision was attributable to anticipated losses associated with certain delinquent tenants whose leases were subsequently terminated. Such tenants were symptomatic of credit risk found in the retail industry, particularly among smaller local and regional tenants. Due to the absence of significant credit losses and due to certain recoveries of receivables previously written off, the Company experienced an improvement in its provision for doubtful accounts in 1993. Interest expense was $9,834,000, $10,787,000, and $8,401,000 for 1993, 1992, and 1991, respectively. The decrease in interest expense in 1993 over 1992 is due to the August 19, 1993 debt refinancing. The Zero Note, with an effective interest rate of 10.4% per annum, and the $16,500,000 in second mortgage financing, bearing interest at rates between 6% and 7% per annum, were replaced with Floating Rates Notes that had an initial interest rate of 4.03% that was reset to 4.28% on November 12, 1993. Interest expense increased in 1992 over 1991 due to the amortization of the discount on the Zero Note. In addition, 1992 interest expense increased due to a full year of interest recognized on the capitalized portion of the Plaza lease, higher interest cost on the line of credit and interest payable on the deferred advisory and property management fees. Other expenses consist primarily of the administrative costs of running the Company. There were no significant fluctuations in these costs during the three-year period ended December 31, 1993. Distributions to security holders were $11,305,000 ($1.10 per Common Share) in 1993, $11,999,000 ($1.168 per Common Share) in 1992, and $13,823,000 ($1.345 per Common Share) in 1991. The Company has paid out substantially all of its net cash flow since inception. Taking into account the anticipated impact on net cash flow of the previously discussed refinancing, distributions were reduced to an annual rate of $1.10 in June 1992. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Registrant's consolidated financial statements and supplementary data listed in Item 14(a) appear immediately following the signature pages. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The Company is managed by members of a Board of Trustees (the 'Managing Trustees') initially comprised of the directors of the Partnership's former managing general partner. It is anticipated that the Board of Trustees will be expanded in 1994 to include additional independent trustees. The Managing Trustees are divided into three classes as nearly equal in number as possible, with the term of office of one class expiring in each year. After expiration of the initial terms as set forth in the following table, trustees will serve for three-year terms. The Managing Trustees will be responsible for electing the Company's executive officers, who will serve at the discretion of the Board of Trustees. Myles H. Tanenbaum will serve as the Company's President and as Chairman of the Company's Board of Trustees. In addition to Mr. Tanenbaum, the Company's executive officers will include Randall C. Stein, who will serve as Senior Vice President; Kimli Cross Smith, who will serve as Vice President-Leasing; Richard P. Ferrell, who will serve as Vice President-Management; and Dennis Harkins, who will serve as Treasurer and Controller. By mid-1994, the Company intends to retain an Assistant Vice President-Construction. Brief summaries of Mr. Tanenbaum's and the other Managing Trustees' and executive officers' business experience and certain other information are set forth following the table. - ------------------ (1) Member of the nominating committee. (2) Member of the audit committee. (3) Member of the compensation committee. Myles H. Tanenbaum, age 63, is a Managing Trustee and President of the Company and Chairman of Arbor Enterprises, an investment and holding company, and formerly a consultant to Equitable Real Estate, of which the former Advisor to the Partnership is a wholly-owned subsidiary. He was formerly the President of EQK Partners (formerly the Partnership's advisor) from its inception in September 1983 until October 1987 and was Chairman until December 1989. Prior to that time, from 1970 he served as Executive Vice President and the Chairman of the Executive Committee of Kravco, Inc. Mr. Tanenbaum is also managing partner of the Partnership's former special general partner, a general partnership which is the sole shareholder of the Partnership's former managing general partner. Prior to joining Kravco, Inc. in 1970, Mr. Tanenbaum had been a partner in the law firm of Wolf, Block, Schorr and Solis-Cohen, Philadelphia, Pennsylvania. He is also a certified public accountant. Mr. Tanenbaum is currently a director of Universal Health Realty Trust, a New York Stock Exchange ('NYSE')-listed real estate investment trust which owns hospitals, and of The Pep Boys--Manny, Moe & Jack, Inc., an NYSE-listed company engaged in the retail sale of automotive parts and accessories, and the provision of automotive services. Sylvan M. Cohen, age 79, has been President and Trustee of Pennsylvania Real Estate Investment Trust, an American Stock Exchange-listed real estate investment trust since its inception in 1960. Mr. Cohen is also a partner in the Philadelphia law firm of Cohen, Shapiro, Polisher, Shiekman and Cohen. Mr. Cohen is a former director of Fidelity Bank, Philadelphia, Pennsylvania, and is a director of FPA Corporation, an American Stock Exchange-listed real estate development company, and a trustee of EQK Realty Investors I, a NYSE-listed real estate investment trust. He formerly served as President of the National Association of Real Estate Investment Trusts and the International Council of Shopping Centers. Alton G. Marshall, age 72, is President of Alton G. Marshall Associates, Inc., a New York City real estate investment firm since 1971. He has been Senior Fellow of the Nelson A. Rockefeller Institute of Government in Albany, New York since January 1, 1991. He was Chairman of the Board and Chief Executive Officer of The Lincoln Savings Bank, FSB, from March 1984 through December 1990, and remains a Director and Chairman of the Bank's Executive Committee. From 1971 to 1981, he was President of the Rockefeller Center, Inc., a real estate, manufacturing and entertainment company. Mr. Marshall is currently a director of the Hudson River Trust, and New York State Electric & Gas Corp., and a trustee of EQK Realty Investors I. He is an independent partner of Alliance Capital and Alliance Capital Retirement Fund. George R. Peacock, age 70, retired in August 1988 after serving as Chairman and Chief Executive Officer of Equitable Real Estate, parent of the Partnership's former Advisor which is a wholly-owned subsidiary of Equitable. Mr. Peacock is a past member of Equitable's Investment Policy Committee. Prior to his retirement he was also a Senior Vice President of parent Equitable for approximately twelve years. Mr. Peacock is a former director of Equitable Real Estate and remains a trustee of EQK Realty Investors I. Phillip E. Stephens, age 46, has been President of Compass Retail, the Partnership's former property manager and a subsidiary of Equitable Real Estate, since January 1992 and was Executive Vice President of the Compass Retail division of Equitable Real Estate from January 1990 to December 1991. He has also served as President of ERPM, the Partnership's former Advisor and a wholly-owned subsidiary of Equitable Real Estate, since December 1989. From October 1987 to December 1989, he was President of EQK Partners (formerly the Partnership's Advisor), the predecessor in interest to ERPM. From its inception in September 1983 to October 1987, he was Senior Vice President of EQK Partners. He is also President and a trustee of EQK Realty Investors I. Randall C. Stein, age 35, has been Senior Vice President of the Trust since March 1994. From February 1992 to January 1994, Mr. Stein was Senior Vice President of Dusco Inc., New York, New York, a company engaged in the fund management of a portfolio of regional malls for institutional investors. Prior to that, from January 1984 to February 1992, Mr. Stein was Director of Development and Acquisitions for Strouse, Greenberg & Co., Philadelphia, Pennsylvania, a company engaged in real estate investment, management, leasing and development. Prior to that, from June 1981, Mr. Stein was Senior Tax Advisor at Laventhol & Horwath, Philadelphia, Pennsylvania. Kimli Cross Smith, age 31, has been a leasing representative for Compass Retail, the Partnership's former property manager and a subsidiary of Equitable Real Estate since November 1990. From March 1988 until she joined Compass Retail, Ms. Smith was a leasing representative for Strouse, Greenberg & Co., Inc., Philadelphia, Pennsylvania. Richard P. Ferrell, age 36, has been Vice President -- Management of the Trust since March 1994. Prior to that, from December 1992, Mr. Ferrell was Vice President of the Partnership's former managing general partner and the Manager of Green Acres Mall. From December 1991 to December 1992 Mr. Ferrell worked for the Rouse Company as Vice President and General Manager of the Citadel, an enclosed mall located in Colorado Springs, Colorado. Prior to that, from February 1989 to December 1991, Mr. Ferrell was employed by the Rouse Company as Manager of Retail Operations for the Cherry Hill Mall in Cherry Hill, New Jersey. Dennis Harkins, age 31, has been the Controller of Green Acres Mall since June 1993. Prior to that, from August 1990 Mr. Harkins was Controller for Hayim and Co., Hempstead, New York, a company engaged in the importation and distribution of rugs. Prior to that, from January 1990 Mr. Harkins was Assistant Controller of the Yarmouth Group, New York, New York, a real estate investment company. From June 1987 until January 1990, Mr. Harkins was an accounting manager for Angeles Corp., Los Angeles, California, a real estate investment company. Pursuant to the Delaware Business Trust Act, the Company is required to have as a trustee a person or entity that is a resident of or has its principal place of business in the State of Delaware. The Delaware resident trustee is Wilmington Trust Company (the 'Resident Trustee'). The Declaration of Trust provides that the management of the Company is vested exclusively in the Managing Trustees who make up the Board of Trustees of the Company and that the Resident Trustee will not participate in the management of the Company except as directed by the Board of Trustees and consented to by the Resident Trustee. The principal offices of the Resident Trustee are located at 1100 N. Market Street, Rodney Square North, Wilmington, Delaware 19890-0001. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers and trustees and persons who own more than ten percent of a registered class of the Company's equity securities, along with the predecessor Partnership's officers and directors and persons who owned more than ten percent of a registered class of the Partnership's equity securities (collectively, the 'Reporting Persons') to file reports of ownership and changes in ownership with the Securities and Exchange Commission and to furnish the Company with copies of these reports. Based on the Company's review of the copies of these reports received by it, and written representations received from Reporting Persons, the Company believes that all filings required to be made by the Reporting Persons during 1993 were made on a timely basis. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. EXECUTIVE COMPENSATION Until the conversion to a REIT on February 28, 1994, the Company was not internally managed, and therefore was not responsible for executive compensation. During 1993, the Partnership reimbursed its managing general partner for the $10,000 annual fees and the $1,000 per meeting fees payable to each of the managing general partner's independent directors, Messrs. Cohen and Marshall. Messrs. Cohen and Marshall also received $25,000 each for services rendered as members of a special committee in connection with their determination of desirability of the proposed conversion of the Partnership into a real estate investment trust and their recommendations with respect to the related terms and conditions. Except for such fees, the directors, officers and employees of the former managing general partner did not receive any salaries or other compensation from the Partnership. The former Advisor received an annual fee of $250,000 and a subordinated incentive advisory fee of $1,375,000 with respect to the year ended December 31, 1993 With respect to the Company, except for those trustees who are also employees of the Company (initially Mr. Tanenbaum), trustees will receive annual fees of $15,000 in connection with their services as trustees of the Company, plus $1,000 for each board meeting and committee meeting they participate in. The Resident Trustee will receive annual fees of $2,500. In connection with Mr. Tanenbaum's service as President and Chief Executive Officer of the Company, Mr. Tanenbaum is expected to receive base salary at the annual rate of $175,000, subject to increases at the discretion of the Company's Board of Trustees. In addition to his base salary, Mr. Tanenbaum is expected to be eligible to receive an annual incentive bonus based upon individual and Company performance. In addition to his cash compensation, Mr. Tanenbaum was granted options in January 1994 to purchase up to 750,000 Common Shares at an exercise price of $10 per Common Share, equal to the market price of the shares on the date of grant. Such options vest at the rate of 20% per year commencing one year after the grant date, or January 25, 1995. The Company estimates that aggregate cash compensation for 1994 payable to the current executive officers listed in Item 10 (other than Mr. Tanenbaum) will be approximately $500,000. Additionally, it is anticipated that an Assistant Vice President-Construction will be retained and will receive aggregate cash compensation of less than $100,000. On January 25, 1994, the Board of Trustees adopted an Incentive Share Plan (the 'Plan'), which provides for the issuance of up to 1,500,000 Common Shares to outside Trustees and officers and key executives of the Company through options to purchase Common Shares, share appreciation rights, and restricted share grants. Common Share options may be options that are intended to qualify as incentive share options under the Internal Revenue Code of 1986, as amended, or options which are not intended to so qualify. Options will be granted at an exercise price that approximates the fair value of Common Shares on the grant date. Concurrent with the adoption of this Plan, the Company granted options to purchase 7,500 Common Shares to each of its four eligible trustees and options to purchase an aggregate of 875,000 Common Shares to certain officers (including options to purchase 750,000 Common Shares granted to Mr. Tanenbaum as described above). Certain officers also received an aggregate of 5,950 restricted Common Shares. All such options have an exercise price of $10 per Common Share and vest ratably commencing one year from the grant date, or January 25, 1995, in equal annual increments over three and five years for the Trustee and Officer options, respectively. The restricted shares become unrestricted in equal annual increments over three years commencing one year from the grant date, or January 25, 1995. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The following table shows the beneficial holdings of Common Shares as of March 1, 1994 of all persons known by the Company, based upon filings with the Securities and Exchange Commission, to be beneficial owners of more than 5% of its outstanding Common Shares, of all Trustees of EQK Green Acres Trust individually, and of all Trustees and Officers of EQK Green Acres Trust as a group. - ------------------ (1) The 308,933 Common Shares issuable to the Advisor on March 30, 1993 pursuant to the termination of the advisory agreement are considered outstanding for the purposes of this computation. (2) Includes the estimated allocation of Common Shares issued to the former general partners of EQK Green Acres, L.P., although a final allocation has not yet been completed. Until the Common Shares are distributed, voting of the shares will be controlled by Mr. Tanenbaum. (3) Includes 1,000 Common Shares owned by Mr. Peacock's wife, of which Mr. Peacock disclaims beneficial ownership. (4) The number of Common Shares represents less than 1% of the outstanding Common Shares. (5) Includes 12,700 Common Shares owned by Mr. Tanenbaum's wife and 10,000 Common Shares owned by a trust of which he is a trustee. Excludes 107,609 Common Shares owned by Mr. Tanenbaum's adult children, of which Mr. Tanenbaum disclaims beneficial ownership. Also excludes 750,000 Common Shares issuable upon exercise of options which were issued to Mr. Tanenbaum and which vest at the rate of 20% per year commencing one year after the January 25, 1994 grant date. (6) Includes Mr. Tanenbaum's share of Common Shares issued to the General Partners pursuant to the Merger. (7) Includes 5,950 restricted Common Shares that will become unrestricted in equal annual increments over three years commencing one year from the grant date, or January 25, 1995. Excludes executive officer options to purchase 875,000 Common Shares (inclusive of Mr. Tanenbaum's options to purchase 750,000 Common Shares) that vest at the annual rate of 20% commencing one year from the grant date, or January 25, 1995, and Trustee options for 30,000 Common Shares that vest in equal annual increments over three years commencing one year from the grant date, or January 25, 1995. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The Property was acquired by the Partnership on August 27, 1986 at a purchase price of $135,859,782 from Green Acres Associates, a general partnership among Equitable, Sunrise Associates and the General Partners of the Partnership. Sunrise Associates, a limited partnership, is an affiliate of the General Partners of the Partnership. On December 1, 1989, a wholly owned subsidiary of Equitable Real Estate acquired the 50% interest in EQK Partners (former advisor to the Partnership) owned by Kravco Partners, Ltd., bringing to 100% Equitable Real Estate's ownership interest in EQK Partners. Mr. Tanenbaum and Mr. Stephens owned, directly or indirectly, 25.2% and 14.4%, respectively, of Kravco Partners, Ltd. Subsequently, ERMP, a wholly owned subsidiary of Equitable Real Estate, became Advisor to the Partnership as the successor in interest to EQK Partners. As Advisor, ERPM received an annual base advisory fee of $250,000 for the years ended December 31, 1993, 1992, and 1991. ERPM also earned a subordinated incentive advisory fee of $1,375,000, $1,459,000, and $1,681,000, respectively, for the years ended December 31, 1993, 1992, and 1991. In addition, ERMP has earned fees of $40,000 in each of 1993, 1992 and 1991 for tax reporting services. Compass will receive a fee of $40,000 for tax reporting services in 1994. In December 1992, the Partnership entered into an agreement with ERPM pursuant to which ERPM provided development services in conjunction with the termination of its lease with Pergament, a former anchor tenant at the Plaza, and the procurement of a new lease with Kmart. The fee for these services was $150,000. Upon sale of all or any portion of any real estate investment of the Partnership, the Advisor was entitled to receive a disposition fee equal to 2% of the gross sale price (including outstanding indebtedness taken subject to or assumed by the buyer and any purchase money indebtedness taken back by the Partnership). The disposition fee was to be reduced by the amount of any brokerage commissions and legal expenses incurred by the Partnership in connection with such sales. Pursuant to this agreement with the Advisor, the Company paid a $290,000 fee to the Advisor during 1993 relating to services rendered in connection with the acquisition and development of the Bulova Parcel and its ultimate transfer to Home Depot (see Items 1,7 and 8). Pursuant to the Merger discussed in Item 4, upon the expiration of a 30 day transition period agreement commencing March 1, 1994, the agreement with the Advisor will be terminated. The Partnership had entered into a property management agreement with Compass, a subsidiary of Equitable Real Estate, effective January 1, 1991. Pursuant to this agreement, property management fees were based on 4% of net rental and service income collected from tenants. In connection with the Merger discussed in Items 1 and 4, the agreement with Compass was amended and restated to extend its termination date by two years to August 31, 1998, and to limit Compass' scope of responsibilities primarily to accounting and financial services currently provided in connection with the operations of the Property. Compass' compensation will be reduced from 4% to 2% of net rental and service income collected from tenants. For the years ended December 31, 1993, 1992 and 1991, management fees earned by Compass were $786,000, $785,000, and $697,000, respectively. In 1992, the Partnership agreed to pay interest to both the Advisor and Compass as consideration for their willingness to defer the payment of fees which were otherwise due and payable. The Advisor and Compass deferred such fees as an accommodation to the Company in connection with its refinancing efforts as described in Items 7 and 8. For the years ended December 31, 1993 and 1992, the Partnership recorded interest expense on deferred fees of $249,000 and $223,000, respectively, representing an interest rate of 7.31% through April 1, 1993 and 8.5% thereafter applied to the cumulative unpaid fee balance. Such fees and the interest thereon were paid in full from the proceeds from the August 19, 1993 issuance of collateralized floating rate notes (see Items 7 and 8). Pursuant to an agreement with the Advisor to provide services in connection with such debt refinancing, the Advisor received a fee of $300,000 in 1993. The Company's executive offices will be located at One Tower Bridge, W. Conshohocken, PA 19428. These offices, including furniture, telephones, and certain ofice services and equipment, will be furnished for a period of between four and seven months at a monthly rate of approximately $11,500 from a partnership owned by Mr. Tanenbaum and his sons. Such terms have been approved by the Board of Trustees, with the abstention of Mr. Tanenbaum, based upon a conclusion that the terms of the lease are as favorable to the Company as those generally available from unaffiliated third parties. For a description of Common Shares issued to the Advisor pursuant to the Merger in connection with the termination of the advisory agreement and of Common Shares issued to the General Partners, see Items 1, 7 and 8. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - ------------------ (1) Incorporated herein by reference to exhibit filed with Registrant's Registration Statement on Form S-11, File No. 33-6992. (2) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1988. (3) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1989. (4) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1990. (5) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1991. (6) Incorporated herein by reference to exhibit filed with Registrant's Form 10-K for the fiscal year ended December 31, 1992. (7) Incorporated herein by reference to exhibit filed with Registrant's Registration Statement on Form S-4, File No. 38-68664. 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, on the 29th day of March, 1994. EQK Green Acres Trust By:/s/ Myles H. Tanenbaum Myles H. Tanenbaum, Chairman of the Board of Trustees, President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 29, 1994 by the following persons on behalf of the Registrant and in the capacities indicated. EQK GREEN ACRES TRUST INDEPENDENT AUDITORS' REPORT To the Board of Trustees and Shareholders of EQK Green Acres Trust: We have audited the accompanying consolidated balance sheets of EQK Green Acres Trust (a Delaware business trust) as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements and the consolidated financial statement schedules discussed below are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of EQK Green Acres Trust as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Our audits also comprehended the consolidated financial statement schedules of EQK Green Acres Trust as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements, present fairly in all material respects the information shown therein. Deloitte & Touche Atlanta, Georgia March 10, 1994 EQK GREEN ACRES TRUST CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT COMMON SHARE DATA) See accompanying Notes to Consolidated Financial Statements EQK GREEN ACRES TRUST CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT COMMON SHARE DATA) See accompanying Notes to Consolidated Financial Statements EQK GREEN ACRES TRUST CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS) See accompanying Notes to Consolidated Financial Statements EQK GREEN ACRES TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See accompanying Notes to Consolidated Financial Statements EQK GREEN ACRES TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: MERGER TRANSACTION AND BASIS OF PRESENTATION EQK Green Acres Trust (the 'Trust'), formed on September 8, 1993 as a Delaware business trust, has an indefinite life and intends to elect real estate investment trust ('REIT') status under the Internal Revenue Code of 1986, as amended. On February 28, 1994, EQK Green Acres, L.P. (the 'Partnership') merged with and into Green Acres Mall Corp., a wholly-owned subsidiary of the Trust. Prior to February 28, 1994, the Trust did not have significant operations. The Trust and the Partnership are collectively referred to herein as the 'Company'. The Partnership had been formed pursuant to an Agreement of Limited Partnership dated as of June 30, 1986 (and amended and restated as of August 27, 1986) to acquire and operate Green Acres Mall (the 'Property' or the 'Mall'), a regional shopping mall located in Nassau County, Long Island, New York. In 1991, the Partnership completed the conversion of a leased industrial building, located adjacent to the Property, into a convenience shopping center known as the Plaza at Green Acres (the 'Plaza'). Pursuant to the merger, Unitholders of the Partnership received 10,172,639 common shares of the Trust (the 'Common Shares') on account of their 98.98% percentage interest in the Partnership; the General Partners of the Partnership received 104,830 Common Shares on account of their 1.02% percentage interest in the Partnership; and the Special General Partner of the Partnership received 1,316,251 Common Shares in satisfaction of its residual interest in the Partnership. Pursuant to the termination of the Partnership's advisory agreement (see Note 5), the Advisor is entitled to receive 308,933 Common Shares on March 30, 1994. The issuance of 10,277,469 Common Shares to the Unitholders and the General Partners on account of their respective interests in the Partnership represents a reorganization of entities under common control and, accordingly, was accounted for in a manner similar to a pooling of interests. The financial statements of the Trust and the Partnership have been combined at historical cost retroactive to January 1, 1991. The issuance of these Common Shares has been reflected as of January 1, 1991 at an amount that equals the Unitholders' and General Partners' original contribution to the Partnership. The issuances of Common Shares to the Special General Partner and the Advisor will be reflected in the Company's financial statements as of February 28, 1994 and March 30, 1994, respectively. The issuance of such Common Shares to the Special General Partner will increase the Trust's carrying value of land and buildings and improvements by $3,024,000 and $13,347,000, respectively, representing the agreed-upon value of the Special General Partner's residual interest in accordance with the allocation methodology utilized by the Partnership in connection with the Merger. Had this Common Share issuance been recorded on January 1, 1991, depreciation expenses would have increased by approximately $342,000 in each of the three years ended December 31, 1993 ($.03 per Common Share outstanding). The issuance of Common Shares to the Advisor will be reflected as a charge to earnings during the first quarter of 1994 in the approximate amount of $3,843,000. In connection with the merger, the Company recorded as expense in 1993 nonrecurring legal, accounting, and printing costs aggregating approximately $1,250,000 ($.12 per Common Share). NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES REVENUE RECOGNITION Minimum rents are recognized on a straight-line basis over the terms of the related leases. Percentage rents are recognized on an accrual basis. CAPITALIZATION, DEPRECIATION AND AMORTIZATION Investments in the Property are recorded at cost. Costs directly associated with major renovations and improvements to mall property and to leased property are capitalized until the related project is substantially complete and ready for its intended use. In 1991, capitalized improvements and additions included $867,000 of interest on funds borrowed to finance construction. No interest was capitalized in 1993 and 1992. Capitalized leases are recorded at the lower of fair market value or the present value of future lease payments. Depreciation of the Property is provided on a straight-line basis over the estimated useful lives of the related assets, ranging generally from 10 to 40 years. Capitalized lease assets are amortized over the lease term. Intangible assets are amortized on a straight-line basis over their estimated useful lives. DEFERRED LEASING COSTS Costs incurred in connection with the execution of a new lease, including leasing commissions, costs associated with the acquisition or buyout of existing leases and legal fees, are deferred and amortized over the term of the new lease. NET INCOME (LOSS) AND DISTRIBUTIONS PER COMMON SHARE Net income (loss) and distributions per Common Share for the years ended December 31, 1993, 1992, and 1991 have been computed based on the 10,277,469 Common Shares outstanding during the periods. INCOME TAXES No provision has been made in the accompanying consolidated financial statements for income tax liabilities since the Unitholders and General Partners of the Partnership were required to include their respective share of profits and losses in their individual tax returns. The ongoing operations of the Company generally will not be subject to Federal income taxes as long as the Company qualifies as a REIT. In order to qualify as a REIT, the Company will be required to distribute at least 95% of its taxable income to the shareholders and to meet certain asset and income tests, as well as certain other requirements. CONSOLIDATED STATEMENTS OF CASH FLOWS Cash equivalents include short-term investments with an original maturity of three months or less. Included in the consolidated statements of cash flows are cash payments for interest (net of amount capitalized) of $3,334,000, $1,986,000 and $789,000 for the years ended December 31, 1993, 1992, and 1991, respectively. At December 31, 1993, accrued refinancing costs amounted to $131,000. In 1992, the Company capitalized $8,084,000 representing the purchase price, plus related expenditures for interest, taxes, insurance and predevelopment costs of the adjacent industrial tract which it had committed to purchase (see Note 6). The corresponding obligation for the unpaid balance of the purchase contract at December 31, 1992, amounting to $4,850,000, was reflected in other liabilities. Such amount was paid in 1993. In 1991, cash used in investing activities included $771,000 of expenditures accrued at December 31, 1990. FINANCIAL INSTRUMENTS Management has reviewed the various assets and liabilities of the Company at December 31, 1993 and 1992 in accordance with Statement of Financial Accounting Standards No. 107, 'Disclosure about Fair Value of Financial Instruments' (which is not applicable to real estate assets). Management has concluded that all of the Company's financial instruments, except for the zero coupon mortgage note outstanding at December 31, 1992, have terms such that their book value approximates fair value. At December 31, 1992 and continuing into 1993, there was no readily available source of zero coupon mortgage financing and, therefore, management determined that the estimation of a fair value of the zero coupon mortgage note was not practicable. On August 19, 1993, the Company retired the zero coupon mortgage note with the proceeds from the issuance of its collateralized floating rate notes (see Note 4). RECLASSIFICATIONS Certain reclassifications have been made to the prior years' consolidated financial statements in order to conform their presentation to that used in the current year. NOTE 3: LEASING ARRANGEMENTS THE COMPANY AS LESSOR The Company leases shopping center space to approximately 200 tenants, generally under non-cancelable operating leases. The leases generally provide for minimum rentals, plus percentage rentals based upon the retail stores' sales volume. Percentage rentals amounted to $2,563,000, $2,621,000 and $2,306,000 for the years ended December 31, 1993, 1992, and 1991, respectively. In addition, the tenants pay certain utility charges to the Company and, in most leases, reimburse their proportionate share of real estate taxes and common area expenses. The Company leases space to national, regional, and local tenants. Diversity in the tenant mix minimizes exposure to credit risk from geographic concentration. However, regional and local tenants may represent a higher level of credit risk. In certain instances, the Company obtains security deposits to mitigate risk from less creditworthy tenants. Future minimum rentals under existing leases at December 31, 1993 are as follows: THE COMPANY AS LESSEE In 1990, the Company entered into a 30-year lease, with three, six-year renewal options, on the Plaza, an adjacent 9-acre site on which there is situated an industrial building that has been renovated and converted into retail shopping space. The Plaza opened for business in September 1991. In addition to specified rents, the Plaza lease requires the Company to pay property taxes, insurance, operating expenses and additional rentals based on a percentage of revenues generated by the operations of the Plaza. No such additional rentals were paid in 1993, 1992 or 1991. In accordance with applicable accounting standards, the portion of the lease related to the building is accounted for as a capital lease while the portion related to the land is accounted for as an operating lease. The following is a schedule of future minimum lease payments under the lease as of December 31, 1993: For the years ended December 31, 1993, 1992, and 1991, total rental expense under the operating lease portion of this lease was $734,000, $709,000 and $329,000, respectively, all of which represented minimum lease payments. As of December 31, 1993, the Company has signed sublease agreements with certain tenants of the Plaza, which agreements generally provide for rentals based on a percentage of tenant sales in addition to base rental. Sublease income of $42,953,000 will be received over the remaining terms of the respective leases. Such income is included in the future minimum rentals table presented above. Sublease income totalled $2,189,000, $2,523,000, and $765,000 for the years ended December 31, 1993, 1992, and 1991, respectively. In January 1993, the Partnership terminated its lease with Pergament Home Improvement Center ('Pergament'), one of the anchor tenants at the Plaza, and entered into a new lease agreement covering Pergament's space and all but one of the Plaza's small store spaces with Kmart Corporation. In connection with the lease termination, the Company paid Pergament $450,000. NOTE 4: DEBT FINANCING On August 19, 1993, the Company completed a comprehensive refinancing by issuing collateralized floating rate notes ('floating rate notes') in the aggregate principal amount of $118,000,000. The proceeds from the sale of the floating rate notes were used, in part, to pay the approximate $95,399,000 purchase price for the zero coupon first mortgage note previously outstanding and retire a $16,500,000 term loan note at face value. The proceeds from the issuance of the floating rate notes were also used to purchase an interest rate cap for $1,023,000 and to pay mortgage recording taxes and other costs incurred in connection with this refinancing. The floating rate notes were recorded net of a $118,000 discount. In connection with the early extinguishment of the zero coupon first mortgage note, the Company recognized an extraordinary charge to earnings of $6,373,000. The floating rate notes are due August 19, 1998 and are collateralized by a first mortgage on substantially all of the real property comprising Green Acres Mall and a first leasehold mortgage on the Plaza. The floating rate notes bear interest at a rate equal to 78 basis points in excess of the three-month LIBOR, which is payable on a quarterly basis commencing November 12, 1993. The interest rate is subject to reset on such interest payment dates. The initial interest rate, 4.03%, was effective for the period August 19, 1993 to November 11, 1993. On November 12, 1993, the interest rate was reset to 4.28%. The interest rate cap provides that the effective interest rate applicable to the $118,000,000 face value of the notes will not exceed 9% per annum through their maturity date. Should such debt's interest rate rise above 9%, the Company would record amounts receivable from the counter-party as a reduction to interest expense. The Company is exposed to certain losses in the event of non-performance by the counter-party to this agreement. The mortgage and indenture agreement relating to the floating rate notes limit additional indebtedness that may be incurred by Green Acres Mall Corp.. Those agreements also contain certain other covenants which, among other matters, effectively subordinate distributions from Green Acres Mall Corp. to debt service requirements of the floating rate notes. As part of its comprehensive debt restructuring, the Company also obtained a $3,400,000 unsecured line of credit facility from a bank. The line of credit agreement bears interest at 1% above the bank's prime rate and will mature in February 1995, unless extended. The line of credit agreement also contains certain covenants which, among other matters, limit the amount of the Company's annual dividend to an amount that does not exceed operating cash flow (as defined), and require the Company to maintain a quarterly debt service coverage ratio (as defined). At December 31, 1993, the Company had borrowed $1,800,000 under this credit facility. The floating rate notes' mortgage agreement places certain limitations on Green Acres Mall Corp.'s ability to borrow under the line of credit agreement. At December 31, 1993, limitations related to future capital expenditures reduced the Company's available borrowing capacity to approximately $1,150,000. Subsequent to year end, the Company borrowed an additional $900,000 under this credit facility. The Partnership had issued the previously outstanding zero coupon mortgage note on August 27, 1986 in connection with its financing of the acquisition of the Property. The zero coupon mortgage note, which was secured by substantially all of the real property comprising Green Acres Mall, had an effective annual interest rate of 10.4% compounded semi-annually. The $16,500,000 term loan note retired on August 19, 1993 originated on June 30, 1993 upon the conversion of a matured line of credit. This line of credit, along with predecessor facilities, bore interest at rates ranging from the bank's prime rate to such prime rate plus 1%. In connection with a renewal and the conversion of the line of credit facility to a term loan in 1993, the Company paid fees to the bank of approximately $125,000. Borrowings under these facilities were secured by a second mortgage on substantially all of the real property comprising Green Acres Mall and a first leasehold mortgage on the Plaza. NOTE 5: ADVISORY AND MANAGEMENT AGREEMENTS Prior to the termination of its advisory agreement as discussed below, Equitable Realty Portfolio Management, Inc., a wholly owned subsidiary of Equitable Real Estate Investment Management, Inc. ('Equitable Real Estate'), acted as 'Advisor' to the Partnership. The Advisor made recommendations to the Managing General Partner concerning investments, administration and day-to-day operations. For performing these services, the Advisor received an annual base advisory fee of $250,000. The Advisor also received an annual subordinated incentive advisory fee of $1,250,000 which increased in proportion to the amount by which aggregate distributions of operating cash flow to Unitholders exceeded a 10% return on the Unitholders' Adjusted Capital Contributions (as defined in the Partnership Agreement). Payment of this fee was subordinated to a minimum annual distribution equal to a 10% return to Unitholders. Portions of the fee not paid in any year because of such subordination were to be deferred and paid from future operating cash flow on a subordinated basis. For the years ended December 31, 1993, 1992, and 1991, the subordinated incentive advisory fee was $1,375,000, $1,459,000, and $1,681,000, respectively. As of December 31, 1992 and 1991, $1,459,000 and $1,264,000, respectively, were reflected as obligations on the Company's consolidated balance sheets. Upon sale of all or any portion of any real estate investment of the Partnership, the Advisor was entitled to receive a disposition fee equal to 2% of the gross sale price (including outstanding indebtedness taken subject to or assumed by the buyer and any purchase money indebtedness taken back by the Partnership). The disposition fee was to be reduced by the amount of any brokerage commissions and legal expenses incurred by the Partnership in connection with such sales. Pursuant to this agreement with the Advisor, the Company paid a $290,000 fee to the Advisor during 1993 relating to services rendered in connection with the acquisition and development of the Bulova Parcel and its ultimate transfer to Home Depot (see Note 6). Such fees paid to the Advisor reduced the amount of the gain recognized from this transaction. Pursuant to an agreement with the Advisor to provide services in connection with the refinancing of the Company's debt as described in Note 4, the Advisor was paid a $300,000 fee in 1993. In December 1992, the Partnership entered into an agreement with the Advisor pursuant to which the Advisor provided development services in conjunction with the termination of its lease with Pergament and the procurement of a new lease with Kmart Corporation (see Note 3). The fee for these services was $150,000, which was paid in 1993. Pursuant to the merger discussed in Note 1, upon the expiration of a 30 day transition period agreement commencing March 1, 1994, the agreement with the Advisor will be terminated. The Partnership had entered into a property management agreement with Compass Retail, Inc. ('Compass'), a subsidiary of Equitable Real Estate, effective January 1, 1991. Pursuant to this agreement, property management fees were based on 4% of net rental and service income collected from tenants. In connection with the merger discussed in Note 1, the agreement with Compass was amended and restated to extend its termination date by two years to August 31, 1998, and to limit Compass' scope of responsibilities primarily to accounting and financial services currently provided in connection with the operations of the Property. Compass' compensation will be reduced from 4% to 2% of net rental and service income collected from tenants. For the years ended December 31, 1993, 1992 and 1991, management fees earned by Compass were $786,000, $785,000, and $697,000, respectively. In 1992, the Partnership agreed to pay interest to both the Advisor and Compass as consideration for their willingness to defer the payment of fees which were otherwise due and payable. The Advisor and Compass deferred such fees as an accommodation to the Partnership in connection with its refinancing effort (see Note 4). For the years ended December 31, 1993 and 1992, the Company recorded interest expense on deferred fees of $249,000 and $223,000 respectively, representing interest rates of 7.31% through April 1, 1993 and 8.5% thereafter applied to the cumulative unpaid fee balances. NOTE 6: DEVELOPMENT ACTIVITIES In January 1992, the Company announced plans for a major expansion of the Mall. The Company filed the required zoning and other related applications necessary for the commencement of such expansion. In June 1992, the Company announced its decision to defer the planned expansion of the Mall due to its inability to secure financing for this project. It is uncertain when, or if, the expansion program will be resumed. Accordingly, capitalized costs related to the predevelopment phase of the expansion were written-off. In April 1993, the Company completed the acquisition of an adjacent industrial tract (the 'Bulova Parcel') through a subsidiary partnership and entered into a lease/purchase agreement for this real estate with Home Depot. Pursuant to the lease/purchase agreement, Home Depot paid $9,500,000 to the Company, a portion of which was used to complete the purchase of the Bulova Parcel. As a result of the completion in 1993 of specified environmental work, the lease/purchase agreement obligated Home Depot to take title to the Bulova Parcel. In connection with this lease/purchase agreement, the Company recognized a gain on sale of real estate of $440,000 during 1993. Subsequent to December 31, 1993, the Company's restricted cash balance of $500,000 was released from escrow. During the first quarter of 1994, the Company completed the sale to Home Depot of an approximate two acre parking lot tract adjacent to the Bulova Parcel. The proceeds for the sale were $1,500,000, resulting in a 1994 gain on sale of real estate of approximately $800,000. NOTE 7: COMMITMENTS AND CONTINGENCIES Pursuant to the terms of the Plaza lease, the Company was required to provide, or cause a third party lender to provide, mortgage financing of $4,800,000 to the lessor. In January 1992, the Company arranged such financing from a third party lender for a term of five years at an interest rate of 10.25%. The Company has an option to extend the financing for an additional five years at a variable rate of interest. This financing replaced an existing mortgage, and is secured by the Plaza property, but is non-recourse to the lessor. The Company is required to make all debt service payments on behalf of the lessor and will receive an annual offset to its minimum rent equal to 12% of the total financing provided to the lessor. NOTE 8: SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a summary of selected quarterly financial data for the years ended December 31, 1993 and 1992. Such data include certain reclassifications to accounts presented in quarterly reports on Form 10-Q in order to conform their presentation to that used in the consolidated statements of operations presented herein. In connection with the merger discussed in Note 1, the Company recorded as expense in the fourth quarter of 1993 nonrecurring legal, accounting, and printing costs aggregating $1,250,000 ($.12 per Common Share). As discussed in Note 6, during the second quarter of 1992, the Company wrote-off $1,439,000 of capitalized costs related to the predevelopment phase of a mall expansion project that was deferred ($.14 per Common Share). NOTE 9: SUBSEQUENT EVENTS On January 25, 1994, the Board of Trustees adopted an Incentive Share Plan (the 'Plan'), which provides for the issuance of up to 1,500,000 Common Shares to outside Trustees, officers and key executives of the Company through options to purchase Common Shares, share appreciation rights, and restricted share grants. Common Share options may be options that are intended to qualify as incentive options under the Internal Revenue Code of 1986, as amended, or options which are not intended to so qualify. Options will be granted with an exercise price that approximates the fair value of the Common Shares on the grant date. Concurrent with the adoption of this Plan, the Company granted options to purchase 7,500 Common Shares to each of its four eligible trustees and options to purchase an aggregate of 875,000 Common Shares to certain officers. Certain officers also received in aggregate 5,950 restricted Common Shares. All such options have an exercise price of $10 per Common Share and vest ratably commencing one year from the grant date in equal annual increments over three and five years for the Trustee and officer options, respectively. The restricted shares become unrestricted in equal annual increments over three years commencing one year from the grant date. - -------------------------------------------------------------------------------- FINANCIAL STATEMENT SCHEDULES DECEMBER 31, 1993 (IN THOUSANDS) - -------------------------------------------------------------------------------- SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (1) Write-offs of accounts receivable - -------------------------------------------------------------------------------- SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- (1) Average of month-end balances outstanding during the period. (2) Year-to-date interest expense divided by average of month-end balances outstanding during the period. - -------------------------------------------------------------------------------- SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION - -------------------------------------------------------------------------------- (1) Substantially all such costs are recovered from tenants based on the provisions of the tenants' leases. (2) Principally represents amortization of deferred financing costs, which is classified as interest expense. - -------------------------------------------------------------------------------- SCHEDULE XI -- REAL ESTATE AND ACCUMULATED DEPRECIATION - -------------------------------------------------------------------------------- (1) Encumbrance is a floating rate note constituting a first lien on the real estate. (2) The Plaza at Green Acres is a leased asset. Encumbrances constitute a first leasehold mortgage collateralizing the floating rate notes ($117,891) and the obligation under the capitalized lease ($6,971). (3) Includes $10,175 representing the deemed value of units issued to affiliates of the former owners of Green Acres Mall and the General Partnership interest ($2,075 in Land, $8,100 in Buildings and Improvements). (4) Original construction was completed in 1955; mall was expanded/renovated in 1982-83 and renovated again in 1990-91. (5) The aggregate tax basis of the Partnership's property is $143,829 as of December 31, 1993.

724941_1993.txt

724941_1993

1993

724941

ITEM 1. BUSINESS. OVERVIEW Merisel, Inc. (together with its subsidiaries, "Merisel" or the "Company") is the largest worldwide publicly-held wholesale distributor of microcomputer hardware and software products. Through its full-line, channel-specialized distribution business, Merisel combines the comprehensive product selection and operational efficiency of a full-line distributor with the customer support of a specialty distributor offering dedicated sales organizations to each of its customer groups. On January 31, 1994, the Company completed the acquisition (the "ComputerLand Acquisition") of certain assets of ComputerLand Corporation's United States franchise and aggregator business ("the ComputerLand Business"). The ComputerLand Business is a leading aggregator, or master reseller, of computer systems and related products from major microcomputer manufacturers, including Apple, Compaq, Hewlett-Packard and IBM, to a network of approximately 750 independently-owned computer product resellers in the United States. With the acquisition of the ComputerLand Business, the Company has become the industry's only "Master Distributor," combining the strengths of a full-line, channel specialized distributor with those of a master reseller. As a Master Distributor, the Company believes it is uniquely positioned to offer a wider selection of microcomputer products to more categories of customers than any of its competitors. At December 31, 1993, Merisel stocked over 25,000 products from more than 900 of the microcomputer hardware and software industry's leading manufacturers including Apple, AST, Borland, Colorado Memory Systems, Compaq, Creative Labs, Digital Equipment Corporation, Epson, Hayes, Hewlett-Packard, IBM, Intel, Lotus, Microsoft, NEC, Novell, Okidata, Sun Microsystems, Symantec, Texas Instruments, 3Com, Toshiba, WordPerfect and Wyse. Merisel sells products to over 65,000 computer resellers worldwide, including value-added resellers, large retail chains and franchisees, computer superstores, mass merchants, Macintosh and Unix resellers, system integrators and original equipment manufacturers. The Company currently maintains 20 distribution centers that serve North America, Europe, Latin America, Australia and other international markets. For the fiscal year ended December 31, 1993, the Company's net sales by geographic region were generated as follows: United States, 63%; Canada, 13%; Europe, 17%; and other international markets, 7%. THE INDUSTRY The microcomputer products distribution industry is large and growing, reflecting both increasing demand worldwide for computer products and the increasing use of wholesale distribution channels by manufacturers for the distribution of their products. The industry moves product from manufacturer to end-user through a complex combination of distribution agreements between manufacturers, wholesale distributors, aggregators and resellers. Historically, there have been two types of companies within the industry: those that sell directly to the end-user ("resellers") and those that sell to resellers ("wholesale distributors" and "aggregators", which are also called "master resellers"). Resellers sell directly to end-users, including large corporate accounts, small- and medium-sized businesses and home users. The major reseller channels are dealers and corporate resellers, value-added sellers ("VARs"), mail-order firms and retailers (computer superstores, office supply chains and mass merchants). VARs, which account for one of the largest segments of the overall reseller channel, typically add value by combining proprietary software and/or services with off-the-shelf hardware and software. Wholesale distributors generally purchase a wide range of products in bulk directly from manufacturers and then ship products in smaller quantities to many different types of resellers, who typically include dealers, VARs, system integrators, mail order resellers, computer products superstores and mass merchants. Aggregators, or master resellers, are functionally similar to wholesale distributors, but they focus on selling relatively few product lines, typically high-volume, brand name computer systems, to a captive network of franchised dealers and affiliates. The larger computer manufacturers, such as Apple, Compaq, Hewlett-Packard and IBM, have historically required resellers to purchase their products from an affiliated aggregator, such as the ComputerLand Business. Wholesale distributors have not been authorized to sell these manufacturers' key microcomputer components, except on a limited basis. These restrictions have been eased recently, and may continue to ease and eventually be eliminated, with the result that the distinction between wholesale distributors and master resellers may blur. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Acquisition of ComputerLand Business." With the acquisition of the ComputerLand Business, the Company has become the industry's only Master Distributor, combining the strengths of a full-line, channel-specialized distributor with those of a master reseller. BUSINESS STRATEGY Merisel has achieved its leading position by pursuing a strategy of offering the industry's leading products and services to its customers at competitive prices, providing superior cost-effective service through operational excellence, expanding the Company's international business and targeting its various customer groups using dedicated sales forces and marketing programs. Providing Leading Products and Services. The Company's objective is to offer the broadest range of leading product brands in each of the product categories it carries. By stocking the leading brands, the Company generates sales of both those product brands as well as other products, as reseller customers often prefer to deal with a single source for many of their product needs. The Company continuously evaluates new products, the demand for its current products and its overall product mix and seeks to develop distribution relationships with suppliers of products that enhance the Company's product offerings. The Company believes that the size of its reseller customer base, its international distribution capability and the breadth and quality of its marketing support programs give it a competitive advantage over smaller, regional distributors in developing supplier relationships. As a result of the ComputerLand Acquisition, the Company, through the ComputerLand Business, is now able to offer to the ComputerLand Business' franchisees and affiliates a broad range of microcomputer systems and other products from Apple, Compaq, Hewlett-Packard and IBM. Although the Company distributes certain products of these leading manufacturers through its wholesale distribution arrangements, neither the Company nor its direct wholesale distribution competitors have been authorized to sell these manufacturers' key microcomputer systems in the United States, except on a limited basis. Instead, these manufacturers historically have distributed their products directly to resellers and through aggregators such as ComputerLand Corporation. See "--The Industry." The Company believes that an opportunity exists to generate additional, higher-margin revenues by offering fee-based services and information to manufacturers and resellers. In 1993, the Company formed the Channel Services Group to provide a variety of these services, including telemarketing, merchandising and electronic software services. Achieving Operational Excellence. The Company believes that high levels of customer service and operating efficiency, or "operational excellence," are significant factors in achieving and maintaining success in the highly competitive microcomputer products distribution industry. The Company measures operational excellence by such standards as "ease of doing business," accuracy and efficiency in delivering products and expediting the delivery of services and information. Merisel constantly strives to improve its operational processes. In furtherance of this strategy, the Company is in the process of significantly upgrading and improving its computer operating systems as well as its warehouse management systems. See "--Operations and Distribution." In addition, the Company is reorganizing its European operations, adding new management personnel and centralizing certain functions to achieve economies of scale. Merisel will seek to continue to refine the operational systems at its foreign sales offices and distribution centers in order to increase the uniformity and efficiency of the Company's worldwide operations. See "--International Operations." These changes are intended to enhance the Company's ability to offer faster, more efficient and accurate service to its customers. Expanding Internationally. Merisel believes that it generates the largest volume of international sales of any U.S.-based distributor, and is the largest wholesale distributor of computer products in Canada and a leading distributor in Europe, Mexico, Australia and Latin America. See "--International Operations." The Company believes that many international markets will continue to offer substantial growth and profit opportunities, due to the immature and fragmented nature of the microcomputer distribution industry in these markets. Merisel believes it is well positioned to capitalize on the opportunities presented in a number of these markets because of the current scope of its international operations and its ability to offer a broader range of products and specialized services than many of its competitors. The Company's strategy is to expand its international operations through internal growth and the possible acquisition of existing distributors or the establishment of new operations in other countries. Targeting Customer Groups. Merisel serves a variety of different reseller channels, which have diverse product, financing and support needs. Merisel was the first full-line distributor in the industry to offer its various customer groups a channel-dedicated sales force as well as customized product offerings, financing programs and marketing and technical support programs, all of which are tailored to address the differing needs of these customer groups. The Company intends to continue to monitor the markets it serves to identify customer opportunities and develop sales and marketing programs that serve these groups more effectively. In furtherance of this strategy, on January 31, 1994 the Company completed the ComputerLand Acquisition. PRODUCTS AND MANUFACTURER SERVICES Merisel provides its manufacturers with access to one of the largest bases of computer resellers worldwide while offering these manufacturers the means to reduce the inventory, credit, marketing and overhead costs associated with establishing a direct relationship with these resellers. This factor, along with Merisel's access to financial resources and its economies of scale, has allowed the Company to establish and develop long-term business relationships with many of the leading manufacturers in the microcomputer industry. Merisel distributes over 25,000 hardware and software products, including products for the MS-DOS, OS/2, Macintosh, Apple and Unix operating environments. For the fiscal year ended December 31, 1993, net worldwide sales of hardware and accessories accounted for approximately 60% of the Company's sales, and sales of software products accounted for the remaining 40% of net sales. Merisel's suppliers include many of the leading microcomputer software and hardware manufacturers, such as Apple, AST, Borland, Colorado Memory Systems, Compaq, Creative Labs, Digital Equipment Corporation, Epson, Hayes, Hewlett- Packard, IBM, Intel, Lotus, Microsoft, NEC, Novell, Okidata, Sun Microsystems, Symantec, Texas Instruments, 3Com, Toshiba, WordPerfect and Wyse. In October 1993, Merisel was selected as one of two distributors in the U.S. of Sun Microsystem's products. Software products include business applications such as spreadsheets, word processing programs and desktop publishing and graphics packages, as well as a broad offering of operating systems, including local area network operating systems, advanced language and utility products. Hardware products offered by the Company include computer systems, printers, monitors, disk drives and other storage devices, modems and other connectivity products, plug-in boards and accessories. The ComputerLand Acquisition increased the Company's ability, through the ComputerLand Business, to distribute the product offerings of Apple, Compaq, Hewlett-Packard and IBM to the ComputerLand Business' franchisees and affiliates. See "--The Industry." In addition to providing manufacturers access to one of the largest bases of computer resellers worldwide, the Company also offers manufacturers the opportunity to efficiently offer a number of special promotions, training programs and marketing services targeted to the needs of specific reseller groups. Merisel runs a variety of special promotions for manufacturers' products, ranging from price discounts and bundled purchase discounts to specialized computer reseller marketing programs, including the Vantage and Frequent Buyer Programs. These promotional programs are designed to encourage computer resellers to increase their volume of purchases, motivate resellers to purchase within a limited time period and highlight specific manufacturers' products or promotion opportunities. Additionally, Merisel provides marketing consultation services for manufacturers' strategic marketing campaigns, as well as the opportunity to be included in Merisel-sponsored trade advertisements. Merisel employs marketing program specialists to work with designated manufacturers to develop and carry out marketing programs such as dealer commission programs, sales contests and other promotions. Merisel can also provide dedicated marketing support and targeted customer information from its database to enhance manufacturers' product promotions. The Company also offers two exclusive training programs: Softeach, a two-day worldwide seminar series whereby manufacturers train resellers about their products, and Selteach, a training seminar series that gives manufacturers an opportunity to provide product information to Merisel's United States sales force. In 1993, Merisel offered Softeach seminars in 11 cities and 26 countries. Merisel, through third-party consultants, also conducts training classes regarding certain Novell, 3Com, The Santa Cruz Operation, Digital Equipment Corporation, Sun Microsystems, Microsoft and Lotus products for its reseller customers. Merisel generally enters into written distribution agreements with the manufacturers of the products it distributes. As is customary in the industry, these agreements usually provide non-exclusive distribution rights and often contain territorial restrictions which limit the countries in which Merisel is permitted to distribute the products. The agreements generally provide Merisel with stock balancing and price protection provisions which reduce in part Merisel's risk of loss due to slow-moving inventory, supplier price reductions, product updates or obsolescence. The Company's agreements generally have a term of at least one year, but often contain provisions permitting earlier termination by either party upon written notice. Some of these agreements contain minimum purchase amounts. Failure to purchase at such minimum levels could result in the termination of the agreement. Although Merisel regularly stocks products and accessories supplied by more than 900 manufacturers, 45% of the Company's net sales in 1993 (as compared to 46% in 1992 and 47% in 1991) were derived from products supplied by Merisel's ten largest manufacturers, with the sale of products manufactured by Microsoft accounting for approximately 16% of net sales in 1993 (as compared to 17% in 1992 and 15% in 1991). The loss of the ability to distribute a particularly popular product could result in losses of sales unrelated to that product. The loss of a direct relationship between the Company and any of its key suppliers could have an adverse impact on the Company's business and financial results. CUSTOMERS AND CUSTOMER SERVICES Merisel sells to more than 65,000 computer resellers worldwide. Merisel's customers include VARs, large hardware and software retail chains and franchisees, computer superstores, mass merchants, Macintosh, Unix and other corporate resellers, systems integrators, and original equipment manufacturers as well as independently owned retail outlets and consultants. Merisel's smaller customers often do not have the resources to establish a large number of direct purchasing relationships or stock significant product inventories. Consequently, they tend to purchase a high percentage of their products from distributors. Larger resellers often establish direct relationships with manufacturers for their more popular products, but utilize distributors for slower-moving products and for fill-in orders of fast-moving products which may not be available on a timely basis from manufacturers. No single customer accounted for more than 2.0% of Merisel's net sales in 1991, 1992 or 1993. In Merisel's wholesale distribution business, the Company offers its customers a single source of supply, prompt delivery, financing programs and customer support. Single Source Provider. Merisel offers computer resellers a single source for over 25,000 competitively priced hardware and software products. By purchasing from Merisel, the reseller only needs to comply with a single set of ordering, billing and product return procedures and may also benefit from attractive volume pricing. In addition, resellers are allowed, within specified time limits, to return slow-moving products from one manufacturer in exchange for more popular products from other manufacturers. Merisel's policy is to not grant cash refunds. Merisel has recently initiated a program that provides incentives to ComputerLand franchisees and Datago affiliates to make all their product purchases from Merisel and the ComputerLand Business. Prompt Delivery. In most areas of the world serviced by the Company, orders received by 5:00 p.m. local time are typically shipped the same day, provided the required inventory is in stock. Merisel maintains sufficient inventory levels in the United States to fill consistently in excess of 95% of all units ordered on the day of receipt. Merisel typically delivers products from its regional warehouses via United Parcel Service and other common carriers, with customers in most areas in the United States receiving orders within one to two working days of shipment. Merisel also will provide overnight air handling if requested and paid for by the customer. These services allow computer resellers to minimize inventory investment and provide responsive service to their customers. For larger customers in the United States, Merisel also provides a fulfillment service so that orders are shipped directly to the computer resellers' customer, thereby reducing the need for computer resellers to maintain inventories of certain products. The Company's foreign subsidiaries may have lower fill rates and longer delivery times due to differing market requirements and the smaller size of their operations. Financing Programs. Merisel's credit policy for qualified resellers eliminates the need to establish multiple credit relationships with a large number of manufacturers. In addition, the Company arranges floor plan and lease financing through a number of credit institutions and offers a program that permits credit card purchases by qualified customers. To allow certain resellers to purchase larger orders in the United States, the Company offers a "financing desk" which seeks to arrange alternative financing such as escrow programs and special bid financing from financial institutions. Customer Support. Merisel offers a number of customer loyalty programs, including the Vantage and Frequent Buyer Programs, which provide incentives to resellers to aggregate their purchases through Merisel. The Vantage Programs offer Merisel's top-volume customers within the VAR and value-added dealer channels increased levels of service and pricing advantages. Merisel's Frequent Buyer Program awards resellers with credits based on the dollar amount of their purchases from Merisel, which credits are redeemable for travel, education, merchandise and for revenue-generating activities such as product promotions and advertisements. The cost of the Frequent Buyer Program is funded by cooperative marketing dollars paid by Merisel's suppliers. Merisel furnishes its computer resellers with a series of publications containing detailed information on products, pricing, promotions and developments in the industry. Merisel publishes a Confidential Reseller Price Book, which lists Merisel's current product offerings. Merisel also publishes the Hot List, which ranks Merisel's current best-selling hardware and software products in four different reseller channels. In addition, Merisel's On-Line Literature Library offers over 20,000 data sheets of product information literature on a fax-back system and on CD-ROM. Merisel provides training and product information to its reseller customers through its well-respected Softeach program, a worldwide series of training forums whereby manufacturers conduct seminars on how to sell their products. Softeach is held periodically in major cities throughout the United States, Canada, Australia and Europe. In 1993, the Company believes that over 15,000 computer resellers attended Softeach seminars held in 11 countries worldwide. Merisel also provides computer resellers with a technical support "hotline," as well as specialized technical support for virtually all product lines sold by Merisel. In addition, Merisel's Technical Support department provides regular product training seminars to Merisel's sales representatives to help them become more product-knowledgeable. SALES AND MARKETING To reach diverse customer segments, the Company has organized its Sales department for its wholesale distribution business in the United States into three channel segments. DEALER CHANNEL. This channel is composed of the following specialized sales divisions: . The RETAILER division serves franchisees, independent retail chains and storefronts, corporate resellers and direct-mail marketers. . The RESELLER FULFILLMENT division serves the needs of direct marketers such as Dell, IBM and Zenith through the fulfillment of orders for third-party hardware and software products. . The MAJOR ACCOUNTS division serves Merisel's large franchisee accounts, computer superstores and computer retail chains through a specialized staff that offers enhanced services, volume purchase agreements, corporate office coordination, marketing programs and sales report data. . The MACINTOSH division provides expertise in sale and support of third- party Macintosh products worldwide through its own separate marketing, sales, products and technical support and purchasing departments. VAR CHANNEL. This channel is composed of the following specialized sales divisions: . The VAR division provides value-added resellers with highly knowledgeable sales representatives, a comprehensive line of computer systems, Unix and connectivity products, education, financial services and technical support. . The ADVANCED PRODUCTS division (formerly the UNIX division) is primarily dedicated to selling and supporting Sun Microsystems and Sun- complimentary products through its own sales, marketing, operations and technical support departments. . The OEM division supports Merisel's customers who integrate and/or manufacture microprocessor-based systems and solutions utilizing OEM versions of Merisel's hardware and software products. . The recently created SYSTEM INTEGRATOR division supports large system and network integrators who require specialized programs and services. CONSUMER CHANNEL. . The CONSUMER PRODUCTS division targets mass merchants such as Circuit City, Montgomery Ward and Office Depot by providing inventory selection and control services, specialized marketing programs and other support services tailored to the needs of mass-market merchandisers. For each of the Company's international subsidiaries, the number and type of specialized sales divisions vary based on market requirements, the size of the subsidiary's sales force and the products carried by the subsidiary. The Company's sales force is comprised of field sales representatives who manage relations with the larger accounts and inside telemarketing sales representatives who receive product orders and answer customer inquiries. When a customer calls Merisel, screen synchronization technology causes a sales profile to appear on the sales representative's computer screen before greetings are exchanged. Customer orders generally are placed via a toll-free telephone call to Merisel's inside sales representatives and are entered on Merisel's SalesNet order entry system, a proprietary local area network created by Merisel to speed the process of taking and processing orders. Using the SalesNet database, sales representatives can immediately enter customer orders, obtain descriptive information regarding products, check inventory status, determine customer credit availability and obtain special pricing and promotion information. Merisel also offers Dial-Up SalesNet, a system that allows a customer, through the use of its own personal computer and a modem, to access Merisel's database to examine pricing, credit information, product description and availability and promotional information and to place orders directly into Merisel's order processing system. For certain of its larger customers, the Company has installed electronic data interchange (EDI) systems which allow participating customers to directly access the Company's mainframe computer system for order processing and account information. OPERATIONS AND DISTRIBUTION The Company operates 20 distribution centers around the world, including eight in the United States, two in Canada, five in Europe, four serving Latin America and one in Australia. All of these distribution centers are leased, except for one facility in Mexico, which is owned by the Company. The Company's United States, Canadian and United Kingdom operations, other than the ComputerLand Business, are conducted using a mainframe-based computer system, originally implemented in the early 1980s, that operates on hardware owned and operated by a third-party service provider. In recent years, the Company has experienced a significant increase in both its sales volume and in the number and type of transactions processed by the computer system. The Company believes that the ability of its existing computer system in North America to process the significantly increased sales volumes contemplated for 1994 and the first three quarters of 1995 is limited without certain modifications to the system. The Company is in the process of implementing such modifications and believes such modifications will be successful. If, however, there is a delay in implementing the modifications, or if the system, as modified, performs below anticipated service levels, the existing system may not be able to accommodate anticipated increases in sales volumes and transaction requirements in the fourth quarter of 1994. As a result, the Company is making a significant investment in new advanced computer and warehouse management systems for its North American operations. These new systems are designed to accommodate substantially higher sales volumes as well as provide greater transaction accuracy and operating efficiency and more flexibility to accommodate a variety of transaction types. The Company began designing the new computer system in early 1993 and currently anticipates that it will convert to the new system in late 1994 and the first half of 1995. The Company presently estimates that its aggregate investment in the new computer systems, including costs of system design, hardware, software, installation and training, will be approximately $20 million. The Company installed its first new warehouse management system, which includes infrared bar coding equipment and advanced computer hardware and software systems, in one warehouse in 1993 and anticipates installation in its remaining North American warehouses during 1994 and 1995. The design and implementation of these new systems are complex projects and involve risks that unanticipated problems may delay implementation of the new systems or cause them to perform below anticipated service levels. The Company therefore is making a substantial investment in the design and installation of these systems and is dedicating a significant number of its personnel on a full-time basis to these projects. In the event the Company experiences significant delays in implementation of these new systems or such systems fail to perform at anticipated service levels, the Company may not be able to accommodate anticipated increases in sales volumes and transaction processing requirements after the third quarter of 1995. INTERNATIONAL OPERATIONS The Company distributes microcomputer products throughout the world. Merisel formed its first international subsidiary in 1982 and now operates in Canada, the United Kingdom, France, Germany, Australia, Switzerland, Austria and Mexico. Merisel also has a subsidiary based in Miami, Florida, which primarily sells products to customers in Latin America and in other parts of the world where Merisel does not have a physical presence. In June 1990, the Company began limited distribution of products in Russia as part of a joint venture. Management believes that its international microcomputer distribution operations are larger than the operations of any other U.S.-based microcomputer distributor. The Company also believes that certain of the markets for microcomputer products outside the United States are less mature and therefore present opportunities for further growth. Accordingly, the Company will seek to further expand its international operations through internal growth and the possible acquisition of existing distributors or establishment of new operations in other countries. The products and services offered by Merisel's international subsidiaries are generally similar to those offered in the United States, although the breadth of the subsidiaries' product lines and the range of manufacturers' and customers' services offered by the subsidiaries are usually smaller due to the smaller size of the subsidiaries and differing market requirements. Certain subsidiaries provide products or services not offered in the United States due to differing manufacturer relationships and market requirements. Operationally, the management and distribution systems at the Company's international subsidiaries vary depending on the size of the subsidiary, its length of operation and local market requirements. As each subsidiary expands, the Company seeks to implement systems and procedures that are more similar to those used in the United States. In Europe, the Company is revising its distribution strategy in response to the reduction in cross-border shipment barriers instituted by the European Economic Community in 1993. With the reduction of cross-border shipping barriers, the Company believes it can more efficiently ship to a large number of countries from a centralized master warehouse or warehouses, supplemented by smaller warehouses in various locations across Europe. At present, the Company maintains a full warehouse in each of the countries in which it has operations, with the exception of Austria. The Company is currently undertaking preparations for development of a master warehouse in Northern Europe for use beginning in mid-to-late 1995. The Company's European operations are managed through a European headquarters, which operates with a staff of pan-European managers to oversee the Company's various European subsidiaries and operations. Merisel currently is increasing its European management team and planning the computer system revisions and other operational changes required to implement its centralized distribution strategy. Because the Company conducts business in a number of countries, that portion of operating results and cash flows that is non-U.S. dollar denominated is subject to certain currency fluctuations. The Company generally employs forward exchange contracts to limit the impact of fluctuations in the relative values of some of the currencies in which it does business. In addition, international operations may also be subject to risks such as the imposition of governmental controls, export license requirements, restrictions on the export of certain technology, political instability, trade restrictions, changes in tariffs, difficulties in staffing and managing international operations and collecting accounts receivable and the impact of local economic conditions and practices. As the Company continues to expand its international operations, its success will be dependent, in part, on its ability to anticipate and deal with these and other risks. There can be no assurance that these or other factors will not have an adverse effect on the Company's international operations. For segment information regarding Merisel's United States and international operations, see Note 11 of Notes to Consolidated Financial Statements. COMPUTERLAND BUSINESS On January 31, 1994, the Company, through its wholly-owned subsidiary, Merisel FAB, Inc. ("Merisel FAB"), completed the ComputerLand Acquisition. As a result of the ComputerLand Acquisition, Merisel, through the ComputerLand Business, will now operate as a master reseller of computer systems and related products from the major microcomputer manufacturers to a network of approximately 750 independently-owned product resellers composed of two customer groups: ComputerLand franchisees, with whom Merisel acts as franchisor by licensing the ComputerLand name and providing both product supply and various support services, and resellers purchasing under the ComputerLand Business' Datago Program, which are independent dealers and value-added resellers that purchase products from the ComputerLand Business on a cost-plus basis, but do not license the ComputerLand name. For its fiscal year ended September 30, 1993, the ComputerLand Business generated revenues of approximately $1.1 billion and income from operations of $16.6 million. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Acquisition of ComputerLand Business." In connection with its purchase of the ComputerLand Business, Merisel purchased substantially all of the ComputerLand Business' franchise and third- party reseller agreements as well as substantially all of the rights in the United States to ComputerLand Corporation's trademarks, trade names, service marks, copyrights, patents and logos. Merisel paid approximately $80 million in cash at the closing of the ComputerLand Acquisition for the acquired assets. In addition, Merisel has agreed to make an additional payment in 1996 of up to $30 million, the amount of which will be determined based upon the growth in Merisel FAB's and the Company's sales of products of designated manufacturers to specified customers over the two-year period ending January 31, 1996. Substantially all of the ComputerLand Business' 66 employees became employees of Merisel FAB in connection with the ComputerLand Acquisition. Merisel did not purchase the order fulfillment systems, warehouses or inventory used by the ComputerLand Business. Instead, the Company eventually intends to integrate these functions into its facilities and systems. As an interim strategy Merisel and ComputerLand Corporation have entered into the Services Agreement pursuant to which ComputerLand Corporation will continue to provide products and distribution and other support services to the ComputerLand Business for two years following the ComputerLand Acquisition. Following its sale of the ComputerLand Business, ComputerLand Corporation continues to operate as a reseller of computer products and services through its company-owned locations throughout the United States and also retains its international operations. ComputerLand Corporation recently changed its name to Vanstar, Inc., but may continue to use the ComputerLand name in connection with operation of its existing company-owned locations in the United States until August 1994. Merisel FAB can sell franchises throughout the United States, except that Merisel FAB may not sell franchises in areas with such ComputerLand Corporation company-owned locations until August 1994. The ComputerLand Business' franchisees operate locations under the ComputerLand name. The ComputerLand Business currently sells products to franchisees at cost and receives a royalty based upon gross sales of the franchisee, irrespective of whether the products sold were purchased from the ComputerLand Business. During 1994, the ComputerLand Business may offer franchisees the opportunity to revise such franchisees' pricing structure by selling products to franchisees at cost plus a mark-up and reducing or eliminating the royalty on overall franchisee sales provided the franchisee achieves minimum purchase targets. Franchisees typically enter into a ten-year exclusive contract, renewable at the option of the franchisee. In addition to the use of the ComputerLand name, the ComputerLand Business provides franchisees a range of services including sales and marketing materials, management and sales support services and a proprietary-dealer management software system. At February 1, 1994, the ComputerLand Business had agreements with franchisee groups operating 198 locations, located primarily in secondary metropolitan markets in the United States. The ComputerLand Business' Datago resellers are independent dealers and value-added resellers. These resellers generally enter into non-exclusive one- year renewable contracts cancelable at the option of either party on short notice. These contracts typically entitle Datago resellers to purchase the full range of the ComputerLand Business' products at cost plus a mark-up, depending on the dollar volume of products purchased. At February 1, 1994, the ComputerLand Business had approximately 549 active Datago resellers. During its fiscal year ended September 30, 1993, no individual franchisee or Datago reseller accounted for more than 10% of the ComputerLand Business revenues. Following the ComputerLand Acquisition, the Company has undertaken an effort to add additional resellers as customers of the ComputerLand Business under its Datago program. Later in 1994, the Company intends to begin adding new ComputerLand franchisees, focusing in particular on locations where no reseller is using the ComputerLand name. In adding new Datago resellers and ComputerLand franchisees, the Company will seek to offer programs that permit customers to leverage their purchases from both the ComputerLand Business and Merisel's existing wholesale distribution business. The ComputerLand Business offers its franchisees and Datago resellers a selection of major microcomputer equipment and peripherals provided by approximately 70 suppliers. For its fiscal year ended September 30, 1993, approximately 76% of the ComputerLand Business revenues were generated by sales of Apple, Compaq, Hewlett-Packard and IBM products. The loss of any one of these four manufacturers, or a change in the way any of these manufacturers markets, prices or distributes its products, could have a material adverse effect on the ComputerLand Business' operations and financial results. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Acquisition of ComputerLand Business." In addition to the products supplied directly by the ComputerLand Business, franchisees and Datago resellers may purchase other products offered by the Company's wholesale distribution business pursuant to separate agreements negotiated on their behalf by Merisel FAB. Under the two-year Services Agreement, ComputerLand Corporation will continue to purchase and warehouse manufacturers' products and fulfill reseller orders for substantially all of the products offered by Merisel FAB. Merisel FAB will purchase such products from ComputerLand Corporation, rather than directly from the supplier, and will pay ComputerLand Corporation a service fee for performing these distribution functions. Resellers will continue to place product orders with Merisel FAB through the order placement system operated by ComputerLand Corporation. ComputerLand Corporation will typically ship products to a customer within two days of receipt of an order. During the term of the Services Agreement, Merisel FAB will be dependent upon ComputerLand Corporation to purchase and maintain inventories of products sufficient to meet resellers' requirements and to receive and fulfill orders at acceptable service levels. Merisel FAB and ComputerLand Corporation will jointly maintain supplier relationships. In the event that ComputerLand Corporation becomes unable to perform its obligations under the Services Agreement, there may be an adverse effect on the operations and financial results of the ComputerLand Business. The Services Agreement contains provisions for monetary penalties in the event that ComputerLand Corporation fails to achieve agreed-upon service levels, as well as provisions permitting Merisel FAB to take over a portion of ComputerLand Corporation's operations to fulfill such obligations under certain circumstances. Substantially all of the ComputerLand Business' sales to its customers currently are financed on behalf of such customers by floor plan financing companies, and the ComputerLand Business typically receives payment from these financing companies within three business days from the date of sale. Such floor plan financing is typically subsidized for the ComputerLand Business' customers by its suppliers. Any material change in the availability or the terms of financing offered by such financing companies or the subsidies provided by suppliers could require Merisel FAB to provide such financing to its customers, thereby substantially increasing the working capital necessary to operate its business. The Company does not have experience in operating a master reseller business such as the ComputerLand Business, with its different merchandising strategy and customer base. While the Company believes that the personnel hired as part of the ComputerLand Acquisition, together with the Company's senior management, will successfully manage the ComputerLand Business, no assurances can be given as to the future performance levels or operating results of the ComputerLand Business. COMPETITION Competition in the microcomputer products distribution industry is intense and is based primarily on price, brand selection, breadth and availability of product offering, speed of delivery, level of training and technical support, marketing services and programs and ability to influence a buyer's decision. Certain of Merisel's competitors have substantially greater financial resources than Merisel. Merisel's principal competitors include large United States-based international distributors such as Ingram Micro and Tech Data Corporation, non-U.S. based international distributors such as Computer 2000, national distributors such as Gates/FA Distributing, Inc. and Robec, Inc. and regional distributors and franchisors. The Company competes internationally with a variety of national and regional distributors on a country-by-country basis. Merisel also competes with manufacturers that sell directly to computer resellers, sometimes at prices below those charged by Merisel for similar products. The Company believes its broad product offering, product availability, prompt delivery and support services may offset a manufacturer's price advantage. In addition, many manufacturers focus their direct sales to large computer resellers because of the high costs associated with dealing with a large number of small-volume computer reseller customers. The ComputerLand Business is subject to competition from other franchisors and aggregators in obtaining and retaining franchisees and third-party resellers, as well as competition from wholesale distributors with respect to sales of products to customers in the ComputerLand Business' network. See "-- The Industry." The Company believes that the ComputerLand Business' pricing, brand selection, product availability and service levels are competitive in the industry. With respect to brand selection, the Company believes that a significant factor in the ComputerLand Business' ability to attract customers is the fact that it is able to offer computer systems and other hardware products from Apple, Compaq, Hewlett-Packard and IBM. These manufacturers historically have sold their products directly to resellers and through a limited number of master resellers such as the ComputerLand Business. The loss of any of these manufacturers, or any change in the way any such manufacturers' markets, prices or distributes its products, could have a material adverse effect on the ComputerLand Business' operations and financial results. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Acquisition of ComputerLand Business." The ComputerLand Business' principal competitors are Intelligent Electronics, MicroAge and InaCom, all of which maintain networks of franchisees and third-party dealers and which carry products of one or more of the Company's major manufacturers. Certain of the ComputerLand Business' competitors have greater financial resources than the Company. EMPLOYEES As of December 31, 1993 Merisel had 2,502 employees. Merisel considers its relations with its employees to be excellent. ITEM 2. ITEM 2. PROPERTIES. The Company maintains distribution centers in the following locations: - -------- *Located in Miami, Florida All of the Company's distribution centers are leased, except for one facility in Mexico, which is owned by the Company. Merisel FAB is located in a 10,120 square-foot facility in Pleasanton, California. The facility has been subleased from ComputerLand for a two-year period ending January 31, 1996. Merisel FAB's customers receive product shipments directly from ComputerLand Corporation's two warehouses located in Livermore, California and Indianapolis, Indiana. The Company's world headquarters are located in El Segundo, California, and the Company also maintains sales offices in various domestic and international locations. The Company believes that its facilities currently provide sufficient space for its present needs, and that suitable additional space will be available on reasonable terms, if needed. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is involved in certain legal proceedings arising in the ordinary course of business, none of which is expected to have a material impact on the financial condition or business of Merisel. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is traded in the over-the-counter market and is quoted on the Nasdaq National Market under the symbol MSEL. The following table sets forth the quarterly high and low sale prices for the Common Stock as reported by the Nasdaq National Market. On March 21, 1994, the closing sale price for the Company's Common Stock was $21.50 per share. As of March 21, 1994, there were 1,020 record holders of the Company's Common Stock. Merisel has never declared or paid any dividends to stockholders. Certain of the Company's debt agreements currently prohibit the payment of dividends by the Company. At this time, the Company intends to continue its policy of retaining earnings for the continued development and expansion of its business. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. - -------- (1) Merisel's fiscal year is the 52- or 53-week period ending on the Saturday nearest to December 31. For clarity of presentation throughout this Annual Report on Form 10-K, Merisel has described year ends presented as if the year ended on December 31. Except for 1992, all fiscal years presented were 52 weeks in duration. In April 1990, the Company acquired Microamerica, Inc. ("Microamerica") in a transaction accounted for as a purchase. Prior to the purchase, the Company operated under the name Softsel Computer Products, Inc. ("Softsel"). The selected financial data set forth above includes that of Softsel prior to the acquisition of Microamerica and that of the combined equity subsequent to that date. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. OVERVIEW The Company was founded in 1980 and has grown both through internal growth and through acquisitions of other computer products distributors. By 1989, the Company had achieved annual revenues of $629.4 million, principally through internal expansion. In April 1990, the Company acquired Microamerica, Inc. ("Microamerica"), another worldwide distributor of microcomputer products, with net sales of approximately $526 million for the year ended December 31, 1989. In the years following the Microamerica acquisition, the Company's revenues increased from $1.6 billion in 1991 to $2.2 billion in 1992 and to $3.1 billion in 1993, reflecting substantial growth in both domestic and international sales as the worldwide market for computer products expanded and manufacturers increasingly turned to wholesale distributors for distribution of their products. The Company's net income as a percentage of sales, or net margin, improved over this period, largely as a result of management's success in reducing selling, general and administrative expenses and interest expense, expressed as a percentage of sales, to more than offset declines in the Company's gross margin to more than offset lower gross margins. On January 31, 1994, the Company completed the acquisition of certain assets of the ComputerLand Business from ComputerLand Corporation. See "Business-- ComputerLand Business." For its fiscal year ended September 30, 1993, the ComputerLand Business generated revenues of approximately $1.1 billion, gross profit of $54.7 million and income from operations of $16.6 million. See "-- Acquisition of ComputerLand Business." The Company anticipates that it will continue to experience downward pressure on gross margins due to industry price competition. In addition, the Company's recently acquired ComputerLand Business generates lower gross margins than the Company's existing wholesale distribution business. However, the ComputerLand Business has lower selling, general and administrative expenses as a percentage of sales than the Company's existing wholesale distribution business. See "-- Acquisition of ComputerLand Business." Although Merisel expects that it will be able to continue to reduce selling, general and administrative expenses as a percentage of sales, no assurance can be given as to whether such reductions will, in fact, occur or as to the actual amount of any such reductions. To the extent gross margins continue to decline and the Company is not successful in reducing selling, general and administrative expenses as a percentage of sales, the Company will experience a negative impact on its operating income. RESULTS OF OPERATIONS For the periods indicated, the following table sets forth selected items from the Company's Consolidated Statements of Income, expressed as a percentage of net sales: YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 The Company's net sales increased 37.8% to $3.1 billion in 1993 from $2.2 billion in 1992, reflecting significant growth in both domestic and international sales. The Company believes this increase is due principally to the establishment of new relationships with manufacturers in various markets around the world, the introduction of new products by existing manufacturers, increased customer demand for computer products and increased use of wholesale distribution by manufacturers in their distribution channels. The Company's 1992 fiscal year included 53 weeks due to the timing of the fiscal year end, while the 1993 fiscal year contained 52 weeks. See Note 1 of Notes to Consolidated Financial Statements. Geographically, the Company's 1993 net sales were generated as follows: United States, $1.95 billion, or 63%; Canada, $395 million, or 13%; Europe, $532 million, or 17%; and other international markets, $207 million, or 7%. From 1992 to 1993, these geographic regions experienced sales growth rates of 32.3%, 30.7%, 64.1% and 51.4%, respectively. The Company's higher sales growth rate in Europe has resulted in part from the addition of significant new manufacturer relationships in various European markets. In the United States, the Company's sales increase is due in part to new product offerings from computer systems and other hardware manufacturers. In the United States, hardware and accessories accounted for 60.5% of net sales, and software accounted for 39.5% of net sales in 1993, as compared to 55.9% and 44.1%, respectively, in 1992. For additional information on the Company's operating results by geographic region, see Note 11 of Notes to Consolidated Financial Statements. Gross profit increased 27.7% to $258.5 million in 1993 from $202.4 million in 1992, reflecting the higher 1993 net sales. Gross margin declined to 8.4% in 1993 from 9.0% in 1992, principally as a result of continuing competitive pricing pressures worldwide. Selling, general and administrative ("SG&A") expenses increased 24.0% to $187.2 million in 1993 from $150.9 million in 1992, primarily as a result of increased expenses associated with the Company's 37.8% increase in net sales. SG&A expenses as a percentage of sales declined to 6.1% in 1993 from 6.7% in 1992, reflecting economies of scale resulting from higher sales volumes as well as improved operating efficiencies. The Company's number of full-time equivalent employees increased from 1,939 at December 31, 1992 to 2,502 at December 31, 1993. Operating income increased 38.6% to $71.4 million in 1993 from $51.5 million in 1992, despite small operating losses at the Company's Swiss, Austrian and French operations. Operating income as a percentage of sales was 2.3% in both 1993 and 1992, as the decline in gross margin of 0.6% in 1993 was offset by a corresponding decline in SG&A as a percentage of sales. Interest expense increased 13.1% to $17.8 million in 1993 from $15.7 million in 1992, but declined as a percentage of sales to 0.6% in 1993 from 0.7% in 1992. The increase in interest expense reflects higher average borrowings, principally to finance the Company's higher sales levels, offset in part by lower average interest rates in 1993. Other expense increased to $2.7 million in 1993 from $1.3 million in 1992, but other expense as a percentage of sales remained at 0.1% in both 1992 and 1993. Other expense in 1993 includes the fees paid by the Company in connection with the sale of an interest in its trade accounts receivables pursuant to an accounts receivable securitization program instituted in the third quarter of 1993. See "--Liquidity and Capital Resources." The Company intends to continue this program in future periods, and other expense is therefore anticipated to increase as additional fees are incurred. Provision for income taxes increased 37.8% to $20.4 million in 1993, reflecting the Company's 47.5% increase in income before income taxes. The Company's effective tax rate decreased to 40.1% in 1993 from 43.0% in 1992, primarily as a result of a $1.7 million income tax benefit related to the restructuring of the Company's Swiss operations in 1993. In addition, net losses of certain of the Company's subsidiaries that derive no tax benefit from such losses under local tax laws decreased in 1993. Net income increased 54.8% to $30.4 million in 1993 from $19.7 million in 1992, while net income per share increased to $1.00 from $0.67. The Company's weighted average number of shares outstanding increased from 29,274,000 shares in 1992 to 30,454,000 shares in 1993, reflecting the issuance of 4,600,000 shares in a public offering of the Company's Common Stock in March 1992 and the exercise of employee stock options. YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 Net sales increased 41.2% to $2.2 billion in 1992 from $1.6 billion in 1991. The Company believes that this increase in net sales was due primarily to an increase in market share, customer demand, sales of new products from existing manufacturers and the establishment of new relationships with manufacturers and customers. In addition, the Company's 1992 fiscal year included 53 weeks due to the timing of the fiscal year end. See Note 1 of Notes to Consolidated Financial Statements. Hardware and accessories sales accounted for 56.6% of United States net sales in 1992, with software sales accounting for the remaining 43.4%. In 1991, hardware and accessories sales accounted for 57.6% of United States net sales, with software sales accounting for the remaining 42.4%. Geographically, the Company's 1992 net sales were generated as follows: United States, $1.48 billion, or 66%; Canada, $303 million, or 14%; Europe, $324 million, or 14%; and other international markets, $137 million, or 6%. The increase in net sales achieved by the European operations was primarily the result of significant sales growth by the Company's United Kingdom and German subsidiaries. This increase was offset in part by lower than expected sales levels in Switzerland and France. For additional information on the Company's operating results by geographic region, see Note 11 of Notes to Consolidated Financial Statements. Gross profit increased 28.2% to $202.4 million in 1992 from $158.0 million in 1991, reflecting the increase in net sales in 1992. Gross margin decreased to 9.0% in 1992 from 10.0% in 1991, reflecting continued competitive pressures on pricing. SG&A expenses increased 26.1% to $150.9 million in 1992 from $119.7 million in 1991, but declined as a percentage of net sales to 6.7% in 1992 from 7.5% in 1991. The absolute dollar increase in SG&A expenses was primarily due to costs associated with the Company's 41.2% increase in net sales. The decrease in SG&A expenses as a percentage of net sales was the result of economies of scale resulting from higher sales volume as well as improved operating efficiencies. The Company's number of full-time equivalent employees increased to 1,939 at December 31, 1992 from 1,450 at December 31, 1991. Operating income increased 34.6% to $51.5 million in 1992 from $38.3 million in 1991, despite continuing operating losses in the Company's Swiss and Austrian subsidiaries and an operating loss at the Company's French subsidiary. Operating income as a percent of sales decreased to 2.3% in 1992 from 2.5% in 1991. The 0.2% decrease in operating income as a percent of net sales reflects the fact that the decrease in gross margin of 1.0% more than offset the decrease SG&A expenses as a percentage of net sales of 0.8%. Interest expense decreased 1.4% to $15.7 million in 1992 from $16.0 million in 1991 and decreased as a percentage of net sales to 0.7% in 1992 from 1.0% in 1991. The decrease in interest expense is attributable to both the Company's lower average borrowings in 1992 and a reduction in average funding cost. The Company's average borrowings under all lines of available credit decreased 2.5% to $151.2 million in 1992 from $155.0 million in 1991. The decrease in average borrowings is a result of a public offering of 4,600,000 shares of the Company's common stock in March 1992, providing net proceeds of $55.7 million, partially offset by an increase in working capital requirements related to the Company's growth and an increase in the Company's investing activities, principally property and equipment expenditures. See "--Liquidity and Capital Resources." The Company's provision for income taxes increased by 39.1% to $14.8 million in 1992 from $10.7 million in 1991, reflecting the Company's increased income before income taxes. The Company's effective tax rate declined to 43.0% in 1992 from 49.6% in 1991. The lower effective tax rate reflects the fact that, although certain of the Company's foreign subsidiaries incurred losses with no corresponding tax benefit, such losses comprised a smaller percentage of the Company's consolidated income before taxes in 1992 as compared to 1991. Net income increased 81.6% to $19.7 million in 1992 from $10.8 million in 1991. Net income per share increased to $0.67 in 1992 from $0.43 in 1991. The Company's weighted average number of shares increased to 29,274,000 shares in 1992 from 24,896,600 shares in 1991, primarily as a result of a public offering of 4,600,000 shares of the Company's common stock in March 1992. VARIABILITY OF QUARTERLY RESULTS AND SEASONALITY Historically, the Company has experienced variability in its net sales and operating margins on a quarterly basis and expects these patterns to continue in the future. Management believes that the factors influencing quarterly variability include: (i) the overall growth in the microcomputer industry; (ii) shifts in short-term demand for the Company's products resulting, in part, from the introduction of new products or updates of existing products; and (iii) the fact that virtually all sales in a given quarter result from orders booked in that quarter. Due to the factors noted above, as well as the fact that the Company participates in a highly dynamic industry, the Company's revenues and earnings may be subject to significant volatility, particularly on a quarterly basis. Additionally, the Company's net sales in the fourth quarter have been higher than in its other three quarters. Management believes that the pattern of higher fourth quarter sales is partially explained by customer buying patterns relating to calendar year-end business purchases and holiday period purchases. For a tabular presentation of certain quarterly financial data with respect to 1992 and 1993, see Note 12 of Notes to Consolidated Financial Statements. ACQUISITION OF COMPUTERLAND BUSINESS Through the ComputerLand Acquisition, Merisel now operates the ComputerLand Business, a leading master reseller of computer systems and related products from the major microcomputer manufacturers to a network of approximately 750 independently-owned computer products resellers, including ComputerLand franchisees and affiliated resellers purchasing through the Datago program. See "Business--ComputerLand Business." For its fiscal year ended September 30, 1993, the ComputerLand Business generated net sales of $1.1 billion, gross profit of $54.7 million and income from operations of $16.6 million. Gross margin and SG&A expenses as a percentage of sales for this period were 5.1% and 3.6%, respectively, reflecting the lower margins and lower SG&A expenses incurred in the master reseller, or aggregator, business as compared to the Company's existing wholesale distribution business. The ComputerLand Business' operating margin as a percentage of sales for this period was 1.5%. As a master reseller, the ComputerLand Business supplies a significantly smaller number of products to a significantly smaller number of customers than the Company's existing distribution business. Master resellers focus on supplying computer systems and other higher-volume products to their customers while the Company's existing business supplies a wide range of products to many different types of customers. Certain of the larger computer manufacturers, such as Apple, Compaq, Hewlett-Packard and IBM, have historically required resellers to purchase their products from an affiliated aggregator, such as the ComputerLand Business. Wholesale distributors have not been authorized to sell these manufacturers' key microcomputer components, except on a limited basis. For the fiscal year ended September 30, 1993, approximately 76% of the ComputerLand Business' revenues were generated from the sale of products from four manufacturers: Apple, Compaq, Hewlett-Packard and IBM. The loss of any one of these four manufacturers, or a change in the way any of these manufacturers markets, prices or distributes its products, could have a material adverse effect on the ComputerLand Business' operating and financial results. Specifically, to the extent that one of the leading four manufacturers changes its current system of limiting authorization to sell its products to master resellers, the ComputerLand Business' sales levels would be adversely affected. The Company believes, however, that its existing wholesale distribution business may benefit from such changes. Substantially all of the ComputerLand Business' franchisees are electronically linked for the purposes of order placement and other communications, reducing the need for sales representatives and support personnel in comparison to the Company's existing business. In addition, substantially all of the ComputerLand Business' customers finance their orders through "floor plan" financing companies or pay on a C.O.D. basis, reducing the need for credit and collection personnel and reducing financing costs because of improved cash flow. As a result of the foregoing as well as other factors, master resellers such as the ComputerLand Business tend to generate both lower gross margins and lower operating expenses as a percentage of sales than those generated by the Company in its existing distribution business. Competition among master resellers is intense (see "Business--Competition"), and the ComputerLand Business may experience downward pressures on its gross margins due to competitive pricing decisions. Under the Services Agreement, ComputerLand Corporation will perform a significant portion of the ComputerLand Business' distribution functions for a contractually agreed-upon fee for a two- year period. As a result of this outsourcing arrangement, the ComputerLand Business does not directly control the costs of those distribution functions, and therefore will be limited in its ability to lower its costs in response to a lower gross margin environment during the two-year term of the Services Agreement. Due to this limitation, the Services Agreement provides that the service fee, as a percentage of sales volume, decreases if the ComputerLand Business' sales volume increases over a specified amount. Further, in the event sales volume does not increase over a specified amount, and the ComputerLand Business' gross margin declines, the Service Agreement provides for a limited reduction in the service fee to offset partially the decline in gross margin. Notwithstanding these contractual provisions, a material decline in the ComputerLand Business' gross margins could have a material adverse effect on the Company's results of operations. Substantially all of the ComputerLand Business' sales to its customers currently are financed on behalf of such customers by floor plan financing companies. The ComputerLand Business typically receives payment from these financing companies within three business days from the date of sale, resulting in reduced cash requirements for the ComputerLand Business as compared to the Company's existing wholesale distribution business. This floor plan financing is typically subsidized for the ComputerLand Business' customers by its manufacturers. Any material change in the availability or the terms of financing offered by such financing companies or in the subsidies provided by manufacturers could require the ComputerLand Business to provide such financing to its customers, thereby substantially increasing the working capital necessary to operate its business. LIQUIDITY AND CAPITAL RESOURCES The Company has financed its growth and cash needs primarily through borrowings, income from operations, the public and private sales of its securities and securitizations of its accounts receivable. Net cash used for operating activities in 1993 was $125.4 million, as compared to net cash used for operating activities in 1992 of $58.6 million. The primary uses of cash in 1993 were increases in accounts receivables of $194.2 million, reflecting the Company's higher sales volumes, especially in December 1993, and greater sales to customers with extended credit terms, and inventories of $142.9 million, reflecting the Company's higher sales volumes. Sources of cash from operating activities included net income, after adjustment for non-cash items, of $55.9 million and an increase in accounts payable of $166.3 million. Net cash used for investing activities in 1993 was $25.1 million, principally reflecting significant investments in new computer systems, new warehouse management systems and new distribution facilities and equipment. The Company presently anticipates that its capital expenditures for 1994 will be approximately $25 million, principally for development and implementation of new computer systems in North America, new warehouse management systems, new computer systems for the Company's European operations and a new distribution center in Europe. See "Business--Operations and Distribution" and "Business-- International Operations." Net cash provided by financing activities in 1993 was $156.8 million, comprised principally of net borrowings under domestic revolving lines of credit of $70.1 million, net borrowings under foreign bank facilities of $10.2 million and proceeds from the sale of an interest in the Company's trade accounts receivables of $75.0 million pursuant to a receivables securitization program. To provide capital for the Company's operating and investing activities, the Company and its subsidiaries, including Merisel Americas, Merisel Europe and Merisel FAB, maintain a number of credit facilities. Merisel Americas and Merisel Europe are co-borrowers under a $150 million unsecured revolving bank credit facility expiring on May 31, 1997. At March 18, 1994, $140.9 million was outstanding under this facility, comprised of $135.9 million in direct borrowings and $5 million in outstanding letters of credit. A portion of the net proceeds of the Offering will be used to reduce the balance due under this facility. See "Use of Proceeds." To provide for its anticipated working capital needs, on December 23, 1993, Merisel FAB entered into a $10 million unsecured revolving credit agreement. This agreement expires on January 29, 1995. At March 18, 1994, no amount was outstanding under this agreement. The Company and its subsidiaries also maintain various local lines of credit, primarily to facilitate overnight and other short-term borrowings. The total amount of outstanding borrowings under these lines as of December 31, 1993 was $50.9 million. Merisel Americas has also entered into a $75 million trade accounts receivable securitization agreement pursuant to which it sells on an ongoing basis an undivided interest of up to $75 million in designated trade receivables to a syndicate of purchasers. The receivables are sold at face value and fees paid in connection with such sales are recorded by the Company as other expense. This facility expires in September 1994. Merisel Americas currently is negotiating an amendment to this facility to increase its amount to $150 million and to extend its expiration date to November 1994. The net proceeds from the increase in this facility will be used to reduce the amount of outstanding borrowings under Merisel Americas' and Merisel Europe's $150 million revolving bank credit facility. To finance the ComputerLand Acquisition, the Company borrowed $65 million under an unsecured credit agreement with a bank lender. This agreement expires on January 29, 1995, but is subject to mandatory prepayment upon any debt or equity issuance by the Company. Merisel FAB also borrowed $16 million, the balance of the ComputerLand Acquisition purchase price, under a separate credit agreement, which was repaid in full on February 15, 1994. Merisel Americas also has outstanding $100 million of 8.58% senior notes due June 30, 1997, and $22 million of 11.28% subordinated notes due in five equal annual principal installments, beginning in March 1996. See Notes 5 and 6 of Notes to Consolidated Financial Statements. In connection with the ComputerLand Acquisition, Merisel FAB and ComputerLand Corporation entered into the Services Agreement pursuant to which ComputerLand will provide significant distribution and other support services to Merisel FAB for up to two years. See "Business--ComputerLand Business." Under the Services Agreement, Merisel FAB has been granted $20 million in extended credit terms on its product purchases from ComputerLand Corporation. ComputerLand Corporation has agreed to use this $20 million account receivable from Merisel FAB to purchase 1,103,144 shares of the Company's Common Stock at a per share price of $18.13, if and when a registration statement covering the resale of such shares is declared effective by the Securities and Exchange Commission. It is presently anticipated that the Company will file such a registration statement in March 1994. Merisel believes that its existing cash balances, together with the proceeds of an offering of 5 million shares of the Company's Common Stock anticipated to occur in the second quarter of 1994, income from operations, proceeds of receivables securitizations and borrowings under lines of credit will be sufficient to meet its working capital and capital investment needs through at least the next twelve months. ASSET MANAGEMENT Merisel attempts to manage its inventory position to maintain levels sufficient to achieve high product availability and same-day order fill rates. Inventory levels may vary from period to period, due in part to increases or decreases in sales levels, Merisel's practice of making large-volume purchases when it deems the terms of such purchases to be attractive and the addition of new manufacturers and products. The Company has negotiated agreements with many of its manufacturers which contain stock balancing and price protection provisions intended to reduce, in part, Merisel's risk of loss due to slow moving or obsolete inventory or manufacturer price reductions. In the event of a manufacturer price reduction, the Company generally receives a credit for products in inventory. In addition, the Company has the right to return a certain percentage of purchases, subject to certain limitations. Historically, price protection and stock return privileges as well as the Company's inventory management procedures have helped to reduce the risk of loss of carrying inventory. The Company offers credit terms to qualifying customers and also sells on a prepay, credit card and cash-on-delivery basis. With respect to credit sales, the Company attempts to control its bad debt exposure through monitoring of customers' creditworthiness and, where practicable, through participation in credit associations that provide credit rating information about its customers. In certain foreign markets, the Company may elect to purchase credit insurance for certain accounts. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEPENDENT AUDITORS' REPORT Merisel, Inc.: We have audited the accompanying consolidated balance sheets of Merisel, Inc. and subsidiaries as of December 31, 1992 and 1993, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed at Item 14. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Merisel, Inc. and subsidiaries at December 31, 1992 and 1993, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche Los Angeles, California February 22, 1994 MERISEL, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) See accompanying notes to consolidated financial statements. MERISEL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT SHARE DATA) See accompanying notes to consolidated financial statements. MERISEL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE DATA) See accompanying notes to consolidated financial statements. MERISEL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See accompanying notes to consolidated financial statements. MERISEL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1991, 1992 AND 1993 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES General--Merisel, Inc. ("Merisel" or the "Company") is a worldwide distributor of microcomputer hardware and software. The consolidated financial statements include the accounts of Merisel and its consolidated subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Revenue Recognition, Returns and Sales Incentives--The Company recognizes revenue from hardware and software sales as products are shipped. The Company, subject to certain limitations, permits its customers to exchange products or receive credits against future purchases. The Company offers its customers several sales incentive programs which, among others, include funds available for cooperative promotion of product sales. Customers earn credit under such programs based upon volume of purchases. The cost of these programs is partially subsidized by marketing allowances provided by the Company's manufacturers. The allowance for sales returns and costs of customer incentive programs is accrued concurrently with the recognition of revenue. Cash Equivalents--The Company considers all highly liquid investments purchased with initial maturities of three months or less to be cash equivalents. Inventories--Inventories are valued at the lower of cost or market; cost is determined on the average cost method. Property and Depreciation--Property and equipment are stated at cost less accumulated depreciation. Depreciation is provided on the straight-line method over the estimated useful lives of the assets, generally three to seven years. Leasehold improvements are amortized over the shorter of the life of the lease or the improvement. Cost in Excess of Net Assets Acquired--Cost in excess of net assets acquired results principally from the acquisition in 1990 of Microamerica, Inc. and is being amortized over a period of forty years using the straight-line method. Accumulated amortization was $2,533,000 and $3,468,000 at December 31, 1992 and 1993, respectively. Income Taxes--Deferred income taxes represent the amounts which will be paid or received in future periods based on the tax rates that are expected to be in effect when the temporary differences are scheduled to reverse. The Company intends to invest the undistributed earnings of its foreign subsidiaries indefinitely. At December 31, 1992 and 1993, the cumulative amount of undistributed earnings on which the Company has not recognized United States income taxes was approximately $11 million and $15 million, respectively. However, it is anticipated that United States income taxes on such amounts would be substantially offset by available foreign income tax credits. The Company adopted Financial Accounting Standards Board Statement No. 109, "Accounting for Income Taxes," effective January 1, 1992. The adoption of this statement had no material effect on the Company's financial statements. Disclosures about the Fair Values of Financial Instruments--The fair values of financial instruments, other than long-term debt, closely approximate their carrying value. The estimated fair value of long-term MERISEL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) debt including current maturities, based on reference to quoted market prices, exceeded the carrying value by approximately $6,000,000 and $8,700,000 as of December 31, 1992 and 1993, respectively. Foreign Currency Translation--Assets and liabilities of foreign subsidiaries are translated into United States dollars at the exchange rate in effect at the close of the period. Revenues and expenses of these subsidiaries are translated at the average exchange rate during the period. The aggregate effect of translating the financial statements of foreign subsidiaries is included in a separate component of stockholders' equity entitled Cumulative Translation Adjustment. In the normal course of business, the Company advances funds to certain of its foreign subsidiaries, which are not expected to be repaid in the foreseeable future. Translation adjustments resulting from these advances are included in Cumulative Translation Adjustment. In an attempt to minimize foreign exchange transaction gains and losses, forward contracts are used to hedge short-term advances to foreign subsidiaries and inventory purchases. Gains and losses on the transactions being hedged are offset by the gains or losses on these contracts. At December 31, 1993, the Company had approximately $85 million of short-term forward contracts outstanding. In 1991, 1992 and 1993, there were net foreign currency gains of $70,000, $843,000 and $283,000, respectively. Net Income per Share--Net income per share is computed by dividing net income by the weighted average number of shares of common stock and common stock equivalents (common stock options) outstanding during the related period, unless such inclusion is antidilutive. The weighted average number of shares includes shares issuable upon the assumed exercise of stock options less the number of shares assumed purchased with the proceeds available from such exercise. Fiscal Periods--The Company's fiscal year is the 52- or 53-week period ending on the Saturday nearest to December 31 and its fiscal quarters are the 13- or 14-week periods ending on the Saturday nearest toMarch 31, June 30, September 30, and December 31. For clarity of presentation, the Company has described year-ends presented as if the years ended on December 31 and quarter-ends presented as if the quarters ended on March 31, June 30, September 30, and December 31. The 1991 and 1993 fiscal years were 52 weeks, while the 1992 fiscal year was 53 weeks in duration. All quarters were 13 weeks except for the quarter ended December 31, 1992 which was 14 weeks in duration. 2. SALE OF ACCOUNTS RECEIVABLE In September 1993, the Company entered into a trade accounts receivable securitization agreement with a securitization company, pursuant to which the securitization company may purchase on an ongoing basis for a one year period up to $75 million of an undivided interest in designated accounts receivable. At December 31, 1993, $75 million of net accounts receivable were sold under this agreement. Fees of $685,000, incurred in connection with the sale of accounts receivable, were included in Other Expense in 1993. MERISEL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) 3. PROPERTY AND EQUIPMENT Property and equipment consisted of the following (in thousands): 4. INCOME TAXES The components of income before income taxes consisted of the following (in thousands): The provision for income taxes consisted of the following (in thousands): MERISEL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Deferred tax liabilities and assets were comprised of the following: The major elements contributing to the difference between the federal statutory tax rate and the effective tax rate are as follows: 5. DEBT At December 31, 1993, the Company had unsecured senior borrowing commitments of $250 million, which consisted of $100 million of 8.58% senior notes ("Senior Notes"), and a $150 million revolving credit agreement ("Revolver"). The Senior Notes are due on June 30, 1997, and the Revolver is due on May 31, 1997. At December 31, 1993, there was $100 million outstanding under the Senior Notes, and $86.5 million outstanding under the Revolver. In addition, the Company had $5 million in outstanding letters of credit under its Revolver. Advances under the Revolver bear interest at specific rates based upon market reference rates and the Company's performance relative to specific levels of debt to total capitalization. The combined average interest rate at December 31, 1993 was approximately 4.7%. The Company is also required to pay a commitment fee on the unused available funds on the Revolver. The Senior Notes and Revolver agreements both contain various covenants, including those which prohibit the payment of cash dividends, require a minimum amount of tangible net worth and place limitations on the acquisition of assets. The agreements also require the Company to maintain certain specified financial ratios, including interest coverage, total debt to total capitalization and inventory turnover. At December 31, 1993, approximately $102 million of outstanding debt was advanced to foreign subsidiaries. In addition, the Company and its subsidiaries have various unsecured lines of credit denominated MERISEL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) in their local currencies under which they may borrow an aggregate of $81 million. The Company had borrowings under the lines of credit of $27.6 million and $50.9 million outstanding at December 31, 1992 and 1993, respectively. 6. LONG-TERM SUBORDINATED DEBT On March 30, 1990, the Company sold an aggregate of $22,000,000 of privately placed subordinated notes. The notes provide for interest at the rate of 11.28% per annum and are repayable in five equal annual installments beginning March 1996. The subordinated debt agreement contains certain restrictive covenants, including those that limit the Company's ability to incur debt, acquire the stock of or merge with other corporations, or sell certain assets and prohibits the payment of dividends. The subordinated debt agreement also requires the Company to maintain specified financial ratios similar in nature, but generally less restrictive, than those described in Note 5. 7. COMMITMENTS AND CONTINGENCIES The Company leases its facilities and certain equipment under noncancelable operating leases. Future minimum rental payments, under leases that have initial or remaining noncancelable lease terms in excess of one year are $12,333,000 in 1994, $9,409,000 in 1995, $8,707,000 in 1996, $7,712,000 in 1997, $7,420,000 in 1998 and $22,402,000 thereafter. Certain of the leases contain inflation escalation clauses and requirements for the payment of property taxes, insurance, and maintenance expenses. Rent expense for 1991, 1992 and 1993 was $8,889,000, $11,007,000, and $12,617,000, respectively. The Company is involved in certain legal proceedings arising in the ordinary course of business, none of which is expected to have a material impact on the Company's financial statements. 8. EMPLOYEE STOCK OPTIONS AND BENEFIT PLANS Under the Company's stock option plans, incentive stock options may be granted to employees and nonqualified options may be granted to employees, directors, and consultants. The plans authorized the issuance of an aggregate of 4,616,200 shares upon exercise of options granted thereunder. The optionees, option prices, vesting provisions, dates of grant and number of shares granted under the plans are determined primarily by the Board of Directors, though incentive stock options must be granted at prices which are no less than the fair market value of the Company's common stock at the date of grant. Options granted under the plans expire ten years from the date of grant. The following summarizes activity in the plans for the three years ended December 31, 1993: MERISEL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) A total of 1,032,000 and 1,089,500 options were exercisable under the stock option plans at December 31, 1992 and 1993, respectively. During 1987, the Company's Board of Directors authorized the issuance of 350,000 nonqualified stock options to an officer of the Company for the purchase of common stock at an exercise price of $.01 per share. The options vested over five years from the date of grant and are exercisable for a period of up to ten years. The difference between the fair market value of the common stock underlying the nonqualified stock options as of the date of grant and the exercise price, an aggregate of $1,484,000, was amortized as compensation expense over the five-year vesting period. Compensation expense related to these stock options was $148,000 and $124,000 in 1991 and 1992, respectively. As of December 31, 1993, 150,000 options remained outstanding. The Company offers a 401(k) savings plan under which all employees who are 21 years of age with at least one month of service are eligible to participate. The plan permits eligible employees to make contributions up to certain limitations, with the Company matching certain of those contributions. The Company's contributions vest 25% per year. The Company contributed $285,000, $378,000 and $443,000 to the plan during the years ended December 31, 1991, 1992 and 1993, respectively. 9. ACQUISITIONS Effective April 1, 1992, the Company purchased a fifty percent interest in a computer products distribution company in Mexico. Merisel paid cash, which was retained by the Mexican distributor in exchange for newly issued common stock. In 1993, the Company paid $214,000 and accrued $786,000 to reflect its minimum liability for the acquisition of an additional 10% interest in the Mexican distributor. The Company will purchase the remaining forty percent interest over the next two years at a price to be determined based upon the distributor's operating results during that period, subject to a minimum price of $4 million. Pro forma income statement information related to this acquisition has not been provided as the financial statement impact is not significant. 10. SUBSEQUENT EVENT On January 31, 1994, the Company, through its wholly-owned subsidiary, Merisel FAB, Inc. ("Merisel FAB"), acquired certain assets of the United States Franchise and Distribution Division of ComputerLand Corporation. The Company paid approximately $80 million in cash at closing for the acquired assets. In addition, the Company has agreed to make an additional payment in 1996 of up to $30 million. This payment will be based upon the growth of the Company's sales of products of designated vendors to specified customers over the two-year period ending January 31, 1996. Merisel FAB has also entered into a Distribution and Services Agreement with ComputerLand Corporation whereby ComputerLand Corporation will provide products and distribution and other support services to Merisel FAB for two years following the acquisition. 11. SEGMENT INFORMATION The Company's operations involve a single industry segment--the wholesale distribution of micro-computer hardware and software products. The geographic areas in which the Company operates are the MERISEL, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) United States, Canada, Europe (United Kingdom, France, Germany, Switzerland, and Austria), and Other International (Latin America and Australia in 1991, and Latin America, Australia and Mexico in 1992 and 1993). Net sales, operating income (before interest, other nonoperating expenses and income taxes) and identifiable assets by geographical area were as follows (in thousands): 12. QUARTERLY FINANCIAL DATA (UNAUDITED) Selected financial information for the quarterly periods for the fiscal years ended 1992 and 1993 is presented below (in thousands, except per share amounts): SCHEDULE II MERISEL, INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES (OTHER THAN RELATED PARTIES) DECEMBER 31, 1991, 1992 AND 1993 SCHEDULE VIII MERISEL, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS DECEMBER 31, 1991, 1992 AND 1993 - -------- (1) Accounts receivable--Other includes allowances for sales returns and uncollectible cooperative advertising credits. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information called for by this item is hereby incorporated by reference from the Registrant's definitive Proxy Statement for the fiscal year ended December 31, 1993, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 30, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information called for by this item is hereby incorporated by reference from the Registrant's definitive Proxy Statement for the fiscal year ended December 31, 1993, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 30, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information called for by this item is hereby incorporated by reference from the Registrant's definitive Proxy Statement for the fiscal year ended December 31, 1993, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 30, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information called for by this item is hereby incorporated by reference from the Registrant's definitive Proxy Statement for the fiscal year ended December 31, 1993, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 30, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) List of documents filed as part of this Report: (1) FINANCIAL STATEMENTS INCLUDED IN ITEM 8: Independent Auditors' Report Consolidated Balance Sheets at December 31, 1992 and 1993. Consolidated Statements of Income for each of the three years in the period ended December 31, 1993. Consolidated Statements of Changes in Stockholders' Equity for each of the three years in the period ended December 31, 1993. Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993. Notes to Consolidated Financial Statements. (2) FINANCIAL STATEMENT SCHEDULES INCLUDED IN ITEM 8: Schedule II--Amounts Receivable from Related Parties and Underwriters, Promoters and Employees (other than Related Parties). Schedule VIII--Valuation and Qualifying Accounts. Schedules other than those referred to above have been omitted because they are not applicable or are not required under the instructions contained in Regulation S-X or because the information is included elsewhere in the Consolidated Financial Statements or the Notes thereto. (3) EXHIBITS The exhibits listed on the accompanying Index of Exhibits are filed as part of this Annual Report. (b) No Reports on Form 8-K were filed during the quarter ended December 31, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. DATE: MARCH 24, 1994 Merisel, Inc. /s/ James L. Brill By______________________________________ James L. Brill Senior Vice President, Finance, Chief Financial Officer and Secretary 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. EXHIBIT INDEX - ------- *Management contract or executive compensation plan or arrangement. (1) Filed as an exhibit to the Form S-1 Registration Statement of Softsel Computer Products, Inc., No. 33-23700, and incorporated herein by this reference. (2) Filed as an exhibit to the Quarterly Report on Form 10-Q for the quarter ended September 30, 1989 of Softsel Computer Products, Inc., and incorporated herein by this reference. (3) Filed as an exhibit to the Quarterly Report on Form 10-Q for the quarter ended March 31, 1990 of Softsel Computer Products, Inc., and incorporated herein by this reference. (4) Filed as an exhibit to the Form S-8 Registration Statement of Softsel Computer Products, Inc., No. 33-34296, filed with the Securities and Exchange Commission April 12, 1990, and incorporated herein by this reference. (5) Filed as an exhibit to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1990 of Softsel Computer Products, Inc., and incorporated herein by this reference. (6) Filed as an exhibit to the Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, and incorporated herein by this reference. (7) Filed as an exhibit to the Form S-8 Registration Statement of Softsel Computer Products, Inc., No. 33-35648, filed with the Securities and Exchange Commission June 29, 1990, and incorporated herein by this reference. (8) Filed as an exhibit to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, and incorporated herein by this reference. (9) Filed as an exhibit to the Form S-3 Registration Statement of Merisel, Inc., No. 33-45696, and incorporated herein by this reference. (10) Filed as an exhibit to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, and incorporated herein by this reference. (11) Filed as an exhibit to the Quarterly Report on Form 10-Q for the quarter ended September 30, 1992 of Merisel, Inc., and incorporated herein by this reference. (12) Filed as an exhibit to the Current Report on Form 8-K dated February 14, 1994.

354707_1993.txt

354707_1993

1993

354707

ITEM 1. BUSINESS HEI HEI was incorporated in 1981 under the laws of the State of Hawaii and is a holding company with subsidiaries engaged in the electric utility, financial services, freight transportation, real estate development and other businesses, in each case primarily or exclusively in the State of Hawaii. HEI's predecessor, HECO, was incorporated under the laws of the Kingdom of Hawaii (now the State of Hawaii) on October 13, 1891. As a result of a 1983 corporate reorganization, HECO became an HEI subsidiary and common shareholders of HECO became common shareholders of HEI. HECO and its subsidiaries, MECO and HELCO, are regulated operating public utilities providing the only public utility electric service on the islands of Oahu, Maui, Lanai, Molokai and Hawaii. HEI also owns directly or indirectly the following nonelectric public utility subsidiaries which comprise its diversified companies: HEIDI and its subsidiary, ASB, and ASB's subsidiaries; HTB and its subsidiary; MPC and its subsidiaries; HEIIC; and LVI. HEIDI is also the holder of record of the common stock of HIG, which was acquired in 1987 and provided property and casualty insurance primarily in Hawaii. HIG is currently in rehabilitation proceedings and it is expected that HEIDI will relinquish all ownership rights in HIG and its subsidiaries during 1994. See "Discontinued operations--The Hawaiian Insurance & Guaranty Co., Limited." ASB was acquired in 1988, is the second largest savings bank in Hawaii as measured by total assets as of September 30, 1993, and has 45 retail branches as of December 31, 1993. HTB was acquired in 1986 and provides ship assist and charter towing services and owns YB, a regulated intrastate public carrier of waterborne freight among the Hawaiian Islands. MPC was formed in 1985 and develops and invests in real estate. HEIIC was formed in 1984 and is a passive investment company which has sold substantially all of its investments in marketable securities over the last few years and currently plans no new investments. In March of 1993, pursuant to the decision made at the end of the third quarter of 1992, the stock of HERS, formerly an HEI wind energy subsidiary, was sold to The New World Power Corporation and LVI became a direct subsidiary of HEI. See "Discontinued operations -- Hawaiian Electric Renewable Systems, Inc." The financial information about the Company's industry segments is incorporated herein by reference to page 28 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). For additional information about the Company, reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations," incorporated herein by reference to pages 29 to 39 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). RATING AGENCIES' ACTIONS On February 8, 1993, Standard & Poor's (S&P) lowered HEI's and HECO's long- term credit ratings. S&P lowered HEI's medium-term note credit rating to BBB from BBB+, citing HECO's reduced credit worthiness and the write-off of HEI's investment in HIG. S&P noted that considerable political and financial uncertainty will remain until the ultimate impact of HIG on HEI is determined. S&P maintained a negative rating outlook reflecting downward pressure on HEI's and HECO's earnings which could intensify in the absence of adequate rate relief for HECO. HEI's commercial paper rating of A-2 was reaffirmed. On February 26, 1993, Duff & Phelps Credit Rating Co. (D&P) lowered HEI's medium-term note rating to BBB+ from A- due to the continuing uncertainty surrounding HEI and its decision to cease operations at HIG. D&P noted that the extent of additional financial responsibility ultimately required, if any, is unknown, which adds risk that was not reflected in D&P's prior rating. HEI's commercial paper rating of Duff 1- (one-minus) was reaffirmed. On February 11, 1994, in response to HEI's announcement that it signed an agreement to settle the lawsuit filed by the Hawaii Insurance Commissioner and Hawaii Insurance Guaranty Association against HEI relating to losses sustained by HIG from Hurricane Iniki, D&P stated that the settlement and additional charge to income fit within the assumptions pertinent to D&P's current ratings for HEI. The settlement agreement is subject to court approval. (See "Discontinued operations -- The Hawaiian Insurance & Guaranty Co., Ltd. for a further discussion on the settlement agreement.) On April 28, 1993, Moody's Investor Service (Moody's) confirmed the credit ratings of HEI, citing HEI's plans to issue additional common equity in order to rebalance its capital structure. Moody's stated that its concerns regarding a lawsuit associated with HIG and stemming from Hurricane Iniki are partially mitigated by the possible long period before a fully litigated decision is reached. The confirmation concluded a review for possible downgrade initiated on December 4, 1992. In October 1993, S&P completed its review of the U.S. investor-owned electric utility industry and concluded that more stringent financial risk standards are appropriate to counter mounting business risk. "S&P believes the industry's credit profile is threatened chiefly by intensifying competitive pressures," the agency said in a statement. It also cited sluggish demand expectations, slow earnings growth prospects, high dividend payouts and environmental cost pressures. Under the new guidelines, S&P rated HECO's business position as average. As of February 11, 1994, HEI's and HECO's S&P, Moody's and D&P security ratings were as follows: N/A Not applicable. (1) S&P. Debt rated BBB or BBB+ is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher rated categories. The ratings may be modified by the addition of a plus or minus sign to show relative standing within the major categories. A commercial paper rating is a current assessment of the likelihood of timely payment of debt having an original maturity of no more than 365 days. Commercial paper rated A-2 indicates that capacity for timely payment on issues is satisfactory. (2) Moody's. Bonds which are rated Baa2 or Baa1 are considered as medium grade obligations, i.e., they are neither highly protected nor poorly secured. Interest payment and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well. Bonds which are rated A3 possess many favorable investment attributes and are to be considered as upper medium grade obligations. Factors giving security to principal and interest are considered adequate but elements may be present which suggest a susceptibility to impairment sometime in the future. Preferred stock rated baa1 is considered to be a medium grade preferred stock, neither highly protected nor poorly secured. Earnings and asset protection appear adequate at present but may be questionable over a great length of time. Numeric modifiers are added to debt and preferred stock ratings. Numeric modifier 1 indicates that the security ranks in the higher end of its generic rating category and numeric modifier 2 indicates a mid-range ranking. Commercial paper rated P-2 is considered to have a strong ability for repayment of senior short-term obligations. This will normally be evidenced by the following characteristics: a) leading market positions in well- established industries, b) high rates of return on funds employed, c) conservative capitalization structure with moderate reliance on debt and ample asset protection, d) broad margins in earnings coverage of fixed financial charges and high internal cash generation and e) well established access to a range of financial markets and assured sources of alternate liquidity. Earnings trends and coverage ratios, while sound, may be more subject to variation. Capitalization characteristics, while still appropriate, may be more affected by external conditions. Ample alternate liquidity is maintained. (3) Duff & Phelps. Debt rated BBB+ is regarded as having below average protection factors, but still considered sufficient for prudent investment. There may be considerable variability in risk during economic cycles. Debt rated A or A- is considered to have protection factors that are average but adequate. However, risk factors are more variable and greater in periods of economic stress. Commercial paper rated Duff 1- indicates a high certainty of timely payment. Liquidity factors are strong and supported by good fundamental protection factors. Risk factors are very small. Each security rating listed above is not a recommendation to buy, sell or hold securities. Each rating may be subject to revision or withdrawal at any time by the assigning rating organization and should be evaluated independently of any other rating. Neither HEI nor HECO management can predict with certainty future rating agency actions or their effects on the future cost of capital of HEI or HECO. ELECTRIC UTILITY HECO AND SUBSIDIARIES AND SERVICE AREAS HECO, MECO and HELCO are regulated operating electric public utilities engaged in the production, purchase, transmission, distribution and sale of electricity on the islands of Oahu; Maui, Lanai and Molokai; and Hawaii, respectively. HECO acquired MECO in 1968 and HELCO in 1970. In 1993, the electric utilities contributed approximately 77% of HEI's consolidated revenues from continuing operations and approximately 76% of HEI's consolidated operating income from continuing operations, excluding unallocated corporate expenses and eliminations. At December 31, 1993, the assets of the electric utilities represented approximately 38% of the total assets of the Company, excluding assets at the corporate level and eliminations. For additional information about the electric utilities, see "Management's Discussion and Analysis of Financial Condition and Results of Operations," incorporated herein by reference to pages 29 to 39 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a) and pages 3 to 9 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). The islands of Oahu, Maui, Lanai, Molokai and Hawaii have a combined population estimated at 1,104,000, or approximately 95% of the population of the State of Hawaii, and cover a service area of 5,766 square miles. The principal communities served include Honolulu (on Oahu), Wailuku and Kahului (on Maui) and Hilo and Kona (on Hawaii). The service areas also include numerous suburban communities, resorts, U.S. Armed Forces installations and agricultural operations. HECO, MECO and HELCO have nonexclusive franchises from the state covering certain areas and authorizing them to construct, operate and maintain facilities over and under public streets and sidewalks. HECO's franchise covers the City & County of Honolulu, MECO's franchises cover the islands of Maui, Lanai and Molokai in the County of Maui and the small County of Kalawao on the island of Molokai, and HELCO's franchise covers the County of Hawaii. Each of these franchises will continue in effect for an indefinite period of time until forfeited, altered, amended or repealed. SALES OF ELECTRICITY HECO, MECO and HELCO provide the only electric public utility service on the islands they serve. The following table sets forth the numberEof their electric customer accounts as of December 31, 1993, 1992 and 1991 and their electric sales revenues for each of the years then ended: (1) Includes the effect of the change in the method of estimating unbilled kilowatthour sales and revenues. Revenues from the sale of electricity in 1993 were from the following types of customers in the proportions shown: Total electricity sales for all three utilities in 1993 were 8,325 million kilowatthours (KWH), a 0.1% decrease from 1992 sales. The relatively low sales in 1993 reflect cooler weather, the slowing in the state economy and conservation efforts. Approximately 10% of consolidated operating revenues of HECO and its subsidiaries was derived from the sale of electricity to various federal government agencies in 1993, 1992 and 1991. HECO's fifth largest customer, the Naval Base at Barbers Point, Oahu, is expected to be closed within the next four to five years. On March 8, 1994, President Clinton signed an Executive Order which mandates that each federal agency develop and implement a program with the intent of reducing energy consumption by 30% by the year 2005 to the extent that these measures are cost-effective. The 30% reductions will be measured relative to the agency's 1985 energy use. HECO is working with various Department of Defense installations to implement demand-side management programs which will help them achieve their energy reduction objectives. It is expected that several Department of Defense installations will sign a Basic Ordering Agreement under which HECO will implement the energy conservation projects. Neither HEI nor HECO management can predict with certainty the impact of President Clinton's Executive Order on the Company's or consolidated HECO's future results of operations. SELECTED CONSOLIDATED ELECTRIC UTILITY OPERATING STATISTICS * Sum of the peak demands on all islands served, noncoincident and nonintegrated. ** Includes the effect of the change in the method of estimating unbilled KWH sales and revenues. *** Excluding the effect of the change in the method of estimating unbilled KWH sales and revenues, losses and system uses would have been 5.6%. GENERATION STATISTICS The following table contains certain generation statistics as of December 31, 1993, and for the year ended December 31, 1993. The capability available for operation at any given time may be less than the generating capability shown because of temporary outages for inspection, maintenance, repairs or unforeseen circumstances. (1) HECO units at normal ratings less 14.0 MW due to capability restrictions, and MECO and HELCO units at reserve ratings. (2) Noncoincident and nonintegrated. (3) Independent power producers - 180.0 MW (Kalaeloa), 180.0 MW (AES-BP) and 46.0 MW (HRRV). (4) Non-utility generation-MECO: 16.0 MW (Hawaiian Commercial & Sugar Company) and HELCO: 25.0 MW (Puna Geothermal Ventures), 18.0 MW (HCPC) and 8.0 MW (Hamakua Sugar Company). Hamakua Sugar Company filed for bankruptcy in 1992 and is expected to discontinue operations in 1994. REQUIREMENTS AND PLANS FOR ADDITIONAL GENERATING CAPACITY Each of the three utilities completed its first Integrated Resource Plan (IRP) in 1993. These plans identified and evaluated a mix of resources to meet near- and long-term consumer energy needs in an efficient and reliable manner at the lowest reasonable cost. The IRPs include demand-side management (DSM) programs to reduce load and fuel consumption and consider the impact on the environment, culture, community lifestyles and economy of the state. On July 1, 1993, HECO filed its first Integrated Resource Plan with the Hawaii Public Utilities Commission (PUC). This plan was subsequently modified in January 1994 due to a change in load forecast. The decrease in the load forecast, the inclusion of the impact of proposed DSM programs, and the deferred retirement of Honolulu Unit Nos. 8 & 9 until 2004, allowed HECO to defer its next generating unit addition to the year 2005. In its plan, HECO recommended that this next generating unit be a coal-fired atmospheric fluidized bed combustion unit to provide a fuel alternative to oil. Because of the uncertainty of the impact of new environmental regulations and the political pressure to remove Honolulu Power Plant from downtown Honolulu earlier than the 2004 time frame, alternate plans are being developed to add generating capacity earlier if necessary. MECO completed construction of its first 58-MW dual-train combined-cycle facility in 1993 at a cost of $78 million. On December 15, 1993, MECO filed its first IRP with the PUC. MECO plans to add a second dual-train combined-cycle unit with the addition of a 20-MW combustion turbine (CT) in 1996, another 20-MW CT in 1999 and the conversion of these units into a 58-MW combined-cycle unit with the addition of an 18-MW steam turbine in 2000. MECO's Molokai Division plans to purchase three 2.2-MW diesel units; two in 1995 and one in 1996. MECO's Lanai Division plans to add three 2.2-MW diesel units in 1996. On October 15, 1993, HELCO filed its first IRP with the PUC. HELCO has a power purchase agreement with Puna Geothermal Ventures (PGV) for 25 MW which became a firm source of power on June 27, 1993. Hamakua Sugar Company filed for bankruptcy in 1992 and ceased power production on May 7, 1993, but resumed on July 15, 1993, under a court-approved harvest plan which is expected to continue over a period of 10 to 16 months. It is expected that Hamakua's capacity of 8MW will be unavailable to HELCO by the end of 1994. Hilo Coast Processing Company (HCPC) will discontinue harvesting sugar cane in late 1994 and has indicated that it may increase its power export capability and switch its primary fuel from bagasse (sugarcane waste) to coal. This would require a new modified power purchase agreement, which would be subject to PUC approval. For capacity planning, HELCO assumed that HCPC would continue to provide 18 MW of firm power to HELCO under the existing power purchase agreement. The installation of a phased combined-cycle unit is proceeding. The service date for the first CT, CT-4, is scheduled for July 1, 1995 pending Conservation District Use Application approval at the existing Keahole Power Plant site. Although capacity after CT-4 is not required until April 1996, CT-5 is scheduled to be installed immediately after CT-4 in September 1995 based on economies of the earlier schedule which allows HELCO to use the same construction contract as CT-4. In addition, the earlier schedule permits HELCO to proceed with the planned retirements of its older, less efficient units and to mitigate uncertainties with respect to deliveries from HELCO's power purchase producers. Conversion of CT-4 and CT-5 to combined-cycle operation with the addition of a steam unit, ST-7 is expected to occur by October 1997. NONUTILITY GENERATION The Company has supported state and federal energy policies which encourage the development of alternate energy sources that reduce dependence on fuel oil. Alternate energy sources range from wind, geothermal and hydroelectric power, to energy produced by the burning of bagasse. Other nonoil projects include a generating unit burning municipal waste and a fluidized bed unit burning coal. HECO currently has three major power purchase agreements. In general, HECO's payments under these power purchase agreements are based upon available capacity and energy. Payments for capacity generally are not required if the contracted capacity is not available, and payments are reduced, under certain conditions, if available capacity drops below contracted levels. In general, the payment rates for capacity have been predetermined for the terms of the agreements. The energy charges will vary over the terms of the agreements and HECO may pass on changes in the fuel component of the energy charges to customers through energy cost adjustment clauses in its rate schedules. HECO does not operate nor does it participate in the operation of any of the facilities that provide power under the three agreements. Title to the facilities does not pass to HECO upon expiration of the agreements, and the agreements do not contain bargain purchase options with respect to the facilities. In March 1988, HECO entered into a power purchase agreement with AES Barbers Point, Inc. (AES-BP), a Hawaii-based cogeneration subsidiary of Applied Energy Services, Inc. (AES) of Arlington, Virginia. The agreement with AES-BP, as amended in August 1989, provides that, for a period of 30 years, HECO will purchase 180 MW of firm capacity, under the control of HECO's system dispatcher. The AES-BP 180-MW coal-fired cogeneration plant utilizes a "clean coal" technology and became operational in September 1992. The facility is designed to sell sufficient steam to qualify under the Public Utility Regulatory Policies Act of 1978 (PURPA) as an unregulated cogenerator. HECO entered into an agreement in October 1988 with Kalaeloa Partners, L.P. (Kalaeloa) a limited partnership whose sole general partner is an indirect, wholly owned subsidiary of ASEA Brown Boveri, Inc., which has guaranteed certain of Kalaeloa's obligations and, through affiliates, has contracted to design, build, operate and maintain the facility. The agreement with Kalaeloa, as amended, provides that HECO will purchase 180 MW of firm capacity for a period of 25 years. The Kalaeloa facility, which was completed in the second quarter of 1991, is a combined-cycle operation, consisting of two oil-fired combustion turbines and a steam turbine which utilizes waste heat from the combustion turbines. The facility is designed to sell sufficient steam to qualify under PURPA as an unregulated cogenerator. HECO has also entered into a power purchase contract and a firm capacity amendment with Honolulu Resource Recovery Venture (HRRV), which has built a 60- MW refuse-fired plant. The HRRV unit began to provide firm energy in the second quarter of 1990 and currently supplies HECO with 46 MW of firm capacity. The PUC has approved and allowed rate recovery for the costs related to HECO's three major power purchase agreements, which provide a total of 406 MW of firm capacity, representing 24% of HECO's total generating and firm purchased capability on the island of Oahu as of December 31, 1993. Assuming that the three independent power producers operate at the minimum availability criteria in the power purchase agreements, aggregate fixed capacity charges under the three major agreements are expected to be between approximately $95 million and $98 million annually from 1994 through 2015, $73 million in 2016, between $59 million and $62 million annually from 2017 through 2021, and $46 million in 2022. As of December 31, 1993, HELCO and MECO had power purchase agreements for 51 MW and 16 MW of firm capacity, respectively, representing 25% and 7% of their respective total generating and firm purchased capabilities. Assuming that the independent power producers operate at the minimum availability criteria in the power purchase agreements, aggregate fixed capacity charges are expected to be approximately $9 million annually in 1994 and 1995, $8 million from 1996 through 1999, $6 million from 2000 through 2002 and $4 million annually from 2003 through 2028. HELCO has a power purchase agreement with PGV for 25 MW of firm capacity. PGV, an independent geothermal power producer which experienced substantial delays in commencing commercial operations, passed an acceptance test in June 1993 and is now considered to be a firm capacity source for 25 MW. HERS owned and operated a windfarm on the island of Oahu and sold the electricity it generated to HECO. The windfarm consisted of 14 600-KW and one 3,200-KW wind turbines. In March 1993, HEI sold the stock of HERS to The New World Power Corporation with the power purchase agreements between HERS and HECO continuing in effect. The stock of LVI was transferred to HEI prior to the sale of HERS. LVI's windfarm on the island of Hawaii consists of 54 20-KW and 34 17.5-KW wind turbines. LVI sells its electricity to HELCO and the Hawaii County Department of Water Supply. See "Discontinued operations--Hawaiian Electric Renewable Systems, Inc." Hamakua Sugar Company has been operating under Federal Bankruptcy Court protection since August 1992. Hamakua is presently in a Chapter 11 bankruptcy proceeding and is conducting a final sugar cane harvest over a period of 10 to 16 months, which began in July 1993. During the harvest, Hamakua has agreed to supply HELCO with 8 MW of firm capacity under an amendment to HELCO's existing power purchase agreement. HELCO has a power purchase agreement with Hilo Coast Processing Company (HCPC) for 18 MW of firm capacity. On July 31, 1992, C. Brewer and Company, Limited publicly announced that Mauna Kea Agribusiness, which is the primary supplier of sugar cane processed by HCPC, will begin converting its acreage to macadamia nuts, eucalyptus trees and other diversified crops as of November 1, 1992, and will discontinue harvesting sugar cane in late 1994. The announcement also indicated that, after the last sugar harvest, HCPC's primary fuel would be coal, supplemented by macadamia nut husks and other biomass material. It is HELCO's understanding that HCPC plans to continue supplying power after 1994 (and may even be in a position to supply more than 18 MW after its sugar processing operations are discontinued), and HELCO has assumed that HCPC's commitment to provide 18 MW of capacity will remain in effect for the current term of the contract, which ends December 31, 2002. BHP Petroleum Americas (Hawaii) Inc. (BHPH), formerly Pacific Resources, Inc., stopped hauling heavy fuel oil from Oahu to the other Hawaiian Islands at the end of May 1992. This may continue to affect the ability of the sugar companies, which relied on the oil delivered by BHPH, to supply power to HELCO and MECO. In light of this situation, some of the sugar companies have or are considering conversion to alternative fuels. Although it currently appears that heavy fuel oil will continue to be commercially available, in the event of the unavailability of heavy fuel oil, certain nonutility generators of electricity with contracts with HELCO and MECO may need to use a more expensive alternative fuel such as diesel. The legislation amending the state Environmental Response Law allows these producers, subject to PUC approval, to charge the utilities rates for energy purchases reflecting their higher fuel costs rather than the currently approved rates and, in turn, permits each utility to pass on the increases to its customers through an automatic rate adjustment clause. To minimize the rate increase of any one utility, the legislation permits the PUC, under certain conditions, to utilize a statewide automatic adjustment clause. In 1993, HELCO received PUC approval for recovery of the higher fuel costs incurred by HCPC. FUEL OIL USAGE AND SUPPLY All rate schedules of the Company's electric utility subsidiaries contain energy cost adjustment clauses whereby the charges for electric energy (and consequently the revenues of the subsidiaries generally) automatically vary with the weighted average price paid for fuel oil and certain components of purchased energy, and the relative amounts of company-generated and purchased power. Accordingly, changes in fuel oil and purchased energy costs are passed on to customers. See "Electric utility -- Rates." HECO's steam power plants burn low sulfur residual fuel oil. HECO's combustion turbines (peaking units) on Oahu burn diesel fuel. MECO and HELCO burn medium sulfur industrial fuel oil in their steam generating plants and diesel fuel in their diesel engine and combustion turbine generating units. In the second half of 1993, HECO concluded agreements with Chevron, U.S.A., Inc. (CUSA) and BHP Petroleum Americas Refining Inc. (BHP), formerly Hawaiian Independent Refinery, Inc., to purchase supplies of low sulfur fuel oil for a two-year term commencing January 1, 1994. The PUC approved these agreements and issued a final order in December 1993 permitting inclusion of costs under the contracts in the energy cost adjustment clause. HECO pays market-related prices for fuel purchases made under these contracts. HECO, MECO and HELCO have extended a contract with CUSA under which they will purchase No. 2 diesel fuel over a period of two years beginning January 1, 1994. The Company's utility subsidiaries jointly purchase medium sulfur residual fuel oil under this same contract and together purchase diesel fuel and residual fuel oil under a recently extended contract with BHP. The contracts with CUSA and BHP have been approved by the PUC which issued a final order in December 1993 permitting inclusion of costs under the contracts in the respective utility's energy cost adjustment clause. Diesel fuel and residual fuel oil supplies purchased under these agreements are priced on a market-related basis. The diesel fuel supplied to the Lanai Division of MECO is provided under an agreement with the CUSA jobber (i.e., wholesale merchant) on Lanai. The Molokai Division of MECO receives diesel fuel supplies through the joint purchase contract between HECO, MECO and HELCO and CUSA referred to above. The low sulfur residual fuel oil burned by HECO on Oahu is derived primarily from Indonesian and domestic crude oils. The medium sulfur residual fuel oil burned by MECO and HELCO is generally derived from domestic crude oil. The fuel oil commitments information in Note 11 to HECO's Consolidated Financial Statements is incorporated herein by reference to page 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). The following table sets forth the average costs of fuel oil used to generate electricity in the years 1993, 1992 and 1991: The average cost per barrel of fuel oil used to generate electricity for HECO, MECO and HELCO reflects the different fuel mix of each company. HECO uses primarily low sulfur residual fuel oil, MECO uses a significant amount of diesel fuel and HELCO uses primarily medium sulfur residual fuel oil and a lesser amount of diesel fuel. In general, medium sulfur fuel oil is the least costly per barrel and diesel fuel is the most expensive. During 1993, the prices of diesel fuel and low sulfur oil declined, while the price of medium sulfur fuel oil displayed no sustained trend. HTB was contractually obligated to ship heavy fuel oil for HELCO and MECO through December 1993. Effective December 31, 1993, HTB exited the heavy fuel oil shipping business. See "Regulation and other matters -- Environmental regulation -- Water quality controls." HELCO and MECO carried out a bidding process to determine who would ship heavy fuel oil beyond 1993. Several bids were received and evaluated and two contracts have been signed with Hawaiian Interisland Towing, Inc., subject to PUC approval (which has been obtained on an interim basis). HELCO and MECO have also begun to convert their generating plants from burning heavy fuel oil to burning either heavy fuel oil or diesel fuel in the event heavy fuel oil is no longer available in the future. Diesel fuel does not pose the same environmental liability concerns as heavy fuel oil, but it is more expensive and the use of diesel fuel could significantly increase HELCO's and MECO's electric rates. Conversion would assure HELCO and MECO more flexibility by permitting use of another type of fuel besides heavy fuel oil. In 1994, it is estimated that 75% of the net energy generated and purchased by HECO and its subsidiaries will come from oil, down from 77% in 1993. Failure by the Company's oil suppliers to provide fuel pursuant to the supply contracts and/or extremely high fuel prices could adversely affect HECO and its subsidiaries' and the Company's financial condition and results of operations. RATES HECO, MECO and HELCO are subject to the regulatory jurisdiction of the PUC with respect to rates, standards of service, issuance of securities, accounting and certain other matters. See "Regulation and other matters -- Electric utility regulation." All rate schedules of HECO and its subsidiaries contain an energy cost adjustment clause to reflect changes in the price paid for fuel oil and certain components of purchased power, and the relative amounts of company-generated and purchased power. Under current law and practices, specific and separate PUC approval is not required for each rate change pursuant to automatic rate adjustment clauses previously approved by the PUC. Rate increases, other than pursuant to such automatic adjustment clauses, require the prior approval of the PUC after public and contested case hearings. PURPA requires the PUC to periodically review the energy cost adjustment clauses of electric and gas utilities in the state, and such clauses, as well as the rates charged by the utilities generally, are subject to change. The PUC has broad discretion in its regulation of the rates charged by the Company's utility subsidiaries. Any adverse decision by the PUC concerning the level or method of determining electric utility rates, the authorized returns on equity or other matters or any delay in rendering a decision in a rate proceeding could have a material adverse effect on consolidated HECO's and the Company's financial condition and results of operations. Upon a showing of probable entitlement, the PUC is required to issue an interim decision in a rate case within 10 months from the date of filing a complete application if the evidentiary hearing is completed -- subject to extension for 30 days if the evidentiary hearing is not completed. However, there is no time limit for rendering a final decision. HECO Rate increase. On July 29, 1991, HECO applied to the PUC for permission to increase electric rates on the island of Oahu in 1992. The rates requested would have provided approximately $138 million in annual revenues, or approximately 26.4% over HECO's then existing rates, based on January 1, 1992 fuel oil and purchased energy prices. The request was based on a 13.5% return on average common equity. On June 30, 1992, HECO received a final decision and order from the PUC. The decision and order granted an increase of $124 million in annual revenues, based on a 13.0% return on average common equity. The increase took effect in steps in 1992. $28 million of the $124 million increase was granted in the interim decision effective April 1, 1992. A step increase of $2.3 million in annual revenues became effective July 8, 1992. Approximately $93 million of the $124 million increase represented a pass-through of costs when HECO began purchasing generating capacity from independent power producer AES-BP in September 1992. The increase is subject to possible adjustments for postretirement benefits other than pensions. The major reason for the difference between revenues requested in HECO's application and the revenues granted by the PUCO's final decision and order relates to postretirement benefits other than pensions expense. HECO requested $11 million in annual revenues to cover the additional expense required under SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The PUC has opened a separate generic docket on postretirement benefits other than pensions and indicated that the total increase granted in the final decision and order will be adjusted to reflect its decision in that docket. The PUC has not yet issued a final decision and order in this generic docket. The information on postretirement benefits other than pensions in Note 10 to HECO's Consolidated Financial Statements is incorporated herein by reference to pages 23 to 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). Pending rate requests. On July 26, 1993, HECO applied to the PUC for permission to increase electric rates, using a 1994 test year and requesting rates designed to produce an increase of approximately $62 million in annual revenues over the revenues provided by rates currently in effect. HECO subsequently revised its rate request from $62 million to approximately $54 million by the close of the evidentiary hearings held in March 1994. The revision resulted primarily from rescheduling certain capital projects from 1994 to 1995, and agreements among the parties with respect to certain issues. The requested increase, as revised, is based on a 12.75% return on average common equity and is needed to cover rising operating costs and the cost of new capital projects to maintain and improve service reliability. In addition, the requested increase includes approximately $9 million for costs arising out of the change to accrual accounting for postretirement benefits other than pensions, and the amount of the required increase will be reduced to the extent that rate relief for these costs is received in another proceeding. The information on postretirement benefits other than pensions in Note 10 to HECO's Consolidated Financial Statements is incorporated herein by reference to pages 23 to 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). HECO has requested an interim increase of approximately $39 million by April 1994, and the remainder of the requested increase in steps in 1994. On December 27, 1993, HECO applied to the PUC for permission to increase electric rates, using a 1995 test year and requesting rates designed to produce an increase of approximately $44 million in annual revenues over revenues provided by the initially proposed 1994 rates. As a result of revisions to the rate increase requested in 1994, the requested increase would be approximately $52 million over revenues provided by proposed 1994 rates. The increase requested by HECO is based on a 12.3% return on average common equity. The rate request based on a 1995 test year is in addition to HECO's pending $54 million rate increase requested for 1994. Both requests combined represent a 16.7% increase, or $106 million, over present rates. Revenue from the proposed increase would be used in part to cover the costs of major transmission and distribution projects on Oahu, including an important transmission corridor to connect power plants on the island's west side with customers throughout Oahu. The 1995 application includes requests for approximately $15 million for additional expenses associated with proposed changes in depreciation rates and methods and $7 million to establish a self-insured property damage reserve for transmission and distribution property in the event of catastrophic disasters. HECO seeks to establish the requested reserve because HECO is self-insured for damage to its transmission and distribution property, except substations. (HECO's subsidiaries are similarly self-insured.) Also, a heightened concern for the risk of loss of this property has grown out of the loss of virtually the entire transmission and distribution system of the unaffiliated electric utility serving the island of Kauai as a result of Hurricane Iniki in September 1992. HECO anticipates that evidentiary hearings on the 1995 application will be held in late 1994. HELCO Rate increase. On July 31, 1991, HELCO asked the PUC to increase rates by $7.5 million a year, or 7.5%. The request was based on a 13.5% return on average common equity and a 1992 test year. On October 2, 1992, HELCO received a final decision and order from the PUC authorizing a total increase of $3.9 million in annual revenues, based on a 13.0% return on average common equity. HELCO's original request for rate increase included approximately $1.9 million to cover the increased cost of postretirement benefits other than pensions, and this request will be considered in a separate generic docket. The PUC has not yet issued a final decision and order in this generic docket. The information on postretirement benefits other than pensions in Note 10 to HECO's Consolidated Financial Statements is incorporated herein by reference to pages 23 to 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). Other rate adjustments could be made based on the results of the PUC's study of HELCO's service reliability. See "Item 3. Legal Proceedings--HELCO reliability investigation." Pending rate request. On November 30, 1993, HELCO applied to the PUC for permission to increase electric rates, using a 1994 test year and requesting rates designed to produce an increase of approximately $15.8 million in annual revenues, or 13.4%, over revenues provided by rates currently in effect. The requested increase is based on a 12.4% return on average common equity and is needed to cover plant, equipment and operating costs to maintain and improve service and provide reliable power for its customers. HELCO anticipates that evidentiary hearings will be held later this year. MECO Pending rate request. In November 1991, MECO filed a request to increase rates by approximately $18.3 million annually, or approximately 17% above the rates in effect at the time of the filing, in several steps. Most of the proposed increase reflected the costs of adding a 58-MW combined-cycle generating unit on Maui in three phases and the costs related to the change in the method of accounting for postretirement benefits other than pensions. Evidentiary hearings were held in January 1993. At the conclusion of the hearings, MECO's final requested increase was adjusted to approximately $11.4 million annually, or approximately 10%, in several steps in 1993. The decrease in the requested rate increase resulted primarily from a reduced cost of capital, lower administrative and general expenses and other revisions to MECO's estimated revenue requirements for the 1993 test year used in the rate case. MECO's revised request reflected a return on average common equity of 13.0%. On January 29, 1993, MECO received an initial interim decision authorizing an annual increase of $2.8 million, or 2.4%, effective February 1, 1993. This interim decision covered, among other things, the costs associated with the first phase of the 58-MW combined-cycle generating unit, which had been placed in service on May 1, 1992. In the interim decision the PUC used a rate of return on average common equity of 12.75% in light of a drop in interest rates and changes in economic conditions since HECO's and HELCO's most recent rate case decisions and orders. The PUC also stated that MECO is less dependent on purchased power than HECO or HELCO, and that MECO's return on average common equity will be more extensively reviewed for purposes of the final decision and order. On May 7, 1993, MECO received a second interim decision authorizing a step increase of an additional $4 million in annual revenues, or 3.6%, effective May 8, 1993. This step increase covered the estimated annual costs of the second phase of the 58-MW combined-cycle generating unit, a combustion turbine which was placed into service on May 1, 1993. On October 21, 1993, MECO received a third interim decision authorizing a step increase of an additional $1 million in annual revenues, or 0.9%, effective October 21, 1993. This step increase covered the estimated annual costs of the third and final phase of the combined-cycle generating unit, which was placed into service on October 1, 1993. On December 9, 1993, MECO received a fourth interim decision authorizing a step increase of an additional $0.4 million in annual revenues, effective December 10, 1993, to cover wage increases that became effective on November 1, 1993. These interim increases are subject to refund with interest, pending the final outcome of the case. MECO's management cannot predict with certainty when a final decision in MECO's rate case will be rendered or the amount of the final rate increase that will be granted. SAVINGS BANK -- AMERICAN SAVINGS BANK, F.S.B. GENERAL ASB was granted a charter as a federal savings bank in January 1987. Prior to that time, ASB operated as the Hawaii division of American Savings & Loan Association of Salt Lake City, Utah since 1925. At September 30, 1993, ASB's total assets were $2.5 billion and it was the second largest savings and loan institution in Hawaii based on total assets. ASB was acquired by the Company for approximately $115 million on May 26, 1988. The acquisition was accounted for using the purchase method of accounting. Accordingly, tangible assets and liabilities were recorded at their estimated fair values at the acquisition date. The acquisition was approved by the Federal Home Loan Bank Board (FHLBB) which required HEI to enter into a Regulatory Capital Maintenance/Dividend Agreement (the FHLBB Agreement). Under the FHLBB Agreement, HEI agreed that ASB's regulatory capital would be maintained at a level of at least 6% of ASB's total liabilities, or at such greater amount as may be required from time to time by regulation. Under the FHLBB Agreement, HEI's obligation to contribute additional capital was limited to a maximum aggregate amount of approximately $65.1 million. HEI elected to contribute additional capital of $0.8 million and $24.0 million to ASB during 1993 and 1992, respectively. The FHLBB Agreement also included limitations on ASB's ability to pay dividends. Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), the regulations of the FHLBB and the FHLBB Agreement were transferred to the Office of Thrift Supervision (OTS). Effective December 23, 1992, ASB was granted a release from the dividend limitations imposed under the FHLBB Agreement. ASB is subject to the OTS regulations for dividends and other distributions applicable to financial institutions regulated by the OTS. ASB acquired First Nationwide Bank's Hawaii branches and deposits on October 6, 1990. The acquisition increased ASB's statewide retail branch network from 36 to 45 branches and its deposit base by $247 million, and provided approximately $239 million in cash. ASB's earnings depend primarily on its net interest income -- the difference between the interest income earned on interest-earning assets (loans receivable, mortgage-backed securities and investments) and the interest expense incurred on interest-bearing liabilities (deposit liabilities and borrowings). Deposits traditionally have been the principal source of ASB's funds for use in lending, meeting liquidity requirements and making investments. ASB also derives funds from receipt of interest and principal on outstanding loans receivable, borrowings from the Federal Home Loan Bank (FHLB) of Seattle, securities sold under agreements to repurchase and other sources, including collateralized medium-term notes. For additional information about ASB, reference is made to Note 5 to HEI's Consolidated Financial Statements, incorporated herein by reference to pages 53 through 57 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). The following table sets forth selected data for ASB for the periods indicated: (1) Net income includes amortization of goodwill and core deposit intangibles. (2) Reflects allocation of corporate-level expenses for segment reporting purposes, which were not billed to ASB. In the second quarter of 1992, HEI changed its method of billing corporate-level expenses to ASB. Under the new billing procedure, only certain direct charges, rather than fully-allocated costs, are billed to ASB. However, no change was made by HEI in the manner in which corporate-level expenses were allocated for segment reporting purposes. CONSOLIDATED AVERAGE BALANCE SHEET The following table sets forth average balances of major balance sheet categories for the periods indicated. Average balances for each period have been calculated using the average month-end balances during the period. ASSET/LIABILITY MANAGEMENT Interest rate sensitivity refers to the relationship between market interest rates and net interest income resulting from the repricing of interest-earning assets and interest-bearing liabilities. Interest rate risk arises when an interest-earning asset matures or when its interest rate changes in a time frame different from that of the supporting interest-bearing liability. Maintaining an equilibrium between rate sensitive interest-earning assets and interest-bearing liabilities will reduce some interest rate risk but it will not guarantee a stable net interest spread because yields and rates may change simultaneously or at different times and such changes may occur in differing increments. Market rate fluctuations could materially affect the overall net interest spread even if interest-earning assets and interest-bearing liabilities were perfectly matched. The difference between the amounts of interest-earning assets and interest-bearing liabilities that reprice during a given period is called "gap." An asset-sensitive position or "positive gap" exists when more assets than liabilities reprice within a given period; a liability-sensitive position or "negative gap" exists when more liabilities than assets reprice within a given period. A positive gap generally produces more net interest income in periods of rising interest rates and a negative gap generally produces more net interest income in periods of falling interest rates. As rates in 1993 have remained at low levels, the gap in the near term (0-6 months) was a negative 4.1% of total assets as compared to a cumulative one-year positive gap position of 3.2% of total assets as of December 31, 1993. The negative near-term gap position reflects customers moving more interest sensitive funds into liquid passbook deposits. The cumulative one-year 1993 "positive gap" was primarily due to a very low interest rate environment that led to faster prepayments of fixed rate loans with high interest rates coupled with the increase of noninterest rate sensitive passbook deposits with a life expectancy of greater than a year. The following table shows ASB's interest rate sensitivity at December 31, 1993: (1) The table does not include $183 million of noninterest-earning assets and $53 million of noninterest-bearing liabilities. (2) The difference between the total interest-earning assets and the total interest-bearing liabilities. INTEREST INCOME AND INTEREST EXPENSE The following table sets forth average balances, interest and dividend income, interest expense and weighted average yields earned and rates paid, for certain categories of interest-earning assets and interest-bearing liabilities for the periods indicated. Average balances for each period have been calculated using the average month-end balances during the period. (1) ASB has no material amount of tax-exempt investments for periods shown. (2) Excludes nonrecurring items. The following table shows the effect on net interest income of (1) changes in interest rates (change in weighted average interest rate multiplied by prior period average portfolio balance) and (2) changes in volume (change in average portfolio balance multiplied by prior period rate). Any remaining change is allocated to the above two categories on a pro rata basis. OTHER INCOME In addition to net interest income, ASB has various sources of other income, including fee income from servicing loans, fees on deposit accounts, rental income from premises and other income. Other income totaled approximately $11.1 million in 1993, compared to $10.4 million in 1992 and $9.7 million in 1991. LENDING ACTIVITIES General. ASB's net loan and mortgage-backed securities portfolio totaled approximately $2.4 billion at December 31, 1993, representing 90.3% of its total assets, compared to $2.2 billion, or 88.3%, and $2.0 billion, or 89.7%, at December 31, 1992 and 1991, respectively. ASB's loan portfolio consists primarily of conventional residential mortgage loans which are not insured by the Federal Housing Administration (FHA) nor guaranteed by the Veterans Administration. At December 31, 1993, mortgage-backed securities represented 26.7% of the loan and mortgage-backed securities portfolio, compared to 32.7% at December 31, 1992 and 41.1% at December 31, 1991. The following tables set forth the composition of ASB's loan and mortgage- backed securities portfolio: (1) Includes renegotiated loans. (1) Includes renegotiated loans. Origination, purchase and sale of loans. Generally, loans originated and purchased by ASB are secured by real estate located in Hawaii. As of December 31, 1993, approximately $11.9 million of loans which were purchased from other lenders were secured by properties located in the continental United States. For additional information, including information concerning the geographic distribution of ASB's mortgage-backed securities portfolio, reference is made to Note 20 to HEI's Consolidated Financial Statements, incorporated herein by reference to page 67 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). The following table shows the amount of loans originated for the years indicated: Residential mortgage lending. During 1993, the demand for adjustable rate mortgage (ARM) loans over fixed rate loans decreased compared with 1992. ARM loans carry adjustable interest rates which are typically set according to a short-term index. Payment amounts may be adjusted periodically based on changes in interest rates. ARM loans represented approximately 24.7% of the total originations of first mortgage loans in 1993, compared to 34.0% and 27.4% in 1992 and 1991, respectively. ASB intends to continue to emphasize the origination and purchase of ARM loans to further improve its asset/liability management. ASB is permitted to lend up to 100% of the appraised value of the real property securing a loan. Its general policy is to require private mortgage insurance when the loan-to-value ratio of owner-occupied property exceeds 80% of the lower of the appraised value or purchase price. On nonowner-occupied residential properties, the loan-to-value ratio may not exceed 80% of the lower of the appraised value or purchase price. Construction and development lending. ASB provides both fixed and adjustable rate loans for the construction of one-to-four residential unit and commercial properties. Construction and development financing generally involves a higher degree of credit risk than long-term financing on improved, occupied real estate. Accordingly, all construction and development loans are priced higher than loans secured by completed structures. ASB's underwriting, monitoring and disbursement practices with respect to construction and development financing are designed to ensure sufficient funds are available to complete construction projects. As of December 31, 1993, 1992 and 1991, construction and development loans represented 1.5%, 2.2% and 2.1%, respectively, of ASB's gross loan portfolio. See "Loan portfolio risk elements." Multi-family residential and commercial real estate lending. Permanent loans secured by multi-family properties (generally apartment buildings), as well as commercial and industrial properties (including office buildings, shopping centers and warehouses), are originated by ASB for its own portfolio as well as for participation with other lenders. In 1993, 1992 and 1991, loans on these types of properties accounted for approximately 6.0%, 8.2% and 7.5%, respectively, of ASB's total mortgage loan originations. The objective of commercial real estate lending is to diversify ASB's loan portfolio to include sound, income-producing properties. Consumer lending. ASB offers a variety of secured and unsecured consumer loans. Loans secured by deposits are limited to 90% of the available account balance. ASB also offers VISA cards, automobile loans, general purpose consumer loans, second mortgage loans, home equity lines of credit, checking account overdraft protection and unsecured lines of credit. In 1993, 1992 and 1991, loans of these types accounted for approximately 4.3%, 4.9% and 11.1%, respectively, of ASB's total loan originations. Corporate banking/commercial lending. ASB is authorized to make both secured and unsecured corporate banking loans to business entities. This lending activity is designed to diversify ASB's asset structure, shorten maturities, provide rate sensitivity to the loan portfolio and attract business checking deposits. As of December 31, 1993, 1992 and 1991, corporate banking loans represented 1.2%, 1.2% and 1.67%, respectively, of ASB's total net loan portfolio. Loan origination fee and servicing income. In addition to interest earned on loans, ASB receives income from servicing of loans, for late payments and from other related services. Servicing fees are received on loans originated and subsequently sold by ASB and also on loans for which ASB acts as collection agent on behalf of third-party purchasers. ASB generally charges the borrower at loan settlement a loan origination fee ranging from 2% to 3% of the amount borrowed. Loan origination fees (net of direct loan origination costs) are deferred and recognized as an adjustment of yield over the life of the loan. Nonrefundable commitment fees (net of direct loan origination costs, if applicable) to originate or purchase loans are deferred. The nonrefundable commitment fees are recognized as an adjustment of yield over the life of the loan if the commitment is exercised. If the commitment expires unexercised, nonrefundable commitment fees are recognized in income upon expiration of the commitment. Loan portfolio risk elements. When a borrower fails to make a required payment on a loan and does not cure the delinquency promptly, the loan is classified as delinquent. If delinquencies are not cured promptly, ASB normally commences a collection action, including foreclosure proceedings in the case of secured loans. In a foreclosure action, the property securing the delinquent debt is sold at a public auction in which ASB may participate as a bidder to protect its interest. If ASB is the successful bidder, the property is classified in a real estate owned account until it is sold. At December 31, 1993, there was only one real estate property, a residential property, acquired in settlement of a loan totaling $0.2 million, or 0.01% of total assets. At December 31, 1992 there was only one real estate property, a commercial property, acquired in settlement of a loan totaling $2.0 million, or 0.08% of total assets. There was no real estate owned at December 31, 1991, 1990 and 1989. In addition to delinquent loans, other significant lending risk elements include: (1) accruing loans which are over 90 days past due as to principal or interest, (2) loans accounted for on a nonaccrual basis (nonaccrual loans), and (3) loans on which various concessions are made with respect to interest rate, maturity, or other terms due to the inability of the borrower to service the obligation under the original terms of the agreement (renegotiated loans). ASB has no loans which are over 90 days past due on which interest is being accrued for the years presented in the table below. The level of nonaccrual and renegotiated loans represented 0.5%, 1.0%, 0.1%, 0.1% and 0.2%, of ASB's total net loans outstanding at December 31, 1993, 1992, 1991, 1990 and 1989, respectively. The following table sets forth certain information with respect to nonaccrual and renegotiated loans for the dates indicated: ASB's policy generally is to place mortgage loans on a nonaccrual status (interest accrual is suspended) when the loan becomes more than 90 days past due or on an earlier basis when there is a reasonable doubt as to its collectability. Loans on nonaccrual status amounted to $5.7 million (0.32% of total loans) at December 31, 1993, $14.2 million (0.94% of total loans) at December 31, 1992, $1.0 million (0.08% of total loans) at December 31, 1991, $1.0 million (0.10% of total loans) at December 31, 1990 and $1.2 million (0.14% of total loans) at December 31, 1989. The significant increase in loans on nonaccrual status from year-end 1991 to 1992 was primarily due to the effects of Hurricane Iniki on the island of Kauai, such as higher unemployment. As of December 31, 1992, real estate loans with remaining principal balances of $8.9 million were restructured to defer monthly contractual principal and interest payments for three months with repayments of the entire deferred amounts due at the end of the three-month period. These loans had been classified as nonaccrual loans as of December 31, 1992. Substantially all of these loans have resumed their normal repayment schedule and are classified as performing loans as of December 31, 1993. For additional information, see "Potential problem loans." There were no loan loss provisions with respect to renegotiated loans in 1993, 1992, 1991, 1990 and 1989 because the estimated net realizable value of the collateral for such loans was determined to be in excess of the outstanding principal amounts of these loans. For additional information, see "Potential problem loans." Potential problem loans. A loan is classified as a potential problem loan when the ability of the borrower to comply with present loan covenants is in doubt. In September 1992, the island of Kauai suffered substantial property damage from Hurricane Iniki. The high unemployment rate on Kauai due to Hurricane Iniki resulted in loan payment defaults or deferrals requiring such loans to be placed on a nonaccrual status. As of December 31, 1992, delinquencies of ASB's Kauai loans were $2.2 million, $2.5 million, $3.1 million and $0.4 million for 1-29 days, 30-59 days, 60-89 days and 90 days and over delinquent, respectively. In anticipation of additional loans falling into the 90 days and over category, ASB added reserves during 1992 of $0.6 million for Kauai loans. As of December 31, 1993, substantially all of these loans have resumed their normal repayment schedule improving delinquencies of ASB's Kauai loans to $2.1 million, $0.5 million, $0.3 million and $0.7 million for 1-29 days, 30-59 days, 60-89 days and 90 days and over delinquent, respectively. Due to the losses created by Hurricane Iniki, several insurance companies have discontinued the sale and/or renewal of homeowners' insurance on real estate in Hawaii. If a borrower is unable to obtain insurance, ASB has procedures to "force place" insurance coverage. The "force place" policies are underwritten by two U.S. insurance companies and would protect ASB, as lender, for loans secured by real estate covered by such policies. The cost of the policy is charged to the borrower. Based on the current circumstances, management believes that the current shortage of homeowners' insurance in Hawaii and the effect of Hurricane Iniki on ASB's future earnings will not be material to the Company's financial condition or results of operations. Allowance for loan losses. The provision for loan losses is dependent upon management's evaluation as to the amount needed to maintain the allowance for loan losses at a level considered appropriate in relation to the risk of future losses inherent in the loan portfolio. While management attempts to use the best information available to make evaluations, future adjustments may be necessary as circumstances change and additional information becomes available. The following table presents the changes in the allowance for loan losses for the periods indicated. ASB's ratio of provisions for loan losses during the period to average loans outstanding was 0.05%, 0.11%, 0.06%, 0.07% and 0.06% for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. The increase in provisions for loan losses during 1992 was primarily due to the 27% increase in average loans outstanding and a $0.6 million additional provision for Kauai loans anticipated to be affected by Hurricane Iniki. See "Potential problem loans." Without the additional $0.6 million provision on Kauai loans, the ratio of provision for loan losses to average loans outstanding for the year ended December 31, 1992 would have been 0.07%, which would be consistent with prior years. The allowance for loan losses for the year ended December 31, 1993 includes the additional provision and charge-off of a single commercial loan of $0.3 million, offset by the reversal of $0.6 million in provisions for Kauai loans reclassified as performing. The ratio of provision for loan losses to average loans outstanding for the year ended December 31, 1993 would have been 0.07%, if the reversal of the $0.6 million in provisions for Kauai loans and the additional provision of $0.3 million for the commercial loan were excluded. INVESTMENT ACTIVITIES In recent years, ASB's investment portfolio has consisted primarily of mortgage-backed securities, federal agency obligations and stock of the FHLB of Seattle. The following table sets forth the composition of ASB's investment portfolio, excluding mortgage-backed securities to be held-to-maturity, at the dates indicated: (1) On investments during the year ended December 31. DEPOSITS AND OTHER SOURCES OF FUNDS General. Deposits traditionally have been the principal source of ASB's funds for use in lending and other investments. ASB also derives funds from receipt of interest and principal on outstanding loans, borrowings from the FHLB of Seattle, securities sold under agreements to repurchase and other sources. ASB borrows on a short-term basis to compensate for seasonal or other reductions in deposit flows. ASB also may borrow on a longer-term basis to support expanded lending or investment activities. Deposits. ASB's deposits are obtained primarily from residents of Hawaii. In 1993, ASB had average deposits aggregating $2.1 billion. Savings outflow for 1993 was approximately $9 million excluding interest credited to deposit accounts. Savings inflows for 1992 and 1991 were approximately $343 million and $31 million, respectively, excluding interest credited to deposit accounts. The substantial decrease in savings flow for 1993 was due primarily to the low interest rate environment and the withdrawal of a trust company deposit account of $92 million. The trust company was recently acquired by another financial institution. The substantial increase in savings inflow for 1992 was due to ASB's strategy to increase its retail market by paying higher rates of interest on savings accounts than most of its competitors in Hawaii during this period. The weighted average rate paid on deposits during 1993 decreased to 3.74%, compared to 5.01% and 6.36% in 1992 and 1991, respectively. In the three years ended December 31, 1993, ASB had no deposits placed by or through a broker. The following table shows the distribution of ASB's average deposits and average daily rates by type of deposit for the years indicated. Average balances for a period have been calculated using the average of month-end balances during the period. At December 31, 1993, ASB had $166 million in certificate accounts of $100,000 or more maturing as follows: Borrowings. ASB obtains advances from the FHLB of Seattle, provided certain standards related to credit-worthiness have been met. Advances are secured under a blanket pledge of the common stock ASB owns in the FHLB of Seattle and each note or other instrument held by ASB and the mortgage securing it. FHLB advances generally are available to meet seasonal and other withdrawals of deposit accounts, to expand lending and to assist in the effort to improve asset and liability management. FHLB advances are made pursuant to several different credit programs offered from time to time by the FHLB of Seattle. At December 31, 1993, 1992 and 1991, advances from the FHLB amounted to $290 million, $194 million and $259 million, respectively. The weighted average rate on the advances from the FHLB outstanding at December 31, 1993, 1992 and 1991 were 6.24%, 7.39% and 7.60%, respectively. The maximum amount outstanding at any month-end during 1993, 1992 and 1991 was $290 million, $259 million and $259 million, respectively. Advances from the FHLB averaged $210 million, $221 million and $203 million during 1993, 1992 and 1991, respectively, and the approximate weighted average rate thereon was 6.84%, 7.65% and 7.99%, respectively. At December 31, 1992 and 1991, securities sold under agreements to repurchase consisted of mortgage-backed securities sold to brokers/dealers under fixed- coupon agreements. The agreements are treated as financings and the obligations to repurchase securities sold are reflected as a liability in the consolidated balance sheets. The dollar amount of securities underlying the agreements remains in the asset accounts. There were no outstanding securities sold under agreements to repurchase as of December 31, 1993. At December 31, 1992 and 1991, $27.2 million (including accrued interest of $0.2 million) and $131.0 million (including accrued interest of $1.8 million), respectively, of the agreements were to repurchase identical securities. The weighted average rates on securities sold under agreements to repurchase outstanding at December 31, 1992 and 1991 were 3.34% and 5.78%, respectively. The maximum amount outstanding at any month-end during 1993, 1992 and 1991 was $27 million, $125 million and $136 million, respectively. Securities sold under agreements to repurchase averaged $20 million, $66 million and $124 million during 1993, 1992 and 1991, respectively, and the approximate weighted average interest rate thereon was 3.39%, 5.15% and 6.67%, respectively. Subject to obtaining certain approvals from the FHLB of Seattle, ASB may offer collateralized medium-term notes due from nine months to 30 years from the date of issue and bearing interest at a fixed or floating rate established at the time of issue. At December 31, 1993, 1992 and 1991, ASB had no outstanding collateralized medium-term notes. The following table sets forth information concerning ASB's advances from FHLB and other borrowings at the dates indicated: (1) On borrowings at December 31. COMPETITION The primary factors in competing for deposits are interest rates, the quality and range of services offered, marketing, convenience of office locations, office hours and perceptions of the institution's financial soundness and safety. Competition for deposits comes primarily from other savings institutions, commercial banks, credit unions, money market and mutual funds and other investment alternatives. Additional competition for deposits comes from various types of corporate and government borrowers, including insurance companies. To meet the competition, ASB offers a variety of savings and checking accounts at competitive rates, convenient business hours, convenient branch locations with interbranch deposit and withdrawal privileges at each office and conducts advertising and promotional campaigns. The primary factors in competing for first mortgage and other loans are interest rates, loan origination fees and the quality and range of lending services offered. Competition for origination of first mortgage loans comes primarily from other savings institutions, mortgage banking firms, commercial banks, insurance companies and real estate investment trusts. ASB believes that it is able to compete for such loans primarily through the interest rates and loan fees it charges, the type of mortgage loan programs it offers and the efficiency and quality of the services it provides its borrowers and the real estate business community. OTHER FREIGHT TRANSPORTATION -- HAWAIIAN TUG & BARGE CORP. AND YOUNG BROTHERS, LIMITED GENERAL HTB and its wholly owned subsidiary, YB, were acquired from Dillingham Corporation in 1986 for $18.7 million. HTB provides interisland marine transportation services in Hawaii and the Pacific area, including charter tug and barge and harbor tug operations. YB, which is a regulated interisland cargo carrier, transports general freight and containerized cargo by barge on a regular schedule between all major ports in Hawaii. YB moved 3.1 million revenue tons of cargo between the islands in 1993, compared to 3.2 million tons of cargo in 1992. A substantial portion of the state's commodities are imported, and almost all of Hawaii's overseas inbound and outbound cargo moves through Honolulu. Cargo destined for the neighbor islands is trans-shipped through the Honolulu gateway. Access to the interisland freight transportation market is generally subject to state or federal regulation, and HTB and YB have active competitors, such as interstate common carriers and, in certain instances, unregulated contract carriers. YB has a nonexclusive Certificate of Public Convenience and Necessity from the PUC to operate as an intrastate common carrier by water. The Certificate will remain in effect for an indefinite period unless suspended or terminated by the PUC. Although YB encounters competition from, among others, interstate carriers and unregulated contract carriers, YB is the only authorized common carrier under the Hawaii Water Carrier Act. YB RATES YB generally must accept for transport all cargo offered. YB rates and charges must be approved by the PUC and the PUC has broad discretion in its regulation of the rates charged by YB. In June 1987, the PUC commenced a proceeding to determine whether YB's rates and charges should be reduced to reflect the effect of the Tax Reform Act of 1986 (TRA). During the period from January 1, 1988 through June 30, 1993, several rate reductions were imposed by the PUC as well as YB voluntarily reducing its rates for selected commodities. On February 13, 1992, YB filed a motion to rescind a 1.1% interim rate reduction which was implemented on January 1, 1989. On June 30, 1993, the PUC approved YB's motion to rescind the 1.1% interim rate reduction, effective July 8, 1993, and in January 1994, the PUC rendered a decision to close the TRA docket. In September 1992, YB filed an application for a tariff change in its minimum bill of lading from $10.43 to $21.03 (later increased to $21.62). This application was suspended on October 7, 1992. On November 5, 1992, YB filed a general rate increase application with the PUC for a 17.1% across the board increase in rates effective December 20, 1992. On December 18, 1992, the PUC ordered that the two applications be consolidated and that the consolidated application be suspended for a period of six months to and including June 19, 1993. On February 12, 1993, YB reduced its general rate increase request to 15.7% from the 17.1% originally requested. The decrease in the request was primarily due to a decrease in rate base resulting from the change in the test year period and an adjustment to YB's capital structure to reflect more leverage. The revised request was based on a rate of return of 16.7% on an imputed equity of 55%. Hearings for this general rate increase and the tariff change were held in May 1993. On June 30, 1993, the PUC issued a decision granting an $18.00 minimum bill of lading charge and a 4.3% general rate increase on all rates excluding the Minimum Bill of Lading and Marine Cargo Insurance rates. The new rates and charges became effective on July 8, 1993. This decision was based on a rate of return of 15.15% on an imputed equity of 55%. YB is also participating in the PUC's generic docket to determine whether SFAS No. 106 should be adopted for rate-making purposes. The information on postretirement benefits other than pensions in Note 18 to HEI's Consolidated Financial Statements is incorporated herein by reference to pages 64 to 66 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). On March 15, 1994, YB filed a Notice of Intent with the PUC informing them that YB will be filing an application for a general rate increase. REAL ESTATE-MALAMA PACIFIC CORP. GENERAL MPC was incorporated in 1985 and engages in real estate development activities, either directly or through joint ventures. MPC's real estate development investments in residential projects are targeted for Hawaii's owner-occupant market. MPC's subsidiaries are currently involved in the active development of five residential projects (Kipona Hills, Kua' Aina Ridge, Westpark, Piilani Village Phase 1 and Sunrise Estates Phase 1) on the islands of Oahu, Maui and Hawaii encompassing approximately 500 homes or lots, of which more than 260 have been completed and sold. Either directly or through its joint ventures, MPC's subsidiaries have access to nearly 450 acres of land for future residential development. Residential development generally requires long lead time to obtain necessary zoning changes, building permits and other required approvals. MPC's projects are subject to the usual risks of real estate development, including fluctuations in interest rates, the receipt of timely and appropriate state and local zoning and other necessary approvals, possible cost overruns and construction delays, adverse changes in general commerce and local market conditions, compliance with applicable environmental and other regulations, and potential competition from other new projects and resales of existing residences. In 1993, Malama's real estate development activities continued to be impacted by the economic conditions affecting the entire nation. Although interest rates remained low, the real estate market experienced slowdowns due to the weakness in the U.S. and Hawaii economies and lack of consumer confidence. Sales prices and velocities are expected to remain relatively flat through most of 1994, with improvement anticipated in late 1994 or 1995. For a discussion of MPC's transactions with related parties, pages 21 to 23 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994 and filed herein as HEI Exhibit 22, are incorporated herein by reference. JOINT VENTURE DEVELOPMENTS Makakilo Cliffs. In 1990, MDC and JGL Enterprises Inc. formed Makakilo Cliffs Joint Venture for the development of a 280-unit multi-family residential project on approximately 26 acres in Makakilo, Hawaii (island of Oahu). MDC's partnership interest was assigned to Malama Makakilo Corp., another wholly owned subsidiary of MPC, in August 1990. Sales of the first 81 units closed in 1991 and all remaining units closed in 1992. The joint venture was dissolved in December 1993. Sunrise Estates. In 1990, MDC and HSC, Inc. formed Sunrise Estates Joint Venture to develop and sell 165 one-acre house lots in Hilo, Hawaii (island of Hawaii). In 1993 and 1992, sales of three lots and 153Elots closed, respectively. Sales of the remaining nine lots are expected in 1994. In 1991, HSC, Inc. and Malama Elua Corp., a wholly owned subsidiary of MPC, formed Sunrise Estates II Joint Venture to develop and sell approximately 140 one-acre house lots in Hilo, Hawaii, adjacent to the Sunrise Estates Joint Venture project. Rezoning was completed in 1993 and site work is expected to commence in late 1994 or early 1995. Ainalani Associates. In 1990, MDC and MDT-BF Limited Partnership (MDT) formed a joint venture known as Ainalani Associates for the acquisition and development of five residential projects on the islands of Kauai, Maui and Hawaii. In 1990, the project on the island of Kauai was completed and sold. In 1992, the land for a project on the island of Maui was sold in bulk. Ainalani Associates also acquired a 50% interest in Palailai Associates, a partnership for the development of residential housing on Oahu. The five projects and partnership interest originally (i.e., before sales) encompassed approximately 270 acres of land. During 1990, MDC assigned its interest in Ainalani Associates to MMO, another wholly owned subsidiary of MPC. On August 17, 1992, MMO acquired MDT's 50% interest in Ainalani Associates. Upon closing of the purchase, Ainalani Associates was dissolved. The amount of consideration for the transfer, which was not material to the Company's financial condition, was determined by arbitration which ended on March 31, 1993 and was based primarily on the net present value of MDT's partnership interest in Ainalani Associates as of June 30, 1992. MMO plans to complete the development and sale of Ainalani Associates three projects on the islands of Maui and Hawaii, described below under "MMO projects," and has assumed Ainalani Associates' 50% partnership interest in Palailai Associates, a partnership with Palailai Holdings, Inc. Baldwin*Malama. In 1990, MDC acquired a 50% general partnership interest in Baldwin*Malama, a partnership with Baldwin Pacific Properties, Inc. (BPPI) established to acquire about 172 acres of land for potential development of about 780 single and multi-family residential units in Kihei on the island of Maui. The project has completed site work for the first phase of single family units. At December 31, 1993, 23 homes were completed and sold, four homes were under construction and six completed units were available for sale. In May 1993, Baldwin*Malama was reorganized as a limited partnership in which MDC is the sole general partner and BPPI is the sole limited partner. In conjunction with the dissolution of the Baldwin*Malama general partnership and formation of the limited partnership, MPC agreed to loan $1.6 million to BPPI and up to $15 million to the limited partnership, and beginning in May 1993, MDC consolidated the accounts of Baldwin*Malama. Previously, MDC accounted for its investment in Baldwin*Malama under the equity method. At December 31, 1993, the outstanding balance on MPC's loan to BPPI was $1.6 million. Palailai Associates. MMO assumed Ainalani Associates' interest in Palailai Associates on August 17, 1992 upon acquiring MDT's 50% interest in Ainalani Associates. In 1993, Palailai Associates completed the development and sale of the first increment of 107 homes and lots and completed the bulk sale of its 38.8 acres of multi-family zoned land in Makakilo, Oahu. The second increment of 69 single family homes is currently in progress, with 35 homes completed and sold as of December 31, 1993. Palailai Associates owns approximately 62 acres of adjacent land zoned for residential development. MMO PROJECTS On August 17, 1992, MMO acquired the Kipona Hills, Kua' Aina Ridge and Hanohano projects of Ainalani as a result of MMO's acquisition of MDT's 50% interest in Ainalani Associates and Ainalani Associates' subsequent dissolution. Kipona Hills is a 66-unit subdivision located in Waikoloa on the island of Hawaii. Through December 31, 1993, 42 homes or lots were completed and sold, and five completed homes and 19 lots were available for sale. Kua' Aina Ridge is a 92-lot-only subdivision in Pukalani, Maui. Subdivision improvements have been completed and sales closings commenced in 1993. As of December 31, 1993, five lots were sold. Kehaulani Place (formerly known as Hanohano), consisting of approximately 50 acres of land in Pukalani, Maui, is currently zoned for agriculture. Rezoning and land-use reclassification will be required before development can commence. Land planning and presentations to local community groups commenced in 1993. PROJECT FINANCING At December 31, 1993, MPC or its subsidiaries were directly liable for $11.5 million of outstanding construction loans and had additional construction loan facilities of $5.8 million. In addition, at December 31, 1993, MPC or its subsidiaries had issued (i) guaranties under which they were jointly and severally contingently liable with their joint venture partners for $2.1 million of outstanding construction loans and (ii) payment guaranties under which MPC or its subsidiaries were severally contingently liable for $4.6 million of outstanding construction loans and $4.7 million of additional undrawn construction loan facilities. In total, at December 31, 1993, MPC or its subsidiaries were liable or contingently liable for $18.2 million of outstanding construction loans and $10.5 million in undrawn construction loan facilities. At December 31, 1993, HEI had agreed with the lenders of construction loans and loan facilities, of which approximately $10.5 million was undrawn and $16.1 million was outstanding, that it will maintain ownership of 100% of the stock of MPC and that it intends, subject to good and prudent business practices, to keep MPC financially sound and responsible to meet its obligations. MPC or its subsidiaries may enter into additional commitments in connection with the financing of future phases of development of MPC's projects and HEI may enter into similar agreements regarding the ownership and financial condition of MPC. MALAMA WATERFRONT CORP. Malama Waterfront Corp., a wholly owned subsidiary of MPC, entered into an agreement to purchase HECO's Honolulu Power Plant in a sale and leaseback transaction. However, HECO is reconsidering the sale of the plant. See a further discussion in "Item 2. ITEM 2. PROPERTIES HEI leases 17,612 square feet of office space in downtown Honolulu. The leases expire at various dates from March 31, 1996 to April 30, 1999 (with an option for HEI to extend one of the leases on most of the office space to March 31, 2001). The properties of HEI's subsidiaries are as follows: ELECTRIC UTILITY HECO owns and operates three generating plants on the island of Oahu at Honolulu, Waiau and Kahe, with an aggregate generating capability of 1,263 MW at December 31, 1993. The three plants are situated on HECO-owned land having a combined area of 535 acres. In addition, HECO owns a total of 114 acres of land on which are located substations, transformer vault sites, distribution base yards and the Kalaeloa cogeneration facility site. Electric lines are located over or under public and nonpublic properties. Most of HECO's leases, easements and licenses have been recorded. At December 31, 1993, HECO owned approximately 828 miles of overhead transmission lines, 1,171 miles of overhead distribution lines, 2,007 miles of underground cables, 70,395 fully-owned or jointly-owned poles and 194 steel or aluminum high voltage transmission towers. The transmission system operates at 46,000 and 138,000 volts. The total capacity of HECO's transmission and distribution substations was 5,414,000 kilovoltamperes at December 31, 1993. HECO owns a building and approximately 11.5 acres of land located in Honolulu which houses its operating, engineering and information services departments and a warehousing center. It also leases an office building and certain office spaces in Honolulu. The lease for the office building expires in November 2002, with an option to further extend the lease to November 2012. The leases for certain office spaces expire on December 31, 1996 with options to extend to December 31, 2001. HECO owns 19.2 acres of land at Barbers Point used to situate fuel oil storage facilities with a combined capacity of 970,700 barrels. HECO also owns fuel oil tanks at each plant site with a total maximum usable capacity of 915,400 barrels. The properties of HECO are subject to a first mortgage securing HECO's outstanding first mortgage bonds. On December 20, 1989, HECO applied to the PUC for the approval of the sale to Malama Waterfront Corp. and leaseback of the Honolulu power plant and Iwilei tank farm, the approval of the transfer values and the approval of the accounting and rate-making treatments thereof. Prior to the PUC rendering a decision on this application, HECO determined that changing conditions altered the economics of the proposed sale such that a later retirement of the Honolulu power plant may be more favorable. As such, HECO withdrew its application for the sale and leaseback of the plant in July 1993. A brief description of the properties of HECO's two electric utility subsidiaries follows: MECO owns and operates two generating plants on the island of Maui, at Kahului and Maalaea, with an aggregate capability of 201.3 MW. The plants are situated on MECO-owned land having a combined area of 28.6 acres. MECO also owns fuel oil storage facilities at these sites with an aggregate maximum usable storage capacity of 145,300 barrels. MECO's administrative offices and engineering and distribution departments are located on 9.1 acres of MECO-owned land in Kahului. MECO also owns and operates smaller distribution and generation systems on the islands of Lanai and Molokai. The properties of MECO are subject to a first mortgage securing MECO's outstanding first mortgage bonds. HELCO owns and operates five generating plants on the island of Hawaii. These plants at Hilo (2), Waimea, Kona and Puna have an aggregate generating capability of 154.6 MW (excluding two small run-of-river hydro units). The plants are situated on HELCO-owned land having a combined area of approximately 43 acres. HELCO owns 6.0 acres of land in Kona, which are used for a baseyard, and it leases 4.0 acres of land for its baseyard in Hilo. The lease expires in 2030. The deeds to the sites located in Hilo contain certain restrictions which do not materially interfere with the use of the sites for public utility purposes. The properties of HELCO are subject to a first mortgage securing HELCO's outstanding first mortgage bonds. SAVINGS BANK ASB owns its executive office building located in downtown Honolulu. The following table sets forth certain information with respect to offices owned and leased by ASB and its subsidiaries at December 31, 1993. The net book value of office facilities is approximately $31 million. Of this amount, $25 million represents the net book value of the land and improvements for the 13 offices owned by ASB. The remaining $6 million represents the net book value of ASB's leasehold improvements. OTHER FREIGHT TRANSPORTATION HTB, currently owns seven tugboats ranging from 1,430 to 2,668 HP, two tenders of 500 HP and three flatdecked barges. HTB owns no real property, but rents on a month-to-month basis or leases its pier property used in its operations from the State of Hawaii under a revocable permit and two-year lease. It is expected that expiring leases will be renewed as necessary. YB, HTB's subsidiary, currently owns four charter tugs, two doubledecked and six flatdecked barges and most of its shoreside equipment, including 20-foot containers, chassis, refrigerated containers, container vans, hi-lifts, flatracks, automobile racks and other related equipment. YB has three- and four-year leases expiring at various dates in 1994 through 1995 for shoreside equipment (containers, flatracks and chassis) at a monthly cost of approximately $8,500. YB owns no real property, but rents on a month-to-month basis or leases various pier property and warehouse facilities from the State of Hawaii under a revocable permit, or under a two-year or five-year lease. All lease terms began on January 1, 1992. It is expected that expiring leases will be renewed as necessary. REAL ESTATE DEVELOPMENT MPC. See Item 1, "Business--Other--Real estate--Malama Pacific Corp." OTHER HEIIC. See Item 1, "Business--Other--HEI Investment Corp." LVI operates a windfarm on the island of Hawaii with a generating capability of 1.7 MW. LVI leases 78 acres of land for its windfarm. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Except as provided for below and in "Item 1. Business," there are no known pending legal proceedings, other than ordinary routine litigation incidental to their respective businesses, to which HEI or any of its subsidiaries is a party or of which any of their property is the subject. HECO POWER OUTAGE On April 9, 1991, HECO experienced a power outage that affected all customers on the island of Oahu. One major transmission line was de-energized for routine maintenance when two major transmission lines tripped, causing another major transmission line to become overloaded and automatically trip. An island-wide power outage resulted. Power was restored over the next twelve hours. The PUC initiated an investigation of the outage by its order dated April 16, 1991. This investigation was consolidated with a pending investigation of an outage that occurred in 1988. The PUC held an initial hearing on the April 9, 1991 outage in May 1991. In July 1991, HECO filed a report of its internal investigative task force with the PUC. The report indicated that the results of the investigation were inconclusive with respect to why one of the major lines tripped and recommended actions to strengthen system reliability. The parties to the investigation (HECO, Consumer Advocate and U.S. Department of Defense) agreed that HECO should retain an independent consultant to investigate the cause of the line trip. By an order dated October 23, 1991, the PUC approved HECO's retention of Power Technologies, Inc. (PTI) and directed that the objectives of the study be to assess the reliability and overall stability of HECO's electric power system, to identify possible weaknesses, deficiencies and conditions within the system that contributed to the island-wide power outage, and to recommend a plan to increase the reliability of HECO's system and minimize the occurrence of future island-wide outages. In its order, the PUC also stated that: "[n]either the [PUC] nor HECO nor any of the other parties to this docket is bound by PTI's report or analysis or is precluded from retaining other consultants." In August 1993, PTI's report was submitted to the PUC. In its report, PTI made more than 100 recommendations for HECO to improve reliability, including selective use of herbicides to control the growth of trees under power lines. PTI said some recommendations are for implementation, some are for further study and possible implementation and some are for consideration. Some of the recommendations relate to the 1991 outage and some do not. PTI identified four recommendations as deserving immediate attention: (1) perform a detailed inspection of 138-kilovolt overhead transmission lines to ensure that present clearance distances to trees, wire crossings and other conductive objects are sufficient for at least one year; (2) determine relationships between tree clearances and "line sag" changes that result from lines carrying different amounts of electricity; (3) build the Waiau-Campbell Industrial Park 138-kilovolt transmission line as soon as possible and consider building the line to operate at higher voltage in the future; and (4) increase the number of "live-line" overhead transmission linemen and engineering and management personnel to support line and right-of-way functions. Regarding the outage, PTI concluded that the fault on the third of four transmission lines was the result of tree contact. This conclusion conflicts with the finding of another consultant who found that certain evidence favored a fault in the line over a pineapple field with no trees. Other PTI recommendations include (1) reviewing reporting systems used by co-generators and independent power producers from whom HECO buys power to be sure they are adequate to reveal problems that could affect system reliability, and (2) keeping in service the downtown Honolulu power plant previously scheduled for retirement in 1996. HECO filed its comments on the PTI recommendations with the PUC in November 1993. Further proceedings have not been scheduled at this time. Management cannot predict the timing and outcome of any decision and order to be issued by the PUC with respect to the outages or with respect to the recommendations made by PTI. HECO's PUC-approved tariff rule states that "[t]he Company will not be liable for interruption or insufficiency of supply or any loss, cost, damage or expense of any nature whatsoever, occasioned thereby if caused by accident, storm, fire, strikes, riots, war or any cause not within the Company's control through the exercise of reasonable diligence and care." Under the rule, customers had 30 days from the date of the power outage to file claims. HECO received approximately 2,900 customer claims which totaled approximately $7 million. Of the 2,900 claims, approximately 1,450 are for property damage. As of December 31, 1993, HECO had settled approximately 542 of these property damage claims, had settlement offers outstanding with respect to approximately 119 more of these claims and anticipates making settlement offers with respect to the remaining property claims upon receipt and review of appropriate supporting documentation. The settlement offers are being made for purposes of settlement and compromise only, and without any admission by HECO of liability for the outage. Not covered in the settlement offers and requests for documentation are approximately 1,450 claims involving alleged personal injury or economic losses, such as lost profits. On April 19, 1991, seven direct or indirect business customers on the island of Oahu filed a lawsuit against HECO on behalf of themselves and an alleged class, claiming $75 million in compensatory damages and additional unspecified amounts for punitive damages because of the April 9, 1991 outage. The lawsuit was dismissed without prejudice in March 1993 and subsequently refiled by the plaintiffs. HECO has filed an answer which denies the principal allegations in the complaint, sets forth affirmative defenses, and asserts that the suit should not be maintained as a class action. Discovery proceedings have been initiated. No trial date has been set. A motion for an order denying class certification of the lawsuit has been filed and is set for hearing in March 1994. A reserve equal to the deductible limits with respect to HECO's insurance coverage has been recorded with respect to claims arising out of the April 1991 outage. In the opinion of management, losses (if any), net of estimated insurance recoveries, resulting from the ultimate outcome of the lawsuit and claims related to the April 9, 1991 outage will not have a material adverse effect on the Company or consolidated HECO. HELCO RELIABILITY INVESTIGATION In July 1991, following service interruptions and rolling blackouts instituted on the island of Hawaii, the PUC issued an order calling for an investigation into the reliability of HELCO's system. An evidentiary hearing was held in September 1991 and public hearings were held in October 1991. In light of approximately 20 subsequent incidents of rolling blackouts and service interruptions resulting from insufficient generation margin, further evidentiary hearings were held in July 1992. With the input from an independent consultant and the parties to the proceedings, the PUC may formulate minimum reliability standards for HELCO, use the standards to assess HELCO's system reliability, and re-examine the rate increase approved in October 1992 to see whether any adjustments are appropriate. HELCO's generation margin has improved with the addition of a 20-MW combustion turbine in August 1992, PGV's commencement of commercial operations and Hamakua's temporary return to commercial operation (see "Item 1. Business--Electric utility-Nonutility generation"). HELCO is proceeding with plans to install two 20-MW combustion turbines in 1995, followed by an 18-MW heat steam recovery generator in 1997, at which time these units will be converted to a combined-cycle unit, subject in each case to obtaining necessary permits. In the opinion of management, the PUC's adjustment, if any, resulting from the reliability investigation will not have a material adverse effect on the Company's or HECO's consolidated financial condition or results of operations. HECO POWER PURCHASE AGREEMENTS DISPUTES HECO is disputing certain amounts billed each month under its power purchase agreements with Kalaeloa Partners, L.P. (Kalaeloa) and AES Barbers Point, Inc. (AES-BP) and has withheld payment of some of the disputed amounts pending resolution. With respect to the billings from Kalaeloa, HECO believes that it has counterclaims which would mitigate, if not more than offset, the disputed amounts billed by Kalaeloa. Disputed amounts billed by Kalaeloa and AES-BP through December 31, 1993 totaled approximately $2.1 million and $1.5 million, respectively. Approximately $0.5 million of the total disputed amounts, if paid, are includable in HECO's energy cost adjustment clause, and would be passed through to customers. HECO has not recognized any portion of the disputed amounts as an expense or liability in its financial statements. Discussions between HECO and Kalaeloa, and HECO and AES-BP to resolve the disputed billing amounts are continuing. In the event the parties are unable to settle the disputes, both the Kalaeloa and AES-BP power purchase agreements contain provisions whereby either party to the agreement may cause the dispute to be submitted to binding arbitration. Kalaeloa has requested that its dispute with HECO be arbitrated and this arbitration process has commenced. Based on information currently available, HECO's management believes that the ultimate outcome of these disputes will not have a material adverse effect on the Company's or HECO's consolidated financial condition or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS HEI and HECO: During the fourth quarter of 1993, no matters were submitted to a vote of security holders of the Registrants. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS HEI: The information required by this item is incorporated herein by reference to pages 67 and 69 (Note 19, "Regulatory restrictions on net assets" and Note 22, "Quarterly information (unaudited)," of the Notes to HEI's Consolidated Financial Statements) and page 27 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). Certain restrictions on dividends and other distributions of HEI are described in "Item 1. Business--Regulation and other matters--Restrictions on dividends and other distributions." The total number of holders of record of HEI common stock as of March 21, 1994, was 24,672. HECO: Market information and holders--not applicable. Since the corporate restructuring on July 1, 1983, all the common stock of HECO has been held solely by its parent, HEI, and is not publicly traded. The dividends declared and paid on HECO's common stock for the four quarters of 1993 and 1992 are as follows: The regulatory restrictions on net assets are incorporated herein by reference to page 27 (Note 12 to HECO's Consolidated Financial Statements, "Regulatory restrictions on distributions to parent") of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 6. ITEM 6. SELECTED FINANCIAL DATA HEI: The information required by this item is incorporated herein by reference to page 27 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). HECO: The information required by this item is incorporated herein by reference to page 2 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS HEI: The information required by this item is incorporated herein by reference to pages 29 to 39 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). HECO: The information required by this item is incorporated herein by reference to pages 3 to 9 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HEI: The information required by this item is incorporated herein by reference to the section entitled "Segment financial information" on page 28 and to pages 41 to 69 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). HECO: The information required by this item is incorporated herein by reference to pages 10 to 29 and to the section entitled "Consolidated quarterly financial information (unaudited)" on page 31 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE HEI AND HECO: None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS HEI: The following persons are, or may be deemed, executive officers of HEI. Their ages are given as of March 10, 1994. Officers are appointed to serve until the meeting of the Board of Directors following the next Annual Meeting of Stockholders (which shall occur on April 19, 1994) and/or until their successors have been appointed and qualified (or until their earlier resignation or removal). Company service includes service with an HEI subsidiary. HEI's executive officers, with the exception of Peter C. Lewis, Charles F. Wall and Andrew I. T. Chang, are officers and/or directors of one or more of HEI's subsidiaries. There are no family relationships between any executive officer or director of HEI and any other executive officer or director of HEI. The list of current directors of HEI is incorporated herein by reference to page 70 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). Information on their business experience and directorships is incorporated herein by reference to pages 3 to 5 of the registrant's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Thurston Twigg-Smith (who is not standing for reelection as a Director) is President, Chief Executive Officer and Director of Persis Corporation; Chairman, Chief Executive Officer and Director of Northwest Media, Inc., and Maryville Alcoa Daily Times; Chairman of the Board of The Honolulu Advertiser; Director of HECO, ASB and The Museum of Contemporary Art (Los Angles); Trustee of the McInerny Foundation, Punahou School, Honolulu Academy of Arts, The Contemporary Museum (Honolulu), Old Sturbridge Village (Massachusetts), The Skowhegan School (Maine) and The Philatelic Foundation, N.Y.; and member of the Governing Board of The Yale Art Gallery (Connecticut). HECO: The following table sets forth certain information concerning the executive officers of HECO. Their ages are given as of March 10, 1994. Officers are appointed to serve until the meeting of the Board of Directors following the next Annual Meeting and/or until their respective successors have been appointed and qualified. Company service includes service with HECO affiliates. HECO's executive officers, Robert F. Clarke, Harwood D. Williamson, Edward Y. Hirata, Paul A. Oyer and Molly M. Egged, are officers of one or more of the affiliated HEI companies. There are no family relationships between any executive officer or director of HECO and any other executive officer or director of HECO. The list of current directors of HECO is incorporated herein by reference to page 33 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). Information on the business experience and directorships of directors of HECO who are also directors of HEI is incorporated herein by reference to pages 3 through 5 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Mildred D. Kosaki, age 69, and Paul C. Yuen, age 65, as of March 10, 1994, are the only outside directors of HECO who are not directors of HEI. Mrs. Kosaki has been a Director of HECO from 1973 to the present. She resigned from the HEI Board in 1987. She was also a Director of the International Pacific University from 1989 to 1991 and a Director on the Board of The Honolulu Advertiser from 1983 to 1989. She is a specialist in education research. Dr. Yuen, who was elected a Director of HECO in April 1993, is Senior Vice President for the University of Hawaii and Executive Vice Chancellor for the University of Hawaii-Manoa. In the past five years, he has had various administrative positions at the University of Hawaii-Manoa. He also serves on the Boards of Cyanotech Corporation, the Pacific International Center for High Technology Research and Hawaii Cultured Pearls, Inc. Information on Mr. Oyer's business experience and directorship is indicated above. The information required under this item by Item 405 of Regulation S-K is incorporated by reference to page 9 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION HEI: The information required under this item for HEI is incorporated by reference to pages 6 to 7 and 9 to 22 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. HECO: The following tables set forth the information required for the chief executive officer of HECO and the four other most highly compensated HECO executive officers serving at the end of 1993. All executive compensation amounts presented for Harwood D. Williamson are duplicative of the amounts presented in HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. SUMMARY COMPENSATION TABLE The following is the summary compensation table which sets forth the annual and long-term compensation of the chief executive officer of HECO and the four other most highly compensated executive officers of HECO serving at the end of 1993. SUMMARY COMPENSATION TABLE (1) Includes directors' fees of $28,000 in 1993 and $25,000 in 1992 for Mr. Williamson and directors' fees of $5,600 in 1993 and $4,700 in 1992 for Mr. Oyer. (2) The named executive officers are eligible for an incentive award under the Company's annual Executive Incentive Compensation Plan (EICP). A decision on EICP bonus payouts is made at the beginning of each year for the previous year's performance period. (3) Covers interest earned on deferred compensation and includes above-market earnings in the amount of $63,467 for 1993 and $57,498 for 1992 on deferred annual and Long-Term Incentive Plan (LTIP) payouts for Mr. Williamson. Also includes above-market earnings in the amount of $10,806 for 1993 and $9,790 for 1992 on deferred annual payouts for Mr. Oyer. (4) Includes a special one-time, premium-priced grant of 40,000 shares without dividend equivalents for Mr. Williamson in 1992. Other options granted in each of the three years for Mr. Williamson included dividend equivalents. For each of the other named executive officers, options granted in 1993 and 1991 did not include dividend equivalents. (5) LTIP payouts are determined in April each year for the three-year cycle ending on December 31 of the previous calendar year. In 1993, only Mr. Williamson was eligible to receive a LTIP payout; however, no LTIP payout was received for the 1990-1992 performance cycle because none of the minimum earnings threshold levels were achieved. The determination of whether there will be a payout for Mr. Williamson under the 1991-1993 LTIP will not be made until April 1994. (6) Represents amounts accrued by the Company in 1993 for certain death benefits provided to the named executive officers. In 1992 and 1991, the Company did not accrue for these benefits. Additional information is incorporated by reference to page 19 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Covers reimbursement of moving expenses for Mr. May in 1992. (7) Mr. May joined HECO as the Senior Vice President on February 1, 1992. OPTION GRANTS IN LAST FISCAL YEAR The following table shows the HEI stock options which were granted in 1993 to the executives named in the HECO Summary Compensation Table, all of which are nonqualified stock options. The practice of granting stock options, which may include dividend equivalent shares, has been followed each year since 1987. (1) For the 20,000 option shares granted with an exercise price of $38.27 per share, additional dividend equivalent shares are granted to Mr. Williamson at no additional cost throughout the four-year vesting period (vesting in equal installments) which begins on the date of grant. Dividend equivalents are computed, as of each dividend record date, both with respect to the number of shares under the option and with respect to the number of dividend equivalent shares previously credited to the participant and not issued during the period prior to the dividend record date. Accelerated vesting is provided in the event a Change-in-Control occurs. No stock appreciation rights have been granted under the Company's current benefit plans. (2) Based on a Binomial Option Pricing Model which is a variation of the Black-Scholes Option Pricing Model. For the stock options granted with a 10-year option period, an exercise price of $38.27, and with additional dividend equivalent shares granted for the first four years of the option, the Binomial Value is $9.66 per share. The following assumptions were used in the model: Stock Price: $38.27; Exercise Price: $38.27; Term: 10 years; Volatility: .55; Interest Rate: 6.0%; and Dividend Rate: 6.4%. The following were the valuation results: Binomial Option Value: $5.03; Dividend Credit Value: $4.63; and Total Value: $9.66. AGGREGATED OPTION EXERCISES AND FISCAL YEAREND OPTION VALUE TABLE The following table shows the HEI stock options, including dividend equivalents, exercised in 1993 by the named executive officers in the HECO Summary Compensation Table. Also shown is the number and value of unexercised options and dividend equivalents at the end of 1993. Under the Stock Option and Incentive Plan, dividend equivalents were granted to Mr. Williamson as part of the stock option award, except for the one-time, premium-priced grant in May 1992. For each of the other named executive officers, options granted in 1993 and 1991 did not include dividend equivalents. Dividend equivalents permit a participant who exercises a stock option to obtain at no additional cost, in addition to the option shares, the amount of dividends declared on the number of shares of common stock with respect to which the option is exercised during the period between the grant and the exercise of the option. Dividend equivalents are computed, as of each dividend record date throughout the four-year vesting period (vesting in equal installments), which begins on date of grant, both with respect to the number of shares underlying the option and with respect to the number of dividend equivalent shares previously credited to the executive officer and not issued during the period prior to the dividend record date. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAREND OPTION VALUES (1) Includes dividend equivalents of $79,916 exercisable and $26,296 unexercisable for Mr. Williamson and dividend equivalents of $25,830 exercisable for Mr. Oyer. All options were in the money (where the option price is less than the closing price on December 31, 1993) except the 1990 stock option grant at $36.01 per share, the 1992 stock option grant at $35.94 per share, and the 1993 stock option grant at $38.27 per share and the 1992 premium-priced grant at $41.00 per share. Value based on closing price of $35.875 per share on the New York Stock Exchange on December 31, 1993. LONG-TERM INCENTIVE PLAN AWARDS TABLE A Long-Term Incentive Plan award was made to one of the named executive officers in the HECO Summary Compensation Table, Mr. Williamson. Additional information required under this item is incorporated by reference to page 13 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. PENSION PLAN The Retirement Plan for Employees of Hawaiian Electric Industries, Inc. and Participating Subsidiaries (the Retirement Plan) provides a monthly retirement pension for life. Additional information required under this item is incorporated by reference to pages 14 to 15 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. As of December 31, 1993, the named executive officers in the HECO Summary Compensation Table had the following number of years of credited service under the Retirement Plan: Mr. Williamson, 37 years; Mr. May, 1 year; Mr. Oyer, 27 years; Mr. Rodrigues, 23 years; and Mr. Iwahiro, 34 years. CHANGE-IN-CONTROL AGREEMENT Messrs. Williamson and May are the only named executive officers in the HECO Summary Compensation Table in which HEI has entered into a Change-in-Control Agreement. Additional information required under this item is incorporated by reference to page 15 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Based on W-2 earnings for the five most recent years (1989-1993) or the portion of such period during which the executive performed personal service for HEI and its subsidiaries, the lump sum severance would be as follows: Mr. Williamson - $1,035,551 and Mr. May - $869,890. COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION INTRODUCTION Decisions on executive compensation for the named executive officers are made by the Compensation Committee of the HEI Board of Directors which is composed of six independent nonemployee directors. All decisions by the Compensation Committee are reviewed by the full HEI Board except for decisions about HEI's stock based plans, which must be made solely by the Committee in order to satisfy Securities Exchange Act Rule 16b-3. The Committee has retained the services of an independent compensation consulting firm to assist in executive compensation matters. Except for specific compensation decisions regarding Mr. Williamson which are discussed below, additional information required under this item is incorporated by reference to pages 16 through 19 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. BASE SALARY Mr. Williamson's base salary is determined based on the recommendation of Robert F. Clarke, President and Chief Executive Officer of HEI and Chairman of the Board of HECO, within the recommended salary range and the Committee's approval. Mr. Clarke's recommendation is based on an overall evaluation of Mr. Williamson's performance during the preceding year. This evaluation is subjective in nature and takes into account all aspects of Mr. Williamson's responsibilities at the discretion of Mr. Clarke. Mr. Williamson's base salary was raised from an annual rate of $300,000 to an annual rate of $320,000, effective May 1, 1993. This action by the Committee was subsequently ratified by the HECO Board of Directors. STOCK OPTIONS The 1993 stock option award to Mr. Williamson of 8,000 shares of HEI Common Stock plus dividend equivalents was based on the consultant's recommendation and the independent evaluation of an appropriate award level by Mr. Clarke and the HEI Compensation Committee. In this evaluation, the Committee took into account prior awards to Mr. Williamson and an overall subjective evaluation of Mr. Williamson's job performance. HECO BOARD OF DIRECTORS COMMITTEES OF THE HECO BOARD The Board of Directors of HECO has only one standing committee, the Audit Committee, which is comprised of three nonemployee directors: Ben F. Kaito, Chairman, and Mildred D. Kosaki and Diane J. Plotts. In 1993, the Audit Committee held four meetings to review with management, the internal auditor and HECO's independent auditors the activities of the internal auditor, the results of the annual audit by the independent auditor and the financial statements which are included in HECO's 1992 Annual Report to Stockholder. The Audit Committee holds such meetings as it deems advisable to review the financial operations of HECO. REMUNERATION OF THE HECO DIRECTORS AND ATTENDANCE AT MEETINGS In 1993, William G. Foster (who passed away in October 1993), Mildred D. Kosaki and Paul C. Yuen were the only nonemployee directors of HECO who were not also directors of HEI. They were paid a retainer of $12,000, one-half of which was distributed in the common stock of HEI pursuant to the HEI Nonemployee Director Stock Plan and one-half of which was distributed in cash. The number of shares of stock distributed was based on a price of $38.27 per share, which is equal to the average of the daily high and low sales prices of HEI common stock for all trading days in March 1993, divided into $6,000, with a cash payment made in lieu of any fractional share. In addition, a fee of $700 was paid in cash to each director for each Board and Committee meeting attended by the director. The Chairman of the Audit Committee was paid an additional $100 for each Committee meeting attended. In 1993, there were six regular bi-monthly meetings and one special meeting of the Board of Directors. All incumbent directors, except William G. Foster, attended at least 75% of the total number of meetings of the Board and Committee on which they served. HECO participates in the Nonemployee Director Retirement Plan described on page 7 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT HEI: The information required under this item is incorporated by reference to pages 8 and 9 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. HECO: HEI owns all of the common stock of HECO, which is HECO's only class of voting securities. HECO has also issued and has outstanding various series of preferred stock, the holders of which, upon certain defaults in dividend payments, have the right to elect a majority of the directors of HECO. The following table shows the shares of HEI common stock beneficially owned by each HECO director, named HECO executive officers as listed in the Summary Compensation Table on page 57 and by HECO directors and officers as a group, as of February 10, 1994, based on information furnished by the respective individuals. * Also a named executive officer listed in the Summary Compensation Table on page 57. ** Excludes HECO directors Messrs. Clarke, Henderson, Kaito, and Williamson and Ms. Plotts, who also serve on the HEI Board of Directors. The information required is incorporated by reference to pages 8 and 9 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Messrs. Clarke and Williamson are also named executive officers listed in the Summary Compensation Table on page 10 of the above-referenced Definitive Proxy Statement of HEI. ***The number of shares of common stock beneficially owned by any HECO director or by all HECO directors and officers as a group does not exceed 1% of the outstanding common stock of HEI. (1) Sole voting and investment power. (2) Shared voting and investment power (shares registered in name of respective individual and spouse). (3) Shares owned by spouse, children or other relatives sharing the home of the director or an officer in the group and in which personal interest of the director or officer is disclaimed. (4) Stock options exercisable within 60 days after February 10, 1994, under the 1987 Stock Option and Incentive Plan, as amended. Shares for Mr. Oyer include accompanying dividend equivalents (720 shares) for stock options awarded in 1988 only. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS HEI: The information required under this item is incorporated by reference to pages 21 to 23 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. HECO: As of December 31, 1992, T. Michael May, Senior Vice President of HECO, was indebted to HECO in the amount of $290,000 by reason of loans made to him by HECO in 1992 for relocation purposes. The noninterest-bearing notes were due in 1993. In 1993, $110,000 of Mr. May's indebtedness was paid and the remaining $180,000 was converted to a 15-year note bearing interest at 6.28%. The note is due in 2008 or upon demand, if Mr. May ceases to be employed by HECO, and is secured by a second mortgage on real estate. As of December 31, 1993, Mr. May was indebted to HECO in the amount of $180,000. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) FINANCIAL STATEMENTS The following financial statements contained in HEI's 1993 Annual Report to Stockholders and HECO's 1993 Annual Report to Stockholder, portions of which are filed by HEI as Exhibit 13(a) and, portions of which are filed by HECO as Exhibit 13(b), respectively, are incorporated by reference in Part II, Item 8, of this Form 10-K: (a)(2) FINANCIAL STATEMENT SCHEDULES The following financial statement schedules for HEI and HECO are included in this Report on the pages indicated below: Certain Schedules, other than those listed, are omitted because they are not required, or are not applicable, or the required information is shown in the consolidated financial statements or notes included in HEI's 1993 Annual Report to Stockholders and HECO's 1993 Annual Report to Stockholder, which financial statements are incorporated herein by reference. (a)(3) EXHIBITS Exhibits for HEI and HECO and their subsidiaries are listed in the "Index to Exhibits" found on pages 87 through 94 of this Form 10-K. The exhibits listed for HEI and HECO are listed in the index under the headings "HEI" and "HECO," respectively, except that the exhibits listed under "HECO" are also considered exhibits for HEI. (b) REPORTS ON FORM 8-K HEI AND HECO: During the fourth quarter of 1993, HEI and HECO filed three Current Reports, Forms 8-K, with the SEC. In the Form 8-K dated October 5, 1993, HEI and HECO filed information under Item 5 regarding HECO and its subsidiaries kilowatthour sales forecast, PTI's report on HECO's power outage, and income taxes. In the Form 8-K dated November 17, 1993, HEI and HECO filed information under Item 5 regarding the HELCO rate case filed in November 1993, MECO rate case filed in November 1991, HECO's comments on PTI's report on HECO's power outage, HELCO and MECO transportation of heavy fuel oil, liquidity and capital resources- electric utility, Kalaeloa Partners, L.P. and AES Barbers Point, Inc. and discontinued operations-insurance companies. In the Form 8-K dated December 27, 1993, HEI and HECO filed information under Item 5 regarding HECO filing its 1995 rate case. (KPMG Peat Marwick Letterhead) INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Hawaiian Electric Industries, Inc.: Under date of February 11, 1994, we reported on the consolidated balance sheets of Hawaiian Electric Industries, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 15 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. Additionally, as discussed in note 18 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits other than pensions. /s/ KPMG Peat Marwick Honolulu, Hawaii February 11, 1994 [KPMG Peat Marwick letterhead] The Board of Directors and Shareholder Hawaiian Electric Company, Inc.: Under date of February 11, 1994, we reported on the consolidated balance sheets and consolidated statements of capitalization of Hawaiian Electric Company, Inc. (a wholly-owned subsidiary of Hawaiian Electric Industries, Inc.) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholder. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 7 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. Additionally, as discussed in note 10 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits other than pensions. /s/ KPMG Peat Marwick Honolulu, Hawaii February 11, 1994 Hawaiian Electric Industries, Inc. SCHEDULE I -- MARKETABLE SECURITIES - OTHER INVESTMENTS December 31, 1993 * Represents cost of each issue, except for: ASB's other securities held for trading, which are stated at market, and mortgage-backed securities, which are stated at amortized cost; and MPC's investment in real estate partnerships, which are stated in accordance with the equity method of accounting. ** Secured by residential property. *** Not actively traded. Fair value considered to equal cost basis or amount at which security is carried in the balance sheet. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES December 31, 1993 (a) Two unsecured promissory notes payable. Interest rate is based on Bank of Hawaii's prime rate plus 2% for the first note and Bank of Hawaii's prime rate plus 0.75% for the second note. (b) In May 1993, Baldwin*Malama (B*M) was reorganized as a limited partnership in which Malama Development Corp. (MDC) is the sole general partner and Baldwin Pacific Properties, Inc. (BPPI) is the sole limited partner. In conjunction with the dissolution of the B*M general partnership and formation of the limited partnership, MPC agreed to loan $1.6 million to BPPI and up to $15 million to the limited partnership, and beginning in May 1993, MDC consolidated the accounts of B*M. Previously, MDC accounted for its investment in B*M under the equity method. At December 31, 1993, the outstanding balances on MPC's loan to B*M was $10.6 million, which was eliminated in consolidation as an intercompany account. The interest rate is based on one-half of Bank of Hawaii's prime plus 8.5%. The loan matures in May 1995 and is secured by security interest in real property, option to purchase land, and assignments of BPPI and MDC's partnership interests. (c) Two unsecured noninterest-bearing notes payable from T. Michael May, Senior Vice President of Hawaiian Electric Company, Inc. (HECO), due and collected in 1993. (d) Unsecured noninterest-bearing note payable from Warren H. W. Lee, President of Hawaii Electric Light Co., Inc. (HELCO), which note was extended and is currently due in 1995 or upon demand, if he ceases to be employed by HELCO. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES December 31, 1992 (a) On August 17, 1992, Malama Mohala Corp. (MMO), a wholly owned subsidiary of Malama Pacific Corp. (MPC), acquired MDT BF Limited Partnership's (MDT) 50% interest in Ainalani Associates (Ainalani), a joint venture between MMO and MDT. Prior to the acquisition of MDT's interest in Ainalani, MMO accounted for its investment in Ainalani under the equity method. Subsequent to the acquisition, MMO consolidated all of Ainalani's assets and liabilities. Consequently, $19,497,000 of accounts receivable from Ainalani was eliminated as a result of the acquisition. Thus, only $1,001,000 of cash was actually collected. (b) Two unsecured promissory notes payable, due December 31, 1992, extension of maturity dates are being arranged. Interest rate is based on Bank of Hawaii's prime rate plus 2% for the first note and Bank of Hawaii's prime rate plus 0.75% for the second note. (c) Two unsecured noninterest-bearing notes payable from T. Michael May, Senior Vice President of Hawaiian Electric Company, Inc. (HECO), due in 1993 or upon demand, if he ceases to be employed by HECO. (d) Unsecured noninterest-bearing note payable from Warren H. W. Lee, President of Hawaii Electric Light Co., Inc. (HELCO), due in 1993 or upon demand, if he ceases to be employed by HELCO. Hawaiian Electric Industries, Inc. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES December 31, 1991 (a) Promissory note payable, due July 1992 with an option to extend to July 1993. Interest rate is based on Bank of Hawaii's prime rate plus 3.5%. Promissory note is secured by real estate, the joint venture's interest in a partnership and contract rights. (b) Promissory note payable, due in 1995, except certain events may trigger earlier partial repayment. Interest rate is based on Bank of Hawaii's prime rate plus 2%. Promissory note is secured by real estate, the joint venture's interest in a partnership and contract rights. (c) Unsecured promissory note payable, due December 1992. Interest rate is based on Bank of Hawaii's prime rate plus 2%. Hawaiian Electric Industries, Inc. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT HAWAIIAN ELECTRIC INDUSTRIES, INC. (PARENT COMPANY) BALANCE SHEETS As of December 31, 1993, HEI guaranteed debt of its subsidiaries and affiliates amounting to $13 million. In addition, in connection with the acquisition of HIG, HEI has agreed to indemnify HIG with respect to 1985 and 1986 claims that exceed an aggregate of $10.8 million up to $12.8 million and 50% of the claims that exceed an aggregate of $12.8 million up to $13.8 million. HEIDI has made a provision for the estimated liability related to these claims. Pursuant to the settlement agreement with the Rehabilitator of HIG entered into in early 1994, which agreement is subject to court approval, HEI will be relieved of all obligations with respect to the indemnification of HIG. The aggregate payments of principal required on long-term debt subsequent to December 31, 1993 are $26 million in 1994, $1 million in 1995, $37 million in 1996, $51 million in 1997, $21 million in 1998 and $65 million thereafter. Hawaiian Electric Industries, Inc. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) HAWAIIAN ELECTRIC INDUSTRIES, INC. (PARENT COMPANY) STATEMENTS OF INCOME Hawaiian Electric Industries, Inc. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) HAWAIIAN ELECTRIC INDUSTRIES, INC. (PARENT COMPANY) STATEMENTS OF CASH FLOWS Supplemental disclosures of noncash activities: In December 1992, the Board of Directors of HEI adopted a resolution which converted $9.5 million of long-term debt of HERS to equity. HEI assumed the $9.5 million of HERS' long-term debt in a noncash transaction. Common stock dividends reinvested by stockholders in HEI common stock in noncash transactions amounted to $17 million in 1993, $15 million in 1992 and $14 million in 1991. Hawaiian Electric Industries, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (a) Additions at cost include a $7.0 million allowance for equity funds used during construction and noncash contributions in aid of construction received in 1993 with an estimated fair value of $2.8 million. (b) Includes transfers, adjustments and other charges and credits. (c) Includes the estimated fair value of noncash contributions in aid of construction of $23 million received in prior years, but recognized in 1993. Hawaiian Electric Industries, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT December 31, 1992 and 1991 (a) Neither additions nor retirements in 1992 and 1991 amounted to more than 10% of the ending balance as of the end of each of those respective years. (b) Additions at cost and retirements amounted to $197.4 million and $13.4 million, respectively, in 1992. The additions include a $6.8 million allowance for equity funds used during construction. (c) Additions at cost and retirements amounted to $161.5 million and $6.9 million respectively, in 1991. The additions include a $4.0 million allowance for equity funds used during construction. Hawaiian Electric Company, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (a) Additions at cost include a $7.0 million allowance for equity funds used during construction and noncash contributions in aid of construction received in 1993 with an estimated fair value of $2.8 million. (b) Includes transfers, adjustments and other charges and credits. (c) Includes the estimated fair value of noncash contributions in aid of construction of $23 million received in prior years, but recognized in 1993. Hawaiian Electric Company, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1992 (a) Additions at cost include a $6.8 million allowance for equity funds used during construction. (b) Includes transfers, adjustments and other charges and credits. Hawaiian Electric Company, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT December 31, 1991 (a) Neither additions nor retirements in 1991 amounted to more than 10% of the ending balance as of December 31, 1991. (b) Additions at cost and retirements amounted to $145.9 million and $4.9 million, respectively, in 1991. The additions include a $4.0 million allowance for equity funds used during construction. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (a) Gross salvage on plant retired, cost of removal, transfers and adjustments. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1992 (a) Gross salvage on plant retired, cost of removal, transfers and adjustments. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1991 (a) Gross salvage on plant retired, cost of removal, transfers and adjustments. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS Years ended December 31, 1993, 1992 and 1991 (a) Primarily bad debts recovered. (b) Bad debts charged off. (c) Net charge-offs. Hawaiian Electric Industries, Inc. SCHEDULE IX--SHORT-TERM BORROWINGS Years ended December 31, 1993, 1992 and 1991 (a) Unsecured promissory notes sold through dealers with a term of three months or less. (b) Borrowed under a formal credit arrangement with a bank with a term of six months. (c) Borrowed under formal credit agreements which, as of yearend, had maturities of less than twelve months. (d) Computed by multiplying the principal amounts of short-term borrowings by the number of days during which those borrowings were outstanding and dividing the sum of the products by the number of days in the year. (e) Computed by dividing interest expense on short-term borrowings for the period by the average amount of short-term borrowings outstanding during the period. Hawaiian Electric Company, Inc. SCHEDULE IX--SHORT-TERM BORROWINGS Years ended December 31, 1993, 1992 and 1991 (a) Unsecured promissory notes sold through dealers with a term of three months or less. (b) Computed by multiplying the principal amounts of short-term borrowings by the number of days during which those borrowings were outstanding and dividing the sum of the products by the number of days in the year. (c) Computed by dividing interest expense on short-term borrowings for the period by the average amount of short-term borrowings outstanding during the period. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 INDEX TO EXHIBITS The exhibits designated by an asterisk (*) are filed herein. The exhibits not so designated are incorporated by reference to the indicated filing. A copy of any exhibit may be obtained upon written request for a $0.20 per page charge from the HEI Stock Transfer Division, P.O. Box 730, Honolulu, Hawaii 96808-0730. Hawaiian Electric Industries, Inc. EXHIBIT 11 -- COMPUTATION OF EARNINGS PER SHARE OF COMMON STOCK Years ended December 31, 1993 1992,1991, 1990 AND 1989 Note: The dilutive effect of stock options is not material. Hawaiian Electric Industries, Inc. EXHIBIT 12(a) -- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Years ended December 31, 1993, 1992, 1990 AND 1989 (1) Excluding interest on ASB deposits. (2) Including interest on ASB deposits. (3) Total interest charges exclude interest on nonrecourse debt from leveraged leases which is not included in interest expense in HEI's consolidated statements of income. Hawaiian Electric Industries, Inc. EXHIBIT 12(a) -- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Years ended December 31, 1993, 1992, 1991, 1990 and 1989--Continued (1) Excluding interest on ASB deposits. (2) Including interest on ASB deposits. (3) Total interest charges exclude interest on nonrecourse debt from leveraged leases which is not included in interest expense in HEI's consolidated statements of income. Hawaiian Electric Company, Inc. EXHIBIT 12(b) -- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Years ended December 31, 1993, 1992, 1991, 1990 and 1989 * Does not reflect corporate-level segment cost and tax allocation policy adjustments in 1990. Hawaiian Electric Industries, Inc. EXHIBIT 21(a) -- LIST OF SUBSIDIARIES The following is a list of all subsidiary corporations of the registrant as of March 21, 1994: Hawaiian Electric Company, Inc. EXHIBIT 21(b) -- LIST OF SUBSIDIARIES The following is a list of all subsidiary corporations of the registrant as of March 21, 1994: [KPMG Peat Marwick letterhead] HEI EXHIBIT 23 The Board of Directors Hawaiian Electric Industries, Inc.: We consent to incorporation by reference in Registration Statement Nos. 33-52520 and 33-58820 on Form S-3 and in Registration Statement Nos. 33-65234 and 33-43892 on Form S-8 of Hawaiian Electric Industries, Inc. of our report dated February 11, 1994, relating to the consolidated balance sheets of Hawaiian Electric Industries, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, which report is incorporated by reference in the 1993 annual report on Form 10-K of Hawaiian Electric Industries, Inc. Our report refers to changes in the method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1993. We also consent to incorporation by reference of our report dated February 11, 1994 relating to the financial statement schedules of Hawaiian Electric Industries, Inc. in the aforementioned 1993 annual report on Form 10-K, which report is included in said Form 10-K. /s/ KPMG Peat Marwick Honolulu, Hawaii March 22, 1994 Hawaiian Electric Company, Inc. EXHIBIT 99(b) -- RECONCILIATION OF ELECTRIC UTILITY OPERATING INCOME PER HEI AND HECO CONSOLIDATED STATEMENTS OF INCOME SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrants have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized. The signatures of the undersigned companies shall be deemed to relate only to matters having reference to such companies and any subsidiaries thereof. 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 registrants and in their capacities at March 22, 1994. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named companies and any subsidiaries thereof. SIGNATURES (continued) SIGNATURES (continued)

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ITEM 1. BUSINESS THE COMPANY Delmarva Power & Light Company (the Company) was incorporated in Delaware in 1909 and in Virginia in 1979. The Company's wholly-owned subsidiaries, also incorporated in Delaware, include Delmarva Energy Company, Delmarva Industries, Inc., Delmarva Services Company, and Delmarva Capital Investments, Inc. For a discussion of the Company's subsidiaries, see "Subsidiaries" on page I-11. The Company is a public utility which provides electric service on the Delmarva Peninsula in an area consisting of about 5,700 square miles with a population of approximately one million. The Company also provides gas service in an area consisting of about 275 square miles with a population of approximately 457,000 in northern Delaware, including the City of Wilmington. SEGMENT INFORMATION See Note 17 of the Notes to Consolidated Financial Statements contained in the Company's 1993 Annual Report to Stockholders filed as Exhibit 13. COMPETITION Competition is increasing for certain electric and gas energy markets historically served by regulated utilities. In recent years, changing laws and governmental regulations, interest in self-generation, and competition from nonregulated energy suppliers are providing some utility customers with alternative sources to satisfy their electric and gas needs. Electric Business The Public Utility Regulatory Policies Act of 1978 (PURPA) facilitated the entry of potential competitors into the electric generation business. Under PURPA, a utility may be required to purchase the electricity generated by qualifying facilities at prices reflecting the utility's avoided cost as determined by utility procedures or state regulatory bodies. The Energy Policy Act of 1992 (the Energy Act) enabled the Federal Energy Regulatory Commission (FERC) to order the provision of transmission service (wheeling of electricity) for wholesale (resale) electricity producers and also provided for the creation of a new category of electric power producers called exempt wholesale generators (EWGs). These provisions of the Energy Act have enhanced the ability of utilities and non-utility generators to compete to serve resale customers currently served by a particular utility. Partly as a result of the Energy Act, industry-wide resale markets are experiencing increased competition. In 1993, gross electric revenues from the Company's resale business were $105.0 million or 13.0% of billed electric sales revenues. In response to the changing environment in the electric utility industry, the Company has modified existing strategies and also developed new strategies. From a customer or market perspective, the Company has concluded that focusing on growing the retail portion of the business provides the best opportunity to meet the twin objectives of satisfying customers' needs while providing a fair return to shareholders. During 1993, the Company began to develop new products and services for its retail markets and to hold preliminary discussions with certain municipalities in Delaware to either purchase their electric systems or enter into long-term supply contracts. In December 1993, the Company offered $103.5 million to purchase the electric system of the City of Dover, Delaware (Dover). Dover has approximately 18,500 electric customers and annual revenues from electricity sales of about $37 million. Although the Company expects that the impact on earnings from the potential purchase would be minimal over the first year or two, incremental earnings are I-1 expected once economies of scale are achieved. It is the Company's understanding that other parties have shown interest in the generation segment of Dover's business, but none have shown interest in purchasing Dover's entire electric system. In February 1994, PECO Energy Company (PECO), formerly known as Philadelphia Electric Company, announced that it is evaluating its strategic alternatives with respect to Conowingo Power Company (COPCO), its Maryland subsidiary, including determining the level of interest that other companies may have in acquiring COPCO. The Company has expressed an interest to PECO in acquiring COPCO and will seek to participate in an acquisition process if such a process is commenced. See "Other Regulatory Matters--Conowingo Power Company" on page I-15 for a further discussion of certain regulatory proceedings related to COPCO in which the Company has intervened. Although the Energy Act permits competition for wholesale customers only, competitive forces exist within the retail market and are expected to increase. Large retail customers (i.e. commercial and industrial customers) have choices to reduce their energy costs, including self-generation and relocation to the service territories of other utilities with lower rates. In addition, regulatory authorities may permit the retail wheeling of electricity, thereby permitting utilities and non-utility generators to compete to serve large retail customers currently served by a particular utility. The Company is positioned well for these competitive forces. The Company's prices for large retail customers are among the lowest in the region and are competitive with alternative sources of energy such as self-generation. The Company's average price for commercial customers in 1992 was 7.04 cents per kilowatt hour (kwh) compared to a regional average of 8.64 cents per kwh. The Company's average price for industrial customers in 1992 was 4.63 cents per kwh compared to a regional average of 6.59 cents per kwh. These regional averages are based on 1992 data for 27 utilities within a 300 mile radius of the Company. In order to keep customer prices competitive, the Company is stepping up its efforts to reduce costs. The Company believes it should have the ability to offer flexible pricing in order to compete to serve large retail customers. Such changes in pricing methods could require modification to the existing regulatory process. In Delaware, the Governor has convened a task force "to recommend reforms to the existing regulatory process, structure and organization that will improve utility efficiency and encourage utility innovation, while assuring continued availability of utility services at affordable and competitive prices." The task force includes representatives from the Delaware Public Service Commission (DPSC), utilities (including the Company), industrial customers, government, and the public. The task force plans to issue recommendations that can be introduced as legislation in June 1994 in the General Assembly. In the resale market, the Company is seeking to reduce the risk associated with a customer switching energy suppliers on short notice because providing electricity service requires investments in capital-intensive facilities which have long lives and require long lead-times for construction. In the Company's most recent resale base rate case, its resale customers agreed to provide a two-year notice for load reductions up to 30% and a five-year notice for load reductions greater than 30%. Prior to this agreement, Old Dominion Electric Cooperative (ODEC), a resale customer, advised the Company that it would purchase up to 150 megawatts (MW) from another utility, beginning January 1, 1995. The Company is continuing to negotiate a partial-requirements service agreement (to serve the balance of ODEC's load) and a transmission service agreement (to transport the electricity ODEC plans to purchase from another utility) to become effective January 1, 1995. The maximum reduction in annual non-fuel revenues that could result from ODEC's purchase of 150 MW from another utility is estimated to be about $24 million or $0.24 per share based on projected shares outstanding in 1995. To mitigate the potential impact of this loss of business and expected increases in operating costs, the Company is pursuing off-system sales of capacity and energy (targeted increase in revenues: $10-$20 million), intensifying cost control efforts (targeted decrease in costs: $15-$20 million), and if necessary, may apply for increases in customer rates (targeted increase in revenues: $10-$15 million). The Company expects that some combination of these strategies will reduce, or possibly eliminate, the adverse earnings per share effect; however, the ultimate effect on future earnings depends on the degree of success experienced by the Company in implementing its strategies. I-2 Gas Business As a result of FERC initiatives, the interstate gas pipeline system has been opened further to permit the transportation of natural gas by end users, including the Company's gas customers. The Company has in place local transportation tariffs to complement this interstate pipeline service. As a result, some Company gas customers now buy gas directly from producers and transport the gas to their facilities in Delaware, paying a transportation fee to the Company for the use of the Company's gas transmission and distribution facilities. An issue contested in the Company's most recent gas base rate case involved the conditions under which firm customers would be able to switch to non-firm service such as Interruptible Gas Transportation (IGT) service. The Company's tariff in effect prior to this case did not allow firm customers to switch to non-firm service. The Company had proposed in this case to allow firm customers to switch to non-firm service with three years' advance notice. Intervenors in the case, comprised of a group of large firm and non-firm industrial gas customers, sought DPSC approval to allow switching to non-firm service with little or no prior notice. In July 1993, the DPSC approved a three-year notice requirement for firm customers switching to non-firm service. This notice period will mitigate the effect on the Company's results of operations of customers switching from firm to non-firm service. In a related matter, during the proceedings in the Company's most recent gas base rate case, the Company's largest firm gas customer filed a complaint in the Delaware Chancery Court seeking rescission of its current firm service agreement with the Company and other relief, including non-firm service as an IGT customer. This case was settled in October 1993, with the customer agreeing for a three-year period to transport or pay for a minimum amount of gas equal to 75% of the average amount of gas it has taken over the past three years. This settlement will not have a material impact on the Company's results of operations. ELECTRIC OPERATIONS Installed Capacity The net installed summer electric generating capacity available to the Company to serve its peak load as of December 31, 1993 is presented below. The Company plans to maintain a balanced approach to energy supply, including conservation and load management, purchases of capacity and energy from other utilities and nonutility generators, and construction of new generating capacity. For a discussion of the energy supply plan, see "Challenge 2000 Plan" which begins on page I-4. The net generating capacity available for operations at any time may be less than the total net installed generating capacity due to generating units being temporarily out of service for inspection, maintenance, repairs, or unforeseen circumstances. See "Item 2 ITEM 2. PROPERTIES Substantially all utility plants and properties of the Company are subject to the lien of the Mortgage under which the Company's First Mortgage Bonds are issued. The Company's electric properties are located in Delaware, Maryland, Virginia, Pennsylvania, and New Jersey. The following table sets forth the net installed generating capacity available to the Company to serve its peak load as of December 31, 1993. - -------- (A) Company portion of jointly owned plants. (B) Represents capacity owned by a refinery customer which is available to the Company to serve its peak load. I-22 Major transmission and distribution lines owned and in service are as follows: The Company's electric transmission and distribution system includes 1,338 transmission poleline miles of overhead lines, 5 transmission cable miles of underground cables, 6,634 distribution poleline miles of overhead lines, and 4,294 cable miles of distribution underground cables. The Company has a liquefied natural gas plant located in Wilmington, Delaware with a storage capacity of 3.045 million gallons and a planned sendout capacity of 25,000 Mcf per day. The Company also owns four natural gas city gate stations at various locations in its gas service territory. These stations have a total sendout capacity of 125,000 Mcf per day. The following table sets forth the Company's gas pipeline miles: -------- * Includes 11 miles of joint-use gas pipeline that is used 10% for gas and 90% for electric. The Company owns and occupies office buildings in Wilmington and Christiana, Delaware and Salisbury, Maryland, and also owns elsewhere in its service area a number of properties that are used for office, service, and other purposes. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In October 1992, the Company's largest firm gas customer filed a complaint in the Delaware Chancery Court seeking rescission of its current firm service agreement with the Company and other relief, including non-firm service as an interruptible Gas Transportation customer. For a discussion of the outcome of this case, see "Competition--Gas Business" on page I-3. In November 1992, DCTC-Glendon, Inc., a subsidiary of the Company, filed a lawsuit in the U.S. District Court for the Eastern District of Pennsylvania against Energenics/Glendon, Inc. (EGI) and Joseph M. Reibman (Reibman), the sole shareholder of EGI. In July 1993, the court entered an order granting EGI's and Reibman's motion to file omitted counterclaims and add counterclaim defendants, including the Company, various subsidiaries of the Company, and certain individual officers and employees of the Company and its subsidiaries. In February 1994, DCTC-Glendon, Inc., Delcap, Reibman and the counterclaim defendants settled the litigation and all claims made by the parties were dismissed with prejudice. In June 1993, the Delaware Coastal Zone Industrial Control Board (the "Board") adopted regulations (the "Regulations") under Delaware's Coastal Zone Act which would, among other things, prohibit the Company from constructing new power-generating facilities or expanding any of its existing power-generating facilities outside a designated boundary. In July 1993, the Company filed a complaint in the Delaware Superior Court seeking to have the Regulations declared null and void. In addition, the Company joined with I-23 other affected parties in filing a complaint in July 1993 in the Delaware Chancery Court. The Chancery Court complaint alleges procedural violations of the Freedom of Information Act by the Board in the passage of the Regulations and requests that the Regulations be declared null and void. The Company cannot predict the outcome of either of these lawsuits. On December 14, 1993, Star filed a complaint against the Company in Delaware Chancery Court alleging that the Company overcharged it for pension and tax- related costs under a contract entered into by the parties' predecessors in 1955. The complaint asks for a refund and damages totalling $9.3 million. While the Company believes that it did not overcharge Star and is defending its position, it cannot predict the outcome of the lawsuit. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders, through the solicitation of proxies or otherwise. I-24 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is listed on the New York and Philadelphia Stock Exchanges and has unlisted trading privileges on the Cincinnati, Midwest, and Pacific Stock Exchanges and had the following dividends declared and high/low prices by quarter for the years 1993 and 1992. The Company had 58,225 registered holders of common stock as of December 31, 1993. The Charter and the Mortgage securing the Company's outstanding bonds contain restrictions on the payment of dividends on common stock which would become applicable if its capital and retained earnings fall below certain specific levels or if preferred stock dividends are in arrears. The retained earnings available for dividends on common stock as of December 31, 1993 were approximately $223,814,000 under the most restrictive of these provisions. While the Board of Directors intends to continue the practice of paying dividends quarterly, amounts and dates of such dividends as may be declared will necessarily be dependent upon the Company's future earnings, financial requirements, and other factors. For a further discussion of dividends, refer to the "Dividends" section of Management's Discussion and Analysis of Financial Condition and Results of Operations included in the 1993 Annual Report to Stockholders, incorporated by reference herein. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA This information is contained on page 18 of the 1993 Annual Report to Stockholders filed herein as Exhibit 13, which portion of such Annual Report is hereby incorporated by reference herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This information is contained on pages 19 through 26 of the 1993 Annual Report to Stockholders filed herein as Exhibit 13, which portion of such Annual Report is hereby incorporated by reference herein. Refer to the "Competition" section of Part I herein for an update to the disclosure included in the "Competition" section of Management's Discussion and Analysis of Financial Condition and Results of Operations concerning strategies to mitigate the expected loss of revenues in 1995 due to the decision of a resale customer (ODEC) to purchase up to 150 MW from another utility. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements, notes 1 through 18 to consolidated financial statements, and related report thereon of Coopers & Lybrand, independent accountants, appear on pages 27 through 46 of the 1993 Annual Report to Stockholders filed herein as Exhibit 13, which portion of such Annual Report is hereby incorporated by reference herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. II-1 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders Delmarva Power & Light Company Wilmington, Delaware Our report, which includes an explanatory paragraph regarding the Company's changes in its methods of accounting for unbilled revenues, income taxes, and postretirement benefits other than pensions, on the consolidated financial statements of Delmarva Power & Light Company has been incorporated by reference in this Form 10-K from page 27 of the 1993 Annual Report to Stockholders of Delmarva Power & Light Company. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index in Item 14 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. Coopers & Lybrand 2400 Eleven Penn Center Philadelphia, Pennsylvania February 4, 1994 II-2 PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT "Proposal No. 1 -- Election of Directors" is incorporated by reference herein from the Definitive Proxy Statement which is expected to be filed on or about April 21, 1994, and information about the executive officers of the registrant is included under Item 1. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION "Executive Compensation" is incorporated by reference herein from the Definitive Proxy Statement which is expected to be filed on or about April 21, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT "Proposal No. 1 -- Election of Directors" is incorporated by reference herein from the Definitive Proxy Statement which is expected to be filed on or about April 21, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. III-1 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Financial Statements--The following financial statements are contained in the Company's 1993 Annual Report to Stockholders filed as Exhibit 13 hereto and incorporated herein by reference. 2. Financial Statement Schedules--The following financial statement schedules are contained in Part IV of this report. All other schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule or because the information required is included in the respective financial statements or the notes thereto. 3. Schedule of Operating Statistics for the three years ended December 31, 1993 can be found on page IV-14 of this report. 4. Exhibits IV-1 b) Reports on Form 8-K (filed during the reporting period): A Report on Form 8-K dated October 28, 1993, containing a press release of the Company concerning third quarter earnings, was filed with the Commission. IV-2 DELMARVA POWER & LIGHT COMPANY SCHEDULE V--UTILITY PLANT PROPERTY FOR THE YEAR ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) IV-3 DELMARVA POWER & LIGHT COMPANY SCHEDULE V -- UTILITY PLANT PROPERTY -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) - -------- (a) Construction and nuclear fuel expenditures, including AFUDC. (b) Includes transfers from construction work in progress and transfers of land and facilities to/from non-utility property, plant held for future use or other functions. (c) Transfers to plant in service. (d) Amortization of acquisition adjustment which is charged against utility operating income. (e) Includes transfers between functions and adjustments to prior closings. IV-4 DELMARVA POWER & LIGHT COMPANY SCHEDULE V -- UTILITY PLANT PROPERTY FOR THE YEAR ENDED DECEMBER 31, 1992 (THOUSANDS OF DOLLARS) - -------------------------------------------------------------------------------- IV-5 DELMARVA POWER & LIGHT COMPANY SCHEDULE V -- UTILITY PLANT PROPERTY -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1992 (THOUSANDS OF DOLLARS) - -------- (a) Construction and nuclear fuel expenditures, including AFUDC. (b) Includes transfers from construction work in progress and transfers of land and facilities to/from non-utility property, plant held for future use or other functions. (c) Transfers to plant in service. (d) Amortization of acquisition adjustment which is charged against utility operating income. (e) Includes transfers between functions and adjustments to prior closings. (f) Reclassified to other property for financial reporting purposes. IV-6 DELMARVA POWER & LIGHT COMPANY SCHEDULE V -- UTILITY PLANT PROPERTY FOR THE YEAR ENDED DECEMBER 31, 1991 (THOUSANDS OF DOLLARS) IV-7 DELMARVA POWER & LIGHT COMPANY SCHEDULE V -- UTILITY PLANT PROPERTY -- (CONTINUED) FOR THE YEAR ENDED DECEMBER 31, 1991 (THOUSANDS OF DOLLARS) - -------- (a) Construction and nuclear fuel expenditures, including AFUDC. (b) Includes transfers from construction work in progress and transfers of land and facilities to/from non-utility property, plant held for future use or other functions. (c) Transfers to plant in service. (d) Amortization of acquisition adjustment which is charged against utility operating income. (e) Includes transfers between functions and adjustments to prior closings. (f) Includes sale of Delaware City Plant. IV-8 DELMARVA POWER & LIGHT COMPANY SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION AND AMORTIZATION (UTILITY PLANT) FOR THE YEAR ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) - -------- (a) Charged to clearing accounts for which subsequent distribution was made to operating and other accounts. (b) Includes removal cost net of salvage. IV-9 DELMARVA POWER & LIGHT COMPANY SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION AND AMORTIZATION (UTILITY PLANT) FOR THE YEAR ENDED DECEMBER 31, 1992 (THOUSANDS OF DOLLARS) - -------- (a) Charged to clearing accounts for which subsequent distribution was made to operating and other accounts. (b) Includes removal cost net of salvage. IV-10 DELMARVA POWER & LIGHT COMPANY SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION AND AMORTIZATION (UTILITY PLANT) FOR THE YEAR ENDED DECEMBER 31, 1991 (THOUSANDS OF DOLLARS) - -------- (a) Charged to clearing accounts for which subsequent distribution was made to operating and other accounts. (b) Includes removal cost net of salvage. (c) Includes sale of Delaware City Plant. IV-11 DELMARVA POWER & LIGHT COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 - -------- (a) Average daily balance based on 365 days. (b) Weighted average monthly rates for debt outstanding. (c) Loan Participation Agreements--Short-term bank loans which are remarketed to investors. (d) Subsidiary debt. IV-12 DELMARVA POWER & LIGHT COMPANY SCHEDULE X -- SUPPLEMENTAL INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) - -------- Note: Other information has been omitted since the required information either is not present in amounts sufficient to require submission or is included in the respective financial statements or the notes thereto. IV-13 DELMARVA POWER & LIGHT COMPANY OPERATING STATISTICS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 The table below sets forth selected financial and operating statistics for the electric and gas divisions for the three years ended December 31, 1993. - -------- (1) Based on average number of customers during period. IV-14 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. Delmarva Power & Light Company (Registrant) Dated: March 22, 1994 /s/ Barbara S. Graham By__________________________________ (Barbara S. Graham, Vice President and Chief Financial Officer) 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 DATE INDICATED. SIGNATURE TITLE DATE /s/ (Howard E. Cosgrove) Chairman of the Board, March 22, 1994 ..................................... President, Chief (Howard E. Cosgrove) Executive Officer, and Director /s/ (H. Ray Landon) Executive Vice March 22, 1994 ..................................... President and (H. Ray Landon) Director /s/ (Barbara S. Graham) Vice President and March 22, 1994 ..................................... Chief Financial (Barbara S. Graham) Officer /s/ (James P. Lavin) Comptroller and Chief March 22, 1994 ..................................... Accounting Officer (James P. Lavin) /s/ (Michael G. Abercrombie) Director March 22, 1994 ..................................... (Michael G. Abercrombie) /s/ (Elwood P. Blanchard, Jr.) Director March 22, 1994 ..................................... (Elwood P. Blanchard, Jr.) /s/ (Robert D. Burris) Director March 22, 1994 ..................................... (Robert D. Burris) /s/ (Audrey K. Doberstein) Director March 22, 1994 ..................................... (Audrey K. Doberstein) /s/ (James H. Gilliam, Jr.) Director March 22, 1994 ..................................... (James H. Gilliam, Jr.) /s/ (Sarah I. Gore) Director March 22, 1994 ..................................... (Sarah I. Gore) /s/ (James C. Johnson, III) Director March 22, 1994 ..................................... (James C. Johnson, III) /s/ (James T. McKinstry) Director March 22, 1994 ..................................... (James T. McKinstry) IV-15 DELMARVA POWER & LIGHT COMPANY 1993 ANNUAL REPORT ON FORM 10-K EXHIBIT INDEX Exhibit Page Number Description Number - ------ ----------- ------ 3-C Copy of the Company's Certificate of Designation and Articles of Amendment establishing the 6 3/4% Preferred Stock. 3-D Copy of the Company's By-laws as amended September 30, 1993. 4-J Copy of the Eighty-Fourth Supplemental Indenture. 4-K Copy of the Eighty-Fifth Supplemental Indenture. 10-F Copy of the severance agreement with members of management. 10-G Copy of the current listing of members of management who have signed the severance agreement. 12-A Computation of ratio of earnings to fixed charges. 12-B Computation of ratio of earnings to fixed charges and preferred dividends. 13 Certain portions of the 1993 Annual Report to Stockholders which are incorporated by reference in this Form 10-K. 23 Consent of Independent Accountants.

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1993

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ITEM 1. BUSINESS (A) General Development of Business The Company started business in 1848 and was incorporated 20 years later in 1864 under the laws of New York State as Downs & Co. Manufacturing Company. In 1869, the Company's name was changed to The Goulds Manufacturing Company and in 1926 the name was changed to Goulds Pumps, Incorporated. Effective December 31, 1984, the Company was reincorporated under the laws of the State of Delaware by virtue of a merger transaction. Goulds Pumps, Incorporated designs, manufactures and services pumps, motors and accessories for industrial, agricultural, commercial and consumer markets. Industrial markets account for approximately 57 percent of the Company's sales. These include: chemical, petrochemical, refining, pulp and paper, utilities, mining and municipal, including waste water treatment systems. The remaining sales, representing approximately 43 percent of the Company's business, include pumps, motors and accessories for home water and sewage systems, agricultural irrigation and commercial uses. 1993 was a year in which the pump industry as a whole continued to be impacted by weak economic conditions and increased competitive pricing pressures. Goulds Pumps' 1993 sales were slightly below 1992 levels, and earnings for the year of $1.12 from continuing operations were 8.2% lower than last year's $1.22 from continuing operations, exclusive of 1992 restructuring charges ($.19 per share) and 7.7% above last year's $1.04 in earnings before the cumulative effect of the accounting changes. The decrease from 1992's $1.22 earnings level is attributable to a consolidated gross margin decline of nearly three percentage points caused by stiff price competition in key markets and lower fourth quarter sales at EPD due to the implementation of CATS II, a new systems- driven manufacturing process. These declines were partially offset by a decrease in selling, general and administrative costs resulting from cost control measures and favorability in the translation of WTG-Europe's (Lowara) expenses, an outstanding performance by our joint venture, Oil Dynamics, Inc., and the tax benefits of the European corporate restructuring and other tax strategies. Reported 1993 earnings per share of $1.07 reflect the recording as of January 1, 1993 of the cumulative effect of the adoption of Financial Accounting Standard No. 112 (SFAS No. 112), "Employers' Accounting for Postemployment Benefits," which decreased earnings by $.05. 1993 highlights included: * The acquisition of Environamics Corporation. Goulds' investment in Environamics reflects the Company's continuing commitment to be the leader in advancing state-of-the-art pump design. The Company believes the Environamics pumps will qualify as the best available technology to control chemical emissions and expects demand for the pumps to increase as manufacturing plants respond to requirements of OSHA and the Clean Air Act. Sales of the Environamics product line could reach $40 million by the late 1990s. * During 1993, the Company's two largest divisions, the Engineered Products Division (EPD) and WTG-America implemented phase II of CATS - Competitive Advantage Through Simplification. This is a systems-driven overhaul of how the Company operates, from customer inquiries to order entry to shipment. While it will take several months for all aspects of Page 3 of 54 these newest introductions of CATS to fully benefit operations, significant improvements are expected in the Company's ability to deliver products efficiently to customers in 1994 and beyond. * The outstanding performance of the 50%-owned joint venture, Oil Dynamics, Inc. (ODI), had a major impact on 1993's results. ODI benefitted from the strength of significant Russian business during 1993. (B) Financial Information About Industry/Market Segments Financial information about market segments contained in Note 12 (Major Market Segment Information) on page 39 of this Annual Report on Form 10-K. (C) Narrative Description of Business Overview The Company designs, manufactures and services pumps for the industrial, agricultural, commercial and consumer markets. The Company's pumps are manufactured for a broad range of uses in the chemical, petrochemical, refining, pulp and paper, utilities and mining industries, home water and sewage systems, agricultural irrigation and office building and other commercial applications. The Company is organized into two groups: the Industrial Products Group ("IPG") and the Water Technologies Group ("WTG"). Prior to 1993, the Ag Turbine portion of the Vertical Products Division in Texas was part of the Industrial Products Group. In 1993, under the Company's restructuring plan, it became part of the Water Technologies Group. Industrial Products Group The Industrial Products Group represented approximately 57% of the Company's sales and 47% of operating earnings for 1993. The types of pumps manufactured for customers served by the Industrial Products Group include end-suction, double-suction, multistage, axial flow, vertical turbine, sump and slurry pumps to meet a wide variety of needs in the industrial and municipal markets including pumps designed for API and ANSI standards. The Company manufactures pumps from nonmetallic materials for applications where metal alloys are unsatisfactory or prohibitively expensive. The Company's vertical industrial turbine pumps are used throughout industries where space limitations or unsatisfactory suction conditions make the use of horizontal pumps impractical. The Company's slurry pumps serve the alumina and phosphate mining and minerals markets. Abrasion resistant pumps are manufactured for mining, utility and steel mill applications. The Company's Pump Repair and Overhaul (PRO) Service Centers play a role in customer service by rebuilding and repairing pumps and other rotating equipment produced by any manufacturer. The Company currently operates nine PRO Service Centers domestically and three in Canada. The Company has a repair parts service organization to assist customers in its key industrial areas of the United States. Service representatives provide emergency service and technical advice on a 24-hour basis. In 1993, IPG posted sales of $316.1 million, a decrease of $6.0 million or 1.9% compared to 1992 results restated for the Texas Ag Turbine restructuring noted above. Without restatement of 1992 results, IPG sales decreased $21.2 million or 6.3% below 1992 Page 4 of 54 results. IPG sales were impacted by shipment delays early in the fourth quarter of 1993, caused by the implementation of CATS II at the Engineered Products Division. IPG experienced a softening of pump order activity in 1993 as customers in key core markets continued to defer spending for major projects. IPG repair parts activity increased slightly over 1992 levels due largely to energy-industry repair business offsetting the negative impact of selective union strikes against coal producers of 1993 which affected the demand for slurry product repair parts during most of 1993. In 1994, IPG expects sales growth internationally and through its increased presence in the $3 billion worldwide energy market due to the 1992 acquisition of energy pump lines from the IDP joint venture which are now produced by EPD. The introduction of the Environamics product lines in late 1994 will further strengthen the Company's position in the chemical market. The Company's industrial sales organization markets pumps for U.S. industrial users through 26 branch sales offices and approximately 100 independent sales representatives and distributors. The services of the independent representatives and distributors are used in geographic areas where it is not economical to maintain a direct branch office and in some of the large metropolitan areas where they supplement branch personnel in servicing specialized markets. The Company employs approximately 60 sales engineers nationwide in its branch sales offices. Water Technologies Group The Water Technologies Group represented approximately 43% of the Company's sales and 53% of operating earnings for 1993. The Group manufactures and sells water pump systems, which include pumps, motors, pressure tanks and related accessories, used to supply water for farms, single and multiple family residences, office buildings, restaurants and other commercial uses, and municipal water supply and sewage treatment facilities. Larger submersible pumps are used to supply water for commercial and municipal customers. A commercial line of pumps is manufactured and sold for light industrial application. Submersible and deep-well turbine pumps are used for irrigation and other agricultural services. The Company believes it is the largest manufacturer of home water pump systems in the world. The home water systems market presently accounts for 60% of Water Technologies Group sales. This market is cyclical, however, because it is tied to general economic conditions and the weather. In 1993, WTG posted sales of $239.6 million, an increase of $2.8 million or 1.2% above 1992 results restated for the Texas Ag Turbine restructuring noted above. Without restatement, the WTG sales increase was $18.0 million or 8.1% above 1992 results. WTG-America sales increased 10.0% for 1993 compared to 1992 as new products and dry U.S. weather conditions in the Northeast and South boosted sales. WTG-Europe (Lowara) sales for 1993 were 10.3% below 1992 on a translated basis. On a local currency basis, sales for the year increased 14.4% over 1992 due to the shipment of new products and marketing initiatives, as well as the weakening of the lira, which makes Italian products more price competitive. Although affecting Lowara's translated results, the weakening of the lira does not negatively impact overall WTG profitability due to a natural hedge that exists since U.S. division imports of Lowara product equal or exceed Lowara's profitability. Page 5 of 54 In 1994, WTG will continue to focus on the development and introduction of new products and expanding and improving existing product lines. Additionally, WTG-Europe is continuing to expand its European presence by establishing a subsidiary in France and other European locations. These expansions are expected to result in sales growth in the future and increased market penetration in key regions. WTG-America (WTG-A) expects to introduce new products during the second and third quarters of 1994 in an effort to gain additional market share. Sales growth is therefore expected for 1994. The Company's agricultural pumps and domestic water systems pumps manufactured by WTG are marketed in the United States through the WTG-America sales force. The Company employs approximately 50 WTG-A field sales force persons to call on approximately 500 distributors throughout the country. These distributors, primarily plumbing, heating and pump specialty wholesalers, sell to and service nearly 7,300 Goulds Pumps Dealers Association members. Joint Ventures Oil Dynamics, Inc., of Tulsa, Oklahoma, is a 50% owned joint venture with Franklin Electric Co. which manufactures and distributes a line of high performance submersible pumps used in secondary oil recovery and provides the necessary sales and service network. This joint venture posted a $3.8 million earnings increase when compared to 1992 results, reflecting the strength of significant Russian business that will continue into the first quarter of 1994. Currently, due to the suspension of Russian financing availability, further ODI shipments to Russia have been halted. Though prior suspensions have been relatively short in duration, the end date cannot be predicted. International joint ventures are discussed on page 7 of this report under "International Operations". (D) General Competition The Company is one of the largest manufacturers of pumps in the United States. There are few competitors in the industrial sector in the United States who carry a diversified product line with a broad service network comparable to that of the Company. The Company competes principally on the basis of product performance, quality, service and price. The Company enjoys the reputation as a "quality" pump manufacturer with a complete repair parts service. It believes it can maintain and strengthen its present competitive position by continuing to improve its customer service levels and manufacturing equipment and processes, by designing and developing new and improved products, by maintaining strategically located parts distribution centers and PRO Service Centers and by promoting the efforts of its sales force in the world market. The pump industry is highly competitive with numerous competitors in the field. Some competitors are divisions of large corporations while others are companies with a limited product line. Page 6 of 54 Product Development The Company is committed to the ongoing development of new products and improvement of existing products. Product development and research activities are carried out at the Company's various manufacturing facilities. Research and development expenditures amounted to $7.2 million, $7.9 million, and $6.1 million for the years ended December 31, 1993, 1992, and 1991, respectively. The higher level of R&D expenses in 1992 relates to the introduction of the SSV vertical multi-stage product line during the second quarter of 1992 by WTG-Europe. In 1994, the Company expects to increase its investment in new product development as well as in enhancements to existing products in order to improve its competitive position in the industry. The acquisition of Environamics Corporation and the expansion into the energy market provide the Company with new products to offer customers in the chemical and energy marketplaces. International Operations The Company has wholly-owned subsidiaries in Italy, Canada, Mexico, Singapore, South Korea, Venezuela, the Netherlands and the Philippines. Sales by foreign affiliates were approximately $152 million, $161 million, and $159 million for 1993, 1992 and 1991, respectively. The decrease noted in 1993 is a result of the currency exchange impact of the weaker lire on translated results. Our largest international subsidiary, Lowara S.p.A. (WTG-Europe) located in Italy, also has wholly-owned subsidiaries in Italy, France, Belgium and the Netherlands, and 90% owned subsidiaries in the United Kingdom and Germany. Lowara fabricates stainless-steel pumps which are sold worldwide and has recently introduced several key new products with significant growth potential. The Canadian operation includes a new manufacturing facility in Cambridge, Ontario, for water systems products and for industrial products, as well as sales offices in Montreal and Calgary. The Philippines subsidiary manufactures residential and agricultural water systems pumps. The Mexican operation manufactures various pumps for industrial and agricultural applications. The Venezuelan subsidiary produces and markets certain industrial and water systems pumps primarily in Venezuelan markets. The Korean operation is an assembly and testing facility opened in May 1992 to provide support to customers in the Asia-Pacific region. The Netherlands operation is an assembly, testing and distribution site for industrial products. The Singapore operation is an assembly and distribution site for both IPG and WTG products serving the Asia-Pacific region. The international sales efforts of the Company's employees are supplemented by local sales representatives. Offices to support foreign sales have been established in Fort Lauderdale, Florida; Singapore, Republic of Singapore; Cairo, Egypt; Athens, Greece; IJmuiden, Netherlands; Dammam, Saudi Arabia; Southhampton, England; Beijing, China; Taipei, Taiwan; Lima, Peru and Seoul, South Korea. In addition, the foreign operations maintain sales personnel to market their respective products. Export sales from the United States were $62 million in 1993, $58 million in 1992, and $53 million in 1991. The Company's export sales are distributed throughout the world without concentration in any one geographic region. The Company also has a joint venture agreement with Nanjing Deep Well Pump Works of Nanjing, China to produce agricultural vertical turbine pumps for sale worldwide. Lowara participates in a joint Page 7 of 54 venture marketing agreement with Tsurumi Company of Japan to market the highly sophisticated Lowara fabricated stainless steel pump line. Raw Materials The principal raw materials essential to manufacturing pumps are nickel, iron, bronze and stainless steel. These are used more specifically in the manufacture of castings produced in the Company's three foundries. These internal foundries supply most stainless steel and hard iron castings to the Company's machining locations, thus reducing the need to purchase these products from external suppliers. In addition, sheets of stainless steel are used in various stamping processes. Other components such as drivers, ball bearings and mechanical seals, along with bar stock for shafts, are purchased from several suppliers. Raw materials for the Company's products are in adequate supply from a number of alternative suppliers and, at present, the Company has the ability to select and apportion among vendors based on price, quality and delivery capability. The Company has entered into several quality alliances with selected vendors in order to focus on improving the quality, delivery and costs related to purchased material. This Total Quality emphasis on vendor performance will continue on an ongoing basis. The Company purchases motors for its domestic water systems pumps primarily from Franklin Electric Company. The Company expects that it will continue to purchase motors from Franklin, but if the Company were required to establish a relationship with another supplier, its manufacturing business could be temporarily disrupted. Employee Relations The Company presently employs approximately 4,100 persons. Approximately 1,200 employees are covered under union contracts stipulating rates of pay, hours of employment and other conditions of employment. During 1993, the Company successfully extended its contract for one year with approximately 80 union employees at the Vertical Products Division, located in City of Industry, California. Including California, contracts with four unions covering approximately 430 employees expire in 1994. An early settlement was reached recently with the International Association of Machinists at the Municipal Business Unit in Baldwinsville, New York, the smallest of the four unions; another proposed early settlement was turned down by the 285-member United Steelworkers Union located at the Slurry Pump Division (SPD) in Ashland, Pennsylvania. The Company believes, however, that settlements will be reached in all cases before the contract expiration dates. The Company considers that its overall labor relations are good with active labor-management committees operating at all locations. Approximately 2,800 persons are employed domestically while approximately 1,300 persons work at foreign affiliate locations. Seasonal Business The Company operates at its lowest level during the first and last quarter of each calendar year due primarily to the Water Page 8 of 54 Technologies Group market decline in winter months. The Industrial Products Group of the Company is not a seasonal business. Environmental Considerations On February 22, 1994, the Company was served with a copy of a sixty day notice given by the Environmental Defense Fund and the National Resources Defense Fund to the Attorney General and other California officials alleging that the Company and other submersible pump manufacturers were in violation of the Proposition 65. The law prohibits the discharge, into sources of drinking water, of chemicals (including lead) known to the State of California to cause cancer or reproduction toxicity and requires a warning if individuals there are being exposed to such chemicals through the normal and intended use of the product. The notifying parties are permitted to commence litigation within sixty days in the event the officials do not so proceed. Violations of the law may result in a maximum civil penalty of $2,500 per day for each violation. The Company has retained counsel in California and will vigorously defend any law suit that may be instituted. It is not possible to determine the extent of liability at this time, if any, or to quantify the cost of settlement or civil penalty that may be imposed. In 1991, the Company recorded a $2.0 million provision for estimated environmental costs. This charge reflects anticipated costs to monitor and remediate a previously disclosed inactive Company landfill site in Seneca Falls, New York. At December 31, 1993, the remaining reserve was $1.7 million. The remediation is expected to occur through late 1995 or early 1996 and the Company does not currently expect any additional material expenses in future years associated with this site. Although the Company is unable to predict what legislation or regulations may be adopted or enacted in the future with respect to environmental protection and waste disposal, existing legislation and regulations have had no material adverse effect on its capital expenditures, earnings or competitive position. Capital expenditures for property, plant and equipment for environmental control were not material during 1993 and are not anticipated to be material in 1994 or 1995. Patents and Trademarks Although the Company owns several beneficial patents, none are considered to be material to its operations. The Company believes its trademark "Goulds" is of importance worldwide, since its products have been sold and used for almost 150 years. Backlog Backlog is primarily in the Industrial Products Group as the Water Technologies Group maintains minimal backlog levels since their products are normally shipped within two weeks from receipt of a customer order. The backlog of orders was $98.6 million at February 28, 1994, a decrease of $1.4 million from December 31, 1993 levels. Page 9 of 54 EXECUTIVE OFFICERS Name Age Present Office and Experience S. V. Ardia 52 President and Chief Executive Officer since 1985; President and Chief Operating Officer 1984-1985; Vice President-Corporate Sales 1982-1984; Vice President-International Operations 1979-1982; General Manager of Standard Pump Division of Worthington Pump Co. 1976-1979; Director of Goulds Pumps International Sales 1974-1976; Director since 1984. E. B. Bradshaw 55 Vice President since 1979; Secretary since 1974; General Counsel since 1969. M. A. Lambertsen 54 Vice President - Human Resources since December, 1991; Previously Vice President of Human Resources of Fisher-Price, Inc., 1978-1991. J. M. Morphy 46 Group Vice President - Industrial Products Group since October 1992; Vice President and Chief Financial Officer 1986-1993; Controller 1985-1986; Previously Vice-President and Controller, Computer Consoles, Inc., Rochester, NY. J. P. Murphy 47 Vice President and Chief Financial Officer since August 1993; Previously Executive Vice President and Chief Financial Officer of Westcan Chromalox, Inc., in Toronto, Canada, 1991-1993; Vice President-Finance and Administration and Chief Financial Officer of Hamilton Beach, Inc., of Waterbury, CT, 1986-1991. F. J. Zonarich 48 Group Vice President - Water Technologies Group since December, 1989; Vice President Sales and Marketing-Industrial Products Group 1986-1989; Commercial Manager, Engineered Products Division 1985-1986; Director of Marketing 1982-1985. No family relationship exists between any of the above executive officers. The term of office for all executive officers listed above runs from one annual meeting to the next, or approximately one year. There were no arrangements or understandings between any of the above executive officers and any other person pursuant to which they were selected as an executive officer. Page 10 of 54 ITEM 2. ITEM 2. PROPERTIES The Company's Corporate headquarters and primary manufacturing facilities are located in Seneca Falls, New York. Other domestic manufacturing facilities are also located in Baldwinsville, New York; Ashland, Pennsylvania; Lubbock, Texas; Hudson, New Hampshire; and City of Industry, California. An assembly, shipping, and receiving facility for water systems is maintained in Auburn, New York. International manufacturing facilities are currently located in Italy, Canada, Mexico, Venezuela, South Korea and the Philippines. Lowara maintains subsidiaries outside of Italy which are located in Germany, Belgium, France, the Netherlands, and the United Kingdom. Substantially all manufacturing sites are owned, and most sales offices, warehouses and service facilities are leased. The Company maintains warehouses or distribution centers in Chicago, Illinois; Houston, Texas; Portland, Oregon; Savannah, Georgia; Baton Rouge, Louisiana; and IJmuiden, the Netherlands, which carry inventories of pumps and parts sold to industrial users. The Company maintains regional warehouses to keep inventories of water pump systems and/or deep-well turbine components readily available in the vicinities of Chicago, Illinois; Orlando, Florida; Fresno, California; Memphis, Tennessee; Melbourne, Australia, and Singapore. During the five years ended December 31, 1993, the Company invested approximately $153 million in capital improvements, primarily relating to upgrades in machinery and equipment. Management believes that the Company's facilities are well maintained and adequate for its operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On February 22, 1994, the Company was served with a copy of a sixty day notice given by the Environmental Defense Fund and the National Resources Defense Fund to the Attorney General and other California officials alleging that the Company and other submersible pump manufacturers were in violation of the Proposition 65. The law prohibits the discharge, into sources of drinking water, of chemicals (including lead) known to the State of California to cause cancer or reproduction toxicity and requires a warning if individuals there are being exposed to such chemicals through the normal and intended use of the product. The notifying parties are permitted to commence litigation within sixty days in the event the officials do not so proceed. Violations of the law may result in a maximum civil penalty of $2,500 per day for each violation. The Company has retained counsel in California and will vigorously defend any law suit that may be instituted. It is not possible to determine the extent of liability at this time, if any, or to quantify the cost of settlement or civil penalty that may be imposed. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of shareholders during the fourth quarter of 1993. Page 11 of 54 Part II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY SECURITIES AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded in the NASDAQ National Market System under the symbol GULD. Quarterly high and low sales prices reported by NASDAQ National Markets and related dividend information for the past two years is set forth below: Market value per share 1993 1992 Quarter High Low Quarter High Low 1st $25.75 $21.25 1st $28.63 $22.75 2nd $25.63 $22.38 2nd $29.38 $22.13 3rd $26.50 $23.38 3rd $24.38 $21.63 4th $26.75 $23.13 4th $25.00 $20.00 Year $26.75 $21.25 Year $29.38 $20.00 Dividend paid per common share Quarter 1993 1992 1st $.20 $.20 2nd $.20 $.20 3rd $.20 $.20 4th $.20 $.20 Year $.80 $.80 The approximate number of record holders of the Company's common stock as of February 28, 1994 was 5,484. The Company's policy is to pay cash dividends quarterly. A quarterly cash dividend has been paid without interruption since 1948. The amount of dividends is within the discretion of the Board of Directors and depends, among other factors, on earnings, capital requirements and the operating and financial condition of the Company. There are no dividend restrictions which materially limit the Company's current ability to pay dividends. Page 12 of 27 ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Page 13 of 54 Page 14 of 54 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's discussion and analysis reviews the Company's operating results for each of the three years in the period ended December 31, 1993, and its financial condition at December 31, 1993. The focus of this review is on the underlying business reasons for significant changes and trends affecting our sales, net earnings, and financial condition. This review should be read in conjunction with the accompanying consolidated financial statements, the related Notes to Consolidated Financial Statements and the Five-Year Summary of Financial Data. OVERVIEW 1993 was a year in which the pump industry as a whole continued to be impacted by weak economic conditions and increased competitive pricing pressures. Goulds Pumps' 1993 sales were slightly below 1992 levels, and earnings for the year of $1.12 from continuing operations were 8.2% lower than last year's $1.22 from continuing operations, exclusive of 1992 restructuring charges ($.19 per share) and 7.7% above last year's $1.04 in earnings before the cumulative effect of the accounting changes. The decrease from 1992's $1.22 earnings level is attributable to a consolidated gross margin decline of nearly three percentage points caused by stiff price competition in key markets and lower fourth quarter sales at EPD due to the implementation of CATS II, a new systems-driven manufacturing process. These declines were partially offset by a decrease in selling, general and administrative costs resulting from cost control measures and favorability in the translation of WTG-Europe's (Lowara) expenses, an outstanding performance by our joint venture, Oil Dynamics, Inc., and the tax benefits of the European corporate restructuring and other tax strategies. Reported 1993 earnings per share of $1.07 reflect the recording as of January 1, 1993 of the cumulative effect of the adoption of Financial Accounting Standard No. 112 (SFAS No. 112), "Employers' Accounting for Postemployment Benefits," which had a $.05 impact. 1993 orders of $558.4 million were down slightly from 1992's record orders level of $560.1 million. Industrial Products Group (IPG) orders decreased 2.4% while Water Technologies Group (WTG) orders increased 2.6%. Fourth quarter 1993 order activity was 8.6% above 1992's fourth quarter, as both IPG and WTG experienced order level upturns. The Company is hopeful that the fourth quarter results are an indication of the beginning of a stronger orders trend into 1994. IPG experienced a softening of pump order activity in 1993 as customers in key core markets continued to defer spending for major projects. IPG repair parts activity increased slightly over 1992 levels due largely to energy-industry repair business offsetting the negative impact of selective union strikes against coal producers which affected the demand for slurry product repair parts during most of 1993. These strikes were settled during the fourth quarter of 1993. Within WTG, WTG-America's (WTG-A) 1993 orders levels increased 12.2% compared to 1992, while orders at WTG-Europe declined 10.3% on a translated basis. On a local currency basis, WTG-Europe's 1993 orders increased 14.4% over 1992, primarily due to new product introductions, marketing initiatives, and the impact of the weaker lira, which makes Lowara's products more price competitive. WTG-A orders increased due the impact of new product promotions and to dry U.S. weather conditions in the Northeast and South. 1993 was a year of many challenges as well as many accomplishments. Highlights of the year include: * The acquisition of Environamics Corporation. Goulds' investment in Environamics reflects the Company's continuing commitment to be the leader in advancing state-of-the-art pump design. The Company believes the Environamics pumps will qualify as the best available technology to control chemical emissions and expects demand for the pumps to increase as manufacturing plants respond to requirements of OSHA and the Clean Air Act. Sales of the Environamics product line could reach $40 million by the late 1990s. * During 1993, the Company's two largest divisions, the Engineered Products Division (EPD) and WTG-America implemented phase II of CATS - Competitive Advantage Through Simplification. This is a systems-driven Page 15 of 54 overhaul of how the Company operates, from customer inquiries to order entry to shipment. While it will take several months for all aspects of these newest introductions of CATS to fully significant improvements are expected in the Company's ability to deliver products efficiently to customers in 1994 and beyond. * During the fourth quarter of 1993, the Company substantially completed personnel reductions in IPG and on the Corporate staff that will result in future cost savings in excess of $4.0 million annually. The Company recognized approximately $1.3 million in severance costs associated with this downsizing in 1993. * The Company continued to expand its international focus and presence as WTG-Europe (Lowara) has established a new subsidiary in France, and will look to add locations during 1994. In 1994, the Company expects to continue the trend toward international growth through increased sales presence in the Asia-Pacific region, South America, and Europe. * The Company implemented several tax planning strategies which resulted in a decreased effective tax rate in 1993. A significant one-time adjustment due to tax code changes and the application of SFAS No. 109 as well as the implementation of the European corporate tax restructuring, were primarily responsible for the rate decrease in 1993. Several of the strategies put in place in 1993 are expected to yield future tax benefits. * The energy-industry product line, which the Company acquired in 1992, exceeded 1993 expectations in terms of profitability, primarily due to strong repair parts shipment activity and cost containment measures. The Company anticipates the commencement of energy pump shipments during 1994. * The outstanding performance of the 50%-owned joint venture, Oil Dynamics, Inc. (ODI), had a major impact on 1993's results. ODI benefitted from the strength of significant Russian business during 1993. * Safety performance in 1993 again showed continuous improvement as the Company's employees incurred the lowest number of accidents on record within Goulds in a one-year period. Safety improvements over the past two years have resulted in lower Worker's Compensation insurance premiums for 1994. Page 16 of 54 Analysis of Operations The following table indicates the percentage relationships of earnings and expense items included in the Consolidated Statements of Earnings for each of the three years ended December 31, 1993 and the percentage change in those items or such years. As a Percentage of Total Percentage Change Net Sales 1993 vs 1992 vs 1993 1992 1991 1992 1991 100.0% 100.0% 100.0% Net Sales (0.6)% (1.4)% 71.9 69.0 69.0 Cost of sales 3.6 (1.3) 20.7 21.4 20.4 SG&A expenses (3.8) 3.5 1.3 1.4 1.0 R&D expenses (9.6) 29.5 -- 1.1 -- Restructuring charge (100.0) -- -- -- 0.4 Environmental provision -- (100.0) Earnings from investments (0.8) (0.1) (0.4) and affiliates 542.6 (71.3) 1.0 0.9 1.1 Interest expense 8.1 (21.3) (0.4) (0.2) (0.4) Interest income 35.7 (36.8) 0.1 0.1 (0.1) Other (income) expense-net 1.9 (175.8) Earnings before income taxes, extraordinary charge and cumulative effect of 6.2 6.4 9.0 accounting changes (3.9) (30.1) 1.9 2.5 3.5 Income taxes (22.4) (30.1) Earnings before extraordinary charge and cumulative effect 4.3 3.9 5.5 of accounting changes 7.9 (30.2) -- -- (0.1) Extraordinary charge -- (100.0) Cumulative effect of (0.2) (5.3) -- accounting changes (96.6) -- 4.1% (1.4)% 5.4% Net earnings (loss) N.M. N.M. N.M. - Not meaningful Net Sales The decrease in total sales of $3.2 million in 1993 compared to 1992 is primarily composed of a $6.0 million or 1.9% decrease in Industrial Products Group sales while Water Technologies Group sales increased $2.8 million or 1.2%. IPG sales were impacted by shipment delays early in the fourth quarter of 1993, caused by the implementation of CATS II at the Engineered Products Division (EPD). We expect that it will take a number of months before we are able to reduce this current shipment backlog. For WTG, WTG-America sales increased 10.0% for 1993 compared to 1992 as new products and dry U.S. weather conditions in the Northeast and South boosted sales. WTG-Europe (Lowara) sales for 1993 were 10.3% below 1992 on a translated basis. On a local currency basis, sales for the year increased 14.4% over 1992 due to the shipment of new products and marketing initiatives, as well as the weakening of the lira, which makes Italian products more price competitive. Although affecting Lowara's translated results, the weakening of the lira does not negatively impact overall WTG profitability due to a natural hedge that exists since U.S. division imports of Lowara product equal or exceed Lowara's profitability. In 1994, IPG expects sales growth internationally and through our increased presence in the $3 billion worldwide energy market due to the 1992 acquisition of energy pump lines from the IDP joint venture, which are now produced by EPD. The introduction of the Environamics product lines in late 1994 will further strengthen the Company's competitive position in the chemical market. WTG will continue to focus on the development and introduction of new products and expanding and improving existing product lines. Additionally, WTG-Europe is continuing to expand its European presence by establishing a subsidiary in France and other European locations. These expansions are expected to result in sales growth in the future and increased market penetration in key regions. WTG-America expects to introduce new products during the second and third quarters of 1994 in an effort to gain additional market share. Sales growth is therefore expected for 1994. Page 17 of 54 During 1992, net sales of $558.9 million represented a decrease of $7.7 million or 1.4% compared to 1991. In 1992, IPG sales decreased due to lower repair parts order activity while WTG sales increased $1.0 million primarily due to translation favorability at WTG-Europe. Costs and Expenses Gross profit as a percentage of net sales was 28.1% for 1993, compared to 31.0% for 1992. The Industrial Products Group gross profit percentage for 1993 decreased to 27.5% from 31.0% a year ago. This decrease is largely attributable to the continued competitive pricing environment in the U.S. and certain international markets and a shipments delay of approximately $9 million early in the fourth quarter at EPD due to the implementation of CATS II. We expect that it will take a number of months before we are able to reduce this current shipment backlog. The Water Technologies Group gross profit percentage decreased to 29.6% in 1993, compared to 32.0% for 1992. This decrease is due in large part to pricing pressure and unfavorable product shipment mix. Selling, general and administrative (SG&A) expenses were 20.7%, 21.4%, and 20.4% of net sales in 1993, 1992, and 1991, respectively. The decrease in 1993 was a result of cost containment measures implemented by the Company, which included restructuring and workforce reductions. Also reducing reported SG&A in 1993 is the favorability associated with the translation of WTG-Europe expenses. During 1993, the Company's investment in research and development (R&D) was $7.2 million, compared to $7.9 million in 1992, and $6.1 million in 1991. The higher level of R&D expenses in 1992 relates to the introduction of the SSV vertical multi-stage product line during the second quarter of 1992 by WTG- Europe. In 1994, the Company expects to increase its investment in new product development as well as in enhancements to existing products in order to improve its competitive position in the industry. The acquisition of Environamics Corporation and the expansion into the energy market provide the Company with new products to offer customers in the chemical and energy marketplaces. Other Income and Expenses Interest expense increased $.4 million due to the higher levels of short-term and long-term debt being maintained in 1993 in comparison to 1992. Interest expense in 1994 is anticipated to be higher as the Company has drawn down on a previously arranged long-term financing agreement at a higher interest rate (see Liquidity and Capital Resources). Earnings from investments and affiliates increased $3.9 million in 1993 compared to the same period in 1992. This increase is due to Goulds' share of the 1993 earnings of Oil Dynamics, Inc. (ODI), a 50%-owned joint venture, which posted a $3.8 million increase when compared to 1992 results, reflecting the strength of significant Russian business that will continue into the first quarter of 1994. Currently, due to the suspension of Russian financing availability, further ODI shipments to Russia have been halted. Though prior suspensions have been relatively short in duration, the end date of this suspension cannot be predicted. The variations in other (income) expense-net in 1992 as compared to 1991 were primarily the result of non-recurring income in 1991 from the receipt of government subsidies related to prior year capital expenditures by WTG-Europe. The provision for income taxes represents 31.5%, 39.0%, and 39.0% of earnings from continuing operations before income taxes in 1993, 1992, and 1991, respectively. In 1993, our effective tax rate decreased due to a third quarter cumulative adjustment associated with recent tax code changes and new accounting rules for income taxes (SFAS No. 109) and the implementation of the corporate European tax restructuring in the fourth quarter. The effective tax rate in 1994 is expected to be 38.5%, reflecting the higher marginal tax rates enacted, less other tax reduction strategies put into place. Page 18 of 54 Return on Equity The percentage return on average shareholders' equity in 1993 increased to 12.4% from 9.6% in 1992. The percentage in 1992 reflects the impact of restructuring charges. Excluding the after-tax effects of the restructuring charge, the 1992 return on average shareholders' equity would have been 11.1%. The increase in 1993 reflects the reductions in shareholders' equity caused by the $12.3 million decrease in cumulative translation adjustments on the consolidated balance sheet and an increase in the level of after-tax earnings from continuing operations, primarily due to the tax restructuring strategy. Non-recurring Charges * Restructuring Charge. During 1992, the Company recorded the impact of a restructuring program designed to reduce costs, improve operating efficiencies, and increase shareholder value. The program included $2.9 million related to the early retirement of employees. In addition, $3.4 million resulted from the relocation of certain product lines and the centralization of contract engineering for high- specification products to better meet customer requirements. The aggregate restructuring program costs are shown as a separate line item in the accompanying consolidated statement of earnings and resulted in an after-tax charge of $3.9 million ($.19 per share) in 1992. The actions considered in the restructuring charge were essentially completed during 1993. The Company began in 1993 to realize the benefits associated with this restructuring through reduced payroll- related costs and improved operating efficiencies. A successful transfer of the industrial sump pump line (Model 3171) from the Lubbock, Texas, facility to the Slurry Pump Division in Ashland, Pennsylvania, was also accomplished. * Environmental Provision. In 1991, the Company recorded a $2.0 million provision for estimated environmental costs. This charge reflects anticipated costs to monitor and remediate an inactive Company landfill site in Seneca Falls, New York. At December 31, 1993, the remaining reserve was $1.7 million. The remediation is expected to occur through late 1995 or early 1996, and the Company does not currently expect any additional material expenses in future years associated with this site. * Extraordinary Charge. In 1991, an extraordinary charge net of tax benefits of $.6 million was recognized for the early retirement of the Company's Convertible Subordinated Debentures. The $25.0 million of Debentures carried an interest rate of 9- 7/8% and were due in the year 2006. This one-time charge was fully recovered during 1992 as we refinanced the debt at substantially lower interest rates. Orders and Backlog In 1993, orders received were $558.4 million, less than 1% below the record 1992 orders level of $560.1 million. Backlog levels at December 31, 1993, increased from 1992 by $3.2 million or 3.3% to $100.0 million, primarily due to the high level of fourth quarter orders activity and the delays in EPD shipments caused by the CATS II implementation. Backlog exists primarily in the Industrial Products Group as the Water Technologies Group maintains minimal backlog levels since its products are normally shipped within two weeks from receipt of a customer order. Liquidity and Capital Resources As reflected in the Consolidated Statements of Cash Flows, the $20.9 million of cash generated by operating activities and $10.9 million of cash provided by net financing activities in 1993, combined with a negative $2.0 million translation effect, was utilized to fund $36.3 million of net investing activities, while decreasing cash and cash equivalents by $6.5 million. Page 19 of 54 Significant items impacting cash flows from operating activities in 1993 include an $18.3 million increase in trade receivables due largely to increased December shipments volume over 1992 at both IPG and WTG and a $12.5 million increase in inventories primarily at WTG-America and WTG-Europe to support higher shipment levels and the promotion of new products. Capital additions in 1993 were $24.7 million, which approximated depreciation of $24.8 million. Significant projects included investments in the CATS II business systems hardware and software upgrades at EPD and equipment additions at domestic locations. In 1994, the Company expects to spend approximately $25-30 million in capital additions. The 1994 spending level includes continued major investments in upgrades of machinery and equipment and product development related expenditures that include the new Environamics technology. In the third quarter of 1993, WTG-Europe entered into an agreement whereby 10 billion lire ($6.1 million) of proceeds from short-term loans were invested in insurance certificates. The net effect of this transaction is to increase WTG-Europe's interest expense and interest income, resulting in increased profit after taxes due to tax rate differentials on these items. Cash flows from investing activities in 1992 reflected the availability of sinking funds, previously restricted and classified as other long-term assets related to Industrial Revenue Bond proceeds. Debt levels at the end of 1993 increased significantly compared to those at December 31, 1992 primarily due to higher levels of inventory and other working capital items. Based on a financing agreement entered into in December 1992, the Company borrowed $20.0 million on August 3, 1993 at a fixed interest rate of 7.18% payable semi-annually. Principal payments are required in equal annual installments at the end of the third through seventh years. Proceeds from this loan were used to refinance a $10.0 million Term Loan due in August 1993 and other short-term debt. Additionally, the Company currently intends to replace its $30 million Revolving Credit Agreement, which will expire on October 31, 1994. The Company believes cash from operations and the $56.1 million of available credit facilities at December 31, 1993, will be sufficient to meet its liquidity needs during 1994. Cumulative translation adjustments on the consolidated balance sheet at December 31, 1993 decreased shareholders' equity by $12.3 million from December 31, 1992 reflecting the weakening of the devalued Italian lira and the Canadian dollar against the U.S. dollar since the fourth quarter of 1992. In 1993, the Company redeemed the rights issued under the Stockholder Rights Plan instituted in 1988. The Company paid shareholders a redemption price of $.01 per share outstanding or approximately $200,000. Inflation The market price of a number of the Company's product lines decreased in 1993 due to worldwide competitive pressures in the pump industry. At the same time, material cost increases from our vendors have been minimal. The Company continues to monitor the impact of inflation in order to minimize its effects in future years through pricing strategies, productivity improvements, and cost reductions. Events Impacting Future Operating Results During 1993, the Company successfully extended its contract for one year with approximately 80 union employees at the Vertical Products Division, located in City of Industry, California. Including California, contracts with four unions covering approximately 430 employees expire in 1994, the largest being the 285-member United Steelworkers located at the Slurry Pump Division (SPD) in Ashland, Pennsylvania. The Company considers that its overall labor relations are good with active labor-management committees operating at all locations. During the fourth quarter of 1993, the Company announced it acquired Environamics Corporation, a privately held company whose patented hermetically sealed pump technology will greatly expand Goulds' ability to help the Page 20 of 54 chemical processing industry lower production costs and also meet increasingly stringent environmental regulations. Environamics is operating as an autonomous subsidiary, augmenting Goulds' current industry distribution channels used by IPG. Shipments of Environamics products are expected to begin near the end of the third quarter of 1994. Sean P. Murphy joined the Company in August 1993 as Vice President and Chief Financial Officer (CFO). Mr. Murphy assumed the CFO duties from John M. Morphy, who continues as Group Vice President of the Industrial Products Group. Earnings of our WTG-Europe (Lowara) subsidiary continue to be impacted by unfavorable currency exchange. Offsetting this negative impact is the natural hedge which exists through the transfer of Lowara products to WTG-America. We will continue to monitor exchange rate fluctuations and where appropriate, consider forward contracts for lira purchases to control the impact of these fluctuations. Accounting Standards Effective in the first quarter of 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." See Note 11 for a detailed discussion of the impact of this change on the Company's consolidated financial statements. Effective in the first quarter of 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions"; SFAS No. 107, "Disclosures About Fair Value of Financial Instruments"; and SFAS No. 109, "Accounting for Income Taxes." See Notes 11, 8, and 10, respectively, for a detailed discussion of the impact of these standards on the Company's consolidated financial statements. In Conclusion The Company is encouraged that it has taken important steps in 1993 that will yield improved results in 1994 and beyond. One milestone achieved this year was the implementation of CATS II and related manufacturing process improvements, which will translate into increased productivity and better customer service. Other important steps have been the acquisition of Environamics Corporation, the Company's expansion in the energy-industry business, and cost containment measures that included reducing the workforce. These actions, when combined with signs of a stronger orders trend, give the Company solid reasons for expecting improvement next year in both sales and profitability. Page 21 of 54 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Page Independent Auditors' Report 23 Consolidated Statements of Earnings 24 Consolidated Balance Sheets 25 Consolidated Statements of Shareholders' Equity 26 Consolidated Statements of Cash Flows 27 Notes to Consolidated Financial Statements 28-39 Supplementary Data Quarterly Financial Data 40 Page 22 of 54 Independent Auditors' Report To the Board of Directors and Shareholders of Goulds Pumps, Incorporated: We have audited the accompanying consolidated balance sheets of Goulds Pumps, Incorporated, and its subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Goulds Pumps, Incorporated, and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 11 to the consolidated financial statements, the Company changed its methods of accounting for postretirement benefits other than pensions (effective January 1, 1992) and postemployment benefits (effective January 1, 1993). DELOITTE & TOUCHE Rochester, New York January 26, 1994 Page 23 of 54 Page 24 of 54 Page 25 of 54 Page 26 of 54 Page 27 of 54 Notes To Consolidated Financial Statements (Dollars in thousands except per share data) 1. Summary of Significant Accounting Policies Consolidation The consolidated financial statements include the accounts of all wholly owned and majority-owned subsidiaries after elimination of all significant intercompany transactions. Investments in affiliates and corporate joint ventures, representing 20% to 50% of the ownership of such companies, are accounted for under the equity method. The majority of the foreign subsidiaries have fiscal year-ends of October 31 or November 30 to facilitate consolidation of the subsidiaries' financial statements. Foreign Currency The Company accounts for its foreign operations in accordance with Statement of Financial Accounting Standards (SFAS) No. 52, "Foreign Currency Translation." For subsidiaries where the local currency is the functional currency, assets and liabilities are translated at current exchange rates. Earnings and expense items are translated using average exchange rates during the year. Translation adjustments are not included in determining net earnings but are accumulated and reported as a separate component of shareholders' equity. For subsidiaries located in highly inflationary economies, balance sheet items are translated using current exchange rates, and average exchange rates are used for statement of earnings items except for inventory, property, and their related statement of earnings accounts, which are translated using historical exchange rates. Resultant translation gains and losses are included in earnings. Cash and Cash Equivalents Cash and cash equivalents include all cash balances and highly liquid investments with original maturities of three months or less. The carrying values of cash and cash equivalents approximate fair values due to the short maturities of these financial instruments. Inventories Domestic inventories are stated at the lower of cost or market, with cost generally determined by the last-in, first-out (LIFO) method. Inventories of foreign subsidiaries are stated at the lower of cost or market, with cost being determined by the first-in, first-out (FIFO) method, or average cost method. Property, Plant and Equipment Property, plant and equipment is stated at cost, less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets ranging from 15 to 50 years for buildings and 3 to 12 years for machinery and equipment. Income Taxes In February 1992, the Financial Accounting Standards Board issued SFAS No. 109, "Accounting for Income Taxes," which requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the Page 28 of 54 difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Effective January 1, 1992, the Company adopted SFAS No. 109. The cumulative effect of this accounting change for income taxes was not significant. Prior to 1992, the provision for income taxes, computed under APB Opinion 11, was based on earnings and expenses included in the accompanying consolidated statements of earnings. Deferred taxes were provided to reflect the tax effects of reporting earnings, expenses, and tax credits in different periods for financial accounting purposes than for income tax purposes. The aggregate undistributed earnings of certain foreign subsidiaries which, under existing law, will not be subject to U.S. tax until distributed as dividends was $55,001 on December 31, 1993. Since the earnings have been or are intended to be indefinitely reinvested in foreign operations, no provision has been made for any U.S. taxes that may be applicable thereto. Any taxes paid to foreign governments on those earnings may be used, in whole or in part, as credits against U.S. tax on any dividends distributed from such earnings. Net Earnings (Loss) Per Share Net earnings (loss) per share of common stock is based upon the weighted average number of shares of common stock outstanding during the year (21,126 in 1993, 21,027 in 1992 and 20,781 in 1991). No effect has been given to options outstanding under the Company's Stock Option Plans since no material dilutive effect would result from the exercise of these items. Financial Presentation Changes Certain prior year amounts have been reclassified to conform to the current- year presentation. 2. Inventories Inventories are summarized as follows: December 31, 1993 1992 Raw materials $ 31,927 $36,764 Work-in-process 49,062 46,434 Finished goods 55,863 48,800 Inventories valued at FIFO 136,852 131,998 LIFO allowance (30,667) (29,967) $106,185 $102,031 Inventories of foreign subsidiaries, valued at FIFO or average cost, are $49,252 and $48,774 at December 31, 1993 and 1992, respectively. 3. Investments, Including Investments in Affiliates Investments, including investments in affiliates, are summarized below: December 31, 1993 1992 Investment in Oil Dynamics, Inc. $11,706 $11,696 Investments in insurance certificates 6,074 -- Other investments 1,068 1,039 $18,848 $12,735 Page 29 of 54 The Company has a 50%-owned joint venture, Oil Dynamics, Inc. (ODI), which manufactures submersible pumps utilized principally in secondary oil recovery. For 1993, 1992, and 1991, the Company recognized earnings of $4,385, $558, and $1,957, respectively. The Company's investment in ODI approximates the Company's share of the underlying equity in the net assets of that Company. Dividends received were $4,375, $1,050, and $1,983, in 1993, 1992, and 1991, respectively. Summarized financial information for Oil Dynamics, Inc., is as follows: October 30, October 31, (In thousands) 1993 1992 Current assets $26,579 $19,387 Non-current assets 12,808 11,777 TOTAL ASSETS $39,387 $31,164 Current liabilities $14,444 $ 6,127 Non-current liabilities 1,497 1,704 Total shareholders' equity 23,446 23,333 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $39,387 $31,164 For the years ended, October 30, October 31, November 2, (In thousands) 1993 1992 1991 Net sales $71,672 $30,424 $39,796 Gross profit 25,408 10,176 13,783 Net earnings 8,770 1,115 3,914 The Company's Italian subsidiary, Lowara S.p.A., entered into a financial contract with a major Italian insurance company. The proceeds from short-term loans were invested in long-term insurance certificates to take advantage of tax rate differentials. At December 31, 1993, carrying value approximates fair value. 4. Property, Plant and Equipment Major classes of property, plant and equipment consist of the following: December 31, 1993 1992 Land and buildings $ 51,605 $ 52,049 Machinery and equipment 310,460 301,715 362,065 353,764 Less accumulated depreciation 213,092 199,178 $148,973 $154,586 5. Stock Option Plans The Company has two stock option plans from which key employees may be granted options to purchase shares of the Company's common stock at 100% of the market price on the date of grant. A maximum of 1,500,000 shares was authorized to be granted under the 1988 Stock Incentive Plan during the period ending May 1998. Grants for 678,947 shares were outstanding at December 31, 1993, of which 172,226 shares were exercisable at that date. An additional 153,481 shares were granted in January 1994. A maximum of 1,000,000 shares was authorized to be granted under the 1981 Incentive Stock Option Plan during the period ended April 1992. Grants for 251,022 shares were outstanding at December 31, 1993, of which 214,320 were exercisable at that date. Page 30 of 54 The following table summarizes stock option activity for the three years ended December 31, 1993: Price Range Shares Per Share Outstanding, January 1, 1991 940,529 $15.00 - 24.63 Granted 210,433 $15.50 - 23.88 Exercised (205,864) $15.00 - 19.88 Cancelled (45,854) $15.50 - 24.13 Outstanding, December 31, 1991 899,244 $15.00 - 24.63 Granted 236,330 $23.25 - 24.63 Exercised (225,607) $15.00 - 24.63 Cancelled (34,972) $15.50 - 24.13 Outstanding, December 31, 1992 874,995 $15.00 - 24.63 Granted 233,579 $23.63 - 25.00 Exercised (78,740) $15.00 - 24.13 Cancelled (99,865) $18.13 - 24.88 Outstanding, December 31, 1993 929,969 $15.00 - 25.00 Page 31 of 54 6. Debt and Credit Agreements Debt consists of the following: December 31, 1993 1992 Foreign overdrafts and short-term loans 4.19%-13.50%, due currently $26,911 $9,795 Foreign notes payable 4.0%-9.0%, due 1994-2006 8,671 7,822 Unsecured committed line of credit Variable, due 1994 (3.75% at December 31, 1993) 9,520 7,647 Industrial revenue bonds 5.0%, due 1994-2006 1,632 1,769 Variable, due 2009 (3.1% at December 31, 1993) 1,850 2,587 Revolving credit agreement Variable, expires 1994 (3.39% at December 31, 1993) 5,000 20,000 Unsecured committed credit facility 3.39%, due 1995 7,869 -- Term loans 7.18%, due 1996-2000 20,000 -- 4.125%, due 1993 -- 10,000 Other borrowings 4.18% (weighted average), due 1994-2007 5,447 4,480 Capital leases 10.51% (weighted average), due 1994-1996 452 1,166 Total 87,352 65,266 Less payments due within one year 48,493 24,379 $38,859 $40,887 The Company has $25,480 of unused short-term committed credit lines available with U.S. banks at money market rates of interest. Foreign subsidiaries have unused short-term credit lines available at prevailing interest rates in the amount of $30,591. The Company obtained Industrial Development Revenue Bond Financing to purchase, renovate, and expand certain facilities. Additionally, the bonds are collateralized by certain property. The Revolving Credit Agreement permits borrowing up to $30,000, at the Company's election, under several interest rate options, which are reflective of current rates. The highest level of revolving credit borrowings during 1993 was $30,000; 1992 - $27,500; 1991 - $12,000. Borrowings under this agreement averaged $22,927 for 1993, with a weighted average interest rate of 3.45%; 1992 - $16,400, at 4.1%; 1991 - $3,000, at 6.41%. The Company borrowed funds through a $10,000 unsecured committed credit facility in 1993 to finance the import of product from its Italian subsidiary. At December 31, 1993, the Company had borrowed $7,869, which is to be repaid in 1995. The $10,000 Term Loan came due and was repaid in 1993. On August 3, 1993 the Company borrowed $20,000 on a long-term note. The balance of the note has Page 32 of 54 been classified as long-term debt in the accompanying consolidated balance sheets since principal repayment commences in 1996. The Company's borrowing agreements impose certain financial restrictions. The Company was in compliance with these restrictions at December 31, 1993. Debt maturities during the next five years are $48,493 in 1994, $9,405 in 1995, $5,533 in 1996, $4,384 in 1997, and $4,933 in 1998. 7. Commitments The Company has various noncancellable lease agreements for sales offices, warehouses, computers, and other equipment. Total rental expense for the years ended December 31, 1993, 1992, and 1991 was $5,010, $4,913, and $5,188, respectively. Future minimum rental payments at December 31, 1993, are as follows: 1994 $3,046 1997 $ 997 1995 1,992 1998 814 1996 1,217 1999 and after 1,755 8. Financial Instruments Off-Balance-Sheet Risk. As part of its currency hedging, the Company utilizes forward exchange and option contracts to minimize the impact of currency fluctuations on transactions. The Company and its subsidiaries held contracts for $10,042 and $7,966 at December 31, 1993 and 1992, respectively, for the purchase or sale of Canadian and other currencies. The fair value of these financial instruments is estimated based on quoted market prices for similar contracts at December 31, 1993 and 1992, respectively. The unrealized gain on these contracts at December 31, 1993 and 1992, is $96 and $214, respectively. At December 31, 1993 and 1992, the Company has letters of credit outstanding totalling $5,356 and $4,899, respectively, which guarantee various trade activities. The contract amount of the letters of credit is a reasonable estimate of the fair value since the value for each is fixed over the life of the commitment. No material loss is anticipated due to nonperformance by counterparties to these agreements. Concentrations of Credit Risk. Financial instruments that potentially subject the Company to concentrations of credit risk, as defined by SFAS No. 105, consist principally of temporary cash investments and trade receivables. The Company places its temporary cash investments with credit-worthy financial institutions and limits the amount of credit exposure to any one financial institution. The Company actively evaluates the credit worthiness of the financial institutions with which it invests. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers constituting the Company's customer base and their dispersion across different businesses and geographic areas. Letters of credit are the principal security obtained to support lines of credit or negotiated contracts when the financial strength of a customer is not considered sufficient. At December 31, 1993 and 1992, the Company had no significant concentrations of credit risks. Fair Value. At December 31, 1993 and 1992, the Company's long-term debt carrying value is a reasonable estimate of its fair value since interest rates are based on prevailing market rates. At December 31, 1993 and 1992, the Company held a note receivable from Wheatley TXT Corporation for $4,000, and $5,000, respectively. The non- current portion of the note receivable is included in other assets. The carrying amount at December 31, 1993 and 1992, respectively, which represents the face value of the note receivable, is a reasonable estimate of its fair value. The interest rate is variable and during 1993 and 1992, the Company recognized $248 and $310, respectively, of interest income on this note. Page 33 of 54 9. Non-recurring Charges Restructuring Charge. During 1992, the Company recorded the impact of a restructuring program designed to reduce costs, improve operating efficiencies, and increase shareholder value. The program included $2,940 related to the early retirement of employees. In addition, $3,360 resulted from the relocation of certain product lines and the centralization of contract engineering for high-specification products to better meet customer requirements. The aggregate restructuring program costs are shown as a separate line item in the accompanying consolidated statement of earnings and resulted in an after-tax charge of $3,900 ($.19 per share) in 1992. During 1993, the restructuring program was substantially completed. Environmental Provision. In 1991, the Company recorded a $2,000 provision for estimated environmental costs. This charge reflects anticipated costs to monitor and remediate an inactive Company landfill site in Seneca Falls, New York. At December 31, 1993, the balance of this reserve was $1,735. The remediation is expected to occur through late 1995 or early 1996, and the Company does not currently expect any additional material expenses in future years associated with this site. Extraordinary Charge. During December 1991, the Company called for the early redemption of the $25,000 - 9.875% Convertible Subordinated Debentures, which had been due in 2006. Of this amount, $24,895 was redeemed at the call price of 103.292%, and the remaining amount of $105 was converted into 3,923 shares of common stock at the conversion price of $26.75 per share. The redemption premium (net of applicable income tax benefit of $313) has been classified as an extraordinary charge of $557, in the accompanying consolidated statements of earnings. 10. Income Taxes The components of the provision for income taxes are as follows: 1993 1992 1991 Current: Federal (U.S.) $ 6,049 $11,363 $13,760 State 1,565 2,544 2,843 Foreign 4,825 6,375 5,992 Deferred: Federal (U.S.) (2,548) (6,119) (3,243) State (5) (905) (644) Foreign 955 718 1,296 Provision for income taxes $10,841 $13,976 $20,004 Reconciliations of the U.S. statutory tax rate with the effective tax rates reported for continuing operations are as follows: 1993 1992 1991 U.S. statutory rate 35.0% 34.0% 34.0% Foreign taxes in excess of U.S. statutory rate 6.1 7.6 3.9 State taxes-net 2.9 3.0 3.3 U.S. benefits of foreign sales corporation (2.0) (1.5) (.5) Deferred income tax rate changes (2.2) -- -- International tax restructuring and recapitalization (4.1) -- -- Other-net (4.2) (4.1) (1.7) Effective tax rate 31.5% 39.0% 39.0% Page 34 of 54 The components of the total net deferred tax asset at December 31, 1993 and 1992 under SFAS No. 109 are as follows: 1993 1992 Deferred tax assets: Postretirement benefits other than pensions $19,517 $17,986 Other nondeductible liabilities and reserves 4,054 3,195 Tax credit carryforwards 2,589 905 Workers' compensation and other claims 2,488 1,439 Accrued vacation pay 2,191 2,162 Deferrals under state jurisdictions-net 1,839 1,880 Deferrals under foreign jurisdictions 1,448 1,925 Pension benefits 1,240 1,326 Miscellaneous 384 662 Inventories 775 1,444 Gross deferred tax assets 36,525 32,924 Valuation allowance for deferred tax assets (1,782) (905) Deferred tax liabilities: Property, plant and equipment (10,895) (10,334) Deferrals under foreign jurisdictions (5,701) (6,951) Other assets and miscellaneous (4,111) (3,307) Deferred gain on Wheatley Gaso transactions (748) (909) Gross deferred tax liabilities (21,455) (21,501) Net deferred tax asset $13,288 $10,518 The components of the deferred tax provision (benefit) under APB11 from continuing operations for 1991 are as follows: Depreciation and amortization $(1,616) Reserves and accruals (1,061) Deferred gain on Wheatley Gaso transactions (1,090) Deferrals under foreign jurisdictions 1,296 Other-net (120) Deferred income tax provision (benefit) $(2,591) Earnings before income taxes resulting from non-U.S. operations for 1993, 1992, and 1991 are $10,359, $13,412, and $15,745, respectively. As discussed in Note 1, the Company adopted SFAS No. 109 as of January 1, 1992. The cumulative effect of this accounting change for income taxes is not significant and hence, prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. The Company and its domestic subsidiaries file a consolidated U.S. federal income tax return. Such returns have been audited and settled through the year 1989. The valuation allowance for deferred tax assets increased by $877 in 1993. At December 31, 1993, the Company has foreign tax credit carryforwards of $2,589 that will expire at the end of the following years if not otherwise utilized: $174 -1995, $216 - 1996, $354 - 1997, and $1,845 - 1998. 11. Employee Benefit Plans Pension Plans The Company has several defined benefit pension plans covering substantially all domestic employees. Plans covering salaried exempt employees provide pension benefits based upon final average salary and years of service. Page 35 of 54 Benefits to other employees are based on a fixed amount for each year of service. During the fourth quarter of 1992, the Company offered an early retirement program to employees meeting certain age and service requirements. The additional expense has been recorded as part of the 1992 net pension cost shown below. The cost of this program is included in the restructuring costs recorded by the Company (see Note 9). The Company's funding policy is to contribute annually an amount that falls within the range determined to be deductible for federal income tax purposes. Plan assets consist primarily of listed stocks and bonds. Net pension cost for 1993, 1992, and 1991 includes the following components: 1993 1992 1991 Service cost $ 3,668 $2,815 $2,189 Interest cost 6,968 5,965 5,294 Actual return on plan assets (11,447) (6,442) (11,822) Net amortization and deferral 4,562 (128) 6,210 Early retirement plan -- 2,940 -- Net pension cost $ 3,751 $5,150 $1,871 The following table sets forth the plans' funded status and the amounts recognized in the Company's consolidated financial statements: In determining the actuarial present value of the projected benefit obligation, the weighted average discount rate was 7.5% and 8.5% as of December 31, 1993, and 1992, respectively; the rate of increase in future compensation levels was 5% as of December 31, 1993, and 6% as of December 31, 1992; and the expected long-term rate of return on assets was 9% as of December 31, 1993 and 1992. As is required by SFAS No. 87, "Employers' Accounting for Pensions," for plans where the accumulated benefit obligation exceeds the fair value of plan assets, the Company has recognized in the accompanying consolidated balance sheets the minimum liability of the unfunded accumulated benefit obligation as a long-term liability with an offsetting intangible asset and equity adjustment, net of tax impact. As of December 31, 1993 and 1992, this minimum Page 36 of 54 liability amounted to $6,410 and $1,405, respectively. The adoption of these provisions had no impact on net earnings or cash flow. The Company's wholly owned subsidiary, Lowara S.p.A., is required by Italian law to provide a lump sum severance payment to personnel upon termination of employment. The amounts are subject to annual revaluation on the basis of indices. The provision for employee severance amounted to $1,873 in 1993, $2,059 in 1992, and $1,905 in 1991, resulting in total reserve balances of $7,772 at December 31, 1993, $8,334 at December 31, 1992, and $7,666 at December 31, 1991. This reserve reflects the amounts accrued at year-end for each employee in accordance with the law and labor contracts. Postretirement Benefits Other Than Pensions In addition to providing pension benefits, the Company and its subsidiaries provide certain health care and life insurance benefits for retired employees. Certain domestic employees may become eligible for these benefits if they retire from the Company with 10 years of service and have reached age 55. The benefit amount is determined based on the age and length of service of the employee at retirement. The plan is currently unfunded, and the Company has the right to modify or terminate the plan in the future. In the fourth quarter of 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," requiring the accrual method of accounting for these benefits effective January 1, 1992. As permitted by SFAS No. 106, the Company elected to recognize the transition obligation as of the adoption date. The Company restated 1992 first quarter operations to record a pre-tax charge of $47,978 ($29,746 after-tax or $1.42 per share) as a cumulative effect of an accounting change at that date. Net postretirement benefit cost for 1993 and 1992 includes the following components: 1993 1992 Service cost on benefits earned during the period $1,440 $2,073 Interest cost on accumulated benefit obligation 4,026 4,251 Amortization of plan amendments (598) -- Net postretirement benefit cost $4,868 $6,324 Retirement medical costs decreased primarily due to cost reductions resulting from amendments to Company-sponsored medical plans. The unamortized amounts for plan amendments, set forth in the table below, represent the accumulated cost reductions resulting from these amendments. The amortization of these amounts will reduce retirement medical costs over the next 14 years. Under the prior accounting method, 1991 retirement medical costs were $1,047. The accumulated postretirement benefit obligation, included in the accompanying consolidated balance sheets, is comprised of the following: 1993 1992 Retirees $25,869 $17,579 Active, eligible employees 5,434 9,606 Active, non-eligible employees 19,132 25,639 Unrecognized gain (loss) (3,007) 76 Unrecognized prior service cost 8,362 -- Accrued postretirement benefit obligation $55,790 $52,900 The December 31, 1992, accrued postretirement benefit obligation was remeasured effective January 1, 1993, to reflect actual experience for 1992 and a plan amendment that was not known at the beginning of 1992. The accrued postretirement benefit obligation was determined using a weighted average discount rate of 8.75% and a medical care cost trend rate of 13%. In determining the accrued postretirement benefit obligation as of December 31, 1993, a weighted average discount rate of 7.75% and a medical care cost trend rate of 12% were used. The medical care cost trend rates used in the Page 37 of 54 actuarial computations were reduced by 1% per year to 5% and 5.5% by 2001 as of December 31, 1993, and 1992, respectively. The effect of a one percentage point increase in the assumed medical care cost trend rate would have increased the 1993 and 1992 net postretirement benefit cost by $925 and $1,162, respectively, and the accrued postretirement benefit obligation at December 31, 1993 and 1992, by $6,400 and $7,261, respectively. Postemployment Benefits In the fourth quarter of 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," requiring the accrual method of accounting for certain of these benefits effective January 1, 1993. The Company restated 1993 first quarter operations to record a pre-tax charge of $1,579 ($1,026 after-tax or $.05 per share) as a cumulative effect of accounting change at that date. Previously, the Company recognized postemployment benefit costs when paid. The annual incremental cost of adopting SFAS No.112 is immaterial on an on-going basis. Page 38 of 54 12. Major Market Segment Information The Company operates in two major market segments, Industrial Products and Water Technologies. The Industrial Products segment produces and sells pumps used in various industries including pulp and paper, chemical processing, petrochemical, food and beverage, oil, mining, municipal, and electric utility and provides parts and repair services for various types of pumps and other rotating equipment. The Water Technologies segment produces and sells pumps for residential, farm, irrigation, and commercial/light industrial use. Intersegment sales and sales between geographic areas are not material. Page 39 of 54 13. Quarterly Financial Data (Unaudited) Page 40 of 54 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING FINANCIAL DISCLOSURE None. Part III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pages 1 through 3 of the Proxy Statement contain information concerning directors which is incorporated herein by reference. Information concerning executive officers is included in Part I of this Form 10-K Annual Report, following Item 1. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Pages 3, 4, and 8 through 14 of the Proxy Statement contain information concerning executive compensation which is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pages 2, 3, and 8 of the Proxy Statement contain information concerning ownership of the Company's common stock which is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Page 9 of the Proxy Statement contains information concerning transactions with directors and others which is incorporated herein by reference. Part IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) Financial Statements: The financial statements of the Company are included in Part II, Item 8. Page in Form 10-K (2) Independent Auditors' Report on Financial Statement Schedules 44 The following schedules are included in this Form 10-K Annual Report: V - Property, Plant and Equipment 45 VI - Accumulated Depreciation of Property, Plant and Equipment 46 VIII - Valuation and Qualifying Accounts 47 IX - Short-term Borrowings 48 X - Supplementary Income Statement Information 49 Page 41 of 54 All other Financial Statement Schedules are omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. (c) Exhibits: Exhibit Number Description of Exhibits (3) Articles of Incorporation and By-Laws: * Restated Certificate of Incorporation filed May 6, 1985. Incorporated by reference to Exhibit 19 to Form 10-Q for the period ending June 30, 1985. * By-Laws. Incorporated by reference to Appendix C of the 1984 Proxy Statement. * Amendment to the Certificates of Incorporation, incorporated by reference from the Company's definitive Proxy Statement for its Annual Meeting of Stockholders held on May 4, 1988, copies of which were filed with the Commission on April 11, 1988, wherein said amendment is identified as exhibit (B). * Amendment to the Certificate of Incorporation as filed by the Delaware Secretary of State on May 31, 1989 (Exhibit (a), Form 10-Q for the quarter ended June 30, 1989). * Amendment to the Company's By-Laws, incorporated by reference from the Company's definitive Proxy Statement for its Annual Meeting of Stockholders held on May 4, 1988, copies of which were filed with the Commission on April 11, 1988, wherein said amendment is identified as exhibit (C). (10) Material Contracts: (iii) Compensatory Plans for Officers: * Goulds Pumps, Incorporated 1994 Incentive Plan to Increase Stockholder Value, effective on date approved by Stockholders of the Company (filed as Exhibit A on page 19 of Proxy Statement dated March 31, 1994). * Goulds Pumps, Incorporated 1994 Stock Option Plan for Non-Employee Directors, effective on date approved by Stockholders of the Company (filed as Exhibit B on page 35 of Proxy Statement dated March 31, 1994). * Goulds Pumps, Incorporated Supplemental Executive Pension Plan, effective January 1, 1992 (filed as Exhibit 10 on page 29 of Form 10-K for year ended December 31, 1991). * Goulds Pumps, Incorporated Senior Executive Severance Agreement, effective May 12, 1983 (Exhibit 19, Form 10-Q for quarter ended June 30, 1983). * Goulds Pumps, Incorporated Investment and Stock Ownership Plan (filed on May 8, 1984, Form S-8, Registration Statement No. 2-90969). * Goulds Pumps, Incorporated Revised Incentive Stock Option Plan, effective March 19, 1987 (Form S-8 Registration Statement No. 2-78145, filed on June 25, 1982. Appendices No. 1 and No. 2 to the prospectus filed with SEC on June 8, 1983 and May 8, 1987 respectively). Page 42 of 54 * Goulds Pumps, Incorporated Stock Purchase Plan for Employees (Form S-8 Registration Statement No. 2-64530, filed on May 21, 1979). * Goulds Pumps, Incorporated 1988 Stock Incentive Plan (Form S-8 Registration Statement No. 33-22902 filed on July 5, 1988). (11) Computation of Earnings Per Share: See page 50 of this Annual Report on Form 10-K. (22) Subsidiaries of the Registrant: See page 51 of this Annual Report on Form 10-K. (23) Consents of Experts and Counsel: For Consent of Independent Auditors see page 52 of this Annual Report on Form 10-K. All other exhibits are omitted because they are not applicable or the required information is shown elsewhere in this Annual Report on Form 10-K. * Incorporated herein by reference as indicated. UNDERTAKINGS The Company, being the registrant under Registration Statement Nos. 2-64847, 2-64530, 2-78145, 2-90969, and 33-22902 on Form S-8, currently on file with the Securities and Exchange Commission, hereby undertakes as follows, which undertaking shall be incorporated by reference into such Registration Statements: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant, the registrant has been advised that, in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. Page 43 of 54 INDEPENDENT AUDITORS' REPORT Goulds Pumps, Incorporated: We have audited the consolidated balance sheets of Goulds Pumps, Incorporated and its subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of earnings, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated January 26, 1994; such report is included elsewhere in this Form 10-K. Our audits also included the financial statement schedules of Goulds Pumps, Incorporated and its subsidiaries, listed in Item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. s/Deloitte & Touche Deloitte & Touche Rochester, New York January 26, 1994 Page 44 of 54 Page 45 of 54 Page 46 of 54 Schedule VIII GOULDS PUMPS, INCORPORATED AND CONSOLIDATED SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) BALANCE ADDITIONS BALANCE AT BEGINNING CHARGED TO DEDUCTIONS AT END OF YEAR INCOME (2) (1) OF YEAR Allowance for Doubtful Accounts, Deducted from Trade Receivables: 1993........... $2,408 $ 814 $1,045 $2,177 1992........... $3,009 $ 472 $1,073 $2,408 1991........... $2,815 $1,110 $ 916 $3,009 (1) Accounts written off, less recoveries. (2) Includes impact of foreign currency translations. Page 47 of 54 Page 48 of 54 Schedule X GOULDS PUMPS, INCORPORATED AND CONSOLIDATED SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993, 1992, and 1991 (IN THOUSANDS) Charged to Costs and Expenses Item 1993 1992 1991 Maintenance and Repairs $15,128 $12,517 $14,302 Depreciation and Amortization of intangible assets, pre-operating costs and similar deferrals * * * Taxes, other than payroll and income taxes * * * Royalties * * * Advertising costs * * * * Less than 1% of total sales. Page 49 of 54 Page 50 of 54 EXHIBIT 22 All subsidiaries of Goulds Pumps, Incorporated listed below are included in the consolidated financial statements. State or Country Ownership Incorporated Subsidiary Percentage or Organized Bombas Goulds de Mexico, S.A. de C.V........ 100 Mexico Bombas Goulds de Venezuela, C.A............. 100 Venezuela Environamics Corp........................... 100 Delaware Goulds Pumps Ag............................. 96 Switzerland Goulds Pumps (Asia), Ltd.................... 100 Hong Kong Goulds Pumps Australia...................... 100 Australia Goulds Pumps B.V............................ 100 Netherlands Goulds Pumps Canada, Inc.................... 100 Canada Goulds Pumps DISC, Inc...................... 100 New York Goulds Pumps Delaware, Inc.................. 100 Delaware Goulds Pumps Europe B.V..................... 100 Netherlands Goulds Pumps Financial Services............. 100 Ireland Goulds Pumps International, Inc. (a DISC)... 100 Delaware Goulds Pumps Korea Co. Ltd.................. 100 South Korea Goulds Pumps (N.Y.), Inc.................... 100 New York Goulds Pumps (Phil.), Inc................... 100 Philippines Goulds Pumps (Singapore) PTE, Ltd........... 100 Singapore Goulds Pumps (Taiwan) Co. Ltd............... 100 Taiwan Goulds Pumps Trading Corp................... 100 Delaware Goulds Pumps World Sales, Ltd. (a FSC)...... 100 Guam Goulds Pumps World Sales (V.I.) Ltd......... 100 U.S. Virgin Islands Goulds Pumps Worldwide, Inc................. 100 Delaware Lowara B.V.................................. 100 Netherlands Lowara Belgium, S.A......................... 100 Belgium Lowara France S.A........................... 100 France Lowara, Gmbh................................ 90 Germany Lowara S.p.A................................ 100 Italy Lowara UK Ltd............................... 90 United Kingdom Marka S.p.A................................. 100 Italy Morris Pumps International, Inc. (a DISC)... 100 New York West Virginia Pump and Supply............... 100 West Virginia World Pump, Srl............................. 100 Italy World Pump Slovenia DoO..................... 100 Slovenia The Company also has equity investments in Oil Dynamics, Inc., a 50 percent owned corporation incorporated in Oklahoma and Nanjing Goulds Pumps Limited Co., of China, a 45 percent owned joint venture. Lowara Co., Ltd. of Osaka, Japan is a 54.8% owned joint venture which Lowara S.p.A. maintains with Tsurumi Company of Japan. Page 51 of 54 EXHIBIT 23 Independent Auditors' Consent Goulds Pumps, Incorporated: We consent to the incorporation by reference in Registration Statement No.s' 2-64847, 2-64530, 2-78145, 2-90969 and 33-22902 of Goulds Pumps, Incorporated and its subsidiaries on Forms S-8 of our reports dated January 26, 1994, appearing in this Annual Report on Form 10-K of Goulds Pumps, Incorporated and its subsidiaries for the year ended December 31, 1993. s/Deloitte & Touche Deloitte & Touche Rochester, New York March 30, 1994 Page 52 of 54 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Goulds Pumps, Inc., has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GOULDS PUMPS, INCORPORATED By: s/Stephen V. Ardia Stephen V. Ardia (President, Chief Executive Officer and Director) Date: March 18, 1994 Page 53 of 54 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 indicated. s/Robert L. Tarnow March 18, 1994 Robert L. Tarnow Date (Chairman of the Board and Director) s/Stephen V. Ardia March 18, 1994 Stephen V. Ardia Date (President, Chief Executive Officer and Director) s/John P. Murphy March 18, 1994 John P. Murphy Date (Vice President and Chief Financial Officer) s/Peter Oddleifson March 18, 1994 Peter Oddleifson Date (Director) s/Melvin Howard March 18, 1994 Melvin Howard Date (Director) s/Arthur M. Richardson March 18, 1994 Arthur M. Richardson Date (Director) s/William R. Fenoglio March 18, 1994 William R. Fenoglio Date (Director) Listed below are those directors not mentioned above: William W. Goessel Barbara B. Lucas Thomas C. McDermott James C. Miller Page 54 of 54

804151_1993.txt

804151_1993

1993

804151

Item 1. Business........................................................ General....................................................... History....................................................... Industry Segments............................................. Discontinued Operation........................................ Restructuring Plan............................................ Competition................................................... Product Distribution and Customers............................ Backlog....................................................... Raw Materials................................................. Patents, Licenses and Trademarks.............................. Research and Development...................................... Environmental Matters......................................... Employees..................................................... 2. Properties...................................................... 3. Legal Proceedings............................................... 4. Submission of Matters to a Vote of Security Holders............. Executive Officers of the Registrant................................ PART II 5. Market for the Registrant's Common Equity and Related Stockholder Matters............................... 6. Selected Financial Data......................................... 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................. 8. Financial Statements and Supplementary Data..................... 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................ PART III 10. Directors and Executive Officers of the Registrant.............. 11. Executive Compensation.......................................... 12. Security Ownership of Certain Beneficial Owners and Management................................................ 13. Certain Relationships and Related Transactions.................. PART IV 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K........................................... Exhibit Index....................................................... Signatures.......................................................... PART I Item 1. Business. General Imo Industries Inc. (hereinafter with its subsidiaries referred to as the "Company") is an integrated multinational manufacturing company that designs, produces and markets proprietary products focused on controls and on engineered power products and their support services. The Company operates in the United States, Canada, several European countries, Mexico and the Pacific Rim. In 1993, the Company redefined its business segments and reclassified previously reported financial information. The Company's continuing core operations are divided into three business segments: The Morse Controls Business segment designs and produces push-pull cable and control systems and automotive products including actuators, window controls, latches and door panels/assemblies. The Pumps, Power Transmission & Controls Business segment designs and produces a broad range of rotary pumps, including a proprietary line of three-screw pumps; electronic adjustable- speed motor drives, gears and speed reducers; and transducers and switches for sensing, measuring and controlling pressure, temperature and liquid level and flow. The Turbomachinery Business segment designs and produces steam turbines, rotary compressors, and steam condensers. The segment also has a coordinated aftermarket parts and services program. In addition to the three segments comprising the Company's continuing core operations, the Company has an Other Business segment included in its continuing operations for financial reporting purposes. This segment includes operations previously sold and operations to be sold as part of the Company's asset divestiture program. The Company has announced that it will sell its Electro-Optical Systems operations and is accounting for this business as a discontinued operation and, accordingly, has not included these operations in the Company's segments. History The Company, founded in 1901 in the United States by Dr. Carl Gustaf Patrik de Laval, a Swedish scientist, was acquired by Transamerica Corporation ("Transamerica") in 1963. In 1964, Transamerica merged its existing wholly owned manufacturing subsidiary, General Metals Corporation, into the Company. At the close of business on December 18, 1986, Transamerica distributed all of the issued and outstanding shares of the Company Common Stock to holders of record of Transamerica Common Stock on the basis of one share of Company Common Stock for each ten shares of Transamerica Common Stock held ("Distribution"). Following the Distribution, the Company has operated as a publicly traded company. Industry Segments A description of the principal products and services offered by each core business segment of the Company, as well as the principal markets for such products and services, are set forth below. Certain information in response to this item with respect to net sales, operating profit, and identifiable assets of each of these segments and by geographic area is contained in Note 10 of the Notes to Consolidated Financial Statements included in Part IV of this Form 10-K Report as indexed at Item 14(a)(1). On October 29, 1992, the Company announced a restructuring plan pursuant to which it divested six of its operating units in 1993 and is seeking to divest certain other non-strategic businesses and underutilized real estate holdings. In January 1994, the Company announced its intention to dispose of its Electro-Optical Systems business, which is being accounted for as a discontinued operation. Additional information regarding the businesses sold and held for sale and the discontinued operation is provided later in this section and is contained in Note 3 and Note 2, respectively, of the Notes to Consolidated Financial Statements. Morse Controls The Morse Controls Business segment operations, consisting of the Morse Controls and Roltra-Morse businesses, manufacture precision mechanical control products and systems that are primarily used for automotive, marine, and industrial applications. This segment produces, among other products, push-pull cable and control systems used to control and actuate functions, such as steering and valve adjustment, and as an alternative to electrical systems. Applications include throttle control and steering systems for both off-the-road vehicles and pleasure boats. The segment also manufactures a manual gear shift system that is currently used in Fiat and Lotus automobiles, and actuators, window controls, latches and door panels/assemblies for Fiat. Pumps, Power Transmission & Controls The Pumps, Power Transmission & Controls Business segment units produce a wide range of products that control the speed, force and direction of motion in processes and products. Major products in this segment include speed reducers, gears, liquid level indicators, transducers and a range of rotary pumps, including a proprietary line of three-screw pumps. These products are used by a diverse customer base in the marine, elevator, oil and gas and general industrial markets. The IMO Pump, Warren Pumps, Boston Gear, Delroyd Worm Gear, Fincor Electronics, Gems Sensors and TransInstruments operations of the Company comprise this Business segment. The segment's pump operations design and manufacture screw-type fuel, lube oil and hydraulic pumps for use primarily by the marine, process, oil and gas and elevator industries. The segment's three-screw pumps are the leading low-noise-level pumps used in United States Navy vessels and in many commercial vessels. These pumps are also used to power hydraulic elevators, lubricate diesel engines and fuel gas turbines. The segment's two-screw pumps are used by the pulp and paper industry and in other high-viscosity-process applications. The segment's power transmission operations produce speed reducers and loose gearing which are recognized as leading products in their market niches. The speed reducers and gear boxes are used to reduce the output speed and increase the torque of power trains. The operations also produce worm gear sets used as speed reducers by original equipment manufacturers, and by oil and gas and industrial machinery customers. In addition, the power transmission sector manufactures AC and DC adjustable-speed motor controls that are utilized to variably adjust the speed of electric motors. Customized systems for process controls used in such applications as printing, tire and glass production and material handling make up a large portion of the segment's motor controls sales. The controls operations of this segment design and manufacture products that perform a wide variety of critical sensing, measuring, monitoring and control functions. Tank level indicators, level switches, solid state relays and flow meters are manufactured principally for marine and general industrial applications. These indicators are used in ocean- going tankers, military vessels, petrochemical facilities and industrial and commercial products around the world. Hundreds of varieties of liquid-level monitors, indicators and switches are manufactured for use by more than 30,000 customers. Pressure transducers are used to measure pressure as a continuous function and are sold to a wide segment of the general industrial market. Turbomachinery The major products of this segment are steam turbines and compressors. Steam turbines principally are used to drive generators, compressors and pumps. Compressors are sold primarily to the oil and gas exploration and production industry, and the chemical and petrochemical industries. The segment continues to manufacture steam condensers, and is the leading supplier of steam condensers for United States Navy nuclear submarine propulsion systems. A primary emphasis of this segment is to service, repair, retrofit and upgrade, and furnish spare parts for a variety of customers operating in the power generation and process, oil and gas industries. The segment has a coordinated aftermarket parts and service program designed to extend the life or increase the efficiency of high-speed rotating machinery manufactured by the Company and others. The aftermarket parts and services program is consolidated in the segment's TurboCare operation. The Turbomachinery segment includes the Delaval Turbine and Delaval Condenser operations as well as the TurboCare operation. Discontinued Operation In January 1994, the Company announced its intention to dispose of its Electro-Optical Systems operations which consists of the Company's subsidiaries Varo Inc. and Baird Corporation. Under a plan approved by the Board of Directors, the Company intends to sell these operations in 1994 and has engaged an outside investment banking firm to assist in the divestiture. In accordance with APB Opinion No. 30, the disposal of this business segment has been accounted for as a discontinued operation and, accordingly, its operating results are segregated and reported as a Discontinued Operation in the accompanying Consolidated Statements of Income. Prior year financial statements have been reclassified to conform to the current year presentation. See Note 2 to the Consolidated Financial Statements located in Part IV of this Form 10-K Report as indexed at Item 14 (A)(1) for additional details regarding the discontinued operation. Restructuring Plan Asset Divestiture Program On October 29, 1992, the Company announced a restructuring plan pursuant to which it was seeking the divestiture of operations representing approximately 15% of its assets. The planned divestitures included units of its aerospace businesses, units of its instruments and transducer businesses, certain other non- strategic businesses and underutilized real estate holdings. In January 1994, the Company announced plans to include the Electro- Optical Systems operations in the asset divestiture program as discussed above. As of December 31, 1993, the Company has sold its Heim Bearings, Aerospace and Barksdale Controls operations for proceeds of approximately $91 million, and thus has completed a significant portion of the asset divestiture program. These proceeds, net of related expenses, were used to repay senior debt in the amount of $81.9 million in 1993 in accordance with the terms of the restructured credit facilities. Excluding the Electro-Optical Systems operations, the remaining assets to be sold in this program consist of a unit of the Company's instruments and transducer businesses, certain other non-strategic businesses and underutilized real estate holdings. The Company targets completion of the divestitures over the next 9 to 12 months. Based on current conditions, management now believes that certain of the remaining assets, both operating units and real estate, are unlikely to net the sale prices originally expected. Accordingly, the Company has deferred gains of $18.0 million on assets divested during 1993 and has provided $10.1 million for the loss now anticipated for the program as a whole. Restructuring Program In January 1994, the Company announced plans to reduce the Company's cost structure and to improve productivity on a worldwide basis. The actions under this restructuring plan will include reductions in the number of employees and the consolidation of certain of the Company's operating units. The Company plans to consolidate its four domestic turbomachinery aftermarket maintenance operations into one operating unit and combine certain operations of its European mechanical controls and automotive components operating units. In the fourth quarter of 1993, the Company recorded a charge of $8.6 million relating to this program. See Note 3 to the Consolidated Financial Statements located in Part IV of this Form 10-K Report as indexed at Item 14(A)(1) for additional details regarding the asset divestiture and restructuring program. Competition The Company's products and services are marketed on a worldwide basis. Approximately 41% of the Company's products are marketed outside of the United States through wholly owned subsidiaries, sales offices and several joint ventures. Most markets in which the Company operates are highly competitive. The principal elements of competition for the products manufactured in each of the Company's business segments are design features, product quality, customer service and price. Product Distribution and Customers The Company's products are sold primarily through the Company's direct sales forces. During 1993, sales by the Company's direct sales forces accounted for approximately 93%, 67%, 73% and 74% of the Morse Controls, Pumps, Power Transmission & Controls, Turbomachinery and Other segments, respectively. The Company's remaining sales are made through distributors, dealers and agents. The Morse Controls segment had sales to one commercial customer (Fiat S.p.A. and its subsidiaries) that accounted for 47%, 57% and 61% of segment sales, and 12%, 15% and 15% of consolidated sales in 1993, 1992 and 1991, respectively. None of the other business segments is dependent on any single customer or a few customers, the loss of which would have a material adverse effect on the respective segments, or on the Company as a whole. Sales as prime contractor to the United States Department of Defense represented 4.7%, 4.8%, and 5.3% of the Company's consolidated sales in 1993, 1992 and 1991, respectively. Total sales to the Department of Defense in the form of prime and subcontracts were approximately 11.1% of net sales in 1993, 12.2% of sales in 1992 and 15.3% of sales in 1991. The products sold to the Department of Defense are for military applications. The government's desire to reduce the national budget deficit continues to exert great pressure on all elements of the federal budget, particularly defense. Nevertheless, the Company believes that the type and array of programs it addresses help minimize the effect of the termination of any one program. The majority of such Department of Defense sales are subject to adjustment of profits or termination at the election of the government. If the government terminates a contract, it may be required to pay termination costs (including a proportionate share of any profit). In the Company's opinion, refunds to the government, if any, resulting from renegotiation of profits or termination of contracts or subcontracts at the election of the government will not have a material adverse effect on the financial position or results of operations of the Company. No customer other than Fiat S.p.A. and its subsidiaries and the United States Department of Defense, accounted for 10% or more of consolidated sales in 1993, 1992 or 1991. Backlog The Company's continuing operations' backlog of unfilled orders at February 28, 1994 and 1993 and at December 31, 1993, 1992 and 1991 by business segment was as follows: February 28 December 31 1994 1993 1993 1992 1991 (Dollars in millions) Morse Controls $ 45.7 $ 43.3 $ 41.1 $ 42.8 $ 47.5 Pumps, Power 62.3 72.7 62.5 75.2 86.4 Transmission & Controls Turbomachinery 91.7 121.1 101.8 118.3 103.4 Other 4.7 41.8 4.6 41.4 56.4 $204.4 $278.9 $210.0 $277.7 $293.7 Backlog is considered significant only to the Warren Pumps and Delaval Turbine operations of the Pumps, Power Transmission & Controls and Turbomachinery Business segments, respectively, which require long lead times for the manufacture of their products, and to the Roltra-Morse operation of the Morse Controls Business segment, the backlog for which is directly tied to a major customer's production schedule. Of the total backlog from continuing operations at December 31, 1993, the Company believes that all but approximately $8.8 million of its orders will be filled in 1994. Raw Materials The Company's operations obtain raw materials, component parts and supplies from a variety of sources, generally from more than one supplier. The sources are based in both the United States and foreign countries. The Company believes that its sources of raw materials are adequate for its needs. Patents, Licenses and Trademarks The Company owns numerous unexpired United States patents (having an initial duration of 17 years and expiring at various times in the future), United States design patents and foreign patents (having an initial term that is governed by the law of the country and expiring at various times in the future), including counterparts of certain of its United States patents, in major industrial countries of the world. The Company's products are marketed under various trade names and registered United States and foreign trademarks (having an initial term that is governed by the law of the country and expiring at various times in the future). However, the Company does not consider any one patent or trademark or any group thereof essential to its business as a whole, or to any of its business segments. The Company relies, to an extent, on proprietary product knowledge and manufacturing processes in its operations. Following the removal of the distinctive modifier "Transamerica" from the corporate name prior to the Distribution, the Company changed its name to "Imo Delaval Inc." in 1986 and to "Imo Industries Inc." in 1989. The Company's use of the name "Delaval" is restricted as a result of a contract by which the Company's assets were acquired from their former Swedish owner preceding the acquisition of the Company by Transamerica. The Company is permitted to use the "Delaval" name in connection with certain products of the Turbomachinery segment although rights to the name are also retained by the former Swedish owner. Research and Development The Company's ongoing research and development programs involve the development of new technologies to enhance the performance or lower the cost of manufacturing the Company's products, and the redesign of existing product lines either to increase their efficiency or to lower their manufacturing cost. Expenditures for research and development charged against continuing operations for 1993, 1992 and 1991 by business segment were as follows: Year Ended December 31 1993 1992 1991 (Dollars in millions) Morse Controls $ 3.3 $ 3.3 $ 3.0 Pumps, Power Transmission 3.6 3.9 3.5 & Controls Turbomachinery 2.1 2.2 2.3 Other 2.3 2.7 2.3 $11.3 $12.1 $11.1 Environmental Matters The State of New Jersey Department of Environmental Protection and Energy (the "DEPE") has determined that the New Jersey Industrial Site Recovery Act ("ISRA") is applicable to the Company's New Jersey "Industrial Establishments" by reason of the Distribution. Under ISRA the Company's three existing New Jersey industrial establishments will undergo a DEPE approved clean-up. All existing adverse environmental conditions and violations are being addressed through this ISRA process. Although the Company will have to correct conditions requiring clean-up under ISRA, the Company does not expect ISRA compliance to have a material adverse effect on its financial condition. In a number of instances the Company has received Notice of Potential Liability from the United States Environmental Protection Agency alleging that various of its divisions had arranged for the disposal of hazardous wastes at a number of facilities that have been targeted for cleanup pursuant to the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"). Although CERCLA liability is joint and several, the Company believes that its liability will not have a material adverse effect on the financial condition of the Company since it believes that it qualifies as a de minimis or minor contributor to each site with a large number of Potential Responsible Parties ("PRP's") owning a greater share. Accordingly, the Company believes that the portion of remediation costs that it will be responsible for will therefore not be material. The Company has operations in numerous locations, some of which require environmental remediation. However, the Company does not know of or believe that any such matters or the cost of any required corrective measure, either individually or in the aggregate, will have a material adverse effect on the financial condition of the Company. However, there can be no guarantee that these matters or other environmental matters not currently known to the Company will not have such a material adverse effect. Employees At December 31, 1993, the Company employed approximately 6,500 persons worldwide of which 4,700 relate to continuing operations. Approximately 4,600 persons were employed in the United States, and approximately 1,900 persons were employed outside of the United States. There are approximately 1,000 persons covered by collective bargaining agreements with various unions expiring at various dates in 1994 through 1996. The Company considers its relations with its employees to be satisfactory. Item 2. Item 2. Properties. The Company has 54 manufacturing facilities in 12 states in the United States, the United Kingdom, Germany, Singapore, Sweden, Switzerland, Mexico, Turkey (held by a joint venture), Italy, France, Spain and Australia of which 32 are owned and 22 are leased. In addition, the Company owns two closed manufacturing facilities (approximately 276,000 square feet of building space on 69 acres of land) that are being offered for sale. The properties owned by the Company consist of approximately 4.06 million square feet of building space, inclusive of the 276,000 square feet of the closed facilities, on approximately 493 acres (including 204 acres of undeveloped land). The leases expire over a period of years from 1994 to 2054 with renewal options for varying terms contained in 6 of the leases. The Company's executive office, which is owned by the Company, is located in Lawrenceville, New Jersey and occupies approximately 41,000 square feet on ten acres. The Company believes that its machinery, plants and offices are in satisfactory operating condition and are adequate for the uses to which they are put. The Company believes that its properties have sufficient capacity to substantially increase their current utilization without incurring any significant additional capital expenditures. The manufacturing facilities of the Company by business segment are summarized below: Square Feet of Building Space Number of Plants (In thousands) Owned Leased Owned Leased Morse Controls 6 11 1,178 658 Pumps, Power Transmission & Controls 10 2 888 188 Turbomachinery 8 2 1,043 40 Other 8 7 671 458 32 22 3,780 1,344 Item 3. Item 3. Legal Proceedings. In August 1985, the Company was named as defendant in a lawsuit filed by Long Island Lighting Company ("LILCO"). The action stemmed from the sale of three diesel generators to LILCO for use at its Shoreham Nuclear Power Station. During testing of the diesel generators, the crankshaft of one of the diesel generators severed. The Company's insurers have defended the action under a reservation of rights. On April 10, 1991, a jury, in a trial limited to liability, in the U.S. District Court in the Southern District of New York, found that the warranty was in effect from the time of shipment of the diesel generators until July 1986. On July 22, 1992, the trial court entered a judgment in the amount of $18.3 million which included interest to the judgment date. On September 22, 1993, the Second Circuit Court of Appeals affirmed all lower court decisions in this matter. On October 25, 1993, the judgment against the Company was satisfied by payment to LILCO of approximately $19.3 million by two of the Company's insurers. In late June 1992, the Company filed an action in the Northern District of California against one of its insurers in an attempt to collect amounts for defense costs paid to counsel retained by the Company in defense of the LILCO litigation. The insurer has refused to reimburse the Company for approximately $8 million in defense costs paid by the Company alleging that defense costs above reasonable levels were expended in defending this litigation. Upon motion by the defendant this action has now been transferred to the Southern District of New York and assigned to one of the judges who heard the underlying LILCO trial. In January 1993, the Company was served a complaint in a case brought in California by another insurer alleging that the insurer was entitled to recover $10 million in defense costs previously paid in connection with the LILCO matter and $1.2 million of the judgment which was paid on behalf of the Company. The complaint alleges inter alia that the insurer's policies did not cover the matters in question in the LILCO case. An Answer denying the complaint has been filed in connection with this matter. The Company and one of its subsidiaries are two of a large number of defendants in a number of lawsuits brought by approximately 20,000 claimants who allege injury caused by exposure to asbestos. Although the Company and its subsidiary have never been producers or direct suppliers of asbestos, it is alleged that the industrial and marine products sold by the Company and the subsidiary had components which contained asbestos. The allegations state a claim for asbestos exposure when Company- manufactured equipment was maintained or installed. Suits against the Company have been tendered to its insurers who are defending under their stated reservation of rights. The insurers for the subsidiary are being identified and will be provided notice. Tentative settlement agreements relating to approximately 10,000 claimants have been reached. Should additional settlements be reached at comparable levels, the settlements would not be expected to have a material effect on the Company. The activities of certain employees of the Ni-Tec Division of the Company's Varo Inc. subsidiary ("Ni-Tec"), headquartered in Garland, Texas, are the focus of an ongoing investigation by the Office of the Inspector General of the United States Department of Defense and the Department of Justice (Criminal Division). On July 16, 1992, Ni-Tec received a subpoena for certain records as a part of the investigation, which subpoena has been responded to. Additional subpoenas for additional documents were received in September 1992, February 1993, and March 1994. The Company responded to the September subpoena, the government subsequently withdrew the February subpoena and the Company is in the process of responding to the March subpoena. The investigation appears directed at quality control, testing and documentation activities which began at Ni-Tec while it was a division of Optic-Electronic Corp. Optic-Electronic Corp. was acquired by the Company in November 1990 and subsequently merged with Varo Inc. in 1991. The Company continues to cooperate fully with the investigation. Regarding environmental matters, the operations of the Company, like those of other companies engaged in similar businesses, involve the use, disposal and cleanup of substances regulated under environmental protection laws. In a number of instances the Company has received Notice of Potential Liability from the United States Environmental Protection Agency alleging that various of its divisions had arranged for the disposal of hazardous wastes at a number of facilities that have been targeted for cleanup pursuant to the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"). Although CERCLA liability is joint and several, the Company believes that its liability will not have a material adverse effect on the financial condition of the Company since it believes that it qualifies as a de minimis or minor contributor to each site with a large number of Potential Responsible Parties ("PRP's") owning a greater share. Accordingly, the Company believes that the portion of remediation costs that it will be responsible for will therefore not be material. The Company currently has pending against it, a lawsuit relating to performance shortfalls in products delivered by its Delaval Turbine Division in a prior year and two lawsuits pending against it relating to breach of contract and warranty claims with respect to its former diesel engine division. These actions seek damage awards ranging individually from $3 million to $8 million. With respect to the litigation and claims described in the preceding paragraphs, it is management's opinion that the Company either expects to prevail, has adequate insurance coverage or has established appropriate reserves to cover potential liabilities; however, the ultimate outcome of any of these matters is indeterminable at this time. In addition, the Company is involved in various other pending legal proceedings arising out of the Company's business. The adverse outcome of any of these legal proceedings is not expected to have a material adverse effect on the financial condition of the Company. However, if all or substantially all of these legal proceedings were to be determined adversely to the Company, which is viewed by the Company as only a remote possibility, there could be a material adverse effect on the financial condition of the Company. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matter was submitted to a vote of the Company's security holders during the fourth quarter of 1993. Executive Officers of the Registrant The following table sets forth information concerning the names, ages and principal occupations of the executive officers of the Company: Name Age Principal Occupation Donald K. Farrar * 55 Chief Executive Officer and President Thomas J. Bird, Jr. 50 Senior Vice President, General Counsel and Secretary William M. Brown 51 Executive Vice President and Chief Financial Officer J. Dwayne Attaway 52 Executive Vice President John J. Carr 51 Executive Vice President Brian Lewis 60 Executive Vice President Gary E. Walker 56 Executive Vice President David C. Christensen 60 Senior Vice President, Human Resources Robert A. Derr, II 48 Vice President and Corporate Controller Geoffrey M. Dobson 56 Vice President and Treasurer *This executive officer is a director of the Company whose current term as a director will expire in 1995. Donald K. Farrar joined the Company in his current position in September 1993. Prior to joining the Company, Mr. Farrar held various positions with Textron, Inc. and Avco Corporation for 24 years. He served as President, Chief Operating Officer and director of Avco until its 1985 acquisition by Textron. Thereafter, he served as Senior Executive Vice President, Operations and a director of Textron, Inc. until December 1989. From January 1990 until joining the Company, Mr. Farrar was a private investor. Thomas J. Bird joined the Company as Vice President and Associate General Counsel in July 1990, and was promoted to his current position in June 1992. Prior to joining the Company, Mr. Bird held various positions with General Electric Company for 18 years, most recently as Group Counsel RCA Aerospace and Defense division from August 1987 to February 1988 and as General Counsel to GE Aerospace of General Electric Company from February 1988 until joining the Company. William M. Brown joined the Company in his current position in June 1992. Prior to joining the Company, Mr. Brown held various positions with ITT Corporation for 25 years, most recently as Corporate Assistant Controller and General Auditor from December 1986 to April 1991 and as Corporate Vice President and Assistant Controller from April 1991 until joining the Company. J. Dwayne Attaway joined the Company as Executive Vice President of the Company's Varo, Inc. operation in July 1989, and was promoted to his current position in December 1989. Mr. Attaway has overall responsibility for the Company's Electro-Optical Systems business which consists of the Company's Varo and Baird operations. Mr. Attaway served as Corporate Vice President of Business Development at Ranco Inc. from 1987 to 1989, as Vice President and General Manager of the Ranco Inc. Electronics Division from 1982 to 1987, and prior to that was with Varo, Inc. for 17 years. John J. Carr was promoted to his current position in July 1989. From July 1985 to July 1989, Mr. Carr was a Group Vice President of the Company. Mr. Carr is responsible for the Boston Gear, CEC Instruments, Delroyd Worm Gear, Fincor Electronics, Gems Sensors, IMO Pump, TransInstruments and Warren Pumps operations of the Company. Brian Lewis was promoted to his current position in July 1989. Mr. Lewis was President and Chief Operating Officer of the Controls Group of Incom International Inc. (acquired by the Company in December 1987) from 1985 until January 1988 and was a Group Vice President of the Company from January 1988 to July 1989. Mr. Lewis has responsibility for the Morse Controls and Roltra-Morse operations. Gary E. Walker was promoted to his current position in February 1993. Mr. Walker served as Group Vice President of the Company from September 1991 to February 1993 and as Vice President and General Manager of the Delaval Turbine operation from September 1988 to September 1991. Prior to joining the Company he served from January 1987 to September 1988 as Vice President and General Manager of Turbonetics Energy Incorporated, a subsidiary of Mechanical Technology Inc. Prior to that, he had held various positions with General Electric for 21 years. Mr. Walker has responsibility for the Company's Delaval Turbine, Delaval Condenser and TurboCare operations. David C. Christensen joined the company in his current position in August 1990. Previously, he was Senior Vice President, Human Resources for Pneumo Abex Corporation (and its predecessor Abex Corporation) from 1980 to September 1988. From September 1988 until joining the Company, Mr. Christensen was an independent human resources consultant. Robert A. Derr, II joined the Company in his current position in 1988. Prior to joining the Company, Mr. Derr held various positions with The Stanley Works for nine years, most recently as Director of Corporate Accounting from 1982 to 1986 and as the Controller of the Vidmar Division of The Stanley Works from 1986 until joining the Company. Geoffrey M. Dobson joined the Company in his current position in April 1990. Prior to joining the Company, Mr. Dobson held various positions with Warner-Lambert Company for 21 years, most recently as Corporate Treasurer from August 1983 to January 1988 and as Vice President of Finance for the American Chicle Division from January 1988 until March 1989. From March 1989 until joining the Company Mr. Dobson served as President of Financial Functions Management, a financial consulting firm. Each of these executive officers will hold office until his successor is chosen and qualifies or until his earlier resignation or removal. Any officer may be removed at any time by the Board of Directors without prejudice to any contract rights which he may have. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. The Company's common stock (the "Common Stock") is listed on the New York Stock Exchange (stock symbol IMD). The following table sets forth, for the quarters indicated, the high and low closing price per share for the Common Stock as reported on the New York Stock Exchange Composite Tape and the amount of per share cash dividends declared by the Company during each quarter on its Common Stock. Dividends Declared High Low Per Share 1992: 1st Quarter $ 13 3/4 $ 10 5/8 $ .125 2nd Quarter 12 7/8 9 5/8 .125 3rd Quarter 12 1/2 9 5/8 .125 4th Quarter 9 7/8 4 1/8 -- 1993: 1st Quarter 7 1/2 4 7/8 -- 2nd Quarter 7 5 7/8 -- 3rd Quarter 8 6 1/4 -- 4th Quarter 9 1/4 6 5/8 -- 1994: 1st Quarter 8 7/8 7 -- (through March 15, 1994) The last sale price for the Company's Common Stock as reported by the New York Stock Exchange on March 15, 1994, was $8 per share. As of March 15, 1994, there were approximately 26,411 holders of record of the Company's Common Stock. Five of the Company's long-term debt agreements contain, among other provisions, a restriction on retained earnings available for payment of dividends. Under the most restrictive provisions the Company was prohibited as of December 31, 1993 and is currently prohibited from declaring or paying cash dividends through at least March 31, 1995. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Restructuring Plan The Company has completed a significant portion of the asset divestiture program adopted in October 1992. The Company sold its Heim Bearings, Aerospace and Barksdale Controls operations for proceeds of approximately $91 million in 1993. Net proceeds from these sales have been used to reduce senior debt. Results of these operations to their date of sale as well as operations remaining to be sold, other than the Electro-Optical Systems business, are included in continuing operations reported in the consolidated financial statements. Gains of $18.1 million on the assets divested during 1993 have been deferred and applied to the reserve for divestitures. Pursuant to a plan announced in January 1994, the Company intends to sell its Electro-Optical Systems business. The post-cold war slowdown in defense spending has impacted the Electro-Optical Systems operations and its recent performance. Selling the business will help the Company reduce debt, halt further cash drains, and concentrate the Company's focus on its core businesses. The sale of this business segment is planned to be consummated within the year. In accordance with APB Opinion No. 30, the disposal of this business segment has been accounted for as a discontinued operation and accordingly, its operating results are segregated and reported as a Discontinued Operation in the accompanying Consolidated Statements of Income. The assets and liabilities have been condensed into net assets of discontinued operation on the accompanying Consolidated Balance Sheets. The prior year amounts have been reclassified to conform to the 1993 presentation. The Company is implementing cost-cutting measures at its remaining operations to reduce its expense structure and to eliminate duplicative functions by consolidating some of its smaller operating units. The Company is consolidating its four domestic turbo-machinery aftermarket maintenance divisions into one TurboCare division; is consolidating certain operations in the European mechanical controls and automotive components divisions; and is revising operating processes and reducing employment levels at the turbomachinery, pumps and other operations. The Company expects these programs to generally be complete by mid-year and the number of employees company-wide is forecast to decline by approximately 450, or 9% from continuing operations, between mid-1993 and mid-1994. The restructurings are expected to provide net cash benefits of approximately $3 million in 1994 and $13 million annually thereafter. Also as a result of restructuring, the Company has realigned its businesses into new groupings for management and segment reporting purposes. The Power Products and Services Group is basically unchanged but will now be known as the Turbomachinery segment. The Mechanical Controls Group, which previously contained three of the Aerospace divisions (sold September 1993), is now called the Morse Controls segment. The Power Transmission Group lost two Aerospace divisions through divestiture but gained Gems Sensors, Fincor Electronics and TransInstruments through realignment. This Group is now known as Pumps, Power Transmission & Controls segment. The Instruments Group no longer exists because the Electro-Optical Systems business is now accounted for as a discontinued operation. Finally, the operating units sold and the remaining assets to be sold as part of the asset divestiture program, except for the Electro-Optical Systems operations, have been grouped as a separate segment entitled Other for segment reporting purposes. Results of Operations The twelve months ended December 31, 1993 include net unusual charges of $17.7 million in loss from continuing operations. These charges include $8.6 million related to the restructuring and consolidation of certain of the Company's operating units (principally comprised of severance costs), $10.1 million for an expected net loss overall, based on current conditions, on the Company's asset divestiture program, and $5 million in debt related financing fees. These charges are net of a reversal of a $6.0 million reserve during the third quarter of 1993, as a result of a change in estimate related to legal costs associated with pending litigation. As a result of unanticipated losses in 1993, the Company provided reserves of $15.0 million against previously recorded future tax benefits. These tax benefits may be realized in future years. The results of operations for the twelve months ended December 31, 1993 also include an extraordinary item of $18.1 million ($1.07 per share) representing fees and expenses related to extinguishment of senior debt of which approximately $4.0 million required immediate cash outlays, approximately $2 million relates to the write-off of previously deferred debt expense and $11.9 million was provided as an estimate for make-whole notes ("Make- Whole Notes") to be issued to the holders of debt being retired. Through December 31, 1993, Make-Whole Notes of $11.5 million have been issued and are included in long-term debt. Additionally, approximately $4 million of fees related to the restructured credit facilities was paid in 1993. This amount is being amortized over the term of the facilities. The twelve months ended December 31, 1992 include unusual charges of $24.0 million in loss from continuing operations principally for the estimated costs associated with pending litigation and certain warranty and claim settlements. Of this amount, $6 million was reversed in the third quarter of 1993 as a result of a change in estimate, approximately $1.6 million and $1.5 million required cash outlays in 1993 and 1992, respectively. The twelve months ended December 31, 1992 include a charge of $27.6 million after tax ($1.64 per share) related to the adoption of FASB Statement No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions." This charge has been reported as a cumulative effect of a change in accounting principle and was retroactively applied as of January 1, 1992. In March 1994, the Company amended its policy regarding retiree medical and life insurance plans. This amendment, which affects some current retirees and all future retirees, phases out the Company subsidy for retiree medical and life insurance over a three year period ending December 31, 1996. The Company expects to amortize associated reserves to income over the phase out period at approximately $7 million per year. The Company does not anticipate a significant increase or decrease in cash requirements related to this change in policy during the phase out period. The Company reduced the discount rate actuarial assumption in 1993 to 7.5% from 8.5% in 1992 in line with the change in the overall economic environment. This change has an insignificant effect on the net periodic postretirement benefit cost. Losses from discontinued operation amounted to $213.3 million or $12.63 per share in 1993 and $32.7 million (net of income tax benefit of $15.6 million) or $1.94 per share in 1992, and income of $1.9 million (net of income tax expense of $1.7 million) or $0.11 per share in 1991. The loss recorded in 1993 includes an estimated loss on disposal of $168.0 million, most of which represents a non-cash adjustment to reduce the carrying value of assets to estimated realizable value. Of the total estimated loss on disposal, cash outlays are not expected to exceed $11 million. The results from operations for the discontinued operation include allocations for interest of $10.2 million, $7.7 million and $7.7 million for 1993, 1992 and 1991, respectively. The Company had a loss from continuing operations before extraordinary item of $39.1 million or $2.32 per share in 1993 primarily as a result of the net unusual charges of $17.7 million and the $15.0 million reserve provided against previously recorded future tax benefits. The Company had a loss from continuing operations before cumulative effect of change in accounting principle of $22.3 million or $1.32 per share in 1992 primarily as a result of unusual charges of $24.0 million. In 1991 there was income from continuing operations of $9.5 million or $0.57 per share. The net loss per share in 1993 was $16.02 compared with a net loss per share of $4.90 in 1992 and net income per share of $0.68 in 1991. 1993 1992 1991 Earnings (loss) per share: Continuing operations before extraordinary item and cumulative effect of change in accounting principle $(2.32) $(1.32) $.57 Discontinued operation $(12.63) $(1.94) $.11 Extraordinary item $(1.07) - - Cumulative effect of change in accounting principle - $(1.64) - Net income (loss) $(16.02) $(4.90) $.68 Net Sales Net sales from continuing operations in 1993 were $641.7 million, a decline of $91.9 million or 12.5% from $733.6 million for 1992. Included in these sales are the sales of divested and soon to be divested divisions (Other segment) amounting to $80.4 million in 1993 and $115.1 million in 1992, accounting for $34.7 million of the decline in sales from continuing operations. Most of this decline is because six divisions were sold in 1993, therefore contributing for only a part of the year versus a full year for 1992. Excluding the Other segment, the Company's core businesses had sales of $561.3 million in 1993 versus $618.5 million in 1992, a decline of $57.2 million or 9.2%. Two-thirds of this decline, approximately $37 million, was due to unfavorable foreign exchange rate effects. The major portion of the remaining decline is attributable to decreases in volume occurring in the turbomachinery and Italian automobile businesses. Net sales from continuing operations in 1992 were $733.6 million compared with $777.3 million in 1991, a decrease of $43.7 million or 5.6%. A decline in defense business, reduced sales to the Italian auto market, reduced revenues from the Turbocare maintenance group and the sluggish economies worldwide all contributed to the decline. The Other segment accounted for $18.1 million of the decreased revenues. Costs and Expenses In 1993, gross profit margins from continuing operations improved to 28.5% of sales compared with 25.6% for 1992. Excluding provisions and other charges recorded in the third quarter of 1992, the gross profit margin for the year was 27.6%. The year- to-year improvement reflects the favorable effects of cost- reduction and other operational improvement programs implemented over the past two years. The gross profit margin from continuing operations for 1991 was 27.2%. Selling, general and administrative expenses for continuing operations decreased $7.8 million from 1992 with the Other segment accountable for $4.6 million of the decrease as a result of six of the divisions having been sold during the year. Selling expenses for the core businesses increased $4.1 million in 1993 primarily because of the consolidation of a joint venture that became wholly-owned in late 1992 and the Company's continued efforts in the market place. General and administrative expenses decreased $8.8 million on a year-to-year basis with the lower costs occurring throughout the Company, including a significant portion at Corporate headquarters, reflecting efforts to keep these costs in line with the level of business. However, because of the lower sales but holding firm on the selling effort, total selling, general and administrative expenses for continuing operations were 21.0% of sales in 1993 compared with 19.5% for 1992. Selling, general and administrative expenses for continuing operations increased $2.1 million in 1992 from 1991 with a major portion of the increase attributable to medical insurance costs, legal fees and settlements, and severance costs. This, combined with the lower sales, resulted in such expenses increasing to 19.5% of sales for 1992 compared with 18.1% in 1991. Research and development expenditures for continuing operations were 1.8% of sales in 1993, 1.6% in 1992 and 1.4% in 1991. Average borrowings in 1993 were $21 million lower than in 1992. As a result, total interest expense (before allocation to discontinued operations) of $57.2 million in 1993 was $2.3 million less than in 1992. Similarly, because average borrowings in 1992 were $18 million lower than in 1991, interest expense of $59.5 million in 1992 (before allocation to discontinued operations) decreased $1.3 million compared with 1991. The interest expense for continuing operations as shown on the Consolidated Statements of Income excludes interest expense incurred by the discontinued operation as well as an interest allocation to the discontinued operation of $10.2 million in 1993, $7.7 million in 1992 and $7.7 million in 1991. Equity in income of unconsolidated companies was $2.6 million, down from the $6.3 million recorded in 1992, primarily because of a reduced level of business in the Company's European-based turbomachinery affiliate, Delaval Stork. Equity in income of unconsolidated companies was $4.9 million in 1991. Income tax expense for 1993 was $15.0 million. This amount is principally comprised of the provision of a reserve against previously recorded tax benefits. The Company has not recorded a benefit for the current year loss. A valuation allowance has been established in accordance with the provisions of FASB Statement No. 109, "Accounting for Income Taxes." These tax benefits may be realized in future years. The Company has a net operating loss carryforward of approximately $49 million expiring in 2008 and has foreign tax credit carryforwards of approximately $5 million expiring through 1998. These carryforwards are available to offset future taxable income and have been reserved in accordance with FASB Statement No. 109. The difference between the tax net operating loss carryforward and the book loss for 1993 is principally non- deductible goodwill and other expenses not currently deductible. Taxes have not been provided on the unremitted earnings of foreign subsidiaries, since it is the Company's intention to indefinitely reinvest these earnings. This policy has no impact on the Company's liquidity since the Company does not anticipate paying any U.S. tax on these unremitted earnings. The amount of foreign withholding taxes that would be payable on remittance of these earnings is approximately $1 million. Segment Operating Results The Morse Controls segment had sales of $163.9 million for the twelve months of 1993, compared with $192.7 million for the same period in 1992, a 15.0% decline resulting from the reduced level of activity in the Italian automotive industry and adverse effects of foreign exchange rates. It is anticipated that sales into the Italian automotive industry will improve in 1994 over 1993. Operating income for the segment was $3.5 million in 1993 compared with $6.6 million in 1992. The decline is primarily attributable to unusual items related to restructuring and facilities consolidations and the sharply reduced level of activity in the Italian automotive industry. Sales in 1992 were flat compared with 1991. Excluding charges of $2.2 million in the third quarter of 1992 relating to reducing certain assets to estimated net realizable values, operating income of the 1992 period was unchanged compared with 1991. The Pumps, Power Transmission & Controls segment had sales of $249.9 million in 1993, a 5.8% decline from the $265.3 million recorded in 1992. Sales were down in each of the three sectors, with the largest declines in pump and instrument sales in European markets. This was caused largely by the weak economic environment in Europe and by the adverse effects of foreign exchange rates. Segment operating income for 1993 was $22.2 million, an 11.1% improvement over 1992. Profits benefited from reduced inventory carrying costs and operational improvements resulting in generally lower expense levels. Sales in 1992 declined 1.8% compared with 1991. Segment operating income was down $4.1 million in 1992 compared with 1991 primarily due to inventory and other asset valuation adjustments. The Turbomachinery segment had revenues of $147.5 million, an 8.0% decline from the $160.4 million for 1992, due primarily to delays in production of turbomachinery units. Offsetting slightly the decline in turbomachinery unit revenues was an increase in aftermarket maintenance and repair activity over the prior year. Operating income for 1993 was $4.7 million in 1993 versus $1.9 million in 1992, including unusual items in both years. If unusual items totaling $2.0 million for restructuring costs in 1993 and $7.3 million for certain warranty and claim settlements in 1992 were excluded, operating income in 1993 would be $6.7 million and in 1992 would be $9.2 million. This decline in operating income was due primarily to lower volume and lower prices. Revenues declined 11.5% in 1992 compared with 1991 due principally to the segment's defense markets and lower revenues from the TurboCare maintenance group. Operating income of $1.9 million in 1992 was down significantly from the $23.4 million reported in 1991 mainly as a result of the provisions for certain warranty and claim settlements, and turbomachinery cost overruns caused by a control mechanism component failure in a major machining center. The Other segment had sales of $115.1 million for the twelve month period of 1992 as compared with $80.4 million for the same period of 1993. This decline in sales is attributable to the divisions sold in 1993 contributing for only a part of the current year versus a full year in 1992. The decline in the Other segment operations will continue as the Company expects to complete the sale of these businesses over the next 9 to 12 months. Operating income for both 1993 and 1992 was heavily impacted by unusual items. In 1993, unusual items included a provision of $10.1 million for expected losses as part of divesting the remaining assets in this segment, offset in part by a $6.0 million credit as a result of a change in estimate related to legal costs associated with pending litigation. In 1992, unusual items included $16.0 million, primarily for estimated costs associated with pending litigation. Including the unusual items, there was operating income of $2.1 million for 1993 and an operating loss of $7.1 million for the year 1992. Sales of the Other segment declined 13.6% in 1992 compared with 1991 due mainly to volume reductions in the aerospace related businesses. In addition to unusual items in 1992, pricing pressures in the Company's aerospace business (which was sold in September 1993) caused the operating income in 1992 to decline compared with 1991. Liquidity and Capital Resources The Company's domestic liquidity requirements are served by a revolving credit facility, while its needs outside the U.S. are covered by short and intermediate term credit facilities from foreign banks. On July 15, 1993, the Company completed a definitive agreement with its domestic senior lenders for the restructuring of its senior credit facilities. The agreement provides the Company with a new credit facility ("New Facility") through March 31, 1995, and includes provisions for letters of credit outstanding at that time to continue through March 31, 1996. The New Facility provides approximately $60 million of revolving credit (reduced in February 1994 from $65 million by agreement of the Company and the lenders thereunder) of which $10 million is for working capital, $40 million is for letters of credit to support commercial contracts and $10 million is for either working capital or letters of credit. As of December 31, 1993, $29.7 million in working capital loans and $38.2 million in standby letters of credit were outstanding under these facilities of which $15 million in working capital loans and $22.5 million in letters of credit were outstanding under the New Facility and the remainder was outstanding under the restructured credit facility. In January 1994, the Company borrowed the remaining $5 million of the New Facility. Both the New Facility and the restructured credit facilities are secured by the assets of the Company's domestic operations and all or a portion of the stock of certain of the Company's subsidiaries. The Company also has approximately $37.5 million in foreign short-term credit facilities with approximately $14.4 million outstanding. As a result of the loss for the fourth quarter of 1993, the Company was not in compliance with several of the financial covenants under its senior credit facilities. It has subsequently received waivers of such defaults and amendments to these agreements from its senior lenders. Moreover, in February, 1994 the Company obtained the consent of its 12.25% Senior Subordinated Debenture holders to amend the indenture governing these debentures and permit the Company to incur up to $35 million indebtedness (including letters of credit and foreign borrowings) above the level outstanding at year-end 1993. The foregoing waivers, amendments, and consent should give the Company sufficient financial flexibility to meet its financial commitments until such time as its recently announced plans to sell the Electro-Optical Systems business are completed. The Company's operating activities provided cash of $24.0 million in 1993 compared with $26.2 million in 1992. Net cash provided by investing activities was $70.8 million in 1993, compared with net cash used of $25.2 million in 1992. The improvement in net cash provided by investing activities is principally a result of net cash generated from the sale of businesses. In 1993, the Company repaid $81.9 million of existing debt from the proceeds of asset sales. Cash and cash equivalents of $19.9 million at December 31, 1993, were up from $15.3 million at December 31, 1992. Working capital as of December 31, 1993 was $107.1 million, a decrease of $3.9 million from the end of 1992. The ratio of current assets to current liabilities was 1.5 at December 31, 1993, compared with 1.4 at December 31, 1992. Principally as a result of the 1993 loss, the Company's total debt as a percent of its total capitalization was 109.2% at December 31, 1993, compared with 66.2% at December 31, 1992. Depreciation for continuing operations decreased $1.7 million to $23.2 million in 1993, from $24.9 million in 1992, which, in turn, was unchanged from 1991. Amortization of intangibles for continuing operations was $6.2 million in 1993, $6.0 million in 1992 and $6.0 million in 1991. Amortization is estimated to decrease $3.0 million over the next five years to $3.2 million in 1998. Additions to property, plant and equipment, made primarily to improve productivity, were $13.9 million in 1993. The Company anticipates that capital expenditures in 1994 will not exceed $19 million. There were no material outstanding commitments for the acquisition of property, plant and equipment at December 31, 1993. The Company presently has outstanding $150 million of 12.25% Senior Subordinated Debentures maturing in 1997 and $150 million of 12% Senior Subordinated Debentures maturing in amounts of $37.5 million in 1999, $37.5 million in 2000 and $75.0 million in 2001. In addition, the Company had at December 31, 1993, a $30 million 12.75% Senior Note due March 31, 1995, which the Company may, at its option, extend to at least December 31, 1996, and, with the concurrence of the holder, through December 1, 2002, in which event, $6 million will become due on December 1 in each of the years 1995 and 1996, and $3 million will be due annually from December 1, 1997 to 2002. The Company also has $4.4 million outstanding of an original $50 million 10.35% Senior Note due in 1994 and $11.5 million of Make-Whole Notes due December 31, 1996, which require quarterly interest payments at 2% above prime. The Company is on schedule with its previously announced divestiture and debt reduction programs. As of December 31, 1993, six divisions have been sold and $81.9 million of the debt from the domestic senior lender group has been repaid from the net proceeds. The Company is planning to sell its Electro- Optical Systems business, certain other non-strategic businesses and under-utilized real estate holdings. The Company does not anticipate sales of assets other than those currently included in the asset divestiture program; however, management is continually evaluating its options in the interest of strengthening the Company. Of the $125 million of debt required to be repaid to the domestic senior lender group by the July 15, 1993 definitive agreement, $81.9 million was repaid in 1993, $8.1 million is due by March 31, 1994 and the final installment of $35 million is due by September 30, 1994. The Company currently anticipates that cash flow from operations together with cash generated by asset sales will be sufficient to permit the required repayments. Without the sale of a sufficient portion of its operating assets currently held for sale or the refinancing of the senior obligations, the Company would not have sufficient cash flow from operations to make the repayment required in September, 1994. The process of disposing of assets is continuing and in addition, management is presently seeking replacement financing. Although significant progress has been made to date, and management believes its plans are achievable, there can be no guarantee as to the Company's ability to sell sufficient assets or obtain refinancing within the necessary time frame. Under circumstances which the Company considers unlikely, failure to meet the required repayment schedule would result in its default of the senior lending agreements and allow for the senior lenders' acceleration of the debt which the Company, under these circumstances, would be unable to pay. Additionally, acceleration by the senior lenders, if not cured, would enable the trustee or holders of the Company's Subordinated Debentures to require the Company by notice to cause the acceleration to be rescinded within 30 days of such notice. If the Company is unable to accomplish this, the trustee or holders of at least 25% of the Subordinated Debentures could demand immediate payment of the Subordinated Debentures. In such event, the Company would not have sufficient funds to pay the $300 million of outstanding Subordinated Debentures. Fourth Quarter Results Net sales from continuing operations of $153.1 million in the fourth quarter of 1993 decreased $48.8 million from $201.9 million in the fourth quarter of 1992. Divested businesses accounted for $20.8 million of the decline since five of the six divisions sold in 1993 were sold prior to the fourth quarter. Most of the balance of the decrease occurred in the Turbomachinery segment and was caused by the uneven distribution of turbomachinery unit completions over the quarters. The fourth quarter of 1993 had a loss from continuing operations before extraordinary item of $47.8 million ($2.82 per share) as compared with income of $3.9 million ($0.23 per share) in the same period of 1992. $23.7 million of unusual items and the provision of a $15.0 million reserve against previously recorded future tax benefits were recorded in the fourth quarter of 1993. Fourth quarter revenue of the Morse Controls segment was down 8.0% from the prior year's level primarily due to the adverse effect of foreign currency rate changes. The fourth quarter of 1993 had an operating loss of $3.7 million as a result of unusual items related to restructuring and facilities consolidations. The fourth quarter of 1992 had operating income of $0.4 million. The Pumps, Power Transmission & Controls segment sales declined 4.4% in the fourth quarter of 1993 to $63.6 million compared with the same period of 1992. Most of the decline is attributed to adverse effects of foreign exchange rates. Operating income of $3.6 million in the fourth quarter of 1993 was $2.2 million lower than the same quarter in 1992. Profits were impacted in the fourth quarter of 1993 by restructuring charges and asset revaluations at an overseas location. Revenues for the Turbomachinery segment were $40.9 million for the fourth quarter of 1993 compared with $62.6 million for the same period of 1992. The variance is attributable to turbomachinery unit completions which tend not to be evenly distributed over the quarters. Completions delayed in the third quarter of 1992 inflated the fourth quarter 1992 revenues, whereas delays in the fourth quarter of 1993 held that period's revenues down. Unusual items consisting of asset revaluations and restructuring costs along with legal settlements pushed this segment into a loss for the fourth quarter of 1993. Compared with the same period last year, operating profit was also impacted by the lower volume in total as well as in high margin products. The Other segment includes the six divisions sold in 1993 along with three other small divisions. In the fourth quarter of 1992 this segment had sales of $29.5 million as contrasted with $8.8 million in the same period of 1993. This segment had operating income of $4.0 million in the fourth quarter of 1992 compared with a $9.8 million loss in the same period of 1993. The loss includes a provision of $10.1 million for expected losses as part of divesting the remaining assets in this segment. There are no additional losses expected on the asset divestiture program. Business Environment General economic conditions worldwide continue to create business uncertainties for the coming year in many of the markets in which the Company operates. Management believes that its multiple niche market strategy helps the Company moderate effects from the cyclical behavior of any particular market segment that it serves. Approximately 49% of the Company's property, plant and equipment of continuing operations has been acquired over the past five years and has a remaining useful life ranging from five years to fifteen years for equipment to thirty years for buildings. In addition, property, plant and equipment of the companies acquired by the Company have been adjusted to their fair value at the time of acquisition. Assets acquired in prior years are expected to be replaced at higher costs but this will take place over many years. The newer assets will result in higher depreciation charges but, in many cases, due to technological improvements, there will be operating cost savings as well. The Company considers these matters in establishing its pricing policies. Approximately 5% of the Company's net sales from continuing operations were on prime contracts to the Department of Defense (DoD) of the United States Government in 1993 and 1992. Total sales to the DoD in the form of prime and subcontracts were approximately 11% of net sales from continuing operations in 1993 and 12% in 1992, adjusted downward from the 22% reported in 1992 to reflect the Company's divestiture program and decision to sell the Electro-Optical Systems business. In recent years, the DoD has taken a more aggressive position with its contractors with respect to contract performance and pricing issues, and has instituted legal action, including fines and curtailment of future defense business, against several contractors. The Company believes its relations with the DoD are satisfactory and currently does not have any significant disputes with the DoD, nor is it aware of any investigations by the DoD with respect to its contracts except for the investigation being conducted by the Office of the Inspector General of the United States Department of Defense at the Ni-Tec division of the Company's Varo Inc. subsidiary. (See Note 14 of Notes to Consolidated Financial Statements.) Revenue and earnings on certain contracts with the DoD are accounted for based on estimated performance over the contract term. In addition, the Company has certain fixed-price development contracts. The Company believes that its cost estimates, with respect to such contracts, are reasonable and that negotiated fixed prices are sufficient to cover estimated development costs, but there can be no assurances that future events would not change the ultimate accuracy of those estimates. The government's desire to reduce the national budget deficit continues to exert great pressure on all elements of the federal budget, particularly defense. Nevertheless, the Company believes that the type and array of programs it addresses help minimize the effect of the termination of any one program. Item 8. Item 8. Financial Statements and Supplementary Data. The consolidated financial statements and supplementary data required by Part II, Item 8 of Form 10-K are included in Part IV of this Form 10-K Report as indexed at Item 14(a)(1). Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not Applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Reference is made to the information to be set forth in the section entitled "Election of Directors" in the Company's Proxy Statement, for the Annual Meeting of Stockholders which will be held on May 24, 1994 (the "Proxy Statement"), which section is incorporated herein by reference. The Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 1993, pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended. The information under the caption "Executive Officers of the Company," following Item 4 of Part I of this Form 10-K Report, is incorporated herein by reference. None of the executive officers or directors of the Company is related to any of the other executive officers or directors of the Company. Item 11. Item 11. Executive Compensation. Reference is made to the information to be set forth in the section entitled "Executive Compensation" in the Proxy Statement, which section (except for its Compensation Committee Report and its Performance Graph) is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Reference is made to the information to be set forth in the section entitled "Beneficial Ownership of Common Stock" in the Proxy Statement, which section is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions. Not Applicable. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) (1) Financial Statements The Financial Statements and Supplementary Data required by Part II, Item 8 of Form 10-K are included in this Part IV of this Form 10-K Report as follows: Page Consolidated Financial Statements Consolidated Statements of Income for the Years Ended December 31, 1993, 1992, and 1991.....................................F-1 Consolidated Balance Sheets at December 31, 1993 and 1992............................F-2 Consolidated Statements of Cash flows for the Years Ended December 31, 1993, 1992 and 1991.................................F-3 Consolidated Statements of Shareholders' Equity (Deficit) for the Years Ended December 31, 1993, 1992 and 1991.........F-4 Notes to Consolidated Financial Statements.F-5 Report of Independent Auditors..................F-6 Quarterly Financial Information.................F-7 (2) Financial Statement Schedules The following consolidated financial statement schedules for the year ended December 31, 1993, 1992 and 1991 are filed as part of this Report and should be read in conjunction with the Company's Consolidated Financial Statements. Schedule Page V Property, Plant and Equipment.........S-1 VI Accumulated Depreciation and Amortization of Property, Plant and Equipment.......................S-2 VIII Valuation and Qualifying Accounts.....S-3 IX Short-Term Borrowings.................S-4 X Supplementary Income Statement Information.........................S-5 All other schedules for which provision is made in the applicable regulation of the Securities and Exchange Commission are omitted because they are not required under the related instructions or because the required information is given in the financial statements or notes thereto. (3) Exhibits The Exhibits listed in the accompanying Index to Exhibits are filed as part of this Report. (b) Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended December 31, 1993. EXHIBIT INDEX Exhibit No. Note No. Description 3(i) (15) The Company's Restated Certificate of Incorporation, as amended March 10, 1989 and November 10, 1992 3(ii) (15) The Company's Bylaws 4.1 (A) (11) Indenture agreement dated August 15, 1987 between the Company and IBJ Schroder Bank & Trust Company, Trustee (B) First Supplemental Indenture dated as of February 14, 1994 between the Company and IBJ Schroder Bank & Trust Company, Trustee 4.2 (11) Indenture agreement dated November 1, 1989 between the Company and IBJ Schroder Bank & Trust Company, Trustee 4.3(A) (5) Rights Agreement dated as of April 22, 1987 between the Company and Philadelphia National Bank, as Rights Agent (B) (15) Amendment dated December 16, 1991 between the Company and First Chicago Trust Company of New York Management Contracts, Compensatory Plans and Arrangements: 10.1(A) (3) The Company's Equity Incentive Plan for Key Employees (B) (7) Amendment to the Equity Incentive Plan for Key Employees 10.2(A) (7) Equity Incentive Plan for Outside Directors (B) (12) Amendment effective as of July 2, 1990 to the Equity Incentive Plan for Outside Directors 10.3(A) (12) Employment Agreement dated September 1, 1986 by and between the Company and William J. Holcombe, as amended October 1, 1987, as restated and amended May 9, 1989, and as amended March 6, 1991 (B) (15) Amendment dated January 1, 1993 to the Employment Agreement between the Company and William J. Holcombe 10.4 (15) Employment Agreement dated May 15, 1992 between the Company and William M. Brown 10.5 (15) Change in Control Agreement dated January 7, 1987 between the Company and William J. Holcombe, as amended June 15, 1990 and as amended January 9, 1991 10.6 (15) Change in Control Agreement dated January 9, 1987 between the Company and John J. Carr 10.7 (15) Change in Control Agreement dated April 8, 1990 between the Company and J. Dwayne Attaway 10.8 (15) Change in Control Agreement dated December 23, 1988 between the Company and Brian Lewis 10.9 (15) Change in Control Agreement dated January 7, 1987 between the Company and Stephen F. Agocs 10.10 (15) Change in Control Agreement dated August 5, 1992 between the Company and William M. Brown 10.11 (15) Change in Control Agreement dated August 13, 1992 between the Company and Thomas J. Bird 10.12 Change in Control Agreement dated April 19, 1993 between the Company and Gary E. Walker and agreed to by him on May 10, 1993 10.13 Employment Agreement dated September 13, 1993 between the Company and Donald K. Farrar 10.14 Change in Control Agreement dated September 13, 1993 between the Company and Donald K. Farrar Other Material Contracts: 10.15 (2) The Company's Retirement Plan for Salaried Employees 10.16(A) (8) The Company's Salaried Employees Stock Savings Plan as (11) amended on July 1, 1987 and as amended on June 14, 1988 (B) (8) Trust Agreement for the Imo Industries Inc. Employees Stock Savings Plan dated April 7, 1987 between the Company and Connecticut National Bank (C) (14) Amendment dated March 16, 1989 to the Imo Industries Inc. Employees Stock Savings Plan (D) (12) Amendments dated September 6, 1990 and February 14, 1991 to the Imo Industries Inc. Employees Stock Savings Plan (E) (13) Amendment dated May 9, 1991 to the Imo Industries Inc. Employees Stock Savings Plan (F) (13) Trust Agreement for the Imo Industries Inc. Employees Stock Savings Plan as of January 1, 1990 between the Company and Bankers Trust Company (G) (14) Trust Agreement for the Imo Industries Inc. Employees Stock Savings Plan as of January 1, 1992 between the Company and Merrill Lynch Trust Company (H) (15) Amendments dated December 30, 1991 and August 3, 1992 to the Imo Industries Inc. Employees Stock Savings Plan 10.17 (1) Distribution Agreement dated December 18, 1986 between Transamerica Corporation and the Company 10.18 (1) Tax Agreement between the Company and Transamerica Corporation 10.19(A) (9)(10) Revolving Credit Agreement, dated September 16, 1988 by and among the Company, Banker's Trust Company, Barclays Bank PLC, Canadian Imperial Bank of Commerce as amended December 15, 1988, as amended February 28, 1989, as amended May 9, 1989 and as amended September 11, 1989 (B) (12) Amendment dated as of August 31, 1990 to the agreement dated September 16, 1988 by and among the Company, Banker's Trust Company, Barclays Bank PLC, Canadian Imperial Bank of Commerce, Manufacturers Hanover Trust Company and National City Bank (C) (14) Amendment dated as of December 31, 1991 to the agreement dated September 16, 1988 by and among the Company, Banker's Trust Company, Barclays Bank PlC, Manufacturers Hanover Trust Company and National City Bank (D)(i) (16) Combined Restated Credit Agreement dated July 15, 1993 among the Company, Bankers Trust Company as lender, issuer and agent, Chemical Bank, CIBC, Inc., Barclays Bank PLC, National City Bank, ABN AMRO Bank N.V., New York Branch, Commerzbank AG, New York Branch, and Istituto Bancario San Paolo Di Torino S.p.A. (ii) Amendment No. 1 dated as of November 22, 1993 to the Combined Restated Credit Agreement dated as of July 15, 1993 among the Company, Bankers Trust Company as lender, issuer and agent, Chemical Bank, CIBC, Inc., Barclays Bank PLC, National City Bank, ABN AMRO Bank N.V., New York Branch, Commerzbank AG, New York Branch, and Istituto Bancario San Paolo Di Torino S.p.A. (E)(i) (16) Credit Agreement dated July 15, 1993 among the Company, Bankers Trust Company as lender, issuer and agent, Chemical Bank, CIBC, Inc., Barclays Bank PLC, National City Bank, ABN AMRO Bank N.V., New York Branch, Commerzbank AG, New York Branch, Istituto Bancario San Paolo Di Torino S.p.A., and The Prudential Insurance Company of America (ii) Amendment No. 1 dated as of November 22, 1993 to the Credit Agreement dated as of July 15, 1993 among the Company, Bankers Trust Company as lender, issuer and agent, Chemical Bank, CIBC, Inc., Barclays Bank PLC, National City Bank, ABN AMRO Bank N.V., New York Branch, Commerzbank AG, New York Branch, Istituto Bancario San Paolo Di Torino S.p.A., and The Prudential Insurance Company of America (F) Guarantee Agreement dated July 15, 1993 by certain of the Company's Subsidiaries in favor of Bankers Trust Company as collateral agent (re-executed to reflect certain signatories which are different from those on the version of this Agreement appended as Exhibit 10.16 (F) to the Company's Form 10K/A for the fiscal year ended December 31, 1992 (G)(i)(16) General Security Agreement dated July 15, 1993 by the Company and certain of its Subsidiaries in favor of Bankers Trust Company as collateral agent (ii) Letter Agreement dated December 1, 1993 between the Company's Varo Inc. Subsidiary and Bankers Trust Company as collateral agent, regarding the General Security Agreement identified herein as Exhibit 10.19 (G)(i) (H)(i)(16) Securities Pledge Agreement dated July 15, 1993 by the Company and certain of its Subsidiaries in favor of Bankers Trust Company as collateral agent (ii) Letter Agreement dated December 1, 1993 between the Company's Varo Inc. Subsidiary and Bankers Trust Company as collateral agent, regarding the Securities Pledge Agreement identified herein as Exhibit 10.19 (H)(i) (I)(i)(16) Intellectual Property Pledge Agreement dated July 15, 1993 by the Company and certain of its Subsidiaries in favor of Bankers Trust Company as collateral agent (ii) Letter Agreement dated December 1, 1993 between the Company's Varo Inc. Subsidiary and Bankers Trust Company as collateral agent, regarding the Intellectual Property Pledge Agreement identified herein as Exhibit 10.19 (I)(i) (J) (16) Collection Deposit and Concentration Account Pledge Agreement dated July 15, 1993 by the Company and certain of its Subsidiaries in favor of Bankers Trust Company as collateral agent (K) (16) Intercreditor and Collateral Agency Agreement dated July 15, 1993 among the Company, Bankers Trust Company as lender, issuer, agent and collateral agent, Chemical Bank, CIBC, Inc., Barclays Bank PLC, National City Bank, ABN AMRO Bank N.V. New York Branch, Commerzbank AG New York Branch, Istituto Bancario San Paolo Di Torino S.p.A., and The Prudential Insurance Company of America (L) (16) Mortgage, Assignment of Rents, Assignment Agreement and Fixture Filing dated July 15, 1993 by the Company in favor of Bankers Trust Company relating to premises in Mercer County, New Jersey (M) (16) Schedule of Omitted Mortgages and Deeds of Trust (N) Schedule of Additional Omitted Mortgages and Deeds of Trust 10.20(A) (4) 12.75% Note Agreement dated December 29, 1982 between the Company and The Prudential Insurance Company of America ("Prudential") (B) (4) Agreement dated December 22, 1986 between the Company and The Prudential amending the 12.75% Note Agreement dated December 29, 1982 between the Company and Prudential (C) (11) Amendment dated as of September 16, 1988 to the Agreement dated December 29, 1982 between the Company and Prudential 10.20(D) (11) Amendment dated as of June 13, 1989 to the Agreement dated December 29, 1982 between the Company and Prudential (E) (12) Amendment dated November 27,1990 to the agreement dated December 29, 1982 between the Company and Prudential (F) (14) Amendment dated April 2, 1991, Amendment dated May 14, 1991, Amendment dated November 5, 1991, Amendment dated November 12, 1991 and Amendment dated February 13, 1992 between the Company and Prudential (G) (15) Amendment dated August 7, 1992 between the Company and Prudential (H) (16) Amendment Agreement dated July 15, 1993 between the Company and The Prudential Insurance Company of America (I)(i)(16) Amended and Restated 12.75% Promissory Note Agreement dated July 15, 1993 between the Company and The Prudential Insurance Company of America (ii) Amendment No. 1 dated as of December 17, 1993 to the Amended and Restated 12.75% Promissory Note Agreement dated July 15, 1993 between the Company and the Prudential Insurance Company of America (J) (16) Warrant dated July 15, 1993 issued by the Company to The Prudential Insurance Company of America 10.21(A) (4) 9.60% Note Agreement dated November 5, 1975 between the Company and Prudential (B) (4) Agreement dated December 22, 1986 between the Company and Prudential amending the 9.60% Note Agreement dated November 5, 1975 between the Company and Prudential 10.22(A) (9) 10.35% Note Agreement dated September 16, 1988 between the Company and Prudential (B) (11) Amendment dated as of June 13, 1989 to the Agreement dated September 16, 1988 between the Company and Prudential (C) (12) Amendment dated November 27, 1990 to the agreement dated September 16, 1988, between the Company and Prudential (D) (14) Amendment dated April 2, 1991, Amendment dated May 14, 1991, Amendment dated November 5, 1991, Amendment dated November 12, 1991 and Amendment dated February 13, 1992 between the Company and Prudential (E) (15) Amendment dated August 7, 1992 between the Company and Prudential (F) (16) Amendment Agreement dated July 15, 1993 between the Company and The Prudential Insurance Company of America (G) (16) Amended and Restated 10.35% Promissory Note Agreement dated July 15, 1993 between the Company and Prudential Insurance Company of America (H) Amendment No. 1 dated as of December 17, 1993 to the Amended and Restated 10.35% Promissory Note Agreement dated July 15, 1993 between the Company and Prudential Insurance Company of America 10.23(A) Amendment No. 2 dated as of December 31, 1993 to the New Credit Agreement, the Combined Restated Credit Agreement and the Prudential Agreements among the Company, Bankers Trust Company as lender, issuer and agent, Chemical Bank, CIBC, Inc., Barclays Bank PLC, National City Bank, ABN AMRO Bank N.V., New York Branch, Commerzbank AG, New York Branch, Istituto Bancario San Paolo Di Torino S.p.A., and The Prudential Insurance Company of America. This Amendment No. 2 Amends: (i) the Combined Restated Credit Agreement identified herein as Exhibit 10.19(D)(i) as amended, (ii) the Credit Agreement identified herein as Exhibit 10.19(E)(i) as amended, (iii) the Amended and Restated 12.75% Promissory Note Agreement identified herein as Exhibit 10.20(I)(i) as amended, and (iv) the Amended and Restated 10.35% Promissory Note Agreement identified herein as Exhibit 10.22(G) as amended. (B) Consent and Amendment No. 3 dated as of February 28, 1994 to the New Credit Agreement, the Combined Restated Credit Agreement and the Prudential Agreements among the Company, Bankers Trust Company as lender, issuer and agent, Chemical Bank, CIBC, Inc., Barclays Bank PLC, National City Bank, ABN AMRO Bank N.V., New York Branch, Commerzbank AG, New York Branch, Istituto Bancario San Paolo Di Torino S.p.A., and The Prudential Insurance Company of America. This Consent and Amendment No. 3 amends: (i) the Combined Restated Credit Agreement identified herein as Exhibit 10.19(D)(i) as amended, (ii) the Credit Agreement identified herein as Exhibit 10.19(E)(i) amended,(iii) the Amended and Restated 12.75% Promissory Note Agreement identified herein as Exhibit 10.20(I)(i) as amended, and (iv) the Amended and Restated 10.35% Promissory Note Agreement identified herein as Exhibit 10.22(G) as amended. 10.24 (6) Agreement and Plan of Merger dated July 13, 1987 among the Company, BC Acquisition Corp. and Baird Corporation 10.25 (4) Stock Purchase Agreement dated November 30, 1987 between the Company and TRIFIN B.V. 10.26 (9) Agreement and Plan of Merger, dated as of August 21, 1988 by and among the Company, VI Acquisition Corp. and Varo, Inc. 10.27 (9) Stock option agreement, dated as of August 21, 1988, between VI Acquisition Corp. and Varo, Inc. 10.28 (11) Agreement for the purchase of the stock of Warren Pumps Inc. by the Company dated April 3, 1989 among the Company, Warren Pumps Inc. and the holders of all of the issued and outstanding stock of Warren Pumps Inc. 10.29 (11) Share Purchase Agreement dated April 27, 1989, among Aureoleena Investments Limited, Bushbranch Investments Limited, and Canape Holdings Limited, as vendors, and R. J. Burns, C.P. Burns and J.A. Burns as guarantors, and Morse Controls Limited as purchaser 10.30 (11) Stock Purchase Agreement dated July 31, 1989 between Immobiliare Marsicana S.R.L. and Ser-Fid Italiana S.p.A. 10.31 (11) Agreement for sale of assets dated November 30, 1989 among Ferguson Gear Company, Robert E. Lewis and the Company 10.32 (12) Agreement for sale of assets dated June 15, 1990 among Clifford G. Brockmyre, Robert Healy, Quabbin Industries Inc., Pro Mac Engineering Inc., BHP Associates, Industrial Airpark Associates and the Company 10.33 (12) Stock Purchase Agreement dated as of May 31, 1990 among United Scientific Holdings PLC, United Scientific Inc. and the Company 10.34 Asset Sale Agreement dated as of May 10, 1993 between the Company and Roller Bearing Company of America 10.35 Stock Sale and Asset Transfer Agreement dated as of July 14, 1993 between the Company and Nova Digm Acquisition, Inc. 10.36(i) Stock Purchase Agreement dated as of October 28, 1993 among the Company, Imo Industries GmbH, Mark Controls Corporation and Mark Controls GmbH i. Gr. (ii) Amendment No. 1 dated as of November 11, 1993 to Stock Purchase Agreement dated as of October 28, 1993, among the Company, Imo Industries GmbH, Mark Controls Corporation and Mark Controls GmbH i. Gr. (iii) Amendment No. 2 dated as of December 1, 1993 to Stock Purchase Agreement dated as of October 28, 1993 among the Company, Mark Controls Corporation, Imo Industries GmbH and Mark Controls GmbH i. Gr. 10.37(i) German Asset Purchase Agreement among Imo Industries GmbH, Mark Controls GmbH i. Gr., the Company and Mark Controls Corporation (ii) Amendment No. 1 dated as of November 23, 1993 to German Asset Purchase Agreement dated as of November 18, 1993 among Imo Industries GmbH, the Company, Mark Controls GmbH i. Gr. and Mark Controls Corporation (iii) Amendment No. 2 dated as of December 1, 1993 to the German Asset Purchase Agreement dated as November 23, 1993 among the Company, Mark Controls Corporation, Imo Industries GmbH and Mark Controls GmbH i. Gr. 20 Proxy Statement for the Company's 1994 Annual Meeting of Stockholders (incorporated by reference to the Company's Proxy Statement to be filed separately with the Commission pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended) 21 Subsidiaries of the Company 23 Consent of Ernst & Young dated March 31, 1994 _______________________________________________ NOTES (1) Incorporated by reference to the Company's Form 8 Amendment No. 2 filed with the Commission on December 9, 1986 amending the Company's Form 10 as filed with the Commission on October 15, 1986. (2) Incorporated by reference to the Company's Form 10-K filed with the Commission for the fiscal year ended December 31, 1986. (3) Incorporated by reference to the Company's Form S-8 as filed with the Commission on April 10, 1987. (4) Incorporated by reference to the Company's Form 8-K filed with the Commission on February 17, 1987. (5) Incorporated by reference to the Company's Form 8-K filed with the Commission on May 4, 1987. (6) Incorporated by reference to the Company's Schedule 14D-1 as filed with the Commission on July 14, 1987. (7) Incorporated by reference to the Company's Form 10-K filed with the Commission on March 28, 1988. (8) Incorporated by reference to the Imo Industries Inc. Employees Stock Savings Plan Form 11-K filed with the Commission on April 13, 1988. (9) Incorporated by reference to the Company's Form 8-K filed with the Commission on October 14, 1988. (10) Incorporated by reference to the Company's Form S-1 filed with the Commission on October 23, 1989. (11) Incorporated by reference to the Company's Form 10-K filed with the Commission on March 29, 1990. (12) Incorporated by reference to the Company's Form 10-K filed with the Commission on March 28, 1991. (13) Incorporated by reference to the Company's Form S-8 filed with the Commission on June 17, 1991. (14) Incorporated by reference to the Company's Form 10-K filed with the Commission on March 26, 1992. (15) Incorporated by reference to the Company's Form 10-K filed with the Commission on April 19, 1993. (16) Incorporated by reference to the Company's Form 10-K/A filed with the Commission on August 6, 1993 amending the Company's Form 10-K as filed with the Commission on April 19, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Imo Industries Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 31, 1994 IMO INDUSTRIES INC. By: /s/ DONALD K. FARRAR Donald K. Farrar Chief Executive Officer, President and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Imo Industries Inc. and in the capacities and on the dates indicated. /s/ DONALD K. FARRAR Chief Executive Officer, Donald K. Farrar President and Director (principal executive officer) March 31, 1994 /s/ WILLIAM M. BROWN Executive Vice President and William M. Brown Chief Financial Officer (principal financial officer) March 31, 1994 /s/ ROBERT A. DERR, II Vice President and Corporate Robert A. Derr, II Controller (principal accounting officer) March 31, 1994 /s/ WILLIAM J. HOLCOMBE Chairman and Director March 31, 1994 William J. Holcombe /s/ STEPHEN F. AGOCS Director March 31, 1994 Stephen F. Agocs /s/ JAMES B. EDWARDS Director March 31, 1994 James B. Edwards /s/ J. SPENCER GOULD Director March 31, 1994 J. Spencer Gould /s/ RICHARD J. GROSH Director March 31, 1994 Richard J. Grosh /s/ CARTER P. THACHER Director March 31, 1994 Carter P. Thacher /s/ ARTHUR E. VAN LEUVEN Director March 31, 1994 Arthur E. Van Leuven Imo Industries Inc. and Subsidiaries Notes to Consolidated Financial Statements Note 1 Significant Accounting Policies Basis of Presentation: The accompanying financial statements have been prepared assuming the Company will continue as a going concern. The Company currently anticipates that cash flow from operations together with cash generated by asset sales will be sufficient to meet the required repayment of its senior debt by September 30, 1994 (see Note 8). Without the sale of a sufficient portion of its assets currently held for sale or the refinancing of its senior obligations, the Company would not have sufficient cash flow from operations to meet this repayment requirement. The process of disposing of assets is continuing and in addition, management is presently seeking replacement financing. Although significant progress has been made to date, and management believes its plans are achievable, there can be no guarantee as to the Company's ability to sell sufficient assets or obtain refinancing within the necessary time frame. Under circumstances which the Company considers unlikely, failure to meet the required repayment schedule would result in its default of the senior lending agreements and allow the senior lenders' acceleration of the debt which the Company would, under these circumstances, be unable to pay. Additionally, acceleration by the senior lenders, if not cured, would enable the trustee or holders of the Company's Subordinated Debentures to require the Company by notice to cause the acceleration to be rescinded within 30 days of such notice. If the Company is unable to accomplish this, the trustee or holders of at least 25% of the Subordinated Debentures could demand immediate payment of the Subordinated Debentures. In such event, the Company would not have sufficient funds to pay the $300 million of outstanding Subordinated Debentures. Consolidation: The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. Significant intercompany transactions have been eliminated in consolidation. The Company uses the equity method to account for investments in a partnership and other corporations in which it does not own a majority voting interest. Translation of Foreign Currencies: Assets and liabilities of international operations are translated into U.S. dollars at current exchange rates. Income and expense accounts are translated into U.S. dollars at average rates of exchange prevailing during the year. Translation adjustments are reflected as a separate component of shareholders' equity. Cash Equivalents: Cash equivalents include investments in government securities funds and certificates of deposit. Investment periods are generally less than one month. Inventories: Inventories are carried at the lower of cost or market, cost being determined principally on the basis of standards which approximate actual costs on the first-in, first-out method. Revenue Recognition: Revenues, other than for long-term contracts, are recorded generally when the Company's products are shipped. Revenues on long-term contracts are recorded principally using the percentage-of-completion method measured on a unit of delivery basis. For long-term construction type contracts not on percentage-of- completion method, revenue is recognized using the completed contract method due to the production cycle as well as historical experience with these products which are manufactured by the Delaval Turbine Division. Depreciation and Amortization: Depreciation and amortization of plant and equipment are computed principally by the straight-line method. Interest Expense: Interest expense incurred during the construction of facilities and equipment is capitalized as part of the cost of those assets. Total interest paid by the Company amounted to $58.6 million in 1993, $58.4 million in 1992 and $60.4 million in 1991. Total interest capitalized was $.1 million in 1993, $.9 million in 1992 and $1.1 million in 1991. Earnings Per Share: Earnings per share are based upon the weighted average number of shares of common stock outstanding. Common stock equivalents related to stock options are excluded because their effect is not material. Intangible Assets: Goodwill of companies acquired is being amortized on the straight-line basis over 40 years. The carrying value of goodwill is reviewed when indicators of impairment are present, by evaluating future cash flows of the associated operations to determine if impairment exists. Goodwill related to continuing operations at December 31, 1993 and 1992 was $74.1 million and $83.9 million, respectively, net of respective accumulated amortization of $13.3 million and $11.5 million. As a result of the decision to sell the Electro-Optical Systems businesses, approximately $104.6 million of associated goodwill was written off at year-end 1993 in connection with the adjustment of the net investment to estimated net realizable value. Patents are amortized over the shorter of their legal or estimated useful lives. Restatements: The Consolidated Financial Statements, and the notes thereto, have been restated to reflect the Company's Electro-Optical Systems business as a discontinued operation in accordance with Accounting Principles Board Opinion No. 30. Certain prior year amounts have been reclassified to conform to the current year presentation. Note 2 Discontinued Operation In January 1994, the Company announced its intention to dispose of its Electro-Optical Systems operations which consists of the Company's subsidiaries Varo Inc. and Baird Corporation. Under a plan approved by the Board of Directors, the Company intends to sell these operations in 1994 and has engaged an outside investment banking firm to assist in the divestiture. In accordance with APB Opinion No. 30, the disposal of this business segment has been accounted for as a discontinued operation and, accordingly, its operating results are segregated and reported as a Discontinued Operation in the accompanying Consolidated Statements of Income. Prior year financial statements have been reclassified to conform to the current year presentation. Net assets and liabilities of the Discontinued Operation consist of the following: December 31 (Dollars in thousands) 1993 1992 Current Assets: Receivables $24,544 $26,378 Inventories 53,093 63,683 Other current assets 1,845 6,172 79,482 96,233 Current Liabilities: Trade accounts payable 13,715 17,010 Other current liabilities 17,774 14,131 31,489 31,141 Net Current Assets $47,993 $65,092 Long-term Assets: Property $40,508 $101,737 Intangible assets - 109,612 Other long-term assets 3,548 2,537 44,056 213,886 Long-term Liabilities 7,049 12,886 Net Long-term Assets $37,007 $201,000 Net Assets $85,000 $266,092 A condensed summary of operations for the Discontinued Operation is as follows: Year Ended December 31 (Dollars in thousands) 1993 1992 1991 Net Sales $171,548 $194,654 $246,674 Income (loss) from operations before income taxes and minority interest (44,933) (48,498) 4,507 Income taxes (benefit) - (15,560) 1,713 Minority interest 383 (198) 903 Income (loss) from operations $(45,316) $(32,740) $ 1,891 Income (loss) from operations of the Discontinued Operation for 1993, 1992 and 1991 includes allocated interest expense. Interest expense of $10.2 million, $7.7 million, and $7.7 million, respectively, was allocated based on the ratio of the estimated net assets to be sold in relation to the sum of the Company's shareholders' equity and the aggregate of outstanding debt at each year end. The 1993 loss from operations of the Discontinued Operation includes unusual charges of $23.3 million. These charges are principally provisions for revised estimates-to-complete on current contracts of $13.9 million, other costs of $5.6 million related to the write-down of assets to net realizable value, $1.9 million of estimated costs associated with settlements of pending litigation and other costs of $1.9 million. Unusual charges of $27.9 million are included in loss from Discontinued Operations in 1992. These charges include provisions for the estimated costs associated with operational disruptions and restructuring, including revised estimates-to-complete on current contracts, of $22 million, costs associated with pending litigation and certain warranty and claim settlements of $4 million, and other costs of $1.9 million related to the write-down of assets, principally inventories, to net realizable value. The Company also recorded charges of $155.3 million at December 31, 1993 (which includes a $104.6 million goodwill write-off. See Note 1) to reduce the carrying amount of the Discontinued Operation to estimated realizable value. Additionally, the Company provided for anticipated operating losses of $12.7 million (including $7.0 million of allocated interest) through the date of sale, which is expected to occur in the last half of 1994. See Note 14 for discussion of contingencies related to the Electro- Optical Systems business. Note 3 Restructuring Plan Asset Divestiture Program On October 29, 1992, the Company announced a restructuring plan pursuant to which it was seeking the divestiture of operations representing approximately 15% of its assets. The planned divestitures included units of its aerospace businesses, units of its instruments and transducer businesses, certain other non-strategic businesses and underutilized real estate holdings. In January 1994, the Company announced plans to include the Electro-Optical Systems operations in the asset divestiture program (See Note 2). As of December 31, 1993, the Company has sold its Heim Bearings, Aerospace and Barksdale Controls operations for proceeds of approximately $91 million, and thus has completed a significant portion of the asset divestiture program. These proceeds, net of related expenses, were used to repay senior debt in the amount of $81.9 million in 1993 in accordance with the terms of the restructured credit facilities (See Note 8). Excluding the Electro-Optical Systems operations, the remaining assets to be sold in this program consist of a unit of the Company's instruments and transducer businesses, certain other non-strategic businesses and underutilized real estate holdings. The Company targets completion of the divestitures over the next 9 to 12 months. Based on current conditions, management now believes that certain of the remaining assets, both operating units and real estate, are unlikely to net the sale prices originally expected. Accordingly, the Company has deferred gains of $18.0 million on the assets divested during 1993 and has provided $10.1 million ($.60 per share) for the net loss now anticipated for the program as a whole. This amount was classified as an unusual charge in loss from continuing operations (See Note 6). The operating units sold and the remaining assets to be sold as part of the asset divestiture program, except for the Electro-Optical Systems operations, have been grouped as a separate segment entitled Other for segment reporting purposes. See Note 10 for segment operating results for the years ending December 31, 1993, 1992 and 1991. These units in total produced essentially break-even results before unusual items and income taxes for the years 1993 and 1992 and income of approximately $4.2 million in 1991. These results are net of $5.9 million, $8.3 million and $8.4 million of interest expense which has been allocated based on net assets for the years 1993, 1992 and 1991, respectively. Restructuring Program In January 1994, the Company announced plans to reduce the Company's cost structure and to improve productivity on a worldwide basis. The actions under this restructuring plan will include reductions in the number of employees and the consolidation of certain of the Company's operating units. The Company plans to consolidate its four domestic turbomachinery aftermarket maintenance operations into one operating unit and combine certain operations of its European mechanical controls and automotive components operating units. In the fourth quarter of 1993, the Company recorded a charge of $8.6 million ($.51 per share) relating to this program, which amount was classified as an unusual charge in loss from continuing operations (See Note 6). The restructuring charge was principally comprised of severance costs and impacts both the Company's industry segments and the Corporate office (See Note 10). At December 31, 1993, $8.4 million is included in accrued expenses and other liabilities related to restructuring costs. Note 4 Inventories Inventories are summarized as follows: December 31 (Dollars in thousands) 1993 1992 Finished products $ 39,074 $ 49,522 Work in process 65,802 69,415 Materials and supplies 45,786 58,147 150,662 177,084 Less customers' progress payments 20,848 16,567 Less valuation allowance 13,560 17,293 $116,254 $143,224 Note 5 Accrued Expenses and Other Liabilities Accrued expenses and other liabilities consist of the following: December 31 (Dollars in thousands) 1993 1992 Accrued contract completion costs $ 967 $ 773 Accrued product warranty costs 8,907 8,666 Accrued litigation and claim costs 14,312 18,751 Payroll and related items 15,139 18,455 Accrued interest payable 11,590 12,934 Customer advance payments 5,168 16,604 Accrued restructuring costs 8,414 - Accrued financing fees 5,000 - Other 19,414 13,954 $ 88,911 $ 90,137 Note 6 Unusual Items During the twelve months ended December 31, 1993, the Company recognized unusual charges of $17.7 million ($1.05 per share) in loss from continuing operations. During the fourth quarter of 1993, the Company recognized charges of $23.7 million that include provisions of $8.6 million related to the restructuring and consolidation of certain of the Company's operating units (See Note 3), $10.1 million expected net loss overall, based on current conditions, related to the Company's asset divestiture program (See Note 3) and $5.0 million in debt related financing fees associated with obtaining consents from holders of its 12.25% Senior Subordinated Debentures to amend the indenture governing these debentures and obtain waivers from its senior lenders for non-compliance with certain financial covenants as a result of the fourth quarter net loss (See Note 8). These charges are net of unusual income of $6.0 million recorded in the third quarter of 1993 as a result of a change in estimate related to legal costs associated with pending litigation. The twelve months ended December 31, 1992 include unusual charges of $24.0 million in loss from continuing operations. These charges are principally provisions for the estimated costs associated with pending litigation and certain warranty and claim settlements. Note 7 Income Taxes The components of income tax expense (benefit) from continuing operations are: Year Ended December 31 (Dollars in thousands) 1993 1992 1991 Current: Federal $ - $ - $2,543 Foreign - - 1,652 State - - 894 - - 5,089 Deferred: Federal 14,400 (5,813) 125 Foreign and State 600 (4,513) 747 15,000 (10,326) 872 $15,000 $(10,326) $5,961 The $15.0 million deferred income tax expense recorded in 1993 relates to adjustments in valuation allowances on deferred tax assets recorded in prior years due to changes in estimates of recoverability. The Company adopted FASB Statement No. 109 "Accounting for Income Taxes" effective January 1, 1992. This Statement supersedes Statement No. 96 "Accounting for Income Taxes" which was adopted by the Company in 1987. The effect of adopting Statement No. 109 on the Company's December 31, 1992 financial statements is not material. Under Statement No. 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities as of December 31, 1993 and 1992 are as follows: December 31 (Dollars in thousands) 1993 1992 Current Long-term Current Long-term Deferred tax assets: Postretirement benefit obligation $ 765 $ 14,340 $ - $ 17,150 Expenses not currently deductible 21,308 32,436 27,997 - Net operating loss carryover - 17,150 - - Tax credit carryover - 1,755 - 1,550 Total deferred tax assets 22,073 65,681 27,997 18,700 Valuation allowance for deferred tax assets (15,061) (45,154) - (1,500) Net deferred tax assets 7,012 20,527 27,997 17,200 Deferred tax liabilities: Tax over book depreciation - 17,708 - 20,251 Difference between book and tax basis of property - 8,455 - 16,659 Difference between book and tax basis of income recognition 4,332 4,332 - - Other - 3,976 42 3,508 Total deferred tax liabilities 4,332 34,471 42 40,418 Net deferred tax assets (liabilities) $ 2,680 $(13,944) $27,955 $(23,218) The components of deferred income tax expense (credit) from continuing operations are as follows for the year ended December 31, 1991: (Dollars in thousands) Accelerated depreciation $ 1,422 Reserves not deductible in year provided 1,344 Inventory valuation (1,635) Difference between book and tax basis of income recognition - Other (259) $ 872 At December 31, 1993, unremitted earnings of foreign subsidiaries were approximately $24 million. Since it is the Company's intention to indefinitely reinvest these earnings, no U.S. taxes have been provided. Determination of the amount of unrecognized deferred tax liability on these unremitted earnings is not practicable. The amount of foreign withholding taxes that would be payable upon remittance of those earnings is approximately $1 million. The components of income (loss) from continuing operations before income taxes, minority interest, extraordinary item and cumulative effect of change in accounting principle are: Year Ended December 31 (Dollars in thousands) 1993 1992 1991 United States $(20,310) $(34,437) $10,170 Foreign (3,667) 2,269 5,519 $(23,977) $(32,168) $15,689 U.S. income tax expense (benefit) at the statutory tax rate is reconciled below to the overall U.S. and foreign income tax expense (benefit). Year Ended December 31 (Dollars in thousands) 1993 1992 1991 Tax at U.S. federal income tax rate $ (8,392) $(10,937) $5,334 State taxes, net of federal income tax effect 396 (1,092) 881 Impact of foreign tax rates and credits - 141 (232) Impact of foreign sales corporation exempt income - (702) (994) Net U.S. tax on distributions of current foreign earnings - 175 (663) Goodwill amortization 694 1,554 1,692 Other/valuation reserve 22,302 535 (57) Income taxes (benefit) $ 15,000 $(10,326) $5,961 Net income tax refunds received during 1993 were $7 million and income taxes paid during 1992 and 1991 were $3.7 million and $6.6 million, respectively. The Company has a net operating loss carryforward of approximately $49 million expiring in 2008, and has foreign tax credit carryforwards of approximately $5 million expiring through 1998. These carryforwards are available to offset future taxable income and have been reserved in accordance with FASB Statement No. 109. Note 8 Notes Payable and Long-Term Debt As of July 15, 1993, the Company completed a definitive agreement with its domestic senior lenders for the restructuring of its senior credit facilities. The agreement provides the Company with a new credit facility ("New Facility") through March 31, 1995, and includes provisions for letters of credit outstanding at that time to continue through March 31, 1996. The New Facility provides approximately $60 million of revolving credit (reduced in February 1994 from $65 million by agreement of the Company and the lenders thereunder) for working capital loans and letters of credit to support commercial contracts. As of December 31, 1993, $29.7 million in loans and $38.2 million in standby letters of credit were outstanding under these facilities of which $15 million in loans and $22.5 million in letters of credit were outstanding under the New Facility and the remainder was outstanding under the restructured credit facility. Moreover, the Company currently has approximately $37.5 million in foreign short-term credit facilities with approximately $14.4 million outstanding. Due to the short-term nature of these debt instruments, it is the Company's opinion that the carrying amounts approximate the fair value. The weighted average interest rate on short-term notes payable was 8.2% at both December 31, 1993 and 1992. In compliance with the agreement, the Company has proceeded with its previously announced divestiture program by reducing the Company's currently existing senior debt and outstanding letters of credit obligations by approximately $81.9 million from the net proceeds of businesses sold as of December 31, 1993. The program requires additional installments of $35 million by March 31, 1994 and September 30, 1994, subject to earlier payment out of asset sale proceeds from the divestiture program. As of December 31, 1993, payments of $26.9 million have been made toward the March 31, 1994 amount due. Senior notes in the amount of $30 million will mature on March 31, 1995, except that the Company may, at its option, extend the notes to at least March 31, 1996 and, with the concurrence of the holder, through December 1, 2002. The agreement modified certain financial covenants and provided for a waiver of defaults arising from the charges taken in the third quarter of 1992. Both the new facility and the current senior debt are secured by the assets of the Company's domestic operations and the stock of certain of the Company's subsidiaries. Long-term debt of continuing operations consists of the following: December 31 (Dollars in thousands) 1993 1992 Promissory note with interest at 12.75%, due March 31, 1995 $ 30,000 $ 30,000 Promissory note with interest at 10.35%, $5 million due annually from 1994 to 2003 4,379 50,000 Make-Whole Notes with interest at 2% over the prime rate, due December 31, 1996 11,519 - Senior subordinated debentures with interest at 12.25%, due August 15, 1997 150,000 150,000 Senior subordinated debentures with interest at 12%, due November 1, 1999 to 2001 150,000 150,000 Other 16,381 19,357 362,279 399,357 Less current portion 8,527 85,083 $353,752 $314,274 The aggregate annual maturities of long-term debt from continuing operations, in thousands, for the four years subsequent to December 31, 1994 are: 1995 - $33,374; 1996 - $13,606; 1997 - $151,446; and 1998 - $926. Total debt of the discontinued operation, in thousands, amounted to $1,919 and $6,352 for 1993 and 1992, respectively. Of these amounts, approximately $1,807 and $5,476 represent the long-term portion. The 12.25% senior subordinated debentures are redeemable in whole or in part at the option of the Company at any time on or after August 15, 1992, at 105% of their principal amount, plus accrued interest, declining to 100% of their principal amount, plus accrued interest, on or after August 15, 1994. Interest is payable semi-annually on February 15 and August 15. The fair value of these instruments at December 31, 1993, based on market bid prices, was $151.5 million. The 12% senior subordinated debentures are redeemable in whole or in part at the option of the Company at any time on or after November 1, 1994, at 105% of their principal amount, plus accrued interest, declining to 100% of their principal amount, plus accrued interest at any time on or after November 1, 1996. Interest is payable semi- annually on May 1 and November 1. The fair value of these instruments at December 31, 1993, based on market bid prices, was $152.25 million. As part of the Company's domestic debt restructuring, the 12.75% and 10.35% senior notes will mature on March 31, 1995, except that the Company may, at its option, extend the $30 million 12.75% senior note to at least December 31, 1996 and, with the concurrence of the holder, through December 1, 2002, in which event, $6 million will become due on December 1 in each of the years 1995 and 1996, and $3 million will be due annually from December 1, 1997 to 2002. At any time at or after the scheduled repayment of $125 million of the Company's currently existing senior debt and outstanding letters of credit obligations, the Company also has the option to prepay the $30 million 12.75% senior notes in whole or in part at 112.33% of their principal amount, plus accrued interest, in 1994, declining to 100% of their principal amount, plus accrued interest, in 2002. The senior 12.75% and 10.35% promissory note agreements and the restructured credit facility require the Company, among other things, to meet certain objectives with respect to financial ratios and they and the 12.25% and 12% senior subordinated debentures contain provisions which place certain limitations on dividend payments and outside borrowings. Under the most restrictive of such provisions, the Company must maintain certain minimum consolidated net worth levels and the Company is prohibited from declaring or paying cash dividends through at least March 31, 1995. The Make-Whole Notes were issued to the Company by one of its senior lenders during 1993 in connection with the reduction of debt owed to that senior lender. The notes require interest payments of 2% over prime payable quarterly on the last day of March, June, September and December. The principal amounts are due on December 31, 1996. Based on borrowing rates currently available to the Company for bank loans with similar terms and maturities, the carrying values of the senior notes and the Make-Whole Notes are estimated to approximate the fair values. As a result of the loss for the fourth quarter of 1993, the Company was not in compliance with several of the financial covenants under its senior credit facilities. It has subsequently received waivers of such defaults and amendments to these agreements from its senior lenders. Moreover, in February, 1994 the Company obtained the consent of its 12.25% Senior Subordinated Debenture holders to amend the indenture governing these debentures and permit the Company to incur up to $35 million indebtedness (including letters of credit and foreign borrowings) above the level outstanding at year-end 1993. The foregoing waivers, amendments, and consent should give the Company sufficient financial flexibility to meet its financial commitments until such time as its recently announced plans to sell the Electro- Optical Systems business are completed. Bank, advisory and legal fees associated with the restructuring amounted to approximately $8.0 million payable in 1993. In addition, 200,000 warrants for the Company's common stock, valued at approximately $.4 million, were issued to one senior lender and, as part of the $125 million repayment plan, the Company has recognized a charge in 1993 of approximately $12 million on the prepayment of its senior notes which was partially financed with Make-Whole Notes from one of its senior lenders and the write-off of approximately $2 million of previously deferred loan costs. Approximately $18.1 million ($1.07 per share) of the above amounts relate to the extinguishment of senior debt and were recorded as an extraordinary item in 1993 . The Company believes that funds generated from operations, together with the restructured credit facilities, anticipated proceeds from the asset divestiture program and available cash, are sufficient to meet its liquidity requirements for the foreseeable future (See Note 1). Note 9 Shareholders' Equity Equity Incentive Plan Under the Company's Equity Incentive Plan, up to 2,200,000 shares of the Company's $1.00 par value common stock can be issued pursuant to the granting of stock options, stock appreciation rights, restricted stock awards and restricted unit awards to key employees. Options can be granted at no less than 100 percent of the fair market value of the stock on the date of grant or on the prospective date fixed by the Board of Directors. None of these options can be exercised for at least a one-year period from the date of grant. After this waiting period, 25 percent of each option, on a cumulative basis, can be exercised in each of the following four years. Additionally, each option shall terminate no later than 10 years from the date of grant. On August 17, 1993, the Board of Directors approved the repricing of certain outstanding non-qualified stock options granted on previous dates under the Plan. This resulted in the replacement of 468,000 non- qualified stock options at various exercise prices ranging from $10.375 to $20.375, by 272,865 non-qualified stock options at an exercise price of $7.375, the fair market value at the date of the replacement grant, subject to the market price of the Company's stock exceeding $10 per share for a period of 30 days. Vested dates are based on the original grant dates of the replaced options. The plan permits awards of restricted stock to key employees subject to a restricted period and a purchase price, if any, to be paid by the employee as determined by the Committee of the Equity Incentive Plan. In 1993, grants of 30,000 shares of restricted stock were made and on December 31, 1993 there were 30,000 of such shares outstanding. Vesting of such awards is subject to a defined vesting period and to the Company's stock achieving certain performance levels during such period. Stock option activity under the plan was as follows: Year Ended December 31 (Shares in thousands) 1993 1992 1991 Options: Grante 498 197 137 Exercised - (14) (47) Cancelled (150) (225) (63) Repricing Cancelled (468) - - Issued 273 - - Outstanding at end of year 1,307 1,154 1,196 Exercisable at end of year 652 767 622 Available for grant at end of year 341 524 496 Option price range per share: Granted $7.375 $11.125- $11.875- $12.00 $14.375 Exercised - $10.375 $7.00 During 1988, the Company adopted the Equity Incentive Plan for Outside Directors. The plan provides for the granting of non-qualified stock options of up to 600,000 shares of the Company's common stock to directors of the Company who are not employees of the Company or any of its affiliates. Pursuant to this plan, options can be granted at no less than 100 percent of the fair market value of the stock on a date five business days after the option is granted and no option granted may be exercised during the first year after its grant. After this waiting period, 25 percent of each option, on a cumulative basis, can be exercised in each of the following four years. In February 1988, 320,000 stock options were granted at $16.19 per share, all of which were exercisable as of December 31, 1993. In December 1990, 40,000 stock options were granted at $10.375 per share, 30,000 of which were exercisable as of December 31, 1993. Preferred Stock Purchase Rights On April 22, 1987, the Board of Directors declared a distribution of one Preferred Stock Purchase Right for each share of common stock outstanding. Each right will entitle the holder to buy from the Company a unit consisting of 1/100 of a share of Junior Participating Preferred Stock, Series A, at an exercise price of $70 per unit. The rights become exercisable ten days after public announcement that a person or group has acquired 20 percent or more of the Company's common stock or has commenced a tender offer for 30 percent or more of common stock. The rights may be redeemed prior to becoming exercisable by action of the Board of Directors at a redemption price of $0.025 per right. If more than 35 percent of the Company's common stock becomes held by a beneficial owner, other than pursuant to an offer deemed in the best interest of the shareholders by the Company's independent directors, each right may be exercised for common stock, or other property, of the Company having a value of twice the exercise price of each right. If the Company is acquired by any person after the rights become exercisable, each right will entitle its holder to receive common stock of the acquiring company having a market value of twice the exercise price of each right. The rights expire on May 4, 1997. Employee Stock Savings Plan Up to 600,000 shares of the Company's common stock are reserved for issuance under the Company's Employee Stock Savings Plan. (See Note 11) Common Stock Warrants In July 1993, the Company issued warrants to purchase 200,000 shares of its common stock at $9.02 per share (subject to adjustment in certain events), to one of its senior lenders in connection with the restructuring of its senior credit facilities. The warrants are exercisable on or before December 31, 1998. Note 10 Operations by Industry Segment and Geographic Area The Company classifies its continuing operations into four business segments: Morse Controls; Pumps, Power Transmission & Controls; Turbomachinery, and Other. Detailed information regarding products by segment is contained in the section entitled "Business" included in Part I, Item 1 of this Form 10-K Report. In 1993, the Company redefined its business segments and restated previously reported financial information. Information about the business of the Company by business segment, foreign operations and geographic area is presented below: Year Ended December 31 (Dollars in thousands) 1993 1992 1991 Net sales Morse Controls $163,876 $192,733 $192,512 Pumps, Power Transmission & Controls 249,896 265,336 270,309 Turbomachinery 147,526 160,420 181,267 Other 80,411 115,114 133,224 Total net sales $641,709 $733,603 $777,312 Segment operating income (loss) Morse Controls $ 3,539 $ 6,626 $ 8,813 Pumps, Power Transmission & Controls 22,201 19,974 24,092 Turbomachinery 4,668 1,945 23,447 Other 2,104 (7,059) 12,707 Total segment operating income 32,512 21,486 69,059 Equity in income of unconsolidated companies 2,550 6,297 4,878 Unallocated corporate expenses (13,460) (10,533) (8,955) Net interest expense (45,579) (49,418) (49,293) Income (loss) from continuing operations before income taxes, minority interest, extraordinary item and cumulative effect of change in accounting principle $(23,977) $(32,168) $15,689 A reconciliation of segment operating income to income from operations follows: Year Ended December 31 (Dollars in thousands) 1993 1992 1991 Segment operating income $ 32,512 $ 21,486 $ 69,059 Unallocated corporate expense (13,460) (10,533) (8,955) Other Income (172) (2,017) (777) Income from operations $ 18,880 $ 8,936 $ 59,327 Segment operating income (loss) for the year ended December 31, 1993, includes $11.5 million of unusual charges, of which $3.7 million, $1.7 million, $2.0 million and $4.1 million relates to the Morse Controls, Pumps, Power Transmission & Controls, Turbomachinery and Other segments, respectively. Unallocated corporate expenses include unusual charges of $6.2 million for the year ended December 31, 1993. Segment operating income (loss) for the year ended December 31, 1992, includes unusual charges of $24.0 million, of which $.3 million, $.4 million, $7.3 million and $16.0 million relates to the Morse Controls, Pumps, Power Transmission & Controls, Turbomachinery and Other segments, respectively. Summary financial information for unconsolidated companies (all Foreign) follows: Year Ended December 31 (Dollars in thousands) 1993 1992 1991 Net sales $ 91,180 $137,385 $120,652 Gross profit 23,984 36,948 33,970 Net income 4,979 12,720 9,827 Equity in income of unconsolidated companies (by associated segment) Morse Controls 40 607 709 Turbomachinery 2,510 5,690 4,169 Equity in income of unconsolidated companies $ 2,550 $ 6,297 $ 4,878 December 31 (Dollars in thousands) 1993 1992 Current assets $ 2,219 $ 33,871 Non-current assets 13,493 12,471 Current liabiliabilities 31,550 32,235 Non-current liabilities 1,557 1,191 Net assets $ 12,605 $ 12,916 Total direct sales on prime contracts to the Department of Defense of the United States Government for continuing operations were $30.1 million in 1993 (Pumps, Power Transmission & Controls segment - $18.6 million; Turbomachinery segment - $3.4 million; and Other - $8.1 million), $35.4 million in 1992 (Pumps, Power Transmission & Controls - - $18.7 million; Turbomachinery segment - $4.6 million; and Other - $12.1 million), and $41.0 million in 1991 (Pumps, Power Transmission & Controls segment - $25.4 million; Turbomachinery - $4.1 million; and Other - $11.5 million). The Morse Controls segment had sales to one commercial customer that accounted for 12%, 15% and 15% of consolidated sales in 1993, 1992 and 1991, respectively. No other customer accounted for 10% or more of consolidated sales in 1993, 1992 or 1991. Year Ended December 31 (Dollars in thousands) 1993 1992 1991 Identifiable assets Morse Controls $155,745 $167,717 $191,748 Pumps, Power Transmission & Controls 196,748 194,408 215,089 Turbomachinery 86,941 99,937 98,484 Other 55,434 130,599 138,663 Corporate 58,043 91,827 51,171 Discontinued Operation 85,000 266,092 286,919 Total identifiable assets $637,911 $950,580 $982,074 Depreciation and amortization Morse Controls $ 6,775 $ 7,737 $ 7,485 Pumps, Power Transmission & Controls 9,449 9,388 9,501 Turbomachinery 6,209 6,627 6,446 Other 3,435 4,622 5,024 Corporate 3,516 2,499 2,439 Total depreciation and amortization $ 29,384 $ 30,873 $ 30,895 Capital expenditures Morse Controls $ 4,907 $ 5,638 $ 5,258 Pumps, Power Transmission & Controls 4,065 5,055 5,526 Turbomachinery 3,492 3,169 3,766 Other 1,069 982 2,037 Corporate 352 3,282 1,813 Total capital expenditures $13,885 $ 18,126 $ 18,400 The continuing operations of the Company on a geographic basis are as follows: Year Ended December 31 (Dollars in thousands) 1993 1992 1991 Net sales United States $452,455 $496,224 $528,849 Foreign (principally Europe) 189,254 237,379 248,463 Total net sales $641,709 $733,603 $777,312 Segment operating income United States $ 31,829 $ 13,947 $ 56,425 Foreign 683 7,539 12,634 Total segment operating income $ 32,512 $ 21,486 $ 69,059 Identifiable assets Continuing Operations: United States $378,739 $503,991 $479,885 Foreign 174,172 180,497 215,270 Discontinued Operation: United States 80,252 262,178 279,834 Foreign 4,748 3,914 7,085 Total identifiable assets $637,911 $950,580 $982,074 Export sales Asia $ 27,521 $ 27,701 $ 34,732 Latin America 12,962 6,877 4,552 Canada 10,882 8,027 9,387 Mexico 7,504 1,837 6,102 Europe 4,901 9,795 7,178 Other 7,992 8,646 8,345 Total export sales $ 71,762 $ 62,883 $ 70,296 Note 11 Pension Plans The Company and its subsidiaries have various pension plans covering substantially all of their employees. Benefits are based on either years of service or years of service and average compensation during the years immediately preceding retirement. Pension expense was $8.4 million in 1993, $8.7 million in 1992, and $8.8 million in 1991, and includes amortization of prior service cost and transition amounts for periods of 6 to 13 years. The Company's divestiture program resulted in a decrease in U.S. pension plan participants during 1993. The total curtailment and settlement gain of $1.2 million was applied to the reserve for divestitures (see Note 3). The Company included a $1.9 million curtailment loss in its estimated loss on disposal related to the discontinued operation. It is the general policy of the Company to fund its pension plans in conformity with requirements of applicable laws and regulations. Pension expense (including $1.1 million, $1.0 million and $0.8 million charged to discontinued operations in 1993, 1992 and 1991, respectively) is comprised of the following: Year Ended December 31 (Dollars in thousands) 1993 1992 1991 Service cost $ 7,678 $ 7,526 $ 7,641 Interest cost on projected benefit obligation 13,802 14,271 13,282 Actual return on plan assets (22,646) (10,620) (26,436) Net amortization and deferral 9,567 (2,452) 14,324 Net pension expense $ 8,401 $ 8,725 $ 8,811 Assumptions used in the accounting for the Company-sponsored defined benefit plans: Year Ended December 31 1993 1992 1991 Weighted average discount rate 7.5% 8.0% 8.5% Rate of increase in compensation levels 5.3% 5.3% 6.0% Expected long-term rate of return on assets 9.0% 9.0% 9.0% The following table sets forth the funded status and amounts recognized in the consolidated balance sheet for the defined benefit pension plans: Year Ended December 31 (Dollars in thousands) 1993 1992 Assets Accumulated Assets Accumulated Exceed Benefits Exceed Benefits Accumulated Exceed Accumulated Exceed Benefits Assets Benefits Assets Actuarial present value of benefit obligations: Vested benefit obligation $102,819 $ 62,394 $ 72,087 $ 79,985 Accumulated benefit obligation $107,089 $ 63,428 $ 73,682 $ 81,938 Projected benefit obligation $128,485 $ 64,432 $ 85,231 $ 96,000 Plan assets at fair value 135,616 49,326 112,877 67,251 Plan assets in excess of (less than) projected benefit obligation 7,131 (15,106) 27,646 (28,749) Unrecognized net (gain) or loss (1,300) 1,752 (7,080) 4,504 Prior service cost not yet recognized in net periodic pension cost 4,779 3,524 6,155 3,256 Unrecognized net (asset) obligation at transition 4,198 1,251 (1,672) 6,857 Adjustment required to recognize minimum liability - (6,507) - (5,834) Pension asset (liability) recognized in the balance sheet $ 14,808 $ (15,086) $ 25,049 $(19,966) Plan assets at December 31, 1993, are invested in fixed dollar, guaranteed investment contracts, United States Government obligations, fixed income investments, guaranteed annuity contracts and equity securities whose values are subject to fluctuations of the securities market. The Company maintains a defined contribution (Employee Stock Savings) plan covering substantially all domestic, non-union employees. Eligible employees may generally contribute from 1% to 12% of their compensation on a pretax basis. The Company's historical matching percentage is 50% of the first 6% of each participant's pretax contribution. The employer matching contributions have been temporarily suspended since July 1992. The Company's expense was $1.8 million and $3.5 million for 1992 and 1991, respectively. Note 12 Postretirement Benefits In addition to providing pension benefits, the Company provides certain health care and life insurance benefits for retired employees. Substantially all of the Company's non-union employees retiring from active service and immediately receiving retirement benefits from one of the Company's pension plans would be eligible to receive such benefits. The Company's unionized retiree benefits are determined by their individually negotiated contracts. The Company's contribution toward the full cost of the benefits is based on the retiree's age and continuous unbroken length of service with the Company. The Company's policy is to pay the cost of medical benefits as claims are incurred. Life insurance costs are paid as insured premiums are due. In December 1990, the FASB issued Statement No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," which requires the accrual method of accounting for postretirement benefits. The accumulated benefit obligation at transition of $44.5 million was recognized as a cumulative effect of a change in accounting principle net of $16.9 million of income taxes calculated in accordance with the FASB's Statement No. 109, "Accounting for Income Taxes" (see Note 5), and retroactively applied as of January 1, 1992. In prior years, the cost for life insurance benefits was recognized as premiums were paid and the cost of retiree health care was recognized when claims were paid. The following tables set forth the plans' combined status reconciled with the amounts included in the consolidated balance sheet: December 31 (Dollars in thousands) 1993 Life Medical Insurance Plans Plans Total Accumulated postretirement benefit obligation: Retirees $28,134 $8,035 $36,169 Fully eligible active plan participants 6,130 1,200 7,330 Other active plan participants 3,750 520 4,270 38,014 9,755 47,769 Plan assets - - - Unrecognized net loss (3,693) (920) (4,613) Postretirement benefit liability recognized in the balance sheet $34,321 $8,835 $43,156 December 31 (Dollars in thousands) 1992 Life Medical Insurance Plans Plans Total Accumulated postretirement benefit obligation: Retirees $22,089 $ 7,925 $30,014 Fully eligible active plan participants 6,970 1,425 8,395 Other active plan participants 3,595 700 4,295 32,654 10,050 42,704 Plan assets - - - Accrued postretirement benefit $32,654 $10,050 $42,704 The 1993 and 1992 accrued postretirement benefits amounts are comprised of current liabilities of $2.2 million and $2.5 million, and long-term liabilities of $41.0 million and $40.2 million, respectively. As a result of the divestitures in 1993, the Company recognized a $2.2 million gain related to the curtailment of its postretirement benefit plans. This curtailment gain was applied to the reserve for divestitures. (See Note 3) As a result of the Company's decision to sell its Electro-Optical Systems operations a curtailment gain of $1.3 million was recognized. This curtailment gain is a component of the estimated loss on disposal of discontinued operations. (See Note 2) Net periodic postretirement benefit cost (including $.3 million charged to discontinued operations in both 1993 and 1992) included the following components: Year Ended December 31 (Dollars in thousands) 1993 1992 Life Life Medical Insurance Medical Insurance Plans Plans Plans Plans Service cost $ 372 $ 63 $ 407 $ 98 Interest cost 2,999 750 2,778 865 Net periodic postretirement benefit cost $ 3,371 $ 813 $ 3,185 $ 963 Actual negotiated health care premiums were used in calculating 1993 and 1992 health care costs. It is expected that the annual increase in medical costs will be 9.6% from 1993 to 1994 and will be 13.5% in 1995, grading down in future years by .5% per year until it reaches a future general medical inflation level of 6%. Inflation has been capped at 200% for active non-union employees. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, a 1% increase in the health care trend rate would increase the accumulated postretirement benefit obligation by $3.1 million at year end 1993 and the net periodic cost by $.2 million for the year. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.5% and 8.5% in 1993 and 1992, respectively. In March 1994, the Company amended its policy regarding retiree medical and life insurance. This amendment, which affects some current retirees and all future retirees, phases out the Company subsidy for retiree medical and life insurance over a three year period ending January 1, 1997. The Company expects to amortize associated reserves to income over the phase out period at approximately $7 million per year. The Company does not anticipate a significant increase or decrease in cash requirements related to this change in policy during the phase out period. The Company also lowered the discount rate in 1993 to 7.5% from 8.5% in 1992 in line with the change in the overall economic environment. This change has an insignificant effect on the net periodic postretirement benefit cost. Postretirement benefit costs for 1991, which were recorded on a cash basis, totaled approximately $3.3 million, net of premiums received from retirees. Note 13 Leases The Company leases certain manufacturing and office facilities, equipment, and automobiles under long-term leases. Future minimum rental payments required under operating leases of continuing operations that have initial or remaining noncancelable lease terms in excess of one year, as of December 31, 1993, are: (Dollars in thousands) 1994 $ 5,532 1995 4,275 1996 3,031 1997 1,646 1998 1,113 Thereafter 3,440 Total minimum lease payments $19,037 Total rental expense under operating leases charged against continuing operations was $10.1 million in 1993, $11.5 million in 1992 and $11.9 million in 1991. Note 14 Contingencies In August 1985, the Company was named as defendant in a lawsuit filed by Long Island Lighting Company ("LILCO"). The action stemmed from the sale of three diesel generators to LILCO for use at its Shoreham Nuclear Power Station. During testing of the diesel generators, the crankshaft of one of the diesel generators severed. The Company's insurers have defended the action under a reservation of rights. On April 10, 1991, a jury, in a trial limited to liability, in the U.S. District Court in the Southern District of New York, found that the warranty was in effect from the time of shipment of the diesel generators until July 1986. On July 22, 1992, the trial court entered a judgment in the amount of $18.3 million which included interest to the judgment date. On September 22, 1993, the Second Circuit Court of Appeals affirmed all lower court decisions in this matter. On October 25, 1993, the judgment against the Company was satisfied by payment to LILCO of approximately $19.3 million by two of the Company's insurers. In late June 1992, the Company filed an action in the Northern District of California against one of its insurers in an attempt to collect amounts for defense costs paid to counsel retained by the Company in defense of the LILCO litigation. The insurer has refused to reimburse the Company for approximately $8 million in defense costs paid by the Company alleging that defense costs above reasonable levels were expended in defending this litigation. Upon motion by the defendant this action has now been transferred to the Southern District of New York and assigned to one of the judges who heard the underlying LILCO trial. In January 1993, the Company was served a complaint in a case brought in California by another insurer alleging that the insurer was entitled to recover $10 million in defense costs previously paid in connection with the LILCO matter and $1.2 million of the judgment which was paid on behalf of the Company. The complaint alleges inter alia that the insurer's policies did not cover the matters in question in the LILCO case. An Answer denying the complaint has been filed in connection with this matter. The Company and one of its subsidiaries are two of a large number of defendants in a number of lawsuits brought by approximately 20,000 claimants who allege injury caused by exposure to asbestos. Although the Company and its subsidiary have never been producers or direct suppliers of asbestos, it is alleged that the industrial and marine products sold by the Company and the subsidiary had components which contained asbestos. The allegations state a claim for asbestos exposure when Company-manufactured equipment was maintained or installed. Suits against the Company have been tendered to its insurers who are defending under their stated reservation of rights. The insurers for the subsidiary are being identified and will be provided notice. A tentative settlement agreement relating to approximately 10,000 claimants has been reached. Should additional settlements be reached at comparable levels, the settlements will not have a material effect on the Company. The activities of certain employees of the Ni-Tec Division of the Company's Varo Inc. subsidiary ("Ni-Tec"), headquartered in Garland, Texas, are the focus of an ongoing investigation by the Office of the Inspector General of the United States Department of Defense and the Department of Justice (Criminal Division). On July 16, 1992, Ni-Tec received a subpoena for certain records as a part of the investigation, which subpoena has been responded to. Additional subpoenas for additional documents were received in September 1992, February 1993 and March 1994. The Company has responded to the September subpoena, the government subsequently withdrew the February subpoena, and the Company is in the process of responding to the March subpoena. The investigation appears directed at quality control, testing and documentation activities which began at Ni-Tec while it was a division of Optic-Electronic Corp. Optic-Electronic Corp. was acquired by the Company in November 1990 and subsequently merged with Varo Inc. in 1991. The Company continues to cooperate fully with the investigation. In a number of instances the Company has received Notice of Potential Liability from the United States Environmental Protection Agency alleging that various of its divisions had arranged for the disposal of hazardous wastes at a number of facilities that have been targeted for cleanup pursuant to the Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"). In each instance the Company believes that it qualifies as a de minimis or minor contributor to each site with a large number of Potential Responsible Parties ("PRP's") owning a greater share. Accordingly, the Company believes that the portion of remediation costs that it will be responsible for will therefore not be material. For additional information see section entitled Environmental Matters in Part I, Item 1 of this Form 10-K Report. The Company currently has pending against it, a lawsuit relating to performance shortfalls in products delivered by its Delaval Turbine Division in a prior year. With respect to the litigation and claims described in the preceding paragraphs, it is management's opinion that the Company either expects to prevail, has adequate insurance coverage or has established appropriate reserves to cover potential liabilities; however, the ultimate outcome of any of these matters is indeterminable at this time. In addition, the Company is involved in various other pending legal proceedings arising out of the Company's business. The adverse outcome of any of these legal proceedings is not expected to have a material adverse effect on the financial condition of the Company. However, if all or substantially all of these legal proceedings were to be determined adversely to the Company, which is viewed by the Company as only a remote possibility, there could be a material adverse effect on the financial condition of the Company. Reported profits from the sale of certain products to the U.S. Government and its agencies are subject to adjustments. In the opinion of management, refunds, if any, will not have a material effect upon the consolidated financial statements. The Company is self-insured for a portion of its product liability and certain other liability exposures. Depending on the nature of the liability claim, and with certain exceptions, the Company's maximum self-insured exposure ranges from $250,000 to $500,000 per claim with certain maximum aggregate policy limits per claim year. With respect to the exceptions, which relate principally to diesel and turbine units sold before 1991, the Company's maximum self-insured exposure is $5 million per claim. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS Board of Directors, Imo Industries Inc. We have audited the accompanying consolidated balance sheets of Imo Industries Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows and shareholders' equity (deficit) for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Imo Industries Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements as a whole, present fairly in all material respects the information set forth herein. As discussed in Note 12 to the financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions. ERNST & YOUNG Princeton, New Jersey March 18, 1994

43952_1993.txt

43952_1993

1993

43952

ITEM 1. Business. Registrant ("Grey") and its subsidiaries (collectively with Grey, the "Company") have been engaged in the planning, creation, supervision and placing of advertising since the Company's formation in 1917. Grey was incorporated in New York in 1925 and changed its state of incorporation to Delaware in 1974. The Company's principal business activity consists of providing a full range of advertising services to its clients. Typically, this involves developing an advertising and/or marketing plan after study of a client's business, the distribution or utilization of the client's products or services and the use of various media (e.g., television, radio, newspapers, magazines, direct mail, outdoor billboards) by which desired market performance can best be achieved. The Company then creates advertising, prepares media recommendations and places advertising in the media. The Company's business also involves it in allied areas such as marketing consultation, audio-visual production, cooperative advertising programs, direct marketing, research, product publicity, public relations and sales promotion. The Company is not engaged in more than one industry segment, and no separate class of similar services contributed 10% or more of the Company's gross income or net income during 1993, 1992 or 1991. The Company serves a diversified client roster in the apparel, automobile, beverage, chemical, community service, computer, corporate, electrical appliance, entertainment, food product, home furnishing, houseware, office product, packaged goods, publishing, restaurant, retailing, toy and travel sectors. Advertising is a highly competitive business in which agencies of all sizes strive to attract new clients or additional assignments from existing clients. Competition for new business, however, is restricted from time to time because large agencies (such as the Company) often are precluded from providing advertising services for products or services that may be viewed as being competitive with those of an existing client. Generally, since advertising agencies charge clients substantially equivalent rates for their services, competitive efforts principally focus on the skills of the competing agencies. Published reports indicate that there are over 500 advertising agencies of all sizes in the United States. In 1993, the Company was the 6th largest United States advertising agency in terms of domestic gross income according to statistics published in Adweek, a trade publication. Approximately 54% of the Grey's present domestic advertising clients, representing a significant majority of the Company's 1993 domestic gross income, have been with the Company since 1989. The agreements between the Company and most of its clients are generally terminable by either the Company or the client on 90 days' notice as is the custom in the industry. During 1993, one client (The Procter & Gamble Company) represented more than 10% of the Company's consolidated income from commissions and fees. No other client represented more than 5% of the Company's total consolidated commissions and fees. The loss of such client or other large clients of the Company may be expected to have an adverse effect on net income. Losses of important clients in past years, however, have not had a long-term effect upon the Company's financial condition or its competitive position. On December 31, 1993, Grey and its consolidated subsidiaries employed approximately 5,038 persons, of whom nine were executive officers of Grey. As is generally the case in the advertising industry, the Company's business traditionally has been seasonal, with greater revenues generated in the second and fourth quarters of each year. This reflects, in large degree, the media placement patterns of the Company's clients. Advertising programs created by the Company are placed principally in media distributed within the United States and overseas through offices in the United States and a number of foreign countries. While the Company operates on a worldwide basis, for the purposes of presenting certain financial information in accordance with Securities and Exchange Commission rules, its operations are deemed to be conducted in three geographic areas. Commissions and fees, and operating profit by each such geographic area for the years ended December 31, 1993, 1992 and 1991, and related identifiable assets at December 31 of each of the years, are summarized in Note N of the Notes to Consolidated Financial Statements, which is hereby incorporated herein by reference. While the Company has no reason to believe that its foreign operations as a whole are presently jeopardized in any material respect, there are certain risks of operating which do not affect domestic operations but which may affect the Company's foreign operations from time to time. Such risks include the possibility of limitations on repatriation of capital or dividends, political instability, currency devaluation and restrictions on the percentage of permitted foreign ownership. Executive Officers of the Registrant as of March 1, 1994 (a) All executive officers are elected annually by the Board of Directors of Grey. Each executive officer has been with Grey for a period more than five years. There exists no family relationship between any of Grey's directors or executive officers and any other director or executive officer or person nominated or chosen to become a director or executive officer. ITEM 2. ITEM 2. Properties. Substantially all offices of the Company are located in leased premises. The Company's principal office is at 777 Third Avenue, New York, New York, where it now occupies total floor space of approximately 357,000 square feet. The main lease covering the bulk of this space expires in 1999. The Company also has significant leases covering other offices in New York, Los Angeles, San Francisco, Amsterdam, Brussels, Copenhagen, Dusseldorf, Hong Kong, London, Madrid, Milan, Paris, Stockholm, Sydney and Toronto. The Company considers all space leased by it to be adequate for the operation of its business and does not foresee any significant difficulty in meeting its space requirements. ITEM 3. ITEM 3. Legal Proceedings. The Company is not involved in any material pending legal proceedings, not covered by insurance or by adequate indemnification, or which, if decided adversely, would have a material effect on the operations, liquidity or financial position of the Company. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders. Inapplicable. ITEM 5. ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters. The Common Stock of Grey is traded on The Nasdaq Stock Market under the symbol GREY and quoted on the National Market System of NASDAQ. As of March 1, 1994, there were 544 holders of record of the Common Stock and 322 holders of record of the Limited Duration Class B Common Stock. The following table sets forth certain information about dividends paid, and the bid and asked prices in the over-the-counter market during the periods indicated (as published in the Wall Street Journal), with respect to the Common Stock: * Such over-the-counter market quotations reflect interdealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. PART II ITEM 6. ITEM 6. Selected Financial Data. (a) During 1991, the Company recognized one-time restructuring charges primarily related to the absorption of the Company's subsidiary, Levine Huntley Vick & Beaver, Inc. (b) After giving effect to amounts attributable to redeemable preferred stock, the assumed exercise of dilutive stock options and, for fully diluted net income per common share, the assumed conversion of 8-1/2% Convertible Subordinated Debentures issued December 1983. (c) After restatement for adoption of FAS 109, Accounting for Income Taxes. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. RESULTS OF OPERATIONS Income from commissions and fees ("gross income") increased 0.5% in 1993 and 6.8% in 1992 when compared to the respective prior years. Absent exchange rate fluctuations, gross income increased 5.9% in 1993 and 5.8% in 1992 as compared to the respective prior years. The increase in revenue in both years, primarily resulted from expanded activities from existing clients, and the continued growth of the Company's general agency and specialized operations. Salaries and employee related expenses increased less than 1% in 1993 and 9.3% in 1992 when compared to the respective prior years. Office and general expenses have increased 1.4% in 1993 and 1.5% in 1992 versus prior years. These increases are generally in line with the increase in gross income shown for such years. Inflation did not have a material effect on either revenue or expenses during 1991, 1992 or 1993. During the fourth quarter of 1991, the Company absorbed the operations of its Levine Huntley Vick & Beaver, Inc. ("LHV&B") subsidiary. In connection therewith, the Company recognized pre-tax charges of approximately $23,850,000 ($11,000,000 after tax) related predominately to the disposal of LHV&B's real estate obligations and leasehold assets, the write off of certain fixed assets and goodwill, and other costs, primarily severance, in connection with the restructuring. The Company also reflected modest similar charges with respect to a small number of related operations. A substantial portion of the lease obligation settlement payments and severance were paid in the fourth quarter of 1991, and the fixed asset and goodwill write offs were charged against the restructuring reserve in 1991. These charges represented a majority of the costs incurred with respect to the restructuring. During 1992 and 1993, most of the remaining costs included in the restructuring charge were settled, and at December 31, 1993 less than 10% of the original restructuring reserve remains on the Company's balance sheet to cover any unsettled obligations. The effective tax rate is 52.7% in 1993, and was 46.9% in 1992, as restated (see next page) and 38.1% in 1991. The increase in the effective tax rate in each year is primarily related to increases in the state and local tax provisions reflecting utilization of the tax benefit associated with the restructuring charge and due to an increased proportion of the income before taxes being derived from higher tax jurisdictions. In addition, the 1993 effective tax rate increased because the U.S. income tax statutory rate rose to 35% from 34%. Minority interest decreased $3,104,000 in 1993 and increased $3,064,000 in 1992 as compared to the respective prior years. The decrease in 1993 and increase in 1992 were primarily due to changes in the level of profits of majority-owned companies. Equity in earnings of nonconsolidated companies increased $1,068,000 in 1993 and $268,000 in 1992 as compared to the respective prior years. These increases are due primarily to an increase in equity holdings and an increase in the profit attributable to levels of the nonconsolidated companies. Net income for 1993 increased 11.2% when compared to net income in 1992; net income for 1992, as restated (see below), increased 7.4% over net income in 1991 excluding restructuring costs. After giving effect to the restructuring charges, net income, as restated (see below), for 1992 increased 317.8% when compared to 1991. Primary net income per share increased 6.2% in 1993 and, excluding the restructuring charge, 8.1% in 1992 as compared to the respective prior periods. In the first quarter of 1993, the Company adopted FAS 109, Accounting for Income Taxes, as of January 1, 1993 and, as permitted, elected to restate prior years financial statements. The effect of the restatement was to increase the tax provision in 1992 by $600,000, reduce 1992 net income by the same amount and reduce 1991 net income by $500,000 by recognizing a cumulative effect of the accounting change adjustment. For purposes of computing primary net income per common share, the Company's net income was (i) reduced by dividends paid on the Company's Preferred Stock and (ii) reduced or increased by the increase or decrease, respectively, in redemption value of the Preferred Stock. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents on December 31, 1993 was $181,267,000 up from $92,755,000 at the end of the prior year; the Company's working capital at year-end increased during 1993 by $12,413,000 to $25,001,000. These increases are largely attributable to enhanced collection and disbursement management, and the effect of the long-term borrowing described below. In addition, the Company invested in long-term, marketable, highly liquid securities during the second half of 1993. At December 31, 1993, the Company's investment in such marketable securities, principally United States Treasury obligations with maturities between two and seven years, was valued at $22,425,000. Domestically, the Company maintains committed bank lines of credit totalling $40,000,000. These lines of credit were partially utilized during both 1993 and 1992 to secure obligations of selected foreign subsidiaries in the respective year-end amounts of $11,100,000 and $13,331,000. The Company also maintains domestic uncommitted lines of credit. These facilities, which are available at the discretion of the offering banks, were not utilized during the period. There were no amounts outstanding under these arrangements at December 31, 1993 or 1992. Other lines of credit are available to the Company in foreign countries in connection with short-term borrowings and bank overdrafts used in the normal course of business. There were $34,751,000 and $27,464,000 outstanding under such facilities at December 31, 1993 and 1992, respectively. Historically, funds from operations and short-term bank borrowings have been sufficient to meet the Company's dividend, capital expenditure and working capital needs. While the Company has not had to utilize long-term borrowing to fund its operating needs, in January 1993, taking advantage of favorable terms offered, it borrowed $30,000,000, at a fixed interest rate of 7.68%, repayable in equal installments in January 1998, 1999 and 2000. The Company does not anticipate any material increased requirement for capital or other expenditures which will adversely affect its liquidity. The Company's business generally has been seasonal with greater commissions and fees earned in the second and fourth quarters, particularly the fourth quarter. As a result, cash, accounts receivable, accounts payable and accrued expenses are typically higher on the Company's year-end balance sheet than at the end of any of the preceding three quarters. ITEM 8. ITEM 8. Financial Statements and Supplementary Data. -------------------------------------------- The information required by this Item is presented elsewhere in this report. ITEM 9. ITEM 9. Changes in and Disagreements with Accountants on ------------------------------------------------ Accounting and Financial Disclosure. None. PART III. ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant. --------------------------------------------------- This information is to be included in the Company's Proxy Statement to be sent to its stockholders in connection with its 1994 annual meeting under the caption "Election of Directors", and is hereby incorporated herein by reference. ITEM 11. ITEM 11. Executive Compensation. ----------------------- This information is to be included in the Company's Proxy Statement to be sent to its stockholders in connection with its 1994 annual meeting under the caption "Management Remuneration and Other Transactions", and is hereby incorporated herein by reference. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and --------------------------------------------------- Management. ----------- This information is to be included in the Company's Proxy Statement to be sent to its stockholders in connection with its 1994 annual meeting under the captions "Voting Securities" and "Election of Directors", and is hereby incorporated herein by reference. ITEM 13. ITEM 13. Certain Relationships and Related Transactions. ----------------------------------------------- This information is to be included in the Company's Proxy Statement to be sent to its stockholders in connection with its 1994 annual meeting under the captions "Election of Directors" and "Voting Securities", and is hereby incorporated herein by reference. PART IV. ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on ------------------------------------------------------- Form 8-K. --------- (a) (1) (2)The information required by this subsection of this Item is presented elsewhere in this report. (b) Reports on Form 8-K: Registrant ------------------- filed no reports on Form 8-K during the last quarter of 1993. (c) Exhibits: Reference is made to -------- the Index of Exhibits annexed hereto and made part hereof. (d) Schedules: The information --------- required by this subsection of this Item is presented elsewhere in this report. The undersigned Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's Registration Statements on Form S-8, filed with the SEC pursuant to Section 6(a) of the '33 Act: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of Registrant pursuant to the foregoing provisions, or otherwise, Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by Registrant of expenses incurred or paid by a director, officer or controlling person of Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. 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. GREY ADVERTISING INC. By:/s/ Edward H. Meyer ------------------------ Edward H. Meyer, Chairman, Chief Executive Officer & President Dated: March 30, 1994 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. /s/ Mark N. Kaplan Dated: March 30, 1994 - --------------------------------------- Mark N. Kaplan, Director /s/ Edward H. Meyer Dated: March 30, 1994 - -------------------------------------- Edward H. Meyer, Director; Principal Executive Officer /s/ O. John C. Shannon Dated: March 30, 1994 - -------------------------------------- O. John C. Shannon, Director; President - Grey International /s/ Richard R. Shinn Dated: March 30, 1994 - ------------------------------------ Richard R. Shinn, Director /s/ Steven G. Felsher Dated: March 30, 1994 - ---------------------------------------- Steven G. Felsher, Principal Financial Officer /s/ William P. Garvey Dated: March 30, 1994 - --------------------------------------- William P. Garvey, Principal Accounting Officer - 19 - Annual Report on Form 10-K Item 8, Item 14(a)(1) and (2) and Item 14(d) Financial Statements and Supplementary Data List of Financial Statements and Financial Statement Schedules Year ended December 31, 1993 Grey Advertising Inc. New York, New York Form 10-K-Item 8, Item 14(a)(1) and (2) Grey Advertising Inc. and Consolidated Subsidiary Companies Index to Financial Statements and Financial Statement Schedules The following consolidated financial statements of Grey Advertising Inc. and consolidated subsidiary companies are included in Item 8: The following consolidated financial statement schedules of Grey Advertising Inc. and consolidated subsidiary companies are included in Item 14(d): All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. Summarized financial information and financial statements for nonconsolidated foreign investee companies accounted for by the equity method have been omitted because such companies, considered individually or in the aggregate, do not constitute a significant subsidiary. Report of Independent Auditors Board of Directors Grey Advertising Inc. We have audited the accompanying consolidated balance sheets of Grey Advertising Inc. and consolidated subsidiary companies as of December 31, 1993 and 1992, and the related consolidated statements of income, common stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Grey Advertising Inc. and consolidated subsidiary companies at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A to the financial statements, in 1993 the Company changed its method of accounting for income taxes. ERNST & YOUNG February 11, 1994 Grey Advertising Inc. and Consolidated Subsidiary Companies Consolidated Balance Sheets See notes to consolidated financial statements. Grey Advertising Inc. and Consolidated Subsidiary Companies Consolidated Balance Sheets (continued) See notes to consolidated financial statements. Grey Advertising Inc. and Consolidated Subsidiary Companies Consolidated Statements of Income See notes to consolidated financial statements. Grey Advertising Inc. and Consolidated Subsidiary Companies Consolidated Statements of Common Stockholders' Equity Years ended December 31, 1993, 1992 and 1991 Grey Advertising Inc. and Consolidated Subsidiary Companies Consolidated Statements of Common Stockholders' Equity (continued) Years ended December 31, 1993, 1992 and 1991 See notes to consolidated financial statements. Grey Advertising Inc. and Consolidated Subsidiary Companies Consolidated Statements of Cash Flows Grey Advertising Inc. and Consolidated Subsidiary Companies Consolidated Statements of Cash Flows (continued) SUPPLEMENTAL INFORMATION REGARDING NON-CASH FINANCING ACTIVITIES. In 1992, the Company granted a loan of $3,170,000 in partial payment for the purchase of common stock (see Note I). See notes to consolidated financial statements. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements December 31, 1993 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries. Material intercompany balances and transactions have been eliminated in consolidation. Certain amounts for years prior to 1993 have been reclassified to conform with the current year classification. COMMISSIONS AND FEES Income derived from advertising placed with media is generally recognized based upon the publication or broadcast dates. Income resulting from expenditures billable to clients is generally recognized when billed. Payroll costs are expensed as incurred. CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The carrying amount of cash equivalents approximates fair value because of the short maturities of those instruments. INVESTMENTS IN AND ADVANCES TO NONCONSOLIDATED AFFILIATED COMPANIES The Company carries its investments in nonconsolidated affiliated companies on the equity method. The Company is amortizing the excess ($6,995,000 in 1993 and $3,669,000 in 1992) of the cost of its investments in certain of these companies over the related net equity at the date of acquisition over periods of up to 20 years. Certain investments which are not material in the aggregate are carried on the cost method. FIXED ASSETS Depreciation of furniture, fixtures and equipment is provided for over their estimated useful lives ranging from three to ten years and has been computed principally by the straight-line method. Amortization of leaseholds and leasehold improvements is provided for principally over the terms of the related leases, which are not in excess of the lives of the assets. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) FOREIGN CURRENCY TRANSLATION Primarily all balance sheet accounts of the Company's foreign operations are translated at the exchange rate in effect at each year end and income statement accounts are translated at the average exchange rates prevailing during the year. Resulting translation adjustments are made directly to a separate component of stockholders' equity. Foreign currency transaction gains and losses are reported in income. During 1993, 1992 and 1991, foreign currency transaction gains and losses were not material. INTANGIBLES The excess ($63,965,000 in 1993 and $63,895,000 in 1992) of purchase price over underlying net equity of certain consolidated subsidiaries at the date of acquisition is being amortized by the straight-line method over periods of up to 20 years. INCOME TAXES Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by FAS 109, Accounting for Income Taxes. As permitted under the new rules, the Company has restated its 1992 and 1991 financial statements (see Note K). The Company provides appropriate foreign withholding taxes on unremitted earnings of consolidated and nonconsolidated foreign companies. MARKETABLE SECURITIES Effective December 31, 1993, the Company has adopted FAS 115, Accounting for Certain Investments in Debt and Equity Securities. The Company has classified its investments in marketable securities as available-for-sale at the time of purchase and re-evaluates such designation as of each balance sheet date. Available-for-sale securities are carried at fair value, based on publicly quoted market prices, with unrealized gains and losses reported as a separate component of stockholders' equity. POSTRETIREMENT BENEFITS During 1992, the Company adopted FAS 106, Accounting for Postretirement Benefits Other Than Pensions. The costs incurred resulting from the adoption of this pronouncement were not material. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) B. FOREIGN OPERATIONS The following financial data is applicable to consolidated foreign subsidiaries: Consolidated retained earnings at December 31, 1993 includes equity in unremitted earnings of nonconsolidated foreign companies of approximately $2,937,000. C. OTHER INCOME (EXPENSE)-NET D. FIXED ASSETS Components of fixed assets-at cost are: Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) E. MARKETABLE SECURITIES At December 31, 1993, the Company's investments in marketable securities consist of U.S. Treasury obligations with maturities of 2 to 7 years and a market value of $22,425,000. At December 31, 1993, the Company has recorded unrealized losses of $147,000 related to these investments. F. CREDIT ARRANGEMENTS AND LONG-TERM DEBT The Company maintains committed lines of credit of $40,000,000 with various banks and may draw against the lines on unsecured demand notes at rates below the applicable bank's prime interest rate. These lines of credit were partially utilized during both 1993 and 1992 to secure obligations of selected foreign subsidiaries in the respective year-end amounts of $11,100,000 and $13,331,000. The Company had $34,751,000 and $27,464,000 outstanding under other uncommitted lines of credit at December 31, 1993 and 1992, respectively. The carrying amount of the debt outstanding under both the committed and uncommitted lines of credit approximates fair value because of the short maturities of the underlying notes. In January 1993, the Company borrowed $30,000,000 from the Prudential Insurance Company at a fixed interest rate of 7.68% repayable in equal installments of $10,000,000 in January 1998, 1999 and 2000. The terms of the loan agreement require, inter alia, that the Company maintain specified levels of net worth, meet certain cash flow requirements and limit its incurrence of additional indebtedness to certain specified amounts. At December 31, 1993, the Company was in compliance with all of these covenants. The fair value of the Prudential debt is estimated to be $31,400,000 at December 31, 1993. This estimate was determined using a discounted cash flow analysis using current interest rates for debt having the similar terms and remaining maturities. The remaining balance of long-term debt consists of 8-1/2% Convertible Subordinated Debentures due December 10, 1996 which are currently convertible into 8.43 shares of Common Stock and an equal amount of Limited Duration Class B Common Stock, subject to certain adjustments, for each $1,000 principal amount of such Debentures. The debt was issued in exchange for cash and a $3,000,000, 9% promissory note, payable December 10, 1997, from an officer of the Company and is included in other assets at Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) F. CREDIT ARRANGEMENTS AND LONG-TERM DEBT (CONTINUED) December 31, 1993 and 1992. During 1991, the Company extended the maturity dates of the debt and related promissory note to the dates indicated above. During each of the years 1993, 1992 and 1991, the Company paid to the officer interest of $257,000 pursuant to the terms of the 8 1/2% Convertible Subordinated Debenture. During each of the years 1993, 1992 and 1991, the officer paid to the Company interest of $270,000 pursuant to the terms of the 9% promissory note. For the years 1993, 1992 and 1991, the Company made interest payments of $6,529,000, $7,242,000 and $6,118,000, respectively. G. REDEEMABLE PREFERRED STOCK The Company has outstanding at December 31, 1993 and 1992, 22,000 and 24,000 shares, respectively, of its Series 1 Preferred Stock and 5,000 shares each of its Series 2 and Series 3 Preferred Stock, which are held by current and former senior employees of the Company including one executive officer. The shares were issued at a price equal to the book value of the Common Stock at the time of issuance less a fixed amount. One dollar per share was paid in cash and the balance was represented by full recourse promissory notes, payable in May 1996, bearing interest at 9% per annum. In April 1993, the Company, at the option of one holder, after attainment of age 65, redeemed 2,000 shares of Series 1 Preferred Stock at a price of $347,000. The Company discharged its obligation by payment of cash of $300,000 and forgiveness of the holder's promissory note of $47,000. The amount of the full recourse promissory notes included in other assets at December 31, 1993 and 1992 was $763,000 and $810,000, respectively. The interest paid to the senior employees in 1993, 1992 and 1991, pursuant to the terms of these notes was $70,000, $77,000, and $77,000, respectively. The redemption price per share for the Preferred Stock is the combined book value per share of the Common Stock and Limited Duration Class B Common Stock as adjusted in accordance with the terms of the respective Certificates of Designation and Terms of each series of Preferred Stock upon redemption less a fixed discount. Holders of the Preferred Stock may have their shares redeemed upon termination of employment prior to age 65. The Company is obligated to redeem such shares following the holder's retirement after age 65. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) G. REDEEMABLE PREFERRED STOCK (CONTINUED) Following the distribution of the new class of Common Stock designated Limited Duration Class B Common Stock, the holders of the Preferred Stock became entitled to eleven votes per share on all matters submitted to the vote of stockholders. The holders of the Series 1 Preferred Stock are entitled, as well, to vote as a single class to elect or remove one-quarter of the Board of Directors, to approve the merger or consolidation of the Company or the sale by it of all or substantially all of its assets, and to approve the authorization or issuance of any other class of Preferred Stock having equivalent voting rights. The holders of the Preferred Stock are entitled to receive cumulative preferential dividends at the annual rate of $.25 per share, and to participate in dividends on the Common Stock and Limited Duration Class B Common Stock to the extent such dividends, on a per share basis, exceed the preferential dividends. In the event of the liquidation of the Company, holders of Preferred Stock are entitled to a preferential liquidation distribution of $1.00 per share in addition to all accrued and unpaid preferential dividends. The total carrying value of the Series 1, 2 and 3 Preferred Stock (applicable to those shares outstanding at each respective year end) increased by $468,000 and $415,000 in 1993 and 1992, respectively, and decreased by $92,000 in 1991, which represents the change in redemption value during those periods. This change is referred to as "Additional Capital Applicable to Redeemable Preferred Stock" in the Certificates of Designation and Terms of the Series 1, 2 and 3 Preferred Stock. H. COMMON STOCK The Company has authorized and outstanding two classes of common stock, Common Stock and Limited Duration Class B Common Stock (Class B Common Stock), both $1 par value per share. The Class B Common Stock has the same dividend and liquidation rights as the Common Stock and a holder of each share of Class B Common Stock is entitled to ten votes on all matters submitted to stockholders. The shares of Class B Common Stock are restricted as to transferability and upon transfer, except to specified limited classes of transferees, will convert into shares of Common Stock which have one vote per share. The Class B Common Stock will automatically convert to Common Stock on April 30, 1996. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) H. COMMON STOCK (CONTINUED) Shares which have been issued and are now outstanding under the provisions of the Company's Restricted Stock Plan are subject to restrictions as to transferability expiring generally five or six years from the date of issue. In 1990, an additional 100,000 shares of Common Stock were authorized under this Plan. During 1993, the restriction lapsed on 1,400 shares of Common Stock and no shares of Class B Common Stock. At December 31, 1993 and 1992, there were 125,000 and 124,800 shares of Common Stock and 49,900 and 49,900 shares of Class B Common Stock, respectively, reserved by the Company and available for issuance under this Plan. Compensation to employees under the Plan of $214,000 representing the unamortized excess of the market value of restricted stock over any cash consideration received, is carried as a reduction of Paid-In Additional Capital and is charged to income ($256,000 in 1993, $252,000 in 1992 and $481,000 in 1991) over the related required period of service of the respective employees. The tax benefit, resulting from the difference between compensation expense deducted for tax purposes and compensation expense charged to income, is recorded as an increase to Paid-In Additional Capital. I. STOCK OPTION PLANS EXECUTIVE GROWTH PLAN Under the terms of the Company's qualified stock option plan (Executive Growth Plan), options may be granted to officers and key employees at prices not less than 100% of the fair market value of the shares on the date of grant. At December 31, 1993 and 1992, there were no options outstanding and no options exercisable and at December 31, 1991 and 1990, there were 25,000 options of Class B Common Stock and 25,000 options of Common Stock outstanding and exercisable under this plan. During 1992, these options were exercised at a total option price of $3,237,000, and were paid for with cash of $67,000 and a note from an officer of the Company in the amount of $3,170,000 due and payable in December 2001 at a fixed interest rate of 6.06%. At December 31, 1993, 142,847 shares of Common Stock and 142,847 shares of Class B Common Stock were reserved by the Company for issuance with respect to the Plan. In addition, the holder of the options was entitled to receive an additional amount representing the dividends which would have been paid if the options had been exercised on the date of grant. The holder used this additional amount ($1,153,000) to purchase an additional 8,905 shares of both Common Stock and Class B Common Stock. The additional amount was reflected as compensation expense in 1992 and in years prior to the exercise. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) I. STOCK OPTION PLANS (CONTINUED) In addition, and in accordance with the terms of the option agreement, the holder of the options issued to the Company a promissory note in the principal amount of $2,340,000 bearing interest at the rate of 6.06%, payable in December 2001, to settle his obligation to provide the Company with funds necessary to pay the required withholding taxes due upon the exercise of the options. The Company received a tax benefit of $1,556,000 upon the exercise of the options. A portion of this note equal to the tax benefit and the full amount of the note for $3,170,000 are reflected in a separate component of stockholders' equity at December 31, 1993 and 1992. The interest paid to the Company by the holder pursuant to the terms of the two notes issued in connection with the option exercise was $334,000 in 1993. No interest payments were made in 1992. INCENTIVE STOCK OPTION PLAN In 1982, the Company adopted an Incentive Stock Option Plan. Under this plan in which options were available to be granted through May 1992, options were granted to key employees, including officers, at a price not less than 100% of the fair market value of the shares on the date of grant. A Committee of the Board of Directors determined the terms and conditions under which options may be granted or exercised. However, options (i) may not be exercised within twelve months from the date of grant, (ii) may not be granted to Committee members, (iii) expire within ten years from the date of grant and (iv) must be exercised in the order of grant. Transactions involving outstanding stock options under this Plan were: Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) I. STOCK OPTION PLANS (CONTINUED) As of December 31, 1993, options to acquire 2,242 shares of Common Stock and 100 shares of Class B Common Stock were exercisable. The Company has reserved 29,684 shares of Common Stock and 29,684 shares of Class B Common Stock for issuance with respect to this plan. NONQUALIFIED STOCK OPTION PLAN On December 2, 1987, the Company adopted a Nonqualified Stock Option Plan, whereby 100,000 shares of Common Stock were reserved for issuance. In 1990, the number of shares of Common Stock authorized for issuance under this Plan was increased to 200,000. At the discretion of a Committee of the Board of Directors, nonqualified stock options are granted to employees eligible to receive options at prices not less than 100% of the fair market value of the shares on the date of grant, and options must be exercised within 10 years of grant and for only specified limited periods beyond termination of employment. Transactions involving outstanding stock options under this Plan were: As of December 31, 1993 and 1992, 19,668 and 8,051 of the outstanding options, respectively, were exercisable. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) J. COMPUTATION OF NET INCOME PER COMMON SHARE The computation of net income per common share is based on the weighted average number of common shares outstanding, including adjustments for the effect of the assumed exercise of dilutive stock options and shares issuable pursuant to the Company's Senior Management Incentive Plan (see Note L(1)) (1,263,900 in 1993, 1,205,241 in 1992 and 1,196,908 in 1991) and, for fully diluted net income per common share, the assumed conversion of the 8-1/2% Convertible Subordinated Debentures issued in December 1983. Also, for the purpose of computing net income per common share, the Company's net income is reduced by dividends on the Preferred Stock and is reduced or increased to the extent of an increase or decrease, respectively, in redemption value of the Preferred Stock. Primary net income per common share is computed as if stock options were exercised at the beginning of the period and the funds obtained thereby used to purchase common shares at the average market price during the period. In computing fully diluted net income per common share, the market price at the close of the period or the average market price, whichever is higher, is used to determine the number of shares which are assumed to be repurchased. The effects of the Preferred Stock dividend requirements and the change in redemption values amounted to $.53, $.52 and $.09 per share in 1993, 1992 and 1991, respectively. K. INCOME TAXES Effective January 1, 1993, the Company adopted FAS 109 (see Note A). As permitted under the new rules, the Company restated its 1992 and 1991 financial statements. The effect of adoption of FAS 109 was to reduce net income in 1992 by $600,000 or $0.50 per share, through an increase to the deferred provision for income taxes. The cumulative effect of adoption as of January 1, 1991 was to reduce net income by $500,000. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. At December 31, 1993, and at December 31, 1992 and 1991, as restated, the Company had deferred tax assets of $16,282,000, $15,334,000 and $21,928,000 and deferred tax liabilities of $12,194,000, $14,517,000 and $15,760,000, respectively, detailed as follows: Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) K. INCOME TAXES (CONTINUED) The components of income before taxes on income are as follows: Provisions (benefits) for Federal, foreign, state and local income taxes consisted of the following: The effective tax rate varied from the statutory Federal income tax rate as follows: During the years 1993, 1992 and 1991, the Company made income tax payments of $18,748,000, $14,435,000 and $13,905,000, respectively. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) L. RETIREMENT PLANS, DEFERRED COMPENSATION, LEASES AND CONTINGENCIES 1. The Company's Profit Sharing Plan is available to all employees of the Company and qualifying subsidiaries meeting certain eligibility requirements. The Plan provides for contributions by the Company at the discretion of the Board of Directors, subject to maximum limitations. The Company also operates a noncontributory Employee Stock Ownership Plan covering eligible employees of the Company and qualifying subsidiaries, under which the Company may make contributions (in stock or cash) to an Employee Stock Ownership Trust ("ESOT") in amounts each year as determined at the discretion of the Board of Directors. The Company made no stock contributions to the Plan in 1993, 1992 and 1991. The Company and the ESOT have certain rights to purchase shares from participants whose employment has terminated. In addition to the two plans noted above, various subsidiaries maintain separate profit sharing and retirement arrangements. Furthermore, the Company also provides additional retirement and deferred compensation benefits to certain officers and employees. The Company maintains a Senior Management Incentive Plan ("SMIP") in which deferred compensation is granted to senior executive or management employees deemed essential to the continued success of the Company. The amount recorded as an expense related to this Plan amounted to $4,581,000, $4,340,000 and $4,529,000 in 1993, 1992 and 1991, respectively. Approximately $3,343,000 and $1,160,000 of Plan expense incurred in 1993 and 1992, respectively, will be payable in Company stock in accordance with the terms of the Plan. These awards convert into 18,461 and 8,624 equivalent shares of Common Stock in 1993 and 1992, respectively. The future obligation related to the stock award has been reflected as an increase to Paid-In Additional Capital. Expenses related to the foregoing plans and benefits aggregated $21,057,000 in 1993, $25,002,000 in 1992, and $20,300,000 in 1991. In December 1990, the Company amended its employment agreement with its Chairman and Chief Executive Officer, which extended the term of that agreement through December 31, 1997. Concurrently, the Company also discharged this individual's pension obligation which had been established pursuant to the terms of his long-standing employment agreement. This obligation was partially satisfied with a distribution of approximately $19.8 million from a trust fund previously established by the Company for this purpose. The remainder of the amount necessary to discharge this obligation (approximately $9.5 million) was distributed from general Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) L. RETIREMENT PLANS, DEFERRED COMPENSATION, LEASES AND CONTINGENCIES (CONTINUED) corporate funds. Included in other assets at December 31, 1993 and 1992 is approximately $9.5 and $11.9 million, respectively, related to this arrangement which is being amortized to expense over the remaining term of the related employment agreement. Pursuant to an employment agreement, dated December 21, 1990, an executive officer of the Company borrowed $1,000,000 from the Company repayable at December 31, 1995, except that one-fifth of the principal of the loan is forgiven by the Company each December 31, beginning with December 31, 1991, provided that the officer continues to be employed by the Company on those dates. In 1993, 1992 and 1991, the Company has included in each year $200,000 of compensation expense, representing the amount of loan forgiven each year. As of December 31, 1993 and 1992, the remaining loan balance was $400,000 and $600,000, respectively (the long term portion of the loan, $200,000 in 1993 and $400,000 in 1992, is included in other assets). 2. Rental expense amounted to approximately $32,725,000 in 1993, $33,741,000 in 1992 and $29,106,000 in 1991 which is net of sub-lease rental income of $2,016,000 in 1993, $3,343,000 in 1992, and $3,483,000 in 1991. Approximate minimum rental commitments, excluding escalations, under noncancellable operating leases are as follows: 3. The Company is not involved in any pending legal proceedings not covered by insurance or by adequate indemnification or which, if decided adversely, would have a material effect on either the results of operations, liquidity or financial position of the Company. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) M. RESTRUCTURING COSTS In November 1991, the Company recorded a charge for restructuring costs of $23,850,000 primarily in connection with the absorption of a former subsidiary. These charges related predominantly to the disposal of the subsidiary's real estate obligations and leasehold assets, the write-off of certain of its fixed assets, goodwill and other costs, primarily severance, in connection with the integration. The restructuring costs also included similar modest charges with respect to a small number of related operations. The components of the restructuring charge as recorded in the fourth quarter of 1991 were as follows: The amount provided in 1991 was for liabilities which existed as of the fourth quarter of 1991 and was not for any events anticipated to happen after December 31, 1991. Most personnel reduction related to the absorption of the former subsidiaries occurred during the fourth quarter of 1991 and the severance accrual was adequate to cover those liabilities. Of the deferred tax benefits totaling $7,411,000, related to the restructuring charge that was recorded in 1991, $1,644,000 was realized in 1992 and $2,236,000 realized in 1993 (see Note K). The remaining deferred tax balance is expected to be realized over the next couple of years. Grey Advertising Inc. and Consolidated Subsidiary Companies Notes to Consolidated Financial Statements (continued) N. INDUSTRY SEGMENT AND RELATED INFORMATION Commissions and fees and operating profit by geographic area for the years ended December 31, 1993, 1992 and 1991, and related identifiable assets at December 31, 1993, 1992 and 1991 are summarized below (000s omitted): COMMISSIONS AND FEES FROM ONE CLIENT AMOUNTED TO 13.0%, 13.4% AND 10.6% OF THE CONSOLIDATED TOTAL IN 1993, 1992 AND 1991, RESPECTIVELY. SCHEDULE I -- MARKETABLE SECURITIES -- OTHER INVESTMENTS GREY ADVERTISING INC. AND CONSOLIDATED SUBSIDIARY COMPANIES YEAR ENDED DECEMBER 31, 1993 (1) SECURITIES AVAILABLE-FOR-SALE ARE CARRIED AT FAIR VALUE WITH UNREALIZED GAINS AND LOSSES INCLUDED AS A SEPARATE COMPONENT OF STOCKHOLDERS' EQUITY. Schedule II-Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties GREY ADVERTISING INC. AND CONSOLIDATED SUBSIDIARY COMPANIES (1)--The amount reflected in Column D (1) represents the amount of the loan forgiven in 1993. (2)--Vasoft Pty. Ltd. is a company controlled by James Allan, a director of Grey Advertising (NSW) Pty. Limited. (3)--Promaton Pty. Ltd. is a company controlled by Garry Murphie, a director of Grey Advertising (NSW) Pty. Limited. (4)--Khun Han Pty. Ltd. is a company controlled by Greg Harper, a director of Grey Advertising (Victoria) Pty. Ltd. Schedule II--Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties GREY ADVERTISING INC. AND CONSOLIDATED SUBSIDIARY COMPANIES (1)--The amount reflected in Column (D)(1) represents the amount of loan forgiven in 1992. (2)--Vasoft Pty. Ltd. is a company controlled by James Allan, a director of Grey Advertising (NSW) Pty. Limited. (3)--Promaton Pty. Ltd. is a company controlled by Garry Murphie, a director of Grey Advertising (NSW) Pty. Limited. (4)--Khun Han Pty. Ltd. is a company controlled by Greg Harper, a director of Grey Advertising (Victoria) Pty. Ltd. Schedule II--Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties (continued) GREY ADVERTISING INC. AND CONSOLIDATED SUBSIDIARY COMPANIES (1) The amount reflected in Column (D) (1) represents the amount of loan forgiven in 1991. SCHEDULE IX--SHORT-TERM BORROWINGS GREY ADVERTISING INC. AND CONSOLIDATED SUBSIDIARY COMPANIES (a)--Notes payable to banks represent borrowings under lines of credit arrangements which are subject to termination at a specified date. (b)--Notes payable to banks represent promissory notes under credit arrangements. (c)--The average amount outstanding during the period is the weighted monthly outstanding balance. (d)--The weighted average interest rate during the period was computed by dividing the actual interest expense by the weighted average outstanding amount. INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS INDEX TO EXHIBITS 10K-Exhibits

225463_1993.txt

225463_1993

1993

225463

ITEM 1. BUSINESS Huffy Corporation, an Ohio corporation, and its subsidiaries (collectively called "Huffy" or the "Company") are engaged in the design, manufacture and sale of Recreation and Leisure Time Products, Juvenile Products, and the furnishing of Services for Retail. The Company's executive offices are located in Miamisburg, Ohio and its principal business offices and/or manufacturing facilities are located in San Diego, California; Aurora, Ontario, Canada; Thornton, Colorado; Miamisburg and Celina, Ohio; Camp Hill and Harrisburg, Pennsylvania; Anderson, South Carolina; Waukesha and Suring, Wisconsin; and Whites Cross, Cork, Ireland. The general development of business within each business segment (Recreation and Leisure Time Products, Juvenile Products and Services for Retail) is discussed in more detail below. See also Part IV herein for financial information relating to each such business segment. RECREATION AND LEISURE TIME PRODUCTS Huffy Bicycle Company, Huffy Sports Company, and True Temper Hardware Company comprise the Recreation and Leisure Time Products segment of the Company. Bicycles are one of the principal products produced within the business segment. Bicycles sold to high volume retailers represented 44.2 percent, 44.6 percent, and 47.5 percent of consolidated revenues of the Company for the years ended December 31, 1993, 1992, and 1991, respectively. Sales to high volume retailers of lawn and garden tools and cutting tools, which are also principal products within the business segment, represented 13.6 percent, 15.6 percent and 10.5 percent of consolidated revenues of the Company for the years ended December 31, 1993, 1992, and 1991, respectively. Although to date the export business is not significant, the companies in the Recreation and Leisure Time Products segment participate in various foreign markets and are actively involved in expanding export volume. a. PRODUCTS, MARKETING AND DISTRIBUTION Huffy Bicycle Company: The Huffy registered trademark bicycle brand is the largest selling brand of bicycles sold in the United States. The full line of Huffy registered trademark bicycles is produced by Huffy Bicycle Company, a division of the Company, whose manufacturing facilities are located in Celina, Ohio. Included in the Huffy registered trademark bicycle line are adult all purpose bicycles; adult all terrain bicycles; a series of innovative boys' and girls' 20" bicycles; and a series of popular children's 16" sidewalk bicycles. Huffy registered trademark bicycles are extensively advertised and are sold predominantly through national and regional high volume retailers, a distribution network accounting for approximately 75 to 80 percent of all bicycles sold in the United States. Over 90 percent of Huffy Bicycle Company's bicycles are sold under the Huffy registered trademark brand name with the balance being sold under private label brands. Huffy Sports Company: Huffy Sports Company, a division of the Company, located in Waukesha, Wisconsin, is the leading supplier of basketball backboards, goals, and related products for use at home. Huffy Sports Company products, which bear the logo of the National Basketball Association ("NBA"), as well as the Huffy Sports registered trademark trademark, are sold predominantly through national and regional high volume retailers in the United States. True Temper Hardware Company: True Temper Hardware Company, a wholly-owned subsidiary of the Company, is headquartered in Camp Hill, Pennsylvania. The Company acquired the True Temper Hardware business from certain affiliates of Black & Decker, Inc. in 1990. True Temper Hardware Company is one of three leading suppliers of non-powered lawn and garden tools, snow tools and cutting tools; products include long-handled shovels, hoes, forks, wheelbarrows, spreaders, snow shovels, rakes, hitched accessories, pruners, and grass shears for use in the home and in agricultural, industrial and commercial businesses. Manufacturing facilities are located in Camp Hill and Harrisburg, Pennsylvania, and Anderson, South Carolina. True Temper Hardware Company also owns five sawmill facilities located in Indiana, New York, Ohio, Pennsylvania, and Vermont and staffs a sales office and distribution center for Canada located in Aurora, Ontario, Canada. In addition, True Temper Limited, an Irish Corporation and a wholly-owned subsidiary of the Company, has offices and a manufacturing facility in Whites Cross, Cork, Ireland. True Temper Hardware products are extensively advertised and are sold both directly, and through wholesale distributors, to national and regional high volume retailers and hardware stores. Over 82 percent of True Temper Hardware's products are sold under the True Temper registered trademark name; the remainder are sold under the Jackson registered trademark, Cyclone registered trademark or other names, or under private labels. In the quarter ended December 31, 1993, the Company recorded a $28,755,000 ($20,329,000 after tax) charge to restructure the True Temper Hardware Company lawn and garden tool business to address inefficiencies in the manufacturing process and to improve future profitability of True Temper Hardware Company. Information regarding the Company's restructure of True Temper Hardware Company is incorporated herein by reference to pages 28 and 29 and note 2 to the consolidated financial statements on page 41 of the Company's Annual Report to Shareholders for the year ended December 31, 1993. b. SUPPLIERS Basic materials such as raw steel, steel tubing, plastic, ash timber, and welding materials used in the manufacturing operations are purchased primarily from domestic sources. Alternate sources are available for all critical products and components, but the sudden loss of any major supplier could, on a temporary basis, cause a negative effect on the segment's operations. c. PATENTS, TRADEMARKS AND LICENSES The patents, trademarks (including the registered trademarks "Huffy", "Huffy Sports", "True Temper" and "Jackson"), licenses (including the license to use the NBA logo) and other proprietary rights of the companies in this segment are deemed important to the Company. The loss by the Company of its rights under any individual patent, trademark (other than "Huffy" or "True Temper"), license or other proprietary right used by this segment would not have a material adverse effect on the Company or the segment. The loss of either the registered trademark "Huffy" or "True Temper" could have a material adverse effect on the Company and this segment. The Company has no reason to believe that anyone has rights to either the trademark "Huffy" or the trademark "True Temper" for the products in connection with which such trademarks are used. d. SEASONALITY AND INVENTORY Due to the relatively short lapse of time between placement of orders for products and shipments, the Company normally does not consider its backlog of orders as significant to this business segment. Because of rapid delivery requirements of their customers, the companies in this segment maintain significant quantities of inventories of finished goods to meet their customers' requirements. Sales of bicycles are seasonal in that sales tend to be higher in the spring and fall of each year. Basketball products tend to have varying degrees of seasonality, none of which are significant to the operations of the Company. Sales of lawn and garden products, cutting tools and snow tools tend to be higher in the spring and winter of each year, respectively. e. COMPETITION AND CUSTOMERS In the high volume retailer bicycle business, Huffy Bicycle Company has numerous competitors in the United States market, only two of which are deemed significant. Although importers in the aggregate provide significant competition, no individual importer is deemed a significant competitor. Even though competition among domestic manufacturers and importers of bicycles is intense, Huffy Bicycle Company believes it is cost competitive in the high volume retailer bicycle market and maintains its position through continued efforts to improve manufacturing efficiency and product value. Huffy Bicycle Company's ability to provide its customers with low cost, innovative new products has enabled it to maintain its market position despite the targeted marketing efforts of competitors from Taiwan, China, and other nations. On December 10, 1993, the Board of Directors of the Company approved plans for Huffy Bicycle Company to establish an additional bicycle manufacturing facility in order to increase manufacturing flexibility and capacity and market share. The selection of a proposed Farmington, Missouri site as the location for the additional manufacturing facility is in the final stages, and acquisition and financing alternatives are currently being examined. Huffy Sports Company has several competitors, but only one is deemed significant. Huffy Sports Company maintains its competitive position by offering its customers high quality, innovative products at competitive prices and by supporting its products with outstanding customer service. True Temper Hardware Company has numerous competitors in the United States and Canada, but considers only two competitors significant. True Temper Hardware Company believes it remains competitive by offering its customers in the home use, agricultural, industrial, and commercial markets competitively priced, high quality, innovative products. The loss by the Recreation and Leisure Time Products segment of either of its two largest customers could result in a short-term, material adverse effect on the segment. JUVENILE PRODUCTS The Juvenile Products segment is comprised of Gerry Baby Products Company, Snugli-Canada, Ltd., and Gerry Wood Products Company (collectively, the "Gerry Companies"). Although to date the export business is not significant, the Gerry Companies participate in various foreign markets and are actively involved in expanding export volume. a. PRODUCTS, MARKETING AND DISTRIBUTION Juvenile Products include products sold under two prominent brand names: "Gerry" and "Snugli". Gerry registered trademark baby products include a wide range of market entries, including car seats, infant carriers, frame carriers, safety gates, toilet trainers, electronic baby monitors, and a broad line of various wood juvenile products including portable cribs, changing tables and safety gates sold under the "Nu-Line" brand name prior to 1992 and under the Gerry registered trademark brand name since 1992. Snugli registered trademark baby products include infant carriers and other accessories. All of the juvenile products have wide distribution; the products are marketed through all of the retail channels that sell juvenile products: mass merchants, toy chains, warehouse clubs, catalog showrooms, national and regional retailers, and specialty shops. Juvenile Products represented 16.4 percent, 16.4 percent, and 15.9 percent of consolidated revenues of the Company for the years ended December 31, 1993, 1992, and 1991, respectively. The Juvenile Products segment has been developed through selective acquisitions and internal growth and expansion. It is comprised of three direct or indirect subsidiaries of the Company: Gerry Baby Products Company ("GBPC"); Snugli-Canada, Ltd.; and Gerry Wood Products Company. GBPC's headquarters and principal manufacturing facilities are located in Thornton, Colorado. Snugli-Canada, Ltd. is located in Vancouver, British Columbia, Canada, and enables GBPC to extend its operations into Canada. Gerry Wood Products Company is a manufacturer of juvenile wooden products and is located in Suring, Wisconsin. In 1987, GBPC entered into a joint venture known as Takata-Gerico Corporation ("TGC"), with Takata Corporation of Japan, to manufacture children's car seats in the United States for distribution by GBPC. The joint venture was subsequently terminated by the parties' mutual agreement in 1992, and in connection with such termination GBPC purchased certain assets of TGC. b. SUPPLIERS Basic materials such as steel and aluminum tubing, plastic, wood, fabric, and resins used in domestic manufacturing operations are purchased primarily from domestic sources. All electronic products and some sewn products are imported. Alternate sources are available for all critical products and components, but the sudden loss of any major supplier could, on a temporary basis, cause a negative effect on the segment's operations. c. PATENTS, TRADEMARKS AND LICENSES The patents, trademarks (including the registered trademarks "Gerry" and "Snugli") and other proprietary rights of the Gerry Companies in this segment are deemed important to the Company. However, the loss of any rights under any individual patent, trademark (other than "Gerry" or "Snugli"), or other proprietary right used by this segment would not have a material adverse effect on the Company or this segment. The loss of the registered trademark "Gerry" or "Snugli" could have a material adverse effect on the Company and this segment, but the Company has no reason to believe anyone has rights to either the "Gerry" or "Snugli" trademark for the products in connection with which either is used. d. SEASONALITY AND INVENTORY The Gerry Companies do not consider their backlog of orders significant to this business segment, due to the relatively short lapse of time between placement of orders for products and shipments. Because of the rapid delivery requirements of their customers, the Gerry Companies maintain significant quantities of inventories of finished goods to meet their customers' requirements. Most products within this business segment are not seasonal. e. COMPETITION AND CUSTOMERS There are numerous juvenile products competitors in the U.S. market, four of which are deemed significant. The Gerry Companies believe they are competitive because of their continued efforts to provide innovative new products of high quality at competitive costs and to support their products with outstanding customer service. The loss by the Gerry Companies of their largest customer could have a short-term, material adverse effect on the segment. SERVICES FOR RETAIL Huffy Service First, Inc. ("HSF") and Washington Inventory Service ("WIS") each provide certain services to retailers. Inventory, assembly, repair and merchandise services provided by WIS and HSF to their customers represented 15.8 percent, 15.6 percent, and 15.5 percent of consolidated revenues of the Company for the years ended December 31, 1993, 1992, and 1991, respectively. a. PRODUCTS, MARKETING AND DISTRIBUTION Huffy Service First: HSF, a wholly-owned subsidiary of the Company, headquartered in Miamisburg, Ohio, serves the needs of major retailers in 50 states, Puerto Rico and the Virgin Islands by providing in-store assembly, repair, and display services for a variety of products, including among other things, bicycles, gas grills, physical fitness equipment, lawn mowers, and furniture. HSF is the only assembly service business of this kind available to high volume retailers on a nationwide basis. HSF also offers merchandising services (installation and periodic maintenance of displays and merchandise replenishment) to vendors who supply high volume retailers. Washington Inventory Service: WIS, a wholly-owned subsidiary of the Company, headquartered in San Diego, California, provides physical inventory services on a nationwide basis to meet the financial reporting and inventory control requirements of mass retailers, drugstores, home centers, sporting goods stores, specialty stores and grocery stores. WIS operates from more than 140 offices nationwide. b. SEASONALITY The demand for services provided by this business segment is seasonal in that assembly service demand is generally strongest in spring and at the winter holiday season, and inventory service demand is generally strongest in the first and third calendar quarters of the year. c. COMPETITION AND CUSTOMERS Although WIS has numerous competitors in the United States market, only one is significant. HSF has numerous competitors in the United States market, none of which is deemed significant. WIS and HSF believe they remain competitive due to their nationwide network of operations, competitive pricing and full service. The loss by either WIS or HSF of its largest customer could result in a short-term, material adverse effect on the segment. Sales to Kmart Corporation and Wal-Mart Corporation aggregated over ten percent or more of the Company's consolidated revenues from each such customer for the year ended December 31, 1993, and the loss of either customer could have a short-term, material adverse effect on the Company and its subsidiaries as a whole. The number of persons employed full-time by the Company (excluding seasonal employees in the Services for Retail Segment) as of December 31, 1993, was 5,854. ITEM 2. ITEM 2. PROPERTIES: Location and general character of the principal plants and other materially important physical properties of the Company as of January 15, 1994. - ------------------------------------------------------------------------------ There are no encumbrances on the Harrisburg, Pennsylvania; Anderson, South Carolina; Suring, Wisconsin; and Whites Cross, Cork, Ireland properties which are owned. The San Diego, California property is subject to a mortgage and to a deed of trust which at December 31, 1993, totaled $939,322. All of the Company's facilities are in good condition and are considered suitable for the purposes for which they are used. The Camp Hill, Pennsylvania manufacturing facility normally operates on a three full shift basis. The Celina, Ohio and Suring, Wisconsin manufacturing facilities normally operate on a two full shift basis, with third shift operations scheduled as needed to meet seasonal production requirements. The Thornton, Colorado, Harrisburg, Pennsylvania, and Waukesha, Wisconsin manufacturing facilities normally operate on a two full shift basis. The Anderson, South Carolina manufacturing facility normally operates on a one full shift basis, with additional shift operations scheduled as needed to meet seasonal production requirements. The Whites Cross, Cork, Ireland, manufacturing facility normally operates on a one full shift basis. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party, nor is its property subject, to any material pending legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The market information and other related security holder matters pertaining to the Common Stock of the Company are incorporated herein by reference to pages 54 and 55 and notes 4, 5 and 6 to the consolidated financial statements on pages 42 through 45 of the Company's Annual Report to Shareholders for the year ended December 31, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected unaudited financial data for each of the last 10 calendar years are incorporated herein by reference to pages 26 and 27 of the Company's Annual Report to Shareholders for the year ended December 31, 1993. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Discussion and analysis of financial condition and results of operations are incorporated herein by reference to pages 28 through 33, and note 4 to the consolidated financial statements on pages 42 and 43 of the Company's Annual Report to Shareholders for the year ended December 31, 1993. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial information included in the Company's Annual Report to Shareholders for the year ended December 31, 1993, is set forth on pages 34 through 53 thereof and is incorporated herein by reference. See also the information contained in Item 14 of Part IV of this Report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS OF THE COMPANY The name, age and background information for each of the Company's Directors is incorporated herein by reference to the section entitled ELECTION OF DIRECTORS and the table therein contained in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders. EXECUTIVE OFFICERS OF THE COMPANY The Executive Officers are elected annually to their respective positions, effective at the April meeting of the Board of Directors. The Executive Officers of the Company at February 15, 1994, were as follows: Prior to being elected an Executive Officer in 1991, Mr. George was Vice President and Treasurer of USAir Inc. and Treasurer of USAir Group Inc. from September, 1989, to July, 1991; prior to that time he served as Director Corporate Finance, Allied-Signal Inc. from 1985 to August, 1989. Prior to being elected an Executive Officer in 1993, Ms. Michaud was Senior Counsel of the Company from 1986 to February, 1993. Prior to being elected President and Chief Executive Officer of the Company in 1993, Mr. Molen served as President and Chief Operating Officer of the Company. Prior to being elected as an Executive Officer in 1993, Mr. Morin was President and General Manager of Huffy Bicycle Company from June, 1992, to February, 1993; prior to that time he served as President and General Manager of Washington Inventory Service from March, 1991, to June, 1992; prior to that time he served as Vice President - Finance, Chief Financial Officer and Treasurer of the Company from 1989 to March, 1991. Prior to being elected an Executive Officer in 1992, Mr. Plotner was Vice President - Quality and Human Resources of Huffy Bicycle Company from 1989 to March, 1992, and prior thereto, Vice President - Human Resources of such company. Prior to being elected an Executive Officer in 1994, Ms. Whipps was Assistant Treasurer and Manager Investor Relations of the Company from 1990 to February 1994; prior to that time she served as Assistant Treasurer and Cash Manager, Robbins & Myers, Inc. Prior to being elected Vice President - Chief Administrative Officer and Secretary of the Company in 1993, Mr. Wieland served as Vice President - General Counsel and Secretary of the Company. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information on executive compensation is incorporated by reference to the sections entitled EXECUTIVE COMPENSATION and the tables therein, contained on pages 17 through 20 in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders. Notwithstanding anything to the contrary set forth herein or in any of the Company's previous filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, that might incorporate future filings, including this Form 10-K, the REPORT OF COMPENSATION COMMITTEE OF BOARD OF DIRECTORS ON EXECUTIVE COMPENSATION which begins on page 11 and ends on page 16 and the graph which is set forth on page 21 in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders are not deemed to be incorporated by reference in this Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The number of shares of Common Stock of the Company beneficially owned by each Director and by all Directors and Officers as a group as of January 1, 1994, is incorporated herein by reference to the section entitled SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT, and the table therein, contained on pages 8 through 11 in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information on certain transactions with management is incorporated herein by reference to the section entitled CERTAIN RELATIONSHIPS AND OTHER RELATED TRANSACTIONS contained on page 16 in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) DOCUMENTS (1) The following Consolidated Financial Statements of the Company included in the Company's Annual Report to Shareholders are incorporated by reference as part of this Report at Item 8 hereof: Consolidated Balance Sheets as of December 31, 1993, and 1992. Consolidated Statements of Operations for the years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991. Notes to Consolidated Financial Statements. The Annual Report to Shareholders for the year ended December 31, 1993, is not deemed to be filed as part of this Report, with the exception of the items incorporated by reference in Items 1, 5, 6, 7 and 8 of this Report and those financial statements and notes thereto listed above. (2) The Accountants' Report on Consolidated Financial Statements and the following Financial Statement Schedules of the Company are included as part of this Report at Item 8 hereof: Schedule VIII. Valuation and Qualifying Accounts -years ended December 31, 1993, 1992, and 1991. Schedule X. Supplementary Income Statement Information - years ended December 31, 1993, 1992, and 1991. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) The exhibits shown in "Index to Exhibits" are filed as a part of this Report. (b) REPORTS ON FORM 8-K During the fiscal quarter ended December 31, 1993, the Company filed no report on Form 8-K. 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. HUFFY CORPORATION By /s/ Richard L. Molen Date: March 21, 1994 ---------------------- Richard L. Molen President and Chief Executive Officer 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. /s/ Richard L. Molen Date: March 21, 1994 ---------------------- Richard L. Molen President and Chief Executive Officer and Director (Principal Executive Officer) /s/ Charlton L. George Date: March 21, 1994 ---------------------- Charlton L. George Vice President-Finance, Chief Financial Officer (Principal Financial Officer) /s/ Timothy G. Howard Date: March 21, 1994 ---------------------- Timothy G. Howard Vice President and Controller (Principal Accounting Officer) /s/ Thomas D. Gleason Date: February 12, 1994 ---------------------- Thomas D. Gleason, Director /s/ William K. Hall Date: February 12, 1994 ---------------------- William K. Hall, Director /s/ Stephen P. Huffman Date: February 12, 1994 ---------------------- Stephen P. Huffman, Director /s/ Linda B. Keene Date: February 12, 1994 ---------------------- Linda B. Keene, Director /s/ Jack D. Michaels Date: February 12, 1994 ---------------------- Jack D. Michaels, Director /s/ Donald K. Miller Date: February 12, 1994 ---------------------- Donald K. Miller, Director /s/ Stuart J. Northrop Date: February 12, 1994 ---------------------- Stuart J. Northrop, Director /s/ Boake A. Sells Date: February 12, 1994 ---------------------- Boake A. Sells, Director /s/ Harry A. Shaw Date: February 12, 1994 ---------------------- Harry A. Shaw III, Director /s/ Geoffrey W. Smith Date: February 12, 1994 ---------------------- Geoffrey W. Smith, Director /s/ Robin B. Smith Date: February 12, 1994 ---------------------- Robin B. Smith, Director /s/ Fred G. Wall Date: February 12, 1994 ---------------------- Fred G. Wall, Director INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES The Board of Directors, Huffy Corporation: Under date of February 11, 1994, we reported on the consolidated balance sheets of Huffy Corporation and subsidiaries as of December 31, 1993, and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the Annual Report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in Part IV, Item 14(a)(2) of Form 10-K. The financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG PEAT MARWICK Cincinnati, Ohio February 11, 1994 ____________________________ INDEPENDENT AUDITORS' CONSENT ----------------------------- The Board of Directors, Huffy Corporation: We consent to the incorporation by reference in the Registration Statements, and the Prospectuses constituting part thereof, of (i) the Form S-8 Registration Statement (Nos. 2-46912, 2-51064, 2-55162, 2-60973) pertaining to the 1974 Stock Option Plan; (ii) the Form S-8 Registration Statement (No. 2-95128) pertaining to the 1984 Stock Option Plan; (iii) the Form S-8 Registration Statement (No. 33-25487) pertaining to the 1988 Stock Option Plan and Restricted Share Plan; (iv) the Form S-8 Registration Statement (No. 33-25143) pertaining to the 1987 Director Stock Option Plan; (v) the Form S-8 Registration Statement (Nos.33-28811, 33-42724) pertaining to the 1989 Employee Stock Purchase Plan; (vi) the Form S-8 Registration Statement (No. 33-44571) pertaining to five company savings plans and (vii) the Form S-8 Registration Statement (No. 33-60900) pertaining to the W.I.S. Savings Plan of our report dated February 11, 1994, relating to the consolidated balance sheets of Huffy Corporation and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, which report appears in the 1993 Annual Report to Shareholders, which is incorporated by reference in the Company's 1993 Annual Report on Form 10-K and our report dated February 11, 1994 relating to the financial statement schedules for each of the years in the three-year period ended December 31, 1993, which report appears in the Company's 1993 Annual Report on Form 10-K. /s/ KPMG PEAT MARWICK Cincinnati, Ohio March 21, 1994

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ITEM 1. BUSINESS General Measurex Corporation provides its customers computer-integrated manufacturing through design, production, marketing and servicing of sensor- based information and control systems. The Company's broad, integrated product line ensures economic results for customers by increasing productivity, reducing raw material usage and energy consumption, and improving product quality and uniformity. Measurex's primary marketplace is within the manufacturing industries that produce products by continuous or batch processes. The principal industries served by the Company are: pulp and paper, plastics, metals, rubber and chemicals. Measurex supports its installed systems with a worldwide field service organization of approximately 1,100 employees. Service technicians work directly with customers, in their plants and mills, providing an important and stable source of revenue. The service teams provide quality installations, training and continuing service support to ensure results for the Company's customers. Measurex was originally incorporated in California in 1968. The Company's state of incorporation was changed from California to Delaware in 1984. Measurex's principal executive offices are located at One Results Way, Cupertino, California, 95014-5991; its telephone number is (408) 255-1500. Unless the context otherwise indicates, the terms "Measurex" and "the Company" include Measurex Corporation, the predecessor California corporation, and its subsidiaries. Current Year's Development On April 7, 1993, the Company acquired Roibox Oy for approximately $1.7 million, net of cash acquired. Located in Kuopio, Finland, Roibox is a worldwide supplier of web-inspection products for the paper industry. The acquisition was accounted for using the purchase method. Product Information The following table shows the annual shipment revenues (in millions of dollars) and the percentages of annual shipment revenues during the last three fiscal years, attributable to the delivery of systems used in the pulp and paper and industrial systems industries. "Industrial Systems" includes systems for plastics, metals, rubber, and other products. For information regarding sales by geographic location see the section "Business Segments" under Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. MXOpen In March 1992 the MXOpen(TM) product line was introduced at the Technical Association of the Pulp and Paper Institute (TAPPI) trade show in Atlanta, Georgia. MXOpen is an integrated information and control system that uses industry-standard computer and communication protocols. The product line was developed over a three-year period and represents a substantial investment in research and development, manufacturing and marketing expenses. In January 1993, at the Canadian Pulp and Paper Association (CPPA) trade show in Montreal, Quebec, Canada, the Company launched the MXOpen PrecisionPLUS(TM) intelligent measurement system. PrecisionPLUS features new distributed sensor intelligence, advanced sensor technology and faster scanning capabilities. The InfrandPlus moisture sensor uses principles of optical physics to ensure accurate moisture measurement consistently on every grade. The MXOpen Integrated Control System provides end-users with a combination of integration and open architecture. MXOpen features: [] Modular systems with capability for total machine optimization; [] Open systems architecture based on international industry standards for flexibility and expandability; and [] Integrated information and control with real-time millwide visibility for management decision-making. The MXOpen millwide product line includes: [] Intelligent Sensors and Scanners [] Distributed Control System [] Profile Actuation [] Web Inspection [] Millwide Information [] Integrated Machine Monitoring [] Complete Integrated Control System The MXOpen Measurement Control System (MCS) was introduced to industrial system customers in October 1992. For plastics, non-wovens and makers of coated materials such as flooring and building products, the MCS is an affordable solution for process improvement - all in a competitive, technologically advanced control system. Measurex 2002 ET Systems Measurex 2002 ET(TM) supervisory systems feature consolidated electronics, operator stations designed for ease of use with a broad range of graphic displays, fiber optic communications and proprietary software. A number of proprietary sensors are offered with these systems to address specific needs of the individual industries. This system provides specific solutions for the aluminum foil and sheet producers and tire manufacturers. The CMU (Computer Management Unit) 2002 ET Configuration is a pre-packaged set of features that offers a low cost option for small paper machines. Proprietary Sensors Measurex provides sensor technology for the process industries, currently offering more than 70 sensors. Its sensors include those that monitor the basis weight, moisture, caliper, ash content, coating, smoothness, gloss, formation, opacity, strength and color of processed paper, as well as the physical properties of other processed products, such as the wire spacing faults on steel belted tires. These sensors use a variety of proprietary applications involving technologies which include microwave, infrared, visible light, ultraviolet, beta, X-ray and gamma radiation. Cross-Direction Controls Measurex is a leader in the complex technology of cross-direction (CD) profile control. The center of this business is in the Measurex Devron Division, based in Vancouver, British Columbia, Canada. CD control, as used for example in the pulp and paper industry, allows precise control of paper characteristics in small segments across the entire width of the paper sheet. Cross-direction controls are complementary to the average profile taken along the paper's direction of travel, referred to as machine direction. The combined control strategy significantly enhances a customer's ability to achieve optimum quality levels, thus reducing raw material and energy usage, lowering scrappage rates and enhancing the customer's competitive position. Measurex has a variety of CD control products including AutoSlice(TM), ThermaTrol(TM), AquaTrol(R), Devronizer(TM), InfraTrol(TM), CalTrol(TM), Calcoil(TM), Calendizer(TM), and GlossTrol(TM) actuators. CD controls can be ordered with new systems or can be integrated into existing installed systems. The CDOpen(TM) System allows Measurex's cross- direction control products to be integrated with non-Measurex measurement systems. Millwide Information Measurex's Management Systems Division (MSD), provides plant level computing expertise for production processes. The Division's OptiVISION(TM) Full Spectrum Production and Quality Management System (PQMS) gives Measurex the ability to offer a system that manages processes from long-term planning and order entry through scheduling, product tracking, shipping and invoicing the product. The OptiVISION system provides users with a modular design that reduces development and installation time. Integrated Machine Monitoring The Integrated Monitoring System (IMS), marketed as a part of the MXOpen product line, consists of digital systems for on-line process and machine monitoring and analysis of the papermaking process and production machinery. IMS products provide process and machine-condition diagnosis and trending, giving papermakers tools to address maintenance problems before failure. Web Inspection Systems The Roibox-developed web inspection system analyzes the moving paper web by measuring the intensity variations of light transmitted through the sheet or reflected from the sheet. The system uses Charge Coupled Device (CCD) camera technology to continuously detect - on line - visual defects in paper or other web-produced material. Like other MXOpen Systems, this web-inspection product helps customers to produce superior quality products at lower cost, adding significantly to the basic value of an Integrated Control System. Strategic Alliances Beloit Corporation In 1990, Measurex and Beloit Corporation, agreed to expand and strengthen their 1987 strategic alliance. This cooperative agreement includes provisions for integrated marketing and sales of all Measurex paper industry products with Beloit's full line of pulp and paper machinery. Simultaneously executed was a seven-year "standstill" agreement between Measurex and Harnischfeger Industries, Inc., Beloit's parent company. Harnischfeger purchased 20 percent of Measurex's stock on the open market, the maximum allowed under the agreement. Mitsubishi Heavy Industries, Ltd. In 1988, Measurex and Mitsubishi Heavy Industries, Ltd. (MHI) entered into an agreement whereby the two companies offered certain products and services to the pulp and papermaking industry of Asia. In 1991, MHI became a signatory to the Measurex/Beloit strategic alliance, and a full participant in that agreement. All Measurex products for the pulp and paper industry are now made available to MHI on the same basis as they are made to Beloit. Siemens AG In June 1993, Siemens AG, pulp and paper division, selected Measurex as its Original Equipment Manufacturer (OEM) for certain MXOpen products. Siemens will integrate these products with other Siemens products for their total turnkey pulp and paper automation projects. Sales and Service Measurex offers its systems, related products and services principally through its own worldwide marketing and service organization. This organization offers customers a broad range of on-site and on-call services including 24- hour-a-day, 365-days-a-year service contracts. To support the Company's product line, Measurex has 47 regional sales offices and service centers which are located in 30 countries throughout the world. The Company has sold over 4,000 systems in 45 countries, primarily located in North America, Latin America, Europe and the Pacific Rim. The sales and service organization consists of regional and area managers who are responsible for selling Measurex's products and supervising service at customer sites. Under their supervision are software control and application engineers who assist customers in making the most efficient use of their systems, technical service engineers and supervisory personnel who are responsible for the installation, start-up and routine preventive maintenance of the systems, as well as any emergency services that may be required. Customers may acquire Measurex systems either by direct purchase or through Measurex lease plans. For additional information, see the Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. Research and Product Development Measurex's systems are the result of the integration of a number of complex technologies including electronics, physics, mechanical design and software. Central to the Company's strategic goals is a commitment to research and development. The Company strongly believes the continued investment in new product development is key to its long-term success. Product development costs were $22.9 million in 1993, 9% of total reveneues and 15% of system revenue. Product development costs were $25.2 million in 1992 and $25.3 million in 1991. Of this total, Measurex capitalized $1.7 million, $4.6 million, and $2.3 million of software development costs in fiscal 1993, 1992 and 1991, respectively. Measurex amortized $3.4 million, $1.7 million and $2.8 million of capitalized software to systems costs in 1993, 1992 and 1991, respectively. The decrease in capitalized software and increase in amortization in 1993 were attributable to the general release of MXOpen software in late 1992. Backlog System backlog at November 28, 1993, was $91 million, 4% lower than the backlog of $95 million at the end of 1992. Approximately 80% of the $91 million year-end 1993 backlog is scheduled to be shipped during fiscal 1994. Patents Measurex follows a policy of filing appropriate patent applications on inventions it considers significant. As of November 28, 1993, the Company had 121 United States patents and 270 foreign patents in effect. Although important to the business, Measurex believes that the invalidity or expiration of any single such patent would not have a material adverse effect on its operations. Supply of Materials and Purchased Components Measurex produces most of the software, sensors, scanners, digital logic circuits, peripheral devices and various terminals used in its systems. Many components, such as integrated circuits, video monitors, printers, disks, and microcomputers are purchased from other manufacturers and integrated into the systems. Measurex currently purchases certain components from single sources of supply. In each instance, components performing similar functions are available from alternative sources, except for radioactive source material which is available from only two suppliers. Use of these alternative components might require a change in the design of certain portions of the system which could result in production delays, additional expenses and contract cancellations while changing vendors. The Company has contracts with certain vendors which entitle, but do not require, Measurex to purchase specific quantities of components. Manufacturing Systems are manufactured at Measurex's facilities in Cupertino, California; Waterford, Republic of Ireland; and Vancouver, British Columbia, Canada. Measurex Management Systems Division products are configured and tested at facilities in Cincinnati, Ohio. The facility in Ireland is primarily used to produce systems for customers in Europe. Web-inspection products are manufactured by Measurex's Roibox subsidiary in Kuopio, Finland. Certain subassemblies are manufactured in Cupertino and shipped to Ireland for incorporation in the final systems. The systems are generally installed at the customer's site under the supervision of Measurex personnel. Competition The market for process measurement and control is highly competitive and is subject to technological change in both hardware and software development. The principal competitive factors in this market are product quality and reliability, product features, customer support, corporate reputation and relative price/performance. Measurex's competitive strategy is to provide customers with greater economic results than available from competitors by focusing on the quality and performance characteristics of systems. However, any inability of the Company to match or exceed the price/performance or other features of the systems offered by its competitors could adversely affect future operating results. The Company's principal competition is from distributed control systems suppliers and packaged system suppliers, as well as factory automation system suppliers. In the supervisory measurement and process control business area, competition includes ABB Asea Brown Boveri Process Automation Inc.; Lippke, a wholly owned subsidiary of Honeywell; the Valmet Automation Group, a division of Valmet Oy; and Yokogawa-YEW in Japan. The distributed control system business area competition includes Honeywell, Fisher, Foxboro (a subsidiary of Siebe, Inc.), Siemens, and many other companies. In the web-inspection products area, the Company faces competition from ABB and other smaller companies. Competition for production management and process analysis and quality management is very fragmented. Employees As of November 28, 1993, Measurex had 2,250 full-time employees, of whom 1,120 were located outside of the United States. Measurex has various employee benefit plans, including a stock purchase plan for all United States and Canadian employees, stock option plans for key employees, a Savings and Deferred Profit Sharing Plan, management incentive programs, pension plans in certain foreign countries, and health, dental, life and disability plans. Nuclear Regulatory Licenses In the United States, Measurex and its customers are subject to licensing and regulation by the United States Nuclear Regulatory Commission (NRC) under the Atomic Energy Act of 1954 (the Act) with respect of those parts of its products and systems which utilize nuclear radiation. The NRC has transferred a portion of its licensing and regulatory functions to several state governments, including California, pursuant to Section 274 of the Act. Measurex holds all such licenses necessary for its current operations. Licenses are renewed periodically as required. Measurex also holds all necessary foreign licenses regarding nuclear radiation for the applicable countries in which it operates. United States customers possessing Measurex systems containing radioactive sources hold the radioactive material under a General or Specific License issued by their state or federal regulatory authority. Similarly, foreign customers hold licenses issued by their local authorities for radioactive material in Measurex systems. Licenses to Export from the United States Measurex is subject to licensing and regulation by the United States Department of Commerce under the Export Administration Act of 1969, as amended and extended, with respect to Measurex systems or parts thereof, exported from the United States or by any of its subsidiaries. Industry Segments Measurex operates within the computer-integrated control and information systems industry. All necessary disclosures regarding revenues, earnings from operations and identifiable assets are included in "Business Segments" under Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. Geographic Segments For information regarding geographic operations in 1993, 1992, and 1991, see "Business Segments" included in the Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. Measurex is subject to the normal risks of foreign currency fluctuations; however, to the extent practical, Measurex attempts to minimize the exposure from losses associated with such risks with foreign exchange contracts and other hedging activities. See Summary of Significant Accounting Policies (Foreign Currency Translation and Foreign Exchange Contracts) and Interest Income and Other in the Notes to the Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders. ITEM 2. ITEM 2. PROPERTIES Located in Cupertino, California, the Company's headquarters, offices, research and manufacturing plant total 360,000 square feet. The offices, research and manufacturing operations of Measurex Management Systems Division are located in a 43,000 square-foot facility in Cincinnati, Ohio. The U.S. Sales and Service Headquarters are located in a 32,000 square-foot facility in Atlanta, Georgia. All of these facilities are owned by the Company. Measurex leases office space for sales and service operations throughout the United States and various other countries. The Measurex Devron Division owns two facilities for its offices, research and manufacturing operations, totaling 94,000 square feet in Vancouver, British Columbia, Canada. In Waterford, Ireland, the Company owns a 60,000 square-foot manufacturing facility and leases 20,000 square feet for manufacturing and storage facilities. Roibox Oy leases an 11,000 square-foot facility in Kuopio, Finland for manufacturing, engineering, and sales support. During 1993, the Company was productively utilizing the space in its facilities, while disposing of space determined to be under-utilized. The Company believes current facilities provide adequate production capacity to meet the Company's planned business activities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings to which the Company or any of its subsidiaries are a party or of which any of their property is the subject, other than ordinary routine litigation incidental to the business. Management believes that the final outcome of such matters will not have a material adverse effect on the Company's consolidated financial position and results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company has not submitted any matters to a vote of security holders during the fourth quarter of the fiscal year ended November 28, 1993. EXECUTIVE OFFICERS OF REGISTRANT The following table shows the executive officers of Measurex Corporation as of January 28, 1994, (ages are as of November 28, 1993), their positions with Measurex, their business experience for the last five years, and the number of years during which they have been executive officers of the Company. Officers are elected annually but may be removed at any time at the discretion of the Board of Directors. There are no family relationships among any of the above officers. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The information under the heading "Market for the Registrant's Common Stock and Related Security Holder Matters," which appears on page 31 of Registrant's 1993 Annual Report to Shareholders, is incorporated by reference in this Form 10-K Annual Report. The Company paid quarterly dividends of $0.11 per quarter in 1993 and 1992. While the Company intends to pay regular quarterly dividends, the payment of any future dividends is within the discretion of the Board of Directors of the Company. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information under the heading "Selected Financial Data," which appears on page 32 of Registrant's 1993 Annual Report to Shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations," which appears on pages 15 to 17 of Registrant's 1993 Annual Report to Shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information under the heading "Financial Statements and Supplementary Data," which appears on pages 18 to 31 of Registrant's 1993 Annual Report to Shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the directors of the Company appears in Registrant's definitive Proxy Statement for the annual meeting of shareholders to be held April 19, 1994, under the caption "Election of Directors" and is incorporated herein by reference. Information concerning the executive officers of the Company appears at the end of Part I, pages 10 and 11, of this Form 10-K Annual Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference to Registrant's definitive Proxy Statement for its annual meeting of shareholders to be held April 19, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference to Registrant's definitive Proxy Statement for its annual meeting of shareholders to be held April 19, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference to Registrant's definitive Proxy Statement for its annual meeting of shareholders to be held April 19, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a.) 1. The consolidated financial statements of Measurex Corporation included herein are set forth in the Index to Financial Statements and Schedules submitted as a separate section of this Report. 2. The Financial Statement Schedules are contained in the accompanying Index to Financial Statements and Schedules submitted as a separate section of this Report. 3. Exhibits See Index to Exhibits, page 20 and 21 (b.) Reports on Form 8-K. No report on Form 8-K was filed in the fourth quarter of fiscal year 1993 and through the date of this filing. 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. MEASUREX CORPORATION (Registrant) Date February 24, 1994 By /S/ DAVID A. BOSSEN ------------------- --------------------------- David A. Bossen Chairman Know all persons by these presents, that each person whose signature appears below constitutes and appoints David A. Bossen and Carl A. Thomsen jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. 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. MEASUREX CORPORATION INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Fiscal Year 1993 ------------------ With the exception of the aforementioned information, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this report unless otherwise noted. Other schedules have not been filed because the conditions requiring the filing do not exist or the required information is given in the financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders Measurex Corporation Our report on the consolidated financial statements of Measurex Corporation and Subsidiaries as of November 28, 1993 and November 29, 1992 and for each of the three fiscal years in the period ended November 28, 1993, has been incorporated by reference in this Form 10-K from page 30 of Measurex Corporation's 1993 Annual Report to Shareholders. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 16 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information required to be included therein. /S/ COOPERS & LYBRAND ------------------------- COOPERS & LYBRAND San Jose, California December 15, 1993 SCHEDULE VIII MEASUREX CORPORATION VALUATION AND QUALIFYING ACCOUNTS (1) Fiscal years 1993, 1992 and 1991 (Amounts in thousands) Notes: (1) See the Notes to Consolidated Financial Statements. (2) Represents write-offs and deductions, net of recoveries. (3) Deductions for returns of systems or parts of systems and for write-off of noncollectible amounts. (4) Deductions for write-offs of obsolete and scrapped parts and translation adjustments. (5) Represents the reclassification of reserves from non-current to current inventories. (6) Includes allowance on contracts receivable. SCHEDULE X MEASUREX CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION Fiscal Years 1993, 1992, and 1991 (Amounts in thousands) Notes: (1) Intangible assets include goodwill, patents and capitalized software. (2) Items omitted are less than 1% of net sales. MEASUREX CORPORATION INDEX TO EXHIBITS Fiscal Year 1993 MEASUREX CORPORATION INDEX TO EXHIBITS Fiscal Year 1993 Other exhibits have not been filed because conditions requiring the filing do not exist.

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1993

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ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER _________MATTERS_____________________________________________________ The information called for by this item is set forth on p. 20 of the Annual Report to Shareholders for the year ended December 31, 1993 which is incorporated herein by reference. ITEM_6_-_SELECTED_FINANCIAL_DATA The information called for by this item is set forth on p. 20 of the Annual Report to Shareholders for the year ended December 31, 1993 which is incorporated herein by reference. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND __________RESULTS_OF_OPERATION__________________________________________ The information called for by this item is set forth on pp. 16 through 18 of the Annual Report to Shareholders for the year ended December 31, 1993 which are incorporated herein by reference. ITEM_8_-_FINANCIAL_STATEMENTS_AND_SUPPLEMENTARY_DATA The information called for by this item is set forth on pp. 5 through 15 and pp. 19 and 20 of the Annual Report to Shareholders for the year ended December 31, 1993 which are incorporated herein by reference. ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND __________FINANCIAL_DISCLOSURE___________________________________________ There were none. PART III ITEM_10_-_DIRECTORS_and_EXECUTIVE_OFFICERS (a) IDENTIFICATION OF DIRECTORS Name, Age, Tenure as a Director, Position with the Corporation (1), Principal Occupation, Business Experience Past Five Years, and Other Directorships in Public_Companies_____________________________________________________________ Louis Berkman (age 85, Director since 1960; current term expires in 1996). Chairman of the Executive Committee of the Corporation for more than five years. He is also President and a director of The Louis Berkman Company (steel products, fabricated metal products, building and industrial supplies). (2)(4) Marshall L. Berkman (age 57, Director since 1970; current term expires in 1995). He has been Chairman of the Board of Directors and Chief Executive Officer of the Corporation for more than five years. He is also an officer and director of The Louis Berkman Company. (2) Robert A. Paul (age 56, Director since 1970; current term expires in 1994). He has been President and Chief Operating Officer of the Corporation for more than five years. He is also an officer and director of The Louis Berkman Company and a director of Integra Financial Corporation. (N)(2) William D. Eberle (age 70, Director since 1982; current term expires in 1994). He is a private investor and consultant and is Chairman of Manchester Associates, Ltd. and Showscan, Inc. He is also a director of Mitchell Energy & Development Co., America Service Group and Fiberboard Corporation, and was Special Representative for Trade Negotiations with the rank of Ambassador. (N)(3)(4) William P. Hackney (age 69, Director since 1979; current term expires in 1996). For more than five years prior to 1992 he had been a partner in the law firm of Reed Smith Shaw & McClay. As of January 1, 1992, he retired and became of counsel to the law firm. (3) Alvin G. Keller (age 84, Director since 1961; current term expires in 1995). He is a private investor who, prior to his retirement, served as a Vice President of Mellon Bank, N.A. (2)(3)(4) Carl H. Pforzheimer, III (age 57, Director since 1982; current term expires in 1996). For more than five years he has been Managing Partner of Carl H. Pforzheimer & Co. (member of the New York and American Stock Exchanges). (3) Ernest G. Siddons (age 60, Director since 1981; current term expires in 1995). He has been Senior Vice President Finance and Treasurer of the Corporation for more than five years. (2) _______________ (N) Nominee for election at the Annual Meeting of Shareholders to be held on April 26, 1994. (1) Officers serve at the discretion of the Board of Directors. (2) Member of Executive Committee. (3) Member (or alternate member) of Audit Committee. (4) Member of Salary Committee. Mr. Siddons is an executive officer of Valley-Vulcan Mold Company, a partnership that filed for bankruptcy in October 1990. He also serves as a director and officer of Vulcan, Inc., a wholly-owned subsidiary of the Corporation, which is a 50% general partner in Valley-Vulcan. The other 50% general partner is unrelated to the Corporation. (b) IDENTIFICATION OF EXECUTIVE OFFICERS In addition to Marshall Berkman, Louis Berkman, Robert A. Paul and Ernest G. Siddons (see "Identification of Directors" above) the following are also Executive Officers of the Corporation: Name, Age, Position with the Corporation (1), Business Experience Past Five_Years______________________________________________________________ Rose Hoover (age 38). Secretary of the Corporation since December, 1990. For more than five years before 1990, she was a Legal Assistant for the Corporation. Robert F. Schultz (age 46). Vice President Industrial Relations and Senior Counsel of the Corporation since December, 1990. From January, 1987 to December 1990 he was Director of Industrial Relations. _______________ (1) Officers serve at the discretion of the Board of Directors and none of the listed individuals serve as a director of a public company. (c)IDENTIFICATION OF CERTAIN SIGNIFICANT EMPLOYEES None. (d) FAMILY RELATIONSHIPS Louis Berkman is the father of Marshall L. Berkman and the father-in-law of Robert A. Paul. There are no other family relationships among the Directors and Officers. EXECUTIVE COMPENSATION The following table sets forth certain information as to the total remuneration received for the past three years by the five most highly compensated executive officers of the Corporation, including the Chief Executive Officer (the "Named Executive Officers"): SUMMARY COMPENSATION TABLE _______________ *Mr. Wasser retired on January 15, 1994. In connection with that retirement, he will receive supplemental payments totalling $55,400 in 1994. (b) COMPENSATION PURSUANT TO PLANS The Corporation has a tax qualified retirement plan applicable to the Executive Officers, to which the Corporation makes annual contributions in amounts determined by the Plan's actuaries. The Plan does not have an offset for Social Security and is fully paid for by the Corporation. Under the Plan, employees become fully vested after five years of participation and normal retirement age under the Plan is age 65 but actuarially reduced benefits may be available for early retirement at age 55. The benefit formula is 1.1% of the highest consecutive five year average earnings in the final ten years, times years of service. The Corporation adopted a Supplemental Executive Retirement Plan (SERP) in 1988, for all officers listed in the compensation table and certain key employees, covering retirement after completion of ten years of service and attainment of age 55. The combined retirement benefit at age 65 provided by the Plan and the SERP is 50% of the highest consecutive five year average earnings in the final ten years of service. The participants are eligible for reduced benefits for early retirement at age 55. A benefit equal to 50% of the benefit otherwise payable at age 65 is paid to the surviving spouse of any participant, who has had at least five years of service, commencing on the later of the month following the participant's death or the month the participant would have reached age 55. In addition, there is an offset for pensions from other companies. Certain provisions, applicable if there is a change of control, are discussed below under Termination of Employment and Change of Control Arrangement. The following shows the annual pension that would be payable, without offset, under the Plan and the SERP to the individuals named in the compensa- tion table assuming continued employment to retirement at age 65, but no change in level of compensation: (c) COMPENSATION OF DIRECTORS In 1993, each Director who was not employed by the Corporation received $1,500 for each Board meeting, and $250 for each Committee meeting attended. In 1994, each Director who is not employed by the Corporation will receive $2,000 for each Board meeting attended and $500 for each Committee meeting attended. Directors will receive one-half of those amounts if not in attendance or if participation is by telephonic connection. (d) TERMINATION OF EMPLOYMENT AND CHANGE OF CONTROL ARRANGEMENTS The Chairman, President, and Senior Vice President Finance have two year contracts (which automatically renew for one year periods unless the Corporation chooses not to extend) providing for compensation equal to five times their annual compensation (with a provision to gross up to cover the cost of any federal excise tax on the benefits) in the event their employment is terminated (including a voluntary departure for good cause) and the right to equivalent office space and secretarial help for a period of one year after a change in control. In addition, the remainder of the officers named in the compensation table and certain key employees have two year contracts providing for three times their annual compensation in the event their employment is terminated after a change in control (including a voluntary departure for good cause). Both types of contracts provide for the continuation of employee benefits, for three years for the three senior executives and two years for the others, and the right to purchase the leased car used by the covered individual at the Corporation's then book value. The same provisions concerning change in control that apply to the contracts apply to the SERP and vest the right to that pension arrangement. A change of control triggers the right to a lump sum payment equal to the present value of the vested benefit under the SERP. (e) SALARY COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISIONS A Salary Committee is appointed each year by the Board of Directors. Committee members abstain from voting on matters which involve their own compensation arrangements. The Salary Committee for the year 1993 was comprised of three Directors: Louis Berkman, Alvin G. Keller and William D. Eberle. Louis Berkman is an employee of the Corporation and Chairman of the Executive Committee of the Board of Directors. He is also the President and a Director of The Louis Berkman Company. The Corporation's Chief Executive Officer and President are also officers and directors of The Louis Berkman Company. The Louis Berkman Company and William D. Eberle had certain transactions with the Corporation which are more fully described under "Certain Relationships and Related Transactions." (f) SALARY COMMITTEE REPORT ON EXECUTIVE COMPENSATION The Salary Committee approves salaries for executive officers within a range from $150,000 up to $200,000 and increases in the salary of any executive officer, which would result in such officer earning a salary within such range. Salaries of $200,000 per year and above must be approved by the Board of Directors or its Executive Committee after a recommendation by the Salary Committee. Salaries for executive officers below the level of $150,000 are set by the Chairman, President and Senior Vice President of the Corporation. Bonuses are discretionary and determined in the same manner as set forth above. All executive compensation is reviewed by the Salary Committee at intervals ranging between twelve and twenty-four months. The compensation of the Chief Executive Officer of the Corporation, as well as the other applicable executive officers, is based on an analysis conducted by the Salary Committee in 1992 and reviewed and, to the extent provided above, approved by the Board of Directors. The Committee does not specifically link remuneration solely to quantitative measures of performance because of the cyclical nature of the industries and markets served by the Corporation. In setting compensation, the Committee also considers various qualitative factors, including competitive compensation arrangements of other companies within relevant industries, individual contributions, leadership ability and an executive officer's overall performance. In this way, it is believed that the Corporation will attract and retain quality management, thereby benefitting the long-term interest of shareholders. In 1993, there were no changes in salary of persons who need approval of the Salary Committee. This report of the Salary Committee shall not be deemed incorporated by reference by any general statement incorporating by reference this 10-K report into any filing under the Securities Act of 1933 or under the Securities Exchange Act of 1934, except to the extent that the Corporation specifically incorporates this report and the information contained herein by reference, and shall not otherwise be deemed filed under such Acts. Louis Berkman William D. Eberle Alvin G. Keller (g) STOCK PERFORMANCE GRAPH Comparative Five-Year Total Returns* Ampco-Pittsburgh ("AP"), S&P 500, Peer Group (Performance results through 12/31/93) Assumes $100 invested at the close of trading on the last trading day preceding January 1 of the fifth preceding fiscal year in AP common stock, S&P 500, and Peer Group. *Cumulative total return assumes reinvestment of dividends. In the above graph, the Corporation has used Value Line's Metals: Steel, Integrated Industry for its peer comparison. The diversity of products produced by subsidiaries of the Corporation made it difficult to match to any one product-based peer group. The Steel Industry was chosen because it is impacted by some of the same end markets that the Corporation ultimately serves, such as the automotive, appliance and construction industries. Historical stock price performance shown on the above graph is not necessarily indicative of future price performance. ITEM_12_-_SECURITY_OWNERSHIP_OF_CERTAIN_BENEFICIAL_OWNERS_AND_MANAGEMENT (a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS As of March 8, 1994, Louis Berkman owned directly 159,388 shares (1.66%) of the Common Stock of the Corporation. As of the same date, The Louis Berkman Company, P. O. Box 576, Steubenville, OH 43952 owned beneficially and of record 1,626,089 shares (16.98%) of the Common Stock of the Corporation. Louis Berkman, an officer and director of The Louis Berkman Company, owns directly 63.66% of its common stock. Marshall L. Berkman, an officer and director of The Louis Berkman Company, owns directly 18.17% of its common stock. Robert A. Paul, an officer and director of The Louis Berkman Company, disclaims beneficial ownership of the 18.17% of its common stock owned by his wife. The Corporation has received two Schedules 13G filed with the Securities and Exchange Commission disclosing that as of December 31, 1993 Norwest Corporation, Sixth & Marquette, Minneapolis, MN 55479 (in various fiduciary and agency capacities) owned 1,611,325 shares or 16.8% and that C.S. McKee & Co., Inc., One Gateway Center, Pittsburgh, PA 15222, owned 611,050 shares or 6.38% of the Corporation's common stock. On June 7, 1989, GAMCO Investors, Inc. and affiliates, Corporate Center at Rye, Rye, NY 10580, filed a Schedule 13D showing they owned 1,872,875 shares or 19.55% and no further filings have been made. (b) SECURITY OWNERSHIP OF MANAGEMENT The following table sets forth as of March 8, 1994 information concerning the beneficial ownership of the Corporation's Common Stock by the Directors and Named Executive Officers and all Directors and Executive Officers of the Corporation as a group: _______________ *less than .1% (1) Includes 159,388 shares owned directly and 1,626,089 shares owned by The Louis Berkman Company. (2) The Louis Berkman Company owns beneficially and of record 1,626,089 shares of the Corporation's Common Stock (16.98%). Louis Berkman is an officer and director of The Louis Berkman Company and owns directly 63.66% of its common shares. Marshall L. Berkman, an officer and director of The Louis Berkman Company, owns directly 18.17% of its common stock. Robert A. Paul, an officer and director of The Louis Berkman Company, disclaims beneficial ownership of the 18.17% of its common stock owned by his wife. The number of shares shown in the table for Marshall L. Berkman and Robert A. Paul does not include any shares held by The Louis Berkman Company. (3) Includes 42,889 shares owned directly and 13,767 shares owned by his wife, in which shares he disclaims beneficial ownership. (4) Includes 40,500 shares owned directly and 1,500 shares owned by his wife, in which shares he disclaims beneficial ownership. (5) Includes 5,333 shares owned directly, 3,000 shares owned jointly with his wife, and 1,420 shares owned by his wife, in which shares he disclaims beneficial ownership. (6) Includes 1,000 shares owned directly, 1,600 shares held by a trust of which he is a principal beneficiary, and 133 shares held by his daughter, in which shares he disclaims beneficial ownership. (7) The shares are owned jointly with his wife. (8) Excludes double counting of shares deemed to be beneficially owned by more than one Director. Unless otherwise indicated the individuals named have sole investment and voting power. (c) CHANGES IN CONTROL The Corporation knows of no arrangements which may at a subsequent date result in a change in control of the Corporation. ITEM_13_-_CERTAIN_RELATIONSHIPS_AND_RELATED_TRANSACTIONS In 1993 the Corporation bought industrial supplies from, and was paid for administration services by, The Louis Berkman Company in transactions in the ordinary course of business amounting to approximately $926,000. Additionally, the disinterested members of the Board of Directors authorized the sale of a life insurance policy (on a person not affiliated with the Corporation) owned by the Corporation to The Louis Berkman Company for the cash surrender value of approximately $92,000. Louis Berkman, Marshall L. Berkman and Robert A. Paul are shareholders, officers or directors in that company. These transactions and services were at prices generally available from outside sources. Transactions between the parties will take place in 1994. In 1989, certain subsidiaries of the Corporation and Tertiary, Inc., a corporation owned by the children of William Eberle, formed three 50/50 partnerships, to manage, develop and operate hotel properties and a subsidiary of the Corporation also invested as a limited partner in one of the operating partnerships. In 1992, Tertiary purchased two of the 50/50 partnerships. In 1993, Tertiary paid the remaining $100,000 from such purchase. Also in 1993, one of the limited partnerships accrued a fee of $31,000 payable to William Eberle for his guarantee of a mortgage loan. At December 31, 1993, there were promissory notes outstanding from certain of the partnerships to subsidiaries of the Corporation totalling $880,000. These notes are due in 1994; however, it is anticipated that the maturity dates will be extended. PART IV ITEM_14_-_EXHIBITS,_FINANCIAL_STATEMENT_SCHEDULES_AND_REPORTS_ON_FORM_8-K (a) 1. FINANCIAL STATEMENTS The consolidated financial statements, together with the report there- on of Price Waterhouse, appearing on pp. 5 through 15 of the accompanying Annual Report are incorporated by reference in this Form 10-K Annual Report. 2. FINANCIAL STATEMENT SCHEDULES The following additional financial data should be read in conjunction with the consolidated financial statements in the accompanying Annual Report. Schedules not included with this additional financial data have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Schedule Page _Number_ Number Index to Ampco-Pittsburgh Corporation Financial Data Report of Independent Accountants Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other Than Related Parties II Property, Plant and Equipment V Accumulated Depreciation of Property, Plant and Equipment VI Short-Term Borrowings IX Supplementary Income Statement Information X 3. EXHIBITS Exhibit No. (3)Articles of Incorporation and By-laws a. Restated Articles of Incorporation Incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended March 31, 1983 b.Amendments to Articles of Incorporation Incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended March 31, 1984, the Quarterly Report on Form 10-Q for the quarter ended March 31, 1985 and the Quarterly Report on Form 10-Q for the quarter ended March 31, 1987 c.Amended and Restated By-laws Incorporated by reference to Form 8-K dated April 9, 1990 d. Amendment to By-laws Incorporated by reference to the Annual Report on Form 10-K for fiscal year ended December 31, 1990 (4)Instruments defining the rights of securities holders a.Rights Agreement between Ampco-Pittsburgh Corporation and Mellon Bank, N.A. dated as of November 1, 1988 Incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended September 30, 1988 b.Revolving Credit Agreement dated as of September 30, 1993 Incorporated by reference to the Quarterly Report on Form 10-Q for quarter ended September 30, 1993 (10)Material Contracts a.Ampco-Pittsburgh Corporation Salaried Employees' Retirement Plan Incorporated by reference to the Annual Report on Form 10-K for fiscal year ended December 31, 1983 Part IV; Item 14

316709_1993.txt

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ITEM 1. BUSINESS (a) General Development of Business. The Charles Schwab Corporation (CSC) is a holding company engaged, through its subsidiaries, in brokerage and related investment services. CSC's principal operating subsidiary, Charles Schwab & Co., Inc. (Schwab), serves an estimated 44% of the discount brokerage market as measured by commission revenue. Another subsidiary, Mayer & Schweitzer, Inc. (M&S), a market maker in Nasdaq securities, provides trade execution services to institutional clients and broker-dealers. During 1993, customer orders handled by M&S totaled over 4 billion shares, or over 6% of the total shares traded on Nasdaq. As used herein, the "Company" refers to CSC and subsidiaries. Schwab was incorporated in California in 1971 and adopted the name Charles Schwab & Co., Inc. after Mr. Charles R. Schwab became its owner and President. In 1974, Schwab participated in the Securities and Exchange Commission's (SEC) pilot program to permit discounts on securities commissions. In 1975, when fixed commission rates were abolished, Schwab focused its strategy on providing financial services to investors who wish to conduct their own research and make their own investment decisions and who do not wish to pay, through brokerage commissions, for research or portfolio management. Schwab grew significantly through January 1983 when, to ensure the availability of sufficient capital for continued expansion, Schwab merged with an affiliate of BankAmerica Corporation (BAC). CSC was incorporated in November 1986 for the purpose of acquiring Schwab from BAC. In March 1987, Schwab was acquired from BAC in a management-led leveraged buyout. In September 1987, the Company raised $123 million in its initial public offering, using the offering proceeds to expand its business and repay debt issued in the leveraged buyout. Since becoming a publicly-owned entity, the Company has continued to experience significant growth in revenues, customer assets and number of accounts. This growth has been accomplished through investment in technology, product and service development, marketing programs and customer service delivery systems. In addition, the Company has broadened its service capability through the acquisition and development of additional businesses. In October 1989, Charles Schwab Investment Management, Inc. (CSIM) was formed as a subsidiary of CSC. In January 1990, CSIM became the general investment adviser (employing a sub-adviser to perform portfolio management for certain funds), as well as the administrator for three money market mutual funds organized as portfolios of the then newly organized The Charles Schwab Family of Funds. Substantially all of the balances previously invested by Schwab customers in other money market mutual funds having similar investment objectives were transferred to these money market mutual funds in January 1990. Schwab subsequently introduced additional mutual funds, some as portfolios of two separate Massachusetts business trusts, Schwab Investments and Schwab Capital Trust. The Company refers to all funds for which CSIM is the investment adviser as the SchwabFunds (registered trademark). During July 1992, Schwab introduced nationally its no-transaction-fee mutual fund service, known as the Mutual Fund OneSource (trademark) service, which by December 31, 1993, enabled customers to trade over 200 mutual funds in 25 well-known fund families without incurring brokerage transaction fees. Customer assets held by Schwab that have been purchased through the Mutual Fund OneSource service, excluding SchwabFunds, totaled $8.3 billion at December 31, 1993. In response to the continued growth of customer trading activity in Nasdaq securities and a desire to secure a capability to execute customer trades in these and other securities, CSC acquired M&S in July 1991. Since the acquisition, M&S has executed essentially all the Nasdaq security trades originated by the customers of Schwab, which in 1993 accounted for approximately 20% of Schwab's total trading volume. Principal transaction revenues generated by M&S have contributed significantly to the Company's operating results. In March 1992, the Company opened The Charles Schwab Trust Company (CSTC), which provides custody services for investment portfolios and serves as trustee for employee benefit plans (primarily 401(k) plans). CSTC, based in San Francisco, is regulated as a limited-purpose bank by the California State Banking Department. CSTC's primary focus is to provide services to independent, fee-based financial advisers and 401(k) plan record keepers and administrators. In November 1992, the Company capitalized Charles Schwab Limited, its first European subsidiary. The wholly owned subsidiary is registered as an arranger with the United Kingdom Securities and Futures Authority, and engages in business development activities on behalf of Schwab. The subsidiary's first office, located in London, was opened in February 1993. DEVELOPMENTS DURING 1993 AND EARLY 1994 During 1993, the Company experienced record revenues, net income, and growth in customer assets and accounts. Net income for 1993 was $118 million, or $1.98 per share, up from $81 million, or $1.39 per share, in 1992 and $49 million, or $.84 per share, in 1991. Reflected in - 1 - THE CHARLES SCHWAB CORPORATION 1993's operating results is an extraordinary charge of $.11 per share relating to CSC's prepayment of its Junior and Senior Subordinated Debentures. Schwab opened 706,000 new accounts during 1993, which contributed significantly to the $30.2 billion, or 46%, increase in assets held in Schwab customer accounts. The Company made significant capital expenditures during 1993, investing $77 million in a new primary data center, a fourth regional customer telephone service center, which opened in January 1994, and enhancements to its data processing and telecommunications systems. The Company also opened 23 branch offices and made improvements to certain existing office facilities. A new Massachusetts business trust, Schwab Capital Trust, was formed in July 1993. During 1993, Schwab added to the SchwabFunds (registered trademark) by introducing two new funds under the Schwab Capital Trust, an international index fund and an index fund that attempts to track the performance of common stocks of the second 1,000 largest United States corporations. During 1993, Schwab also introduced a long-term government bond fund and two short/intermediate tax-free bond funds. Customer assets invested in the SchwabFunds at December 31, 1993 totaled $15.8 billion, a 39% increase over the prior year. Several financing transactions were completed during 1993. The Company prepaid its 10% Senior and 9% Junior Subordinated Debentures totaling $116 million, and paid a related prepayment premium of approximately $11 million. The Company prepaid the debentures using proceeds received from the issuance of medium-term notes with an average interest rate of 5.91%. In March 1993, the Company's Board of Directors approved a three-for-two stock split of the Company's common stock, which was effected in the form of a 50% stock dividend. The stock dividend was paid on June 1, 1993 to stockholders of record May 3, 1993. In January 1994, the Board increased the Company's quarterly cash dividend 40% to $.070 per share payable February 15, 1994 to stockholders of record February 1, 1994. (b) Financial Information About Industry Segments. The Company operates in a single industry segment: securities brokerage and related investment services. No material part of the Company's consolidated revenues is received from a single customer or group of customers, or from foreign operations. As of December 31, 1993, approximately 29% of Schwab's total customer accounts were located in California. The next highest geographic concentrations of total customer accounts were approximately 7% in each of New York and Florida. (c) Narrative Description of Business. Schwab provides brokerage and related investment services to more than 2.5 million active investor accounts. These accounts held $95.8 billion in assets at December 31, 1993. M&S operates four offices in four states offering trade execution services for Nasdaq securities to institutional clients and broker-dealers, including Schwab. Schwab's primary focus is serving retail clients who seek a wide selection of quality investment services at fees that, in most cases, are substantially lower than those of full-commission firms. The table on the following page sets forth on a comparative basis the Company's revenues for the three years ended December 31, 1993. These revenue figures reflect developments in, and the composition of, the Company's business. Schwab provides its customers, most of whom are retail investors, with convenient and prompt execution of their orders to purchase and sell securities, and with rapid access to market-related information. A key to both the quality and speed of Schwab's service and to its ability to provide commission discounts is its sophisticated communications and information processing systems. Schwab primarily serves investors who wish to conduct their own research and make their own investment decisions and do not wish to pay, through brokerage commissions, for research or portfolio management. To attract and accommodate investors who want research and portfolio management services, however, Schwab offers a variety of fee-based (primarily third-party) research and portfolio management products. This customer segment has become increasingly significant to Schwab's growth in customer assets and accounts. During 1993, Schwab client assets held in customer accounts managed by financial advisors increased $9.6 billion (73%) to a total of $22.9 billion. Schwab does not generally maintain inventories of securities for sale to its customers or engage in principal transactions with its customers. Exceptions to this general rule include: (1) having temporary positions resulting from execution errors, unavailability of the various exchanges' automated trade execution facilities, or nonpayment by customers, (2) positioning of listed securities to accommodate institutional customers, and (3) engaging in certain riskless principal and other similar transactions where, in response to a customer order, Schwab will purchase securities (generally municipal and government securities) from another source and resell them to customers at a markup. Schwab concentrates on the execution of unsolicited transactions on an agency basis. Schwab's customer service delivery system reduces dependency on the need for personal relationships between Schwab's customers and employees to generate orders. Schwab does not generally assign customers to individual employees. Each customer-contact employee has immediate access to the customer account and market-related information necessary to respond to any customer's inquiries, and for most customer orders, can enter the order and confirm the transaction. Customer orders involving certain - 2 - THE CHARLES SCHWAB CORPORATION SOURCES OF REVENUES (DOLLAR AMOUNTS IN THOUSANDS) Certain prior years' revenues and expenses have been reclassified to conform to the 1993 presentation. This table should be read in connection with the Company's consolidated financial statements and notes in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. - ------------------------------------------------------------------------------- types of transactions, such as those in fixed income securities and mutual funds, are handled by separate groups of registered representatives that specialize in such transactions. As a result of this approach, the departure of a registered representative generally does not result in a loss of customers for the firm. As a market maker in Nasdaq securities, M&S executes customer trades generally as principal. M&S' business practices call for competitively priced customer executions. As a member of the National Association of Securities Dealers, Inc. (NASD), M&S provides its customers with the highest bid price on a customer's sell order and the lowest offer price on a customer's buy order available through the network of NASD member firms that are market makers. Customer trades exceeding certain sizes are executed on a negotiated basis. M&S maintains inventories in Nasdaq securities on both a "long" and "short" basis. While long inventory positions represent M&S' ownership of securities, short inventory positions represent obligations of M&S to deliver specified securities at a contracted price, which may differ from market prices prevailing at the time of completion of the transaction. Accordingly, long or short inventory positions may result in gains or losses to M&S as market values of these securities fluctuate. The securities brokerage industry is directly affected by - 3 - THE CHARLES SCHWAB CORPORATION fluctuations in volumes and price levels of securities transactions generally, which are affected by many national and international economic and political factors that cannot be predicted, including broad trends in business and finance, legislation and regulation affecting the United States and international business and financial communities, currency values, and the level and volatility of interest rates. Sustained low volumes of retail investment activity or of securities transactions generally, particularly if accompanied by low securities prices, could substantially reduce the Company's transaction-based revenues and could lead to reduced margin account balances, thus reducing interest revenue as well. Shifts in customer investment vehicle preferences from individual equity securities to products that have lower commissions per transaction, such as mutual funds, could also reduce transaction-based revenues. In connection with its information processing systems, its branch network, and other aspects of its business, the Company incurs substantial expenses that do not vary directly, at least in the short term, with fluctuations in securities transaction volumes and revenues. In the event of a material reduction in revenues, the Company may not reduce such expenses quickly and, as a result, the Company could experience reduced profitability or losses. Conversely, sudden surges in transaction volume can result in increased profits and profit margins. To ensure that it has the capacity to process projected increases in transaction volumes, the Company has historically made substantial capital and operating expenditures in advance of such projected increases, including during periods of low transaction volumes. In the event that such growth in transaction volumes does not occur, the expenses related to such investments could, as they have in the past, cause reduced profitability or losses. COMPETITION The Company encounters rigorous competition from full-commission and discount brokerage firms, as well as from financial institutions, mutual fund sponsors, market makers in Nasdaq securities and other organizations. The recent general financial success of the securities industry has strengthened existing competitors, and management believes that such success will continue to attract additional competitors such as banks and insurance companies. Some of these competitors are larger, more diversified, and have greater capital resources than the Company. In many instances the Company is competing with such organizations for the same customers. Management believes that the main competitive factors are quality, convenience, price of services and products offered, and breadth of product line. Most discount brokerage firms charge commissions lower than Schwab. Full- commission brokerage firms also offer discounted commissions to selected retail customers. Many brokerage firms employ substantial funds in advertising and direct solicitation of customers to increase their market share of commission dollars and other securities-related income. If the well-capitalized brokerage firms pursue these competitive strategies successfully, Schwab's new account growth, commission revenues and profit margins could be adversely affected. Many of the large full-commission brokerage firms, as well as other financial institutions, including commercial banks and insurance companies, offer a wider range of services and financial products than does the Company. Particularly as financial services and products proliferate, to the extent such competitors are able to attract and retain customers on the basis of the convenience of one-stop shopping, the Company's business or its ability to grow could be adversely affected. Schwab's philosophy of generally refraining from directly recommending particular securities and its methods of marketing may cause it not to offer some of the financial products and services offered by others. MARKETING AND PROMOTION Advertising plays a crucial role in obtaining new customers, which have constituted an important source of revenue and revenue growth for the Company. The Company's advertising and market development expense for the years ended December 31, 1993, 1992 and 1991 was $41 million, $34 million and $25 million, respectively. For the same years, the numbers of new accounts opened were approximately 706,000, 562,000 and 384,000, respectively. New account openings represent a significant portion of the growth in customer assets, which the Company believes is critical to growth in revenues. The Company estimates that accounts opened during 1993 generated 16% of total commission revenues during that year and that accounts opened during 1992 and 1991 generated 18% and 19% of total commission revenues during each of those years, respectively. The branch office network also plays a key role in building Schwab's business. Many customers prefer to open accounts in person in Schwab branch offices. With the customer service support of the regional customer telephone service centers and TeleBroker (trademark), branch personnel are able to focus a significant portion of their time on business development. Branch training programs and compensation plans emphasize identifying customer needs that can be satisfied with Schwab products and services, and increasing customer assets held in Schwab accounts. Schwab advertises regularly in financially-oriented newspapers and periodicals and occasionally in general circulation publications. Schwab advertisements appear regularly on national and local cable television and - 4 - THE CHARLES SCHWAB CORPORATION periodically on radio and independent television stations. Schwab's national network television advertising campaign, launched during the fourth quarter of 1991, has resulted in significant increases in Schwab brand awareness among investors. Schwab employs volume-buying and other strategies to minimize the expense of broadcast advertising. Through these broadcast-buying strategies and by using Schwab employees to produce and buy print advertising, management believes Schwab realizes savings on its promotional expenses. Schwab also engages extensively in targeted direct mail advertising through monthly statement "inserts" and special mailings. In its advertising, as well as in promotional events such as press appearances, Schwab has aggressively promoted the name and likeness of its Chairman, Mr. Schwab. The Company believes there is a substantial benefit related to Mr. Schwab's association with the Company and that Schwab's marketing programs and overall business is dependent on the ability to continue to use Mr. Schwab's name and likeness. The Company has entered into an agreement with Mr. Schwab by which he, subject to certain limitations, has assigned to the Company and Schwab all service mark, trademark, and trade name rights in his name (and variations thereon) and likeness. PRODUCTS AND SERVICES Securities and Other Investments Available. Schwab's customers may purchase and sell both listed and unlisted corporate securities, and listed put, call and index options. Through its Mutual Fund Marketplace (registered trademark) program, Schwab purchases and redeems for its customers shares of over 700 mutual funds in approximately 100 fund families sponsored by third parties. This program provides Schwab's customers with the convenience of purchasing and redeeming mutual fund shares with a single telephone call and of using margin credit to purchase most mutual fund shares. Schwab charges a transaction fee on trades placed in the funds included in its Mutual Fund Marketplace (except as described below), or in some cases, receives compensation directly from the funds and/or fund sponsors. Commissions from customer transactions in mutual fund shares comprised approximately 9% of Schwab's total commission revenues in 1993, compared to approximately 8% in 1992 and approximately 7% in 1991. During July 1992, Schwab introduced nationally its no-transaction-fee mutual fund service, known as the Mutual Fund OneSource (trademark) service, which by December 31, 1993, enabled customers to trade over 200 mutual funds in 25 well-known fund families without incurring brokerage transaction fees. The service is particularly attractive to investors who previously chose to execute mutual fund trades directly with multiple mutual fund companies to avoid brokerage transaction fees and achieve investment diversity among fund families. Mutual fund trades placed through the Mutual Fund OneSource service grew from an average of 1,000 per day in July 1992, including 500 per day in SchwabFunds (registered trademark), to an average of 9,800 per day in December 1993, including 1,200 per day in SchwabFunds. While Schwab does not receive transaction fees (commissions) on customer trades in the Mutual Fund OneSource participating mutual funds, it is compensated directly by the participating funds or their sponsors via fees received for providing record keeping and shareholder services. Such compensation is ongoing, based on daily balances of customer assets invested in the participating funds and held at Schwab. These revenues are recorded as mutual fund service fees. Fixed income investments available through Schwab include U.S. Treasuries, zero-coupon bonds, listed and OTC corporate bonds, municipal bonds, GNMAs, unit investment trusts and bond mutual funds. Schwab also makes available to its customers certificates of deposit (CDs) with specific financial institutions located in a variety of states. Schwab does not perform a credit evaluation of such institutions. Such institutions pay Schwab fees for its services in making such CDs available and in transmitting funds and performing certain accounting functions. Schwab's customers do not pay any commission or fee when they purchase CDs. Accounts and Features. Each Schwab customer has a brokerage account through which securities may be purchased or sold. If approved for margin transactions, a customer may borrow a portion of the price of certain securities purchased through Schwab, or may sell securities short. Customers must have specific approval to trade options; as of December 31, 1993, approximately 131,000 accounts were so approved. To write uncovered options, customers must go through an additional approval process and must maintain a significantly higher level of equity in their brokerage accounts. Because Schwab does not pay interest on cash balances in basic brokerage accounts, it provides customers with an option to have cash balances in their accounts automatically swept into money market mutual fund portfolios available through the SchwabFunds. For basic brokerage accounts opened after January 1, 1991, cash balances (that exceed specified minimum amounts) are automatically swept into the Schwab Money Market Fund unless customers elect otherwise. A customer may receive additional services by qualifying for and opening a Schwab One (registered trademark) Brokerage Account. A customer may remove available funds from his or her Schwab One account either with a personal check or a VISA debit card. If a Schwab One customer is approved for margin trading, which most are, the checks and debit card also provide access to margin cash available. For cash - 5 - THE CHARLES SCHWAB CORPORATION balances awaiting investment, Schwab pays interest to Schwab One (registered trademark) customers at a discretionary rate of interest. Alternatively, Schwab One customers seeking tax-exempt interest income may elect to have cash balances swept into one of three tax-exempt money market mutual funds, including two that are available through the SchwabFunds (registered trademark). During 1993, the number of active Schwab One accounts increased 19% and the customer assets in all Schwab One accounts increased 42%. The Company considers all customer accounts with cash balances, positions or trading activity within the preceding twelve months to be active. Schwab acts as custodian, as well as broker, for Individual Retirement Accounts (IRAs). In Schwab IRAs, cash balances are swept daily into one of three SchwabFunds money market mutual funds. During 1993, active IRAs increased 31% and customer assets in all IRAs increased 53%. Schwab also acts as custodian and broker for Keogh accounts. During 1992, Schwab introduced an IRA that does not carry an annual fee for accounts with balances of $10,000 or more, which was offered to existing and prospective IRA customers. The Company had previously charged an annual account fee of $22 on virtually all IRAs. At December 31, 1993, over two-thirds of the Company's 760,000 active IRAs were included in the no-annual-fee program. In order for the Company to maintain a competitive pricing structure, this lifetime no-annual-fee offer will continue through 1994. Customer Financing. Customers' securities transactions are effected on either a cash or margin basis. Generally, a customer buying securities in a cash-only brokerage account is required to make payment by settlement date, usually five business days after the trade is executed. However, for purchases of certain types of securities, such as mutual fund shares, a customer must have a cash balance in his or her account sufficient to pay for the trade prior to execution. When selling securities, a customer is required to deliver the securities, and is entitled to receive the proceeds, on the settlement date. In an account authorized for margin trading, Schwab may lend its customer a portion of the market value of certain securities up to the limit imposed by the Federal Reserve Board, which for most equity securities is initially 50%. Such loans are collateralized by the securities in the customer's account. "Short" sales of securities represent sales of borrowed securities and create an obligation to purchase the securities at a later date. Customers may sell securities "short" in a margin account subject to minimum equity and applicable margin requirements and the availability of such securities to be borrowed and delivered. Interest on margin loans to customers provides an important source of revenue to Schwab. During the year ended December 31, 1993, Schwab's outstanding margin loans to its customers averaged approximately $2.2 billion, up from 1992's average of $1.6 billion. In permitting a customer to engage in transactions, Schwab takes the risk of such customer's failure to meet his or her obligations in the event of adverse changes in the market value of the securities positions in his or her account. Under applicable rules and regulations for margin transactions, Schwab, in the event of such an adverse change, requires the customer to deposit additional securities or cash, so that the amount of the customer's obligation is not greater than specified percentages of the cash and market values of the securities in the account. As a matter of policy, Schwab generally requires its customers to maintain higher percentages of collateral values than the minimum percentages required under these regulations. Schwab may use cash balances in customer accounts to extend margin credit to other customers. Under the SEC's Rule 15c3-3, the portion of such cash balances not used to extend margin credit (increased or decreased by certain other customer-related balances) must be held in segregated investment accounts. The balances in these segregated investment accounts may be invested in qualified interest-bearing securities. To the extent customer cash balances are available for use by Schwab at interest costs lower than Schwab's costs of borrowing from alternative sources (e.g., balances in Schwab One brokerage accounts) or at no interest cost (e.g., balances in other accounts and outstanding checks that have not yet cleared Schwab's bank), Schwab's cost of funds is reduced and its net income is enhanced. Such interest savings contribute substantially to Schwab's profitability and, if a significant reduction of customer cash balances were to occur, Schwab's borrowings from other sources would have to increase and such profitability would decline. To the extent Schwab's customers elect to have cash balances in their brokerage accounts swept into certain SchwabFunds money market mutual funds, the cash balances available to Schwab for investments or for financing margin loans are reduced. However, Schwab receives mutual fund service fees from such funds based on the average daily invested balances. See also "Regulation" on page 9 and "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Stockholders, which is incorporated herein by reference to Exhibit No. 13.1 of this report. Mutual Funds. CSIM provides investment advisory and administrative services to the SchwabFunds, which consisted of six money market funds, a broad-based equity index fund, an international index fund, an index fund that attempts to track the performance of common stocks of the second 1,000 largest United States corporations and six bond funds at December 31, 1993. Customer assets invested in the SchwabFunds totaled approximately $15.8 billion at December 31, 1993. - 6 - THE CHARLES SCHWAB CORPORATION The Company intends to offer additional mutual funds to its customers in the future. Market Making In Nasdaq Securities. M&S provides trade execution services in Nasdaq securities to institutional and broker-dealer clients. These services feature highly automated, competitively priced executions of both Nasdaq and non-Nasdaq stocks and warrants. In most instances, customer orders are routed directly to M&S' trading system and are executed automatically. Other Activities. To attract the business of accounts managed by independent fee-based financial advisors, Schwab has a dedicated group through which, among other things, it assigns specific, experienced registered representatives to individual financial advisors and occasionally provides certain research materials for the benefit of the advised accounts. Financial advisors participating in this program may access the information in their clients' accounts directly from Schwab's computer data bases. During 1993, Schwab added approximately 1,000 advisors to this program, which at December 31, 1993 included more than 4,200 financial advisors. Schwab has taken other steps to provide services tailored to meet the specialized needs of other professional investors, including corporations and institutions such as pension funds and investment companies. For example, Schwab's institutional brokerage department provides its customers with technical information and analysis of general conditions and trends in the securities market. Schwab also acts as agent for corporations in repurchasing their securities and in implementing dividend reinvestment plans. Schwab's brokerage business generated by financial advisors and other professional investors represented approximately 11% of Schwab's total commission revenues in 1993, 10% in 1992 and 9% in 1991. DELIVERY SYSTEMS Branch Office Network. Schwab believes that the existence of branch offices is important to increasing new account openings and maintaining high levels of customer satisfaction. At December 31, 1993, the Company maintained a network of 198 branches throughout the United States, including a branch office in the United Kingdom. Schwab plans to continue its branch expansion program in 1994 by opening approximately 28 new branches. Customers can use branch offices to obtain market information, place orders, open accounts, deliver and receive checks and securities and obtain related customer services in person, yet most branch activities are conducted by telephone and mail. Branch offices remain open during normal market hours to service customers in person and by telephone. Many branch offices offer extended office hours. Customer calls received during nonbranch hours are routed to customer telephone service centers. Customer Telephone Service Centers. Schwab's four customer telephone service centers, located in Indianapolis, Denver, Phoenix and Orlando (which opened in January 1994), handle calls to many of Schwab's toll-free numbers, customer calls that otherwise would have to wait for available registered representatives at branches during business hours, and calls routed from branches after hours and on weekends. Through the service centers, customers may place orders twenty-four hours a day, seven days a week, except for certain holidays. Customer orders placed during nonmarket hours are routed to appropriate markets the following business day. The capacity of the service centers allows new branches to be opened and maintained at lower staffing levels. The service centers, the first of which was opened in 1990, have developed into a significant component of Schwab's overall service delivery system and handled 28% of customer calls and 31% of customer trades during 1993. Electronic Delivery Services. Schwab provides automated brokerage services through which investors may place orders, receive account information and obtain securities market information. These services are designed to provide added convenience for customers and minimize Schwab's costs of responding to and processing routine customer transactions. Schwab's TeleBroker Service (registered trademark), which enables customers to place orders for stocks, options and certain mutual funds, as well as obtain real-time securities quotes and account information electronically from any touchtone telephone, was introduced in 1989 and was made available to customers nationally during 1991. TeleBroker (trademark), which provides customers with an additional 10% discount on commissions, has become increasingly important in providing customers access to Schwab, particularly during periods of heavy customer activity. During 1992, Schwab more than doubled the processing capacity of TeleBroker to accommodate increased customer usage and continued to increase capacity in 1993. In November 1993, TeleBroker was enhanced to accommodate Mutual Fund OneSource (trademark) transactions. On-line access to brokerage and investment information services is also available through Schwab's on-line trading software, StreetSmart (trademark) for Windows (trademark), introduced in October 1993. During 1993, TeleBroker and other on-line brokerage services handled over 53% of Schwab's customer calls and 22% of customer trades. Information Systems. Schwab's system for processing a securities transaction is highly automated. Registered - 7 - THE CHARLES SCHWAB CORPORATION representatives equipped with on-line computer terminals can access customer account information, obtain securities prices and related information and enter orders on-line. Most equity market orders are automatically executed and the representative is able to confirm execution to the customer while on the telephone. A written confirmation is generated automatically and is generally sent to the customer on the next business day. Under normal circumstances, most customer orders are executed without any Schwab employee filling out a single piece of paper. To support its service delivery system, as well as other applications such as clearing functions, account administration, record keeping and direct customer access to investment information, Schwab maintains a sophisticated computer network connecting all of the branch offices. Schwab's computers are also linked to the major registered United States securities exchanges, M&S, the National Securities Clearing Corporation and The Depository Trust Company. In 1979, Schwab obtained from Beta Systems, Inc. a non-exclusive license to use its basic software for executing brokerage functions. Since that time, Schwab has made substantial additions and modifications to that program. Schwab's computer systems also support on-line employee training, management information systems, software development activities and telecommunication network control functions. During periods of exceptionally high trading volume, the Company takes steps to provide customer service functions with maximum processing capacity. These steps include rescheduling processing jobs unrelated to customer trading functions and restricting on-line access to the Company's mainframe computer functions. The Company's computer capacity is continuously monitored and efforts are made to achieve an optimal balance between the costs of additional processing capacity and the customer service benefits it provides during high-volume periods. Schwab's operations rely heavily on its information processing and communications systems. External events, such as an earthquake or power failure, loss of external information feeds, such as security price information, as well as internal malfunctions, could render part of or all such systems inoperative. To enhance the reliability of the system and integrity of data, Schwab maintains carefully monitored backup and recovery functions. These include logging of all critical files intraday, duplication and storage of all critical data outside of its central computer site every 24 hours, and maintenance of facilities for backup and communications in San Francisco. They also include the maintenance and periodic testing of a disaster recovery plan that management believes would permit Schwab to recommence essential operations within 72 hours if its central computer site were to become inaccessible. In March 1994, Schwab installed a new recovery system which permits essential operations to recommence within 24 hours. Failure of Schwab's information processing or communications systems for a significant period of time could limit Schwab's ability to process its large volume of transactions accurately and rapidly, could cause it to be unable to satisfy its obligations to customers and other securities firms, and could result in regulatory violations. The Company constructed a computer data center in Phoenix and relocated its primary data center to this site in 1993. This move strengthens the Company's backup recovery capability and provides additional support in the event of extended interruptions in existing processing capability. CLEARING AND ACCOUNT MAINTENANCE Schwab performs clearing services for all securities transactions in customer accounts. These services involve the confirmation, receipt, execution, settlement and delivery functions involved in securities transactions. Among other things, performing its own clearing services allows Schwab to provide margin loans and use customer cash balances to finance them. During the year ended December 31, 1993, Schwab processed over nine million separate securities, options and mutual fund trades. Schwab clears the vast majority of customer transactions through the facilities of the National Securities Clearing Corporation or the Options Clearing Corporation. Certain other transactions, such as mutual fund transactions and transactions in securities not eligible for settlement through a clearing corporation, are settled directly with the mutual funds or other financial institutions. Schwab is obligated to settle transactions with clearing corporations, mutual funds and other financial institutions even if Schwab's customer fails to meet his or her obligations to Schwab. In addition, for transactions that do not settle through a clearing corporation, Schwab takes the risk of the other party's failure to settle the trade. See "Commitments, Contingent Liabilities and Other Information" in the Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. Customer securities are typically held by Schwab in nominee name, on deposit at one or more of the recognized securities industry depository trust companies, or in the case of government and certain other fixed-income securities and other instruments (e.g., certain limited partnership interests), at a custodial bank. Schwab collects dividends and interest on securities held in nominee name, making the appropriate credits to customer accounts. Schwab also facilitates exercise of subscription rights on securities held for customers. Schwab arranges for the transmittal of proxy and tender offer materials and company reports to customers. - 8 - THE CHARLES SCHWAB CORPORATION EMPLOYEES As of December 31, 1993, the Company had approximately 6,500 employees, including full-time, part-time and temporary employees, as well as persons employed on a contract basis. None of the employees are represented by a union, and the Company believes its relations with its employees are good. REGULATION The securities industry in the United States is subject to extensive regulation under both Federal and state laws. The SEC is the Federal agency charged with administration of the Federal securities laws. Schwab and M&S are registered as broker-dealers with the SEC. Schwab and CSIM are registered as investment advisers with the SEC. Much of the regulation of broker-dealers has been delegated to self-regulatory organizations, principally the NASD and the national securities exchanges such as the New York Stock Exchange, Inc. (NYSE), which has been designated by the SEC as Schwab's primary regulator with respect to its securities activities. The NASD has been designated as M&S' primary regulator by the SEC with respect to its securities activities. During 1993, the NASD was Schwab's designated primary regulator with respect to options trading activities. Currently, the American Stock Exchange is Schwab's designated primary regulator with respect to options trading activities. These self-regulatory organizations adopt rules (subject to approval by the SEC) governing the industry and conduct periodic examinations of broker-dealers. Securities firms are also subject to regulation by state securities commissions in the states in which they do business. Schwab is registered as a broker-dealer in 50 states, the District of Columbia and Puerto Rico. M&S is registered as a broker-dealer in 17 states as of December 1993. The regulations to which broker-dealers and investment advisers are subject cover all aspects of the securities business, including sales methods, trading practices among broker-dealers, uses and safekeeping of customers' funds and securities, capital structure of securities firms, record keeping, fee arrangements, disclosure to clients, and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and by self-regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules may directly affect the method of operation and profitability of broker-dealers and investment advisers. The SEC, self-regulatory organizations, and state securities commissions may conduct administrative proceedings which can result in censure, fine, cease and desist orders, or suspension or expulsion of a broker-dealer or an investment adviser, its officers, or employees. In the past, Schwab occasionally has been the subject of such administrative proceedings. The principal purpose of regulations and discipline of broker-dealers and investment advisers is the protection of customers and the securities markets, rather than protection of creditors and stockholders of broker-dealers and investment advisers. As registered broker-dealers and NASD member organizations, Schwab and M&S are required by Federal law to belong to the Securities Investor Protection Corporation (SIPC), which provides, in the event of the liquidation of a broker-dealer, protection for securities held in customer accounts held by the firm of up to $500,000 per customer, subject to a limitation of $100,000 on claims for cash balances. SIPC is funded through assessments on registered broker-dealers. SIPC assessments currently are .054% of net operating revenues (as defined) per year. In addition, Schwab has purchased from private insurers additional account protection of up to $24.5 million per customer, as defined, in 1993 for customer securities positions only. This account protection is up from protection in 1992 of $2 million. Mutual funds, including money market funds, are considered securities for the purposes of SIPC coverage and the supplemental coverage. Schwab is also authorized by the Municipal Securities Rulemaking Board to effect transactions in municipal securities on behalf of its customers and has obtained certain additional registrations with the SEC and state regulatory agencies necessary to permit it to engage in certain other activities incidental to its brokerage business. For example, Schwab is registered with the SEC as a transfer agent in connection with certain services it provides to the SchwabFunds (registered trademark). Margin lending by Schwab and M&S is subject to the margin rules of the Board of Governors of the Federal Reserve System and the NYSE. Under such rules, broker-dealers are limited in the amount they may lend in connection with certain purchases and short sales of securities and are also required to impose certain maintenance requirements on the amount of securities and cash held in margin accounts. In addition, those rules and rules of the Chicago Board Options Exchange govern the amount of margin customers must provide and maintain in writing uncovered options. As a California state-chartered trust company, CSTC is authorized to conduct business in California, and is primarily regulated by the California State Banking Department. Since it provides custody services to employee benefit plan trusts, CSTC is also required to comply with the Employee Retirement Income Security Act of 1974 (ERISA) and, consequently, is subject to oversight by both the Internal Revenue Service and Department of Labor. CSTC is required under state law to maintain a fidelity bond for the protection of account holders. - 9 - THE CHARLES SCHWAB CORPORATION NET CAPITAL REQUIREMENTS As registered broker-dealers, Schwab and M&S are subject to the Uniform Net Capital Rule (Rule 15c3-1) promulgated by the SEC (the Net Capital Rule), which has also been adopted through incorporation by reference in NYSE Rule 325. Schwab is a member firm of the NYSE and the NASD, and M&S is a member firm of the NASD. The Net Capital Rule specifies minimum net capital requirements for all registered broker-dealers and is designed to measure financial integrity and liquidity. Failure to maintain the required net capital may subject a firm to suspension or expulsion by the NYSE and the NASD, certain punitive actions by the SEC and other regulatory bodies, and ultimately may require a firm's liquidation. Because CSC itself is not a registered broker-dealer, it is not subject to the Net Capital Rule. However, Schwab's failure to maintain specified levels of net capital would constitute a default by CSC under certain debt covenants. "Net capital" is essentially defined as net worth (assets minus liabilities), plus qualifying subordinated borrowings, less certain deductions that result from excluding assets that are not readily convertible into cash and from conservatively valuing certain other assets. These deductions include charges that discount the value of firm security positions to reflect the possibility of adverse changes in market value prior to disposition. During 1991, the SEC adopted Net Capital Rule amendments which limit withdrawals of equity capital from broker-dealers. The amendments require notice of withdrawals be provided to the SEC prior to and subsequent to withdrawals exceeding certain sizes. The amendments prohibit withdrawals that would reduce a broker-dealer's net capital to an amount less than 25% of its deductions required by the Net Capital Rule as to its security positions. The amendments also allow the SEC, under limited circumstances, to restrict a broker-dealer from withdrawing net capital for up to 20 business days. Schwab has elected the alternative method of calculation under paragraph (a)(1)(ii) of the Net Capital Rule, which requires a broker-dealer to maintain minimum net capital equal to 2% of its "aggregate debit items", computed in accordance with the Formula for Determination of Reserve Requirements for Brokers and Dealers (SEC Rule 15c3-3). "Aggregate debit items" are assets that have as their source transactions with customers, primarily margin loans. Under the alternative method of the Net Capital Rule, a broker-dealer may not (a) pay, or permit the payment or withdrawal of, any subordinated borrowings or (b) pay cash dividends or permit equity capital to be removed if, after giving effect to such payment, withdrawal, or removal, its net capital would be less than 5% of its aggregate debit items. Under NYSE Rule 326, Schwab is required to reduce its business if its net capital is less than 4% of aggregate debit items for 15 consecutive days; NYSE Rule 326 also prohibits the expansion of business if net capital is less than 5% of aggregate debit items for 15 consecutive days. The provisions of NYSE Rule 326 also become operative if capital withdrawals (including scheduled maturities of subordinated borrowings during the following six months) would result in a reduction of a firm's net capital to the levels indicated. Since its acquisition by the Company and through February 27, 1992, M&S computed net capital under the aggregate indebtedness method of the Net Capital Rule. Effective February 28, 1992, M&S elected to compute net capital under the alternative method of the Net Capital Rule. If compliance with applicable net capital rules were to limit Schwab's or M&S' operations and Schwab's ability to repay its subordinated debt to the Company, this in turn could limit the Company's ability to repay debt, pay cash dividends, and purchase shares of its outstanding stock. See "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Stockholders, which is incorporated herein by reference to Exhibit No. 13.1 of this report. At December 31, 1993, Schwab was required to maintain minimum net capital under the Net Capital Rule of $53 million and had total regulatory net capital of $260 million. At December 31, 1993, the amounts in excess of 2%, 4% and 5% of aggregate debit items were $207 million, $155 million and $128 million, respectively. At December 31, 1993, M&S was required to maintain minimum net capital under the Net Capital Rule of $1 million and had total regulatory net capital of $13 million. At December 31, 1993, the amounts in excess of 2%, 4% and 5% of aggregate debit items all exceeded $12 million. During 1993, CSIM was deemed no longer to be subject to the regulations for investment advisers promulgated by the State of California Department of Corporations and, therefore, has no net capital requirements. CSTC's capital requirement is established by the California Superintendent of Banks under the California Financial Code. The Code requires that CSTC's ratio of contributed capital, as defined, to accumulated deficit shall exceed 2.5 to 1. At December 31, 1993 the ratio of contributed capital to accumulated deficit was 2.8 to 1. If CSTC's capital declines, or if the Superintendent of Banks determines that additional capital is required for other reasons, CSC could be required to contribute additional capital to CSTC. - 10 - THE CHARLES SCHWAB CORPORATION ITEM 2. ITEM 2. PROPERTIES The Company's corporate headquarters are located in a 28-story building at 101 Montgomery Street in San Francisco. The building contains approximately 295,000 square feet and is leased by Schwab under a term expiring in the year 2000. The current rental is approximately $8.6 million per year, subject to certain increases and obligations to pay certain operating expenses such as utilities, insurance and taxes. Schwab has three successive five-year options to renew the lease at the then market rental value. Schwab also leases space in other buildings for its San Francisco operations aggregating approximately 380,000 square feet at year-end 1993. M&S' headquarters are located in leased office space in Jersey City, New Jersey. In 1992, the Company purchased land in the Phoenix area and in 1993 completed construction of a data center that is Schwab's centralized computer processing facility. The data center has approximately 105,000 square feet of floor space. All of Schwab's branch offices and customer telephone service centers and M&S' branch offices are located in leased premises, generally with lease expiration dates five to ten years from inception. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The information required to be furnished pursuant to this item is set forth under the caption "Commitments, Contingent Liabilities and Other Information" in the Notes to the Consolidated Financial Statements in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Company's security holders during the fourth quarter of 1993. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT See Item 10 in Part III of this report. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required to be furnished pursuant to this item is set forth under the captions "Common Stock Data" and "Quarterly Financial Information (Unaudited)" in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required to be furnished pursuant to this item is set forth under the captions "Operating Results (for the year)," "Other (at year end)" and "Other (for the year)" in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required to be furnished pursuant to this item is set forth under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Stockholders, which is incorporated herein by reference to Exhibit No. 13.1 of this report. Additional statistics for the fourth quarters of 1993 and 1992 are presented as follows. - 11 - THE CHARLES SCHWAB CORPORATION Average balances and interest rates for the fourth quarters of 1993 and 1992 are summarized as follows (dollars in millions): Average balances of investments increased 3% and margin loans to customers increased 38% from the fourth quarter of 1992 to the fourth quarter of 1993. The average yield on investments and margin loans to customers increased one basis point from the fourth quarter of 1992 to the fourth quarter of 1993. Over this same period, interest-bearing customer cash balances increased 11%, and the average interest rate paid on these balances declined 30 basis points. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required to be furnished pursuant to this item is set forth in the Consolidated Financial Statements and under the caption "Quarterly Financial Information (Unaudited)" in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information relating to directors of the Company required to be furnished pursuant to this item is incorporated by reference from portions of the Company's definitive proxy statement for its annual meeting of stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after December 31, 1993 (the Proxy Statement) under the captions "Election of Directors" (excluding all information under the subcaption "Information about the Board of Directors and Committees of the Board") and "Principal Stockholders." Executive Officers of the Registrant The following table provides certain information about each of the Company's current executive officers. Executive officers are elected by and serve at the discretion of the Company's Board of Directors. - 12 - THE CHARLES SCHWAB CORPORATION EXECUTIVE OFFICERS OF THE REGISTRANT MR. SCHWAB has been Chairman and Chief Executive Officer and a director of the Company since its incorporation in November 1986. Mr. Schwab was a founder of Schwab in 1971 and has been its Chairman since 1978. He also served as Chief Executive Officer of Schwab from 1978 to July 1988. Mr. Schwab is currently a director of The Gap, Inc., Transamerica Corporation and Chairman of Schwab Investments and The Charles Schwab Family of Funds and was formerly a director of BankAmerica Corporation. Mr. Schwab currently serves as Governor-at-Large of the National Association of Securities Dealers, Inc. MR. STUPSKI has been Vice Chairman of the Company since July 1992 and a director of the Company since its incorporation in November 1986. Mr. Stupski was Chief Operating Officer of the Company from November 1986 to March 1994, the Company's President from November 1986 to July 1992, and its Chief Financial Officer from April 1987 to March 1988. Mr. Stupski has been a director of Schwab since 1981. He also served as President of Schwab from 1981 to July 1988, and as Chief Executive Officer of Schwab from that date to July 1992. He served as Chief Operating Officer of Schwab from 1981 to July 1992. During 1990 and 1991, Mr. Stupski was a member of the board of directors of the Chicago Board Options Exchange. From 1982 to 1985, Mr. Stupski was a Governor of The Pacific Stock Exchange Incorporated. MR. POTTRUCK was named Chief Operating Officer and a director of the Company in March 1994 and has been President of the Company since July 1992. Mr. Pottruck was Executive Vice President from March 1987 until July 1992. Mr. Pottruck joined Schwab in 1984 and served as Executive Vice President - Marketing and Branch Management until his appointment as President and a director of Schwab in July 1988. He was promoted to Chief Executive Officer of Schwab in July 1992. Mr. Pottruck was Senior Vice President of Consumer Marketing and Advertising for Shearson/American Express from 1981 until joining Schwab, with responsibility for execution of all retail marketing, advertising, direct response and consumer communications. MR. READMOND has been Senior Executive Vice President of the Company and Schwab, as well as Chief Operating Officer of Schwab, since July 1992. From August 1989 until July 1992, he was Executive Vice President - Operations, Trading and Credit of the Company and Schwab. Prior to joining Schwab, Mr. Readmond held various positions with Alex Brown & Sons, Inc., including Operations Principal in 1985, Managing Director in 1986 and Division Manager of Information Systems and Operations from 1987 until he joined Schwab. - 13 - THE CHARLES SCHWAB CORPORATION MR. SEIP was named Senior Executive Vice President - Retail Brokerage of the Company and Schwab in March 1994. He has been President of Charles Schwab Investment Management, Inc. (CSIM) since July 1992 and Chief Operating Officer of CSIM since June 1991. From July 1992 until March 1994, he was Executive Vice President - Mutual Funds and Fixed Income Products. Mr. Seip has been with the Company since January 1983. Prior to becoming Senior Vice President of the Company and assuming his mutual fund responsibilities in June 1991, Mr. Seip was the divisional executive in charge of Schwab's retail branches east of the Mississippi. From 1985 to 1988, Mr. Seip founded and was responsible for Schwab's Financial Advisors Service. Before joining Schwab, he was a Vice President and Partner at Korn Ferry International. MR. CHOATE has been Executive Vice President - Retail Service Delivery of the Company and Schwab since March 1991. Mr. Choate was Executive Vice President of Branch Systems with Security Pacific Bank from 1988 until joining Schwab, responsible for the statewide branch banking system. He held a full range of branch administration positions with Security Pacific Bank from 1969 to 1988, including Division Administrator, Regional Vice President and Branch Manager. MR. COGHLAN has been Executive Vice President and General Manager of Schwab Institutional of the Company and Schwab since July 1992. Mr. Coghlan joined Schwab in 1986, became a Vice President in 1988 and became Senior Vice President in 1990. From 1988 to 1990, he was also an Adjunct Professor of Marketing at the McLaren School of Business at the University of San Francisco and from 1985 to 1987 he was a Lecturer in the Department of Marketing and Management in the School of Business at San Francisco State University. MR. GAMBS has been Executive Vice President and Chief Financial Officer of the Company and Schwab since March 1988. Mr. Gambs was Deputy Treasurer of Merrill Lynch & Co., Inc. from 1987 until he joined Schwab, and from 1984 to 1987 was Vice President/Corporate Staff, with responsibilities for financing, cash management and credit relationships. MS. LEPORE has been Executive Vice President and Chief Information Officer of the Company and Schwab since October 1993. Ms. Lepore joined Schwab in 1983, became a Vice President in 1987 and became Senior Vice President in 1989. Prior to joining Schwab, Ms. Lepore was a consultant with Informatics, an information consulting firm in San Francisco. MS. OJHA has been Executive Vice President - Core Services of the Company and Schwab since March 1993. Before joining the Company, Ms. Ojha served as a Director and then a Partner in the National Advanced Technology Group, of Coopers & Lybrand, an international professional service firm, since 1987. From 1975 to 1987, Ms. Ojha was a consultant in the Operations Research Practice and then a manager in the Center for Applied Artificial Intelligence of Arthur D. Little, Inc. MS. SAWI was named Executive Vice President - Mutual Funds in March 1994 and she was Executive Vice President - Marketing and Advertising from January 1992 until March 1994. Ms. Sawi joined Schwab in 1982, became a Vice President in 1984 and became Senior Vice President in 1985. Before joining Schwab in 1982, Ms. Sawi was a Marketing Manager for the travel and entertainment card division of American Express. MR. TOGNINO joined the Company in October 1993 as the Executive Vice President of Capital Markets and Trading. Prior to joining Schwab, Mr. Tognino was a Managing Director at Merrill Lynch in New York since 1991, and was based in London as Managing Director of the equity product from 1990 to 1991. He served as Managing Director of Unlisted Trading from 1987 to 1988, and previously served as Managing Director of the OTC department, which included agency orders, institutional sales trading and market making. Mr. Tognino serves on the Nasdaq Board of Governors as Chairman of the Securities Traders Association and as President of the Securities Traders Association of New York. MR. VALENCIA joined the Company and was named Executive Vice President - Human Resources of the Company and Schwab in March 1994. Before joining the Company, Mr. Valencia served as a Managing Director of Commercial Credit Corp., a subsidiary of the Travelers engaged in consumer finance for the Travelers, from January 1993 to February 1994. From 1975 to 1993, he held various positions with Citicorp, including Regional Business Manager in the New York Banking Division from 1981 to 1984, President and Chief Executive Officer of Citicorp Savings from 1984 to 1990, and President and Chief Executive Officer of Transaction Technology, a subsidiary of Citicorp, from 1990 to 1993. Prior to Citicorp, Mr. Valencia held Human Resource positions with Pfizer, Inc. - 14 - THE CHARLES SCHWAB CORPORATION ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required to be furnished pursuant to this item is incorporated by reference from portions of the Proxy Statement under the captions "Executive Compensation" (excluding all information under the subcaption "Board Compensation Committee Report on Executive Compensation" and "Performance Graph") and "Certain Transactions." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required to be furnished pursuant to this item is incorporated by reference from portions of the Proxy Statement under the caption "Principal Stockholders." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND TRANSACTIONS The information required to be furnished pursuant to this item is incorporated by reference from a portion of the Proxy Statement under the caption "Certain Transactions." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this Report 1. Financial Statements The financial statements and independent auditors' report are set forth in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report and are listed below: Consolidated Statement of Income Consolidated Balance Sheet Consolidated Statement of Cash Flows Consolidated Statement of Stockholders' Equity Notes to Consolidated Financial Statements Independent Auditors' Report 2. Financial Statement Schedules The financial statement schedules required to be furnished pursuant to this item are listed in the accompanying index appearing on page. (b) Reports on Form 8-K None filed during the last quarter of 1993. - 15 - THE CHARLES SCHWAB CORPORATION (c) Exhibits The exhibits listed below are filed as part of this annual report on Form 10-K. - 16 - THE CHARLES SCHWAB CORPORATION - 17 - THE CHARLES SCHWAB CORPORATION - 18 - THE CHARLES SCHWAB CORPORATION - 19 - THE CHARLES SCHWAB CORPORATION * Incorporated by reference to the identically-numbered exhibit to Registrant's Registration Statement No. 33-16192 on Form S-1, as amended and declared effective on September 22, 1987. - 20 - THE CHARLES SCHWAB CORPORATION 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, on March 30, 1994. THE CHARLES SCHWAB CORPORATION (Registrant) By: CHARLES R. SCHWAB /s/ ----------------------------- Charles R. Schwab Chairman 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 indicated, on March 30, 1994. - 21 - THE CHARLES SCHWAB CORPORATION INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules not listed are omitted because of the absence of the conditions under which they are required or because the information is included in the Company's consolidated financial statements and notes in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. INDEPENDENT AUDITORS' REPORT To the Stockholders and Board of Directors of The Charles Schwab Corporation: We have audited the consolidated financial statements of The Charles Schwab Corporation (the Company) and subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 17, 1994 (February 25, 1994 as to Subsequent Event note); such consolidated financial statements and report are included in your 1993 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the financial statement schedules of the Company and subsidiaries appearing on pages through. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE San Francisco, California February 17, 1994 (February 25, 1994 as to Subsequent Event note) SCHEDULE III THE CHARLES SCHWAB CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET (In thousands, except share data) * Reflects the 1993 three-for-two common stock split. See Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report, for a discussion of long-term and subordinated borrowings and contingent liabilities. SCHEDULE III THE CHARLES SCHWAB CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENT OF INCOME AND RETAINED EARNINGS (In thousands) SCHEDULE III THE CHARLES SCHWAB CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENT OF CASH FLOWS (In thousands) Prior years' financial statements have been reclassified to conform to the 1993 presentation. See Notes to the Consolidated Financial Statements in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report, for a discussion of additional cash flow information. SCHEDULE VIII THE CHARLES SCHWAB CORPORATION VALUATION AND QUALIFYING ACCOUNTS (In thousands) (1) Primarily represents collections of previously written off accounts. Amounts for 1993, 1992 and 1991 include a $57, a $123 and a $65 reduction, respectively, to the allowance recorded in connection with CSC's 1989 acquisition of Rose & Company Investment Brokers, Inc. SCHEDULE IX THE CHARLES SCHWAB CORPORATION SHORT-TERM BORROWINGS (In thousands) (1) Bank loans are under lines of credit, are payable on demand, and may be collateralized by customer securities. (2) Represents the weighted average daily balances outstanding for days on which there were borrowings - 25 days in 1993, 42 days in 1992 and 41 days in 1991. (3) Weighted average interest rate computed by dividing the daily interest expense by the daily amounts outstanding. SCHEDULE X THE CHARLES SCHWAB CORPORATION SUPPLEMENTAL INCOME STATEMENT INFORMATION (In thousands) Items not shown have been omitted because they do not exceed 1% of total revenues.

315858_1993.txt

315858_1993

1993

315858

ITEM 1. BUSINESS General Description of Business BFC Financial Corporation is a savings bank holding company operating principally through its approximately 48.17% owned subsidiary, BankAtlantic, A Federal Savings Bank ("BankAtlantic"). BFC Financial Corporation and its subsidiaries are collectively identified herein as the "Registrant", "BFC" or the "Company". The Company acquired control of BankAtlantic in 1987 for a total investment of approximately $43 million. From 1987 through June 1993, BFC increased its ownership in BankAtlantic and BankAtlantic was consolidated in BFC Financial Corporation's financial statements since October 1987. During November 1993, a public offering of 2,070,000 million shares of BankAtlantic common stock at a price of $13.50 per common share was consummated. Of the shares sold, 1,400,000 shares were sold by BFC Financial Corporation. Net proceeds to BFC Financial Corporation from the sale amounted to approximately $17.7 million. Upon the sale of the 2,070,000 shares, BFC Financial Corporation's ownership of BankAtlantic decreased from 77.83% to 48.17%. With the Company's ownership position less than 50%, BankAtlantic is no longer consolidated in BFC Financial Corporation's financial statements. BankAtlantic represented approximately 97% of the Company's consolidated assets when it was consolidated with the Company. Now based on the equity method of accounting for the Company's investment in BankAtlantic, the investment represents approximately 43% of the Company's consolidated assets. At September 30, 1993, BankAtlantic ranked seventh in size among all savings institutions headquartered in the State of Florida and first in size among all financial institutes headquartered in Broward County, Florida based on its total assets at such date. During March 1992, BFC, which was formerly known as BankAtlantic Financial Corporation changed its name to BFC Financial Corporation, to eliminate confusion with its subsidiary, BankAtlantic, A Federal Savings Bank. In addition to its investment in BankAtlantic, the Company owns and manages real estate. Since its inception in 1980, and prior to the acquisition of control of BankAtlantic, the Company's primary business was the organization, sale and management of real estate investment programs. Effective as of December 31, 1987, the Company ceased the organization and sale of new real estate investment programs, but continues to manage the real estate assets owned by its existing programs. Subsidiaries of the Company continue to serve as the corporate general partners of 4 public limited partnerships which file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Subsidiaries of the Company also serve as corporate general partners of a number of private limited partnerships formed in prior years. The Company and/or its predecessors and affiliates have been engaged in real estate investment activities since 1972. Registrant was organized in its current corporate form in 1980 as the result of a statutory merger which consolidated I.R.E. Series I, Inc., I.R.E. Series II, Inc. and I.R.E. Series III, Inc. Such corporations were originally organized as limited partnerships sponsored by predecessors and affiliates of the Company. In March 1989, (the "1989 Exchange") the Company acquired all of the assets and liabilities of three affiliated public limited partnerships, I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23 and I.R.E. Real Estate Fund, Ltd.- Series 24 in exchange for approximately $30,000,000 in subordinated unsecured debentures which mature in 2009. In connection with the transaction, the Company acquired 14 real properties, 3 of which are still owned by the Company. In February 1991, the Company acquired all of the assets and liabilities of two affiliated public limited partnerships, I.R.E. Real Estate Fund, Ltd. - Series 25 and I.R.E. Real Estate Fund, Ltd. - Series 27 in exchange for approximately $9,308,000 in subordinated unsecured debentures which mature in 2011. In June 1991, the Company acquired all of the assets and liabilities of an affiliated public limited partnership, I.R.E. Real Estate Income Fund, Ltd., in exchange for approximately $6,057,000 in subordinated unsecured debentures that mature in 2011. In connection with these transactions, (the "1991 Exchange") the Company acquired 8 real properties, 4 of which are still owned by the Company. Numerous lawsuits were filed against the Company in connection with both the 1989 and 1991 Exchange offers and in December 1992, a jury returned a verdict for $8 million but extinguished approximately $16 million of subordinated debentures issued in connection with the 1989 Exchange. As discussed above, BFC sold 1.4 million BankAtlantic shares in November 1993. The proceeds from such sale provided BFC with the current resources necessary to allow it to attempt to negotiate settlements with respect to these lawsuits. In March 1994, a settlement agreement, with respect to the lawsuits against the Company pertaining to the 1991 Exchange, was entered into whereby BFC Financial Corporation will pay approximately eighty-one percent of the face amount of the outstanding debentures held by class members and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. (See Item 3. "Legal Proceedings" and "Liquidity and Capital Resources" in Managements Discussion and Analysis.) The Company is pursuing discussions with the remaining plaintiffs in litigation relating to the Exchange offers with a view to settling the ongoing litigation but there is no assurance that a settlement will be resolved. The Company is actively seeking buyers for all of the real property held by it with a view to selling the properties and reducing mortgage indebtedness. As indicated above, during 1987, the Company acquired a controlling interest in BankAtlantic and became a savings bank holding company. Although the Company's current ownership in BankAtlantic is less than 50%, the Company's principal business is still the business of the savings bank as conducted by BankAtlantic. Therefore, set forth below, as excerpted from BankAtlantic's 1993 Annual Report on Form 10-K, is a description of BankAtlantic's business. A description of the Company's real estate partnership program business and related real estate activities follows. The Business Of BankAtlantic General BankAtlantic is a federal savings bank headquartered in Ft. Lauderdale, Florida that provides traditional retail banking services, a full range of commercial banking products and related financial services directly and through subsidiary corporations. The principal business of BankAtlantic is attracting checking and savings deposits from the public and general business customers and using these deposits to originate commercial, mortgage and installment loans and to make other permitted investments such as mortgage-backed securities and tax certificates and other investment securities. BankAtlantic has attempted to shift its primary activities from those of a traditional savings and loan to those generally associated with commercial banking. In an effort to cause its loan portfolio to adjust more rapidly to market conditions, BankAtlantic has shifted its emphasis in lending from fixed-rate, long-term residential loans to shorter term and variable rate consumer and commercial loans and investments. BankAtlantic operates through 31 branch offices located in Dade, Broward and Palm Beach Counties in South Florida. Based on its consolidated assets at September 30, 1993, BankAtlantic is currently the largest independent financial institution headquartered in Broward County, Florida and seventh in size among all savings institutions headquartered in the State of Florida. BankAtlantic is regulated and examined by the Office of Thrift Supervision ("OTS") and its deposit accounts are insured up to applicable limits by the Federal Deposit Insurance Corporation ("FDIC"). BankAtlantic's revenues are derived principally from interest earned on loans, mortgage-backed securities and tax certificates and other investment securities. BankAtlantic's major expense items are interest paid on deposits and borrowings, the provision for loan losses and general and administrative expenses. Lending Activities General - BankAtlantic's lending activities are currently divided into three primary segments: residential real estate lending, commercial lending (consisting of commercial real estate and commercial business lending) and installment lending (primarily consisting of loans secured by second liens on residential real property, loans secured by automobiles and boats and unsecured signature loans). See "Regulation and Supervision" for a description of restrictions on BankAtlantic's lending activities. Commercial lending is currently BankAtlantic's main lending focus. Substantially all of BankAtlantic's commercial loans are made in or relate to Dade, Broward and Palm Beach Counties, Florida. BankAtlantic's residential real estate lending consists primarily of home mortgage loans secured by residential real estate located in Dade, Broward and Palm Beach Counties, Florida. Installment loans are primarily solicited through mass market advertising and through the distribution and display of advertising materials at branch offices. BankAtlantic's loan underwriting procedures are designed to assess both the borrower's ability to make principal and interest payments and the value of the collateral securing the loan. Employment and financial information is solicited from prospective borrowers, credit records are reviewed and the value of any collateral for the loan is analyzed. Loan information supplied by a prospective borrower is independently verified. Loan officers or other loan production personnel in a position to directly benefit monetarily through loan solicitation fees from individual loan transactions do not have approval authority and commercial and residential loans of $500,000 or more and installment loans of $100,000 or more, require the approval of BankAtlantic's Major Loan Committee. The Major Loan Committee consists of the Chairman of the Board, the Vice Chairman, the President, the Senior Executive Vice President, certain Executive Vice Presidents and certain other officers of BankAtlantic. Interest rates and origination fees charged on loans originated by BankAtlantic are generally competitive with other financial institutions and other mortgage originators in BankAtlantic's general market area under the provisions of the Community Reinvestment Act of 1977, as amended (the "CRA"). BankAtlantic has an affirmative obligation to serve the credit needs of the communities in which it operates, and management believes that BankAtlantic fulfills its obligations under the CRA. See "Regulation and Supervision--Community Reinvestment." Commercial Real Estate Loans - BankAtlantic's commercial real estate loans include permanent mortgage loans on commercial and industrial properties, construction loans secured by income producing properties (or for residential development and land acquisition) and development loans. BankAtlantic generally lends not more than 70% of the securing property's appraised value and requires borrowers to maintain, at BankAtlantic, appropriate escrow accounts for the secured property's real estate taxes and insurance. In making lending decisions, BankAtlantic generally considers, among other things, the overall quality of the loan, the credit of the borrower, the location of the real estate, the projected income stream of the property and the reputation and quality of management constructing or administering the property. No one factor is determinative and such factors may be accorded different weights in any particular lending decision. As a general rule, BankAtlantic also requires that these loans be guaranteed by one or more individuals who have made a significant equity investment in the property. Commercial real estate loans generally have shorter terms, adjust more rapidly to interest rate fluctuations and bear higher rates of interest than alternative investments. Income from this type of loan should be more responsive to changes in the general level of interest rates. However, construction and permanent commercial real estate lending is generally considered to have higher credit risk than single-family residential lending because repayment typically is dependent on the successful operation of the related real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or the economy, generally. Construction loans involve additional risks because loan funds are advanced based on the security of the project under construction, which is of uncertain value prior to completion, and because it is relatively difficult to evaluate accurately the total amount required to complete a project. Commercial Business Loans - BankAtlantic's corporate lending activities are generally directed to small to medium size companies located in Dade, Broward and Palm Beach Counties, Florida. BankAtlantic's corporate lending division makes both secured and unsecured loans, although the majority of such lending is done on a secured basis. The development of ongoing customer relationships with commercial borrowers is an important part of BankAtlantic's efforts to attract more low-interest and non-interest bearing demand deposits and to generate other fee-based, non-lending services. The average corporate loan is approximately $1 million and is generally secured by the receivables, inventory, equipment, and/or general corporate assets of the borrower. These loans are originated on both a line of credit basis, and on a fixed-term basis ranging from one to five years in duration. Commercial business loans generally have annual maturities and prime-based interest rates. However, commercial business loans generally have a higher degree of credit risk than residential loans because they are more likely to be adversely affected by unfavorable economic conditions. Residential Mortgage Loans - BankAtlantic's branch banking network is largely responsible for a majority of its residential loan originations. BankAtlantic originates fixed rate and adjustable rate mortgage ("ARM") loans with 15 and 30-year amortization periods; however, substantially all of these loans are sold to correspondents. Applicable regulations require that all loans in excess of 90% of appraised value be insured by private mortgage insurance. BankAtlantic's policy is to require private mortgage insurance on all residential loans with a loan to value ratio greater than 80%. In connection with residential loans insured by the Federal Housing Administration or guaranteed by the Veterans Administration, BankAtlantic may lend up to the maximum percentage of the appraised value acceptable to the insuring or guaranteeing agency. Appraised values are determined by on-site inspections conducted by qualified independent appraisers. BankAtlantic does not presently originate a significant amount of residential mortgage loans for its portfolio and follows regulatory and agency guidelines when it originates such loans for sale. Federal regulations permit savings institutions to originate and purchase mortgage loans secured by one- to-four family residences on which the payment amount, the loan terms, the principal balance or a combination thereof change periodically as a result of changes in interest rates. Pursuant to such regulations, changes in the interest rate must be based on the movement of an index that is beyond the control of the institution and must be agreed to by the institution and the borrower. Under such regulations, "ARMs" must specify the maximum interest rate which may be imposed during the term of the loan. One-to-four family residential loans generally are of a longer duration and bear lower rates of interest than commercial or installment loans; however, there is a lower credit risk associated with these types of loans. BankAtlantic generally does not purchase individual residential mortgage loans. Installment Loans - BankAtlantic significantly reduced its installment lending activities during early 1991 by eliminating indirect consumer loans (installment loans made by others and acquired by BankAtlantic) and significantly decreasing originations of direct installment loans (loans made directly to consumers rather than through dealers). However, during 1993, BankAtlantic has focused on originating installment loans directly through its branch network and slightly increased the volume of its direct installment lending during the latter part of the year. It is anticipated that volume of direct installment lending will increase in 1994 from 1993 levels. Federal savings institutions are authorized to make secured and unsecured consumer installment loans in an aggregate amount up to 35% of their assets. In addition, BankAtlantic has lending authority above this 35% limit for certain consumer loans, such as second mortgages, home improvement loans, mobile home loans and loans secured by savings accounts. Installment loans typically involve a higher degree of credit risk than one-to-four family residential loans secured by first mortgages, but they generally carry higher yields and have shorter terms to maturity. Second mortgage loans are secured by a junior lien on residential real property and are typically based on a maximum 80% loan-to-value ratio. Personal loans may be secured by various forms of collateral, both real and personal, or to a minimal extent, may be made on an unsecured basis. Such loans generally bear interest at floating rates with the exception of personal unsecured loans which bear interest at a fixed rate. Prior to 1991, BankAtlantic funded dealer reserves to dealers who originated consumer loans which were then purchased by BankAtlantic ("indirect consumer loans"). The risk of any amounts advanced to the dealer is primarily associated with loan performance but, secondarily, is dependent on the financial condition of the dealer. The dealer is generally responsible to BankAtlantic for the amount of the reserve only if a loan giving rise to the reserve becomes delinquent or is prepaid. However, the dealer's ability to refund any portion of the unearned reserve to BankAtlantic is subject to economic conditions, generally, and the financial condition of the dealer. A decline in economic conditions could adversely affect both the performance of the loans and the financial condition of the dealer. There is no assurance that BankAtlantic can successfully recover amounts advanced in the event it pursues the dealer for amounts due. See "Management's Discussion and Analysis of Results of Operations and Financial Condition" regarding recovery from BankAtlantic's fidelity bond carrier of certain amounts associated with certain indirect consumer loans. Loan Commitments - BankAtlantic issues commitments to make residential and commercial real estate loans and commercial business loans on specified terms which are conditioned upon the occurrence of stated events. Loan commitments are generally issued in connection with (i) the origination of loans for the financing of residential properties by prospective purchasers, (ii) construction or permanent loans secured by commercial and multi-unit residential income-producing properties and (iii) loans to corporate borrowers in connection with loans secured by corporate assets. The commitment procedure followed by BankAtlantic depends on the type of loan underlying the commitment. Residential loan commitments are generally limited to 30 days and are issued after the loan is approved. However, loan commitments may be extended based on the circumstances. BankAtlantic offers interest rate "locks" for periods of up to 150 days. BankAtlantic also issues short-term commitments on commercial real estate loans and commercial business loans. Short-term commitments generally remain open for no more than 90 days. BankAtlantic usually charges a commitment fee of 1% to 2% on short-term commitments relating to commercial real estate loans and commercial business loans. In most cases, half of the fee is payable upon the acceptance of the commitment and is non-refundable. If the loan is ultimately made, the remainder of the commitment fee is collected at closing. Loan Servicing Rights - BankAtlantic generally retains servicing rights on loans which it sells and has sought to purchase additional servicing rights from third parties. BankAtlantic derives fees for providing the servicing of mortgage loans, including, among other fees, assumption fees and late charges. The amount of revenue earned from loan servicing is dependent on the prepayments of the underlying loans. Generally, as interest rates fall, loan prepayments accelerate, resulting in lower net revenues earned on loan servicing rights. Conversely, as interest rates rise, loan prepayments decline, resulting in higher net revenues earned on loan servicing rights. Usury Limitations - The maximum rate of interest that BankAtlantic may charge for any particular loan transaction varies depending upon the purpose of the loan, the nature of the borrower, the security and other various factors set forth in Florida and federal interest rate laws. Under Florida law, BankAtlantic is not subject to any usury ceiling on loans secured by a first lien on residential real estate and certain other secured loans. Other types of loans are subject to Florida's statutory usury ceiling which is currently 18% per annum, although certain types of loans in excess of $500,000 may legally carry an interest rate of up to 25% per annum. Non-Performing and Classified Assets, Loan Delinquencies and Defaults - When a borrower fails to make a required payment on a loan, BankAtlantic attempts to have the deficiency cured by communicating with the borrower. In most cases, deficiencies are cured promptly. If the delinquency is not cured within 90 days, it is BankAtlantic's general policy to institute appropriate legal action to collect the loan, including foreclosing on any collateral securing the loan and obtaining a deficiency judgment against the borrower, if appropriate. Current regulations provide for the classification of loans and other assets considered by examiners to be of lesser quality as "special mention," "substandard," "doubtful" or "loss" assets. The special mention category applies to assets not warranting classification as substandard but possessing credit deficiencies or potential weaknesses necessitating management's close attention. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that such weaknesses make collection of the loan or liquidation in full on the basis of currently existing facts, conditions and values, highly questionable or improbable. Assets classified as a loss are considered uncollectible and of such little value that their continued treatment as assets is not warranted. The asset classification regulations require insured institutions to classify their own assets and to establish prudent general allowances for loan losses. However, regulators have considerable discretion to review asset classifications and loss allowances of insured institutions, and, if a regulator concludes that the valuation allowances established by an institution are inadequate, the regulator may determine, subject to certain reviews, the need for, and extent of, any increase necessary in the institution's general allowance for loan losses. Management of BankAtlantic has identified certain assets as "Risk elements". These assets include: (i) loans accounted for on a non-accrual basis; (ii) loans not included in category (i), which are contractually 90 days or more past due as to interest or principal payments; (iii) assets acquired in settlement of loans; and (iv) restructured loans. Non-accrual loans are loans on which interest recognition has been suspended until realized because of doubts as to the borrower's ability to repay principal or interest. Restructured loans are loans on which the terms have been altered to provide a reduction or deferral of interest or principal because of a deterioration in the borrower's financial position. Such restructured loans may be removed from the restructured category based upon various factors, including a period of satisfactory loan performance under the revised terms. Allowance for Loan Losses - Management of BankAtlantic establishes allowances for loan losses in amounts which it believes are sufficient to provide for potential future losses. In establishing its allowance for loan losses, management considers past loss experience, present indicators such as delinquency rates, economic conditions, collateral values and the potential for loan losses in future periods. The evaluation of potential losses in BankAtlantic's loan portfolio includes a review of all loans for which full collectibility may not be reasonably assured. Increases in the allowance for loan losses are recorded when losses are both probable and estimable. In the case of loans in foreclosure or probable foreclosure, the estimated fair value of the underlying collateral, and such other factors which, in management's judgment, deserve recognition under existing economic conditions are considered in estimating loan losses. Investment Activities BankAtlantic maintains an investment portfolio consisting primarily of mortgage-backed securities and tax certificates. Additionally, BankAtlantic has purchased banker's acceptances, which have been classified as loans. Federal regulations limit the types and quality of instruments in which BankAtlantic may invest. Mortgage-backed securities are pools of residential loans which are made to consumers and then generally sold to governmental agencies, such as the Government National Mortgage Corporation ("GNMA"), the Federal National Mortgage Corporation ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC"). Mortgage-backed securities are either 15-30 year maturity, 5-7 year balloon maturity or ARMs. BankAtlantic generally invests in ARMs or 5-7 year balloon maturity mortgage-backed securities. Banker's acceptances are unconditional obligations of the issuing bank and are collateralized by various means, including inventory and receivables of borrowers of the issuing bank. BankAtlantic's portfolio also includes tax lien certificates issued by various counties in the State of Florida. Tax certificates represent a priority lien against real property for which assessed real estate taxes are delinquent. Although tax certificates have no stated maturity, the certificate holder has the right to collect the delinquent tax amount, plus interest, and can file for a deed to the underlying property if the delinquent tax amount is unpaid at the end of two years. If the certificate holder does not file for the deed within seven years, the certificate becomes null and void. BankAtlantic's experience with this type of investment has been favorable as rates earned are generally higher than many alternative investments, substantial repayment generally occurs over a two year period and losses to date, have been minimal. The primary risks BankAtlantic has experienced with tax certificates have related to the risk that additional funds may be required to purchase other certificates relating to the property, the risk that the liened property may be unusable and the risk that potential environmental concerns may make taking title to the property untenable. The OTS is reviewing the amount, and procedures utilized in the acquisition and administration of tax certificates by savings institutions. The purpose of such review is believed to be the establishment of specific regulatory guidelines and procedures so as to insure safety and soundness, generally. BankAtlantic has participated with the OTS in this review and, based upon current practices, BankAtlantic believes its procedures comply with applicable safety and soundness requirements. Additionally, the Southeast Regional Office of the OTS requested that BankAtlantic limit its purchases of tax certificates at 1993 tax certificate auctions to an aggregate amount not to exceed $85 million. Based on market conditions, BankAtlantic purchased only approximately $64 million in tax certificates at auctions in 1993. BankAtlantic is also aware that on November 17, 1992, the FDIC issued an Interpretive Letter stating its view that it constitutes an unsafe or unsound banking practice for a non-member commercial bank to invest in tax certificates. Although the FDIC currently has supervisory and examination jurisdiction with respect to thrifts such as BankAtlantic (see "Regulation and Supervision"), BankAtlantic is unaware of any similar statement published by the FDIC concerning investments in tax certificates by savings banks. BankAtlantic has been advised that the FDIC may be preparing or may have issued a memorandum or policy statement concerning tax certificates and has made a request under the Freedom of Information Act to obtain a copy of any such memorandum or policy statement. However, to date, the FDIC has not made any such memorandum or policy statement publicly available. If the FDIC or the OTS were to make a determination in the future that such investments are improper, either regulator could seek to impose restrictions or sanctions, prohibit or limit investments in tax certificates or require additional regulatory reserves with respect to these investments. For descriptions of BankAtlantic's investments in tax certificates and other investment securities, see Note 3 to the Consolidated Financial Statements. Based upon current discussions with the Southeast Regional Office of the OTS, BankAtlantic believes the OTS has completed its current review of tax certificate investments and has determined that savings institutions may continue to invest in tax certificates, subject to certain volume limitations and adherence to specific underwriting, asset classification and other procedural guidelines. BankAtlantic believes it is in a position to comply with OTS requirements and that compliance will not significantly change BankAtlantic's tax certificate investment activities or practices. For a discussion of regulatory limitations on BankAtlantic's investments, see "Regulation and Supervision." Sources of Funds General - Historically, deposits have been the principal source of BankAtlantic's funds for use in lending and for other general business purposes. Loan repayments, sales of securities, advances from the Federal Home Loan Bank ("FHLB") of Atlanta and other borrowings, including the issuance of subordinated debentures, and the use of repurchase agreements have been additional sources of funds. Loan amortization payments, deposit inflows and outflows are significantly influenced by general interest rates. Borrowings may be used by BankAtlantic on a short-term basis to compensate for reductions in normal sources of funds such as savings inflows, and to provide additional liquidity investments. On a long-term basis, borrowings may support expanded lending activities. Historically, BankAtlantic has borrowed primarily from the FHLB of Atlanta and through the use of repurchase agreements. Deposit Activities - BankAtlantic offers several types of deposit programs designed to attract both short-term and long-term funds from the general public by providing an assortment of accounts and rates. BankAtlantic believes that its product line is comparable to that offered by its competitors. BankAtlantic offers the following accounts: commercial and retail demand deposit accounts; regular passbook and statement savings accounts; money market accounts; fixed-rate, fixed-maturity certificates of deposit, ranging in maturity from 30 days to 8 years; variable-maturity jumbo certificates of deposit; and various NOW accounts. BankAtlantic also offers IRA and Keogh retirement accounts. BankAtlantic's deposit accounts are insured by the FDIC through the Savings Association Insurance Fund ("SAIF") up to a maximum of $100,000 for each insured depositor. BankAtlantic solicits deposits through advertisements in newspapers and magazines of general circulation and on radio and television in Dade, Broward and Palm Beach Counties, Florida. Most of its depositors are residents of these three counties at least part of the year. BankAtlantic does not hold any deposits obtained through brokers. Borrowings - BankAtlantic has utilized wholesale repurchase agreements as a means of obtaining funds and increasing yields on its investment portfolio. In a wholesale repurchase transaction, BankAtlantic sells a portion of its current investment portfolio (usually government and mortgage-backed securities) at a negotiated rate and agrees to repurchase the same or substantially identical assets on a specified date. Proceeds from such transactions are treated as secured borrowings pursuant to applicable regulations. See Note 14 to the Consolidated Financial Statements. BankAtlantic is a member of the FHLB and is authorized to apply for secured advances from the FHLB of Atlanta. See "Regulation and Supervision." BankAtlantic has used advances from the FHLB to repay other borrowings, meet deposit withdrawals and expand its lending and short-term investment activities. See Note 13 to the Consolidated Financial Statements. Competition Based on its total assets, at September 30, 1993, BankAtlantic ranked seventh in size among all savings institutions headquartered in the State of Florida and first in size among all financial institutions headquartered in Broward County, Florida. BankAtlantic has substantial competition in attracting and retaining deposits and in lending funds. The primary factors in competing for deposits are the range and quality of financial services offered, the ability to offer attractive rates and the availability of convenient office locations. There is direct competition for deposits from credit unions and commercial banks and other savings institutions. Additional significant competition for savings deposits comes from other investment alternatives, such as money market mutual funds and corporate and government securities. The primary factors in competing for loans are the range and quality of lending services offered, interest rates and loan origination fees. Competition for origination of real estate loans normally comes from other savings and financial institutions, commercial banks, mortgage bankers and insurance companies. Past legislative and regulatory action has increased competition between savings institutions and other financial institutions, such as commercial banks, by expanding the ranges of financial services that may be offered by savings institutions (e.g., interest bearing checking accounts, trust services and consumer and commercial lending authority), while reducing or eliminating the difference between thrift institutions and commercial banks with respect to long-term lending authority, taxation and maximum rates of interest that may be paid on savings deposits. Current and future regulatory requirements may adversely affect BankAtlantic's competitive position by restricting its operations. BankAtlantic's operating goal is to provide a broad range of financial services with a strong emphasis on customer service to individuals and businesses in South Florida. REGULATION AND SUPERVISION General BankAtlantic is a member of the FHLB system and its deposit accounts are insured up to applicable limits by the FDIC. BankAtlantic is subject to supervision, examination and regulation by the OTS and to a lesser extent by the FDIC as the insurer of its deposits. BankAtlantic must file reports with the OTS and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions. There are periodic examinations by the OTS and the FDIC to examine BankAtlantic's compliance with various regulatory requirements. The regulatory structure also gives regulatory authorities extensive discretion in connection with their supervisory and enforcement policies with respect to the classification of non-performing and other assets and the establishment of adequate loan loss reserves for regulatory purposes. Additionally, as a company having a class of publicly held equity securities, BankAtlantic is subject to the reporting and other requirements of the Securities Exchange Act of 1934, as amended. Legislative Developments In recent years, measures have been taken to reform the thrift and banking industries and to strengthen the insurance funds for depository institutions. The most significant of these measures was the Financial Institution Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), which has had a major impact on the operations and regulation of savings associations generally. In 1991, a comprehensive deposit insurance and banking reform plan, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), became law. Although FDICIA's primary purpose is to recapitalize the Bank Insurance Fund (the "BIF") of the FDIC, FDICIA also affects the supervision and regulation of all federally insured depository institutions, including federal savings banks such as BankAtlantic. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 - FIRREA, enacted in response to concerns regarding the soundness of the thrift industry, brought about a significant regulatory restructuring, limited savings institutions' business activities and increased savings institutions' regulatory capital requirements. FIRREA abolished the FHLB Board and the Federal Savings and Loan Insurance Corporation ("FSLIC") and established the OTS as the primary federal regulator for savings institutions. Deposits at BankAtlantic are insured through the SAIF, a separate fund managed by the FDIC for institutions whose deposits were formerly insured by the FSLIC. Regulatory functions relating to deposit insurance are generally exercised by the FDIC. The Federal Deposit Insurance Corporation Improvement Act of 1991 - FDICIA authorizes the regulators to take prompt corrective action to solve the problems of critically undercapitalized institutions. As a result, banking regulators are required to take certain supervisory actions against undercapitalized institutions, the severity of which increases as an institution's level of capitalization decreases. Pursuant to FDICIA, federal banking agencies have established the levels at which an insured institution is considered to be "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." See "Savings Institution Regulations--Prompt Regulatory Action" below for a discussion of the applicable capital levels. Based upon these established capital levels, BankAtlantic meets the definition of a "well capitalized" institution. FDICIA requires federal banking agencies to revise their risk-based capital requirements to include components for interest rate risk, concentration of credit risk and the risk of non-traditional activities. See "Savings Institution Regulations--Regulatory Capital" below for a discussion of the interest rate risk component in the risk-based capital requirement effective June 30, 1994. In addition, FDICIA requires each federal banking agency to establish standards relating to internal controls, information systems, and internal audit systems that are designed to assess the financial condition and management of the institution, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. FDICIA lowered the Qualified Thrift Lender ("QTL") investment percentage applicable to institutions insured by SAIF. See "Regulation and Supervision--Savings Institution Regulations--Qualified Thrift Lender--Insurance of Accounts." FDICIA further requires annual on-site full examinations of depository institutions, with certain exceptions, and annual reports on institutions' financial and management controls. Other proposals are currently being considered which could have a significant impact on BankAtlantic, including proposals, which would consolidate the regulatory agencies having authority over financial institutions. It is not yet clear which, if any, proposals will be adopted or the impact such proposals may have on BankAtlantic. Savings Institution Regulations Regulatory Capital - Both the OTS and the FDIC have promulgated regulations setting forth capital requirements applicable to savings institutions. The effect and interrelationship of these regulations are discussed below. Savings institutions must meet the OTS' specific capital standards which by law must be no less stringent than capital standards applicable to national banks with exceptions for risk-based capital requirements to reflect interest rate risk or other risk. Capital calculated pursuant to the OTS' regulations varies substantially from capital calculated pursuant to generally accepted accounting principles ("GAAP"). At December 31, 1993, BankAtlantic met all applicable capital requirements. The capital requirements are as follows: (a) The leverage limit requires savings institutions to maintain core capital of at least 3% of adjusted total assets. Adjusted total assets are calculated as GAAP total assets, minus intangible assets (except those included in core capital as described below). Core capital consists of common shareholders' equity, including retained earnings, noncumulative perpetual preferred stock and related surplus, less specified intangible assets (a percentage of purchased mortgage servicing rights ("PMSRs")). In addition, a portion of PMSRs may be included in core capital. Generally, an amount may be included in core capital equal to the lowest of (i) 90% of the fair market value of readily marketable PMSRs or (ii) the current amortized book value as determined under GAAP. However, the amount of PMSRs included in core capital is limited to a maximum of 50% of core capital. (b) Under the tangible capital requirement, savings institutions must maintain tangible capital in an amount not less than 1.5% of adjusted total assets. Tangible capital is defined in the same manner as core capital, except that all intangible assets, except PMSRs, must be deducted. The percentage of PMSRs which may be included in tangible capital is equal to the lesser of (a) 100% of the amount of tangible capital that exists before the deduction of any disallowed PMSRs or (b) the amount of PMSRs allowed to be included in core capital. (c) The risk-based standards of the OTS currently require maintenance of core capital equal to at least 4% of risk-weighted assets, and total capital equal to at least 8% of risk-weighted assets. Total capital includes core capital plus supplementary capital, but supplementary capital that may be included in computing total capital for this purpose may not exceed core capital. Supplementary capital includes cumulative perpetual preferred stock, allowable subordinated debt and general loan loss allowances, within specified limits. Such general loss allowances may not exceed 1.25% of risk-weighted assets. Additionally, investments in non-includable subsidiaries will be subject to a 100% exclusion from risk-based capital by July 1, 1994. Risk-weighted assets are determined by assigning to all assets designated risk weights ranging from 0% to 100%, based on the credit risk assumed to be associated with the particular asset. Generally, zero weight is assigned to risk-free assets, such as cash and unconditionally guaranteed United States government securities such as mortgage-backed securities issued or guaranteed by GNMA. A weight of 20% is assigned to, among other things, certain obligations of United States government-sponsored agencies (such as the FNMA and the FHLMC), stock of a FHLB and high quality mortgage-related securities. A weight of 50% is assigned to qualifying mortgage loans and certain other residential mortgage-related securities. A weight of 100% is assigned to consumer, commercial and other loans, repossessed assets and assets that are 90 days or more past due and all other assets not identified in the categories above. In addition to the capital requirements set forth in the OTS' regulations, the OTS has delegated to its Regional Directors the authority to establish higher individual minimum capital requirements for savings institutions based upon a determination that the institution's capital is or may become inadequate in view of its circumstances. For example, circumstances which may be considered by the Regional Directors are the institution: (i) receiving special supervisory attention; (ii) having or expected to have losses resulting in capital inadequacy; (iii) having a high degree of exposure to interest-rate, prepayment, credit or similar risks or a high proportion of off-balance sheet risk; (iv) having poor liquidity or cash flow; (v) growing, internally or through acquisitions, at such a rate that supervisory problems are presented that are not dealt with adequately by other OTS regulations; (vi) having potential adverse effects from the activities or condition of its affiliates or others with which it has significant business relationships, including concentrations of credit; (vii) having a portfolio reflecting weak credit quality; (viii) having inadequate underwriting policies or procedures for loans and investments; (ix) having a record of operational losses that exceeds the average of other, similarly situated savings institutions; (x) having management deficiencies; or (xi) having a poor record of supervisory compliance. In August 1993, the OTS adopted a final rule incorporating an interest-rate risk component into the risk-based capital regulation. Under the rule, an institution with a greater than "normal" level of interest-rate risk will be subject to a deduction of its interest-rate risk component from total capital for purposes of calculating the risk-based capital requirement. As a result, such an institution will be required to maintain additional capital in order to comply with the risk-based capital requirement. An institution with a greater than "normal" interest-rate risk is defined as an institution that would suffer a loss of net portfolio value exceeding 2.0% of the estimated market value of its assets in the event of a 200 basis point increase or decrease (with certain minor exceptions) in interest rates. The interest-rate risk component will be calculated, on a quarterly basis, as one-half of the difference between an institution's measured interest-rate risk and 2.0% multiplied by the market value of its assets. The rule also authorizes the director of the OTS, or his designee, to waive or defer an institution's interest-rate risk component on a case-by-case basis. The final rule is effective as of January 1, 1994, subject however to a two quarter "lag" time between the reporting date of the data used to calculate an institution's interest-rate risk and the effective date of each quarter's interest-rate risk component. Thus, an institution with greater than "normal" risk will not be subject to any deduction from total capital until July 1, 1994. Additionally, the Office of the Comptroller of the Currency (the "OCC"), which is the primary regulator for national banks, has adopted a final rule increasing the leverage ratio requirements for all but the most highly rated national banks. Pursuant to FIRREA, the OTS is required to issue capital standards for savings institutions that are no less stringent than those applicable to national banks. Accordingly, savings institutions must maintain a leverage ratio (defined as the ratio of core capital to adjusted total assets) of between 4% and 5%. The OTS indicated in the final rule that it intended to lower the leverage ratio requirement (in its prompt corrective action regulation) to 3.0% from the current level of 4.0%, on July 1, 1994. If this rule and the interest rate component discussed above were in effect at December 31, 1993, BankAtlantic believes it would be in full compliance with the new rules and would have risk-based capital substantially in excess of applicable risk-based capital requirements. The OTS also issued a final rule, effective March 1, 1994, which excludes core deposit intangibles ("CDIs") in the determination of regulatory capital. As BankAtlantic's CDIs have been fully amortized at December 31, 1993, BankAtlantic is not currently effected by this exclusion from capital. Insurance of Accounts - BankAtlantic's deposits are insured by the SAIF up to $100,000 for each insured account holder, the maximum amount currently permitted by law. Pursuant to the FDICIA, the FDIC adopted transitional regulations implementing risk-based insurance premiums that became effective on January 1, 1993. Under these regulations, institutions are divided into groups based on criteria consistent with those established pursuant to the prompt regulatory action provisions of the FDICIA (see "Savings Institution Regulations -- Prompt Regulatory Action" below). Each of these groups is further divided into three subgroups, based on a subjective evaluation of supervisory risk to the insurance fund posed by the institution. Insurance premiums range from 23 to 31 basis points, with well capitalized institutions in the highest supervisory subgroup paying 23 basis points and undercapitalized institutions in the lowest supervisory subgroup paying 31 basis points. As an insurer, the FDIC issues regulations and conducts examinations of its insured members. Insurance of deposits by the SAIF may be terminated by the FDIC, after notice and hearing, upon a finding that an institution has engaged in unsafe and unsound practices, is in an unsafe and unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the OTS or the FDIC. When conditions warrant, the FDIC may impose less severe sanctions as an alternative to termination of insurance. BankAtlantic's management does not know of any present condition pursuant to which the FDIC would seek to impose sanctions on BankAtlantic or terminate insurance of its deposits. Prompt Regulatory Action - The OTS and other federal banking regulators have established capital levels for institutions to implement the "prompt regulatory action" provisions of the FDICIA. Capital levels have been established for which an insured institution will be categorized as well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized. The FDICIA requires federal banking regulators, including the OTS, to take prompt corrective action to solve the problems of those institutions that fail to satisfy their applicable minimum capital requirements. The level of regulatory scrutiny and restrictions imposed become increasingly severe as an institution's capital level falls. A "well capitalized" institution must have risk-based capital of 10% or more, core capital of 5% or more and Tier 1 risk-based capital (based on the ratio of core capital to risk-weighted assets) of 6% or more and may not be subject to any written agreement, order, capital directive or prompt corrective action directive issued by the OTS to meet and maintain a specific capital level for a specific capital measure. An institution will be categorized as: "adequately capitalized" if it has total risk-based capital of 8% or more, Tier 1 risk-based capital of 4% or more and core capital of 4% or more; "undercapitalized" if it has total risk-based capital of less than 8%, Tier 1 risk-based capital of less than 4% or core capital of less than 4%; "significantly undercapitalized" if it has total risk-based capital of less than 6%, Tier 1 risk-based capital of less than 3% or core capital of less than 3%; and "critically undercapitalized" if it has tangible capital of less than 2%. Any savings institution that fails its regulatory capital requirement is subject to enforcement action by the OTS or the FDIC. BankAtlantic meets the capital requirements of a well capitalized institution as defined above. An undercapitalized institution is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. The plan must specify (i) the steps the institution will take to become adequately capitalized, (ii) the capital levels to be attained each year, (iii) how the institution will comply with any regulatory sanctions then in effect against the institution and (iv) the types and levels of activities in which the institution will engage. The banking agency may not accept a capital restoration plan unless the agency determines, among other things, that the plan is based on realistic assumptions, and is likely to succeed in restoring the institution's capital and would not appreciably increase the risk to which the institution is exposed. Under FDICIA, an insured depository institution cannot make a capital distribution (as broadly defined to include, among other things, dividends, redemptions and other repurchases of stock), or pay management fees to any person that controls the institution, if thereafter it would be undercapitalized. The appropriate federal banking agency, however, may (after consultation with the FDIC) permit an insured depository institution to repurchase, redeem, retire or otherwise acquire its shares if such action (i) is taken in connection with the issuance of additional shares or obligations in at least an equivalent amount and (ii) will reduce the institution's financial obligations or otherwise improve its financial condition. An undercapitalized institution is generally prohibited from increasing its average total assets. An undercapitalized institution is also generally prohibited from making any acquisitions, establishing any branches or engaging in any new line of business except in accordance with an accepted capital restoration plan or with the approval of the FDIC. In addition, the appropriate federal banking agency is given authority with respect to any undercapitalized depository institution to take any of the actions it is required to or may take with respect to a significantly undercapitalized institution as described below if it determines "that those actions are necessary to carry out the purpose" of FDICIA. FDICIA provides that the appropriate federal regulatory agency must require an insured depository institution that (i) is significantly undercapitalized or (ii) is undercapitalized and either fails to submit an acceptable capital restoration plan within the time period allowed by regulation or fails in any material respect to implement a capital restoration plan accepted by the appropriate federal banking agency, to take one or more of the following actions: (i) sell enough shares, including voting shares, to become adequately capitalized; (ii) merge with (or be sold to) another institution (or holding company), but only if grounds exist for appointing a conservator or receiver; (iii) restrict certain transactions with banking affiliates as if the "sister bank" exception to the requirements of Section 23A of the Federal Reserve Act ("FRA") did not exist; (iv) otherwise restrict transactions with bank or non-bank affiliates; (v) restrict interest rates that the institution pays on deposits to "prevailing rates" in the institution's "region;" (vi) restrict asset growth or reduce total assets; (vii) alter, reduce or terminate activities; (viii) hold a new election of directors; (ix) dismiss any director or senior officer who held office for more than 180 days immediately before the institution became undercapitalized; provided that in requiring dismissal of a director or senior officer, the agency must comply with certain procedural requirements, including the opportunity for an appeal in which the director or officer will have the burden of proving his or her value to the institution; (x) employ "qualified" senior officers; (xi) cease accepting deposits from correspondent depository institutions; (xii) divest certain non-depository affiliates which pose a danger to the institution; (xiii) be divested by a parent holding company; and (xiv) take any other action which the agency determines would better carry out the purposes of the prompt corrective action provisions. In addition to the foregoing sanctions, without the prior approval of the appropriate federal banking agency, a significantly undercapitalized institution may not pay any bonus to any senior officer or increase the rate of compensation for such an officer without regulatory approval. Furthermore, in the case of an undercapitalized institution that has failed to submit or implement an acceptable capital restoration plan, the appropriate federal banking agency cannot approve any such bonus. Not later than 90 days after an institution becomes critically undercapitalized, the appropriate federal banking agency for the institution must appoint a receiver or, with the concurrence of the FDIC, a conservator, unless the agency, with the concurrence of the FDIC, determines that the purposes of the prompt corrective action provisions would be better served by another cause of action. The FDICIA requires that any alternative determination be "documented" and reassessed on a periodic basis. Notwithstanding the foregoing, a receiver must be appointed after 270 days unless the FDIC determines that the institution has positive net worth, is in compliance with a capital plan, is profitable or has a sustainable upward trend in earnings and is reducing its ratio of non-performing loans to total loans and the head of the appropriate federal banking agency and the chairperson of the FDIC certify that the institution is viable and not expected to fail. The FDIC is required, by regulation or order, to "restrict the activities" of such critically undercapitalized institutions. The restrictions must include prohibitions on the institution's doing any of the following without prior approval of the FDIC: entering into any material transactions not in the usual course of business, extending credit for any highly leveraged transaction, engaging in any "covered transaction" (as defined in Section 23A of the FRA) with an affiliate, paying "excessive compensation or bonuses," and paying interest on "new or renewed liabilities" that would increase the institution's average cost of funds to a level significantly exceeding prevailing rates in the market. Appointment of Receiver or Conservator - The grounds for appointment of a conservator or receiver for a savings institution include the following events: (i) "substantially insufficient capital;" (ii) incurrence or likely incurrence of losses that will substantially deplete all of the institution's capital in the absence of reasonable prospects for replenishing that capital without federal assistance; (iii) a violation of law or regulation that is likely to weaken the institution's condition; (iv) assets insufficient for the satisfaction of its obligations; (v) substantial dissipation of assets or earnings; (vi) unsafe and unsound condition; (vii) willful violation of cease and desist orders; (viii) concealment of information; (ix) inability to meet obligations in the normal course of business; (x) violations of law; (xi) consent by resolution of the institution's board of directors or shareholders; (xii) cessation of insured status; (xiii) under-capitalization; and (xiv) other capital problems. Supervisory Agreement - On April 16, 1991, BankAtlantic voluntarily entered into a Supervisory Agreement with the OTS. The Supervisory Agreement required BankAtlantic to implement additional policies and reporting procedures relating to the internal operations of BankAtlantic within specified time frames, and to particularly address concerns relating to classified assets, general valuation allowances and the policies, procedures, information reporting and guidelines in the consumer loan department. On March 16, 1994, the OTS notified BankAtlantic that it had been released from the Supervisory Agreement, BankAtlantic's management does not believe that the Agreement had any material impact on BankAtlantic's business or operations. Restrictions on Dividends and Other Capital Distributions - Current regulations applicable to the payment of cash dividends by savings institutions impose limits on capital distributions based on an institution's regulatory capital levels and net income. An institution that meets or exceeds all of its fully phased-in capital requirements (both before and after giving effect to the distribution) and is not in need of more than normal supervision would be a "Tier 1 association." A Tier 1 association may make capital distributions during a calendar year up to the greater of (i) 100% of net income for the current calendar year plus 50% of its capital surplus or (ii) 75% of its net income over the most recent four quarters. Any additional capital distributions would require prior regulatory approval. An institution that meets the minimum regulatory capital requirements but does not meet the fully phased-in capital requirements would be a "Tier 2 association," which may make capital distributions of between 25% and 75% of its net income over the most recent four-quarter period, depending on the institution's risk-based capital level. A "Tier 3 association" is defined as an institution that does not meet all of the minimum regulatory capital requirements and therefore may not make any capital distributions without the prior approval of the OTS. Savings institutions must provide the OTS with at least 30 days written notice before making any capital distributions. All such capital distributions are also subject to the OTS' right to object to a distribution on safety and soundness grounds. The FHLB System - BankAtlantic is a member of the FHLB system, which consists of 12 regional FHLBs governed and regulated by the Federal Housing Finance Board ("FHFB"). The FHLBs provide a central credit facility for member institutions. BankAtlantic, as a member of the FHLB of Atlanta, is required to acquire and hold shares of capital stock in the FHLB of Atlanta in an amount at least equal to the greater of 1% of the aggregate principal amount of its unpaid residential mortgage loans, home purchase contracts and similar obligations as of the close of each calendar year, or 5% of its borrowings from the FHLB of Atlanta (including advances and letters of credit issued by the FHLB on BankAtlantic's behalf). BankAtlantic is currently in compliance with this requirement. Each FHLB makes loans (advances) to members in accordance with policies and procedures established by the board of directors of the FHLB. These policies and procedures are subject to the regulation and oversight of the FHFB. The FHLB Act establishes collateral requirements for advances from the FHLB. First, all advances from the FHLB must be fully secured by sufficient collateral as determined by the FHLB of Atlanta. The FHLB Act prescribes eligible collateral as first mortgage loans less than 90 days delinquent or securities evidencing interests therein, securities (including mortgage-backed securities) issued, insured or guaranteed by the federal government or any agency thereof, deposits with the FHLB and, to a limited extent, real estate with readily ascertainable value in which a perfected security interest may be obtained. All long-term advances are required to provide funds for residential home financing. The FHLB of Atlanta has established standards of community service that members must meet to maintain access to long-term advances. Fees and Assessments of the OTS - The OTS has adopted regulations to assess fees on savings institutions to fund the operations of the OTS. The regulations provide for the OTS' assessments to be made based on the total consolidated assets of a savings institution as shown on its most recent report to the agency. Troubled savings institutions (generally, those operating in conservatorship or with the lowest two (of five) supervisory subgroup ratings) are to be assessed at a rate 50% higher than similarly sized thrifts that are not experiencing problems. Investment Activities - As a federally-chartered savings bank, BankAtlantic is subject to various restrictions and prohibitions with respect to its investment activities. These restrictions and prohibitions are set forth in the Home Owner's Loan Act ("HOLA") and in the rules of the OTS and include dollar amount limitations and procedural limitations. BankAtlantic is in compliance with these restrictions. Under the Federal Deposit Insurance Act ("FDIA"), a savings institution is required to provide 30 days' prior notice to the FDIC and the OTS of its desire to establish or acquire a new subsidiary or conduct any new activity through a subsidiary. The institution is also required to conduct the activities of the subsidiary in accordance with the OTS' orders and regulations. The Director of the OTS has the power to force divestiture of any subsidiary or the termination of any activity it determines is a serious threat to the safety, soundness or stability of the savings institution or is otherwise inconsistent with sound banking principles. Additionally, the FDIC is authorized to determine whether any specific activity poses a threat to the SAIF and to prohibit any member of the SAIF from engaging directly in the activity, even if it is an activity that is permissible for a federally-chartered savings institution or for a subsidiary of a state-chartered savings institution. Safety and Soundness - The FDIA authorizes the appropriate federal agency (in the case of BankAtlantic, the OTS) to prescribe, for all federally insured depository institutions, operational, managerial and compensation standards for internal controls, information systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation and benefits for bank officers, employees, directors and principal shareholders. The statute further empowers the OTS to set standards for any other facet of institution operations not specifically covered in this list. The OTS is required to prescribe asset quality, earnings and stock valuation standards specifying: (i) a maximum ratio of classified assets to capital; (ii) minimum earnings sufficient to absorb losses without impairing capital; (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of the institution; and (iv) such other standards relating to asset quality, earnings and valuation as the OTS deems appropriate. An institution failing to meet these standards must file a plan to bring the institution into compliance and have the plan approved by the OTS. Continued non-compliance allows the OTS to prohibit growth, require higher capital, restrict interest rates paid on deposits or take any other appropriate action. Loans to One Borrower - Generally, a savings institution's total loans and extensions of credit to one borrower or related group of borrowers, outstanding at one time and not fully secured by readily marketable collateral, may not exceed 15% of the institutions' unimpaired capital and surplus. Except as set forth below for certain highly rated securities, an institution's investment in commercial paper and corporate debt securities of any one issuer or related entity must be aggregated "loans" for purposes of the immediately preceding sentence. Savings institutions may invest, in addition to the 15% general limitation, up to 10% of unimpaired capital and surplus in commercial paper of one issuer rated by two nationally recognized rating services in the highest category, or in corporate debt securities rated in one of the two highest categories by at least one such service. A savings institution may also lend up to 10% of unimpaired capital and surplus, if the loan is fully secured by readily marketable collateral which is defined to include certain securities and bullion, but generally does not include real estate. A savings institution which meets its fully phased-in capital requirements may make loans to one borrower to develop domestic residential housing units, up to the lesser of $30,000,000 or 25% of the savings institution's unimpaired capital and surplus if certain other conditions are satisfied. These loans are an alternative to the 15% limitation and not in addition to that limitation. At December 31, 1993, BankAtlantic was in compliance with the loans to one borrower limitations. Qualified Thrift Lender ("QTL") - BankAtlantic, like all other savings institutions, is required to meet the QTL test for, among other things, future eligibility for advances from the FHLB. The QTL test requires that a savings institution's qualified thrift investments equal or exceed 65% of the savings institution's portfolio assets calculated on a monthly average basis in nine out of every twelve months. For the purposes of the QTL test, portfolio assets are total assets less intangibles, properties used to conduct business and liquid assets (up to 10% of total assets). The following assets are included as qualified thrift investments without limit: (i) domestic residential housing or manufactured housing loans; (ii) home equity loans and mortgage-backed securities secured by residential housing or manufactured housing loans; and (iii) certain obligations of the FDIC and other related entities. Other qualifying assets which may be included up to an aggregate of 20% of portfolio assets are: (i) 50% of originated residential mortgage loans sold within 90 days of origination; (ii) investments in debt or equity securities of service corporations that derive at least 80% of their gross revenues from housing-related activities; (iii) 200% of certain loans to and investments in low-cost, one-to-four family housing; (iv) 200% of loans for residential real property, churches, nursing homes, schools and small businesses in areas where credit needs of low-to-moderate income families are not met; (v) other loans for churches, schools, nursing homes and hospitals; and (vi) consumer and education loans up to 10% of total portfolio assets. Any savings institution that fails to meet the QTL test must convert to a commercial bank charter or limit its future investments and activities to those permitted for both savings institutions and national banks. Additionally, any such savings institution that does not convert to a commercial bank charter will be ineligible to receive future advances from the FHLB and, beginning three years after the loss of QTL status, will be required to repay all outstanding advances from the FHLB and dispose of or discontinue all preexisting investments and activities not permitted for both savings institutions and national banks. If an institution converts to a commercial bank charter, it will remain insured by the SAIF until December 31, 1993, or until the FDIC permits it to transfer to BIF, if later. Generally, a transfer to BIF is not permitted until August 1994. If any institution that fails the QTL test and is subject to these restrictions on activities and advances and is controlled by a holding company, then, within one year after the failure, the holding company must register as a bank holding company and will be subject to all restrictions on bank holding companies. At December 31, 1993, BankAtlantic was in compliance with current QTL requirements. Transaction with Affiliates - As a federally chartered savings institution, BankAtlantic is subject to the OTS' regulations relating to transactions with affiliates, including officers and directors. BankAtlantic is subject to substantially similar restrictions regarding affiliate transactions as those imposed on member banks under Sections 22(g), 22(h), 23A, and 23B of the FRA. Sections 22(g) and 22(h) establish restrictions on loans to directors, controlling shareholders and their related companies and certain officers. Section 22(g) provides that no institution may extend credit to an executive officer unless (i) the bank would be authorized to make such extension of credit to borrowers other than its officers, (ii) the extension of credit is on terms not more favorable than those afforded to other borrowers, (iii) the officer has submitted a detailed current financial statement and (iv) the extension of credit is on the condition that it shall become due and payable on demand at any time that the officer is indebted to any other bank or banks on account of extensions of credit in any one of the following three categories, respectively, in an aggregate amount greater than the amount of credit of the same category that could be extended to the officer by the institution: (a) an extension of credit secured by a first lien on a dwelling which is expected to be owned by the officer and used by the officer as his or her residence; (b) an extension of credit to finance the education of the children of the officer; or (c) for any other purpose prescribed by the OTS. Section 22(g) also imposes reporting requirements on both the officers to whom it applies and on the institution. Section 22(h) requires that loans to directors, controlling shareholders and their related companies and certain officers be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and that those loans do not involve more than the normal risk of repayment or present other unfavorable features. Section 23A limits transactions with any one affiliate to 10% of the institution's capital and surplus (including supervisory goodwill to the extent that it may be included in core capital through July 1, 1995) and limits aggregate affiliate transactions to 20% of such capital and surplus. Sections 23A and 23B provide that a loan transaction with an affiliate generally must be collateralized (other than by a low-quality asset or by securities issued by an affiliate) and that all covered transactions as well as the sale of assets, the payment of money or the providing of services by a savings institution to an affiliate must be on terms and conditions that are substantially the same, or at least as favorable to the savings institution, as those prevailing for comparable non-affiliated transactions. A covered transaction is defined as a loan to an affiliate, the purchase of securities issued by an affiliate, the purchase of assets from an affiliate (with some exceptions), the acceptance of securities issued by an affiliate as collateral for a loan or the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. The OTS regulations clarify that transactions between either a thrift or a thrift subsidiary and an unaffiliated person that benefit an affiliate are considered covered transactions. A savings institution may make loans to or otherwise extend credit to an affiliate only if the affiliate is engaged solely in activities permissible for bank holding companies. In addition, no savings institution may purchase the securities of any affiliate other than the shares of a subsidiary. The Director of the OTS may further restrict these transactions in the interest of safety and soundness. At December 31, 1993, BankAtlantic was in compliance with the restrictions regarding affiliate transactions. Subordinated Debentures - Insured institutions may increase their regulatory risk-based capital by selling subordinated debentures only with the prior written approval of the OTS. Applicable regulations also prohibit the inclusion in regulatory risk-based capital of subordinated debentures which have an original maturity of less than seven years and restrict the timing of sinking fund payments with respect to such securities. Pursuant to FIRREA, maturing capital instruments issued on or before November 7, 1989 includable as regulatory capital must be amortized pursuant to a schedule that permits 100% to be included when the years to maturity are greater than or equal to seven, and decreases by approximately one-seventh each year thereafter. Subordinated debentures issued after November 7, 1989 may, subject to regulatory approval prior to inclusion, be includable in regulatory capital, but such inclusion is limited based on one of two elections to be chosen by the issuing institution. The institution may elect to phase capital inclusion out on a straight-line basis over the last five years to maturity of the instrument, or may elect to limit the inclusion of the subordinated debt with less than seven years to maturity to 20% of the institution's capital. The OTS is permitted to determine the treatment of subordinated debentures if an institution is in receivership. At December 31, 1993, all of BankAtlantic's subordinated debentures had been redeemed. Liquidity Requirements of the OTS - The OTS' regulations currently require all member savings institutions to maintain an average daily balance of liquid assets (cash, certain time deposits, banker's acceptances, specified United States government, state or federal agency obligations and other corporate debt obligations and commercial paper) equal to 5% of the sum of the average daily balance during the preceding calendar month of net withdrawable accounts and short-term borrowings payable in one year or less. The liquidity requirement may vary from time to time (between 4% and 10%) depending upon economic conditions and savings flows of all savings institutions. All savings institutions are also required to maintain an average daily balance of short-term liquid assets (generally having maturities of 12 months or less) equal to at least 1% of the average daily balance of net withdrawable accounts and current borrowings. Monetary penalties may be imposed by the OTS for failure to meet liquidity requirements. At December 31, 1993 BankAtlantic was in compliance with all applicable liquidity requirements. The Federal Reserve System - BankAtlantic is subject to certain regulations promulgated by the Federal Reserve Board (the "FRB"). Pursuant to such regulations, savings institutions are required to maintain non-interest bearing reserves against their transaction accounts (which include deposit accounts that may be accessed by writing checks) and non-personal time deposits. The FRB has authority to adjust reserve percentages and to impose in specified circumstances emergency and supplemental reserves in excess of the percentage limitations otherwise prescribed. The balances maintained to meet the reserve requirements imposed by the FRB may be used to satisfy liquidity requirements which may be imposed by the OTS. In addition, FRB regulations limit the periods within which depository institutions must provide availability for and pay interest on deposits to transaction accounts. Depository institutions are required to disclose their check holding policies and any changes to those policies in writing to customers. BankAtlantic believes that it is in compliance with all such FRB regulations. Community Reinvestment - Under the CRA, as implemented by OTS regulations, a savings institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low- and moderate-income neighborhoods. CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with CRA. CRA requires the OTS, in connection with its examination of a savings institution, to assess the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution. Effective July 1, 1990, the CRA, as amended by FIRREA, requires public disclosure of an institution's CRA rating and requires that the OTS provide a written evaluation of an institution's CRA performance utilizing a four-tiered descriptive rating system. The four ratings are "outstanding record of meeting community credit needs", "satisfactory record of meeting community credit needs", "needs to improve record of meeting community credit needs" and "substantial non-compliance in meeting community credit needs." An institution's CRA rating is taken into account in determining whether to grant charters, branches and other deposit facilities, relocations, mergers, consolidations and acquisitions. Poor CRA performance may be the basis for denying an application. BankAtlantic received a "satisfactory record of meeting community credit needs" during its most recent OTS examination. Holding Company Regulation - By virtue of its ownership of approximately 48.17% of the Common Stock, BFC Financial Corporation ("BFC") is a savings institution holding company subject to the regulatory oversight of the OTS. As such, BFC is required to register and file reports with the OTS and is subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over BFC and its non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings institution. As an insured institution and a subsidiary of a savings institution holding company, BankAtlantic is subject to restrictions in its dealings with BFC and any other companies that are "affiliates" of BFC under the HOLA, and certain provisions of the FRA that are made applicable to savings institutions by FIRREA and OTS regulations. As a result of FIRREA, a savings institution's transactions with its affiliates are subject to limitations set forth in the HOLA and OTS regulations, which incorporate Section 23A, 23B, 22(g) and 22(h) of the FRA and Regulation O adopted by the FRB. Under Section 23A, an "affiliate" of an institution is defined generally as (i) any company that controls the institution and any other company that is controlled by the company that controls the institution, (ii) any company that is controlled by the shareholders who control the institution or any company that controls the institution or (iii) any company that is determined by regulation or order to have a relationship with the institution (or any subsidiary or affiliate of the institution) such that "covered transactions" with the company may be affected by the relationship to the detriment of the institution. "Control" is determined to exist if a percentage stock ownership test is met or if there is control over the election of directors or the management or policies of the company or institution. "Covered transactions" generally include loans or extensions of credit to an affiliate, purchases of securities issued by an affiliate, purchases of assets from an affiliate) (except as may be exempted by order or regulation), and certain other transactions. See "Transaction with Affiliates" above for a general discussion of the restrictions on dealing with affiliates. Further, BankAtlantic is currently considering the formation of a holding company which would own 100% of BankAtlantic's common stock. Any such formation will be subject to shareholder approval and will involve the exchange of BankAtlantic shares for shares in the new entity. If approved, a shareholder's proportionate ownership position in the new entity would be equal to the proportionate interest previously held in BankAtlantic. BFC has indicated that it would vote in favor of this type of shareholder proposal. Capital Maintenance Agreement Pursuant to an agreement entered into on May 10, 1989 between BFC, its affiliates and BankAtlantic's primary regulator, BFC is obligated to infuse additional capital into BankAtlantic in the event that BankAtlantic's net capital (as defined) falls below the lesser of the industry's minimum capital requirement (as defined) or 6% of BankAtlantic's assets. This obligation will expire ten years from the date of the agreement, or at such earlier time as BankAtlantic's net capital exceeds its fully phased-in capital requirement (as defined) for a period of two consecutive years. BankAtlantic's capital has exceeded its fully phased-in capital requirement since December 31, 1992. New Accounting Standards and Policies During May 1993, the Financial Accounting Standards Board approved two new accounting standards. Financial Accounting Standards No. 114--Accounting by Creditors for Impairment of a Loan ("FAS 114"), and Financial Accounting Standards No. 115--Accounting for Certain Investments in Debt and Equity Securities ("FAS 115"). FAS 114 addresses the collectibility of both contractual interest and contractual principal of all receivables when assessing the need for a loss accrual. This standard requires that unpaid loans be measured at the present value of expected cash flows by discounting those cash flows at the loan's effective interest rate. FAS 114 must be adopted by 1995, prospectively. If BankAtlantic implemented FAS 114 at December 31, 1993, its effect would be immaterial. BankAtlantic intends to adopt FAS 114 in 1995. In a related matter, in August 1993, the OTS issued Regulatory Bulletin 31 "Classification of Assets", which incorporates the OTS policy on the classification of troubled, collateral-dependent loans. Effective September 1993, OTS' policy for troubled, collateral-dependent loans (where proceeds for repayment can be expected to come only from the operation and sale of the collateral) is as follows: (a) For a troubled, collateral-dependent loan where, based on current information and events, it is probable that the lender will be unable to collect all amounts due (both principal and interest), any excess of the recorded investment in the loan over its "value" should be classified Loss, and the remainder should generally be classified Substandard. (b) For a troubled, collateral-dependent loan, the "value" is either (1) the present value of the expected future cash flows, discounted at the loan's effective interest rate, based on the original contractual terms ("loan-rate present value"); (2) the loan's observable market price; or (3) the fair value of the collateral. (c) For a troubled, collateral-dependent loan, it is probable that the lender will be unable to collect all amounts due when the expected future cash flows, on an undiscounted basis, from the operation and sale of the collateral over a period of time not to exceed the intermediate term (e.g., five years) are less than the principal and interest payments due according to the contractual terms of the loan agreement. The term "all amounts due" is based on the original contractual terms, except as discussed below. (d) For a troubled, collateral-dependent loan (whether or not restructured) where, based on current information it is probable, but not reasonably assured, that the lender will be able to collect all amounts due (both principal and interest), any excess of the recorded investment in the loan over its value should be classified Doubtful, and the remainder should generally be classified Substandard. An exception to this policy is for a loan that was restructured in a troubled debt restructuring involving a modification of terms prior to December 31, 1993. For loans restructured before December 31, 1993, the evaluation for probability of collection may be based on the collectibility of principal and interest under the restructured contractual terms. For all restructured loans, including loans modified before and after December 31, 1993, that become impaired after modification, the measurement of value is based on the same standard discussed above: (1) the present value of the expected future cash flows discounted at the loan's original contractual interest rate; (2) the loan's observable market price; or (3) the fair value of the collateral, if the loan is collateral dependent. OTS does not allow savings institutions to use general valuation allowances to cover any amount considered to be a Loss under the above policy; however, specific valuation allowances may be used in lieu of charge-offs. BankAtlantic experienced no material write-downs as the result of complying with Regulatory Bulletin 31. FAS 115 addresses the valuation and recording of debt securities as held-to-maturity, trading and available for sale. Under this standard, only debt securities that BankAtlantic has the positive intent and ability to hold to maturity would be classified as held to maturity and reported at amortized cost. All others would be reported at fair value. FAS 115 must be adopted by January 1,1994, prospectively. If FAS 115 were effective at December 31, 1993, BankAtlantic does not believe that it would be required to reclassify its debt securities. The effect of implementation increased stockholders' equity by approximately $2.7 million on January 1, 1994. However, BankAtlantic believes that implementation of FAS 115 may result in the volatility of capital amounts reported over time and could in the future negatively impact the institution's regulatory capital position. FEDERAL AND STATE TAXATION For federal income tax purposes, BankAtlantic reports its income and expenses on the accrual method of accounting. Savings institutions that meet certain definitional tests and other conditions prescribed by the Internal Revenue Code of 1986 (the "Code"), relating primarily to the composition of their assets and the nature of their business activities are, within certain limitations, permitted to establish, and deduct additions to, reserves for bad debts in amounts in excess of those which would otherwise be allowable on the basis of actual loss experience. A qualifying savings institution may elect annually, and is not bound by such election in any subsequent year, one of the following two methods for computing additions to its bad debt reserves for losses on "qualifying real property loans" (generally, loans secured by interests in improved real property): (i) the experience method or (ii) the percentage of taxable income method. BankAtlantic has utilized both the percentage of taxable income method and the experience method in computing the tax-deductible addition to its bad debt reserves. Additions to the reserve for losses on non-qualifying loans, however, must be computed under the experience method and reduce the current year's addition to the reserve for losses on qualifying real property loans, unless that addition also is determined under the experience method. The sum of the addition to each reserve for each year is BankAtlantic's annual bad debt deduction. If the percentage of BankAtlantic's specified qualifying assets (generally, loans secured by residential real estate or deposits, banker's acceptances, educational loans, cash, government obligations and certain certificates of deposit) were to fall below 60% of its total assets, BankAtlantic would not be eligible to claim further bad debt reserve deductions, and would recapture into income all previously accumulated bad debt reserves. As of December 31, 1993, BankAtlantic's qualifying assets were in excess of 60% of total assets. The experience method allows a savings institution to deduct the greater of an amount based upon a six-year moving average of loan losses or an amount determined with respect to its bad debt reserve for the "base year". The "base year" is, for these purposes, the last taxable year beginning before 1988. For the past four taxable years, BankAtlantic has utilized the experience method. Under the percentage of taxable income method, the bad debt deduction equals 8% of taxable income determined without regard to that deduction and with certain adjustments. The percentage bad debt deduction thus computed is reduced by the amount permitted as a deduction for the addition to the reserve for losses on non-qualifying loans, which must be computed under the experience method. The availability of the percentage of taxable income method permits qualifying savings institutions to be taxed at a lower maximum effective federal income tax rate than that applicable to corporations generally. The effective maximum marginal federal income tax rate applicable to a qualifying savings institution (exclusive of the alternative minimum tax), assuming the maximum percentage bad debt deduction, is approximately 32.2%. The percentage of taxable income method is available only to the extent that amounts accumulated in reserves for losses on qualifying real property loans do not exceed 6% of such loans at year-end. Use of this method is further limited to the greater of (i) the amount which, when added to the amount computed for the addition to the reserve for losses on non-qualifying loans, equals the amount by which 12% of savings deposits or withdrawable accounts of depositors at year-end exceeds the sum of surplus, undivided profits and reserves at the beginning of the year or (ii) the amount determined under the experience method. None of these limitations would have restricted the deduction for the addition to the reserve for bad debts available to BankAtlantic for 1993. BankAtlantic's reserve for bad debts included $6.6 million, for which no deferred income taxes have been provided at December 31, 1993. To the extent that (i) a savings institution's reserve for losses on qualifying real property loans exceeds the amount that would have been allowed under the experience method and (ii) it makes distributions to shareholders that are considered to result in withdrawals from that excess bad debt reserve, then the amounts withdrawn will be included in its taxable income. The amount considered to be withdrawn by a distribution will be the amount of the distribution plus the amount necessary to pay the tax with respect to the withdrawal. Dividends paid out of the savings institution's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in withdrawals from its bad debt reserves. The Internal Revenue Service has examined the consolidated federal income tax returns of BankAtlantic through calendar year 1988. In February 1992, FAS 109, Accounting for Income Taxes, was issued, and it significantly changes the method of accounting for deferred income taxes. The standard requires the use of the asset and liability method in accounting for income taxes and eliminates, on a prospective basis, the former exception for the provision of deferred income taxes on thrift bad debt reserves. BankAtlantic implemented, on a prospective basis, FAS 109 on January 1, 1993, and there was no cumulative effect adjustment required upon implementation. New Tax Legislation - The Omnibus Budget Reconciliation Act of 1993 (the "Omnibus Act") was passed by Congress and signed into law by the President during August, 1993. The Omnibus Act increased the maximum federal income tax rate applicable to BankAtlantic from 34% to 35% retroactive to January 1, 1993. The effect of the Omnibus Act on BankAtlantic at the date of enactment was to increase the income tax provision by approximately $175,000. BankAtlantic may also be impacted by other provisions of the Omnibus Act either directly as a consequence of additional provisions applicable to it or indirectly as a consequence of their impact on BankAtlantic's borrowers or the economy in general. Florida Franchise Tax - The State of Florida imposes a corporate franchise tax on savings and loan institutions at the rate of 5.5% on taxable income as determined for Florida franchise tax purposes, in lieu of the Florida corporate income tax. Taxable income for this purpose is based on federal taxable income in excess of $5,000 as adjusted by certain items. A credit is available against up to 65% of the franchise tax otherwise due for certain intangible taxes imposed by the State of Florida. The corporate franchise tax, exclusive of this credit availability, is substantially equivalent to the Florida corporate income tax. Real Estate and Other Activities As discussed in "General Description of Business", the Company prior to its investment in BankAtlantic had been primarily engaged in the real estate business. From 1981 through 1987, eleven public real estate partnerships were formed for which the Company provided property management, for fees, and administrative and accounting services, for cost reimbursements. In March 1989, February 1991 and June 1991, the assets and liabilities of six partnerships were exchanged for subordinated debentures of the Company. Three other partnerships have been or are in the process of being liquidated. It is the Company's intent to liquidate the assets acquired in the Exchanges and at December 31, 1993 only seven of the twenty-two properties acquired in the 1989 and 1991 Exchanges remain. In addition to its investment in BankAtlantic and unrelated to the public limited partnership programs and its property management activities noted in the paragraphs above, the Company holds mortgage notes receivable of approximately $9.1 million which were received in connection with the sale of properties previously owned by the Company. Holding Company Regulation - As the holder of approximately 48.2% of BankAtlantic's Common Stock, BFC is a non-diversified savings and loan holding company within the meaning of the National Housing Act of 1934, as amended. As such, BFC is registered with and is subject to examination and supervision by the OTS as well as subject to certain reporting requirements. As an FDIC- insured subsidiary of a savings bank holding company, BankAtlantic is subject to certain restrictions in dealing with BFC and with other persons affiliated with BFC. Employees At December 31, 1993, BankAtlantic employed approximately 603 full-time (with an additional 19 employees on leave of absence) and 20 part-time employees. In addition to the above BFC Financial Corporation employed 5 full-time and 1 part-time employee. Management believes that its relations with its employees are satisfactory. The employee benefits offered by the Company are considered by management to be generally competitive with employee benefits provided by other major employers in Florida. The Company's employees are not represented by any collective bargaining group. ITEM 2. ITEM 2. Properties BankAtlantic's principal and executive offices are located at 1750 East Sunrise Boulevard, Fort Lauderdale, Florida 33304. In addition to its principal office, BankAtlantic currently conducts business at 30 branch offices located in Dade, Broward and Palm Beach Counties, Florida. BankAtlantic owns the land and building on which its executive offices are located and also owns 20 of the branch offices. BankAtlantic leases either the land, the building or both in connection with the operation of its 10 other branch offices. BankAtlantic has seven leased branch office sites in Broward County, with lease expiration dates ranging from 1994 to 1998; two leased branch office sites in Dade County, with lease expiration dates ranging from 1995 to 2003; and one leased branch office in Palm Beach County, with a lease expiring in 1999. BankAtlantic also maintains a ground lease for a drive-in facility in Broward County which expires in 1999. At December 31, 1993, the aggregate net book value of premises and equipment, including leasehold improvements and equipment, was $37.4 million. Other Properties Held By the Company at December 31, 1993 Prior to January 31, 1994, BFC's principal executive offices of approximately 6,200 square feet of office space was located at 1320 South Dixie Highway, Coral Gables, Florida. The space was leased pursuant to a lease expiring upon the giving of six (6) months written notice to landlord and was utilized by the Company and its affiliates other than BankAtlantic. Effective January 31, 1994, BFC relocated its offices to approximately 1,500 square feet located in BankAtlantic's executive offices. The space is leased pursuant to a lease with BankAtlantic on terms no less favorable than could be obtained from an independent third party, expiring December 20, 1994. The commercial properties listed below are not utilized by the Company but are held by the Company as investments. All are zoned for their current uses. Lease terms do not include options. Land Approximately subject to an Springfield, Massachusetts 5 acres estate for years expiring in Land and Restaurant Building 5,000 square subject to a Galesburg, Illinois foot building net lease expiring in 1995 Clinton Plaza Shopping 129,575 square owned, subject Center, Knoxville, TN feet leasable to a ground lease IBM Executive Office 48,050 square owned Building, Kingsport, TN feet leasable Delray Industrial Park 134,237 square owned Delray Beach, FL feet leasable Burlington Manufacturers Outlet Center 277,965 square owned Burlington, NC feet leasable Pinebrook Square 285,365 square owned Charlotte, NC feet leasable Professional Towers 128,125 square owned Louisville, KY feet leasable Lennar Medical Professional Center 75,584 square owned Miami, FL feet leasable ITEM 3. ITEM 3. LEGAL PROCEEDINGS The following is a description of certain lawsuits to which the Company is a party. Timothy J. Chelling vs. BFC Financial Corporation, Alan B. Levan, I.R.E. Advisors Series 21, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida Case No. 89-1850-Civ Nesbitt. John D. Purcell and Debra A. Purcell vs. BFC Financial Corporation, Alan B. Levan, Scott Kranz, Frank Grieco, I.R.E. Advisors Series 23, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida, Case No. 89-1284- Civ-Ryskamp. William A. Smith and Else M. Smith vs. BFC Financial Corporation, Alan B. Levan and I.R.E. Advisors Series 24, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida, Case No. 89-1605- Civ-Marcus. These actions were filed by the plaintiffs as class actions during September 1989, June 1989 and August 1989, respectively. The actions arose out of an Exchange Offer made by the Company to the limited partners of I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23, and I.R.E. Real Estate Fund, Ltd. - Series 24. The plaintiffs, who were limited partners of the above named partnerships who did not consent to the Exchange Offer, brought this action purportedly on behalf of all limited partners that did not consent to the Exchange Offer. The Exchange Offer was made through the solicitation of consents pursuant to a Proxy Statement/Prospectus dated February 14, 1989 and was approved by the holders of a majority of the limited partnership interests of each of the Partnerships in March 1989. Messrs. Levan, Grieco and Kranz served as individual general partners of each of the Partnerships, and Mr. Levan is the President and a director of the Company. The plaintiffs alleged that the Proxy Statement/Prospectus contained material misstatements and omissions, that defendants violated the federal securities laws in connection with the offer and Exchange, that the Exchange breached the respective Limited Partners Agreement and that the defendants violated the Florida Limited Partnership statute in effectuating the Exchange. The complaint also alleged that the defendant general partners violated their fiduciary duties to the plaintiffs. In a memorandum opinion and order dated December 17, 1991, the Court granted the defendant's motion for summary judgement and denied the plaintiff's motion for summary judgement, ruling that the Exchange did not violate the partnership agreements or the Florida partnership statute. In July 1992, the Court granted summary judgment in favor of the defendants and dismissed the plaintiffs' claims for breach of fiduciary duty. Subsequently, the court entered summary judgment in favor of the defendants on all claims of misrepresentations or omissions except with respect to the statement in the Proxy Statement/Prospectus to the effect that BFC, Alan Levan and the Managing General Partners believed the Exchange transaction was fair. The case on that issue was tried in December 1992, and the jury returned a verdict in the amount of $8 million but extinguished approximately $16 million of debentures held by the plaintiffs. BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the reduction in its debt resulting from the verdict, but it nonetheless believes that the verdict was not supported by the evidence at trial. Based on the verdict, BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the extinguishment of the $16 million of outstanding debt. No amounts have been reflected in the financial statements because the judgement amount was less that the Company's carrying amount of the debentures and related accrued interest and because the Company intends to appeal the verdict. The court denied plaintiffs' motion for prejudgment interest as to Series 21 and Series 23 and awarded prejudgment interest to plaintiffs in Series 24 to be calculated to run from March 31, 1989 through December 18, 1992, the date of entry of final judgment, at the rate of 3.54%. The plaintiffs appealed the court's denial for prejudgment interest in Series 21 and Series 23. The Company also appealed the judgment as well as the court's denial of various post-trial motions filed by the Company. Pursuant to the request of the Eleventh Circuit Court of Appeals, the parties submitted briefs regarding the issue of whether the Eleventh Circuit has jurisdiction to hear the appeal. In February 1994, the Eleventh Circuit Court dismissed the appeal for lack of jurisdiction. In September 1993, the court granted the Company's motion to stay of the execution of the final judgment pending appeal and to allow alternative form of security. In December 1993, the Company filed with the district court a motion to correct the judgment to reflect the cancellation of the outstanding debentures, which motion is still pending. Arthur Arrighi, et al. vs. KPMG Peat Marwick, BFC Financial Corporation; Alan B. Levan; Frank V. Grieco; Glen Gilbert; Al DiBenedetto; BankAtlantic, A Federal Savings Bank; Georgeson & Company, Inc.,; First Equity Corporation of Florida; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors, Corp.; and National Realty Consultants, in the United States District Court for the District of New Jersey, Case No. 92-1206-CDR. This case was filed on March 20, 1992 by more than 2,000 former limited partners in Series 25, Series 27 and Income Fund. The complaint alleged that BFC and certain other defendants developed a fraudulent scheme commencing in 1972 to sell the plaintiffs limited partnership units with the undisclosed goal of later taking over the assets of the partnerships in exchange for securities in a new entity in which the defendant Alan B. Levan would be a major shareholder. The complaint further alleged that the defendants made material misrepresentations and omissions in connection with the sale of the original limited partnership units in the 1980s and in connection with the 1991 Exchange, and fraudulently tallied the votes in connection with the 1991 Exchange and Solicitation of Consents described above. On March 2, 1994, the parties entered into an agreement to settle this action pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Marjory Meador, Shirley B. Daniels, Robert A. and Ruby L. Avans, and Dr. and Mrs. Czerny, individually and on behalf of all others similarly situated, Plaintiffs, vs. BFC Financial Corporation; BankAtlantic, A Federal Savings Bank; Alan B. Levan; I.R.E. Advisors Series 21, Corp.; I.R.E. Advisors Series 23, Corp.; I.R.E. Advisors Series 24, Corp.; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors Corp.; and First Equity Corporation of Florida; Defendants, in the Circuit Court of the Seventeenth Judicial Circuit in and for Broward County, Florida, Case No. 91- 29892 (CA-17). This action was filed as a class action during October 1991 and is brought on behalf of all persons who were limited partners in (a) I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23, or I.R.E. Real Estate Fund, Ltd. -Series 24 on the effective date of the 1989 Exchange Transaction not otherwise included in the action by limited partners who voted against the Exchange; or (b) were limited partners in I.R.E. Real Estate Fund, Ltd. - Series 25, I.R.E. Real Estate Fund, Ltd. - Series 27 or I.R.E. Real Estate Income Fund, Ltd. on the effective dates of the 1991 Exchange Transactions. The action alleges breach of the limited partnership agreements, breach of fiduciary duty, aiding and abetting a breach of fiduciary duty by BFC Financial Corporation and BankAtlantic, and negligent misrepresentation by all defendants. The action seeks damages in an unstated amount, imposition of a constructive trust on the assets of the exchanging partnerships, attorney's fees, costs and such other relief as the courts may deem appropriate. Plaintiffs have voluntarily dismissed all claims which arose out of or related to the 1991 Exchange. Shirley B. Daniels, Robert S. and Ruby L. Avans, and Dr. and Mrs. Czerny, individually and on behalf of all others similarly situated, Plaintiffs, vs. BFC Financial Corporation; BankAtlantic, A Federal Savings Bank; Alan B. Levan; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors Corp.; First Equity Corporation of Florida, Defendants, in the United States District Court for the Southern District of Florida, Fort Lauderdale Division, Case No. 92-6588-Civ-King. On January 18, 1991, BFC issued a prospectus and solicitation of consents in which it offered to exchange up to $17 million in subordinated unsecured debentures for all of the assets and liabilities of I.R.E. Real Estate Fund, Ltd.- ("Series 25"), I.R.E. Real Estate Fund, Ltd.- ("Series 27"), I.R.E. Real Estate ("Income Fund") and I.R.E. Pension Investors, Ltd the ("1991 Exchange"). The 1991 Exchange was approved by a majority of the limited partners in all of the partnerships except I.R.E. Pension Investors, Ltd. The Exchange subsequently was effectuated without I.R.E. Pension Investors, Ltd. In December 1992, plaintiffs filed an amended complaint, the result of which is to enlarge the class to all limited partners in the 1991 Exchange. Plaintiffs allege that the defendants orchestrated the Exchange for their own benefit and caused the issuance of the Exchange Offer and Solicitation of Consents, which contained materially misleading statements and omissions. The complaint contains counts against BFC for violations of the Securities Act and the Exchange Act. Plaintiffs also allege that Alan Levan and the managing general partners breached the limited partnership agreements, breached fiduciary duties and that BFC and BankAtlantic aided and abetted these alleged breach of fiduciary duties, that Alan Levan, the managing general partners, BFC and BankAtlantic committed fraud in connection with the 1991 Exchange and made certain negligent misrepresentations to the plaintiffs. The complaint seeks damages and prejudgment interest in an unspecified amount, attorneys' fees and costs. The defendants have filed an answer and affirmative defenses to the amended complaint. On March 2, 1994, the parties entered into an agreement to settle this action pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Cheryl and Wayne Hubbell, et al., vs. I.R.E. Advisors Series 26, Corp. et al., in the California Superior Court in Los Angeles, California, Case No. BC049913. This action was filed as a class action during March 1992 on behalf of all purchasers of I.R.E. Real Estate Fund, Ltd. - Series 25, I.R.E. Real Estate Fund, Ltd. - Series 26, I.R.E. Real Estate Fund, Ltd. - Series 27, I.R.E. Real Estate Growth Fund, Ltd. - Series 28 and I.R.E. Real Estate Income Fund, Ltd. against the managing and individual general partners of the above named partnerships and the officers and directors of those entities. The plaintiffs allege that the offering materials distributed in connection with the promotions of these limited partnerships contained misrepresentations of material fact and that the defendants misrepresented and concealed material facts from the plaintiffs during the time the partnerships were in existence. The complaint asserts two causes of action for fraud, one of which is based on a claim for intentional misrepresentation and concealment and one of which is based on a claim of negligent misrepresentation. The complaint also contains a claim for breach of fiduciary duty. The complaint seeks unspecified compensatory and punitive damages, attorneys' fees and costs. Plaintiffs filed an amended complaint, which the Court dismissed in February 1993 pursuant to a motion to dismiss filed by the Defendants. Plaintiffs thereafter filed a second amended complaint in February 1993. which was also dismissed. Plaintiffs filed a third amended complaint which defendants answered in April 1993. Management intends to vigorously defend this action. Martha Hess, et. al., on behalf of themselves and all others similarly situated, v. Gordon, Boula, Financial Concepts, Ltd., KFB Securities, Inc., et al. In the Circuit Court of Cook County, Illinois. On or about May 20, 1988, an individual investor filed the above referenced action against two individual defendants, who allegedly sold securities without being registered as securities brokers, two corporations organized and controlled by such individuals, and against approximately sixteen publicly offered limited partnerships, including two partnerships that the Company acquired the assets and liabilities of in the 1991 Exchange transaction, (the "predecessor partnerships") interests in which were sold by the individual and corporate defendants. Plaintiff alleged that the sale of limited partnership interests in the predecessor partnerships (among other affiliated and unaffiliated partnerships) by persons and corporations not registered as securities brokers under the Illinois Securities Act constitutes a violation of such Act, and that the Plaintiff, and all others who purchased securities through the individual or corporate defendants, should be permitted to rescind their purchases and recover their principal plus 10% interest per year, less any amounts received. The predecessor partnerships' securities were properly registered in Illinois and the basis of the action relates solely to the alleged failure of the Broker Dealer to be properly registered. In November 1988, Plaintiff's class action claims were dismissed by the Court. Amended complaints, including additional named plaintiffs, were filed subsequent to the dismissal of the class action claims. Motions to dismiss were filed on behalf of the predecessor partnerships and the other co-defendants. In December 1989, the Court ordered that the predecessor partnerships and the other co-defendants rescind sales of any plaintiff that brought suit within three years of the date of sale. Under the Court's order of December 1989, one of the predecessor partnerships rescinded sales of $41,500 of units. Plaintiffs appealed, among other items, the Court's order with respect to plaintiffs that brought suit after three years of the date of sale In February 1993, the Appellate court ruled that the statute of limitations was tolled during the pendency of the class action claims. Therefore, those investors that brought suit within 3.6 years and potentially 4 years from the date of sale may be entitled to rescission. The Company and the other co- defendants sought leave to appeal before the Illinois Supreme Court and on October 6, 1993, the leave to appeal was denied. Plaintiff's claims are now pending in Circuit Court. Plaintiffs have indicated that they will file amended complaints against the predecessor partnerships and other co- defendants. The amended complaints will include both individual and class claims. The individual and corporate defendants sold a total of $1,890,500 of limited partnership interests in the predecessor partnerships. Limited partners holding approximately $1,042,800 of limited partnership interests have filed an action for recision. Under the appellate decision, if recision was made to all limited partners that filed an action, refunds, at March 31, 1993, (including interest payments thereon) would amount to approximately $1,800,000. A provision for such amount has been made in the accompanying financial statements. Short vs. Eden United, Inc., et al. in the Marion County Superior Court, State of Indiana. Civil Division Case No. S382 0011. In January, 1982, an individual filed suit against a subsidiary of the Company, Eden United, Inc. ("Eden"), seeking return of an earnest money deposit held by an escrow agent and liquidated damages in the amount of $85,000 as a result of the failure to close the purchase and sale of an apartment complex in Indianapolis, Indiana. Eden was to have purchased the apartment complex from a third party and then immediately resell it to plaintiff. The third party was named as a co-defendant and such third party has also filed a cross claim against Eden, seeking to recover the earnest money deposit. In September 1983, Plaintiff filed an amended complaint, naming additional subsidiaries of the Company and certain officers of the Company as additional defendants. The amended complaint sought unspecified damages based upon alleged fraud and interference with contract. In interrogatory answers served in September 1987, Plaintiff stated for the first time that he was seeking damages in the form of lost profits in the amount of approximately $6,350,000. The case went to trial during October 1988. On April 26, 1989, the Court entered a judgement against Eden, the Company and certain additional subsidiaries of the Company jointly and severally in the sum of $85,000 for liquidated damages with interest accruing at 8% per annum from September 1, 1981, normal compensatory damages of $1.00, and punitive damages in the sum of $100,000. The judgement also rewards the Plaintiff the return of his $85,000 escrow deposit, and awards the third party $85,000 in damages plus interest accruing from September 14, 1981 against Eden. The Company has charged expense for the above amounts. Both Short and the Company appealed the judgement and in June 1991, the appellate court reversed the trial court's decision on the issue of compensatory damages, determined that Short maybe entitled to an award of compensatory damages and remanded the case to the trial court to determine the amount of compensatory damages to be awarded. The Indiana Supreme Court denied review. A hearing on remand was held on February 3, 1993. On February 25, 1994, the court on remand awarded plaintiff a judgment in the amount of $85,000 for liquidated damages for breach of contract jointly and severally from the subsidiary, the Registrant and certain named affiliates, plus prejudgment interest of $52,108 through May 1, 1989, plus post-judgment interest of 10% per annum thereafter until paid. Additionally, plaintiff was awarded a judgment against the defendants in the amount of $2,570,000 for tortious interference, plus prejudgment interest of $469,400 through May 1, 1989, plus post-judgment interest of 10% per annum thereafter until paid. The Registrant which was advised of the courts decision on March 2, 1994 intends to appeal the trial court's order. Scott Kranz and Investment Management Group, Inc. vs. Alan B. Levan, BFC Financial Corporation, I.R.E. Investments, Inc., Frank V. Grieco, I.R.E. Advisors Series 23, Corp., I.R.E. Advisors Series 24, Corp., I.R.E. Advisors Series 25, Corp., I.R.E. Advisors Series 26, Corp., and I.R.E. Real Estate Institutional Corp., in the Eleventh Judicial Circuit in and for Dade County, Florida, Case No. 85-08751 (the "employment case"), Scott G. Kranz in the name of I.R.E. Realty Advisory Group, Inc., vs I.R.E. Realty Advisory Group, Inc. et al in the Eleventh Judicial Circuit in and for Dade County, Florida, Case No. 84-40012 (CA25) (the "appraisal case"). On March 5, 1985 Scott Kranz and Investment Management Group, Inc. filed suit seeking damages in excess of $1,800,000 and punitive damages of at least $10,000,000 plus costs. Investment Management Group, Inc. ("IMG") is a real estate development corporation of which Scott Kranz is the President. Until his termination on August 1, 1984, Scott Kranz was associated with Registrant and/or various of its affiliates either individually or through IMG. The Complaint alleges that Alan B. Levan, acting on his own behalf and on behalf of Registrant and certain unnamed affiliates and in combination with one or more unnamed defendants wrongfully caused the termination of certain contractual relationships between the Company and Scott Kranz and IMG and of Scott Kranz as general partner of five publicly registered real estate limited partnerships. On October 29, 1984, Scott G. Kranz, a 10% shareholder of I.R.E. Realty Advisory Group, Inc. ("RAG"), of which Registrant is a 50% shareholder, filed suit in the name of RAG seeking a declaration of the rights and liabilities of the parties in relation to a merger effective August 21, 1984 by and among Gables Advisors, Inc., I.R.E. Real Estate Funds, Inc. and RAG. Plaintiff seeks damages in the amount of the fair market value of his shares in RAG as of the day before the merger. He further claims punitive damages, attorneys fees and costs. On January 30, 1985, plaintiff amended his complaint, to add claims of breach of statutory duty and willful failure to submit the merger transactions to a vote at a meeting of shareholders, in addition to a claim for punitive damages. On June 17, 1985, Plaintiff again amended his complaint adding a claim of constructive fraud. In March 1986, Plaintiff's motion for summary judgement was denied. On January 21, 1987, the Court ordered this action consolidated for trial with the action described immediately above. Defendants denied Plaintiff's claims and filed a counterclaim. The defendants also filed a motion to strike all of Kranz's and IMG's pleadings in both cases and to enter a default judgement against Kranz and IMG for gross and continuing violations of discovery orders. By order dated June 26, 1990, the judge struck all of the pleadings filed by Kranz and IMG including both of their complaints and both of their answers to the Company's counterclaims. On February 12, 1991, the trial judge entered final judgement in favor of the individual defendants, Alan Levan and Frank Grieco, specifically reserving jurisdiction for further proceedings as to the corporate entities to enter final judgement against the plaintiffs on the complaint. Kranz and IMG appealed the judgement in favor of the individual defendants and the judgement was affirmed. The corporate defendants have filed a motion for entry of judgment against Kranz and IMG and requesting damages and attorney's fees. Joseph Roma vs. I.R.E. Advisors Series 29, Corp., et al., in the Circuit Court of Cook County, Illinois, County Department, Chancery Division, Case No. 91CH2429. - This action was filed as a class action during March 1991. The action, brought on behalf of investors in I.R.E. Real Estate Fund, Ltd. - Series 29 ("Series 29"), alleged fraud and fraudulent inducement, breach of fiduciary duty, negligent misrepresentation and violations of the Blue Sky Laws by defendants relating to their promotion, marketing, control and management of Series 29, a public limited partnership. The action sought rescission of the investments, contracts and agreements relating to investments in Series 29, damages in an unstated amount and other relief as the court deemed appropriate. This action was dismissed by the court. Plaintiffs appealed such dismissal and in February 1994, the Appellate Court affirmed the dismissal in favor of all defendants. John F. Weaver, Trustee for the Bankruptcy Estate of Milton A. Turner vs. I.R.E. Real Estate Investments, Inc., in the United States Bankruptcy Court for the Eastern District of Tennessee, Case No. 3-89-01210. - On July 25, 1991, an action was filed by John Weaver alleging that the conveyance of Turner's equity of $1,642,001 under a wrap note to I.R.E. Real Estate Investments, Inc. (successor to I.R.E. Real Estate Fund, Ltd. - Series 23) in connection with the sale of property by Series 23 to Turner was a fraudulent conveyance, as defined, in that Turner conveyed an asset, namely the cancellation of a wrap note and wrap trust, without fair consideration while insolvent. The trial on the complaint to avoid fraudulent conveyance was heard before the Bankruptcy Court in May 1993. Judgment was entered in favor of BFC and the complaint was dismissed. No appeal was taken from the judgment and it is now final. Alan B. Levan and BFC Financial Corporation v. Capital Cities/ABC, Inc. and William H. Wilson, in the United States District Court for the Southern District of Florida, Case No. 92-325-Civ-Atkins. On November 29, 1991, The ABC television program 20/20 broadcast a story about Alan B. Levan and BFC which purportedly depicted some securities transactions in which they were involved. The story contained numerous false and defamatory statements about the Company and Mr. Levan and, February 7, 1992, a defamation lawsuit was filed on behalf of the Company and Mr. Levan against Capital Cities/ABC, Inc. and William H. Wilson, the producer of the broadcast. In July 1993, a magistrate recommended that summary judgment be entered against Mr. Levan on their defamation claims. Objections to and an appeal from that recommendation were filed with the presiding judge. Such appeal remains pending. On March 21, 1988, an action captioned Elliot Borkson, et al. vs. Alan Levan, Jack Abdo and BankAtlantic, Case No. 88-12063, was filed by a group of approximately 54 shareholders of BankAtlantic in the Circuit Court of the Eleventh Judicial Circuit in and for Dade County, Florida. The complaint alleges that Messrs. Levan and Abdo breached their fiduciary duties as directors of BankAtlantic by disregarding the rights of minority shareholders under a certain option agreement between BFC and a third party dated April 9, 1986, by taking actions to depress the value of BankAtlantic's stock, by denying access to BankAtlantic's books and records and by allegedly wasting corporate assets. BankAtlantic is a nominal party to the proceeding. Plaintiffs seek punitive damages of $10.0 million, compensatory damages, attorneys' fees, costs and injunctive relief. Discovery is proceeding and the defendants are vigorously defending the action. No trial date has been set. Counsel has obtained a letter from counsel for plaintiffs in which counsel for plaintiffs conclude that there is insufficient evidence to maintain the claim against the defendants. This matter has been set for jury trial during the two-week period commencing June 6, 1994. Elliot Borkson, et al vs. BFC Financial Corporation. Circuit Court of the 11th Judicial Circuit in and for Dade County Florida. Case No. 88-11171 (CA 10). In March 1988, a group of approximately 54 shareholders of BankAtlantic filed a class action suit against Registrant alleging Registrant had breached its agreement, contained in an option agreement ("the Pearce Agreement") pursuant to which Registrant had purchased shares of BankAtlantic, to offer to acquire all of the remaining outstanding shares of BankAtlantic at a price equal to the greater of (i) $18 per share or (ii) an amount per share which, in the opinion of an investment banking firm of recognized national standing, is fair to the stockholders of BankAtlantic. Such obligation was subject to receipt of all required regulatory approvals and was relieved if there occurred a material adverse change in financial conditions affecting the savings and loan industry. Plaintiffs seek to recover compensatory damages arising from Registrant's alleged breach of contract, costs, interest and attorneys fees. In April 1988, BankAtlantic joined in a motion to stay the proceedings pending resolution of a similar action filed in Pennsylvania and transferred to the United States District Court for the Southern District of Florida. The stay with respect to the proceedings remains in effect. Marvin E. Blum, et al vs. BFC Financial Corporation; Alan B. Levan and Jack Abdo. Case No. 88-6277, U.S. District Court for the Southern District of Florida. This litigation was commenced on February 11, 1988, by International Apparel Associates as a class action against BFC Financial Corporation and Alan Levan. Subsequently, the Borkson plaintiffs and their counsel were substituted for International Apparel, with Dr. Marvin Blum being designated as the class representative. Jack Abdo was also added as a party defendant. The plaintiff class was certified by the district court as "all persons, other than defendants, and their affiliates, officers, and members of their immediate family who owned shares of BankAtlantic common stock on February 6, 1988, or their successors in interest". The Second Amended Complaint, upon which this action is presently based, asserts a claim for breach of contract and a claim for violation of Section 10(b) of the Securities Exchange Act of 1934. Plaintiffs allege that they, as minority shareholders of BankAtlantic, A Federal Savings Bank, are third party beneficiaries of an option agreement between BFC Financial Corporation and Dr. Pearce requiring BFC Financial Corporation to offer to purchase all their shares of BankAtlantic subject to certain conditions. Plaintiffs claim that none of the conditions set forth in the Pearce Agreement arose to excuse BFC Financial Corporation from offering to buy the shares; defendants claim that those conditions did in fact occur and that BFC Financial Corporation did not, therefore, have any obligation to offer to purchase the shares. Plaintiffs also allege that defendants made certain misrepresentations regarding their intentions to perform pursuant to the Pearce agreement, which defendants deny. Settlement negotiations, which had been progressing, have terminated. The plaintiffs have requested that this matter be rescheduled for trial. Pretrial conference has been conducted, however, no trial date has been set. During 1989 and 1991, the Company exchanged subordinated debentures for the assets and liabilities of certain affiliated partnerships. While, to the Company's knowledge, no formal order of investigation is pending, the Securities and Exchange Commission ("SEC") has advised the Company that it is currently reviewing the transactions. Following is a description of additional legal proceedings in which the Company's significant subsidiary, BankAtlantic, is a party: Caroline Berger, on behalf of herself and all others similarly situated vs. Joseph Giarizzo, Ron Scott, Leon Martin, Paul Tedaldy, Sal Giarizzo, James Gansky, Harbor Crest Assocs. Ltd., Queens Window Systems Ltd., Dartmouth Plan Inc., Wendover Funding, Inc., Midwest Federal Savings Bank, Sterling Resources Ltd., Bencharge Credit Service of New York, Inc., Skopbank, David Beyer, Jeffrey Beyer, BankAtlantic, National City Bank of Akron, Suburban Equity Corp., Oxford Home Equity Loan Co., National Westminster Bank, Embanque Capital Corp., Chrysler First, Capital Resources Corp., Green Point Savings, United States District Court, Eastern District of New York, CV-90-2500, Platt, C.J. This action was originally filed on July 13, 1990 by the plaintiff, Caroline Berger ("Berger"), in her individual capacity, against Joseph Giarizzo, Harbor Crest Associates, Ltd., Queens Window Systems Ltd., Dartmouth Plan, Inc., Wendover Funding Inc., Midwest Federal Savings Bank, Sterling Resources Ltd., Bencharge Credit Service of New York Inc., SkopBank, David Beyer and Jeffrey Beyer. The original complaint asserted a variety of state and federal causes of action. The plaintiff, Berger, is allegedly suing on behalf of herself and all others similarly situated. Berger asserts that she was defrauded by Dartmouth Plan Inc., Midwest Federal Savings Bank and by Harbor Crest, a home improvement contractor affiliated with Dartmouth. The plaintiff maintains that Dartmouth and Harbor Crest operated a scheme pursuant to which Harbor Crest would identify individuals on small incomes with little or no education and sell them home improvements at substantially marked up prices. The plaintiff also maintains that the home improvements were provided in a shoddy and unprofessional manner and that the requirements of the truth in lending laws were not met. In related matters, BankAtlantic is represented by counsel in connection with a suit filed by the New Jersey Attorney General has filed suit against Sterling and certain contractors originating Sterling paper (some of which was subsequently sold to BankAtlantic). In that action, the New Jersey Attorney General seeks civil remedies against the contractor and Sterling and seeks to cancel or modify the mortgage loans. These are some of the same Sterling loans discussed above. The New Jersey Attorney General staff has stated that some of the New Jersey customers have better claims than others and have asked BankAtlantic to recommend a procedure for independent evaluation of any claims relating to these loans. On June 15, 1992, BankAtlantic sent the New Jersey Attorney General a written recommendation regarding the procedures that should be utilized to evaluate the claims relating to the Sterling loans held by BankAtlantic on a case-by-case basis. The New Jersey Attorney General is in the process of reviewing and revising the suggested procedures. In an action entitled BankAtlantic, A Federal Savings Bank, a federally chartered savings bank vs. National Union Fire Insurance Co. of Pittsburgh, Pennsylvania, a Pennsylvania corporation, United States District Court, Southern District of Florida, 91-2940-CIV-MORENO, BankAtlantic and National Union entered into a Covenant Not To Execute (the "Covenant"). Pursuant to the Covenant, BankAtlantic will continue to pursue its litigation against National Union but has agreed to limit execution on any judgment obtained against National Union to $18 million. Further, BankAtlantic agreed to join certain third parties as defendants in the action. Pursuant to the Covenant, National Union paid BankAtlantic approximately $6.1 million on execution of the Covenant, and agreed to pay an additional $3 million, which was paid when due on November 1993, and approximately $2.9 million on November 1, 1994. Further, National Union agreed to reimburse BankAtlantic for additional losses (as defined) incurred by it in connection with the Subject Portfolio, if any, provided that in no event will National Union be obligated to pay BankAtlantic in the aggregate more than $18 million. In the event of recovery by BankAtlantic of damages against third party wrongdoers, BankAtlantic will be entitled to retain such amounts until such amounts plus any payments received from National Union equal $22 million. Thereafter National Union will be entitled to any such recoveries to the extent of its payments to BankAtlantic. On July 21, 1987, a foreclosure action captioned Atlantic Federal Savings and Loan Association of Fort Lauderdale and BankAtlantic Development Corporation vs. Promenade at Inverrary, et. al., Case No. 87-19998CM, was filed in the Circuit Court of the Seventeenth Judicial Circuit in and for Broward County, Florida, against Promenade at Inverrary. On November 27, 1991, the state court judge entered a final judgment in favor of BankAtlantic and BankAtlantic Development Corporation for $11,957,820.73 and against the Kozich defendants on their counterclaims. BankAtlantic, and two other financial institutions (a junior mortgagee who challenged the priority of certain of one of the other institution's mortgages on the borrower's properties) were ordered to attend mediation shortly before a November 1992 trial date. At mediation, a settlement was reached whereby the other institution agreed to sell certain of its mortgages at a discount and assign them to BankAtlantic, dismiss its defenses to the second amended complaint so that BankAtlantic could proceed to complete the foreclosure without the necessity of trial and dismiss the appeals it had taken in both the state and bankruptcy courts. In exchange for BankAtlantic's payment of a nominal sum, the other institution agreed to dismiss its challenge to the priority of one of the other institution's mortgages and thereby release its mortgages from the properties. The trial court entered an order allowing BankAtlantic to credit the bid at the foreclosure sale for the amount of the junior mortgages that were assigned to it from the other institution. The Bankruptcy Court has released the five Kozich properties from bankruptcy and the trustee turned the properties over to a management company selected by BankAtlantic until the foreclosure case was completed in 1993. BankAtlantic now owns the properties and is seeking to dispose of the subject properties. An action to recover $750,000 captioned BankAtlantic, A Federal Savings Bank, f/k/a Atlantic Federal Savings and Loan Association of Fort Lauderdale, vs. Jetborne International, Inc., a Delaware corporation, Allen Blattner, individually and Benjamin Friedman, individually, was filed on April 28, 1989, in the Circuit Court of the Eleventh Judicial Circuit in and for Dade County, Florida; Case No. 89-18792 CA 16, for breach of three separate promissory notes for $250,000 each executed by Allen Blattner, individually. As disclosed previously on Form 10K, BankAtlantic also sought to enforce a guarantee executed by Jetborne International of all three promissory notes. On September 12, 1991, judgement was entered in favor of BankAtlantic and against all defendants. Judgments against Jetborne and Allen Blattner were in the amount of $706,800 and $769,282, respectively. On December 12, 1991 an involuntary bankruptcy petition was filed against Jetborne. Jetborne did not contest the bankruptcy filing and converted to a voluntary proceeding. BankAtlantic is pursuing its claim as a creditor in the bankruptcy proceeding on the judgment against Allen Blattner. Jetborne has filed a Plan of Reorganization in its bankruptcy case which was confirmed in 1993. BankAtlantic has reached an agreement as to the treatment of BankAtlantic's claim. Jetborne paid BankAtlantic $100,000 in the first quarter of 1994 and the remainder of BankAtlantic's claim is to be paid in full over a period of approximately five years. On July 2, 1990, an action entitled BankAtlantic, A Federal Savings Bank, f/k/a Atlantic Federal Savings and Loan Association of Fort Lauderdale vs. Aircraft Modular Products, Inc., Case No. 90-31870 CA19, was filed in the Circuit Court of the Eleventh Judicial Circuit in and for Dade County, Florida by BankAtlantic seeking to enforce a guaranty. This case is related to BankAtlantic vs. Jetborne et. al. described above. The defendant, Aircraft Modular Products, Inc., is a subsidiary of Jetborne International. The guaranty executed by Jetborne of Allen Blattner's indebtedness also includes "subsidiaries". As part of the preliminary settlement reached between BankAtlantic and Jetborne as described above, BankAtlantic released its claims against Aircraft Modular Products, Inc. and its indebtedness is to be satisfied in full under Jetborne's Plan of Reorganization, and BankAtlantic was released by Aircraft Modular Products from any claim. BankAtlantic is also a defendant in various other legal proceedings arising in the ordinary course of its business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS a) The following table sets forth the high bid and low offer prices on the NASD OTC Bulletin Board of Registrant's common stock for the last three quarters of 1993, as reported to the Registrant by the National Quotation Bureau, and the quarter end market price for the year 1992 and the first quarter of 1993, as reported on the pink sheets. Year: High Low Quarter Market Price Bid Offer ------- ------------ ----- ----- 1992: 1st Quarter .50 2nd Quarter .75 3rd Quarter .75 4th Quarter 2.00 1993: 1st Quarter 2.25 2nd Quarter 3.00 2.25 3rd Quarter 5.00 2.00 4th Quarter 5.00 3.00 b) The approximate number of shareholders of record of common stock as of March 18, 1994 was 1,350. c) No dividends have been paid by Registrant since its inception. There are no restrictions on the payment of dividends by Registrant except that no dividends may be paid to the holders of any equity securities of the Company while any deferred interest on the Company's Exchange debentures remains unpaid. Since December 31, 1991, the Company has deferred the interest payments relating to the debentures issued in both the 1989 Exchange and the 1991 Exchange, amounting to a total of approximately $12.1 million. Additionally, as noted in Part I, Item I under "Business - Regulation - Dividend Restrictions," there are restrictions on the payment of dividends by BankAtlantic. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. BFC FINANCIAL CORPORATION'S MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General - The Company became a savings bank holding company during 1987 by acquiring a controlling interest in BankAtlantic, A Federal Savings Bank ("BankAtlantic"). The Company's ownership interest in BankAtlantic has been recorded by the purchase method of accounting. On November 12, 1993, BankAtlantic closed a public offering of 1.8 million common shares. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million by the Company. On November 10, 1993, the underwriters exercised the option to purchase 270,000 additional shares of BankAtlantic's common stock. Upon the sale of the 2,070,000 shares of BankAtlantic, the company's ownership of BankAtlantic was reduced to 48.17%. Because of the decrease in ownership, the Company's investment, commencing in 1993 is carried on the equity method rather than consolidated. Therefore, the discussion in management's discussion and analysis of financial condition and results of operations which follows relates to the changes of BFC Financial Corporation and subsidiaries excluding BankAtlantic. The following table presents comparative information for 1992 and 1991 as if BankAtlantic was carried on the equity basis for those periods also. For information relating to changes affecting BankAtlantic for 1993 and 1992, see management's discussion and analysis of financial condition and results of operations of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. See note 2 of notes to consolidated financial statements for a discussion of the Company's investment in BankAtlantic. 1993 1992 1991 ------------------------------ Interest income: Interest and fees on loans 767 913 1,534 Interest and dividends on tax certificates and other investment securities 299 257 181 ------------------------------ 1,066 1,170 1,715 ------------------------------ Interest expense: Interest on exchange debentures 6,031 5,163 4,199 Interest-other 3,032 4,309 4,828 ------------------------------ 9,063 9,472 9,027 ------------------------------ Net interest (expense) (7,997) (8,302) (7,312) ------------------------------ Non-interest income: Equity in earnings of BankAtlantic before accounting for income taxes and extraordinary items 10,764 12,683 (6,926) Gain on sale of BankAtlantic common stock 1,050 - - Earnings on real estate operations 1,647 3,200 3,326 Other 318 335 441 ------------------------------ 13,779 16,218 (3,159) ------------------------------ Non-interest expense: Employee compensation and benefits 1,453 1,416 2,257 Occupancy and equipment 331 159 213 Provision for litigation 4,034 1,800 - Foreclosed asset activity, net - 67 - Write down of real estate acquired in debenture exchanges - 89 3,353 Other 1,267 1,828 1,415 ------------------------------ 7,085 5,359 7,238 ------------------------------ Income (loss) before cumulative effect of change on accounting for income taxes and extraordinary item (1,303) 2,557 (17,709) Extraordinary item - BankAtlantic - - 350 Cumulative effect of change in accounting for income taxes (501) - - ------------------------------ Net income (loss) (1,804) 2,557 (17,359) ============================== In addition to its investment in BankAtlantic, the Company owns and manages real estate. Since its inception in 1980 and prior to the acquisition of control of BankAtlantic in 1987, the Company's primary business was the organization, sale and management of real estate investment programs. Effective as of December 31, 1987, the Company ceased the organization and sale of new real estate investment programs, but continues to manage the real estate assets owned by its existing programs. At December 31, 1993, subsidiaries of the Company continue to serve as the corporate general partners of 4 public limited partnerships which file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended. Subsidiaries of the Company also serve as corporate general partners of a number of private limited partnerships formed in prior years. In March 1989, the Company acquired all of the assets and liabilities of three affiliated public limited partnerships, I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23 and I.R.E. Real Estate Fund, Ltd. - Series 24 in exchange for approximately $30,000,000 in subordinated unsecured debentures which mature in 2009 (the "1989 Exchange"). In connection with the transaction, the Company acquired 14 real properties, 3 of which are still owned by the Company. In February 1991, the Company acquired all of the assets and liabilities of two affiliated public limited partnerships, I.R.E. Real Estate Fund, Ltd. - Series 25 and I.R.E. Real Estate Fund, Ltd. - Series 27 in exchange for approximately $9,308,000 in subordinated unsecured debentures which mature in 2011 (the "1991 Exchange"). In June 1991, the Company acquired all of the assets and liabilities of an affiliated public limited partnership, I.R.E. Real Estate Income Fund, Ltd., in exchange for approximately $6,057,000 in subordinated unsecured debentures that mature in 2011. In connection with these transactions, the Company acquired 8 real properties, 4 of which are still owned by the Company. The Company is actively seeking buyers for the properties held by it with a view to selling the properties and reducing mortgage indebtedness. See note 2 of notes to consolidated financial statements for more information on these transactions. Litigation has been brought against the Company relating to both the 1989 and 1991 Exchange transactions. In December 1992, a jury returned a verdict in favor of the plaintiffs for approximately $8 million but extinguished approximately $16 million of subordinated debt. In March 1994, the Company entered into an agreement to settle litigation relating to the 1991 exchange transaction. See "Legal Proceedings". Net loss amounted to approximately $1.8 million in 1993 and net earnings amounted to approximately $2.6 million in 1992 as compared to a net loss of approximately $17.4 million in 1991. A major component in each of the above amounts related to the Company's ownership position in BankAtlantic. Operations for 1993 included a charge aggregating $501,000 from the cumulative effect of a change in accounting for income taxes. Operations for 1991 include extraordinary gain of $350,000 (the 1991 extraordinary gain of $350,000 related to BankAtlantic). During 1993 and 1992, the Company recorded net earnings from BankAtlantic of approximately $10.8 and 12.7 million and during 1991 the Company recorded a net loss from BankAtlantic of approximately $6,576,000 after the extraordinary item. Exclusive of the Company's ownership of BankAtlantic, the Company and its other subsidiaries generated net losses in 1993, 1992 and 1991 of $12.6 million. $10.1 million, and $10.8 million, respectively. Approximately $6,031,000, $5,163,000, and $4,199,000 of 1993, 1992 and 1991 operations related to interest expense on the debentures issued in the Exchange transactions described above. Approximately $4.0 million of 1993 operations related to a provision for the Short litigation and approximately $1.8 million of 1992 operations related to a provision arising from an appellate court decision in connection with the Hess litigation. (See Item 3. "Legal Proceedings.") Approximately $3,353,000 of 1991 operations resulted from the write-down of real estate owned, of which $2,882,000 related to properties acquired in the 1989 Exchange and $471,000 related to an apartment complex acquired in October 1990 through foreclosure. In addition to its investment in BankAtlantic, the Company's other primary sources of revenues are from the net interest earnings on its mortgage note receivables, fees received for property management services rendered to affiliated public limited partnerships and operation of the properties acquired in the 1989 and 1991 Exchange transactions. Results of Operations - The Company reported a net loss of approximately $1.8 million for the year ended December 31, 1993, as compared to net earnings of $2.6 million for the year ended December 31, 1992 and a net loss of $17.4 million for the year ended December 31, 1991. The 1993 net loss included a $501,000 charge due to the cumulative effect of a change in accounting for income taxes. (See note 18 of notes to consolidated financial statements.) Operations for the fourth quarter and year 1993 included the gain on the sale of 1.4 million shares of BankAtlantic common stock as discussed further in note 2 of notes to consolidated financial statements. The 1992 net income included a $548,000 net extraordinary gain during the fourth quarter, net of minority interest of $208,000, for the utilization of state net operating loss carryforwards from BankAtlantic. Net Interest Expense - BFC net interest expense decreased by $305,000 for the year ended December 31, 1993 as compared with the same period in 1992 primarily due to a decrease in interest expense, partially offset with by decrease in interest income. The decrease in interest expense for the year ended December 31, 1993 as compared to the same period in 1992 was primarily due to a reduction in interest expense - other. This decrease was offset with an increase in interest payable on the Exchange debentures. Other interest expense decreased for the year ended December 31, 1993 as compared to the 1992 and 1991 periods primarily due to the elimination of mortgage debt principally related to the sale of two properties acquired in the 1991 Exchange, the foreclosure of one property during the first quarter of 1993, acquired in the 1989 Exchange and other reductions in borrowing. Interest on the Exchange debentures increased for the year ended December 31, 1993 as compared to the same period in 1992 due to the accrual of interest on the previously deferred interest relating to the debentures issued in both 1989 and 1991 exchange transactions. Interest on Exchange debentures for 1992 increased as compared to 1991 because 1992 reflects a full year of interest on both the 1989 and 1991 Exchange debentures as compared to 1991 which includes only ten months relating to the February 1991 Exchange transaction and six months relating to the June 1991 Exchange transaction. Non-Interest Income - Non-interest income decreased approximately $2.4 million for the year ended December 31, 1993 as compared to 1992 primarily due to the decline in equity in earnings of BankAtlantic of approximately $1.9 million caused by BFC's decreased ownership of BankAtlantic resulting from the November 1993 sale of 1,400,000 shares of BankAtlantic common stock, a decline in earnings from real estate operations and a decline in non-interest income, other. Partially offsetting these declines was a gain of $1.1 million relating to the sale of BankAtlantic common stock. On November 12, 1993, BankAtlantic closed a public offering of 1.8 million common shares at a price of $13.50 per common share. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million were sold by BFC. Net proceeds to BFC from the sale on the 1.4 million shares was approximately $17.7 million and a net cost of approximately $16.6 million, including purchase accounting of $1.4 million, was recorded on the sale of BankAtlantic common stock, resulting in a net gain of approximately $1.1 million on the sale. In connection with the public offering, BankAtlantic granted the underwriters a 30 day option to purchase up to 270,000 additional shares of common stock to cover over - allotments. On November 10, 1993, the underwriters exercised this option to purchase the 270,000 shares. Upon the sale of 2,070,000 shares, BFC's ownership of BankAtlantic decreased from 77.83% to 48.17%. The decrease of BFC's ownership in BankAtlantic investment in common stock resulted in the deconsolidation of the Company's assets and business operations for the year 1993 and the $10.8 million in equity in earnings of BankAtlantic was separately accounted for in the consolidated financial statements for the year ended December 31, 1993. Earnings on Real Estate Operations - Earnings on real estate operations include earnings from the 1989 and 1991 Exchange properties and BFC deferred profit recognition on sales of real estate by the Company and its subsidiaries other than BankAtlantic (excluding the 1989 and 1991 Exchange properties). Earnings on real estate operations for the years ended December 31, 1993, 1992, and 1991 amounted to $1.6 million, $3.2 million, and $3.3 million, respectively. The decrease in earnings on real estate operations for the year ended December 31, 1993 as compared to the same periods in 1992 and 1991 was primarily due to the disposal of properties acquired in the 1991 Exchange transaction and an increase in legal fees associated with litigation relating to the Exchanges. Non-Interest Income-Other - The decrease of non-interest income, other for the year ended December 31, 1992 as compared to the same period in 1991 was primarily due to reduction of property management fee income due to the sale of properties acquired in the 1989 and 1991 Exchanges. Non-Interest Expense -The increase in non-interest expense for the year ended December 31, 1993 as compared to the same period in 1992 was primarily due to an increase in the provision for litigation and an increase in occupancy and equipment expense. This increase was offset with a decrease in other non- interest expense. Provision for Litigation - The 1993 provision for litigation was due to a $4.0 million provision in connection with the court decision in the Short vs. Eden United, Inc. litigation and the $1.8 million 1992 provision was attributable to an appellate court decision in the Hess litigation. (See Item 3, "Legal Proceedings".) Occupancy and Equipment - Occupancy and equipment expense increased in 1993 compared to 1992 primarily due to the accrual of expenses in connection with the relocation of the Company's offices. Non-interest expense, other decreased primarily due to a loss in 1992 relating to the pay-off of a mortgage receivable at a discount, the write down in 1992 of a mortgage receivable, the write-off of some receivables from affiliated partnerships and legal fees incurred in 1992 in connection with the Exchange litigation. Financial Condition - BFC's total assets at December 31, 1993, and at December 31, 1992, were $87.5 million and $1.3 billion, respectively. The majority of the difference at December 31, 1993 as compared to December 31, 1992 is due to the deconsolidation in 1993 of BankAtlantic. The decrease of $2.0 million and $1.8 million in real estate acquired in the 1989 and 1991 Exchange transactions and mortgage payables and other borrowings, respectively, was attributable to the sale of properties acquired in the 1991 Exchange and the foreclosure of a property acquired in the 1989 Exchange. Purchase Accounting - The acquisition of BankAtlantic has been accounted for as a purchase and accordingly, the assets and liabilities acquired have been revalued to reflect market values at the dates of acquisition. The discounts and premiums arising as a result of such revaluation are generally being accreted or amortized (i.e. added into income or deducted from income), net of tax, using the level yield or interest method over the remaining life of the assets and liabilities. The net impact of such accretion, amortization and other purchase accounting adjustments for 1993 was to decrease net loss by approximately $191,000, increase net earnings during 1992 by approximately $807,000, and increase net loss during 1991 by approximately $792,000. Liquidity and Capital Resources - In connection with certain litigation related to the 1989 Exchange transaction (See Item 3. "Litigation", Timothy J. Chelling vs. BFC Financial Corporation, et.al.), in December 1992, a jury found that BFC Financial Corporation's issuance of debentures was unfair to investors. The jury found that those limited partners who did not vote in favor of the transaction are entitled to receive $8 million, rather than the approximately $16 million of subordinated debentures which were issued to them as a consequence of the Exchange. Based on the verdict, the Company would record a pre-tax gain from the reduction of its debt of approximately $6 million, but it nonetheless believes the verdict was not supported by the evidence at trial. Accordingly, the Company intends to appeal the verdict and the gain is not reflected in the financial statements. The court denied plaintiffs' motion for prejudgment interest as to Series 21 and Series 23 and awarded prejudgment interest to plaintiffs in Series 24 to be calculated to run from March 31, 1989 through December 18, 1992, the date of entry of final judgment, at the rate of 3.54%. In connection with the stay of the judgment without a bond and to secure the final judgment during the pendency of the appeal, BFC agreed to place shares of the BankAtlantic Common Stock owned by it into an escrow or collateral account for the benefit of the plaintiffs. Initially 800,000 shares have been delivered pursuant to the agreement but additional shares will be delivered in the event that the market value of the 800,000 shares delivered falls below $10 million. In connection with the litigation related to the purchase and sale of an apartment complex in Indiana (See item 3. "Litigation ", Short vs Eden United, Inc., et.al.), on February 25, 1994, the court on remand awarded plaintiff a judgment totaling approximately $4.5 million, including interest. The Company intends to appeal the trial court's order and may have to post a bond during the appeal process. The Company had accrued approximately $400,000 in prior years and based upon this order, at December 31, 1993, accrues an additional $4.1 million bringing to a total of $4.5 million the provision for this litigation in the financial statements. In connection with other litigation against the Company relating to the 1991 Exchange transaction (See item 3. "Litigation ", Arthur Arrighi, et.al. and Shirley B. Daniels, Robert and Ruby Avans, et.al.), on March 2, 1994, the parties entered into an agreement to settle these actions pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. On November 12, 1993, a public offering of 1.8 million BankAtlantic common shares at a price of $13.50 per common share was closed. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million shares were sold by BFC. Net proceeds to BFC and BankAtlantic from the sale was approximately $17.7 million and $4.6 million, respectively. In connection with the public offering, BankAtlantic granted the underwriters a 30 day option to purchase up to 270,000 additional shares of common stock to cover over-allotments. On November 10, 1993, the underwriters exercised this option to purchase the 270,000 shares, with a settlement date of November 18, 1993. The additional net proceeds to BankAtlantic will be approximately $3.4 million. Upon the sale of the 2,070,000 shares, BFC's ownership of BankAtlantic decreased from 77.83% to 48.17%. Proceeds from such sales will be utilized to fund the Exchange II settlements. The Company, during March 1993 placed $12.5 million in an escrow account to fund the settlement. In addition to the litigation discussed above, an appellate court has entered an order reversing a lower court decision in favor of the Company and its affiliates which related to the sale of units in two partnerships which participated in the 1991 Exchange transaction. (See Item 3. "Litigation", Martha Hess, et.al. vs Gordon, Boula, et.al.) The effect of this decision, which the Company intends to appeal, is to create a potential liability of approximately $1.8 million. Such amount was accrued at December 31, 1992. There is no requirement for a bond in connection with the appeal of this matter. The Company's ability to meet its obligations and to pay interest on its Exchange debentures is substantially dependent on the earnings and regulatory capital position of BankAtlantic. However, pursuant to the terms of the debentures issued in the 1989 and 1991 Exchange transactions, the Company may elect to defer interest payments on its subordinated debentures if management of the Company determines in its discretion that the payment of interest would impair the operations of the Company. Such deferral does not create a default. Since December 31, 1991, the Company has deferred interest payments amounting to approximately $12 million. The Company, not considering BankAtlantic, has sufficient current liquidity to meet its normal operating expenses, but it is not anticipated that it will make current payments of interest on the Exchange debentures until at least such time as the issues relating to the $8 million judgment discussed above and the other litigation discussed in Item 3. "Litigation" have been resolved. Pursuant to an agreement entered into on May 10, 1989 between BFC, its affiliates and BankAtlantic's primary regulator, BFC is obligated to infuse additional capital into BankAtlantic in the event that BankAtlantic's net capital (as defined) falls below the lesser of the industry's minimum capital requirement (as defined) or six percent of BankAtlantic's assets. However, there is no assurance that BFC will be in a position to infuse additional capital in the event it is called upon to do so. This obligation will expire ten years from the date of the agreement, or at such earlier time as BankAtlantic's net capital exceeds its fully phased-in capital requirement (as defined) for a period of two consecutive years. BankAtlantic's net capital exceeded its fully phased in capital requirement at December 31, 1993. Effective June 30, 1993, the Company exercised its warrants which were held to purchase 1,126,327 shares of BankAtlantic's common stock by tendering approximately $2.0 million of BankAtlantic subordinated debentures, including accrued interest. The purchase increased BFC's ownership percentage of BankAtlantic's common stock to 77.83%. On November 1993, BFC decreased its ownership percentage of BankAtlantic's common stock to 48.17% primarily due to the sale of 1.4 million shares of BankAtlantic common stock. An OTS regulation, effective August 1, 1990, limits all capital distributions made by savings institutions, including cash dividends, by permitting only certain institutions that meet specified capital levels to make capital distributions without prior OTS approval. The regulation established a three- tiered system, with the greatest flexibility afforded to well-capitalized institutions. An institution that meets all of its fully phased-in capital requirements and is not in need of more than normal supervision would be a "Tier 1 Institution". An institution that meets its minimum regulatory capital requirements but does not meet its fully phased-in capital requirements would be a "Tier 2 Institution". An institution that does not meet all of its minimum regulatory capital requirements would be "Tier 3 Institution". A Tier 1 Institution may, after prior notice but without the approval of the OTS, make capital distributions during a calendar year up to 100% of net income earned to date during the current calendar year plus 50% of its capital surplus ("surplus" being the amount of capital over its fully phased-in capital requirement). Any additional capital distributions would require prior regulatory approval. A Tier 2 Institution may, after prior notice but without the approval of the OTS, make capital distributions of between 50% and 75% of its net income over the most recent four-quarter period (less any dividends previously paid during such four-quarter period) depending on how close the institution is to its fully phased-in risk-based capital requirement. A Tier 3 Institution would not be authorized to make any capital distributions without the prior approval of the OTS. Notwithstanding the provision described above, the OTS also reserves the right to object to the payment of a dividend on safety and soundness grounds. In August and December 1993, BankAtlantic declared cash dividends of $0.06 per share, payable September 1993 and January 1994, respectively, to its common stockholders. A 15% common stock dividend was declared in May, 1993. In March 1994, the Board of Directors declared a cash dividend of $0.06 per share, payable in April 1994 to its common stockholders. BankAtlantic presently meets all required and fully phased-in capital requirements and has had operating income in the prior eight quarters. BankAtlantic has indicated that it expects to continue dividend payments on its non-cumulative preferred stock. Future cash dividends on common and preferred stock will be subject to declaration by BankAtlantic's Board of Directors, in its discretion, to additional regulatory notice or approval, and continued compliance with capital requirements. See note 29 of the Notes to the Consolidated Financial Statements. Cash Flows - A summary of the Company's consolidated cash flows follows (in thousands): December 31, --------------------------------------- 1993 1992 1991 ---- ---- ---- Net cash provided (used) by: Operating activities $ (523) 17,638 23,415 Investing activities 1,384 139,627 405,103 Financing activities (932) (164,465) (435,814) ------- ------- ------- Decrease in cash and due from depository institutions $ (71) (7,200) (7,296) ======= ======= ======= The changes in cash flow used or provided in operating activities are affected by the changes in operations, which are discussed elsewhere herein, and by certain other adjustments. These adjustments include additions to operating cash flows for non-operating charges such as depreciation and the provision for loan losses and write downs of assets. Cash flow of operating activities is also adjusted to reflect the use or the providing of cash for increases and decreases respectively, in operating assets and decreases or increases, respectively, of operating liabilities. Accordingly, the changes in cash flow of operating activities in the periods indicated above has been impacted not only by the changes in operations during the periods but also by these other adjustments. The primary sources of funds to the Company for the year ended December 31, 1993 was the proceeds received of approximately $17.7 million from the sale of BankAtlantic's common stock, revenues from property operations, collections on mortgage receivables and the dividend from BankAtlantic. These funds, excluding the proceeds from the sale of BankAtlantic common stock, were primarily utilized for operating expenses at the properties, capital improvements at the properties, mortgage payables on the properties and general and administrative expenses. The proceeds from the sale of BankAtlantic common stock will be utilized to fund the Exchange II settlements. Investing activities for the years ended December 31, 1993 included proceeds from the sale of BankAtlantic common stock of approximately $17.7 million and December 31, 1992, and 1991, included proceeds from the sale of real estate acquired in the 1991 and 1989 Exchange transactions of $5.6 million, and $7.6 million, respectively. The other major portions of the cash flows indicated above for financing and investing activities relate to BankAtlantic for the year ended December 31, 1992 and 1991. Impact of Inflation - The financial statements and related financial data and notes presented herein have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Virtually all of the assets and liabilities of BankAtlantic are monetary in nature. As a result, interest rates have a more significant impact on BankAtlantic's performance than the effects of general price levels. Although interest rates generally move in the same direction as inflation, the magnitude of such changes varies. The possible effect of fluctuating interest rates is discussed more fully under BankAtlantic's section of managements discussion and analysis of financial condition and results of operations entitled "Interest Rate Sensitivity". BFC does not believe that inflation has had any material impact on the Company, however, economic conditions generally have had an adverse effect on the values and operations of its real estate assets. ITEM 8. ITEM 8. INDEX TO FINANCIAL STATEMENTS Independent Auditors' Report Financial Statements: Consolidated Statements of Financial Condition - December 31, 1993 and Consolidated Statements of Operations - For each of the Years in the Three Year Period ended December 31, 1993 Consolidated Statements of Stockholders' Equity (Deficit) - For each of the Years in the Three Year Period ended December 31, 1993 Consolidated Statements of Cash Flows - For each of the Years in the Three Year Period ended December 31, 1993 Notes to Consolidated Financial Statements Independent Auditors' Report The Board of Directors BFC Financial Corporation: We have audited the accompanying consolidated statements of financial condition of BFC Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders equity (deficit) and cash flows for each of the years in the three year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of BFC Financial Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in note 25 to the consolidated financial statements, BFC Financial Corporation is a defendant in various lawsuits, the ultimate outcome of which cannot be presently determined. The consolidated financial statements do not include any adjustments that might result from these uncertainties. As discussed in notes 1 and 2 to the consolidated financial statements, in 1993, BFC Financial Corporation sold certain of its investment in the outstanding common stock of BankAtlantic, A Federal Savings Bank ("the Bank") and, as a result, no longer controlled a majority voting interest in the Bank as of December 31, 1993. As a result, the Company utilized the equity method of accounting for its investment in the Bank in 1993 and accordingly, financial position, results of operations and cash flows were not consolidated as in 1992 and 1991. As discussed in note 18 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standards Board's SFAS No. 109, "Accounting for Income Taxes". KPMG PEAT MARWICK Fort Lauderdale, Florida March 30, 1994 BFC FINANCIAL CORPORATION Consolidated Statements of Financial Condition December 31, 1993 and December 31, 1992 (in thousands, except share data) ASSETS --------- 1993 1992 --------- --------- Cash and due from depository institutions $ 78 31,357 Tax certificates and other investment securities, net (at cost which approximates market value) 20,644 125,047 Investment in BankAtlantic, a Federal Savings Bank 36,436 - Loans receivable (net of unearned discount of $1,733 in 1992) 9,179 574,882 Loans originated for resale - 7,641 Less: allowance for loan losses - (16,500) ---------- ---------- Total loans receivable, net 9,179 566,023 ---------- ---------- Mortgage-backed securities (approximate market value $353,984 in 1992) - 349,531 Mortgage-backed securities available for sale (approximate market value of $145,011 in 1992) - 137,355 Accrued interest receivable 8 22,196 Real estate owned - 14,997 Real estate acquired in debenture exchange, net 18,315 20,330 Office properties and equipment, net 28 36,032 Federal Home Loan Bank stock at cost, which approximates market value ($924 in 1992 available for sale) - 8,366 Investment in and advances to joint ventures - 1,217 Excess cost over fair value of net assets acquired, net - 1,925 Dealer reserves, net - 4,533 Other assets 2,807 21,556 ---------- ---------- Total assets $ 87,495 1,340,465 ========== ========== (Continued) LIABILITIES AND STOCKHOLDERS' DEFICIT --------------------------------------------------- 1993 1992 --------- --------- Deposits $ - 1,108,115 Advances from Federal Home Loan Bank - 66,100 Securities sold under agreements to repurchase - 21,532 Capital notes and other subordinated debentures - 7,928 Exchange debentures, net 35,651 38,996 Mortgages payable and other borrowings 30,367 32,168 Drafts payable - 1,246 Advances by borrowers for taxes and insurance - 9,193 Deferred interest on the exchange debentures 12,049 6,126 Other liabilities 8,602 22,527 Deferred income taxes 2,038 2,380 ---------- ---------- Total liabilities 88,707 1,316,311 Commitments and contingencies Minority interest - 16,258 Preferred stock of BankAtlantic - 7,036 Redeemable common stock (353,478 shares) (redemption amount $299 in 1993 and $655 in 1992) 5,776 5,776 Stockholders' deficit: Preferred stock of $.01 par value; authorized 10,000,000 shares; none issued - - Special class A common stock of $.01 par value; authorized 20,000,000 shares; none issued - - Common stock of $.01 par value; authorized 20,000,000 shares; issued 2,351,021 in 1993 and 1992 17 17 Additional paid-in capital 15,264 15,532 Accumulated deficit (21,989) (20,185) Less: treasury stock (45,339 shares for 1993 and 1992) (280) (280) ---------- ---------- Total stockholders' deficit (6,988) (4,916) ---------- ---------- Total liabilities and stockholders' deficit $ 87,495 1,340,465 ========== ========== See accompanying notes to consolidated financial statements. BFC FINANCIAL CORPORATION AND SUBSIDIARIES Consolidated Statement of Operations For each of the years in the three year period ended December 31, 1993 (in thousands, except per share data) 1993 1992 1991 --------- --------- --------- Interest income: Interest and fees on loans $ 767 63,181 91,200 Interest on mortgage-backed securities - 37,170 35,173 Interest on mortgage-backed securities available for sale - 642 1,172 Interest and dividends on tax certificates and other investment securities 299 17,320 20,518 ---------- ---------- ---------- Total interest income 1,066 118,313 148,063 ---------- ---------- ---------- Interest expense: Interest on deposits - 47,393 83,227 Interest on advances from FHLB - 3,697 3,587 Interest on securities sold under agreements to repurchase - 2,881 1,671 Interest on capital notes and other subordinated debentures - 1,440 2,020 Interest on exchange debentures 6,031 5,163 4,199 Interest - other 3,032 4,309 5,240 ---------- ---------- ---------- Total interest expense 9,063 64,883 99,944 ---------- ---------- ---------- Net interest income (expense) (7,997) 53,430 48,119 Provision for loan losses - 6,650 17,540 ---------- ---------- ---------- Net interest income (expense) after provision for loan losses (7,997) 46,780 30,579 ---------- ---------- ---------- Non-interest income: Loan servicing and other loan fees - 3,189 4,344 Gain on sales of loans - 976 330 Gain on sales of mortgage-backed securities - 8,116 748 Gain on sales of investment securities - 143 85 Equity in earnings of BankAtlantic 10,764 - - Gain on sale of BankAtlantic common stock 1,050 Earnings on real estate operations 1,647 3,200 3,384 Non interest income - other 318 7,672 9,063 ---------- ---------- ---------- Total non-interest income 13,779 23,296 17,954 ---------- ---------- ---------- (Continued) Non-interest expenses: Employee compensation and benefits 1,453 20,618 26,319 Occupancy and equipment 331 8,747 10,629 Federal insurance premium - 2,772 3,281 Advertising and promotion - 480 1,143 (Income) loss from joint venture investments - 245 (2,335) Foreclosed asset activity, net - 4,390 9,451 Write-down of real estate acquired in debenture exchanges - 89 2,882 (Recovery) write-down of dealer reserve - (2,739) 2,739 Provision for branch consolidation - 2,085 Provision for litigation 4,034 1,800 - Minority interest in BankAtlantic - 3,964 (2,977) Non interest expenses - other 1,267 18,500 17,901 ---------- ---------- ---------- Total non-interest expenses 7,085 58,866 71,118 ---------- ---------- ---------- Income (loss) before cumulative effect of change in accounting for income taxes, income taxes and extraordinary items (1,303) 11,210 (22,585) Provision (benefit) for income taxes - 9,201 (4,876) ---------- ---------- ---------- Income (loss) before cumulative effect of change in accounting for income taxes and extraordinary items (1,303) 2,009 (17,709) Cumulative effect of change in accounting for income taxes (501) - - Extraordinary items: Gain on early retirement of capital notes net of applicable income taxes of $340 and minority interest of $197 - - 350 Utilization of state net operating loss carryforwards, net of minority interest of $208,000 - 548 - ---------- ---------- ---------- Net income (loss) $ (1,804) 2,557 (17,359) ========== ========== ========== Earnings (loss) per share: Net earnings (loss) before cumulative effect of change in accounting for income taxes and extraordinary items $ (1.18) 0.78 (10.71) Cumulative effect of change in accounting for income taxes (0.29) - - Extraordinary items - 0.32 .20 ---------- ---------- ---------- Net earnings (loss) per share $ (1.47) 1.10 (10.51) ========== ========== ========== Weighted average number of shares outstanding 1,702 1,702 1,718 ========== ========== ========== See accompanying notes to consolidated financial statements. BFC FINANCIAL CORPORATION Consolidated Statements of Stockholders' Equity (Deficit) For each of the years in the three year period ended December 31, 1993 (in thousands, except share data) Addi- tional Accu- Trea- Common Paid-in mulated sury Stock Capital Deficit Stock Total -------- -------- -------- -------- -------- Balance at December 31, 1990 18 15,584 (5,383) (280) 9,939 Purchase of treasury stock - - - (53) (53) Retirement of treasury stock (1) (52) - 53 - Net (loss) - - (17,359) - (17,359) -------- -------- -------- -------- -------- Balance at December 31, 1991 17 15,532 (22,742) (280) (7,473) Net income - - 2,557 - 2,557 -------- -------- -------- -------- -------- Balance at December 31, 1992 17 15,532 (20,185) (280) (4,916) Effect of issuance of BankAtlantic's common stock to BankAtlantic minority shareholders - (268) - - (268) Net (loss) - - (1,804) - (1,804) -------- -------- -------- -------- -------- Balance at December 31, 1993 17 15,264 (21,989) (280) (6,988) ======== ======== ======== ======== ======== See accompanying notes to consolidated financial statements. Consolidated Statements of Cash Flows For each of the years in the three year period ended December 31, 1993 (In thousands) 1993 1992 1991 --------- --------- --------- Operating activities: Income (loss) before extraordinary items and cumulative effect of change in accounting for income taxes $ (1,303) 2,009 (17,709) Adjustments to reconcile income (loss) before extraordinary items and cumulative effect of change in accounting for income taxes to net cash provided (used) by operating activities: Equity in earnings of BankAtlantic (10,764) - - Provision for loan losses - 6,650 17,540 Provision for declines in real estate owned - 3,916 10,626 FHLB stock dividends - (498) (618) Depreciation 1,658 4,998 4,920 Amortization of purchased servicing rights - 2,573 1,274 Increase (decrease) in deferred income taxes - 1,775 (4,480) Utilization of net operating loss carryforwards before minority interest - 756 - Net accretion of securities - (456) (243) Net amortization of deferred loan origination fees - (41) (40) Accretion on exchange debentures and mortgage payables 285 505 783 Tax effect of real estate acquired in debenture exchange (92) (136) (189) Amortization of discount on loans receivable (70) (107) (321) Loss (gain) on sales of real estate owned - (602) 59 Proceeds from loans originated for sale - 37,030 15,279 Origination of loans for sale - (39,888) (18,756) Write-off of office properties and equipment - 600 461 Loss of mortgage receivables - 408 17 Gain on sales of loans - (976) (330) Gain on sales of mortgage-backed securities available for sale - (8,116) (748) Gain on sale of BankAtlantic common stock (1,050) - - Gain on sales of investment securities - (143) (85) Loss (gain) on sales of office properties and equipment - 71 (7) Loss (income) from joint venture operations - 245 (2,335) Decrease in drafts payable - (9,410) (1,403) Decrease in accrued interest receivable - 2,257 4,615 Increase in exchange debentures deferred interest 5,923 4,985 1,140 Increase (decrease) in other liabilities 354 (1,444) 4,163 Decrease (increase) in other assets 502 (4,236) 3,522 Minority interest of BankAtlantic - 3,964 (2,977) (Continued) 1993 1992 1991 --------- --------- --------- Purchase accounting adjustments: Amortization of excess cost over fair value of net assets acquired - 320 238 Amortization of intangible assets - - 296 Amortization (accretion) of purchase accounting adjustments, net - 1,263 (986) Amortization of dealer reserve - 6,406 5,491 Write-down of dealer reserve - - 2,739 Prepayments of dealer reserve - - (1,417) Provision for tax certificates losses - 1,160 811 Provision for branch consolidation - - 2,085 Provision for litigation 4,034 1,800 - ---------- ---------- ---------- Net cash (used) provided by operating activities $ (523) 17,638 23,415 ---------- ---------- ---------- Investing activities: Cash received in debenture exchange $ - - 4,613 Sales of real estate acquired in debenture exchanges - 5,563 7,598 Proceeds from the sale of BankAtlantic common stock 17,691 - - Increase in BankAtlantic investment in common stock (1,971) - - Dividends received from BankAtlantic investment in common stock 271 - - Proceeds from sales of investment securities - 2,137 30,235 Purchase of tax certificates and other investment securities (14,245) (129,415) (123,451) Proceeds from redemption and maturities of tax certificates and other investment securities - 111,070 118,447 Loan sales - - - Loans purchased - - (2,182) Principal reduction on loans 252 299,347 298,462 Loans originated - (136,179) (122,511) Proceeds from sales of mortgage-backed securities available for sale - 155,243 70,903 Mortgage-backed securities purchased - (271,041) (98,587) Principal collected on mortgage-backed securities - 95,266 56,634 Proceeds from sales of real estate owned - 12,589 2,937 Purchases and additional investments in real estate owned - - (1,374) Additions to office properties and equipment (32) (748) (1,037) Sales of office equipment - 105 525 Advances to joint ventures - (26) (2,690) Repayments of advances to joint ventures - 77 12,929 Investments in joint ventures - - (115) Cash distributions from joint ventures - - 561 FHLB stock sales - 142 3,071 FHLB stock purchased - (65) - Improvements to real estate acquired in debenture exchanges (582) (606) (1,094) (Continued) 1993 1992 1991 --------- --------- --------- Servicing rights purchased - (3,832) (3,457) Settlement of amount due from broker - - 154,686 ---------- ---------- ---------- Net cash provided by investing activities $ 1,384 139,627 405,103 ---------- ---------- ---------- Financing activities: Net decrease in deposits $ - (190,907) (272,307) Interest credited to deposits - 43,509 71,853 Proceeds from FHLB advances - 107,300 - Repayments of FHLB advances - (78,400) (25,700) Net decrease in securities sold under agreement to repurchase - (35,600) (189,847) Preferred stock issuance costs - - (353) Payment for exchange of capital notes for preferred stock - - (1,855) Redemption of capital notes - (7,022) (338) Receipts of advances by borrowers for taxes and insurance, net - 33,933 34,794 Payment for advances by borrowers for taxes and insurance - (33,220) (32,678) Increase (decrease) in federal funds purchased - - (14,500) Increase in borrowings - - 1,722 Repayments of borrowings (932) (4,058) (6,408) Purchase of treasury stock - - (53) Proceeds from the issuance of subordinated debt - - 8 Loan cost - - (160) Common stock and warrants purchased by minority shareholders of BankAtlantic - - 8 ---------- ---------- ---------- Net cash (used) by financing activities (932) (164,465) (435,814) ---------- ---------- ---------- Decrease in cash and cash equivalents (71) (7,200) (7,296) Cash and due from depository institutions at beginning of period 149 38,557 45,853 ---------- ---------- ---------- Cash and due from depository institution at end of period $ 78 31,357 38,557 ========== ========== ========== See accompanying notes to consolidated financial statements. Notes to Consolidated Financial Statements For the years ended December 31, 1993, 1992 and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Financial Statement Presentation - The financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP"). In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statements of consolidated financial condition and income and expenses for the periods presented. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the next year relate to the determination of the allowance for real estate acquired in connection with the Exchange transactions and in satisfaction of loans. In connection with the determination of the allowance for loan losses and real estate owned, management obtains independent appraisals for significant properties, when it is deemed prudent. Where applicable, reference is made to the financial statements and notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. Differences in amounts between those financial statements and these financial statements would primarily pertain to amounts related to BFC Financial Corporation or purchase accounting adjustments discussed in note 2 of the notes to consolidated financial statements of BFC Financial Corporation and Subsidiaries. Principles of Consolidation - BFC Financial Corporation ("BFC" or "the Company") is a savings and loan holding company as a consequence of its ownership of the common stock of BankAtlantic, A Federal Savings Bank ("BankAtlantic"). The consolidated financial statements for the year 1993 include the accounts of BFC Financial Corporation, and its wholly-owned subsidiaries. Because the Company's ownership interest in BankAtlantic was reduced below 50% in 1993, BankAtlantic is not consolidated but is carried on the equity method for 1993. The consolidated financial statements for the years 1992 and 1991 include the accounts of BFC Financial Corporation, its majority-owned subsidiary, BankAtlantic, and its wholly owned subsidiaries. The 1993 operations includes the equity in earnings from BankAtlantic. For 1992 and 1991, the adjustments to operations relating to changes in the Company's percentage ownership of BankAtlantic are reflected in minority interest. All significant intercompany accounts and transactions have been eliminated in consolidation. Cash Equivalents - Cash and due from banks include demand deposits at other financial institutions. Tax Certificates and Other Investment Securities and Mortgage-Backed Securities - In 1992 and 1991, substantially all of these securities are owned by BankAtlantic. Tax certificates, other investment securities and mortgage-backed securities held for investment are carried at cost. Real Estate Owned - Real estate acquired in the Exchange transactions discussed in note 2 is stated at the lower of cost or net realizable value in the accompanying statements of financial condition. Profit on real estate sold is recognized when the collectibility of the sales price is reasonably assured and BankAtlantic is not obligated to perform significant activities after the sale. Any estimated loss is recognized in the period in which it becomes apparent. Office Properties and Equipment - Land is carried at cost. Office properties and equipment are carried at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets which generally range up to 50 years for buildings and 10 years for equipment. The cost of leasehold improvements is being amortized using the straight-line method over the terms of the related leases. Expenditures for new properties and equipment and major renewals and betterments are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred and gains or losses on disposal of assets are reflected in current operations. Income Taxes - The Company does not include BankAtlantic and its subsidiaries in its consolidated income tax return with its wholly-owned subsidiaries, since the Company owns less than 80% of the outstanding stock of BankAtlantic. Income taxes are provided on the Company's interest in the portion of the BankAtlantic's earnings not subject to the 80% dividends received exclusion. Deferred income taxes are provided on elements of income that are recognized for financial accounting purposes in periods different than such items are recognized for income tax purposes. In February 1992, the Financial Accounting Standard Board ("FASB") issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 requires a change from the deferred method to the asset and liability method to account for income taxes. Under the asset and liability method of FAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to the 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 those temporary differences are expected to be recovered or settled. Under FAS 109, the effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the statutory enactment date. BFC adopted FAS 109, as of January 1, 1993. The cumulative effect of this change in accounting for income taxes was a charge aggregating approximately $501,000. Pursuant to the deferred method under APB Opinion 11, which was applied in 1992 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rates applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. The Omnibus Budget Reconciliation Act of 1993 (the "Omnibus Act") was passed by Congress and signed into law by the President during August 1993. The Omnibus Act increased the maximum federal income tax rate applicable to BFC from 34% to 35% retroactive to January 1, 1993. This change did not have a material impact on the Company. Excess Cost Over Fair Value of Net Assets Acquired (Goodwill) - The ownership position in BankAtlantic was acquired at different times. At the February 1987, October 1989, June 1990, October 1990 and November 1991 acquisitions, the fair market value of the net assets of BankAtlantic were greater than the Company's cost. At other increases in ownership, the Company's cost was in excess of the fair market value of BankAtlantic's net assets. The excess of fair market value over cost was recorded as a reduction to the fair market value of non-current assets, including identified intangible assets. The excess of cost over fair market value was recorded as goodwill and is being amortized on the straight line basis over a 15 year period. Identified intangibles consist of loan servicing and escrows. These intangibles are amortized over the remaining life of the applicable loan and escrow accounts using the level yield method and at the end of 1993 had been completely amortized. The minor 3.3%, 4%, 0.5% and 2.4% increases in ownership of BankAtlantic in October 1989, June 1990, October 1990 and November 1991 were recorded utilizing BankAtlantic's cost basis of assets and liabilities as fair market value. The excess of such cost over the Company's purchase price was recorded as a reduction to property and equipment and is being amortized on a straight-line basis over a ten year period. Redeemable Common Stock - In May 1989, the Company exchanged, among other things, 353,478 shares of its common stock (including 117,483 shares of treasury stock) for 282,782 shares of common stock of BankAtlantic (See also Note 2). The exchange ratio for the shares was 1.25 to 1. The original holders of the Company's shares issued in this transaction have the right to require the Company, at any time, to purchase such shares for the higher of (i) their book value as of the date of notice or (ii) the average market value of such shares. The term "average market value" is defined as the product of (i) the average of the closing price of the common stock as reported on the over-the-counter market for the (x) 20 trading days prior to the date of the notice, (y) the date of the notice, if a trading day, and (z) 20 trading days following the date of the notice, times (ii) the number of shares of common stock held by the original holders. The Company and Alan B. Levan, individually, have the right to buy and to require the original holders to sell such shares to each, respectively, on the same terms indicated above. At the transaction date the book value of the shares was greater than their market value. Accordingly, the amount initially recorded for this redeemable common stock, $5,776,000, was at book value. Amounts subsequently reflected in the Company's Statements of Financial Condition will be adjusted to reflect the maximum liability based on the higher of either the market price or the book value of the shares. However, such liability will not be reduced from the amount initially reflected at the time of acquisition. There has been no adjustment to the amount stated since the May 1989 acquisition date. In February 1994, the parties mutually agreed to cancel the agreement with respect to the requirement to buy and or sell shares. Therefore, during the first quarter of 1994, the amount classified as redeemable common stock will be reclassified to the stockholders' deficit section of the Statement of financial condition. Earnings (Loss) Per Common Share - Earnings (loss) per share is computed using the more dilutive of (a) the weighted average number of shares outstanding, or (b) the weighted average number of shares outstanding assuming that the shares of redeemable common stock are reacquired for debt, from the latter of their date of issuance (May 10, 1989) or the beginning of the computation period, at the greater of the amount originally recorded, or the higher of the then book value or market price of the shares. Computation (b) has been utilized, assuming a rate of 12% on indebtedness for 1993, 1992 and 1991. Shares issued in connection with a 1984 acquisition are considered outstanding after elimination of 250,000 shares, representing the Company's 50% ownership of the shares issued in the acquisition. Reclassifications - For comparative purposes, certain prior year balances have been reclassified to conform with the 1993 financial statement presentation. New Accounting Standards - During May 1993, the Financial Accounting Standards Board approved two new accounting standards. Statement of Financial Accounting Standards No. 114 - Accounting by Creditors for Impairment of a Loan ("FAS 114"), and Statement of Financial Accounting Standards No. 115 - Accounting for Certain Investments in Debt and Equity Securities ("FAS 115"). FAS 114 addresses the collectibility of both contractual interest and contractual principal of all receivables when assessing the need for a loss accrual. This standard requires that unpaid loans be measured at the present value of expected cash flows by discounting those cash flows at the loan's effective interest rate. FAS 114 must be adopted by 1995, prospectively. The Company intends to implement FAS 114 in 1995. At December 31, 1993, the effect of implementation of this standard on the Company is estimated to be immaterial. FAS 115 addresses the valuation and recording of debt securities as held-to- maturity, trading and available for sale. Under this standard, only debt securities that the Company has the positive intent and ability to hold to maturity would be classified as held to maturity and reported at amortized cost. All others would be reported at fair value. FAS 115 must be adopted by 1994, prospectively. If FAS 115 were effective at December 31, 1993, the Company does not believe that based on its current portfolio any adjustment would be required. See note 1 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 2. INVESTMENTS IN BANKATLANTIC AND OTHER ACQUISITIONS AND DISPOSITIONS The Company has acquired its current 48.17% ownership of BankAtlantic through various acquisitions and sales as follows (Amounts adjusted for June 1993 15% stock dividend): Cumulative Shares Ownership % ---------- ------------ Prior to 1987 333,155 9.9% February 1987 1,214,952 43.7% October 1987 345,000 53.4% May 1989 325,199 62.3% October 1989 495,506 65.6% June 1990 541,430 69.6% October 1990 24,150 70.1% November 1991 115,000 72.5% June 1993 1,126,327 77.8% November 1993 (1,400,000) 48.2% The Company's ownership of BankAtlantic has been recorded by the purchase method of accounting. Since January 1, 1987 to December 1992, the accounts of BankAtlantic have been consolidated with those of the Company. The shares in the May 1989 acquisition were acquired from Mr. John Abdo and certain members of his family ("Mr. Abdo") in exchange for, among other things, 353,478 shares of the Company's redeemable common stock. The shares in the October 1989 acquisition were acquired directly from BankAtlantic in connection with an offering by BankAtlantic of 500,000 units, at $12.00 per unit, to its existing stockholders. Each unit consisted of one share of its common stock and three warrants, with each warrant entitling the holder to purchase one share of common stock at an exercise price of $10.00 at any time prior to May 31, 1991. On June 30, 1990, BFC exercised its warrants and converted $2.5 million of subordinated debt of BankAtlantic to 541,430 shares of BankAtlantic common stock, increasing BFC's ownership percentage of BankAtlantic to 69.6%. (See note 15.) In October 1990, the Company increased its ownership of BankAtlantic to 70.12% by purchasing 24,150 shares of BankAtlantic common stock from the BankAtlantic Security Plus Plan (the "Plan") at a cost of $2.625 per share (average of bid and asked price on date of purchase). The Plan disposed of these shares in order to meet employees withdrawal requests. In November 1991, BFC purchased 115,000 shares of BankAtlantic common stock from an unaffiliated third party at a cost of approximately $0.761 per share, increasing BFC's ownership of BankAtlantic to 72.5%. In June 1993, the Company exercised its right to purchase 1,126,327 shares of BankAtlantic's common stock at the exercise price of $1.75 per share, for a total purchase price of $1,971,072. The payment of $1,971,072 was through the tender of subordinated debentures held by BFC as of February 28, 1993 and the related accrued interest as of that date. The debentures were issued to BFC in connection with the use of funds from and escrow account established by BFC to make preferred stock dividend payments, and in connection with the related accrued interest on the debentures through February 1993. As a result of the above transaction, BFC increased its ownership in BankAtlantic to 77.83% of BankAtlantic's outstanding common stock. During July 1993, BFC received $83,704 for the interest accrued on the subordinated debentures from February 28, 1993 to June 30, 1993. Share and exercise price were adjusted subject to the dilution provisions contained in the subordinated debt agreement to reflect BankAtlantic's 15% common stock dividend of June 7, 1993. The aggregate purchase price allocation for the June 30, 1993 acquisition of BankAtlantic's common stock is as follows (in thousands): Company's interest in net assets of BankAtlantic (book value on dates of acquisition) $ 3,550 Company's ownership interest of capital contributions 1,530 Adjustment to net assets: Accretion on investment and mortgage- backed securities 1,099 Accretion loans receivable 684 Increase in other assets 39 Premium on deposits (553) Premium on FHLB advances (43) Increase in other liabilities (5) Increase in deferred income taxes (80) Decrease in office properties and equipment (4,250) ------- Purchase price of interest in BankAtlantic's common stock $ 1,971 ======= The adjustment to net assets indicated above are non-cash investing and financing activities. On November 12, 1993, a public offering of 1.8 million BankAtlantic common shares at a price of $13.50 per common share was closed. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million shares were sold by BFC. Net proceeds to BFC and BankAtlantic from the sale were approximately $17.7 million and $4.6 million, respectively. In connection with the public offering, BankAtlantic granted the underwriters a 30 day option to purchase up to 270,000 additional shares of common stock to cover over-allotments. On November 10, 1993, the underwriters exercised this option to purchase the 270,000 shares, with a settlement date of November 18, 1993. The additional net proceeds to BankAtlantic was approximately $3.4 million. Upon the sale of the 2,070,000 shares, BFC's ownership of BankAtlantic decreased to 48.17%. The sale of the BankAtlantic shares provided the Company with the current liquidity to enable it to hold settlement discussions on the Exchange litigation discussed below. During 1992, the effect of purchase accounting, including income taxes and net amortization/accretion of adjustments to net assets acquired was to increase consolidated net earnings by approximately $807,000 and decrease consolidated net loss during 1993 and increase consolidated net loss in 1991 by approximately $252,000 and $792,000, respectively. The 1991 net loss includes an extraordinary gain of $350,000 as discussed in note 15. Assuming no sales or dispositions of the related assets or liabilities, the Company does not believe the net increase (decrease) in earnings resulting from the net amortization/accretion of the adjustments to net assets acquired resulting from the use of the purchase method of accounting will be significant in future years. Excess cost over fair value of net assets acquired at December 31, 1993 and 1992, was approximately $1,068,000 and $1,925,000, respectively. As a result of the deconsolidation in 1993, excess cost over fair value of net assets acquired at December 31, 1993 is included in the investment of BankAtlantic in the accompanying statements of financial condition. A reconciliation of the carrying value in BankAtlantic to BankAtlantic's Stockholders equity is as follows: BankAtlantic Stockholders' equity $ 90,652 Preferred stock (7,036) ------- BankAtlantic common stockholders' equity 83,616 Partnership percentage 48.17% ------ 40,278 Purchase accounting adjustments (3,842) ------ Investment in BankAtlantic $ 36,436 ======= BFC also owns 5,600 shares of BankAtlantic 12.25% Series A Preferred Stock, 529 shares of BankAtlantic 10.00% Series B Preferred Stock and 4,636 shares of BankAtlantic 8.00% Series C Preferred Stock. The aggregate purchase price relating to the acquisition of these shares was approximately $100,000. See the consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. On February 27, 1991 and June 12, 1991, the Company exchanged (the "1991 Exchange") approximately $9.3 million and $6.1 million (the "Original Principal Amount") of its subordinated unsecured debentures (the "Debentures") for all of the assets and liabilities of two and one affiliated limited partnership(s), respectively. The major assets and liabilities of these partnerships consisted principally of eight commercial real estate properties and related non-recourse mortgage debt. On March 29, 1989, the Company exchanged (the "1989 Exchange") approximately $30 million (the "Original Principal Amount") of its subordinated unsecured debentures (the "Debentures") for all of the assets and liabilities of three affiliated limited partnerships. The major assets and liabilities of these partnerships consisted principally of fourteen commercial real estate properties, and related non-recourse mortgage debt. The Debentures in the 1991 Exchange bear interest at a rate equal to 10.5% per annum until March 31, 1992, 11.5% per annum thereafter until March 31, 1993 and 12.5% per annum thereafter until maturity on July 1, 2011. The Debentures in the 1989 Exchange bear interest at a rate equal to 8% per annum until June 30, 1990, 9% per annum thereafter until June 30, 1991, and 10% thereafter until maturity on July 1, 2009. Interest on the Debentures in the 1991 and 1989 Exchange are due at maturity but is anticipated to be paid quarterly unless management reasonably determines that such quarterly interest payments would impair the operations of the Company. Any interest not paid quarterly by the Company ("Deferred Interest") will accrue interest at the same rate as the Debentures until paid. In the event the Company determines not to pay interest on the Debentures for eight quarters, the interest rate on the Debentures in the 1991 and 1989 Exchanges will increase to, and remain at, 13% and 12%, respectively, per annum until maturity. No dividends may be paid to the holders of any equity securities of the Company while any deferred interest remains unpaid. Since December 31, 1991, the Company has deferred the interest payments relating to the debentures issued in both the 1989 Exchange and the 1991 Exchange and therefore,the interest on the debentures in the 1991 and 1989 Exchange is now 13% and 12%, respectively per annum. The deferred interest on the exchange debentures was approximately $12 million and $6.1 million at December 31, 1993 and 1992, respectively. Debenture holders are also entitled to receive 100% of the aggregate Net Proceeds (as defined in the Debenture) received by the Company in excess of the Original Principal Amount of the Debentures issued, payable on the Distribution Date (as defined below) in cash or additional Debentures (the "Additional Consideration"). The Distribution Date is the earlier of February 1995 or 90 days after the sale of all of the real estate acquired in the 1991 Exchange. The Distribution Date was June 1993 for the 1989 Exchange. At that time, there was no Additional Consideration due with respect to the 1989 Exchange. Any Debentures issued in payment of the Additional Consideration will be identical to the Debentures originally issued, except there will be no further Additional Consideration payable with respect thereto. For financial statement purposes, the Debentures in the 1991 and 1989 Exchange have been discounted to yield 19% and 12%, respectively, over their term and the non-recourse mortgage debt has been discounted to yield 11% over its term. Such mortgage debt in the 1991 Exchange: a) had original aggregate outstanding stated principal balances of approximately $37.0 million; b) had maturities at various dates between 1991 and 2009; c) had stated interest rates ranging from 8.75% to 12.0%; and d) required aggregate monthly payments of approximately $376,000 for principal and interest. Such mortgage debt in the 1989 Exchange: a) had original aggregate outstanding stated principal balances of approximately $28.7 million; b) had maturities at various dates between 1991 and 2003; c) had stated interest rates ranging from 7.75% to 13.5%; and d) required aggregate monthly payments of approximately $275,000 for principal and interest. No value has been assigned to the Additional Consideration in the 1991 Exchange. However, future financial statements will reflect accruals as a "Cost of Sale", to the extent appropriate, for any anticipated Additional Consideration payable based on sales of properties received by the Company in this transaction, through the date of the financial statements. To the extent Additional Consideration is payable on the Distribution Date relating to unsold properties, the basis in such properties will be increased at such time by the fair value of the Additional Consideration payable as a consequence thereof. For purposes of determining Net Proceeds, such unsold properties will be appraised by an independent certified appraisal firm within 90 days of the Distribution Date. A summary of the non-cash investing and financing activities related to the 1991 transaction is as follows (in thousands): ---- Subordinated Debentures issued $ 11,926 Non-recourse mortgage debt related to real estate acquired 38,612 Other liabilities assumed 1,421 Real estate acquired (46,057) Other assets acquired (1,289) ------- Net cash received $ 4,613 ======= Through December 31, 1993, three properties acquired in the 1991 Exchange were sold to unaffiliated third parties. The properties had an aggregate sales price of approximately $28.3 million. Stated mortgage debt of approximately $18 million was eliminated including the remaining $2.0 million balance on a $5.0 million note that was also secured by 2,370,846 shares of BankAtlantic stock owned by BFC. Cash proceeds from the sales, after prorations and closing costs, of approximately $8.2 million was received. Through December 31, 1993, ten properties acquired in the 1989 Exchange were sold to unaffiliated third parties. The properties had an aggregate sales price of approximately $42.3 million. Stated mortgage debt of approximately $21.1 million was eliminated and cash proceeds, after prorations and closing costs, of approximately $20.0 million was received. No Additional Consideration is estimated to be payable with respect to these sales. In litigation brought against the Company in connection with the 1989 and 1991 Exchanges, some plaintiffs have sought to impose a constructive trust on property acquired by the Company in the Exchanges. A network television program has given wide publicity to these claims which may impair the ability of the Company to sell or refinance properties acquired in the Exchanges. There is no assurance that liquidity will be available from the disposition or refinancing of Exchange properties. In connection with the October and November 1992 sales of two properties acquired in the 1991 Exchange, BFC has agreed to limit the disposition of proceeds from these sales pending resolution of certain litigation or further order of the court. At December 31, 1992 and 1993, approximately $3.5 million currently held in escrow is included in "Tax certificates and other investment securities" in the accompanying financial statements. On December 17, 1992, a jury found that BFC Financial Corporation's issuance in 1989 of debentures in exchange for the assets and liabilities of three affiliated public limited partnerships was unfair to investors. The jury determined that BFC Financial Corporation, the affiliated Managing General Partners and BFC Financial Corporation's President, Alan Levan, did not believe that the terms of the Exchange were fair to the limited partners as stated in the prospectus. Based on that determination, the jury found that those limited partners who did not vote in favor of the transaction are entitled to receive approximately $8 million, the amount which they claimed they would have received if the partnerships had been liquidated, rather than the approximately $16 million of subordinated debentures which were issued to them as a consequence of the Exchange and those debentures will be extinguished in connection with the verdict. BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the reduction in its debt resulting from the verdict, but it nonetheless believes that the verdict was not supported by the evidence at trial. The Company intends to appeal the verdict. No amounts have been reflected in the financial statements because the judgement amount was less than the Company's carrying amount of the debentures and related accrued interest and because the Company intends to appeal the verdict. In March 1994, an agreement was entered into to settle the litigation pertaining to the 1991 Exchange. Pursuant to the agreement, the company will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Other lawsuits have been filed against the Company in connection with the Exchange offers. The Company is pursuing discussions with the remaining plaintiffs in litigation relating to the Exchange offers with a view to settling the ongoing litigation but there is no assurance that a settlement will be reached. 3. TAX CERTIFICATES AND OTHER INVESTMENT SECURITIES A comparison of the book value, gross unrealized appreciation, gross unrealized depreciation and approximate market value of tax certificates and other investment securities is as follows (in thousands): ---- Gross Gross Approximate Book Unrealized Unrealized Market Value Appreciation Depreciation Value ------ ------------ ------------ ----------- Tax certificates-net $ 120,295 - - 120,295 Asset-backed securities 129 - - 129 Treasury bills 3,514 - - 3,514 Repurchase agreements 725 - - 725 Certificate of deposits 220 - - 220 Other securities 164 - - 164 -------- ------- ------- ------- Total tax certificates and other investment securities $ 125,047 - - 125,047 ========= ======= ======= ======= Included in tax certificates and other investment securities at December 31, 1993 was approximately $3,304,000, $16,881,000 and $459,000 of U.S. Treasury Bills, commercial paper and other investments, respectively. Market value at December 31, 1993 approximates book value. See note 2 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 4. LOANS RECEIVABLE - NET Loans receivable, net consist of the following (in thousands): 1993 1992 ------- ------- Real estate loans: Conventional mortgages - $ 147,654 Conventional mortgages available for sale - 7,641 Construction and development - 12,961 FHA and VA insured - 9,854 Commercial 13,161 170,257 Other loans: Second Mortgages - 72,508 Commercial (non-real estate) - 33,071 Deposit overdrafts - 356 Installment loans held by individuals - 140,553 -------- -------- 13,161 594,855 Deduct: Undisbursed portion of loans in process - 6,492 Deferred loan fees, net - 55 Unearned discounts on purchased loans - 29 Unearned discounts on installment loans - 1,704 Deferred profit related to real estate sales 3,982 4,052 Allowance for loan losses - 16,500 ------- ------- Loans receivable - net $ 9,179 566,023 ======= ======= Included in loans receivable, net at December 31, 1993 and 1992 was approximately $8,083,000 and $8,252,000, respectively, of loans due from affiliates. Activity in the allowance for loan losses is (in thousands): For the Years Ended December 31, ------------------------------ 1992 1991 ------ ------ Balance, beginning of period $ 13,750 $ 15,741 Charge-offs: Commercial loans (776) (1,694) Installment loans (10,430) (18,903) Real estate mortgages (1,473) (259) ---------- -------- (12,679) (20,856) ---------- -------- Recoveries: Commercial loans 175 191 Installment loan 8,584 1,035 Real estate mortgages 20 99 ---------- --------- 8,779 1,325 ---------- --------- Net charge-offs (3,900) (19,531) Additions charged to operations 6,650 17,540 ---------- --------- Balance, end of period $ 16,500 $ 13,750 ========== ========= Average outstanding loans during the period $ 662,809 $ 891,385 ========== ========= Ratio of net charge-offs to average outstanding loans .59% 2.19% ========== ========= See note 3 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 5. MORTGAGE-BACKED SECURITIES See note 4 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 6. ACCRUED INTEREST RECEIVABLE Accrued interest relates to the following (in thousands): 1993 1992 ------ ------ Loans receivable $ - $ 4,166 Tax certificates and other investment securities 8 14,370 Mortgage-backed securities - 3,660 ------- ------- $ 8 $ 22,196 ======= ======== See note 5 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 7. NON-PERFORMING ASSETS AND RESTRUCTURED LOANS See note 6 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 8. REAL ESTATE ACQUIRED IN DEBENTURE EXCHANGE Real estate acquired in debenture exchange consists of the following (in thousands): December 31 --------------------------- Estimated Lives 1993 1992 --------------- -------- ------- Land - $ 3,912 4,074 Buildings and improvements 14 to 31.5 years 29,509 31,126 -------- ------- 33,421 35,200 Less: Accumulated depreciation 5,295 3,942 Deferred profit 7,957 7,957 Allowance for real estate owned (a) 1,854 2,971 -------- ------- 15,106 14,870 -------- ------- $ 18,315 20,330 ======== ======= (a) The Company provided an allowance for three properties' net carrying value in 1992 and 1991 of $2,971,000 and $2,882,000, respectively, based on estimated sales price. During 1993 the allowance declined because one of the three properties was deeded back to the lender. In connection to the property deeded back to the lender the following 1993 non-cash items were removed from the financial statements: Land $ 162 Building 2,200 Less: accumulated depreciation 281 ----- 2,081 Less: prior years write-down of real estate 1,117 ----- Mortgage payables eliminated 954 Accrued interest payable eliminated 10 ----- - ===== Condensed operations and significant cash flows for real estate acquired in the debenture Exchange is as follows for the year ended December 31, 1993, 1992 and 1991 (in thousands) (a): 1993 1992 1991 -------- -------- ------- Operating Information: - ---------------------- Revenues: Property operations $ 6,805 9,724 9,257 Net gain (loss) on sales and dispositions - 2,935 2,643 Deferred (gain) loss on sales and dispositions - (2,935) (2,643) -------- -------- ------- Net revenues 6,805 9,724 9,257 -------- -------- ------- Cost and expenses: Mortgage interest 2,514 3,524 3,319 Depreciation 1,633 2,239 2,003 Property operating expenses 3,483 4,250 3,790 Write-down of real estate - 89 2,882 -------- -------- ------- Total costs and expenses 7,630 10,102 11,994 -------- -------- ------- Excess (deficit) of revenues over expenses (825) (378) (2,737) ======== ======== ======= Cash Flow Information: Operating activities: Excess (deficit) of revenues over expenses $ (825) (378) (2,737) Depreciation 1,633 2,239 2,003 Write down of real estate - 89 2,882 ------- ------- ------ Cash provided by operating activities 808 1,950 2,148 ------- ------- ------ Investing activities: Proceeds from sales of real estate (b) - 5,563 7,598 Property improvements (582) (606) (1,094) ------- -------- ------ Net cash provided by investing activities (582) 4,957 6,504 ------- -------- ------ Total cash provided $ 226 6,907 8,652 ======= ======== ====== (a) Operating and cash flow information does not include interest expense for the debentures issued in connection with the acquisition of this real estate. Mortgage interest is included with "Interest Other", interest on loans receivable is included with "Interest and fees on loans" and interest on other investments is included with "Interest and dividends on tax certificates and other investment securities" in the accompanying statements of consolidated operations. See also note 2 for additional information on the debenture Exchange and sale of properties. (b) In connection with the 1992 sales of two properties acquired in the 1991 Exchange, BFC has agreed to limit disposition of proceeds from the sales pending resolution of certain litigation. (Approximately $3.5 million.) (See also note 2.) 9. OFFICE PROPERTIES AND EQUIPMENT Office properties and equipment consist of the following (in thousands): December 31, ------------ Estimated Lives 1993 1992 --------------- ------ ------ Land - $ - 9,838 Buildings and improvements 30 to 50 years - 35,158 Furniture and equipment 5 to 10 years 1,259 14,071 ------ ------ Total 1,259 59,067 Less accumulated depreciation 1,231 23,035 ------ ------ Office properties and equipment-net $ 28 36,032 ====== ====== See note 7 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 10. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES See note 20 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 11. Other Assets A detail of other assets at December 31, 1993 and 1992 follows (in thousands): 1993 1992 ---- ---- Other intangible assets, net: Excess of fair value of pension plan assets over projected benefit obligation $ - 1,048 Loan servicing fees - - Purchased servicing rights, net of amortization - 7,282 Repossessed collateral on consumer loans - 461 Receivable from insurance carrier - 6,485 Other 2,807 6,280 ------ ------ $ 2,807 21,556 ====== ====== 12. DEPOSITS Deposits at December 31, 1992 are as follows (in thousands): Weighted Average Rate at 1992 ---- December 31, 1992 Amount Percent ----------------- ------ ------- Interest-free checking - $ 52,426 4.73% Insured money fund savings 3.07% 330,255 29.80% NOW accounts 1.61% 143,580 12.96% Savings accounts 2.06% 130,379 11.77% ------- ------ Total non-certificate accounts 2.30% 656,640 59.26% ------- ------ Certificate accounts: 0.00% to 3.00% - 72,657 6.56% 3.01% to 4.00% - 164,378 14.83% 4.01% to 5.00% - 87,327 7.89% 5.01% to 6.00% - 47,015 4.24% 6.01% to 7.00% - 35,939 3.24% 7.01% and greater - 44,012 3.97% ------- ------ Total certificate accounts 4.46% 451,328 40.73% ------- ------ Total deposit accounts 1,107,968 99.99% --------- ------ Interest earned not credited to deposit accounts 147 .01% --------- ------ Total 3.18% $ 1,108,115 100.00% ========= ======= Interest expense by deposit category is (in thousands): For the Years Ended December 31, ---------------------- 1992 1991 ---- ---- Money fund savings and NOW accounts $ 14,028 24,861 Savings accounts 3,298 5,101 Certificate accounts 30,319 53,842 Less early withdrawal penalty (252) (577) ------ ------ Total $ 47,393 83,227 ====== ====== See note 8 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 13. ADVANCES FROM FEDERAL HOME LOAN BANK See note 9 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 14. SECURITIES SOLD UNDER AGREEMENT TO REPURCHASE See note 10 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 15. CAPITAL NOTES AND OTHER SUBORDINATED DEBENTURES, COMMON STOCK WARRANTS, AND COMMON STOCK OPTIONS AT BANKATLANTIC See note 11 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 16. INTEREST RATE SWAPS In March 1991, a $35.0 million interest rate swap expired. This agreement called for fixed rate interest payments by BankAtlantic of 12.00% in exchange for variable rate payments based on the corporate bond equivalent of the three month U.S. Treasury Bill rate. The net interest expense relating to interest rate swaps was approximately $450,000 for the year ended December 31, 1991 ($406,000 reflected in consolidation after purchase accounting adjustments). The impact related to these agreements on the Company's results of operations, after purchase adjustments, income taxes and minority interests, is insignificant. (See note 2.) BankAtlantic was exposed to credit loss in the event of nonperformance by the other party to the agreements, however no performance by the counterparty was required during the term of the agreement. See note 12 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 17. MORTGAGES PAYABLE AND OTHER BORROWINGS Mortgages payable and other borrowings at December 31, 1993 and 1992 are summarized as follows (in thousands): Approximate Type of Debt Maturity Interest Rate 1993 1992 - ------------ -------- ------------- ---- ---- Related to mortgage 6% - Prime receivables 1994-2010 plus 1% $ 5,105 5,335 Related to real estate 1994-2003 7.75%- Prime plus 1.5% 24,312 25,814 Other borrowings 1994 Prime plus 1% 950 1,019 ------ ------ $ 30,367 32,168 ======= ====== All mortgage payables and other borrowings above are from unaffiliated parties. Included in 1993 and 1992 amounts related to other borrowings is approximately $950,000 and $1,019,000, respectively due to financial institutions. At December 31, 1993, $3,266,000 included above in related to real estate was in default. The Company and the lender have agreed to an extension but the terms and documentation have not yet been finalized. At December 31, 1993, $950,000 included above in other borrowings is in default. The lender has exercised the acceleration provision in the note and the Company is attempting to negotiate an extension. At December 31, 1993 the aggregate principal amount of the above indebtedness maturing in each of the next five years is approximately as follows (in thousands): Years ended December 31, Amount ------------ ------ 1994 $ 5,598 1995 4,524 1996 10,175 1997 4,065 1998 881 Thereafter 5,124 ------ $30,367 ====== The above amounts relate entirely to the Company and its subsidiaries other than BankAtlantic. The majority of the Company's (not including BankAtlantic) marketable securities, mortgage receivables and real estate acquired in the 1989 and 1991 debenture Exchange are as to real estate and marketable securities, encumbered by, or, as to mortgages receivable, subordinate to mortgages payable and other debt. (See also note 28.) In June 1991, BFC's $6.4 million credit line and unsecured $1.0 million line of credit were consolidated, restated and amended into a promissory note in the original principal amount of $5.0 million. Security for the $5.0 million note included 2,370,846 shares of BankAtlantic owned by BFC, deeds of trust on three properties and an assignment of a mortgage receivable. In October 1992, the above promissory note was satisfied and the collateral released. 18. INCOME TAXES BFC adopted FAS 109 as of January 1, 1993. The cumulative effect of this change in accounting for income taxes was a charge aggregating approximately $501,000. The tax effects of temporary differences that give rise to significant components of the deferred tax assets and tax liabilities at December 31, 1993 were (in thousands): Deferred tax assets: Real estate, net $ 1,898 Mortgages payable 7 Litigation accruals 2,205 Other liabilities 12 Net operating loss carryforwards 9,394 ----- Total gross deferred tax assets 13,516 Less: Valuation allowance 9,073 ------ Net deferred tax assets 4,443 Deferred tax liabilities: Investment in BankAtlantic 3,269 Exchange Debentures 3,212 ------ Total gross deferred tax liabilities 6,481 ------ Deferred income taxes at December 31, 1993 2,038 Deferred income taxes at January 1, 1993 2,038 ------ Deferred income tax expense for 1993 $ - ====== The provision for income tax expense (benefit) consists of the following (in thousands): For the Years Ended December 31, -------------------------------------- 1993 1992 1991 ---- ---- ---- Current: Federal $ - 6,469 (396) State - 201 - ----- ----- ----- $ - 6,670 (396) ----- ----- ----- Deferred : Federal - 1,792 (4,480) State - (17) - ----- ----- ----- - 1,775 (4,480) ----- ----- ----- Utilization of net operating loss carryforward (1): Federal - (389) - State - 1,145 - ----- ----- ----- - 756 - ----- ----- ----- Total $ - 9,201 (4,876) ===== ===== ====== (1) Represents extraordinary item, before minority interest of $208,000. A reconciliation from the statutory federal income tax rates of 35% in 1993, and 34% in 1992 and 1991 to the effective tax rate is as follows (in thousands): (1) Expected tax is computed based upon earnings (loss) before minority interest in BankAtlantic and extraordinary items. (2) Expected tax is computed based upon the Company's loss before equity in earnings of BankAtlantic. At December 31, 1993, the Company had estimated state net operating loss carry forwards for state income tax purposes of approximately $21,935,000 of which $793,000 expires in 2002, $3,240,000 expires in 2003, $586,000 expires in 2004 $2,757,000 expires in 2005, $2,001,000 expires in 2006, $4,235,000 expires in 2007 and $8,323,000 expires in 2008. The Company also has a net operating loss carry forward for federal income tax purposes of approximately $26,839,000 of which $237,000 expires in 2003, $1,089,000 expires in 2004, $5,237,000 expires in 2005, $4,743,000 expires in 2006, $7,181,000 expires in 2007 and $8,323,000 expires in 2008. BankAtlantic is not included in the Company's consolidated tax return. The Company made income tax payments of $1,900 and $3,600 during the years ended December 31, 1993 and 1992, respectively. See note 13 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 19. STOCKHOLDERS' EQUITY The Company's Articles of Incorporation authorize the issuance of up to 10,000,000 shares of $.01 par value preferred stock. The Board of Directors has the authority to divide the authorized preferred stock into series or classes having the relative rights, preferences and limitations as may be determined by the Board of Directors without the prior approval of shareholders. The Board of Directors has the power to issue this preferred stock on terms which would create a preference over the Company's common stock with respect to dividends, liquidation and voting rights. No further vote of security holders would be required prior to the issuance of the shares. The Company's Articles of Incorporation authorize the Company to issue 20,000,000 shares of Special Class A Common Stock, par value $.01 per share. To the extent permitted by law, the Special Class A Common Stock may be issued in one or more series as determined from time to time by the Board of Directors and having the relative rights and preferences determined by the Board of Directors which are set forth in the Articles of Incorporation. However, in no event will the voting rights of shares of Special Class A Common Stock equal or exceed the voting rights of the Company's present Common Stock. At such time as the Board of Directors authorizes the issuance of the newly created Special Class A Common Stock the Company's presently outstanding Common Stock will be automatically redesignated Class B Common Stock and holders thereof shall have the right at any time to convert their shares to shares of the Special Class A Common Stock on a one-for-one basis at the holder's sole election. 20. EARNINGS ON REAL ESTATE OPERATIONS Following are the components of earnings on real estate operations for each of the years in the three year period ending December 31, 1993 (in thousands) (a): 1993 1992 1991 ------ ------ ------ Deferred profit recognized $ 70 67 63 Operations of properties acquired in debenture Exchange (see note 8) 1,577 3,133 3,321 ------ ------ ------ $ 1,647 3,200 3,384 ====== ====== ====== (a) The above amounts relate entirely to the company and its subsidiaries other than BankAtlantic. 21. OTHER NON-INTEREST INCOME Included in other non-interest income is approximately $5.0 million, and $5.2 million of checking account fees for the years ended December 31, 1992, and 1991, respectively, and a $415,000 recovery of prior periods reconciliation differences was also included in other non-interest income for December 31, 1991. Also, included in other non-interest income for the years ended December 31, 1993, 1992, and 1991,is approximately $69,000, $69,000, and $273,000, respectively, of property management fees earned from services provided to affiliated public real estate partnerships. 22. RELATED PARTY TRANSACTIONS (a) Related party transactions arise from transactions with affiliated entities. In addition to transactions described in notes 2, 4 and 10, a summary of significant originating related party transactions is as follows (in thousands): Year Ended December 31, ------------------------ 1993 1992 1991 ------ ------ ------ Property management fee revenue $ 69 69 273 ===== ====== ====== Reimbursement revenue for administrative, accounting and legal services $ 114 143 339 ====== ====== ====== (b) The Company has a 49.5% interest and affiliates and third parties have a 50.5% interest in a limited partnership formed in 1979, for which the Company's Chairman serves as the individual General Partner. The partnership's primary asset is real estate subject to net lease agreements. The Company's cost for this investment (approximately $441,000) and was written off in 1990 due to the bankruptcy of the entity leasing the real estate. Any recovery will be recognized in income when received. (c) The Company had amounts due from affiliates as follows (in thousands): December 31, -------------- Description 1993 1992 ----------- ---- ---- 8.5% wraparound mortgage note, due in monthly installments until maturity in December 1998, when a balloon payment of $153,174 is due $ - 187 Other receivables, due primarily from affiliated partnerships collected in the subsequent quarter 129 235 ---- ---- $ 129 422 ==== ==== (d) Alan B. Levan, President and Chairman of the Board of the Company also serves as Chairman of the Board and Chief Executive Officer of BankAtlantic (e) John E. Abdo, a director of the Company also serves as Vice Chairman of the Board of Directors of BankAtlantic and President of BankAtlantic Development Corporation a wholly owned subsidiary of BankAtlantic. (f) In May 1986, the Company issued 895 shares of stock to an officer. The aggregate price, which was at the then market value of $19.00 per share, was approximately $17,000 and payment for the shares is in the form of a non-interest bearing note that matures in May 1996 and is secured by collateral other than the stock issued. (g) Florida Partners Corporation acquired 100,000 of the 850,000 shares of the common stock sold by the Company in February 1987 and, in June 1990, acquired in a privately negotiated transaction, an additional 33,314 shares of the Company's common stock. Alan B. Levan is the principal shareholder and Chairman of the Board of Florida Partners Corporation. Other members of the Company's Board of Directors also hold positions with Florida Partners Corporation. 23. EMPLOYEE BENEFIT PLANS The Company's 1983 Stock Incentive Plan provided for the grant of stock options to purchase up to 125,000 shares of the Company's common stock to various employees of the Company and its subsidiaries upon terms and conditions (including price, exercise date and number of shares) determined by a committee appointed by the Board of Directors to administer the plan. The exercise price of $12.00 per share was equal to or greater than the market price as of the date of grant. Such options generally become exercisable over an approximate four year period. The plan expired in 1992 and the 28,211 options outstanding at the end of 1991 were canceled. On November 19, 1993, BFC Financial Corporation's stockholders approved a Stock Option Plan under which options to purchase up to 250,000 shares of common stock may be granted. The plan provided for the grant of both incentive stock options and non-qualifying options. The exercise price of an incentive stock option will not be less than the fair market value of the common stock on the date of the grant. The exercise price of non-qualifying options will be determined by a committee of the Board of Directors. On November 22, 1993, in accordance with the terms of the Stock Option Plan, non-qualifying stock options for 10,000 shares of common stock were granted to non-employee directors. The options were issued at $4.50 per share, the fair market value at the date of grant. The Company has an employee's profit-sharing plan which provides for contributions to a fund, to be held in trust by a corporate fiduciary, of a sum as defined, but not to exceed the amount permitted under the Internal Revenue Service Code as deductible expense. The provision charged to operations was approximately $5,000 for each of the years ended December 31, 1993, 1992 and 1991. Contributions are funded on a current basis. 24. PENSION PLAN OF BANKATLANTIC See note 14 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 25. LITIGATION The following is a description of certain lawsuits to which the Company is a party. Timothy J. Chelling vs. BFC Financial Corporation, Alan B. Levan, I.R.E. Advisors Series 21, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida Case No. 89-1850-Civ Nesbitt. John D. Purcell and Debra A. Purcell vs. BFC Financial Corporation, Alan B. Levan, Scott Kranz, Frank Grieco, I.R.E. Advisors Series 23, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida, Case No. 89-1284- Civ-Ryskamp. William A. Smith and Else M. Smith vs. BFC Financial Corporation, Alan B. Levan and I.R.E. Advisors Series 24, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida, Case No. 89-1605- Civ-Marcus. These actions were filed by the plaintiffs as class actions during September 1989, June 1989 and August 1989, respectively. The actions arose out of an Exchange Offer made by the Company to the limited partners of I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23, and I.R.E. Real Estate Fund, Ltd. - Series 24. The plaintiffs, who were limited partners of the above named partnerships who did not consent to the Exchange Offer, brought this action purportedly on behalf of all limited partners that did not consent to the Exchange Offer. The Exchange Offer was made through the solicitation of consents pursuant to a Proxy Statement/Prospectus dated February 14, 1989 and was approved by the holders of a majority of the limited partnership interests of each of the Partnerships in March 1989. Messrs. Levan, Grieco and Kranz served as individual general partners of each of the Partnerships, and Mr. Levan is the President and a director of the Company. The plaintiffs alleged that the Proxy Statement/Prospectus contained material misstatements and omissions, that defendants violated the federal securities laws in connection with the offer and Exchange, that the Exchange breached the respective Limited Partners Agreement and that the defendants violated the Florida Limited Partnership statute in effectuating the Exchange. The complaint also alleged that the defendant general partners violated their fiduciary duties to the plaintiffs. In a memorandum opinion and order dated December 17, 1991, the Court granted the defendant's motion for summary judgement and denied the plaintiff's motion for summary judgement, ruling that the Exchange did not violate the partnership agreements or the Florida partnership statute. In July 1992, the Court granted summary judgment in favor of the defendants and dismissed the plaintiffs' claims for breach of fiduciary duty. Subsequently, the court entered summary judgment in favor of the defendants on all claims of misrepresentations or omissions except with respect to the statement in the Proxy Statement/Prospectus to the effect that BFC, Alan Levan and the Managing General Partners believed the Exchange transaction was fair. The case on that issue was tried in December 1992, and the jury returned a verdict in the amount of $8 million but extinguished approximately $16 million of debentures held by the plaintiffs. BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the reduction in its debt resulting from the verdict, but it nonetheless believes that the verdict was not supported by the evidence at trial. Based on the verdict, BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the extinguishment of the $16 million of outstanding debt. No amounts have been reflected in the financial statements because the judgement amount was less that the Company's carrying amount of the debentures and related accrued interest and because the Company intends to appeal the verdict. The court denied plaintiffs' motion for prejudgment interest as to Series 21 and Series 23 and awarded prejudgment interest to plaintiffs in Series 24 to be calculated to run from March 31, 1989 through December 18, 1992, the date of entry of final judgment, at the rate of 3.54%. The plaintiffs appealed the court's denial for prejudgment interest in Series 21 and Series 23. The Company also appealed the judgment as well as the court's denial of various post-trial motions filed by the Company. Pursuant to the request of the Eleventh Circuit Court of Appeals, the parties submitted briefs regarding the issue of whether the Eleventh Circuit has jurisdiction to hear the appeal. In February 1994, the Eleventh Circuit Court dismissed the appeal for lack of jurisdiction. In September 1993, the court granted the Company's motion to stay of the execution of the final judgment pending appeal and to allow alternative form of security. In December 1993, the Company filed with the district court a motion to correct the judgment to reflect the cancellation of the outstanding debentures, which motion is still pending. Arthur Arrighi, et al. vs. KPMG Peat Marwick, BFC Financial Corporation; Alan B. Levan; Frank V. Grieco; Glen Gilbert; Al DiBenedetto; BankAtlantic, A Federal Savings Bank; Georgeson & Company, Inc.,; First Equity Corporation of Florida; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors, Corp.; and National Realty Consultants, in the United States District Court for the District of New Jersey, Case No. 92-1206-CDR. This case was filed on March 20, 1992 by more than 2,000 former limited partners in Series 25, Series 27 and Income Fund. The complaint alleged that BFC and certain other defendants developed a fraudulent scheme commencing in 1972 to sell the plaintiffs limited partnership units with the undisclosed goal of later taking over the assets of the partnerships in exchange for securities in a new entity in which the defendant Alan B. Levan would be a major shareholder. The complaint further alleged that the defendants made material misrepresentations and omissions in connection with the sale of the original limited partnership units in the 1980s and in connection with the 1991 Exchange, and fraudulently tallied the votes in connection with the 1991 Exchange and Solicitation of Consents described above. On March 2, 1994, the parties entered into an agreement to settle this action pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Settlement of this matter will result in a gain to BFC for financial statement purposes. Marjory Meador, Shirley B. Daniels, Robert A. and Ruby L. Avans, and Dr. and Mrs. Czerny, individually and on behalf of all others similarly situated, Plaintiffs, vs. BFC Financial Corporation; BankAtlantic, A Federal Savings Bank; Alan B. Levan; I.R.E. Advisors Series 21, Corp.; I.R.E. Advisors Series 23, Corp.; I.R.E. Advisors Series 24, Corp.; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors Corp.; and First Equity Corporation of Florida; Defendants, in the Circuit Court of the Seventeenth Judicial Circuit in and for Broward County, Florida, Case No. 91- 29892 (CA-17). This action was filed as a class action during October 1991 and is brought on behalf of all persons who were limited partners in (a) I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23, or I.R.E. Real Estate Fund, Ltd. -Series 24 on the effective date of the 1989 Exchange Transaction not otherwise included in the action by limited partners who voted against the Exchange; or (b) were limited partners in I.R.E. Real Estate Fund, Ltd. - Series 25, I.R.E. Real Estate Fund, Ltd. - Series 27 or I.R.E. Real Estate Income Fund, Ltd. on the effective dates of the 1991 Exchange Transactions. The action alleges breach of the limited partnership agreements, breach of fiduciary duty, aiding and abetting a breach of fiduciary duty by BFC Financial Corporation and BankAtlantic, and negligent misrepresentation by all defendants. The action seeks damages in an unstated amount, imposition of a constructive trust on the assets of the exchanging partnerships, attorney's fees, costs and such other relief as the courts may deem appropriate. Plaintiffs have voluntarily dismissed all claims which arose out of or related to the 1991 Exchange. Shirley B. Daniels, Robert S. and Ruby L. Avans, and Dr. and Mrs. Czerny, individually and on behalf of all others similarly situated, Plaintiffs, vs. BFC Financial Corporation; BankAtlantic, A Federal Savings Bank; Alan B. Levan; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors Corp.; First Equity Corporation of Florida, Defendants, in the United States District Court for the Southern District of Florida, Fort Lauderdale Division, Case No. 92-6588-Civ-King. On January 18, 1991, BFC issued a prospectus and solicitation of consents in which it offered to exchange up to $17 million in subordinated unsecured debentures for all of the assets and liabilities of I.R.E. Real Estate Fund, Ltd.- ("Series 25"), I.R.E. Real Estate Fund, Ltd.- ("Series 27"), I.R.E. Real Estate ("Income Fund") and I.R.E. Pension Investors, Ltd the ("1991 Exchange"). The 1991 Exchange was approved by a majority of the limited partners in all of the partnerships except I.R.E. Pension Investors, Ltd. The Exchange subsequently was effectuated without I.R.E. Pension Investors, Ltd. In December 1992, plaintiffs filed an amended complaint, the result of which is to enlarge the class to all limited partners in the 1991 Exchange. Plaintiffs allege that the defendants orchestrated the Exchange for their own benefit and caused the issuance of the Exchange Offer and Solicitation of Consents, which contained materially misleading statements and omissions. The complaint contains counts against BFC for violations of the Securities Act and the Exchange Act. Plaintiffs also allege that Alan Levan and the managing general partners breached the limited partnership agreements, breached fiduciary duties and that BFC and BankAtlantic aided and abetted these alleged breach of fiduciary duties, that Alan Levan, the managing general partners, BFC and BankAtlantic committed fraud in connection with the 1991 Exchange and made certain negligent misrepresentations to the plaintiffs. The complaint seeks damages and prejudgment interest in an unspecified amount, attorneys' fees and costs. The defendants have filed an answer and affirmative defenses to the amended complaint. On March 2, 1994, the parties entered into an agreement to settle this action pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Settlement of this matter will result in a gain to BFC for financial statement purposes. Cheryl and Wayne Hubbell, et al., vs. I.R.E. Advisors Series 26, Corp. et al., in the California Superior Court in Los Angeles, California, Case No. BC049913. This action was filed as a class action during March 1992 on behalf of all purchasers of I.R.E. Real Estate Fund, Ltd. - Series 25, I.R.E. Real Estate Fund, Ltd. - Series 26, I.R.E. Real Estate Fund, Ltd. - Series 27, I.R.E. Real Estate Growth Fund, Ltd. - Series 28 and I.R.E. Real Estate Income Fund, Ltd. against the managing and individual general partners of the above named partnerships and the officers and directors of those entities. The plaintiffs allege that the offering materials distributed in connection with the promotions of these limited partnerships contained misrepresentations of material fact and that the defendants misrepresented and concealed material facts from the plaintiffs during the time the partnerships were in existence. The complaint asserts two causes of action for fraud, one of which is based on a claim for intentional misrepresentation and concealment and one of which is based on a claim of negligent misrepresentation. The complaint also contains a claim for breach of fiduciary duty. The complaint seeks unspecified compensatory and punitive damages, attorneys' fees and costs. Plaintiffs filed an amended complaint, which the Court dismissed in February 1993 pursuant to a motion to dismiss filed by the Defendants. Plaintiffs thereafter filed a second amended complaint in February 1993. which was also dismissed. Plaintiffs filed a third amended complaint which defendants answered in April 1993. Management intends to vigorously defend this action. Martha Hess, et. al., on behalf of themselves and all others similarly situated, v. Gordon, Boula, Financial Concepts, Ltd., KFB Securities, Inc., et al. In the Circuit Court of Cook County, Illinois. On or about May 20, 1988, an individual investor filed the above referenced action against two individual defendants, who allegedly sold securities without being registered as securities brokers, two corporations organized and controlled by such individuals, and against approximately sixteen publicly offered limited partnerships, including two partnerships that the Company acquired the assets and liabilities of in the 1991 Exchange transaction, (the "predecessor partnerships") interests in which were sold by the individual and corporate defendants. Plaintiff alleged that the sale of limited partnership interests in the predecessor partnerships (among other affiliated and unaffiliated partnerships) by persons and corporations not registered as securities brokers under the Illinois Securities Act constitutes a violation of such Act, and that the Plaintiff, and all others who purchased securities through the individual or corporate defendants, should be permitted to rescind their purchases and recover their principal plus 10% interest per year, less any amounts received. The predecessor partnerships' securities were properly registered in Illinois and the basis of the action relates solely to the alleged failure of the Broker Dealer to be properly registered. In November 1988, Plaintiff's class action claims were dismissed by the Court. Amended complaints, including additional named plaintiffs, were filed subsequent to the dismissal of the class action claims. Motions to dismiss were filed on behalf of the predecessor partnerships and the other co-defendants. In December 1989, the Court ordered that the predecessor partnerships and the other co-defendants rescind sales of any plaintiff that brought suit within three years of the date of sale. Under the Court's order of December 1989, one of the predecessor partnerships rescinded sales of $41,500 of units. Plaintiffs appealed, among other items, the Court's order with respect to plaintiffs that brought suit after three years of the date of sale In February 1993, the Appellate court ruled that the statute of limitations was tolled during the pendency of the class action claims. Therefore, those investors that brought suit within 3.6 years and potentially 4 years from the date of sale may be entitled to rescission. The Company and the other co- defendants sought leave to appeal before the Illinois Supreme Court and on October 6, 1993, the leave to appeal was denied. Plaintiff's claims are now pending in Circuit Court. Plaintiffs have indicated that they will file amended complaints against the predecessor partnerships and other co- defendants. The amended complaints will include both individual and class claims. The individual and corporate defendants sold a total of $1,890,500 of limited partnership interests in the predecessor partnerships. Limited partners holding approximately $1,042,800 of limited partnership interests have filed an action for recision. Under the appellate decision, if recision was made to all limited partners that filed an action, refunds, at March 31, 1993, (including interest payments thereon) would amount to approximately $1,800,000. A provision for such amount has been made in the accompanying financial statements. Short vs. Eden United, Inc., et al. in the Marion County Superior Court, State of Indiana. Civil Division Case No. S382 0011. In January, 1982, an individual filed suit against a subsidiary of the Company, Eden United, Inc. ("Eden"), seeking return of an earnest money deposit held by an escrow agent and liquidated damages in the amount of $85,000 as a result of the failure to close the purchase and sale of an apartment complex in Indianapolis, Indiana. Eden was to have purchased the apartment complex from a third party and then immediately resell it to plaintiff. The third party was named as a co-defendant and such third party has also filed a cross claim against Eden, seeking to recover the earnest money deposit. In September 1983, Plaintiff filed an amended complaint, naming additional subsidiaries of the Company and certain officers of the Company as additional defendants. The amended complaint sought unspecified damages based upon alleged fraud and interference with contract. In interrogatory answers served in September 1987, Plaintiff stated for the first time that he was seeking damages in the form of lost profits in the amount of approximately $6,350,000. The case went to trial during October 1988. On April 26, 1989, the Court entered a judgement against Eden, the Company and certain additional subsidiaries of the Company jointly and severally in the sum of $85,000 for liquidated damages with interest accruing at 8% per annum from September 1, 1981, normal compensatory damages of $1.00, and punitive damages in the sum of $100,000. The judgement also rewards the Plaintiff the return of his $85,000 escrow deposit, and awards the third party $85,000 in damages plus interest accruing from September 14, 1981 against Eden. The Company has charged expense for the above amounts. Both Short and the Company appealed the judgement and in June 1991, the appellate court reversed the trial court's decision on the issue of compensatory damages, determined that Short may be entitled to an award of compensatory damages and remanded the case to the trial court to determine the amount of compensatory damages to be awarded. The Indiana Supreme Court denied review. A hearing on remand was held on February 3, 1993. On February 25, 1994, the court on remand awarded plaintiff a judgment in the amount of $85,000 for liquidated damages for breach of contract jointly and severally from the subsidiary, the Registrant and certain named affiliates, plus prejudgment interest of $52,108 through May 1, 1989, plus post-judgment interest of 10% per annum thereafter until paid. Additionally, plaintiff was awarded a judgment against the defendants in the amount of $2,570,000 for tortious interference, plus prejudgment interest of $469,400 through May 1, 1989, plus post-judgment interest of 10% per annum thereafter until paid. The Registrant which was advised of the courts decision on March 2, 1994 intends to appeal the trial court's order. A provision for the above is included in the accompanying financial statements. Scott Kranz and Investment Management Group, Inc. vs. Alan B. Levan, BFC Financial Corporation, I.R.E. Investments, Inc., Frank V. Grieco, I.R.E. Advisors Series 23, Corp., I.R.E. Advisors Series 24, Corp., I.R.E. Advisors Series 25, Corp., I.R.E. Advisors Series 26, Corp., and I.R.E. Real Estate Institutional Corp., in the Eleventh Judicial Circuit in and for Dade County, Florida, Case No. 85-08751 (the "employment case"), Scott G. Kranz in the name of I.R.E. Realty Advisory Group, Inc., vs I.R.E. Realty Advisory Group, Inc. et al in the Eleventh Judicial Circuit in and for Dade County, Florida, Case No. 84-40012 (CA25) (the "appraisal case"). On March 5, 1985 Scott Kranz and Investment Management Group, Inc. filed suit seeking damages in excess of $1,800,000 and punitive damages of at least $10,000,000 plus costs. Investment Management Group, Inc. ("IMG") is a real estate development corporation of which Scott Kranz is the President. Until his termination on August 1, 1984, Scott Kranz was associated with Registrant and/or various of its affiliates either individually or through IMG. The Complaint alleges that Alan B. Levan, acting on his own behalf and on behalf of Registrant and certain unnamed affiliates and in combination with one or more unnamed defendants wrongfully caused the termination of certain contractual relationships between the Company and Scott Kranz and IMG and of Scott Kranz as general partner of five publicly registered real estate limited partnerships. On October 29, 1984, Scott G. Kranz, a 10% shareholder of I.R.E. Realty Advisory Group, Inc. ("RAG"), of which Registrant is a 50% shareholder, filed suit in the name of RAG seeking a declaration of the rights and liabilities of the parties in relation to a merger effective August 21, 1984 by and among Gables Advisors, Inc., I.R.E. Real Estate Funds, Inc. and RAG. Plaintiff seeks damages in the amount of the fair market value of his shares in RAG as of the day before the merger. He further claims punitive damages, attorneys fees and costs. On January 30, 1985, plaintiff amended his complaint, to add claims of breach of statutory duty and willful failure to submit the merger transactions to a vote at a meeting of shareholders, in addition to a claim for punitive damages. On June 17, 1985, Plaintiff again amended his complaint adding a claim of constructive fraud. In March 1986, Plaintiff's motion for summary judgement was denied. On January 21, 1987, the Court ordered this action consolidated for trial with the action described immediately above. Defendants denied Plaintiff's claims and filed a counterclaim. The defendants also filed a motion to strike all of Kranz's and IMG's pleadings in both cases and to enter a default judgement against Kranz and IMG for gross and continuing violations of discovery orders. By order dated June 26, 1990, the judge struck all of the pleadings filed by Kranz and IMG including both of their complaints and both of their answers to the Company's counterclaims. On February 12, 1991, the trial judge entered final judgement in favor of the individual defendants, Alan Levan and Frank Grieco, specifically reserving jurisdiction for further proceedings as to the corporate entities to enter final judgement against the plaintiffs on the complaint. Kranz and IMG appealed the judgement in favor of the individual defendants and the judgement was affirmed. The corporate defendants have filed a motion for entry of judgment against Kranz and IMG and requesting damages and attorney's fees. Joseph Roma vs. I.R.E. Advisors Series 29, Corp., et al., in the Circuit Court of Cook County, Illinois, County Department, Chancery Division, Case No. 91CH2429. - This action was filed as a class action during March 1991. The action, brought on behalf of investors in I.R.E. Real Estate Fund, Ltd. - Series 29 ("Series 29"), alleged fraud and fraudulent inducement, breach of fiduciary duty, negligent misrepresentation and violations of the Blue Sky Laws by defendants relating to their promotion, marketing, control and management of Series 29, a public limited partnership. The action sought rescission of the investments, contracts and agreements relating to investments in Series 29, damages in an unstated amount and other relief as the court deemed appropriate. This action was dismissed by the court. Plaintiffs appealed such dismissal and in February 1994, the Appellate Court affirmed the dismissal as in favor of all defendants. John F. Weaver, Trustee for the Bankruptcy Estate of Milton A. Turner vs. I.R.E. Real Estate Investments, Inc., in the United States Bankruptcy Court for the Eastern District of Tennessee, Case No. 3-89-01210. - On July 25, 1991, an action was filed by John Weaver alleging that the conveyance of Turner's equity of $1,642,001 under a wrap note to I.R.E. Real Estate Investments, Inc. (successor to I.R.E. Real Estate Fund, Ltd. - Series 23) in connection with the sale of property by Series 23 to Turner was a fraudulent conveyance, as defined, in that Turner conveyed an asset, namely the cancellation of a wrap note and wrap trust, without fair consideration while insolvent. The trial on the complaint to avoid fraudulent conveyance was heard before the Bankruptcy Court in May 1993. Judgment was entered in favor of BFC and the complaint was dismissed. No appeal was taken from the judgment and it is now final. Alan B. Levan and BFC Financial Corporation v. Capital Cities/ABC, Inc. and William H. Wilson, in the United States District Court for the Southern District of Florida, Case No. 92-325-Civ-Atkins. On November 29, 1991, The ABC television program 20/20 broadcast a story about Alan B. Levan and BFC which purportedly depicted some securities transactions in which they were involved. The story contained numerous false and defamatory statements about the Company and Mr. Levan and, February 7, 1992, a defamation lawsuit was filed on behalf of the Company and Mr. Levan against Capital Cities/ABC, Inc. and William H. Wilson, the producer of the broadcast. In July 1993, a magistrate recommended that summary judgment be entered against Mr. Levan on their defamation claims. Objections to and an appeal from that recommendation were filed with the presiding judge. Such appeal remains pending. On March 21, 1988, an action captioned Elliot Borkson, et al. vs. Alan Levan, Jack Abdo and BankAtlantic, Case No. 88-12063, was filed by a group of approximately 54 shareholders of BankAtlantic in the Circuit Court of the Eleventh Judicial Circuit in and for Dade County, Florida. The complaint alleges that Messrs. Levan and Abdo breached their fiduciary duties as directors of BankAtlantic by disregarding the rights of minority shareholders under a certain option agreement between BFC and a third party dated April 9, 1986, by taking actions to depress the value of BankAtlantic's stock, by denying access to BankAtlantic's books and records and by allegedly wasting corporate assets. BankAtlantic is a nominal party to the proceeding. Plaintiffs seek punitive damages of $10.0 million, compensatory damages, attorneys' fees, costs and injunctive relief. Discovery is proceeding and the defendants are vigorously defending the action. No trial date has been set. Counsel has obtained a letter from counsel for plaintiffs in which counsel for plaintiffs conclude that there is insufficient evidence to maintain the claim against the defendants. This matter has been set for jury trial during the two-week period commencing June 6, 1994. Elliot Borkson, et al vs. BFC Financial Corporation. Circuit Court of the 11th Judicial Circuit in and for Dade County Florida. Case No. 88-11171 (CA 10). In March 1988, a group of approximately 54 shareholders of BankAtlantic filed a class action suit against Registrant alleging Registrant had breached its agreement, contained in an option agreement ("the Pearce Agreement") pursuant to which Registrant had purchased shares of BankAtlantic, to offer to acquire all of the remaining outstanding shares of BankAtlantic at a price equal to the greater of (i) $18 per share or (ii) an amount per share which, in the opinion of an investment banking firm of recognized national standing, is fair to the stockholders of BankAtlantic. Such obligation was subject to receipt of all required regulatory approvals and was relieved if there occurred a material adverse change in financial conditions affecting the savings and loan industry. Plaintiffs seek to recover compensatory damages arising from Registrant's alleged breach of contract, costs, interest and attorneys fees. In April 1988, BankAtlantic joined in a motion to stay the proceedings pending resolution of a similar action filed in Pennsylvania and transferred to the United States District Court for the Southern District of Florida. The stay with respect to the proceedings remains in effect. Marvin E. Blum, et al vs. BFC Financial Corporation; Alan B. Levan and Jack Abdo. Case No. 88-6277, U.S. District Court for the Southern District of Florida. This litigation was commenced on February 11, 1988, by International Apparel Associates as a class action against BFC Financial Corporation and Alan Levan. Subsequently, the Borkson plaintiffs and their counsel were substituted for International Apparel, with Dr. Marvin Blum being designated as the class representative. Jack Abdo was also added as a party defendant. The plaintiff class was certified by the district court as "all persons, other than defendants, and their affiliates, officers, and members of their immediate family who owned shares of BankAtlantic common stock on February 6, 1988, or their successors in interest". The Second Amended Complaint, upon which this action is presently based, asserts a claim for breach of contract and a claim for violation of Section 10(b) of the Securities Exchange Act of 1934. Plaintiffs allege that they, as minority shareholders of BankAtlantic, A Federal Savings Bank, are third party beneficiaries of an option agreement between BFC Financial Corporation and Dr. Pearce requiring BFC Financial Corporation to offer to purchase all their shares of BankAtlantic subject to certain conditions. Plaintiffs claim that none of the conditions set forth in the Pearce Agreement arose to excuse BFC Financial Corporation from offering to buy the shares; defendants claim that those conditions did in fact occur and that BFC Financial Corporation did not, therefore, have any obligation to offer to purchase the shares. Plaintiffs also allege that defendants made certain misrepresentations regarding their intentions to perform pursuant to the Pearce agreement, which defendants deny. Settlement negotiations, which had been progressing, have terminated. The plaintiffs have requested that this matter be rescheduled for trial. Pretrial conference has been conducted, however, no trial date has been set. During 1989 and 1991, the Company exchanged subordinated debentures for the assets and liabilities of certain affiliated partnerships. While, to the Company's knowledge, no formal order of investigation is pending, the Securities and Exchange Commission ("SEC") has advised the Company that it is currently reviewing the transactions. 26. COMMITMENTS AND CONTINGENCIES See note 15 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 27. QUARTERLY FINANCIAL INFORMATION (unaudited) Following is quarterly financial information for the years ended 1993, 1992 and 1991 (in thousands, except per share data): During the fourth quarter of 1993, the company's ownership interest in BankAtlantic's decreased from 77.83% to 48.17% with the ownership percentage less than 50% the accounts of BankAtlantic Financial Corporation have been removed from the consolidated financial statement and the company's investment in BankAtlantic Financial Corporation is recorded using the equity methods. The effect of this change has been applied effective January 1, 1993. The company's quarterly filings for the first three quarters of 1993 were done with the accounts of BankAtlantic Financial Corporation on a consolidated basis but are reflected herein without the inclusion of the accounts of BankAtlantic Financial Corporation. During the fourth quarter 1992, BankAtlantic sold approximately $115.4 million of mortgage-backed securities at a gain of $6.8 million including purchase accounting adjustments of $1.6 million. Additionally, BankAtlantic recovered $3.3 million in expenses, recorded loan loss recoveries of $7.3 million and increased interest income by $1.9 million for circumstances relating to the Subject Portfolio and the Covenant Not to Execute discussed in note 30. Also during the fourth quarter, the Company recorded a $548,000 ($.32 per share) extraordinary gain, net of minority interest of $208,000 from the utilization of state net operating loss carryforwards. During the quarter ended March 31, 1991, an extraordinary gain of $350,000 net of applicable taxes and minority interest amounting to $340,000 and $197,000, respectively, was attributable to the early extinguishment of 1986 Notes. 28. PARENT COMPANY FINANCIAL INFORMATION A summary of the Company's condensed statements of financial condition as of December 31, 1993 and 1992, and condensed statements of operations and cash flows for each of the years in the three year period ended December 31, 1993 follows (in thousands): STATEMENTS OF FINANCIAL CONDITION ASSETS December 31, ------------ 1993 1992 ---- ---- Cash and short term investments $ (21) 133 Investments - other 17,169 489 Investment in BankAtlantic 36,436 42,984 Investment in other subsidiaries 34,562 40,125 Mortgages receivable 1,097 1,110 Subordinated debentures receivable from BankAtlantic - 1,776 Other assets 923 944 ------ ------ $ 90,166 87,561 ====== ====== LIABILITIES AND STOCKHOLDERS' (DEFICIT) December 31, ------------ 1993 1992 ---- ---- Exchange debentures, net $ 35,651 38,996 Mortgages payable and other debt 1,250 1,323 Deferred interest exchanged debentures 12,049 6,126 Other liabilities (primarily due to subsidiaries 40,390 38,218 other than BankAtlantic) Deferred income tax 2,038 2,038 ------ ------ Total liabilities 91,378 86,701 Redeemable common stock 5,776 5,776 Stockholders' (deficit) Preferred stock of $.01 par value; authorized 10,000,000 shares; none issued - - Special class A common stock of $.01 par value; authorized 20,000,000 shares: none issued - - Common stock of $.01 par value; authorized 20,000,000 shares; issued 2,351,021 in 1993 and 1992 17 17 Additional paid in capital 15,264 15,532 Accumulated deficit (21,989) (20,185) Treasury stock (45,339 shares in 1993 and 1992) (280) (280) ------ ------- Total stockholders' (deficit) (6,988) (4,916) ------ ------- $ 90,166 87,561 ======= ======= STATEMENTS OF OPERATIONS 1993 1992 1991 ---- ---- ---- Revenue-interest and other $ 1,834 1,062 1,672 Expenses-interest and other 8,338 9,495 7,759 ------ ------ ------- (Loss) before equity in earnings (loss) of subsidiaries and extraordinary items (6,504) (8,433) (6,087) Equity in earnings (loss) of BankAtlantic before extraordinary items and cumulative effect of change in accounting for income taxes 10,764 12,135 (6,926) Equity in (loss) of other subsidiaries (5,563) (1,693) (4,696) ------ ------ ------- Earnings (loss) before income taxes, extraordinary items and cumulative effect of change in accounting for income taxes (1,303) 2,009 (17,709) Income tax benefits - - - ------ ------ ------- Earnings (loss) before extraordinary items and cumulative effect of change in accounting for income taxes (1,303) 2,009 (17,709) Cumulative effect of change in accounting for income taxes (501) - - Extraordinary item related to BankAtlantic - 548 350 ------ ------ ------- Net earnings (loss) $ (1,804) 2,557 (17,359) ====== ====== ======= STATEMENTS OF CASH FLOWS 1993 1992 1991 ---- ---- ---- Operating Activities: Earnings (loss) before extraordinary items and cumulative effect of change in accounting for income taxes (1,303) 2,009 (17,709) Adjustments to reconcile earnings (loss) to net cash used by operating activities: Equity in (earnings) loss of BankAtlantic before extraordinary item (10,764) (12,135) 6,926 Equity in net loss of other subsidiaries 5,563 1,693 4,696 Depreciation 25 11 18 Amortization of discount on loans receivable - (43) (238) Accretion on subordinated debentures 173 320 539 Tax effect on debentures (65) (107) (142) Gain on sale of real estate owned - (90) - Loss of mortgage receivables - 209 17 Gain on sale of BankAtlantic common stock (1,050) - - Increase in deferred interest on the exchange debentures 5,923 4,985 1,140 Decrease (increase) in other assets 215 269 (51) Increase (decrease) in other liabilities 362 1,811 (287) ------ ------ ------ Net cash used by operating activities (921) (1,068) (5,091) ------ ------ ------ Investing Activities: Cash used in debenture exchange - - (282) Loans purchased or originated - - (2,182) Principal collected on loans 13 1,013 87 Proceeds from sale of BankAtlantic common stock 17,691 - - Dividends from BankAtlantic common stock 271 - - Increase in investment in BankAtlantic (1,971) (88) Decrease (increase) in other investments (16,680) 717 (1,206) Increase (decrease) in subordinated debentures of BankAtlantic 1,776 (1,025) (751) Advances (to) and from other subsidiaries (228) 3,273 13,403 Additions to office properties and equipment (32) (17) (11) Proceeds from sale of real estate owned - 429 - ------ ------ ------ Net cash provided by investing activities 840 4,390 8,970 ------ ------ ------ Financing Activities: Borrowings - - 1,722 Repayment of borrowings (73) (3,098) (5,395) Purchase of treasury stock - - (53) Loan cost - - (160) ------ ------- ------ Net cash (used) by financing activities (73) (3,098) (3,886) ------ ------- ------ Increase (decrease) in cash and short term investments (154) 224 (7) Cash and short term investments at beginning of period 133 (91) (84) ------ ------- ------ Cash and short term investments at end of period $ (21) 133 (91) ====== ======= ======= Interest paid on other borrowings and subordinated debentures amounted to approximately $94,000, $342,000 and $3,720,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Income taxes paid amounted to approximately $3,600, and $4,000 for the years ended December 31, 1992, and 1991 respectively. Non-cash investing activities during 1991 consisted of the Company's capitalization of subsidiaries contribution of the real estate, related mortgage debt and other assets and liabilities received by the Company in Exchange for its issuance of subordinated debentures. (See note 2.) Other non-cash investing and financing activities of BFC are the retirement of treasury stock, the issuance of redeemable common stock, loans transferred to real estate owned and proceeds from sale of real estate owned. Short term investments are defined as those investments with a maturity of three months or less. For a description of dividend restrictions related to BankAtlantic, see note 16 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 29. REGULATORY MATTERS See note 16 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 30. Dealer Reserve See note 17 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 31. Consolidated Statements of Cash Flows In addition to the non-cash investing and financing activities described in notes 2 and 8, other non-cash investing and financing activities are as follows: December 31, -------------------- 1993 1992 1991 ------ ------ ------ Retirement of treasury stock: Decrease in treasury stock $ - - 53 Decrease in common stock - - (1) Decrease in additional paid in capital - - l52 Securitization of loans - - 40,361 Loans transferred to REO and other repossessed assets - 7,994 10,810 Effect of issuance of BankAtlantic common stock to BankAtlantic minority stockholders 268 - - Loan charge-offs - 12,679 20,856 Costs of assets transferred to available for sale - 305,731 67,269 Mortgages eliminated in connection with sales of real estate acquired in debenture Exchanges - 8,821 6,951 Real estate owned charge-offs - 2,398 6,973 BankAtlantic dividends on common stock declared and not received 187 - - Interest paid on borrowings 2,948 59,933 99,980 32. Estimated Fair Value of Financial Instruments The information set forth below provides disclosure of the estimated fair value of the Company's financial instruments presented in accordance with the requirements of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (FAS 107) issued by the FASB. Management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, management has no basis to determine whether the fair value presented would be indicative of the value negotiated in an actual sale. The Company's fair value estimates do not consider the tax effect that would be associated with the disposition of the assets or liabilities at their fair value estimates. Fair value for the 1989 Exchange debentures is based upon the value established in a December 1992 jury verdict in connection with litigation regarding that transaction. With respect to the 1991 Exchange debentures, fair value has been determined based upon the amount included in a settlement agreement regarding litigation pertaining to those debentures. The following table presents information for the Company's financial instruments as of December 31, 1993 and 1992 (in thousands): 1993 1992 -------------- -------------- Carrying Fair Carrying Fair Amount Value Amount Value -------- ----- ------- ------- Financial assets: Cash and due from depository institutions $ 78 78 31,357 31,357 Mortgage-backed securities - - 486,886 498,995 Tax certificates and other investment securities 20,644 20,644 125,047 126,911 Loans receivable 9,179 9,179 582,523 607,153 Financial liabilities: Deposits - - 1,108,115 1,118,194 Securities sold under agreements to repurchase - - 21,532 21,532 Capital notes and other subordinated debentures - - 7,928 8,572 Mortgage payable and other borrowings 30,367 30,367 32,168 32,168 Exchange debentures, net 35,651 29,166 38,996 32,385 Advances from Federal Home Loan Bank - - 66,100 66,921 ======== ====== ======= ======= See note 21 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III -------- Items 10 through 13 is incorporated by reference to the Company's definitive proxy statement to be filed with the Securities and Exchange Commission, no later than 120 days after the end of the year covered by this Form 10-K, or, alternatively, by amendment to this Form 10-K under cover of Form 8 not later than the end of such 120 day period. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)-1 Financial Statements - See Item 8 (a)-2 Financial Statement Schedules - All schedules are omitted as the required information is either not applicable or presented in the financial statements or related notes. (a)-3 Index to Exhibits (3) Articles of Incorporation, as amended - See Exhibit (3) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. By-laws - See Exhibit E of Proxy Statement/Prospectus dated June 20, 1980. (4) Instruments defining the rights of security holders, including indentures - Not applicable. (9) Voting trust agreement - Not applicable. (10) Material contracts: - Proposed form of Supervisory Agreement. Attached as Exhibit 10. - Stock Purchase Agreement dated as of December 22, 1987 by and among John E. Abdo and certain members of his immediate family and BFC Financial Corporation. See Exhibit (10) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1987. (11) Statement re computation of per share earnings - Not applicable. (12) Statement re computation of ratios - Ratio of earnings to fixed charges - attached as Exhibit 12. (13) Annual Report to security holders, Form 10-Q or quarterly report to security holders - Not applicable. (16) Letter re change in certifying accountant - Not applicable. (18) Letter re change in accounting principles - Not applicable. (19) Previously unfiled documents - Not applicable. (22) Subsidiaries of the registrant: State of Name Organization ---- ------------ BankAtlantic, A Federal Savings Bank Federal Charter Realty 2000 Corporation Florida Eden Services, Inc. Florida Eden United, Inc. Florida First Pensacola Mortgage Company, Inc. Florida U.S. Capital Securities, Inc. Florida I.R.E. Property Analysts, Inc. Florida I.R.E. Realty Advisory Group, Inc. Florida I.R.E. Real Estate Investments, Inc. Florida I.R.E Real Estate Investments, Series 2, Inc. Florida I.R.E. Property Management, Inc. Florida I.R.E. Real Estate Funds, Inc. Florida I.R.E. Advisors Series 21, Corp. Florida I.R.E. Advisors Series 23, Corp. Florida I.R.E. Advisors Series 24, Corp. Florida I.R.E. Advisors Series 25, Corp. Florida I.R.E. Advisors Series 26, Corp. Florida I.R.E. Advisors Series 27, Corp. Florida I.R.E. Advisors Series 28, Corp. Florida I.R.E. Advisors Series 29, Corp. Florida I.R.E. Income Advisors Corp. Florida I.R.E. Pension Advisors, Corp. Florida I.R.E. Pension Advisors II, Corp. Florida (23) Published report regarding matters submitted to vote of security holders - Not applicable. (24) Consents of experts and counsel - Not applicable. (25) Power of attorney - Not applicable. (28) Additional exhibits - Not applicable. (b) Reports on Form 8-K No reports on Form 8-K have been filed during the last quarter of the period covered by this report. (c) Exhibits - See 14(a) - 3 above. (d) Financial statements of subsidiaries not consolidated and fifty percent or less owned persons: BankAtlantic, A Federal Savings Bank and Subsidiaries: Consolidated Financial Statements: Independent Auditors' Report Consolidated Statements of Financial Condition as of December 31, 1993 and 1992 Consolidated Statements of Operations for each of the years in the three year period ended December 31, 1993 Consolidated Statements of Stockholders' Equity for each of the years in the three year period ended December 31, 1993 Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 1993 Notes to Consolidated Financial Statements Selected Consolidated Financial Data Management's Discussion and Analysis of Results of Operations and Financial Condition 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. BFC FINANCIAL CORPORATION Registrant By: /S/ Alan B. Levan ------------------------------ Alan B. Levan, President 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. /S/ Alan B. Levan March 30, 1994 - ---------------------------------------- ALAN B. LEVAN, Director and Principal Executive Officer /S/ Glen R. Gilbert March 30, 1994 - ---------------------------------------- GLEN R. GILBERT, Chief Financial Officer /S/ John E. Abdo March 30, 1994 - ---------------------------------------- JOHN E. ABDO, Director /S/ Earl Pertnoy March 30, 1994 - ---------------------------------------- EARL PERTNOY, Director /S/ Carl E.B. McKenry, Jr. March 30, 1994 - ---------------------------------------- CARL E. B. McKENRY, JR., Director Consolidated Financial Statements: Independent Auditors' Report Consolidated Statements of Financial Condition as of December 31, 1993 and 1992 Consolidated Statements of Operations for each of the years in the three year period ended December 31, 1993 Consolidated Statements of Stockholders' Equity for each of the years in the three year period ended December 31, 1993 Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 1993 Notes to Consolidated Financial Statements Selected Consolidated Financial Data Management's Discussion and Analysis of Results of Operations and Financial Condition INDEPENDENT AUDITORS' REPORT The Board of Directors BankAtlantic, A Federal Savings Bank: We have audited the accompanying consolidated statements of financial condition of BankAtlantic, A Federal Savings Bank ("the Bank") and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Bank's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of BankAtlantic, A Federal Savings Bank and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 13, the Bank changed its method of accounting for income taxes on 1993 to adopt the provisions of the Financial Accounting Standard Board's SFAS No. 109, "Accounting for Income Taxes." March 8, 1994 KPMG Peat Marwick CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION December 31, 1993 1992 ---------- ---------- (In thousands, except share data) ASSETS Cash and due from depository institutions $ 36,351 31,208 Tax certificates and other investment securities (approximate market value $97,588 and $120,424) 97,701 120,424 Loans receivable (net of unearned discount of $2,944 and $1,733) 607,135 565,521 Loans originated for resale 5,752 7,641 Less: Allowance for loan losses (17,000) (16,500) ---------- ---------- Total loans receivable, net 595,887 556,662 ---------- ---------- Mortgage-backed securities (approximate market value: $453,346 and $353,984) 443,249 349,531 Mortgage-backed securities available for sale (approximate market value: $87,572 and $145,011) 83,116 137,963 Accrued interest receivable 17,574 22,188 Real estate owned 9,651 14,997 Office properties and equipment, net 37,373 38,596 Federal Home Loan Bank stock at cost, which approximates market value ($1,288 and $924 available for sale) 8,730 8,366 Purchased mortgage servicing rights 19,833 7,282 Deferred tax asset, net 423 - Other assets 9,307 15,854 ---------- ---------- Total assets $ 1,359,195 1,303,071 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Deposits $ 1,076,360 1,108,115 Advances from FHLB 128,300 66,100 Securities sold under agreements to repurchase 21,135 21,532 Capital notes and other subordinated debentures - 9,524 Drafts payable 573 1,246 Advances by borrowers for taxes and insurance 15,991 9,193 Other liabilities 26,184 18,816 Deferred income taxes, net - 2,380 ---------- ---------- Total liabilities 1,268,543 1,236,906 ---------- ---------- Commitments and contingencies Stockholders' equity: Non-cumulative preferred stock, $25.00 per share preference value, $0.01 par value: 10,000,000 shares authorized all series; 12.25% Series A, 188,600; 10.00% Series B, 17,120; 8.00% Series C, 129,870 3 3 Additional paid-in capital - preferred stock 7,033 7,033 Common stock, $0.01 par value, authorized 15,000,000 shares; issued and outstanding, 6,478,605 and 4,681,628 shares 65 41 Additional paid-in capital 46,726 29,394 Retained earnings 36,825 29,694 ---------- ---------- Total stockholders' equity 90,652 66,165 ---------- ---------- Total liabilities and stockholders' equity $ 1,359,195 1,303,071 ========== ========== See Notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- (In thousands, except per share data) Interest income: Interest and fees on loans $ 47,649 62,229 89,638 Interest on mortgage-backed securities 24,891 36,541 34,364 Interest on mortgage-backed securities available for sale 9,473 527 1,172 Interest and dividends on tax certificates and other investment securities 11,903 17,179 20,358 Other 587 - - ---------- ---------- ---------- Total interest income 94,503 116,476 145,532 ---------- ---------- ---------- Interest expense: Interest on deposits 31,798 47,411 83,253 Interest on advances from FHLB 2,359 3,725 3,603 Interest on securities sold under agreements to repurchase 1,082 2,881 1,671 Interest on capital notes and other subordinated debentures 748 1,550 2,014 Other - - 457 ---------- ---------- ---------- Total interest expense 35,987 55,567 90,998 ---------- ---------- ---------- Net interest income 58,516 60,909 54,534 Provision for loan losses 3,450 6,650 17,540 ---------- ---------- ---------- Net interest income after provision for loan losses 55,066 54,259 36,994 Non-interest income: Loan servicing and other loan fees 2,080 3,189 4,344 Gain on sales of loans 1,246 976 330 Gain on sales of mortgage-backed securities - 5,726 748 Gain on sales of investment securities - 143 62 Other 8,265 7,337 8,622 ---------- ---------- ---------- Total non-interest income 11,591 17,371 14,106 ---------- ---------- ---------- Non-interest expenses: Employee compensation and benefits 19,617 19,202 24,062 Occupancy and equipment 8,417 8,864 10,626 Federal insurance premium 2,750 2,772 3,281 Advertising and promotion 960 480 1,143 (Income) loss from joint venture investments 25 245 (2,335) Foreclosed asset activity, net 1,243 4,323 8,922 (Recovery) write-down of dealer reserve - (2,739) 2,739 Provision for branch consolidation - - 1,618 Other 10,474 13,990 15,108 ---------- ---------- ---------- Total non-interest expenses 43,486 47,137 65,164 ---------- ---------- ---------- (Continued) For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- Income (loss) before income taxes and extraordinary items 23,171 24,493 (14,064) Provision (benefit) for income taxes 7,093 9,201 (4,841) ---------- ---------- ---------- Income (loss) before extraordinary items 16,078 15,292 (9,223) Extraordinary items - 756 660 ---------- ---------- ---------- Net income (loss) 16,078 16,048 (8,563) Dividends on non-cumulative preferred stock paid by BFC escrow 147 880 715 Dividends on non-cumulative preferred stock 733 0 0 ---------- ---------- ---------- Total dividends on non-cumulative preferred stock 880 880 715 ---------- ---------- ---------- Net income (loss) on common shares $ 15,198 15,168 (9,278) ========== ========== ========== Income (loss) per common and common equivalent share: Income (loss) before extraordinary items $ 2.52 3.07 (2.12) Extraordinary items - 0.16 0.14 ---------- ---------- ---------- Net income (loss) $ 2.52 3.23 (1.98) ========== ========== ========== Income per common and common equivalent share assuming full dilution: Income before extraordinary item $ 2.51 2.65 N/A Extraordinary item - 0.14 N/A ---------- ---------- ---------- Net income $ 2.51 2.79 N/A ========== ========== ========== See Notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For Each of the Years in the Three Year Period Ended December 31, 1993 Additional Paid-in Additional Capital Common Paid-in Retained Preferred Preferred Stock Capital Earnings Stock Stock Total ----- -------- -------- -------- -------- -------- (In thousands) Balance, December 31, 1990 $ 41 29,385 23,804 - - 53,230 Net loss - - (8,563) - - (8,563) Dividends on preferred stock - - (715) - - (715) Conversion of subordinated debt to preferred stock - - - 3 7,033 7,036 Proceeds from issuance of common stock and warrants - 9 - - - 9 ----- -------- -------- -------- -------- -------- Balance, December 31, 1991 $ 41 29,394 14,526 3 7,033 50,997 Net income - - 16,048 - - 16,048 Dividends on preferred stock - - (880) - - (880) ----- -------- -------- -------- -------- -------- Balance, December 31, 1992 $ 41 29,394 29,694 3 7,033 66,165 Net income - - 16,078 - - 16,078 Dividends on preferred stock - - (880) - - (880) Dividends on common stock - - (738) - - (738) 15% common stock dividend 6 7,323 (7,329) - - 0 Common stock issued to BFC upon conversion of warrants 11 1,960 - - - 1,971 Proceeds from issuance of common stock 7 8,049 - - - 8,056 ----- -------- -------- -------- -------- -------- Balance 65 46,726 36,825 3 7,033 90,652 December 31, 1993 ===== ======== ======== ======== ======== ======== See Notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- (In thousands) Operating activities: Income (loss) before extraordinary item $ 16,078 15,292 (9,223) Adjustments to reconcile income (loss) before extraordinary item to net cash provided by operating activities: Provision for loan losses 3,450 6,650 17,540 Provision for declines in real estate owned 2,675 3,827 7,273 FHLB stock dividends (364) (498) (618) Depreciation 3,408 3,332 2,868 Amortization of purchased mortgage servicing rights 4,452 2,573 1,274 Increase (decrease) in deferred income taxes (2,803) 1,775 (4,480) Utilization of net operating loss carryforward - 756 - Net accretion of securities 9 (456) (243) Net amortization of deferred loan origination fees (794) (41) (40) Loss (gain) on sales of real estate owned (1,211) (648) 59 Proceeds from loans originated for sale 46,229 37,030 15,279 Origination of loans for sale (43,094) (39,888) (18,756) Gain on sales of loans (1,246) (976) (330) Gain on sales of mortgage-backed securities available for sale - (5,726) (748) Loss (gain) on sales of office properties and equipment 73 71 (7) Gain on sale of investment securities - (143) (62) Loss (income) from joint venture operations 25 245 (2,335) Decrease in accrued interest receivable 4,614 2,253 4,647 Amortization of dealer reserve 3,464 6,406 5,491 Prepayments of dealer reserve - - (1,417) Write-down of dealer reserve - - 2,739 (Increase) decrease in other assets 3,057 (4,567) 3,481 Decrease in drafts payable (673) (9,410) (1,403) Increase (decrease) in other liabilities 7,206 (757) 3,524 Write-off of office properties and equipment 222 - 461 Provision for branch consolidation - - 1,618 Provision for tax certificate losses 1,660 1,160 811 ---------- ---------- ---------- Net cash provided by operating activities $ 46,437 18,260 27,403 ---------- ---------- ---------- Investing activities: Proceeds from sales of investment securities$ - 2,137 30,235 Purchase of tax certificates and other investment securities (121,538) (125,197) (121,826) Proceeds from redemption and maturities of tax certificates and other investment securities 142,559 110,695 117,714 Loans purchased (5,142) - - Principal reduction on loans 289,037 297,263 298,076 Loans originated for portfolio (220,130) (136,179) (122,511) Bankers acceptances purchased (109,931) - - Proceeds from sales of mortgage-backed securities available for sale - 155,243 70,903 (Continued) For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- Mortgage-backed securities purchased (206,854) (271,041) (98,587) Principal collected on mortgage-backed securities 168,016 95,266 56,634 Proceeds from sales of real estate owned 6,278 11,113 2,937 Purchases and additional investments in real estate owned - - (1,374) Additions to office properties and equipment (2,525) (728) (1,026) Sales of office equipment 46 105 525 Advances to joint ventures - (26) (2,690) Repayments of advances to joint ventures - 77 12,929 Investments in joint ventures - - (115) Cash distributions from joint ventures - - 561 FHLB stock sales - 142 3,071 FHLB stock purchased - (65) - Settlement of amount due from broker - - 154,686 Servicing rights purchased (17,003) (3,832) (3,457) ---------- ---------- ---------- Net cash provided (used) by investing activities $ (77,187) 134,973 396,685 ---------- ---------- ---------- Financing activities: Net decrease in deposits $ (59,370) (190,907) (272,307) Interest credited to deposits 27,615 43,509 71,853 Proceeds from FHLB advances 95,000 107,300 - Repayments of FHLB advances (32,800) (78,400) (25,700) Net decrease in securities sold under agreements to repurchase (397) (35,600) (189,847) Decrease in federal funds purchased - - (14,500) Payments for exchange of capital notes for preferred stock - - (1,855) Redemption of capital notes and other subordinated debentures (7,927) (7,022) (225) Issuance of common stock and warrants, net 8,056 - 9 Receipts of advances by borrowers for taxes and insurance 43,782 33,933 34,794 Payment for advances by borrowers for taxes and insurance (36,984) (33,220) (32,678) Preferred stock issuance costs - - (353) Proceeds from issuance of subordinated debt - - 8 Preferred stock dividends paid (733) - - Common stock dividends paid (349) - - ---------- ---------- ---------- Net cash provided (used) by financing activities 35,893 (160,407) (430,801) ---------- ---------- ---------- Increase (decrease) in cash and cash equivalents 5,143 (7,174) (6,713) Cash and cash equivalents at beginning of period 31,208 38,382 45,095 Cash and cash equivalents at ---------- ---------- ---------- end of period $ 36,351 31,208 38,382 ========== ========== ========== For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- Supplementary disclosure of non-cash investing and financing activities: Interest paid on borrowings $ 36,536 55,795 92,814 Income taxes paid 11,198 5,800 355 Income taxes refunded 1,629 370 - Loans transferred to real estate owned 2,396 7,994 6,729 Loans charged-off 4,487 12,679 20,856 Real estate owned charged-off 775 1,927 6,973 Costs of assets transferred to available for sale - 305,731 67,269 Capital notes exchanged for preferred stock - - (8,389) Preferred stock issued - - 7,389 Extraordinary gain from early extinguishment of capital notes - - 660 Extraordinary gain-income taxes payable - - 340 Subordinated debentures due to BFC which was utilized by BFC to exercise related warrants to purchase common stock of BankAtlantic 1,971 - - Common stock issued to BFC upon exercise of warrants (1,971) - - Issuance of subordinated debentures to BFC for payment of preferred stock dividends 147 880 715 Preferred stock dividends paid by BFC escrow (147) (880) (715) Common stock dividends declared and not paid 389 - - Loans securitized - - 40,361 ========== ========== ========== See Notes to Consolidated Financial Statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. Summary of Significant Accounting Policies Basis of Financial Statement Presentation - The financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP"). In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statements of financial condition and operations for the periods presented. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the next year relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosure or in satisfaction of loans. In connection with the determination of the allowances for loan losses and real estate owned, management obtains independent appraisals for significant properties when it is deemed prudent. Principles of Consolidation - The consolidated financial statements include the accounts of BankAtlantic and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. At December 31, 1993, BankAtlantic, a Federal Savings Bank ("BankAtlantic") was 48.17% owned by BFC Financial Corporation ("BFC"). Certain amounts for prior years have been reclassified to conform with statement presentations for 1993. The reclassifications have no effect on the financial position or results of operations as previously reported. Cash Equivalents - Cash and due from depository institutions include demand deposits at other financial institutions and federal funds sold. Generally, federal funds are sold for one-day periods. Tax Certificates, Other Investment Securities and Mortgage-Backed Securities - Tax certificates, other investment securities and mortgage-backed securities held for investment are carried at cost. Amortization of premiums and accretion of discounts is based on the interest method which for mortgage- backed securities relates to the estimated remaining lives of the underlying loans. Mortgage-backed securities available for sale are carried at the lower of aggregate cost or market value. The held for investment classification includes only those securities that management has both the intent and ability to hold until maturity. The available for sale category would include all securities that BankAtlantic may elect to sell when events which were not reasonably foreseeable at the time of acquisition make a sale advisable including such events as changes in the interest rate environment, changes in BankAtlantic's interest rate position and sensitivity gap, nature of other available investments, and existing and proposed regulatory requirements make such sales likely. Securities transferred to the available for sale category are transferred at the lower of aggregate cost or market value. Any excess of aggregate cost over market is charged to operations at the time of transfer. Gains or losses on sales of securities are determined by the specific identification method. Allowance for Loan Losses - The allowance for loan losses represents the total amount available to absorb loan losses. Management believes that the allowance for loan losses is adequate. The allowance is based on management's evaluation, which includes a review of all loans on which full collectibility may not be reasonably assured and considers, among other matters, the estimated fair value of the underlying collateral on the loan and such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific non-performing loans, and current economic conditions and trends that may affect the borrower's ability to repay. Increases in the allowance for loan losses are recorded when losses are both probable and estimable. In addition, various regulatory agencies, as an integral part of their examination process, periodically review BankAtlantic's allowance for loan losses. Such agencies may require BankAtlantic to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. Construction and Development Lending - BankAtlantic's construction and development lending generally requires an equity investment in the form of contributed assets from the borrower. Other than advances to joint ventures, BankAtlantic has no loans which provide for a participation in profits at December 31, 1993 and 1992. Accordingly, construction and development lending arrangements have been classified and accounted for as loans. Non-Accrual Loans and Real Estate Owned - Loans are generally placed on non-accrual status when the loans become 90 days past due as to principal and interest or when, in management's opinion, collection of interest or principal becomes uncertain. Accrued interest is reversed against current income, amortization of deferred net fees and discounts are discontinued, and interest income collected is recognized when the loan is returned to a current status. Loans that have been placed on non-accrual are generally not restored to an accrual basis until all delinquent principal and/or interest has been brought current. Real estate owned ("REO") is comprised of real estate acquired in settlement of loans and loans treated as in-substance foreclosures. Real estate acquired for development by BankAtlantic, or joint ventures in which BankAtlantic has an equity interest, is stated at the lower of cost or estimated net realizable value. During the period of the accompanying financial statements, BankAtlantic did not have any real estate acquired for development. Profit on real estate sold is recognized when the collectibility of the sales price is reasonably assured and BankAtlantic is not obligated to perform significant activities after the sale. Any estimated loss is recognized in the period in which it becomes apparent. REO is recorded at the lower of the loan balance, plus acquisition costs, or fair value, less estimated disposition costs. Expenditures for capital improvements made thereafter are generally capitalized. Real estate acquired in settlement of loans is anticipated to be sold and valuation allowance adjustments are made to reflect any subsequent changes in fair values from the initially recorded amount. Costs of holding REO are charged to operations as incurred. Provisions and recoveries in the REO valuation allowance are reflected in operations. Office Properties and Equipment - Land is carried at cost. Office properties and equipment are carried at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets which generally range up to 50 years for buildings and 10 years for equipment. The cost of leasehold improvements is being amortized using the straight-line method over the terms of the related leases. Expenditures for new properties and equipment and major renewals and betterments are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred and gains or losses on disposal of assets are reflected in current operations. Investments in Joint Ventures - Investments in joint ventures are accounted for by the equity method. Loans Originated for Sale - Residential first mortgage loans originated for sale are reported at the lower of cost or market. Loan origination fees and related direct loan origination costs for these loans are deferred until the related loan is sold. Generally these loans are committed for sale prior to origination. Accordingly, the holding period for such loans is minimal. Loan Origination and Commitment Fees, Premiums and Discounts on Loans and Mortgage Banking Activities - Origination and commitment fees collected are deferred net of direct costs and are being amortized to interest income over the loan life using the level yield method. Amortization of deferred fees is discontinued when collectibility of the related loan is deemed to be uncertain. Commitment fees related to expired commitments are recognized as income when the commitment expires. Unearned discounts on installment, second mortgage and home improvement loans are amortized to income using the level yield over the terms of the related loans. Unearned discounts on purchased loans are amortized to income using the effective interest method over the estimated life of the loans. Loan Servicing Fees - BankAtlantic services mortgage loans for investors. These mortgage loans serviced are not included in the accompanying consolidated statements of financial condition. Loan servicing fees are based on a stipulated percentage of the outstanding loan principal balances being serviced and are recognized as income when related loan payments from mortgagors are collected. Loan servicing costs are charged to expense as incurred. Amounts paid for purchased mortgage servicing rights are amortized to expense using the level yield over the estimated life of the loan, and continually adjusted for prepayments. Management evaluates the carrying value of purchased mortgage servicing by estimating the future net servicing income of the portfolio on a discounted, disaggregated basis, based on estimates of the remaining loan lives. Mortgage servicing rights related to loans originated by BankAtlantic, are not capitalized. Dealer Reserves, Net - The dealer reserve receivable represents the portion of interest rates passed through to dealers on indirect consumer loans. BankAtlantic had funded 0 - 100% of the total dealer reserve at the inception of the loan. Dealer reserves are amortized over the contractual life of the related loans, adjusted for actual prepayments, using the interest method except for the Subject Portfolio discussed further in Note 17 herein. Dealer reserves are stated net of accumulated amortization, allowances, valuation adjustments, and any unfunded amounts due to the dealer. Income Taxes - BankAtlantic and its subsidiaries file consolidated federal and state income tax returns. In February 1992, the FASB issued FAS 109. FAS 109, which was implemented by BankAtlantic in 1993, requires a change from the deferred method to the asset and liability method to account for income taxes. Under the asset and liability method of FAS 109, 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 those temporary differences are expected to be recovered or settled. Under FAS 109, the effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the statutory enactment date. Pursuant to the deferred method under APB Opinion 11, which was applied in 1992 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. Preferred Stock - All three Series of Preferred Stock have a preference value of $25.00 per share and are redeemable by BankAtlantic at $25.25 per share in 1994 and $25.00 thereafter. At December 31, 1993, no shares of Preferred Stock had been redeemed. Income (Loss) Per Common Share - In calculating income (loss) per common and common equivalent share ("primary income per share") preferred stock dividends are deducted from income before extraordinary item and the resulting amount and any extraordinary item is divided by the weighted average number of common and common equivalents shares outstanding, when dilutive. Common stock equivalents consist of common stock warrants and options. Income per common and common equivalent share assuming full dilution ("fully diluted income per share") is calculated as above and, if dilutive, after adjustment for interest charges as a result of the hypothetical conversion of the BFC subordinated debentures, through their actual conversion date of June 30, 1993. Fully diluted income per share also utilizes the period end market price of common stock if such price is greater than the average market price utilized in computing primary income per share. During 1991, no effect was given to options outstanding under BankAtlantic's Stock Option Plan and the common stock warrants issued as a result of the 1989 and 1991 rights offering and in connection with the issuance of the 1990 and 1991 subordinated debentures since the effect of their exercise was anti-dilutive. Common stock equivalents are not reflected in income per share until the market price of the common stock obtainable has been in excess of the exercise price for substantially all of three consecutive months, ending with the last month of the period. For the Years Ended December 31 ------------------------------------- 1993 1992 1991 ---------- --------- --------- Weighted average number of common and common equivalent shares outstanding 6,054,402 4,694,099 4,680,439 ========== ========= ========= Weighted average number of common and common equivalent shares outstanding assuming full dilution 6,091,800 5,440,798 N/A ========== ========== ========== New Accounting Standards - During May 1993, the Financial Accounting Standards Board approved two new accounting standards. Financial Accounting Standards No. 114 - Accounting by Creditors for Impairment of a Loan ("FAS 114"), and Financial Accounting Standards No. 115 - Accounting for Certain Investments in Debt and Equity Securities ("FAS 115"). FAS 114 addresses the collectibility of both contractual interest and contractual principal of all receivables when assessing the need for a loss accrual. This standard requires that unpaid loans be measured at the present value of expected cash flows by discounting those cash flows at the loan's effective interest rate. FAS 114 must be adopted by 1995, prospectively. BankAtlantic intends to implement FAS 114 in 1995. At December 31, 1993, the effect of implementation of this standard on BankAtlantic is estimated to be immaterial. FAS 115 addresses the valuation and recording of debt securities as held-to-maturity, trading and available for sale. Under this standard, only debt securities that BankAtlantic has the positive intent and ability to hold to maturity would be classified as held to maturity and reported at amortized cost. All others would be reported at fair value. FAS 115 must be adopted by 1994, prospectively. If FAS 115 were effective at December 31, 1993, BankAtlantic does not believe that it would be required to reclassify its debt securities and that the effect of implementation would be an increase in stockholders' equity of approximately $2.7 million, net of tax; the amount resulting when BankAtlantic implemented FAS 115 on January 1, 1994. However, BankAtlantic believes that implementation of FAS 115 may result in the volatility of capital amounts reported over time and could in the future negatively impact the institution's regulatory capital position. 2. Tax Certificates and Other Investment Securities A comparison of the book value, gross unrealized appreciation, gross unrealized depreciation, and approximate market value of BankAtlantic's tax certificates and other investment securities at December 31 was (in thousands): ---------------------------------------------------- Gross Gross Approximate Book Unrealized Unrealized Market Value Appreciation Depreciation Value --------- ------------ ------------ --------- Tax certificates-net $ 83,927 - - 83,927 Asset-backed securities 111 - - 111 Corporate bonds 3,663 - 7 3,656 Federal agency obligations 10,000 - 106 9,894 --------- ------------ ------------ --------- Total tax certificates and other investment securities $ 97,701 - 113 97,588 ========= ============ ============= ========= ==================================================== Gross Gross Approximate Book Unrealized Unrealized Market Value Appreciation Depreciation Value --------- ------------ ------------ --------- Tax certificates-net $ 120,295 - - 120,295 Asset-backed securities 129 - - 129 --------- ------------ ------------ --------- Total tax certificates and other investment securities $ 120,424 - - 120,424 ========= ============ ============= ========= Management considers approximate market value equivalent to book value for tax certificates since these securities have no readily traded market. However, for the fair value of tax certificates based on Financial Accounting Standards Board Statement Number 107 ("FASB 107") assumptions, see Note 20. Contractual or estimated maturities by category are shown below with related market values as of December 31, 1993. Actual maturities will probably differ from the maturities indicated below: Book Value Market Value ------------- ------------- Tax Certificates (In thousands) Due in one year or less $ 60,225 $ 60,225 Due after one year through five years 23,561 23,561 Due after five years through ten years 141 141 ------------- ------------- Total Tax Certificates 83,927 83,927 ------------- ------------ Other Investment Securities Due in one year or less 10,024 9,918 Due after one year through five years 3,750 3,743 ------------- ------------- Total Other Investments 13,774 13,661 ------------- ------------- Total Tax Certificates and Other Investment Securities $ 97,701 97,588 ============= ============= During the year ended December 31, 1993, BankAtlantic invested in repurchase agreements. The maximum amount of repurchase agreements outstanding at any month end and the average amount invested for the period was $29.0 million and $13.1 million, respectively. The underlying securities were in the possession of BankAtlantic. Proceeds from the sale of other investment securities were $2.1 million and $30.2 million for the years ended December 31, 1992, and 1991, respectively. The gross realized gains were $143,000 and $62,000 for the years ended December 31, 1992 and 1991, respectively. There were no sales of investment securities during the year ended December 31, 1993. In Florida, tax certificates represent a priority lien against real property for which assessed real estate taxes are delinquent. BankAtlantic's experience with this type of investment has been favorable as rates earned are generally higher than many alternative investments and substantial repayment occurs over a two year period. The primary risks BankAtlantic has experienced with tax certificates have related to the risk that additional funds may be required to purchase other certificates related to the property, the risk that the liened property may be unusable and the risk that potential environmental concerns may make taking title to the property untenable. 3. Loans Receivable - Net December 31 ------------------------------ 1993 1992 ------------- ----------- (In thousands) ------------------------------ Real estate loans: Conventional mortgages $ 120,531 $ 147,654 Conventional mortgages available for sale 5,752 7,641 Construction and development 11,333 12,961 FHA and VA insured 7,972 9,854 Commercial 198,095 156,844 Other loans: Second mortgages 52,563 72,508 Commercial (non-real estate) 27,979 33,071 Banker's acceptance 110,652 Deposit overdrafts 419 356 Installment loans held by individuals 86,138 140,553 ------------- ----------- Total gross loans 621,434 581,442 Deduct: Undisbursed portion of loans in process 5,570 6,492 Deferred loan fees, net 33 55 Unearned discounts on commercial loans 2,124 - Unearned discounts on installment and purchased loans 820 1,733 Allowance for loan losses 17,000 16,500 ------------- ----------- Loans receivable - net $ 595,887 556,662 ============= =========== No loans were securitized during the years ended December 31, 1993 and 1992. BankAtlantic is subject to economic conditions which could adversely affect both the performance of the borrower or the collateral securing the loan. At December 31, 1993, 79% of total aggregate outstanding loans were to borrowers in Florida, 12% of total loans were to borrowers in the Northeastern United States and 9% were to borrowers located elsewhere. Commitments to sell residential mortgage loans were $12.8 million and $7.6 million at December 31, 1993 and 1992, respectively. Approximately $1.8 million and $5.0 million of commitments to sell relate to residential mortgage loans with variable rates of interest whereas $11.0 million and $2.7 million of commitments to sell relate to residential mortgage loans with fixed rates of interest at December 31, 1993 and 1992, respectively. Such residential mortgage loan sales relate to loans recently originated for sale. Activity in the allowance for loan losses was (in thousands): For the Years Ended (1) December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Balance, beginning of period $ 16,500 $ 13,750 $ 15,741 Charge-offs: Commercial loans (835) (776) (1,694) Installment loans (3,350) (10,430) (18,903) Real estate mortgages (302) (1,473) (259) ------------- ---------- ---------- (4,487) (12,679) (20,856) ------------- ---------- ---------- Recoveries: Commercial loans 262 175 191 Installment loans 1,259 8,584 1,035 Real estate mortgages 16 20 99 ------------- ---------- ---------- 1,537 8,779 1,325 ------------- ---------- ---------- Net charge-offs (2,950) (3,900) (19,531) Additions charged to operations 3,450 6,650 17,540 ------------- ---------- ---------- Balance, end of period 17,000 16,500 13,750 ============= ========== ========== Average outstanding loans during the period 532,317 652,374 876,283 ============= ========== ========== Ratio of net charge-offs to average outstanding loans 0.56%(1) 0.60% 2.23% ============= ========== ========== (1) Excludes banker's acceptances. The percentage would be 0.55% if banker's acceptances were included. Included in installment loan recoveries for 1993 and 1992 is approximately $1.0 million and $7.3 million received from BankAtlantic's fidelity bond carrier (see Note 17). The ratio of net charge-offs to average outstanding loans, excluding this recovery, would have been 0.74% and 1.72% for 1993 and 1992, respectively. At December 31, 1993, 1992 and 1991, BankAtlantic serviced loans for the benefit of others amounting to approximately $1.9 billion, $1.0 billion and $868.4 million, respectively. At December 31, 1993 and 1992, other liabilities includes approximately $2.4 million and $2.3 million, respectively, of loan payments due to others. Activity in purchased mortgage servicing rights was (in thousands): For the Years Ended December 31, ---------------------------------------- 1993 1992 1991 ------------- ----------- ----------- Balance, beginning of period $ 7,282 $ 6,023 $ 3,840 Servicing rights purchased 17,003 3,832 3,457 Amortization of purchased servicing rights (4,452) (2,573) (1,274) ------------- ----------- ----------- Balance, end of period $ 19,833 7,282 6,023 ============= =========== =========== Aggregate loans to and repayments of loans by directors, executive officers, principal stockholders and other related interests for the years ended December 31, 1993 and 1992, were (in thousands): (1) $450 of the 1992 deletions relates to a loan to an executive officer no longer employed by BankAtlantic. (2) Not included herein are conventional mortgage loans of approximately $372 to executive officers. These loans were originated for sale and were sold to unrelated third parties. (3) $772 of the 1993 deletions relates to a loan to a related party no longer associated with BankAtlantic. 4. Mortgage-Backed Securities Mortgage-backed securities held for investment consisted of (in thousands): The amortized cost, gross unrealized appreciation, gross unrealized depreciation and approximate market value of mortgage-backed securities held for investment was (in thousands): BankAtlantic's held for investment portfolio at December 31, 1993 consisted of FNMA fixed rate 7 year balloon securities that mature in 1999, FHLMC fixed rate 5 and 7 year balloon securities that mature in 1996 - 2000 and FHLMC adjustable rate securities that mature in 2022 and 2023. Pledged as collateral were $3.7 million, $500,000 and $2.8 million of mortgage-backed securities for commercial letters of credit, treasury tax and loan and retail repurchase agreements, respectively. An objective of BankAtlantic has been to improve its cumulative rate sensitivity gap. In furtherance of this objective, BankAtlantic purchased, from 1990 through December 31, 1993, approximately $504.8 million of five and seven year balloon FNMA and FHLMC mortgage backed securities. Purchases of this type of security are directed at reducing the intermediate term interest rate sensitivity, reinvesting funds from principal repayments, reducing market volatility compared to the longer term fixed rate mortgage-backed securities and also providing future opportunities to improve liquidity. Funds for the purchase of these securities were obtained from principal repayments, proceeds from sales of longer term fixed rate mortgage-backed securities, and short to intermediate term borrowings. Due to monetary policy changes which resulted in additional interest rate cuts and the continued outflow of time deposits, management decided in September 1992 to dispose of the fixed rate mortgage-backed securities in order to, among other things, fund substantially all of the purchases of these replacement securities. BankAtlantic has the ability and intent to hold its remaining mortgage- backed securities held for investment until their scheduled maturities. Market values of the securities available for sale at December 31, 1993 were greater than BankAtlantic's cost of such securities. All fixed rate mortgage- backed securities having original maturities of 15 to 30 years are classified as available for sale. The amortized cost, gross unrealized appreciation, gross unrealized depreciation and approximate market value at December 31, 1993 and 1992 of mortgage-backed securities available for sale were (in thousands): During the year ended December 31, 1993, there were no sales of mortgage-backed securities. During the year ended December 31, 1992, BankAtlantic transferred to available for sale approximately $305.7 million of fixed rate mortgage-backed securities and received proceeds amounting to $144.6 million for sales of FNMA securities and $10.6 million of FHLMC securities for gross realized gains of $5.2 million and $500,000, respectively. Proceeds from the sales of FHLMC and FNMA securities were $ 49.0 million and $ 21.9 million, respectively, for the year ended December 31, 1991. Gross realized gains from the sales of FHLMC and FNMA securities were $174,000 and $574,000, respectively, for the year ended December 31, 1991. All sales occurred subsequent to classification as available for sale. 5. Accrued Interest Receivable December 31 ------------------------------ 1993 1992 ------------- ------------ (In thousands) ------------------------------ Loans receivable $ 3,403 $ 4,158 Tax certificates and other investment Securities 10,473 14,370 Mortgage-backed securities 3,698 3,660 ------------- ------------ $ 17,574 $ 22,188 ============= ============ 6. Non-Performing Assets and Restructured Loans Risk elements consist of non-accrual loans, restructured loans, past-due loans, REO, repossessed assets, and other loans which management has doubts about the borrower's ability to comply with the contractual repayment term. Non-accrual loans are loans on which interest recognition has been suspended because of doubts as to the borrower's ability to repay principal or interest. Restructured loans are where the terms have been altered to provide a reduction or deferral of interest or principal because of a deterioration in the borrower's financial position. BankAtlantic did not have any commitments outstanding to lend additional funds on restructured loans at December 31, 1993. Past-due loans are accruing loans that are contractually past due 90 days or more as to interest or principal payments. The following summarizes the risk elements at the dates indicated were (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Non-accrual $ 7,246 $ 10,436 $ 13,745 90 days or more past due 2,580 (1) 1,108 689 Real Estate Owned 9,651 14,997 21,295 Other Repossessed assets 512 461 902 ------------- ---------- ---------- Total non-performing $ 19,989 $ 27,002 $ 36,631 Restructured $ 2,647 $ 2,661 $ 7,580 ------------- ---------- ---------- Total risk elements $ 22,636 $ 29,663 $ 44,211 ============= ========== ========== (1) The majority of these loans have matured, but are current as to payments under the prior loan terms. At December 31, 1993, there were no loans which were not disclosed in the above schedule where known information about the possible credit problems of the borrowers caused management to have serious doubts as to the ability of the borrower to comply with present loan repayment terms and which may result in disclosure of such loans in the schedule above in the future. Interest income which would have been recorded under the original terms of non-accrual and restructured loans and the interest income actually recognized are summarized below (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Interest income which would have been recorded $ 1,068 $ 1,301 $ 2,476 Interest income recognized (486) (311) (1,581) ------------- ---------- ---------- Interest income foregone $ 582 $ 990 $ 895 ============= ========== ========== The components of "Foreclosed asset activity, net" were (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Real estate acquired in settlement of loans: Operating expenses (income), net $ (221) $ 1,144 $ 1,590 Provision of declines in REO 2,675 3,827 7,273 Net (gains) losses on sales (1,211) (648) 59 ------------- ---------- ---------- $ 1,243 $ 4,323 $ 8,922 Total ============= ========== ========== Activity in the allowance for real estate owned consisted of (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Balance, beginning of period $ 2,200 $ 300 $ - Charge-offs: Commercial loans $ (706) (1,816) (6,760) Residential loans (69) (111) (213) ------------- ---------- ---------- (775) (1,927) (6,973) 2,675 $ 3,827 7,273 ------------- ---------- ---------- $ 4,100 $ 2,200 $ 300 Total ============= ========== ========== 7. Office Properties and Equipment December 31 ------------------------------ 1993 1992 ------------- ------------ (In thousands) ------------------------------ Land $ 9,618 $ 9,838 Building and improvements 35,906 35,158 Furniture and equipment 16,139 14,362 ------------- ------------ Total $ 61,663 $ 59,358 Less accumulated depreciation 24,290 20,762 ------------- ------------ Other properties and equipment-net $ 37,373 $ 38,596 ============= ============ 8. Deposits The weighted average nominal interest rate payable on deposit accounts at December 31, 1993 and 1992 was 2.83% and 3.18%, respectively. The stated rates and balances at which BankAtlantic paid interest on deposits were: Interest expense by deposit category was (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Money fund savings and NOW accounts $ 11,413 $ 14,028 $ 24,861 Savings accounts 2,363 3,298 5,101 Certificate accounts - below $100,000 16,247 27,449 50,647 Certificate accounts, $100,000 and above 1,941 2,888 3,221 Less early withdrawal penalty (166) (252) (577) -------------- ---------- --------- Total $ 31,798 $ 47,411 $ 83,253 ============== ========== ========= Included in other non-interest income is approximately $5.2 million, $5.0 million and $5.2 million of checking account fees for the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993, the amounts of scheduled maturities of certificate accounts were (in thousands): Time deposits $100,000 and over have the following maturities at (in thousands): December 31 ------------------------------ 1993 1992 ------------- ------------ Less than 3 months $ 8,071 $ 2,976 3 to 6 months 6,377 7,104 6 to 12 months 15,784 16,827 More than 12 months 21,195 15,433 ------------- ------------ Total $ 51,427 $ 42,340 ============= ============ Beginning in 1990, the Office of the Comptroller for the State of Florida ("Comptroller") commenced a review of BankAtlantic's procedures for the assessment of fees on dormant accounts. The Comptroller subsequently indicated that BankAtlantic was not in compliance with applicable Florida law as interpreted by the Comptroller. The difference in interpretation concerns approximately $500,000 and has not yet been resolved. BankAtlantic intends to amend its procedures to satisfy the Comptroller's interpretation. However, pending resolution of the issue and modification of the procedures, dormant account assessments, approximately $10,000 per month, have been eliminated since 1992, and an allowance has been established for the amount which is in question. 9. Advances from Federal Home Loan Bank Advances from Federal Home Loan Bank ("FHLB advances") incur interest and were repayable as follows (in thousands): Repayable During Year Interest December 31, Ending December 31, ---------------------- Rate 1993 1992 -------------------------- ----------- --------- 1993 3.50% to 7.80% $ - $ 32,800 1994 3.25% to 7.80% 111,250 18,300 1995 4.92% to 7.80% 17,050 15,000 ----------- --------- Total $ 128,300 $ 66,100 =========== ========= Overnight FHLB advances at December 31, 1993 and 1992, amounted to $95.0 million and $26.0 million, respectively. At December 31, 1993 and 1992, BankAtlantic pledged specific adjustable rate mortgage loans as collateral in the amount of $33.3 million and $71.6 million, respectively, for FHLB advances. During October, 1992 and December, 1993, the FHLB granted BankAtlantic, subject to various terms and conditions, lines of credit of $300 million and $115 million expiring in October 1995 and December, 1994, respectively. As of December 31, 1993 BankAtlantic had not utilized these lines of credit. 10. Securities Sold Under Agreements to Repurchase The following table provides information on the agreements (dollars in thousands): Periods Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Maximum borrowing at any month-end within the period $ 69,295 $ 120,207 $ 87,252 Average borrowing during the period 33,962 73,309 25,426 Average interest cost during the period 3.19% 3.93% 6.57% Average interest at end of the period 3.30% 3.38% 4.62% ============= ========== ========== Average borrowing was computed based on average daily balances during the period. Average interest rate during the period was computed by dividing interest expense for the period by the average borrowing during the period. Securities sold under agreements to repurchase are summarized below (in thousands): December 31, ---------------------- 1993 1992 ----------- --------- Agreements to repurchase the same security $ 18,152 $ 20,000 Customer repurchase agreements 2,983 1,532 ----------- --------- Total $ 21,135 $ 21,532 =========== ========= The following table lists the book and approximate market value of securities sold under repurchase agreements, and the repurchase liability associated with such transactions was (dollars in thousands): Weighted Approximate Average Book Market Repurchase Interest Value Value Balance Rate --------- ------------ ------------ ---------- December 31, 1993 FNMA $ 13,406 $ 13,424 $ 13,165 $ 3.50% FHLMC 10,983 11,521 7,970 2.96% --------- ------------ ------------ ---------- Total $ 24,389 $ 24,945 $ 21,135 $ 3.30% ========= ============ ============ ========== December 31, 1992 FHLMC $ 25,101 $ 25,833 $ 21,532 $ 3.38% ========= ============ ============ ========== All repurchase agreements at December 31, 1993 and 1992, matured and were repaid in January 1994 and 1993, respectively. These securities were held by unrelated broker dealers. 11. Capital Notes and Other Subordinated Debentures, Preferred Stock, Common Stock Warrants, and Common Stock Options In order to increase its regulatory capital, BankAtlantic issued $25.0 million of its 1986 Capital Notes between January and August 1986. In March 1991, $10.2 million of 1986 Capital Notes were exchanged for noncumulative preferred stock, cash payments and cash bonuses. The Preferred Stock was recorded at a fair value of $7.0 million, net of offering costs of $353,000 and BankAtlantic recognized an extraordinary gain of $660,000 net of applicable income taxes of $340,000 due to this early extinguishment of the 1986 Capital Notes. All three series of Preferred Stock have a preference value of $25 per share and are redeemable by BankAtlantic at $25.25 per share in 1994 and $25.00 per share thereafter. At December 31, 1993, no shares of Preferred Stock have been redeemed. Effective July 31, 1992, BankAtlantic redeemed approximately $6.9 million of 1986 Capital Notes. Such redemption was at face value plus accrued interest and without payment of any penalty or premium. The portion of 1986 Capital Notes selected for redemption had an average interest rate of approximately 11.7%, and matured primarily in 1993. At December 31, 1993 and 1992, BFC owned 5.600, 529 and 4,636 shares of the Series A, B and C Preferred Stock, respectively. Such ownership was obtained through open market purchases and represents approximately 2.97%, 3.09% and 3.57% of the Series A, B and C Preferred Stock, respectively. As a condition of the exchange of 1986 Capital Notes for Preferred Stock, BFC placed cash in an escrow account equal to dividends payable on the Preferred Stock for the first two years. The amount placed in escrow was approximately $1.7 million. This escrow account had been utilized by BankAtlantic to pay the Preferred Shareholder dividends during the first two years after issuance. Upon establishing the escrow account, BankAtlantic entered into an agreement with BFC, that BFC will be issued 13% subordinated debentures in the amount of the escrow utilized, as well as non-detachable warrants to acquire additional shares of BankAtlantic common stock on the basis of $1.75 per share purchase price to the extent of subordinated debentures issued and any interest accrued and not currently paid thereon. As of December 31, 1992, BankAtlantic had issued approximately $1.6 million of subordinated debentures to BFC for the payment of monthly Preferred Stock dividends. The related warrants were to expire at maturity of the related subordinated debentures on March 7, 1998. At December 31, 1992, interest of $180,000 had accrued to BFC on its debentures and approximately 1,017,750 warrants had been issued. The exercise price of the warrants subject to the agreement was established at the greater of 120% of the average market price of BankAtlantic stock during the 30 days prior to the funding of the escrow or $1.74 per common share. At March 7, 1991, 120% of the average market price of BankAtlantic common stock was $1.75, resulting in the exercise price of the warrants being set at $1.75 per common share. The subordinated debentures issued to BFC for payment of Preferred Stock dividends, related interest and the dividends paid are reflected herein. For regulatory capital purposes, dividend amounts, although paid by BFC, are not includable as capital and the related subordinated debentures issued were not includable in determining risk-based capital until BFC exercised the warrants issued to it in connection with the subordinated debentures. Payments of any interest or principal to BFC on any subordinated debentures issued to BFC in consideration of the utilization of the escrowed amounts was subject to regulatory approvals. Effective June 30, 1993, BFC exercised its warrants to acquire 1,126,327 shares of BankAtlantic's common stock at an exercise price of $1.75 per share. The payment of the $1,971,072 purchase price was through the tender of subordinated debentures held by BFC. During July 1993, accrued interest of $83,704 was paid to BFC for interest accrued on the subordinated debentures from March 1, 1993 to June 30, 1993. From March 1991 through February 1993, BFC provided funds for the payment of dividends on BankAtlantic's preferred stock. BFC has no further obligation to provide funds for payment of any dividends by BankAtlantic. Future dividends, if declared, will be paid by BankAtlantic and will be subject to receipt of all required regulatory approvals. BankAtlantic has paid the preferred stock dividends since March 1993 and expects to continue paying such dividends; subject to maintaining capital at least equal to the fully phased-in capital requirements. Future payments will be subject to approval by the Board of Directors, to additional regulatory notice or approval, and continued compliance with capital requirements. In July 1993, BankAtlantic received approval from the OTS to redeem all remaining capital notes and other subordinated debentures. BankAtlantic redeemed the $6.8 million of 1986 Capital Notes and $1 million of 14% other subordinated debentures on August 31, 1993 at par. The Capital Notes bore interest at a weighted average rate of 11.83%, substantially in excess of then current market rates. Funds for the redemption were provided from loan repayments. On February 28, 1990, BankAtlantic filed an application with the OTS to issue up to $12.0 million of subordinated debentures in private transactions and to include such subordinated debentures as regulatory capital. This offering was closed in 1990. During the quarter ended March 31, 1990, BFC advanced BankAtlantic $2.5 million for the purchase of such subordinated debentures, subject to regulatory approval. On May 30, 1990, BankAtlantic received OTS approval, subject to certain conditions, to include up to $12.0 million of the subordinated debentures as regulatory capital. Effective March 30, 1990, BFC acquired $2.5 million of such subordinated debentures. In June 1990, a third party acquired $1.0 million of BankAtlantic's subordinated debentures. The subordinated debentures had an interest rate of 14% per annum. The subordinated debentures was issued with warrants entitling the holder to purchase shares of BankAtlantic common stock at an exercise price of $4.62 per share at any time prior to maturity. On June 30, 1990, BFC exercised its warrants and converted $2.5 million of subordinated debentures to 541,430 shares of BankAtlantic common stock, increasing BFC's common stock ownership percentage of BankAtlantic to 69.9% at that time. The conversion of the subordinated debentures to common stock was approved at BankAtlantic's Annual Meeting of shareholders held on July 10, 1990. Included in risk-based capital at December 31, 1992 was $3.8 million of Capital Notes and subordinated debentures. The $1.0 million subordinated debentures issued to the unaffiliated third party was to mature in June 1997 and had detachable warrants to purchase 216,573 common shares of BankAtlantic, at $4.62 per share. On March 31, 1991, BankAtlantic issued to its existing shareholders, 4,878 shares of common stock and $8,000 of 14% subordinated debentures, having a March 1998 maturity date, with related warrants to purchase 4,600 shares of common stock. The warrants for the 4.600 shares may be exercised at $1.74 per share any time prior to maturity of the related debentures by payment of the exercise price in cash or by surrendering related debentures having an outstanding principal amount and accrued interest, if any, equal to the amount payable or a combination thereof. The remaining $1.0 million and $8,000 of subordinated debentures were redeemed along with the Capital Notes on August 31, 1993. However, the warrants related to such debentures are detachable and may remain outstanding until the earlier of exercise or original maturity of the subordinated debentures. The warrants outstanding at December 1993, relating to the redeemed debentures are 216,573 and 4,025 with exercise prices of $4.62 and $1.74, respectively. On November 12, 1993, BankAtlantic closed a public offering of 1.8 million common shares at a price of $13.50 per common share. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million shares were sold by BFC. Net proceeds to BankAtlantic from the sale of the 400,000 shares were approximately $4.6 million. In connection with the public offering, BankAtlantic granted the underwriters a 30 day option to purchase up to 270,000 additional shares of common stock to cover over-allotments. On November 10,1993, the underwriters exercised this option to purchase the 270,000 shares, with a closing date of November 18, 1993. The additional net proceeds to BankAtlantic were approximately $3.4 million. Upon sale of the 2,070,000 shares, BFC's ownership of BankAtlantic changed from 77.83% to 48.17%. On April 6, 1984, BankAtlantic's stockholders approved a Stock Option Plan under which options to purchase up to 310,000 shares of common stock may be granted. The plan provided for the grant of both incentive stock options and non-qualifying options. The exercise price of an incentive stock option will not be less than the fair market value of the common stock on the date of the grant. The exercise price of non-qualifying options will be determined by a committee of the Board of Directors. On May 25, 1993, the Board of Directors authorized the issuance of 232,440 incentive stock options and 66,560 non-qualifying options. Of the incentive and non-qualifying stock options, 43,560 were issued at 110% of the fair market value at the date of grant. The remaining incentive and non- qualifying stock options were issued at the fair market value at the date of grant. Non-qualifying stock options for 23,000 shares were issued outside of the Plan to non-employee directors. These options have similar terms and conditions as non-qualifying options under the Plan. A summary of plan activity was: Exercisable Price Shares Per Share ------------ -------------------------------- Outstanding December 31, 1990 71,191 $ 8.70 - 11.63 Expired (44,563) 11.30 - 11.63 Outstanding December 31, 1991 and 1992 26,628 8.70 - 11.63 Expired (173) 11.30 Issued 299,000 11.48 - 12.63 ------------ -------------------------------- Outstanding December 31, 1993 325,455 $ 8.70 - 12.63 ============ ================================ The stock options issued in May 1993 expire on May 25, 1998, and have the following commencement dates based on applicable vesting schedules: 99,667 on May 25, 1993; 99,667 on May 25, 1994 and 99,666 on May 25, 1995. The remaining 26,455 options outstanding may currently be exercised and will expire in August 1996. At May 31, 1993, all issuable options under the Plan were outstanding and no further options will be granted under the Plan. 12. Interest Rate Swaps In March 1991, a $35.0 million interest rate swap expired. This agreement called for fixed rate interest payments by BankAtlantic of 12.00% in exchange for variable rate payments based on the corporate bond equivalent of the three month U.S. Treasury Bill rate. The net interest expense relating to the interest rate swap was approximately $450,000 for the year ended December 31, 1991. BankAtlantic was exposed to credit loss in the event of nonperformance by the other party to the agreements, however no performance by the counter-party was required during the term of the agreement. 13. Income Taxes BankAtlantic is permitted under the Internal Revenue Code to deduct an annual addition to a reserve for bad debts in determining taxable income, subject to certain limitations. To the extent that (i) a savings institution's reserve for losses on qualifying real property loans exceeds the amount that would have been allowed under the experience method and (ii) it makes distributions to shareholders that are considered to result in withdrawals from that excess bad debt reserve, then the amounts withdrawn will be included in its taxable income. The amount considered to be withdrawn by a distribution will be the amount of the distribution plus the amount necessary to pay the tax with respect to the withdrawal. Dividends paid out for the savings institution's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in withdrawals from its bad debt reserves. Accordingly, purchases of its outstanding common or preferred stock by BankAtlantic could result in an increase in BankAtlantic's taxable income in the period such stock is repurchased. The increase in taxable income would be the lesser of the amount repurchased divided by the reciprocal of the income tax rate or at December 31, 1993, $4.8 million. BankAtlantic adopted FAS 109 as of January 1, 1993. The cumulative effect of this change in accounting for income taxes was immaterial, and thus, there was no cumulative effect adjustment. In accordance with FAS 109 deferred tax liabilities are not recognized on the base year tax bad debt reserve unless it becomes apparent that the reserve will be reduced and result in taxable income in the foreseeable future. At December 31, 1993, BankAtlantic's base year tax bad debt reserve was $6.6 million for which no deferred income taxes have been provided. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and tax liabilities at December 31, 1993 were: (In thousands) Deferred tax assets: Bad debt reserves for financial statement purposes $ 5,686 Allowances recorded for financial statement purposes not currently recognized for tax purposes 4,770 Deferred compensation accrued for financial statement purposes not currently recognized for tax purposes 112 Unearned commitment fees 204 Other 228 --------------- Total gross deferred tax assets 11,000 Less valuation allowance (1,464) --------------- Total deferred tax assets 9,536 Deferred tax liabilities: Bad debt reserve recorded for tax purposes not recorded for financial statement purposes 1,164 Office properties and equipment, due to differences in depreciation 1,537 FHLB stock, due to differences in the recognition of stock dividends 1,647 Deferred point income, due to differences in the recognition of loan origination fees 1,507 Receivable from the carrier recorded for financial statement purposes 865 Discount on mortgage-backed securities, due to the accretion of discounts 848 Capital leases for financial reporting purposes and operating leases for tax purposes 686 Pre-paid pension expenses 459 Other 400 --------------- Total gross deferred tax liabilities 9,113 --------------- Net deferred tax assets at December 31, 1993 423 Deferred income tax liability at December 31, 1992 2,380 --------------- Deferred income tax (benefit) for 1993 $ (2,803) =============== The valuation allowance for deferred tax assets as of January 1, 1993 was $2.4 million. The net change in the total valuation allowance for the year ended December 31, 1993 was a decrease of $963,000. The change in the valuation allowance was due to management's determination that, more likely than not, this deferred tax asset is realizable. The provision (benefit) for income taxes consisted of (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Current: Federal $ 9,695 $ 6,469 $ (361) State 1,633 201 - ------------- ---------- ---------- 11,328 6,670 (361) ------------- ---------- ---------- Deferred: Federal (2,445) 1,792 (4,480) State (358) (17) - ------------- ---------- ---------- (2,803) 1,775 (4,480) ------------- ---------- ---------- Utilization of net operating loss carryforwards: Federal - (389) - State - 1,145 - ------------- ---------- ---------- - 756 - ------------- ---------- ---------- Settlement with IRS, net (1,432) - - ------------- ---------- ---------- Total $ 7,093 $ 9,201 $ (4,841) ============= ========== ========== BankAtlantic's actual provision (benefit) differs from the Federal expected income tax provision (benefit) as follows (in thousands): For the Years Ended December 31, ----------------------------------- 1993 1992 1991 --------- ---------- ---------- Income tax provision (benefit) at expected federal income tax rate(1) $ 8,110 $ 8,328 $ (4,782) Increase (decrease) resulting from: Adjustment to allowance for loan losses recognized for financial statement purposes not currently recognized for tax purposes 613 - - Tax-exempt interest income (119) (115) (58) Provision for state taxes net of federal benefit 828 877 - Other-net (4) 111 (1) Change in the beginning of the year balance of the valuation allowance for deferred tax assets allocated to income tax expense (963) - - Adjustment to deferred tax assets and liabilities for enacted changes in the tax laws and rates 60 - - Settlement with IRS, net(2) (1,432) - - --------- ---------- ---------- Total $ 7,093 $ 9,201 $ (4,841) ========= ========== ========== (1) The federal income tax rate is 35% for the year ended December 31, 1993 and 34% for the years ended December 31, 1992 and 1991. (2) During the second quarter of 1993, BankAtlantic settled a claim with the IRS relating to net operating loss carrybacks and previous Federal income tax examinations through 1988, resulting in an increase in other interest income of $587,000 and a reduction in the provision for income taxes of $1.4 million. Deferred income tax expense (benefit) was comprised of (in thousands): At December 31, 1991, BankAtlantic had a net operating loss carryforward for federal income tax purposes of approximately $5.2 million which would have expired in 2006. All 1991 net operating loss carryforwards were utilized during the year ended December 31, 1992. At December 31, 1991, BankAtlantic had a net operating loss carryforward for state income tax purposes of approximately $21.6 million of which approximately $1.6 million expire in 1999, $4.7 million expire in 2003, $8.5 million expire in 2004, and $6.8 million expire in 2006. All state net operating loss carryforwards were utilized during the year ended December 31, 1992. On August 12, 1993, President Clinton signed the Omnibus Budget Reconciliation Act of 1993 (the "Omnibus Act"). The most significant change to be implemented by the 1993 Omnibus Act, as it relates to BankAtlantic, is to increase the highest corporate rate from 34% to 35% retroactively to January 1, 1993. The impact on BankAtlantic's Consolidated Statement of Earnings at the enactment date was to increase the provision for income taxes by approximately $175,000. 14. Pension Plan BankAtlantic sponsors a non-contributory defined benefit pension plan (the "Plan") covering substantially all of its employees. The benefits are based on years of service and the employee's average earnings received during the highest five consecutive years out of the last ten years of employment. The funding policy is to contribute an amount not less than the ERISA minimum funding requirement nor more than the maximum tax-deductible amount under Internal Revenue Service rules and regulations. No contributions were made to the Plan during the three years ended December 31, 1993. Plan assets consist generally of fixed income investment securities, corporate equities and cash equivalents as of the most recent reporting date. The following table sets forth the Plan's funded status and amounts recognized in BankAtlantic's Statements of Financial Condition: December 31 ------------------------------ 1993 1992 ------------- ----------- (In thousands) ------------------------------ Actuarial present value of accumulated benefit obligation, including vested benefits of $9,093 and $6,225 $ (9,555) $ (6,561) --------------- ----------- Actuarial present value of projected benefit for service rendered to date (12,609) (8,882) Plan assets at fair value 11,362 11,002 Plan assets in excess (below) projected benefit --------------- ----------- obligation (1,247) 2,120 Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions 4,805 1,694 Prior service cost not yet recognized in net periodic pension cost (95) (11) Unrecognized net asset at October 1, 1987 being recognized over 15 years (2,344) (2,612) --------------- ----------- Prepaid pension cost included in other assets $ 1,119 $ 1,191 =============== =========== Net pension cost includes the following components: For the Years Ended December 31, ----------------------------------- 1993 1992 1991 --------- ---------- ---------- Service cost benefits earned during the period $ 594 $ 610 $ 602 Interest cost on projected benefit obligation 714 642 612 Actual return on plan assets (793) (325) (890) Net amortization and deferral (442) (1,006) (224) Curtailment gain - - (351) --------- ---------- ---------- Net period pension benefit $ 73 $ (79) $ (251) ========= ========== ========== During the year ended December 31, 1991, BankAtlantic reduced its work force resulting in a pension curtailment gain of $351,000. The assumptions used in accounting for the Plan were: 1993 1992 1991 --------- -------- ------- Weighted average discount rate 7.00% 8.25% 8.25% Rate of increase in future compensation levels 4.00% 5.00% 5.00% Expected long-term rate of return(1) 9.50% 9.50% 9.50% ======== ======== ======= (1) The expected long-term rate of return has been adjusted during 1994 to 9.00%. BankAtlantic sponsors a defined contribution plan ("401k Plan") for all employees that have completed six months of service. Employees can contribute up to 14% of their salary, not to exceed $8,994 at December 31, 1993. For employees that fall within the highly compensated criteria, maximum contributions are 8% of salary. During part of 1991, BankAtlantic matched employee contributions based on employee's salary and BankAtlantic's profits. Effective October 1991, BankAtlantic's 401k Plan was amended to include only a discretionary match as deemed appropriate by the Board of Directors. In November 1993 and 1992, the Board of Directors declared discretionary matches in the aggregate amount of approximately $60,000 and $40,000, respectively to be paid during March 1994 and 1993 to participants of record as of December 31, 1993 and 1992. Included in employee compensation and benefits on the consolidated statement of operations was $72,000 and $52,000 and $113,000 of expenses related to the 401k Plan for the years ended December 31, 1993, 1992 and 1991, respectively. 15. Commitments and Contingencies BankAtlantic is lessee under various operating leases for real estate and equipment extending to the year 2072. The approximate minimum rental under such leases, at December 31, 1993, for the periods shown was (in thousands): Year Ending December 31, Amount ----------------- 1994 $ 1,400 1995 1,083 1996 646 1997 247 1998 199 Thereafter 2,970 ----------------- Total $ 6,545 ================= Rental expense for premises and equipment was $2.3 million, $3.5 million and $4.6 million for the years ended December 31, 1993, 1992 and 1991, respectively. Included in other liabilities at December 31, 1993 and 1992, is an allowance of $400,000 and $740,000, respectively, for future rental payments on closed branches. During the ordinary course of business, BankAtlantic and its subsidiaries are involved as plaintiff or defendant in various lawsuits. Management, based on discussions with legal counsel, is of the opinion that no significant loss will result from these actions. BankAtlantic is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby and documentary letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the statement of financial position. BankAtlantic's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit written is represented by the contractual amount of those instruments. BankAtlantic uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Financial instruments with off-balance sheet risk were (in thousands) : December 31, ---------------------- 1993 1992 ----------- --------- Commitments to extend credit, including the undisbursed portion of loans in process $ 77,509 $ 32,834 Standby and documentary letters of credit $ 3,898 $ 7,154 Commitments to purchase mortgage-backed securities $ 10,000 $ 80,000 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. BankAtlantic evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by BankAtlantic upon extension of credit is based on management's credit evaluation of the counter-party. Collateral held varies but may include first mortgages on commercial and residential real estate. As part of the commitment for standby letters of credit, BankAtlantic is required to collateralize 120% of the commitment balance with mortgage- backed securities. At December 31, 1993, $7.5 million of mortgage-backed securities were pledged against the commitment balance. Standby letters of credit written are conditional commitments issued by or for the benefit of BankAtlantic to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. BankAtlantic may hold certificates of deposit and residential and commercial liens as collateral supporting those commitments which are collateralized similar to other types of borrowings. BankAtlantic is required to maintain average reserve balances with the Federal Reserve Bank. Such reserves consisted of cash and amounts due from banks of $9.4 million and $15.3 million at December 31, 1993 and 1992, respectively. BankAtlantic is a member of the FHLB system. As a member, BankAtlantic is required to purchase and hold stock in the FHLB of Atlanta, in amounts at least equal to the greater of (i) 1% of its aggregate unpaid residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year or (ii) 5% of its outstanding advances from the FHLB of Atlanta. As of December 31, 1993, BankAtlantic was in compliance with this requirement with an investment of approximately $8.7 million in stock of the FHLB of Atlanta. 16. Regulatory Matters The Financial Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA) was signed into law on August 9, 1989, and FIRREA's regulations for savings institutions' minimum capital requirements went into effect on December 7, 1989. The regulations require savings institutions to have minimum regulatory tangible capital equal to 1.5% of adjusted total assets, a minimum 3% core capital ratio and a minimum 8.0% risk-based capital ratio. Among other things, the ability to include investments in impermissible activities in core and tangible capital will be phased out by July 1, 1994. At December 31, 1993, BankAtlantic's regulatory capital position was (unaudited): Tangible Core Risk-Based Capital Capital Capital ------------- ----------- ---------- GAAP stockholders' equity $ 90,652 $ 90,652 $ 90,652 Adjustments: Non-includable subsidiaries (642) (642) (642) Additional capital: Allowable allowances for loans and tax certificates - - 9,035 ------------- ----------- ---------- Regulatory capital 90,010 90,010 99,045 Minimum capital requirement 20,378 40,757 59,176 ------------- ----------- ---------- Regulatory capital excess $ 69,632 $ 49,253 $ 39,869 ============= =========== ========== Regulatory capital as a percent of adjusted total assets: Required 1.50% 3.00% 8.00% ============= =========== ========== Actual 6.63% 6.63% 13.40% ============= =========== ========== In addition, savings institutions are also subject to the provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which was signed into law on December 19, 1991. Regulations implementing the prompt corrective action provisions of FDICIA became effective on December 19, 1992. In addition to the prompt corrective action requirements, FDICIA includes significant changes to the legal and regulatory environment for insured depository institutions, including reductions in insurance coverage for certain kinds of deposits, increased supervision by the federal regulatory agencies, increased reporting requirements for insured institutions, and new regulations concerning internal controls, accounting and operations. The FDICIA requires financial institutions to take certain actions relating to their internal operations, including: providing annual reports on financial condition and management to the appropriate Federal banking regulators, having an annual independent audit of financial statements performed by an independent public accountant, and establishing an independent audit committee comprised solely of outside directors. The FDICIA also imposes certain operational and managerial standards on financial institutions relating to internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees, and benefits. The prompt corrective action regulations define specific capital categories based on an institution's capital ratios. The capital categories, in declining order, are "well capitalized," "adequately capitalized," "undercapitalized" "significantly undercapitalized", and "critically undercapitalized." Institutions categorized as "undercapitalized" or worse are subject to certain restrictions, including requirements to file a capital plan with the OTS, prohibitions on the payment of dividends and management fees, restrictions on executive compensation, and increased supervisory monitoring, among other things. Other restrictions may be imposed on the institution either by the OTS or by the FDIC, including requirements to raise additional capital, sell assets, or sell the entire institution. Once an institution becomes "critically undercapitalized" it is generally placed in receivership or conservatorship within 90 days. To be considered "well capitalized," a savings institution must generally have a core capital ratio of at least 5%, a Tier 1 risk-based capital ratio of at least 6%, and a total risk-based capital ratio of at least 10%. An institution is deemed to be "critically undercapitalized" if it has a tangible equity ratio of 2% or less. At December 31, 1993 BankAtlantic's core, Tier 1 risk-based and total risk based capital ratios were 6.63%, 12.18% and 13.40%, respectively, thus, meeting the requirements of "well capitalized" (unaudited). The payment of dividends by BankAtlantic is limited by federal regulations. Effective August 1, 1990, the OTS adopted a new regulation that limits all capital distributions made by savings institutions, including cash dividends, by permitting only certain institutions that meet specified capital levels to make capital distributions without prior OTS approval. The regulation established a three-tiered system, with the greatest flexibility afforded to well-capitalized institutions. An institution that meets all of its fully phased-in capital requirements and is not in need of more than normal supervision would be a "Tier 1 Institution." An institution that meets its minimum regulatory capital requirements but does not meet its fully phased-in capital requirements would be a "Tier 2 Institution." An institution that does not meet all of its minimum regulatory capital requirements would be a "Tier 3 Institution." A Tier 1 Institution may, after prior notice, but without the approval of the OTS, make capital distributions during a calendar year up to 100% of net income earned to date during the current calendar year plus 50% of its capital surplus ("Surplus" being the amount of capital over its fully phased-in capital requirement). Any additional capital distributions would require prior regulatory approval. A Tier 2 institution may, after prior notice, but without the approval of the OTS, make capital distributions of between 50% and 75% of its net income over the most recent four-quarter period (less any dividends previously paid during such four- quarter period) depending on how close the institution is to its fully phased- in risk-based capital requirement. A Tier 3 Institution would not be authorized to make any capital distributions without the prior approval of the OTS. Notwithstanding the provision described above, the OTS also reserves the right to object to the payment of a dividend on safety and soundness grounds. In August and December, 1993, BankAtlantic declared cash dividends of $0.06 per share (totaling $0.12 per share), payable September 1993 and January 1994, respectively, to its common stockholders. A 15% common stock dividend was declared in May, 1993. BankAtlantic expects to continue dividend payments on its non-cumulative preferred stock. In March 1994, the Board of Directors declared a cash dividend of $.06 per share payable in April 1994 to its common stockholders. On April 16, 1991, BankAtlantic voluntarily entered into a Supervisory Agreement ("Agreement") with the OTS. The Agreement required BankAtlantic to implement additional policies and reporting procedures relating to the internal operations of BankAtlantic within specified time frames, and to particularly address concerns relating to classified assets, general valuation allowances and the policies, procedures, information reporting and guidelines in the consumer loan department. Furthermore, BankAtlantic has agreed it will not increase the level of its consumer loans above its April 16 1991 level of consumer loans until such time as BankAtlantic's new consumer lending policy is deemed acceptable by the OTS. BankAtlantic believes that it has addressed the requirements of the agreements and that it is in compliance with such agreements. BankAtlantic does not believe that the terms and conditions of the agreements will have any material adverse effect on its anticipated business or that they will materially effect BankAtlantic's relationships with its customers or depositors and accordingly, should not have any significant effect on its financial condition and results of operations. 17. Subject Portfolio From 1987 through 1990, BankAtlantic purchased in excess of $50 million of indirect home improvement loans from certain dealers, primarily in the northeastern United States. BankAtlantic ceased purchasing loans from such dealers in the latter part of 1990. These dealers are affiliated with each other but are not affiliated with BankAtlantic. In connection with loans originated through these dealers, BankAtlantic funded amounts to the dealers as a dealer reserve. Such loans and related dealer reserves are hereafter referred to as the "Subject Portfolio." The risk of amounts advanced to the dealers is primarily associated with loan performance but secondarily is dependent on the financial condition of the dealers. The dealers were to be responsible to BankAtlantic for the amount of the reserve only if the loan giving rise to the reserve became delinquent or was prepaid. These dealers have currently not indicated any financial ability to fund the dealer reserve. In late 1990, questions arose relating to the practices and procedures used in the origination and underwriting of the Subject Portfolio, which suggested that the dealers, certain home improvement contractors and borrowers engaged in practices intended to defraud BankAtlantic. Due to these questions and potential exposure, BankAtlantic performed, and continues to perform, certain investigations, notified appropriate regulatory and law enforcement agencies, and notified its fidelity bond carrier. After an initial review and discussions with the carrier, BankAtlantic concluded that any losses sustained from the Subject Portfolio would adequately be covered by its fidelity bond coverage and, in fact, on August 13, 1991, the carrier advanced $1.5 million against BankAtlantic's losses. This payment and future payments by the carrier were to be subject to identification and confirmation of the losses which are appropriately covered under the fidelity bond. Subsequently, commencing in September, 1991, as a consequence of issues raised by the carrier, BankAtlantic reviewed the Subject Portfolio without regard to the availability of any fidelity bond coverage. As a result of the review, the provision for loan losses for the year ended December 31, 1991 was increased by approximately $5.7 million, approximately $5.5 million of loans were charged off, and $2.7 million of dealer reserves were charged to current operations. On December 20, 1991, the carrier denied coverage and BankAtlantic thereafter filed an appropriate action against the carrier. On October 30, 1992, BankAtlantic and the carrier entered into the Covenant Not To Execute (the "Covenant"). Pursuant to the Covenant, BankAtlantic will continue to pursue its litigation against the carrier, which is currently in the early stages of discovery, but has agreed to limit execution on any judgement obtained against the carrier to $18 million. Further, BankAtlantic agreed to join certain third parties as defendants in that action. The carrier paid BankAtlantic $6.1 million during the fourth quarter of 1992 and paid an additional $3 million in November 1993, and has agreed to pay an additional $2.9 million in November 1994. Such amounts related to losses and expenses previously charged to operations by BankAtlantic. Additional reimbursements are made on a quarterly reporting basis commencing with the period ended December 31, 1992. Reimbursable amounts are as defined in the Covenant. Based upon such definitions BankAtlantic has and will continue to record estimated charges to operations in advance of when such charges become reimbursable. Amounts to be reimbursed will be reflected in the period for which reimbursement is requested. Through December 31, 1993, the carrier has paid or committed to pay approximately $15.4 million. The 1993 and 1994 committed amounts noted above have been accrued after imputing interest at 9%. The financial statement effect of the Covenant for the fourth quarter and year ended December 31, 1992 was to reduce expenses by $3.3 million, increase interest income by $1.9 million and to record $7.3 million of loan loss recoveries. The financial statement effect of the Covenant for 1993 was to reduce expenses by $942,000, to increase interest income by $757,000 and record $972,000 of loan loss recoveries. Included in other assets was a $3.3 million receivable due from the carrier at December 31, 1993. In no event will the carrier be obligated to pay BankAtlantic in the aggregate more than $18 million. However, in the event of recovery by BankAtlantic of damages from third party wrongdoers, BankAtlantic will be entitled to retain such amounts until such amounts, plus any payments received from the carrier equal to $22 million. Thereafter, the carrier will be entitled to any such recoveries to the extent of its payments to BankAtlantic. To the extent that BankAtlantic incurs losses in excess of $18 million plus available recoveries from third parties, BankAtlantic will be required to absorb any such losses. At December 31, 1993, the remaining amount of reimbursement available from the carrier was approximately $2.6 million. BankAtlantic does not currently anticipate that the aggregate losses in the Subject Portfolio will exceed $18 million. BankAtlantic also agreed to exercise reasonable collection activities with regard to the Subject Portfolio and to provide the carrier with a credit for any recoveries with respect to such loans against future losses that the carrier would otherwise be obligated to reimburse. The balance of the loans and dealer reserve associated with the Subject Portfolio amounted to approximately $24.4 million and zero at December 31, 1993, and $29.9 million and $2.5 million at December 31, 1992, respectively. At December 31, 1993, 10% of the loans were secured by collateral in South Florida and 90% of such loans were secured by collateral in the northeastern United States. Collateral for these loans in generally a second mortgage on the borrower's property. However, it appears that in most cases, the property is encumbered with loans having high loan to value ratios. Although as indicated above, the dealer reserves are not collateralized, the risk relating to amounts advanced to the dealers are primarily associated with loan performance. Loans in the "Subject Portfolio" are charged-off if payments are more than 90 days delinquent. Related to the above are suits filed in New Jersey and New York. The New Jersey action seeks civil remedies against certain contractors and a dealer and also seeks to cancel or modify certain mortgage loans. BankAtlantic had purchased individual loans from the named dealer and such purchased loans include loans for which a named contractor is listed as providing home improvements. While BankAtlantic is not a party to that action, a status conference was held in December 1993 which indicated that discovery is to be completed by May 1994 and BankAtlantic must determine by April 1994 whether to intervene in the action. The New York action purports to be a class action against over 25 individuals and entities, including BankAtlantic. The named plaintiffs purport to also represent other unnamed plaintiffs that may have obtained loans from dealers who subsequently sold such loans to BankAtlantic. Plaintiffs base their claims on various grounds and seek, among other things, rescission of the loan agreements, damages, punitive damages, costs, attorney fees, penalties under the truth in lending act and treble damages under RICO. The plaintiffs' Motion to Certify the Class was made in November, 1993. The court has not yet ruled on this motion. 18. Selected Quarterly Results (Unaudited) The following tables summarize the quarterly results of operations for the years ended December 31, 1993 and 1992 (in thousands except per share data): During the second quarter, BankAtlantic settled a claim with the IRS relating to net operating loss carrybacks and previous Federal income tax examinations through 1988, resulting in an increase in other interest income of $587,000 and a reduction in the provision for income taxes of $1.4 million. The weighted average number of common and common equivalent shares outstanding during the first quarter of 1993 were not restated to reflect the exercise of warrants by BFC. During the fourth quarter, BankAtlantic sold approximately $115.4 million of mortgage-backed securities at a gain of $5.2 million. Additionally, BankAtlantic recovered $3.3 million in expenses, recorded loan loss recoveries of $7.3 million and increased interest income by $1.9 million for circumstances relating to the Subject Portfolio and the Covenant discussed in Note 17. Also during the fourth quarter, BankAtlantic recorded a $756,000 ($.16 and $.14 per share for primary and fully diluted income per share, respectively) extraordinary gain from the utilization of state net operating loss carryforwards. 19. Other Information On November 14, 1991, BFC increased its common stock ownership in BankAtlantic to 72.50% by acquiring in the open market an additional 115,000 shares of BankAtlantic common stock at a per share price of $.76. The increase in ownership was subject to all regulatory approvals which have been received. As further discussed in Note 11, BFC increased its common stock ownership in BankAtlantic to 77.83% at June 30, 1993 and subsequently, in November 1993, sold 1.4 million shares of BankAtlantic common stock to decrease their ownership percentage to 48.17% at December 31, 1993. The Chairman and President of BFC is Alan B. Levan, who also serves as the Chairman and Chief Executive Officer of BankAtlantic. John E. Abdo, a director of BFC, is the Vice Chairman of BankAtlantic and Chairman and President of BankAtlantic Development Corporation, a wholly owned subsidiary of BankAtlantic. BankAtlantic is exploring the formation of a holding company which will own 100% of BankAtlantic's common stock. Any such formation would be subject to shareholder approval and would generally involve a shareholder exchanging their shares of BankAtlantic for shares in the new entity. At the time of any such exchange, a shareholder's proportionate ownership position in the new entity would be equal to the proportionate interest previously held in BankAtlantic. BFC has indicated that it would vote in favor of this type of shareholder proposal. 20. Investments In and Advances To Joint Ventures BankAtlantic, through its wholly-owned subsidiary, BankAtlantic Development Corporation ("BDC"), has non-consolidated equity interests ranging from 35% to 50% in joint ventures engaged primarily in the acquisition, development and construction of various real estate projects. By December 31, 1991, all development and construction activities had been completed and the remaining real estate of the ventures consists of single family homes and lots held for sale. Included in "Other Assets" in the consolidated statement of condition is $1.2 million of investments and advances to joint ventures at December 31, 1993 and 1992, respectively. Summarized combined financial information (unaudited) of the joint ventures was (in thousands): December 31 ------------------------------ 1993 1992 ------------- ------------- Condensed Statements of Financial Condition Assets: Cash $ 864 $ 298 Real estate held for sale 313 1,014 Other assets 249 104 ------------- ------------- Total income $ 1,426 $ 1,416 ============= ============= Liabilities and partners' equity: Loans and notes payable $ 1,264 $ 1,269 Accounts payable and other liabilities 448 378 Partners' (deficit) equity (286) (231) ------------- ------------- Total $ 1,426 $ 1,416 ============= ============= For the Years Ended December 31, ----------------------------------- 1993 1992 1991 --------- ---------- ---------- Condensed Statements of Operations Income: Sales $ 721 $ 160 $ 47,527 Cost of sales 725 162 40,983 --------- ---------- ---------- Net (loss) gain on sales (4) (2) 6,544 Interest and other income 87 90 2,208 --------- ---------- ---------- Total income 83 88 8,752 --------- ---------- ---------- Expenses: Interest expense 73 84 1,433 Other expense 65 198 2,531 --------- ---------- ---------- Total expenses 138 282 3,964 --------- ---------- ---------- Net (loss) income $ (55) $ (194) $ 4,788 ========= ========== ========== Included in loans and notes payable above as of December 31, 1993 and 1992, respectively, was $1.0 million due to BankAtlantic. These loans are included with "Investments In and Advances To Joint Ventures" in BankAtlantic's financial statements. During 1991, two joint venture projects were sold for gains of $1.9 million and $1.2 million. Proceeds from the sales reduced the investments in and advances to joint ventures by approximately $8.4 million in 1991. During 1992, BDC established a $250,000 allowance account against its investment in the remaining properties, of which a balance of $182,000 remained at December 31, 1993. Such amount is included in (income) loss from joint venture investments in BankAtlantic's Consolidated Statement of Operations, but is not in the condensed statement of the ventures due to a dispute and related litigation with the joint venture partners. 21. Estimated Fair Value of Financial Instruments The information set forth below provides disclosure of the estimated fair value of BankAtlantic's financial instruments presented in accordance with the requirements of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (FAS 107) issued by the FASB. Management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, management has no basis to determine whether the fair value presented would be indicative of the value negotiated in an actual sale. BankAtlantic's fair value estimates do not consider the tax effect that would be associated with the disposition of the assets or liabilities at their fair value estimates. Fair values are estimated for loan portfolios with similar financial characteristics. Loans are segregated by category such as commercial, commercial real estate, residential mortgage, second mortgages, and other installment. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and non-performing categories. The fair value of performing loans, except residential mortgage and adjustable rate loans, is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of average maturity is based on BankAtlantic's historical experience with prepayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for national historical prepayment estimates using discount rates based on secondary market sources adjusted to reflect differences in servicing and credit costs. For adjustable rate loans, the fair value is estimated at book value after adjusting for credit risk inherent in the loan. BankAtlantic's interest rate risk is considered insignificant since the majority of BankAtlantic's adjustable rate loans are based on prime rates or one year Constant Maturity Treasuries ("CMT") rates and adjust monthly or generally not greater than one year. Fair values of non-performing loans are based on the assumption that non- performing loans are on a non-accrual status discounted at market rates during a 24 month work-out period. Assumptions regarding credit risk are judgementally determined using available market information and specific borrower information. The fair value of tax certificates and other investment securities is calculated by discounting estimated cash flows using estimated market discount rates that reflect the credit and interest rate risk inherent in the investment. Tax certificates do not have stated maturities. Estimated cash flows were based on BankAtlantic's historical experience, modified by current economic conditions. Fair value of mortgage-backed securities is estimated based on bid prices available from security dealers. Under FAS 107, the fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings and NOW accounts, and money market and checking accounts, is equal to the amount payable on demand at December 31, 1993. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using alternative borrowing rates adjusted for maintenance and insurance costs. The book value of securities sold under agreements to repurchase approximates market value. The fair values of advances from FHLB, capital notes and other subordinated debentures were based upon comparable terms to maturity, interest rates and issuer credit standing. The following table presents information for BankAtlantic's financial instruments at December 31, 1993 and 1992 (in thousands): The contract amount and related fees of BankAtlantic's commitments to extend credit, standby letters of credit, and financial guarantees approximates fair value (see Note 16 for the contractual amounts of BankAtlantic's financial instrument commitments). BankAtlantic, A Federal Savings Bank and Subsidiaries ITEM 6. SELECTED FINANCIAL DATA Selected Consolidated Financial Data December 31, ------------------------------------------------- 1993 1992 1991 1990 1989 --------- --------- --------- --------- --------- (In thousands) Statement of Financial Condition: Total assets $1,359,195 1,303,071 1,455,822 1,896,587 1,886,453 Loans receivable-net 595,887 556,662 728,515 964,863 1,116,313 Mortgage-backed securities 526,365 487,494 460,780 439,509 461,406 Tax certificates and other investment securities, net (1) 97,701 120,424 109,076 115,763 142,057 Purchased mortgage servicing rights and other intangibles 19,833 7,655 6,748 4,663 4,067 Deposits 1,076,360 1,108,115 1,255,513 1,455,967 1,430,219 Advances from FHLB and securities sold under agreements to repurchase 149,435 87,632 94,332 309,879 329,875 Total stockholders' equity $ 90,652 66,165 50,997 53,230 57,977 ========= ========= ========= ========= ========= For the Years Ended December 31, ------------------------------------------ 1993 1992 1991 1990 1989 --------- --------- --------- --------- --------- (In thousands, except share data) Statement of Operations Data: Total interest income $ 94,503 116,476 145,532 175,979 192,453 Total interest expense 35,987 55,567 90,998 127,718 149,451 --------- --------- --------- --------- --------- Net interest income 58,516 60,909 54,534 48,261 43,002 Provision for loan losses 3,450 6,650 17,540 17,655 5,350 --------- --------- --------- --------- --------- Net interest income after provision for loan losses 55,066 54,259 36,994 30,606 37,652 --------- --------- --------- --------- --------- Non-interest income: Loan servicing and other loan fees 2,080 3,189 4,344 4,188 3,409 Gain on sales of loans and mortgage-backed securities 1,246 6,702 1,078 6,727 1,589 Gain (loss) on sales of investment securities 0 143 62 (151) (282) Other 8,265 7,337 8,622 7,772 7,747 --------- --------- --------- --------- --------- Total non-interest income 11,591 17,371 14,106 18,536 12,463 --------- --------- --------- --------- --------- Non-interest expenses: Employee compensation and benefits 19,617 19,202 24,062 26,254 26,745 Occupancy and equipment 8,417 8,864 10,626 11,218 10,659 Federal insurance premium 2,750 2,772 3,281 2,883 3,060 Advertising and promotion 960 480 1,143 2,498 2,728 (Income) loss from joint venture investments 25 245 (2,335) 897 819 Foreclosed asset activity-net 1,243 4,323 8,922 1,704 1,049 Other 10,474 11,251 19,465 12,887 13,881 --------- --------- --------- --------- --------- Total non-interest expense 43,486 47,137 65,164 58,341 58,941 --------- --------- --------- --------- --------- Income (loss) before income taxes and extraordinary items 23,171 24,493 (14,064) (9,199) (8,826) Provision (benefit) for income taxes 7,093 9,201 (4,841) (1,952) (2,941) --------- --------- --------- --------- --------- Income (loss) before extraordinary items 16,078 15,292 (9,223) (7,247) (5,885) Extraordinary items net of taxes - 756 660 - 2,331 --------- --------- --------- --------- --------- Net Income (loss) $ 16,078 16,048 (8,563) (7,247) (3,554) ========= ========= ========= ========= ========= Income (loss) per common and common equivalent share: Income (loss) before extraordinary items $ 2.52 3.07 (2.12) (1.64) (1.60) Extraordinary items - 0.16 0.14 - 0.63 --------- --------- --------- --------- --------- Net income (loss) $ 2.52 3.23 (1.98) (1.64) (0.97) ========= ========= ========= ========= ========= Actual common shares outstanding at year end 6,478,605 4,681,628 4,681,628 4,676,750 4,135,320 ========= ========= ========= ========= ========= Weighted average number of common and common equivalent shares outstanding 6,054,402 4,694,099 4,680,439 4,409,743 3,669,019 ========= ========= ========= ========= ========= Income per common and common equivalent share assuming full dilution: Income before extraordinary items $ 2.51 2.65 N/A N/A N/A Extraordinary items - 0.14 N/A N/A N/A --------- --------- --------- --------- --------- Net income $ 2.51 2.79 N/A N/A N/A ========= ========= ========= ========= ========= Weighted average number of common and common equivalent shares assuming full dilution 6,091,800 5,440,798 N/A N/A N/A ========= ========= ========= ========= ========= BankAtlantic, A Federal Savings Bank and Subsidiaries SELECTED CONSOLIDATED FINANCIAL DATA Years Ended December 31, ---------------------------------- 1993 1992 1991 1990 1989 ------- ------- ------- ------- ------- Other Financial and Statistical Data: Performance Ratios: Income (loss) on average assets (5) 1.25 % 1.10 % (0.57)% (0.38)% (0.29)% Income (loss) on average equity (5) 21.32 % 27.09 % (16.36)% (12.48)% (10.26)% Dividend payout percent (6) 4.78 % N/A N/A N/A N/A Average equity to average assets 5.85 % 4.07 % 3.51 % 3.08 % 2.81 % Interest rate margin during period 4.90 % 4.78 % 3.71 % 2.76 2.24 % Average yield on loans, mortgage-backed securities, tax certificates, and investment securities 7.95 % 9.14 % 9.89 % 10.05 % 10.05 % Average cost of deposits and borrowings 3.18 % 4.45 % 6.24 % 7.41 % 8.01 % Net interest spread (7) - during period 4.77 % 4.69 % 3.65 % 2.64 % 2.04 % Net interest spread (7) - end of period 4.36 % 4.63 % 4.28 % 2.80 % 2.32 % Operating expenses as a percent of net interest income plus non-interest income 62.03 % 60.22 % 94.94 % 87.34 % 106.27 % Asset quality ratios: Non-performing assets as a percent of total loans and real estate owned 3.21 % 4.59 % 4.80 % 4.36 % 1.79% Charge-offs as a percent of total loans 0.73 % 2.21 % 2.81 % 0.88 % 0.51% Loan loss allowance as a percent of total loans 2.77 % 2.88 % 1.85 % 1.61 % 0.52% Loan loss allowance as a percent of non-performing loans 173.01 % 142.93 % 95.26 % 88.31 % 71.81% Non-performing loans as a percent of total loans 1.60 % 2.01 % 1.94 % 1.82 % 0.72% Non-performing assets as a percent of total assets 1.47 % 2.07 % 2.52 % 2.31 % 1.08% Ratio of earnings to fixed charges: (8) Including interest on deposits 1.64 1.44 0.85 0.93 0.94 Excluding interest on deposits 6.53 4.00 (0.82) 0.71 0.79 Dollar deficiency of earnings to fixed interest charges (000's omitted) $ - $ - $ 14,064 $ 9,199 $ 8,826 Number of: Offices (all full-service) 31 31 34 46 46 Deposit accounts 113,459 120,558 144,942 165,486 175,547 Total loans 19,163 27,761 36,936 46,218 42,926 ======= ======= ======= ======= ======= MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION General BankAtlantic commenced operations in 1952 as Atlantic Federal Savings and Loan Association, a federally chartered mutual savings and loan association; converting to a stock association in 1983. In 1987, BFC Financial Corporation acquired control of BankAtlantic. From 1952 to 1987, BankAtlantic operated as a traditional savings and loan association. During the periods ended December 31, 1987 and 1988, BankAtlantic had a thin capital base (with a surplus of only $258,000 of capital over the applicable requirements at December 31, 1988), high cost interest sensitive time deposits and borrowings, low levels of fee income, poorly structured interest rate swaps, no automatic teller machines, no drive through operations, outdated computer systems and a loan portfolio primarily consisting of long term , fixed rate mortgages. Additionally, shortly after the 1987 change in control, it was announced that the FSLIC was insolvent and all savings and loans associations, including BankAtlantic, were required to write-off their FSLIC secondary reserve fund assets. Based on the industry wide problems and the institution's structure, management concluded that a new direction and focus was required in order for the institution to survive and prosper in the changing economic and regulatory climate. The fundamental strategy was to shift from traditional thrift activities to activities more closely related to commercial banking. This strategy emphasized changing the deposit mix to transaction accounts from time deposits and providing a full range of other banking services to customers. Acting upon this plan, the institution, in 1987, converted to a federal savings bank and changed its name from Atlantic Federal Savings and Loan Association of Fort Lauderdale to BankAtlantic, A Federal Savings Bank. This overall strategy required substantial expenditures for marketing, equipment, computer software and personnel. During the same time period, regulations requiring increased capital ratios for savings institutions were adopted. As a consequence, in addition to its efforts to restructure its assets and liabilities, BankAtlantic was required to focus on increasing capital. As of December 31, 1993, BankAtlantic met all of the more stringent capital requirements established by FIRREA and FDICIA. It did so by reducing its size, operations earnings and increasing its equity capital. Results of Operations Net income of $16.1 million, $16.0 million and a net loss of $8.6 million were recorded for the three years ended December 31, 1993, 1992 and 1991, respectively. Operations for 1993 include, during the second quarter, settlement of a claim with the Internal Revenue Service ("IRS") relating to net operating loss carrybacks and previous federal income tax examinations through 1988, resulting in an increase in other interest income of $587,000 and a reduction in the provision for income taxes of $1.4 million. Net income during December 31, 1992 included a $756,000 net extraordinary gain during the fourth quarter, resulting from the utilization of state net operating loss carryforwards. Operations during the fourth quarter of 1992 also included amounts relating to the October 30, 1992 Covenant and to the Subject Portfolio. During the fourth quarter of 1992, and for the year ended December 31, 1992, the financial effect of the Covenant was to reduce expenses by $3.3 million, increase interest income by $1.9 million and recognize loan loss recoveries of $7.3 million. The Covenant was operative for all of 1993 and the financial effect of the Covenant for 1993 was to reduce expenses by $942,000, increase interest income by $757,000 and recognize loan loss recoveries of $972,000. Non-interest income for December 31, 1992 also includes gains of $5.9 million from sales of mortgage-backed and investment securities, compared to gains of $810,000 in 1991 and none in 1993, due to an absence of such sales. The loss during December 31, 1991 included a $660,000 net extraordinary gain from BankAtlantic's early retirement of $10.2 million of Capital Notes by exchanging cash payments, cash bonuses, and Non-Cumulative Preferred Stock ("Preferred Stock") to Capital Noteholders. During 1991, BankAtlantic wrote off $2.7 million in dealer reserves relating to loans in the Subject Portfolio, which, as indicated above, was subsequently recovered in 1992 from BankAtlantic's fidelity bond carrier. Income per common and common equivalent share (primary income per share) and income assuming full dilution (fully dilutive income per share) for the years ended December 31, 1993 and 1992 were $2.52 and $2.51; $3.23 and $2.79, respectively. For the year ended December 31, 1991, loss per common and common equivalent share was $1.98. Although 1993 net earnings increased compared to 1992, income per share in 1993 decreased due to the approximately 1.7 million of additional shares issued during 1993 relating to the second quarter exercise of warrants to acquire common stock by BFC and also the additional 670,000 shares issued in a November 1993 public offering. The effect of these new shares and the impact relating to the calculation of common stock equivalent shares outstanding decreased primary and fully dilutive income per share during 1993. The average and end-of-period stock price utilized in the calculation of dilutive securities was $12.88 and $13.75, and $3.84 and $7.17 at December 31, 1993 and 1992, respectively. Operations for the years ended December 31, 1993 and 1992 were also favorably impacted by lower provisions for loan losses and improved results in the operation and disposition of foreclosed properties as compared to each prior year. Another significant operating benefit during the three year period ended December 31, 1993 related to the interest rate environment and BankAtlantic's interest rate sensitivity gap position during these periods. From 1991 through mid-1993, BankAtlantic had a one-year negative interest rate sensitivity gap. Since that time, BankAtlantic has had a positive one-year interest rate sensitivity gap. A negative interest rate sensitivity gap provides the potential for widening interest margins and increased earnings during times of declining rates, the environment that existed during the periods under discussion. However, a negative gap will correspondingly negatively impact earnings when rates increase. During periods of declining rates, a significant amount of repayments and prepayments of loans and mortgage-backed securities occur due to refinancing alternatives at lower rates. BankAtlantic continues to experience this type of activity which will generally result in lower rates earned on interest-bearing assets newly acquired or which bear floating interest rates compared to the interest rates earned on prior year investments, loans and mortgage-backed securities. However, rates earned in 1994 will benefit from the final amortization in 1993 of dealer reserves relating to the Subject Portfolio, such net amortization amounted to approximately $2.2 million in 1993. Additional details concerning the items discussed above are contained in specific sections and tables of this Management's Discussion and Analysis. Net-Interest Income A financial summary of net interest income follows: The changes in net interest income for the years ended December 31, 1993, 1992 and 1991 resulted from the following: the decrease in interest on loans primarily resulted from lower average loan balances and secondarily lower yields. BankAtlantic's average loan portfolio balances declined from $876.3 million during 1991 to $652.4 million during 1992 and to $532.3 million during 1993. These declines resulted from principal repayments exceeding loan originations primarily due to reduced originations in consumer lending and prepayments of residential loans and consumer loans. The average yield on BankAtlantic's loan portfolio has declined from 10.23% for the year ended December 31, 1991 to 8.95% for the year ended December 31, 1993. The decline in loan yields reflects the general decline in market interest rates, and repayment of higher yielding consumer loans. The decline in loan yields in 1993 was partially offset by an overall improvement in BankAtlantic's non- accruing loan balances, resulting in fewer reversals of interest income. The decrease in interest and dividends on tax certificates and other investment securities resulted primarily from lower yields on tax certificates during the comparable periods, and lower tax certificate balances during 1993 compared to 1992 and 1991. BankAtlantic purchased $78 million, $125.2 million and $121.8 million of tax certificates (at auctions and by purchases of deeds) during the years ended December 31, 1993, 1992 and 1991, respectively. Decreased interest on mortgage-backed securities resulted from lower yields earned on the mortgage-backed securities portfolio, offset, in whole or in part, by higher mortgage-backed securities portfolio balances in 1993 compared to 1992 and in 1992 compared to 1991. The higher balances and lower yields were the result of BankAtlantic restructuring its securities portfolio during 1992 and 1993 by using proceeds from loan repayments and sales of long-term fixed rate mortgage-backed securities to purchase adjustable rate and fixed rate five and seven year balloon mortgage-backed securities. During the year ended December 31, 1993, BankAtlantic used principal repayments on loans and tax certificates to purchase an additional $206.9 million of adjustable rate and fixed rate seven year balloon mortgage-backed securities. These actions reflected management's goal to minimize interest income volatility. Other interest income was solely related to an IRS settlement in June 1993. The decreases in interest expense on deposits resulted substantially from lower certificate account balances and lower short-term interest rates in 1993 and 1992 compared to the preceding years, and the continuing change in the deposit mix in 1993 from generally higher rate certificates of deposit to lower rate transaction accounts. Average transaction accounts to total deposits increased from 45.1% in 1991 to 51.3% and 58.5% in 1992 and 1993, respectively. The change in the deposit mix resulted from management's decision to pay commercial bank interest rates on time deposits and to actively pursue transaction and relationship accounts. Management's goal in changing the deposit mix is to improve BankAtlantic's net margin. Total deposits declined by $179 million from $1.26 billion at December 31, 1991 to $1.1 billion at December 31, 1993. During the period, time deposits declined by $206 million, while non-interest bearing deposits increased by $14.5 million. Management believes that a significant portion of the decline is a result of a historically low interest rate environment and the increasing availability of alternative investments for time deposits. The decline in interest on Capital Notes and other subordinated debentures was primarily due to the July 1992 redemption at par of $6.9 million of 1986 Capital Notes, the redemption of the remaining $67.8 million of both 1986 Capital Notes and the $1 million of 14% subordinated debentures during the third quarter of 1993, at par and the June 30, 1993 conversion of approximately $2.0 million of 13% subordinated debentures due to BFC into common stock of BankAtlantic. The Capital Notes and subordinated debentures were redeemed because the rates paid on this debt was in excess of the then current market rates. The effect of these redemptions on regulatory capital was not material. The decline in interest on FHLB advances was due to the maturity of higher yielding FHLB advances during 1992 and 1993, offset by higher balances of lower yielding short-term adjustable rate FHLB advances during 1992. Interest on securities sold under agreements to repurchase declined due to lower average borrowings and yields in 1993 compared to 1992, while the benefit of decreased yields paid during 1992 was more than offset by higher borrowings compared to 1991. During each of the three years ended December 31, 1993, BankAtlantic's average interest earning assets and average interest bearing liabilities decreased and the average rates earned and paid, respectively, also declined. The effect of lower rates and decreased volume resulted in lower interest income of $22.6 million in 1993. This decline was partially offset by a $19.6 million benefit from lower interest expenses due to lower volume and lower interest rates. These significant volume and rate changes occurred in 1992, with lower interest income of $29.1 million and lower interest expense of $35.4 million compared to 1991. Other interest expense declined in 1992 due to the March 1991 expiration of a $35.0 million interest rate swap. Details of these changes are further discussed below and are illustrated in the "Yields Earned and Rates Paid" and "Rate/Volume Analysis" tables included elsewhere herein. The average interest margin was 4.90%, 4.78% and 3.71% for the three years ended December 31, 1993, 1992 and 1991, respectively. The improved margin in 1993 compared to 1992 and 1991 resulted from the shift in the deposit mix previously discussed, lower short term interest rates, the redemption of Capital Notes and subordinated debentures, and the expiration of the interest rate swap. The present interest rate environment is expected to continue to reduce the average rate earned by BankAtlantic on its interest earning assets. However, this reduction may be offset, in whole or in part, by lower borrowing rates and a continued shift in the deposit mix to lower rate transaction accounts from higher rate time deposits. As described in "Asset and Liability Management", BankAtlantic has been changing the composition of its loan portfolio to shorter term, adjustable rate, higher yielding loans from traditional fixed rate, long term mortgage loans. This change in portfolio composition is intended to produce a continuing benefit in BankAtlantic's interest rate margin volatility. Shorter term, adjustable rate, higher yielding loans include consumer, construction and permanent (5-7 year) commercial real estate loans. These loans are generally considered to involve a higher risk of default than single-family residential loans. Repayment of construction and permanent commercial real estate loans is generally dependent on the successful operation of the related real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy. Construction loans involve additional risks because loan funds are advanced upon the security of the project under construction, which is of uncertain value prior to completion of construction. Provision for Loan Losses and Declines in Value of Real Estate Owned Management conducts a monthly review of BankAtlantic's allowance for loan losses and all identified potentially problematic loans to determine if the allowance is adequate to absorb estimated loan losses and to evaluate appropriate courses of action. This review includes risk elements, all loans for which full collectibility may not be reasonably assured, and takes into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific non-performing loans, and current economic conditions and trends that may affect the borrower's ability to repay. The review is conducted by using the most current information available to BankAtlantic such as appraisals, inspection reports and borrower financial statements. An evaluation is also made of the estimated fair value of any underlying loan collateral. During the years ended December 31, 1993, 1992 and 1991, the provision for loan losses was $3.5 million, $6.7 million and $17.5 million, respectively. The provision in each of these years was substantially impacted by installment loan quality. Installment loan charge-offs amounted to $3.4 million, $10.4 million and $18.9 million in 1993, 1992 and 1991, respectively. Management believes that the declines in charge-offs resulted from portfolio maturity and runoff, lower interest rates and improved collection activity. Net installment loan charge-offs of $2.1 million, $1.8 million and $17.9 million in 1993, 1992 and 1991, respectively, were significantly impacted by the recoveries associated with the October 1992 Covenant with an insurance carrier. Installment loan recoveries from this source were $7.3 million in 1992 and $1 million in 1993. Charge-offs related to the installment loans for which the Covenant was executed, declined from $5.5 million 1991 to $2.5 million in 1992 and to $1 million in 1993. BankAtlantic's "risk elements" consist of restructured loans and "non- performing" assets. The classification of loans as "non-performing" is based upon management's evaluation of the overall loan portfolio and current and anticipated future economic conditions. BankAtlantic generally designates any loan that is 90 days or more delinquent as non-performing. BankAtlantic may designate loans as non-performing prior to the loan becoming 90 days delinquent, if the borrower's ability to repay is questionable. A "non- performing" classification alone does not indicate an inherent principal loss; however, it generally indicates that management does not expect the asset to earn a market rate of return in the current period. Restructured loans are loans for which BankAtlantic has modified the loan terms due to the financial difficulties of the borrower. At both December 31, 1993 and 1992, restructured loans were $2.7 million compared to $7.6 million in 1991. Non- performing assets, net of write downs and allowances, decreased in 1993 by $7.0 million to $20.0 million at December 31, 1993. Risk elements, net of write downs and dispositions, decreased in 1993 by $7.0 million to $22.6 million at December 31, 1993 and decreased in 1992 by $14.5 million to $29.7 million at December 31, 1992. The 1993 decline primarily resulted from sales of $5.1 million of real estate owned and a $3.2 million decline in non-accruing loans. The 1992 decrease primarily related to a $6.3 million decrease in real estate owned, a $3.3 million decrease in non- accrual assets, primarily consumer, and a $4.9 million decrease in restructured loans. The decrease in real estate owned primarily resulted from a provision for declines in value of real estate owned of $3.8 million, and proceeds received from the sales of real estate owned of $11.1 million offset by transfers of $2.4 million and $5.5 million of residential and commercial loans to real estate owned. The $3.3 million decrease in non-accrual assets resulted primarily from a $2.6 million and $476,000 decline in consumer and tax certificate non-accruals as of December 31, 1992, respectively. The decline in consumer non-accruals related to (a) repossessions occurring at an earlier stage in the collection process, (b) a reduction in size of the general loan portfolio, (c) charge-offs and (d) more stringent underwriting standards on new loans. The non-accrual tax certificate decline resulted from write-downs of affected certificates prior to reaching a non-accrual status. The $4.9 million decrease in restructured loans resulted from $7.2 million of commercial loans being taken off restructured status in 1992 offset by $2.3 million of commercial loans being restructured. At December 31, 1993, gross real estate loans amounted to $343.7 million, $134.3 million of which were residential loans which management believes carry minimal credit risk. The remaining real estate loans consisted of $198.1 million of commercial real estate loans, and $11.3 million of construction and development loans. Management believes that BankAtlantic's commercial real estate loans are adequately collateralized and generally involve no unusual risks of collectibility. Gross other loans amounted to $277.8 million, and included commercial (non-real estate) loans, bankers acceptances and installment (including second mortgage) loans of $28.0 million, $110.7 million and $139.1 million, respectively. Commercial and installment loans involve greater risks of collectibility, but management does not believe that such risks have been greater than normal industry experience for these types of loans except for the Subject Portfolio discussed under "Financial Condition." Bankers acceptances are short-term loans with minimal credit risk. Management estimates that net charge-offs for 1994 will be approximately $3-4 million for consumer loans, and $2-3 million for real estate and other loans. During the years ended December 31, 1993, 1992 and 1991, BankAtlantic's provisions for declines in real estate owned were $2.7 million, $3.8 million and $7.3 million, respectively. For the years ended December 31, 1993, 1992 and 1991, charge-offs were $775,000, $1.9 million and $7.0 million, respectively. The allowance for real estate owned is established by management based on its evaluation of the foreclosed properties. The 1993 charge-offs included a $350,000 write-off of an insubstance foreclosed commercial real estate loan due to an unfavorable environmental analysis of the property. The 1992 charge-offs included a $600,000 write down of a shopping center. The remaining charge-offs for 1993 and 1992 were related to various commercial and residential real estate properties. During 1991, BankAtlantic wrote-down one commercial residential construction property by $2.8 million and one commercial shopping center by $1.7 million. The remaining 1991 charge-offs related to various commercial and residential real estate properties based on the depressed real estate market in South Florida and management's evaluation of the properties at the time. Non-Interest Income A financial summary of non-interest income follows: During 1993, 1992 and 1991, BankAtlantic paid $17.0 million, $3.8 million, and $3.5 million, respectively, for the purchase of $1.2 billion, $333.8 million, and $253.0 million, respectively, of mortgage servicing from other financial institutions. The purchase of servicing provides BankAtlantic with an opportunity to replace normal run-off, upgrade its portfolio, and utilize economies of scale in the loan servicing function. BankAtlantic upgraded its portfolio by purchasing the servicing of loans with higher average balances than contained in its previous portfolio. However, income from servicing declined in 1993 and 1992 by $875,000 and $880,000, respectively, due to accelerated amortization of servicing acquisition fees resulting from early prepayments of the underlying mortgage loans. The early prepayments were caused by the refinancing of mortgage loans due to declining long term interest rates throughout the three years ended December 31, 1993. The servicing purchased during 1993 related to recently originated loans in the Southeast United States. The early prepayments were caused by the refinancing of mortgage loans due to declining long-term interest rates throughout the two years ended December 31, 1993. During 1991, prepayments were approximately 7% of loans serviced, compared to approximately 22% in 1992 and 19% in 1993. Based upon the significant amount of servicing purchased in 1993 relating to recently originated loans and a relatively stable residential interest rate environment, BankAtlantic's recent monthly prepayment experience has been less than that experienced in 1992 and 1993. The impact of prepayments on servicing income is partially offset by increased gains from sales of recently originated residential loans. See also "Sales on Mortgage-Backed Securities, Investment Securities and Loans." The major component of non-interest income-other was fees from transaction accounts which amounted to $5.2 million, $5.0 million and $5.2 million in 1993, 1992 and 1991, respectively. The increase in non-interest income-other for the year ended December 31, 1993, as compared to the same period in 1991 was due to additional income received from a broker dealer that rents space in BankAtlantic's branches and fee income received related to cashier and operating checks. The decrease in non-interest income-other for the year ended December 31, 1992, as compared to the same period in 1991, was due to a reversal in 1991 of a $415,000 allowance related to reconciliation differences recorded in prior years and a reversal in 1992 of dormant account fee income. Beginning in 1990, the Office of the Comptroller for the State of Florida ("Comptroller") commenced a review of BankAtlantic's procedures for the assessment of fees on dormant accounts. The Comptroller subsequently indicated that BankAtlantic was not in compliance with applicable Florida law as interpreted by the Comptroller. The difference in interpretation concerns approximately $500,000 and has not yet been resolved. Pending resolution of the issue and modification of the procedures, dormant account assessments, approximately $10,000 per month, have been eliminated since 1992, and an allowance has been established for the amount which is in question. Non-Interest Expense A financial summary of non-interest expense follows: The decline in occupancy and equipment expenses for the year ending December 31, 1993, as compared to December 31, 1992, primarily resulted from BankAtlantic discontinuing its lease agreement on teller equipment as part of its branch network modernization project. See "Liquidity and Capital Resources" for a further discussion of these efforts. During the year ended December 31, 1992, occupancy expenses declined from the comparable periods in 1991 due to BankAtlantic consolidating back office operations into bank owned buildings during the latter part of 1990 and in 1991. The office space consolidation resulted in a decline in rental expense of approximately $1.1 million during the year ended December 31, 1992, compared to the year ended December 31, 1991. Foreclosed asset activity, net decreased during 1993 compared to 1992, primarily due to a decline in real estate owned which resulted in $1.4 million lower related operating expenses, and $1.2 million lower provision for declines in real estate owned and a $563,000 increased in gains on sales of foreclosed properties. Foreclosed asset activity, net decreased for the year ended December 31, 1992, compared to the year ended December 31, 1991. The decline was the result of a $3.4 million decrease in the provision for declines in value of real estate owned, a $446,000 decrease in expenses associated with such real estate owned expenses and a $707,000 improvement in net gains and losses on sales of real estate owned. For a further discussion, see "Provision for Loan Losses and Declines in Value of Real Estate Owned." Employee compensation and benefits during 1993 remained approximately at 1992 levels. The decline in employee compensation and benefits during 1992 as compared to 1991 was due to BankAtlantic closing 15 branches, resulting in a decline in the number of employees. In addition, the branch consolidation also resulted in lower occupancy expenses during 1992 as compared to the same period in 1991. During early 1992, BankAtlantic completed the consolidation of 15 branches into existing branches. The consolidation, which commenced during 1991, required a provision for costs relating to employee severance, lease terminations and write-offs of leasehold improvements at December 31, 1991. Due primarily to the branch consolidation, and a reduction in BankAtlantic's back office operations, BankAtlantic's full time equivalent employees decreased from 765 at December 31, 1990, to 620 at December 31, 1992 and increased to 632 at December 31, 1993, resulting in a reduction of employee compensation and benefits for the year ended December 31, 1992, compared to the same period in 1991. The slight increase during 1993, compared to 1992 related primarily to additional personnel and salary changes. The 1991 reduction in employees and the branch consolidations resulted from BankAtlantic downsizing its operations in order to gain operating efficiencies and to assist it in meeting regulatory capital requirements. Included in employee compensation and benefits was a $351,000 pension curtailment gain arising from the reduction in work force during 1991. The increase during the year ended December 31, 1993 compared to the year ended December 31, 1992 in advertising and promotion was due to increased media expenses incurred to promote new transaction account packages and to originate residential mortgage loans for resale. The reduced advertising during 1992, compared to 1991 was a result of BankAtlantic's downsizing discussed above. The decline in non-interest expense-other during the year ended December 31, 1993 compared to the same period in 1992 resulted from a $550,000 decline in legal fees inclusive of $800,000, relating to the reimbursement under the Covenant, and a $300,000 decline in supervisory and examination expenses which management believes was due mainly to BankAtlantic's status as a well capitalized institution. An additional $450,000 decrease related to improved operations in the installment collections and repossessions areas. The remaining decline in non-interest expense-other was due to lower operating expenses in 1993 as compared to 1992. The decrease in non-interest expense- other for the year ended December 31, 1992, was the result of a $568,000 recovery of legal fees pursuant to the Covenant and a $1.2 million decline in repossession expenses and write-downs in 1992 compared to the same period in 1991. The decline in repossession expenses and write-downs resulted from management's decision to charge-off consumer loans at an earlier stage in the collection process during the latter part of 1991, and reduced consumer loan originations. Included in (income) loss from joint venture investments for the year ended December 31, 1991 was a gain of $3.1 million. The gain was generated by one of BankAtlantic's wholly-owned subsidiaries, BankAtlantic Development Corporation ("BDC"), which participated with joint venture partners in the sales of real estate projects. At December 31, 1991, all development and construction activities had been completed and the remaining real estate of the ventures consists of a minimal amount of single family homes and lots available for sale. There were no significant sales of joint venture properties during the year ended December 31, 1993 and 1992. Included in (income) loss from joint venture investments for 1992 was a $250,000 allowance against BankAtlantic's investment in the remaining properties. For the year ended December 31, 1991, the gains on the sale of the joint venture properties were partially offset by operations of the properties. During the year ended December 31, 1991, BankAtlantic wrote down $2.7 million of dealer reserves related to the Subject Portfolio. During the year ended December 31, 1992, BankAtlantic recovered the same amount from its fidelity bond carrier pursuant to the Covenant. Sale of Mortgage-Backed Securities, Investment Securities and Loans During the year ended December 31, 1992, BankAtlantic, in its efforts to reduce its interest rate sensitivity, transferred to available for sale all fixed rate mortgage-backed securities having original terms of 15 and 30 years to maturity. In accordance with then existing Generally Accepted Accounting Principles ("GAAP"), assets available for sale are recorded at the lower of cost or market and, since the aggregate market value was greater than cost at the date of transfer and at all times subsequent, through December 31, 1993, this reclassification had no effect on net income or stockholders' equity at the transfer date and through December 31, 1993. upon implementation of FAS 15, commencing on January 1, 1994. During the year ended December 31, 1993, there were no mortgage-backed securities or investment securities transferred to available for sale. Approximately $139.4 million of Federal National Mortgage Corporation ("FNMA") securities and $10.1 million of Federal Home Loan Mortgage Corporation ("FHLMC") securities of the $305.7 million of securities transferred to available for sale during 1992 were sold in 1992 for gains of $5.2 million and $500,000, respectively. In addition, BankAtlantic sold $2.0 million of federal agency obligations for a gain of $143,000. The 1992 gains on sales of investment securities and mortgage-backed securities all resulted from sales of securities classified as available for sale. Proceeds from these sales were used to purchase fixed rate balloon mortgage- backed securities having five to seven year maturities, adjustable rate mortgage-backed securities and tax certificates and to repay borrowings. During the years ended December 31, 1993, 1992 and 1991, BankAtlantic sold $45.0 million, $36.1 million and $14.9 million, respectively of recently originated fixed rate and adjustable rate residential loans for gains of $1.2 million, $976,000 and $330,000, respectively. BankAtlantic currently sells substantially all residential mortgage loans it originates. Commencing on January 1, 1994, upon implementation of FAS 115, changes in carrying classifying values of assets held for sale will be reflected as a component of stockholders' equity. BankAtlantic currently sells substantially all residential mortgage loans which it originates. During the year ended December 31, 1991, BankAtlantic securitized $40.4 million of loans and sold the resulting FHLMC mortgage-backed securities for a loss of $30,000. BankAtlantic also sold $8.5 million and $21.3 million of FHLMC and FNMA securities and $30.0 million of treasury notes and federal agency obligations for gains of $200,000, and $574,000 and $62,000, respectively. BankAtlantic sold , for a total gain of $62,000. BankAtlantic has the ability and positive intent to hold its mortgage- backed securities held for investment until their scheduled maturities. Market values of both investments and mortgage-backed securities available for sale at December 31, 1993 were greater than BankAtlantic's cost of such securities. Financial Condition BankAtlantic's total assets at December 31, 1993 and at December 31, 1992 were approximately $1.36 billion and $1.30 billion, respectively. At December 31, 1993, compared to December 31, 1992, mortgage-backed securities (including mortgage-backed securities available for sale) and loans increased by $38.9 million and $39.7 million, while tax certificates and other investment securities declined by $22.7 million. The increase in mortgage-backed securities was due primarily to the purchase of approximately $206.9 million of adjustable rate and balloon mortgage-backed securities during 1993. The decrease in tax certificates and other investment securities was due to the repayment of $112.9 million of tax certificates offset by the purchase of an aggregate of approximately $78.2 million of tax certificates during 1993, including both tax certificates purchased at the 1993 tax certificate auctions (approximately $64 million) and tax certificates purchased in connection with "Applications for Deed" in connection with obtaining title to the underlying property (approximately $14 million). See "Business--Investment Activities". The increase in loans was primarily due to the purchase of $110 million of bankers acceptances, all of which mature by March 1994, offset by principal repayments exceeding loan originations. However, 1993 loan originations exceeded 1992 originations by approximately 50% and 1992 originations exceeded 1991 originations by 25%. Loan originations during the 1993 period amounted to $263.2 million, compared to $289.0 million of loan repayments. At December 31, 1993, compared to December 31, 1992, deposits declined by $31.8 million. The decline in deposits was related to decreased certificate and insured money fund accounts, partially offset by increased deposits in interest-free checking and lower costing NOW accounts. At December 31, 1993, BankAtlantic met all applicable regulatory capital and liquidity requirements. Subject Portfolio From 1987 through 1990, BankAtlantic purchased in excess of $50 million of indirect home improvement loans from certain dealers, primarily in the northeastern United States. BankAtlantic ceased purchasing loans from such dealers in the latter part of 1990. These dealers are affiliated with each other but are not affiliated with BankAtlantic. In connection with loans originated through these dealers, BankAtlantic funded amounts to the dealers as a dealer reserve. Such loans and related dealer reserves are hereafter referred to as the "Subject Portfolio." The risk of amounts advanced to the dealers is primarily associated with loan performance but secondarily is dependent on the financial condition of the dealers. The dealers were to be responsible to BankAtlantic for the amount of the reserve only if the loan giving rise to the reserve became delinquent or was prepaid. These dealers have currently not indicated any financial ability to fund the dealer reserve.There is no assurance that if called upon, a dealer will have the financial ability to fund the unearned dealer reserve. In late 1990, questions arose relating to the practices and procedures used in the origination and underwriting of the Subject Portfolio, which suggested that the dealers, certain home improvement contractors and borrowers engaged in practices intended to defraud BankAtlantic. Due to these questions and potential exposure, BankAtlantic performed, and continues to perform, certain investigations, notified appropriate regulatory and law enforcement agencies, and notified its fidelity bond carrier. After an initial review and discussions with the carrier, BankAtlantic concluded that any losses sustained from the Subject Portfolio would adequately be covered by its fidelity bond coverage and, in fact, on August 13, 1991, the carrier advanced $1.5 million against BankAtlantic's losses. This payment and future payments by the carrier were to be subject to identification and confirmation of the losses which are appropriately covered under the fidelity bond. Subsequently, commencing in September, 1991, as a consequence of issues raised by the carrier, BankAtlantic reviewed the Subject Portfolio without regard to the availability of any fidelity bond coverage. As a result of the review, the provision for loan losses for the year ended December 31, 1991 was increased by approximately $5.7 million, approximately $5.5 million of loans were charged off, and $2.7 million of dealer reserves were charged to current operations. On December 20, 1991, the carrier denied coverage and BankAtlantic thereafter filed an appropriate action against the carrier. On October 30, 1992, BankAtlantic and the carrier entered into the Covenant. Pursuant to the Covenant, BankAtlantic will continue to pursue its litigation against the carrier, which is currently in the early stages of discovery, but has agreed to limit execution on any judgement obtained against the carrier to $18 million. Further, BankAtlantic agreed to join certain third parties as defendants in that action. The carrier paid BankAtlantic $6.1 million during the fourth quarter of 1992 and paid an additional $3 million in November 1993, and has agreed to pay an additional $2.9 million in November 1994. Such amounts related to losses and expenses previously charged to operations by BankAtlantic. Additional reimbursements will be made on a quarterly reporting basis commencing with the period ended December 31, 1992. Reimbursable amounts are as defined in the Covenant. Based upon such definitions BankAtlantic has and will continue to record estimated charges to operations in advance of when such charges become reimbursable. Amounts to be reimbursed will be reflected in the period for which reimbursement is requested. Through December 31, 1993, the carrier has paid or committed to pay approximately $15.4 million. The 1993 and 1994 committed amounts noted above have been accrued after imputing interest at 9%. The financial statement effect of the Covenant for the fourth quarter and year ended December 31, 1992 was to reduce expenses by $3.3 million, increase interest income by $1.9 million and to record $7.3 million of loan loss recoveries. The financial statement effect of the Covenant for 1993 was to reduce expenses by $942,000, to increase interest income by $757,000 and record $972,000 of loan loss recoveries. Included in other assets was a $3.3 million receivable due from the carrier at December 31, 1993. In no event will the carrier be obligated to pay BankAtlantic in the aggregate more than $18 million. However, in the event of recovery by BankAtlantic of damages from third party wrongdoers, BankAtlantic will be entitled to retain such amounts until such amounts, plus any payments received from the carrier equal to $22 million. Thereafter, the carrier will be entitled to any such recoveries to the extent of its payments to BankAtlantic. To the extent that BankAtlantic incurs losses in excess of $18 million plus available recoveries from third parties, BankAtlantic will be required to absorb any such losses. At December 31, 1993, the remaining amount of reimbursement available from the carrier was approximately $2.6 million. BankAtlantic does not currently anticipate that the aggregate losses in the Subject Portfolio will exceed $18 million. BankAtlantic also agreed to exercise reasonable collection activities with regard to the Subject Portfolio and to provide the carrier with a credit for any recoveries with respect to such loans against future losses that the carrier would otherwise be obligated to reimburse. The balance of the loans and dealer reserve associated with the Subject Portfolio amounted to approximately $24.4 million and zero at December 31, 1993, and $29.9 million and $2.5 million at December 31, 1992, respectively. At December 31, 19932, 10% of the loans were secured by collateral in South Florida and 90% of such loans were secured by collateral in the northeastern United States. Collateral for these loans is generally a second mortgage on the borrower's property. However, it appears that in most cases, the property is encumbered with loans having high loan to value ratios. Although as indicated above, the dealer reserves are not collateralized, the risk relating to amounts advanced to the dealers are primarily associated with loan performance. Loans in the "Subject Portfolio" are charged-off if payments are more than 90 days delinquent. Related to the above are suits filed in New Jersey and New York. The New Jersey action seeks civil remedies against certain contractors and a dealer and also seeks to cancel or modify certain mortgage loans. BankAtlantic had purchased individual loans from the named dealer and such purchased loans include loans for which a named contractor is listed as providing home improvements. While BankAtlantic is not a party to that action, a status conference was held in December 1993 which indicated that discovery is to be completed by May 1994 and BankAtlantic must determine by April 1994 whether to intervene in the action. The New York action purports to be a class action against over 25 individuals and entities, including BankAtlantic. The named plaintiffs purport to also represent other unnamed plaintiffs that may have obtained loans from dealers who subsequently sold such loans to BankAtlantic. Plaintiffs base their claims on various grounds and seek, among other things, rescission of the loan agreements, damages, punitive damages, costs, attorney fees, penalties under the truth in lending act and treble damages under RICO. The plaintiffs' Motion to Certify the Class was made in November, 1993. The court has not yet ruled on this motion. Asset and Liability Management During the past several years, BankAtlantic's operating objectives have included actions to increase its regulatory capital and to reduce its negative interest rate sensitivity gap. However, activities in furtherance of these various objectives sometimes involve conflicting short term strategies. In general, BankAtlantic has attempted to achieve these objectives through the replacement of fixed rate, long term securities with floating rate mortgage- backed securities or intermediate term fixed rate, balloon mortgage-backed securities, restructuring deposit liabilities by reducing interest rate sensitive certificates of deposit as a percent of total liabilities and focusing on transaction accounts, and changing the emphasis of loan originations. See "Sale of Mortgage-Backed Securities, Investment Securities and Loans." Included in these replacement securities are tax certificates, adjustable rate mortgage-backed securities, five- and seven-year balloon mortgage-backed securities amounting to approximately $83.9 million, $92.9 million and $350.3 million, respectively, at December 31, 1993. BankAtlantic has been attempting to change the composition of its loan portfolio from predominately long term, fixed rate mortgage loans by currently emphasizing the origination of floating rate commercial business and commercial real estate loans, which generally achieve a two to three year duration. and mortgage loans, which are considered higher yielding. These types of loans generally have higher interest rates than residential loans. However, these loans also involve a greater credit risk and will generally result in higher loan loss experience than that of traditional mortgage lending. Management is of the opinion that the increased credit risk will be offset by the increased rates earned on such loans and the positive effect these shorter terms have on the interest rate sensitivity gap. Origination and underwriting policies and practices for such loans are designed to limit BankAtlantic's exposure to normal industry risk for this form of lending. Additionally, as previously indicated, during the first quarter of 1991 BankAtlantic reduced loan production in its consumer lending portfolio, and BankAtlantic is not currently originating indirect consumer loans. However, BankAtlantic anticipates increasing 1994 consumer loan originations from amounts originated in the prior three years. BankAtlantic continues to originate fixed-rate mortgage loans with 15 and 30 year amortization periods, but these loans are generally originated for sale. Included as loans at December 31, 1993 are $110.7 million of banker's acceptances, all of which were purchased in the fourth quarter of 1993 and all of which mature by March 1994. Based upon BankAtlantic's capital position, alternate uses for funds and availability of acceptable borrowing alternatives, BankAtlantic may continue to utilize banker's acceptances to increase net interest income. Interest Rate Sensitivity BankAtlantic's net earnings are materially affected by the difference between the income it receives from its loan portfolio (including mortgage- backed securities) and investment securities portfolio and its cost of funds. The interest paid by BankAtlantic on deposits and borrowings determines its cost of funds. The yield on BankAtlantic's loan portfolio changes principally as a result of loan repayments and the rate and the volume of new loans. Fluctuations in income from tax certificates and other investment securities will occur based on the amount invested during the period and interest rate levels yielded by such securities. BankAtlantic's net interest spread will fluctuate in response to interest rate changes. because BankAtlantic's cost of funds responds more quickly to changes in interest rates than does its income from loans and investments Like many savings institutions, BankAtlantic's interest rate sensitive liabilities (generally, deposits with maturities of one year or less) has in the past exceeded its interest rate sensitive assets (assets which reprice based on an index or which have short term maturities). This imbalance is referred to as a negative interest rate sensitivity gap, and measures an institution's ability to adjust to changes in the general level of interest rates. The effect of the "mismatch" is that a rise in interest rates will have a negative impact on earnings as the cost of funds increases to a greater extent than the yield earned on interest-earning assets, while a decline in interest rates will have a positive impact on earnings. The larger the gap, whether positive or negative, the greater the impact of changing interest rates. One of BankAtlantic's long term objectives has been the reduction of its interest rate sensitivity gap. However, short-term strategies may differ from this objective in order to meet other objectives, such as compliance with applicable regulatory requirements. BankAtlantic has taken steps, when possible, to minimize its interest rate sensitivity gap. Such actions have included reducing fixed-rate mortgage loan production held in portfolio, purchasing shorter term and adjustable rate mortgage-backed securities and increasing its emphasis on the production of floating rate commercial business loans and commercial real estate loans which generally have a shorter duration and a higher yield than longer term fixed-rate residential mortgage loans. Also, extensive efforts have been made to attract transaction accounts which are generally less rate sensitive than other types of accounts. These actions have involved employing experienced commercial bankers, focusing sales and marketing on transaction oriented customer segments, training existing staff in product sales and commercial operations, offering new transaction products, improving data processing so as to handle increased check clearing and building and remodeling branches so as to accommodate transaction account customers. Further, BankAtlantic has reduced the rates which it offers on certificates of deposit to the rates generally offered by commercial banks (rates generally lower than those offered by savings and loan institutions). Assets such as commercial loans are interest rate sensitive assets both because they generally bear interest at an adjustable rate and because they generally have a shorter term maturity. Consumer and commercial real estate loans are generally considered interest rate sensitive because of the short term nature of such loans. Long term residential loans are considered interest rate sensitive only if they bear interest at an adjustable rate. On the liability side, long term certificates of deposit are generally not interest rate sensitive. As a result of implementing and continuing these asset and liability initiatives, and the accelerated prepayments of long-term mortgage loans due to declining interest rates, BankAtlantic's one year interest rate gap, which is the difference between the amount of interest bearing liabilities which are projected to mature or reprice within one year and the amount of interest earning assets which are similarly projected to mature or reprice, all divided by total assets, amounted to a positive 3.79% at December 31, 1993 compared to a negative 15.83% at December 31, 1992. The absolute amount of BankAtlantic's one year gap changed from a negative $206.2 million at December 31, 1992 to a positive $51.5 million at December 31, 1993. Liquidity and Capital Resources BankAtlantic's primary sources of funds have been deposits, principal repayments of loans, mortgage-backed securities and tax certificates, proceeds from the sale of loans originated for sale, mortgage-backed securities and investment securities, proceeds from securities sold under agreements to repurchase, advances from the FHLB, operations and capital transactions. These funds were primarily utilized to fund loan disbursements, paydowns of securities sold under agreements to repurchase, maturity of advances from the FHLB, purchases of mortgage-backed securities and tax certificates, bankers acceptances and payments of maturing certificates of deposit. During October, 1992 and December, 1993, the FHLB granted BankAtlantic, subject to various terms and conditions, lines of credit of $300 million and $115 million expiring in October 1995 and December, 1994, respectively. As of December 31, 1993 BankAtlantic had not utilized these lines of credit. During the first quarter of 1993, management approved a plan to modernize BankAtlantic's branch network. Management believes that the branch re- engineering project will improve overall efficiencies and enable BankAtlantic to offer additional products and financial services to its customers. In order to achieve the branch modernization, management approved capital expenditures of $2.1 million, of which approximately $965,000 was disbursed for replacement equipment installed during 1993. The branch modernization project is expected to be completed during the second quarter of 1994. Regulations currently require that savings institutions maintain an average daily balance of liquid assets (cash and short-term United States Government and other specified securities) equal to 5% of net withdrawable accounts and borrowings payable in one year or less. BankAtlantic had a liquidity ratio of 28.22% under these regulations at December 31, 1993, respectively. See "Regulation and Supervision." Total commitments to originate and purchase loans and mortgage-backed securities, excluding the undisbursed portion of loans in process, were approximately $64.3, $93.5 and $37.5 million at December 31, 1993, 1992 and 1991, respectively. BankAtlantic expects to fund its commitments out of loan repayments and, for a limited period of time, short-term borrowings. At December 31, 1993, loan commitments were approximately 9.11% of loans receivable, net. In order to increase its regulatory capital, BankAtlantic issued in prior years, $25.0 million of its 1986 Capital Notes. On May 30, 1990, BankAtlantic received OTS approval, subject to certain conditions, to issue up to an additional $12.0 million of subordinated debt in private transactions and to include such subordinated debentures as regulatory capital. On June 19, 1990, an unaffiliated third party acquired $1.0 million of such subordinated debentures bearing interest at the rate of 14% per annum and maturing in seven years from the date of issuance, and including detachable warrants to purchase 216,450 shares of BankAtlantic's common stock, at $4.62 per share. BFC also acquired $2.5 million of such subordinated debt and warrants. On June 30, 1990, BFC exercised its warrants and converted the debt for 541,430 shares of BankAtlantic common stock. During November 1990, BankAtlantic offered to the holders of the Capital Notes, the option to exchange their Capital Notes for any one of three combinations of non-cumulative Preferred Stock ("Preferred Stock"), cash payments and cash bonuses. The Preferred Stock issued in this transaction improved BankAtlantic's regulatory and equity capital. Effective July 31, 1992, BankAtlantic redeemed, at par and prior to scheduled maturity approximately $6.9 million of the Capital Notes. This redemption had no significant effect on liquidity and capital resources. In July 1993, BankAtlantic received approval from the OTS to redeem all remaining Capital Notes and other subordinated debentures. BankAtlantic redeemed the $7.8 million of Capital Notes and other subordinated debentures during the third quarter of 1993 at par. The Capital Notes debt bore a weighted average rate at 11.83%, substantially in excess of current market rates and at June 30, 1993, only $3.2 million relating to the Capital Notes and other subordinated debentures was included in regulatory risk-based capital. Funds for the redemption were provided from loan repayments. On March 31, 1991, BankAtlantic issued to its existing shareholders, 4,878 shares of common stock and $8,000 of subordinated debentures with related warrants to purchase 4,600 shares of common stock. The subordinated debentures were redeemed in August 1993, whereas the warrants remain outstanding. During the first quarter of 1993, warrants were exercised to purchase 575 shares at a price of $1.74 per share. Effective June 30, 1993, BFC exercised its warrants to purchase 1,126,327 shares of BankAtlantic common stock, resulting in BFC's ownership percentage in BankAtlantic increasing to 77.83%. The purchase price in connection with the exercise was paid by the tender and subsequent retirement of approximately $2.0 million of subordinated debentures held by BFC. See Note 11 of the Consolidated Financial Statements for further discussion. On November 12, 1993, BankAtlantic sold, in a public offering, 400,000 common shares at a price of $13.50 per common share. As part of that offering, BFC sold 1.4 million shares of BankAtlantic common stock. Net proceeds to BankAtlantic from the sale of the 400,000 shares were approximately $4.6 million. In connection with the public offering, BankAtlantic granted the underwriters a 30-day option to purchase up to 270,000 additional shares of common stock to cover over-allotments. On November 10, 1993, the underwriters exercised this option to purchase the 270,000 shares, with a closing date of November 18, 1993. The additional net proceeds to BankAtlantic were approximately $3.4 million. Upon completion of this public offering, BFC owned 48.17% of BankAtlantic common stock.The sale decreased BFC's ownership in BankAtlantic to 48.17%. As more fully described under "Regulation and Supervision--Capital Requirements," BankAtlantic is required to meet all capital standards promulgated pursuant to FIRREA and FDICIA. Under FIRREA, capital standards are: core capital equal to at least 3.0% of adjusted total assets, tangible capital equal to at least 1.5% of adjusted total assets, and total capital equal to at least 8.0% of its risk-weighted assets. To be considered "well capitalized" under FDICIA, a savings institution must generally have a core capital ratio of at least 5%, a Tier 1 risk-based capital ratio of at least 6%, and a total risk-based capital ratio of at least 10%. BankAtlantic, at December 31, 1993, met all regulatory capital requirements, and its regulatory capital met the definition of "well capitalized." At December 31, 1993, BankAtlantic's regulatory capital position was: Dividends In August and December, 1993, BankAtlantic declared cash dividends of $0.06 per share (totaling $0.12 per share), payable September 1993 and January 1994, respectively, to its common stockholders. A 15% common stock dividend was declared in May, 1993. Where appropriate, amounts throughout this report have been adjusted to reflect this stock dividend. BankAtlantic expects to continue dividend payments on its non-cumulative preferred stock. In March 1994, the Board of Directors declared a cash dividend of $.06 per share payable in April 1994 to its common stockholders. Effective August 1, 1990, the OTS adopted a new regulation that limits all capital distributions made by savings institutions, including cash dividends, by permitting only certain institutions that meet specified capital levels to make capital distributions without prior OTS approval. BankAtlantic presently meets all required and fully phased-in capital requirements and has had operating income in the prior eight quarters. BankAtlantic currently intends to seek to pay Common Stock dividends on a regular basis in the future; however, all such capital distributions will be subject to the OTS' right to object to a distribution on safety and soundness grounds. BankAtlantic has paid the preferred stock dividends since March 1993 and has received OTS approval through June 1994 to pay the preferred stock dividends; subject to maintaining capital at least equal to the fully phased in capital requirements. Future cash dividends on common and preferred stock will be subject to declaration by the Board of Directors in its discretion, to additional regulatory notice or approval, and continued compliance with capital requirements. Accordingly, there is no assurance that such dividends will be paid in the future. Preferred Stock All three Series of Preferred Stock have a preference value of $25.00 per share and are redeemable by BankAtlantic at $25.25 per share in 1994 and $25.00 thereafter. At December 31, 1993, no shares of Preferred Stock had been redeemed. Cash Flows Liquidity refers to BankAtlantic's ability to generate sufficient cash to meet funding needs to support loan demand, to meet deposit withdrawals and to pay operating expenses. BankAtlantic's investment portfolio provides an internal source of liquidity as a consequence of its short-term investments as well as scheduled maturities and interest payments. Loan repayments and sales also provide an internal source of liquidity. A summary of BankAtlantic's consolidated cash flows follows (in thousands): The changes in cash used or provided in operating activities are affected by the changes in operations, which are discussed elsewhere herein, and by certain other adjustments. These other adjustments include additions to operating cash flows for nonoperating charges such as depreciation and the provision for loan losses and write downs of assets. Cash flow of operating activities is also adjusted to reflect the use or the providing of cash for increases and decreases in operating assets and decreases or increases, in operating liabilities. Accordingly, the changes in cash flow of operating activities in the periods indicated above has been impacted not only by the changes in operations during the periods but also by these other adjustments. The reasons for the changes in investing and financing activities are discussed in "Asset and Liability Management", "Liquidity and Capital Resources" and "Sale of Mortgage-Backed Securities, Investment Securities and Loans." Management believes that BankAtlantic has adequate liquidity to meet its business needs and regulatory requirements. Impact of Inflation The financial statements and related financial data and notes presented herein have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all of the assets and liabilities of BankAtlantic are monetary in nature. As a result, interest rates have a more significant impact on BankAtlantic's performance than the effects of general price levels. Although interest rates generally move in the same direction as inflation, the magnitude of such changes varies. The possible effect of fluctuating interest rates is discussed more fully under the previous section entitled "Interest Rate Sensitivity." RISK ELEMENTS December 31, --------------------------------------------- 1993 1992 1991 1990 1989 -------- -------- -------- -------- -------- (In thousands) Contractually Past Due 90 Days or More - ------------------------- (1) Commercial $ 2,580 1,108 689 - - Consumer - - - 5,048 3,448 --------- --------- --------- --------- --------- 2,580 1,108 689 5,048 3,448 --------- --------- --------- --------- --------- Non-Accrual - ------------------------- 1-4 Family 2,468 3,642 3,514 4,136 1,898 Commercial 3,802 5,317 5,660 8,641 2,745 Consumer 976 1,477 4,095 - - Tax certificates - - 476 - - --------- --------- --------- --------- --------- 7,246 10,436 13,745 12,777 4,643 --------- --------- --------- --------- --------- Repossessed - ------------------------- 1-4 Family 319 756 1,660 1,379 1,107 Commercial real estate 9,332 14,241 19,635 22,082 9,444 Consumer 512 461 902 2,470 1,645 --------- --------- --------- --------- --------- 10,163 15,458 22,197 25,931 12,196 --------- --------- --------- --------- --------- TOTAL NON-PERFORMING ASSETS$ 19,989 27,002 36,631 43,756 20,287 --------- --------- --------- --------- --------- Restructured - ------------------------- Commercial 2,647 2,661 7,580 3,781 4,428 --------- --------- --------- --------- --------- TOTAL RISK ELEMENTS $ 22,636 29,663 44,211 47,537 24,715 ========= ========= ========= ========= ========= Total risk elements as a percentage of: Total assets 1.67% 2.28% 3.04% 2.51% 1.31% ========= ========= ========= ========= ========= Loans and real estate owned 3.64% 5.04% 5.79% 4.73% 2.18% ========= ========= ========= ========= ========= TOTAL ASSETS $1,359,195 1,303,071 1,455,822 1,896,587 1,886,453 ========= ========= ========= ========= ========= TOTAL LOANS AND REAL ESTATE OWNED $ 622,538 588,159 763,560 1,004,065 1,132,674 ========= ========= ========= ========= ========= (1) The majority of these loans have matured, but are current as to payments under the prior loan terms. At December 31, 1993, there were no loans which were not disclosed in the above schedule where known information about the possible credit problems of the borrowers caused management to have serious doubts as to the ability of the borrower to comply with present loan repayment terms and which may result in disclosure of such loans in the schedule above in the future. Interest income which would have been recorded under the original terms of nonaccrual and restructured loans and the interest income actually recognized for the years indicated are summarized below (in thousands): For the Years Ended December 31, --------------------------- 1993 1992 1991 -------- -------- -------- (In thousands) Interest income which $ would have been recorded 1,068 1,301 2,476 Interest income recognized (486) (311) (1,581) --------- --------- --------- Interest income foregone 582 990 1,572 $ ========= ========= ========= Changes in the allowance for loan losses were: For the Years Ended December 31, --------------------------------------------- 1993 1992 1991 1990 1989 -------- -------- -------- -------- -------- (In thousands) Balance, beginning of period $ 16,500 13,750 15,741 5,810 5,611 Charge-offs: Commercial loans (835) (776) (1,694) (2,349) (1,586) Installment loans (3,350) (10,430) (18,903) (5,605) (3,801) Real estate mortgages (302) (1,473) (259) (667) (380) --------- --------- --------- --------- --------- (4,487) (12,679) (20,856) (8,621) (5,767) --------- --------- --------- --------- --------- Recoveries: Commercial loans 262 175 191 117 6 Installment loans 1,259 8,584 1,035 735 422 Real estate mortgages 16 20 99 45 188 --------- --------- --------- --------- --------- 1,537 8,779 1,325 897 616 --------- --------- --------- --------- --------- Net charge-offs (2,950) (3,900) (19,531) (7,724) (5,151) Additions charged to operations 3,450 6,650 17,540 17,655 5,350 --------- --------- --------- --------- --------- $ 17,000 16,500 13,750 15,741 5,810 ========= ========= ========= ========= ========= Allowance as a percentage of (1) Total loans 3.38% 2.88% 1.85% 1.61% 0.52% Non-performing assets 85.05% 61.11% 37.54% 35.97% 28.64% ========= ========= ========= ========= ========= Ratio of net charge-offs to (1) average outstanding loans 0.56% 0.60% 2.23% 0.69% 0.46% ========= ========= ========= ========= ========= (1) Excludes $110.7 million of banker's acceptances. Including these banker's acceptances, its percentages would be 2.77% and 0.55%, respectively. The allocation of the allowance for loan losses by loan category and the percent of the related gross loans in each category to total loans follows (in thousands): (1) Excludes banker's acceptances. Prior to 1992, BankAtlantic did not allocate the allowance for loan loss by category. Relevant information for prior years is discussed under "Provision for Loan Losses and Declines in Value of Real Estate Owned." Tax Certificate and Other Investment Securities A comparison of the book value and approximate market value of tax certificates and other investment securities wasis (in thousands): The maturities of tax certificates and other investment securities at December 31, 1993 were are (in thousands): (1) There is no contractual maturity; amounts indicated are based on historical payment experience. (2) Based upon contractual maturity. Activity in the allowance for tax certificate losses was: For the Years Ended December 31, -------------------------------------------- 1993 1992 1991 ------------- ------------ ------------- Balance, beginning of period $ 1,558 $ 795 $ 104 Charge-offs (810) (552) (395) Recoveries 562 155 275 ------------- ------------ ------------- Net charge-offs (248) (397) (120) Additions charged to operations 1,660 1,160 811 ------------- ------------ ------------- Balance, end of period $ 2,970 $ 1,558 $ 795 ------------- ------------ ------------- Average yield on tax certificates and other Investment securities during the period 9.08% 10.94% 12.83% ============ ============ ============= Loan Activity - The following table shows loan activity by major categories for the periods indicated (in thousands): For the Years Ended December 31, --------------------------------------------- 1993 1992 1991 1990 1989 -------- -------- -------- -------- -------- (In thousands) Originations: Residential loans $ 52,674 41,336 17,320 33,302 63,283 Construction loans 13,744 18,912 10,157 36,608 65,849 Commercial loans 186,584 108,744 85,931 93,085 275,904 Installment loans 10,222 7,075 27,859 211,184 223,419 --------- --------- --------- --------- --------- Total originations 263,224 176,067 141,267 374,179 628,455 --------- --------- --------- --------- --------- Purchases:(2) Commercial loans 5,142 - - 20 - Banker's acceptances 109,931 - - - - Residential loans - - - 689 - --------- --------- --------- --------- --------- Total purchases 115,073 - - 709 - --------- --------- --------- --------- --------- Total loan production 378,297 176,067 141,267 374,888 628,455 --------- --------- --------- --------- --------- Loan sales (44,983) (36,054) (14,949) (45,503) - Principal reductions (289,037) (297,263) (298,076) 340,133 (549,064) Loan securitization - - (40,361) (106,080) - Transfer to real estate owned(1) (2,396) (7,994) (6,729) (17,208) (2,532) --------- --------- --------- --------- --------- Net loan activity $ 41,881 (165,244) (218,848) (134,036) 76,859 ========= ========= ========= ========= ========= (1) Includes foreclosures and loans treated as in substance foreclosures. (2) Does not include individual installment loans purchased through dealers. Principal Repayments - The following table sets forth the scheduled contractual principal repayments at maturity date of BankAtlantic's loan portfolios and mortgage-backed securities at December 31, 1993. As of December 31, 1993, the total amount of principal repayments on loans and mortgage-backed securities contractually due after December 31, 1994 was $928.4 million, $663.3 million of which had fixed interest rates and $265.1 million of which had floating or adjustable interest rates. Year Ended December 31, (1) (In thousands) --------------------------------------------------------- 1997- 1998- 2004- 1994 1995 1996 1998 2003 2008 >2009 Total ------- --------------------- ------- -------------- ------- Real estate mortgage $ 59,702 11,155 13,167 54,889 76,913 21,989 94,535 332,350 Banker's acceptances 110,652 - - - - - - 110,652 Real estate construction 11,333 - - - - - - 11,333 Installment 15,947 7,296 8,948 9,816 23,513 16,179 57,421 139,120 Commercial non- real estate 21,714 1,668 1,981 743 1,873 - - 27,979 ------- ------ ------ ------- ------- ------ ------- ------- Total loans $219,348 20,119 24,096 65,448 102,299 38,168 151,956 621,434 ======= ====== ====== ======= ======= ====== ======= ======= Total mortgage- backed securities $ 12 95 43,093 126,917 249,744 6,774 99,730 526,365 ======= ====== ====== ======= ======= ====== ======= ======= (1) Does not include deductions for undisbursed portion of loans in process, deferred loan fees, unearned discounts and allowance for loan losses. Loan Concentration - BankAtlantic's loan concentration of total loans at December 31, 1993 was: Florida 79% Northeast 12% Other 9% The loan concentration for BankAtlantic's portfolio is primarily in South Florida where the economic conditions have improved in the latter part of 1992 and 1993. The concentration of BankAtlantic's loan portfolio in the Northeastern states is primarily related to those loans identified in the Subject Portfolio. Economic conditions in the Northeast have remained sluggish with high rates of unemployment and declining real estate values, however, 1993 has shown some signs of improvement. The rest of the portfolio is throughout the United States without any specific concentration. Loan maturities and sensitivity of loans to changes in interest rates for commercial non-real estate loans and real estate construction loans at December 31, 1993 were (in thousands): Commercial Non-Real Real Estate Estate Construction Total ---------- ---------- ---------- One year or less $ 19,484 11,333 30,817 Over one year but less than five years 8,495 - 8,495 Over five years - - - ---------- ---------- ---------- $ 27,979 11,333 39,312 ========== ========== ========== Sensitivity of loans to changes in interest rates - loans due agter one year Pre-determined interest rate $ 6,399 - 6,399 Floating or adjustable interest rate 2,096 - 2,096 ---------- ---------- ---------- $ 8,495 - 8,495 ========== ========== ========== Deposits - Deposit accounts consisted of the following (in thousands): December 31, ------------------------------ 1993 1992 1991 ---------- ---------- ---------- Non-interest bearing deposits $ 62,065 52,426 47,576 Interest bearing deposits: Insured money fund savings 301,572 330,255 312,781 NOW account 152,186 143,580 129,326 Savings account 124,699 130,379 124,163 Time deposits less than $100,000 384,411 409,135 580,489 Time deposits $100,000 and over 51,427 42,340 61,178 ---------- ---------- ---------- Total $ 1,076,360 1,108,115 1,255,513 ========== ========== ========== Time deposits, $100,000 and over, have the following maturities at December 31, 1993: Less than three months $ 8,071 3 to 6 months 6,377 6 to 12 months 15,784 More than 12 months 21,195 ---------- $ 51,427 ========== The stated rates at which BankAtlantic paid interest on deposits were (in thousands): December 31, ------------------------------ 1993 1992 1991 ---------- ---------- ---------- Interest free checking $ 62,065 52,426 47,576 Insured money fund savings: 2.52% at December 31, 1993, 3.07% at December 31, 1992 and 4.22% at December 31, 1991 301,572 330,255 312,781 NOW account: 1.79% at December 31, 1993, 1.61% at December 31, 1992 and 2.93% at December 31, 1991 152,186 143,580 129,326 Savings account: 1.78% at December 31, 1993, 2.06% at December 31, 1992 and 3.74% at December 31, 1991 124,699 130,379 124,163 ---------- ---------- ---------- Total non-certificate accounts 640,522 656,640 613,846 ---------- ---------- ---------- Certificate accounts: 0.00% to 3.00% 106,521 72,657 3,059 3.01% to 4.00% 135,753 164,378 3,623 4.01% to 5.00% 105,214 87,327 81,104 5.10% to 6.00% 48,770 47,015 186,279 6.01% to 7.00% 15,690 35,939 196,738 7.01% and greater 23,757 44,012 170,595 ---------- ---------- ---------- Total certificate accounts 435,705 451,328 641,398 ---------- ---------- ---------- 1,076,227 1,107,968 1,255,244 ---------- ---------- ---------- Interest earned not credited to deposit accounts 133 147 269 ---------- ---------- ---------- Total deposit accounts $ 1,076,360 1,108,115 1,255,513 ========== ========== ========== Weighted average stated interest rate on at the end of each respective period 2.83% 3.18% 5.10% ========== ========== ========== At December 31, 1993, the amounts of scheduled maturities of certificate accounts were: The following table sets forth the deposit activities for the periods indicated (in thousands): December 31, ------------------------------ 1993 1992 1991 ---------- ---------- ---------- Net decrease before interest credited (59,370) (190,907) (272,307) Interest credited 27,615 43,509 71,853 ---------- ---------- ---------- Total (31,755) (147,398) (200,454) ========== ========== ========== A summary of the cost and gross excess (deficiency) of market value compared to cost of tax certificates and other investment securities and mortgage-backed securities, including mortgage-backed securities available for sale, follows: December 31, 1993 --------------------------------------------- Gross Gross Approximate Book Unrealized Unrealized Market Value AppreciationDepreciation Value ----------- ----------- ----------- ----------- Tax certificates and other investment securities: Cost equals market $ 83,927 - - 83,927 Cost over market 13,774 - 113 13,661 Mortgage-backed securities: Market over cost 489,453 14,620 - 504,073 Cost over market 36,912 - 67 36,845 ----------- ----------- ----------- ----------- $ 624,066 14,620 180 638,506 =========== =========== =========== =========== December 31, 1992 --------------------------------------------- Gross Gross Approximate Book Unrealized Unrealized Market Value AppreciationDepreciation Value ----------- ----------- ----------- ----------- Tax certificates and other investment securities: Cost equals market $ 120,424 - - 120,424 Mortgage-backed securities: Market over cost 336,720 12,234 - 348,954 Cost over market 150,774 - 733 150,041 ----------- ----------- ----------- ----------- $ 607,918 12,234 733 619,419 =========== =========== =========== =========== December 31, 1991 --------------------------------------------- Gross Gross Approximate Book Unrealized Unrealized Market Value AppreciationDepreciation Value ----------- ----------- ----------- ----------- Tax certificates and other investment securities: Cost equals market $ 107,082 - - 107,082 Cost over market 1,994 109 - 2,103 Mortgage-backed securities: Market over cost 454,596 22,950 - 477,546 Cost over market 6,184 - 74 6,110 ----------- ----------- ----------- ----------- $ 569,856 23,059 74 592,841 =========== =========== =========== =========== BankAtlantic, A Federal Savings Bank and Subsidiaries Loans receivable composition, including mortgaged-backed securities, at the dates indicated was (dollars in thousands): 1993 1992 1991 1990 1989 ------------- ------------- ------------- ------------- ------------- Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Loans receivable: Real estate loans: Conventional mortgages $ 120,531 20.23 % $ 147,654 26.52 % $ 185,677 25.49 % $ 260,577 27.00 % $ 393,783 35.28 % Conventional mortgages available for sale 5,752 0.96 7,641 1.37 3,807 0.52 - - - - Construction and development 11,333 1.90 12,961 2.33 23,913 3.28 33,452 3.47 62,903 5.63 FHA and VA insured 7,972 1.34 9,854 1.77 11,459 1.57 13,223 1.37 15,536 1.39 Commercial 198,095 33.24 156,844 28.18 157,878 21.67 186,205 19.30 211,471 18.94 Other loans: Home improvement 52,563 8.82 72,508 13.03 100,556 13.80 104,546 10.84 66,838 5.99 Commercial (non-real estate) 27,979 4.70 33,071 5.94 38,742 5.32 58,220 6.03 68,746 6.16 Bankers acceptances 110,652 18.57 - - - - - - - - Installment loans held by individuals 86,557 14.53 140,909 25.31 233,165 32.01 345,768 35.84 345,892 30.99 --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Total 621,434 104.29 581,442 104.45 755,197 103.66 1,001,991 103.85 1,165,169 104.38 --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Deduct: Undisbursed portion of loans in process 5,570 0.93 6,492 1.17 9,033 1.24 13,399 1.39 29,884 2.68 Deferred loan fees 33 0.01 55 0.01 99 0.01 385 0.04 780 0.07 Unearned discounts on commercial loans 2,124 0.36 - - - - - - - - Unearned discounts on purchaed & installment loans 820 0.14 1,733 0.31 3,800 0.52 7,603 0.79 12,382 1.11 Allowance for loan losses 17,000 2.85 16,500 2.96 13,750 1.89 15,741 1.63 5,810 0.52 --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Loans receivable, net $ 595,887 100.00 % $ 556,662 100.00 % $ 728,515 100.00 % $ 964,863 100.00 % $1,116,313 100.00 % ========= ======= ========= ======= ========= ======= ========= ======= ========= ======= Mortgage-backed securities: FNMA participation certificates 178,928 33.99 % $ 174,666 35.83 % $ 214,700 46.59 % $ 270,196 61.48 % $ 249,878 54.16 % GNMA and FHLMC mortgage- backed securities 347,437 66.01 312,828 64.17 246,080 53.41 169,313 38.52 211,528 45.84 Mortgage-backed --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- securities $ 526,365 100.00 % $ 487,494 100.00 % $ 460,780 100.00 % $ 439,509 100.00 % $ 461,406 100.00 % ========= ======= ========= ======= ========= ======= ========= ======= ========= ======= /TABLE BankAtlantic, A Federal Savings Bank and Subsidiaries CUMULATIVE RATE SENSITIVITY GAP 0-90 91-180 181 Days 1-3 3-5 5-10 10-20 >20 Days Days - 1 Year Years Years Years Years Years Total -------- -------- -------- -------- -------- -------- -------- -------- -------- (Dollars in thousands) Interest earning assets: Tax certificates and other investment securities (5) $ 42,575 $ 17,074 $ 18,370 $ 25,392 $ 2,879 $ 141 $ - $ - $ 106,431 Residential loans (1) (2) Conventional single family 7,084 6,150 10,039 21,978 8,622 9,577 585 21 64,056 Adjustable single family 31,576 15,571 23,052 - - - - - 70,199 Mortgage-backed securities FHLMC and FNMA (3) 63,924 53,744 87,828 182,149 39,901 5,583 341 12 433,482 Adjustable montgage-backed securities 47,770 1,722 42,657 734 - - - - 92,883 Commercial real estate loans 6,256 6,396 13,229 68,918 66,522 5,241 - - 166,562 Adjustable commercial real estate loans 42,866 - - - - - - - 42,866 Other loans: Commercial business 585 599 1,243 7,713 782 - - - 10,922 Commercial business adjustabl 17,057 - - - - - - - 17,057 Bankers acceptances 110,652 - - - - - - - 110,652 Installment 13,900 12,337 20,661 46,845 17,402 3,179 6,102 - 120,426 Installment prime rate 18,694 - - - - - - - 18,694 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total interest earning assets$ 402,939 $ 113,593 $ 217,079 $ 353,729 $ 136,108 $ 23,721 $ 7,028 $ 33 $1,254,230 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Interest bearing liabilities: Money fund savings (4) 59,560 47,797 76,715 61,558 29,308 26,634 - - 301,572 Savings and NOW (4) 19,377 17,850 32,904 87,457 35,910 83,387 - - 276,885 Certificate accounts 117,628 85,151 92,790 103,501 34,678 1,957 - - 435,705 Borrowings: Securities sold under agreements to repurchase 21,135 - - - - - - - 21,135 Advances from FHLB 97,150 2,050 12,050 17,050 - - - - 128,300 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total interest bearing liabilities $ 314,850 $ 152,848 $ 214,459 $ 269,566 $ 99,896 $ 111,978 $ - $ - $1,163,597 ========== ========== ========== ========== ========== ========== ========== ========== ========== GAP (repricing difference) $ 88,089 $ (39,255)$ 2,620 $ 84,163 $ 36,212 $ (88,257)$ 7,028 $ 33 $ 90,633 Cumulative GAP $ 88,089 $ 48,834 $ 51,454 $ 135,617 $ 171,829 $ 83,572 $ 90,600 $ 90,633 Cumulative ratio of GAP to total assets 6.48 % 3.59 % 3.79 % 9.98 % 12.64 % 6.15 % 6.67 % 6.67 % ========== ========== ========== ========== ========== ========== ========== ========== (1) Fixed rate mortgages are shown in periods which reflect normal amortization plus prepayments of 18-64% per annum depending on coupon. (2) Adjustable rate mortgages are shown in the periods in which the mortgages are scheduled for repricing. (3) MBS are shown in periods which reflect normal amortization plus prepayments equal to BankAtlantic's experience of 42% per annum. (4) BankAtlantic determines deposit run-off on money fund checking, savings and NOW accounts based on statistics developed in conjunction with the OTS. BankAtlantic does not believe its experience differs significantly from the OTS. Interest free transaction accounts are non-interest bearing liabilities and are accordingly, excluded from the cumulative rate sensivity gap analysis. Within 1-3 3-5 Over 5 1 Year Years Years Years -------- -------- -------- -------- Savings accounts decay rates 17% 17% 16% 14% Insured money fund savings (excluding tiered savings) decay rates 79% 31% 31% 31% NOW and tiered savings accounts decay rates 37% 32% % 17% 17% ========== ========== ========== ========== (5) Includes FHLB Stock. /TABLE

93444_1993.txt

93444_1993

1993

93444

Item 2. PROPERTIES The Company owns or leases the manufacturing properties described below. All properties are in good condition. Location Owned Square Feet -------------------------------------------------- Jenkintown, Pennsylvania............ 683,000(a) Cleveland, Ohio .................... 413,000(a) Santa Ana, California............... 305,000(a)(i) Salt Lake City, Utah ............... 86,000(a) Marengo, Illinois .................. 442,000(b) Muskegon, Michigan ................. 110,000(b) Norfolk, Nebraska .................. 103,000(b) Sevierville, Tennessee ............. 65,000(b) Ogallala, Nebraska ................. 26,000(b) Anasco, Puerto Rico................. 129,000(a)(j) Coventry, England .................. 240,000(a) Birmingham, England ................ 137,000(a) Leicester, England ................. 88,000(a) Melbourne, Australia ............... 44,000(a) Leased Lease Expires Square Feet ------------------------------------------------------------ Walled Lake, Michigan April 30, 1994 21,000(a) Leicester, England (c) (d) 90,000(a) Shannon, Ireland (e) (f) (g) 233,000(a) Barcelona, Spain April 20, 2005 129,000(a) Tarragona, Spain (h) 11,000(a) ---------- (a) Fastener segment (b) Materials segment (c) Lease for 38,000 square feet expires January 12, 1997. (d) Lease for 52,000 square feet expires July 1, 1995. (e) Lease for 54,000 square feet expires April 1, 1996. (f) Lease for 75,000 square feet expires November 15, 2010. (g) Lease for 104,000 square feet expires November 13, 2010. (h) Lease expires November 1, 1994, with biennial renewal options. (i) Approximately 70,000 square feet used for manufacturing purposes, with the remaining 235,000 square feet held for lease. (j) Closed and held for sale. The Company also owns a 63,000 square-foot corporate headquarters facility in Newtown, Pennsylvania. This facility is currently held for sale. Industrial Development Revenue Bonds were issued to finance the acquisition and improvement of the Salt Lake City, Utah, facility. These bonds are collateralized by a first mortgage on this facility and a bank letter of credit. Item 3. Item 3. LEGAL PROCEEDINGS For discussion of legal proceedings, see Note 14 to the Company's Consolidated Financial Statements on page 12 in the 1993 Annual Report to Shareholders which is incorporated herein by reference. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT All executive officers of the Company are named below and are appointed by the Board of Directors. The date that each officer was first appointed to his present position is indicated. No officer listed was appointed as a result of any arrangement between him and any other person as that phrase is understood under the Securities Exchange Act regulations. No family relationship exists among the executive officers of the Company. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS Information regarding the principal markets on which SPS Technologies common stock is traded, the high and low sales price for the stock on the New York Stock Exchange for each quarterly period during the past two years, the quarterly cash dividends declared by SPS Technologies with respect to its common stock during the past two years, and the approximate number of holders of common stock at March 7, 1994 is included under the caption entitled "Common Stock Information" on page 21 in the 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA A summary of selected financial data for SPS Technologies for the years and year ends specified is included under the caption entitled "Selected Financial Data" on page 23 in the 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information regarding SPS Technologies financial condition, changes in financial condition and results of operations is included under the caption entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 24 to 27 in the 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated Financial Statements for SPS Technologies included on pages 4 through 19 in the 1993 Annual Report to Shareholders, together with required supplementary data that is included in Footnote 23, "Summary of Quarterly Results" on page 20 in the 1993 Annual Report to Shareholders, are incorporated herein by reference. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) Identification of directors: Information regarding directors is incorporated by reference to the Definitive Proxy Statement, Election of Directors, if filed with the Securities and Exchange Commission (SEC) within 120 days after December 31, 1993. To the extent not so filed, such information will be provided on a Form 10-K/A filed with the SEC. (b) Identification of executive officers: Information regarding executive officers is contained in Part I of this report (page 5). Item 11. Item 11. EXECUTIVE COMPENSATION Information regarding executive compensation is incorporated by reference to the Definitive Proxy Statement, Executive Compensation and Board Meetings, Committees and Compensation, if filed with the SEC within 120 days after December 31, 1993. To the extent not so filed, such information will be provided on a Form 10-K/A filed with the SEC. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding security ownership of certain beneficial owners and management is incorporated by reference to the Definitive Proxy Statement, Ownership of Voting Securities, if filed with the SEC within 120 days after December 31, 1993. To the extent not so filed, such information will be provided on a Form 10-K/A filed with the SEC. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this Report: 1. The Consolidated Financial Statements and related Notes set forth on pages 4 through 19 of the 1993 Annual Report to Shareholders are incorporated by reference (See Exhibit 13). The Report of Independent Accountants, which covers both the Consolidated Financial Statements and the financial statement schedules, appears on page 11 of this report. 2. Financial Statement Schedules: The following supplemental schedules are located in this report on the pages indicated. Page ---- V Property, Plant and Equipment 12 VI Accumulated Depreciation and Amortization of Property, Plant and Equipment 13 VIII Valuation and Qualifying Accounts 14 IX Short-Term Borrowings 14 X Supplementary Income Statement Information 14 Schedules other than those listed above are omitted for the reason that they are either not applicable or not required or because the information required is contained in the financial statements or notes thereto. 3. Exhibits: (b) Reports on Form 8-K: Form 8-K was filed on December 1, 1993 stating that the Board of Directors had elected Charles W. Grigg as Chairman of the Board and Chief Executive Officer, and a Director of the Company, effective December 1, 1993. SIGNATURE 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. SPS TECHNOLOGIES, INC. ------------------------------------ (Registrant) DATE: March 28, 1994 /s/ WILLIAM M. SHOCKLEY ------------------------------------ William M. Shockley Controller 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. REPORT OF INDEPENDENT ACCOUNTANTS THE SHAREHOLDERS AND BOARD OF DIRECTORS SPS TECHNOLOGIES, INC.: We have audited the consolidated financial statements of SPS Technologies, Inc. and subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which financial statements are included on pages 4 through 19 of the 1993 Annual Report to Shareholders of SPS Technologies, Inc. and subsidiaries and incorporated by reference herein. We have also audited the financial statement schedules as listed in Item 14(a)2 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of SPS Technologies, Inc. and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1992. /s/ COOPERS & LYBRAND ------------------------- COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania 19103 March 2, 1994, except as to Note 12 for which the date is March 21, 1994 SCHEDULE V SPS TECHNOLOGIES, INC. AND SUBSIDIARIES Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 (Thousands of dollars) Depreciation is provided substantially on a straight-line basis over the estimated useful lives of the respective assets, generally as follows: Buildings, 5 to 50 years; Machinery and equipment, 3 to 20 years. ---------- The 1992 and 1991 amounts have been reclassified (see Note 3 to the Consolidated Financial Statements) (a) Transfers among accounts and miscellaneous adjustments, net. (b) Translation adjustments. (c) The May 3, 1991, balances, and subsequent additions, retirements and translation adjustments reclassified to net assets held for sale. (d) Amounts include $59 of land, $757 of buildings and $2,084 of machinery and equipment related to the acquisition of a bonded magnet business in December 1992. SCHEDULE VI SPS TECHNOLOGIES, INC. AND SUBSIDIARIES Accumulated Depreciation and Amortization of Property, Plant and Equipment Years ended December 31, 1993, 1992 and 1991 (Thousands of dollars) ---------- The 1992 and 1991 amounts have been reclassified (see Note 3 to the Consolidated Financial Statements). (a) Transfers among accounts and miscellaneous adjustments, net. (b) Translation adjustments. (c) The May 3, 1991, balances, and subsequent additions, retirements and translation adjustments reclassified to net assets held for sale. SPS TECHNOLOGIES, INC. AND SUBSIDIARIES Years ended December 31, 1993, 1992 and 1991 (Thousands of dollars) SCHEDULE VIII Valuation and Qualifying Accounts ---------- The 1992 and 1991 amounts have been reclassified (see Note 3 to the Consolidated Financial Statements). (a) Uncollectible receivables less recoveries. (b) Transfers to net assets held for sale. SCHEDULE IX Short-Term Borrowings ---------- (a) For general terms, see Note 10 to the Consolidated Financial Statements. (b) The average amount outstanding during each period is the average of the month end balances. (c) The weighted average interest rate during the period is determined by dividing interest expense related to short-term borrowings by the average of the month end balances. SCHEDULE X Supplementary Income Statement Information Charged to Costs and Expenses ITEM 1993 1992 1991 ------------------------------------------------------------------------- Maintenance and Repairs .......... $9,096 $8,925 $9,920 =========================================================================

743653_1993.txt

743653_1993

1993

743653

ITEM 1. BUSINESS GENERAL Convex Computer Corporation ("Convex" or the "Company") designs, manufactures, markets and services a family of high performance computers for engineering, scientific and technical users. The Company's current product family ranges from metacomputing, consisting of specialized hardware integrated with advanced software, to a single-processor scalar/vector machine to a multiprocessor parallel supercomputer, and ranges in price from under $300,000 to more than $8 million. Convex shipped its first production system in March 1985, and most recently introduced its third generation of supercomputers in May 1991. In addition, the Company has announced that it is currently developing a fourth generation product as well as a scalable parallel product that it plans to introduce in 1994. The Company has installed 1290 systems at 643 industrial and research customers in 48 countries. Convex Computer Corporation was incorporated under the laws of the State of Delaware on September 8, 1982. MARKETS and CUSTOMERS The growing need for computer-aided simulation techniques in the development of new products, combined with the improved price/performance relationships available in scientific and engineering computer systems, has contributed to the growth of the technical computing market. Within that market, Convex focuses on the following segments: Discrete Manufacturing encompasses the use of computers in the process of designing and manufacturing products or structures. This market includes mechanical engineering applications. The availability of third-party software packages is especially important to end-users in this market segment. Key software programs which address this market and which run on Convex computers include Nastran and Ansys, two of the major structural analysis packages. Convex customers in this market include Ford Motor Company, Mercedes Benz AG, and Gulfstream Aerospace. Approximately 26% of the Convex installed base as of December 31, 1993 is in this market. The government/aerospace market includes applications such as computational fluid dynamics, signal and image processing, telemetry, cryptography, pattern recognition and other data acquisition and processing functions. Command and control systems, training simulators and support and logistics systems are other important segments of this market. Convex customers in this market include the U.S. National Aeronautics and Space Administration, the U.S. Department of Defense, Lockheed Missiles and Space Company, and Arnold Air Force Base. Approximately 19% of the Convex installed base as of December 31, 1993 is in this market. Computational chemistry is a potential growth market being addressed by Convex. Use of computers to simulate chemical reactions is greatly increasing the productivity of research laboratories and supplementing the use of "wet labs" in many new areas. Convex customers in this market include research institutions such as the U.S. National Institutes of Health, General Electric Company and the Max Planck Institute in Germany, software vendors and universities such as Harvard and Oxford, all of whom are developing software for this new market, and commercial pharmaceutical users such as Schering-Plough and Bayer. Approximately 12% of the Convex installed base as of December 31, 1993 is in this market. The petroleum market is characterized by applications relating to the exploration for and the management of natural resources. These applications include seismic data processing and interpretation, well logging analysis, reservoir modeling and production analysis. Convex customers in this market include major oil and gas companies such as Royal Dutch Shell, Mobil and PEMEX, seismic contractors such as Digicon Inc., Compagnie General de Geophysique, universities such as Cambridge and Stanford and third- party software vendors developing software for this industry. Approximately 15% of the Convex installed base as of December 31, 1993 is in this market. Advanced research has historically been a major market for computers of all types and represents an important market for the Company. Examples of applications in this market include medical research and high-definition television development. Customers include academic institutions such as the University of London Computing Center, Delft University of Technology, and Universite Catholique de Louvain, government laboratories, research institutes and research departments of large corporations such as Sony. Approximately 19% of the Convex installed base as of December 31, 1993 is in advanced research. Data Management is a growing market where computers are used as a server to manage, store, archive, and retrieve data. In these applications, computer platforms are integrated with high performance software and peripherals, including RAID disk technology, tape robots, and multiple network connections. Demand for these applications comes from the other segments served by the Company and include customers such as Mobil Exploration and Production Services Inc., the University of London Computing Centre, the Centre for Scientific Computing (Helsinki, Finland), and the Numerical Aerodynamic Simulation Systems Division at NASA Ames Research Center. Approximately 2% of the Convex installed base is in this market, but it represented approximately 17% of the 1993 installations. Emerging markets represent new applications and market opportunities for Convex products. New uses for Convex supercomputers include environmental research, oceanographic studies, linear programming, pipeline management, construction, real-time simulation and visualization. Customers in this market include the Danish Meteorological Institute, METEO, and DKRZ, the German Climate Computer Center. Approximately seven percent of the Convex installed base is in emerging markets. HARDWARE PLATFORMS Convex currently offers the C3 Series of 20 compatible and expandable supercomputers, as well as a series of systems which feature fully integrated real-time hardware and software capabilities and additionally a metacomputing environment consisting of specialized hardware systems integrated with advanced software. All Convex supercomputers offer a broad range of price and performance for its customers. These families of systems provide a smooth growth path from a single-processor scalar/vector machine to a high- end, eight-processor, tightly-coupled, parallel supercomputer. The Company's memory subsystem ensures that memory access is rarely a bottleneck and that processors can operate at their full potential. Large physical memory, expandable up to four gigabytes, allows applications to fit in physical memory, thereby reducing the time required for large simulations. Convex systems utilize all three forms of processing common in scientific and engineering applications: scalar processing in which operations are performed on one element at a time; vector processing, in which simultaneous operations occur on arrays of data; and parallel processing, in which two or more processors simultaneously operate on different portions of a program. A distinctive hardware- based technology, Automatic Self-Allocating Processors ("ASAP"), automatically takes software code that has been parallelized by the Convex compilers and splits it among the available processors. This technique is faster and more efficient than the commonly used static allocation technique which assigns processors to execute a single job and leaves idle processors waiting for parallel code that may never arrive. Unlike other parallel processing architectures, the ASAP approach never requires the programmer to use special programming techniques to take advantage of the parallel hardware technology. The Company is also presently developing the next generation C Series family of products. This generation is intended to replace the existing C3 Series of products. The new products will be compatible with existing C Series products and are planned to deliver improved performance at approximately the same prices as the existing products. As planned, the system will offer up to 6 GFLOPS of maximum performance with up to 4GB of physical memory. The development effort for this product family is nearing completion, but the completion and ultimate introduction of this product line is dependent on the Company receiving a number of key semiconductor components from its suppliers. While the Company believes that it will receive the necessary devices, there can be no assurance that the suppliers of these devices will successfully complete their development efforts or once completed that they will be capable of manufacturing these devices in quantities sufficient to allow the Company to achieve volume production of the new product family. In March of 1994, Convex introduced the Exemplar product line, a new family of scalable parallel processing systems. The system is based on RISC microprocessors from Hewlett-Packard Company and incorporates a completely new hardware architecture from that previously delivered in the C Series product family. The system is planned to scale from 2 to 128 processors with scalable memory, I/O and operating system features that are balanced with the processing capability in any processor configuration. The system is planned to deliver up to 25 GFLOPS of processing with up to 32 GB of shared memory. Initial shipments of entry level configurations (up to 8 processors) will begin in the first quarter of 1994. Systems in larger configurations are planned to be introduced throughout 1994 as the final development effort on larger configurations is completed. SOFTWARE PRODUCTS Convex offers a wide range of software products to assist its customers in achieving maximum speed and productivity with minimal incremental resource investments. C Series products are fully software compatible. Convex customers can move up the Convex product line taking advantage of all of the software, both third-party and internally developed, that they have been using on their current Convex products. Convex believes that the combination of its UNIX-based operating system, advanced compiler technology, third party application program availability, and networking products offer its customers increased productivity and ease-of-use, thereby increasing market acceptance of its systems. The foundation of the Convex software environment is the ConvexOS operating system, an enhanced high- performance version of UNIX 4.2 and 4.3bsd developed at the University of California, Berkeley. Extensions range from file system performance enhancements, which enable programs to profit from the innate parallelism in the input/output systems, to features allowing a single process greater access to system resources such as memory. One of the Company's major technological achievements has been its development of a vectorizing/optimizing/parallelizing compiler technology that enables Convex systems to utilize existing applications software. This compiler technology, currently available for FORTRAN, C and Ada, permits programmers to take advantage of vector and parallel processing without learning new programming techniques. The compilers identify opportunities for optimization and vectorization, instruction pipelining, and parallel processing and then automatically generate software code that best utilizes the Convex architecture. In addition, Convex offers the Convex Application Compiler which identifies opportunities for parallelization across a customer's entire software application. The availability of third-party application software is often a critical element of a customer's decision criteria when evaluating computer systems. Convex actively promotes and supports the development and conversion of third-party application software to run on Convex hardware. Over 1300 third-party applications are now available on Convex systems, including industry-leading programs used in each of the Company's target markets. Key industrial and research applications which are available include structural analysis, computational fluid dynamics, graphics and leading applications for the petroleum, electronics and chemistry markets. To aid communication between computer systems, Convex offers connectivity to almost every industry-standard network interface. The Convex Network File System allows users to share a common base of files across different systems. In addition, Convex supports X Windows, a network-based window system which provides users access to a wide array of computing resources and the ability to execute multiple applications simultaneously. In March of 1994, Convex introduced the Exemplar product line, a new family of computer systems. The software elements of this new product family include a new operating system that incorporates components from several sources. The integration and performance tuning of these components is critical to the overall success of the product. These efforts will continue throughout 1994 as the development efforts for the top-end of the product line are completed. While the Company believes that these efforts will be successful, there can be no assurance that overall performance of the new operating system will reach satisfactory levels as a result of these efforts. Market acceptance of this product family is also highly dependent on third party software vendors porting their applications to the product. While the Company is working with a number of vendors to accomplish this result, there can be no assurance that the third party vendors will undertake the necessary efforts, or that the porting efforts will yield competitive software applications on the Company's new product. SALES AND DISTRIBUTION Convex sells directly to end-users in the United States, Canada, the United Kingdom, France, Germany, Italy, The Netherlands, Switzerland, Denmark, Sweden, Greece, Norway, Finland, Belgium, Japan, Australia, Singapore and Taiwan. Convex has contracted with OEMs and with full-service independent distributors in certain other countries, including Japan, Spain, South Korea, Hong Kong, Malaysia, Indonesia and India. The Company attempts to ship product to its customers as promptly as practicable upon receipt of a purchase order and generally does not maintain a significant backlog. However, backlog for C3800 systems and upgrades was reported at approximately $42 million in 1991 and $20 million in 1992, which the Company believes was due to availability limitations. During 1993 the C3800 backlog declined to near zero and remained at that level through year-end. Adding to the difficulty of predicting future revenues, a significant portion of the Company's sales often occur in the last month of a fiscal quarter, a pattern that the Company believes is common in the computer industry and due in part to the budgetary cycles of its customers. Accordingly, revenues and net income have the potential to fluctuate on a quarterly basis depending upon the timing of orders and shipments. Several of the Company's customers which are agencies of the U.S. government collectively accounted for approximately 16% of total revenue in 1993, approximately 13% of total revenue in 1992 and approximately 15% in 1991. During 1989, one distributor of the Company's products, Tokyo Electron Limited, accounted for 12% of total revenues. No single end-user customer has accounted for more than 10% of total revenues in the last five years. SERVICE AND SUPPORT The Company's direct service organization includes hardware engineers, technicians and software experts who provide customer assistance, support installations, conduct training classes, perform periodic maintenance and provide on-demand service and support in the event of any customer problems. Convex also provides a dial-in hotline and remote diagnostic capabilities to provide problem resolution from the Company's headquarters. In 1992 the Company entered the systems integration business in which it performs a service for the customer by integrating hardware and software. The growth in service revenue for the last two years has been sustained by the increase in this business which is now approximately 32% of service revenue. Service revenue in total has grown from 20% of total revenue in 1991 to just under 40% of total revenue in 1993. MANUFACTURING AND QUALITY To maintain product quality and to control production cycles to satisfy customer demand, Convex has implemented an internal manufacturing capability. The Company's manufacturing operations are located in Richardson, Texas, and consist primarily of assembly and test of parts, components and subassemblies and final assembly of the product. Convex principally uses standard off-the-shelf components available from multiple vendors. However, certain parts and components used in the Company's products are currently available only from limited sources. These include such items as custom VLSI gate arrays, which are designed by Convex and manufactured by Fujitsu Microelectronics Incorporated, custom gallium arsenide gate arrays manufactured by Vitesse Semiconductor Corporation, and custom BiCMOS gate arrays manufactured by Texas Instruments. In 1994 both the next generation C Series product and the scalable parallel product will make use of leading edge semiconductor devices. As a result, the Company has only one source for certain key components. There are still significant technical and manufacturing uncertainties involved in the Company successfully bringing these new products to market. In addition, the Company's ability to manufacture its new products in quantities adequate to meet potential demand will require that the Company receive sufficient quantities of these semiconductor devices. Convex attempts to reduce risks of interruption in its supply of components by establishing backup vendors where feasible. RESEARCH AND PRODUCT DEVELOPMENT The Company's research and development programs are currently focused on developing its next generation of C Series product and a scalable parallel product based on Hewlett-Packard Company's PA- RISC technology. A significant percentage of the Company's research and development investment is being devoted to software development. Convex intends to continue making substantial investments in research and development activities to enhance its competitive position. For the fiscal years ended December 31, 1991, 1992 and 1993, research and development expenses were $30 million, $33 million and $33 million, respectively. COMPETITION The computer business is intensely competitive and characterized by rapid technological advances in both hardware and software. The entire Convex product line competes with that of Cray Research, Inc. ("Cray"). Convex products compete with those IBM products which incorporate vector facilities. The Company's products also compete with systems offered by DEC. Each of these competitors is much larger than Convex and has substantial financial resources and a large installed base of customers. The Company also competes against several vendors who offer high-performance workstation and server products at relatively low prices. Convex expects to see additional direct competition, both from established companies and new market entrants. New competition could result from existing computer vendors electing to address the Company's traditional markets with product offerings incorporating vector and parallel processing techniques. New competition may also result from vendors providing increasingly powerful workstation and server products which incorporate relatively inexpensive microprocessors. Finally, companies are continually evaluating new computer architectures, an example of which is massively parallel processors, which could be targeted at the same customers being served by Convex. The potential impact on the Company's business of new products from Cray, IBM, DEC and others is not known. However, introduction of new products could cause delays in customer orders as customers evaluate the new product offerings before reaching a final purchase decision. Convex competes on the basis of price, performance and ease of use. Convex believes that its current family of products is facing increasingly difficult competition and the new products planned for introduction in 1994 will be necessary to compete favorably with respect to these factors. PATENTS AND LICENSES The Company has been issued 17 patents in the United States and 2 in certain foreign countries. Additionally, the Company has 16 applications for patents pending in the United States and 5 patent applications pending in certain foreign countries. The patents and patent applications relate to various aspects of the Company's product architecture. There can be no assurance that patents will be issued or that, once issued, the patents can be successfully defended. Convex believes that, while patents may offer a measure of legal protection, they are less significant to the success of the Company than such factors as innovation and technical expertise. Convex has entered into a cross-license agreement with Cray Research, Inc. which grants a perpetual cross-license of each company's existing and pending patents as of May 29, 1986. Neither party is responsible for any fees or royalties to the other under this agreement. The Company has also entered into a non-exclusive perpetual license with American Telephone and Telegraph Company for the UNIX operating system under which the Company may grant sublicenses to its customers. Convex also has been granted other non-exclusive licenses for certain software which permit the Company to grant sublicenses to its customers. RELATIONSHIP WITH THE HEWLETT-PACKARD COMPANY In March of 1992, the Company entered into a series of technology and commercial agreements as well as a Stock Purchase Agreement with the Hewlett-Packard Company ("HP"). Under the technology and commercial agreements, Convex and HP exchanged certain core technologies including HP providing Convex with RISC compiler technology and Convex providing HP with supercomputer compiler technology. In addition, Convex has the right to purchase from HP various PA-RISC components for the Company's future MPP products. Finally, Convex and HP have entered into a non-exclusive cross-license covering various of each company's existing, pending and future computer-related products. In April of 1993, this agreement was extended to include HP's license to Convex for its HP-UX operating system and related software technologies in return for current and future software technologies from Convex. Pursuant to the Stock Purchase Agreement, HP purchased approximately 1.2 million shares of Common Stock from the Company (which represents approximately 5% of the total outstanding Common Stock of the Company) at a purchase price of approximately $18 million. In connection with this Agreement, the Company and HP agreed to meet in late 1994 and again in late 1996 to discuss possible increases in ownership by HP, although no right or obligation to purchase additional shares was established. During the term of the Stock Purchase Agreement, the Company has agreed to certain covenants. These include the right of HP in certain circumstances to acquire additional shares from the Company if the Company sells shares of Common Stock to third parties. In addition, the Company has agreed that, if HP's ownership reaches 10% of the Company's outstanding Common Stock, HP will be entitled to designate one nominee for election to the Company's Board of Directors. Finally, the Company granted HP certain registration rights. EMPLOYEES As of December 31, 1993, the Company employed 1,006 full-time employees, of whom 252 were employed in research and development, 504 in sales, support and marketing, 165 in manufacturing and quality and 85 in finance and administration. None of the Company's employees is represented by a labor union and Convex believes its employee relations to be excellent. ITEM 2. ITEM 2. PROPERTIES The Company has occupied its current location since 1989. This single-tenant facility in Richardson houses the corporate headquarters, research and development and the manufacturing facilities. It was expanded during 1990 from approximately 260,000 square feet to a total of approximately 300,000 square feet. It is located in the Dallas metropolitan area, and is under a fifteen year lease expiring in 2004. Land is available at the new site to accommodate total office and manufacturing space of over 500,000 square feet. In addition, the Company has entered into an agreement to lease an additional 70,000 square feet at a site adjacent to its corporate headquarters. The Company leases 51 sales and service offices in other locations throughout North America, Europe and the Pacific Rim. The Company also plans to add additional sales and service offices as required. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On August 2 and 7, 1991, two separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Northern District of Texas. The two cases were consolidated. Plaintiffs filed a Consolidated Amended Complaint (the "Amended Complaint") on October 18, 1991, which purports to be a class action lawsuit on behalf of persons who purchased Convex stock between January 31, 1991 and July 29, 1991. The Amended Complaint alleges that defendants violated specific provisions of the federal securities laws, namely Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and Texas common law. Subsequent to December 31, 1993 the Company reached an agreement in principle to settle this class action lawsuit, subject to final approval by the court. The Company has included a charge for the $2.5 million estimated cost of settlement in the 1993 results. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The names of the Company's executive officers and certain information about them are set forth below: Name Age Position with Company - - - -------------------- --- ----------------------------------------------- Robert J. Paluck 46 Chairman of the Board and Chief Executive Officer Steven J. Wallach 48 Senior Vice President, Technology; Director James A. Balthazar 40 Vice President, Marketing Matthew S. Blanton 53 Vice President, Advanced Development William G. Bock 43 Senior Vice President, Worldwide Sales Philip N. Cardman 46 Vice President, General Counsel; Secretary Thomas M. Jones 47 Vice President, Data Management Systems J. Cameron McMartin 37 Vice President, Finance and Chief Financial Officer Daniel N. McQuay 49 Vice President, Manufacturing Terrence L. Rock 47 President Mr. Paluck, a founder of the Company, has served as Chief Executive Officer and as a director since the Company's inception in September 1982, and as President from inception until May 1993. Mr. Paluck was appointed Chairman in July 1989. Before founding Convex, Mr. Paluck was Vice President, Product Development and Marketing for Mostek Corporation, a semiconductor manufacturer, where he spent eleven years. Mr. Paluck holds a BSEE from the University of Illinois and an MBA from Southern Methodist University. Mr. Wallach, a founder of the Company, has served as Vice President, Technology and has been a director since its inception in September 1982. Mr. Wallach was named Senior Vice President in January 1990. Prior to founding Convex, he served as Product Marketing Manager at ROLM Corporation for the 32-bit mil-spec computer system from 1981 to 1982. Mr. Wallach was Manager of Advanced Development of Eclipse Systems for Data General Corporation from 1975 to 1981, where he was the principal architect of the 32-bit Eclipse MV superminicomputer series. Mr. Wallach received a BSEE from the Polytechnic Institute of Brooklyn, an MSEE from the University of Pennsylvania and an MBA from Boston University. He is the inventor with respect to 33 patents in various areas of computer design. Mr. Balthazar joined Convex in April 1984. He initially worked in third party marketing, moving to Manager of Product Marketing in 1987 and to European Sales and Marketing Director in 1989. In January 1991, he was promoted to Vice President, Marketing. Prior to joining Convex, Mr. Balthazar worked as a mechanical engineering consultant for Structural Dynamics Research Corporation, Cincinnati, Ohio, and for University Computing Corporation, Dallas, Texas. Mr. Balthazar holds a BS in Agricultural Engineering from the University of Maryland and an MS from Cornell University in Theoretical and Applied Mechanics. Mr. Blanton joined Convex in November 1990 and held various positions in engineering management. In February 1993 Mr. Blanton was named Vice President, Advanced Development. Prior to joining Convex, Mr. Blanton served as president of Vadis, Inc from 1989 to 1990. Mr. Blanton worked for ROLM Corporation from 1981 through 1989 and served as General Manager of their desktop products division. He holds an MSEE degree from Southern Methodist University and a BSEE degree from Texas A & M. Mr. Bock joined Convex in May 1984 as Vice President, Finance and Chief Financial Officer, and was named Senior Vice President in January 1990. In February 1993, Mr. Bock was named Senior Vice President, Worldwide Sales. From 1975 to 1984, Mr. Bock worked for Texas Instruments in various finance and accounting positions, most recently as the Vice President and Controller for the Data Systems Group. Mr. Bock has a BS in Computer Science from Iowa State University and an MS in Industrial Administration from Carnegie-Mellon University and is a certified public accountant in the State of Texas. Mr. Cardman joined Convex in July 1989 as Vice President, General Counsel and Secretary. From 1981 to 1989, Mr. Cardman was employed by Tandem Computers Incorporated. Mr. Cardman's two most recent positions with Tandem were as General Counsel and Director of Business Development for Tandem Computers Europe and as the Director of International Business. Mr. Cardman holds a BA from Washington University and a JD from Duke University. Mr. Jones joined Convex in October 1982 as the Manager of Hardware Development, and in March 1988 was appointed Vice President, Advanced Development. In March 1993 Mr. Jones was named Vice President and General Manager, Data Management Systems. Prior to joining Convex, Mr. Jones was Manager of Logic Design at the Data General facility in North Carolina. Mr. Jones holds a BS in Engineering Physics from the University of California, Berkeley. Mr. McMartin joined Convex in May 1989 as Director, Treasury Services and Investor Relations and was named Controller, Worldwide Sales, Service and Marketing in July 1990. Mr. McMartin was promoted to Vice President, Finance and Chief Financial Officer in March 1993. Prior to joining Convex, Mr. McMartin worked for Texas Instruments Incorporated in various finance and accounting positions, most recently as Controller, Peripheral Products Division. Mr. McMartin holds a BA from Trinity University and an MBA from the University of Michigan. Mr. McQuay joined Convex in 1984 as Material Operations Manager. In April 1993, Mr. McQuay was named Vice President of Manufacturing. He worked approximately 14 years for Texas Instruments in manufacturing, production control, and material planning management before joining Convex. Mr. McQuay holds a BA degree in Marketing from the University of Houston. Mr. Rock joined Convex as Vice President of Operations in November 1983, and was named Senior Vice President in January 1990. In April 1993, Mr. Rock was promoted to Senior Vice President and Chief Operating Officer, and was named President in May 1993. Mr. Rock previously worked for Texas Instruments from 1970 to 1983, in a variety of manufacturing and materials positions, most recently as Materials Manager for the Data Systems Group. Mr. Rock holds a BSME from the South Dakota School of Mines and Technology. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is listed on the New York Stock Exchange under the symbol "CNX." The tables below present the range of high and low prices for the Common Stock for the period indicated. On December 31, 1993, there were 1,941 holders of record of the Company's Common Stock. The Company has not paid dividends on its Common Stock since its incorporation and anticipates that for the foreseeable future it will continue to retain its earnings for use in its business. 1993 Quarters ------------------------------------ 4th 3rd 2nd 1st -------- -------- -------- -------- Price range per share High $6 1/8 $5 7/8 $6 7/8 $8 5/8 Low $5 $3 5/8 $4 1/4 $5 1/4 1992 Quarters ------------------------------------ 4th 3rd 2nd 1st -------- -------- -------- -------- Price range per share High $8 1/8 $7 7/8 $11 5/8 $16 3/8 Low $4 3/4 $5 1/4 $ 7 $10 1/4 ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Overview In the first quarter of 1993, the Company reported revenues equal to the levels achieved in 1992. However, the Company also experienced a significant drop in the order rate and a resulting decline in the value of its backlog. When the low order rate continued in the second quarter of 1993 and product revenues declined, the Company implemented a restructuring program designed to reduce costs, to increase the Company's competitive strength and to improve its financial performance. The Company believes the expenses in the second half of 1993 showed a reduction due to the implementation of the restructuring program. In the second half of 1993, order rates remained low and the Company operated at a net loss in both the third and fourth quarters. The Company believes that order rates for the Company's products will continue to be adversely affected by economic uncertainties and tight customer budgets in the U.S., and in Europe and Japan, the Company's major markets outside the U.S. In addition, customers in the high-performance technical marketplace are faced with a wide array of choices of technology which the Company believes will also result in delayed buying decisions, lengthened sales cycles and intense price competition. As a result, the Company expects to see continued pricing pressure in 1994 with first half revenue levels at or below the levels achieved in the second half of 1993. The Company expects to introduce two new products in the first half of 1994 (see discussion under "Research and Development") which will result in an increase in capital expenditures (see discussion under "Liquidity and Capital Resources"). Revenue For the year ended December 31, 1993, total revenue decreased 17% to $193 million after a 17% increase to $232 million in 1992, as shown below. Revenue ($000,000) 1993 1992 1991 ----------------------------------- --------- -------- --------- Product and Other 120 178 159 Service 73 54 39 Total 193 232 198 Percent Change - Annual ----------------------------------- Product and Other Revenue -32% 12% -13% Service Revenue 35% 37% 42% Total Revenue -17% 17% -5% Unit Shipments --------------------- C3800 30 48 7 C3400 37 68 33 Meta Series 37 2 - The 32% decline in product revenue in 1993 is primarily due to decreased order rates for the C3 product line. The Company experienced increased competition from workstations in the compute- server markets, as well as order delays due to customers anticipating new product introductions in 1994. Both the C3800 and the C3400 products experienced lower demand throughout the year. The Meta Series product line was introduced in October 1992 and has shown rapid growth; however, Meta Series revenue growth has not been sufficient to offset the drop in the C3 product line. The increase in product revenue in 1992 over 1991 is believed to be attributable to increased availability of the C3 line in 1992. Both products were announced in mid-1991 but were shipped in limited quantities due to constrained supplies of key semiconductor components needed to build them. These supply constraints were resolved in 1992. Service revenue increased 35% in 1993 after a 37% increase in 1992 and a 42% increase in 1991. This component of revenue now accounts for 38% of the Company's total revenue. This revenue includes both maintenance contracts as well as systems integration revenue. Systems integration is a line of business the Company entered during 1992 in which it performs a service for the customer by integrating hardware and software from other vendors with Convex hardware and software. Systems integration revenue includes the integration components of both the Data Management business and the Meta Series product line. The growth in service revenue during the last two years has been sustained by the increase in the systems integration business with revenue from systems integration of $8 million in 1992 and $23 million in 1993. The Company believes the amount of systems integration revenue will fluctuate from quarter-to- quarter and will depend to a large degree on the success of the Data Management business. In addition, the Company believes that in the future, modest growth in maintenance contract revenue is possible if the Company is able to achieve growth in product revenues. The Company believes the current economic and competitive environment is causing its customers and prospects to reduce their capital spending levels and to delay making decisions to purchase high dollar capital goods such as the Company's products. The Company also believes the current competitive environment has put increased pressure on the Company's present compute-server products. In addition, the Company plans to introduce two new product families in 1994 (please refer to the discussion under "Research and Development"). Some customers, anticipating the availability of these new products, may further delay purchases of the Company's current products until the new products are available. There can be no assurance that the Company will be able to equal the level of product shipments achieved in the second half of 1993. The Company manufactures and ships its products as promptly as practicable upon receipt of a purchase order, and generally does not maintain a significant backlog. The Company did establish a backlog position in the C3800 product in 1991 and 1992, which the Company believes was due to product availability issues; however, that backlog declined to zero in 1993. With no backlog entering 1994, the Company's future financial performance will depend on its ability to generate new orders for shipment in the same quarter in which the orders are received. Finally, because a significant portion of the Company's shipments occur in the last month of a quarter, minor timing differences in the receipt of customer purchase orders and in the Company's shipments can have a significant impact on the Company's quarterly financial results. Due to the high average selling price and low unit volume of the Company's sales, failure to complete a small number of sales transactions before the end of a quarter can have a significant negative impact on financial results. Gross Margin Product margin remained at 50% through 1991, 1992 and the first quarter of 1993, but dropped to 45% for the year 1993. The Company believes two factors accounted for the margin decline: Competitive pricing pressures have increased for the last three quarters of 1993; and the absorption of fixed manufacturing costs on the lower product revenue which resulted in approximately a 4 percentage point reduction in product margins. Gross Margins % Revenue 1993 1992 1991 ----------------------------------- --------- -------- ------- Product Margin 45% 50% 50% Service Margin 32% 37% 35% Total Margin 40% 47% 47% Gross margin on the service business has dropped to 32% in 1993, a reduction from 37% in 1992. This change was caused by the increase in the lower margin systems integration business which has grown from approximately 14% of service revenues in 1992 to approximately 32% in 1993. Expenses Expenses for the Company are summarized below. In general, expenses for 1993 were held constant with the previous year with the exception of the restructuring and other charges taken during the year. Expenses ($000,000) 1993 1992 1991 - - - --------------------------------------- --------- --------- --------- Research and Development 33 33 30 Selling, General and Administrative 69 69 73 Restructuring and Other 36 - - Expenses - % Revenue 1993 1992 1991 - - - ---------------------------------------- --------- -------- --------- Research and Development 17% 14% 15% Selling, General and Administrative 36% 30% 37% Restructuring and Other 19% - - Research and Development Research and development expenditures of $33 million in 1993 were unchanged from the previous year. The decline in revenue this year has increased these expenditures as a percentage of revenue, but the Company remains committed to aggressive efforts to bring two new product families to market in 1994. In 1994 the Company expects to maintain research and development expenses at approximately the same amount as 1993. However, because these two product families are critical to the Company's competitiveness and future financial results, some increase in spending may be necessary to complete these two products. The Company is developing both the fourth generation of C-Series computers as well as a new scalable parallel computer family based on Hewlett-Packard Company's PA-RISC technology. The scalable parallel product will introduce both a completely new hardware platform and a completely new suite of software products. The software products include a new operating system that incorporates components from several sources. The integration and performance tuning of these components is critical to the overall success of the product. Market acceptance of this product is also highly dependent on third-party software vendors porting their applications to the product. While the Company is working with a number of vendors to accomplish this result, there can be no assurance that the third- party vendors will undertake the necessary efforts, or that the porting efforts will yield competitive software applications on the Company's new product. Both the next generation C-Series product and the scalable parallel product make use of leading edge semiconductor devices. The Company currently has only one source for certain key components. The Company's ability to manufacture its new products in production quantities will require that the Company receive sufficient quantities of these semiconductor devices from its vendors. There are still significant technical and manufacturing uncertainties involved in the Company successfully bringing these new products to the market, and there can be no assurance that these products, once introduced, will gain market acceptance, or that the Company will receive adequate supplies of critical components. Selling, General and Administrative Expenses Selling, general and administrative expenses for 1993 were also unchanged from the 1992 level, after a decrease from 1991 to 1992 due to cost controls which included both staffing reductions and a six-month salary freeze. These expenses as a percentage of revenue have increased in 1993, but the Company believes the current selling resources will be necessary to support the introduction of the new products planned for 1994. The Company continues to focus on tight expense management and has maintained the same total cost year-to-year, including one-time charges incurred in the fourth quarter of 1993 related to the bankruptcy of an international leasing company and financial difficulties of another customer. Restructuring and Other Charges With a substantial decline in order rates and revenue in the first half of 1993, in July the Company implemented a restructuring program designed to reduce annualized costs by $22 million and to increase the efficiency of the Company's operations. The restructuring also reflected a strategic decision to write down certain assets based on an analysis of future demand for both the C3800 and C3400 product families. The $32 million charge taken in the second quarter was comprised of $7 million for severance costs of approximately 185 employees, $22 million for costs associated with reducing factory capacity in the Richardson manufacturing facility and to write down certain of the Company's assets, and $3 million in miscellaneous and other charges. An additional $5 million charge was taken in the fourth quarter for the estimated cost of settling the 1991 class action lawsuit and for additional asset write-downs. The $36 million restructuring charge involves cash expenditures of approximately $17 million, all funded from working capital. Of this amount, $9 million had been spent at the end of 1993 and the Company expects the remaining $8 million to be substantially spent by mid-1994. In addition, the Company estimates that it has reduced annual expenses by over $22 million. The expense reductions include payroll and benefit expenses of approximately $15 million, depreciation, rent and maintenance expenses of $5 million and $2 million of other expenses. There can be no assurance, however, that this program will improve the Company's financial performance. The Company ended the year with 1006 employees, 158 fewer than the previous year with most of the reductions coming in the manufacturing area. Other Income and Expense Other income for 1993 was also unchanged from the previous year at $2 million expense. This item consists of interest earned less interest expenses incurred and certain costs associated with implementing the Company's foreign currency hedging program. In 1992 this expense increased due to a decline in the rate of interest earned on cash and short-term investments, combined with an increase in expenses related to the Company's foreign currency hedging program. In 1993 short-term interest rates continued to decrease and interest income declined, but this was offset by lower costs of foreign currency hedging. Income Taxes The operating loss for the Company in 1993 resulted in a limited U.S. tax benefit in the current year. The domestic tax benefit was offset by tax expenses in various foreign subsidiaries, with a net result of a $1 million tax expense for the year. No benefit has been recorded on approximately $25 million of domestic book losses. At December 31, 1993 the Company had operating loss carryforwards in various foreign subsidiaries which are available to offset future taxable income. The realization of the tax benefits related to the domestic losses without tax benefit and foreign carryforwards is dependent on the future profitability of the Company and its foreign subsidiaries. During 1992, the Company adopted Statement No. 109, "Accounting for Income Taxes," which requires a change from the deferred method of accounting for income taxes to the liability method. The effect of the adoption on the Company's financial position was not material. Liquidity and Capital Resources After an increase of $8 million in working capital in 1992, primarily the result of a profitable year and an $18 million stock purchase by the Hewlett-Packard Company, Convex experienced a $47 million decline in working capital in 1993. The primary reason for this decrease is the net loss of $64 million for the year. Capital expenditures for the year were well below historical levels at $11 million in 1993, down from $18 million in 1992 and $16 million in 1991. The Company believes capital requirements in 1994 will increase for the two new products planned for introduction during the year and expenditures will equal or exceed the $18 million incurred in 1992. The Company's most recent major product introduction, the C3 product series, was supported by capital expenditures of $25 million in 1990. The Company's cash, cash equivalents and investment balances totaled approximately $70 million at the end of 1993. The Company believes this source of liquidity will be sufficient to meet cash requirements for at least the next twelve months. However, with financial performance in the first half of 1994 expected to be at or below the levels achieved in the second half of 1993, the Company expects cash balances to decrease. To help ensure the transition to the new products, the Company may seek to secure lines of working capital. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Notes to Consolidated Financial Statements-December 31, 1993 Note 1. Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of Convex Computer Corporation and its wholly owned subsidiaries ("Convex" or the "Company"). All significant intercompany accounts and transactions have been eliminated. Certain amounts have been reclassified from previously reported financial statements to conform with current presentation. Revenue Recognition Product revenue is generally recognized at the time of shipment. Certain sales agreements provide for compliance at the customer's site with specified functional and performance criteria which are generally factory-tested prior to shipment. Revenue recognition may be deferred in certain cases, depending upon contract terms or funding contingencies. An accounts receivable reserve is established for potential returns pending completion of customer product acceptance and payment. Service revenue is recognized ratably over the contractual period or as the services are provided. Customers are given the option to prepay for twelve months of service in which case the prepayment is accounted for as deferred revenue and recognized ratably over a twelve month period in the Company's financial statements. Risk Concentration Financial instruments which potentially subject the Company to concentrations of credit risk are primarily cash, investments and accounts receivable. The Company attempts to minimize the concentration of credit risk for cash and investments by limiting the amount of credit exposure to any one commercial issuer. Concentrations of credit risk with respect to the receivables are limited due to the large number of customers in the Company's customer base, and their dispersion across different industries and geographic areas. The Company maintains an allowance for losses based upon the expected collections of its accounts receivable. Cash and Cash Equivalents Cash in excess of daily requirements is invested primarily in investment grade short-term commercial paper, repurchase agreements, time deposits, and U.S. government securities. These investments are stated at cost which approximates fair value as determined by quoted market prices. Investments purchased with a maturity of three months or less are considered cash equivalents. Short-term Investments Investments purchased with a maturity of more than three months and less than one year are considered short-term investments. These include U.S. government and government agency securities and corporate bonds. These investments are stated at cost. Due to the short-term maturity of these securities, fair value, as determined by quoted market prices, closely approximates the carrying value. Long-term Investments Investments in securities for which the holding period is greater than one year are considered long-term investments. The majority of the long- term portfolio consists of mortgage-backed securities either issued or guaranteed by the United States government or by its agencies. Although there is minimal credit risk, interest rate and prepayment fluctuations impact the market value of these securities. The carrying value of these investments approximates fair value as determined by quoted market prices. Interest income for the years ended December 31, 1993, 1992, and 1991 was $4,464,000, $5,899,000, and $6,779,000, respectively. Fixed Assets Fixed assets are stated at cost. Depreciation and amortization are computed primarily on a straight-line basis over asset lives of three years for office and research equipment, certain computer equipment and purchased software used in research and development activities, and five years for furniture and fixtures, manufacturing equipment, certain computer equipment, and certain purchased software. Fixed assets include the following (in thousands): 1993 1992 --------- ---------- Equipment $ 98,668 $91,132 Furniture and fixtures 14,997 14,294 Purchased software 9,566 7,612 --------- ---------- 123,231 113,038 Less accumulated depreciation (84,321) (64,932) --------- ---------- $ 38,910 $48,106 ========= ========== Inventory Inventory is recorded at the lower of cost (on a first-in, first-out basis) or market. Inventory consists of the following (in thousands): 1993 1992 ---------- ---------- Raw material $ 9,489 $14,426 Work-in-process 5,044 7,498 Finished goods 14,617 16,610 ---------- ---------- $29,150 $38,534 ========== ========== Equipment Leased to Customers The Company leases equipment to customers under agreements which are classified as sales-type leases in accordance with Statement of Financial Accounting Standards ("SFAS") No. 13. Accordingly, the fair market value of the leased equipment in these agreements has been recorded as revenue. The present value of the lease payments to be received under these agreements has been recorded as current and long-term receivables. Receivables from these leases at December 31, 1993 and 1992 were as follows (in thousands): 1993 1992 ---------- ---------- Future minimum lease payments $ 36,921 $ 45,693 Unearned interest income (2,733) (3,246) ---------- ---------- 34,188 42,447 Less current portion (13,622) (15,626) ---------- ---------- Long-term receivables $20,566 $ 26,821 ========== ========== As of December 31, 1993, future minimum lease payments from lease receivables are as follows: $14,820 in 1994, $12,754 in 1995, $5,058 in 1996, $2,734 in 1997, $917 in 1998, and $638 thereafter. The Company has a vendor leasing program whereby the majority of trade lease receivables are used to obtain non-recourse borrowings from several financial institutions or sold on a non-recourse basis to certain third-party leasing companies. See Note 2 for further information. Capitalization of Internally Developed Software The Company engages in the development of software products and certain costs associated with the development of these software products are capitalized in accordance with SFAS No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed." These costs are capitalized as incurred and are amortized over a two year period. Unamortized software development costs included in other assets at December 31, 1993 and 1992 were $1,809,000 and $1,580,000, respectively. Amortization expense for 1993 and 1992 was $1,431,000 and $1,533,000, respectively. Foreign Currency Translation The functional currency of the Company's foreign subsidiaries has been determined to be the local currency of each foreign subsidiary. Accordingly, all subsidiaries' assets and liabilities are translated to U.S. dollars at current exchange rates as of the balance sheet date. Revenues and expenses are translated at the average exchange rates during the period. Gains and losses resulting from foreign currency translation as of the balance sheet date are recorded as a separate component of shareholders' equity. Gains and losses resulting from foreign currency transactions, and remeasurement of non-functional currency assets and liabilities, are included in net income. Foreign Exchange Contracts The Company enters into foreign exchange contracts to hedge the impact of foreign currency fluctuations on certain assets and liabilities denominated in non-functional currencies. Gains and losses on these contracts are offset against the foreign exchange gains or losses on the underlying assets and liabilities. At December 31, 1993, the Company had contracts with major banks maturing on February 2, 1994 in the amount of $13,220,000 which amount approximates fair value as determined by year-end spot rates. Earnings Per Common and Common Equivalent Share The computation of primary earnings per share is based on the weighted average number of common and common equivalent (stock options) shares assumed to be outstanding during the year. In loss periods, common stock equivalents and the assumed conversion of the convertible debentures are excluded from the computation since their inclusion would have an anti-dilutive effect on earnings per share. For the three years presented, the computation of fully diluted earnings per share resulted in no significant additional dilution. The number of shares used in the computation of earnings per share for the years ended December 31, 1993, 1992 and 1991 is determined as follows (in thousands): 1993 1992 1991 --------- --------- -------- Weighted average common shares outstanding during the year 25,222 24,138 22,122 Dilutive common share equivalents related to outstanding stock options -- 439 -- --------- --------- -------- Weighted average shares used in computation 25,222 24,577 22,122 ========= ========= ======== Note 2. Long-term Debt Vendor Leasing Program The Company has a vendor leasing program whereby the Company sells equipment to customers under sales-type leases. The majority of trade lease receivables are used to obtain borrowings from several financial institutions or sold on a non-recourse basis to certain third-party leasing companies. The borrowings are collateralized by the leased equipment, whereby the Company gives the financial institution a first security interest. Collection of the lease receivables is performed by the noteholders. The outstanding borrowings at December 31, 1993 were approximately $25,440,000 at an interest rate of approximately 7.0% which approximates current market rates. Outstanding borrowings at December 31, 1992 were approximately $28,888,000 at an interest rate of approximately 10.0%. Convertible Debentures The Company has outstanding $53,500,000 of 6% Convertible Subordinated Debentures, due March 1, 2012. The debentures are convertible into common stock of the Company prior to maturity, unless previously redeemed, at a conversion price of $21.75 per share, subject to adjustment under certain conditions. The debentures are redeemable at par value. The debentures have mandatory sinking fund requirements which provide for the annual redemption of $2,675,000 plus accrued interest beginning March 1, 1998 and ending March 1, 2011. The bonds on December 31, 1993 had an approximate fair value of $35,310,000. The fair value for the Company's long-term debt is determined based on the quoted market price for the debentures. Long-Term Debt Aggregate maturities of long-term debt are as follows: $11,347,000 in 1994, $8,597,000 in 1995, $3,502,000 in 1996, $1,755,000 in 1997, and $2,914,000 in 1998. Interest expense for the years ended December 31, 1993, 1992 and 1991 was $6,298,000, $7,933,000, and $6,832,000, respectively. Note 3. Lease Obligations The Company leases its headquarters building under a noncancelable operating lease which expires in 2004. The lease agreement contains two ten-year renewal options. Leases of sales offices are also classified as operating leases and expire in various years through 2000. Future minimum lease payments under noncancelable operating leases are as follows (in thousands): 1994 $6,780 1995 5,287 1996 4,945 1997 4,144 1998 3,462 Later years 19,228 -------- Total $43,846 ======== Total rental expense was $7,107,000 in 1993, $7,314,000 in 1992, and $7,816,000 in 1991. Note 4. Income Taxes Effective January 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by SFAS No. 109, "Accounting for Income Taxes." As permitted under the new rules, prior years' financial statements have not been restated. The effects of adopting Statement 109 were not material. The provision (benefit) for income taxes for the years ended December 31, 1993, 1992 and 1991 consists of the following (in thousands): 1993 1992 1991 ---------- ---------- --------- Current State $ (61) $ 152 $ (534) Federal (3,180) 1,579 (3,149) Foreign 1,602 (45) 294 ---------- ---------- --------- $(1,639) $1,686 $(3,389) Deferred Federal 2,379 (216) 896 Foreign 76 (156) 243 ---------- ---------- --------- 2,455 (372) 1,139 ---------- ---------- --------- Total $ 816 $1,314 $(2,250) ========== ========== ========= The foreign provision for income taxes is based upon net foreign pretax losses of $1,079,000, $3,453,000, and $4,548,000 in 1993, 1992, and 1991, respectively. The significant components of deferred tax assets and liabilities included on the balance sheet at December 31 are as follows (in thousands): 1993 1992 ----------- ----------- Revenue recognition differences $ (9,492) $(12,285) Other (1,567) (1,167) ----------- ----------- Gross deferred tax liabilities (11,059) (13,452) ----------- ----------- Fixed assets 5,613 3,449 Inventory valuation 6,108 3,515 Other accrued expenses 6,274 2,551 Tax credits 7,540 5,395 Foreign loss carryforwards 3,552 4,866 ----------- ----------- Gross deferred tax assets 29,087 19,776 Asset valuation allowance (19,654) (5,495) ----------- ----------- Net deferred tax asset (liability) $ (1,626) $ 829 =========== =========== Deferred income taxes were provided for the timing differences in the recognition of revenue and expenses for tax and financial statement purposes in 1991. The sources of deferred income tax and the tax effect of each are as follows (in thousands): ---------- Depreciation $ 792 Inventory valuation (24) Revenue recognition differences 4,757 Other accrued expenses (691) Utilization of research and development credits (3,849) Other (net) 154 ---------- Total $ 1,139 ========== A reconciliation of the recorded provision to income taxes provided at the statutory rate is as follows (in thousands): 1993 1992 1991 ----------- ---------- ---------- Expected tax (benefit) provision $(21,416) $1,395 $(3,109) State income taxes, net of federal benefit (40) 100 (353) Impact of foreign taxes 1,317 301 (230) Foreign sales corporation -- (506) (691) Research and development tax credit -- (740) -- Foreign losses without tax benefit 1,117 1,348 1,987 Domestic losses without tax benefit 19,117 -- -- Utilization of foreign losses (398) (884) -- Other 1,119 300 146 ------------ ---------- ---------- Provision (benefit) for income taxes $ 816 $1,314 $(2,250) ============ ========== ========== At December 31, 1993, the Company has foreign tax loss carryforwards of approximately $10.5 million that expire in years 1996 through 2002. The Company has $5.7 million of research and development credits which expire in various amounts from the year 1999 to the year 2008 and $1.6 million of alternative minimum tax credits which have no expiration date. For financial reporting purposes, a valuation allowance of $20 million (which includes a $14 million increase in 1993) has been recognized to fully offset the deferred tax assets related to the foreign losses, tax credit carryforwards, and domestic losses without tax benefit. Note 5. Shareholders' Equity Stock Option Plan The Company has a stock option plan which provides for the issuance to employees of stock options with a term of up to ten years. Stock options generally vest to the employees over periods of one to four years. Options granted pursuant to the plan are generally exercisable by the optionee ahead of vesting. Unvested shares purchased on exercise of an option are subject to a repurchase right of the Company, and may not be sold by an optionee, until the shares vest. At December 31, 1993, a total of 11,390,158 shares of common stock had been reserved for issuance under this plan and former plans and options for 258,898 shares were available for grant. At December 31, 1992, a total of 10,280,158 shares of common stock had been reserved for issuance under the plans and 1,466,225 options were available for grant. The following table summarizes stock option activity for the years ended December 31, 1991, 1992 and 1993: Number Option Options of Shares Price - - - --------------------------------------- ------------ --------------- Outstanding at December 31, 1990 4,067,855 $ .80-14.125 Granted 77,450 $ 9.75-17.625 Exercised (735,688) $ 6.50-15.875 Forfeited (146,120) $ .80-17.625 ------------ --------------- Outstanding at December 31, 1991 3,263,497 $ 6.50-17.625 Granted 1,253,875 $6.125-14.500 Exercised (493,167) $6.125-13.000 Forfeited (274,307) $6.125-17.625 ------------ --------------- Outstanding at December 31, 1992 3,749,898 $6.125-14.375 Granted 2,520,575 $ 4.00-7.0000 Exercised (31,899) $ 4.00-6.1250 Forfeited (412,043) $ 4.00-13.875 ------------ --------------- Outstanding at December 31, 1993 5,826,531 $ 4.00-11.250 ============ =============== Of the total options outstanding at December 31, 1993 and December 31, 1992, 2,451,994 and 2,006,420, respectively, were fully vested. On July 30, 1993, the Board of Directors offered to reprice all then outstanding options that had exercise prices above the fair market value on that date. The new option price reflected the fair market value on July 30, 1993. The total number of amended options was 4,135,482. Employee Stock Purchase Plan The Company has an employee stock purchase plan available to all full-time employees, excluding those who own 5% or more of the Company's common stock. Through a payroll deduction program, employees are given the opportunity semiannually to purchase the Company's common stock at a 15% discount from the fair market value on the purchase date or enrollment date, whichever is lower. Each employee may elect to make these purchases up to a maximum of 10% of each individual's regular earnings and commissions. As of December 31, 1993, 2,774,036 shares have been issued under this plan at an average price of $6.65 per share. A total of 2,970,000 shares have been reserved for issuance under this plan. During 1993, the Board of Directors elected to suspend the employee stock purchase plan on an indefinite basis. Note 6. Related Party Transactions In 1992, the Hewlett-Packard Company and the Company entered into an agreement pursuant to which Hewlett-Packard purchased 1,213,855 shares of common stock from the Company at $14.875 per share generating $18,056,093 in proceeds which have been used for general corporate purposes. Additionally, in 1992, the Company began purchasing components from Hewlett-Packard for use in computer systems the Company sells. These purchases amounted to $8,272,000 in 1993 and $1,290,000 in 1992. The Company has guaranteed a $5,000,000 lease line for Vitesse Semiconductor Corporation ("Vitesse") in exchange for warrants. These warrants were exercised in 1991 and the Company purchased 88,888 shares of Vitesse common stock. This common stock is carried at cost of $400,000 which approximates fair value at December 31, 1993. The Company's obligation to guarantee the $5,000,000 lease line will terminate no later than January 1, 1995. The Company does not anticipate any liability will accrue to the Company as a result of this lease line guarantee. The Company also purchases components from Vitesse. Amounts paid to Vitesse for the years ended December 31, 1993, 1992, and 1991 were $4,531,000, $14,943,000 and $5,594,000, respectively. Additionally, certain directors of the Company were also directors of other corporations with which the Company does business. Amounts paid to these companies for the years ended December 31, 1993, 1992, and 1991 were $833,000, $217,000 and $243,000, respectively. Note 7. Segment Information and Major Customers The Company's operations involve a single industry segment which is the design, manufacture, sale and service of high performance computer systems primarily for scientific, engineering and technical users. The Company's customers are typically major corporations, universities and governmental agencies. Currently, the Company has ten foreign sales and service subsidiaries. Segment information including revenue, operating income (loss) and identifiable assets is as follows (in thousands): 1993 1992 1991 ---------- ---------- ---------- Sales to unaffiliated customers: United States $ 94,955 $123,123 $105,395 Europe 75,057 89,811 74,994 Other international 23,106 18,885 17,710 Sales between geographic areas: United States 55,813 70,155 66,357 Europe 966 883 200 Other international -- -- 223 Eliminations (56,778) (71,038) (66,780) ----------- ---------- ---------- Total revenue $193,119 $231,819 $198,099 =========== ========== ========== Operating income (loss): United States $(59,031) $ 9,024 $ (68) Europe (4,239) (2,781) (4,268) Other international (997) 406 (1,663) Eliminations 3,406 (455) (2,978) ---------- ---------- ----------- Total operating income (loss) $(60,861) $ 6,194 $ (8,977) ========== ========== =========== Identifiable assets: United States $257,196 $309,305 $268,854 Europe 58,918 75,893 77,490 Other international 23,451 21,456 15,672 Eliminations (85,289) (94,460) (89,368) ---------- ---------- ---------- Total identifiable assets $254,276 $312,194 $272,648 ========== ========== ========== Export sales--United States $ 8,079 $ 18,311 $ 10,887 ========== ========== ========== During 1993, 1992 and 1991, no single distributor or end-user customer accounted for more than 10% of total revenue. However, several of the Company's customers which are agencies of the U.S. government collectively accounted for approximately 16% of total revenue in 1993, approximately 13% of total revenue in 1992, and approximately 15% in 1991. Note 8. Legal Proceedings On August 2 and 7, 1991, two separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Northern District of Texas. The two cases were consolidated. Plaintiffs filed a Consolidated Amended Complaint, (the "Amended Complaint"), on October 18, 1991, which purports to be a class action lawsuit on behalf of persons who purchased Convex Stock between January 31, 1991 and July 29, 1991. The Amended Complaint alleges that defendants violated specific provisions of the federal securities laws, namely Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and Texas common law. Subsequent to December 31, 1993 the Company reached an agreement in principle to settle this class action lawsuit, subject to final approval by the court. The Company has included a charge for the $2.5 million estimated cost of settlement in the 1993 results. Note 9. Restructuring and Other Charges With a substantial decline in order rates and revenue in the first half of 1993, in July the Company implemented a restructuring program designed to reduce annualized costs by $22 million and to increase the efficiency of the Company's operations. The restructuring also reflected a strategic decision to write down certain assets based on an analysis of future demand for both the C3800 and C3400 product families. The $31.5 million charge taken in the second quarter comprised $7 million for severance costs of approximately 185 employees, $21.5 million for costs associated with reducing factory capacity in the Richardson manufacturing facility and to write down certain of the Company's assets, and $3 million in miscellaneous and other charges. An additional $4.5 million charge was taken in the fourth quarter for the estimated cost of settling the 1991 class action lawsuit (Note 8) and for additional asset write-downs. Report of Independent Auditors Shareholders and Board of Directors Convex Computer Corporation We have audited the accompanying consolidated balance sheets of Convex Computer Corporation at December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Convex Computer Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As described in Note 1 to the consolidated financial statements, in 1992 the Company changed its method of accounting for income taxes. ERNST & YOUNG Dallas, Texas March 25, 1994 Quarterly Financial Summary (Unaudited) (In thousands, except per share data) 1993 Quarters ----------------------------------------------- 4th 3rd 2nd 1st --------- -------- --------- -------- Revenue $45,959 $42,986 $45,090 $59,084 Gross margin 18,013 17,448 15,769 26,139 Operating income (loss) (12,919) (1) (5,989) (42,665) (1) 712 Net income (loss) (15,749) (1) (6,280) (41,821) (1) 46 Earnings (loss) per share: (0.62) (1) (0.25) (1.67) (1) 0.00 1992 Quarters ---------------------------------------------- 4th 3rd 2nd 1st --------- --------- --------- --------- Revenue $61,947 $57,862 $57,537 $54,473 Gross margin 28,199 27,629 26,595 25,846 Operating income (loss) 1,687 1,582 1,821 1,104 Net income (loss) 851 778 755 404 Earnings (loss) per share: 0.03 0.03 0.03 0.02 (1) Includes restructuring and other charges of $31.5 million in the second quarter of 1993 and $4.5 million in the fourth quarter of 1993. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III Certain information required by Part III is omitted from this Report in that the Registrant intends to file a definitive proxy statement pursuant to Regulation 14A with the Securities and Exchange Commission (the "Proxy Statement") relating to its annual meeting of stockholders not later than 120 days after the end of the fiscal year covered by this Report, and such information is incorporated by reference herein. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information concerning the Company's directors required by this Item is incorporated by reference to the Company's Proxy Statement under the heading "Election of Directors." Information regarding executive officers is included in Part I hereof under the caption "Executive Officers of the Registrant" and is incorporated by reference into this Item 10. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to the Company's Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference to the Company's Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference to the Company's Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents Filed with Report 1. Financial Statements The following Consolidated Financial Statements and Report of Independent Auditors are included in Part II Item 8 of this Form 10-K. The consolidated balance sheets at December 31, 1993 and 1992, and the consolidated statements of operations, statements of shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993, together with the notes thereto. The report of Ernst & Young, independent auditors, dated March 25, 1994. 2. Financial Statement Schedules The following financial statement schedules should be read in conjunction with the consolidated financial statements and the notes thereto. Page ---- Schedule I Marketable Securities - Other Investments S-1 Schedule VIII Valuation and Qualifying Accounts S-2 Report of Ernst & Young, Independent S-3 Auditors All other schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule or because the information required is included in the consolidated financial statements, including the notes thereto. 3. Exhibits Exhibit Number Description - - - --------- ----------------------------- 3.1* Restated Certificate of Incorporation, as amended. 3.2 Restated By-Laws. 4.1** Indenture between Registrant and The First National Bank of Boston, Trustee covering $53,500,000 of 6% Convertible Subordinated Debentures due 2012 (including form of Debenture). 10.1* Shareholder's Agreement dated January 13, 1986 between Registrant and Sam K. Smith, a director, covering the sale of 10,000 shares of Common Stock. 10.2* License Agreement dated November 1, 1982 between Registrant and AT&T. 10.3* Cross License Agreement dated May 29, 1986 between Registrant and Cray Research, Inc. 10.4* Master Lease Agreement, as amended, dated December 31, 1986 between Registrant and Ford Equipment Leasing Company covering property substantially located at 3000 Waterview Parkway, Richardson, Texas. 10.5* Form of Indemnification Agreement entered into between the Registrant and each of its officers and directors. 10.6**** Commercial Lease dated January 26, 1989, as amended, between Registrant and Synergy Park Associates covering property located at Synergy Park, Richardson, Texas. 10.7**** Registrant's 1991 Stock Option Plan and form of Non- Statutory Stock Option Agreement. 10.8***** Common Stock Purchase Agreement dated March 18, 1992 between Registrant and Hewlett-Packard Company. 10.9***** Registration Rights Agreement dated March 18, 1992 between Registrant and Hewlett-Packard Company. 21.1 Subsidiaries of Registrant. 23.1 Consent of Ernst & Young, Independent Auditors. 24.1 Power of Attorney (immediately following exhibits schedule). * Incorporated by reference from the Company's Registration Statement on Form S-1 (No. 33-6109). ** Incorporated by reference from the Company's Registration Statement on Form S-1 (No. 33-12106). *** Incorporated by reference from the Company's Registration Statement on Form S-8 (No. 33-33700). **** Incorporated by reference to the Company's annual report on Form 10-K for year ended December 31, 1990. ***** Incorporated by reference to the Company's annual report on Form 10-K for year ended December 31, 1991. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the fiscal quarter ended December 31, 1993. 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. CONVEX COMPUTER CORPORATION Registrant BY: ROBERT J. PALUCK --------------------------- Robert J. Paluck, Chairman of the Board, and Chief Executive Officer March 25, 1994 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Robert J. Paluck and J. Cameron McMartin, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and conforming all that each of said attorneys-in-fact, or his substitute or substitutes, any do or cause to be done by virtue hereof. 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. Signature Capacity in Which Signed Date - - - -------------------- ------------------------------------ ---------------- ROBERT J. PALUCK Chairman of the Board March 25, 1994 - - - -------------------- and Chief Executive (Robert J. Paluck) Officer (Principal Executive Officer) and Director J. CAMERON MCMARTIN Chief Financial Officer March 25, 1994 - - - -------------------- and Vice President, (J. Cameron McMartin) Finance (Principal Finance and Accounting Officer) STEVEN J. WALLACH Director March 25, 1994 - - - -------------------- (Steven J. Wallach) Director March 25, 1994 - - - -------------------- (H. Berry Cash) SAM K. SMITH Director March 25, 1994 - - - -------------------- (Sam K. Smith) HOWARD D. WOLFE Director March 25, 1994 - - - -------------------- (Howard D. Wolfe) ERICH BLOCH Director March 25, 1994 - - - -------------------- (Erich Bloch) REPORT OF ERNST & YOUNG INDEPENDENT AUDITORS We have audited the consolidated financial statements of Convex Computer Corporation as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated March 25, 1994. Our audits also included the financial statement schedules listed in Item 14(a)(2) of this Form 10-K. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Dallas, Texas March 25, 1994 S-3

9672_1993.txt

9672_1993

1993

9672

Item 3. Legal Proceedings - -------------------------------------------------------------------------------- The Corporation, because of the nature of its business, is subject to various threatened or filed legal actions. Although the amount of the ultimate exposure, if any, cannot be determined at this time, the Corporation, based upon the advice of counsel, does not expect the final outcome of threatened or filed suits to have a material adverse effect on its financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - -------------------------------------------------------------------------------- None. PART II =============================================================================== Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters - ------------------------------------------------------------------------------- Information on dividend restrictions, dividend payments, the principal market for and trading price of the Parent's common stock, and the number of holders of such stock is incorporated by reference from page 17, Note 25 on pages 74 and 75, and Note 27 on page 77 of the 1993 Annual Report to Shareholders. Item 6. Item 6. Selected Financial Data - ------------------------------------------------------------------------------- Selected financial data is incorporated by reference from page 17 of the 1993 Annual Report to Shareholders. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - ------------------------------------------------------------------------------- Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated by reference from pages 16 through 41 of the 1993 Annual Report to Shareholders. Item 8. Item 8. Financial Statements and Supplementary Data - ------------------------------------------------------------------------------- The Report of Independent Auditors and the consolidated financial statements of the Corporation are incorporated by reference from pages 43 through 77 of the 1993 Annual Report to Shareholders. See Item 14 of this report for information concerning financial statements and schedules filed with this report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure - ------------------------------------------------------------------------------- None. PART III ================================================================================ Item 10. Item 10. Directors and Executive Officers of the Registrant - -------------------------------------------------------------------------------- Reference is made to the text under the captions, "Executive Compensation, Benefits and Related Matters" and "Item No. 1-- Election of Directors" in the Proxy Statement for the May 26, 1994 Annual Meeting of Shareholders of the Parent for incorporation of information concerning directors and persons nominated to become directors. Information concerning executive officers of the Parent as of March 1, 1994 is set forth below. Richard M. Rosenberg was appointed Chairman of the Board and Chief Executive Officer of the Parent and the Bank on May 24, 1990, in addition to his title as President. He was appointed President of the Parent and the Bank on February 5, 1990. On May 23, 1992, Mr. Rosenberg relinquished his title as President, but was reappointed President on October 5, 1992. Previously, Mr. Rosenberg was Vice Chairman of the Board of the Parent and the Bank from 1987 to 1990. Lewis W. Coleman was appointed Chief Financial Officer and Treasurer of the Parent and the Bank on February 1, 1993, in addition to his title of Vice Chairman of the Board. He was appointed Vice Chairman of the Board of the Parent and the Bank on February 5, 1990. Previously, he was Vice Chairman of the Parent and the Bank from 1988 to 1990. From 1987 to 1988, he was Executive Vice President of the Bank and head of the Bank's Capital Markets Group. David A. Coulter was appointed Vice Chairman of the Parent and the Bank on February 1, 1993. Previously, he was Group Executive Vice President of the Bank and head of the Bank's U.S. Division from 1992 to February 1993. From 1990 to 1992, he was Executive Vice President of the Bank and head of the Bank's U.S. Division. From 1989 to 1990, he was Executive Vice President and head of the Bank's Capital Markets Division. In 1988, he was appointed Senior Vice President of the Bank and Director of Corporate Finance-Americas. ================================================================================ Luke S. Helms was appointed Vice Chairman of the Parent and the Bank on August 2, 1993. Previously, he was Chairman and Chief Executive Officer of Seafirst and Seattle-First. He was appointed President of Seafirst and Seatle-First in 1987. Jack L. Meyers was appointed Vice Chairman of the Parent and the Bank on October 4, 1993. He was appointed Chief Credit Officer of the Bank on September 3, 1993. He was Group Executive Vice President responsible for the Bank's Commercial Business Group from 1991 to 1993. He was named head of the Commercial Banking Division in September 1990. He was Executive Vice President of the California Commercial Banking Group from 1989 to 1990. He was head of Credit Risk Management of the California Commercial Banking Group from 1986 to 1989. Thomas E. Peterson was appointed Vice Chairman of the Parent and the Bank on February 5, 1990. Previously, he was appointed Executive Vice President of the Bank and head of Retail Banking Division in 1987. Michael E. Rossi was appointed Vice Chairman of the Parent and the Bank on October 7, 1991. He was appointed Executive Vice President of the Parent on December 3, 1990, when he was also designated to be the head of Credit Policy for the Bank. He was Executive Vice President of the Commercial Banking Division--Commercial Markets Group of the Bank from 1988 to 1990. He was Executive Vice President and Chief Credit Officer of the World Banking Group of the Bank from 1987 to 1988. Martin A. Stein was appointed Vice Chairman of the Parent and the Bank on April 27, 1992. He was appointed Executive Vice President of the Parent and the Bank on June 25, 1990. At the same time, he was appointed head of the BankAmerica Systems Engineering Group of the Bank. Prior to joining the Bank, he was Executive Vice President, Director of National Operations, and Chief Information Officer for PaineWebber, Inc., New York, New York from 1985 to 1990. Kathleen J. Burke was appointed Executive Vice President and Personnel Relations Officer of the Parent and Executive Vice President of the Bank on April 22, 1992 and Group Executive Vice President of the Bank on April 27, 1992. From 1989 to 1992, Ms. Burke served as Executive Vice President of SPC and SPNB. She also served as Executive Vice President and Secretary of SPC and SPNB from May 1989 to June 1989, Senior Vice President and Secretary from April 1988 to May 1989, and First Vice President and Assistant Secretary from December 1987 to April 1988. The present term of office for each of the officers named above will expire on May 26, 1994 or on their earlier retirement, resignation, or removal. There is no family relationship between any such officers. ================================================================================ Item 11. Item 11. Executive Compensation - -------------------------------------------------------------------------------- Information concerning executive compensation is incorporated by reference from the text under the captions, "Corporate Governance-Director Remuneration, Retirement Policy and Attendance" and "Executive Compensation, Benefits and Related Matters" (excluding the material under the headings "Report of the Executive Personnel and Compensation Committee" and "Shareholder Return Performance Graph" therein) in the Proxy Statement for the May 26, 1994 Annual Meeting of Shareholders. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - -------------------------------------------------------------------------------- Information concerning ownership of equity stock of the Parent by certain beneficial owners and management is incorporated by reference from the text under the caption, "Ownership of BAC Stock and Equivalents" in the Proxy Statement for the May 26, 1994 Annual Meeting of Shareholders. Item 13. Item 13. Certain Relationships and Related Transactions - -------------------------------------------------------------------------------- Information concerning certain relationships and related transactions with officers and directors is incorporated by reference from the text under the caption, "Executive Compensation, Benefits and Related Matters" in the Proxy Statement for the May 26, 1994 Annual Meeting of Shareholders. PART IV ================================================================================ Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------------------------------------------------------------------------------- (a)(1) The report of independent auditors and the following Financial consolidated financial statements of the Corporation are Statements incorporated herein by reference from the 1993 Annual Report to Shareholders; page number references are to the 1993 Annual Report to Shareholders. - -------------------------------------------------------------------------------- (a)(2) Schedules to the consolidated financial statements (Nos. I and Financial II of Rule 9-07) for which provision is made in the applicable Statement accounting regulation of the Securities and Exchange Commission Schedules (Regulation S-X) are inapplicable and, therefore, are not included. Financial statements and summarized financial information of unconsolidated subsidiaries or 50% or less owned persons accounted for by the equity method are not included as such subsidiaries do not, either individually or in the aggregate, constitute a significant subsidiary. - -------------------------------------------------------------------------------- (a)(3) Exhibits ================================================================================ - -------------------- /a/Management contract or compensatory plan, contract, or arrangement. ------------------------- /a/Management contract or compensatory contract, or arrangement. - -------------------------------------------------------------------------------- (b)Reports on During the fourth quarter of 1993, the Parent filed a report on Form 8-K Form 8-K dated October 20, 1993. The October 20, 1993 report filed, pursuant to Items 5 and 7 of the report, a copy of the Parent's press release titled "BankAmerica Third Quarter Earnings." After the fourth quarter of 1993, the Parent filed reports on Form 8-K dated January 19, 1994, January 27, 1994, and March 11, 1994. The January 19, 1994 report filed, pursuant to Items 5 and 7 of the report, a copy of the Parent's press release titled "BankAmerica Fourth Quarter Earnings." The January 27, 1994 report disclosed, pursuant to Items 5 and 7 of the report, Continental's agreement to merge with and into the Parent and a related stock option agreement to purchase Continental common stock dated as of January 27, 1994. The March 11, 1994 report disclosed, pursuant to Items 5 and 7 of the report, certain information regarding the pending Continental acquisition. 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. March 16, 1994 BANKAMERICA CORPORATION By /s/ Joseph B. Tharp ------------------------------ (Joseph B. Tharp, Executive Vice President and Financial Controller) 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. Signature Title Principal Executive Officer and Director: /s/ Richard M. Rosenberg Chairman of the Board and Chief - ----------------------------------------- Executive Officer (Richard M. Rosenberg) Principal Financial Officer and Director: /s/ Lewis W. Coleman Vice Chairman of the Board and - ----------------------------------------- Chief Financial Officer (Lewis W. Coleman) Principal Accounting Officer: /s/ Joseph B. Tharp Executive Vice President - ----------------------------------------- and Finacial Controller (Joseph B. Tharp) Directors: JOSEPH F. ALIBRANDI* Director FRANK L. HOPE, JR.* Director PETER B. BEDFORD* Director LAWRENCE O. KITCHEN* Director ANDREW F. BRIMMER* Director IGNACIO E. LOZANO, JR.* Director RICHARD A. CLARKE* Director CORNELL C. MAIER* Director TIMM F. CRULL* Director WALTER E. MASSEY* Director C. R. DAHL* Director RUBEN F. METTLER* Director KATHLEEN FELDSTEIN* Director A. MICHAEL SPENCE* Director DONALD E. GUINN* Director JACQUES S. YEAGER* Director PHILIP M. HAWLEY* Director A majority of the members of the Board of Directors. *By /s/ Cheryl Sorokin ---------------------------------- (Cheryl Sorokin, Attorney-in-Fact) Dated: March 16, 1994 Other information about BankAmerica Corporation may be found it its Quarterly Reports to Shareholders and its Annual Report to Shareholders. These reports, as well as additional copies of this Form 10-K, may be obtained from: Corporate Public Relations #3124 Bank of America P.O. Box 37000 San Francisco, CA 94137 ================================================================================ [BANKAMERICA CORPORATION LOGO APPEARS HERE] BankAmerica Corporation - -------------------------------------------------------------------------------- NL-9 2-94 Recycled [Recycled paper logo appears here] Paper ================================================================================ ------------------------------ /a/Management contract or compensatory plan, contract, or arrangement. ================================================================================ - ------------------------------------ /a/ Management contract or compensatory plan, contract, or arrangement.

93675_1993.txt

93675_1993

1993

93675

Item 1. Business Starrett Housing Corporation was organized in New York in 1922. Through its subsidiary Levitt Corporation ("Levitt"), the Company engages in the construction and sale of single-family homes and garden apartments in the United States and Puerto Rico. See "Levitt Corporation." Over the years Starrett and its subsidiaries have constructed a wide range of office, industrial, public and institutional buildings, among the most notable being the Empire State Building, the AT&T World Headquarters, Citicorp Center, Chemical Bank World Headquarters and the New York State Javits Convention Center, and many well-known residential communities and developments, including Starrett City, Manhattan Park at Roosevelt Island and Trump Tower in New York City. The Company today is actively engaged in various construction, development, management and related businesses. See "Starrett's Construction Activities," "Development Activities" and "Management and Rental Services." Unless the context otherwise requires, references to the "Company," the "Registrant" or "Starrett" include Starrett Housing Corporation and/or one or more of its subsidiaries. Levitt Corporation Levitt's operations include sale of single family detached homes and garden apartments, development of rental apartments, mortgage banking and the development and management of senior citizen health and congregate care facilities. Housing Levitt's residential housing operations are concentrated in Florida and Puerto Rico. In Puerto Rico, Levitt believes it is the largest home builder and has been active on the island since 1960. Florida operations were started in 1978 and are currently conducted on Florida's southeast and southwest coasts. During 1993, several new sites were acquired in Florida which were opened or are scheduled for opening for sales in 1994. Although these projects are in the beginning phase of marketing, there has been a strong initial response from home-buyers to these new subdivisions. During 1994, Levitt expects an increase in sales resulting from these new subdivisions in Florida. Additionally, as the older projects are being completed, contracts are being entered into for new sites. Levitt has concentrated its significant Puerto Rican homebuilding activities in the greater San Juan area. In recent years, Puerto Rico operations have provided the majority of revenue and profits for Levitt. Levitt has a major development called Encantada and other subdivisions in the San Juan metropolitan area. Encantada is a planned unit development located in a suburb of San Juan with excellent access to schools, shopping and business centers. Encantada is planned for 2,600 homes of which more than 1,300 homes have been contracted for sale with over 1,000 deliveries as of February 28, 1994. Both single family homes and garden apartments are offered for sale at various prices in the community. The Company believes that Encantada's success can be attributed to the quality of the community, quality of the housing and the family lifestyle provided. With approximately 1,300 more homes to be sold, Encantada, together with the region's other projects, is expected to continue as an important source of revenues and profits for the Company. With the new Florida developments being introduced during 1994, Levitt's domestic operations are expected to be profitable and Puerto Rico should maintain its level of profitability. Levitt's performance in 1993 reflects the finalization of its program involving the disposition of high cost land in Virginia, New York and New Jersey as these areas were phased out. The disposition of land by selling and constructing homes at reduced prices resulted in a loss or minimal profit, but accelerated the receipt of cash from such dispositions. The disposition program has been virtually completed in 1993. Levitt's business is affected by other issues such as housing affordability, increased land costs, legislative growth restrictions, sewer and water moratoriums, possible changes in the Internal Revenue Code, including changes in Section 936 of the Internal Revenue Code relating to the taxability of corporations doing business in Puerto Rico, and increasing infrastructure demands. Levitt's backlog of homes contracted for sale at December 31, 1993 was $32,320,000 compared to $33,765,000 at December 31, 1992. Backlog consists of units which are under sales contract but where title has not yet passed, and comprises completed and uncompleted houses as well as houses where construction has not yet begun. The following table sets forth information concerning homes contracted for sale (net of cancellations during each period), housing units delivered (construction completed and title passed), and backlog: The Company's backlog at February 28, 1994 increased significantly from the amount at December 31, 1993 and February 28, 1993. This increase is attributable to the higher level of sales experienced in the Company's new projects in Florida and Puerto Rico. The backlog as of February 28, 1994 includes 23 units under contract with a contract value of $3,500,000 relating to a joint venture in which the Company has a 50% interest. After the initial contract has been received, contracts for the sale of houses may be canceled at or prior to closing for various reasons, including failure of the buyer to make the remainder of the required contract deposit or qualify for mortgage financing and default by the buyer. Levitt retains the buyer's deposit only if cancellation results from default by the buyer, except in Puerto Rico where under local law Levitt can retain only a portion of the deposit. When computing homes contracted for sale and backlog, Levitt makes no deduction for future cancellations, but nets cancellations as they occur against sales contracts. Levitt generally estimates that of the sales contracts entered into by buyers, approximately 65% have historically resulted in delivered homes. Contracts of sale are not recorded as revenues until the houses have been completed and title delivered. Levitt generally builds subdivisions on undeveloped suburban land having access to water and sewer services, although it does occasionally purchase fully developed land. Development plans must be approved by local authorities, which may take two years or more after the signing of a purchase contract. See "Regulation of the Company's Activities," page 8. Levitt provides home purchasers with warranties against construction defects for a period of up to two years from the date of purchase. In Puerto Rico there is a statutory warranty for certain construction defects which appear generally within ten years after completion. Rental Apartment Development In 1991, Levitt, in joint venture with an established apartment developer, constructed its first apartment project in Florida. This 224 unit apartment complex was completed and sold in 1992 to an institutional investor at a substantial profit. The Company and the joint venture partner have completed a second complex and have contracted to sell it to an institutional investor at a profit in 1994. A third development with Levitt's joint venture partner is scheduled to begin in the second quarter of 1994 and a fourth project is projected to begin in the last quarter of 1994. Levitt's current policy is to develop, lease and sell the apartment projects and not hold them for investment. The apartment development program is an integral part of Levitt's business and is anticipated to provide it with a continuous source of income. It is the Company's plan to develop at least one or more apartment projects each year. Mortgage Banking Levitt Mortgage Corp. ("Mortgage") is a full service mortgage lender that processes and originates loans in Puerto Rico and processes mortgage loans domestically. Mortgage is a designated approved direct endorser of FHA loans in Puerto Rico but does not service loans. In Puerto Rico, Mortgage also acts as a mortgage banker for third parties and processes and issues the mortgages it underwrites. These mortgages are sold to investors in accordance with firm purchase commitments with the investors. Mortgages are solicited through four offices in the San Juan area. Mortgage is the fifth largest mortgage banker in Puerto Rico. Health Care Facilities and Management Levitt Care Corporation ("Care") develops and manages adult congregate care ("ACLF") and assisted living facilities ("AL"). In 1987, the Company developed Northpark, a 376 unit ACLF in Hollywood, Florida. The facility was sold in 1989, and Care continues to manage it. Care is seeking to acquire existing ACLFs and AL facilities to rehabilitate and market them on a profitable basis and to develop sites for AL complexes. The facilities provide the resident, on a rental basis, meal service, weekly cleaning of the residents apartment, social activities and scheduled transportation to doctors' offices, shopping and cultural events. The rental cost of an apartment, is based on the size of the unit and the level of service required by the resident. In addition to the independent level of care in Northpark, an assisted living facility is available to the residents. This facility serves those individuals that require a greater level of care; such as assistance with bathing, dressing and eating. Management believes that the growing elderly population will increase the need for ACLF and AL facilities. Therefore, Care is seeking opportunities to expand in these areas. Development Activities In its development activities, the Company's services, in addition to those of a construction manager or general contractor, may include initial planning and development, acquisition of the property, arranging for financing and ownership of the project typically through general or limited partnerships, and providing management, consulting and related services. The Company anticipates marketing its development projects to investors or other purchasers, based principally on cash flow, capital appreciation and other non-tax considerations, and may in some instances retain ownership of such projects. In connection with its sale of projects, the Company may provide guarantees of completion and cash flow for varying periods. The Company has focused its development efforts in the areas of rental housing and projects sponsored by municipalities. The Company is proceeding with certain development projects. While the Company has generally been successful in developing such projects, these projects are in differing stages of development, and there can be no assurance that any particular project will be completed. Ownership of Partnership Interests The Company reviews from time to time projects in which it acts as a general partner or in which it has an equity interest (which for the most part have a low income tenancy subsidized in whole or in part by government-assistance programs) to determine the possibility of refinancing, resyndicating, selling, converting to condominiums, or co-oping such projects to obtain fees and other economic benefits. The Company has three projects located on the Upper West Side of Manhattan, in which it has a 50% residual partnership interest, with respect to which the Company has made application for incentives under the Low Income Housing Preservation and Resident Homeownership Act ("LIHPRHA"). LIHPRHA provides owners of certain federally subsidized projects with financial incentives in return for their agreement to continue the use of a project as affordable housing in lieu of converting the project to fair-market rentals or ownership. The financial incentives are designed to provide an owner with the approximate economic equivalent of what an owner would have received had the project discontinued its low income use and converted to a market rate rental or ownership, based upon an appraisal valuation and underwriting process set forth in the statute regulations and HUD guidelines. In May 1992, the Company commenced processing the first of its projects with the United States Department of Housing and Urban Development ("HUD"). On April 28, 1993, HUD provided the Partnership with a Value Determination Letter establishing a substantial value for the project, and in August and October 1993 HUD provided technical comments on the Plan of Action necessary to complete the processing. HUD has notified the Company that it is reversing its prior Value Determination and consequently will require the Partnership to reprocess the project, using a different formula for valuation, presently being developed by HUD. Under HUD's revised formula, the project may have a substantially diminished value. The Company disagrees with the reversal of HUD's prior Value Determination position, has so notified HUD and discussions are in process regarding this matter. In light of the foregoing, the amount of cash proceeds and profits, if any, the Company could receive for its 50% residual interest in the project as well as the time required to complete the processing is uncertain. The revised HUD position also affects processing under LIHPRHA for the two similar projects in which the Company owns a 50% residual interest located on the Upper West Side of Manhattan. If sustained, the revised HUD position will affect all New York projects of a similar nature. Starrett's Construction Activities Through its HRH Construction Corporation subsidiary ("HRH"), the Company primarily acts as construction manager in the construction of institutional, office and residential projects, most of which are located in the New York Metropolitan area. HRH builds projects either as a construction manager on a cost plus fee basis or a general contractor in which case it assumes the construction risk. The construction management and general contracting fees and other income earned by HRH during 1993, 1992 and 1991 were $4,000,000, $5,396,000 and $8,117,000, respectively. See "Segment Information," page 8. As a result of the economic slowdown, HRH has focused its activities on institutional construction and construction funded by City, State and Federal governments and is seeking to diversify into new areas of construction, all of which are subject to intense competition. In the case of projects where HRH acts as general contractor rather than construction manager (which has included projects in which the Company acts as a developer or has an ownership interest), the Company is required from time to time, as is customary in projects of this kind, to furnish payment and performance bonds assuring payment to subcontractors. The Company believes its bonding capacity is adequate for both present and projected requirements. The aggregate amount of bonds or other security the Company can obtain at any one time is dependent upon its overall financial strength. HRH's estimated backlog of fees for development work and uncompleted construction in connection with construction projects, including fees for projects where development work has begun but contracts have not yet been executed, was $8,151,000 at December 31, 1993 as compared to $8,158,000 and $9,409,000 at the end of 1992 and 1991, respectively. HRH is actively seeking to increase its backlog of business, particularly in the governmental and institutional sectors. Management and Rental Services Grenadier Realty Corp. ("Grenadier") is licensed in New York, New Jersey and Connecticut and manages many different properties with rental, condominium and cooperative residential units, commercial and retail space, and garage parking. Grenadier provides a full range of real estate management services, including on-site administration, accounting, security, maintenance, procurement, capital budgeting and owner and tenant communication programs to private owners and to governmental and institutional property owners as well as banks and thrift institutions. Grenadier operates two power plants and provides technical services for the development of energy conservation programs. In addition, Grenadier provides technical support for the implementation and operation of reliable, cost-effective electrical and mechanical building systems. Grenadier also designs security systems and provides security services to a variety of residential, commercial and industrial clients. Regulation of the Company's Activities The development business and home building industry in which the Company is engaged have, in the last several years, become subject to increased environmental, building, land use, zoning and sales regulations administered by various federal, state and local authorities, which affect construction activities as well as sales activities and other dealings with customers. Additionally, sewer moratoriums have been imposed from time to time in Puerto Rico which have caused delays in the delivery of homes to customers. The Company must obtain for its development and housing activities the approval of numerous governmental authorities which often have wide discretion in such matters. Changes in local circumstances or applicable law may necessitate applications for additional approvals or the modification of existing approvals. Compliance with these regulations has extended the time required to market projects by prolonging the time between the initiation of projects and the commencement and completion of construction. The Company is currently in various stages of securing governmental approvals for its development and homebuilding projects. Delay or inability to obtain all required approvals for a project could have a materially adverse effect on the marketability or profitability of such a project. Segment Information The Company's operations consist of (i) the development, management and ownership of real estate properties; (ii) the single-family home and garden apartment business conducted through its Levitt subsidiary; and (iii) the supplying of construction services through its HRH subsidiary. The Company groups its business into these three segments. The following table sets forth the Company's revenues and operating profit attributable to the respective segments of its operations for each of the years 1991 through 1993, and the identifiable assets attributable to the respective segments as at the end of each of those years: Operating profit is comprised of revenues less operating expenses. In computing operating profit, general corporate expenses and income taxes have not been deducted. There were no individual customers from which the Company derived 10% or more of its revenues in 1991, 1992 or 1993. Competition The construction, development and home building industries in all of the areas in which the Company operates are highly competitive, and the Company competes with major concerns as well as with smaller contractors or builders, some of whom have greater financial resources than the Company. Raw Materials and Equipment Substantially all the materials used by the Company in projects now under construction, including fixtures, appliances and systems, are readily available from many sources. The Company has from time to time experienced some shortages, delays and increased costs in connection with material shortages and increases in material prices but the Company does not believe the effect to have been significant. Employees--Labor Relations The Company directly employed, at December 31, 1993, a total of approximately 1,100 persons. The Company considers that it has satisfactory relations with the unions whose members it employs. Item 2. Item 2. Properties The Company leases 25,000 square feet of space for its corporate offices and its main office for the construction management business, HRH, located at 909 Third Avenue in New York City. The lease for such space, which it occupied in 1973, expires in 1997. The Company also maintains a mobile field office at each of its construction sites. Levitt leases approximately 5,700 square feet of office space which it uses for its executive office and main office for its Florida homebuilding operation in Boca Raton, Florida, and also leases office space in San Juan, Puerto Rico. Item 3. Item 3. Legal Proceedings The Company is involved in litigation and claims incident to the normal conduct of its business. Management believes that such litigation and claims will not have a materially adverse effect on the Company's business operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not Applicable Executive Officers of the Company The following table sets forth the names and ages of all executive officers of the Company, the positions and offices with the Company held by each such person, and the period during which each such person has served as an executive officer. The term of office of each executive officer continues until the first meeting of the Board of Directors of the Company following the next annual meeting of shareholders, and until the election and qualification of such officer's successor. There is no family relationship between the executive officers listed above, or between such executive officers and directors. All of the executive officers except Paul Milstein have been principally engaged in his present employment for more than five years. Mr. Milstein became Chairman on January 1, 1994, and for more than five years has been active as a real estate developer and investor. PART II Item 5. Item 5. Market for the Company's Common Equity and Related Stockholder Matters On March 16, 1994, there were 792 record holders of the Company's common stock and approximately 1,500 additional persons whose shares of Common Stock were held in street name. Such common stock is listed on the American Stock Exchange, which is the principal market on which such stock is traded. High and low sales prices on the American Stock Exchange for the Company's common stock during the last two years have been as follows: The Company paid an extraordinary dividend of $.25 per share in 1992. While the directors will consider the payment of dividends in 1994, at this time it is not anticipated that the Company will pay dividends on its common stock. Item 6. Item 6. Selected Financial Data Starrett Housing Corporation and Subsidiaries Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 1993 Compared to 1992 During the year ended December 31, 1993 the Company had income from operations of $2,140,000 ($.34 per share) compared to $284,000 ($.04 per share) for the year ended December 31, 1992. In addition, during the year ended December 31, 1992, the Company reported an extraordinary gain net of tax of $824,000 and an accounting change of $1,287,000 or $.13 and $.20 per share, respectively, which when combined with the income from operations increased net income to $2,395,000 ($.37 per share). Earnings per share were based on average shares outstanding of 6,356,000 and 6,417,000 in 1993 and 1992, respectively. The Company's revenues increased $10,327,000 compared with the similar period in 1992. This increase was primarily attributable to an increase in revenues from the Company's Levitt division resulting from an increase in the number of houses delivered in the Company's Puerto Rico region. The increase in revenues from Levitt was offset by a decrease in revenues in the Company's development and construction management divisions in 1993. In 1992 revenues also included Levitt's Joint Venture share of the gain on the sale of a rental apartment project. Levitt's backlog of homes contracted for sale at December 31, 1993 was $32,320,000 compared to $33,765,000 at December 31, 1992. The backlog at February 28, 1994 was $63,179,000 as compared to $42,943,000 at February 28, 1993. General and administrative expenses (which were reduced for all divisions other than Grenadier which showed an overhead increase for the year) declined by $3,044,000 in 1993 following a $2,200,000 reduction in 1992 as a result of continuing cost reduction programs. Interest expense decreased by $655,000 for 1993 as compared to 1992 primarily as a result of both a decrease in borrowings and a decline in interest rates. Levitt's interest, real estate taxes and sales costs incurred with certain properties are capitalized in order to achieve better matching of costs with revenues. The Company's interest incurred on loans was $3,893,000 in 1993 and $5,964,000 in 1992, of which $2,959,000 in 1993 and $4,150,000 in 1992 was capitalized by Levitt in its operations. Levitt amortized capitalized interest of $5,802,000 in 1993 and $5,177,000 in 1992 to construction and related costs. HRH's estimated backlog of fees for development work and uncompleted construction in connection with construction projects, including fees for projects where development work has begun but contracts have not yet been executed, was $8,151,000 at December 31, 1993 as compared to $8,158,000 and $9,409,000 at the end of 1992 and 1991, respectively. HRH is actively seeking to increase its backlog of business, particularly in the governmental and institutional sectors, while at the same time continuing to reduce its overhead (overhead was reduced 21%, 25% and 20% in 1993, 1992 and 1991, respectively) to reflect the lower level of business activity. Grenadier continued its steady profitability in 1993 and has expanded its management services to private owners and institutional property owners as well as banks and thrift institutions. The Company has three projects located on the Upper West Side of Manhattan, in which it has a 50% residual partnership interest, with respect to which the Company has made application for incentives under the Low Income Housing Preservation and Resident Homeownership Act ("LIHPRHA"). On April 28, 1993, HUD provided the Partnership with a Value Determination Letter for the first of its projects establishing a substantial value for the project, and in August and October 1993 HUD provided technical comments on the Plan of Action necessary to complete the processing. HUD has notified the Company that it is reversing its prior Value Determination and consequently will require the Partnership to reprocess the project, using a different formula for valuation, presently being developed by HUD. Under HUD's revised formula, the project may have a substantially diminished value. The Company disagrees with the reversal of HUD's prior Value Determination position, has so notified HUD and discussions are in process regarding this matter. In light of the foregoing, the amount of cash proceeds and profits, if any, the Company could receive for its 50% residual interest in the project as well as the time required to complete the processing is uncertain. The revised HUD position also affects processing under LIHPRHA for the two similar projects in which the Company owns a 50% residual interest located on the Upper West Side of Manhattan. If sustained, the revised HUD position will affect all New York projects of a similar nature. See "Business - Ownership of Partnership Interests," page 6. 1992 Compared to 1991 During the year ended December 31, 1992 the Company had net income of $2,395,000 ($.37 per share) as compared with $1,384,000 ($.21 per share) in 1991. The accounting change and the extraordinary item described below added $1,287,000 and $824,000 or $.20 and $.13 per share, respectively, to net income for the year ended December 31, 1992. Earnings per share were based on average shares outstanding of 6,417,000 for 1992 and 6,495,000 for 1991. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109 - Accounting for Income Taxes, which requires the Company to adjust deferred taxes for the temporary differences between the tax bases of its assets and liabilities and the amounts reported in the financial statements at enacted statutory tax rates. In September 1992, the Company repurchased a $2,600,000 outstanding mortgage loan (including accrued interest) for approximately $1,300,000, including transaction costs. The extraordinary gain, net of income tax effect, was $824,000. In October 1992, Roosevelt Island Associates ("RIA"), a partnership in which a Company subsidiary is one of several partners, defaulted on its mortgage payment obligations to the New York City Housing Development Corporation. The default was cured on January 15, 1993, by RIA entering into a bond refunding transaction with respect to its FHA insured $157,500,000 mortgage loan. This transaction resulted in an interest rate reduction to approximately 6.66%, from a prior rate of approximately 9.7%. The refinancing reduced RIA's debt service by $4,200,000 annually, thereby substantially reducing RIA's operating deficits which the Company, as a joint venture partner, has a continuing obligation to fund. As part of the refunding transaction, the Company provided cash flow guarantees to the investor partner. HRH reported a small profit for 1992. Its fee backlog decreased to $8,158,000 at December 31, 1992 as compared with $9,409,000 at the end of 1991. The Company's development activities also contributed to profits during 1992 with the recognition of $1,000,000 of income from its Livingston Plaza project, and the successful development, construction and sale by its Levitt division of a rental apartment project to a major institutional investor at a $1,800,000 profit. Grenadier continued its steady profitability in 1992. Grenadier is now providing management services to private owners and to institutional property owners as well as banks and thrift institutions. The Company's Levitt subsidiary reported income before taxes for 1992 of $864,000 as compared with a loss before taxes of $4,575,000 in 1991. The income in 1992 was before giving effect to the extraordinary gain on the repurchase of debt or the accounting change previously described. Sales in Puerto Rico increased to $48,616,000 for the year compared with $35,598,000 in 1991 and Levitt's company-wide backlog was $33,765,000 at December 31, 1992 compared with $27,043,000 for 1991. Domestically, Levitt's profitability was adversely affected by slow sales in certain of its projects. Levitt continued with its aggressive land disposition program, and in 1993 largely completed the liquidation of certain of its domestic land positions by selling and building homes at reduced prices. As a result of this program, in 1992 the Company increased its non-cash reserve by $1,810,000 to reduce the carrying value of its real estate inventory to its estimated net realizable value. Revenues increased $766,000 for the year 1992 compared with the similar period in 1991 as a result of an increase in revenues from Levitt of $10,327,000, offset principally by a decrease in revenues recognized upon the completion of a large project, Livingston Plaza in 1991, which was built and sold to The New York City Transit Authority, as well as a decrease in revenues of the Company's HRH division. General and administrative expenses (which were reduced for all divisions other than Grenadier which showed an overhead increase for the year) were reduced $2,200,000 in 1992 following a $3,000,000 reduction in 1991 as a result of continuing cost reduction programs. Interest expense decreased by $1,000,000 for 1992 as compared to 1991 primarily as a result of both a decrease in borrowings and a decline in interest rates. Levitt's interest, real estate taxes and sales costs incurred with certain properties are capitalized in order to achieve better matching of costs with revenues. The Company's interest incurred on loans was $5,964,000 in 1992 and $8,264,000 in 1991, of which $4,150,000 in 1992 and $5,314,000 in 1991 was capitalized by Levitt in its operations. Levitt amortized capitalized interest of $5,177,000 in 1992 and $4,909,000 in 1991 to construction and related costs. Cash Flow and Liquidity While the Company presently has various banking relationships, it does not have any formal lines of credit other than in connection with its Levitt subsidiary as described below. Levitt's business and earnings are substantially dependent on its ability to obtain financing on acceptable terms for it's activities. The Company has a $18,400,000 balance on a term loan, previously a revolving credit loan which was converted to a term loan in November 1991. As of December 31, 1993, the loan agreement provides for semi-annual principal payments of $1,000,000 in January and July in 1994 and 1995, a $3,000,000 payment in January 1996, a $1,000,000 payment in July 1996, a $3,000,000 payment in January 1997 and a final payment of $7,400,000 in July 1997. Levitt's Puerto Rico operations are partially financed by an unsecured $15,000,000 revolving credit facility with a Puerto Rico bank. As a result of greater than anticipated house sales in Levitt's Puerto Rico Encantada planned community in 1992 and a resultant increase in capital needed to complete such homes, Levitt obtained a short-term secured loan for $6,000,000 in June 1992. This facility was repaid in full in March 1993. In September 1993, the Puerto Rico mortgage branch operations entered into a $3,000,000 revolving credit agreement, with a Puerto Rico bank to finance the warehousing of mortgage note receivables originated by the mortgage operation. As of December 31, 1993, no amount was outstanding on its warehousing line of credit. Levitt also finances the acquisition of property for its operations on deferred payment terms provided by sellers of such property. Levitt anticipates that funds generated by operations, together with its existing credit relationships, will provide it with adequate financial resources to satisfy its operating needs and to meet its anticipated capital requirements for new projects. The timing of introducing Levitt's new projects to the market, weather conditions in certain of Levitt's regions, and traditional periods of greater customer activity have tended to create seasonal trends in Levitt's residential home building activities. Historically, the number of homes delivered has been greater in the second half of the calendar year. Net Operating Loss Carryforwards At December 31, 1993 the Company had net tax operating loss carryforwards which can be utilized against future taxable income of approximately $12,957,000 expiring in 2001 through 2008. Under current tax laws, if the aggregate voting stock owned by the Company's 5% shareholders increases over the lowest percentage owned by such shareholders during a three-year period by an amount exceeding 50% of Starrett's total voting stock, then Starrett's utilization of the net tax operating loss carryforwards could be limited to an amount per year equal to the market value of all Starrett equity securities multiplied by an adjusted federal long-term interest rate. In general, all non-5% shareholders are treated as a single 5% shareholder for the purpose of such calculations. Such an ownership change might be caused by sales of shares by the Company's shareholders, repurchases of shares by the Company, certain reorganizations, or certain other transactions. Inflation The Company believes that inflation has not had a material adverse effect upon its construction, development and management business. Levitt has from time to time been adversely affected by high interest costs and increases in material and labor costs which it has not been able to pass through entirely to home purchasers. Item 8. Item 8. Consolidated Financial Statements and Supplementary Data See "Table of Contents to Consolidated Financial Statements and Financial Statement Schedules," page 19. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure None PART III The information called for by Items 10, 11, 12 and 13 is incorporated herein by reference from the following portions of the definitive proxy statement to be filed by the Company in connection with its 1994 Meeting of Shareholders. Item Incorporated from Item 10. Item 10. Directors and Executive "Election of Directors" Officers of the Company Item 11. Item 11. Executive Compensation "Compensation and Certain Transactions" Item 12. Item 12. Security Ownership of "Information as to Certain Beneficial Stock Ownership" Owners and Management Item 13. Item 13. Certain Relationships "Compensation and and Related Transactions Certain Transactions" PART IV Item 13. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) See the accompanying Table of Contents to Consolidated Financial Statements and Schedules and the accompanying Exhibit Index. (b) Reports on Form 8-K: The Registrant did not file any report on Form 8-K during the quarter ended December 31, 1993. TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Financial Statement Schedules, other than that listed above, are omitted because of the absence of the conditions under which they are required, or because the information required therein is set forth in the financial statements or the notes thereto. [DELOITTE & TOUCHE LETTERHEAD] INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders of Starrett Housing Corporation We have audited the consolidated financial statements and the related financial statement schedule of Starrett Housing Corporation and consolidated subsidiaries, listed in the foregoing table of contents. These consolidated financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company and its consolidated subsidiaries at December 31, 1993 and 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in note 6, the Company changed its method of accounting for income taxes effective January 1, 1992 to conform with Statement of Financial Accounting Standard No. 109. Deloitte & Touche March 21, 1994 STARRETT HOUSING CORPORATION AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED FINANCIAL POSITION December 31, 1993 and 1992 (In Thousands) See Notes to Consolidated Financial Statements STARRETT HOUSING CORPORATION AND SUBSIDIARIES STATEMENTS OF CONSOLIDATED OPERATIONS For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands Except Per Share Data) See Notes to Consolidated Financial Statements STARRETT HOUSING CORPORATION AND SUBSIDIARIES STATEMENTS OF STOCKHOLDERS' EQUITY For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands Except Share Data) See Notes to Consolidated Financial Statements STARRETT HOUSING CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands) See Notes to Consolidated Financial Statements STARRETT HOUSING CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. Principles of Consolidation: The consolidated financial statements include the accounts of Starrett Housing Corporation (the "Company") and all of its subsidiaries. Intercompany accounts and transactions have been eliminated in the consolidated financial statements. B. Recognition of Income: The Company follows the percentage-of-completion method of recording revenues and related costs from construction contracts using the cost-to-cost method and provides currently for estimated losses on uncompleted contracts. Profits relating to sales of limited partnership interests and development fees are recognized on the percentage-of-completion method and full accrual method as appropriate. Revenue from the sale of real estate in which the Company has a continuing involvement is recognized in accordance with Statement of Financial Accounting Standards No. 66. Reflected in the deferred revenues account is that portion of the profit from the sale which is required to be deferred under the provisions of such Statement. Revenues from house sales and all related costs and expenses are recognized upon passage of title to the buyer and receipt of an adequate down payment. Revenues from cost-plus fee contracts are recognized on the basis of costs incurred during the period plus the fee earned. C. Inventory of Real Estate: Inventory of real estate is stated at the lower of cost or estimated net realizable value. Cost includes direct acquisition, development and construction costs, interest and other indirect construction costs. Estimated net realizable value is defined as an estimate of sales proceeds less all estimated costs of carrying, completing and disposing of the property. Interest is capitalized at the effective interest rates paid on borrowings for interest costs incurred on real estate inventory components during the preconstruction and planning stage and the periods that projects are under development. Capitalization of interest is discontinued if development ceases at a project. Land and improvement costs are allocated based on a method that approximates the relative sales value method. Construction costs are charged to individual homesites based on specific identification. D. Land Held for Investment: Land parcels in which the Company has no formal plans to develop or sell are classified as land held for investment. Land held for investment is carried at cost. Land parcels previously included in inventory of real estate and reclassified to land held for investment are valued at the lower of their acquisition cost or fair value at the time of transfer. The carrying value of land held for investment is evaluated for other than temporary declines in value. For the years 1993 and 1992, no adjustments for other than temporary declines were necessary. E. Rental and Other Property and Equipment: Rental and other property and equipment are carried at cost less accumulated depreciation and are depreciated using the straight-line method over the estimated useful lives of the assets which range from three to fifty years. Expenditures for maintenance and repairs are charged to expense as incurred. Costs of major renewals and betterments which extend useful lives are capitalized. F. Capitalized Costs: Mortgage interest, real estate taxes, and sales costs incurred in connection with certain properties are capitalized in order to achieve better matching of costs with revenues. Interest incurred on loans was $3,893,000 in 1993, $5,964,000 in 1992 and $8,264,000 in 1991, of which $2,959,000 in 1993, $4,150,000 in 1992 and $5,314,000 in 1991 was capitalized. Amortization of capitalized interest of $5,802,000 in 1993, $5,177,000 in 1992 and $4,909,000 in 1991 was charged to construction costs. Certain tangible costs incurred that are used directly throughout the selling period to aid in the sale of units, such as model furnishings and decorations, sales office furnishings and facilities, exhibits, displays and signage, are capitalized as deferred selling costs and amortized over the number of units to be delivered. Costs incurred during the initial and due diligence phases of a project, such as land deposits and studies, are capitalized as preacquisition costs. The unrecovered preacquisition costs are written off in the period the Company abandons development of the project. G. Income Taxes: The Company adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1992. The Company has reported the change in accounting for income taxes as a cumulative effect of a change in accounting method. Prior year amounts have not been restated (Note 6). H. Investments in Partnerships: Investments in partnerships in which the Company does not have a controlling interest are accounted for at cost and investments in a partnership in which the Company does have a controlling interest is accounted for on the equity method. I. Cash and Cash Equivalents: The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. J. Reclassifications: Certain prior year amounts have been reclassified in the financial statements and segment information to conform with the 1993 presentation. 2. RECEIVABLES Receivables are summarized as follows: It is expected that the receivables at December 31, 1993 as set forth above will be collected as follows: $15,198,000 in 1994, $1,610,000 in 1995, $46,000 in 1996, $51,000 in 1997, $56,000 in 1998 and $5,763,000 thereafter. At December 31, 1993, approximately $2,201,000 ($5,400,000 at December 31, 1992) of these mortgage notes receivable have been pooled into GNMA certificates which are guaranteed by the United States Government. The Company has pledged the mortgage notes as collateral to borrow funds from institutions at interest rates lower than those earned on the mortgage notes receivable and as collateral for GNMA matched payment serial notes (Note 7). The remaining mortgage notes receivable have been originated by the Company under firm commitments for sale to various third parties. The mortgage notes receivable, which result primarily from sales of homes in Puerto Rico, are payable in monthly installments and earn interest at stated interest rates which ranged from 7.5 to 12% in 1993 and 1992. 3. INVENTORY OF REAL ESTATE Inventory of real estate is summarized as follows: Due to the decline in demand for housing and the resultant weak real estate markets in New York, New Jersey, Virginia-Washington, D.C. and certain projects in Florida, the Company in 1990, implemented aggressive home sales programs to reduce land positions and thereby generate cash which can be used to invest in better yielding opportunities. The Company liquidated these land positions by selling and building homes at reduced prices. Due to the continuation of this program, the Company in 1992 increased the noncash reserve to reduce the net carrying value of inventory of real estate to its estimated net realizable value by $1,810,000. At December 31, 1993, the balance of these reserves is $725,000 (at December 31, 1992 - $2,289,000) and has been recorded as an allowance to reduce the inventory of land and land development costs. 4. RENTAL AND OTHER PROPERTY AND EQUIPMENT Rental and other property and equipment are summarized as follows: Rental properties consisted of two self storage mini-warehouse facilities which were sold for cash during 1993. 5. OTHER ASSETS Other assets are summarized as follows: 6. INCOME TAXES The Company and its domestic subsidiaries file a consolidated federal income tax return. The provision for income taxes consists of the following: Deferred income taxes result from temporary differences in the recognition of revenue and expense for tax and financial reporting purposes. The sources of these differences are primarily tax losses from limited partnerships, recognition of fee income, non-cash valuation reserves on land inventory and capitalization of interest and overhead. At December 31, 1993 the Company had a net tax operating loss carryforward, which can be utilized against future taxable income, of approximately $12,957,000 expiring in 2001 through 2008. There is no net operating loss carryforward for financial statement reporting purposes. Cash payments for income taxes during the years ended December 31, 1993, 1992 and 1991 were $2,251,000, $1,143,000 and $2,405,000, respectively. The effective tax rate was different from the statutory Federal tax rate for the following reasons: In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109 - Accounting for Income Taxes ("SFAS 109"). SFAS 109 requires the Company to recognize deferred taxes for the temporary differences between the tax bases of its assets and liabilities and the amounts reported in the financial statements at enacted statutory tax rates. The Company adopted SFAS 109 as of January 1, 1992. The cumulative effect of this change is reported separately in the Statement of Consolidated Operations for the Year Ended December 31, 1992. The tax effect of each type of temporary difference that gave rise to the Company's deferred tax liability is as follows: Total deferred tax assets and liabilities were $11,709,000 and $15,817,000, respectively, at December 31, 1993 and $10,188,000 and $15,870,000, respectively, at December 31, 1992. No valuation allowance was required for deferred tax assets. 7. DEBT Notes, mortgages payable and long-term obligations are summarized as follows: (A) On December 31, 1990, the Company redeemed all of American Financial Corporation's $5.81 cumulative convertible preferred stock and issued six equal subordinated promissory notes in the aggregate principal amount of $8,800,000, maturing 1992 through 1997. The notes bear simple interest at the rate of 15% per annum. In January 1994 the third promissory note in the amount of $1,466,667 was paid. In connection with the redemption of its preferred stock, the Company also had a $4,379,000 note payable to ITT Corporation at December 31, 1992 which was paid in January 1993. (B) The Company has a balance of $18,400,000 under an unsecured bank credit facility. The terms of the agreement require the Company to maintain certain financial ratios, and restrict the payment of cash dividends under certain conditions. This facility was converted from an unsecured revolving credit loan to an unsecured term loan as of November 1991. The term loan as of December 31, 1993 which was originally $28,000,000 provides for semi-annual principal payments in January and July of $1,000,000 in 1994 and 1995, then $3,000,000 in January 1996, $1,000,000 in July 1996, $3,000,000 in January 1997 and a final payment of $7,400,000 in July 1997. (C) In June 1992, the Company amended its unsecured $15,000,000 revolving credit agreement with its Puerto Rico bank to increase the facility $6,000,000 to $21,000,000 and extended the maturity to March 1993. The additional $6,000,000 facility is secured by certain developed and undeveloped lots. At December 31, 1992, $15,000,000 and $1,436,000 were outstanding on the unsecured and secured portions of the credit facility, respectively. As of March 1993, the secured portion of the facility was repaid. In April 1993, the Company renewed the unsecured revolving portion of the credit facility for an additional three years. The agreement provides for revolving loans up to $15,000,000. Terms of the agreement require the Company's subsidiary to maintain certain financial ratios and restrict the payment of cash dividends under certain circumstances. (D) On December 31, 1993, the Company had loans totalling $2,201,000 (secured by a pledge of GNMA certificates in the same amount) through the issuance of long-term debentures by a subsidiary of a non-profit community development corporation in Puerto Rico. Both the short-term loans and debentures, which are secured by mortgage notes receivable pooled into GNMA certificates, bear interest at rates lower than the interest rates on such mortgage receivables. (E) In September 1992, the Company repurchased a $2,600,000 mortgage loan (including accrued interest) for approximately $1,300,000, including transaction costs. The Company recorded an extraordinary gain of $824,000 net of income taxes of $490,000. In September 1993, the Company's Puerto Rico mortgage branch operations entered into a $3,000,000 revolving credit agreement with a Puerto Rico bank to finance the warehousing of mortgage note receivables originated by the mortgage operation. As of December 31, 1993, no amount was outstanding on this warehousing line of credit. Notes and mortgages payable were collateralized by land inventory, land held for investment, rental properties and mortgage notes receivable with net carrying values aggregating $28,415,000 and $43,333,000 at December 31, 1993 and 1992, respectively. Debt obligations are scheduled to mature as follows: $6,496,000 in 1994, $4,207,000 in 1995, $20,513,000 in 1996, $14,287,000 in 1997, $56,000 in 1998 and $1,970,000 thereafter. Certain mortgage notes contain provisions for reducing the principal as individual homes are sold by the Company. Interest paid (net of amounts capitalized) for the years ended December 31, 1993, 1992 and 1991 was $1,362,000, $1,923,000 and $4,509,000, respectively. As of December 31, 1993, the Company had outstanding letters of credit totalling approximately $1,175,000 on which there are service charges ranging from 0.5% to 1% on the outstanding balances. The Company also had outstanding financial security bonds in the amount of $7,443,000 securing various obligations. 8. PENSION PLAN The Company and its subsidiaries have a noncontributory defined benefit pension plan (the "Plan") covering employees not represented by a union. The benefits are based on years of service and the employees' compensation over the last five years. Effective July 31, 1992, the Board of Directors amended the Plan to freeze accrued benefits for all participants. The Company will continue to fund the Plan as required, including any interest at the assumed average rate of return on Plan assets. As of December 31, 1993, the plan held fixed income securities, life insurance policies and short-term investments. Assumed average future rate of return on Plan assets was 8% for the years ended December 31, 1993 and 1992, and the projected benefit obligation was based on a 7.75% and 8% assumed discount rate at December 31, 1993 and 1992, respectively, and a 5% assumed long-term rate of compensation increase. The total pension plan cost was $880,000 in 1991. The components of net periodic pension (benefit) cost for the years ended December 31, 1993 and 1992 are as follows: The following table sets forth the Plan's funded status as of December 31, 1993 and 1992: In accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions," an additional minimum pension liability, representing the excess of accumulated benefits over plan assets and accrued pension costs, was recognized at December 31, 1993. A corresponding amount, net of income tax benefit, was recorded as a separate reduction to stockholders' equity. The Company does not provide postretirement or postemployment benefits other than pensions to employees. Therefore, SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS No. 112, "Employers' Accounting for Postemployment Benefits" have no impact on the Company's financial statements. 9. SEGMENT INFORMATION The Company's operations consist of (i) the development, management and ownership of real estate properties; (ii) the single-family home and garden apartment business conducted through its Levitt subsidiary; and (iii) the supplying of construction services through its HRH subsidiary. The Company groups its business into these three segments. The following table sets forth the Company's revenues and operating profit attributable to the respective segments of its operations for each of the years 1991 through 1993, and the identifiable assets attributable to the respective segments as at the end of each of those years: (1) Operating profit is comprised of revenues less operating expenses. In computing operating profit, general corporate expenses and income taxes have not been deducted. (2) There were no customers from which the Company derived more than 10% of its revenues in 1993, 1992 or 1991. 10. COMMITMENTS AND CONTINGENCIES Roosevelt Island Associates ("RIA"), a partnership in which a Company subsidiary is one of several partners, has provided guaranteed payments to the investor partner. The Company's share of such guarantees was $250,000 for 1993 and $465,000 for 1994 and approximately $100,000 each year until 2005, which will be paid by the Company if project cash flow is insufficient to cover these amounts. In connection with this project, the Company also provided cash flow guarantees from which it will be released if the project achieves a certain cash flow level over a specified period of time. The Company is also jointly and severally liable for $3,225,000 of a loan made in connection with a mini-warehouse facility in which it has an ownership interest. The Company's Levitt subsidiary provides for estimated warranty costs when homes are sold and continuously monitors its warranty exposure and service program. Rent expense for the years ended December 31, 1993, 1992 and 1991 was $1,004,000, $1,042,000 and $1,225,000, respectively. At December 31, 1993 the Company and its subsidiaries are committed under long-term leases expiring at various dates through 1998. The minimum rentals are $923,000 in 1994, $896,000 in 1995, $804,000 in 1996, $161,000 in 1997, and $102,000 in 1998, or an aggregate of $2,886,000. The Company is involved in litigation and claims incident to the normal conduct of its business. Management believes that such litigation and claims will not have a materially adverse effect on the Company's consolidated financial position or results of operations. 11. QUARTERLY FINANCIAL DATA (Unaudited) The quarterly financial data are set forth below (dollars in thousands, except per share amounts): (A) Includes the effect of $1,810,000 in non-cash reserves to reduce the carrying value of land to its estimated net realizable value. Certain quarterly amounts have been reclassified to conform with the annual presentation. Schedule III STARRETT HOUSING CORPORATION (Parent Company Only) CONDENSED STATEMENTS OF FINANCIAL POSITION December 31, 1993 and 1992 (In Thousands) STARRETT HOUSING CORPORATION (Parent Company Only) CONDENSED STATEMENTS OF OPERATIONS For the Years Ended December 31, 1993, 1992 and 1991 (In Thousands) Schedule III STARRETT HOUSING CORPORATION (Parent Company Only) CONDENSED STATEMENTS OF CASH FLOWS (In Thousands) 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. STARRETT HOUSING CORPORATION Date: March 21, 1994 BY /s/ Paul Milstein -------------------------------- Paul Milstein Chairman of the Board 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. Date: March 21, 1994 By /s/ Paul Milstein -------------------------------- Paul Milstein, Principal Director Date: March 21, 1994 By /s/ Lewis A. Weinfeld -------------------------------- Lewis A. Weinfeld, Principal Financial and Accounting Officer Date: March 21, 1994 By /s/ Henry Benach -------------------------------- Henry Benach, Director STARRETT HOUSING CORPORATION EXHIBITS DECEMBER 31, 1993 COMMISSION FILE NUMBER 1-6736 STARRETT HOUSING CORPORATION EXHIBIT INDEX

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Item 1. BUSINESS General Dover Corporation ("Dover" or the "Company") was originally incorporated in 1947 in the State of Delaware and commenced operations as a public company in 1954 with four operating divisions, engaged primarily in the manufacture of metal fabricated industrial products. Primarily through acquisitions, the Company has grown to encompass over 60 different businesses which fabricate, install and service elevators, and manufacture a broad range of specialized industrial products and electronic components and sophisticated manufacturing equipment. The primary criteria for Dover operating companies is that they strive to be the market leader in their respective market, meeting customer needs with superior products and services with appropriate increased compensation, while achieving long-term earnings growth, high cash flow and superior return on stockholders' equity. The Company's businesses are divided into five business segments. Dover Elevator manufacturers, sells, installs and services elevators primarily in North America. Dover Resources manufactures products primarily to serve the automotive, fuel handling and service and petroleum industries. Dover Industries makes products for use in the waste handling, bulk transport, automotive service, commercial food service and machine tool industries. Dover Technologies builds primarily sophisticated automated electronic assembly equipment and to a lesser degree specialized electronic components. Dover Diversified builds heat transfer equipment, larger power generation, sophisticated assembly and production machines, as well as sophisticated products and control systems for use in the defense, aerospace and commercial building industries. Dover sells its products and services both directly and through various distributors, sales and commission agents and manufacturers representatives, in all cases consistent generally with the custom of the industry and market being served. For more information on these segments and their products, sales, markets served, earnings before tax and total assets for the six years ended December 31, 1993, see pages 6 through 16 of the 1993 Annual Report, which are hereby incorporated by reference. During the past five years, Dover has spent approximately $550 million on acquisitions of which $321 million was expended in 1993. For more detail regarding acquisitions, see pages 1 through 5 of the 1993 Annual Report as well as Note 2 to the Consolidated Financial Statements on pages 21-22 of the 1993 Annual Report, which are hereby incorporated by reference. - 3 - Raw Materials Dover's operating companies use a wide variety of raw materials, primarily metals, semi-processed or finished components, which are generally available from a number of sources. Temporary shortages may occur occasionally, but have not resulted in business interruptions or major problems, nor are any such problems anticipated. Research and Development Dover's operating companies are encouraged to develop new products as well as upgrade and improve existing products to satisfy customer needs, expand sales opportunities and improve product reliability and reduce production costs. During 1993, approximately $60 million was spent on research and development, compared with $68 million and $62 million in 1992 and 1991, respectively. Dover holds or is licensed to use a substantial number of U.S. patents covering a number of its product lines, and to a far lesser degree patents in certain foreign countries where it conducts business. Dover licenses some of its patents to other companies for which it collects royalties which are not significant. These patents have been obtained over a number of years and expire at various times. Although patents in the aggregate are important to Dover, the loss or expiration of any one patent or group of patents would not materially affect Dover or any of its segments. Where patents have expired, Dover believes that its commitment to leadership in continuous engineering improvements, manufacturing techniques, and other sales, service and marketing efforts are significant to maintaining its general market leadership position. Trademarks and Tradenames Several of the Company's products are sold under various trademarks and tradenames owned or licensed by the Company. Among the most significant are: Dover, Heil, Norris, Universal, DEK, Brown & Sharpe, Marathon, OPW, Duncan, Blackmer, Rotary Lift, Groen, Annubar, Sargent, A-C Compressor and Tipper Tie. Seasonality Dover's operations are generally not seasonal. Customers Dover's businesses serve thousands of customers, no one of which accounted for more than 10% of sales. Within each of the five segments, no customer accounted for more than 10% of segment sales. - 4 - Backlog Backlog generally is not considered a significant factor in Dover's businesses, as most products have relatively short delivery periods. The only exceptions are in those businesses which produce larger and more sophisticated machines, or have long-term government contractor subcontracts, particularly in the Diversified Group (Belvac, A-C Compressor, Sargent Controls and Sargent Technologies) and the Technologies Group (Universal). Total Company backlog as of December 31, 1993 and 1992 was $710,977,000 and $606,681,000 respectively. Competition Dover's competitive environment is complex because of the wide diversity of products manufactured and markets served. In general, Dover companies are market leaders which compete with only a few companies. In addition, since most of Dover's manufacturing operation are in the United States, Dover usually is a more significant competitor domestically than in foreign markets. There are some exceptions. In the Elevator segment, Dover competes for the manufacture and installation of elevators with a few generally large multinational competitors and maintains a strong domestic position. For service work, there are numerous local, regional and national competitors. In the Technologies segment, Dover competes globally against a few very large companies, primarily based in Japan or Europe. Within the other three segments, there are a few companies whose markets and competition are international, particularly Wittemann, AOT, Tipper Tie and Belvac. International For foreign sales and assets, see Note 3 to the Consolidated Financial Statements on page 22 of the 1993 Annual Report and information about the Company's Operations in Different Geographic Areas on page 27 of the 1993 Annual Report, which are incorporated herein by reference. Export sales of domestic operations were $392 million in 1993 and $432 million in 1992. Although international operations are subject to certain risks, such as price and exchange rate fluctuations and other foreign governmental restrictions, Dover intends to increase its expansion into foreign markets, particularly with respect to its elevator business, as domestic markets mature. The countries where most of Dover's foreign subsidiaries and affiliates are based are Canada, Great Britain and Germany. - 5 - Environmental Matters Dover believes its operations generally are in substantial compliance with applicable regulations. In some instances, particular plants and businesses have been the subject of administrative and legal proceedings with governmental agencies relating to the discharge or potential discharge of materials. Where necessary, these matters have been addressed with specific consent orders to achieve compliance. Dover believes that continued compliance will not have any material impact on the Company's financial position going forward and will not require significant capital expenditures beyond normal requirements. Employees The Company had approximately 20,500 employees as of December 31, 1993. Item 2. Item 2. DESCRIPTION OF PROPERTY The number, type, location and size of the Company's properties are shown on the following charts, by segment. The facilities are generally well maintained and suitable for the operations conducted and their productive capacity is adequate for current needs. Item 3. Item 3. LEGAL PROCEEDINGS Dover is party to a number of legal proceedings arising out of the normal course of its businesses. In general, most claims arise in connection with activities of its Elevator segment - 6 - operations and certain of its other businesses which make products used by the public. In recent years, Dover has also been involved with the Internal Revenue Service regarding tax assessments for the eight years ended December 31, 1989 and certain patent litigation. In addition, matters have arisen under various environmental laws, as well as under local regulatory compliance agencies. For a further description of such matters, see Note 13 to the Consolidated Financial Statements on page 26 of the 1993 Annual Report, which is incorporated herein by reference. Based on insurance availability, established reserves and periodic reviews of those matters, management is of the opinion that the ultimate resolution of current pending claims and known contingencies should not have a material adverse effect on Dover's financial position taken as a whole. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT All officers are elected annually at the first meeting of the Board of Directors following the annual meeting of stockholders and are subject to removal at any time by the Board of Directors. The executive officers of Dover as of March 11, 1994, and their positions with the Company for the past five years are as follows: - 7 - PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The principal market in which the Company's Common Stock is traded is the New York Stock Exchange. Information on the high and low prices of such stock and the frequency and the amount of dividends paid during the last two years, is set forth on Page 32 of the 1993 Annual Report and incorporated herein by reference. The number of holders of record of the Registrant's Common Stock as of February 28, 1994 is approximately 3,100. Item 6. Item 6. SELECTED FINANCIAL DATA The information for the years 1983 through 1993 is set forth in the Annual Report on pages 30 and 31 and is incorporated herein by reference. - 8 - Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth in the Annual Report on pages 28 and 29 is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information set forth in the Annual Report on pages 17 through 27 is incorporated herein by reference. Item 9. Item 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information with respect to the directors of the Company required to be included pursuant to this Item 10 is included under the caption "Election of Directors" in the 1994 Proxy Statement relating to the 1994 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission (the "Commission") pursuant to Rule 14a-6 under the Securities Exchange Act of 1934, as amended, and is incorporated in this Item 10 by reference. The information with respect to the executive officers of the Company required to be included pursuant to this Item 10 is included under the caption "Executive Officers of the Company" in Part I of this Annual Report on Form 10-K. Item 11. Item 11. EXECUTIVE COMPENSATION The information with respect to executive compensation required to be included pursuant to this Item 11 is included under the caption "Compensation" in the 1994 Proxy Statement and is incorporated in this Item 11 by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information regarding security ownership of certain beneficial owners and management that is required to be included pursuant to this Item 12 is included under the captions "General" and "Security Ownership" in the 1994 Proxy Statement and is incorporated in this Item 12 by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information with respect to any reportable transaction, business relationship or indebtedness between the Company and the beneficial owners of more than 5% of the Common Stock, the directors or nominees for director of the Company, the - 9 - executive officers of the Company or the members of the immediate families of such individuals that is required to be included pursuant to this Item 13 is included under the caption "Election of Directors" in the 1994 Proxy Statement and is incorporated in this Item 13 by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1). Financial Statements The following consolidated financial statements of Dover Corporation and its subsidiaries are set forth in the 1993 Annual Report, which financial statements are incorporated herein by reference: (A) Independent Auditors' Report. (B) Consolidated balance sheets as of December 31, 1993, 1992 and 1991. (C) Consolidated statements of earnings for the years ended December 31, 1993, 1992 and 1991. (D) Consolidated statements of retained earnings for the years ended December 31, 1993, 1992 and 1991. (E) Consolidated statements of cash flows for the years ended December 31, 1993, 1992 and 1991. (F) Notes to consolidated financial statements. (2) Financial Statement Schedules The following financial statement schedules are included in Part IV of this report: Independent Auditors' Report on Schedules and Consent II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties VIII - Valuation and Qualifying Accounts IX - Short-term Borrowings X - Supplementary Income Statement Information All other schedules are not required and have been omitted. (b) No reports on Form 8-K have been filed during the fourth quarter of the fiscal year ended December 31, 1993. - 10 - (c) Exhibits: (13) Dover's Annual Report to Stockholders for its fiscal year ended December 31, 1993. (21) Subsidiaries of Dover. (23) Independent Auditors' consent. (See Independent Auditors' Report on Schedules and Consent) (24) Powers of Attorney. SIGNATURES Pursuant to the requirements of Section 13 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. DOVER CORPORATION Gary L. Roubos By: ------------------------ Gary L. Roubos Chairman Date: March 29, 1994 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 in the capacities and on the dates indicated. - 11 - Robert G. Kuhbach * By ------------------------- Robert G. Kuhbach Attorney-in-Fact - 12 - INDEPENDENT AUDITORS' REPORT ON SCHEDULES AND CONSENT The Board of Directors and Shareholders Dover Corporation: Under date of February 22, 1994, we reported on the consolidated balance sheets of Dover Corporation and subsidiaries as of December 31, 1993, 1992 and 1991 and the related consolidated statements of earnings, retained earnings, and cash flows of the years then ended, as contained in the 1993 annual report to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules listed in answer to Part IV, item 14(A)2 of Form 10-K. These financial statement schedules are the responsibility of the Company's management. Our responsibility is the express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. In addition, we consent to the incorporation by reference of our above- mentioned report dated February 22, 1984 in the Registration Statement (No. 2-58037) on Form S-8 (1974 Incentive Stock Option Plan) in the Registration Statement (No. 33-11229) on Form S-8 the Prospectus dated January 28, 1987 (1984 Incentive Stock Option Plan) and in the Registration Statement (No. 2-91561) on Form S-8 dated July 1, 1984 to the Dover Corporation Employee Savings and Investment Plan. We also consent to the reference to our firm under the heading "Financial Statements and Experts" in the Prospectuses. KPMG Peat Marwick New York, New York March 29, 1994 SCHEDULE II DOVER CORPORATION AND SUBSIDIARIES Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties Years ended December 31, 1993, 1992 and 1991 Notes: (1) Unsecured loan to employee, payable on demand, bearing interest at 4.16%. (2) Loan to employee for purchase of residence, payable on demand, bearing interest at 8.75%, secured by residence. SCHEDULE VIII DOVER CORPORATION AND SUBSIDIARIES Valuations and Qualifying Accounts Years ended December 31, 1992 and 1991 Notes: (1) Represents uncollectible accounts written off and reductions of prior years over provision less recoveries of accounts previously written off, net of additions and deductions relating to acquired and divested companies. SCHEDULE IX DOVER CORPORATION AND SUBSIDIARIES Short-Term Borrowings Years ended December 31, 1993, 1992 and 1991 Notes: (1) Represents maximum amount outstanding at any month-end. (2) Average of 13 month-end balances (including December of previous year). (3) Weighted average of interest rates on all commercial paper outstanding at month-end. (4) Includes $250,000 classified as long-term debt. SCHEDULE X DOVER CORPORATION AND SUBSIDIARIES Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 Notes: * Amounts not shown are not in excess of 1% of total sales. EXHIBIT INDEX - 13 -

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Item 1. Business 1 Item 2. Item 2. Properties 15 Item 3. ITEM 3. LEGAL PROCEEDINGS The Company has been made a defendant in a lawsuit brought by Entech Sales & Service, Inc., on behalf of a purported class of contractors engaged in the service and repair of commercial air conditioning equipment. The suit, which was filed on March 5, 1993, in the United States District Court for the Northern District of Texas, alleges principally that the manner in which Air Conditioning Products distributes repair service parts for its equipment violates Federal antitrust laws and demands $680 million in damages (which are subject to trebling under the antitrust laws) and injunctive relief. The Company has filed an answer denying all claims and is preparing to defend itself vigorously. The issue of whether Entech may maintain this action as a class action is pending before the court. In management's opinion the litigation should not have any material adverse effect on the financial position, cash flows, or results of operations of the Company. There are no other material legal proceedings. For a discussion of German tax issues see "ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- Liquidity and Capital Resources". For a discussion of environmental issues see "ITEM 1. BUSINESS - -- Regulations and Environmental Matters." ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS By the unanimous written consent of the sole holder of the common stock of the Company dated as of December 2, 1993, the following individuals were elected as directors of the Company, each to serve in office until the next annual meeting of the stockholder of the Company or until such individual's respective successor shall have been elected and shall qualify, or until such individual's earlier death, resignation or removal as provided in the By-laws of the Company: Horst Hinrichs Frank T. Nickell Emmanuel A. Kampouris J. Danforth Quayle George H. Kerckhove John Rutledge Shigeru Mizushima Joseph S. Schuchert THIS PAGE LEFT BLANK INTENTIONALLY PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's only issued and outstanding common equity, 1,000 shares of common stock $.01 par value, is owned by Holding. There is no established public trading market for these shares. There were no dividends declared on the Company's common stock in 1992 and 1993. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As a result of the Acquisition, results of operations include purchase accounting adjustments and reflect a highly leveraged capital structure. Sales Year Ended December 31, 1993 1992 1991 (Dollars in millions) Air Conditioning Products(a) $2,100 $ 1,892 $ 1,836 Plumbing Products 1,167 1,170 1,018 Transportation Products 563 730 741 Sales $3,830 $ 3,792 $ 3,595 ====== ======= ======= Operating Income (Loss) Before Income Taxes, Extraordinary Loss, and Cumulative Effects of Changes in Accounting Methods Year Ended December 31, 1993 1992 1991 (Dollars in millions) Air Conditioning Products(a) $133 $ 104 $ 55 Plumbing Products 108 108 66 Transportation Products 41 88 121 Operating income 282 300 242 Interest expense (278) (289) (286) Corporate items(b) (85) (63) (44) Loss before income taxes, extraordinary loss, and cumulative effects of changes in accounting methods $(81) $ (52) $ (88) ==== ===== ===== (a) For 1991 the amounts presented for Air Conditioning Products include the following amounts for Tyler Refrigeration (which was sold on September 30, 1991): sales of $99 million and operating loss of $18 million (including a $22 million loss on the sale). (b) Corporate items include administrative and general expenses, accretion charges on postretirement benefit liabilities, minority interest, foreign exchange transaction gains and losses, and miscellaneous income and expense. The following section summarizes the Company's consolidated results of operations and then discusses the results of its three operating segments. The Company's businesses are cyclical. Air Conditioning Products and Plumbing Products are particularly affected by the level of residential and commercial building activity. The following table presents a summary of statistics on U.S. non-residential construction activity and housing starts for the years 1989 through 1993. U.S. Non- Residential Contract Awards U.S. Housing (Millions % Change Starts % Change of square Year (Thousands of Year feet)(a) to Year units)(b) to Year 1989 1,322 - 1% 1,376 - 8% 1990 1,155 -13% 1,193 -13% 1991 953 -17% 1,015 -15% 1992 903 - 5% 1,200 +18% 1993 (c) 930 + 3% 1,290 + 7% (a) Source: F.W. Dodge Division, McGraw Hill, Inc. (b) Source: U.S. Department of Commerce, Bureau of Census. (c) Preliminary data. The market for replacement sales and servicing of air conditioning and plumbing products, which accounts for a substantial portion of sales for Air Conditioning Products and Plumbing Products, is less cyclical and sometimes countercyclical. The following table presents a summary of statistics on unit production of trucks, buses, and trailers in excess of six tons in Western Europe for the years 1989 through 1993 (units in thousands). Western Europe % Change Western Europe % Change Truck and Bus Year Trailer Year Production(a) to Year Production(a) to Year 1989 376 4% 125 9% 1990 343 -9% 128 2% 1991 353 3% 139 9% 1992 314 -11% 115 -17% 1993 223 -29% 88 -23% (a) Principal sources: Verband der Deutschen Automobilindustrie (Germany); Society of Motor Manufacturers and Traders (United Kingdom); and Chambre Syndicate des Constructeurs Automobiles (France). 1993 Compared with 1992 U.S. housing starts increased by 7% in 1993 from the 1992 level, which was up 18% over 1991 after four consecutive years of decline. U.S. non-residential contract awards increased by 3% in 1993 after five years of decline. The 1993 improvement in housing starts came in the second half of the year with third- and fourth-quarter starts up 10% and 12%, respectively, over the preceding quarter. The gain in non-residential awards occurred over the last nine months of 1993. Western European truck and bus production declined 29% in 1993 after an 11% decline in 1992. However, the rate of decline in the truck market slowed in the fourth quarter of 1993. Consolidated sales for 1993 were $3.83 billion, an increase of 1% (6% excluding the unfavorable effects of foreign exchange) over the $3.79 billion for 1992. A sales increase of 11% for Air Conditioning Products was partly offset by a sales decline for Transportation Products of 23% (16% excluding the unfavorable effects of foreign exchange). Sales for Plumbing Products were flat (but up by 9% excluding the effects of foreign exchange). Operating income for 1993 was $282 million, a decrease of $18 million, or 6% (but an increase of less than 1% excluding the effects of foreign exchange), from $300 million in 1992. The increase in operating income of 28% for Air Conditioning Products was more than offset by a 53% decrease in operating income for Transportation Products. Plumbing Products' operating income was flat (but increased 15% excluding the effects of foreign exchange). The gain for Air Conditioning Products was the result of higher volume, increased sales of higher-margin products, the benefits of manufacturing improvements, and the effects of restructuring and cost-containment efforts undertaken in 1991 and 1992, offset partly by the costs of further restructuring in 1993. For Plumbing Products the effects of increased volume for the Far East Group were offset partly by lower margins for the U.S. group and lower volumes and unfavorable foreign exchange effects for the European group. Transportation Products' operating income decreased primarily as a result of lower volumes due to reduced demand in depressed markets in Europe, offset partly by the effects of improvements in manufacturing efficiency. Air Conditioning Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales: Domestic portion $1,786 $1,572 $1,453 Foreign portion 314 320 284 Subtotal 2,100 1,892 1,737 Tyler Refrigeration - - 99 Total $2,100 $1,892 $1,836 ====== ====== ====== Operating income (loss): Domestic portion $ 148 $ 112 $ 58 Foreign portion (15) (8) 15 Subtotal 133 104 73 Tyler Refrigeration - - (18)(a) Total $ 133 $ 104 $ 55 ====== ====== ====== Assets $1,167 $1,156 $1,174 Goodwill and purchase accounting adjustments included in assets 372 398 417 Capital expenditures 38 33 46(b) Depreciation and amortization 53 55 56(c) (a) Includes $22 million loss on the sale of Tyler Refrigeration. (b) Includes capital expenditures of Tyler Refrigeration of $1 million. (c) Includes depreciation and amortization of Tyler Refrigeration of $3 million. The domestic portion of Air Conditioning Products is composed of the Unitary Products Group, the Commercial Systems Group (excluding Canada), and exports from the United States by the International Group. The foreign portion consists of the foreign-based operations of the International Group and the Canadian operations of the Commercial Systems Group. Sales and operating income of Air Conditioning Products both increased in 1993 despite the continuing recession in U.S. and Canadian commercial new construction and only moderate increase in residential new construction in the U.S. and despite the economic decline in Europe. Sales of Air Conditioning Products, which accounted for approximately 55% of the Company's 1993 sales, increased by 11% (with little effect from foreign exchange) to $2,100 million in 1993 from $1,892 million in 1992. There was a significant sales increase for each of the three operating groups. Operating income of Air Conditioning Products increased year to year by 28% (with little effect from foreign exchange) to a record high of $133 million in 1993 from $104 million in 1992. The increase was attributable to gains achieved by all three groups. Unitary Products Group In 1993 sales of the Unitary Products Group, which accounted for approximately 42% of Air Conditioning Products sales, increased by 15% over the 1992 sales level. Residential markets were up 15%, as a result of an unusually hot summer in the northern United States and a 7% increase in housing starts. Sales of residential products increased by 18% year over year, principally because of higher volumes driven by the improved market, increased furnace sales in the replacement market, and a shift in the market to more efficient products, offset partly by the continuation from 1992 of price degradation due to competitive pressures. Commercial markets for unitary products were up 9% overall from the 1992 markets, as the commercial replacement market strengthened further. New-construction activity continued to struggle, however. Sales of commercial unitary products increased by 10% overall, primarily as a result of higher volume (driven by the strong replacement market for both light and large commercial products); a shift to higher-priced, higher-tonnage products; and a gain in market share for light commercial products due to the success of the large Voyager products (packaged rooftop air conditioners). As a result of these factors, together with product cost improvements, improved labor productivity, and the benefits of organizational restructuring which reduced the salaried workforce in 1992, the operating income for Unitary Products in 1993 increased by 43% year over year. This improvement was achieved even though 1993 included the initial start-up costs of the new national distribution center in St. Louis, Missouri, and higher advertising costs. Unitary Products' sales increased through the success of new and redesigned products introduced recently and improved distribution channels. Commercial products that were introduced included the 20-to-25-ton Voyager products in 1992, which more than doubled market share in that size range; commercial microprocessor-controlled products; a line of convertible air handlers; and rooftop and air cooled chiller products using more efficient scroll compressors. Residential products introduced included the American-Standard brand outdoor units and new lines of luxury and conventional retail residential products. Commercial Systems Group Sales of the Commercial Systems Group, which accounted for approximately 37% of Air Conditioning Products' sales, increased 10%, primarily on volume increases for most product lines, especially air handling systems and water chillers (principally due to improved replacement markets and increased market share), and increased revenue from Company-owned sales offices (acquisitions and volume growth). These gains were partly offset by lower volume in Canada, which continues to be adversely affected by recession. The non-residential new-construction market increased 3% in the United States in 1993, following decreases of 5% in 1992 and 17% in 1991. The non-residential replacement market was up by 6% over 1992. Operating income for Commercial Systems increased 12% in 1993 over the recession-affected amount of 1992. The increase was primarily the result of volume gains, improvements in manufacturing efficiency, operating expense reductions, and the benefits of restructuring actions taken in 1992. The effects of these factors were partly offset by slightly lower prices, increases in material, labor, and benefit costs, the costs of additional restructuring actions in 1993, and a larger loss in the weak Canadian market. Product development emphasis for Commercial Systems in 1993 and 1992 was on new compressor, heat transfer and microelectronic control technology; adaptation of products to refrigerants that comply with recent government regulations; energy-efficient products; products for the aftermarket and replacement market (which exceeded the new-construction market in both 1993 and 1992); and products redesigned to improve manufacturing productivity. This strategy benefited operations in 1993 and 1992, and the Company expects that this product development emphasis will result in greater sales over the next several years. International Group Sales of Air Conditioning Products' International Group, which accounted for approximately 21% of Air Conditioning Products' 1993 sales, increased 7% from those of 1992 (10% excluding the unfavorable effect of foreign exchange). Most of the gain was from higher volume in the Far East (especially Hong Kong, Taiwan, and export sales from the U.S.) resulting from expanded markets and increased penetration; higher export sales from the U.S. to the Middle East (markets were significantly stronger) and Latin America (improved penetration in a market that was up 20%); and higher volumes in Mexico. These gains were partly offset by lower sales in Europe (lower prices and volumes in a declining market). Markets were down in all European countries except the U.K., but the effect was partly offset by increased revenues from service companies acquired in 1992 and prior years. Market growth in the Far East was 6% overall, led by the PRC market, which was up by 21%. The sales growth in Hong Kong was driven by the very strong market in the PRC. Markets in Thailand also grew, and the Latin American market grew by 20%. Operating income for the International Group increased by approximately 39% in 1993. The increase was primarily the result of higher export sales from the U.S. to the Middle East and Far East, offset partly by a larger operating loss in Europe primarily because of the weak markets and lower margins, costs related to restructuring in response to the lower markets, and the unfavorable effects of lower volume on factory performance. Overall, income from the Far East and Latin America was essentially unchanged from the prior year, as volume gains were offset by increased costs related to expansion of distribution channels and joint ventures and development of new and improved products to support present and future growth. Environmental Matters For a discussion of environmental matters see "Business -- Regulations and Environmental Matters." Backlog The worldwide backlog for Air Conditioning Products at the end of 1993 was $407 million, up 13% from 1992, excluding the effects of foreign exchange. The backlog increased as a result of increased volume for the Commercial Systems Group, market penetration and improved distribution channels in the Middle East and Far East, and sales growth for commercial Unitary Products. Plumbing Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales: Foreign portion $ 865 $ 885 $ 783 Domestic portion 302 285 235 Total $1,167 $1,170 $1,018 ====== ====== ====== Operating income (loss): Foreign portion $ 131 $ 124 $ 93 Domestic portion (23) (16) (27) Total $ 108 $ 108 $ 66 ====== ====== ====== Assets $ 960 $1,002 $1,069 Goodwill and purchase accounting adjustments included in assets 376 392 447 Capital expenditures 46 48 40 Depreciation and amortization 49 49 48 The foreign portion of Plumbing Products is composed of the European Plumbing Products Group, the Americas International Group, and the Far East Group. The domestic portion of sales and operating results is generated primarily by the U.S. Plumbing Products Group and by export sales from the U.S. Sales of Plumbing Products in 1993, at $1,167 million, which accounted for approximately 30% of the Company's 1993 sales, were at essentially the same level as the $1,170 million of sales in 1992 (but increased by 9% excluding the unfavorable effects of foreign exchange). Sales increases of 42% for the Far East Group (46% excluding foreign exchange), 9% for the Americas International Group (14% excluding foreign exchange), and 6% for the U.S. Plumbing Products Group were offset partly by a sales decrease of 10% for the European Plumbing Products Group (which had a 4% increase excluding the effects of foreign exchange). In 1993 operating income of Plumbing Products was $108 million, the same amount as in 1992, but excluding the unfavorable effects of foreign exchange operating income increased by 15%. The increase (on an exchange-adjusted basis) was attributable primarily to increased profitability for the Far East Group and for the Americas International Group, offset partly by a decline for the U.S. group. European Plumbing Products Group Sales of the European group, which accounted for approximately 51% of Plumbing Products' sales for 1993, decreased 10% in 1993 from 1992 but increased by 4% excluding the unfavorable effects of foreign exchange. The exchange-adjusted gain resulted from price increases, especially in Italy, Germany, the U.K., and Greece, offset partly by lower volume in most countries because of depressed markets. In Italy sales were up with price increases for most product lines, offset partly by lower volume and a less favorable product mix. The German market was stable in total, as price gains were offset by volume and mix declines. Greece, which had been in recession for three years, recovered somewhat in 1993. The European group's strength has been sales in the replacement market, which has more than made up for the effects of poor new-construction markets. Operating income for the European group decreased 7% but increased 10% excluding the effects of foreign exchange. This increase occurred primarily because of the price gains and cost reductions resulting from restructuring and efficiency improvements in the U.K., France, Italy, and Germany. Partly offsetting those favorable effects were the effects of lower volumes and the unfavorable effect on margins caused by the decline in value of many European currencies agains the Deutschemark. The increased cost of fittings purchased from Germany could not be completely recovered through sales price increases in most of the operations in other countries. U.S. Plumbing Products Group Sales of the U.S. group, which accounted for approximately 26% of total 1993 Plumbing Products sales, increased 6% in 1993. During 1993 the U.S. building industry continued to be adversely affected by the low level of new construction, although non-residential construction increased 3% from 1992 and new residential construction continued to recover from the lowest levels since the mid-1940's (up by 7% in 1993 and 18% in 1992 but still below pre-1990 levels). A basic shift from wholesale distribution channels to retail channels has been developing over the last few years, a trend the Company believes will continue and will be beneficial to the Company because of strong product and brand-name recognition. Retail markets now account for 20% of the total sales of the U.S. group. The growth of sales for the U.S. group was largely the result of increased export sales from the U.S. and to a lesser extent price increases on certain products, a more favorable sales mix, and a small increase in the growing retail channel business. The overall gain in the retail business was small because significant volume gains due to an expanding customer base were partly offset by the loss of an important customer. The operating loss for the U.S. group in 1993 was greater than that of the prior year. Despite higher sales, operating results were poorer primarily because of lower margins on both domestic and export sales, increased advertising costs and other expenses associated with expansion of the retail distribution channel, costs related to start-up and expansion of the low-water-volume toilet line (now mandated for new construction), and factory performance problems caused in part by the effects of fluctuating volumes. In addition, costs were incurred in business system re-engineeering activities intended to improve customer service. Americas International and Far East Groups Combined sales of the Americas International and Far East Groups, which accounted for approximately 23% of total Plumbing Products sales, increased 21% in 1993 (26% excluding the effects of foreign exchange). The sales gain was due primarily to the consolidation of Incesa (a previously unconsolidated group of Central American joint ventures) effective January 1, 1993, as a result of the purchase of additional shares of stock, and to higher volume and prices in Thailand, the PRC, the Philippines, and Brazil, offset partly by decreases in sales in Mexico, Canada, and Korea. Combined operating income of the Americas International and Far East Groups in 1993 increased 72% over the 1992 level. Gains were realized in all operations except Mexican chinaware operations, which were adversely affected by poor economic conditions and the uncertainty related to the North American Free Trade Agreement. The increase was primarily from higher prices and volumes in Brazil, Thailand, and the PRC the consolidation of Incesa, and a smaller loss for Mexican fittings operations. Environmental Matters For a discussion of environmental matters see "ITEM 1. BUSINESS -- Regulations and Environmental Matters." Backlog Plumbing Products' year-end 1993 backlog of $143 million was down 9% from 1992, excluding foreign exchange effects. The decrease resulted from a significant drop for European Plumbing Products (particularly Italy because of economic uncertainty, tempered somewhat by increases for England and Germany), and a drop in backlog for export sales from the U.S., partly offset by increases in the Far East (primarily Thailand). Transportation Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales $ 563 $730 $741 Operating income 41 88 121 Assets 652 722 828 Goodwill and purchase accounting adjustments included in assets 422 458 510 Capital expenditures 14 27 24 Depreciation and amortization 35 37 34 Sales of Transportation Products, which accounted for 15% of the Company's 1993 sales, were $563 million, down 23% from $730 million in 1992 (16% excluding the effects of foreign exchange). The sales decrease was due primarily to a volume decline in Germany as a result of a 29% decrease in Western European truck and bus production, led by a 34% decline in Germany, and a 23% decrease in Western European trailer production. Volumes were also down in all other European countries in which Transportation Products has operations, although at the end of 1993 sales and order trends were upward. Volume in Brazil was slightly higher. Original equipment sales volume in Europe was down 22%, and aftermarket business was down 10%. These declines affected both conventional and electronic products. Operating income for Transportation Products in 1993 decreased 53% (50% excluding foreign exchange effects) to $41 million from $88 million in 1992, principally because of the lower sales and production volume and the inability to pass on material and labor cost increases in a very competitive, declining market. In response to reduced production levels, plant employment was reduced by 15%, the costs of which further depressed 1993 operating income. Those effects were partly offset by the favorable effects of cost improvements in manufacturing from Demand Flow implementa- tion and reduced operating expenses. Despite the market downturn, significant progress was made during 1993 in obtaining market acceptance of electronically controlled air suspension systems for commercial vehicles and for antilock braking systems on trailers. Backlog Transportation Products' year-end 1993 order backlog of $185 million was 2% lower than the 1992 year-end backlog, excluding the effects of foreign exchange, as a result of the poor market conditions. Financial Review 1993 Compared with 1992 The Company's financing and corporate costs were $363 million and $352 million in 1993 and 1992, respectively. The principal causes of the increase were effects of year-to-year changes in foreign exchange transaction gains and losses, higher minority interest, lower equity income, higher accretion expense on postretirement benefits, and lower miscellaneous income. Interest expense, which accounted for most of these costs, decreased primarily because of lower overall interest rates on new debt issued as part of the Refinancing (described below), partly offset by additional interest expense as a result of the exchange of the 12-3/4% Exchangeable Preferred Stock for the 12-3/4% Junior Subordinated Debentures. The tax provision for 1993 was $36 million despite a pre-tax loss of $81 million, whereas in 1992 the tax provision was $5 million on a pre-tax loss from continuing operations of $52 million. The 1993 provision reflected taxes payable on profitable foreign operations and was higher than in 1992 primarily because no tax benefits were available on domestic losses. The unusual relationship between the pre-tax losses and the tax provision is explained by the nondeductibility for tax purposes of the amortization of goodwill and other purchase accounting adjustments and the share allocations made by the Company's ESOP as well as by tax rate differences and withholding taxes on foreign earnings. As a result of the Refinancing in 1993 there was an extraordinary charge of $92 million related to the debt retired (including call premiums, the write-off of deferred debt issuance costs, and loss on cancellation of foreign currency swap contracts) on which there was no tax benefit. Liquidity and Capital Resources As a result of the Acquisition the Company's capital structure became highly leveraged. Net cash flow from operations, after cash interest expense of $195 million, was $201 million for the year ended December 31, 1993. Utilizing this cash flow and cash on hand at December 31, 1992, the Company devoted $98 million to capital expenditures, including $8 million of investments in affiliated companies, and repaid $50 million of term loans. In July 1993 the Company completed a refinancing (the "Refinancing") that included (a) the issuance of $200 million principal amount of 9-7/8% Senior Subordinated Notes Due 2001; (b) the issuance of approximately $751 million principal amount of 10-1/2% Senior Subordinated Discount Debentures Due 2005, which yielded proceeds of approximately $450 million; (c) the amendment and restatement of the Company's 1988 Credit Agreement (the "1988 Credit Agreement" and as so amended and restated, the "Credit Agreement") to establish a $1 billion secured, multi-currency, multi-borrower credit facility; and (d) the application of the proceeds of such issuances and such borrowings as follows: (i) the redemption on July 1, 1993, of all of the outstanding 12-7/8% Senior Subordinated Debentures Due 2000 at a redemption price of 104.83% ($571.3 million), (ii) the redemption on July 2, 1993, of a majority of the outstanding 14-1/4% Subordinated Discount Debentures Due 2003 at a redemption price of 105% ($389.5 million), (iii) the refunding of bank borrowings ($405 million of term loans and $77 million of other bank debt including revolving credit debt), (iv) the refunding of letters of credit ($58 million), and (v) payment of related fees and expenses. The Credit Agreement provided to American Standard Inc. and certain subsidiaries (the "Borrowers") a $1 billion facility as follows: (a) a $250 million multi-currency revolving credit facility (the "Revolving Credit Facility") available to all Borrowers, which expires in 2000; (b) a $225 million multi-currency periodic access facility (the "Periodic Access Facility") available to all Borrowers, which expires in 2000; and (c) three term loan facilities (the "Term Loans") consisting of a $225 million U.S. dollar facility available to American Standard Inc., which expires in 2000; a $200 million Deutschemark facility available to a German subsidiary, which expires in 1997; and a $100 million U.S. dollar facility available to all Borrowers, which expires in 1999. In August 1993 the Company repaid $50 million, and the amount available under the Credit Agreement by its terms was reduced to $950 million. The Company is required to reduce to $50 million the amount of borrowings outstanding under the Revolver for at least 30 consecutive days in each 12-month period ending May 31. In December 1993 the Company met this requirement for the 12 months ending May 31, 1994. Commencing August 31, 1994, the Revolver is reduced by $8.3 million annually, with a final maturity on June 1, 2000. In addition, the Company is required to repay the full amount of each of its outstanding revolving loans at the end of each interest period (a maximum of six months). The Company may, however, immediately reborrow such amounts subject to compliance with applicable conditions of the Credit Agreement. The Credit Agreement provides the Company with increased operating and financial flexibility, including the ability to shift from time to time a portion of borrowings among borrowers and currencies. As a result of the Refinancing there was a significant reduction in annual interest expense, which was partly offset by additional interest expense on the 12-3/4% Junior Subordinated Debentures exchanged for the 12-3/4% Exchangeable Preferred Stock. The Company believes that the amounts available from operating cash flows and under the Revolving Credit Facility will be sufficient to meet its expected cash needs, including planned capital expenditures. As described in Note 8 of Notes to Consolidated Financial Statements, the Credit Agreement contains various covenants that limit, among other things, indebtedness, dividends on and redemptions of capital stock of the Company, purchases and redemptions of other indebtedness of the Company (including its outstanding debentures and notes), rental expense, liens, capital expenditures, investments or acquisitions, disposal of assets, the use of proceeds from asset sales, and certain other business activities and require the Company to meet certain financial tests. In order to maintain compliance with the covenants and restrictions contained in the 1988 Credit Agreement, the Company from time to time has had to obtain waivers and amendments. In February 1994 the Company obtained an amendment to the Credit Agreement that among other things relaxed certain financial tests and convenants, and facilitated the investment in an air conditioning joint venture and the formation of a holding company to establish joint ventures in the People's Republic of China for the manufacture and sale of plumbing products. The Company currently believes it will comply with the amended financial tests and covenants but may have to obtain similar amendments or waivers in the future. On June 30, 1993, in exchange for all of the Company's outstanding shares of 12-3/4% Exchangeable Preferred Stock, the Company issued $141.8 million of 12-3/4% Junior Subordinated Debentures Due 2003 to the holder of the Exchangeable Preferred Stock. Those debentures were sold by the holder in a registered public offering in August 1993. The Company received none of the proceeds of this offering. The indentures related to the Company's debentures and notes contain various covenants which, among other things, limit debt and preferred stock of the Company and its subsidiaries, dividends on and redemption of capital stock of the Company and its subsidiaries, redemption of certain subordinated obligations of the Company, the use of proceeds from asset sales, and certain other business activities. In connection with examinations of the tax returns of the Company's German subsidiaries for the years 1984 through 1990, the German tax authorities have raised questions regarding the treatment of certain significant matters. The Company has paid approximately $20 million of a disputed German income tax. A suit is pending to obtain a refund of this tax. The Company anticipates that the German tax authorities may propose other adjustments resulting in additional taxes of approximately $105 million, plus penalties and interest for the tax return years under audit. In addition, significant transactions similar to those which gave rise to such possible adjustments occurred in years subsequent to 1990. The Company, on the basis of the opinion of legal counsel, believes the tax returns are substantially correct as filed and intends to vigorously contest any adjustments which have been or may be assessed. Accordingly, the Company had not recorded any loss contingency at December 31, 1993, with respect to such matters. Under German tax law the authorities may demand immediate payment of a tax assessment prior to final resolution of the issues. The Company also believes, on the basis of opinion of legal counsel, that it is highly likely that a suspension of payment will be obtained if additional taxes are assessed. However, if payment is required the Company expects that it will be able to meet such payment from available sources of liquidity or credit support but that future cash flows and capital expenditures, and therefore subsequent results of operations for any particular quarterly or annual period, could be adversely affected. Capital Expenditures The Company's capital expenditures for 1993 amounted to $98 million, including investments of $8 million in affiliated companies. The amount of capital expenditures was $10 million less than in 1992 ($6 million less excluding the effects of foreign exchange). Decreases in capital spending by Plumbing Products and Transportation Products were partly offset by an increase in spending by Air Conditioning Products. The Company believes capital spending was sufficient for maintenance purposes, for important product and process redesigns, for expansion projects, and for strategic investments. Capital expenditures by Air Conditioning Products were $38 million in 1993. This amount was 15% more than that of 1992. Capital expenditures in 1993 included continuing projects related to Demand Flow and spending on new products such as the Voyager III (medium-tonnage product line), the scroll compressor, and the Series R chiller line, expansion of Voyager I and Voyager II capacity and tooling and equipment for the American Standard product line. Plumbing Products' capital expenditures in 1993 were $46 million, including investments of $8 million in affiliated companies in France (Porcher) and the Czech Republic. Excluding the investments in affiliated companies and the effects of foreign exchange, capital spending was 34% higher than in 1992 as a result of spending increases in Europe and the Far East. Major projects included capacity expansion in Thailand and China and various projects related to Demand Flow implementation. Capital expenditures for Transportation Products totaled $14 million in 1993. Excluding the effects of foreign exchange, capital spending was 41% less than in 1992, a year with significant spending related to Demand Flow cost-reduction projects in production and material flow. 1992 Compared with 1991 U.S. housing starts increased by 18% in 1992 from the 1991 level, but non-residential contract awards decreased by 5%. Both of these economic indicators had declined in each of the previous four years. Consolidated sales for 1992 were $3.8 billion, an increase of 5% (4% excluding the favorable effects of foreign exchange) over the $3.6 billion for 1991. The 1991 amount included the sales of Tyler Refrigeration, which was sold September 30, 1991. Excluding Tyler Refrigeration, sales in 1992 were up 8% (7% excluding foreign exchange effects). Sales increases of 15% for Plumbing Products and 9% for Air Conditioning Products (excluding Tyler Refrigeration) were partly offset by a sales decline for Transportation Products of 1% (6% excluding the favorable effects of foreign exchange). Operating income for 1992 was $300 million, an increase of $58 million, or 24% (19% excluding the effects of foreign exchange), from $242 million in 1991. The 1991 amount included a loss for Tyler Refrigeration. Excluding Tyler Refrigeration, operating income in 1992 was up 15% (10% excluding foreign exchange effects.) Increases in operating income of 42% for Air Conditioning Products (excluding Tyler Refrigeration) and 64% for Plumbing Products were partly offset by a 27% decrease in operating income for Transportation Products. Except as otherwise indicated, the following discussion, including the financial comparisons, does not include the results of Tyler Refrigeration or the $22 million loss on the sale of Tyler Refrigeration in 1991. Air Conditioning Products Segment Sales of Air Conditioning Products, which accounted for approximately 50% of the Company's 1992 sales, increased by 9% to $1,892 million in 1992 from $1,737 million in 1991. There was a significant sales increase for each of the three operating groups -- for the Unitary Products Group in both residential and commercial products primarily because of higher volume and more favorable product mix (partly offset by lower prices), for the Commercial Systems Group primarily because of higher volume and prices, and for the International Group principally because of increased volume in Europe and the Far East. Operating income of Air Conditioning Products increased year to year by 42% (with little effect from foreign exchange) to $104 million in 1992 from $73 million in 1991. The increase was attributable to the sales gains, the benefits of manufacturing improvements and restructuring and cost containment in the Unitary Products and Commercial Systems Groups, and the fact that in 1991 results of the Commercial Systems Group had been adversely affected by a 54-day work stoppage at its LaCrosse, Wisconsin, facility. The impact of these factors was partly offset by a margin decline for the International Group and costs related to the start-up of new facilities, sales offices, and distribution channels. Unitary Products Group Sales in 1992 of the Unitary Products Group, which accounted for approximately 41% of Air Conditioning Products sales, increased by 6% over the 1991 sales level. Commercial markets for unitary products were up 6% overall from the depressed 1991 markets, as a very strong commercial replacement market more than offset the effects of low new-construction activity. Sales of commercial unitary products increased by 7% overall, primarily as a result of higher volume (driven by the strong replacement market), a shift to higher-priced, higher-tonnage products, and a gain in market share for light commercial products. Residential markets were down 3.5%, as poor replacement activity, a result of an unseasonably cool summer, more than offset the 18% increase in new housing starts. Despite this poorer market, sales of residential products increased by 5% year over year, principally because of larger market share, improved furnace markets, and a partial shift in the market to more efficient products stimulated by Federal standards, offset partly by price degradation due to competitive pressures. As a result of these factors, together with benefits of manufacturing improvements, cost containment, and organizational restructuring which reduced the salaried workforce, the operating profit for Unitary Products in 1992 increased by 50% from the depressed level of 1991. Commercial Systems Group Sales of the Commercial Systems Group, which accounted for approximately 38% of Air Conditioning Products' sales, increased 9% primarily on volume increases in aftermarket replacement and parts sales, increased revenue from Company-owned sales offices (volume growth and acquisitions), and small price increases on most product lines. Other factors contributing to the increase were higher sales of large applied systems and the fact that in 1991 there was a 54-day work stoppage at the LaCrosse, Wisconsin, plant. These gains were partly offset by lower volume in Canada, which was adversely affected by recession. Operating income for Commercial Systems increased 129% in 1992 over the recession-affected and work-interrupted level of 1991. The increase was primarily the result of the volume and price gains, improvements in manufacturing efficiency, cost containment and restructuring, and the fact that 1991 included the adverse impact of the LaCrosse work stoppage. The effects of these factors were partly offset by slightly lower gross margins, as the price increases did not completely recover increases in material, labor and benefits costs. International Group Sales of Air Conditioning Products' International Group, which accounted for approximately 21% of Air Conditioning Products' 1992 sales, increased 15% from those of 1991 (10% excluding the favorable effect of foreign exchange). Most of the gain was from higher volumes in Mexico (two new sales offices resulted in expanded distribution and penetration), the Far East (especially Hong Kong and Singapore), the Middle East (markets were significantly stronger), and Europe (sales of new products and increased penetration despite declining markets). Markets were down in almost all European countries except Italy, with the largest drop in the U.K., offset partly by increased revenues from acquired service companies. Operating income for the International Group decreased by approximately 68% in 1992. The decline occurred in Europe, primarily because of the weak markets and lower prices, costs related to the start-up of new facilities and new distribution networks in the U.K. and France, costs related to the introduction of new products, start-up costs of a company in Spain acquired near the end of 1991, and foreign exchange transaction losses from currency fluctuations in the latter half of 1992. Income from the Far East and Latin America was essentially unchanged from the prior year, as volume gains were offset by increased costs related to expanded distribution channels, start-up of new joint ventures, and development of new and improved products to support present and future growth. Plumbing Products Segment Sales of Plumbing Products, which accounted for approximately 31% of the Company's 1992 sales, increased by 15% in 1992 (14% excluding the effects of foreign exchange) to $1,170 million from $1,018 million in 1991. The improvement resulted from sales increases of 9% (7% excluding the effects of foreign exchange) for the European Plumbing Products Group, 21% for the U.S. Plumbing Products Group, 4% for the Americas International Group (7% excluding foreign exchange), and 101% for the Far East Group (98% excluding foreign exchange). In 1992 operating income of Plumbing Products increased 64% (56% excluding the effects of foreign exchange) to $108 million from $66 million in 1991. The increase was attributable primarily to increased profitability for the European group on higher prices and volumes (especially in Italy and Germany) although improved results in the U.S., Americas International, and Far East groups contributed. European Plumbing Products Group Sales of the European group, which accounted for approximately 57% of Plumbing Products' sales for 1992, increased 9% in 1992 over 1991, 7% excluding the favorable effects of foreign exchange. The gain resulted primarily from price and volume increases, especially in Italy and Germany, offset partly by lower volume in France from declining demand and lower prices in the U.K. caused by a very poor market. In Italy sales were up 9%, with gains for most product lines in price, volume and market share. The gains in Germany were the result of higher volumes and prices for brass fittings and luxury chinaware. Operating income for the European group increased 28% (23% excluding the effects of foreign exchange) primarily from the price and volume gains in Italy and Germany and higher margins on German brass operations resulting from improved manufacturing processes and cost containment, offset partly by lower profitability in France because of decreased volume and in the U.K. because of the recession. A recession depressed operating results in Greece. U.S. Plumbing Products Group Sales of the U.S. group, which accounted for approximately 24% of total 1992 Plumbing Products sales, increased 21% in 1992. During 1992 the U.S. building industry continued to be severely affected by the low level of new construction, with non-residential construction down 5% from 1991 and with new residential construction recovering from the lowest levels since the mid-1940's (though up by 18%, it was still low in historical terms). The U.S. market for plumbing products was up an estimated 3% to 4%, with more than half the gain occurring in the replacement and remodeling markets, which accounts for about 60% of the total U.S. market. The growth of sales for the U.S. group was largely a result of the strength of retail business (which had a significant increase in volume and accounted for 20% of sales of the U.S. group in 1992) and increased export sales from the U.S., together with smaller gains resulting from price increases and higher wholesaler distribution sales. Sales of AMERICAST products more than doubled in 1992, and smaller volume gains were achieved for acrylic products, fixtures, and faucets. The operating loss for the U.S. group in 1992 was less than that of the prior year. The improvement was primarily due to price increases and secondarily to volume and margin gains (as a result of sourcing product from the Company's Latin American plants), offset partly by non-recurring costs related to implementation of improved manufacturing processes and the effects of a shift in overall sales mix from commercial and luxury to lower-margin products. Americas International and Far East Groups Combined sales of the Americas International and Far East Groups, which accounted for approximately 19% of total Plumbing Products sales, increased 26% in 1992 (28% excluding the effects of foreign exchange). The sales gain was due primarily to the consolidation in 1992 of a previously unconsolidated joint venture in Thailand and to a lesser extent to price and volume increases in Mexico and Korea and higher volumes in Brazil, offset partly by lower sales in Canada, which were adversely affected by severe recession. Combined operating income of the Americas International and Far East Groups in 1992 increased 134% over the 1991 level. Gains were realized in all operations except Canada and the Philippines, both of which were adversely affected by poor economies. The increase was primarily from price and volume gains in Mexico and Korea, higher volume and margins in Brazil, and higher volume in China. Transportation Products Segment Sales of Transportation Products, which accounted for 19% of the Company's 1992 sales, were $730 million, down 1% from $741 million in 1991 (6% excluding the effects of foreign exchange). The sales decrease was due primarily to a volume decline in Germany as a result of a significant decrease in truck and bus production. Volumes were also down in nearly all other European countries in which Transportation Products has operations except the U.K. There was also a decline in prices of electronic control products, primarily as a result of industry cost reductions. Operating income for Transportation Products in 1992 decreased 27% (32% excluding foreign exchange effects) to $88 million from $121 million in 1991, principally because of the lower sales and production volume, lower prices, and increased spending for product engineering. Plant employment was kept in line with reduced production levels, but the costs associated with these reductions also depressed 1992 operating income. Those effects were partly offset by the favorable effects of cost reductions and increases in efficiency achieved in manufacturing operations. Financial Review 1992 Compared with 1991 The Company's financing and corporate costs were $352 million and $330 million in 1992 and 1991, respectively. The principal causes of the increase were year-to-year effects of changes in foreign exchange transaction gains and losses, higher minority interest, and lower miscellaneous income. Interest expense and accretion expense on postretirement benefits, which accounted for most of these costs, also increased. The tax provision for 1992 was $5 million despite a pre-tax loss of $52 million, whereas in 1991 the tax provision was $23 million on a pre-tax loss from continuing operations of $88 million. The 1992 provision reflected taxes payable on profitable foreign operations offset partly by available domestic tax benefits. The 1992 provision was lower than in 1991 primarily because of lower pre-tax earnings in foreign operations. In 1992 the provision was also lower because of future income tax benefits resulting from carrybacks of foreign net operating losses and the existence of deferred tax credits which reverse in the carryforward period applicable to other foreign net operating losses. The unusual relationship between the pre-tax losses and the tax provision is explained by the nondeductibility for tax purposes of the amortization of goodwill and other purchase accounting adjustments and the share allocations made by the Company's ESOP as well as by tax rate differences and withholding taxes on foreign earnings. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA RESPONSIBILITY FOR FINANCIAL STATEMENTS The accompanying consolidated balance sheets at December 31, 1993 and 1992, and related consolidated statements of operations, stockholder's equity (deficit), and cash flows for the years ended December 31, 1993, 1992 and 1991, have been prepared in conformity with generally accepted accounting principles, and the Company believes the statements set forth a fair presentation of financial condition and results of operations. The Company believes that the accounting systems and related controls that it maintains are sufficient to provide reasonable assurance that the financial records are reliable for preparing financial statements and maintaining accountability for assets. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control must be related to the benefits derived and that the balancing of those factors requires estimates and judgment. Reporting on the financial affairs of the Company is the responsibility of its principal officers, subject to audit by independent auditors, who are engaged to express an opinion on the Company's financial statements. The Board of Directors has an Audit Committee of non-employee Directors which meets periodically with the Company's financial officers, internal auditors, and the independent auditors and monitors the accounting affairs of the Company. American Standard Inc. New York, New York March 14, 1994 REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors American Standard Inc. We have audited the accompanying consolidated balance sheets of American Standard Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity (deficit), and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Standard Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /s/Ernst & Young Ernst & Young New York, New York March 14, 1994 AMERICAN STANDARD INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (Dollars in thousands) Year Ended December 31, 1993 1992 1991 Sales $3,830,462 $3,791,929 $3,595,267 Costs and expenses Cost of sales 2,902,562 2,852,230 2,752,068 Selling and administrative expenses 692,229 678,742 614,259 Other expense 38,281 24,672 8,082 Interest expense (includes debt issuance cost amortization of $11,461 for 1993, $5,983 for 1992 and $5,335 for 1991) 277,860 288,851 286,316 Loss on sale of Tyler Refrigeration - - 22,391 3,910,932 3,844,495 3,683,116 Loss before income taxes, extra- ordinary loss and cumulative effects of changes in accounting methods (80,470) (52,566) (87,849) Income taxes 36,165 4,672 23,033 Loss before extraordinary loss and cumulative effects of changes in accounting methods (116,635) (57,238) (110,882) Extraordinary loss on retirement of debt (Note 8) (91,932) - - Cumulative effects of changes in accounting methods (Notes 2 and 3) - - (32,291) Net loss (208,567) (57,238) (143,173) Preferred dividend (8,624) (15,707) (13,855) Net loss applicable to common shares $ (217,191) $ (72,945) $ (157,028) ========== ========== ========== See notes to consolidated financial statements. AMERICAN STANDARD INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars in thousands) ASSETS At December 31, 1993 1992 Current assets Cash and certificates of deposit $ 53,237 $ 111,549 Cash in escrow 932 1,722 Accounts receivable, less allowance for doubtful accounts-- 1993, $15,666; 1992, $12,827 507,322 468,731 Inventories 325,819 384,857 Future income tax benefits 24,562 33,192 Other current assets 29,811 31,199 Total current assets 941,683 1,031,250 Facilities, at cost net of accumulated depreciation 820,523 832,811 Other assets Goodwill, net of accumulated amortization -- 1993, $169,879; 1992 $141,858 1,025,774 1,101,716 Debt issuance costs, net of accumulated amortization-- 1993 $9,670; 1992, $77,776 78,102 51,308 Prepaid ESOP expense 4,331 9,527 Other 120,997 109,333 $2,991,410 $3,135,945 ========== ========== LIABILITIES AND STOCKHOLDER'S DEFICIT Current liabilities Loans payable to banks $ 38,036 $ 99,150 Current maturities of long-term debt 105,939 13,458 Accounts payable 307,326 271,855 Accrued payrolls 99,758 105,400 Other accrued liabilities 258,322 225,335 Taxes on income 47,003 18,848 Total current liabilities 856,384 734,046 Long-term debt 2,191,737 2,032,064 Other long-term liabilities Reserve for postretirement benefits 387,038 368,868 Deferred tax liabilities 45,625 73,307 Other 204,170 212,383 Total liabilities 3,684,954 3,420,668 Commitments and contingencies Exchangeable preferred stock - 133,176 Stockholder's deficit Preferred stock, Series A, 1,000 shares issued and outstanding, par value $.01 - - Common stock, 1,000 shares issued and outstanding, par value $.01 - - Capital surplus 211,333 210,409 Accumulated deficit (750,003) (541,436) Foreign currency translation effects (149,220) (86,872) Minimum pension liability adjustment ( 5,654) - Total stockholder's deficit (693,544) (417,899) $2,991,410 $3,135,945 ========== ========== See notes to consolidated financial statements. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Basis of Presentation On March 17, 1988, American Standard Inc. and subsidiaries (the "Company") agreed to be acquired by an affiliate of Kelso & Company L.P. ("Kelso"), an investment banking firm that specializes in leveraged buyouts. On March 21, 1988, the Kelso affiliate commenced a tender offer (the "Tender Offer") for all of the Company's common stock at $78 per share in cash. On April 27, 1988, the Kelso affiliate completed the Tender Offer with the purchase of approximately 95% of the Company's shares. Pursuant to an Agreement and Plan of Merger, a merger was consummated (the "Merger") on June 29, 1988, whereby the Company became a wholly owned subsidiary of ASI Holding Corporation, a Delaware corporation ("Holding") organized by Kelso to participate in the acquisition of the Company. At that time the remaining shares of the Company's common stock were converted into the right to receive cash of $78 per share. The Tender Offer, Merger, and related transactions are hereinafter referred to as the "Acquisition." For financial statement purposes the Acquisition has been accounted for under the purchase method. Note 2. Accounting Policies Consolidation The financial statements include on a consolidated basis the results of all majority-owned subsidiaries. All material intercompany transactions are eliminated. Investments in affiliated companies are included at cost plus the Company's equity in their net results. Translation of Foreign Financial Statements Assets and liabilities of most foreign operations are translated at year-end rates of exchange, and the income statements are translated at the average rates of exchange for the period. Gains or losses resulting from translating foreign currency financial statements are accumulated in a separate component of stockholder's equity until the entity is sold or substantially liquidated. Gains or losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity's local currency) are included in net income. For operations in countries that have high rates of inflation, net income includes gains and losses from translating assets and liabilities at year-end rates of exchange, except for inventories and facilities, which are translated at historical rates. Revenue Recognition Sales are recorded when shipment to a customer occurs. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Statement of Cash Flows Cash and certificates of deposit include all highly liquid investments with an original maturity of three months or less. Inventories Inventory costs are determined by the use of the last-in, first-out (LIFO) method on a worldwide basis, and inventories are stated at the lower of such cost or realizable value. Facilities The Company capitalizes costs, including interest during construction, of fixed asset additions, improvements, and betterments that add to productive capacity or extend the asset life. Maintenance and repair expenditures are charged against income. Significant foreign investment grants are amortized into income over the period of benefit. Goodwill Goodwill is being amortized over 40 years. Debt Issuance Costs The costs related to the issuance of debt are amortized using the interest method over the lives of the related debt. Warranties The Company provides for estimated warranty costs at the time of sale. Warranty obligations beyond one year are included in other long-term liabilities. The Company changed its method of accounting for revenues from extended warranty contracts at the beginning of 1991 to conform with the FASB Technical Bulletin, "Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts." The bulletin requires the deferral of the revenue from the sales of such contracts and amortization thereof on a straight-line basis over the terms of the contracts. The cumulative effect of this accounting change for all contracts in place as of December 31, 1990, increased the net loss in 1991 by $7 million, net of income tax benefit. The effect on the 1991 net loss, excluding the cumulative effect upon adoption, was not material. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Leases The asset values of capitalized leases are included with facilities, and the associated liabilities are included with long-term debt. Postretirement Benefits Postretirement benefits are provided for substantially all employees of the Company, both in the United States and abroad. In the United States the Company also provides various postretirement health care and life insurance benefits for some of its employees. Effective January 1, 1991, such costs are calculated in accordance with Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"). Depreciation Depreciation and amortization are computed on the straight-line method based on the estimated useful life of the asset or asset group. Research and Development Expenses Research and development costs are expensed as incurred except for costs incurred (after technological feasibility is established) for computer software products expected to be sold. The Company expensed costs of approximately $41 million in 1993, $40 million in 1992, and $36 million in 1991 for research activities and product development. Computer software product development costs capitalized in 1993 amounted to $2 million. Income Taxes In 1991 the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"), and elected to apply the provisions retroactively to January 1, 1989. The Company recognizes deferred tax assets for the tax effects of items that will be deducted for tax purposes in later years together with the tax effects of income items included in current reporting for tax purposes but in later years for financial statement purposes and the effects of certain tax attributes such as net operating losses. The Company provides for United States income taxes and foreign withholding taxes on foreign earnings expected to be repatriated. Deferred tax liabilities are provided on the excess of the financial statement basis over the tax basis of certain assets, primarily for inventories and fixed assets, including fair value adjustments resulting from purchase accounting in connection with the Acquisition; fixed assets due to accelerated depreciation deductions for tax purposes; and non-permanent investments in certain foreign subsidiaries. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Financial Instruments with Off-Balance-Sheet Risk The Company from time to time enters into foreign currency exchange agreements in the management of foreign currency exposure. Gains and losses from exchange rate changes are included in income unless the contract hedges a net investment in a foreign entity or a firm commitment, in which case gains and losses are deferred as a component of foreign currency translation effects in stockholder's equity or included as a component of the transaction. Note 3. Postretirement Benefits The Company sponsors postretirement benefit plans covering substantially all employees, including an Employee Stock Ownership Plan (the "ESOP") for the Company's U.S. salaried employees and certain U.S. hourly employees. In 1988 in conjunction with the Acquisition the ESOP purchased 5,000,000 shares (adjusted for a 100-for-1 stock split) of common stock of Holding. The ESOP is an individual account, defined contribution plan. The valuation of the ESOP shares is determined by independent appraisals. The common stock acquired by the ESOP is being allocated to the accounts of eligible employees over a period not exceeding eight plan years, including basic allocation of 3% of covered compensation and a matching Company contribution of up to 6% of covered compensation invested in the Company's savings plan by employees. Pension plan benefits are generally based on years of service and employees' compensation during the last years of employment. In the United States the Company also provides various postretirement health care and life insurance benefits for some of its employees. Funding decisions are based upon the tax and statutory considerations in each country. Accretion expense is the implicit interest cost associated with amounts accrued and not funded and is included in "other expense". At December 31, 1993, funded plan assets related to pensions were held primarily in fixed income and equity funds. Postretirement health and life insurance benefits are not prefunded. Effective January 1, 1991, the Company changed its method of accounting for postretirement benefits other than pensions to conform with FAS 106. The cumulative effect of this change increased the recorded obligation for such benefits by $40 million, thereby increasing the net loss in 1991 by $25 million (net of the related income tax benefit). The effect of the change on the 1991 net loss, excluding the cumulative effect upon adoption, was not material. The following table sets forth the Company's postretirement plans' funded status and amounts recognized in the balance sheet at December 31, 1993 and 1992. Total postretirement costs were: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Pension benefits $37.5 $35.4 $32.4 Health and life insurance benefits 17.8 16.7 15.2 Defined benefit plan cost 55.3 52.1 47.6 Defined contribution plan cost (a) 22.4 20.4 20.0 Total postretirement cost, including accretion expense $77.7 $72.5 $67.6 ===== ===== ===== (a) Principally ESOP cost. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 4. Other Expense Other income (expense) was as follows: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Interest income $ 8.5 $ 8.7 $ 8.3 Royalties 2.6 3.8 2.5 Equity in net income (loss) of affiliated companies (0.1) 4.9 10.2 Minority interest (14.0) (9.8) (3.1) Accretion expense (30.5) (29.8) (27.9) Other, net (4.8) (2.5) 1.9 $(38.3) $(24.7) $ (8.1) ====== ====== ====== The decrease in equity in net income of affiliated companies and the increase in minority interest in 1993 and 1992 compared with 1991 were primarily the result of consolidation of the plumbing companies in Thailand, the People's Republic of China, and Incesa, previously unconsolidated joint ventures. Note 5. Income Taxes The Company's loss before income taxes, extraordinary loss, and cumulative effects of changes in accounting methods ("pre-tax income (loss)") and the applicable provision (benefit) for income taxes were: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Pre-tax income (loss): Domestic $ (223.2) $ (170.1) $(272.6) Foreign 142.7 117.5 184.8 Pre-tax loss $ (80.5) $ (52.6) $ (87.8) Provision (benefit) for income taxes: Current: Domestic $ 12.4 $ 5.1 $ 5.1 Foreign 43.0 63.0 71.3 55.4 68.1 76.4 Deferred: Domestic 1.1 (35.8) (52.4) Foreign (20.3) (27.6) (1.0) (19.2) (63.4) (53.4) Total provision $ 36.2 $ 4.7 $ 23.0 ======== ======== ======= AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A reconciliation between the actual income tax expense provided and the income tax benefit computed by applying the statutory federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the pre-tax loss is as follows: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Tax benefit at statutory rate $(28.2) $(17.9) $(29.9) Nondeductible goodwill charged to operations 10.4 10.5 10.6 Nondeductible goodwill related to operations sold - 25.1* Nondeductible ESOP allocations 6.1 4.9 4.6 Rate differences and withholding taxes related to foreign operations 9.0 1.4 4.7 Foreign exchange gains (7.0) (6.3) (2.1) State tax benefits (5.5) (3.3) (3.4) Other, net 8.7 5.5 5.6 Increase in valuation allowance 42.7 9.9 7.8 Total provision $ 36.2 $ 4.7 $ 23.0 ====== ====== ====== * Includes goodwill eliminated in the sale of Tyler Refrigeration. In addition to the valuation allowance increase of $42.7 million shown above, a valuation allowance of $32.1 million was provided for the entire amount of the tax benefit related to the extraordinary loss on retirement of debt (see Note 8 of Notes to Consolidated Financial Statements). The following table details the gross deferred liabilities and the gross deferred tax assets and the related valuation allowances. At December 31, 1993 1992 (dollars in millions) Deferred tax liabilities: Facilities (accelerated depreciation, capitalized interest and purchase accounting differences) $ 141.1 $ 154.1 Inventory (LIFO and purchase accounting differences) 18.5 30.3 Employee benefits 11.0 6.6 Foreign investments 50.1 48.8 Other 26.2 26.6 246.9 266.4 Deferred tax assets: Employee benefits (pensions and other postretirement benefits) 110.7 97.7 Warranties 37.4 30.0 Alternative minimum tax 19.4 21.8 Foreign tax credits and net operating losses 57.5 42.3 Reserves 58.7 45.1 Other 46.0 18.5 Valuation allowances (103.9) (29.1) 225.8 226.3 Net deferred tax liabilities $ 21.1 $ 40.1 ========= ======== AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deferred tax assets related to foreign tax credits, net operating loss carryforwards, and future tax deductions have been reduced by a valuation allowance since realization is dependent in part on the generation of future foreign source income as well as on income in the legal entity which gave rise to tax losses. Other deferred tax assets have not been reduced by valuation allowances because of carrybacks and existing deferred tax credits which reverse in the carryforward period. The foreign tax credits and net operating losses are available for utilization in future years. In some tax jurisdictions the carryforward period is limited to as little as five years; in others it is unlimited. As a result of the Acquisition (see Note 1) and the allocation of purchase accounting (principally goodwill) to foreign subsidiaries, the book basis in the net assets of the foreign subsidiaries exceeds the related U.S. tax basis in the subsidiaries' stock. Such investments are considered permanent in duration, and accordingly no deferred taxes have been provided on such differences, which are significant. It is impracticable because of the complex legal structure of the Company and the numerous tax jurisdictions in which the Company operates to determine such deferred taxes. Cash taxes paid were $41 million, $56 million, and $79 million in the years 1993, 1992, and 1991, respectively. In connection with examinations of the tax returns of the Company's German subsidiaries for the years 1984 through 1990, the German tax authorities have raised questions regarding the treatment of certain significant matters. The Company has paid approximately $20 million of a disputed German income tax. A suit is pending to obtain a refund of this tax. The Company anticipates that the German tax authorities may propose other adjustments resulting in additional taxes of approximately $105 million, plus penalties and interest for the tax return years under audit. In addition, significant transactions similar to those which gave rise to such possible adjustments occurred in years subsequent to 1990. The Company, on the basis of the opinion of legal counsel, believes the tax returns are substantially correct as filed and intends to vigorously contest any adjustments which have been or may be assessed. Accordingly, the Company had not recorded any loss contingency at December 31, 1993 with respect to such matters. Under German tax law the authorities may demand immediate payment of a tax assessment prior to final resolution of the issues. The Company also believes, on the basis of opinion of legal counsel, that it is highly likely that a suspension of payment will be obtained if additional taxes are assessed. However, if payment is required, the Company expects that it will be able to make such payment from available sources of liquidity or credit support but that future cash flows and capital expenditures and therefore subsequent results of operations for any particular quarterly or annual period could be adversely affected. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 6. Inventories The components of inventory are as follows: At December 31, 1993 1992 (Dollars in millions) Finished products $169.0 $200.6 Products in process 78.0 95.8 Raw materials 78.8 88.5 Inventory at cost $325.8 $384.9 ====== ====== The carrying cost of inventories reflects purchase accounting adjustments and therefore exceeds current cost. Note 7. Facilities The components of facilities, at cost, are as follows: At December 31, 1993 1992 (Dollars in millions) Land $ 66.2 $ 65.0 Buildings 314.6 310.2 Machinery and equipment 739.9 719.4 Improvements in progress 54.4 45.6 Gross facilities 1,175.1 1,140.2 Less: accumulated depreciation 354.6 307.4 Net facilities $ 820.5 $ 832.8 ======== ======== Note 8. Debt The 1993 Refinancing In July 1993 the Company completed a refinancing (the "Refinancing") that included (a) the issuance of $200 million principal amount of 9-7/8% Senior Subordinated Notes Due 2001; (b) the issuance of approximately $751 million principal amount of 10-1/2% Senior Subordinated Discount Debentures Due 2005, which yielded proceeds of approximately $450 million; (c) the amendment and restatement of the Company's 1988 Credit Agreement (the "1988 Credit Agreement" and as so amended and restated, the "Credit Agreement") to establish a $1 billion secured, multi-currency, multi-borrower credit facility; and (d) the application of the proceeds of such issuances and such borrowings as follows: (i) the redemption on July 1, 1993, of all of the outstanding 12-7/8% Senior Subordinated Debentures Due 2000 (the "12-7/8% Senior Subordinated Debentures") at a redemption price of 104.83% ($571.3 million), (ii) the redemption on July 2, 1993, of AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS a majority of the outstanding 14-1/4% Subordinated Discount Debentures Due 2003 (the "14-1/4% Subordinated Discount Debentures") at a redemption price of 105% ($389.5 million), (iii) the refunding of bank borrowings ($405 million of term loans and $77 million of other bank debt including revolving credit debt), (iv) the refunding of letters of credit ($58 million), and (v) payment of related fees and expenses. The Credit Agreement provided to American Standard Inc. and certain subsidiaries (the "Borrowers") a $1 billion facility as follows: (a) a $250 million multi-currency revolving credit facility (the "Revolving Credit Facility") available to all Borrowers, which expires in 2000; (b) a $225 million multi-currency periodic access facility (the "Periodic Access Facility") available to all Borrowers, which expires in 2000; and (c) three term loan facilities (the "Term Loans") consisting of a $225 million U.S. dollar facility ("Tranche A") available to American Standard Inc., which expires in 2000; a $200 million Deutschemark facility ("Tranche B") available to a German subsidiary, which expires in 1997; and a $100 million U.S. dollar facility ("Tranche C") available to all Borrowers, which expires in 1999. In August 1993 the Company repaid $50 million and the amount available under the Credit Agreement by its terms was reduced to $950 million. Borrowings under the Periodic Access Facility and the Term Loans generally bear interest at the London interbank offered rate ("LIBOR") plus 2-1/2% except for the $225 million U.S. dollar facility, which bears interest at LIBOR plus 3%, and the $200 million Deutschemark facility, which bears interest at LIBOR plus 2%. The Company pays a commitment fee of 0.5% per annum on the unused portion of the Revolving Credit Facility and a fee of 2.5% plus issuance fees for letters of credit. As a result of the Refinancing, results for the year ended December 31, 1993, included an extraordinary charge of $92 million related to the debt retired (including call premiums, the write-off of deferred debt issuance costs, and loss on cancellation of foreign currency swap contracts) on which there was no tax benefit (see Note 5). Short-term The Revolving Credit Facility (the "Revolver") provides for aggregate borrowings of up to $250 million for working capital purposes, of which up to $200 million may be used for the issuance of letters of credit and $40 million of which is available for same-day short-term borrowings ("Swingline Loans"). At December 31, 1993, there were $7 million of borrowings outstanding under the Revolver and $66 million of letters of credit. Availability under the Revolver at December 31, 1993, was $177 million. Average borrowings under this facility and under the revolving credit facility available under the previous 1988 Credit Agreement for 1993, 1992, and 1991 were $39 million, $14 million, and $44 million, respectively. The Revolver and the Swingline Loans bear interest at the prime rate plus 1-1/2% or LIBOR plus 2-1/2%. The Company is required to reduce to $50 million the amount of borrowings outstanding under the Revolver for at least 30 consecutive days in each 12-month period ending May 31. In December 1993 the Company met this requirement for the 12-month period ending May 31, 1994. Commencing August 31, 1994, the Revolver is reduced by $8.3 million annually, with a AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS final maturity on June 1, 2000. In addition, the Company is required to repay the full amount of each of its outstanding revolving loans at the end of each interest period (a maximum of six months). The Company may, however, immediately reborrow such amounts subject to compliance with applicable conditions of the Credit Agreement. Other short-term borrowings are available outside the United States under informal credit facilities and are typically a result of overdrafts. At December 31, 1993, the Company had $31 million of such foreign short-term debt outstanding at an average interest rate of 11% per annum. The Company also had an additional $50 million of unused foreign facilities. These facilities may be withdrawn by the banks at any time. Long-term Long-term debt was as follows: At December 31, 1993 1992 (Dollars in millions) Credit Agreement $ 689.9 $ - 1988 Credit Agreement - 402.3 9 1/4% sinking fund debentures, due in installments from 1997 to 2016 150.0 150.0 10 7/8% senior notes due 1999 150.0 150.0 11 3/8% senior debentures due 2004 250.0 250.0 9 7/8% senior subordinated notes due 2001 200.0 - 10 1/2% senior subordinated discount debentures (net of unamortized discount of $272.9 million in 1993) due in installments from 2003 to 2005 477.8 - 12 7/8% senior subordinated debentures - 545.0 14 1/4% subordinated discount debentures (net of unamortized discount of $36.3 million in 1992) due in installments from 2002 to 2003 175.0 509.5 Other long-term debt 63.1 53.3 12 3/4% junior subordinated debentures due in installments from 2001 to 2003 (Note 9) 141.8 - Foreign currency swap contracts - (14.6) 2,297.6 2,045.5 Less current maturities 105.9 13.4 $ 2,191.7 $ 2,032.1 ========= ========= The amounts of long-term debt maturing from 1995 through 1998 are: 1995-$126.3 million, 1996-$123.5 million, 1997 $121.2 million, 1998-$117.5 million. Interest costs capitalized as part of the cost of constructing facilities for the years ended December 31, 1993, 1992, and 1991, were $2.7 million, $3.1 million, and $3.6 million, respectively. Cash interest paid for those same years on all outstanding indebtedness amounted to $198 million, $210 million, and $224 million, respectively. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Credit Agreement loans, maturities, and effective weighted average interest rates in effect at December 31, 1993, were as follows: U.S. Dollar Equivalent (in millions) Periodic Access Facility, due in semi-annual installments from February 1994 to February 2000: British sterling loans at 7.85% $ 95.8 Deutschemark loans at 9.06% 49.4 Canadian dollar loans at 6.50% 20.2 French franc loans at 9.17% 18.5 Italian lira loans at 12.19% 8.7 Total Periodic Access loans 192.6 Term Loans: Tranche A U.S. dollar loans, due in semi-annual installments from August 1997 to February 2000 at 6.50% 225.0 Tranche B Deutschemark loans, due in semi-annual installments from February 1994 to February 1997 at 7.88% 172.3 Tranche C U.S. dollar loans, due in semi-annual installments from February 1994 to August 1999 at 6.01% 100.0 Total Term Loans 497.3 Total Credit Agreement long-term loans 689.9 Revolver loans at 7.5% 7.0 Total Credit Agreement loans $ 696.9 ======== Under the 1988 Credit Agreement the various term loans and effective weighted average interest rates in effect at December 31, 1992, were as follows: U.S. Dollar Equivalent (in millions) Deutschemark loans at 11.4% $249.8 Canadian dollar loans at 13.05% 152.5 Total $402.3 ====== The 9-7/8% Senior Subordinated Notes may be redeemed at the Company's option, in whole or in part, on and after June 1, 1998, at redemption prices declining from 102.82% in 1998 to 100% on June 1, 2000, and thereafter. The 10-1/2% Senior Subordinated Discount Debentures may be redeemed at the Company's option, in whole or in part, on and after June 1, 1998, at redemption prices declining from 104.66% in 1998 to 100% on June 1, 2002, and thereafter. The payment of the principal and interest on the AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9-7/8% Senior Subordinated Notes and on the 10-1/2% Senior Subordinated Discount Debentures (together the "Senior Subordinated Debt") is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement and the 9-1/4% Sinking Fund Debentures, the 10-7/8% Senior Notes, and the 11-3/8% Senior Debentures (the said notes and debentures together the "Senior Securities"). The 9-1/4% Sinking Fund Debentures are redeemable at the Company's option, in whole or in part, at redemption prices declining from 105.55% in 1994 to 100% in 2006 and thereafter. The 10-7/8% Senior Notes are not redeemable by the Company. The 11-3/8% Senior Debentures are redeemable at the option of the Company, in whole or in part, on or after May 15, 1997, at redemption prices declining from 105.69% in 1997 to 100% on May 15, 2002, and thereafter. The 14-1/4% Subordinated Discount Debentures are redeemable at the Company's option, in whole or in part, at redemption prices of 105% prior to June 30, 1994, declining to 100% on and after June 30, 1995. The payment of the principal and interest on the 14-1/4% Subordinated Discount Debentures issued by the Company in 1988 is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement, the Senior Securities, and the Senior Subordinated Debt. The 14-1/4% Subordinated Discount Debentures rank senior to the 12-3/4% Junior Subordinated Debentures (described below). The 12-3/4% Junior Subordinated Debentures may be redeemed, at the Company's option, in whole or in part at a redemption price of 101.8% prior to June 30, 1994, and at 100% thereafter. The payment of principal and interest on the 12-3/4% Junior Subordinated Debentures is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement, the Senior Securities, the Senior Subordinated Debt, and the 14-1/4% Subordinated Discount Debentures. Obligations under the Credit Agreement are guaranteed by ASI Holding Corporation (the Company's parent), the Company, and significant domestic subsidiaries of the Company (with foreign borrowings also guaranteed by certain foreign subsidiaries) and are secured by U.S., Canadian, and U.K. properties, plant, and equipment; by liens on receivables, inventories, intellectual property, and other intangibles; and by a pledge of the Company's stock and nearly all shares of subsidiary stock. In addition, the obligations of the Company under the Senior Securities are secured, to the extent required by the related indentures, by mortgages on the principal U.S. properties of the Company equally and ratably with the indebtedness under the Credit Agreement and certain related indebtedness. The Senior Subordinated Debt, the 14-1/4% Subordinated Discount Debentures, and the 12-3/4% Junior Subordinated Debentures are unsecured. The Credit Agreement contains various covenants that limit, among other things, indebtedness, dividends on and redemption of capital stock of the Company, purchases and redemptions of other indebtedness of the Company (including its outstanding debentures and notes), rental expense, liens, capital expenditures, investments or acquisitions, disposal of assets, the AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS use of proceeds from asset sales, and certain other business activities and require the Company to meet certain financial tests. In order to maintain compliance with the covenants and restrictions contained in the 1988 Credit Agreement, the Company from time to time has had to obtain waivers and amend- ments. In February 1994 the Company obtained an amendment to the Credit Agreement that among other things relaxed certain financial tests and covenants and facilitated the investment in an air conditioning joint venture and the formation of a holding company to establish joint ventures in the People's Republic of China for the manufacture and sale of plumbing products. The Company currently believes it will comply with the amended financial tests and covenants but may have to obtain similar waivers or amendments in the future. The indentures related to the Company's debentures and notes contain various covenants which, among other things, limit debt and preferred stock of the Company and its subsidiaries, dividends on and redemption of capital stock of the Company and its subsidiaries, redemption of certain subordinated obligations of the Company, the use of proceeds from asset sales, and certain other business activities. Note 9. Exchange of Exchangeable Preferred Stock On June 30, 1993, in exchange for all of the Company's outstanding shares of 12-3/4% Exchangeable Preferred Stock, the Company issued $141.8 million of 12-3/4% Junior Subordinated Debentures Due 2003 to the holder of the Exchangeable Preferred Stock. Those debentures were sold by the holder in a registered public offering in August 1993. The Company received none of the proceeds of this offering. Note 10. Foreign Currency Translation Assets and liabilities of most foreign operations are translated at year-end rates of exchange, and the resulting gains or losses, net of income tax effects, are accumulated in a separate component of stockholder's equity. Changes in exchange rates which gave rise to significant translation effects included in stockholder's equity for the years ended December 31, 1993, 1992, and 1991, are summarized in the accompanying table. Change in End of Period Exchange Rate Currency 1993 1992 1991 British sterling (2)% (19)% (3)% Canadian dollar (4) ( 9) - French franc (6) (6) (2) Deutschemark (7) (6) (1) Italian lira (14) (22) (2) ===== ===== ===== Translation loss included in stockholder's equity, net of tax (dollars in millions) $ (62.3) $ (36.2) $ (2.1) ====== ====== ===== AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The allocation of purchase costs increased the net asset exposure of foreign operations; however, since June 29, 1988, the date of the Merger, the effects of exchange volatility have been ameliorated by the fact that a portion of the Company's borrowings has been denominated in foreign currencies. The losses from foreign currency transactions and translation from operations in countries with high inflation rates reflected in expense were $21.9 million in 1993, $19.3 million in 1992, and $14.4 million in 1991. Note 11. Fair Values of Financial Instruments Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Values of Financial Instruments" ("FAS 107"), requires disclosure information about all financial instruments of a company except certain excluded instruments and instruments for which it is not practicable to estimate fair value. The fair values presented below are estimates as of December 31, 1993, and are not necessarily indicative of amounts the Company could realize or settle currently or indicative of the intent or ability of the Company to dispose of or liquidate such instruments. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and certificates of deposit: The carrying amount reported in the balance sheet for cash and certificates of deposit approximates its fair value. Long- and short-term debt: The fair values of the Company's Credit Agreement loans are estimated using indicative market quotes obtained from a major bank. The fair values of senior notes, senior debentures, senior subordinated notes, senior subordinated discount debentures, subordinated discount debentures, the sinking fund debentures, and the junior subordinated debentures are based on indicative market quotes obtained from a major securities dealer. The fair values of other loans approximate their carrying value. The carrying amounts and estimated fair values of selected financial instruments at December 31, 1993 are as follows: (dollars in millions) Carrying Fair Amount Value Credit Agreement loans $ 697 $ 679 10 7/8% senior notes 150 163 11 3/8% senior debentures 250 276 9 7/8% senior subordinated notes 200 208 10 1/2% senior subordinated discount debentures 478 505 14 1/4% subordinated discount debentures 175 184 9 1/4% sinking fund debentures 150 152 12-3/4% junior subordinated debentures 142 143 Other loans 63 63 AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 12. Related Party Transactions The Company received non-cash capital contributions from Holding in the form of shares of common stock awarded to employees under various stock compensation plans totalling $5.3 million, $3.8 million, and $7.1 million in 1993, 1992 and 1991 respectively. The Company has agreed to pay Kelso an annual fee of $2.75 million for providing management consulting and advisory services. In June 1993 the Company issued 1,000 shares of a new, non-voting Series A Preferred Stock, par value $.01 per share, for $10,000 to an affiliate of Kelso & Company. The Company is committed to contribute $5 million of capital to a Kelso limited partnership. In addition, Tyler Refrigeration was sold to an affiliate of Kelso in 1991. Note 13. Leases The cumulative minimum rental commitments under the terms of all noncancellable operating leases in effect at December 31, 1993, were $108 million. Net rental expenses for operating leases were $34 million, $32 million, and $28 million for the years ended December 31, 1993, 1992, and 1991, respectively. Note 14. Commitments and Contingencies The Company and certain of its subsidiaries are parties to a number of pending legal and tax proceedings. The Company is also subject to federal, state and local environmental laws and regulations and is involved in environmental proceedings concerning the investigation and remediation of numerous sites. In those instances where it is probable that the Company will incur costs from such proceedings and the amounts can be reasonably determined the Company has recorded a liability. The Company believes that these legal, tax, and environmental proceedings will not have a material adverse effect on its consolidated financial position, cash flows, or results of operations. The tax returns of the Company's German subsidiaries are currently under examination by the German tax authorities (see Note 5). Note 15. Segment Data Sales and operating income by geographic location for the years ended December 31, 1993, 1992, and 1991, are shown on the following page. Identifiable assets are also shown as at years ended 1993, 1992, and 1991. See "Business" for a description of each business segment and "Management's Discussion and Analysis of Financial Condition and Results of Operations" for capital expenditures and depreciation and amortization. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS QUARTERLY DATA (Unaudited) (Dollars in millions) First Second Third Fourth Sales $879.4 $995.5 $976.5 $979.1 Cost of sales 650.5 754.5 727.7 769.9 Income (loss) before income taxes and extraordinary loss (9.5) (28.2) 4.1 (46.9) Tax provision 8.1 6.1 7.2 14.8 Loss before extraordinary loss (17.6) (34.3) (3.1) (61.7) Extraordinary loss (Note 8) - (91.9) - - Net loss $(17.6) $(126.2) $ (3.1) $(61.7) ====== ======= ====== ====== First Second Third Fourth Sales $901.0 $995.9 $980.9 $914.1 Cost of sales 672.0 734.1 742.2 703.9 Income (loss) before income taxes (8.1) 11.4 (16.5) (39.3) Tax provision (benefit) 5.5 9.2 (1.5) (8.5) Net income (loss) $(13.6) $ 2.2 $(15.0) $(30.8) ====== ======= ====== ====== ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCING DISCLOSURE. Not applicable. MANAGEMENT ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth certain information as of March 31, 1994, with respect to each person who is an executive officer or director of the Company: Name Age Position with Company Emmanuel A. Kampouris 59 Chairman, President and Chief Executive Officer, and Director Horst Hinrichs 61 Senior Vice President, Transportation Products, and Director George H. Kerckhove 56 Senior Vice President, Plumbing Products, and Director Fred A. Allardyce 52 Vice President and Chief Financial Officer Alexander A. Apostolopoulos 51 Vice President and Group Executive, Americas, Plumbing Products Thomas S. Battaglia 51 Vice President and Treasurer Roberto Canizares M. 44 Vice President, Air Conditioning Products' Asia/America Zone Wilfried Delker 53 Vice President and Group Executive, Worldwide Fittings, Plumbing Products Adrian B. Deshotel 48 Vice President, Human Resources Cyril Gallimore 65 Vice President, Systems and Technology Luigi Gandini 55 Vice President and Group Executive, European Plumbing Products Daniel Hilger 53 Vice President and Group Executive, Air Conditioning Products in Europe, Middle East and Africa Joachim D. Huwendiek 63 Vice President, Automotive Products in Germany Name Age Position with Company Frederick W. Jaqua 72 Vice President and General Counsel and Secretary W. Craig Kissel 42 Vice President and Group Executive, Unitary Products Group William A. Klug 62 Vice President, Trane International Philippe Lamothe 57 Vice President, Automotive Products in France G. Eric Nutter 58 Vice President, Automotive Products in the United Kingdom Raymond D. Pipes 44 Vice President and Group Executive, Plumbing Products in the Far East Bruce R. Schiller 49 Vice President and Group Executive, Compressor Business James H. Schultz 45 Vice President and Group Executive, Commercial Systems Group G. Ronald Simon 52 Vice President and Controller Wade W. Smith 43 Vice President, U.S. Plumbing Products Benson I. Stein 56 Vice President, General Auditor Robert M. Wellbrock 47 Vice President, Taxes Shigeru Mizushima 50 Director Roger W. Parsons 52 Director Frank T. Nickell 46 Director J. Danforth Quayle* 47 Director John Rutledge 45 Director Joseph S. Schuchert* 65 Director * The Management Development Committee functions as the compensation committee of the Company. Since December 2, 1993, its members have been Messrs. Quayle and Schuchert. Prior thereto Mr. Schuchert and two other directors who retired in December, Richard M. Cyert and Edward Donley, served as members of the committee. Directors are elected to hold office until the next annual meeting of stockholders or until their successors are elected. Messrs. Kampouris, Mizushima, Nickell, and Schuchert were elected in 1988; Mr. Kerckhove in September 1990; Mr. Hinrichs in March 1991; Dr. Rutledge in March 1993; Mr. Quayle in September 1993; and Mr. Parsons in March 1994. Holding, Kelso ASI Partners, L.P. (the 73 percent owner of Holding) ("ASI Partners"), and executive officers and certain other management personnel of the Company who purchased shares of Holding common stock ("Management Investors") entered into a Stockholders Agreement that, among other things, provides for arrangements regarding the control of the election of directors of Holding. Until the earlier of (i) the occurrence of a public offering pursuant to an effective registration statement under the Securities Act covering the offer and sale of Holding common stock to the public and underwritten by an investment banking firm of nationally recognized standing and (ii) July 7, 1998, the Management Investors as a group are entitled to nominate at least two directors to the Board of Directors of Holding, and ASI Partners is entitled to nominate the remaining directors. As a result, during such period ASI Partners will control the Board of Directors. To effectuate their rights, the Management Investors and ASI Partners have agreed in the Stockholders' Agreement to grant an irrevocable proxy to the Secretary of Holding to vote their shares of common stock in accordance with such nominations. Such grant of an irrevocable proxy terminates upon Holding's becoming subject to the proxy rules under the Securities Exchange Act of 1934. At present the Board of Directors of Holding consists of nine directors. The sole holder of the outstanding common stock of American Standard Inc. is Holding, and Holding exclusively elects the directors of American Standard Inc. Currently the directors of Holding are also the directors of American Standard Inc. Set forth below is the principal occupation of each of the executive officers and directors named above during the past five years (except as noted, all positions are with the Company). Mr. Kampouris was elected Chairman in December 1993 and President and Chief Executive Officer in February 1989. Prior thereto he was Senior Vice President, Building Products, from 1984 to February 1989. He is also a director of Daido Hoxan Inc. Mr. Kampouris has served as a director of the Company since July 1988. Mr. Hinrichs was elected Senior Vice President, Transportation Products, in December 1990. Prior thereto he served as Vice President and Group Executive, Automotive Products, from 1987 to 1990. Mr. Hinrichs has served as a director of the Company since March 1991. Mr. Kerckhove was elected Senior Vice President, Plumbing Products, in June 1990. Prior thereto he was Vice President (from 1985 until June 1990) and Group Executive (from 1988 until June 1990) of European Plumbing Products. Mr. Kerckhove has served as a director of the Company since September 1990. Mr. Allardyce was elected Vice President and Chief Financial Officer in January 1992. Prior thereto he served as Vice President and Controller from February 1983 until December 1991. Mr. Apostolopoulos was elected Vice President and Group Executive, Americas Plumbing Products, in December 1990. Prior thereto he served as the executive in charge of Plumbing Products' joint ventures from September 1989 to November 1990 and Managing Director of the Company's Egyptian subsidiary from July 1984 to August 1989. Mr. Battaglia was elected Vice President and Treasurer in September 1991. Prior thereto he was Assistant Treasurer. Mr. Canizares was elected Vice President, Air Conditioning Products' Asia/America Zone, in December 1990. Prior thereto he served as the executive in charge of this zone and Manager of Planning and Distribution from November 1986 to November 1990. Mr. Delker was elected Vice President and Group Executive, Worldwide Fittings, Plumbing Products, in April 1990. Prior thereto he served as executive in charge of the Company's brass fittings manufacturing operations from June 1982 until March 1990. Mr. Deshotel was elected Vice President, Human Resources, in January 1992. Prior thereto he served as Group Vice President, Human Resources, for U.S. Plumbing Products from September 1986 until December 1991. Mr. Gallimore was elected Vice President, Systems and Technology, in December 1990. Prior thereto he served as the executive in charge of Manufacturing and Technology from 1984 to November 1990. Mr. Gandini was elected Vice President and Group Executive, European Plumbing Products, in July 1990. Prior thereto he served as General Manager of Ideal Standard S.p.A., the Italian subsidiary of the Company, from January 1978 until June 1990. Mr. Hilger was elected Vice President and Group Executive, Air Conditioning Products, in Europe, Middle East and Africa, in June 1988. Mr. Huwendiek was elected Vice President, Automotive Products in Germany, in January 1992. Prior thereto he served as Managing Director of WABCO Germany since June 1987. Mr. Jaqua was elected Vice President and General Counsel and Secretary in April 1989. Prior thereto he was Associate General Counsel and Assistant Secretary. Mr. Kissel was elected Vice President in charge of Air Conditioning Products' Unitary Products Group in January 1992, becoming Group Executive in March 1994. He served as Vice President, Sales and Distribution, for Air Conditioning Products, from December 1990 until January 1992 and served as divisional Senior Vice President in charge of U.S. Sales from January to November 1990. He was in charge of Western Regional Sales from January 1989 to January 1990. Mr. Klug was elected Vice President in 1985 and has been in charge of Trane International since December 1993. He served as Group Executive, Unitary Products Group, from April 1990 until December 1993. He was Group Executive, North American Sales and Distribution, Air Conditioning Products, from October 1987 to March 1990. Mr. Lamothe was elected Vice President, Automotive Products in France, in January 1992. He served as Group Vice President of the French transportation business during 1991 and prior thereto was General Manager of the French transportation subsidiary. Mr. Nutter was elected Vice President, Automotive Products in the United Kingdom, in January 1992. Prior thereto he served as Vice President and General Manager of WABCO Transportation U.K. Limited, the United Kingdom transportation subsidiary of the Company from March 1991 until December 1991 and Group Managing Director of the United Kingdom transportation subsidiary from June 1987 until February 1991. Mr. Pipes was elected Vice President and Group Executive for the Far East Region of Plumbing Products in May 1992. Prior thereto he served as Managing Director of the Company's Philippine subsidiary from May 1990 until April 1992 and was Group Vice President, Control & Finance, of U.S. Plumbing Products from March 1985 until April 1990. Mr. Schiller was elected Vice President and Group Executive, Compressor Business (Air Conditioning Products) in March 1994. Prior thereto he served as General Manager, Compressor Business Group, from May 1993 to February 1994 and Manager and then General Manager of the Company's Tyler, Texas, facility from March 1986 to April 1993. Mr. Schultz was elected Vice President and Group Executive, Commercial Systems, in 1987. Mr. Simon was elected Vice President and Controller in January 1992. Prior thereto he served as Vice President and Controller of the Air Conditioning Products' Commercial Systems Group from December 1984 to December 1991. Mr. Wade W. Smith was elected Vice President, U.S. Plumbing Products, in May 1992. Prior thereto he served as Group Vice President in charge of the Chinaware Business Unit of U.S. Plumbing Products from February 1992 until April 1992 and from April 1987 to February 1992 he was Vice President and General Manager of the Building Automation Systems Division of the Commercial Systems Group of Air Conditioning Products. Mr. Stein was elected Vice President, General Auditor, in March 1994; from December 1986 to February 1994 he was the Company's General Auditor. Mr. Wellbrock was elected Vice President, Taxes, effective January 1, 1994. Prior thereto he served as Director of Taxes from 1988 through 1993. Mr. Mizushima has been President and Chief Operating Officer of Daido Hoxan Inc. since the merger in April 1993 of Hoxan Corporation with Daido Sanso Company (a subsidiary of Air Products and Chemicals Inc.). Prior thereto Mr. Mizushima was President of Hoxan Corporation, a position he held since 1984. He is also a director of Daido Hoxan. Daido Hoxan Inc is the second largest supplier of industrial gases in Japan. One of its subsidiaries is a distributor of American-Standard plumbing products in Japan. Mr. Mizushima has served as a director of the Company since July 1988. Mr. Nickell has been President and a director of Kelso & Companies, Inc., since March 1989. Kelso & Companies, Inc. is the general partner of Kelso & Company, L.P. From 1984 to 1989 Mr. Nickell was a general partner of Kelso & Company, L.P. He is also a director of Club Car, Inc.; King Holding Corp; and Tyler Holdings Corporation. Mr. Nickell has served as a director of the Company since May 1988. Mr. Parsons is Managing Director of Rea Brothers Group PLC ("Rea Brothers Group"), which he joined in 1988 after a long banking career. Rea Brothers Group is a U.K. holding company of subsidiaries engaged in the investment banking business. He also holds directorships in several subsidiaries of Rea Brothers Group. Mr. Parsons was elected as a director of the Company on March 2, 1994. Mr. Quayle served as Vice President of the United States from January 1989 to January 1993. Since leaving that office Mr. Quayle has been associated with Circle Investors, Inc. (an investment planning and consulting firm), and FX Strategic Advisors, Inc. (an international trade consulting firm), both of which he serves as Chairman. He is a Director of Central Newspapers, Inc. Mr. Quayle has served as a director of the Company since September 1993. Dr. Rutledge has been Chairman of Rutledge & Company, Inc., a merchant banking firm, since January 1991. He is the founder and Chairman of Claremont Economics Institute, an economic research firm established in 1975. He is also a director of Earle M. Jorgensen & Company, Lazard Freres Funds, Medical Specialties Group, and Utendahl Capital Partners and is a special advisor to Kelso & Company. Dr. Rutledge has served as a director of the Company since March 1993. Mr. Schuchert has been Chairman, CEO, and a director of Kelso & Companies, Inc., since March 1989. Kelso & Companies, Inc. is the general partner of Kelso & Company, L.P. From 1984 to 1989 Mr. Schuchert was managing general partner of Kelso & Company, L.P. He is also a director of Earle M. Jorgensen & Company. Mr. Schuchert has served as a director of the Company since May 1988. On December 23, 1992, Kelso & Company and its chief executive officer, Mr. Schuchert, without admitting or denying the findings contained therein, consented to an administrative order in respect of a Securities and Exchange Commission ("Commission") inquiry relating to the 1990 acquisition of a portfolio company by a Kelso affiliate. The order found that Kelso's tender offer filing in connection with the acquisition did not comply fully with the Commission's tender offer reporting requirements, and required Kelso and Mr. Schuchert to comply with these requirements in the future. Compensation Committee Interlocks and Insider Participation Mr. Schuchert is a member of the Management Development Committee (the Compensation Committee) of the Company's Board of Directors. He is Chairman of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.) and a general partner of American Standard Partners, the general partner of Kelso ASI Partners. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V") in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P., is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Supplemental Plan benefits are based on credited years of service and average annual compensation for the highest three calendar years of the final ten calendar years of employment (not exceeding 60 percent of average annual compensation for such years of service) and are reduced by an offset consisting of certain other retirement benefits, including amounts payable under the Terminated Plan, annual allocations to the executive officer's Employee Stock Ownership Plan ("ESOP") accounts, and Social Security benefits. Benefits under the Supplemental Plan are vested after five years of service or employment continuation through age 65. Compensation used in determining Supplemental Plan benefits (covered compensation) includes only salary and bonus reflected in the Summary Compensation Table above. No covered compensation of any Named Officer differs by more than 10% from the salary and bonus set forth in the Summary Compensation Table. The years of credited service under the Supplemental Plan for the Named Officers are as follows: Mr. Kampouris, 28 years; Mr. Hinrichs, 35 years; Mr. Kerckhove, 32 years; Mr. Allardyce, 17 years; Mr. Gandini, 33 years; and Mr. H.T. Smith, 13 years. The current annual target benefit for Mr. Kampouris is approximately 20 percent higher than that shown in the above table since a different benefit formula under the pre-1990 version of the Supplemental Plan applies to his period of service and earnings prior to April 27, 1991. The method of calculating the lump sum payable to Mr. Kampouris that is attributable to his accrued benefit through April 27, 1991, has been adjusted to reflect the recent increase in the Federal ordinary income tax rates. An amendment to the Supplemental Plan in 1993 established minimum annual lump sum payments for certain Named Officers which, after giving effect to Plan offsets, are estimated as follows: Mr. Kampouris, $427,000; Mr. Hinrichs, $143,000; Mr. Kerckhove, $37,000; and Mr. Gandini, $24,000. Shares of Holding Common Stock distributable to Plan participants are delivered to a grantor's trust for their benefit. The trust will terminate following a public offering of Holding Common Stock, at which time shares or cash credited to each participant's account is to be distributed. Payment, however, may be deferred if an event of default under the Company's loan agreements or debt indentures has occurred or will occur as a result of such payment. Until distribution, assets of the trust are subject to the claims of creditors of Holding or the Company. Shares held by the trust are voted by the trustee in accordance with the Company's directions. Directors' Fees and Other Arrangements In the first half of 1993 each outside director was paid a fee of $5,000 per calendar quarter and in addition received a fee of $500 for each meeting of the Board attended; in the last half each outside director was paid a fee of $6,750 per calendar quarter and in addition received a fee of $1,000 for each meeting of the Board attended. Effective with the third quarter, an outside director is also paid $1,000 for attending a Committee meeting. (Previously an outside director was paid $500 for attending a Committee meeting not held on the day of a Board meeting.) The only directors currently eligible for directors' fees are directors who are neither employees of the Company or Kelso. They are Messrs. Mizushima, Parsons, Quayle, and Rutledge. All directors are reimbursed for reasonable expenses incurred in connection with attendance at any meetings. No separate directors' fees are paid for attendance at meetings of Holding that are held on the same day the Company's Board meets. A Supplemental Compensation Plan for Outside Directors ("Supplemental Compensation Plan") was adopted in June 1989. A Plan Account was establish- ed for each participating director at that time consisting of units equivalent to $50,000 of Holding common stock with each unit having a value of $19 per share, the independently appraised value of the shares of Holding as of December 31, 1988. For the purpose of providing a measure of parity among the directors, the $50,000 amount was increased to $100,000 for participating directors who became Board Members after January 1, 1993, with such amount converted into units for the account of such directors at the rate of $42.96 per unit ($42.96 representing the independently appraised value of the shares of Holding as of December 31, 1992). When a participating director ceases to be a member of the Board, he or his beneficiary will receive a cash payment equal to the number of units in his Plan Account multiplied by the per-share value of Holding common stock based on the then last year-end appraisal. If a participating director is removed for cause, his entire interest in the Plan is forfeited. Employee-directors and Messrs. Nickell and Schuchert do not participate in this Plan. Mr. Donley and Dr. Cyert, directors who retired in December 1993, each received a payment of $113,053 pursuant to the Supplemental Compensation Plan. Corporate Officers Severance Plan and Other Employment or Severance Arrangements The Board of Directors approved a severance plan for executive officers (the "Officers Severance Plan"), effective April 27, 1991. The Officers Severance Plan provides that any participant whose employment is involuntarily terminated by the Company without "Cause" (as defined in the Officers Severance Plan) or who leaves the Company for "Good Reason" (as defined in the Officers Severance Plan) shall be paid an amount equal to the sum of two (three in the case of the Chief Executive Officer) times such participant's annual base salary at the rate in effect at the time of termination, a proration of the then Annual Incentive Plan target award (described previously), and one (two in the case of the Chief Executive Officer) times such target award. In addition, group life, accident, and disability insurance coverages, as well as group medical coverage, will be continued for up to 24 (36 in the case of the Chief Executive Officer) months following such officer's termination. The Named Officers (other than Mr. Smith, who retired in December 1993) are participants in this Plan. An agreement was entered into with H. Thompson Smith in December 1993 concerning the terms of his termination of employment and retirement. Under that agreement he is entitled to receive his 1993 Annual Incentive Plan award in the amount of $154,000 and will be entitled to receive the same amount in March 1995. In addition, Mr. Smith is retained as a consultant through 1995 at the rate of $29,583 per month. In the event of Mr. Smith's death, the fees remaining through the end of 1995 are payable in a lump sum to his spouse or estate. He is also entitled to receive payments under the Company's Long-Term Incentive Compensation Plan for the 1992-1994 and 1993-1995 performance periods in accordance with its terms, such awards to be prorated to December 31, 1993. Mr. Smith continues under the Company's medical and life insurance programs through 1995. ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of the common stock, $.01 par value, of American Standard Inc., the only voting stock of American Standard Inc., is owned by Holding. Set forth below is the number of shares of Common Stock, par value $.01 per share, of Holding, the only outstanding voting stock of Holding, beneficially owned as of March 10, 1994, by each Director and nominee, each Named Executive Officer, all Directors and executive officers of Holding as a group, and each 5% holder. Shares Percent Name and Address Beneficially of Title of Class of Beneficial Owner Owned Class Holding common stock, par value - Kelso ASI Partners, L.P.(a) 18,000,000 73% $.01 per share ("ASI Partners") Joseph S. Schuchert(a) 18,000,000(d) 73% (d) Frank T. Nickell(a) 18,000,000(d) 73% (d) George E. Matelich(a) 18,000,000(d) 73% (d) Thomas R. Wall IV(a) 18,000,000(d) 73% (d) Emmanuel A. Kampouris(b) 225,000 * George H. Kerckhove(b) 113,000 * Horst Hinrichs(b) 90,000 * Fred A. Allardyce(b) 113,000 * American-Standard Employee Stock Ownership Plan(c) 4,267,710 17% All current directors and executive officers of Holding and the Company as a group 18,824,900(e) 77% (e) * Less than one percent. (a) The business address for such persons is c/o Kelso & Company, 350 Park Avenue, New York, N.Y. 10022. (b) Mr. Kampouris is Chairman, President and Chief Executive Officer and a director of the Company and of Holding. Messrs. Hinrichs and Kerckhove are Named Officers and directors of the Company and of Holding, and Mr. Allardyce is a Named Officer of the Company and of Holding. (c) The business address for the ESOP is c/o American Standard Inc., 1114 Avenue of the Americas, New York, N.Y. 10036. At December 31, 1993, 3,548,609 Plan shares were allocated to executive officers of Holding and the Company and other ESOP participants. The number of shares shown for executive officers in the table above does not reflect shares allocated to their accounts in the ESOP. Shares in the ESOP account are voted by the ESOP trustee as directed by the plan board (the board administering the trust which currently consists of executive officers of the Company). However, participants may direct the vote of their ESOP account shares in matters involving mergers, recapitalizations, or dispositions of substantial assets. Until termination of employment a participant cannot dispose of shares in his ESOP account. Shares distributed to a participant on termination are subject to the Company's right of first refusal. The shares in the Named Officers ESOP accounts are as follows: Mr. Kampouris, 3,995 shares; Mr. Kerckhove, 3,953 shares; Mr. Hinrichs, 4,266 shares; Mr. Allardyce, 4,246 shares; and Mr. Gandini, 2,225 shares. The shares in the ESOP accounts for all executive officers total 69,218 shares. The number of shares shown for executive officers in the table above also does not reflect shares of Holding Common Stock issued as part of the payouts under the LTIP and held for them in trust under a trust agreement dated as of January 1, 1993. Shares in the trust are voted by the trustee as directed by the Company. Until termination of the trust, a beneficiary of the Trust cannot dispose of shares credited to his account. Shares in the Named Officers' accounts in the trust are as follows: Mr. Kampouris, 4,453 shares; Mr. Kerckhove, 2,012 shares; Mr. Hinrichs, 1,787 shares; Mr. Allardyce, 1,224 shares; and Mr. Gandini, 1,176 shares. The shares in the trust accounts for all executive officers total 28,620 shares. Also not included above are 19,198 shares of ASI Holding common stock held in a similar grantor's trust for the account of certain executive officers. These were earned by them under an employee incentive plan prior to their becoming officers. (d) Messrs. Schuchert and Nickell, each a director of the Company and of Holding, and Messrs. Matelich and Wall may be deemed to share beneficial ownership of shares owned of record by ASI Partners by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. Messrs. Schuchert, Nickell, Matelich and Wall share investment and voting power with respect to securities owned by ASI Partners. See "Certain Transactions and Relationships." Dr. Cyert, who was a director of Holding and the Company until December 1993, is a limited partner in one of the Kelso partnerships that has invested in ASI Partners. (e) Out of such 18,824,900 shares, 18,000,000 shares represent shares of Common Stock owned by ASI Partners in which Messrs. Schuchert and Nickell, each a director of Holding, may be deemed to share beneficial ownership by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. ITEM 13. CERTAIN TRANSACTIONS AND RELATIONSHIPS Messrs. Schuchert and Nickell, directors of Holding and the Company, are Chairman and President, respectively, of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.), and are general partners of American Standard Partners, the general partner of Kelso ASI Partners. Mr. Schuchert is also a member of the Management Development Committee (the compensation committee) of the Company's Board of Directors. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also has entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V"), in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P. is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Company will invest in a Cayman Islands corporation, A-S China Plumbing Products Limited ("ASPPL"), to be used for the establishment of various joint ventures in the People's Republic of China. The Company will have a 21% voting interest in ASPPL. Shares in ASPPL will also be sold in a private placement to certain institutions and other investors, including certain executive officers and employees of the Company and its subsidiaries. Mr. Mizushima, a director of the Company and of Holding, is President and Chief Operating Officer of Daido Hoxan Inc., a Japanese corporation which has an approximately 11 percent limited partnership interest in ASI Partners. Daido Hoxan Inc. is the largest distributor of the Company's plumbing products in Japan. Its transactions as distributor with the Company and its subsidiaries in 1992, which were on customary terms and in the ordinary course of business, were not material to either the Company or Daido Hoxan Inc. The Company also entered into leasing transactions with an affiliate of Daido Hoxan whereby it has leased certain machinery and equipment on financial terms that were comparable to those available from other leasing companies. The leasing transactions were not material to either the Company or Daido Hoxan Inc. Fidelity Management Trust Company ("Fidelity") is the owner of record of the shares of Holding held by the ESOP, a 17% owner of Holding shares. Fidelity was paid by the Company approximately $180,000 in 1993 for services in connection with administering the Company's ESOP and Savings Plan. Mr. Nickell's father is an officer and owns more than 10 percent of AC Corporation, a contracting company which purchases air conditioning products from the Company's Trane Division. Such purchases in 1993 were on customary terms and in the ordinary course of business and were not material to either the Company or AC Corporation. Management Investors Stockholders Agreement Under the Stockholders Agreement, pursuant to which Management Investors purchased shares of Holding common stock, Holding is obligated to repurchase, subject to the limitations contained in the Company's lending arrangements and debt instruments, such shares at certain fair market prices in case of the death, disability, retirement, or termination of employment of a Management Investor. Shares are paid for within the constraints of the Company's lending arrangement and debt instruments, as supplemented by a Schedule of Priorities established by Holding's Board of Directors. The Named Officers (other than Mr. Gandini) and most of the executive officers are Management Investors and parties to the Stockholders Agreement. PART IV ITEM 14. CONSOLIDATED EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1 and 2. Financial statements and financial statement schedules The financial statements and schedules listed in the accompanying index to financial statements are filed as part of this annual report on Form 10-K. 3. Exhibits The exhibits listed on the accompanying index to exhibits are filed as part of this annual report on Form 10-K. Included in the exhibits are the following management contracts or compensatory plan arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K American Standard Inc. Long-Term Incentive Compensation Plan, as amended Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan American Standard Inc. Annual Incentive Plan American Standard Inc. Management Partner's Bonus Plan with amendments American Standard Inc. Executive Supplemental Retirement Benefit Program American Standard Employee Stock Ownership Plan with amendments Estate Preservation Plan with amendments Corporate Officers Severance Plan American Standard Inc. Supplemental Compensation Plan for Outside Directors ASI Holding Corporation 1989 Stock Purchase Loan Program Summary of Terms of Unfunded Deferred Compensation Plan Letter of Agreement with respect to H. Thompson Smith's retirement and consulting services (b) Reports on Form 8-K for the quarter ended December 31, 1993. None 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. AMERICAN STANDARD INC. By /s/ Emmanuel A. Kampouris (Emmanuel A. Kampouris) (Chairman, President and Chief Executive Officer) March 30, 1994 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: /s/ Emmanuel A. Kampouris Director, Chairman and President March 30, 1994 (Emmanuel A. Kampouris) (Chief Executive Officer) /s/ Fred A. Allardyce Vice President and Chief March 30, 1994 (Fred A. Allardyce) Financial Officer /s/ G. Ronald Simon Vice President & Controller March 30, 1994 (G. Ronald Simon) (Principal Accounting Officer) /s/ Horst Hinrichs Director March 30, 1994 (Horst Hinrichs) /s/ George H. Kerckhove Director March 30, 1994 (George H. Kerckhove) /s/ Shigeru Mizushima Director March 30, 1994 (Shigeru Mizushima) /s/ Frank T. Nickell Director March 30, 1994 (Frank T. Nickell) /s/ J. Danforth Quayle Director March 30, 1994 (J. Danforth Quayle) /s/ Roger W. Parsons Director March 30, 1994 (Roger W. Parsons) /s/ Joseph S. Schuchert Director March 30, 1994 (Joseph S. Schuchert) /s/ John Rutledge Director March 30, 1994 (John Rutledge) AMERICAN STANDARD INC. AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14 (a)) Form 10-K (Pages) 1. Financial Statements Consolidated Balance Sheet at December 31, 1993 and 1992 42 Years ended December 31, 1993, 1992 and 1991, Consolidated Statement of Operations 41 Consolidated Statement of Stockholder's Equity (Deficit) 43 Consolidated Statement of Cash Flows 44-45 Notes to Consolidated Financial Statements 46-62 Segment Data 63 Segment data for capital expenditures, depreciation and amortization 23-29 Quarterly Data (Unaudited) 64 Report of Independent Auditors 40 2. Financial statement schedules, years ended December 31, 1993, 1992 and 1991: Report of Independent Auditors 84 V Facilities 85 VI Accumulated Depreciation of Facilities 86 VIII Reserves 87 IX Short-Term Borrowings 88 X Supplementary Income Statement Information 89 All other schedules have been omitted because the information is not applicable or is not material or because the information required is included in the financial statements or the notes thereto. Report of Independent Auditors Stockholders and Board of Directors American Standard Inc. We have audited the consolidated financial statements of American Standard Inc. as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated March 14, 1994 (included elsewhere in this Annual Report on Form-10K). Our audits also included the consolidated schedules listed in Item 14(a)2. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the consolidated schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be stated therein. /s/ Ernst & Young Ernst & Young March 14, 1994 AMERICAN STANDARD INC. INDEX TO EXHIBITS (Item 14(a)3 - Exhibits Required by Item 601 of Regulation S-K and Additional Exhibits) (The File Number of American Standard Inc., the Registrant, and for all Exhibits incorporated by reference is 1-470, except those Exhibits incorporated by reference in filings made by ASI Holding Corporation ("Holding") whose File Number is 33-23070) (3) (i) Restated Certificate of Incorporation of American Standard Inc. (the "Company"); previously filed as Exhibit (3)(i) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (ii) Certificate of Designation, Preferences and Relative, Participating, Optional and other Special Rights of Preferred Stock and Qualifications, Limitations and Restrictions thereof of Series A Preferred Stock. (iii) By-laws of the Company; previously filed as Exhibit (3)(ii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (4) (i) Indenture, dated as of November 1, 1986, between the Company and Manufacturers Hanover Trust Company, Trustee, including the form of 9-1/4% Sinking Fund Debenture Due 2016 issued pursuant thereto on December 9, 1986, in the aggregate principal amount of $150,000,000; previously filed as Exhibit (4)(iii) in the Company's Form l0-K for the fiscal year ended December 31, 1986, and herein incorporated by reference. (ii) Instrument of Resignation, Appointment and Acceptance, dated as of April 25, 1988 among the Company, Manufacturers Hanover Trust Company (the "Resigning Trustee") and Wilmington Trust Company (the "Successor Trustee"), relating to resignation of the Resigning Trustee and appointment of the Successor Trustee under the Indenture referred to in Exhibit (4)(i) above; previously filed as Exhibit 4(ii) in Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (iii) Form of Indenture, dated as of July 1, 1988, between the Company and Shawmut Bank Connecticut, National Association (formerly known as The Connecticut National Bank), as Trustee, relating to the Company's 14-1/4% Subordinated Discount Debentures due 2003; previously filed as Exhibit 4.3 in Amendment No. 2 to Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iv) Form of Debenture evidencing the 14-1/4% Subordinated Discount Debentures due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(iii) above. (v) Indenture dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 10-7/8% Senior Notes due 1999, in the aggregate principal amount of $150,000,000; previously filed as Exhibit (4)(i) in the Company's Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (vi) Form of 10-7/8% Senior Notes due 1999 included as Exhibit A to the Indenture described in (4)(v) above. (vii) Indenture dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 11-3/8% Senior Debentures due 2004, in the aggregate principal amount of $250,000,000; previously filed as Exhibit (4)(iii) in the Company's Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (viii) Form of 11-3/8% Senior Debentures due 2004 included as Exhibit A to the Indenture described in (4)(vii) above. (ix) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 9-7/8% Senior Subordinated Notes Due 2001; previously filed as Exhibit 4(xxxi) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Note evidencing the 9-7/8% Senior Subordinated Notes Due 2001 included as Exhibit A to the Form of Indenture referred to in 4(ix) above. INDEX TO EXHIBITS - (Continued) (xi) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 10-1/2% Senior Subordinated Discount Debentures Due 2005; previously filed as Exhibit (4)(xxxiii) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xii) Form of Debenture evidencing the 10-1/2% Senior Subordinated Discount Debentures Due 2005 included as Exhibit A to the Form of Indenture referred to in (4)(xi) above. (xiii) Form of Indenture, dated as of October 25, 1990, as amended and restated as of June 15, 1993, between the Company and Shawmut Bank, N.A., as Trustee, relating to Company's 12-3/4% Junior Subordinated Debentures Due 2003; previously filed as Exhibit (4)(xx) in Amendment No. 2 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xiv) Form of Indenture evidencing the 12-3/4% Junior Subordinated Debentures Due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(xiii) above. (xv) Assignment and Amendment Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company, Bankers Trust Company, as agent under the 1988 Credit Agreement, the financial institutions named as Lenders in the 1988 Credit Agreement and certain additional Lenders and Chemical Bank, as Administrative Agent and Arranger; previously filed as Exhibit (4)(xiii) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xvi) Credit Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company and the lending institutions listed therein, Chemical Bank, as Administrative Agent and Arranger; Bankers Trust Company, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A., Deutsche Bank AG, The Long-Term Credit Bank of Japan, Ltd., New York Branch, and NationsBank of North Carolina, N.A., as Managing Agents, and Banque Paribas, Citibank, N.A., and Compagnie Financiere de CIC et de l'Union Europeenne, New York Branch, as Co-Agents; previously filed as Exhibit (4)(xiv) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xvii) First Amendment, Consent and Waiver, dated as of February 10, 1994, to the Credit Agreement referred to in (4)(xvi) above. INDEX TO EXHIBITS - (Continued) (xviii) Stockholders Agreement, dated as of July 7, 1988, as amended as of August 1, 1988, among Holding, Kelso ASI Partners, L.P., and the Management Stockholders named therein; previously filed as Exhibit 4.19 in Amendment No. 2 in the Registration Statement No. 33-23070 of Holding under the Securities Act of 1933, as amended, and herein incorporated by reference. (xix) Amendment to Section 2.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of January 1, 1991; previously filed as Exhibit (4)(xxvii) by Holding in its Form 10-K for the year ended December 31, 1992, and herein incorporated by reference. (xx) Supplement and Amendment dated as of September 4, 1991 to the Stockholders Agreement, dated as of July 7, 1988, as amended, referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(ii) by Holding in its Form 10-Q for the quarter ended September 30, 1991, and herein incorporated by reference. (xxi) Amended Section 6.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of September 2, 1993; copy of amended Section is being filed as Exhibit (4)(xvii) by Holding in its Form l0-K for the year ended December 31, 1993, concurrently with the filing of the Company's Form 10-K for the same year, and herein incorporated by reference. (xxii) Revised Schedule of Priorities effective as of September 5, 1991, as adopted by the Board of Directors of Holding, pursuant to the Stockholders Agreement referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(iii) by Holding in its Form l0-Q for the quarter ended September 30, 1991 and herein incorporated by reference. (10) (i) Agreement and Plan of Merger, dated as of March 16, 1988, among the Company, ASI Acquisition Company and Holding and Offer Letter, dated March 16, 1988, between the Company and Kelso & Company, L.P.; previously filed as Exhibit 2 to the Company's Schedule 14D-9 filed March 21, 1988, in connection with the offer for all the shares of the Company's Common Stock by a corporation formed by Kelso & Company, L.P., and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ii) Amendment, dated June 3, 1988 to Agreement and Plan of Merger referred to in (l0)(i) above; previously filed as Exhibit 2.50 in Amendment No. 1 to the Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iii) American Standard Inc. Long-Term Incentive Compensation Plan, as amended through February 6, 1992; previously filed as Exhibit (10)(iv) in the Company's Form 10-K for the fiscal year ended December 31, 1992, and herein incorporated by reference. (iv) Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan. (v) American Standard Inc. Annual Incentive Plan; previously filed as Exhibit (l0)(vii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (vi) American Standard Inc. Management Partners' Bonus Plan effective as of July 7, 1988; previously filed as Exhibit (l0)(i) in the Company's Form l0-Q for the quarter ended September 30, 1988, and herein incorporated by reference; amendments to Plan adopted on June 7, 1990, previously filed as Exhibit (4)(ii) in the Company's Form l0-Q for the quarter ended June 30, 1990, and herein incorporated by reference. (vii) American Standard Inc. Executive Supplemental Retirement Benefit Program, as restated to include all amendments through December 31, 1993. (viii) Stock Purchase Agreement, dated April 27, 1988, between ASI Acquisition Company and General Electric Capital Corporation (without schedules); previously filed as Exhibit 2.4 in Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ix) Amendment, dated June 3, 1988, to Stock Purchase Agreement referred to in (l0)(viii) above; previously filed as Exhibit 2.6 in Amendment No. 1 in Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Composite American-Standard Employee Stock Ownership Plan incorporating amendments through December 3, 1992; previously filed as Exhibit (10)(x) in Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xi) American-Standard Employee Stock Ownership Trust Agreement, dated as of December 1, 1991, between ASI Holding Corporation and Fidelity Management Trust Company (as successor to Citizens & Southern Trust Company (Georgia), N.A.), as trustee; previously filed as Exhibit (10)(xiv) in the Company's Form 10-K for the year ended December 31, 1991, and herein incorporated by reference. (xii) Consulting Agreement made July 1, 1988, with Kelso & Company, L.P. concerning general management and financial consulting services to the Company; previously filed as Exhibit (l0)(xviii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (xiii) American Standard Inc. Supplemental Compensation Plan for Outside Directors, as amended through September 1993. (xiv) ASI Holding Corporation 1989 Stock Purchase Loan Program; previously filed as Exhibit l0(i) in Holding's Form l0-Q for the quarter ended September 30, 1989, and herein incorporated by reference. (xv) Corporate Officers Severance Plan adopted in December, 1990, effective April 27, 1991; previously filed as Exhibit (l0)(xix) in the Company's Form l0-K for the fiscal year ended December 31, 1990, and herein incorporated by reference. (xvi) Estate Preservation Plan adopted in December, 1990; previously filed as Exhibit (l0)(xx) in the Company's Form l0-K for the fiscal year ended December 31, 1990, and herein incorporated by reference. (xvii) Amendment adopted in March 1993 to Estate Preservation Plan referred to in (10)(xvi) above. (xviii) Summary of terms of Unfunded Deferred Compensation Plan, adopted December 2, 1993.) (xix) Retirement/Consulting Agreement, dated December 28, 1993, between H. Thompson Smith and the Company. (21) Listing of the Company's subsidiaries. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As a result of the Acquisition, results of operations include purchase accounting adjustments and reflect a highly leveraged capital structure. Sales Year Ended December 31, 1993 1992 1991 (Dollars in millions) Air Conditioning Products(a) $2,100 $ 1,892 $ 1,836 Plumbing Products 1,167 1,170 1,018 Transportation Products 563 730 741 Sales $3,830 $ 3,792 $ 3,595 ====== ======= ======= Operating Income (Loss) Before Income Taxes, Extraordinary Loss, and Cumulative Effects of Changes in Accounting Methods Year Ended December 31, 1993 1992 1991 (Dollars in millions) Air Conditioning Products(a) $133 $ 104 $ 55 Plumbing Products 108 108 66 Transportation Products 41 88 121 Operating income 282 300 242 Interest expense (278) (289) (286) Corporate items(b) (85) (63) (44) Loss before income taxes, extraordinary loss, and cumulative effects of changes in accounting methods $(81) $ (52) $ (88) ==== ===== ===== (a) For 1991 the amounts presented for Air Conditioning Products include the following amounts for Tyler Refrigeration (which was sold on September 30, 1991): sales of $99 million and operating loss of $18 million (including a $22 million loss on the sale). (b) Corporate items include administrative and general expenses, accretion charges on postretirement benefit liabilities, minority interest, foreign exchange transaction gains and losses, and miscellaneous income and expense. The following section summarizes the Company's consolidated results of operations and then discusses the results of its three operating segments. The Company's businesses are cyclical. Air Conditioning Products and Plumbing Products are particularly affected by the level of residential and commercial building activity. The following table presents a summary of statistics on U.S. non-residential construction activity and housing starts for the years 1989 through 1993. U.S. Non- Residential Contract Awards U.S. Housing (Millions % Change Starts % Change of square Year (Thousands of Year feet)(a) to Year units)(b) to Year 1989 1,322 - 1% 1,376 - 8% 1990 1,155 -13% 1,193 -13% 1991 953 -17% 1,015 -15% 1992 903 - 5% 1,200 +18% 1993 (c) 930 + 3% 1,290 + 7% (a) Source: F.W. Dodge Division, McGraw Hill, Inc. (b) Source: U.S. Department of Commerce, Bureau of Census. (c) Preliminary data. The market for replacement sales and servicing of air conditioning and plumbing products, which accounts for a substantial portion of sales for Air Conditioning Products and Plumbing Products, is less cyclical and sometimes countercyclical. The following table presents a summary of statistics on unit production of trucks, buses, and trailers in excess of six tons in Western Europe for the years 1989 through 1993 (units in thousands). Western Europe % Change Western Europe % Change Truck and Bus Year Trailer Year Production(a) to Year Production(a) to Year 1989 376 4% 125 9% 1990 343 -9% 128 2% 1991 353 3% 139 9% 1992 314 -11% 115 -17% 1993 223 -29% 88 -23% (a) Principal sources: Verband der Deutschen Automobilindustrie (Germany); Society of Motor Manufacturers and Traders (United Kingdom); and Chambre Syndicate des Constructeurs Automobiles (France). 1993 Compared with 1992 U.S. housing starts increased by 7% in 1993 from the 1992 level, which was up 18% over 1991 after four consecutive years of decline. U.S. non-residential contract awards increased by 3% in 1993 after five years of decline. The 1993 improvement in housing starts came in the second half of the year with third- and fourth-quarter starts up 10% and 12%, respectively, over the preceding quarter. The gain in non-residential awards occurred over the last nine months of 1993. Western European truck and bus production declined 29% in 1993 after an 11% decline in 1992. However, the rate of decline in the truck market slowed in the fourth quarter of 1993. Consolidated sales for 1993 were $3.83 billion, an increase of 1% (6% excluding the unfavorable effects of foreign exchange) over the $3.79 billion for 1992. A sales increase of 11% for Air Conditioning Products was partly offset by a sales decline for Transportation Products of 23% (16% excluding the unfavorable effects of foreign exchange). Sales for Plumbing Products were flat (but up by 9% excluding the effects of foreign exchange). Operating income for 1993 was $282 million, a decrease of $18 million, or 6% (but an increase of less than 1% excluding the effects of foreign exchange), from $300 million in 1992. The increase in operating income of 28% for Air Conditioning Products was more than offset by a 53% decrease in operating income for Transportation Products. Plumbing Products' operating income was flat (but increased 15% excluding the effects of foreign exchange). The gain for Air Conditioning Products was the result of higher volume, increased sales of higher-margin products, the benefits of manufacturing improvements, and the effects of restructuring and cost-containment efforts undertaken in 1991 and 1992, offset partly by the costs of further restructuring in 1993. For Plumbing Products the effects of increased volume for the Far East Group were offset partly by lower margins for the U.S. group and lower volumes and unfavorable foreign exchange effects for the European group. Transportation Products' operating income decreased primarily as a result of lower volumes due to reduced demand in depressed markets in Europe, offset partly by the effects of improvements in manufacturing efficiency. Air Conditioning Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales: Domestic portion $1,786 $1,572 $1,453 Foreign portion 314 320 284 Subtotal 2,100 1,892 1,737 Tyler Refrigeration - - 99 Total $2,100 $1,892 $1,836 ====== ====== ====== Operating income (loss): Domestic portion $ 148 $ 112 $ 58 Foreign portion (15) (8) 15 Subtotal 133 104 73 Tyler Refrigeration - - (18)(a) Total $ 133 $ 104 $ 55 ====== ====== ====== Assets $1,167 $1,156 $1,174 Goodwill and purchase accounting adjustments included in assets 372 398 417 Capital expenditures 38 33 46(b) Depreciation and amortization 53 55 56(c) (a) Includes $22 million loss on the sale of Tyler Refrigeration. (b) Includes capital expenditures of Tyler Refrigeration of $1 million. (c) Includes depreciation and amortization of Tyler Refrigeration of $3 million. The domestic portion of Air Conditioning Products is composed of the Unitary Products Group, the Commercial Systems Group (excluding Canada), and exports from the United States by the International Group. The foreign portion consists of the foreign-based operations of the International Group and the Canadian operations of the Commercial Systems Group. Sales and operating income of Air Conditioning Products both increased in 1993 despite the continuing recession in U.S. and Canadian commercial new construction and only moderate increase in residential new construction in the U.S. and despite the economic decline in Europe. Sales of Air Conditioning Products, which accounted for approximately 55% of the Company's 1993 sales, increased by 11% (with little effect from foreign exchange) to $2,100 million in 1993 from $1,892 million in 1992. There was a significant sales increase for each of the three operating groups. Operating income of Air Conditioning Products increased year to year by 28% (with little effect from foreign exchange) to a record high of $133 million in 1993 from $104 million in 1992. The increase was attributable to gains achieved by all three groups. Unitary Products Group In 1993 sales of the Unitary Products Group, which accounted for approximately 42% of Air Conditioning Products sales, increased by 15% over the 1992 sales level. Residential markets were up 15%, as a result of an unusually hot summer in the northern United States and a 7% increase in housing starts. Sales of residential products increased by 18% year over year, principally because of higher volumes driven by the improved market, increased furnace sales in the replacement market, and a shift in the market to more efficient products, offset partly by the continuation from 1992 of price degradation due to competitive pressures. Commercial markets for unitary products were up 9% overall from the 1992 markets, as the commercial replacement market strengthened further. New-construction activity continued to struggle, however. Sales of commercial unitary products increased by 10% overall, primarily as a result of higher volume (driven by the strong replacement market for both light and large commercial products); a shift to higher-priced, higher-tonnage products; and a gain in market share for light commercial products due to the success of the large Voyager products (packaged rooftop air conditioners). As a result of these factors, together with product cost improvements, improved labor productivity, and the benefits of organizational restructuring which reduced the salaried workforce in 1992, the operating income for Unitary Products in 1993 increased by 43% year over year. This improvement was achieved even though 1993 included the initial start-up costs of the new national distribution center in St. Louis, Missouri, and higher advertising costs. Unitary Products' sales increased through the success of new and redesigned products introduced recently and improved distribution channels. Commercial products that were introduced included the 20-to-25-ton Voyager products in 1992, which more than doubled market share in that size range; commercial microprocessor-controlled products; a line of convertible air handlers; and rooftop and air cooled chiller products using more efficient scroll compressors. Residential products introduced included the American-Standard brand outdoor units and new lines of luxury and conventional retail residential products. Commercial Systems Group Sales of the Commercial Systems Group, which accounted for approximately 37% of Air Conditioning Products' sales, increased 10%, primarily on volume increases for most product lines, especially air handling systems and water chillers (principally due to improved replacement markets and increased market share), and increased revenue from Company-owned sales offices (acquisitions and volume growth). These gains were partly offset by lower volume in Canada, which continues to be adversely affected by recession. The non-residential new-construction market increased 3% in the United States in 1993, following decreases of 5% in 1992 and 17% in 1991. The non-residential replacement market was up by 6% over 1992. Operating income for Commercial Systems increased 12% in 1993 over the recession-affected amount of 1992. The increase was primarily the result of volume gains, improvements in manufacturing efficiency, operating expense reductions, and the benefits of restructuring actions taken in 1992. The effects of these factors were partly offset by slightly lower prices, increases in material, labor, and benefit costs, the costs of additional restructuring actions in 1993, and a larger loss in the weak Canadian market. Product development emphasis for Commercial Systems in 1993 and 1992 was on new compressor, heat transfer and microelectronic control technology; adaptation of products to refrigerants that comply with recent government regulations; energy-efficient products; products for the aftermarket and replacement market (which exceeded the new-construction market in both 1993 and 1992); and products redesigned to improve manufacturing productivity. This strategy benefited operations in 1993 and 1992, and the Company expects that this product development emphasis will result in greater sales over the next several years. International Group Sales of Air Conditioning Products' International Group, which accounted for approximately 21% of Air Conditioning Products' 1993 sales, increased 7% from those of 1992 (10% excluding the unfavorable effect of foreign exchange). Most of the gain was from higher volume in the Far East (especially Hong Kong, Taiwan, and export sales from the U.S.) resulting from expanded markets and increased penetration; higher export sales from the U.S. to the Middle East (markets were significantly stronger) and Latin America (improved penetration in a market that was up 20%); and higher volumes in Mexico. These gains were partly offset by lower sales in Europe (lower prices and volumes in a declining market). Markets were down in all European countries except the U.K., but the effect was partly offset by increased revenues from service companies acquired in 1992 and prior years. Market growth in the Far East was 6% overall, led by the PRC market, which was up by 21%. The sales growth in Hong Kong was driven by the very strong market in the PRC. Markets in Thailand also grew, and the Latin American market grew by 20%. Operating income for the International Group increased by approximately 39% in 1993. The increase was primarily the result of higher export sales from the U.S. to the Middle East and Far East, offset partly by a larger operating loss in Europe primarily because of the weak markets and lower margins, costs related to restructuring in response to the lower markets, and the unfavorable effects of lower volume on factory performance. Overall, income from the Far East and Latin America was essentially unchanged from the prior year, as volume gains were offset by increased costs related to expansion of distribution channels and joint ventures and development of new and improved products to support present and future growth. Environmental Matters For a discussion of environmental matters see "Business -- Regulations and Environmental Matters." Backlog The worldwide backlog for Air Conditioning Products at the end of 1993 was $407 million, up 13% from 1992, excluding the effects of foreign exchange. The backlog increased as a result of increased volume for the Commercial Systems Group, market penetration and improved distribution channels in the Middle East and Far East, and sales growth for commercial Unitary Products. Plumbing Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales: Foreign portion $ 865 $ 885 $ 783 Domestic portion 302 285 235 Total $1,167 $1,170 $1,018 ====== ====== ====== Operating income (loss): Foreign portion $ 131 $ 124 $ 93 Domestic portion (23) (16) (27) Total $ 108 $ 108 $ 66 ====== ====== ====== Assets $ 960 $1,002 $1,069 Goodwill and purchase accounting adjustments included in assets 376 392 447 Capital expenditures 46 48 40 Depreciation and amortization 49 49 48 The foreign portion of Plumbing Products is composed of the European Plumbing Products Group, the Americas International Group, and the Far East Group. The domestic portion of sales and operating results is generated primarily by the U.S. Plumbing Products Group and by export sales from the U.S. Sales of Plumbing Products in 1993, at $1,167 million, which accounted for approximately 30% of the Company's 1993 sales, were at essentially the same level as the $1,170 million of sales in 1992 (but increased by 9% excluding the unfavorable effects of foreign exchange). Sales increases of 42% for the Far East Group (46% excluding foreign exchange), 9% for the Americas International Group (14% excluding foreign exchange), and 6% for the U.S. Plumbing Products Group were offset partly by a sales decrease of 10% for the European Plumbing Products Group (which had a 4% increase excluding the effects of foreign exchange). In 1993 operating income of Plumbing Products was $108 million, the same amount as in 1992, but excluding the unfavorable effects of foreign exchange operating income increased by 15%. The increase (on an exchange-adjusted basis) was attributable primarily to increased profitability for the Far East Group and for the Americas International Group, offset partly by a decline for the U.S. group. European Plumbing Products Group Sales of the European group, which accounted for approximately 51% of Plumbing Products' sales for 1993, decreased 10% in 1993 from 1992 but increased by 4% excluding the unfavorable effects of foreign exchange. The exchange-adjusted gain resulted from price increases, especially in Italy, Germany, the U.K., and Greece, offset partly by lower volume in most countries because of depressed markets. In Italy sales were up with price increases for most product lines, offset partly by lower volume and a less favorable product mix. The German market was stable in total, as price gains were offset by volume and mix declines. Greece, which had been in recession for three years, recovered somewhat in 1993. The European group's strength has been sales in the replacement market, which has more than made up for the effects of poor new-construction markets. Operating income for the European group decreased 7% but increased 10% excluding the effects of foreign exchange. This increase occurred primarily because of the price gains and cost reductions resulting from restructuring and efficiency improvements in the U.K., France, Italy, and Germany. Partly offsetting those favorable effects were the effects of lower volumes and the unfavorable effect on margins caused by the decline in value of many European currencies agains the Deutschemark. The increased cost of fittings purchased from Germany could not be completely recovered through sales price increases in most of the operations in other countries. U.S. Plumbing Products Group Sales of the U.S. group, which accounted for approximately 26% of total 1993 Plumbing Products sales, increased 6% in 1993. During 1993 the U.S. building industry continued to be adversely affected by the low level of new construction, although non-residential construction increased 3% from 1992 and new residential construction continued to recover from the lowest levels since the mid-1940's (up by 7% in 1993 and 18% in 1992 but still below pre-1990 levels). A basic shift from wholesale distribution channels to retail channels has been developing over the last few years, a trend the Company believes will continue and will be beneficial to the Company because of strong product and brand-name recognition. Retail markets now account for 20% of the total sales of the U.S. group. The growth of sales for the U.S. group was largely the result of increased export sales from the U.S. and to a lesser extent price increases on certain products, a more favorable sales mix, and a small increase in the growing retail channel business. The overall gain in the retail business was small because significant volume gains due to an expanding customer base were partly offset by the loss of an important customer. The operating loss for the U.S. group in 1993 was greater than that of the prior year. Despite higher sales, operating results were poorer primarily because of lower margins on both domestic and export sales, increased advertising costs and other expenses associated with expansion of the retail distribution channel, costs related to start-up and expansion of the low-water-volume toilet line (now mandated for new construction), and factory performance problems caused in part by the effects of fluctuating volumes. In addition, costs were incurred in business system re-engineeering activities intended to improve customer service. Americas International and Far East Groups Combined sales of the Americas International and Far East Groups, which accounted for approximately 23% of total Plumbing Products sales, increased 21% in 1993 (26% excluding the effects of foreign exchange). The sales gain was due primarily to the consolidation of Incesa (a previously unconsolidated group of Central American joint ventures) effective January 1, 1993, as a result of the purchase of additional shares of stock, and to higher volume and prices in Thailand, the PRC, the Philippines, and Brazil, offset partly by decreases in sales in Mexico, Canada, and Korea. Combined operating income of the Americas International and Far East Groups in 1993 increased 72% over the 1992 level. Gains were realized in all operations except Mexican chinaware operations, which were adversely affected by poor economic conditions and the uncertainty related to the North American Free Trade Agreement. The increase was primarily from higher prices and volumes in Brazil, Thailand, and the PRC the consolidation of Incesa, and a smaller loss for Mexican fittings operations. Environmental Matters For a discussion of environmental matters see "ITEM 1. BUSINESS -- Regulations and Environmental Matters." Backlog Plumbing Products' year-end 1993 backlog of $143 million was down 9% from 1992, excluding foreign exchange effects. The decrease resulted from a significant drop for European Plumbing Products (particularly Italy because of economic uncertainty, tempered somewhat by increases for England and Germany), and a drop in backlog for export sales from the U.S., partly offset by increases in the Far East (primarily Thailand). Transportation Products Segment Year Ended December 31, 1993 1992 1991 (Dollars in millions) Sales $ 563 $730 $741 Operating income 41 88 121 Assets 652 722 828 Goodwill and purchase accounting adjustments included in assets 422 458 510 Capital expenditures 14 27 24 Depreciation and amortization 35 37 34 Sales of Transportation Products, which accounted for 15% of the Company's 1993 sales, were $563 million, down 23% from $730 million in 1992 (16% excluding the effects of foreign exchange). The sales decrease was due primarily to a volume decline in Germany as a result of a 29% decrease in Western European truck and bus production, led by a 34% decline in Germany, and a 23% decrease in Western European trailer production. Volumes were also down in all other European countries in which Transportation Products has operations, although at the end of 1993 sales and order trends were upward. Volume in Brazil was slightly higher. Original equipment sales volume in Europe was down 22%, and aftermarket business was down 10%. These declines affected both conventional and electronic products. Operating income for Transportation Products in 1993 decreased 53% (50% excluding foreign exchange effects) to $41 million from $88 million in 1992, principally because of the lower sales and production volume and the inability to pass on material and labor cost increases in a very competitive, declining market. In response to reduced production levels, plant employment was reduced by 15%, the costs of which further depressed 1993 operating income. Those effects were partly offset by the favorable effects of cost improvements in manufacturing from Demand Flow implementa- tion and reduced operating expenses. Despite the market downturn, significant progress was made during 1993 in obtaining market acceptance of electronically controlled air suspension systems for commercial vehicles and for antilock braking systems on trailers. Backlog Transportation Products' year-end 1993 order backlog of $185 million was 2% lower than the 1992 year-end backlog, excluding the effects of foreign exchange, as a result of the poor market conditions. Financial Review 1993 Compared with 1992 The Company's financing and corporate costs were $363 million and $352 million in 1993 and 1992, respectively. The principal causes of the increase were effects of year-to-year changes in foreign exchange transaction gains and losses, higher minority interest, lower equity income, higher accretion expense on postretirement benefits, and lower miscellaneous income. Interest expense, which accounted for most of these costs, decreased primarily because of lower overall interest rates on new debt issued as part of the Refinancing (described below), partly offset by additional interest expense as a result of the exchange of the 12-3/4% Exchangeable Preferred Stock for the 12-3/4% Junior Subordinated Debentures. The tax provision for 1993 was $36 million despite a pre-tax loss of $81 million, whereas in 1992 the tax provision was $5 million on a pre-tax loss from continuing operations of $52 million. The 1993 provision reflected taxes payable on profitable foreign operations and was higher than in 1992 primarily because no tax benefits were available on domestic losses. The unusual relationship between the pre-tax losses and the tax provision is explained by the nondeductibility for tax purposes of the amortization of goodwill and other purchase accounting adjustments and the share allocations made by the Company's ESOP as well as by tax rate differences and withholding taxes on foreign earnings. As a result of the Refinancing in 1993 there was an extraordinary charge of $92 million related to the debt retired (including call premiums, the write-off of deferred debt issuance costs, and loss on cancellation of foreign currency swap contracts) on which there was no tax benefit. Liquidity and Capital Resources As a result of the Acquisition the Company's capital structure became highly leveraged. Net cash flow from operations, after cash interest expense of $195 million, was $201 million for the year ended December 31, 1993. Utilizing this cash flow and cash on hand at December 31, 1992, the Company devoted $98 million to capital expenditures, including $8 million of investments in affiliated companies, and repaid $50 million of term loans. In July 1993 the Company completed a refinancing (the "Refinancing") that included (a) the issuance of $200 million principal amount of 9-7/8% Senior Subordinated Notes Due 2001; (b) the issuance of approximately $751 million principal amount of 10-1/2% Senior Subordinated Discount Debentures Due 2005, which yielded proceeds of approximately $450 million; (c) the amendment and restatement of the Company's 1988 Credit Agreement (the "1988 Credit Agreement" and as so amended and restated, the "Credit Agreement") to establish a $1 billion secured, multi-currency, multi-borrower credit facility; and (d) the application of the proceeds of such issuances and such borrowings as follows: (i) the redemption on July 1, 1993, of all of the outstanding 12-7/8% Senior Subordinated Debentures Due 2000 at a redemption price of 104.83% ($571.3 million), (ii) the redemption on July 2, 1993, of a majority of the outstanding 14-1/4% Subordinated Discount Debentures Due 2003 at a redemption price of 105% ($389.5 million), (iii) the refunding of bank borrowings ($405 million of term loans and $77 million of other bank debt including revolving credit debt), (iv) the refunding of letters of credit ($58 million), and (v) payment of related fees and expenses. The Credit Agreement provided to American Standard Inc. and certain subsidiaries (the "Borrowers") a $1 billion facility as follows: (a) a $250 million multi-currency revolving credit facility (the "Revolving Credit Facility") available to all Borrowers, which expires in 2000; (b) a $225 million multi-currency periodic access facility (the "Periodic Access Facility") available to all Borrowers, which expires in 2000; and (c) three term loan facilities (the "Term Loans") consisting of a $225 million U.S. dollar facility available to American Standard Inc., which expires in 2000; a $200 million Deutschemark facility available to a German subsidiary, which expires in 1997; and a $100 million U.S. dollar facility available to all Borrowers, which expires in 1999. In August 1993 the Company repaid $50 million, and the amount available under the Credit Agreement by its terms was reduced to $950 million. The Company is required to reduce to $50 million the amount of borrowings outstanding under the Revolver for at least 30 consecutive days in each 12-month period ending May 31. In December 1993 the Company met this requirement for the 12 months ending May 31, 1994. Commencing August 31, 1994, the Revolver is reduced by $8.3 million annually, with a final maturity on June 1, 2000. In addition, the Company is required to repay the full amount of each of its outstanding revolving loans at the end of each interest period (a maximum of six months). The Company may, however, immediately reborrow such amounts subject to compliance with applicable conditions of the Credit Agreement. The Credit Agreement provides the Company with increased operating and financial flexibility, including the ability to shift from time to time a portion of borrowings among borrowers and currencies. As a result of the Refinancing there was a significant reduction in annual interest expense, which was partly offset by additional interest expense on the 12-3/4% Junior Subordinated Debentures exchanged for the 12-3/4% Exchangeable Preferred Stock. The Company believes that the amounts available from operating cash flows and under the Revolving Credit Facility will be sufficient to meet its expected cash needs, including planned capital expenditures. As described in Note 8 of Notes to Consolidated Financial Statements, the Credit Agreement contains various covenants that limit, among other things, indebtedness, dividends on and redemptions of capital stock of the Company, purchases and redemptions of other indebtedness of the Company (including its outstanding debentures and notes), rental expense, liens, capital expenditures, investments or acquisitions, disposal of assets, the use of proceeds from asset sales, and certain other business activities and require the Company to meet certain financial tests. In order to maintain compliance with the covenants and restrictions contained in the 1988 Credit Agreement, the Company from time to time has had to obtain waivers and amendments. In February 1994 the Company obtained an amendment to the Credit Agreement that among other things relaxed certain financial tests and convenants, and facilitated the investment in an air conditioning joint venture and the formation of a holding company to establish joint ventures in the People's Republic of China for the manufacture and sale of plumbing products. The Company currently believes it will comply with the amended financial tests and covenants but may have to obtain similar amendments or waivers in the future. On June 30, 1993, in exchange for all of the Company's outstanding shares of 12-3/4% Exchangeable Preferred Stock, the Company issued $141.8 million of 12-3/4% Junior Subordinated Debentures Due 2003 to the holder of the Exchangeable Preferred Stock. Those debentures were sold by the holder in a registered public offering in August 1993. The Company received none of the proceeds of this offering. The indentures related to the Company's debentures and notes contain various covenants which, among other things, limit debt and preferred stock of the Company and its subsidiaries, dividends on and redemption of capital stock of the Company and its subsidiaries, redemption of certain subordinated obligations of the Company, the use of proceeds from asset sales, and certain other business activities. In connection with examinations of the tax returns of the Company's German subsidiaries for the years 1984 through 1990, the German tax authorities have raised questions regarding the treatment of certain significant matters. The Company has paid approximately $20 million of a disputed German income tax. A suit is pending to obtain a refund of this tax. The Company anticipates that the German tax authorities may propose other adjustments resulting in additional taxes of approximately $105 million, plus penalties and interest for the tax return years under audit. In addition, significant transactions similar to those which gave rise to such possible adjustments occurred in years subsequent to 1990. The Company, on the basis of the opinion of legal counsel, believes the tax returns are substantially correct as filed and intends to vigorously contest any adjustments which have been or may be assessed. Accordingly, the Company had not recorded any loss contingency at December 31, 1993, with respect to such matters. Under German tax law the authorities may demand immediate payment of a tax assessment prior to final resolution of the issues. The Company also believes, on the basis of opinion of legal counsel, that it is highly likely that a suspension of payment will be obtained if additional taxes are assessed. However, if payment is required the Company expects that it will be able to meet such payment from available sources of liquidity or credit support but that future cash flows and capital expenditures, and therefore subsequent results of operations for any particular quarterly or annual period, could be adversely affected. Capital Expenditures The Company's capital expenditures for 1993 amounted to $98 million, including investments of $8 million in affiliated companies. The amount of capital expenditures was $10 million less than in 1992 ($6 million less excluding the effects of foreign exchange). Decreases in capital spending by Plumbing Products and Transportation Products were partly offset by an increase in spending by Air Conditioning Products. The Company believes capital spending was sufficient for maintenance purposes, for important product and process redesigns, for expansion projects, and for strategic investments. Capital expenditures by Air Conditioning Products were $38 million in 1993. This amount was 15% more than that of 1992. Capital expenditures in 1993 included continuing projects related to Demand Flow and spending on new products such as the Voyager III (medium-tonnage product line), the scroll compressor, and the Series R chiller line, expansion of Voyager I and Voyager II capacity and tooling and equipment for the American Standard product line. Plumbing Products' capital expenditures in 1993 were $46 million, including investments of $8 million in affiliated companies in France (Porcher) and the Czech Republic. Excluding the investments in affiliated companies and the effects of foreign exchange, capital spending was 34% higher than in 1992 as a result of spending increases in Europe and the Far East. Major projects included capacity expansion in Thailand and China and various projects related to Demand Flow implementation. Capital expenditures for Transportation Products totaled $14 million in 1993. Excluding the effects of foreign exchange, capital spending was 41% less than in 1992, a year with significant spending related to Demand Flow cost-reduction projects in production and material flow. 1992 Compared with 1991 U.S. housing starts increased by 18% in 1992 from the 1991 level, but non-residential contract awards decreased by 5%. Both of these economic indicators had declined in each of the previous four years. Consolidated sales for 1992 were $3.8 billion, an increase of 5% (4% excluding the favorable effects of foreign exchange) over the $3.6 billion for 1991. The 1991 amount included the sales of Tyler Refrigeration, which was sold September 30, 1991. Excluding Tyler Refrigeration, sales in 1992 were up 8% (7% excluding foreign exchange effects). Sales increases of 15% for Plumbing Products and 9% for Air Conditioning Products (excluding Tyler Refrigeration) were partly offset by a sales decline for Transportation Products of 1% (6% excluding the favorable effects of foreign exchange). Operating income for 1992 was $300 million, an increase of $58 million, or 24% (19% excluding the effects of foreign exchange), from $242 million in 1991. The 1991 amount included a loss for Tyler Refrigeration. Excluding Tyler Refrigeration, operating income in 1992 was up 15% (10% excluding foreign exchange effects.) Increases in operating income of 42% for Air Conditioning Products (excluding Tyler Refrigeration) and 64% for Plumbing Products were partly offset by a 27% decrease in operating income for Transportation Products. Except as otherwise indicated, the following discussion, including the financial comparisons, does not include the results of Tyler Refrigeration or the $22 million loss on the sale of Tyler Refrigeration in 1991. Air Conditioning Products Segment Sales of Air Conditioning Products, which accounted for approximately 50% of the Company's 1992 sales, increased by 9% to $1,892 million in 1992 from $1,737 million in 1991. There was a significant sales increase for each of the three operating groups -- for the Unitary Products Group in both residential and commercial products primarily because of higher volume and more favorable product mix (partly offset by lower prices), for the Commercial Systems Group primarily because of higher volume and prices, and for the International Group principally because of increased volume in Europe and the Far East. Operating income of Air Conditioning Products increased year to year by 42% (with little effect from foreign exchange) to $104 million in 1992 from $73 million in 1991. The increase was attributable to the sales gains, the benefits of manufacturing improvements and restructuring and cost containment in the Unitary Products and Commercial Systems Groups, and the fact that in 1991 results of the Commercial Systems Group had been adversely affected by a 54-day work stoppage at its LaCrosse, Wisconsin, facility. The impact of these factors was partly offset by a margin decline for the International Group and costs related to the start-up of new facilities, sales offices, and distribution channels. Unitary Products Group Sales in 1992 of the Unitary Products Group, which accounted for approximately 41% of Air Conditioning Products sales, increased by 6% over the 1991 sales level. Commercial markets for unitary products were up 6% overall from the depressed 1991 markets, as a very strong commercial replacement market more than offset the effects of low new-construction activity. Sales of commercial unitary products increased by 7% overall, primarily as a result of higher volume (driven by the strong replacement market), a shift to higher-priced, higher-tonnage products, and a gain in market share for light commercial products. Residential markets were down 3.5%, as poor replacement activity, a result of an unseasonably cool summer, more than offset the 18% increase in new housing starts. Despite this poorer market, sales of residential products increased by 5% year over year, principally because of larger market share, improved furnace markets, and a partial shift in the market to more efficient products stimulated by Federal standards, offset partly by price degradation due to competitive pressures. As a result of these factors, together with benefits of manufacturing improvements, cost containment, and organizational restructuring which reduced the salaried workforce, the operating profit for Unitary Products in 1992 increased by 50% from the depressed level of 1991. Commercial Systems Group Sales of the Commercial Systems Group, which accounted for approximately 38% of Air Conditioning Products' sales, increased 9% primarily on volume increases in aftermarket replacement and parts sales, increased revenue from Company-owned sales offices (volume growth and acquisitions), and small price increases on most product lines. Other factors contributing to the increase were higher sales of large applied systems and the fact that in 1991 there was a 54-day work stoppage at the LaCrosse, Wisconsin, plant. These gains were partly offset by lower volume in Canada, which was adversely affected by recession. Operating income for Commercial Systems increased 129% in 1992 over the recession-affected and work-interrupted level of 1991. The increase was primarily the result of the volume and price gains, improvements in manufacturing efficiency, cost containment and restructuring, and the fact that 1991 included the adverse impact of the LaCrosse work stoppage. The effects of these factors were partly offset by slightly lower gross margins, as the price increases did not completely recover increases in material, labor and benefits costs. International Group Sales of Air Conditioning Products' International Group, which accounted for approximately 21% of Air Conditioning Products' 1992 sales, increased 15% from those of 1991 (10% excluding the favorable effect of foreign exchange). Most of the gain was from higher volumes in Mexico (two new sales offices resulted in expanded distribution and penetration), the Far East (especially Hong Kong and Singapore), the Middle East (markets were significantly stronger), and Europe (sales of new products and increased penetration despite declining markets). Markets were down in almost all European countries except Italy, with the largest drop in the U.K., offset partly by increased revenues from acquired service companies. Operating income for the International Group decreased by approximately 68% in 1992. The decline occurred in Europe, primarily because of the weak markets and lower prices, costs related to the start-up of new facilities and new distribution networks in the U.K. and France, costs related to the introduction of new products, start-up costs of a company in Spain acquired near the end of 1991, and foreign exchange transaction losses from currency fluctuations in the latter half of 1992. Income from the Far East and Latin America was essentially unchanged from the prior year, as volume gains were offset by increased costs related to expanded distribution channels, start-up of new joint ventures, and development of new and improved products to support present and future growth. Plumbing Products Segment Sales of Plumbing Products, which accounted for approximately 31% of the Company's 1992 sales, increased by 15% in 1992 (14% excluding the effects of foreign exchange) to $1,170 million from $1,018 million in 1991. The improvement resulted from sales increases of 9% (7% excluding the effects of foreign exchange) for the European Plumbing Products Group, 21% for the U.S. Plumbing Products Group, 4% for the Americas International Group (7% excluding foreign exchange), and 101% for the Far East Group (98% excluding foreign exchange). In 1992 operating income of Plumbing Products increased 64% (56% excluding the effects of foreign exchange) to $108 million from $66 million in 1991. The increase was attributable primarily to increased profitability for the European group on higher prices and volumes (especially in Italy and Germany) although improved results in the U.S., Americas International, and Far East groups contributed. European Plumbing Products Group Sales of the European group, which accounted for approximately 57% of Plumbing Products' sales for 1992, increased 9% in 1992 over 1991, 7% excluding the favorable effects of foreign exchange. The gain resulted primarily from price and volume increases, especially in Italy and Germany, offset partly by lower volume in France from declining demand and lower prices in the U.K. caused by a very poor market. In Italy sales were up 9%, with gains for most product lines in price, volume and market share. The gains in Germany were the result of higher volumes and prices for brass fittings and luxury chinaware. Operating income for the European group increased 28% (23% excluding the effects of foreign exchange) primarily from the price and volume gains in Italy and Germany and higher margins on German brass operations resulting from improved manufacturing processes and cost containment, offset partly by lower profitability in France because of decreased volume and in the U.K. because of the recession. A recession depressed operating results in Greece. U.S. Plumbing Products Group Sales of the U.S. group, which accounted for approximately 24% of total 1992 Plumbing Products sales, increased 21% in 1992. During 1992 the U.S. building industry continued to be severely affected by the low level of new construction, with non-residential construction down 5% from 1991 and with new residential construction recovering from the lowest levels since the mid-1940's (though up by 18%, it was still low in historical terms). The U.S. market for plumbing products was up an estimated 3% to 4%, with more than half the gain occurring in the replacement and remodeling markets, which accounts for about 60% of the total U.S. market. The growth of sales for the U.S. group was largely a result of the strength of retail business (which had a significant increase in volume and accounted for 20% of sales of the U.S. group in 1992) and increased export sales from the U.S., together with smaller gains resulting from price increases and higher wholesaler distribution sales. Sales of AMERICAST products more than doubled in 1992, and smaller volume gains were achieved for acrylic products, fixtures, and faucets. The operating loss for the U.S. group in 1992 was less than that of the prior year. The improvement was primarily due to price increases and secondarily to volume and margin gains (as a result of sourcing product from the Company's Latin American plants), offset partly by non-recurring costs related to implementation of improved manufacturing processes and the effects of a shift in overall sales mix from commercial and luxury to lower-margin products. Americas International and Far East Groups Combined sales of the Americas International and Far East Groups, which accounted for approximately 19% of total Plumbing Products sales, increased 26% in 1992 (28% excluding the effects of foreign exchange). The sales gain was due primarily to the consolidation in 1992 of a previously unconsolidated joint venture in Thailand and to a lesser extent to price and volume increases in Mexico and Korea and higher volumes in Brazil, offset partly by lower sales in Canada, which were adversely affected by severe recession. Combined operating income of the Americas International and Far East Groups in 1992 increased 134% over the 1991 level. Gains were realized in all operations except Canada and the Philippines, both of which were adversely affected by poor economies. The increase was primarily from price and volume gains in Mexico and Korea, higher volume and margins in Brazil, and higher volume in China. Transportation Products Segment Sales of Transportation Products, which accounted for 19% of the Company's 1992 sales, were $730 million, down 1% from $741 million in 1991 (6% excluding the effects of foreign exchange). The sales decrease was due primarily to a volume decline in Germany as a result of a significant decrease in truck and bus production. Volumes were also down in nearly all other European countries in which Transportation Products has operations except the U.K. There was also a decline in prices of electronic control products, primarily as a result of industry cost reductions. Operating income for Transportation Products in 1992 decreased 27% (32% excluding foreign exchange effects) to $88 million from $121 million in 1991, principally because of the lower sales and production volume, lower prices, and increased spending for product engineering. Plant employment was kept in line with reduced production levels, but the costs associated with these reductions also depressed 1992 operating income. Those effects were partly offset by the favorable effects of cost reductions and increases in efficiency achieved in manufacturing operations. Financial Review 1992 Compared with 1991 The Company's financing and corporate costs were $352 million and $330 million in 1992 and 1991, respectively. The principal causes of the increase were year-to-year effects of changes in foreign exchange transaction gains and losses, higher minority interest, and lower miscellaneous income. Interest expense and accretion expense on postretirement benefits, which accounted for most of these costs, also increased. The tax provision for 1992 was $5 million despite a pre-tax loss of $52 million, whereas in 1991 the tax provision was $23 million on a pre-tax loss from continuing operations of $88 million. The 1992 provision reflected taxes payable on profitable foreign operations offset partly by available domestic tax benefits. The 1992 provision was lower than in 1991 primarily because of lower pre-tax earnings in foreign operations. In 1992 the provision was also lower because of future income tax benefits resulting from carrybacks of foreign net operating losses and the existence of deferred tax credits which reverse in the carryforward period applicable to other foreign net operating losses. The unusual relationship between the pre-tax losses and the tax provision is explained by the nondeductibility for tax purposes of the amortization of goodwill and other purchase accounting adjustments and the share allocations made by the Company's ESOP as well as by tax rate differences and withholding taxes on foreign earnings. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA RESPONSIBILITY FOR FINANCIAL STATEMENTS The accompanying consolidated balance sheets at December 31, 1993 and 1992, and related consolidated statements of operations, stockholder's equity (deficit), and cash flows for the years ended December 31, 1993, 1992 and 1991, have been prepared in conformity with generally accepted accounting principles, and the Company believes the statements set forth a fair presentation of financial condition and results of operations. The Company believes that the accounting systems and related controls that it maintains are sufficient to provide reasonable assurance that the financial records are reliable for preparing financial statements and maintaining accountability for assets. The concept of reasonable assurance is based on the recognition that the cost of a system of internal control must be related to the benefits derived and that the balancing of those factors requires estimates and judgment. Reporting on the financial affairs of the Company is the responsibility of its principal officers, subject to audit by independent auditors, who are engaged to express an opinion on the Company's financial statements. The Board of Directors has an Audit Committee of non-employee Directors which meets periodically with the Company's financial officers, internal auditors, and the independent auditors and monitors the accounting affairs of the Company. American Standard Inc. New York, New York March 14, 1994 REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors American Standard Inc. We have audited the accompanying consolidated balance sheets of American Standard Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity (deficit), and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Standard Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /s/Ernst & Young Ernst & Young New York, New York March 14, 1994 AMERICAN STANDARD INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (Dollars in thousands) Year Ended December 31, 1993 1992 1991 Sales $3,830,462 $3,791,929 $3,595,267 Costs and expenses Cost of sales 2,902,562 2,852,230 2,752,068 Selling and administrative expenses 692,229 678,742 614,259 Other expense 38,281 24,672 8,082 Interest expense (includes debt issuance cost amortization of $11,461 for 1993, $5,983 for 1992 and $5,335 for 1991) 277,860 288,851 286,316 Loss on sale of Tyler Refrigeration - - 22,391 3,910,932 3,844,495 3,683,116 Loss before income taxes, extra- ordinary loss and cumulative effects of changes in accounting methods (80,470) (52,566) (87,849) Income taxes 36,165 4,672 23,033 Loss before extraordinary loss and cumulative effects of changes in accounting methods (116,635) (57,238) (110,882) Extraordinary loss on retirement of debt (Note 8) (91,932) - - Cumulative effects of changes in accounting methods (Notes 2 and 3) - - (32,291) Net loss (208,567) (57,238) (143,173) Preferred dividend (8,624) (15,707) (13,855) Net loss applicable to common shares $ (217,191) $ (72,945) $ (157,028) ========== ========== ========== See notes to consolidated financial statements. AMERICAN STANDARD INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars in thousands) ASSETS At December 31, 1993 1992 Current assets Cash and certificates of deposit $ 53,237 $ 111,549 Cash in escrow 932 1,722 Accounts receivable, less allowance for doubtful accounts-- 1993, $15,666; 1992, $12,827 507,322 468,731 Inventories 325,819 384,857 Future income tax benefits 24,562 33,192 Other current assets 29,811 31,199 Total current assets 941,683 1,031,250 Facilities, at cost net of accumulated depreciation 820,523 832,811 Other assets Goodwill, net of accumulated amortization -- 1993, $169,879; 1992 $141,858 1,025,774 1,101,716 Debt issuance costs, net of accumulated amortization-- 1993 $9,670; 1992, $77,776 78,102 51,308 Prepaid ESOP expense 4,331 9,527 Other 120,997 109,333 $2,991,410 $3,135,945 ========== ========== LIABILITIES AND STOCKHOLDER'S DEFICIT Current liabilities Loans payable to banks $ 38,036 $ 99,150 Current maturities of long-term debt 105,939 13,458 Accounts payable 307,326 271,855 Accrued payrolls 99,758 105,400 Other accrued liabilities 258,322 225,335 Taxes on income 47,003 18,848 Total current liabilities 856,384 734,046 Long-term debt 2,191,737 2,032,064 Other long-term liabilities Reserve for postretirement benefits 387,038 368,868 Deferred tax liabilities 45,625 73,307 Other 204,170 212,383 Total liabilities 3,684,954 3,420,668 Commitments and contingencies Exchangeable preferred stock - 133,176 Stockholder's deficit Preferred stock, Series A, 1,000 shares issued and outstanding, par value $.01 - - Common stock, 1,000 shares issued and outstanding, par value $.01 - - Capital surplus 211,333 210,409 Accumulated deficit (750,003) (541,436) Foreign currency translation effects (149,220) (86,872) Minimum pension liability adjustment ( 5,654) - Total stockholder's deficit (693,544) (417,899) $2,991,410 $3,135,945 ========== ========== See notes to consolidated financial statements. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Basis of Presentation On March 17, 1988, American Standard Inc. and subsidiaries (the "Company") agreed to be acquired by an affiliate of Kelso & Company L.P. ("Kelso"), an investment banking firm that specializes in leveraged buyouts. On March 21, 1988, the Kelso affiliate commenced a tender offer (the "Tender Offer") for all of the Company's common stock at $78 per share in cash. On April 27, 1988, the Kelso affiliate completed the Tender Offer with the purchase of approximately 95% of the Company's shares. Pursuant to an Agreement and Plan of Merger, a merger was consummated (the "Merger") on June 29, 1988, whereby the Company became a wholly owned subsidiary of ASI Holding Corporation, a Delaware corporation ("Holding") organized by Kelso to participate in the acquisition of the Company. At that time the remaining shares of the Company's common stock were converted into the right to receive cash of $78 per share. The Tender Offer, Merger, and related transactions are hereinafter referred to as the "Acquisition." For financial statement purposes the Acquisition has been accounted for under the purchase method. Note 2. Accounting Policies Consolidation The financial statements include on a consolidated basis the results of all majority-owned subsidiaries. All material intercompany transactions are eliminated. Investments in affiliated companies are included at cost plus the Company's equity in their net results. Translation of Foreign Financial Statements Assets and liabilities of most foreign operations are translated at year-end rates of exchange, and the income statements are translated at the average rates of exchange for the period. Gains or losses resulting from translating foreign currency financial statements are accumulated in a separate component of stockholder's equity until the entity is sold or substantially liquidated. Gains or losses resulting from foreign currency transactions (transactions denominated in a currency other than the entity's local currency) are included in net income. For operations in countries that have high rates of inflation, net income includes gains and losses from translating assets and liabilities at year-end rates of exchange, except for inventories and facilities, which are translated at historical rates. Revenue Recognition Sales are recorded when shipment to a customer occurs. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Statement of Cash Flows Cash and certificates of deposit include all highly liquid investments with an original maturity of three months or less. Inventories Inventory costs are determined by the use of the last-in, first-out (LIFO) method on a worldwide basis, and inventories are stated at the lower of such cost or realizable value. Facilities The Company capitalizes costs, including interest during construction, of fixed asset additions, improvements, and betterments that add to productive capacity or extend the asset life. Maintenance and repair expenditures are charged against income. Significant foreign investment grants are amortized into income over the period of benefit. Goodwill Goodwill is being amortized over 40 years. Debt Issuance Costs The costs related to the issuance of debt are amortized using the interest method over the lives of the related debt. Warranties The Company provides for estimated warranty costs at the time of sale. Warranty obligations beyond one year are included in other long-term liabilities. The Company changed its method of accounting for revenues from extended warranty contracts at the beginning of 1991 to conform with the FASB Technical Bulletin, "Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts." The bulletin requires the deferral of the revenue from the sales of such contracts and amortization thereof on a straight-line basis over the terms of the contracts. The cumulative effect of this accounting change for all contracts in place as of December 31, 1990, increased the net loss in 1991 by $7 million, net of income tax benefit. The effect on the 1991 net loss, excluding the cumulative effect upon adoption, was not material. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Leases The asset values of capitalized leases are included with facilities, and the associated liabilities are included with long-term debt. Postretirement Benefits Postretirement benefits are provided for substantially all employees of the Company, both in the United States and abroad. In the United States the Company also provides various postretirement health care and life insurance benefits for some of its employees. Effective January 1, 1991, such costs are calculated in accordance with Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"). Depreciation Depreciation and amortization are computed on the straight-line method based on the estimated useful life of the asset or asset group. Research and Development Expenses Research and development costs are expensed as incurred except for costs incurred (after technological feasibility is established) for computer software products expected to be sold. The Company expensed costs of approximately $41 million in 1993, $40 million in 1992, and $36 million in 1991 for research activities and product development. Computer software product development costs capitalized in 1993 amounted to $2 million. Income Taxes In 1991 the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"), and elected to apply the provisions retroactively to January 1, 1989. The Company recognizes deferred tax assets for the tax effects of items that will be deducted for tax purposes in later years together with the tax effects of income items included in current reporting for tax purposes but in later years for financial statement purposes and the effects of certain tax attributes such as net operating losses. The Company provides for United States income taxes and foreign withholding taxes on foreign earnings expected to be repatriated. Deferred tax liabilities are provided on the excess of the financial statement basis over the tax basis of certain assets, primarily for inventories and fixed assets, including fair value adjustments resulting from purchase accounting in connection with the Acquisition; fixed assets due to accelerated depreciation deductions for tax purposes; and non-permanent investments in certain foreign subsidiaries. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Financial Instruments with Off-Balance-Sheet Risk The Company from time to time enters into foreign currency exchange agreements in the management of foreign currency exposure. Gains and losses from exchange rate changes are included in income unless the contract hedges a net investment in a foreign entity or a firm commitment, in which case gains and losses are deferred as a component of foreign currency translation effects in stockholder's equity or included as a component of the transaction. Note 3. Postretirement Benefits The Company sponsors postretirement benefit plans covering substantially all employees, including an Employee Stock Ownership Plan (the "ESOP") for the Company's U.S. salaried employees and certain U.S. hourly employees. In 1988 in conjunction with the Acquisition the ESOP purchased 5,000,000 shares (adjusted for a 100-for-1 stock split) of common stock of Holding. The ESOP is an individual account, defined contribution plan. The valuation of the ESOP shares is determined by independent appraisals. The common stock acquired by the ESOP is being allocated to the accounts of eligible employees over a period not exceeding eight plan years, including basic allocation of 3% of covered compensation and a matching Company contribution of up to 6% of covered compensation invested in the Company's savings plan by employees. Pension plan benefits are generally based on years of service and employees' compensation during the last years of employment. In the United States the Company also provides various postretirement health care and life insurance benefits for some of its employees. Funding decisions are based upon the tax and statutory considerations in each country. Accretion expense is the implicit interest cost associated with amounts accrued and not funded and is included in "other expense". At December 31, 1993, funded plan assets related to pensions were held primarily in fixed income and equity funds. Postretirement health and life insurance benefits are not prefunded. Effective January 1, 1991, the Company changed its method of accounting for postretirement benefits other than pensions to conform with FAS 106. The cumulative effect of this change increased the recorded obligation for such benefits by $40 million, thereby increasing the net loss in 1991 by $25 million (net of the related income tax benefit). The effect of the change on the 1991 net loss, excluding the cumulative effect upon adoption, was not material. The following table sets forth the Company's postretirement plans' funded status and amounts recognized in the balance sheet at December 31, 1993 and 1992. Total postretirement costs were: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Pension benefits $37.5 $35.4 $32.4 Health and life insurance benefits 17.8 16.7 15.2 Defined benefit plan cost 55.3 52.1 47.6 Defined contribution plan cost (a) 22.4 20.4 20.0 Total postretirement cost, including accretion expense $77.7 $72.5 $67.6 ===== ===== ===== (a) Principally ESOP cost. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 4. Other Expense Other income (expense) was as follows: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Interest income $ 8.5 $ 8.7 $ 8.3 Royalties 2.6 3.8 2.5 Equity in net income (loss) of affiliated companies (0.1) 4.9 10.2 Minority interest (14.0) (9.8) (3.1) Accretion expense (30.5) (29.8) (27.9) Other, net (4.8) (2.5) 1.9 $(38.3) $(24.7) $ (8.1) ====== ====== ====== The decrease in equity in net income of affiliated companies and the increase in minority interest in 1993 and 1992 compared with 1991 were primarily the result of consolidation of the plumbing companies in Thailand, the People's Republic of China, and Incesa, previously unconsolidated joint ventures. Note 5. Income Taxes The Company's loss before income taxes, extraordinary loss, and cumulative effects of changes in accounting methods ("pre-tax income (loss)") and the applicable provision (benefit) for income taxes were: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Pre-tax income (loss): Domestic $ (223.2) $ (170.1) $(272.6) Foreign 142.7 117.5 184.8 Pre-tax loss $ (80.5) $ (52.6) $ (87.8) Provision (benefit) for income taxes: Current: Domestic $ 12.4 $ 5.1 $ 5.1 Foreign 43.0 63.0 71.3 55.4 68.1 76.4 Deferred: Domestic 1.1 (35.8) (52.4) Foreign (20.3) (27.6) (1.0) (19.2) (63.4) (53.4) Total provision $ 36.2 $ 4.7 $ 23.0 ======== ======== ======= AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A reconciliation between the actual income tax expense provided and the income tax benefit computed by applying the statutory federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to the pre-tax loss is as follows: Year Ended December 31, 1993 1992 1991 (Dollars in millions) Tax benefit at statutory rate $(28.2) $(17.9) $(29.9) Nondeductible goodwill charged to operations 10.4 10.5 10.6 Nondeductible goodwill related to operations sold - 25.1* Nondeductible ESOP allocations 6.1 4.9 4.6 Rate differences and withholding taxes related to foreign operations 9.0 1.4 4.7 Foreign exchange gains (7.0) (6.3) (2.1) State tax benefits (5.5) (3.3) (3.4) Other, net 8.7 5.5 5.6 Increase in valuation allowance 42.7 9.9 7.8 Total provision $ 36.2 $ 4.7 $ 23.0 ====== ====== ====== * Includes goodwill eliminated in the sale of Tyler Refrigeration. In addition to the valuation allowance increase of $42.7 million shown above, a valuation allowance of $32.1 million was provided for the entire amount of the tax benefit related to the extraordinary loss on retirement of debt (see Note 8 of Notes to Consolidated Financial Statements). The following table details the gross deferred liabilities and the gross deferred tax assets and the related valuation allowances. At December 31, 1993 1992 (dollars in millions) Deferred tax liabilities: Facilities (accelerated depreciation, capitalized interest and purchase accounting differences) $ 141.1 $ 154.1 Inventory (LIFO and purchase accounting differences) 18.5 30.3 Employee benefits 11.0 6.6 Foreign investments 50.1 48.8 Other 26.2 26.6 246.9 266.4 Deferred tax assets: Employee benefits (pensions and other postretirement benefits) 110.7 97.7 Warranties 37.4 30.0 Alternative minimum tax 19.4 21.8 Foreign tax credits and net operating losses 57.5 42.3 Reserves 58.7 45.1 Other 46.0 18.5 Valuation allowances (103.9) (29.1) 225.8 226.3 Net deferred tax liabilities $ 21.1 $ 40.1 ========= ======== AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deferred tax assets related to foreign tax credits, net operating loss carryforwards, and future tax deductions have been reduced by a valuation allowance since realization is dependent in part on the generation of future foreign source income as well as on income in the legal entity which gave rise to tax losses. Other deferred tax assets have not been reduced by valuation allowances because of carrybacks and existing deferred tax credits which reverse in the carryforward period. The foreign tax credits and net operating losses are available for utilization in future years. In some tax jurisdictions the carryforward period is limited to as little as five years; in others it is unlimited. As a result of the Acquisition (see Note 1) and the allocation of purchase accounting (principally goodwill) to foreign subsidiaries, the book basis in the net assets of the foreign subsidiaries exceeds the related U.S. tax basis in the subsidiaries' stock. Such investments are considered permanent in duration, and accordingly no deferred taxes have been provided on such differences, which are significant. It is impracticable because of the complex legal structure of the Company and the numerous tax jurisdictions in which the Company operates to determine such deferred taxes. Cash taxes paid were $41 million, $56 million, and $79 million in the years 1993, 1992, and 1991, respectively. In connection with examinations of the tax returns of the Company's German subsidiaries for the years 1984 through 1990, the German tax authorities have raised questions regarding the treatment of certain significant matters. The Company has paid approximately $20 million of a disputed German income tax. A suit is pending to obtain a refund of this tax. The Company anticipates that the German tax authorities may propose other adjustments resulting in additional taxes of approximately $105 million, plus penalties and interest for the tax return years under audit. In addition, significant transactions similar to those which gave rise to such possible adjustments occurred in years subsequent to 1990. The Company, on the basis of the opinion of legal counsel, believes the tax returns are substantially correct as filed and intends to vigorously contest any adjustments which have been or may be assessed. Accordingly, the Company had not recorded any loss contingency at December 31, 1993 with respect to such matters. Under German tax law the authorities may demand immediate payment of a tax assessment prior to final resolution of the issues. The Company also believes, on the basis of opinion of legal counsel, that it is highly likely that a suspension of payment will be obtained if additional taxes are assessed. However, if payment is required, the Company expects that it will be able to make such payment from available sources of liquidity or credit support but that future cash flows and capital expenditures and therefore subsequent results of operations for any particular quarterly or annual period could be adversely affected. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 6. Inventories The components of inventory are as follows: At December 31, 1993 1992 (Dollars in millions) Finished products $169.0 $200.6 Products in process 78.0 95.8 Raw materials 78.8 88.5 Inventory at cost $325.8 $384.9 ====== ====== The carrying cost of inventories reflects purchase accounting adjustments and therefore exceeds current cost. Note 7. Facilities The components of facilities, at cost, are as follows: At December 31, 1993 1992 (Dollars in millions) Land $ 66.2 $ 65.0 Buildings 314.6 310.2 Machinery and equipment 739.9 719.4 Improvements in progress 54.4 45.6 Gross facilities 1,175.1 1,140.2 Less: accumulated depreciation 354.6 307.4 Net facilities $ 820.5 $ 832.8 ======== ======== Note 8. Debt The 1993 Refinancing In July 1993 the Company completed a refinancing (the "Refinancing") that included (a) the issuance of $200 million principal amount of 9-7/8% Senior Subordinated Notes Due 2001; (b) the issuance of approximately $751 million principal amount of 10-1/2% Senior Subordinated Discount Debentures Due 2005, which yielded proceeds of approximately $450 million; (c) the amendment and restatement of the Company's 1988 Credit Agreement (the "1988 Credit Agreement" and as so amended and restated, the "Credit Agreement") to establish a $1 billion secured, multi-currency, multi-borrower credit facility; and (d) the application of the proceeds of such issuances and such borrowings as follows: (i) the redemption on July 1, 1993, of all of the outstanding 12-7/8% Senior Subordinated Debentures Due 2000 (the "12-7/8% Senior Subordinated Debentures") at a redemption price of 104.83% ($571.3 million), (ii) the redemption on July 2, 1993, of AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS a majority of the outstanding 14-1/4% Subordinated Discount Debentures Due 2003 (the "14-1/4% Subordinated Discount Debentures") at a redemption price of 105% ($389.5 million), (iii) the refunding of bank borrowings ($405 million of term loans and $77 million of other bank debt including revolving credit debt), (iv) the refunding of letters of credit ($58 million), and (v) payment of related fees and expenses. The Credit Agreement provided to American Standard Inc. and certain subsidiaries (the "Borrowers") a $1 billion facility as follows: (a) a $250 million multi-currency revolving credit facility (the "Revolving Credit Facility") available to all Borrowers, which expires in 2000; (b) a $225 million multi-currency periodic access facility (the "Periodic Access Facility") available to all Borrowers, which expires in 2000; and (c) three term loan facilities (the "Term Loans") consisting of a $225 million U.S. dollar facility ("Tranche A") available to American Standard Inc., which expires in 2000; a $200 million Deutschemark facility ("Tranche B") available to a German subsidiary, which expires in 1997; and a $100 million U.S. dollar facility ("Tranche C") available to all Borrowers, which expires in 1999. In August 1993 the Company repaid $50 million and the amount available under the Credit Agreement by its terms was reduced to $950 million. Borrowings under the Periodic Access Facility and the Term Loans generally bear interest at the London interbank offered rate ("LIBOR") plus 2-1/2% except for the $225 million U.S. dollar facility, which bears interest at LIBOR plus 3%, and the $200 million Deutschemark facility, which bears interest at LIBOR plus 2%. The Company pays a commitment fee of 0.5% per annum on the unused portion of the Revolving Credit Facility and a fee of 2.5% plus issuance fees for letters of credit. As a result of the Refinancing, results for the year ended December 31, 1993, included an extraordinary charge of $92 million related to the debt retired (including call premiums, the write-off of deferred debt issuance costs, and loss on cancellation of foreign currency swap contracts) on which there was no tax benefit (see Note 5). Short-term The Revolving Credit Facility (the "Revolver") provides for aggregate borrowings of up to $250 million for working capital purposes, of which up to $200 million may be used for the issuance of letters of credit and $40 million of which is available for same-day short-term borrowings ("Swingline Loans"). At December 31, 1993, there were $7 million of borrowings outstanding under the Revolver and $66 million of letters of credit. Availability under the Revolver at December 31, 1993, was $177 million. Average borrowings under this facility and under the revolving credit facility available under the previous 1988 Credit Agreement for 1993, 1992, and 1991 were $39 million, $14 million, and $44 million, respectively. The Revolver and the Swingline Loans bear interest at the prime rate plus 1-1/2% or LIBOR plus 2-1/2%. The Company is required to reduce to $50 million the amount of borrowings outstanding under the Revolver for at least 30 consecutive days in each 12-month period ending May 31. In December 1993 the Company met this requirement for the 12-month period ending May 31, 1994. Commencing August 31, 1994, the Revolver is reduced by $8.3 million annually, with a AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS final maturity on June 1, 2000. In addition, the Company is required to repay the full amount of each of its outstanding revolving loans at the end of each interest period (a maximum of six months). The Company may, however, immediately reborrow such amounts subject to compliance with applicable conditions of the Credit Agreement. Other short-term borrowings are available outside the United States under informal credit facilities and are typically a result of overdrafts. At December 31, 1993, the Company had $31 million of such foreign short-term debt outstanding at an average interest rate of 11% per annum. The Company also had an additional $50 million of unused foreign facilities. These facilities may be withdrawn by the banks at any time. Long-term Long-term debt was as follows: At December 31, 1993 1992 (Dollars in millions) Credit Agreement $ 689.9 $ - 1988 Credit Agreement - 402.3 9 1/4% sinking fund debentures, due in installments from 1997 to 2016 150.0 150.0 10 7/8% senior notes due 1999 150.0 150.0 11 3/8% senior debentures due 2004 250.0 250.0 9 7/8% senior subordinated notes due 2001 200.0 - 10 1/2% senior subordinated discount debentures (net of unamortized discount of $272.9 million in 1993) due in installments from 2003 to 2005 477.8 - 12 7/8% senior subordinated debentures - 545.0 14 1/4% subordinated discount debentures (net of unamortized discount of $36.3 million in 1992) due in installments from 2002 to 2003 175.0 509.5 Other long-term debt 63.1 53.3 12 3/4% junior subordinated debentures due in installments from 2001 to 2003 (Note 9) 141.8 - Foreign currency swap contracts - (14.6) 2,297.6 2,045.5 Less current maturities 105.9 13.4 $ 2,191.7 $ 2,032.1 ========= ========= The amounts of long-term debt maturing from 1995 through 1998 are: 1995-$126.3 million, 1996-$123.5 million, 1997 $121.2 million, 1998-$117.5 million. Interest costs capitalized as part of the cost of constructing facilities for the years ended December 31, 1993, 1992, and 1991, were $2.7 million, $3.1 million, and $3.6 million, respectively. Cash interest paid for those same years on all outstanding indebtedness amounted to $198 million, $210 million, and $224 million, respectively. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Credit Agreement loans, maturities, and effective weighted average interest rates in effect at December 31, 1993, were as follows: U.S. Dollar Equivalent (in millions) Periodic Access Facility, due in semi-annual installments from February 1994 to February 2000: British sterling loans at 7.85% $ 95.8 Deutschemark loans at 9.06% 49.4 Canadian dollar loans at 6.50% 20.2 French franc loans at 9.17% 18.5 Italian lira loans at 12.19% 8.7 Total Periodic Access loans 192.6 Term Loans: Tranche A U.S. dollar loans, due in semi-annual installments from August 1997 to February 2000 at 6.50% 225.0 Tranche B Deutschemark loans, due in semi-annual installments from February 1994 to February 1997 at 7.88% 172.3 Tranche C U.S. dollar loans, due in semi-annual installments from February 1994 to August 1999 at 6.01% 100.0 Total Term Loans 497.3 Total Credit Agreement long-term loans 689.9 Revolver loans at 7.5% 7.0 Total Credit Agreement loans $ 696.9 ======== Under the 1988 Credit Agreement the various term loans and effective weighted average interest rates in effect at December 31, 1992, were as follows: U.S. Dollar Equivalent (in millions) Deutschemark loans at 11.4% $249.8 Canadian dollar loans at 13.05% 152.5 Total $402.3 ====== The 9-7/8% Senior Subordinated Notes may be redeemed at the Company's option, in whole or in part, on and after June 1, 1998, at redemption prices declining from 102.82% in 1998 to 100% on June 1, 2000, and thereafter. The 10-1/2% Senior Subordinated Discount Debentures may be redeemed at the Company's option, in whole or in part, on and after June 1, 1998, at redemption prices declining from 104.66% in 1998 to 100% on June 1, 2002, and thereafter. The payment of the principal and interest on the AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9-7/8% Senior Subordinated Notes and on the 10-1/2% Senior Subordinated Discount Debentures (together the "Senior Subordinated Debt") is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement and the 9-1/4% Sinking Fund Debentures, the 10-7/8% Senior Notes, and the 11-3/8% Senior Debentures (the said notes and debentures together the "Senior Securities"). The 9-1/4% Sinking Fund Debentures are redeemable at the Company's option, in whole or in part, at redemption prices declining from 105.55% in 1994 to 100% in 2006 and thereafter. The 10-7/8% Senior Notes are not redeemable by the Company. The 11-3/8% Senior Debentures are redeemable at the option of the Company, in whole or in part, on or after May 15, 1997, at redemption prices declining from 105.69% in 1997 to 100% on May 15, 2002, and thereafter. The 14-1/4% Subordinated Discount Debentures are redeemable at the Company's option, in whole or in part, at redemption prices of 105% prior to June 30, 1994, declining to 100% on and after June 30, 1995. The payment of the principal and interest on the 14-1/4% Subordinated Discount Debentures issued by the Company in 1988 is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement, the Senior Securities, and the Senior Subordinated Debt. The 14-1/4% Subordinated Discount Debentures rank senior to the 12-3/4% Junior Subordinated Debentures (described below). The 12-3/4% Junior Subordinated Debentures may be redeemed, at the Company's option, in whole or in part at a redemption price of 101.8% prior to June 30, 1994, and at 100% thereafter. The payment of principal and interest on the 12-3/4% Junior Subordinated Debentures is subordinated in right of payment to the payment when due of all Senior Debt (as defined in the related indenture) of the Company, including all indebtedness under the Credit Agreement, the Senior Securities, the Senior Subordinated Debt, and the 14-1/4% Subordinated Discount Debentures. Obligations under the Credit Agreement are guaranteed by ASI Holding Corporation (the Company's parent), the Company, and significant domestic subsidiaries of the Company (with foreign borrowings also guaranteed by certain foreign subsidiaries) and are secured by U.S., Canadian, and U.K. properties, plant, and equipment; by liens on receivables, inventories, intellectual property, and other intangibles; and by a pledge of the Company's stock and nearly all shares of subsidiary stock. In addition, the obligations of the Company under the Senior Securities are secured, to the extent required by the related indentures, by mortgages on the principal U.S. properties of the Company equally and ratably with the indebtedness under the Credit Agreement and certain related indebtedness. The Senior Subordinated Debt, the 14-1/4% Subordinated Discount Debentures, and the 12-3/4% Junior Subordinated Debentures are unsecured. The Credit Agreement contains various covenants that limit, among other things, indebtedness, dividends on and redemption of capital stock of the Company, purchases and redemptions of other indebtedness of the Company (including its outstanding debentures and notes), rental expense, liens, capital expenditures, investments or acquisitions, disposal of assets, the AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS use of proceeds from asset sales, and certain other business activities and require the Company to meet certain financial tests. In order to maintain compliance with the covenants and restrictions contained in the 1988 Credit Agreement, the Company from time to time has had to obtain waivers and amend- ments. In February 1994 the Company obtained an amendment to the Credit Agreement that among other things relaxed certain financial tests and covenants and facilitated the investment in an air conditioning joint venture and the formation of a holding company to establish joint ventures in the People's Republic of China for the manufacture and sale of plumbing products. The Company currently believes it will comply with the amended financial tests and covenants but may have to obtain similar waivers or amendments in the future. The indentures related to the Company's debentures and notes contain various covenants which, among other things, limit debt and preferred stock of the Company and its subsidiaries, dividends on and redemption of capital stock of the Company and its subsidiaries, redemption of certain subordinated obligations of the Company, the use of proceeds from asset sales, and certain other business activities. Note 9. Exchange of Exchangeable Preferred Stock On June 30, 1993, in exchange for all of the Company's outstanding shares of 12-3/4% Exchangeable Preferred Stock, the Company issued $141.8 million of 12-3/4% Junior Subordinated Debentures Due 2003 to the holder of the Exchangeable Preferred Stock. Those debentures were sold by the holder in a registered public offering in August 1993. The Company received none of the proceeds of this offering. Note 10. Foreign Currency Translation Assets and liabilities of most foreign operations are translated at year-end rates of exchange, and the resulting gains or losses, net of income tax effects, are accumulated in a separate component of stockholder's equity. Changes in exchange rates which gave rise to significant translation effects included in stockholder's equity for the years ended December 31, 1993, 1992, and 1991, are summarized in the accompanying table. Change in End of Period Exchange Rate Currency 1993 1992 1991 British sterling (2)% (19)% (3)% Canadian dollar (4) ( 9) - French franc (6) (6) (2) Deutschemark (7) (6) (1) Italian lira (14) (22) (2) ===== ===== ===== Translation loss included in stockholder's equity, net of tax (dollars in millions) $ (62.3) $ (36.2) $ (2.1) ====== ====== ===== AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The allocation of purchase costs increased the net asset exposure of foreign operations; however, since June 29, 1988, the date of the Merger, the effects of exchange volatility have been ameliorated by the fact that a portion of the Company's borrowings has been denominated in foreign currencies. The losses from foreign currency transactions and translation from operations in countries with high inflation rates reflected in expense were $21.9 million in 1993, $19.3 million in 1992, and $14.4 million in 1991. Note 11. Fair Values of Financial Instruments Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Values of Financial Instruments" ("FAS 107"), requires disclosure information about all financial instruments of a company except certain excluded instruments and instruments for which it is not practicable to estimate fair value. The fair values presented below are estimates as of December 31, 1993, and are not necessarily indicative of amounts the Company could realize or settle currently or indicative of the intent or ability of the Company to dispose of or liquidate such instruments. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and certificates of deposit: The carrying amount reported in the balance sheet for cash and certificates of deposit approximates its fair value. Long- and short-term debt: The fair values of the Company's Credit Agreement loans are estimated using indicative market quotes obtained from a major bank. The fair values of senior notes, senior debentures, senior subordinated notes, senior subordinated discount debentures, subordinated discount debentures, the sinking fund debentures, and the junior subordinated debentures are based on indicative market quotes obtained from a major securities dealer. The fair values of other loans approximate their carrying value. The carrying amounts and estimated fair values of selected financial instruments at December 31, 1993 are as follows: (dollars in millions) Carrying Fair Amount Value Credit Agreement loans $ 697 $ 679 10 7/8% senior notes 150 163 11 3/8% senior debentures 250 276 9 7/8% senior subordinated notes 200 208 10 1/2% senior subordinated discount debentures 478 505 14 1/4% subordinated discount debentures 175 184 9 1/4% sinking fund debentures 150 152 12-3/4% junior subordinated debentures 142 143 Other loans 63 63 AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 12. Related Party Transactions The Company received non-cash capital contributions from Holding in the form of shares of common stock awarded to employees under various stock compensation plans totalling $5.3 million, $3.8 million, and $7.1 million in 1993, 1992 and 1991 respectively. The Company has agreed to pay Kelso an annual fee of $2.75 million for providing management consulting and advisory services. In June 1993 the Company issued 1,000 shares of a new, non-voting Series A Preferred Stock, par value $.01 per share, for $10,000 to an affiliate of Kelso & Company. The Company is committed to contribute $5 million of capital to a Kelso limited partnership. In addition, Tyler Refrigeration was sold to an affiliate of Kelso in 1991. Note 13. Leases The cumulative minimum rental commitments under the terms of all noncancellable operating leases in effect at December 31, 1993, were $108 million. Net rental expenses for operating leases were $34 million, $32 million, and $28 million for the years ended December 31, 1993, 1992, and 1991, respectively. Note 14. Commitments and Contingencies The Company and certain of its subsidiaries are parties to a number of pending legal and tax proceedings. The Company is also subject to federal, state and local environmental laws and regulations and is involved in environmental proceedings concerning the investigation and remediation of numerous sites. In those instances where it is probable that the Company will incur costs from such proceedings and the amounts can be reasonably determined the Company has recorded a liability. The Company believes that these legal, tax, and environmental proceedings will not have a material adverse effect on its consolidated financial position, cash flows, or results of operations. The tax returns of the Company's German subsidiaries are currently under examination by the German tax authorities (see Note 5). Note 15. Segment Data Sales and operating income by geographic location for the years ended December 31, 1993, 1992, and 1991, are shown on the following page. Identifiable assets are also shown as at years ended 1993, 1992, and 1991. See "Business" for a description of each business segment and "Management's Discussion and Analysis of Financial Condition and Results of Operations" for capital expenditures and depreciation and amortization. AMERICAN STANDARD INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS QUARTERLY DATA (Unaudited) (Dollars in millions) First Second Third Fourth Sales $879.4 $995.5 $976.5 $979.1 Cost of sales 650.5 754.5 727.7 769.9 Income (loss) before income taxes and extraordinary loss (9.5) (28.2) 4.1 (46.9) Tax provision 8.1 6.1 7.2 14.8 Loss before extraordinary loss (17.6) (34.3) (3.1) (61.7) Extraordinary loss (Note 8) - (91.9) - - Net loss $(17.6) $(126.2) $ (3.1) $(61.7) ====== ======= ====== ====== First Second Third Fourth Sales $901.0 $995.9 $980.9 $914.1 Cost of sales 672.0 734.1 742.2 703.9 Income (loss) before income taxes (8.1) 11.4 (16.5) (39.3) Tax provision (benefit) 5.5 9.2 (1.5) (8.5) Net income (loss) $(13.6) $ 2.2 $(15.0) $(30.8) ====== ======= ====== ====== ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCING DISCLOSURE. Not applicable. MANAGEMENT ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth certain information as of March 31, 1994, with respect to each person who is an executive officer or director of the Company: Name Age Position with Company Emmanuel A. Kampouris 59 Chairman, President and Chief Executive Officer, and Director Horst Hinrichs 61 Senior Vice President, Transportation Products, and Director George H. Kerckhove 56 Senior Vice President, Plumbing Products, and Director Fred A. Allardyce 52 Vice President and Chief Financial Officer Alexander A. Apostolopoulos 51 Vice President and Group Executive, Americas, Plumbing Products Thomas S. Battaglia 51 Vice President and Treasurer Roberto Canizares M. 44 Vice President, Air Conditioning Products' Asia/America Zone Wilfried Delker 53 Vice President and Group Executive, Worldwide Fittings, Plumbing Products Adrian B. Deshotel 48 Vice President, Human Resources Cyril Gallimore 65 Vice President, Systems and Technology Luigi Gandini 55 Vice President and Group Executive, European Plumbing Products Daniel Hilger 53 Vice President and Group Executive, Air Conditioning Products in Europe, Middle East and Africa Joachim D. Huwendiek 63 Vice President, Automotive Products in Germany Name Age Position with Company Frederick W. Jaqua 72 Vice President and General Counsel and Secretary W. Craig Kissel 42 Vice President and Group Executive, Unitary Products Group William A. Klug 62 Vice President, Trane International Philippe Lamothe 57 Vice President, Automotive Products in France G. Eric Nutter 58 Vice President, Automotive Products in the United Kingdom Raymond D. Pipes 44 Vice President and Group Executive, Plumbing Products in the Far East Bruce R. Schiller 49 Vice President and Group Executive, Compressor Business James H. Schultz 45 Vice President and Group Executive, Commercial Systems Group G. Ronald Simon 52 Vice President and Controller Wade W. Smith 43 Vice President, U.S. Plumbing Products Benson I. Stein 56 Vice President, General Auditor Robert M. Wellbrock 47 Vice President, Taxes Shigeru Mizushima 50 Director Roger W. Parsons 52 Director Frank T. Nickell 46 Director J. Danforth Quayle* 47 Director John Rutledge 45 Director Joseph S. Schuchert* 65 Director * The Management Development Committee functions as the compensation committee of the Company. Since December 2, 1993, its members have been Messrs. Quayle and Schuchert. Prior thereto Mr. Schuchert and two other directors who retired in December, Richard M. Cyert and Edward Donley, served as members of the committee. Directors are elected to hold office until the next annual meeting of stockholders or until their successors are elected. Messrs. Kampouris, Mizushima, Nickell, and Schuchert were elected in 1988; Mr. Kerckhove in September 1990; Mr. Hinrichs in March 1991; Dr. Rutledge in March 1993; Mr. Quayle in September 1993; and Mr. Parsons in March 1994. Holding, Kelso ASI Partners, L.P. (the 73 percent owner of Holding) ("ASI Partners"), and executive officers and certain other management personnel of the Company who purchased shares of Holding common stock ("Management Investors") entered into a Stockholders Agreement that, among other things, provides for arrangements regarding the control of the election of directors of Holding. Until the earlier of (i) the occurrence of a public offering pursuant to an effective registration statement under the Securities Act covering the offer and sale of Holding common stock to the public and underwritten by an investment banking firm of nationally recognized standing and (ii) July 7, 1998, the Management Investors as a group are entitled to nominate at least two directors to the Board of Directors of Holding, and ASI Partners is entitled to nominate the remaining directors. As a result, during such period ASI Partners will control the Board of Directors. To effectuate their rights, the Management Investors and ASI Partners have agreed in the Stockholders' Agreement to grant an irrevocable proxy to the Secretary of Holding to vote their shares of common stock in accordance with such nominations. Such grant of an irrevocable proxy terminates upon Holding's becoming subject to the proxy rules under the Securities Exchange Act of 1934. At present the Board of Directors of Holding consists of nine directors. The sole holder of the outstanding common stock of American Standard Inc. is Holding, and Holding exclusively elects the directors of American Standard Inc. Currently the directors of Holding are also the directors of American Standard Inc. Set forth below is the principal occupation of each of the executive officers and directors named above during the past five years (except as noted, all positions are with the Company). Mr. Kampouris was elected Chairman in December 1993 and President and Chief Executive Officer in February 1989. Prior thereto he was Senior Vice President, Building Products, from 1984 to February 1989. He is also a director of Daido Hoxan Inc. Mr. Kampouris has served as a director of the Company since July 1988. Mr. Hinrichs was elected Senior Vice President, Transportation Products, in December 1990. Prior thereto he served as Vice President and Group Executive, Automotive Products, from 1987 to 1990. Mr. Hinrichs has served as a director of the Company since March 1991. Mr. Kerckhove was elected Senior Vice President, Plumbing Products, in June 1990. Prior thereto he was Vice President (from 1985 until June 1990) and Group Executive (from 1988 until June 1990) of European Plumbing Products. Mr. Kerckhove has served as a director of the Company since September 1990. Mr. Allardyce was elected Vice President and Chief Financial Officer in January 1992. Prior thereto he served as Vice President and Controller from February 1983 until December 1991. Mr. Apostolopoulos was elected Vice President and Group Executive, Americas Plumbing Products, in December 1990. Prior thereto he served as the executive in charge of Plumbing Products' joint ventures from September 1989 to November 1990 and Managing Director of the Company's Egyptian subsidiary from July 1984 to August 1989. Mr. Battaglia was elected Vice President and Treasurer in September 1991. Prior thereto he was Assistant Treasurer. Mr. Canizares was elected Vice President, Air Conditioning Products' Asia/America Zone, in December 1990. Prior thereto he served as the executive in charge of this zone and Manager of Planning and Distribution from November 1986 to November 1990. Mr. Delker was elected Vice President and Group Executive, Worldwide Fittings, Plumbing Products, in April 1990. Prior thereto he served as executive in charge of the Company's brass fittings manufacturing operations from June 1982 until March 1990. Mr. Deshotel was elected Vice President, Human Resources, in January 1992. Prior thereto he served as Group Vice President, Human Resources, for U.S. Plumbing Products from September 1986 until December 1991. Mr. Gallimore was elected Vice President, Systems and Technology, in December 1990. Prior thereto he served as the executive in charge of Manufacturing and Technology from 1984 to November 1990. Mr. Gandini was elected Vice President and Group Executive, European Plumbing Products, in July 1990. Prior thereto he served as General Manager of Ideal Standard S.p.A., the Italian subsidiary of the Company, from January 1978 until June 1990. Mr. Hilger was elected Vice President and Group Executive, Air Conditioning Products, in Europe, Middle East and Africa, in June 1988. Mr. Huwendiek was elected Vice President, Automotive Products in Germany, in January 1992. Prior thereto he served as Managing Director of WABCO Germany since June 1987. Mr. Jaqua was elected Vice President and General Counsel and Secretary in April 1989. Prior thereto he was Associate General Counsel and Assistant Secretary. Mr. Kissel was elected Vice President in charge of Air Conditioning Products' Unitary Products Group in January 1992, becoming Group Executive in March 1994. He served as Vice President, Sales and Distribution, for Air Conditioning Products, from December 1990 until January 1992 and served as divisional Senior Vice President in charge of U.S. Sales from January to November 1990. He was in charge of Western Regional Sales from January 1989 to January 1990. Mr. Klug was elected Vice President in 1985 and has been in charge of Trane International since December 1993. He served as Group Executive, Unitary Products Group, from April 1990 until December 1993. He was Group Executive, North American Sales and Distribution, Air Conditioning Products, from October 1987 to March 1990. Mr. Lamothe was elected Vice President, Automotive Products in France, in January 1992. He served as Group Vice President of the French transportation business during 1991 and prior thereto was General Manager of the French transportation subsidiary. Mr. Nutter was elected Vice President, Automotive Products in the United Kingdom, in January 1992. Prior thereto he served as Vice President and General Manager of WABCO Transportation U.K. Limited, the United Kingdom transportation subsidiary of the Company from March 1991 until December 1991 and Group Managing Director of the United Kingdom transportation subsidiary from June 1987 until February 1991. Mr. Pipes was elected Vice President and Group Executive for the Far East Region of Plumbing Products in May 1992. Prior thereto he served as Managing Director of the Company's Philippine subsidiary from May 1990 until April 1992 and was Group Vice President, Control & Finance, of U.S. Plumbing Products from March 1985 until April 1990. Mr. Schiller was elected Vice President and Group Executive, Compressor Business (Air Conditioning Products) in March 1994. Prior thereto he served as General Manager, Compressor Business Group, from May 1993 to February 1994 and Manager and then General Manager of the Company's Tyler, Texas, facility from March 1986 to April 1993. Mr. Schultz was elected Vice President and Group Executive, Commercial Systems, in 1987. Mr. Simon was elected Vice President and Controller in January 1992. Prior thereto he served as Vice President and Controller of the Air Conditioning Products' Commercial Systems Group from December 1984 to December 1991. Mr. Wade W. Smith was elected Vice President, U.S. Plumbing Products, in May 1992. Prior thereto he served as Group Vice President in charge of the Chinaware Business Unit of U.S. Plumbing Products from February 1992 until April 1992 and from April 1987 to February 1992 he was Vice President and General Manager of the Building Automation Systems Division of the Commercial Systems Group of Air Conditioning Products. Mr. Stein was elected Vice President, General Auditor, in March 1994; from December 1986 to February 1994 he was the Company's General Auditor. Mr. Wellbrock was elected Vice President, Taxes, effective January 1, 1994. Prior thereto he served as Director of Taxes from 1988 through 1993. Mr. Mizushima has been President and Chief Operating Officer of Daido Hoxan Inc. since the merger in April 1993 of Hoxan Corporation with Daido Sanso Company (a subsidiary of Air Products and Chemicals Inc.). Prior thereto Mr. Mizushima was President of Hoxan Corporation, a position he held since 1984. He is also a director of Daido Hoxan. Daido Hoxan Inc is the second largest supplier of industrial gases in Japan. One of its subsidiaries is a distributor of American-Standard plumbing products in Japan. Mr. Mizushima has served as a director of the Company since July 1988. Mr. Nickell has been President and a director of Kelso & Companies, Inc., since March 1989. Kelso & Companies, Inc. is the general partner of Kelso & Company, L.P. From 1984 to 1989 Mr. Nickell was a general partner of Kelso & Company, L.P. He is also a director of Club Car, Inc.; King Holding Corp; and Tyler Holdings Corporation. Mr. Nickell has served as a director of the Company since May 1988. Mr. Parsons is Managing Director of Rea Brothers Group PLC ("Rea Brothers Group"), which he joined in 1988 after a long banking career. Rea Brothers Group is a U.K. holding company of subsidiaries engaged in the investment banking business. He also holds directorships in several subsidiaries of Rea Brothers Group. Mr. Parsons was elected as a director of the Company on March 2, 1994. Mr. Quayle served as Vice President of the United States from January 1989 to January 1993. Since leaving that office Mr. Quayle has been associated with Circle Investors, Inc. (an investment planning and consulting firm), and FX Strategic Advisors, Inc. (an international trade consulting firm), both of which he serves as Chairman. He is a Director of Central Newspapers, Inc. Mr. Quayle has served as a director of the Company since September 1993. Dr. Rutledge has been Chairman of Rutledge & Company, Inc., a merchant banking firm, since January 1991. He is the founder and Chairman of Claremont Economics Institute, an economic research firm established in 1975. He is also a director of Earle M. Jorgensen & Company, Lazard Freres Funds, Medical Specialties Group, and Utendahl Capital Partners and is a special advisor to Kelso & Company. Dr. Rutledge has served as a director of the Company since March 1993. Mr. Schuchert has been Chairman, CEO, and a director of Kelso & Companies, Inc., since March 1989. Kelso & Companies, Inc. is the general partner of Kelso & Company, L.P. From 1984 to 1989 Mr. Schuchert was managing general partner of Kelso & Company, L.P. He is also a director of Earle M. Jorgensen & Company. Mr. Schuchert has served as a director of the Company since May 1988. On December 23, 1992, Kelso & Company and its chief executive officer, Mr. Schuchert, without admitting or denying the findings contained therein, consented to an administrative order in respect of a Securities and Exchange Commission ("Commission") inquiry relating to the 1990 acquisition of a portfolio company by a Kelso affiliate. The order found that Kelso's tender offer filing in connection with the acquisition did not comply fully with the Commission's tender offer reporting requirements, and required Kelso and Mr. Schuchert to comply with these requirements in the future. Compensation Committee Interlocks and Insider Participation Mr. Schuchert is a member of the Management Development Committee (the Compensation Committee) of the Company's Board of Directors. He is Chairman of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.) and a general partner of American Standard Partners, the general partner of Kelso ASI Partners. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V") in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P., is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Supplemental Plan benefits are based on credited years of service and average annual compensation for the highest three calendar years of the final ten calendar years of employment (not exceeding 60 percent of average annual compensation for such years of service) and are reduced by an offset consisting of certain other retirement benefits, including amounts payable under the Terminated Plan, annual allocations to the executive officer's Employee Stock Ownership Plan ("ESOP") accounts, and Social Security benefits. Benefits under the Supplemental Plan are vested after five years of service or employment continuation through age 65. Compensation used in determining Supplemental Plan benefits (covered compensation) includes only salary and bonus reflected in the Summary Compensation Table above. No covered compensation of any Named Officer differs by more than 10% from the salary and bonus set forth in the Summary Compensation Table. The years of credited service under the Supplemental Plan for the Named Officers are as follows: Mr. Kampouris, 28 years; Mr. Hinrichs, 35 years; Mr. Kerckhove, 32 years; Mr. Allardyce, 17 years; Mr. Gandini, 33 years; and Mr. H.T. Smith, 13 years. The current annual target benefit for Mr. Kampouris is approximately 20 percent higher than that shown in the above table since a different benefit formula under the pre-1990 version of the Supplemental Plan applies to his period of service and earnings prior to April 27, 1991. The method of calculating the lump sum payable to Mr. Kampouris that is attributable to his accrued benefit through April 27, 1991, has been adjusted to reflect the recent increase in the Federal ordinary income tax rates. An amendment to the Supplemental Plan in 1993 established minimum annual lump sum payments for certain Named Officers which, after giving effect to Plan offsets, are estimated as follows: Mr. Kampouris, $427,000; Mr. Hinrichs, $143,000; Mr. Kerckhove, $37,000; and Mr. Gandini, $24,000. Shares of Holding Common Stock distributable to Plan participants are delivered to a grantor's trust for their benefit. The trust will terminate following a public offering of Holding Common Stock, at which time shares or cash credited to each participant's account is to be distributed. Payment, however, may be deferred if an event of default under the Company's loan agreements or debt indentures has occurred or will occur as a result of such payment. Until distribution, assets of the trust are subject to the claims of creditors of Holding or the Company. Shares held by the trust are voted by the trustee in accordance with the Company's directions. Directors' Fees and Other Arrangements In the first half of 1993 each outside director was paid a fee of $5,000 per calendar quarter and in addition received a fee of $500 for each meeting of the Board attended; in the last half each outside director was paid a fee of $6,750 per calendar quarter and in addition received a fee of $1,000 for each meeting of the Board attended. Effective with the third quarter, an outside director is also paid $1,000 for attending a Committee meeting. (Previously an outside director was paid $500 for attending a Committee meeting not held on the day of a Board meeting.) The only directors currently eligible for directors' fees are directors who are neither employees of the Company or Kelso. They are Messrs. Mizushima, Parsons, Quayle, and Rutledge. All directors are reimbursed for reasonable expenses incurred in connection with attendance at any meetings. No separate directors' fees are paid for attendance at meetings of Holding that are held on the same day the Company's Board meets. A Supplemental Compensation Plan for Outside Directors ("Supplemental Compensation Plan") was adopted in June 1989. A Plan Account was establish- ed for each participating director at that time consisting of units equivalent to $50,000 of Holding common stock with each unit having a value of $19 per share, the independently appraised value of the shares of Holding as of December 31, 1988. For the purpose of providing a measure of parity among the directors, the $50,000 amount was increased to $100,000 for participating directors who became Board Members after January 1, 1993, with such amount converted into units for the account of such directors at the rate of $42.96 per unit ($42.96 representing the independently appraised value of the shares of Holding as of December 31, 1992). When a participating director ceases to be a member of the Board, he or his beneficiary will receive a cash payment equal to the number of units in his Plan Account multiplied by the per-share value of Holding common stock based on the then last year-end appraisal. If a participating director is removed for cause, his entire interest in the Plan is forfeited. Employee-directors and Messrs. Nickell and Schuchert do not participate in this Plan. Mr. Donley and Dr. Cyert, directors who retired in December 1993, each received a payment of $113,053 pursuant to the Supplemental Compensation Plan. Corporate Officers Severance Plan and Other Employment or Severance Arrangements The Board of Directors approved a severance plan for executive officers (the "Officers Severance Plan"), effective April 27, 1991. The Officers Severance Plan provides that any participant whose employment is involuntarily terminated by the Company without "Cause" (as defined in the Officers Severance Plan) or who leaves the Company for "Good Reason" (as defined in the Officers Severance Plan) shall be paid an amount equal to the sum of two (three in the case of the Chief Executive Officer) times such participant's annual base salary at the rate in effect at the time of termination, a proration of the then Annual Incentive Plan target award (described previously), and one (two in the case of the Chief Executive Officer) times such target award. In addition, group life, accident, and disability insurance coverages, as well as group medical coverage, will be continued for up to 24 (36 in the case of the Chief Executive Officer) months following such officer's termination. The Named Officers (other than Mr. Smith, who retired in December 1993) are participants in this Plan. An agreement was entered into with H. Thompson Smith in December 1993 concerning the terms of his termination of employment and retirement. Under that agreement he is entitled to receive his 1993 Annual Incentive Plan award in the amount of $154,000 and will be entitled to receive the same amount in March 1995. In addition, Mr. Smith is retained as a consultant through 1995 at the rate of $29,583 per month. In the event of Mr. Smith's death, the fees remaining through the end of 1995 are payable in a lump sum to his spouse or estate. He is also entitled to receive payments under the Company's Long-Term Incentive Compensation Plan for the 1992-1994 and 1993-1995 performance periods in accordance with its terms, such awards to be prorated to December 31, 1993. Mr. Smith continues under the Company's medical and life insurance programs through 1995. ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of the common stock, $.01 par value, of American Standard Inc., the only voting stock of American Standard Inc., is owned by Holding. Set forth below is the number of shares of Common Stock, par value $.01 per share, of Holding, the only outstanding voting stock of Holding, beneficially owned as of March 10, 1994, by each Director and nominee, each Named Executive Officer, all Directors and executive officers of Holding as a group, and each 5% holder. Shares Percent Name and Address Beneficially of Title of Class of Beneficial Owner Owned Class Holding common stock, par value - Kelso ASI Partners, L.P.(a) 18,000,000 73% $.01 per share ("ASI Partners") Joseph S. Schuchert(a) 18,000,000(d) 73% (d) Frank T. Nickell(a) 18,000,000(d) 73% (d) George E. Matelich(a) 18,000,000(d) 73% (d) Thomas R. Wall IV(a) 18,000,000(d) 73% (d) Emmanuel A. Kampouris(b) 225,000 * George H. Kerckhove(b) 113,000 * Horst Hinrichs(b) 90,000 * Fred A. Allardyce(b) 113,000 * American-Standard Employee Stock Ownership Plan(c) 4,267,710 17% All current directors and executive officers of Holding and the Company as a group 18,824,900(e) 77% (e) * Less than one percent. (a) The business address for such persons is c/o Kelso & Company, 350 Park Avenue, New York, N.Y. 10022. (b) Mr. Kampouris is Chairman, President and Chief Executive Officer and a director of the Company and of Holding. Messrs. Hinrichs and Kerckhove are Named Officers and directors of the Company and of Holding, and Mr. Allardyce is a Named Officer of the Company and of Holding. (c) The business address for the ESOP is c/o American Standard Inc., 1114 Avenue of the Americas, New York, N.Y. 10036. At December 31, 1993, 3,548,609 Plan shares were allocated to executive officers of Holding and the Company and other ESOP participants. The number of shares shown for executive officers in the table above does not reflect shares allocated to their accounts in the ESOP. Shares in the ESOP account are voted by the ESOP trustee as directed by the plan board (the board administering the trust which currently consists of executive officers of the Company). However, participants may direct the vote of their ESOP account shares in matters involving mergers, recapitalizations, or dispositions of substantial assets. Until termination of employment a participant cannot dispose of shares in his ESOP account. Shares distributed to a participant on termination are subject to the Company's right of first refusal. The shares in the Named Officers ESOP accounts are as follows: Mr. Kampouris, 3,995 shares; Mr. Kerckhove, 3,953 shares; Mr. Hinrichs, 4,266 shares; Mr. Allardyce, 4,246 shares; and Mr. Gandini, 2,225 shares. The shares in the ESOP accounts for all executive officers total 69,218 shares. The number of shares shown for executive officers in the table above also does not reflect shares of Holding Common Stock issued as part of the payouts under the LTIP and held for them in trust under a trust agreement dated as of January 1, 1993. Shares in the trust are voted by the trustee as directed by the Company. Until termination of the trust, a beneficiary of the Trust cannot dispose of shares credited to his account. Shares in the Named Officers' accounts in the trust are as follows: Mr. Kampouris, 4,453 shares; Mr. Kerckhove, 2,012 shares; Mr. Hinrichs, 1,787 shares; Mr. Allardyce, 1,224 shares; and Mr. Gandini, 1,176 shares. The shares in the trust accounts for all executive officers total 28,620 shares. Also not included above are 19,198 shares of ASI Holding common stock held in a similar grantor's trust for the account of certain executive officers. These were earned by them under an employee incentive plan prior to their becoming officers. (d) Messrs. Schuchert and Nickell, each a director of the Company and of Holding, and Messrs. Matelich and Wall may be deemed to share beneficial ownership of shares owned of record by ASI Partners by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. Messrs. Schuchert, Nickell, Matelich and Wall share investment and voting power with respect to securities owned by ASI Partners. See "Certain Transactions and Relationships." Dr. Cyert, who was a director of Holding and the Company until December 1993, is a limited partner in one of the Kelso partnerships that has invested in ASI Partners. (e) Out of such 18,824,900 shares, 18,000,000 shares represent shares of Common Stock owned by ASI Partners in which Messrs. Schuchert and Nickell, each a director of Holding, may be deemed to share beneficial ownership by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. ITEM 13. CERTAIN TRANSACTIONS AND RELATIONSHIPS Messrs. Schuchert and Nickell, directors of Holding and the Company, are Chairman and President, respectively, of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.), and are general partners of American Standard Partners, the general partner of Kelso ASI Partners. Mr. Schuchert is also a member of the Management Development Committee (the compensation committee) of the Company's Board of Directors. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also has entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V"), in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P. is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Company will invest in a Cayman Islands corporation, A-S China Plumbing Products Limited ("ASPPL"), to be used for the establishment of various joint ventures in the People's Republic of China. The Company will have a 21% voting interest in ASPPL. Shares in ASPPL will also be sold in a private placement to certain institutions and other investors, including certain executive officers and employees of the Company and its subsidiaries. Mr. Mizushima, a director of the Company and of Holding, is President and Chief Operating Officer of Daido Hoxan Inc., a Japanese corporation which has an approximately 11 percent limited partnership interest in ASI Partners. Daido Hoxan Inc. is the largest distributor of the Company's plumbing products in Japan. Its transactions as distributor with the Company and its subsidiaries in 1992, which were on customary terms and in the ordinary course of business, were not material to either the Company or Daido Hoxan Inc. The Company also entered into leasing transactions with an affiliate of Daido Hoxan whereby it has leased certain machinery and equipment on financial terms that were comparable to those available from other leasing companies. The leasing transactions were not material to either the Company or Daido Hoxan Inc. Fidelity Management Trust Company ("Fidelity") is the owner of record of the shares of Holding held by the ESOP, a 17% owner of Holding shares. Fidelity was paid by the Company approximately $180,000 in 1993 for services in connection with administering the Company's ESOP and Savings Plan. Mr. Nickell's father is an officer and owns more than 10 percent of AC Corporation, a contracting company which purchases air conditioning products from the Company's Trane Division. Such purchases in 1993 were on customary terms and in the ordinary course of business and were not material to either the Company or AC Corporation. Management Investors Stockholders Agreement Under the Stockholders Agreement, pursuant to which Management Investors purchased shares of Holding common stock, Holding is obligated to repurchase, subject to the limitations contained in the Company's lending arrangements and debt instruments, such shares at certain fair market prices in case of the death, disability, retirement, or termination of employment of a Management Investor. Shares are paid for within the constraints of the Company's lending arrangement and debt instruments, as supplemented by a Schedule of Priorities established by Holding's Board of Directors. The Named Officers (other than Mr. Gandini) and most of the executive officers are Management Investors and parties to the Stockholders Agreement. PART IV ITEM 14. CONSOLIDATED EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1 and 2. Financial statements and financial statement schedules The financial statements and schedules listed in the accompanying index to financial statements are filed as part of this annual report on Form 10-K. 3. Exhibits The exhibits listed on the accompanying index to exhibits are filed as part of this annual report on Form 10-K. Included in the exhibits are the following management contracts or compensatory plan arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K American Standard Inc. Long-Term Incentive Compensation Plan, as amended Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan American Standard Inc. Annual Incentive Plan American Standard Inc. Management Partner's Bonus Plan with amendments American Standard Inc. Executive Supplemental Retirement Benefit Program American Standard Employee Stock Ownership Plan with amendments Estate Preservation Plan with amendments Corporate Officers Severance Plan American Standard Inc. Supplemental Compensation Plan for Outside Directors ASI Holding Corporation 1989 Stock Purchase Loan Program Summary of Terms of Unfunded Deferred Compensation Plan Letter of Agreement with respect to H. Thompson Smith's retirement and consulting services (b) Reports on Form 8-K for the quarter ended December 31, 1993. None 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. AMERICAN STANDARD INC. By /s/ Emmanuel A. Kampouris (Emmanuel A. Kampouris) (Chairman, President and Chief Executive Officer) March 30, 1994 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: /s/ Emmanuel A. Kampouris Director, Chairman and President March 30, 1994 (Emmanuel A. Kampouris) (Chief Executive Officer) /s/ Fred A. Allardyce Vice President and Chief March 30, 1994 (Fred A. Allardyce) Financial Officer /s/ G. Ronald Simon Vice President & Controller March 30, 1994 (G. Ronald Simon) (Principal Accounting Officer) /s/ Horst Hinrichs Director March 30, 1994 (Horst Hinrichs) /s/ George H. Kerckhove Director March 30, 1994 (George H. Kerckhove) /s/ Shigeru Mizushima Director March 30, 1994 (Shigeru Mizushima) /s/ Frank T. Nickell Director March 30, 1994 (Frank T. Nickell) /s/ J. Danforth Quayle Director March 30, 1994 (J. Danforth Quayle) /s/ Roger W. Parsons Director March 30, 1994 (Roger W. Parsons) /s/ Joseph S. Schuchert Director March 30, 1994 (Joseph S. Schuchert) /s/ John Rutledge Director March 30, 1994 (John Rutledge) AMERICAN STANDARD INC. AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14 (a)) Form 10-K (Pages) 1. Financial Statements Consolidated Balance Sheet at December 31, 1993 and 1992 42 Years ended December 31, 1993, 1992 and 1991, Consolidated Statement of Operations 41 Consolidated Statement of Stockholder's Equity (Deficit) 43 Consolidated Statement of Cash Flows 44-45 Notes to Consolidated Financial Statements 46-62 Segment Data 63 Segment data for capital expenditures, depreciation and amortization 23-29 Quarterly Data (Unaudited) 64 Report of Independent Auditors 40 2. Financial statement schedules, years ended December 31, 1993, 1992 and 1991: Report of Independent Auditors 84 V Facilities 85 VI Accumulated Depreciation of Facilities 86 VIII Reserves 87 IX Short-Term Borrowings 88 X Supplementary Income Statement Information 89 All other schedules have been omitted because the information is not applicable or is not material or because the information required is included in the financial statements or the notes thereto. Report of Independent Auditors Stockholders and Board of Directors American Standard Inc. We have audited the consolidated financial statements of American Standard Inc. as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated March 14, 1994 (included elsewhere in this Annual Report on Form-10K). Our audits also included the consolidated schedules listed in Item 14(a)2. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the consolidated schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be stated therein. /s/ Ernst & Young Ernst & Young March 14, 1994 AMERICAN STANDARD INC. INDEX TO EXHIBITS (Item 14(a)3 - Exhibits Required by Item 601 of Regulation S-K and Additional Exhibits) (The File Number of American Standard Inc., the Registrant, and for all Exhibits incorporated by reference is 1-470, except those Exhibits incorporated by reference in filings made by ASI Holding Corporation ("Holding") whose File Number is 33-23070) (3) (i) Restated Certificate of Incorporation of American Standard Inc. (the "Company"); previously filed as Exhibit (3)(i) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (ii) Certificate of Designation, Preferences and Relative, Participating, Optional and other Special Rights of Preferred Stock and Qualifications, Limitations and Restrictions thereof of Series A Preferred Stock. (iii) By-laws of the Company; previously filed as Exhibit (3)(ii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (4) (i) Indenture, dated as of November 1, 1986, between the Company and Manufacturers Hanover Trust Company, Trustee, including the form of 9-1/4% Sinking Fund Debenture Due 2016 issued pursuant thereto on December 9, 1986, in the aggregate principal amount of $150,000,000; previously filed as Exhibit (4)(iii) in the Company's Form l0-K for the fiscal year ended December 31, 1986, and herein incorporated by reference. (ii) Instrument of Resignation, Appointment and Acceptance, dated as of April 25, 1988 among the Company, Manufacturers Hanover Trust Company (the "Resigning Trustee") and Wilmington Trust Company (the "Successor Trustee"), relating to resignation of the Resigning Trustee and appointment of the Successor Trustee under the Indenture referred to in Exhibit (4)(i) above; previously filed as Exhibit 4(ii) in Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (iii) Form of Indenture, dated as of July 1, 1988, between the Company and Shawmut Bank Connecticut, National Association (formerly known as The Connecticut National Bank), as Trustee, relating to the Company's 14-1/4% Subordinated Discount Debentures due 2003; previously filed as Exhibit 4.3 in Amendment No. 2 to Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iv) Form of Debenture evidencing the 14-1/4% Subordinated Discount Debentures due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(iii) above. (v) Indenture dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 10-7/8% Senior Notes due 1999, in the aggregate principal amount of $150,000,000; previously filed as Exhibit (4)(i) in the Company's Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (vi) Form of 10-7/8% Senior Notes due 1999 included as Exhibit A to the Indenture described in (4)(v) above. (vii) Indenture dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 11-3/8% Senior Debentures due 2004, in the aggregate principal amount of $250,000,000; previously filed as Exhibit (4)(iii) in the Company's Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (viii) Form of 11-3/8% Senior Debentures due 2004 included as Exhibit A to the Indenture described in (4)(vii) above. (ix) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 9-7/8% Senior Subordinated Notes Due 2001; previously filed as Exhibit 4(xxxi) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Note evidencing the 9-7/8% Senior Subordinated Notes Due 2001 included as Exhibit A to the Form of Indenture referred to in 4(ix) above. INDEX TO EXHIBITS - (Continued) (xi) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 10-1/2% Senior Subordinated Discount Debentures Due 2005; previously filed as Exhibit (4)(xxxiii) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xii) Form of Debenture evidencing the 10-1/2% Senior Subordinated Discount Debentures Due 2005 included as Exhibit A to the Form of Indenture referred to in (4)(xi) above. (xiii) Form of Indenture, dated as of October 25, 1990, as amended and restated as of June 15, 1993, between the Company and Shawmut Bank, N.A., as Trustee, relating to Company's 12-3/4% Junior Subordinated Debentures Due 2003; previously filed as Exhibit (4)(xx) in Amendment No. 2 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xiv) Form of Indenture evidencing the 12-3/4% Junior Subordinated Debentures Due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(xiii) above. (xv) Assignment and Amendment Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company, Bankers Trust Company, as agent under the 1988 Credit Agreement, the financial institutions named as Lenders in the 1988 Credit Agreement and certain additional Lenders and Chemical Bank, as Administrative Agent and Arranger; previously filed as Exhibit (4)(xiii) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xvi) Credit Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company and the lending institutions listed therein, Chemical Bank, as Administrative Agent and Arranger; Bankers Trust Company, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A., Deutsche Bank AG, The Long-Term Credit Bank of Japan, Ltd., New York Branch, and NationsBank of North Carolina, N.A., as Managing Agents, and Banque Paribas, Citibank, N.A., and Compagnie Financiere de CIC et de l'Union Europeenne, New York Branch, as Co-Agents; previously filed as Exhibit (4)(xiv) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xvii) First Amendment, Consent and Waiver, dated as of February 10, 1994, to the Credit Agreement referred to in (4)(xvi) above. INDEX TO EXHIBITS - (Continued) (xviii) Stockholders Agreement, dated as of July 7, 1988, as amended as of August 1, 1988, among Holding, Kelso ASI Partners, L.P., and the Management Stockholders named therein; previously filed as Exhibit 4.19 in Amendment No. 2 in the Registration Statement No. 33-23070 of Holding under the Securities Act of 1933, as amended, and herein incorporated by reference. (xix) Amendment to Section 2.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of January 1, 1991; previously filed as Exhibit (4)(xxvii) by Holding in its Form 10-K for the year ended December 31, 1992, and herein incorporated by reference. (xx) Supplement and Amendment dated as of September 4, 1991 to the Stockholders Agreement, dated as of July 7, 1988, as amended, referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(ii) by Holding in its Form 10-Q for the quarter ended September 30, 1991, and herein incorporated by reference. (xxi) Amended Section 6.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of September 2, 1993; copy of amended Section is being filed as Exhibit (4)(xvii) by Holding in its Form l0-K for the year ended December 31, 1993, concurrently with the filing of the Company's Form 10-K for the same year, and herein incorporated by reference. (xxii) Revised Schedule of Priorities effective as of September 5, 1991, as adopted by the Board of Directors of Holding, pursuant to the Stockholders Agreement referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(iii) by Holding in its Form l0-Q for the quarter ended September 30, 1991 and herein incorporated by reference. (10) (i) Agreement and Plan of Merger, dated as of March 16, 1988, among the Company, ASI Acquisition Company and Holding and Offer Letter, dated March 16, 1988, between the Company and Kelso & Company, L.P.; previously filed as Exhibit 2 to the Company's Schedule 14D-9 filed March 21, 1988, in connection with the offer for all the shares of the Company's Common Stock by a corporation formed by Kelso & Company, L.P., and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ii) Amendment, dated June 3, 1988 to Agreement and Plan of Merger referred to in (l0)(i) above; previously filed as Exhibit 2.50 in Amendment No. 1 to the Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iii) American Standard Inc. Long-Term Incentive Compensation Plan, as amended through February 6, 1992; previously filed as Exhibit (10)(iv) in the Company's Form 10-K for the fiscal year ended December 31, 1992, and herein incorporated by reference. (iv) Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan. (v) American Standard Inc. Annual Incentive Plan; previously filed as Exhibit (l0)(vii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (vi) American Standard Inc. Management Partners' Bonus Plan effective as of July 7, 1988; previously filed as Exhibit (l0)(i) in the Company's Form l0-Q for the quarter ended September 30, 1988, and herein incorporated by reference; amendments to Plan adopted on June 7, 1990, previously filed as Exhibit (4)(ii) in the Company's Form l0-Q for the quarter ended June 30, 1990, and herein incorporated by reference. (vii) American Standard Inc. Executive Supplemental Retirement Benefit Program, as restated to include all amendments through December 31, 1993. (viii) Stock Purchase Agreement, dated April 27, 1988, between ASI Acquisition Company and General Electric Capital Corporation (without schedules); previously filed as Exhibit 2.4 in Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ix) Amendment, dated June 3, 1988, to Stock Purchase Agreement referred to in (l0)(viii) above; previously filed as Exhibit 2.6 in Amendment No. 1 in Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Composite American-Standard Employee Stock Ownership Plan incorporating amendments through December 3, 1992; previously filed as Exhibit (10)(x) in Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xi) American-Standard Employee Stock Ownership Trust Agreement, dated as of December 1, 1991, between ASI Holding Corporation and Fidelity Management Trust Company (as successor to Citizens & Southern Trust Company (Georgia), N.A.), as trustee; previously filed as Exhibit (10)(xiv) in the Company's Form 10-K for the year ended December 31, 1991, and herein incorporated by reference. (xii) Consulting Agreement made July 1, 1988, with Kelso & Company, L.P. concerning general management and financial consulting services to the Company; previously filed as Exhibit (l0)(xviii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (xiii) American Standard Inc. Supplemental Compensation Plan for Outside Directors, as amended through September 1993. (xiv) ASI Holding Corporation 1989 Stock Purchase Loan Program; previously filed as Exhibit l0(i) in Holding's Form l0-Q for the quarter ended September 30, 1989, and herein incorporated by reference. (xv) Corporate Officers Severance Plan adopted in December, 1990, effective April 27, 1991; previously filed as Exhibit (l0)(xix) in the Company's Form l0-K for the fiscal year ended December 31, 1990, and herein incorporated by reference. (xvi) Estate Preservation Plan adopted in December, 1990; previously filed as Exhibit (l0)(xx) in the Company's Form l0-K for the fiscal year ended December 31, 1990, and herein incorporated by reference. (xvii) Amendment adopted in March 1993 to Estate Preservation Plan referred to in (10)(xvi) above. (xviii) Summary of terms of Unfunded Deferred Compensation Plan, adopted December 2, 1993.) (xix) Retirement/Consulting Agreement, dated December 28, 1993, between H. Thompson Smith and the Company. (21) Listing of the Company's subsidiaries. ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of the common stock, $.01 par value, of American Standard Inc., the only voting stock of American Standard Inc., is owned by Holding. Set forth below is the number of shares of Common Stock, par value $.01 per share, of Holding, the only outstanding voting stock of Holding, beneficially owned as of March 10, 1994, by each Director and nominee, each Named Executive Officer, all Directors and executive officers of Holding as a group, and each 5% holder. Shares Percent Name and Address Beneficially of Title of Class of Beneficial Owner Owned Class Holding common stock, par value - Kelso ASI Partners, L.P.(a) 18,000,000 73% $.01 per share ("ASI Partners") Joseph S. Schuchert(a) 18,000,000(d) 73% (d) Frank T. Nickell(a) 18,000,000(d) 73% (d) George E. Matelich(a) 18,000,000(d) 73% (d) Thomas R. Wall IV(a) 18,000,000(d) 73% (d) Emmanuel A. Kampouris(b) 225,000 * George H. Kerckhove(b) 113,000 * Horst Hinrichs(b) 90,000 * Fred A. Allardyce(b) 113,000 * American-Standard Employee Stock Ownership Plan(c) 4,267,710 17% All current directors and executive officers of Holding and the Company as a group 18,824,900(e) 77% (e) * Less than one percent. (a) The business address for such persons is c/o Kelso & Company, 350 Park Avenue, New York, N.Y. 10022. (b) Mr. Kampouris is Chairman, President and Chief Executive Officer and a director of the Company and of Holding. Messrs. Hinrichs and Kerckhove are Named Officers and directors of the Company and of Holding, and Mr. Allardyce is a Named Officer of the Company and of Holding. (c) The business address for the ESOP is c/o American Standard Inc., 1114 Avenue of the Americas, New York, N.Y. 10036. At December 31, 1993, 3,548,609 Plan shares were allocated to executive officers of Holding and the Company and other ESOP participants. The number of shares shown for executive officers in the table above does not reflect shares allocated to their accounts in the ESOP. Shares in the ESOP account are voted by the ESOP trustee as directed by the plan board (the board administering the trust which currently consists of executive officers of the Company). However, participants may direct the vote of their ESOP account shares in matters involving mergers, recapitalizations, or dispositions of substantial assets. Until termination of employment a participant cannot dispose of shares in his ESOP account. Shares distributed to a participant on termination are subject to the Company's right of first refusal. The shares in the Named Officers ESOP accounts are as follows: Mr. Kampouris, 3,995 shares; Mr. Kerckhove, 3,953 shares; Mr. Hinrichs, 4,266 shares; Mr. Allardyce, 4,246 shares; and Mr. Gandini, 2,225 shares. The shares in the ESOP accounts for all executive officers total 69,218 shares. The number of shares shown for executive officers in the table above also does not reflect shares of Holding Common Stock issued as part of the payouts under the LTIP and held for them in trust under a trust agreement dated as of January 1, 1993. Shares in the trust are voted by the trustee as directed by the Company. Until termination of the trust, a beneficiary of the Trust cannot dispose of shares credited to his account. Shares in the Named Officers' accounts in the trust are as follows: Mr. Kampouris, 4,453 shares; Mr. Kerckhove, 2,012 shares; Mr. Hinrichs, 1,787 shares; Mr. Allardyce, 1,224 shares; and Mr. Gandini, 1,176 shares. The shares in the trust accounts for all executive officers total 28,620 shares. Also not included above are 19,198 shares of ASI Holding common stock held in a similar grantor's trust for the account of certain executive officers. These were earned by them under an employee incentive plan prior to their becoming officers. (d) Messrs. Schuchert and Nickell, each a director of the Company and of Holding, and Messrs. Matelich and Wall may be deemed to share beneficial ownership of shares owned of record by ASI Partners by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. Messrs. Schuchert, Nickell, Matelich and Wall share investment and voting power with respect to securities owned by ASI Partners. See "Certain Transactions and Relationships." Dr. Cyert, who was a director of Holding and the Company until December 1993, is a limited partner in one of the Kelso partnerships that has invested in ASI Partners. (e) Out of such 18,824,900 shares, 18,000,000 shares represent shares of Common Stock owned by ASI Partners in which Messrs. Schuchert and Nickell, each a director of Holding, may be deemed to share beneficial ownership by virtue of their status as general partners of American Standard Partners, the general partner of ASI Partners. ITEM 13. ITEM 13. CERTAIN TRANSACTIONS AND RELATIONSHIPS Messrs. Schuchert and Nickell, directors of Holding and the Company, are Chairman and President, respectively, of Kelso & Companies, Inc. (the general partner of Kelso & Company, L.P.), and are general partners of American Standard Partners, the general partner of Kelso ASI Partners. Mr. Schuchert is also a member of the Management Development Committee (the compensation committee) of the Company's Board of Directors. The Company pays Kelso an annual fee of $2.75 million for providing management consulting and advisory services, including those of Messrs. Schuchert and Nickell. The fee is reduced depending on the number of shares Kelso controls of Holding or the Company, with final termination when Kelso's ownership control falls below 20 percent. The Company also has entered into a transaction with Kelso Insurance Services, Incorporated (an affiliate of Kelso) ("Kelso Insurance"), and American Telephone and Telegraph Company ("AT&T") pursuant to which the Company as well as other Kelso affiliated companies participates in a telecommunications network under which AT&T provides communications services to the group at a special lower tariff rate. In connection with that transaction the Company has guaranteed a minimum annual usage by it of $2 million for a period of five years commencing 1993. No fee was paid by the Company to Kelso Insurance in connection with this transaction. In August 1993 the Company purchased a limited partnership interest in Kelso Investment Associates V, L.P. ("KIA V"), in exchange for its commitment to make a capital contribution of $5 million to KIA V. KIA V was formed to seek out business opportunities and invest primarily in equity securities, leveraged buy-outs, and joint ventures. Kelso Partners V, L.P. serves as the general partner of KIA V. The general partners of Kelso Partners V, L.P., include Messrs. Schuchert and Nickell. Kelso & Co., L.P. is the manager of KIA V and, as such, acts as investment adviser of KIA V. The management fee relating to the interest held by the Company has been waived. The Company will invest in a Cayman Islands corporation, A-S China Plumbing Products Limited ("ASPPL"), to be used for the establishment of various joint ventures in the People's Republic of China. The Company will have a 21% voting interest in ASPPL. Shares in ASPPL will also be sold in a private placement to certain institutions and other investors, including certain executive officers and employees of the Company and its subsidiaries. Mr. Mizushima, a director of the Company and of Holding, is President and Chief Operating Officer of Daido Hoxan Inc., a Japanese corporation which has an approximately 11 percent limited partnership interest in ASI Partners. Daido Hoxan Inc. is the largest distributor of the Company's plumbing products in Japan. Its transactions as distributor with the Company and its subsidiaries in 1992, which were on customary terms and in the ordinary course of business, were not material to either the Company or Daido Hoxan Inc. The Company also entered into leasing transactions with an affiliate of Daido Hoxan whereby it has leased certain machinery and equipment on financial terms that were comparable to those available from other leasing companies. The leasing transactions were not material to either the Company or Daido Hoxan Inc. Fidelity Management Trust Company ("Fidelity") is the owner of record of the shares of Holding held by the ESOP, a 17% owner of Holding shares. Fidelity was paid by the Company approximately $180,000 in 1993 for services in connection with administering the Company's ESOP and Savings Plan. Mr. Nickell's father is an officer and owns more than 10 percent of AC Corporation, a contracting company which purchases air conditioning products from the Company's Trane Division. Such purchases in 1993 were on customary terms and in the ordinary course of business and were not material to either the Company or AC Corporation. Management Investors Stockholders Agreement Under the Stockholders Agreement, pursuant to which Management Investors purchased shares of Holding common stock, Holding is obligated to repurchase, subject to the limitations contained in the Company's lending arrangements and debt instruments, such shares at certain fair market prices in case of the death, disability, retirement, or termination of employment of a Management Investor. Shares are paid for within the constraints of the Company's lending arrangement and debt instruments, as supplemented by a Schedule of Priorities established by Holding's Board of Directors. The Named Officers (other than Mr. Gandini) and most of the executive officers are Management Investors and parties to the Stockholders Agreement. PART IV ITEM 14. ITEM 14. CONSOLIDATED EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1 and 2. Financial statements and financial statement schedules The financial statements and schedules listed in the accompanying index to financial statements are filed as part of this annual report on Form 10-K. 3. Exhibits The exhibits listed on the accompanying index to exhibits are filed as part of this annual report on Form 10-K. Included in the exhibits are the following management contracts or compensatory plan arrangements required to be filed as exhibits pursuant to Item 14(c) of Form 10-K American Standard Inc. Long-Term Incentive Compensation Plan, as amended Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan American Standard Inc. Annual Incentive Plan American Standard Inc. Management Partner's Bonus Plan with amendments American Standard Inc. Executive Supplemental Retirement Benefit Program American Standard Employee Stock Ownership Plan with amendments Estate Preservation Plan with amendments Corporate Officers Severance Plan American Standard Inc. Supplemental Compensation Plan for Outside Directors ASI Holding Corporation 1989 Stock Purchase Loan Program Summary of Terms of Unfunded Deferred Compensation Plan Letter of Agreement with respect to H. Thompson Smith's retirement and consulting services (b) Reports on Form 8-K for the quarter ended December 31, 1993. None 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. AMERICAN STANDARD INC. By /s/ Emmanuel A. Kampouris (Emmanuel A. Kampouris) (Chairman, President and Chief Executive Officer) March 30, 1994 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: /s/ Emmanuel A. Kampouris Director, Chairman and President March 30, 1994 (Emmanuel A. Kampouris) (Chief Executive Officer) /s/ Fred A. Allardyce Vice President and Chief March 30, 1994 (Fred A. Allardyce) Financial Officer /s/ G. Ronald Simon Vice President & Controller March 30, 1994 (G. Ronald Simon) (Principal Accounting Officer) /s/ Horst Hinrichs Director March 30, 1994 (Horst Hinrichs) /s/ George H. Kerckhove Director March 30, 1994 (George H. Kerckhove) /s/ Shigeru Mizushima Director March 30, 1994 (Shigeru Mizushima) /s/ Frank T. Nickell Director March 30, 1994 (Frank T. Nickell) /s/ J. Danforth Quayle Director March 30, 1994 (J. Danforth Quayle) /s/ Roger W. Parsons Director March 30, 1994 (Roger W. Parsons) /s/ Joseph S. Schuchert Director March 30, 1994 (Joseph S. Schuchert) /s/ John Rutledge Director March 30, 1994 (John Rutledge) AMERICAN STANDARD INC. AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (Item 14 (a)) Form 10-K (Pages) 1. Financial Statements Consolidated Balance Sheet at December 31, 1993 and 1992 42 Years ended December 31, 1993, 1992 and 1991, Consolidated Statement of Operations 41 Consolidated Statement of Stockholder's Equity (Deficit) 43 Consolidated Statement of Cash Flows 44-45 Notes to Consolidated Financial Statements 46-62 Segment Data 63 Segment data for capital expenditures, depreciation and amortization 23-29 Quarterly Data (Unaudited) 64 Report of Independent Auditors 40 2. Financial statement schedules, years ended December 31, 1993, 1992 and 1991: Report of Independent Auditors 84 V Facilities 85 VI Accumulated Depreciation of Facilities 86 VIII Reserves 87 IX Short-Term Borrowings 88 X Supplementary Income Statement Information 89 All other schedules have been omitted because the information is not applicable or is not material or because the information required is included in the financial statements or the notes thereto. Report of Independent Auditors Stockholders and Board of Directors American Standard Inc. We have audited the consolidated financial statements of American Standard Inc. as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated March 14, 1994 (included elsewhere in this Annual Report on Form-10K). Our audits also included the consolidated schedules listed in Item 14(a)2. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the consolidated schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be stated therein. /s/ Ernst & Young Ernst & Young March 14, 1994 AMERICAN STANDARD INC. INDEX TO EXHIBITS (Item 14(a)3 - Exhibits Required by Item 601 of Regulation S-K and Additional Exhibits) (The File Number of American Standard Inc., the Registrant, and for all Exhibits incorporated by reference is 1-470, except those Exhibits incorporated by reference in filings made by ASI Holding Corporation ("Holding") whose File Number is 33-23070) (3) (i) Restated Certificate of Incorporation of American Standard Inc. (the "Company"); previously filed as Exhibit (3)(i) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (ii) Certificate of Designation, Preferences and Relative, Participating, Optional and other Special Rights of Preferred Stock and Qualifications, Limitations and Restrictions thereof of Series A Preferred Stock. (iii) By-laws of the Company; previously filed as Exhibit (3)(ii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (4) (i) Indenture, dated as of November 1, 1986, between the Company and Manufacturers Hanover Trust Company, Trustee, including the form of 9-1/4% Sinking Fund Debenture Due 2016 issued pursuant thereto on December 9, 1986, in the aggregate principal amount of $150,000,000; previously filed as Exhibit (4)(iii) in the Company's Form l0-K for the fiscal year ended December 31, 1986, and herein incorporated by reference. (ii) Instrument of Resignation, Appointment and Acceptance, dated as of April 25, 1988 among the Company, Manufacturers Hanover Trust Company (the "Resigning Trustee") and Wilmington Trust Company (the "Successor Trustee"), relating to resignation of the Resigning Trustee and appointment of the Successor Trustee under the Indenture referred to in Exhibit (4)(i) above; previously filed as Exhibit 4(ii) in Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (iii) Form of Indenture, dated as of July 1, 1988, between the Company and Shawmut Bank Connecticut, National Association (formerly known as The Connecticut National Bank), as Trustee, relating to the Company's 14-1/4% Subordinated Discount Debentures due 2003; previously filed as Exhibit 4.3 in Amendment No. 2 to Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iv) Form of Debenture evidencing the 14-1/4% Subordinated Discount Debentures due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(iii) above. (v) Indenture dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 10-7/8% Senior Notes due 1999, in the aggregate principal amount of $150,000,000; previously filed as Exhibit (4)(i) in the Company's Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (vi) Form of 10-7/8% Senior Notes due 1999 included as Exhibit A to the Indenture described in (4)(v) above. (vii) Indenture dated as of May 15, 1992, between the Company and First Trust National Association, Trustee, relating to the Company's 11-3/8% Senior Debentures due 2004, in the aggregate principal amount of $250,000,000; previously filed as Exhibit (4)(iii) in the Company's Form 10-Q for the quarter ended June 30, 1992, and herein incorporated by reference. (viii) Form of 11-3/8% Senior Debentures due 2004 included as Exhibit A to the Indenture described in (4)(vii) above. (ix) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 9-7/8% Senior Subordinated Notes Due 2001; previously filed as Exhibit 4(xxxi) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Note evidencing the 9-7/8% Senior Subordinated Notes Due 2001 included as Exhibit A to the Form of Indenture referred to in 4(ix) above. INDEX TO EXHIBITS - (Continued) (xi) Form of Indenture, dated as of June 1, 1993, between the Company and United States Trust Company of New York, as Trustee, relating to the Company's 10-1/2% Senior Subordinated Discount Debentures Due 2005; previously filed as Exhibit (4)(xxxiii) in Amendment No. 1 to Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xii) Form of Debenture evidencing the 10-1/2% Senior Subordinated Discount Debentures Due 2005 included as Exhibit A to the Form of Indenture referred to in (4)(xi) above. (xiii) Form of Indenture, dated as of October 25, 1990, as amended and restated as of June 15, 1993, between the Company and Shawmut Bank, N.A., as Trustee, relating to Company's 12-3/4% Junior Subordinated Debentures Due 2003; previously filed as Exhibit (4)(xx) in Amendment No. 2 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xiv) Form of Indenture evidencing the 12-3/4% Junior Subordinated Debentures Due 2003 included as Exhibit A to the Form of Indenture referred to in (4)(xiii) above. (xv) Assignment and Amendment Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company, Bankers Trust Company, as agent under the 1988 Credit Agreement, the financial institutions named as Lenders in the 1988 Credit Agreement and certain additional Lenders and Chemical Bank, as Administrative Agent and Arranger; previously filed as Exhibit (4)(xiii) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xvi) Credit Agreement, dated as of June 1, 1993, among the Company, Holding, certain subsidiaries of the Company and the lending institutions listed therein, Chemical Bank, as Administrative Agent and Arranger; Bankers Trust Company, The Bank of Nova Scotia, The Chase Manhattan Bank, N.A., Deutsche Bank AG, The Long-Term Credit Bank of Japan, Ltd., New York Branch, and NationsBank of North Carolina, N.A., as Managing Agents, and Banque Paribas, Citibank, N.A., and Compagnie Financiere de CIC et de l'Union Europeenne, New York Branch, as Co-Agents; previously filed as Exhibit (4)(xiv) in Amendment No. 1 to Registration Statement No. 33-64450 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xvii) First Amendment, Consent and Waiver, dated as of February 10, 1994, to the Credit Agreement referred to in (4)(xvi) above. INDEX TO EXHIBITS - (Continued) (xviii) Stockholders Agreement, dated as of July 7, 1988, as amended as of August 1, 1988, among Holding, Kelso ASI Partners, L.P., and the Management Stockholders named therein; previously filed as Exhibit 4.19 in Amendment No. 2 in the Registration Statement No. 33-23070 of Holding under the Securities Act of 1933, as amended, and herein incorporated by reference. (xix) Amendment to Section 2.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of January 1, 1991; previously filed as Exhibit (4)(xxvii) by Holding in its Form 10-K for the year ended December 31, 1992, and herein incorporated by reference. (xx) Supplement and Amendment dated as of September 4, 1991 to the Stockholders Agreement, dated as of July 7, 1988, as amended, referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(ii) by Holding in its Form 10-Q for the quarter ended September 30, 1991, and herein incorporated by reference. (xxi) Amended Section 6.1 of the Stockholders Agreement referred to in paragraph (4)(xviii) above, effective as of September 2, 1993; copy of amended Section is being filed as Exhibit (4)(xvii) by Holding in its Form l0-K for the year ended December 31, 1993, concurrently with the filing of the Company's Form 10-K for the same year, and herein incorporated by reference. (xxii) Revised Schedule of Priorities effective as of September 5, 1991, as adopted by the Board of Directors of Holding, pursuant to the Stockholders Agreement referred to in paragraph (4)(xviii) above; previously filed as Exhibit (4)(iii) by Holding in its Form l0-Q for the quarter ended September 30, 1991 and herein incorporated by reference. (10) (i) Agreement and Plan of Merger, dated as of March 16, 1988, among the Company, ASI Acquisition Company and Holding and Offer Letter, dated March 16, 1988, between the Company and Kelso & Company, L.P.; previously filed as Exhibit 2 to the Company's Schedule 14D-9 filed March 21, 1988, in connection with the offer for all the shares of the Company's Common Stock by a corporation formed by Kelso & Company, L.P., and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ii) Amendment, dated June 3, 1988 to Agreement and Plan of Merger referred to in (l0)(i) above; previously filed as Exhibit 2.50 in Amendment No. 1 to the Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (iii) American Standard Inc. Long-Term Incentive Compensation Plan, as amended through February 6, 1992; previously filed as Exhibit (10)(iv) in the Company's Form 10-K for the fiscal year ended December 31, 1992, and herein incorporated by reference. (iv) Trust Agreement for American Standard Inc. Long-Term Incentive Compensation Plan. (v) American Standard Inc. Annual Incentive Plan; previously filed as Exhibit (l0)(vii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (vi) American Standard Inc. Management Partners' Bonus Plan effective as of July 7, 1988; previously filed as Exhibit (l0)(i) in the Company's Form l0-Q for the quarter ended September 30, 1988, and herein incorporated by reference; amendments to Plan adopted on June 7, 1990, previously filed as Exhibit (4)(ii) in the Company's Form l0-Q for the quarter ended June 30, 1990, and herein incorporated by reference. (vii) American Standard Inc. Executive Supplemental Retirement Benefit Program, as restated to include all amendments through December 31, 1993. (viii) Stock Purchase Agreement, dated April 27, 1988, between ASI Acquisition Company and General Electric Capital Corporation (without schedules); previously filed as Exhibit 2.4 in Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. INDEX TO EXHIBITS - (Continued) (ix) Amendment, dated June 3, 1988, to Stock Purchase Agreement referred to in (l0)(viii) above; previously filed as Exhibit 2.6 in Amendment No. 1 in Registration Statement No. 33-22126 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (x) Form of Composite American-Standard Employee Stock Ownership Plan incorporating amendments through December 3, 1992; previously filed as Exhibit (10)(x) in Registration Statement No. 33-61130 of the Company under the Securities Act of 1933, as amended, and herein incorporated by reference. (xi) American-Standard Employee Stock Ownership Trust Agreement, dated as of December 1, 1991, between ASI Holding Corporation and Fidelity Management Trust Company (as successor to Citizens & Southern Trust Company (Georgia), N.A.), as trustee; previously filed as Exhibit (10)(xiv) in the Company's Form 10-K for the year ended December 31, 1991, and herein incorporated by reference. (xii) Consulting Agreement made July 1, 1988, with Kelso & Company, L.P. concerning general management and financial consulting services to the Company; previously filed as Exhibit (l0)(xviii) in the Company's Form l0-K for the fiscal year ended December 31, 1988, and herein incorporated by reference. (xiii) American Standard Inc. Supplemental Compensation Plan for Outside Directors, as amended through September 1993. (xiv) ASI Holding Corporation 1989 Stock Purchase Loan Program; previously filed as Exhibit l0(i) in Holding's Form l0-Q for the quarter ended September 30, 1989, and herein incorporated by reference. (xv) Corporate Officers Severance Plan adopted in December, 1990, effective April 27, 1991; previously filed as Exhibit (l0)(xix) in the Company's Form l0-K for the fiscal year ended December 31, 1990, and herein incorporated by reference. (xvi) Estate Preservation Plan adopted in December, 1990; previously filed as Exhibit (l0)(xx) in the Company's Form l0-K for the fiscal year ended December 31, 1990, and herein incorporated by reference. (xvii) Amendment adopted in March 1993 to Estate Preservation Plan referred to in (10)(xvi) above. (xviii) Summary of terms of Unfunded Deferred Compensation Plan, adopted December 2, 1993.) (xix) Retirement/Consulting Agreement, dated December 28, 1993, between H. Thompson Smith and the Company. (21) Listing of the Company's subsidiaries.

97886_1993.txt

97886_1993

1993

97886

ITEM 1. BUSINESS a. General Development of Business. The Company began operations in 1928 and has grown through both internal expansion and new business acquisitions. Efforts since 1984 have focused on expansion of the Lighting Segment and the Compressors and Vacuum Pumps Segment as the two core businesses. The significant recent additions to these two core segments have been ASF, Pneumotive, Brey, and WISA, all compressor and vacuum pump companies, acquired from 1987 through 1990; and the Lumec and Day-Brite Lighting additions in 1987 and 1989, respectively. These acquisitions have been strategically important to the Company, as they allow us to offer a more complete product line and make us a more prominent participant in both the lighting and compressor and vacuum pump markets. The Lighting Segment operates in a multi-faceted industry, serving the residential, commercial, industrial, and outdoor markets. The industry is dominated by five companies in the U.S. and Canada, one of which is Thomas Industries. Although the industry is subject to the cyclicality of residential and commercial construction activity, replacement and renovation activity moderates these cycles somewhat. Operations of the Compressors and Vacuum Pump Segment help the Company moderate the impact of the Lighting Segment's vulnerability to construction and economic cycles. Thomas believes it is the major supplier to the original equipment manufacturer (OEM) medical market and a significant participant in its other OEM compressor and vacuum pump markets. The Company's other disassociated businesses consist of three smaller operating units that provide commercial construction hardware and consumer fireplaces and fireplace accessory products. b. Financial Information about Industry Segments. The information required by this item is set forth in the registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, in Note 11 of Notes to Consolidated Financial Statements found on page 29 (under the caption "Industry Segment Information"), which information is incorporated herein by reference. c. Narrative Description of Business. The Company's principal businesses are lighting, including residential, commercial, industrial, and outdoor lighting fixtures; compressors and vacuum pumps; and other products (including door control devices and hardware, fire screens, gas log sets, fireplace accessories, insulated metal chimneys, and zero-clearance fireplaces). The Company designs, manufactures, markets, and sells these products; and maintains corporate offices in Louisville, Kentucky. The Company operates ITEM 1. (Continued) numerous divisions and subsidiaries, with facilities throughout the U.S. and operations in Canada and Germany. The Company also maintains sales offices in Brazil, England, Italy, and Japan and has joint ventures in Japan and in the U.S. and Canada with a Belgian company. Lighting Segment The Company's residential lighting products--its original base--are designed for a broad range of consumers. The Company stresses product development to meet changing needs and demands. The Company typically targets the more upscale, single-family homeowner but also has a line for the do-it-yourself homeowner. The Company also is strongly involved in the replacement lighting market, which is a growing component of the overall lighting industry. Under the Thomas and Premier brand names, the Company's residential lighting line includes high-style chandeliers and bathroom fixtures, plus quality lighting products for foyers, dining rooms, living rooms, entertainment areas, kitchens, bedrooms, and outdoors. The Thomas and Premier lines are distributed throughout the United States through a network of electrical distributors, retail lighting showrooms, and home centers, which, in turn, sell to electrical contractors, builders, and consumers. Residential lighting fixtures are manufactured and sold in the U.S. and Canada under the Thomas and Premier trade names; and those trade names are recognized as important to this Segment's business. The Company believes it has established a reputation as an innovator and pioneer in track and recessed lighting technology and is one of the nation's leading manufacturers of fluorescent and high-intensity discharge ("HID") commercial and industrial products, as well as signal and security equipment. The Company's commercial and industrial product line can be applied to virtually any application, using a variety of lamp sources, and is designed for efficiency as well as energy savings. The Company's outdoor lighting products are known for their high performance in efficiency, glare control, and uniformity of illumination. Products are manufactured and sold in the U.S. and Canada under the Day-Brite/Benjamin, Gardco, Capri, Electro/Connect, McPhilben, Omega, Emco, Lumec, and Thomas Lighting trade names. The Lighting Segment accounted for 66 percent of the Company's sales in 1993, compared to 68 percent in 1992 and 69 percent in 1991. Compressors and Vacuum Pumps Segment This Segment includes air compressors and vacuum pumps manufactured under the Thomas name for use in the finished products of other domestic or foreign manufacturers. Its products also are manufactured for private-label sale in the construction compressor ITEM 1. (Continued) industry. Thomas specializes in compressor applications below 1.5 horsepower. Such compressors and vacuum pumps are found in medical equipment, vending machines, photocopiers, computer tape drives, automotive and transportation equipment, liquid dispensing applications, gasoline vapor recovery, and waste disposal equipment. Thomas is the major compressor and vacuum pump participant in the medical OEM industry worldwide. The Company offers a wide selection of branded standard air compressors and vacuum pumps and will modify or design its products to meet exacting OEM applications. In addition, the Company manufactures and sells compressors and related accessories for commercial and consumer use. Sales, both domestic and international, traditionally are made through hardware stores, home centers, building supply dealers, and mass merchandisers. The Pneumotive Division manufactures rotary vane and piston compressors and vacuum pumps, as well as air motors and vacuum ejectors, for a variety of applications to the OEM market as well as through fluid power and large compressor distributors. The Brey Division produces a complementary line of rotary vane compressors and vacuum pumps, with expertise in applications of less than 1/8 horsepower. These products are currently distributed for sale primarily in Europe, with increasing worldwide marketing. Under the ASF name, the Company produces diaphragm and peristaltic compressors and vacuum pumps with applications in photography, medical, air and gas sampling, and dish washing equipment, as well as laboratory instruments and leak detection devices. These products are marketed worldwide to original equipment manufacturers. WISA produces a line of linear-type vibrating and diaphragm compressors and vacuum pumps for various applications, the foremost of which is gas analyzers. Sales and distribution are made primarily in Europe and the U.S., with expanding availability worldwide. The Thomas, ASF, Pneumotive, Brey, WISA, and Sprayit trade names are recognized in the market and are important to the Segment. The Compressors and Vacuum Pumps Segment accounted for 29 percent of the Company's sales in 1993, compared to 26 percent in 1992 and 25 percent in 1991. Other Products Other, smaller divisions of the Company manufacture and market architectural door trim, hardware, and door controls through contract hardware distributors. Door closers, exit devices, and pivots are marketed through original equipment manufacturers. Other products include high-quality glass fire screens, gas log sets, factory-built ITEM 1. (Continued) fireplaces, chimneys, and fireplace accessories marketed through specialty shops, distributors, and special equipment dealers. Jackson Exit Device, Builders Brass Works, Oliver-MacLeod, Portland Willamette, Glassfyre, Premier, Ultrafyre, and Pro-Jet are important trade names to these businesses. These products, on a combined basis, accounted for 5 percent of the Company's sales in 1993, compared to 6 percent in 1992 and 6 percent in 1991. -------------------- No single customer of the Company accounted for more than 10 percent of consolidated net sales or more than 10 percent of any segment's net sales in 1993, and no material part of the business is dependent upon a single customer the loss of which could have a materially adverse effect on the business of the Company. The backlog of unshipped orders was $86 million at December 31, 1993-- 56 percent Lighting, 43 percent Compressors and Vacuum Pumps, and 1 percent Other--and $91 million at December 31, 1992--59 percent Lighting, 40 percent Compressors and Vacuum Pumps, and 1 percent Other. The Company believes substantially all of such orders are firm, although some orders are subject to cancellation. Substantially all of these orders are filled in the succeeding year. Competition in the lighting industry is strong in all markets served by the Company. The industry has been consolidating significantly over the last few years. It is estimated that five companies control the majority of the market in the U.S. and Canada. Thomas Industries is one of these top five. The Company stresses high quality and energy efficient lighting products, while providing value and strong customer support to compete in its markets. The Compressors and Vacuum Pumps Segment competes worldwide in the fractional horsepower compressor and vacuum pump markets. Management believes it is the major supplier to the OEM medical market and a significant participant in its other OEM markets. The Company believes that it has adequate sources of materials and supplies for each of its businesses. There is no significant seasonal impact on the business of any industry segment of the Company. Many of the lighting businesses continue to be dependent on the construction markets, which are subject to the overall health of the economy. Working capital is provided principally from operating profits. The Company maintains adequate lines of credit and financial resources to meet the anticipated cash requirements in the year ahead. ITEM 1. (Continued) The Company has various patents and trademarks but does not consider its business to be materially dependent upon any individual patent or trademark. During 1993, the Company spent $12.4 million on research activities relating to the development of new products and the improvement of existing products. Substantially all of this amount was Company- sponsored activity. During 1992, the Company spent $12.5 million on these activities and during 1991, $12.1 million. Continued compliance with present and reasonably expected federal, state, and local environmental regulations is not expected to have any material effect upon capital expenditures, earnings, or the competitive position of the Company and its subsidiaries. The Company employs approximately 3,400 people. d. Financial Information about Foreign and Domestic Operations and Export Sales. See Note 11 of Notes to Consolidated Financial Statements found on page 30 of the Annual Report to Shareholders for financial information about foreign and domestic operations. Export sales for the years 1993, 1992, and 1991, were $34,500,000, $32,800,000, and $29,500,000, respectively. e. Executive Officers of the Registrant. All other officers listed have been executive officers for the past five years. ITEM 2. ITEM 2. PROPERTIES The Corporate offices of the Company are located in Louisville, Kentucky. Due to the large number of individual locations and the diverse nature of the operating facilities, it is neither practical nor significant to describe all of the properties owned and leased by the Company. All of the buildings are of steel, masonry, and concrete construction, are in generally good condition, provide adequate and suitable space for the operations at each location, and are of sufficient capacity for present and foreseeable future needs. With the reduction in volumes within the Lighting Segment due to the decline in commercial and residential construction from 1991 through 1993, capacity at these facilities is somewhat in excess of that required to meet current demand. The following listing summarizes the Company's properties. ITEM 2. (Continued) ITEM 3. ITEM 3. LEGAL PROCEEDINGS In the normal course of business, the Company and its subsidiaries are parties to litigation. Management believes that these suits will be resolved with no materially adverse impact on the financial condition of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The information required by this item is set forth in registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, on page 17 (under the caption "Common Stock Market Prices and Dividends") and on pages 25 and 26 (under the caption "Note 5, Shareholders' Equity"), which information is hereby incorporated by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this item is set forth in registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, on pages 32 and 33 (under the captions "Earnings Statistics, Financial Position, and Data per Common Share"), which information is hereby incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item is set forth in registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, on pages ITEM 7. (Continued) 16 and 17 (under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations"), which information is hereby incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is set forth in registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, on pages 18 through 31 in the Consolidated Financial Statements, which information is hereby incorporated herein by reference. The supplementary data regarding quarterly results of operations is set forth in registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, on page 28 (under the caption "Note 10, Summary of Quarterly Results of Operations, Unaudited"), which information is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT a. Directors of the Company The information required by this item is set forth in registrant's Proxy Statement for the Annual Meeting of Shareholders to be held on April 21, 1994, on pages 3 through 5 (under the caption "Election of Directors"), and on page 15 (under the caption "Compliance with Section 16(a)"), which information is hereby incorporated herein by reference. b. Executive Officers of the Company Reference is made to "Executive Officers of the Registrant" in Part I, Item 1e. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is set forth in registrant's Proxy Statement for the Annual Meeting of Shareholders to be held on April 21, 1994, on pages 6 through 12 (under the captions "Executive Compensation," "Compensation Committee Report on Executive Compensation," and "Performance Graph") and on page 13 (under the caption "Compensation Committee Interlocks and Insider Participation"), which information is hereby incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is set forth in registrant's Proxy Statement for the Annual Meeting of Shareholders to be held on April 21, 1994, on pages 2 through 3 (under the caption "Securities Beneficially Owned by Principal Shareholders and Management"), which information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is set forth in registrant's Proxy Statement for the Annual Meeting of Shareholders to be held on April 21, 1994, on pages 3 through 5 (under the caption "Election of Directors"). PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a. (1) Financial Statements The response to this portion of Item 14 is submitted as a separate section of this report beginning on page 15. (2) Financial Statement Schedules The response to this portion of Item 14 is submitted as a separate section of this report beginning on page 15. (3) Listing of Exhibits b. Reports on Form 8-K There were no reports on Form 8-K for the three months ending December 31, 1993. A Form 8-K report was filed on February 11, 1994, incorporating the Company's press release dated February 10, 1994. This release announced that the Company's earnings for the fourth quarter and year ended December 31, 1993, includes pretax charges of $3,500,000 ($2,040,000 after tax) for restructuring charges to further consolidate its Commercial & Industrial Lighting operations, including the closing of the Long Island, New York, facility. c. Exhibits The response to this portion of Item 14 is submitted as a separate section of this report beginning on page 24. S I G N A T U R E S 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. THOMAS INDUSTRIES INC. Date March 18, 1994 By /S/ Timothy C. Brown Timothy C. Brown, President 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. ANNUAL REPORT ON FORM 10-K ITEM 14(a)(1) AND (2) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 THOMAS INDUSTRIES INC. LOUISVILLE, KENTUCKY FORM 10-K ITEM 14(a)(1) AND (2) THOMAS INDUSTRIES INC. AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Thomas Industries Inc. and subsidiaries, included in the annual report of the registrant to its shareholders for the year ended December 31, 1993, are included in Item 8: Consolidated Balance Sheets--December 31, 1993 and 1992 Consolidated Statements of Income--Years ended December 31, 1993, 1992, and Consolidated Statements of Shareholders' Equity--Years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Cash Flows--Years ended December 31, 1993, 1992, and 1991 Notes to Consolidated Financial Statements--December 31, 1993 The following consolidated financial statement schedules of Thomas Industries Inc. and subsidiaries are included in Item 14(a)(2): Schedule V -- Property, Plant, and Equipment Schedule VI -- Accumulated Depreciation, Depletion, and Amortization of Property, Plant, and Equipment Schedule VIII -- Valuation and Qualifying Accounts Schedule IX -- Short-Term Borrowings Schedule X -- Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. KPMG PEAT MARWICK Independent Auditors' Report The Board of Directors and Shareholders Thomas Industries Inc. We have audited the consolidated balance sheet of Thomas Industries Inc. and subsidiaries as of December 31, 1993, and the related consolidated statements of income, shareholders' equity, and cash flows for the year then ended as listed in the accompanying index. In connection with our audit of the 1993 consolidated financial statements, we also have audited the 1993 financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these 1993 consolidated financial statements and financial statement schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the 1993 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Thomas Industries Inc. and subsidiaries as of December 31, 1993, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also in our opinion, the related 1993 financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 7 to the consolidated financial statements, the Company changed its method of accounting for postretirement benefits in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions. As discussed in Note 3, the Company changed its method of accounting for income taxes in 1993 to adopt the provisions of SFAS No. 109, Accounting for Income Taxes. As discussed in Note 1, the Company changed its method of accounting for certain inventories in 1993. /S/KPMG PEAT MARWICK Louisville, Kentucky February 10, 1994 ERNST & YOUNG Report of Independent Auditors Board of Directors and Shareholders Thomas Industries Inc. We have audited the accompanying consolidated balance sheet of Thomas Industries Inc. and subsidiaries as of December 31, 1992 and the related consolidated statements of income, shareholders' equity, and cash flows for each of the two years in the period ended December 31, 1992. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Thomas Industries Inc. and subsidiaries at December 31, 1992, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 1992 in conformity with generally accepted accounting principles. /S/ERNST & YOUNG Louisville, Kentucky February 11, 1993 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations: Consolidated net sales during 1993 increased 7% from 1992 to $450.1 million, following an increase of 3% from 1991. Net income of $3.8 million for 1993 was up from the $2.0 million loss in 1992 and equal to net income of $3.8 million in 1991. In February 1994, the Company made the decision to further consolidate its Commercial and Industrial Lighting operations by taking a $2.0 million after-tax charge in the fourth quarter of 1993, primarily related to the closing of our Long Island facility. The 1992 net loss includes an after-tax charge of $4.0 million to establish a reserve for the costs associated with restructuring and consolidating certain of the operations within the Lighting Segment and other operations. The 1993 net income includes an after-tax gain of $1.1 million due to a change in the method of applying LIFO for certain inventories within the Lighting Segment, while 1991 net income includes an after-tax gain of $1.2 million due to LIFO inventory reductions at certain operating units. The Lighting Segment net sales of $298.4 million in 1993 were 4% higher than 1992, after a 1% increase over 1991. The 1993 increase resulted from higher unit volumes due to improving residential and commercial and industrial construction markets, while pricing remained very competitive. Sales were relatively flat in 1992 as U.S. construction activity stabilized at lower levels. The Thomas Lighting Division in Canada experienced a substantial reduction in volume in 1992 with the decline in the Canadian economy and overall construction activity. The Lighting Segment reported an operating income drop to $.1 million for 1993 due to the restructuring charge and the significant competitive pricing pressures experienced by the Residential and the Commercial & Industrial Lighting operations during the year. Significant efforts were also made during the year to prune excess product offerings, resulting in increased costs to dispose of these items. Operating income for 1992 of $2.7 million was down from the $7.9 million of 1991, primarily due to the restructuring charge taken in the first quarter of 1992. Cost of products sold at these divisions during 1993 and 1991 was reduced by LIFO inventory adjustments, the effect of which decreased cost of products sold, and therefore increased operating income by $1.9 million in both 1993 and in 1991. The Compressors and Vacuum Pumps Segment continued to extend its record sales pace with an increase of 16% in 1993 over 1992, after an 11% improvement from 1991. The increases for both years are attributable to the sustained growth of the Original Equipment Manufacturers (OEM) medical products market and the success of new products and new applications for existing products. The most significant increases have come from growing markets in the U.S. International sales have grown at an even faster pace, although activity in Europe has been slow due to their stalled economies. Operating income improved 37% for the Segment over 1992, which was 13% higher than 1991, due to the volume increases during both years along with increased productivity gains resulting from continued investment in more efficient manufacturing processes. Net sales of the three divisions grouped as "Other" were flat compared to 1992, following a decline of 6% from 1991, as the residential and commercial construction markets they serve have stabilized. Operating income recovered somewhat from the low 1992 levels, which were down 64% from 1991, as these operations benefited in 1993 from cost reduction programs and staffing cutbacks to adjust to the lower level of business. Interest expense for 1993 was virtually unchanged from 1992 as the benefit from lower short-term rates offset the increase in short-term bank borrowings during 1993. In 1992, interest expense was 5% below 1991, with principal payments made on the foreign long-term debt related to the acquisition of the German compressor divisions reducing foreign interest expense. The Company, like other similar manufacturers, is subject to environmental rules and regulations regarding the use, disposal, and clean up of substances regulated under environmental protection laws. It is the Company's policy to comply with these rules and regulations, and the Company believes that its practices and procedures are designed properly to meet this compliance. The Company is involved in remedial efforts at certain of its present and former locations; and when costs can be reasonably estimated, the Company records appropriate liabilities for such matters. While it is difficult to reasonably estimate the potential costs due to changes in the laws, regulations, technology, and circumstances, Management continues to believe that compliance with present laws governing environmental protection will not materially affect the financial condition of the Company. During 1993, the Company employed an average of 3,390 people, down from 3,480 in 1992 and 3,530 in 1991, due primarily to the staff reductions resulting from restructuring and effected consolidation plans. Liquidity and Sources of Capital: Cash and cash equivalents decreased to $2.4 million at December 31, 1993, compared to $3.5 million at year-end 1992 and $14.2 million at year-end 1991. Cash flows from operations during 1993 amounted to $15.7 million compared to $10.7 million in 1992 and $28.1 million in 1991. These funds, along with the net change in cash on hand, have been utilized in funding of capital expenditures, business acquisitions, and dividends over the three-year period, along with the net pay down of debt during 1991 and 1992 totaling $20.1 million, of which $11.7 million was prepaid in 1991, without penalty. Working capital increased $8.0 million during 1993 from the December 31, 1992 level which declined $6.9 million from year-end 1991. The 1993 working capital includes the recognition of a $7.0 million deferred tax asset resulting from the required change in accounting for income taxes. Accounts receivable levels have increased in support of the higher sales levels compared to 1992. Notes payable to banks also have increased over 1992, principally to fund working capital related to the sales increase. Certain loan agreements of the Company include restrictions on working capital, operating leases, tangible net worth, and the payment of cash dividends and stock distributions. Under the most restrictive of these arrangements, retained earnings of $10.3 million are not restricted at December 31, 1993. As of December 31, 1993, the Company had available credit of $67 million with banks under short-term borrowing arrangements and a revolving line of credit, $52 million of which was available at year-end. Anticipated funds from operations, along with available short-term credit and other resources, are expected to be sufficient to meet cash requirements in the year ahead. Cash in excess of operating requirements will continue to be invested in high grade, short-term securities. Common Stock Market Prices and Dividends: The Company's Common Stock is traded on the New York Stock Exchange (ticker symbol TII). On February 10, 1994, there were a total of 2,863 security holders of record. High and low stock prices and dividends (see Note 4) for the last two years were: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Accounting Policies Principles of Consolidation: The consolidated financial statements include the accounts of Thomas Industries Inc. and subsidiaries (the Company). Equity in minority-owned affiliates is accounted for using the equity method, under which the Company s share of earnings of these affiliates is included in income as earned. Intercompany accounts and transactions are eliminated. Inventories: Inventories are valued at the lower of cost or market. Inventories valued using the last-in, first-out (LIFO) method represented approximately 79% and 26% of consolidated inventories at December 31, 1993 and 1992, respectively, as all U.S. manufacturing operations previously using the first-in, first-out (FIFO) method adopted LIFO in 1993. The effect of this change on net income for the year ended December 31, 1993 was not significant. In addition, the Company changed its method of applying LIFO for certain inventories within the Lighting segment as required by changes in the nature of the Company's business. The effect of this change on the results of operations for the year ended December 31, 1993 was to increase net income in the fourth quarter by approximately $1,148,000 ($.11 per share). The Company believes these changes are preferable because they provide a better matching of costs with related revenues. The cumulative effect of these changes and the pro forma effects on prior years' earnings have not been included because such effects cannot be reasonably determined. The impact on the Company's first, second, and third quarters of 1993 was not material. Inventories which are not on LIFO are valued using FIFO. On a current cost basis, inventories would have been $16,992,000 and $19,087,000 higher than that reported at December 31, 1993 and 1992, respectively. Inventories consist of the following: Inventory quantities at certain operating units decreased in 1991. As a result, cost of products sold includes cost of inventories based on prior years' LIFO values which were less than current replacement costs, the effect of which increased net income by $1,215,000 ($.12 per share) in 1991. Property, Plant and Equipment: The cost of property, plant and equipment is depreciated principally by the straight-line method. Estimated useful lives are 30 to 45 years for buildings and 3 to 10 years for machinery and equipment. Property, plant and equipment consist of the following: Intangible Assets: Intangible assets represent the excess of cost over the fair value of net assets of companies acquired and are stated net of accumulated amortization of $12,176,000 and $10,346,000 at December 31, 1993 and 1992, respectively. The excess is being amortized over 40 years by the straight-line method. Net Income (Loss) Per Share: Net income (loss) per share is based on the weighted daily average number of common shares outstanding during the year. Outstanding stock options have an insignificant dilutive effect. Research and Development Costs: Research and development costs, which include costs of product improvements and design, are expensed as incurred ($12,431,000 in 1993, $12,464,000 in 1992 and $12,061,000 in 1991). Financial Instruments: Various methods and assumptions were used by the Company in estimating its fair value disclosures for significant financial instruments. Fair values of cash equivalents approximate their carrying amount because of the short maturity of those investments. The fair value of short- term debt approximates its carrying amount. The fair value of long-term debt is based on the present value of the underlying cash flows discounted at the current estimated borrowing rates available to the Company. Other: Cash equivalents are highly liquid investments with a maturity of less than three months when purchased. Note 2. Restructuring Costs In February 1994, the Company made the decision to further consolidate its commercial and industrial lighting operations and recorded a $3,500,000 ($2,040,000 after tax) restructuring charge in the fourth quarter of 1993. During the first quarter of 1992, the Company recorded a $5,925,000 ($3,986,000 after tax) charge to establish a reserve for the costs associated with restructuring and consolidating certain of its operations. The restructuring included the nonrecurring costs of severance payments, relocation, environmental remediation and disposal of assets related to the consolidation of certain operations in the Lighting Segment. This included the closing of one of three residential lighting plants, disposition of the Company's electronic ballast technology and related assets, and the consolidation of certain manufacturing and administrative functions. Other charges relate to the discontinuance of a joint venture and other nonproducing assets. Note 3. Income Taxes Effective January 1, 1993, the Company adopted the asset and liability method of SFAS No. 109, "Accounting for Income Taxes." The Company previously used the asset and liability method under SFAS No. 96, "Accounting for Income Taxes." The effect of this change on net income for 1993 was not significant. A summary of the provision for income taxes follows: The components of the provision (benefit) for deferred income taxes are as follows: The components of the deferred tax assets and deferred tax liabilities at December 31, 1993 are as follows: SFAS No. 109 requires that deferred tax asset and liabilities are classified according to the related asset and liability classification on the balance sheet. The realization of deferred tax assets is dependent upon the Company generating future taxable income when temporary differences become deductible. Based upon historical and projected levels of taxable income, management believes it is more likely than not the Company will realize the benefits of the deductible differences, net of the valuation allowance, of $3,078,000. The valuation allowance is provided for loss carryforwards in states and foreign jurisdictions, the realization of which is not assured within the carryforward periods. The U.S. and foreign components of income before income taxes follow: A reconciliation of the normal statutory federal income tax with the Company's provision for income taxes follows: The Company's foreign subsidiaries have accumulated undistributed earnings ($12,857,000) on which U.S. taxes have not been provided. Under current tax regulations and with the availability of certain tax credits, it is management's belief that the likelihood of the Company incurring significant taxes on any distribution of such accumulated earnings is remote. Dividends, if any, would be paid principally from current earnings. At December 31, 1993, the Company had foreign net operating loss carryforwards for financial reporting purposes of approximately $7,800,000. For income tax purposes, these carryforwards are approximately $7,300,000 and expire $1,100,000, $5,200,000 and $1,000,000 on January 1, 1999, 2000 and 2001, respectively. The Company made federal, state and foreign income tax payments of $4,655,000 in 1993, $4,147,000 in 1992 and $4,326,000 in 1991. Note 4. Long-Term Debt and Credit Arrangements A summary of long-term debt follows: As current interest rates are generally lower than the above rates, the fair value of the Company's long-term debt at December 31, 1993 was $98,800,000. Maturities of long-term debt for the next five years are as follows: 1994 - $2,206,195; 1995 - $8,744,517; 1996 - $8,723,581; 1997 - $8,140,091; and 1998 - - - - - - - - - - $7,740,091. Certain loan agreements include restrictions on working capital and tangible net worth and the payment of cash dividends and stock distributions. Under the most restrictive of these arrangements, retained earnings of $10,300,000 are not restricted at December 31, 1993. The Company has a $50,000,000 variable rate revolving line of credit expiring June 30, 1994. In addition, the Company has short-term lines of credit under which it may borrow up to $17,000,000, expiring on various dates during 1994. The Company plans to renew these lines annually. Actual cash paid for interest was $10,185,000 in 1993, $10,454,000 in 1992 and $11,144,000 in 1991. Note 5. Shareholders' Equity Under the Company's 1987 Incentive Stock Plan, options may be granted through 1997 at not less than market value at date of grant and expire ten years after date of grant. The Company's 1977 Incentive Stock Plan, amended in 1982 for the issuance of incentive stock options, terminated in 1987 except with respect to outstanding options which will remain exercisable until 1997. Following is a summary of outstanding stock options: Options outstanding at December 31, 1993, of which 245,135 options were exercisable, had option prices ranging from $9.87 to $18.75 (with an average option price of $12.25) and expire at various dates between December 12, 1995 and December 12, 2003. There were 197,509 shares reserved for future grant. On December 23, 1987, the Company's Board of Directors authorized the repurchase, at management's discretion, of up to 1,000,000 shares of its common stock in the open market or through privately negotiated transactions. At December 31, 1993, 377,023 shares had been purchased at a cost of $5,759,000 (none purchased during 1993 and 1992). The Board of Directors of the Company adopted a shareholder rights plan (the Rights Plan) in 1987 pursuant to which preferred stock purchase rights (the Rights) were declared and distributed to the holders of the Company's common stock. On October 18, 1991, the Board of Directors of the Company adopted certain amendments to the Rights Plan. The Rights Plan, as amended, provides that the Rights separate from the common stock and become exercisable if a person or group of persons working together acquires at least 20% of the common stock (a 20% Acquisition) or announces a tender offer which would result in ownership by that person or group of at least 20% of the common stock (a 20% Tender Offer). Upon a 20% Acquisition, the holders of Rights may purchase the common stock at half-price. If following the separation of the Rights from the common stock the Company is acquired in a merger or sale of assets, holders of Rights may purchase the acquiring company s stock at half-price. Notwithstanding the foregoing discussion, under the Rights Plan, the Board of Directors has flexibility in certain events. In order to provide maximum flexibility, the Board of Directors may delay the date upon which the Rights become exercisable in the event of a 20% Tender Offer. In addition, the Board of Directors has the option to exchange one share of common stock for each outstanding Right at any time after a 20% Acquisition but before the acquirer has purchased 50% of the outstanding common stock. The Rights may also be redeemed at two cents per Right at any time prior to a 20% Acquisition or a 20% Tender Offer. Note 6. Retirement Plans The Company has noncontributory defined benefit pension plans principally covering its hourly union employees. Such plans primarily provide flat benefits of stated amounts for each year of service. The Company's policy is to fund pension costs deductible for income tax purposes. The Company also sponsors defined contribution pension plans covering substantially all employees whose compensation is not determined by collective bargaining. Annual contributions are determined by the Board of Directors. A summary of pension expense follows: The assumptions used in the accounting for the funded status of defined benefit plans follows: The following table sets forth the funded status and amounts recognized in the consolidated balance sheets for the Company's defined benefit pension plans: At December 31, 1993, approximately 92% of plan assets are invested in listed stocks and bonds. Note 7. Other Postretirement Benefit Plans The Company provides postretirement medical and life insurance benefits for certain retirees and employees. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other than Pensions." This statement requires the cost of postretirement benefits to be accrued during the service lives of employees. The Company elected the prospective method of recognizing the accumulated postretirement benefit obligation. The effect of adopting SFAS No. 106 on 1993 on-going operations is an increase in expense of $294,000 ($176,000 net of income tax benefit), with the net periodic cost during 1993 of $779,000. Prior to 1993, the Company recognized the cost of these benefits on the cash basis. The following table presents the Plan's funded status reconciled with amounts recognized in the Company's consolidated balance sheet at December 31, 1993: Net periodic postretirement benefit cost for 1993 includes the following components: For measurement purposes, a 11% annual rate of increase in the per capita cost of future health benefits was assumed for 1994; the rate was assumed to decrease gradually to 5.5% by the year 2004, converging toward the assumed long-term rate of 5% thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $650,000 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1993 by $50,000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.25% as of December 31, 1993. Note 8. Leases, Commitments and Contingencies Total rental expense amounted to $5,321,000 in 1993, $5,444,000 in 1992 and $5,346,000 in 1991. Future minimum rentals (on leases in effect at December 31, 1993) for the five years ending December 31, 1998, and in the aggregate thereafter, are as follows: 1994 - $3,668,000; 1995 - $2,847,000; 1996 - $2,480,000; 1997 - $2,015,000; 1998 - $1,048,000; and thereafter - $7,107,000. Capital leases are not significant. The Company has various letters of credit outstanding in the amount of $9,000,000 at December 31, 1993. The Company is involved in environmental remedial efforts at certain of its present and former locations; and when costs can be reasonably estimated, the Company records appropriate liabilities for such matters. While it is difficult to reasonably estimate the potential costs due to changes in the laws, regulations, technology, and circumstances, Management believes that compliance with present laws governing environmental protection will not materially affect the financial condition of the Company. In the normal course of business, the Company and its subsidiaries are parties to litigation. Management believes that these suits will be resolved with no material adverse impact on the financial condition of the Company. Note 9. Accrued Expenses and Other Current Liabilities A summary of accrued expenses and other current liabilities follows: Note 10. Summary of Quarterly Results of Operations (Unaudited) The following is a tabulation of the unaudited quarterly results of operations for the years ended December 31, 1993 and 1992: Note 11. Industry Segment Information The Company's segments consist of Lighting, including residential, commercial, industrial and outdoor lighting products; Compressors and Vacuum Pumps; and other products. Industry segment information follows: Intersegment and interlocation sales are not significant and have been eliminated from the above tabulation. Operating income by segment is gross profit less operating expenses (including certain restructuring costs), excluding interest, general corporate expenses, other income, and income taxes. Corporate assets consist principally of highly liquid investments. Capital expenditures exclude property, plant and equipment of acquired companies at date of acquisition. Information by geographic area follows: Financial Review Responsibility for Financial Reporting The Board of Directors and Shareholders Thomas Industries Inc. The financial statements herein have been prepared under management direction from accounting records which management believes present fairly the transactions and financial position of the Company. They were developed in accordance with generally accepted accounting principles appropriate in the circumstances. Management has established internal control systems and procedures, including an internal audit function, to provide reasonable assurance that assets are maintained and accounted for in accordance with its authorizations and that transactions are recorded in a manner to ensure reliable financial information. The Company has a formally stated and communicated policy demanding of employees high ethical standards in their conduct of its business. The Audit Committee of the Board of Directors is composed of outside directors who meet regularly with management, internal auditors, and independent auditors to review audit plans and fees, independence of auditors, internal controls, financial reports, and related matters. The Committee has unrestricted access to the independent and internal auditors with or without management attendance. /S/Timothy C. Brown /S/Phillip J. Stuecker Timothy C. Brown Phillip J. Stuecker President and Vice President of Finance Chief Executive Officer Chief Financial Officer Secretary Louisville, Kentucky February 10, 1994 Independent Auditors' Report The Board of Directors and Shareholders Thomas Industries Inc. We have audited the accompanying consolidated balance sheet of Thomas Industries Inc. and subsidiaries as of December 31, 1993, and the related consolidated statements of income, shareholders' equity, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. The consolidated financial statements of Thomas Industries Inc. and subsidiaries as of December 31, 1992 and for the years ended December 31, 1992 and 1991, were audited by other auditors whose report thereon dated February 11, 1993, expressed an unqualified opinion on those statements. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the 1993 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Thomas Industries Inc. and subsidiaries as of December 31, 1993, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. As discussed in Note 7 to the consolidated financial statements, the Company changed its method of accounting for postretirement benefits in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." As discussed in Note 3, the Company changed its method of accounting for income taxes in 1993 to adopt the provisions of SFAS No. 109, "Accounting for Income Taxes." As discussed in Note 1, the Company changed its method of accounting for certain inventories in 1993. S/KPMG Peat Marwick Louisville, Kentucky February 10, 1994 11-Year Summary of Operations and Statistics Exhibit 18. Letter Regarding Change in Accounting Principles March 17, 1994 The Board of Directors Thomas Industries Inc. Gentlemen: We have audited the consolidated balance sheet of Thomas Industries Inc. and subsidiaries as of December 31, 1993, and the related consolidated statements of income, shareholders' equity, and cash flows for the year then ended, and have reported thereon under date of February 10, 1994. The aforementioned consolidated financial statements and our audit report thereon are incorporated by reference in the Company's annual report on Form 10-K for the year ended December 31, 1993. As stated in Note 1 to those financial statements, the Company changed its method of accounting for certain domestic inventories from the FIFO method to the LIFO method and, for certain other inventories within the Lighting segment, in the method of applying LIFO as required by changes in the nature of the Company's business and states that the newly adopted accounting principles are preferable in the circumstances because these changes provide a better matching of costs with related revenues. In accordance with your request, we have reviewed and discussed with Company officials the circumstances and business judgment and planning upon which the decision to make these changes in the method of accounting was based. With regard to the aforementioned accounting changes, authoritative criteria have not been established for evaluating the preferability of one acceptable method of accounting over another acceptable method. However, for purposes of Thomas Industries Inc.'s compliance with the requirements of the Securities and Exchange Commission, we are furnishing this letter. Based on our review and discussion, with reliance on management's business judgment and planning, we concur that the newly adopted methods of accounting are preferable in the Company's circumstances. Very truly yours, S/KPMG PEAT MARWICK Exhibit 23. CONSENT OF INDEPENDENT AUDITORS The Board of Directors Thomas Industries Inc. We consent to incorporation by reference in the registration statements (No. 33-16257) on Form S-8 and (No. 33-51653) on Form S-8 of Thomas Industries Inc. of our report dated February 10, 1994, relating to the consolidated balance sheet of Thomas Industries Inc. and subsidiaries as of December 31, 1993, and the related consolidated statements of income, shareholders' equity, and cash flows and related schedules for the year then ended, which report appears in the December 31, 1993 annual report on Form 10-K of Thomas Industries Inc. Our report refers to a change in the method of accounting for postretirement benefits, income taxes, and certain inventories. /S/KPMG PEAT MARWICK Louisville, Kentucky March 17, 1994 Exhibit 23.a CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements (Form S-8 No. 33-16257) pertaining to the stock option plan and (Form S-8 No. 33-51653) pertaining to the retirement savings and investment plan of Thomas Industries Inc. of our report dated February 11, 1993, with respect to the 1992 and 1991 consolidated financial statements and related schedules of Thomas Industries Inc. included and/or incorporated by reference in this Annual Report (Form 10-K) for the year ended December 31, 1993. /S/ERNST & YOUNG March 17, 1994

58492_1993.txt

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1993

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ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS. The Company was incorporated in 1901 as the successor to a partnership formed in 1883 at Carthage, Missouri. That partnership was a pioneer in the manufacture and sale of steel coil bedsprings. Products produced and sold for the furnishings industry constitute the largest portion of the Company's business. These include primarily components used by companies making furniture and bedding for homes, offices and institutions. Also in the furnishings area, the Company produces and sells some finished furniture and carpet cushioning materials. In addition, a group of diversified products is produced and sold. The Company believes it is the largest producer of a diverse range of furniture and bedding components in the United States. The term "Company," unless the context requires otherwise, refers to Leggett & Platt, Incorporated and its majority owned subsidiaries. The Company completed several acquisitions during 1993, primarily businesses engaged in manufacturing components for the furnishings industry and raw materials used by the Company in the manufacture of its products. In September 1993 the Company acquired Hanes Holding Company ("Hanes"), headquartered in Winston-Salem, North Carolina. Hanes is a converter and distributor of woven and nonwoven construction fabrics, primarily in the furnishings industry. Hanes also is a commission dye/finisher of nonfashion fabrics for the furnishings and apparel industries. Immediately following the Company's acquisition of Hanes, the Company (through Hanes) completed the acquisition of VWR Textiles & Supplies, Inc., which converts and distributes woven and nonwoven construction fabrics and manufactures other soft goods components for sale to manufacturers of furniture and bedding. Also, in September 1993 the Company acquired full ownership of several wire drawing mills which had been previously jointly owned. For further information concerning acquisitions reference is made to Note B of the Notes to Consolidated Financial Statements. PRODUCTS AND MARKET. The Company is engaged primarily in the manufacture and distribution of components used by companies that manufacture furniture and bedding for homes, offices and institutions. Manufacturers of finished furniture and bedding use many component parts which can be standardized and more efficiently produced in volumes beyond the individual needs of most such manufacturers. It is this market for component parts which the Company serves through its furniture and bedding component product lines. The Company's components customers manufacture bedding (mattresses and boxsprings), upholstered furniture and other finished products for sale to wholesalers, retailers, institutions and others. Historically, the furnishings industry has been highly fragmented and included many relatively small companies, widely dispersed geographically. Although there has been a trend toward consolidation in the furnishings industry, the industry as a whole remains fragmented to a substantial degree. The Company's component products are sold and distributed primarily through the Company's sales personnel. In addition to components, the Company manufactures and sells finished products for the furnishings industry. These finished products include sleep-related finished furniture and carpet cushioning materials. Some of the finished furniture products are sold to bedding and furniture manufacturers which resell the finished furniture under their own labels to wholesalers or retailers. Certain finished furniture such as bed frames, fashion beds, daybeds and other select items are also sold by the Company directly to retailers. The Company's carpet cushioning materials are sold primarily to floor covering distributors with some direct contract sales. The following list is representative of the principal products produced by the Company in the furnishings industry: BEDDING COMPONENTS Lectro-LOK-R-, Web-LOK-TM-, LOK-Fast-TM-, Flex-Deck-TM-, and Semiflex-TM- boxspring components Edge and corner stabilizer spring supports Foam and fiber cushioning materials Gribetz computerized single needle (Class V) and multi-needle chain stitch (Class I-IV) quilting machinery, material handling systems, panel cutters, tape edge and border serging machines Hanes construction fabrics Mira-Coil-R-, Super-Lastic-R-, Lura-Flex-TM-, Hinge Flex-TM-, and Ever-Flex-TM- innerspring assemblies for mattresses Mounted and crated boxsprings and foundation units Nova-Bond-R- and other insulator pads for mattresses and boxsprings Perm-A-Lator-R-, Plasteel-R-, Posturizer-TM-, Flexnet-TM- and other mattress insulators Spring and basic wire Synthetic, wool, cotton, and silk cushioning materials Wood frames and dimension lumber for boxspring frames FINISHED PRODUCTS Bed frames Bunk beds made of wood and steel Daybeds made of brass and wood Electric beds Genuine Brass, Lustre Brass-R- and other metal fashion beds and headboards Pedestal bed bases DURAPLUSH-TM-, Permaloom-R- and other carpet cushioning materials Rollaway beds Trundle beds Wood headboards FURNITURE COMPONENTS Chair controls, casters and other components for office furniture ClassicTouch-TM- and Modular Wallhugger-R- mechanisms for motion upholstered groups Coil-Flex-TM- and ModuCoil-R- spring assemblies for upholstered furniture Components for office panel systems Die cast aluminum, fabricated steel, and injection molded plastic bases for office furniture and dinettes Flex-Cord-R- paper covered wire Hanes construction fabrics Mechanisms for adjustable height work tables MPI/No-Sag-R- and other foam cushioning No-Sag-R- seating systems and clips Metal bed rails for bedroom suites Molded plastic recliner handles and other plastic furniture components No-Sag-R- rocker springs Perm-A-Lator-R- wire seating insulators Perma-eze-R- seat and back springs PETCO weltcord and furniture edgings Ring-Flex-R- polyethylene foam edgings SOFA PLUS-TM-, MAX-R-, and Classic-TM- Series sofa sleeper mechanisms Spring wire Swivel, rocker and glider components for motion furniture Synthetic fiber, densified fiber batting, seat pads and other cushioning materials System Seating-TM-, Seat Pleaser-R- and other furniture coils and accessories Tackit-TM- tackstrips Wallhugger-R- and Concept-TM- mechanisms for reclining chairs Webline-TM- seating systems Welded steel tubing Outside the furnishings industry, the Company produces and sells for home, industrial and commercial uses a diversified line of components and other products made principally from steel, steel wire, aluminum, plastics, textile fibers and woven and nonwoven fabrics. The Company's diversified products require manufacturing technologies similar to those used in making furniture and bedding components and certain raw materials which the Company produces for its own use. The following list is representative of the Company's principal diversified products: DIVERSIFIED PRODUCTS Aluminum die cast custom products and aluminum ingot Cyclo-Index-R- motion controls for manufacturing equipment Flex-O-Lators-R- and No-Sag-R- automotive seat suspension systems Gribetz single needle quilters, multi-needle chain stitch quilters, and panel cutters Hanes industrial and apparel fabrics Industrial wire Injection molded plastic products Mechanical springs Metal and wire shelving for utility vehicles and consumer products Point-of-purchase display racks Sound insulation materials Specialty foam products Textile fiber wiping cloths and other products Welded steel tubing The table below sets out further information concerning sales of each class of the Company's products: LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES SUMMARY OF SALES 1993-1988 Reference is also made to Note I of the Notes to Consolidated Financial Statements for further segment information. The Company's international division is involved primarily in the sale of machinery and equipment designed to manufacture the Company's Mira-Coil-R- (Continuous Coil) innersprings and certain other spring products and the licensing of patents owned and presently maintained by the Company in a number of foreign countries. The Company also sells quilting machines and similar equipment and certain other component products in some foreign countries. Foreign sales are a minor portion of the Company's business. CUSTOMERS. The Company has several thousand customers, most of which are engaged in manufacturing finished bedding and furniture products. None of the Company's customers account for as much as 10% of sales and, in management's opinion, the loss of any single customer would not have a material adverse effect on the Company's business as a whole. SOURCES OF RAW MATERIALS. Steel rod (from which steel wire is drawn) and coil steel are the Company's most important raw materials. Other raw materials used by the Company include aluminum ingot, aluminum scrap, angle steel, sheet steel, various woods, textile scrap, foam chemicals, foam scrap, woven and nonwoven fabrics and plastic. Substantially all of the Company's requirements for steel wire, an important component in many of the Company's products, are supplied by Company-owned wire drawing mills. A substantial portion of the steel rod used by these wire drawing mills is purchased pursuant to a rod supply agreement with a major steel rod producer. The Company also produces, at various locations, for its own consumption and for sale to customers not affiliated with the Company, slit coil steel, welded steel tubing, textile fibers, dimension lumber and aluminum ingot. Numerous supply sources for the raw materials used by the Company are available. The Company did not experience any significant shortages of raw materials during the past year. PATENTS: RESEARCH AND DEVELOPMENT. The Company holds numerous patents concerning its various product lines. No single patent or group of patents is material to the Company's business as a whole. The Company's more significant trademarks include those listed with the Company's principal products. The Company maintains research, engineering and testing centers at Carthage, Missouri, and also does research and development work at several of its other facilities. The Company is unable to precisely calculate the cost of research and development since the personnel involved in product and machinery development also spend portions of their time in other areas. However, the Company believes that the cost of research and development approximated $5 million in each of the last three years. EMPLOYEES. The Company has approximately 13,000 employees of whom approximately 10,000 are engaged in production. Approximately 40% of the Company's production employees are represented by labor unions. The Company did not experience any material work stoppage related to the negotiation of contracts with labor unions during 1993. Management is not aware of any circumstance which is likely to result in a material work stoppage related to the negotiations of any contracts expiring during 1994. COMPETITION. The markets for components and other products the Company produces are highly competitive in all aspects. There are numerous companies offering products which compete with those products offered by the Company. The Company believes it is the largest supplier in the United States of a diverse range of furniture and bedding components to the furnishings industry. GOVERNMENT REGULATION. The Company's various operations are subject to federal, state, and local laws and regulations related to the protection of the environment, worker safety, and other matters. Environmental regulations include those relating to air and water emissions, underground storage tanks, waste handling, and the like. While the Company cannot forecast policies that may be adopted by various regulatory agencies, management believes that compliance with these various laws and regulations will not have a material adverse effect on the consolidated financial condition or results of operations of the Company. From time to time, the Company is involved in proceedings, or takes remedial or other actions, relating to environmental matters. In one instance, the United States Environmental Protection Agency ("EPA") has directed one of the Company's subsidiaries to investigate potential releases into the environment and, if necessary, to perform corrective action. The subsidiary appealed the EPA's action. On February 4, 1994, the EPA Environmental Appeals Board remanded the matter to the EPA for further proceedings. One-half of any costs associated with any such investigation or corrective action would be reimbursed to the Company under a contractual obligation of a former joint owner of the subsidiary. The outcome of this matter cannot be reasonably predicted. Accordingly, no provision for the cost of performing any required investigation and corrective action has been recorded on the books of the Company. Management believes the cost to perform any investigation and corrective action, if eventually required, will not have a material adverse effect on the consolidated financial condition or results of operations of the Company. ITEM 2. ITEM 2. PROPERTIES The Company owns or leases approximately 150 facilities throughout the United States and Canada. Its corporate headquarters is located in Carthage, Missouri. The Company's most important physical properties are its owned or leased manufacturing plants. Such plants include five wire drawing mills in Missouri, Florida, Kentucky, Indiana and Massachusetts; welded steel tubing mills in Mississippi and Tennessee; and an aluminum smelting plant in Alabama. All of these mills manufacture some products which are either transferred to and used by the Company's other manufacturing plants, or are sold to others. Other major manufacturing plants are located in Alabama, Arkansas, California, Georgia, Illinois, Indiana, Kentucky, Massachusetts, Michigan, Mississippi, Missouri, North Carolina, Ohio, Pennsylvania, Tennessee, Texas, Wisconsin, and Canada. In addition, the Company owns or leases a large number of other facilities located in approximately 30 states utilized mainly for assembly, warehousing and distribution of Company products. Most of the Company's major manufacturing plants are owned by the Company or are held under operating leases. Leases expire at various dates through 2010. For additional information regarding lease obligations, reference is made to Note E of the Notes to Consolidated Financial Statements. The Company's machinery, equipment and buildings are maintained in good condition and are suitable for its current operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is a defendant in numerous ordinary, routine workers' compensation, product liability, vehicle accident, employment termination, and other claims and legal proceedings, the resolution of which Management believes will not have a material adverse effect on the consolidated financial condition or results of operations of the Company. The Company is presently party to a small number of proceedings in which a governmental authority is a party and which involve provisions enacted regulating the discharge of materials into the environment. These proceedings deal primarily with waste disposal site remediation. Management believes that potential monetary sanctions, if imposed in any or all of these proceedings, or any capital expenditures or operating expenses attributable to these proceedings, will not have a material adverse effect on the consolidated financial condition or results of operations of the Company. The EPA has alleged that two of the Company's facilities in Grafton, Wisconsin violated wastewater pretreatment requirements under the Clean Water Act. No action is pending. The EPA has not requested any specific relief, but has indicated it intends to bring an action. Management believes the cost to resolve this matter will not have a material adverse effect on the consolidated financial condition or results of operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS Leggett & Platt's common stock is listed on The New York and Pacific Stock Exchanges with the trading symbol LEG. The table below highlights quarterly and annual stock market information for the last two years. Price and volume data reflect composite transactions and closing prices as reported daily by The Wall Street Journal adjusted, as appropriate, for a 2-for-1 stock split on June 15, 1992. At February 25, 1994 the Company had approximately 6,969 shareholders of record. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company's previously issued financial statements have been restated to reflect pooling of interests acquisitions. Therefore, the following discussion and analysis reflects the Company's capital resources and liquidity and results of operations as restated for these acquisitions. CAPITAL RESOURCES AND LIQUIDITY The Company's financial position reflects several important principles and guidelines of management's capital policy. These include management's belief that corporate liquidity must always be adequate to support the Company's projected internal growth rate. At the same time, liquidity must assure management that the Company will be able to withstand any amount of financial adversity that can reasonably be anticipated. Management also intends to direct capital to strategic acquisitions and other investments that provide additional opportunities for expansion and enhanced profitability. Financial planning to meet these needs reflects management's belief that the Company should never be forced to expand its capital resources, whether debt or equity, at a time not of its choosing. Management also believes that financial flexibility is more important than maximization of earnings through excessive leverage. The Company's primary source of capital to meet these objectives is from internally generated funds. Operating activities provided $349.1 million in cash during the last three years. An additional $3.5 million in cash was generated from the issuance of the Company's common stock. Cash dividends paid on the stock were $57.2 million and repurchases of stock for the Company's treasury totaled $3.2 million during the three year period. Management continuously provides for available credit in excess of the Company's worst-case projections. Policy guidelines provide that long-term debt, composed of two "layers", will normally be maintained in a range of 30% to 40% of total capitalization. Obligations having scheduled maturities are the base "layer" of debt capital. At the end of 1993, these obligations totaled $122.3 million, consisting primarily of privately placed institutional loans and tax-exempt industrial development bonds. At the end of 1992, debt with scheduled maturities totaled $112.5 million, which was down from $135.4 million a year earlier. Near the end of the third quarter of 1993, the Company issued $50 million in unsecured privately placed debt under a medium-term note program. These notes were issued with average lives of approximately nine years and fixed interest rates averaging 5.8%. Debt of a company acquired in a September pooling of interests transaction was repaid with the majority of the proceeds from these notes. In 1992, the Company also issued approximately $26 million of medium-term notes near the beginning of the fourth quarter. These notes were issued with average lives of approximately five years and fixed interest rates averaging 6.15%. Proceeds from the notes issued in 1992 were used to repay debt outstanding under the Company's revolving bank credit agreements. Standard & Poor's and Moody's, the nations two leading debt rating agencies, both increased their ratings of the Company's senior debt in July 1992. Standard & Poor's increased its rating to A- from BBB+, and Moody's increased its rating to A3 from Baa1. In March 1992, substantially all of the $40 million of 6 1/2% convertible subordinated debentures, which had been outstanding at the end of 1991, were converted into 2.1 million shares of the Company's common stock. The resulting increase in shareholders' equity enhanced the Company's flexibility in capital management and increased yearly after-tax cash flow by approximately $.7 million. The Company's second "layer" of debt capital consists of revolving credit agreements with six banks. Over the years, management has renegotiated these bank credit agreements to keep pace with the Company's projected growth and to maintain a highly flexible source of debt capital. When utilized, the credit under these agreements is a long-term obligation. At the same time, however, the credit is available for short-term borrowings and repayments. In 1993, there was $43.5 million in revolving debt outstanding at the end of the year, up from $35.4 million in 1992. At the end of 1991, $97.3 million in revolving debt was outstanding. The 1993 increase in revolving debt reflected a portion of funds borrowed to finance cash acquisitions in the third quarter. In the fourth quarter of 1993 and prior to recent acquisitions, revolving bank debt was reduced with internally generated funds. Additional details of long-term debt outstanding, including scheduled maturities and the revolving credit, are discussed in Note D of the Notes to Consolidated Financial Statements. Net capital investments to modernize and expand manufacturing capacity internally totaled $109.0 million in the last three years. During this period, acquisitions accounted for by the purchase method of accounting involved a net cash investment of $93.3 million, plus an assumption of $5.7 million in long-term debt of the acquired businesses. In addition, the Company issued 1.8 million shares of common stock in three acquisitions accounted for as poolings of interests during this period. The largest acquisitions were completed during the third quarter of 1993. On September 1, the Company acquired Hanes Holding Company for 1.6 million shares of common stock, in a pooling of interests, and purchased VWR Textiles & Supplies, Inc. (through Hanes) for $26 million in cash. The Company also purchased full ownership of several wire drawing mills, which previously had been jointly owned. This transaction involved $33 million, plus the assumption of $3.6 million in long-term debt. Additional details of acquisitions are discussed in Note B of the Notes to Consolidated Financial Statements. The following table shows, in millions, the Company's capitalization at the end of the three most recent years. It also shows the amount of additional capital available through the revolving bank credit agreements and the Company's commercial paper program. The amount of cash and cash equivalents is also shown. The Company has the additional availability of short-term uncommitted credit from several banks. However, there was no short-term debt outstanding at the end of any of the last three years. The Company has substantial capital resources to support additional capital investments at or above recent levels. Working capital increased $32.5 million in the last three years. To gain additional flexibility in capital management and to improve the rate of return on shareholders' equity, the Company continuously seeks efficient use of working capital. The following table shows the annual turnover on average year-end working capital, trade receivables and inventories. Future commitments under lease obligations are described in Note E and contingent obligations in connection with environmental matters are discussed in Note J of the Notes to Consolidated Financial Statements. RESULTS OF OPERATIONS The results of operations during the last three years reflect various elements of the Company's long-term growth strategy, along with general trends in the economy and the furnishings industry. The Company's growth strategy continues to include both internal programs and acquisitions, which broaden product lines and provide for increased market penetration and operating efficiencies. With a continuing emphasis on the development of new and improved products and advancements in production technology, the Company is able to consistently offer high quality products, competitively priced. Trends in the general economy were favorable during the last two years. Economic growth increased in the fourth quarter of 1993, following more modest growth during most of the year. Consumer confidence also improved near the end of the year, and final demand for durable goods, including furniture and bedding, generally remained stronger than the demand for non-durable goods. Consumers reacted favorably to lower long-term interest rates and increased availability of credit. In 1992, a post-election recovery in consumer confidence quickly led to increased consumer spending and accelerated growth in the economy. However, compared with previous first year recoveries from recessionary lows, economic improvement was modest during most of 1992. During 1991, the economy began to recover from recessionary lows early in the year, when the war in the Middle East ended and consumer confidence temporarily improved. Consumer confidence soon turned back down and the pace of overall business remained depressed at the end of 1991. Demand in the furnishings industry followed a pattern similar to the general economy during the last three years. Annual growth in retail sales and manufacturers' shipments of bedding and furniture was somewhat stronger in 1993 than in 1992. Increased consumer spending near the end of the last two years helped offset some of the seasonal slowdown in demand for bedding, furniture and other furnishings the industry normally experiences. In 1991, industry sales and shipments reached recessionary lows in the first quarter, and recovered slowly during the remainder of the year. Management is anticipating further modest growth in the economy and the markets the Company serves in 1994. Severe winter weather and the California earthquake have impacted overall business activity at the beginning of the year, in several parts of the country. However, these are temporary adversities. Management is cautious in its outlook for business generally, primarily because of concerns about higher income tax rates, proposals for governmental health care programs, and inflationary trends. Inflation in the United States generally remained modest during the last three years. However, the Company experienced renewed inflation in prices for raw materials, principally steel and wire, throughout 1993. Modest price increases were implemented on some Company products during the second and third quarters of 1993 to help offset earlier cost increases and the renewed inflation in prices for raw materials. However, some of this inflation has not yet been reflected in the Company's selling prices. Therefore, the Company is continuing to experience cost/price pressures in affected product lines. In 1992, the Company was able to refrain from raising prices, as previously weaker economic conditions had reduced inflation for most raw materials. During 1991, the Company implemented modest price increases on some products in the second quarter. Prices for urethane foam products were raised more than others, in response to the 1990 acceleration in prices for petrochemicals. The Company's consolidated net sales in 1991 were modestly reduced after the mid-year divestiture of certain urethane foam operations. At the same time, the Company's profitability improved through the partial elimination of the operating losses these operations experienced in 1990. The operating results of the Company's restructured Fashion Bed Group, which manufactures sleep-related finished furniture, also began to improve near the end of 1992. In 1993, the Company's overall profitability reflected improved efficiencies in the remaining foam operations. The Fashion Bed Group also attained improved efficiencies in 1993, but continues to perform below management's expectations. The Company's consolidated net sales in 1993 increased 16% over the prior year. Excluding acquisitions accounted for as purchases, sales increased 10%, reflecting higher unit volumes and modestly higher prices on some products. In 1992, consolidated net sales increased 8% over 1991, due almost entirely to higher unit volumes. Sales, excluding purchase acquisitions and divestitures, also increased 8% in 1992. The following table shows various measures of earnings as a percentage of sales for the last three years. It also shows the effective income tax rate and the coverage of interest expense by pre-tax earnings plus interest. The Company's profit margins, like sales, continued to improve since 1991. In 1993, the gross profit margin was substantially unchanged from 1992. Operating efficiencies resulting from increased sales and production, cost cutting, and constant attention to cost containment were largely offset by inflation in prices for some key raw materials. Reflecting this inflation, LIFO expense reduced the gross profit margin by 0.2% in 1993. This experience was in contrast to the previous two years, when LIFO income slightly increased gross profit margins. The replacement cost of the LIFO inventory is discussed in Note A of the Notes to Consolidated Financial Statements. The 1993 pre-tax profit margin increased to 9.2% of sales. This improvement primarily reflected a 0.7% reduction in selling, distribution and administrative expenses, as a percentage of sales. Increased efficiencies and reduced bad debt expense contributed to the improvement in operating expense ratios. These factors and a slight increase in other income more than offset one time charges related to recent acquisitions and the Company's implementation of new accounting statements issued by the Financial Accounting Standards Board. The new accounting statements are mentioned separately at the end of this discussion, and in Note A of the Notes to Consolidated Financial Statements. Interest expense, as a percentage of sales, was reduced 0.4% in 1993 and further improved the pre-tax profit margin. Reduced debt outstanding (before recent acquisitions) and lower interest rates were reflected in this improvement. The effective income tax rate was 39.1% in 1993, up from 38.5% in 1992. In the third quarter of 1993, corporate federal income tax rates were increased from 34% to 35%, retroactive to January 1, 1993. Additional details of income taxes for the last three years are discussed in Note H of the Notes to Consolidated Financial Statements. In 1992, the gross profit margin increased to 22.8% of sales. This 1.4% increase over 1991 primarily reflected an improvement in operating efficiencies and earlier cost cutting at many locations. The 1992 pre-tax profit margin increased to 8.1% of sales. In addition to the improvement in the gross profit margin, the pre-tax margin benefitted from a 0.7% reduction in selling, distribution and administrative expenses, as a percentage of sales. Improved operating efficiencies and reduced bad debt expense were reflected in the lower 1992 operating expense ratios. Interest expense, as a percentage of sales, was reduced 0.6% in 1992 and further improved the pre-tax profit margin. Reduced debt outstanding and lower interest rates both contributed to this improvement, which was partially offset by an increase in other deductions, net of other income. The 1992 earnings contribution from associated (50% owned) companies was down modestly from 1991. STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS ADOPTED The Company adopted three accounting statements in 1993 issued by the Financial Accounting Standards Board. The new statements included Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions;" SFAS No. 109, "Accounting for Income Taxes;" and SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The Company fully expensed any previously unrecorded liabilities related to these accounting statements in 1993. The Company's financial statements, contrary to those of many other companies, have not been impacted in any significant way by the implementation of the new accounting rules. All new accounting statements issued by the Financial Accounting Standards Board that could impact the Company were fully implemented by the end of 1993. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and supplementary data included in this Report begin on page 14. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is made to the sections entitled "Election of Directors" and "Compliance With Section 16(a) of the Securities Exchange Act of 1934" in the Company's definitive Proxy Statement for the Company's Annual Meeting of Shareholders to be held on May 11, 1994, said section being incorporated by reference, for a description of the directors of the Company. The following table sets forth the names, ages and positions of all executive officers of the Company. Executive officers are elected annually by the Board of Directors at the first meeting of directors following the Annual Meeting of Shareholders. The description of the executive officers of the Company is as follows: Subject to the employment agreements and severance benefit agreements listed as Exhibits to this Report, officers serve at the pleasure of the Board of Directors. Harry M. Cornell, Jr. has served as the Company's Chief Executive Officer, Chairman of the Board and Chairman of the Board's Executive Committee for more than the last five years. Felix E. Wright was elected President in 1985 and has served as Chief Operating Officer since 1979. Roger D. Gladden was elected Senior Vice President in 1992. Mr. Gladden has been President -- Commercial Products Group since 1984 and previously served as Vice President -- Administration. Michael A. Glauber was elected Senior Vice President, Finance and Administration in 1990. Mr. Glauber was elected Vice President -- Finance in 1979 and Vice President -- Finance and Treasurer in 1980. David S. Haffner was elected Senior Vice President and President -- Furniture and Automotive Components Group in 1992. Mr. Haffner was appointed President -- Furniture Components Group in 1985 and was elected Vice President of the Company in 1985. Robert A. Jefferies, Jr. was elected Senior Vice President, Mergers, Acquisitions and Strategic Planning in 1990. Mr. Jefferies formerly served as Vice President and the Senior Vice President, General Counsel and Secretary of the Company from 1977 through 1992. Duane W. Potter was elected Vice President in 1978 and Senior Vice President in 1983. Mr. Potter has been President -- Bedding Components Group since 1985. Thomas D. Sherman, prior to joining the Company on January 1, 1993, served as Vice President, General Counsel and Secretary to Coca-Cola Enterprises Inc. and engaged in the private practice of law. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The section entitled "Executive Compensation and Related Matters" in the Company's definitive Proxy Statement for the Company's Annual Meeting of Shareholders to be held on May 11, 1994, is incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The section entitled "Ownership of Common Stock" in the Company's definitive Proxy Statement for the Company's Annual Meeting of Shareholders to be held on May 11, 1994, is incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The subsection entitled "Related Transactions" of the section entitled "Executive Compensation and Related Matters" in the Company's definitive Proxy Statement for the Company's Annual Meeting of Shareholders to be held on May 11, 1994 is incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K 1. FINANCIAL STATEMENTS The Financial Statements listed below are included in this Report: - Consolidated Statements of Earnings for each of the years in the three year period ended December 31, 1993 - Consolidated Balance Sheets at December 31, 1993 and 1992 - Consolidated Statements of Changes in Shareholders' Equity for each of the years in the three year period ended December 31, 1993 - Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 1993 - Notes to Consolidated Financial Statements - Report of Independent Accountants 2. FINANCIAL STATEMENT SCHEDULES Reports of Independent Accountants on Financial Statement Schedules Schedules (at December 31, 1993 and 1992, and for each of the years in the three year period ended December 31, 1993) All other information schedules have been omitted as the required information is inapplicable, not required, or the information is included in the financial statements or notes thereto. 3. EXHIBITS -- See Exhibit Index. 4. REPORTS ON FORM 8-K FILED DURING THE LAST QUARTER OF 1993: None. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES QUARTERLY SUMMARY OF EARNINGS LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS YEAR ENDED DECEMBER 31 The accompanying notes are an integral part of these financial statements. LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31 ASSETS The accompanying notes are an integral part of these financial statements. LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these financial statements. LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these financial statements. LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN MILLIONS, EXCEPT PER SHARE DATA) DECEMBER 31, 1993, 1992 AND 1991 A -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of Leggett & Platt, Incorporated and its majority-owned subsidiaries (the Company). The Company's previously issued financial statements have been restated to reflect pooling of interests acquisitions as discussed in Note B. All significant intercompany transactions and accounts have been eliminated in consolidation. CASH EQUIVALENTS: Cash equivalents include cash in excess of daily requirements which is invested in various financial instruments with maturities of three months or less. INVENTORIES: All inventories are stated at the lower of cost or market. Cost includes materials, labor and production overhead. Cost is determined by the last-in, first-out (LIFO) method for approximately 70% of the inventories at December 31, 1993 and 1992. The first-in, first-out (FIFO) method is used for the remainder. The FIFO cost of inventories at December 31, 1993 and 1992 approximated replacement cost. DEPRECIATION AND AMORTIZATION: Property, plant and equipment and other intangibles are depreciated or amortized over their estimated lives, principally by the straight-line method. Accelerated methods are used for tax purposes. The excess cost of purchased companies over net assets acquired is amortized by the straight-line method over forty years. COMPUTATIONS OF EARNINGS PER SHARE: Earnings per share is based on the weighted average number of common and common equivalent shares outstanding. Common stock equivalents result from the assumed issuance of shares under stock option plans. CONCENTRATION OF CREDIT RISK: The Company specializes in manufacturing, marketing and distributing components and other related products for the furnishings industry and diversified markets. The Company performs ongoing credit evaluations of its customers' financial conditions and, generally, requires no collateral from its customers, some of which are highly leveraged. The Company maintains allowances for potential credit losses and such losses generally have been within management's expectations. FAIR VALUE OF FINANCIAL INSTRUMENTS: The carrying value of the Company's financial instruments approximates market value. ACCOUNTING STANDARDS ADOPTED: During 1993, the Company adopted three new statements issued by the Financial Accounting Standards Board. These statements were: 1) Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions;" 2) SFAS No. 109, "Accounting for Income Taxes;" and 3) SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The adoption of these statements did not have a material effect on the Company's financial position or results of operations. RECLASSIFICATIONS: Certain reclassifications have been made to the prior years' consolidated financial statements to conform to the 1993 presentation. B -- ACQUISITIONS In September 1993, the Company issued 1,579,354 shares of common stock to acquire Hanes Holding Company (Hanes) in a transaction accounted for as a pooling of interests. Options to purchase an additional 45,743 shares of common stock were also extended by the Company in substitution for previously existing options. Hanes' business consists of converting and distributing woven and nonwoven construction fabrics, primarily in the furnishings industry. In addition, Hanes is a LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) B -- ACQUISITIONS (CONTINUED) commission dye/finisher of non-fashion fabrics for the furnishings and apparel industries. In another pooling of interests transaction, the Company issued 68,788 shares of common stock to acquire a company whose business is manufacturing furniture components for the furnishings industry. Previously issued financial statements have been restated to reflect the poolings. Separate results of operations for the years ended December 31, 1993, 1992 and 1991 are as follows: In September 1993, the Company acquired VWR Textiles & Supplies, Inc. (through Hanes) which converts and distributes construction fabrics and manufactures and distributes other soft goods components to the furnishings industry. The purchase price of this acquisition was approximately $26.0. Also in 1993, the Company acquired full ownership of several wire drawing mills which previously had been jointly owned. This transaction involved $33.0 in cash and the assumption of approximately $3.6 of long term debt. In addition, the Company acquired several smaller companies during 1993 which primarily manufacture and distribute products to the furnishings industry. The following unaudited pro forma information shows the results of operations for the years ended December 31, 1993 and 1992 as though the 1993 acquisitions accounted for as purchases had occurred on January 1 of each year presented. These pro forma amounts reflect purchase accounting adjustments, interest on incremental borrowings and the tax effects thereof. This pro forma financial information is not necessarily indicative of either results of operations that would have occurred had the purchases been made on January 1 of each year or of future results of the combined companies. During 1992, the Company acquired the assets of one small company that primarily manufactures bedding and furniture components for the furnishings industry. The purchase price of this acquisition was approximately $5.8. Assuming this acquisition had occurred at the beginning of the year, it would not have had a material impact on net sales, net earnings or earnings per share. Also during 1992, the Company acquired a business accounted for as a pooling of interests. The business primarily manufactures bedding and furniture components for the furnishings industry. In exchange for all of the outstanding capital stock of the business, the Company issued 100,903 shares of its common stock. The Company elected not to restate prior year's financial statements as the effect was immaterial. During 1991, the Company acquired the assets of two small companies that primarily manufacture bedding and furniture components for the furnishings industry. The purchase price of these acquisitions was approximately $10.0. Assuming these acquisitions had occurred at the beginning of the year, they would not have had a material impact on net sales, net earnings or earnings per share. LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) B -- ACQUISITIONS (CONTINUED) The above acquisitions, except for the 1993 and 1992 poolings, have been accounted for as purchases, and, where applicable, the excess of the total acquisition cost over the fair value of the net assets acquired is being amortized by the straight-line method over forty years. The results of operations of these companies since the dates of acquisition have been included in the consolidated financial statements. The purchase prices as originally reported represent the initial amounts of cash and common stock of the Company issued at the time of the acquisitions. Some purchase agreements also contain provisions for additional payments if certain minimum earnings requirements are met. All such provisions expired during 1993. Amounts earned under the terms of the agreements are recorded as increases in the excess of the total acquisition cost over the fair value of the net assets acquired. Such additional payments were approximately $6.4 and $2.7 during 1993 and 1992, respectively. C -- ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accrued expenses and other current liabilities at December 31 consist of the following: D -- LONG-TERM DEBT Long-term debt at December 31 consists of the following: LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) D -- LONG-TERM DEBT (CONTINUED) The revolving credit agreements provide for a maximum line of credit of $160.0. For any revolving credit agreement, the Company may elect to pay interest based on 1) the bank's base lending rate, 2) LIBOR, 3) an adjusted certificate of deposit rate, or 4) the money market rate, as specified in the revolving agreements. Any outstanding balances at the end of the third year of the revolving credit agreements may be converted into term loans payable in ten equal semi-annual installments. Commitment fees during the revolving agreement period are 3/16 of 1% per annum of the unused credit line, payable on a quarterly basis. The revolving credit agreements and certain other long-term debt contain restrictive covenants which, among other restrictions, limit the amount of additional debt, require working capital to be maintained at specified amounts and restrict payments of dividends. Unrestricted retained earnings available for dividends at December 31, 1993 were approximately $137.1. Maturities of long-term debt for each of the five years following 1993 are: E -- LEASE OBLIGATIONS The Company conducts certain of its operations in leased premises and also leases most of its automotive and trucking equipment and some other assets. Terms of the leases, including purchase options, renewals and maintenance costs, vary by lease. Total rental expense entering into the determination of results of operations was approximately $17.4, $16.8 and $17.0 for the years ended December 31, 1993, 1992 and 1991, respectively. Future minimum rental commitments for all long-term noncancelable operating leases are as follows: The above lease obligations expire at various dates through 2010. Certain leases contain renewal and/or purchase options. Aggregate rental commitments above include renewal amounts where it is the intention of the Company to renew the lease. F -- CAPITAL STOCK At December 31, 1993, the Company had 1,724,973 common shares authorized for issuance under stock option plans. All options are granted at not less than quoted market value on the date of grant and generally become exercisable in varying installments, beginning 6 to 18 months after the date of grant. LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) F -- CAPITAL STOCK (CONTINUED) Other data regarding the Company's stock options is summarized below: The Company has also authorized shares for issuance in connection with certain employee stock benefit plans discussed in Note G. In 1989, the Company declared a dividend distribution of one preferred stock purchase right (a Right) for each share of common stock. The Rights are attached to and traded with the Company's common stock. The Rights may only become exercisable under certain circumstances involving actual or potential acquisitions of the Company's common stock. Depending upon the circumstances, if the Rights become exercisable, the holder may be entitled to purchase shares of Series A junior preferred stock of the Company, shares of the Company's common stock or shares of common stock of the acquiring entity. The Rights remain in existence until February 15, 1999, unless they are exercised, exchanged or redeemed at an earlier date. On May 12, 1993 the Company's shareholders approved an amendment to the Company's Restated Articles of Incorporation increasing authorized Common Stock to 300,000,000 shares from 100,000,000 shares and reducing the par value of Common Stock to $.01 from $1.00. The amendment provided that the stated capital of the Company would not be affected as of the date of the amendment. Accordingly, stated capital of the Company exceeds the amount reported as common stock in the financial statements by approximately $39.0. G -- EMPLOYEE BENEFIT PLANS The Company sponsors contributory and non-contributory pension and retirement plans. Substantially all employees, other than union employees covered by multiemployer plans under collective bargaining agreements, are eligible to participate in the plans. Retirement benefits under the contributory plans are based on career average earnings. Retirement benefits under the non-contributory plans are based on years of service, employees' average compensation and social security benefits. It is the Company's policy to fund actuarially determined costs as accrued. LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) G -- EMPLOYEE BENEFIT PLANS (CONTINUED) Information at December 31, 1993, 1992 and 1991 as to the funded status of Company sponsored defined benefit plans, net pension income from the plans for the years then ended and weighted average assumptions used in the calculations are as follows: Plan assets are invested in a diversified portfolio of equity, debt and government securities, including 294,000 shares of the Company's common stock at December 31, 1993. Contributions to union sponsored, multiemployer pension plans were $.2, $.2 and $.4 in 1993, 1992 and 1991, respectively. These plans are not administered by the Company and contributions are determined in accordance with provisions of negotiated labor contracts. As of 1993, the actuarially computed values of vested benefits for these plans were equal to or less than the net assets of the plans. Therefore, the Company would have no withdrawal liability. However, the Company has no present intention of withdrawing from any of these plans, nor has the Company been informed that there is any intention to terminate such plans. Net pension income (expense), including Company sponsored defined benefit plans, multiemployer plans and other plans, was $.7, $.8 and $(.4) in 1993, 1992 and 1991, respectively. The Company also has a contributory stock purchase/stock bonus plan (SPSB Plan), a non-qualified executive stock purchase program (ESPP) and an employees' discount stock plan (DSP). The SPSB Plan provides Company pre-tax contributions of 50% of the amount of employee contributions. The ESPP provides cash payments of 50% of the employees' contributions, along with an additional payment to assist employees in paying taxes on the cash payments. These contributions to the ESPP are invested in the Company's common stock through the DSP. In addition, the Company matches its LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) G -- EMPLOYEE BENEFIT PLANS (CONTINUED) contributions when certain profitability levels, as defined in the SPSB Plan and the ESPP, have been attained. The Company's total contributions to the SPSB Plan and the ESPP were $2.5, $2.2 and $2.0 for 1993, 1992 and 1991, respectively. Under the DSP, eligible employees may purchase a maximum of 4,000,000 shares of Company common stock. The purchase price per share is 85% of the closing market price on the last business day of each month. Shares purchased under the DSP were 181,306, 237,713 and 267,212 during 1993, 1992 and 1991, respectively. Purchase prices ranged from $12 to $43 per share. Since inception of the DSP in 1982, a total of 2,120,413 shares have been purchased by employees. H -- INCOME TAXES The components of earnings before income taxes are as follows: Income tax expense is comprised of the following components: Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities. The major temporary differences that give rise to deferred tax assets or liabilities at December 31, 1993 and 1992 are as follows: LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) H -- INCOME TAXES (CONTINUED) Deferred tax assets and liabilities included in the consolidated balance sheets are as follows: Income tax expense, as a percentage of earnings before income taxes, differs from the statutory federal income tax rate as follows: Tax benefits of approximately $2.0 associated with the Company's restructuring charge were not recognized during 1990. These tax benefits became available during 1992 and were recognized accordingly. I -- INDUSTRY SEGMENT INFORMATION The Company's operations principally consist of the manufacturing of components and related finished products for the furnishings industry. In addition, the Company supplies a diversified group of industries with products which are similar in manufacturing technology to its furnishings operations. Other than furnishings, no industry segment is significant. The Company's products are sold primarily through its own sales personnel to customers in all states of the United States. Foreign sales are a minor portion of the Company's business. No single customer accounts for as much as 10% of sales. Operating profit is determined by deducting from net sales the cost of goods sold and the selling, distribution, administrative and other expenses attributable to the segment operations. Corporate expenses not allocated to the segments include corporate general and administrative expenses, interest expense and certain other income and deduction items which are incidental to the Company's operations. Capital expenditures, as defined herein, include amounts relating to acquisitions as well as internal expenditures. The identifiable assets of industry segments are those used in the Company's LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) I -- INDUSTRY SEGMENT INFORMATION (CONTINUED) operations of each segment. Corporate identifiable assets include cash, land, buildings and equipment used in conjunction with corporate activities, and sundry assets. Financial information by segment is as follows: J -- CONTINGENCIES From time to time, the Company is involved in proceedings related to environmental matters. In one instance, the United States Environmental Protection Agency ("EPA") has directed one of the Company's subsidiaries to investigate potential releases into the environment and, if necessary, to perform corrective action. The subsidiary appealed the EPA's action and the outcome cannot be reasonably predicted. Costs to perform the actions directed by the EPA, if the outcome is unfavorable, cannot be reasonably estimated. One-half of any such costs would be reimbursed to the Company under a contractual obligation of a former joint owner of the subsidiary. No provision for costs of performing investigation and corrective action, if ultimately required, have been recorded in the Company's financial statements. If any such investigation and corrective action is required, management believes the possibility of incurring unreimbursed costs, with a material adverse effect on the Company's consolidated financial condition or results of operations, is remote. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Leggett & Platt, Incorporated: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of earnings, changes in shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Leggett & Platt, Incorporated and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE St. Louis, Missouri February 17, 1994 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. Dated: March 28, 1994 LEGGETT & PLATT, INCORPORATED By: ____/s/__HARRY M. CORNELL, JR.____ Harry M. Cornell, Jr. CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER 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. EXHIBIT INDEX REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Shareholders of Leggett & Platt, Incorporated: Our audits of the consolidated financial statements referred to in our report dated February 17, 1994, appearing on page 29 of Leggett & Platt, Incorporated's Annual Report on Form 10-K for the year ended December 31, 1993, also included an audit of the Financial Statement Schedules listed in Item 14 - 2 in Part IV of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE St. Louis, Missouri February 17, 1994 LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 (AMOUNTS IN MILLIONS) LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1992 (AMOUNTS IN MILLIONS) LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1991 (AMOUNTS IN MILLIONS) LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 (AMOUNTS IN MILLIONS) LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1992 (AMOUNTS IN MILLIONS) LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1991 (AMOUNTS IN MILLIONS) LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (AMOUNTS IN MILLIONS) LEGGETT & PLATT, INCORPORATED AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (AMOUNTS IN MILLIONS)

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Item 1. BUSINESS - ------- -------- General - ------- LSB Industries, Inc. (the "Company") was formed in 1968 as an Oklahoma corporation, and in 1977 became a Delaware corporation. The Company is a diversified holding company which is engaged, through its subsidiaries, in (i) the manufacture and sale of chemical products for the explosives, agricultural and industrial acids markets (the "Chemical Business"), (ii) the manufacture and sale of a broad range of air handling and heat pump products for use in commercial and residential air conditioning systems (the "Environmental Control Business"), (iii) the manufacture or purchase and sale of certain automotive and industrial products, including automotive bearings and other automotive replacement parts (the "Automotive Products Business") and the purchase and sale of machine tools (the "Industrial Products Business") and (iv) the financial services business (the "Financial Services Business"). Recent Development - ------------------ The Company and Fourth Financial Corporation ("Fourth Financial") have entered into a Stock Purchase Agreement, dated as of February 9, 1994 ("Acquisition Agreement"), in which the Company has agreed to sell, and Fourth Financial has agreed to buy, the Company's wholly owned subsidiary, Equity Bank for Savings, F.A. ("Equity Bank"), which constitutes the Financial Services Business of the Company. Fourth Financial is to acquire all of the outstanding shares of capital stock of Equity Bank. The closing of this transaction is contingent upon several factors being met, including , but not limited to, regulatory approvals, minimum tangible book value (as defined) of Equity Bank and stockholder approval of the Company. Under the Acquisition Agreement, the Company is to acquire from Equity Bank, prior to closing, certain subsidiaries of Equity Bank ("Retained Corporations") that own the real and personal property and other assets contributed by the Company to Equity Bank at the time of the acquisition of the predecessor of Equity Bank by the Company for Equity Bank's carrying value of the assets contributed at the time of such purchase, which the Company estimates will be approximately $65.4 million. At the time of closing of the sale of Equity Bank, the Company is also required under the Acquisition Agreement to acquire: (A) the loan and mortgage on and an option to purchase Equity Tower located in Oklahoma City, Oklahoma, ("Equity Tower Loan"), which Equity Bank previously classified as an in-substance foreclosure on its books, (B) other real estate owned by Equity Bank that was acquired by Equity Bank through foreclosure (the Equity Tower Loan and other real estate owned by Equity Bank acquired through foreclosure are collectively call the "Retained Assets"), and (C) the outstanding accounts receivable sold to Equity Bank by the Company and its subsidiaries under various Receivables Purchase Agreements, dated March 8, 1988 ("the Receivables"). The Retained Assets are to be acquired for an amount equal to Equity Bank's carrying value of the Retained Assets at time of closing of the sale of Equity Bank, which were approximately $18.9 million at February 28, 1994. In addition, the Company has the option, but not the obligation, to acquire any loan owned by Equity Bank that has been charged off or written down for a price equal to the net book value of such loan that has been written down and for a price of $1.00 in the case of each loan that has been charged off ("Other Loans"). The purchase price ("Purchase Price") to be paid by Fourth Financial for Equity Bank under the Acquisition Agreement at the closing is estimated to be approximately $92 million. The exact amount of the Purchase Price is based on a formula, with the exact amount of such formula to be determined at closing as the sum of the following: (i) the tangible book value of Equity Bank (defined as the aggregate consolidated stockholders' equity of Equity Bank, less the amounts in the accounts relating to purchased mortgage servicing rights, goodwill, and United BankCard goodwill) at the closing, plus a premium over Equity Bank's tangible book value of the following determined at the closing: (a) $9.3 million for Equity Bank's credit card business, (b) 1% of the aggregate of the unpaid principal balance at closing of Equity Bank's loans secured by fixed rate mortgages having fully amortizing original terms of fifteen (15) years or less, excluding loans originated after October 31, 1993, (c) 6% of the aggregate unpaid principal balance at closing of Equity Bank's loans secured by fixed rate mortgages having fully amortizing original terms in excess of (15) years but not more than thirty (30) years, excluding loans originated after October 31, 1993, and (d) 2% of the aggregate unpaid principal balance at closing of Equity Bank's loans secured by variable rate mortgages, excluding loans originated after October 31, 1993; (ii) an amount at the closing equal to the unamortized discount on Equity Bank's mortgages included in (i)(b), (c), and (d) above; (iii) an amount at the closing equal to (a) 0.65% of the aggregate unpaid principal balance of loans serviced by Equity Bank prior to March 1, 1993, on which Equity Bank performs mortgage servicing (other than loans serviced for the account of Equity Bank), (b) 1% of such balance on such loans serviced by Equity Bank that were originated after March 31, 1993, secured by fixed or adjustable rate mortgages of fully amortizing original terms of at least ten (10) but not more than fifteen (15) years, and (c) 1.25% of such balance on such loans originated on or after March 1, 1993, secured by fixed or adjustable rate mortgages having original fully amortized terms of more than fifteen (15) but not more than thirty (30) years, (iv) an amount obtained by subtracting the "required reserve" (as defined below) from Equity Bank's actual loan loss reserve account at the closing, with the "required reserve" meaning $2.7 million as adjusted by the amount by which Equity Bank's loan loss account would have been adjusted at the closing under normal and prudent banking practice to reflect aggregate changes of at least $500,000 occurring subsequent to October 31, 1993, or originating since October 31, 1993, and not reviewed in advance by Fourth Financial; provided, that no such change in the quality of a loan is to be included in the calculation to the extent such change has been reflected in the tangible book value of Equity Bank at the closing or if such change is less that $25,000; (v) to the extent not otherwise reflected in the tangible book value of Equity Bank, an amount either positive or negative, by which the aggregate fair market value of Equity Bank's securities portfolio at the closing differs from Equity Bank's book value of such portfolio at the closing; (vi) the difference, positive or negative, between the carrying value of Equity Bank's time deposits and the aggregate value of such deposits after repricing them to the Treasury yield curve at the closing; (vii) $10.5 million for Equity Bank's net operating loss; (vii) $11.0 million for Equity Bank's deposit balance; and, (ix) $1.4 million for certain of Equity Bank's branches. The percentages specified in (i)(b) and (c) immediately above are determined utilizing the spread between the bank's average portfolio yield and FNMA required thirty (30) day yield as of August 31, 1993. If, at the time of the closing, such spreads have fluctuated by more than 0.25%, the applicable percentages in such subparagraphs (i)(b) and (c) will be adjusted up or down by one-fourth of 1% for each full one-eighth of 1% change in the spread, in the case of loans with an original term of fifteen (15) years or less, and by three-eighths of 1% for each full one-eighth of 1% change in the spread, in the case of loans with an original terms of more than fifteen (15) but not more than thirty (30) years. Based on the above, the Company estimates that at closing the Purchase Price will be approximately $92 million, which amount is estimated based upon estimates which cannot be definitively determined until the closing. Management of the Company has made estimates with respect to the variables which make up the Purchase Price. The Purchase Price will be affected by, among other things, the results of operations of and the fluctuation of interest rates between the date of this report and the closing. As a result, the exact amount of the Purchase Price may be higher or lower depending on factors of the formula that can only be determined at time of closing of the sale of Equity Bank. Notwithstanding the foregoing, if the Purchase Price, as finally determined at the closing, is less than $92 million, the Company may, at its option, terminate the Acquisition Agreement. The Company will use approximately $65.4 million, plus interest, of the Purchase Price to repay certain indebtedness the Company intends to incur to finance the purchase from Equity Bank of the Retained Corporations. In addition, it is anticipated that the Company will use approximately $18.9 million of the Purchase Price to purchase from Equity Bank the Retained Assets, which is the carrying value of the Retained Assets on the books of Equity Bank as of February 28, 1994. As of this date, the Company has made no decision if it will acquire any of the Other Loans. As of March 31, 1994, Equity Bank owned approximately $13.5 million of the Receivables, which if the closing occurs on or about June 30, 1994, the Company expects such to be less than $10 million as of the closing. On March 30, 1994, the Company entered into a $25 million accounts receivable financing line of credit with Bank IV Oklahoma, N.A., a wholly owned subsidiary of Fourth Financial, and expects to use borrowings under such line of credit to purchase the outstanding Receivables from Equity Bank at the closing. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations" The balance of the Purchase Price, if any, remaining after (i) repayment of the indebtedness incurred by the Company to purchase the Retained Corporations, (ii) purchase from Equity Bank of the Retained Assets, and (iii) payment of the transactional costs relating to the sale of Equity Bank under the Acquisition Agreement will be used by the Company for general working capital. See "Business - Financial Services Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" for further discussion as to matters affecting the proposed sale of Equity Bank. Segment Information and Foreign and Domestic Operations and Export Sales - ------------------------------------------------------------------------ Schedules of the amounts of revenues, operating profit and loss, and identifiable assets attributable to each of the Company's lines of business and of the amount of export sales of the Company in the aggregate and by major geographic area for each of the Company's last three fiscal years appear in Note 15 of the Notes to Consolidated Financial Statements included elsewhere in this report. A discussion of any risks attendant as a result of a foreign operation or the importing of products from foreign countries appears below in the discussion of each of the Company's business segments. Chemical Business - ----------------- General: ------- The Chemical Business manufactures and sells the following types of chemical products to the mining, agricultural and other industries: sulfuric acid, concentrated nitric acid, prilled ammonium nitrate fertilizer and ammonium nitrate-based blasting products. In addition, the Chemical Business markets emulsions that it purchases from others for resale to the mining industry. In July 1993, the Chemical Business acquired Total Energy Systems Limited ("TES"), an Australian explosives business, which sells blasting agents and high explosives to the Australian mining industry. For 1993, approximately 33% of the revenues of the Chemical Business consisted of sales of fertilizer and related chemical products for agricultural purposes, which represented approximately 12% of the Company's 1993 consolidated revenues, and 43% consisted of sales of ammonium nitrate and other chemical-based blasting products for the mining industry, which represented approximately 15% of the Company's 1993 consolidated revenues. The Chemical Business accounted for approximately 42% and 43% of the Company's 1993 and 1992 consolidated revenues, respectively. Seasonality: ----------- The Company believes that the only seasonal products of the Chemical Business are fertilizer and related chemical products sold to the agricultural industry. The selling seasons for those products generally occur during the spring and fall planting seasons, i.e., from February through May and from September through November. In addition, sales to the agricultural markets depend upon weather conditions and other circumstances beyond the control of the Company. Raw Materials: ------------- Ammonia represents an essential component in the production of most of the products of the Chemical Business, and the price of those products generally fluctuates with the price of ammonia. The Company has a contract with a supplier of ammonia pursuant to which the supplier has agreed to supply the ammonia requirements of the Chemical Business on terms the Company considers favorable. The Company believes that it could obtain ammonia from other sources in the event of a termination of that contract. Marketing and Distribution: -------------------------- The Chemical Business sells and markets its products directly through its own sales force, 35 distribution centers and to wholesalers. See "Properties". The Chemical Business sells low density prilled ammonium nitrate-based explosives primarily to the surface coal mining industry through nine company-owned distribution centers located in close proximity to the customers' surface mines in the coal producing states of Kentucky, West Virginia, Indiana and Illinois. In addition, sales of explosives are made on a wholesale basis to independent wholesalers and other explosives companies. The Chemical Business sells high density prilled ammonium nitrate for use in agricultural markets in geographical areas within a freight-logical distance from its El Dorado, Arkansas, manufacturing plant, primarily Texas, Oklahoma, Arkansas and Louisiana. The products are sold through 20 distribution centers, with 15 centers located in Northern and Eastern Texas, two centers located in Missouri and three centers located in Tennessee. The Chemical Business also sells its agricultural products directly to wholesale customers. The Company believes that it is a leader in the Texas ammonium nitrate market. The Chemical Business sells its industrial acids, consisting primarily of high grade concentrated nitric acid and sulfuric acid, primarily to the food, paper, chemical and electronics industries. Concentrated nitric acid is a special grade of nitric acid used in the manufacture of pharmaceuticals, explosives, and other chemical products. The Company believes that the Chemical Business is one of the leading producers of concentrated nitric acid in the United States for third party sales. Patents: ------- The Company believes that the Chemical Business does not depend upon any patent or license; however, the Chemical Business does own certain patents that it considers important in connection with the manufacture of certain blasting agents and high explosives. These patents expire through 1997. Regulatory Matters: ------------------ Each of the Chemical Business' blasting product distribution centers are licensed by the Bureau of Alcohol, Tobacco and Firearms in order to manufacture and distribute blasting products. The Chemical Business also must comply with substantial governmental regulations dealing with environmental matters. See "PROPERTIES - Chemical Business" for a discussion as to an environmental issue regarding the Company's El Dorado, Arkansas, manufacturing facility. Competition: ----------- The Chemical Business competes with other chemical companies, in its markets, many of whom have greater financial resources than the Company. The Company believes that the Chemical Business is competitive as to price, service, warranty and product performance. Environmental Control Business - ------------------------------ General: ------- The Company's Environmental Control Business manufactures and sells a broad range of fan coil, air handling, air conditioning, heating, heat pumps and dehumidification products targeted to both new building construction and renovation, as well as industrial application. The fan coil products consist of in-room terminal air distribution equipment utilizing air forced over a fin tube heat exchanger which, when connected to centralized equipment manufactured by other companies, creates a centralized air conditioning and heating system that permits individual room temperature control. The heat pump products manufactured by the Environmental Control Business consist of heat-recovery, water-to-air heat pumps that include a self-contained refrigeration circuit and blower, which allow the unit to heat or cool the space it serves when supplied with water at mild temperatures. The Environmental Control Business accounted for approximately 25% and 22% of the Company's 1993 and 1992 consolidated revenues, respectively, with fan coil products accounting for approximately 14% and heat pump products accounting for approximately 11%, respectively, of the Company's 1993 consolidated revenue. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" for a discussion relating to two letters of intent with foreign customers to supply such customers with equipment and technology to manufacture certain types of air handling products. Production and Backlog: - ---------------------- Most of the Environmental Control Business' production of the above- described products occurs on a specific order basis. The Company manufactures the units in many sizes, as required by the purchaser, to fit the space and capacity requirements of hotels, motels, schools, hospitals, apartment buildings, office buildings and other commercial or residential structures. As of December 31, 1993, the backlog of confirmed orders for the Environmental Control Business was approximately $17 million, as compared to approximately $13 million as of December 31, 1992. A customer generally has the right to cancel an order prior to the order being released to production. Past experience indicates that customers generally do not cancel orders after the Company receives them. As of December 31, 1993, the Company had released approximately $14 million of backlog orders in the Environmental Control Business to production, all of which are expected to be filled by December 31, 1994. Distribution: ------------ The Environmental Control Business sells its products to mechanical contractors, original equipment manufacturers and distributors. The Company's sales to mechanical contractors primarily occur through independent manufacturer's representatives, who also represent complimentary product lines not manufactured by the Company. Original equipment manufacturers generally consist of other air conditioning and heating equipment manufacturers who resell under their own brand name the products purchased from the Environmental Control Business as a separate item in competition with the Company or as part of a package with other air conditioning-heating equipment products to form a total air conditioning system which they then sell to mechanical contractors or end-users for commercial application. Sales to original equipment manufacturers accounted for approximately 36.4% of the sales of the Environmental Control Business in 1993. Construction Industry: --------------------- The Environmental Control Business depends primarily on the commercial construction industry, including new construction and the remodeling and renovation of older buildings. Raw Materials: ------------- Numerous domestic and foreign sources exist for the materials used by the Environmental Control Business, which materials include aluminum, copper, steel, electric motors and compressors. The Company does not expect to have any difficulties in obtaining any necessary materials for the Environmental Control Business. Competition: ----------- The Environmental Control Business competes with approximately eight companies, several of whom are also customers of the Company. Some of the competitors have greater financial resources than the Company. The Company believes that the Environmental Control Business manufactures a broader line of fan coil and water source heat pump products than any other manufacturer in the United States, and, that it is competitive as to price, service, warranty and product performance. Automotive Products Business - ---------------------------- General: ------- The Automotive Products Business is primarily engaged in the manufacture and sale of a line of anti-friction bearings, which includes straight-thrust and radial-thrust ball bearings, angular contact ball bearings, and certain other automotive replacement parts. These products are used in automobiles, trucks, trailers, tractors, farm and industrial machinery, and other equipment. In 1993, the Automotive Products Business manufactured approximately 48.5% of the products it sold and approximately 61% in 1992, and purchased the balance of its products from other sources, including foreign sources. Distribution and Market: ----------------------- The automotive and truck replacement market serves as the principal market for the Automotive Products Business. This business sells its products domestically and for export, principally through independent manufacturers' representatives who also sell other automotive products. Those manufacturers' representatives sell to retailers (including major chain stores), wholesalers, distributors and jobbers. The Automotive Products Business also sells its products directly to original equipment manufacturers and certain major chain stores. Inventory: --------- The Company generally produces or purchases the products sold by the Automotive Products Business in quantities based on a general sales forecast, rather than on specific orders from customers. The Company fills most orders for the automotive replacement market from inventory. The Company generally produces or purchases bearings for original equipment manufacturers after receiving an order from the manufacturer. Raw Materials: ------------- The principal materials that the Automotive Products Business needs to produce its products consist of high alloy steel tubing, steel bars, flat strip coil steel and bearing components produced to specifications. The Company acquires those materials from a variety of domestic and foreign suppliers at competitive prices. The Company does not anticipate having any difficulty in obtaining those materials in the near future. Competition: ----------- The Automotive Products Business engages in a highly competitive business. Competitors include other domestic and foreign bearing manufacturers, which sell in the original equipment and replacement markets. Many of those manufacturers have greater financial resources than the Company. Industrial Products Business - ---------------------------- General: ------- The Industrial Products Business purchases and markets a proprietary line of machine tools and also markets industrial supplies. The current line of machine tools distributed by the Industrial Products Business includes milling, drilling, turning, fabricating and grinding machines. The Industrial Products Business purchases most of the machine tools marketed by it from foreign companies, which manufacture the machine tools to the Company's specifications. Distribution and Market: ----------------------- The Industrial Products Business distributes its machine tools in the United States, Mexico, Canada and certain other foreign markets and distributes its industrial supplies principally in Oklahoma. The Industrial Products Business sells and distributes its products through its own sales personnel, who call directly on end users. The Industrial Products Business also sells its machine tools through independent machine tool dealers throughout the United States and Canada, who purchase the machine tools for resale to end users. The principal markets for machine tools, other than independent machine tool dealers, consist of manufacturing and metal working companies, maintenance facilities, utilities and schools. Customer: -------- The Industrial Products Business does not depend on any single customer, or a few customers, the loss of any one or more of which would have a material adverse effect on the Industrial Products Business. A significant increase in the revenues of the Industrial Products Business occurred during 1992 and 1993 as a result of an agreement with a foreign company ("Buyer"), dated July 6, 1992, to supply the Buyer with equipment, technology and technical services to manufacture certain types of automotive bearing products. The agreement provides for a total contract amount of approximately $56.0 million, with $12.0 million of the contract amount to be retained by the Buyer as the Company's subsidiary's equity participation in the Buyer. The Company's subsidiary has valued its equity participation in the Buyer at a nominal amount. The balance of approximately $44.0 million has been or will be paid to the Company's subsidiary as follows: (i) approximately $13.1 million was paid through December 31, 1993, and (ii) the balance of approximately $30.9 million payable in equal quarterly installments over a ten (10) year period, plus interest. Payment of the quarterly installments has been delayed from time to time. However, during the fourth quarter of 1993, approximately $791,000 of such balance was paid by the Buyer to the Industrial Products Business under this agreement. The Company has shipped to the Buyer certain machinery and equipment and expects to deliver the balance of such machinery and equipment and the tooling and designs to the Buyer by the end of June, 1994. Circumstances could arise that could delay the delivery of the machinery, equipment, designs and tooling to the Buyer. Under the agreement, the Company's subsidiary will use its best efforts to purchase approximately $14.5 million of bearing products from the Buyer each year over a period of ten (10) years; provided, however, that the Company's subsidiary is not required to purchase more product from the Buyer in any one (1) year than the amount of tapered bearings the Company's subsidiary is able to sell in its market. The Company presently manufactures and purchases from outside sources tapered bearings. During 1993 and 1992, the Company sold approximately $10.0 million and $6.9 million, respectively, of tapered bearings. The Company believes that the purchase price of these bearings will be favorable compared to its present cost in purchasing these products from other sources or manufacturing these products. Such prices are subject to increases or decreases based upon price increases or decreases sustained in the United States bearing industry. The Company will recognize revenues and profits on the sale of equipment and technology over the term of the agreement as they are realized. The revenue and profits realized during the delivery and installation period are being recognized on a percentage of completion basis. During the years ended December 31, 1993 and 1992, the Company recorded sales of approximately $7.5 million and $6.2 million, respectively, in connection with the agreement. The percentage of completion is determined by relating the productive costs incurred to date to the total productive costs estimated to complete the performance under the contract for delivery and installation. The Company presently meets all of its obligations under the contract which generally coincides with the payout term. During the fourth quarter of 1993, the Industrial Products Business exchanged its rights to the equity interest in the Buyer to a foreign non- affiliated company ("Purchaser of the Interest") for $12.0 million in notes. The Company has been advised that the Buyer has agreed to repurchase from the Purchaser of the Interest up to $6 million of such equity interest over a six (6) year period, with payment to be either in cash or bearing products. The notes issued to the Industrial Products Business for its rights to the equity interest in the Buyer will only be payable when, as and if the Purchaser of the Interest collects from the Buyer for such equity interest, and the method of payment to the Company will be either cash or bearing products in the same manner as received by the Purchaser of the Interest from the Buyer. Due to the Company's inability to determine what payments, if any, it will receive on such notes, the Company will carry such notes at a nominal amount. See "MANAGEMENT'S DISCUSSION AND ANALYSIS" and Note 8 to Consolidated Financial Statements for further discussion of this agreement. Foreign Risk: ------------ By purchasing a majority of the machine tools from foreign manufacturers, the Industrial Products Business must bear certain import duties and international economic risks, such as currency fluctuations and exchange controls, and other risks from political upheavals and changes in United States or other countries' trade policies. Most of the current contracts for the purchase of foreign-made machine tools provide for payment in United States dollars. Circumstances beyond the control of the Company could eliminate or seriously curtail the supply of machine tools from any one or all of the foreign countries involved. Competition: ----------- The Industrial Products Business competes with manufacturers and other distributors of machine tools and industrial supplies, many of whom have greater financial resources than the Company. The Company's machine tool business generally is competitive as to price, warranty and service, and maintains personnel to install and service machine tools. Financial Services Business - --------------------------- Recent Developments: ------------------- See "Business - Recent Developments" under this section, "Management's Discussion and Analysis of Financial Condition" and Note 1 to Notes to Consolidated Financial Statements for discussion of the proposed sale of Equity Bank, which comprises all of the Company's Financial Services Business. General: ------- The Company is engaged in the Financial Services Business through its wholly owned subsidiary, Equity Bank and its subsidiaries. The Financial Services Business offers retail banking services, mortgage, consumer and commercial lending, and other related financial products and services through 15 branch offices located in the Oklahoma City metropolitan area and western Oklahoma. The Company's Financial Services Business operates an Oklahoma based credit card division ("BankCard") which provides MasterCard and Visa credit card services to member financial institutions and their customers and merchants. As of December 31, 1993, BankCard had approximately $62.9 million in credit card receivables outstanding, approximately 96,000 cardholders and approximately 7,200 merchant accounts. At December 31, 1993, approximately $23.6 million of credit card receivables are serviced for member financial institutions without recourse to BankCard. The Financial Services Business engages in, among other things, the business of attracting deposits from commercial and retail customers and uses those deposited funds and other borrowed funds to originate one to four family residential loans and other loans. The loans, along with other investments, serve as a major source of the assets utilized by the Financial Services Business to generate its net interest income. Net interest income represents a significant source of income for Equity Bank and results from the difference between the amount of income earned on interest-earning assets and the expense incurred on interest-bearing liabilities. Equity Bank earns other income and fees principally in connection with credit card services, rental income, the origination, sale and servicing of loans and checking servicing of accounts. In 1993 and 1992, the Financial Services Business accounted for approximately 15% and 19% of the Company's consolidated revenues, respectively. Affiliated Transactions: ----------------------- In connection with the acquisition of Equity Bank in March, 1988, and the approval of the appropriate regulatory authority at that time, the Company and several of its subsidiaries transferred certain properties to Northwest Financial Corporation ("Northwest Financial"), a wholly-owned service corporation of Equity Bank. The properties included, but were not limited to, the then manufacturing facilities and the then existing distribution facilities of the Chemical Business, a portion of the real estate which the Environmental Control, the Automotive Products and Industrial Products Businesses conduct manufacturing and distribution operations and certain other assets (collectively, the "Transferred Assets"). Based upon approvals by the appropriate regulatory authority at that time, Equity Bank was allowed to record, on a stand-alone basis, the Transferred Assets at their then current fair market value based on MAI appraisals approved by the appropriate regulatory agency at that time. The MAI appraisals relating to the Transferred Assets were, in the aggregate, approximately $69.8 million. The Transferred Assets were transferred to Northwest Financial subject to approximately $21.5 million in debt. Equity Bank was allowed to reflect the MAI appraised values of the Transferred Assets, less the associated debt, for capital purposes. The Company continued to reflect the historical cost, less depreciation to date, for such Transferred Assets on the Company's consolidated financial statements. The Company's historical cost for all of the Transferred Assets, less depreciation, equaled approximately $18.8 million as of the time such were transferred to Northwest Financial. In order for the Company and its subsidiaries to continue their operations on those properties, Northwest Financial entered into agreements to lease or sublease certain of the Transferred Assets back to their original users for an original term of twelve (12) years expiring in the year 2000, with an option to renew for an additional term of ten (10) years, at an aggregate annual rental for the leased Transferred Assets of $3.2 million. Due to an agreement with its regulators as hereafter discussed in this section, certain of the lease agreements involving certain of the Transferred Assets were amended. Under the amendments, the aggregate rentals relating to all of the Transferred Assets were increased to $4.3 million and the lease terms as to certain of the Transferred Assets were amended by eliminating the options to renew. Subject to the terms of the leases between Northwest Financial and the Company's subsidiary leasing such, Northwest Financial transferred beneficial ownership of these properties to two general partnerships in which Northwest Financial owns 99.0% of the partnership interest and the other 1.0% is owned by another subsidiary of the Company. Northwest Financial continues to hold record title to the real properties that constitute part of the Transferred Assets. As part of the acquisition of Equity Bank and thereafter Arrowhead and the approval of the appropriate regulatory authority at that time, the Company and its subsidiaries were permitted to sell up to $60.0 million of eligible accounts receivable at any one time to Equity Bank with recourse to the seller ("Receivable Financing"). Under such Receivable Financing, each of the Receivables sold to Equity Bank was sold at 100% of face value. The OTS has taken the position that the initial five (5) year approvals granted in 1988 allowing for the Receivable Financing between Equity Bank and the Company and certain of its other subsidiaries expired, and because of an intervening change in the law, beginning in September, 1993, the amount of the Receivable Financing was to be reduced to amounts allowable under current regulations relating to transactions with affiliated companies which is based on a percentage of Equity Bank's capital. As part of the negotiations with the OTS, the parties agreed to a phase-down period regarding the Receivable Financing instead of having to reduce such to the applicable percentage of Equity Bank's capital by September, 1993. It was agreed that: (i) at no one time subsequent to September 28, 1993, but prior to September 1, 1994, would the total amount of such Receivable Financing outstanding at any one time exceed $33.6 million; (ii) beginning February 1, 1994, Equity Bank will not purchase any new Receivables from the Company and/or its subsidiaries under the Receivable Financing arrangement if such would result in Equity Bank owning an amount that would exceed the amount allowed by current regulations, and (iii) on and after September 1, 1994, the outstanding amount of such Receivable Financing at any one time must be in compliance with current regulations. Assuming that on December 31, 1993, Equity Bank has been required to meet current regulations regarding such Receivable Financing, the amount would have had to be reduced to approximately $9.2 million as of such date. During 1993 and 1992, the Financial Services Business earned a significant portion of its income from two affiliated sources, which transactions were previously approved by the appropriate federal regulatory agency. These include rental income from payments made by the Company and certain of its subsidiaries of approximately $4.3 million in 1993 and $4.2 million in 1992 for the use of certain of the Transferred Assets In addition, the Financial Services Business earned fees of $2.7 million in 1993 and 2.7 million in 1992 in connection with the Receivable Financing. At March 31, 1994, Equity bank held approximately $13.5 million of such Receivables. As provided in "Business - Recent Developments" The Company will, (a) if the Acquisition Agreement is to be consummated, acquire from Equity Bank the Retained Corporations that own the Transferred Assets one (1) day prior to consummation of the proposed sale of Equity Bank to Fourth Financial, and (b) upon consummation of the Acquisition Agreement, acquire from Equity Bank the Retained Assets and the outstanding Receivables owned by Equity Bank on the day of closing of the proposed sale of Equity Bank. See "Business - Recent Developments", "Management's Discussion and Analysis of Financial Condition" and Note 1 to Notes to Consolidated Financial Statements for further discussion of the terms of the proposed sale of Equity Bank, the amounts that the Company will pay for the Retained Corporations, the Transferred Assets and the Receivables and the method that the Company intends to use to purchase such assets from Equity Bank. Competition: ----------- The Financial Services Business experiences substantial competition in attracting and retaining deposits and in making loans. The primary factors in competing for deposits consist of the ability to offer attractive rates and the availability of convenient office locations. Competition for financial services historically comes from other savings institutions, commercial banks and credit unions. However, securities firms and mortgage companies are also competitors. Government and corporate securities also represent a source of competition for savings and loan institutions, especially during periods of declining interest rates when those securities may yield higher rates than those offered by savings institutions. Competition for loans comes principally from other savings institutions, commercial banks, mortgage companies, insurance companies and other institutional investors. In recent years, the Oklahoma market for financial institutions like Equity Bank has changed as a result of large out-of-state banks establishing operations in Oklahoma. The primary factors in competing for loans consist of interest rates, loan origination fees and other terms and services offered. Currently, Oklahoma allows interstate banking only in limited cases involving the acquisition of failing institutions. Regulatory Matters: ------------------ (a) Capital Compliance The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), which became effective in August, 1989, significantly affects the business conducted by Equity Bank. The Office of Thrift Supervision ("OTS") is Equity Bank's primary regulator. Deposits in Equity Bank are insured by, the Savings Association Insurance Fund ("SAIF"), which is administered by the Federal Deposit Insurance Corporation ("FDIC") and backed by the full faith and credit of the United States. The OTS has adopted regulations specifying capital standards for all savings institutions that are no less stringent than capital standards for national banks, and the standards under these regulations exceed those required by FIRREA. If Equity Bank should fail to meet any of its capital requirements, such failure could have a material adverse effect on Equity Bank, its operations and the Company. In addition, Equity Bank would be required to submit a capital plan to the OTS to demonstrate the manner in which Equity Bank will come into capital compliance and would also be subject to various operating restrictions on its business activities which could have a substantial impact on Equity Bank's profitability. See "Regulatory Matters" of this section discussing the Financial Services Business for further discussion as to Equity Bank's capital compliance. FIRREA requires that Equity Bank meet progressively higher capital requirements each year until they are "fully phased-in" through December 31, 1994, except for certain assets for which the "phase-in" period has been extended through July, 1996. Equity Bank currently does and believes that it will be able to meet all applicable requirements of law and federal regulation relating to capital requirements as presently in effect and as the same become effective during the phase-in period, although there are no assurances that Equity Bank will be able to so comply. At December 31, 1993, Equity Bank exceeded the current regulatory capital requirements and under the technical definition and calculation of fully phased-in capital as prescribed by FIRREA, Equity Bank believes that it meets future capital standards as presently mandated by FIRREA. Equity Bank updated and submitted to the OTS a three (3) year business plan that indicates all future capital requirements will be met, See "Regulatory Matters" of this section discussing the Financial Services Business, "Management's Discussion and Analysis of Financial Condition", and Note 5 to Consolidated Financial Statements for further discussion as to the status of regulatory matters. The Federal Deposit Insurance Corporation Improvements Act of 1991 ("FDICIA"), resulted in extensive changes to the federal banking laws and will result in extensive changes to banking regulations. The primary purpose of the law is to authorize additional borrowings by the FDIC in order to provide funds for the resolution of failing financial institutions. FDICIA institutes certain changes to the supervisory process and contains various provisions that may affect the operations of savings institutions like Equity Bank. Certain of these changes are discussed below and in, "Management's Discussion and Analysis - Financial Services Business, Savings Institution Regulation". FDICIA made a number of significant changes to the statutory and regulatory framework within which Equity Bank and the Company, as a savings and loan holding company, must operate. Among the more significant regulations is that FDICIA requires the federal banking regulators to take prompt corrective action if an institution fails to satisfy certain minimum capital requirements. Under FDICIA, capital requirements include a leverage limit, a risk-based capital requirement, and any other measure of capital deemed appropriate by the federal banking regulators for measuring the capital adequacy of an insured depository institution. Depending on its capital structure, an institution will be classified as "well capitalized", "adequately capitalized", "undercapitalized", "significantly undercapitalized" or "critically undercapitalized". A financial institution is considered "well capitalized" if it is under no regulatory order or action and its leverage ratio is at least 5% and its Tier 1 and Total Risk-Based Capital ratios are at least 6% and 10% respectively. Equity Bank is deemed "well capitalized" under these regulations. FDICIA amended the Federal Deposit Insurance Act to prohibit insured depository institutions that are not well-capitalized from accepting brokered deposits unless a waiver has been obtained from the FDIC. FDICIA also directed the FDIC to establish a risk-based assessment system for deposit insurance. Pursuant to FDICIA, the federal bank regulatory agencies are required to adopt uniform regulations for real estate mortgage and construction loans. The federal bank regulatory agencies are required to biannually review risk-based capital standards to ensure that they adequately address interest rate risk, concentration of credit risk and risks from non- traditional activities. The FDIC, which insures the deposits of Equity Bank, has adopted a regulation which provides that any insured depository institution with a ratio of Tier 1 capital to total assets of less than 2% will be deemed to be operating in an unsafe or unsound condition, which would constitute grounds for the initiation of termination of deposit insurance proceedings. The FDIC, however, will not initiate termination of insurance proceedings if the depository institution has entered into and is in compliance with a written agreement with its primary regulator, and the FDIC is a party to the agreement, to increase its Tier 1 capital to such level as the FDIC deems appropriate. Tier 1 capital is defined as the sum of common stockholders' equity, noncumulative perpetual preferred stock (including any related surplus) and minority interests in consolidated subsidiaries, minus all intangible assets other than eligible purchased mortgage servicing rights and qualifying supervisory goodwill eligible for inclusion in core capital under OTS regulations and minus identified losses and investments in certain securities subsidiaries. Insured depository institutions with Tier 1 capital equal to or greater than 2% of total assets may also be deemed to be operating in an unsafe or unsound condition notwithstanding such capital level. The regulation further provides that in considering applications that must be submitted to it by savings institutions, the FDIC will take into account whether the savings institution is meeting the Tier 1 capital requirement for state non-member banks of 4% of total assets for all but the most highly rated state non-member banks. At December 31, 1993, Equity Bank had Tier 1 capital of 7.71%.FIRREA required that the value of certain assets be phased-out by 1994 in accordance with a prescribed schedule. The Housing and Community Development Act of 1992 authorized the OTS to permit eligible institutions to defer this phase-out to 1996 with regard to certain assets. Equity Bank received approval from the OTS to utilize this deferred phase-out schedule with regard to assets carried at a capital value of approximately $11.5 million as of December 31, 1993. (b) Borrowing Privileges: So long as Equity Bank maintains an appropriate level of certain investments ("Qualified Thrift Investments") and otherwise qualifies as a "Qualified Thrift Lender," it will continue to enjoy full borrowing privileges from the Federal Home Loan Bank. The required percentage of Qualified Thrift Investment is 65% of portfolio assets, and such investments must continue to equal or exceed that percentage on a monthly basis in nine out of every twelve months. Qualified Thrift Investments include (i) loans that were made to purchase, refinance, construct, improve or repair domestic residential or manufactured housing; (ii) home equity loans; (iii) securities backed by or representing an interest in mortgages on domestic residential or manufactured housing; (iv) obligations issued by the federal deposit insurance agencies; and (v) stock in Federal Home Loan Bank, the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation. Subject to a 20% of assets limitation, the amended definition of Qualified Thrift Investments allows savings institutions to include consumer loans, investments in certain subsidiaries, loans for the purchase or construction of schools, churches, nursing homes and hospitals and 200% of investments in loans for low-to- moderate income housing and certain other community-oriented investments. The OTS amended the Qualified Thrift Lender ("QTL") regulations to reflect the statutory changes to the definition of Qualified Thrift Investments and to provide that a savings association that was not subject to penalties for failure to maintain QTL status as of June 30, 1991 shall be deemed a QTL as long as its percentage of Qualified Thrift Investments continues to equal or exceed 65% in at least nine out of each 12 months. Beginning January 1, 1993, a savings association will cease to be a QTL when its percentage of Qualified Thrift Investments as measured by monthly averages over the immediately preceding 12-month period falls below 65% for four or more months. At December 31, 1993, approximately 73% of Equity Bank's assets were invested in Qualified Thrift Investments, which was in excess of the percentage required to qualify the Association under the QTL test in effect at that time. FDICIA liberalized the Qualified Thrift Lender test to require that Qualified Thrift Investments equal or exceed 65% of portfolio assets on a monthly basis in nine out of every 12 months, raised the amount of liquidity investments excluded from portfolio assets to 20% of total assets and expanded the range of assets constituting Qualified Thrift Investments. (c) Internal Controls, Compensation, etc.: FDICIA requires the federal bank regulatory agencies to prescribe, by regulation, standards for all insured depository institutions and depository institution holding companies relating to: (i) internal controls, information systems and audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; and (vi) compensation, fees and benefits. These regulations became effective in July 1993. The compensation standards prohibit employment contracts, compensation or benefit arrangements, stock option plans, fee arrangements or other compensatory arrangements that would provide excessive compensation, fees or benefits or could lead to material financial loss. In addition, the federal banking regulatory agencies are required to prescribe by regulation standards specifying: (i) maximum classified assets to capital ratios; (ii) minimum earnings sufficient to absorb losses without impairing capital; and (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of depository institutions and depository institution holding companies. All institutions, regardless of their capital levels, are restricted from making any capital distribution or paying any management fees that would cause the institution to fail to satisfy the minimum levels for any of its capital requirements. An institution that failed to meet the minimum level for any relevant capital measure (an "undercapitalized institution") will be: (i) subject to increased monitoring by the appropriate federal banking regulator; (ii) required to submit an acceptable capital restoration plan within 45 days; (iii) subject to asset growth limits; and (iv) required to obtain prior regulatory approval for acquisitions, branching and new lines of businesses. The capital restoration plan must include a guarantee by the institution's holding company that the institution will comply with the plan until it has been adequately capitalized on average for four consecutive quarters. Under such guarantee the holding company would be liable up to the lesser of 5% of the institution's total assets or the amount necessary to bring the institution into capital compliance as of the date it failed to comply with its capital restoration plan. A significantly undercapitalized institution, as well as any undercapitalized institution that did not submit an acceptable capital restoration plan, will be subject to regulatory demands for recapitalization, broader application of restrictions on transactions with affiliates, limitations on interest rates paid on deposits, asset growth and other activities, possible replacement of directors and officers, and restrictions on capital distributions by any bank holding company controlling the institution. Any company controlling the institution could also be required to divest the institution. The senior executive officers of a significantly undercapitalized institution may not receive bonuses or increases in compensation without prior approval and the institution is prohibited from making payments of principal or interest on its subordinated debt. If an institution's ratio of tier 1 capital to total assets falls below a level established by the appropriate federal banking regulator, which may not be less than 2% nor more than 65% of the minimum tier 1 capital level otherwise required (the "critical capital level"), the institution will be subject to conservatorship or receivership within 90 days unless periodic determinations are made that forbearance from such action would better protect the deposit insurance fund. Unless appropriate fundings and certifications are made by the appropriate federal bank regulatory agencies, a critically undercapitalized institution must be placed in receivership if it remains critically undercapitalized. Most of these new capital requirements and applicable federal banking laws became effective in December , 1992, and the OTS has adopted regulations implementing these provisions. (d) Qualified Thrift Lender: In connection with the acquisition of Equity Bank by the Company, the predecessor of the OTS provided certain modifications to the Qualified Thrift Lender requirements applicable to Equity Bank. Pursuant to these modifications, Equity Bank was relieved of immediate compliance with the statutory Qualified Thrift Lender test. At December 31, 1993, Equity Bank maintained Qualified Thrift Investment of 73% of portfolio assets, meeting not only the lower modified requirement but also the full statutory requirement. If Equity Bank continues to meet the modified requirement as it phases in toward the full statutory requirement and thereafter meets the full percentage requirement provided by law, Equity Bank will continue to maintain its status as a Qualified Thrift Lender. If Equity Bank should fail to maintain its status as a Qualified Thrift Lender, the Company would be required within one year thereof to qualify and register as a bank holding company. Under present regulations, the Company is a savings and loan holding company, and, as a result of it's present operations, is not qualified to be a bank holding company. Thus, if the Company were to be required to become a bank holding company, it would be necessary under present regulations for the Company to either dispose of Equity Bank or dispose of its non-banking operations in order to continue to own Equity Bank. A failure to maintain Qualified Thrift Lender status will also result in the following restrictions on the operations of a savings institution: (i) the savings institution may not engage in any new activity or make any new investment, directly or indirectly, unless such activity or investment is permissible for a national bank; (ii) the branching powers of the institution shall be restricted to those of a national bank, (iii) the institution shall not be eligible to obtain any advances from the appropriate governmental agency; (iv) payment of dividends by the institution shall be subject to the rules regarding payment of dividends by a national bank; and (v) change its method for accounting for bad debts to the direct charge off method. No subsidiary savings institution of a savings and loan holding company may declare or pay a dividend on its permanent or non- withdrawable stock unless it first gives the Director of the OTS thirty (30) days advance notice of such declaration and payment. Any dividend declared during such period without the giving of such notice shall be invalid. "See Market for Company's Common Equity and Related Stockholder Matters". (e) Acquiring other savings institutions: The Home Owners Loan Act ("HOLA"), generally prohibits the Company, without prior approval of the Director of the OTS, from (i) acquiring control of any other savings institution or savings and loan holding company or the assets thereof or (ii) acquiring or retaining more than 5% of the voting shares of a savings institution or holding company thereof which is not a subsidiary. Except with the prior approval of the Director of the OTS, no director or officer of the Company or person owning or controlling by proxy or otherwise more than 25% of the Company's stock, may acquire control of any savings institution, other than a subsidiary association, or any other savings and loan holding company. (f) Limitations in transactions with other savings institutions, officers and others: Transactions between savings institutions and any affiliate are governed by the FRA and regulations of the OTS. An affiliate of a savings institution is any company or entity which controls, is controlled by or is under common control with the savings institution. In a holding company context, the parent holding company of a savings institution (such as the Company) and any company which is controlled by such parent holding company are affiliates of the savings institution. Generally, the FRA (i) limits the extent to which Equity Bank or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and limit all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus, and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to Equity Bank or its subsidiary as those provided to a non-affiliate. The term "Covered Transaction" includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions. In addition to the restrictions imposed by the FRA, FIRREA has further provided that Equity Bank may not, without the prior approval of the appropriate governmental agency, (i) loan or otherwise extend credit to an affiliate, except for any affiliate which engages only in activities which are permissible for bank holding companies, which would exclude the Company and most of its industrial subsidiaries, or (ii) purchase or invest in any stocks, bonds, debentures, notes or similar obligations of any affiliate, except for those which are subsidiaries of the savings institution. See discussions elsewhere under this "BUSINESS - Financial Services Business" section for transactions between Equity Bank and the Company, or subsidiaries of the Company. Further, FIRREA and FDICIA have extended to savings institutions the restrictions contained in FRA on loans to directors, executive officers and principal stockholders, wherein loans to an executive officer and to a greater than 10% stockholder of a savings institution and certain affiliated entities of either, may not exceed, together with all other outstanding loans to such person and affiliated entities, the association's loan-to-one-borrower limit as established by FIRREA. FRA also prohibits loans, above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and greater than 10% stockholders of a savings institution, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the association with any "interested" director not participating in the voting. The Federal Reserve Board has prescribed the loan amount (which includes all other outstanding loans to such person), as to which such prior board of director approval, if required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Further, the Federal Reserve Board pursuant to FRA requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons. (g) Savings and Loan Holding Company: The Board of Directors of the Company presently intends to continue to operate the Company as a unitary savings and loan holding company until Equity Bank is sold to Fourth Financial pursuant to the Acquisition Agreement. There are generally no restrictions on the activities of a unitary savings and loan holding company. However, if the Director of the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity constitutes a serious risk to the financial safety, soundness, or stability of its subsidiary savings institution, the Director of the OTS may impose such restrictions as deemed necessary to address such risk and limiting (i) payment of dividends by the savings institution, (ii) transactions between the savings institution and its affiliates, and (iii) any activities of the savings institution that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings institution. See "Termination of Supervisory Agreement" under this section. As a diversified unitary savings and loan holding company engaged in a variety of commercial and industrial businesses, the Company is restricted in its ability to acquire other savings institutions. Acquisition of such a second savings institution would result in the Company becoming a "multiple savings and loan holding company" and the statutory restrictions on the types of permissible business activities for such entities is wholly inconsistent with the predominant nature of its current businesses. However, acquisitions of other savings institutions which result in a merger or similar consolidation with Equity Bank and retain the Company's status as a unitary savings and loan holding company are permitted. Also, an acquisition of a failing savings institution certified as such by the OTS would not result in the Company's loss of status as a unitary holding company. The Change in Bank Control Act provides that no person, acting directly or indirectly or through or in concert with one or more other persons, may acquire control of the Company unless the OTS receives sixty (60) days prior written notice. The HOLA provides that no company may acquire "control" of the Company without the prior approval of the OTS. Any company that acquires control becomes a "savings and loan holding company" subject to registration, examination and regulation by the OTS. Applicable statutes and regulations conclusively deem any person to have acquired "control" of the Company by, among other things, the acquisition of more than 25% of any class of voting stock of the Company or the ability to control the election of a majority of the directors of the Company. In addition, applicable regulations presume a person to have acquired control (subject to rebuttal), upon the acquisition of more than 10% of any class of voting stock or of more than 25% of any class of stock of the Company, when certain enumerated "control factors" also exist. The OTS may prohibit an acquisition of control if it finds, among other things, that (1) the acquisition would result in a monopoly or substantially less competition, (2) the financial condition of the acquiring person might jeopardize the financial stability of Equity Bank, or (3) the competence, experience or integrity of the acquiring person indicates that it would not serve the interest of the depositors or the public to permit the acquisition of control by the person. Inherent Risk: ------------- During 1993, Equity Bank's Board of Directors and management continued to place their priority on monitoring asset quality and maintaining profitability. Approximately 70% of non-performing loans were real estate related. Adverse economic conditions experienced in the southwest and in the Oklahoma economy which produced a general oversupply of developed real estate have stabilized and in some areas improved during the year. "Potential problem loans" are those loans which, although currently performing, have credit weaknesses such that management has serious doubts as to the borrowers' future ability to comply with present terms, and thus may result in a change to non-performing status. Equity Bank has identified, through internal credit ratings, certain performing loans which demonstrate some deterioration in credit quality and, accordingly, are scrutinized more carefully. At December 31, 1993 these loans totaled $3.7 million. Exposure to loss of principal on such loans was estimated to be approximately $273,000, all of which was considered in the reserve for possible loan losses at December 31, 1993. Under the Acquisition Agreement the Company has agreed to purchase from Equity Bank at the closing of the Sale of Equity Bank the real estate owned by Equity Bank that was acquired by Equity Bank through foreclosure for Equity Bank's then carrying value for such real estate. In addition, the Company has the option, but not the obligation to acquire any loan owned by Equity Bank that has been charged off or written down for a price equal to the net book value of such loan that has been written down and for a price of $1.00 in the case of each loan that has been charged off. See "Business- Recent Developments". Loans to executive officers and directors (or their associates) of Equity Bank and its principal subsidiaries are made in the ordinary course of business. These transactions are conducted on substantially the same terms as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risk or present other unfavorable features at the time they are made. No related party loans were identified by management as potential problem loans at December 31, 1993. Termination of Supervisory Agreement: ------------------------------------ During May 1991, as a result of a regulatory examination in 1990, Equity Bank entered into a Supervisory Agreement with the OTS. This agreement contained operating restrictions on Equity Bank, including limiting the overall growth of Equity Bank's assets and liabilities to specified levels, restricting investments, precluding the payment of cash and stock dividends and increasing reporting requirements. The agreement also mandated certain administrative actions to be taken, including the preparation and/or modification of policies and procedures and the addition of Board members considered not affiliated with its parent or other subsidiaries. In September 1993, Equity Bank was notified in writing by the OTS that such Supervisory Agreement had been terminated. Non-Accrual Policies: -------------------- Interest income is not accrued on loans which are ninety (90) days or more delinquent. The interest previously accrued on these delinquent loans is reversed from income. Delinquent loans are reviewed on a monthly basis to determine the propriety of non-accrual status for each loan. Management also considers the financial strength of the borrower, collateral valuations, business operations and current status of each borrower to determine non- accrual status. Normally, loans are not reinstated to accrual status unless all interest and principal payments have been brought current. Loan Loss and Asset Valuation Reserve: ------------------------------------- Equity Bank's loan portfolio is reviewed on a monthly basis by internal management. The portfolio review normally includes large loans, delinquent loans and previously classified loans. These loans are classified utilizing general regulatory agency criteria. Specific losses identified by loan or asset are charged against income as a loss provision expense. The loan or asset balance is then written down upon approval by the Executive Committee of the Board of Directors. In addition, a General Valuation Allowance ("GVA") is computed as a percentage of the net book balance of the loan or asset. The computed allowance is charged against income as a loss provision expense and a general reserve is established to absorb potential future losses associated with the asset. A GVA is computed for all internally classified assets and all appropriate unclassified loans and other assets. The GVA percentage utilized for these calculations ranges between 1% and 7.5% of the net book balance of the asset. Credit Risk Concentration: ------------------------- Loan concentrations are another important factor in the assessment of inherent risks of Equity Bank. The composition of the loan portfolio at year- end for the past five years is presented elsewhere in this report. As indicated therein, approximately 61% of Equity Bank's loan portfolio at December 31, 1993 was in real estate. While real estate values have stabilized and in some instances improved, Equity Bank has continuing exposure to declining real estate values. Included in foreclosed real estate as an in-substance foreclosure is a $13.8 million first mortgage real estate loan collateralized by the building in which Equity Bank's corporate office is located. As required by regulation for this type of asset, a marketing plan for the disposal of the asset has been prepared and submitted to the OTS. Equity Bank continues to work with the borrower and building manager affiliate to maximize the asset's net operating income while competing for optimum occupancy levels. Investment Portfolio Policy: --------------------------- SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," was issued by the FASB in May 1993. This Statement requires investments to be classified in three categories and accounted for as follows: * Debt securities that Equity Bank has the positive intent and ability to hold to maturity are to be classified as held-to maturity securities and reported at amortized cost. * Debt and equity securities that are bought and held principally for the purpose of selling in the near future are to be classified as trading securities and reported at fair value, with unrealized gains and losses included in current earnings. * Debt and equity securities not classified as either held-to- maturity securities or trading securities are to be classified as available-for-sale securities and reported at fair value, with unrealized gains and losses reported as a separate component of stockholder's equity. The Statement is effective for fiscal years beginning after December 15, 1993 and is to be initially applied as of the beginning of the fiscal year. Equity Bank will adopt the provisions of this Statement as of January 1, 1994. Management has determined that the effect of the adoption of this statement will not be material to Equity Bank. Termination of Assistance Agreement: ----------------------------------- In connection with the acquisition of Arrowhead, Equity Bank and FSLIC entered into an Assistance Agreement with an original term of ten years. The Assistance Agreement provided for various forms of financial assistance and indemnifications to Equity Bank during the term of the Agreement and required payments to FSLIC for sharing of certain items including capital losses, net income and tax benefits. In March 1993, Equity Bank, the Company and the RTC (FDIC as manager of the FSLIC Resolution Fund) finalized an agreement terminating the Assistance Agreement (the "Termination Agreement"). Under the Termination Agreement, the RTC paid Equity Bank approximately $14.2 million in cash and all of the obligations of both parties under the Assistance Agreement were terminated. As a result of the Termination Agreement, Equity Bank assumed all credit risk with respect to existing "covered assets." Equity Bank allocated a substantial portion of such $14.2 million to record the previously covered loans and foreclosed real estate at estimated fair value. As a result, the Company believes that there are adequate reserves relating to the assets to reserve for the credit risk which was assumed. Also as a result of the Termination Agreement, the Equity Bank is no longer indemnified for any potential claim relating to any covered asset arising out of, or based upon, any liability, action or failure to act of Equity Bank, or any of the Equity Bank affiliates, officers or directors from and after December 30, 1988 that are asserted against the FDIC. The effect of the accounting for the Termination Agreement included reclassifying previously covered assets to reflect their status at the date of termination of the Assistance Agreement (on a fair value basis), all related receivables and payables were extinguished, the cash payment from the FDIC Manager was recorded and goodwill existing relating to the Arrowhead acquisition was adjusted for this resolution of a contingent purchase price. The Company has reserved a substantial portion of the $14.2 million, and, as a result, the Company believes that there are adequate loss reserves on these assets. Termination of the Assistance Agreement (including receipt of the $14.2 million) did not result in a charge or credit to the Company's income statement. Recording of the Termination Agreement increased (decreased) the following accounts (in millions): Cash and cash equivalents $14.2 Receivables from FSLIC (18.9) Assets covered by FSLIC Assistance (33.1) Loans receivable, net 13.3 Foreclosed real estate, net 8.7 Excess of purchase price over fair value of net assets acquired 6.7 Payable to FSLIC (9.1) The Financial Services Business' earnings include the following assistance income: 1992 1991 ---- ---- (Dollars in Millions) Yield Maintenance on Covered Assets $ .9 $2.8 Interest Income on the FSLIC Note Receivable - .6 ---- ---- FSLIC Assistance Income .9 3.4 Reimbursement of Capital Losses on Covered Assets 3.1 3.8 ---- ---- $ 4.0 $ 7.2 ==== ==== Since the Assistance Agreement was terminated effective January 1, 1993, there was no income under the Assistance Agreement for the year ended December 31, 1993. FINANCIAL SERVICES STATISTICAL INFORMATION ------------------------------------------- The following tables present statistical information regarding Equity Bank's operations for the periods listed. Average Balance Sheet - The following table sets forth certain information relating to Equity Bank's average balance sheet on a stand-alone basis and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields earned and rates paid at December 31, 1993, 1992 and 1991. The table includes assets transferred to Equity Bank by the Company in connection with the acquisition at fair value of approximately $69 million rather than at the depreciated book value of approximately $18.8 million at the date of acquisition. The yields and costs result from dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented. The table uses month-end balances in calculating average balances. Management does not believe that the use of month-end balances instead of daily average balances has caused any material difference in the information presented. For presentation purposes, non-interest earning assets include plant, property and equipment, foreclosed real estate, accounts receivable from FSLIC, excess of purchase price over fair value of net assets acquired, loan servicing rights and other assets. Non accrual loans have been included in the category "Loan Receivable, net". The tables also set forth the ratios of average interest-earning assets to average interest-bearing liabilities, return on assets, return on equity and equity to assets by Equity Bank for the fiscal years ended December 31, 1993, 1992 and 1991: YEAR ENDED DECEMBER 31, 1993 ----------------------------------- AVERAGE REVENUE/ YIELD/ BALANCE EXPENSE COST ----------------------------------- (Dollars in Thousands) Interest Earning Assets: Loan and Securities: Loans Receivable, net $151,446 $17,483 11.54% Mortgage-Backed Securities 188,820 8,976 4.75% Investment Securities 1,184 34 2.87% ------- ------ 341,450 26,493 7.76% Other interest earning assets: Cash and cash equivalents- principally overnight funds 16,519 579 3.51% Federal Home Loan Bank Stock 6,417 449 7.00% Accounts receivable purchased from affiliates 29,775 2,659 8.93% ------- ------ 52,711 3,687 6.99% ------- ------ Total Interest Earning Assets 394,161 30,180 7.66% Non-Interest Earning Assets 119,306 ------- Total Assets $513,467 ======= Interest-Bearing Liabilities: Deposits $334,447 12,505 3.74% Borrowed Funds 120,217 4,668 3.88% ------- ------ Total Interest-Bearing Liabilities 454,664 17,173 3.78% ------ Non-Interest Bearing Liabilities 3,937 ------- Total Liabilities 458,601 Stockholder's Equity-average (Actual at December 31, 1993 was $58,627,000) 54,866 ------- Total Liabilities and Stockholder's Equity $513,467 ======= Net Interest Income $ 13,007 ======= Interest Rate Spread 3.88% ====== Net Yield on Interest Earning Assets 7.66% ====== Ratio of Average Interest-Earning Assets To Average Interest-Bearing Liabilities 86.69% ====== Ratio of Return on Assets (Net Interest Income/Average Total Assets) 2.53% ====== Ratio of Return on Equity (Net Interest Income/Average Equity) 23.71% ====== Ratio of Equity to Assets (Average Equity/average Total Assets) 10.69% ====== YEAR ENDED DECEMBER 31, 1992 -------------------------------------- AVERAGE REVENUE/ YIELD/ BALANCE EXPENSE COST -------------------------------------- (Dollars in Thousands) Interest Earning Assets: Loans and Securities Loans Receivable, net $125,544 $18,006 14.34% Mortgage-Backed Securities 185,132 10,710 5.79% Investment Securities 1,385 64 4.62% ------- ------ 312,061 28,780 9.22% Other interest earning assets: Cash and cash equivalents- principally overnight funds 25,414 846 3.33% Federal Home Loan Bank Stock 6,386 545 8.53% Accounts receivable purchased from affiliates 29,966 2,713 9.05% Assets covered by FSLIC assistance 40,485 2,821 6.97% ------- ------- 102,251 6,925 6.77% ------- ------- Total Interest Earning Assets 414,312 35,705 8.62% Non-Interest Earning Assets 126,522 ------- Total Assets $540,834 ======= Interest-Bearing Liabilities: Deposits $347,198 16,445 4.74% Borrowed Funds 134,034 5,853 4.37% Payable to FSLIC 9,034 829 9.18% ------- ------ Total Interest-Bearing Liabilities 490,266 23,127 4.72% ------ Non-Interest Bearing Liabilities 3,882 ------- Total Liabilities 494,148 Stockholder's Equity-average (Actual at December 31, 1992 was $50,423,000) 46,686 ------- Total Liabilities and Stockholder's Equity $540,834 ======= Net Interest Income $12,578 ====== Interest Rate Spread 3.90% ====== Net Yield on Interest Earning Assets 8.62% ====== Ratio of Average Interest-Earning Assets to Average Interest-Bearing Liabilities 84.51% ====== Ratio of Return on Assets (Net Interest Income/Average Total Assets) 2.33% ====== Ratio of Return on Equity (Net Interest Income/Average Equity) 26.94% ====== Ratio of Equity to Assets (Average Equity/Average Total Assets) 8.63% ====== YEAR ENDED DECEMBER 31, 1991 -------------------------------------- AVERAGE REVENUE/ YIELD/ BALANCE EXPENSE COST -------------------------------------- (Dollars in Thousands) Interest Earning Assets: Loan and Securities: Loans Receivable, net $142,481 $21,758 15.27% Mortgage-Backed Securities 118,507 9,506 8.02% Investment Securities 3,082 215 6.98% ------- ------ 264,070 31,749 12.02% Other interest earning assets: Cash and Cash Equivalents- Principally overnight funds 43,381 2,392 5.51% Federal Home Loan Bank Stock 5,879 579 9.85% Accounts receivable purchased from affiliates 30,457 3,615 11.87% Assets covered by FSLIC assistance 55,791 5,274 9.45% Note receivable from FSLIC 6,732 589 8.75% ------- ------ 142,240 12,449 8.75% ------- ------ Total Interest Earning Assets 406,310 43,928 10.81% Non-Interest Earning Assets 133,761 ------- Total Assets $540,071 ======= Interest-Bearing Liabilities: Deposits $356,993 23,144 6.48% Borrowed Funds 129,137 8,234 6.38% Payable to FSLIC 8,341 746 8.94% ------- ------ Total Interest-Bearing Liabilities 494,471 32,124 6.50% ------ Non-Interest Bearing Liabilities 5,609 ------- Total Liabilities 500,080 Stockholder's Equity - Average (Actual at December 31, 1991 Was $43,405,000) 39,991 ------- Total Liabilities and Stockholder's Equity $540,071 ======= Net Interest Income $11,804 ====== Interest Rate Spread 4.31% ====== Net Yield on Interest Earning Assets 10.81% ====== Ratio of Average Interest-Earning Assets To Average Interest-Bearing Liabilities 82.17% ====== Ratio of Return on Assets (Net Interest Income/Average Total Assets 2.19% ====== Ratio of Return on Equity (Net Interest Income/Average Equity) 29.52% ====== Ratio of Equity to Assets (Average Equity/Average Total Assets) 7.40% ====== Changes in Interest Income and Expense - -------------------------------------- Changes in Interest Income and Expense - -------------------------------------- Composition of Loan Portfolio - ----------------------------- The following indicates the loan distribution of Equity Bank as of December 31, 1993, 1992, 1991, 1990 and 1989. Note: The amounts included above do not include accrued interest receivable. Investment Portfolio - -------------------- The following table sets forth the book value of the investment securities portfolio, short-term investments, and mortgage-backed securities of Equity Bank at the date indicated. At December 31, 1993, 1992 and 1991, the market values of Equity Bank's investment securities portfolio was $216.9 million and $174.5 million and $185.9 million, respectively. December 31, ------------------- 1993 1992 1991 ---- ---- ---- Investment securities (Dollars in Thousands) U.S. Treasury securities $ 1,299 $ 406 $ 719 Corporate bonds - - 2,002 Other 90 187 241 _______ _______ _______ Total 1,389 593 2,962 Mortgage-backed securities held for investment 201,623 174,241 181,358 Mortgage-backed securities held for sale 13,947 - - _______ _______ _______ Total investment securities $216,959 $174,834 $184,320 ======== ======== ======== Note: The above investment amounts do not include FHLB stock or accrued interest receivable. Investment Portfolio - December 31, 1993 - ---------------------------------------- The following table sets forth the scheduled maturities, book values, market values, and weighted average yields for the investment securities of Equity Bank at December 31, 1993 (excluding FHLB stock). (1) Mortgage-backed securities scheduled maturities are based on contractual maturity dates. Payments on these securities are received monthly based upon payments of the underlying mortgage loans. Analysis of the Allowance for Loan Losses - ----------------------------------------- This table summarizes the Equity Bank loan loss experience for each of the years ended: In connection with the termination of the Assistance Agreement, Equity Bank assumed the credit risk of $13.3 million in loans whose credit risk had previously been covered under the Assistance Agreement. At December 31, 1993, approximately $1.4 million in unearned nonaccretable discounts exist to provide as additional reserves on these loans. These amounts are included as unearned discounts and are not included in the allowance for loan losses above. The following tables show an allocation of the allowance for loan losses as of the end of each of the years ending: Allocation of the Allowance for Loan Losses (Dollars in Thousands) December 31, 1993 ------------------------------- Percentage of Loans in each Category to Total Amount Percent Loans ------ ------- ---------- Real estate $1,592 43.92% 61.34% Commercial 142 3.92% 2.54% Consumer and other 1,891 52.16% 36.12% ------ -------- -------- $3,625 100.00% 100.00% ======= ======== ======== December 31, 1992 ----------------------------- Percentage of Loans in each Category to Total Amount Percent Loans ------ ------- ---------- Real estate $1,285 40.90% 64.49% Commercial 116 3.69% 1.39% Consumer and other 1,741 55.41% 34.12% ------- -------- -------- $3,142 100.00% 100.00% ======= ======== ======== Allocation of the Allowance for Loan Losses (Dollars in Thousands) December 31, 1991 ---------------------------- Percentage of Loans in each Category to Total Amount Percent Loans ------ ------- ---------- Real estate $1,441 42.09% 59.39% Commercial 667 19.48% 11.49% Consumer and other 1,316 38.43% 29.12% ------- -------- -------- $3,424 100.00% 100.00% ======= ======== ======== December 31, 1990 ---------------------------- Percentage of Loans in each Category to Total Amount Percent Loans ------- -------- --------- Real estate $1,518 40.90% 61.94% Commercial 813 21.90% 11.69% Consumer and other 1,381 37.20% 26.37% ------- -------- -------- $3,712 100.00% 100.00% ======= ======== ======== Allocation of the Allowance for Loan Losses (Dollars in Thousands) December 31, 1989 ---------------------------- Percentage of Loans in each Category to Total Amount Percent Loans ------- -------- --------- Real estate $1,091 40.23% 62.99% Commercial 244 9.00% 20.45% Consumer and other 1,377 50.77% 16.56% ------- -------- -------- $2,712 100.00% 100.00% ======= ======== ======== Note: For purposes of the above real estate mortgage and real estate construction are combined due to the insignificance of real estate construction loans and the related reserve. Return on Equity and Assets - --------------------------- The table below sets forth certain performance ratios of Equity Bank for the periods indicated. Years Ended December 31, ------------------- 1993 1992 1991 ---- ---- ---- (Dollars in Thousands) - ---------------------------------------------------------------------------- Net Income $8,204 $ 7,017 $ 7,035 Return on assets (net income divided by average total assets) 1.60% 1.30% 1.30% Return on equity (net income divided by average equity) 14.95% 15.03% 17.59% Equity to assets (average equity divided by average total asset) 10.69% 8.63% 7.40% Dividend payout ratio (dividends declared per share divided by net income per share) 0.00% 0.00% 0.00% Short-Term Borrowing - -------------------- The following tables set forth certain information regarding short-term borrowings by Equity Bank at the end of and during the periods indicated: At December 31, 1993 1992 1991 ---- ---- ---- (Dollars in Thousands) ---------------------- Summary of short-term borrowings: Advances from the Federal Home Loan Bank with thirty day to one year maturities $31,000 $73,500 $ 72,500 Securities sold under agreements to repurchase $38,721 $50,344 $ 66,744 Weighted average rate: - --------------------- FHLB advances 3.41% 4.13% 4.57% Securities sold under agreements to repurchase 3.38% 3.57% 4.44% During the year-ended December 31, 1993 1992 1990 ---- ---- ---- (Dollars in Thousands) ---------------------- Maximum amount of short-term borrow- ings outstanding at any month-end - ---------------------------- FHLB advances $73,500 $73,500 $ 73,125 Securities sold under agreements to repurchase $50,344 $66,744 $ 82,162 Approximate average short-term borrowings outstanding with respect to: - -------------------------------------- FHLB advances $53,250 $71,769 $ 53,708 Securities sold under agreements to repurchase $44,473 $57,553 $ 74,549 Approximate weighted average rate paid on: - --------------------------------- FHLB advances 4.03% 4.42% 6.13% Securities sold under agreements to repurchase 3.47% 4.12% 6.57% Deposits - -------- The following table sets forth the average consolidated deposits and average rates paid for the years ended December 31, 1993, 1992 and 1991: Weighted Type Average Rate Paid Deposits - ------------------------------------------------------------------------------- 1993 1992 1991 1993 1992 1991 - ------------------------------------------------------------------------------- (Dollars in Thousands) Demand 2.58% 3.28% 4.31% $ 86,283 $ 80,268 $ 58,151 Savings 3.02% 3.86% 5.47% 17,554 13,587 11,183 Time 4.26% 5.24% 6.92% 229,684 253,343 287,659 ------- ------- ------- $333,521 $347,198 $356,993 ======= ======= ======== Time certificates of deposits in amounts of $100,000 or more totaled approximately $27.0 million at December 31, 1993. The following table sets forth the maturities of time certificates of deposit of $100,000 or more outstanding at December 31, 1993: (Dollars in Thousands) 3 months or less $ 6,743 Over 3 through 6 months 9,167 Over 6 through 12 months 6,925 Over 12 months 4,122 ------- $26,957 ======= Analysis of Non-Accrual, Past Due and Restructured Loans - -------------------------------------------------------- The following table Summarizes the non-accrual, past due, and restructured loans: : At December 31, 1993 1992 1991 1990 1989 ----------------------------------------------- (Dollars in Thousands) Non Accrual Loans $1,964 $2,117 $1,316 $2,753 $2,550 Accruing Loans past due 90 days or more - - - - - Restructured Loans 1,019 641 500 1,300 - ------ ------ ------ ------ ------ $2,983 $2,758 $1,816 $4,053 $2,500 ====== ====== ====== ====== ====== Interest income that would have been recorded under the original terms of such loans and the interest income actually recognized for the year ended December 31, 1993 are summarized below: Interest income that would have been recorded $ 397 Interest income recognized (83) ------ Interest income foregone $ 314 ====== Loan Maturity The following table shows the maturity of loans (excluding real estate mortgage loans and consumer loans) outstanding at December 31, 1993. Maturing ------------------------------------------------ 1 year 1 year to over or less 5 years 5 years Total ------------------------------------------------ (Dollars in Thousands) Commercial Loans $2,326 $ 809 $ 96 $3,231 Real estate - Construction 1,029 - - 1,029 ------ ----- ----- ------ $3,355 $ 809 $ 96 $4,260 ====== ===== ===== ====== Loans maturing after one year with: Fixed interest rates $ 68 $ - Variable interest rates 741 96 ----- ----- $ 809 $ 96 ===== ===== Employees - --------- As of December 31, 1993, the Company employed 1,671 persons. As of that date, (a) the Environmental Control Business employed 595 persons, (none of which is represented by a union)(b) the Automotive Products Business employed 236 persons with 106 represented by unions under an agreement that expired in August, 1990, (c) the Chemical Business employed 459 persons, with 110 represented by unions under agreements expiring in August, 1995, and (d) the Financial Services Businessemployed 204 persons, none of which are represented by unions. The union contract within the Automotive Product Business expired on August 1, 1990, and the employees within that business have continued to work without a contract. The employees did not strike in 1990 when their contract expired, and as of the date of this report, there are no indications that the employees are considering striking. There are no pending negotiations in connection with the expired union contract. The Company does not believe such employees will strike within the foreseeable future, but there are no assurances to that effect. Research and Development - ------------------------ The Company spent approximately $788,000 in 1993, $684,000 in 1992, and $454,000 in 1991 on research and development relating to the development of new products or the improvement of existing products. All expenditures for research and development related to the development of new products and improvements are sponsored by the Company. Environmental Compliance - ------------------------ The Company does not anticipate, based on facts presently known to the Company, that it will be required during 1994 to incur any material capital expenditures for environmental control facilities relating to its industrial businesses. However, a subsidiary of the Company in its Automotive Products Business has been notified that it is a potentially responsible party as a result of having been a generator of waste disposed of at the Mosley site (as defined in the first paragraph of Item 3 of this report). See Item 3 "Legal Proceedings" for a discussion of the Mosley site. In addition, a subsidiary of the Company in its Chemical Business has been notified that its chemical manufacturing facility located in El Dorado, Arkansas, has been placed into the Environmental Protection Agency's data based tracking system and that there has occurred certain releases of contaminates at it's El Dorado, Arkansas facility. See Item 2 Item 2. PROPERTIES - ------------------- In connection with the acquisition of Equity Bank, the Company and several of its subsidiaries transferred certain properties to Northwest Financial Corporation ("Northwest Financial"), a wholly-owned service corporation of Equity Bank. The properties include, but are not limited to, the then existing manufacturing facilities at the site (as defined below under Chemical Business) and the then existing distribution facilities of the Chemical Business, a portion of the manufacturing facilities of the Environmental Control Business and certain other facilities. In order for the Company (and its subsidiaries) to continue their operations on those properties, Northwest Financial entered into several agreements to lease or sublease the properties back to their original users. Subject to the terms of the leases between Northwest Financial and the Chemical Business, Northwest Financial transferred beneficial ownership of these properties to two general partnerships in which Northwest Financial owns 99% of the partnership interest and the other 1% is owned by another subsidiary of the Company. Northwest Financial continues to hold record title to such real properties. See "BUSINESS - Financial Services Business." The Company has agreed to purchase these properties from Equity Bank in connection with the proposed sale of Equity Bank in 1994 under the Acquisition Agreement. See "Business - Recent Developments", "Business - Financial Service Business" , "Management's Discussion and Analysis" and Note 1 to Notes to Consolidated Financial Statements. Chemical Business - ----------------- The Chemical Business primarily conducts manufacturing operations (i) on 150 acres of a 1400 acre tract of land located in El Dorado, Arkansas (the "Site") and (ii) on 10 acres of land in a facility of approximately 60,000 square feet located in Hallowell, Kansas ("Kansas facility") . As of December 31, 1993, the manufacturing facility at the Site was being utilized to the extent of approximately 85%, based on the continuous operation of those facilities. As of December 31, 1993, manufacturing operations at the Kansas facility were being utilized to the extent of approximately 80% based on one 10 hour shift per day and a 5 day week. In addition, the Chemical Business distributes its products through 35 agricultural and blasting distribution centers. The Chemical Business currently operates 19 agricultural distribution centers, with 14 of the centers located in Texas ( 11 of which the Company owns and 3 of which it leases); 2 centers located in Missouri (1 of which the Company owns and 1 of which it leases); and 3 centers located in Tennessee (all of which the Company owns). The Chemical Business currently operates 16 blasting distribution centers located in Bonne Terre, Missouri (owned); Central City, Combs, and Pilgrim, Kentucky (leased); Midland, Indiana (leased); Rawlins, Wyoming (leased); Logan and Cabin Creek, West Virginia (leased); Percy, Illinois (leased); Carlsbad, New Mexico (leased); Homer, Georgia (leased); and Pryor, Oklahoma (leased). The Chemical Business also has manufacturing facilities in Australia located at: Peaks Down; Kalgoorlie; Karratha; and, Hunter Valley (all leased). The Chemical Business also operates its business from buildings located on an approximate four acre site on the perimeter of the JayHawk Industrial site in southeastern Kansas, and a research and testing facility comprising of a one square mile tract of land including buildings and equipment thereon also located in southeastern Kansas which it leases for an annual rental of $100 for a lease term of ten (10) years. All facilities owned by the Chemical Business are subject to mortgages. During November, 1993, the Company's Chemical Business acquired an additional concentrated nitric acid plant and related assets ("Plant and Assets") for approximately $1.9 million. The Chemical Business is in the process of moving such Plant and Assets from Illinois to, and installing such at, its manufacturing plant located in El Dorado, Arkansas. The Company anticipates that the total amount that will be expended to acquire, move and install the Plant and Assets will be approximately $12.0 million. As a result of such expansion and the present utilization of the Chemical Business' manufacturing facilities, the Company believes that it's present manufacturing facilities are suitable for it's current operations. Since the 1940's, the Site has been a manufacturing facility for ammonium nitrate compounds, and until 1969, was a manufacturing facility for ammonia. In 1955, the Site was acquired by Monsanto Company ("Monsanto"), and in June, 1983, Monsanto sold the Site to El Dorado Chemical Company ("EDC"). EDC was acquired by the Company in 1984. Under the agreement with Monsanto, Monsanto agreed to indemnify EDC for any claim which is suffered, incurred or arises due solely out of Monsanto's disposal of chemical or chemical byproducts prior to acquisition of the Site by EDC from Monsanto or the use by Monsanto of any substance prior to the date EDC acquired the Site from Monsanto which is subsequently determined to be deleterious or dangerous to the public's health, safety or welfare. Under the agreement with Monsanto, the indemnification is not assignable to a party to which EDC transfers the Site without the prior written consent of Monsanto, except to any company 100% of the voting stock of which is owned or controlled, directly or indirectly, by EDC. Although EDC has operated the Site since its acquisition from Monsanto in 1983, in 1988, EDC transferred ownership of the Site to the Company, which in turn transferred title to its Financial Services subsidiary. All of the outstanding stock of EDC and the Financial Services subsidiary are, directly or indirectly, wholly owned by the Company. Although no consent was obtained from Monsanto when EDC transferred ownership of the Site to its affiliated company to assign the Monsanto indemnification, if such a consent was required under the agreement with Monsanto, the Monsanto indemnification remains applicable to EDC. Recently, the Company's Chemical Business was advised that the Site had been placed in the Environmental Protection Agency's ("EPA") data based tracking system (the "System"). The System maintains an inventory of sites in the United States where it is known or suspected that a release of hazardous waste has occurred. Notwithstanding inclusion in the System, EPA's regulations recognize that such does not represent a determination of liability or a finding that any response action will be necessary. Over 36,000 sites in the United States are presently listed in the System. If a site is placed in the System, EPA regulations require that the government or its agent perform a preliminary assessment of the site. If the preliminary assessment determines that there has been a release, or that there is suspected to have occurred a release, at the site of certain types of contamination, the EPA will perform a site investigation. Pursuant to such regulations, the State of Arkansas performed such preliminary assessment for the EPA. The preliminary assessment report prepared by the State of Arkansas, dated September 30, 1992, regarding the Site states, in part, that a release of certain types of contaminants is suspected to have occurred at the Site. It is anticipated that the EPA will, at some future date, perform a site inspection at the Site, which inspection will usually involve the gathering of additional data including environmental sampling of the Site. After conducting the site inspection, the regulations provide that the EPA may determine that: (i) the Site does not warrant further involvement in the evaluation process, or (ii) that further study of the Site is warranted to determine what appropriate action is to be taken in response to a release, if any, of contaminants at the Site or whether such release, if any, justifies the Site being placed on the National Priorities List. Being placed in the System will generally be the first step in the EPA's determination as to whether a site will be placed on the National Priorities List. After the EPA completes its site inspection and evaluates other information, the EPA will then assess the Site using the Hazard Ranking System to ascertain whether the Site poses a sufficient risk to human health or the environment to be proposed for the National Priorities List. There are approximately 1,200 sites in the United States presently listed on the National Priorities List. The Company has been advised that there have occurred certain releases of contaminants at the Site. However, the Company does not believe that such releases should warrant the Site being placed on the National Priorities List, but there are no assurances to that effect. The Company is in the process of studying the Site in an attempt to determine the extent of such releases at the Site and when such releases may have occurred. In addition, as a result of certain releases of contaminants at the Site, EDC may be subject to assessment of certain civil penalties. The Company has not yet received from the appropriate governmental agency of the State of Arkansas a determination as to the appropriate plan of remediation of the Site and what contaminants, if any, must be remediated. The Company is unable to estimate the cost of such remediation until the Company receives an acceptable plan from such agency. The Company believes that it will receive such plan from the State of Arkansas in the near future, and at that time the Company will be able to estimate the cost of such remediation at the Site. While there are no assurances, based on information presently available to the Company, the Company does not believe, as of the date of this report, that the Site being placed in the System or the response to any contamination at the Site or the assessment of penalties, if any, due to release of certain contaminants at the Site should have any material adverse effect on the Company or the Company's financial condition. Environmental Control Business - ------------------------------ The Environmental Control Business conducts its fan coil manufacturing operations in various facilities, including two adjacent facilities located in Oklahoma City, Oklahoma, consisting of approximately 240,000 square feet owned by the Company. As of December 31, 1993, the Environmental Control Business was using the productive capacity of the above-referenced facility to the extent of approximately 92%, based on two, 8-hour shifts per day and a 5-day week. The Environmental Control Business manufactures most of its heat pump products in a leased 230,000 square foot facility in Oklahoma City, Oklahoma. The lease carries a five year term beginning March 1, 1988, with options to renew for five additional five year periods, and currently provides for the payment of rent in the amount of $52,389 per month. The Company also has an option to acquire the facility at any time in return for the assumption of the then outstanding balance of the lessor's mortgage. As of December 31, 1993, the productive capacity of this manufacturing operation was being utilized to the extent of approximately 59%, based on one, 8 hour shift per day and a 5- day week. The Environmental Control Business owns a 60,000 square foot facility in Juarez, Mexico, which it leases to a third party tenant. The Environmental Control Business also leases sales offices in Los Angeles and Chicago. All of the properties utilized by the Environmental Control Business are considered by Company management to be suitable and adequate to meet the current needs of that business. Automotive Products Business - ---------------------------- The Automotive Products Business conducts its operations in plant facilities principally located in Oklahoma City, Oklahoma which are considered by Company management to be suitable and adequate to meet its needs. One of the manufacturing facilities occupies a building owned by the Company, subject to mortgages, totaling approximately 178,000 square feet. The Automotive Products Business also uses additional manufacturing facilities located in Oklahoma City, Oklahoma, owned and leased by the Company. During 1993, the Automotive Products Business under-utilized the productive capacity of its facilities. In December 1993, International Bearings, Inc. ("IBI") of Memphis, Tennessee, was acquired as a wholly owned subsidiary of the Company operating as a separate entity within the Automotive Products Division. IBI is a warehouse unit operating from a leased warehouse of approximately 45,000 square feet in an industrial park section of Memphis, TN. Industrial Products Business - ---------------------------- The Company owns several buildings, some of which are subject to mortgages, totaling approximately 668,000 square feet located in Oklahoma City and Tulsa, Oklahoma, which the Industrial Products Business uses for showrooms, offices and warehouse facilities. The Company also owns real property located near or adjacent to the above-referenced buildings, which the Industrial Products Business uses for parking and storage. The Industrial Products Business also leases a facility from an entity owned by the immediate family of the Company's President, which facility occupies approximately seven acres in Oklahoma City, Oklahoma, with buildings having approximately 44,000 square feet. The Industrial Products Business also has an office in Europe to coordinate its European activities. All of the properties utilized by the Industrial Products Business are considered by Company management to be suitable and adequate to meet the needs of the Industrial Products Business. Financial Services Business - --------------------------- The Financial Services Business' corporate headquarters is located in approximately 26,700 square feet of leased office space in Oklahoma City, Oklahoma. In addition to the corporate facility, the Financial Services Business operates 14 branch offices. These facilities are considered by Company management to be suitable and adequate to meet the needs of the Financial Services Business. On January 4, 1989, Northwest Financial Corporation ("Northwest Financial"), a wholly-owned subsidiary of Equity Bank, acquired an option to purchase a 22-story, 340,000 square foot office building in Oklahoma City, Oklahoma, which contains the corporate headquarters of the Financial Services Business. This property is known as "Equity Tower". Northwest Financial acquired the option for $100,000 contemporaneously with Equity Bank's acquisition of the note and mortgage relating to the property ("Equity Tower Loan"). Northwest Financial may exercise its option at any time during the six-month period beginning December 31, 1995. The option agreement provides that the purchase price for the property upon exercise of the option will equal the sum of (1) the then outstanding restated mortgage indebtedness secured by the property and (2) the greater of (a) $100,000 or (b) 20% of the difference between (i) the appraised fair market value of the property and (ii) $15.1 million plus any additional advances under the loan plus any unpaid "cumulative deficiency amounts," as defined, accrued under the loan. As previously discussed, the Company has agreed under the Acquisition Agreement to acquire the Equity Tower Loan and option to purchase the Equity Tower at the time of closing of the sale of Equity Bank to Fourth Financial at Equity Bank's then current carrying value of the Equity Tower Loan on the books of Equity Bank. The carrying value of the Equity Tower Loan on the books of Equity Bank as of February 28, 1994, was approximately $13.8 million. Item 3. Item 3. LEGAL PROCEEDINGS - -------------------------- In December 1987, the United States Environmental Protection Agency ("EPA") notified L&S Bearing Company ("L&S") of potential responsibility for releases of hazardous substances at the Mosley Road Landfill in Oklahoma ("the Mosley Site"). The recipients of such notification were: a) generators of industrial waste allegedly sent to the Mosley Site (including L&S), and b) the current owner/operator of the Mosley Site, Waste Management of Oklahoma ("WMO") (collectively, "PRPs"). Between February 20, and August 24, 1976, the Mosley Site was authorized to accept industrial hazardous waste. During this time, a number of industrial waste shipments allegedly were transported from L&S to the Mosley Site. In February 1990, EPA added the Mosley Site to the National Priorities List. WMO and the U.S. Air Force conducted the remedial investigation ("RI") and feasibility study ("FS"). It is too early to evaluate the probability of a favorable or unfavorable outcome of the matter for L&S. However, it is the PRP Group's position that WMO as the Mosley Site owner and operator should be responsible for at least half of total liability as the Mosley Site, and that 75% to 80% of the remaining liability, if allocated on a volumetric basis, should be assignable to the U.S. Air Force. The Company is unable at this time to estimate the amount of liability, if any, since the estimated costs of clean-up of the Mosley Site are continuing to change and the percentage of the total waste which were alleged to have been contributed to the Mosley Site by L&S has not yet been determined. If an action is brought against the Company in this matter, the Company intends to vigorously defend itself and assert the above position. Although there are no assurances to this effect, the Company is exploring whether it has insurance coverage for this claim. Insurance coverage, however, is not considered since it is not known whether insurance coverage will be provided in connection with this matter. The Company does not believe that the ultimate outcome of this matter will have a material adverse effect on the Company's financial position or results of operations. In April, 1989, a subsidiary, International Environmental Corporation ("IEC") was named as a third party defendant in a lawsuit brought by Economy Mechanical Industries of Illinois, Inc. ("Economy"), in an action pending in the Circuit Court of Cook County, Illinois, in connection with a project in Chicago, Illinois. Economy had purchased fan coil units for the project from IEC and the units were built in accordance with Economy's specifications. This litigation initially resulted from disputes between the owner of the project and the general contractor, and in connection therewith, the owner withheld payment from the general contractor. The general contractor and a number of subcontractors (including Economy) filed mechanics liens against the property. The general contractor filed this action to foreclose on its lien and the owner has asserted numerous claims against the general contractor and certain subcontractors (including Economy) in the total amount of $20,610,599. One of the counterclaims made by the owner relates to the fan coil system manufactured by IEC. As a result Economy brought a third party action against IEC alleging that if the fan coil system is defective, such was the responsibility of IEC and in breach of IEC's implied and express warranties. IEC has denied that the fan coils are defective and contends that any failures, if any, were caused by improper installation or other causes beyond IEC's control. IEC has filed fourth party complaints against certain of its suppliers. Discovery in this proceeding is ongoing. The Company does not believe this matter will have a material adverse effect on the financial condition or results of operations of the Company due to the probable receipt of insurance proceeds in the event of an adverse outcome. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ Not applicable. Item 4A. EXECUTIVE OFFICERS OF THE COMPANY - ------------------------------------------- Identification of Executive Officers. The following table identifies the ------------------------------------ executive officers of the Company. Position and Served as Offices With an Officer Name Age the Company From - ---- ---- ------------- ----------- Jack E. Golsen 65 Board Chairman December, 1968 and President Barry H. Golsen 43 President of the August, 1981 Environmental Control Businesses and Director David R. Goss 53 Senior Vice March, 1969 President of Operations and Director Tony M. Shelby 52 Senior Vice March, 1969 President - Chief Financial Officer, and Director Jim D. Jones 52 Vice President - April, 1977 Treasurer and Corporate Controller Michael Tepper 54 Senior Vice June, 1985 President - International Operations David M. Shear 34 Vice President and March, 1990 General Counsel Heidi L. Brown 35 Vice President and March, 1990 Managing Counsel Michael Adams 44 Vice President- March, 1990 Internal Audit - -------------------------------------------------------------- The Company's officers serve one-year terms, renewable on an annual basis by the Board of Directors. With the exception of Messrs. Adams and Shear and Ms. Brown, all of the individuals listed above have served in substantially the same capacity with the Company and/or its subsidiaries for the last five years. Prior to becoming an officer of the Company, Mr. Shear served as an antitrust attorney for the Federal Trade Commission and was in private law practice in Boston, Massachusetts. Ms. Brown was in private law practice in Boston, Massachusetts prior to joining the Company. Mr. Adams has been employed by the Company for the last five years, serving as Assistant Vice President - Internal Audit since 1985 before being elected Vice President of the Company. Family Relationships. The only family relationships that exist among the executive officers of the Company are the following: (i) Jack E. Golsen is the father of Barry H. Golsen, (ii) Jack E. Golsen is the uncle of Heidi L. Brown and (iii) David M. Shear and Heidi L. Brown are husband and wife. PART II Item 5. Item 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market Information. The Company's Common Stock trades on the American Stock Exchange, Inc. ("AMEX") The following table shows, for the periods indicated, the high and low closing sales prices for the Company's Common Stock. Fiscal Year Ended December 31, ---------------------------- 1993 1992 ---- ---- Quarter High Low High Low ------- ---- --- ---- --- First 11-1/8 6-3/4 2-7/8 1-1/4 Second 12 9 4-7/8 2-3/8 Third 12-3/8 10 6-1/2 3-3/4 Fourth 11-3/8 8-1/8 7-3/4 4-3/4 Stockholders. As of March 14, 1994, the Company had 1,539 record holders of its Common Stock. Issuance of Preferred Stock - On May 27, 1993, the Company completed a public offering of $46 million of a new series of Class C Preferred Stock, designated as $3.25 Convertible Exchangeable Class C Preferred Stock, Series 2, no par value ("Series 2 Preferred"). The Series 2 Preferred has a liquidation preference of $50.00 per share plus accrued and unpaid dividends and is convertible at the option of the holder at any time, unless previously redeemed, into Common Stock, $0.10 par value, of the Company, at an initial conversion price of $11.55 per share (equivalent to a conversion rate of approximately 4.3 shares of Common Stock for each share of Series 2 Preferred), subject to adjustment under certain conditions. If under certain conditions there occurs a Corporate Change or Ownership Change (as such terms are defined in the underlying documents creating the Series 2 Preferred) with respect to the Company, then, under certain conditions, each holder of Series 2 Preferred shall have the right, at the holder's option, for a period of 45 days after mailing of a notice by the Company that such change has occurred, to convert all, but not less than all, of such holders Series 2 Preferred into the Company's Common Stock or common stock of any corporation that is a successor to the Company at a special conversion rate. The shares of Series 2 Preferred are not entitled to vote except under limited circumstances. Each share of outstanding Series 2 Preferred is entitled to receive, if,when and as declared by the Board of Directors, an annual dividend of $3.25 per share payable quarterly in the arrears. See "Dividends" of this Item 5 below. The Series 2 Preferred is not redeemable prior to June 15, 1996. The Series 2 Preferred will be redeemable at the option of the Company, in whole or in part, at $52.28 per share if redeemed on or after June 15, 1996, and thereafter at prices decreasing rateably annually to $50.00 per share on and after June 15, 2003, plus accrued and unpaid dividends to the redemption date. Dividends. Holders of the Company's Common Stock are entitled to receive dividends only when, as and if declared by the Board of Directors. No dividends may be paid on the Company's Common Stock until all required dividends are paid on the outstanding shares of the Company's preferred stock, or declared and amounts set apart for the current period, and, if cumulative, prior periods. The Company has issued and outstanding as of December 31, 1993, 920,000 shares of Series 2 Preferred, 1,632.5 shares of a series of Convertible Non Cumulative Preferred Stock ("Non Cumulative Preferred Stock") and 20,000 shares of Series B 12% Convertible, Cumulative Preferred Stock ("Series B Preferred"). Each share of preferred stock is entitled to receive an annual dividend, if, as and when declared by the Board of Directors, payable as follows: (i) Series 2 Preferred at the rate of $3.25 a share payable quarterly in arrears on June 15, September 15, December 15, and March 15, (ii) Non Cumulative Preferred Stock at the rate of $10 a share, and (iii) Series B Preferred at the rate of $12.00 a share. The Company did not pay cash dividends on its Common Stock for many years. During the first part of 1993, the Company's Board of Directors approved the adoption of a policy as to the payment of cash dividends on its outstanding Common Stock pursuant to which an annual cash dividend of $.06 per share will be declared by the Board of Directors and paid on the Company's outstanding shares of Common Stock payable at $.03 per share semiannually, subject to change or termination by the Board of Directors at any time. The Company paid a cash dividend of $.03 a share on its outstanding Common Stock on July 1, 1993, and January 1, 1994; however, there are no assurances that this policy will not be terminated or changed by the Board of Directors. See Notes 9, 11, 12 and 13 to Notes to Consolidated Financial Statements. Under the terms of a loan agreement between El Dorado Chemical Company ("EDC") and its lenders, EDC cannot transfer funds to the Company in the form of cash dividends or other advances, except (i) for the amount of taxes that EDC would be required to pay if it was not consolidated with the Company and (ii) an amount equal to twenty-five percent (25%) of EDC's cumulative adjusted net income (as reduced by cumulative net losses), as defined, any time EDC has a Total Capitalization Ratio, as defined, greater than .65:1 and after EDC has a Total Capitalization Ratio of .65:1 or less, 50% of EDC's cumulative adjusted net income (as reduced by cumulative net losses). See Note 9 of Notes to Consolidated Financial Statements and "Management's Discussion and Analysis". The Company is a holding company and, accordingly, its ability to pay dividends on its preferred stock and its common stock is dependent in large part on its ability to obtain funds from its subsidiaries. The ability of EDC, International Environmental Corporation and Equity Bank to pay dividends to the Company, to fund the payment of dividends by the Company or for other purposes, is restricted by certain agreements to which they are parties and, in the case of Equity Bank, subject to the restrictions promulgated by FIRREA. See "Business - Financial Service Business". On February 17, 1989, the Company's Board of Directors declared a dividend to its stockholders of record on February 27, 1989, of one preferred stock purchase right on each of the Company's outstanding shares of common stock. The rights expire on February 27, 1999. The Company issued the rights, among other reasons, in order to assure that all of the Company's stockholders receive fair and equal treatment in the event of any proposed takeover of the Company and to guard against partial tender abusive tactics to gain control of the Company. The rights will become exercisable only if a person or group acquires beneficial ownership of 30% or more of the Company's common stock or announces a tender or exchange offer the consummation of which would result in the ownership by a person or group of 30% or more of the common stock, except any acquisition by Jack E. Golsen, Chairman of the Board and President of the Company, and certain other related persons or entities. Each right (other than the rights, owned by the acquiring person or members of a group that causes the rights to become exercisable, which became void) will entitle the stockholder to buy one-hundredth of a share of a new series of participating preferred stock at an exercise price of $14.00 per share. Each one one-hundredth of a share of the new preferred stock purchasable upon the exercise of a right has economic terms designed to approximate the value of one share of the Company's common stock. If another person or group acquires the Company in a merger or other business combination transaction, each right will entitle its holder (other than rights owned by that person or group, which become void) to purchase at the right's then current exercise price, a number of the acquiring company's common shares which at the time of such transaction would have a market value two times the exercise price of the right. In addition, if a person or group (with certain exceptions) acquires 30% or more of the Company's outstanding common stock, each right will entitle its holder, (other than the rights owned by the acquiring person or members of the group that results in the rights becoming exercisable, which become void), to purchase at the right's then current exercise price, a number of shares of the Company's common stock having a market value of twice the right's exercise price in lieu of the new preferred stock. Following the acquisition by a person or group of beneficial ownership of 30% or more of the Company's outstanding common stock (with certain exceptions) and prior to an acquisition of 50% or more of the Company's common stock by the person or group, the Board of Directors may exchange the rights (other than rights owned by the acquiring person or members of the group that results in the rights becoming exercisable, which become void), in whole or in part, for shares of the Company's common stock. That exchange would occur at an exchange ratio of one share of common stock, or one one-hundredth of a share of the new series of participating preferred stock, per right. Prior to the acquisition by a person or group of beneficial ownership of 30% or more of the Company's common stock (with certain exceptions) the Company may redeem the rights for one cent per right at the option of the Company's Board of Directors. The Company's Board of Directors also has the authority to reduce the 30% thresholds to not less than 10%. Item 6. Item 6. SELECTED FINANCIAL DATA - ------- ----------------------- Item 6. SELECTED FINANCIAL DATA (Continued) - ------- ----------------------------------- Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------ --------------------------------------------------------------- RESULTS OF OPERATIONS --------------------- The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with a review of the Company's December 31, 1993 Consolidated Financial Statements, Item 6 "SELECTED FINANCIAL DATA," and "BUSINESS" included elsewhere in this report. Overview - -------- The Company is a diversified holding company which is engaged, through its subsidiaries, in the Chemical Business, the Environmental Control Business, the Automotive Products Business, the Industrial Products Business and the Financial Services Business. The Chemical Business, the Environmental Control Business and the Financial Services Business accounted for approximately 12%, 4% and 77% respectively, of the Company's assets at December 31, 1993, and approximately 42%, 25%, and 15% respectively, of the Company's revenues for the year then ended. The operating income of the Company increased from $16.5 million in 1991, to $25.9 million in 1992, to $30.6 million in 1993. As a result of significantly higher operating income and lower interest expense, the Company's net income was approximately $12.4 million in 1993, as compared to a net income of $9.3 million in 1992 and a net loss of $1.1 million in 1991. As previously discussed in this report, the Company has entered into an agreement to sell Equity Bank (which comprises the Company's Financial Service Business) to Fourth Financial, which agreement has been previously defined as the Acquisition Agreement. See "Liquidity and Capital Resources" of this "Management Discussion and Analysis", "Business - Recent Developments", "Business- Financial Service Business" and Note 1 to Notes to Consolidated Financial Statements for further discussion of the proposed sale of Equity Bank. Results of Operations - --------------------- Comparison of 1993 with 1992 Revenues Total revenues for the years ended December 31, 1993 and 1992 were $276.6 million and $246.8 million, respectively (an increase of $29.8 million). Interest and other income attributable to the operations of the Financial Services Business included in total revenues was $41.8 million in 1993, compared to $46.9 million for 1992. The decrease resulted primarily from a net decrease in interest income of $5.5 million due to decreased interest income from loans receivable and mortgage-backed securities of $5.4 million due to declining interest rates. Net Sales Consolidated net sales for the year 1993 were $232.6 million, compared to $198.4 for the year 1992, an increase of $34.2 million or 17.2%. This increase in sales resulted principally from: (i) increased sales in the Chemical Business of $8.9 million, primarily due to the acquisition of Total Energy Systems Limited ("TES") in July, 1993, sales by Slurry Explosive Corporation ("Slurry") to an expanded customer base for twelve months in 1993 compared to only eleven months in 1992, and sales of Universal Tech Corporation ("UTC"), which was acquired in September, 1992, offset by reduced sales by El Dorado Chemical Company due to the effects of coal mine strikes in the eastern United States; (ii) increased sales in the Environmental Control Business of $14.6 million, primarily due to an expanded customer base in 1993 and the effects in 1992 of a strike at the fan coil manufacturing plant of this business; (iii) increased sales in the Automotive Products Business of $8.5 million due to an expanded customer base in 1993; and (iv) increase sales in the Industrial Products Business of $2.2 million, primarily due to increased sales to a foreign customer (see Note 8 to Notes to Consolidated Financial Statements and discussion under the "Liquidity and Capital Resources" section of this report). Gross Profit Gross profit was 25.0% for 1993, compared to 26.2% for 1992. The decline in the gross profit percentage was due primarily to (i) lower efficiency in the heat pump manufacturing plant of the Environmental Control Business as a result of period costs associated with start up of production requirements related to an agreement entered into with a major United States air conditioning company; (ii) a shift in sales mix in the Industrial Products Business to lower margin items; and (iii) higher cost of the primary raw material (ammonia) in the Chemical Business. During 1993 the average cost of ammonia was approximately 12.2% higher than the average cost of ammonia during 1992. This higher cost was not fully passed on to customers in the form of price increases. These factors were offset in part by gross profits recognized on the foreign sales contract (See Note 8 to Notes to Consolidated Financial Statements) of $5.3 million in 1993, compared to only $3.6 million in 1992, and the effects in 1992 of a strike at the fan coil manufacturing plant of the Environmental Control Business. Selling, General and Administrative Expense Selling, general and administrative expenses for the non-financial services businesses as a percent of net sales was 18.9% in 1993 and 18.9% in 1992. The Financial Services Business recorded a decrease of $733,000 in SG&A expenses in 1993 compared to 1992. The decrease included (i) a $0.2 million reduction in data processing expenses associated with conversion costs due to changing service bureaus in 1992, reduction in advertising expense, and various fees and assessments associated with the credit card operations; (ii) a $0.7 million reduction in other expenses primarily relating to the potential income sharing provision of the assistance agreement; and (iii) a $2.5 million increase in profitability related to real estate operations, offset by increased goodwill amortization of $2.4 million. See "Termination of Assistance Agreement" discussed elsewhere in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 3 of Notes to Consolidated Financial Statements for further discussion of the effects of the termination of the Assistance Agreement between Equity Bank and the RTC. Interest Expense Interest expense for the Company was approximately $22.0 million during 1993 compared to approximately $29.6 million during 1992. The decrease primarily resulted from lower interest rates and lower average balances of deposits and borrowed funds. Income Before Taxes The Company had income before income taxes of $13.3 million in 1993, compared to $9.8 million in 1992. The improved profitability of $3.5 million, after the one time charge to expense of $1.8 million for settlement of a dispute with Customs, was due to higher sales in the Chemical, Environmental Control, and Automotive Products businesses, an increase of $1.7 million in estimated earnings on the foreign sales contract, and increased net interest margin in the financial service business resulting from declining interest rates in 1993 as compared to 1992. As a result of the Company's net operating loss carryforward for income tax purposes as discussed elsewhere herein and in Note 10 of Notes to Consolidated Financial Statements, the Company's provisions for income taxes for 1993 and 1992 are for current state income taxes and federal alternative minimum taxes. Comparison of 1992 with 1991 Revenues Total revenues for the years ended December 31, 1992 and 1991 were $246.8 million and $234.2 million, respectively (an increase of $12.6 million). Interest and other income attributable to the operations of the Financial Services Business included in total revenues was $46.9 million in 1992, compared to $55.0 million for 1991. The decrease resulted primarily from a net decrease in interest income of $7.3 million due to (i) decreased interest income from loans receivable of $4.3 million due to declining interest rates and reduced outstanding principal balances; (ii) a decline in yield maintenance assistance of $2.5 million due to a declining guaranteed yield rate and a reduction in covered asset balances; (iii) lower income from other interest earning assets (principally overnight deposits) of $1.5 million due to declining rates offered for these types of assets in addition to reduced amounts available to invest. These decreases were offset by an increase in interest income from mortgage-backed securities of $1.2 million resulting from additional investments of excess cash into mortgage-backed securities to enhance interest rate spreads. Net Sales Consolidated net sales for the year 1992 were $198.4 million, compared to $177.0 for the year 1991, an increase of $21.4 million or 12.1%. This increase in sales resulted principally from an increase in sales of $17.1 million by the Chemical Business from increased demand in the blasting products, fertilizer, and acid products markets ($6.9 million) and sales due to the acquisition of Slurry in January 1992 ($10.2 million). Sales increases and decreases by other businesses were: Environmental Control Business - decrease $3.3 million; Automotive Products Business increase $2.9 million; and Industrial Products Business - increase $4.7 million. The low order level in the Environmental Control Business, which began in the second half of 1990 and continued into 1991 and 1992, is a result of a general decline in the construction industry. Additionally, sales reductions in the Environmental Control Business were due to a strike which began on May 20, 1992, at the fan coil manufacturing plant of this business. The plant resumed operations in July, 1992 with new employees that are not members of a union. Productivity is continuing to improve at the plant and reached near normal levels by December 31, 1992. The Sales increases in the Automotive Products Business are due to stronger market conditions and an expanded customer base. Sales in 1992 for the Industrial Products Business include $6.2 million in earned revenues related to the Foreign Sales Contract discussed in the Liquidity and Capital Resources section and Note 8 of Notes to Consolidated Financial Statements. Sales declines in the remaining sectors of the Industrial Products Business were primarily the result of depressed market conditions. Gross Profits Gross profit was 26.2% for 1992, compared to 23.0% for 1991. This increase in gross profit percentage is partially due to improved absorption of manufacturing costs in the Chemical Business and Automotive Products Business commensurate with their increased sales and manufacturing requirements. In addition, the Chemical Business benefited from a lower cost of its primary raw material (ammonia) in 1992 compared to 1991. Gross profit related to the Foreign Sales Contract for 1992 amounted to $3.6 million. These gross profit percentage improvements were partially offset by decreases in the Environmental Control Business due to lower sales and inefficiencies in the manufacturing process attributable to the effect of the strike discussed above. Selling, Gains and Administrative Expenses Selling, general and administrative ("SGA") expenses for the non- financial services businesses as a percent of net sales were 18.9% in 1992 and 20.7% in 1991. As sales increased, normal SGA costs did not increase proportionately, thus resulting in a lower percentage. Additionally, the Company experienced reductions in 1992 expense levels in the areas of bad debts, insurance and other administrative expenses. The Financial Services Business recorded an increase of $580,000 in SGA expenses for 1992 compared to 1991. This increase is due primarily to an increase in expenses related to real estate operations. Interest Expense Interest expense of the Company in 1992 was approximately $29.6 million, compared to approximately $39.3 million in 1991. The decrease resulted from: (i) $6.7 million decrease in interest on deposits due principally to lower rates, (ii) $2.3 million reduction in interest expense on borrowed funds of the Financial Services Business due to lower rates on such borrowed funds, and (iii) $650,000 decrease in interest on long-term debt of the Non-Financial Services Businesses resulting from lower rates and lower average balances of borrowed funds. Income Before Taxes The Company had a consolidated income before income taxes of $9,771,000 in 1992 compared to a loss of $950,000 for 1991. The increased profitability of $10.7 million is primarily due to improved sales in the Chemical Business, the acquisition of Slurry, improvement in the results of operations in the Automotive Products Business, $3.6 million in estimated earnings related to the Foreign Sales Contract and reduced interest rates. As a result of the Company's net operating loss carryforward for income tax purposes as discussed elsewhere herein and in Note 10 to Consolidated Financial Statements, the Company's provisions for income taxes for 1992 and 1991 are for current state income taxes and federal alternative minimum taxes. Liquidity and Capital Resources - ------------------------------- The Company is a diversified holding Company and its liquidity is dependent, in large part, on the operations of its subsidiaries and credit agreements with lenders. As a regulated business, Equity Bank is limited in the transactions which it can enter into with the Company, except as specifically approved by the appropriate regulatory agencies. As a result, the Company does not guarantee the obligations of Equity Bank nor does Equity Bank guarantee the obligations of the Company. Accordingly, the Financial Services and Non-Financial Services Businesses are discussed independently. Existing financial arrangements between the Company's Financial and Non- Financial Services Businesses are important elements of the liquidity and capital resources of the Non-Financial Services Businesses. Non-Financial Services Businesses (Company and its subsidiaries other than - -------------------------------------------------------------------------- Equity Bank) - ------------ Substantially all of the capital requirements, other than the equity capital of the Company and its subsidiaries, are funded by three sources: (1) Pursuant to approvals by the then appropriate governmental agency in 1988, the Company and its subsidiaries have been selling eligible accounts receivable to Equity Bank with recourse to the particular seller. Under such arrangement, an account receivables sold to Equity Bank at 100% of the unpaid face value of such account receivable. Under the prior approvals, the Company and its subsidiaries were allowed to sell Equity Bank, at any one time, up to $60 million of eligible accounts receivables. At December 31, 1993, $33.6 million of such accounts receivable were owned by Equity Bank. The Office of Thrift Supervision ("OTS"), the primary regulator of Equity Bank, has taken the position that the approvals granted in 1988 allowing such accounts receivable transactions between the Company, its subsidiaries and Equity Bank have expired. As a result, Equity Bank and the OTS have agreed that (i) at no one time subsequent to September 28, 1993, but prior to September 1, 1994, shall the total amount of such accounts receivable owned by Equity Bank exceed $33.6 million; (ii) beginning February 1, 1994, Equity Bank will not purchase any new accounts receivable from the Company and/or its subsidiaries if such would result in Equity Bank owning an amount that would exceed the amount allowed by current regulations for transactions with affiliated companies, which amount is based on a percentage of Equity Bank's capital, and (iii) on and after September 1, 1994, the amount of such accounts receivable owned by Equity Bank at any one time must be in compliance with current regulations for transactions with affiliated companies. Assuming that on December 31, 1993, Equity Bank had been required to meet current regulations regarding the amount of such outstanding accounts receivable owned by Equity Bank, the amount of such accounts receivable would have had to be reduced to approximately $9.2 million as of such date. The Company has temporarily replaced a substantial portion of the accounts receivable financing previously provided by Equity Bank with Bank IV of Oklahoma, N.A. ("Bank IV") a subsidiary of Fourth Financial which is providing the Company with a $25 million accounts receivable financing line of credit at 80% of the unpaid face value of such accounts receivable ("Bank IV Line of Credit"). The Bank IV line of Credit is temporary and will expire during 1994 unless extended. . The Company intends to continue to use the accounts receivable financing arrangement with Equity Bank to the extent described above and as allowed by regulations until Equity Bank is sold as discussed elsewhere herein. The Company has begun negotiations for a comprehensive line of credit. Although the Company believes it will be successful in obtaining the comprehensive line of credit to replace most, if not all, of its present credit facilities, there are no assurances that it will be successful in negotiating such. (2) The Company and its subsidiaries (other than Equity Bank and the Chemical Business) are parties to a credit agreement ("Agreement"), with an unrelated lender ("Lender"), collateralized by certain inventory and certain other assets of the Company and its subsidiaries (including the capital stock of International Environmental Corporation) other than the assets and capital stock of Equity Bank and the Chemical Business. The Credit Agreement provides for a revolving credit facility ("Revolver") for direct borrowing up to $8 million, including the issuance of letters of credit. The Revolver provides for advances at varying percentages of eligible inventory. This Agreement expires on June 30, 1994, but the Company believes the Agreement can be extended at that time. At December 31, 1993, the availability based on eligible collateral approximated the credit line. Borrowings (including letters of credit) under the Revolver outstanding at December 31, 1993, were $.6 million. The Revolver requires reductions of principal equal to reductions as they occur in the underlying inventory times the advance rate. When the offering of the Series 2 Preferred was completed, the Company repaid $6.8 million of the Revolver with a portion of the net proceeds from the offering of the Series 2 Preferred. The Company presently intends to keep the Credit Agreement in effect if it can renegotiate certain of its terms. (3) The Company's wholly-owned subsidiaries, El Dorado Chemical Company and Slurry Explosive Corp., which comprise the Company's Chemical Business , are parties to a loan agreement ("Loan Agreement") with two institutional lenders ("Lenders"). This Loan Agreement, as amended in conjunction with an unscheduled payment of $7.2 million in the third quarter of 1993, provides for a seven year term loan of $28.5 million ("Term Loan"), a $10 million asset based revolving credit facility ("Revolving Facility"), and an additional revolving credit line of $7.2 million. Available borrowings under this additional revolving credit line at December 31, 1993 was the full $7.2 million and decreases annually until its termination in March, 1997. The balance of the Term Loan at December 31, 1993 was $20.6 million. The annual principal payment of the Term Loan for 1993, paid June 30, 1993, was $4.4 million. Annual principal payments on the Term Loan escalate each year from $4.8 million in 1994 to a final payment of $5.5 million on March 31, 1997. In addition to the $4.4 million principal payment on the Term Loan, a $1.5 million principal payment was made on June 30, 1993 on a term loan which was subsequently converted into the additional revolving credit line of $7.2 million discussed above. Borrowings under the Revolving Facility are available up to the lesser of $10 million or the borrowing base. The borrowing base is determined by deducting 100% of Chemical's accounts receivable sold to Equity Bank from the maximum borrowing availability as defined in the Revolving Facility. The maximum line availability based on eligible collateral under the Revolving Facility at December 31, 1993 was approximately $8.7 million, net of approximately $1.1 million reserved for the issuance of a standby letter of credit. At December 31, 1993 there were outstanding borrowings under the Revolving Facility of $2.1 million. The Revolving Facility requires reductions of principal equal to reductions as they occur in the underlying accounts receivable and inventory times the applicable advance rate, assuming that the outstanding balance under the Revolving Credit Facility is less than the then maximum line availability based on eligible collateral. During 1993 and 1992, borrowings under the Revolving Facility were reduced to zero for forty-five (45) consecutive days as required by its terms. Annual interest at the agreed to interest rates, if calculated on the $22.7 million outstanding balance at December 31, 1993 would be approximately $2.7 million. The Term Loan and Revolving Facility are secured by substantially all of the assets and capital stock of Chemical. The Loan Agreement requires Chemical to maintain certain financial ratios and contains other financial covenants, including tangible net worth requirements and capital expenditures limitations. As of the date of this report, Chemical is in compliance with all financial covenants. Under the terms of the Loan Agreement, Chemical cannot transfer funds to the Company in the form of cash dividends or other advances, except for (i) the amount of taxes that Chemical would be required to pay if it was not consolidated with the Company; (ii) an amount equal to fifty percent (50%) of Chemical's cumulative adjusted net income as long as Chemical's Total Capitalization Ratio, as defined, is .65:1 or below and, (iii) borrowings under the additional revolving credit line of $7.2 million. Cash Flows - Non-Financial Services ----------------------------------- Net cash used by operating activities in 1993, after adjustment for non- cash expenses of $7.1 million, was $7.9 million. This cash used by operating activities included the following changes in assets and liabilities: (i) accounts receivable increased $12.3 million; (ii) accounts payable and accrued liabilities decreased $1.6 million; (iii) increased costs and estimated earnings in excess of billings on the foreign sales contract of $5.6 million; (iv) inventory reduced $2.3 million; and (v) increased supplies, prepaid items, and other assets of $2.0 million. The increase in accounts receivable is due to higher sales in the Chemical, Environmental Control and Automotive Products Businesses. The decrease in accounts payable and accrued liabilities resulted from paydown of approximately $5 million with the net proceeds from the offering of the Series 2 Preferred, partially offset by increases resulting from higher business activity and expanded customer bases in the Chemical, Environmental Control, and Automotive Products Business. The decrease in inventories is due to reduced inventory levels in the Environmental Control Business, which was increased beyond required levels in 1992. The increase in supplies, prepaid items and other assets is due to increased business activity and prepayments for supplies, insurance, and computer software and services. Financing activities in 1993 included $43.9 million of net proceeds from issuance of 920,000 shares of the Series 2 Preferred and proceeds of $3.2 million from issuance of Common Stock, primarily in connection with the redemption of the Company's $2.20 Series 1 Convertible Exchangeable Class C Preferred Stock during the first quarter of 1993. Such increases have been offset by dividend payments of $2.7 million and paydown of long term debt of $24.9 million. Cash flows used in investing activities included capital expenditures for property, plant and equipment of $5.5 million related to the Chemical Business, $1.5 million related to plant improvements in the Environmental Control Business, and $1.7 million related to improvements to the Automotive Products Business' warehouse facilities in Oklahoma City, in addition to tooling and other upgrades made to machinery used in the Automotive Products Business manufacturing facility. Future cash requirements include working capital requirements for anticipated sales increases in the Environmental Control Business, the Chemical Business and the Automotive Products Business, and funding for future capital expenditures, primarily in the Chemical Business and the Environmental Control Business. Funding for the higher accounts receivable resulting from anticipated sales increases will be provided by the Chemical Business' revolving credit facilities previously discussed and the accounts receivable financing provided by Bank IV. As previously discussed, the accounts receivable financing is temporary and will be replaced with the comprehensive line of credit that the Company is attempting to negotiate. Inventory requirements for the higher anticipated sales activity should be met by scheduled reductions in the inventories of the Environmental Control and Automotive Products Businesses, both of which increased their inventories in 1992 beyond required levels. During November 1993, the Company's Chemical Business acquired an additional concentrated nitric acid plant and related assets for approximately $1.9 million. The Chemical Business is in the process of moving such plant and assets from Illinois to, and installing such at, its manufacturing plant located in El Dorado, Arkansas. The Company anticipates that the total amount that will be expended to acquire, move and install the plant and assets will be approximately $12.0 million for which the Company expects to obtain financing secured by such assets. The Company expects the plant and asset installation to be compete and operational by the end of 1994. The Company also has planned capital expenditures for the Environmental Control Business to acquire certain machinery and equipment for approximately $4 million in 1994. Approximately $2 million of these expenditures are expected to be financed by the sellers of said machinery and equipment. The remaining $2 million is expected to be financed from operations. Management believes that cash flows from operations and other sources, including the comprehensive line of credit that the Company is presently negotiating will be adequate to meet its presently anticipated capital expenditure, working capital, debt service and dividend requirements. The Company currently has no material commitment for capital expenditures, other than those related to Chemical's acquisition of an additional concentrated nitric acid plant, the Environmental Control Business' acquisition of machinery and equipment as discussed above, and a commitment of a subsidiary of the Company to purchase from Equity Bank in the year 2000 for the then carrying value for regulatory capital purposes certain of the Transferred Assets presently being leased by Equity Bank to the subsidiary. Equity Bank's carrying value for all of the Transferred Assets at December 31, 1993 was approximately $65.4 million. The Company has agreed under the Acquisition Agreement to repurchase all of the Transferred Assets by purchasing the subsidiaries of Equity Bank that own the Transferred Assets at least one (1) day prior to consummation of the Acquisition Agreement. However, if the sale of Equity Bank does not occur, the Company believes that it will be able to obtain satisfactory financing from non-affiliated parties to fulfill this commitment on or prior to the date that the subsidiary of the Company is required to purchase such assets. The Company's Board of Directors has approved the adoption of a new policy as to the payment of annual cash dividends of $.06 per share on its outstanding Common Stock, subject to termination or change by the Board of Directors at any time. The Board of Directors declared a cash dividend of $.03 per share on the Company's outstanding shares of Common Stock, which was paid July 1, 1993, to the stockholders of record as of the close of business on June 15, 1993. On November 11, 1993 the Company's Board of Directors declared a (i) $.03 a share cash dividend on each outstanding share of its Common Stock, payable January 1, 1994, to stockholders of record on December 15, 1993, (ii) $3.00 a share quarterly cash dividend on each outstanding share of its Series B 12% Cumulative Convertible Preferred Stock, $100 par value, payable January 1, 1994, to stockholders of record on December 1, 1993, (for the fourth quarter of 1993), (iii) $12.00 a share annual cash dividend on each outstanding share of its Series B 12% Cumulative Convertible Preferred Stock, $100 par value, payable January 1, 1994 to stockholders of record on December 1, 1993, which is the annual dividend on this series of preferred stock for 1994, and (iv) $.81 a share quarterly cash dividend on each outstanding share of its Series 2 Preferred, paid December 15, 1993 to shareholders of record on December 1, 1993. Foreign Sales Contract - A subsidiary of the Company entered into an agreement with a foreign company ("Buyer") to supply the Buyer with equipment, technology and technical services to manufacture certain types of automotive bearing products. The agreement provides for a total contract amount of approximately $56 million, with $12 million of the contract amount to be retained by the Buyer as the Company's subsidiary's equity participation in the Buyer, which will represent a minority interest. Through December 31, 1993, the Company's subsidiary has received $13.1 million from the buyer under the agreement. During 1993, the Company and the foreign customer agreed to a revised payment schedule which deferred the beginning of payments under the contract from June 30, 1993 to one $791,000 principal payment on November 1, 1993 and then principal payments of $791,000 due March 31, 1994 and quarterly, thereafter, until the contract is paid in full. The customer made the November 1 payment as agreed and the Company expects that the customer will make future payments as they become due, starting with the payment due March 31, 1994. See "Business - Industrial Products Business" and Note 8 to Notes to Consolidated Financial Statements. Business Acquisitions - In July, 1993, the Company acquired an Australian explosives business, Total Energy Systems Limited ("TES"). At December 31, 1993 the Company has investments and advances of approximately $3.4 million related to TES. In December 1993,IBI, an automotive products distributor, was acquired as a wholly owned subsidiary of the Company operating as a separate entity within the Automotive Products Business, for a cash payment of $1.8 million and a note payable of $0.2 million. At December 31, 1993, IBI had assets of $2.2 million. In March 1994, a subsidiary of the Company advanced to Deepwater Iodides, Inc. ("Deepwater"), a specialty chemical company, $450,000 on a demand basis. In connection with the loan, Deepwater and the Company agreed to finalize an option allowing the Company to purchase from Deepwater an amount of stock of Deepwater equal to fifty-one percent of the outstanding shares of Deepwater for $1.95 million. The Company anticipates exercising this option prior to the end of 1994, subject to the results of due diligence presently being conducted. See Note 2 to Notes to Consolidated Financial Statements for further discussion of business acquisitions. Settlement of U.S. Customs Matter - During the third quarter of 1993, the Company paid $1.8 million to U.S.Customs in settlement of a long standing dispute over a "notice of redelivery" served by U.S. Customs in a prior year. Settlement of Litigation - In 1993 the Company filed suit against certain transportation companies and certain of the Company's insurers over damage sustained to certain of the Industrial Products Business' machine inventory while in the transportation companies' possession. Subsequent to December 31, 1993, the Company settled its litigation with one of it's insurers for $2.8 million, net of related costs, which was paid to the Company on March 11, 1994. The Company continues to pursue litigation against two insurers that were not parties to said settlement and against the transportation companies. Letters of Intent with Foreign Customers - During the second and third quarters of 1993, a subsidiary of the Company signed two separate letters of intent to supply separate customers, one in the former Soviet Union and one in Poland, with equipment to manufacture environmental control products. Upon completion, the agreements are expected to include the sale of licenses, designs, tooling, machinery, equipment, technical information, proprietary know how, and technical services. The total sales price for the two contracts is expected to be approximately $98 million. The agreements are also expected to include a provision that, in lieu of cash, the Company will accept payment in kind of anhydrous ammonia from the foreign customers at the foreign customers' option. The projects are subject to completion of two separate definitive agreements between each of the foreign customers and the Company's subsidiary. There are no assurances that definitive contracts with either of these two customers will be finalized. See "Business - Environmental Control Business". Availability of Company's Loss Carryovers - The Company anticipates that its cash flow in future years will benefit to some extent from its ability to use net operating loss ("NOL") carryovers from prior periods to reduce the federal income tax payments which it would otherwise be required to make with respect to income generated in such future years. As of December 31, 1993, the Company, excluding amounts applicable to Equity Bank, had available NOL carryovers of approximately $37 million, based on its federal income tax returns as filed with the Internal Revenue Service for taxable years through 1992, and on the Company's estimates for 1993. These NOL carryovers will expire beginning in the year 1999. The amount of these carryovers has not been audited or approved by the Internal Revenue Service and, accordingly, no assurance can be given that such carryovers will not be reduced as a result of audits in the future. In addition, the ability of the Company to utilize these carryovers in the future will be subject to a variety of limitations applicable to corporate taxpayers generally under both the Internal Revenue Code of 1986, as amended, and the Treasury Regulations. These include, in particular, limitations imposed by Code Section 382 and the consolidated return regulations. Contingencies - As discussed in Item 3 and in Note 14 of Notes to the Consolidated Financial Statements, the Company has several contingencies that could impact its liquidity in the event that the Company is unsuccessful in defending against the claimants. Although management does not anticipate that these claims will result in substantial adverse impacts on its liquidity it is not possible to determine the outcome. Financial Services Business -------------------------- Termination of Assistance Agreement - During the first quarter of 1993, Equity Bank finalized an agreement with the RTC terminating the Assistance Agreement entered into between Equity Bank and the FSLIC in 1988 (the "Assistance Agreement"), in connection with Equity Bank's acquisition of Arrowhead. In connection with such termination, the RTC paid Equity Bank approximately $14.2 million and all of the obligations of both parties under the Assistance Agreement were terminated. As a result of the termination of the Assistance Agreement, Equity Bank assumed the credit risk with respect to approximately $30.8 million of assets (as of the date the Assistance Agreement was terminated ) that had been acquired from Arrowhead in 1988, with respect to which the FSLIC had previously borne the credit risk. Equity Bank reserved a substantial portion of such $14.2 million to provide for potential future losses relating to loans and real estate in which Equity Bank assumed the credit risk as a result of the termination. As a result, the Company believes that there are adequate loss reserves relating to the assets for which the credit risk was assumed. Regulatory Capital Compliance - At December 31, 1993 Equity Bank's regulatory core capital was $38.6 million or 7.7% of assets compared to the 3% minimum requirement. Tangible Capital was $34.8 million or 6.9% of assets compared to the 1.5% minimum requirement, and Risk-Based Capital was $41.4 million or 15.1% compared to the 8% requirement. Management believes that Equity Bank will be able to meet all applicable requirements of law and federal regulation under FIRREA, although there are no assurances that they will be able to do so. Fully Phased-In Capital - FIRREA requires that Equity Bank meet progressively higher capital requirements each year until they are "fully phased-in" through December 31, 1994, except for certain assets for which the "phase-in" period has been extended through July, 1996. Equity Bank currently does and will, in the judgement of the Company, be able to meet applicable requirements of law and regulations relating to capital requirements as presently in effect and as the same become effective during the phase-in period under current law and regulations, although there are no assurances that Equity Bank will be able to so comply. At December 31, 1993, Equity Bank exceeded the current regulatory capital requirements and under the technical definition and calculation of fully phased-in capital as prescribed by FIRREA, Equity Bank believes that it meets future capital standards as presently mandated by FIRREA. The OTS has issued a final rule adding an interest rate risk component (IRR Component) to its risk-based capital rule. The final rule is effective January 1, 1994. The IRR component is a dollar amount that will be deducted from total capital for the purpose of calculating an institution's risk-based capital requirements. The IRR component is equal to one-half the difference between an institutions' "measured exposure" and a "normal" level of exposure. An institution's interest rate risk exposure will be measured in terms of the sensitivity of its net portfolio value (NPV) to changes in interest rates. The OTS will calculate changes in an institution's NPV based on financial data submitted by the institution in its quarterly reports. An institution's "Measured Interest Rate Risk" (Measured IRR) will be expressed as the change that occurs in its NPV as a result of a hypothetical 200 basis point increase or decrease in interest rates (whichever leads to the lower NPV) divided by the estimated economic value (Present value) of its assets. An institution with a "normal" level of interest rate risk is defined as one whose Measured IRR is less than 2 percent, as estimated by the OTS Model. Only institutions whose Measured IRR exceed 2 percent will be required to maintain an IRR component. Based on Equity Bank's current levels of liquid assets and regulatory capital, management does not expect Equity Bank's interest rate risk component to have a material adverse effect on Equity Bank's regulatory capital level or its compliance with regulatory capital requirements, although there can be no assurance to this effect. Liquidity - The liquidity of Equity Bank has consistently been significantly in excess of regulatory liquidity requirements. Cash is normally invested in Federal Home Loan Bank ("FHLB") overnight deposits that earn a floating rate of interest. Equity Bank's cash and liquidity are monitored on a daily basis. A comparison of the required liquidity and actual liquidity is also performed on a daily basis. Additionally, Equity Bank, as an insured institution, is required to maintain cash and eligible liquid investments equal to at least 5% of net withdrawable deposits accounts and short term borrowings. Equity Bank's liquidity ratio, so calculated was 8.04% at December 31, 1993. For liquidity purposes, Equity Bank's mortgage-backed securities portfolio and FHLB stock are considered ineligible liquid investments. Based on a calculation considering these types of investments as eligible, Equity Bank's liquidity ratio would be approximately 49%. The primary liquid assets of Equity Bank consist of overnight and demand deposits and short-term investment securities. Funding Sources - Equity Bank has several significant sources of funding. The primary sources of funding are: internal operating revenues, including receipts of FSLIC assistance; loan repayments of interest and principal; new and current depositor activity; maturities of investments and sales of mortgage loans; FHLB advances based on the collateral value of Equity Bank's assets; and reverse repurchase debt based on the collateral value of new investments or mortgage-backed securities to be purchased. At December 31, 1993, deposits totaled approximately $332.5 million and had a weighted average interest rate of 3.50%; FHLB advances totaled approximately $87.7 million, had a weighted average interest rate of 3.59% and have maturities through 1998. The primary uses of cash and liquidity include the funding of loans, payments of interest on savings deposits, payments for savings withdrawals, payment of operating expenses and investing activity. During 1993, Equity Bank used approximately $14.6 million in operating activities, used $0.9 million in investing activities and used $7.8 million in financing activities, resulting in a net decrease in cash of $23.3 million. Net cash used in operating activities included $24.4 million net increase in loans and mortgage-backed securities held for sale offset by net income of $8.2 million (on a stand-alone basis). The net cash used by investing activities included purchases of mortgage-backed securities of $85.7 million offset by principle payments on loans and mortgage-backed securities, net of loan originations of $63.2 million and payment received for termination of the FSLIC Assistance Agreement of $14.2 million. The net cash used by financing activities included reductions in deposits of $3.5 million and a net reduction in borrowings of $4.1 million. At December 31, 1993, Equity Bank held $201.6 million of mortgage- backed securities held for investment. These investments were primarily financed with FHLB advances and reverse repurchase agreements. Risk Management - Equity Bank's management is dedicated to operating within prudent risk management policies and procedures. This includes the extension of credit to borrowers, investment purchases and liability funding. Equity Bank currently adheres to stringent loan underwriting procedures. Loans are made primarily within Equity Bank's geographical presence. All loans other than credit card loans currently generated for portfolio purposes are adjustable rate loans. A significant number of fixed-rate mortgage loans are made each month, but are sold to the secondary market normally within 90 to 120 days after origination. The total dollar amount of unsold fixed-rate mortgage loans is dictated and monitored by the Board of Directors. Investment purchases are approved by the Investment Committee of the Board of Directors based on the recommendations of management. Management utilizes an internal asset/liability modeling software system to analyze the current condition and matching of the balance sheet and potential investment purchases. The interest rate sensitivity of the balance sheet is monitored monthly. An upward or downward movement of interest rates of 400 basis points is projected each month to determine whether the sensitivity of assets and liabilities and the market valuation of portfolio equity is within the guidelines set forth by the Board of Directors. Equity Bank consistently operates within the approved risk limitations. Equity Bank's Asset/Liability Committee ("ALCO") is dedicated to maintaining the deposit base at the lowest cost of funds without significantly disturbing customer service. All sources and costs of funding are reviewed on a weekly basis. Proposed Sale of Equity Bank - As previously discussed, the Company and Fourth Financial have entered into the Acquisition Agreement,whereby the Company has agreed to the sale of Equity Bank , which constitutes the Financial Services Business of the Company, to Fourth Financial. Fourth Financial is to acquire all of the outstanding shares of capital stock of Equity Bank. Under the Acquisition Agreement, the Company is to acquire from Equity Bank (i) prior to the completion of the sale of Equity Bank under the Acquisition Agreement certain subsidiaries of Equity Bank ("Retained Corporations") that own the Transferred Assets contributed by the Company to Equity Bank at the time of the acquisition of the predecessor of Equity Bank by the Company for Equity Bank's carrying values of such Retained Corporations at the time of the acquisition of the Retained Corporations from Equity Bank, and (ii) at the time of the closing of the sale of Equity Bank under the Acquisition Agreement, the Equity Tower Loan and other real estate owned by Equity Bank that was acquired by Equity Bank through foreclosure ("OREO"), which have collectively been previously defined as the "Retained Assets". The Retained Assets are to be acquired for an amount equal to Equity Bank's carrying value of the Retained Assets at time of closing of the sale of Equity Bank. In addition, the Company has the option, but not the obligation, to acquire any loan owned by Equity Bank at book value or $1.00 in the case of a loan that has been charged off ("Other Loans"). The Company currently expects that the Purchase Price to be paid by Fourth Financial for Equity Bank will be approximately $92 million, subject to determination and adjustment in accordance with the Acquisition Agreement. . The Purchase Price is based on a number of estimates, and the amount of the Purchase Price will not be determined exactly until the closing of the sale of Equity Bank. See "Business - Recent Developments " for a discussion of the formula to determine the Purchase Price. Of the approximately $92 million, the Company will use approximately $65.4 million, plus interest, to repay a certain indebtedness the Company intends to incur to finance the purchase from Equity Bank of the Retained Corporations. In addition, the Company will use approximately $18.9 million (Equity Bank's carrying value at February 28, 1994) to purchase the Retained Assets. As of this date, the company has made no decision if it will acquire any of the Other Loans. The Company is further required under the Acquisition Agreement to purchase from Equity Bank at the closing of the proposed sale the outstanding amount of Receivables. As of March 31, 1994, Equity Bank owned $13.5 million of such Receivables. The Company plans to use borrowings from the Bank IV Line of Credit to purchase such Receivables from Equity Bank. Further, the Company will use the net balance of the Purchase Price, if any (after repaying the indebtedness incurred to purchase the Retained Corporations and paying for the Retained Assets and transactional costs relating to the sale of Equity Bank) for general working capital purposes. The sale of Equity Bank pursuant to the Acquisition Agreement is currently estimated to result in a pre-tax gain for financial reporting purposes for the Company of approximately $25.0 million, based upon the currently-expected Purchase Price of approximately $92 million. The exact amount of the Purchase Price will depend on certain factors at the time of closing, and, as a result, the pre-tax gain for financial reporting purposes could be higher or lower depending upon the ultimate amount of the Purchase Price. The Company's tax basis in Equity Bank is higher than its basis for financial reporting purposes. Under current federal income tax laws, the consummation of the Acquisition Agreement and the sale of Equity Bank will not have any federal income tax consequences to either the Company or to the shareholders of the Company. There are, however, certain proposed regulations which, if adopted by the Internal Revenue Service ("IRS") before the consummation of the sale of Equity Bank, could result in the Company having a gain for federal income tax purposes in connection with the sale of Equity Bank, but will not have any federal income tax effect on the shareholders of the Company. If the proposed regulations become effective prior to completion of the sale of Equity Bank, the Company has the right to terminate the Acquisition Agreement. As a federally chartered savings institution, the acquisition of Equity Bank by Fourth Financial is subject to regulatory approvals. The proposed sale of Equity Bank is also conditioned on, among other things, the affirmative vote of the holders of a majority of the outstanding voting stock, voting as a single class, of the Company. It is anticipated that the sale of Equity Bank will occur on or before June 30, 1994. See "Business - Recent Developments", "Business - Financial Service Business" and Note 1 to Notes to Consolidated Financial Statements. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------ ------------------------------------------- The Company has included the financial statements and supplementary financial information required by this item immediately following Part IV of this report and hereby incorporates by reference the relevant portions of those statements and information into this Item 8. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------ ----------------------------------------------------------------- FINANCIAL DISCLOSURE -------------------- No disagreements between the Company and its accountants have occurred within the 24-month period prior to the date of the Company's most recent financial statements. PART III -------- Item 10. Item 10. Directors and Executive Officers of the Company - ------- ----------------------------------------------- Directors. The Company's Certificate of Incorporation and Bylaws provide for the division of the Board of Directors into three classes, each class consisting (as nearly as possible) of one-third of the whole. The terms of office of one class of directors expires each year, with each class of directors being elected for a term of three years and until the shareholders or directors have elected or appointed their qualified successors. The Company's bylaws presently provide that the number of directors may consist of not less than three nor more than nine, and the Board of Directors presently has set the number of directors at nine. The following table sets forth the name, principal occupation, age, year in which the individual first became director, and year in which the director's term will expire. Name and First Became Term Principal Occupation a Director Expires Age - -------------------- ------------- ------- --- Raymond B. Ackerman (1) 1993 1996 71 Chairman Emeritus of Ackerman McQueen, Inc. Robert C. Brown, M.D. (2) 1969 1995 63 President of Northwest Internal Medicine Associates, Inc. Barry H. Golsen (3) 1981 1994 43 President of the Environmental Control Business of the Company Jack E. Golsen (4) 1969 1995 65 President and Chairman of the Board of Directors of the Company David R. Goss (5) 1971 1994 53 Senior Vice President - Operations of the Company Bernard G. Ille (6) 1971 1996 67 Investments Jerome D. Shaffer, M.D. (7) 1969 1994 77 Investments Tony M. Shelby (8) 1971 (8) 1996 52 Senior Vice President - Finance of the Company C.L. Thurman (9) 1969 1995 75 Investments - ---------------------------------- (1) Mr. Ackerman is retired. Prior to his retirement, he served for more than five years as President of Ackerman McQueen, Inc., which is a public relations and advertising firm, located in Oklahoma. (2) Dr. Brown has practiced medicine in Oklahoma City, Oklahoma for the past five years. (3) For the past five years, Barry H. Golsen has served as the President of the Company's Environmental Control Business. (4) Mr. Golsen has served in the same capacity with the Company for the past five years. (5) Mr. Goss, a certified public accountant, has served in substantially the same capacity with the Company for the past five years. (6) Mr. Ille has served as President and Chief Executive Officer of First Life Assurance Company ("First Life") since May, 1988, and on March 31, 1994, he retired from that position. In 1991, First Life was placed in conservatorship under the Oklahoma Department of Insurance and was sold on March 31, 1994. For more than five (5) years prior to that time, Mr. Ille also served as President of United Founders Life Insurance Company. Mr. Ille also serves as a director of Landmark Land Company Inc. ("Landmark") and served as a director of Landmark's wholly-owned savings and loan subsidiary. Such savings and loan subsidiary was placed in receivership in 1991 by the Federal Deposit Insurance Corporation while Mr. Ille served as a director. First Life was a subsidiary of Landmark until such was placed in conservatorship. (7) Dr. Shaffer retired from the practice of medicine in 1987. Prior to that time, Dr. Shaffer practiced medicine in Oklahoma City, Oklahoma, for more than five years. (8) Mr. Shelby, a certified public accountant, has served in substantially the same capacity with the Company during the past five years. (9) Prior to his retirement in September of 1987, Mr. Thurman served a s President of the industrial supply operations of the Company's Industrial Products Business for more than five years. Family Relationships. Jack E. Golsen is the father of Barry H. Golsen; Jack E. Golsen and Robert C. Brown, M.D., are brothers-in-law; and Robert C. Brown, M.D. is the uncle of Barry H. Golsen. Compliance with section 16(a) of the Exchange Act. Based solely on a review of copies of the Forms 3, 4 and 5 and amendments thereto furnished to the Company with respect to 1993, or written representations that no such reports were required to be filed with the Securities and Exchange Commission, the Company believes that during 1993 all directors and officers of the Company and beneficial owners of more than ten percent (10%) of any class of equity securities of the Company registered pursuant to Section 12 of the Exchange Act filed their required Forms 3, 4, or 5, as required by Section 16(a) of the Exchange Act on a timely basis, except that each of Sylvia H. Golsen and Raymond B. Ackerman filed late their respective Forms 3 relating to when Mrs. Golsen became the beneficial owner of more than 10% of the Company's common stock and when Mr. Ackerman was elected as a director of the Company; C.L. Thurman timely filed one Form 5 representing one late Form 4 relating to the exercise of three stock options; and, Michael D. Tepper timely filed one Form 5 representing one late Form 4 relating to three different transactions on the same day. Item 11. Item 11. Executive Compensation - ------- ---------------------- The following table shows the aggregate cash compensation which the Company and its subsidiaries paid or accrued to the Chief Executive Officer and each of the other four (4) most highly-paid executive officers of the Company (which includes the President of the Company's Environmental Control Business, who also serves as a director of the Company and who performs key policy making functions for the Company). The table includes cash distributed for services rendered during 1993, plus any cash distributed during 1993 for services rendered in a prior year, less any amount relating to those services previously included in the cash compensation table for a prior year. Summary Compensation Table -------------------------- Long-term Compen- sation Annual Compensation Awards ------------------- ------ Other All Annual Securities Other Compen- Underlying Compen- Name and Salary Bonus sation Stock sation Position Year ($) ($) ($)(2) Options ($) - ---------- ---- ------ ------ -------- ---------- ------ [S] [C] [C] [C] [C] [C] [C] Jack E. Golsen 1993 379,615 100,000 - - - Chairman of the 1992 359,395 160,000(1) - 50,000 - Board and Chief 1991 353,779 - - - - Executive Officer Barry H. Golsen 1993 165,000 60,000 - - - President of the 1992 168,671 100,000(1) - 10,000 - Environmental 1991 165,000 25,000 - - - Control Business David R. Goss 1993 142,000 60,000 - - - Senior Vice 1992 145,099 100,000(1) - 10,000 - President - 1991 142,000 25,000 - - 17,000(3) Operations Tony M. Shelby 1993 142,000 60,000 - - - Senior Vice 1992 144,975 100,000(1) - 10,000 20,000(3) President/Chief 1991 142,000 25,000 - - - Financial Officer David M. Shear 1993 111,846 30,000 - - - Vice President/ 1992 98,032 20,000 - 25,000 - General Council 1991 86,688 15,000 - - - [/TABLE] (1) Includes the following amounts paid in 1992 as bonuses for 1991: Jack E. Golsen - $60,000; Barry H. Golsen - $40,000; David R. Goss - $40,000; and Tony M. Shelby - $40,000. (2) Does not include perquisites and other personal benefits, securities or property for the named executive officer in any year if the aggregate amount of such compensation for such year does not exceed the lesser of either $50,000 or 10% of the total of annual salary and bonus reported for the named executive officer for such year. (3) In 1991, the Company paid to Messrs. Goss and Shelby an additional bonus of $17,000 and $20,000, respectively, which they returned to the Company in payment of a debt each owed to the Company. Option Grants in 1993. No stock options were granted by the Company to any named executive officer in 1993. Aggregated Option Exercises in 1993 and Fiscal Year End Option Values ------------------------------------- The following table sets forth information concerning each exercise of stock options by each of the named executive officers during the last fiscal year and the year-end value of unexercised options: Number of Value Securities of Unexercised Underlying In-the-Money Unexercised Options at Options at FY End FY End (#)(3) ($) (3) (4) -------------- ------------ Shares Acquired Value on Exercise Realized Exercisable/ Exercisable Name (#)(1) ($) (2) Unexercisable Unexercisable - -------------- ----------- --------- ------------- ------------ Jack E. Golsen 35,800 $ 290,201 175,000/ (5) $1,238,750/ 30,000 189,360 Barry H. Golsen 39,170 339,372 14,000/ 111,475/ 6,000 37,872 David R. Goss 184,500 1,654,687 5,000/ 38,375/ 6,000 39,750 Tony M. Shelby 196,650 1,777,706 5,000/ 38,375/ 6,000 39,750 David M. Shear 8,000 75,250 8,000/ 58,250/ 15,000 99,375 - -------------------------------- (1) Each number represents the number of shares received by the named individual upon exercise. (2) The values set forth in the columns below are between the market value of the Company's common stock on the date the particular option was exercised and the exercise price of such option. (3) The options granted under the Company's Plans become exercisable 20% after one year from date of grant, an additional 20% after two years, an additional 30% after three years, and the remaining 30% after four years. (4) The values are based on the price of the Company's common stock on the American Stock Exchange at the close of trading on December 31, 1993 of $9.75 per share. The actual value realized by a named executive on the exercise of these options depends on the market value of the Company's common stock on the date of exercise. (5) The amount shown includes 165,000 non-qualified stock options which vest and are exercisable on the date of grant. Other Plans. The Board of Directors has adopted an LSB Industries, Inc. Employee Savings Plan (the "401(k) Plan") for the employees (including executive officers) of the Company and its subsidiaries, excluding certain (but not all) employees covered under union agreements. The 401(k) Plan is an employee contribution plan, and the Company and its subsidiaries make no contributions to the 401(k) Plan. The amount that an employee may contribute to the 401(k) Plan equals a certain percentage of the employee's compensation, with the percentage based on the employee's income and certain other criteria as required under Section 401(k) of the Internal Revenue Code. The Company or subsidiary deducts the amounts contributed to the 401(k) Plan from the employee's compensation each pay period, in accordance with the employee's instructions, and pays the amount into the 401(k) Plan for the employee's benefit. The Summary Compensation Table set forth above includes any amount contributed and deferred during the 1993 fiscal year pursuant to the 401(k) Plan by the named executive officers of the Company. The Company has a death benefit plan for certain key employees. Under the plan, the designated beneficiary of an employee covered by the plan will receive a monthly benefit for a period of ten (10) years if the employee dies while in the employment of the Company or a wholly-owned subsidiary of the Company. The agreement with each employee provides, in addition to being subject to other terms and conditions set forth in the agreement, that the Company may terminate the agreement as to any employee at anytime prior to the employee's death. The Company has purchased life insurance on the life of each employee covered under the plan to provide, in large part, a source of funds for the Company's obligations under the Plan. The Company also will fund a portion of the benefits by investing the proceeds of a policy received by the Company upon the employee's death. The Company is the owner and sole beneficiary of the insurance policy, with the proceeds payable to the Company upon the death of the employee. The following table sets forth the amounts of annual benefits payable to the designated beneficiary or beneficiaries of the executive officers named in the Summary Compensation Table set forth above under the above-described death benefits plan. Amount of Name of Individual Annual Payment ------------------ -------------- Jack E. Golsen $175,000 Barry H. Golsen $ 30,000 David R. Goss $ 35,000 Tony M. Shelby $ 35,000 David M. Shear $ 0 In addition to the above-described plans, during 1991 the Company entered into a non-qualified arrangement with certain key employees of the Company and its subsidiaries to provide compensation to such individuals in the event that they are employed by the Company or a subsidiary of the Company at age 65. Under the plan, the employee will be eligible to receive for the life of such employee, a designated benefit as set forth in the plan. In addition, if prior to attaining the age 65 the employee dies while in the employment of the Company or a subsidiary of the Company, the designated beneficiary of the employee will receive a monthly benefit for a period of ten (10) years. The agreement with each employee provides, in addition to being subject to other terms and conditions set forth in the agreement, that the Company may terminate the agreement as to any employee at any time prior to the employee's death. The Company has purchased insurance on the life of each employee covered under the plan where the Company is the owner and sole beneficiary of the insurance policy, with the proceeds payable to the Company to provide a source of funds for the Company's obligations under the plan. The Company may also fund a portion of the benefits by investing the proceeds of such insurance policies. Under the terms of the plan, if the employee becomes disabled while in the employment of the company or a wholly-owned subsidiary of the Company, the employee may request the Company to cash-in any life insurance on the life of such employee purchased to fund the Company's obligations under the plan. Jack E. Golsen does not participate in the plan. The following table sets forth the amounts of annual benefits payable to the executive officers named in the Summary Compensation Table set forth above under such retirement plan. Amount of Name of Individual Annual Payment ------------------ -------------- Barry H. Golsen $17,480 David R. Goss $17,403 Tony M. Shelby $15,605 David M. Shear $17,822 Compensation of Directors. In 1993, the Company compensated each non- management director of the Company (with the exception of Raymond B. Ackerman) for his services in the amount of $4,500. The non-management directors of the Company also received $500 for every meeting of the Board of Directors attended during 1993. Each member of the Audit Committee, consisting of Messrs. Ille, Brown and Shaffer, also received an additional $20,000 for their services in 1993. The Company did not compensate the directors that also served as officers or employees of the Company or its subsidiaries for their services as directors. In addition, the Company paid C.L. Thurman $20,000 as compensation for his services as Chairperson of the Special Projects Committee of the Board of Directors for 1993. In September 1993, the company adopted the 1993 Non-Employee Director Stock Option Plan (the "Outside Director Plan"). The Outside Director Plan authorizes the grant of non-qualified stock options to each member of the Company's Board of Directors who is not an officer or employee of the Company or its subsidiaries. The maximum shares for which options may be issued under the Outside Director Plan will be 150,000 shares (subject to adjustment as provided in the Outside Director Plan). The Company shall automatically grant to each outside director an option to acquire 5,000 shares of the Company's common stock on April 30 following the end of each of the Company's fiscal years in which the Company realizes net income of $9.2 million or more for such fiscal year. The exercise price for an option granted under the Outside Director Plan shall be the fair market value of the shares of common stock at the time the option is granted. Each option granted under the Outside Director Plan, to the extent not exercised, shall terminate upon the earlier of the termination of the outside director as a member of the Company's Board of Directors or the fifth anniversary of the date such option was granted. No options are currently outstanding under the Outside Director Plan. Termination of Employment and Change in Control Arrangements. In 1989 and 1991, the Company entered into severance agreements with Jack E. Golsen, Barry H. Golsen, Tony M. Shelby, David R. Goss, David Shear and certain other executive officers of the Company and subsidiaries of the Company. Each severance agreement provides (among other things) that if, within twenty-four (24) months after the occurrence of a change in control (as defined) of the Company, the Company terminates the officer's employment other than for cause (as defined) or the officer terminates his employment for good reason (as defined) the Company must pay the officer an amount equal to 2.9 times the officer's base amount (as defined). The phrase "base amount" means the average annual gross compensation paid by the Company to the officer and includable in the officer's gross income during the period consisting of the most recent five (5) year period immediately preceding the change in control. If the officer has been employed by the Company for less than 5 years, the base amount is calculated with respect to the most recent number of taxable years ending before the change in control that the officer worked for the Company. The severance agreements provide that a "change in control" means a change in control of the Company of a nature that would require the filing of a Form 8-K with the Securities and Exchange Commission and, in any event, would mean when: (1) any individual, firm, corporation, entity or group (as defined in Section 13(d)(3) of the Securities Exchange Act of 1934, as amended) becomes the beneficial owner, directly or indirectly, of thirty percent (30%) or more of the combined voting power of the Company's outstanding voting securities having the right to vote for the election of directors, except acquisitions by: (a) any person, firm, corporation, entity or group which, as of the date of the severance agreement, has that ownership, or (b) Jack E. Golsen, his wife; his children and the spouses of his children; his estate; executor or administrator of any estate, guardian or custodian for Jack E. Golsen, his wife, his children, or the spouses of his children, any corporation, trust, partnership or other entity of which Jack E. Golsen, his wife, children, or the spouses of his children own at least eighty percent (80%) of the outstanding beneficial voting or equity interests, directly or indirectly, either by any one or more of the above-described persons, entities or estates; and certain affiliates and associates of any of the above- described persons, entities or estates; (2) individuals who, as of the date of the severance agreement, constitute the Board of Directors of the Company (the "Incumbent Board") and who cease for any reason to constitute a majority of the Board of Directors except that any person becoming a director subsequent to the date of the severance agreement, whose election or nomination for election is approved by a majority of the Incumbent Board (with certain limited exceptions), will constitute a member of the Incumbent Board; or (3) the sale by the Company of all or substantially all of its assets. The termination of an officer's employment with the Company "for cause" means termination because of: (a) the mental or physical disability from performing the officer's duties for a period of one hundred twenty (120) consecutive days or one hundred eighty days (even though not consecutive) within a three hundred sixty (360) day period; (b) the conviction of a felony; (c) the embezzlement by the officer of Company assets resulting in substantial personal enrichment of the officer at the expense of the Company; or (d) the willful failure (when not mentally or physically disabled) to follow a direct written order from the Company's Board of Directors within the reasonable scope of the officer's duties performed during the sixty (60) day period prior to the change of control. The termination of an officer's employment with the Company for "good reason" means termination because of (a) the assignment to the officer of duties inconsistent with the officer's position, authority, duties or responsibilities during the sixty (60) day period immediately preceding the change in control of the Company or any other action which results in the diminishment of those duties, position, authority, or responsibilities; (b) the relocation of the officer; (c) any purported termination by the Company of the officer's employment with the Company otherwise than as permitted by the severance agreement; or (d) in the event of a change in control of the Company, the failure of the successor or parent company to agree, in form and substance satisfactory to the officer, to assume (as to a successor) or guarantee (as to a parent) the severance agreement as if no change in control had occurred. Each severance agreement runs until the earlier of: (a) three years after the date of the severance agreement, or (b) the officer's normal retirement date from the Company. However, beginning on the first anniversary of the severance agreement and on each anniversary thereafter, the term of the severance agreement automatically extends for an additional one-year period, unless the Company gives notice otherwise at least sixty (60) days prior to the anniversary date. Compensation Committee Interlocks and Insider Participation. The Company's Executive Salary Review Committee has the authority to set the compensation of all officers of the Company, except the President, which the Board of Directors sets. This Committee generally considers and approves the recommendations of the President. The members of the Executive Salary Review Committee are the following non-management directors: Robert C. Brown, M.D., Jerome D. Shaffer, M.D., and Bernard G. Ille. During 1993, the Executive Salary Review Committee had one meeting. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Security Ownership of certain Beneficial Owners. The following table shows the total number and percentage of the outstanding shares of the Company's voting common stock and voting preferred stock beneficially owned as of April 15, 1994, with respect to each person (including any "group" as used in Section 13(d)(3) of the Securities Act of 1934, as amended) that the Company knows to have beneficial ownership of more than five percent (5%) of the Company's voting common stock and voting preferred stock. A person is deemed to be the beneficial owner of voting shares of Common Stock of the Company which he or she could acquire within sixty (60) days of April 1, 1994, such as upon the exercise of options. Because of the requirements of the Securities and Exchange Commission as to the method of determining the amount of shares an individual or entity may beneficially own, the amounts shown below for an individual or entity may include shares also considered beneficially owned by others. Amounts Name and Address Title of Shares Percent of of Beneficially of Beneficial Owner Class Owned(1) Class - ----------------- ------ ------------ ------- Jack E. Golsen and Common 4,038,645 (3)(5)(6) 27.8% members of his family(2) Voting Preferred 20,000 (4)(6) 92.3% - -------------------------------- (1) The Company based the information with respect to beneficial ownership on information furnished by the above-named individuals or entities or contained in filings made with the Securities and Exchange Commission or the Company's records. (2) Includes Jack E. Golsen and the following members of his family: wife, Sylvia H. Golsen; son, Barry H. Golsen (a director of the Company and President of several subsidiaries of the Company); son, Steven J. Golsen (Executive officer of several subsidiaries of the Company), and daughter, Linda F. Rappaport. The address of Jack E. Golsen, Sylvia H. Golsen and Linda F. Rappaport is 16 South Pennsylvania Avenue, Oklahoma City, Oklahoma 73107; Barry H. Golsen's address is 5000 S.W. Seventh Street, Oklahoma City, Oklahoma 73125; and Steven J. Golsen's address is 518 North Indiana Avenue, Oklahoma City, Oklahoma 73107. (3) Includes (a) the following shares that Jack E. Golsen ("J. Golsen") has the sole voting and investment power: (i) 89,028 shares that he owns of record, (ii) 165,000 shares that he has the right to acquire under a non-qualified stock option, (iii) 4,000 shares that he has the right to acquire upon conversion of a promissory note, (iv) 133,333 shares that he has the right to acquire upon the conversion of 4,000 shares of the Company's Series B 12% Cumulative Convertible Preferred Stock (the "Series B Preferred") owned of record by him, and (v) 10,000 shares that he has the right to acquire within the next sixty (60) days under the Company's stock option plans; (b) 1,295,184 shares owned of record by Sylvia H. Golsen, in which she and her husband, J. Golsen share voting and investment power; (c) 264,526 shares that Barry H. Golsen ("B Golsen") has the sole voting and investment power, 533 shares that he shares the voting and investment power with his wife that are owned of record by his wife, and 14,000 shares that he has the right to acquire within the next sixty (60) days under the Company's stock option plans; (d) 225,897 shares that Steven J. Golsen ("S. Golsen") has the sole voting and investment power and 14,000 shares that he has the right to acquire within the next sixty (60) days under the Company's stock option plans; (e) 145,460 shares held in trust for the grandchildren of Jack E. and Sylvia H. Golsen of which B. Golsen, S. Golsen an Linda F. Rappaport jointly or individually are trustees; (f) 82,552 shares owned of record by Linda F. Rappaport, which Mrs. Rappaport has the sole voting an investment power, and (g) 1,061,799 shares owned of record by Golsen Petroleum Corporation ("GPC) and 533,333 shares that GPC has the right to acquire upon conversion of 16,000 shares of Series B Preferred owned of record by GPC. GPC is wholly-owned by J. Golsen, Sylvia H. Golsen, B. Golsen, S. Golsen and Linda F. Rappaport, with each owning twenty percent (20%) of the outstanding stock of GPC, and as a result, GPC, J. Golsen, Sylvia H. Golsen, B. Golsen, S. Golsen, and Linda F. Rappaport share the voting and investment power of the shares beneficially owned by GPC. GPC's address is 16 South Pennsylvania Avenue, Oklahoma City, Oklahoma 73107. (4) Includes: (a) 4,000 shares of series B Preferred owned of record by J. Golsen, which he has the sole voting and investment power; and (b) 16,000 shares of Series B Preferred owned of record by GPC, in which GPC, J. Golsen, Sylvia H. Golsen, B. Golsen, S. Golsen and Linda F. Rappaport share the voting and investment power. (5) Does not include 144,260 shares of Common stock that Linda F. Rappaport's husband owns of record and 14,000 shares which he has the right to acquire within the next sixty (60) days under the Company's stock option plans, all of which Linda F. Rappaport disclaims beneficial ownership. (6) J. Golsen disclaims beneficial ownership of the shares that B. Golsen, S. Golsen and Linda F. Rappaport each have the sole voting and investment power over as noted in footnote (3) above. B. Golsen, S. Golsen and Linda F. Rappaport disclaim beneficial ownership of the shares that J. Golsen has the sole voting and investment power over as noted in footnotes (3) and (4) and the shares owned of record by Sylvia H. Golsen. Sylvia H. Golsen disclaims beneficial ownership of the shares that J. Golsen has the sole voting and investment power over as noted in footnotes (3) and (4) above. Security Ownership of Management. The following table sets forth information obtained from the directors of the Company and the directors and executive officers of the Company as a group as to their beneficial ownership of the Company's voting common stock and voting preferred stock as of April 1, 1994. Because of the requirements of the Securities and Exchange Commission as to the method of determining the amount of shares an individual or entity may own beneficially, the amount shown below for an individual may include shares also considered beneficially owned by others. Any shares of stock which a person does not own, but which he or she has the right to acquire within sixty (60) days of April 1, 1994 are deemed to be outstanding for the purpose of computing the percentage of outstanding stock of the class owned by such person but are not deemed to be outstanding for the purpose of computing the percentage of the class owned by any other person. Amounts of Shares Name of Title of Beneficially Percent of Beneficial Owner Class Owned Class - ---------------- ------- ------------ ---------- Raymond B. Ackerman Common 680 (2) * Robert C. Brown, M.D. Common 253,329 (3) 1.8% Barry H. Golsen Common 2,019,651 (4) 14.8% Voting Preferred 16,000 (4) 74.0% Jack E. Golsen Common 3,291,677 (5) 23.8% Voting Preferred 20,000 (5) 92.5% David R. Goss Common 266,477 (6) 1.9% Bernard G. Ille Common 125,000 (7) * Jerome D. Shaffer,M.D. Common 135,374 (8) 1.0% Tony M. Shelby Common 262,882 (9) 1.9% C.L. Thurman Common 66,833 (10) * Directors and Common 5,075,499 (11) 36.8% Executive Officers Voting Preferred 20,000 (11) 92.5% as a group(12 persons) - ------------------------------------------ * Less than 1%. (1) The Company based the information with respect to beneficial ownership on information furnished by each director or officer, contained in filings made with the Securities and Exchange Commission, or contained in the Company records. (2) Mr. Ackerman has sole voting and investment power of these shares, which shares are held in a trust in which Mr. Ackerman is both the settlor and the trustee and in which he hasthe vested interest in both the corpus and income. (3) The amount shown includes 65,000 shares of common stock that Dr. Brown may acquire pursuant to currently exercisable non-qualified stock options granted to him by the Company. The shares with respect to which Dr. Brown shares the voting and investment power consist of 117,516 shares owned by Dr. Brown's wife, 50,727 shares owned by Robert C. Brown, M.D., Inc., a corporation wholly-owned by Dr. Brown, and 20,086 shares held by the Robert C. Brown M.D., Inc. Employee Profit Sharing Plan, of which Dr. Brown serves as the trustee. The amount shown does not include 56,090 shares directly owned by the children of Dr. Brown, all of which Dr. Brown disclaims beneficial ownership. (4) See footnotes (3), (4), and (6) of the table under "Security Ownership of Certain Beneficial Owners and Management" of this Item for a description of the amount and nature of the shares beneficially owned by B. Golsen, including 14,000 shares B. Golsen has the right to acquire within sixty (60) days. (5) See footnotes (3), (4), and (6) of the table under "Security Ownership of Certain Beneficial Owners and Management" of this Item for a description of the amount and nature of the shares beneficially owned by J. Golsen, including the 10,000 shares J. Golsen has the right to acquire within sixty (60) days. (6) The amount shown includes 5,000 shares that he has the right to acquire within sixty (60) days pursuant to options granted under the Company's Incentive Stock Option Plans ("ISOs"), all of Mr. Goss has the sole voting and investment power. Mr. Goss shares voting and investment power over 2,429 shares owned by Mr. Goss's wife, individually and/or as custodian for Mr. Goss's children and has sole voting and investment power over the balance of the shares. (7) The amount includes 65,000 shares that Mr. Ille may purchase pursuant to currently exercisable non-qualified stock options, all of which Mr. Ille has the sole voting and investment power. Mr. Ille disclaims beneficial ownership of 60,000 shares owned by Mr. Ille's wife. (8) Dr. Shaffer has the sole voting and investment power over these shares, which includes 65,000 shares that Dr. Shaffer may purchase pursuant to currently exercisable non-qualified stock options. (9) Mr. Shelby has the sole voting and investment power over these shares, which include 5,000 shares that he has the right to acquire within sixty (60) days pursuant to options granted under the Company's ISOs. (10) Mr. Thurman has the sole voting and investment power over these shares. (11) The amount shown includes 489,380 shares of common stock that officers and directors, or entities controlled by officers and directors of the Company, have the right to acquire within sixty (60) days. Item 13. Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- A subsidiary of the Company, Hercules Energy Mfg. Corporation ("Hercules"), leases land and a building in Oklahoma City, Oklahoma from Mac Venture, Ltd. ("Mac Venture"), a limited partnership. GPC serves as the general partner of Mac Venture. The limited partners of Mac Venture include GPC and the three children of Jack E. Golsen. See "Security Ownership of Certain Beneficial Owners and Management", above, for a discussion of the stock ownership of GPC. The land leased by Hercules from Mac Venture consists of a total of 341,000 square feet, with 44,000 square feet in the building. Hercules leases the property from Mac Venture for $7,500 per month under a triple net lease which began as of January 1, 1982, and expires on December 31, 1998. Also, at January 1, 1991, GPC owed Hercules approximately $62,000 for purchases of oilfield equipment in prior years. Beginning in 1991, the balance of $62,000 was payable at the rate of $1,000 per month, and at March 31, 1994, $51,000 was owing by GPC to Hercules. At January 1, 1992, there were outstanding loans and advances to Tony M. Shelby of $105,000. $5,000 of such loans and advances were non-interest bearing. $100,000 of such loans and advances bears an annual rate of interest of 7.0%. During 1993, Mr. Shelby sold to the Company 9782 shares of the Company's common stock at market value at that time and used the proceeds in payment of such loan plus accrued interest. The market value of the shares transferred on the date transferred was $11.25 per share (aggregate $110,000). Prior to 1993 Equity made a loan to Douglas Barton which loan bears an annual rate of interest equal to the Citibank, N.A.'s prime rate plus 1.5%. As of June 30, 1993, Mr. Barton owed Equity the sum of $358,158 on this loan. This loan was secured by Mr. Barton's home in Carmel, California and 155,000 shares of Landmark Land Company common stock. This loan was paid in full in January 1994. The loan made by Equity to Mr. Barton was made in Equity's ordinary course of business and made on substantially the same terms, including interest rate and collateral, as those prevailing at the time for comparable transactions with other persons. Mr. Barton is the son of Gerald G. Barton, who the Company believed owned more than five percent of the Company's common stock from January 1, 1992 until March 1993, when he ceased, to the Company's knowledge, being an owner of record of more than five percent of any class of the Company's voting securities. Northwest Internal Medicine Associates, ("Northwest") a division of Plaza Medical Group., P.C., has an agreement with the Company to perform medical examinations of the management and supervisory personnel of the Company and its subsidiaries. Under such agreement, Northwest is paid $4,000 a month to perform all such examinations. Dr. Robert C. Brown (a director of the Company) is a co-owner of Plaza Medical Group., P.C. In 1983, LSB Chemical Corp. ("LSB Chemical"), a subsidiary of the Company, acquired all of the outstanding stock of El Dorado Chemical Company ("EDC") from its then four stockholders ("Ex-Stockholders"). A substantial portion of the purchase price consisted of an earnout based primarily on the annual after-tax earnings of EDC for a ten-year period. During 1989, two of the Ex-Stockholders received LSB Chemical promissory notes for a portion of their earnout, in lieu of cash, totaling approximately $896,000, payable $496,000 in January, 1990, and $400,000 in May, 1994. LSB Chemical agreed to a buyout of the balance of the earnout from the four Ex-Stockholders for an aggregate purchase amount of $1,231,000. LSB Chemical purchased for cash the earnout from two of the Ex-Stockholders and issued multi-year promissory notes totaling $676,000 to the other two Ex-Stockholders. Jack E. Golsen guaranteed LSB Chemical's payment obligation under the promissory notes, which is $400,000 at March 31, 1994. At the request of a lender to the Company and several of its subsidiaries, during the first half of 1992, Jack E. Golsen guaranteed the repayment of a term loan in the original principal amount of $2,000,000 made by such lender to several subsidiaries of the Company. This loan was repaid by the Company in May, 1993. PART IV ------- Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - ------- ---------------------------------------------------------------- (a) (1) Financial Statements. The following consolidated financial statements of the Company appear immediately following this Part IV: Pages --------------- Report of Independent Auditors Consolidated Balance Sheets at December 31, 1993 and 1992 to Consolidated Statements of Operations for each of the three years in the period ended December 31, 1993 Consolidated Statements of Non-redeemable Preferred Stock, Common Stock and Other Stockholders' Equity for each of the three years in the period ended December 31, 1993 to Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 to Notes to Consolidated Financial Statements to Quarterly Financial Data (Unaudited) to (a)(2) Financial Statement Schedules. The Company has included the following schedules in this report: Pages ---------------- II - Amounts Receivable from Employees III - Condensed Financial Information of Registrant to VIII - Valuation and Qualifying Accounts X - Supplementary Statement of Operations Information The Company has omitted all other schedules because the conditions requiring their filing do not exist or because the required information appears in the Company's Consolidated Financial Statements, including the notes to those statements. (a)(3) Exhibits. The Company has filed the following exhibits with this report: 2.1 Stock Purchase Agreement dated as of February 9, 1994, between Fourth Financial Corporation, the Company and Prime Financial Corporation ("Stock Purchase Agreement"), which the Company hereby incorporates by reference from Exhibit A to the Company's Proxy Statement, dated March 22, 1994 and filed with the Commission on March 23, 1994. A copy of the schedules and exhibits to the Stock Purchase Agreement will be furnished supplementally to the Commission upon request. 3.1. Restated Certificate of Incorporation, and the Certificate of Designation dated February 17, 1989, which the Company hereby incorporates by reference from Exhibit 3.01 to the Company's Form 10-K for fiscal year ended December 31, 1989. 3.2. Bylaws, as amended, which the Company hereby incorporates by reference from Exhibit 3.02 to the Company's form 10-K for fiscal year ended December 31, 1990. 4.1. Loan Agreement and Accounts Receivable Security Agreement, Security Agreement, General Security Agreement, Guarantee and Waivers, Letter of Credit Purchase Guarantee Supplement, Pledge and Security Agreement, Trademark and Patent Security Agreement and Subordination Agreement, dated March 29, 1984, among the Company, certain subsidiaries of the Company, and Congress Financial Corporation ("Congress"), which the Company hereby incorporates by reference from Exhibits 10(e), 10(f), 10(h), 10(i), 10(j), 10(k) and 10(l) to the Company's Form 10-K for the fiscal year ended December 31, 1983. 4.2. Amendment to Loan Agreement and Pledge and Security Agreement, dated August 16, 1985, among the Company, Friedrich Climate Master, Inc. ("FCM"), certain other subsidiaries of the Company, and Congress, which the Company hereby incorporates by reference from Exhibits 4.1 and 4.2 to the Company's Form 8-K, dated August 16, 1985. 4.3. Letter Agreement, Trademark and Patent Security Agreement and Guarantee and Waiver, dated August 16, 1985, between FCM and Congress, which the Company hereby incorporates by reference from Exhibits 4.2, 4.3, 4.4 and 4.5 to the Company's Form 8-K, dated August 16, 1985. 4.4. Modification, dated March 14, 1986, to Loan Agreement among Congress, the Company, and certain of the Company's subsidiaries, which the Company hereby incorporates by reference from Exhibit 4.5 to the Company's Form 10-K for the fiscal year ended December 31, 1985. 4.5. Second Amendment to Loan Agreement, dated April 3, 1986, among Congress, the Company, and certain subsidiaries of the Company, which the Company hereby incorporates by reference from Exhibit 19.1 to the Company's Form 10-Q for the quarter ended March 31, 1986. 4.6. Third and Fourth Amendments to Loan Agreement, dated October 26, 1986, and December 17, 1986, among Congress, the Company, and certain subsidiaries of the Company, which the Company hereby incorporates by reference from Exhibits 4.31 and 4.32 to the Company's Registration Statement No. 33-9848. 4.7. Specimen Certificate for the Company's Non-cumulative Preferred Stock, having a par value of $100 per share, which the Company hereby incorporates by reference from Exhibit 4.1 to the Company's Form 10-Q for the quarter ended June 30, 1983. 4.8. Specimen Certificate for the Company's Series B Preferred Stock, having a par value of $100 per share, which the Company hereby incorporates by reference from Exhibit 4.27 to the Company's Registration Statement No. 33-9848. 4.9 Specimen Certificate for the Company's Series 2 Preferred Stock, which the Company hereby incorporates by reference from Exhibit 4.5 to the Company's Registration Statement No. 33-61640 4.10. Rights Agreement, dated as of February 17, 1989, between the Company and The Liberty National Bank and Trust Company of Oklahoma City, which the Company hereby incorporates by reference from Exhibit 2.1 to the Company's Form 8-A Registration Statement dated February 22, 1989. 4.11. Fifth Amendment to Loan Agreement, dated May 7, 1988, among Congress, the Company, and certain subsidiaries of the Company which the Company hereby incorporates by reference from Exhibit 4.16 to the Company's Form 10-K for the year ended December 31, 1987. 4.12. Sixth Amendment to Loan Agreement, dated March 31, 1989, among Congress, the Company, and certain subsidiaries of the Company which the Company hereby incorporates by reference from Exhibit 4.17 to the Company's Form 10-K for the year ended December 31, 1988. 4.13. Amended and Restated Secured Credit Agreement, dated as of January 21, 1992, between El Dorado Chemical Company ("EDC"), Slurry Explosive Corporation ("Slurry"), Household Commercial Financial Services, Inc. ("Household"), Connecticut Mutual Life Insurance Company ("CML") and CM Life Insurance Company which the Company hereby incorporates by reference from Exhibit 4.15 to the Company's form 10K for the year ended December 31,1991. The agreement contains a list of schedules and exhibits omitted from the filed copy and the Company agrees to furnish supplementally a copy of any of the omitted schedules or exhibits to the Commission upon request. 4.14. Second Amended and Restated Working Capital Loan Agreement, dated as of January 21, 1992, between EDC, Slurry and Household which the Company hereby incorporates by reference from Exhibit 4.16 to the Company's Form 10K for the year ended December 31, 1991. The agreement contains a list of schedules and exhibits omitted from the filed copy and the Company agrees to furnish supplementally a copy of any of the omitted schedules or exhibits to the Commission upon request. 4.15. Seventh Amendment to Loan Agreement, dated May 18, 1990, between Congress Financial Corporation ("Congress"), LSB Industries, Inc. ("LSB") and other subsidiaries of LSB, which the Company hereby incorporates by reference from Exhibit 28.14 to the Company's Form 10-Q for the quarter ended June 30, 1990. 4.16. Eighth and Ninth Amendments to Loan Agreement, dated May 1, 1991, and February 25, 1992, respectively between Congress, LSB and other subsidiaries of LSB which the Company hereby incorporates by reference from Exhibit 4.18 to the Company's Form 10K for the year ended December 31, 1991. 4.17 Tenth Amendment to Loan Agreement, dated March 31, 1992 and Eleventh Amendment to Loan Agreement, dated December 10, 1992 between Congress, the Company and certain subsidiaries of the Company which the Company hereby incorporates by reference from Exhibit 4.18 to the Company's Registration Statement No. 33-55608. 4.18 First Amendment to the Second Amended and Restated Working Capital Loan Agreement, dated December 9, 1992, between El Dorado Chemical Company and Household Commercial Financial Services, Inc., which the Company hereby incorporates by reference from Exhibit 4.21 to the Company's Registration Statement No. 33-55608. 4.19 First Amendment to the Amended and Restated Secured Credit Agreement, dated December 9, 1992, between El Dorado Chemical Company, Slurry Explosive Corporation, Household Commercial Financial Services Inc., Connecticut Mutual Insurance Company and C.M. Life Insurance Company, which the Company hereby incorporates by reference from Exhibit 4.22 to the Company's Registration Statement No. 33-55608. 4.20 Consent Agreement, dated December 9, 1992, between El Dorado Chemical Company and Household Commercial Financial Services, Inc., which the Company hereby incorporates by reference from Exhibit 4.23 to the Company's Registration Statement No. 33-55608. 4.21 First Amendment to Lease Agreements, made and entered into effective December 10, 1992 between Chemical Plant Venture, Chemical Plant Venture II and El Dorado Chemical Company, which the Company hereby incorporates by reference from Exhibit 28.15 to the Company's Registration Statement No. 33-55608. 4.22. Twelfth Amendment to Loan Agreement, dated April 23, 1993, Thirteenth Amendment to Loan Agreement, dated June 24, 1993; Fourteenth Amendment to Loan Agreement, dated September 23, 1993; Fifteenth Amendment to Loan Agreement, date November 29, 1993; Sixteenth Amendment to Loan Agreement, dated January 25, 1994; and Seventeenth Amendment to Loan Agreement dated March 30, 1994 between Congress, the Company and certain subsidiaries of the Company. 4.23 Amendment Agreement, dated as of March 30, 1994, among El Dorado Chemical Company, Slurry Explosive Corporation, Household Commercial Financial Services, Inc., and Prime Financial Corporation. 10.1. Form of Death Benefit Plan Agreement between the Company and the employees covered under the plan, which the Company hereby incorporates by reference from Exhibit 10(c)(1) to the Company's Form 10-K for the year ended December 31, 1980. 10.2. The Company's 1981 Incentive Stock Option Plan, as amended, and 1986 Incentive Stock Option Plan, which the Company hereby incorporates by reference from Exhibits 10.1 and 10.2 to the Company's Registration Statement No. 33-8302. 10.3. Form of Incentive Stock Option Agreement between the Company and employees as to the Company's 1981 Incentive Stock Option Plan, which the Company hereby incorporates by reference from Exhibit 10.10 to the Company's Form 10-K for the fiscal year ended December 31, 1984. 10.4. Form of Incentive Stock Option Agreement between the Company and employees as to the Company's 1986 Incentive Stock Option Plan, which the Company hereby incorporates by reference from Exhibit 10.6 to the Company's Registration Statement No. 33-9848. 10.5. The 1987 Amendments to the Company's 1981 Incentive Stock Option Plan and 1986 Incentive Stock Option Plan, which the Company hereby incorporates by reference from Exhibit 10.7 to the Company's Form 10-K for the fiscal year ended December 31, 1986. 10.6 1993 Stock Option and Incentive Plan. 10.7 1993 Non-employee Director Stock Option Plan. 10.8. Union Contracts, dated August 1, 1992, between EDC and the Oil, Chemical and Atomic Workers, United Steel Workers of America, United Mine Workers and the International Association of Machinists and Aerospace Workers. 10.9. Lease Agreement, dated March 26, 1982, between Mac Venture, Ltd. and HEC, which the Company hereby incorporates by reference from Exhibit 10.32 to the Company's Form 10-K for the fiscal year ended December 31, 1981. 10.10. Agreement, dated March 1, 1991, between El Dorado Chemical Company and Farmland Industries, Inc., which the Company hereby incorporates by reference from Exhibit 10.09 to the Company's Form 10-K for the fiscal year ended December 31, 1990. 10.11. Non-qualified Stock Option Agreement, dated April 26, 1990, between the Company and Robert C. Brown, M.D., which the Company hereby incorporates by reference from Exhibit 10.10 to the Company's Form 10-K for the fiscal year ended December 31, 1990. The Company entered into substantially identical agreements with Bernard G. Ille, Jerome Shaffer and C.L. Thurman, and the Company will provide copies thereof to the Commission upon request. 10.12. Non-qualified Stock Option Agreement, dated November 19, 1987, between the Company and C.L. Thurman, which the Company hereby incorporates by reference from Exhibit 10.25 to the Company's Form 10-K for the fiscal year ended December 31, 1987. The Company entered into substantially identical agreements with Jerome D. Shaffer, Bernard G. Ille, and Robert C. Brown and the Company will provide copies thereof to the Commission upon request. 10.13. Undertaking, dated March 7, 1988, executed by Northwest Federal and Northwest Financial in favor of the Company, Prime, and the Company's other subsidiaries and affiliates, which the Company hereby incorporates by reference from Exhibit 28.01 to the Company's Form 8-K, dated March 7, 1988. 10.14. Agreement, dated March 7, 1988, between the Company and Northwest Federal, which the Company hereby incorporates by reference from Exhibit 28.03 to the Company's Form 8-K, dated March 7, 1988. 10.15. Lease Agreement, dated March 7, 1988, between Northwest Financial and the Company, which the Company hereby incorporates by reference from Exhibit 28.04 to the Company's Form 8-K, dated March 7, 1988. Rotex, Summit and Tribonetics entered into substantially identical agreements, with the only differences being the parties to the agreements, the property covered by the agreement, and the amount of the annual rental set forth in the agreement and the Company will provide copies thereof to the Commission upon request. 10.16. Lease Agreement, dated March 7, 1988, between Northwest Financial and IEC, which the Company hereby incorporates by reference from Exhibit 28.05 to the Company's Form 8-K, dated March 7, 1988. The filed copy omits Exhibit B to the Lease Agreement, which the Company undertakes to furnish supplementally to the Commission upon request. 10.17. Assignment of Lease, dated March 7, 1988, executed by IEC in favor of Northwest Federal, which the Company hereby incorporates by reference from Exhibit 28.06 to the Company's Form 8-K, dated March 7, 1988. 10.18. Lease Agreement, dated March 7, 1988, between Northwest Financial and El Dorado Chemical Company, which the Company hereby incorporates by reference from Exhibit 28.07 to the Company's Form 8-K, dated March 7, 1988. Northwest Financial and EDC entered into 15 substantially identical lease agreements covering the real properties discussed under Item 2 of this report, with the only differences being the specific real property covered and the amount of the annual rental specified in the agreement and the Company will provide copies thereof to the Commission upon request. 10.19. Assignment and Agreement to Sublease, dated March 7, 1988, between EDC and Northwest Financial, which the Company hereby incorporates by reference from Exhibit 28.08 to the Company's Form 8-K, dated March 7, 1988. 10.20. Dividend Limitation Stipulation, dated January 6, 1989, executed by the Company, Northwest Federal Savings and Loan Association, and Prime Financial Corporation, which the Company hereby incorporates by reference from Exhibit 28.02 to the Company's Form 8-K, dated December 30, 1988. 10.21. Lease Agreement dated November 12, 1987, between Climate Master, Inc. and West Point Company and amendments thereto, which the Company hereby incorporates by reference from Exhibits 10.32, 10.36, and 10.37, to the Company's Form 10-K for fiscal year ended December 31, 1988. 10.22. Severance Agreement, dated January 17, 1989, between the Company and Jack E. Golsen, which the Company hereby incorporates by reference from Exhibit 10.48 from Form 10-K for fiscal year ended December 31, 1988. The Company also entered into identical agreements with Tony M. Shelby, David R. Goss, Michael Tepper, and Barr H. Golsen and the Company will provide copies thereof to the Commission upon request. 10.23. Third Amendment to Lease Agreement, dated as of December 31, 1987, between Mac Venture, Ltd. and Hercules Energy Mfg. Corporation, which the Company hereby incorporates by reference from Exhibit 10.49 to the Company's Form 10-K for fiscal year ended December 31, 1988. 10.24. Option to Purchase Real Estate, dated January 4, 1989, between Northwest Financial Corporation and Northwest Tower Limited Partnership, which the Company hereby incorporates by reference from Exhibit 10.50 to the Company's Form 10-K for fiscal year ended December 31, 1988. 10.25. Agreement for Purchase of Receivables, dated March 31, 1989, between Equity Bank and Summit Machine Tool Manufacturing Corp, which the Company hereby incorporates by reference from Exhibit 10.54 to the Company's Form 10-K for fiscal year end December 31, 1988. The following subsidiaries of the Company entered into identical agreements with Northwest Federal: Climate Master, Inc.; El Dorado Chemical Company; Hercules Energy Mfg. Corporation; International Environmental Corporation; and L & S Bearing Co.and the Company will provide copies thereof to the Commission upon request. 10.26. Chemical Plant Venture Agreement between Northwest Financial Corporation and LSB Chemical Corp., dated April 1, 1989, which the Company hereby incorporates by reference from Exhibit 10.26 to the Company's Form 10-K for fiscal year ended December 31, 1990. This Agreement contains a list of exhibits and schedules omitted from the filed copy, and the Company undertakes to furnish supplementally a copy of any of the omitted schedules or exhibits to the Commission upon request. 10.27. Chemical Plant Venture II Agreement between Northwest Capital Corporation and LSB Chemical Corp., dated as of December 31, 1991 which the Company hereby incorporates by reference from Exhibit 10.28 to the Company's Form 10K for fiscal year ended December 31, 1991. This agreement contains a list of exhibits and schedules omitted from the filed copy, and the Company undertakes to furnish supplementally a copy of any of the omitted schedules or exhibits to the Commission upon request. 10.28 Technical License, Technology Assistance, Engineering and Manufacturing Plant sales Agreement between L&S Automotive Products Company, Inc. and ZVL-ZKL A.S., dated July 6, 1992, as amended by Addendums, which the Company hereby incorporates by reference from Exhibit 28.1 to the Company's Form 10-Q for the quarter ended September 30, 1992. 10.29 Letter, dated November 9, 1992, amending the agreement between L&S Automotive Products Co. and ZVL-ZKL A.S., which the Company hereby incorporates by reference from Exhibit 28.2 to the Company's Registration Statement No. 33-55608. 10.30 Supply Agreement, dated November 4, 1992, between Climate Master, Inc. and Carrier Corporation,,which the Company hereby incorporates by reference from Exhibit 28.3 to the Company's Registration Statement No. 33-55608. 10.31 Right of First Refusal, dated November 4, 1992, between the Company, Climate Master, Inc. and Carrier Corporation, which the Company hereby incorporates by reference from Exhibit 28.4 to the Company's Registration Statement No. 33-55608. 10.32 Fixed Assets Purchase Parts Purchase and Asset Consignment Agreement, dated November 4, 1992, between Climate Master, Inc. and Carrier Corporation, which the Company hereby incorporates by reference from Exhibit 28.5 to the Company's Registration Statement No. 33-55608. 10.33 Amendment to Lease Agreements, made and entered into effective December 10, 1992, between Chemical Plant Venture, Chemical Plant Venture II and El Dorado Chemical Company, which the Company hereby incorporates by reference from Exhibit 28.9 to the Company's Registration Statement No. 33-55608. 10.34 Agreement for Purchase and Sale of Property, made and entered into effective December 10, 1992, between Chemical Plant Venture, Chemical Plant Venture II and El Dorado Chemical Company, which the Company hereby incorporates by reference from Exhibit 28.10 to the Company's Registration Statement No. 33-55608. 10.35 Letter, dated November 20, 1992, from the Office of Thrift Supervision to Equity Bank for Savings, F.A., which the Company hereby incorporates by reference from Exhibit 28.11 to the Company's Registration Statement No. 33-55608. 10.36 Agreement between Monsanto Company and El Dorado Chemical Company, which the Company hereby incorporates by reference from Exhibit 28.12 to the Company's Registration Statement No. 33-55608. 10.37 Non-Qualified Stock Option Agreement, dated June 1, 1992, between the Company and Robert C. Brown, M.D. The Company entered into substantially identical agreements with Bernard G. Ille, Jerome D. Shaffer and C.L.Thurman, and the Company will provide copies thereof to the Commission upon request. 10.38 Loan Agreement, dated as of March 30, 1994, by and between Prime Financial Corporation, an Okklahoma corporation and Bank IV Oklahoma, N.A., a national banking association. 10.38 Guaranty Agreement, dated as of March 30, 1994, by and between LSB Industries, Inc. as Guarantor and Bank IV Oklahoma, N.A. as Lender. 11.1. Statement re: Computation of Per Share Earnings. 22.1. Subsidiaries of the Company 24.1. Consent of Independent Auditors (b) Reports on Form 8-K. The Company filed a report on Form 8-K during the fourth quarter of 1993 concerning the proposed sale of Equity Bank. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Company has caused the undersigned, duly-authorized, to sign this report on its behalf of this 13th day of April, 1994. LSB INDUSTRIES, INC. By:/s/ Jack E. Golsen ---------------------------------- Jack E. Golsen Chairman of the Board and President (Principal Executive Officer) By:/s/ Tony M. Shelby ---------------------------------- Tony M. Shelby Senior Vice President of Finance (Principal Financial Officer) By:/s/ Jim D. Jones --------------------------------- Jim D. Jones Vice President, Controller and Treasurer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the undersigned have signed this report on behalf of the Company, in the capacities and on the dates indicated. Dated: April 13, 1994 By:/s/ Jack E. Golsen -------------------------------- Jack E. Golsen, Director Dated: April 13, 1994 By:/s/ Tony M. Shelby -------------------------------- Tony M. Shelby, Director Dated: April 13, 1994 By: -------------------------------- David R. Goss, Director Dated: April 13, 1994 By:/s/ Barry H. Golsen -------------------------------- Barry H. Golsen, Director Dated: April 13, 1994 By: -------------------------------- C. L. Thurman, Director Dated: April 13, 1994 By:/s/ Robert C. Brown -------------------------------- Robert C. Brown, Director Dated: April 13, 1994 By:/s/ Bernard G. Ille -------------------------------- Bernard G. Ille, Director Dated: April 13, 1994 By:/s/ Jerome D. Shaffer -------------------------------- Jerome D. Shaffer, Director Dated: April 13, 1994 By:/s/ Raymond B. Ackerman -------------------------------- Raymond B. Ackerman, Director Report of Independent Auditors The Board of Directors and Stockholders LSB Industries, Inc. We have audited the accompanying consolidated balance sheets of LSB Industries, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, non-redeemable preferred stock, common stock and other stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a)(2). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of LSB Industries, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Oklahoma City, Oklahoma March 15, 1994 LSB Industries, Inc. Consolidated Balance Sheets December 31, 1993 1992 ------------------------------ (In Thousands) Assets Cash and cash equivalents $ 11,687 $ 33,271 Trade accounts receivable, less allowance for doubtful accounts of $2,583,000 in 1993 and $3,082,000 in 1992 49,533 36,050 Loans held for sale 18,574 6,358 Mortgage-backed securities held for sale 13,946 Loans receivable, including related accrued interest receivable, net (Note 5) 124,060 119,278 Mortgage-backed securities held for investment, including related accrued interest receivable (Note 5) 202,723 175,427 Other securities held for investment 7,806 7,010 Inventories 48,384 48,373 FSLIC receivables and assets covered by assistance (Note 4) 52,004 Supplies and prepaid items 5,459 4,134 Foreclosed real estate (Note 5) 19,262 15,151 Property, plant and equipment, net 65,670 58,049 Excess of purchase price over net assets acquired, net of accumulated amortization of $15,470,000 in 1993 and $10,777,000 in 1992 (Notes 3 and 4) 22,184 19,866 Other assets 8,224 7,277 ----------------------- $597,512 $582,248 ======================= December 31, 1993 1992 ------------------------ (In Thousands) Liabilities, preferred and common stocks and other stockholders equity Liabilities: Deposits (Note 5) $332,511 $336,053 Accounts payable 22,645 18,906 Drafts payable 1,220 4,549 Securities sold under agreements to repurchase 38,721 50,344 Payable to FSLIC (Note 4) - 9,107 Billings in excess of costs and estimated earnings - 4,858 Accrued liabilities 9,444 9,458 Federal Home Loan Bank advances (Note 5) 87,650 80,150 Long-term debt (Note 9) 30,295 50,321 ---------------------- Total liabilities 522,486 563,746 Commitments and contingencies (Note 14) Redeemable, noncumulative, convertible preferred stock, $100 par value; 1,660 shares issued and outstanding (1,772 in 1992) (Note 12) 155 163 Non-redeemable preferred stock, common stock and other stockholders equity (Notes 9, 11 and 12): Series B 12% cumulative, convertible preferred stock, $100 par value; 20,000 shares issued and outstanding 2,000 2,000 Series 1 $2.20 convertible, exchangeable Class C preferred stock, $20 stated value; 767,832 shares issued in 1992 - 15,357 Series 2 $3.25 convertible, exchangeable Class C preferred stock, $50 stated value; 920,000 shares issued in 1993 46,000 - Common stock, $.10 par value; 75,000,000 shares authorized, 14,514,056 shares issued (8,097,532 in 1992) 1,451 810 Capital in excess of par value 37,120 21,978 Accumulated deficit (7,541) (17,227) ---------------------- 79,030 22,918 Less treasury stock, at cost: Common stock, 840,085 shares (703,855 in 1992) 4,159 2,699 Series 1 $2.20 convertible, exchangeable Class C preferred stock, 104,682 shares in 1992 - 1,880 --------------------- Total non-redeemable preferred stock, common stock and other stockholders equity 74,871 18,339 --------------------- $597,512 $582,248 ===================== See accompanying notes. LSB Industries, Inc. Consolidated Statements of Operations Year ended December 31, 1993 1992 1991 ------------------------------ (In Thousands, Except Per Share Amounts) Revenues: Net sales $232,616 $198,373 $177,035 Interest on loans and investments 27,761 32,205 40,548 Credit card and other 16,217 15,269 13,167 FSLIC interest and yield maintenance - 936 3,441 ------------------------------------ 276,594 246,783 234,191 Costs and expenses: Cost of sales 174,504 146,391 136,258 Selling, general and administrative: Financial services 21,549 22,282 21,702 Nonfinancial services 43,864 37,476 36,560 Interest: Deposits 12,505 16,445 23,144 Long-term debt and other 9,517 13,194 16,142 Provision for loan losses (Note 5) 1,382 1,224 1,335 ----------------------------------- 263,321 237,012 235,141 Income (loss) before provision for ----------------------------------- income taxes 13,273 9,771 (950) Provision for income taxes (Note 10) 874 516 197 ---------------------------------- Net income (loss) $ 12,399 $ 9,255 $ (1,147) ================================== Net income (loss) applicable to common stock $ 10,357 $ 7,428 $ (3,090) ================================== Net income (loss) per common share: Primary $.77 $.94 $(.48) ================================== Fully diluted $.71 $.66 $(.48) ================================== See accompanying notes. LSB Industries, Inc. Consolidated Statements of Non-redeemable Preferred Stock, Common Stock and Other Stockholders' Equity (Continued on following page) LSB Industries, Inc. Consolidated Statements of Non-redeemable Preferred Stock, Common Stock and other Stockholders' Equity (continued) See accompanying notes. LSB Industries, Inc. Consolidated Statements of Cash Flows Year ended December 31, 1993 1992 1991 -------------------------------- (In Thousands) Cash flows from operations Net income (loss) $12,399 $ 9,255 $ (1,147) Adjustments to reconcile net income (loss) to cash flows provided (absorbed) by operations: Depreciation, depletion and amortization: Property, plant and equipment 6,549 6,588 6,284 Goodwill 4,693 2,318 2,355 Other, primarily premiums on loans and mortgage-backed securities 2,895 2,971 890 Provisions for losses: Trade accounts receivable 439 972 1,567 Loans and real estate 1,382 1,374 1,335 Accretion of interest expense on payable to FSLIC - 829 745 Net decrease (increase) in loans and mortgage-backed securities held for sale (24,547) 2,511 1,784 Net gain on sales of assets (3,574) (2,524) (3,295) FHLB stock dividends - (263) (578) Cash provided (used) by changes in assets and liabilities, before acquisitions: Trade accounts receivable (12,304) (3,980) 17,844 Inventories 2,348 (6,332) 3,329 FSLIC receivables - 5,510 8,039 Supplies and prepaid items (1,282) 414 (4,093) Other assets (1,237) 927 1,032 Accounts payable (718) (277) 1,193 Billings in excess of costs and estimated earnings (4,858) 4,858 - Accrued liabilities (759) (785) (134) Cash flows provided (absorbed) by ------------------------------------ operations (18,574) 24,366 37,150 Cash flows from investing activities Net loan originations and principal payments on loans 6,901 8,052 9,682 Principal payments on mortgage-backed securities 56,556 61,984 23,049 Purchases of mortgage-backed securities (85,718) (56,909) (114,224) Proceeds from covered asset reductions - 14,401 15,450 Proceeds from sales and maturities of investment securities 325 2,647 1,295 Purchases of investment securities (1,168) (300) (668) Capital expenditures (10,541) (5,345) (3,919) Sales of properties, equipment and real estate owned 6,656 1,176 1,975 Proceeds from termination of Assistance Agreement 14,169 - - Cash and cash equivalents acquired in connection with acquisitions 1,228 55 - Payments for acquisitions (1,747) (140) - Cash flows provided by (used in) ------------------------------------ investing activities (13,339) 25,621 (67,360) (Continued on following page) LSB Industries, Inc. Consolidated Statements of Cash Flows (continued) Year ended December 31, 1993 1992 1991 ------------------------------------ (In Thousands) Cash flows from financing activities Net decrease in deposits $ (3,542) $(23,175) $ (5,174) Collection of FSLIC note receivable - - 40,390 Payments on long-term and other debt (60,352) (28,903) (86,526) Payments for securities repurchased (11,623) - - Long-term and other borrowings 50,000 13,501 57,894 Net change in revolving loans (4,950) (1,108) 145 Net change in drafts payable (3,329) 919 114 Dividends paid on common and preferred stocks (2,713) (1,827) (1,943) Purchases of treasury stock (302) (144) (46) Net proceeds from issuance of common and preferred stock 47,140 687 - ---------------------------------- Cash flows provided by (used in) financing activities 10,329 (40,050) 4,854 ---------------------------------- Net increase (decrease) in cash and cash equivalents (21,584) 9,937 (25,356) Cash and cash equivalents at beginning of year 33,271 23,334 48,690 ---------------------------------- Cash and cash equivalents at end of year $11,687 $ 33,271 $ 23,334 ================================== Noncash financing and investing activities Exercise of stock options - stock tendered and added to treasury Shares at market value $ 1,048 $ 1,800 $ - ================================== Patents purchased by reduction of note receivable (Note 3) $ $ 2,344 $ - ================================== Long-term debt issued for property, plant and equipment $ 1,500 $ - $1,700 ================================== See Note 3 for noncash assets and liabilities related to acquisitions in 1993 and 1992. See Note 4 for noncash assets and liabilities related to the terminated Assistance Agreement in 1993. See accompanying notes. LSB Industries, Inc. Notes to Consolidated Financial Statements December 31, 1993, 1992 and 1991 1. Basis of Presentation The accompanying consolidated financial statements include the accounts of LSB Industries, Inc. (the Company ) and its subsidiaries, including its financial services subsidiaries. Since the Company s financial services subsidiaries do not typically distinguish between current and noncurrent assets and liabilities, the accompanying balance sheets are presented on an unclassified basis. Condensed classified balance sheet and other information is provided in Note 15. Proposed Disposition of Assets On February 9, 1994, the Company signed a Stock Purchase Agreement (the Acquisition Agreement ) for the sale of its wholly-owned subsidiary, Equity Bank for Savings, F.A. ( Equity Bank ), which constitutes the Financial Services Business of the Company. The Purchaser is to acquire all of the outstanding shares of capital stock of Equity Bank. The closing of this transaction is contingent upon several factors including regulatory approvals, minimum tangible book value (as defined), acceptance by the Company of the selling price determined under the terms of the Acquisition Agreement and stockholders' approval. If the appropriate approvals are not received or an acceptable selling price is not received, the Company can terminate the Acquisition Agreement and, accordingly, the Financial Services Business has not been reported as a discontinued operation. Under the Acquisition Agreement, the Company is to acquire from Equity Bank, prior to closing, certain subsidiaries of Equity Bank ( Retained Corporations ) that own the real and personal property and other assets contributed by the Company to Equity Bank at the time of the acquisition of the predecessor of Equity Bank by the Company for Equity Bank s carrying value of the assets contributed. At the time of closing of the sale of Equity Bank, the Company is required under the Acquisition Agreement to acquire: (A) the loan and mortgage on and an option to purchase Equity Tower located in Oklahoma City, Oklahoma ( Equity Tower Loan ), which Equity Bank previously classified as an in-substance foreclosure on its books, (B) other real estate owned by Equity Bank that was acquired by Equity Bank through foreclosure (the Equity Tower Loan and other real estate owned are collectively called the Retained Assets ), and (C) the outstanding accounts receivable sold to Equity Bank by the Company and its subsidiaries under various purchase agreements, dated March 8, 1988 (the Receivables ). These assets are to be acquired for an amount equal to Equity Bank s carrying value of the Retained Assets at time of closing of the sale of Equity Bank. In addition, the Company has the option, but not the obligation, to acquire any loan owned by Equity Bank that has been charged off or written down for a price equal to the net book value of such loan that has been written down and for a price of $1.00 in the case of each loan that has been charged off ( Other Loans ). The Company currently expects that the purchase price to be paid by the Purchaser for Equity Bank will be approximately $92 million, subject to determination and adjustment in accordance with the Acquisition Agreement (the Purchase Price ). The Purchase Price is based on a number of estimates, and the amount of the Purchase Price cannot be determined exactly until the closing of the sale of Equity Bank. The Company will use approximately $65.4 million, plus interest, of the Purchase Price to repay certain indebtedness the Company intends to incur to finance the purchase from Equity Bank of the Retained Corporations. In addition, it is anticipated that the Company will use approximately $19.2 million of the Purchase Price to purchase from Equity LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 1. Basis of Presentation (continued) Bank the Retained Assets, which is the carrying value of the Retained Assets on the books of Equity Bank as of December 31, 1993. As of this date, the Company has made no decision if it will acquire any of the Other Loans. As of December 31, 1993, Equity Bank owned approximately $33.6 million of the Receivables, which if the closing occurs on or about June 30, 1994, the Company expects such to be less than $10 million as of the closing. On or prior to the closing, the Company expects to have secured an accounts receivable line of credit to replace, in whole or in part, the accounts receivable financing provided by Equity Bank. The Company expects to use the proceeds to be received from the new accounts receivable line of credit to finance the repurchase of the Receivables from Equity Bank at the closing. The balance of the Purchase Price, if any, remaining after (i) repayment of the indebtedness incurred by the Company to purchase the Retained Corporations, (ii) purchase from Equity Bank of the Retained Assets, and (iii) payment of the transactional costs relating to the sale of Equity Bank under the Acquisition Agreement will be used by the Company for general working capital. The following unaudited Pro Forma Condensed Consolidated Balance Sheet as of December 31, 1993, and the Pro Forma Condensed Consolidated Statement of Income for the fiscal year ended December 31, 1993, are presented to give effect to the proposed sale of Equity Bank. The pro forma adjustments reflected herein are based on available information and certain assumptions that the Company s management believes are reasonable. Pro forma adjustments made in the Pro Forma Condensed Consolidated Balance Sheet assume that the sale of Equity Bank was consummated on December 31, 1993, and do not reflect the impact of Equity Bank s historical operating results or changes in other balance sheet amounts subsequent to December 31, 1993. The pro forma adjustments related to the Pro Forma Condensed Consolidated Statement of Income assume that the sale of Equity Bank was consummated on January 1, 1993. The Pro Forma Condensed Consolidated Balance Sheet and Pro Forma Condensed Consolidated Statement of Income are based on assumptions and approximations and, therefore, do not reflect in precise numerical terms the impact of the transaction on the historical financial statements. In addition, such pro forma financial statements should not be used as a basis for forecasting the future operations of the Company. Pro Forma Condensed Consolidated Balance Sheet (Unaudited) 1. Basis of Presentation (continued) December 31, 1993 --------------------------------------------- Pro Forma Adjustments As Actual (Note A) (Note B) Adjusted ---------------------------------------------- (Amounts in Thousands) Assets Cash and cash equivalents $ 11,687 $65,416 $ (76,048) $ 1,055 Trade accounts receivable 49,533 49,533 Loans 142,634 (142,634) Mortgage-backed and investment securities 224,475 (224,475) Inventories 48,384 48,384 Foreclosed real estate 19,262 (3,928) 15,334 Net property, plant and equipment 65,670 (7,617) 58,053 Excess of purchase price over net assets acquired 22,184 (17,041) 5,143 Other assets 13,683 (3,179) 10,504 ------------------------------------------- $597,512 $65,416 $ (474,922) $ 188,006 =========================================== Liabilities, preferred and common stocks and other stockholders equity Liabilities: Deposits $332,511 $(332,511) $ - Notes payable - $65,416 (65,416) - Securities sold under agreements to repurchase 38,721 (38,721) - Other liabilities 33,309 (2,690) 30,619 Federal Home Loan Bank advances 87,650 (87,650) - Long-term debt 30,295 27,066 57,361 ---------------------------------------------- 522,486 65,416 (499,922) 87,980 Redeemable, noncumulative, convertible preferred stock 155 155 Total non-redeemable preferred stock, common stock and other stockholders equity 74,871 25,000 99,871 --------------------------------------------- $597,512 $65,416 $(474,922) $188,006 ============================================= LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 1. Basis of Presentation (continued) Note A Pro forma adjustment to recognize the cash required by the Company to purchase the Retained Corporations from Equity Bank prior to the sale of Equity Bank to the Purchaser. The Company is negotiating with a lender to borrow the funds with which to fund the purchase. The borrowed funds plus interest will be repaid from the proceeds of the sale of Equity Bank. As the carrying value of the Retained Assets and Retained Corporations on a consolidated basis will not change as a result of the purchase, no adjustment to such carrying value is necessary. Note B Pro forma adjustment to recognize the sale of Equity Bank as though consummated on December 31, 1993. The adjustment is based on an estimated selling price of $92 million resulting in an estimated financial gain of $25 million after consideration of costs of the transaction. The reductions in the detail balance sheet amounts represent the historical carrying values of such accounts that will remain assets and liabilities of Equity Bank after the sale and after acquisition by the Company of the Retained Assets and Retained Corporations. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 1. Basis of Presentation (continued) Pro Forma Condensed Consolidated Statement of Income (Unaudited) Year ended December 31, 1993 ------------------------------------------ Pro Forma As Actual Adjustments Adjusted ------------------------------------------ (Amounts In Thousands Except Per Share Data) Revenues: Net sales $232,616 $232,616 Interest income on loans and investments 27,761 $(27,521)(C) 240 Credit card and other 16,217 (14,315)(C) 213 (D) 2,115 ------------------------------------------ Total revenues 276,594 (41,623) 234,971 Costs and expenses: Cost of sales 174,504 174,504 Selling, general and administrative: Financial Services 21,549 (21,549)(C) - Nonfinancial services 43,864 (750)(C) 133 (D) 43,247 Interest: Deposits 12,505 (12,505)(C) - Long-term debt and other 9,517 (2,010)(C) (781)(D) 6,726 Provision for loan losses 1,382 (1,382)(C) - ----------------------------------------- 263,321 (38,844) 224,477 ----------------------------------------- Income from continuing operations before provision for income taxes 13,273 (2,779) 10,494 Provision for income taxes 874 (460)(C) 557 (D) 971 ---------------------------------------- Income from continuing operations $ 12,399 $(2,876) $ 9,523 ======================================== Income from continuing operations applicable to common stock $ 10,357 $ 7,481 ======= ====== Earnings from continuing operations per common share: Primary $.77 $.59 ===== ===== Fully diluted $.71 $.55 ===== ===== LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 1. Basis of Presentation (continued) Note C Reclassification of revenues and expenses of Equity Bank as a discontinued operation of the Company for the period presented. Such amounts are reconciled to reported segment data (Note 15) as follows: Year ended December 31, 1993 -------------------- (In Thousands) Financial Services operating profit, as reported $ 4,390 Allocation of general corporate expenses (750) Allocation of income taxes (460) Losses on Retained Assets 46 ------ Income from discontinued operations $ 3,226 ====== Note D Pro forma adjustments to reflect the estimated effect on earnings of acquiring the Retained Assets is considered. These include reduced interest expense on financing of the Company s accounts receivable with a new lender and the earnings on real estate assets acquired as Retained Assets. 2. Accounting Policies Statements of Cash Flows As permitted by Statement of Financial Accounting Standards ( SFAS ) No. 104, the Company reports in their statements of cash flows net cash receipts and payments for (a) deposits placed with other financial institutions and withdrawal of deposits, (b) time deposits accepted and repayment of deposits, (c) loans made to customers and principal collections of loans, and (d) loans originated for sale and proceeds from sales thereof. For purposes of reporting cash flows, cash and cash equivalents include cash, overnight funds and interest bearing deposits with original maturities when purchased by the Company of 90 days or less. Cash payments for interest and income taxes were as follows: 1993 1992 1991 --------------------------------------------- (In Thousands) Interest: Deposits $12,506 $16,553 $23,204 Long-term debt and other 8,841 12,959 15,638 Income taxes (1992 is net refunds received) 928 (102) 257 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2. Accounting Policies (continued) Securities Held for Investment Securities held for investment are carried at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity. Management has the intent and ability to hold these securities to maturity. Gains and losses on sales are determined using the specific identification method. Mortgage-Backed Securities Held for Investment Mortgage-backed securities held for investment are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using a method that approximates level yield. Management has the intent and ability to hold these assets to maturity. Should any be sold, gains and losses will be recognized based on the specific identification method. Mortgage-Backed Securities Held for Sale Mortgage-backed securities which management may sell in response to market conditions or for other reasons are classified as held for sale. These securities are carried at the lower of cost or estimated market value in the aggregate at the balance sheet date. Net unrealized losses on such securities are recognized through a valuation allowance that is shown as a reduction in the carrying value of the related securities and as a corresponding charge to income. These securities are comprised of FHLMC collateralized mortgage obligations. The cost at December 31, 1993 was $14,020,790 and the market values of these securities were $13,946,511. Gross unrealized losses at December 31, 1993 were $74,279 and there were no gross unrealized gains at December 31, 1993. No sales of these securities have occurred in 1993; however, gains and losses realized on sales of these securities would be determined using the specific identification method. SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires investments to be classified in three categories and accounted for as follows: o Debt securities that the Company has the positive intent and ability to hold to maturity are to be classified as held-to-maturity securities and reported at amortized cost. o Debt and equity securities that are bought and held principally for the purpose of selling in the near future are to be classified as trading securities and reported at fair value, with unrealized gains and losses included in current earnings. o Debt and equity securities not classified as either held-to-maturity securities or trading securities are to be classified as available-for- sale securities and reported at fair value, with unrealized gains and losses reported as a separate component of stockholder s equity. The Statement is effective for fiscal years beginning after December 15, 1993 and is to be initially applied as of the beginning of the fiscal year. The Company will adopt the provisions of this Statement January 1, 1994. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2. Accounting Policies (continued) Management has determined that the effect of the adoption of this Statement will not be material to the Company. Securities Sold Under Agreements to Repurchase Securities sold under agreements to repurchase are collateralized by mortgage- backed securities. These fixed-coupon agreements are carried at their contractual amounts and are accounted for as financings. Loans Receivable Loans receivable are stated at unpaid principal balances, less the allowance for loan losses, deferred loan origination fees and discounts. Discounts on first mortgage loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for prepayments. The allowance for loan losses is increased by charges to income and decreased by chargeoffs (net of recoveries). Management s periodic evaluation of the adequacy of the allowance is based on Equity Bank s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower s ability to repay, the estimated value of the underlying collateral, and current economic conditions. As discussed in Note 4, losses on covered assets were reimbursable and, accordingly, no allowance for loss was recorded on loans included in covered assets. Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Gains and losses on sales of these mortgage loans are determined using the specific identification method. Uncollectible interest on loans that are contractually past due (generally in excess of 90 days) is charged against income, or an allowance is established based on management s periodic evaluation. The allowance is established by a charge to interest income equal to all interest previously accrued, and income is subsequently recognized only to the extent that cash payments are received until, in management s judgment, the borrower has demonstrated the ability to make periodic interest and principal payments, in which case the loan is returned to accrual status. SFAS No. 114, Accounting by Creditors for Impairment of a Loan, amends SFAS No. 5 to clarify that a creditor should evaluate both principal and interest when assessing the need for a loss accrual. This Statement also requires creditors to measure impairment of a loan based on the present value of expected future cash flows discounted at the loan s effective interest rate or based on the fair value of the collateral if the loan is collateral dependent. The Statement does not apply to large groups of smaller-balance homogeneous loans that are collectively valued for impairment (i.e., consumer installment loans, residential mortgage loans, credit card loans, etc.). The Statement also amends Practice Bulletin 7 ("PB7") guidance on accounting for in- substance foreclosures ("ISFs"). PB7 requires creditors to account for the operations of the collateral underlying ISFs, even though the creditor has not taken possession of collateral, as if foreclosure had occurred. SFAS No. 114 recognizes the practical problems of accounting for the operation of an asset the creditor does not possess and, therefore, states that a loan for which foreclosure is probable should continue to be accounted for as a loan. The effect of this provision will require all ISFs, which are currently classified as foreclosed real estate for financial statement purposes (Note 9), to be LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2. Accounting Policies (continued) reclassified as loans for reporting purposes. SFAS No. 114 is effective for financial statements for fiscal years beginning after December 15, 1994. Inventories Purchased machinery and equipment are carried at specific cost plus duty, freight and other charges, not in excess of net realizable value. All other inventory is priced at the lower of cost or market, with cost being determined using the first-in, first-out (FIFO) basis, except for certain heat pump products with a value of $7,191,000 at December 31, 1993 ($8,357,000 at December 31, 1992), which are priced at the lower of cost or market, with cost being determined using the last-in, first-out (LIFO) basis. The difference between the LIFO basis and current cost is $571,000 at December 31, 1993 ($625,000 at December 31, 1992). Foreclosed Real Estate Real estate properties acquired through, or in lieu of, loan foreclosure are recorded at the lower of cost or fair value, less estimated costs to sell the underlying property. Costs relating to the improvement of property are capitalized, whereas costs relating to the holding of the property are expensed. Valuations are periodically performed by management, and chargeoffs are reflected by a charge to operations if the carrying value of a property exceeds its estimated fair value. Depreciation For financial reporting purposes, depreciation, depletion and amortization is primarily computed using the straight-line method over the estimated useful lives of the assets. Excess of Purchase Price Over Net Assets Acquired The excess of purchase price over net assets acquired is being amortized by the interest or straight-line methods, as appropriate, primarily over periods of 12 to 15 years. The carrying value of the excess of purchase price over net assets acquired is reviewed if the facts and circumstances suggest that it may be impaired. Research and Development Costs Costs incurred in connection with product research and development are expensed as incurred. Such costs amounted to $788,000 in 1993, $684,000 in 1992 and $454,000 in 1991. Net Income (Loss) Applicable to Common Stock Net income (loss) applicable to common stock is computed by adjusting net income or loss by the amount of preferred stock dividends, including unpaid dividends, if cumulative. Earnings Per Share Primary earnings per common share are based upon the weighted average number of common shares and dilutive common equivalent shares outstanding during each year after giving appropriate effect to preferred stock dividends. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2. Accounting Policies (continued) Fully diluted earnings per share are based on the weighted average number of common shares and dilutive common equivalent shares outstanding and the assumed conversion of dilutive convertible securities outstanding after appropriate adjustment for interest and related income tax effects on convertible notes payable. Average common shares outstanding used in computing earnings per share are as follows: 1993 1992 1991 -------------------------------------- Primary 13,401,194 8,188,492 6,105,222 Fully diluted 15,397,886 14,413,179 6,105,222 Fair Value of Financial Instruments The following discussion of fair values is not indicative of the overall fair value of the Company s balance sheet since the provisions of the SFAS No. 107, Disclosures About Fair Value of Financial Instruments does not apply to all assets, including intangibles. The following methods and assumptions were used by the Company in estimating its fair value of financial instruments: Cash and Cash Equivalents: Carrying value approximates fair value. Mortgage-Backed Securities and Other Securities Held for Investment: Fair values for investment and mortgage-backed securities are based on quoted market prices where available. Where quoted market prices are not available, fair values are based upon dealer quotes or quoted market prices of comparable instruments. The carrying value of FHLB stock approximates estimated fair value since there is no active market for this stock and the stock can be redeemed for par value which equals carrying value. Loans: For variable-rate loans with no significant change in credit risk since loan origination, fair values approximate carrying amounts. Fair values for fixed-rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality and for the same remaining maturities. Loans designated by the Company as problem or potential problem loans are reduced by an estimated impairment allowance in consideration of credit quality. Fair values for loans held for sale are based upon quoted market prices. Deposits: The fair values of demand deposits, interest-bearing demand deposits and savings accounts are the amount payable on demand. The carrying amount for variable rate certificates of deposit approximates their fair value. Fair values for fixed rate certificates of deposit are estimated using discounted cash flow analyses that apply interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on the time deposits. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 2. Accounting Policies (continued) Borrowed Funds: Fair values for fixed rate borrowings are estimated using a discounted cash flow analysis that applies interest rates currently being offered on borrowings of similar amounts and terms to those currently outstanding. Carrying values for variable rate borrowings approximate their fair value. Securities Sold Under Agreements to Repurchase: Fair values for these obligations are estimated using a discounted cash flow analysis that applies interest rates currently being offered on borrowings of similar amounts and terms to those currently outstanding. 3. Business Combinations In July 1993, a subsidiary in the Company s Chemical Business acquired an Australian explosives business, Total Energy Systems, Limited ( TES ). TES is a distributor of blasting products and provides blasting services. In January 1992, subsidiaries in the Company s Chemical Business acquired all of the outstanding stock of Slurry Explosive Corporation and certain patent rights from Universal Tech Corporation ( UTC ). One of these subsidiaries acquired the outstanding stock of UTC in September 1992. These acquisitions expand the Company s Chemical Business to include the production and sale of certain patented blasting products and related accessories and services and allow the Company to sell license rights to other companies to manufacture the patented blasting products. In December 1993, the Company purchased International Bearings Incorporated ("IBI"). IBI is a distributor of agricultural and industrial bearings and is included in the Automotive Products Business. The results of operations of the acquired entities, recorded using the purchase method of accounting, are included in the accompanying consolidated financial statements from the date of acquisition. The pro forma effects of the acquisitions on the Company s results of operations for 1993 and 1992 are not significant. Following is a detail of the assets and liabilities acquired in connection with the acquisitions discussed above: TES and IBI Slurry ---------------------------- 1993 1992 ---------------------------- (In Thousands) Cash and cash equivalents $1,228 $ 55 Trade accounts receivable 1,618 1,186 Inventories 2,359 1,109 Supplies and prepaid items 43 130 Property, plant and equipment 2,143 861 Excess of purchase price over net assets acquired 343 196 Patents and other assets 490 2,285 --------------------------- Total assets 8,224 5,822 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 3. Business Combinations (continued) TES and IBI Slurry ---------------------------- 1993 1992 ---------------------------- (In Thousands) Accounts payable $4,456 $ 1,458 Accrued liabilities 745 131 Long-term debt 1,276 1,749 ----------------------------- Total liabilities 6,477 3,338 ----------------------------- Total purchase price 1,747 2,484 Reduction of note receivable from UTC - (2,344) ----------------------------- Net cash payment $1,747 $ 140 ============================ 4. Assets Covered by FSLIC Assistance and FSLIC Receivables and Payable On December 30, 1988, Equity Bank acquired Arrowhead Federal Savings and Loan Association (Arrowhead), which had assets of approximately $317 million, through a Federal Savings and Loan Insurance Corporation (FSLIC) assisted acquisition. Arrowhead was merged into Equity Bank and its separate existence was terminated. In connection with the acquisition of Arrowhead, Equity Bank and FSLIC entered into an Assistance Agreement with an original term of ten years. The Assistance Agreement provided for various forms of financial assistance and indemnifications to Equity Bank during the term of the Assistance Agreement and required payments to FSLIC for sharing of certain items including capital losses, net income and tax benefits. From the date of the acquisition by Equity Bank of Arrowhead in December 1988 and continuing through 1992, Equity Bank had been subject to assistance considerations by the FSLIC. The terms and effects of such assistance are set forth in the following discussion as such assistance continued through 1992 and has been given effect in the consolidated financial position and results of operations through December 31, 1992. In March 1993, Equity Bank, the Company, the Federal Deposit Insurance Corporation (FDIC - as manager of the FSLIC Resolution Fund) and the Resolution Trust Corporation (RTC) finalized an agreement terminating the Assistance Agreement. In connection with this Termination Agreement, the RTC paid Equity Bank approximately $14.2 million in cash and all of the obligations of both parties under the Assistance Agreement were terminated. As a result of the Termination Agreement, Equity Bank assumed all credit risk with respect to existing covered assets. Equity Bank allocated a substantial portion of such $14.2 million to record the previously covered loans and foreclosed real estate at estimated fair value. As a result, Equity Bank believes that there are adequate discounts relating to the assets to reserve for the credit risk which was assumed. Also as a result of the LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 4. Assets Covered by FSLIC Assistance and FSLIC Receivables and Payables (continued) Termination Agreement, Equity Bank is no longer indemnified for any potential claim relating to any covered asset arising out of, or based upon, any liability, action or failure to act of Equity Bank or any of Equity Bank s affiliates, officers or directors from and after December 30, 1988 that are asserted against the FDIC or Equity Bank related to covered assets. The effect of the accounting for the Termination Agreement included reclassifying previously covered assets to reflect their status at the termination date (on a fair value basis), all related receivables and payables were extinguished, the cash payment from the FDIC Manager was recorded and goodwill existing relating to the Arrowhead acquisition was adjusted for this resolution of a contingent purchase price. Completion of the Termination Agreement had no effect on total stockholders equity and did not result in a charge or credit to the Company s statement of operations. The termination of the Assistance Agreement was recorded effective as of January 1, 1993; therefore, no assistance income from the FSLIC has been recognized in 1993. Recording of the Termination Agreement increased (decreased) the following accounts (in millions): Cash and cash equivalents $14.2 FSLIC receivables (18.9) Assets covered by FSLIC assistance (33.1) Loans receivable, net 13.3 Foreclosed real estate, net 8.7 Excess of purchase price over fair value of net assets acquired 6.7 Payable to FSLIC (9.1) Covered Assets Prior to the Termination Agreement, FSLIC had guaranteed the December 30, 1988 book value of covered assets, as defined, of Arrowhead, under the provisions of the Assistance Agreement. Covered assets were defined to include all Arrowhead assets acquired except cash and marketable securities, performing one to four family residential first mortgage loans, certain fixed assets and assets owned by subsidiaries. An analysis of the changes in assets covered by FSLIC assistance for the year ended December 31, 1992 is as follows (in thousands): Carrying amount at December 31, 1991 $48,291 Additions 349 Sales, net of financings (9,097) Chargeoffs (159) Loan principal paid by borrowers (6,324) ------- Carrying amount at December 31, 1992 $33,060 ======= Yield Maintenance Prior to the Termination Agreement and under the provisions of the Assistance Agreement, Equity Bank was provided yield maintenance guarantees on covered assets. Yield maintenance assistance payments were based upon the difference LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 4. Assets Covered by FSLIC Assistance and FSLIC Receivables and Payable (continued) between the actual net yield on the covered assets and the guaranteed net yield amount. The guaranteed yield maintenance rate is the FHLB District 10 cost of funds rate plus an additional amount as specified in the Assistance Agreement. At December 31, 1992, the aggregate yield maintenance rate was 6.28% and the average aggregate rate for 1992 was 6.94%. Yield maintenance assistance was $936,000 in 1992 and $2,851,000 in 1991. Mark-to-Market Adjustment Under the Assistance Agreement, Equity Bank was reimbursed for the acquisition date mark-to-market adjustments associated with certain investment securities and one to four family residential mortgage loans of Arrowhead that did not qualify as covered assets. A receivable for this reimbursement of $36.3 million was recorded at December 30, 1988. The receivable did not bear interest and was payable in annual installments over ten years or at the time a loan was paid off. The receivable balance of $15.8 million at December 31, 1992 was settled under provisions of the Termination Agreement. Other FSLIC Receivables Equity Bank had various other amounts receivable and payable from FSLIC pursuant to the Assistance Agreement. The following table summarizes the components of other net amounts receivable at December 31, 1992 which were settled under provisions of the Termination Agreement (in thousands): Reimbursement for capital losses, net of recoveries $2,668 Yield maintenance receivable 612 Other (105) ------ $3,175 ====== Payable to FSLIC Pursuant to the provisions of the Assistance Agreement, Equity Bank was required to pay FSLIC $435,000 quarterly for seven years beginning in March 1992 in lieu of tax benefits arising from the acquisition of Arrowhead. The present value of amounts due under this provision of the Assistance Agreement at December 31, 1992 was $9.1 million. Interest expense of $829,000 in 1992 and $745,000 in 1991 was added to the payable based on a rate of approximately 10%. This liability was settled by provisions of the Termination Agreement. 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) Credit Concentrations and Other Risk Factors Equity Bank is active in originating, selling and servicing residential mortgage loans, as well as originating commercial real estate loans and originating and servicing credit card loans. Equity Bank conducts its operations in Oklahoma, an area, like many other parts of the country, in which real estate markets are considered depressed. The collateral securing Equity Bank s residential and commercial real estate LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) loan portfolios is located in this geographical area, and the ultimate recoverability of these portfolios may be dependent upon the economic and market conditions in which Equity Bank conducts its operations. While management uses current available information to provide for losses, future additions to the allowances for losses may be necessary based on changes in economic and market conditions. In addition, Equity Bank is subject to competition, regulations of certain federal agencies, and undergoes periodic examinations by those regulatory agencies. These agencies may require Equity Bank to recognize additions to the allowances for losses based on their judgments of information available to them at the time of their examination. Equity Bank is not committed to lend additional funds to debtors whose loans have been modified. Securities Held for Investment The carrying values (amortized cost) and estimated market values of investment securities and mortgage-backed securities at December 31, 1993 and 1992 are summarized as follows: Gross Gross Estimated Amortized Unrealized Unrealized Market 1993 Cost Gains Losses Value - ------------------------------------------------------------------------------ (In Thousands) U.S. Treasury securities $ 1,299 $ 5 $ $ 1,304 Federal Home Loan Bank stock 6,417 - - 6,417 Other 90 - (18) 72 ---------------------------------------------- $ 7,806 $ 5 $ (18) $ 7,793 ============================================== Mortgage-backed securities held for investment, excluding accrued interest receivable of $1,099,000 $201,623 $ 793 $ (807) $201,609 ============================================== - ------------------------------------------------------------------------------- U.S. Treasury securities $ 406 $ 6 $ - $ 412 Federal Home Loan Bank stock 6,417 - - 6,417 Other 187 - - 187 --------------------------------------------- $ 7,010 $ 6 $ - $ 7,016 ============================================= Mortgage-backed securities held for investment, excluding accrued interest receivable of $1,186,000 $174,241 $1,143 $(1,492) $173,892 ==================================================== LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) The amortized cost and estimated market value of securities held for investment at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Amortized Market Cost Value ---------------------- (In Thousands) Due in one year or less $1,283 $1,264 Due after one year through five years106 112 Other 6,417 6,417 --------------------- Total investment securities $7,806 $7,793 ====================== At December 31, 1993 and 1992, U.S. Treasury securities with an amortized cost of approximately $1,299,000 and $400,000, respectively, were pledged to secure customer deposits and FHLB advances. Mortgage-Backed Securities Held for Investment The carrying values and estimated market values of mortgage-backed securities held for investment, excluding accrued interest receivable, at December 31, 1993 and 1992 are summarized as follows: Estimated Principal Unamortized Unearned Carrying Market 1993 Balance Premiums Discounts Value Value - -------------------------------------------------------------------------- (In Thousands) FHLMC certificates $ 44,705 $ 905 $ - $ 45,610 $ 45,396 FNMA certificates 58,983 1,567 - 60,550 60,399 GNMA certificates 44,384 379 (299) 44,464 45,013 FHLMC collateralized mortgage obligations 5,014 27 - 5,041 5,047 FNMA collateralized mortgage obligations 41,666 57 (2) 41,721 41,543 Private issue collateralized mortgage obligations 4,185 30 - 4,215 4,187 Other 22 - - 22 24 -------------------------------------------------- $198,959 $2,965 $(301) $201,623 $201,609 ================================================== LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) Estimated Principle Unamortized Unearned Carrying Market 1992 Balance Premiums Discounts Value Value - ------------------------------------------------------------------------------ (In Thousands) FHLMC certificates $ 50,569 $1,129 $ (79) $ 51,619 $ 52,242 FNMA certificates 56,611 1,516 58,127 58,076 GNMA certificates 39,454 386 (317) 39,523 39,327 FHLMC collateralized mortgage obligations 12,330 484 12,814 12,471 REMICs 11,674 457 12,131 11,750 Other 27 27 26 ------------------------------------------------------ $170,665 $3,972 $(396) $174,241 $173,892 ====================================================== Mortgage-backed securities at December 31, 1993 had contractual maturities in installments to 2030. Mortgage-backed securities with a carrying value at December 31, 1993 of $39.1 million are pledged to secure outstanding repurchase agreements of $38.7 million ($52.1 million were pledged to secure outstanding repurchase agreements of $50.3 million in 1992). Mortgage-backed securities, with a carrying value of $162.5 million at December 31, 1993, are pledged to secure FHLB advances and certain deposits ($132.2 million in 1992). Loans Receivable A summary of loans receivable at December 31, 1993 and 1992 is as follows: 1993 1992 ------------------------ (In Thousands) Principal balances on first mortgage loans: Secured by one to four family residences $ 63,757 $ 73,124 Secured by other properties 6,385 5,898 Commercial 18,955 12,495 Construction loans 1,029 1,234 Other 516 78 --------------------- 90,642 92,829 Less: Unearned discounts 11,812 13,372 Undisbursed portion of construction loans 819 768 Net deferred loan origination fees 63 188 -------------------- Total first mortgage loans 77,948 78,501 LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) 1993 1992 ---------------------- (In Thousands) Principal balances on consumer and other loans: Commercial $ 3,231 $ 1,686 Loans on deposits 2,551 2,181 Credit cards 39,358 36,478 Other 3,984 2,887 -------------------- 49,124 43,232 Accrued interest receivable Less allowance for loan losses 3,625 3,142 -------------------- $124,060 $119,278 ==================== Loans held for sale $ 18,574 $ 6,358 ==================== The estimated fair values for loans receivable are approximately $134.7 million and $132.4 million at December 31, 1993 and 1992, respectively. The estimated fair value for loans held for sale are approximately $18.6 million and $6.4 million at December 31, 1993 and 1992, respectively. Weighted average interest rates of loans receivable were 9.28% and 9.72% at December 31, 1993 and 1992, respectively. Commercial real estate, consumer and other loans with a carrying amount of approximately $14 million at December 31, 1992, were not included above and were included in Assets Covered by FSLIC Assistance in the balance sheet (Note 4). LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) Activity in the allowance for loan losses is summarized as follows for the years ended December 31: 1993 1992 1991 ------------------------------ (In Thousands) Balance at the beginning of the year $3,142 $3,424 $3,712 Provision charged to income 1,382 1,224 1,335 Chargeoffs (1,151) (1,635) (1,901) Recoveries 252 129 278 ------------------------------ Balance at the end of the year $3,625 $3,142 $3,424 ============================== In connection with the termination of the Assistance Agreement, Equity Bank assumed the credit risk of $13.3 million in loans whose credit risk had previously been covered under terms of the Assistance Agreement. At December 31, 1993, approximately $1.4 million in unearned nonaccretable discounts exist to provide as additional reserves on these loans. These amounts are included as unearned discounts and are not included in the allowance for loan losses above. Nonaccrual and renegotiated or restructured potentially problem loans approximate $3.1 million and $2.8 million at December 31, 1993 and 1992, respectively. Interest income that would have been recorded under the original terms of such loans and the interest income actually recognized for the years ended December 31 are summarized below: 1993 1992 1991 ----------------------------------- Interest income that would have been recorded $397,000 $351,000 $156,000 Interest income recognized (84,000) (63,000) (58,000) ----------------------------------- Interest income foregone $313,000 $288,000 $ 98,000 =================================== Loan Servicing Mortgage loans and credit cards and other loans serviced for others are not included in the consolidated financial statements. The unpaid principal balances of these loans at December 31 are summarized as follows: LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) 1993 1992 ----------------------- (In Thousands) Mortgage loans underlying FNMA passthrough securities $ 38,273 $ 42,784 Mortgage loan portfolios serviced for: FNMA 3,305 4,449 FHLMC 158,265 132,112 Other investors 8,865 11,939 Credit cards and other loans serviced for others 23,589 32,454 ----------------------- $232,297 $223,738 ======================= Custodial escrow balances maintained in connection with the foregoing loan servicing were approximately $1,239,000 and $1,211,000 at December 31, 1993 and 1992, respectively. Foreclosed Real Estate A summary of changes in foreclosed real estate is as follows: 1993 1992 1991 ------------------------------------ (In Thousands) Balance at the beginning of the year $15,151 $16,165 $17,289 Additions: Related to Termination Agreement 8,743 Other additions 423 614 320 Sales (4,941) (1,148) (814) Chargeoffs and other (114) (480) (630) --------------------------------- Balance at the end of the year $19,262 $15,151 $16,165 ================================ Foreclosed real estate with a carrying value of $19 million at December 31, 1992 is not included above and is included in Assets Covered by FSLIC Assistance (Note 4). Foreclosed real estate includes loans considered in-substance foreclosures of $13.9 million at December 31, 1993 and $14.2 million at December 31, 1992. The majority of this balance is comprised of a commercial real estate property which is the office building in which Equity Bank s corporate office is located. This property was determined to be an in-substance foreclosure in 1990. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) Deposits Deposits at December 31 are summarized as follows: The fair values for deposits at December 31, 1993 and 1992 are approximately $333.4 million and $337.4 million, respectively. The aggregate amount of jumbo certificates of deposit and other accounts with a minimum denomination of $100,000 was approximately $39.7 million and $31.2 million at December 31, 1993 and 1992, respectively. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) At December 31, 1993, scheduled maturities of certificates of deposit are as follows: Year ending December 31, ------------------------------------------------------------- 1994 1995 1996 1997 1998 Total ------------------------------------------------------- (In Thousands) 0.99% to 2.99% $ 1,083 $ - $ - $ - $ - $ 1,083 3.00% to 4.99% 166,670 19,723 5,099 - 360 191,852 5.00% to 6.99% 17,022 2,775 356 2,442 9,641 32,236 7.00% to 8.99% 2,073 124 - - - 2,197 9.00% to 10.99% 245 - - - - 245 13.00% to 14.99% 102 - - - - 102 ------------------------------------------------------- $187,195 $22,622 $5,455 $2,442 $10,001 $227,715 ======================================================= Interest expense on deposits is as follows: Type 1993 1992 1991 - ---------------------------------------------------------------- (In Thousands) Demand, money market and NOW $ 2,223 $ 2,634 $ 2,748 Savings 530 524 522 Time 9,752 13,287 19,874 ------------------------ $12,505 $16,445 $23,144 ======================== Federal Home Loan Bank Advances Advances at December 31, 1993 and 1992 were $87.7 million and $80.1 million, respectively. The advances have maturities ranging from 31 days to five years and have interest rates ranging from 3.30% to 6.40% at December 31, 1993 (3.85% to 6.40% at December 31, 1992) and are secured by mortgage-backed securities. The estimated fair values of FHLB advances at December 31, 1993 and 1992 are $87.7 million and $80.3 million, respectively. Interest expense on FHLB advances was $3,122,000 in 1993, $3,343,000 in 1992 and $3,211,000 in 1991. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) Securities Sold Under Agreements to Repurchase Securities sold under agreements to repurchase of $38.7 million at December 31, 1993 and $50.3 million at December 31, 1992 are treated as financings and the underlying collateral is included in mortgage-backed securities. The agreements outstanding at December 31, 1993 had interest rates of 3.38% (3.57% on agreements outstanding at December 31, 1992) and mature in March 1994. The underlying securities, which are held by a single counterparty (Prudential- Bache Securities), were mortgage-backed certificates with a book value of $39.1 million ($52.1 million at December 31, 1992) and a market value of approximately $39.1 million ($52.6 million at December 31, 1992). Interest expense on securities sold under agreements to repurchase was $1.5 million in 1993, $2.4 million in 1992 and $4.9 million in 1991. Estimated fair values for securities sold under agreements to repurchase were $38.7 million and $50.3 million at December 31, 1993 and 1992, respectively. The maximum amount of repurchase agreements outstanding at any month end was $50.3 million in 1993, $66.7 million in 1992 and $82.2 million in 1991. The daily average amount outstanding was $44 million in 1993, $58 million in 1992 and $75 million in 1991. Off-Balance-Sheet Risk Equity Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. At December 31, 1993, these financial instruments include commitments of undisbursed funds on loan commitments of $5.4 million, unfunded lines of credit of $2.4 million, and unfunded credit card availability of approximately $147 million. Equity Bank uses the same credit and collateral policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Equity Bank s exposure to credit loss in the event of nonperformance by the other party to these financial instruments is generally represented by the contractual notional amount of these instruments. Equity Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Unless noted otherwise, Equity Bank does not require collateral or other security to support financial instruments with credit risk. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) necessarily represent future cash requirements. Equity Bank evaluates each customer s credit worthiness on a case by case basis. The amount of collateral obtained, if it is deemed necessary by Equity Bank upon extension of credit, is based on management s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment and income producing commercial properties. Regulatory and Other Matters As discussed in Note 4, on August 9, 1989, the FIRREA legislation transferred FSLIC s rights and obligations under the Assistance Agreement to the FSLIC Resolution Fund, which is administered principally by the FDIC. Under FIRREA, the Office of Thrift Supervision (OTS), which is a bureau of the U.S. Treasury Department, became the primary regulator of thrift institutions and thrift holding companies. Deposit insurance for all banks and thrifts is now the responsibility of the FDIC through two agencies, the Savings Association Insurance Fund and the Bank Insurance Fund. In connection with the Company s acquisition of Equity Bank and Equity Bank s acquisition of Arrowhead, Equity Bank received forbearances, approvals and waivers related to certain regulatory requirements, which were for specified periods of time in some instances. These included, among other things, approval for the purchase and financing, with full recourse, of affiliates accounts receivable and forbearances related to the Qualified Thrift Lender regulatory requirements, among other things. The maximum amount of the receivables purchased could not exceed $60 million. In March 1993, the five- year waiver from regulatory limitations expired and the balance of purchased receivables is now subject to transactions with affiliates limitations as set forth in Sections 23A and 23B of the Federal Reserve Act (FRA). Equity Bank was notified by regulatory authorities that it is expected to be in full compliance with FRA 23A and 23B no later than September 1, 1994. The balance of these purchased accounts receivable at December 31, 1993 and 1992 is $33.6 million and $32.4 million, respectively. At December 31, 1993, approximately $24.4 million of these receivables were in excess of the FRA 23A and 23B limitations. The Company is presently in process of obtaining alternative financing to meet its working capital needs. Regulations for savings institutions minimum capital requirements went into effect on December 7, 1989. In addition to the capital requirements, FIRREA includes provisions for changes in the federal regulatory structure for institutions, including a new deposit insurance system, increased deposit insurance premiums, and restricted investment activities with respect to noninvestment-grade corporate debt and certain other investments. FIRREA also increases the required ratio of housing related assets needed to qualify as a savings institution. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) As a federally chartered institution and a member of the Federal Savings and Loan System, Equity Bank is subject to restrictions on the payments of capital distributions. At December 31, 1993, approximately $6 million of retained earnings are available for future dividends. Minimum capital standards for the thrift industry, which Equity Bank is subject to, prescribe three separate measurements of capital adequacy. The regulatory net worth requirements provide for tangible capital (1.5%), core capital (3.0%) and risk-based capital (8.0%) requirements. A comparison of Equity Bank s regulatory capital requirements at December 31, 1993 with actual amounts and percentages is as follows (amounts in thousands): Requirements Actual --------------------------------------- Amount Percent Amount Percent --------------------------------------- Tangible $ 7,554 1.5% $34,812 6.9% Core 15,108 3.0 38,589 7.7 Risk-based 21,986 8.0 41,431 15.1 The following is a reconciliation of GAAP capital to regulatory capital: Regulatory ------------------------------- Tangible Core Risk-Based Capital Capital Capital ------------------------------- (In Thousands) GAAP capital, as adjusted $58,627 $58,627 $58,627 Nonallowable assets: Investments in nonincludable subsidiaries (6,774) (6,774) (6,774) Goodwill and other intangible assets (17,041) (17,041) (17,041) Qualifying supervisory goodwill - 3,777 3,777 Equity investments - - (598) Additional capital items: General valuation allowances - limited - - 3,440 ------------------------------ Regulatory capital - computed 34,812 38,589 41,431 Minimum capital requirement 7,554 15,108 21,986 ------------------------------ Regulatory capital - excess $27,258 $23,481 $19,445 ============================== Effective December 16, 1992, the banking regulations adopted final rules regarding the FDIC Improvement Act of 1991 s establishment of five capital levels, ranging from well capitalized to critically undercapitalized. If an institution s capital level falls below well capitalized, it becomes subject to increasing regulatory oversight and restrictions on banking LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 5. Financial Services Subsidiaries (See Note 1 for Discussion of Proposed Sale of Equity Bank) (continued) activities for each lower capital level. In addition, FDIC insurance premiums are now, in part, based upon the institution s capital level. A financial institution is considered well capitalized if it is under no regulatory order or action and its leverage ratio is at least 5% and its Tier 1 and Total Risk-Based Capital ratios are at least 6% and 10%, respectively. Equity Bank is considered well capitalized as defined. 6. Inventories Inventories at December 31, 1993 and 1992 consist of: Finished (or Purchased) Work-In- Raw Goods Process Materials Total -------------------------------------------- (In Thousands) 1993: Air handling units $ 2,050 $ 2,281 $ 7,447 $11,778 Machinery and industrial supplies 10,287 - - 10,287 Automotive products 9,588 3,508 712 13,808 Chemical products 5,015 3,854 3,642 12,511 -------------------------------------- Total $26,940 $ 9,643 $11,801 $48,384 ====================================== 1992 total $27,877 $10,734 $ 9,762 $48,373 ====================================== 7. Property, Plant and Equipment Property, plant and equipment, at cost, consist of: December 31, 1993 1992 ------------------- (In Thousands) Land and improvements $ 5,534 $ 5,534 Buildings and improvements 23,116 20,822 Machinery, equipment and automotive 81,476 70,691 Furniture, fixtures and store equipment 8,385 7,481 Producing oil and gas properties 3,405 3,410 ------------------- 121,916 107,938 Less accumulated depreciation, depletion and amortization 56,246 49,889 ------------------ $ 65,670 $ 58,049 ================== LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 8. Foreign Sales Contract On July 6, 1992, a subsidiary of the Company signed an agreement to supply a foreign customer with equipment, technology and technical assistance to manufacture certain types of automotive products. The total contract price is $56 million with $12 million to be retained by the customer, as the subsidiary s equity participation, which represents a minority interest in the customer. The subsidiary values its equity participation in the customer at a nominal amount. Of the balance of the contract price of $44 million, $13.1 million has been billed and collected by the Company. The remaining $30.9 million is to be collected in 39 equal quarterly installments of $791,000, plus interest at a rate of 7.5% per annum. The Company s subsidiary has agreed to make its best effort to purchase approximately $14.5 million of bearing products each year for ten years commencing in the customer s first year of operations, which is anticipated to be in 1994. However, the subsidiary is not required to purchase more product from the customer in any one year than the quantity of tapered bearing products the subsidiary is able to sell in its market. The customer has also agreed to repurchase within four years, $6 million of the subsidiary s equity participation in the customer. In the event that the customer is unable to repurchase such equity participation, the parties may renegotiate and modify the agreement for purchase of the Company s subsidiary to purchase products from the customer. During the last quarter of 1993, the Company s subsidiary exchanged its rights to the equity interest in the customer with a foreign nonaffiliated company ( Purchaser of the Interest ) for $12.0 million in notes. The Company has been advised that the customer has agreed to repurchase from the Purchaser of the Interest up to $6 million of such equity interest over a six-year period, with payment to the Purchaser of the Interest to be either in cash or bearing products. The notes issued to the subsidiary for its rights to the equity interest in the customer will only be payable when, as and if the Purchaser of the Interest collects from the customer for such equity interest, and the method of payment to the subsidiary will be either cash or bearing products, in the same manner as received by the Purchaser of the Interest from the customer. Due to the Company s inability to determine what payments, if any, it will receive on such notes, the Company will continue to carry such notes at a nominal amount. Revenues, costs and profits related to the contract are being recognized in two separate phases. The first phase involves the purchase, modification, development and delivery of the machinery, tooling, designs and other technical information and services. Sales to be recognized during this phase are limited to the expected collections under the contract during this phase. Sales and costs during the first phase will be recognized using the percentage of completion method of accounting based on the ratio of total costs incurred, excluding the cost of purchased machinery, to estimated total costs, excluding the cost of purchased machinery. Since the inception of the contract, the Company has collected $13.1 million of the contract price and recognized sales and cost of sales of $13.7 million and $4.8 million, respectively. For the year ended December 31, 1993, the Company recognized sales and cost of sales of $7.5 million and $2.2 million, respectively. The cumulative effect of future revisions in the contract terms or total cost estimates will be reflected in the period in which these changes become known. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 8. Foreign Sales Contract (continued) The second phase of the contract includes payments by the customer under the financing terms set forth above and purchases of bearing products by the Company s subsidiary from the customer. Contract revenues will be recognized as the Company performs its obligation to purchase products from the customer, which timing generally coincides with the timing that amounts are to be collected from the customer. Interest will be recognized as the amounts are collected from the customer. 9. Long-Term Debt Long-term debt is detailed as follows: December 31, 1993 1992 ----------------- (In Thousands) Subordinated debt: 13-3/4% Subordinated Sinking Fund Debentures $ - $ 2,225 Other: Secured loans of a subsidiary with interest payable quarterly at rates indicated (A): 10.415% to 12.72% term loans 20,583 24,938 Revolving loans with interest at the corporate base rate of a certain bank plus a specified percentage (7.5% at December 31, 1993) 2,100 - Variable rate term loan - 8,750 Secured revolving loans with interest payable monthly at the prime rate of a bank affiliated with the lender plus a specified percentage (9.0% aggregate rate at December 31, 1993) (B) 470 6,853 Other 7,142 7,555 ---------------- $30,295 $50,321 ================ (A) This agreement between a subsidiary of the Company and two institutional lenders provides for two series of seven-year term loans aggregating $28.5 million, a $10 million asset-based revolving credit facility, and an additional revolving line of credit of $7.2 million. Available borrowings under this additional revolving credit line at December 31, 1993 were $7.2 million and decreases annually until its termination in March 1997. The asset-based revolving loans are available to the subsidiary based on varying percentages of the carrying value of eligible assets available for collateral, as specified in the agreement. At December 31, 1993, there was $2.1 million in borrowings outstanding against the revolving credit facility. At December 31, 1993, the available asset-based revolving loans amounted to approximately $6.6 million, based on eligible assets after reduction by $1.1 million for an outstanding letter of credit related to a leasing arrangement for precious metals (Note 14). The subsidiary is required to pay a .5% fee for the excess of available over outstanding revolving loans. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 9. Long-Term Debt (continued) The agreement is secured by substantially all of the subsidiary s assets and capital stock. It requires the subsidiary to maintain certain financial ratios and contains other financial covenants, including working capital, fixed charge coverage and tangible net worth requirements and capital expenditure limitations. Payments to the parent company are limited to (i) the amount of income taxes that the subsidiary would pay if the subsidiary filed separate income tax returns, (ii) management and other fees required for reimbursement of reasonable costs and expenses, consistent with past practices and (iii) other payments to the parent company up to 25% or 50% of the cumulative net income of the subsidiary, depending on the capitalization ratio, as defined, of the subsidiary. As a result of the various restrictions under the agreement, net assets of the subsidiary of approximately $5.3 million cannot be transferred to the parent company. Annual principal payments of the term loans began on June 30, 1992 starting at $4.8 million and escalate each year to a final payment of $5.5 million on March 31, 1997. (B) The revolving loans are generally available to the Company, up to a maximum of $8 million, based on varying percentages of the carrying value of eligible assets available for collateral, as specified in the agreement. At December 31, 1993, the unused portion of available revolving loans amounted to $7.4 million. The loan agreement requires the Company to maintain consolidated net worth, as defined, of not less than $6 million. The agreement also requires the Company to maintain consolidated working capital (excluding the assets and liabilities of Equity Bank and other subsidiaries not parties to the agreement and excluding amounts owed under this agreement) of not less than $9 million at the end of each fiscal quarter. The agreement provides for certain other restrictions which, among other things, (a) limit certain future liens, (b) prohibit declaration and payment of cash dividends on common stock in excess of $1,896,000 annually, and (c) limit cumulative treasury stock purchases. Borrowings are collateralized by certain inventory and a security interest in certain other assets of the Company and its subsidiaries. This agreement continues to March 31, 1994. The Company has not determined whether the agreement will be extended past March 31, 1994. Maturities of long-term debt for each of the five years after December 31, 1993 are: 1994 - $10,651,000; 1995 - $5,568,000; 1996 - $5,667,000; 1997 - $5,769,000 and 1998 and after - $2,640,000. All drafts payable mature in 1994. The estimated fair value of the Company s long-term debt is $31.8 million and $52.2 million at December 31, 1993 and 1992, respectively. 10. Income Taxes Prior to 1992, the Company computed income taxes in accordance with Accounting Principles Board Opinion No. 11. Effective January 1, 1992, the Company elected to adopt FASB Statement No. 109, Accounting for Income Taxes. Pursuant to the provisions of Statement No. 109, the Company elected not to restate prior years financial statements. The Company has determined that the LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10. Income Taxes (continued) cumulative effect of the change in accounting for income taxes was not significant. Statement No. 109 provides that deferred income taxes will be determined using the liability method. Specifically, Statement No. 109 requires companies to recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards. Measurement of such liabilities and assets is based on provisions of enacted tax laws. Deferred tax assets are reduced, if necessary, by the amount of tax benefits, based on available evidence, that are not expected to be realized. The provision for income taxes consists of the following: Deferred Liability Method Method -------------------------- 1993 1992 1991 --------------------------- (In Thousands) Current: Federal $440 $215 $ - State 434 301 197 -------------------------- $874 $516 $197 ========================== The approximate tax effects of each type of temporary difference and carryforward that are used in computing deferred tax assets and liabilities and the valuation allowance related to deferred tax assets at December 31, 1993 and 1992 are as follows: 1993 1992 ------------------- Deferred tax asset (In Thousands) Allowances for doubtful accounts and loan losses not deductible for tax purposes $2,898 $ 2,869 Partnership losses not deductible for tax purposes 2,294 1,843 Capitalization of certain costs as inventory for tax purposes 1,668 1,455 Foreclosed real estate basis differences 539 709 Net operating loss carryforward 38,493 43,661 Investment tax and alternative minimum tax credit carryforwards 1,356 948 Other 262 990 -------------------- Total deferred tax assets 47,510 52,475 Less valuation allowance 34,865 39,915 -------------------- Net deferred tax assets $12,645 $12,560 ==================== LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10. Income Taxes (continued) 1993 1992 ------------------- Deferred tax liability (In Thousands) Accelerated depreciation used for tax purposes $ 7,061 $ 6,083 Asset basis differences resulting from business combinations: Inventories 2,139 2,084 Investments 314 306 Loan servicing costs 194 280 Tax bad debt deduction over base year 2,234 3,179 FHLB stock dividends 598 583 Other 105 45 ------------------ Total deferred tax liabilities $12,645 $12,560 ================== The Company is able to realize deferred tax assets up to an amount equal to the future reversals of existing taxable temporary differences. The majority of the taxable temporary differences will turn around in the loss carryforward period as the differences are depreciated or amortized. Other differences will turn around as the assets are disposed in the normal course of business or by tax planning strategies which management considers prudent and feasible. The differences between the amount of the provision for income taxes and the amount which would result from the application of the federal statutory rate to Income (loss) before provision for income taxes and extraordinary item are detailed below: Deferred Liability Method Method ------------------ --------- 1993 1992 1991 ------------------------------ (In Thousands) Provision (credit) for income taxes at federal statutory rate $4,646 $ 3,322 $ (323) FSLIC interest and assistance - (1,095) (2,215) Changes in the valuation allowance related to deferred tax assets (5,050) (1,295) - Net operating losses for which no current benefit is available - - 4,754 Amortization of mark-to-market adjustments (1,029) (1,493) (1,947) State income taxes, net of federal benefit 282 198 130 Amortization of excess of purchase price over net assets acquired 1,643 788 800 Settlement of dispute with governmental agency 618 - - Recoveries of previously covered foreclosed real estate (574) - - Excess provision for losses on loans and foreclosed real estate for financial purposes less than tax bad debt deduction - - (1,516) Utilization of net operating loss carryforward - (309) - Alternative minimum tax 440 215 - Other (102) 185 514 --------------------------------- Provision for income taxes $ 874 $ 516 $ 197 ================================= LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 10. Income Taxes (continued) At December 31, 1993, the Company has net operating loss ( NOL ) carryforwards for tax purposes of approximately $101 million including approximately $64 million allocable to Equity Bank (See Note 1 for discussion of proposed sale of Equity Bank). Such amounts expire beginning in 1999. The Company also has investment tax credit carryforwards of approximately $600,000, which expire beginning in 1994. Savings and loan associations which meet certain definitional tests and operating requirements prescribed by the Internal Revenue Code are allowed a special bad debt deduction. If a savings and loan does not continue to meet the federal income tax requirements necessary to meet these definitions, the association may lose the benefits of this deduction. 11. Stockholders Equity Stock Options and Warrants In November 1981, the Company adopted the 1981 Incentive Stock Option Plan, in March 1986, the Company adopted the 1986 Incentive Stock Option Plan and in September 1993, the Company adopted the 1993 Incentive Stock Plan. Under these plans, the Company is authorized to grant options to purchase up to 3,700,000 shares of the Company s common stock to key employees of the Company and its subsidiaries. These options become exercisable 20% after one year from date of grant, 40% after two years, 70% after three years, 100% after four years and lapse at the end of ten years. The exercise price of options to be granted under this plan is equal to the fair market value of the Company s common stock at the date of grant. For participants who own 10% or more of the Company s common stock at the date of grant, the option price is 110% of the fair market value at the date of grant and the options lapse after five years from the date of grant. Activity in the Company s stock option plans during each of the three years in the period ended December 31, 1993 is as follows: 1993 1992 1991 ----------------------------------- Outstanding options at beginning of year 1,340,300 2,501,700 2,719,700 Granted 14,000 280,000 - Exercised (791,636) (1,411,400) - Surrendered, forfeited or expired (6,000) (30,000) (218,000) ----------------------------------- Outstanding options at end of year 556,664 1,340,300 2,501,700 =================================== LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 11. Stockholders' Equity (continued) 1993 1992 1991 ------------------------------ At end of year: Prices of outstanding options $1.13 $1.13 $1.13 to to to $9.00 $3.44 $3.03 Average option price per share $2.44 $2.10 $1.73 Options exercisable 280,640 852,566 1,803,580 Options available for future grants 926,300 84,300 334,300 The Company s Board of Directors approved the grant of non-qualified stock options to the Company s outside directors, President and a key employee of one of the Company s subsidiaries, as detailed below. The option price was based on the market value of the Company s common stock at the date of grant and these options are exercisable at any time after the date of grant and expire five years from such date. During 1993, one of the Company s directors exercised options to purchase 65,000 shares of the Company s stock at an average price of $2.26 per share. During 1992, three of the Company s directors exercised options to purchase 150,000 shares of the Company s stock at $1.25 per share and an option to purchase 50,000 shares at $1.25 per share expired. Number of Shares Subject to Options Option Price Outstanding at Date Granted Per Share December 31, 1993 - -------------------------------------------------------------------------- June 1989 $2.625 243,000 April 1990 $1.375 100,000 June 1992 $3.125 45,000 In September 1993, the Company adopted the 1993 Non-Employee Director Stock Option Plan (the "Outside Director Plan"). The Outside Director Plan authorizes the grant of nonqualified stock options to each member of the Company's Board of Directors who is not an officer or employee of the Company or its subsidiaries. The maximum number of shares of common stock of the Company that may be issued under the Outside Director Plan is 150,000 shares (subject to adjustment as provided in the Outside Director Plan). The Company shall automatically grant to each outside director an option to acquire 5,000 shares of the Company's common stock on April 30 following the end of each of the Company's fiscal years in which the Company realizes net income of $9.2 million or more for such fiscal year. The exercise price for an option granted under this plan shall be the fair market value of the shares of common stock at the time the option is granted. Each option granted under this plan to the extent not exercised shall terminate upon the earlier of the termination as a member of the Company's Board of Directors or the fifth anniversary of the date such option was granted. No options are outstanding under this plan. Preferred Share Purchase Rights In February 1989, the Company s Board of Directors declared a dividend distribution of one Preferred Share Purchase Right (the Preferred Right ) for each outstanding share of the Company s common stock. The Preferred Rights are designed to ensure that all of the Company s stockholders receive fair and equal treatment in the event of a proposed takeover or abusive tender offer. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 11. Stockholders' Equity (continued) The Preferred Rights are generally exercisable when a person or group, other than the Company s Chairman and his affiliates, acquire beneficial ownership of 30% or more of the Company s common stock (such a person or group will be referred to as the Acquirer ). Each Preferred Right (excluding Preferred Rights owned by the Acquirer) entitles stockholders to buy one one-hundredth (1/100) of a share of a new series of participating preferred stock at an exercise price of $14. Following the acquisition by the Acquirer of beneficial ownership of 30% or more of the Company s common stock, and prior to the acquisition of 50% or more of the Company s common stock by the Acquirer, the Company s Board of Directors may exchange all or a portion of the Preferred Rights (other than Preferred Rights owned by the Acquirer) for the Company s common stock at the rate of one share of common stock per Preferred Right. Following acquisition by the Acquirer of 30% or more of the Company s common stock, each Preferred Right (other than the Preferred Rights owned by the Acquirer) will entitle its holder to purchase a number of the Company s common shares having a market value of two times the Preferred Right s exercise price. If the Company is acquired, each Preferred Right (other than the Preferred Rights owned by the Acquirer) will entitle its holder to purchase a number of the Acquirer s common shares having a market value at the time of two times the Preferred Right s exercise price. Prior to the acquisition by the Acquirer of beneficial ownership of 30% or more of the Company s stock, the Company s Board of Directors may redeem the Preferred Rights for $.01 per Preferred Right. 12. Redeemable Preferred Stock Each share of the noncumulative redeemable preferred stock, $100 par value, is convertible into 40 shares of the Company s common stock at any time at the option of the holder; entitles the holder to one vote and is redeemable at par. The redeemable preferred stock provides for a noncumulative annual dividend of 10%, payable when and as declared. 13. Non-redeemable Preferred Stock The 20,000 shares of Series B cumulative, convertible preferred stock, $100 par value, are convertible, in whole or in part, into 666,666 shares of the Company s common stock (33.3333 shares of common stock for each share of preferred stock) at any time at the option of the holder and entitles the holder to one vote per share. The Series B preferred stock provides for annual cumulative dividends of 12% from date of issue, payable when and as declared. Dividend payments are current at December 31, 1993. On May 27, 1993, the Company completed a public offering of $46 million of a new series of Class C preferred stock, designated as a $3.25 convertible exchangeable Class C preferred stock, Series 2, no par value ( Series 2 Preferred ). The Series 2 Preferred has a liquidation preference of $50.00 per share plus accrued and unpaid dividends and is convertible at the option of the holder at any time, unless previously redeemed, into common stock of the Company at an initial conversion price of $11.55 per share (equivalent to a conversion rate of approximately 4.3 shares of common stock for each share of Series 2 Preferred), subject to adjustment under certain conditions. Upon the mailing of notice of certain corporate actions, holders will have special conversion rights for a 45-day period. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 13. Non-redeemable Preferred Stock (continued) The Series 2 Preferred is not redeemable prior to June 15, 1996. The Series 2 Preferred will be redeemable at the option of the Company, in whole or in part, at $52.28 per share if redeemed on or after June 15, 1996, and thereafter at prices decreasing ratably annually to $50.00 per share on or after June 15, 2003, plus accrued and unpaid dividends to the redemption date. Dividends on the Series 2 Preferred are cumulative and are payable quarterly in arrears. The Series 2 Preferred also is exchangeable in whole, but not in part, at the option of the Company on any dividend payment date beginning June 15, 1996, for the Company s 6.50% Convertible Subordinated Debentures due 2018 (the Debentures ) at the rate of $50.00 principal amount of Debentures for each share of Series 2 Preferred. Interest on the Debentures, if issued, will be payable semiannually in arrears. The Debentures will, if issued, contain conversion and optional redemption provisions similar to those of the Series 2 Preferred and will be subject to a mandatory annual sinking fund redemption of five percent of the amount of Debentures initially issued, commencing June 15, 2003 (or the June 15 following their issuance, if later). The 663,150 shares of Series 1 Convertible, Exchangeable Class C Preferred Stock (Series 1 Preferred Stock) outstanding at December 31, 1992 were converted into 5,008,558 shares of common stock. The remaining 5,760 shares of Series 1 Preferred Stock not converted to common stock, were redeemed at $20.88 per share plus accrued dividends by the Company. At December 31, 1993, the Company is authorized to issue an additional 228,363 shares of $100 par value preferred stock and an additional 5,000,000 shares of no par value preferred stock. Upon issuance, the Board of Directors of the Company is to determine the specific terms and conditions of such preferred stock. 14. Commitments and Contingencies Operating Leases The Company leases certain property, plant and equipment. Future minimum payments on operating leases with initial or remaining terms of one year or more at December 31, 1993 are as follows: (In Thousands) 1994 $1,386 1995 980 1996 625 1997 234 1998 113 After 1998 36 -------- $3,374 ======= LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 14. Commitments and Contingencies (continued) Rent expense under all operating lease agreements, including month-to-month leases, was $2,073,000 in 1993, $2,934,000 in 1992 and $2,944,000 in 1991. Renewal options are available under certain of the lease agreements for various periods at approximately the existing annual rental amounts. Rent expense paid to related parties was $120,000 in 1993, 1992 and 1991. A subsidiary of the Company has an operating lease agreement for specified quantities of precious metals used in the subsidiary s production process. The lease, which expires in May 1994, requires, among other things, (i) rentals generally based on a percentage (5.5%) of the leased metals market values, (ii) the subsidiary to provide to the lessor a letter of credit equal to approximately 80% of the leased metals market value (approximately $1.1 million at December 31, 1993) and (iii) the subsidiary to purchase the leased metals at market value at the end of the lease term, if not renewed, or return to the lessor the quantities of metals subject to the lease. A substantial portion of Equity Bank s lease expense relates to the corporate office space occupied by Equity Bank. In 1989, Equity Bank made a $15 million first mortgage real estate loan collateralized by the building in which Equity Bank s corporate office is located. In connection with the origination of this loan, Equity Bank obtained an option to purchase the building. The option period is from December 31, 1995 through June 30, 1996 at a price to be determined at the time of exercise. This loan was determined to be an in- substance foreclosure during 1990 and is included in foreclosed real estate at December 31, 1993 and 1992 (Note 4). During 1993, the Company s Chemical Business acquired an additional nitric acid plant for approximately $1.9 million. The Chemical Business is in the process of moving such plant from Illinois and installing the plant in Arkansas. The Company anticipates the total expenditures to move and install the plant will be approximately $12 million, of which $1.9 million had been incurred at December 31, 1993. Legal Matters Following is a summary of certain legal actions involving the Company: A. In 1987, the U.S. Government notified one of the Company s subsidiaries, along with numerous other companies, of potential responsibility for clean-up of a waste disposal site in Oklahoma. No legal action has yet been filed. The amount of the Company s cost associated with the clean- up of the site is unknown due to continuing changes in (i) the estimated total cost of clean-up of the site and (ii) the percentage of the total waste which was alleged to have been contributed to the site by the Company, accordingly, no provision for any liability which may result has been made in the accompanying financial statements. The subsidiary s insurance carriers have been notified of this matter; however, the amount of possible coverage, if any, is not yet determinable. B. The primary manufacturing facility of the Company s Chemical Business has been placed in the Environmental Protection Agency s ( EPA ) tracking system ("System") of sites which are known or suspected to be a site of a release of contaminated waste. Inclusion in the EPA s tracking system does not represent a determination of liability or a finding that any response action is necessary, accordingly, no provision for any liability that may result has been made in the consolidated financial LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 14. Commitments and Contingencies (continued) statements. As a result of being placed in the System, the State of Arkansas performed a preliminary assessment. The Company has been advised that there have occurred certain releases of contaminants at the Site. In addition, as a result of certain releases of contaminants at the Site, the Company s subsidiary may be subject to assessment of certain civil penalties. The Company s subsidiary has not yet received from the appropriate governmental agency of the State of Arkansas a determination as to the appropriate plan of remediation of the Site and what contaminants, if any, must be remediated. The subsidiary is unable to estimate the cost of such remediation until the subsidiary receives an acceptable plan from such agency. The subsidiary believes that it will receive such a plan from the appropriate Arkansas state agency in the near future and at that time will be able to estimate the cost of such remediation at the Site. The Company does not believe that the response to any contamination at the Site or the assessment of penalties, if any, due to the release of certain contaminants at the Site would have a material adverse effect on the Company or its financial condition. C. A subsidiary of the Company was named in April 1989 as a third party defendant in a lawsuit alleging defects in fan coil units installed in a commercial building. The amount of damages sought by the owner against the general contractor and the subsidiary s customer are substantial. The subsidiary s customer alleges that to the extent defects exist in the fan coil units, it is entitled to recovery from the subsidiary. The Company s subsidiary generally denies their customer s allegations and that any failures in the fan coil units were a result of improper design by the customer, improper installation or other causes beyond the subsidiary s control. The subsidiary has in turn filed claims against the suppliers of certain materials used to manufacture the fan coil units to the extent any failures in the fan coil units were caused by such materials. Discovery in these proceedings is continuing. The Company believes it is probable that it will receive insurance proceeds in the event of an unfavorable outcome. The Company, including its subsidiaries, is a party to various other claims, legal actions, and complaints arising in the ordinary course of business. In the opinion of management after consultation with counsel, all claims, legal actions (including those described above) and complaints are adequately covered by insurance, or if not so covered, are without merit or are of such kind, or involve such amounts that unfavorable disposition would not have a material effect on the financial position or results of operations of the Company. During 1993 the Company settled an outstanding dispute with the U.S. Customs Service. Pursuant to the terms of the settlement agreement, the Company made a payment of $1.8 million. This settlement payment has been included in nonfinancial services selling, general and administrative expenses in 1993. In connection with its loan servicing activities, Equity Bank is contingently liable for certain mortgage loans sold with recourse to investors. At December 31, 1993, the outstanding principal balance of such loans is approximately $17.9 million. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 15. Segment Information The Company and its subsidiaries operate principally in five industries. Chemical This segment manufactures and sells chemical products for mining, agricultural, electronic, paper and other industries. Sales to customers of this segment, which primarily include coal mining companies throughout the United States and farmers in Texas, Missouri and Tennessee, are generally unsecured. Environmental Control This business segment manufactures and sells a variety of air handling and heat pump products for use in commercial and residential air conditioning and heating systems. Sales to customers of this segment, which primarily include original equipment manufacturers, contractors and independent sales representatives located throughout the world, are generally secured by a mechanic s lien, except for sales to original equipment manufacturers, which are generally unsecured. Financial Services (See Note 1 for Discussion of Proposed Sale of Equity Bank) This segment provides a wide variety of financial services to various customers, located primarily in Oklahoma. See Notes 2, 4 and 5 for a more complete discussion of the Financial Services Business, customers and other matters. Industrial Products This segment purchases and sells machine tools and industrial supplies to machine tool dealers and end users throughout the world. Sales of industrial supplies are generally unsecured, whereas the Company generally retains a security interest in machine tools sold until payment is received. Automotive Products This segment manufactures and sells, generally on an unsecured basis, anti-friction bearings and other products for automotive applications to wholesalers, retailers and original equipment manufacturers located throughout the world. For all but the Financial Services Business for which credit granting is discussed in Note 5, credit is extended to customers based on an evaluation of the customer s financial condition and other factors. Credit losses are provided for in the financial statements based on historical experience and periodic assessment of outstanding accounts receivable, particularly those accounts which are past due. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company s customer bases, and their dispersion across many different industries and geographic areas. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 15. Segment Information (continued) Information about the Company s operations in different industry segments for each of the three years in the period ended December 31, 1993 is detailed below. 1993 1992 1991 -------------------------------------- (In Thousands) Revenues: Chemical $115,631 $107,219 $ 90,226 Environmental Control 69,644 55,019 57,861 Financial Services 41,835 46,909 55,029 Industrial Products 20,719 17,590 14,012 Automotive Products 28,765 20,046 17,063 -------------------------------------- $276,594 $246,783 $234,191 ====================================== Gross profit: Chemical $ 27,557 $ 26,572 $ 18,831 Environmental Control 15,651 13,839 15,532 Industrial Products 5,160 4,904 3,419 Automotive Products 9,744 6,667 2,995 -------------------------------------- $ 58,112 $ 51,982 $ 40,777 ====================================== Operating profit (loss): Chemical $ 17,632 $ 18,427 $ 12,278 Environmental Control 3,900 3,269 2,030 Financial Services 4,390 2,989 3,483 Industrial Products 2,120 257 558 Automotive Products 2,528 954 (1,809) -------------------------------------- 30,570 25,896 16,540 General corporate expenses (9,789) (6,900) (6,714) Interest expense, excluding Financial Services (7,508) (9,225) (10,776) --------------------------------------- Income (loss) before provision for income taxes $ 13,273 $ 9,771 $ (950) ======================================= Depreciation, depletion and amortization of property, plant and equipment: Chemical $ 3,696 $ 3,566 $ 3,274 ====================================== Environmental Control $ 1,015 $ 965 $ 938 ====================================== Financial Services $ 883 $ 821 $ 805 ====================================== Industrial Products $ 118 $ 141 $ 92 ====================================== Automotive Products $ 502 $ 620 $ 687 ====================================== LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 15. Segment Information (continued) 1993 1992 1991 -------------------------------------- (In Thousands) Additions to property, plant and equipment: Chemical $ 9,036 $ 3,916 $ 2,224 ====================================== Environmental Control $ 1,584 $ 400 $ 274 ====================================== Financial Services $ 1,156 $ 719 $ 293 ====================================== Industrial Products $ 560 $ 471 $ 1,830 ====================================== Automotive Products $ 1,875 $ 769 $ 792 ====================================== Identifiable assets: Chemical $ 71,299 $ 57,138 $ 55,474 Environmental Control 24,394 22,517 21,430 Financial Services 457,330 466,065 492,101 Industrial Products 18,451 15,353 18,255 Automotive Products 22,957 18,682 14,911 -------------------------------------- 594,431 579,755 602,171 Corporate assets 3,081 2,493 3,342 -------------------------------------- Total assets $ 597,512 $582,248 $605,513 ====================================== Revenues by industry segment include revenues from unaffiliated customers, as reported in the consolidated financial statements. Intersegment revenues, which are accounted for at transfer prices ranging from the cost of producing or acquiring the product or service to normal prices to unaffiliated customers, are not significant. Gross profit by industry segment represents net sales less cost of sales. In 1993 and 1992, gross profit of the Industrial Products and Automotive Products segments has been increased for the profits recognized on the long-term contract discussed in Note 8. The profits are divided equally between the two segments. Operating profit by industry segment represents revenues less operating expenses. In computing operating profit, none of the following items have been added or deducted: general corporate expenses, income taxes or interest expense (except the interest expense of the Financial Services segment is deducted in computing operating profit). The 1993 and 1992 operating profit of the Industrial Products and the Automotive Products segments has been increased for the profits recognized on the long-term contract discussed in Note 8. The profits are divided equally between the two segments. LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 15. Segment Information (continued) Identifiable assets by industry segment are those assets used in the operations in each industry. Accounts receivable purchased by the Financial Services segment from the other business segments are included in the Financial Services identifiable assets since the financing income related thereto is included in the Financial Services operating profit. Corporate assets are those principally owned by the parent company. Revenues from unaffiliated customers include direct foreign export sales as follows: Geographic Area 1993 1992 1991 - -------------------------------------------------------------------------- (In Thousands) Mexico and Central and South America $ 6,419 $ 4,075 $4,075 Canada 11,850 8,123 4,571 Slovakia 9,231 6,203 - Other 5,183 2,679 590 ---------------------------------- $32,683 $21,080 $9,236 ================================== In addition, revenues from unaffiliated customers include sales in 1993, 1992 and 1991 amounting to $5,917,000, $2,088,000 and $7,491,000, respectively, which the Company believes were ordered for export shipment. As discussed in Note 1, the Company s consolidated balance sheet is prepared on an unclassified basis due to the inclusion of the financial services subsidiaries on a fully consolidated basis. The following detail presents the financial services subsidiaries on the equity method and presents the other assets and liabilities of the Company on the traditional classified basis: 1993 1992 ---------------------- (In Thousands) Current assets: Cash $ 1,055 $ 279 Trade accounts receivable, net 17,689 4,535 Inventories 48,384 48,373 Advances and prepaid items 5,459 4,134 ---------------------- Total current assets 72,587 57,321 Investment in, net of advances from, Financial Services subsidiaries and other noncurrent assets 21,484 12,160 Property, plant and equipment, net41,845 34,482 ---------------------- $135,916 $103,963 ===================== LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 15. Segment Information (continued) 1993 1992 ---------------------- (In Thousands) Current liabilities: Drafts payable due within one year $ 1,220 $ 3,738 Accounts payable 22,645 18,906 Billings in excess of costs and estimated earnings - 4,858 Accrued liabilities 6,755 6,877 Long-term debt due within one year 14,349 9,158 ---------------------- Total current liabilities 44,969 43,537 Long-term debt and drafts payable due after one year 15,921 41,924 Redeemable, noncumulative, convertible preferred stock, $100 par value 155 163 Non-redeemable preferred stock, common stock and other stockholders equity 74,871 18,339 ---------------------- $135,916 $103,963 ====================== The following detail presents summarized asset and liability amounts included in the consolidated financial statements at December 31, 1993 and 1992 for the Company s financial services subsidiaries. Real estate, office buildings and equipment include the assets transferred to Equity Bank in connection with the acquisition at the historical cost of $18.8 million rather than at the fair value of $69 million at which they are recorded in Equity Bank s stand-alone financial statements: 1993 1992 --------------------- (In Thousands) Assets Cash and securities $ 18,438 $ 40,002 Loans and mortgage-backed securities 359,303 301,063 Trade accounts receivable 31,844 31,515 Assets covered by FSLIC - 52,004 Real estate, office buildings and equipment, net 43,086 38,718 Excess of purchase price over net assets acquired 17,041 14,645 Other assets 3,179 3,677 ---------------------- $472,891 $481,624 ====================== LSB Industries, Inc. Notes to Consolidated Financial Statements (continued) 15. Segment Information (continued) 1993 1992 --------------------- (In Thousands) Liabilities: Deposits $332,511 $336,053 FHLB advances 87,650 80,150 Long-term borrowings 25 50 Securities sold under agreements to repurchase 38,721 50,344 Payable to FSLIC - 9,107 Other liabilities 2,689 2,581 Investment and advances 11,295 3,339 ----------------------- $472,891 $481,624 ======================= LSB Industries, Inc. Supplementary Financial Data Quarterly Financial Data (Unaudited) (In Thousands, Except Per Share Amounts) (Three months ended) March 31 June 30 Sept. 30 Dec. 31 ------------------------------------------------------- Total revenues $63,419 $78,415 $68,773 $65,987 ======================================================= Gross profit on net sales $13,286 $18,067 $13,454 $13,305 ======================================================= Net interest income related to the Financial Services Business* $ 3,008 $ 3,232 $ 3,409 $ 3,358 ======================================================= Net income $ 2,657 $ 5,758 $ 2,424 $ 1,560 ======================================================= Net income applicable to common stock $ 2,580 $ 5,408 $ 1,616 $ 753 ======================================================= Primary earnings per common share $.25 $.40 $.09 $.05 ======================================================= Total revenues $56,796 $70,820 $60,622 $58,545 ======================================================= Gross profit on net sales $11,520 $15,886 $11,553 $13,023 ======================================================= Net interest income related to the Financial Services Business* $ 2,857 $ 3,150 $ 3,076 $ 3,496 ======================================================= Net income $ 1,108 $ 4,276 $ 2,097 $ 1,774 ======================================================= Net income applicable to common stock $ 614 $ 3,806 $ 1,659 $ 1,349 ======================================================= Primary earnings per common share $.10 $.49 $.19 $.16 ======================================================= *This amount includes interest income earned on accounts receivable purchased, with recourse, from the Company's other subsidiaries. See Note 5 to the Consolidated Financial Statements. Net income in the fourth quarter of 1993 was increased approximately $3.5 million for additions to fixed assets resulting from capitalizable expenditures previously being expensed and the collection of an insurance settlement relating to the foreign project inventory (see Note 8 to the Consolidated Financial Statements for further discussions relating to the foreign sales contract). LSB Industries, Inc. Supplementary Financial Data Quarterly Financial Data (Unaudited) (continued) Net income in the fourth quarter of 1992 was increased by approximately $3.5 million for adjustments to inventories resulting from book-to-physical differences, adjustments to estimated accruals and deferrals of certain operating expenses and profits recognized on a foreign sales contract (see Note 8 to the Consolidated Financial Statements for further discussion related to the foreign sales contract). LSB Industries, Inc. Schedule II - Amounts Receivable From Employees and Directors Years ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Balance at Balance Beginning at End Name of Debtor of Year Additions Payments of Year - ---------------------------------------------------------------------------- Year ended December 31, 1993: David Houston, former President of the Company's savings and loan subsidiary - Advances, bearing interest at 10% (resigned in January 1991) $299 $ - $ - $299 David R. Goss, Director and Senior Vice President, Operations - 100 - 100 Tony M. Shelby, Director and Senior Vice President, Finance 100 - 100 - C.L. Thurman, Director - 147 - 147 ---------------------------------------------- $399 $247 $100 $546 ============================================== Year ended December 31, 1992: David Houston, former President of the Company's savings and loan subsidiary - Advances, bearing interest at 10% (resigned in January 1991) $299 $ - $ - $299 Tony M. Shelby, Director and Senior Vice President, Finance 100 - - 100 ---------------------------------------------- $399 $ - $ - $399 ============================================== Year ended December 31, 1991: David Houston, former President of the Company's savings and loan subsidiary - Advances, bearing interest at 10% (resigned in January 1991) $299 $ - $ - $299 Tony M. Shelby, Director and Senior Vice President, Finance 100 - - 100 ---------------------------------------------- $399 $ - $ - $399 ============================================== LSB Industries, Inc. Schedule III - Condensed Financial Information of Registrant Condensed Balance Sheets December 31, 1993 1992 ----------------- (In Thousands) Assets Current assets: Cash $ 52 $ 702 Accounts receivable 381 90 Prepaid expenses 1,687 1,102 ------------------- Total current assets 2,120 1,894 Property, plant and equipment 4,555 4,399 Less allowance for depreciation (3,116) (2,734) ------------------- 1,439 1,665 Excess of purchase price over net assets acquired, net 319 397 Other assets (principally investments in and amounts due from wholly-owned subsidiaries) (Notes A and B) 76,313 23,639 ------------------- $80,191 $27,595 =================== Liabilities and stockholders' equity Current liabilities $ 4,196 $ 4,728 Long-term debt (Note B) 138 1,654 Commitments and contingencies (Notes C and D) Redeemable preferred stock 155 163 Non-redeemable preferred stock, common stock and other stockholders' equity: Common stock 1,451 810 Preferred stock 48,000 17,357 Other stockholders' equity 26,251 2,883 ------------------ 75,702 21,050 ------------------ $80,191 $27,595 ================== See accompanying notes. LSB Industries, Inc. Schedule III - Condensed Financial Information of Registrant (continued) Condensed Statements of Operations Year ended December 31, 1993 1992 1991 ---------------------------------- (In Thousands) Management fees from consolidated subsidiaries $ 7,524 $ 7,459 $ 7,278 Interest income, primarily intercompany 3,078 1,807 7,073 Other income 808 800 1,250 ---------------------------------- 11,410 10,066 15,601 Costs and expenses: General and administrative expenses 9,023 7,789 8,320 Interest expense, primarily intercompany 1,666 1,930 4,901 Settlement of dispute 1,767 - - --------------------------------- 12,456 9,719 13,221 --------------------------------- Income (loss) before credit for income taxes and equity in net income (loss) of subsidiaries (1,046) 347 2,380 Credit for income taxes 4,347 3,348 2,311 --------------------------------- Income before equity in net income (loss) of subsidiaries 3,301 3,695 4,691 Equity in net income (loss) of subsidiaries 9,098 5,560 (5,838) --------------------------------- Net income (loss) $12,399 $ 9,255 $(1,147) ================================= See accompanying notes. LSB Industries, Inc. Schedule III - Condensed Financial Information of Registrant (continued) Condensed Statements of Cash Flows Year ended December 31, 1993 1992 1991 --------------------------------- (In Thousands) Cash from operating activities $ 1,256 $4,658 $5,426 Investing activities Capital expenditures (156) (206) (158) Advances to, net of advances and dividends from subsidiaries (43,613) (1,811) (3,166) ---------------------------------- (43,769) (2,017) (3,324) Financing activities Payment on long-term debt (2,262) (676) (636) Dividends paid on common and preferred stocks (2,713) (1,827) (1,943) Proceeds from issuance of preferred stock 43,871 - - Proceeds from issuance of common stock 3,269 687 - Purchase of treasury stock (302) - - --------------------------------- 41,863 (1,816) (2,579) --------------------------------- Increase (decrease) in cash $ (650) $ 825 $(477) ================================= See accompanying notes. LSB Industries, Inc. Schedule III - Condensed Financial Information of Registrant (continued) Notes to Condensed Financial Statements Note A - Basis of Presentation In the parent-company-only financial statements, the Company's investment in subsidiaries is stated at cost plus equity in undistributed earnings (losses) of subsidiaries since date of acquisition. Parent-company-only financial statements should be read in conjunction with the Company's consolidated financial statements. Note B - Long-Term Debt Redemption of Debentures - On June 1, 1993, the Company called for redemption of all of its outstanding shares of 13-3/4% Subordinated Debentures due 1995 ("Debentures"). The Debentures were redeemed on July 1, 1993. Each outstanding Debenture was redeemed at $1,000, the principal amount of such Debenture, plus accrued and unpaid interest on the Debentures to the redemption date of July 1, 1993. There were approximately $2.2 million in outstanding Debentures at the redemption date. Note C - Guarantees The Company has guaranteed the payment of principal and interest under the terms of various debt agreements of the Company's subsidiaries. Subsidiaries' long-term debt outstanding at December 31, 1992 which is guaranteed by the parent is $1,697,000. The Company has guaranteed a subsidiary's obligation to pay into affiliated partnerships any deficit which exists in the subsidiary's partnership capital accounts at the time of liquidation of the partnerships, reduced by the difference between the net book value of the partnerships' assets and the fair market value (or sales price in the case of liquidation) of assets. At December 31, 1993, the deficit in the subsidiary's partnership capital accounts was $10,994,000. Note D - Commitments and Contingencies See Note 14 to the Company's consolidated financial statements for discussion of material contingencies. See Notes 12 and 13 for a discussion of matters related to the Company's preferred stocks and other stockholders' equity matters. LSB Industries, Inc. Schedule VIII - Valuation and Qualifying Accounts Years ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Additions Deductions --------- ---------- Charged Write- Balance at to Costs offs/ Balance Beginning and Costs at End Description of Year Expenses Incurredof Year - ----------------------------------------------------------------------------- Allowance for doubtful accounts (1): 1993 $3,082 $ 439 $ 938 $2,583 ====================================================== 1992 $3,354 $ 972 $1,244 $3,082 ====================================================== 1991 $2,866 $1,873 $1,385 $3,354 ====================================================== Product warranty liability: 1993 $ 613 $ 427 $ 387 $ 653 ===================================================== 1992 $ 649 $ 547 $ 583 $ 613 ===================================================== 1991 $ 579 $ 831 $ 761 $ 649 ===================================================== (1) Deducted in the balance sheet from the related assets to which the reserve applies. Other valuation and qualifying accounts are detailed in the Company's notes to consolidated financial statements. LSB Industries, Inc. Schedule X - Supplementary Statement of Operations Information Years ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Charged to Costs and Expenses 1993 1992 1991 ---------------------------------------- Maintenance and repairs $5,350 $4,569 $3,737 ======================================= Taxes, other than payroll and income taxes, royalties, amortization of deferred costs and advertising costs did not exceed 1% of gross revenues during any of the three years in the period ended December 31, 1993.

711513_1993.txt

711513_1993

1993

711513

Item 1. Business General McDonnell Douglas Finance Corporation and its subsidiaries (the "Company") is a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation ("MDFS"), a wholly-owned subsidiary of McDonnell Douglas Corporation ("MDC"). The Company was incorporated in Delaware in 1968 and originally financed only MDC manufactured commercial jet transport aircraft. While this continues to represent a significant portion of the Company's business, the Company also provides a diversified range of financing including loans, finance leases and operating leases, primarily involving equipment for commercial and industrial customers. At December 31, 1993, the Company had approximately 110 employees. Beginning in 1990, as a result of the lowering of the Company's credit ratings, capital constraints imposed by MDC, the recession and the failure of most of its non-core businesses to achieve a satisfactory return, the Company significantly scaled back its operations and focused its new business efforts almost entirely within its two core business units, commercial aircraft financing and commercial equipment leasing ("CEL"), businesses in which the Company historically has achieved satisfactory returns. For the five years ended 1993, the core businesses earned $262.0 million or 133% of the total net earnings of the Company, excluding the 1989 cumulative effect of change in accounting principle. In 1991, the Company determined to exit each of its non-core businesses as market conditions permitted. The Company now operates in three segments: commercial aircraft financing, CEL and non-core businesses. Non-core businesses represent market segments in which the Company is no longer active. The non-core businesses consist primarily of the remaining assets of three business units: McDonnell Douglas Bank Limited ("MD Bank"), receivable inventory financing ("RIF") and real estate financing ("RE"). Non-core new business volume in 1993 and 1992 represent previous contractual commitments and extensions of maturing transactions. The Company does not intend to seek new contractual commitments in its non-core businesses. The Company is actively managing the remaining non-core business portfolios with a view toward liquidating those portfolios over time. Information on the Company's new business volume and portfolio balances is included in the following tables. New Business Volume Years ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Commercial aircraft $ 411.4 $153.2 $100.9 $ 155.4 $ 121.0 financing Commercial equipment 41.5 50.7 91.8 189.1 305.4 leasing Non-core businesses 0.1 2.6 38.6 416.8 536.2 $ 453.0 $206.5 $231.3 $ 761.3 $ 962.6 Portfolio Balances December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Commercial aircraft $ 1,237.5 $1,001.1 $ 907.8 $ 1,048.1 $ 948.1 financing Commercial equipment 422.3 557.4 668.9 965.1 1,001.2 leasing Non-core businesses 173.7 227.9 595.6 1,245.9 1,113.2 $ 1,833.5 $1,786.4 $2,172.3 $ 3,259.2 $ 3,062.5 For financial information about the Company's segments, see Notes to Consolidated Financial Statements included in Item 8. Commercial Aircraft Financing Segment The Company's commercial aircraft financing group, located in Long Beach, California, provides customer financing services to Douglas Aircraft Company, a division of MDC, and finances the acquisition of MDC aircraft by purchasing such aircraft subject to lease to airlines and by providing secured and unsecured notes receivable financing in connection with the acquisition of such aircraft. Beginning in 1986, the Company began providing financing to airlines for aircraft manufactured by manufacturers other than MDC, but a substantial majority of the commercial aircraft portfolio is comprised of aircraft manufactured by MDC. Portfolio balances for the Company's commercial aircraft financing segment are summarized as follows: Commercial Aircraft Portfolio by Product Type December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Aircraft leases: Finance leases Domestic $ 638.8 $601.5 $609.2 $ 798.2 $ 717.4 Foreign 297.3 54.6 70.9 71.5 83.6 Operating leases Domestic 149.8 111.4 81.5 56.9 53.6 Foreign 50.3 39.9 10.9 10.9 - 1,136.2 807.4 772.5 937.5 854.6 Aircraft related notes receivable: Domestic obligors Senior 51.5 88.0 47.1 20.4 25.5 Subordinated - - 14.5 13.5 13.6 Foreign obligors Senior 49.8 105.7 73.7 76.7 54.4 101.3 193.7 135.3 110.6 93.5 $ 1,237.5 1,001.1 $907.8 $1,048.1 $ 948.1 Commercial Aircraft Portfolio by Aircraft Type December 31, (Dollars in millions) 1993 1992 1991 1990 1989 MDC aircraft financing: Finance leases $ 813.1 $ 506.2 $465.6 $ 604.7 $ 592.0 Operating leases 144.2 93.7 30.0 15.6 20.2 Notes receivable 77.7 169.4 107.4 66.6 82.6 1,035.0 769.3 603.0 686.9 694.8 Other commercial aircraft financing: Finance leases 123.0 149.9 214.6 265.0 209.0 Operating leases 55.9 57.6 62.3 52.2 33.4 Notes receivable 23.6 24.3 27.9 44.0 10.9 202.5 231.8 304.8 361.2 253.3 $1,237.5 $ 1,001.1 $907.8 $ 1,048.1 $ 948.1 At December 31, 1993, the Company's commercial aircraft portfolio was comprised of finance leases to 23 customers (18 domestic and five foreign) with a carrying amount of $936.1 million (51.1% of total Company portfolio), notes receivable from eight customers (four domestic and four foreign) with a carrying amount of $101.3 million (5.5% of total Company portfolio) and operating leases to nine customers (seven domestic and two foreign) with a carrying amount of $200.1 million (10.9% of total Company portfolio). The five largest commercial aircraft financing customers accounted for $718.5 million (39.2% of total Company portfolio) and $445.1 million (24.9% of total Company portfolio) at December 31, 1993 and 1992. At December 31, 1993, 56.5% of the Company's total portfolio consisted of financings related to MDC aircraft, compared with 43.1% and 27.8% in 1992 and 1991. - - - Factors Affecting the Commercial Aircraft Financing Portfolio A substantial portion of the Company's aircraft financings are to airlines which either have recently emerged from bankruptcy or are in poor financial health. The Company's two largest commercial aircraft financing customers, Trans World Airlines, Inc. ("TWA") and Continental Airlines, Inc. and its affiliated companies ("Continental"), have recently emerged from bankruptcy. Company financings to TWA accounted for $253.2 million (13.8% of total Company portfolio) and $102.9 million (5.8% of total Company portfolio) at December 31, 1993 and 1992. On November 3, 1993, TWA emerged from Chapter 11 bankruptcy. At December 31, 1993, the Company had commitments to provide additional aircraft-related financing to TWA of $22.9 million. Company financings to Continental accounted for $116.4 million (6.4% of total Company portfolio) and $120.9 million (6.8% of total Company portfolio) at December 31, 1993 and 1992. During periods in 1991 and 1992 when Continental was in bankruptcy, the Company agreed to accept the deferral of certain payments due from Continental which totaled $6.1 million at December 31, 1993. On April 27, 1993, Continental emerged from Chapter 11 bankruptcy. Pursuant to the terms of supplemental guaranties recently executed by MDC in favor of the Company, up to an additional $25.0 million of the Company's financings to TWA and up to an additional $15.0 million of the Company's financings to Continental are guaranteed by MDC. These guaranties supplement individual guaranties provided by MDC with respect to certain of the Company's financings to TWA and Continental to the extent that the estimated fair market value of the financings (after applying the individual guaranties) is less than the net asset value of the financings on the Company's books. The supplemental guaranties terminate in March 1996, but may be extended under certain circumstances. In June 1991, America West Airlines, Inc. ("America West") filed for protection under Chapter 11 of the Federal Bankruptcy Code. The Company participated in the financing of six aircraft which were returned by America West in December 1992. Five of the aircraft are on lease to a new customer and the sixth will be sold, subject to partial financing, in early 1994. During 1993, the Company and America West entered into an agreement whereby the Company settled its bankruptcy claims against America West in exchange for America West airline passenger tickets. The Company continues to market these tickets. As part of a reorganization plan, on November 30, 1992, PWA Corporation ("PWA") ceased making payments to all of its creditors. Time Air, Inc. ("Time Air"), a subsidiary of PWA, became delinquent in December 1992 under its financing of a commuter aircraft which as of December 31, 1993, had a net carrying value of $5.7 million. The Company has agreed to a deferral of certain payments with Time Air, which agreement was amended in February 1994 to lengthen the deferral. The Company has not suffered a material adverse effect upon its financial condition as a result of the above-mentioned bankruptcies. In addition, the Company historically has not been materially adversely affected by bankruptcies involving its commercial aircraft customers because of the collateral value of the aircraft and, to a lesser extent, MDC guaranties obtained in connection with certain of the financings. However, should one or more of the Company's major airline customers encounter financial difficulties and liquidate its fleet, the large number of aircraft which would be added to the already saturated market would make it difficult for the Company to realize the carrying value of the aircraft leased to such airline(s). In March 1994, the Company reached an agreement in principle with an airline leasing an aircraft with a December 31, 1993 carrying amount of $23.0 million who had become delinquent on its lease payments. Pursuant to the agreement in principle , the term of the lease was extended and the payment schedule was adjusted. - - - Current Commercial Aircraft Market Conditions The current severe economic downturn within the airline industry has diminished significantly the demand for new and used aircraft, with some airlines defaulting on contracts for firm orders or postponing orders with the manufacturer while also disposing of or grounding a portion of their fleets. This has resulted in an oversupply of aircraft in the market, which has materially adversely affected the values of the Company's aircraft. It is not clear whether this decline in aircraft values will continue. Despite the erosion of aircraft values, the Company believes that the value of realizable sales prices at the end of the lease terms for substantially all the aircraft the Company has leased exceeds the book value projected at the end of the lease terms. If aircraft values remain depressed or continue to decline and the Company is required as a result of customer defaults to repossess a substantial number of aircraft prior to the expiration of the related lease or financing, the Company could incur substantial losses in remarketing the aircraft, which could have a material adverse effect on the financial condition of the Company. In this regard, the Company's financial performance is dependent in part upon general economic conditions which may affect the profitability of commercial airlines. During 1993, the Company held for sale or lease 17 aircraft and successfully remarketed 11 aircraft, reducing its inventory of aircraft to six at December 31, 1993, with a carrying value of $26.3 million. At December 31, 1993, five of the six aircraft in inventory were the subject of lease commitments with TWA and will be delivered during 1994. The remaining aircraft will be sold to TWA, on a partially financed basis, in early 1994. - - - Aircraft Leasing The Company normally purchases commercial aircraft for lease to airlines only when such aircraft are subject to a signed lease contract. At December 31, 1993, the Company owned or participated in the ownership of 109 leased commercial aircraft, including 56 jet transports manufactured by MDC. - - - Factors Affecting Aircraft Financing Volume As in the past, the Company anticipates continued fluctuations in the volume of its aircraft financing transactions. Current market conditions may limit many airlines' ability to access financing and present more opportunities to the Company. The Company's decision to exit its non-core businesses and the increased need of certain of MDC's commercial aircraft customers for financing resulted in the Company financing a substantial amount of aircraft manufactured by MDC in 1993. The Company had commitments to provide aircraft related financing of $38.5 million at December 31, 1993 and $1.8 million at December 31, 1992. (See "Competition and Economic Factors.") The following lists information on new business volume for the Company's commercial aircraft financing segment: Years ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 MDC aircraft financing volume: Finance leases $ 357.3 $ 95.0 $ 19.2 $ 29.7 $ 37.3 Operating leases 33.8 53.5 30.0 - - Notes receivable 19.1 4.7 21.5 - - 410.2 153.2 70.7 29.7 37.3 Other commercial aircraft financing volume: Finance leases - - 23.9 69.3 67.9 Operating leases 0.7 - 6.3 21.0 13.8 Notes receivable 0.5 - - 35.4 2.0 1.2 - 30.2 125.7 83.7 $ 411.4 $ 153.2 $ 100.9 $ 155.4 $ 121.0 - - - Aircraft Financing Guaranties At December 31, 1993, the Company had $318.2 million of guaranties with respect to its commercial aircraft financing portfolio relating to transactions with a carrying value of $1,237.5 million (25.7% of the commercial aircraft financing portfolio). The following table summarizes such guaranties: (Dollars in millions) Domestic Foreign Total Amounts guaranteed by: MDC $127.2 $134.4 $261.6 Foreign governments - 14.5 14.5 Other 28.3 13.8 42.1 Total guaranties $155.5 $162.7 $318.2 The Company has no reason to believe that any such guaranteed amounts will be ultimately unenforceable or uncollectible. See "Relationship With MDC." Commercial Equipment Leasing Segment CEL provides single-investor, tax-oriented lease financing as its primary product. CEL, which maintains its principal operation in Long Beach, California and has marketing offices in Chicago, Illinois and Detroit, Michigan, obtains its business primarily through direct solicitation by its marketing personnel. CEL specializes in leasing equipment such as over-the- road transportation equipment, executive aircraft, machine tools, shipping containers, printing equipment, textile manufacturing equipment and other types of equipment which it believes will maintain strong collateral and residual values. The lease term is generally between three and ten years and transaction sizes usually range between $2.0 million and $10.0 million. In addition to financing transactions for the Company, CEL arranges third party financings of equipment. Portfolio balances for the Company's CEL segment are summarized as follows: December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Finance leases $ 235.2 $325.9 $ 425.9 $ 655.8 $ 705.4 Operating leases 157.5 179.9 198.7 244.8 222.3 Notes receivable 28.8 50.7 41.5 59.4 64.0 Preferred and preference 0.8 0.9 2.8 5.1 9.5 stock $ 422.3 $557.4 $ 668.9 $ 965.1 $ 1,001.2 - - - Factors Affecting CEL Volume The Company's recent CEL volume has been affected by limitations on the availability of capital to commit to new transactions and higher cost of capital. In addition, there has been an increased need of certain of MDC's commercial aircraft customers for financing, resulting in the Company devoting a higher percentage of its available capital to MDC aircraft financing. Based on the Company's current increased availability to lower cost funds, CEL's new business volume in 1994 is expected to exceed its 1993 volume. At December 31, 1993 and 1992, the Company had commitments to provide CEL leasing and financing of $4.6 million and $20.7 million. The following lists information on new business volume for the Company's CEL segment: Years ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Finance leases $ 15.3 $ 24.9 $ 55.6 $ 109.4 $ 143.6 Operating leases 22.9 18.2 30.3 73.2 98.3 Notes receivable 3.3 7.6 5.9 6.5 63.5 $ 41.5 $ 50.7 $ 91.8 $ 189.1 $ 305.4 Non-Core Businesses Segment Since 1990, the Company has significantly scaled back its operations and is focusing its new business efforts within its two core businesses, commercial aircraft financing and CEL. The non-core businesses consist primarily of the following three business units: - - - McDonnell Douglas Bank Limited While MD Bank is an indirect wholly-owned subsidiary of MDC, through intercompany arrangements between MDC and the Company, MD Bank is treated as a wholly-owned subsidiary of the Company. MD Bank, located in the United Kingdom, has not written any new business since 1991 and in 1993, surrendered its banking license and returned deposits. The remaining portfolio of MD Bank is being run off and disposed of as conditions permit. - - - Receivable Inventory Financing RIF finances dealers of rent-to-own products such as home appliances, electronics and furniture through note arrangements secured by the products and the rental amounts to be collected. RIF ceased pursuing new business during 1991, but continues to service and finance its existing customers. - - - Real Estate Financing RE previously specialized in fixed-rate, medium-term loans secured by a first deed-of-trust or mortgage on commercial real estate properties such as office buildings and small shopping centers. RE ceased originating new transactions in 1990 but continues to manage its current portfolio. On September 28, 1993, the Company sold, at estimated fair value, six real estate owned properties to McDonnell Douglas Realty Company, a wholly-owned subsidiary of MDC, and financed the sale by taking a $28.9 million note. The Company recorded a pretax loss of $5.7 million (after applying reserves) on the transfer, which is reflected in other expenses in the consolidated statement of income. The note is payable on demand and accrues interest at a rate equal to the average borrowing cost of MDFS. At December 31, 1993, the largest concentration of the Company's real estate assets was in the Western region of the U.S., representing $70.3 million or 54.6% of the Company's real estate holdings. At December 31, 1993, the Company had $33.9 million or 26.3% of its real estate holdings in Southern California, where values continue to remain depressed. Office buildings, which represent the largest Southern California real estate holding, totaled $41.8 million at December 31, 1993. At December 31, 1993 and 1992, real estate owned through foreclosure totaled $12.9 million and $55.2 million. Portfolio balances for the Company's non-core businesses segment are summarized as follows: December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Finance leases $ 2.2 $ 11.8 $ 174.1 $ 587.2 $ 464.8 Operating leases 0.6 1.7 121.1 181.6 192.7 Notes receivable 170.9 214.4 300.4 477.1 455.7 $ 173.7 $ 227.9 $ 595.6 $ 1,245.9 $ 1,113.2 Business units comprising the Company's non-core businesses segment portfolio are summarized as follows: (Dollars in millions) December 31, Business Unit 1993 1992 1991 1990 1989 Real estate financing $ 115.8 $ 136.9 $ 181.9 $ 213.9 $ 264.0 Receivable inventory 31.0 43.5 52.8 55.8 40.0 financing McDonnell Douglas Bank 20.7 36.0 216.3 354.9 205.0 Limited Marketable debt securities 3.3 7.4 24.2 130.6 120.6 Business credit group 2.2 2.6 2.9 100.9 65.2 McDonnell Douglas Capital Corporation 0.7 1.5 44.9 66.1 85.9 McDonnell Douglas Auto Leasing Corporation - - - 210.1 211.1 McDonnell Douglas Truck - - 72.6 113.6 121.4 Services Inc. $ 173.7 $ 227.9 $ 595.6 $ 1,245.9 $ 1,113.2 - - - Factors Affecting Non-Core Business Volume As a result of the Company's decision to exit its non-core businesses, there has been almost no new business volume since 1991. Non-core new business volume in 1993 and 1992 represent previous contractual commitments and extensions of maturing transactions. The Company does not intend to seek new contractual commitments in its non-core businesses. The Company is actively managing the remaining non-core business portfolios with a view toward liquidating those portfolios over time. At December 31, 1993 and 1992, unused credit lines available to RIF customers totaled $6.6 million and $14.3 million. The Company had no commitments to provide non-core business financing at December 31, 1993 and had commitments of $0.6 million at December 31, 1992. The following lists information on new business volume for the Company's non-core businesses: Years ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Finance leases $ - $ - $ 12.8 $ 240.7 $ 331.0 Operating leases - 0.8 5.5 39.7 95.6 Notes receivable 0.1 1.8 20.1 136.4 109.6 $ 0.1 $ 2.6 $ 38.6 $ 416.8 $ 536.2 Non-U.S. Financing A portion of the Company's business, primarily in the commercial aircraft financing segment, is conducted with non-U.S. companies. In evaluating non- U.S. transactions, the Company must take into account certain additional risks not encountered in U.S. transactions. For example, payment obligations of non-U.S. obligors from time to time may be subject to foreign exchange restrictions of their respective countries. Additionally, equipment financing is subject to potential risks related to taxation, national policies, political and economic instability, limitations on legal remedies, and currency fluctuations. The Company has not experienced any material problems related to such risks, but no assurances can be given that such factors will not adversely affect the Company in the future. (See "Competition and Economic Factors" and Notes to Consolidated Financial Statements included in Item 8.) Cross-Border Outstandings The extension of credit to borrowers located outside of the U.S. is called "cross-border" credit. In addition to the credit risk associated with any borrower, these particular credits are also subject to "country risk" - economic and political risk factors specific to the country of the borrower which may make the borrower unable or unwilling to pay principal and interest according to contractual terms. Other risks associated with these credits include the possibility of insufficient foreign exchange and restrictions on its availability. To minimize country risk, the Company monitors its foreign credits in each country with specific consideration given to maturity, currency, industry and geographic concentration of the credits. The Company has minimal local currency outstandings to the individual countries listed in the following table that are not hedged or are not funded by local currency borrowings. The countries in which the Company's cross border outstandings exceeded 1% of consolidated assets consist of the following at December 31: (Dollars in millions) December 31, Country Finance Notes Operating 1993 Leases Receivable Leases Guaranties Total Indonesia $154.8 $ - $ - $ - $154.8 Mexico 23.0 - 23.6 - 46.6 United Kingdom 14.3 23.0 - - 37.3 $192.1 $ 23.0 $ 23.6 $ - $238.7 Canada $ 12.7 $ 5.7 $ 0.3 $ 3.5 $ 22.2 Mexico 24.3 - 26.5 - 50.8 United Kingdom 23.9 42.7 0.4 - 67.0 $ 60.9 $ 48.4 $ 27.2 $ 3.5 $ 140.0 Mexico $ 39.9 $ 4.0 $ - $ - 43.9 United Kingdom 184.4 34.8 10.0 - 229.2 $ 224.3 $ 38.8 $ 10.0 $ - $ 273.1 As of December 31, 1993, the Company had equipment in the Netherlands under an operating lease agreement with a net carrying amount of $18.0 million, representing outstandings between 0.75% and 1% of the Company's total assets. As of December 31, 1992 and 1991, there were no countries whose outstandings were between 0.75% and 1% of the Company's total assets. Maturities and Sensitivity to Interest Rate Changes The following table shows the maturity distribution and sensitivity to changes in interest rates of the Company's domestic and foreign financing receivables at December 31, 1993: (Dollars in millions) Maturity Distribution Domestic Foreign Total 1994 $ 259.1 $ 64.0 $ 323.1 1995 203.3 40.3 243.6 1996 166.0 37.7 203.7 1997 137.7 34.7 172.4 1998 131.8 37.2 169.0 1999 and thereafter 547.7 308.5 856.2 $ 1,445.6 $ 522.4 $ 1,968.0 Financing Receivables Due 1995 and Thereafter Fixed interest rates $ 1,127.6 $ 269.0 $ 1,396.6 Variable interest rates 57.7 189.4 247.1 $ 1,185.3 $ 458.4 $ 1,643.7 Allowance for Losses on Financing Receivables and Credit Loss Experience Analysis of Allowance for Losses on Financing Receivables December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Allowance for losses on financing $ 37.4 $ 46.7 $ 61.6 $ 46.9 $ 44.1 receivables at beginning of year Provision for losses 8.6 19.1 47.2 57.3 13.2 Write-offs, net of (10.4) (27.4) (56.7) (44.1) (11.4) recoveries Other - (1.0) (5.4) 1.5 1.0 Allowance for losses on financing receivables at $ 35.6 $ 37.4 $ 46.7 $ 61.6 $ 46.9 end of year Allowance as percent of 1.9% 2.1% 2.2% 1.9% 1.5% total portfolio Net write-offs as percent of average portfolio 0.6% 1.4% 2.0% 1.4% 0.4% More than 90 days delinquent: Amount of delinquent $ 3.7 $ 4.6 $ 19.0 $ 5.2 $ 6.5 instalments Total receivables due from delinquent obligors $ 108.4 $ 10.5 $ 42.8 $ 42.1 $ 52.8 Total receivables due from delinquent obligors as a percentage of total 5.9% 0.6% 2.0% 1.3% 1.7% portfolio The 1993 increase of total receivables from delinquent obligors is primarily attributable to rent not paid by a single airline customer who has agreed to repay the past due rents in 1994. The portfolio at December 31, 1993 includes 13 CEL obligors, two airline obligors and four non-core obligors to which payment extensions have been granted. At December 31, 1993, payments so extended amounted to $14.8 million ($5.4 million airline-related), and the aggregate carrying amount of the related receivables was $167.8 million ($122.2 million airline-related). Receivable Write-offs, Net of Recoveries by Business Unit The following table summarizes the loss experience for each of the business units: Years ended % of Respective December 31, Average Portfolio (Dollars in millions) 1993 1992 1993 1992 Commercial aircraft financing $ (1.5) $ 6.6 (0.15)% 0.68% Commercial equipment leasing 3.9 5.3 0.80 0.89 Core businesses 2.4 11.9 Non-Core Businesses: Real estate financing 6.4 7.7 5.15 4.67 Receivable inventory financing - 3.2 - 6.77 Marketable debt securities 0.8 1.2 12.75 6.77 McDonnell Douglas Bank Limited 0.3 2.8 1.26 1.81 McDonnell Douglas Truck Services - 0.5 - 2.88 Inc. McDonnell Douglas Capital 0.1 0.1 5.53 0.47 Corporation Business credit group 0.4 - 20.90 - 8.0 15.5 $ 10.4 $ 27.4 In its analysis of the allowance for losses on financing receivables, the Company has taken into consideration the current economic and market conditions and provided $8.6 million and $19.1 million in 1993 and 1992 for losses. The Company believes that the allowance for losses on financing receivables is adequate at December 31, 1993 to cover potential losses in the Company's total portfolio. If, however, certain major customers defaulted and the Company were forced to take possession of and dispose of significant amounts of real estate, aircraft or equipment, losses in excess of the allowance could be incurred, which would be charged directly against earnings. The Company's receivable write-offs, net of recoveries, have decreased in 1993 as compared to 1992. The decrease is largely due to the substantial liquidation during 1992 and 1991 of the asset portfolios in the non-core businesses segment. - - - The commercial aircraft financing segment experienced recoveries of $1.5 million and write-offs of $6.6 million in 1993 and 1992 related to aircraft returned by America West. - - - The asset portfolios in the non-core businesses segment have declined from $1,245.9 million at December 31, 1990 to $173.7 million at December 31, 1993 and, therefore, net write-offs also have declined. Nonaccrual and Past Due Financing Receivables Financing receivables accounted for on a nonaccrual basis consisted of the following at December 31: (Dollars in millions) 1993 1992 Domestic $ 17.1 $ 25.0 Foreign 23.7 0.9 $ 40.8 $ 25.9 Financing receivables being accrued which are contractually past due 90 days or more as to principal and interest payments consisted of domestic financings of $76.6 million and $2.7 million at December 31, 1993 and 1992. Borrowing Operations The following table sets forth the average debt of the Company by borrowing classification: (Dollars in millions) Average Average Years ended Short-Term Long-Term Average December 31, Debt Debt Total Debt 1993 $ 113.0 1,153.7$ $1,266.7 1992 118.2 1,513.1 1,631.3 1991 341.1 1,750.4 2,091.5 1990 393.2 1,888.0 2,281.2 1989 263.6 1,656.3 1,919.9 The weighted average interest rates on all outstanding indebtedness computed for the relevant period were as follows: Weighted Average Weighted Average Weighted Average Years ended Short-Term Long-Term Total Debt December 31, Interest Rate Interest Rate Interest Rate 1993 5.97% 9.53% 9.19% 1992 12.38 8.75 9.00 1991 10.28 9.73 9.82 1990 10.86 9.62 9.83 1989 10.56 9.85 9.95 (See Schedule IX - "Short Term Borrowings" and Notes to Consolidated Financial Statements included in Item 8.) In February 1993, Moody's Investor Service ("Moody's") announced the downgrade of MDC's debt credit ratings. Concurrent with this downgrade of the parent, Moody's reduced the Company's senior debt, subordinated debt and commercial paper to Ba1, Ba3 and Not Prime, respectively. In March 1994, Moody's announced the upgrade to Baa3, Ba2 and P3 for MDC's and the Company's senior debt, subordinated debt and commercial paper credit ratings. In June 1993, Duff and Phelps, Inc. rated the Company's senior and subordinated debt as BBB and BBB-, and Standard and Poor's Corporation affirmed the Company's senior and subordinated debt ratings of BBB and BBB-. A security rating is not a recommendation to buy, sell or hold securities. In addition, a security rating is subject to revision or withdrawal at any time by the assigning rating organization and each rating should be evaluated independently of any other rating. Competition and Economic Factors The Company is subject to competition from other financial institutions, including commercial banks, finance companies and leasing companies, some of which are larger than the Company and have greater financial resources, greater leverage ability and lower effective borrowing costs. These factors permit many competitors to provide financing at lower rates than the Company. In its commercial equipment leasing and commercial aircraft financing segments, the ability of the Company to compete in the marketplace is principally based on rates which the Company charges its customers, which rates are related to the Company's access to and cost of funds and to the ability of the Company to utilize tax benefits attendant to leasing. (See "Relationship With MDC.") Competitive factors also include, among other things, the Company's ability to be flexible in its financing arrangements with new and existing customers. The Company has in the past obtained a significant portion of its leasing business and notes receivable in connection with the lease or sale of MDC aircraft. The Company's relationship with MDC has in many cases presented opportunities for such business and has caused MDC to offer to the Company substantially all of the notes receivable taken by MDC upon the sale of its aircraft. (See "Relationship With MDC".) In past years many customers have obtained their financing for MDC aircraft through sources other than the Company or MDC, reflecting a broader range of competitive financing alternatives available to MDC customers. However, the worldwide downturn in the airline business, together with the general tightening of credit has presented and may continue to present increased opportunities for aircraft financing business for the Company. The Company's ability to take advantage of these opportunities depends in substantial part on its ability to obtain the necessary capital. The consolidation in the U.S. airline industry as a result of bankruptcies and mergers has resulted in an increase in the concentration of the Company's MDC aircraft financings in a smaller number of larger airlines at the same time that the Company's decision to exit its non- core businesses has resulted in a greater concentration of the Company's portfolio in commercial aircraft financing. With a larger portion of the portfolio concentrated in MDC aircraft financings, the risk to the Company resulting from the declining creditworthiness of many airlines has increased. (See "Commercial Aircraft Financing Segment" and "Analysis of Allowance for Losses on Financing Receivables and Credit Loss Experience.") Aircraft owned or financed by the Company may become significantly less valuable because of the introduction of new aircraft models, which may be more economical to operate, the aging of particular aircraft, technological obsolescence such as that caused by legislation for noise abatement which will over time prohibit the use of older, noisier (Stage 2) aircraft in the U.S., or an oversupply of aircraft for sale (such as presently exists). In any such event, carrying amounts on the Company's books may be reduced if, in the judgment of management, such carrying amounts are greater than market value, which would result in recognition of a loss to the Company. At December 31, 1993, the Company's carrying amount of Stage 2 aircraft totaled $68.4 million (5.4% of the Company's total aircraft portfolio, including held for sale or re-lease), which includes $26.3 million of aircraft held for sale or re-lease. Although the Company is particularly subject to risks attendant to the airline and aircraft manufacturing industries, the ability of the Company to generate new business also is dependent upon, among other factors, the capital equipment requirements of U.S. businesses and the availability of capital. Relationship With MDC MDC is principally engaged in the design, development and production of defense and commercial aerospace products. For the year ended December 31, 1993, MDC recorded revenues of $14.5 billion and net earnings of $396.0 million. At December 31, 1993, MDC had assets of $12.0 billion and shareholders' equity of $3.4 billion. One of the five directors of the Company is a director of MDC and four of the Company's directors are officers of MDC. The financial well-being of MDC is vital to the Company's ability to enter into significant amounts of new business in the future. Primarily as a result of certain downgrades in the credit ratings of MDC in 1991 and in early 1993, the Company's credit ratings were downgraded at the same time. Beginning in the early 1990's and continuing through mid-1993, the Company's access to new capital was severely limited due to a lowering of the Company's credit ratings, the recession and constraints imposed by MDC. However, as 1993 progressed, all of these factors had a much smaller impact on the Company and consequently, the Company's access to new capital improved. Approximately 25% of the receivables from the Company's total aircraft portfolio are supported by guaranties from MDC. In the event a substantial portion of the guaranties become payable and in the unlikely event that MDC is unable to honor its obligations under these guaranties, such event could have a material adverse effect on the financial condition of the Company. In addition, MDC participates as an intermediary in financings to a small number of the Company's commercial aircraft customers and largely as a result thereof, MDC is the fourth largest commercial aircraft financing customer of the Company. Two of the principal industry segments in which MDC operates, military aircraft and commercial aircraft, are especially competitive and have a limited number of customers. As the Company focuses on its core businesses, and primarily aircraft financing, its future business prospects become more closely tied to the success of MDC, and especially the ability of MDC's commercial aircraft business to generate additional sales. The commercial aircraft business is market sensitive, which causes disruptions in production and procurement and attendant costs, and requires large investments to develop new derivatives of existing aircraft or new aircraft. The depressed conditions in the airline industry have resulted and may continue to result in airlines not taking deliveries of commercial transport aircraft, defaulting on contracts for firm orders, requests for changes in delivery schedules of existing orders, not exercising options or reserves and a dramatic decline in new orders. MDC expects the weakness of the commercial aircraft market to continue during 1994 and MDC does not expect a strong industry-wide resumption in orders for new aircraft until 1995, at the earliest. MDC's market share of firm order backlog for new commercial aircraft has declined significantly in the past several years and operating revenues for MDC's commercial aircraft segment decreased 28% in 1993. MDC also has made guaranties to non-affiliate third parties in connection with the marketing of commercial aircraft. MDC does not anticipate that the existence of such guaranties will have a material adverse effect upon its financial condition. In addition, some existing commercial aircraft contracts contain provisions requiring MDC to repurchase used aircraft at the option of the commercial customers. In view of the current market conditions for used aircraft, MDC's earnings and cash flows could be adversely impacted by the exercise of such options. However, it is not anticipated that the existence of such repurchase obligations will have a material adverse effect on MDC's cash flow or financial position. The trend of reduced commercial aircraft orders and reduced defense spending has resulted in a significant downsizing of MDC over the last several years. MDC's most significant customer in its military aircraft and missiles, space, and electronic systems segments is the U.S. Government. In addition to the risks found in any business, companies engaged in supplying military and space equipment to the U.S. Government are subject to a number of other risks, including dependence on Congressional appropriations and annual administrative allotment of funds, general reductions in the U.S. defense budget, and changes in Government policies. Defense spending by the U.S. Government has declined and is likely to continue to decline. Further significant reductions in defense spending and a decision made by the U.S. Government to emphasize weapons research over production may have a material impact on MDC. The loss of a major program or a major reduction or stretch-out in one or more programs could have a material adverse impact on MDC's future revenues, earnings and cash flow. MDC also incurs risk if it enters into firm fixed-price contracts with the U.S. Government pursuant to which work is performed and paid for at a fixed amount without adjustment for actual costs experienced in connection with the contract. While this arrangement offers MDC opportunities for increased profits if costs are lower than expected, risk of loss due to increased cost is also borne by MDC. MDC, as a large defense contractor, is subject to many audits, reviews and investigations by the U.S. Government of its negotiation and performance of, accounting for, and general practices relating to U.S. Government contracts. An indictment of a contractor may result in suspension from eligibility for award of any new government contract, and a guilty plea or conviction may result in debarment from eligibility for awards. The U.S. Government may, in certain cases, also terminate existing contracts, recover damages, and impose other sanctions and penalties. Contracts may be terminated by the U.S. Government either for default, if the contractor materially breaches the contract, or "for the convenience" of the Government. Under contracts terminated for the convenience of the Government, a contractor is generally entitled to receive payments for its contract cost and the proportionate share of its fee or earnings for work done, subject to availability of funding. One of MDC's largest programs for the U.S. Government is the C-17 Globemaster III. The C-17 program is completing development and moving into full production. However, MDC has incurred significant C-17 related losses as a result of its cost estimate at completion exceeding the fixed-price ceiling set for development and initial production. In addition, as of December 31, 1993, the U.S.Air Force had withheld approximately $312 million from MDC's progress payment requests principally as a result of the higher cost estimates and the reclassification of certain costs. In May 1993, a Defense Acquisition Board initiated by the Under Secretary of Defense for Acquisition began a review of the C-17 program in an effort to resolve outstanding issues and to make recommendations regarding the C-17's future. In connection with the review, MDC provided data and participated in numerous discussions. In January 1994, MDC and the Department of Defense agreed to a business settlement of a variety of issues concerning the C-17. MDC and the U.S. Air Force will be developing plans and contractual modifications and agreements to implement the business settlement, which is subject to Congressional authorization and appropriations. This process is expected to be completed during 1994. The settlement covered issues open as of the date of the settlement, including the allocation of sustaining engineering costs to the development and production contracts, the sharing of flight test costs over a previous level, and the resolution of claims and of performance/specification issues. The settlement also stipulated that MDC will expend additional funds in an effort to achieve product and systems improvements. MDC estimated the financial impact of the settlement in conjunction with a review of the estimated remaining costs on the C-17 development and initial production contracts. As a result, MDC recorded a loss provision of $450 million (excluding general and administrative and other period expenses) in the fourth quarter of 1993. On June 7, 1991, the U.S. Navy notified MDC and General Dynamics Corporation ("GD") that it was terminating for default the contract for development and initial production of the A-12 aircraft. The Navy has agreed to continue to defer repayment of $1.335 billion alleged to be due, with interest, from MDC and GD as a result of the termination for default of the A-12 program. The agreement provides that it will remain in force until the dispute as to the type of termination is resolved by pending litigation in the U.S. Court of Federal Claims or negotiated settlement, subject to review by the U.S. Government annually on December 1, to determine if there has been a substantial change in the financial condition of either MDC or GD such that deferment is no longer in the best interest of the Government. The Government, which extended the December 1, 1993 review beyond the time to which MDC and GD agreed, has not advised the contractors of the results of that review. However, the United States Court of Federal Claims has issued an order deferring rulings on the merits of the A-12 termination case until July 21, 1994. The court's order is based upon an undertaking by the Government that it would not seek to terminate the A-12 deferment agreement between MDC, GD and the Navy in the interim. MDC firmly believes it is entitled to continuation of the deferment agreement in accordance with its terms. However, if the agreement is not continued, MDC intends to contest collection efforts. If payment of the deferred amounts were required, such payment would have a material adverse effect on MDC's cash flows. Although MDC has established a provision of $350 million for loss on the contract, if, contrary to MDC's belief, the termination of the contract is not determined to be for the convenience of the U.S. Government, it is estimated that an additional loss would be incurred which could amount to approximately $1.2 billion. Also, a 1991 Securities and Exchange Commission investigation looking into whether MDC violated certain federal securities laws in connection with disclosures about, and accounting for, the A-12 aircraft has been broadened to include the C-17 and possibly other programs. For a further description of these and other factors which may affect MDC's financial condition, see MDC's Form 10-K for the year ended December 31, 1993 (Securities and Exchange Commission file number 1-3685.) - - - Operating Agreement The relationship between the Company and MDC is governed by an operating agreement (the "Operating Agreement"), which formalizes certain aspects of the relationship between the companies, principally those relating to the purchase and sale of MDC aircraft receivables, the leasing of MDC aircraft, the resale of MDC aircraft returned to, or repossessed by, the Company under leases or secured notes, and the allocation of federal income taxes between the companies. Under the Operating Agreement, MDC is required to offer to the Company all promissory notes, conditional sales contracts and certain other receivables obtained by MDC in connection with the sale of its commercial transport aircraft, except for any receivable that MDC acquires in a transaction which, in its opinion, involves unusual or exceptional circumstances or which it acquires with the expressed intention of selling to a purchaser other than the Company. The Company is obligated under the Operating Agreement to purchase all aircraft receivables offered to it, unless (a) it is unable or deems it inappropriate to obtain or allocate funds for the acquisition, (b) the receivables do not meet the Company's customary standards as to terms and conditions or creditworthiness, or (c) the amount of the receivable offered, when added to the amount of receivables of the same obligor then held by the Company, would exceed the amount that the Company deems prudent to hold. The prices to be paid for notes receivable purchased from MDC are intended to produce reasonable returns to the Company, taking into account the rates of return realized by independent finance companies, the Company's assessment of the credit risk and the Company's projected borrowing costs and expenses. In cases where credit risks associated with a note receivable are not acceptable to the Company, the Company will refuse to accept the note receivable or will condition its acceptance upon receipt of a guaranty from MDC with a negotiated fee to be paid by the Company for the guaranty. (See "Commercial Aircraft Financing Segment - Aircraft Financing Guaranties.") With respect to aircraft leasing activities, unlike the purchase of other aircraft receivables which are acquired by MDC and sold to the Company, the Company may make lease proposals directly to the prospective customers. If a lease proposal is accepted, the Company enters into a lease with the customer and purchases the aircraft from MDC on the terms negotiated between MDC and the customer. Under the Operating Agreement the Company may make a lease proposal to any customer desiring to lease an aircraft for two years or more, but the Company may decline to make a proposal or may condition its proposal upon a full or partial guaranty from MDC, with a negotiated fee to be paid by the Company for the guaranty. The Company has the option under the Operating Agreement to tender to MDC any MDC aircraft returned to or repossessed by the Company under a lease or security instrument at a price equal to the fair market value of the aircraft less 10%. This provision does not include MDC aircraft leased under a partnership arrangement in which the Company is one of the partners, or MDC aircraft subject to third party liens or other security interests, unless the Company and MDC determine that purchase by MDC is desirable. At December 31, 1993, the carrying amount of MDC aircraft and MDC aircraft held for sale or lease excluded by this provision amounts to approximately $127.4 million and $1.3 million, respectively. - - - Federal Income Taxes The Company and MDC presently file consolidated federal income tax returns, with the consolidated tax payments, if any, being made by MDC. The Operating Agreement provides that so long as consolidated federal tax returns are filed, payments shall be made, directly or indirectly, by MDC to the Company or by the Company to MDC, as appropriate, equal to the difference between the consolidated tax liability and MDC's tax liability computed without consolidation with the Company. If, subsequent to any such payments by MDC, it incurs tax losses which may be carried back to the year for which such payments were made, the Company nevertheless will not be obligated to repay to MDC any portion of such payments. The Company and MDC have been operating since 1975 under an informal arrangement which has entitled the Company to rely upon the realization of tax benefits for the portion of projected taxable earnings of MDC allocated to the Company. This has been important in planning the volume of and pricing for the Company's leasing activities. Under this arrangement, the Company is entitled to receive on a current basis not less than 50% of the potential tax savings generated by the Company's leasing activities with the remaining portion of such tax benefits to be deferred for a one-year period. The Company's ability to price its business competitively and obtain new business volume is significantly dependent on its ability to realize the tax benefits generated by its leasing business. In some cases, the yields on receivables, without regard to tax benefits, may be less than the Company's related financing costs. To the extent that MDC would be unable on a long- term basis to utilize such tax benefits, or if the informal arrangement is not continued in its present form, the Company would be required to restructure its financing activities and to reprice its new financing transactions so as to make them profitable without regard to MDC's utilization of tax benefits since there can be no assurance that the Company would be able to utilize such benefits currently. No assurances can be given that the Company would be successful in restructuring its financing activities. (See "Competition and Economic Factors.") - - - Intercompany Services MDC provides to the Company certain payroll, employee benefit, facilities and other services, for which the Company generally pays MDC the actual cost. (See Notes to Consolidated Financial Statements included in Item 8.) Commencing in the second quarter of 1994, the Company will move to new facilities to be leased by the Company from MDC. The Company formerly provided substantial financial services to MDC in connection with MDC's marketing of its aircraft, particularly in assisting its customers in obtaining financing for their aircraft acquisitions. The Company's function in this area included assistance with respect to the form and terms of MDC's participation in such financing where necessary, and negotiation of these terms with the customer on behalf of MDC. In January 1994, the 10 Company employees who were primarily responsible for providing these services were transferred to Douglas Aircraft Company, a division of MDC, to more closely align them with the primary focus of their efforts. - - - Intercompany Credit Arrangements The Company and MDC maintain separate borrowing facilities and there are no arrangements for joint use of credit lines by the companies. Bank credit and other borrowing facilities are negotiated by the Company on its own behalf. There are no provisions in the Company's debt instruments that provide that a default by MDC on MDC debt constitutes a default on Company debt. There are no guaranties, direct or indirect, by MDC of the payment of any debt of the Company. The Company has an arrangement with MDC, terminable at the discretion of either of the parties, pursuant to which the Company may borrow from MDC and MDC may borrow from the Company, funds for 30-day periods at a market rate of interest or at MDFS's average borrowing rate. Under these arrangements, there were no outstanding balances at December 31, 1993 and at December 31, 1992, $49.0 million was receivable from MDC. During 1992, the Company made no borrowings under this agreement and the maximum receivable from MDC under this arrangement was $49.0 million. Under a similar borrowing arrangement, McDonnell Douglas Realty Company owed the Company $29.6 million at December 31, 1993. As of that date, the Company was also owed $18.3 million by MDFS under a borrowing based on short-term borrowing costs of the Company, supporting a bridge financing which was repaid in March 1994. Item 2. Item 2. Properties The Company leases all of its office space and other facilities. Commencing in the second quarter of 1994, the Company will sublease from MDC, at fair market value, approximately 40,000 square feet of office space to be used as the Company's principal offices. The Company believes that its properties, including the equipment located therein, are suitable and adequate to meet the requirements of its business. Item 3. Item 3. Legal Proceedings In 1990, the Company was named as a defendant in three class action suits (the Carpi, Edelman, and Waldman "Actions") for alleged violations of securities laws in connection with the public offering of limited partnership interests in certain equipment leasing limited partnerships, the sponsor of which was McDonnell Douglas Capital Corporation ("MDCC"), a wholly-owned subsidiary of the Company. A court-approved settlement of the Carpi, Edelman, and Waldman Actions became effective as of December 1, 1993, pursuant to which the defendants will pay plaintiffs approximately $14.8 million, approximately $13.4 million of which will be paid by MDCC, its corporate affiliates and the individual defendants (a portion of which will be paid from the officers and directors liability insurance covering the individual defendants). As part of the settlement, MDCC purchased the equipment portfolios of the limited partnerships for 121% of the $1.0 million net book value. The Company adequately reserved for the settlement of the Actions and the settlement will not have a significant adverse impact on its financial condition or results of operations. In March 1993, Wilmington Trust Company, CoreStates Bank, N.A., Midlantic National Bank and Continental Bank (collectively the "Banks") filed suit against the Company's wholly-owned subsidiary, MDFC Equipment Leasing Corporation ("ELC"), in the Superior Court of the State of Delaware seeking to recover payments made under letters of credit issued by the Banks in an aggregate amount of $2.8 million plus interest on such payments. In March 1994, ELC reached an agreement in principle to settle the suit by agreeing to pay the Banks a de minimus amount. Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. All of the Company's preferred and common stock is owned by MDFS. In 1993, the Company declared and paid no dividends to MDFS on its common stock compared to $102.3 million declared and paid in 1992. The 1992 common stock dividends declared and paid were unusually high due to the downsizing of the Company. The Company paid $3.6 million and $3.5 million in dividends on its preferred stock in 1993 and 1992. Preferred stock dividends of $0.5 million payable to MDFS were accrued at December 31, 1993. The Company currently expects to pay common stock dividends of at least $13.0 million to MDFS in 1994. The provisions of various credit and debt agreements require the Company to maintain a minimum net worth, restrict indebtedness, and limit cash dividends and other distributions. Under the most restrictive provision, $49.4 million of the Company's income retained for growth was available for dividends at December 31, 1993. Item 6. Selected Financial Data The selected consolidated financial data should be read in conjunction with the Company's consolidated financial statements at December 31, 1993 and for the year then ended and with Item 7. The following table sets forth selected consolidated financial data for the Company: Years Ended December 31, (Dollars in millions) 1993 1992 1991 1990 1989 Financing volume $ 453.0 $ 206.5 $ 231.3 $ 761.3 $ 962.6 Operating income: Finance lease income $ 94.7 $ 113.0 $ 179.3 $ 210.0 $ 174.2 Interest on notes 35.8 47.9 61.5 80.8 65.8 receivable Operating lease 34.3 33.3 34.1 36.9 32.7 income, net Net gain on disposal or re-lease 23.7 37.1 45.8 90.0 34.8 of assets Postretirement - 2.8 - - - benefit curtailment Other 9.9 20.6 21.6 13.1 13.2 198.5 254.7 342.3 430.8 320.7 Expenses: Interest expense 116.4 145.9 198.5 216.4 184.0 Provision for losses 8.6 19.1 47.2 57.3 13.2 Operating expenses 20.3 27.4 35.6 55.1 41.5 Other 12.4 14.3 3.8 3.1 6.4 157.7 206.7 285.1 331.9 245.1 Income from continuing operations before income taxes 40.8 48.0 57.2 98.9 75.6 and cumula- tive effect of accounting change Provision for taxes 24.0 15.9 19.1 34.6 24.9 on income Income from continuing operations before cumulative 16.8 32.1 38.1 64.3 50.7 effect of accounting change Discontinued - (2.5) (1.4) 1.2 (1.0) operations, net Cumulative effect of - (1.9) - - 100.0 accounting change Net income $ 16.8 $ 27.7 $ 36.7 $ 65.5 $ 149.7 Cash dividends paid $ 3.6 $ 105.8 $ 59.0 $ 23.5 $ 142.2 Ratio of income to 1.34 1.32 1.28 1.45 1.41 fixed charges Balance sheet data: Total assets $2,063.1 $1,999.0 $2,582.3 $3,443.7 $ 3,133.7 Total debt 1,361.2 1,330.4 1,730.7 2,443.2 2,222.3 Shareholder's equity 269.4 256.4 340.5 364.9 317.0 Dividends accrued on preferred stock at $ 0.6 $ 0.5 $ 0.5 $ 0.5 $ 0.5 year end (1) For the purpose of computing the ratio of income to fixed charges, income consists of income from continuing operations before income taxes, cumulative effect of accounting change and fixed charges; and fixed charges consist of interest expense and preferred stock dividends. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following should be read in conjunction with the consolidated financial statements included in Item 8. Capital Resources and Liquidity The Company has significant liquidity requirements. If cash provided by operations, borrowings under bank credit lines, unsecured term borrowings and the normal run-off of the Company's portfolio do not provide the necessary liquidity, the Company would be required to restrict its new business volume unless it obtained access to other sources of capital at rates that would allow for a reasonable return on new business. The Company has been accessing the public debt market since mid-1993 and anticipates using proceeds from the issuance of additional public debt to fund future growth. The Company has traditionally attempted to match-fund its business such that scheduled receipts from its portfolio will at least cover its expenses and debt payments as they become due. The Company believes that, absent a severe or prolonged economic downturn which results in defaults materially in excess of those provided for, receipts from the portfolio will cover the payment of expenses and debt payments when due. In funding its operations, the Company had traditionally obtained cash from operating activities, placements of term debt, issuance of commercial paper and the normal run-off of its portfolio. However, beginning in the early 1990's and continuing through mid-1993, the Company's access to new capital was severely limited due to a lowering of the Company's credit ratings, the recession, and capital constraints imposed by MDC (see "Relationship With MDC") and, as a result, the Company used asset sales and secured borrowings as a source of funding at various times during this period. However, as 1993 progressed, all of these conditions had a much smaller impact on the Company and the Company's access to new capital improved. Beginning late in the second quarter of 1993, the Company resumed issuing public debt. In June 1993 the Company commenced offering securities as part of a $250 million retail medium term note program. As of December 31, 1993, the Company had issued $81.1 million of retail medium term notes. Beginning in the fourth quarter of 1993, the Company returned to the institutional medium term note market, issuing $90.0 million in debt as of December 31, 1993. During the years ended 1993, 1992 and 1991, the Company reduced the portfolio amount in its non-core businesses segment by a total of $1,117.4 million. The majority of the proceeds received from this reduction has been used to repay outstanding debt. At December 31, 1993, the Company had committed revolving credit agreements under which it could borrow a maximum of $170.0 million through January 31, 1994. The maximum amount which the Company can borrow will be reduced by $25.0 million each quarter through January 1995. At December 31, 1993, the Company had borrowed $53.0 million under these facilities, leaving $117.0 million unused. 1993 vs. 1992 Finance lease income decreased $18.3 million (16.2%) in 1993 compared to 1992 primarily due to the 1992 disposition of a significant portion of the assets of MD Bank and the normal run-off of the portfolio. Interest on notes receivable in 1993 was $12.1 million (25.3%) lower than 1992, reflecting an overall smaller portfolio. Net gain on disposal or re-lease of assets decreased $13.4 million (36.1%) in 1993, primarily attributable to 1992 non-recurring gains aggregating $9.4 million recorded in connection with the disposition of a significant portion of the assets of MD Bank. A lower level of short-term investments largely contributed to the 1993 decrease of $10.7 million (51.9%) in other income. The higher level of short- term investments during 1992 resulted from excess cash generated from the 1992 sales of selected assets and the sale of the Company's full-service leasing segment, operating as McDonnell Douglas Truck Services, Inc. Interest expense decreased $29.5 million (20.2%) in 1993 compared to 1992, resulting from decreased bank borrowings, retirement of debt with call options due to increased liquidity of the Company, offset by issuances of debt with favorable interest rates. The provision for losses decreased $10.5 million (55.0%) during 1993 compared to 1992, primarily as a result of the 1992 disposition of MD Bank assets, decreased write-offs within the real estate portfolio and an overall smaller portfolio. Operating expenses decreased $7.1 million (25.9%) during 1993 compared to 1992, attributable primarily to reductions in the Company's personnel and lower costs associated with administering a smaller asset portfolio. During the third quarter of 1993, the Company's effective tax rate was affected by an additional tax provision of $8.4 million associated with the tax rate increase included in the Omnibus Budget Reconciliation Act of 1993. 1992 vs. 1991 Finance lease income decreased $66.3 million (37.0%) in 1992 compared to 1991 due to the 1991 sale of substantially all the assets of McDonnell Douglas Auto Leasing Corporation ("MDAL") and the business credit group ("BCG"), the 1992 disposition of a significant portion of the assets of MD Bank, the sale of selected assets and the normal run-off of the portfolio. Interest on notes receivable in 1992 was $13.6 million (22.1%) lower than 1991 reflecting the sale of high-yield corporate bonds, delinquent real estate loans on nonaccrual status and an overall smaller portfolio. Interest expense decreased $52.6 million (26.5%) in 1992 compared to 1991, resulting from decreased short-term bank borrowings by MD Bank, the repurchase of debt securities, scheduled debt maturities and retirement of debt with call options. Total debt decreased to $1.3 billion at December 31, 1992 from $1.7 billion at December 31, 1991. The provision for losses decreased $28.1 million (59.5%) during 1992 compared to 1991, primarily as result of a change in the classification to other expenses of foreclosure expenses and writedowns of real estate owned totaling $7.9 million in 1992, which were previously charged to the allowance, the 1991 sale of substantially all of the assets of MDAL and BCG and decreased write- offs in 1992. Operating expenses decreased $8.2 million (23.0%) during 1992 compared to 1991 due primarily to major reductions in the Company's personnel and lower costs attendant to administering a smaller portfolio. At December 31, 1992, the Company had approximately 175 employees, reduced from 600 employees at December 31, 1991. Other expenses increased $10.5 million in 1992 compared to 1991 attributable to foreclosure expenses and writedowns in 1992 of real estate owned. These expenses were charged to the allowance in 1991. New Accounting Standards In December 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The Statement is effective in 1994 and requires using an accrual approach for accounting for benefits other than retiree health care to former or inactive employees. The impact of the Company's adoption of this Statement is not expected to be material. In May 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This Statement requires that impaired loans be measured on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Adoption of this Statement is required no later than 1995, although earlier application is permitted. The Company presently intends to adopt this pronouncement in 1995. The effect of applying this Statement is not expected to have a material impact on the financial statements of the Company. Item 8. Financial Statements and Supplementary Data The following pages include the consolidated financial statements of the Company as described in Item 14.(a) 1. and 2. herein. Report of Independent Auditors Shareholder and Board of Directors McDonnell Douglas Finance Corporation We have audited the accompanying consolidated balance sheet of McDonnell Douglas Finance Corporation (a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income and income retained for growth, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of McDonnell Douglas Finance Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We have also previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheets as of December 31, 1991, 1990 and 1989, and the related consolidated statements of income and income retained for growth, and cash flows for the years ended December 31, 1990 and 1989 (none of which are presented separately herein); and we expressed unqualified opinions on those consolidated financial statements. In our opinion, the information set forth in the selected financial data for each of the five years in the period ended December 31, 1993, appearing on pages 26 - 28, is fairly stated in all material respects in relation to the consolidated financial statements from which it has been derived. As discussed in the notes to the consolidated financial statements, in 1992 the Company changed its method of accounting for retiree health care benefits. /s/ Ernst & Young Orange County, California January 18, 1994 McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Balance Sheet December 31, (Dollars in millions, except per share amounts) 1993 1992 ASSETS Financing receivables: Investment in finance leases $1,173.5 $ 993.8 Notes receivable 301.8 459.7 1,475.3 1,453.5 Allowance for losses on financing (35.6) (37.4) receivables Financing receivables, net 1,439.7 1,416.1 Cash and cash equivalents 65.5 11.6 Equipment under operating leases, net 358.2 332.9 Equipment held for sale or re-lease 32.0 56.6 Real estate owned 12.9 55.2 Accounts with MDC and MDFS 70.4 40.9 Other assets 84.5 85.7 $2,063.2 $ 1,999.0 LIABILITIES AND SHAREHOLDER'S EQUITY Short-term notes payable $ 202.6 $ 133.5 Accounts payable and accrued expenses 59.2 41.2 Other liabilities 74.5 73.9 Deferred income taxes 298.9 297.1 Long-term debt: Senior 1,080.8 1,104.2 Subordinated 77.8 92.7 1,793.8 1,742.6 Commitments and contingencies - Note 8 Shareholder's equity: Preferred stock - no par value; authorized 100,000 shares: Series A; $5,000 stated value; authorized, issued and outstanding 50.0 50.0 10,000 shares Common stock $100 par value; authorized 100,000 shares; issued 5.0 5.0 and outstanding 50,000 shares Capital in excess of par value 89.5 89.5 Income retained for growth 129.6 116.4 Cumulative foreign currency (4.7) (4.5) translation adjustment 269.4 256.4 $2,063.2 $ 1,999.0 See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Statement of Income and Income Retained for Growth Years ended December 31, (Dollars in millions) 1993 1992 1991 OPERATING INCOME Finance lease income $ 94.7 $ 113.0 $ 179.3 Interest income on notes receivable 35.8 47.9 61.5 Operating lease income, net of depreciation expense of $39.0, $48.8 34.4 33.3 34.1 and $60.0 in 1993, 1992 and 1991, respectively Net gain on disposal or re-lease of 23.7 37.1 45.8 assets Postretirement benefit curtailment - 2.8 - gain Other 9.9 20.6 21.6 198.5 254.7 342.3 EXPENSES Interest expense 116.4 145.9 198.5 Provision for losses 8.6 19.1 47.2 Operating expenses 20.3 27.4 35.6 Other 12.4 14.3 3.8 157.7 206.7 285.1 Income from continuing operations before income taxes and cumulative 40.8 48.0 57.2 effect of accounting change Provision for income taxes 24.0 15.9 19.1 Income from continuing operations before cumulative effect 16.8 32.1 38.1 of accounting change Discontinued operations, net - (2.5) (1.4) Cumulative effect of new accounting standard for postretirement benefits - (1.9) - Net income 16.8 27.7 36.7 Income retained for growth at beginning 116.4 194.5 216.8 of year Dividends (3.6) (105.8) (59.0) Income retained for growth at end of $ 129.6 $ 116.4 $ 194.5 year See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Statement of Cash Flows Years Ended December 31, (Dollars in millions) 1993 1992 1991 OPERATING ACTIVITIES Income from continuing operations before cumulative effect of $ 16.8 $ 32.1 $ 38.1 accounting change Adjustments to reconcile income from continuing operations before cumulative effect of accounting change to net cash provided by (used in) operating activities: Depreciation expense - 39.0 48.8 60.0 equipment under operating leases Net gain on disposal or re- (23.7) (37.1) (45.8) lease of assets Provision for losses 8.6 19.1 47.2 Change in assets and liabilities: Accounts with MDC and MDFS (29.5) 18.4 (58.1) Other assets 1.2 (8.2) (9.9) Accounts payable 18.0 (16.1) (32.5) Other liabilities 0.6 (6.2) 5.3 Deferred income taxes 1.8 (76.6) (97.3) Other, net 4.2 (16.2) 1.7 Discontinued operations - 0.4 18.5 37.0 (41.6) (72.8) INVESTING ACTIVITIES Net change in short-term notes and 91.3 (77.9) (21.2) leases receivable Purchase of equipment for operating (57.4) (71.8) (66.7) leases Proceeds from disposition of 139.5 323.2 790.6 equipment, notes and leases receivable Collection of notes and leases 202.7 278.7 354.5 receivable Acquisition of notes and leases (385.7) (153.2) (168.9) receivable Discontinued operations - 69.4 19.8 (9.6) 368.4 908.1 FINANCING ACTIVITIES Net change in short-term borrowings 69.1 16.5 (444.4) Debt having maturities more than 90 days: Proceeds 183.0 34.9 585.6 Repayments (222.0) (440.8) (840.9) Payment of cash dividends (3.6) (105.8) (59.0) Discontinued operations - (6.9) (2.7) 26.5 (502.1) (761.4) Increase (decrease) in cash and cash 53.9 (175.3) 73.9 equivalents Cash and cash equivalents at 11.6 186.9 113.0 beginning of year Cash and cash equivalents $ 65.5 $ 11.6 $ 186.9 at end of year See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Notes to Consolidated Financial Statements December 31, 1993 Note 1 - Organization and Summary of Significant Accounting Policies Organization McDonnell Douglas Finance Corporation (the "Company") is a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation ("MDFS"), a wholly-owned subsidiary of McDonnell Douglas Corporation ("MDC"). The Company was incorporated in Delaware in 1968 and provides a diversified range of equipment financing and leasing arrangements to commercial and industrial markets. Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Certain amounts have been reclassified to conform to the 1993 presentation. Finance Leases At lease commencement, the Company records the lease receivable, estimated residual value of the leased equipment and unearned lease income. Income from leases is recognized over the terms of the leases so as to approximate a level rate of return on the net investment. Residual values, which are reviewed periodically, represent the estimated amount to be received at lease termination from the disposition of leased equipment. Initial Direct Costs Initial direct costs are deferred and amortized over the related financing terms. Cash Equivalents The Company considers all cash investments with original maturities of three months or less to be cash equivalents. Cash equivalents at December 31, 1993 were $58.8 million. There were no cash equivalents at December 31, 1992. At December 31, 1993 and 1992, the Company has classified as other assets restricted cash deposited with banks in interest bearing accounts of $44.3 million and $39.7 million for compensating balances, specific lease rents and contractual purchase price related to certain aircraft leased by the Company under capital lease obligations, and security against recourse provisions related to certain note and lease receivable sales. Allowance for Losses on Financing Receivables The allowance for losses on financing receivables includes consideration of such factors as the risk rating of individual credits, economic and political conditions, prior loss experience and results of periodic credit reviews. Collateral that is formally or substantively repossessed in satisfaction of a receivable is written down to estimated fair value and is transferred to equipment held for sale or re-lease or real estate owned. Subsequent to such transfer, these assets are carried at the lower of cost or estimated net realizable value. In May 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This Statement requires that impaired loans be measured on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. Adoption of this Statement is required no later than 1995, although earlier application is permitted. The Company presently intends to adopt this pronouncement in 1995. The effect of applying this Statement is not expected to have a material impact on the financial condition or results of operations of the Company. Equipment Under Operating Leases Rental equipment subject to operating leases is recorded at cost and depreciated over its useful life or lease term to an estimated salvage value, primarily on a straight-line basis. Income Taxes The operations of the Company and its subsidiaries are included in the consolidated federal income tax return of MDC. MDC presently charges or credits the Company for the corresponding increase or decrease in MDC's taxes resulting from such inclusion. Intercompany payments are made when such taxes are due or tax credits are realized by MDC. Investment tax credits (which were repealed by the Tax Reform Act of 1986) related to property subject to financing transactions are deferred and amortized over the terms of the financing transactions. The provision for taxes on income is computed at current tax rates and adjusted for items that do not have tax consequences, temporary differences and the cumulative effect of any changes in tax rates from those previously used to determine deferred income taxes. In 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The impact of the adoption of SFAS No. 109 had no material effect on the Company's accounting for income taxes. SFAS No. 109 requires financial statements reflect deferred income taxes for future tax consequences of events recognized in different years for financial and tax reporting purposes. Foreign Currency Translation McDonnell Douglas Bank Limited ("MD Bank"), a United Kingdom company, is an indirect wholly-owned subsidiary of MDC. Through intercompany arrangements between MDC and the Company, MD Bank is consolidated as if it were a wholly-owned subsidiary of the Company. Adjustments from translating the assets and liabilities of MD Bank from the functional currency of the pound sterling into U.S. dollars at the year-end exchange rate are accumulated and reported as a separate component of equity. Operating results are translated at average monthly exchange rates. Note 2 - Dispositions During the second quarter of 1992, the Company completed the sale of the remaining assets of its full-service leasing segment, operating as McDonnell Douglas Truck Services Inc. ("MDTS"). These assets were sold to various parties for approximately $58.6 million. This segment has been reported as a discontinued operation. Accordingly, the consolidated financial statements for 1992 and 1991 have been reclassified to report separately the operating results of this discontinued operation. Included in 1992 discontinued operations is the MDTS loss on sale of $1.6 million, net of income tax benefits of $0.9 million and the MDTS loss from operations of $0.9 million, net of income tax benefits of $0.5 million. Included in 1991 discontinued operations is the MDTS loss from operations of $1.4 million, net of income tax benefits of $0.8 million. Operating income of MDTS was $3.4 million and $22.9 million for 1992 and 1991. During 1992, in three separate transactions, MD Bank sold a significant portion of its portfolio and received cash proceeds of approximately $70.8 million and an amortizing note receivable of $29.7 million. These sales resulted in pretax gains aggregating $9.4 million. The cash proceeds were applied to reduce MD Bank's bank borrowings, resulting in losses totaling $2.3 million on the termination of interest rate swaps. The note, which was concurrently sold to the Company at par, bears an interest rate of LIBOR plus 1.5%. At December 31, 1993 and 1992, $4.5 million and $18.7 million was outstanding under this note. At December 31, 1993, the Company had an outstanding foreign currency swap agreement to hedge this note. Foreign currency transaction losses incurred in conjunction with this note amounted to $0.4 million and $1.2 million in 1993 and 1992. During the fourth quarter 1992, the Company sold substantially all of the assets of McDonnell Douglas Capital Corporation ("MDCC"), a wholly-owned subsidiary of the Company, for $13.5 million, resulting in a pretax gain of $1.3 million. The assets consisted primarily of equipment subject to operating leases. Operating income of MDCC was $5.9 million and $4.7 million in 1992 and 1991. On October 18, 1991, the Company completed the sale of substantially all of the assets of McDonnell Douglas Auto Leasing Corporation ("MDAL"), a wholly- owned subsidiary of the Company, for $154.7 million. The Company recorded a pretax loss of $2.5 million on the disposition. Operating income of MDAL was $17.2 million in 1991. In two separate transactions, the Company sold substantially all of the assets of the business credit group ("BCG"). The first transaction, occurring in May 1991, resulted in proceeds of $19.9 million and a pretax loss of $1.2 million. On July 1, 1991, the second transaction was consummated and provided the Company with proceeds of $58.7 million and a pretax gain of $0.6 million. Note 3 - Investment in Finance Leases The following lists the components of the investment in finance leases at December 31: (Dollars in millions) 1993 1992 Minimum lease payments receivable $ 1,668.9 $ 1,326.7 Estimated residual value of leased assets 273.2 221.7 Unearned income (772.3) (558.8) Deferred initial direct costs 3.7 4.2 $ 1,173.5 $ 993.8 The following lists the components of the investment in finance leases at December 31 that relate to aircraft leased by the Company under capital leases that have been leased to others: (Dollars in millions) 1993 1992 Minimum lease payments receivable $ 81.2 $ 88.5 Estimated residual value of leased 15.1 15.1 assets Unearned income (41.1) (45.9) Deferred initial direct costs 0.2 0.2 $ 55.4 $ 57.9 At December 31, 1993, finance lease receivables of $267.9 million serve as collateral to senior long-term debt. At December 31, 1993, finance lease receivables are due in installments as follows: 1994, $216.6 million; 1995, $187.4 million; 1996, $166.8 million; 1997, $150.1 million; 1998, $141.0 million; 1999 and thereafter, $807.0 million. During 1993, the Company leased, under a finance lease agreement, a DC-10-30 aircraft to MDC with a carrying amount of $32.9 million at December 31, 1993. The lease requires monthly rent payments of $0.4 million through April 14, 2004. Note 4 - Notes Receivable The following lists the components of notes receivable at December 31: (Dollars in millions) 1993 1992 Principal $ 299.1 $ 454.2 Accrued interest 2.8 5.6 Unamortized discount (1.3) (1.7) Deferred initial direct costs 1.2 1.6 $ 301.8 $ 459.7 At December 31, 1993, notes receivables are due in installments as follows: 1994, $106.5 million; 1995, $56.2 million; 1996, $36.9 million; 1997, $22.3 million; 1998, $28.0 million; 1999 and thereafter, $49.2 million. Note 5 - Equipment Under Operating Leases Equipment under operating leases consists of the following at December 31: (Dollars in millions) 1993 1992 Commercial aircraft $ 216.4 $ 160.1 Executive aircraft 88.7 91.9 Highway vehicles 76.7 108.2 Printing equipment 32.0 17.2 Medical equipment 21.9 26.8 Machine tools and production equipment 21.1 27.1 Computers and related equipment 9.3 4.1 Other 3.1 2.6 469.2 438.0 Accumulated depreciation and (106.6) (103.4) amortization Rentals receivable 5.0 7.8 Deferred lease income (10.8) (11.1) Deferred initial direct costs 1.4 1.6 $ 358.2 $ 332.9 At December 31, 1993, future minimum rentals scheduled to be received under the noncancelable portion of operating leases are as follows: 1994, $60.3 million; 1995, $45.6 million; 1996, $38.6 million; 1997, $34.1 million; 1998, $27.4 million; 1999 and thereafter, $41.1 million. At December 31, 1993, equipment under operating leases of $30.4 million are assigned as collateral to senior long-term debt. Equipment under operating leases of $15.3 million at December 31, 1993, relate to commercial aircraft leased by the Company under capital lease obligations. Under an operating lease agreement, the Company leases four MD-82 aircraft to MDC. The leases require quarterly rent payments of $2.1 million through May 31, 2002. At December 31, 1993 and 1992, the carrying amount of these aircraft was $60.4 million and $64.6 million. Note 6 - Income Taxes The components of the provision (benefit) for taxes on income from continuing operations before cumulative effect of accounting change are as follows: (Dollars in millions) 1993 1992 1991 Current: Federal $ 19.8 $ 48.1 $ 100.2 State 2.4 3.4 2.7 22.2 51.5 102.9 Deferred: Federal 1.0 (36.6) (82.7) Foreign 0.8 1.0 (1.1) 1.8 (35.6) (83.8) $ 24.0 $ 15.9 $ 19.1 Temporary differences represent the cumulative taxable or deductible amounts recorded in the financial statements in different years than recognized in the tax returns. The components of the net deferred income tax liability consist of the following at December 31: (Dollars in millions) 1993 1992 Deferred tax assets: Allowance for losses $ 11.9 $ 12.8 Other 20.0 2.6 31.9 15.4 Deferred tax liabilities: Leased assets (311.6) (291.9) Deferred installment sales (2.8) (3.4) MD Bank - (3.7) Other (16.4) (13.5) (330.8) (312.5) Net deferred tax liability $ (298.9) $ (297.1) Income taxes computed at the United States federal income tax rate and the provision for taxes on income from continuing operations before cumulative effect of accounting change differ as follows: (Dollars in millions) 1993 1992 1991 Tax computed at federal $ 14.3 $ 16.3 $ 19.4 statutory rate State income taxes, net of 1.5 1.3 1.8 federal tax benefit Effect of foreign tax rates 0.1 0.8 - U.S. tax effect on foreign 0.8 (2.1) - income Effect of investment tax (0.6) (1.1) (1.7) credits Effect of tax rate change 8.4 - - Other (0.5) 0.7 (0.4) $ 24.0 $ 15.9 $ 19.1 During the third quarter of 1993, the Company's effective tax rate was affected by an additional tax provision of $8.4 million associated with the tax rate increase included in the Omnibus Budget Reconciliation Act of 1993. MDFS is currently under examination by the Internal Revenue Service ("IRS") for the tax years 1986 through 1989. The IRS audit is not expected to have a material effect on the Company's financial condition or results of operations. Provisions have been made for estimated United States and foreign income taxes which may be incurred upon the repatriation of MD Bank's undistributed earnings. Income taxes paid by the Company totaled $54.0 million in 1993, $86.1 million in 1992 and $76.2 million in 1991. Note 7 - Indebtedness Short-term notes payable consist of the following at December 31: (Dollars in millions) 1993 1992 Short-term bank borrowings $ 149.6 $ - Lines of credit 53.0 124.0 MDFS - 9.5 $ 202.6 $ 133.5 At December 31, 1993, the Company had a revolving credit agreement under which it could borrow a maximum of $125.0 million to be reduced by $25.0 million each quarter through January 1995. The interest rate, at the option of the Company, is either a floating rate generally based on a defined prime rate, a fixed rate related to either LIBOR or a certificate of deposit rate, or a rate as quoted under a competitive bid. Borrowings of $53.0 million and $108.0 million were outstanding under this agreement at December 31, 1993 and 1992. At December 31, 1993, MDFS and the Company had a joint revolving credit agreement under which MDFS could borrow a maximum of $6.0 million and the Company could borrow a maximum of $45.0 million, reduced by any MDFS borrowings under this agreement. The interest rate, at the option of the Company, is either a floating rate generally based on a defined prime rate or fixed rate related to LIBOR. There were no outstanding borrowings under this agreement at December 31, 1993. At December 31, 1993, the Company had non-recourse short-term bank borrowings totaling $149.6 million, at LIBOR based interest rates, due and payable on November 4, 1994. MD Bank borrowings of $16.0 million were outstanding at December 31, 1992 under a committed credit agreement which subsequently expired. Senior long-term debt consists of the following at December 31: (Dollars in millions) 1993 1992 9.0% Note due through 1993 $ - $ 9.7 7.75% - 7.91% Notes due through 1993 - 3.3 5.0% Note due through 1994, net of discount based on imputed interest rate 0.5 1.1 of 7.95% 13.0% Notes due through 1995 0.6 1.1 9.15% Note due 1994 19.4 17.4 8.46% Note due 1995 8.0 8.0 10.52% Note due 1995 52.0 52.0 7.0% Notes due through 1996 2.1 3.0 7.0% Notes due through 1998, net of discount based on imputed interest rate 3.4 4.1 of 10.8% 3.9% Notes due through 1999, net of discount based on imputed interest 9.4 10.9 rates of 9.15% - 10.6% 5.75% - 6.875% Notes due through 2000, net of discount based on imputed 11.8 13.3 interest rates of 9.75% - 11.4% 6.65% - 10.18% Notes due through 2001 93.2 94.9 5.25% - 8.375% Retail medium term notes 79.1 - due through 2008 4.625% - 13.55% Medium term notes due 713.4 792.0 through 2005 Capital lease obligations due through 87.9 93.4 $ 1,080.8 $ 1,104.2 The 9.15% Note due 1994, related to a borrowing denominated in Japanese yen, and the 10.52% Note due 1995, related to a borrowing denominated in Swiss francs, have been adjusted by $20.9 million at December 31, 1993 ($19.0 million at December 31, 1992) to reflect the dollar value of each liability at the current exchange rate. To hedge against the risk of future currency exchange rate fluctuations on such debt, the Company entered into foreign currency swap agreements at the time of borrowing whereby it may purchase foreign currency sufficient to retire such debt at exchange rates in effect at the initial dates of the agreements. Changes in the market value of the swap agreements due to changes in exchange rates are included in other assets and effectively offset changes in the value of the foreign denominated obligations. As of December 31, 1993, $98.6 million of senior long-term debt was collateralized by equipment. This debt is composed of the 7.0% Notes due through 1996, 7.0% Notes due through 1998, and the 6.65% - 10.18% Notes due through 2001. The Company leases aircraft under capital leases which have been sub-leased to others. The Company has guaranteed the repayment of $9.7 million in capital lease obligations associated with a 50% partner. Subordinated long-term debt consists of the following at December 31: (Dollars in millions) 1993 1992 12.63% Note due 1993 $ - $ 5.0 8.25% - 9.26% Notes due through 1996 5.0 10.0 10.25% Notes due through 1997 20.0 25.0 12.35% Note due 1997 20.0 20.0 8.93% - 9.92% Medium term notes due through 32.8 32.7 $ 77.8 $ 92.7 Payments required on long-term debt and capital lease obligations during the years ending December 31 are as follows: Long-Term Capital (Dollars in millions) Debt Leases 1994 $ 185.7 $ 15.1 1995 202.2 15.1 1996 98.5 15.1 1997 106.4 15.1 1998 135.8 15.1 1999 and thereafter 347.4 62.1 1,076.0 137.6 Deferred debt expenses (5.4) (0.9) Imputed interest - (48.8) $ 1,070.6 $ 87.9 The provisions of various credit and debt agreements require the Company to maintain a minimum net worth, restrict indebtedness, and limit cash dividends and other distributions. Under the most restrictive provision, $49.4 million of the Company's income retained for growth was available for dividends at December 31, 1993. Interest payments totaled $116.3 million in 1993, $154.0 million in 1992 and $205.2 million in 1991. Note 8 - Commitments and Contingencies At December 31, 1993 and 1992, the Company had unused credit lines available to customers totaling $6.6 million and $14.3 million; and commitments to provide leasing and other financing totaling $43.6 million and $23.1 million. In 1990, the Company was named as a defendant in three class action suits (the "Actions") for alleged violations of securities laws in connection with the public offering of limited partnership interests in certain equipment leasing limited partnerships, the sponsor of which was MDCC. In 1993, the Company settled the Actions for approximately $14.8 million. As part of the settlement, MDCC purchased the equipment portfolios of the limited partnerships for 121% of the $1.0 million net book value, which approximated fair value. The Company adequately reserved for the settlement of the Actions. At December 31, 1993, in conjunction with prior asset dispositions, at December 31, 1993, the Company is subject to a maximum recourse of $42.0 million. Based on trends to date, the Company's exposure to such loss is not expected to be significant. Note 9 - Transactions with MDC and MDFS Accounts with MDC and MDFS consist of the following at December 31: (Dollars in millions) 1993 1992 Notes receivable $ 47.9 $ 49.0 Federal income tax payable 25.8 (15.4) State income tax receivable - 8.3 Other payables (3.3) (1.0) $ 70.4 $ 40.9 The Company has arrangements with MDC, terminable at the discretion of either of the parties, pursuant to which the Company may borrow from MDC and MDC may borrow from the Company, funds for 30-day periods at a market rate of interest or at MDFS's average borrowing rate. Under these arrangements, there were no outstanding balances at December 31, 1993 and at December 31, 1992, $49.0 million was receivable from MDC. Under a similar arrangement, the Company may borrow from MDFS and MDFS may borrow from the Company, funds for 30-day periods at the Company's cost of funds for short-term borrowings. Under these arrangements, receivables of $18.3 million and borrowings of $9.5 million were outstanding at December 31, 1993 and 1992. On September 28, 1993, the Company sold, at estimated fair value, real estate owned properties to McDonnell Douglas Realty Company, a wholly-owned subsidiary of MDC, and financed the sale by taking a $28.9 million note. The Company recorded a pretax loss of $5.7 million on the transfer, which is included in other expenses in the consolidated statement of income. The note is payable on demand and accrues interest at a rate equal to the average borrowing cost of MDFS. At December 31, 1993, $29.6 million was outstanding under this note. During 1993, 1992 and 1991, the Company purchased aircraft and aircraft related notes from MDC in the amount of $400.2 million, $160.5 million and $119.1 million, respectively. At December 31, 1993 and 1992, $270.0 million and $152.2 million of the commercial aircraft financing portfolio was guaranteed by MDC. During 1993, 1992 and 1991, the Company collected $0.2 million, $0.6 million and $0.8 million, respectively, under these guaranties. On September 29, 1992, the Company purchased a bridge note issued by Irish Aerospace Leasing Limited, a wholly-owned subsidiary of Irish Aerospace Limited, which previously was 25% owned by MDC, for $22.0 million with an effective interest rate of 9.4%. This note was repaid in 1993. On December 31, 1991, MDC sold an MD-11 flight simulator to the Company for $30.0 million and simultaneously leased it back under an operating lease agreement. On March 5, 1992, the Company sold the MD-11 flight simulator to a third party for approximately book value. During 1992, the $9.9 million long-term debt issued by MDFS to MD Bank in 1990 was prepaid. This note was payable in ten equal semi-annual instalments beginning on May 20, 1996, at LIBOR based interest rates. The Series A Preferred Stock is redeemable at the Company's option at $5,000 per share, has no voting privileges and is entitled to cumulative semi-annual dividends of $175 per share. Such dividends have priority over cash dividends on the Company's common stock. Accrued dividends on preferred stock amounted to $0.6 and $0.5 million at December 31, 1993 and 1992. Substantially all employees of MDC and its subsidiaries are members of defined benefit pension plans and insurance plans. MDC also provides eligible employees the opportunity to participate in savings plans that permit both pretax and after-tax contributions. MDC generally charges the Company with the actual cost of these plans which are included with other MDC charges for support services and reflected in operating expenses. MDC charges for services provided during 1993, 1992 and 1991 totaled $1.1 million, $2.1 million and $2.9 million, respectively. Additionally, the Company was compensated by certain affiliates for a number of support services, which are net against operating expenses, amounting to $1.8 million, $2.5 million and $2.7 million in 1993, 1992 and 1991, respectively. Prior to 1992, Company-paid retiree health care benefits were included in costs as covered expenses were actually incurred. In December 1990, the Financial Accounting Standards Board issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Statement required companies to change, by 1993, their method of accounting for the costs of these benefits to one that accelerates the recognition of costs by causing their full accrual over the employees' years of service up to their date of full eligibility. MDC, and therefore the Company, elected to implement this Statement for 1992 by immediately recognizing the January 1, 1992 accumulated postretirement benefit obligation of $3.1 million ($1.9 million after-tax). On October 8, 1992, effective January 1, 1993, MDC terminated Company-paid retiree health care for both current and future non-union retirees and their survivors and replaced it with a new arrangement that will be funded entirely by participant contributions. The Company recorded a pretax curtailment gain of $2.8 million ($1.7 million after-tax) in the fourth quarter of 1992, reflecting the termination of Company-paid retiree health care for both current and future non-union retirees. In December 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The Statement will be effective in 1994 and will require using an accrual approach for accounting for benefits other than retiree health care to former or inactive employees. The impact of the Company's adoption of this Statement is not expected to be material. Note 10 - Fair Value of Financial Instruments The estimated fair value amounts of the Company's financial instruments have been determined by the Company, using appropriate market information and valuation methodologies. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents Because of the short maturity of these instruments, the carrying amount approximates fair value. Notes Receivable For variable rate notes that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values of fixed rate notes are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Short and Long-Term Debt The carrying amount of the Company's short-term borrowings approximates its fair value. The fair value of the Company's long- term debt is estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. Off-Balance Sheet Instruments Fair values for the Company's off-balance sheet instruments (swaps and financing commitments) are based on quoted market prices of comparable instruments (currency and interest rate swaps); and the counterparties' credit standing, taking into account the remaining terms of the agreements (financing commitments). The estimated fair values of the Company's financial instruments consist of the following at December 31: (Dollars in millions) 1993 1992 Carrying Fair Carrying Fair Asset (Liability) Amount Value Amount Value ASSETS Cash and cash equivalents $ 65.5 $ 65.5 $ 11.6 $ 11.6 Notes receivable 301.8 301.8 459.7 458.2 LIABILITIES Short-term notes payable (203.3) (203.3) (124.2) (124.2) to banks Long-term debt: Senior, excluding capital (1,014.0) (1,090.3) (1,034.8) (1,055.2) lease obligations Subordinated (80.7) (89.1) (96.1) (99.2) OFF BALANCE SHEET INSTRUMENTS Commitments to extend (50.2) (50.2) (16.8) (16.8) credit Foreign currency swaps 20.9 18.5 19.0 13.3 Interest rate swaps (0.2) (0.7) (0.1) (1.4) Note 11 - Segment Information The Company provides a diversified range of financing and leasing arrangements to customers and industries throughout the United States, the United Kingdom and, to a lesser extent, other countries. The Company's operations include three financial reporting segments: commercial aircraft financing, commercial equipment leasing and non-core businesses. The commercial aircraft financing segment provides customer financing services to MDC components, primarily Douglas Aircraft Company, and also provides financing for the acquisition of non-MDC aircraft. The commercial equipment leasing segment is principally involved in large financing and leasing transactions for a diversified range of equipment. Non- core businesses represent market segments in which the Company is no longer active. The non-core businesses consist primarily of the remaining assets of three business units: MD Bank, receivable inventory financing and real estate financing. MD Bank provided financing in the United Kingdom similar to that provided in the United States by the commercial equipment leasing segment. Receivable inventory financing provides financing to dealers of rent-to-own products. Real estate financing previously specialized in fixed rate, medium term commercial real estate loans. The Company's financing and leasing portfolio consists of the following at December 31: (Dollars in millions) 1993 1992 Commercial aircraft financing: MDC aircraft financing $ 1,035.1 56.5% $ 769.3 43.1% Other commercial aircraft 202.4 11.0 231.8 13.0 financing 1,237.5 67.5 1,001.1 56.1 Commercial equipment leasing: Transportation services 69.3 3.8 96.9 5.4 Transportation equipment 42.7 2.3 39.0 2.2 Trucking and warehousing 38.7 2.1 66.6 3.7 Other 271.6 14.8 354.9 19.9 422.3 23.0 557.4 31.2 Non-core businesses: Real estate 123.6 6.7 146.7 8.2 Furniture and home furnishings stores 31.0 1.7 43.2 2.4 Air transportation 5.1 0.3 5.5 0.3 Other 14.0 0.8 32.5 1.8 173.7 9.5 227.9 12.7 Total portfolio $1,833.5 100.0% $1,786.4 100.0% The single largest commercial aircraft financing customer accounted for $253.2 million (13.8% of total Company portfolio) and $120.9 million (6.8% of total Company portfolio) at December 31, 1993 and 1992. The five largest commercial aircraft financing customers accounted for $718.5 million (39.2% of total Company portfolio) and $445.1 million (24.9% of total Company portfolio) at December 31, 1993 and 1992. There were no significant concentrations by customer within the commercial equipment leasing and non-core businesses portfolios. The Company generally holds title to all leased equipment and generally has a perfected security interest in the assets financed through note and loan arrangements. Information about the Company's operations in its different financial reporting segments for the past three years is as follows: (Dollars in millions) 1993 1992 1991 Operating income: Commercial aircraft financing $ 107.4 $ 107.7 $ 125.6 Commercial equipment leasing 64.0 79.1 117.5 Non-core businesses 24.4 56.1 94.3 Corporate 2.7 11.8 4.9 $ 198.5 $ 254.7 $ 342.3 Income (loss) from continuing operations before income taxes and cumulative effect of accounting change: Commercial aircraft financing $ 26.3 $ 28.3 $ 50.7 Commercial equipment leasing 30.8 31.1 42.0 Non-core businesses (10.7) (11.4) (25.6) Corporate (5.6) - (9.9) $ 40.8 $ 48.0 $ 57.2 Identifiable assets at December 31: Commercial aircraft $ 1,369.0 $ 1,085.2 $ 1,106.7 financing Commercial equipment leasing 420.2 590.5 747.2 Non-core businesses 247.6 301.2 694.3 Corporate 26.4 22.1 34.1 $ 2,063.2 $ 1,999.0 $ 2,582.3 Depreciation expense - equipment under operating leases: Commercial aircraft financing $ 10.1 $ 5.9 $ 2.6 Commercial equipment leasing 28.2 31.8 39.4 Non-core businesses 0.7 11.1 18.0 $ 39.0 $ 48.8 $ 60.0 Equipment acquired for operating leases, at cost: Commercial aircraft financing $ 34.5 $ 53.5 $ 36.3 Commercial equipment leasing 22.9 18.2 30.3 Non-core businesses - 0.1 0.1 $ 57.4 $ 71.8 $ 66.7 The Company's operations are classified into two geographic segments, the United States and the United Kingdom. United Kingdom operations consist of MD Bank. Information about the Company's operations in its different geographic segments for the past three years is as follows: (Dollars in millions) 1993 1992 1991 Operating income: United States $ 194.1 $227.7 $305.7 United Kingdom 4.4 27.0 36.6 $ 198.5 $254.7 $342.3 Income (loss) from continuing operations before income taxes and cumulative effect of accounting change: United States $ 41.2 $ 41.0 $ 60.5 United Kingdom (0.4) 7.0 (3.3) $ 40.8 $ 48.0 $ 57.2 Identifiable assets at December 31: United States $ 2,033.7 $ 1,950.0 $ 2,347.8 United Kingdom 29.5 49.0 234.5 $ 2,063.2 $ 1,999.0 $ 2,582.3 Operating income from financing of assets located outside the United States by the Company's United States geographic segment totaled $20.9 million, $21.6 million and $18.1 million in 1993, 1992 and 1991, respectively. McDonnell Douglas Finance Corporation and Subsidiaries Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties Balance at (Dollars in End of millions) Deductions Year ------------------- ----------------- Balance at Amounts Beginning of Amounts Written Non Year Additions Collected Off Current Current 1993: Irish $ 22.3 $ - $ 22.3 $ - $ - $ - 1992: Irish $ 6.3 $ 22.3 $ 6.3 $ - $ 22.3 $ - 1991: Irish $ - $ 6.3 $ - $ - $ 6.3 $ - McDonnell Douglas Finance Corporation and Subsidiaries Schedule VIII - Valuation and Qualifying Accounts (Dollars in millions) Balance Charged Allowance for at to Balance Losses on Beginning Costs at end Financing of and Other Deductions of Receivables Year Expenses Year 1993 $ 37.4 $ 8.6 $ - $ (10.4) $ 35.6 1992 $ 46.7 $ 19.1 $ (1.0) $ (27.4) $ 37.4 1991 $ 61.6 $ 47.2 $ (5.4) $ (56.7) $ 46.7 The 1991 amount includes allowances that were reclassified in conjunction with the sale of substantially all of the assets of MDAL and BCG. Write-offs net of recoveries. McDonnell Douglas Finance Corporation and Subsidiaries Schedule IX - Short-Term Borrowings (Dollars in millions) Weighted Average Weighted Average Maximum Interest Amount Amount Average Balance Rate Outstanding Outstanding Interest Category of at End of at End During the During the Rate Aggregate Period of Period Period Period During the Short-term Period Borrowings Year ended December 31, 1993: MDC $ - - % $ 190.4 $ 23.0 4.33% MDFS - - 27.5 6.0 4.96 Banks - U.S. 202.6 4.35 203.0 72.8 4.66 Banks - U.K. - - 15.9 11.3 13.13 Year ended December 31, 1992: MDFS $9.5 5.94% $ 16.1 $ 6.4 5.35% Banks - U.S. 108.0 6.00 108.0 24.5 3.94 Banks - U.K. 16.0 12.44 124.1 87.3 14.68 Year ended December 31, 1991: Commercial $ - -% $ 44.0 $ 2.1 9.20% paper MDC - - 4.6 0.5 8.85 MDFS 4.4 5.83 22.9 1.0 8.02 Banks - U.S. - - 300.0 140.2 7.10 Banks - U.K. 158.0 12.25 289.3 197.2 12.34 Commercial paper was issued from time to time at various maturities and short-term notes payable to MDC are issued for 30 days. Computed by dividing the total of daily principal balances by the number of days in the year. Computed by dividing the actual interest expense by average short-term debt outstanding. The effective interest rate on short-term borrowings including the effect of fees was 5.97% in 1993, 12.38% in 1992 and 10.28% in 1991. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Part IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page Number in Form 10-K (a) 1. Financial Statements Report of Independent Auditors 33 Consolidated Balance Sheet at December 31, 1993 and 1992 34 Consolidated Statement of Income and Income Retained for Growth for the Years Ended December 31, 1993, 1992 and 1991 36 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 38 Notes to Consolidated Financial Statements 40-55 2. Financial Statement Schedules Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties 56 Schedule VIII - Valuation and Qualifying Accounts 58 Schedule IX - Short-Term Borrowings 60 Schedules for which provision is made in the applicable regulation of the Securities and Exchange Commission (the "SEC"), except Schedules II, VIII and IX which are included herein, have been omitted because they are not required, or the information is set forth in the financial statements or notes thereto. 3. Exhibits 3.1 Restated Certificate of Incorporation of the Company dated June 29, 1989. 3.2 By-Laws of the Company, as amended to date. 4.4 Form of Indenture, dated as of April 1, 1983, between the Company and Bankers Trust Company, incorporated herein by reference to Exhibit 4(a) to Amendment No. 1 to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.5 Form of Subordinated Indenture, dated as of June 15, 1988, by and between the Company and Bankers Trust Company of California, N.A., as Subordinated Indenture Trustee, incorporated by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.6 Form of Indenture, dated as of April 15, 1987, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company as filed with the SEC on April 24, 1987. 4.7 Form of Series I Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.8 Form of Series II Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form 8-K of the Company dated August 22, 1983. 4.9 Form of Series III Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.10 Form of Series IV Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.11 Form of Series V Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company , as filed with the SEC on April 24, 1987. 4.12 Form of Series VI Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.13 Form of Series VII Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.14 Form of Series VIII Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.15 Form of Series VIII Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.16 Form of Series IX Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.17 Form of Series IX Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.18 Form of General Term Note(R), incorporated herein by reference to Exhibit 4(c) to Form 8-K of the Company dated May 26, 1993. Pursuant to Item 601 (b)(4)(iii) of Regulation S-K, the Company is not filing certain instruments with respect to its long-term debt since the total amount of securities currently provided for under each of such instruments does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. The Company hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10.1 Amended and Restated Operating Agreement among MDC, the Company and MDFS dated as of April 12, 1993. 10.2 Operating Agreement by and between the Company and MDFS effective as of February 8, 1989, incorporated herein by reference to Exhibit 10.3 to the Company's Form 10-K for the year ended December 31, 1989. 10.3 By-Laws of MDC as amended January 29, 1993, incorporated by reference from MDC's Exhibit 3.2 to its Form 8-K Report filed February 1, 1993 (file No. 1-3685). 10.4 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 10.5 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 12.1 Statement regarding computation of ratio of earnings to fixed charges. 23.1 Consent of Ernst & Young. (b) Reports on Form 8-K On February 3, 1994, the Company filed a current report on Form 8-K, which included the Company's Consolidated Balance Sheet at December 31, 1993 and 1992 and Consolidated Statement of Income and Income Retained for Growth for each of the years ended December 31, 1993, 1992 and 1991. 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. McDonnell Douglas Finance Corporation By /s/ Douglas E. Scudamore March 30, 1994 Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Herbert J. Lanese Chairman March 30, 1994 /s/ George M. Rosen President and Director March 30, 1994 (Principal Executive Officer) /s/ Robert W. Owsley Sr. Vice President March 30, 1994 (Principal & Treasurer Financial Officer) /s/ Douglas E. Scudamore Vice President March 30, 1994 (Principal & Controller Accounting Officer) F. Mark Kuhlmann Director /s/ Thomas J. Lawlor, Jr. Director March 30, 1994 John F. McDonnell Director Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. All of the Company's preferred and common stock is owned by MDFS. In 1993, the Company declared and paid no dividends to MDFS on its common stock compared to $102.3 million declared and paid in 1992. The 1992 common stock dividends declared and paid were unusually high due to the downsizing of the Company. The Company paid $3.6 million and $3.5 million in dividends on its preferred stock in 1993 and 1992. Preferred stock dividends of $0.5 million payable to MDFS were accrued at December 31, 1993. The Company currently expects to pay common stock dividends of at least $13.0 million to MDFS in 1994. The provisions of various credit and debt agreements require the Company to maintain a minimum net worth, restrict indebtedness, and limit cash dividends and other distributions. Under the most restrictive provision, $49.4 million of the Company's income retained for growth was available for dividends at December 31, 1993. Item 6. Item 6. Selected Financial Data The selected consolidated financial data should be read in conjunction with the Company's consolidated financial statements at December 31, 1993 and for the year then ended and with Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following should be read in conjunction with the consolidated financial statements included in Item 8. Item 8. Financial Statements and Supplementary Data The following pages include the consolidated financial statements of the Company as described in Item 14.(a) 1. and 2. herein. Report of Independent Auditors Shareholder and Board of Directors McDonnell Douglas Finance Corporation We have audited the accompanying consolidated balance sheet of McDonnell Douglas Finance Corporation (a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income and income retained for growth, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of McDonnell Douglas Finance Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We have also previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheets as of December 31, 1991, 1990 and 1989, and the related consolidated statements of income and income retained for growth, and cash flows for the years ended December 31, 1990 and 1989 (none of which are presented separately herein); and we expressed unqualified opinions on those consolidated financial statements. In our opinion, the information set forth in the selected financial data for each of the five years in the period ended December 31, 1993, appearing on pages 26 - 28, is fairly stated in all material respects in relation to the consolidated financial statements from which it has been derived. As discussed in the notes to the consolidated financial statements, in 1992 the Company changed its method of accounting for retiree health care benefits. /s/ Ernst & Young Orange County, California January 18, 1994 McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Balance Sheet December 31, (Dollars in millions, except per share amounts) 1993 1992 ASSETS Financing receivables: Investment in finance leases $1,173.5 $ 993.8 Notes receivable 301.8 459.7 1,475.3 1,453.5 Allowance for losses on financing (35.6) (37.4) receivables Financing receivables, net 1,439.7 1,416.1 Cash and cash equivalents 65.5 11.6 Equipment under operating leases, net 358.2 332.9 Equipment held for sale or re-lease 32.0 56.6 Real estate owned 12.9 55.2 Accounts with MDC and MDFS 70.4 40.9 Other assets 84.5 85.7 $2,063.2 $ 1,999.0 LIABILITIES AND SHAREHOLDER'S EQUITY Short-term notes payable $ 202.6 $ 133.5 Accounts payable and accrued expenses 59.2 41.2 Other liabilities 74.5 73.9 Deferred income taxes 298.9 297.1 Long-term debt: Senior 1,080.8 1,104.2 Subordinated 77.8 92.7 1,793.8 1,742.6 Commitments and contingencies - Note 8 Shareholder's equity: Preferred stock - no par value; authorized 100,000 shares: Series A; $5,000 stated value; authorized, issued and outstanding 50.0 50.0 10,000 shares Common stock $100 par value; authorized 100,000 shares; issued 5.0 5.0 and outstanding 50,000 shares Capital in excess of par value 89.5 89.5 Income retained for growth 129.6 116.4 Cumulative foreign currency (4.7) (4.5) translation adjustment 269.4 256.4 $2,063.2 $ 1,999.0 See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Statement of Income and Income Retained for Growth Years ended December 31, (Dollars in millions) 1993 1992 1991 OPERATING INCOME Finance lease income $ 94.7 $ 113.0 $ 179.3 Interest income on notes receivable 35.8 47.9 61.5 Operating lease income, net of depreciation expense of $39.0, $48.8 34.4 33.3 34.1 and $60.0 in 1993, 1992 and 1991, respectively Net gain on disposal or re-lease of 23.7 37.1 45.8 assets Postretirement benefit curtailment - 2.8 - gain Other 9.9 20.6 21.6 198.5 254.7 342.3 EXPENSES Interest expense 116.4 145.9 198.5 Provision for losses 8.6 19.1 47.2 Operating expenses 20.3 27.4 35.6 Other 12.4 14.3 3.8 157.7 206.7 285.1 Income from continuing operations before income taxes and cumulative 40.8 48.0 57.2 effect of accounting change Provision for income taxes 24.0 15.9 19.1 Income from continuing operations before cumulative effect 16.8 32.1 38.1 of accounting change Discontinued operations, net - (2.5) (1.4) Cumulative effect of new accounting standard for postretirement benefits - (1.9) - Net income 16.8 27.7 36.7 Income retained for growth at beginning 116.4 194.5 216.8 of year Dividends (3.6) (105.8) (59.0) Income retained for growth at end of $ 129.6 $ 116.4 $ 194.5 year See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Consolidated Statement of Cash Flows Years Ended December 31, (Dollars in millions) 1993 1992 1991 OPERATING ACTIVITIES Income from continuing operations before cumulative effect of $ 16.8 $ 32.1 $ 38.1 accounting change Adjustments to reconcile income from continuing operations before cumulative effect of accounting change to net cash provided by (used in) operating activities: Depreciation expense - 39.0 48.8 60.0 equipment under operating leases Net gain on disposal or re- (23.7) (37.1) (45.8) lease of assets Provision for losses 8.6 19.1 47.2 Change in assets and liabilities: Accounts with MDC and MDFS (29.5) 18.4 (58.1) Other assets 1.2 (8.2) (9.9) Accounts payable 18.0 (16.1) (32.5) Other liabilities 0.6 (6.2) 5.3 Deferred income taxes 1.8 (76.6) (97.3) Other, net 4.2 (16.2) 1.7 Discontinued operations - 0.4 18.5 37.0 (41.6) (72.8) INVESTING ACTIVITIES Net change in short-term notes and 91.3 (77.9) (21.2) leases receivable Purchase of equipment for operating (57.4) (71.8) (66.7) leases Proceeds from disposition of 139.5 323.2 790.6 equipment, notes and leases receivable Collection of notes and leases 202.7 278.7 354.5 receivable Acquisition of notes and leases (385.7) (153.2) (168.9) receivable Discontinued operations - 69.4 19.8 (9.6) 368.4 908.1 FINANCING ACTIVITIES Net change in short-term borrowings 69.1 16.5 (444.4) Debt having maturities more than 90 days: Proceeds 183.0 34.9 585.6 Repayments (222.0) (440.8) (840.9) Payment of cash dividends (3.6) (105.8) (59.0) Discontinued operations - (6.9) (2.7) 26.5 (502.1) (761.4) Increase (decrease) in cash and cash 53.9 (175.3) 73.9 equivalents Cash and cash equivalents at 11.6 186.9 113.0 beginning of year Cash and cash equivalents $ 65.5 $ 11.6 $ 186.9 at end of year See notes to consolidated financial statements. McDonnell Douglas Finance Corporation and Subsidiaries Notes to Consolidated Financial Statements December 31, 1993 Note 1 - Organization and Summary of Significant Accounting Policies Organization McDonnell Douglas Finance Corporation (the "Company") is a wholly-owned subsidiary of McDonnell Douglas Financial Services Corporation ("MDFS"), a wholly-owned subsidiary of McDonnell Douglas Corporation ("MDC"). The Company was incorporated in Delaware in 1968 and provides a diversified range of equipment financing and leasing arrangements to commercial and industrial markets. Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Certain amounts have been reclassified to conform to the 1993 presentation. Finance Leases At lease commencement, the Company records the lease receivable, estimated residual value of the leased equipment and unearned lease income. Income from leases is recognized over the terms of the leases so as to approximate a level rate of return on the net investment. Residual values, which are reviewed periodically, represent the estimated amount to be received at lease termination from the disposition of leased equipment. Initial Direct Costs Initial direct costs are deferred and amortized over the related financing terms. Cash Equivalents The Company considers all cash investments with original maturities of three months or less to be cash equivalents. Cash equivalents at December 31, 1993 were $58.8 million. There were no cash equivalents at December 31, 1992. At December 31, 1993 and 1992, the Company has classified as other assets restricted cash deposited with banks in interest bearing accounts of $44.3 million and $39.7 million for compensating balances, specific lease rents and contractual purchase price related to certain aircraft leased by the Company under capital lease obligations, and security against recourse provisions related to certain note and lease receivable sales. Allowance for Losses on Financing Receivables The allowance for losses on financing receivables includes consideration of such factors as the risk rating of individual credits, economic and political conditions, prior loss experience and results of periodic credit reviews. Collateral that is formally or substantively repossessed in satisfaction of a receivable is written down to estimated fair value and is transferred to equipment held for sale or re-lease or real estate owned. Subsequent to such transfer, these assets are carried at the lower of cost or estimated net realizable value. In May 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This Statement requires that impaired loans be measured on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. Adoption of this Statement is required no later than 1995, although earlier application is permitted. The Company presently intends to adopt this pronouncement in 1995. The effect of applying this Statement is not expected to have a material impact on the financial condition or results of operations of the Company. Equipment Under Operating Leases Rental equipment subject to operating leases is recorded at cost and depreciated over its useful life or lease term to an estimated salvage value, primarily on a straight-line basis. Income Taxes The operations of the Company and its subsidiaries are included in the consolidated federal income tax return of MDC. MDC presently charges or credits the Company for the corresponding increase or decrease in MDC's taxes resulting from such inclusion. Intercompany payments are made when such taxes are due or tax credits are realized by MDC. Investment tax credits (which were repealed by the Tax Reform Act of 1986) related to property subject to financing transactions are deferred and amortized over the terms of the financing transactions. The provision for taxes on income is computed at current tax rates and adjusted for items that do not have tax consequences, temporary differences and the cumulative effect of any changes in tax rates from those previously used to determine deferred income taxes. In 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The impact of the adoption of SFAS No. 109 had no material effect on the Company's accounting for income taxes. SFAS No. 109 requires financial statements reflect deferred income taxes for future tax consequences of events recognized in different years for financial and tax reporting purposes. Foreign Currency Translation McDonnell Douglas Bank Limited ("MD Bank"), a United Kingdom company, is an indirect wholly-owned subsidiary of MDC. Through intercompany arrangements between MDC and the Company, MD Bank is consolidated as if it were a wholly-owned subsidiary of the Company. Adjustments from translating the assets and liabilities of MD Bank from the functional currency of the pound sterling into U.S. dollars at the year-end exchange rate are accumulated and reported as a separate component of equity. Operating results are translated at average monthly exchange rates. Note 2 - Dispositions During the second quarter of 1992, the Company completed the sale of the remaining assets of its full-service leasing segment, operating as McDonnell Douglas Truck Services Inc. ("MDTS"). These assets were sold to various parties for approximately $58.6 million. This segment has been reported as a discontinued operation. Accordingly, the consolidated financial statements for 1992 and 1991 have been reclassified to report separately the operating results of this discontinued operation. Included in 1992 discontinued operations is the MDTS loss on sale of $1.6 million, net of income tax benefits of $0.9 million and the MDTS loss from operations of $0.9 million, net of income tax benefits of $0.5 million. Included in 1991 discontinued operations is the MDTS loss from operations of $1.4 million, net of income tax benefits of $0.8 million. Operating income of MDTS was $3.4 million and $22.9 million for 1992 and 1991. During 1992, in three separate transactions, MD Bank sold a significant portion of its portfolio and received cash proceeds of approximately $70.8 million and an amortizing note receivable of $29.7 million. These sales resulted in pretax gains aggregating $9.4 million. The cash proceeds were applied to reduce MD Bank's bank borrowings, resulting in losses totaling $2.3 million on the termination of interest rate swaps. The note, which was concurrently sold to the Company at par, bears an interest rate of LIBOR plus 1.5%. At December 31, 1993 and 1992, $4.5 million and $18.7 million was outstanding under this note. At December 31, 1993, the Company had an outstanding foreign currency swap agreement to hedge this note. Foreign currency transaction losses incurred in conjunction with this note amounted to $0.4 million and $1.2 million in 1993 and 1992. During the fourth quarter 1992, the Company sold substantially all of the assets of McDonnell Douglas Capital Corporation ("MDCC"), a wholly-owned subsidiary of the Company, for $13.5 million, resulting in a pretax gain of $1.3 million. The assets consisted primarily of equipment subject to operating leases. Operating income of MDCC was $5.9 million and $4.7 million in 1992 and 1991. On October 18, 1991, the Company completed the sale of substantially all of the assets of McDonnell Douglas Auto Leasing Corporation ("MDAL"), a wholly- owned subsidiary of the Company, for $154.7 million. The Company recorded a pretax loss of $2.5 million on the disposition. Operating income of MDAL was $17.2 million in 1991. In two separate transactions, the Company sold substantially all of the assets of the business credit group ("BCG"). The first transaction, occurring in May 1991, resulted in proceeds of $19.9 million and a pretax loss of $1.2 million. On July 1, 1991, the second transaction was consummated and provided the Company with proceeds of $58.7 million and a pretax gain of $0.6 million. Note 3 - Investment in Finance Leases The following lists the components of the investment in finance leases at December 31: (Dollars in millions) 1993 1992 Minimum lease payments receivable $ 1,668.9 $ 1,326.7 Estimated residual value of leased assets 273.2 221.7 Unearned income (772.3) (558.8) Deferred initial direct costs 3.7 4.2 $ 1,173.5 $ 993.8 The following lists the components of the investment in finance leases at December 31 that relate to aircraft leased by the Company under capital leases that have been leased to others: (Dollars in millions) 1993 1992 Minimum lease payments receivable $ 81.2 $ 88.5 Estimated residual value of leased 15.1 15.1 assets Unearned income (41.1) (45.9) Deferred initial direct costs 0.2 0.2 $ 55.4 $ 57.9 At December 31, 1993, finance lease receivables of $267.9 million serve as collateral to senior long-term debt. At December 31, 1993, finance lease receivables are due in installments as follows: 1994, $216.6 million; 1995, $187.4 million; 1996, $166.8 million; 1997, $150.1 million; 1998, $141.0 million; 1999 and thereafter, $807.0 million. During 1993, the Company leased, under a finance lease agreement, a DC-10-30 aircraft to MDC with a carrying amount of $32.9 million at December 31, 1993. The lease requires monthly rent payments of $0.4 million through April 14, 2004. Note 4 - Notes Receivable The following lists the components of notes receivable at December 31: (Dollars in millions) 1993 1992 Principal $ 299.1 $ 454.2 Accrued interest 2.8 5.6 Unamortized discount (1.3) (1.7) Deferred initial direct costs 1.2 1.6 $ 301.8 $ 459.7 At December 31, 1993, notes receivables are due in installments as follows: 1994, $106.5 million; 1995, $56.2 million; 1996, $36.9 million; 1997, $22.3 million; 1998, $28.0 million; 1999 and thereafter, $49.2 million. Note 5 - Equipment Under Operating Leases Equipment under operating leases consists of the following at December 31: (Dollars in millions) 1993 1992 Commercial aircraft $ 216.4 $ 160.1 Executive aircraft 88.7 91.9 Highway vehicles 76.7 108.2 Printing equipment 32.0 17.2 Medical equipment 21.9 26.8 Machine tools and production equipment 21.1 27.1 Computers and related equipment 9.3 4.1 Other 3.1 2.6 469.2 438.0 Accumulated depreciation and (106.6) (103.4) amortization Rentals receivable 5.0 7.8 Deferred lease income (10.8) (11.1) Deferred initial direct costs 1.4 1.6 $ 358.2 $ 332.9 At December 31, 1993, future minimum rentals scheduled to be received under the noncancelable portion of operating leases are as follows: 1994, $60.3 million; 1995, $45.6 million; 1996, $38.6 million; 1997, $34.1 million; 1998, $27.4 million; 1999 and thereafter, $41.1 million. At December 31, 1993, equipment under operating leases of $30.4 million are assigned as collateral to senior long-term debt. Equipment under operating leases of $15.3 million at December 31, 1993, relate to commercial aircraft leased by the Company under capital lease obligations. Under an operating lease agreement, the Company leases four MD-82 aircraft to MDC. The leases require quarterly rent payments of $2.1 million through May 31, 2002. At December 31, 1993 and 1992, the carrying amount of these aircraft was $60.4 million and $64.6 million. Note 6 - Income Taxes The components of the provision (benefit) for taxes on income from continuing operations before cumulative effect of accounting change are as follows: (Dollars in millions) 1993 1992 1991 Current: Federal $ 19.8 $ 48.1 $ 100.2 State 2.4 3.4 2.7 22.2 51.5 102.9 Deferred: Federal 1.0 (36.6) (82.7) Foreign 0.8 1.0 (1.1) 1.8 (35.6) (83.8) $ 24.0 $ 15.9 $ 19.1 Temporary differences represent the cumulative taxable or deductible amounts recorded in the financial statements in different years than recognized in the tax returns. The components of the net deferred income tax liability consist of the following at December 31: (Dollars in millions) 1993 1992 Deferred tax assets: Allowance for losses $ 11.9 $ 12.8 Other 20.0 2.6 31.9 15.4 Deferred tax liabilities: Leased assets (311.6) (291.9) Deferred installment sales (2.8) (3.4) MD Bank - (3.7) Other (16.4) (13.5) (330.8) (312.5) Net deferred tax liability $ (298.9) $ (297.1) Income taxes computed at the United States federal income tax rate and the provision for taxes on income from continuing operations before cumulative effect of accounting change differ as follows: (Dollars in millions) 1993 1992 1991 Tax computed at federal $ 14.3 $ 16.3 $ 19.4 statutory rate State income taxes, net of 1.5 1.3 1.8 federal tax benefit Effect of foreign tax rates 0.1 0.8 - U.S. tax effect on foreign 0.8 (2.1) - income Effect of investment tax (0.6) (1.1) (1.7) credits Effect of tax rate change 8.4 - - Other (0.5) 0.7 (0.4) $ 24.0 $ 15.9 $ 19.1 During the third quarter of 1993, the Company's effective tax rate was affected by an additional tax provision of $8.4 million associated with the tax rate increase included in the Omnibus Budget Reconciliation Act of 1993. MDFS is currently under examination by the Internal Revenue Service ("IRS") for the tax years 1986 through 1989. The IRS audit is not expected to have a material effect on the Company's financial condition or results of operations. Provisions have been made for estimated United States and foreign income taxes which may be incurred upon the repatriation of MD Bank's undistributed earnings. Income taxes paid by the Company totaled $54.0 million in 1993, $86.1 million in 1992 and $76.2 million in 1991. Note 7 - Indebtedness Short-term notes payable consist of the following at December 31: (Dollars in millions) 1993 1992 Short-term bank borrowings $ 149.6 $ - Lines of credit 53.0 124.0 MDFS - 9.5 $ 202.6 $ 133.5 At December 31, 1993, the Company had a revolving credit agreement under which it could borrow a maximum of $125.0 million to be reduced by $25.0 million each quarter through January 1995. The interest rate, at the option of the Company, is either a floating rate generally based on a defined prime rate, a fixed rate related to either LIBOR or a certificate of deposit rate, or a rate as quoted under a competitive bid. Borrowings of $53.0 million and $108.0 million were outstanding under this agreement at December 31, 1993 and 1992. At December 31, 1993, MDFS and the Company had a joint revolving credit agreement under which MDFS could borrow a maximum of $6.0 million and the Company could borrow a maximum of $45.0 million, reduced by any MDFS borrowings under this agreement. The interest rate, at the option of the Company, is either a floating rate generally based on a defined prime rate or fixed rate related to LIBOR. There were no outstanding borrowings under this agreement at December 31, 1993. At December 31, 1993, the Company had non-recourse short-term bank borrowings totaling $149.6 million, at LIBOR based interest rates, due and payable on November 4, 1994. MD Bank borrowings of $16.0 million were outstanding at December 31, 1992 under a committed credit agreement which subsequently expired. Senior long-term debt consists of the following at December 31: (Dollars in millions) 1993 1992 9.0% Note due through 1993 $ - $ 9.7 7.75% - 7.91% Notes due through 1993 - 3.3 5.0% Note due through 1994, net of discount based on imputed interest rate 0.5 1.1 of 7.95% 13.0% Notes due through 1995 0.6 1.1 9.15% Note due 1994 19.4 17.4 8.46% Note due 1995 8.0 8.0 10.52% Note due 1995 52.0 52.0 7.0% Notes due through 1996 2.1 3.0 7.0% Notes due through 1998, net of discount based on imputed interest rate 3.4 4.1 of 10.8% 3.9% Notes due through 1999, net of discount based on imputed interest 9.4 10.9 rates of 9.15% - 10.6% 5.75% - 6.875% Notes due through 2000, net of discount based on imputed 11.8 13.3 interest rates of 9.75% - 11.4% 6.65% - 10.18% Notes due through 2001 93.2 94.9 5.25% - 8.375% Retail medium term notes 79.1 - due through 2008 4.625% - 13.55% Medium term notes due 713.4 792.0 through 2005 Capital lease obligations due through 87.9 93.4 $ 1,080.8 $ 1,104.2 The 9.15% Note due 1994, related to a borrowing denominated in Japanese yen, and the 10.52% Note due 1995, related to a borrowing denominated in Swiss francs, have been adjusted by $20.9 million at December 31, 1993 ($19.0 million at December 31, 1992) to reflect the dollar value of each liability at the current exchange rate. To hedge against the risk of future currency exchange rate fluctuations on such debt, the Company entered into foreign currency swap agreements at the time of borrowing whereby it may purchase foreign currency sufficient to retire such debt at exchange rates in effect at the initial dates of the agreements. Changes in the market value of the swap agreements due to changes in exchange rates are included in other assets and effectively offset changes in the value of the foreign denominated obligations. As of December 31, 1993, $98.6 million of senior long-term debt was collateralized by equipment. This debt is composed of the 7.0% Notes due through 1996, 7.0% Notes due through 1998, and the 6.65% - 10.18% Notes due through 2001. The Company leases aircraft under capital leases which have been sub-leased to others. The Company has guaranteed the repayment of $9.7 million in capital lease obligations associated with a 50% partner. Subordinated long-term debt consists of the following at December 31: (Dollars in millions) 1993 1992 12.63% Note due 1993 $ - $ 5.0 8.25% - 9.26% Notes due through 1996 5.0 10.0 10.25% Notes due through 1997 20.0 25.0 12.35% Note due 1997 20.0 20.0 8.93% - 9.92% Medium term notes due through 32.8 32.7 $ 77.8 $ 92.7 Payments required on long-term debt and capital lease obligations during the years ending December 31 are as follows: Long-Term Capital (Dollars in millions) Debt Leases 1994 $ 185.7 $ 15.1 1995 202.2 15.1 1996 98.5 15.1 1997 106.4 15.1 1998 135.8 15.1 1999 and thereafter 347.4 62.1 1,076.0 137.6 Deferred debt expenses (5.4) (0.9) Imputed interest - (48.8) $ 1,070.6 $ 87.9 The provisions of various credit and debt agreements require the Company to maintain a minimum net worth, restrict indebtedness, and limit cash dividends and other distributions. Under the most restrictive provision, $49.4 million of the Company's income retained for growth was available for dividends at December 31, 1993. Interest payments totaled $116.3 million in 1993, $154.0 million in 1992 and $205.2 million in 1991. Note 8 - Commitments and Contingencies At December 31, 1993 and 1992, the Company had unused credit lines available to customers totaling $6.6 million and $14.3 million; and commitments to provide leasing and other financing totaling $43.6 million and $23.1 million. In 1990, the Company was named as a defendant in three class action suits (the "Actions") for alleged violations of securities laws in connection with the public offering of limited partnership interests in certain equipment leasing limited partnerships, the sponsor of which was MDCC. In 1993, the Company settled the Actions for approximately $14.8 million. As part of the settlement, MDCC purchased the equipment portfolios of the limited partnerships for 121% of the $1.0 million net book value, which approximated fair value. The Company adequately reserved for the settlement of the Actions. At December 31, 1993, in conjunction with prior asset dispositions, at December 31, 1993, the Company is subject to a maximum recourse of $42.0 million. Based on trends to date, the Company's exposure to such loss is not expected to be significant. Note 9 - Transactions with MDC and MDFS Accounts with MDC and MDFS consist of the following at December 31: (Dollars in millions) 1993 1992 Notes receivable $ 47.9 $ 49.0 Federal income tax payable 25.8 (15.4) State income tax receivable - 8.3 Other payables (3.3) (1.0) $ 70.4 $ 40.9 The Company has arrangements with MDC, terminable at the discretion of either of the parties, pursuant to which the Company may borrow from MDC and MDC may borrow from the Company, funds for 30-day periods at a market rate of interest or at MDFS's average borrowing rate. Under these arrangements, there were no outstanding balances at December 31, 1993 and at December 31, 1992, $49.0 million was receivable from MDC. Under a similar arrangement, the Company may borrow from MDFS and MDFS may borrow from the Company, funds for 30-day periods at the Company's cost of funds for short-term borrowings. Under these arrangements, receivables of $18.3 million and borrowings of $9.5 million were outstanding at December 31, 1993 and 1992. On September 28, 1993, the Company sold, at estimated fair value, real estate owned properties to McDonnell Douglas Realty Company, a wholly-owned subsidiary of MDC, and financed the sale by taking a $28.9 million note. The Company recorded a pretax loss of $5.7 million on the transfer, which is included in other expenses in the consolidated statement of income. The note is payable on demand and accrues interest at a rate equal to the average borrowing cost of MDFS. At December 31, 1993, $29.6 million was outstanding under this note. During 1993, 1992 and 1991, the Company purchased aircraft and aircraft related notes from MDC in the amount of $400.2 million, $160.5 million and $119.1 million, respectively. At December 31, 1993 and 1992, $270.0 million and $152.2 million of the commercial aircraft financing portfolio was guaranteed by MDC. During 1993, 1992 and 1991, the Company collected $0.2 million, $0.6 million and $0.8 million, respectively, under these guaranties. On September 29, 1992, the Company purchased a bridge note issued by Irish Aerospace Leasing Limited, a wholly-owned subsidiary of Irish Aerospace Limited, which previously was 25% owned by MDC, for $22.0 million with an effective interest rate of 9.4%. This note was repaid in 1993. On December 31, 1991, MDC sold an MD-11 flight simulator to the Company for $30.0 million and simultaneously leased it back under an operating lease agreement. On March 5, 1992, the Company sold the MD-11 flight simulator to a third party for approximately book value. During 1992, the $9.9 million long-term debt issued by MDFS to MD Bank in 1990 was prepaid. This note was payable in ten equal semi-annual instalments beginning on May 20, 1996, at LIBOR based interest rates. The Series A Preferred Stock is redeemable at the Company's option at $5,000 per share, has no voting privileges and is entitled to cumulative semi-annual dividends of $175 per share. Such dividends have priority over cash dividends on the Company's common stock. Accrued dividends on preferred stock amounted to $0.6 and $0.5 million at December 31, 1993 and 1992. Substantially all employees of MDC and its subsidiaries are members of defined benefit pension plans and insurance plans. MDC also provides eligible employees the opportunity to participate in savings plans that permit both pretax and after-tax contributions. MDC generally charges the Company with the actual cost of these plans which are included with other MDC charges for support services and reflected in operating expenses. MDC charges for services provided during 1993, 1992 and 1991 totaled $1.1 million, $2.1 million and $2.9 million, respectively. Additionally, the Company was compensated by certain affiliates for a number of support services, which are net against operating expenses, amounting to $1.8 million, $2.5 million and $2.7 million in 1993, 1992 and 1991, respectively. Prior to 1992, Company-paid retiree health care benefits were included in costs as covered expenses were actually incurred. In December 1990, the Financial Accounting Standards Board issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Statement required companies to change, by 1993, their method of accounting for the costs of these benefits to one that accelerates the recognition of costs by causing their full accrual over the employees' years of service up to their date of full eligibility. MDC, and therefore the Company, elected to implement this Statement for 1992 by immediately recognizing the January 1, 1992 accumulated postretirement benefit obligation of $3.1 million ($1.9 million after-tax). On October 8, 1992, effective January 1, 1993, MDC terminated Company-paid retiree health care for both current and future non-union retirees and their survivors and replaced it with a new arrangement that will be funded entirely by participant contributions. The Company recorded a pretax curtailment gain of $2.8 million ($1.7 million after-tax) in the fourth quarter of 1992, reflecting the termination of Company-paid retiree health care for both current and future non-union retirees. In December 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The Statement will be effective in 1994 and will require using an accrual approach for accounting for benefits other than retiree health care to former or inactive employees. The impact of the Company's adoption of this Statement is not expected to be material. Note 10 - Fair Value of Financial Instruments The estimated fair value amounts of the Company's financial instruments have been determined by the Company, using appropriate market information and valuation methodologies. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents Because of the short maturity of these instruments, the carrying amount approximates fair value. Notes Receivable For variable rate notes that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values of fixed rate notes are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Short and Long-Term Debt The carrying amount of the Company's short-term borrowings approximates its fair value. The fair value of the Company's long- term debt is estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. Off-Balance Sheet Instruments Fair values for the Company's off-balance sheet instruments (swaps and financing commitments) are based on quoted market prices of comparable instruments (currency and interest rate swaps); and the counterparties' credit standing, taking into account the remaining terms of the agreements (financing commitments). The estimated fair values of the Company's financial instruments consist of the following at December 31: (Dollars in millions) 1993 1992 Carrying Fair Carrying Fair Asset (Liability) Amount Value Amount Value ASSETS Cash and cash equivalents $ 65.5 $ 65.5 $ 11.6 $ 11.6 Notes receivable 301.8 301.8 459.7 458.2 LIABILITIES Short-term notes payable (203.3) (203.3) (124.2) (124.2) to banks Long-term debt: Senior, excluding capital (1,014.0) (1,090.3) (1,034.8) (1,055.2) lease obligations Subordinated (80.7) (89.1) (96.1) (99.2) OFF BALANCE SHEET INSTRUMENTS Commitments to extend (50.2) (50.2) (16.8) (16.8) credit Foreign currency swaps 20.9 18.5 19.0 13.3 Interest rate swaps (0.2) (0.7) (0.1) (1.4) Note 11 - Segment Information The Company provides a diversified range of financing and leasing arrangements to customers and industries throughout the United States, the United Kingdom and, to a lesser extent, other countries. The Company's operations include three financial reporting segments: commercial aircraft financing, commercial equipment leasing and non-core businesses. The commercial aircraft financing segment provides customer financing services to MDC components, primarily Douglas Aircraft Company, and also provides financing for the acquisition of non-MDC aircraft. The commercial equipment leasing segment is principally involved in large financing and leasing transactions for a diversified range of equipment. Non- core businesses represent market segments in which the Company is no longer active. The non-core businesses consist primarily of the remaining assets of three business units: MD Bank, receivable inventory financing and real estate financing. MD Bank provided financing in the United Kingdom similar to that provided in the United States by the commercial equipment leasing segment. Receivable inventory financing provides financing to dealers of rent-to-own products. Real estate financing previously specialized in fixed rate, medium term commercial real estate loans. The Company's financing and leasing portfolio consists of the following at December 31: (Dollars in millions) 1993 1992 Commercial aircraft financing: MDC aircraft financing $ 1,035.1 56.5% $ 769.3 43.1% Other commercial aircraft 202.4 11.0 231.8 13.0 financing 1,237.5 67.5 1,001.1 56.1 Commercial equipment leasing: Transportation services 69.3 3.8 96.9 5.4 Transportation equipment 42.7 2.3 39.0 2.2 Trucking and warehousing 38.7 2.1 66.6 3.7 Other 271.6 14.8 354.9 19.9 422.3 23.0 557.4 31.2 Non-core businesses: Real estate 123.6 6.7 146.7 8.2 Furniture and home furnishings stores 31.0 1.7 43.2 2.4 Air transportation 5.1 0.3 5.5 0.3 Other 14.0 0.8 32.5 1.8 173.7 9.5 227.9 12.7 Total portfolio $1,833.5 100.0% $1,786.4 100.0% The single largest commercial aircraft financing customer accounted for $253.2 million (13.8% of total Company portfolio) and $120.9 million (6.8% of total Company portfolio) at December 31, 1993 and 1992. The five largest commercial aircraft financing customers accounted for $718.5 million (39.2% of total Company portfolio) and $445.1 million (24.9% of total Company portfolio) at December 31, 1993 and 1992. There were no significant concentrations by customer within the commercial equipment leasing and non-core businesses portfolios. The Company generally holds title to all leased equipment and generally has a perfected security interest in the assets financed through note and loan arrangements. Information about the Company's operations in its different financial reporting segments for the past three years is as follows: (Dollars in millions) 1993 1992 1991 Operating income: Commercial aircraft financing $ 107.4 $ 107.7 $ 125.6 Commercial equipment leasing 64.0 79.1 117.5 Non-core businesses 24.4 56.1 94.3 Corporate 2.7 11.8 4.9 $ 198.5 $ 254.7 $ 342.3 Income (loss) from continuing operations before income taxes and cumulative effect of accounting change: Commercial aircraft financing $ 26.3 $ 28.3 $ 50.7 Commercial equipment leasing 30.8 31.1 42.0 Non-core businesses (10.7) (11.4) (25.6) Corporate (5.6) - (9.9) $ 40.8 $ 48.0 $ 57.2 Identifiable assets at December 31: Commercial aircraft $ 1,369.0 $ 1,085.2 $ 1,106.7 financing Commercial equipment leasing 420.2 590.5 747.2 Non-core businesses 247.6 301.2 694.3 Corporate 26.4 22.1 34.1 $ 2,063.2 $ 1,999.0 $ 2,582.3 Depreciation expense - equipment under operating leases: Commercial aircraft financing $ 10.1 $ 5.9 $ 2.6 Commercial equipment leasing 28.2 31.8 39.4 Non-core businesses 0.7 11.1 18.0 $ 39.0 $ 48.8 $ 60.0 Equipment acquired for operating leases, at cost: Commercial aircraft financing $ 34.5 $ 53.5 $ 36.3 Commercial equipment leasing 22.9 18.2 30.3 Non-core businesses - 0.1 0.1 $ 57.4 $ 71.8 $ 66.7 The Company's operations are classified into two geographic segments, the United States and the United Kingdom. United Kingdom operations consist of MD Bank. Information about the Company's operations in its different geographic segments for the past three years is as follows: (Dollars in millions) 1993 1992 1991 Operating income: United States $ 194.1 $227.7 $305.7 United Kingdom 4.4 27.0 36.6 $ 198.5 $254.7 $342.3 Income (loss) from continuing operations before income taxes and cumulative effect of accounting change: United States $ 41.2 $ 41.0 $ 60.5 United Kingdom (0.4) 7.0 (3.3) $ 40.8 $ 48.0 $ 57.2 Identifiable assets at December 31: United States $ 2,033.7 $ 1,950.0 $ 2,347.8 United Kingdom 29.5 49.0 234.5 $ 2,063.2 $ 1,999.0 $ 2,582.3 Operating income from financing of assets located outside the United States by the Company's United States geographic segment totaled $20.9 million, $21.6 million and $18.1 million in 1993, 1992 and 1991, respectively. McDonnell Douglas Finance Corporation and Subsidiaries Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties Balance at (Dollars in End of millions) Deductions Year ------------------- ----------------- Balance at Amounts Beginning of Amounts Written Non Year Additions Collected Off Current Current 1993: Irish $ 22.3 $ - $ 22.3 $ - $ - $ - 1992: Irish $ 6.3 $ 22.3 $ 6.3 $ - $ 22.3 $ - 1991: Irish $ - $ 6.3 $ - $ - $ 6.3 $ - McDonnell Douglas Finance Corporation and Subsidiaries Schedule VIII - Valuation and Qualifying Accounts (Dollars in millions) Balance Charged Allowance for at to Balance Losses on Beginning Costs at end Financing of and Other Deductions of Receivables Year Expenses Year 1993 $ 37.4 $ 8.6 $ - $ (10.4) $ 35.6 1992 $ 46.7 $ 19.1 $ (1.0) $ (27.4) $ 37.4 1991 $ 61.6 $ 47.2 $ (5.4) $ (56.7) $ 46.7 The 1991 amount includes allowances that were reclassified in conjunction with the sale of substantially all of the assets of MDAL and BCG. Write-offs net of recoveries. McDonnell Douglas Finance Corporation and Subsidiaries Schedule IX - Short-Term Borrowings (Dollars in millions) Weighted Average Weighted Average Maximum Interest Amount Amount Average Balance Rate Outstanding Outstanding Interest Category of at End of at End During the During the Rate Aggregate Period of Period Period Period During the Short-term Period Borrowings Year ended December 31, 1993: MDC $ - - % $ 190.4 $ 23.0 4.33% MDFS - - 27.5 6.0 4.96 Banks - U.S. 202.6 4.35 203.0 72.8 4.66 Banks - U.K. - - 15.9 11.3 13.13 Year ended December 31, 1992: MDFS $9.5 5.94% $ 16.1 $ 6.4 5.35% Banks - U.S. 108.0 6.00 108.0 24.5 3.94 Banks - U.K. 16.0 12.44 124.1 87.3 14.68 Year ended December 31, 1991: Commercial $ - -% $ 44.0 $ 2.1 9.20% paper MDC - - 4.6 0.5 8.85 MDFS 4.4 5.83 22.9 1.0 8.02 Banks - U.S. - - 300.0 140.2 7.10 Banks - U.K. 158.0 12.25 289.3 197.2 12.34 Commercial paper was issued from time to time at various maturities and short-term notes payable to MDC are issued for 30 days. Computed by dividing the total of daily principal balances by the number of days in the year. Computed by dividing the actual interest expense by average short-term debt outstanding. The effective interest rate on short-term borrowings including the effect of fees was 5.97% in 1993, 12.38% in 1992 and 10.28% in 1991. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Part IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page Number in Form 10-K (a) 1. Financial Statements Report of Independent Auditors 33 Consolidated Balance Sheet at December 31, 1993 and 1992 34 Consolidated Statement of Income and Income Retained for Growth for the Years Ended December 31, 1993, 1992 and 1991 36 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 38 Notes to Consolidated Financial Statements 40-55 2. Financial Statement Schedules Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties 56 Schedule VIII - Valuation and Qualifying Accounts 58 Schedule IX - Short-Term Borrowings 60 Schedules for which provision is made in the applicable regulation of the Securities and Exchange Commission (the "SEC"), except Schedules II, VIII and IX which are included herein, have been omitted because they are not required, or the information is set forth in the financial statements or notes thereto. 3. Exhibits 3.1 Restated Certificate of Incorporation of the Company dated June 29, 1989. 3.2 By-Laws of the Company, as amended to date. 4.4 Form of Indenture, dated as of April 1, 1983, between the Company and Bankers Trust Company, incorporated herein by reference to Exhibit 4(a) to Amendment No. 1 to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.5 Form of Subordinated Indenture, dated as of June 15, 1988, by and between the Company and Bankers Trust Company of California, N.A., as Subordinated Indenture Trustee, incorporated by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.6 Form of Indenture, dated as of April 15, 1987, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company as filed with the SEC on April 24, 1987. 4.7 Form of Series I Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.8 Form of Series II Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form 8-K of the Company dated August 22, 1983. 4.9 Form of Series III Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.10 Form of Series IV Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.11 Form of Series V Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company , as filed with the SEC on April 24, 1987. 4.12 Form of Series VI Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.13 Form of Series VII Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.14 Form of Series VIII Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.15 Form of Series VIII Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.16 Form of Series IX Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.17 Form of Series IX Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.18 Form of General Term Note(R), incorporated herein by reference to Exhibit 4(c) to Form 8-K of the Company dated May 26, 1993. Pursuant to Item 601 (b)(4)(iii) of Regulation S-K, the Company is not filing certain instruments with respect to its long-term debt since the total amount of securities currently provided for under each of such instruments does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. The Company hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10.1 Amended and Restated Operating Agreement among MDC, the Company and MDFS dated as of April 12, 1993. 10.2 Operating Agreement by and between the Company and MDFS effective as of February 8, 1989, incorporated herein by reference to Exhibit 10.3 to the Company's Form 10-K for the year ended December 31, 1989. 10.3 By-Laws of MDC as amended January 29, 1993, incorporated by reference from MDC's Exhibit 3.2 to its Form 8-K Report filed February 1, 1993 (file No. 1-3685). 10.4 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 10.5 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 12.1 Statement regarding computation of ratio of earnings to fixed charges. 23.1 Consent of Ernst & Young. (b) Reports on Form 8-K On February 3, 1994, the Company filed a current report on Form 8-K, which included the Company's Consolidated Balance Sheet at December 31, 1993 and 1992 and Consolidated Statement of Income and Income Retained for Growth for each of the years ended December 31, 1993, 1992 and 1991. 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. McDonnell Douglas Finance Corporation By /s/ Douglas E. Scudamore March 30, 1994 Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Herbert J. Lanese Chairman March 30, 1994 /s/ George M. Rosen President and Director March 30, 1994 (Principal Executive Officer) /s/ Robert W. Owsley Sr. Vice President March 30, 1994 (Principal & Treasurer Financial Officer) /s/ Douglas E. Scudamore Vice President March 30, 1994 (Principal & Controller Accounting Officer) F. Mark Kuhlmann Director /s/ Thomas J. Lawlor, Jr. Director March 30, 1994 John F. McDonnell Director Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page Number in Form 10-K (a) 1. Financial Statements Report of Independent Auditors 33 Consolidated Balance Sheet at December 31, 1993 and 1992 34 Consolidated Statement of Income and Income Retained for Growth for the Years Ended December 31, 1993, 1992 and 1991 36 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 38 Notes to Consolidated Financial Statements 40-55 2. Financial Statement Schedules Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties 56 Schedule VIII - Valuation and Qualifying Accounts 58 Schedule IX - Short-Term Borrowings 60 Schedules for which provision is made in the applicable regulation of the Securities and Exchange Commission (the "SEC"), except Schedules II, VIII and IX which are included herein, have been omitted because they are not required, or the information is set forth in the financial statements or notes thereto. 3. Exhibits 3.1 Restated Certificate of Incorporation of the Company dated June 29, 1989. 3.2 By-Laws of the Company, as amended to date. 4.4 Form of Indenture, dated as of April 1, 1983, between the Company and Bankers Trust Company, incorporated herein by reference to Exhibit 4(a) to Amendment No. 1 to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.5 Form of Subordinated Indenture, dated as of June 15, 1988, by and between the Company and Bankers Trust Company of California, N.A., as Subordinated Indenture Trustee, incorporated by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.6 Form of Indenture, dated as of April 15, 1987, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company as filed with the SEC on April 24, 1987. 4.7 Form of Series I Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective April 22, 1983. 4.8 Form of Series II Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form 8-K of the Company dated August 22, 1983. 4.9 Form of Series III Medium Term Note, incorporated herein by reference to Exhibit 4(b) to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.10 Form of Series IV Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company effective June 17, 1985. 4.11 Form of Series V Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company , as filed with the SEC on April 24, 1987. 4.12 Form of Series VI Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.13 Form of Series VII Medium Term Note, incorporated herein by reference to Exhibit 4 to the Form S-3 Registration Statement of the Company, as filed with the SEC on April 24, 1987. 4.14 Form of Series VIII Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.15 Form of Series VIII Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on June 24, 1988. 4.16 Form of Series IX Senior Medium Term Note, incorporated herein by reference to Exhibit 4(c) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.17 Form of Series IX Subordinated Medium Term Note, incorporated herein by reference to Exhibit 4(d) to the Form S-3 Registration Statement of the Company, as filed with the SEC on October 4, 1989. 4.18 Form of General Term Note(R), incorporated herein by reference to Exhibit 4(c) to Form 8-K of the Company dated May 26, 1993. Pursuant to Item 601 (b)(4)(iii) of Regulation S-K, the Company is not filing certain instruments with respect to its long-term debt since the total amount of securities currently provided for under each of such instruments does not exceed 10 percent of the total assets of the Company and its subsidiaries on a consolidated basis. The Company hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10.1 Amended and Restated Operating Agreement among MDC, the Company and MDFS dated as of April 12, 1993. 10.2 Operating Agreement by and between the Company and MDFS effective as of February 8, 1989, incorporated herein by reference to Exhibit 10.3 to the Company's Form 10-K for the year ended December 31, 1989. 10.3 By-Laws of MDC as amended January 29, 1993, incorporated by reference from MDC's Exhibit 3.2 to its Form 8-K Report filed February 1, 1993 (file No. 1-3685). 10.4 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 10.5 Supplemental Guaranty Agreement by and between the Company and MDC, dated as of December 30, 1993. 12.1 Statement regarding computation of ratio of earnings to fixed charges. 23.1 Consent of Ernst & Young. (b) Reports on Form 8-K On February 3, 1994, the Company filed a current report on Form 8-K, which included the Company's Consolidated Balance Sheet at December 31, 1993 and 1992 and Consolidated Statement of Income and Income Retained for Growth for each of the years ended December 31, 1993, 1992 and 1991. 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. McDonnell Douglas Finance Corporation By /s/ Douglas E. Scudamore March 30, 1994 Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Herbert J. Lanese Chairman March 30, 1994 /s/ George M. Rosen President and Director March 30, 1994 (Principal Executive Officer) /s/ Robert W. Owsley Sr. Vice President March 30, 1994 (Principal & Treasurer Financial Officer) /s/ Douglas E. Scudamore Vice President March 30, 1994 (Principal & Controller Accounting Officer) F. Mark Kuhlmann Director /s/ Thomas J. Lawlor, Jr. Director March 30, 1994 John F. McDonnell Director

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1993

276478

Item 1. Business General American Transportation Corporation (GATC) is a wholly-owned subsidiary of GATX Corporation (GATX) and is engaged in the leasing and management of railroad tank cars and specialized freight cars and owns and operates tank storage terminals, pipelines and related facilities. Industry Segments Railcar Leasing and Management The Railcar Leasing and Management segment (Transportation) is principally engaged in leasing specialized railcars, primarily tank cars, under full service leases. As of December 31, 1993, its fleet consisted of approximately 55,800 railcars, including 48,000 tank cars and 7,800 specialized freight cars, primarily Airslide covered hopper cars and plastic pellet cars. Transportation has upgraded its fleet over time by adding new larger capacity cars and retiring older, smaller capacity cars. Transportation's railcars have a useful life of approximately 30 to 33 years. The average age of the railcars in Transportation's fleet is approximately 15 years. Transportation's customers use its railcars to ship over 700 different commodities, primarily chemicals, petroleum, food products and minerals. For 1993, approximately 55% of railcar leasing revenue was attributable to shipments of chemical products, 21% to petroleum products, 18% to food products and 6% to other products. Many of these products require cars with special features; Transportation offers a wide variety of sizes and types of cars to meet these needs. Transportation leases railcars to over 700 customers, including major chemical, oil, food and agricultural companies. No single customer accounts for more than 6% of total railcar leasing revenue. Transportation typically leases new equipment to its customers for a term of five years or longer, whereas renewals or leases of used cars are typically for periods ranging from less than a year to seven years with an average lease term of about three years. The utilization rate of Transportation's railcars as of December 31, 1993 was approximately 93%. Under its full service leases, Transportation maintains and services its railcars, pays ad valorem taxes, and provides many ancillary services. Through its Car Status Service System, for example, the company provides customers with timely information about the location and readiness of their leased cars to enhance and maximize the utilization of this equipment. Transportation also maintains a network of service centers consisting of four major service centers and 23 mobile trucks in 16 locations. Transportation also utilizes independent third-party repair shops. Transportation purchases most of its new railcars from Trinity Industries, Inc. (Trinity), a Dallas-based metal products manufacturer, under a contract entered into in 1984 and extended from time to time thereafter, most recently in 1992. Transportation anticipates that through this contract it will continue to be able to satisfy its customers' new car lease requirements. Transportation's engineering staff provides Trinity with design criteria and equipment specifications, and works with Trinity's engineers to develop new technology where needed in order to upgrade or improve car performance or in response to regulatory requirements. The full-service railcar leasing industry is comprised of Transportation, Union Tank Car Company, General Electric Railcar Service Corporation, Shippers Car Line division of ACF Industries, Incorporated, and many smaller companies. Of the approximately 192,000 tank cars owned and leased in the United States at December 31, 1993, Transportation had approximately 48,000. Principal competitive factors include price, service and availability. Terminals and Pipelines GATX Terminals Corporation (Terminals) is engaged in the storage, handling and intermodal transfer of petroleum and chemical commodities at key points in the bulk liquid distribution chain. All of its terminals are located near major distribution and transportation points and most are capable of receiving and shipping bulk liquids by ship, rail, barge and truck. Many of the terminals are also linked with major interstate pipelines. In addition to storing, handling and transferring bulk liquids, Terminals provides blending and testing services at most of its facilities. Terminals also owns or holds interests in four refined product pipeline systems. As of December 31, 1993, Terminals owned and operated 27 terminals in 14 states, nine of which are associated with Terminals' pipeline interests, and eight facilities in the United Kingdom; Terminals also had joint venture interests in 12 international facilities. As of December 31, 1993, Terminals had a total storage capacity of 71 million barrels. This includes 53 million barrels of bulk liquid storage capacity in the United States, 6 million barrels in the United Kingdom, and an equity interest in another 12 million barrels of storage capacity in Europe and the Far East. Terminals' smallest bulk liquid facility has a storage capacity of 100,000 barrels while its largest facility, located in Pasadena, Texas, has a capacity of over 12 million barrels. During 1993, Terminals handled approximately 635 million barrels of product through its wholly-owned bulk liquid storage facilities, with capacity utilization of 92% at the end of 1993. For 1993, 77% of Terminals' revenue was derived from petroleum products and 20% from a variety of chemical products. Demand for Terminals' facilities is dependent in part upon demand for petroleum and chemical products and is also affected by refinery output, foreign imports, and the expansion of its customers into new geographical markets. Terminals serves nearly 200 customers, including major oil and chemical companies as well as trading firms and larger independent refiners. No single customer accounts for more than 7% of Terminals' revenue. Customer service contracts are both short term and long term. Terminals along with two Dutch companies, Paktank N.V. and Van Ommeren N.V., are the three major international public terminalling companies. The domestic public terminalling industry consists of Terminals, Paktank Corporation, International-Matex Tank Terminals, and many smaller independent terminalling companies. In addition to public terminalling companies, oil and chemical companies, which generally do not make their storage facilities available to others, also have significant storage capacity in their own private facilities. Terminals' pipelines compete with rail, trucks and other pipelines for movement of liquid petroleum products. Principal competitive factors include price, location relative to distribution facilities, and service. Trademarks, Patents and Research Activities Patents, trademarks, licenses, and research and development activities are not material to these businesses taken as a whole. Customer Base GATC and its subsidiaries are not dependent upon a single customer or a few customers. The loss of any one customer would not have a material adverse effect on any segment or GATC as a whole. Employees GATC and its subsidiaries have approximately 1,800 active employees, of whom 35% are hourly employees covered by union contracts. Item 2. Item 2. Properties Information regarding the location and general character of certain properties of GATC is included in Item 1, Business, of this document. The major portion of Terminals' land is owned; the balance is leased. Item 3. Item 3. Legal Proceedings A railcar owned by Transportation was involved in a derailment near Dunsmuir, California in July 1991 that resulted in a spill of metam sodium into the Sacramento River. Various lawsuits seeking damages in unspecified amounts have been filed against GATC, or an affiliated company, most of which have been consolidated in the Superior Court of the State of California for the City and County of San Francisco (Nos. 2617 and 2620). GATC has now been dismissed by the class plaintiffs in those cases but remains in the cases with respect to the plaintiffs who have opted out of the class and with respect to indemnity and contribution claims. There is one other case seeking recovery for response costs and natural resource damages: State of California, et al, vs. Southern Pacific, et al, filed in the Eastern District of California (CIV-S-92 1117). All other actions have been consolidated with these two cases. GATC also has been named as a potentially responsible party by the State of California with respect to the assessment and remediation of possible damages to natural resources which claim has also been consolidated in the suit in the Eastern District of California. GATC has entered into provisional settlement agreements with the United States of America, the state of California, Southern Pacific and certain other defendents settling all material claims arising out of the above incident in an amount not material to GATC. Such settlement, however, is conditional on further court action. It is the opinion of management that if damages are assessed and taking into consideration the probable insurance recovery, this matter will not have a material effect on GATC's consolidated financial position or results of operations. Various lawsuits have been filed in the Superior Court for the State of California and served upon Terminals, Calnev Pipe Line Company, or another GATX subsidiary seeking an unspecified amount of damages arising out of the May 1989 explosion in San Bernardino, California. Those suits, all of which were filed in the County of San Bernardino unless otherwise indicated, are: Aguilar, et al, v. Calnev Pipe Line Company, et al, filed February 1990 in the County of Los Angeles (No. 0751026); Alba, et al, v. Southern Pacific Railroad Co., et al, filed November 1989 (No. 252842); Terry, et al, v. Southern Pacific Transportation Corporation, et al, filed December 1989 (No. 253603) and settled February 1994; Terry, et al, v. Southern Pacific, et al, filed December 1989 (No. 253604); Charles, et al, v. Calnev Pipe Line, Inc., et al, filed May 1990 (No. 256269); Raman, et al, v. Southern Pacific Railroad Company, et al, filed May 1990 (No. 256181) and settled October 1993; Abrego, et al, v. Southern Pacific Transportation Corporation, et al, filed May 1990 in the County of Los Angeles (No. BC 000947); Glaspie, et al, v. Southern Pacific Transportation, et al, filed May 1990 in the County of Los Angeles (No. BC002047); Jackson, et al, v. City of San Bernardino, et al, filed May 1990 (No. 256172) and settled February 1993; Burney, et al, v. Southern Pacific, et al, filed May 1990 in the County of Los Angeles (BC000876); Hawkins, et al, v. Southern Pacific, et al, filed May 1990 in the County of Los Angeles (BC000825) and since dismissed as to all GATX subsidiaries; Ledbetter, et al, v. City of San Bernardino, et al, filed May 1990 (No. 256173); Mary Washington v. Southern Pacific, et al, filed May 1990 (No. 256346); Stewart, et al, v. Southern Pacific Railroad Co., et al, filed May 1990 (No. 256464); Yost, et al, v. Southern Pacific Railroad, et al, filed June 1989 (No. 250308) and dismissed January 1993; Riley, et al, v. Lake Minerals Corp., et al, filed May 1990 (No. 256163) and settled September 1993; Pearson v. Calnev Pipe Line Company, et al, filed May 1990 in the County of San Bernardino (No. 256206); Pollack v. Southern Pacific Transportation, et al, filed May 1992 (No. 271247); Davis v. Calnev Pipe Line Company, et al, filed May 1990 (No. 256207); J. Roberts, et al, v. Southern Pacific Transportation, et al, filed November 1992 (No. 275936); Brooks, et al, v. Southern Pacific, et al, filed May 1990 (No. 256176) and settled February 1994; Goldie, et al, v. Southern Pacific, et al, filed May 1990 and dismissed July 1993, appeal pending; Irby, et al, v. Southern Pacific, et al, (No. 255715) filed April 1990; Esparza, et al, v. Southern Pacific, et al, (No. 256433) filed May 1990 and settled February 1994; Reese, et al, v. Southern Pacific, et al (No. 256434) filed May 1990; Nancy Washington, et al, v. Southern Pacific, et al, (No. 256435) filed May 1990. In addition, GATC is aware of approximately 10 other cases (the majority involving multiple plaintiffs) seeking damages arising out of this incident which have named but not served a subsidiary of GATC or a subsidiary officer. Based upon information known to management, it remains management's opinion that if damages are assessed and taking into consideration probable insurance recovery, the ultimate resolution of the lawsuits arising out of the May 1989 explosion will not have a material effect on GATC's consolidated financial position or results of operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not required. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Shareholder Matters GATX Corporation owns all of the outstanding common stock of GATC. Item 6. Item 6. Selected Financial Data Not required. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations GATC's reported net income for 1993 of $74 million compared to $66 million in 1992. The comparison between years is impacted by the Federal tax rate increase in 1993 and the adoption of two accounting pronouncements in 1992. Overall, operating income improved in 1993 compared to 1992 due to better results at both Transportation and Terminals. Transportation's earnings increased as higher revenues and lower ownership costs were somewhat offset by increased fleet repair expenses. Income at Terminals increased as a result of higher revenues, reduced interest expense, and improved margins which were partially offset by higher SG&A expense and decreased earnings at its foreign affiliates. Transportation's 1992 earnings compared to 1991 were unfavorably affected by a weak economy and regulatory pressure on the industry which increased repair costs. Terminals' results in 1992 improved over 1991 as margins increased due to domestic facility improvements and cost controls, combined with increased earnings from foreign affiliates. As a result of new tax legislation which increased the federal income tax rate from 34% to 35% retroactively to January 1, 1993, net income for 1993 included an increase to income taxes of $7 million for the cumulative increase in deferred income taxes and a $1 million increase for the current year. The impact of the tax rate change by segment is shown in a table on page 35. In 1992, GATC adopted Statement of Financial Accounting Standards (SFAS) No. 106 and SFAS No. 109. SFAS No. 106 changed the method of accounting for postretirement benefits from the pay-as-you-go method to the accrual basis. This resulted in a one-time charge to earnings of $45 million for the transition obligation. SFAS No. 109 revised the method of accounting for deferred income taxes to the liability method which resulted in a $38 million favorable adjustment. These adjustments are shown by segment in a table on page 35. GROSS INCOME Consolidated gross income for 1993 of $602 million exceeded 1992 revenue of $579 million and 1991 revenue of $559 million. Transportation's 1993 gross income of $302 million increased $13 million from 1992. Rental revenues increased 4% attributable to an average of 940 additional cars on lease and higher average rental rates. The increased level of additions to the fleet was in anticipation of increased demand for new tank cars. Transportation had approximately 51,900 railcars on lease at December 31, 1993 compared to 50,100 a year earlier and fleet utilization improved to 93% from 92% at the end of 1992. Terminals' 1993 gross income of $281 million increased $15 million from 1992 reflecting continuing strong demand for tanks and blending services at domestic petroleum terminals. Capacity utilization at the wholly-owned facilities was 92% at year end, up from 91% a year ago. Throughput from these facilities of 635 million barrels was down 4 million barrels from 1992 reflecting changes in the operating pattern of certain customers. Transportation's 1992 gross income of $289 million increased $4 million over 1991. Higher average rental rates were offset by a slightly lower average number of railcars on lease during the year. Average cars on lease of 49,800 were down 200 cars from 1991. Fleet utilization at December 31, 1992 was 92% on a fleet size of 54,400 railcars compared to 93% on a fleet size of 53,600 at the end of 1991. Terminals' 1992 gross income of $266 million increased $17 million from 1991. This increase was the result of the completion of a number of capital projects and strong results at many domestic operations. Capacity utilization at Terminals' wholly-owned facilities increased 3% from 1991 to 91% at the end of 1992. Throughput of 639 million barrels was down slightly from 650 million barrels in 1991. COSTS AND EXPENSES Operating expenses in 1993 increased $16 million over 1992. Transportation's operating expenses of $119 million increased $15 million from 1992 due to increased railcar repair costs and higher operating lease expenses which increased due to the increased level of operating lease assets. Transportation continues to utilize sale leasebacks to finance its railcar additions. The leaseback is recorded as an operating lease which removes the asset and related liability from the balance sheet; the payments under the operating leases are recorded as operating lease expense. Fleet repair costs increased 9% over 1992 reflecting higher volumes as a result of regulatory and customer requirements. Operating margins decreased slightly as the increase in fleet repair costs exceeded the growth in revenues. The pressure on operating margins is expected to continue as Transportation's own commitment to provide its customers with well maintained railcars coupled with stricter maintenance standards in the industry and increased work required as a result of mandated inspection programs continue to increase repair costs. The project to upgrade the company's repair facilities is intended to control costs by improving the efficiency and productivity of the repair process for the company's railcars. Terminals operating costs of $153 million increased $1 million over 1992. Even though revenues increased, operating costs were flat with 1992 due to cost controls, resulting in improved operating margins. However, ongoing maintenance spending is expected to continue to grow in keeping with GATC's commitment to operate environmentally responsible facilities. Operating expenses in 1992 increased $25 million over 1991. Transportation's operating expenses of $104 million increased $13 million from 1991 due to increased fleet repair costs and additional operating lease rentals. Terminals' operating costs of $152 million increased $12 million over 1991 largely due to higher maintenance, remediation and claims expenses. Interest expense of $79 million in 1993 decreased $17 million from 1992 due to lower interest rates, the full-year effect of the 1992 refinancings at lower rates, and the effect of interest rate swaps. A portion of the decrease in interest expense is offset by the increase in the operating lease rent component of operating expenses as a result of the sale leasebacks. During 1993, GATC implemented the findings of an asset liability management study at Transportation which affirmed the correlation between certain railcar lease rates and interest rates. As a result, interest rate swaps were entered into to better match the maturity of the debt portfolio to the terms of the railcar leases. This program will be managed on an ongoing basis. Interest expense of $96 million in 1992 decreased $5 million from 1991 due to lower interest rates and a reduced debt balance as a result of the sale/leasebacks. At 1992 year end, total debt was $34 million less than the 1991 year-end balance. During the year $151 million of debt was refinanced at lower rates. The provision for depreciation and amortization increased $4 million from 1992 which in turn increased $3 million over 1991. Depreciation increased as result of the continued growth in capital assets. Selling, general and administrative expenses of $41 million increased $3 million from 1992 primarily due to higher relocation costs, contract consulting fees, and information systems costs at Terminals. Selling, general and administrative expenses of $38 million in 1992 decreased $3 million from 1991 primarily due to the elimination of regional offices at Terminals. Income tax expense of $45 million was $13 million higher than 1992 expense due to the increased level of income and the change in the federal tax rate from 34% to 35% retroactive to January 1, 1993. The 1993 effective tax rate of 43% exceeded the statutory rate primarily as the result of the increase in deferred taxes due to the increased tax rate. Income tax expense in 1992 of $32 million increased $3 million over 1991. The effective tax rate of 36% in 1992 was 3% higher than in 1991 as the result of the elimination of the deferred tax turnaround under the prior method of accounting for income taxes. EQUITY IN NET EARNINGS OF AFFILIATED COMPANIES Equity in net earnings of affiliated companies of $15 million decreased $2 million from 1992 which had in turn increased $2 million from 1991. Terminals' equity earnings decreased in 1993 reflecting the weak economies in Europe and Japan, partially offset by favorable results at the Singapore affiliates due to expansion and demand for services. The 1992 increase was primarily due to the expansion of Terminals' Singapore operations. Transportation's 1993 equity earnings in a Canadian railcar leasing company were comparable to 1992 and 1991 earnings. INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGES Income before the cumulative effect of accounting changes increased $1 million from 1992. An increase in income from operations of $9 million in 1993 was largely offset by the $8 million increase in taxes as the result of the change in the tax rate which increased Transportation's taxes by $5 million and Terminals' taxes by $3 million. Income before the cumulative effect of accounting changes in 1992 decreased $1 million from 1991. Transportation's 1993 income from operations increased 7% over 1992 as higher revenues and lower ownership costs were somewhat offset by increased fleet repair expenses. Ownership costs, consisting of rental expense, depreciation and interest, decreased slightly despite an increased fleet size due to lower interest rates, debt refinancings and interest rate swaps which were executed to more closely match Transportation's debt with the railcar lease terms. Terminals' 1993 income from operations increased 24% from the prior year. Higher revenues, reduced interest expense reflecting lower interest rates and debt refinancings, and improved margins were partially offset by higher SG&A expense and decreased earnings at foreign affiliates. Transportation's 1992 income from operations decreased 11% from 1991 as operating margins continued to decline. The gain in 1991 from the sale of its Mexican affiliates further adversely affected the comparison of 1992 results. Also, earnings for 1992 reflected a $1 million pretax charge related to refinancing equipment trust certificates at favorable rates. Terminals' 1992 income from operations increased 23% from 1991. Late in 1991, Terminals established a business unit structure and eliminated its regional offices to better control margins. The improved results represent increased margins due to domestic facility improvements and cost controls, combined with increased earnings from foreign affiliates. Earnings in 1992 were negatively affected by $2 million of pretax charges relating to the recognition of debt issuance costs and call premiums associated with debt refinancings at favorable terms and interest rates. CUMULATIVE EFFECT OF ACCOUNTING CHANGES The cumulative effect of accounting changes generated a $7 million reduction in 1992 net income. This adjustment resulted from the recording of a one-time non- cash net accounting charge for postretirement benefits and deferred taxes. SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, requires that certain postretirement benefits, principally health care and life insurance, be recognized in the financial statements on an accrual basis rather than on a pay-as-you-go basis. GATC recorded a one-time aftertax charge of $45 million for the transition obligation related to the implementation of this Standard. The principal change resulting from SFAS No. 109, Accounting for Income Taxes, is the recording of deferred taxes at amounts ultimately considered payable, which resulted in a $38 million favorable adjustment. NET INCOME Consolidated net income of $74 million in 1993 increased $8 million from 1992 primarily due to improved operating performance in 1993. Consolidated net income in 1992 decreased $8 million from 1991 primarily due to the cumulative effect of accounting changes. ASSETS Total assets of $2.2 billion were slightly higher than 1992. Property, plant and equipment increased $94 million to $2.8 billion. Transportation invested $171 million in new and used railcars and $24 million to upgrade its repair shops, which was partially offset by the sale and leaseback of $138 million of railcar additions. As the leaseback qualified as an operating lease, the assets were removed from the balance sheet. Terminals invested $78 million for tank construction and other modifications and improvements. LIABILITIES AND EQUITY Total debt decreased $29 million primarily due to sale leasebacks at Transportation. Proceeds were used to repay short-term debt and fund investment activities. Deferred income taxes increased $16 million primarily due to the increase in the federal tax rate from 34% to 35%. Other deferred items increased $13 million primarily due to increased environmental reserves and accrued rents payable. Consolidated equity increased $25 million attributable to 1993 earnings of $74 million partially reduced by dividends paid to GATX Corporation of $43 million. The balance of the change is attributable to foreign currency translation adjustments. LIQUIDITY AND CAPITAL RESOURCES GATC generates a significant amount of cash from operations. Most of its capital expenditures represent additions to its railcar fleet and expansion and upgrades to its service centers, terminals and pipelines and are considered discretionary capital expenditures. However, the non-discretionary level of Terminals' capital program has grown due to the increasing regulatory and environmental requirements of the terminalling business. The level of discretionary capital spending can be rapidly adjusted as conditions in the economy or GATC's businesses warrant. Cash provided by operating activities in 1993 of $206 million increased $16 million compared to 1992. Net income adjusted for non-cash items generated $193 million of cash, up $5 million from 1992. Other generated $11 million more cash than last year primarily as the result of the increase in payables. Cash provided by operating activities in 1992 of $190 million increased $13 million compared to 1991. Net income adjusted for non-cash items generated $189 million of cash, up $4 million from 1991. Other generated $9 million more cash than in 1991 primarily due to the timing of operating lease rental payments. Cash used in investing activities increased $10 million in 1993 from the prior year. Capital additions of $273 million were up $80 million from last year's level of $193 million. Transportation invested $171 million in the railcar fleet, up $63 million from the prior year. In addition, Transportation invested $24 million on its multi-year program to significantly upgrade its repair facilities, up $16 million from 1992. Terminals expended $78 million in 1993, similar to 1992 levels, for tank construction and other modifications and improvements. Proceeds from asset dispositions of $152 million in 1993 included $138 million received on the sale leaseback of railcar additions at Transportation. GATC has used this method of financing its railcar fleet as an attractive opportunity given GATX's alternative minimum tax position. Cash used in investing activities in 1992 increased $8 million from 1991. Capital additions of $193 million were up $5 million from 1991's level of $188 million. Transportation invested $108 million in the railcar fleet, up modestly from the $101 million invested in the prior year, and $8 million as it began its multi-year program to significantly upgrade its repair facilities. Terminals invested $76 million in tank construction and other modifications and improvements in 1992 compared to $85 million in 1991. Proceeds from other asset dispositions of $82 million in 1992 included $75 million received on the sale leaseback of railcar additions at Transportation. Cash used in financing activities was $79 million in 1993, comparable to 1992. GATC finances its capital additions mainly through cash generated by operating activities, debt financings, and the sale leaseback of railcars. During the year, $63 million of long-term debt was issued and $67 million of long-term obligations were repaid. Short-term debt decreased by $29 million to a balance of $104 million. Cash used in financing activities was $80 million in 1992 compared to $116 million in the prior year. Significant financing activity in 1992 involved refinancing existing debt obligations to take advantage of current low interest rates and to secure the economic benefit to the company. Transportation's equipment trust certificates totaling $66 million were redeemed. A total of $60 million of Terminals' long-term floating rate bonds were refinanced with fixed- rate bonds. Terminals also refinanced three series of fixed-rate industrial revenue bonds totaling $25 million; two of these series were delayed settlements whose cash closings occurred in 1993 or will occur in 1994. GATC recognized charges of $3 million related to these refinancings but is now receiving the benefit of the lower interest costs. GATC and GATX Terminals have revolving credit facilities. GATC also has a commercial paper program and uncommitted money market lines which are used to fund operating needs. In late 1992, GATC signed a new four-year credit facility. Under the covenants of the commercial paper programs and rating agency guidelines, GATC must keep unused revolver capacity at least equal to the amount of commercial paper and money market lines outstanding. At December 31, 1993, GATC and its subsidiaries had available unused committed lines of credit amounting to $188 million. In February 1994, GATC filed a $650 million shelf registration for pass through trust certificates and debt securities, none of which have been issued. At year end, GATC had $115 million of commitments to acquire assets, $114 million of which is scheduled to fund in 1994. Environmental Matters Certain of GATC's operations present potential environmental risks principally through the transportation or storage of various commodities. Recognizing that some risk to the environment is intrinsic to its operations, GATC is committed to protecting the environment, as well as complying with applicable environmental protection laws and regulations. GATC, as well as its competitors, is subject to extensive regulation under federal, state and local environmental laws which have the effect of increasing the costs and liabilities associated with the conduct of its operations. In addition, GATC's foreign operations are subject to environmental regulations in effect in each respective jurisdiction. GATC's policy is to monitor and actively address environmental concerns in a responsible manner. GATC has received notices from the U.S. Environmental Protection Agency (EPA) that it is a potentially responsible party (PRP) for study and clean-up costs at 11 sites under the requirements of the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (Superfund). Under Superfund and comparable state laws, GATC may be required to share in the cost to clean-up various contaminated sites identified by the EPA and other agencies. In all but one instance, GATC is one of several financially responsible PRPs and has been identified as contributing only a small percentage of the contamination at each of the sites. Due to various factors such as the required level of remediation and participation in clean-up efforts by others, GATC's total clean-up costs at these sites cannot be predicted with certainty; however, GATC's best estimates for remediation and restoration of these sites have been determined and are included in its environmental reserves. Future costs of environmental compliance are indeterminable due to unknowns such as the magnitude of possible contamination, the timing and extent of the corrective actions that may be required, the determination of the company's liability in proportion to other responsible parties, and the extent to which such costs are recoverable from third parties including insurers. Also, GATC may incur additional costs relating to facilities and sites where past operations followed practices and procedures that were considered acceptable at the time but in the future may require investigation and/or remedial work to ensure adequate protection to the environment under current standards. If future laws and regulations contain more stringent requirements than presently anticipated, expenditures may be higher than the estimates, forecasts, and assessments of potential environmental costs provided below. However, these costs are expected to be at least equal to the current level of expenditures. GATC's environmental reserve at the end of 1993 was $65 million and reflects GATC's best estimate of the cost to remediate its environmental conditions. Additions to the reserve were $17 million in both 1993 and 1992. Expenditures charged to the reserve amounted to $10 million and $12 million in 1993 and 1992, respectively. In 1993, GATC made capital expenditures of $18 million for environmental and regulatory compliance compared to $16 million in 1992. These projects included marine vapor recovery, discharge prevention compliance, impervious dikes and tank car cleaning systems. Environmental projects authorized or currently under consideration would require capital expenditures of approximately $25 million in 1994. It is anticipated that GATC will make annual expenditures at a similar annual level over the next five years for regulatory and environmental requirements. Item 8. Item 8. Financial Statements and Supplementary Data The response to this item is submitted under Item 14 (a)(1) of this report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Not required. Item 11. Item 11. Executive Compensation Not required. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Not required. Item 13. Item 13. Certain Relationships and Related Transactions Not required. PART IV Item 14. Item 14. Financial Statement Schedules, Reports on Form 8-K and Exhibits (a) (1) Financial Statements The consolidated financial statements of General American Transportation Corporation and its subsidiaries which are required in Item 8 are listed below: PAGE Statements of Consolidated Income and Reinvested Earnings-- years ended December 31, 1993, 1992 and 1991............. 19 Consolidated Balance Sheets--December 31, 1993 and 1992..... 20 Statements of Consolidated Cash Flows-- years ended December 31, 1993, 1992 and 1991.............. 22 Notes to Consolidated Financial Statements.................. 23 PART IV (CONT'D) Item 14. Financial Statement Schedules, Reports on Form 8-K and Exhibits PAGE (2) Financial Statement Schedules Schedule IV Indebtedness of and to Related Parties....... 37 Schedule V Property, Plant and Equipment ............... 38 Schedule VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment ............................... 42 Schedule VIII Valuation and Qualifying Accounts............ 46 Schedule IX Short-Term Borrowings ....................... 47 Schedule X Supplementary Income Statement Information ................................. 48 All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. (b) No reports on Form 8-K were filed during the reporting period. (c) Exhibit Index Exhibit Number Exhibit Description Page 3A. Certificate of Incorporation of General American Transportation Corporation, incorporated by reference to the GATC Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 2-54754. 3B. Bylaws of General American Transportation Corporation, incorporated by reference to the GATC Annual Report on Form 10-K for the fiscal year ended December 31, 1991, file number 2-54754. 4A. Indenture dated October 1, 1987, incorporated by reference to Exhibit 4.1 to the GATC Registration Statement on Form S-3 filed October 8, 1987, file number 33-17692; Indenture Supplement dated May 15, 1988, incorporated by reference to the GATC Quarterly Report on Form 10-Q for the quarter ended June 30, 1988, file number 2-54754. Second Supplemental Indenture dated as of March 15, 1990, incorporated by reference to GATC Quarterly Report on Form 10-Q for the quarter ended March 30, 1990, file number 2-54754. Exhibit Number Exhibit Description Page 4B. General American Transportation Corporation Notices 1 through 6 dated from November 6, 1987 through April 12, 1988 defining the rights of holders of GATC's Medium-Term Notes Series A issued during that period, incorporated by reference to the GATC Quarterly Report on Form 10-Q for the quarter ended June 30, 1988, file number 2-54754. 4C. General American Transportation Corporation Notices 1 through 3 dated from October 17, 1988 through October 24, 1988 and 4 through 6 dated from November 7, 1988 through March 3, 1989 defining the rights of holders of GATC's Medium-Term Notes Series B issued during those periods, Notices 1 through 3 incorporated by reference to the GATC Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, and Notices 4 through 6 incorporated by reference to the GATC Annual Report on Form 10-K for the fiscal year ended December 31, 1988, file number 2-54754. 4D. General American Transportation Corporation Notices 1 and 2 dated from March 30, 1989 through March 31, 1989, Notices 3 through 8 dated from April 4, 1989 through June 29, 1989, Notices 9 through 16 dated from July 19, 1989 through September 29, 1989, and Notices 17 through 21 dated from October 2, 1989 through October 9, 1989 defining the rights of the holders of GATC's Medium-Term Notes Series C issued during those periods. Notices 1 and 2, Notices 3 through 8 and Notices 9 through 16 are incorporated by reference to the GATC Quarterly Reports on Form 10-Q for the quarters ended March 31, 1989, June 30, 1989 and September 30, 1989, respectively, and Notices 17 through 21 incorporated by reference to the GATC Annual Report on Form 10-K for the fiscal year ended December 31, 1989, file number 2-54754. 4E. General American Transportation Corporation Notices 1 and 2 dated February 27, 1992, Notices 3 through 5 dated from December 7, 1992 through December 14, 1992 and notices 6 through 10 dated from May 18, 1993 through May 25, 1993 defining the rights of the holders of GATC's Medium-Term Notes Series D issued during those periods. Notices 1 and 2 are incorporated by reference to the GATC Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, Notices 3 through 5 are incorporated by reference to the GATC Annual Report on Form 10-K for the fiscal year ended December 31, 1992, and Notices 6 through 10 are incorporated by reference to the GATC Quarterly Report on Form 10-Q for the quarter ending June 30, 1993, file number 2-54754. Exhibit Number Exhibit Description Page 10A. Second Amended and Restated Revolving Credit Agreement dated as of November 13, 1992, incorporated by reference to GATC's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, file number 2-54754. 10B. Revolving Credit Facility Agreement for GATX Terminals Limited as borrower and GATC as guarantor dated as of July 13, 1993, incorporated by reference to GATC's Quarterly Report on Form 10-Q for the period ended September 30, 1993, file number 2-54754. 12. Statement regarding computation of ratios of earnings 49 to fixed charges. 24. Consent of Independent Auditors 50 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. GENERAL AMERICAN TRANSPORTATION CORPORATION (Registrant) /s/D. Ward Fuller ---------------------------------- D. Ward Fuller President, Chief Executive Officer and Director March 21, 1994 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 date indicated. /s/D. Ward Fuller ---------------------------------- D. Ward Fuller President, Chief Executive Officer and Director March 21, 1994 /s/Melvin D. Kusta ---------------------------- Melvin D. Kusta Controller and Principal Accounting Officer March 21, 1994 /s/James J. Glasser --------------------------- James J. Glasser Director March 21, 1994 /s/Paul A. Heinen --------------------------- Paul A. Heinen Director March 21, 1994 REPORT OF INDEPENDENT AUDITORS Board of Directors General American Transportation Corporation We have audited the consolidated financial statements and related schedules of General American Transportation Corporation (a wholly-owned subsidiary of GATX Corporation) and subsidiaries listed in Item 14(a)(1) and (2) of the Annual Report on Form 10-K of General American Transportation Corporation for the year ended December 31, 1993. These financial statements and related schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and related schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and related schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of General American Transportation Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, it is our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects, the information set forth therein. As discussed in the notes to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and income taxes. ERNST & YOUNG Chicago, Illinois January 25, 1994 GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES See notes to consolidated financial statements. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES See notes to consolidated financial statements. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A--SIGNIFICANT ACCOUNTING POLICIES Significant accounting policies of General American Transportation Corporation (GATC) and its consolidated subsidiaries are discussed below. Consolidation: The consolidated financial statements include the accounts of GATC and its majority-owned subsidiaries. Investments in 20 to 50 percent-owned companies and joint ventures are accounted for under the equity method and are shown as investments in affiliated companies. Less than 20 percent-owned affiliated companies are recorded using the cost method. Cash Equivalents: GATC considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. The carrying amounts reported in the balance sheet for cash and cash equivalents approximate the fair value of those assets. Property, Plant and Equipment: Property, plant and equipment are stated principally at cost. Assets acquired under capital leases are included in property, plant and equipment and the related obligations are recorded as liabilities. Provisions for depreciation include the amortization of the cost of capital leases and are computed by the straight-line method which results in equal annual depreciation charges over the estimated useful lives of the assets. Goodwill: GATC has classified as goodwill the cost in excess of the fair value of net assets acquired. Goodwill, which is included in other assets, is being amortized on a straight-line basis over 40 years. Goodwill, net of accumulated amortization of $1.9 million and $1.3 million, was $18.7 million and $18.5 million as of December 31, 1993 and 1992, respectively. Amortization expense was $.5 million for each year 1993, 1992 and 1991. Income Taxes: In February 1992, Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, was issued by the Financial Accounting Standards Board (FASB) which, among other things, requires that recognition of deferred income taxes be measured by the provisions of enacted tax laws in effect at the date of the financial statements. This Statement was adopted by GATC in the first quarter of 1992. The cumulative effect of the adoption of this Statement was to reduce the deferred tax liability by $37.8 million in 1992. This amount was added to net income and thereby to shareholders' equity. United States income taxes have not been provided on the undistributed earnings of foreign subsidiaries and affiliates which GATC intends to permanently reinvest in these foreign operations. The cumulative amount of such earnings was $89.5 million at December 31, 1993. Other Deferred Items: Other deferred items include the accrual for postretirement benefits other than pensions in addition to environmental, general liability, and workers' compensation reserves and other deferred credits. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE A--SIGNIFICANT ACCOUNTING POLICIES (CONT'D) Environmental Liabilities: Expenditures that relate to current or future operations are expensed or capitalized as appropriate. Expenditures that relate to an existing condition caused by past operations and do not contribute to current or future revenue generation are charged to environmental reserves. Reserves are recorded in accordance with accounting guidelines to cover work at identified sites when GATC's liability for environmental clean-up is both probable and a minimum estimate of associated costs can be made; adjustments to initial estimates are recorded as necessary. Off-Balance Sheet Financial Instruments: Fair values of GATC's off-balance sheet financial instruments (futures, swaps, forwards, options, and purchase commitments) are based on current market prices, settlement values or fees currently charged to enter into similar agreements. Revenue Recognition: The majority of GATC's gross income is derived from the rentals of railcars and terminals and other services. Foreign Currency Translation: The assets and liabilities of operations located outside the United States are translated at exchange rates in effect at year end, and income statements are translated at the average exchange rates for the year. Gains or losses resulting from the translation of foreign currency financial statements are deferred and recorded as a separate component of consolidated shareholder's equity. Incremental unrealized translation (losses) gains recorded in the cumulative foreign currency translation adjustment account were $(5.8) million, $(2.8) million and $4.8 million during 1993, 1992, and 1991, respectively. Reclassifications: Certain amounts in the 1992 and 1991 financial statements have been reclassified to conform to the 1993 presentation. NOTE B--ACCOUNTING FOR LEASES The following information pertains to GATC as a lessor: Operating leases: Railcar and tankage assets included in property, plant and equipment are classified as operating leases. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE B--ACCOUNTING FOR LEASES (CONT'D) The following information pertains to GATC as a lessee: Capital leases: Certain railcars are leased by GATC under capital lease agreements. Property, plant and equipment includes cost and related allowances for depreciation of $153.2 million and $63.5 million, respectively, at December 31, 1993 and $159.9 million and $60.3 million, respectively, at December 31, 1992 for these railcars. The cost of these assets is amortized on the straight-line basis with the charge included in depreciation expense. Operating leases: GATC has financed railcars through sale leasebacks which are accounted for as operating leases. In addition, GATC leases certain other assets and office facilities. Total rental expense for the years ended December 31, 1993, 1992, and 1991 was $39.8 million, $29.8 million, and $22.0 million, respectively. The above capital lease amounts do not include the cost of licenses, taxes, insurance and maintenance which GATC is required to pay. Interest expense on the above capital lease obligations was $11.8 million in 1993, $12.3 million in 1992, and $12.7 million in 1991. NOTE C--ADVANCES TO/FROM PARENT Interest income on advances to GATX, which is included in gross income on the income statement, was $18.4 million in 1993, $23.4 million in 1992, and $23.9 million in 1991. Interest income was based on an interest rate which was periodically adjusted in accordance with short-term commercial paper rates and averaged 4.30% in 1993, 6.20% in 1992, and 6.34% in 1991. Interest expense on advances from GATX to GATC was $2.2 million in 1993, $2.7 million in 1992, and $2.7 million in 1991. These advances have no fixed maturity date. Interest expense was based on interest rates computed as described in the preceding paragraph. The carrying amounts reported in the balance sheet for the Due from GATX Corporation at December 31, 1993 approximate fair value. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE D--INVESTMENTS IN AFFILIATED COMPANIES GATC has investments in 20 to 50 percent-owned companies and joint ventures which are accounted for using the equity method. These investments include a Canadian railcar company and foreign tank storage terminals. Distributions received from such jointly-owned companies were $3.1 million, $3.1 million, and $3.2 million in 1993, 1992, and 1991, respectively. NOTE E--FOREIGN OPERATIONS Foreign operations were not material to the consolidated gross income or pretax income of GATC for any of the years presented. GATC has investments in affiliated companies which are located in foreign countries. Equity income from these foreign affiliates for 1993, 1992 and 1991 was $14.6 million, $16.3 million and $14.7 million, respectively. The foreign identifiable assets of GATC are investments in affiliated companies and a United Kingdom terminalling operation which is fully consolidated. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE F--SHORT-TERM DEBT AND LINES OF CREDIT Under a revolving credit agreement with a group of banks, GATC may borrow up to $200.0 million. The revolving credit agreement contains various restrictive covenants which include, among other things, minimum net worth, restrictions on additional indebtedness, and requirements to maintain certain financial ratios for GATC. Under the agreement GATC was required to maintain a minimum net worth of $528.2 million at December 31, 1993. While at year end no borrowings were outstanding under the agreement, the available line of credit was reduced by $25.5 million of commercial paper outstanding. GATC had borrowings of $55.0 million under unsecured money market lines. Also, GATX Terminals has a revolving credit agreement of pounds25.0 million of which pounds9.0 million was available at year end. The carrying amounts reported in the balance sheet for short-term debt at December 31, 1993 approximate fair value. Interest expense on short-term debt was $4.2 million in 1993, $3.9 million in 1992, and $4.8 million in 1991. NOTE G--LONG-TERM DEBT The fair value of the fixed rate debt was $822.2 million and $791.2 million at December 31, 1993 and 1992, respectively. Fair value was estimated by aggregating the notes and performing a discounted cash flow calculation using a weighted average note term and market rate based on GATC's current incremental borrowing rate for similar types of borrowing arrangements. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE G--LONG-TERM DEBT (CONT'D) Interest cost incurred on long-term debt, net of capitalized interest, was $60.5 million in 1993, $77.1 million in 1992, and $80.5 million in 1991. Interest cost capitalized as part of the cost of acquisition or construction of major assets was $2.4 million in 1993, $2.8 million in 1992, and $2.8 million in 1991. In 1992, a loss of $3.3 million was recorded on the early retirement of debt. In 1990, GATC entered into a currency swap agreement to finance the purchase of a United Kingdom terminalling operation. GATC swapped a U.S. dollar borrowing of $59.7 million with interest stated at 10.125% for a liability of pounds 37.0 million with associated interest at 12.87%. The exchange of interest and principal payments over the 12 year term of the notes was fixed accordingly. The swap was terminated in 1993, resulting in a net cash payment to GATC of $2.3 million; at the same time, an offsetting translation loss was recognized for the unrealized loss on the translation of pounds into dollars. GATC uses interest rate swaps, caps, forwards and other similar contracts to set interest rates on existing or anticipated transactions. At December 31, 1993, GATC has used $900 million of interest rate swaps to better match the duration of the debt portfolio to the lease terms of the railcar assets. Net amounts paid or received on these contracts that qualify as hedges are recognized over the term of the contract as an adjustment to interest expense of the hedged financial instrument. The fair values of the swap components at year end would result in a net payment to GATC of $7.5 million if the swaps were terminated. These financial instruments terminate in 1994-2006. GATC manages the credit risk of counterparties by only dealing with institutions that are considered financially sound and by avoiding concentrations of risk with a single counterparty. NOTE H--PENSION BENEFITS GATC and its subsidiaries contributed to several pension plans sponsored by GATX which cover substantially all employees. Benefits under the plans are based on years of service and/or final average salary. The funding policy for all plans is based on an actuarially determined cost method allowable under Internal Revenue Service regulations. Contributions to these plans were $6.7 million in 1993, $5.1 million in 1992, and $6.0 million in 1991. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE H-- PENSION BENEFITS (CONT'D) Costs pertaining to the GATX plans are allocated to GATC on the basis of payroll costs with respect to normal cost and on the basis of actuarial determinations for prior service cost. Net periodic pension cost for 1993, 1992, and 1991 was $3.4 million, $3.4 million, and $3.3 million, respectively. Plan benefit obligations, plan assets, and the components of net periodic cost for individual subsidiaries of GATX have not been determined. NOTE I--POSTRETIREMENT BENEFITS OTHER THAN PENSIONS GATC provides health care, life insurance and other benefits for certain retired employees who meet established criteria. Most domestic employees are eligible for health care and life insurance benefits if they retire from GATC with immediate pension benefits under the GATX pension plan. The plans are either contributory or non-contributory, depending on various factors. In 1992, GATC implemented Statement of Financial Accounting Standards (SFAS) No. 106 - "Employers' Accounting for Postretirement Benefits Other Than Pensions" using the immediate recognition transition method, effective as of January 1, 1992. SFAS No. 106 requires recognition of the cost of postretirement benefits during an employee's active service life. GATC's previous practice was to expense these costs as they were paid. GATC recorded a charge of $44.5 million ($68.6 million pretax) in the first quarter of 1992 to reflect the cumulative effect of the change in accounting principle for periods prior to 1992. Aside from the one-time impact of the transition obligation, adoption of SFAS No. 106 was not material to 1992 financial results. Prior to 1992, the cost of providing these benefits to retired employees was recognized primarily as payments were made and totaled $6.7 million in 1991. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE I--POSTRETIREMENT BENEFITS OTHER THAN PENSIONS (CONT'D) The accrued postretirement benefit liability was determined using an assumed discount rate of 7.75% for 1993, 8.5% for 1992, and 9.0% at January 1, 1992 when the transition obligation was calculated. The effect of this change in the discount rate assumption was a deferred loss of $4.2 million in 1993 and $2.4 million in 1992. For measurement purposes, blended rates ranging from 13% decreasing to 5% over the next four years and remaining at that level thereafter were used for the increase in the per capita cost of covered health care benefits. The health care cost trend rate assumption has a significant effect on the amount of the obligation and periodic cost reported. An increase in the assumed health care cost trend rates by 1% would increase the accumulated postretirement benefit obligation by $4.6 million and would increase aggregate service and interest cost components of net periodic postretirement benefit cost by $.4 million per year. NOTE J--INCOME TAXES Effective January 1, 1992, GATC changed its method of accounting for income taxes from the deferred method to the liability method required by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." As permitted under the new rules, prior years' financial statements have not been restated. The cumulative effect of adopting Statement 109 as of January 1, 1992 was to increase net income by $37.8 million. Aside from the one-time impact due to the reassessment of deferred taxes, adoption of SFAS No. 109 was not material to 1992 financial results. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE J--INCOME TAXES (CONT'D) At December 31, 1993, GATC has an alternative minimum tax credit of $5.2 million that can be carried forward indefinitely to reduce future regular tax liabilities. The results of operations of GATC and its United States subsidiaries are included in the consolidated federal income tax return of GATX. Current provisions for federal income taxes represent amounts payable to GATX resulting from inclusion of GATC's operations in the consolidated federal income tax return. Amounts shown as currently payable for federal income taxes represent taxes payable due to the alternative minimum tax. GATC's sources of income before income taxes and equity in net earnings of affiliated companies were almost entirely domestic. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE J--INCOME TAXES (CONT'D) The reasons for the differences between reported income tax expense (credit) and the amount computed by applying the statutory federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to income before income taxes were (in millions): NOTE K--COMMITMENTS, CONTINGENCIES AND CONCENTRATIONS OF CREDIT RISK GATC's revenues are derived from a wide range of industries and companies. However, approximately 85% of total revenues are generated from the transportation and storage of products for the chemical and petroleum industries. Under its lease agreements, GATC retains legal ownership of the asset. GATC performs credit evaluations prior to approval of a lease contract. Subsequently, the creditworthiness of the customer is monitored on an ongoing basis. GATC maintains an allowance for possible losses to provide for future losses should customers become unable to discharge their obligations to GATC. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE K--COMMITMENTS, CONTINGENCIES AND CONCENTRATIONS OF CREDIT RISK (CONT'D) At December 31, 1993 GATC had firm commitments to acquire railcars and to upgrade facilities totaling $115 million. GATC and its subsidiaries are engaged in various matters of litigation and have a number of unresolved claims pending, including proceedings under governmental laws and regulations related to environmental matters. While the amounts claimed are substantial and the ultimate liability with respect to such litigation and claims cannot be determined at this time, it is the opinion of management that such liability, to the extent not recoverable from third parties including insurers, is not likely to be material to GATC's consolidated financial position or results of operations. NOTE L--FINANCIAL DATA OF BUSINESS SEGMENTS GATC is engaged in the following businesses: Railcar Leasing and Management represents General American Transportation Corporation and its foreign affiliate, which lease and manage tank cars and other specialized railcars. Terminals and Pipelines represents GATX Terminals Corporation and its domestic and foreign subsidiaries and affiliates, which own and operate tank storage terminals, pipelines and related facilities. Intersegment sales are not significant in amount or meaningful to an understanding of GATC's business segments. The following presentation of segment profitability includes the direct costs incurred at the segment's operating level plus expenses allocated by GATX. These allocated expenses represent costs for services provided by GATX which these operations would have incurred otherwise and are determined on a usage basis; management believes that this method is reasonable. Such costs do not include general corporate expense nor interest on debt of GATX. Interest costs associated with segment indebtedness are included in the determination of profitability of each segment since interest expense directly influences any investment decision and the evaluation of subsequent operational performance. Interest costs by segment have been shown separately so the reader can ascertain segment profitability before deducting interest expense. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE L--FINANCIAL DATA OF BUSINESS SEGMENTS (CONT'D) (A) Income has been reduced by $7.7 million as a result of the change in the federal tax rate (see following table for breakdown by segment). (B) Income was further reduced by $6.7 million for the cumulative effect of accounting changes resulting in net income of $66.1 million (see following table for a breakdown by segment). GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE L--FINANCIAL DATA OF BUSINESS SEGMENTS (CONT'D) FEDERAL TAX RATE CHANGE IN 1993 The following table shows the effect of the new federal tax legislation enacted in 1993 which increased the federal income tax rate from 34% to 35% retroactively to January 1, 1993. The income amounts for 1992 are shown before the cumulative effect of accounting changes (SFAS No. 106 and No. 109) for comparative purposes to 1993 income before the tax rate change. GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONT'D) NOTE L--FINANCIAL DATA OF BUSINESS SEGMENTS (CONT'D) See notes to Schedule V on page 41. See notes to Schedule V on page 41. See notes to Schedule V on page 41. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (CONT'D) GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES Note A - The estimated useful lives of depreciable assets are as follows: Railcars 20-33 years Buildings, leasehold improvements, storage tanks and pipelines 5-45 years Machinery and related equipment 3-20 years Note B - Represents primarily the sale and leaseback of certain railcar additions. Note C - Represents adjustments associated with transfers and reclassification of certain facilities and other assets and foreign currency translation adjustments. See notes to Schedule VI on page 45. See notes to Schedule VI on page 45. See notes to Schedule VI on page 45. SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (CONT'D) GENERAL AMERICAN TRANSPORTATION CORPORATION AND SUBSIDIARIES Note A - In 1993, represents $2.8 million of accumulated depreciation related to the sale leaseback of railcars and $3.5 million related to the early disposal of railcars, offset by $.9 million of reserves for the cost of scrapped railcars. In 1992, represents $6.0 million of accumulated depreciation related to the sale leaseback of railcars and $1.2 million for an early disposal, offset by $5.5 million of reserves for the cost of scrapped railcars. In 1991, represents $3.0 million of accumulated depreciation related to the sale leaseback of railcars increased by a $.9 million loss on the cost of scrapped railcars. Note B - Represents adjustments associated with transfers and reclassifications of certain facilities and other assets and foreign currency translation adjustments.

72162_1993.txt

72162_1993

1993

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ITEM 1. BUSINESS GENERAL NL Industries, Inc., organized as a New Jersey corporation in 1891, conducts its operations through its principal wholly-owned subsidiaries, Kronos, Inc. and Rheox, Inc. At December 31, 1993, Valhi, Inc. held approximately 49% of NL's outstanding stock and Tremont Corporation, a 48%-owned affiliate of Valhi, held an additional 18% of NL's outstanding common stock. Contran Corporation holds, directly or through subsidiaries, approximately 90% of Valhi's outstanding common stock. All of Contran's outstanding voting stock is held by trusts established for the benefit of the children and grandchildren of Harold C. Simmons of which Mr. Simmons is the sole trustee. Mr. Simmons, the Chairman of the Board of each of Contran, Valhi and NL and a director of Tremont, may be deemed to control each of such companies. NL and its consolidated subsidiaries are sometimes referred to herein collectively as the "Company". Kronos is the world's fourth largest producer of titanium dioxide pigments ("TiO2") with an estimated 11% share of the worldwide market. Approximately one-half of Kronos' 1993 sales volume was in Europe, where Kronos is the second largest producer of TiO2. Kronos accounted for 87% of the Company's sales and 58% of its operating income in 1993. Rheox is the world's largest producer of rheological additives for solvent-based systems, supplying an estimated 40% of the worldwide market. KRONOS INDUSTRY Titanium dioxide pigments are chemical products used for imparting whiteness, brightness and opacity to a wide range of products, including paints, paper, plastics, fibers and ceramics. TiO2 is considered to be a "quality-of-life" product with demand affected by the gross domestic product in various regions of the world. Demand, supply and pricing of TiO2 have historically been cyclical and the last cyclical peak for TiO2 prices occurred in early 1990. While prices for TiO2 are currently depressed, the Company believes that the TiO2 industry has significant long-term potential. However, the Company expects that the TiO2 industry will continue to operate at lower capacity utilization levels over the next few years relative to the high utilization levels prevalent during the late 1980s, primarily because of the slow recovery from the worldwide recession and the impact of capacity additions since the late 1980s. The economic recovery has been particularly slow in Europe where a significant portion of the Company's TiO2 manufacturing facilities are located. Kronos has an estimated 17% share of European TiO2 sales and an estimated 9% share of U.S. TiO2 sales. Consumption per capita in the United States and Western Europe far exceeds that in other areas of the world and these regions are expected to continue to be the largest geographic markets for TiO2 consumption. However, if the economies in Eastern Europe, the Far East and China continue to develop, a significant market for TiO2 could emerge in those countries and Kronos believes that it is well positioned to participate in the Eastern European market. - 1 - PRODUCTS AND OPERATIONS The Company believes that there are no effective substitutes for TiO2. However, extenders such as kaolin clays, calcium carbonate and polymeric opacifiers are used in a number of Kronos' markets. Generally, extenders are used to reduce to some extent the utilization of higher cost TiO2. The use of extenders has not significantly affected TiO2 consumption over the past decade because extenders generally have, to date, failed to match the performance characteristics of TiO2. The Company believes that the use of extenders will not materially alter the growth of the TiO2 business in the foreseeable future. Kronos currently produces over 40 different TiO2 grades, sold under the Kronos and Titanox trademarks, which provide a variety of performance properties to meet customers' specific requirements. Kronos' major customers include international paint, paper and plastics manufacturers. Kronos is one of the world's leading producers and marketers of TiO2. Kronos and its distributors and agents sell and provide technical services for its products to over 5,000 customers with the majority of sales in Europe, the United States and Canada. Kronos' international operations are conducted through Kronos International, Inc. ("KII"), a German-based holding company formed in 1989 to manage and coordinate the Company's manufacturing operations in Germany, Canada, Belgium and Norway and its sales and marketing activities in over 100 countries worldwide. The Company believes that KII's structure allows it to capitalize on expertise and technology developed in Germany over a 60-year period. Kronos and its predecessors have produced and marketed TiO2 in North America and Europe for over 70 years. As a result, Kronos believes that it has developed considerable expertise and efficiency in the manufacture, sale, shipment and service of its products in domestic and international markets. By volume, one-half of Kronos' 1993 TiO2 sales were to Europe, with 38% to North America and the balance to export markets. Kronos is also engaged in the mining and sale of ilmenite ores (a raw material used in the sulfate pigment production process), and the manufacture and sale of iron-based water treatment chemicals (derived from co-products of the pigment production processes). Water treatment chemicals are used as treatment and conditioning agents for industrial effluents and municipal wastewater and in the manufacture of iron pigments. MANUFACTURING PROCESS AND RAW MATERIALS TiO2 is manufactured by Kronos using either the chloride or sulfate pigment production process. Although most end-use applications can use pigments produced by either process, chloride process pigments are generally preferred in certain segments of the coatings and plastics applications, and sulfate process pigments are generally preferred for paper, fibers and ceramics applications. Due to environmental factors and customer considerations, the proportion of TiO2 industry sales represented by chloride process pigments has increased relative to sulfate process pigments. Approximately two-thirds of Kronos' current production capacity is based on an efficient chloride process technology. Kronos produced approximately 352,000 metric tons of TiO2 in 1993, compared to approximately 358,000 metric tons in 1992 and 293,000 metric tons in 1991. The increase in production during 1992 was primarily at Kronos' chloride process - 2 - plants, including the plant in Lake Charles, Louisiana. Kronos achieved record production levels of chloride process pigments in 1992 through improved operational efficiencies. In response to weakened demand, production rates were reduced in late 1992 and during 1993 in order to reduce inventory levels. Kronos believes its annual attainable production capacity is approximately 380,000 metric tons, including its one- half interest in the Louisiana plant. The primary raw materials used in the TiO2 chloride production process are chlorine, coke and titanium-containing feedstock derived from beach sand ilmenite and rutile. Chlorine and coke are available from a number of suppliers. Titanium-containing feedstock suitable for use in the chloride process is available from a limited number of suppliers around the world, principally in Australia, Africa, India and the United States. Kronos purchases slag refined from beach sand ilmenite from Richards Bay Iron and Titanium (Proprietary) Ltd. (South Africa), approximately 50% of which is owned by Q.I.T. Fer et Titane Inc. ("QIT"), an indirect subsidiary of RTZ Corp. Natural rutile ore is purchased from a number of sources. The primary raw materials used in the TiO2 sulfate production process are sulfuric acid and titanium-containing feedstock derived primarily from rock and beach sand ilmenite. Sulfuric acid is available from a number of suppliers. Titanium-containing feedstock suitable for use in the sulfate process is available from a limited number of suppliers around the world. Currently, the principal active sources are located in Norway, Canada, Australia, India and South Africa. As one of the few vertically-integrated producers of sulfate process pigments, Kronos operates a rock ilmenite mine near Hauge i Dalane, Norway, which provided all of Kronos' feedstock for its European sulfate process pigment plants in 1993. Kronos' mine is also a commercial source of rock ilmenite for other sulfate process producers in Europe supplying, the Company believes, nearly 40% of the European demand, including the Company, for sulfate feedstock. Additionally, Kronos purchases sulfate grade slag under contracts negotiated annually with QIT and Tinfos Titanium and Iron K/S. Kronos believes the availability of titanium-containing feedstock for both the chloride and sulfate processes is adequate in the near term; however, tightening supplies for the chloride process may be encountered in the late 1990s. Kronos does not anticipate experiencing any interruptions of its raw material supplies. TIO2 MANUFACTURING JOINT VENTURE In October 1993, Kronos formed a manufacturing joint venture with Tioxide Group, Ltd., a wholly-owned subsidiary of Imperial Chemicals Industries PLC ("Tioxide"). The joint venture, which is equally owned by subsidiaries of Kronos and Tioxide (the "Partners"), owns and operates the Louisiana chloride process TiO2 plant formerly owned by Kronos. Under the terms of the joint venture and related agreements, Kronos contributed the plant to the joint venture, Tioxide paid an aggregate of approximately $205 million, including its tranche of the joint venture debt, and Kronos and certain of its subsidiaries exchanged proprietary chloride process and product technologies with Tioxide and certain of its affiliates. Of the total consideration paid by Tioxide, $30 million was attributable to the exchange of technologies and is being reported as a component of operating income ratably over three years beginning in October 1993. Production from the plant is being shared equally by Kronos and Tioxide pursuant to separate offtake agreements. The formation of the manufacturing joint venture resulted in a 12% decrease in Kronos' total TiO2 production capacity; however, Kronos' remaining capacity is 10% higher than 1993 sales volume, and is believed to be sufficient to provide Kronos with the - 3 - capability to meet current market requirements and continue its worldwide presence in future years. A supervisory committee, composed of four members, two of whom are appointed by each Partner, directs the business and affairs of the joint venture, including production and output decisions. Two general managers, one appointed and compensated by each Partner, manage the day- to-day operations of the joint venture acting under the direction of the supervisory committee. Upon formation, the joint venture obtained $216 million in new financing consisting of two equal tranches, one attributable to each Partner, which is serviced through the purchase of the plant's TiO2 output in equal quantities by the Partners. The Partners are each required to make capital contributions to the joint venture to pay principal on their respective portion of the joint venture indebtedness. Kronos' pro rata share of the joint venture debt is reflected as outstanding indebtedness of the Company because Kronos has guaranteed the purchase obligation relative to the debt service of its tranche. The manufacturing joint venture is intended to be operated on a break-even basis and, accordingly, Kronos' transfer price for its share of the TiO2 produced is equal to its share of the joint venture's operating expenses (fixed and variable costs of production and interest expense). Kronos' share of the fixed and variable production costs are reported as cost of sales as the related TiO2 acquired from the joint venture is sold, and its share of the joint venture's interest expense is reported as a component of interest expense. COMPETITION The TiO2 industry is highly competitive. During the late 1980s worldwide demand approximated available supply and the major producers, including Kronos, were operating at or near available capacity. In the past few years, supply has exceeded demand, in part due to new chloride process capacity coming on-stream. Relative supply/demand relationships, which had a favorable impact on industry-wide prices during the late 1980s, have had a negative impact since prices peaked in early 1990. Worldwide capacity additions in the TiO2 market are slow to develop because of the significant capital expenditures and substantial lead time (typically three to five years in the Company's experience) for, among other things, planning, obtaining environmental approvals and construction. Kronos competes primarily on the basis of price, product quality and technical service, and the availability of high performance pigment grades. Although certain TiO2 grades are considered specialty pigments, the majority of grades and substantially all of Kronos' production are considered commodity pigments with price generally being the most significant competitive factor. Kronos has an estimated worldwide TiO2 market share of 11%, and believes that it is the leading marketer of TiO2 in a number of countries, including Germany and Canada. Kronos' principal competitors are E.I. du Pont de Nemours & Co. ("DuPont"); Imperial Chemical Industries PLC (Tioxide); Hanson PLC (SCM Chemicals); Kemira Oy; Bayer AG; and Ishihara Sangyo Kaisha, Ltd.. These six competitors have estimated individual worldwide market shares ranging from 5% to 21%, and an estimated aggregate 65% share. DuPont has over one-half of total U.S. TiO2 production capacity and is Kronos' principal North American competitor. Kronos has substantially completed a major environmental protection and improvement program commenced in the early 1980s to replace or modify its - 4 - European TiO2 production facilities for compliance with various environmental laws by their respective effective dates. All of Kronos' European plants now use either the low-waste yielding chloride process, or the sulfate process with reprocessing or neutralization of waste acid. Kronos has commenced construction of a $25 million waste acid neutralization facility for its Canadian sulfate process TiO2 plant, which is expected to be completed in mid-1994. Although these upgrades increased operating costs, they are expected to reduce future capital expenditures that Kronos would otherwise need to incur as environmental standards are increased. The Company believes that certain competitors have not upgraded their facilities and are expected to do so in the future or be forced to curtail production due to lack of environmental compliance. See "Regulatory and Environmental Matters". RHEOX PRODUCTS AND OPERATIONS Rheological additives control the flow and leveling characteristics for a variety of products, including paints, inks, lubricants, sealants, adhesives and cosmetics. Organoclay rheological additives are clays which have been chemically reacted with organic chemicals and compounds. Rheox produces rheological additives for both solvent-based and water-based systems. Rheox is the world's largest producer of rheological additives for solvent-based systems, supplying, the Company believes, approximately 40% of the worldwide market, and is also a supplier of rheological additives used in water-based systems. Rheological additives for solvent-based systems accounted for approximately 90% of Rheox's sales in 1993, with the remainder being principally rheological additives for water-based systems. Rheox introduced a number of new products during the past three years, many of which are for water-based systems, which currently represent a larger portion of the market than solvent-based systems and which the Company believes, in the long term, will account for an increasing portion of the market. Rheox also focused on product development for environmental applications with new products introduced for de-inking recycled paper and soil stabilization at contaminated sites. Sales of rheological additives generally follow overall economic growth in Rheox's principal markets and are influenced by the volume of shipments of the worldwide coatings industry. Since Rheox's rheological additives are also used in industrial coatings, plant and equipment spending also has an influence on demand for this product line. MANUFACTURING PROCESS AND RAW MATERIALS The primary raw materials utilized in the production of rheological additives are bentonite clays, hectorite clays, quaternary amines, polyethylene waxes and castor oil derivatives. Bentonite clays are currently purchased under a three-year contract, renewable through 2004, with a subsidiary of Dresser Industries, Inc. ("Dresser"), which has significant bentonite reserves in Wyoming. This contract assures Rheox the right to purchase its anticipated requirements of bentonite clays for the foreseeable future and Dresser's reserves are believed to be sufficient for such purpose. Hectorite clays are mined from Company-owned reserves in Newberry Springs, California, which the Company believes are adequate to supply its needs for the foreseeable future. The Newberry Springs ore body contains the largest known commercial deposit of hectorite clays in the world. Quaternary amines are purchased primarily from a joint venture company 50%-owned by Rheox and are also generally available on the open market from a number of suppliers. Castor oil-based rheological additives - 5 - are purchased from sources in the United States and abroad. Rheox has a supply contract with a manufacturer of these products which may not be terminated without 180 days notice by either party. COMPETITION Competition in the specialty chemicals industry is generally concentrated in the areas of product uniqueness, quality and availability, technical service, knowledge of end-use applications and price. Rheox's principal competitors for rheological additives for solvent-based systems are Laporte PLC, Sud-Chemie AG and Akzo NV. Rheox's principal competitors for water-based systems are Rohm and Haas Company, Hercules Incorporated, The Dow Chemical Company and Union Carbide Corporation. RESEARCH AND DEVELOPMENT The Company's annual expenditures for research and development and technical support programs have averaged approximately $10 million annually during the past three years with Kronos accounting for approximately three-quarters of the annual total. Research and development activities related to TiO2 are conducted principally at the Leverkusen, Germany facility. Such activities are directed primarily toward improving both the chloride and sulfate production processes, improving product quality and strengthening Kronos' competitive position by developing new pigment applications. Activities relating to rheological additives are conducted primarily in the United States and are directed towards the development of new products for water-based systems, environmental applications and new end-use applications for existing product lines. PATENTS AND TRADEMARKS Patents held for products and production processes are believed to be important to the Company and contribute to the continuing business activities of Kronos and Rheox. The Company continually seeks patent protection for its technical developments, principally in the United States, Canada and Europe, and from time to time enters into licensing arrangements with third parties. In connection with the formation of the manufacturing joint venture with Tioxide, Kronos and certain of its subsidiaries exchanged proprietary chloride process and product technologies with Tioxide and certain of its affiliates. Use by each recipient of the other's technology in Europe is restricted until October 1996. See "Kronos - TiO2 manufacturing joint venture". The Company's major trademarks, including Kronos, Titanox and Rheox, are protected by registration in the United States and elsewhere with respect to those products it manufactures and sells. FOREIGN OPERATIONS The Company's chemical businesses have operated in international markets since the 1920s. Most of Kronos' current production capacity is located in Europe and Canada, and approximately one-third of Rheox's sales in the past three years have been attributable to European production. Approximately three-quarters of the Company's 1993 consolidated sales were attributable to non-U.S. customers, including 12% attributable to customers in areas other than Europe and Canada. See Note 3 to the Consolidated Financial Statements. Political and economic uncertainties in certain of the countries in which the Company operates may expose it to risk of loss. The Company does not believe - 6 - that there is currently any likelihood of material loss through political or economic instability, seizure, nationalization or similar event. The Company cannot predict, however, whether events of this type in the future could have a material effect on its operations. NL's manufacturing and mining operations are also subject to extensive and diverse environmental regulation in each of the foreign countries in which they operate. See "Regulatory and Environmental Matters". CUSTOMER BASE AND SEASONALITY The Company believes that neither its aggregate sales nor those of any of its principal product groups are concentrated in or materially dependent upon any single customer or small group of customers. Neither the Company's business as a whole nor that of any of its principal product groups is seasonal to any significant extent. Due in part to the increase in paint production in the spring to meet the spring and summer painting season demand, TiO2 sales are generally higher in the second and third calendar quarters than in the first and fourth calendar quarters. Sales of rheological additives are influenced by the worldwide industrial protective coatings industry, where second calendar quarter sales are generally the strongest. EMPLOYEES As of December 31, 1993, the Company employed approximately 3,200 persons, excluding the joint venture employees, with approximately 400 employees in the United States and approximately 2,800 at sites outside the United States. Hourly employees in production facilities worldwide are represented by a variety of labor unions, with labor agreements having various expiration dates. The Company believes its labor relations are good. REGULATORY AND ENVIRONMENTAL MATTERS Certain of the Company's businesses are and have been engaged in the handling, manufacture or use of substances or compounds that may be considered toxic or hazardous within the meaning of applicable environmental laws. As with other companies engaged in similar businesses, certain past and current operations and products of the Company have the potential to cause environmental or other damage. The Company has implemented and continues to implement various policies and programs in an effort to minimize these risks. The policy of the Company is to achieve compliance with applicable environmental laws and regulations at all its facilities and to strive to improve environmental performance. It is possible that future developments, such as stricter requirements of environmental laws and enforcement policies thereunder, could affect the Company's production, handling, use, storage, transportation, sale or disposal of such substances. The Company's U.S. manufacturing operations are governed by federal environmental and worker health and safety laws and regulations, principally the Resource Conservation and Recovery Act, the Occupational Safety and Health Act, the Clean Air Act, the Clean Water Act, the Safe Drinking Water Act, the Toxic Substances Control Act and the Comprehensive Environmental Response, Compensation and Liability Act, as amended by the Superfund Amendments and Reauthorization Act ("CERCLA"), as well as the state counterparts of these statutes. The Company believes that all of its U.S. plants and the Louisiana plant owned and operated by the joint venture are in substantial compliance with applicable requirements of these laws. From time to time, the Company's facilities may be subject to environmental regulatory enforcement under such statutes. Resolution of such - 7 - matters typically involves the establishment of compliance programs. Occasionally, resolution may result in the payment of penalties, but to date such penalties have not involved amounts having a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. The Company's European and Canadian production facilities operate in an environmental regulatory framework in which governmental authorities typically are granted broad discretionary powers which allow them to issue operating permits required for the plants to operate. The Company believes all its European plants are in substantial compliance with applicable environmental laws. While the laws regulating operations of industrial facilities in Europe vary from country to country, a common regulatory denominator is provided by the European Union (the "EU"). Germany, Belgium and the United Kingdom, members of the EU, follow the initiatives of the EU. Norway, although not a member, generally patterns its environmental regulatory actions after the EU. The Company believes Kronos is in substantial compliance with agreements reached with European environmental authorities and with an EU directive to control the effluents produced by TiO2 production facilities. The Company believes Rheox is in substantial compliance with the environmental regulations in Germany and the United Kingdom. In order to reduce sulfur dioxide emissions into the atmosphere, Kronos is installing off-gas desulfurization systems at its German plants at an estimated cost of $24 million. The manufacturing joint venture is installing an off-gas desulfurization system at the Louisiana plant at an estimated cost of $15 million. The German systems are scheduled to be completed in 1996 and the Louisiana system is scheduled for completion in 1995. Kronos' ilmenite mine near Hauge i Dalane had a permit for the offshore disposal of tailings through February 1994. In February 1994, Kronos completed the $15 million onshore disposal system to replace the offshore disposal of tailings. Onshore disposal will result in a modest increase in the mine's operating costs. The Quebec provincial government is an environmental regulatory body with authority over Kronos' Canadian TiO2 production facilities in Varennes, Quebec, which currently consist of plants utilizing both the chloride and sulfate process technologies. The provincial government regulates discharges into the St. Lawrence River. In May 1992, the Quebec provincial government extended Kronos' right to discharge effluents from its Canadian sulfate process TiO2 plant into the St. Lawrence River until June 1994, at which time Kronos' new $25 million waste acid neutralization facility is expected to be completed. In January 1993, the Quebec provincial government granted a permit to Kronos to construct the facility and established the future permit parameters, which Kronos will be required to meet upon completion of the facility. Notwithstanding the above-described agreement, in March 1993 Kronos' Canadian subsidiary and two of its directors were charged by the Canadian federal government with five violations of the Canadian Fisheries Act relating to discharges into the St. Lawrence River from the Varennes sulfate process TiO2 production facility. The penalty for these violations, if proven, could be up to Canadian $15 million. Additional charges, if brought, could involve additional penalties. The Company has moved to dismiss the case on constitutional grounds. The Company believes that this charge is inconsistent with the extension granted by provincial authorities, referred to above. - 8 - The Company's future capital expenditures related to its ongoing environmental protection and improvement program are currently expected to be approximately $75 million, including $30 million in 1994. The Company has been named as a defendant, PRP, or both, pursuant to CERCLA and similar state laws, in approximately 80 governmental enforcement and private actions associated with waste disposal sites and facilities currently or previously owned, operated or used by the Company, many of which are on the U.S. Environmental Protection Agency's Superfund National Priorities List or similar state lists. See Item 3 - "Legal Proceedings". ITEM 2. ITEM 2. PROPERTIES Kronos currently operates four TiO2 facilities in Europe (Leverkusen and Nordenham, Germany; Langerbrugge, Belgium; and Fredrikstad, Norway), a facility in Varennes, Quebec, Canada and through the manufacturing joint venture described above, a one-half interest in a plant in Lake Charles, Louisiana which commenced production in 1992. Prior to October 1993, Kronos owned all of the Louisiana plant. Kronos' principal German operating subsidiary leases the land under its Leverkusen TiO2 production facility pursuant to a lease expiring in 2050. The Leverkusen facility, with approximately one-third of Kronos' current TiO2 production capacity, is located within the lessor's extensive manufacturing complex, and Kronos is the only unrelated party so situated. Under a separate supplies and services agreement, which expired in 1991 and to which an extension through 2011 has been agreed in principle, the lessor provides some raw materials, auxiliary and operating materials and utilities services necessary to operate the Leverkusen facility. Kronos and the lessor are continuing discussions regarding a definitive agreement for the extension of the supplies and services agreement. Both the lease and the supplies and services agreement restrict Kronos' ability to transfer ownership or use of the Leverkusen facility. All of Kronos' principal production facilities described above are owned, except for the land under the Leverkusen facility. Kronos has a governmental concession through 2007 to operate its ilmenite mine in Norway. Specialty chemicals are produced by Rheox at facilities in Charleston, West Virginia; Newberry Springs, California; St. Louis, Missouri; Livingston, Scotland and Nordenham, Germany. All of such production facilities are owned. ITEM 3. ITEM 3. LEGAL PROCEEDINGS LEAD PIGMENT LITIGATION The Company was formerly involved in the manufacture of lead pigments for use in paint and lead-based paint. The Company has been named as a defendant or third party defendant in various legal proceedings alleging that the Company and other manufacturers are responsible for personal injury and property damage allegedly associated with the use of lead pigments. The Company is vigorously defending such litigation. Considering the Company's previous involvement in the lead pigment and lead-based paint businesses, there can be no assurance that additional litigation, similar to that described below, will not be filed. In addition, various legislation and administrative regulations have, from time to time, been enacted or proposed at the state, local and federal levels that seek - 9 - to (a) impose various obligations on present and former manufacturers of lead pigment and lead-based paint with respect to asserted health concerns associated with the use of such products and (b) effectively overturn court decisions in which the Company and other pigment manufacturers have been successful. One such bill that would subject lead pigment manufacturers to civil liability for damages caused by lead- based paint on the basis of market share, and extends certain statutes of limitations, passed the Massachusetts House of Representatives in 1993. The same bill has been reintroduced in the Massachusetts legislature in 1994. No legislation or regulations have been enacted to date which are expected to have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. The Company has not accrued any amounts for the pending lead pigment litigation. Although no assurance can be given that the Company will not incur future liability in respect of this litigation, based on, among other things, the results of such litigation to date, the Company believes that the pending lead pigment litigation is without merit. Any liability that may result is not reasonably capable of estimation. In 1987, an action was filed against the Company and other defendants for injuries allegedly caused by lead pigment purportedly supplied by the defendants (Spriggs v. Sherwin-Williams, et al., No. LE3121-5-87 Housing Court of Massachusetts, Hampden County). The complaint sought compensatory and punitive damages for alleged negligent product design, failure to warn, breach of warranty, and concert of action from the Company, other alleged manufacturers of lead pigment (together with the Company, the "pigment manufacturers") and the Lead Industries Association (the "LIA"). In November 1993, a stipulation of dismissal with prejudice was filed with the court. In July 1992, the Company was served with a complaint entitled Boston Housing Authority v. Sherwin-Williams Company, C.A. No. 92-10624- Y, United States District Court for the District of Massachusetts. The complaint asserted a claim for contribution from the Company, other pigment manufacturers and the LIA based on their alleged negligence in product design, manufacture and distribution; negligent failure to warn; breach of warranty; aiding and abetting; and conspiracy. The plaintiff sought contribution to its $1.45 million cost of settling a claim by an individual who was allegedly injured by exposure to lead pigment in the period from 1973 to 1977. In November 1993, the parties filed a stipulation of dismissal with prejudice with the court. In November and December 1990, the Company and others were served with third-party complaints in actions entitled Coren, et al. v. Cardozo v. Sherwin-Williams, et al. (No. 29101) and Pacheco, et al. v. Ortiz v. The Sherwin-Williams Company, et al. (No. 90-3067-B) in the Housing Court of Massachusetts, Suffolk County. The third-party complaints against the pigment manufacturers and the LIA contain allegations similar to those in the Spriggs action and also seek contribution and indemnification for any relief awarded to plaintiffs. In Coren, the third-party defendants removed the case to federal court. In 1992, the federal court dismissed the direct claims and remanded the indemnification and contribution claims to the housing court. Thereafter, the housing court granted the third-party defendants' motion to stay discovery, pending trial on the main action. The Company has answered the third-party complaint, denying all allegations of wrongdoing. In Pacheco, plaintiffs settled with the defendant landlords for less than $100,000. The third-party claims are in discovery. Third-party plaintiffs have proposed a stay of this matter pending the outcome of the appeal in another personal injury action, which was thereafter resolved in the Company's favor. In October 1991, the Company and others were served with a third-party - 10 - complaint by the owner of the plaintiff's apartment in an action entitled Barros v. Pires v. Sherwin-Williams Co., et al., (Civ. No. 01011), in the Housing Court of Massachusetts, Suffolk County. The third party complaint against the pigment manufacturers and the LIA alleges negligent product design, negligent failure to warn, breach of warranty, aiding and abetting, and concert of action, and also seeks contribution and indemnification for any relief awarded to plaintiff for damages allegedly suffered due to exposure to lead-based paint. In May 1992, the court granted the third-party defendants' motion to dismiss. In June 1992, the third-party plaintiffs moved for reconsideration or for reversal of the dismissal. In 1989 and 1990, the Housing Authority of New Orleans ("HANO") filed third-party complaints for indemnity and/or contribution against the pigment manufacturers and the LIA in 14 actions commenced by residents of HANO units seeking compensatory and punitive damages for injuries allegedly caused by lead pigment. The actions are pending in the Civil District Court for the Parish of Orleans, State of Louisiana. Subsequently, HANO agreed to dismiss all such complaints and to consolidate them for purposes of appeal. In March 1992, the Louisiana Court of Appeals, Fourth Circuit, dismissed HANO's appeal as untimely with respect to three of these cases. With respect to the other eight cases also included in the appeal, the court of appeals reversed the lower court decision dismissing the cases due to inadequate pleading of facts. These eight cases have been remanded to the district court for further proceedings. Discovery is proceeding. In December 1991, the Company received a copy of a complaint filed in the Civil District Court for the Parish of Orleans seeking indemnification and/or contribution against the Company and eight other defendants for approximately $4.5 million in settlements paid to Housing Authority residents (Housing Authority of New Orleans v. Hoechst Celanese Corp., et al., No. 91-28067). These claims appear to be based upon the same theories which HANO had previously filed. The Company has not been served. In June 1989, a complaint was filed in the Supreme Court of the State of New York, County of New York, against the pigment manufacturers and the LIA. Plaintiffs seek damages, contribution and/or indemnity in an amount in excess of $50 million for monitoring and abating alleged lead paint hazards in public and private residential buildings, diagnosing and treating children allegedly exposed to lead paint in city buildings, the costs of educating city residents to the hazards of lead paint, and liability in personal injury actions against the City and the Housing Authority based on alleged lead poisoning of city residents (The City of New York, the New York City Housing Authority and the New York City Health and Hospitals Corp. v. Lead Industries Association, Inc., et al., No. 89-4617). In December 1991, the court granted the defendants' motion to dismiss claims alleging negligence and strict liability and denied the remainder of the motion. In January 1992, defendants appealed the denial. The Company has answered the remaining portions of the complaint denying all allegations of wrongdoing, and the case is in discovery. In December 1992, plaintiffs filed a motion to stay the claims of the City of New York and the New York City Health and Hospitals Corporation pending resolution of the Housing Authority's claim. In May 1993, the Appellate Division of the Supreme Court affirmed the denial of the motion to dismiss plaintiffs' fraud, restitution, conspiracy and concert of action claims. In August 1993, the defendants' motion for leave to appeal was denied. Discovery is proceeding. In March 1992, the Company was served with a complaint in Skipworth v. - 11 - Sherwin-Williams Co., et al. (No. 92-3069), Court of Common Pleas, Philadelphia County. Plaintiffs are a minor and her legal guardians seeking damages from lead paint and pigment producers, the LIA, the PHA and the owners of the plaintiffs' premises for bodily injuries allegedly suffered by the minor from lead-based paint. Plaintiffs' counsel asserted that approximately 200 similar complaints would be served shortly, but no such complaints have yet been served. Defendants moved to dismiss various claims, but the court dismissed only the claim for loss of consortium. Defendants answered the complaint denying allegations of wrongdoing. The case is in discovery. In August 1992, the Company was named as a defendant and served with an amended complaint in Jackson, et al. v. The Glidden Co., et al., Court of Common Pleas, Cuyahoga County, Cleveland, Ohio (Case No. 236835). Plaintiffs seek compensatory and punitive damages for personal injury caused by the ingestion of lead, and an order directing defendants to abate lead-based paint in buildings. Plaintiffs purport to represent a class of similarly situated persons throughout the State of Ohio. The amended complaint identifies 18 other defendants who allegedly manufactured lead products or lead-based paint, and asserts causes of action under theories of strict liability, negligence per se, negligence, breach of express and implied warranty, fraud, nuisance, restitution, and negligent infliction of emotional distress. The complaint asserts several theories of liability including joint and several, market share, enterprise and alternative liability. In October 1992, the Company and the other defendants moved to dismiss the complaint with prejudice. In July 1993, the court dismissed the complaint. In September 1993, the plaintiffs appealed. In November 1993, the Company was served with a complaint in Brenner, et al. v. American Cyanamid, et al., Supreme Court, State of New York, Erie County alleging injuries to two children purportedly caused by lead pigment. The complaint seeks $24 million in compensatory and $10 million in punitive damages for alleged negligent failure to warn, strict products liability, fraud and misrepresentation, concert of action, civil conspiracy, enterprise liability, market share liability, and alternative liability. In January 1994, the Company answered the complaint, denying liability. The Company believes that the foregoing lead pigment actions are without merit and intends to continue to deny all allegations of wrongdoing and liability and to defend such actions vigorously. The Company has filed declaratory judgment actions against various insurance carriers seeking costs of defense and indemnity coverage for certain of its environmental and lead pigment litigation. NL Industries, Inc. v. Commercial Union Insurance Cos., et al., Nos. 90-2124, -2125 (HLS). In May 1990, the Company filed an action in the United States District Court for the District of New Jersey against Commercial Union Insurance Company ("Commercial Union") seeking to recover defense costs incurred in the City of New York lead pigment case and two other cases which have since been resolved in the Company's favor. In July 1991, the court granted the Company's motion for summary judgment and ordered Commercial Union to pay the Company's reasonable defense costs for such cases. In June 1992, the Company filed an amended complaint in the United States District Court for the District of New Jersey against Commercial Union seeking to recover costs incurred in defending four additional lead pigment cases which have since been resolved in the Company's favor. In August 1993, the court granted the Company's motion for summary judgment and ordered Commercial Union to pay the reasonable costs of defending those cases. The court has not made any rulings on defense costs or indemnity coverage with respect to the Company's pending environmental litigation or on indemnity coverage in the lead pigment - 12 - litigation. No trial dates have been set. Other than rulings to date, the issue of whether insurance coverage for defense costs or indemnity or both will be found to exist depends upon a variety of factors, and there can be no assurance that such insurance coverage will exist in other cases. The Company has not included amounts in any accruals in anticipation of insurance coverage for lead pigment or environmental litigation. ENVIRONMENTAL MATTERS AND LITIGATION The Company has been named as a defendant, PRP, or both, pursuant to CERCLA and similar state laws in approximately 80 governmental and private actions associated with waste disposal sites and facilities currently or previously owned, operated or used by the Company, or its subsidiaries, or their predecessors, many of which are on the U.S. Environmental Protection Agency's ("U.S. EPA") Superfund National Priorities List or similar state lists. These proceedings seek cleanup costs, damages for personal injury or property damage, or both. Certain of these proceedings involve claims for substantial amounts. Although the Company may be jointly and severally liable for such costs, in most cases, it is only one of a number of PRPs who are also jointly and severally liable. In addition to the matters noted above, certain current and former facilities of the Company, including several divested secondary lead smelter and former mining locations, are the subject of environmental investigations or litigation arising out of industrial waste disposal practices and mining activities. The extent of CERCLA liability cannot be determined until the Remedial Investigation and Feasibility Study ("RIFS") is complete, the U.S. EPA issues a record of decision and costs are allocated among PRPs. The extent of liability under analogous state cleanup statutes and for common law equivalents are subject to similar uncertainties. The Company believes it has provided adequate accruals for reasonably estimable costs for CERCLA matters and other environmental liabilities. At December 31, 1993, the Company had accrued $70 million in respect of those environmental matters which are reasonably estimable. The Company determines the amount of accrual on a quarterly basis by analyzing and estimating the range of possible costs to the Company. Such costs include, among other things, remedial investigations, monitoring, studies, clean-up, removal and remediation. It is not possible to estimate the range of costs for certain sites. The Company has estimated that the upper end of the range of reasonably possible costs to the Company for sites for which it is possible to estimate costs is approximately $105 million. No assurance can be given that actual costs will not exceed accrued amounts or the upper end of the range for sites for which estimates have been made, and no assurance can be given that costs will not be incurred with respect to sites as to which no estimate presently can be made. The imposition of more stringent standards or requirements under environmental laws or regulations, new developments or changes respecting site cleanup costs or allocation of such costs among PRPs, or a determination that the Company is potentially responsible for the release of hazardous substances at other sites could result in expenditures in excess of amounts currently estimated by the Company to be required for such matters. Further, there can be no assurance that additional environmental matters will not arise in the future. More detailed descriptions of certain legal proceedings relating to environmental matters are set forth below. The Company has been identified as a PRP by the U.S. EPA because of its former ownership of three secondary lead smelters (battery recycling plants) in Pedricktown, New Jersey; Granite City, Illinois; and Portland, Oregon. In all three matters, the Company voluntarily entered into administrative consent orders - 13 - with the U.S. EPA requiring the performance of a RIFS, a study with the objective of identifying the nature and extent of the hazards, if any, posed by the sites, and selecting a remedial action, if necessary. At Pedricktown, the U.S. EPA divided the site into two operable units. Operable unit one covers contaminated ground water, surface water, soils and stream sediments. The Company submitted the final RIFS for operable unit one to the U.S. EPA in May 1993. In July 1993, the U.S. EPA issued the proposed remediation plan for operable unit one, which the U.S. EPA estimates will cost approximately $24.5 million. In addition, the U.S. EPA proposed that a removal action be performed on the soils and sediments of a stream at the site, estimated to cost approximately $1.3 million. The U.S. EPA has not yet issued the record of decision. The U.S. EPA issued a Unilateral Administrative Order (Index No. II-CERCLA 20205) with respect to operable unit two in March 1992 to the Company and 30 other PRPs directing immediate removal activities including the cleanup of waste, surface water and building surfaces. The Company has agreed to pay approximately 50% of the operable unit two costs, up to $2.5 million. At Granite City, the RIFS is complete, and the U.S. EPA selected a remedy estimated to cost approximately $28 million. In July 1991, the United States filed an action in the U.S. District Court for the Southern District of Illinois against the Company and others (United States of America v. NL Industries, Inc., et al., Civ. No. 91-CV 00578) with respect to the Granite City smelter. The complaint seeks injunctive relief to compel the defendants to comply with an administrative order issued pursuant to CERCLA, and fines and treble damages for the alleged failure to comply with the order. The Company and the other parties did not comply with the order believing that the remedy selected by the U.S. EPA was invalid, arbitrary, capricious and not in accordance with law. The complaint also seeks recovery of past costs of $.3 million and a declaration that the defendants are liable for future costs. Although the action was filed against the Company and ten other defendants, there are 330 other PRPs who have been notified by the U.S. EPA. Some of those notified were also respondents to the administrative order. In February 1992, the court entered a case management order directing that the remedy issues be tried before the liability aspects are presented. At a status conference in January 1993, the court ordered the parties to consider the submission of proposals to a Technical Advisory Committee, whose role would be to advise the court as to the technical issues in the case. The government has opposed the establishment of a Technical Advisory Committee. The court has not ruled on the matter. The government has agreed to reopen the administrative record to receive additional public comments on the selected remedy and the court stayed the action until the record is again closed. Having completed the RIFS at Portland, the Company conducted predesign studies to explore the viability of the U.S. EPA's selected remedy pursuant to a June 1989 consent decree captioned U.S. v. NL Industries, Inc., Civ. No. 89-408, United States District Court for the District of Oregon. Subsequent to the completion of the predesign studies, the U.S. EPA issued notices of potential liability to approximately 20 PRPs, including the Company, directing them to perform the remedy, which was initially estimated to cost approximately $17 million, exclusive of administrative and overhead costs and any additional costs for the disposition of recycled materials from the site. In January 1992, the U.S. EPA issued unilateral administrative orders Docket No. 1091-01-10-106 to the Company and six other PRPs directing the performance of the remedy. The Company and others have commenced performance of the remedy and, through December 31, 1993, the Company and the PRPs had spent approximately $5.5 million. Based upon - 14 - site operations to-date, the remedy is not proceeding in accordance with engineering expectations or cost projections; therefore, the Company and the other PRPs have met with the U.S. EPA to discuss alternative remedies. Pursuant to an interim allocation, the Company's share of remedial costs is approximately 50%. In November 1991, Gould Inc., the current owner of the site, filed an action, Gould Inc. v. NL Industries, Inc., No. 91-1091, United States District Court for the District of Oregon, against the Company for damages for alleged fraud in the sale of the smelter, rescission of the sale, past CERCLA response costs and a declaratory judgment allocating future response costs and $5 million in punitive damages. The court granted Gould's motion to amend the complaint to add additional defendants (adjoining current and former landowners) and third party defendants (generators). The amended complaint deletes the fraud and punitive damages claims asserted against NL; thus, the pending action is essentially one for allocation of past and future cleanup costs. In March 1993, the parties agreed to a case management order limiting discovery until 1995, after which time full discovery will proceed. A trial date has been tentatively set for September 1996. There are several actions pending relating to alleged contamination at other properties formerly owned or operated by the Company or its subsidiaries or their predecessors. In one of those cases, suit was filed in November 1992 against the Company asserting claims arising out of the sale of a former business of the Company to Exxon Chemical Company (Exxon Chemical Company v. NL Industries, Inc., United States District Court for the Southern District of Texas, No. H-92-3360). The action seeks contractual indemnification, contribution under CERCLA for costs associated with the environmental assessment and cleanup at nine properties included in the sale, a declaration of liability for future environmental cleanup costs, and punitive damages for fraud. Plaintiff has asserted that past and future cleanup costs, business interruption, and asset value losses and legal and site assessment costs are approximately $25 million. In February 1994, the court entered an order referring the case to mediation which is to occur by April 1994. The Company and other PRPs entered into an administrative consent order with the U.S. EPA requiring the performance of a RIFS at two sites in Cherokee County, Kansas, where the Company and others formerly mined lead and zinc. The Company mined at the Baxter Springs subsite, where it is the largest viable PRP. The final RIFS was submitted to the U.S. EPA in May 1993. The estimated cost of proposed remedies at the Baxter Springs subsite ranges from approximately $1 million to $28 million, plus annual operation and maintenance costs. In January 1989, the State of Illinois brought an action against the Company and several other subsequent owners and operators of the former lead oxide plant in Chicago, Illinois (People of the State of Illinois v. NL Industries, et al., No. 88-CH-11618, Circuit Court, Cook County). The complaint seeks recovery of $2.27 million of cleanup costs expended by the Illinois Environmental Protection Agency, plus penalties and treble damages. In October 1992, the Supreme Court of Illinois reversed the Appellate Division, which had affirmed the trial court's earlier dismissal of the complaint, and remanded the case for further proceedings. In December 1993, the trial court denied the State's petition to reinstate the complaint, and dismissed the case with prejudice. In February 1994, the State filed a notice of appeal. In 1980, the State of New York commenced litigation against the Company in connection with the operation of a plant in Colonie, New York formerly owned by the Company. Flacke v. NL Industries, Inc., No. 1842-80 ("Flacke I") and Flacke v. Federal Insurance Company and NL Industries, Inc., No. 3131-92 ("Flacke II"), New York Supreme Court, Albany County. The plant manufactured military and - 15 - civilian products from depleted uranium and was acquired from the Company by the U.S. Department of Energy ("DOE") in 1984. Flacke I seeks penalties for alleged violations of New York's Environmental Conservation Law, and of a consent order entered into to resolve these alleged violations. Flacke II seeks forfeiture of a $200,000 surety bond posted in connection with the consent order, plus interest from February 1980. The Company denied liability in both actions. The litigation had been inactive since 1984. In July 1993, the State moved for partial summary judgment for approximately $1.5 million on certain of its claims in Flacke I and for summary judgment in Flacke II. In January 1994, the Company cross-moved for summary judgment in Flacke I and Flacke II. Residents in the vicinity of the Company's former Philadelphia lead chemicals plant commenced a class action allegedly comprised of over 7,500 individuals seeking medical monitoring and damages allegedly caused by emissions from the plant. Wagner, et al. v. Anzon and NL Industries, Inc., No. 87-4420, Court of Common Pleas, Philadelphia County. The complaint seeks compensatory and punitive damages from the Company and the current owner of the plant, and alleges causes of action for, among other things, negligence, strict liability, and nuisance. A class was certified to include persons who reside, owned or rented property, or who work or have worked within up to approximately three- quarters of a mile from the plant from 1960 through the present. The Company has answered the complaint, denying liability. The case is in discovery. Residents also filed consolidated actions in the United States District Court for the Eastern District of Pennsylvania, Shinozaki v. Anzon, Inc. and Wagner and Antczak v. Anzon and NL Industries, Inc. Nos. 87-3441 and 87-3502. The consolidated action is a putative class action seeking CERCLA response costs, including cleanup and medical monitoring, declaratory and injunctive relief and civil penalties for alleged violations of the Resource Conservation and Recovery Act ("RCRA"), and also asserting pendent common law claims for strict liability, trespass, nuisance and punitive damages. The court dismissed the common law claims without prejudice, dismissed two of the three RCRA claims as against the Company with prejudice, and stayed the case pending the outcome of the state court litigation. The trial is set for June 1994. In July 1991, a complaint was filed in the United States District Court for the Central District of California, United States of America v. Peter Gull and NL Industries, Inc., Civ. No. 91-4098. The complaint seeks to recover $2 million in costs incurred by the United States in response to the alleged release of hazardous substances into the environment from a facility located in Norco, California, treble damages and $1.75 million in penalties for the Company's alleged failure to comply with the U.S. EPA's administrative order No. 88-13. The order, which alleged that the Company arranged for the treatment or disposal of materials at the Norco site, directed the immediate removal of hazardous substances from the site. The Company carried out a portion of the remedy at the Norco site, but did not complete the ordered activities because it believed they were in conflict with California law. The Company answered the complaint denying liability. The government now claims it expended in excess of $2.7 million for this matter. Trial was held in March and April 1993. The judge has preliminarily indicated that the Company will be ordered to pay response costs plus an amount which is the product of a multiplier of 1.625 to be applied to a portion of those costs, which amount has not yet been determined. In May 1993, the government submitted Proposed Supplemental Findings of Fact and Conclusions of Law Regarding Response Costs and Penalty Amount stating that the amount owed is $6.7 million. The Company's response states that the total of recoverable response costs and penalty is $6.4 million. The Court has not yet entered final judgment in this matter. - 16 - At a municipal and industrial waste disposal site in Batavia, New York, the Company and six others have been identified as PRPs. The U.S. EPA has divided the site into two operable units. Pursuant to an administrative consent order entered into with the U.S. EPA, the Company is conducting a RIFS for operable unit one, the closure of the industrial waste disposal section of the landfill. The Company's RIFS costs to date are approximately $1.9 million. With respect to the second operable unit, the extension of the municipal water supply, the U.S. EPA estimated the costs at $1 million plus annual operation and maintenance costs. The Company and the other PRPs are performing the work comprising operable unit two. The U.S. EPA has also demanded approximately $.9 million in past costs from the PRPs. In July 1990, the Company notified the U.S. EPA that it was investigating the possibility that certain chemicals manufactured during the period in which Kronos owned a former subsidiary were not appropriately listed with the U.S. EPA pursuant to the Toxic Substances Control Act. The Company believes that the manufacture of the chemicals in question was initiated by a prior owner of the subsidiary. The Company intends to cooperate fully with the U.S. EPA in investigating this matter and determining whether any manufacture of non-listed chemicals occurred. If such manufacture is found to have occurred, the U.S. EPA may levy fines against the Company and possibly others. If any fines are levied, the Company will attempt to seek reimbursement from the prior owner of the subsidiary. See Item 1 - "Business - Regulatory and Environmental Matters". OTHER LITIGATION In April 1990, the Company filed a complaint in the United States District Court for the Central District of California against Lockheed Corporation and its directors in connection with Lockheed's 1990 annual meeting of stockholders, (NL Industries, Inc. v. Lockheed Corporation, et al., No. CV-90-1950 RMT (Bx)), which complaint was subsequently amended. In December 1992, a unanimous jury verdict was returned in the Company's favor in the amount of $30 million, which award is a gain contingency not recorded as income by the Company. The jury found that Lockheed violated the federal securities laws by making false and misleading public statements about Lockheed's employee stock ownership plan. Lockheed has appealed. The Company has cross appealed with respect to its claims against Lockheed's directors. On February 24, 1994, the case was settled with a cash payment to the Company by Lockheed of $27 million resulting in net proceeds to the Company of approximately $20 million. In January 1990, an action was filed in the United States District Court for the Southern District of Ohio against NLO, Inc., a subsidiary of the Company, and the Company on behalf of a putative class of former NLO employees and their families and former frequenters and invitees of the Feed Materials Production Center ("FMPC") in Ohio (Day, et al. v. NLO, Inc., et al, No. C-1-90-067). The FMPC is owned by the DOE and was formerly managed under contract by NLO. The complaint seeks damages for, among other things, emotional distress and damage to personal property allegedly caused by exposure to radioactive and/or hazardous materials at the FMPC and punitive damages. A trial was held separately on the defendants' defense that the statute of limitations barred the plaintiffs' claims. In November 1991, the jury returned a verdict against six of the ten named plaintiffs, finding that their claims were time barred. Without denying the plaintiffs' motion to vacate the verdict, the court certified this action as a class action. A merits trial is expected to be held in 1994. Although no assurance can be given, the Company believes that, consistent with a July 1987 - 17 - DOE contracting officer's decision, the DOE will indemnify NLO in the event of an adverse decision just as it did when two previous cases relating to NLO's management of the FMPC were settled; therefore, the resolution of the Day matter is not expected to have a material adverse affect on the Company. In the 1987 decision, the contracting officer affirmed NLO's entitlement to indemnification under its contract for the operation of the FMPC for all liability, including the cost of defense, arising out of those two previous cases. The Company is also involved in various other environmental, contractual, product liability and other claims and disputes incidental to its present and former businesses, and the disposition of past properties and former businesses. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS NL's common stock is listed and traded on the New York and Pacific Stock Exchanges under the symbol "NL". As of February 28, 1994, there were approximately 11,000 holders of record of NL common stock. The following table sets forth the high and low sales prices for NL common stock on the New York Stock Exchange ("NYSE") Composite Tape, and dividends declared during the periods indicated. On February 28, 1994, the closing price of NL common stock according to the NYSE Composite Tape was $8-7/8. ____________________ The Company suspended its regular quarterly dividend in October 1992, in view of, among other things, the continuing weakness in TiO2 prices. The Company's Senior Notes generally limit the ability of the Company to pay dividends to 50% of consolidated net income, as defined, subsequent to October 1993. At December 31, 1993, no amounts were available for dividends. - 18 - ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected consolidated financial data set forth below should be read in conjunction with the Consolidated Financial Statements and Notes thereto, and Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS GENERAL The Company's operations are conducted in two business segments - TiO2 conducted by Kronos and specialty chemicals conducted by Rheox. The future profitability of the Company is dependent upon, among other things, improved pricing for TiO2. Selling prices for TiO2 are significantly influenced by industry capacity and demand. As discussed below, TiO2 selling prices declined significantly from their peak in early 1990, and largely as a result thereof, Kronos' operating income and margins significantly declined during the past three years. In the fourth quarter of 1993, selling prices increased slightly in certain markets. Based on, among other things, the Company's current near-term outlook for its TiO2 business, the Company expects its results for 1994, while improved from 1993, will still result in a net loss for the year. NET SALES AND OPERATING INCOME - 20 - The worldwide TiO2 industry continues to be adversely affected by, among other things, production capacity in excess of current demand. Largely as a result thereof, TiO2 selling prices continued to decline during most of 1993 and Kronos' operating income and margins significantly declined. Recessionary economic conditions in Europe and changes in the relative values of European currencies were principal additional factors influencing demand and pricing levels during 1993. In billing currency terms, Kronos' 1993 average TiO2 selling prices were approximately 8% lower than in 1992 and were 6% lower in 1992 than in 1991. A significant amount of sales are denominated in currencies other than the U.S. dollar, and fluctuations in the value of the U.S. dollar relative to other currencies further decreased 1993 sales by $45 million compared to 1992 and increased 1992 sales by $22 million compared to 1991. Average TiO2 prices at the end of 1993 were approximately 5% below year-end 1992 levels and approximately one-third below those of the last cyclical peak in early 1990. While TiO2 prices are significantly below prior year levels, most of the 1993 decline occurred in the first half of the year as average prices declined only slightly during the third quarter and increased slightly during the fourth quarter. TiO2 sales volume of 346,000 metric tons in 1993 increased 3% compared to 1992, as increases in North American sales volume more than offset weakened demand in Europe. In response to weakened demand, and in order to reduce inventories, Kronos made further reductions in its TiO2 production rates during 1993. TiO2 sales volume increased 11% in 1992 compared to 1991, primarily in U.S. and European markets. Approximately one-half of Kronos' 1993 TiO2 sales, by volume, were attributable to markets in Europe with approximately 38% attributable to North America and the balance to export markets. As a result of continued cost reduction and containment efforts, Kronos' raw material and production costs increased only slightly in 1993 compared to year-ago levels. Start-up costs at the chloride process plant in Lake Charles, Louisiana, which commenced production during the first half of 1992, unfavorably impacted operating income in 1992. Kronos' 1992 operating income was also impacted by slightly lower unit production costs resulting from its continued emphasis on cost reduction efforts and increased production volumes. Kronos' water treatment chemicals business, which utilizes TiO2 co-products, increased its contribution to operating income in 1992 but such contribution was lower in 1993 than in 1992. Demand, supply and pricing of TiO2 have historically been cyclical and, as noted above, the last cyclical peak for TiO2 prices occurred in early 1990. Kronos believes that its operating income and margins for 1994 will be higher than in 1993 due principally to slightly higher sales and production volumes, and the favorable effect of the joint venture. However, the Company expects that the TiO2 industry will continue to operate at lower capacity utilization levels over the next few years relative to the high utilization levels prevalent during the late 1980s, primarily because of the slow recovery from worldwide recession and the impact of capacity additions since the late 1980s. The economic recovery has been particularly slow in Europe, where a significant portion of Kronos' TiO2 manufacturing facilities are located. During the current period of depressed TiO2 prices, the Company has operated with a strategy to maintain its competitive position. During the past three years, Kronos has increased its estimated worldwide market share from 10% to 11%. Kronos has implemented a cost reduction and control program which favorably impacted Kronos' operating results, and Kronos has continued its environmental improvement efforts. In October 1993, the Company formed a manufacturing joint - 21 - venture with Tioxide and refinanced certain debt which, among other things, increased the Company's liquidity, reduced its aggregate debt level and extended its debt maturities. See also "Liquidity and Capital Resources". The manufacturing joint venture, which is equally owned by subsidiaries of Kronos and Tioxide, owns and operates the chloride process TiO2 plant in Lake Charles, Louisiana formerly owned by Kronos. Under the terms of the joint venture and related agreements, Kronos contributed the plant to the joint venture, Tioxide paid an aggregate of approximately $205 million, including its tranche of the joint venture debt, and Kronos and certain subsidiaries exchanged proprietary chloride process and product technologies with Tioxide and certain of its affiliates. Of the total consideration paid by Tioxide, $30 million was attributable to the exchange of technologies and is being reported as a component of operating income ratably over three years from October 1993. Production from the plant is being shared equally by Kronos and Tioxide pursuant to separate offtake agreements. The formation of the joint venture resulted in a 12% decrease in Kronos' total TiO2 production capacity; however, Kronos' remaining capacity is about 10% higher than Kronos' 1993 sales volume. Rheox's operating results have been relatively consistent during the past three years. Changes in currency exchange rates had a negative effect in 1993 and a positive effect in 1992 compared to the respective prior year, and operating costs generally increased during both years. The Company has substantial operations and assets located outside the United States. Foreign operations are subject to currency exchange rate fluctuations and the Company's results of operations have in the past been both favorably and unfavorably affected by the fluctuations in currency exchange rates. To the extent the Company both manufactures and sells in a given country, the impact of currency exchange rate fluctuations is to some extent mitigated. GENERAL CORPORATE The following table sets forth certain information regarding general corporate income (expense). Interest and dividend income fluctuates based upon the amount of funds invested and yields thereon. Amounts available for investment and the yields thereon in 1993 were lower than in 1992 and 1991. After the two unsuccessful attempts to gain representation on the board of directors of Lockheed Corporation, the Company disposed of its interest in Lockheed in 1991, and the significant securities transactions loss in 1991 relates principally to that disposition. Securities transactions in 1992 and 1993 relate principally to U.S. Treasury securities. The Company does not - 22 - anticipate acquiring marketable securities (other than U.S. Treasury or similar securities) in the foreseeable future. The Company adopted the accounting for certain marketable debt and equity securities prescribed by SFAS No. 115 effective December 31, 1993. Accordingly, the timing of recognition of gains and losses related to marketable securities beginning in 1994 will, in certain respects, be different than in prior years. Corporate expenses, net have decreased slightly during each of the past two years. In 1992, reductions in certain proxy solicitation and litigation settlement expenses of $5 million and $9 million, respectively, compared to 1991, were partially offset by an $11 million increase in environmental remediation costs. INTEREST EXPENSE Lower levels of indebtedness in 1993, principally Kronos' Deutsche Mark-denominated bank credit facility, and lower DM interest rates reduced the Company's interest expense in 1993 compared to the 1992 periods. In addition, 1992 interest expense reflected the benefit of $9 million of capitalized interest related principally to the Louisiana plant completed in March 1992. Interest expense increased from 1991 to 1992 due to the net effects of lower average levels of indebtedness, a $17 million decline in capitalized interest and a $9 million reduction in the Company's accrual for income tax related interest in 1991. Overall, the Company expects its October 1993 reduction and refinancing of certain indebtedness will result in a modest decrease in the Company's interest expense. See "Liquidity and Capital Resources". PROVISION FOR INCOME TAXES The principal reasons for the difference between the U.S. federal statutory income tax rates and the Company's effective income tax rates are explained in Note 14 to the Consolidated Financial Statements. The Company's operations are conducted on a worldwide basis and the geographic mix of income can significantly impact the Company's effective income tax rate. In both 1992 and 1993, the geographic mix, including losses in certain jurisdictions for which no current refund was available and in which recognition of a deferred tax asset is not currently considered appropriate, contributed significantly to the Company's effective tax rate varying from a normally expected rate. The Company's deferred income tax status at December 31, 1993 is discussed in "Liquidity and Capital Resources". In 1991, realization of the available capital loss carryback of the Company's securities transactions at a relatively low rate due to the alternative minimum tax rates in prior years also significantly impacted the Company's effective tax rate. EXTRAORDINARY ITEMS See Note 16 to the Consolidated Financial Statements. CHANGES IN ACCOUNTING PRINCIPLES See Notes 2 and 19 to the Consolidated Financial Statements. Statement of Financial Accounting Standards ("SFAS") No. 112, "Employers' Accounting for Postemployment Benefits", requires the accrual method of accounting for benefits provided to former employees after employment but before - 23 - retirement. The Company expects to adopt SFAS No. 112 in the first quarter of 1994. Adoption is not expected to have a material impact on the Company's consolidated financial position, results of operations or liquidity. LIQUIDITY AND CAPITAL RESOURCES The Company's consolidated cash flows provided by operating, investing and financing activities for each of the past three years are presented below. During 1993, the Company's operations continued to use significant amounts of cash. TiO2 production rates were reduced in late 1992 and during 1993 in order to reduce inventory levels. The $30 million received from Tioxide in October 1993 related to the exchange of technologies, which is being recognized as a component of operating income over three years, favorably impacted 1993 cash flow from operating activities. Other relative changes in working capital items, which result principally from the timing of purchases, production and sales, also contributed to the comparative decrease in the Company's cash used by operating activities in 1993. The significant deterioration in the Company's cash flow from operating activities from 1991 to 1992 resulted primarily from the decline in earnings and the relative change in the Company's receivables, inventories and payables. Cash provided by investing activities relates primarily to net sales of marketable securities in each period to fund debt repayments, capital expenditures and operations, and in 1993 includes $161 million net cash generated related to the formation of the manufacturing joint venture with Tioxide. The Company's capital expenditures during the past three years include an aggregate of $204 million related to the completion of the Louisiana chloride process TiO2 plant and an aggregate of $57 million ($30 million in 1993) for the Company's ongoing environmental protection and compliance programs, including a Canadian waste acid neutralization facility, a Norwegian onshore tailings disposal system and off-gas desulfurization systems. The Company's estimated 1994 capital expenditures are $44 million and include $30 million in the area of environmental protection and compliance primarily related to the Canadian waste acid neutralization facility and the German off-gas desulfurization systems. The capital expenditures of the manufacturing joint venture are not included in the Company's capital expenditures. Net repayments of indebtedness in 1993 included payments on the DM bank credit facility of DM 552 million ($342 million when paid), a $110 million net reduction in indebtedness related to the Louisiana plant and $350 million proceeds from the Company's October 1993 public offering of debt, all as - 24 - discussed below. Net repayments of indebtedness in 1992 included payments on the DM term loan aggregating DM 350 million ($225 million when paid) and $61 million drawn under Kronos' Louisiana plant credit facilities. Net borrowings in 1991 included a $115 million Rheox term loan, a $52 million increase in the Louisiana plant term construction loan and a DM 150 million ($87 million when paid) reduction in the DM term loan. NL and Kronos have agreed, under certain conditions, to provide Kronos' principal international subsidiary with up to an additional DM 125 million through January 1, 2001. In October 1993, the Company (i) completed the formation of the manufacturing joint venture with Tioxide, including related refinancing of the Louisiana plant indebtedness, (ii) completed a public offering of $250 million of 11.75% Senior Secured Notes due 2003 and $100 million proceeds ($188 million principal amount at maturity) of 13% Senior Secured Discount Notes due 2005 (collectively, the "Notes"), (iii) prepaid DM 552 million ($342 million when paid) of the DM bank credit facility and amended the DM loan agreement, and (iv) redeemed the remaining $10 million of the Company's 7.5% sinking fund debentures. The DM bank credit facility, as amended, consists of a DM 448 million term loan and a DM 250 million revolving credit facility, of which DM 100 million is outstanding and DM 150 million was available for future borrowings at December 31, 1993. During February 1994, the Company borrowed an additional DM 25 million under the revolving credit facility. The final maturities of the term and revolving portion of the DM credit facility were extended to 1999 and 2000, respectively, with the first payment of the term loan due in 1997. Upon formation, the manufacturing joint venture obtained $216 million in new financing consisting of two equal tranches, one attributable to each Partner, which is serviced through the purchase of the plant's TiO2 output in equal quantities by the Partners. The Partners are required to make capital contributions to the joint venture to pay principal on their respective portion of the joint venture indebtedness. Kronos' pro rata share of the joint venture debt is reflected as outstanding indebtedness of the Company because Kronos has guaranteed the purchase obligation relative to the debt service of its tranche. Formation of the joint venture and related refinancing, issuance of the Notes and prepayment of a portion of the DM bank credit facility significantly improved the Company's liquidity and financial flexibility by (i) increasing cash and cash equivalents by approximately $75 million, (ii) reducing total outstanding indebtedness by approximately $109 million, (iii) providing for approximately DM 150 million of borrowing availability under the revolving portion of the amended DM bank credit facility, (iv) eliminating the near-term principal amortization requirements and extending the remaining principal amortization schedule of the DM bank credit facility, and (v) replacing approximately $100 million of outstanding debt with the Senior Secured Discount Notes which do not require cash interest payments for five years. Financing activities also include treasury stock purchases, including $181 million expended in 1991 in connection with a "Dutch auction" self-tender offer. Dividends paid were $35 million in 1991 and $18 million in 1992. The Company suspended dividend payments in October 1992. - 25 - At December 31, 1993, the Company had cash, cash equivalents and current marketable securities aggregating $148 million (25% held by non-U.S. subsidiaries) including restricted cash and cash equivalents of $18 million. The Company's subsidiaries had $14 million and $117 million available for borrowing at December 31, 1993 under existing U.S. and non-U.S. credit facilities, respectively. The Company has taken and continues to take measures to manage its near-term and long-term liquidity requirements, including cost reduction efforts, tightening of controls over working capital, deferral and reduction of capital expenditures, discontinuance of unrelated business acquisition activities, suspension of dividends, formation of the manufacturing joint venture and the refinancing discussed above. The Company currently expects to have sufficient liquidity to meet near-term obligations including operations, capital expenditures and debt service. A prolonged period of depressed selling prices and continued use of cash by operations would, however, over the long term, have an adverse effect on liquidity and financial condition. Certain of the Company's income tax returns in various U.S. and non-U.S. jurisdictions, including Germany, are being examined and tax authorities have proposed or may propose tax deficiencies. In June 1993, German tax authorities issued assessment reports in connection with examinations of the Company's German income tax returns disallowing the Company's claims for refunds, primarily for 1989 and 1990, aggregating DM 160 million ($92 million at year-end exchange rates), and proposing additional taxes of approximately DM 100 million ($58 million). The Company has applied for administrative relief from collection procedures and may grant a lien on certain German assets while the Company contests the proposed adjustments. Although the Company believes that it will ultimately prevail, in June 1993 the Company reclassified the DM 160 million of refundable income tax claims disallowed by the German tax authorities from current assets to noncurrent assets due to the uncertain timing of a resolution. The Company believes that it has adequately provided accruals for additional income taxes and related interest expense which may ultimately result from such examinations and believes that the ultimate disposition of all such examinations should not have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. Pursuant to the amended DM bank credit facility, any receipt of the refundable German income taxes will be applied ratably to prepay installments of the term portion of the DM bank credit facility, with any remaining proceeds of the tax refund used to permanently reduce the revolving credit portion. At December 31, 1993, the Company had recorded net deferred tax liabilities of $139 million. The Company operates in several tax jurisdictions, in certain of which it has temporary differences that net to deferred tax assets (before valuation allowance). The Company has provided a deferred tax valuation allowance of $133 million, principally related to the U.S. and Germany, for deferred tax assets which the Company believes may not currently meet the "more likely than not" realization criteria for asset recognition. In addition to the chemicals businesses conducted through Kronos and Rheox, the Company also has certain interests and associated liabilities relating to certain discontinued or divested businesses and other holdings of marketable equity securities including securities issued by Valhi and another Contran subsidiary. - 26 - The Company has been named as a defendant, PRP, or both, in a number of legal proceedings associated with environmental matters, including waste disposal sites currently or formerly owned, operated or used by the Company, many of which disposal sites or facilities are on the U.S. EPA's Superfund National Priorities List or similar state lists. On a regular basis, the Company evaluates the potential range of its liability at sites where it has been named as a PRP or defendant. The Company believes it has provided adequate accruals for reasonably estimable costs of such matters, but the Company's ultimate liability may be affected by a number of factors, including changes in remedial alternatives and costs and the allocation of such costs among PRPs. The Company is also a defendant in a number of legal proceedings seeking damages for personal injury and property damage arising out of the sale of lead pigments and lead-based paints. The Company has not accrued any amounts for the pending lead pigment litigation. Although no assurance can be given that the Company will not incur future liability in respect of this litigation, based on, among other things, the results of such litigation to date, the Company believes that the pending lead pigment litigation is without merit. Any liability that may result is not reasonably capable of estimation. The Company currently believes the disposition of all claims and disputes, individually or in the aggregate, should not have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. There can be no assurance that additional matters of these types will not arise in the future. See Item 3 - "Legal Proceedings" and Note 18 to the Consolidated Financial Statements. The Company periodically evaluates its liquidity requirements, capital needs and availability of resources in view of, among other things, its debt service requirements and estimated future operating cash flows. As a result of this process, the Company has in the past and may in the future seek to refinance or restructure indebtedness, raise additional capital, restructure ownership interests, sell interests in subsidiaries, marketable securities or other assets, or take a combination of such steps or other steps to increase or manage its liquidity and capital resources. - 27 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is contained in a separate section of this Annual Report. See "Index of Financial Statements and Schedules" on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item is incorporated by reference to NL's definitive Proxy Statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this report (the "NL Proxy Statement"). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to the NL Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference to the NL Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference to the NL Proxy Statement. See also Note 17 to the Consolidated Financial Statements. - 28 - PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K (a) and (d) Financial Statements and Schedules The consolidated financial statements and schedules listed by the Registrant on the accompanying Index of Financial Statements and Schedules (see page) are filed as part of this Annual Report. (b) Reports on Form 8-K Reports on Form 8-K for the quarter ended December 31, 1993. October 13, 1993 - reported items 5 and 7. October 19, 1993 - reported items 5 and 7. October 20, 1993 - reported items 5 and 7. October 26, 1993 - reported items 5 and 7. (c) Exhibits Included as exhibits are the items listed in the Exhibit Index. NL will furnish a copy of any of the exhibits listed below upon payment of $4.00 per exhibit to cover the costs to NL of furnishing the exhibits. Instruments defining the rights of holders of long-term debt issues which do not exceed 10% of consolidated total assets will be furnished to the Securities and Exchange Commission upon request. Item No. Exhibit Index - -------- ------------- 3.1 By-Laws, as amended on June 28, 1990 - incorporated by reference to Exhibit 3.1 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 3.2 Certificate of Amended and Restated Certificate of Incorporation dated June 28, 1990 - incorporated by reference to Exhibit 1 to the Registrant's Proxy Statement on Schedule 14A for the annual meeting held on June 28, 1990. 4.1 Registration Rights Agreement dated October 30, 1991, by and between the Registrant and Tremont Corporation - incorporated by reference to Exhibit 4.3 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991. 4.2 Indenture dated October 20, 1993 governing the Registrant's 11.75% Senior Secured Notes due 2003, including form of Senior Note - incorporated by reference to Exhibit 4.1 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 4.3 Senior Mirror Notes dated October 20, 1993 - incorporated by reference to Exhibit 4.3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. - 29 - 4.4 Senior Note Subsidiary Pledge Agreement dated October 20, 1993 between Registrant and Kronos, Inc. - incorporated by reference to Exhibit 4.4 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 4.5 Third Party Pledge and Intercreditor Agreement dated October 20, 1993 between Registrant, Chase Manhattan Bank (National Association) and Chemical Bank - incorporated by reference to Exhibit 4.5 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 4.6 Indenture dated October 20, 1993 governing the Registrant's 13% Senior Secured Discount Notes due 2005, including form of Discount Note - incorporated by reference to Exhibit 4.6 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 4.7 Discount Mirror Notes dated October 20, 1993 - incorporated by reference to Exhibit 4.8 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 4.8 Discount Note Subsidiary Pledge Agreement dated October 20, 1993 between Registrant and Kronos, Inc. - incorporated by reference to Exhibit 4.9 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.1 Amended and Restated Loan Agreement dated as of October 15, 1993 among Kronos International, Inc., the Banks set forth therein, Hypobank International S.A., as Agent and Banque Paribas, as Co-agent - incorporated by reference to Exhibit 10.17 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.2 Amended and Restated Liquidity Undertaking dated October 15, 1993 by the Registrant, Kronos, Inc. and Kronos International, Inc. to Hypobank International S.A., as agent, and the Banks set forth therein - incorporated by reference to Exhibit 10.18 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.3 Credit Agreement dated as of March 20, 1991 between Rheox, Inc. and Subsidiary Guarantors and The Chase Manhattan Bank (National Association) and the Nippon Credit Bank, Ltd., as Co-agents -incorporated by reference to Exhibit 10.4 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 10.4 Amendments 1 and 2 dated May 1, 1991 and February 15, 1992, respectively, to the Credit Agreement between Rheox, Inc. and Subsidiary Guarantors and the Chase Manhattan Bank (National Association) and the Nippon Credit Bank, Ltd. as Co-Agents- incorporated by reference to Exhibit 10.2 to the Registrant's Quarterly Report on form 10-Q for the quarter ended June 30, 1992. - 30 - 10.5 Third amendment to the Credit Agreement, dated March 5, 1993 between Rheox, Inc. and Subsidiary Guarantors and the Chase Manhattan Bank (National Association) and the Nippon Credit Bank, Ltd as Co-Agents - incorporated by reference to Exhibit 10.7 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. 10.6 Credit Agreement dated as of October 18, 1993 among Louisiana Pigment Company, L.P., as Borrower, the Banks listed therein and Citibank, N.A., as Agent - incorporated by reference to Exhibit 10.11 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.7 Security Agreement dated October 18, 1993 from Louisiana Pigment Company, L.P., as Borrower, to Citibank, N.A., as Agent - incorporated by reference to Exhibit 10.12 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.8 Security Agreement dated October 18, 1993 from Kronos Louisiana, Inc. as Grantor, to Citibank, N.A., as Agent - incorporated by reference to Exhibit 10.13 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.9 KLA Consent and Agreement dated as of October 18, 1993 between Kronos Louisiana, Inc. and Citibank, N.A., as Agent - incorporated by reference to Exhibit 10.14 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.10 Guaranty dated October 18, 1993, from Kronos, Inc., as guarantor, in favor of Lenders named therein, as Lenders, and Citibank, N.A., as Agent - incorporated by reference to Exhibit 10.15 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.11 Mortgage by Louisiana Pigment Company, L.P. dated October 18, 1993 in favor of Citibank, N.A. - incorporated by reference to Exhibit 10.16 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.12 Lease Contract dated June 21, 1952, between Farbenfabrieken Bayer Aktiengesellschaft and Titangesellschaft mit beschrankter Haftung (German language version and English translation thereof) - incorporated by reference to Exhibit 10.14 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 10.13 Contract dated September 9, 1971, between Farbenfabrieken Bayer Aktiengesellschaft and Titangesellschaft mit beschrankter Haftung concerning supplies and services (German language version and English translation thereof) - incorporated by reference to Exhibit 10.15 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. - 31 - 10.14 Agreement dated February 8, 1984, between Bayer AG and Kronos Titan GmbH (German language version and English translation thereof) - incorporated by reference to Exhibit 10.16 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985. 10.15 Formation Agreement dated as of October 18, 1993 among Tioxide Americas Inc., Kronos Louisiana, Inc. and Louisiana Pigment Company, L.P. - incorporated by reference to Exhibit 10.2 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.16 Joint Venture Agreement dated as of October 18, 1993 between Tioxide Americas Inc. and Kronos Louisiana, Inc. - incorporated by reference to Exhibit 10.3 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.17 Kronos Offtake Agreement dated as of October 18, 1993 between Kronos Louisiana, Inc. and Louisiana Pigment Company, L.P. - incorporated by reference to Exhibit 10.4 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.18 Tioxide Americas Offtake Agreement dated as of October 18, 1993 between Tioxide Americas Inc. and Louisiana Pigment Company, L.P. - incorporated by reference to Exhibit 10.5 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.19 TCI/KCI Output Purchase Agreement dated as of October 18, 1993 between Tioxide Canada Inc. and Kronos Canada, Inc. - incorporated by reference to Exhibit 10.6 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.20 TAI/KLA Output Purchase Agreement dated as of October 18, 1993 between Tioxide Americas Inc. and Kronos Louisiana, Inc. - incorporated by reference to Exhibit 10.7 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.21 Master Technology Exchange Agreement dated as of October 18, 1993 among Kronos, Inc., Kronos Louisiana, Inc., Kronos International, Inc., Tioxide Group Limited and Tioxide Group Services Limited - incorporated by reference to Exhibit 10.8 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.22 Parents' Undertaking dated as of October 18, 1993 between ICI American Holdings Inc. and Kronos, Inc. - incorporated by reference to Exhibit 10.9 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. 10.23 Allocation Agreement dated as of October 18, 1993 between Tioxide Americas Inc., ICI American Holdings, Inc., Kronos, Inc. and Kronos Louisiana, Inc. - incorporated by reference to Exhibit 10.10 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. - 32 - 10.24* 1985 Long Term Performance Incentive Plan of NL Industries, Inc., as adopted by the Board of Directors on February 27, 1985 - incorporated by reference to Exhibit A to the Registrant's Proxy Statement on Schedule 14A for the annual meeting held on April 24, 1985. 10.25 Form of Director's Indemnity Agreement between NL and the independent members of the Board of Directors of NL - incorporated by reference to Exhibit 10.20 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1987. 10.26* 1989 Long Term Performance Incentive Plan of NL Industries, Inc. as adopted by the Board of Directors on February 14, 1989 - incorporated by reference to Exhibit A to the Registrant's Proxy Statement on Schedule 14A for the annual meeting held on May 2, 1989. 10.27 Savings Plan for Employees of NL Industries, Inc. as adopted by the Board of Directors on February 14, 1989 - incorporated by reference to Exhibit B to the Registrant's Proxy Statement on Schedule 14A for the annual meeting held May 2, 1989. 10.28* NL Industries, Inc. 1992 Non-Employee Director Stock Option Plan, as adopted by the Board of Directors on February 13, 1992 - incorporated by reference to Appendix A to the Registrant's Proxy Statement on Schedule 14A for the annual meeting held April 30, 1992. 10.29 Intercorporate Services Agreement by and between Valhi, Inc. and the Registrant effective as of January 1, 1994. 10.30 Intercorporate Services Agreement by and between Contran Corporation and the Registrant effective as of January 1, 1994. 10.31 Insurance Sharing Agreement, effective January 1, 1990, by and between the Registrant, NL Insurance, Ltd. (an indirect subsidiary of Tremont Corporation) and Baroid Corporation - incorporated by reference to Exhibit 10.20 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991. 10.32* Employment Agreement dated as of January 1, 1990 among Kronos, Inc., the Registrant and Dr. Lawrence A. Wigdor - incorporated by reference to Exhibit 10.19 to Amendment 2 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. 10.33* Executive Severance Agreement effective as of December 31, 1991 by and between the Registrant and J. Landis Martin - incorporated by reference to Exhibit 10.22 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991. 10.34* Supplemental Executive Retirement Plan for Executives and Officers of NL Industries, Inc. effective as of January 1, 1991 - incorporated by reference to Exhibit 10.26 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. * Management contract, compensatory plan or arrangement. - 33 - 21.1 Subsidiaries of the Registrant. 23.1 Consent of Independent Accountants. 99.1 Annual Report of Savings Plan for Employees of NL Industries, Inc. (Form 11-K) to be filed under Form 8 to the Registrant's Annual Report on Form 10-K within 180 days after December 31, 1993. - 34 - 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. NL Industries, Inc. (Registrant) By /s/ J. LANDIS MARTIN --------------------------------------- J. Landis Martin, March 1, 1994 President and Chief Executive Officer 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 date indicated: - 35 - NL INDUSTRIES, INC. ANNUAL REPORT ON FORM 10-K Items 8, 14(a) and 14(d) Index of Financial Statements and Schedules All other schedules are omitted because they are not applicable or not required, or because the required information is included in the consolidated financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors of NL Industries, Inc.: We have audited the accompanying consolidated balance sheets of NL Industries, Inc. as of December 31, 1992 and 1993, and the related consolidated statements of operations, shareholders' deficit, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of NL Industries, Inc. as of December 31, 1992 and 1993, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 2 and 19 to the consolidated financial statements, in 1993 the Company changed its method of accounting for certain investments in debt and equity securities in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, and in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and income taxes in accordance with SFAS Nos. 106 and 109, respectively. COOPERS & LYBRAND Houston, Texas February 9, 1994 except for Note 21, as to which the date is February 24, 1994 NL INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1992 and 1993 (In thousands, except per share data) NL INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED) December 31, 1992 and 1993 (In thousands, except per share data) Commitments and contingencies (Notes 14 and 18) See accompanying notes to consolidated financial statements. NL INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Years ended December 31, 1991, 1992 and 1993 (In thousands, except per share data) NL INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED) Years ended December 31, 1991, 1992 and 1993 (In thousands, except per share data) See accompanying notes to consolidated financial statements. NL INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' DEFICIT Years ended December 31, 1991, 1992 and 1993 (In thousands, except per share data) See accompanying notes to consolidated financial statements. NL INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1991, 1992 and 1993 (In thousands) NL INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Years ended December 31, 1991, 1992 and 1993 (In thousands) NL INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Years ended December 31, 1991, 1992 and 1993 (In thousands) See accompanying notes to consolidated financial statements. NL INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION: NL Industries, Inc. is primarily a holding company and conducts its operations through its wholly-owned subsidiaries, Kronos, Inc. (titanium dioxide pigments ("TiO2")) and Rheox, Inc. (specialty chemicals). At December 31, 1993, Valhi, Inc. held approximately 49% of NL's outstanding common stock and Tremont Corporation, a 48%-owned affiliate of Valhi, held an additional 18% of NL's outstanding common stock. Contran Corporation holds, directly or through subsidiaries, approximately 90% of Valhi's outstanding common stock. All of Contran's outstanding voting stock is held by trusts established for the benefit of the children and grandchildren of Harold C. Simmons, of which Mr. Simmons is the sole trustee. Mr. Simmons, the Chairman of the Board of each of Contran, Valhi and NL and a director of Tremont, may be deemed to control each of such companies. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of consolidation The accompanying consolidated financial statements include the accounts of NL and its majority-owned subsidiaries (collectively, the "Company"). All material intercompany accounts and balances have been eliminated. Certain prior year amounts have been reclassified to conform to the 1993 presentation. Translation of foreign currencies Assets and liabilities of subsidiaries whose functional currency is deemed to be other than the U.S. dollar are translated at year-end rates of exchange and revenues and expenses are translated at weighted average exchange rates prevailing during the year. Resulting translation adjustments, gains and losses from hedges of investments in non-U.S. entities and the related income tax effects are accumulated in the currency translation adjustments component of shareholders' deficit. Currency transaction gains and losses are recognized in income currently. Cash and cash equivalents Cash equivalents include U.S. Treasury securities purchased under short-term agreements to resell, bank deposits, and government and commercial notes and bills with original maturities of three months or less. Cash and cash equivalents includes $6 million and $18 million at December 31, 1992 and 1993, respectively, which are restricted for letters of credit and certain indebtedness agreements. Marketable securities and securities transactions The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities" effective December 31, 1993, and the Company's marketable securities were classified as either "available-for-sale" or "trading" and are carried at market. Unrealized gains and losses on trading securities are recognized in income currently. Unrealized gains and losses on available-for-sale securities, and the related deferred income tax effects, are accumulated in the marketable securities adjustment component of shareholders' deficit. See Notes 4 and 19. SFAS No. 115 superseded SFAS No. 12 under which marketable securities were generally carried at the lower of aggregate market or amortized cost and unrealized net gains were not recognized. Realized gains or losses are computed based on specific identification of the securities sold. Inventories Inventories are stated at the lower of cost (principally average cost) or market. Amounts are removed from inventories at average cost. Investment in joint ventures Investments in 20% to 50%-owned entities are accounted for by the equity method. Intangible assets Intangible assets, included in other noncurrent assets, are amortized by the straight-line method over the periods expected to be benefitted. Property, equipment, depreciation and depletion Property and equipment are stated at cost. Interest costs related to major, long-term capital projects are capitalized as a component of construction costs. Maintenance, repairs and minor renewals are expensed; major improvements are capitalized. Depreciation is computed principally by the straight-line method over the estimated useful lives of ten to 40 years for buildings and three to 20 years for machinery and equipment. Depletion of mining properties is computed by the unit-of-production and straight-line methods. Employee benefit plans Accounting and funding policies for retirement plans and postretirement benefits other than pensions ("OPEB") are described in Note 11. Net sales Sales are recognized as products are shipped. Income taxes Deferred income tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the income tax and financial reporting carrying amounts of assets and liabilities, including investments in subsidiaries and unconsolidated affiliates not included in the Company's U.S. tax group (the "NL Tax Group"). Loss per share of common stock Loss per share of common stock is based upon the weighted average number of common shares outstanding. Common stock equivalents are excluded from the computation because they are antidilutive. NOTE 3 - BUSINESS AND GEOGRAPHIC SEGMENTS: The Company's operations are conducted in two business segments - TiO2 conducted by Kronos and specialty chemicals conducted by Rheox. Titanium dioxide pigments are used to impart whiteness, brightness and opacity to a wide variety of products, including paints, plastics, paper, fibers and ceramics. Specialty chemicals include rheological additives which control the flow and leveling characteristics of a variety of products, including paints, inks, lubricants, sealants, adhesives and cosmetics. General corporate assets consist principally of cash, cash equivalents and marketable securities. NOTE 4 - MARKETABLE SECURITIES AND SECURITIES TRANSACTIONS: Upon adoption of SFAS No. 115 as of December 31, 1993, the Company classified its portfolio of U.S. Treasury Securities as trading securities and its marketable equity securities as available-for-sale. Net gains and losses from securities transactions are composed of: NOTE 5 - INVENTORIES: NOTE 6 - INVESTMENT IN JOINT VENTURES: In October 1993, Kronos Louisiana, Inc. ("KLA"), a wholly-owned subsidiary of Kronos, formed a manufacturing joint venture with Tioxide Group, Ltd., a wholly-owned subsidiary of Imperial Chemicals Industries PLC ("Tioxide"). Under the terms of the joint venture and related agreements, KLA contributed the Louisiana plant to the joint venture, Tioxide paid an aggregate of approximately $205 million, including its tranche of the joint venture debt, and Kronos and certain of its subsidiaries exchanged proprietary chloride process and product technologies with Tioxide and certain of its affiliates. Of the total consideration paid by Tioxide, $30 million is attributable to the exchange of technologies. The manufacturing joint venture, which was equally owned by KLA and a subsidiary of Tioxide, owns and operates the Louisiana chloride process TiO2 plant formerly owned by KLA. Upon formation, the joint venture obtained $216 million in new financing, which is collateralized by the partnership interests of the partners and substantially all of the assets of the joint venture. The new financing consists of two equal tranches, one attributable to each partner, and each tranche is serviced through (i) the purchase of the plant's TiO2 output in equal quantities by the partners and (ii) cash capital contributions. KLA has entered into an Offtake Agreement which requires the purchase of one-half of the TiO2 produced by the joint venture. Kronos' pro rata share of the joint venture debt is reflected as outstanding indebtedness of the Company because Kronos has guaranteed the purchase obligation relative to the debt service of its tranche. See Note 10. The manufacturing joint venture is intended to be operated on a break-even basis and, accordingly, Kronos' transfer price for its share of the TiO2 produced is equal to its share of the joint venture's operating expenses (fixed and variable costs of production and interest expense). Kronos' share of the fixed and variable production costs are reported as cost of sales as the related TiO2 acquired from the joint venture is sold, and its share of the joint venture's interest expense is reported as a component of interest expense. A summary balance sheet of the manufacturing joint venture is shown below. NOTE 7 - OTHER NONCURRENT ASSETS: NOTE 8 - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES: NOTE 9 - OTHER NONCURRENT LIABILITIES: NOTE 10 - NOTES PAYABLE AND LONG-TERM DEBT: In October 1993, NL issued $250 million principal amount of 11.75% Senior Secured Notes due 2003 and $188 million principal amount at maturity ($100 million proceeds at issuance) of 13% Senior Secured Discount Notes due 2005 (collectively, the "Notes"). The Notes are collateralized by a series of intercompany notes from Kronos International, Inc. ("KII"), a wholly-owned subsidiary of Kronos, to NL, the terms of which mirror those of the respective Notes (the "Mirror Notes"). The Senior Secured Notes are also collateralized by a first priority lien on the stock of Kronos and a second priority lien on the stock of Rheox. The Senior Secured Notes and the Senior Secured Discount Notes are redeemable, at the Company's option, after October 2000 and October 1998, respectively, except that up to one-third of the aggregate principal amount of the Senior Secured Discount Notes are redeemable (at 113% of the then-accreted value) upon any Common Stock Offering, as defined, prior to October 1996. For redemptions, other than redemptions pursuant to any Common Stock Offering, the redemption prices range from 101.5% (starting October 2000) declining to 100% (after October 2001) of the principal amount for the Senior Secured Notes and range from 106% (starting October 1998) declining to 100% (after October 2001) of the then-accreted value of the Senior Secured Discount Notes. In the event of a Change of Control, as defined, the Company would be required to make an offer to purchase the Notes at 101% of the principal amount of the Senior Secured Notes and 101% of the then-accreted value of the Senior Secured Discount Notes. The Notes are issued pursuant to indentures which contain a number of covenants and restrictions which, among other things, restrict the ability of the Company and its subsidiaries to incur debt, incur liens, pay dividends or merge or consolidate with, or sell or transfer all or substantially all of its assets to, another entity. At December 31, 1993, there were no amounts available for payment for dividends pursuant to the terms of the indentures. The Senior Secured Discount Notes do not require cash interest payments for the first five years. At December 31, 1993, the quoted market price per $100 principal amount at maturity of the Senior Secured Notes and the Senior Secured Discount Notes was $104 and $57.75, respectively. The DM credit facility, as amended, consists of a DM 448 million term loan due from 1997 to 1999 and a DM 250 million revolving credit facility due no later than 2000, of which DM 100 million is outstanding and DM 150 million was available for future borrowings by KII at December 31, 1993. During February 1994, the Company borrowed an additional DM 25 million under the revolving credit facility. Borrowings bear interest at DM LIBOR plus 1.625% (8.19% at December 31, 1993). KII has entered into agreements with certain banks in the syndicate which caps DM LIBOR at 10.5% on DM 520 million principal amount of the loan. The principal amount subject to the cap declines as the loan is repaid. NL and Kronos have agreed, under certain circumstances, to provide KII with up to DM 125 million through January 1, 2001. The DM credit facility is collateralized by pledges of the stock of certain KII subsidiaries. The credit agreement restricts KII's ability to incur additional indebtedness, restricts its dividends and other payments to affiliates, requires it to maintain specified debt service coverage and other ratios, and contains other provisions and restrictive covenants customary in lending transactions of this type. Borrowings under KLA's tranche of the joint venture term loan bear interest at LIBOR plus 1.625% (5.01% at December 31, 1993) and are repayable in quarterly installments through September 2000. See Note 6. Rheox has a credit agreement providing for a seven-year term loan due in quarterly installments through December 1997 and a $15 million revolving credit/letter of credit facility due March 1994. At December 31, 1993, letters of credit aggregating $1 million were outstanding. Borrowings bear interest, at Rheox's option, at prime rate plus 1.5% or LIBOR plus 2.5% (5.83% at December 31, 1993), and are collateralized by the stock of Rheox and its domestic subsidiary and by Rheox's U.S. assets. The credit agreement restricts Rheox's ability to incur additional indebtedness, restricts its dividend payments and contains other provisions and restrictive covenants customary in lending transactions of this type. The Company has initiated discussions with the agent bank regarding the extension of the revolving credit/letter of credit facility. In connection with the credit agreement, Rheox has entered into interest rate swap agreements to mitigate the impact of changes in interest rates on the term loan. These swap agreements, which mature December 31, 1994, effectively convert the interest rate on $60 million of the loan (at December 31, 1993) from a variable rate to a fixed rate of 8.1% The effective interest rate on the Rheox term loan was 7.3% at December 31, 1993, including the impact of the swap agreements. At December 31, 1993, the fair value of the swap agreements payable is estimated to be $1 million, which amount represents the estimated cost to the Company if it were to terminate the swap agreements at that date. Rheox is exposed to interest rate risk in the event of nonperformance by the other parties to the agreements. However, Rheox does not anticipate nonperformance by such parties. Unused lines of credit available for short-term borrowings under U.S. and non-U.S. credit facilities approximated $14 million and $117 million, respectively, at December 31, 1993. Other loans consist of non-U.S. mortgage and other borrowings of the Company's subsidiaries denominated primarily in non-U.S. currencies. Substantially all of the long-term debt of subsidiaries, except to the extent of the interest rate swap agreements relating to the Rheox term loan as noted above, have variable interest rates which adjust with changes in market interest rates or have short terms to maturity, and the book value of such indebtedness is deemed to approximate fair value. The aggregate maturities of long-term debt at December 31, 1993 are shown in the table below. NOTE 11 - EMPLOYEE BENEFIT PLANS: Company-sponsored pension plans The Company maintains various defined benefit and defined contribution pension plans covering substantially all employees. Personnel employed by non-U.S. subsidiaries are covered by separate plans in their respective countries and U.S. employees are covered by various plans including the Retirement Programs of NL Industries, Inc. (the "NL Pension Plan"). A majority of U.S. employees are eligible to participate in a contributory savings plan with partial matching contributions by the Company. The Company's expense related to matching contributions was $.6 million, $1.0 million and nil in 1991, 1992 and 1993, respectively. Defined pension benefits are generally based upon years of service and compensation under fixed-dollar, final pay or career average formulas, and the related expenses are based upon independent actuarial valuations. The funding policy for U.S. defined benefit plans is to contribute amounts which satisfy funding requirements of the Employee Retirement Income Security Act of 1974, as amended. Non-U.S. defined benefit pension plans are funded in accordance with applicable statutory requirements. The funded status of the Company's defined benefit pension plans is set forth below. The rates used in determining the actuarial present value of benefit obligations were (i) discount rates - 7% to 8.5% (1992 - 8% to 9%) and (ii) rates of increase in future compensation levels - nil to 6% (1992 - nil to 7%). The expected long-term rates of return on assets used ranged from 8% to 10% in both 1992 and 1993. Plan assets are comprised primarily of investments in U.S. and non-U.S. corporate equity and debt securities, short-term investments, mutual funds and group annuity contracts. SFAS No. 87, "Employers' Accounting for Pension Costs" requires that an additional pension liability be recognized when the unfunded accumulated pension benefit obligation exceeds the unfunded accrued pension liability. Variances from actuarially assumed rates, including the rate of return on pension plan assets, will result in additional increases or decreases in accrued pension liabilities, pension expense and funding requirements in future periods. The components of the net periodic defined benefit pension cost are set forth below. Incentive bonus programs The Company has incentive bonus programs for certain employees providing for annual payments, which may be in the form of NL common stock, based on formulas involving the profitability of Kronos and Rheox in relation to the annual operating plan of the employee's business unit and individual performance. Postretirement benefits other than pensions In addition to providing pension benefits, the Company currently provides certain health care and life insurance benefits for eligible retired employees. Certain of the Company's U.S. and Canadian employees may become eligible for such postretirement health care and life insurance benefits if they reach retirement age while working for the Company. In 1989, the Company began phasing out such benefits for currently active U.S. employees over a ten-year period. The majority of all retirees are required to contribute a portion of the cost of their benefits and certain current and future retirees are eligible for reduced health care benefits at age 65. The Company's policy is to fund medical claims as they are incurred, net of any contributions by the retirees. Effective January 1, 1993, the Company's postretirement medical plans were revised to, among other things, increase the deductible and maximum out-of-pocket amounts, increase the retiree copayment percentage and pass on future cost increases to the participants through increased contributions or decreased reimbursements. The rates used in determining the actuarial present value of the accumulated benefit obligations were (i) discount rate - 7% (1992 - 7.75%), (ii) rate of increase in future compensation levels - 4% (1992 - 5%), (iii) rate of increase in future health care costs - 11% in 1994, gradually declining to 5% in 2000 and thereafter (1992 - 14% in 1993, gradually declining to 6% in 2000 and thereafter) and (iv) return on plan assets - 9% in both 1992 and 1993. If the health care cost trend rate was increased by one percentage point for each year, postretirement benefit expense would have increased approximately $.4 million in 1993, and the actuarial present value of accumulated benefit obligations at December 31, 1993 would have increased by approximately $3.5 million. The components of the Company's net periodic postretirement benefit cost pursuant to SFAS No. 106 for 1992 and 1993 are set forth below: The aggregate net pay-as-you-go cost to the Company for these benefits approximated $7 million in 1991. NOTE 12 - SHAREHOLDERS' DEFICIT: Common stock During 1990, NL's Board of Directors authorized the purchase of up to five million shares of NL's common stock over an unspecified period of time, to be held as treasury shares available for general corporate purposes. Pursuant to this authorization, the Company purchased 1.6 million and .3 million shares of its common stock in the open market at an aggregate cost of $21 million and $4 million in 1991 and 1992, respectively. In September 1991, the Company purchased 11.3 million shares of its common stock pursuant to a "Dutch auction" self-tender offer for an aggregate cost of $181 million, including 10.9 million shares purchased from Valhi for $175 million. Common stock options The 1989 Long Term Performance Incentive Plan of NL Industries, Inc. (the "NL Option Plan") provides for the discretionary grant of restricted common stock, stock options, stock appreciation rights ("SARs") and other incentive compensation to officers and other key employees of the Company. Although certain stock options and SARs granted pursuant to similar plans which preceded the NL Option Plan ("the Predecessor Option Plans") remain outstanding at December 31, 1993, no additional options may be granted under the Predecessor Option Plans. Up to five million shares of NL common stock may be issued pursuant to the NL Option Plan. The NL Option Plan provides for the grant of options that qualify as incentive options and for options which are not so qualified. Generally, stock options and SARs (collectively, "options") are granted at a price equal to 100% of the market price at the date of grant, vest over a five year period and expire ten years from the date of grant. Restricted stock, forfeitable unless certain periods of employment are completed, is held in escrow in the name of the grantee until the restriction period expires. No SARs have been granted under the NL Option Plan. Changes in outstanding options granted pursuant to the NL Option Plan and the Predecessor Option Plans are summarized in the table below. At December 31, 1993, options to purchase 610,081 shares were exercisable and options to purchase 259,000 shares become exercisable in 1994. At December 31, 1993, an aggregate of 3.5 million shares were available for future grants under the NL Option Plan. Preferred stock The Company is authorized to issue a total of five million shares of preferred stock. The rights of preferred stock as to dividends, redemption, liquidation and conversion are determined upon issuance. NOTE 13 - OTHER INCOME, NET: NOTE 14 - INCOME TAXES: The components of (i) loss before income taxes, minority interest, extraordinary items and cumulative effect of changes in accounting principles ("pretax income (loss)"), (ii) the difference between the provision for income taxes attributable to pretax income (loss) and the amounts that would be expected using the U.S. federal statutory income tax rate of 34% in 1991 and 1992 and 35% in 1993, (iii) the provision for income taxes and (iv) the comprehensive tax provision (benefit) are presented below. Changes in deferred income taxes related to the adoption of new accounting standards are disclosed in Note 19. During 1993, the Company's valuation allowance, in the aggregate, increased by $47 million. The components of the net deferred tax liability are summarized below: The components of the provision for deferred income taxes for 1991 (a disclosure no longer required upon the adoption of SFAS No. 109) is summarized below. At December 31, 1993, the Company had $250 million of non-U.S. income tax loss carryforwards with no expiration dates. In addition, the Company had, for U.S. federal income tax purposes, capital loss carryforwards of $17 million which expire during 1996, net operating loss carryforwards of $30 million, of which $7 million expires in 2007 and $23 million expires in 2008, and an alternative minimum tax credit carryforward of $11 million with no expiration date. Certain of the Company's income tax returns in various U.S. and non-U.S. jurisdictions, including Germany are being examined and tax authorities have proposed or may propose tax deficiencies. In June 1993, the German tax authorities issued assessment reports in connection with examinations of the Company's German income tax returns, disallowing the Company's claims for refunds, primarily for 1989 and 1990, aggregating DM 160 million ($92 million at December 31, 1993) and proposing additional taxes of DM 100 million ($58 million at December 31, 1993). The Company has applied for administrative relief from collection procedures and may grant a lien on certain German assets while the Company contests the proposed adjustments. Although the Company believes it will ultimately prevail, in June 1993, the Company reclassified refundable income tax claims of approximately DM 160 million ($92 million) from current assets to noncurrent assets due to the uncertain timing of a resolution. The Company believes that it has adequately provided accruals for additional income taxes and related interest expense which may ultimately result from such examinations and believes that the ultimate disposition of such examinations should not have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. In July 1992, the Company paid $15 million of previously accrued interest and income taxes related to the settlement of examinations of the Company's U.S. federal income tax returns for the years ended December 31, 1979 through 1984. In 1991, based upon revisions in the Company's estimate of liabilities for income taxes and related interest expense which may ultimately result from the examinations referred to above, the Company reduced its accrual for income tax related interest by $9 million. This change in estimate considered, among other things, the Company's settlement with the IRS of a matter related to the qualified status of certain of the Company's defined benefit pension plans, which plans were determined to be qualified with respect to the periods in question. NOTE 15 - OTHER ITEMS: Research, development and sales technical support expense approximated $9 million in 1991, $11 million in 1992 and $10 million in 1993. Interest capitalized in connection with long-term capital projects was $26 million in 1991, $9 million in 1992 and $1 million in 1993. NOTE 16 - EXTRAORDINARY ITEMS: The extraordinary loss in 1993 relates to the settlement of certain interest rate swap agreements for $20 million in cash in conjunction with repaying the Louisiana plant indebtedness and the write-off of deferred financing costs related to such repayment and the paydown of a portion of the DM bank credit facility. Upon adoption of SFAS No. 109 in 1992, utilization of tax loss and tax credit carryforwards are not classified as extraordinary items. NOTE 17 - RELATED PARTY TRANSACTIONS: The Company may be deemed to be controlled by Harold C. Simmons. Corporations that may be deemed to be controlled by or affiliated with Mr. Simmons sometimes engage in (a) intercorporate transactions such as guarantees, management and expense sharing arrangements, shared fee arrangements, joint ventures, partnerships, loans, options, advances of funds on open account, and sales, leases and exchanges of assets, including securities issued by both related and unrelated parties and (b) common investment and acquisition strategies, business combinations, reorganizations, recapitalizations, securities repurchases, and purchases and sales (and other acquisitions and dispositions) of subsidiaries, divisions or other business units, which transactions have involved both related and unrelated parties and have included transactions which resulted in the acquisition by one related party of a publicly-held minority equity interest in another related party. While no transactions of the type described above are planned or proposed with respect to the Company, the Company from time to time considers, reviews and evaluates, and understands that Contran, Valhi and related entities consider, review and evaluate, such transactions. Depending upon the business, tax and other objectives then relevant, and restrictions under the indentures and other agreements, it is possible that the Company might be a party to one or more such transactions in the future. It is the policy of the Company to engage in transactions with related parties on terms, in the opinion of the Company, no less favorable to the Company than could be obtained from unrelated parties. During August 1991, the Company entered into a revolving demand loan agreement with Valhi in an amount not to exceed the lesser of $200 million or the amount Valhi has available under bank credit agreements. The Company advanced $150 million pursuant to this agreement which Valhi repaid in September 1991. Interest income on the amount advanced under the demand loan agreement was $.6 million in 1991. Baroid Corporation, a former wholly-owned subsidiary of the Company and currently a subsidiary of Dresser Industries, Inc., and the Company are parties to an intercorporate services agreement (the "Baroid ISA") pursuant to which, as amended, Baroid agreed to make certain services available to the Company on a fee basis subject to termination or renewal by mutual agreement. Management services fee expense pursuant to the Baroid ISA approximated $4.3 million in 1991, $2.3 million in 1992 and $.3 million in 1993. The Company is a party to an intercorporate services agreement with Valhi (the "Valhi ISA") whereby Valhi provides certain management, financial and administrative services to the Company on a fee basis. Management services fee expense related to the Valhi ISA was $1.5 million in 1991, $1.4 million in 1992 and $.7 million in 1993. The Company was party to an intercorporate services agreement with Tremont (the "Tremont ISA") until June 1993 when the agreement was terminated. Under the terms of the contract, the Company provided certain management, financial and legal services to Tremont on a fee basis. Management services fee income related to the Tremont ISA was $.3 million in 1991, $.5 million in 1992 and $.1 million in 1993. Purchases from Tremont in the ordinary course of business pursuant to a long-term supply contract were $.6 million in 1991, $.6 million in 1992 and $.4 million in 1993. Sales to Baroid in the ordinary course of business were $1.8 million in 1991, $2.1 million in 1992 and $1.8 million in 1993. Purchases in the ordinary course of business from unconsolidated joint ventures were approximately $9 million in 1991 and 1992 and $22 million in 1993. Certain employees of the Company have been granted options to purchase Valhi common stock under the terms of Valhi's stock option plans. The Company and Valhi have agreed that the Company will pay Valhi the aggregate difference between the option price and the market value of Valhi's common stock on the exercise date of such options. For financial reporting purposes, the Company accounts for the related expense (nil in 1991, 1992 and 1993) in a manner similar to accounting for SARs. At December 31, 1993, employees of the Company held options to purchase 365,000 shares (347,000 shares vested) of Valhi common stock at exercise prices ranging from $5 to $15 per share. In conjunction with the formation of Baroid, the Company and Baroid entered into a Cross-Indemnification Agreement pursuant to which, as amended, the Company agreed to indemnify Baroid with regard to all liabilities not expressly assumed by Baroid and Baroid agreed to indemnify the Company with regard to all liabilities assumed by Baroid. Net amounts payable to affiliates are summarized in the following table. NOTE 18 - COMMITMENTS AND CONTINGENCIES: Leases The Company leases, pursuant to operating leases, various manufacturing and office space and transportation equipment. Most of the leases contain purchase and/or various term renewal options at fair market and fair rental values, respectively. In most cases management expects that, in the normal course of business, leases will be renewed or replaced by other leases. In addition, Kronos has a governmental concession through 2007 to operate its ilmenite mine in Norway. Kronos' principal German operating subsidiary leases the land under its Leverkusen TiO2 production facility pursuant to a lease expiring in 2050. The Leverkusen facility, with approximately one-third of Kronos' current TiO2 production capacity, is located within the lessor's extensive manufacturing complex, and Kronos is the only unrelated party so situated. Under a separate supplies and services agreement, which expired in 1991 and to which an extension through 2011 has been agreed in principle, the lessor provides some raw materials, auxiliary and operating materials and utilities services necessary to operate the Leverkusen facility. Kronos and the lessor are continuing discussions regarding a definitive agreement for the extension of the supplies and services agreement. Both the lease and the supplies and services agreements restrict the Company's ability to transfer ownership or use of the Leverkusen facility. Net rent expense aggregated $6 million in 1991, $9 million in 1992 and $8 million in 1993. At December 31, 1993, minimum rental commitments under the terms of noncancellable operating leases were as follows: Legal proceedings Lead pigment litigation. Since 1987, the Company, other past manufacturers of lead pigments for use in paint and lead-based paint and the Lead Industries Association have been named as defendants in various legal proceedings seeking damages for personal injury and property damage allegedly caused by the use of lead-based paints. Certain of these actions have been filed by or on behalf of large United States cities or their public housing authorities. These legal proceedings seek recovery under a variety of theories, including negligent product design, failure to warn, breach of warranty, conspiracy/concert of action, enterprise liability, market share liability, intentional tort, and fraud and misrepresentation. The plaintiffs in these actions generally seek to impose on the defendants responsibility for lead paint abatement and asserted health concerns associated with the use of lead-based paints, which was permitted for interior residential use in the United States until 1973, including damages for personal injury, contribution and/or indemnification for medical expenses, medical monitoring expenses and costs for educational programs. Most of these legal proceedings are in various pre-trial stages; several are on appeal. The Company believes that these actions are without merit, intends to continue to deny all allegations of wrongdoing and liability and to defend all actions vigorously. Considering the Company's previous involvement in the lead and lead pigment businesses, there can be no assurance that additional litigation similar to that currently pending will not be filed. Environmental matters and litigation. Some of the Company's current and former facilities, including several divested secondary lead smelters and former mining locations, are the subject of civil litigation, administrative proceedings or of investigations arising under federal and state environmental laws. Additionally, in connection with past disposal practices, the Company has been named a potential responsible party ("PRP") pursuant to the Comprehensive Environmental Response, Compensation and Liability Act, as amended by the Superfund Amendments and Reauthorization Act ("CERCLA") in approximately 80 governmental enforcement and private actions associated with hazardous waste sites and former mining locations, some of which are on the U.S. Environmental Protection Agency's Superfund National Priorities List. These actions seek cleanup costs and/or damages for personal injury or property damage. While the Company may be jointly and severally liable for such costs, in most cases, it is only one of a number of PRPs who are also jointly and severally liable. In addition, the Company is a party to a number of lawsuits filed in various jurisdictions alleging CERCLA or other environmental claims. At December 31, 1993, the Company had accrued $70 million in respect of those environmental matters which are reasonably estimable. It is not possible to estimate the range of costs for certain sites. The upper end of the range of reasonably possible costs to the Company for sites which it is possible to estimate costs is approximately $105 million. No assurance can be given that actual costs will not exceed accrued amounts or the upper end of the range for sites for which estimates have been made and no assurance can be given that costs will not be incurred with respect to sites as to which no estimate presently can be made. The imposition of more stringent standards or requirements under environmental laws or regulations, new developments or changes respecting site cleanup costs or allocation of such costs among PRPs, or a determination that the Company is potentially responsible for the release of hazardous substances at other sites could result in expenditures in excess of amounts currently estimated by the Company to be required for such matters. Further, there can be no assurance that additional environmental matters will not arise in the future. Certain of the Company's businesses are and have been engaged in the handling, manufacture or use of substances or compounds that may be considered toxic or hazardous within the meaning of applicable environmental laws. As with other companies engaged in similar businesses, certain operations and products of the Company have the potential to cause environmental or other damage. The Company continues to implement various policies and programs in an effort to minimize these risks. The Company's policy is to comply with environmental laws and regulations at all of its facilities and to continually strive to improve environmental performance in association with applicable industry initiatives. It is possible that future developments, such as stricter requirements of environmental laws and enforcement policies thereunder, could affect the Company's production, handling, use, storage, transportation, sale or disposal of such substances. Other litigation. The Company is involved in other litigation, including litigation regarding the Feed Materials Production Center in Ohio owned by the U.S. Department of Energy, formerly managed under contract by NLO, Inc., a wholly-owned subsidiary of the Company, and other matters. The Company is also involved in various other environmental, contractual, product liability and other claims and disputes incidental to its present and former businesses. The Company currently believes the disposition of all claims and disputes individually or in the aggregate, should not have a material adverse effect on the Company's consolidated financial condition, results of operations or liquidity. Concentrations of credit risk Sales of TiO2 accounted for almost 90% of net sales during the past three years. TiO2 is sold to the paint, paper and plastics industries. Such markets are generally considered "quality-of-life" markets whose demand for TiO2 is influenced by the relative economic well- being of the various geographic regions. TiO2 is sold to over 5,000 customers, none of which represents a significant portion of net sales. In the past three years, approximately one-half of the Company's TiO2 sales by volume were to Europe and approximately one-third in 1991 and 1992 and 38% in 1993 of sales were attributable to North America. Consolidated cash and cash equivalents includes $22 million and $64 million invested in U.S. Treasury securities purchased under short- term agreements to resell at December 31, 1992 and 1993, respectively. Such securities are held in trust for the Company by a single U.S. bank. NOTE 19 - CHANGES IN ACCOUNTING PRINCIPLES: In 1993, the Company adopted SFAS No. 115 (marketable securities) as of December 31, 1993. In 1992, the Company (i) elected early compliance with both SFAS No. 106 (OPEB) and SFAS No. 109 (income taxes) as of January 1, 1992; (ii) elected immediate recognition of the OPEB transition obligation; and (iii) elected to apply SFAS No. 109 prospectively and not restate prior years. The cumulative effect of changes in accounting principles adjustments are shown below. NOTE 20 - QUARTERLY FINANCIAL DATA (UNAUDITED): NOTE 21 - SUBSEQUENT EVENT: On February 24, 1994, the Company settled its lawsuit against Lockheed Corporation and its directors in connection with Lockheed's 1990 annual meeting of stockholders. Under the terms of the settlement, Lockheed made a cash payment to the Company of $27 million with net proceeds to the Company of approximately $20 million. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES Our report on the consolidated financial statements of NL Industries, Inc. is included on page of this Annual Report on Form 10-K. As discussed in Notes 2 and 19 to the consolidated financial statements, in 1993 the Company changed its method of accounting for marketable securities, and in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and income taxes. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Houston, Texas February 9, 1994 except for Note 21, as to which the date is February 24, 1994 S-1 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES (a) December 31, 1993 (In thousands) (a) The Company adopted SFAS No. 115 effective December 31, 1993. (b) A majority-owned subsidiary of Contran Corporation. S-2 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III-CONDENSED FINANCIAL INFORMATION OF REGISTRANT Condensed Balance Sheets December 31, 1992 and 1993 (In thousands) S-3 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III-CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) Condensed Statements of Operations Years ended December 31, 1991, 1992 and 1993 (In thousands) S-4 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III-CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) Condensed Statements of Cash Flows Years ended December 31, 1991, 1992 and 1993 (In thousands) S-5 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III-CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) Condensed Statements of Cash Flows (Continued) Years ended December 31, 1991, 1992 and 1993 (In thousands) S-6 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) Notes to Condensed Financial Information NOTE 1 - BASIS OF PRESENTATION: The Consolidated Financial Statements of NL Industries, Inc. (the "Company") and the related Notes to Consolidated Financial Statements are incorporated herein by reference. NOTE 2 - NET PAYABLE TO (RECEIVABLE FROM) SUBSIDIARIES AND AFFILIATES: NOTE 3 - LONG-TERM DEBT: See Note 10 of the Consolidated Financial Statements for a description of the Notes. S-7 The aggregate maturities of the Company's long-term debt at December 31, 1993 are shown in the table below. The Company and Kronos have agreed, under certain circumstances, to provide Kronos' principal international subsidiary with up to DM 125 million through January 1, 2001. S-8 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE V-PROPERTY AND EQUIPMENT (In thousands) (a) Net of amounts transferred to applicable property and equipment accounts. (b) Includes costs for chloride process TiO2 plant in Lake Charles, Louisiana. (c) Includes contribution of a chloride process TiO2 plant in Lake Charles, Louisiana to the new manufacturing joint venture. S-9 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE VI-ACCUMULATED DEPRECIATION AND DEPLETION OF PROPERTY AND EQUIPMENT (In thousands) (a) Includes contribution of a chloride process TiO2 plant in Lake Charles, Louisiana to the new manufacturing joint venture. S-10 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (In thousands) ______________ (a) Amounts written off, less recoveries. S-11 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (In thousands, except percentages) (a) The average amount outstanding during the year is calculated based on the average of the month-end balances of short-term borrowings during the year. (b) The weighted average interest rate during the year is calculated based on total interest expense on short-term borrowings divided by the average amount outstanding during the year. S-12 NL INDUSTRIES, INC. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) S-13

77278_1993.txt

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1993

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ITEM 1. BUSINESS The Company Pennsylvania Power Company (Company) was organized under the laws of the Commonwealth of Pennsylvania in 1930 and owns property and does business as an electric public utility in that state. The Company is authorized to do business and owns property in the State of Ohio. It is a wholly owned subsidiary of Ohio Edison Company (Edison), an Ohio corporation which does business as an electric public utility in Ohio. The Company and Edison are referred to herein collectively as Companies. The Company furnishes electric service to communities in a 1,500 square mile area of western Pennsylvania. The Company also provides transmission services and electric energy for resale to certain municipalities in Pennsylvania. The area served by the Company has a population of approximately 360,000. Central Area Power Coordination Group (CAPCO) In September 1967, the CAPCO companies, consisting of the Company, Edison, The Cleveland Electric Illuminating Company (CEI), Duquesne Light Company (Duquesne) and The Toledo Edison Company (Toledo), announced a program for joint development of power generation and transmission facilities. Included in the program are Unit 7 at the W. H. Sammis Plant, Units 1, 2 and 3 at the Bruce Mansfield Plant, Unit 1 at the Beaver Valley Power Station and Unit 1 at the Perry Nuclear Power Plant, each now in service. Perry Unit 2, a CAPCO nuclear generating unit whose construction had been previously suspended, has been abandoned by the CAPCO companies (see "Perry Unit 2"). Arrangements Among the CAPCO Companies The present CAPCO Basic Operating Agreement provides, among other things, for coordinated maintenance responsibilities among the CAPCO companies, a limited and qualified mutual backup arrangement in the event of outage of CAPCO units and certain capacity and energy transactions among the CAPCO companies. The agreements among the CAPCO companies generally treat the Companies as a single system as between them and the other three CAPCO companies, but, in agreements between the CAPCO companies and others, all five companies are treated as separate entities. Subject to any rights that might arise among the CAPCO companies as such, each member company, severally and not jointly, is obligated to pay the cost of constructing and operating only its proportionate share of the facilities and the cost of required fuel. The CAPCO companies have agreed that any modification of their arrangements or of their agreed-upon programs requires their unanimous consent. Should any member become unable to continue to pay its share of the costs associated with a CAPCO facility, each of the other CAPCO companies could be adversely affected in varying degrees because it may become necessary for the remaining members to assume such costs for the account of the defaulting member. Reliance on the CAPCO Companies Under the agreements governing the construction and operation of CAPCO generating units, the responsibility is assigned to a specific CAPCO company. CEI has such responsibilities for Perry Unit 1 and Duquesne is responsible for Beaver Valley Unit 1. The Companies monitor activities in connection with these units but must rely to a significant degree on the operating company for necessary information. The Companies in their oversight role as a practical matter cannot be privy to every detail; it is the operating company that must directly supervise activities and then exercise its reporting responsibilities to the co-owners. The Companies critically review the information given to them by the operating company, but they cannot be absolutely certain that things that they would have considered significant have been reported or that they would always have reached exactly the same conclusion about matters that are reported. In addition, the time that is necessarily part of the compiling and analyzing process creates a lag between the occurrence of events and the time the Companies become aware of their significance. The Company has similar responsibilities to the other CAPCO companies with respect to Bruce Mansfield Units 1, 2 and 3 and Edison has those responsibilities with respect to W. H. Sammis Unit 7. Perry Unit 2 In December 1993, the Company announced that it will not participate in further construction of Perry Unit 2 and has abandoned Perry Unit 2 as a possible electric generating plant. The Company expects its Perry Unit 2 investment to be recoverable from its Pennsylvania Public Utility Commission (PPUC) jurisdictional customers based on Section 520 of the Pennsylvania Public Utility Code. Due to the anticipated delay in commencement of recovery and taking into account the expected PPUC and Federal Energy Regulatory Commission (FERC) rate treatment, the Company recognized an impairment to its Perry Unit 2 investment of $24,458,000 in 1993, reducing net income by $14,165,000. Financing and Construction The Company accesses the capital markets from time to time to provide funds for its construction program and to refinance existing securities. Future Financing The Company's total construction costs, excluding nuclear fuel, amounted to approximately $34,000,000 in 1993. Such costs included expenditures for the betterment of existing facilities and for the construction of transmission lines, distribution lines, substations and other additions. For the years 1994-1998, such construction costs are estimated to be approximately $140,000,000, of which approximately $27,000,000 is applicable to 1994. See "Environmental Matters" below with regard to possible environment-related expenditures not included in the estimate for 1994-1998. During the 1994-1998 period, maturities of, and sinking fund requirements for, long-term debt (excluding nuclear fuel) and preferred stock will require the expenditure by the Company of approximately $58,000,000, of which approximately $2,000,000 is applicable to 1994. All or a major portion of maturing debt is expected to be refunded at or prior to maturity. The Company leases its nuclear fuel requirements from OES Fuel, Incorporated (a wholly owned subsidiary of Edison). Investments for additional nuclear fuel during the 1994-1998 period are estimated to be approximately $38,000,000, of which approximately $9,000,000 applies to 1994. During the same periods, the Company's nuclear fuel investments are expected to be reduced by approximately $44,000,000 and $10,000,000, respectively, as the nuclear fuel is consumed. The Company recovers the cost of nuclear fuel consumed through its electric rates. Based on its present plans, the Company may provide for its cash requirements in 1994 from: funds to be received from operations; available cash and temporary cash investments (approximately $13,000,000 as of December 31, 1993); funds available under short-term bank credit arrangements presently aggregating $35,000,000; and the ability to borrow up to $50,000,000 from Edison, if available, under a system funds pool agreement. Additionally, the Company has $37,000,000 of unused bank facilities which may be borrowed for up to several days at the banks' discretion. The Company currently expects that, for the period 1994-1998, external financings may be necessary to provide a portion of its cash requirements. The extent and type of future financings will depend on the need for external funds as well as market conditions, the maintenance of an appropriate capital structure and the ability of the Company to comply with coverage requirements in order to issue first mortgage bonds and preferred stock. The Company will continue to monitor financial market conditions and, where appropriate, may take advantage of opportunities to refund outstanding high-cost debt and preferred stock to the extent that its financial resources permit. Except as otherwise indicated, the foregoing statements with respect to construction expenditures are based on estimates made in February 1994 and are subject to change based upon the progress of and changes required in the construction program, including periodic reviews of costs, changing customer requirements for electric energy, the level of earnings and resulting changes in applicable coverage requirements, conditions in capital markets, changes in regulatory requirements and other relevant factors. Coverage Requirements The coverage requirements contained in the first mortgage indenture under which the Company issues first mortgage bonds provide that, except for certain refunding purposes, the Company may not issue first mortgage bonds unless applicable net earnings (before income taxes), calculated as provided in the indenture, for any period of twelve consecutive months within the fifteen calendar months preceding the month in which such additional bonds are issued, are at least twice annual interest requirements on outstanding first mortgage bonds, including those being issued. The Company's articles of incorporation prohibit the sale of preferred stock unless applicable gross income, calculated as provided in the articles of incorporation, is equal to at least 1-1/2 times the aggregate of the annual interest requirements on indebtedness outstanding immediately thereafter plus the annual dividend requirements on all preferred stock which will be outstanding at that time. With respect to the issuance of first mortgage bonds, other requirements also apply and are more restrictive than the earnings test at the present time. The Company is currently able to issue $96,000,000 principal amount of first mortgage bonds, with up to $15,000,000 of such amount issuable against property additions; the remainder could be issued against previously retired bonds. The Company could issue approximately $50,000,000 of additional preferred stock before the end of the first quarter of 1994. For the remainder of 1994, however, the earnings coverage test contained in the Company's charter precludes the issuance of additional preferred stock due to the inclusion of the charge for the Perry Unit 2 impairment in the earnings test. Additional preferred stock capability is expected to be restored in January 1995. If the Company were to issue additional debt at or prior to the time it issued preferred stock, the amount of preferred stock which would be issuable would be reduced. To the extent that coverage requirements or market conditions restrict the Company's ability to issue desired amounts of first mortgage bonds or preferred stock, the Company may seek other methods of financing. Such financings could include the sale of common stock to Edison, or of such other types of securities as might be authorized by the PPUC which would not otherwise be sold and could result in annual interest charges and/or dividend requirements in excess of those that would otherwise be incurred. In addition, the Company might, to the extent possible, reduce its expenditures for construction and other purposes. Utility Regulation The Company is subject to broad regulation as to rates and other matters by the PPUC. With respect to its wholesale and interstate electric operations and rates, the Company is subject to regulation, including regulation of its accounting policies and practices, by the FERC. The Energy Policy Act of 1992 (1992 Act) amends portions of the Public Utility Holding Company Act of 1935, providing independent power producers and other nonregulated generating facilities easier entry into the electric generation markets. The 1992 Act also amends portions of the Federal Power Act, authorizing the FERC, under certain circumstances, to mandate access to utility-owned transmission facilities. The Company is currently unable to predict the ultimate effects on its operations resulting from this legislation. The Company sells power to its wholesale customers under agreements which were accepted by the FERC in 1984. The agreements provide that the Company's wholesale customers will be charged the applicable prevailing retail electric rates, and will remain full requirements customers through August 1994 as to three of these customers and through August 1995 as to the other two customers. Negotiations are currently underway to extend these agreements. The Company uses a "levelized" energy cost rate (ECR) for the recovery of fuel and net purchased power costs which are not otherwise recovered through base rates from its customers. The ECR, which includes adjustment for any over or under collection from customers, is recalculated each year. Nuclear Regulation The construction and operation of nuclear generating units are subject to the regulatory jurisdiction of the Nuclear Regulatory Commission (NRC) including the issuance by it of construction permits and operating licenses. The NRC's procedures with respect to application for construction permits and operating licenses afford opportunities for interested parties to request public hearings on health, safety, environmental and antitrust issues. In this connection, the NRC may require substantial changes in operation or the installation of additional equipment to meet safety or environmental standards with resulting delay and added costs. The possibility also exists for modification, denial or revocation of licenses or permits. Full power operating licenses were issued for Beaver Valley Unit 1 and Perry Unit 1 on July 1, 1976 and November 13, 1986, respectively. The construction permit and operating license issued by the NRC applicable to Perry Unit 1 is conditioned to require, among other things: (i) maintenance, emergency, economy and wholesale power and reserve sharing to be made available to, (ii) interconnections to be made with, and (iii) wheeling to be provided for, electric generating and/or distribution systems (or municipalities or cooperatives with the right to engage in such functions) if such entities so request and to permit such entities to become members of CAPCO (subject to certain prerequisites with respect to size), or to acquire a share of the capacity of Perry Unit 1 or any other future nuclear units, if they so desire. In September 1987, Edison asked the NRC to suspend these license conditions. In April 1991, the NRC Staff denied Edison's application; accordingly, Edison petitioned the NRC for a hearing. Pursuant to this request the matter was referred to the Atomic Safety and Licensing Board (ASLB). The ASLB ruled against Edison in November 1992. Edison petitioned the NRC to review the ASLB decision in December 1992. On August 3, 1993, the NRC ruled that the license conditions will not be suspended. On October 1, 1993, Edison appealed the NRC decision in the United States Court of Appeals for the District of Columbia Circuit. If these license conditions are not suspended, they could have a materially adverse but presently undeterminable effect on the Company's future business operations. The NRC has promulgated and continues to promulgate additional regulations related to the safe operation of nuclear power plants. The Company cannot predict what additional regulations will be promulgated or design changes required or the effect that any such regulations or design changes, or the consideration thereof, may have upon Beaver Valley Unit 1 and Perry Unit 1. Although the Company has no reason to anticipate an accident at any nuclear plant in which it has an interest, if such an accident did happen, it could have a material but presently undeterminable adverse effect on the Company's financial position. In addition, such an accident at any operating nuclear plant, whether or not owned by the Company, could result in regulations or requirements that could affect the operation or licensing of plants that the Company does own with a consequent but presently undeterminable adverse impact, and could affect the Company's ability to raise funds in the capital markets. Nuclear Insurance The Price-Anderson Act limits the public liability which can be assessed with respect to a nuclear power plant to $9,396,000,000 (assuming 116 units licensed to operate) for a single nuclear incident, which amount is covered by: (i) private insurance amounting to $200,000,000; and (ii) $9,196,000,000 provided by an industry retrospective rating plan required by the NRC pursuant thereto. Under such retrospective rating plan, in the event of a nuclear incident at any unit in the United States resulting in losses in excess of private insurance, up to $75,500,000 (but not more than $10,000,000 per unit per year in the event of more than one incident) must be contributed for each nuclear unit licensed to operate in the country by the licensees thereof to cover liabilities arising out of the incident. Based on its present ownership interest in Beaver Valley Unit 1 and Perry Unit 1, the Company's maximum potential assessment under these provisions (assuming the other CAPCO companies were to contribute their proportionate share of any assessments under the retrospective rating plan) would be $18,100,000 per incident but not more than $2,300,000 in any one year for each incident. In addition to the public liability insurance provided pursuant to the Price-Anderson Act, the Company has also obtained insurance coverage in limited amounts for economic loss and property damage arising out of nuclear incidents. The Company is a member of Nuclear Electric Insurance Limited (NEIL) which provides coverage (NEIL I) for the extra expense of replacement power incurred due to prolonged accidental outages of nuclear units. Under NEIL I, the Company has policies, renewable yearly, corresponding to its interest in Beaver Valley Unit 1 and Perry Unit 1, which provide an aggregate indemnity of up to approximately $53,000,000 for replacement power costs incurred during an outage after an initial 21- week waiting period. Members of NEIL I pay annual premiums and are subject to assessments if losses exceed the accumulated funds available to the insurer. The Company's present maximum aggregate assessment for incidents occurring during a policy year would be approximately $555,000. The Company is insured as to its interest in Beaver Valley Unit 1 and the Perry Plant under property damage insurance provided by American Nuclear Insurers (ANI) and Mutual Atomic Energy Liability Underwriters (MAELU) to the operating company for each plant. Under the ANI/MAELU arrangements, $500,000,000 of primary coverage and $800,000,000 of excess coverage for decontamination costs, debris removal and repair and/or replacement of property is provided for Beaver Valley Unit 1 and the Perry Plant. The Company pays annual premiums for this coverage and is not liable for retrospective assessments. A secondary level of coverage for Beaver Valley Unit 1 and the Perry Plant over and above the ANI/MAELU policy is provided by a decontamination liability, excess property and decommissioning liability insurance policy issued to each operating company by NEIL (NEIL II). Under NEIL II a minimum of $1,400,000,000 of coverage is available to pay costs required for decontamination operations in excess of the $1,350,000,000 provided by the primary ANI/MAELU policy. Additionally, a maximum of $250,000,000, as provided by NEIL II, would cover decommissioning costs in excess of funds already collected for decommissioning. Any remaining portion of the NEIL II proceeds after payment of decontamination costs will be available to pay excess property damage losses.Members of NEIL II pay annual premiums and are subject to assessments if losses exceed the accumulated funds available to the insurer. The Company's present maximum assessment for NEIL II coverage for accidents occurring during a policy year would be approximately $2,100,000. The NEIL II policy is renewable yearly. The Company intends to maintain insurance against nuclear risks as described above as long as it is available. To the extent that replacement power, property damage, decontamination, decommissioning, repair and replacement costs and other such costs arising from a nuclear incident at any of the Company's plants exceed the policy limits of the insurance from time to time in effect with respect to that plant, to the extent a nuclear incident is determined not to be covered by the Company's insurance policies, or to the extent such insurance becomes unavailable in the future, the Company would remain at risk for such costs. The NRC requires nuclear power plant licensees to obtain minimum property insurance coverage of $1,060,000,000 or the amount generally available from private sources, whichever is less. The proceeds of this insurance are required to be used first to ensure that the licensed reactor is in a safe and stable condition and can be maintained in that condition so as to prevent any significant risk to the public health and safety. Within 30 days of stabilization, the licensee is required to prepare and submit to the NRC a cleanup plan for approval. The plan is required to identify all cleanup operations necessary to decontaminate the reactor sufficiently to permit the resumption of operations or to commence decommissioning. Any property insurance proceeds not already expended to place the reactor in a safe and stable condition must be used first to complete those decontamination operations that are ordered by the NRC. The Company is unable to predict what effect these requirements may have on the availability of insurance proceeds to the Company for the Company's bondholders. Environmental Matters Various federal, state and local authorities regulate the Company with regard to air and water quality and other environmental matters. The Company has estimated capital expenditures for environmental compliance of approximately $17,000,000, which is included in the construction estimate given under "Financing and Construction - Future Financing" for 1994 through 1998. Air Regulation Under the provisions of the Clean Air Act of 1970, both the Commonwealth of Pennsylvania and the State of Ohio adopted ambient air quality standards, and related emission limits, including limits for sulfur dioxide (SO2) and particulates. In addition, the U.S. Environmental Protection Agency (EPA) promulgated an SO2 regulatory plan for Ohio which became effective for W. H. Sammis Unit 7 in 1977. Generating plants to be constructed in the future and some future modifications of existing facilities will be covered not only by the applicable state standards but also by EPA emission performance standards for new sources. In both Pennsylvania and Ohio the construction or modification of emission sources requires approval from appropriate environmental authorities, and the facilities involved may not be operated unless a permit or variance to do so has been issued by those same authorities. The Clean Air Act Amendments of 1990 require significant reductions of SO2 and oxides of nitrogen from the Company's coal-fired generating units by 1995 and additional emission reductions by 2000. Compliance options include, but are not limited to, installing additional pollution control equipment, burning less polluting fuel, purchasing emission allowances from others, operating existing facilities in a manner which minimizes pollution and retiring facilities. In a system compliance plan for the Company and Edison submitted to the PPUC and to the EPA, the Company stated that reductions for the years 1995 through 1999 are likely to be achieved by burning lower sulfur fuel, generating more electricity at their lower emitting plants and/or purchasing emission allowances. The Company continues to evaluate its compliance plan and other compliance options as they arise. Plans for complying with the year 2000 reductions are less certain at this time. The Company is required to meet federally approved SO2 regulations, and the violation of such regulations can result in injunctive relief, including shutdown of the generating unit involved, and/or civil or criminal penalties of up to $25,000 per day of violation. The EPA has an interim enforcement policy for the SO2 regulations in Ohio which allows for compliance with the regulations based on a 30-day averaging period. The EPA has proposed regulations which could cause changes in the interim enforcement policy including a revision of methods of determining compliance with emission limits. The Company cannot predict what action the EPA may take in the future with respect to the interim enforcement policy. Water Regulation Various water quality regulations, the majority of which are the result of the federal Clean Water Act and its amendments, apply to the Company's plants. In addition, Pennsylvania and Ohio have water quality standards applicable to the Company's operations. As provided in the Clean Water Act, authority to grant federal National Pollutant Discharge Elimination System (NPDES) water discharge permits can be assumed by a state. Pennsylvania and Ohio have assumed such authority. The Ohio Environmental Protection Agency (Ohio EPA) has issued an NPDES Permit for the W.H. Sammis Plant. The plant is in compliance with chemical limitations of the permit. The permit conditions would have required the addition of cooling towers to the W. H. Sammis Plant, however, the EPA and Ohio EPA have approved a variance request eliminating the current need for cooling towers. Waste Disposal As a result of the Resource Conservation and Recovery Act of 1976, as amended, and the Toxic Substances Control Act of 1976, federal and state hazardous waste regulations have been promulgated. These regulations may result in significantly increased costs to dispose of waste materials. The ultimate effect of these requirements cannot presently be determined. The Pennsylvania Department of Environmental Resources has issued regulations dealing with the storage, treatment, transportation and disposal of residual waste such as coal ash and scrubber sludge. These regulations impose additional requirements relating to permitting, ground water monitoring, leachate collection systems, closure, liability insurance and operating matters. The Company is developing and analyzing various compliance options and is currently unable to determine the ultimate increase in capital and operating costs at existing sites. Summary Environmental controls are still in the process of development and require, in many instances, balancing the needs for additional quantities of energy in future years and the need to protect the environment. As a result, the Company cannot now estimate the precise effect of existing and potential regulations and legislation upon any of its existing and proposed facilities and operations or upon its ability to issue additional first mortgage bonds under its mortgage. The mortgage contains covenants by the Company to observe and conform to all valid governmental requirements at the time applicable unless in course of contest, and provisions which, in effect, prevent the issuance of additional bonds if there is a completed default under the mortgage. The provisions of the mortgage, in effect, also require, in the opinion of counsel for the Company, that certification of property additions as the basis for the issuance of bonds or other action under the mortgage be accompanied by an opinion of counsel that the Company certifying such property additions has all governmental permissions at the time necessary for its then current ownership and operation of such property additions. The Company intends to contest any requirements it deems unreasonable or impossible for compliance or otherwise contrary to the public interest. Developments in these and other areas of regulation may require the Company to modify, supplement or replace equipment and facilities, and may delay or impede the construction and operation of new facilities, at costs which could be substantial. The Company expects that the impact of any such costs would eventually be reflected in its rate schedules. Fuel Supply The Company's sources of generation during 1993 were 76.8% coal and 23.2% nuclear. With the 1993 expiration of a long-term coal contract, the Company's coal supply for the New Castle Plant is currently supplied through spot purchases of coal produced from nearby reserves. The Company estimates its 1994 coal requirement to be 1,200,000 tons (including its share of the coal requirements of CAPCO's W. H. Sammis Unit 7 and the Bruce Mansfield Plant). The coal requirements of W. H. Sammis Unit 7 are furnished from mines located in Ohio, Pennsylvania and West Virginia through spot purchases and Edison contracts which expire at various times through February 28, 2003. See "Environmental Matters" for factors pertaining to meeting environmental regulations affecting coal- fired generating units. The Company, together with the other CAPCO companies, has several guarantees (the Company's composite percentage being approximately 6.7%) of certain debt and lease obligations in connection with a coal supply contract for the Bruce Mansfield Plant (see Note 8 of Notes to Financial Statements). As of December 31, 1993, the Company's share of the guarantees was $12,708,000. The price under the coal supply contract, which includes certain minimum payments, has been determined to be sufficient to satisfy the debt and lease obligations. This contract extends to December 31, 1999. The Company's fuel costs (excluding disposal costs) for each of the five years ended December 31, 1993, were as follows: 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Cost of Fuel consumed per million BTU's: Coal $1.37 $1.42 $1.41 $1.39 $1.34 Nuclear $ .97 $ .94 $1.05 $ .98 $ .98 Average fuel cost per kilowatt-hour generated (cents) 1.36 1.34 1.41 1.38 1.39 Nuclear Fuel OES Fuel is the sole lessor for the Company's nuclear fuel requirements (see "Financing and Construction - Future Financing" and Note 1 of Notes to Financial Statements). The Company and OES Fuel have contracts for the supply of uranium sufficient to meet projected needs through 2000 and conversion services sufficient to meet projected needs through 2001. Fabrication services for fuel assemblies have been contracted by the CAPCO companies for the next two reloads for Beaver Valley Unit 1 (through approximately 1996), and the next seven reloads for Perry Unit 1 (through approximately 2003). The CAPCO companies have a contract with the U.S. Enrichment Corporation for enrichment services for all CAPCO nuclear units through 2014. Prior to the expiration of existing commitments, the Company intends to make additional arrangements for the supply of uranium and for the subsequent conversion, enrichment, fabrication, reprocessing and/or waste disposal services, the specific prices and availability of which are not known at this time. Due to the present lack of availability of domestic reprocessing services, to the continuing absence of any program to begin development of such reprocessing capability and questions as to the economics of reprocessing, the Company is calculating nuclear fuel costs based on the assumption that spent fuel will not be reprocessed. On- site spent fuel storage facilities for the Perry Plant are expected to be adequate through 2010; facilities at Beaver Valley Unit 1 are expected to be adequate through 2011. After on-site storage capacity is exhausted, additional storage capacity will have to be obtained which could result in significant additional costs unless reprocessing services or permanent waste disposal facilities become available. The Federal Nuclear Waste Policy Act of 1982 provides for the construction of facilities for the disposal of high-level nuclear wastes, including spent fuel from nuclear power plants operated by electric utilities; however, the selection of a suitable site has become embroiled in the political process. Duquesne and CEI have each previously entered into contracts with the U.S. Department of Energy for the disposal of spent fuel from Beaver Valley Unit 1 and the Perry Plant, respectively. Capacity and Reserves The 1993 net maximum hourly demand on the Company of 690,000 kW (including 63,000 kW of firm power sales which extend through 2005 as discussed under "Competition") occurred on August 26, 1993. The seasonal capability of the Company on that day was 901,000 kW. Of that system capability, 23% was available to serve additional load, after giving effect to term power sales to other utilities. Based on existing capacity, the load forecast made in November 1993 and anticipated term power sales to other utilities, the capacity margins during the 1994-1998 period are expected to range from about 16% to 23%. Regional Reliability The Companies participate with 26 other electric companies operating in nine states in the East Central Area Reliability Coordination Agreement (ECAR), which was organized for the purpose of furthering the reliability of bulk power supply in the area through coordination of the planning and operation by the ECAR members of their bulk power supply facilities. The ECAR members have established principles and procedures regarding matters affecting the reliability of the bulk power supply within the ECAR region. Procedures have been adopted regarding: i) the evaluation and simulated testing of systems' performance; ii) the establishment of minimum levels of daily operating reserves; iii) the development of a program regarding emergency procedures during conditions of declining system frequency; and iv) the basis for uniform rating of generating equipment. Competition The Company competes with other utilities for intersystem bulk power sales and for sales to municipalities. The Company competes with suppliers of natural gas and other forms of energy in connection with its industrial and commercial sales and in the home climate control market, both with respect to new customers and conversions, and with all other suppliers of electricity. To date, there has been no substantial cogeneration by the Company's customers. In an effort to more fully utilize its facilities and hold down rates to its other customers, the Company has entered into a long-term power sales agreement with another utility. Currently, the Company is selling 63,000 kW annually under this contract through December 31, 2005. The Company has the option to reduce this commitment by 21,000 kW beginning June 1, 1996. Employees At December 31, 1993, the Company had 1,355 employees. ITEM 2. ITEM 2. PROPERTIES The Company's First Mortgage Indenture dated as of November 1, 1945, between the Company and Citibank, N.A. (successor to The First National Bank of the City of New York), as amended and supplemented, constitutes, in the opinion of the Company's counsel, a direct first lien on substantially all of the Company's physical property, subject only to excepted encumbrances, as defined in the Indenture. See Notes 5 and 6 of Notes to the Financial Statements for information concerning leases and financing encumbrances affecting certain of the Company's properties. The Company owns, individually or, together with one or more of the other CAPCO companies as tenants in common, the generating units in service shown below: Net Demonstrated Capacity (kW) ------------------------- Company's Ownership Plant-Location Unit Total Entitlement Interest -------------- ---- ----- ----------- --------- Coal-Fired Units - ---------------- New Castle-West Pittsburg, PA 3-5 333,000 333,000 100.00% Bruce Mansfield-Shippingport, PA 1 780,000 33,000 4.20% 2 780,000 53,000 6.80% 3 800,000 50,000 6.28% W. H. Sammis-Stratton, OH 7 600,000 125,000 20.80% Nuclear Units - ------------- Beaver Valley-Shippingport, PA 1 810,000 142,000 17.50% Perry-North Perry Village, OH 1 1,194,000 63,000 5.24% Oil-Fired Units - --------------- Various 164,000 25,000 15.18% ------- Total 824,000 ======= Prolonged outages of existing generating units might make it necessary for the Company, depending upon the state of demand from time to time for electric service upon its system, to use to a greater extent than otherwise, less efficient and less economic generating units, or purchased power, and in some cases may require the reduction of load during peak periods under the Company's interruptible programs, all to an extent not presently determinable. The Company's generating plants and load centers are connected by a transmission system consisting of elements having various voltage ratings ranging from 23 kilovolts (kV) to 345 kV. The Company's transmission lines aggregate 605 miles. Its electric distribution systems include 5,002 miles of pole line carrying primary, secondary and street lighting circuits. It owns, individually or, together with one or more of the other CAPCO companies as tenants in common, 84 substations with a total installed transformer capacity of 3,710,960 kilovolt-amperes, of which 16 are transmission substations, including 8 located at generating plants. The Company's transmission lines also interconnect with those of Edison, Duquesne and West Penn Power Company. These interconnections make possible utilization by the Company of generating capacity constructed as a part of the CAPCO program, as well as providing opportunities for the sale of power to other utilities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS See "Item 1 - Business - Nuclear Regulation" for information with respect to legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company is a wholly owned subsidiary of Ohio Edison Company. Quarterly dividends of $.85 and $1.10 per share were paid on the Company's common stock during 1993 and 1992, respectively. For information with respect to certain restrictions on the payment of cash dividends on common stock, see Note 6(a) of Notes to Financial Statements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by Items 6 through 8 is incorporated herein by reference to the Selected Financial Data, Management's Discussion and Analysis of Results of Operations and Financial Condition, and Financial Statements included on pages 1 through 4 and 6 through 19, respectively, in the Company's 1993 Annual Report to Stockholders. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The present term of office of each director extends until the next succeeding annual meeting of stockholders and until his successor is elected and shall qualify. The executive officers are elected at the annual organization meeting of the Board of Directors, held immediately after the annual meeting of stockholders, and hold office until the next such organization meeting, unless the Board of Directors shall otherwise determine, or unless a resignation is submitted. H. Peter Burg-Age 47 Senior Vice President and Chief Financial Officer of the Company's parent, Ohio Edison Company, since 1989. Vice President of Ohio Edison Company from 1986 to 1989. Director of the Company since 1988. Mr. Burg is also a director of Ohio Edison Company, Society National Bank, Akron District, and Energy Insurance Mutual. Robert H. Carlson-Age 67 Retired. President and Chief Executive Officer from 1988 to 1989 of Universal-Rundle Corporation, New Castle, Pennsylvania, a manufacturer of plumbing fixtures. Director of the Company since 1983. Mr. Carlson is also a director of Ohio Edison Company, First Federal Savings Bank of New Castle and its parent, First Shenango Bancorp, Inc. J. R. Edgerly-Age 63 Vice President, Secretary and General Counsel of the Company since 1987. Director of the Company since 1973. Willard R. Holland-Age 57 Chairman of the Board, Chief Executive Officer, and Chief Financial Officer of the Company and President and Chief Executive Officer of the Company's parent, Ohio Edison Company, since 1993. President and Chief Operating Officer of Ohio Edison Company from 1991 to 1993. Senior Vice President from 1988 to 1991 of Detroit Edison Company, an electric utility. Director of the Company since 1991. Mr. Holland is also a director of Ohio Edison Company. Robert L. Kensinger-Age 59 President of the Company since 1991. Division Manager of the Company's parent, Ohio Edison Company, from 1982 to 1991. Director of the Company since 1991. Mr. Kensinger is also a director of First Western Bank, N.A., New Castle, Pennsylvania, a subsidiary of First Western Bancorp, Inc. Joseph J. Nowak-Age 62 Retired. Consultant during 1993 and Vice President during 1992 of Armco Inc., and Executive Vice President-Operations from 1988 to 1992 of Cyclops Industries, Inc., manufacturers of steel products. Cyclops Industries, Inc. merged with Armco Inc. in 1992. Director of the Company since 1982. Jack E. Reed-Age 51 Vice President of the Company since 1992. Manager, Substation and Distribution, from 1991 to 1992 and Manager, Transmission and Distribution Maintenance, from 1988 to 1991 of the Company's parent, Ohio Edison Company. Director of the Company since 1992. Richard L. Werner-Age 62 Chairman of the Board, President, and Chief Executive Officer since 1980 of R. D. Werner Co., Inc., manufacturer of aluminum extrusions, ladders and scaffolding. Director of the Company since 1993. Mr. Werner is also a director of Integra National Bank/North, Oil City, Pennsylvania, a subsidiary of Integra Financial Corporation. Robert P. Wushinske-Age 54 Vice President and Treasurer of the Company since 1987. David W. McKean-Age 41 Comptroller of the Company since 1992. Director of Financial Reporting of the Company's parent, Ohio Edison Company, from 1985 to 1992. (1) See Long-Term Incentive Plan Table for Incentive Compensation Plan awards mandatorily or voluntarily deferred into the Common Stock Equivalent Account. (2) Consists of reimbursement for income tax obligations on Executive Indemnity Program premium and on certain other executive perquisites. (3) For 1993, amount is comprised of (1) matching Edison Common Stock contributions under the tax qualified Savings Plan: Holland - $706; Rogers - $559; Kensinger - $5,806; Reed -$4,604; Edgerly - $4,513; Wushinske - $2,930; (2) the current dollar value of the Executive Supplemental Life Plan benefit at age 65 that is attributable to the Company's portion of the premiums it paid in 1993: Holland - $1,930; Rogers - $4,840; Kensinger - $2,797; Reed - $933; Edgerly - $2,896; Wushinske - $1,219; (3) above market interest earned under the Executive Deferred Compensation Plan: Holland - $1,701; Rogers - 1,989; Kensinger -$2,539; Reed -$960; Edgerly - $0; Wushinske - $0; and (4) a portion of the Executive Indemnity Program premium reportable as income: Holland - $0; Rogers -$3,798; Kensinger - $72; Reed - $21; Edgerly - $0; Wushinske - $0. (4) Mr. Holland was elected Chairman of the Board effective March 1, 1993, the day of Mr. Rogers' retirement. (5) Mr. Kensinger was elected President effective August 24, 1991. For 1991, amounts include compensation by Edison and the Company. (6) Mr. Reed was elected Vice President effective August 18, 1992. For 1992, amounts include compensation by Edison and the Company. Messrs. Holland and Kensinger must defer 50% of their annual Executive Incentive Compensation Plan award into a Common Stock Equivalent Account. Messrs. Reed, Edgerly, and Wushinske may voluntarily defer a portion of their annual incentive award into the Common Stock Equivalent Account. At the end of a four-year performance period, the Common Stock Equivalent Account attributed to the deferred award for that period will be valued as if the compensation deferred into the account had been invested in Edison's Common Stock and any dividends that would have been paid on such stock were reinvested on the date paid. This value may be increased or decreased based upon the total return of Edison's Common Stock relative to an electric utility industry index during the period and the Companies' price change to residential customers relative to a peer group of twenty electric utilities. The final value of an executive's account will be paid to the executive in cash. If an executive retires, dies or otherwise leaves the employment of the Company prior to the end of the four-year deferral period, the executive's account will be valued and paid to the executive or the executive's beneficiary in the year following such event. Mr. J. T. Rogers, Jr. retired on March 1, 1993. His account was valued and paid on March 1, 1994. The maximum amount in the above table will be earned if the Companies' price change to residential customers is ranked in the lowest (fifth) quintile of the peer group (i.e., the lowest 20 percent of the peer group) and Edison's total shareholder return is in the top (first) quintile compared to the index. The target amount will be earned if the Companies' price change to residential customers is in the fourth quintile and Edison's total shareholder return is in the second quintile. The threshold amount will be earned if the Companies' price change to residential customers is above the third quintile and Edison's total shareholder return is below the third quintile. Supplemental Executive Retirement Plan The Company participates in the Ohio Edison System Supplemental Executive Retirement Plan. Currently, two of the executive officers listed above (W. R. Holland and R. L. Kensinger) are eligible to participate in the Plan. At normal retirement, eligible senior executives of the Company who have five or more years of service with the Ohio Edison System are provided a retirement benefit equal to 65 percent of their highest annual salary from the Company, reduced by the executive's pensions under tax- qualified pension plans of the Company or other employers, any supplementary pension under the Company's Executive Deferred Compensation Plan, and Social Security benefits. Subject to exceptions that might be made in specific cases, senior executives retiring prior to age 65, or with less than five years of service, or both, may receive a similar but reduced benefit. This Plan also provides for disability and surviving spouse benefits. As of the end of 1993, the estimated annual retirement benefits of W. R. Holland from all of the above sources was $49,584 and the estimated annual retirement benefits of R. L. Kensinger from such sources was $98,547. Mr. J. T. Rogers, Jr. retired on March 1, 1993 with an annual retirement benefit from the above sources of $64,729. Pension Plan The Company's trusteed noncontributory Pension Plan covers substantially all full-time employees including officers of the Company. Pension benefits are determined using a formula based on a Pension Plan participant's years of accrued service and average rate of monthly earnings for the highest 60 months of the last 120 months of accrued service immediately preceding retirement or termination of service. Compensation covered by the Pension Plan consists of basic cash wages and compensation deferred through the Savings Plan up to the maximum amount permitted under the Internal Revenue Code of 1986, as adjusted in accordance with regulations. This amount was $235,840 per year for 1993 and is $150,000 per year for 1994. In addition, a supplementary pension benefit may be payable to participants in the Executive Deferred Compensation Plan. Compensation for 1993 covered by these two plans for the officers shown in the Executive Compensation Table who are not currently participants in the Ohio Edison System Supplemental Executive Retirement Plan is shown under the Salary column of the Table. The credited years of service for these same officers are as follows: J. E. Reed-27 years; J. R. Edgerly-28 years and R. P. Wushinske-20 years. The following table shows the estimated annual amounts payable upon retirement as pension benefits under the Pension Plan and the supplemental pension benefit under the Executive Deferred Compensation Plan, based on specified compensation and years of credited service classifications, assuming continuation of both such present Plans and employment until age 65. Retirement prior to age 62 results in a reduction of pension benefits. The amounts shown are subject to a reduction based on an individual's covered compensation, date of birth and years of credited service as defined by the Pension Plan and its optional survivorship provision and to limitations based on requirements contained in the Internal Revenue Code of 1986, as amended, which limited the maximum annual retirement benefits under the Plans to $115,641 in 1993 and would limit benefits to $118,800 in 1994. Estimated Annual Retirement Payment from the Pension Plan and the Annual Supplementary Pension Benefit under the Executive Deferred Compensation Plan ------------------------------------------------------ Applicable 15 Years 25 Years 35 Years 45 Years Annual Earnings Service Service Service Service --------------- --------- --------- --------- --------- $ 80,000 $22,800 $36,000 $ 45,600 $ 55,600 100,000 28,500 45,000 57,000 69,500 120,000 34,200 54,000 68,400 83,400 140,000 39,900 63,000 79,800 97,300 160,000 45,600 72,000 91,200 111,200 180,000 51,300 81,000 102,600 125,100 Additional Information Regarding Compensation The Board of Directors has no compensation committee. The Company's practice is to have the board, other than Mr. Holland, establish the compensation of Mr. Holland as chief executive officer and have Mr. Holland establish the compensation of the other executive officers of the Company. J.R. Edgerly, R.L. Kensinger and J.E. Reed are executive officers of the Company who also serve as directors. Both Mr. Holland and Mr. Burg are directors and executive officers of Edison. Compensation of Directors Directors who are not employees of the Companies receive an annual retainer of $4,200 and 100 shares of Edison Common Stock for each full year of service. Such directors are also paid a meeting fee of $375 for each board meeting attended and are reimbursed for expenses for the attendance thereof, if any. Directors who are also employees of the Company or of Edison receive no compensation for serving as directors. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Security Ownership of Certain Beneficial Owners at March 23, 1994: Name and Address of Amount and Nature of Percent Title of Class Beneficial Owner Beneficial Ownership of Class -------------- -------------------- -------------------- -------- Common Stock, Ohio Edison Company 6,290,000 shares 100% $30 par value 76 South Main Street held directly Akron, Ohio 44308 (b) Security Ownership of Management at January 1, 1994: Title of Class Percent of Class -------------- ---------------- Edison Nature of Edison Common Stock Beneficial Common ------------ Ownership Stock No. of Shares ------------- H. Peter Burg 7,624 Direct or Indirect Less than one percent Robert H. Carlson 3,069 " " J. R. Edgerly 1,649 " " Willard R. Holland 3,227 " " Robert L. Kensinger 1,369 " " Joseph J. Nowak 7,110 " " Jack E. Reed 2,961 " " Richard L. Werner 85 Robert P. Wushinske 1,208 " " All directors and officers as a group (12 persons) 34,352 " " (c) Changes in Control: Not applicable ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements Included in Part II of this report and incorporated herein by reference to the Company's 1993 Annual Report to Stockholders (Exhibit 13 below) at the pages indicated. Page No. -------- Statements of Income-Three Years Ended December 31, 1993 6 Balance Sheets-December 31, 1993 and 1992 7 Statements of Capitalization-December 31, 1993 and 1992 8 Statements of Retained Earnings-Three Years Ended December 31, 1993 9 Statements of Capital Stock and Other Paid-In Capital- Three Years Ended December 31, 1993 9 Statements of Cash Flows-Three Years Ended December 31, 1993 10 Statements of Taxes-Three Years Ended December 31, 1993 11 Notes to Financial Statements 12-19 Report of Independent Public Accountants 19 2. Financial Statement Schedules Included in Part IV of this report: Page No. -------- Report of Independent Public Accountants on Schedules 27 Schedules - Three Years Ended December 31, 1993: V - Property, Plant and Equipment 28-30 VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 31-33 VIII - Valuation and Qualifying Accounts and Reserves 34 IX - Short-Term Borrowings 35 X - Supplementary Income Statement Information 36 Schedules other than those listed above are omitted for the reason that they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. 3. Exhibits Exhibit Number - ------ 3-1 - Agreement of Merger and Consolidation dated April 1, 1929, among Pennsylvania Power Company ("Penn Power"), Harmony Electric Company and Peoples Power Company (consummated May 31, 1930), copies of Letters Patent issued thereon, together with the Election Return and Treasurer's Return, relative to decrease of capital stock; Election Return authorizing change of capital stock and increase of indebtedness; Election Return authorizing change of capital stock; Election Return authorizing increase of capital stock; Election Return establishing 4.24% Preferred Stock; Certificate with respect to the establishment of the 4.64% Preferred Stock; Election Returns and Certificates of Actual Sale in connection with the purchase by Penn Power of all the property of Pine-Mercer Electric Company, Industry Borough Electric Company, Ohio Township Electric Company, and Shippingport Borough Electric Company; Certificate of Change of Location of Penn Power's principal office; Certificate of Consent authorizing increase in authorized Common Stock; Certificate of Consent with respect to the removal of limitations on the authorized amount of indebtedness of Penn Power; Election Returns and Certificates of Actual Sale in connection with the purchase by Penn Power of all the property of Borolak Public Service Company, Eastfax Public Service Company, Norango Public Service Company, Sadwick Public Service Company, Sosango Public Service Company, Surrick Public Service Company, Wesango Public Service Company, and Westfax Public Service Company; Certificate of Change of Location of Penn Power's principal office; Amendment to the Charter extending the territory in which Penn Power may operate in the Borough of Shippingport, Beaver County, Pennsylvania; Certificate of Consent authorizing increase in authorized Common Stock; Certificate with respect to the establishment of the 8% Preferred Stock; Certificate accepting Business Corporation Law of Pennsylvania for government and regulation of affairs of Penn Power; Articles of Amendment incorporating certain protective provisions relating to Preferred Stock, increasing amount of authorized Preferred Stock and authorizing future increases in amounts of authorized Preferred Stock without a vote of the holders of Preferred Stock; Articles of Amendment increasing the authorized number of shares of Common Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 7.64% Preferred Stock; Articles of Amendment increasing the authorized number of shares of Common Stock; Articles of Amendment increasing the number of authorized shares of Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 8.48% Preferred Stock; Articles of Amendment authorizing sinking fund requirements for Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 11% Preferred Stock; Articles of Amendment increasing the authorized number of shares Exhibit Number - ------ of Common Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 9.16% Preferred Stock; Articles of Amendment increasing authorized number of shares of Common Stock; Articles of Amendment increasing authorized number of shares of Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 8.24% Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 10.50% Preferred Stock; Articles of Amendment increasing authorized number of shares of Common Stock; Articles of Amendment increasing authorized number of shares of Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 15.00% Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 11.50% Preferred Stock; Articles of Amendment increasing authorized number of shares of Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 13.00% Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 11.50% Preferred Stock, Series B; Articles of Amendment effective April 2, 1987, adding a standard of care for, and limiting the personal liability of, officers and directors; Articles of Amendment effective April 1, 1992, setting forth corporate purposes of the Company; and Statement With Respect to Shares with respect to the establishment of the 7.625% Preferred Stock.(Physically filed and designated respectively, as follows: in Form A-2, Registration No. 2-3889, as Exhibit A-1; in Form 1-MD for 1938, File No. 2-3889, as Exhibit (a)-1; in Form 1-MD for 1945, File No. 2-3889, as Exhibit A; in Form U-1, File No. 70-2310, as Exhibit A-3 (d); in Form 8-K for March 1951, File No. 1-3491, as Exhibit B; in Form 8-K for June 1958, File No. 1-3491B, as Exhibit 1; in Form 10-K for 1959 as Exhibits 1, 2, 3 and 4; in Form 8-K for March 1960, File No. 1-3491B as Exhibit A; in Form U-1, File No. 70-3971, as Exhibit A-2; in Form U-1, File No. 70- 4055, as Exhibit A-2; as Exhibits 1 through 8 in Form 8-K for January 1962, File No. 1-3491; as Exhibit A in Form 8-K for August 1963, File No. 1-3491; as Exhibits A and B in Form 8-K for September 1969, File No. 1-3491; as Exhibit B in Form 8-K for April 1971, File No. 1-3491; as Exhibit B in Form 8-K for September 1971, File No. 1-3491; in Form U-1, File No. 70-5264, as Exhibit A-2; as Exhibit A in Form 8-K for September 1972, File No. 1-3491; as Exhibit A in Form 8-K for December 1972, File No. 1-3491; as Exhibit A in Form 8-K for March 1973, File No. 1-3491; as Exhibit A in Form 8-K for December 1973, File No. 1-3491; as Exhibits A and C in Form 8-K for February 1974, File No. 1-3491; as Exhibits A and B in Form 8-K for January 1975, File No. 1-3491; as Exhibit F in Form 8-K for May 1975, File No. 1-3491; as Exhibit A in Form 8-K for April 1976, File No. 1- 3491; as Exhibit G in Form 10-Q for quarter ended June 30, 1977, File No. 1-3491; as Exhibit C in Form 10-K for 1977, File No. 1-3491; as Exhibit A in Form 10-K for 1977, File No. 1-3491; as Exhibit D in Form 10-Q for quarter ended June 30, 1980, File No. 1-3491; as Exhibit (4) in Form 10-Q for quarter ended June 30, 1981, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended June 30, 1982, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended September 30, 1982, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended September 30, 1983, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended March 31, 1984, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended June 30, 1984, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended September 30, 1985, File No. 1-3491; as Exhibit 3-2 in Form 10-K for 1987 File No. 1-3491; as Exhibit 3-2 in Form 10-K for 1992 File No. 1-3491; and as Exhibit 19-2 in Form 10-K for 1992 File No. 1-3491.) (A)3-2 - Statement With Respect to Shares with respect to the establishment of the 7.75% Preferred Stock. 3-3 - By-Laws of the Company as amended March 25, 1992.(1992 Form 10-K, Exhibit 3-3, File No. 1-3491.) Exhibit Number - ------- 4-1* - Indenture dated as of November 1, 1945, between the Company and The First National Bank of the City of New York (now Citibank, N.A.), as Trustee, as supplemented and amended by Supplemental Indentures dated as of May 1, 1948, March 1, 1950, February 1, 1952, October 1, 1957, September 1, 1962, June 1, 1963, June 1, 1969, May 1, 1970, April 1, 1971, October 1, 1971, May 1, 1972, December 1, 1974, October 1, 1975, September 1, 1976, April 15, 1978, June 28, 1979, January 1, 1980, June 1, 1981, January 14, 1982, August 1, 1982, December 15, 1982, December 1, 1983, September 6, 1984, December 1, 1984, May 30, 1985, October 29, 1985, August 1, 1987, May 1, 1988, November 1, 1989, December 1, 1990, September 1, 1991, May 1, 1992, July 15, 1992, and August 1, 1992.(Physically filed and designated as Exhibits 2(b) (1)-1 through 2(b) (l)-15 in Registration Statement File No. 2-60837; as Exhibits 2(b) (2), 2(b) (3), and 2 (b) (4) in Registration Statement File No. 2-68906; as Exhibit 4-2 in Form 10-K for 1981 File No. 1-3491; as Exhibit 19-1 in Form 10-K for 1982 File No. 1-3491; as Exhibit 19-1 in Form 10- K for 1983 File No. 1-3491; as Exhibit 19-1 in Form 10-K for 1984 File No. 1-3491; as Exhibit 19-1 in Form 10-K for 1985 File No. 1-3491; as Exhibit 19-1 in Form 10-K for 1987 File No. 1-3491; as Exhibit 19- 1 in Form 10-K for 1988 File No. 1-3491; as Exhibit 19 in Form 10-K for 1989 File No. 1-3491; as Exhibit 19 in Form 10-K for 1990 File No. 1-3491; as Exhibit 19 in Form 10-K for 1991 File No. 1-3491; and as Exhibit 19-1 in Form 10-K for 1992 File No. 1-3491.) - ---------------- * Pursuant to paragraph (b) (4) (iii) (A) of Item 601 of Regulation S-K, the Company has not filed as an exhibit to this Form 10-K any instrument with respect to long-term debt if the total amount of securities authorized thereunder does not exceed 10% of the total assets of the Company, but hereby agrees to furnish to the Commission on request any such instruments. (A)4-2 - Supplemental Indentures dated as of May 1, 1993, July 1, 1993, August 31, 1993, September 1, 1993, September 15, 1993, October 1, 1993, and November 1, 1993, between the Company and Citibank, N.A., as Trustee. 10-1 - Administration Agreement between the CAPCO Group dated as of September 14, 1967. (Registration Statement of Ohio Edison Company, File No. 2-43102, Exhibit 5 (c) (2).) 10-2 - Amendment No. 1 dated January 4, 1974 to Administration Agreement between the CAPCO Group dated as of September 14, 1967. (Registration Statement No. 2-68906, Exhibit 5 (c) (3).) 10-3 - Transmission Facilities Agreement between the CAPCO Group dated as of September 14, 1967. (Registration Statement of Ohio Edison Company, File No. 2-43102, Exhibit 5 (c) (3).) 10-4 - Amendment No. 1 dated as of January 1, 1993 to Transmission Facilities Agreement between the CAPCO Group dated as of September 14, 1967. (1993 Form 10-K, Exhibit 10-4, Ohio Edison Company.) 10-5 - Agreement for the Termination or Construction of Certain Agreements effective September 1, 1980 among the CAPCO Group. (Registration Statement No. 2-68906, Exhibit 10-4.) 10-6 - Amendment dated as of December 23, 1993 to Agreement for the Termination or Construction of Certain Agreements effective September 1, 1980 among the CAPCO Group. (1993 Form 10-K, Exhibit 10-6, Ohio Edison Company.) 10-7 - CAPCO Basic Operating Agreement, as amended September 1, 1980. (Physically filed and designated in Registration Statement No. 2-68906, as Exhibit 10-5.) 10-8 - Amendment No. 1 dated August 1, 1981 and Amendment No. 2 dated September 1, 1982, to CAPCO Basic Operating Agreement as amended September 1, 1980. (September 30, 1981 Form 10-Q, Exhibit 20-1, and 1982 Form 10-K, Exhibit 19-3, File No. 1-2578, of Ohio Edison Company.) 10-9 - Amendment No. 3 dated as of July 1, 1984, to CAPCO Basic Operating Agreement as amended September 1, 1980. (1985 Form 10- K, Exhibit 10-7, File No. 1-2578, of Ohio Edison Company.) 10-10 - Basic Operating Agreement between the CAPCO Companies as amended October 1, 1991. (1991 Form 10-K, Exhibit 10-8, File No. 1-2578, of Ohio Edison Company.) 10-11 - Basic Operating Agreement between the CAPCO Companies, as amended January 1, 1993. (1993 Form 10-K, Exhibit 10-5, Ohio Edison Company.) 10-12 - Memorandum of Agreement effective as of September 1, 1980, among the CAPCO Group. (1991 Form 10-K, Exhibit 19-2, Ohio Edison Company.) 10-13 - Operating Agreement for Beaver Valley Power Station Units Nos. 1 and 2 as Amended and Restated September 15, 1987, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 10-15, File No. 1-2578, of Ohio Edison Company.) 10-14 - Construction Agreement with respect to Perry Plant between the CAPCO Group dated as of July 22, 1974. (Registration Statement of Toledo Edison Company, File No. 2-52251, as Exhibit 5 (yy).) 10-15 - Participation Agreement No. 1 relating to the financing of the development of certain coal mines, dated as of October 1, 1973, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration Statement of Ohio Edison Company, File No. 2-61146, Exhibit 5 (e) (1).) 10-16 - Amendment No. 1 dated as of September 15, 1978, to Participation Agreement No. 1 dated as of October 1, 1973, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 5 (e) (2).) 10-17 - Participation Agreement No. 2 relating to the financing of the development of certain coal mines, dated as of August 1, 1974, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Ohio Edison Company, File No. 2-53059, Exhibit 5 (h) (2).) 10-18 - Amendment No. 1 dated as of September 15, 1978, to Participation Agreement No. 2 dated as of August 1, 1974, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 5 (e) (4).) 10-19 - Participation Agreement No. 3 relating to the financing of the development of certain coal mines, dated as of September 15, 1978, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 5 (e) (5).) Exhibit Number - ------- 10-20 - Participation Agreement No. 4 relating to the financing of the development of certain coal mines, dated as of October 31, 1980, among Quarto Mining Company, the CAPCO Group, the Loan Participants listed in Schedule A thereto and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 10-16.) 10-21 - Participation Agreement No. 5 dated as of May 1, 1986, among Quarto Mining Company, the CAPCO Companies, the Loan Participants listed in Schedule A thereto, and National City Bank, as Bond Trustee. (1986 Form 10-K, Exhibit 10-22, File No. 1-2578, Ohio Edison Company.) 10-22 - Participation Agreement No. 6 dated as of December 1, 1991, among Quarto Mining Company, the CAPCO Companies, the Loan Participants listed in Schedule A thereto, National City Bank, as Mortgage Bond Trustee, and National City Bank, as Refunding Bond Trustee. (1991 Form 10-K, Exhibit 10-19, File No. 1-2578, Ohio Edison Company.) 10-23 - Agreement entered into as of October 20, 1981, among the CAPCO Companies regarding the use of Quarto Coal at Mansfield Units Nos. 1, 2 and 3. (1981 Form 10-K, Exhibit 20-1 Form 10-K, File No. 1-2578, Ohio Edison Company.) 10-24 - Restated Option Agreement dated as of May 1, 1983, by and between The North American Coal Corporation and the CAPCO Companies. (1983 Form 10-K, Exhibit 19-1, File No. 1-2578, Ohio Edison Company.) 10-25 - Trust Indenture and Mortgage dated as of October 1, 1973, between Quarto Mining Company and National City Bank, as Bond Trustee, together with Guaranty, dated as of October 1, 1973, with respect thereto by the CAPCO Group. (Registration Statement of Ohio Edison Company, File No. 2-61146, Exhibit 5 (e) (5).) 10-26 - Amendment No. 1 dated August 1, 1974, to Trust Indenture and Mortgage dated as of October 1, 1973, between Quarto Mining Company and National City Bank, as Bond Trustee, together with Amendment No. 1 dated August 1, 1974, to Guaranty dated as of October 1, 1973, with respect thereto by the CAPCO Group. (Registration Statement of Ohio Edison Company, File No. 2- 53059, Exhibit 5 (h) (2).) 10-27 - Amendment No. 2 dated as of September 15, 1978, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee, together with Amendment No. 2 dated as of September 15, 1978, to Bond Guaranty dated as of October 1, 1973, as amended, between the CAPCO Group and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibits 5 (e) (11) and 5 (e) (12).) 10-28 - Amendment No. 3 dated as of October 31, 1980, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 10-16.) 10-29 - Amendment No. 4 dated as of July 1, 1985, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee. (1985 Form 10-K, Exhibit 10-28 in Form 10-K, File No. 1-2578, Ohio Edison Company.) 10-30 - Amendment No. 5 dated as of May 1, 1986, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee. (1986 Form 10-K, Exhibit 10-30, File No. 1-2578, Ohio Edison Company.) 10-31 - Amendment No. 6 dated as of December 1, 1991, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee. (1991 Form 10-K, Exhibit 10-28, File No. 1-2578, Ohio Edison Company.) Exhibit Number - ------- 10-32 - Trust Indenture dated as of December 1, 1991, between Quarto Mining Company and National City Bank, as Bond Trustee. (1991 Form 10-K, Exhibit 10-29, File No. 1-2578, Ohio Edison Company.) 10-33 - Amendment No. 3 dated as of October 31, 1980, to the Bond Guaranty dated as of October 1, 1973, as amended, with respect to the CAPCO Group. (Registration Statement No. 2-68906, Exhibit 10-16.) 10-34 - Amendment No. 4 dated as of July 1, 1985, to the Bond Guaranty dated as of October 1, 1973, as amended, by the CAPCO Companies to National City Bank, as Bond Trustee. (1985 Form 10-K, Exhibit 10-30 , File No. 1-2578, Ohio Edison Company.) 10-35 - Amendment No. 5 dated as of May 1, 1986, to the Bond Guaranty dated as of October 1, 1973, as amended, by the CAPCO Companies to National City Bank, as Bond Trustee. (1986 Form 10-K, Exhibit 10-33, File No. 1-2578, Ohio Edison Company.) 10-36 - Amendment No. 6A dated as of December 1, 1991, to the Bond Guaranty dated as of October 1, 1973, as amended, by the CAPCO Companies to National City Bank, as Bond Trustee. (1991 Form 10- K, Exhibit 10-33, File No. 1-2578, Ohio Edison Company.) 10-37 - Amendment No. 6B dated as of December 30, 1991, to the Bond Guaranty dated as of October 1, 1973, as amended, by the CAPCO Companies to National City Bank, as Bond Trustee. (1991 Form 10- K, Exhibit 10-34, File No. 1-2578, Ohio Edison Company.) 10-38 - Bond Guaranty dated as of December 1, 1991, by the CAPCO Companies to National City Bank, as Bond Trustee. (1991 Form 10- K, Exhibit 10-35, File No. 1-2578, Ohio Edison Company.) 10-39 - Open End Mortgage dated as of October 1, 1973, between Quarto Mining Company and the CAPCO Companies and Amendment No. 1 thereto dated as of September 15, 1978. (Registration Statement No. 2-68906, Exhibit 10-23.) 10-40 - Restructuring Agreement dated as of April 1, 1985, among Quarto Mining Company, the CAPCO Companies, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in schedules thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (1985 Form 10-K, Exhibit 10-33, File No. 1-2578, Ohio Edison Company.) 10-41 - Unsecured Note Guaranty dated as of July 1, 1985, by the CAPCO Companies to General Electric Credit Corporation. (1985 Form 10- K, Exhibit 10-34, File No. 1-2578, Ohio Edison Company.) 10-42 - Memorandum of Understanding dated as of March 31, 1985, among the CAPCO Companies. (1985 Form 10-K, Exhibit 10-35, File No. 1-2578, Ohio Edison Company.) (B)10-43- Ohio Edison Company Executive Incentive Compensation Plan (which includes, by definition, Pennsylvania Power Company). (1984 Form 10-K, Exhibit 19-2, File No. 1-2578, Ohio Edison Company.) (B)10-44- Ohio Edison Company Executive Incentive Compensation Plan as amended February 16, 1987. (1986 Form 10-K, Exhibit 10-40, File No. 1-2578, Ohio Edison Company.) (B)10-45- Ohio Edison System Restated and Amended Executive Deferred Compensation Plan. (1989 Form 10-K, Exhibit 10-36, File No. 1- 2578, Ohio Edison Company.) (B)10-46- Ohio Edison System Restated and Amended Supplemental Executive Retirement Plan. (1989 Form 10-K, Exhibit 10-37, File No. 1- 2578, Ohio Edison Company.) 10-47- Operating Agreement for Perry Unit No. 1 dated March 10, 1987, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 28- 24, File No. 1-2578, Ohio Edison Company.) Exhibit Number - ------- 10-48- Operating Agreement for Bruce Mansfield Units Nos. 1, 2 and 3 dated as of June 1, 1976, and executed on September 15, 1987, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 28- 25, File No. 1-2578, Ohio Edison Company.) 10-49- Operating Agreement for W. H. Sammis Unit No. 7 dated as of September 1, 1971, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 28-26, File No. 1-2578, Ohio Edison Company.) 10-50- OE-APS Power Interchange Agreement dated March 18, 1987, by and among Ohio Edison Company and Pennsylvania Power Company, and Monongahela Power Company and West Penn Power Company and The Potomac Edison Company. (1987 Form 10-K, Exhibit 28-27, File No. 1-2578, of Ohio Edison Company.) 10-51- OE-PEPCO Power Supply Agreement dated March 18, 1987, by and among Ohio Edison Company and Pennsylvania Power Company and Potomac Electric Power Company. (1987 Form 10-K, Exhibit 28-28, File No. 1-2578, of Ohio Edison Company.) 10-52- Supplement No. 1 dated as of April 28, 1987, to the OE-PEPCO Power Supply Agreement dated March 18, 1987, by and among Ohio Edison Company, Pennsylvania Power Company and Potomac Electric Power Company. (1987 Form 10-K, Exhibit 28-29, File No. 1-2578, of Ohio Edison Company.) 10-53- APS-PEPCO Power Resale Agreement dated March 18, 1987, by and among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Potomac Electric Power Company. (1987 Form 10-K, Exhibit 28-30, File No. 1-2578, of Ohio Edison Company.) 10-54- Pennsylvania Power Company Master Decommissioning Trust Agreement for Beaver Valley Power Station Unit No. 1 dated as of March 15, 1988. (1988 Form 10-K, Exhibit 10-41, File No. 1- 3491.) 10-55- Pennsylvania Power Company Qualified Decommissioning Trust Agreement for Perry Nuclear Power Plant Unit No. 1 dated March 10, 1989. (1988 Form 10-K, Exhibit 10-42, File No. 1-3491.) 10-56- First Amendment dated May 31, 1991 to Pennsylvania Power Company Qualified Decommissioning Trust Agreement for Perry Nuclear Power Plant Unit No. 1. (1991 Form 10-K, Exhibit 10-46, File No. 1-3491.) 10-57- Nuclear Fuel Lease dated as of March 31, 1989, between OES Fuel, Incorporated, as Lessor, and Pennsylvania Power Company, as Lessee. (1989 Form 10-K, Exhibit 10-39, File No. 1-3491.) (A)13- 1993 Annual Report to Stockholders. (Only those portions expressly incorporated by reference in this Form 10-K are to be deemed "filed" with the Securities and Exchange Commission.) 18 - Letter from Independent Public Accountants regarding a change in accounting. 23 - Consent of Independent Public Accountants. (A) Provided herein in electronic format as an exhibit. (B) Management contract or compensatory plan contract or arrangements filed pursuant to Item 601 of Regulation S-K. (b) Reports on Form 8-K The Company filed one report on Form 8-K since September 30, 1993. A report dated December 13, 1993, reported the abandonment of Perry Unit 2 as a possible electric generating plant. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Pennsylvania Power Company: We have audited, in accordance with generally accepted auditing standards, the financial statements included in Pennsylvania Power Company's Annual Report to stockholders incorporated by reference in this Form 10-K and have issued our report thereon dated February 1, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, N.Y. February 1, 1994 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. PENNSYLVANIA POWER COMPANY BY /s/Willard R.Holland --------------------------------- Willard R. Holland Chairman of the Board and Chief Executive Officer Date: March 23, 1994 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 date indicated: /s/Willard R. Holland /s/Robert P. Wushinske - -------------------------------------- --------------------------- Willard R. Holland Robert P. Wushinske Chairman of the Board and Chief Vice President and Treasurer Executive Officer (Principal Executive (Principal Accounting Officer) Officer and Principal Financial Officer) /s/H. Peter Burg /s/Robert L. Kensinger - -------------------------------------- --------------------------- H. Peter Burg Robert L. Kensinger Director Director /s/Robert H. Carlson /s/Joseph J. Nowak - -------------------------------------- --------------------------- Robert H. Carlson Joseph J. Nowak Director Director /s/J. R. Edgerly /s/Jack E. Reed - -------------------------------------- --------------------------- J. R. Edgerly Jack E. Reed Director Director --------------------------- Richard L. Werner Director Date: March 23, 1994 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Security Ownership of Certain Beneficial Owners at March 23, 1994: Name and Address of Amount and Nature of Percent Title of Class Beneficial Owner Beneficial Ownership of Class -------------- -------------------- -------------------- -------- Common Stock, Ohio Edison Company 6,290,000 shares 100% $30 par value 76 South Main Street held directly Akron, Ohio 44308 (b) Security Ownership of Management at January 1, 1994: Title of Class Percent of Class -------------- ---------------- Edison Nature of Edison Common Stock Beneficial Common ------------ Ownership Stock No. of Shares ------------- H. Peter Burg 7,624 Direct or Indirect Less than one percent Robert H. Carlson 3,069 " " J. R. Edgerly 1,649 " " Willard R. Holland 3,227 " " Robert L. Kensinger 1,369 " " Joseph J. Nowak 7,110 " " Jack E. Reed 2,961 " " Richard L. Werner 85 Robert P. Wushinske 1,208 " " All directors and officers as a group (12 persons) 34,352 " " (c) Changes in Control: Not applicable ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements Included in Part II of this report and incorporated herein by reference to the Company's 1993 Annual Report to Stockholders (Exhibit 13 below) at the pages indicated. Page No. -------- Statements of Income-Three Years Ended December 31, 1993 6 Balance Sheets-December 31, 1993 and 1992 7 Statements of Capitalization-December 31, 1993 and 1992 8 Statements of Retained Earnings-Three Years Ended December 31, 1993 9 Statements of Capital Stock and Other Paid-In Capital- Three Years Ended December 31, 1993 9 Statements of Cash Flows-Three Years Ended December 31, 1993 10 Statements of Taxes-Three Years Ended December 31, 1993 11 Notes to Financial Statements 12-19 Report of Independent Public Accountants 19 2. Financial Statement Schedules Included in Part IV of this report: Page No. -------- Report of Independent Public Accountants on Schedules 27 Schedules - Three Years Ended December 31, 1993: V - Property, Plant and Equipment 28-30 VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 31-33 VIII - Valuation and Qualifying Accounts and Reserves 34 IX - Short-Term Borrowings 35 X - Supplementary Income Statement Information 36 Schedules other than those listed above are omitted for the reason that they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. 3. Exhibits Exhibit Number - ------ 3-1 - Agreement of Merger and Consolidation dated April 1, 1929, among Pennsylvania Power Company ("Penn Power"), Harmony Electric Company and Peoples Power Company (consummated May 31, 1930), copies of Letters Patent issued thereon, together with the Election Return and Treasurer's Return, relative to decrease of capital stock; Election Return authorizing change of capital stock and increase of indebtedness; Election Return authorizing change of capital stock; Election Return authorizing increase of capital stock; Election Return establishing 4.24% Preferred Stock; Certificate with respect to the establishment of the 4.64% Preferred Stock; Election Returns and Certificates of Actual Sale in connection with the purchase by Penn Power of all the property of Pine-Mercer Electric Company, Industry Borough Electric Company, Ohio Township Electric Company, and Shippingport Borough Electric Company; Certificate of Change of Location of Penn Power's principal office; Certificate of Consent authorizing increase in authorized Common Stock; Certificate of Consent with respect to the removal of limitations on the authorized amount of indebtedness of Penn Power; Election Returns and Certificates of Actual Sale in connection with the purchase by Penn Power of all the property of Borolak Public Service Company, Eastfax Public Service Company, Norango Public Service Company, Sadwick Public Service Company, Sosango Public Service Company, Surrick Public Service Company, Wesango Public Service Company, and Westfax Public Service Company; Certificate of Change of Location of Penn Power's principal office; Amendment to the Charter extending the territory in which Penn Power may operate in the Borough of Shippingport, Beaver County, Pennsylvania; Certificate of Consent authorizing increase in authorized Common Stock; Certificate with respect to the establishment of the 8% Preferred Stock; Certificate accepting Business Corporation Law of Pennsylvania for government and regulation of affairs of Penn Power; Articles of Amendment incorporating certain protective provisions relating to Preferred Stock, increasing amount of authorized Preferred Stock and authorizing future increases in amounts of authorized Preferred Stock without a vote of the holders of Preferred Stock; Articles of Amendment increasing the authorized number of shares of Common Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 7.64% Preferred Stock; Articles of Amendment increasing the authorized number of shares of Common Stock; Articles of Amendment increasing the number of authorized shares of Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 8.48% Preferred Stock; Articles of Amendment authorizing sinking fund requirements for Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 11% Preferred Stock; Articles of Amendment increasing the authorized number of shares Exhibit Number - ------ of Common Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 9.16% Preferred Stock; Articles of Amendment increasing authorized number of shares of Common Stock; Articles of Amendment increasing authorized number of shares of Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 8.24% Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 10.50% Preferred Stock; Articles of Amendment increasing authorized number of shares of Common Stock; Articles of Amendment increasing authorized number of shares of Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 15.00% Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 11.50% Preferred Stock; Articles of Amendment increasing authorized number of shares of Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 13.00% Preferred Stock; Statement Affecting Class or Series of Shares with respect to the establishment of the 11.50% Preferred Stock, Series B; Articles of Amendment effective April 2, 1987, adding a standard of care for, and limiting the personal liability of, officers and directors; Articles of Amendment effective April 1, 1992, setting forth corporate purposes of the Company; and Statement With Respect to Shares with respect to the establishment of the 7.625% Preferred Stock.(Physically filed and designated respectively, as follows: in Form A-2, Registration No. 2-3889, as Exhibit A-1; in Form 1-MD for 1938, File No. 2-3889, as Exhibit (a)-1; in Form 1-MD for 1945, File No. 2-3889, as Exhibit A; in Form U-1, File No. 70-2310, as Exhibit A-3 (d); in Form 8-K for March 1951, File No. 1-3491, as Exhibit B; in Form 8-K for June 1958, File No. 1-3491B, as Exhibit 1; in Form 10-K for 1959 as Exhibits 1, 2, 3 and 4; in Form 8-K for March 1960, File No. 1-3491B as Exhibit A; in Form U-1, File No. 70-3971, as Exhibit A-2; in Form U-1, File No. 70- 4055, as Exhibit A-2; as Exhibits 1 through 8 in Form 8-K for January 1962, File No. 1-3491; as Exhibit A in Form 8-K for August 1963, File No. 1-3491; as Exhibits A and B in Form 8-K for September 1969, File No. 1-3491; as Exhibit B in Form 8-K for April 1971, File No. 1-3491; as Exhibit B in Form 8-K for September 1971, File No. 1-3491; in Form U-1, File No. 70-5264, as Exhibit A-2; as Exhibit A in Form 8-K for September 1972, File No. 1-3491; as Exhibit A in Form 8-K for December 1972, File No. 1-3491; as Exhibit A in Form 8-K for March 1973, File No. 1-3491; as Exhibit A in Form 8-K for December 1973, File No. 1-3491; as Exhibits A and C in Form 8-K for February 1974, File No. 1-3491; as Exhibits A and B in Form 8-K for January 1975, File No. 1-3491; as Exhibit F in Form 8-K for May 1975, File No. 1-3491; as Exhibit A in Form 8-K for April 1976, File No. 1- 3491; as Exhibit G in Form 10-Q for quarter ended June 30, 1977, File No. 1-3491; as Exhibit C in Form 10-K for 1977, File No. 1-3491; as Exhibit A in Form 10-K for 1977, File No. 1-3491; as Exhibit D in Form 10-Q for quarter ended June 30, 1980, File No. 1-3491; as Exhibit (4) in Form 10-Q for quarter ended June 30, 1981, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended June 30, 1982, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended September 30, 1982, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended September 30, 1983, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended March 31, 1984, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended June 30, 1984, File No. 1-3491; as Exhibit 4 in Form 10-Q for quarter ended September 30, 1985, File No. 1-3491; as Exhibit 3-2 in Form 10-K for 1987 File No. 1-3491; as Exhibit 3-2 in Form 10-K for 1992 File No. 1-3491; and as Exhibit 19-2 in Form 10-K for 1992 File No. 1-3491.) (A)3-2 - Statement With Respect to Shares with respect to the establishment of the 7.75% Preferred Stock. 3-3 - By-Laws of the Company as amended March 25, 1992.(1992 Form 10-K, Exhibit 3-3, File No. 1-3491.) Exhibit Number - ------- 4-1* - Indenture dated as of November 1, 1945, between the Company and The First National Bank of the City of New York (now Citibank, N.A.), as Trustee, as supplemented and amended by Supplemental Indentures dated as of May 1, 1948, March 1, 1950, February 1, 1952, October 1, 1957, September 1, 1962, June 1, 1963, June 1, 1969, May 1, 1970, April 1, 1971, October 1, 1971, May 1, 1972, December 1, 1974, October 1, 1975, September 1, 1976, April 15, 1978, June 28, 1979, January 1, 1980, June 1, 1981, January 14, 1982, August 1, 1982, December 15, 1982, December 1, 1983, September 6, 1984, December 1, 1984, May 30, 1985, October 29, 1985, August 1, 1987, May 1, 1988, November 1, 1989, December 1, 1990, September 1, 1991, May 1, 1992, July 15, 1992, and August 1, 1992.(Physically filed and designated as Exhibits 2(b) (1)-1 through 2(b) (l)-15 in Registration Statement File No. 2-60837; as Exhibits 2(b) (2), 2(b) (3), and 2 (b) (4) in Registration Statement File No. 2-68906; as Exhibit 4-2 in Form 10-K for 1981 File No. 1-3491; as Exhibit 19-1 in Form 10-K for 1982 File No. 1-3491; as Exhibit 19-1 in Form 10- K for 1983 File No. 1-3491; as Exhibit 19-1 in Form 10-K for 1984 File No. 1-3491; as Exhibit 19-1 in Form 10-K for 1985 File No. 1-3491; as Exhibit 19-1 in Form 10-K for 1987 File No. 1-3491; as Exhibit 19- 1 in Form 10-K for 1988 File No. 1-3491; as Exhibit 19 in Form 10-K for 1989 File No. 1-3491; as Exhibit 19 in Form 10-K for 1990 File No. 1-3491; as Exhibit 19 in Form 10-K for 1991 File No. 1-3491; and as Exhibit 19-1 in Form 10-K for 1992 File No. 1-3491.) - ---------------- * Pursuant to paragraph (b) (4) (iii) (A) of Item 601 of Regulation S-K, the Company has not filed as an exhibit to this Form 10-K any instrument with respect to long-term debt if the total amount of securities authorized thereunder does not exceed 10% of the total assets of the Company, but hereby agrees to furnish to the Commission on request any such instruments. (A)4-2 - Supplemental Indentures dated as of May 1, 1993, July 1, 1993, August 31, 1993, September 1, 1993, September 15, 1993, October 1, 1993, and November 1, 1993, between the Company and Citibank, N.A., as Trustee. 10-1 - Administration Agreement between the CAPCO Group dated as of September 14, 1967. (Registration Statement of Ohio Edison Company, File No. 2-43102, Exhibit 5 (c) (2).) 10-2 - Amendment No. 1 dated January 4, 1974 to Administration Agreement between the CAPCO Group dated as of September 14, 1967. (Registration Statement No. 2-68906, Exhibit 5 (c) (3).) 10-3 - Transmission Facilities Agreement between the CAPCO Group dated as of September 14, 1967. (Registration Statement of Ohio Edison Company, File No. 2-43102, Exhibit 5 (c) (3).) 10-4 - Amendment No. 1 dated as of January 1, 1993 to Transmission Facilities Agreement between the CAPCO Group dated as of September 14, 1967. (1993 Form 10-K, Exhibit 10-4, Ohio Edison Company.) 10-5 - Agreement for the Termination or Construction of Certain Agreements effective September 1, 1980 among the CAPCO Group. (Registration Statement No. 2-68906, Exhibit 10-4.) 10-6 - Amendment dated as of December 23, 1993 to Agreement for the Termination or Construction of Certain Agreements effective September 1, 1980 among the CAPCO Group. (1993 Form 10-K, Exhibit 10-6, Ohio Edison Company.) 10-7 - CAPCO Basic Operating Agreement, as amended September 1, 1980. (Physically filed and designated in Registration Statement No. 2-68906, as Exhibit 10-5.) 10-8 - Amendment No. 1 dated August 1, 1981 and Amendment No. 2 dated September 1, 1982, to CAPCO Basic Operating Agreement as amended September 1, 1980. (September 30, 1981 Form 10-Q, Exhibit 20-1, and 1982 Form 10-K, Exhibit 19-3, File No. 1-2578, of Ohio Edison Company.) 10-9 - Amendment No. 3 dated as of July 1, 1984, to CAPCO Basic Operating Agreement as amended September 1, 1980. (1985 Form 10- K, Exhibit 10-7, File No. 1-2578, of Ohio Edison Company.) 10-10 - Basic Operating Agreement between the CAPCO Companies as amended October 1, 1991. (1991 Form 10-K, Exhibit 10-8, File No. 1-2578, of Ohio Edison Company.) 10-11 - Basic Operating Agreement between the CAPCO Companies, as amended January 1, 1993. (1993 Form 10-K, Exhibit 10-5, Ohio Edison Company.) 10-12 - Memorandum of Agreement effective as of September 1, 1980, among the CAPCO Group. (1991 Form 10-K, Exhibit 19-2, Ohio Edison Company.) 10-13 - Operating Agreement for Beaver Valley Power Station Units Nos. 1 and 2 as Amended and Restated September 15, 1987, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 10-15, File No. 1-2578, of Ohio Edison Company.) 10-14 - Construction Agreement with respect to Perry Plant between the CAPCO Group dated as of July 22, 1974. (Registration Statement of Toledo Edison Company, File No. 2-52251, as Exhibit 5 (yy).) 10-15 - Participation Agreement No. 1 relating to the financing of the development of certain coal mines, dated as of October 1, 1973, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration Statement of Ohio Edison Company, File No. 2-61146, Exhibit 5 (e) (1).) 10-16 - Amendment No. 1 dated as of September 15, 1978, to Participation Agreement No. 1 dated as of October 1, 1973, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 5 (e) (2).) 10-17 - Participation Agreement No. 2 relating to the financing of the development of certain coal mines, dated as of August 1, 1974, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Ohio Edison Company, File No. 2-53059, Exhibit 5 (h) (2).) 10-18 - Amendment No. 1 dated as of September 15, 1978, to Participation Agreement No. 2 dated as of August 1, 1974, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 5 (e) (4).) 10-19 - Participation Agreement No. 3 relating to the financing of the development of certain coal mines, dated as of September 15, 1978, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 5 (e) (5).) Exhibit Number - ------- 10-20 - Participation Agreement No. 4 relating to the financing of the development of certain coal mines, dated as of October 31, 1980, among Quarto Mining Company, the CAPCO Group, the Loan Participants listed in Schedule A thereto and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 10-16.) 10-21 - Participation Agreement No. 5 dated as of May 1, 1986, among Quarto Mining Company, the CAPCO Companies, the Loan Participants listed in Schedule A thereto, and National City Bank, as Bond Trustee. (1986 Form 10-K, Exhibit 10-22, File No. 1-2578, Ohio Edison Company.) 10-22 - Participation Agreement No. 6 dated as of December 1, 1991, among Quarto Mining Company, the CAPCO Companies, the Loan Participants listed in Schedule A thereto, National City Bank, as Mortgage Bond Trustee, and National City Bank, as Refunding Bond Trustee. (1991 Form 10-K, Exhibit 10-19, File No. 1-2578, Ohio Edison Company.) 10-23 - Agreement entered into as of October 20, 1981, among the CAPCO Companies regarding the use of Quarto Coal at Mansfield Units Nos. 1, 2 and 3. (1981 Form 10-K, Exhibit 20-1 Form 10-K, File No. 1-2578, Ohio Edison Company.) 10-24 - Restated Option Agreement dated as of May 1, 1983, by and between The North American Coal Corporation and the CAPCO Companies. (1983 Form 10-K, Exhibit 19-1, File No. 1-2578, Ohio Edison Company.) 10-25 - Trust Indenture and Mortgage dated as of October 1, 1973, between Quarto Mining Company and National City Bank, as Bond Trustee, together with Guaranty, dated as of October 1, 1973, with respect thereto by the CAPCO Group. (Registration Statement of Ohio Edison Company, File No. 2-61146, Exhibit 5 (e) (5).) 10-26 - Amendment No. 1 dated August 1, 1974, to Trust Indenture and Mortgage dated as of October 1, 1973, between Quarto Mining Company and National City Bank, as Bond Trustee, together with Amendment No. 1 dated August 1, 1974, to Guaranty dated as of October 1, 1973, with respect thereto by the CAPCO Group. (Registration Statement of Ohio Edison Company, File No. 2- 53059, Exhibit 5 (h) (2).) 10-27 - Amendment No. 2 dated as of September 15, 1978, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee, together with Amendment No. 2 dated as of September 15, 1978, to Bond Guaranty dated as of October 1, 1973, as amended, between the CAPCO Group and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibits 5 (e) (11) and 5 (e) (12).) 10-28 - Amendment No. 3 dated as of October 31, 1980, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee. (Registration Statement No. 2-68906, Exhibit 10-16.) 10-29 - Amendment No. 4 dated as of July 1, 1985, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee. (1985 Form 10-K, Exhibit 10-28 in Form 10-K, File No. 1-2578, Ohio Edison Company.) 10-30 - Amendment No. 5 dated as of May 1, 1986, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee. (1986 Form 10-K, Exhibit 10-30, File No. 1-2578, Ohio Edison Company.) 10-31 - Amendment No. 6 dated as of December 1, 1991, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee. (1991 Form 10-K, Exhibit 10-28, File No. 1-2578, Ohio Edison Company.) Exhibit Number - ------- 10-32 - Trust Indenture dated as of December 1, 1991, between Quarto Mining Company and National City Bank, as Bond Trustee. (1991 Form 10-K, Exhibit 10-29, File No. 1-2578, Ohio Edison Company.) 10-33 - Amendment No. 3 dated as of October 31, 1980, to the Bond Guaranty dated as of October 1, 1973, as amended, with respect to the CAPCO Group. (Registration Statement No. 2-68906, Exhibit 10-16.) 10-34 - Amendment No. 4 dated as of July 1, 1985, to the Bond Guaranty dated as of October 1, 1973, as amended, by the CAPCO Companies to National City Bank, as Bond Trustee. (1985 Form 10-K, Exhibit 10-30 , File No. 1-2578, Ohio Edison Company.) 10-35 - Amendment No. 5 dated as of May 1, 1986, to the Bond Guaranty dated as of October 1, 1973, as amended, by the CAPCO Companies to National City Bank, as Bond Trustee. (1986 Form 10-K, Exhibit 10-33, File No. 1-2578, Ohio Edison Company.) 10-36 - Amendment No. 6A dated as of December 1, 1991, to the Bond Guaranty dated as of October 1, 1973, as amended, by the CAPCO Companies to National City Bank, as Bond Trustee. (1991 Form 10- K, Exhibit 10-33, File No. 1-2578, Ohio Edison Company.) 10-37 - Amendment No. 6B dated as of December 30, 1991, to the Bond Guaranty dated as of October 1, 1973, as amended, by the CAPCO Companies to National City Bank, as Bond Trustee. (1991 Form 10- K, Exhibit 10-34, File No. 1-2578, Ohio Edison Company.) 10-38 - Bond Guaranty dated as of December 1, 1991, by the CAPCO Companies to National City Bank, as Bond Trustee. (1991 Form 10- K, Exhibit 10-35, File No. 1-2578, Ohio Edison Company.) 10-39 - Open End Mortgage dated as of October 1, 1973, between Quarto Mining Company and the CAPCO Companies and Amendment No. 1 thereto dated as of September 15, 1978. (Registration Statement No. 2-68906, Exhibit 10-23.) 10-40 - Restructuring Agreement dated as of April 1, 1985, among Quarto Mining Company, the CAPCO Companies, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in schedules thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (1985 Form 10-K, Exhibit 10-33, File No. 1-2578, Ohio Edison Company.) 10-41 - Unsecured Note Guaranty dated as of July 1, 1985, by the CAPCO Companies to General Electric Credit Corporation. (1985 Form 10- K, Exhibit 10-34, File No. 1-2578, Ohio Edison Company.) 10-42 - Memorandum of Understanding dated as of March 31, 1985, among the CAPCO Companies. (1985 Form 10-K, Exhibit 10-35, File No. 1-2578, Ohio Edison Company.) (B)10-43- Ohio Edison Company Executive Incentive Compensation Plan (which includes, by definition, Pennsylvania Power Company). (1984 Form 10-K, Exhibit 19-2, File No. 1-2578, Ohio Edison Company.) (B)10-44- Ohio Edison Company Executive Incentive Compensation Plan as amended February 16, 1987. (1986 Form 10-K, Exhibit 10-40, File No. 1-2578, Ohio Edison Company.) (B)10-45- Ohio Edison System Restated and Amended Executive Deferred Compensation Plan. (1989 Form 10-K, Exhibit 10-36, File No. 1- 2578, Ohio Edison Company.) (B)10-46- Ohio Edison System Restated and Amended Supplemental Executive Retirement Plan. (1989 Form 10-K, Exhibit 10-37, File No. 1- 2578, Ohio Edison Company.) 10-47- Operating Agreement for Perry Unit No. 1 dated March 10, 1987, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 28- 24, File No. 1-2578, Ohio Edison Company.) Exhibit Number - ------- 10-48- Operating Agreement for Bruce Mansfield Units Nos. 1, 2 and 3 dated as of June 1, 1976, and executed on September 15, 1987, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 28- 25, File No. 1-2578, Ohio Edison Company.) 10-49- Operating Agreement for W. H. Sammis Unit No. 7 dated as of September 1, 1971, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 28-26, File No. 1-2578, Ohio Edison Company.) 10-50- OE-APS Power Interchange Agreement dated March 18, 1987, by and among Ohio Edison Company and Pennsylvania Power Company, and Monongahela Power Company and West Penn Power Company and The Potomac Edison Company. (1987 Form 10-K, Exhibit 28-27, File No. 1-2578, of Ohio Edison Company.) 10-51- OE-PEPCO Power Supply Agreement dated March 18, 1987, by and among Ohio Edison Company and Pennsylvania Power Company and Potomac Electric Power Company. (1987 Form 10-K, Exhibit 28-28, File No. 1-2578, of Ohio Edison Company.) 10-52- Supplement No. 1 dated as of April 28, 1987, to the OE-PEPCO Power Supply Agreement dated March 18, 1987, by and among Ohio Edison Company, Pennsylvania Power Company and Potomac Electric Power Company. (1987 Form 10-K, Exhibit 28-29, File No. 1-2578, of Ohio Edison Company.) 10-53- APS-PEPCO Power Resale Agreement dated March 18, 1987, by and among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Potomac Electric Power Company. (1987 Form 10-K, Exhibit 28-30, File No. 1-2578, of Ohio Edison Company.) 10-54- Pennsylvania Power Company Master Decommissioning Trust Agreement for Beaver Valley Power Station Unit No. 1 dated as of March 15, 1988. (1988 Form 10-K, Exhibit 10-41, File No. 1- 3491.) 10-55- Pennsylvania Power Company Qualified Decommissioning Trust Agreement for Perry Nuclear Power Plant Unit No. 1 dated March 10, 1989. (1988 Form 10-K, Exhibit 10-42, File No. 1-3491.) 10-56- First Amendment dated May 31, 1991 to Pennsylvania Power Company Qualified Decommissioning Trust Agreement for Perry Nuclear Power Plant Unit No. 1. (1991 Form 10-K, Exhibit 10-46, File No. 1-3491.) 10-57- Nuclear Fuel Lease dated as of March 31, 1989, between OES Fuel, Incorporated, as Lessor, and Pennsylvania Power Company, as Lessee. (1989 Form 10-K, Exhibit 10-39, File No. 1-3491.) (A)13- 1993 Annual Report to Stockholders. (Only those portions expressly incorporated by reference in this Form 10-K are to be deemed "filed" with the Securities and Exchange Commission.) 18 - Letter from Independent Public Accountants regarding a change in accounting. 23 - Consent of Independent Public Accountants. (A) Provided herein in electronic format as an exhibit. (B) Management contract or compensatory plan contract or arrangements filed pursuant to Item 601 of Regulation S-K. (b) Reports on Form 8-K The Company filed one report on Form 8-K since September 30, 1993. A report dated December 13, 1993, reported the abandonment of Perry Unit 2 as a possible electric generating plant. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Pennsylvania Power Company: We have audited, in accordance with generally accepted auditing standards, the financial statements included in Pennsylvania Power Company's Annual Report to stockholders incorporated by reference in this Form 10-K and have issued our report thereon dated February 1, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, N.Y. February 1, 1994 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. PENNSYLVANIA POWER COMPANY BY /s/Willard R.Holland --------------------------------- Willard R. Holland Chairman of the Board and Chief Executive Officer Date: March 23, 1994 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 date indicated: /s/Willard R. Holland /s/Robert P. Wushinske - -------------------------------------- --------------------------- Willard R. Holland Robert P. Wushinske Chairman of the Board and Chief Vice President and Treasurer Executive Officer (Principal Executive (Principal Accounting Officer) Officer and Principal Financial Officer) /s/H. Peter Burg /s/Robert L. Kensinger - -------------------------------------- --------------------------- H. Peter Burg Robert L. Kensinger Director Director /s/Robert H. Carlson /s/Joseph J. Nowak - -------------------------------------- --------------------------- Robert H. Carlson Joseph J. Nowak Director Director /s/J. R. Edgerly /s/Jack E. Reed - -------------------------------------- --------------------------- J. R. Edgerly Jack E. Reed Director Director --------------------------- Richard L. Werner Director Date: March 23, 1994

94887_1993.txt

94887_1993

1993

94887

Item 1. Business - ------- -------- General - ------- The Stride Rite Corporation is the leading marketer of high quality children's footwear in the United States and a major marketer of athletic and casual footwear for children and adults. The Company manufactures products in its own facilities in the United States and Puerto Rico and also imports a significant portion of its products from abroad. Footwear products are distributed through independent retail stores, Company-owned stores and footwear departments in department stores. Unless the context otherwise requires, the "Company" and "The Stride Rite Corporation" refer to The Stride Rite Corporation and all of its wholly-owned subsidiaries. Products - -------- Children's footwear, designed primarily for youngsters between the ages of six months and 12 years, encompasses a complete line of products, including dress and recreational shoes, boots and sneakers, in traditional and contemporary styles. Those products are marketed under the Company's STRIDE RITE(R) trademark in medium to high price ranges. The Company also markets sneakers and casual footwear for adults and children under the KEDS(R) and PRO-Keds(R) trademarks and casual footwear for women under the GRASSHOPPERS(R) label. Boating footwear and portions of the Company's outdoor recreational, dress and casual footwear for adults and children are marketed under the Company's SPERRY TOP-SIDER(R) trademark. Products sold under the SPERRY TOP-SIDER(R) label also include sneakers and sandals for men and women. Sales and Distribution - ---------------------- During the 1993 fiscal year, the Company sold its products nationwide to customers operating retail outlets, including department stores, sporting goods stores and marinas, as well as Stride Rite Bootery stores and other shoe stores operated by independent retailers. In addition, the Company sold footwear products to consumers through Company-owned stores, including two Company-owned manufacturers' outlet stores opened in fiscal year 1993, and footwear departments in department stores. The Company's largest single customer accounted for less than 6% of consolidated net sales for the fiscal year ended December 3, 1993. The Company provides assistance to a limited number of qualified specialty retailers to enable them to operate independent Stride Rite children's footwear stores. Such assistance sometimes includes the sublease of a desirable retail site by the Company to a dealer. There are approximately 81 independent dealers who currently sublease store locations from the Company. A newly constructed automated distribution center located in Louisville, Kentucky provides 520,000 square feet of space and is owned by the Company. Reference is hereby made to the section of the Company's annual report to stockholders entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" for additional information concerning the distribution center in Louisville, Kentucky. The Company also owns a central warehouse in Boston, Massachusetts, which provides 565,000 square feet of space. The Company closed, during the first quarter of fiscal year 1994, a warehouse located in New Bedford, Massachusetts, consisting of approximately 742,000 square feet, which was leased by the Company. The Company maintains an in-stock inventory of its various branded footwear in a wide range of sizes and widths for shipment to its wholesale customers. It is the Company's policy to attempt to ship promptly every order (except for orders placed in advance of seasonal requirements) received for footwear included in its in-stock inventory. This policy enables retailers to minimize the amount of their capital invested in inventory, while providing the availability of footwear for which customer demand exists. In accordance with practices in the footwear industry, the Company encourages early acceptance of merchandise by shipping some products to customers in advance of their seasonal requirements and permitting payment for such merchandise at specified later dates. In fiscal 1993, in addition to the United States, the Company distributed its SPERRY TOP-SIDER(R) brand products in Italy, Germany, Japan, Turkey and the United Kingdom, as well as other countries in Europe, South America and Asia, through local distributors. During fiscal year 1992, the Company formed a new subsidiary to distribute SPERRY TOP-SIDER(R) products in certain Western European countries. This subsidiary commenced operations in the first quarter of fiscal 1993, with sales mainly in France. In fiscal 1993, in addition to the United States, KEDS(R) brand products were distributed by the Company in Argentina, Brazil, Chile, Denmark, England, France, Germany, Greece, Hong Kong, Israel, Italy, Japan, Portugal, Singapore, Sweden and the United Kingdom, as well as in several other countries in Latin America and Asia, again using local distributors. KEDS(R) brand products are also sold by a distributor in Israel under a license agreement and PRO-Keds(R) brand products are sold by a distributor in Japan, also under a license agreement. Further, KEDS(R) products are sold in Central America, Bolivia, Ecuador, Peru, Venezuela and in the Caribbean countries and territories (except the United States and French territories) under a license agreement. The Company is also a party to foreign license agreements in which independent companies operate Stride Rite retail stores outside the United States. An aggregate of 13 stores are currently operating in Canada, Costa Rica, Guatemala, Honduras, Hong Kong, Mexico and Singapore. In addition, the Company also distributes STRIDE RITE(R) brand products to several retailers in the Caribbean, Korea, Mexico and Panama. The Company also distributes SPERRY TOP-SIDER(R), STRIDE RITE(R) and KEDS(R) products in Canada through its Canadian subsidiary. International Sourcing - ---------------------- The Company purchases a significant portion of its product line overseas. It maintains a staff of approximately 60 professional and technical personnel in Korea and Thailand where a substantial portion of its canvas and leather sneakers are produced. The Company is a party to a joint venture agreement with a foreign footwear manufacturer which operates a manufacturing facility in Thailand. The Company has a 49.5% interest in the Thai corporation operating this facility, which manufactures vulcanized canvas and leather footwear. During fiscal 1993, approximately 21% of the Company's total production requirements for canvas and leather sneakers were fulfilled by the Thai facility. In addition, the Company uses the services of buying agents to source merchandise, including one buying agent which the Company estimates will source approximately 35% of its total production requirements in fiscal year 1994. Having closed several of its manufacturing facilities in the United States and the Caribbean over the years, the Company has increased the volume of leather footwear and leather footwear components for which it contracts from independent offshore suppliers. It is anticipated that overseas resources will continue to be utilized in the future. The Company purchases certain raw materials (particularly leather) from overseas resources. By virtue of its international activities, the Company is subject to the usual risks of doing business abroad, such as the risks of expropriation, acts of war, political disturbances and similar events, including loss of most favored nation trading status. Management believes that over a period of time, it could arrange adequate alternative sources of supply for the products obtained from its present foreign suppliers. However, disruption of such sources of supply could, particularly on a short-term basis, have a material adverse impact on the Company's operations. The Company's contracts to procure finished goods and other materials are denominated in United States dollars, thereby eliminating short term risks attendant to foreign currency fluctuations. Retail Operations - ----------------- As of December 3, 1993, the Company operated 135 Stride Rite Bootery stores, 52 leased children's shoe departments in leading department stores, one retail store for KEDS(R) brand products and two manufacturers' outlet stores for STRIDE RITE(R), KEDS(R) and SPERRY TOP-SIDER(R) brand products. The product and merchandising formats of the Stride Rite Bootery stores are utilized in the 52 leased children's shoe departments which the Company operates in certain Macy's, Jordan Marsh, Abraham & Straus and Rich's department stores. The Stride Rite Bootery stores carry a complete line of the Company's STRIDE RITE(R) children's footwear and a portion of the KEDS(R) children's product line. The Keds store, in the Mall of America in Minneapolis, Minnesota, carries a complete line of KEDS(R) products. The stores are located primarily in larger regional shopping malls, clustered generally in the major marketing areas of the United States. The manufacturers' outlet stores are located in malls consisting only of outlet stores. During the 1993 fiscal year, the Company opened 10 Stride Rite Bootery stores, 12 leased departments, the Keds store and one manufacturers' outlet store. During 1993, the Company closed six booteries and one leased department. In addition during this period, one bootery was closed by the Company and subsequently sold to an independent dealer. The Company currently plans to open approximately 10 retail stores during fiscal 1994 and close or sell approximately five Stride Rite retail stores during fiscal 1994. Sales through the Company's retail operations accounted for approximately 12% of consolidated net sales for the fiscal year ended December 3, 1993. Apparel Licensing Activities - ---------------------------- The Company has a license agreement under which hosiery for men, women and children is marketed under the KEDS(R) and PRO-Keds(R) brands for distribution in the United States and Canada. During the first quarter of fiscal 1993, the Company entered into a license agreement under which apparel, using the KEDS(R) trademark, is marketed in Japan. In addition, during fiscal year 1993, the Company terminated a license agreement for the KEDS(R) trademark on women's apparel, in the United States and Canada. License royalties accounted for less than one percent of the Company's sales in fiscal year 1993. The Company continually evaluates new licensees, for both footwear and non-footwear products. Raw Materials - ------------- The Company purchases its raw materials from a number of domestic and foreign sources. See "International Sourcing". The Company does not believe that any particular raw materials supplier is dominant. Backlog - ------- At December 3, 1993 and November 27, 1992, the Company had a backlog of orders amounting to approximately $201,000,000 and $184,000,000, respectively. To a significant extent, the backlog at the end of each fiscal year represents orders for the Company's spring footwear styles, and traditionally substantially all of such orders are delivered during the first two quarters of the next fiscal year. For a discussion of the impact on backlog of the opening of the Company's new distribution center in Louisville, Kentucky, reference is hereby made to the portion of the Company's annual report to stockholders entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources". Competition - ----------- The Company competes with a number of suppliers of children's footwear, a few of which are divisions of companies which have substantially greater net worth and/or sales revenue than the Company. Management believes, however, that on the basis of sales, the Company is the largest supplier of nationally branded children's footwear. In the highly fragmented sneaker, casual and recreational footwear industry, numerous domestic and foreign competitors, some of which have substantially greater net worth and/or sales revenue than the Company, produce and/or market goods which are comparable to, and compete with, the Company's products in terms of price and general level of quality. In addition, the domestic shoe industry has experienced substantial foreign competition, which is expected to continue. Management believes that creation of attractive styles, together with specialized engineering for fit, durability and quality, and high service standards are significant factors in competing successfully in the marketing of all types of footwear. Management believes that the Company is competitive in all such respects. In operating its own retail outlets, the Company competes in the children's retail shoe industry with numerous businesses, ranging from large retail chains to single store operators. Employees - --------- As of December 3, 1993, the Company employed approximately 3,300 full-time and part-time employees, approximately 1,000 of whom were represented by collective bargaining units. Management believes that its relations with its employees are good. The Company entered into an amendment to a collective bargaining agreement and a new collective bargaining agreement in 1993, in connection with the closing of its distribution center in New Bedford, Massachusetts and the proposed closing of its distribution center in Boston, Massachusetts, respectively. Environmental Matters - --------------------- Compliance with federal, state and local regulations with respect to the environment have had, and are expected to have, no material effect on the capital expenditures, earnings or competitive position of the Company. Patents, Trademarks and Licenses; Research and Development - ---------------------------------------------------------- The Company believes that its patents and trademarks are important to its business and are generally sufficient to permit the Company to carry on its business as presently conducted. The Company depends principally upon its design, engineering, manufacturing and marketing skills and the quality of its products for its ability to compete successfully. The Company conducts research and development for footwear products; however, the level of expenditures with respect to such activity is not significant. Executive Officers of the Registrant - ------------------------------------ The information with respect to the executive officers of the Company listed below is as of February 24, 1994. Executive Officers of the Registrant - ------------------------------------ Executive Officers of the Registrant - ------------------------------------ These executive officers are generally elected at the Board of Director's Annual Meeting and serve at the pleasure of the Board. Item 2. Item 2. Properties - ------- ---------- The Company manufactures footwear and footwear components at three factories located in Missouri as well as at one facility located in Puerto Rico. The Company also manufactures footwear components at a 30,000 square foot facility in the Dominican Republic. Present manufacturing space totals approximately 214,000 square feet. Approximately 44,000 square feet is owned by the Company and the balance is leased. Such leases include either renewal options or favorable purchase options. Management believes that all leases are at commercially reasonable rates. A newly constructed automated distribution center located in Louisville, Kentucky provides 520,000 square feet of space and is owned by the Company. Reference is hereby made to the section of the Registrant's annual report to stockholders entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" for additional information concerning the distribution center in Louisville, Kentucky. The Company also owns a central warehouse in Boston, Massachusetts, which provides 565,000 square feet of space and closed during the first quarter of 1994, a warehouse located in New Bedford, Massachusetts, consisting of approximately 742,000 square feet, which was leased by the Company. The Company's Canadian subsidiary leases approximately 28,000 square feet for warehousing in Mississauga, Ontario. The Company leases approximately 119,000 square feet for its headquarters and administrative offices in Cambridge, Massachusetts in an office building owned by a partnership in which the Company is a limited partner. The Company is in negotiations to lease an additional 9,700 square feet of administrative offices in Cambridge. In addition, the Company leases approximately 1,700 square feet of office space in Paris, France for its Sperry Top-Sider European distribution subsidiary. At December 3, 1993, the Company operated 138 retail stores throughout the country on leased premises which, in the aggregate, covered approximately 171,700 square feet of space. The Company also operates 52 departments in four major department store chains. In addition, the Company is the lessee of 81 retail locations totaling approximately 91,600 square feet which are subleased to independent Stride Rite dealers and other tenants. For further information concerning the Company's lease obligations, see Note 8 to the Company's consolidated financial statements, which are contained in the annual report to stockholders and are incorporated by reference herein. Management believes that, except as stated above, all properties and facilities of the Company are suitable, adequate and fit for their intended purposes. Item 3. Item 3. Legal Proceedings - ------- ----------------- On September 27, 1993, the Company announced that The Keds Corporation, a wholly owned subsidiary of the Company, entered into settlement agreements with the Attorneys General of all 50 states, the Corporation Counsel of the District of Columbia and the Federal Trade Commission, to resolve various investigations into Keds' adoption and enforcement of its suggested retail pricing policy. In entering into these settlements, Keds, without admitting any liability, fully settled suits brought by the Attorneys General in the United States District Court for the Southern District of New York, in their parens patriae capacity, on behalf of all consumers who purchased certain KEDS(R) shoes during the relevant period. The settlements required Keds to pay $5.7 million to several charities nationwide, as well as $1.5 million to provide nationwide notice to potential class members and other administrative expenses. Keds has agreed to the imposition of certain injunctive relief. Following preliminary Court approval on September 27, 1993, Keds paid the administrative costs and part of the settlement amount. Keds will make the remaining payments after final court approval of the settlements. The Company is a party to various litigation arising in the normal course of business. Having considered facts which have been ascertained and opinions of counsel handling these matters, management does not believe the ultimate resolution of such litigation will have a material adverse effect on the Company's financial position or results of operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ------- --------------------------------------------------- None PART II ------- Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder - ------- ---------------------------------------------------------------- Matters ------------------- The information required by this item is included in the Registrant's 1993 Annual Report to Stockholders on pages 15, 28 and 31, and is incorporated herein by reference. Item 6. Item 6. Selected Financial Data - ------- ----------------------- The information required by this item is included in the Registrant's 1993 Annual Report to Stockholders on pages 15, 23 and 28 and is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and - ------- --------------------------------------------------------------- Results of Operations --------------------- The information required by this item is included in the Registrant's 1993 Annual Report to Stockholders on pages 16 through 18 and is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data - ------- ------------------------------------------- The information required by this item is included in the Registrant's 1993 Annual Report to Stockholders on pages 19 through 28 and is incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and - ------- --------------------------------------------------------------- Financial Disclosure -------------------- None. PART III -------- Item 10. Item 10. Directors and Executive Officers of the Registrant - -------- -------------------------------------------------- Reference is made to the information set forth under the caption "Executive Officers of the Registrant" in Item 1 of Part I of this report and to information under the captions "Information as to Directors and Nominees for Director", "Meetings of the Board of Directors and Committees" and "Compliance with Section 16(a) of the Securities and Exchange Act of 1934" in the Registrant's definitive proxy statement relating to its 1994 Annual Meeting of Stockholders, which will be filed with the Commission within 120 days after the close of the Registrant's fiscal year ended December 3, 1993, all of which information is incorporated herein by reference. Item 11. Item 11. Executive Compensation - ------- ---------------------- Reference is made to the information set forth in the Registrant's definitive proxy statement relating to its 1994 Annual Meeting of Stockholders under the caption "Compensation Committee Interlocks and Insider Interlocks" and continuing through the caption "Certain Transactions with Management" (excluding the information set forth under the caption "Compensation Committee Report") which will be filed with the Commission within 120 days after the close of the Registrant's fiscal year ended December 3, 1993, which information is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management - ------- -------------------------------------------------------------- Reference is made to the information set forth under the caption "Ownership of Equity Securities" in the Registrant's definitive proxy statement relating to its 1994 Annual Meeting of Stockholders, which will be filed with the Commission within 120 days after the close of the Registrant's fiscal year ended December 3, 1993, which information is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions - ------- ---------------------------------------------- Reference is made to the information set forth under the caption "Certain Transactions with Management" in the Registrant's definitive proxy statement relating to its 1994 Annual Meeting of Stockholders, which will be filed with the Commission within 120 days after the close of the Registrant's fiscal year ended December 3, 1993, which information is incorporated herein by reference. PART IV ------- Item 14. Item 14. Exhibits, Financial Statements, Schedules and Reports on Form - ------- ------------------------------------------------------------- 8-K --- (a) Financial Statements. The following financial statements and -------------------- financial statement schedules are contained herein or are incorporated herein by reference: Schedules other than those listed above are omitted because they are either not required or the information is otherwise included. * Incorporated herein by reference. See Part II, Item 8 on page 11 of this Annual Report on Form 10-K. Exhibits. The following exhibits are contained herein or are incorporated - -------- herein by reference: *Denotes a management contract or compensatory plan or arrangement. On October 28, 1993, the Registrant filed a Current Report on Form 8-K to announce the hiring of Robert C. Siegel as Chairman of the Board of Directors, President and Chief Executive Officer, effective December 13, 1993. *Denotes a management contract or compensatory plan or arrangement. 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. THE STRIDE RITE CORPORATION THE STRIDE RITE CORPORATION - --------------------------- --------------------------- By:/s/ John M. Kelliher By:/s/ Robert C. Siegel ------------------------------ ------------------------------ John M. Kelliher, Vice Robert C. Siegel, Chairman of President, Finance the Board, President and Chief Treasurer and Controller Executive Officer (Principal Accounting Officer) Date: March 1, 1994 Date: March 1, 1994 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. /s/ Robert C. Siegel /s/ Donald R. Gant - --------------------------------- --------------------------------- Robert C. Siegel, Chairman of the Donald R. Gant, Director Board of Directors, President and Chief Executive Officer Date: March 1, 1994 Date: March 1, 1994 /s/ Arnold Hiatt /s/ Theodore Levitt - --------------------------------- --------------------------------- Arnold Hiatt, Director Theodore Levitt, Director Date: March 1, 1994 Date: March 1, 1994 /s/ Margaret A. McKenna /s/ Myles J. Slosberg - --------------------------------- --------------------------------- Margaret A. McKenna, Director Myles J. Slosberg, Director Date: March 1, 1994 Date: March 1, 1994 /s/ W. Paul Tippett /s/ Robert Seelert - --------------------------------- ---------------------------------- W. Paul Tippett, Director Robert Seelert, Director Date: March 1, 1994 Date: March 1, 1994 REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Directors of The Stride Rite Corporation: Our report on the consolidated financial statements of The Stride Rite Corporation has been incorporated by reference in this Annual Report on Form 10-K from the 1993 Annual Report to Stockholders of The Stride Rite Corporation and appears on page 29 therein. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 13 of this Annual Report on Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Boston, Massachusetts January 20, 1994 THE STRIDE RITE CORPORATION SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS (in thousands) (a) No individual security issue exceeds 2% of total assets. THE STRIDE RITE CORPORATION SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES (in thousands) (a) No individuals have loans in excess of $100,000 in the year 1991. (b) Amount represents an interest-free loan in connection with relocation to, and purchase of, a home in the Boston, Massachusetts area. Repayment terms are generally over a three-year period. THE STRIDE RITE CORPORATION Schedule VIII - VALUATION AND QUALIFYING ACCOUNTS (in thousands) __________ (a) Amounts written off as uncollectible. (b) Amounts charged against the reserve. THE STRIDE RITE CORPORATION SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (in thousands) __________ THE STRIDE RITE CORPORATION ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 3, 1993 Index to Exhibits *Denotes a management contract or compensatory plan or arrangement. THE STRIDE RITE CORPORATION FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 3, 1993 Addendum 10 (vi) THE STRIDE RITE CORPORATION FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 3, 1993 Addendum 10 (vii) * As amended on January 29, 1990 THE STRIDE RITE CORPORATION EXHIBIT 10 (ix) CONSULTING CONTRACT ------------------- AGREEMENT dated as of the 28th day of June, 1993 by and between The Stride Rite Corporation ("Stride Rite"), a Massachusetts corporation with principal offices at Five Cambridge Center, Cambridge, Massachusetts 02142, and John J. Phelan ("Phelan"), an individual residing at 29 Royalcrest Drive, North Andover, Massachusetts 01845. WHEREAS, Stride Rite is desirous of securing the services of a consultant who is experienced in and knowledgeable of the management, operation and administration of a footwear company; and WHEREAS, Phelan is a consultant with the knowledge and experience sought by Stride Rite, and is desirous of providing to Stride Rite the knowledge and experience it is seeking on a consulting basis; NOW, THEREFORE, the parties hereto agree as follows: 1. Services. -------- Stride Rite hereby retains Phelan to perform consulting services as described hereinbelow, and Phelan hereby accepts appointment as Stride Rite's consultant to perform the following services during the Term of this Agreement: a. To function as the Chief Executive Officer and President of Stride Rite; b. To assist and oversee the supervision of the activities of all personnel employed by Stride Rite; and c. To oversee the day-to-day operations of Stride Rite. 2. Compensation and Expenses. ------------------------- a. In consideration of his performance of the services set forth in Subsections (a) through (c) of Paragraph 1 hereof, Stride Rite shall pay Phelan a weekly fee of Seven Thousand Five Hundred ($7,500.00) Dollars, which payment shall be made to Phelan on or about the thirtieth (30th) day of each month during the Term hereof. Stride Rite and Phelan anticipate that Phelan will render services regularly during the Term. b. Stride Rite shall also reimburse Phelan for such reasonable and necessary business expenses as he may incur in fulfillment of this Agreement at his cost, dollar for dollar, in accordance with Stride Rite's corporate expense policy. Phelan shall be entitled to reimbursement for travel to and from Stride Rite's offices and Phelan's office, including mileage and hotel or a furnished rental apartment in the Cambridge area. 3. Term. ---- a. The parties hereto agree that the term of this Agreement shall commence upon June 28, 1993 and shall continue for a guaranteed minimum period of Ten (10) weeks (the "Term"), or longer if the parties so agree. b. In the event of a material breach of this Agreement, the non- defaulting party shall provide written notice specifying the material breach and intent to terminate the contract to the other. If the material breach is not cured within ten (10) days of receipt of notice, then the non-defaulting party may terminate this Agreement upon issuance of written notice to the other party. All notices shall be sent by U.S. certified mail, return receipt requested and shall be effective upon receipt or, if refused or undeliverable, upon five (5) business days from the date of deposit with the U.S. Postal Service. Notice to Phelan shall be addressed to him at 29 Royalcrest Drive, Andover, Massachusetts 01845; any notice to Stride Rite shall be addressed to The Stride Rite Corporation, Five Cambridge Center, Cambridge, Massachusetts 02142, Attention: General Counsel, Legal Department. Either party may change the notice address on 30 days prior written notice to the other party. 4. Assignment. ---------- Phelan acknowledges that his services are unique and personal and that, accordingly, this Agreement, and his duties and responsibilities hereunder, are not assignable. 5. Relationship of the Parties. --------------------------- Nothing in this Agreement shall be construed to place the parties in the relationship of employer/employee, partners or joint venturers, and neither party shall have the power to obligate or bind the other in any manner whatsoever, except as otherwise provided for in this Agreement. The parties hereto hereby acknowledge that Phelan is acting as an independent contractor in connection herewith. 6. Supplemental Retirement Income Agreement. ---------------------------------------- This Agreement shall in no way be construed to affect the terms and conditions of The Supplemental Retirement Income Agreement between The Stride Rite Corporation and John J. Phelan dated as of September 16, 1992 and Phelan's rights to benefits under that Agreement. 7. Confidentiality. --------------- Phelan understands and acknowledges that, in rendering services hereunder, Stride Rite may deliver confidential information to Phelan and Phelan agrees to hold in confidence and not use or disclose any such confidential information except upon the prior written consent of the Chairman of the Board of Directors of Stride Rite, which consent shall be granted or denied in Stride Rite's sole discretion, and Phelan shall not disclose, utilize or commercialize the same, directly or indirectly, for his own or any third party's benefit, now or in the future provided, however, that the parties agree that Phelan shall not be so restricted with respect to any information which he can establish is in the public domain, was known to him prior to disclosure by Stride Rite or was disclosed to him by a third party and such disclosure was not in breach of any agreement by such third party with Stride Rite. 8. Governing Law. ------------- This Agreement shall be construed to be a Massachusetts contract governed by the laws of the Commonwealth of Massachusetts. The parties agree that this Agreement represents the entire agreement of the parties with respect to the consulting services to be performed hereunder and supersedes all prior communications regarding the same. 9. Modifications. ------------- This Agreement may not be modified, amended or altered without a written agreement signed by both parties. The parties hereby set their hands and seals to this Agreement as of the 28th day of June, 1993. THE STRIDE RITE CORPORATION By: /s/ Margaret A. McKenna --------------------------- /s/ John Phelan ------------------------------ John Phelan THE STRIDE RITE CORPORATION EXHIBIT 10 (x) EMPLOYMENT AGREEMENT -------------------- This Contract of Employment (the "Agreement") is entered into as of this 21st day of October, 1993 by and between The Stride Rite Corporation (the "Company") and Robert Siegel (the "Executive"). WHEREAS, the Company desires to employ an experienced, qualified individual to serve in its capacities of Chairman, Chief Executive Officer and President of the Company, and WHEREAS, the Executive desires to be employed by the Company in its capacities of Chairman, Chief Executive Officer and President, NOW, THEREFORE, the Company and Executive, each in consideration of the promises of the other hereinafter contained, agree as follows: 1. Employment. The Company hereby agrees to and does hereby employ the ---------- Executive, and the Executive hereby agrees to and does hereby enter the employ of the Company for the period set forth in Section 2 below (the "Employment Period") in the positions and with the duties and responsibilities set forth in Section 3 below, and upon the terms and conditions set forth in this Agreement. 2. Employment Period. The Employment Period shall commence on December ----------------- 13, 1993 and except as otherwise expressly provided hereinbelow, shall continue until the close of business on December 31, 1996 (the "Term"). 3. Positions. It is contemplated that during the Employment Period, the --------- Executive shall serve as a principal officer of the Company with the offices and titles of Chairman, Chief Executive Officer and President, reporting directly to the Board of Directors. With respect to those offices, the Executive shall have powers and duties as provided in the Company's Bylaws in effect as of the date and as those may be amended from time to time during the Employment Period. It is further contemplated that at the meeting of the Board of Directors approving the Agreement, the Executive shall be elected to serve as a director of the Company and as a director of each of the Company's subsidiaries by their respective Boards of Directors and/or stockholders. In the event that the Executive is not elected by the Board of Directors to serve as Chairman, Chief Executive Officer and President or by the Board of Directors or the stockholders to serve as a director of the Company, his employment with the Company shall be terminated by the Company subject to the terms of Section 10 of this Agreement. 4. Performance. Throughout the Employment Period, the Executive agrees to ----------- devote his full time and undivided attention to the business and affairs of the Company, and in particular to the performance of all of the duties and responsibilities of the Chairman, Chief Executive Officer and President of the Company, and as a director of each of its subsidiaries, except for reasonable vacation and except for temporary illness or incapacity. The Executive shall be entitled to up to four (4) weeks of vacation per year. The Executive shall serve the Company and each of its subsidiaries loyally, diligently and effectively and at all times exert his best efforts to promote the success of their respective activities. The Executive shall discharge his duties and responsibilities in an efficient, trustworthy and businesslike manner and shall do nothing which will in any way impair or prejudice the name or reputation of the Company or any of its subsidiaries. Nothing in this Agreement shall preclude the Executive from devoting reasonable periods required for: a. serving as director, trustee or member of a committee of any organization involving no conflict of interest with the interests of the Company; b. engaging in charitable and community activities; and c. managing his personal investments; provided that such activities do not, individually or collectively, interfere with the regular performance of the Executive's duties and responsibilities under this Agreement. 5. Salary and Incentive Compensation. During the Employment Period, as --------------------------------- long as the Executive is employed by the Company, the Executive shall be entitled to compensation from the Company as follows: a. For all services to be rendered by the Executive to the Company during the Employment Period, including, without limitation, services as an executive, officer, director, employee or member of any committee of the Company or its subsidiaries, divisions, business units or affiliates, the Executive shall be paid compensation in the form of a base or fixed salary, payable not less often than once each month, at the annual rate of Four Hundred Eighty Thousand Dollars ($480,000), with the opportunity for periodic annual reviews and increases in such rate as shall be determined in the sole discretion of the Board of Directors. b. The Executive shall be paid additional compensation in the form of incentive compensation as follows: i. The Executive shall be an "Eligible Employee" as that term is defined in the Company's Annual Executive Incentive Compensation Plan (the "Annual Incentive Plan") and may receive incentive compensation as provided by the terms of such Plan. Pursuant to the Annual Incentive Plan, the Executive's "Bonus Percentage" (as defined therein) will be 50%. The Executive's participation in the Annual Incentive Plan is subject to the terms and conditions of the Annual Incentive Plan, or any amended version of the Annual Incentive Plan or any successor or other annual incentive compensation plan which may be adopted and become legally effective during the Employment Period. ii. Notwithstanding the foregoing, for the Company's 1994 fiscal year, the Executive shall be guaranteed a minimum cash bonus of Two Hundred Twenty Five Thousand Dollars ($225,000) under the Annual Incentive Plan. iii. The Executive shall be an "Eligible Employee" as that term is defined in the Company's Key Executive Long-Term Incentive Compensation Plan (the "Long- Term Plan"), and may receive incentive compensation as provided by the terms of such Plan. The portion of the Executive's base salary upon which incentive compensation under the Long-Term Plan may be earned will be 55% of base pay for each of the three ongoing cycles, and the Executive's participation in Cycle VIII which ends in 1994 will be 33 1/3%, in Cycle IX which ends in 1995 and cycles thereafter will be 100%. Except as so modified the Executive's participation in the Long-Term Plan is subject to the terms and conditions of the Long-Term Plan, or any amended version of the Long-Term Plan or any successor or other long-term incentive compensation plan which may be adopted and become legally effective during the Employment Period. iv. On December 13, 1993, the Company shall grant to the Executive rights to purchase 60,000 shares of the Company's common stock at a purchase price of $.25 per share and otherwise subject to all the terms and conditions of the Company's 1975 Executive Incentive Purchase Plan, as amended ("Incentive Stock Plan") except that (1) the Executive's rights to purchase such 60,000 shares ------ shall vest according to the following schedule: 20,000 shares on December 13, 1994, 20,000 shares on December 13, 1995 and 20,000 shares on December 13, 1996, and (2) all shares purchased by the Executive upon exercise of such rights shall at all times be "free shares" as defined in the Incentive Stock Plan and, as such, shall not be subject to any restrictions as to sale or disposition or any obligation to offer to resell such shares to the Company as set forth in Section 8 of the Incentive Stock Plan. In the event that the Executive's employment with the Company is terminated at any time for any reason other than (i) by the Company for cause or (ii) by the Executive for other than a "Good Reason" as defined in the Severance Agreement referred to in Section 15 c. of this Agreement, the Company shall immediately pay to the Executive (or in the case of death, to the Executive's legal representative) a cash amount equal to the excess, if any, of (A) $951,000 over (B) the aggregate fair market value of all shares acquired by the Executive upon exercise of purchase rights granted under this paragraph iv (such fair market values to be determined as of the dates of such exercise) less the aggregate purchase price paid for such shares. "Fair market value" shall mean the closing price for the Company's common stock on the New York Stock Exchange - Composite on the exercise dates. v. On December 13, 1993, the Company shall grant to the Executive rights to purchase 30,000 shares of the Company's common stock at a purchase price of $.25 per share and otherwise subject to all of the terms and conditions of the Incentive Stock Plan except that all shares purchased by the Executive upon ------ exercise of such rights shall at all times be "free shares" as defined in the Incentive Stock Plan and, as such, shall not be subject to any restrictions as to sale or disposition or any obligation to offer to resell such shares to the Company as set forth in Section 8 of the Incentive Stock Plan. vi. On December 13, 1993, the Company shall grant to the Executive rights to purchase 200,000 shares of the Company's common stock at a per share purchase price equal to the closing price of such stock on the New York Stock Exchange - Composite on the date of this Agreement and otherwise subject to all of the terms and conditions of the Incentive Stock Plan except that (1) the Executive's ------ rights to purchase such 200,000 shares shall vest according to the following schedule: 40,000 shares on each of the first, second, third, fourth and fifth anniversaries of October 21, 1993, and (2) all shares purchased by the Executive upon exercise of such rights shall at all times be "free shares" as defined in the Incentive Stock Plan and, as such, shall not be subject to any restrictions as to sale or disposition or any obligation to offer to resell such shares to the Company as set forth in Section 8 of the Incentive Stock Plan. vii. The Company agrees to take any action necessary to carry out the terms of the stock purchase rights granted to the Executive under paragraphs iv., v. and vi. above, including but not limited to causing the Incentive Stock Plan to be amended, if necessary, and waiving any rights that the Company may otherwise have with respect to enforcing restrictions on disposition of shares purchased by the Executive or requiring the Executive to offer to resell those shares to the Company. The Executive is relying on the Company's description of the income tax consequences relating to the purchase rights granted, and shares purchased, under the Incentive Stock Plan contained in the Prospectus dated March 5, 1992 for the Incentive Stock Plan and on the Company's assurance that these consequences will apply to the Executive's purchase rights under Sections 5b iv., v. and vi. c. In the event of the death of the Executive during the Employment Period, the legal representative of the Executive shall be entitled to the base or fixed salary provided for in Section 5a above for the month in which the death shall have occurred, at the rate being paid at the time of death, and the Employment Period shall be deemed to have ended as of the close of business on the last day of the month in which the death shall have occurred, but without prejudice to any payments otherwise due in respect of the Executive's death, including any payment under Section 5b iv., or to any rights that the Executive's legal representative may have to exercise the purchase rights granted under Section 5b iv., v. and vi. 6. Perquisites. During the Employment Period, the Executive shall be ----------- entitled to the perquisites as follows: a. The Executive shall be provided with an appropriate office and secretarial and clerical staff. b. The Company's lease of an automobile, (the "Vehicle"), shall be provided by the Company for the Executive's use, pursuant to the Company's leased car policy as currently in effect. Under the Company's leased car policy, an amount of up to 4% of the Executive's base salary (as provided in Section 5a of this Agreement) will be paid by the Company toward the lease payments, insurance and maintenance costs of the Vehicle. Should such costs for the Vehicle exceed that allowance, the Executive will be responsible for payment of any differential. The Executive shall be responsible for the cost of fuel consumed in the use of the Vehicle. Pursuant to the Company's current automobile policy, the Company will pay the Executive a mileage allowance as reimbursement for the use of the Vehicle in conducting the Company's business. c. Pursuant to the Company's reserved parking policies, the Company shall pay all but $50.00 per month of the cost of a reserved parking space for the Executive at the Company's offices at Five Cambridge Center, Cambridge, Massachusetts. d. The Company shall reimburse the Executive for up to $5,000.00 per year for the Executive's use of personal financial planning services. 7. Employment Benefits; Life Insurance. At the normal employee ----------------------------------- contribution rate to the Executive, the Company will provide the Executive with Master Medical coverage for the Executive and eligible members of the Executive's family (effective as of the beginning of the Employment Period), insurance on his life equal to One Million Dollars ($1,000,000) payable to a beneficiary designated by the Executive (in lieu of lesser coverage available under the usual terms of the life insurance policy which the Company offers) and long-term disability coverage. The Executive shall also be entitled to participate in all of the various employee benefit plans which the Company maintains and/or adopts during the Employment Period, including a defined benefit Retirement Plan and various elective programs, including, without limitation, a dental insurance plan (effective as of the beginning of the Employment Period), Employee Stock Purchase Plan and Employee Savings and Investment Plan (pursuant to Section 401K of the Internal Revenue Code of 1986, as amended), subject to their respective terms and requirements, including, without limitation, their eligibility and vesting requirements. The Executive shall be enrolled in all of these plans as of December 13, 1993. Nothing in this Agreement shall preclude the Company from amending or terminating any employee benefit plan or practice, but it is the intent of the parties that the Executive shall continue to be entitled during the Employment Period to benefits at least equal in the aggregate to those attached to his position as of the date of this Agreement. 8. Residence Requirement. The Executive agrees that by May 1, 1994 the --------------------- Executive will establish residence for himself and his family in the greater Boston (Massachusetts) area and that the Executive shall maintain such residence throughout his continued employment by the Company. 9. Relocation Expenses. The Company agrees to pay for (i) the broker's ------------------- commission and closing costs incurred by the Executive with respect to the sale of his principal residence in San Rafael to the extent the amount of such fees and costs are customary in such community and are customarily borne by the Seller. The Executive shall obtain two appraisals of the value of his current California residence during the month of December, 1993. If the Executive sells such residence before March 10, 1994 for a price less than the average of such two appraised values, the Company shall immediately pay to the Executive in cash the amount of such shortfall. If the Executive does not sell his residence before March 10, 1994, and the Executive notifies the Company that he is unable to sell his residence, the Company shall purchase the residence itself at a price equal to the average of the values determined by two independent real estate appraisers. In addition, the Company shall pay the Executive's reasonable expenses incurred to move the Executive's personal property and family from San Rafael to the permanent residence to be purchased by the Executive in the Boston area. The Company will also reimburse the Executive for expenses for deposits or "switch on" fees for utilities at the new residence and fees to install any major appliances which are incurred as part of the move to the Boston area. From the date of this Agreement until the earlier of (i) the time the Executive establishes a permanent residence in the Boston area, or (ii) May 1, 1994, the Company agrees to reimburse the Executive up to $6,000 per month for reasonable living expenses incurred in connection with the rental of a furnished apartment for the Executive's use in the Boston area, in addition to reimbursement of reasonable expenses incurred by the Executive for parking, telephones, cable television and utilities. In addition, during such period, the Company will reimburse the Executive for the reasonable cost of a cleaning service for the Executive's apartment and for the Executive's laundry and dry cleaning expenses. The Company, furthermore, agrees to reimburse the Executive for the cost of a round-trip airfare (business, if business is not available then first class) for travel between Boston and the Executive's present residence in San Rafael up to four (4) times per month by the Executive and his wife and children until the earlier of (i) the establishment of the Executive's permanent residence in the Boston area or (ii) May 1, 1994. 10. Termination of Employment during Employment Period. The Executive -------------------------------------------------- hereby acknowledges and agrees that the Company by entering into this Agreement shall not be deemed to have waived any of its rights during the Employment Period or thereafter, including, without limitation, the right to terminate the Executive's employment for any reason. In the event that the Company terminates the Executive's employment during the Employment Period for any reason other than for Cause (as defined below), the Company shall pay the Executive a severance allowance consisting of either (i) a lump sum payment equal to the present value (using as a discount rate the prime rate charged by the Bank of Boston on the date of the Executive's termination) of the base or fixed salary payable pursuant to Section 5a of the Agreement for the remainder of the Employment Period, or (ii) if the termination occurs during the last year of this Agreement a monthly severance allowance payable at the end of each month following termination of the Executive's employment until the earliest of (a) twelve months following the Company's termination of the Executive's employment, or (b) the date of the Executive's death. Such monthly severance allowance shall be an amount equal to the monthly fixed or base salary paid to the Executive pursuant to Section 5a of the Agreement at the time of the termination of his employment. In addition to the monthly severance allowance, until the earlier of (i) the Executive's reemployment (other than self-employment or employment by an entity which does not provide comparable medical benefits to employees), or (ii) the end of the Employment Period, the Executive shall continue to be entitled to participate (without cost to the Executive) in the Company's medical and dental insurance programs and the Executive's life insurance benefit as provided by this Agreement shall be continued. In addition, the Executive shall be entitled to any cash payments provided by Section 5b iv., any payments earned pursuant to the terms of the Annual Incentive Plan and the Long-Term Plan, and any rights to exercise the vested portion of the stock purchase rights under Section 5b iv., v. and vi. If the Executive's employment with the Company is terminated on account of the Executive's death or permanent disability, then except for (i) the cash payments provided by Section 5b iv. and 5c of this Agreement, (ii) any payments earned pursuant to the terms of the Annual Incentive Plan and the Long-Term Plan and (iii) the rights of the Executive or his legal representative to exercise the vested portion of the stock purchase rights granted to the Executive under Sections 5b iv., v. and vi., payment to the Executive or the Executive's estate will be made exclusively under the Company's applicable death or disability plans or policies. In the event that the Executive's employment is terminated during the Employment Period for Cause, then the Executive shall not be entitled to receive any severance allowance or compensation of any kind (except (i) incentive compensation which may have been fully earned pursuant to the terms and conditions of the Annual Incentive Plan and/or the Long-Term Plan and (ii) the cash payment due under Section 5b iv. and (iii) the rights of the Executive or his legal representative to exercise the vested portion of the stock purchase rights granted to the Executive under Sections 5b iv., v. and vi.) nor continue to be entitled to any of the Company's employee benefits, including any benefits provided in this Agreement or under the Company's medical, dental, health and life insurance plans (except to the extent the same may be required by law), or to perquisites of any kind, from and after the date upon which the Executive's employment is terminated. For the purposes of this section and any other provision of this Agreement, termination of the Executive's employment shall be deemed to have been for Cause only if: a. termination of his employment shall have been so deemed by the Board of Directors of the Company by virtue of (i) an act or acts of dishonesty, (ii) commission of a felony or act of moral turpitude, (iii) a wrongful act or acts resulting or intended to result directly or indirectly in gain or personal enrichment at the expense of the Company, (iv) a willful act or acts which constitute a material violation or violations of the federal securities laws, or (v) a willful act or acts which constitute material insubordination or a material violation of the Company's Conflict of Interest policy or any of its other policies communicated to the Executive in writing; or b. there has been a breach by the Executive during the Employment Period of any of the material provisions of this Agreement, and, with respect to any alleged breach, that the Executive shall have failed to remedy such alleged breach within thirty (30) days from his receipt of written notice from the Clerk of the Company pursuant to the resolution duly adopted by the Board of Directors of the Company after notice to the Executive and an opportunity to be heard demanding that the Executive remedy such alleged breach. In the event that the Executive's employment is terminated by his voluntary resignation, the Executive shall not be entitled to payment of any severance allowance, or compensation of any kind (except (i) incentive compensation which may have been fully earned pursuant to the terms and conditions of the Annual Incentive Plan and/or the Long-Term Plan, (ii) the cash payment due under Section 5b iv. and (iii) the rights of the Executive to exercise the vested portion of the stock rights granted to the Executive under Sections 5b iv., v. and vi.) or to the continuance of any of the Company's employee benefits or perquisites of any kind. In the event that the severance arrangements provided for in this Section 10 are triggered, the Executive will be required, as a condition to payment, to execute a release acknowledging full and final settlement of all claims arising from his employment and agreeing to provide reasonable cooperation to the Company. 11. Agreement Not to Compete. The Executive hereby covenants and agrees ------------------------ that for a period of one (1) year following termination of the Executive's employment with the Company for any reason, the Executive will not, directly or indirectly, within the United States (the same being the area in which the Company's business is conducted), in any capacity, enter into or engage in the same or a substantially similar business as that conducted and carried on by the Company and being directly competitive with the Company or any of its business units or subsidiaries, including, but not limited to, specialty retailing of infant's, toddler's and children's footwear, the design, manufacture of footwear of any type on the wholesale level, and any and all components of the foregoing, whether as an individual for his own account, or as a partner, joint venturer, employee, agent, consultant, officer or director for or with any person or entity, or as a shareholder (greater than one percent (1%) of any corporation), or otherwise. 12. Agreement of Confidentiality. With respect to any secret, proprietary ---------------------------- or confidential information obtained by the Executive during his employment at the Company, except with the prior written agreement of the Company, which consent shall be granted or withheld in the sole discretion of the Company, the Executive will not, at any time, disclose or use for competitive purposes (other than the Company's competitive purposes) any such information. For purposes hereof, secret, proprietary or confidential information shall include, by way of example but not by way of limitation, any information of a technical, financial, commercial or other nature pertaining to the business of the Company or to that of any of its clients, customers, consultants, licensees, business units, subsidiaries or affiliates, including but not limited to, its and their operations, plans, financial condition, product development, customers, sources of supply, manufacturing techniques or procedures, marketing, sales, production or other competitive information acquired by the Executive during the course of his employment by the Company and all other information that the Company itself does not disclose to the public. 13. Notice. For the purposes of this Agreement, notices and all other ------ communications provided for in this Agreement shall be in writing and shall be deemed to have been duly given when delivered personally or mailed by United States registered or certified mail, return receipt requested, postage prepaid, addressed to the Executive at 534 Biscayne Drive, San Rafael, California 94901, until such time as the Executive establishes permanent residence in Boston and thereafter at such address; and to the Company at Five Cambridge Center, Cambridge, Massachusetts 02142 (or at such other address to which it may relocate its headquarters during the term of this Agreement), directed to the Board of Directors with a copy of the Clerk of the Company. 14. Heirs and Successors Bound. This Agreement shall be binding upon the -------------------------- heirs, administrators and executors of the Executive and upon the successors or assigns of the Company. 15. Miscellaneous. ------------- a. No provision of this Agreement may be modified, waived or discharged, unless such waiver, modification or discharge is agreed to in writing and signed by the Executive and such officer as may be specifically designated by the Board of Directors. No waiver by either party hereto at any time of any breach by the other party hereto of, or in compliance with any condition or provision of this Agreement to be performed by the other party shall be deemed a waiver of similar or dissimilar provisions or conditions at the time or at any prior or subsequent time. b. The Executive agrees that the remedy at law for any breach by the Executive of the provisions of Sections 11 or 12 of this Agreement will be inadequate and that the Company will also be entitled to injunctive relief without bond against any such breach. Such injunctive relief will not be exclusive but will be in addition to any other relief that the Company may have. c. There are no agreements or understandings, oral or written, between the parties hereto other than those set forth in this Agreement, and there are no agreements or understandings which in any way alter, modify, amend or otherwise change this Agreement, with the exception of a certain Severance Agreement between the Executive and the Company, dated as of October 21, 1993, as such may be further modified, amended or replaced (the "Severance Agreement"). In the event that any "change in control" as defined in the Severance Agreement occurs during the Employment Period, which event triggers the terms of the Severance Agreement, then the parties hereto hereby agree that the Severance Agreement shall thenceforth be deemed to supersede this Agreement in all respects, except that Executive shall retain all his rights under Section 5b iv., v. and vi. d. The validity, interpretation, construction and performance of this Agreement shall be governed by the laws of the Commonwealth of Massachusetts applicable to instruments under seal. e. The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement, which shall remain in full force and effect. f. This Agreement may be executed in two counterparts, each of which shall be deemed an original but all of which together will constitute one and the same instrument. g. The section headings contained in this Agreement are for reference purposes only and shall not affect in any way the meaning or interpretation of this Agreement. NOW THEREFORE, the parties set their hands and seals on this 21st day of October, 1993. Signed: /s/ Robert C. Siegel -------------------------------- THE STRIDE RITE CORPORATION Signed: /s/ Margaret McKenna -------------------------------- Margaret McKenna, Chairman of the Compensation Committee of the Board of Directors EXHIBIT 11 THE STRIDE RITE CORPORATION CALCULATION OF NET INCOME PER SHARE FOR THE FIVE FISCAL YEARS ENDED DECEMBER 3, 1993 (a) Net income and net income per common share in 1992 included nonrecurring charges of $18,319,000 (an after-tax charge of $11,087,000 or $.22 per share). (b) Net income and net income per common share in 1993 includes nonrecurring charges of $7,200,000 (an after-tax charge of $4,274,000 or $.08 per share). Net income and net income per common share in 1993 were also reduced by the cumulative effect of change in accounting principle related to income taxes, which amounted to $2,034,000 or $.04 per share, respectively. EXHIBIT 13 FINANCIAL HIGHLIGHTS * Amounts are in thousands, except for per share information ** Amount in 1993 includes a charge of $2,034,000 ($.04 per share) representing the cumulative effect of an accounting change. SELECTED FINANCIAL DATA 1. Financial data is in thousands, except for per share information. 2. Net income in 1989 is after a loss from discontinued operations of $494,000 or $.01 per share. 3. Net income includes nonrecurring charges of $7,200,000 ($4,274,000, net of income taxes or $.08 per share) in 1993 and $18,319,000 ($11,087,000, net of income taxes, or $.22 per share) in 1992 as described in Note 2 to the consolidated financial statements. 4. Net income is reduced by $2,034,000 ($.04 per share) in 1993 representing the cumulative effect of an accounting change related to income taxes. MANAGEMENT'S DISCUSSION AND ANALYSIS FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS OVERVIEW - 1989 TO 1993 The information provided in the preceding table, entitled "Selected Financial Data", highlights Stride Rite's progress in the last five years. During this five-year period, the Company's net sales and net income have increased at an average annual rate of 6%. Excluding nonrecurring items and accounting changes, the five-year income growth rate would be slightly higher at 8.5% per year. Over the five-year period, the Company's gross profit percent has contracted somewhat due to the reduced significance of retail operations to the consolidated total and changes in product mix at Keds. Selling and administrative expenses in the last five years, excluding nonrecurring charges, have increased at an average annual rate of 3% compared to the net sales growth of 6%. While the lower rate of increase in expenses was due, in part, to retail store closings, selling expenses in these years also included higher advertising spending with costs increasing an average of 12% per year since 1989. This relatively low expense growth over the years has offset the impact of gross profit percent contraction so that, before one-time costs, operating income as a percent of net sales finished at 17.3% in fiscal 1993, the same return rate experienced in fiscal 1989. The Company's favorable cash flow also helped overall profitability in the period as net interest income has increased from an expense of $1.4 million in 1989 to income of $2.7 million in 1993. When compared to 1989's performance, the Company's after-tax return on net sales has remained essentially the same at 10% of sales. With income adjusted to exclude losses related to discontinued operations in 1989 and an accounting change and nonrecurring charge in 1993 (see Note 2 to the consolidated financial statements), the comparison of the 1989 and 1993 profitability measure produces a 9% improvement. Excluding nonrecurring items, the 1993 return on sales was 11.1%, compared to the return of 10.2% achieved in 1989. The 1993 return on equity of 20.2% fell short of the 30.5% return of fiscal 1989. The 1993 rate was negatively impacted by one-time items and by increased levels of short-term investments, which have yields that are low in relation to the Company's operating businesses. Adjusted for the accounting change and the nonrecurring charge, fiscal 1993's operating results produced a return on equity of 21.9%. OPERATING RESULTS 1991 TO 1993 The table below and the paragraphs which follow summarize the Company's performance in the last three fiscal years: NET SALES Net sales decreased $3 million in fiscal 1993 from the sales level achieved in fiscal 1992. Unit shipments of current line merchandise increased 1.2% in 1993 and the sales level also benefited from increased retail sales. The sales increases were offset by lower average selling prices, primarily due to product mix changes in the Keds division. Excluding the impact of product mix changes, consolidated net sales in 1993 were also reduced by approximately $4 million due to selling price deflation. Sales of the Keds division, the Company's largest business, in fiscal 1993 were 3% below last year's revenue total. Sales of Keds children's products decreased 6% from 1992, while sales of Keds women's product line in 1993 were off 4% from last year. The performance of the women's category was negatively impacted by lower average selling prices due to product mix changes and reduced sales of leather styles. Sales of Keds basic Champion style declined 9% in 1993. The decline was partially offset by the division's efforts to broaden the women's product offering which resulted in a 6% sales gain for other Keds women's products. Net sales of the Stride Rite Children's Group increased 6% in fiscal 1993 with additional retail sales accounting for just over half of the Group's sales increase. Sales of the retail booteries and leased departments operated by the Children's Group were up 8% in 1993, while sales to independently owned specialty stores, department stores and family shoe stores increased 4%. The Children's Group operated an average of 176 stores in each year, but finished the 1993 year with 189 stores, up from 173 locations in November 1992. The Children's Group had closed or sold 19 stores in fiscal 1992 and 37 stores in fiscal 1991. Approximately 40% of the retail sales gains in 1993 were related to comparable stores' results with the balance of the sales increase related to new stores and the fact that the 1993 fiscal year included 53 weeks. The Sperry Top-Sider division's sales in fiscal 1993 were down 11% from 1992 with sales of current line merchandise off 10% and revenues from the liquidation of discontinued styles down $1.1 million or 15%. Sales of leather boat shoes and other styles in 1993 were even with last year, while sales of canvas footwear and sandals were down 40% from 1992. The Company's International division continued to make steady progress in fiscal 1993 as sales were up $3.8 million or 17% from 1992. Higher sales of Keds products in international markets along with the initial deliveries of Stride Rite products to independently owned bootery stores in Latin America offset lower Sperry Top-Sider sales. The Company's Canadian subsidiary posted a 10% sales increase in 1993, but lower exchange rates reduced the sales gain in US dollars to 3%. Net sales in fiscal 1992 increased $11.5 million or 2% from fiscal 1991's results. In 1992, increased unit shipments and a change in mix toward higher priced leather styles offset $9 million of selling price deflation. Keds division sales were up 5% in 1992 as a 14% increase in sales of leather products helped both the children's and women's categories to post increases above 1991's sales. Sales of the Stride Rite Children's Group declined 7% in 1992 with retail sales down $5.1 million due to weak sales in the Group's leased departments and an average store count which was 11% lower than in 1991 due to the closing of underperforming retail locations. Children's Group sales to independent accounts were also lower in 1992, a decrease of 6% from the 1991 level. In 1992, sales of the Sperry Top-Sider division fell 10% from 1991 with lower shipments of canvas styles causing most of the decrease. International division sales were above 1991 by $8.6 million or 61% as increased sales of Keds products to distributors in Europe, South America and Japan offset a 10% sales decline in Canada. GROSS PROFIT In fiscal 1993, the Company's consolidated gross profit rate of 41.7% was below the 43.5% rate achieved in fiscal 1992. LIFO adjustments had little impact on 1993's gross profit performance, increasing margins by $0.2 million. In 1992, the impact of LIFO increased gross profit by $4.6 million or 0.8% of net sales. Stable leather prices and the continuing shift of product sourcing to lower cost countries produced deflation in overall product costs in 1992. The changing sales mix in the Keds division negatively impacted gross profit in 1993, as margins on new women's styles were generally lower than those of the basic Champion canvas styles. Increased product sourcing and warehousing costs also reduced gross profit in 1993 as staffing was expanded to cover new resources in the Far East. Gross profit percent performance was helped by the increased significance of the Stride Rite Children's Group's retail sales, the division of the Company with the highest gross profit percentage, as retail sales accounted for 11.6% of consolidated sales in 1993 compared to 10.7% in 1992. In addition, increased production levels at the domestic facilities operated by the Stride Rite Children's Group resulted in improved capacity utilization in 1993. In fiscal 1992, the Company's gross profit rate improved by 0.7 percentage points from the 42.8% rate achieved in fiscal 1991. The LIFO benefits (0.8% of net sales) included in the 1992 results accounted for all of the improvement as LIFO reduced gross profit in 1991 by $0.5 million or 0.1% of net sales. In 1992, gross profit also benefited from lower air freight costs ($2.4 million or 0.4% of net sales). The increased shipments of Keds leather styles in 1992 reduced the gross profit percent from that achieved in 1991 as the leather product line carries a lower margin rate than Keds' traditional canvas styles. Lower sales at the retail level and $1.7 million of costs associated with the closing of a manufacturing facility also hurt gross profit performance in 1992. OPERATING COSTS Selling and administrative expenses in fiscal 1993 increased $4.1 million or 3%. Selling and administrative costs as a percent to net sales increased by 0.8 percentage points, 24.5% in 1993 compared to 23.7% in 1992. Higher advertising and sales promotion expenses contributed to the cost increase in 1993 as spending was above 1992 by $2.5 million or 8%. Advertising expense represented 5.6% of net sales in 1993 compared to 5.2% in 1992. The increased significance of retail sales, where selling expenses are high relative to the Company's other divisions, to the consolidated total resulted in a 0.4% increase in the selling expense to sales ratio. In 1993, selling and administrative expenses also include additional costs totaling $1.9 million related to international trademark rights acquired during 1992 and start-up expenses of a European sales subsidiary. The Company's contributions to its charitable foundation were reduced by $4.3 million in 1993 in response to current profitability trends. Sufficient funds exist in the Stride Rite Charitable Foundation so that donations to scholarship and other charitable causes will not be impacted. In fiscal 1992, selling and administrative expenses decreased $1.7 million (1.2%) from 1991 despite the 2% increase in net sales. Advertising costs were up $0.6 million or 2.1% in 1992. The closing of retail stores during 1992 resulted in reduced costs of approximately $3.1 million. Nonrecurring charges, as described in Note 2 to the consolidated financial statements, impacted operating results during the last two years. In fiscal 1993, the Company incurred costs amounting to $7.2 million pre-tax related to the settlement of an investigation of Keds' suggested retail pricing policy. The nonrecurring charges in fiscal 1992, totaling $18.3 million, were primarily related to the Company's decision to consolidate and relocate its distribution function to a new facility in Kentucky. OTHER INCOME AND TAXES Non-operating income (expense) increased pre-tax earnings by $4.6 million in fiscal 1993 compared to increases of $2.3 million in the 1992 and 1991 fiscal years. Interest income increased $0.2 million in 1993 as a 36% increase in the funds available for investment during the year offset lower yields on short-term investments. In 1992, interest income decreased $0.5 million from 1991 as lower investment yields and the increased use of tax-exempt fixed income securities offset a 15% increase in funds available for investment. In 1993, interest expense was down slightly from last year after decreasing $0.2 million from 1991. Lower average borrowings under the Company's bank lines of credit and lower interest rates contributed to the reduced cost in 1992. In 1993, other income includes a gain of $3 million related to cash distributions from an investment in a limited partnership. This gain was partially offset by expenses related to a new company-owned life insurance program. The provisions for income taxes in fiscal 1993 and 1992 were below the prior year amount by $1.1 million and $2.9 million, respectively, because of lower pre-tax earnings. Despite the higher federal income tax rates, which took effect January 1, 1993, the Company's effective tax rate of 38.4% in 1993 decreased slightly from the effective rates in 1992 (38.6%) and 1991 (38.7%). Increased tax exempt investment income and tax savings related to a Company owned life insurance program offset the impact of the higher statutory rates (0.9%). NET INCOME Income before the cumulative effect of a change in accounting principle in fiscal 1993 decreased $1.2 million or 1.9% from the income level achieved in 1992. When adjusted for the nonrecurring charges in both years, the 1993 income amount was below 1992's results by $8 million ($64.6 million in 1993 compared to $72.6 million in 1992) or 11%. The income reduction in 1993 was caused by lower sales levels, the reduced gross profit rate and increased selling expenses. During the third quarter of fiscal 1993, the Company adopted, retroactive to November 28, 1992, Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". The cumulative effect of the change in accounting principle reduced net income in 1993 by $2 million. Including the impact of the change in accounting principle, net income for 1993 decreased $3.2 million or 5.2% from the 1992 total. In fiscal 1992, net income was below the 1991 level by $4.4 million or 6.8% as the impact of the nonrecurring charges ($11.1 million after tax) offset the increased operating earnings. Before the nonrecurring charge, 1992 net income was above the 1991 results by $6.6 million or 10.1%. LIQUIDITY AND CAPITAL RESOURCES As of the end of fiscal 1993, the Company's balance sheet reflected the results of the Company's continued positive cash flow. A current ratio of 3.4 to 1 and a debt to equity relationship of 0.8% demonstrate the Company's ability to provide internal financing for the future growth of its existing businesses. Over the last three fiscal years, the Company's operations have generated $189.3 million of positive cash flow. Fiscal 1993's operating results produced $67.3 million or 36% of this three-year total. The Company has used $33.9 million or 18% of this operating cash flow in the last three years to repurchase 1,895,100 common shares and $71.5 million or 38% of this amount has been added to the balance sheet in higher levels of cash and short-term investments. During 1993, the Company's cash and short-term investments increased by $6.2 million despite increased capital expenditures and the use of $15.2 million to fund higher dividend payments and to repurchase common shares. In fiscal 1993, the Company used $29.4 million of operating cash flow to fund the construction and equipping of a 520,000 square foot distribution center in Louisville, Kentucky. The elements of working capital, other than cash and short-term investments, decreased $4.3 million in 1993, with the investment in receivables and inventory declining by $6.5 million or 3% from the 1992 total. In addition to internal sources of capital, the Company maintains bank lines of credit to satisfy any seasonal borrowing requirements that may be imposed by the sales pattern characteristics of the footwear industry. In fiscal 1993, no significant amounts were borrowed under these arrangements and the Company's borrowings averaged only $0.7 million and $2.1 million during fiscal 1992 and 1991, respectively. No short-term borrowings were outstanding at the end of 1993 or 1992. In the last three years, additions to property and equipment aggregated $41.2 million with $33.9 million of the expenditures occurring in 1993. The largest project undertaken in fiscal 1993 was the Company's new distribution center in Louisville, Kentucky. Construction of the facility was completed in the fourth quarter and shipments of Keds products to customers commenced in January 1994 following the closing of the Keds distribution facility in New Bedford, Massachusetts in December 1993. The Company's sales performance in the first half of fiscal 1994 will be impacted by start-up difficulties at the new distribution center. In the first two months of fiscal 1994, the Keds division has experienced service interruptions on reorders, and deliveries of future orders to customers are behind schedule by approximately five weeks. As a result, Keds sales in the first quarter, which ends March 4, 1994, are expected to be 10% to 15% below the 1993 level. Consolidated net income for the first quarter of fiscal 1994 is expected to be off from the comparable period in fiscal 1993 at a more significant rate than the sales decline because of expenses related to the shipping delays as well as increased marketing costs. The Company anticipates the problems to continue into the second quarter of fiscal 1994 as deliveries are expected to run behind schedule until late April. The later deliveries on new Spring styles will probably result in lower reorders for the Spring season. The new distribution center should be fully operational for the Fall 1994 season. The Company expects to close its Boston, Massachusetts facility, which distributes Stride Rite and Sperry Top-Sider products to customers, and to transfer activity to the Kentucky facility in the second half of fiscal 1994. The Company opened 24 retail locations during fiscal 1993 with eight booteries purchased from independent dealers and 12 of the new locations representing additional leased department operations. The Company also closed 7 retail locations in 1993. In the 1990 to 1992 period, the Company emphasized the expansion of its dealer network of independently operated children's booteries rather than opening its own retail stores. Capital expenditures related to retail stores were lower in this period as only 10 Company-owned stores were opened over the three years. This pace of store openings was down significantly from the 47 stores opened in the 1987 to 1989 period. While the Company expects to accelerate the amount of retail store openings in fiscal 1994, capital expenditures will return to more normal levels due to the completion of the Kentucky facility. Funding for capital expenditures generally will be provided from internal sources. Over the last three years, the Company's Board of Directors has increased the dividend rate so that it is now almost double the rate of the fourth quarter of fiscal 1990. In addition, the Board has authorized a stock repurchase program for 16,000,000 shares of common stock. In fiscal 1993, the Company expended $13.4 million to repurchase 915,200 common shares. Adjusted for the stock splits in 1989 and 1991, the 1993 transactions brought the shares repurchased under the Board authorization to 12,948,100 shares, or 81% of the authorized total, for an aggregate expenditure of $106.6 million since the current repurchase program was initiated in the fourth quarter of 1987. The aggregate shares repurchased represent 21% of the total shares outstanding prior to the Board's authorization. Funds for these repurchases were provided from internal sources. Consolidated Balance Sheets The accompanying notes are an integral part of the consolidated financial statements CONSOLIDATED STATEMENTS OF INCOME The accompanying notes are an integral part of the consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY The accompanying notes are an integral part of the consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation-The consolidated financial statements of The Stride Rite Corporation include the accounts of the Company and all its wholly-owned subsidiaries. Intercompany transactions between the Company and its consolidated subsidiaries have been eliminated. The Company's investment in an unconsolidated, 49.5% owned affiliate is accounted for in the consolidated financial statements using the equity method of accounting. Under this method, the Company's share of the affiliate's income or loss is included in the consolidated statement of income. Earnings related to transactions between the affiliate and the Company's consolidated subsidiaries are deferred until merchandise is resold by those subsidiaries. Certain reclassifications have been made to prior years' consolidated financial statements to conform to the fiscal 1993 presentation. Cash Equivalents and Short-term Investments-Cash equivalents represent highly liquid investments, including repurchase agreements, with a maturity of three months or less. Due to the short-term nature of repurchase agreements, the Company does not take possession of the securities, which are instead held in the Company's safekeeping account by the bank. For these investments, the value of the collateral is at least equal to the amount of the repurchase agreements. Short-term investments, representing bank certificates of deposit and tax-exempt debt instruments with a maturity of between three months and one year, are stated at cost, which approximates market value. Financial Instruments-Financial instruments consist principally of cash, short- term investments, trade receivables and payables and long-term debt. The Company places its investments in highly rated financial institutions and investment grade short-term financial instruments, which limits the amount of credit exposure. The Company sells footwear to numerous retailers. Historically, the Company has not experienced significant losses related to investments or trade receivables. The Company calculates the fair value of all financial instruments and includes this additional information in the consolidated financial statements when the fair value is different than book value. The Company uses quoted market prices when available to calculate these fair values. Inventory Valuation-Inventories are stated at the lower of cost or market. The cost of substantially all inventories is determined on the last-in, first-out (LIFO) basis. Property and Equipment-Property and equipment are stated at cost. Depreciation, which is calculated primarily on the straight-line method, is provided by periodic charges to expense over the estimated useful lives of the assets. Leaseholds and leasehold improvements are amortized over the terms of the related leases or their estimated useful lives, whichever is shorter, using the straight-line method. Goodwill and Trademarks-Goodwill represents the excess of the amount paid over the fair value of net assets acquired. Trademark rights are stated at acquisition cost. These assets are being amortized on a straight-line basis primarily over a 25-year period. Income Taxes-Deferred income taxes are provided for timing differences between financial and taxable income. Deferred taxes are also provided on undistributed earnings of subsidiaries and affiliates located outside the United States at rates expected to be applicable at the time of repatriation. Accounting Change - During fiscal 1993, the Company adopted, effective November 28, 1992, Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". The cumulative effect of adopting this Statement was to decrease 1993's net income by $2,034,000 or $.04 per share. Prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. Accounting Pronouncements - In December 1990, the Financial Accounting Standard Board issued SFAS No. 106, "Employers' Accounting for Post-retirement Benefits Other Than Pensions." Since the Company does not currently provide retirees with health and other benefits, the Statement has no impact on the Company's financial statements. Net Income Per Common Share-Net income per common share is computed by dividing net income by the average number of common shares and common equivalents outstanding during the year. Industry Segment Information-The Company operates primarily within the footwear industry; therefore, no segment information is required. 2. NONRECURRING CHARGES On September 27, 1993, the Company announced that its wholly-owned subsidiary, The Keds Corporation, reached settlement agreements with the Attorneys General of all fifty states, the Corporation Counsel of The District of Columbia and The Federal Trade Commission concerning their investigations of Keds' suggested retail pricing policy. Under the settlement, which is subject to court approval, Keds agreed to contribute $5,700,000 to five charitable organizations nationwide and to pay $1,500,000 in notice and other administration expenses. Keds' suggested retail pricing policy, which was instituted on September 1, 1992 and withdrawn on June 25, 1993, covered six of its women's shoes, including the leather and canvas Champion Oxford styles. The Company believes that Keds' pricing policy did not in any way violate any antitrust laws or any other laws and continues to believe that its pricing policy was entirely lawful. Keds decided to resolve this complicated legal issue expeditiously in order to avoid any further disruption to its business. The full cost of the settlement, $4,274,000 net of income taxes or $.08 per share, is included in the consolidated statement of income for the year ended December 3, 1993. The Company's operating results for the fiscal year ended November 27, 1992 included the accrual of $18,319,000 in nonrecurring charges. These charges were primarily related to the Company's decision to consolidate and relocate its two Massachusetts distribution centers to a new facility in Louisville, Kentucky. The nonrecurring charges included the estimated costs of severance, relocation, training and other expenses associated with the move to the new facility, as well as estimated losses on the disposal of property and equipment. The Company completed construction of the new facility in December 1993. Capital expenditures in fiscal 1993 includes $29,423,000 representing the cost of constructing and equipping the new facility. 3. INVENTORIES The cost of inventories at December 3, 1993 and November 27, 1992, was determined primarily on a last-in, first-out (LIFO) basis. A summary of inventory values is as follows: During 1993, the LIFO reserve decreased by $183,000 to $22,928,000 at December 3, 1993. If all inventories had been valued on a FIFO basis, net income would have been lower by $108,000 (less than $.01 per share) in 1993. During 1992, the LIFO reserve decreased by $4,636,000 and in 1991 the reserve increased by $535,000. If all inventories had been valued on a FIFO basis, net income would have been lower in 1992 by $2,770,000 ($.05 per share) and, in 1991, net income would have been higher by $319,000 ($.01 per share). During each year, reductions in certain inventory quantities resulted in the sale of products carried at costs prevailing in prior years which were different than current costs. As a result of these inventory reductions, net income was decreased in 1993 by $444,000 ($.01 per share) and was increased in 1992 and 1991 by $1,304,000 and $1,421,000, respectively ($.03 per share in each year). 4. PROPERTY AND EQUIPMENT The components of property and equipment at December 3, 1993 and November 27, 1992 are as follows: 5. OTHER ASSETS As of December 3, 1993 and November 27, 1992, other assets includes $8,622,000 and $7,369,000, respectively, related to long-term investments. In 1986, the Company agreed to invest $5,000,000 in a limited partnership which is authorized to make investments in assets and securities of all kinds. Cash distributions are made to the limited partners as investments are sold. In 1993, the Company recognized a gain of $3,004,000 due to the sale of certain investments by the limited partnership and the recovery of previously recorded valuation reserves. The Company had reduced the carrying value of this investment by $140,000 in 1992 and $411,000 in 1991 because of declines in the market value of certain assets of the limited partnership. The Company's investment in this limited partnership, which is accounted for under the cost method, amounted to $2,243,000 at December 3, 1993 and $2,495,000 at November 27, 1992. The fair value of this investment as of September 30, 1993, the latest valuation as determined by the General Partner, totaled approximately $2,700,000. Long-term investments also includes the Company's affiliate in Thailand, which is accounted for under the equity method. During 1988 and 1989, the Company invested a total of $1,948,000 in a joint venture with a foreign manufacturer to construct and operate a footwear manufacturing facility in Thailand. The consolidated statements of income include income of $1,043,000 in 1993, $1,809,000 in 1992 and $2,298,000 in 1991, representing the Company's share of the joint venture's operating results in those years. The joint venture paid cash dividends of $1,292,000 and $586,000 to shareholders in 1992 and 1991, respectively, which reduced the carrying value of the Company's investment. The Company's investment in the affiliate amounted to $5,758,000 at December 3, 1993 and $4,715,000 at November 29, 1992. Other assets also includes $8,934,000 and $11,099,000 at December 3, 1993 and November 27, 1992, respectively, related to goodwill, trademark rights and other intangible assets. These other assets are presented net of accumulated amortization of $4,919,000 at December 3, 1993 and $2,471,000 at November 27, 1992. In 1992, the Company entered into an agreement to acquire trademark registrations in certain countries and to terminate existing license arrangements relating to the use of the Keds(R) and PRO-Keds(R) trademarks outside the United States, Canada and Puerto Rico. As part of the agreement, the Company paid $10 million and also entered into a new license agreement relating to the distribution of Keds(R) and PRO-Keds(R) products in certain countries in the Caribbean and Central and South America. The trademark rights acquired in the transaction ($874,000) are being amortized over a 25-year period. The other intangible assets associated with this agreement ($9,126,000) are being amortized over a four-year period, the remaining term of the terminated license agreements. 6. DEBT The Company utilizes short-term bank loans to finance seasonal working capital requirements. Banks have extended lines of credit to the Company amounting to $80 million, of which $10 million is formally committed by agreement. Compensation for these lines is paid with fees, which are computed on the committed amount. During fiscal 1993, 1992 and 1991, borrowings under these lines averaged $17,000, $741,000 and $2,101,000, respectively, with a maximum amount outstanding of $4,300,000 in 1993, $8,200,000 in 1992 and $12,200,000 in 1991. The weighted average interest rate paid on these borrowings during the year was 3.6% in 1993, 4.6% in 1992 and 6.8% in 1991. No short-term borrowings were outstanding on December 3, 1993 or November 27, 1992. Long-term debt at December 3, 1993 and November 27, 1992 ($2,500,000 and $3,333,000, respectively) represents loans due to several institutional lenders in connection with the Company's 8.45% Senior Notes. The Senior Notes require mandatory prepayments amounting to $833,000 per year. An agreement signed in connection with the loan requires that certain levels of working capital be maintained, restricts the amount of other borrowings and lease obligations and limits dividend payments and treasury stock purchases. Such dividend payments and treasury stock purchases may not reduce stockholders' equity below $33,537,000. Amounts due on long-term debt in future years are $833,000 per year from 1995 through 1997. Interest payments amounted to $373,000, $477,000 and $656,000 in fiscal 1993, 1992 and 1991, respectively. 7. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accrued expenses and other current liabilities at December 3, 1993 and November 27, 1992 consist of the following: 8. LEASES The Company leases office and retail store space, certain factory space and equipment. A portion of the retail store space is sublet. Some of the leases have provisions for additional rentals based on increased property taxes and the leases for retail store space generally require additional rentals based on sales volume in excess of certain levels. Manufacturing equipment leases generally require additional rentals based on usage. Some leases have renewal options. Rent expense for operating leases for the three years in the period ended December 3, 1993 was as follows: The future minimum rental payments for all non-cancellable operating leases and the amounts due from tenants on related subleases at December 3, 1993 are as follows: 9. BENEFIT PLANS The Company has several non-contributory defined benefit pension plans covering eligible employees. A plan covering salaried, management, sales and non- production hourly employees provides pension benefits based on the employee's service and compensation. Plans covering production employees provide pension benefits at a fixed unit rate based on service. As a result of the distribution center consolidation and relocation, the Company merged two of its pension plans into a third plan as of December 31, 1993. Net assets of these plans are sufficient to fund the related projected benefit obligations. Pension expense, including amortization of prior service costs over the remaining service periods of employees and the remaining lives of vested and retired employees, consists of the following: The prepaid pension cost in the Company's consolidated balance sheets at December 3, 1993 and November 27, 1992 includes the following: At December 3, 1993, the accumulated benefit obligation, which represents the actuarial present value of the Company's pension obligation if the plans were to be discontinued, totaled $24,134,000, including a vested benefit obligation of $23,216,000. The accumulated benefit obligation at November 27, 1992 was $18,945,000, including a vested benefit obligation of $18,469,000. Discount rates of 7.5% in 1993 and 9% in 1992 and an annual compensation increase at the rates of 4% in 1993 and 5.5% in 1992 were assumed to determine these liabilities. During fiscal 1993, approximately 66% of the plan assets were invested in equity investments with the remaining 34% in fixed income securities. In 1992, approximately 60% of the plan assets were invested in equity investments with the remaining 40% invested in fixed income securities. The expected long-term rate of return, net of related expenses, on plan assets is 9%. The Stride Rite Corporation Employee Savings and Investment Plan, as amended, enables eligible employees to defer a portion of their salary to be held by the Trustees of the Plan. The Company makes an additional contribution to the Plan equal to a maximum of 25% of the first 6% of savings by each participant. During fiscal 1993, 1992 and 1991, this contribution amounted to $471,000, $437,000 and $375,000, respectively. 10. STOCK PURCHASE AND OPTION PLANS An Employee Stock Purchase Plan, as amended, permits eligible employees to elect to subscribe for an aggregate of 5,640,000 shares of common stock of the Company. Under the Plan, participating employees may authorize the Company to withhold either 2.5% or 5% of their earnings for a one-or two-year payment period for the purchase of shares. At the conclusion of the period, employees may purchase shares at the lesser of 85% of the market value of the Company's common stock on either their entry date into the Plan or ten days prior to the end of the payment period. The Board of Directors may set a minimum price for the stock. For the payment period which ended in fiscal 1993, 183,145 shares were issued under the plan for an aggregate amount of $2,471,000. In 1991, 223,098 shares were issued under the plan for an aggregate amount of $2,362,000. Funds are currently being withheld from 895 participating employees during a payment period ending October 31, 1995. As of December 3, 1993, $167,000 has been withheld from employees' earnings and, if all participating employees had been allowed to exercise their stock purchase rights, approximately 12,800 shares could have been purchased at a price of $13.07 per share. At December 3, 1993, a total of 4,792,281 shares had been purchased under the Plan and 847,719 shares are available for purchase by participating employees. Under the 1975 Executive Incentive Stock Purchase Plan, as amended, rights to purchase up to an aggregate of 5,600,000 shares of the Company's common stock may be granted from time to time to officers and other key employees of the Company at a price determined by the Board of Directors. This price may not be less than the current par value of the Company's common stock, which is $.25 per share. In 1993, 64 employees were eligible to participate in the Plan and 81 employees held outstanding rights under the Plan. Rights to purchase shares may be exercised at any time within ten years of the grant date, cannot be transferred and must be paid for in full at the time of exercise. Shares issued under the Plan may be subject to restrictions. Restricted shares may not be sold, pledged or otherwise transferred and generally must be resold to the Company upon termination of employment. Restrictions on transfer of shares and the obligation to resell shares to the Company generally will lapse at the rate of one-third of the granted shares at the end of the third year, the fourth year and the fifth year following the date of grant. The Company charges to compensation expense the difference between the fair market value at the date of grant and the purchase price over a five- year period. This Plan expires on December 31, 1995. The purchase price for all rights granted was at par value as of the date of grant. The activity in stock rights for the three years in the period ended December 3, 1993 was as follows: At December 3, 1993, a total of 3,817,458 shares had been granted under the Plan and rights to purchase an additional 1,782,542 shares (1,739,506 shares at November 27, 1992) could be granted. Under the Company's Key Executive Long-Term Incentive Plan, income goals are established for three-year cycles and a certain number of performance shares, which are equivalent in value to the Company's common stock, are granted to each participant. Payments under the Plan are based on the income achieved by the Company in relation to the goals established for each cycle. Payments are made in cash, Company common stock or a combination of both at the discretion of the Compensation Committee of the Board of Directors. The Company issued 16,878 shares to eight individuals in 1993, 55,830 shares to nine individuals in 1992 and 6,436 shares to one individual in 1991 as a result of performance against the goals for the cycles which ended in 1992, 1991 and 1990. For the cycles ending in 1993, 1994 and 1995, performance shares totaling 30,466, 20,707 and 36,986, respectively, have been granted to ten individuals. The Company charges to compensation expense the costs associated with the Plan. 11. PREFERRED STOCK PURCHASE RIGHTS In 1987, the Company's Board of Directors adopted a Stockholder Rights Plan and declared a dividend under the Plan at the rate of one preferred stock purchase right for each share of outstanding common stock. Effective with the stock splits in December 1991, July 1989 and December 1987, one-eighth of one preferred stock purchase right attaches to each share of common stock. The rights may be exercised (in whole units only), or transferred apart from the common stock, beginning 10 days after a person or group acquires 20% or more of the Company's outstanding common stock or 10 business days after a person or group announces a tender offer that would result in the person or group owning at least 30% of the Company's common stock. In 1989, the Plan was amended to allow the exercise of rights immediately after an "adverse person" has become the beneficial owner of at least 10% of the shares of common stock then outstanding and a determination is made by the continuing directors and outside directors that such ownership is intended to cause the Company to repurchase the shares or to cause a material adverse impact on the business or prospects of the Company. Subject to possible extension, the rights may be redeemed by the Company at $.05 per whole right at any time until 10 days after 20% or more of the Company's common stock is acquired by a person or group. Once exercisable, unless redeemed, one whole right entitles the holder to purchase 1/100 of a share of Series A Junior Participating Preferred Stock for $132 per share, subject to adjustment. If the continuing directors and the outside directors determine that a person is an "adverse person," or at any time after the rights become exercisable the Company is the surviving corporation in a merger with a person or group owning 20% or more of the Company's common stock, or a person or group acquires at least 30% of the Company's common stock (with one exception), or a person or group owning 20% or more of the Company's common stock engages in certain "self-dealing" transactions, or an event occurs which increases by more than 1% the ownership of a person or group already owning at least 20% of the Company's common stock, then each whole right (except those owned by an "adverse person" or a person or group owning at least 20% of the Company's common stock) will entitle the holder to receive, upon exercise, shares of the Company's common stock (or in certain circumstances cash, property or other securities of the Company) having a value equal to $264, subject to adjustment. Alternatively, if, after the rights become exercisable, the Company is acquired in a certain merger or other business combination transaction and is not the surviving entity, or 50% or more of the Company's assets or earning power is sold or transferred, then each whole right will entitle the holder to receive, upon exercise, common stock in the acquiring company having a value equal to $264, subject to adjustment. The rights, which have no voting power, expire on July 17, 1997. Preferred stock purchase rights outstanding at December 3, 1993, November 27, 1992 and November 29, 1991 totaled 6,284,982, 6,363,488 and 6,435,079, respectively. 12. LITIGATION The Company is a party to various litigation arising in the normal course of business. Having considered facts which have been ascertained and opinions of counsel handling these matters, management does not believe the ultimate resolution of such litigation will have a material adverse effect on the Company's financial position or results of operation. 13. INCOME TAXES The provision for income taxes, which in 1993 is computed under SFAS No. 109, consists of the following for the three years in the period ended December 3, 1993: The deferred provision for income taxes in 1992 included a tax benefit of $7,232,000 related to the nonrecurring charges described in Note 2. The deferred provision in 1991 included tax benefits of $2,880,000 related to timing differences on "safe harbor" lease agreements. With the adoption of SFAS No. 109, net deferred tax assets of $23,459,000 as included on the Company's consolidated balance sheet at November 27, 1992 have been reduced by $2,034,000, the cumulative effect of the change in accounting principle. Net deferred tax assets as of December 3, 1993 and November 28, 1992, restated for the adoption of SFAS No. 109, have the following significant components: A valuation allowance has not been assigned to the deferred tax assets since the Company expects to fully realize the benefits of such tax assets. The effective income tax rate differs from the statutory federal income tax rate as follows: Payments of income taxes amounted to $40,224,000, $39,265,000 and $40,544,000 in 1993, 1992 and 1991, respectively. 14. QUARTERLY DATA (UNAUDITED) The following table provides quarterly data for the fiscal years ended December 3, 1993 and November 27, 1992. In the third quarter of 1993, net income included a nonrecurring charge of $7,200,000 ($4,274,000 after tax or $.08 per share) related to the settlement of an investigation into Keds suggested retail selling price policy. Net income in the fourth quarter of 1992 included $18,319,000 in nonrecurring charges ($11,087,000 after-tax or $.22 per share). These charges related primarily to the Company's decision, which was announced on January 7, 1993, to relocate its distribution facilities from Massachusetts to Kentucky. MANAGEMENT'S REPORT ON FINANCIAL INFORMATION Management of The Stride Rite Corporation is responsible for the preparation and integrity of the financial information included in this annual report. The financial statements have been prepared in accordance with generally accepted accounting principles. Where required, the financial statements reflect our best estimates and judgments. It is the Company's policy to maintain a control-conscious environment through an effective system of internal accounting controls supported by formal policies and procedures communicated throughout the Company. These controls are adequate to provide reasonable assurance that assets are safeguarded against loss or unauthorized use and to produce the records necessary for the preparation of financial information. There are limits inherent in all systems of internal control based on the recognition that the costs of such systems should be related to the benefits to be derived. We believe the Company's systems provide this appropriate balance. The control environment is complemented by the Company's internal auditors who perform audits and evaluate the adequacy of and the adherence to these controls, policies and procedures. In addition, the Company's independent public accountants have developed an understanding of our accounting and financial controls and have conducted such tests as they consider necessary to support their report below. The Board of Directors pursues its oversight role for the financial statements through the Audit Committee, which consists solely of outside directors. The Audit Committee meets regularly with management, the corporate internal auditors and Coopers & Lybrand to review management's process of implementation and administration of internal accounting controls, and auditing and financial reporting matters. The independent and internal auditors have unrestricted access to the Audit Committee. The Company maintains high standards in selecting, training and developing personnel to help ensure that management's objectives of maintaining strong, effective internal controls and unbiased, uniform reporting standards are attained. We believe it is essential for the Company to conduct its business affairs in accordance with the highest ethical standards as expressed in The Stride Rite Corporation's Code of Ethics. Robert C. Siegel J. Patrick Spainhour John M. Kelliher, Chairman of the Board Executive Vice President, Vice President, Finance of Directors and Finance and Operations Treasurer and Controller Chief Executive Officer REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Directors The Stride Rite Corporation: We have audited the accompanying consolidated balance sheets of The Stride Rite Corporation as of December 3, 1993 and November 27, 1992, and the related consolidated statements of income, cash flows and changes in stockholders' equity for each of the three years in the period ended December 3, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Stride Rite Corporation as of December 3, 1993 and November 27, 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 3, 1993, in conformity with generally accepted accounting principles. Boston, Massachusetts January 20, 1994 ABOUT STRIDE RITE The Stride Rite Corporation is the leading marketer of high quality children's footwear in the United States and is a major marketer of athletic and casual footwear for children and adults. The Company manufactures products in its own facilities in the United States and Puerto Rico and imports products from abroad. The Company markets children's footwear under the trademarks STRIDE RITE(R) and KEDS(R). Boating shoes and outdoor recreational and casual footwear are marketed under the Company's SPERRY TOP-SIDER(R) trademark. Additionally, casual and athletic footwear is marketed under the Company's KEDS(R), PRO- KEDS(R) and GRASSHOPPERS(R) trademarks. The Company sells its products nationwide to independent retail shoe stores, department stores, sporting goods stores, and marinas. The Company also markets its products directly to consumers by selling children's footwear through 135 of its own Stride Rite Bootery stores and in 52 leased departments within leading department stores. Products of the Company's brands are also sold directly to consumers in 2 manufacturers' outlet stores. BOARD OF DIRECTORS Robert C. Siegel Margaret A. McKenna Chairman of the Board of Directors, President, Lesley College President and Chief Executive Officer Donald R. Gant Robert L. Seelert Limited Partner of The Goldman Private Investor and Former Chief Sachs Group, L.P. Executive Officer of Kayser-Roth Corporation Arnold Hiatt Myles J. Slosberg Former Chairman of the Board of Former Executive Vice President, Directors Assistant Attorney General for President and a Director, the Commonwealth of Massachusetts The Stride Rite Charitable Foundation, Inc. Theodore Levitt W. Paul Tippett Edward W. Carter Professor Chairman and Chief Executive of Business Administration Emeritus Officer of the Council of Harvard Business School Great Lakes Industries COMMITTEES OF THE BOARD AUDIT COMMITTEE INVESTMENT COMMITTEE Donald R. Gant Myles J. Slosberg Robert L. Seelert Arnold Hiatt Myles J. Slosberg Robert L. Seelert COMPENSATION COMMITTEE NOMINATING COMMITTEE Margaret A. McKenna Theodore Levitt Donald R. Gant Margaret A. McKenna Theodore Levitt W. Paul Tippett W. Paul Tippett CORPORATE DATA EXECUTIVE OFFICERS Robert C. Siegel Chairman of the Board of Directors, President and Chief Executive Officer J. Patrick Spainhour Executive Vice President, Finance and Operations Jonathan D. Caplan President, The Keds Corporation Karen K. Crider General Counsel and Clerk John M. Kelliher Vice President, Finance, Treasurer and Controller John P. McMahon, Jr. Vice President, Human Resources Robert B. Moore, Jr. President, Sperry Top-Sider, Inc. Margaret C. Whitman President, Stride Rite Children's Group, Inc. EXECUTIVE OFFICES Five Cambridge Center Cambridge, Massachusetts 02142 (617) 491-8800 MAJOR SUBSIDIARIES The Keds Corporation Sperry Top-Sider,Inc. Sperry Top-Sider Europe, S.A.R.L. Stride Rite Children's Group, Inc. Stride Rite Canada Limited Stride Rite International Corp. Stride Rite Sourcing International, Inc. AUDITORS Coopers & Lybrand Boston, Massachusetts STOCK LISTING The Stride Rite Corporation's common stock is listed on the New York Stock Exchange and is identified by the symbol SRR. ANNUAL MEETING The 1994 Annual Meeting of Stockholders of The Stride Rite Corporation will be held on Wednesday, April 13, 1994 at 10:00 A.M. in the auditorium of the First National Bank of Boston, 100 Federal Street, Boston, Massachusetts. TRANSFER AGENT, REGISTRAR AND DIVIDEND DISBURSING AGENT Communication concerning transfer requirements, address changes, dividend reinvestment plan enrollment, and lost certificates should be addressed to: The First National Bank of Boston Shareholder Services Department Investor Relations Unit 45-02-09 P.O. Box 644 Boston, MA 02102-0644 The telephone number is (617) 575-2900. AUTOMATIC DIVIDEND REINVESTMENT AND STOCK PURCHASE PLANS For shareholders' submission of enrollment cards, withdrawal and redemption requests and cash investments, contact: The First National Bank of Boston Shareholder Services Department Dividend Reinvestment Unit 45-01-06 P.O. Box 1681 Boston, MA 02105-1681 FORM 10-K The Stride Rite Corporation's Annual Report on Form 10-K, filed with the Securities and Exchange Commission, is available without charge upon request and may be obtained by writing to Shareholder Relations at the Company's executive offices. COMMON STOCK PRICES Based on closing prices on the New York Stock Exchange-Composite. EXHIBIT 21 SUBSIDIARIES OF THE STRIDE RITE CORPORATION The subsidiaries of the Registrant, all of which are wholly-owned by the Registrant except for PSR Footwear Company Limited (49.5% owned), are listed below: EXHIBIT 23 CONSENT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of The Stride Rite Corporation: We consent to the incorporation by reference in the Registration Statements on Form S-8 (SEC File No. 2-76795, 2-85041 and 33-19562) of The Stride Rite Corporation of our reports dated January 20, 1994 on our audits of the consolidated financial statements and financial statement schedules of The Stride Rite Corporation as of December 3, 1993 and November 27, 1992 and for the years ended December 3, 1993, November 27, 1992 and November 29, 1991 which reports are included or incorporated by reference in this Annual Report on Form 10-K. Boston, Massachusetts COOPERS & LYBRAND February 25, 1994

73020_1993.txt

73020_1993

1993

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ITEM 1. BUSINESS General - ------- Northwest Natural Gas Company (the Company) was incorporated under the laws of Oregon in 1910. The Company and its predecessors have supplied gas service to the public since 1859. The Company is principally engaged in the distribution of natural gas to customers in western Oregon and southwestern Washington, including the Portland metropolitan area. Basic industries served by the Company include pulp, paper and other forest products; the processing of farm and food products; lumber and plywood; the production of various mineral products; the manufacture of electronic, electrochemical and electrometallurgical products; metal fabrication and casting; and the production of machine tools, machinery and textiles. The City of Portland, Oregon is the principal retail and manufacturing center in the Columbia River Basin. It is a major port and growing nucleus for trade with Pacific Rim nations such as Japan and Korea. The Company has four subsidiaries, each of which is incorporated in the State of Oregon: Oregon Natural Gas Development Corporation (Oregon Natural), NNG Financial Corporation (Financial Corporation), NNG Energy Systems, Inc. (Energy Systems) and Pacific Square Corporation (Pacific Square). Oregon Natural is engaged in natural gas exploration, development and production in Oregon and other western states, and, through its wholly-owned subsidiary, Canor Energy Ltd. (Canor), an Alberta Corporation, also engages in gas and oil exploration, development and production in Alberta and Saskatchewan, Canada. Oregon Natural also holds an equity investment in a Boeing 737-300 aircraft. (See Part I, Item 2, and Part II, Item 8, Note 2 and Note 11.) Financial Corporation holds financial investments as a limited partner in four solar electric generating plants, four wind power electric generation projects and a hydroelectric project, all located in California, and in a low-income housing project in Portland. Financial Corporation also arranges short- term financing for the Company's operating subsidiaries. (See Part II, Item 8, Note 11.) Energy Systems, through its wholly-owned subsidiary, Agrico Cogeneration Corporation (Agrico), formerly owned a 25 megawatt cogeneration plant near Fresno, California. In December 1991, Agrico filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. In November 1992, Agrico entered into a settlement with Pacific Gas & Electric Company (PG&E), the utility which purchased plant energy and capacity from Agrico, and Wellhead Electric Company (Wellhead), the contract operator of the Agrico plant, with respect to PG&E's claimed overpayments to Agrico for power purchased in 1990 and 1991. In January 1994, the California Public Utilities Commission's order approving Agrico's settlement with PG&E and Wellhead became final, and the U.S. Bankruptcy Court entered its order confirming Agrico's reorganization plan. The Court's order and the reorganization plan became final and the sale of Agrico's assets to Wellhead closed in February 1994. (See Part I, Item 3, and Part II, Item 8, Note 3.) Pacific Square is engaged in real estate management, principally in connection with two office buildings in Portland and other Company-owned properties adjacent to those buildings. Pacific Square has entered into an agreement to sell its interests in the partnership that owns these buildings. (See Part I, Item 2, and Part II, Item 8, Note 2 and Note 12.) Service Area - ------------ The Oregon Public Utility Commission (OPUC) has allocated to the Company as its exclusive service area a major portion of western Oregon, including most of the fertile Willamette Valley and the coastal area from Astoria to Coos Bay. The Company also holds certificates from the Washington Utilities and Transportation Commission (WUTC) granting it exclusive rights to serve portions of three Washington counties bordering the Columbia River. Gas service is provided in 95 cities, together with neighboring communities, in 16 Oregon counties, and in nine cities and neighboring communities in three Washington counties. The Company's service areas have a population of about 2,600,000, including about 78 percent of the population of the State of Oregon. Gas Supply - ---------- General ------- The Company meets the needs of its core market (residential, commercial and firm industrial) customers through natural gas purchases from a variety of suppliers. The Company has a diverse portfolio of short-, medium- and long-term firm gas supply contracts, and, during periods of peak demand, supplements this supply with gas from storage facilities which are either owned by or contractually committed to the Company. Natural gas for the Company's core market is transported by Northwest Pipeline Corporation (NPC) under a contract expiring September 30, 2013, providing for the delivery of firm requirements of up to 2,460,440 therms(1) per day. NPC's rates for this service are established by the Federal Energy Regulatory Commission (FERC) under NPC's primary firm transportation rate schedule, as amended or superseded from time to time. Commencing in April 1993, the Company added 500,000 therms per day of firm transportation capacity for its core market through participation in an expansion of NPC's system, and an expansion of Pacific Gas Transmission's (PGT) pipeline through central Oregon, southeastern Washington and northern Idaho. In combination, this additional firm transportation capacity provides a connection through Alberta Natural Gas Company Ltd.'s (ANG) system to producing regions of Alberta, Canada. The cost of gas to supply the Company's core market consists of amounts paid to suppliers of the gas commodity and peaking services plus transportation charges paid to pipelines in the United States and Canada. While the rates for pipeline transportation and peaking services are regulated, the prices of gas purchased under the supply contracts are not. Although both gas commodity and pipeline costs have increased, the Company has been able to minimize the effect of such increases on core market prices by taking advantage of medium-term fixed price supply contracts negotiated in 1991, and by negotiating off-system sales agreements which partially offset pipeline costs in periods when the core market does not require full utilization of firm pipeline capacity. The Company supplies many of its larger industrial interruptible customers (those customers with full or partial dual fuel capabilities) through gas transportation service, delivering gas purchased by these customers directly from suppliers. Core Market System Supply ------------------------- The Company purchases gas for its core market from a variety of suppliers located in the western United States and Canada. At December 31, 1993, the Company had 19 contracts with 15 suppliers with original terms of from four months to 15 years which provided for a maximum of 2,718,250 therms of firm gas per - ----------------------- [FN] (1) For gas quantities expressed in therms, one therm is equivalent to 100 cubic feet of natural gas at an assumed heat content of 1,000 British Thermal Units (Btu's) per cubic foot. MMBtu means one million Btu's, or 10 therms. For gas quantities expressed in cubic feet, unless otherwise indicated, all volumes are stated at a pressure base of 14.73 pounds per square inch absolute at 60 degrees Fahrenheit, and in some instances are rounded to the nearest major multiple. Mcf means one thousand cubic feet, Mmcf means one million cubic feet and Bcf means one billion cubic feet. day during the peak winter season and 1,804,060 therms per day during the non-peak season. About three-fourths of this supply comes from Canada and the remainder from the United States, including a small portion which is locally produced in Oregon. The terms of the Company's principal purchase agreements are summarized as follows: An agreement expiring November 1, 2003 with CanWest Gas Supply, Inc. (CanWest), an aggregator for gas producers in British Columbia, Canada, entitles the Company to purchase up to approximately 960,000 therms of firm gas per day. This agreement contains a demand and commodity pricing structure and a provision for annual renegotiations of the commodity price to reflect then-prevailing market prices. The demand charges reflect the reservation of firm transportation space on the Westcoast Energy, Inc. pipeline system in British Columbia. These demand charges are subject to change as approved by the Canadian National Energy Board (NEB) in rate proceedings similar to those conducted in the United States by the FERC. Under this agreement, the Company also has the ability to purchase gas between May 1 and October 31 each year for injection into storage facilities at a commodity price, to be renegotiated annually, substantially below the commodity price for gas for current use. This contract contains a pro rata market share commitment and minimum purchase obligations. An agreement also expiring November 1, 2003 with Amoco Canada Petroleum Company, Ltd., on terms similar to the CanWest agreement, entitles the Company to purchase up to approximately 83,300 therms of firm gas per day. This gas is aggregated from production in Alberta and the Canadian Yukon and Northwest Territories. This contract contains a pro rata market share commitment and minimum purchase obligations. An agreement with Poco Petroleums, Ltd. (Poco), a Canadian producer, expiring September 30, 2003, entitles the Company to purchase up to 155,160 therms per day during the winter and up to 110,000 therms per day during the summer. The gas is produced in Alberta and makes use of the Company's added capacity from transportation on the PGT and ANG systems. Two agreements expiring September 30, 2003 with Westcoast Gas Services entitle the Company to purchase up to 140,000 therms per day year-round, plus up to 92,750 therms per day of winter season supply. This gas is produced in Alberta and makes use of the Company's new capacity on the PGT and ANG systems. Pricing for supplies under this agreement can be renegotiated annually. The current pricing arrangement includes demand charges for upstream capacity on the Canadian pipeline systems, a monthly reservation charge and a fixed commodity price. An agreement expiring October 31, 1996 with Poco entitles the Company to purchase up to 200,000 therms of firm gas per day. This agreement contains a demand and commodity pricing structure, a provision for annual renegotiations of the commodity price, minimum purchase obligations and a pro rata market share commitment. The demand charge is subject to NEB regulation. This gas is produced in Alberta and British Columbia. An agreement expiring September 30, 2000 with Summit Resources Ltd. entitles the Company to purchase up to 77,580 therms per day during the winter and up to 50,000 therms per day during the summer. This gas is produced in Alberta and makes use of the Company's added capacity from transportation on the PGT and ANG systems. Pricing for supplies under this agreement can be renegotiated annually. The current pricing arrangement includes demand charges for upstream capacity on NOVA Corporation of Alberta's system and commodity charges that are separated into three tiers. An agreement expiring October 31, 1994 with Natural Gas Clearinghouse, one of the largest independent gas marketers in the United States, entitles the Company to purchase up to 100,000 therms of firm gas per day. This gas is produced in the United States Rocky Mountain region. The pricing structure for this agreement contains a monthly reservation charge plus a commodity charge based on monthly trade indices. Prices are renegotiated annually. This contract contains a pro rata market share commitment. An agreement with Nahama & Weagant Energy Company (NWEC) expiring January 1, 1995 entitles the Company to purchase all of the production from the wells at Mist, Oregon that previously had been under contract with Atlantic Richfield (ARCO). Although production from these wells continues to decline, it provides a supply delivered within the Company's service territory. Production from these wells averages nearly 50,000 therms per day and is priced based on the Company's weighted average cost of gas. An agreement with NWEC expiring December 31, 1994 entitles the Company to purchase all of the production from new wells at Mist. Production from these wells currently provides the Company with more than 70,000 therms per day. Pricing is based on an average of monthly spot price indices adjusted for delivery to the Company's service territory. During 1993, new purchase agreements for firm gas were entered into with Vastar Resources, Inc. for 200,000 therms per day; with Coastal Gas Marketing Company for 180,000 therms per day; with Enron Gas Marketing for 100,000 therms per day; with Grand Valley Gas Company for 100,000 therms per day; with Universal Resources for 50,000 therms per day; and with Union Pacific Fuels for 100,000 therms per day. These agreements are similarly structured, as follows: each is for a four-month term, from November 1, 1993 through February 28, 1994; each provides volumes based on a combination of reservation charges and indexed commodity prices; and all but one has a minimum volume obligation at a fixed price. All of the gas purchased under these agreements is produced in the United States Rocky Mountain and San Juan Basin regions. The Company also purchases small volumes of gas on the spot (30 days or less) market as necessary to supplement its firm core market supplies, to extend the deliverability of its storage resources and to take advantage of available favorable pricing opportunities. During 1993, less than one percent of the Company's purchases for its core market was from this source. The Company manages gas purchases for its core market in a manner that will meet customers' needs at reasonable prices. The Company believes that gas supplies available from suppliers in the western United States and Canada are adequate to serve its core market customers for the foreseeable future. Future gas costs, generally, will track prevailing market conditions for supplies of similar reliability. Peaking Supplies ---------------- During peak demand periods, the Company supplements its firm gas supplies through Company-owned or contracted peaking facilities in which gas can be stored during periods of low demand for redelivery during periods of peak demand. In addition to enabling the Company to meet its peak demand, these facilities make it possible to lower the cost of gas by allowing the Company to reduce its pipeline transportation contract demand and to purchase gas for storage during the summer months when purchase prices are generally at their lowest. The Company has contracts with NPC for firm storage services from the underground gas storage field at Jackson Prairie and the liquefied natural gas (LNG) facility at Plymouth, Washington which together provide a daily deliverability of 831,380 therms and a total seasonal capacity of 13,082,647 therms through October 2004. In addition, the Company has contracted with NPC for an additional daily deliverability of 94,670 therms and an additional 2,779,970 therms of seasonal capacity from the Jackson Prairie storage field through April 1996. The Company owns and operates two LNG plants which it uses to liquefy gas during the summer months for redelivery into its system during the peak winter season. These two plants, one located in Portland and the other near Newport, Oregon, provide a maximum daily deliverability of 1,800,000 therms and a total seasonal capacity of 17,000,000 therms. The LNG plants provide a cost-effective winter peaking resource of high reliability and flexibility. The Company also owns and operates an underground gas storage facility at Mist, Oregon. This facility has a maximum daily deliverability of 1,000,000 therms and a total seasonal working gas capacity of about 70,000,000 therms, or about 15 percent of the Company's annual core customer usage. These underground gas storage facilities provide a reliable, cost- effective winter supply that is available for a much longer period than the LNG plants. In January 1993, the Company and Portland General Electric Company (PGE) entered into an agreement expiring in 2010 that provides the Company with a cost-effective winter peaking supply and PGE with needed firm pipeline transportation. With certain limitations, the Company may interrupt gas deliveries to PGE, use that gas for the Company's own markets, and compensate PGE by paying PGE's cost for replacement fuel oil. The daily volume is 300,000 therms, increasing to a maximum of 760,000 therms in November 1995. This agreement makes it possible for the Company to recover the full cost of firm transportation capacity while obtaining firm gas deliveries during peak load periods at a cost that is competitive with other peaking services. Transportation - -------------- By 1992, most of the Company's large industrial interruptible sales customers had switched from sales service to transportation service. Since 1992, about half of these customers have returned to sales service, primarily because the Company's industrial sales rates were lower than those customers' costs of purchasing and shipping their own gas. The ability of industrial customers to switch between sales service and transportation service has assisted the Company in retaining most of these customers and has not had a material effect on the Company's results of operations. (See "Competition and Marketing" and Part II, Item 7.) Regulation and Rates - -------------------- The Company is subject to regulation with respect to, among other matters, rates, systems of accounts and issuance of securities by the OPUC and the WUTC. In 1993, approximately 90.0 percent of the Company's gas deliveries and 94.6 percent of its utility operating revenues were derived from Oregon and the balance from Washington. The Company is exempt from the provisions of the federal Natural Gas Act by order of the Federal Power Commission. The Company's most recent general rate case in Oregon, which was effective in 1989, authorized rates designed to produce a return on common equity of 13.25 percent. The most recent general rate increase in Washington, which was effective in 1986, authorized rates also designed to produce a return on common equity of 13.25 percent. Actual revenues resulting from the OPUC's and WUTC's general rate orders are dependent on weather, economic conditions, competition and other factors affecting gas usage in the Company's service area. The Company has no plans to file general rate cases in either Oregon or Washington in 1994. The Company's returns on average common equity from consolidated operations were 5.8 percent in 1992 and 13.7 percent in 1993. In Oregon, the Company has a Purchased Gas Cost Adjustment (PGA) tariff under which the Company's net income derived from Oregon operations is affected only within defined limits by changes in purchased gas costs. The PGA tariff provides for periodic revisions in rates due to changes in the Company's cost of purchased gas. Costs included in the PGA adjustments are based on the Company's gas requirements for the 12-month period ended each June 30. Any resulting rate adjustments, derived from gas prices negotiated for the gas supply contract year commencing on the following November 1, are made effective on the following December 1. The PGA tariff also provides that 80 percent of any difference between actual gas commodity costs and related costs incorporated into rates will be deferred for amortization in subsequent periods. If actual gas commodity costs exceed those incorporated in rates, the Company subsequently will adjust its rates upward to recover 80 percent of the deficiency from core market customers. Similarly, if actual commodity costs are lower than those reflected in rates, rates will be adjusted downward to refund to core market customers 80 percent of such gas commodity cost savings. In Washington, the Company is permitted to track increases and decreases in its cost of purchased gas coincidental with their incurrence, with the result that net income is not directly affected by changes in purchased gas costs. In April 1992, the FERC issued Order No. 636 and subsequently largely affirmed that order on rehearing in Order Nos. 636-A and 636-B. These orders required significant changes in the structure of service provided by interstate pipelines and required such pipelines to restructure or "unbundle" their services and eliminate their role as gas merchants. In October 1992, NPC, the primary interstate pipeline serving the Company, made a filing with the FERC to comply with Order No. 636 and filed a general rate case seeking FERC approval to increase its rates. The impact of these filings, as approved by the FERC, was an increase in the Company's annual cost of interstate pipeline service of approximately $16.5 million effective April 1, 1993. NPC's rate increase also included the cost of its $432 million "Phase I Expansion" completed in April 1993, under which the Company subscribed to 500,000 therms per day of new firm capacity, and reflected a change in NPC's rate design to the FERC-mandated "straight fixed-variable" method, which collects all fixed costs through monthly demand charges. In April 1993, the Company filed with the OPUC for rate increases averaging 6.2 percent in its residential, commercial and industrial firm schedules to offset the Company's higher costs for interstate pipeline capacity approved by the FERC for NPC. The OPUC approved these rate increases effective May 1, 1993. Effective June 1, 1993, the WUTC approved rate increases averaging 6.7 percent for the Company's Washington customers to offset the same cost increases. In August 1993, the Company filed with the OPUC for rate increases averaging 3 percent. The OPUC approved the increases effective October 1, 1993. These rate increases were due to the removal of temporary rate discounts in effect since November 1990 to refund to customers gas cost savings and pipeline rate refunds resulting from NPC's transition to "open access" transportation. In November 1993, the Company filed for rate increases under its PGA tariffs averaging 3.7 percent for Oregon customers and 7.6 percent for Washington customers. The OPUC and WUTC approved these increases for their respective states effective December 1, 1993. These rate increases passed through to customers the effect of higher gas costs, and removed temporary rate discounts related to prior gas cost savings which had applied to rates for firm gas service since December 1992. In connection with filings by the Company each year under the PGA tariff, the OPUC has reviewed the Company's earnings as determined for a recently-completed 12-month period, normalized for average weather conditions and certain other adjustments to revenues or expenses as applied in the Company's last general rate case. The OPUC has taken the position that it may reduce the amount of a rate increase requested to offset higher gas costs if its review of normalized earnings were to show that the resulting return on equity would exceed a reasonable range for the Company under then-current financial conditions. Based upon such a review in 1993, the Company and the OPUC staff negotiated an agreement whereby the Company reduced the revenue increase requested pursuant to its November 1993 PGA filing by about $2,334,000 per year. The Company expects the OPUC to conduct a similar review in connection with its PGA filing to be effective in December 1994, but cannot predict whether the effect, if any, of such a review on future earnings would be material. In Oregon, the Company has an Interruptible Sales Adjustment (ISA) tariff schedule which levels margin (sales price less cost of gas) fluctuations resulting from the volatility of sales to large industrial interruptible customers caused by price competition between natural gas and residual fuel oil. Under the ISA tariff schedule, the Company's rates are increased or decreased at least annually to compensate for deviations in actual industrial interruptible margins from assumed base margins. If the actual margin is below the base margin for any month, the Company's rates applicable to core market customers are adjusted upward to recover 80 percent of the margin deficiency, plus interest. Likewise, if the actual margin is above the base margin, rates subsequently are adjusted downward to return 80 percent of the margin excess, plus interest. At year-end 1993, the ISA account had a credit (refund) balance of $2.4 million. This tariff schedule enhances the Company's opportunity to achieve its allowed rate of return and reduces fluctuations in earnings due to changes in industrial interruptible sales. The OPUC and WUTC have approved transportation tariffs under which the Company may contract with customers to deliver customer-owned gas. Under these tariffs, revenues from the transportation of customer-owned gas, except that of large industrial customers having the capability of bypassing the Company's system, generally are equivalent to the margins that would have been realized from sales of Company-owned gas. (See "Transportation" and "Competition and Marketing".) The OPUC and WUTC have instituted "least-cost planning" processes under which utilities develop plans defining alternative growth scenarios and resource acquisition strategies. In 1991, the OPUC and WUTC acknowledged and accepted the Company's submissions of its first Least Cost Plan, and required further planning during 1992 and 1993, including the development of demand-side (conservation) resources. In October 1993, the Company filed its 1993 Integrated Resource (Least Cost) Plan, with the OPUC and the WUTC. The plan discusses potential growth in gas demand and describes a range of possible future supply-side and demand-side resource options to meet the demand. The plan forecasts growth in peak day load averaging 2.9 percent per year from 1993 to 2002, 2.3 percent from 1993 to 2012 and 2 percent from 1993 to 2022. The long-term resources available to meet this growth include the interstate pipelines, storage, conservation and long-term industrial contracts with provisions for the recall of released pipeline capacity and gas supplies. An updated Least Cost Plan will be filed in mid-1994 in Oregon and then in Washington. Competition and Marketing - ------------------------- Although the Company has no direct competition in the territory it serves from other natural gas utility distributors, it competes with NPC to serve large industrial customers; with oil and, to a lesser extent, electricity, for industrial uses; with oil, electricity and wood for residential use; and with oil and electricity for commercial uses. Competition among these forms of energy is based on price, quality of service, efficiency and performance. In 1993, the Company maintained its competitive price advantage over electricity and approximate price parity with fuel oil in both the residential and commercial markets. Throughout 1993, natural gas rates continued to be substantially lower than rates for electricity provided by the investor-owned utilities which serve approximately 75 percent of the homes in the Company's Oregon service area. The Company believes that this rate advantage will continue for the foreseeable future. As a result of substantial price increases in recent years by the Bonneville Power Administration, the wholesale supplier of much of the electricity sold by publicly-owned electric utilities in the Pacific Northwest, natural gas for home heating also is more competitive with electricity provided by public utility districts. During 1993, the Company provided gas for spaceheating to about 85 percent of the new single family homes built within the reach of the Company's system. The relatively low (estimated at between 30 and 35 percent) residential (single family and attached dwelling) saturation of natural gas in the Company's service territory, together with the price advantage of natural gas compared with electricity and its operating convenience over fuel oil, provides the potential for continuing growth in the residential conversion market. In 1993, 17,941 net (after subtracting disconnected or terminated services) residential customers were added, including 8,710 units of existing residential housing which were reconnected to the system or were converted from oil or electric appliances to natural gas. More than half of these customers also use gas for water heating. In addition, 1,501 net commercial customers were connected in 1993. The net total of all new customers added in 1993 was 19,449. This constituted a growth rate of 5.5 percent, more than double the national average for local distribution companies as reported by the American Gas Association. Residential and commercial volumes increased 26.8 percent to 481.3 million therms in 1993, largely due to increased heating requirements resulting from colder weather. For the year 1993, temperatures in the Company's service territory, as expressed in heating degree days, were 22 percent colder than those of 1992, and were 3 percent colder than the 20-year average. Residential and commercial revenues in 1993 constituted approximately 80 percent of the Company's total utility operating revenues which were derived from 46 percent of the total therms delivered. (See Part II, Item 7.) Natural gas sales and transportation deliveries to industrial firm customers during 1993 totalled 99.8 million therms which was 5.6 percent above the 1992 level of 94.5 million therms. In 1993, 10 percent of total utility operating revenues and 10 percent of total therms delivered were derived from deliveries to industrial firm customers. Total natural gas sales and transportation deliveries to industrial interruptible customers decreased 22.0 percent in 1993, from 591.1 million therms in 1992, to 462.5 million therms in 1993. These deliveries included the transportation of 29.3 million therms to two electric generating plants in 1993, down from 165.2 million therms transported to the same plants in 1992. In 1993, 10 percent of total utility operating revenues and 44 percent of total therms delivered were derived from sales and transportation deliveries to industrial interruptible customers. The Company and most of its largest industrial customers have entered into high-volume interruptible transportation agreements to replace agreements that were scheduled to expire. During 1993, the Company negotiated new agreements with these customers on a case-by-case basis with terms extending from two years to ten years. These agreements are designed to provide rates that are competitive with costs for alternative fuels, such as heavy oil, by reducing the per-therm transportation rate. They also are designed to provide rates competitive with "bypass" (direct connection to interstate pipelines) by applying fixed charges that vary with each customer's distance from NPC's facilities. These agreements prohibit bypass during their terms. In November 1993, the Company's second largest industrial customer, the James River Corporation plant at Camas, Washington, switched to NPC for the delivery of gas, thus bypassing the Company's system. This customer accounted for about 2.7 percent of total deliveries and 0.2 percent of total revenues in 1992. The Company does not expect a significant number of its other large customers to bypass its system in the foreseeable future since these customers typically are served under tariffs which are designed to be competitive with capital and operating costs of direct connections to NPC's system. (See Part II, Item 7.) In February 1994, the OPUC authorized the Company to enter into agreements with industrial customers, without prior regulatory approval, providing for the Company to release, at negotiated rates, rights to portions of its firm pipeline capacity and natural gas transportation services. In its order authorizing the Company to enter into such agreements, the OPUC concluded that rate flexibility was warranted because competition for such services exists. The OPUC's order, which implements legislation adopted by the Oregon legislature in 1993, allows the Company to compete effectively in this market. Eighty percent of all positive net revenues (gross revenues less the actual cost of gas or pipeline capacity) generated from these agreements will be credited to core customer gas costs. Construction and Financing Programs - ----------------------------------- See Part II, Item 7, Management's Discussion and Analysis of Results of Operations and Financial Condition. Environment - ----------- The Company is subject to air, water and other environmental regulation by state and federal authorities and has complied in all material respects with applicable regulations. Compliance with these regulations has had no material effect upon the capital expenditures, earnings or the competitive position of the Company. The Company owns property in Linnton, Oregon and previously owned property in Salem, Oregon that were former sites of gas manufacturing plants. Both sites are under investigation for potential remediation. (See Part II, Item 7, and Item 8, Note 12.) Employees - --------- At year-end 1993, the Company had 1,293 employees, of which 932 were members of the Office and Professional Employees International Union, Local No. 11. These union employees approved a five-year Joint Accord covering wages, benefits and working conditions effective April 1, 1992. ITEM 2. ITEM 2. PROPERTIES The Company's natural gas distribution system consists of 9,313 miles of mains, as well as service pipes, meters and regulators, and gas regulating and metering stations. The mains and feeder lines are located in municipal streets or alleys pursuant to valid franchise or occupation ordinances, in county roads or state highways pursuant to valid agreements or permits granted pursuant to statute, or on lands of others pursuant to valid easements obtained from the owners of such lands. The Company also holds all necessary permits for the crossing of the Willamette River and a number of small rivers by its mains. The Company owns service facilities in Portland, as well as various satellite service centers, garages, warehouses, and other buildings necessary and useful in the conduct of its business. It leases office space in Portland for its corporate headquarters. (See below.) District offices are maintained on owned or leased premises at convenient points in the distribution system. The Company owns LNG facilities in Portland and near Newport, Oregon, and also owns two natural gas reservoirs at Mist, Oregon. The Company considers all of its properties currently used in its operations, both owned and leased, to be well maintained, in good operating condition, and adequate for its present and foreseeable future needs. The Company's Mortgage and Deed of Trust constitutes a first mortgage lien on substantially all of the real property constituting its utility plant. Oregon Natural holds interests in United States oil and gas leases covering 52,606 net acres. These interests are located in western Oregon, California, Sweetwater County, Wyoming, and La Plata and Rio Blanco Counties in Colorado. Canor owns interests in 19 gas properties and six oil properties in southern Alberta and southern Saskatchewan covering mineral rights on 124,052 net acres. Most Canadian gas production is sold under long-term contracts to markets in both Canada and the United States. Oregon Natural also holds an equity investment in a Boeing 737-300 aircraft. Energy Systems formerly owned a 25 megawatt combined-cycle cogeneration system near Fresno, California through its wholly-owned subsidiary, Agrico, which filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code in December 1991. The U.S. Bankruptcy Court confirmed Agrico's reorganization plan in January 1994, allowing the sale of Agrico's assets to Wellhead Electric Company, the contract operator of the Agrico facility, to close in February 1994. (See Part I, Item 3, and Part II, Item 7, and Item 8, Note 2 and Note 3.) Pacific Square, the Company's subsidiary engaged in real estate management, owns a one-half interest in One Pacific Square, a 227,000 square foot office building in Northwest Portland, through a partnership known as Pacific Square Associates. The Company's corporate headquarters occupy about 63 percent of this building which is 100 percent leased. Pacific Square Associates, in partnership with the Portland Metropolitan Chamber of Commerce, owns a 31,000 square foot office building adjacent to One Pacific Square. This building is fully leased. In January 1994, Pacific Square entered into an agreement to sell all of its partnership interests in the two buildings to Hillman Properties Northwest (Hillman), Pacific Square's joint venture partner. Under the agreement, Hillman will purchase Pacific Square's interests in the Pacific Square Associates partnership and assume all of the partnership's joint obligations. The transaction is expected to close by the end of April 1994. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company previously reported that Agrico had entered into a conditional settlement with PG&E and Wellhead with respect to PG&E's claimed overpayments to Agrico for power purchased in 1990 and 1991. (See Part II, Item 8 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992.) In December 1993, this settlement was approved by the California Public Utilities Commission. In January 1994, the U.S. Bankruptcy Court confirmed Agrico's reorganization plan, including the terms of the settlement with PG&E and Wellhead. Following such confirmation, in February 1994, Agrico's assets were sold to Wellhead in a transaction that will not have a material effect on 1994 earnings. Under the terms of the sale to Wellhead, Energy Systems received $860,000 in cash and $2.4 million in notes in return for its secured debt interests in Agrico. In March 1994, Energy Systems provided a fund of $150,000 from the cash proceeds for pro rata distribution to Agrico's unsecured creditors. (See Part II, Item 8, Note 3.) The Company is party to certain legal actions in which claimants seek material amounts. Although it is impossible to predict the outcome with certainty, based upon the opinions of legal counsel, management does not expect disposition of these matters to have a material adverse effect on the Company's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the year ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) The outstanding common stock of the Company is traded in the over-the-counter market and its price and volume data are reported by the National Association of Securities Dealers Automated Quotation (NASDAQ) system. The Company's common stock is included in the NASDAQ National Market System through which the high, low and closing transaction prices, as well as volume data, are reported. The Company's common stock is included on the Federal Reserve Board's list of over-the-counter securities determined to be subject to margin requirements under the Board's regulations. The quarterly high and low closing trades for the Company's common stock, as quoted on the NASDAQ National Market System and published by the Wall Street Journal, were as follows: ------------------- 1993 1992 ------------------- ------------------ Quarter Ended High Low High Low - ------------- ------- ------- ------- ------- March 31 $31-1/2 $28-1/2 $31 $27-1/2 June 30 34 30-3/4 30-1/2 26-1/2 September 30 38 34 33 29 December 31 36-3/4 32 33-3/4 28-1/4 The closing quotation for the common stock on December 31, 1993 was $34-1/4. On December 31, 1992 the closing quotation was $28-1/2. The Company's convertible preference stock $2.375 Series is traded in the over-the-counter market. Because of the small number of shares of this series outstanding trading is infrequent. The quarterly high and low closing bid price quotations reported by NASDAQ were as follows: Bid Prices ------------------------------------------ 1993 1992 ----------------- ----------------- Quarter Ended High Low High Low - ------------- ---- --- ---- --- March 31 $51 $47-1/2 $48-1/4 $44-1/4 June 30 55-1/4 49-3/4 47-3/4 43 September 30 59 55-1/4 51 47-3/4 December 31 59 52-1/2 51 47-1/2 The closing quotations for the convertible preference stock on December 31, 1993 and December 31, 1992 were $53-1/2 Bid, $57-1/2 Ask and $47-1/2 Bid, $51-1/2 Ask, respectively. Outstanding shares are convertible into shares of common stock at a rate of 1.6502 shares of common stock for each share of convertible preference stock. (b) As of January 31, 1994 there were 13,181 holders of record of the Company's common stock and 138 holders of record of its convertible preference stock. (c) The Company has paid quarterly dividends on its common stock in each year since the stock first was issued to the public in 1951. Annual common dividend payments have increased each year since 1956. Dividends per share paid during the past two years were as follows: Payment Date 1993 1992 ------------ ---- ----- February 15 $0.43 $0.43 May 15 0.44 0.43 August 16 0.44 0.43 November 15 0.44 0.43 ----- ----- Total per share $1.75 $1.72 ===== ===== It is the intention of the Board of Directors to continue to pay cash dividends on the Company's common stock on a quarterly basis. However, future dividends will necessarily be dependent upon the Company's earnings, its financial condition and other factors. The Company's Dividend Reinvestment and Stock Purchase Plan permits registered owners of common stock to reinvest all or a portion of their quarterly dividends in additional shares of the Company's common stock at the current market price. Shareholders also may invest cash on a monthly basis in additional shares at the current market price. The Plan was amended effective January 1, 1994 to allow shareholders to invest up to $50,000 per calendar year. Previously shareholders were allowed to invest up to $5,000 per quarter. During 1993, with about 50 percent of the Company's shareholders participating, dividend reinvestments and optional cash investments under the Plan aggregated $5.2 million and resulted in the issuance of 154,900 shares of common stock. During the sixteen years the Plan has been available the Company has issued and sold 2,676,800 shares of common stock which produced $49.1 million in additional capital. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Northwest Natural Gas Company's (Northwest Natural) consolidated wholly-owned subsidiaries consist of Oregon Natural Gas Development Corporation (Oregon Natural); NNG Energy Systems, Inc. (Energy Systems); NNG Financial Corporation (Financial Corporation); and Pacific Square Corporation (Pacific Square) (see "Subsidiary Operations" below and Note 2 to the Consolidated Financial Statements). Together, Northwest Natural and these subsidiaries are referred to herein as the "Company." The following is management's assessment of the Company's financial condition including the principal factors that impact results of operations. The discussion refers to the consolidated activities of the Company for the three years ended December 31, 1993. Earnings and Dividends - ----------------------- The Company earned $2.61 per share in 1993, compared to $1.11 per share in 1992 and $1.01 per share in 1991. The improved 1993 performance was due to cooler weather, customer growth and improved subsidiary performance. The Company's earnings for 1992 were depressed by the effects of record-setting warm weather and a loss related to Agrico Cogeneration Corporation (Agrico), a subsidiary of Energy Systems. The Company's earnings for 1991 also were depressed by a charge which related to Agrico. The Company earned $2.72 per share from utility operations in 1993, compared to $1.41 per share and $2.56 per share in 1992 and 1991, respectively. Weather conditions in the Company's service territory in 1993 were 22 percent colder than in 1992 and 5 percent colder than in 1991. The Company incurred a loss equivalent to $0.11 per share from subsidiary operations in 1993, compared to losses equivalent to $0.30 per share and $1.55 per share in 1992 and 1991, respectively (see "Subsidiary Operations" below). 1993 was the 38th consecutive year in which the Company's dividends paid have increased. In 1993, dividends paid on common stock were $1.75, up 1.7 percent from a year ago and 3.6 percent higher than 1991. The indicated annual dividend rate is $1.76 per share. Results of Operations - --------------------- Regulatory Matters ------------------ In April 1993, Northwest Natural filed with the Oregon Public Utility Commission (OPUC) for rate increases averaging 6.2 percent in its residential, commercial, and industrial firm rate schedules. The OPUC approved the Oregon increases effective May 1, 1993. Effective June 1, 1993, the Washington Utilities and Transportation Commission (WUTC) approved rate increases averaging 6.7 percent for the Company's Washington customers. The rate increases offset Northwest Natural's higher costs for interstate pipeline capacity under rates approved by the Federal Energy Regulatory Commission for Northwest Pipeline Corporation (NPC), the primary pipeline supplying the Pacific Northwest. In August 1993, Northwest Natural filed with the OPUC for rate increases averaging 3 percent. The OPUC approved the increases effective October 1, 1993. These rate increases were due to the removal of temporary rate discounts in effect since November 1990 to distribute gas cost savings and pipeline rate refunds resulting from the transition to "open access" transportation by NPC. In November 1993, Northwest Natural filed with the OPUC and the WUTC for rate increases which averaged 3.7 percent and 7.6 percent for Oregon and Washington operations, respectively. The new rates pass through the impact of higher gas costs and remove temporary rate discounts in place since December 1992 for the amortization of prior gas cost savings. Both increases were approved effective December 1, 1993. None of the above rate increases has a material effect on net income. The cumulative effect of the increases is not expected to impair Northwest Natural's competitive position in its key markets. Comparison of Gas Operations ----------------------------- The following table summarizes the composition of utility gas volumes and revenues for the three years ended December 31, 1993: Residential and Commercial -------------------------- Typically, 75 percent or more of the Company's annual utility operating revenues are derived from gas sales to weather- sensitive residential and commercial customers. Accordingly, dramatic shifts in temperatures from one period to the next can significantly impact volumes of gas sold to these customers. Normal weather conditions are based upon a 20 year average measured by degree days. Weather conditions were three percent cooler than normal in 1993, 16 percent warmer than normal in 1992, and three percent warmer than normal in 1991. 1993 was 22 percent colder than 1992. Cooler weather, the addition of 19,400 customers, and the rate increases approved by the OPUC and WUTC combined to produce a 34 percent increase in revenues from residential and commercial customers in 1993 compared to 1992 on therm deliveries to these customers which were 27 percent higher than in 1992. The Company's residential and commercial customer growth continued at a rapid pace. In the last three years, almost 52,500 of these customers have been added to the system, representing an average growth rate of 5.2 percent. Industrial, Transportation and Other ------------------------------------ Total volumes delivered to industrial firm, industrial interruptible and transportation customers were 123 million therms lower in 1993 than in 1992, while corresponding revenues from such deliveries were $10.8 million higher. The combined net operating revenue (margin) from industrial firm and interruptible sales and transportation customers increased from $42.7 million in 1992 to $44.4 million in 1993. Transportation volumes declined due to a 136 million therm reduction in deliveries to an electric generation plant which was served under a low-margin transportation tariff. This plant is now served primarily by a new natural gas pipeline which is a joint venture between Oregon Natural and Portland General Electric Company. Transportation revenues from this customer were $0.2 million and $2.5 million in 1993 and 1992, respectively. However, due to the effect of a regulatory balancing mechanism in Oregon, under which the Company credits 80 percent of the transportation revenues received for deliveries to this plant to a deferred account for future refunds to other customers, the reduced volume of deliveries in 1993 resulted in a decrease in margin revenues of only $0.5 million. Since 1992, approximately half of Northwest Natural's transportation customers have switched to sales service. These customers, which have the option of purchasing natural gas from Northwest Natural or of purchasing gas directly from suppliers and transporting it on the systems of Northwest Natural and its pipeline suppliers for a fee, select the option which from time to time provides the lowest cost. Management believes that the migration from transportation to sales tariffs by these customers was primarily due to the fact that, in 1993, Northwest Natural's industrial sales tariffs have been lower than the cost to these customers of purchasing and shipping their own gas. The increase in revenue attributable to this migration was offset by an increase in the cost of gas, since transportation rate schedules are designed to provide the same margin as industrial sales tariffs and thus had little effect on the Company's income from operations. Industrial sales and transportation deliveries remained relatively stable during 1992 and 1991, at 686 million therms in 1992 compared to 670 million therms in 1991. Related revenues were $57 million in 1992, essentially unchanged from 1991. Transportation revenues decreased $3.9 million between these two years, although related volumes remained relatively stable, primarily due to rate reductions in certain transportation tariffs. Unbilled revenues are a recognition of revenues for all gas consumption through the end of the month for all customers, regardless of the meter reading date, in order to better match revenues with associated purchased gas costs. Other revenues are primarily related to regulatory balancing accounts (see Note 1 to the Consolidated Financial Statements). The Company and most of its large industrial customers have entered into high-volume interruptible transportation agreements which are designed to provide rates competitive with "bypass" (direct connection to interstate pipelines) by applying fixed charges that vary with each customer's distance from pipeline facilities. These agreements prohibit bypass during their terms. However, management believes that, during the period 1994 to 1998 it might lose from four to six large industrial customers through bypass. In total, these customers represented approximately 10 percent of 1993 volumes, but less than 3 percent of 1993 margin revenues. Given the far greater effect on margin revenues of temperature fluctuations, economic conditions and growth in residential and commercial customers, management believes the impact of bypass will not materially affect the Company's future results of operations or its financial position. Cost of Gas ----------- The cost of gas sold during 1993 was 36 percent greater than in 1992. The primary contributing factors were a 34 percent increase in total volumes sold and a 2 percent increase in the cost of gas per therm which includes purchased gas cost adjustments and net storage gas activity. The cost of gas sold in 1992 was 5 percent lower than in 1991 primarily due to a 3 percent decrease in total volumes sold and a lower average cost of gas per therm. Subsidiary Operations --------------------- Consolidated subsidiary results for the three years ended December 31, 1993, 1992, and 1991, were losses equivalent to $0.11 per share, $0.30 per share and $1.55 per share, respectively. The subsidiaries' results for 1993 reflect a fourth quarter write-down in the value of unproven gas and oil reserves equivalent to $0.11 per share and increased federal income tax expense equivalent to $0.05 per share (see "Depreciation, Depletion and Amortization" and "Income Taxes" below). Results of operations for the individual subsidiaries for 1993, including the adjustments described above, were a net loss of $0.4 million for Energy Systems; a net loss of $1.4 million for Oregon Natural; a net loss of $0.4 million for Financial Corporation; and net income of $0.7 million for Pacific Square. The 1992 and 1991 losses resulted primarily from charges equivalent to $0.24 per share and $1.23 per share, respectively, related to Agrico. Future charges, if any, related to Agrico, are expected to be immaterial (see Note 3 to the Consolidated Financial Statements). The following discussion summarizes operating expenses, interest charges and income taxes. Operating Expenses ------------------ Operations and Maintenance -------------------------- Operations and maintenance expenses were $6.5 million, or 10 percent, higher in 1993 compared to 1992. Utility expenses constituted $6.2 million of this increase including a $3.1 million, or 10 percent, increase in payroll expenses; a $1.3 million increase in employee benefit costs, including an increase of $0.7 million resulting from the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions;" a $1.2 million increase in the allowance for uncollectible accounts primarily due to higher residential and commercial gas sales; and a $0.5 million accrual for estimated environmental investigation costs (see Note 12 to the Consolidated Financial Statements). Utility operations and maintenance expenses were $3.4 million, or 6 percent, higher in 1992 than in 1991. Subsidiary operations and maintenance expenses were $4.7 million, or 45 percent, lower. Higher utility operating and maintenance expenses resulted primarily from a $1.5 million, or 5 percent, increase in payroll due to wage and salary increases, a $0.5 million increase in employee benefit costs, and increases in claims for injuries and damages and weatherization costs of $0.5 million and $0.4 million, respectively. Subsidiary expenses were lower in 1992 than in 1991 due to a five-month suspension of Agrico operations during 1992. Taxes Other Than Income ----------------------- Taxes other than income increased $4.7 million, or 23 percent, in 1993 compared to 1992 due to a $2.5 million increase in utility property tax accruals and a $1.8 million increase in franchise taxes resulting from higher utility operating revenues. Approximately $0.9 million of the increased property tax accrual is non-recurring and relates to a dispute with the OPUC over the amount of prior-year savings on property taxes which must be refunded to Oregon customers. The balance of this increase resulted from property taxes on plant additions made primarily to serve new customers. Taxes other than income decreased $0.2 million, or 1 percent, in 1992 compared to 1991. This resulted primarily from a reduction of $0.6 million in utility franchise taxes which occurred due to decreased utility operating revenues. This decrease was offset by a $1.0 million increase in property taxes, again due to new plant additions made primarily to serve new customers. Depreciation, Depletion and Amortization ---------------------------------------- Utility depreciation expense increased $1.9 million, or 7 percent, in 1993 and $1.0 million, or 3.5 percent, in 1992, primarily due to additional utility plant in service. $0.4 million of the increased 1993 expense related to the removal of all of the Company's underground gasoline tanks. Subsidiary depreciation expense increased $4.7 million in 1993 and decreased $1.6 million in 1992. The 1993 increase resulted primarily from charges totalling $3.5 million, from the write-downs of Oregon Natural's unproven gas and oil properties (see Note 2 to the Consolidated Financial Statements). $1.5 million of the 1992 decrease in depreciation expense resulted from the suspension of depreciation on Agrico's assets upon its bankruptcy. Interest Charges ---------------- Utility interest expense for 1993 decreased $1.3 million compared to 1992. The decrease was a result of debt refinancings which reduced interest expense by $0.6 million; $11.5 million lower average outstanding commercial paper balances; and a decrease in average interest rates for utility commercial paper from 3.9 percent in 1992 to 3.3 percent in 1993. Subsidiary interest expense for 1993 decreased $0.3 million compared to 1992 due to a decrease in interest expense under Financial Corporation's commercial paper program. Financial Corporation's average outstanding commercial paper balances decreased $4.4 million from 1992 to 1993. In addition, Financial Corporation's average interest rates for commercial paper decreased from 4.1 percent in 1992 to 3.3 percent in 1993. Utility interest expense for 1992 was $3.0 million higher than for 1991. Although total utility debt outstanding was $4.9 million lower at year end 1992 than at year end 1991, the average monthly debt balances were higher due to the increased use of commercial paper in 1992. Commercial paper borrowing increased as warmer-than-average weather reduced revenues. The effect of the increased borrowings was partially offset by a decrease in average interest rates for utility commercial paper from 6.3 percent in 1991 to 3.9 percent in 1992, and a decrease in average interest expense of utility long-term debt from 9.7 percent in 1991 to 9.3 percent in 1992. The 1992 increase in utility interest expense was offset in part by a $2.8 million decrease in subsidiary interest expense which resulted primarily from the reduction of Financial Corporation's outstanding commercial paper balances and a decrease in Financial Corporation's average interest rates for commercial paper from 6.3 percent in 1991 to 4.1 percent in 1992. Income Taxes ------------ The effective corporate income tax rates for the three years ended December 31, 1993, 1992, and 1991 were 37 percent, 31 percent, and 14 percent, respectively, compared to the Company's statutory tax rates for these periods of 39 percent, 38 percent, and 38 percent, respectively. The effective income tax rate for 1991 was lower than the Company's statutory tax rate primarily as a result of non-recurring adjustments that reduced amounts provided for income taxes in prior years by $4.5 million. The adoption of SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993, did not materially affect results of operations. However, for 1993, the federal income tax rate for corporations increased from 34 to 35 percent. The cumulative effect of the tax rate increase was recorded in the third quarter of 1993 and resulted in additional income tax expense of $0.6 million, an increase in deferred tax liabilities of $3.0 million, and an increase in regulatory assets of $2.6 million. Financial Condition - ------------------- The weather-sensitive nature of gas usage by Northwest Natural's residential and commercial customers influences the Company's financial condition, including its financing requirements, from one quarter to the next. Liquidity requirements are satisfied primarily through the use of commercial paper, which is supported by commercial bank lines of credit (see "Lines of Credit" and "Commercial Paper" below). Capital Structure ----------------- The Company's long-term goal is to maintain a capital structure comprised of 40 to 45 percent common stock equity, 5 to 10 percent preferred and preference stock and 45 to 50 percent short-term and long-term debt. This target structure is managed by issuing new debt or equity in response to market conditions and the status of accumulated earnings. The Company also uses these sources to meet long-term debt and preferred stock redemption requirements (see Notes 4 and 6 to the Consolidated Financial Statements). Cash Flows ---------- Operating Activities -------------------- Cash provided from operating activities was higher in 1993 and 1991 as compared to 1992, primarily due to higher revenues from gas sales resulting from colder weather. Also, a portion of the increased cash provided from operating activities in 1991 was due to the effects of unusually cold weather in December 1990, which produced substantial increases in the year- end 1990 balances for accounts receivable, unbilled revenue and accounts payable. These balances, which were collected in 1991, provided $26 million of additional funds during 1991. The Company has lease and purchase commitments related to its operating activities which will continue to be financed with cash flows from operations (see Note 12 to the Consolidated Financial Statements). Investing Activities -------------------- Cash requirements for utility construction, primarily related to system improvements and customer growth, totalled $70.4 million, up $9.7 million, or 16 percent, from 1992 and up $12.0 million, or 21 percent, from 1991. The 1993 increase includes $6.3 million in expenditures related to a project initiated in 1993 to replace the existing customer information system. It is estimated that this project will involve a total investment of about $25 million between 1993 and 1996. A large part of the Company's utility capital expenditures is required for utility construction resulting from customer growth and system improvements. While the Company finances most of these requirements from cash from operations, it also uses short-term borrowings and periodically refinances these borrowings through the sale of long-term debt or equity securities. Utility construction expenditures totalling $75 million are projected for 1994. Over the five year period 1994 through 1998, total utility capital expenditures are estimated at between $325 and $350 million. It is anticipated that approximately 50 percent of the funds required for these expenditures during this period will be internally generated, and that the remainder will be funded through short-term borrowings which will be refinanced periodically through the sale of long-term debt and equity securities. Capital expenditures for the Company's operating subsidiaries in 1994 are expected to be limited to funds internally generated by the subsidiaries. In 1993, Oregon Natural sold and exchanged gas producing properties resulting in net cash inflows of $2.3 million. Investments shown on the Consolidated Balance Sheets under "Investments and Other" for 1992 included a $5.5 million restricted cash deposit with a commercial bank which related to Pacific Square. This deposit was reclassified as a current asset in 1993 due to the pending sale of Pacific Square's primary real estate investments to which it relates. The sale of Pacific Square's investments, which is expected to close in 1994, would not be at a loss to the Company. Financing Activities -------------------- During 1993 and 1992, the Company sold $100 million and $45 million, respectively, of its Medium-Term Notes. Of the proceeds from 1993 sales, $82.6 million was used to redeem higher-cost long-term debt, and the remainder was used to meet capital requirements for the Company's ongoing construction program and to reduce short-term borrowing. Of the proceeds from the 1992 sales, $30 million was used to redeem higher-cost long- term debt and $15 million was used to reduce short-term borrowing. As a result of these transactions, the average interest expense on long-term debt declined from 9.7 percent at December 31, 1991 to 8.3 percent at December 31, 1993. Additionally, in order to meet the Company's capital requirements for its ongoing construction program, to refund higher-cost Preferred Stock, and to increase its equity ratios, the Company sold $25 million of Preference Stock and $28.5 million, or 990,000 shares, of Common Stock during the fourth quarter of 1992. In January 1993, approximately $9 million of the proceeds from the sale of Preference Stock was used to redeem all of the outstanding shares of the Company's $8.00 and $2.42 Series of Preferred Stock. Also in 1993, the Company redeemed all of the outstanding shares of its $6.875 Series of Preferred Stock (see Consolidated Statements of Capitalization). The Company reached an agreement with the sole shareholder of the $8.75 Series of Preferred Stock, with a total stated value of $15 million, to issue an equivalent amount of the $7.125 Series of Preferred Stock in exchange for cancellation of the $8.75 Series, effective as of December 1, 1993. Lines of Credit --------------- Northwest Natural has available through September 30, 1994, lines of credit totalling $80 million consisting of a primary fixed amount of $40 million plus an excess amount of up to $40 million available as needed, at Northwest Natural's option, on a monthly basis. Under the terms of these bank lines, Northwest Natural pays a commitment fee but is not required to maintain compensating bank balances. The interest rates on borrowings under these lines of credit are based on current market rates as negotiated. There were no outstanding balances as of December 31, 1993. Financial Corporation has available through September 30, 1994, lines of credit with two commercial banks totalling $20 million, including $10 million committed and $10 million uncommitted. Financial Corporation pays a fee on the committed line but not on the uncommitted line; it is not required to maintain compensating bank balances on either line. The interest rates on borrowings under these lines of credit also are based on current market rates as negotiated. Financial Corporation's lines are supported by the unconditional guaranty of Northwest Natural. There were no outstanding balances as of December 31, 1993 under the Financial Corporation bank lines. Commercial Paper ---------------- The Company's primary source of short-term funds is commercial paper. Both Northwest Natural and Financial Corporation issue commercial paper which is supported by the committed bank lines discussed above. Financial Corporation's commercial paper is unconditionally guarantied by Northwest Natural (see Note 7 to the Consolidated Financial Statements). Agrico Term Loan ---------------- At December 31, 1991, $14.0 million was outstanding under a term loan agreement between Agrico and United States National Bank of Oregon (U.S. Bank). Under a settlement agreement between Energy Systems, U.S. Bank, and Northwest Natural, U.S. Bank assigned the term loan to Energy Systems in exchange for payments by Energy Systems and Northwest Natural totalling $7.2 million. Such payments were made, and the debt was retired during 1992 (see Note 3 to the Consolidated Financial Statements). Ratio of Earnings to Fixed Charges ---------------------------------- For the years ended December 31, 1993, 1992, and 1991, the Company's ratio of earnings to fixed charges, computed by the Securities and Exchange Commission method, was 3.22, 1.81, and 1.59, respectively. Earnings consist of net income to which has been added taxes on income and fixed charges. Fixed charges consist of interest on all indebtedness, amortization of debt expense and discount or premium, and the estimated interest portion of rentals charged to income. Environmental Matters - --------------------- In June 1992, the City of Salem, Oregon, requested the Company's participation in its review of an environmental assessment of riverfront property in Salem that is the proposed site for a park and other public developments. Within the property is a block previously owned by the Company which was the former site of a manufactured gas plant. The Company's corporate predecessor operated the plant for less than four months in 1929 before closing it upon completion of a pipeline providing gas transmission from Portland to Salem. The City has determined that there is environmental contamination on the site, and that a remediation process involving the Company and at least two other prior owners of the block will be required. To date the Company has not obtained sufficient information to determine the extent of its liability for any such remediation. The Company owns property in Linnton, Oregon, that is the former site of a gas manufacturing plant that was closed in 1956. Although limited testing for environmental contamination has been undertaken by other parties on portions of the site, no comprehensive studies have been performed. The Company submitted a work plan for the site to the Oregon Department of Environmental Quality (ODEQ) in 1987, but those efforts were suspended at ODEQ's request while the Company and other parties participated in a joint hydrogeologic study of an area adjacent to the site. In September 1993, pursuant to ODEQ procedures, the Company submitted a notice of intent to participate in the ODEQ's Voluntary Cleanup Program. In January 1994, this site was formally placed in the program. It is anticipated that the site investigation will commence during 1994. In September 1993, the Company recorded an expense of $500,000 for the estimated costs of consultants' fees, ODEQ oversight cost reimbursements, and legal fees in connection with the voluntary investigation at the Linnton site. To date, the Company has not obtained sufficient information to determine whether any remediation will be required at this site or, if so, the extent of its liability for any such remediation. The Company expects that its costs of investigation and any remediation for which it may be liable should be recoverable, in large part, from insurance or through future rates. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ----------------- Page ---- 1. Management's Responsibility for Financial Statements . . . 33 2. Independent Auditors' Report . . . . . . . . . . . . . . . . . 34 3. Consolidated Financial Statements: Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . 35 Consolidated Statements of Earnings Invested in the Business for the Years Ended December 31, 1993, 1992 and 1991 . . . . 36 Consolidated Balance Sheets, December 31, 1993 and 1992. . . . 37 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . 39 Consolidated Statements of Capitalization, December 31, 1993 and 1992. . . . . . . . . . . . . . . . . . . . . . . . 40 Notes to Consolidated Financial Statements . . . . . . . . . . 41 4. Quarterly Financial Information (unaudited). . . . . . . . . . 61 5. Supplemental Schedules for the Years Ended December 31, 1993, 1992 and 1991 Schedule V - Property, Plant and Equipment . . . . . . . . . . 62 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment. . . . . . . . 65 Schedule IX - Short-term Borrowings. . . . . . . . . . . . . . 66 Schedule X - Supplementary Income Statement Information. . . . 67 Supplemental Schedules Omitted All other schedules are omitted because of the absence of the conditions under which they are required or because the required information is included elsewhere in the financial statements. MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS ---------------------------------------------------- The financial statements in this report were prepared by management, which is responsible for their objectivity and integrity. The statements have been prepared in conformity with generally accepted accounting principles and, where appropriate, reflect informed estimates based on judgments of management. The responsibility of the Company's independent auditors is to render an independent report on the financial statements. The Company's system of internal accounting controls is designed to provide reasonable assurance that assets are safeguarded and transactions are executed in accordance with management's authorizations, that transactions are recorded to permit the preparation of financial statements in conformity with orders of regulatory authorities and generally accepted accounting principles and that accountability for assets is maintained. The Company's system of internal controls has provided such reasonable assurances during the periods reported herein. The system includes written policies, procedures and guidelines, an organization structure that segregates duties and an established program for monitoring the system by internal auditors. In addition, Northwest Natural Gas Company has prepared and annually distributes to its management employees a Code of Ethics covering its policies for conducting business affairs in a lawful and ethical manner. Ongoing review programs are carried out to ensure compliance with these policies. The Board of Directors, through its Audit Committee, oversees management's financial reporting responsibilities. The committee meets regularly with management, the internal auditors, and representatives of Deloitte & Touche, the Company's independent auditors. Both internal and external auditors have free and independent access to the committee and the Board of Directors. No member of the committee is an employee of the Company. The committee reports the results of its activities to the full Board of Directors. Annually, the Audit Committee recommends the nomination of independent auditors to the Board of Directors for shareholder approval. /s/ Robert L. Ridgley ------------------------------- Robert L. Ridgley President and Chief Executive Officer /s/ Bruce R. DeBolt ------------------------------- Bruce R. DeBolt Senior Vice President, Finance, and Chief Financial Officer DELOITTE & TOUCHE - ----------------------------------------------------------------- 3900 US Bancorp Tower Telephone: (503) 222-1341 111 SW Fifth Avenue Facsimile: (503) 224-2172 Portland, Oregon 97204-3698 INDEPENDENT AUDITORS' REPORT ---------------------------- To the Board of Directors and Shareholders Northwest Natural Gas Company Portland, Oregon We have audited the accompanying consolidated financial statements of Northwest Natural Gas Company and subsidiaries, listed in the accompanying table of contents to financial statements and financial statement schedules at Item 8. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the consolidated financial position of Northwest Natural Gas Company and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 8 and 10 to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits in the year ended December 31, 1993. /s/ Deloitte & Touche DELOITTE & TOUCHE February 25, 1994 NORTHWEST NATURAL GAS COMPANY CONSOLIDATED STATEMENTS OF INCOME (Thousands, Except Per Share Amounts) Year Ended December 31 1993 1992 1991 - ------------------------------------------------------------------------ NET OPERATING REVENUES: Revenues: Utility $347,852 $266,183 $281,073 Other 10,865 8,183 14,865 -------- -------- -------- Total operating revenues 358,717 274,366 295,938 -------- ------- -------- Cost of sales: Utility 138,833 101,733 107,398 Other - 183 3,201 -------- -------- ------- Total cost of sales 138,833 101,916 110,599 -------- -------- ------- Net operating revenues 219,884 172,450 185,339 -------- -------- ------- OPERATING EXPENSES: Operations and maintenance 70,723 64,249 65,529 Taxes other than income taxes 25,561 20,865 21,104 Depreciation, depletion and amortization 39,683 33,035 33,623 Loss on cogeneration facility - 4,575 23,200 -------- ------- -------- Total operating expenses 135,967 122,724 143,456 -------- ------- -------- INCOME FROM OPERATIONS 83,917 49,726 41,883 -------- ------- -------- OTHER INCOME (EXPENSE) 933 (267) 1,406 -------- ------- -------- INTEREST CHARGES: Interest on long-term debt 22,578 23,001 21,977 Other interest 1,906 3,223 4,266 Amortization of debt discount and expense 775 511 348 -------- ------- ------- Total interest charges 25,259 26,735 26,591 Allowance for borrowed funds used during construction and capitalized interest (152) (2) - -------- -------- -------- Total interest charges-net 25,107 26,733 26,591 -------- -------- -------- INCOME BEFORE INCOME TAXES 59,743 22,726 16,698 INCOME TAXES 22,096 6,951 2,321 --------- -------- -------- NET INCOME 37,647 15,775 14,377 Preferred and preference stock dividend requirements 3,488 2,560 2,593 -------- ------- ------- EARNINGS APPLICABLE TO COMMON STOCK $ 34,159 $ 13,215 $ 11,784 ======== ======== ======== AVERAGE COMMON SHARES OUTSTANDING 13,074 11,909 11,698 EARNINGS PER SHARE OF COMMON STOCK $2.61 $1.11 $1.01 ===== ===== ===== DIVIDENDS PER SHARE OF COMMON STOCK $1.75 $1.72 $1.69 ===== ===== ===== - ------------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. NORTHWEST NATURAL GAS COMPANY CONSOLIDATED STATEMENTS OF EARNINGS INVESTED IN THE BUSINESS (Thousands of Dollars) 1993 1992 1991 - ------------------------------------------------------------------------- BALANCE AT BEGINNING OF YEAR $77,690 $86,361 $94,325 Net Income 37,647 15,775 14,377 Cash dividends: Preferred and preference stock (3,401) (2,525) (2,608) Common stock (22,853) (20,406) (19,728) Capital stock expense and other (586) (1,515) (5) ------- ------- ------- BALANCE AT END OF YEAR $88,497 $77,690 $86,361 ======= ======= ======= - ------------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. NORTHWEST NATURAL GAS COMPANY CONSOLIDATED BALANCE SHEETS (Thousands) December 31 1993 1992 - ------------------------------------------------------------------------ ASSETS: PLANT AND PROPERTY IN SERVICE: Utility plant in service $840,030 $779,274 Less accumulated depreciation 255,282 233,385 -------- -------- Utility plant - net 584,748 545,889 Non-utility property 42,764 44,629 Less accumulated depreciation and depletion 20,646 15,480 -------- -------- Non-utility property - net 22,118 29,149 -------- -------- Total plant and property in service 606,866 575,038 -------- -------- INVESTMENTS AND OTHER: Investments 32,818 32,818 Restricted cash and long-term notes receivable 1,756 7,518 ------- ------- Total investments and other 34,574 40,336 ------- ------- CURRENT ASSETS: Cash and cash equivalents 4,198 7,537 Accounts receivable - customers 45,340 33,956 Allowance for uncollectible accounts (1,368) (948) Accrued unbilled revenue 25,890 20,738 Inventories of gas, materials and supplies 16,838 15,797 Prepayments and other current assets 16,412 8,220 -------- -------- Total current assets 107,310 85,300 -------- -------- OTHER REGULATORY TAX ASSETS 62,130 - DEFERRED DEBITS AND OTHER 38,156 31,160 -------- -------- TOTAL ASSETS $849,036 $731,834 ======== ======== - ----------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. NORTHWEST NATURAL GAS COMPANY CONSOLIDATED BALANCE SHEETS (Thousands) December 31 1993 1992 - ----------------------------------------------------------------------- CAPITALIZATION AND LIABILITIES: CAPITALIZATION (See Consolidated Statements of Capitalization): Common stock equity $ 41,728 $ 41,080 Premium on common stock 128,340 122,768 Earnings invested in the business 88,497 77,690 -------- -------- Total common stock equity 258,565 241,538 Preference stock 26,633 26,766 Redeemable preferred stock 17,041 28,218 Long-term debt 272,931 253,766 -------- -------- Total capitalization 575,170 550,288 -------- -------- CURRENT LIABILITIES: Notes payable 72,548 47,109 Accounts payable 44,318 40,282 Long-term debt due within one year - 2,138 Taxes accrued 6,757 4,790 Interest accrued 4,438 6,792 Other current and accrued liabilities 10,180 9,387 -------- -------- Total current liabilities 138,241 110,498 -------- -------- DEFERRED INVESTMENT TAX CREDITS 14,567 15,603 DEFERRED INCOME TAXES 104,300 34,929 REGULATORY BALANCING ACCOUNTS AND OTHER 16,758 20,516 COMMITMENTS AND CONTINGENT LIABILITIES (Note 12) - - -------- -------- TOTAL CAPITALIZATION AND LIABILITIES $849,036 $731,834 ======== ======== - ------------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: - ------------------------------------------------ Organization and Principles of Consolidation - --------------------------------------------- The consolidated financial statements include: Regulated utility: --Northwest Natural Gas Company (Northwest Natural) Non-regulated wholly-owned businesses: --Oregon Natural Gas Development Corporation (Oregon Natural) --NNG Financial Corporation (Financial Corporation) --Pacific Square Corporation (Pacific Square) --NNG Energy Systems, Inc. (Energy Systems) Together these businesses are referred to herein as the "Company." Intercompany accounts and transactions have been eliminated. Investments in corporate joint ventures and partnerships in which the Company's ownership is 50 percent or less are accounted for by the equity method or the cost method (see Note 11). Certain amounts from prior years have been reclassified to conform with the 1993 presentation. Industry Regulation - ------------------- The Company's principal business is the distribution of natural gas which is regulated by the Oregon Public Utility Commission (OPUC) and the Washington Utilities and Transportation Commission (WUTC). Accounting records and practices conform to the requirements and uniform system of accounts prescribed by these regulatory authorities. Utility Plant - ------------- Utility plant for Northwest Natural is stated at original cost. When a depreciable unit of property is retired, the cost is credited to utility plant and debited to the accumulated provision for depreciation together with the cost of removal, less any salvage. No gain or loss is recognized upon normal retirement. Allowance for Funds Used During Construction (AFUDC), a non- cash item, is calculated using actual commercial paper interest rates. If commercial paper balances are insufficient to finance the amount of work in progress, a NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- composite of interest costs of debt, shown as a reduction to interest charges, and a return on equity funds, shown as other income, is used to compute AFUDC. This amount is added to utility plant which is a component of rate base. While cash is not realized currently from AFUDC, it is realized in the ratemaking process over the service life of the related property through increased revenues resulting from higher rate base and higher depreciation expense. The Company's weighted average AFUDC rates for 1993 and 1992 were 3.5 percent and 4.5 percent, respectively. No AFUDC was recorded in 1991. Northwest Natural's provision for depreciation of utility property, which is computed under the straight-line, age-life method in accordance with independent engineering studies and as approved by regulatory authorities, approximated 4.1 percent of average depreciable plant in 1993, 4.0 percent for 1992 and 4.2 percent for 1991. Regulatory Balancing Accounts - ----------------------------- Regulatory balancing accounts are established pursuant to orders of the state utility regulatory commissions, in general rate proceedings or expense deferral proceedings, in order to provide for recovery of revenues or expenses from, or refunds to, Northwest Natural's utility customers. Inventories - ----------- Northwest Natural's inventories of gas in storage and materials and supplies are stated at the lower of average cost or net realizable value. Income Taxes - ------------ The Company adopted Statement of Financial Accounting Standard (SFAS) No. 109, "Accounting for Income Taxes" on January 1, 1993, with no material effect on earnings (see Note 8). The Company provides deferred federal income tax for the timing differences between book depreciation and tax depreciation under the Accelerated Cost Recovery System (ACRS) for 1981 - 1985 property additions and Modified Accelerated Cost Recovery System (MACRS) for post-1985 property additions. Consistent with rate and accounting instructions of regulatory authorities, deferred income taxes are not currently collected for those income tax temporary differences where the prescribed regulatory accounting methods do not provide for current recovery in rates. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Investment tax credits on utility property additions which reduce income taxes payable are deferred for financial statement purposes and are amortized over the life of the related property. Investment and energy tax credits generated by non-regulated subsidiaries are amortized over a period of two to five years. Unbilled Revenue - ---------------- Northwest Natural accrues for gas deliveries not billed to customers from the meter reading dates to month end. Cash and Cash Equivalents - ------------------------- For purposes of reporting cash flows, cash and cash equivalents include cash on hand and highly liquid temporary investments with original maturity dates of three months or less. Earnings Per Share - ------------------ Earnings per share are computed based on the weighted average number of common shares outstanding each year. Outstanding stock options are common stock equivalents but are excluded from primary earnings per share computations due to immateriality. 2. CONSOLIDATED SUBSIDIARY OPERATIONS: - ---------------------------------------- Oregon Natural Gas Development Corporation - ------------------------------------------ Oregon Natural is a natural gas exploration and production subsidiary of the Company. Approximately $22 million of Oregon Natural's total assets of $39 million are invested in its wholly-owned subsidiary, Canor Energy Ltd., which manages and develops natural gas and oil properties in Canada. Oregon Natural accounts for its exploration costs under the successful-efforts method. Costs to acquire and develop oil and gas properties are capitalized until the volume of proved gas reserves is determined. If there are inadequate gas reserves, the related deferred costs are expensed. Capitalized costs associated with properties under development were $1.4 million at December 31, 1993. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- NNG Financial Corporation - ------------------------- Financial Corporation provides short-term financing for Oregon Natural, Pacific Square and Energy Systems and has several financial investments, including investments as a limited partner in four solar electric generating systems, four windpower electric generating projects, a hydroelectric facility and a low-income housing project (see Note 11). Pacific Square Corporation - -------------------------- Pacific Square is a real estate management subsidiary of the Company. Pacific Square owns a 50 percent interest in a joint venture partnership that owns and operates the building in which the Company leases its general offices. Pacific Square also effectively owns a one-third interest in another partnership that owns and operates an adjacent building. Pacific Square has agreed to sell its interests in these partnerships to its joint venture partner through transactions expected to close in 1994 (see Note 12). The sale of Pacific Square's interests as proposed would not be at a loss to the Company. NNG Energy Systems, Inc. - ------------------------- Energy Systems was formed to design, construct, own and operate cogeneration facilities. Energy Systems' only subsidiary, Agrico Cogeneration Corporation (Agrico), has been in reorganization under Chapter 11 of the U.S. Bankruptcy Code (see Note 3). NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Summarized financial information for the consolidated subsidiaries follows: Consolidated Subsidiaries (Thousands) 1993 1992 1991 - -------------------------------------------------------------------------- Statements of Income for the year ended December 31: Total Operating Revenues $ 10,865 $ 8,183 $ 14,865 Less cost of sales - 183 3,201 -------- -------- -------- Net Operating Revenues 10,865 8,000 11,664 Operating Expenses: Operations and maintenance 5,942 5,598 10,264 Taxes other than income taxes 240 153 489 Depreciation, depletion and amortization 7,986 3,309 4,905 Loss on cogeneration facility* - 4,575 23,200 -------- -------- -------- Total operating expenses 14,168 13,635 38,858 -------- -------- -------- Loss from Operations (3,303) (5,635) (27,194) Other Expense and Interest Charges* (374) (1,670) (3,230) -------- -------- -------- Loss Before Income Taxes (3,677) (7,305) (30,424) Income Tax Benefit 2,188 3,682 12,323 -------- -------- -------- Net Loss $ (1,489) $ (3,623) $(18,101) ======== ======== ======== Balance Sheets as of December 31: Assets: Non-utility property $ 39,435 $ 41,048 $ 47,660 Accumulated depreciation and depletion (18,395) (13,137) (11,044) Investments and other* 34,731 39,781 34,010 Current assets 34,028 16,001 39,955 -------- -------- -------- Total Assets $ 89,799 $ 83,693 $110,581 ======== ======== ======== Capitalization and Liabilities: Capitalization $ 21,843 $ 24,189 $ 29,005 Current liabilities 42,538 33,940 58,458 Other liabilities 25,418 25,564 23,118 -------- -------- -------- Total Capitalization and Liabilities $ 89,799 $ 83,693 $110,581 ======== ======== ======== - -------------------------------------------------------------------------------- *For additional information regarding subsidiary operations, see Notes 3 and 11. 3. AGRICO COGENERATION CORPORATION: - ------------------------------------- Agrico is a wholly-owned subsidiary of Energy Systems. In December 1991, Agrico filed with the United States Bankruptcy Court for the Eastern District of California a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code. In view of the uncertainty NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- regarding the financial viability of Agrico, the Company recorded a write-down of $23.2 million (pre-tax) in 1991, resulting in an after-tax charge equivalent to $1.23 per share. In 1992, Energy Systems and Northwest Natural entered a settlement agreement with United States National Bank of Oregon (U.S. Bank) with respect to U.S. Bank's $14 million secured loan to Agrico. Agrico also entered a conditional settlement agreement with Pacific Gas & Electric Company (PG&E), the purchaser of power produced by Agrico, with respect to PG&E's claimed overpayments to Agrico for power purchased in 1990 and 1991. Agrico also entered a conditional agreement with Wellhead Electric Company (Wellhead), the contract operator of the Agrico facility, for the sale of Agrico's assets to Wellhead. Based upon the estimated costs to the Company under the settlements with U. S. Bank and PG&E, the estimated net proceeds to be received from the sale of Agrico's assets to Wellhead, and other elements of a Chapter 11 reorganization plan, the Company recorded a charge of $4.6 million in 1992, resulting in an after-tax charge of $2.8 million, or 24 cents per share. The California Public Utilities Commission approved Agrico's settlement with PG&E in December 1993, and the U. S. Bankruptcy Court confirmed Agrico's reorganization plan in January 1994. The sale of Agrico's assets to Wellhead closed in February 1994. No material impact to 1994 earnings is expected related to these events. 4. CAPITAL STOCK: - ------------------- Common Stock - ------------ At December 31, 1993, Northwest Natural had reserved 98,720 shares of common stock for issuance under the Employee Stock Purchase Plan, 623,203 shares under its Dividend Reinvestment and Stock Purchase Plan, 153,985 shares under its 1985 Stock Option Plan (see Note 5), 107,866 shares for future conversions of its convertible preference stock and 472,427 shares for future conversions of its 7-1/4 percent Convertible Debentures. Preference Stock - ---------------- The $2.375 Series of Convertible Preference Stock is convertible into shares of common stock at a conversion rate of 1.6502 shares of common stock for each share of preference stock. Subject to certain restrictions, it is NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- callable at stipulated prices, plus accrued dividends. The $6.95 Series of Preference Stock is not redeemable prior to December 31, 2002, but is subject to mandatory redemption on that date. Redeemable Preferred Stock - -------------------------- The mandatory preferred stock redemption requirements aggregate $1,042,000 in 1994 and $1,110,000 in 1995, 1996, 1997 and 1998. These requirements are noncumulative. At any time the Company is in default on any of its obligations to make the prescribed sinking fund payments, it may not pay cash dividends on common stock or preference stock. Upon involuntary liquidation, all series of redeemable preferred stock are entitled to their stated value. Generally, the redeemable preferred stock is callable at stipulated prices, plus accrued dividends, subject to certain restrictions. At December 31, 1993, redemption prices were $100 per share for the $4.68 and $4.75 Series. Shares of the $7.125 Series are redeemable on or after May 1, 1998 at a price of $104.75 per share decreasing each year thereafter to $100 per share on or after May 1, 2008. The following table shows the changes in the number of shares of the Company's capital stock and the premium on common stock for the years 1993, 1992 and 1991: NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- - -------------------------------------------------------------------------- 5. STOCK OPTION AND PURCHASE PLANS: - ------------------------------------- Northwest Natural's 1985 Stock Option Plan (Plan) authorizes an aggregate of 300,000 shares of common stock for issuance as incentive or non-statutory stock options. These options may be granted only to officers and key employees of the Company designated by its Board of Directors. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- All options granted are at an option price not less than market value at the date of grant and may be exercised for a period not exceeding 10 years from the date of grant. Option holders may exchange shares owned by them for at least one year, at the current market price, to purchase shares at the option price. During 1985 and 1990, 150,000 and 86,500 options were granted under the Plan at option prices of $17.625 and $24.875, respectively. Information regarding the Plan is summarized below: Options ---------------------------- Year Ended December 31 1993 1992 1991 ----------------------------------------------------------- Outstanding, beginning of year 101,326 138,408 158,029 $17.625 Options: Exchanged by holders (6,184) (7,673) (6,659) Exercised (9,334) (13,440) (5,362) $24.875 Options: Exchanged by holders (4,729) (6,017) (5,294) Exercised (9,776) (6,652) (2,306) Expired - (3,300) - ------- ------- ------- Outstanding, end of year 71,303 101,326 138,408 ======= ======= ======= Available for grant, end of year 82,682 82,682 79,382 ======= ======= ======= -------------------------------------------------------------- Northwest Natural also has an employee stock purchase plan whereby employees may purchase common stock at 92 percent of average bid and ask market price on the subscription date. The subscription date is set annually, and each employee may purchase up to 600 shares payable through payroll deduction over a six to twelve month period. 6. LONG TERM DEBT: - -------------------- The issuance of first mortgage bonds under the Mortgage and Deed of Trust is limited by property, earnings and other provisions of the mortgage. The Company's Mortgage and Deed of Trust constitutes a first mortgage lien on substantially all of its utility property. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- The 7-1/4 percent Series of Convertible Debentures may be converted at any time for 33-1/2 shares of common stock for each $1,000 face value ($29.85 per share). The sinking fund requirements and maturities for the five years ending December 31, 1998, on the long-term debt outstanding at December 31, 1993, amount to: none in 1994; $1.0 million in 1995; $21.0 million in 1996; $26.0 million in 1997; and $16.0 million in 1998. 7. NOTES PAYABLE AND LINES OF CREDIT: - --------------------------------------- Northwest Natural has available through September 30, 1994, lines of credit totalling $80 million consisting of a primary fixed amount of $40 million plus an excess amount of up to $40 million available as needed, at Northwest Natural's option, on a monthly basis. Under the terms of these bank lines, Northwest Natural pays a commitment fee but is not required to maintain compensating bank balances. The interest rates on borrowings under these lines of credit are based on current market rates as negotiated. There were no outstanding balances as of December 31, 1993. Financial Corporation has available through September 30, 1994, lines of credit with two commercial banks totalling $20 million, including $10 million committed and $10 million uncommitted. Financial Corporation pays a fee on the committed line but not on the uncommitted line; it is not required to maintain compensating bank balances on either line. The interest rates on borrowings under these lines of credit also are based on current market rates as negotiated. Financial Corporation's lines are supported by the unconditional guaranty of Northwest Natural. There were no outstanding balances as of December 31, 1993 under the Financial Corporation bank lines. Northwest Natural and Financial Corporation issue domestic commercial paper under agency agreements with a commercial bank. The amounts and average interest rates of commercial paper outstanding were as follows at December 31: 1993 1992 ---------------- ---------------- Average Average Millions Amount Rate Amount Rate ----------------------------------------------------------- Northwest Natural $53.4 3.4% $34.4 3.8% Financial Corporation 19.1 3.4% 11.9 3.7% ----- ----- Total $72.5 $46.3 ===== ===== ------------------------------------------------------------ NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Commercial paper issued by Northwest Natural and Financial Corporation is supported by committed bank lines. Additionally, Financial Corporation's commercial paper is supported by the unconditional guaranty of Northwest Natural. 8. INCOME TAXES: - ----------------- The Company adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993. The adoption of the new standard results in an increase in net deferred tax liabilities of $62 million to reflect deferred taxes on differences previously flowed-through and to adjust existing deferred taxes to the level required at the current statutory rate. An offsetting regulatory asset of $62 million was also recorded. The regulatory asset is primarily based upon differences between the book and tax basis of utility plant in service and the accumulated provision for depreciation. It is expected that the regulatory asset will be recovered in future rates. The implementation of SFAS No. 109 did not significantly impact results of operations. A reconciliation between income taxes calculated at the statutory federal tax rate and the tax provision reflected in the financial statements is as follows: NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- 9. EMPLOYEE RETIREMENT PLANS: - ------------------------------- The Company has two non-contributory defined benefit retirement plans covering all regular, full-time employees with more than one year of service. The benefits under the plans are based upon years of service and the employee's average compensation during the final years of service. The Company's funding policy is to make the annual contribution required by applicable regulations and recommended by its actuary. Plan assets consist primarily of marketable securities, corporate obligations, U.S. government obligations, real estate and cash equivalents. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Effective January 1, 1994, the Company changed the assumed discount rate used in determining the funded status of the plans from 8.00 percent to 7.50 percent. The new discount rate was used in determining the funded status of the plans at year-end 1993 and will be used to determine annual pension cost in 1994. The Company has a qualified "Retirement K Savings Plan" under Internal Revenue Code Section 401(k) and a non- qualified "Executive Deferred Compensation Plan", for eligible employees. These plans are designed to enhance the existing retirement program of employees and to assist them NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- in strengthening their financial security by providing an incentive to save and invest regularly. Company contributions to these plans in 1993, 1992 and 1991 were $450,000, $315,000 and $290,000, respectively. The Company has a non-qualified supplemental retirement plan for eligible executive officers which it is funding with trust-owned life insurance. The amount of coverage is designed to provide sufficient returns to recover all costs of the plan if assumptions made as to mortality experience, policy earnings, and other factors are realized. Expenses related to the plan were $840,000, $883,000 and $894,000 in 1993, 1992 and 1991, respectively. 10. POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS: - ------------------------------------------------------------ The Company currently provides continued health care and life insurance coverage after retirement for exempt employees. These benefits and similar benefits for active employees are provided by insurance companies and related premiums are based on the amount of benefits paid during the year. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." SFAS No. 106 requires the Company to accrue the estimated cost of retiree benefit payments during the years of employees' active service. The Company previously expensed the cost of these benefits, which are principally health care, as premiums were paid. SFAS No. 106 allows recognition of the cumulative effect of the liability in the year of adoption or amortization of the obligation over a period of up to 20 years. The Company elected to recognize this obligation of approximately $11,300,000 over a period of 20 years. The Company's cash flows are not affected by implementation of this Statement, but implementation decreased income from operations for 1993 by $715,000. The incremental costs of approximately $1,110,000 per year (pre-tax) relating to SFAS No. 106 are not currently included in the Company's rates. The staff of the OPUC has recommended that the portion of these costs allocated to Oregon (approximately 95 percent) be authorized for recovery in rates only pursuant to a general rate case filing, and has recommended against the use of deferred accounting treatment for their recovery. The Company is charging the Oregon portion of these costs to expense. The WUTC has approved deferred accounting treatment for the portion of these costs allocated to Washington (approximately 5 percent), pending final approval for recovery in a general rate case filing. The Company will continually review its NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- need for general rate cases covering these and other expenses but has no present plans to file a general rate case in Oregon or Washington. In 1993, 1992 and 1991, the Company recognized $1,751,000, $671,000 and $588,000, respectively, as the cost of postretirement health care and life insurance benefits. The following table sets forth the health care plan's status at December 31, 1993: Accumulated postretirement benefit obligation (Thousands): ---------------------------------------------------------- Retirees $ 6,675 Fully eligible active plan participants 260 Other active plan participants 4,815 -------- Total accumulated postretirement benefit obligation 11,750 Fair value of plan assets - -------- Accumulated postretirement benefit obligation in excess of plan assets 11,750 Unrecognized transition obligation (10,716) Unrecognized gain 76 -------- Accrued postretirement benefit cost $ 1,110 ======== Net postretirement benefit cost (Thousands): -------------------------------------------- Service cost - benefits earned during the period $ 255 Return on plan assets (if any) - Interest cost on accumulated postretirement benefit obligation 932 Amortization of transition obligation 564 -------- Net postretirement benefit cost $ 1,751 ======== ------------------------------------------------------------ The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation for pre- Medicare eligibility is 12 percent for 1994; 10 percent for 1995; then decreasing over the next 10 years to 5 percent. The rate for HMO plan and post-Medicare eligibility is 9 percent for 1994-5, decreasing over the next 10 years to 5 percent. A one-percentage-point change in the assumed health care cost trend rate for each year would adjust the accumulated postretirement benefit obligation as of December 31, 1993 and net postretirement health care cost by approximately 16 percent. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.5 percent. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- 11. INVESTMENTS: - ----------------- The following table summarizes the Company's year-end investments in affiliated entities accounted for under the equity and cost methods, and its investment in a leveraged lease. Thousands 1993 1992 ------------------------------------------------------------ Electric generation (solar and wind-power) $21,043 $22,757 Aircraft leveraged lease 9,079 8,264 Automated meter-reading technology 1,301 1,352 Gas pipeline and other 1,395 445 ------- ------- Total investments and other $32,818 $32,818 ======= ======= ----------------------------------------------------------- Financial Corporation has invested in four solar electric generation plants located near Barstow, California. Power generated by these stations is sold to Southern California Edison Company. Financial Corporation's ownership interests in these projects range from 4.0 percent to 5.3 percent. Financial Corporation also has invested in four U. S. Windpower Partners electric generating projects, with facilities located near Livermore and Palm Springs, California. The wind-generated power is sold to PG&E and Southern California Edison Company under long-term contracts. Financial Corporation's ownership interests in these projects range from 8.5 percent to 41 percent. In 1987, Oregon Natural purchased a Boeing 737-300 aircraft which was leased to Continental Airlines for 20 years under a leveraged lease agreement. In 1990, the Company invested in a developer of automated meter-reading devices, with facilities located in Spokane, Washington. The Company's ownership interest is 10 percent. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- 12. COMMITMENTS AND CONTINGENT LIABILITIES: - -------------------------------------------- Lease Commitments ----------------- Future lease commitments are: $5.2 million in 1994; $4.9 million in 1995; $4.2 million in 1996; $4.0 million in 1997; and $1.8 million in 1998. Thereafter, total commitments amount to $12.0 million. These commitments principally relate to the lease of the Company's office headquarters and computer systems. The pending sale of the Company's investment in the partnership which owns and operates its office headquarters building (see Note 2) will not affect the Company's lease which extends through 2006, with options to extend beyond that date. Rent paid by the Company to the partnership was $2.8 million in 1993, and $2.2 million in 1992 and 1991. Total rental expense for 1993, 1992 and 1991 was $5.2 million, $4.4 million and $4.5 million, respectively. Purchase Commitments -------------------- The Company has signed agreements providing for the availability of firm pipeline capacity. Under these agreements, the Company must make fixed monthly payments for contracted capacity. The pricing component of the monthly payment is established, and subject to change, by U.S. or Canadian regulatory bodies. The aggregate amount of such required payments was as follows at December 31, 1993: Commitments (Thousands) ------------------------------------------------------------ 1994 $ 58,961 1995 62,123 1996 77,232 1997 74,237 1998 74,012 Thereafter 874,867 ---------- Total 1,221,432 Less: Amount representing interest 504,957 ---------- Total at present value $ 716,475 ========== ------------------------------------------------------------ The Company's total payments of fixed charges under these agreements in 1993, 1992 and 1991 were $46.7 million, $34.7 million and $32.5 million, respectively. In addition, the NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Company is required to pay per-unit charges based on the actual quantities shipped under the agreements. In certain of the Company's take-or-pay purchase commitments, annual deficiencies may be offset by prepayments subject to recovery over a longer term if future purchases exceed the minimum annual requirements. The Company has contracted with an external vendor for the development of a customer information system for a fixed contract price of $12 million to be incurred over four years as follows: $3.6 million in 1993; $4.7 million in 1994; $0.7 million in 1995; and $3.0 million in 1996. Environmental Matters --------------------- In June 1992, the City of Salem, Oregon, requested the Company's participation in its review of an environmental assessment of riverfront property in Salem that is the proposed site for a park and other public developments. Within the property is a block previously owned by the Company which was the former site of a manufactured gas plant. The Company's corporate predecessor operated the plant for less than four months in 1929 before closing it upon completion of a pipeline providing gas transmission from Portland to Salem. The City has determined that there is environmental contamination on the site, and that a remediation process involving the Company and at least two other prior owners of the block will be required. To date the Company has not obtained sufficient information to determine the extent of its liability for any such remediation. The Company owns property in Linnton, Oregon, that is the former site of a gas manufacturing plant that was closed in 1956. Although limited testing for environmental contamination has been undertaken by other parties on portions of the site, no comprehensive studies have been performed. The Company submitted a work plan for the site to the Oregon Department of Environmental Quality (ODEQ) in 1987, but those efforts were suspended at ODEQ's request while the Company and other parties participated in a joint hydrogeologic study of an area adjacent to the site. In September 1993, pursuant to ODEQ procedures, the Company submitted a notice of intent to participate in the ODEQ's Voluntary Cleanup Program. In January 1994, this site was formally placed in the program. It is anticipated that the site investigation will commence during 1994. In September 1993, the Company recorded an expense of $500,000 for the estimated costs of consultants' fees, ODEQ oversight cost reimbursements, and legal fees in connection with the voluntary investigation at the Linnton site. To date, the Company has not obtained sufficient information to NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- determine whether any remediation will be required at this site or, if so, the extent of its liability for any such remediation. The Company expects that its costs of investigation and any remediation for which it may be liable should be recoverable, in large part, from insurance or through future rates. Litigation ---------- The Company is party to certain legal actions in which claimants seek material amounts. Although it is impossible to predict the outcome with certainty, based upon the opinions of legal counsel, management does not expect disposition of these matters to have a materially adverse effect on the Company's financial position or results of operations. 13. FAIR VALUE OF FINANCIAL INSTRUMENTS: - ----------------------------------------- The estimated fair values of the Company's financial instruments have been determined by the Company using available market information and appropriate valuation methodologies. The following is a list of financial instruments whose carrying values are sensitive to market conditions: December 31, 1993 December 31, 1992 -------------------- ------------------- Carrying Estimated Carrying Estimated Thousands of Dollars Amount Fair Value Amount Fair Value - ---------------------------------------------------------------- Preference stock $ 26,633 $ 26,698 $ 26,766 $ 28,354 Redeemable preferred stock 17,041 16,573 28,218 26,947 Long-term debt 272,931 301,358 255,904 283,280 - ---------------------------------------------------------------- NORTHWEST NATURAL GAS COMPANY QUARTERLY FINANCIAL INFORMATION (UNAUDITED) ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III (Item 10. Directors and Executive Officers of the Registrant; Item 11. Executive Compensation; Item 12. Security Ownership of Certain Beneficial Owners and Management; and Item 13. Certain Relationships and Related Transactions.) Information called for by Part III (Items 10., 11., 12. and 13.) is incorporated herein by reference to the Company's definitive proxy statement, "Item (1) - Election of Directors, Executive Compensation and Compensation Pursuant to Certain Plans." See the Additional Item included in Part I for information concerning executive officers of the Company. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The following documents are filed as part of this report: 1. A list of all Financial Statements and Supplementary Schedules is incorporated by reference to Item 8. 2. List of Exhibits filed: *(3a.) Restated Articles of Incorporation, as filed and effective June 24, 1988 and amended December 8, 1992 and December 1, 1993 (incorporated herein by reference to Exhibit 4(a) to File No. 33-51271). (3b.) Bylaws as amended December 16, 1993. *(4a.) Copy of Mortgage and Deed of Trust, dated as of July 1, 1946, to Bankers Trust and R. G. Page (to whom Stanley Burg is now successor), Trustees (incorporated herein by reference to Exhibit 7(j) in File No. 2-6494); and copies of Supplemental Indentures Nos. 1 through 14 to the Mortgage and Deed of Trust, dated respectively, as of June 1, 1949, March 1, 1954, April 1, 1956, February 1, 1959, July 1, 1961, January 1, 1964, March 1, 1966, December 1, 1969, April 1, 1971, January 1, 1975, December 1, 1975, July 1, 1981, June 1, 1985 and November 1, 1985 (incorporated herein by reference to Exhibit 4(d) in File No. 33-1929); Supplemental Indenture No. 15 to the Mortgage and Deed of Trust, dated as of July 1, 1986 (filed as Exhibit (4)(c) in File No. 33-24168); Supplemental Indentures Nos. 16, 17 and 18 to the Mortgage and Deed of Trust, dated, respectively, as of November 1, 1988, October 1, 1989 and July 1, 1990 (incorporated herein by reference to Exhibit (4)(c) in File No. 33-40482); and Supplemental Indenture No. 19 to the Mortgage and Deed of Trust (incorporated herein by reference to Exhibit 4(c) in File No. 33-64014). (4a.(1)) Copy of Supplemental Indenture No. 20 to the Mortgage and Deed of Trust, dated as of June 1, 1993. *(4d.) Copy of Indenture, dated as of June 1, 1991, between the Company and Bankers Trust Company, Trustee, relating to the Company's Unsecured Medium-Term Notes (incorporated herein by reference to Exhibit 4(e) in File No. 33-64014). (4e.) Officers' Certificate dated June 12, 1991 creating Series A of the Company's Unsecured Medium-Term Notes. (4f.) Officers' Certificate dated June 18, 1993 creating Series B of the Company's Unsecured Medium-Term Notes. (10j.) Transportation Agreement, dated June 29, 1990, between the Company and Northwest Pipeline Corporation. *(10j.(1)) Replacement Firm Transportation Agreement, dated July 31, 1991, between the Company and Northwest Pipeline Corporation (incorporated herein by reference to Exhibit (10j.(2)) to Form 10-K for 1992, File No. 0-994). (10j.(2)) Firm Transportation Service Agreement, dated November 10, 1993, between the Company and Pacific Gas Transmission Company. (11) Statement re computation of fully- diluted per share earnings. (12) Statement re computation of ratios. (23) Independent Auditors' Consent. Executive Compensation Plans and Arrangements: ---------------------------------------------- *(10a.) Employment agreement, dated October 27, 1983, between the Company and an executive officer (incorporated herein by reference to Exhibit (10a.) to Form 10-K for 1989, File No. 0-994). *(10b.) Executive Supplemental Retirement Income Plan, 1989 Republication, effective January 1, 1989 (incorporated herein by reference to Exhibit (10b.) to Form 10-K for 1988, File No. 0-994). *(10c.) 1985 Stock Option Plan, as amended effective January 1, 1987 (incorporated herein by reference to Exhibit (10c.) to Form 10-K for 1992, File No. 0-994). *(10e.) Executive Deferred Compensation Plan, 1990 Restatement, effective January 1, 1990 (incorporated herein by reference to Exhibit (10e.) to Form 10-K for 1990, File No. 0-994). *(10e.-1) Amendment No. 1 to Executive Deferred Compensation Plan (incorporated by reference to Exhibit (10e.-1) to Form 10-K for 1991, File No. 0-994). *(10f.) Directors Deferred Compensation Plan, 1988 Restatement, effective January 1, 1988 (incorporated herein by reference to Exhibit (10g.) to Form 10-K for 1987, File No. 0-994). *(10g.) Form of Indemnity Agreement as entered into between the Company and each director and executive officer (incorporated herein by reference to Exhibit (10g.) to Form 10-K for 1988, File No. 0-994). *(10i.) Non-Employee Directors Stock Compensation Plan, as amended effective July 1, 1991 (incorporated herein by reference to Exhibit (10i.) to Form 10-K for 1991, File No. 0-994). *(10k.) Executive Annual Incentive Plan, effective March 1, 1990, as amended effective January 1, 1992 (incorporated herein by reference to Exhibit (10k.) to Form 10-K for 1991, File No. 0-994). *(10l.) Employment agreement dated November 27, 1989, between the Company and an executive officer (incorporated herein by reference to Exhibit (10l.) to Form 10-K for 1991, File No. 0-994). The Company agrees to furnish the Commission, upon request, a copy of certain instruments defining rights of holders of long-term debt of the Company or its consolidated subsidiaries which authorize securities thereunder in amounts which do not exceed 10% of the total assets of the Company. (b) Reports on Form 8-K. No Current Reports on Form 8-K were filed during the quarter ended December 31, 1993. [FN] ___________________________________ *Incorporated herein by reference as indicated. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Northwest Natural Gas Company's (Northwest Natural) consolidated wholly-owned subsidiaries consist of Oregon Natural Gas Development Corporation (Oregon Natural); NNG Energy Systems, Inc. (Energy Systems); NNG Financial Corporation (Financial Corporation); and Pacific Square Corporation (Pacific Square) (see "Subsidiary Operations" below and Note 2 to the Consolidated Financial Statements). Together, Northwest Natural and these subsidiaries are referred to herein as the "Company." The following is management's assessment of the Company's financial condition including the principal factors that impact results of operations. The discussion refers to the consolidated activities of the Company for the three years ended December 31, 1993. Earnings and Dividends - ----------------------- The Company earned $2.61 per share in 1993, compared to $1.11 per share in 1992 and $1.01 per share in 1991. The improved 1993 performance was due to cooler weather, customer growth and improved subsidiary performance. The Company's earnings for 1992 were depressed by the effects of record-setting warm weather and a loss related to Agrico Cogeneration Corporation (Agrico), a subsidiary of Energy Systems. The Company's earnings for 1991 also were depressed by a charge which related to Agrico. The Company earned $2.72 per share from utility operations in 1993, compared to $1.41 per share and $2.56 per share in 1992 and 1991, respectively. Weather conditions in the Company's service territory in 1993 were 22 percent colder than in 1992 and 5 percent colder than in 1991. The Company incurred a loss equivalent to $0.11 per share from subsidiary operations in 1993, compared to losses equivalent to $0.30 per share and $1.55 per share in 1992 and 1991, respectively (see "Subsidiary Operations" below). 1993 was the 38th consecutive year in which the Company's dividends paid have increased. In 1993, dividends paid on common stock were $1.75, up 1.7 percent from a year ago and 3.6 percent higher than 1991. The indicated annual dividend rate is $1.76 per share. Results of Operations - --------------------- Regulatory Matters ------------------ In April 1993, Northwest Natural filed with the Oregon Public Utility Commission (OPUC) for rate increases averaging 6.2 percent in its residential, commercial, and industrial firm rate schedules. The OPUC approved the Oregon increases effective May 1, 1993. Effective June 1, 1993, the Washington Utilities and Transportation Commission (WUTC) approved rate increases averaging 6.7 percent for the Company's Washington customers. The rate increases offset Northwest Natural's higher costs for interstate pipeline capacity under rates approved by the Federal Energy Regulatory Commission for Northwest Pipeline Corporation (NPC), the primary pipeline supplying the Pacific Northwest. In August 1993, Northwest Natural filed with the OPUC for rate increases averaging 3 percent. The OPUC approved the increases effective October 1, 1993. These rate increases were due to the removal of temporary rate discounts in effect since November 1990 to distribute gas cost savings and pipeline rate refunds resulting from the transition to "open access" transportation by NPC. In November 1993, Northwest Natural filed with the OPUC and the WUTC for rate increases which averaged 3.7 percent and 7.6 percent for Oregon and Washington operations, respectively. The new rates pass through the impact of higher gas costs and remove temporary rate discounts in place since December 1992 for the amortization of prior gas cost savings. Both increases were approved effective December 1, 1993. None of the above rate increases has a material effect on net income. The cumulative effect of the increases is not expected to impair Northwest Natural's competitive position in its key markets. Comparison of Gas Operations ----------------------------- The following table summarizes the composition of utility gas volumes and revenues for the three years ended December 31, 1993: Residential and Commercial -------------------------- Typically, 75 percent or more of the Company's annual utility operating revenues are derived from gas sales to weather- sensitive residential and commercial customers. Accordingly, dramatic shifts in temperatures from one period to the next can significantly impact volumes of gas sold to these customers. Normal weather conditions are based upon a 20 year average measured by degree days. Weather conditions were three percent cooler than normal in 1993, 16 percent warmer than normal in 1992, and three percent warmer than normal in 1991. 1993 was 22 percent colder than 1992. Cooler weather, the addition of 19,400 customers, and the rate increases approved by the OPUC and WUTC combined to produce a 34 percent increase in revenues from residential and commercial customers in 1993 compared to 1992 on therm deliveries to these customers which were 27 percent higher than in 1992. The Company's residential and commercial customer growth continued at a rapid pace. In the last three years, almost 52,500 of these customers have been added to the system, representing an average growth rate of 5.2 percent. Industrial, Transportation and Other ------------------------------------ Total volumes delivered to industrial firm, industrial interruptible and transportation customers were 123 million therms lower in 1993 than in 1992, while corresponding revenues from such deliveries were $10.8 million higher. The combined net operating revenue (margin) from industrial firm and interruptible sales and transportation customers increased from $42.7 million in 1992 to $44.4 million in 1993. Transportation volumes declined due to a 136 million therm reduction in deliveries to an electric generation plant which was served under a low-margin transportation tariff. This plant is now served primarily by a new natural gas pipeline which is a joint venture between Oregon Natural and Portland General Electric Company. Transportation revenues from this customer were $0.2 million and $2.5 million in 1993 and 1992, respectively. However, due to the effect of a regulatory balancing mechanism in Oregon, under which the Company credits 80 percent of the transportation revenues received for deliveries to this plant to a deferred account for future refunds to other customers, the reduced volume of deliveries in 1993 resulted in a decrease in margin revenues of only $0.5 million. Since 1992, approximately half of Northwest Natural's transportation customers have switched to sales service. These customers, which have the option of purchasing natural gas from Northwest Natural or of purchasing gas directly from suppliers and transporting it on the systems of Northwest Natural and its pipeline suppliers for a fee, select the option which from time to time provides the lowest cost. Management believes that the migration from transportation to sales tariffs by these customers was primarily due to the fact that, in 1993, Northwest Natural's industrial sales tariffs have been lower than the cost to these customers of purchasing and shipping their own gas. The increase in revenue attributable to this migration was offset by an increase in the cost of gas, since transportation rate schedules are designed to provide the same margin as industrial sales tariffs and thus had little effect on the Company's income from operations. Industrial sales and transportation deliveries remained relatively stable during 1992 and 1991, at 686 million therms in 1992 compared to 670 million therms in 1991. Related revenues were $57 million in 1992, essentially unchanged from 1991. Transportation revenues decreased $3.9 million between these two years, although related volumes remained relatively stable, primarily due to rate reductions in certain transportation tariffs. Unbilled revenues are a recognition of revenues for all gas consumption through the end of the month for all customers, regardless of the meter reading date, in order to better match revenues with associated purchased gas costs. Other revenues are primarily related to regulatory balancing accounts (see Note 1 to the Consolidated Financial Statements). The Company and most of its large industrial customers have entered into high-volume interruptible transportation agreements which are designed to provide rates competitive with "bypass" (direct connection to interstate pipelines) by applying fixed charges that vary with each customer's distance from pipeline facilities. These agreements prohibit bypass during their terms. However, management believes that, during the period 1994 to 1998 it might lose from four to six large industrial customers through bypass. In total, these customers represented approximately 10 percent of 1993 volumes, but less than 3 percent of 1993 margin revenues. Given the far greater effect on margin revenues of temperature fluctuations, economic conditions and growth in residential and commercial customers, management believes the impact of bypass will not materially affect the Company's future results of operations or its financial position. Cost of Gas ----------- The cost of gas sold during 1993 was 36 percent greater than in 1992. The primary contributing factors were a 34 percent increase in total volumes sold and a 2 percent increase in the cost of gas per therm which includes purchased gas cost adjustments and net storage gas activity. The cost of gas sold in 1992 was 5 percent lower than in 1991 primarily due to a 3 percent decrease in total volumes sold and a lower average cost of gas per therm. Subsidiary Operations --------------------- Consolidated subsidiary results for the three years ended December 31, 1993, 1992, and 1991, were losses equivalent to $0.11 per share, $0.30 per share and $1.55 per share, respectively. The subsidiaries' results for 1993 reflect a fourth quarter write-down in the value of unproven gas and oil reserves equivalent to $0.11 per share and increased federal income tax expense equivalent to $0.05 per share (see "Depreciation, Depletion and Amortization" and "Income Taxes" below). Results of operations for the individual subsidiaries for 1993, including the adjustments described above, were a net loss of $0.4 million for Energy Systems; a net loss of $1.4 million for Oregon Natural; a net loss of $0.4 million for Financial Corporation; and net income of $0.7 million for Pacific Square. The 1992 and 1991 losses resulted primarily from charges equivalent to $0.24 per share and $1.23 per share, respectively, related to Agrico. Future charges, if any, related to Agrico, are expected to be immaterial (see Note 3 to the Consolidated Financial Statements). The following discussion summarizes operating expenses, interest charges and income taxes. Operating Expenses ------------------ Operations and Maintenance -------------------------- Operations and maintenance expenses were $6.5 million, or 10 percent, higher in 1993 compared to 1992. Utility expenses constituted $6.2 million of this increase including a $3.1 million, or 10 percent, increase in payroll expenses; a $1.3 million increase in employee benefit costs, including an increase of $0.7 million resulting from the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions;" a $1.2 million increase in the allowance for uncollectible accounts primarily due to higher residential and commercial gas sales; and a $0.5 million accrual for estimated environmental investigation costs (see Note 12 to the Consolidated Financial Statements). Utility operations and maintenance expenses were $3.4 million, or 6 percent, higher in 1992 than in 1991. Subsidiary operations and maintenance expenses were $4.7 million, or 45 percent, lower. Higher utility operating and maintenance expenses resulted primarily from a $1.5 million, or 5 percent, increase in payroll due to wage and salary increases, a $0.5 million increase in employee benefit costs, and increases in claims for injuries and damages and weatherization costs of $0.5 million and $0.4 million, respectively. Subsidiary expenses were lower in 1992 than in 1991 due to a five-month suspension of Agrico operations during 1992. Taxes Other Than Income ----------------------- Taxes other than income increased $4.7 million, or 23 percent, in 1993 compared to 1992 due to a $2.5 million increase in utility property tax accruals and a $1.8 million increase in franchise taxes resulting from higher utility operating revenues. Approximately $0.9 million of the increased property tax accrual is non-recurring and relates to a dispute with the OPUC over the amount of prior-year savings on property taxes which must be refunded to Oregon customers. The balance of this increase resulted from property taxes on plant additions made primarily to serve new customers. Taxes other than income decreased $0.2 million, or 1 percent, in 1992 compared to 1991. This resulted primarily from a reduction of $0.6 million in utility franchise taxes which occurred due to decreased utility operating revenues. This decrease was offset by a $1.0 million increase in property taxes, again due to new plant additions made primarily to serve new customers. Depreciation, Depletion and Amortization ---------------------------------------- Utility depreciation expense increased $1.9 million, or 7 percent, in 1993 and $1.0 million, or 3.5 percent, in 1992, primarily due to additional utility plant in service. $0.4 million of the increased 1993 expense related to the removal of all of the Company's underground gasoline tanks. Subsidiary depreciation expense increased $4.7 million in 1993 and decreased $1.6 million in 1992. The 1993 increase resulted primarily from charges totalling $3.5 million, from the write-downs of Oregon Natural's unproven gas and oil properties (see Note 2 to the Consolidated Financial Statements). $1.5 million of the 1992 decrease in depreciation expense resulted from the suspension of depreciation on Agrico's assets upon its bankruptcy. Interest Charges ---------------- Utility interest expense for 1993 decreased $1.3 million compared to 1992. The decrease was a result of debt refinancings which reduced interest expense by $0.6 million; $11.5 million lower average outstanding commercial paper balances; and a decrease in average interest rates for utility commercial paper from 3.9 percent in 1992 to 3.3 percent in 1993. Subsidiary interest expense for 1993 decreased $0.3 million compared to 1992 due to a decrease in interest expense under Financial Corporation's commercial paper program. Financial Corporation's average outstanding commercial paper balances decreased $4.4 million from 1992 to 1993. In addition, Financial Corporation's average interest rates for commercial paper decreased from 4.1 percent in 1992 to 3.3 percent in 1993. Utility interest expense for 1992 was $3.0 million higher than for 1991. Although total utility debt outstanding was $4.9 million lower at year end 1992 than at year end 1991, the average monthly debt balances were higher due to the increased use of commercial paper in 1992. Commercial paper borrowing increased as warmer-than-average weather reduced revenues. The effect of the increased borrowings was partially offset by a decrease in average interest rates for utility commercial paper from 6.3 percent in 1991 to 3.9 percent in 1992, and a decrease in average interest expense of utility long-term debt from 9.7 percent in 1991 to 9.3 percent in 1992. The 1992 increase in utility interest expense was offset in part by a $2.8 million decrease in subsidiary interest expense which resulted primarily from the reduction of Financial Corporation's outstanding commercial paper balances and a decrease in Financial Corporation's average interest rates for commercial paper from 6.3 percent in 1991 to 4.1 percent in 1992. Income Taxes ------------ The effective corporate income tax rates for the three years ended December 31, 1993, 1992, and 1991 were 37 percent, 31 percent, and 14 percent, respectively, compared to the Company's statutory tax rates for these periods of 39 percent, 38 percent, and 38 percent, respectively. The effective income tax rate for 1991 was lower than the Company's statutory tax rate primarily as a result of non-recurring adjustments that reduced amounts provided for income taxes in prior years by $4.5 million. The adoption of SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993, did not materially affect results of operations. However, for 1993, the federal income tax rate for corporations increased from 34 to 35 percent. The cumulative effect of the tax rate increase was recorded in the third quarter of 1993 and resulted in additional income tax expense of $0.6 million, an increase in deferred tax liabilities of $3.0 million, and an increase in regulatory assets of $2.6 million. Financial Condition - ------------------- The weather-sensitive nature of gas usage by Northwest Natural's residential and commercial customers influences the Company's financial condition, including its financing requirements, from one quarter to the next. Liquidity requirements are satisfied primarily through the use of commercial paper, which is supported by commercial bank lines of credit (see "Lines of Credit" and "Commercial Paper" below). Capital Structure ----------------- The Company's long-term goal is to maintain a capital structure comprised of 40 to 45 percent common stock equity, 5 to 10 percent preferred and preference stock and 45 to 50 percent short-term and long-term debt. This target structure is managed by issuing new debt or equity in response to market conditions and the status of accumulated earnings. The Company also uses these sources to meet long-term debt and preferred stock redemption requirements (see Notes 4 and 6 to the Consolidated Financial Statements). Cash Flows ---------- Operating Activities -------------------- Cash provided from operating activities was higher in 1993 and 1991 as compared to 1992, primarily due to higher revenues from gas sales resulting from colder weather. Also, a portion of the increased cash provided from operating activities in 1991 was due to the effects of unusually cold weather in December 1990, which produced substantial increases in the year- end 1990 balances for accounts receivable, unbilled revenue and accounts payable. These balances, which were collected in 1991, provided $26 million of additional funds during 1991. The Company has lease and purchase commitments related to its operating activities which will continue to be financed with cash flows from operations (see Note 12 to the Consolidated Financial Statements). Investing Activities -------------------- Cash requirements for utility construction, primarily related to system improvements and customer growth, totalled $70.4 million, up $9.7 million, or 16 percent, from 1992 and up $12.0 million, or 21 percent, from 1991. The 1993 increase includes $6.3 million in expenditures related to a project initiated in 1993 to replace the existing customer information system. It is estimated that this project will involve a total investment of about $25 million between 1993 and 1996. A large part of the Company's utility capital expenditures is required for utility construction resulting from customer growth and system improvements. While the Company finances most of these requirements from cash from operations, it also uses short-term borrowings and periodically refinances these borrowings through the sale of long-term debt or equity securities. Utility construction expenditures totalling $75 million are projected for 1994. Over the five year period 1994 through 1998, total utility capital expenditures are estimated at between $325 and $350 million. It is anticipated that approximately 50 percent of the funds required for these expenditures during this period will be internally generated, and that the remainder will be funded through short-term borrowings which will be refinanced periodically through the sale of long-term debt and equity securities. Capital expenditures for the Company's operating subsidiaries in 1994 are expected to be limited to funds internally generated by the subsidiaries. In 1993, Oregon Natural sold and exchanged gas producing properties resulting in net cash inflows of $2.3 million. Investments shown on the Consolidated Balance Sheets under "Investments and Other" for 1992 included a $5.5 million restricted cash deposit with a commercial bank which related to Pacific Square. This deposit was reclassified as a current asset in 1993 due to the pending sale of Pacific Square's primary real estate investments to which it relates. The sale of Pacific Square's investments, which is expected to close in 1994, would not be at a loss to the Company. Financing Activities -------------------- During 1993 and 1992, the Company sold $100 million and $45 million, respectively, of its Medium-Term Notes. Of the proceeds from 1993 sales, $82.6 million was used to redeem higher-cost long-term debt, and the remainder was used to meet capital requirements for the Company's ongoing construction program and to reduce short-term borrowing. Of the proceeds from the 1992 sales, $30 million was used to redeem higher-cost long- term debt and $15 million was used to reduce short-term borrowing. As a result of these transactions, the average interest expense on long-term debt declined from 9.7 percent at December 31, 1991 to 8.3 percent at December 31, 1993. Additionally, in order to meet the Company's capital requirements for its ongoing construction program, to refund higher-cost Preferred Stock, and to increase its equity ratios, the Company sold $25 million of Preference Stock and $28.5 million, or 990,000 shares, of Common Stock during the fourth quarter of 1992. In January 1993, approximately $9 million of the proceeds from the sale of Preference Stock was used to redeem all of the outstanding shares of the Company's $8.00 and $2.42 Series of Preferred Stock. Also in 1993, the Company redeemed all of the outstanding shares of its $6.875 Series of Preferred Stock (see Consolidated Statements of Capitalization). The Company reached an agreement with the sole shareholder of the $8.75 Series of Preferred Stock, with a total stated value of $15 million, to issue an equivalent amount of the $7.125 Series of Preferred Stock in exchange for cancellation of the $8.75 Series, effective as of December 1, 1993. Lines of Credit --------------- Northwest Natural has available through September 30, 1994, lines of credit totalling $80 million consisting of a primary fixed amount of $40 million plus an excess amount of up to $40 million available as needed, at Northwest Natural's option, on a monthly basis. Under the terms of these bank lines, Northwest Natural pays a commitment fee but is not required to maintain compensating bank balances. The interest rates on borrowings under these lines of credit are based on current market rates as negotiated. There were no outstanding balances as of December 31, 1993. Financial Corporation has available through September 30, 1994, lines of credit with two commercial banks totalling $20 million, including $10 million committed and $10 million uncommitted. Financial Corporation pays a fee on the committed line but not on the uncommitted line; it is not required to maintain compensating bank balances on either line. The interest rates on borrowings under these lines of credit also are based on current market rates as negotiated. Financial Corporation's lines are supported by the unconditional guaranty of Northwest Natural. There were no outstanding balances as of December 31, 1993 under the Financial Corporation bank lines. Commercial Paper ---------------- The Company's primary source of short-term funds is commercial paper. Both Northwest Natural and Financial Corporation issue commercial paper which is supported by the committed bank lines discussed above. Financial Corporation's commercial paper is unconditionally guarantied by Northwest Natural (see Note 7 to the Consolidated Financial Statements). Agrico Term Loan ---------------- At December 31, 1991, $14.0 million was outstanding under a term loan agreement between Agrico and United States National Bank of Oregon (U.S. Bank). Under a settlement agreement between Energy Systems, U.S. Bank, and Northwest Natural, U.S. Bank assigned the term loan to Energy Systems in exchange for payments by Energy Systems and Northwest Natural totalling $7.2 million. Such payments were made, and the debt was retired during 1992 (see Note 3 to the Consolidated Financial Statements). Ratio of Earnings to Fixed Charges ---------------------------------- For the years ended December 31, 1993, 1992, and 1991, the Company's ratio of earnings to fixed charges, computed by the Securities and Exchange Commission method, was 3.22, 1.81, and 1.59, respectively. Earnings consist of net income to which has been added taxes on income and fixed charges. Fixed charges consist of interest on all indebtedness, amortization of debt expense and discount or premium, and the estimated interest portion of rentals charged to income. Environmental Matters - --------------------- In June 1992, the City of Salem, Oregon, requested the Company's participation in its review of an environmental assessment of riverfront property in Salem that is the proposed site for a park and other public developments. Within the property is a block previously owned by the Company which was the former site of a manufactured gas plant. The Company's corporate predecessor operated the plant for less than four months in 1929 before closing it upon completion of a pipeline providing gas transmission from Portland to Salem. The City has determined that there is environmental contamination on the site, and that a remediation process involving the Company and at least two other prior owners of the block will be required. To date the Company has not obtained sufficient information to determine the extent of its liability for any such remediation. The Company owns property in Linnton, Oregon, that is the former site of a gas manufacturing plant that was closed in 1956. Although limited testing for environmental contamination has been undertaken by other parties on portions of the site, no comprehensive studies have been performed. The Company submitted a work plan for the site to the Oregon Department of Environmental Quality (ODEQ) in 1987, but those efforts were suspended at ODEQ's request while the Company and other parties participated in a joint hydrogeologic study of an area adjacent to the site. In September 1993, pursuant to ODEQ procedures, the Company submitted a notice of intent to participate in the ODEQ's Voluntary Cleanup Program. In January 1994, this site was formally placed in the program. It is anticipated that the site investigation will commence during 1994. In September 1993, the Company recorded an expense of $500,000 for the estimated costs of consultants' fees, ODEQ oversight cost reimbursements, and legal fees in connection with the voluntary investigation at the Linnton site. To date, the Company has not obtained sufficient information to determine whether any remediation will be required at this site or, if so, the extent of its liability for any such remediation. The Company expects that its costs of investigation and any remediation for which it may be liable should be recoverable, in large part, from insurance or through future rates. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ----------------- Page ---- 1. Management's Responsibility for Financial Statements . . . 33 2. Independent Auditors' Report . . . . . . . . . . . . . . . . . 34 3. Consolidated Financial Statements: Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . 35 Consolidated Statements of Earnings Invested in the Business for the Years Ended December 31, 1993, 1992 and 1991 . . . . 36 Consolidated Balance Sheets, December 31, 1993 and 1992. . . . 37 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . 39 Consolidated Statements of Capitalization, December 31, 1993 and 1992. . . . . . . . . . . . . . . . . . . . . . . . 40 Notes to Consolidated Financial Statements . . . . . . . . . . 41 4. Quarterly Financial Information (unaudited). . . . . . . . . . 61 5. Supplemental Schedules for the Years Ended December 31, 1993, 1992 and 1991 Schedule V - Property, Plant and Equipment . . . . . . . . . . 62 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment. . . . . . . . 65 Schedule IX - Short-term Borrowings. . . . . . . . . . . . . . 66 Schedule X - Supplementary Income Statement Information. . . . 67 Supplemental Schedules Omitted All other schedules are omitted because of the absence of the conditions under which they are required or because the required information is included elsewhere in the financial statements. MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS ---------------------------------------------------- The financial statements in this report were prepared by management, which is responsible for their objectivity and integrity. The statements have been prepared in conformity with generally accepted accounting principles and, where appropriate, reflect informed estimates based on judgments of management. The responsibility of the Company's independent auditors is to render an independent report on the financial statements. The Company's system of internal accounting controls is designed to provide reasonable assurance that assets are safeguarded and transactions are executed in accordance with management's authorizations, that transactions are recorded to permit the preparation of financial statements in conformity with orders of regulatory authorities and generally accepted accounting principles and that accountability for assets is maintained. The Company's system of internal controls has provided such reasonable assurances during the periods reported herein. The system includes written policies, procedures and guidelines, an organization structure that segregates duties and an established program for monitoring the system by internal auditors. In addition, Northwest Natural Gas Company has prepared and annually distributes to its management employees a Code of Ethics covering its policies for conducting business affairs in a lawful and ethical manner. Ongoing review programs are carried out to ensure compliance with these policies. The Board of Directors, through its Audit Committee, oversees management's financial reporting responsibilities. The committee meets regularly with management, the internal auditors, and representatives of Deloitte & Touche, the Company's independent auditors. Both internal and external auditors have free and independent access to the committee and the Board of Directors. No member of the committee is an employee of the Company. The committee reports the results of its activities to the full Board of Directors. Annually, the Audit Committee recommends the nomination of independent auditors to the Board of Directors for shareholder approval. /s/ Robert L. Ridgley ------------------------------- Robert L. Ridgley President and Chief Executive Officer /s/ Bruce R. DeBolt ------------------------------- Bruce R. DeBolt Senior Vice President, Finance, and Chief Financial Officer DELOITTE & TOUCHE - ----------------------------------------------------------------- 3900 US Bancorp Tower Telephone: (503) 222-1341 111 SW Fifth Avenue Facsimile: (503) 224-2172 Portland, Oregon 97204-3698 INDEPENDENT AUDITORS' REPORT ---------------------------- To the Board of Directors and Shareholders Northwest Natural Gas Company Portland, Oregon We have audited the accompanying consolidated financial statements of Northwest Natural Gas Company and subsidiaries, listed in the accompanying table of contents to financial statements and financial statement schedules at Item 8. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the consolidated financial position of Northwest Natural Gas Company and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 8 and 10 to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits in the year ended December 31, 1993. /s/ Deloitte & Touche DELOITTE & TOUCHE February 25, 1994 NORTHWEST NATURAL GAS COMPANY CONSOLIDATED STATEMENTS OF INCOME (Thousands, Except Per Share Amounts) Year Ended December 31 1993 1992 1991 - ------------------------------------------------------------------------ NET OPERATING REVENUES: Revenues: Utility $347,852 $266,183 $281,073 Other 10,865 8,183 14,865 -------- -------- -------- Total operating revenues 358,717 274,366 295,938 -------- ------- -------- Cost of sales: Utility 138,833 101,733 107,398 Other - 183 3,201 -------- -------- ------- Total cost of sales 138,833 101,916 110,599 -------- -------- ------- Net operating revenues 219,884 172,450 185,339 -------- -------- ------- OPERATING EXPENSES: Operations and maintenance 70,723 64,249 65,529 Taxes other than income taxes 25,561 20,865 21,104 Depreciation, depletion and amortization 39,683 33,035 33,623 Loss on cogeneration facility - 4,575 23,200 -------- ------- -------- Total operating expenses 135,967 122,724 143,456 -------- ------- -------- INCOME FROM OPERATIONS 83,917 49,726 41,883 -------- ------- -------- OTHER INCOME (EXPENSE) 933 (267) 1,406 -------- ------- -------- INTEREST CHARGES: Interest on long-term debt 22,578 23,001 21,977 Other interest 1,906 3,223 4,266 Amortization of debt discount and expense 775 511 348 -------- ------- ------- Total interest charges 25,259 26,735 26,591 Allowance for borrowed funds used during construction and capitalized interest (152) (2) - -------- -------- -------- Total interest charges-net 25,107 26,733 26,591 -------- -------- -------- INCOME BEFORE INCOME TAXES 59,743 22,726 16,698 INCOME TAXES 22,096 6,951 2,321 --------- -------- -------- NET INCOME 37,647 15,775 14,377 Preferred and preference stock dividend requirements 3,488 2,560 2,593 -------- ------- ------- EARNINGS APPLICABLE TO COMMON STOCK $ 34,159 $ 13,215 $ 11,784 ======== ======== ======== AVERAGE COMMON SHARES OUTSTANDING 13,074 11,909 11,698 EARNINGS PER SHARE OF COMMON STOCK $2.61 $1.11 $1.01 ===== ===== ===== DIVIDENDS PER SHARE OF COMMON STOCK $1.75 $1.72 $1.69 ===== ===== ===== - ------------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. NORTHWEST NATURAL GAS COMPANY CONSOLIDATED STATEMENTS OF EARNINGS INVESTED IN THE BUSINESS (Thousands of Dollars) 1993 1992 1991 - ------------------------------------------------------------------------- BALANCE AT BEGINNING OF YEAR $77,690 $86,361 $94,325 Net Income 37,647 15,775 14,377 Cash dividends: Preferred and preference stock (3,401) (2,525) (2,608) Common stock (22,853) (20,406) (19,728) Capital stock expense and other (586) (1,515) (5) ------- ------- ------- BALANCE AT END OF YEAR $88,497 $77,690 $86,361 ======= ======= ======= - ------------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. NORTHWEST NATURAL GAS COMPANY CONSOLIDATED BALANCE SHEETS (Thousands) December 31 1993 1992 - ------------------------------------------------------------------------ ASSETS: PLANT AND PROPERTY IN SERVICE: Utility plant in service $840,030 $779,274 Less accumulated depreciation 255,282 233,385 -------- -------- Utility plant - net 584,748 545,889 Non-utility property 42,764 44,629 Less accumulated depreciation and depletion 20,646 15,480 -------- -------- Non-utility property - net 22,118 29,149 -------- -------- Total plant and property in service 606,866 575,038 -------- -------- INVESTMENTS AND OTHER: Investments 32,818 32,818 Restricted cash and long-term notes receivable 1,756 7,518 ------- ------- Total investments and other 34,574 40,336 ------- ------- CURRENT ASSETS: Cash and cash equivalents 4,198 7,537 Accounts receivable - customers 45,340 33,956 Allowance for uncollectible accounts (1,368) (948) Accrued unbilled revenue 25,890 20,738 Inventories of gas, materials and supplies 16,838 15,797 Prepayments and other current assets 16,412 8,220 -------- -------- Total current assets 107,310 85,300 -------- -------- OTHER REGULATORY TAX ASSETS 62,130 - DEFERRED DEBITS AND OTHER 38,156 31,160 -------- -------- TOTAL ASSETS $849,036 $731,834 ======== ======== - ----------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. NORTHWEST NATURAL GAS COMPANY CONSOLIDATED BALANCE SHEETS (Thousands) December 31 1993 1992 - ----------------------------------------------------------------------- CAPITALIZATION AND LIABILITIES: CAPITALIZATION (See Consolidated Statements of Capitalization): Common stock equity $ 41,728 $ 41,080 Premium on common stock 128,340 122,768 Earnings invested in the business 88,497 77,690 -------- -------- Total common stock equity 258,565 241,538 Preference stock 26,633 26,766 Redeemable preferred stock 17,041 28,218 Long-term debt 272,931 253,766 -------- -------- Total capitalization 575,170 550,288 -------- -------- CURRENT LIABILITIES: Notes payable 72,548 47,109 Accounts payable 44,318 40,282 Long-term debt due within one year - 2,138 Taxes accrued 6,757 4,790 Interest accrued 4,438 6,792 Other current and accrued liabilities 10,180 9,387 -------- -------- Total current liabilities 138,241 110,498 -------- -------- DEFERRED INVESTMENT TAX CREDITS 14,567 15,603 DEFERRED INCOME TAXES 104,300 34,929 REGULATORY BALANCING ACCOUNTS AND OTHER 16,758 20,516 COMMITMENTS AND CONTINGENT LIABILITIES (Note 12) - - -------- -------- TOTAL CAPITALIZATION AND LIABILITIES $849,036 $731,834 ======== ======== - ------------------------------------------------------------------------- See Accompanying Notes to Consolidated Financial Statements. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: - ------------------------------------------------ Organization and Principles of Consolidation - --------------------------------------------- The consolidated financial statements include: Regulated utility: --Northwest Natural Gas Company (Northwest Natural) Non-regulated wholly-owned businesses: --Oregon Natural Gas Development Corporation (Oregon Natural) --NNG Financial Corporation (Financial Corporation) --Pacific Square Corporation (Pacific Square) --NNG Energy Systems, Inc. (Energy Systems) Together these businesses are referred to herein as the "Company." Intercompany accounts and transactions have been eliminated. Investments in corporate joint ventures and partnerships in which the Company's ownership is 50 percent or less are accounted for by the equity method or the cost method (see Note 11). Certain amounts from prior years have been reclassified to conform with the 1993 presentation. Industry Regulation - ------------------- The Company's principal business is the distribution of natural gas which is regulated by the Oregon Public Utility Commission (OPUC) and the Washington Utilities and Transportation Commission (WUTC). Accounting records and practices conform to the requirements and uniform system of accounts prescribed by these regulatory authorities. Utility Plant - ------------- Utility plant for Northwest Natural is stated at original cost. When a depreciable unit of property is retired, the cost is credited to utility plant and debited to the accumulated provision for depreciation together with the cost of removal, less any salvage. No gain or loss is recognized upon normal retirement. Allowance for Funds Used During Construction (AFUDC), a non- cash item, is calculated using actual commercial paper interest rates. If commercial paper balances are insufficient to finance the amount of work in progress, a NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- composite of interest costs of debt, shown as a reduction to interest charges, and a return on equity funds, shown as other income, is used to compute AFUDC. This amount is added to utility plant which is a component of rate base. While cash is not realized currently from AFUDC, it is realized in the ratemaking process over the service life of the related property through increased revenues resulting from higher rate base and higher depreciation expense. The Company's weighted average AFUDC rates for 1993 and 1992 were 3.5 percent and 4.5 percent, respectively. No AFUDC was recorded in 1991. Northwest Natural's provision for depreciation of utility property, which is computed under the straight-line, age-life method in accordance with independent engineering studies and as approved by regulatory authorities, approximated 4.1 percent of average depreciable plant in 1993, 4.0 percent for 1992 and 4.2 percent for 1991. Regulatory Balancing Accounts - ----------------------------- Regulatory balancing accounts are established pursuant to orders of the state utility regulatory commissions, in general rate proceedings or expense deferral proceedings, in order to provide for recovery of revenues or expenses from, or refunds to, Northwest Natural's utility customers. Inventories - ----------- Northwest Natural's inventories of gas in storage and materials and supplies are stated at the lower of average cost or net realizable value. Income Taxes - ------------ The Company adopted Statement of Financial Accounting Standard (SFAS) No. 109, "Accounting for Income Taxes" on January 1, 1993, with no material effect on earnings (see Note 8). The Company provides deferred federal income tax for the timing differences between book depreciation and tax depreciation under the Accelerated Cost Recovery System (ACRS) for 1981 - 1985 property additions and Modified Accelerated Cost Recovery System (MACRS) for post-1985 property additions. Consistent with rate and accounting instructions of regulatory authorities, deferred income taxes are not currently collected for those income tax temporary differences where the prescribed regulatory accounting methods do not provide for current recovery in rates. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Investment tax credits on utility property additions which reduce income taxes payable are deferred for financial statement purposes and are amortized over the life of the related property. Investment and energy tax credits generated by non-regulated subsidiaries are amortized over a period of two to five years. Unbilled Revenue - ---------------- Northwest Natural accrues for gas deliveries not billed to customers from the meter reading dates to month end. Cash and Cash Equivalents - ------------------------- For purposes of reporting cash flows, cash and cash equivalents include cash on hand and highly liquid temporary investments with original maturity dates of three months or less. Earnings Per Share - ------------------ Earnings per share are computed based on the weighted average number of common shares outstanding each year. Outstanding stock options are common stock equivalents but are excluded from primary earnings per share computations due to immateriality. 2. CONSOLIDATED SUBSIDIARY OPERATIONS: - ---------------------------------------- Oregon Natural Gas Development Corporation - ------------------------------------------ Oregon Natural is a natural gas exploration and production subsidiary of the Company. Approximately $22 million of Oregon Natural's total assets of $39 million are invested in its wholly-owned subsidiary, Canor Energy Ltd., which manages and develops natural gas and oil properties in Canada. Oregon Natural accounts for its exploration costs under the successful-efforts method. Costs to acquire and develop oil and gas properties are capitalized until the volume of proved gas reserves is determined. If there are inadequate gas reserves, the related deferred costs are expensed. Capitalized costs associated with properties under development were $1.4 million at December 31, 1993. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- NNG Financial Corporation - ------------------------- Financial Corporation provides short-term financing for Oregon Natural, Pacific Square and Energy Systems and has several financial investments, including investments as a limited partner in four solar electric generating systems, four windpower electric generating projects, a hydroelectric facility and a low-income housing project (see Note 11). Pacific Square Corporation - -------------------------- Pacific Square is a real estate management subsidiary of the Company. Pacific Square owns a 50 percent interest in a joint venture partnership that owns and operates the building in which the Company leases its general offices. Pacific Square also effectively owns a one-third interest in another partnership that owns and operates an adjacent building. Pacific Square has agreed to sell its interests in these partnerships to its joint venture partner through transactions expected to close in 1994 (see Note 12). The sale of Pacific Square's interests as proposed would not be at a loss to the Company. NNG Energy Systems, Inc. - ------------------------- Energy Systems was formed to design, construct, own and operate cogeneration facilities. Energy Systems' only subsidiary, Agrico Cogeneration Corporation (Agrico), has been in reorganization under Chapter 11 of the U.S. Bankruptcy Code (see Note 3). NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Summarized financial information for the consolidated subsidiaries follows: Consolidated Subsidiaries (Thousands) 1993 1992 1991 - -------------------------------------------------------------------------- Statements of Income for the year ended December 31: Total Operating Revenues $ 10,865 $ 8,183 $ 14,865 Less cost of sales - 183 3,201 -------- -------- -------- Net Operating Revenues 10,865 8,000 11,664 Operating Expenses: Operations and maintenance 5,942 5,598 10,264 Taxes other than income taxes 240 153 489 Depreciation, depletion and amortization 7,986 3,309 4,905 Loss on cogeneration facility* - 4,575 23,200 -------- -------- -------- Total operating expenses 14,168 13,635 38,858 -------- -------- -------- Loss from Operations (3,303) (5,635) (27,194) Other Expense and Interest Charges* (374) (1,670) (3,230) -------- -------- -------- Loss Before Income Taxes (3,677) (7,305) (30,424) Income Tax Benefit 2,188 3,682 12,323 -------- -------- -------- Net Loss $ (1,489) $ (3,623) $(18,101) ======== ======== ======== Balance Sheets as of December 31: Assets: Non-utility property $ 39,435 $ 41,048 $ 47,660 Accumulated depreciation and depletion (18,395) (13,137) (11,044) Investments and other* 34,731 39,781 34,010 Current assets 34,028 16,001 39,955 -------- -------- -------- Total Assets $ 89,799 $ 83,693 $110,581 ======== ======== ======== Capitalization and Liabilities: Capitalization $ 21,843 $ 24,189 $ 29,005 Current liabilities 42,538 33,940 58,458 Other liabilities 25,418 25,564 23,118 -------- -------- -------- Total Capitalization and Liabilities $ 89,799 $ 83,693 $110,581 ======== ======== ======== - -------------------------------------------------------------------------------- *For additional information regarding subsidiary operations, see Notes 3 and 11. 3. AGRICO COGENERATION CORPORATION: - ------------------------------------- Agrico is a wholly-owned subsidiary of Energy Systems. In December 1991, Agrico filed with the United States Bankruptcy Court for the Eastern District of California a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code. In view of the uncertainty NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- regarding the financial viability of Agrico, the Company recorded a write-down of $23.2 million (pre-tax) in 1991, resulting in an after-tax charge equivalent to $1.23 per share. In 1992, Energy Systems and Northwest Natural entered a settlement agreement with United States National Bank of Oregon (U.S. Bank) with respect to U.S. Bank's $14 million secured loan to Agrico. Agrico also entered a conditional settlement agreement with Pacific Gas & Electric Company (PG&E), the purchaser of power produced by Agrico, with respect to PG&E's claimed overpayments to Agrico for power purchased in 1990 and 1991. Agrico also entered a conditional agreement with Wellhead Electric Company (Wellhead), the contract operator of the Agrico facility, for the sale of Agrico's assets to Wellhead. Based upon the estimated costs to the Company under the settlements with U. S. Bank and PG&E, the estimated net proceeds to be received from the sale of Agrico's assets to Wellhead, and other elements of a Chapter 11 reorganization plan, the Company recorded a charge of $4.6 million in 1992, resulting in an after-tax charge of $2.8 million, or 24 cents per share. The California Public Utilities Commission approved Agrico's settlement with PG&E in December 1993, and the U. S. Bankruptcy Court confirmed Agrico's reorganization plan in January 1994. The sale of Agrico's assets to Wellhead closed in February 1994. No material impact to 1994 earnings is expected related to these events. 4. CAPITAL STOCK: - ------------------- Common Stock - ------------ At December 31, 1993, Northwest Natural had reserved 98,720 shares of common stock for issuance under the Employee Stock Purchase Plan, 623,203 shares under its Dividend Reinvestment and Stock Purchase Plan, 153,985 shares under its 1985 Stock Option Plan (see Note 5), 107,866 shares for future conversions of its convertible preference stock and 472,427 shares for future conversions of its 7-1/4 percent Convertible Debentures. Preference Stock - ---------------- The $2.375 Series of Convertible Preference Stock is convertible into shares of common stock at a conversion rate of 1.6502 shares of common stock for each share of preference stock. Subject to certain restrictions, it is NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- callable at stipulated prices, plus accrued dividends. The $6.95 Series of Preference Stock is not redeemable prior to December 31, 2002, but is subject to mandatory redemption on that date. Redeemable Preferred Stock - -------------------------- The mandatory preferred stock redemption requirements aggregate $1,042,000 in 1994 and $1,110,000 in 1995, 1996, 1997 and 1998. These requirements are noncumulative. At any time the Company is in default on any of its obligations to make the prescribed sinking fund payments, it may not pay cash dividends on common stock or preference stock. Upon involuntary liquidation, all series of redeemable preferred stock are entitled to their stated value. Generally, the redeemable preferred stock is callable at stipulated prices, plus accrued dividends, subject to certain restrictions. At December 31, 1993, redemption prices were $100 per share for the $4.68 and $4.75 Series. Shares of the $7.125 Series are redeemable on or after May 1, 1998 at a price of $104.75 per share decreasing each year thereafter to $100 per share on or after May 1, 2008. The following table shows the changes in the number of shares of the Company's capital stock and the premium on common stock for the years 1993, 1992 and 1991: NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- - -------------------------------------------------------------------------- 5. STOCK OPTION AND PURCHASE PLANS: - ------------------------------------- Northwest Natural's 1985 Stock Option Plan (Plan) authorizes an aggregate of 300,000 shares of common stock for issuance as incentive or non-statutory stock options. These options may be granted only to officers and key employees of the Company designated by its Board of Directors. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- All options granted are at an option price not less than market value at the date of grant and may be exercised for a period not exceeding 10 years from the date of grant. Option holders may exchange shares owned by them for at least one year, at the current market price, to purchase shares at the option price. During 1985 and 1990, 150,000 and 86,500 options were granted under the Plan at option prices of $17.625 and $24.875, respectively. Information regarding the Plan is summarized below: Options ---------------------------- Year Ended December 31 1993 1992 1991 ----------------------------------------------------------- Outstanding, beginning of year 101,326 138,408 158,029 $17.625 Options: Exchanged by holders (6,184) (7,673) (6,659) Exercised (9,334) (13,440) (5,362) $24.875 Options: Exchanged by holders (4,729) (6,017) (5,294) Exercised (9,776) (6,652) (2,306) Expired - (3,300) - ------- ------- ------- Outstanding, end of year 71,303 101,326 138,408 ======= ======= ======= Available for grant, end of year 82,682 82,682 79,382 ======= ======= ======= -------------------------------------------------------------- Northwest Natural also has an employee stock purchase plan whereby employees may purchase common stock at 92 percent of average bid and ask market price on the subscription date. The subscription date is set annually, and each employee may purchase up to 600 shares payable through payroll deduction over a six to twelve month period. 6. LONG TERM DEBT: - -------------------- The issuance of first mortgage bonds under the Mortgage and Deed of Trust is limited by property, earnings and other provisions of the mortgage. The Company's Mortgage and Deed of Trust constitutes a first mortgage lien on substantially all of its utility property. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- The 7-1/4 percent Series of Convertible Debentures may be converted at any time for 33-1/2 shares of common stock for each $1,000 face value ($29.85 per share). The sinking fund requirements and maturities for the five years ending December 31, 1998, on the long-term debt outstanding at December 31, 1993, amount to: none in 1994; $1.0 million in 1995; $21.0 million in 1996; $26.0 million in 1997; and $16.0 million in 1998. 7. NOTES PAYABLE AND LINES OF CREDIT: - --------------------------------------- Northwest Natural has available through September 30, 1994, lines of credit totalling $80 million consisting of a primary fixed amount of $40 million plus an excess amount of up to $40 million available as needed, at Northwest Natural's option, on a monthly basis. Under the terms of these bank lines, Northwest Natural pays a commitment fee but is not required to maintain compensating bank balances. The interest rates on borrowings under these lines of credit are based on current market rates as negotiated. There were no outstanding balances as of December 31, 1993. Financial Corporation has available through September 30, 1994, lines of credit with two commercial banks totalling $20 million, including $10 million committed and $10 million uncommitted. Financial Corporation pays a fee on the committed line but not on the uncommitted line; it is not required to maintain compensating bank balances on either line. The interest rates on borrowings under these lines of credit also are based on current market rates as negotiated. Financial Corporation's lines are supported by the unconditional guaranty of Northwest Natural. There were no outstanding balances as of December 31, 1993 under the Financial Corporation bank lines. Northwest Natural and Financial Corporation issue domestic commercial paper under agency agreements with a commercial bank. The amounts and average interest rates of commercial paper outstanding were as follows at December 31: 1993 1992 ---------------- ---------------- Average Average Millions Amount Rate Amount Rate ----------------------------------------------------------- Northwest Natural $53.4 3.4% $34.4 3.8% Financial Corporation 19.1 3.4% 11.9 3.7% ----- ----- Total $72.5 $46.3 ===== ===== ------------------------------------------------------------ NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Commercial paper issued by Northwest Natural and Financial Corporation is supported by committed bank lines. Additionally, Financial Corporation's commercial paper is supported by the unconditional guaranty of Northwest Natural. 8. INCOME TAXES: - ----------------- The Company adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993. The adoption of the new standard results in an increase in net deferred tax liabilities of $62 million to reflect deferred taxes on differences previously flowed-through and to adjust existing deferred taxes to the level required at the current statutory rate. An offsetting regulatory asset of $62 million was also recorded. The regulatory asset is primarily based upon differences between the book and tax basis of utility plant in service and the accumulated provision for depreciation. It is expected that the regulatory asset will be recovered in future rates. The implementation of SFAS No. 109 did not significantly impact results of operations. A reconciliation between income taxes calculated at the statutory federal tax rate and the tax provision reflected in the financial statements is as follows: NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- 9. EMPLOYEE RETIREMENT PLANS: - ------------------------------- The Company has two non-contributory defined benefit retirement plans covering all regular, full-time employees with more than one year of service. The benefits under the plans are based upon years of service and the employee's average compensation during the final years of service. The Company's funding policy is to make the annual contribution required by applicable regulations and recommended by its actuary. Plan assets consist primarily of marketable securities, corporate obligations, U.S. government obligations, real estate and cash equivalents. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Effective January 1, 1994, the Company changed the assumed discount rate used in determining the funded status of the plans from 8.00 percent to 7.50 percent. The new discount rate was used in determining the funded status of the plans at year-end 1993 and will be used to determine annual pension cost in 1994. The Company has a qualified "Retirement K Savings Plan" under Internal Revenue Code Section 401(k) and a non- qualified "Executive Deferred Compensation Plan", for eligible employees. These plans are designed to enhance the existing retirement program of employees and to assist them NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- in strengthening their financial security by providing an incentive to save and invest regularly. Company contributions to these plans in 1993, 1992 and 1991 were $450,000, $315,000 and $290,000, respectively. The Company has a non-qualified supplemental retirement plan for eligible executive officers which it is funding with trust-owned life insurance. The amount of coverage is designed to provide sufficient returns to recover all costs of the plan if assumptions made as to mortality experience, policy earnings, and other factors are realized. Expenses related to the plan were $840,000, $883,000 and $894,000 in 1993, 1992 and 1991, respectively. 10. POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS: - ------------------------------------------------------------ The Company currently provides continued health care and life insurance coverage after retirement for exempt employees. These benefits and similar benefits for active employees are provided by insurance companies and related premiums are based on the amount of benefits paid during the year. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." SFAS No. 106 requires the Company to accrue the estimated cost of retiree benefit payments during the years of employees' active service. The Company previously expensed the cost of these benefits, which are principally health care, as premiums were paid. SFAS No. 106 allows recognition of the cumulative effect of the liability in the year of adoption or amortization of the obligation over a period of up to 20 years. The Company elected to recognize this obligation of approximately $11,300,000 over a period of 20 years. The Company's cash flows are not affected by implementation of this Statement, but implementation decreased income from operations for 1993 by $715,000. The incremental costs of approximately $1,110,000 per year (pre-tax) relating to SFAS No. 106 are not currently included in the Company's rates. The staff of the OPUC has recommended that the portion of these costs allocated to Oregon (approximately 95 percent) be authorized for recovery in rates only pursuant to a general rate case filing, and has recommended against the use of deferred accounting treatment for their recovery. The Company is charging the Oregon portion of these costs to expense. The WUTC has approved deferred accounting treatment for the portion of these costs allocated to Washington (approximately 5 percent), pending final approval for recovery in a general rate case filing. The Company will continually review its NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- need for general rate cases covering these and other expenses but has no present plans to file a general rate case in Oregon or Washington. In 1993, 1992 and 1991, the Company recognized $1,751,000, $671,000 and $588,000, respectively, as the cost of postretirement health care and life insurance benefits. The following table sets forth the health care plan's status at December 31, 1993: Accumulated postretirement benefit obligation (Thousands): ---------------------------------------------------------- Retirees $ 6,675 Fully eligible active plan participants 260 Other active plan participants 4,815 -------- Total accumulated postretirement benefit obligation 11,750 Fair value of plan assets - -------- Accumulated postretirement benefit obligation in excess of plan assets 11,750 Unrecognized transition obligation (10,716) Unrecognized gain 76 -------- Accrued postretirement benefit cost $ 1,110 ======== Net postretirement benefit cost (Thousands): -------------------------------------------- Service cost - benefits earned during the period $ 255 Return on plan assets (if any) - Interest cost on accumulated postretirement benefit obligation 932 Amortization of transition obligation 564 -------- Net postretirement benefit cost $ 1,751 ======== ------------------------------------------------------------ The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation for pre- Medicare eligibility is 12 percent for 1994; 10 percent for 1995; then decreasing over the next 10 years to 5 percent. The rate for HMO plan and post-Medicare eligibility is 9 percent for 1994-5, decreasing over the next 10 years to 5 percent. A one-percentage-point change in the assumed health care cost trend rate for each year would adjust the accumulated postretirement benefit obligation as of December 31, 1993 and net postretirement health care cost by approximately 16 percent. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.5 percent. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- 11. INVESTMENTS: - ----------------- The following table summarizes the Company's year-end investments in affiliated entities accounted for under the equity and cost methods, and its investment in a leveraged lease. Thousands 1993 1992 ------------------------------------------------------------ Electric generation (solar and wind-power) $21,043 $22,757 Aircraft leveraged lease 9,079 8,264 Automated meter-reading technology 1,301 1,352 Gas pipeline and other 1,395 445 ------- ------- Total investments and other $32,818 $32,818 ======= ======= ----------------------------------------------------------- Financial Corporation has invested in four solar electric generation plants located near Barstow, California. Power generated by these stations is sold to Southern California Edison Company. Financial Corporation's ownership interests in these projects range from 4.0 percent to 5.3 percent. Financial Corporation also has invested in four U. S. Windpower Partners electric generating projects, with facilities located near Livermore and Palm Springs, California. The wind-generated power is sold to PG&E and Southern California Edison Company under long-term contracts. Financial Corporation's ownership interests in these projects range from 8.5 percent to 41 percent. In 1987, Oregon Natural purchased a Boeing 737-300 aircraft which was leased to Continental Airlines for 20 years under a leveraged lease agreement. In 1990, the Company invested in a developer of automated meter-reading devices, with facilities located in Spokane, Washington. The Company's ownership interest is 10 percent. NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- 12. COMMITMENTS AND CONTINGENT LIABILITIES: - -------------------------------------------- Lease Commitments ----------------- Future lease commitments are: $5.2 million in 1994; $4.9 million in 1995; $4.2 million in 1996; $4.0 million in 1997; and $1.8 million in 1998. Thereafter, total commitments amount to $12.0 million. These commitments principally relate to the lease of the Company's office headquarters and computer systems. The pending sale of the Company's investment in the partnership which owns and operates its office headquarters building (see Note 2) will not affect the Company's lease which extends through 2006, with options to extend beyond that date. Rent paid by the Company to the partnership was $2.8 million in 1993, and $2.2 million in 1992 and 1991. Total rental expense for 1993, 1992 and 1991 was $5.2 million, $4.4 million and $4.5 million, respectively. Purchase Commitments -------------------- The Company has signed agreements providing for the availability of firm pipeline capacity. Under these agreements, the Company must make fixed monthly payments for contracted capacity. The pricing component of the monthly payment is established, and subject to change, by U.S. or Canadian regulatory bodies. The aggregate amount of such required payments was as follows at December 31, 1993: Commitments (Thousands) ------------------------------------------------------------ 1994 $ 58,961 1995 62,123 1996 77,232 1997 74,237 1998 74,012 Thereafter 874,867 ---------- Total 1,221,432 Less: Amount representing interest 504,957 ---------- Total at present value $ 716,475 ========== ------------------------------------------------------------ The Company's total payments of fixed charges under these agreements in 1993, 1992 and 1991 were $46.7 million, $34.7 million and $32.5 million, respectively. In addition, the NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- Company is required to pay per-unit charges based on the actual quantities shipped under the agreements. In certain of the Company's take-or-pay purchase commitments, annual deficiencies may be offset by prepayments subject to recovery over a longer term if future purchases exceed the minimum annual requirements. The Company has contracted with an external vendor for the development of a customer information system for a fixed contract price of $12 million to be incurred over four years as follows: $3.6 million in 1993; $4.7 million in 1994; $0.7 million in 1995; and $3.0 million in 1996. Environmental Matters --------------------- In June 1992, the City of Salem, Oregon, requested the Company's participation in its review of an environmental assessment of riverfront property in Salem that is the proposed site for a park and other public developments. Within the property is a block previously owned by the Company which was the former site of a manufactured gas plant. The Company's corporate predecessor operated the plant for less than four months in 1929 before closing it upon completion of a pipeline providing gas transmission from Portland to Salem. The City has determined that there is environmental contamination on the site, and that a remediation process involving the Company and at least two other prior owners of the block will be required. To date the Company has not obtained sufficient information to determine the extent of its liability for any such remediation. The Company owns property in Linnton, Oregon, that is the former site of a gas manufacturing plant that was closed in 1956. Although limited testing for environmental contamination has been undertaken by other parties on portions of the site, no comprehensive studies have been performed. The Company submitted a work plan for the site to the Oregon Department of Environmental Quality (ODEQ) in 1987, but those efforts were suspended at ODEQ's request while the Company and other parties participated in a joint hydrogeologic study of an area adjacent to the site. In September 1993, pursuant to ODEQ procedures, the Company submitted a notice of intent to participate in the ODEQ's Voluntary Cleanup Program. In January 1994, this site was formally placed in the program. It is anticipated that the site investigation will commence during 1994. In September 1993, the Company recorded an expense of $500,000 for the estimated costs of consultants' fees, ODEQ oversight cost reimbursements, and legal fees in connection with the voluntary investigation at the Linnton site. To date, the Company has not obtained sufficient information to NORTHWEST NATURAL GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------- determine whether any remediation will be required at this site or, if so, the extent of its liability for any such remediation. The Company expects that its costs of investigation and any remediation for which it may be liable should be recoverable, in large part, from insurance or through future rates. Litigation ---------- The Company is party to certain legal actions in which claimants seek material amounts. Although it is impossible to predict the outcome with certainty, based upon the opinions of legal counsel, management does not expect disposition of these matters to have a materially adverse effect on the Company's financial position or results of operations. 13. FAIR VALUE OF FINANCIAL INSTRUMENTS: - ----------------------------------------- The estimated fair values of the Company's financial instruments have been determined by the Company using available market information and appropriate valuation methodologies. The following is a list of financial instruments whose carrying values are sensitive to market conditions: December 31, 1993 December 31, 1992 -------------------- ------------------- Carrying Estimated Carrying Estimated Thousands of Dollars Amount Fair Value Amount Fair Value - ---------------------------------------------------------------- Preference stock $ 26,633 $ 26,698 $ 26,766 $ 28,354 Redeemable preferred stock 17,041 16,573 28,218 26,947 Long-term debt 272,931 301,358 255,904 283,280 - ---------------------------------------------------------------- NORTHWEST NATURAL GAS COMPANY QUARTERLY FINANCIAL INFORMATION (UNAUDITED) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III (Item 10. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The following documents are filed as part of this report: 1. A list of all Financial Statements and Supplementary Schedules is incorporated by reference to Item 8. 2. List of Exhibits filed: *(3a.) Restated Articles of Incorporation, as filed and effective June 24, 1988 and amended December 8, 1992 and December 1, 1993 (incorporated herein by reference to Exhibit 4(a) to File No. 33-51271). (3b.) Bylaws as amended December 16, 1993. *(4a.) Copy of Mortgage and Deed of Trust, dated as of July 1, 1946, to Bankers Trust and R. G. Page (to whom Stanley Burg is now successor), Trustees (incorporated herein by reference to Exhibit 7(j) in File No. 2-6494); and copies of Supplemental Indentures Nos. 1 through 14 to the Mortgage and Deed of Trust, dated respectively, as of June 1, 1949, March 1, 1954, April 1, 1956, February 1, 1959, July 1, 1961, January 1, 1964, March 1, 1966, December 1, 1969, April 1, 1971, January 1, 1975, December 1, 1975, July 1, 1981, June 1, 1985 and November 1, 1985 (incorporated herein by reference to Exhibit 4(d) in File No. 33-1929); Supplemental Indenture No. 15 to the Mortgage and Deed of Trust, dated as of July 1, 1986 (filed as Exhibit (4)(c) in File No. 33-24168); Supplemental Indentures Nos. 16, 17 and 18 to the Mortgage and Deed of Trust, dated, respectively, as of November 1, 1988, October 1, 1989 and July 1, 1990 (incorporated herein by reference to Exhibit (4)(c) in File No. 33-40482); and Supplemental Indenture No. 19 to the Mortgage and Deed of Trust (incorporated herein by reference to Exhibit 4(c) in File No. 33-64014). (4a.(1)) Copy of Supplemental Indenture No. 20 to the Mortgage and Deed of Trust, dated as of June 1, 1993. *(4d.) Copy of Indenture, dated as of June 1, 1991, between the Company and Bankers Trust Company, Trustee, relating to the Company's Unsecured Medium-Term Notes (incorporated herein by reference to Exhibit 4(e) in File No. 33-64014). (4e.) Officers' Certificate dated June 12, 1991 creating Series A of the Company's Unsecured Medium-Term Notes. (4f.) Officers' Certificate dated June 18, 1993 creating Series B of the Company's Unsecured Medium-Term Notes. (10j.) Transportation Agreement, dated June 29, 1990, between the Company and Northwest Pipeline Corporation. *(10j.(1)) Replacement Firm Transportation Agreement, dated July 31, 1991, between the Company and Northwest Pipeline Corporation (incorporated herein by reference to Exhibit (10j.(2)) to Form 10-K for 1992, File No. 0-994). (10j.(2)) Firm Transportation Service Agreement, dated November 10, 1993, between the Company and Pacific Gas Transmission Company. (11) Statement re computation of fully- diluted per share earnings. (12) Statement re computation of ratios. (23) Independent Auditors' Consent. Executive Compensation Plans and Arrangements: ---------------------------------------------- *(10a.) Employment agreement, dated October 27, 1983, between the Company and an executive officer (incorporated herein by reference to Exhibit (10a.) to Form 10-K for 1989, File No. 0-994). *(10b.) Executive Supplemental Retirement Income Plan, 1989 Republication, effective January 1, 1989 (incorporated herein by reference to Exhibit (10b.) to Form 10-K for 1988, File No. 0-994). *(10c.) 1985 Stock Option Plan, as amended effective January 1, 1987 (incorporated herein by reference to Exhibit (10c.) to Form 10-K for 1992, File No. 0-994). *(10e.) Executive Deferred Compensation Plan, 1990 Restatement, effective January 1, 1990 (incorporated herein by reference to Exhibit (10e.) to Form 10-K for 1990, File No. 0-994). *(10e.-1) Amendment No. 1 to Executive Deferred Compensation Plan (incorporated by reference to Exhibit (10e.-1) to Form 10-K for 1991, File No. 0-994). *(10f.) Directors Deferred Compensation Plan, 1988 Restatement, effective January 1, 1988 (incorporated herein by reference to Exhibit (10g.) to Form 10-K for 1987, File No. 0-994). *(10g.) Form of Indemnity Agreement as entered into between the Company and each director and executive officer (incorporated herein by reference to Exhibit (10g.) to Form 10-K for 1988, File No. 0-994). *(10i.) Non-Employee Directors Stock Compensation Plan, as amended effective July 1, 1991 (incorporated herein by reference to Exhibit (10i.) to Form 10-K for 1991, File No. 0-994). *(10k.) Executive Annual Incentive Plan, effective March 1, 1990, as amended effective January 1, 1992 (incorporated herein by reference to Exhibit (10k.) to Form 10-K for 1991, File No. 0-994). *(10l.) Employment agreement dated November 27, 1989, between the Company and an executive officer (incorporated herein by reference to Exhibit (10l.) to Form 10-K for 1991, File No. 0-994). The Company agrees to furnish the Commission, upon request, a copy of certain instruments defining rights of holders of long-term debt of the Company or its consolidated subsidiaries which authorize securities thereunder in amounts which do not exceed 10% of the total assets of the Company. (b) Reports on Form 8-K. No Current Reports on Form 8-K were filed during the quarter ended December 31, 1993. [FN] ___________________________________ *Incorporated herein by reference as indicated.

354964_1993.txt

354964_1993

1993

354964

ITEM 1. BUSINESS. GENERAL Household International, Inc. ("Household International" or the "Company") is a publicly owned corporation which, with its subsidiaries, provides a broad range of diversified financial services for individuals and businesses. The Company employs approximately 16,900 people and serves approximately 17 million customers in the United States, Canada, the United Kingdom and Australia. In 1993 Household International was ranked as the 61st largest publicly owned company, based on total assets by Forbes magazine which annually lists the 500 largest public corporations in the United States. The Company's operations are divided into three business segments: Finance and Banking, Individual Life Insurance, and Liquidating Commercial Lines. Household International was created in 1981 as a result of a shareholder approved restructuring of Household Finance Corporation ("HFC"), a publicly owned corporation since 1925, whereby Household International became a holding company for various subsidiaries, including HFC. At that time Household International had operations in the financial services, manufacturing, transportation and merchandising industries. In 1985 the Company began to restructure its operations away from being a diversified conglomerate. This action resulted in the disposition of its merchandising (1985), transportation (1986) and manufacturing (1989-1990) businesses, including the spin-off to its common stock shareholders of three manufacturing companies in 1989: Eljer Industries, Inc., Schwitzer, Inc. and Scotsman Industries, Inc. The products offered by Household International, a description of the geographic markets in which the Company operates and summary financial information for each of the Company's business segments is set forth in the Company's Annual Report to Shareholders (the "1993 Annual Report"), portions of which are incorporated herein by reference. See pages 12, 13 and 33 through 80 of the 1993 Annual Report. The Company markets its products to its customers through a number of different distribution channels, including consumer finance branch offices, consumer bank branch offices, loan origination offices, retail merchants, independent insurance agents, direct mail and telemarketing, and retail securities brokerage offices. 1993 DEVELOPMENTS. In 1993 the Company's bankcard operations continued to grow, principally through the continuing success of the GM Card(sm). The GM Card is a general-purpose credit card which allows the users thereof to earn credit toward the purchase of new General Motors vehicles. The GM Card was publicly introduced in September 1992 and as of December 31, 1993, there were approximately 5.9 million accounts which had generated approximately $4.9 billion credit card receivables. As of this date, the GM Card accounts are generally active and are of high credit quality. In the fourth quarter, the Company announced expansion of its alliance with General Motors Corporation with the introduction of a GM Card from Vauxhall in the United Kingdom, permitting users to earn rebates toward the purchase of a new Vauxhall vehicle. The card will be issued by HFC Bank plc, the Company's principal operating subsidiary in the United Kingdom. Also in the fourth quarter, the Company announced an alliance to issue a new co-branded credit card with Charles Schwab & Co. In 1993 Household International strengthened its capital base through the issuance of additional equity securities. In March 1993 the Company raised additional capital of approximately $269 million (net of issuance costs) through the sale of 4,025,000 shares of common stock (on a pre-split basis). In addition, during the year the Company issued approximately $44 million of common stock through employee benefit and dividend reinvestment plans. The Company also issued 4,000,000 depositary shares, with each depositary share representing a one-fortieth interest in a share of the Company's 7.35% Cumulative Preferred Stock, Series 1993-A. The underwritten public offering raised approximately $97 million (net of issuance costs) for the Company. The issuance of this common and preferred stock, together with a conservative growth posture, strengthened its capital ratios. In October, the Company's common stock was split 2-for-1 through a 100% stock dividend. The split doubled the number of shares of common stock outstanding and was affected for the primary purpose of making the common stock more affordable to a broader base of investors. The lowest interest rates in the United States in over twenty years contributed to high prepayment rates in the first mortgage portfolio, resulting in write-downs of capitalized servicing rights and lower earnings for the mortgage banking operation. In foreign operations, despite continuing weak economic growth in the United Kingdom, Household International's United Kingdom operation was profitable for the first time in five years. The improvement was primarily attributable to actions taken in prior years such as implementing tightened underwriting standards and improved collections efforts. For the year, the United Kingdom operation earned $10.3 million compared to a 1992 loss of $45.9 million. The Company's operation in Canada was adversely affected by a continuing poor economic environment resulting in low receivables origination volume. The Company's performance in Canada was also impacted by establishment of higher loss reserves during the fourth quarter as a result of the completion of the first phase of a strategic assessment of the Canadian market, economic conditions, products and the Company's Canadian cost structure and policies. The Company's Australian operation was profitable, comparable with its 1992 results. FINANCE AND BANKING Total Finance and Banking receivables at December 31, classified by type, consisted of the following (in millions): CONSUMER OPERATIONS. Household International is primarily a consumer financial services company, with consumer receivables of $18.6 billion, representing approximately 96 percent of Finance and Banking owned receivables and approximately 59 percent of total assets at December 31, 1993, excluding the discontinued commercial product lines. The Company's primary target customer for consumer lending is generally between 25 and 50 years of age with a household income of $15,000 to $50,000. Approximately 82 percent of the Company's Finance and Banking receivables are located in the United States. Through its consumer lending businesses, the Company competes with banks, thrifts, finance companies and other financial institutions through the offering of a variety of products, a strong service orientation and innovative marketing programs. The Company believes that the fragmented nature of the consumer financial services industry provides ample opportunity for the Company to increase market share, and therefore profitability. The Company has focused on being a low-cost producer in its consumer financial services businesses. Highly automated processing facilities have been developed to support underwriting, loan administration and collection functions across business lines. By supporting its multiple-distribution networks with centralized processing centers, the Company has improved efficiency through specialization and economies of scale. In addition, by removing such functions from branch offices, the Company is able to concentrate on sales activities in the branch offices. Underwriting and collection of consumer credit products and internal controls over these functions have been improved over the last few years through the segregation of the sales, underwriting and collection functions. For example, loan approvals are handled by non-sales personnel located in regional servicing centers ("RSC") whose primary concern is credit quality, not volume. Underwriting and collections are supported by automated systems which analyze the likelihood of delinquency or bankruptcy. The Company believes it is an industry leader in implementing automated underwriting and collection management systems which improve its ability to manage credit quality. The Company considers factors such as the applicant's income, expenses, paying habits, value of collateral, if any, and length and stability of employment, in its effort to determine whether the borrower has the ability to support the loan. The objective of the Company's program to automate and centralize the back office processing of U.S. consumer finance accounts has been to transfer the record keeping and collection tasks necessary to service accounts from its branch offices to an RSC. The RSCs were created to provide higher quality customer service and cost savings resulting from greater efficiency through economies of scale. By doing so, the Company's branch offices have been able to focus on sales and marketing efforts. The Company's first RSC began operations in Illinois in 1987. By the first quarter of 1990, all U.S. branch offices of HFC were served by RSCs. As a result of efficiencies achieved since that time, the operations of the servicing centers have been further consolidated, and in 1993 the servicing operation for all HFC originated loans was moved to a single servicing center located in Illinois. The former western region RSC, which began operations in the first quarter of 1989, now supports HFC's portfolio acquisition business and services acquired consumer credit receivables. The former eastern region RSC, which opened in Virginia in the fourth quarter of 1989, now supports the GM Card exclusively. Additional facilities exist to provide the Company's bankcard and merchant participation business with centralized automated support. The Company has also established regional processing centers ("RPC") in California, Illinois, Maryland, Nevada and Ohio to perform payment processing, check processing, statement billings and other administrative tasks for all domestic consumer operations. In the United Kingdom, HFC Bank plc's Birmingham Business Center provides operating and administrative functions in centers modeled after the RSCs and RPCs used in the United States. In 1990, the Canadian operation opened two centers similar to the United Kingdom center and the Australian operation opened one center. Over the last few years, the Company has invested in the development of its bankcard, private-label credit card and consumer and mortgage banking services which have been an important contributor to the Company's growth. Net income on an operating basis from these newer businesses increased from $7 million in 1988 to $201 million in 1993. At December 31, 1993, the Company had acquired intangibles associated with acquisitions of thrift institutions and bankcard portfolios of approximately $473 million. The Company amortizes purchased credit card intangibles on a straight-line basis, not to exceed 10 years and other intangibles over their estimated life not exceeding 15 years. The average amortization period for the acquired intangibles was approximately 7 years in 1993. Since 1988 the Company has increased significantly its portfolio of receivables sold and serviced with limited recourse. This portfolio has grown to $9.8 billion at year-end 1993 from none at the beginning of 1988. The Company was the first public issuer of home equity loan asset-backed securities in 1988 and continues to be one of the largest issuers of asset-backed securities. In 1993, including replenishments of certificateholders interests, the Company securitized and sold $9.4 billion of receivables. In addition, the Company sells first mortgages with no recourse and retains the servicing and also acquires servicing rights for first mortgages. This portfolio of first mortgage receivables serviced with no recourse has grown to $13.9 billion at year-end 1993 from $500 million at year-end 1986. In the third quarter of 1993, the Company began servicing an unsecured consumer portfolio without recourse which totaled $1.3 billion at December 31, 1993. Major consumer business units within the Finance and Banking segment are described below. Household Finance Corporation Household Finance Corporation, the Company's principal business, traces its origins to a loan office established in 1878. HFC offers a variety of secured and unsecured lending products to middle-income customers through a network of 432 branch lending offices throughout the United States. This business is conducted primarily through state-licensed companies. Home equity loans, and to a lesser extent, unsecured credit products have been HFC's primary focuses over the last several years as these products are preferred by consumers due to the flexible nature of the credit relationship, where the timing and amount of borrowing can be tailored to the borrower's particular circumstances. These products also are advantageous to HFC due to lower relative administrative costs and typically have variable rate terms which move with market rates of interest. Home equity loans and unsecured consumer credit products in the HFC domestic network represented approximately 30 percent of total Finance and Banking managed receivables at December 31, 1993. Home equity loans, representing approximately 27 percent of total Finance and Banking managed receivables at December 31, 1993, have lower chargeoff rates than the unsecured credit products. In 1992, HFC launched a new portfolio acquisition business focusing on open-end and closed-end home equity loan products. In 1993, HFC acquired approximately 3,800 new accounts aggregating $430 million in such receivables. In addition, in 1993 HFC acquired the right to service without recourse approximately 1.1 million accounts aggregating approximately $2.0 billion in unsecured loans. The Company believes that the portfolio acquisition business provides an additional source for developing new customer relationships. Household Retail Services Household Retail Services ("HRS") is a revolving credit merchant participation business. HRS purchases and services merchants' revolving charge accounts. These accounts result from consumer purchases of furniture, appliances, home improvement products and other durable merchandise, and generally are without credit recourse to the originating merchant. Loans are underwritten by HRS based on its credit standards. This business is an important source of new customers to HFC's direct lending business. HRS became a separate business unit in 1988 and is currently the second largest provider of private-label credit cards in the United States. This business is conducted through state-licensed companies and through Household Bank (Illinois), National Association. Household Bank, f.s.b. Household Bank, f.s.b. (the "Bank"), a federally chartered savings bank, comprises the majority of the Company's consumer banking and mortgage business. At December 31, 1993, the Bank's assets totaled $9.1 billion, which includes $2.2 billion of receivables attributable to the GM Card. Although there was a slight decline in deposits in 1993 from $6.5 billion at December 31, 1992, deposits have increased to $6.2 billion at December 31, 1993 from $1.6 billion at year-end 1986. Much of the strategic growth of the Company has been through its consumer banking operations, where the Company believes the most efficient use of capital can be achieved. The Company's consumer banking strategy is intended to diversify its funding base, provide a stable and relatively low-cost funding source, create a more competitively leveraged entity and market financial service products to a different customer base. In 1988, the Company formalized its consumer banking strategy and launched its consumer bank development program with a geographic focus on California and the arc of states from Illinois to Maryland. At December 31, 1993 the Bank had 171 branches in 7 states: California (54); Illinois (44); Ohio (26); Maryland (24); Virginia (15); Indiana (5); and Kansas (3). The Bank is a full-service consumer bank, marketing itself as "America's Family Bank"(R). It operates as a single institution in all states where it is active, with common marketing programs and processing systems. The Company believes the Bank is one of the few consumer banks of its size to operate in this manner. The Bank's acquisition strategy involves identification of institutions which complement the existing network in target markets. The ideal acquisition includes only deposits, customer relationships and branches. Acquired institutions are quickly integrated into the existing network. The integration process includes new signage, decor, product offerings, pricing and back office systems. Since the Bank generally does not need acquired administrative and executive personnel and facilities, operating expenses of the acquired entity have been reduced in most acquisitions. First mortgages are originated in branch locations and loan production offices by Household Mortgage Services, a division of the Bank, or may be acquired from correspondents and other wholesale sources. In 1993, Household Mortgage Services originated approximately $4 billion in first mortgages. However, refinancing resulting from the record low interest rates caused the first mortgage portfolio to decline by approximately $1 billion in 1993. At December 31, 1993, $2 billion, or approximately 28 percent, of the Bank's owned receivables represented first mortgages for single-family residences. Adjustable-rate mortgage loans represented approximately 43 percent of this portfolio. This first mortgage portfolio is well-diversified geographically and the Bank has originated no negative amortization loans. The weighted average loan-to-value ratio at the origination of the loan for the entire portfolio was approximately 70 percent. While emphasizing single-family mortgage lending, the Bank also provides mortgage loans for various multi-family and income-producing properties and makes various types of consumer loans, including savings account secured loans and secured and unsecured lines of credit. Household Credit Services Household Credit Services is the tradename used for the marketing of bankcards throughout the United States issued by one of the Company's subsidiary national credit card banks, the Bank, or one of the other financial institutions affiliated with Household International. The Company had $8.8 billion of bankcard receivables owned and serviced with limited recourse at December 31, 1993, up from $207 million at year-end 1986. The Company is one of the top 6 issuers of VISA and MasterCard credit cards in the United States. The Company strives to build its bankcard business by developing strategic alliances with industry leaders to effectively create and market general purpose credit cards to targeted consumers. In accordance with this philosophy, in 1991 the Company established a program with Ameritech Corporation, in 1992 established a program with General Motors Corporation and in 1993 expanded the relationship through an agreement with General Motors to issue the GM Card from Vauxhall in the United Kingdom. Also in 1993 the Company announced an alliance with Charles Schwab & Co. See "1993 Developments." The Company intends to continue to explore other co-branding relationships of this type with various entities. The Company also seeks to build its bankcard business by selectively purchasing portfolios while managing geographic concentrations. The Company evaluates bankcard acquisitions utilizing criteria related to strategic fit and economic value. To assess strategic fit, the Company considers the following: the composition and behavior of the customer franchise; product pricing compatibility with the Company's pricing strategies; geographic distribution of the customer base; and opportunities to add value through improved portfolio management. To assess economic value, the Company evaluates the risk/return characteristics of the portfolio, particularly with respect to revenue generating potential and asset quality, and identifies and quantifies legitimate opportunities to add value through price changes, more efficient servicing, improved collections, and credit line management. The Company also applies traditional financial analysis techniques to evaluate financial returns in relation to the proposed investment. The bankcard business is a highly competitive and fragmented industry currently in the process of consolidation. The Company believes that its relatively large size in the industry provides substantial competitive advantages over smaller credit card issuers through reduced operating expense ratios. The Company's focus is to develop a nationally diverse customer franchise that contains three to four hubs of concentration while employing value-based pricing. These hubs are expected to promote operating and marketing efficiencies without creating overdependence on a single geographic area that would potentially expose the Company to regional credit risk and usage patterns. Currently, the Company's largest account base is in California supplemented by significant hubs in the Midwest and on the East coast. International Operations International operations in Canada, the United Kingdom and Australia accounted for approximately 18 percent of the Finance and Banking owned receivables at December 31, 1993. In Canada, the Company operates consumer finance, private-label credit card and consumer banking operations similar to its businesses in the United States. With 30 offices at December 31, 1993, the Canadian consumer finance business operates under the HFC tradename. The Canadian consumer banking business, with 12 branches, operates as Household Trust Company. At December 31, 1993, the Canadian operations had $1.9 billion of receivables. In the United Kingdom, the Company owns HFC Bank plc, a fully licensed United Kingdom bank. HFC Bank plc had 150 branches at December 31, 1993 and approximately $1.2 billion of receivables. In Australia, the Company operates primarily as a consumer finance company under the HFC tradename. The Company had 22 offices in Australia at December 31, 1993 and approximately $375 million of consumer receivables. Credit Insurance In conjunction with its consumer lending operations and where applicable laws permit, the Company makes credit life, credit accident and health, term and specialty insurance products available to its customers. This insurance generally is directly written by or reinsured with Alexander Hamilton Life Insurance Company of America ("Alexander Hamilton"). Financial results for sales of these types of products through affiliated operations are reported as part of the Finance and Banking segment. Hamilton Investments Hamilton Investments was acquired by Household International during 1989 as part of the Bank's acquisition of a savings institution. Hamilton Investments is a retail-oriented investment banking and brokerage firm. It has 24 branch offices which are located in the following states: Illinois (9); Wisconsin (6); Minnesota (5); Michigan (2); and one each in Indiana and Nebraska. In addition, Hamilton operates through 150 Household Bank locations. In 1992 Hamilton Investments acquired Craig-Hallum, Inc., a Minneapolis-based investment banking and brokerage firm with 100 registered representatives and 26,000 customer accounts. Hamilton Investments is registered as a broker-dealer with the Securities and Exchange Commission and as a futures commission merchant with the Commodities Futures Trading Commission. It is a member of the National Association of Securities Dealers, the New York Stock Exchange, the American Stock Exchange, the Chicago Stock Exchange and the National Futures Association. A subsidiary of Hamilton Investments acts as the investment adviser to the Oberweis Emerging Growth Fund, the Household Personal Portfolios and General Securities, Inc., mutual funds with assets of approximately $101, $26 and $28 million, respectively, at year-end 1993. COMMERCIAL OPERATIONS. Approximately 3 percent of the Finance and Banking managed receivables portfolio at December 31, 1993 consisted of leveraged leases, other equipment financing, and specialized corporate lending. Products in these areas include loan and lease financing for aircraft, other transportation equipment, capital equipment and specialized secured corporate loans. In addition, the Company invests in term preferred stocks. See also "Liquidating Commercial Lines" below. The commercial finance business of the Company has been operated under Household Commercial Financial Services ("Household Commercial") since 1974. The industry in which Household Commercial operates is highly competitive and the Company's position in this market is relatively small. Commercial loans are underwritten based upon specific criteria by product, which include the following items: borrower's financial strength; underlying value of any collateral; ability of the property/business to generate cash flow and pricing considerations. For financing commitments in excess of $1 million, the loan request must be approved by an investment committee consisting of senior management. The financial and operating performance of all borrowers is monitored and reported to management on an ongoing basis. Additionally, the conclusions of this monitoring process are reported to the senior management of the Company on a quarterly basis. A description of Household's operational policy with respect to commercial receivables is set forth on page 41 of the 1993 Annual Report. INDIVIDUAL LIFE INSURANCE The Company's individual life insurance operations are conducted by Alexander Hamilton Life Insurance Company of America. Alexander Hamilton markets universal life, term life and annuity products to a higher income category consumer than that targeted by the consumer lending businesses. Alexander Hamilton also underwrites credit life, credit accident and health, and other specialty products sold through the Company's consumer businesses. The Alexander Hamilton products sold by affiliated entities are included in results of the Finance and Banking segment. Alexander Hamilton offers universal life insurance, term life insurance and annuity products through approximately 16,300 independent agents and 1,790 licensed consumer finance and banking employees. These individual products are sold in all states, with the largest concentration in 10 states (California, Florida, Illinois, Maryland, Michigan, New Jersey, New York, Ohio, Pennsylvania and Wisconsin) accounting for 63 percent of premium income in 1993. The Company also sells credit insurance to customers of banks and retail merchants which are not affiliated with Household International. Alexander Hamilton has been assigned a claims-paying ability rating of "AA" from three nationally recognized statistical rating organizations. LIQUIDATING COMMERCIAL LINES As of December 31, 1991, Household International ceased offering certain commercial product lines. The decision to withdraw from these product lines was made to enable Household International to concentrate its resources on operations it believes offer the opportunity for more consistent financial returns relative to risks assumed. These liquidating commercial lines are: speculative real estate secured lending; highly leveraged acquisition finance transactions; subordinated corporate lending; higher-risk equipment loans and leases and other commercial assets. These discontinued product lines are managed by Household Commercial separately from continuing commercial lines. The Company intends to liquidate this portfolio over time in a manner that will maximize the value of these assets and believes that, depending on the economic environment, it should be able to liquidate these portfolios over the next several years. Liquidating commercial assets at December 31, 1993 consisted of the following (in millions): INVESTMENT SECURITIES Investment securities of the Company are principally held by Alexander Hamilton. At December 31, 1993, Alexander Hamilton had $6.4 billion or approximately 73 percent of the Company's $8.8 billion total investment portfolio. The composition of this portfolio is set forth on pages 59 and 60 of the 1993 Annual Report. Investment securities are also held by the Bank, Household Global Funding, Inc., the United States holding company for Household's operations in Canada and the United Kingdom, and Household Commercial and represent approximately 14, 6 and 4 percent, respectively, of the Company's total investment portfolio. FUNDING RESOURCES As a financial services organization, Household International must have access to funds at competitive rates, terms and conditions to be successful. Household International and its subsidiaries fund their operations in the global capital markets, primarily through the use of commercial paper, medium-term notes and long-term debt, and have used financial instruments to hedge their currency and interest-rate exposure. Four nationally recognized statistical rating organizations currently assign investment grade ratings to the debt and preferred stock issued by the Company and its subsidiaries. In addition, these organizations rated the commercial paper of HFC in their highest rating category. The securitization and sale of consumer receivables is an important source of liquidity for HFC and the Bank. During 1993 the Company's subsidiaries securitized and sold, including replenishments of certificateholder interests, approximately $9.4 billion of home equity, merchant participation and bankcard receivables compared to $4.8 billion in 1992. To diversify its funding base and add more stability to funding costs, the Company developed a retail deposit base in recent years through its consumer banking business. Customer deposits have grown from $3.9 billion at year-end 1988 to $7.5 billion at December 31, 1993. The Company intends to continue to expand this deposit base through selective acquisitions of savings institutions. See "Finance and Banking-- Household Bank, f.s.b.". REGULATION AND COMPETITION REGULATION. The Company's businesses are subject to various regulations covering their conduct. Generally, HFC's consumer branch lending offices are regulated by legislation and licensed in those jurisdictions where they operate. Such licenses have limited terms but are renewable, and are revocable for cause. In addition to licensing provisions, statutes in some jurisdictions may provide that a loan not exceed a certain period of time, or may place limits on the size or interest rate of the loan. HFC's sales finance business is also subject to regulatory legislation in certain jurisdictions which, among other things, may limit the interest rates or fees which may be charged or which may inhibit HFC's ability to collect or foreclose upon delinquent loans. All of Household International's consumer finance operations are subject to federal laws relating to discrimination in credit extensions, use of credit reports, disclosure of credit terms, and correction of billing errors. The Bank is chartered by the Office of Thrift Supervision ("OTS") and is a member of the Federal Home Loan Bank System. The Bank has its customer deposit accounts insured for up to $100,000 per insured depositor by the Federal Deposit Insurance Corporation ("FDIC"), for which the Bank is assessed a fee. The Bank is subject to examination and supervision by the OTS and FDIC and to federal regulations governing such matters as general investment authority, acquisitions of financial institutions, transactions with affiliates, establishment of branch offices, subsidiaries' investments and activities, and restrictions on dividend payments to Household International. The Bank is also subject to regulatory requirements setting forth minimum capital and liquidity levels. In addition, regulations of the Federal Reserve Board require the Bank to maintain non- interest bearing reserves against the Bank's transaction accounts (primarily NOW and money-market checking accounts) and non-personal time deposits. Because of its ownership of the Bank, Household International is a savings and loan holding company subject to reporting and other regulations of the OTS. Household International has agreed with the OTS to maintain the regulatory capital of the Bank at certain specified levels. This agreement between Household International and the OTS was amended in 1989 to reflect regulatory changes in the methodology of calculating the Bank's regulatory capital. Household Bank, National Association, Household Bank (Illinois), National Association, Household Bank (Nevada), National Association and Household Bank (SB), National Association are chartered by the Comptroller of the Currency and are members of the Federal Reserve System. The deposit accounts of these national banks are insured by the FDIC. National banks are generally subject to the same type of regulatory supervision and restrictions as the Bank, although these national banks only engage in credit card operations. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), enacted in December 1991, significantly expanded the regulatory and enforcement powers of federal banking regulators, in particular the FDIC. FDICIA also created additional reporting, disclosure and independent auditing requirements, changed FDIC insurance premiums from flat amounts to a new system of risk-based assessments, and placed limits on the ability of depository institutions to acquire brokered deposits. Under FDICIA, there are five tiers of capital measurement for regulatory purposes ranging from "Well-Capitalized" to "Critically Undercapitalized". FDICIA directs banking regulators to take increasingly strong corrective steps, based on the capital tier of any subject insured depository institution, to cause such bank to achieve and maintain capital adequacy. Even if an insured depository institution is adequately capitalized, the banking regulators are authorized to apply corrective measures if the insured depository institution is determined to be in an unsafe or unsound condition or engaging in an unsafe or unsound activity. FDICIA grants the banking regulators broad powers to require undercapitalized institutions to adopt and implement a capital restoration plan and to restrict or prohibit a number of activities, including the payment of cash dividends, which may impair or threaten the capital adequacy of the insured depository institution. FDICIA also expanded the grounds upon which a receiver or conservator may be appointed for an insured depository institution. Pursuant to FDICIA, federal banking regulatory agencies have proposed new safety and soundness standards governing operational and managerial activities of insured depository institutions and their holding companies, regarding internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), among other things, provides generally that, upon the default of any insured institution, the FDIC may assess an affiliated insured depository institution for the estimated losses incurred by the FDIC. Specifically, FIRREA provides that a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. "In danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance. As an insurance company, Alexander Hamilton is subject to regulatory supervision under the laws of the states in which it operates. Regulations vary from state to state but generally cover licensing of insurance companies, premium rates, dividend restrictions, types of insurance that may be sold, permissible investments, policy reserve requirements, and insurance marketing practices. COMPETITION. The consumer credit industry is highly fragmented, with thousands of banks, thrifts and other financial institutions competing in the United States alone. The industry has been consolidating in recent years, and the Company expects this consolidation to continue. The Company believes it has positioned itself to compete effectively and benefit from this consolidation because of its centralized distribution, processing and marketing capabilities, and advanced technology to support these activities. The financial services industry is highly competitive, and the Company's financial services businesses compete with a number of institutions that extend credit to consumers and businesses, some of which are larger than the Company. The Company competes not only with other finance companies, banks, and savings and loan companies, but also with credit unions and retailers. Alexander Hamilton competes with many other life insurance companies offering similar products. ITEM 2. ITEM 2. PROPERTIES. Household International has operations in 35 states in the United States, 10 provinces in Canada, 6 states and 2 territories in Australia and in the United Kingdom with principal facilities located in Anaheim, California; Chesapeake, Virginia; Chicago, Illinois; Elmhurst, Illinois; Farmington Hills, Michigan; Hanover, Maryland; Las Vegas, Nevada; North York, Ontario, Canada; Pomona, California; Prospect Heights, Illinois; St. Leonards, New South Wales, Australia; Salinas, California; Windsor, Berkshire, United Kingdom; Wood Dale, Illinois; and Worthington, Ohio. Substantially all branch offices, bank branches, divisional offices, corporate offices, RPC and RSC space is operated under lease with the exception of the principal executive offices of Household International in Prospect Heights, Illinois, the headquarters building for HFC Bank plc in the United Kingdom, Alexander Hamilton's headquarters building in Farmington Hills, Michigan, and administration buildings in Northbrook, Illinois and Salinas, California. An additional administrative facility is currently under construction in Las Vegas, Nevada. The Company believes that such properties are in good condition and are adequate to meet Household International's current and reasonably anticipated needs. Household International has, and will continue to, invest in property and technological improvements to achieve greater efficiencies in the marketing, servicing and production of its loan products. During 1993 the Company invested $110 million in capital expenditures, compared to $90 million in 1992. Automobiles, office equipment and real estate properties owned and in use by the Company are not significant in relation to the total assets of the Company. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company and its subsidiaries are parties to various legal proceedings, including product liability and environmental claims, resulting from ordinary business activities related to its current operations and/or former businesses which were managed as independent subsidiaries of the Company. Certain of these actions are or purport to be class actions seeking damages in very large amounts. Due to the uncertainties in litigation and other factors, no assurance can be given that the Company or its subsidiaries will ultimately prevail in each instance. However, for all litigation involving the Company and/or its subsidiaries, the Company believes that amounts, if any, that may ultimately be paid by the Company as damages in any such proceedings will not have a material adverse effect on the consolidated financial position of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT. The following information on executive officers of Household International is included pursuant to Item 401(b) of Regulation S-K. Information with respect to Mr. Clark is incorporated herein by reference to "Election of Household Directors--Information Regarding Nominees" in Household International's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders scheduled to be held May 11, 1994 (the "1994 Proxy Statement"). References herein to "Household" refer to Household International, Inc. for all periods after June 26, 1981 (the date of the corporate restructuring by which Household International became the holding company of Household Finance Corporation) and to Household Finance Corporation on and before such date. Robert F. Elliott, age 53, was appointed Group Executive-Office of the President in 1993. Prior thereto he was the Group Executive-U.S. Consumer Finance and Australia. Mr. Elliott joined Household in 1964 and has served in various capacities in the Company's consumer finance business during his career with Household. Joseph W. Saunders, age 48, was appointed Group Executive-Office of the President in 1993, having previously served as Group Executive-U.S. BankCard and Canada: He is also President of the Company's subsidiary, Household Bank, National Association. Prior to joining Household in 1985, Mr. Saunders was Vice President-Credit Card Operations of Bank of America. Antonia Shusta, age 44, was appointed to her present position as Group Executive-Office of the President in 1993. Ms. Shusta joined Household in 1988 as Group Executive-Mortgage Banking and Acquisitions and most recently served as Group Executive-U.S. Consumer and Mortgage Banking and the United Kingdom. Prior to joining Household, she was employed with Citicorp for 16 years, most recently as division executive for its Northern Latin American operation. Glen O. Fick, age 47, was appointed Group Executive-Commercial Finance and President of Household Commercial in 1991. Mr. Fick joined Household in 1971 and has served in various capacities in the Company's treasury, corporate finance and investor relations departments, as well as the specialty commercial services division of its commercial finance business. Gary D. Gilmer, age 43, was appointed President and Chief Executive Officer of Alexander Hamilton in 1993. Mr. Gilmer joined Household in 1972 and has served in various capacities within the consumer finance and banking divisions, most recently as President of Household Retail Services. Richard H. Headlee, age 63, has been Chairman of the Board of Alexander Hamilton since 1988. Mr. Headlee joined Alexander Hamilton in 1970 and served as its Chief Executive Officer from 1972 to 1993. Gaylen N. Larson, age 54, is Group Vice President of Household. Mr. Larson has previously served Household as Chief Accounting Officer, Controller and Group Vice President-Finance. Mr. Larson was a partner of the accounting firm of Deloitte & Touche prior to joining Household in 1979. David B. Barany, age 50, was appointed to his present position as Vice President-Chief Information Officer of Household in 1988. Mr. Barany joined Household in 1985 as Vice President/Controller of Household's financial services business. Prior to joining Household, he was employed by Four Phase Systems, Inc., a subsidiary of Motorola, Inc., as Vice President/Finance. John W. Blenke, age 38, is Assistant General Counsel and Secretary of Household. Mr. Blenke joined Household in 1989 as Corporate Finance Counsel, was promoted to Assistant General Counsel-Securities & Corporate Law and Assistant Secretary in 1991 and was appointed Secretary in 1993. Prior to joining Household, Mr. Blenke was employed with a subsidiary of Transamerica Corporation. Michael A. DeLuca, age 45, joined Household in 1985 as Director of Tax Planning and Tax Counsel and was appointed to his present position as Vice President-Taxes in 1988. Colin P. Kelly, age 51, is Vice President-Human Resources of Household. Mr. Kelly joined Household in 1965 and has served in various management positions, most recently as Senior Vice President-Human Resources of Household's financial services business. Mr. Kelly was appointed to his present position in 1988. Michael H. Morgan, age 39, was appointed to his present position as Vice President-Corporate Communications in 1989. Mr. Morgan joined Household in 1984, and has served in various capacities within the planning and analysis and investor relations areas. From 1978 until joining Household, Mr. Morgan was employed with Arthur Andersen & Co. Randall L. Raup, age 40, was appointed Vice President-Planning in 1992, having most recently served as Vice President-Financial Control Treasury. Since joining Household in 1984, Mr. Raup has held positions in the treasury control, corporate reporting and internal audit areas. Prior to joining Household, he served as an auditor with Esmark, Inc. and KPMG Peat Marwick. Kenneth H. Robin, age 47, was appointed Vice President-General Counsel of Household in 1993, having previously served as Assistant General Counsel -- Financial Services. Prior to joining Household in 1989, Mr. Robin was employed with Citicorp from 1977 to 1989, most recently as a vice president responsible for legal policies for its operations in 23 countries in the Caribbean, Central America and South America. David A. Schoenholz, age 42, was appointed Vice President-Chief Accounting Officer of Household in 1993, Vice President in 1989 and Controller in 1987. He joined Household in 1985 as Director-Internal Audit. Prior to joining Household, Mr. Schoenholz was employed with The Commodore Corporation, a manufacturer of mobile homes, as Vice President/Controller from 1983 to 1985. Charles R. Wallace, age 45, was appointed Corporate Controller of Household in 1993, having previously served as Executive Vice President-Chief Operating Officer of Hamilton Investments since 1989. Prior to joining Household, Mr. Wallace was employed with Clayton Brown & Associates, Inc. and Ernst & Young. There are no family relationships among the executive officers of the Company. The term of office of each executive officer is at the discretion of the Board of Directors. PART II. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The number of record holders of Household International's Common Stock, as of March 16, 1994, was 14,679. Additional information required by this Item is incorporated by reference to page 32 of Household International's 1993 Annual Report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Information required by this Item is incorporated by reference to page 34 of Household International's 1993 Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Information required by this Item is incorporated by reference to pages 38 through 51 of Household International's 1993 Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Financial Statements of Household International and subsidiaries meeting the requirements of Regulation S-X, and supplementary financial information specified by Item 302 of Regulation S-K, is incorporated by reference to pages 35 through 37 and pages 52 through 80 of Household International's 1993 Annual Report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information required by this Item is incorporated by reference to "Election of Household Directors-- Information Regarding Nominees" and "Shares of Household Stock Beneficially Owned by Directors and Executive Officers" in Household International's 1994 Proxy Statement. Also, information on certain Executive Officers appears in Part I of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information required by this Item is incorporated by reference to "Remuneration of Executive Officers", "Savings--Stock Ownership and Pension Plans", "Incentive and Stock Option Plans", and "Directors' Compensation" in Household International's 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information required by this Item is incorporated by reference to "Shares of Household Stock Beneficially Owned by Directors and Executive Officers" and "Security Ownership of Certain Beneficial Owners" in Household International's 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information required by this Item is incorporated by reference to "Remuneration of Executive Officers" in Household International's 1994 Proxy Statement. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) FINANCIAL STATEMENTS. The following financial statements, together with the opinion thereon of Arthur Andersen & Co., dated February 1, 1994, appearing on pages 35 through 37 and pages 52 through 80 of Household International's 1993 Annual Report are incorporated herein by reference. An opinion of Arthur Andersen & Co. is included in this Annual Report on Form 10-K. Household International, Inc. and Subsidiaries: Statements of Income for the Three Years Ended December 31, 1993. Balance Sheets, December 31, 1993 and 1992. Statements of Cash Flows for the Three Years Ended December 31, 1993. Statements of Changes in Preferred Stock and Common Shareholders' Equity for the Three Years Ended December 31, 1993. Business Segment Data. Notes to Financial Statements. Independent Auditors' Report. Selected Quarterly Financial Data (Unaudited). (B) REPORTS ON FORM 8-K. During the three months ended December 31, 1993, the Company did not file with the Securities and Exchange Commission any Current Report on Form 8-K. (C) EXHIBITS. Copies of exhibits referred to above will be furnished to stockholders upon written request at a cost of fifteen cents per page. Requests should be made to Household International, Inc., 2700 Sanders Road, Prospect Heights, Illinois 60070, Attention: Office of the Secretary. (D) SCHEDULES. Report of Independent Public Accountants. III--Condensed Financial Information of Registrant. VIII--Valuation and Qualifying Accounts. X--Supplementary Statement of Income Information. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, HOUSEHOLD INTERNATIONAL, INC. HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. HOUSEHOLD INTERNATIONAL, INC. Dated: March 28, 1994 By /s/ D. C. CLARK ------------------------------------ D. C. Clark, Chairman of the Board and Chief Executive Officer PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF HOUSEHOLD INTERNATIONAL, INC. AND IN THE CAPACITIES AND ON THE DATE INDICATED. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS Household International, Inc.: We have audited in accordance with generally accepted auditing standards, the financial statements included in Household International, Inc.'s 1993 annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 1, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14(d) are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois February 1, 1994 SCHEDULE III HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONDENSED STATEMENTS OF INCOME (ALL DOLLAR AMOUNTS EXCEPT PER SHARE DATA ARE STATED IN MILLIONS.) - --------------- * Amounts have been restated to reflect the two-for-one stock split in the form of a 100 percent stock dividend, effective October 15, 1993. See accompanying notes to condensed financial statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONDENSED BALANCE SHEETS (IN MILLIONS) See accompanying notes to condensed financial statements. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CONDENSED STATEMENTS OF CASH FLOWS (IN MILLIONS) See accompanying notes to condensed financial statements - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT 1. FINANCE RECEIVABLES Receivables at December 31 consisted of the following (in millions): 2. SENIOR DEBT (WITH ORIGINAL MATURITIES OVER ONE YEAR) Debt at December 31 consisted of the following (in millions): 3. COMMITMENTS Under an agreement with the Office of Thrift Supervision, the Company will maintain the net worth of Household Bank, f.s.b., at a level consistent with certain minimum net worth requirements. The Company has guaranteed payment of all debt obligations issued subsequent to 1989 (excluding deposits) of Household Financial Corporation Limited ("HFCL"), a Canadian subsidiary. The amount of guaranteed debt outstanding at HFCL on December 31, 1993 was approximately $853 million. The Company has also guaranteed payment of all debt obligations (excluding certain deposits) of Household International (U.K.) Limited ("HIUK"). The amount of guaranteed debt outstanding at HIUK on December 31, 1993 was approximately $936 million. The Company has guaranteed payment of a $62 million deposit held by one of its operating subsidiaries on behalf of another operating subsidiary. 4. CONVERTIBLE PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION At December 31, 1993 and 1992, the Company had outstanding 385,439 and 720,415 shares, respectively, of the $6.25 cumulative convertible preferred stock subject to mandatory redemption provisions (the "$6.25 stock"). Each share of the $6.25 stock is convertible, at the option of its holder, into 4.654 shares of common stock, is entitled to one vote, as are common shares, and has a liquidation value of $50 per share. Holders of such stock are entitled to payment before any capital distribution is made to common shareholders. The Company is required to call for redemption, on an annual basis through 2010, a minimum of 4 percent to a maximum of 8 percent of the 3.5 million originally issued shares and is required to redeem all of the remaining unconverted and unredeemed shares in 2011. The Company called for redemption 8 percent of the originally issued shares in both 1993 and 1992. The Company redeemed 2,323 and 4,711 shares for $50 per share in 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT -- (CONTINUED) and 1992, respectively. The remaining shares called, but not redeemed for cash, were converted into common stock. If certain conditions are met, the Company may redeem the entire $6.25 stock issue at $50 per share plus accrued and unpaid dividends. At December 31, 1993, 1.8 million shares of common stock were reserved for conversion of the $6.25 stock. 5. COMMON STOCK On September 14, 1993 the Board of Directors of the Company declared a two-for-one stock split in the form of a 100 percent stock dividend effective October 15, 1993. The stock split resulted in an increase in common stock and a reduction in additional paid-in capital of $56.6 million. All share and per share data, except as otherwise indicated, have been restated to give retroactive effect to the stock split. On March 8, 1993 the Company sold 4,025,000 shares of common stock at $68.88 per share, on a pre-split basis. Net proceeds of approximately $269 million were used for general corporate purposes, including investments in the Company's subsidiaries and reduction of short-term debt. Assuming the additional shares of common stock had been issued on January 1, 1993 and the proceeds resulted in after-tax interest savings from reduction of short-term debt since that date, earnings per share for 1993 would have been $2.82 per share on a fully diluted basis. Common stock at December 31 consisted of the following (millions of shares): - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT -- (CONTINUED) 6. PREFERRED STOCK Preferred stock at December 31 consisted of the following (in millions): - --------------- (1) Depositary share represents 1/4 share of preferred stock. (2) Depositary share represents 1/10 share of preferred stock. (3) Depositary share represents 1/40 share of preferred stock. Dividends on the 9.50 percent preferred stock, Series 1989-A, are cumulative and payable quarterly. The Company may, at its option, redeem in whole or in part the 9.50 percent preferred stock, Series 1989-A, at $26.19 per depositary share beginning on November 9, 1994 and at amounts declining to $25 per depositary share thereafter, plus accrued and unpaid dividends. Dividends on the 9.50 percent preferred stock, Series 1991-A, are cumulative and payable quarterly. The Company may, at its option, redeem in whole or in part the 9.50 percent preferred stock, Series 1991-A, on any date after August 13, 1996 for $10 per depositary share plus accrued and unpaid dividends. Dividends on the 8.25 percent preferred stock, Series 1992-A, are cumulative and payable quarterly. The Company may, at its option, redeem in whole or in part the 8.25 percent preferred stock, Series 1992-A, on any date after October 15, 2002 for $25 per depositary share plus accrued and unpaid dividends. Dividends on the 7.35 percent preferred stock, Series 1993-A, are cumulative and payable quarterly. The Company may, at its option, redeem in whole or in part the 7.35 percent preferred stock, Series 1993-A, on any date after October 15, 1998 for $25 per depositary share plus accrued and unpaid dividends. On October 1, 1993 the Company redeemed 450,000 shares (equivalent to 4,500,000 depositary shares) of the 11.25 percent Enhanced Rate Cumulative Preferred Stock for $102.50 per share plus accrued and unpaid dividends. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE III (CONTINUED) HOUSEHOLD INTERNATIONAL, INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT -- (CONTINUED) On July 13, 1993 the Company redeemed 350,000 shares of the Flexible Rate Auction Preferred Stock ("Flex APS"), Series A, for $100 per share plus accrued and unpaid dividends. Dividends on the Flex APS are cumulative and payable when and as declared by the Board of Directors of the Company. The initial dividend rate on the Flex APS, Series B, is 9.50 percent. The initial rate on the Flex APS, Series B, extends through July 15, 1995, with subsequent dividend rates determined in accordance with a formula based on orders placed in a dutch auction generally held every 49 days. The Company may, at its option, redeem in whole or in part the Flex APS, Series B, for $100 per share plus accrued and unpaid dividends beginning on July 15, 1995. Each preferred stock issue ranks equally with the $6.25 stock and has a liquidation value of $100 per share except for the 8.25 percent preferred stock, Series 1992-A, and the 7.35 percent preferred stock, Series 1993-A, each of which have a liquidation value of $1,000 per share. Holders of all issues of preferred stock are entitled to payment before any capital distribution is made to common shareholders. The Company is authorized to issue cumulative nonconvertible preferred stock in one or more series in an amount not to exceed $620 million, and currently has $320 million of such preferred stock outstanding. 7. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS No. 109"). As a result of implementing FAS No. 109, retained earnings for all periods between 1986 and 1992 have been reduced by approximately $63 million from amounts previously reported. The statements of income for those periods subsequent to December 31, 1986 have not been restated as the impact of FAS No. 109 on net income is immaterial to any such year and in total. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE VIII HOUSEHOLD INTERNATIONAL, INC. VALUATION AND QUALIFYING ACCOUNTS FOR THE THREE YEARS ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SCHEDULE X HOUSEHOLD INTERNATIONAL, INC. SUPPLEMENTARY STATEMENT OF INCOME INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - --------------- * Represents less than 1 percent of total revenues as reported in the related consolidated statements of income. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- EXHIBIT INDEX

21267_1993.txt

21267_1993

1993

21267

ITEM 1. BUSINESS. INTRODUCTION Coastal, acting through its subsidiaries, is a diversified energy holding company with subsidiary operations in natural gas marketing, processing, storage and transmission; petroleum refining, marketing and distribution; gas and oil exploration and production; coal mining; chemicals; independent power production; and trucking. The Company was incorporated under the laws of Delaware in 1972 to become the successor parent, through a corporate restructuring, of a corporate enterprise founded in 1955. The Company employed approximately 16,000 persons as of December 31, 1993. Annual Reports on Form 10-K for the year ended December 31, 1993, are also filed by Coastal's subsidiaries, ANR Pipeline and Colorado, and by each of the six limited partnership oil and gas drilling programs, of which Coastal's subsidiary, Coastal Limited Ventures, Inc., is the managing general partner. Such reports contain additional details concerning the reporting organizations. The operating revenues and operating profit of the Company by industry segment for the years ended December 31, 1993, 1992 and 1991, and the related identifiable assets as of December 31, 1993, 1992 and 1991, are set forth in Note 10 of the Notes to Consolidated Financial Statements included herein. Information concerning inventories is set forth in Note 2 of the Notes to Consolidated Financial Statements included herein. NATURAL GAS SYSTEMS OPERATIONS GENERAL Natural gas operations involve the production, purchase, gathering, processing, transportation, balancing, storage and sale of natural gas to and for utilities, industrial customers, distributors, other pipeline companies and end-users. ANR Pipeline is involved in the storage, transportation and balancing of natural gas. ANR Pipeline provides these services for various customers through its facilities located in Arkansas, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Michigan, Mississippi, Missouri, Nebraska, New Jersey, Ohio, Oklahoma, Tennessee, Texas, Wisconsin, Wyoming and offshore in federal waters. Prior to November 1, 1993, ANR Pipeline was also engaged in the sale for resale of natural gas. With ANR Pipeline's implementation of Order 636 effective November 1, 1993, ANR Pipeline no longer provides a merchant service. However, former gas sales customers of ANR Pipeline have largely retained their firm storage and transportation service levels previously included in their "bundled" gas sales services. ANR Pipeline will auction gas on the open market as part of its gas restructuring program designed to handle the continuation of certain gas purchase contracts pending renegotiation or expiration of such contracts. ANR Pipeline's gas sales for resale customers previously included 51 local distributors in Michigan, Wisconsin, Illinois, Indiana, Iowa, Kansas, Missouri, Ohio and Tennessee. ANR Pipeline operates two major offshore gas pipeline systems in the Gulf of Mexico which are owned by HIOS and UTOS, general partnerships composed of ANR Pipeline subsidiaries and subsidiaries of other pipeline companies. ANR Pipeline also operates Empire, a 156-mile pipeline extending from Niagara Falls to Syracuse, New York, in which an affiliate of ANR Pipeline has a 45% interest. During 1993, approximately 62% of ANR Pipeline's gas supply was purchased from gas producers and marketers in Illinois, Indiana, Kansas, Louisiana, Michigan, Mississippi, Oklahoma, Texas, Wisconsin, Wyoming and the Texas and Louisiana offshore areas; approximately 32% was obtained from three Canadian suppliers; and approximately 6% was purchased from the Dakota Gasification Company in North Dakota. ANR Pipeline's two interconnected large-diameter multiple pipeline systems transport gas to the Midwest from (a) the Hugoton Field and other fields in the Anadarko Basin in Texas and Oklahoma and (b) the Louisiana onshore and Louisiana and Texas offshore areas. Gas from Wyoming and Canada is obtained by ANR Pipeline through transportation and exchange agreements with other companies. ANR Pipeline's principal pipeline facilities at December 31, 1993 consisted of 12,657 miles of pipeline and 97 compressor stations with 1,069,788 installed horsepower. At December 31, 1993, the design peak day delivery capacity of the transmission system, considering supply sources, storage, markets and transportation for others, was approximately 5.6 Bcf per day. Colorado is involved in all phases of the production, gathering, processing, transportation, storage and sale of natural gas. Colorado purchases and produces natural gas and makes sales of such gas principally to local gas distribution companies for resale. Separately, Colorado contracts to gather, process, transport and store natural gas owned by third parties. Colorado's gas transmission system extends from gas production areas in the Texas Panhandle, western Oklahoma and western Kansas, northwesterly through eastern Colorado to the Denver area, and from production areas in Montana, Wyoming and Utah, southeasterly to the Denver area. Colorado's gas gathering and processing facilities are located throughout the production areas adjacent to its transmission system. Most of Colorado's gathering facilities connect directly to its transmission system, but some gathering systems are connected to other pipelines. Colorado also has certain gathering facilities located in New Mexico. Colorado owns four underground gas storage fields; three located in Colorado, and one in Kansas. Colorado's principal pipeline facilities at December 31, 1993 consisted of 6,347 miles of pipeline and 65 compressor stations with approximately 346,000 installed horsepower. At December 31, 1993, the design peak day delivery capacity of the transmission system was approximately 2.0 Bcf per day. The underground storage facilities have a working capacity of approximately 29 Bcf per year and a peak day delivery capacity of approximately 769 MMcf. The Company formed CGS as a wholly-owned subsidiary in early 1993 to consolidate its unregulated natural gas businesses. CGS and its subsidiaries operate certain of Coastal's natural gas gathering and processing, gas supply and marketing, price risk management and producer financing activities. COMPETITION ANR Pipeline and Colorado have historically competed with interstate and intrastate pipeline companies in the sale, storage and transportation of gas and with independent producers, brokers, marketers and other pipelines in the gathering, processing and sale of gas within their service areas. On October 1, 1993 and November 1, 1993, Colorado and ANR Pipeline, respectively, implemented Order 636 on their systems. As a consequence, ANR Pipeline is no longer a seller of natural gas to resale customers. Order 636 also mandated implementation of capacity release and secondary delivery point options allowing a pipeline's firm transportation customers to compete with the pipeline for interruptible transportation, which may result in reduced interruptible transportation revenue of pipelines. Additional information on this subject is included under "Regulations Affecting Gas Systems" included herein. Natural gas competes with other forms of energy available to customers, primarily on the basis of price. These competitive forms of energy include electricity, coal, propane and fuel oils. Changes in the availability or price of natural gas or other forms of energy, as well as changes in business conditions, conservation, legislation or governmental regulations, capability to convert to alternate fuels, changes in rate structure, taxes and other factors may affect the demand for natural gas in the areas served by ANR Pipeline and Colorado. ANR Pipeline's storage, transportation and balancing services are influenced by its customers' access to alternative providers of such services. ANR Pipeline competes directly with Panhandle Eastern Pipe Line Company, Trunkline Gas Company, Northern Natural Gas Company, Natural Gas Pipeline Company of America, Michigan Consolidated Gas Company and CMS Energy Company in its principal market areas of Michigan and Wisconsin for its storage, transportation and balancing business. ANR PIPELINE GAS SALES FOR RESALE AND TRANSPORTATION ANR Pipeline transports gas to markets on its system and other markets under transportation and exchange arrangements with other companies, including distributors, intrastate and interstate pipelines, producers, brokers, marketers and end-users. Typically, these arrangements call for ANR Pipeline to transport such gas to points of interconnection with local distribution companies or other interstate pipelines. Transportation service revenues provided by ANR Pipeline amounted to $533 million for 1993 compared to $463 million for 1992 and $382 million for 1991. During the period January through October of 1993, ANR Pipeline sold 228 Bcf of gas, of which approximately 71% was sold to its three largest customers: Michigan Consolidated Gas Company, Wisconsin Gas Company and Wisconsin Natural Gas Company. Michigan Consolidated Gas Company serves the City of Detroit and certain surrounding areas, the industrial cities of Grand Rapids and Muskegon, the communities of Ann Arbor and Ypsilanti and numerous other communities in Michigan. Wisconsin Gas Company serves the Milwaukee metropolitan area and numerous other communities in Wisconsin. Wisconsin Natural Gas Company serves the industrial cities of Racine, Kenosha, Appleton and their surrounding areas in Wisconsin. In 1993, ANR Pipeline provided 71% and 33% of the total gas requirements for Wisconsin and Michigan, respectively. Gas sales for resale by ANR Pipeline amounted to $604 million for 1993, compared to $635 million for 1992 and $641 million for 1991. ANR Pipeline's deliveries for the years 1993, 1992 and 1991 are as follows: On November 1, 1992, as part of its Interim Settlement, ANR Pipeline implemented a restructuring of its traditional sales service by replacing existing services with a combination of competitive service alternatives. This restructuring provided a number of options for pipeline customers and was designed to enhance competition in ANR Pipeline's service areas. Under this restructuring, the sales service was "unbundled" on an interim basis into firm sales, transportation, flexible storage and flexible delivery services. Prior to the restructuring, the cost of providing transportation services for sales customers was recovered as part of ANR Pipeline's total resale rate and therefore, was classified as part of gas sales revenue. Under the restructuring, these costs were recovered through a separate rate and were included in transportation revenue. Additional information concerning the restructuring is set forth in "Regulations Affecting Gas Systems - Rate Matters" included herein. Effective November 1, 1993, ANR Pipeline implemented Order 636. This Order required significant changes in the services provided by ANR Pipeline, and resulted in the elimination of ANR Pipeline's merchant service. ANR Pipeline now offers an array of "unbundled" storage, transportation and balancing service options. Additional information concerning Order 636, including transportation and storage, is set forth in "Regulations Affecting Gas Systems - General" included herein. GAS PURCHASES Effective November 1, 1993, as a result of the elimination of ANR Pipeline's merchant service, as mentioned above, ANR Pipeline's gas purchases decreased substantially. However, ANR Pipeline still purchases gas under a number of gas purchase contracts. ANR Pipeline's Order 636 restructured tariff provides mechanisms for the purpose of recovering from or refunding to its customers any pricing differential between costs incurred to purchase this gas and the amount ANR Pipeline recovers through auctioning of gas on the open market. Of ANR Pipeline's gas purchases in 1993, approximately 62% was obtained directly from producers, including 17% from affiliates. In addition, ANR Pipeline received approximately 32% of its gas supply from Canadian suppliers and 6% from a producer of synthetic fuels. The border price of gas originating in Canada has been based on policies, established in 1984 by the NEB and the OFE, allowing exporters and importers to negotiate market-responsive prices. Gas purchase contracts with producers generally provide for minimum purchase obligations based on estimated reserves under the well, the well's ability to produce or allowable gas takes set by state regulatory agencies. The prices paid depend upon, among other things, contractual requirements, market conditions, and the quality, condition of delivery and location of the gas. Under the NGWDA, effective July 26, 1989, all gas which would otherwise continue to be subject to price controls under the NGPA was deregulated over a three-year period and complete deregulation became effective January 1, 1993. Some of ANR Pipeline's remaining gas purchase contracts with independent producers contain provisions which require taking minimum volumes and/or making prepayments for volumes not taken if purchases fall below specified levels during the contract year ("take-or-pay"). Additional information on take-or-pay matters is set forth in Note 3 of the Notes to Consolidated Financial Statements included herein. GAS STORAGE ANR Pipeline owns seven and leases eight underground storage facilities in Michigan. The total working storage capacity of the system is approximately 193 Bcf, with a maximum day delivery capacity of 2 Bcf as late as the end of February. However, of the 193 Bcf, ANR Pipeline has proposed to the FERC to reclassify 62.1 Bcf of working gas to recoverable base gas. ANR Pipeline also has the contract rights for 42 Bcf of storage capacity provided by Blue Lake Gas Storage Company, 30 Bcf of storage capacity provided by ANR Storage and 10 Bcf of storage capacity provided by Michigan Consolidated Gas Company. The contract with Michigan Consolidated Gas Company expires in March 1994. Underground storage services of up to 166 Bcf of gas are provided by ANR Pipeline to customers on a firm basis. ANR Pipeline also provides interruptible storage services for customers on a short-term basis. Coastal's independent engineers, Huddleston, have estimated that ANR Pipeline's gas storage reserves as of December 31, 1993, 1992 and 1991 were 106.5 Bcf, 128 Bcf and 134 Bcf, respectively. The 1993 gas storage reserves are comprised of 19.4 Bcf of natural gas, maintained under ANR Pipeline's own account as working gas for system balancing and no-notice storage services; 25 Bcf of recoverable base gas reserves in seven owned storage fields; and 62.1 Bcf of working gas which ANR Pipeline has proposed to the FERC to reclassify as recoverable base gas. The decrease in the gas storage reserves between 1993 and 1992 reflects ANR Pipeline's elimination of its merchant service. Effective November 1, 1993, ANR Pipeline storage reserves are solely used to facilitate the overall operations of the system. COLORADO GAS SALES, STORAGE AND TRANSPORTATION Beginning in October 1993, Colorado implemented Order 636 on its system and as required by the Order, Colorado's gas sales are now made at "upstream" locations (typically the wellhead). Colorado's gas sales contracts extend through September 30, 1996, but provide for reduced customer purchases to be made each year. Under Order 636, Colorado's certificate to sell gas for resale allows sales to be made at negotiated prices and not at prices established by FERC. Colorado is also authorized to abandon all sales for resale at such time as the contracts expire and without prior FERC approval. Effective October 1, 1993, Colorado formed an unincorporated Merchant Division to conduct most of Colorado's sales activity in the Order 636 environment. The gas sales volumes reported include those sales which continue to be made by Colorado together with those of its Merchant Division. Effective on October 1, 1993, Colorado assigned an undivided interest in a portion of its company-owned leases (representing approximately 20% of Colorado's owned reserves) to a new subsidiary. The subsidiary has entered into a contract to sell the production to Colorado's Merchant Division, which utilizes the gas primarily for its sales to Colorado's traditional customers. The reserve volumes reported represent those interests retained by Colorado together with those assigned to the new subsidiary. Gas sales revenues were $223 million in 1993, compared to $261 million in 1992. This decrease is due largely to the fact that prior to the mandated restructuring under Order 636 the costs of providing gathering, storage and transportation services for sales customers were recovered as part of the total resale rate and were classified as part of gas sales revenue. Subsequent to restructuring, these costs are now recovered under separate rates for each service. Colorado has engaged in "open access" transportation and storage of gas owned by third parties for several years. In addition, prior to October 1, 1993, Colorado provided storage and transportation services as part of its "bundled" sales service. As a result of Order 636, the Company has "unbundled" these services from its sales services and will continue to provide these services to third parties under individual contracts. Such services will be at negotiated rates that are within minimum and maximum levels established by the FERC. Also, pursuant to Order 636, Colorado, on September 30, 1993, sold all of its working gas except for 3.8 Bcf which it retained for operational needs. Colorado's deliveries for the years 1993, 1992 and 1991 are as follows: GAS GATHERING AND PROCESSING Prior to Order 636, Colorado gathered and processed gas incident to its "bundled" sales service (which also included storage and transportation activities). However, in compliance with the FERC mandated restructuring, Colorado now provides gathering and processing services on an "unbundled" or stand-alone basis. Colorado contracts for these services under terms which are negotiated. With respect to gathering, Colorado is limited to charging rates which are between minimum and maximum levels approved by the FERC. Processing terms are not subject to FERC approval, but Colorado is required to provide "open access" to its processing facilities. Colorado has 2,994 miles of gathering lines and 110,500 horsepower of compression in its gathering operations. Colorado owns and operates six gas processing plants which recovered approximately 86 million gallons of liquid hydrocarbons in 1993, compared to 77 million gallons in 1992 and 61 million gallons in 1991, and 4,400 long tons of sulfur in 1993 and 3,600 long tons in both 1992 and 1991. Additionally, in 1993, Colorado processed approximately 12 million gallons of liquid hydrocarbons owned by others compared to 10 million in 1992 and 11 million in 1991. These plants, with a total operating capacity of approximately 697 MMcf daily, recover mainly propane, butanes, natural gasoline, sulfur and other by-products, which are sold to refineries, chemical plants and other customers. ANR STORAGE ANR Storage develops and operates gas storage reservoirs to store gas for customers under firm long-term contracts. ANR Storage owns four underground storage fields and related facilities in northern Michigan, the working storage capacity of which is approximately 53 Bcf, including 30 Bcf contracted to ANR Pipeline. ANR Storage also owns a 50% equity interest in 3 joint venture storage facilities located in Michigan and New York with a total working storage capacity of approximately 60 Bcf, including 42 Bcf contracted to ANR Pipeline. GAS SYSTEM RESERVES AND AVAILABILITY ANR PIPELINE With the termination of its merchant service, ANR Pipeline no longer reports on gas system reserves and availability and, therefore, this report has been replaced by a general discussion set forth in "Supply Area Deliverability", presented below. SUPPLY AREA DELIVERABILITY Shippers on ANR Pipeline have direct access to the two most prolific gas supply areas in the United States, the Gulf Coast and Midcontinent. Statistics published by the Energy Information Agency, Office of Oil and Gas, U.S. Department of Energy, indicate that approximately 82% of all natural gas in the lower 48 states is produced from these two supply areas. Interconnecting pipelines provide shippers with access to all other major gas supply areas in the United States and Canada. Gas deliverability available to shippers on ANR Pipeline's system from the Midcontinent and Gulf Coast supply areas through direct connections and interconnecting pipelines and gatherers is approximately 3,800 MMcf per day. An additional 275 MMcf per day of deliverability is accessible to shippers on ANR Pipeline owned, or partially owned, pipeline segments not directly connected to an ANR Pipeline mainline. ANR Pipeline remains active in locating and connecting new gas supply sources to facilitate transportation arrangements made by third party shippers. During 1993, field development, newly connected supply sources and pipeline interconnections contributed 515 MMcf per day to total deliverability accessible to shippers on ANR Pipeline. COLORADO Colorado has reported in its Form 10-K for the year ended December 31, 1993 the current and future availability of Colorado's gas system reserves based on information prepared by Huddleston, the Company's independent engineers. Colorado, even with the restructuring under Order 636, continues to dedicate certain of its reserves pursuant to contract. Additional information is set forth in "Reserves Dedicated to a Particular Customer," presented below. RESERVES DEDICATED TO A PARTICULAR CUSTOMER Colorado is committed to provide gas to Mesa Operating Company, formerly Mesa Operating Limited Partnership ("Mesa"), a customer, from specific owned gas reserves in the West Panhandle Field of Texas. Production from this area contributed approximately 46% of Colorado's total supply in 1993. Approximately 68% of those volumes were delivered to Mesa. Under an agreement which was effective January 1, 1991, as amended, Colorado has the right to take a cumulative 23% of the total net production from such reserves for its customers other than Mesa. RECONCILIATION WITH FERC FORM 15 REPORT The FERC Form 15 Annual Report of Gas Supplies is no longer required pursuant to FERC Order No. 554 issued July 13, 1993. WYOMING INTERSTATE COMPANY, LTD. WIC, a limited partnership owned by two wholly-owned Coastal subsidiaries, owns a 269-mile, 36-inch diameter pipeline across southern Wyoming. It has a throughput capacity of approximately 500 MMcf of gas daily. The WIC pipeline connects with an 88-mile western segment in which a Coastal subsidiary has a 10% interest and is the center section of the 800-mile Trailblazer pipeline system built by a group of companies to move gas from the Overthrust Belt and other Rocky Mountain areas to supply midwestern and eastern markets. Colorado and three other pipeline companies for which the WIC line transports gas have entered into long-term contracts having demand volumes totaling 500 MMcf daily. In 1993, the WIC line transported an average of 228 MMcf daily, compared to 261 MMcf daily in 1992. On January 1, 1992, WIC became an unrestricted open access transporter. GREAT LAKES GAS TRANSMISSION LIMITED PARTNERSHIP Coastal and TransCanada, a non-affiliated company, each own 50% of Great Lakes which owns a 1,985-mile, 36-inch diameter gas pipeline system from the Manitoba-Minnesota border to an interconnection on the Michigan-Ontario border at St. Clair, Michigan. Great Lakes transported 854 Bcf in 1993 as compared to 789 Bcf in 1992. Great Lakes has contract commitments to transport a total of 1.3 Bcf per day for TransCanada. It also transports up to 800 MMcf per day primarily for United States markets, including 77 MMcf per day to ANR Pipeline. Great Lakes exchanges gas with ANR Pipeline by delivering gas in the upper peninsula of Michigan and receiving an equal amount of gas in the lower peninsula of Michigan. This arrangement reduces the distance that gas must be transported by Great Lakes and ANR Pipeline. COASTAL GAS SERVICES COMPANY The Company formed CGS, a wholly-owned subsidiary, in early 1993 to consolidate its unregulated natural gas businesses. CGS and its subsidiaries operate certain of Coastal's natural gas gathering and processing, gas supply and marketing, price risk management and producer financing activities. CGS' subsidiary, ANR Gas Supply Company, was formed to provide merchant services to former ANR Pipeline customers contracting for such service. ANR Gas Supply Company has executed 25 contracts with former ANR Pipeline customers with an aggregate service commitment of 85 MMcf per day. CGMC is the largest of CGS's subsidiaries and continues to be one of the most successful natural gas marketing companies in North America. CGMC managed the sale and delivery of 828 Bcf of natural gas in 1993 as compared to 788 Bcf in 1992. CGMC conducts business on over 60 pipelines and has over 1,000 producer and market customers in North America, including imports and exports with Canada and Mexico. REGULATIONS AFFECTING GAS SYSTEMS GENERAL Under the NGA, the FERC has jurisdiction over ANR Pipeline, Colorado, WIC, ANR Storage and Great Lakes as to sales, transportation, balancing of gas, rates and charges, the construction of new facilities, extension or abandonment of service and facilities, accounts and records, depreciation and amortization policies and certain other matters. Under Order 636, the FERC has determined that it will not regulate sales rates by pipelines including these companies. Additionally FERC has asserted rate-regulation (but not certificate regulation) over gathering. Colorado is challenging the FERC's assertion of rate jurisdiction over gathering, but has agreed in a settlement that for three years beginning October 1, 1993 Colorado will post in its tariff the minimum and maximum gathering rates which will be established by FERC. ANR Pipeline, Colorado, WIC, ANR Storage and Great Lakes, where required, hold certificates of public convenience and necessity issued by the FERC covering their jurisdictional facilities, activities and services. ANR Pipeline, Colorado, WIC, ANR Storage and Great Lakes are also subject to regulation with respect to safety requirements in the design, construction, operation and maintenance of their interstate gas transmission and storage facilities by the Department of Transportation. Operations on United States government land are regulated by the Department of the Interior. On November 1, 1990, the FERC issued Order No. 528 in which it sets forth guidelines for an acceptable allocation method for a fixed direct charge to collect take-or-pay settlement costs. Pursuant to Order No. 528, ANR Pipeline has filed for and received approval to recover 75% of expenditures associated with resolving producer claims and renegotiating gas purchase contracts. The approved filings provide for recovery of 25% of such expenditures via a direct bill to ANR Pipeline's former sales for resale customers and 50% via a surcharge on all transportation volumes. Contract reformation and take-or-pay costs incurred as a result of the mandated Order 636 restructuring will be recovered under the transition costs mechanisms of Order 636 as well as through negotiated agreements with ANR Pipeline's customers. FERC Order Nos. 500 and 528 allowed regulated pipelines, including Colorado, to recover, through a fixed charge, from 25% to 50% of the cost of payments made to producers to extinguish outstanding claims under existing gas purchase contracts or to secure reformation of existing contracts. Fixed charges are paid by pipeline customers without regard to volumes of gas purchased. Under this election, however, an amount equivalent to the amount included in the fixed charge must be borne by the pipeline. Colorado has incurred costs related to contract reformation and settlements of take-or-pay claims, a portion of which have been recovered under Order Nos. 500 and 528. On April 8, 1992, the FERC issued Order Nos. 636, 636-A and 636-B (collectively "Order 636"), which required significant changes in the services provided by interstate natural gas pipelines. Subsidiaries of the Company and numerous other parties have sought judicial review of aspects of Order 636. Notwithstanding those appeals, ANR Pipeline, Colorado, WIC, ANR Storage and Great Lakes have successfully complied with the requirements of Order 636. On July 2, 1993, Colorado submitted to the FERC an unanimous offer of settlement which resolved all the Order 636 restructuring issues which had been raised in its restructuring proceedings. That settlement was ultimately approved (except for minor issues), and Colorado's restructured services became effective October 1, 1993. Under that settlement, Colorado has "unbundled" its gas sales from its other services. Separate gathering, transportation, storage, no notice transportation and storage and other services are available on a "stand alone" basis to any customers desiring them. Colorado's Order 636 transition costs are not expected to be material and are expected to be recovered through Colorado's rates. ANR Pipeline placed its restructured services under Order 636 into effect on November 1, 1993. ANR Pipeline now offers a wide range of "unbundled" transportation, storage and balancing services. Several persons, including ANR Pipeline, have sought judicial review of aspects of the FERC's orders approving ANR Pipeline's restructuring filings. Order 636 also provides mechanisms for recovery of transition costs associated with compliance with that Order. These transition costs include gas supply realignment costs, the cost of stranded pipeline investment and the cost of new facilities required to implement Order 636. ANR Pipeline expects that it will incur transition costs of approximately $150 million. As a result of the recovery mechanisms provided under Order 636, ANR Pipeline anticipates that these transition costs will not have a material adverse effect on ANR Pipeline's consolidated financial position or its results of operations. RATE MATTERS ANR PIPELINE. All of ANR Pipeline's 1993 service options were subject to rate regulation by the FERC. Under the NGA, ANR Pipeline must file with the FERC to establish or adjust its service rates. The FERC may also initiate proceedings to determine whether ANR Pipeline rates are "just and reasonable." On March 10, 1992, ANR Pipeline submitted to the FERC a comprehensive Interim Settlement designed to resolve all outstanding issues resulting from its 1989 rate case and its 1990 proposed service restructuring proceeding. The Interim Settlement involved, inter alia, an array of new sales, delivery, transportation and storage service alternatives and the implementation of a gas inventory charge, designed to compensate ANR Pipeline for the costs of standing ready to serve its sales customers. The Interim Settlement reflected a decrease in cost of service of approximately $45 million, which was largely attributable to a reduction in depreciation rates from 3.4% to 1.82%. Also included was a provision which allowed ANR Pipeline to direct bill its customers for its remaining unrecovered purchased gas costs. The Interim Settlement became effective November 1, 1992 and expired with ANR Pipeline's implementation of Order 636 on November 1, 1993. Specific provisions of the Interim Settlement relating to the deferral and future recovery of certain costs remain in effect. On December 17, 1992, the FERC issued a policy statement that outlined changes on how pipelines may recover the costs of employees' postretirement benefits other than pensions. The FERC's policy will be to recognize, as a component of jurisdictional cost-based rates, allowances for FAS No. 106 costs of company employees when determined on an accrual basis, provided certain conditions are met. On November 1, 1993, ANR Pipeline filed a general rate increase with the FERC. The proposed rates reflect a $121 million increase in ANR Pipeline's cost of service from that approved in the Interim Settlement and a $218 million increase over ANR Pipeline's approved rates for its restructured services. The increase represents higher plant investment, Order 636 restructuring costs, rate of return and tax rate changes and increased costs related to the required adoption of recent accounting rule changes, i.e., FAS Nos. 106 and 112. (See Note 11 of the Notes to Consolidated Financial Statements for a discussion of FAS Nos. 106 and 112.) The FERC has permitted ANR Pipeline to place its new rates into effect on May 1, 1994, subject to refund and subject to certain required compliance changes and the outcome of an evidentiary hearing on all remaining issues. COLORADO. Under the NGA, Colorado continues to be required to file with the FERC to establish or adjust certain of its service rates. The FERC may also initiate proceedings to determine whether Colorado's rates are "just and reasonable". On March 31, 1993, Colorado filed at FERC to increase its rates by approximately $26.5 million annually. Such rates (adjusted to reflect Colorado's Order 636 program) became effective subject to refund on October 1, 1993. WIC. WIC settled a rate case with the FERC, as principal payments and associated interest of $68.1 million were paid to WIC's shippers on October 8, 1991, exclusive of amounts which are being held until the resolution of pending bankruptcy proceedings involving its customer, Columbia Gas Transmission Corporation, which is currently pending before the U.S. Bankruptcy Court for the District of Delaware. Should such refunds be required, there would be no effect on the results of operations as accruals have been previously established. In 1993 the FERC initiated proceedings under Section 5 of the NGA to determine if WIC's rates approved in 1991 had become excessive. Administrative hearings were held in December of 1993, but no decision has been issued. Any decrease in rates that the FERC may ultimately require will only take effect prospectively following the issuance of a final order by the FERC that is no longer subject to rehearing by the agency. Certain regulatory issues remain unresolved among ANR Pipeline, Colorado, WIC and ANR Storage, their customers, their suppliers, and the FERC. ANR Pipeline, Colorado, WIC and ANR Storage have made provisions which represent management's assessment of the ultimate resolution of these issues. While these companies estimate the provisions to be adequate to cover potential adverse rulings on these and other issues, they cannot estimate when each of these issues will be resolved. OTHER DEVELOPMENTS The Empire State Pipeline Project, in which an affiliate of ANR Pipeline has a 45% interest and ANR Pipeline is the operator, was placed in service on November 1, 1993. The 156-mile pipeline system, extending from Niagara Falls to Syracuse, New York, will carry up to 570 MMcf per day to western and central New York and provide ANR Pipeline access to markets in the Northeastern United States. In August 1993, ANR Pipeline and Arkla, Inc. ("Arkla") announced execution of a restructured agreement under which ANR Pipeline will purchase an ownership interest in 250 MMcf per day of capacity in existing natural gas transmission facilities from Arkla. The restructured agreement resolved certain conditions imposed by the FERC in its October 1, 1992 authorization of the original purchase and sale agreement. As restructured, ANR Pipeline will own capacity interests in facilities valued at approximately $90 million, subject to receipt of all required regulatory approvals. The reduction in value of the facilities from the original purchase and sale agreement is the result of negotiations between ANR Pipeline and Arkla in light of the FERC's orders. ANR Pipeline and a subsidiary of CGS are partners in the SunShine Pipeline Project which is designed to capture a share of the growing Florida power generation market, as well as markets located in Mississippi, Alabama and the Florida Panhandle. SunShine Interstate Transmission Company ("SITCO"), the interstate pipeline segments of this project, will extend 170 miles from Pascagoula, Mississippi to Okaloosa, Florida where it will connect with Sunshine Pipeline Company, ("SunShine") the intrastate segment of this project. SunShine will be a 545-mile pipeline starting in Okaloosa and extending down Florida's west coast to the Tampa area. ANR Pipeline, through a wholly-owned subsidiary, will have a 40% interest in SITCO and a subsidiary of CGS will have a 40% interest in SunShine. Florida Power Corporation and TransCanada will both hold a 30% equity interest in each of the two projects. SITCO will have an initial capacity of 329.5 MMcf per day and SunShine will have an initial capacity of 249.5 MMcf per day. Both SITCO and SunShine have signed precedent agreements for a portion of their initial pipeline capacity. SITCO, which will be subject to FERC jurisdiction, has filed with the FERC to obtain a Certificate of Public Convenience and Necessity. FERC approval is expected in March, 1995. SunShine, which will be subject to the jurisdiction of the Florida Public Service Commission ("FPSC"), has received approval of its request for a Determination of Need from the FPSC. SunShine also expects environmental approval, in early 1995, under the procedures set forth in Florida's Natural Gas Transmission Pipeline Siting Act. Both projects are targeted to be placed into service in December 1995. The SunShine pipeline is expected to cost approximately $462 million and the SITCO pipeline is expected to cost approximately $188 million. A subsidiary of ANR Pipeline will have a 25% equity interest in the proposed Liberty Pipeline project, a 38-mile pipeline extending from New Jersey across New York Harbor to Long Island with a potential capacity of 500 MMcf per day. The pipeline is expected to serve local distribution company participants and independent power producers. A filing to obtain a Certificate of Public Convenience and Necessity has been made and is currently pending before the FERC. Subject to receiving applicable governmental approvals, an in-service date of late 1995 is possible, at an estimated cost of $160 million. ANR Pipeline (20% equity interest) and Interprovincial Pipe Line System Inc. plan to participate in the construction of the InterCoastal Pipe Line, a project designed to serve incremental markets in southern Ontario and potentially Quebec and the Northeastern United States. The project will involve converting approximately 130 miles of existing oil pipeline to natural gas service, originating in Sarnia, Ontario and extending to Toronto, and the construction of approximately 25 miles of new pipeline. In connection with the project, facilities in Michigan will be constructed by ANR Pipeline to deliver gas from domestic sources. The project, which will have a maximum capacity of 175 MMcf per day, is projected to cost $37.6 million. The InterCoastal Pipe Line is subject to regulatory approval in Canada, and the ANR Pipeline facilities are subject to regulatory approvals in the United States. Filings seeking necessary authorizations from the NEB were made in the second quarter of 1993, and with the FERC on July 19, 1993. The project could be in service as early as November 1, 1994. A subsidiary of ANR Pipeline and affiliates of TransCanada and Brooklyn Union Gas Company have entered into a partnership agreement for the construction of the Mayflower Pipeline, which is expected to expand natural gas sales and storage services to markets in the Northeastern United States. ANR Pipeline will have a 45% interest in this project. The proposed 240-mile pipeline will extend east from the Iroquois Gas Transmission System at Canajoharie, New York to a location near Boston, Massachusetts and have an initial design capacity of 350 MMcf per day. The total project cost is expected to be $540 million. The pipeline is expected to be in service in late 1997. Construction of the project is subject to receipt of all federal regulatory approvals. Colorado owns approximately 20% of Natural Fuels Corporation ("NFC") which is headquartered in Denver, Colorado. NFC's business is to develop compressed natural gas ("CNG") as an alternative vehicular fuel. Major services provided by NFC include vehicle conversions to CNG, fuel sales, CNG equipment sales, maintenance services, and training. Besides operating a full service conversion center which converts vehicles to CNG, NFC has installed 44 stations in Colorado, 26 of which are open to the public. NFC, in joint partnership with Total Petroleum, installs natural gas refueling facilities at selected Total Petroleum stores along the Colorado Front Range. This project is one of the largest public fueling station development commitments in the United States. As of January 1994, seven stations were operational and one was under construction. Also, Colorado is a co-sponsor in the testing of two Colorado Springs buses that are powered by dual-fueled engines modified to run on up to 90% natural gas. On July 8, 1993, Young Gas Storage Company, Ltd. ("Young"), a limited partnership, filed an application with the FERC for a Certificate of Public Convenience and Necessity authorizing, in part, the development, construction and operation of an underground natural gas storage field. The $44.4 million storage field project, to be located in Morgan County, Colorado, will be capable of storing 5.3 Bcf of working gas with a withdrawal rate of 200 MMcf per day when fully developed in 1998. The total capacity is under long-term contracts. On March 3, 1994, the FERC issued an Order Granting Preliminary Determination which approved the non-environmental aspects of the project. The Company is reviewing this Order and intends to seek rehearing with respect to some aspects of this Order. CIG Gas Storage Company and Young Gas Storage Company, the two general partners in the Young Partnership, are affiliates of Coastal. The limited partner is the City of Colorado Springs, a municipal corporation of the State of Colorado. CGS has established a producer and market services division to provide financing services to producers. This division will arrange funding for acquisitions and development of oil and gas reserves and other producer capital requirements. As a result of these activities, CGS will obtain access to long- term oil and gas supplies enhancing CGS' marketing capabilities. Coastal States Gas Transmission Company, a subsidiary of the Company, is building a natural gas intrastate pipeline from the Bob West Field in South Texas to run initially 26 miles north to the Midcon Texas Pipeline System at a cost of approximately $8 million. This new pipeline is expected to be completed prior to June 1994 and will transport up to 200 MMcf per day of natural gas without compression and up to 350 MMcf per day with compression. Funding for certain pending and proposed natural gas pipeline projects is anticipated to be provided through non-recourse financings in which the projects' assets and contracts will be pledged as collateral. This type of financing typically requires the participants to make equity investments totaling approximately 20% to 30% of the cost of the project, with the remainder financed on a long-term basis. REFINING, MARKETING AND DISTRIBUTION The Company has subsidiary operations involved in refining, marketing and distribution of petroleum products. The petroleum industry is highly competitive in the United States and throughout most of the world. This industry also competes with other industries in supplying the energy needs of various types of consumers. REFINING Subsidiaries of the Company operated their wholly-owned refineries at 87% of year 1993 average combined capacity compared to 82% in 1992. The aggregate sales volumes (millions of barrels) of Coastal's wholly-owned refineries for the three years ended December 31, 1993, were 134.9 (1993), 136.7 (1992) and 141.2 (1991). A joint venture, Pacific Refining Company, had sales of 19.9 million barrels in 1993, 21.3 million barrels in 1992 and 27.4 million barrels in 1991 which were excluded from Coastal's 1993, 1992 and 1991 sales. Of the total refinery sales in 1993, 30% was gasoline, 46% was middle distillates, such as jet fuel, diesel fuel and home heating oil, and 24% was heavy industrial fuels and other products. The average daily processing capacity of crude oil at December 31, 1993, average daily throughput and storage capacity at the Company's wholly-owned operating refineries are set forth below: The Company has curtailed refining operations at its three Kansas refinery locations as part of an overall restructuring plan for refining and marketing undertaken in 1992. Two of these locations, Wichita and El Dorado, are still operating as refined products terminals. Refinery units have been mothballed and are being evaluated for utilization either by the company or by third parties. Pacific Refining at Hercules, California has a refining capacity of 55,000 barrels per day at December 31, 1993. Since January 1989, the China National Chemicals Import & Export Corporation has held a 50% interest in Coastal's west coast refining and marketing properties, including Pacific Refining Company. The Hercules refinery was operated during 1993 and processed 46,200 barrels per day of crude oil and other feedstocks. Present plans are to continue operation of the refinery through 1994 and most likely through 1995, consistent with resolution of regulatory issues and attainment of earnings objectives. The Company is evaluating several future options for the facility. These include expansion of asphalt facilities and installation of Clean Air Act of 1990 and California Air Resources Board regulations compliance upgrades and conversion of the Hercules site to alternative uses. In addition, Coastal's international operations include a minority interest, through a foreign subsidiary, in a refinery located in Hamburg, Germany which has a refining capacity of 100,000 barrels per day and a storage capacity of 1,800,000 barrels for crude oil and 5,200,000 barrels for products. The Company's refineries produce a full range of petroleum products ranging from transportation fuels to paving asphalt. The refineries are operated to produce the particular products required by customers within each refinery's geographic area. In 1993, the products emphasized included premium gasolines and products for specialty markets such as petrochemical feedstocks, aviation fuels and asphalt. MARKETING AND DISTRIBUTION REFINED PRODUCTS MARKETING. Sales volumes for distribution activities of Coastal subsidiaries, including products from Company refineries and purchases from other suppliers, for the three years ended December 31, 1993, are set forth below (thousands of barrels): Subsidiaries of the Company market refined products and liquefied petroleum gas at wholesale in 36 states through 322 terminals. Coastal Refining & Marketing, Inc. serves customers in the Midwest, Mississippi Valley and the Southwest through 221 product and liquified petroleum gas terminals in 27 states. On the Gulf and East Coasts, Coastal Fuels Marketing, Inc., Coastal Oil New York, Inc. and Coastal Oil New England, Inc. serve home, industry, utility, defense and marine energy needs. In 1993, these subsidiaries' sales volumes were 132 million barrels, which accounted for approximately 45% of the total marketing and distribution sales. Effective January 1, 1994, the refined products marketing operations of these subsidiaries were consolidated into Coastal Refining & Marketing, Inc. International subsidiaries that acquire feedstocks for the refineries and products for the distribution system are located in Aruba, Bahrain, Bermuda, London, Madrid and Singapore. In March 1993, Coastal Petroleum N.V., a subsidiary of Coastal, and The Subic Bay Metropolitan Authority signed a long-term lease for petroleum storage facilities located at the former U.S. naval base at Subic Bay in the Philippines. Coastal is leasing 304 acres of land, with 68 individual storage tanks totalling 2.4 million barrels of storage, most of which are underground, and 40 miles of pipeline connecting the terminal with other facilities within the Subic Bay Freeport Zone. Additionally, in late 1993, another subsidiary of Coastal signed a joint venture agreement with a subsidiary of the Malaysian national oil company, Petronas, for use of the entire capacity of this storage facility for independent marketing efforts throughout the region and for joint marketing in the Subic Bay Freeport Zone. The Company, through Coastal Mart, Inc. and branded marketers, conducts retail marketing, using the C-MART(R) and/or COASTAL(R) trademarks, in 36 states through approximately 1,532 Coastal branded outlets, with 578 of those outlets operated by the Company. Fleet fueling operations include 17 outlets in Texas and 7 in Florida. Coastal Unilube, Inc., based in West Memphis, Arkansas, blends, packages and distributes lubricants and automotive products under the UNILUBE(R), DUPLEX(R), CUI(R) and UNIPRO(R) brand names. Coastal Unilube, Inc. distributes lubricants and automotive products through 14 warehouses servicing customers in 36 states. TRANSPORTATION. The Company's transportation facilities include petroleum liquids pipelines, tank cars, tankers, tank trucks and barges. Coastal has approximately 3,900 miles of pipeline for gathering and transporting an average of 334,000 barrels daily of crude oil, condensate, natural gas liquids and refined products. These lines are located principally in Texas and Kansas and include 358 miles of crude oil pipelines, 784 miles of refined products pipelines and 671 miles of natural gas liquids pipelines, all 100% owned and operated by Coastal subsidiaries, and 1,997 miles of 50% owned crude oil pipelines and 80 miles of jointly-owned products pipelines with less than a 50% interest. In 1993, throughput of crude oil pipelines averaged 148,199 barrels per day, compared to 155,386 barrels per day in 1992. In 1993, throughput of refined products and natural gas liquid pipelines averaged 186,430 barrels per day, compared to 162,696 barrels per day in 1992. Other transportation facilities for marketing operations of Coastal subsidiaries include a regional tank truck fleet which distributes refined and liquefied petroleum gas products to customers in parts of Florida, New England and New York, and another fleet of trucks, which transport petroleum products and liquefied petroleum gas products for Coastal marketing subsidiaries serving the Texas area. The marine transportation total fleet at December 31, 1993 consisted of 17 tug boats, 24 oil barges, 6 owned tankers used for the transportation of refined petroleum products and crude oil and 3 time-chartered tankers. EXPLORATION AND PRODUCTION GAS AND OIL PROPERTIES Coastal subsidiaries are engaged in gas and oil exploration, development and production operations in the United States and Argentina. Argentine operations are discussed in Supplemental Information on Oil & Gas Producing Activities (Unaudited), as set forth in Item 14(a)1 hereof. United States operations are principally in Alabama, Arkansas, California, Colorado, Kansas, Louisiana, Michigan, Mississippi, Montana, New Mexico, North Dakota, Oklahoma, Texas, Utah, West Virginia, Wyoming and offshore in the Gulf of Mexico. In 1993, the Company's domestic operations sold approximately 53% of all the gas it produced to its natural gas system affiliates and a gas brokerage affiliate. The Company's domestic operations make short-term gas sales directly to industrial users and distribution companies to increase utilization of its excess current gas production capacity. Oil is sold primarily under short-term contracts at field prices posted by the principal purchasers of oil in the areas in which the producing properties are located. Acreage held under gas and oil mineral leases as of December 31, 1993 is summarized as follows: The domestic net acreage held for production is concentrated principally in Texas (37%), Utah (20%), Oklahoma (10%), West Virginia (7%), Kansas (6%) and Wyoming (6%). Approximately 21%, 22% and 23% of the Company's total undeveloped net acreage is under leases that have minimum remaining primary terms expiring in 1994, 1995 and 1996, respectively. Productive wells as of December 31, 1993 are as follows (domestic): EXPLORATION AND DRILLING During 1993, Coastal's domestic exploration and production units participated in drilling 158 gross wells, 75.5 net wells, to the Company's interest. Coastal's participation in wells drilled in the three years ended December 31, 1993, is summarized as follows: Wells in progress as of December 31, 1993 are as follows (domestic): During the course of 1992 and 1991 development drilling focused on natural gas wells which qualified under a federal tax incentive program providing for future tax credits on wells producing from tight sands gas formations. To qualify, wells must have been spudded before January 1, 1993. During 1993, development drilling focused on replacing and increasing production capacity as natural gas prices stabilized at acceptable levels. Coastal Limited Ventures, Inc., a domestic subsidiary of Coastal, is the general partner in six limited partnership drilling programs which have been offered to Coastal's employees and shareholders. Information pertaining thereto can be located in the Annual Report on Form 10-K filed by each limited partnership and available from the Company. GAS AND OIL PRODUCTION Natural gas production during 1993 averaged 334 MMcf daily, compared to 277 MMcf daily in 1992. Production from non-pipeline-owned wells averaged 207 MMcf daily in 1993, compared to 147 MMcf daily in 1992. Crude oil, condensate and natural gas liquids production averaged 13,534 barrels daily in 1993, compared to 13,002 barrels daily in 1992. The following table shows gas, oil, condensate and natural gas liquids production volumes attributable to Coastal's domestic interest in gas and oil properties for the three years ended December 31, 1993: Many of Coastal's domestic gas wells are situated in areas near, and are connected to, its gas systems. In other areas, gas production is sold to pipeline companies and other purchasers. Generally, Coastal's domestic production of crude oil, condensate and natural gas liquids is purchased at the lease by its marketing and refinery affiliates. Some quantities are delivered via Coastal's gathering and transportation lines to its refineries, but most quantities are redelivered to Coastal through various exchange agreements. The following table summarizes sales price (net of production taxes) and production cost information for domestic exploration and production operations during the three years ended December 31, 1993: NATURAL GAS PROCESSING ANR Production Company and Coastal Oil & Gas Corporation, domestic subsidiaries of the Company, are also engaged in the processing of natural gas for the extraction and sale of natural gas liquids. In 1993, total revenues of $36.7 million were generated from the extraction and sale of 136 million gallons of ethane, propane, iso-butane, normal butane and natural gasoline from natural gas processing plants. Sales prices of natural gas liquids fluctuate widely as a result of market conditions and changes in the prices of other fuels and chemical feedstocks. COMPANY-OWNED RESERVES Coastal's domestic proved reserves of crude oil, condensate and natural gas liquids at December 31, 1993, as estimated by Huddleston, its independent engineers, were 28.8 million barrels, compared to 33.1 million barrels at the end of 1992. Proved gas reserves as of December 31, 1993, net to Coastal's interest, were estimated by the engineers to be 925.5 Bcf compared to 974.8 Bcf as of December 31, 1992. For information as to Company-owned reserves of oil and gas, see "Supplemental Information On Oil and Gas Producing Activities" as set forth in Item 14(a)1 hereof. COMPETITION In the United States, the Company competes with major integrated oil companies and independent oil and gas companies for suitable prospects for oil and gas drilling operations. The availability of a ready market for gas discovered and produced depends on numerous factors frequently beyond the Company's control. These factors include the extent of gas discovery and production by other producers, crude oil imports, the marketing of competitive fuels, and the proximity, availability and capacity of gas pipelines and other facilities for the transportation and marketing of gas. The production and sale of oil and gas is subject to a variety of federal and state regulations, including regulation of production levels. REGULATION In all states in the United States in which Coastal engages in oil and gas exploration and production, its activities are subject to regulation. Such regulations may extend to requiring drilling permits, the spacing of wells, the prevention of waste and pollution, the conservation of natural gas and oil, and various other matters. Such regulations may impose restrictions on the production of natural gas and crude oil by reducing the rate of flow from individual wells below their actual capacity to produce. Likewise, oil and gas operations on all federal lands are subject to regulation by the Department of the Interior and other federal agencies. COAL The Company, through ANR Coal Company and its subsidiaries ("ANR Coal") in the eastern United States and through Coastal States Energy Company and its subsidiaries ("Coastal States Energy") in the west, produces and markets high quality bituminous coal from its reserves in Kentucky, Virginia, West Virginia and Utah. In addition, subsidiaries of ANR Coal lease interests in their reserves to unaffiliated producers and market third-party coal through brokerage sales operations. At December 31, 1993, coal properties consisted of the following: - ------------------------ (1) Based on a 65% recovery rate. In September 1993, a subsidiary of the Company acquired Soldier Creek Coal Company and its parent, Sage Point Coal Company. This acquisition added approximately 86 million tons of new recoverable coal reserves to Coastal's reserve base. Substantially all of the acquired reserves satisfy the sulfur emissions requirements of the Clean Air Act of 1990. At December 31, 1993, the Company controlled approximately 871 million recoverable tons of bituminous coal reserves. Production in 1993 from the Company's reserves totalled 23.6 million tons of which 18.4 million tons were produced from captive operations and 5.2 million tons were produced by lessees under royalty agreements. In its eastern captive operations, ANR Coal contracts with independent mine operators to mine and deliver coal to Company owned and operated processing and loading facilities. Captive production and processing from ANR Coal and Coastal States Energy in 1993 totalled 9.2 and 9.2 million tons, respectively. Captive sales from ANR Coal and Coastal States Energy were 7.2 million and 8.9 million tons, respectively, in 1993. Brokerage sales in which the Company receives a commission on coal sold for third parties totalled 1.3 million tons for the same period. In 1993, approximately 70% of sales were to domestic utilities, 12% of sales were to domestic industrial customers and 18% of sales were to export markets primarily in Asia and Canada. Of the total 1993 tonnage sold, 12.1 million tons (75%) were sold under long-term contracts. At December 31, 1993, the weighted average remaining life of these contracts was 63 months. The Company had approximately 21.2 million tons of annual production capacity at December 31, 1993. In the eastern United States, the Company owns and operates five coal preparation plants and nine loading facilities with a combined annual capacity of 10.6 million tons. Coastal States Energy's mines in Utah employ three longwall mining systems, diesel shuttle cars and have a combined annual capacity of 10.6 million tons. In addition to its bituminous coal operations, the Company controls overriding royalty interests in approximately 484 million tons of lignite reserves in North Dakota. Production from these reserves in 1993 totalled 16.1 million tons. The Company, through its captive operations, leasing programs and brokerage activities, participates in all aspects of the national bituminous coal industry and is a significant competitor in international coal markets. A significant portion of its eastern reserves and all of its Utah reserves are low-sulfur, compliance coal which will allow the Company to remain a major supplier of steam coal to domestic utilities under the Clean Air Act of 1990. The Company competes with a large number of coal producers and land holding companies across the United States. The principal factors affecting the Company's coal sales are price, quality (BTU, sulfur and ash content), royalty rates, employee productivity and rail freight rates. CHEMICALS Coastal Chem, Inc. ("Coastal Chem"), a Coastal subsidiary, operates a plant near Cheyenne, Wyoming, which produces anhydrous ammonia, ammonium nitrate, nitric acid, food grade liquid carbon dioxide and urea for use as agricultural fertilizers, livestock feed supplements, blasting agents and various other industrial applications. This plant has the capacity to produce 500 tons per day of anhydrous ammonia, 750 tons per day of ammonium nitrate, 275 tons per day of urea, 700 tons per day of nitric acid and 400 tons per day of food grade liquid carbon dioxide. Coastal Chem also owns a plant at Table Rock, Wyoming, which has a production capacity of 150 tons of liquid fertilizer per day. In addition, Coastal Chem operates a low density ammonium nitrate ("LoDAN/(R)/") facility in Battle Mountain, Nevada. The LoDAN/(R)/ is used primarily as a blasting agent in surface mining. This facility produces 400 tons per day of LoDAN/(R)/. Coastal Chem completed a urea expansion project in 1992 with full production commencing in mid 1993. This expanded facility increased the previous capacity of 175 tons per day to 275 tons per day. During the last six months, the facility has operated at its designed capacity. Coastal Chem commenced production from its integrated methyl tertiary butyl ether ("MTBE") plant in 1993. MTBE is a gasoline additive which adds oxygen and boosts octane of the blended mixture. The plant has a production capacity of 4,000 barrels per day. Sales volumes for the three years ended December 31, 1993, are set forth below (thousands of tons): INDEPENDENT POWER PRODUCTION Coastal Power Production Company ("Coastal Power") and certain of its affiliates develop, operate and are equity participants in cogeneration plants which produce and sell electricity and thermal products, including steam and chilled water. Affiliates of Coastal Power currently own interests in four operating cogeneration facilities in the United States. Capitol District Energy Center Cogeneration Associates ("CDECCA") owns a cogeneration facility with an approximate 56 megawatt capacity. An affiliate of Coastal Power owns a 50% interest in CDECCA and is the project manager and Coastal Technology, Inc. ("CTI"), a Coastal subsidiary, is the operator of the plant. Electricity from the facility is sold to the local utility under a long- term contract. Steam and chilled water produced from the plant help to serve the thermal requirements of the City of Hartford and the plant's co-owner. An affiliate of Coastal Power is the managing partner and 50% owner of a combined cycle cogeneration plant at Coastal's Eagle Point, New Jersey refinery. The plant has a permitted nameplate rating of approximately 260 megawatts and currently operates at approximately 225 megawatts. Power from the plant is sold to a local utility and Coastal's refinery under long-term contracts. Steam from the plant is also sold to the refinery under long-term contract. Gas supply and transmission is provided to the cogeneration plant by other Coastal affiliates. CTI is the operator of the cogeneration plant. Coastal Power and an affiliate own a gas-fired cogeneration facility in Fulton, New York with an approximate 47 megawatt capacity. Electricity from this project is sold under a long-term contract to a New York utility. Steam is sold to a neighboring plant owned by a major candy manufacturer. Approximately half of the gas supply requirements for the cogeneration plant are supplied by an affiliate of Coastal Power. CTI is the plant operator. Coastal, through a wholly-owned subsidiary, has a 10.9% equity interest in the Midland Cogeneration Venture Limited Partnership, the largest gas-fired cogeneration plant in the United States. Coastal subsidiaries supply and transport a portion of the gas to this facility. TRUCKING OPERATIONS ANR Freight System, Inc. ("ANR Freight") is a regional common and contract carrier by motor vehicle, conducting operations in both interstate and intrastate commerce. During 1993, ANR Freight transported approximately 1.4 million tons of freight, consisting of both truckload shipments (10,000 pounds or more) and less than truckload (LTL) shipments (less than 10,000 pounds) versus 1.3 million tons in 1992. LTL shipments comprised approximately 42% of total tonnage hauled by ANR Freight and generated approximately 82% of its operating revenues. As of December 31, 1993, ANR Freight operated 40 terminals and almost 4,000 trucks, tractors and trailers. Regulatory actions by the Interstate Commerce Commission ("ICC") allowing relatively easy entry into and expansion of the motor freight business have tended to increase competition among motor carriers and also between motor carriers and other modes of transportation. ANR Freight competes primarily with other regular route motor carriers of general freight and, to a lesser extent, with irregular route motor carriers, individual truckers and private carriers (for truckload general freight) and with surface freight forwarders, railroads, airlines and air freight forwarders. The extent of competition between various modes of transportation is largely determined by their rate structures and by the service requirements of the shippers. Over-capacity in the motor carrier industry has increased competition for freight, and discounting programs, which effectively reduce the rates filed with the ICC, have been adopted by many carriers. ANR Freight continues to participate, on a limited basis, in collective rate making within the regional rate bureaus as authorized by the Interstate Commerce Act. ANR Freight also carries freight under contract and under general and individually published tariff arrangements. ANR Freight is subject to regulation by the ICC with regard to accounting. The carriers are regulated as to rates and routes of travel by the ICC for freight transported in interstate commerce and by state regulatory agencies for freight transported in intrastate commerce. The Department of Transportation regulates certain aspects of carrier operations such as the transportation of hazardous materials, motor vehicle maintenance, motor vehicle safety devices and appliances and driver qualifications. Various states regulate the gross weight and length of vehicles which travel over the highways of such states. COMPETITION Coastal and its subsidiaries are subject to competition. In all the Company's business segments, competition is based primarily on price with factors such as reliability of supply, service and quality being considered. The coal, chemicals, independent power production and trucking subsidiaries of Coastal are engaged in highly competitive businesses against competitors, some of which have significantly larger facilities and market share. See the discussion of competition under "Natural Gas Systems," "Refining, Marketing and Distribution" and "Exploration and Production" herein. ENVIRONMENTAL The Company's operations are subject to extensive federal, state and local environmental laws and regulations. The Company anticipates annual capital expenditures of $20 to $40 million over the next several years aimed at compliance with such laws and regulations. Additionally, appropriate governmental authorities may enforce the laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties and remediation requirements. The Comprehensive Environmental Response, Compensation and Liability Act, also known as "Superfund," as reauthorized, imposes liability, without regard to fault or the legality of the original act, for disposal of a "hazardous substance." Certain subsidiaries of the Company have been named as a potentially responsible party ("PRP") in several "Superfund" waste disposal sites. At the 15 sites for which the EPA has developed sufficient information to estimate total clean-up costs of approximately $350 million, the Company estimates its pro-rata exposure to be paid over a period of several years is approximately $5 million and has made appropriate provisions. At 3 other sites, the EPA is currently unable to provide the Company with an estimate of total clean-up costs and, accordingly, the Company is unable to calculate its share of those costs. Finally, at 5 other sites, the Company has paid amounts to other PRPs as its proportional share of associated clean-up costs. As to these latter sites, the Company believes that its activities were de minimis. The following administrative proceedings and suits involve subsidiaries of the Company: 1. In October 1993, the Bay Area Air Quality Management District brought an administrative action against Pacific Refining Company, in which Coastal has an indirect 50% interest. In March 1994, the parties agreed upon a structured settlement amount of $300,000 regarding certain compliance issues relating to the installation of a sulfur recovery unit at Pacific Refining Company's refinery. 2. In January 1993, the State of Texas filed suit against the Corpus Christi, Texas refinery of Coastal Refining & Marketing, Inc., a subsidiary of Coastal, alleging failure to comply in 1992 with certain administrative orders relating to groundwater contamination and seeking penalties in unspecified amounts. The Company believes that this suit could result in monetary sanctions which, while not material to the Company and its subsidiaries, could exceed $100,000. 3. In February 1993, the State of Texas filed suit against Coastal Refining & Marketing, Inc., seeking civil penalties in unspecified amounts for alleged public nuisance odor violations occurring in 1991 and 1992 at the Corpus Christi refinery. In July 1993, the proceeding was amended to include a claim for excess benzene emissions and to seek civil penalties. The Company believes that this suit could result in monetary sanctions which, while not material to the Company and its subsidiaries, could exceed $100,000. There are additional areas of environmental remediation responsibilities which may fall on the Company. Future information and developments will require the Company to continually reassess the expected impact of these environmental matters. However, the Company has evaluated its total environmental exposure based on currently available data, including its potential joint and several liability, and believes that compliance with all applicable laws and regulations will not have a material adverse impact on the Company's liquidity or financial position. ITEM 2. ITEM 2. PROPERTIES. Information on properties of Coastal is included in Item 1, "Business" and certain encumbrances on its properties are described in Note 5 of the Notes to Consolidated Financial Statements included herein. The real property owned by the Company with regard to its subsidiary pipelines is owned in fee and consists principally of sites for compressor and metering stations and microwave and terminal facilities. With respect to the subsidiary owned storage fields, the Company holds title to gas storage rights representing ownership of, or has long-term leases on, various subsurface strata and surface rights and also holds certain additional mineral rights. Under the NGA, the Company and its pipeline subsidiaries may acquire by the exercise of the right of eminent domain, through proceedings in United States District Courts or in state courts, necessary rights-of-way to construct, operate and maintain pipelines and necessary land or other property for compressor and other stations and equipment necessary to the operation of pipelines. All of the principal properties of ANR Pipeline are subject to the lien of its Mortgage and Deed of Trust dated as of September 1, 1948, securing its First Mortgage Pipe Line Bonds, and some of such properties are subject to "permitted liens" as defined in such Mortgage and Deed of Trust. The First Mortgage Pipe Line Bonds were retired in 1993 and ANR Pipeline is in the process of terminating the associated Mortgage and Deed of Trust. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In December 1992, certain of Colorado's natural gas lessors in the West Panhandle Field filed a complaint in the U.S. District Court for the Northern District of Texas, claiming underpayment, breach of fiduciary duty, fraud and negligent misrepresentation. Management believes that Colorado has numerous defenses to the lessors' claims, including (i) that the royalties were properly paid, (ii) that the majority of the claims were released by written agreement, and (iii) that the majority of the claims are barred by the statute of limitations. A subsidiary of Coastal has initiated a suit against TransAmerican Natural Gas Corporation ("TransAmerican") in the District Court of Webb County, Texas, for breach of two gas purchase agreements. In February 1993, TransAmerican filed a Third Party Complaint and a Counterclaim in this action against Coastal and certain subsidiaries. TransAmerican alleges breach of contract, fraud, conspiracy, duress, tortious interference and violations of the Texas Free Enterprises and Anti-trust Act arising out of the gas purchase agreements. TransAmerican seeks compensatory damages, exemplary damages and attorney fees. The trial began on March 14, 1994. Numerous other lawsuits and other proceedings which have arisen in the ordinary course of business are pending or threatened against the Company or its subsidiaries. Although no assurances can be given and no determination can be made at this time as to the outcome of any particular lawsuit or proceeding, the Company believes there are meritorious defenses to substantially all of the above claims and that any liability which may finally be determined should not have a material adverse effect on the Company's consolidated financial position. Additional information regarding legal proceedings is set forth in Notes 3 and 14 of the Notes to Consolidated Financial Statements included herein. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The principal market on which Coastal Common Stock is traded is the New York Stock Exchange; Coastal Common Stock is also listed on The Stock Exchange in London, the Stock Exchanges of Dusseldorf, Frankfurt, Hamburg and Munich in Germany and on the Amsterdam Stock Exchange. The Class A Common Stock of Coastal is non-transferable; however, such stock is convertible share-for-share into Coastal Common Stock. As of March 16, 1994, the approximate number of holders of record of Common Stock was 12,550 and of the Class A Common Stock was 3,900. The following table presents the high and low sales prices for Coastal common shares based on the daily composite listing of transactions for New York Stock Exchange stocks. Coastal expects to continue paying dividends in the future. Dividends of $.09 per share were paid on the Class A Common Stock for each quarterly period in 1993 and 1992. At December 31, 1993, under the most restrictive of its financing agreements, the Company was prohibited from paying dividends and distributions on its Common Stock, Class A Common Stock and preferred stocks in excess of approximately $409.9 million. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following selected financial data (in millions of dollars except per share amounts) is derived from the Consolidated Financial Statements included herein and Item 6 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. The Notes to Consolidated Financial Statements included herein contain other information relating to this data. * In addition, cash dividends of $.36, $.36, $.36 and $.18, respectively, were paid on the Company's Class A Common Stock in 1993, 1992, 1991 and 1990. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The Management's Discussion and Analysis of Financial Condition and Results of Operations is presented on pages through hereof. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Financial Statements and Supplementary Data required hereunder are included in this Annual Report as set forth in Item 14(a) hereof. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information called for by this Item with respect to the directors is set forth under "Election of Directors" and "Information Regarding Directors" in the Coastal Proxy Statement for the May 5, 1994 Annual Meeting of Stockholders filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is incorporated herein by reference. The executive officers of the Registrant as of March 16, 1994, were as follows: The above named persons bear no family relationship to each other. Their respective terms of office expire coincident with the officer elections at the Annual Board of Directors' meeting which follows Coastal's Annual Meeting of Stockholders. Each of the officers named above have been officers of Coastal, ANR Pipeline and/or Colorado for five years or more with the following exceptions: Mr. Arnold was elected Vice President of Coastal in August 1993. He has been a Vice President of Coastal States Management Corporation, a subsidiary of Coastal, since 1977. Mr. Bullock was elected Senior Vice President of Coastal in August 1992. From 1987 to 1990, he was an Executive Vice President of British Petroleum's BP Exploration Company and a director and a member of the management committee of BP Exploration USA. From 1990 to 1992, he was an independent petroleum consultant for several major exploration companies. Mr. Corrallo was elected Senior Vice President and General Counsel of Coastal in March 1993. He has served as a Senior Vice President of Coastal States Management Corporation, a subsidiary of Coastal, since August 1991 and prior thereto as Vice President since December 1986. Mr. Gullquist was elected Senior Vice President of Coastal in March 1994. From 1988 to 1989 he served as Vice President, Finance at Enron Corporation; from 1989 to 1990 he served as president of Enron Finance Corporation. Mr. Hart was elected Vice President of Coastal in March 1994. From 1989 through 1994, he was president of Hart Associates, Inc., an energy development firm. Mr. Iglesias was elected a Senior Vice President of Coastal in January 1992. He was president of Mobile Bay Refining Company from 1982 to 1987 and of Mo-Bel Corporation from 1987 to 1990. Mr. King was elected Executive Vice President of Coastal in May 1992. From 1987 to 1990, he was Senior Vice President of refining, supply and transportation for Crown Central Petroleum Corporation. Mr. Oglesby was elected a Vice President of Coastal in August 1991. He served as an Executive Vice President of Colorado and ANR Pipeline from January 1988 to May 1993. He was Senior Vice President for Marketing and Transportation of Valero Transmission Company from 1985 to 1987. Mr. Powell was elected Vice President of Coastal and Senior Vice President of Coastal States Management Corporation in August 1993. From 1984 to 1993 he was in private law practice with the law firms of Powell, Popp & Ikard and Powell & Associates representing Coastal and other corporations. Prior thereto he was employed at Coastal since 1978. Mr. Simpson was elected a Vice President of Coastal in April 1990 and of Colorado in May 1990. He has been a Vice President of Coastal States Management Corporation, a subsidiary of Coastal, for the past ten years. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information called for by this item is set forth under "Executive Compensation" in the Coastal Proxy Statement for the May 5, 1994 Annual Meeting of Stockholders filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information called for by this item is set forth under "Stock Ownership," "Election of Directors" and "Information Regarding Directors" in the Coastal Proxy Statement for the May 5, 1994 Annual Meeting of Stockholders filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information called for by this item is set forth under "Election of Directors," "Transactions with Management and Others" and "Certain Business Relationships" in the Coastal Proxy Statement for the May 5, 1994 Annual Meeting of Stockholders filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this Annual Report or incorporated herein by reference: 1. Financial Statements and Supplemental Information. The following Consolidated Financial Statements of Coastal and Subsidiaries and Supplemental Information are included in response to Item 8 hereof on the attached pages as indicated: 2. Financial Statement Schedules. The following schedules of Coastal and Subsidiaries are included on the attached pages as indicated: Schedules other than those referred to above are omitted as not applicable or not required, or the required information is shown in the Consolidated Financial Statements or Notes thereto. 3. Exhibits. _________________________ Note: + Indicates documents incorporated by reference from the prior filing indicated. * Indicates documents filed herewith. (b) Reports on Form 8-K. No reports on Form 8-K were filed during the quarter ended December 31, 1993. POWERS OF ATTORNEY Each person whose signature appears below hereby appoints David A. Arledge, Coby C. Hesse and Austin M. O'Toole and each of them, any one of whom may act without the joinder of the others, as his attorney-in-fact to sign on his behalf and in the capacity stated below and to file all amendments to this Annual Report on Form 10-K, which amendment or amendments may make such changes and additions thereto as such attorney-in-fact may deem necessary or appropriate. 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. THE COASTAL CORPORATION (Registrant) By: DAVID A ARLEDGE -------------------- David A. Arledge President March 29, 1994 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. By: O. S. WYATT, JR. --------------------- O. S. Wyatt, Jr. Chairman of the Board and Chief Executive Officer March 29, 1994 By: DAVID A. ARLEDGE ---------------------- David A. Arledge Principal Financial Officer and Director March 29, 1994 By: COBY C. HESSE --------------------- Coby C. Hesse Principal Accounting Officer March 29, 1994 By: JOHN M. BISSELL --------------------- John M. Bissell Director March 29, 1994 * * * By: GEORGE L. BRUNDRETT, JR. By: KENNETH O. JOHNSON ---------------------------- --------------------------- George L. Brundrett, Jr. Kenneth O. Johnson Director Director March 29, 1994 March 29, 1994 By: ERVIN O. BUCK By: JEROME S. KATZIN ---------------------------- --------------------------- Ervin O. Buck Jerome S. Katzin Director Director March 29, 1994 March 29, 1994 By: HAROLD BURROW By: THOMAS R. McDADE ---------------------------- --------------------------- Harold Burrow Thomas R. McDade Director Director March 29, 1994 March 29, 1994 By: ROY D. CHAPIN, JR. By: J. HOWARD MARSHALL, II ---------------------------- --------------------------- Roy D. Chapin, Jr. J. Howard Marshall, II Director Director March 29, 1994 March 29, 1994 By: JAMES F. CORDES By: L. D. WOODDY, JR. ---------------------------- --------------------------- James F. Cordes L. D. Wooddy, Jr. Director Director March 29, 1994 March 29, 1994 By: ROY L. GATES ---------------------------- Roy L. Gates Director March 29, 1994 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Notes to Consolidated Financial Statements contain information that is pertinent to the following analysis. LIQUIDITY AND CAPITAL RESOURCES The Company uses the following consolidated ratios to measure liquidity and ability to meet future funding needs and debt service requirements. The changes in the ratio of net return on average common stockholders' equity can be attributed primarily to changes in earnings, as earnings increased in 1993 and decreased in 1992. The 1993 increase in the cash flow from operating activities to long-term debt ratio resulted from increased cash flow from operations and reduced long-term debt, while the 1992 decrease can be attributed to decreased cash flow from operations and increased long-term debt. The total debt to total capitalization ratio improved in 1993 as debt was paid down while equity was increased through retained earnings and stock issuances. The 1992 increase was due to increased debt and reduced equity. The 1993 increase in the times interest earned ratio resulted from increased earnings and reduced interest expense; while the 1992 decrease resulted from decreased earnings and increased interest expense. Cash flows provided from operating activities were $809.8 million in 1993 and $434.2 million in 1992. The 1993 increase can be attributed to increased earnings and a reduction in inventories and other working capital requirements. Capital expenditures amounted to $392.7 million in 1993 and $573.5 million in 1992. The Company, which had emphasized its capital expansion program in 1992 and 1991 in order to expand its earnings base, returned to a lower level of capital spending in 1993, as it emphasized debt reduction. Prepayments for gas supply and payments for settlement of natural gas contract disputes required investments of $11.4 million and $43.8 million in 1993 and 1992, respectively. The Company was able to reduce total debt by $471.3 million in 1993 primarily by the use of internally generated funds and $193.5 million of proceeds resulting from the issuance of preferred stock in April 1993. Dividend payments increased by $11.0 million as a result of the new preferred stock issue. Capital expenditures for 1994, including the Company's equity investments in partnerships and joint ventures, are currently budgeted at approximately $500.0 million. These expenditures are primarily for completion of projects in process, operational necessities, environmental requirements, expansion projects and increased efficiency. Other expansion opportunities will continue to be evaluated. Financing for budgeted expenditures and mandatory debt retirements in 1994 will be accomplished by the use of internally generated funds, existing credit lines and new financings. Funding for certain proposed natural gas pipeline projects is anticipated to be provided through non-recourse project financings in which the projects' assets and contracts will be pledged as collateral. Equity participation by other entities will also be considered. To the extent required, cash for equity contributions to projects will be from general corporate funds. On September 23, 1993, ANR Pipeline filed a shelf registration statement with the Securities and Exchange Commission for the public offering of up to $200 million in senior unsecured debt securities which became effective October 5, 1993. In February 1994, ANR Pipeline completed an offering of $125.0 million of 7-3/8% Debentures due in 2024. The net proceeds from the sale will be used for capital expenditures and for other general corporate purposes. Unused lines of credit at December 31, 1993, were as follows (millions of dollars): Credit agreements of certain subsidiaries contain covenants which limit the making of advances to affiliates and payment of dividends. Where applicable, restrictions are generally in the form of computed capacities with respect to advances and the payment of dividends. At December 31, 1993, net assets of consolidated subsidiaries amounted to approximately $5.1 billion, of which approximately $1.7 billion was restricted. These provisions have not and are not expected to have any meaningful impact on the ability of the Company to meet its cash obligations. In 1994, the Company adopted Statement of Financial Accounting Standards ("FAS") No. 112, "Employer's Accounting for Postemployment Benefits." This standard covers the accounting for estimated costs of benefits provided to former or inactive employees before their retirement. The implementation of this new standard is not expected to have a significant effect on the Company's results of operations or financial position. In 1993, the Company adopted changes in accounting for post-retirement benefits as required by FAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions." See Note 11 in the Notes to Consolidated Financial Statements. The Company's operations are subject to extensive federal, state and local environmental laws and regulations. The Company anticipates annual capital expenditures of $20 to $40 million over the next several years aimed at compliance with such laws and regulations. Additionally, appropriate governmental authorities may enforce the laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties and remediation requirements. The Comprehensive Environmental Response, Compensation and Liability Act, also known as "Superfund," as reauthorized, imposes liability, without regard to fault or the legality of the original act, for disposal of a "hazardous substance." Certain subsidiaries of the Company have been named as a potentially responsible party ("PRP") in several "Superfund" waste disposal sites. At the 15 sites for which the Environmental Protection Agency ("EPA") has developed sufficient information to estimate total clean-up costs of approximately $350 million, the Company estimates its pro-rata exposure to be paid over a period of several years is approximately $5 million, and has made appropriate provisions. At three other sites, EPA is currently unable to provide the Company with an estimate of total clean-up costs and, accordingly, the Company is unable to calculate its share of those costs. Finally, at five other sites, the Company has paid amounts to other PRPs as its proportional share of associated clean-up costs. As to these latter sites, the Company believes that its activities were de minimis. There are additional areas of environmental remediation responsibilities which may fall on the Company. Future information and developments will require the Company to continually reassess the expected impact of these environmental matters. However, the Company has evaluated its total environmental exposure based on currently available data, including its potential joint and several liability, and believes that compliance with all applicable laws and regulations will not have a material adverse impact on the Company's liquidity or financial position. RESULTS OF OPERATIONS The Company operates principally in the following lines of business: natural gas, refining and marketing, exploration and production, and coal. NATURAL GAS. Natural gas operations involve the production, purchase, gathering, storage, transportation and sale of natural gas, principally to utilities, industrial customers and other pipelines, and include the operations of natural gas liquids extraction plants. In the fourth quarter of 1993, ANR Pipeline Company and Colorado Interstate Gas Company ("CIG") placed their Order 636 (See Note 14 in the Notes to Consolidated Financial Statements) service structures into effect and now offer an array of unbundled transportation, storage and balancing service options. Under Order 636, the interstate pipeline companies will no longer offer sales for resale services, with the exception of certain gas sales services provided by CIG, which are being phased out over a three-year period. Former gas sales customers of the interstate pipelines have largely retained their firm storage and transportation services levels. These services were previously contracted as part of bundled sales services. Consequently, while operating revenues will be reduced as a result of the implementation of Order 636, purchases and other related costs will be reduced by a similar amount. 1993 Versus 1992. The increase in operating revenues of $501 million can be attributed to increased sales volumes for the interstate pipelines and gas marketing companies, higher prices for the gas marketing companies, and increased storage and transportation revenues. Decreased gas sales prices for the interstate pipelines partially offset the increase. Total throughput volumes for the interstate pipelines increased by approximately 1%, while the volume for the gas marketing companies increased by 10%. Purchases increased $529 million over 1992, primarily due to volume increases for the interstate pipelines and gas marketing companies and cost of gas increases for the gas marketing companies, resulting in a reduction in the gross profit of $28 million. The operating profit increase of $2 million results from increased sales volumes of $7 million; higher storage and transportation revenues of $137 million; and reduced depreciation, depletion and amortization of $41 million offset by lower margins of $166 million, increased operating expenses of $11 million and other decreases of $6 million. The primary factor contributing to the increase in storage and transportation revenues and the decrease in margins is the restructuring of pipeline bundled sales services into separate service components, as required by changing regulations. The depreciation, depletion and amortization decrease of $41 million results from lower pipeline rates for ANR Pipeline due to a settlement with the FERC. 1992 Versus 1991. Operating revenues increased in 1992 as a result of increased sales volumes for the interstate pipelines and gas marketing companies, higher prices for the gas marketing companies, increased storage and transportation revenues and the benefit from resolution of outstanding rate matters and litigation. Decreased gas sales prices for the interstate pipelines partially offset the increase. Purchases increased by $267 million in 1992, primarily due to volume increases for interstate pipelines and gas marketing companies and higher costs for the gas marketing companies, resulting in a gross profit increase of $74 million. The operating profit increase of $1 million results from increased sales volumes of $14 million, improved storage and transportation revenues of $37 million and other increases of $21 million which were partially offset by lower margins of $32 million, increased operating expenses of $29 million and increased depreciation, depletion and amortization of $10 million. The other increases are primarily due to the settlement of outstanding rate matters and litigation. The sales volumes were up and the margins were down for both the interstate pipeline companies and gas marketing companies. The storage and transportation revenue increase results from increased transportation volumes and improved storage revenues. The operating expense increase results from increases for compressor fuel, gas and gas liquids handling charges and rate settlement related expenses. The depreciation, depletion and amortization increase results from a non-recurring 1991 retroactive adjustment related to Wyoming Interstate Company, Ltd. REFINING AND MARKETING. Refining and marketing operations involve the purchase, transportation and sale of refined products, crude oil, condensate and natural gas liquids; the operation of refining and chemical plants; the sale at retail of gasoline, petroleum products and convenience items; petroleum product terminaling and marketing of crude oil and refined petroleum products worldwide. 1993 Versus 1992. The decrease in operating revenues of $360 million results from decreased sales prices and lower volumes. Sales volumes decreased primarily due to a reduction in the sales of products purchased from others. In addition, crude processing was suspended at the Company's three refineries in Kansas during 1993. Purchases for the refining and marketing segment decreased by $550 million, a result of lower costs and volumes, and increased emphasis on hedging activities to minimize the impact of price volatility. This resulted in an increased gross profit of $190 million. Increased margins of $187 million, increased revenues from marine operations of $4 million and other increases of $8 million, which were partially offset by reduced volumes of $9 million, make up the gross profit increase. A portion of the margin increase can be attributed to the Company concentrating on marketing higher margin, value-added products and services. The Company eliminated almost 50 marginal third party locations from its distribution system in 1993. These steps also added to the volume decline in 1993. The operating profit increase of $290 million results from the improved gross profit of $190 million, reduced operating expenses of $47 million and lower depreciation, depletion and amortization of $53 million. The reduction in operating expenses results from the suspension of crude oil processing at the Company's refineries in Kansas and the nonrecurrence of the related $35 million restructuring charge in 1992. Partially offsetting these decreases were increased expenses for new foreign operations. Depreciation, depletion and amortization decreased as a result of a 1992 restructuring charge of $50 million not recurring. 1992 Versus 1991. The increase in 1992 operating revenues of $264 million can be attributed to increased volumes, primarily for the terminal and marketing operations, which were partially offset by decreased prices and reduced marine revenues. The lower prices affected all areas of the segment's operations. Purchases for the segment increased by $185 million, a result of increased volumes and lower costs, resulting in a gross profit increase of $79 million. This $79 million gross profit increase results from volume increases of $84 million and margin increases of $37 million being partially offset by lower marine revenues of $17 million, reduced gross profit from the sale, trading and exchanging of third-party products of $12 million and other decreases of $13 million. The operating profit decrease of $93 million results from increased operating expenses of $114 million and increased depreciation, depletion and amortization of $58 million more than offsetting the increased gross profit of $79 million. The increased operating expenses are attributable to charges for restructuring and increased maintenance costs. Depreciation, depletion and amortization increased primarily from a $50 million charge for the restructuring of certain refining assets. EXPLORATION AND PRODUCTION. Exploration and production operations involve the exploration, development and production of natural gas, crude oil, condensate and natural gas liquids. The segment also includes related intrastate natural gas marketing activities and gas plant processing operations. 1993 Versus 1992. The increase in operating revenues of $47 million can be attributed to increased sales volumes for all products and increased natural gas prices being partially offset by lower prices for oil, condensate and natural gas liquids. Natural gas revenue increases of $51 million were partially offset by decreases for oil, condensate and natural gas liquids of $3 million and other of $1 million. The operating profit increase of $4 million results from increased volumes for all products of $48 million and natural gas price increases of $13 million being offset by reduced prices for crude oil, condensate and natural gas liquids of $13 million, increased operating expenses of $15 million, increased depreciation, depletion and amortization of $26 million and other of $3 million. The increase in operating expenses results from additional wells in operation and higher costs associated with operating natural gas plants. Depreciation, depletion and amortization increased as a result of an increase in volumes. 1992 Versus 1991. Operating revenues decreased in 1992 as reduced revenues from gas brokerage, lower prices for crude oil, condensate and plant products and decreased other income were partially offset by increased natural gas prices and increased volumes for all products. The decrease in other income is due to the sale in 1991 of two gathering systems. The operating profit increase for the segment resulted from increased volumes for all products of $31 million and increased natural gas prices of $5 million being partially offset by lower prices for oil, condensate and natural gas liquids of $10 million; increased depreciation, depletion and amortization of $14 million; reduced revenue from gas brokerage of $2 million and other decreases of $9 million. Included in the other decreases are non-recurring gains of $7 million from 1991 property sales. The increase in depreciation, depletion and amortization can be attributed to increased volumes. COAL. Coal operations include mining, processing and marketing of coal from Company-owned reserves and from other sources, and the brokering of coal for others. 1993 Versus 1992. The decrease in coal revenues results from decreased prices more than offsetting increased volumes sold and brokered. The purchase of the Soldier Creek Mine in late 1993 added 600,000 tons/year of new capacity. The operating profit increase results from increased volumes of $13 million, reduced operating expenses of $6 million and other of $1 million more than offsetting lower prices of $18 million. Operating expenses were reduced by expanding the percentage of overall production from the lower-cost Utah operations. 1992 Versus 1991. The decrease in operating revenues is a result of decreased sales volumes and lower prices. The tonnage, excluding brokerage, decreased approximately 1%. Sales prices decreased at all mines. Operating profit increased in 1992 as decreases for coal costs and operating expenses of $20 million more than offset reduced revenues of $18 million and increased depreciation, depletion and amortization of $1 million. The decrease for coal costs and operating expenses results from lower volumes sold and more efficient operations. OTHER. Other operations involve trucking, power production operations and other activities. 1993 Versus 1992. The $9 million reduction in operating revenues results from volume decreases for the trucking operations and lower cogeneration revenues. The $7 million decrease in operating loss results from reduced operating expenses of $16 million, primarily for the trucking operations, exceeding the revenue decline; as trucking operations increased by $11 million offset by a $4 million decrease for the other operations. The decreased operating expenses result from reduced wages and lower rent expense. 1992 Versus 1991. The $27 million increase in 1992 in operating revenues can be attributed to volume increases for the trucking operations and increased cogeneration revenues. The operating loss increase of $15 million results from a $19 million increased loss for trucking partially offset by a $4 million income increase for other operations, as increased operating expenses more than offset improved revenues. The increased operating expenses of $41 million are a result of increased freight volumes and increased cogeneration activities. OTHER INCOME - NET 1993 Versus 1992. Other income-net increased by $53 million in 1993 due to increased equity income from unconsolidated subsidiaries of $8 million, nonrecurrence of the 1992 writedown of refining investments and other assets of $43 million and other increases of $2 million. 1992 Versus 1991. Other income-net decreased by $43 million in 1992 as a result of decreased gains from sales of investments of $13 million, the writedown of refining investments and other assets in 1992 of $43 million, reduced dividend and interest income of $6 million and other decreases of $18 million offset by increased equity income from unconsolidated subsidiaries of $37 million. INTEREST AND DEBT EXPENSE 1993 Versus 1992. Interest and debt expense decreased by $43 million in 1993, primarily as a result of lower average debt outstanding and lower interest rates more than offsetting reduced capitalized interest and other financial costs. At December 31, 1993, after giving effect to interest rate swaps, approximately 16% of the Company's debt was tied to money market-related rates. 1992 Versus 1991. Interest and debt expense increased by $47 million in 1992, primarily as a result of higher average debt outstanding and reduced capitalized interest more than offsetting lower average interest rates and reduced interest on pipeline customer refunds. TAXES ON INCOME Income taxes fluctuated primarily as a result of changing levels of income before taxes and changes in the effective federal income tax rate. The 1993 taxes include a $29 million charge for the cumulative effect of adjusting the deferred federal income tax liability to reflect the change in the corporate federal income tax rate from 34% to 35%. EXTRAORDINARY ITEM The extraordinary loss, net of income taxes, resulted from the early retirement of debt. See Note 13 in the Notes to Consolidated Financial Statements. INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders The Coastal Corporation Houston, Texas We have audited the accompanying consolidated balance sheets of The Coastal Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, common stock and other stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of The Coastal Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 11 to the consolidated financial statements, in 1993 the Company changed its method of accounting for postretirement benefits other than pensions to conform with Statement of Financial Accounting Standards No. 106. DELOITTE & TOUCHE Houston, Texas February 3, 1994 THE COASTAL CORPORATION AND SUBSIDIARIES STATEMENT OF CONSOLIDATED OPERATIONS (Millions of Dollars Except Per Share) See Notes to Consolidated Financial Statements THE COASTAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Millions of Dollars) See Notes to Consolidated Financial Statements THE COASTAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Millions of Dollars) See Notes to Consolidated Financial Statements THE COASTAL CORPORATION AND SUBSIDIARIES STATEMENT OF CONSOLIDATED CASH FLOWS (Millions of Dollars) See Notes to Consolidated Financial Statements THE COASTAL CORPORATION AND SUBSIDIARIES STATEMENT OF CONSOLIDATED COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY (Millions of Dollars and Thousands of Shares) See Notes to Consolidated Financial Statements THE COASTAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include accounts of the Company and its wholly owned subsidiaries, after eliminating all significant intercompany transactions. The equity method of accounting is used for investments in which the Company has a 20% to 50% continuing interest and exercises significant influence. Investments in which the Company has less than a 20% interest are accounted for by the cost method. STATEMENT OF CASH FLOWS - For purposes of this statement, cash equivalents include time deposits, certificates of deposit and all highly liquid instruments with original maturities of three months or less. Cash flows of a hedging instrument that are accounted for as a hedge of an identifiable transaction are classified in the same category as the cash flows from the item being hedged. The Company made cash payments for interest and financing fees (net of amounts capitalized) of $447.2 million, $480.6 million and $426.6 million in 1993, 1992 and 1991, respectively. Cash payments (refunds) for income taxes amounted to $21.0 million, ($9.8) million and $81.0 million for 1993, 1992 and 1991, respectively. INVENTORIES - Inventories of refined products and crude oil are accounted for by the first-in, first-out cost method ("FIFO") or market, if lower. Natural gas inventories are accounted for on the basis used for rate making and in reporting to the Federal Energy Regulatory Commission ("FERC"). Colorado Interstate Gas Company ("CIG") uses the last-in, first-out method, while ANR Pipeline Company uses the first-in, first-out method. Inventories of coal are accounted for at average cost, or market, if lower. Inventories of materials and supplies are accounted for at average cost. HEDGES - The Company frequently enters into futures and other contracts to hedge the price risks associated with inventories, commitments and certain anticipated transactions. Coastal defers the impact of changes in the market value of these contracts until such time as the hedged transaction is completed. PROPERTY, PLANT AND EQUIPMENT - Property additions include acquisition costs, administrative costs and, where appropriate, capitalized interest allocable to construction. Capitalized interest amounted to $8.4 million, $10.7 million and $22.1 million in 1993, 1992 and 1991, respectively. All costs incurred in the acquisition, exploration and development of gas and oil properties, including unproductive wells, are capitalized under the full-cost method of accounting. Depreciation, depletion and amortization of gas and oil properties are provided on the unit-of-production basis whereby the unit rate for depreciation, depletion and amortization is determined by dividing the total unrecovered carrying value of gas and oil properties plus estimated future development costs by the estimated proved reserves included therein, as estimated by an independent engineer. The average amortization rate per equivalent unit of a thousand cubic feet of gas production for oil and gas operations was $1.00 each for 1993, 1992 and 1991. Provisions for depletion of coal properties, including exploration and development costs, are based upon estimates of recoverable reserves using the unit-of-production method. Provision for depreciation of other property is primarily on a straight-line basis over the estimated useful life of the properties. Costs of minor property units (or components thereof) retired or abandoned are charged or credited, net of salvage, to accumulated depreciation, depletion and amortization. Gain or loss on sales of major property units is credited or charged to income. GOODWILL - Goodwill, which primarily relates to the acquisitions of American Natural Resources Company and Colorado Interstate Gas Company, amounted to $563.3 million at December 31, 1993, and is being amortized on a straight-line basis over a 40-year period. Amortization expense charged to operations was approximately $19.0 million for 1993, 1992 and 1991, respectively. As warranted by facts and circumstances, the Company periodically assesses the recoverability of the cost of goodwill from future operating income. INCOME TAXES - The Company follows the liability method of accounting for deferred income taxes as required by the provisions of Statement of Financial Accounting Standards No. 109 - Accounting for Income Taxes. REVENUE RECOGNITION - The Company's subsidiaries recognize revenues for the sale of their respective products in the period of delivery. Revenues for services are recognized in the period the services are provided. CURRENCY TRANSLATION - The U.S. dollar is the functional currency for substantially all the Company's foreign operations. For those operations, all gains and losses from currency translations are included in income currently. EARNINGS PER SHARE - Earnings (loss) per common and common equivalent share amounts are based on the average number of common and Class A common shares outstanding during each period, assuming conversion of preferred stocks which are common stock equivalents and exercise of all stock options having exercise prices less than the average market price of the common stock using the treasury stock method. Average shares entering into the computations are: STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 71 (FAS 71) - The interstate natural gas pipeline operations and certain storage subsidiaries are subject to the regulations and accounting procedures of the FERC. These subsidiaries meet the criteria and, accordingly, follow the reporting and accounting requirements of FAS 71. RECLASSIFICATION OF PRIOR PERIOD STATEMENTS - Certain minor reclassifications have been made to conform with current reporting practices. The effect of the reclassifications was not material to the Company's results of operations or financial position. NOTE 2. INVENTORIES Inventories at December 31 were (millions of dollars): Elements included in inventory cost are material, labor and manufacturing expenses. The excess of replacement cost over the carrying value of natural gas in underground storage carried by the last-in, first-out method was approximately $52.6 million and $47.8 million at December 31, 1993 and 1992, respectively. Natural gas in underground storage at December 31, 1993, includes $161.5 million, pending approval by the FERC, which is to be transferred to Property, Plant and Equipment for regulatory and accounting purposes. NOTE 3. TAKE-OR-PAY OBLIGATIONS Other assets include $134.0 million and $225.6 million at December 31, 1993 and 1992, respectively, relating to prepayments for gas under gas purchase contracts with producers and settlement payment amounts relative to the restructuring of gas purchase contracts as negotiated with producers. Currently, FERC regulations allow for the billing of a portion of the costs of take-or-pay settlements and renegotiating gas purchase contracts. Prepayments are normally recoupable through future deliveries of natural gas. As a result of the implementation of Order 636 by CIG on October 1, 1993 (See Note 14 in the Notes to Consolidated Financial Statements), CIG's future gas sales will be made at negotiated prices and will not be subject to regulatory price controls. This will not affect the recoverability or the results of pending take-or-pay litigation or any take-or-pay or contractual reformation settlements that CIG may achieve with respect to periods before October 1, 1993. A portion of the costs associated with take-or-pay incurred prior to October 1, 1993, may continue to be recovered by CIG pursuant to FERC's Order No. 528. Contract reformation and take-or-pay costs incurred as a result of the mandated Order 636 restructuring will be recovered under the transition cost mechanisms of Order 636, as well as through negotiated agreements with customers. The Company believes that these mechanisms provide adequate coverage for such costs. Several producers have instituted litigation arising out of take-or-pay claims against subsidiaries of the Company. In the Company's experience, producers' claims are generally vastly overstated and do not consider all adjustments provided for in the contract or allowed by law. The subsidiaries have resolved the majority of the exposure with their suppliers for approximately 13% of the amounts claimed. At December 31, 1993, the Company estimated that unresolved asserted and unasserted producers' claims amounted to approximately $31 million. The remaining disputes will be settled where possible and litigated if settlement is not possible. At December 31, 1993, the Company was committed to make future purchases under certain take-or-pay contracts with fixed, minimum or escalating price provisions. Based on contracts in effect at that date, and before considering reductions provided in the contracts or applicable law, such commitments are estimated to be $38 million, $30 million, $23 million, $15 million and $4 million for the years 1994-1998, respectively, and $9 million thereafter. Such commitments have also not been adjusted for all amounts which may be assigned or released, or for the results of future litigation or negotiation with producers. The Company has made provisions, which it believes are adequate, for payments to producers that may be required for settlement of take-or-pay claims and restructuring of future contractual commitments. In determining the net loss relating to such provisions, the Company has also made accruals for the estimated portion of such payments which would be recoverable pursuant to FERC- approved settlements with customers. NOTE 4. INVESTMENTS The Company has interests in corporations and partnerships which are accounted for on an equity basis. These investments, included in Other Assets, are Great Lakes Gas Transmission Limited Partnership (50% interest), which operates an interstate pipeline system; Pacific Refining Company (50% interest), which operates a refinery and terminal facilities in California; Javelina Company (40% interest), which operates a gas processing plant in Corpus Christi, Texas; Eagle Point Cogeneration Partnership (50% interest), which operates a cogeneration facility in New Jersey; corporate joint ventures (50% interest), which have developed gas and oil properties in Argentina; and several pipeline and other ventures. The Company's investment in these entities, including advances, amounted to $424.7 million and $330.2 million at December 31, 1993 and 1992, respectively. The Company's equity in income of the investments was $71.9 million, $63.8 million and $26.6 million in 1993, 1992 and 1991, respectively, while dividends and partnership distributions received amounted to $17.5 million, $47.8 million and $18.9 million in 1993, 1992 and 1991, respectively. The 1992 equity in income excludes the restructuring charges as discussed in Note 10. Summarized financial information of these entities is as follows (millions of dollars): NOTE 5. DEBT LONG-TERM DEBT - Balances at December 31 were (millions of dollars): At December 31, 1993, long-term credit agreements with banks totaled $1,198.1 million, including $308.0 million available to The Coastal Corporation. Loans under these agreements bear interest at money market-related rates (weighted average 4.16% at December 31, 1993). Annual commitment fees range up to 1/2% payable on the unused portion of the applicable facility. At December 31, 1993, $653.5 million was outstanding. Notes payable to banks of $400.0 million are obligations of a wholly owned subsidiary, Coastal Natural Gas Company (CNG), for which CNG has pledged the common stock of its first-tier subsidiaries as collateral. The agreements contain restrictive covenants which, among other things, limit the payment of dividends by CNG and the amount of additional indebtedness of CNG and its subsidiaries. The subsidiary project financing note bears interest at money market-related rates. Various agreements contain restrictive covenants which, among other things, limit the payment of advances or dividends by certain subsidiaries and additional indebtedness of certain subsidiaries. At December 31, 1993, net assets of consolidated subsidiaries amounted to approximately $5.1 billion, of which $1.7 billion was restricted by such provisions. In February 1994, ANR Pipeline Company sold $125.0 million of 7-3/8% Debentures due in 2024. The net proceeds from the sale will be used for capital expenditures and for other general corporate purposes. INTEREST RATE AND CURRENCY SWAPS - The Company has entered into a number of interest rate swap agreements which have effectively fixed interest rates on $563.5 million of floating rate debt. Under these agreements, Coastal will pay the counterparties interest at a fixed rate, and the counterparties will pay Coastal interest at a variable rate based on the London Interbank Offered Rate (LIBOR). At December 31, 1993, the weighted average fixed rate payable under these agreements was 9.61%. The Company has also entered into a number of offsetting interest rate swap agreements which have effectively converted $250.0 million of fixed rate debt into floating rate debt. Terms expire at various dates through the third quarter of 1996. The foreign currency exposure relating to certain of the Swiss franc denominated debt of the Company and one of its subsidiaries and Japanese yen denominated debt of the Company has been hedged to maturity, resulting in effective borrowing costs ranging from 8.2% to 11.1%. Coastal and its subsidiaries have entered into these interest rate and currency swaps with major banking institutions to reduce the impact of interest rate and exchange rate fluctuations with respect to certain floating rate and foreign currency denominated debt. In certain instances, the Company has also entered into interest rate swaps to convert a portion of its fixed rate debt into floating rates. Coastal is exposed to loss if one or more of the counterparties default. Interest rate swap transactions generally involve exchanges of fixed and floating interest payment obligations without exchanges of underlying principal amounts. Similarly, currency swaps involve exchanges of interest payments in differing currencies but provide for the exchange of principal amounts at maturity, usually through an escrow arrangement to limit credit risk. Consequently, Coastal's exposure to credit loss is significantly less than the contracted amounts. Neither the Company nor the counterparties are required to collateralize their respective obligations under these swaps. At December 31, 1993, Coastal had no exposure to credit loss on interest rate swaps and approximately $108.7 million of exposure to credit loss on currency swaps. SUBORDINATED LONG-TERM DEBT - Balances at December 31 were (millions of dollars): MATURITIES - The aggregate amounts of long-term debt (including subordinated) maturities for the five years following 1993 are (millions of dollars): NOTES PAYABLE - At December 31, 1993, Coastal and its subsidiaries had $264.0 million of outstanding indebtedness to banks under short-term lines of credit, compared to $221.4 million at December 31, 1992. As of December 31, 1993, $413.0 million was available to be drawn under short-term credit lines. RESTRICTIONS ON PAYMENT OF DIVIDENDS - Under the terms of the most restrictive of the Company's financing agreements, approximately $409.9 million was available at December 31, 1993, for payment of dividends on the Company's common and preferred stocks. GUARANTEES - Coastal and certain subsidiaries have guaranteed specific obligations of several unconsolidated affiliates. Such affiliates are generally not required to collateralize their contingent liabilities to the Company. At December 31, 1993, the Company had guaranteed 50% of a construction financing entered into by a partially owned partnership, 45% of a construction financing of a second partnership and 100% of a construction financing entered into by a third partnership. The Company's proportionate share of the outstanding principal balances under these guarantees was $135.0 million at December 31, 1993. Other guarantees and indemnities related to obligations of unconsolidated affiliates amounted to approximately $224.9 million as of the same date. The Company anticipates that two of the guaranteed construction loans will be refinanced in 1994 and the third in early 1995, all on a non-recourse basis. The Company is of the opinion that its unconsolidated affiliates will be able to perform under their respective financings and other obligations and that no payments will be required and no losses will be incurred under such guarantees and indemnities. Coastal and certain subsidiaries have guaranteed approximately $16.7 million of obligations of third parties under leases and borrowing arrangements. Where possible, the Company has obtained security interests and guarantees by the principals. Cash requirements and losses under these guarantees are expected to be nominal. NOTE 6. LEASES The Company and its subsidiaries had rental expense of approximately $98.2 million, $92.6 million and $98.1 million in 1993, 1992 and 1991, respectively, excluding leases covering natural resources. Aggregate minimum lease payments under existing noncapitalized long-term leases are estimated to be $82.8 million, $80.5 million, $77.3 million, $71.0 million, and $59.5 million for the years 1994-1998, respectively, and $720.7 million thereafter. NOTE 7. MANDATORY REDEMPTION PREFERRED STOCK Shares and aggregate redemption value of mandatory redemption preferred stock outstanding, excluding shares redeemable within one year, were (thousands of shares and millions of dollars): CIG has 550,000 shares of $100 par value cumulative preferred stock authorized, of which 5,560 shares were outstanding at December 31, 1993. The stock outstanding is due in 1997 with an annual dividend rate of 5.5%. The series is to be redeemed at par value through annual sinking fund payments. ANR Pipeline Company had 1,086,640 outstanding shares of $1.00 par value redeemable cumulative preferred stock at December 31, 1993. The stock consists of three series with dividends per share of $2.675, $2.12 and $12.00. The $2.675 and $2.12 series were issued at $25 per share and the $12.00 series was issued at $100 per share. The current per share redemption prices are $25.268 for the $2.675 Series (decreases to issue price by 1995), $25.318 for the $2.12 Series (decreases to issue price by 1996) and $103.790 for the $12.00 Series (decreases to issue price by 1999). All series are to be redeemed through annual sinking fund payments. The aggregate amount of share redemption requirements for the five years following 1993 are (millions of dollars): NOTE 8. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value amounts of the Company's financial instruments have been determined by the Company, using appropriate market information and valuation methodologies. Considerable judgment is required to develop the estimates of fair value, thus, the estimates provided herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The estimated value of the Company's long-term debt and mandatory redemption preferred stock is based on interest rates at December 31, 1993 and 1992, respectively, for new issues with similar remaining maturities. The fair market value of the Company's interest rate and foreign currency swaps is based on the estimated termination values at December 31, 1993 and 1992, respectively. NOTE 9. COMMON AND PREFERRED STOCK Shares of common stock and Class A common stock reserved for future issuance as of December 31, 1993 were: Common stock reserved for conversion is at the rate of one share for each share of Class A common stock, 3.6125 shares for each share of Series A or Series B preferred stock and 7.1121094 shares for each share of Series C preferred stock. Each share of common stock and Series A, Series B and Series C preferred stock is entitled to one vote while each share of Class A common stock is entitled to 100 votes. However, 25% of the Company's directors standing for election at each annual meeting will be determined solely by holders of the common stock and preferred stocks mentioned above, voting as a class. In April 1993, the Company completed the public offering of 8,000,000 shares of $2.125 Cumulative Preferred Stock, Series H, at $25 per share. The net proceeds from the sale were used to retire short- and long-term debt of the Company. Under the 1980 Stock Option Plan, no options were exercisable at December 31, 1993, and 904 common shares and 25 Class A common shares were exercisable at December 31, 1992. No additional options may be granted under the 1980 Plan. Under the 1984 Plan, 4,113 Class A common shares and 13,442 common shares were available for granting of options, and options for 39,262 Class A common shares and 92,288 common shares were exercisable at December 31, 1993. At December 31, 1992, nine Class A common shares and 12 common shares were available for granting of options, and options for 124,448 Class A common shares and 185,080 common shares were exercisable. Under the 1985 Plan, 69,758 common shares were available for granting of options, and options for 953,898 common shares were exercisable at December 31, 1993. At December 31, 1992, 102,773 common shares were available for granting of options, and options for 1,194,414 common shares were exercisable. Under the 1990 Plan, 23,717 common shares were available for granting of options, and options for 181,380 common shares were exercisable at December 31, 1993. At December 31, 1992, 368,690 common shares were available for granting of options, and options for 42,002 common shares were exercisable. Options are currently granted under the plans at 100% of market value. The following table presents a summary of stock option transactions for the three years ended December 31, 1993: NOTE 10. SEGMENT REPORTING The Company operates principally in the following lines of business: natural gas, refining and marketing, exploration and production, and coal. Natural gas operations involve the production, purchase, gathering, storage, transportation and sale of natural gas, principally to utilities, industrial customers and other pipelines, and include the operation of natural gas liquids extraction plants. Refining and marketing operations involve the purchase, transportation and sale of refined products, crude oil, condensate and natural gas liquids; the operation of refineries and a chemical plant; the sale at retail of gasoline, petroleum products and convenience items; petroleum product terminaling; and marketing of crude oil and refined petroleum products worldwide. Exploration and production operations involve the exploration, development and production of natural gas, crude oil, condensate and natural gas liquids. The segment also includes related intrastate natural gas marketing activities and gas plant processing operations. Coal operations include the mining, processing and marketing of coal from Company-owned reserves and from other sources, and the brokering of coal for others. Other operations include regional trucking operations involving activities as common carriers in interstate and intrastate commerce and activities in power production and other projects. Operating revenues by segment include both sales to unaffiliated customers, as reported in the Company's Statement of Consolidated Operations, and intersegment sales, which are accounted for on the basis of contract, current market or internally established transfer prices. The intersegment sales are primarily sales from the exploration and production segment to the natural gas and refining and marketing segments and from the natural gas segment to the refining and marketing segment. Operating profit is total revenues less interest income from affiliates and operating costs and expenses. Operating expenses exclude income taxes, corporate general and administrative expenses and interest. Identifiable assets by segment are those assets that are used in the Company's operations in each segment. Corporate assets are those assets which are not specifically identifiable with a segment. The Company's operating revenues, operating profit, capital expenditures, and depreciation, depletion and amortization expense for the years ended December 31, 1993, 1992 and 1991, and identifiable assets as of December 31, 1993, 1992 and 1991, by segment, are shown as follows (millions of dollars): Refining and marketing revenues include gross profit arising from the selling, trading and exchanging of third party products. Approximate amounts from these transactions included in revenues and the impact on earnings, exclusive of interest costs, were (millions of dollars): The number and magnitude of such transactions may vary significantly from year to year, particularly in view of conditions in world petroleum markets. Results for 1992 reflect a primarily non-cash $125 million pretax charge for restructuring certain refining and marketing operations. The charge reflects numerous actions to reduce costs and working capital, limit risks and eliminate marginal activities, and primarily relates to reducing the carrying value of certain assets. Eighty-five million dollars of the charge relates to wholly owned assets and was made against operating profit. The remaining $40 million relates to partially owned investments and was included in Other Income-Net. OTHER INCOME - Net for 1991 includes gains of $13.2 million from the sale of securities. Also included are equity method earnings related to the business segments as follows (millions of dollars): Revenues from sales to any single customer during 1993, 1992 or 1991 did not amount to 10% or more of the Company's consolidated revenues for any year. NOTE 11. BENEFIT PLANS The Company has non-contributory pension plans covering substantially all U.S. employees. These plans provide benefits based on final average monthly compensation and years of service. The Company's funding policy is to contribute the amount necessary for the plan to maintain its qualified status under the Employee Retirement Income Security Act of 1974. The pension benefit for 1993, 1992 and 1991 is shown in the following table (millions of dollars): The discount rate used in determining the actuarial present value of the projected benefit obligation was 7.25% in 1993 and 8.25% in 1992 and 1991. The expected increase in future compensation levels was 4% in 1993 and 6% in 1992 and 1991, and the expected long-term rate of return on assets was 11%. The following table sets forth the funded status of the plans and the amounts recognized in the Company's Consolidated Balance Sheet (millions of dollars): Plan assets include common stock and Class A common stock of the Company amounting to a total of 3.75 million shares at December 31, 1993 and 1992. The Company also participates in several multi-employer pension plans for the benefit of its employees who are union members. Company contributions to these plans were $7.1 million each for 1993, 1992 and 1991. The data available from administrators of the multi-employer pension plans is not sufficient to determine the accumulated benefit obligations, nor the net assets attributable to the multi-employer plans in which Company employees participate. The Company also makes contributions to a thrift plan, which is a trusteed, voluntary and contributory plan for eligible employees of the Company. The Company's contributions, which match the contributions made by employees, amounted to $17.7 million, $16.6 million and $15.4 million in 1993, 1992 and 1991, respectively. The Company provides certain health care and life insurance benefits for retired employees. Substantially all U.S. employees are provided these benefits. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"). FAS 106 requires the Company to accrue the estimated cost of retiree benefit payments during the years the employee provides services. The Company previously expensed the cost of these benefits, which are principally health care, as claims were incurred. FAS 106 allows recognition of the cumulative effect of the liability in the year of the adoption or the amortization of the obligation over a period of up to 20 years. The Company has elected to recognize the initial postretirement benefit obligation of approximately $133.1 million over a period of 20 years. The Company's cash flows were not affected by implementation of FAS 106 and the incremental impact on the Company's 1993 results of operations before income taxes is approximately $13.6 million, of which $8.3 million is being deferred by the Company's rate regulated subsidiaries. The subsidiaries have filed to include such deferred costs in their rates. [CAPTION] The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 16.0% in 1993, declining gradually to 7.0% by the year 2004. A one percentage point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, and net postretirement health care cost by approximately 4.7%. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.25%. The Company adopted Statement of Financial Accounting Standards No. 112, "Employer's Accounting for Postemployment Benefits" ("FAS 112") effective January 1, 1994. This standard covers the accounting for estimated costs of benefits provided to former or inactive employees before their retirement. The effect of the new standard will not have a material effect on the Company's results of operations or financial position. NOTE 12. TAXES ON INCOME Pretax earnings (loss) before extraordinary item are composed of the following (millions of dollars): Provisions for income taxes (benefits) before extraordinary item are composed of the following (millions of dollars): The Company and the Internal Revenue Service ("IRS") Appeals Office have concluded a tentative settlement of all contested adjustments to federal income tax returns filed for the years 1982 through 1984. The settlement is in the process of being finalized. The Company's federal income tax returns filed for the years 1985 through 1987 have been examined by the IRS, and the Company has received notice of proposed adjustments to the returns for each of those years. The Company currently is contesting certain of these adjustments with the IRS Appeals Office. Examinations of the Company's federal income tax returns for 1988, 1989 and 1990 are currently in progress. It is the opinion of management that adequate provisions for federal income taxes have been reflected in the consolidated financial statements. The Company increased its deferred tax liability as a result of legislation enacted in 1993 increasing the Corporate federal income tax rate from 34% to 35% commencing in 1993. Provisions for income taxes were different than the amount computed by applying the statutory U.S. federal income tax rate to earnings before tax. The reasons for these differences are (millions of dollars): Deferred tax liabilities (assets) which are recognized for the estimated future tax effects attributable to temporary differences and carryforward are (millions of dollars): NOTE 13. EXTRAORDINARY ITEM In June 1993, the Company retired $500.0 million of 11 1/4% Senior Notes due in 1996. The transaction resulted in an extraordinary loss of $2.5 million ($.02 per share), net of income taxes of $1.3 million. NOTE 14. LITIGATION AND REGULATORY MATTERS LITIGATION - In December 1992, certain of CIG's natural gas lessors in the West Panhandle Field filed a complaint in the U.S. District Court for the Northern District of Texas, claiming underpayment, breach of fiduciary duty, fraud and negligent misrepresentation. Management believes that CIG has numerous defenses to the lessors' claims, including (i) that the royalties were properly paid, (ii) that the majority of the claims were released by written agreement, and (iii) that the majority of the claims are barred by the statute of limitations. A subsidiary of Coastal has initiated a suit against TransAmerican Natural Gas Corporation in the District Court of Webb County, Texas for breach of two gas purchase agreements. In February 1993 TransAmerican Natural Gas Corporation filed a Third Party Complaint and a Counterclaim in this action against Coastal and certain subsidiaries. TransAmerican alleges breach of contract, fraud, conspiracy, duress, tortious interference and violations of the Texas Free Enterprises and Anti-trust Act arising out of the gas purchase agreements. TransAmerican seeks compensatory damages, exemplary damages and attorney fees. The matter is set for trial on March 14, 1994. Numerous other lawsuits and other proceedings which have arisen in the ordinary course of business are pending or threatened against the Company or its subsidiaries. Although no assurances can be given and no determination can be made at this time as to the outcome of any particular lawsuit or proceeding, the Company believes there are meritorious defenses to substantially all of the above claims and that any liability which may finally be determined should not have a material adverse effect on the Company's consolidated financial position. RATE REGULATION - On April 8, 1992, the FERC issued Order No. 636 ("Order 636"), which required significant changes in the services provided by interstate natural gas pipelines. Subsidiaries of the Company and numerous other parties have sought judicial review of aspects of Order 636. ANR Pipeline placed its restructured services under Order 636 into effect on November 1, 1993. ANR Pipeline now offers a wide range of unbundled transportation, storage and balancing services. Several persons, including ANR Pipeline, have sought judicial review of aspects of the FERC's orders approving ANR Pipeline's restructuring filings. Order 636 also provides mechanisms for recovery of transition costs associated with compliance with that Order. These transition costs include gas supply realignment costs, the cost of stranded pipeline investment and the cost of new facilities required to implement Order 636. ANR Pipeline expects that it will incur transition costs of approximately $150 million. As a result of the recovery mechanisms provided under Order 636, the Company anticipates that these transition costs will not have a material adverse effect on the Company's consolidated financial position or its results of operations. On December 17, 1992, the FERC issued a policy statement that outlined changes on how pipelines may recover the costs of employees' post-retirement benefits other than pensions. The FERC's policy will be to recognize, as a component of jurisdictional cost-based rates, allowances for FAS 106 costs of company employees when determined on an accrual basis, provided certain conditions are met. On November 1, 1993, ANR Pipeline filed a general rate increase with the FERC. The proposed rates reflect a $121 million increase in ANR Pipeline's cost of service from that approved in the settlement of ANR Pipeline's last rate case and a $218 million increase over ANR Pipeline's approved rates for its restructured services. The increase represents higher plant investment, Order 636 restructuring costs, rate of return and tax rate changes and increased costs related to the required adoption of recent accounting rule changes, i.e., FAS 106 and FAS 112. The FERC has permitted ANR Pipeline to place its new rates into effect on May 1, 1994, subject to refund, and subject to further orders. On July 2, 1993, CIG submitted to the FERC an unanimous offer of settlement which resolved all the Order 636 restructuring issues which had been raised in its restructuring proceedings. That settlement was ultimately approved (except for minor issues), and CIG's restructured services became effective October 1, 1993. CIG has "unbundled" its gas sales from its other services. Separate gathering, transportation, storage and other services are available on a "stand- alone" basis to any customers desiring them. CIG's Order 636 transition costs are not expected to be material. On March 31, 1993, CIG filed at FERC to increase its rates by approximately $26.5 million annually. Such rates (adjusted to reflect CIG's Order 636 program) became effective subject to refund on October 1, 1993. CIG, ANR Pipeline, ANR Storage Company and Wyoming Interstate Company, Ltd., subsidiaries, are regulated by the FERC. Certain regulatory issues remain unresolved among these companies, their customers, their suppliers and the FERC. The Company has made provisions which represent management's assessment of the ultimate resolution of these issues. While the Company estimates the provisions to be adequate to cover potential adverse rulings on these and other issues, it cannot estimate when each of these issues will be resolved. ENVIRONMENTAL REGULATION - The Company's operations are subject to extensive federal, state and local environmental laws and regulations. The Company anticipates annual capital expenditures of $20 to $40 million over the next several years aimed at compliance with such laws and regulations. Additionally, appropriate governmental authorities may enforce the laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties and remediation requirements. The Comprehensive Environmental Response, Compensation and Liability Act, also known as "Superfund," as reauthorized, imposes liability, without regard to fault or the legality of the original act, for disposal of a "hazardous substance." Certain subsidiaries of the Company have been named as a potentially responsible party ("PRP") in several "Superfund" waste disposal sites. At the 15 sites for which the EPA has developed sufficient information to estimate total clean-up costs of approximately $350 million, the Company estimates it pro-rata exposure to be paid over a period of several years is approximately $5 million and has made appropriate provisions. At three other sites, the EPA is currently unable to provide the Company with an estimate of total clean-up costs and, accordingly, the Company is unable to calculate its share of those costs. Finally, at five other sites, the Company has paid amounts to other PRPs as its proportional share of associated clean-up costs. As to these latter sites, the Company believes that its activities were de minimis. There are additional areas of environmental remediation responsibilities which may fall on the Company. Future information and developments will require the Company to continually reassess the expected impact of these environmental matters. However, the Company has evaluated its total environmental exposure based on currently available data, including its potential joint and several liability, and believes that compliance with all applicable laws and regulations will not have a material adverse impact on the Company's liquidity or financial position. NOTE 15. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Results of operations by quarter for the years ended December 31, 1993 and 1992 were (millions of dollars except per share): SUPPLEMENTAL INFORMATION ON OIL AND GAS PRODUCING ACTIVITIES Reserves, capitalized costs, costs incurred in oil and gas acquisition, exploration and development activities, results of operations and the standardized measure of discounted future net cash flows are presented for the exploration and production segment. Natural gas systems reserves and the related standardized measure of discounted future net cash flows are separately presented for natural gas operations. Substantially all of the Company's properties are located in the United States. In 1992, the Company acquired an equity method investment with operations in Argentina. The 1991 revisions of previous estimates of Natural Gas Systems reserves of natural gas are related to the Company's independent engineer's interpretation of an agreement, effective January 1, 1991, between the Company's subsidiary, CIG, and Mesa Operating Limited Partnership. Such revisions are not due to change in gross reserve estimates for the affected properties. ESTIMATED QUANTITIES OF PROVED RESERVES Changes in proved reserves since the end of 1990 are shown in the following table. Total proved reserves for natural gas systems exclude storage gas and liquids volumes. The natural gas systems storage gas volumes are 147,549, 183,741 and 191,351 million cubic feet and storage liquids volumes are approximately 150,000, 159,000 and 207,000 barrels at December 31, 1993, 1992 and 1991, respectively. CAPITALIZED COSTS RELATING TO EXPLORATION AND PRODUCTION ACTIVITIES The Company follows the full-cost method of accounting for oil and gas properties. COSTS INCURRED IN OIL AND GAS ACQUISITION, EXPLORATION AND DEVELOPMENT ACTIVITIES (Millions of dollars) RESULTS OF OPERATIONS FOR EXPLORATION AND PRODUCTION ACTIVITIES (Millions of dollars) The average amortization rate per equivalent Mcf was $1.00 for the years 1993, 1992 and 1991. STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED OIL AND GAS RESERVE QUANTITIES. Future cash inflows from the sale of proved reserves and estimated production and development costs as calculated by the Company's independent engineers are discounted by 10% after they are reduced by the Company's estimate for future income taxes. The calculations are based on year-end prices and costs, statutory tax rates and nonconventional fuel source tax credits that relate to existing proved oil and gas reserves in which the Company has mineral interests. The standardized measure is not intended to represent the market value of reserves and, in view of the uncertainties involved in the reserve estimation process, including the instability of energy markets, may be subject to material future revisions (millions of dollars): Principal sources of change in the standardized measure of discounted future net cash flows during each year are (millions of dollars): None of the amounts include any value for natural gas systems storage gas, which was approximately 41 Bcf of gas for CIG, 107 Bcf for ANR Pipeline and 150,000 barrels of liquids for CIG at the end of 1993. Share of Equity Method Investment - At December 31, 1993, the net investment in Argentine properties amounted to $58.5 million, representing net proved reserves of 144.5 Bcf of gas and 6.51 million barrels of oil, condensate and natural gas liquids. The standardized measure of discounted future net cash flows related to these reserves is $78.6 million at December 31, 1993. The Company's share of earnings for 1993 was approximately $5 million. SUPPLEMENTAL STATISTICS FOR COAL MINING OPERATIONS The following table contains Coastal's estimated recoverable coal reserves for operating properties. Reserves estimates are prepared by independent mining consultants and by internal sources (Coastal geologists and engineers). The reliability of the estimates is a function of the amount and quality of the geological data generated to date on each property and varies considerably from property to property. The reserve amounts are subject to change depending on additional geological data generated and/or actual mining operations. THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT THE COASTAL CORPORATION BALANCE SHEET (Millions of Dollars) See Notes to Condensed Financial Statements. S-1 THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT THE COASTAL CORPORATION BALANCE SHEET (Millions of Dollars) See Notes to Condensed Financial Statements. S-2 THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT THE COASTAL CORPORATION STATEMENT OF OPERATIONS (Millions of Dollars) See Notes to Condensed Financial Statements. S-3 THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT THE COASTAL CORPORATION STATEMENT OF CASH FLOWS (Millions of Dollars) See Notes to Condensed Financial Statements. S-4 THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT THE COASTAL CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation -- The financial statements of the Company reflect the investment in wholly-owned subsidiaries using the equity method. Statement of Cash Flows -- For purposes of this statement, cash equivalents include time deposits, certificates of deposit and all highly liquid instruments with original maturities of three months or less. The Company made cash payments for interest and financing fees of $357.1 million, $375.6 million and $313.6 million in 1993, 1992 and 1991, respectively. Cash payments (refunds - primarily from subsidiaries) for income taxes amounted to $(49.8) million, $(63.9) million and $(6.9) million for 1993, 1992 and 1991, respectively. Federal Income Taxes -- The Company follows the liability method of accounting for income taxes as required by the provisions of FAS 109, "Accounting for Income Taxes." The Company files a consolidated federal income tax return with its wholly- owned subsidiaries. Members of the consolidated group with taxable incomes are charged with the amount of income taxes as if they filed separate federal income tax returns, and members providing deductions and credits which result in income tax savings are allocated credits for such savings. Reclassification of Prior Period Statements - Certain minor reclassifications of prior period statements have been made to conform with current reporting practices. The effect of the reclassifications was not material to the Company's results of operations or financial position. NOTE 2. CONSOLIDATED FINANCIAL STATEMENTS Reference is made to the Consolidated Financial Statements and related Notes of Coastal and Subsidiaries for additional information. NOTE 3. DEBT AND GUARANTEES Information on the debt of the Company is disclosed in Note 5 of the Notes to Consolidated Financial Statements included herein. The Company has guaranteed certain long-term debt of its subsidiaries (approximately $82.4 million outstanding at December 31, 1993, including current maturities) and certain other obligations arising in the ordinary course of business. The Company and certain of its subsidiaries have entered into interest rate and currency swaps with major banking institutions. The Company is exposed to loss if one or more counterparties default. In addition, the Company or certain of its subsidiaries are guarantors on certain bank loans of corporations and partnerships in which the Company or certain subsidiaries have equity interests. Information on the swaps and guarantees is disclosed in Note 5 of the Notes to Consolidated Financial Statements. The aggregate amounts of long-term debt (including subordinated debt) maturities of Coastal for the five years following 1993 are (millions of dollars): NOTE 4. DIVIDENDS RECEIVED Cash dividends received from consolidated subsidiaries were as follows: 1993 - - $66.6 million, 1992 - $142.8 million and 1991 - $68.1 million. S-5 THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (Millions of Dollars) - -------------------- (A) Reclassifications and other miscellaneous adjustments. (B) Intercompany transfer. (C) Amortization of exploration cost charged to income. (D) Writedown of property, plant and equipment. (E) Reclass -- Investment in partially-owned company. S-6 Depreciation, depletion and amortization of gas and oil properties costs are provided on the unit-of-production basis whereby the unit rate for depreciation, depletion and amortization is determined by dividing the total unrecovered carrying value of all gas and oil properties plus estimated future development costs by the estimated proved reserves included therein, as estimated by an independent engineer. Provisions for depletion of coal properties are based upon estimates of recoverable reserves using the unit-of-production method. Provision for depreciation of other property is made primarily on a straight-line basis over the estimated useful lives of the property. The annual rates of depreciation are as follows: S-7 THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Millions of Dollars) - --------------- (A) Reclassifications and other miscellaneous adjustments. (B) Intercompany transfer. S-8 THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Millions of Dollars) - ----------------- (A) Accounts charged off net of recoveries. S-9 THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Millions of Dollars) The average amount of borrowings were computed by averaging the daily outstanding balances. Where interest expense was affected by commitment and/or facility fees, the weighted average interest rates were computed by averaging the daily interest rates, including such fees. If there were no such fees, the weighted average interest rates were computed by dividing the total interest for the year by the average aggregate borrowings outstanding. S-10 THE COASTAL CORPORATION AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (Millions of Dollars) - ----------- (1) Amounts are charged to operating costs and expenses with the exception of an insignificant amount which, together with other expenses, are redistributed to operating, construction and other accounts. (2) Production taxes are charged against operating revenues. S-11 EXHIBIT INDEX Exhibit Number Document - ------ -------- [C] [S] 3.1+ Restated Certificate of Incorporation of Coastal, as restated on March 22, 1994. (Filed as Module TCC-Artl-Incorp on March 28, 1994). 3.2+ By-Laws of Coastal, as amended on January 16, 1990 (Exhibit 3.4 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1989). 4 (With respect to instruments defining the rights of holders of long-term debt, the Registrant will furnish to the Commission, on request, any such documents). 10.1+ The Coastal Corporation Stock Option Plan (Exhibit 10.1 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1980). 10.2+ Employment Agreement between Coastal States Gas Corporation and Sam F. Willson, Jr., dated December 1, 1979 (Exhibit 10.41 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1980). 10.3+ First Amendment of The Coastal Corporation Stock Option Plan, dated September 3, 1981 (Exhibit 10.11 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1982). 10.4+ 1984 Stock Option Plan (Appendix B to Coastal's Proxy Statement for the 1984 Annual Meeting of Stockholders, dated May 14, 1984). 10.5+ 1985 Stock Option Plan (Appendix A to Coastal's Proxy Statement for the 1986 Annual Meeting of Stockholders, dated March 27, 1986). 10.6+ The Coastal Corporation Performance Unit Plan effective as of January 1, 1987 (Exhibit 10.5 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). 10.7+ The Coastal Corporation Replacement Pension Plan effective as of November 1, 1987 (Exhibit 10.6 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). 10.8+ Description of Coastal's Key Employees Bonus Plan (Exhibit 10.7 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). 10.9+ The Coastal Corporation Stock Purchase Plan, as restated on January 1, 1994 (Appendix B to Coastal's Proxy Statement for the 1994 Annual Meeting of Stockholders dated March 29, 1994). 10.10+ The Coastal Corporation Stock Grant Plan, effective December 1, 1988 (Exhibit 10.12 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.11+ The Coastal Corporation Deferred Compensation Plan for Directors (Exhibit 10.13 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 10.12+ The Coastal Corporation 1990 Stock Option Plan (Exhibit 10.13 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1989). 10.13+ Employment Agreement between The Coastal Corporation and James F. Cordes dated April 12, 1990 (Exhibit 10.13 to Coastal's Annual Report on Form 10-K for the fiscal year ended December 31, 1990). EXHIBIT INDEX _________________________ Note: + Indicates documents incorporated by reference from the prior filing indicated. * Indicates documents filed herewith.

7974_1993.txt

7974_1993

1993

7974

ITEM 1. BUSINESS. The following description of business is provided in accordance with General Instruction J.(2)(d). Associates First Capital Corporation ("First Capital" or the "Company"), a Delaware corporation, is an indirect subsidiary of Ford Motor Company ("Ford"). All the outstanding Common Stock of First Capital is owned by Ford Holdings, Inc. ("Holdings"). First Capital's principal operating subsidiary is Associates Corporation of North America ("Associates"), the second largest independent finance company in the United States as of September 30, 1993. Unless the context otherwise requires, reference to First Capital or Associates includes each parent company and all its subsidiaries. At December 31, 1993, First Capital had 1,390 branch offices in the United States and employed approximately 12,400 persons. Corporate headquarters are located in Irving, Texas. First Capital's primary business activities are consumer finance, commercial finance and insurance underwriting. See NOTE 17 to the consolidated financial statements for financial information by business segment. Consumer Finance Consumer finance consists of making and investing in residential real estate-secured loans to individuals, making secured and unsecured installment loans to individuals, purchasing consumer retail installment obligations, investing in credit card receivables, financing manufactured housing ("MHO") purchases, and providing other consumer financial services. In addition, First Capital offers insurance to its consumer finance customers. Loans made to individuals are secured by mortgages on real property, by liens on personal property (the realizable value of which may be less than the amount of the loans secured) or are unsecured. At December 31, 1993, 74% of the gross outstanding balance of residential real estate-secured receivables was secured by first mortgages. At December 31, 1993, the gross consumer finance receivables included credit card receivables ($3.3 billion) owned or originated by Associates National Bank (Delaware), a subsidiary of First Capital. The interest rates currently charged on all types of consumer finance receivables average approximately 16% simple interest per annum. At December 31, 1993, the interest rates charged on approximately 38% of the net consumer finance receivables outstanding varied during the term of the contract at specified intervals in relation to a base rate established at the time the loan was made. State laws establish maximum allowable finance charges for certain consumer loans; approximately 91% of the outstanding gross consumer finance receivables were either not subject to such state maximums, or if subject, such maximum finance charges did not, in most cases, materially restrict the interest rates charged. Original maturities of residential real estate-secured receivables average 147 months and original maturities of other consumer receivables, excluding credit card and manufactured housing receivables, average 35 months. Original maturities of manufactured housing receivables average 240 months. Commercial Finance Commercial finance consists of the purchase of time sales obligations and leases, direct leases and secured direct loans, and sales of other financial services, including automobile club, mortgage banking and relocation services. In addition, First Capital offers insurance to its commercial finance customers. The types of equipment financed or leased are heavy-duty trucks, truck trailers, autos and other transportation equipment, construction equipment, machinery used in various manufacturing and distribution processes and communications equipment. Except for lease transactions in which First Capital owns the equipment, liens on the equipment financed secure the receivables. In many cases, First Capital obtains the endorsement or a full or limited repurchase agreement of the seller or the manufacturer of the goods, and in some cases, a portion of the purchase price of the installment obligations is withheld as a reserve. At December 31, 1993, the interest rates charged on approximately 13% of the net commercial finance receivables were established to vary during the term of the contract in relation to a base rate. Commercial finance receivables are generally not subject to maximum finance charges established by state law, and where such restrictions apply, at the present time, they do not materially restrict the interest rates charged. The interest rates currently charged on all types of commercial finance receivables average approximately 9% simple interest per annum. Original maturities of the commercial receivables average 36 months. Volume of Financing The following tables set forth the gross volume of finance business by major categories and average size and number of accounts based on gross finance receivables volume (excluding wholesale receivables) for the periods indicated: During the year ended December 31, 1993, 23% of the total gross volume of consumer loans, excluding credit card receivables, was made to current creditworthy customers that requested additional funds. The average balance prior to making an additional advance was $9,115 and the average additional advance was $3,112. Finance Receivables The following tables set forth the amounts of gross finance receivables held at year end by major categories and average size and number of accounts held at year end for the years indicated: Gross Finance Receivables Held at End of Year Consumer Finance Commercial Finance Residential Installment, Heavy-Duty Truck Total Real Estate- MHO and and Industrial Gross Secured Credit Card Equipment Finance Receivables Receivables Receivables Receivables (Dollar Amounts in Millions) At December 31 1993 $10,626.0 $9,869.8 $9,077.2 $29,573.0 36% 33% 31% 100% 1992 $ 9,820.0 $8,122.6 $7,672.0 $25,614.6 38% 32% 30% 100% 1991 $ 8,146.0 $7,188.7 $7,209.7 $22,544.4 36% 32% 32% 100% 1990 $ 4,900.5 $5,236.1 $6,310.2 $16,446.8 30% 32% 38% 100% 1989 $ 3,766.4 $4,176.6 $6,144.1 $14,087.1 27% 29% 44% 100% Average Size and Number of Accounts Based on Gross Finance Receivables Held at End of Year Consumer Finance Commercial Finance Residential Installment, Heavy-Duty Truck Real Estate- MHO and and Industrial Secured Credit Card Equipment Receivables Receivables Receivables At December 31 1993 Average Size $37,787 $2,489 $31,218 Number of Accounts 281,206 3,965,781 290,765 1992 Average Size $36,725 $2,551 $27,792 Number of Accounts 267,394 3,183,747 276,055 1991 Average Size $33,829 $2,469 $27,506 Number of Accounts 240,798 2,910,995 262,110 1990 Average Size $33,928 $2,097 $28,002 Number of Accounts 144,438 2,496,411 225,349 1989 Average Size $32,310 $2,055 $28,357 Number of Accounts 116,570 2,032,490 216,670 The ten largest customer accounts at December 31, 1993, other than accounts with affiliates (as described in NOTE 14 to the consolidated financial statements), represented 0.8% of the total gross finance receivables outstanding. Of such ten accounts, five were secured by heavy- duty trucks or truck trailers, two were secured by construction equipment, two were secured by a manufacturer's endorsement and related to communications equipment and one was secured by auto leasing arrangements. At December 31, 1993, the largest gross balance outstanding in such accounts was $31.2 million and the average gross balance was $24.9 million. Credit Loss and Delinquency Experience The credit loss experience, net of recoveries, of the finance business for the years indicated is set forth in the following table (dollar amounts in millions): Year Ended or at December 31 1993 1992 1991 1990 1989 NET CREDIT LOSSES Consumer Finance Amount $371.3 $382.9 $354.2 $254.2 $186.1 % of Average Net Receivables 2.19% 2.64% 2.84% 3.06% 2.59% % of Receivables Liquidated 3.41 4.57 5.65 5.51 5.05 Commercial Finance Amount $ 22.4 $ 41.8 $ 34.6 $ 23.4 $ 11.7 % of Average Net Receivables .30% .64% .60% .44% .22% % of Receivables Liquidated .26 .61 .61 .41 .20 Total Net Credit Losses Amount $393.7 $424.7 $388.8 $277.6 $197.8 % of Average Net Receivables 1.61% 2.02% 2.13% 2.03% 1.59% % of Receivables Liquidated 2.03 2.80 3.24 2.69 2.09 ALLOWANCE FOR LOSSES Balance at End of Period $808.9 $699.2 $590.9 $449.7 $390.1 % of Net Receivables 3.07% 3.06% 2.93% 3.02% 3.07% The allowance for losses on finance receivables is based on percentages of net finance receivables established by management for each major category of receivables based on historical loss experience, plus an amount for possible adverse deviation from historical experience. Additions to the allowance are charged to the provision for losses on finance receivables. An analysis of changes in the allowance for losses is included in NOTE 4 to the consolidated financial statements. Finance receivables are charged to the allowance for losses when they are deemed to be uncollectible. Additionally, Company policy provides for charge-off of various types of accounts as follows: consumer direct installment receivables, except those collateralized by residential real estate, are charged to the allowance for losses when no cash payment has been received for six months; credit card receivables are charged to the allowance for losses when the receivable becomes contractually six months delinquent; all other finance receivables are charged to the allowance for losses when any of the following conditions occur: (i) the related security has been converted or destroyed; (ii) the related security has been repossessed and sold or held for sale for one year; or (iii) the related security has not been repossessed and the receivable has become contractually one year delinquent. Recoveries on losses previously charged to the allowance are credited to the allowance at the time the recovery is collected. Delinquency on consumer residential real estate-secured and direct installment and credit card receivables is determined by the date of the last cash payment received from the customer (recency of payment basis), a delinquent loan being one on which the customer has paid no cash whatsoever for a period of time. It is not First Capital's policy to accept token payments on delinquent accounts. A delinquent account on all types of receivables, other than consumer residential real estate-secured and direct installment and credit card receivables, is one on which the customer has not made payments as contractually agreed (contractual payment basis). Extensions are granted on receivables from customers with satisfactory credit and with prior approval of management. The following tables show (i) the gross account balances delinquent sixty through eighty-nine days, ninety days and more, and total gross balances delinquent sixty days and more; and (ii) total gross balances delinquent sixty days and more by type of business at the dates indicated (dollar amounts in millions): Insurance Underwriting First Capital is engaged in the property and casualty and accidental death and dismemberment insurance business through Associates Insurance Company ("AIC") and in the credit life, credit accident and health insurance business through Associates Financial Life Insurance Company ("AFLIC"), principally for customers of the finance operations of First Capital. At December 31, 1993, AIC was licensed to do business in 50 states, the District of Columbia and Canada, and AFLIC was licensed to do business in 49 states and the District of Columbia. In addition, First Capital receives compensation for certain insurance programs underwritten by other companies through marketing arrangements in a number of states. The operating income produced by the finance operations' sale of insurance products is included in the respective finance operations' operating income. The following table sets forth the net property and casualty insurance premiums written by major lines of business for the years indicated (in millions): Year Ended December 31 1993 1992 1991 1990 1989 Automobile Physical Damage $ 97.6 $ 79.9 $ 69.2 $ 86.8 $ 85.0 Fire and Extended Coverage 41.3 27.8 15.8 31.2 30.7 Other Liability (a) 20.1 25.0 23.6 17.0 14.5 Total Net Premiums Written $159.0 $132.7 $108.6 $135.0 $130.2 (a) Includes contractual liability for auto club road service program. The following table sets forth the aggregate premium income relating to credit life, credit accident and health and accidental death and dismemberment insurance for the years indicated, and the life insurance in force at the end of each respective year (in millions): The following table summarizes the revenue of the insurance operation for the years indicated (in millions): Year Ended December 31 1993 1992 1991 1990 1989 Premium Revenue (a) $242.2 $209.9 $202.5 $212.7 $196.9 Investment Income 38.4 41.5 53.3 58.4 56.3 Total Revenue $280.6 $251.4 $255.8 $271.1 $253.2 (a) Includes compensation for insurance programs underwritten by other companies through marketing arrangements. Competition and Regulation The interest rates charged for the various classes of receivables of First Capital's finance business vary with the type of risk and maturity of the receivable and are generally affected by competition, current interest rates and, in some cases, governmental regulation. In addition to competition with finance companies, competition exists with, among others, commercial banks, thrift institutions, credit unions and retailers. Consumer finance operations are subject to detailed supervision by state authorities under legislation and regulations which generally require finance companies to be licensed and which, in many states, govern interest rates and charges, maximum amounts and maturities of credit and other terms and conditions of consumer finance transactions, including disclosure to a debtor of certain terms of each transaction. Licenses may be subject to revocation for violations of such laws and regulations. In some states, the commercial finance operations are subject to similar laws and regulations. Customers may seek damages for violations of state and Federal statutes and regulations governing lending practices, interest rates and other charges. Federal legislation preempts state interest rate ceilings on first mortgage loans and state laws which restrict various types of alternative residential real estate-secured receivables, except in those states which have specifically opted out of such preemption. Certain Federal and state statutes and regulations, among other things, require disclosure of the finance charges in terms of an annual percentage rate, make credit discrimination unlawful on a number of bases, require disclosure of a maximum rate of interest on variable or adjustable rate mortgage loans, and limit the types of security that may be taken in connection with non-purchase money consumer loans. Federal and state legislation in addition to that mentioned above has been, and from time to time may be, introduced which seeks to regulate the maximum interest rate and/or other charges on consumer finance receivables, including credit cards. Associates National Bank (Delaware) (the "Bank"), is under the supervision of, and subject to examination by, the Office of the Comptroller of the Currency. In addition, the Bank is subject to the rules and regulations of the Federal Reserve Board and the Federal Deposit Insurance Corporation ("FDIC"). Associates Investment Corporation is regulated by the FDIC and the Utah Department of Financial Institutions. Areas subject to regulation by these agencies include capital adequacy, loans, deposits, consumer protection, the payment of dividends and other aspects of operations. The insurance business is subject to detailed regulation, and premiums charged on certain lines of insurance are subject to limitation by state authorities. Most states in which insurance subsidiaries of First Capital are authorized to conduct business have enacted insurance holding company legislation pertaining to insurance companies and their affiliates. Generally, such laws provide, among other things, limitations on the amount of dividends payable by any insurance company and guidelines and standards with respect to dealings between insurance companies and affiliates. It is not possible to forecast the nature or the effect on future earnings or otherwise of present and future legislation, regulations and decisions with respect to the foregoing, or other related matters. ITEM 2. ITEM 2. PROPERTIES. The furniture, equipment and other physical property owned by First Capital and its subsidiaries represent less than 1% of total assets at December 31, 1993 and are therefore not significant in relation to total assets. The branch finance operations are generally conducted on leased premises under short-term operating leases normally not exceeding five years. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Because the finance and insurance businesses involve the collection of numerous accounts, the validity and priority of liens, and loss or damage claims under many types of insurance policies, the finance and insurance subsidiaries of First Capital are plaintiffs and defendants in numerous legal proceedings, including class action lawsuits. Neither First Capital nor any of its subsidiaries is a party to, nor is the property thereof the subject of, any pending legal proceedings which depart from the ordinary routine litigation incident to the kinds of business conducted by First Capital and its subsidiaries or, if such proceedings constitute other than routine litigation, in which there is a reasonable possibility of an adverse decision which could have any material adverse effect upon the financial condition of First Capital. There are no proceedings pending or, to the Company's knowledge, threatened by or on behalf of any administrative board or regulatory body which would materially affect or impair the right of First Capital or any of its subsidiaries to carry on any of their respective businesses. PART II ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted in accordance with General Instruction J.(2)(c) to Form 10-K. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All of the outstanding Common Stock of First Capital is owned by Ford Holdings, Inc. There is no market for First Capital stock. Dividends on the Common Stock are paid when declared by the Board of Directors. Annual Common Stock dividends of $226.0 million and $190.0 million were paid during the years ended December 31, 1993 and 1992, respectively. Associates, First Capital's principal operating subsidiary, is subject to various limitations under the provisions of its outstanding debt and revolving credit agreements, including limitations on the payment of dividends. See Liquidity/Capital Resources under Item 7, herein, for a description of such limitations. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information that follows is being provided in lieu of the information called for by Item 6 of Form 10-K, in accordance with General Instruction J.(2)(a) to Form 10-K. The following table sets forth selected consolidated financial information regarding the Company's financial position and operating results which has been extracted from the Company's consolidated financial statements for the five years ended December 31, 1993. The information should be read in conjunction with the Management's Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and accompanying footnotes included elsewhere in this report (dollar amounts in millions): ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following management's narrative analysis of the results of operations is provided in lieu of management's discussion and analysis, in accordance with General Instruction J.(2)(a) to Form 10-K. Results of Operations REVENUE - Total revenue for the year ended December 31, 1993 increased $359.0 million (11%), compared with the year ended December 31, 1992. The components of the increase were as follows: Finance charges increased $316.0 million (11%), primarily caused by an increase in average net finance receivables outstanding, which was partially offset by a decrease in average revenue rates. Average net finance receivables outstanding were $24.4 billion and $21.0 billion for the years ended December 31, 1993 and 1992, respectively, a 16% increase. Total net finance receivables increased by approximately $3.5 billion (15%) from December 31, 1992 to December 31, 1993. Of the total growth, 23% was in the residential real estate-secured portfolio, 20% was in the direct installment and credit card portfolios, 19% was in the manufactured housing and other portfolios, 23% was in the heavy-duty truck portfolio and 15% was in the industrial equipment portfolio. The growth was due, in part, to the acquisitions of finance businesses or finance receivables of Allied Finance Company (April 1993), and Mack Financial Corporation and Great Western Financial Corporation (September 1993) as described in NOTE 3 to the consolidated financial statements. The average revenue rates on aggregate net receivables were 13.4% and 14.1% for the years ended December 31, 1993 and 1992, respectively. The decline in the average revenue rates was principally due to changes in market conditions, including lower prevailing market rates affecting yields on new business and variable and adjustable rate loans, and a shift in the loan portfolio mix toward a higher percentage of commercial loans, which generally have lower yields than consumer loans. Insurance premiums increased $32.3 million (15%) as a result of increased sales of insurance products, primarily in the credit life and credit accident and health insurance programs. Investment and other income increased $10.7 million (6%), due to an increase in fee-based financial services revenue, which was partially offset by a decrease in interest income from loans to former foreign subsidiaries of First Capital as a result of decreased balances outstanding, and a general decrease in the interest rates on investments. EXPENSES - Total expenses for the year ended December 31, 1993 increased $213.6 million (8%), compared with the year ended December 31, 1992. The components of the increase were as follows: Interest expense increased $59.1 million (5%). This change was caused by an increase in average outstanding debt ($186.7 million) attributable to higher net finance receivables outstanding, which was partially offset by a decrease in average interest rates ($127.6 million). The annual average interest rates on total debt, including amortization of discount and issuance expense, were as follows: Year Ended December 31 1993 1992 Short-term Debt 3.11% 3.68% Long-term Debt 8.03 8.78 Total Debt 5.94 6.55 The net interest margin was 7.92% and 7.98% for the years ended December 31, 1993 and 1992, respectively. Operating expenses increased $176.1 million (21%), primarily as a result of increased salaries, employment benefits and other operating expenses generally related to increased volumes of business, including acquisitions. The provision for loan losses decreased by $36.5 million (7%), primarily due to decreased losses. Net credit losses, measured in dollars and as a percent of average net finance receivables, declined during the twelve-month period ended December 31, 1993, compared to the same period ended December 31, 1992. The allowance for losses increased $109.7 million (16%) to $808.9 million at December 31, 1993 from $699.2 million at December 31, 1992. The increase primarily relates to the growth in net finance receivables. The allowance for losses, measured as a percent of net finance receivables, remained at a relatively constant level at December 31, 1993 (3.07%) compared to December 31, 1992 (3.06%). The allowance for losses is maintained at a level which considers, among other factors, historical loss experience, possible deviations from historical loss experience and varying economic conditions. Insurance benefits paid or provided increased $14.9 million (15%) in 1993, primarily due to an increase in property and casualty insurance claims. EARNINGS BEFORE PROVISION FOR INCOME TAXES AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - As a result of the aforementioned changes, earnings before provision for income taxes and cumulative effect of changes in accounting principles increased $145.4 million (24%) during 1993. PROVISION FOR INCOME TAXES - The provision for income taxes represented 37.5% and 35.2% of earnings before provision for income taxes for the years ended December 31, 1993 and 1992, respectively. The increase in the effective tax rate is primarily related to an increase in the Federal statutory rate and the method of computing state taxes as described in NOTE 8 to the consolidated financial statements. EARNINGS BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - Earnings before cumulative effect of changes in accounting principles increased $76.9 million (20%) during 1993. CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - In 1992, the Company recorded a one-time charge of $10.4 million relating to the adoption of two new accounting standards. See NOTE 2 to the consolidated financial statements for additional information. NET EARNINGS - As a result of the aforementioned changes, net earnings increased $87.3 million (23%) during 1993. Liquidity/Capital Resources The following sets forth liquidity and capital resources for First Capital and its subsidiaries other than Associates and its subsidiaries. First Capital's primary sources of funds have been (i) borrowings from both commercial banks and the public and (ii) borrowings and dividends from Associates. The amount of dividends which may be paid by Associates is limited by certain provisions of its outstanding debt and revolving credit agreements. A restriction contained in one series of debt securities maturing August 1, 1996, generally limits payments of cash dividends on Associates Common Stock in any one year to not more than 50% of Associates consolidated net earnings for such year, subject to certain exceptions, plus increases in contributed capital and extraordinary gains. Any such amounts available for the payment of dividends in such fiscal year and not so paid, may be paid in any one or more of the five subsequent fiscal years. In accordance with this provision, at December 31, 1993, $221.9 million was available for dividends. A restriction contained in certain revolving credit agreements requires Associates to maintain a minimum tangible net worth, as defined, of $1.5 billion. At December 31, 1993, Associates tangible net worth was approximately $2.9 billion. A debt agreement of Associates limits the total of all affiliate-related receivables, as defined, to 7% of the aggregate gross receivables owned by Associates. An affiliate within the meaning of affiliate-related receivables includes First Capital, its parent corporation, and any corporation, other than Associates and its subsidiaries, of which First Capital or its parent corporation owns or controls at least 50% of its stock. The net total of all affiliate-related receivables which Associates owned at December 31, 1993 and 1992, amounted to 1.5% and 1.2%, respectively, of its aggregate gross receivables as of those dates. At December 31, 1993, First Capital had contractually committed bank lines of credit of $75.0 million, and revolving credit facilities of $250.0 million, none of which was in use. During 1993, First Capital raised $209.3 million through public and private offerings of medium- and long-term debt. The following sets forth liquidity and capital resources for Associates: Associates endeavors to maximize its liquidity by diversifying its sources of funds, which include: (i) its operations; (ii) the issuance of commercial paper; (iii) the issuance of unsecured intermediate-term debt in the public and private markets; (iv) borrowings available from short-term and revolving credit facilities with commercial banks; and (v) receivables purchase facilities. Issuance of Short- and Intermediate-Term Debt Commercial paper, with maturities ranging from 1 to 270 days, is the primary source of short-term debt. The average commercial paper interest rate incurred during 1993 was 3.11%. Associates issues intermediate-term debt publicly and privately in the domestic and foreign markets. During the year ended December 31, 1993, Associates raised $3.6 billion through public and private offerings at a weighted average effective interest rate and a weighted average term of 5.64% and 6.5 years, respectively. Credit Facilities and Related Borrowings Associates policy is to maintain bank credit facilities in support of its net short-term borrowings consistent with market conditions. Bank credit facilities provide a means of refinancing maturing commercial paper obligations as needed. At December 31, 1993, short-term bank lines and revolving credit facilities with banks totaled $8.2 billion, none of which was in use at that date. These facilities represented 80% of net short-term borrowings outstanding at December 31, 1993. Bank lines and revolvers may be withdrawn only under certain standard conditions. Associates pays fees or maintains compensating balances or utilizes a combination of both to maintain the availability of its bank credit facilities. Fees are .05% to .25% of 1% per annum of the amount of the facilities. At December 31, 1993 and 1992, Associates short-term debt, as defined, as a percent of total debt was 52%. Short-term debt, for purposes of this computation, includes the current portion of long-term debt but excludes short-term investments. See NOTES 5, 6 and 7 to the consolidated financial statements for a description of credit facilities, notes payable and long- term debt, respectively. Recent Accounting Pronouncements Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 112, "Employers' Accounting for Postretirement Benefits" and SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". The adoption of these standards was not significant to the Company's consolidated financial statements. The Financial Accounting Standards Board has issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" effective 1995, SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" effective 1994, and SFAS No. 116, "Accounting for Contributions Received and Contributions Made" effective 1995. Adoption of these pronouncements is not expected to be significant to the Company's consolidated financial statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF INDEPENDENT ACCOUNTANTS Board of Directors Associates First Capital Corporation We have audited the consolidated financial statements and the financial statement schedule listed in Item 14(a) of this Form 10-K of Associates First Capital Corporation (an indirect subsidiary of Ford Motor Company). These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Associates First Capital Corporation as of December 31, 1993 and 1992 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. As discussed in NOTE 2 to the consolidated financial statements, effective January 1, 1992, the Company changed its methods of accounting for postretirement benefit costs other than pensions and income taxes. COOPERS & LYBRAND Dallas, Texas February 1, 1994 ASSOCIATES FIRST CAPITAL CORPORATION CONSOLIDATED STATEMENT OF EARNINGS (In Millions) Year Ended December 31 1993 1992 1991 REVENUE Finance charges $3,276.3 $2,960.3 $2,786.9 Insurance premiums 242.2 209.9 202.5 Investment and other income 187.1 176.4 197.7 3,705.6 3,346.6 3,187.1 EXPENSES Interest expense 1,340.5 1,281.4 1,347.8 Operating expenses 1,022.3 846.2 773.6 Provision for losses on finance receivables - NOTE 4 476.1 512.6 434.2 Insurance benefits paid or provided 114.9 100.0 91.1 2,953.8 2,740.2 2,646.7 EARNINGS BEFORE PROVISION FOR INCOME TAXES AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES 751.8 606.4 540.4 PROVISION FOR INCOME TAXES - NOTE 8 281.7 213.2 193.1 EARNINGS BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES 470.1 393.2 347.3 CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - NOTE 2 (10.4) NET EARNINGS $ 470.1 $ 382.8 $ 347.3 See notes to consolidated financial statements. The weighted average interest rate for total long-term debt was 7.54% for 1993 and 8.33% for 1992. The estimated fair value of long-term debt at December 31, 1993 was $14.5 billion. The fair value was determined by discounting expected cash flows at discount rates currently available to the Company for debt with similar terms and remaining maturities. Long-term borrowing maturities during the next five years, including the current portion of notes payable after one year are: 1994, $2,203.1 million; 1995, $2,097.6 million; 1996, $2,334.4 million; 1997, $2,029.6 million; 1998, $1,316.1 million; and 1999 and thereafter $3,620.0 million. Certain debt issues contain call provisions or may be subject to repayment provisions at the option of the holder on specified dates prior to the maturity date. At December 31, 1993, approximately 3,500 warrants were outstanding to purchase $154.8 million aggregate principal amount of senior notes at par with interest rates ranging from 7.00% to 10.50%. The warrants are exercisable at various dates through October 1, 1999 at prices ranging from $1,000 to $25,000,000 per warrant. All of the above issues are unsecured except for a $50 million, 8.25% Senior Note due August 15, 2001, which is collateralized by First Capital's corporate offices. NOTE 8 - PROVISION FOR INCOME TAXES On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 (the "Act") was enacted. Among other changes, the Act increased the Federal income tax rate for corporations by one percentage point to 35% effective January 1, 1993. Net income for 1993 included a reduction of $2.1 million in the provision for income taxes as a result of restating deferred tax balances. The favorable effect reflects the higher tax rate applied to the Company's net deferred tax assets. Effective January 1, 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes". The cumulative effect of the accounting change was recognized in the December 31, 1992 Consolidated Statement of Earnings as a one-time increase to net earnings in the amount of $29.8 million. The following table sets forth the components of the provision for U.S. Federal and State income taxes and deferred income tax (benefit) for the periods indicated (in millions): Federal State Total Year ended December 31, 1993 Current $337.1 $20.5 $357.6 Deferred: Leasing transactions 3.6 3.6 Finance revenue 3.9 3.9 Provision for losses on finance receivables and other (83.4) (83.4) $261.2 $20.5 $281.7 Year ended December 31, 1992 Current $226.0 $ 8.8 $234.8 Deferred: Leasing transactions 13.6 13.6 Finance revenue 12.9 12.9 Provision for losses on finance receivables and other (48.1) (48.1) $204.4 $ 8.8 $213.2 Year ended December 31, 1991 Current $182.7 $ 6.4 $189.1 Deferred: Leasing transactions 15.1 15.1 Finance revenue 16.8 16.8 Provision for losses on finance receivables and other (27.9) (27.9) $186.7 $ 6.4 $193.1 In 1993, the Company entered into a tax-sharing agreement with Ford whereby state income taxes are provided on a separate-return basis. Prior to 1993, state income taxes were provided on a consolidated-return basis. At December 31, 1993 and 1992, the components of the Company's net deferred tax asset were as follows (in millions): 1993 1992 Deferred tax assets: Provision for losses on finance receivables and other $ 368.8 $ 301.7 Postretirement and other employee benefits 68.1 45.8 436.9 347.5 Deferred tax liabilities: Leasing transactions (145.9) (143.4) Finance revenue and other (192.6) (182.6) (338.5) (326.0) Net deferred tax asset $ 98.4 $ 21.5 Due to the Company's earnings levels, no valuation allowance related to the deferred tax asset has been recorded. The effective tax rate differed from the statutory U.S. Federal income tax rate as follows: % of Pretax Income Year Ended December 31 1993 1992 1991 Statutory tax rate 35.0% 34.0% 34.0% State and other 2.5 1.2 1.7 Effective tax rate 37.5% 35.2% 35.7% NOTE 9 - DEBT RESTRICTIONS Associates, First Capital's principal operating subsidiary, is subject to various limitations under the provisions of its outstanding debt and revolving credit agreements. The most significant of these limitations are summarized as follows: LIMITATION ON PAYMENT OF DIVIDENDS A restriction contained in one series of debt securities maturing August 1, 1996, generally limits payments of cash dividends on Associates Common Stock in any year to not more than 50% of Associates consolidated net earnings for such year, subject to certain exceptions, plus increases in contributed capital and extraordinary gains. Any such amounts available for the payment of dividends in such fiscal year and not so paid, may be paid in any one or more of the five subsequent fiscal years. In accordance with this provision, at December 31, 1993, $221.9 million was available for dividends. LIMITATION ON MINIMUM TANGIBLE NET WORTH A restriction contained in certain revolving credit agreements requires Associates to maintain a minimum tangible net worth, as defined, of $1.5 billion. At December 31, 1993, Associates tangible net worth was approximately $2.9 billion. LIMITATION ON AFFILIATE RECEIVABLES A debt agreement of Associates limits the total of all affiliate-related receivables, as defined, to 7% of the aggregate gross receivables owned by Associates. An affiliate within the meaning of affiliate-related receivables includes First Capital, its parent corporation, and any corporation, other than Associates and its subsidiaries, of which First Capital or its parent corporation owns or controls at least 50% of its stock. The net total of all affiliate-related receivables which Associates owned at December 31, 1993 and 1992, amounted to 1.5% and 1.2%, respectively, of its aggregate gross receivables as of those dates. NOTE 10 - LEASE COMMITMENTS Leases are primarily short-term and generally provide for renewal options not exceeding the original term. Total rent expense for the years ended December 31, 1993, 1992 and 1991 was $43.9 million, $38.3 million, and $34.5 million, respectively. Minimum rental commitments as of December 31, 1993 for all noncancelable leases (primarily office leases) for the years ending December 31, 1994, 1995, 1996, 1997 and 1998, are $37.0 million, $29.8 million, $22.2 million, $11.4 million and $5.1 million, respectively, and $4.6 million thereafter. NOTE 11 - EMPLOYEE BENEFITS DEFINED BENEFIT PLANS The Company sponsors various qualified and nonqualified pension plans (the "Plan" or "Plans"), which together cover substantially all permanent employees who meet certain eligibility requirements. Net periodic pension cost for the years indicated includes the following components (in millions): December 31 (a) 1993 1992 1991 Service cost $ 10.0 $ 8.4 $ 6.6 Interest cost 18.1 16.1 13.9 Actual return on Plan assets (21.6) (10.0) (28.4) Net amortization 7.4 (2.5) 19.0 Net periodic pension cost $ 13.9 $ 12.0 $ 11.1 The funded status of the Plans is as follows (in millions): The projected benefit obligation at December 31, 1993 and 1992 was determined using a discount rate of 7.0% and 8.0%, respectively, projected compensation increases of 6.0% and expected return on plan assets of 9.5%. A determination of the Federal income tax status related to the qualified Pension Plan has not been requested because the Internal Revenue Service has only recently begun accepting certain qualified pension plan applications. An application is expected to be filed during 1994. If a favorable determination letter is not received, First Capital has agreed to make any changes required to receive a favorable determination letter. RETIREMENT SAVINGS AND PROFIT SHARING PLAN The Company sponsors a defined contribution plan intended to provide assistance in accumulating personal savings for retirement and is designed to qualify under Sections 401(a) and 401(k) of the Internal Revenue Code. The savings plan has not been submitted to the Internal Revenue Service for approval as a qualified tax-exempt plan. Consequently, the plan provisions are subject to issuance of a favorable determination letter by the Internal Revenue Service. For the years ended December 31, 1993, 1992 and 1991, the Company's pretax contributions to the plan were $14.0 million, $12.1 million and $9.9 million, respectively. EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company provides certain postretirement benefits through unfunded plans sponsored by First Capital. These benefits are currently provided to substantially all permanent employees who meet certain eligibility requirements. The benefits or the plan can be modified or terminated at the discretion of the Company. The Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1992. As of January 1, 1992, the Company recorded a one-time charge to net earnings of approximately $40.2 million, which represents the estimated accumulated postretirement benefit obligation on that date of $64.9 million, net of deferred income taxes of approximately $20.7 million and amounts recorded as purchase accounting adjustments of approximately $4.0 million. This amount has been reflected in the Consolidated Statement of Earnings as a component of the cumulative effect of changes in accounting principles. Prior to 1992, the cost of providing these benefits was recognized as a charge to income as claims were paid. The amount paid for postretirement benefits for the years ended December 31, 1993, 1992 and 1991 was approximately $1.5 million, $2.1 million and $1.2 million, respectively. Net periodic postretirement benefit cost for 1993 and 1992 includes the following components (in millions): December 31 1993 1992 Service cost $ 4.2 $3.2 Interest cost 6.3 5.8 Net amortization (0.7) Net periodic postretirement benefit cost $ 9.8 $9.0 Accrued postretirement benefit cost at December 31, 1993 and 1992 is composed of the following (in millions): December 31 1993 1992 Accumulated postretirement benefit obligation ("APBO"): Retired participants $ 33.6 $27.8 Fully eligible participants 21.1 15.6 Other active participants 30.7 32.8 total APBO 85.4 76.2 Unamortized amendments 11.5 Unrecognized actuarial loss (16.8) (4.4) Accrued postretirement benefit cost $ 80.1 $71.8 For measurement purposes, a 12.50% and 13.32% weighted average annual rate of increase in per capita cost of covered health care benefits was assumed for 1993 and 1992, respectively, decreasing gradually to 5.50% by the year 2009. Discount rates of 7.50% and 8.50% were used in measuring the APBO at December 31, 1993 and 1992, respectively. Increasing the assumed health care cost trend rate by one percentage point each year would increase the APBO as of December 31, 1993 and 1992 by $6.2 million and $5.1 million, respectively, and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for each year then ended by $0.8 million. NOTE 12 - COMMITMENTS AND CONTINGENCIES First Capital and its subsidiaries are defendants in various legal proceedings which arose in the normal course of business. In management's judgment (based upon the advice of counsel) the ultimate liabilities, if any, from such legal proceedings will not have a material adverse effect on the financial position of First Capital. NOTE 13 - OTHER ASSETS The components of Other Assets at December 31, 1993 and 1992 were as follows (in millions): December 31 1993 1992 Balances with related parties - NOTE 14 $ 167.5 $ 193.2 Goodwill 382.2 405.2 Other 666.0 589.9 Total other assets $1,215.7 $1,188.3 Other assets include residential real estate-secured receivables held for sale by Associates National Mortgage Corporation, a subsidiary of the Company. At December 31, 1993, the aggregate book value was $77.6 million, which approximates estimated fair value. The estimated fair value was determined by discounting expected cash flows from such receivables at current market rates. NOTE 14 - TRANSACTIONS AND BALANCES WITH RELATED PARTIES CAPITAL TRANSACTIONS Effective as of December 15, 1993, First Capital received from Ford Holdings a capital contribution of $200.0 million in the form of cash. OTHER TRANSACTIONS AND BALANCES First Capital, through Associates, provided debt financing to certain of its former foreign subsidiaries. At December 31, 1993 and 1992, amounts due from foreign affiliates totaled $167.5 million and $193.2 million, respectively, and were included in Other Assets. These receivables bear fluctuating interest rates and are payable on demand. Interest income related to these transactions was $21.3 million, $34.0 million and $47.5 million for the years ended December 31, 1993, 1992 and 1991, respectively. The estimated fair value of these receivables was $175.6 million at December 31, 1993. At December 31, 1992, the gross consumer finance receivables included a participation in consumer receivables of $142.0 million of First Nationwide Bank, FSB, an affiliate of First Capital. This balance was included in Finance Receivables. The Company provides certain services of an administrative nature, use of certain tangible and intangible assets, including trademarks, guarantees of debt and related interest, and other management services to certain of its foreign affiliates in Japan, Canada, Puerto Rico and the United Kingdom. Such services and usage are charged to the affiliates based on the nature of the service. Fees for such guarantees range from .25% to 1% of the average outstanding debt guaranteed. Management believes the percentages represent fair value. The amounts paid or accrued under these arrangements for the years ended December 31, 1993, 1992 and 1991 were $40.1 million, $35.5 million and $25.3 million, respectively. At December 31, 1993 and 1992, the Company was a guarantor on debt and related accrued interest of its foreign affiliates in Canada and Puerto Rico amounting to $256.7 million and $154.5 million, respectively. At December 31, 1993 and 1992, First Capital's current income taxes payable to Holdings amounted to $40.2 million and $45.1 million, respectively. NOTE 15 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISKS The Company maintains cash, cash equivalents, investments, and certain other financial instruments with various major financial institutions. To the extent such deposits exceed maximum insurance levels, they are uninsured. Currency swap contracts are entered into as part of the Company's funding strategy. The Company has an interest rate swap contract acquired as part of a business acquisition. Amounts under currency and interest rate swap contracts at December 31, 1993 were approximately $202.9 million. Should a counterparty to these contracts fail to meet the terms of the contracts, the Company could be at market risk for any currency and/or interest rate differentials. At December 31, 1993, the Company estimated its exposure to loss resulting from currency and interest rate differentials, in event of non-performance by all counterparties, was $14.0 million, which also approximated the estimated fair value of amounts under contract. Associates National Bank (Delaware) a subsidiary of First Capital, makes available credit lines to holders of their credit cards. The unused portion of the available credit is revocable by the bank under specified conditions. The unused portion of the available credit at December 31, 1993 approximated $8.2 billion. The potential risk associated with, and the estimated fair value of, the unused credit lines are not considered to be significant. The consumer operation grants revolving lines of credit to certain of its customers. At December 31, 1993, the unused portion of these lines aggregated approximately $712.4 million. The potential risk associated with, and the estimated fair value of, the unused credit lines are not considered to be significant. The commercial operation grants lines of credit to certain dealers of truck, construction equipment and manufactured housing. At December 31, 1993, the unused portion of these lines aggregated approximately $684.6 million. The potential risk associated with, and the estimated fair value of, the unused credit lines are not considered to be significant. NOTE 16 - INVESTMENTS IN MARKETABLE SECURITIES DEBT SECURITIES Debt security investments, principally bonds and notes, are intended to be held for the foreseeable future and are carried at amortized cost. However, if market conditions or other factors subsequently change, such securities may be sold prior to maturity with the realized gain or loss included in investment and other income. Amortized cost at December 31, 1993 and 1992 was $598.7 million and $480.0 million, respectively. The following table sets forth, by type of security issuer, the amortized cost, gross unrealized gains and estimated market value at December 31, 1993 (in millions): Gross Estimated Amortized Unrealized Market Cost Gains Value U.S. Government obligations $456.5 $12.4 $468.9 Corporate obligations 58.0 0.8 58.8 Mortgage-backed and other obligations 84.2 0.1 84.3 Total debt securities $598.7 $13.3 $612.0 The amortized cost and estimated market value of debt securities at December 31, 1993, by contractual maturity, are shown below (in millions): Estimated Amortized Market Cost Value Due in one year or less $ 52.3 $ 52.4 Due after one year through five years 370.1 378.2 Due after five years through ten years 168.5 172.9 Due after ten years 7.8 8.5 $598.7 $612.0 EQUITY SECURITIES Equity security investments, principally common stock held by the Company's insurance subsidiaries, are recorded at market value. Market value at December 31, 1993 and 1992 was $35.0 million and $27.3 million, respectively. Historical cost of these investments at December 31, 1993 and 1992 was $28.9 million and $21.8 million, respectively. Estimated market values of debt and equity securities are based on quoted market prices. NOTE 17 - BUSINESS SEGMENT INFORMATION First Capital's primary business activities are consumer finance, commercial finance and insurance underwriting. The consumer finance operation is engaged in making and investing in residential real estate-secured receivables, consumer direct installment and revolving credit receivables, including credit card receivables, primarily through a wholly-owned credit card bank, purchasing consumer retail installment obligations, and providing other consumer financial services. The commercial finance operation is principally engaged in financing sales of transportation and industrial equipment and leasing, and sales of other financial services, including automobile club, mortgage banking and relocation services. The insurance operation is engaged in underwriting credit life and credit accident and health, property, casualty and accidental death and dismemberment insurance, principally for customers of the finance operations, and such sales are the principal amounts included in the intersegment revenue shown below. The following table sets forth information by business segment (in millions): NOTE 18 - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) Condensed unconsolidated financial information of Associates First Capital Corporation as of or for the years ended December 31, 1993, 1992 and 1991 were as follows (in millions): CONDENSED STATEMENT OF EARNINGS Year Ended December 31 1993 1992 1991 Revenue Interest and other income $ 6.7 $ 6.1 $ 20.9 Dividends from subsidiaries 242.7 191.6 201.3 249.4 197.7 222.2 Expenses Interest expense 51.1 56.5 78.5 Operating expenses 15.3 15.2 10.3 66.4 71.7 88.8 Income before credit for Federal income taxes and equity in net earnings of subsidiaries 183.0 126.0 133.4 Credit for Federal income taxes resulting from tax agreements with subsidiaries 21.2 21.7 23.1 Earnings before equity in undistributed earnings of subsidiaries 204.2 147.7 156.5 Equity in undistributed earnings of subsidiaries 265.9 235.1 190.8 Net earnings $470.1 $382.8 $347.3 CONDENSED BALANCE SHEET December 31 1993 1992 Assets Investment in and advances to subsidiaries, eliminated in consolidation, and other $3,198.9 $2,773.7 Total assets $3,198.9 $2,773.7 Liabilities and Stockholder's Equity Accounts payable and accruals $ 19.9 $ 26.4 Notes payable and long-term debt (1) 672.7 685.4 Stockholder's equity (2) 2,506.3 2,061.9 Total liabilities and stockholder's equity $3,198.9 $2,773.7 The estimated fair value of notes payable and long-term debt at December 31, 1993 was $685.3 million. Fair values were estimated by discounting expected cash flows at discount rates currently available to the Company for debt with similar terms and remaining maturities. See notes to condensed financial information. CONDENSED STATEMENT OF CASH FLOWS (In Millions) Year Ended December 31 1993 1992 1991 Cash Flows from Operating Activities Net earnings $ 470.1 $ 382.8 $ 347.3 Adjustments to net earnings for noncash items: Amortization and depreciation 0.1 0.1 0.1 (Decrease) increase in accounts payable and accruals (6.5) (13.7) 6.4 Equity in undistributed earnings of subsidiaries (265.9) (235.1) (190.8) Other (0.6) 1.0 2.9 Net cash provided from operating activities 197.2 135.1 165.9 Cash Flows from Investing Activities Cash dividends from subsidiaries (1) 242.7 191.6 201.3 Increase in investments in and advances to subsidiaries (402.7) (151.7) (96.2) Net cash provided from (used for) investing activities (160.0) 39.9 105.1 Cash Flows from Financing Activities Increase in notes payable and long-term debt (2) 231.6 241.8 23.2 Cash dividends paid (226.0) (190.0) (173.0) Retirement of long-term debt (244.2) (228.4) (271.0) Capital contribution from parent 200.0 154.0 Net cash used for financing activities (38.6) (176.6) (266.8) (Decrease) increase in cash and cash equivalents (1.4) (1.6) 4.2 Cash and cash equivalents at beginning of period 0.5 2.1 (2.1) Cash and cash equivalents at end of period $ (0.9) $ 0.5 $ 2.1 NOTES TO CONDENSED FINANCIAL INFORMATION: (1) The ability of the Company's subsidiaries to transfer funds to the Company in the form of cash dividends is restricted pursuant to the terms of certain debt agreements entered into by the Company's principal operating subsidiary, Associates Corporation of North America. See NOTE 9 to the consolidated financial statements for a summary of the most significant of these restrictions. (2) Notes payable and long-term debt bear interest at rates from 4.00% to 13.75%. The estimated maturities of the notes outstanding, at December 31, 1993, during subsequent years were as follows (in millions): 1994 $356.0 1995 120.5 1996 89.5 1997 60.3 1998 46.4 $672.7 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by Items 10-13 has been omitted in accordance with General Instruction J.(2)(c) to Form 10-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) Financial Statements Page Report of Independent Accountants 16 Consolidated Statement of Earnings for the years ended December 31, 1993, 1992 and 1991 17 Consolidated Balance Sheet at December 31, 1993 and 1992 18 Consolidated Statement of Changes in Stockholder's Equity for the years ended December 31, 1993, 1992 and 1991 19 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 20 Notes to consolidated financial statements 21 (2) Financial Statement Schedules II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties. All other schedules are omitted because either they are not applicable or the information required to be included therein is provided in the consolidated financial statements or related notes. (b) Reports on Form 8-K. During the quarter ended December 31, 1993, First Capital filed no Current Reports on Form 8-K. (c) Exhibits (3) (a) Certificate of Incorporation. Incorporated by reference to Exhibit 3(a) to the Company's Form 10-K for the fiscal year ended October 31, 1986. (b) By-laws. Incorporated by reference to Exhibit 3 to the Company's Form 10-K for the year ended December 31, 1990. (4) Instruments with respect to issues of long-term debt have not been filed as exhibits to this annual report on Form 10-K as the authorized principal amount of any one of such issues does not exceed 10% of the total assets of the registrant and its consolidated subsidiaries. Registrant agrees to furnish to the Commission a copy of each such instrument upon its request. (12) Computation of Ratio of Earnings to Fixed Charges. (22) Subsidiaries of the registrant. Omitted in accordance with General Instruction J.(2)(b) to Form 10-K. (24) Consent of Independent Accountants. (25) Powers of Attorney. SIGNATURES No annual report to security holders or proxy material has been or will be sent to security holders. 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. ASSOCIATES FIRST CAPITAL CORPORATION By /s/ ROY A. GUTHRIE Senior Vice President and Comptroller March 25, 1994 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 date indicated. Signature Title Date REECE A. OVERCASH, JR.* Chairman of the Board, (Reece A. Overcash, Jr.) Principal Executive Officer and Director KEITH W. HUGHES* President, Chief Operating (Keith W. Hughes) Officer and Director JAMES E. JACK* Senior Executive Vice President and (James E. Jack) Principal Financial Officer ROY A. GUTHRIE* Senior Vice President, March 25, 1994 (Roy A. Guthrie) Comptroller and Principal Accounting Officer HAROLD D. MARSHALL* Director (Harold D. Marshall) JOSEPH M. McQUILLAN* Director (Joseph M. McQuillan) By signing his name hereto, Roy A. Guthrie signs this document on behalf of himself and each of the other persons indicated above pursuant to powers of attorney duly executed by such persons. *By /s/ ROY A. GUTHRIE Attorney-in-fact SCHEDULE II INDEX TO EXHIBITS Sequentially Exhibit Numbered Number Exhibit Page (3) (a) Certificate of Incorporation. Incorporated by reference to Exhibit 3(a) to the Company's Form 10-K for the fiscal year ended October 31, 1986. (b) By-laws. Incorporated by reference to Exhibit 3 to the Company's Form 10-K for the year ended December 31, 1990. (4) Instruments with respect to issues of long-term debt have not been filed as exhibits to this annual report on Form 10-K as the authorized principal amount of any one of such issues does not exceed 10% of the total assets of the registrant and its consolidated subsidiaries. Registrant agrees to furnish to the Commission a copy of each such instrument upon request. (12) Computation of Ratio of Earnings to Fixed Charges. (22) Subsidiaries of the registrant. Omitted in accordance with General Instruction J.(2)(b) to Form 10-K. (24) Consent of Independent Accounts. (25) Powers of Attorney. EXHIBIT 12 EXHIBIT 12 ASSOCIATES FIRST CAPITAL CORPORATION COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (Dollar Amounts In Millions) Year Ended December 31 1993 1992 1991 Fixed Charges (a) Interest expense $1,340.5 $1,281.4 $1,347.8 Implicit interest in rent 1.9 1.6 2.2 Total fixed charges $1,342.4 $1,283.0 $1,350.0 Earnings (b) $ 751.8 $ 606.4 $ 540.4 Fixed charges 1,342.4 1,283.0 1,350.0 Earnings, as defined $2,094.2 $1,889.4 $1,890.4 Ratio of Earnings to Fixed Charges 1.56 1.47 1.40 (a) For purposes of such computation, the term "Fixed Charges" represents interest expense and a portion of rentals representative of an implicit interest factor for such rentals. (b) For purposes of such computation, the term "Earnings" represents earnings before provision for income taxes and cumulative effect of changes in accounting principles, plus fixed charges. EXHIBIT 24 EXHIBIT 24 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statement of Associates First Capital Corporation on Form S-3 (No. 33-65752) of our report dated February 1, 1994, on our audits of the consolidated financial statements and financial statement schedule of Associates First Capital Corporation as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992, and 1991, which report is included in this Annual Report on Form 10-K. COOPERS & LYBRAND Dallas, Texas March 25, 1994 EXHIBIT 25 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Reece A. Overcash, Jr. Reece A. Overcash, Jr. OFFICE: Chairman of the Board, Principal Executive Officer and Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Keith W. Hughes Keith W. Hughes OFFICE: President, Chief Operating Officer and Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Harold D. Marshall Harold D. Marshall OFFICE: Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Joseph M. McQuillan Joseph M. McQuillan OFFICE: Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ James E. Jack James E. Jack OFFICE: Senior Executive Vice President, Principal Financial Officer and Director POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, an officer and/or a director of ASSOCIATES FIRST CAPITAL CORPORATION (the "Company"), has made, constituted and appointed and by these presents does hereby make, constitute and appoint THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, his true and lawful attorneys, for him and in his name, place and stead, and in his office and capacity as aforesaid, to sign and file the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, and any and all amendments thereto and any and all other documents to be signed and filed with the Securities and Exchange Commission in connection therewith, hereby granting to said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., and each of them, full power and authority to do and perform each and every act and thing whatsoever requisite and necessary to be done in the premises, as fully, to all intents and purposes, as he might or could do if personally present, hereby ratifying and confirming in all respects all that said THOMAS E. DALE, ROY A. GUTHRIE, CHESTER D. LONGENECKER and REECE A. OVERCASH, JR., or any of them, as said attorneys, may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has set his hand this 28th day of February, 1994. SIGNATURE:/s/ Roy A. Guthrie Roy A. Guthrie OFFICE: Senior Vice President, Comptroller and Principal Accounting Officer

100858_1993.txt

100858_1993

1993

100858

Item 1. Business - Registrant (Union Light) - ------- ----------------------------------- General - ------- Union Light, a wholly-owned subsidiary of The Cincinnati Gas & Electric Company (CG&E), was incorporated in Kentucky in 1901, and operates in that portion of Kentucky contiguous to the area served by CG&E. Both companies are managed by substantially the same principal officers and have their principal executive offices at the same address, 139 East Fourth Street, Cincinnati, Ohio. In January 1994, Union Light transferred its former subsidiary, Enertech Associates International, Inc., to CGE Corp., which is a wholly-owned non- regulated subsidiary of CG&E. Union Light provides electric or gas service, or both, to a population of about 280,000 in an area of about 500 square miles in six counties in northern Kentucky. In December 1992, CG&E, PSI Resources, Inc. (PSI) and PSI Energy, Inc., PSI's principal subsidiary, an Indiana electric utility (PSI Energy), entered into an agreement which, as subsequently amended (the Merger Agreement) provides for the merger of PSI into a newly formed corporation named CINergy Corp. (CINergy) and the merger of a newly formed subsidiary of CINergy into CG&E. CINergy will become a holding company required to be registered under the Public Utility Holding Company Act of 1935 (PUHCA) with two operating subsidiaries, CG&E and PSI Energy. Union Light will remain a subsidiary of CG&E. The merger will be accounted for as a "pooling of interests", and it is anticipated that the transaction will be completed in the third quarter of 1994. The merger is subject to approval by the Securities and Exchange Commission (SEC) and the Federal Energy Regulatory Commission (FERC). Shareholders of both companies approved the merger in November 1993. FERC issued conditional approval of the CINergy merger in August 1993, but several intervenors, including The Public Utilities Commission of Ohio (PUCO) and the Kentucky Public Service Commission (KPSC), filed for rehearing of that order. On January 12, 1994, FERC withdrew its conditional approval of the merger and ordered the setting of FERC-sponsored settlement procedures to be held. On March 4, 1994, CG&E reached a settlement agreement with the PUCO and the Ohio Office of Consumers' Counsel on merger issues identified by FERC. On March 2, PSI Energy and Indiana's consumer representatives had reached a similar agreement. Both settlement agreements have been filed with FERC. These documents address, among other things, the coordination of state and federal regulation and the commitment that neither CG&E nor PSI electric base rates, nor CG&E's gas base rates, will rise because of the merger, except to reflect any effects that may result from the divestiture of CG&E's gas operations if ordered by the SEC in accordance with the requirements of PUHCA discussed below. CG&E also filed with FERC a unilateral offer of settlement addressing all issues raised in the KPSC's application for rehearing with FERC. Although it is the belief of CG&E and PSI that no state utility commissions have jurisdiction over approval of the proposed merger, an application has been filed with the KPSC to comply with the Staff of the KPSC's position that the KPSC's authorization is required for the indirect acquisition of control of Union Light by CINergy. As part of the settlement offer, Union Light will agree not to increase gas base rates as a result of the merger except to reflect any effects that may result from the divestiture of Union Light's gas operations discussed below. If the settlement agreements filed with FERC are not acceptable, FERC could set issues for hearing. If a hearing is held by FERC, consummation of the merger would likely be extended beyond the third quarter of 1994. PUHCA imposes restrictions on the operations of registered holding company systems. Among these are requirements that securities issuances, sales and acquisitions of utility assets or of securities of utility companies and acquisitions of interests in any other business be approved by the SEC. PUHCA also limits the ability of registered holding companies to engage in non-utility ventures and regulates holding company system service companies and the rendering of services by holding company affiliates to the system's utilities. The SEC has interpreted the PUHCA to preclude registered holding companies, with some exceptions, from owning both electric and gas utility systems. The SEC may require that CG&E and Union Light divest their gas properties within a reasonable time after the merger in order to approve the merger as it has done in many cases involving the acquisition by a holding company of a combination gas and electric company. In some cases, the SEC has allowed the retention of the gas properties or deferred the question of divestiture for a substantial period of time. In those cases in which divestiture has taken place, the SEC usually has allowed companies sufficient time to accomplish the divestiture in a manner that protects shareholder value. CG&E and Union Light believe good arguments exist to allow retention of the gas assets, and will request that the Companies be allowed to do so. Electric Operations - ------------------- Union Light does not own or operate any electric generating facilities. Its requirements for electric energy are purchased from CG&E at rates regulated by FERC. The maximum net peak load experienced by Union Light in 1993 of 661,397 Kw exceeded by 10% the previous record net peak load of 598,889 Kw established in 1991. Union Light owns an electric transmission system and an electric distribution system in Covington, Newport and other smaller communities and in adjacent rural territory within all or parts of the Counties of Kenton, Campbell, Boone, Grant, and Pendleton, in Kentucky. The Energy Policy Act of 1992 (Energy Act) addresses several matters affecting electric utilities including mandated open access to the electric transmission system and greater encouragement of independent power production and cogeneration. Union Light cannot predict the long-term consequences the Energy Act will have on its operations. Gas Operations and Gas Supply - ----------------------------- In 1992, FERC issued Order 636 which restructures the relationships between interstate gas pipelines companies and their customers, including Union Light, for gas sales and transportation services. Order 636 has changed the way Union Light purchases gas supplies and contracts for transportation and storage services. Union Light has contracts that provide adequate supply and storage capacity, including transportation services, to meet normal demand, as well as unanticipated load swings. Union Light expects to purchase approximately 5% of its annual firm gas requirements on the spot market. Order 636 also allows pipelines to recover transition costs they incur in complying with the Order from customers, including Union Light. The KPSC has issued an order which allows recovery of these transition costs through Union Light's purchased gas adjustment clause. Order 636 transition costs are not expected to significantly impact Union Light. Union Light has an approved rate structure for the transportation of gas allowing its gas price to remain competitive with alternate fuels. Union Light transports gas for certain large-volume customers. Without this program, Union Light would have lost many of these customers to alternate fuels. Union Light can either transport gas purchased by its customers for a transportation charge, or buy spot market gas which is then sold to customers at a rate competitive with alternate fuels. Rate Matters - ------------ In September 1992, Union Light filed a request with the KPSC to increase annual gas revenues by approximately $9 million. In accordance with Kentucky law, on April 26, 1993, Union Light implemented the proposed rate increase, subject to refund. On July 23, 1993, the KPSC issued an Order authorizing Union Light to increase annual gas revenues by $3.9 million effective retroactively to April 26, 1993. The authorized rates were not placed into effect pending resolution of Union Light's request for rehearing of the Order. On August 31, 1993, the KPSC granted an additional annual increase of $247,000. Union Light has placed these rates into effect and has refunded the excess revenue collected with interest to customers. Rules established by the KPSC pertaining to Union Light's electric fuel adjustment clause provide for public hearings at six-month intervals to review past calculations, reconciliation of over- or under-recovery of fuel costs, and a public hearing every two years to review the application of the adjustment charge and fuel procurement practices. In accordance with a purchased gas adjustment clause approved by the KPSC, Union Light is permitted to make quarterly adjustments in gas costs and reconciliation of over- or under- recovery of gas costs. In conjunction with these rules, Union Light expenses the costs of gas and electricity purchased as recovered through revenue and defers the portion of these costs recoverable or refundable in future periods. Construction - ------------ During 1993, construction expenditures amounted to $24.4 million. Of this amount, $14.5 million was for electric facilities and $6.8 million for gas facilities and $3.1 million for facilities used in both electric and gas operations. Construction expenditures for Union Light are estimated to be $20.3 million for 1994 and $120.2 million for the five years 1994-1998. These estimates are under continuing review and are subject to adjustment. In October 1993, Union Light filed its second integrated resource plan (IRP) in the state of Kentucky. The primary emphasis of IRP is on procedures for the evaluation of long-term electric forecasts and the integration of demand and supply alternatives for meeting future electric needs. The KPSC is currently reviewing this report. A review conference is scheduled for April 19, 1994. Environmental Matters - --------------------- CG&E has advised Union Light that CG&E's inability to comply with potential environmental regulations, and more rigid enforcement policies with respect to existing standards and regulations, could cause substantial capital expenditures in addition to those included in CG&E's construction program, and increase the cost per Kwh of generation to CG&E and, ultimately, the cost of electric energy purchased by Union Light from CG&E by reducing the amount of electricity available for delivery or by necessitating increased fuel and/or operating and capital costs, and may cause serious fuel supply problems for CG&E, or require it to cease operating a portion of its generating facilities. Union Light is subject to regulation by various Federal, state, and local authorities relative to air and water quality, solid and hazardous waste disposal, and other environmental matters. Pursuant to Federal law, the Secretary of the Natural Resources and Environmental Protection Cabinet (NREPC) administers regulations prescribing air and water quality standards and regulations pertaining to solid and hazardous wastes. NREPC is generally empowered by Kentucky environmental laws to issue construction and operating permits and variances for facilities which may contribute to air pollution and issue similar permits for facilities which discharge pollutants into the waters of the state, as well as permits for the disposal of solid and hazardous waste. The Kentucky implementation plan is fully enforceable by the state and, to the extent approved by the U.S. Environmental Protection Agency, is also enforceable by it. The Comprehensive Environmental Response Compensation and Liability Act (CERCLA) expanded reporting and liability requirements covering the release of hazardous substances into the environment. Some of these substances, including polychlorinated biphenyls (PCBs), a substance regulated under the Toxic Substances Control Act, are contained in certain equipment currently used by Union Light. Union Light cannot predict the occurrence and effect of a release of such substances. CERCLA provides, among other things, for a trust fund, drawn from industry and federal appropriations, to finance cleanup and containment efforts of improperly managed hazardous waste sites. Under CERCLA, and other laws, responsible parties may be strictly, and jointly and severally, liable for money expended by the government to take necessary corrective action at such sites. The Superfund Amendments and Reauthorization Act of 1986 (SARA) significantly amended CERCLA and established programs dealing with emergency preparedness and community right-to-know, leaking underground storage tanks, and other matters. SARA provides for a significant increase in CERCLA funding, adopts strict cleanup standards and schedules, places limitations on the timing and scope of court review of government cleanup decisions, authorizes state and citizen participation in cleanup plans, enforcement actions, and court proceedings, including provisions for citizens' suits against both private and public entities to enforce CERCLA's requirements, expands liability provisions, and increases civil and criminal penalties for violations of CERCLA. Employee Relations - ------------------ Union Light presently employs about 340 full-time employees, of whom about 280 belong to bargaining units. Approximately 90 employees are represented by the International Brotherhood of Electrical Workers (IBEW), 110 by the United Steelworkers of America (USWA) and 80 by the Independent Utilities Union (IUU). The collective bargaining agreements with the IBEW and USWA expire on April 1, and May 15, 1994, respectively. The three-year agreement with the IUU, which expires in March 1995, has a wage reopener for the third year of the contract. Negotiations with both the IBEW and IUU are presently under way. Item 2. Item 2. Properties - ------- ---------- Union Light owns an electric transmission system and an electric distribution system in Covington, Newport, and other smaller communities and in adjacent rural territory within all or parts of the Counties of Kenton, Campbell, Boone, Grant, and Pendleton, in Kentucky. Union Light owns a gas distribution system in Covington, Newport, and other smaller communities and in adjacent rural territory within all or parts of the Counties of Kenton, Campbell, Boone, Grant, Gallatin, and Pendleton, in Kentucky. Union Light owns a 7,000,000 gallon capacity underground cavern for the storage of liquid propane and a related vaporization and mixing plant and feeder lines, located in Kenton County, Kentucky near the Kentucky-Ohio line and adjacent to one of the gas lines which transports natural gas to CG&E. The cavern and vaporization and mixing plant are used primarily to augment CG&E's and Union Light's supply of natural gas during periods of peak demand and emergencies. Under the terms of the mortgage indenture securing first mortgage bonds issued by Union Light, substantially all property is subject to a direct first mortgage lien. Item 3. Item 3. Legal Proceedings - ------- ----------------- The registrant has no material pending legal proceedings. Item 4. Item 4. Submission of Matters to a Vote of Security Holders - ------- --------------------------------------------------- Omitted pursuant to Instruction J(2)(c). PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters - ------- ---------------------------------------------------------------------- All of Union Light's Capital Shares are owned by CG&E. Union Light declared a dividend of $5.00 per capital share during the fourth quarter of 1993. No dividends were declared in 1992. Item 6. Item 6. Selected Financial Data - ------- ----------------------- Omitted pursuant to Instruction J(2)(a). Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and - ------- --------------------------------------------------------------- Results of Operations --------------------- Earnings per capital share increased in 1993 to $15.95 from $2.23 in 1992. The increase was due to a gas rate increase in 1993, higher gas and electric sales volumes and cost control efforts. For information on the gas rate increase see "Future Outlook" herein. In 1992, earnings per capital share decreased to $2.23 from $12.48 in 1991. The decrease was primarily due to Union Light incurring increased purchased power costs from CG&E which were not reflected in Union Light's electric revenues for the period and to the KPSC ordering a $2.5 million decrease in the retail portion of Union Light's electric rates in May 1992. Electric operating revenues increased $16.0 million in 1993 due to an increase in electric Kwh sales of 5.8% and to the full effect of a rate increase that became effective in May 1992. In 1992, electric operating revenues increased $6.3 million primarily due to a rate increase that became effective in May 1992 and to a 1.4% increase in sales volumes. Gas operating revenues increased $13.1 million in 1993 due to the operation of an adjustment clause reflecting increases in the cost of gas purchased, a rate increase (see "Future Outlook" herein), and a 5.8% increase in total volumes sold and transported. In 1992, gas operating revenues increased $3.7 million primarily due to a 7.0% increase in total volumes sold and transported. Electricity purchased increased $7.1 million in 1993 due to a 6.3% increase in volumes purchased. In 1992, electricity purchased increased $14.8 million due to a 10.9% increase in the average cost per Kwh purchased and to a 2.1% increase in volume purchased. Gas purchased expense for 1993 increased $8.0 million due to an 11.8% increase in the average cost per Mcf purchased and to a 9.5% increase in volumes purchased. In 1992, gas purchased expense increased $1.9 million due to a 3.5% increase in volumes purchased and a 2.0% increase in the average cost per Mcf purchased. Other operation expense decreased $1.2 million in 1993 due to a number of factors including reduced electric and gas distribution expenses and cost control efforts. In 1992, maintenance expense decreased $.8 million primarily due to reduced maintenance costs related to gas and electric distribution facilities. Depreciation expense increased $1.5 million in 1993 due to an increase in depreciable plant in service and to increases in depreciation accrual rates on gas and common plant in accordance with a KPSC rate order issued in 1993. Depreciation expense increased $.7 million in 1992 due to an increase in depreciable plant in service. Allowance for funds used during construction (AFC) decreased $.6 million in 1992 due to lower AFC rates. Increases in interest on long-term debt of $.7 million and $.5 million in 1993 and 1992, respectively, were due to the issuance of additional first mortgage bonds in August 1992. Other interest expense decreased $.6 million in 1993 due to a decrease in the amount of short-term borrowings and lower interest rates. Liquidity and Capital Resources - ------------------------------- During 1993, internally generated funds provided 51% of the amount needed for construction expenditures, an increase from 34% in 1992. External funds were obtained in 1993 from the net issuance of $18.5 million of short-term debt. Union Light also retired at maturity $6.5 million of first mortgage bonds in 1993. The issuance of first mortgage bonds by Union Light is limited by earnings coverage and fundable property provisions of Union Light's First Mortgage Indenture. Certain provisions in the mortgage indenture of CG&E prohibit the sale by Union Light of debt securities except to CG&E if, after giving effect to the sale of such securities, the outstanding debt securities of Union Light are in excess of 75% of the net plant of Union Light. Bonds may be issued upon the basis of property additions and cash deposits only if net earnings, as defined in the Mortgage, are at least 2.00 times the annual interest charges on all outstanding indebtedness having an equal or prior lien. In accordance with the most restrictive of these provisions, Union Light would have been permitted to issue at December 31, 1993, at least $50 million of additional first mortgage bonds at current interest rates. In addition, Union Light presently can issue $9.1 million of first mortgage bonds against previously retired bonds without regard to the Indenture's earnings coverage or fundable property requirements. The construction expenditures for Union Light are estimated to be $20.3 million for 1994 and $120.2 million over the next five years (1994-1998). These estimates are under continuing review and are subject to adjustment. Construction and financing plans for the future are dependent on, among other things, the amount and timing of rate changes, sales volumes, changes in construction plans, cost control efforts, market conditions, regulatory actions, and the ability to obtain financing. Short-term indebtedness will be used to supplement internal sources of funds for the interim financing of the construction program. Union Light presently has authorized a maximum amount of short-term indebtedness of $35 million through December 31, 1994, and $25.0 million of short-term borrowings were outstanding at December 31, 1993. Union Light has authority to issue to CG&E up to $15 million of Capital Stock through December 31, 1994. Ratings on Union Light's first mortgage bonds by Standard & Poor's and Moody's Investors Service are BBB+ and Baa1, respectively. Future Outlook - -------------- Union Light's future earnings will be affected by its ability to secure adequate and timely rate relief. In September 1992, Union Light filed a request with the KPSC to increase annual gas revenues by approximately $9 million. In accordance with Kentucky law, on April 26, 1993, Union Light implemented the proposed rate increase, subject to refund. On July 23, 1993, the KPSC issued an Order authorizing Union Light to increase annual gas revenues by $3.9 million effective retroactively to April 26, 1993. The authorized rates were not placed into effect pending resolution of Union Light's request for rehearing of the Order. On August 31, 1993, the KPSC granted an additional annual increase of $247,000. Union Light has placed these rates into effect and has refunded the excess revenue collected with interest to customers. In April 1992, FERC issued Order 636 which restructures the relationships between interstate gas pipelines and their customers for gas sales and transportation services. Order 636 will result in changes in the way Union Light purchases gas supplies and contracts for transportation and storage services, and will result in increased risks in managing the ability to meet demand. Order 636 also allows pipelines to recover transition costs they incur in complying with the Order from customers, including Union Light. The KPSC has issued an Order which allows recovery of these transition costs through Union Light's purchased gas adjustment clause. Order 636 transition costs are not expected to significantly impact Union Light. The Energy Act addresses several matters affecting electric utilities including mandated open access to the electric transmission system and greater encouragement of independent power production and cogeneration. Union Light cannot predict the long-term consequences the Energy Act will have on its operations. In recent years several new accounting standards have been issued by the Financial Accounting Standards Board. While the impact on earnings and cash flow associated with the new standards has been relatively minor, these accounting changes do affect the recognition and presentation of amounts reported in Union Light's financial statements. For information in addition to that provided below on recently adopted accounting standards, see Note 1 to the Financial Statements. In 1993, CG&E and its subsidiaries adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106). Union Light is a participating company under CG&E's health care and life insurance benefit plans. SFAS No. 106 requires the accrual of the expected cost of providing postretirement benefits other than pensions to an employee and the employee's covered dependents during the employee's active working career. SFAS No. 106 also requires the recognition of the actuarially determined total postretirement benefit obligation earned by existing retirees. Currently, SFAS No. 106 health care costs are being expensed. The adoption of SFAS No. 106 did not have a material effect on results on operations. Also in 1993, Union Light adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). SFAS No. 109 requires deferred tax recognition for all temporary differences in accordance with the liability method, requires that deferred tax liabilities and assets be adjusted for enacted changes in tax laws or rates and prohibits net-of-tax accounting and reporting. Union Light believes it is probable that any net future increase or decrease in income taxes payable will be reflected in future rates. In accordance with SFAS No. 109, Union Light has recorded a net regulatory liability at December 31, 1993. Adoption of SFAS No. 109 had no impact on results of operations. In 1993, CG&E and its subsidiaries adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). SFAS No. 112 requires the accrual of the cost of certain postemployment benefits provided to former or inactive employees. The adoption of SFAS No. 112 did not have a material effect on results of operations. Over the past several years, the rate of inflation has been relatively low. Union Light believes that the recent inflation rates do not materially affect its results of operations or financial condition. However, under existing regulatory practice, only the historical cost of plant is recoverable from customers. As a result, cash flows designed to provide recovery of historical plant costs may not be adequate to replace plant in future years. Item 8. Item 8. Financial Statements and Supplementary Data - ------- ------------------------------------------- THE UNION LIGHT, HEAT AND POWER COMPANY --------------------------------------- NOTES TO FINANCIAL STATEMENTS ----------------------------- (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Union Light follows the Uniform Systems of Accounts prescribed by the Federal Energy Regulatory Commission (FERC), and is subject to the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation". The more significant accounting policies are summarized below: UTILITY PLANT. Property, plant and equipment is stated at the original cost of construction, which includes payroll and related costs such as taxes, pensions and other fringe benefits, general and administrative costs, and an allowance for funds used during construction. REVENUES AND PURCHASED GAS AND ELECTRICITY COSTS. Union Light recognizes revenues for gas and electric service rendered during the month, which includes revenue for sales unbilled at the end of each month. Union Light expenses the costs of gas and electricity purchased as recovered through revenues and defers the portion of these costs recoverable or refundable in future periods. DEPRECIATION AND MAINTENANCE. Union Light determines its provision for depreciation using the straight-line method and by the application of rates to various classes of property, plant and equipment. The rates are based on periodic studies of the estimated service lives and net cost of removal of the properties. The percentages of the annual provisions for depreciation to the weighted average of depreciable property during the three years ended December 31, 1993, were equivalent to: 1993 1992 1991 ---- ---- ---- Electric 3.3 3.3 3.3 Gas 2.9 2.7 2.7 Common 5.0 1.7 1.8 In a July 1993 rate order, the Kentucky Public Service Commission (KPSC) authorized changes in depreciation accrual rates on Union Light's gas and common plant. These changes resulted in an increase in depreciation expense for 1993 of approximately $500,000. Expenditures for maintenance and repairs of units of property, including renewals of minor items, are charged to the appropriate maintenance expense accounts. A betterment or replacement of a unit of property is accounted for as an addition and retirement of property, plant and equipment. At the time of such a retirement, the accumulated provision for depreciation is charged with the original cost of the property retired and also for the net cost of removal. INCOME TAXES. For income tax purposes, Union Light uses liberalized depreciation methods and deducts removal costs as incurred. Consistent with regulatory treatment, Union Light provides for income tax deferrals resulting from the use of liberalized depreciation and from interest deductions associated with borrowed funds used during construction. Union Light adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), in 1993. SFAS No. 109 requires deferred tax recognition for all temporary differences in accordance with the liability method, requires that deferred tax liabilities and assets be adjusted for enacted changes in tax laws or rates and prohibits net-of-tax accounting and reporting. Union Light believes it is probable that any net future increase or decrease in income taxes payable will be reflected in future rates. In accordance with SFAS No. 109, Union Light has recorded a net regulatory liability at December 31, 1993. Adoption of SFAS No. 109 had no impact on results of operations. The following are the tax effects of temporary differences resulting in deferred tax assets and liabilities: The following table reconciles the change in the net deferred tax liability to the deferred income tax expense included in the accompanying Statement of Income for the year ended December 31, 1993: In August 1993, President Clinton signed into law the Omnibus Budget Reconciliation Act of 1993. Among the Act's provisions is an increase in the corporate Federal income tax rate from 34% to 35%, retroactive to January 1, 1993. Under SFAS No. 109, the increase in the tax rate has resulted in an increase in the net deferred tax liability and a decrease in income tax related regulatory liabilities. In the above table, this decrease in regulatory liabilities has been included in "Change in income taxes refundable through rates". The increase in the Federal income tax rate has not had a material impact on Union Light's results of operations. RETIREMENT INCOME PLANS. Union Light is a participating company under CG&E's trusteed non-contributory retirement income plans covering substantially all regular employees. The benefits are based on the employee's compensation, years of service, and age at retirement. Union Light's funding policy is to contribute annually to the plans an amount which is not less than the minimum amount required by the Employee Retirement Income Security Act of 1974 and not more than the maximum amount deductible for income tax purposes. The plans' funded status and amounts recognized by CG&E and its subsidiary companies for the years 1993 and 1992 are presented below: During 1992, CG&E and its subsidiaries recorded $28.4 million ($2.8 million applicable to Union Light) of accrued pension cost in accordance with Statement of Financial Accounting Standards No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits". This amount represented the costs associated with additional benefits extended in connection with an early retirement program and workforce reduction discussed below. The following assumptions were used in accounting for pensions: Net pension cost for CG&E and its subsidiary companies for the years 1993, 1992 and 1991 included the following components: EARLY RETIREMENT PROGRAM AND WORKFORCE REDUCTIONS. As a result of unfavorable rate orders received in 1992, CG&E and its subsidiaries eliminated approximately 900 regular, temporary and contract positions. The workforce reduction was accomplished through a voluntary early retirement program and involuntary separations. At December 31, 1992, the accrued liability for CG&E and its subsidiaries associated with the workforce reduction was $30.4 million ($3.0 million applicable to Union Light), including $28.4 million ($2.8 million for Union Light) of additional pension benefits discussed above. In accordance with a July 1993 Order of the KPSC, Union Light is recovering the majority of these costs associated with gas operations through gas rates over a period of ten years. Costs associated with electric operations shall be addressed by the KPSC in Union Light's next electric rate case. The balance of unrecovered costs at December 31, 1993, totalled $2.9 million and is reflected in "Other Assets" on the Balance Sheet. POSTRETIREMENT BENEFITS. Effective January 1, 1993, CG&E and its subsidiaries adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106). Union Light is a participating company under CG&E's health care and life insurance benefit plans. SFAS No. 106 requires the accrual of the expected cost of providing postretirement benefits other than pensions to an employee and the employee's covered dependents during the employee's active working career. SFAS No. 106 also requires the recognition of the actuarially determined total postretirement benefit obligation earned by existing retirees. CG&E offers health care and life insurance benefits which are subject to SFAS No. 106. Life insurance benefits are fully paid by the Companies for qualified employees. Eligibility to receive postretirement coverage is limited to those employees who had participated in the plans and earned the right to postretirement benefits prior to January 1, 1991. In 1988, CG&E and its subsidiaries recognized the actuarially determined accumulated benefit obligation for postretirement life insurance benefits earned by retirees. The accumulated benefit obligation for active employees is being amortized over 15 years, the employees' estimated remaining service lives. The accounting for postretirement life insurance benefits is not impacted by the adoption of SFAS No. 106. Postretirement health care benefits are subject to deductibles, copayment provisions and other limitations. Retirees can participate in health care plans by paying 100% of the group coverage premium. Prior to the adoption of SFAS No. 106, the cost of postretirement health care benefits was expensed by the Companies as paid. Beginning in 1993, the Companies began recognizing the accumulated postretirement benefit obligation over 20 years in accordance with SFAS No. 106. Currently, SFAS No. 106 health care costs are being expensed. The adoption of SFAS No. 106 did not have a material effect on results on operations. The net periodic postretirement cost for the Companies' postretirement benefit plans for 1993 are presented below. The Companies' accumulated postretirement benefit obligation and accrued postretirement benefit cost under the plans at December 31, 1993 are as follows: The following assumptions were used to determine the accumulated postretirement benefits obligation: Increasing the assumed medical care cost trend rates by one percentage point in each year would increase the estimated accumulated postretirement benefit obligation as of December 31, 1993 by $10.5 million and the net periodic postretirement cost by $1.2 million. No funding has been established by the Companies for postretirement benefits. POSTEMPLOYMENT BENEFITS. In 1993, CG&E and its subsidiaries adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). SFAS No. 112 requires the accrual of the cost of certain postemployment benefits provided to former or inactive employees. The adoption of SFAS No. 112 did not have a material effect on results of operations. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION. The applicable regulatory uniform systems of accounts define "allowance for funds used during construction" (AFC) as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used." This amount of AFC constitutes an actual cost of construction and, under established regulatory rate practices, a return on and recovery of such costs heretofore has been permitted in determining the rates charged for utility services. AFC was accrued at average pre-tax rates of 8.79%, 3.96% and 8.38% compounded semi-annually for 1993, 1992 and 1991, respectively. AFC represents non-cash earnings and, as a result, does not affect current cash flow. STATEMENT OF CASH FLOWS. For purposes of the Statement of Cash Flows, Union Light considers short-term investments having maturities of three months or less at time of purchase to be cash equivalents. The cash amounts of interest (net of allowance for borrowed funds used during construction) and income taxes paid by Union Light in 1993, 1992 and 1991 are as follows: 1993 1992 1991 ---------- ---------- ---------- Interest...................... $8,404,058 $7,597,202 $7,523,242 Income Taxes.................. $4,001,150 $ (440,612) $2,395,392 RECLASSIFICATIONS. Certain reclassifications of previously reported amounts have been made to conform with current classifications. These reclassifications had no effect on earnings on common shares. (2) INCOME TAXES: The provision for income taxes included in the accompanying Statement of Income consists of the following components: Federal income taxes (included in the total provision for income tax expense set forth above) are different from the amount which would be computed by applying the statutory Federal income tax rate to income before provision for Federal income taxes; the principal reasons for this difference are as follows: (3) CAPITAL STOCK: Union Light sold $15 million of Capital Stock to CG&E in December 1992 and has authority from the KPSC to issue up to an additional $15 million of Capital Stock through December 31, 1994. Also in 1992, CG&E purchased, from the remaining minority shareholders, 36-63/94 shares of the capital stock of Union Light. As a result, all of Union Light's Capital Shares are owned by CG&E. (4) LONG-TERM DEBT: Under the terms of the mortgage indenture securing first mortgage bonds issued by Union Light, substantially all property is subject to a direct first mortgage lien. Improvement and sinking fund provisions contained in the indenture applicable to the First Mortgage Bonds of Union Light issued prior to 1981 require deposits with the Trustee, on or before April 30 of each year, of amounts in cash and/or principal amount of bonds equal to 1% ($200,000) of the principal amount of bonds of the applicable series originally outstanding less certain designated retirements. In lieu of such cash deposits or delivery of bonds and as permitted under the terms of the indenture, historically Union Light has followed the practice of pledging unfunded property additions to the extent of 166-2/3% of the annual sinking fund requirements. (5) RATES: Reference is made to "Rate Matters" on page 3 herein with respect to electric and gas rate matters. (6) FAIR VALUE OF FINANCIAL INSTRUMENTS: The Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (SFAS No. 107), requires disclosure of the estimated fair value of certain financial instruments of Union Light. This information does not purport to be a valuation of Union Light as a whole. The following methods and assumptions were used to estimate the fair value of each major class of financial instrument of Union Light as required by SFAS No. 107: CASH, NOTES PAYABLE, ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE. The carrying amount as reflected on the Balance Sheet approximates the fair value of these instruments due to the short period to maturity. LONG-TERM DEBT. At December 31, 1993 and 1992, Union Light's first mortgage bonds had an estimated fair value of approximately $107,078,000 and $103,782,000, respectively. The aggregate fair value for the first mortgage bonds is based on the present value of future cash flows. The discount rate used approximates the incremental borrowing cost for similar instruments. (7) COMMITMENTS AND CONTINGENCIES: In December 1992, CG&E, PSI Resources, Inc. (PSI) and PSI Energy, Inc., PSI's principal subsidiary, an Indiana electric utility (PSI Energy), entered into an agreement which, as subsequently amended (the Merger Agreement) provides for the merger of PSI into a newly formed corporation named CINergy Corp. (CINergy) and the merger of a newly formed subsidiary of CINergy into CG&E. CINergy will become a holding company required to be registered under the Public Utility Holding Company Act of 1935 (PUHCA) with two operating subsidiaries, CG&E and PSI Energy. Union Light will remain a subsidiary of CG&E. The merger will be accounted for as a "pooling of interests", and it is anticipated that the transaction will be completed in the third quarter of 1994. The merger is subject to approval by the Securities and Exchange Commission (SEC) and FERC. Shareholders of both companies approved the merger in November 1993. FERC issued conditional approval of the CINergy merger in August 1993, but several intervenors, including The Public Utilities Commission of Ohio (PUCO) and the KPSC, filed for rehearing of that order. On January 12, 1994, FERC withdrew its conditional approval of the merger and ordered the setting of FERC-sponsored settlement procedures to be held. On March 4, 1994, CG&E reached a settlement agreement with the PUCO and the Ohio Office of Consumers' Counsel on merger issues identified by FERC. On March 2, PSI Energy and Indiana's consumer representatives had reached a similar agreement. Both settlement agreements have been filed with FERC. These documents address, among other things, the coordination of state and federal regulation and the commitment that neither CG&E nor PSI electric base rates, nor CG&E's gas base rates, will rise because of the merger, except to reflect any effects that may result from the divestiture of CG&E's gas operations if ordered by the SEC in accordance with the requirements of PUHCA discussed below. CG&E also filed with FERC a unilateral offer of settlement addressing all issues raised in the KPSC's application for rehearing with FERC. Although it is the belief of CG&E and PSI that no state utility commissions have jurisdiction over approval of the proposed merger, an application has been filed with the KPSC to comply with the Staff of the KPSC's position that the KPSC's authorization is required for the indirect acquisition of control of Union Light by CINergy. As part of the settlement offer, Union Light will agree not to increase gas base rates as a result of the merger except to reflect any effects that may result from the divestiture of Union Light's gas operations discussed below. If the settlement agreements filed with FERC are not acceptable, FERC could set issues for hearing. If a hearing is held by FERC, consummation of the merger would likely be extended beyond the third quarter of 1994. PUHCA imposes restrictions on the operations of registered holding company systems. Among these are requirements that securities issuances, sales and acquisitions of utility assets or of securities of utility companies and acquisitions of interests in any other business be approved by the SEC. PUHCA also limits the ability of registered holding companies to engage in non-utility ventures and regulates holding company system service companies and the rendering of services by holding company affiliates to the system's utilities. The SEC has interpreted the PUHCA to preclude registered holding companies, with some exceptions, from owning both electric and gas utility systems. The SEC may require that CG&E and Union Light divest their gas properties within a reasonable time after the merger in order to approve the merger as it has done in many cases involving the acquisition by a holding company of a combination gas and electric company. In some cases, the SEC has allowed the retention of the gas properties or deferred the question of divestiture for a substantial period of time. In those cases in which divestiture has taken place, the SEC usually has allowed companies sufficient time to accomplish the divestiture in a manner that protects shareholder value. CG&E and Union Light believe good arguments exist to allow retention of the gas assets, and will request that the Companies be allowed to do so. CG&E and Union Light are subject to regulation by various Federal, state and local authorities relative to air and water quality, solid and hazardous waste disposal, and other environmental matters. Compliance programs necessary to meet existing and future environmental laws and regulations will increase the cost of utility service. Reference is made to "Gas Operations and Gas Supply" herein for information relating to FERC Order 636 and commitments for the purchase of gas and to "Construction" with respect to estimated construction expenditures. (8) COMPENSATING BANK BALANCES AND NOTES PAYABLE: At December 31, 1993, Union Light had lines of credit totaling $30 million, which were maintained by compensating balances. Unused lines of credit at December 31, 1993 totaled $9.0 million (generally subject to withdrawal by the banks). Substantially all of the cash balances of Union Light are maintained to compensate the respective banks for banking services and to obtain lines of credit; however, Union Light has the right of withdrawal of such funds. The maximum amount of outstanding short-term notes payable authorized by Union Light's Board of Directors and approved by FERC to be incurred at any time through December 31, 1994 is $35 million. (9) SUPPLEMENTARY INCOME INFORMATION: Taxes other than income taxes as set forth in the Statement of Income are as follows: (10) FINANCIAL INFORMATION BY BUSINESS SEGMENTS: REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Union Light, Heat and Power Company: We have audited the accompanying balance sheet of THE UNION LIGHT, HEAT AND POWER COMPANY (a Kentucky corporation and a subsidiary of The Cincinnati Gas & Electric Company) as of December 31, 1993 and 1992, and the related statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Union Light, Heat and Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As explained in Note 1 to the financial statements, the Company changed its methods of accounting for income taxes, postretirement health care benefits and postemployment benefits effective January 1, 1993. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental schedules listed in Item 14 are presented for purposes of complying with the Securities and Exchange Commission's Rules and Regulations under the Securities Exchange Act of 1934 and are not a required part of the basic financial statements. The supplemental schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Cincinnati, Ohio, January 24, 1994. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and - ------ --------------------------------------------------------------- Financial Disclosure -------------------- Not Applicable. PART III Items 10., 11., 12. and 13. - --------------------------- Omitted pursuant to Instruction J(2)(c). PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------- ----------------------------------------------------------------- (a) Listed below are all financial statements, schedules, and exhibits attached hereto, incorporated herein, and filed as a part of this Annual Report. (1) Financial Statements: Statement of Income for the Three Years Ended December 31, Statement of Cash Flows for the Three Years Ended December 31, 1993 Balance Sheet, December 31, 1993 and 1992 Statement of Changes in Shareholders' Equity for the Three Years Ended December 31, 1993 Notes to Financial Statements Report of Independent Public Accountants (2) Financial Statement Schedules: #Schedule V -- Property, Plant and Equipment (1993, 1992, and 1991) #Schedule VI -- Accumulated Provisions for Depreciation (1993, 1992, and 1991) #Schedule VIII -- Other Accumulated Provisions (1993, 1992, and 1991) #Schedule IX -- Short-Term Borrowings (1993, 1992, and 1991) (3) Exhibits: Exhibit No. ------- *3-A --Copy of Restated Articles of Incorporation made effective May 7, 1976 (filed as Exhibit 1 to Form 8-K, May 1976) *3-B --Copy of By-Laws of Union Light as amended, adopted by shareholders May 3, 1989 (filed as Exhibit 3-B under cover of Form SE dated August 8, 1989) *4-A-1 --Copy of First Mortgage dated as of February 1, 1949, between Union Light and The Bank of New York (filed as Exhibit 7 to Registration Statement No. 2-7793) *4-A-2 --Copy of Fifth Supplemental Indenture dated as of January 1, 1967, between Union Light and The Bank of New York (filed as Exhibit 2-C-6 to Registration Statement No. 2-60961 of CG&E) *4-A-3 --Copy of Seventh Supplemental Indenture dated as of October 1, 1973, between Union Light and The Bank of New York (filed as Exhibit 2-C-7 to Registration Statement No. 2-60961 of CG&E) *4-A-4 --Copy of Eighth Supplemental Indenture dated as of December 1, 1978, between Union Light and The Bank of New York (filed as Exhibit 2-C-8 to Registration Statement No. 2-63591 of CG&E) *4-A-5 --Copy of Tenth Supplemental Indenture dated as of July 1, 1989 between Union Light and The Bank of New York (filed as Exhibit 4-B to Form 10-Q for the quarter ended June 30, 1989 of CG&E) *4-A-6 --Copy of Eleventh Supplemental Indenture dated as of June 1, 1990 between Union Light and The Bank of New York (filed as Exhibit 4-B to Form 10-Q for the quarter ended June 30, 1990 of CG&E) *4-A-7 --Copy of Twelfth Supplemental Indenture dated as of November 15, 1990, between Union Light and The Bank of New York (filed as Exhibit 4-B-8 to 1990 Form 10-K of CG&E) *4-A-8 --Copy of Thirteenth Supplemental Indenture dated as of August 1, 1992, between Union Light and The Bank of New York (filed as Exhibit 4-B-9 to 1992 Form 10-K of CG&E) 23 --Consent of Independent Public Accountants dated as of March 15, 1994 (b) No reports on Form 8-K were filed during the three months ended December 31, 1993. ---------------- #All schedules other than Schedules V, VI, VIII and IX, are omitted, as the information is not required or is otherwise furnished, per Title 17, Section 210.5-04, CFR. *The exhibits with an asterisk have been filed with the Securities and Exchange Commission and are incorporated herein by reference. 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, on this 15th day of March, 1994. THE UNION LIGHT, HEAT AND POWER COMPANY By Jackson H. Randolph ______________________________________ (Jackson H. Randolph, Chairman of the Board, President and Chief Executive Officer) 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. (i) Principal Executive Officer: Chairman of the Board, President and Chief Jackson H. Randolph Executive Officer March 15, 1994 _____________________________________ (Jackson H. Randolph) (ii) Principal Financial Officer: Senior Vice-President Finance C. R. Everman and Director March 15, 1994 ____________________________________ (C. Robert Everman) (iii) Principal Accounting Officer: Daniel R. Herche Controller March 15, 1994 _____________________________________ (Daniel R. Herche) (iv) A Majority of the Board of Directors: Terry E. Bruck Director March 15, 1994 _____________________________________ (Terry E. Bruck) James J. Mayer Director March 15, 1994 _____________________________________ (James J. Mayer) George H. Stinson Director March 15, 1994 _____________________________________ (George H. Stinson) W. D. Waymire Director March 15, 1994 _____________________________________ (W. Denis Waymire) R. P. Wiwi Director March 15, 1994 _____________________________________ (R. P. Wiwi) Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - -------- ----------------------------------------------------------------- (a) Listed below are all financial statements, schedules, and exhibits attached hereto, incorporated herein, and filed as a part of this Annual Report. (1) Financial Statements: Statement of Income for the Three Years Ended December 31, Statement of Cash Flows for the Three Years Ended December 31, 1993 Balance Sheet, December 31, 1993 and 1992 Statement of Changes in Shareholders' Equity for the Three Years Ended December 31, 1993 Notes to Financial Statements Report of Independent Public Accountants (2) Financial Statement Schedules: #Schedule V -- Property, Plant and Equipment (1993, 1992, and 1991) #Schedule VI -- Accumulated Provisions for Depreciation (1993, 1992, and 1991) #Schedule VIII -- Other Accumulated Provisions (1993, 1992, and 1991) #Schedule IX -- Short-Term Borrowings (1993, 1992, and 1991) (3) Exhibits: Exhibit No. ------- *3-A --Copy of Restated Articles of Incorporation made effective May 7, 1976 (filed as Exhibit 1 to Form 8-K, May 1976) *3-B --Copy of By-Laws of Union Light as amended, adopted by shareholders May 3, 1989 (filed as Exhibit 3-B under cover of Form SE dated August 8, 1989) *4-A-1 --Copy of First Mortgage dated as of February 1, 1949, between Union Light and The Bank of New York (filed as Exhibit 7 to Registration Statement No. 2-7793) *4-A-2 --Copy of Fifth Supplemental Indenture dated as of January 1, 1967, between Union Light and The Bank of New York (filed as Exhibit 2-C-6 to Registration Statement No. 2-60961 of CG&E) *4-A-3 --Copy of Seventh Supplemental Indenture dated as of October 1, 1973, between Union Light and The Bank of New York (filed as Exhibit 2-C-7 to Registration Statement No. 2-60961 of CG&E) *4-A-4 --Copy of Eighth Supplemental Indenture dated as of December 1, 1978, between Union Light and The Bank of New York (filed as Exhibit 2-C-8 to Registration Statement No. 2-63591 of CG&E) *4-A-5 --Copy of Tenth Supplemental Indenture dated as of July 1, 1989 between Union Light and The Bank of New York (filed as Exhibit 4-B to Form 10-Q for the quarter ended June 30, 1989 of CG&E) *4-A-6 --Copy of Eleventh Supplemental Indenture dated as of June 1, 1990 between Union Light and The Bank of New York (filed as Exhibit 4-B to Form 10-Q for the quarter ended June 30, 1990 of CG&E) *4-A-7 --Copy of Twelfth Supplemental Indenture dated as of November 15, 1990, between Union Light and The Bank of New York (filed as Exhibit 4-B-8 to 1990 Form 10-K of CG&E) *4-A-8 --Copy of Thirteenth Supplemental Indenture dated as of August 1, 1992, between Union Light and The Bank of New York (filed as Exhibit 4-B-9 to 1992 Form 10-K of CG&E) 23 --Consent of Independent Public Accountants dated as of March 15, 1994 (b) No reports on Form 8-K were filed during the three months ended December 31, 1993. ---------------- #All schedules other than Schedules V, VI, VIII and IX, are omitted, as the information is not required or is otherwise furnished, per Title 17, Section 210.5-04, CFR. *The exhibits with an asterisk have been filed with the Securities and Exchange Commission and are incorporated herein by reference. 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, on this 15th day of March, 1994. THE UNION LIGHT, HEAT AND POWER COMPANY By Jackson H. Randolph ______________________________________ (Jackson H. Randolph, Chairman of the Board, President and Chief Executive Officer) 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. (i) Principal Executive Officer: Chairman of the Board, President and Chief Jackson H. Randolph Executive Officer March 15, 1994 _____________________________________ (Jackson H. Randolph) (ii) Principal Financial Officer: Senior Vice-President Finance C. R. Everman and Director March 15, 1994 ____________________________________ (C. Robert Everman) (iii) Principal Accounting Officer: Daniel R. Herche Controller March 15, 1994 _____________________________________ (Daniel R. Herche) (iv) A Majority of the Board of Directors: Terry E. Bruck Director March 15, 1994 _____________________________________ (Terry E. Bruck) James J. Mayer Director March 15, 1994 _____________________________________ (James J. Mayer) George H. Stinson Director March 15, 1994 _____________________________________ (George H. Stinson) W. D. Waymire Director March 15, 1994 _____________________________________ (W. Denis Waymire) R. P. Wiwi Director March 15, 1994 _____________________________________ (R. P. Wiwi)

277577_1993.txt

277577_1993

1993

277577

ITEM 1. BUSINESS (Continued) Business Plan and Investment Policy (Continued) acquired through foreclosure, the Trust intends to enhance the value of such properties through renovations and, if possible, to finance such properties with first mortgages. The Trust also intends to pursue its rights vigorously with respect to mortgage notes that are in default. Management of the Trust Although the Trust's Board of Trustees is directly responsible for managing the affairs of the Trust and for setting the policies which guide it, the day-to-day operations of the Trust are performed by a contractual advisor under the supervision of the Trust's Board of Trustees. From March 1989 until March 31, 1994, Basic Capital Management, Inc. ("BCM" or the "Advisor") performed such services. The duties of the advisor include, among other things, locating, investigating, evaluating and recommending real estate and mortgage note investment and sales opportunities, as well as financing and refinancing sources, for the Trust. The advisor also serves as a consultant in connection with the business plan and investment policy decisions made by the Trust's Board of Trustees. William S. Friedman, the President and a Trustee of the Trust, served as the President of BCM until May 1, 1993. BCM is beneficially owned by a trust for the benefit of the children of Gene E. Phillips. Mr. Phillips served as a Trustee of the Trust until December 31, 1992. Messrs. Phillips and Friedman served as directors of BCM until December 22, 1989, and Mr. Phillips served as Chief Executive Officer of BCM until September 1, 1992. BCM is more fully described in ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT - The Advisor". BCM has provided advisory services to the Trust since March 28, 1989. Renewal of the Trust's advisory agreement with BCM was approved by the Trust's shareholders at the Trust's last annual meeting of shareholders held on April 26, 1993, as required by Section 4.2 of the Trust's Declaration of Trust. BCM has resigned as advisor to the Trust effective March 31, 1994. BCM also serves as advisor to Continental Mortgage and Equity Trust ("CMET"), Income Opportunity Realty Trust ("IORT") and Transcontinental Realty Investors, Inc. ("TCI"). All of the Trustees of the Trust, except for John A. Doyle, William S. Friedman and Carl B. Weisbrod, are also directors or trustees of CMET, IORT and TCI. Mr. Phillips is also a general partner and until March 4, 1994, Mr. Friedman was a general partner of the general partner of National Realty, L.P. ("NRLP"). BCM performs certain administrative functions for NRLP and National Operating, L.P. ("NOLP"), the operating partnership of NRLP, on a cost-reimbursement basis. BCM also serves as advisor to American Realty Trust, Inc. ("ART"). Messrs. Phillips and Friedman served as executive officers and directors of ART until November 16, 1992 and December 31, 1992, respectively. On February 10, 1994, the Trust's Board of Trustees selected Tarragon Realty Advisors, Inc. ("Tarragon") to replace BCM as the Trust's advisor. Commencing April 1, 1994, Tarragon will provide advisory ITEM 1. BUSINESS (Continued) Management of the Trust (Continued) services to the Trust under an advisory agreement as discussed in ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR TO THE REGISTRANT - The Advisor." Mr. Friedman serves as director and Chief Executive Officer of Tarragon. Tarragon is owned by Lucy N. Friedman, Mr. Friedman's wife, and Mr. Doyle, who serves as Director, President and Chief Operating Officer of Tarragon and Trustee and Executive Vice President of the Trust. Mr. Friedman's family owns approximately 30% of the outstanding shares of the Trust. Tarragon also serves as advisor to Vinland Property Trust ("VPT"). All of the trustees of VPT serve as Trustees of the Trust. Commencing April 1, 1994, Tarragon will provide property management services to the Trust. Tarragon intends to subcontract with other entities for the provision of much of the property-level management services to the Trust. From February 1, 1990 through March 31, 1994, affiliates of BCM provided property management services to the Trust. Through March 31, 1994, affiliates of BCM also received real estate brokerage commissions in accordance with the terms of a non-exclusive brokerage agreement as discussed in ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR TO THE REGISTRANT - The Advisor." Competition The Trust has no employees. Employees of the Advisor render services to the Trust. The real estate business is highly competitive and the Trust competes with numerous entities engaged in real estate activities (including certain entities described in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Related Party Transactions"), some of which may have greater financial resources than those of the Trust. The Trust's management believes that success against such competition is dependent upon the geographic location of the property, the performance of the property managers in areas such as marketing, collection and the ability to control operating expenses, the amount of new construction in the area and the maintenance and appearance of the property. Additional competitive factors with respect to commercial and industrial properties are the ease of access to the property, the adequacy of related facilities, such as parking, and sensitivity to market conditions in setting rent levels. With respect to apartments, competition is also based upon the design and mix of the units and the ability to provide a community atmosphere for the tenants. The Trust's management believes that general economic conditions and trends and new properties in the vicinity of each of the Trust's properties are also competitive factors. To the extent that the Trust seeks to sell any of its real estate portfolio, the sales price for such properties may be affected by competition from governmental and financial institutions seeking to liquidate foreclosed properties. ITEM 1. BUSINESS (Continued) Competition (Continued) As described above and in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Related Party Transactions", most of the Trustees of the Trust also serve as officers, directors or trustees of CMET, IORT, TCI, VPT and Tarragon. The Trust's Trustees owe fiduciary duties to such other entities as well as to the Trust under applicable law. In determining to which entity a particular investment opportunity will be allocated, the trustees or directors and Tarragon consider the respective investment objectives of each such entity and the appropriateness of a particular investment in light of each such entity's existing real estate and mortgage notes receivable portfolios. To the extent that any particular investment opportunity is appropriate to more than one of such entities, such investment opportunity will be allocated to the entity which has had uninvested funds for the longest period of time or, if appropriate, the investment may be shared among all or some of such entities. In addition, also as described in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Certain Business Relationships", the Trust also competes with other entities which may have investment objectives similar to the Trust's and that may compete with the Trust in purchasing, selling, leasing and financing real estate and real estate related investments. In resolving any potential conflicts of interest which may arise, Tarragon has informed the Trust that it intends to exercise its best judgment as to what is fair and reasonable under the circumstances in accordance with applicable law. Certain Factors Associated with Real Estate and Related Investments The Trust is subject to all the risks incident to ownership and financing of real estate and interests therein, many of which relate to the general illiquidity of real estate investments. These risks include, but are not limited to, changes in general or local economic conditions, changes in interest rates and the availability of permanent mortgage financing which may render the acquisition, sale or refinancing of a property difficult or unattractive and which may make debt service burdensome, changes in real estate and zoning laws, increases in real estate taxes, federal or local economic or rent controls, floods, earthquakes and other acts of God and other factors beyond the control of the Trust or the Advisor. The illiquidity of real estate investments generally may impair the ability of the Trust to respond promptly to changing circumstances. The Trust's management believes that such risks are partially mitigated by the diversification by geographic region and property type of the Trust's real estate and mortgage notes receivable portfolios. However, to the extent new equity investments and mortgage lending are concentrated in any particular region, the advantages of geographic diversification may be mitigated. ITEM 2. ITEM 2. PROPERTIES The Trust's principal offices are located at One Turtle Creek, 3878 Oak Lawn Avenue, Suite 300, Dallas, Texas 75219. In the opinion of the ITEM 2. PROPERTIES (Continued) Trust's management, the Trust's offices are adequate for its present operations. Details of the Trust's real estate and mortgage notes receivable portfolios at December 31, 1993, are set forth in Schedules XI and XII, respectively, to the Consolidated Financial Statements included at ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA". The discussions set forth below under the headings "Real Estate" and "Mortgage Loans" provide certain summary information concerning the Trust's real estate and mortgage notes receivable portfolios. The Trust's real estate portfolio consists of properties held for investment (which includes direct equity investments and partnerships) and properties held for sale, primarily obtained through foreclosure of mortgage notes receivable. The discussion set forth below under the heading "Real Estate" provides certain summary information concerning the Trust's real estate and further summary information with respect to the portion of the Trust's real estate which consists of properties held for investment, the portion which consists of investments in partnerships and the portion which consists of properties held for sale. At December 31, 1993, only the Century Centre II Office Building, with a carrying value of $24.5 million, accounted for 10% or more of the Trust's total assets. At December 31, 1993, 85% of the Trust's assets consisted of investments in real estate, 6% consisted of investments in partnerships and 6% consisted of mortgage notes and interest receivable. The remaining 3% of the Trust's assets at December 31, 1993, were cash, cash equivalents and other assets. It should be noted, however, that the percentage of the Trust's assets invested in any one category is subject to change and no assurance can be given that the composition of the Trust's assets in the future will approximate the percentages listed above. At December 31, 1993, the Trust held mortgage notes receivable secured by real estate located in several geographic regions of the continental United States, with a concentration in the Southeast, as shown more specifically in the table under "Mortgage Loans" below. The Trust's real estate is also geographically diverse. At December 31, 1993, the Trust held investments in apartments and commercial real estate in each of the geographic regions of the continental United States, although its apartments are concentrated in the Southeast, as shown more specifically in the table under "Real Estate" below. To continue to qualify for federal taxation as a REIT under the Internal Revenue Code of 1986, as amended, the Trust will, among other things, be required to hold at least 75% of the value of its total assets in real estate assets, government securities, cash and cash equivalents at the close of each quarter of each taxable year. ITEM 2. PROPERTIES (Continued) Geographic Regions The Trust has divided the continental United States into the following six geographic regions. Northeast region comprised of the states of Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island and Vermont, and the District of Columbia. Southeast region comprised of the states of Alabama, Florida, Georgia, Mississippi, North Carolina, South Carolina, Tennessee and Virginia. Southwest region comprised of the states of Arizona, Arkansas, Louisiana, New Mexico, Oklahoma and Texas. Midwest region comprised of the states of Illinois, Indiana, Iowa, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota, West Virginia and Wisconsin. Mountain region comprised of the states of Colorado, Idaho, Montana, Nevada, Utah and Wyoming. Pacific region comprised of the states of California, Oregon and Washington. Real Estate At December 31, 1993, 85% of the Trust's assets were invested in real estate located throughout the continental United States. The Trust's real estate portfolio consists of properties held for investment, investments in partnerships, properties held for sale, primarily obtained through foreclosure of mortgage notes receivable, and an investment in the equity securities of CMET, a REIT advised by BCM. Types of Real Estate Investments. The Trust's real estate consists of apartments and commercial properties, primarily office buildings and shopping centers, or similar properties having established income-producing capabilities. In selecting real estate, the location, age and type of property, gross rentals, lease terms, financial and business standing of tenants, operating expenses, fixed charges, land values and ITEM 2. PROPERTIES (Continued) physical condition are considered. The Trust may acquire properties subject to, or assume, existing debt and may mortgage, pledge or otherwise obtain financing for a portion of its real estate. The Trust's Board of Trustees may alter the types of and criteria for selecting new equity investments and for obtaining financing without a vote of shareholders to the extent such policies are not governed by the Declaration of Trust. Although the Trust has typically invested in developed real estate, the Trust may invest in new construction or development either directly or in partnership with affiliated or unaffiliated partners. To the extent that the Trust invests in construction and development projects, the Trust would be subject to business risks, such as cost overruns and delays, associated with such high risk activities. At December 31, 1993, the Trust was making significant capital improvements to five of its properties, the Dunhill/Devonshire, Huntington Green and Lakepointe Apartments and the Emerson Center and Rancho Sorrento Office Buildings. In the opinion of the Trust's management, the real estate owned by the Trust is adequately covered by insurance. The following table sets forth the percentages, by property type and geographic region, of the Trust's real estate (other than the unimproved land and a single-family residence described below) at December 31, 1993. The foregoing table is based solely on the number of apartment units and amount of commercial square footage owned by the Trust and does not reflect the value of the Trust's investment in each region. The Trust also owns one parcel of unimproved land of 46.27 acres located in the Southeast region and one single-family residence located in the Southwest region. See Schedule XI to the Consolidated Financial Statements included at ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA" for a more detailed description of the Trust's real estate portfolio. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 2. PROPERTIES (Continued) Real Estate (Continued) A summary of activity in the Trust's owned real estate portfolio during 1993 is as follows: (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 2. PROPERTIES (Continued) Real Estate (Continued) Properties Held for Investment. Set forth below are the Trust's properties held for investment and monthly rental rate for apartments and the average annual rental rate for commercial properties and occupancy thereof at December 31, 1993 and 1992: ITEM 2. PROPERTIES (Continued) Real Estate (Continued) Occupancy presented above and throughout this ITEM 2. is without reference to whether leases in effect are at, below or above market rates. In June 1993, the Trust obtained first mortgage financing secured by the Bayfront Apartments in the amount of $2.1 million. The Trust received net cash of $1.8 million. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. The Trust paid a 1% mortgage brokerage and equity refinancing fee of $21,000 to BCM based upon the new first mortgage financing of $2.1 million. In October 1991, after determining that further investment in the Century Centre II Office Building could not be justified without a substantial modification of the mortgage debt, the property was placed in bankruptcy. A plan of reorganization was filed with the bankruptcy court in March 1993 and the bankruptcy court confirmed the Plan in November 1993. The confirmed Plan of Reorganization reduces the interest rate on the $21 million first mortgage to 1-1/2% above LIBOR, which currently results in an interest rate of 5 1/2% per annum. The reduced interest rate was retroactively applied as of October 15, 1991. The Plan also extends the note's maturity two years to November 1995, with three consecutive one-year extension options. Under the Plan, the Trust deposited $1.0 million in cash with the lender to pay accrued and unpaid interest, 1993 property taxes and all closing costs associated with the transaction. In 1994, the Trust will be required to maintain a $200,000 balance in the escrow account with the lender. The Trust has also pledged one of its properties held for sale, Stewart Square Shopping Center, as additional collateral on the first mortgage. Also pursuant to the Plan of Reorganization, the Trust acquired the $7.5 million second mortgage plus all accrued and unpaid interest of $1.7 million, for $300,000 in cash. The Trust recognized an extraordinary gain of $8.9 million in connection with the debt modification and discounted debt purchase. ITEM 2. PROPERTIES (Continued) Real Estate (Continued) In 1990, the Trust ceased making payments on the first mortgage secured by a portion of the Dunhill/Devonshire Apartments. At the time, the Trust was the holder and 50% owner of this first mortgage. The other 50% of the mortgage was owned by a financial institution in receivership, which refused to fund its share of advances necessary to preserve the value of the property. Accordingly, the Trust, as mortgage holder, foreclosed on this property and was, for its own accord, the high bidder at the foreclosure sale. To date, the Trust has not received an executed release of lien. In lieu of recording a gain of $1.3 million on this transaction, the Trust has written down the carrying value of such property by that amount. The $1.6 million first mortgage secured by the Palm Court Apartments, located in Miami, Florida, matured in July 1993. Prior to the maturity, the Trust obtained the lender's written agreement to extend the note. Thereafter, the lender refused to execute the extension documents and has subsequently rejected the Trust's tender of mortgage payments in accordance with the extension agreement. The matter is presently in litigation. If adversely determined, the Trust is prepared to payoff the mortgage debt. In January 1994, the Trust obtained first mortgage financing secured by the Bay West Apartments in the amount of $5.1 million. The Trust received net cash of $1.0 million after the payoff of $3.9 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. The Trust paid a mortgage brokerage and equity refinancing fee of $51,000 to BCM based upon the new first mortgage financing of $5.1 million. In March 1994, the Trust obtained first mortgage financing secured by the Carlyle Towers Apartments in the amount of $4.5 million. The Trust received net cash of $2.3 million after the payoff of $2.2 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. Also in March 1994, the Trust obtained first mortgage financing secured by the Woodcreek Apartments, located in Denver, Colorado, in the amount of $3.0 million. The Trust received net cash of $1.2 million after the payoff of $1.7 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. Partnership Properties. Set forth below are the Trust's investments in partnership properties and the average annual rental rate and occupancy thereof at December 31, 1993 and 1992: ITEM 2. PROPERTIES (Continued) Real Estate (Continued) The Trust, in partnership with CMET, owns Sacramento Nine ("SAC 9"), which currently owns two office buildings in the vicinity of Sacramento, California. The Trust has a 70% interest in the partnership. The SAC 9 partnership agreement requires the consent of both the Trust and CMET for any material changes in the operations of the partnership's properties, including sales, refinancings and changes in the property manager. Therefore, the Trust is a noncontrolling partner and accounts for its investment in the partnership under the equity method. The Trustees of the Trust, except for Messrs. Friedman, Doyle and Weisbrod, also serve as trustees of CMET. BCM, the Trust's advisor until March 31, 1994, also serves as advisor to CMET. See ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS". In April 1993, SAC 9 sold one of its office buildings for $1.2 million. SAC 9 received $123,000 in cash, of which the Trust's equity share was $86,000, after the payoff of an existing first mortgage with a principal balance of $685,000. SAC 9 also provided $356,000 of purchase money financing. The note receivable bears interest at 9% per annum, requires monthly payments of principal and interest and matures in June 1998. SAC 9 recognized a gain of $59,000 on the sale, of which the Trust's equity share was $41,000. In June 1993, SAC 9 sold two other of its office buildings. One was sold for $1.3 million in cash, of which the Trust's equity share was $910,000. SAC 9 recognized a gain of $437,000 on the sale, of which the Trust's equity share was $306,000. SAC 9 paid a 3% sales commission of $39,000 to Carmel Realty, Inc., an affiliate of BCM, ("Carmel Realty") based upon the $1.3 million sales price of the property. The other office building was sold for $2.0 million. SAC 9 received $1.1 million in cash, of which the Trust's equity share was $750,000. SAC 9 also provided $887,000 of purchase money financing. SAC 9 recognized a gain of $720,000 on the sale, of which the Trust's equity share was $504,000. One note receivable with a principal balance of $410,000 bears interest at a variable interest rate, currently 6% per annum, requires monthly interest only payments and matures in June 1994. A second note receivable, with a principal balance of $477,000 bears interest at 10% per annum, and all principal and accrued interest are due at maturity in May 1994. SAC 9 paid a 3% sales commission of $59,000 to Carmel Realty based upon the $2.0 million sales price of the property. The Trust and CMET are also the partners in Income Special Associates ("ISA"), a joint venture partnership in which the Trust has a 40% partnership interest. ISA owns a 100% interest in Adams Properties Associates ("APA"). APA owns 33 industrial warehouses. The Trust accounts for its investment in the APA partnership under the equity method. See ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS". In November 1992, the Trust acquired all of the general and limited partnership interests in Consolidated Capital Properties II ("CCP II"), ITEM 2. PROPERTIES (Continued) Real Estate (Continued) whose assets included a 23% limited partnership interest in English Village Partners, L.P. ("English Village"). On July 1, 1993, CCP II made an additional capital contribution to English Village of $464,000 to increase its limited partnership ownership interest to 49% and to acquire a 1% general partnership interest in the partnership. The Trust continues to account for its investment in English Village under the equity method. Properties Held for Sale. Set forth below are the Trust's properties held for sale (primarily obtained through foreclosure), except for a single-family residence, and the monthly rental rate for apartments and the average annual rental rate for commercial properties and occupancy thereof at December 31, 1993 and 1992: ________________________ * Property obtained through foreclosure in 1993. N/A - Not applicable as property is shut down. In January 1993, the Trust shut down the Lake Highlands Apartments as a result of a change in zoning of the property. No assurance can be given that the Trust will be able to operate the property as an apartment complex in the future. Based on the land value under the current zoning, the Trust does not anticipate incurring a loss in excess of previously established reserves. In March 1993, the Trust recorded the insubstance foreclosure of the Lakepointe Apartments, a 540 unit apartment complex in Memphis, Tennessee. The Lakepointe Apartments had an estimated fair value (minus estimated costs of sale) of at least $8.3 million at the date of foreclosure. In connection with this insubstance foreclosure, the Trust recorded the $6.7 million mortgage payable secured by the property. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. Also in March 1993, the Trust recorded the insubstance foreclosure of the Huntington Green Apartments, an 81 unit apartment complex in West Town, Pennsylvania. The Huntington Green Apartments had an estimated ITEM 2. PROPERTIES (Continued) Real Estate (Continued) fair value (minus estimated costs of sale) of at least $1.8 million at the date of foreclosure. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. In 1993, the State of Wisconsin commenced eminent domain proceedings to acquire the Pepperkorn Building, located in Manitowoc, Wisconsin, for highway development. The State of Wisconsin's initial offer was $175,000, which is being appealed by the Trust. There is no assurance that the Trust's appeal will be successful or of the amount, if any, of additional compensation that it may receive. However, based on the information presently available, the Trust does not anticipate incurring any losses in excess of previously established reserves. Mortgage Loans In addition to real estate, a portion of the Trust's assets consist of mortgage notes, principally secured by income-producing properties including first, wraparound and junior mortgages. The Trust's investment policy is described in ITEM 1. "BUSINESS - Business Plan and Investment Policy." Types of Properties Subject to Mortgages. The types of properties securing the Trust's mortgage portfolio at December 31, 1993, consisted of office buildings, apartments, shopping centers, single-family residences, a retirement home and developed land. To the extent the Declaration of Trust does not control such matters, the Trust's Board of Trustees may alter the types of mortgages in which the Trust invests without a vote of the Trust's shareholders. In addition to restricting the types of collateral and priority of mortgages, the Declaration of Trust imposes certain restrictions on transactions with related parties which limits the entities to which the Trust may make a mortgage, as discussed in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS". At December 31, 1993, the Trust's mortgage portfolio included 12 mortgage loans with an aggregate outstanding balance of $18.1 million, secured by income-producing properties located throughout the United States, 4 mortgage loans with an outstanding balance of $437,000 secured by single-family residences located in the Southwest and Pacific regions of the United States and one mortgage loan with a carrying value of $856,000 secured by 55 acres of land located near Sacramento, California. At December 31, 1993, 6% of the Trust's assets were invested in mortgages (5.1% in first mortgage loans, .2% in a wraparound mortgage and .7% in junior mortgage loans). The following table sets forth the percentages (based on the outstanding mortgage note balance), by both property type and geographic region, of the properties that serve as collateral for the Trust's outstanding mortgages at December 31, 1993. The table does not include the $437,000 in single-family mortgages or the $856,000 mortgage secured by land discussed in the preceding paragraph. See Schedule XII to the Consoli- ITEM 2. PROPERTIES (Continued) Mortgage Loans (Continued) dated Financial Statements included at ITEM 8. "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA" for further details of the Trust's mortgage notes receivable portfolio. A summary of activity in the Trust's mortgage notes receivable portfolio during 1993 is as follows: First Mortgage Loans. The Trust may make first mortgage loans, with either short, medium or long-term maturities. These loans generally provide for level periodic payments of principal and interest sufficient to substantially repay the loan prior to maturity, but may involve interest-only payments or moderate amortization of principal and a "balloon" principal payment at maturity. With respect to first mortgage loans, it is the Trust's general policy to require that the borrower provide a mortgagee's title policy or an acceptable legal opinion of title as to the validity and the priority of the mortgage lien over all other obligations, except liens arising from unpaid property taxes and other exceptions normally allowed by first mortgage lenders in the relevant area. The Trust may grant to other lenders participations in first mortgage loans originated by the Trust. The Trust did not originate or acquire any first mortgage loans during 1993. The following discussion briefly describes the events that affected previously funded or otherwise acquired first mortgage loans during 1993: During 1993, the Trust received payment in full, totaling $2.4 million, on three first mortgages. At December 31, 1993, two of the Trust's first mortgages were classified as nonperforming. One note, with an outstanding principal balance of $943,000, is secured by an apartment complex located in Paris, Texas. The Trust has obtained a judgment against the maker and guarantors for the amount of this mortgage. The Trust does not anticipate incurring a loss in excess of previously established reserves on this note. ITEM 2. PROPERTIES (Continued) Mortgage Loans (Continued) Another nonperforming first mortgage note with a carrying value of $856,000 and legal balance of $1.2 million at December 31, 1993 is secured by 55 acres of developed land located near Sacramento, California. The borrower on this note has recently confirmed a plan of reorganization, and has begun making principal payments on the note as parcels are sold. In addition, the note was modified to require monthly interest only payments at 9%, increasing to 24% until maturity in February 1999. The Trust does not anticipate incurring a loss on this note as the estimated value of the property is in excess of the total debt on the property. As discussed in "Real Estate" above, in March 1993, the Trust recorded the insubstance foreclosure of the Huntington Green Apartments, an apartment complex which secured a $2.4 million first mortgage. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. See "Real Estate" above. Wraparound Mortgage Loans. The Trust may invest in wraparound mortgage loans on real estate subject to prior mortgage indebtedness. A wraparound mortgage loan is a mortgage loan having an original principal amount equal to the outstanding balance under the prior existing mortgage plus the amount actually advanced under the wraparound mortgage loan. Wraparound mortgage loans may provide for full, partial or no amortization of principal. The Trust's policy is to make wraparound mortgage loans in amounts and on properties as to which it would otherwise make first mortgage loans. The Trust did not originate or acquire any wraparound mortgage loans in 1993. The following discussion briefly describes the events that affected previously funded or otherwise acquired wraparound mortgage loans during 1993. As part of the Trust's 1992 acquisition of the general and limited partnership interests in CCP II, the Trust received a wraparound mortgage note secured by the Plaza Jardin, an office building located in El Toro, California. In May 1993, the Trust foreclosed on the property securing the note receivable. Immediately following the foreclosure, the Trust sold the property for $200,000 in cash, subject to the $3.3 million underlying mortgage debt. The Trust recognized a $94,000 gain on the sale of the property. Junior Mortgage Loans. The Trust may invest in junior mortgage loans. Such loans are secured by mortgages that are subordinate to one or more prior liens either on the fee or a leasehold interest in real estate. Recourse on such loans ordinarily includes the real estate on which the loan is made, other collateral and personal guarantees by the borrower. The Trust's Declaration of Trust restricts investment in junior mortgage loans, excluding wraparound mortgage loans, to not more than 10% of the Trust's assets. At December 31, 1993, .7% of the Trust's assets were invested in junior mortgage loans. ITEM 2. PROPERTIES (Continued) Mortgage Loans (Continued) The Trust did not originate or acquire any junior mortgage loans in 1993. As discussed in "Real Estate" above, in March 1993, the Trust recorded the insubstance foreclosure of the Lakepointe Apartments, an apartment complex which secured a $3.8 million junior mortgage loan. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. At December 31, 1993, four of the Trust's junior mortgages were classified as nonperforming. A nonperforming junior mortgage note with a principal balance of $256,000 at December 31, 1993 is secured by a retirement center in Tuscon, Arizona. The borrower on this note, Eldercare Housing Foundation ("Eldercare"), is currently in bankruptcy. The Trust does not anticipate incurring losses on this note in excess of previously established reserves. Ted P. Stokely, a Trustee of the Trust, was employed as a real estate consultant for Eldercare from April 1992 to December 1993. The three remaining nonperforming junior mortgage notes have an aggregate principal balance of $1.3 million and were acquired in a package of similar loans in 1991. All three loans are secured by shopping centers net leased to a major national tenant. The Trust is currently negotiating a settlement of these loans with the owners. The Trust expects that such settlement will not result in any loss in excess of previously established reserves. Equity Investment in REIT In December 1990, the Trust's Board of Trustees, based on the recommendation of its Related Party Transaction Committee, authorized the purchase of up to $1.0 million of the shares of beneficial interest of CMET through negotiated or open market transactions. The Trustees of the Trust, except for Messrs. Friedman, Doyle and Weisbrod, are also trustees of CMET. BCM, the Trust's advisor, also serves as advisor to CMET. BCM resigned as advisor to the Trust effective March 31, 1994. At December 31, 1993, the Trust owned 54,500 shares of beneficial interest of CMET which it had purchased through open market transactions in 1990 and 1991, at a total cost to the Trust of $250,000. At December 31, 1993, the market value of such shares was $702,000. Pursuant to an amendment to the Trust's Declaration of Trust approved by the Trust's shareholders, the Trust may hold the shares of CMET until July 30, 1996. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Securities and Exchange Commission Inquiry On December 1, 1988, the Trust was informed in writing that the staff of the Securities and Exchange Commission (the "Commission") had made a preliminary determination to recommend administrative proceedings ITEM 3. LEGAL PROCEEDINGS (Continued) Securities and Exchange Commission Inquiry (Continued) against the Trust, CMET and Consolidated Capital Equities Corporation, among others, for various alleged reporting violations in public filings made during certain periods in 1985, and possibly other matters. The allegations relate to a time prior to the time when the Trust's current management and Advisor or any of its personnel became associated with the Trust. No administrative proceeding was ever commenced and due to the lapse of time the Trust's management believes there will be no further activity involving this matter. Olive Litigation In February 1990, the Trust, together with CMET, IORT and TCI, three real estate entities with the same officers, directors or trustees and advisor as the Trust at the time, entered into a settlement of a class and derivative action entitled Olive et al. v. National Income Realty Trust et al., relating to the operation and management of each of such entities. On April 23, 1990, the court granted final approval of the terms of the settlement. By agreeing to settle these actions, the defendants, including the Trust, did not and do not admit any liability whatsoever. An evidentiary hearing was held in February and April 1993 concerning allegations by the plaintiffs that the terms of the settlement had been breached by the Trust, CMET, IORT and TCI. No determination on the matters has been made by the court pending the outcome of ongoing settlement discussions. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. (THIS SPACE INTENTIONALLY LEFT BLANK.) PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S SHARES OF BENEFICIAL INTEREST AND RELATED SHAREHOLDER MATTERS The Trust's shares of beneficial interest are traded in the over-the-counter market on the National Association of Securities Dealers Automated Quotation ("NASDAQ") system using the symbol "NIRTs". Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions. The following table sets forth the high and low bid quotations as reported by the NASDAQ system: As of March 11, 1994, the closing price of the Trust's shares of beneficial interest on the NASDAQ system was $12.50 per share. As of March 11, 1994, the Trust's shares of beneficial interest were held by 7,443 holders of record. Based on the performance of the Trust's properties, the Trust's Board of Trustees, at their July 1993 meeting, voted to resume regular quarterly distributions. The distributions paid in 1993 were as follows: In addition, on July 1, 1993, the Trust's Board of Trustees approved the payment of a 10% stock dividend, which was paid on September 1, 1993 to shareholders of record on August 16, 1993. No distributions were declared or paid in 1992. On December 5, 1989, the Trust's Board of Trustees approved a program for the Trust to repurchase its shares of beneficial interest. The Trust's Board of Trustees has authorized the Trust to repurchase a total of 1,026,667 of its shares of beneficial interest pursuant to such program. As of March 11, 1994, the Trust had repurchased 849,631 shares pursuant to such program at a cost to the Trust of $6.7 million. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (1) Funds from operations is defined as net income (loss) before gains or losses from the sale of properties and debt restructurings plus depreciation and amortization. FUNDS FROM OPERATIONS DOES NOT REPRESENT CASH AVAILABLE TO FUND THE TRUST'S OPERATIONS. ITEM 6. SELECTED FINANCIAL DATA (Continued) Share and per share data have been restated to give effect to the 10% share distribution declared in July 1993 and the one-for-three reverse share split effected March 26, 1990. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction National Income Realty Trust (the "Trust") invests in real estate through acquisitions, leases and partnerships and in mortgages on real estate. The Trust was organized on October 31, 1978 and commenced operations on March 27, 1979. Liquidity and Capital Resources Cash and cash equivalents aggregated $1.1 million at December 31, 1993 compared with $1.8 million at December 31, 1992. The Trust's principal sources of cash have been and will continue to be property operations, proceeds from property sales, the collection of mortgage notes receivable and borrowings. The Trust expects that funds from operations, collection of mortgage notes receivable and from anticipated external sources, such as property sales and refinancings, will be sufficient to meet the Trust's various cash needs, including debt service obligations, property maintenance and improvements and continuation of regular distributions, as more fully discussed in the paragraphs below. The Trust's cash flow from property operations (rentals collected less payments for property operating expenses) has increased from $10.1 million for 1992 to $14.4 million for 1993. This increase in cash flow from property operations is primarily attributable to four apartment complexes purchased in November 1992 and two apartment complexes obtained through foreclosure in March 1993. Cash flows from property operations decreased from $10.7 million in 1991 to $10.1 million in 1992, primarily attributable to an increase in payments for property taxes in 1992. The Trust's interest collected decreased from $3.2 million in 1991 to $2.1 million in 1992 and $1.5 million in 1993. The decrease from 1991 to 1992 is primarily attributable to interest of $849,000 collected in 1991 on a revolving loan to National Operating, L.P. ("NOLP"), which was paid in full in September 1991. In addition, $166,000 of the decrease relates to other loans which were paid in full in 1991 and 1992. Of the decrease from 1992 to 1993, $245,000 is due to a note which was paid in full in March 1993 and $221,000 is due to interest payments received in 1992 on a cash flow mortgage, but not received in 1993. Interest collections are expected to continue to decline due to the $2.4 million in loans paid off in 1993. Interest paid on the Trust's indebtedness increased from $7.7 million in 1992 to $9.3 million in 1993. Of this increase, $1.3 million is due to interest paid on mortgages secured by properties acquired by the Trust ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity and Capital Resources (Continued) during 1992 and 1993 and an additional $723,000 of the increase is attributable to interest paid on the mortgage secured by the Century Centre II Office Building, on which the Trust made a $1.0 million payment of accrued interest in accordance with the confirmed Plan of Reorganization as discussed in NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." These increases were partially offset by a decrease in interest of $314,000 due to the mortgage secured by Pinecrest Apartments, whose variable interest rate decreased from 1992 to 1993. An additional decrease of $213,000 is attributable to two mortgages on which the Trust stopped making payments in 1993 also as discussed in NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." The Trust was not involved in significant investing activities during 1993. The Trust did however, make $3.1 million of improvements to its properties in 1993. The Trust anticipates making capital improvements to its properties of approximately $4 million in 1994. The Trust received $410,000 in net cash from the sale of three foreclosed properties during 1993. In addition, the Trust also received payment in full on three notes receivable resulting in cash of $2.4 million. Principal payments of $113,000 on other notes were also received. In the second quarter of 1993, Sacramento Nine ("SAC 9"), a joint venture partnership in which the Trust owns a 70% interest, sold 3 of its office buildings for $2.5 million in cash, of which the Trust's equity share was $1.7 million. In October 1992, the Trust borrowed $1.6 million from a bank secured by a $1.6 million unsecured note receivable of the Trust. The note payable was paid in full on its maturity date in March 1993 from the collection of the note receivable. In June 1993, the Trust obtained first mortgage financing secured by the Bayfront Apartments in the amount of $2.1 million, of which the Trust received net cash of $1.8 million from the financing proceeds. In January 1994, the Trust obtained first mortgage financing secured by the Bay West Apartments in the amount of $5.1 million. The Trust received net cash of $1.0 million after the payoff of $3.9 million in existing debt. In March 1994, the Trust also obtained first mortgage financing on both the Carlyle Towers Apartments and the Woodcreek Apartments totaling $7.5 million. The Trust received net cash of $3.5 million after the payoff of $4.0 million in existing debt. The Trust intends to increase its emphasis on obtaining financing or refinancing of its properties. However, there is no assurance that the Trust will continue to be successful in its efforts in this regard. Principal payments on the Trust's notes payable of $11.9 million are due in 1994. Of this amount, $1.6 million relates to a nonrecourse debt which had matured December 31, 1993. The Trust is currently negotiating a modification and extension of this debt secured by an apartment complex in Miami, Florida. However, in the event that the Trust is ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Liquidity and Capital Resources (Continued) unsuccessful in extending this note, the Trust is prepared to payoff the mortgage debt. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." During 1993, the Trust repurchased 280,038 of its shares of beneficial interest at a cost of $2.4 million pursuant to the repurchase program originally announced by the Trust on December 5, 1989. The Trust's Board of Trustees has authorized the repurchase of a total of 1,026,667 shares under such repurchase program of which 177,036 shares remain to be purchased as of March 11, 1994. Based on the performance of the Trust's properties, the Trust's Board of Trustees voted in July 1993 to resume the payment of regular quarterly distributions to shareholders. The Trust paid distributions totaling $617,000 ($0.20 per share) to its shareholders in 1993, and also paid a 10% stock dividend to its shareholders in 1993. On a quarterly basis, the Trust's management reviews the carrying value of the Trust's mortgages, properties held for investment and properties held for sale. Generally accepted accounting principles require that the carrying value of an investment held for sale cannot exceed the lower of its cost or its estimated net realizable value. In those instances in which estimates of net realizable value of the Trust's properties are less than the carrying value thereof at the time of evaluation, a provision for loss is recorded by a charge against operations. The estimate of net realizable value of the mortgage loans is based on management's review and evaluation of the collateral properties securing the mortgage loans. The review generally includes selective property inspections, a review of the property's current rents compared to market rents, a review of the property's expenses, a review of the maintenance requirements, discussions with the manager of the property and a review of the surrounding area. Results of Operations 1993 compared to 1992. For the year ended December 31, 1993, the Trust had net income of $5.8 million, as compared to a net loss of $8.3 million for the year ended December 31, 1992. The primary factors contributing to the improvement in the Trust's operating results are discussed in the following paragraphs. Net rental income (rental income less property operating expenses) increased from $9.4 million in 1992 to $14.6 million in 1993. Of this increase, $1.3 million is due to four apartment complexes acquired in November 1992 and an additional $654,000 is due to two apartment complexes obtained through foreclosure in 1993. An additional $618,000 is due to a decrease in the amortization of free rent at the Century Centre Office Building and $295,000 is due to a decrease in replacements at Park Dale Gardens, the renovation of which was completed in 1992. The remaining increase is due to increased occupancy and rental rates at ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) the Trust's apartment complexes, primarily in the Southeast and Southwest regions, and overall expense control at certain of the Trust's apartment and commercial properties. Interest income decreased from $2.5 million in 1992 to $1.6 million in 1993. Of this decrease, $553,000 is due to loans which were placed on nonaccrual status or loans on which the collateral securing the loan was foreclosed in 1993. In addition, a decrease of $245,000 is due to a note which was paid in full in March 1993 and a decrease of $221,000 is due to interest payments received in 1993 compared to 1992 on a mortgage where interest is recognized on the cash flow basis. Interest income is anticipated to decline further in 1994 due to notes which were paid off in 1993. The Trust's equity in income of partnerships was income of $204,000 in 1992 compared to a loss of $34,000 in 1993. This decrease in operating results is primarily due to the sale of three properties by the SAC 9 partnership in the second quarter of 1993. Interest expense decreased from $10.4 million in 1992 to $9.7 million in 1993. A decrease of $1.2 million is attributable to a reduction in the interest rate on the first mortgage secured by the Century Centre II Office Building and the purchase of the second mortgage at a significant discount. An additional decrease of $163,000 is due to a reduction in the variable interest rate on the note payable secured by Pinecrest Apartments and $414,000 is due to interest expense on the underlying note payable associated with one of the Trust's wraparound mortgage notes receivable, which was concurrently foreclosed and sold in 1993. These decreases were partially offset by an increase of $857,000 due to interest expense recorded on mortgages secured by four apartment complexes which were acquired in November 1992 and an additional $416,000 attributable to interest expense recorded on the underlying mortgage secured by a property acquired through foreclosure in March 1993. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." Depreciation expense increased from $4.0 million in 1992 to $4.6 million in 1993, primarily due to the acquisition of four apartment complexes in November 1992 and two additional apartment complexes through foreclosure in March 1993. Advisory fees increased from $1.4 million in 1992 to $1.5 million in 1993, as a result of increase in the average monthly gross assets of the Trust, calculated in accordance with the terms of the advisory agreement. Commencing April 1, 1994, Tarragon Realty Advisors, Inc. ("Tarragon") will become the Trust's advisor. The terms of the Trust's advisory agreement with Tarragon are substantially the same as those with Basic Capital Management, Inc., the Trust's current advisor, except for the annual base advisory fee and the elimination of the net income fee. If the ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) Tarragon advisory agreement had been in effect in 1993 the Trust's annual base advisory fee would have been reduced by approximately $1.0 million. See NOTE 8. "ADVISORY AGREEMENT." General and administrative expenses decreased from $2.2 million in 1992 to $1.8 million in 1993. Of this decrease, $250,000 is due to a reduction in legal fees, an additional $123,000 is related to the Trust's March 1992 annual meeting of shareholders and the February 1992 Rights redemption and $198,000 is due to a decrease in professional fees related to the reduced level of property acquisitions in 1993 compared to 1991 and 1992. For the year 1993, the Trust expensed $1.0 million for the issuance of a $1.0 million convertible subordinated debenture to John A. Doyle, Trustee and Executive Vice President of the Trust, in exchange for his 10% participation in the profits of the Consolidated Capital Properties II ("CCP II") assets, which were acquired in November 1992, over a year before Mr. Doyle's affiliation with the Trust. This participation was granted as consideration for Mr. Doyle's services to the Trust in connection with the CCP II portfolio. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." For the year 1993, the Trust recorded a provision for losses of $1.4 million to provide for estimated losses on one of the Trust's properties held for sale and one of the Trust's first lien mortgage notes. A provision for losses of $2.4 million was recorded in 1992 to reserve against certain junior mortgage notes receivable. For the year ended December 31, 1993, the Trust recognized gains on sales of real estate of $851,000 related to the sale of three properties by SAC 9 and $94,000 on the sale of the Plaza Jardin Office Building. No gains on sales of real estate were recognized in 1992. Also for the year 1993, the Trust recorded an extraordinary gain on the forgiveness of debt of $8.9 million related to the discounted purchase of the second lien mortgage secured by Century Centre II Office Building, which was purchased by the Trust for $300,000 as part of a bankruptcy Plan of Reorganization. The Trust recorded no extraordinary gain in 1992. 1992 compared to 1991. For the year ended December 31, 1992, the Trust had a net loss of $8.3 million as compared with a net loss of $3.1 million for the year ended December 31, 1991. The primary factors contributing to the increase in the Trust's net loss are discussed in the following paragraphs. Net rental income (rental income less property operations expenses) increased from $8.5 million in 1991 to $9.4 million in 1992. Of this increase $1.7 million is the result of net rental income recorded on properties purchased in 1992 and the fourth quarter of 1991 and an ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) additional $776,000 is attributable to increased net rental income at Pinecrest Apartments, where a major renovation was substantially completed during 1992. In addition, net rental income also increased $800,000 due to increased rental and occupancy rates at certain of the Trust's apartment complexes, primarily in the Southeast and Southwest. These increases were partially offset by a decrease in net rental income of $1.4 million at the Century Centre II Office Building, attributable to the temporary increases in vacancy coincident with the bankruptcy filing in October 1991. In addition, net rental income decreased $279,000 due to the transfer of the Afton Aero Business Park to the senior lienholder in August 1991, decreased $378,000 due to properties sold during 1992 and the fourth quarter of 1991 and decreased $340,000 due to a decrease in occupancy and rental rates at Rancho Sorrento Business Park related to weakness in the San Diego office market. Interest income on mortgage receivables decreased from $2.8 million in 1991 to $2.4 million in 1992. Of this decrease, $415,000 is attributable to interest recognized in 1991 on a $7.0 million revolving loan to NOLP, which was paid in full in September 1991. An additional $393,000 is due to interest income not being recognized on notes receivable classified as nonperforming and $190,000 of the decrease is related to notes which were paid off in 1991 and 1992. These decreases were partially offset by an increase of $332,000 attributable to interest income on mortgage loans funded or acquired during 1991 and $128,000 attributable to a note classified as nonperforming in 1991 which was brought current in 1992. Equity in results of operations of partnerships produced income of $204,000 in 1992 as compared to a loss of $171,000 in 1991. The 1991 loss was attributable to Adams Properties Associates ("APA"), a partnership in which the Trust has a 40% interest, recording a $1.2 million charge against earnings for the permanent write-down of three of the partnership's warehouses to their estimated net realizable value. The Trust's equity share of such charge was $480,000. In addition, SAC 9, a partnership in which the Trust has 70% interest, recorded a $1.1 million charge against earnings in 1991 relating to a property which was transferred to the senior lienholder. The Trust's equity share of such charge was $770,000. Neither partnership incurred similar charges in 1992. Interest expense increased from $9.4 million in 1991 to $10.4 million in 1992. Of this increase, $2.0 million is attributable to interest expense on notes payable secured by properties which were acquired in 1991 and 1992. This increase is partially offset by a decrease of $531,000 in the interest accrual rate, attributable to a decrease in the interest rate, on the Century Centre II first mortgage, a decrease of $222,000 related to the Afton Aero Business Park, which was returned to the senior lienholder in August 1991, and a decrease of $135,000 due to the restructuring of the mortgage secured by Emerson Center, which emerged from bankruptcy in March 1992. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Results of Operations (Continued) General and administrative expenses decreased from $2.4 million in 1991 to $2.2 million in 1992. This decrease is due to a decrease of $200,000 in legal fees paid in 1992 in connection with the Olive litigation discussed in NOTE 15. "COMMITMENTS AND CONTINGENCIES - Olive Litigation." In addition, $104,000 was recorded in 1991 for the settlement of the adversary proceedings with Southmark Corporation. For the year ended December 31, 1992, the Trust recorded a provision for losses of $2.4 million to reserve against certain junior mortgages. No such provision for losses was recorded in 1991. For the year ended December 31, 1991, the Trust reported gains on sales of real estate of $257,000 related to APA and SAC 9 partnerships and $205,000 on the sale of Coronado Village Apartments. No gains on sales of real estate were recognized in 1992. The Trust also recognized an extraordinary gain on the extinguishment of debt of $2.2 million for 1991 related to the return of one of the SAC 9 office buildings to the senior lienholder. None was recorded in 1992. Environmental Matters Under various federal, state and local environmental laws, ordinances and regulations, the Trust may be potentially liable for removal or remediation costs, as well as certain other potential costs relating to hazardous or toxic substances (including governmental fines and injuries to persons and property) where property-level managers have arranged for the removal, disposal or treatment of hazardous or toxic substances. In addition, certain environmental laws impose liability for release of asbestos- containing materials into the air, and third parties may seek recovery from the Trust for personal injury associated with such materials. The Trust's management is not aware of any environmental liability relating to the above matters that would have a material adverse effect on the Trust's business, assets or results of operations. Inflation The effects of inflation on the Trust's operations are not quantifiable. Revenues from property operations fluctuate proportionately with increases and decreases in housing costs. Fluctuations in the rate of inflation also affect the sales values of properties and, correspondingly, the ultimate gains to be realized by the Trust from property sales. Inflation also has an effect on the Trust's earnings from short-term investments. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Tax Matters For the years ended December 31, 1993, 1992 and 1991, the Trust elected, and in the opinion of the Trust's management, qualified to be taxed as a Real Estate Investment Trust ("REIT") as defined under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"). The Code requires a REIT to distribute at least 95% of its REIT taxable income plus 95% of its net income from foreclosure property, as defined in Section 857 of the Code, on an annual basis to shareholders. Recent Accounting Pronouncements The Financial Accounting Standards Board ("FASB") has recently issued Statement of Financial Accounting Standards ("SFAS") No. 114 - "Accounting by Creditors for Impairment of a Loan", which amends SFAS No. 5 - "Accounting for Contingencies" and SFAS No. 15 - "Accounting by Debtors and Creditors for Troubled Debt Restructurings." The statement requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. SFAS No. 114 is effective for fiscal years beginning after December 15, 1994. The Trust's management has not fully evaluated the effects of implementing this statement, but expects that they will not be material as the statement is applicable to debt restructurings and loan impairments after the earlier of the effective date of the statement or the Trust's adoption of the statement. At its January 26, 1994 meeting, the FASB directed its staff to prepare an exposure draft, that if approved, would eliminate the provisions of SFAS No. 114 that describe how a creditor should recognize income on an impaired loan and add disclosure requirements on income recognized on impaired loans. The effective date of SFAS No. 114 is not anticipated to change. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS All other schedules are omitted because they are not required, are not applicable or the information required is included in the Consolidated Financial Statements or the notes thereto. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Board of Trustees of National Income Realty Trust We have audited the accompanying consolidated balance sheets of National Income Realty Trust and Subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. We have also audited the schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedules. We believe our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Income Realty Trust and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the schedules referred to above present fairly, in all material respects, the information set forth therein. BDO SEIDMAN Dallas, Texas March 25, 1994 NATIONAL INCOME REALTY TRUST CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) The accompanying notes are an integral part of these Consolidated Financial Statements. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The accompanying Consolidated Financial Statements of National Income Realty Trust and consolidated entities (the "Trust") have been prepared in conformity with generally accepted accounting principles, the most significant of which are described in NOTE 1. "SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES". These, along with the remainder of the Notes to Consolidated Financial Statements, are an integral part of the Consolidated Financial Statements. The data presented in the Notes to Consolidated Financial Statements are as of December 31 of each year and for the year then ended, unless otherwise indicated. Dollar amounts in tables are in thousands, except per share amounts. Certain balances for 1991 and 1992 have been reclassified to conform to the 1993 presentation. NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Trust business. National Income Realty Trust ("NIRT"), is a California business trust organized on October 31, 1978. The Trust was formed to invest in real estate. Since 1991, the Trust has sought only to make equity investments and accordingly, its mortgage note receivable portfolio represents an increasingly smaller portion of the Trust's assets. Basis of consolidation. The Consolidated Financial Statements include the accounts of NIRT and partnerships and subsidiaries which it controls. All intercompany transactions and balances have been eliminated. Interest recognition on notes receivable. It is the Trust's policy to cease recognizing interest income on notes receivable that have been delinquent for 60 days or more. In addition, accrued but unpaid interest income is only recognized to the extent that the net realizable value of the underlying collateral exceeds the carrying value of the receivable. Allowance for estimated losses. Valuation allowances are provided for estimated losses on notes receivable and properties held for sale to the extent that the investment in the notes or properties exceeds the Trust's estimate of net realizable value of the property or collateral securing each such note, or fair value of the collateral if foreclosure is probable. In estimating net realizable value, consideration is given to the current estimated collateral or property value adjusted for costs to complete or improve, hold and dispose. The cost of funds, one of the criteria used in the calculation of estimated net realizable value (approximately 5.4% and 5.5% as of December 31, 1993 and 1992, respectively), is based on the average cost of all capital. The provision for losses is based on estimates, and actual losses may vary from current estimates. Such estimates are reviewed periodically and any additional provision determined to be necessary is charged against earnings in the period in which it becomes reasonably estimable. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Foreclosed real estate held for sale. Foreclosed real estate is initially recorded at new cost, defined as the lower of original cost or fair value minus estimated costs of sale. After foreclosure, the excess of new cost, if any, over fair value minus estimated costs of sale is recognized in a valuation allowance. Subsequent changes in fair value either increase or decrease such valuation allowance. See "Allowance for estimated losses" above. Properties held for sale are depreciated in accordance with the Trust's established depreciation policies. See "Real estate and depreciation" below. Annually, all foreclosed properties held for sale are reviewed by the Trust's management and a determination is made if the held for sale classification remains appropriate. The following are among the factors considered in determining that a change in classification to held for investment is appropriate: (i) the property has been held for at least one year; (ii) Trust management has no intent to dispose of the property within the next twelve months; (iii) the property is a "qualifying asset" as defined in the Internal Revenue Code of 1986, as amended; (iv) property improvements have been funded; and (v) the Trust's financial resources are such that the property can be held long-term. The subsequent classification of property previously held for sale to held for investment does not result in a restatement of previously reported revenues, expenses or net income (loss). Real estate and depreciation. Real estate is carried at the lower of cost or estimated net realizable value, except for foreclosed properties held for sale, which are recorded initially at the lower of original cost or fair value minus estimated costs of sale. Depreciation is provided for by the straight-line method over the estimated useful lives of the assets, which range from 5 to 40 years. Present value premiums/discounts. The Trust provides for present value premiums and discounts on notes receivable or payable that have interest rates that differ substantially from prevailing market rates and amortizes such premiums and discounts by the interest method over the lives of the related notes. The factors considered in determining a market rate for receivables include the borrower's credit standing, nature of the collateral and payment terms of the note. Revenue recognition on the sale of real estate. Sales of real estate are recognized when and to the extent permitted by Statement of Financial Accounting Standards No. 66, "Accounting for Sales of Real Estate" ("SFAS No. 66"). Until the requirements of SFAS No. 66 for full profit recognition have been met, transactions are accounted for using either the deposit, the installment, the cost recovery or the financing method, whichever is appropriate. Investment in noncontrolled partnerships. The Trust uses the equity method to account for investments in partnerships which the Trust does NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) not control. Under the equity method, the Trust's initial investment, recorded at cost, is increased by the Trust's proportionate share of the partnership's operating income and additional advances and decreased by the Trust's proportionate share of the partnership's operating losses and distributions received. Marketable equity securities. Marketable equity securities are considered to be available-for-sale and are carried at fair value, defined as year end closing market value. Net unrealized holding gains and losses are reported as a separate component of shareholders' equity. Such securities were carried at adjusted cost in the Trust's December 31, 1992 Consolidated Balance Sheet. Fair value of financial instruments. The Trust used the following assumptions in estimating the fair value of its notes receivable, marketable equity securities and notes payable. For performing notes receivable, the fair value was estimated by discounting future cash flows using current interest rates for similar loans. For nonperforming notes receivable, the estimated fair value of the Trust's interest in the collateral property was used. For marketable equity securities, fair value was based on the year end closing market price of each security. The estimated fair values presented do not purport to present amounts to be ultimately realized by the Trust. The amounts ultimately realized may vary significantly from the estimated fair values presented. For notes payable, the fair value was estimated using current rates for mortgages with similar terms and maturities. Cash equivalents. For purposes of the Consolidated Statements of Cash Flows, the Trust considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Earnings per share. Income (loss) per share of beneficial interest is computed based upon the weighted average number of shares of beneficial interest outstanding during each year. (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 2. NOTES AND INTEREST RECEIVABLE Notes and interest receivable consisted of the following: The Trust does not recognize interest income on nonperforming notes receivable. Notes receivable are considered to be nonperforming when they become 60 days or more delinquent. For the years 1993, 1992 and 1991, unrecognized interest income on nonperforming notes totaled $833,000, $867,000 and $561,000, respectively. Notes receivable at December 31, 1993 mature from 1994 through 2021, with interest rates ranging from 6% to 24% and an effective weighted average interest rate of 6.4%. Notes receivable are generally nonrecourse and are generally collateralized by real estate. Scheduled principal maturities of $2.5 million are due in 1994, including $1.8 million in mortgage notes receivable classified as nonperforming at December 31, 1993. The Trust received payment in full on three mortgage loans during 1993 totaling $2.4 million. In addition, the Trust foreclosed on three mortgage loans with principal balances totaling $6.2 million, with the Trust obtaining three properties with a fair value of $10.1 million and assumed a $6.7 million mortgage payable secured by one of the properties. These transactions resulted in no loss to the Trust in 1993 as all losses had been previously provided. See NOTE 4. "REAL ESTATE AND DEPRECIATION." In May 1993, the Trust foreclosed on the Plaza Jardin mortgage receivable. Immediately following the foreclosure, the Trust sold the property for $200,000 in cash subject to the $3.3 million underlying mortgage. The Trust recognized a $94,000 gain on the sale of the property. At December 31, 1993, five mortgage notes receivable with a principal balance totaling $3.1 million were classified as nonperforming. The Trust does not anticipate incurring losses in excess of the reserves established at December 31, 1993. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 2. NOTES AND INTEREST RECEIVABLE (Continued) During 1992, the Trust funded or purchased two mortgage loans with principal balances totaling $3.8 million, and an additional mortgage loan with a principal balance of $550,000 was created through the sale of real estate. The Trust also received payment in full on four mortgage loans during 1992 totaling $975,000 and received payment on an additional mortgage note receivable, receiving cash of $775,000 and accepting a new second lien mortgage in the amount of $306,000. In addition, in 1992 the Trust foreclosed on one mortgage loan with a principal balance of $91,000 and wrote off as uncollectible another mortgage loan with a principal balance of $200,000. These transactions resulted in no loss to the Trust in 1992 as all losses had been previously provided. NOTE 3. ALLOWANCE FOR ESTIMATED LOSSES Activity in the allowance for estimated losses was as follows: NOTE 4. REAL ESTATE AND DEPRECIATION In January 1993, the Trust shut down the Lake Highlands Apartments as a result of a change in zoning of the property. No assurance can be given that the Trust will be able to operate the property as an apartment complex in the future. The Trust does not anticipate incurring a loss in excess of previously established reserves. In March 1993, the Trust recorded the insubstance foreclosure of the Lakepointe Apartments, a 540 unit apartment complex in Memphis, Tennessee. The Lakepointe Apartments had an estimated fair value (minus estimated costs of sale) of $8.3 million at the date of foreclosure. In connection with this insubstance foreclosure, the Trust recorded the $6.7 million mortgage payable secured by the property. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. Also in March 1993, the Trust recorded the insubstance foreclosure of the Huntington Green Apartments, an 81 unit apartment complex in West Town, Pennsylvania. The Huntington Green Apartments had an estimated fair value (minus estimated costs of sale) of $1.8 million at the date of foreclosure. The foreclosure resulted in no loss to the Trust in excess of previously established reserves. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 4. REAL ESTATE AND DEPRECIATION (Continued) In 1992, the Trust sold two of its properties held for sale, receiving net cash of $368,000 and financing an additional $550,000 through a purchase money mortgage. Also in 1992, the Trust acquired all of the general and limited partnership interest in Consolidated Capital Properties II ("CCP II") for $2.6 million. CCP II's assets included cash of $1.6 million, four apartment complexes, a partnership interest, a note receivable participation and a note receivable. In connection with the acquisition, the Trust granted John A. Doyle, Trustee and Executive Vice President of the Trust since February 1994, a 10% participation in the profits of the acquired CCP II assets in excess of the return of the Trust's investment and a 10% annual cumulative return to the Trust. This participation was granted as consideration for Mr. Doyle's services to the Trust in connection with the CCP II portfolio. In December 1993, the Trust's Board of Trustees approved the issuance of a $1.0 million convertible subordinated debenture to Mr. Doyle in settlement of the Trust's participation obligation. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." NOTE 5. INVESTMENT IN EQUITY METHOD PARTNERSHIPS The Trust's investment in equity method partnerships consisted of the following: The Trust, in partnership with Continental Mortgage and Equity Trust ("CMET"), owns SAC 9, which currently owns two office buildings in the vicinity of Sacramento, California. The Trust has a 70% interest in the partnership's earnings, losses and distributions. The SAC 9 partnership agreement requires unanimous consent of both the Trust and CMET for any material changes in the operations of the partnership's properties, including sales, refinancings and changes in property management. The Trust, as a noncontrolling partner, accounts for its investment in the partnership under the equity method. Certain Trustees of the Trust are also trustees of CMET. In April 1993, SAC 9 sold one of its office buildings for $1.2 million. SAC 9 received $123,000 in cash, of which the Trust's equity share was $86,000, after the payoff of an existing first mortgage with a principal balance of $685,000. SAC 9 provided $356,000 of purchase money financing. The note receivable bears interest at a rate of 9% per NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 5. INVESTMENT IN EQUITY METHOD PARTNERSHIPS (Continued) annum, requires monthly payments of principal and interest and matures in June 1998. SAC 9 recognized a gain of $59,000 on the sale, of which the Trust's equity share was $41,000. In June 1993, SAC 9 sold two other of its office buildings. One was sold for $1.3 million in cash, of which the Trust's equity share was $910,000. SAC 9 recognized a gain of $437,000 on the sale, of which the Trust's equity share was $306,000. The other office building was sold for $2.0 million. SAC 9 received $1.1 million in cash, of which the Trust's equity share was $750,000, and provided $887,000 of purchase money financing. One note receivable with a principal balance of $410,000 bears interest at a variable interest rate, currently 6%, requires monthly interest only payments and matures in June 1994. A second note receivable with a principal balance of $477,000 bears interest at 10% per annum, and all principal and accrued interest are due at maturity in May 1994. SAC 9 recognized a gain of $720,000 on the sale, of which the Trust's equity share was $504,000. The Trust and CMET are also partners in Income Special Associates ("ISA"), a joint venture partnership in which the Trust has a 40% interest in earnings, losses and distributions. ISA in turn owns a 100% interest in APA, which owns 33 industrial warehouses. In November 1992, the Trust acquired all of the general and limited partnership interests in CCP II, whose assets included a 23% limited partnership interest in English Village Partners, L.P. ("English Village"). English Village owns a 300 unit apartment complex located in Memphis, Tennessee. On July 1, 1993, CCP II made an additional capital contribution to English Village of $464,000 to increase its limited partnership ownership interest to 49% and to acquire a 1% general partnership interest in the partnership. The Trust continues to account for its investment in English Village under the equity method. (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 5. INVESTMENT IN EQUITY METHOD PARTNERSHIPS (Continued) Set forth below are summarized financial data for all partnerships the Trust accounts for using the equity method (unaudited): NOTE 6. NOTES, DEBENTURES AND INTEREST PAYABLE Notes, debentures and interest payable consisted of the following: Scheduled principal payments on notes payable are due as follows: NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 6. NOTES, DEBENTURES AND INTEREST PAYABLE (Continued) In June 1993, the Trust obtained first mortgage financing secured by the Bayfront Apartments in the amount of $2.1 million. The Trust received $1.8 million in net cash from the financing proceeds and the remainder of the proceeds were used to fund escrows for replacements and repairs and to pay various closing costs associated with the financing. In October 1991, after determining that further investment in the Century Centre II Office Building could not be justified without a substantial modification of the mortgage debt, the property was placed in bankruptcy. A plan of reorganization was filed with the bankruptcy court in March 1993 and the bankruptcy court confirmed the Plan in November 1993. The confirmed Plan of Reorganization reduces the interest rate on the $21 million first mortgage to 1-1/2% above LIBOR, which currently results in an interest rate of 5 1/2% per annum. The reduced interest rate was retroactively applied as of October 15, 1991. The Plan also extends the note's maturity by two years to November 1995, with three consecutive one-year extension options. Under the Plan, the Trust deposited $1.0 million in cash with the lender to pay accrued and unpaid interest, 1993 property taxes and all closing costs associated with the transaction. In 1994, the Trust will be required to maintain a $200,000 balance in the escrow account with the lender. The Trust has also pledged one of its properties held for sale, Stewart Square Shopping Center, as additional collateral on the first mortgage. Also pursuant to the Plan of Reorganization, the Trust acquired the $7.5 million second mortgage plus all accrued but unpaid interest of $1.7 million, for $300,000 in cash. The Trust recognized an extraordinary gain of $8.9 million in connection with the debt modification and discounted debt purchase. In 1993, the State of Wisconsin commenced eminent domain proceedings to acquire the Pepperkorn Building, located in Manitowoc, Wisconsin, for highway development and made an initial offer of $175,000. Such purchase price is being appealed by the Trust. There is no assurance that the Trust will be successful or of the amount, if any, of additional compensation that it may receive. Based on the information presently available, the Trust does not anticipate any losses in excess of previously established reserves. The $1.6 million first mortgage secured by the Palm Court Apartments, located in Miami, Florida, matured in July 1993. Prior to the maturity, the Trust obtained the lender's written agreement to extend the note. Thereafter, the lender refused to execute the extension documents and has subsequently rejected the Trust's tender of mortgage payments in accordance with the extension agreement. The matter is presently in litigation. If adversely determined, the Trust is prepared to payoff the mortgage debt. Notes payable at December 31, 1993 bear interest at rates ranging from 4.2% to 19.7% and mature from 1994 through 2022. These notes payable NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 6. NOTES, DEBENTURES AND INTEREST PAYABLE (Continued) are nonrecourse and are collateralized by deeds of trust on real estate with a carrying value of $157.0 million. In December 1993, the Trust's Board of Trustees approved the issuance of a $1.0 million convertible subordinated debenture to Mr. Doyle, Trustee and Executive Vice President of the Trust since February 1994, in exchange for his 10% participation in the profits of the CCP II assets, which the Trust had acquired in November 1992. This participation was granted as consideration for Mr. Doyle's services to the Trust in connection with the CCP II portfolio. The debenture bears interest at a rate of 6% per annum, matures in five years and is convertible into 76,923 of the Trust's shares of beneficial interest. Mr. Doyle also serves as Director, President and Chief Operating Officer and is a 50% shareholder of Tarragon Realty Advisors, Inc. ("Tarragon"), the Trust's advisor commencing April 1, 1994. See NOTE 4. "REAL ESTATE AND DEPRECIATION." NOTE 7. DISTRIBUTIONS The Trust's Board of Trustees voted at their July 1993 meeting to resume the payment of regular quarterly distributions. The first quarterly distribution of $.10 per share of beneficial interest and a 10% stock distribution was paid on September 1, 1993 to shareholders of record on August 16, 1993. On December 21, 1993, the Trust paid a distribution of $.10 per share of beneficial interest to shareholders of record on December 6, 1993. On May 15, 1991, the Trust's Board of Trustees declared a distribution of $2.11 per share of beneficial interest. The distribution, totaling $7.4 million, was paid on May 23, 1991 to shareholders of record on May 20, 1991. Such distribution had been accrued at December 31, 1990, in accordance with the terms of the Olive settlement as described in NOTE 15. "COMMITMENTS AND CONTINGENCIES - Olive Litigation". No distributions were declared or paid in 1992. The Trust reported to the Internal Revenue Service that 100% of the distribution paid in 1993 was taxable to Trust shareholders as ordinary income and 100% of the 1991 distribution represented a return of capital. NOTE 8. ADVISORY AGREEMENT Basic Capital Management, Inc. ("BCM" or the "Advisor") has served as advisor to the Trust since March 28, 1989. At the Trust's annual meeting of shareholders held on April 26, 1993, the renewal of the Trust's Advisory Agreement with BCM was approved. BCM resigned as advisor to the Trust effective March 31, 1994. William S. Friedman, the President and a Trustee of the Trust, served as President of BCM until May 1, 1993 and, prior to December 22, 1989, also served as director of NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 8. ADVISORY AGREEMENT (Continued) BCM. BCM is beneficially owned by a trust for the benefit of the children of Gene E. Phillips. Mr. Phillips served as a Trustee of the Trust until December 31, 1992. Mr. Phillips served as a director of BCM until December 22, 1989, and served as Chief Executive Officer of BCM until September 1, 1992. On February 10, 1994, the Trust's Board of Trustees selected Tarragon to replace BCM as the Trust's advisor. Commencing April 1, 1994, Tarragon will provide advisory services to the Trust under an advisory agreement. Mr. Friedman serves as a director and Chief Executive Officer of Tarragon. Tarragon is owned by Lucy N. Friedman, Mr. Friedman's wife, and Mr. Doyle, who serves as a director, President and Chief Operating Officer of Tarragon and as a Trustee and Executive Vice President of the Trust. Mr. Friedman's family owns approximately 30% of the outstanding shares of the Trust. The provisions of the Trust's advisory agreement with Tarragon are substantially the same as those of the BCM advisory agreement except for the annual base advisory fee and the elimination of the net income fee. The Tarragon advisory agreement calls for an annual base advisory fee of $100,000 plus an incentive advisory fee in the amount of 16% of the Trust's adjusted funds from operations before deduction of the advisory fee. Adjusted funds from operations is defined as net income (loss) before gains or losses from the sale of properties and debt restructurings plus depreciation and amortization plus any loss due to the writedown or sale of any real property or mortgage loan acquired prior to January 1, 1989. The BCM advisory agreement provided for BCM to be responsible for the day-to-day operations of the Trust and to receive an advisory fee comprised of a gross asset fee of .0625% per month (.75% per annum) of the average of the gross asset value of the Trust (total assets less allowance for amortization, depreciation or depletion and valuation reserves) and an annual net income fee equal to 7.5% per annum of the Trust's net income. Under both the Tarragon and the BCM advisory agreements, the advisor is required to formulate and submit annually for approval by the Trust's Board of Trustees a budget and business plan for the Trust containing a twelve-month forecast of operations and cash flow, a general plan for asset sales or acquisitions, lending, foreclosure and borrowing activity, and other investments, and the advisor is required to report quarterly to the Trust's Board of Trustees on the Trust's performance against the business plan. In addition, all transactions or investments by the Trust shall require prior approval by the Trust's Board of Trustees unless they are explicitly provided for in the approved business plan or are made pursuant to authority expressly delegated to the advisor or to the Trust's President by the Trust's Board of Trustees. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 8. ADVISORY AGREEMENT (Continued) Each of the advisory agreements also require prior approval of the Trust's Board of Trustees for the retention of all consultants and third party professionals, other than legal counsel. The advisory agreements provide that the advisor shall be deemed to be in a fiduciary relationship to the Trust's shareholders; contain a broad standard governing the advisor's liability for losses by the Trust; and contain guidelines for the advisor's allocation of investment opportunities as among itself, the Trust and other entities it advises. Each of the advisory agreements also provide for the advisor to receive an annual incentive sales fee equal to 10% of the amount, if any, by which the aggregate sales consideration for all real estate sold by the Trust during such fiscal year exceeds the sum of: (i) the cost of each such property as originally recorded in the Trust's books for tax purposes (without deduction for depreciation, amortization or reserve for losses), (ii) capital improvements made to such assets during the period owned by the Trust, and (iii) all closing costs, (including real estate commissions) incurred in the sale of such property; provided, however, no incentive fee shall be paid unless (i) such real estate sold in such fiscal year, in the aggregate, has produced an 8% simple annual return on the Trust's net investment including capital improvements, calculated over the Trust's holding period before depreciation and inclusive of operating income and sales consideration and (ii) the aggregate net operating income from all real estate owned by the Trust for each of the prior and current fiscal years shall be at least 5% higher in the current fiscal year than in the prior fiscal year. Additionally, pursuant to each of the advisory agreements, the advisor or an affiliate of the advisor is to receive an acquisition commission for supervising the acquisition, purchase or long term lease of real estate for the Trust equal to the lesser of (i) up to 1% of the cost of acquisition, inclusive of commissions, if any, paid to nonaffiliated brokers or (ii) the compensation customarily charged in arm's-length transactions by others rendering similar property acquisition services as an ongoing public activity in the same geographical location and for comparable property; provided that the purchase price of each property (including acquisition commissions and all real estate brokerage fees) may not exceed such property's appraised value at acquisition. Each of the advisory agreements require the advisor or any affiliate of the advisor to pay to the Trust one-half of any compensation received from third parties with respect to the origination, placement or brokerage of any loan made by the Trust; provided, however, that the compensation retained by the advisor or any affiliate of the advisor shall not exceed the lesser of (i) 2% of the amount of the loan committed by the Trust or (ii) a loan brokerage and commitment fee which is reasonable and fair under the circumstances. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 8. ADVISORY AGREEMENT (Continued) Each of the advisory agreements also provide that the advisor or an affiliate of the advisor is to receive a mortgage or loan acquisition fee with respect to the acquisition or purchase from an unaffiliated party of any existing mortgage or loan by the Trust equal to the lesser of (i) 1% of the amount of the loan purchased or (ii) a loan brokerage or commitment fee which is reasonable and fair under the circumstances. Such fee will not be paid in connection with the origination or funding by the Trust of any mortgage loan. Under each of the advisory agreements, the advisor or an affiliate of the advisor is also to receive a mortgage brokerage and equity refinancing fee for obtaining loans to the Trust or refinancing on Trust properties equal to the lesser of (i) 1% of the amount of the loan or the amount refinanced or (ii) a brokerage or refinancing fee which is reasonable and fair under the circumstances; provided, however, that no such fee shall be paid on loans from the advisor or an affiliate of the advisor without the approval of the Trust's Board of Trustees. No fee shall be paid on loan extensions. Under each of the advisory agreements, the advisor is to receive reimbursement of certain expenses incurred by it in the performance of advisory services to the Trust. Under each of the advisory agreements (as required by the Trust's Declaration of Trust) all or a portion of the annual advisory fee must be refunded by the advisor to the Trust if the Operating Expenses of the Trust (as defined in the Trust's Declaration of Trust) exceed certain limits specified in the Declaration of Trust based on the book value, net asset value and net income of the Trust during such fiscal year. The operating expenses of the Trust did not exceed such limitation in 1991, 1992 or 1993. Additionally, if the Trust were to request that the advisor render services to the Trust other than those required by the advisory agreements, the advisor or an affiliate of the advisor will be separately compensated for such additional services on terms to be agreed upon from time to time. As discussed in NOTE 9. "PROPERTY MANAGEMENT", the Trust has hired Carmel Realty Services, Ltd. ("Carmel, Ltd."), an affiliate of BCM, to provide property management services for the Trust's properties and, as discussed in NOTE 10. "REAL ESTATE BROKERAGE", the Trust has engaged, on a non-exclusive basis, Carmel Realty, Inc. ("Carmel Realty"), also an affiliate of BCM, to perform brokerage services for the Trust. NOTE 9. PROPERTY MANAGEMENT Since February 1, 1990, affiliates of BCM have provided property management services to the Trust. Currently, Carmel, Ltd. provides property management services for a fee of 5% or less of the monthly NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 9. PROPERTY MANAGEMENT (Continued) gross rents collected on the properties under management. In many cases, Carmel, Ltd. subcontracts with other entities for the property-level management services to the Trust at various rates. The general partner of Carmel, Ltd. is BCM. The limited partners of Carmel, Ltd. are (i) Syntek West, Inc. ("SWI"), of which Mr. Phillips is the sole shareholder, (ii) Mr. Phillips and (iii) a trust for the benefit of the children of Mr. Phillips. Carmel, Ltd. subcontracts the property-level management and leasing of eleven of the Trust's commercial properties and the commercial properties owned by two of the real estate partnerships in which the Trust is a partner, to Carmel Realty, which is owned by SWI. Carmel, Ltd. has resigned as property manager for the Trust's properties effective March 31, 1994. Commencing April 1, 1994, Tarragon will provide property management services to the Trust for a fee of 4.5% of the monthly gross rents collected on apartment properties and not in excess of 5% of the monthly gross rents collected on commercial properties. Tarragon intends to subcontract with other entities for the provision of property-level management services to the Trust. NOTE 10. REAL ESTATE BROKERAGE Prior to December 1, 1992, affiliates of BCM provided brokerage services to the Trust and received brokerage commissions in accordance with the advisory agreement. The Trust's Board of Trustees approved, effective December 1, 1992, the non-exclusive engagement by the Trust of Carmel Realty to perform brokerage services for the Trust. Such agreement terminates March 31, 1994. Carmel Realty is entitled to receive a real estate acquisition commission for locating and negotiating the lease or purchase by the Trust of any property equal to the lesser of (i) up to 3% of the purchase price, inclusive of commissions, if any, paid by the Trust to other brokers or (ii) the compensation customarily charged in arm's-length transactions by others rendering similar property acquisition services in the same geographical location and for comparable property. Any commission which is paid to Carmel Realty by the seller shall be credited against the commission to be paid by the Trust. Carmel Realty is also entitled to receive a real estate sales commission for the sale of each Trust property equal to the lesser of (i) 3% (inclusive of fees, if any, paid by the Trust to other brokers) of the sales price of each property or (ii) the compensation customarily charged in arm's-length transactions paid by others rendering similar services in the same geographic location for comparable property. (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 11. ADVISORY FEES, PROPERTY MANAGEMENT FEES, ETC. Fees and cost reimbursements to BCM, the Trust's advisor until March 31, 1994, and its affiliates: - -------------------------------- * Net of property management fees paid to subcontractors. NOTE 12. INCOME TAXES For the years 1993, 1992 and 1991, the Trust has elected and qualified to be treated as a Real Estate Investment Trust ("REIT"), as defined in Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"), and as such, will not be taxed for federal income tax purposes on that portion of its taxable income which is distributed to shareholders, provided that at least 95% of its REIT taxable income, plus 95% of its taxable income from foreclosure property as defined in Section 857 of the Code, is distributed. See NOTE 7. "DISTRIBUTIONS." The Trust had a net loss for federal income tax purposes in 1991, 1992 and 1993; therefore, the Trust recorded no provision for income taxes. The Trust's tax basis in its net assets differs from the amount at which its net assets are reported for financial statement purposes, principally due to the accounting for gains and losses on property sales, the difference in the allowance for estimated losses, depreciation on owned properties and investments in joint venture partnerships. At December 31, 1993, the Trust's tax basis in its net assets exceeded its basis for financial statement purposes by $53.2 million. As a result, aggregate future income for income tax purposes will be less than such amount for financial statement purposes, and the Trust will be able to maintain its REIT status without distributing 95% of its financial statement income. Additionally, at December 31, 1993, the Trust had a tax net operating loss carryforward of $41 million expiring through 2007. As a result of the Trust's election to be treated as a REIT for income tax purposes and of its intention to distribute its taxable income, no deferred tax asset, liability or valuation allowance was recorded. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 13. RENTALS UNDER OPERATING LEASES The Trust's rental operations include the leasing of office buildings and shopping centers. The leases thereon expire at various dates through 2005. The following is a schedule of minimum future rentals on non-cancelable operating leases as of December 31, 1993: NOTE 14. EXTRAORDINARY GAIN In 1993, the Trust acquired the $7.5 million second mortgage secured by its Century Center II Office Building for $300,000. In addition, the first lien holder retroactively reduced the interest rate on the debt owed by the Trust. The Trust recognized an extraordinary gain of $8.9 million in connection with the debt modification and discounted debt purchase. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." During 1991, SAC 9, a joint venture partnership, returned properties to senior lienholders in lieu of foreclosure proceedings. SAC 9 recognized an extraordinary gain of $3.1 million in 1991, of which the Trust's equity share was $2.2 million, from the forgiveness of nonrecourse mortgage debt and a provision for loss of $1.1 million, of which the Trust's equity share was $770,000. The provision for loss is included in equity in income of partnerships in 1991. This provision for losses and the extraordinary gain represent the amounts by which the nonrecourse mortgage debt exceeded the fair market value of the properties on the dates the properties were returned to the lienholders. NOTE 15. COMMITMENTS AND CONTINGENCIES Securities and Exchange Commission Inquiry. On December 1, 1988, the Trust was informed in writing that the staff of the Securities and Exchange Commission (the "Commission") had made a preliminary determination to recommend administrative proceedings against the Trust, CMET and Consolidated Capital Equities Corporation, a former advisor to the Trust, among others, for various alleged reporting violations in public filings made during certain periods in 1985, and possibly other matters. The allegations relate to a time prior to the time when the Trust's current management and BCM or any of its personnel became associated with the Trust. No administrative proceeding has been commenced and due to the lapse of time, the Trust's management believes that there will be no further activity regarding this matter. NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 15. COMMITMENTS AND CONTINGENCIES (Continued) Olive Litigation. In February 1990, the Trust, together with CMET, Income Opportunity Realty Trust ("IORT") and Transcontinental Realty Investors, Inc. ("TCI"), three real estate entities with, at the time, the same officers, directors or trustees and advisor as the Trust, entered into a settlement of a class and derivative action entitled Olive et al. v. National Income Realty Trust et al., relating to the operation and management of each of the entities. On April 23, 1990, the court granted final approval of the terms of the settlement. By agreeing to settle these actions, the defendants, including the Trust, did not and do not admit any liability whatsoever. Among other things, the settlement required the creation of committees of the Board of Trustees to review transactions with related parties and certain litigation involving members of the Trust's management. In January 1991, the plaintiffs in this action filed a motion with the court for the appointment of a receiver for the Trust, CMET, IORT and TCI, based on an alleged failure by the trustees or directors of these entities to abide by the terms of the court-approved settlement. In March 1991, the court appointed a Special Master to review the facts and determine whether there had been any breach of the settlement agreement by the Trust, CMET, IORT or TCI. In his report to the court filed July 26, 1991, the Special Master found that the breaches which were found did not constitute deliberate violations of the settlement agreement and that the other allegations did not constitute breaches. In September and November 1991, hearings were held relating to the Special Master's report. An order was issued by the court on November 27, 1991. Under the order: (i) the plaintiffs' request for the appointment of a receiver was denied; (ii) the findings of the Special Master were confirmed and adopted by the court; (iii) independent counsel to the Related Party Transaction Committee and Litigation Committee of each of the Trust, CMET, IORT and TCI was required to submit, until December 1992, a written bimonthly report to the Special Master concerning the activities of such committees, and the Special Master was required to report periodically to the court on the activities of these committees; (iv) the Litigation Committees of each of the Trust, CMET, IORT and TCI were directed to evaluate the nature and quality of the allegations made in any litigations or investigations involving Messrs. Phillips and Friedman in order to assess whether Messrs. Phillips and Friedman should continue to act as trustees or directors of each entity and to assess whether BCM should continue to serve as advisor to each entity; and (v) the court retained jurisdiction to enforce the terms of its order and to issue subsequent orders if circumstances so dictate. A status conference was held in December 1992 to determine whether the bimonthly reports to the Special Master by the committees' independent NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 15. COMMITMENTS AND CONTINGENCIES (Continued) counsel and the Special Master's periodic reports to the court should be continued, or whether other appropriate relief should be ordered. The court held an evidentiary hearing on these matters in February and April 1993 concerning allegations by the plaintiffs that the terms of the settlement had been breached by the Trust, CMET, IORT and TCI. No determination on the matters has been made by the court pending the outcome of ongoing settlement discussions. Other litigation. The Trust is also involved in various lawsuits arising in the ordinary course of business. The Trust's management is of the opinion that the outcome of these lawsuits would have no material impact on the Trust's financial condition. NOTE 16. SUBSEQUENT EVENTS In January 1994, the Trust obtained first mortgage financing secured by the Bay West Apartments in the amount of $5.1 million. The Trust received net cash of $1.0 million after the payoff of $3.9 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. In March 1994, the Trust obtained first mortgage financing secured by the Carlyle Towers Apartments in the amount of $4.5 million. The Trust received net cash of $2.3 million after the payoff of $2.2 million in existing debt. Also in March 1994, the Trust obtained first mortgage financing secured by the Woodcreek Apartments, located in Denver, Colorado, in the amount of $3.0 million. The Trust received net cash of $1.2 million after the payoff of $1.7 million in existing debt. The remainder of the financing proceeds were used to fund escrows for replacements and repairs and to pay closing costs associated with the financing. (THIS SPACE INTENTIONALLY LEFT BLANK.) NATIONAL INCOME REALTY TRUST NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) NOTE 17. QUARTERLY RESULTS OF OPERATIONS The following is a tabulation of the quarterly results of operations for the years ended December 31, 1993 and 1992 (unaudited): Fourth quarter results include a charge against earnings of $1.4 million to provide for estimated losses on one of the Trust's properties held for sale and one of the Trust's first lien notes receivable. In addition, $1.0 million was charged to operations in the fourth quarter in connection with the issuance of a $1.0 million convertible subordinated debenture in exchange for the buyout of the CCP II profit participation. See NOTE 6. "NOTES, DEBENTURES AND INTEREST PAYABLE." Third quarter results include a charge against earnings of $2.4 million to provide for estimated losses on certain of the Trust's junior lien notes receivable. SCHEDULE X NATIONAL INCOME REALTY TRUST SUPPLEMENTARY STATEMENT OF OPERATIONS INFORMATION SCHEDULE XI NATIONAL INCOME REALTY TRUST REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 SCHEDULE XI (Continued) NATIONAL INCOME REALTY TRUST REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 SCHEDULE XI (Continued) NATIONAL INCOME REALTY TRUST REAL ESTATE AND ACCUMULATED DEPRECIATION December 31, 1993 - --------------- (1) The aggregate cost for federal income tax purposes is $195,478. (2) Also pledged as additional collateral on the $21 million first mortgage secured by Century Centre II. SCHEDULE XI (Continued) NATIONAL INCOME REALTY TRUST REAL ESTATE AND ACCUMULATED DEPRECIATION SCHEDULE XII NATIONAL INCOME REALTY TRUST MORTGAGE LOANS ON REAL ESTATE December 31, 1993 SCHEDULE XII (Continued) NATIONAL INCOME REALTY TRUST MORTGAGE LOANS ON REAL ESTATE December 31, 1993 SCHEDULE XII (Continued) NATIONAL INCOME REALTY TRUST MORTGAGE LOANS ON REAL ESTATE December 31, 1993 _______________________ (1) The aggregate cost for federal income tax purposes is $19,547. (2) Note brought current subsequent to yearend. SCHEDULE XII (Continued) NATIONAL INCOME REALTY TRUST MORTGAGE LOANS ON REAL ESTATE ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ______________________________________ PART III ITEM 10. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT Trustees The affairs of National Income Realty Trust (the "Trust" or the "Registrant") are managed by a ten-member Board of Trustees. The Trustees are elected at the annual meeting of shareholders or appointed by the incumbent Board of Trustees and serve until the next annual meeting of shareholders or until a successor has been elected or approved. The Trustees of the Trust are listed below, together with their ages, terms of service, all positions and offices with the Trust or its advisor, Basic Capital Management, Inc. ("BCM" or the "Advisor"), or Tarragon Realty Advisors, Inc. ("Tarragon"), the Trust's advisor commencing April 1, 1994, their principal occupations, business experience and directorships with other companies during the last five years or more. The designation "Affiliated", when used below with respect to a Trustee, means that the Trustee is an officer, director or employee of BCM or Tarragon or an officer or employee of the Trust. The designation "Independent", when used below with respect to a Trustee, means that the Trustee is neither an officer or employee of the Trust nor a director, officer or employee of BCM or Tarragon, although the Trust may have certain business or professional relationships with such Trustee as discussed in ITEM 13. "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Certain Business Relationships." WILLIE K. DAVIS: Age 62, Trustee (Independent) (since October 1988). President (1971 to 1985) and Chairman and 50% shareholder (since 1985) of Mid-South Financial Corporation, holding company for Mid-South Mortgage Company and Gibbs Mortgage Company; President (since 1978) and Chairman and sole shareholder (since December 1985) of FMS, Inc. ("FMS"), a property management and real estate development firm; President (1983 to February 1990) of BVT Management Services, Inc., a real estate advisory and tax service firm; Director (since 1987) of SouthTrust Bank of Middle Tennessee; Trustee and Treasurer (since 1986) of Baptist Hospital, Inc., Tennessee General Welfare nonprofit corporation; and Director or Trustee (since October 1988) of Continental Mortgage and Equity Trust ("CMET"), Income Opportunity Realty Trust ("IORT"), Transcontinental Realty Investors, Inc. ("TCI") and Vinland Property Trust ("VPT"). ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) JOHN A. DOYLE: Age 35, Trustee (Affiliated) and Executive Vice President (since February 1994). Trustee and Executive Vice President (since February 1994) of VPT; Director, President, Chief Operating Officer and 50% shareholder (since February 1994) of Tarragon; President and Chairman of the Board (since December 1993) of Investors General Acquisition Corp., which owns 100% of the shares of Investors General, Inc.; Director, President and Chief Executive Officer (since June 1992) of Garden Capital Incorporated; Director (since October 1993) of Home States Holdings; Director and Chief Operating Officer (October 1990 to December 1991) of ConCap Equities, Inc.; President, Chief Executive Officer, Chief Operating Officer and sole Director (April 1989 to October 1990) of Consolidated Capital Equities Corporation ("CCEC"); Director of Restructuring, Reorganization and Insolvency Services (February 1987 to April 1989) of Arthur Young & Co., independent certified public accountants; and Certified Public Accountant (since 1985). GEOFFREY C. ETNIRE: Age 45, Trustee (Independent) (since January 1993). Attorney engaged in the private practice of real estate law in Pleasanton, California (since 1981); Licensed Real Estate Broker in California (since 1985); Director (1985 to 1989) of Mission Valley Bancorp; Director (1984 to 1989) and Chairman (1986 to 1989) of Bank of Pleasanton; and Managing Partner (1981 to 1988) with Smith, Etnire, Polson & Scott law firm; and Trustee or Director (since January 1993) of CMET, IORT and TCI. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) WILLIAM S. FRIEDMAN: Age 50, Trustee (Affiliated) (since March 1988). Chief Executive Officer (since December 1993), President (since December 1988) and formerly Acting Chief Financial Officer (May 1990 to February 1991), Treasurer (August to September 1989) and Acting Principal Financial and Accounting Officer (December 1988 to August 1989). Trustee (since March 1988), Chief Executive Officer (since December 1993), President (since December 1988), Acting Chief Financial Officer (May 1990 to February 1991), Treasurer (August to September 1989) and Acting Principal Financial and Accounting Officer (December 1988 to August 1989) of VPT; Trustee or Director (March 1988 to February 1994), Chief Executive Officer (December 1993 to February 1994), President (December 1988 to February 1994), Acting Chief Financial Officer (May 1990 to February 1991), Treasurer (August to September 1989) and Acting Principal Accounting Officer (December 1988 to August 1989) of CMET, IORT and TCI; Director and Chief Executive Officer (since December 1990) of Tarragon, the Advisor to the Trust effective April 1, 1994; President (February 1989 to March 1993) and Director (February to December 1989) of BCM, the advisor to the Trust (March 1989 to March 1994); General Partner (1987 to March 1994) of Syntek Asset Management, L.P. ("SAMLP"), which is the General Partner of National Realty, L.P. ("NRLP") and National Operating, L.P. ("NOLP"); Director and President (March 1989 to February 1994)) and Secretary (March 1989 to December 1990) of Syntek Asset Management, Inc. ("SAMI"), the Managing General Partner of SAMLP and a corporation owned by BCM; President (1982 to October 1990) of Syntek Investment Properties, Inc. ("SIPI"), which has invested in, developed and syndicated real estate through its subsidiaries and other related entities since 1973; Director and President (1982 to October 1990) of Syntek West, Inc. ("SWI"); Vice President (1984 to October 1990) of Syntek Finance Corporation; Director (1981 to December 1992), President (July 1991 to December 1992), Vice President and Treasurer (January 1987 to July 1991) and Acting Chief Financial Officer (May 1990 to February 1991) of American Realty Trust, Inc. ("ART"); Practicing Attorney (since 1971) with the Law Offices of William S. Friedman; Director and Treasurer (November 1989 to February 1991) of Carmel Realty Services, Inc. ("CRSI"); Limited Partner (January 1991 to December 1992) of Carmel Realty Services, Ltd. ("Carmel, Ltd."); Trustee (1987 to November 1989) of Wespac Investors Trust; Director (1985 to April 1989) of Pratt Hotel Corporation; and Trustee (March 1988 to February 1989) of The Consolidated Companies. Until January 1989, Mr. Friedman served in the following positions: Director (from 1980), Vice Chairman of the Board of Directors (from 1982) and Secretary (from 1984) of Southmark Corporation; Director of Pacific Standard Life Insurance Company (from 1984), Servico, Inc. (from 1985), NACO Finance Corporation (from 1986), Integon Corporation (from 1986), Southmark San Juan, Inc. (from 1987), Thousand Trails, Inc. (from 1987), MGF Oil Corporation (from 1988), and two former advisors to the Trust - Consolidated Capital Equities Corporation and Consolidated Advisors, Inc. (from March 1988). ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) DAN L. JOHNSTON: Age 56, Trustee (Independent) (April 1990 to June 1990 and since February 1991). Attorney in solo practice in New York, New York (since 1991); Chief Counsel, Subcommittee on Criminal Justice, U.S. House of Representatives (June 1990 to January 1991); Executive Director (1986 to 1990) of Prosecuting Attorneys' Research Council, a nationwide organization of metropolitan prosecutors which acts to further research to improve the prosecutorial function; Consultant (February 1985 to June 1990) to the Edna McConnell Clark Foundation, which supports efforts of District Attorneys to reduce jail and prison overcrowding; Member (October 1987 to June 1990) of the Civilian Complaint Review Board of the New York City Police Department; Project Director (March 1985 to February 1986) and Consultant (January 1984 to March 1985) of the Vera Institute of Justice; County Attorney (March 1977 to March 1985) of Polk County, Des Moines, Iowa; Assistant Iowa Attorney General in charge of consumer fraud division (1965); Director or Trustee (April 1990 to June 1990 and since February 1991) of CMET, IORT and TCI; and Trustee (since December 1992) of VPT. A. BOB JORDAN: Age 61, Trustee (Independent) (since October 1992). Attorney in solo practice in Oklahoma City, Oklahoma; and Director or Trustee (since October 1992) of CMET, IORT and TCI. RAYMOND V.J. SCHRAG: Age 48, Trustee (Independent) (since October 1988). Attorney in solo practice in New York, New York (since 1975); Trustee (1986 to December 1989) of Hidden Strength Mutual Funds; and Director or Trustee (since October 1988) of CMET, IORT, TCI and VPT. BENNETT B. SIMS: Age 61, Trustee (Independent) (since April 1990). Author (since February 1964); Screen and Television Writer (since January 1960); Independent Marketing Consultant (since January 1980) for various companies; Professor of Dramatic Writing (since September 1987) at Tisch School of the Arts, New York University; Director or Trustee (since April 1990) of CMET, IORT and TCI; and Trustee (since December 1992) of VPT. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) TED P. STOKELY: Age 60, Trustee (Independent) (since April 1990). General Manager (since January 1993) of Minority and Elderly Housing Assistance Foundation, Inc., a nonprofit corporation; Part- time unpaid Consultant (since January 1993) of Eldercare Housing Foundation ("Eldercare"); Real Estate Consultant (April 1992 to December 1993) for Eldercare, a nonprofit corporation engaged in the acquisition of low income and elderly housing; President (since April 1992) of PSA Group (real estate management and consulting); Executive Vice President (1987 to 1991) of Key Companies Inc., a publicly traded company that develops, acquires and sells water and minerals; Managing General Partner (1985 to 1987) of RCB Houston Venture I, a Texas Partnership; Executive Vice President (1982 to 1985) of Success Properties, a Texas real estate investment company; and Director or Trustee (since April 1990) of CMET, IORT and TCI. CARL B. WEISBROD: Age 49, Trustee (Independent) (since February 1994). Consultant (since 1994), President and Chief Executive Officer (April 1990 to 1994) of New York City Economic Development Corporation; President (May 1987 to April 1990) of 42nd Street Development Project, Inc. of New York State Urban Development Corporation; Executive Director (March 1986 to May 1987) of Department of City Planning of the City of New York; and Executive Director (July 1984 to March 1986) of City Volunteer Corps of the City of New York. Separation of Messrs. Phillips and Friedman from Southmark. Until January 1989, Gene E. Phillips, who served as a Trustee of the Trust until December 31, 1992, and William S. Friedman, the President and a Trustee of the Trust, were executive officers and directors of Southmark Corporation ("Southmark"). Mr. Phillips served as Chairman of the Board and Director (since 1980) and President and Chief Executive Officer (since 1981) and Mr. Friedman served as Vice Chairman of the Board (since 1982), Director (since 1980) and Secretary (since 1984) of Southmark. As a result of a deadlock on Southmark's Board of Directors, Messrs. Phillips and Friedman reached a series of related agreements with Southmark on January 17, 1989 (collectively, the "Separation Agreement"), whereby Messrs. Phillips and Friedman resigned their positions with Southmark and certain of Southmark's subsidiaries and affiliates. The Separation Agreement was later modified by certain agreements in another set of agreements dated as of June 30, 1989 (collectively, the "June Agreements"). Southmark filed a voluntary petition in bankruptcy under Chapter 11 of the United States Bankruptcy Code on July 14, 1989. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) Litigation Against Southmark or its Affiliates Alleging Fraud or Mismanagement. In addition to the litigation related to the Southmark bankruptcy, there were several lawsuits filed against Southmark, its former officers and directors (including Messrs. Phillips and Friedman) and others, alleging, among other things, that such persons and entities engaged in conduct designed to defraud and mislead the investing public by intentionally misrepresenting the financial condition of Southmark. In so far as such allegations related to them, Messrs. Phillips and Friedman deny them. Those lawsuits in which Mr. Friedman was also a defendant are summarized below. THE TRUST IS NOT A DEFENDANT IN ANY OF THESE LAWSUITS. In Burt v. Grant Thornton, Gene E. Phillips and William S. Friedman, the plaintiff, a purchaser of Southmark preferred stock, alleged that the defendants disseminated false and misleading corporate reports, financial analysis and news releases in order to induce the public to continue investing in Southmark. Grant Thornton served as independent certified public accountants to Southmark and, for 1988 and 1989, to the Trust. The plaintiff sought actual damages in the amount of less than $10,000, treble damages and punitive damages in an unspecified amount plus attorneys' fees and costs. This case was settled in October 1993 for a nominal payment. Consolidated actions entitled Salsitz v. Phillips et al., purportedly brought as class actions on behalf of purchasers of Southmark securities during specified periods, were pending before the United States District Court for the Northern District of Texas. These actions alleged violations of the federal securities laws and state laws, based upon claims of fraud, deceit and negligent misrepresentations made in connection with the sale of Southmark securities. The plaintiffs sought unspecified damages, attorneys' fees and costs. The defendants included Messrs. Phillips and Friedman, among others. Messrs. Phillips and Friedman entered into a settlement agreement with the plaintiffs, which was approved by the court in October 1993. Messrs. Phillips and Friedman also served as directors of Pacific Standard Life Insurance Company ("PSL"), a wholly-owned subsidiary of Southmark, from October 1984 to January 1989. In a proceeding brought by the California Insurance Commissioner, a California Superior Court appointed a conservator for PSL on December 11, 1989, and directed that PSL cease doing business. On October 12, 1990, the California Insurance Commissioner filed suit against Messrs. Phillips and Friedman and other former directors of PSL seeking damages of $12 million and additional punitive damages. Such lawsuit alleged, among other things, that the defendants knowingly and willfully conspired among themselves to breach their duties as directors of PSL and to loot and waste corporate assets of PSL to benefit Southmark and its other subsidiaries and certain of the defendants (including Messrs. Phillips and Friedman), resulting in a required write-down of $25 million, PSL's insolvency and conservatorship. Such suit further alleged that the defendants caused ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Trustees (Continued) PSL to make loans to, or enter into transactions with, Southmark, Southmark affiliates and others in violation of applicable state laws, and to make loans and investments that could not be included as assets on PSL's balance sheet to entities controlled by Charles H. Keating, Jr. It is also alleged that PSL's board of directors failed to convene meetings and delegated to Mr. Phillips authority to make decisions regarding loans, investments and other transfers and exchanges of PSL assets. In August 1993, five former directors of PSL, including Messrs. Phillips and Friedman, settled this lawsuit without admitting any liability. Southmark Partnership Litigation. One of Southmark's principal businesses was real estate syndication and from 1981 to 1987 Southmark raised over $500 million in investments from limited partners of several hundred limited partnerships. Several lawsuits have been filed by investors against Messrs. Phillips and Friedman alleging breach of fiduciary duties. The following actions relate to and involve such activities. In Adkisson, et al. v. Friedman et al., the plaintiffs, limited partners in a tax shelter partnership sponsored by Southmark, alleged violations of state consumer protection laws, negligence and fraud. This case was settled in July 1993 for a nominal payment. In Sable et al. v. Southmark/Envicon Capital Corp. et al., the plaintiffs, limited partners in nine Southmark-sponsored limited partnerships, made several claims alleging breach of fiduciary duty and waste or mismanagement of partnership assets, among other things. In April 1993, the court dismissed all of the claims and awarded Messrs. Phillips and Friedman sanctions against plaintiffs' counsel. In Southmark/CRCA Healthcare Fund VIII, L.P. v. Southmark Investment Group 87, Inc., et al., the plaintiff, a former Southmark related public limited partnership, alleged that in 1988 the defendants caused the plaintiff to purchase five nursing homes in violation of the partnership agreement. The plaintiff sought to recover actual damages in an unspecified amount, plus punitive damages and attorneys' fees and costs. The defendants included, among others, Messrs. Phillips and Friedman and TCI, which provided refinancing for the properties. The case was settled in October 1993. In an action filed in January 1993 in a Michigan state court captioned Van Buren Associates Limited Partnership, et.al. v. Friedman, et. al., the plaintiff, an affiliate of the plaintiff in two other cases against Messrs. Phillips and Friedman which have been dismissed without payment, alleges a claim in connection with an alleged 1988 transfer of certain property by the partnership. The plaintiff seeks damages in an unspecified amount, plus costs and attorney's fees. The plaintiff also seeks to quiet title to the property at issue. The defendants include, among others, Messrs. Phillips and Friedman. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Board Committees The Trust's Board of Trustees held nine meetings during 1993. For such year, no incumbent Trustee attended fewer than 75% of the aggregate of (i) the total number of meetings held by the Board of Trustees during the period for which he had been a Trustee and (ii) the total number of meetings held by all committees of the Board of Trustees on which he served during the periods that he served. The Trust's Board of Trustees has an Audit Committee, the function of which is to review the Trust's operating and accounting procedures. The current members of the Audit Committee, all of whom are Independent Trustees, are Messrs. Schrag (Chairman), Davis and Etnire. The Audit Committee met three times during 1993. The Trust's Board of Trustees does not have Nominating or Compensation Committees. The Trust's Board of Trustees has a Related Party Transaction Committee which reviews and makes recommendations to the Board of Trustees with respect to transactions involving the Trust and any other party or parties related to or affiliated with the Trust, any of its Trustees or any of their affiliates, and a Litigation Committee which reviews litigation involving Messrs. Phillips and Friedman. Messrs. Johnston (Chairman), Davis, Etnire, Schrag, Sims and Stokely, all of whom are Independent Trustees, are the members of the Related Party Transaction Committee, while Messrs. Johnston (Chairman), Etnire, Jordan, Schrag, Sims and Stokely comprise the Litigation Committee. During 1993, the Related Party Transaction Committee met six times and the Litigation Committee met six times. The Litigation Committee has formally requested each of Messrs. Phillips and Friedman to furnish the Advisor's in-house counsel with copies of the complaints filed in all pending litigation in which either is named as a defendant. The Advisor's counsel, in turn, has furnished the Litigation Committee with summaries of the allegations contained in each such complaint as well as summaries of developments in existing and new matters. The Litigation Committee is represented by independent counsel, which counsel periodically reviews certain litigation matters and reports to the Committee thereon. The Litigation Committee evaluates the nature and quality of the allegations made in any litigations or investigations involving Messrs. Phillips and Friedman in order to assess whether Mr. Friedman should continue to act as a Trustee and to assess whether BCM should continue to act as the advisor to the Trust. The Litigation Committee, while not needing to duplicate the adjudicatory process, is also required to conduct any investigation that is appropriate and necessary to discharge the above obligations. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Executive Officers The following persons currently serve as executive officers of the Trust: William S. Friedman, President and Chief Executive Officer; John A. Doyle, Executive Vice President; and Ivan Roth, Treasurer and Chief Financial Officer. Their positions with the Trust are not subject to a vote of shareholders. The age, terms of service, all positions and offices with the Trust, BCM or Tarragon, other principal occupations, business experience and directorships with other companies during the last five years or more of Messrs. Friedman and Doyle are set forth above. Corresponding information regarding Mr. Roth is set forth below. IVAN ROTH: Age 58, Treasurer and Chief Financial Officer (since February 1994). Treasurer and Chief Financial Officer (since February 1994) of VPT; Treasurer (since February 1994) of Tarragon and Tarragon Capital Corporation; Treasurer and Chief Financial Officer (1978 to 1992) of Servico, Inc.; Financial Controller (1970 to 1978) of New York Motel Enterprises, Inc.; General Manager (1968 to 1970) of Affiliated Financial Corporation; and Certified Public Accountant (since 1968). On September 19, 1990, Servico, Inc. filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code and was reorganized effective August 5, 1992. Officers Although not executive officers of the Trust, the following persons currently serve as officers of the Trust: Cary L. Newburger, Vice President - General Counsel; John C. Stricklin, Vice President - Real Estate and Mary E. Montagnino, Secretary. Their positions with the Trust are not subject to a vote of shareholders. Their ages, terms of service, all positions and offices with the Trust, BCM or Tarragon, other principal occupations, business experience and directorships with other companies during the last five years or more are set forth below. CARY L. NEWBURGER: Age 34, Vice President - General Counsel (since February 1994) and Vice President - Real Estate (1992 to February 1994). Vice President - General Counsel (since February 1994) of VPT; Vice President (since February 1994) of Tarragon; Vice President and Real Estate Counsel (1990 to 1994) of BCM; Vice President (1993 to February 1994) of ART; Vice President and Real Estate Counsel (1992 to February 1994) of CMET, IORT and TCI; Attorney (1987 to 1989) of Southmark; and Associate (1985 to 1987) with the law firm of Baker & McKenzie. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Officers (Continued) JOHN C. STRICKLIN: Age 47, Vice President - Real Estate (since January 1994). Vice President - Real Estate (since February 1994) of VPT; Senior Vice President (since February 1994) of Tarragon; Vice President (June 1992 to January 1994) of Carmel Realty, Inc.; Real Estate Broker (June 1989 to May 1992) with Carmel, Ltd.; Executive Vice President (June 1980 to May 1989) of Windsor Financial Corporation; and Vice President (June 1975 to June 1980) of Syntek Corporation. MARY E. MONTAGNINO: Age 35, Secretary (since February 1994). Secretary (since February 1994) of VPT; Secretary and Paralegal (since February 1994) of Tarragon; Paralegal (1989 to February 1994) of BCM; and Paralegal (1984 to 1989) of Southmark. In addition to the foregoing officers, the Trust has other officers who are not listed herein. Compliance with Section 16(a) of the Securities Exchange Act of 1934 Under the securities laws of the United States, the Trust's Trustees, executive officers, and any persons holding more than ten percent of the Trust's shares of beneficial interest are required to report their ownership of the Trust's shares and any changes in that ownership to the Securities and Exchange Commission (the "Commission"). Specific due dates for these reports have been established and the Trust is required to report any failure to file by these dates during 1993. During 1993, all of these filing requirements were satisfied by its Trustees and executive officers and ten percent holders. In making these statements, the Trust has relied on the written representations of its incumbent Trustees and executive officers and its ten percent holders and copies of the reports that they have filed with the Commission. The Advisor Although the Trust's Board of Trustees is directly responsible for managing the affairs of the Trust and for setting the policies which guide it, the day-to-day operations of the Trust are performed by a contractual advisory firm under the supervision of the Trust's Board of Trustees. The duties of the advisor include, among other things, locating, investigating, evaluating and recommending real estate and mortgage note investment and sales opportunities, as well as financing and refinancing sources for the Trust. The advisor also serves as a consultant in connection with the business plan and investment policy decisions made by the Trust's Board of Trustees. CCEC was the sponsor of and original advisor of the Trust. CCEC was replaced as advisor on August 1, 1988, by Consolidated Advisors, Inc. ("CAI"), the parent of CCEC. On December 2, 1988, CCEC filed a petition ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) seeking reorganization under Chapter 11 of the United States Bankruptcy Code in the United States District Court for the Northern District of Texas. Mr. Friedman was a director of CCEC and CAI from March 1988 through January 1989. Mr. Doyle was President, Chief Executive Officer, Chief Operating Officer and sole director of CCEC from April 1989 through October 1990. Southmark was a controlling shareholder of The Consolidated Companies, the parent of CAI, from March 1988 through February 1989. In February 1989, the Trust's Board of Trustees voted to retain BCM as the Trust's advisor. BCM has served as the Trust's advisor since March 1989. Prior to December 22, 1989, Messrs. Phillips and Friedman also served as directors of BCM. Mr. Phillips served as chief executive officer of BCM until September 1, 1992 and Mr. Friedman served as President of BCM until May 1, 1993. BCM is beneficially owned by a trust for the benefit of the children of Mr. Phillips, who served as a Trustee of the Trust until December 7, 1992. At the Trust's annual meeting of shareholders held on April 26, 1993, the Trust's shareholders approved the renewal of the Trust's advisory agreement with BCM. BCM has resigned as advisor to the Trust effective March 31, 1994. On February 10, 1994, the Trust's Board of Trustees selected Tarragon to replace BCM as the Trust's advisor. Commencing April 1, 1994, Tarragon will provide advisory services to the Trust under an advisory agreement. Mr. Friedman serves as a director and Chief Executive Officer of Tarragon. Tarragon is owned by Lucy N. Friedman, Mr. Friedman's wife, and Mr. Doyle, who serves as a director, President and Chief Operating Officer of Tarragon and Trustee and Executive Vice President of the Trust. Mr. Friedman's family owns approximately 30% of the outstanding shares of the Trust. The provisions of the Trust's advisory agreement with Tarragon are substantially the same as to those of the BCM advisory agreement except for the annual base advisory fee and the elimination of the net income fee. The Tarragon advisory agreement calls for an annual base advisory fee of $100,000 plus an incentive advisory fee equal to 16% of the Trust's adjusted funds from operations before deduction of the advisory fee. Adjusted funds from operations is defined as net income (loss) before gains or losses from the sales of properties and debt restructurings plus depreciation and amortization plus any loss due to the writedown or sale of any real property or mortgage loan acquired prior to January 1, 1989. The BCM advisory agreement provided for BCM to be responsible for the day-to-day operations of the Trust and to receive an advisory fee comprised of a gross asset fee of .0625% per month (.75% per annum) of the average of the gross asset value of the Trust (total assets less allowance for amortization, depreciation or depletion and valuation reserves) and an annual net income fee equal to 7.5% per annum of the Trust's net income. ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) Under both the Tarragon and the BCM advisory agreements, the advisor is required to formulate and submit annually for approval by the Trust's Board of Trustees a budget and business plan for the Trust containing a twelve-month forecast of operations and cash flow, a general plan for asset sales or acquisitions, lending, foreclosure and borrowing activity, and other investments, and the advisor is required to report quarterly to the Trust's Board of Trustees on the Trust's performance against the business plan. In addition, all transactions or investments by the Trust shall require prior approval by the Trust's Board of Trustees unless they are explicitly provided for in the approved business plan or are made pursuant to authority expressly delegated to the advisor by the Trust's Board of Trustees. Both the Tarragon and the BCM advisory agreements also require prior approval of the Trust's Board of Trustees for retention of all consultants and third party professionals, other than legal counsel. The advisory agreements provide that the advisor shall be deemed to be in a fiduciary relationship to the Trust's shareholders; contain a broad standard governing the advisor's liability for losses by the Trust; and contain guidelines for the advisor's allocation of investment opportunities as among itself, the Trust and other entities it advises. The advisory agreements also provide for the advisor to receive an annual incentive sales fee equal to 10% of the amount, if any, by which the aggregate sales consideration for all real estate sold by the Trust during such fiscal year exceeds the sum of: (i) the cost of each such property as originally recorded in the Trust's books for tax purposes (without deduction for depreciation, amortization or reserve for losses), (ii) capital improvements made to such assets during the period owned by the Trust and (iii) all closing costs, (including real estate commissions) incurred in the sale of such property; provided, however, no incentive fee shall be paid unless (i) such real estate sold in such fiscal year, in the aggregate, has produced an 8% simple annual return of the Trust's net investment including capital improvements, calculated over the Trust's holding period before depreciation and inclusive of operating income and sales consideration and (ii) the aggregate net operating income from all real estate owned by the Trust for each of the prior and current fiscal years shall be at least 5% higher in the current fiscal year than in the prior fiscal year. Additionally, pursuant to each of the advisory agreements, the advisor or an affiliate of the advisor is to receive an acquisition commission for supervising the acquisition, purchase or long term lease of real estate for the Trust equal to the lesser of (i) up to 1% of the cost of acquisition, inclusive of commissions, if any, paid to nonaffiliated brokers or (ii) the compensation customarily charged in arm's-length transactions by others rendering similar property acquisition services as an ongoing public activity in the same geographical location and for ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) comparable property; provided that the purchase price of each property (including acquisition commissions and all real estate brokerage fees) may not exceed such property's appraised value at acquisition. Each of the advisory agreements require the advisor or any affiliate of the advisor to pay to the Trust one-half of any compensation received from third parties with respect to the origination, placement or brokerage of any loan made by the Trust, provided, however, that the compensation retained by the advisor or any affiliate of the advisor shall not exceed the lesser of (i) 2% of the amount of the loan committed by the Trust or (ii) a loan brokerage and commitment fee which is reasonable and fair under the circumstances. Each of the advisory agreements also provide that the advisor or an affiliate of the advisor is to receive a mortgage or loan acquisition fee with respect to the acquisition or purchase from an unaffiliated party of any existing mortgage or loan by the Trust equal to the lesser of (i) 1% of the amount of the loan purchased or (ii) a loan brokerage or commitment fee which is reasonable and fair under the circumstances. Such fee will not be paid in connection with the origination or funding by the Trust of any mortgage loan. Under each of the advisory agreements, the advisor or an affiliate of the advisor is also to receive a mortgage brokerage and equity refinancing fee for obtaining loans to the Trust or refinancing on Trust properties equal to the lesser of (i) 1% of the amount of the loan or the amount refinanced or (ii) a brokerage or refinancing fee which is reasonable and fair under the circumstances; provided, however, that no such fee shall be paid on loans from the advisor or an affiliate of the advisor without the approval of the Trust's Board of Trustees. No fee shall be paid on loan extensions. Under each of the advisory agreements, the advisor is to receive reimbursement of certain expenses incurred by it in the performance of advisory services to the Trust. Under each of the advisory agreements (as required by the Trust's Declaration of Trust) all or a portion of the annual advisory fee must be refunded by the advisor to the Trust if the Operating Expenses of the Trust (as defined in the Trust's Declaration of Trust) exceed certain limits specified in the Declaration of Trust based on the book value, net asset value and net income of the Trust during such fiscal year. The operating expenses of the Trust did not exceed such limitation in 1991, 1992 or 1993. Additionally, if the Trust were to request that the advisor render services to the Trust other than those required by the advisory agreement, the advisor or an affiliate of the advisor would be separately compensated for such additional services on terms to be agreed upon from time to time. As discussed below under "Property ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) Management," the Trust has hired Carmel, Ltd., an affiliate of BCM, to provide property management services for the Trust's properties. Commencing, April 1, 1994, Tarragon will provide property management services for the Trust's properties. Also as discussed below under "Real Estate Brokerage," the Trust has engaged, on a non-exclusive basis, Carmel Realty, Inc. ("Carmel Realty"), also an affiliate of BCM, to perform brokerage services for the Trust until March 31, 1994. Approval of the renewal of the Tarragon advisory agreement is required by the Trust's shareholders. The advisory agreement may only be assigned with the prior consent of the Trust. The directors and principal officers of BCM are set forth below. MICKEY NED PHILLIPS: Director RYAN T. PHILLIPS: Director OSCAR W. CASHWELL: President and Director of Property and Asset Management KARL L. BLAHA: Executive Vice President and Director of Commercial Management HAMILTON P. SCHRAUFF: Executive Vice President and Chief Financial Officer CLIFFORD C. TOWNS, JR: Executive Vice President, Finance THOMAS A. HOLLAND: Senior Vice President and Chief Accounting Officer DREW D. POTERA: Vice President, Treasurer and Securities Manager ROBERT A. WALDMAN: Vice President, Corporate Counsel and Secretary Mickey Ned Phillips is Gene E. Phillips' brother and Ryan T. Phillips is Gene E. Phillips' son. The directors and principal officers of Tarragon are set forth below: WILLIAM S. FRIEDMAN: Director and Chief Executive Officer JOHN A. DOYLE: Director, President and Chief Operating Officer ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) The Advisor (Continued) CHRIS CLINTON: Senior Vice President TODD MINOR: Senior Vice President JOHN C. STRICKLIN: Senior Vice President CARY L. NEWBURGER: Vice President - General Counsel IVAN ROTH: Treasurer MARY E. MONTAGNINO: Secretary Property Management Since February 1, 1990, affiliates of BCM have provided property management services to the Trust. Currently Carmel, Ltd. provides property management services for a fee of 5% or less of the monthly gross rents collected on the properties under management. In many cases, Carmel, Ltd. subcontracts with other entities for the provision of the property-level management services to the Trust at various rates. The general partner of Carmel, Ltd. is BCM. The limited partners of Carmel, Ltd. are (i) SWI, of which Mr. Phillips is the sole shareholder, (ii) Mr. Phillips and (iii) a trust for the benefit of the children of Mr. Phillips. Carmel, Ltd. subcontracts the property-level management and leasing of eleven of the Trust's commercial properties and the commercial properties owned by two of the real estate partnerships in which the Trust is a partner to Carmel Realty, which is owned by SWI. Carmel, Ltd. has resigned as property manager for the Trust's properties effective March 31, 1994. Commencing April 1, 1994, Tarragon will provide property management services to the Trust for a fee of 4.5% of the monthly gross rents collected on apartment properties and not in excess of 5% of the monthly gross rents collected on commercial properties. Tarragon intends to subcontract with other entities for the provision of most of the property-level management services to the Trust. Real Estate Brokerage Prior to December 1, 1992, affiliates of BCM provided brokerage services to the Trust and received brokerage commissions in accordance with the advisory agreement. Effective December 1, 1992, the Trust's Board of Trustees approved the non-exclusive engagement by the Trust of Carmel Realty to provide brokerage services for the Trust. Such agreement terminates March 31, 1994. Carmel Realty is entitled to receive a real estate acquisition commission for locating and negotiating the lease or purchase by the Trust of any property equal to the lesser of (i) up to 3% of the purchase price, inclusive of commissions, if any, paid by the Trust to other brokers or (ii) the compensation customarily charged in arm's-length transactions by others rendering similar property ITEM 10. TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT (Continued) Real Estate Brokerage (Continued) acquisition services in the same geographical location and for comparable property. Any commission which is paid to Carmel Realty by the seller shall be credited against the commission to be paid by the Trust. Carmel Realty is also entitled to receive a real estate sales commission for the sale of each Trust property equal to the lesser of (i) 3% (inclusive of fees, if any, paid by the Trust to other brokers) of the sales price of each property or (ii) the compensation customarily charged in arm's-length transactions paid by others rendering similar services in the same geographic location for comparable property. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The Trust has no employees, payroll or benefit plans and pays no compensation to the executive officers of the Trust. The Trustees and executive officers of the Trust who are also officers or employees of the Trust's Advisor are compensated by the Advisor. Such affiliated Trustees and executive officers of the Trust perform a variety of services for the Advisor and the amount of their compensation is determined solely by the Advisor. BCM does not allocate the cash compensation of its officers among the various entities for which it serves as advisor. See ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT - The Advisor" for a more detailed discussion of the compensation payable to BCM or Tarragon by the Trust. The only direct remuneration paid by the Trust is to the Trustees who are not officers or directors of BCM or Tarragon or their affiliated companies. The Independent Trustees (i) review the business plan of the Trust to determine that it is in the best interest of the Trust's shareholders, (ii) review the Trust's contract with the advisor, (iii) supervise the performance of the Trust's advisor and review the reasonableness of the compensation which the Trust pays to its advisor in terms of the nature and quality of services performed, (iv) review the reasonableness of the total fees and expenses of the Trust and (v) select, when necessary, a qualified independent real estate appraiser to appraise properties acquired by the Trust. The Independent Trustees receive compensation in the amount of $6,000 per year, plus reimbursement for expenses. In addition, each Independent Trustee receives (i) $3,000 per year for each committee of the Board of Trustees on which he serves, (ii) $2,500 per year for each committee chairmanship and (iii) $1,000 per day for any special services rendered by him to the Trust outside of his ordinary duties as Trustee, plus reimbursement for expenses. During 1993, $128,516 was paid to the Independent Trustees in total Trustees' fees for all services, including the annual fee for service during the period June 1, 1993 through May 31, 1994, and 1993 special service fees: Willie K. Davis, $14,875; Geoffrey C. Etnire, $19,625; Randall K. Gonzalez, $12,750; Dan L. Johnston, $25,250; A. Bob Jordan, $10,042; Raymond V.J. Schrag, $17,500; Bennett B. Sims, $13,500; and Ted P. Stokely, $14,974. ITEM 11. EXECUTIVE COMPENSATION (Continued) Messrs. Davis and Schrag serve on the Fairness Committee of NRLP (for which they each received $4,000 in 1993) whose function is to review certain transactions between NRLP and its general partner and affiliates of such general partner. TMC, a company of which Mr. Gonzalez, a Trustee of the Trust until February 18, 1994, is the Managing Partner and President, provides property-level management services, as a sub-contractor to Carmel, Ltd., for certain properties owned by the Trust. In 1993, TMC earned fees of $58,000 for performing such services. TMC also provides property-level management services, as a subcontractor to Carmel, Ltd., for properties owned by ART, CMET, NOLP and TCI and through April 1993, for a property owned by a partnership which includes IORT and TCI. Christon, a company for which Mr. Gonzalez serves as Vice President, provides property leasing services, as a subcontractor to Carmel, Ltd., to such partnership. Mr. Gonzalez is the son of Al Gonzalez, an ART director not affiliated with BCM. Since January 1, 1993, FMS, a company of which Mr. Davis is Chairman, President and sole shareholder, has been providing property- level management services, as a subcontractor to Carmel, Ltd., for two properties owned by the Trust. In 1993, FMS earned fees of $54,000 for performing such services. During 1993, Mr. Jordan performed legal services for BCM and its affiliates, as well as for ART, TCI and the Trust. The Trust paid Mr. Jordan $4,000 in legal fees and cost reimbursements in 1993. The Trust believes that such fees received by FMS, TMC and Mr. Jordan were at least as favorable to the Trust as those that would be paid to unaffiliated third parties for the performance of similar services. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 11. EXECUTIVE COMPENSATION (Continued) Performance Graph The following performance graph compares the cumulative total shareholder return on the Trust's shares of beneficial interest with the Standard & Poor's 500 Stock Index ("S&P 500 Index") and the National Association of Real Estate Investment Trusts, Inc. Hybrid REIT Total Return Index ("REIT Index"). The comparison assumes that $100 was invested on December 30, 1988 in the Trust's shares of beneficial interest and in each of the indices and further assumes the reinvestment of all dividends. Past performance is not necessarily an indicator of future performance. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Security Ownership of Certain Beneficial Owners. The following table sets forth the ownership of the Trust's shares of beneficial interest, both beneficially and of record, both individually and in the aggregate for those persons or entities known by the Trust to be beneficial owners of more than 5% of its shares of beneficial interest as of the close of business on March 11, 1994. - --------------- (1) Percentages are based upon 3,088,663 shares of beneficial interest outstanding at March 11, 1994. (2) Includes 12,612 shares owned by Lucy N. Friedman's husband, William S. Friedman. (3) Includes 609,595 shares owned by Lucy N. Friedman. In addition, includes 44,512 shares and 44,259 shares owned by Lucy N. Friedman's minor sons, Gideon and Samuel Friedman. Lucy Friedman has control of such shares. (4) Does not include 49,894 shares owned by Lucy N. Friedman's adult son, Ezra Friedman, and 48,190 shares owned by Lucy N. Friedman's adult daughter, Tanya Friedman. Mrs. Friedman disclaims beneficial ownership of such shares. (5) Includes 23,942 shares owned by a trust for the benefit of the children and grandchildren of Samuel Friedman, deceased, William S. Friedman's father, for which Robert A. Friedman and Gerald C. Friedman, siblings of William S. Friedman and Ruth Friedman, his mother, are the trustees. Lucy N. Friedman disclaims beneficial ownership of such shares. (6) Includes 33,000 shares owned by Tarragon Capital Corporation, of which Lucy N. Friedman and William S. Friedman are executive officers and directors and 34,466 shares owned by Tarragon Partners, Ltd., of which Lucy N. Friedman and William S. Friedman are limited partners. Mrs. Friedman disclaims beneficial ownership of such shares. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (Continued) Security Ownership of Management. The following table sets forth the ownership of the Trust's shares of beneficially interest, both beneficially and of record, both individually and in the aggregate for the Trustees and executive officers of the Trust as of the close of business on March 11, 1994. - --------------- * Less than 1%. (1) Percentages are based upon 3,088,663 shares of beneficial interest outstanding at March 11, 1994. (2) Includes 28,968 shares held by a trust for the benefit of the children of Gene E. Phillips for which William S. Friedman is the trustee. Mr. Friedman disclaims beneficial ownership of such shares. Mr. Friedman also owns 12,612 shares of beneficial interest personally. (3) Includes 609,595 shares owned by William S. Friedman's wife, Lucy Friedman. Mr. Friedman disclaims beneficial ownership of such shares. In addition, includes 44,512 shares and 44,259 shares owned by William S. Friedman's minor sons, Gideon and Samuel Friedman. Lucy Friedman has control of such shares. Mr. Friedman disclaims beneficial ownership of such shares. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (Continued) (4) Does not include 49,894 shares owned by William S. Friedman's adult son, Ezra Friedman, and 44,259 shares owned by William S. Friedman's adult daughter, Tanya Friedman. Mr. Friedman disclaims beneficial ownership of such shares. (5) Includes 23,942 shares owned by a trust for the benefit of the children and grandchildren of Samuel Friedman, deceased, William S. Friedman's father, for which Robert A. Friedman and Gerald C. Friedman, siblings of William S. Friedman and Ruth Friedman, his mother, are the trustees. Mr. Friedman disclaims beneficial ownership of such shares. (6) Includes 33,000 shares owned by Tarragon Capital Corporation, of which Lucy N. Friedman, William S. Friedman and John A. Doyle are executive officers and directors. (7) Includes 34,466 shares owned by Tarragon Partners, Ltd., of which Lucy N. Friedman and William S. Friedman are limited partners. Mr. Friedman disclaims beneficial ownership of such shares. (8) Includes 69,903 shares owned by CMET of which Messrs. Davis, Etnire, Johnston, Jordan, Schrag, Sims and Stokely may be deemed to be beneficial owners by virtue of their positions as CMET trustees. (9) Includes 76,923 shares in which Mr. Doyle has beneficial interest as a result of a $1.0 million subordinated debenture which is convertible to 76,923 of the Trust's shares. John A. Doyle also owns 2,860 shares personally. (10) Raymond V.J. Schrag owns 2,750 shares personally. (THIS SPACE INTENTIONALLY LEFT BLANK.) ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Certain Business Relationships In February 1989, the Trust's Board of Trustees voted to retain BCM as the Trust's advisor as discussed in ITEM 10. "TRUSTEES, EXECUTIVE OFFICERS AND ADVISOR OF THE REGISTRANT - The Advisor." BCM is a corporation of which Messrs. Cashwell, Blaha, Schrauff and Holland serve as executive officers. Messrs. Phillips and Friedman served as directors of BCM until December 22, 1989. Mr. Phillips served as Chief Executive Officer of BCM until September 1, 1992 and Mr. Friedman served as President of BCM until May 1, 1993. BCM is beneficially owned by a trust for the benefit of the children of Mr. Phillips. On February 10, 1994, the Trust's Board of Trustees selected Tarragon to replace BCM as the Trust's advisor. Commencing April 1, 1994, Tarragon will be providing advisory services to the Trust under an advisory agreement. Mr. Friedman serves as director and Chief Executive Officer of Tarragon. Tarragon is owned by Lucy N. Friedman, Mr. Friedman's wife, and Mr. Doyle, who serves as President and Chief Operating Officer of Tarragon and Trustee and Executive Vice President of the Trust. Mr. Friedman's family owns approximately 30% of the outstanding shares of the Trust. Also on February 10, 1994, VPT's Board of Trustees selected Tarragon to replace BCM as VPT's advisor commencing March 1, 1994. Messrs. Davis, Doyle, Friedman, Johnson, Schrag, Sims and Weisbrod, Trustees of the Trust, serve as trustees of VPT. Tarragon occupies office space at VPT's One Turtle Creek Office/Retail Complex, which serves as the Trust's executive offices. Since February 1, 1990, affiliates of BCM have provided property management services to the Trust. Currently, Carmel, Ltd. provides property management services for a fee of 5% or less of the monthly gross rents collected on the properties under management. In many cases, Carmel, Ltd. subcontracts with other entities for the property-level management services to the Trust at various rates. The general partner of Carmel, Ltd. is BCM. The limited partners of Carmel, Ltd. are (i) SWI, of which Mr. Phillips is the sole shareholder, (ii) Mr. Phillips and (iii) a trust for the benefit of the children of Mr. Phillips. Carmel, Ltd. subcontracts the property-level management and leasing of eleven of the Trust's commercial properties and the commercial properties owned by two of the real estate partnerships in which the Trust is a partner to Carmel Realty, which is owned by SWI. Carmel, Ltd. resigned as property manager for the Trust's properties effective March 31, 1994. Commencing April 1, 1994, Tarragon will provide property management services to the Trust. Prior to December 1, 1992, affiliates of BCM provided brokerage services to the Trust and received brokerage commissions in accordance with the advisory agreement. Effective December 1, 1992, the Trust engaged Carmel Realty, on a non-exclusive basis, to provide brokerage services for the Trust. Carmel Realty is owned by SWI. Such agreement terminates March 31, 1994. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Certain Business Relationships (Continued) The Trustees, with the exception of Messrs. Etnire, Jordan and Stokely, and the officers of the Trust serve as trustees and officers of VPT. The Trustees, with the exception of Messrs. Friedman, Doyle and Weisbrod, also serve as trustees or directors of CMET, IORT and TCI. The Trust's Trustees owe fiduciary duties to such entities as well as to the Trust under applicable law. VPT has the same relationship with Tarragon as the Trust. CMET, IORT and TCI have the same relationships with BCM as the Trust. Mr. Phillips is the general partner and until March 4, 1994, Mr. Friedman was a general partner of the general partner of NRLP and NOLP. BCM performs certain administrative functions for NRLP and NOLP on a cost-reimbursement basis. BCM also serves as advisor to ART. Messrs. Phillips and Friedman served as executive officers and directors of ART until November 16, 1992 and December 31, 1992, respectively. As discussed in ITEM 11. "EXECUTIVE COMPENSATION," Messrs. Davis and Schrag serve on the Fairness Committee of NRLP, whose function is to review certain transactions between NRLP and its general partner and affiliates of such general partner. TMC, a company of which Mr. Gonzalez, a trustee of the Trust until February 18, 1994, is the Managing Partner and President, provides property-level management services as a subcontractor to Carmel, Ltd. for certain properties owned by ART, CMET, NOLP, TCI and the Trust and through April 30, 1993, for a property owned by a partnership which includes IORT and TCI. Christon, a company of which Mr. Gonzalez serves as Vice President, provides property leasing services, as a subcontractor to Carmel, Ltd., for such partnership property. Mr. Gonzalez is the son Al Gonzalez, a director of ART not affiliated with BCM. From April 1992 to December 31, 1993, Mr. Stokely was employed as a Real Estate Consultant for Eldercare, a nonprofit corporation engaged in the acquisition of low income and elderly housing. Eldercare has a revolving loan commitment from SWI which is owned by Mr. Phillips and affiliated with BCM. In addition, in November 1991, the Trust funded a $230,000 loan to Eldercare. Eldercare filed for bankruptcy protection in October 1993. At December 31, 1993, the Trust's loan to Eldercare was in default. During 1993, Mr. Jordan performed legal services for BCM and its affiliates, as well as for TCI, ART and the Trust. Related Party Transactions Historically, the Trust has engaged in and may continue to engage in business transactions, including real estate partnerships, with related parties. All related party transactions entered into by the Trust must be approved by a majority of the Trust's Board of Trustees, including a majority of the Independent Trustees. In addition, the Related Party Transaction Committee of the Trust's Board of Trustees must review all such transactions prior to their submission to the Trust's Board of Trustees for consideration. The Trust's management believes that all of ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Related Party Transactions (Continued) the related party transactions represented the best investments available at the time and were at least as advantageous to the Trust as could have been obtained from unrelated third parties. As more fully described in ITEM 2. "PROPERTIES - Real Estate", the Trust is a partner with CMET in the Sacramento Nine and Adams Properties Associates partnerships. On December 10, 1990, the Trust's Board of Trustees, based on the recommendation of its Related Party Transaction Committee, authorized the purchase of up to $1.0 million of the shares of beneficial interest of CMET through negotiated or open market transactions. At December 31, 1993, the Trust owned 54,500 shares of beneficial interest of CMET which it purchased in 1990 and 1991 through open market transactions, at a total cost to the Trust of $250,000. At December 31, 1993, the aggregate market value of the CMET shares was $702,000. See ITEM 2. "PROPERTIES - Equity Investment in REIT." In December 1993, the Trust's Board of Trustees approved the issuance of a $1.0 million convertible subordinated debenture to Mr. Doyle, Trustee and Executive Vice President of the Trust since February 1994, in exchange for his 10% participation in the profits of the Consolidated Capital Properties II ("CCP II") assets, which the Trust had acquired in November 1992. This participation was granted as consideration for Mr. Doyle's services to the Trust in connection with the CCP II portfolio. The debenture bears interest at a rate of 6% per annum, matures in five years and is convertible into 76,923 of the Trust's shares of beneficial interest. Mr. Doyle also serves as Director, President and Chief Operating Officer and is a 50% shareholder of Tarragon Realty Advisors, Inc. ("Tarragon"), the Trust's advisor commencing April 1, 1994. See NOTE 4. "REAL ESTATE AND DEPRECIATION." In 1993, the Trust paid BCM and its affiliates $1.5 million in advisory fees, $21,000 in real estate and mortgage brokerage commissions and $360,000 in property management fees and leasing commissions. In addition, as provided in the Advisory Agreement, BCM received cost reimbursements from the Trust of $627,000 in 1993. Restrictions on Related Party Transactions The Trust's Declaration of Trust provides that: "(t)he Trustees shall not . . . purchase, sell or lease any Real Properties or Mortgages to or from . . . the Advisor or any of (its) Affiliates," and that "(t)he Trustees shall not . . . make any loan to . . . the Advisor or any of (its) Affiliates." ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Restrictions on Related Party Transactions (Continued) Moreover, the Declaration of Trust further provides that: (t)he Trust shall not purchase or lease, directly or indirectly, any Real Property or purchase any Mortgage from the Advisor or any affiliated Person, or any partnership in which any of the foregoing may also be a general partner, and the Trust will not sell or lease, directly or indirectly, any of its Real Property or sell any Mortgage to any of the foregoing Persons." The Declaration of Trust further provides that "the Trust shall not directly or indirectly, engage in any transaction with any Trustee, officer or employee of the Trust or any director, officer or employee of the Advisor . . . or of any company or other organization of which any of the foregoing is an Affiliate, except for . . . (among other things) transactions with . . . the Advisor or Affiliates thereof involving loans, real estate brokerage services, real property management services, the servicing of Mortgages, the leasing of real or personal property, or other services, provided such transactions are on terms not less favorable to the Trust than the terms on which nonaffiliated parties are then making similar loans or performing similar services for comparable entities in the same area and are not entered into on an exclusive basis. The Declaration of Trust defines "Affiliate" as follows: (A)s to any Person, any other Person who owns beneficially, directly, or indirectly, 1% or more of the outstanding capital stock, shares, or equity interests of such Person or of any other Person which controls, is controlled by, or is under common control with, such Person or is an officer, retired officer, director, employee, partner, or trustee (excluding independent trustees not otherwise affiliated with the entity) of such Person or of any other Person which controls, is controlled by, or is under common control with, such Person. The Declaration of Trust further provides that: The Trustees shall not...invest in any equity Security, including the shares of other REITs for a period in excess of 18 months, except for shares of a qualified REIT subsidiary, as defined in Section 856(i) of the Internal Revenue Code, and regular or residual interests in REMICs...(or) acquire Securities in any company holding investments or engaging in activities prohibited by this Section... As discussed in "Related Party Transactions," above, since September 1990, the Trust has invested in shares of CMET. As of March 11, 1994, the Trust owned 54,500 shares of CMET. CMET has the same advisor as the Trust and certain of its Trustees are also trustees of CMET. As noted above, under the terms of its Declaration of Trust, the Trust is prohibited from investing in equity securities for a period in excess of 18 months. The Trust's shareholders approved an amendment to the Trust's Declaration of Trust allowing the Trust to hold these shares of CMET until July 30, 1996. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (Continued) Restrictions on Related Party Transactions (Continued) All related party transactions that the Trust may enter into must be reviewed by the Related Party Transaction Committee of the Trust's Board of Trustees to determine whether such transactions are (i) fair to the Trust and (ii) are permitted by the Trust's governing documents. Each of the members of the Related Party Transaction Committee is a Trustee who is not an officer, director or employee of the Trust's advisor, BCM or Tarragon, and is not an officer or employee of the Trust. ____________________________________ PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Report: 1. Consolidated Financial Statements Report of Independent Certified Public Accountants Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Operations - Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity - Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Financial Statement Schedules Schedule X - Supplementary Income Statement Information Schedule XI - Real Estate and Accumulated Depreciation Schedule XII - Mortgage Loans on Real Estate All other schedules are omitted because they are not applicable or because the required information is shown in the Consolidated Financial Statements or the notes thereto. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (Continued) 3. Exhibits The following documents are filed as Exhibits to this report: Exhibit Number Description - ------- ----------- 3.1 Second Amended and Restated Declaration of Trust (incorporated by reference to the Registrant's Current Report on Form 8- K dated August 14, 1987). 3.2 Amendment No. 1 to the Second Amended and Restated Declaration of Trust, (incorporated by reference to the Registrant's Current Report on Form 8-K dated July 5, 1989) reporting change in name of Trust. 3.3 Amendment No. 2 to the Second Amended and Restated Declaration of Trust, (incorporated by reference to the Registrant's Current Report on Form 8-K dated March 22, 1990,) reporting deletion of liquidation provisions. 3.4 Amendment No. 3 to the Second Amended and Restated Declaration of Trust, (incorporated by reference to the Registrant's Current Report on Form 8-K dated June 3, 1992) reporting the extension of the holding period of the Trust's marketable equity securities. 3.5 Restated Trustees' Regulations dated as of April 21, 1989, (incorporated by reference to the Registrant's Current Report on Form 8-K dated March 24, 1989). 10.1 Advisory Agreement dated as of December 1, 1992, between National Income Realty Trust and Basic Capital Management, Inc. (incorporate by reference to Exhibit No. 10.2 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.2 Brokerage Agreement dated as of December 1, 1992, between National Income Realty Trust and Carmel Realty, Inc. (incorporated by reference to Exhibit No. 10.3 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992). 10.3 Advisory Agreement dated as of February 15, 1994, between National Income Realty Trust and Tarragon Realty Advisors, Inc. (incorporated by reference to Exhibit No. 10 to the Registrant's Current Report on Form 8-K dated February 10, 1994). ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K (Continued) (b) Reports on Form 8-K. A Current Report on Form 8-K, dated November 10, 1993, was filed with respect to Item 5, which reports the confirmation of the Plan of Reorganization of the Century Centre II Office Building. A Current Report on Form 8-K, dated February 10, 1994, was filed with respect to Item 5, which reports the selection of Tarragon Realty Advisors, Inc. as the new advisor to the Registrant. 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. NATIONAL INCOME REALTY TRUST Dated: March 30, 1994 By: /s/ William S. Friedman William S. Friedman President, Chief Executive Officer and Trustee 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 date indicated. By: /s/ Willie K. Davis By: /s/ A. Bob Jordan Willie K. Davis A. Bob Jordan Trustee Trustee By: /s/ John A. Doyle By: /s/ Raymond V. J. Schrag John A. Doyle Raymond V. J. Schrag Trustee and Executive Vice President Trustee By: By: /s/ Bennett B. Sims Geoffrey C. Etnire Bennett B. Sims Trustee Trustee By: /s/ William S. Friedman By: /s/ Ted P. Stokely William S. Friedman Ted P. Stokely President, Chief Executive Officer Trustee and Trustee By: /s/ Dan L. Johnston By: /s/ Carl Weisbrod Dan L. Johnston Carl Weisbrod Trustee Trustee By: /s/ Ivan Roth Ivan Roth Treasurer and Chief Financial Officer Dated: March 30, 1994

726601_1993.txt

726601_1993

1993

726601

Item 1. Business 3 Item 2. Item 2. Properties Capital City Bank Group, Inc., is headquartered in Tallahassee, Florida. The Company's offices are in the First National Bank building located on the corner of Tennessee and Monroe Streets in downtown Tallahassee. The building is owned by First National Bank but is located, in part, on land leased under a long-term agreement. City National's main office is located on land leased from the Smith Interest General Partnership in which several directors and officers have an interest. Lease payments during 1993 totalled approximately $51,900. As of March 1, 1994, the Company had 30 banking locations. Of the 30 locations, the Company leases either the land or buildings (or both) at 8 locations and owns the land and buildings at the remaining 22. Item 3. Item 3. Legal Proceedings Not Applicable Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not Applicable PART II Item 5. Item 5. Market for the Registrant's Securities and Related Stockholder Matters There is currently no established trading market for the common stock of Capital City Bank Group, Inc., and therefore, no bid or sale quotations are generally available. Based on sales of stock of which the Company has knowledge, the stock has traded in a range of $24.00 to $26.00 per share for the two-year period ended December 31, 1993, with the most recent trades at $26.00 per share. Item 6. Item 6. Selected Financial And Other Data For the Years Ended December 31, 1993 1992 1991 1990 1989 (Dollars in Thousands, Except Per Share Data) Interest Income $ 46,395 $48,306 $54,801 $58,527 $58,913 Net Interest Income 31,555 29,775 28,195 27,851 27,444 Provision for Loan Losses 960 1,216 1,817 3,342 2,447 Income Before Accounting Change 8,728 8,376 7,272 6,590 7,234 Net Income 8,244 8,376 7,272 6,590 7,234 Per Common Share: Income Before Accounting Changes $ 2.99 $ 2.86 $ 2.46 $ 2.16 $ 2.33 Net Income 2.82 2.86 2.46 2.16 2.33 Cash Dividends Declared .83 .78 .73 .69 .65 Book Value 23.56 21.59 19.55 17.89 16.76 Based on Net Income: Return on Average Assets Before Accounting Change 1.21% 1.27% 1.15% 1.05% 1.18% Return on Average Assets 1.14 1.27 1.15 1.05 1.18 Return on Average Equity Before Accounting Change 13.15 13.71 13.07 12.25 14.48 Return on Average Equity 12.43 13.71 13.07 12.25 14.48 Dividend Payout Ratio 29.44 27.25 29.65 31.50 27.72 Averages for the Year: Loans, Net of Unearned Interest $381,807 $358,876 $368,555 $378,405 $379,939 Earning Assets 651,042 598,127 571,165 561,741 550,638 Assets 722,286 662,150 633,963 624,732 614,335 Deposits 630,324 573,162 546,291 537,774 527,524 Long-Term Debt 1,381 3,156 5,555 5,703 7,368 Shareholders' Equity 66,328 61,078 55,635 53,791 49,949 Year-End Balances: Loans, Net of Unearned Interest $399,424 $369,911 $364,773 $380,127 $380,828 Earning Assets 675,273 619,929 568,720 555,237 556,782 Assets 762,335 686,966 639,540 643,968 626,047 Deposits 662,745 597,497 555,092 550,336 536,950 Long-Term Debt 1,900 2,000 4,000 6,225 6,000 Shareholders' Equity 67,140 63,169 57,723 53,444 51,956 Equity to Assets Ratio 8.81% 9.20% 9.03% 8.30% 8.30% Other Data: Average Shares Outstanding 2,924,022 2,932,123 2,958,920 3,049,992 3,103,535 Shareholders of Record* 754 748 731 727 734 Banking Locations* 30 27 27 26 26 Full-Time Equivalent Employees* 476 466 469 489 478 *As of March 1st of the following year. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Review This section provides supplemental information which should be read in conjunction with the consolidated financial statements and related notes. The Financial Review is divided into three subsections entitled Earnings Analysis, Financial Condition, and Liquidity and Capital Resources. Information therein should facilitate a better understanding of the major factors and trends which affect the Company's earnings performance and financial condition, and how the Company's performance during 1993 compares with prior years. Throughout this section, Capital City Bank Group, Inc., and its subsidiaries, collectively, are referred to as "CCBG" or the "Company". The year-to-date averages used in this report are based on daily balances for each respective year. In certain circumstances comparing average balances for the fourth quarter of consecutive years may be more meaningful than simply analyzing year-to-date averages. Therefore, where appropriate, fourth quarter averages have been presented for analysis and have been clearly noted as such. Earnings Analysis In 1993, the Company's earnings were $8.7 million, or $2.99 per share, before accounting for the adoption of Statement of Financial Accounting Standards No. 109 ("Accounting for Income Taxes"), which resulted in a one-time, non-cash charge of $484,000, or $.17 per share. This compares with earnings of $8.4 million, or $2.86 per share in 1992, and $7.3 million, or $2.46 per share in 1991. On a per share basis, before the effect of the accounting change, earnings increased 4.5% in 1993 versus an increase of 16.3% in 1992. Factors, other than the accounting change, which had a significant impact on the Company's earnings in 1993, as compared to 1992, include: * Higher average earning assets resulted in an increase in net interest income of $1.8 million, or 6.0%. * Improving asset quality and a low level of net charge-offs enabled the Company to reduce the provision for loan losses by $256,000, or 21.0%. * Higher volume in mortgage originations and gains on the sale of other real estate served to boost noninterest income $536,000, or 4.7%. * The Company's expansion into Citrus County, adding three new locations, contributed to an increase in noninterest expense of $2.1 million, or 7.3%. These and other factors are discussed throughout the Financial Review. A condensed earnings summary is presented in Table 1. Table 1 CONDENSED SUMMARY OF EARNINGS (Dollars in Thousands) For the Years Ended December 31, 1993 1992 1991 Interest and Dividend Income $46,395 $48,306 $54,801 Taxable-Equivalent Adjustments 1,663 1,583 1,567 48,058 49,889 56,368 Interest Expense 14,840 18,531 26,606 Net Interest Income 33,218 31,358 29,762 Provision for Loan Losses 960 1,216 1,817 Taxable-Equivalent Adjustments 1,663 1,583 1,567 Noninterest Income 12,014 11,478 10,814 Noninterest Expense 30,572 28,497 27,440 Income Before Income Taxes 12,037 11,540 9,752 Income Taxes 3,309 3,164 2,480 Income Before Accounting Change 8,728 8,376 7,272 Cumulative Effect of Accounting Change (484) -- -- Net Income $ 8,244 $8,376 $7,272 Income Per Share Before Accounting Change $ 2.99 $ 2.86 $ 2.46 Net Income Per Share $ 2.82 $ 2.86 $ 2.46 Net Interest Income Net interest income represents the Company's single largest source of earnings and is equal to interest income and fees generated by earning assets less interest expense paid on interest bearing liabilities. An analysis of the Company's net interest income, including average yields and rates, is presented in Tables 2 and 3. This information is presented on a "taxable-equivalent" basis to reflect the tax-exempt status of income earned on certain loans and investments, the majority of which are state and local government debt obligations. In 1993, taxable-equivalent net interest income increased $1.9 million, or 5.9%. This follows an increase of $1.6 million, or 5.4%, in 1992 and $249,000, or .8%, in 1991. During the period 1991 through 1993, higher levels of earning assets and a more favorable mix of funding sources have served to increase the Company's taxable-equivalent net interest income. Interest rates, in general, have trended downward in recent years. Since the first quarter of 1991, the prime rate has declined from 10.0% to 6.0% and the Federal Reserve Bank's discount rate has fallen from 6.5% to 3.0%. In 1993 both rates were stable at 6.0% and 3.0%, respectively. The Company's taxable-equivalent yield on average earning assets decreased 96 basis points in 1993 from 8.36% to 7.40%, and 152 basis points in 1992 from 9.88% to 8.36%. The lower yields are reflective of declining interest rates and sluggish loan volume. As the Company's interest sensitive assets mature and/or reprice, the lower rates adversely impact the portfolio yields. Additionally, the loan portfolio, which is the largest and highest yielding component of earning assets, has declined from 64.5% of earning assets in 1991 to 58.6% in 1993, reflecting a weakened economy. However, management is encouraged by some improvement in loan volume during the latter part of 1993. The average rate paid on interest bearing liabilities in 1993 was 2.97% versus 3.97% in 1992 and 5.85% in 1991. Lower interest rates and a more favorable deposit mix were the primary factors contributing to the reduction in the average rate. Noninterest bearing deposits increased from 21.5% of the Company's average deposits in 1991 to 23.7% in 1993, while other time deposits (i.e., certificates of deposit) decreased from 45.0% to 33.1%, over the same period. The Company's interest rate spread (defined as the taxable-equivalent yield on average earning assets less the average rate paid on interest bearing liabilities) increased 4 basis points in 1993 and 36 basis points in 1992. Improvement in the interest rate spread reflects declining interest rates and a more rapid repricing of interest sensitive liabilities versus earning assets. The Company's net interest margin (defined as taxable-equivalent interest income less interest expense divided by average earning assets) fell to 5.11% in 1993, from 5.26% in 1992 and 5.23% in 1991. These relatively strong margins will be difficult to maintain, particularly in light of the continuing pressure on the pricing and/or repricing of assets. Continued strengthening in the economy and opportunities to profitably employ investable funds in the loan portfolio without compromising credit quality, will be key to management's ability to maintain strong margins in 1994. A further discussion of the Company's earning assets and funding sources can be found in the section entitled "Financial Condition". Provision for Loan Losses The provision for loan losses was $960,000 in 1993 versus $1.2 million in 1992 and $1.8 million in 1991. The decrease over this period is attributable to a reduction in net charge-offs and a reserve which management considers to be adequate based on the current level of nonperforming loans and the potential for loss inherent in the portfolio at year-end. The provision in 1993 enabled the Company to cover net charges to the allowance for loan losses and to maintain the level of the allowance at 1.9% of outstanding loans. See the section entitled "Financial Condition" for further discussion regarding the allowance for loan losses. Selected loss coverage ratios are presented below: 1993 1992 1991 Provision for Loan Losses as a Multiple of Net Charge-offs 1.0x 0.9x 1.1x Pre-tax Income Plus Provision for Loan Losses as Multiple of Net Charge-offs 13.7x 9.8x 6.9x Noninterest Income Noninterest income increased $536,000, or 4.7%, in 1993 compared with $665,000, or 6.1%, in 1992. Factors affecting noninterest income are discussed below. Trust fees increased $60,000, or 10.3%, in 1993, due to growth in assets under management. Trust assets totalled $336.9 million at December 31, 1993. Assets under management grew $18.3 million, or 25.3%, in 1993, to a total of $90.7 million. Trust fees increased $98,000, or 20.3%, in 1992, reflecting growth of $12.6 million, or 21.1%, in assets under management and repricing of certain services. Service charges on deposit accounts decreased $51,000, or 0.9%, in 1993, compared to an increase of $111,000, or 2.0%, in 1992. Service charge revenues in any one year are dependent on the number of accounts, primarily transaction accounts, and the level of activity subject to service charges. Data processing revenues were down $66,000, or 2.7%, in 1993 versus an increase of $213,000, or 9.5%, in 1992. The data processing center provides computer services to both financial and non-financial clients in North Florida and South Georgia. For the year ended December 31, 1993, services provided to non- financial clients represented 50% of total revenues, which was down slightly from 52.2% in 1992. The decrease in 1993 is primarily attributable to repricing of certain servicing agreements. The increase in 1992 is attributable to the growth in services provided to non-financial entities. Net securities gains recognized during 1993 totalled $28,000, versus a loss of $2,000 in 1992. The net gain in 1993 consisted of gross gains of $69,000 and losses of $41,000. All gains and losses recognized in 1993 were related to the redemption of principal from mortgage-backed securities and bonds which were called during the year. See Notes 1 and 5 in the Notes to Financial Statements for additional information on the Company's investment portfolio and recognition of gains and losses. Other noninterest income increased $562,000, or 20.1%, in 1993 versus $250,000, or 9.8% in 1992. The Company originates residential mortgage loans to sell in the secondary market. Significant increases in origination volume generated fee increases of $477,000, or 93.8%, and $315,000, or 159.2%, in 1993 and 1992, respectively. Gains on the sale of other real estate totalled $225,000 and was up slightly over the prior year. Noninterest income as a percent of average earning assets represented 1.85% in 1993 compared to 1.92% in 1992 and 1.89% in 1991. Noninterest Expense Total noninterest expense for 1993 was $30.6 million, an increase of $2.1 million, or 7.3%, over 1992. This followed an increase of $1.1 million, or 3.9%, in 1992. The most significant factor impacting the Company's noninterest expense during 1993 was expansion into Citrus County through the acquisition of branch offices. The acquisition was consummated on March 15, adding three new office locations and increasing deposits by $37.0 million. The Company's compensation expense totalled $16.2 million, an increase of $1.6 million, or 11.4%, over 1992. There were several factors which impacted the Company's compensation expense, including addition of the three Citrus County offices which added 13 new employees, higher pension expense and implementation of the Company's stock incentive plan. Management has revised the interest rate assumptions incorporated in the pension plan to reflect the lower interest rate environment. Lower rates reduced projected earnings on the plan assets and increased current funding requirements, both of which result in higher pension expense. Management anticipates rate assumptions will require revision again in 1994. Nineteen ninety-three was the first year the Company incurred stock compensation expense as plan participants became eligible to earn shares under the Company's 1992 Stock Incentive Plan. The 1993 expense reflects the cost of shares earned in 1993, plus an allocation of expense for shares eligible for issuance if specified long-term goals are achieved in future years. The Company's compensation expense totalled $14.5 million in 1992, an increase of $485,000, or 3.5%, over 1991. The increase in 1992 is attributable to normal raises and higher pension expense. Occupancy expense (including furniture, fixtures & equipment) was up by $207,000 (4.2%) and $200,000 (4.3%) in 1993 and 1992, respectively. These increases are primarily attributable to an increase in the number of operating facilities and maintenance of existing locations. Other noninterest expense increased $215,000, or 2.4%, in 1993, compared to an increase of $372,000, or 4.3%, in 1992. The increase in 1993 is primarily attributable to expenses associated with the opening of the three new offices. Offsetting a significant portion of the increase due to expansion was a reduction of $497,000 in the costs associated with other real estate, including write-downs and related expenses. The increase in 1992 is attributable to higher costs associated with other real estate holdings, which increased, in aggregate, $475,000 over 1991. Net noninterest expense (defined as noninterest income minus noninterest expense) as a percentage of average earning assets was 2.85% in 1993 compared to 2.85% in 1992 and 2.90% in 1991. Income Taxes The consolidated provision for federal and state income taxes was $3.3 million in 1993 compared to $3.2 million in 1992 and $2.5 million in 1991. The increases in the tax provision over the last three years is primarily attributable to the higher level of taxable income. The effective tax rate was 27.5% in 1993, 27.4% in 1992 and 25.4% in 1991. These rates differ from the statutory tax rates due primarily to tax-exempt income. The increase in the effective tax rate from 1991 to 1992 is attributable to the decreasing level of tax-exempt income relative to pre-tax income. Tax-exempt income (net of the adjustment for disallowed interest) as a percent of pre-tax income was 26.8% in 1993, 26.6% in 1992 and 31.2% in 1991. Change in Accounting Principle On January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", which changed the method of accounting to the "liability" method from the "deferred" method previously required by Accounting Principles Board Opinion No. 11. The cumulative effect of adopting the new accounting standard was a reduction in the Company's net income of $484,000, which was recognized in the first quarter. See Note 1 in the Notes to Financial Statements. Financial Condition Average assets increased $60.1 million (9.1%) from $662.2 million in 1992 to $722.3 million in 1993. Average earning assets increased to $651.0 million in 1993, a $52.9 million, or 8.8% increase over 1992. Slower loan growth in 1991 and 1992 resulted in a decrease in average loans of $9.9 million, or 2.6% in 1991 and $9.7 million, or 2.6% in 1992. In 1993, while still sluggish, loan volume began to improve and the Citrus County acquisitions added $12.0 million in loans, resulting in an increase in average loans of $22.9 million, or 6.4%. In addition to funding loan growth, the majority of the Company's deposit growth, including $44 million in acquired deposits, was used to fund growth in the investment portfolio. During 1993, the Company significantly increased its investment in taxable and tax-exempt securities, extending maturities to take advantage of more favorable yields. In making the determination as to how investable funds are to be allocated, management takes into consideration market yields and the Company's liquidity position. The Company's average investment portfolio increased $38.0 million, or 22.7%, during 1993. This followed an increase of $41.9 million, or 33.4%, in 1992. In 1993, average taxable investments increased $24.5 million, or 21.2%, while tax- exempt investments increased $13.5 million, or 26.0%. Since the enactment of the Tax Reform Act of 1986, which significantly reduced the tax benefits associated with tax-exempt investments, management has monitored the level of tax-exempt investments and, until 1992, has consistently reduced its holdings. Even with the growth in tax-exempt investments in 1992 and 1993, the tax-exempt portfolio as a percent of average earning assets has declined from 18.9% in 1986 to 10.0% in 1993. Table 2 on page 15 provides information on average balances while Table 4 highlights the changing mix of the Company's earning assets over the last three years. Loans In the last few years new loan volume has been sluggish, though in the last half of 1993 loan activity began to increase. Loan growth has been impacted by a number of factors including general economic conditions, particularly in the real estate market; continued emphasis on credit quality and an effort by the State of Florida to control growth. At the local level, consumer spending has been adversely affected by slowing employment growth by the State in addition to a general slowdown in economic growth. Florida communities are still adjusting to new land development rules, which have created dislocations in the real estate markets. Counties which are served by the Group banks have adopted comprehensive plans, mandated by the State, which require certain infrastructure to be in place before development can begin. This effort by the State to control growth is having the effect, at least in the near-term, of significantly restricting development in certain markets. The general deterioration in economic conditions, particularly in the real estate market, during the period 1990 to 1993, has resulted in refinement of underwriting standards and a sharper focus on credit quality. Lending is a major component of the Company's business and is key to profitability. While management strives to grow the Company's loan portfolio, it can do so only by adhering to sound banking principles applied in a prudent and consistent manner. Management is hopeful 1994 will show signs of economic improvement, affording opportunities to increase loans outstanding and enhance the portfolio's overall contribution to earnings. The composition of the Company's loan portfolio at December 31, for each of the past five years is shown in Table 5. Consistent with bank regulatory reporting requirements, Bankers' Acceptances purchased (as opposed to originated) and Term Federal Funds (funds placed with another financial institution generally having a maturity of less than 90 days) are classified as loans and included in the commercial loan category. Management views these instruments not as loans but as investment alternatives in managing short-term liquidity. Bankers' Acceptances and Term Federal Funds, combined, totalled $6.5 million at December 31, 1993 and $14.7 million at December 31, 1992. Exclusive of Bankers' Acceptances and Term Federal Funds, commercial loans were flat and total loans increased $36.6 million. Table 5 LOANS BY CATEGORY (Dollars in Thousands) As of December 31, 1993 1992 1991 1990 1989 Commercial, Financial and Agricultural $ 46,963 $57,188 $57,692 $78,279 $78,124 Real Estate - Construction 22,968 19,103 18,714 14,527 17,284 Real Estate - Mortgage 242,741 212,080 208,091 206,600 206,712 Consumer 93,895 89,848 89,529 90,468 89,067 Total Loans $406,567 $378,219 $374,026 $389,874 $391,187 The Company's average loan-to-deposit ratio has decreased over the last three years from 67.5% in 1991 to 60.6% in 1993. The reduction in this percentage in 1993 was attributable more to the acquisition of $44 million in deposits than the lack of loan growth. Real estate construction and mortgage loans, combined, represented 65.4% of total loans in 1993 versus 61.1% in 1992. See the section entitled "Risk Element Assets" for a discussion concerning loan concentrations. Table 6 arrays the Company's total loan portfolio as of December 31, 1993, based upon repricing opportunities. Loans are arrayed as to those which can be repriced in one year or less, over one through five years and over five years. Demand loans and overdrafts are reported in the category of one year or less. As a percent of the total portfolio, loans with a fixed interest rate have declined from 55.2% in 1992 to 46.9% in 1993. Table 6 LOAN REPRICING OPPORTUNITIES (Dollars in Thousands) Repricing Periods Over One Over One Year Through Five Or Less Five Years Years Total Commercial, Financial and Agricultural $ 36,677 $ 8,990 $ 1,296 $ 46,963 Real Estate 185,355 64,846 15,508 265,709 Consumer 63,063 30,330 502 93,895 Total $285,095 $104,166 $17,306 $406,567 Loans with Fixed Rates $ 90,917 $ 83,605 $16,109 $190,631 Loans with Floating or Adjustable Rates 194,178 20,561 1,197 215,936 Total $285,095 $104,166 $17,306 $406,567 Allowance for Loan Losses Management attempts to maintain the allowance for loan losses at a level sufficient to provide for potential losses in the loan portfolio. The allowance for loan losses is established through a provision charged to expense. Loans are charged against the allowance when management believes collection of the principal is unlikely. Management evaluates the adequacy of the allowance for loan losses on a quarterly basis. The evaluations are based on the collectibility of loans and take into consideration such factors as growth and composition of the loan portfolio, evaluation of potential losses, past loss experience and general economic conditions. As part of these evaluations, management reviews all loans which have been classified internally or through regulatory examination and, if appropriate, allocates a specific reserve to each of these individual loans. Further, management establishes a general reserve to provide for potential losses which are, as yet, unidentified in the loan portfolio. The general reserve is based upon historical experience. The allowance for loan losses is compared against the sum of the specific reserves plus the general reserve and adjustments are made, as appropriate. Table 7 analyzes the activity in the allowance over the last five years. Table 7 ANALYSIS OF ALLOWANCE FOR LOAN LOSSES (Dollars in Thousands) For the Years Ended December 31, 1993 1992 1991 1990 1989 Balance at Beginning of Year $7,585 $7,670 $7,526 $6,168 $5,355 Allowance for Loan Losses Acquired Through Acquisition - - - - 186 Charge-Offs: Commercial, Financial and Agricultural 556 511 724 878 911 Real Estate - Construction - 33 - - - Real Estate - Mortgage 81 460 175 169 178 Consumer 884 929 1,263 1,331 1,180 Total Charge-Offs 1,521 1,933 2,162 2,378 2,269 Recoveries: Commercial, Financial and Agricultural 198 231 177 126 109 Real Estate - Construction - - - - - Real Estate - Mortgage 8 7 18 14 21 Consumer 364 394 294 254 319 Total Recoveries 570 632 489 394 449 Net Charge-Offs 951 1,301 1,673 1,984 1,820 Provision for Loan Losses 960 1,216 1,817 3,342 2,447 Balance at End of Year $7,594 $7,585 $7,670 $7,526 $6,168 Ratio of Net Charge-Offs During Year to Average Loans Out- standing, Net Unearned Interest .25% .36% .45% .52% .48% Allowance for Loan Losses as Percentage of Loans, Net of Un- earned Interest, at End of Year 1.90% 2.05% 2.10% 1.98% 1.62% Allowance for Loan Losses as a Multiple of Net Charge-Offs 7.99x 5.83x 4.58x 3.79x 3.39x The allowance for loan losses at December 31, 1993 of $7.6 million equals 1.90% of year-end loans. This compares to $7.6 million, or 2.05% in 1992, and $7.7 million, or 2.10% in 1991. The level of the allowance remains unchanged from 1992. The reduction in the percentage of the allowance relative to total loans is attributable to loan growth during the year. Management closely monitors its nonperforming loans, allocated reserves and any potential for loss. With the uncertainty surrounding the economy in recent years and the level of nonperforming loans, management has considered it prudent to maintain the allowance at a level above that of historical levels. If, during 1994, management is successful in reducing the level of nonperforming loans, net charge-offs remain low and the economy continues to show evidence of improvement, management may then be afforded the opportunity to reduce the allowance from these historically high levels. There can be no assurance that in particular periods the Company will not sustain loan losses which are substantial in relation to the size of the allowance. When establishing a provision, management makes various estimates regarding the value of collateral and future economic events. Actual experience may differ from these estimates. It is management's opinion that the allowance at December 31, 1993, is adequate to absorb possible losses from loans in the portfolio as of year-end. Table 8 provides an allocation of the allowance for loan losses to specific loan categories for each of the last five years. The unallocated portion of the allowance is the residual after allocating to specific loan categories and is intended to provide a cushion to absorb potential unidentified losses. The Company's method of establishing the allowance does not permit a precise allocation of the allowance by loan category since such an allocation is not as critical as management's assessment of the adequacy of the allowance in total. However, in response to regulatory disclosure requirements, the information in Table 8 is presented based upon management's best estimates utilizing available information such as regulatory examinations, internal loan reviews and historical charge-off levels. Risk Element Assets Risk element assets consists of nonaccrual loans, renegotiated loans, other real estate, loans past due 90 days or more, potential problem loans and loan concentrations. Table 9 depicts certain categories of the Company's risk element assets as of December 31, for each of the last five years. Potential problem loans and loan concentrations are discussed within the narrative portion of this section. Table 9 RISK ELEMENT ASSETS (Dollars in Thousands) As of December 31, 1993 1992 1991 1990 1989 Nonaccruing Loans $ 9,353 $ 6,987 $ 8,423 $10,898 $5,229 Restructured 65 169 176 297 522 Total Nonperforming Loans 9,418 7,156 8,599 11,195 5,751 Other Real Estate 3,466 4,416 4,385 3,253 882 Total Nonperforming Assets $12,884 $11,572 $12,984 $14,448 $6,633 Past Due 90 Days or More $ 104 $ 2,564 $ 622 $ 1,671 $1,206 Nonperforming Loans to Loans, Net of Unearned Interest 2.36% 1.93% 2.36% 2.95% 1.51% Nonperforming Assets to Loans, Net of Unearned Interest Plus Other Real Estate 3.20% 3.09% 3.52% 3.77% 1.74% Nonperforming Assets to Capital(1) 17.24% 16.36% 19.86% 23.70% 11.41% Reserve to Nonperforming Loans 80.64% 105.99% 89.20% 67.23% 107.25% (1) For computation of this percentage, "capital" refers to shareholders' equity plus the allowance for loan losses. The Company's nonaccruing loans increased $2.4 million, or 33.9%, from a level of $7.0 million at December 31, 1992 to $9.4 million at December 31, 1993. During 1993, loans totalling approximately $5.0 million were placed on nonaccrual, while loans totalling $2.6 million were removed from nonaccruing status. Of the $5.0 million, three credit relationships comprised $3.8 million of the total. All three relationships are secured with real estate and management has allocated specific reserves to these credits to absorb any anticipated losses. Of the $2.6 million removed from the nonaccrual category, $910,000 was transferred to other real estate and $413,000 was charged-off. The remaining decrease of $1.3 million represents principal reductions, loans which were refinanced and loans which were brought current and returned to an accrual basis. The majority of nonaccrual loans are collateralized with real estate. Management continually reviews these loans and believes specific reserve allocations are sufficient to cover any potential loss exposure associated with these loans. Interest on nonaccrual loans is recognized only when received. Cash collected on nonaccrual loans is applied against the principal balance or recognized as interest income based upon management's expectations as to the ultimate collectibility of principal and interest in full. If nonaccruing loans had been on a fully accruing basis, interest income recorded would have been $846,000 higher for the year ended December 31, 1993. Restructured loans, which are those loans with reduced interest rates or deferred payment terms due to deterioration in the financial position of the borrower, were nominal. Other real estate totalled $3.4 million at December 31, 1993, versus $4.4 million at December 31, 1992. This category includes property owned by Group banks which was acquired either through foreclosure procedures or by receiving a deed in lieu of foreclosure. During 1993, the Company added approximately 8 properties totalling $910,000 and liquidated, partially or completely, 18 other properties totalling $1.9 million, resulting in a net reduction in other real estate of $1.0 million. Two properties accounted for $653,000 of the $910,000 in total additions during 1993. At the current time, management does not anticipate any significant losses associated with other real estate. Potential problem loans are defined as those loans which are now current but where management has doubt as to the borrower's ability to comply with present loan repayment terms. Potential problem loans totalled $192,000 at December 31, 1993. In management's judgement these loans are adequately collateralized and no significant losses are anticipated. Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities which cause them to be similarly impacted by economic or other conditions and such amounts exceed 10% of total loans. Due to the lack of diversified industry within the markets served by the Group banks, and the relatively close proximity of the markets, the Company has both geographic concentrations as well as concentrations in the types of loans funded. Seven of the ten Group banks representing 81% of the Company's total loans at year-end are located within a thirty-mile radius of one another. Further, due to the nature of the Company's markets, a significant portion of the portfolio is associated either directly or indirectly with real estate. At December 31, 1993, approximately 65% of the portfolio consisted of real estate loans. Residential properties, including land acquisition and development loans for residential projects, comprise approximately 51% of the real estate portfolio. Management is continually analyzing its loan portfolio in an effort to identify and resolve its problem assets as quickly and efficiently as possible. As of December 31, 1993, management believes it has identified and adequately reserved for such problem assets. However, management recognizes that many factors can adversely impact various segments of its markets, creating financial difficulties for certain borrowers. As such, management will continue to focus its attention on promptly identifying and providing for potential losses as they arise. Investment Securities The investment portfolio is a significant component of the Company's operations and, as such, it functions as a key element of liquidity and asset/liability management. It is not management's intent nor practice to participate in the trading of investment securities for the purpose of recognizing gains. At the time of purchase, management has both the ability and the intent to hold the securities for the foreseeable future and thus the securities are carried on the books at amortized cost, adjusted for the amortization of premiums and accretion of discounts. Sales of securities are minimal and the gains or losses recognized from such sales are not material to the Company's financial performance. See the section entitled "Accounting Pronouncements" on page 38 for a discussion of Statement of Financial Accounting Standards No. 115 - "Accounting for Certain Investments in Debt and Equity Securities", which was adopted by the Company on January 1, 1994. In 1993, proceeds from "called" bonds and principal redemption of mortgage- backed securities totalled $31.7 million and the Company recognized gains of $69,000 and losses of $41,000. Proceeds from the sale of securities were nominal. During 1993, the Company's average investment portfolio increased 22.7% from $167.2 million in 1992 to $205.1 million in 1993. The growth in the investment portfolio is primarily due to the lack of loan production in recent years. As discussed previously, management made a conscious decision to shift from tax- exempt to taxable securities in response to lower tax rates and the ramifications of the Tax Reform Act of 1986. Tax-exempt securities as a percent of the total investment portfolio have declined from 70.8% in 1986 to 31.8% at December 31, 1993. Management will, however, continue to purchase "bank qualified" municipal issues when it considers the yield to be attractive and the Company can do so without adversely impacting its tax position. In 1993, the tax-exempt investment portfolio increased, on average, $13.5 million, or 26.0%, which is the largest increase since 1986, reflecting a more favorable market for tax-exempt securities. The average maturity of the portfolio at December 31, 1993 and 1992, was 2.34 and 1.81 years, respectively. During 1993, the average maturity for U.S. Treasury and Government Agency securities increased from 1.12 to 1.80 years. The average maturity for municipal securities increased from 2.82 to 3.64 years. The weighted average taxable-equivalent yield of the investment portfolio at December 31, 1993, was 5.51% versus 6.54% in 1992. The quality of the municipal portfolio at such date is depicted in the chart to the right. There were no investments in obligations of any one state, municipality, political subdivision or any other issuer that exceeded 10% of the Company's shareholders' equity at December 31, 1993. The unrealized gain in the portfolio at December 31, 1993, of $2.7 million compares with $3.8 million at December 31, 1992. Tables 10 and 11 present a detailed analysis of the Company's investment securities as to type, maturity and yield. Table 10 DISTRIBUTION OF INVESTMENT SECURITIES (Carrying Value - Dollars in Thousands) As of December 31, 1993 1992 1991 U.S. Treasury $111,233 $100,946 $74,693 Government Agencies and Corporations 35,315 25,365 7,951 States and Political Subdivisions 67,070 55,984 51,363 Other Securities 5,005 4,142 3,899 Total Investment Securities $218,623 $186,437 $137,906 Table 11 MATURITY DISTRIBUTION OF INVESTMENT SECURITIES (Dollars in Thousands) As of December 31, 1993 Weighted Carrying Value Market Value Average Yield(1) U. S. GOVERNMENTS Due in 1 year or less $ 53,756 $ 53,904 5.48% Due over 1 year thru 5 years 87,248 87,371 4.50% Due over 5 years thru 10 years 4,596 5,067 5.82% Due over 10 years 948 934 6.28% TOTAL $146,548 $147,276 4.91% MUNICIPALS Due in 1 year or less $ 9,827 $ 9,958 8.51% Due over 1 year thru 5 years 36,629 38,088 7.44% Due over 5 years thru 10 years 19,960 20,256 6.25% Due over 10 years 654 647 6.48% TOTAL $ 67,070 $ 68,949 7.23% Other Securities $ 5,005 $ 5,049 Total Investment Securities $218,623 $221,274 (1) Weighted average yields are calculated on the basis of the carrying value of the security. The weighted average yields on tax-exempt obligations are computed on a taxable-equivalent basis using a 34% tax rate. Carrying Value Moody's Rating (000's) Percentage AAA $ 39,750 59.3% AA-1 1,170 1.7% AA 3,535 5.3% A-1 5,400 8.1% A 9,285 13.8% BAA 1,000 1.5% Not Rated(1) 6,930 10.3% Total $ 67,070 100.0% (1) Of the securities not rated by Moody's, $4.3 million are rated "A" or higher by S & P. Deposits Average total deposits increased from $573.2 million in 1992 to $630.3 million in 1993. Contributing to this growth was the acquisition of approximately $44 million in deposits during the first quarter of 1993. The most significant developments during 1992-3 were the strong growth in noninterest bearing deposits and the shift in funding sources from "Other Time" to other deposit categories. As a percent of average total deposits, noninterest bearing increased from 21.5% in 1991 to 23.7% in 1993, while "Other Time" deposits decreased from 45.0% to 33.1%. These two developments have had a favorable impact on the Company's net interest margin. Both developments discussed in the preceding paragraph run counter to the Company's historical trends. Since the Company's formation in 1984, two major trends have impacted the mix of deposits. First, the shift from noninterest bearing to interest bearing, and second, a majority of the Company's deposit growth during this period has been in certificates of deposit, which traditionally represent the highest yielding deposit offering. The historical shift from noninterest bearing to interest bearing deposits is a result of deregulation which began in the early 1980's, and has adversely affected the Company's net interest margin. Based on annual averages, interest bearing deposits as a percent of total deposits has increased from 62.8% in 1984 to 76.3% in 1993, which is down from 1991 when this percent reached 78.5%. Historically, a majority of the Company's deposit growth has been in the category of "Other Time", which consists primarily of certificates of deposit. This growth was generated both internally and through acquisitions. However, during the last two years, deposit growth from interest bearing sources came primarily from the category of "Savings". Since 1991, the average balance for Savings has increased 161.2% from $43.6 million to $113.9 million in 1993, while the average balance for Other Time deposits decreased 15.1% from $246.0 million to $208.7 million. This shift in the source of deposit growth from Other Time to Savings is due to the low interest rate environment, particularly during periods when yields on certificates of deposit were below the regular savings rate. Table 2 on page 15 provides an analysis of the Company's average deposits, by category, and average rates paid thereon for each of the last three years. Table 12 reflects the shift in the Company's deposit mix over the last three years and Table 13 provides a maturity distribution of time deposits in denominations of $100,000 and over. Table 12 SOURCES OF DEPOSIT GROWTH (Average Balances - Dollars in Thousands) 1992 to Percentage 1993 of Total Components of Total Deposits Change Change 1993 1992 1991 Noninterest Bearing Deposits $21,072 36.9% 23.7% 22.4% 21.5% NOW Accounts 10,964 19.2 12.4 11.7 11.4 Money Market Accounts 5,954 10.4 12.7 12.9 14.1 Savings 21,797 38.1 18.1 16.1 8.0 Other Time (2,625) (4.6) 33.1 36.9 45.0 Total Deposits $57,162 100.0% 100.0% 100.0% 100.0% Table 13 MATURITY DISTRIBUTION OF CERTIFICATES OF DEPOSIT $100,000 OR OVER (Dollars in Thousands) December 31, 1993 Time Certificates of Deposit Percent Three months or less $11,961 29.2% Over three through six months 11,291 27.6 Over six through twelve months 11,313 27.6 Over twelve months 6,371 15.6 Total $40,936 100.0% Liquidity and Capital Resources Liquidity for a banking institution is the availability of funds to meet increased loan demand and/or excessive deposit withdrawals. Management monitors the Company's financial position to ensure it has ready access to sufficient liquid funds to meet normal transaction requirements, take advantage of investment opportunities and cover unforeseen liquidity demands. In addition to core deposit growth, sources of funds available to meet liquidity demands include cash received through ordinary business activities such as the collection of interest and fees, federal funds sold, loan and investment maturities, bank lines of credit for the Company and approved lines for the purchase of federal funds by the Group banks. On January 24, 1992, the Company established a $6.0 million revolving line of credit with Trust Company Bank, Atlanta, Georgia, and simultaneously amended its master note and loan agreement with Wachovia Bank of Georgia to provide for a $6.0 million revolving line of credit. The Trust Company facility expired on January 24, 1994, and was renewed until January 24, 1996. The Wachovia facility expires on May 31, 1994. At the expiration of the Wachovia line, the Company has the option to pay the loan or convert the outstanding balance to a term loan which will amortize in 24 equal quarterly installments. As of December 31, 1993, the Company had debt outstanding of $1.4 million with Trust Company and $500,000 with Wachovia. During 1993, the Company borrowed additional funds totalling $1.4 million and made principal reductions on the Wachovia line totalling $1.5 million, leaving an outstanding balance at year-end of $1.9 million. The average rate on debt outstanding during 1993 was 4.06%. See Note 10 in the Notes to Financial Statements for additional information on the Company's debt. The Company's long-term debt agreements impose certain limitations on the level of CCBG's equity capital, and federal and state regulatory agencies have established regulations which govern the payment of dividends to bank holding companies by its bank subsidiaries. Based on the Company's current financial condition, these limitations and/or regulations do not impair the Company's ability to meet its cash obligations or limit the Company's ability to pay future dividends on its common stock. See Notes 10 and 14 in the Notes to Financial Statements for additional information. Federal Funds Purchased and Securities Sold Under Repurchase Agreements (Dollars in Thousands) 1993 1992 1991 Year End Balance $23,264 $17,561 $14,912 Rate at Year End 2.78% 2.53% 3.60% Average Balance $17,765 $18,163 $19,017 Average Rate 3.08% 2.95% 5.24% Maximum Outstanding at Month-End $27,449 $26,441 $24,026 The Company is a party to financial instruments with off-balance-sheet risks in the normal course of business to meet the financing needs of its customers. At December 31, 1993, the Company had $97.6 million in commitments to extend credit and $1.9 million in standby letters of credit. Commitments to extend credit are agreements to lend to a customer so long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The Company uses the same credit policies in establishing commitments and issuing letters of credit as it does for on-balance-sheet instruments. If obligations arising from these financial instruments continue to require funding at historical levels, management does not anticipate that such funding will adversely impact its ability to meet on-going obligations. It is anticipated capital expenditures for purposes of refurbishing certain bank facilities and purchasing equipment will approximate $3.7 million over the next twelve months. Over the next five years the Company anticipates spending $4.9 million (including the $3.7 million) on refurbishing existing locations and building and equipping new branch facilities. Management believes these capital expenditures can be funded internally without impairing the Company's ability to meet its on-going obligations. Shareholders' equity as of December 31, for each of the last three years is presented below. Shareholders' Equity (Dollars in Thousands) 1993 1992 1991 Common Stock $ 31 $ 31 $ 31 Surplus 5,857 5,857 5,858 Retained Earnings 67,753 61,937 55,842 Subtotal 73,641 67,825 61,731 Less: Treasury Stock (6,501) (4,656) (4,008) Total Shareholders' Equity $67,140 $63,169 $57,723 The Company continues to maintain a strong capital position. The ratio of shareholders' equity to total assets at year-end was 8.81%, 9.20% and 9.03% in 1993, 1992 and 1991, respectively, which ratios exceeded all minimum required regulatory capital levels. The lower capital ratio in 1993 primarily reflects the purchase of $1.8 million in treasury stock during the year. The Company has traditionally satisfied its regulatory capital requirements through earnings, and expects to continue to do so. The company is subject to risk-based capital guidelines that measure capital relative to risk weighted assets and off-balance-sheet financial instruments. Capital guidelines issued by the Federal Reserve Board in effect at December 31, 1993 require bank holding companies to have a minimum total risk-based capital ratio of 8.00%, with at least half of the total capital in the form of Tier 1 capital. Capital City Bank Group, Inc., significantly exceeded these capital guidelines, with a total risk-based capital ratio of 16.3% and a Tier I ratio of 15.1%. In addition, a tangible leverage ratio is now being used in connection with the risk-based capital standards and is defined as Tier I capital divided by average assets. The minimum leverage ratio under this standard is 3% for the highest- rated bank holding companies which are not undertaking significant expansion programs. An additional 1% to 2% may be required for other companies, depending upon their regulatory ratings and expansion plans. On December 31, the Company had a leverage ratio of 8.6%, which is in excess of regulatory requirements. In 1993, the Board of Directors declared dividends totalling $.83 per share, consisting of $.10 per share payable in July 1993 and $.73 per share payable in January 1994. The Company declared dividends of $.78 per share in 1992 and $.73 per share in 1991. The dividend payout ratio was 29.4%, 27.3% and 29.7% for 1993, 1992 and 1991, respectively. Dividends declared in 1993 represented a 6.4% increase over 1992. At December 31, 1993, the Company's common stock had a book value of $23.56 per share compared to $21.59 in 1992 and $19.55 in 1991. There is currently no established trading market for the common stock of Capital City Bank Group, Inc., and therefore, no bid or sale quotations are generally available. Based on sales of stock of which the Company has knowledge, the stock has traded in a range of $24.00 to $26.00 per share for the two-year period ended December 31, 1993, with the most recent trades at $26.00 per share. The Company began a stock repurchase plan in 1989, which remains in effect and provides for the repurchase of up to 300,000 shares. As of December 31, 1993, the Company has repurchased 255,927 shares, of which 77,011 shares were acquired during 1993. The shares acquired in 1993 were purchased at an average cost of $24.00 per share. Shares acquired under the plan are currently being held as treasury stock. On January 21, 1994, 2,218 shares were issued to participants for achieving certain established performance goals for the year ended December 31, 1993. The total value of the shares issued was $57,668 based on a stock price of $26.00 per share. Interest Rate Sensitivity Table 14 on page 37 presents the Company's consolidated interest rate sensitivity position as of year-end 1993. The objective of interest rate sensitivity analysis is to attempt to measure the impact on the Company's net interest income due to fluctuations in interest rates. Interest rate sensitivity is managed at the bank level, enabling bank management to incorporate its own interest rate projections, liquidity needs and factors specific to the local market into the analysis. As such, the Company does not manage its interest rate sensitivity from a consolidated position. The information in Table 14 has been assembled and presented in response to regulatory reporting requirements. Inflation The impact of inflation on the banking industry differs significantly from that of other industries in which a large portion of total resources are invested in fixed assets such as property, plant and equipment. Assets and liabilities of financial institutions are virtually all monetary in nature, and therefore are primarily impacted by interest rates rather than changing prices. While the general level of inflation underlies most interest rates, interest rates react more to change in the expected rate of inflation and to changes in monetary and fiscal policy. Net interest income and the interest rate spread are good measures of the Company's ability to react to changing interest rates and are discussed in further detail in the section entitled "Earnings Analysis" beginning on page 13. Accounting Pronouncements The Company adopted SFAS No. 109, "Accounting for Income Taxes," which changed the accounting for income taxes to the asset and liability method from the deferral method previously required by Accounting Principles Board Opinion 11. A tax expense of $484,000 reflecting the cumulative effect of adopting this new standard is included in 1993 net income. The adoption of SFAS No. 109 will not impact the effective tax rate. However, since SFAS No. 109 requires that deferred tax assets and liabilities be adjusted to reflect the effect of tax law or rate changes, the outcome of future tax legislation may have an impact on future income tax expense. The Financial Accounting Standards Board ("FASB") issued a new accounting pronouncement "Accounting for Certain Investments in Debt and Equity Securities" which is effective for fiscal years beginning after December 15, 1993. The pronouncement requires securities be classified into three categories: (1) Held to Maturity, (2) Available for Sale, and (3) Trading. Category three is not applicable since the Company does not engage in securities trading. The criteria for maintaining securities in the "Held To Maturity" category are restrictive and the ability to sell a security in this category is very limited. Management believes to properly manage interest rate risks and liquidity it is prudent to place a portion (approximately 30%) of the investment portfolio into the "Available for Sale" category. This was done in January of 1994. See Note 1 in the Notes to Financial Statements. Securities remaining in the "Held To Maturity" category will be reported at amortized cost, without recognition of unrealized gains and losses, which is consistent with the Company's prior accounting practices. Securities in the "Available For Sale" category will be reported at fair value with unrealized gains and losses reported as a separate component of shareholders' equity. When the statement was adopted in January 1994, it resulted in the addition, net of deferred taxes, of approximately $847,000, or 1.3%, to the Company's equity capital. In May 1993, the Financial Accounting Standards Board issued Statement No. 114 - "Accounting by Creditors for Impairment of a Loan." This statement requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loans effective interest rate, or at the loan's observable market price, or at the fair value of the collateral if the loan is collateral dependent. The statement applies to financial statements for fiscal years beginning after December 15, 1994. Management has not yet determined the impact, if any, this statement may have on the Company's financial condition or results of operations when adopted on a prospective basis in 1995. In December 1990, FASB issued SFAS No. 106, "Employers' Accounting for Post- Retirement Benefits Other Than Pension," which requires that the projected future cost of providing post-retirement health care and other benefits be recognized as employees provide services to earn those benefits. The Company does not offer post-retirement benefits, thus this statement is not applicable. SFAS No. 112, "Employers' Accounting for Post-Employment Benefits," which is effective for fiscal years beginning after December 15, 1993, requires employers who provide benefits to former or inactive employees after employment, but before retirement, to recognize these obligations as employees provide services to earn the benefits. The Company does not offer post-employment benefits, thus this statement is not applicable. Item 8. Item 8. Financial Statements and Supplementary Data Report of Independent Accountants Consolidated Statements of Condition Consolidated Statements of Income Consolidated and Parent Company Statements of Shareholders' Equity Consolidated Statements of Cash Flows Notes to Financial Statements Report of Independent Accountants Shareholders and Board of Directors Capital City Bank Group, Inc. Tallahassee, Florida We have audited the accompanying consolidated statements of condition of Capital City Bank Group, Inc., and subsidiaries as of December 31, 1993 and 1992, and the related statements of income, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining on a test basis evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Capital City Bank Group, Inc., as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 1 to the Financial Statements, Capital City Bank Group, Inc., changed its method of accounting for income taxes in 1993. JAMES D. A. HOLLEY & CO. Tallahassee, Florida February 4, 1994 Consolidated Statements of Condition As of December 31, 1993 1992 ASSETS Cash and Due From Banks $ 56,664,688 $43,690,111 Interest Bearing Deposits in Other Banks 1,256,516 1,955,817 Investment Securities (market value $221,273,916 and $190,262,011 in 1993 and 1992) (Note 5) 218,622,520 186,437,464 Federal Funds Sold 55,970,000 61,625,000 Loans (Notes 6 and 7) 406,566,731 378,218,710 Unearned Interest (7,142,943) (8,308,084) Allowance for Loan Losses (7,594,101) (7,584,958) Loans, Net 391,829,687 362,325,668 Premises and Equipment (Note 8) 20,820,473 15,901,857 Accrued Interest Receivable 5,467,174 5,127,718 Intangibles (Note 2) 1,719,491 658,353 Other Assets 9,984,232 9,244,273 Total Assets $762,334,781 $686,966,261 LIABILITIES Deposits: Noninterest Bearing Deposits $171,984,693 $147,870,679 Interest Bearing Deposits (Note 9) 490,760,129 449,626,770 Total Deposits 662,744,822 597,497,449 Federal Funds Purchased and Securities Sold Under Repurchase Agreements 23,264,047 17,561,214 Short-Term Borrowings 1,201,565 1,221,123 Long-Term Debt (Note 10) 1,900,000 2,000,000 Other Liabilities 6,084,592 5,517,780 Total Liabilities 695,195,026 623,797,566 SHAREHOLDERS' EQUITY Common Stock, $.01 par value; 4,000,000 shares authorized; 3,105,243 issued 31,052 31,052 Surplus 5,856,794 5,857,194 Retained Earnings 67,753,475 61,936,427 73,641,321 67,824,673 Treasury Stock: 255,927 shares in 1993 and 179,016 shares in 1992 at Cost (6,501,566) (4,655,978) Total Shareholders' Equity 67,139,755 63,168,695 Total Liabilities and Shareholders' Equity $762,334,781 $686,966,261 The accompanying Notes to Financial Statements are an integral part of these statements. For the Years Ended December 31, 1993 1992 1991 Net Income $8,243,711 $8,376,536 $7,272,476 Adjustments to Reconcile Net Income to Cash Provided by Operating Activities: Provision for Loan Losses 960,114 1,215,868 1,816,883 Depreciation 1,881,207 1,862,930 1,732,620 Amortization of Intangible Assets 337,994 259,171 302,915 Deferred Income Taxes 74,585 (143,529) (218,139) Cumulative Effect of Accounting Change 484,495 - - Net (Increase) Decrease in Interest Receivable (339,456) 68,761 208,180 Net (Increase) Decrease in Other Assets (1,393,182) (231,349) (986,758) Net Increase (Decrease) in Other Liabilities 318,515 (1,183,076) (151,038) Net Cash from Operating Activities 10,567,983 10,225,312 9,977,139 Cash Flows from Investing Activities: Proceeds from Payments/Maturities of Investment Securities 82,540,933 31,163,153 45,083,468 Purchase of Investment Securities (114,725,989) (79,694,258) (65,614,794) Net (Increase) Decrease in Loans (17,234,818) (6,438,547) 13,680,540 Purchase of Premises & Equipment (6,952,279) (1,337,346) (1,618,160) Sales of Premises & Equipment 1,007,775 31,744 193,898 Cash Acquired in Bank Acquisitions 28,811,166 - - Net Cash from Investing Activities (26,553,212) (56,275,254) (8,275,048) Cash Flows from Financing Activities: Net Increase (Decrease) in Deposits 21,150,418 42,405,239 4,755,974 Net Increase (Decrease) in Federal Funds Purchased 5,702,833 2,648,874 (10,572,406) Net Increase (Decrease) in Other Borrowed Funds (19,558) (19,247) (606,217) Addition to Long-Term Debt 1,400,000 - 403,800 Repayment of Long-Term Debt (1,500,000) (2,000,000) (2,628,800) Dividends Paid (2,282,200) (2,153,230) (2,065,029) Sale (Purchase) of Treasury Stock (1,845,988) (648,000) (834,842) Net Cash from Financing Activities 22,605,505 40,233,636 (11,547,520) Net Increase (Decrease) in Cash and Cash Equivalents ( 6,620,276) (5,816,306) (9,845,429) Cash and Cash Equivalents at Beginning of Period 107,270,928 113,087,234 122,932,663 Cash and Cash Equivalents at End of Period $113,891,204 $107,270,928 $113,087,234 The accompanying Notes to Financial Statements are an integral part of these statements. Notes to Financial Statements Note 1 SIGNIFICANT ACCOUNTING POLICIES The Company and its subsidiaries follow generally accepted accounting principles and reporting practices applicable to the banking industry. Prior year financial statements and other statistical information have been reclassified to conform to the presentation adopted for 1993. The principles which materially affect the financial position, results of operations and cash flows are summarized below. Principles of Consolidation The consolidated financial statements include the accounts of Capital City Bank Group, Inc., and its subsidiaries, all of which are wholly-owned. All material intercompany transactions and accounts have been eliminated. Investment Securities Securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Gains and losses on securities are accounted for by the specific identification method. The investment portfolio is a by-product of the Company's operations and, as such, it functions as a key component of liquidity and asset/liability management. It is not management's intent nor practice to participate in the trading of investment securities. Sales of securities are minimal and the gains or losses recognized from such sales are not material to the Company's financial performance. On January 1, 1994, the Company adopted Statement of Financial Accounting Standards No. 115 ("Accounting for Certain Investments in Debt and Equity Securities") and management transferred approximately 30% of the Company's portfolio to the "Available for Sale" category. Securities transferred to the "Available for Sale" category on the date the statement was adopted are as follows: Amortized Category Costs U. S. Treasuries $31,364,293 U. S. Government Agencies and Corporations 10,089,014 State and Political Subdivisions 20,853,825 Other Securities 500,000 Total Available for Sale $62,807,132 Securities in this category are recorded at fair value with unrealized gains and losses, net of deferred taxes, reported as a separate component of equity capital. Fluctuations in the net unrealized gain or loss will not impact the Company's earnings. Loans Loans are stated at the principal amount outstanding. Interest income on certain loans, which are made on the discount basis, is recognized using the sum-of-the- months-digits method which does not differ materially from the interest method. Interest income on all other loans, except for those designated as non-accrual loans, is accrued based on the outstanding daily balances. Under FASB Statement No. 91, fees charged to originate loans and loan origination costs are to be deferred and amortized over the life of the loan. Management has elected not to net the costs against the loan fees but to defer only fees. The effect of this practice does not have a material impact on the consolidated financial statements. Allowance for Possible Loan Losses Provisions for possible loan losses are charged to operating expenses and added to the allowance to maintain it at a level deemed appropriate by management to absorb known and inherent risks in the loan portfolio. When establishing a provision, management makes various estimates regarding the value of collateral and future economic events. Actual future experience may differ from these estimates. Recognized loan losses are charged to the allowance when loans are deemed to be uncollectible due to such factors as the borrower's failure to pay principal and interest or when loans are classified as losses under internal or external review criteria. Recoveries of principal on loans previously charged- off are added to the allowance. Loans are placed on nonaccrual status when management believes the borrower's financial condition, after giving consideration to economic conditions and collection efforts, is such that collection of interest is doubtful. Generally, loans are placed on nonaccrual status when interest becomes past due 90 days or more, or management deems the ultimate collection of principal and interest, in full, is in doubt. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation, computed on the straight-line method over estimated useful lives of thirty to forty years for buildings and three to twenty years for fixtures and equipment. Additions and major facilities are capitalized and depreciated in the same manner. Repairs and maintenance are charged to operating expense as incurred. Other Real Estate Other real estate includes property owned by the Group banks which was acquired either through foreclosure or by receiving a deed in lieu of foreclosure. The properties are included in "other assets" on the statement of condition and are recorded at an amount which approximates market. Other real estate totalled $3.4 and $4.4 million at December 31, 1993 and 1992, respectively. Income Taxes The Company and its subsidiaries file consolidated federal and state income tax returns. In general, the parent company and its subsidiaries compute their tax provisions (benefits) as separate entities prior to recognition of any tax expenses (benefits) which may accrue from filing a consolidated return. Effective January 1, 1993, the company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", which mandates the asset and liability method of accounting for deferred income taxes. The Company had previously accounted for deferred taxes under the deferral method required by Accounting Principles Board (APB) Opinion 11. The cumulative effect of adopting the new accounting standard was a reduction in the Company's net income of $484,495, which was recognized the first quarter of 1993. See Note 11 in Notes to Financial Statements for further discussion. Note 2 Branch Acquisitions On March 15, 1993, Capital City First National Bank, a wholly-owned subsidiary of Capital City Bank Group, Inc., consummated the purchase and assumption of three branch offices located in Citrus County, Florida. First National acquired two of the office facilities and is leasing the third. In connection with these acquisitions, First National assumed $37.0 million in deposits and purchased $12.0 million in loans, consisting primarily of first mortgage residential real estate loans. On February 1, 1993, Branford State Bank, a wholly-owned subsidiary of Capital City Bank Group, Inc., consummated the assumption of $7.0 million in deposits. Loans purchased were minimal and no office facilities were acquired. Assets and liabilities acquired through acquisition, on a combined basis, are as follows: Loans $(13,229,315) Premises & Equipment (855,319) Other Assets (1,304,989) Total Assets $44,200,789 Deposits 44,096,955 Other Liabilities 103,834 Cash Acquired in Acquisitions $28,811,166 Intangible assets, including goodwill, recorded in connection with the Company's acquisitions are being amortized over periods of one to twenty-five years with the majority being written off over an average life of approximately 10 years. Intangibles recorded during 1993 totalled $1.2 million. The pre-tax amortization was $338,000 in 1993, $259,000 in 1992 and $303,000 in 1991. The amortization of intangibles for each of the next five years is as follows: Year Amount 1994 $363,000 1995 $284,000 1996 $244,000 1997 $185,000 1998 $159,000 Note 3 STATEMENT OF CASH FLOWS The statement of cash flows is presented using the indirect method of presentation. For purposes of this statement, the Company considers cash, due from banks, interest bearing deposits in banks and federal funds sold to be cash equivalents. Supplemental Disclosures of Cash Flow Information: 1993 1992 1991 Cash paid during the year for: Interest on Deposits and Other Funds Purchased $14,943,964 $19,213,697 $26,921,413 Interest on Long-Term Debt 56,009 $ 178,619 $ 445,245 Taxes Paid 3,013,311 $ 2,763,567 $ 2,504,278 Supplemental Schedule of Noncash Investing and Financing Activities: 1993 1992 1991 Loans Foreclosed and Transferred to Other Real Estate $910,228 $2,311,826 $3,200,742 Note 4 CASH & DUE FROM BANK ACCOUNTS Six of the ten Group banks are members of the Federal Reserve Bank of Atlanta and are required to maintain reserve balances. The average amount of those reserve balances for the years ended December 31, 1993 and 1992, was $25,031,000 and $24,168,000, respectively. Note 5 INVESTMENT SECURITIES The carrying value and related market value of investment securities at December 31, were as follows: Gross Gross Carrying Market Unrealized Unrealized Value Value U.S. Treasury $111,233,251 $111,722,854 $ 578,434 $ 88,831 U.S. Government Agencies and Corporations 35,314,555 35,552,676 320,299 82,178 States and Political Subdivisions 67,069,825 68,949,454 1,991,218 111,589 Other Securities 5,004,889 5,048,932 47,657 3,614 Total Investment Securities $218,622,520 $221,273,916 $2,937,608 $ 286,212 Gross Gross Carrying Market Unrealized Unrealized Value Value Gains Losses U.S. Treasury $100,946,059 $102,462,213 $l,516,154 - U.S. Government Agencies and Corporations 25,364,688 25,622,085 262,811 5,414 States and Political Subdivisions 55,984,326 57,995,657 2,013,753 2,422 Other Securities 4,142,391 4,182,056 43,733 4,068 Total Investment Securities $186,437,464 $190,262,011 $3,836,451 $11,904 The total proceeds from the sale of investment securities and the gross realized gains and losses from the sale of such securities for each of the last three years is presented below: Total Gross Gross Year Proceeds Realized Gains Realized Losses 1993 $31,681,176 69,249 41,722 1992 8,700,297 42,338 44,485 1991 917,837 10,051 5,127 Total proceeds in the above chart include principal reductions in mortgage backed securities and proceeds from securities which were called of $31,581,176, $8,293,692 and $585,693 in 1993, 1992 and 1991, respectively. As of December 31, 1993, the Company's debt securities had the following maturity distribution: Carrying Value Market Value Due in one year or less $ 68,588,734 $ 68,911,234 Due after one through five years 123,877,247 125,459,023 Due after five through ten years 24,554,631 25,322,697 Over ten years 1,601,908 1,580,962 Total Investment Securities $218,622,520 $221,273,916 Securities with a carrying value of $86,441,723 and $71,436,898 at December 31, 1993 and 1992, respectively, were pledged to secure public deposits and for other purposes as required by law. Note 6 LOANS At December 31, the composition of the Company's loan portfolio was as follows: 1993 1992 Commercial, Financial and Agricultural $ 46,962,666 $ 57,187,674 Real Estate - Construction 22,968,331 19,102,946 Real Estate - Mortgage 242,740,428 212,080,485 Consumer 93,895,306 89,847,605 Total Loans $ 406,566,731 $378,218,710 Nonaccruing loans amounted to $9,352,869 and $6,987,198 at December 31, 1993 and 1992, respectively. Restructured loans amounted to $64,661 and $169,314 at December 31, 1993 and 1992, respectively. If such nonaccruing and restructured loans had been on a fully accruing basis, interest income would have been $846,000 higher in 1993 and $696,000 higher in 1992. Due to the lack of diversified industry within the markets served by the Group banks, a significant portion of the loan portfolio is associated either directly or indirectly with real estate. At December 31, 1993, approximately 65% of the portfolio consisted of real estate related loans. Note 7 ALLOWANCE FOR LOAN LOSSES An analysis of the changes in the allowance for loan losses for the years ended December 31, is as follows: 1993 1992 1991 Balance, Beginning of Year $7,584,958 $7,669,915 $7,526,414 Provision for Loan Losses 960,114 1,215,868 1,816,883 Recoveries on Loans Previously Charged-Off 569,765 632,219 488,844 Loans Charged-Off (1,520,736) (1,933,044) (2,162,226) Balance, End of Year $7,594,101 $7,584,958 $7,669,915 Note 8 PREMISES AND EQUIPMENT The composition of the Company's premises and equipment at December 31, was as follows: 1993 1992 Land $ 4,300,563 $ 4,112,299 Buildings 18,348,113 12,827,586 Fixtures and Equipment 14,358,167 13,457,612 37,006,843 30,397,497 Accumulated Depreciation (16,186,370) (14,495,640) Premises and Equipment, Net $20,820,473 $15,901,857 Depreciation of $1,881,207, $1,862,930, and $1,732,620 was charged to operations for 1993, 1992 and 1991, respectively. Note 9 DEPOSITS Interest bearing deposits, by category, as of December 31, are as follows: 1993 1992 NOW Accounts $100,184,541 $ 71,357,466 Money Market Accounts 77,301,643 71,719,744 Savings Accounts 110,127,691 111,206,053 Other Time Deposits 203,146,254 195,343,507 Total Interest Bearing Deposits $490,760,129 $449,626,770 Time deposits in denominations of $100,000 or more totalled $40,936,000 and $45,658,000, at December 31, 1993 and 1992, respectively. Interest expense for each of these deposit categories for the three years ended December 31, is as follows: 1993 1992 1991 NOW Accounts $ 1,616,631 $1,770,024 $2,786,570 Money Market Accounts 1,778,928 2,315,965 3,885,783 Savings Accounts 2,953,208 3,651,544 2,219,917 Other Time Deposits 7,864,445 10,047,391 16,225,982 Total $14,213,212 $17,784,924 $25,118,252 Note 10 LONG-TERM DEBT On January 24, 1992, the Company established a $6.0 million revolving line of credit with Trust Company Bank, Atlanta, Georgia, and simultaneously amended its master note and loan agreement with Wachovia Bank of Georgia (formerly "The First National Bank of Atlanta") to provide for a $6.0 million revolving line of credit. The two credit facilities are collateralized by 100% of the common stock of Capital City First National Bank of Tallahassee. The Trust Company facility expires on January 24, 1996, and the Wachovia facility expires on May 31, 1994, at which time the outstanding balance under the revolving line of credit may convert to a term loan which will amortize in 24 equal quarterly installments. As of December 31, 1993, there was $1.4 million outstanding to Trust Company and $500,000 outstanding to Wachovia. Under the two credit facilities the Company, at its option, may select from various loan rates including prime, LIBOR or the certificate of deposit ("CD") rate, plus or minus increments thereof. The LIBOR or CD rates may be fixed for a period of up to six months. The average interest rate on debt outstanding during 1993 was 4.06%, and the weighted average rate at year-end was 3.97%. The loan agreements place certain restrictions on the amount of capital which must be maintained by the Company. On December 31, 1993, the Company's capital exceeded the most restrictive covenants of either agreement. Note 11 INCOME TAXES The provision for income taxes reflected in the statement of income was comprised of the following components: 1993 1992 1991 Currently Payable: Federal $2,846,900 $2,903,663 $2,411,439 State 387,129 404,207 286,231 Deferred: Federal 59,198 (129,880) (186,756) State 15,387 (13,649) (31,383) Total $3,308,614 $3,164,341 $2,479,531 The net deferred tax asset and liability and the temporary differences comprising those balances at December 31, 1993, are detailed below: Deferred Tax Assets: Allowance for Loan Losses $2,857,660 Deferred Loan Fees 313,883 Writedown of Real Estate Held for Sale 22,495 Other 72,369 Total Deferred Tax Assets $3,266,407 Deferred Tax Liabilities: Premises and Equipment 839,327 Employee Benefits 235,616 Other 30,039 Total Deferred Tax Liabilities 1,104,982 Net Deferred Tax Assets $2,161,425 Income taxes amounted to less than the tax expense computed by applying the statutory federal income tax rates to income. The reasons for these differences are as follows: 1993 1992 1991 Computed Tax Expense $4,092,519 $3,923,898 $3,315,682 Increases (Decreases) Resulting From: Tax-Exempt Interest Income (1,087,346) (1,001,370) (1,015,315) State Income Taxes, Net of Federal Income Tax Benefits 265,660 257,768 168,200 Other 37,781 (15,955) 10,964 Actual Tax Expense $3,308,614 $3,164,341 $2,479,531 The items that caused timing differences and the resulting deferred income taxes for 1992 and 1991, are as follows: 1992 1991 Asset Writedowns $(137,520) $ - Provision for Loan Losses 30,736 (51,916) Deferred Loan Fees (21,088) 12,297 Pension Expense 178,259 (205,883) Depreciation (75,646) 26,990 Other (118,270) 373 Total $(143,529) $(218,139) Note 12 EMPLOYEE BENEFITS The Company sponsors a noncontributory pension plan covering substantially all of its employees. Benefits under this plan generally are based on the employee's years of service and compensation during the years immediately preceding retirement. The Company's general funding policy is to contribute amounts deductible for federal income tax purposes. The following table details the components of pension expense, the funded status of the plan and amounts recognized in the Company's consolidated statements of condition, and major assumptions used to determine these amounts. 1993 1992 1991 Components of Pension Expense: Service Cost $685,449 $674,980 $ 530,645 Interest Cost 845,301 763,211 742,002 Actual Return on Plan Assets (525,422) (363,931) (1,568,273) Net Amortization and Deferral (330,861) (492,809) 915,451 Total $674,467 $581,451 $ 619,825 Actuarial Present Value of Projected Benefit Obligations: Accumulated Benefit Obligations: Vested $6,896,007 $5,833,309 $4,022,661 Nonvested 1,066,503 935,972 487,853 $7,962,510 $6,769,281 $4,510,514 Plan Assets at Fair Value (primarily listed stocks and bonds, U.S. Government secur- ities and interest bearing deposits) $10,898,324 $10,144,450 $9,105,747 Projected Benefit Obligation (11,824,763) (10,616,298) (9,311,574) Plan Assets in Excess of: Projected Benefit Obligation (926,439) (471,848) (205,827) Unrecognized Net Loss 3,465,697 2,926,291 2,421,063 Unrecognized Net Asset (1,884,324) (2,120,407) (2,356,490) Prepaid (Accrued) Pension Cost $ 654,934 $ 334,036 $ (141,254) Major Assumptions: Discount Rate 7.5% 8.0% 9.0% Rate of Increase in Compensation Levels 5.5% 6.0% 6.0% Expected Long-Term Rate of Return on Plan Assets 7.5% 8.5% 9.0% The Company has a stock incentive plan under which shares of the Company's stock are issued as incentive awards to selected participants. The cost of this plan in 1993 was $354,000. Note 13 RELATED PARTY TRANSACTIONS The Chairman of the Board of Capital City Bank Group, Inc., is chairman of the law firm which serves as general counsel to the Company and its subsidiaries. Fees paid by the Company and its subsidiaries for these services, in aggregate, approximated $266,000, $286,000, and $285,900 during 1993, 1992 and 1991, respectively. Under a lease agreement expiring in 2024, a bank subsidiary leases land from a partnership in which several directors and officers have an interest. The lease agreement provides for annual lease payments of approximately $51,900, to be adjusted for inflation in future years. At December 31, 1993 and 1992, certain officers and directors were indebted to the Company's bank subsidiaries in the aggregate amount of $10,257,576 and $12,463,712, respectively. During 1993, $7,709,884 in new loans were made and repayments totalled $9,916,020. These loans were made on the same terms as loans to other individuals of comparable creditworthiness. Note 14 DIVIDEND RESTRICTIONS The approval of the appropriate regulatory authority is required if the total of all dividends declared by a subsidiary bank in any calendar year exceeds the bank's net profits (as defined) for that year combined with its retained net profits for the preceding two calendar years. In 1994, the subsidiaries may declare dividends without regulatory approval of $7.8 million plus an additional amount equal to the net profits of the Company's subsidiary banks for 1994 up to the date of any such dividend declaration. Note 15 SUPPLEMENTARY INFORMATION Components of noninterest income and noninterest expense in excess of 1% of total operating income, which are not disclosed separately elsewhere, are presented below for each of the respective periods. 1993 1992 1991 Noninterest Expense: Employee Insurance $ 954,397 $887,618* $808,694* Payroll Taxes 879,249 802,370* 785,595* Maintenance and Repairs 1,274,555 1,243,497 1,552,134 Professional Fees 659,414 468,418* 434,933* Advertising 658,696 438,655* 615,638* Printing & Supplies 1,065,122 875,023 934,818 Insurance (other than employee) 1,708,134 1,490,156 1,518,206 *Less than 1% of operating income in the year reported Note 16 FINANCIAL INSTRUMENTS AND CONCENTRATIONS OF CREDIT RISKS The Company is a party to financial instruments with off-balance-sheet risks in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. The Company does not participate in financial guarantees, options, interest rate caps and floors, interest rate swaps or futures contracts. The Company's maximum exposure to credit loss under standby letters of credit and commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in establishing commitments and issuing letters of credit as it does for on-balance-sheet instruments. As of December 31, 1993, the amounts associated with the Company's off-balance-sheet obligations were as follows: Off-Balance-Sheet Financial Instruments Amount Commitments to Extend Credit(1) $97,647,248 Standby Letters of Credit 1,875,305 (1) Commitments include unfunded loans, revolving lines of credit (including credit card lines) and other unused commitments. Commitments to extend credit are agreements to lend to a customer so long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued by the corporation to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities. In general, management does not anticipate any material losses as a result of participating in these types of transactions. However, any potential losses arising from such transactions are reserved for in the same manner as management reserves for its other credit facilities. For both on and off-balance-sheet financial instruments, the Company requires collateral to support such instruments when it is deemed necessary. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained upon extension of credit is based on management's credit evaluation of the counterparty. Collateral held varies, but may include deposits held in financial institutions; U.S. Treasury Securities; other marketable securities; real estate; accounts receivable; property, plant and equipment; and inventory. Due to the close proximity and the nature of the markets served by the Group banks, the Company has both a geographic concentration as well as a concentration in the types of loans funded. Seven of the ten Group banks representing 81% of the Company's total loans at year-end are located within a 30-mile radius. At December 31, 1993, approximately 65% of the Company's loan portfolio consisted of real estate related loans. Note 17 FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments," requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. The resulting fair values may be significantly affected by the assumptions used, including the discount rates and estimates of future cash flows. Many of the Company's assets and liabilities are short-term financial instruments whose carrying values approximate fair value. These items include Cash and Due From Banks, Interest Bearing Balances with Other Banks, Federal Funds Sold, Federal Funds Purchased and Securities Sold Under Repurchase Agreements, and Other Short-term Borrowings. The methods and assumptions used to estimate the fair value of the Company's other financial instruments are as follows: Investment Securities - Fair values for investment securities are based on quoted market prices. If a quoted market price is not available, fair value is estimated using market prices for similar securities. Loans - The loan portfolio is segregated into categories of loans with similar financial characteristics. The fair value of each loan category is calculated using present value techniques based upon projected cash flows and estimated discount rates. The calculated present values are then reduced by an allocation of the allowance for loan losses against each respective loan category. Deposits - The fair value of Noninterest Bearing Deposits, NOW Accounts, Money Market Accounts and Savings Accounts are the amounts payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. Long-Term Debt - Carrying value of the Company's long-term debt approximates fair value due to the repricing frequency of the debt. The debt is generally repriced every 90 to 180 days and all long-term debt currently outstanding will reprice on or before March 31, 1994. Commitments to Extend Credit and Standby Letters of Credit - The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the present creditworthiness of the counterparties. Fair value of these fees is not material. The Company's financial instruments which have estimated fair values differing from their respective carrying values are presented below. As Of December 31, 1993 1992 Estimated Estimated Carrying Fair Carrying Fair Value Value Value Value Financial Assets: Investment Securities $218,623 $221,274 $186,437 $190,262 Loans, Net of Allowance for Loan Losses 391,830 394,171 362,326 363,891 Financial Liabilities: Deposits 662,745 663,665 597,497 598,848 Certain financial instruments and all nonfinancial instruments are excluded from the disclosure requirements. The disclosures also do not include certain intangible assets such as customer relationships, deposit base intangibles and goodwill. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. Note 18 PARENT COMPANY FINANCIAL INFORMATION The following is a condensed statement of financial condition of the parent company at December 31: Parent Company Statements of Condition 1993 1992 ASSETS Cash and Due from Banks $ 2,788,987 $2,607,749 Investment in Group Banks 68,733,692 64,719,116 Other Assets 358,919 206,597 Total Assets $71,881,598 $67,533,462 LIABILITIES Dividends Payable $ 2,134,240 $ 1,989,777 Long-Term Debt (Note 10) 1,900,000 2,000,000 Other Liabilities 707,603 374,990 Total Liabilities 4,741,843 4,364,767 SHAREHOLDERS' EQUITY Common Stock, $.01 par value; 4,000,000 shares authorized; 3,105,243 issued 31,052 31,052 Surplus 5,856,794 5,857,194 Retained Earnings 67,753,475 61,936,427 73,641,321 67,824,673 Treasury Stock: 255,927 shares in 1993 and 179,016 shares in 1992, at Cost (6,501,566) (4,655,978) Total Shareholders' Equity 67,139,755 63,168,695 Total Liabilities and Shareholders' Equity $71,881,598 $67,533,462 The operating results of the parent company for the three years ended December 31 are shown below: Parent Company Statements of Income 1993 1992 1991 OPERATING INCOME Income Received from Group Banks: Dividends (Note 14) $4,675,000 $4,800,000 $5,800,000 Group Overhead Fees 1,985,566 2,017,566 1,846,977 Total Operating Income 6,660,566 6,817,566 7,646,977 OPERATING EXPENSE Salaries and Employee Benefits 1,617,059 1,138,963 1,108,250 Legal Fees 63,458 47,936 30,004 Professional Fees 171,291 137,393 145,008 Advertising 432,978 304,886 377,360 Travel and Entertainment 62,481 49,783 36,246 Amortization of Excess of Purchase Price Over Book Value of Net Assets Acquired 51,617 56,818 146,745 Interest on Debt 56,009 178,619 445,245 Dues and Memberships 41,601 44,598 39,882 Other 180,176 239,705 220,476 Total Operating Expense 2,676,670 2,198,701 2,549,216 Income Before Income Taxes and Equity in Undistributed Earnings of Group Banks 3,983,896 4,618,865 5,097,761 Income Tax Expense (Benefit) (229,736) (81,497) (264,098) Income Before Equity in Undistributed Earnings of Group Banks 4,213,632 4,700,362 5,361,859 Equity in Undistributed Earnings of Group Banks 4,030,079 3,676,174 1,910,617 Net Income $8,243,711 $8,376,536 $7,272,476 The cash flows for the parent company for the three years ended December 31 were as follows: Parent Company Statements of Cash Flows 1993 1992 1991 Net Income $8,243,711 $8,376,536 $7,272,476 Adjustments to Reconcile Net Income to Cash Provided by Operating Activities: Equity in Earnings of Group Banks (8,705,079) (8,476,174) (7,710,617) Amortization of Excess of Purchase Price Over Book Value of Net Assets Acquired 51,038 56,818 146,745 (Increase) Decrease in Other Assets (187,857) 163,945 (1,702) Net Increase (Decrease) in Other Liabilities 332,613 (54,215) (9,434) Net Cash from Operating Activities (265,574) 66,910 (302,532) Cash Flows from Investing Activities: Dividends Received from Group Banks 4,675,000 4,800,000 5,800,000 Cash Flows from Financing Activities: Addition to Long-Term Debt 1,400,000 - 403,800 Repayment of Long-Term Debt (1,500,000) (2,000,000) (2,628,800) Payment of Dividends (2,282,200) (2,153,230) (2,065,029) Sale (Purchase) of Treasury Stock (1,845,988) (648,000) (834,842) Net Cash from Financing Activities (4,228,188) (4,801,230) (5,124,871) Net Increase (Decrease) in Cash 181,238 65,680 372,597 Cash at Beginning of Period 2,607,749 2,542,069 2,169,472 Cash at End of Period $2,788,987 $ 2,607,749 $2,542,069 Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures. The Board of Directors has appointed Arthur Andersen & Co., independent certified public accountants, as independent auditors for Capital City Bank Group, Inc., and its subsidiaries for the current fiscal year ending December 31, 1994, subject to ratification by the shareholders. Fiscal 1994 will be the first year Arthur Andersen & Co. will audit the books and records of the Company. The decision to change the Company's independent auditors from James D. A. Holley & Co. to Arthur Andersen & Co. was made by the Company's Board of Directors on January 21, 1994. Arthur Andersen & Co. was engaged on April 5, 1994. During the periods in which James D. A. Holley & Co. audited the books and records of the Company, none of the reports issued by such firm on the financial statements of the Company contained an adverse opinion or disclaimer of opinion, or was qualified or modified as to uncertainty, audit scope or accounting principles. The Company has never had any disagreements with James D. A. Holley & Co. on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure. Item 10. Item 10. Directors and Executive Officers of the Registrant Incorporated herein by reference to the sections entitled "Election of Directors" and "Executive Officers" in the Registrant's Proxy Statement dated April 7, 1994, to be filed on or before April 7, 1994. Item 11. Item 11. Executive Compensation Incorporated herein by reference to the section entitled "Executive Compensation" in the Registrant's Proxy Statement dated April 7, 1994, to be filed on or before April 7, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Incorporated herein by reference to the subsection entitled "Information Concerning Nominees" under the section entitled "Election of Directors", and "Principal Shareholders" in the Registrant's Proxy Statement dated April 7, 1994, to be filed on or before April 7, 1994. Item 13. Item 13. Certain Relationships and Related Transactions Incorporated herein by reference to the subsection entitled "Compensation Committee Interlocks and Insider Participation" under the section entitled "Executive Compensation" in the Registrant's Proxy Statement dated April 7, 1994, to be filed on or before April 7, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K EXHIBITS 3(a) Articles of Incorporation, As Amended, of Capital City Bank Group, Inc., were filed as Exhibit 3(a) to the Registrant's Form S-14 filed on August 26, 1983 (File No. 2-86158), and are incorporated herein by reference. 3(b) Capital City Bank Group, Inc.'s By-Laws, As Amended are incorporated herein by reference to Exhibit 3(b) of the Company's 1983 Form 10-K (File No. 2-86158). 10(a) Reorganization Agreement and Plan of Merger among Capital City Bank Group, Inc., Capital City First National Bank of Tallahassee, Capital City Second National Bank, Industrial National Bank, City National Bank, Havana State Bank and First National Bank of Jefferson County dated as of May 16, 1983, is incorporated herein by reference to Registrant's Rule 424(b) Prospectus/Joint Proxy Statement used in connection with Registration Statement No. 2-86158. 10(b) Master Note and Loan and Security Agreement evidencing a line of credit between Registrant and The First National Bank of Atlanta, Georgia, (now "Wachovia Bank of Georgia") dated December 22, 1989 is incorporated herein by reference to Exhibit A in Registrant's Form 8-K dated December 19, 1989. 10(c) Amendment to Master Note and Loan and Security Agreement in item 10(b) above, dated January 24, 1992, is incorporated herein by reference to Exhibit B in Registrant's Form 10-K dated March 29, 1993. 10(d) Promissory Note and Pledge and Security Agreement evidencing a line of credit between Registrant and Trust Company Bank, Atlanta, Georgia, dated January 24, 1992, is incorporated herein by reference to Exhibit B in Registrant's Form 10-K dated March 29, 1993. 16 Letter Regarding Change in Certifying Accountant 22 For a listing of Capital City Bank Group's subsidiaries see Item I 23 (a) Report of Independent Accountants FINANCIAL STATEMENT SCHEDULES Other schedules and exhibits are omitted because the required information either is not applicable or is shown in the financial statements or the notes thereto. REPORTS ON FORM 8-K Capital City Bank Group, Inc. ("CCBG") filed no Form 8-K during the fourth quarter of 1993. 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 March 15, 1994, on its behalf by the undersigned, thereunto duly authorized. CAPITAL CITY BANK GROUP, INC. /s/ Godfrey Smith President (Principal Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 15, 1994, by the following persons in the capacities indicated. /s/ GODFREY SMITH Godfrey Smith President (Principal Executive Officer) /s/ J. KIMBROUGH DAVIS J. Kimbrough Davis Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Directors: /s/ DuBose Ausley /s/ Thomas A. Barron /s/ Payne H. Midyette, Jr. /s/ Godfrey Smith /s/ William G. Smith, Jr.

893486_1993.txt

893486_1993

1993

893486

ITEM 1. BUSINESS DESCRIPTION OF THE TRUST The Santa Fe Energy Trust (the Trust), created under the laws of the State of Texas, maintains its offices at the office of the Trustee, Texas Commerce Bank National Association (the Trustee), 600 Travis, Suite 1150, Houston, Texas 77002. The telephone number of the Trust is (713) 216-5100. The Trust was formed pursuant to an Organizational Trust Agreement dated as of October 22, 1992. Effective November 19, 1992, the Organizational Trust Agreement was amended and restated by the Trust Agreement of Santa Fe Energy Trust between Santa Fe Energy Resources, Inc. (Santa Fe) and Texas Commerce Bank National Association (the Trust Agreement). Under the terms of the Trust Agreement, Santa Fe conveyed royalty interests in certain oil and gas properties to the Trust. In exchange for the conveyance of such royalty interests, the Trust issued 6,300,000 units of undivided beneficial interest (Trust Units). The Trust Units and the Treasury Obligations (hereinafter defined) were deposited with Texas Commerce Bank National Association, as depositary (the Depositary) in exchange for 6,300,000 Depositary Units (hereinafter defined). Each Depositary Unit consists of beneficial ownership of one Trust Unit and a $20 face amount beneficial ownership interest in a $1,000 face amount zero coupon United States Treasury obligation (Treasury Obligation) maturing on February 15, 2008 (Liquidation Date). The Depositary Units are evidenced by Secure Principal Energy Receipts (SPERs), which are issued and transferable only in denominations of 50 Depositary Units or an integral multiple thereof. The Depositary Units are traded on the New York Stock Exchange under the symbol SFF. The Trust Units and Treasury Obligations are held by the Depositary for the holders of Depositary Units (Holders). The Treasury Obligations consist of a portfolio of United States Treasury stripped interest coupons that mature on the Liquidation Date in the aggregate face amount of $126,000,000, which amount equals $20 multiplied by the aggregate number of Depositary Units issued and outstanding. Since Depositary Units may be issued or transferred only in denominations of 50 or integral multiples thereof, each holder of 50 Depositary Units owns the entire beneficial interest in a discrete Treasury Obligation, in a face amount of $1,000, the minimum denomination of such Treasury Obligations. The Treasury Obligations do not pay current interest. See 'Description of Trust Units and Depositary Units -- Federal Income Tax Matters'. The Trust is a grantor trust formed by Santa Fe to hold royalty interests in certain oil and gas properties owned by Santa Fe (the Royalty Properties). The principal asset of the Trust consists of (i) two term royalty interests (the Wasson ODC Royalty and the Wasson Willard Royalty-collectively, the Wasson Royalties) conveyed to the Trust out of Santa Fe's royalty interests in two production units (the Wasson ODC Unit and the Wasson Willard Unit) in the Wasson Field, and (ii) a net profits royalty interest (the Net Profits Royalties) conveyed to the Trust out of Santa Fe's royalty interests and working interests in a diversified portfolio of oil and gas properties (the Net Profits Properties) located in 12 states (collectively, the Royalty Interests). The terms of the Trust Agreement provide, among other things, that: (1) the Trust cannot acquire any asset other than the Royalty Interests or engage in any business or investment activity of any kind whatsoever, except that cash being held by the Trustee as a reserve for liabilities or for distribution at the next distribution date will be placed in bank accounts or certificates; (2) the Trustee can establish cash reserves and borrow funds to pay liabilities of the Trust and can pledge assets of the Trust to secure payment of the borrowing; (3) the Trustee will receive the payments attributable to the Royalty Interests and pay all expenses, liabilities and obligations of the Trust; (4) the Trustee will make quarterly distributions to Holders of cash available for distribution in February, May, August and November of each year; (5) the Trustee is not required to make business decisions affecting the Trust Units or the Trust assets, but under certain circumstances, the Trustee may be required to approve or disapprove an extraordinary transaction affecting the Trust and the Holders; and (6) the Trust will be liquidated on or prior to the Liquidation Date. The discussion of terms of the Trust Agreement contained herein is qualified in its entirety by reference to the Trust Agreement itself, which is an exhibit to this Form 10-K and is available upon request from the Trustee. The Trustee is paid an annual fee of approximately $12,500. The Trust is responsible for paying all legal, accounting, engineering and stock exchange fees, printing costs and other administrative expenses incurred by or at the direction of the Trustee. The total of all Trustee fees and Trust administrative expenses is anticipated to aggregate approximately $250,000 per year, although such costs could be greater or less depending on future events. The Trust paid Santa Fe an annual fee of $200,000 in 1993. Such fee will increase by 3.5% per year, payable quarterly, to reimburse Santa Fe for overhead expenses. The Wasson Royalties were conveyed from Santa Fe to the Trust pursuant to a single instrument of conveyance (the Wasson Conveyance). The Net Profits Royalties were conveyed from Santa Fe to the Trust pursuant to separate, substantially similar conveyances (the Net Profits Conveyances) except with respect to the Net Profits Royalties in properties located within the State of Louisiana and its related state waters. Due to the effect of certain Louisiana laws governing the transfer of properties to trusts, the Louisiana Net Profits Royalties were conveyed from Santa Fe to the Trust pursuant to a separate conveyance in the form of a secured interest in proceeds of production from such properties (the Louisiana Conveyance). The Louisiana Conveyance provides the Trust with the economic equivalent of the Net Profits Royalties determined with respect to the Net Profits Properties located in Louisiana. The Net Profits Conveyances, Wasson Conveyance and Louisiana Conveyance are referred to collectively as the Conveyances. Santa Fe owns the Royalty Properties subject to and burdened by the Royalty Interests. Santa Fe will receive all payments relating to the sale of production from the Royalty Properties and will be required, pursuant to the Conveyances, to pay to the Trust the portion thereof attributable to the Royalty Interests. Under the Conveyances, the amounts payable with respect to the Royalty Interests will be computed with respect to each calendar quarter, and such amounts will be paid by Santa Fe to the Trust not later than 60 days after the end of each calendar quarter. The amounts paid to the Trust will not include interest on any amounts payable with respect to the Royalty Interests which are held by Santa Fe prior to payment to the Trust. Santa Fe will be entitled to retain any amounts attributable to the Royalty Properties which are not required to be paid to the Trust with respect to the Royalty Interests. The following descriptions of the Wasson Royalties and the Net Profits Royalties, and the calculation of amounts payable to the Trust in respect thereof, are subject to and qualified by the more detailed provisions of the Conveyances included as exhibits to this Form 10-K and available upon request from the Trustee. THE WASSON ROYALTIES THE WASSON ODC ROYALTY. The Wasson ODC Royalty was conveyed out of Santa Fe's 12.3934% royalty interest in the Wasson ODC Unit and entitles the Trust to receive quarterly royalty payments with respect to oil production from the Wasson ODC Unit for each calendar quarter (or two-month period in the case of the initial period ended December 31, 1992) during the period ending on December 31, 2007. The royalties payable with respect to the Wasson ODC Royalty for any calendar quarter is determined by multiplying (a) the Average Per Barrel Price (as defined below) received for such quarter with respect to oil production from the Wasson ODC Unit by (b) the Royalty Production (as defined below) for such quarter related to the Wasson ODC Royalty. 'Royalty Production' for the Wasson ODC Royalty is defined as 12.3934% of the lesser of (i) the actual number of gross barrels of oil produced for such quarter from the Wasson ODC Unit and (ii) the applicable maximum quarterly gross production limitation set forth in the table below. The table also shows the maximum number of barrels of Royalty Production that may be produced per quarter in respect of the Wasson ODC Royalty (12.3934% of the quarterly gross production limitation). The Wasson ODC Royalty will terminate on December 31, 2007. Thus, the Trustee will make a final quarterly distribution from the Wasson ODC Royalty in respect of the fourth quarter of 2007 on or about the Liquidation Date. THE WASSON WILLARD ROYALTY. The Wasson Willard Royalty was conveyed out of Santa Fe's 6.8355% royalty interest in the Wasson Willard Unit and entitles the Trust to receive quarterly royalty payments with respect to oil production from the Wasson Willard Unit for each calendar quarter (or two-month period in the case of the initial period ended December 31, 1992) during the period ending on December 31, 2003. The royalty payable for any calendar quarter is determined by multiplying (a) the Average Per Barrel Price (as defined below) received for such quarter with respect to oil production from the Wasson Willard Unit by (b) the Royalty Production (as defined below) for such quarter related to the Wasson Willard Royalty. 'Royalty Production' for the Wasson Willard Royalty is defined as 6.8355% of the lesser of (i) the actual number of gross barrels of oil produced for such quarter from the Wasson Willard Unit and (ii) thc applicable maximum quarterly gross production limitation set forth in the table below. The table also shows the maximum number of barrels of Royalty Production that may be produced per quarter in respect of the Wasson Willard Royalty (6.8355% of the quarterly gross production limitation). AVERAGE PER BARREL PRICE. The 'Average Per Barrel Price' with respect to the Wasson Royalties for any calendar quarter generally means (a) the aggregate revenues received by Santa Fe for such quarter from the sale of oil production from its royalty interest in the Wasson Field production unit to which the particular Wasson Royalty relates less certain actual costs for such quarter which consist of post-production costs (including gathering, transporting, separating, processing, treatment, storing and marketing charges), costs of litigation concerning title to or operations of the Wasson Royalties, severance taxes, ad valorem taxes, excise taxes (including windfall profits taxes, if any), sales taxes and other similar taxes imposed upon the reserves or upon production, delivery or sale of such production, costs of audits, insurance premiums and amounts reserved for the foregoing, divided by (b) the aggregate number of barrels produced for such quarter from its royalty interest in the Wasson Field production unit to which the particular Wasson Royalty relates. THE NET PROFITS ROYALTIES The Net Profits Royalties entitle the Trust to receive, on a quarterly basis, 90% of the Net Proceeds (as defined in the Net Profits Conveyances) from the sale of production from the Net Profits Properties. The Net Profits Royalties are not limited in term, although under the Trust Agreement the Trustee is directed to sell the Net Profits Royalties prior to the Liquidation Date. The definitions, formulas, accounting procedures and other terms governing the computation of Net Proceeds are detailed and extensive, and reference is made to the Net Profits Conveyances and the Louisiana Conveyance for a more detailed discussion of the computation thereof. CALCULATION OF NET PROCEEDS. 'Net Proceeds' generally means, for any calendar quarter, (a) with respect to Net Profits Properties that are conveyed from working interests, the excess of Gross Proceeds (as defined below) over all costs, expenses and liabilities incurred in connection with exploring, prospecting and drilling for, operating, producing, selling and marketing oil and gas, including, without limitation, all amounts paid as royalties, overriding royalties, production payments or other burdens against production pursuant to permitted encumbrances, delay rentals, payments in connection with the drilling or deferring of drilling of any well in the vicinity, adjustment payments to others in connection with contributions upon pooling, unitization or communitization, rent for use of or damage to the surface, costs under any joint operating unit or similar agreement, costs incurred with respect to reworking, drilling, equipping, plugging back, completing and recompleting wells, making production ready or available for market, constructing production and delivery facilities, producing, transporting, compressing, dehydrating, separating, treating, storing and marketing production, secondary or tertiary recovery or other operations conducted for the purpose of enhancing production, litigation concerning title to or operation of the working interests, renewals and extensions of leases, and taxes, and (b) with respect to Net Profits Properties that are conveyed from royalty interests, the excess of Gross Proceeds over all costs, expenses and liabilities incurred in making production available or ready for market, including, without limitation, costs paid for gathering, transporting, compressing, dehydrating, separating, treating, storing and marketing oil and gas, litigation concerning title to or operation of royalty interests, taxes, costs of audits and insurance premiums. 'Gross Proceeds' generally means, for any calendar quarter, the amount of cash received by Santa Fe during such quarter from the sales of oil and gas produced from the Net Profits Properties excluding (a) all amounts attributable to nonconsent operations conducted with respect to any working interest in which Santa Fe or its assignee is a nonconsenting party and which is dedicated to the recoupment or reimbursement of penalties, costs and expenses of the consenting parties, (b) damages arising from any cause other than drainage or reservoir injury, (c) rental for reservoir use, (d) payments in connection with the drilling of any well on or in the vicinity of the Net Profits Properties and (e) all amounts set aside as reserved amounts. Gross Proceeds will not include (x) consideration for the transfer or sale of the Net Profits Properties (except as provided below under 'Description of the Trust -- Support Payments') or (y) any amount not received for oil and gas lost in the production or marketing thereof or used by the owner of the Net Profits Properties in drilling, production and plant operations. Gross Proceeds includes payments for future production to the extent they are not subject to repayment in the event of insufficient subsequent production. If a dispute arises as to the correct or lawful sales prices of any oil or gas produced from any of the Net Profits Properties, then for purposes of determining whether the amounts have been received by the owner of the Net Profits Properties and therefore constitute Gross Proceeds (a) the amounts withheld by a purchaser and deposited with an escrow agent shall not be considered to be received by the owner of the Net Profits Properties until actually collected, (b) amounts received by the owner of the Net Profits Properties and promptly deposited with a non-affiliated escrow agent will not be considered to have been received until disbursed to it by such escrow agent and (c) amounts received by the owner of the Net Profits Properties and not deposited with an escrow agent will be considered to have been received. The Trust is not liable to the owners or operators of the Net Profits Properties for any operating, capital or other costs or liabilities attributable to the Net Profits Properties or oil and gas produced therefrom, and the Trustee is not obligated to return any income received from the Net Profits Royalties. Overpayments to the Trust will reduce future amounts payable. The Net Profits Properties generally consist of mature producing properties and Santa Fe does not anticipate substantial additional development costs during the producing lives of these properties. SUPPORT PAYMENTS The Wasson Conveyance provides that the Trust is entitled to additional quarterly royalty payments (Support Payments), subject to certain limitations herein described, from an additional royalty out of Santa Fe's interests in the Wasson ODC Unit during the period ending on December 31, 2002 (the Support Period) in the event that the net cash available for distribution to Holders from the Royalty Interests for any calendar quarter during the Support Period is less than an amount sufficient to distribute to Holders a minimum supported quarterly royalty per Depositary Unit equal to $0.40 per Depositary Unit (the Minimum Quarterly Royalty). The distribution with respect to the fourth quarter of 1993 (paid in the first quarter of 1994) included a Support Payment of $362,000 (approximately $0.06 per Depositary Unit). This Support Payment was required primarily due to lower realized oil prices and capital expenditures incurred with respect to the Net Profits Properties, a substantial portion of which related to the drilling of new wells. Based on current prices, it is expected that the distribution with respect to the first quarter of 1994 (to be paid in the second quarter of 1994) will include a Support Payment, the amount of which has not been determined. CALCULATION OF AMOUNT OF SUPPORT PAYMENT. Support Payments payable to the Trust for any calendar quarter during the Support Period shall be equal to the additional amount necessary to cause the Minimum Quarterly Royalty for such quarter to be paid by the Trust in respect of all outstanding Trust Units; provided, that the aggregate amount of Support Payments, net of any amounts recouped by Santa Fe pursuant to reductions in the royalties payable with respect to the Royalty Interests as described below, will be limited to $20 million (the Aggregate Support Payment Limitation Amount), as such amount may be replenished upon recoupment of certain amounts as described in the following paragraph. REDUCTION OF ROYALTY INTERESTS. In the event Support Payments are paid to the Trust for any quarter, the royalties payable with respect to the Wasson Royalties will be reduced in future quarters (including quarters after the Support Period but prior to the Liquidation Date) after the Trust has received (or amounts are set aside for payment of) proceeds from all of the Royalty Interests in amounts sufficient to pay 112.5% of the Minimum Quarterly Royalty ($0.45 per Depositary Unit) on all Trust Units outstanding at the end of such quarter in order to permit Santa Fe to recoup the aggregate amount of the Support Payments. Any such reduction in royalties payable with respect to the Royalty Interests would be made first to the Wasson ODC Royalty and then, if additional reductions are necessary, from the Wasson Willard Royalty. The effect of such reductions in the royalties payable with respect to the Wasson Royalties would be to eliminate distributions in excess of $0.45 per Depositary Unit until the Support Payments, if any, received by the Trust have been recouped by Santa Fe through such reductions in the Wasson Royalties. PROPORTIONATE REDUCTION OF MINIMUM QUARTERLY ROYALTY AND AGGREGATE SUPPORT PAYMENT LIMITATION AMOUNT UPON CERTAIN SALES. In the event that Santa Fe causes the Trust to sell or release a portion of the Net Profits Royalties in connection with the sale by Santa Fe of underlying Net Profits Properties, the Minimum Quarterly Royalty and the Aggregate Support Payment Limitation Amount will be adjusted proportionately downward to equal the product resulting from multiplying each of the Minimum Quarterly Royalty and the Aggregate Support Payment Limitation Amount by a fraction, the numerator of which will be the Remaining Royalty Interests Amount (as defined below) and the denominator of which will be the Existing Royalty Interests Amount (as defined below). For such purposes, the 'Remaining Royalty Interests Amount' means, at any time, the Existing Royalty Interests Amount (as defined below) less the present value of the future net revenues attributable to the portion of the Net Profits Royalties sold or released by the Trust, determined by reference to the reserve report for the Royalty Properties prepared in accordance with guidelines of the Securities and Exchange Commission (Commission) as of the December 31 immediately preceding the date of the sale. The 'Existing Royalty Interests Amount' means, at any time, the then present value of the future net revenues attributable to the Royalty Interests (including the portion sold or released by the Trust), determined by reference to the reserve report for the Royalty Properties prepared in accordance with Commission guidelines as of the December 31 immediately preceding the date of the sale. Following any such sale of Net Profits Royalties, the Trustee will notify the Holders of the adjusted Minimum Quarterly Royalty and the adjusted Aggregate Support Payment Limitation Amount. OTHER MATTERS Payments to the Trust are attributable to the sale of depleting assets. Thus, the reserves attributable to the Royalty Properties are expected to decline over time. Based on the estimated production volumes in the Reserve Report (hereinafter defined), on an equivalent basis the oil and gas production from proved reserves attributable to the Royalty Interests in the year preceding the Liquidation Date is expected to be approximately 25% of the initial production rate attributable to the Royalty Properties. Under the terms of the Conveyances, neither the Trustee, the Trust nor the Holders will be able to influence or control the operation or future development of the Royalty Properties. Santa Fe operates only a small number of the Royalty Properties and is not expected to be able to significantly influence the operations or future development of the Royalty Properties that are royalty interests or that consist of relatively small working interests. Such operations will generally be controlled by persons unaffiliated with the Trustee and Santa Fe. Santa Fe, however, owns working interests in the Wasson ODC Unit and the Wasson Willard Unit and may be able to exercise some influence, though not control, over unit operations. The tertiary recovery operations in the Wasson Field have required substantial capital expenditures and will involve significant future capital expenditures for CO2 acquisition, particularly in the Wasson Willard Unit. A prolonged oil price downturn could cause the operators in the Wasson Field to reassess the economic viability of capital intensive production operations notwithstanding their substantial unrecovered investment. Such decisions will not be in the control of either Santa Fe or the Trustee and could have the effect of substantially reducing expected production from the Wasson Field. The current operators of the Royalty Properties are under no obligation to continue operating such properties, and neither the Trustee, the Holders nor Santa Fe will be able to appoint or control the appointment of replacement operators. The operators of the Net Profits Properties and any transferee have the right to abandon any well or property on a Net Profits Property that is a working interest, if, in their opinion, such well or property ceases to produce or is not capable of producing in commercially paying quantities, and upon termination of any such lease that portion of the Net Profits Royalties relating thereto will be extinguished. The Trust Agreement provides that Santa Fe may sell the Royalty Properties, subject to and burdened by the Royalty Interests, without the consent of the Holders. In addition, Santa Fe may, without the consent of the Holders, require the Trust to release up to $5 million of the Net Profit Royalties in any 12-month period (limited to $15 million in the aggregate for all sales prior to January 1, 2002) in connection with a sale of the Net Profits Properties provided that the Trust receives an amount equal to 90% of the net proceeds received by Santa Fe with respect to the Net Profits Properties so sold and such cash price represents the fair market value of such properties (which fair market value for sales in excess of $500,000 will be determined by independent appraisal). Such sales can be required of the Trust without regard to any dollar limitation on and after December 31, 2005. Any net sales proceeds paid to the Trust are distributable to Holders for the quarter in which such proceeds are received. Pursuant to the Trust Agreement, the Trust may not sell the Wasson ODC Royalty or the Wasson Willard Royalty without the consent of Santa Fe. Under the Trust Agreement, Santa Fe has a right of first refusal to purchase any of the Royalty Interests at fair market value, or if applicable the offered third-party price, prior to the Liquidation Date. The Trust has no employees. Administrative functions of the Trust are performed by the Trustee. DESCRIPTION OF THE TRUST UNITS AND DEPOSITARY UNITS The following information is subject to the detailed provisions of the Custodial Deposit Agreement entered into by Santa Fe, the Trustee, the Depositary and all holders from time to time of SPERs (the Deposit Agreement), which is an exhibit to this Form 10-K and is available upon request from the Trustee. The functions of the Depositary under the Deposit Agreement are custodial and ministerial in nature and for the benefit of Holders. The Deposit Agreement and the issuance of SPERs thereunder provide Holders an administratively convenient form of holding an investment in the Trust and a Treasury Obligation. Each Depositary Unit is evidenced by a SPER, which is issued by the Depositary and transferable only in denominations of 50 Depositary Units or an integral multiple thereof. Accordingly, each Holder of 50 Depositary Units owns a beneficial interest in 50 Trust Units and the entire beneficial interest in a discrete Treasury Obligation in a face amount of $1,000, or $20 per Depositary Unit. The deposited Trust Units and Treasury Obligations are held solely for the benefit of the Holders and do not constitute assets of the Depositary or the Trust. The Depositary has no power to assign, transfer, pledge or otherwise dispose of any of the Trust Units or Treasury Obligations, except as described under 'Possible Divestiture of Depositary Units and Trust Units'. Generally, the Depositary Units are entitled to participate in distributions with respect to the Trust Units and such distributions with respect to the Treasury Obligations and the liquidation of the remaining assets of the Trust. Upon the written request of a Holder for withdrawal of Trust Units and Treasury Obligations evidenced by SPERs in denominations of 50 Depositary Units or an integral multiple thereof from deposit and the surrender of such Holder's SPER in compliance with the terms of the Deposit Agreement, the Holder surrendering such Depositary Units will be entitled to receive the underlying Trust Units, which will be uncertificated, and whole Treasury Obligation as described herein. These withdrawn Trust Units will be evidenced on the books of the Trustee by a transfer of such Trust Units from the name of the Depositary to the name of the withdrawing Holder. Holders of withdrawn Trust Units will be entitled to receive Trust distributions and periodic Trust information (including tax information) directly from the Trustee. Due to the accreting nature of the value of the zero coupon Treasury Obligations, the withdrawal and sale of a Treasury Obligation underlying Depositary Units prior to its maturity will result in the Holder receiving less than the face value for its Treasury Obligation investment. The amount a withdrawing Holder may receive from the sale of a Treasury Obligation prior to its maturity will be affected by such factors as then current interest rates and the small size of the Treasury Obligation relative to typical trades in the secondary market for United States Treasury obligations (which may result in a discount to quoted market values). Pursuant to the Trust Agreement and the related transfer application, withdrawn Trust Units are not transferable except by operation of law. A holder of withdrawn Trust Units may, however, transfer such Trust Units in denominations of 50 (or an integral multiple thereof) to the Depositary for redeposit, together with Treasury Obligations in the face amount equal to $1,000 for each 50 Trust Units redeposited, in exchange for Depositary Units. Such redeposit may be effected by delivering written notice of such transfer jointly to the Depositary and the Trustee together with proper documentation necessary to transfer the requisite Treasury Obligations into the name of the Depositary. DISTRIBUTIONS The Trustee determines for each calendar quarter during the term of the Trust the amount of cash available for distribution to holders of Depositary Units and the Trust Units evidenced thereby. Such amount (the Quarterly Distribution Amount) is equal to the excess, if any, of the cash received by the Trust from the Royalty Interests then held by the Trust during such quarter, plus any other cash receipts of the Trust during such quarter, over the liabilities of the Trust paid during such quarter, subject to adjustments for changes made by the Trustee during such quarter in any cash reserves established for the payments of contingent or future obligations of the Trust. Based on industry practice and the payment procedures relating to the Net Profits Royalties, cash received by the Trustee in a particular quarter from the Net Profits Royalties generally represents proceeds from sales of production for the three months ending two months prior to the end of such quarter with respect to gas, and one month prior to the end of such quarter with respect to oil. For example, the royalty income received by the Trust for the third calendar quarter with respect to gas is attributable to production in the months of May, June and July (for which Santa Fe would have received payment from the purchasers in July, August and September, respectively). Since proceeds from the sale of production from the Wasson Properties are received within one month of production, payments in respect of the Wasson Royalties are made for production from the calendar quarter to which the Quarterly Distribution Amount relates. The Quarterly Distribution Amount for each quarter is payable to Holders of Depositary Units of record on the 45th day following each calendar quarter (or the next succeeding business day following such day if such day is not a business day) or such later date as the Trustee determines is required to comply with legal or stock exchange requirements (the Quarterly Record Date). The Trustee distributes cash to the Holders within two months after the end of each calendar quarter to each person who was a Holder of Depositary Units of record on a Quarterly Record Date. The net taxable income of the Trust for each calendar quarter will be reported by the Trustee for tax purposes as belonging to the Holders of record to whom the Quarterly Distribution Amount was or will be distributed. Because the Trust will be classified for tax purposes as a 'grantor trust' (see 'Federal Income Tax Matters'), the net taxable income will be realized by the Holders for tax purposes in the calendar quarter received by the Trustee, rather than in the quarter distributed by the Trustee. Taxable income of a Holder may differ from the Quarterly Distribution Amount because the Wasson Royalties and Treasury Obligations are treated as generating interest income for tax purposes. There may also be minor variances because of the possibility that, for example, a reserve will be established in one quarter that will not give rise to a tax deduction until a subsequent quarter, an expenditure paid for in one quarter will have to be amortized for tax purposes over several quarters, etc. See 'Federal Income Tax Matters.' Each Holder of Depositary Units (including the underlying Trust Units) of record as of the business day next preceding the Liquidation Date will be entitled to receive a liquidating distribution equal to a pro rata portion of the net proceeds from the sale of the Net Profits Royalties (to the extent not previously distributed) and a pro rata portion of the proceeds from the matured Treasury Obligations. POSSIBLE DIVESTITURE OF DEPOSITARY UNITS AND TRUST UNITS The Trust Agreement imposes no restrictions based on nationality or other status of holders of Trust Units. However, the Trust Agreement and the Deposit Agreement provide that in the event of certain judicial or administrative proceedings seeking the cancellation or forfeiture of any property in which the Trust has an interest because of the nationality, citizenship, or any other status, of any one or more holders of Trust Units including Holders of Depositary Units, the Trustee will give written notice thereof to each holder whose nationality, citizenship or other status is an issue in the proceeding, which notice will constitute a demand that such holder dispose of his Depositary Units or withdrawn Trust Units within 30 days. If any holder fails to dispose of his Depositary Units or withdrawn Trust Units in accordance with such notice, cash distributions on such units are subject to suspension. In the event a holder fails to dispose of Depositary Units in accordance with such notice, the Depositary may cancel such holder's Depositary Units and reissue them in the name of the Trustee, whereupon the Trustee will use its reasonable efforts to sell the Depositary Units and remit the net sale proceeds to such holder. In the case of Trust Units withdrawn from deposit with the Depositary, the Trustee shall redeem such Trust Units not divested in accordance with such notice, for a cash price equal to the then-current market price of the Depositary Units less the then-current, over-the-counter bid price of the related, withdrawn Treasury Obligations. The redemption price will be paid out in quarterly installments limited to the amount that otherwise would have been distributed in respect of such redeemed Trust Units. LIABILITY OF HOLDERS The Trust is intended to be classified as an 'express trust' under Texas law and thus subject to the Texas Trust Code. Under the Texas Trust Code, a trust beneficiary will not be held personally liable for obligations incurred by the Trust except in limited circumstances principally related to wrongful conduct by the trust beneficiary. It is unclear whether the Trust constitutes an 'express trust' under the Texas Trust Code. If the Trust were held not to be an express trust, a Holder could be jointly and severally liable for any liability of the Trust in the event that (i) the satisfaction of such liability was not by contract limited to the assets of the Trust and (ii) the assets of the Trust were insufficient to discharge such liability. Examples of such liability would include liabilities arising under environmental laws and damages arising from product liability and personal injury in connection with the Trust's business. Each Holder should weigh this potential exposure in deciding whether to retain or transfer his Trust Units. LIQUIDATION OF THE TRUST The Trust will be liquidated and the Net Profits Royalties will be sold on or prior to the Liquidation Date. Holders of record as of the business day next proceeding the Liquidation Date will be entitled to receive a terminating distribution with respect to each Depositary Unit equal to a pro rata portion of the net proceeds from the sale of the Net Profits Royalties (to the extent not previously distributed) and a pro rata portion of the proceeds from the matured Treasury Obligations. Under the Trust Agreement, Santa Fe has a right of first refusal to purchase any of the Royalty Interests at fair market value, or if applicable, the offered third-party price, prior to the Liquidation Date. FEDERAL INCOME TAX MATTERS This section is a summary of Federal income tax matters of general application which addresses all material tax consequences of the ownership and sale of Depositary Units. Except where indicated, the discussion below describes general Federal income tax considerations applicable to individuals who are citizens or residents of the United States. Accordingly, the following discussion has limited application to domestic corporations and persons subject to specialized Federal income tax treatment, such as tax-exempt entities, regulated investment companies and insurance companies. The following discussion does not address tax consequences to foreign persons. It is impractical to comment on all aspects of Federal, state, local and foreign laws that may affect the tax consequences of the transactions contemplated hereby and of an investment in Depositary Units as they relate to the particular circumstances of every prospective Holder. EACH HOLDER SHOULD CONSULT HIS OWN TAX ADVISOR WITH RESPECT TO HIS PARTICULAR CIRCUMSTANCES. This summary is based on current provisions of the Internal Revenue Code of 1986, as amended (the Code), existing and proposed regulations thereunder and current administrative rulings and court decisions, all of which are subject to changes that may or may not be retroactively applied. Some of the applicable provisions of the Code have not been interpreted by the courts or the Internal Revenue Service (IRS). No ruling has been or will be requested from the IRS with respect to any matter affecting the Trust or Holders, and thus no assurance can be provided that the statements set forth herein (which do not bind the IRS or the courts) will not be challenged by the IRS or will be sustained by a court if so challenged. TREATMENT OF DEPOSITARY UNITS A purchaser of a Depositary Unit will be treated, for Federal income tax purposes, as purchasing directly an interest in the Treasury Obligations and a Trust Unit. A purchaser will therefore be required to allocate the purchase price of his Depositary Unit between the interest in the Treasury Obligations and the Trust Unit in the proportion that the fair market value of each bears to the fair market value of the Depositary Unit. Information regarding purchase price allocations will be furnished to Holders by the Trustee. CLASSIFICATION AND TAXATION OF THE TRUST The Trust will be taxable as a grantor trust and not as an association taxable as a corporation. As a grantor trust, the Trust will not be subject to tax. For tax purposes, Holders will be considered to own and receive the Trust's income and principal as though no trust were in existence. The Trust will file an information return, reporting all items of income, credit or deduction which must be included in the tax returns of Holders. If the Trust were determined to be an association taxable as a corporation, it would be treated as a separate entity subject to corporate tax on its taxable income, Holders would be treated as shareholders, and distributions to Holders from the Trust would be treated as nondeductible corporate distributions. Such distributions would be taxable to a Holder, first, as dividends to the extent of the Holder's pro rata share of the Trust's earnings and profits, then as a tax-free return of capital to the extent of his basis in his Trust Units, and finally as capital gain to the extent of any excess. DIRECT TAXATION OF HOLDERS Because the Trust will be treated as a grantor trust for Federal income tax purposes, and a Holder will be treated, for Federal income tax purposes, as owning a direct interest in the Treasury Obligations and the assets of the Trust, each Holder will be taxed directly on his pro rata share of the income attributable to the Treasury Obligations and the assets of the Trust and will be entitled to claim his pro rata share of the deductions attributable to the Trust (subject to certain limitations discussed below). Income and expenses attributable to the assets of the Trust and the Treasury Obligations will be taken into account by Holders consistent with their method of accounting and without regard to the taxable year or accounting method employed by the Trust. The Trust will make quarterly distributions to Holders of record on each Quarterly Record Date. The terms of the Trust Agreement seek to assure to the extent practicable that taxable income attributable to such distributions will be reported by the Holder who receives such distributions, assuming that he is the owner of record on the Quarterly Record Date. In certain circumstances, however, a Holder will not receive the distribution attributable to such income. For example, if the Trustee establishes a reserve or borrows money to satisfy debts and liabilities of the Trust, income associated with the cash used to establish that reserve or to repay that loan must be reported by the Holder, even though that cash is not distributed to him. In addition, Holders will be required to recognize certain interest income attributable to the Treasury Obligations with respect to which no current cash distributions will be made. The Trust intends to allocate income and deductions to Holders based on record ownership at Quarterly Record Dates. It is unknown whether the IRS will accept that allocation or will require income and deductions of the Trust to be determined and allocated daily or require some method of daily proration, which could result in an increase in the administrative expenses of the Trust. TREATMENT OF TRUST UNITS Because the Trust is treated as a grantor trust for tax purposes, each Holder will be treated as purchasing directly an interest in the Royalty Interests. The purchaser of a Depositary Unit will be required to allocate the portion of his total purchase price allocated to the Trust Unit among the Royalty Interests in the proportion that the fair market value of each of the Royalty Interests bears to the total fair market value of all of the Royalty Interests. For purposes of making this allocation, the Royalty Interests will include the Wasson ODC Royalty, the Wasson Willard Royalty and the Net Profits Royalties. Information regarding purchase price allocations will be furnished to Holders by the Trustee. INTEREST INCOME Based on representations made by Santa Fe regarding the reserves burdened by the Wasson Royalties and the expected life of the Wasson Royalties, the Wasson Royalties will be treated as 'production payments' under Section 636(a) of the Code. Thus, each Holder will be treated as making a mortgage loan on the Wasson Properties to Santa Fe in an amount equal to the amount of the purchase price of each Depositary Unit allocated to the Wasson Royalties. Because they are treated as debt instruments for tax purposes, the Wasson Royalties will be subject to the Original Issue Discount (OID) rules of Sections 1272 through 1275 of the Code. Section 1272 generally requires the periodic inclusion of original issue discount in income of the purchaser of a debt instrument. Section 1275 provides special rules and authorizes the IRS to prescribe regulations modifying the statutory provisions where, by reason of contingent payments, the tax treatment provided under the statutory provisions does not carry out the purposes of such provisions. The IRS has not yet issued either temporary or final regulations dealing with contingent payments. Proposed regulations dealing with contingent payments were issued in 1986 and modified in 1991 (the Proposed Regulations). Under the Proposed Regulations, each payment (at the time the amount of such payment becomes fixed) made to the Trust with respect to the Wasson Royalties will be treated first as consisting of a payment of interest to the extent of interest deemed accrued under the OID rules and the excess (if any) will be treated as a payment of principal. The total amount treated as principal will be limited to the amount of the purchase price of each Depositary Unit allocated to the Wasson Royalties. For purposes of determining the amount of accrued interest, the Proposed Regulations require the use of the Applicable Federal Rate based on the due date of the final payment due under the terms of each of the production payments, which for the Wasson Willard Royalty and the Wasson ODC Royalty is December 31, 2003 and December 31, 2007, respectively. Holders will also be required to recognize and report OID interest income attributable to the Treasury Obligations. In general, the total amount of OID interest income a Holder will be required to recognize will be calculated as the difference between the amount of the purchase price of a Depositary Unit allocated to the Treasury Obligations and the pro rata portion of the face amount of such Treasury Obligations attributable to the Depositary Unit. The amount of OID interest income so calculated will be included in income by a Holder on the basis of a constant interest rate computation. ROYALTY INCOME AND DEPLETION The income from the Net Profits Royalties will be royalty income subject to an allowance for depletion. The depletion allowance must be computed separately by each Holder for each oil or gas property (within the meaning of Code Section 614). The IRS presently takes the position that a net profits interest carved out of multiple properties is a single property for depletion purposes. Accordingly, the Trust intends to take the position that the Net Profits Royalties are a single property for depletion purposes until such time as the issue is resolved in some other manner. The allowance for depletion with respect to a property is determined annually and is the greater of cost depletion or, if allowable, percentage depletion. Percentage depletion is generally available to 'independent producers' (generally persons who are not substantial refiners or retailers of oil or gas or their primary products) on the equivalent of 1,000 barrels of production per day. Percentage depletion is a statutory allowance equal to 15% of the gross income from production from a property subject to a net income limitation which is 100% of the taxable income from the property, computed without regard to depletion deductions and certain loss carrybacks. The depletion deduction attributable to percentage depletion for a taxable year is limited to 65% of the taxpayer's taxable income for the year before allowance of 'independent producers' percentage depletion and certain loss carrybacks. Unlike cost depletion, percentage depletion is not limited to the adjusted tax basis of the property, although it reduces such adjusted tax basis (but not below zero). In computing cost depletion for each property for any year, the adjusted tax basis of that property at the beginning of that year is divided by the estimated total units (Bbls of oil or Mcf of gas) recoverable from that property to determine the per-unit allowance for such property. The per-unit allowance is then multiplied by the number of units produced and sold from that property during the year. Cost depletion for a property cannot exceed the adjusted tax basis of such property. Since the Trust will be taxed as a grantor trust, each Holder will compute cost depletion using his basis in his Trust Units allocated to the Net Profits Royalties. Information will be provided to each Holder reflecting how that basis should be allocated among each property represented by his Trust Units. OTHER INCOME AND EXPENSES It is anticipated that the Trust may generate some interest income on funds held as a reserve or held until the next distribution date. Expenses of the Trust will include administrative expenses of the Trustee. Under the Code, certain miscellaneous itemized deductions of an individual taxpayer are deductible only to the extent that in the aggregate they exceed 2% of the taxpayer's adjusted gross income. Certain administrative expenses attributable to the Trust Units may have to be aggregated with an individual Holder's other miscellaneous itemized deductions to determine the excess over 2% of adjusted gross income. It is anticipated that the amount of such expenses will not be significant in relation to the Trust's income. NON-PASSIVE ACTIVITY INCOME AND LOSS The income and expenses of the Trust will not be taken into account in computing the passive activity losses and income under Code Section 469 for a Holder who acquires and holds Depositary Units as an investment. UNRELATED BUSINESS TAXABLE INCOME Certain organizations that are generally exempt from tax under Code Section 501 are subject to tax on certain types of business income defined in Code Section 512 as unrelated business income. The income of the Trust will not be unrelated business taxable income within the meaning of Code Section 512 so long as the Trust Units are not 'debt-financed property' within the meaning of Code Section 524(b). In general, a Trust Unit would be debt-financed if the Holder incurs debt to acquire a Trust Unit or otherwise incurs or maintains a debt that would not have been incurred or maintained if such Trust Unit had not been acquired. Legislative proposals have been made from time to time which, if adopted, would result in the treatment of income attributable to the Net Profits Royalties as unrelated business income. SALE OF DEPOSITARY UNITS; DEPLETABLE BASIS Generally, a Holder will realize gain or loss on the sale or exchange of his Depositary Units measured by the difference between the amount realized on the sale or exchange and his adjusted basis for such Depositary Units. Gain or loss on the sale of Depositary Units by a Holder who is not a dealer with respect to such Depositary Units and who has a holding period for the Depositary Units of more than one year will be treated as long-term capital gain or loss except to the extent of the depletion recapture amount. A Holder's basis in his Depositary Units will be equal to the amount paid for such Depositary Units. Such basis will be increased by the amount of any OID interest income recognized by the Holder attributable to the Treasury Obligations. Such basis will be reduced by deductions for depletion claimed by the Holder (but not below zero). In addition, such basis will be reduced by the amount of any payments attributable to the Wasson Royalties which are treated as payments of principal under the OID rules. For Federal income tax purposes, the sale of a Depositary Unit will be treated as a sale by the Holder of his interest in the Treasury Obligations and the assets of the Trust. Thus, upon the sale of Depositary Units, a Holder must treat as ordinary income his depletion recapture amount, which is an amount equal to the lesser of (i) the gain on that sale attributable to disposition of the Net Profits Royalties or (ii) the sum of the prior depletion deductions taken with respect to the Net Profits Royalties (but not in excess of the initial basis of such Depositary Units allocated to the Net Profits Royalties). It is possible that the IRS would take the position that a portion of the sales proceeds is ordinary income to the extent of any accrued income at the time of sale allocable to the Depositary Units sold, but which is not distributed to the selling Holder. SALE OF NET PROFITS ROYALTIES In certain circumstances, Santa Fe may cause the Trustee, without the consent of the Holders, to release a portion of the Net Profits Royalties in connection with a sale by Santa Fe of the underlying Net Profits Properties. Additionally, the assets of the Trust, including the Net Profits Royalties, will be sold by the Trustee prior to the Liquidation Date in anticipation of the termination of the Trust. A sale by the Trust of Net Profits Royalties will be treated for Federal income tax purposes as a sale of Net Profits Royalties by a Holder. Thus, a Holder will recognize gain or loss on a sale of Net Profits Royalties by the Trust. A portion of that income may be treated as ordinary income to the extent of depletion recapture. See 'Sale of Depositary Units; Depletable Basis,' above. BACKUP WITHHOLDING In general, distributions of Trust income will not be subject to 'backup withholding' unless: (i) the Holder is an individual or other noncorporate taxpayer and (ii) such Holder fails to comply with certain reporting procedures. TAX SHELTER REGISTRATION Code Section 6111 requires a tax shelter organizer to register a 'tax shelter' with the IRS by the first day on which interests in the tax shelter are offered for sale. The Trust is registered as a tax shelter with the IRS. The Trust's tax shelter registration number is 92322000636. A Holder who sells or otherwise transfers a Trust Unit in a subsequent transaction must furnish the tax shelter registration number to the transferee. The penalty for failure of the transferor of a Trust Unit to furnish such tax shelter registration number to a transferee is $100 for each such failure. Holders must disclose the tax shelter registration number of the Trust on Form 8271 to be attached to the tax return on which any deduction, loss, credit or other benefit generated by the Trust is claimed or income of the Trust is included. A Holder who fails to disclose the tax shelter registration number on his return, without reasonable cause for such failure, will be subject to a $50 penalty for each such failure. (Any penalties discussed herein are not deductible for income tax purposes.) ISSUANCE OF A TAX SHELTER REGISTRATION NUMBER DOES NOT INDICATE THAT AN INVESTMENT IN DEPOSITARY UNITS OR TRUST UNITS OR THE CLAIMED TAX BENEFITS HAVE BEEN REVIEWED, EXAMINED OR APPROVED BY THE IRS. ERISA CONSIDERATIONS The Employee Retirement Income Security Act of 1974, as amended (ERISA), imposes certain requirements on pension, profit-sharing and other employee benefit plans to which it applies (Plans), and contains standards on those persons who are fiduciaries with respect to such Plans. In addition, under the Code, there are similar requirements and standards which are applicable to certain Plans and individual retirement accounts (whether or not subject to ERISA) (collectively, together with Plans subject to ERISA, referred to herein as Qualified Plans). A fiduciary of a Qualified Plan should carefully consider fiduciary standards under ERISA regarding the Plan's particular circumstances before authorizing an investment in Trust Units. A fiduciary should first consider (i) whether the investment satisfies the prudence requirements of Section 404(a)(1)(B) of ERISA, (ii) whether the investment satisfies the diversification requirements of Section 404(a)(1)(C) of ERISA and (iii) whether the investment is in accordance with the documents and instruments governing the Plan as required by Section 404(a)(1)(D) of ERISA. In order to avoid the application of certain penalties, a fiduciary must also consider whether the acquisition of Trust Units and/or operation of the Trust might result in direct or indirect nonexempt prohibited transactions under Section 406 of ERISA and Code Section 4975. In determining whether there are such prohibited transactions, a fiduciary must determine whether there are 'plan assets' involved in the transaction. On November 13, 1986, the Department of Labor published final regulations (the DOL Regulations) concerning whether or not a Qualified Plan's assets (such as a Trust Unit) would be deemed to include an interest in the underlying assets of an entity (such as the Trust) for purposes of the reporting, disclosure and fiduciary responsibility provisions of ERISA and analogous provisions of the Code, if the Plan acquires an 'equity interest' in such entity. The DOL Regulations provide that the underlying assets of an entity will not be considered 'plan assets' if the interests in the entity are a publicly offered security. Trust Units are considered to be 'publicly offered' for this purpose if they are part of a class of securities that is (i) widely held (I.E., owned by more than 100 investors independent of the issuer and each other), (ii) freely transferable, and (iii) registered under Section 12(b) or 12(g) of the Exchange Act. Although no assurances can be given, it is believed that these requirements have been satisfied with respect to Trust Units. Fiduciaries, however, will need to determine whether the acquisition of Trust Units is a nonexempt prohibited transaction under the general requirements of ERISA Section 406 and Code Section 4975. Due to the complexity of the prohibited transaction rules and the penalties imposed upon persons involved in prohibited transactions, it is important that potential Qualified Plan investors consult with their counsel regarding the consequences under ERISA and the Code of their acquisition and ownership of Trust Units. STATE TAX CONSIDERATIONS The following is intended as a brief summary of certain information regarding state income taxes and other state tax matters affecting individuals who are Holders. Holders are urged to consult their own legal and tax advisors with respect to these matters. Prospective investors should consider state and local tax consequences of an investment in Depositary Units. The Trust owns the Royalty Interests burdening oil and gas properties located in Alabama, Arkansas, California, Colorado, Kansas, Louisiana, Mississippi, New Mexico, North Dakota, Oklahoma, Texas and Wyoming. Of these, all but Texas and Wyoming have income taxes applicable to individuals. As stated, Texas currently has no income tax and the Reserve Report reflects that more than 50% of the estimated future net cash inflows generated by the Trust will be attributable to properties located in Texas. A Holder may be required to file state income tax returns and/or to pay taxes in those states imposing income taxes and may be subject to penalties for failure to comply with such requirements. Further, in some states the Trust may be taxed as a separate entity. The Depositary will provide information prepared by the Trustee concerning the Depositary Units sufficient to identify the income from Depositary Units that is allocable to each state. Holders of Depositary Units should consult their own tax advisors to determine their income tax filing requirements with respect to their share of income of the Trust allocable to states imposing an income tax on such income. The Trust Units represented by Depositary Units may constitute real property or an interest in real property under the inheritance, estate and probate laws of some or all of the states listed above. If the Depositary Units are held to be real property or an interest in real property under the laws of a state in which the Royalty Properties are located, the holders of Depositary Units may be subject to devolution, probate and administration laws, and inheritance or estate and similar taxes under the laws of such state. DESCRIPTION OF THE TREASURY OBLIGATIONS The Treasury Obligations consist of a portfolio of interest coupons stripped from United States Treasury Bonds. All of the Treasury Obligations become due on the Liquidation Date in the aggregate face amount of $126,000,000, which amount equals $20 per outstanding Depositary Unit. The Treasury Obligations were purchased on behalf of the Depositary at a deep discount from face value at a price of $30.733 per hundred dollars, which was approximately the asked price on the over-the-counter U.S. Treasury market for such obligations on November 12, 1992 (after adjustment for five-day settlement). The Treasury Obligations were deposited with the Depositary on November 19, 1992 in connection with the initial public offering of Depositary Units. The Treasury Obligations were issued under the Separate Trading of Registered Interest and Principal of Securities program of the U.S. Treasury, which permits the trading of the Treasury Obligations in book-entry form. The Treasury Obligations are held for the benefit of Holders in the name of the Depositary in book-entry form with a Federal Reserve Bank subject to withdrawal by a Holder. The deposited Treasury Obligations are not considered assets of the Depositary or the Trust. In the unlikely event of default by the U.S. Treasury in the payment of the Treasury Obligations when due, each Holder would have the right to withdraw a deposited Treasury Obligation in a face amount of $1,000 for each 50 Depositary Units and, as a real party in interest and as the owner of the entire beneficial interest in discrete Treasury Obligations, proceed directly and individually against the United States of America in whatever manner he deems appropriate without any requirement to act in concert with the Depositary, other Holders or any other person. Santa Fe makes available quarterly to the Depositary for distribution to Holders certain information regarding the Treasury Obligations including high, low and recent asked prices quoted during each calendar quarter on the over-the-counter United States Treasury market. The Treasury Obligations pay no current interest. DESCRIPTION OF THE ROYALTY PROPERTIES THE WASSON PROPERTIES The Wasson Royalties were conveyed to the trust out of Santa Fe's 12.3934% royalty interest in the Wasson ODC Unit and its 6.8355% royalty interest in the Wasson Willard Unit, located in the Wasson Field. Santa Fe also owns significant working interests in each of these units. Santa Fe's production from the Wasson Field commenced in 1939. A secondary waterflooding phase in the Wasson Field began in the early 1960s. The Wasson Field has been significantly redeveloped for tertiary recovery operations utilizing CO2 flooding, which commenced in 1984. Gross capital expenditures in excess of $600 million have been made by all working interest owners in respect of these operations in the Wasson ODC Unit and Wasson Willard Unit. Most of the capital expenditures for plant, facilities, wells and equipment necessary for such tertiary recovery operations have been made, although significant ongoing capital expenditures for CO 2 acquisition will be required to complete the flood of the Wasson Field, particularly the Wasson Willard Unit. The Wasson Royalties are not subject to development costs or operating costs (including CO2 acquisition costs). The Wasson ODC Unit and the Wasson Willard Unit are production units formed by the various interest owners in the Wasson Field to facilitate development and production of certain geographically concentrated leases. The Wasson ODC Unit covers approximately 7,840 acres with approximately 315 producing wells and is operated by Amoco Production Company. The Wasson Willard Unit covers approximately 13,520 acres with approximately 338 producing wells and is operated by a subsidiary of Atlantic Richfield Company. Production attributable to Santa Fe's royalty interests in the Wasson ODC Unit and Wasson Willard Unit is marketed by Santa Fe and in some cases is sold at the wellhead at market responsive prices that approximate spot oil prices for West Texas Sour crude, and in other cases is sold at points within common carrier pipeline systems on terms whereby Santa Fe pays the cost of transporting same to such points. Santa Fe may sell its royalty interests in the Wasson Field subject to and burdened by the Wasson Royalties, without the consent of the Trustee of the Trust or the Holders. The Wasson Royalties may not be sold by the Trust without the consent of Santa Fe. THE NET PROFITS PROPERTIES The Royalty Properties burdened by the Net Profits Royalties consist of royalty and working interests in a diversified portfolio of producing properties located in established oil and gas producing areas in 12 states. Over 90% of the discounted present value of estimated future net revenues attributable to the Net Profits Royalties is generated from Net Profits Properties located in Texas, Oklahoma and Louisiana and related state waters. No single property or field accounts for more than 7% of the estimated future net revenues attributable to the Net Profits Royalties. The Net Profits Properties generally consist of mature producing properties and Santa Fe does not anticipate substantial additional development during the producing lives of these properties. Production attributable to the Net Profits Properties is principally sold at market responsive prices. Santa Fe owns the Net Profits Properties subject to and burdened by the Net Profits Royalties, and is entitled to proceeds attributable to its ownership interest in excess of 90% of the Net Proceeds paid to the Trust. Santa Fe is required to receive payments representing the sale of production from the Net Profits Properties, deduct the costs described above and pay 90% of the net amount to the Trust. Santa Fe may sell the Net Profits Properties subject to and burdened by the Net Profits Royalties. In addition, Santa Fe may, subject to certain limitations, cause the Trust to release portions of the Net Profits Royalties in connection with the sale of the underlying Net Profits Properties. Santa Fe estimates that as of December 31, 1993, the Net Profits Properties covered approximately 246,000 gross acres (approximately 36,000 net to Santa Fe). Productive well information generally is not made available by operators to owners of royalties and overriding royalties. Accordingly, such information is unavailable to Santa Fe for the Net Profits Properties. TITLE TO PROPERTIES The Wasson Properties have been owned by Santa Fe for over 40 years. The Conveyances contain a warranty of title, limited to claims by, through or under Santa Fe, and covering the Wasson Properties and certain of the Net Profits Properties aggregating approximately 82% of the discounted present value of the proved reserves attributable to the Royalty Interests according to the Reserve Report. The Conveyances contain no title warranty with respect to the remaining Net Profits Properties. As is customary in the oil and gas industry, Santa Fe or the operator of its properties performs only a perfunctory title examination when it acquires leases, except leases covering proved reserves. Generally, prior to drilling a well, a more thorough title examination of the drill site tract is conducted and curative work is performed with respect to significant title defects, if any, before proceeding with operations. The Royalty Properties are typically subject, to one degree or another, to one or more of the following: (i) royalties and other burdens and obligations, expressed and implied, under oil and gas leases; (ii) overriding royalties (such as the Royalty Interests) and other burdens created by Santa Fe or its predecessors in title; (iii) a variety of contractual obligations (including, in some cases, development obligations) arising under operating agreements, farmout agreements, production sales contracts and other agreements that may affect the properties or their titles; (iv) liens that arise in the normal course of operations, such as those for unpaid taxes, statutory liens securing unpaid suppliers and contractors and contractual liens under operating agreements; (v) pooling, unitization and communitization agreements, declarations and orders; and (vi) easements, restrictions, rights-of-way and other matters that commonly affect property. To the extent that such burdens and obligations affect Santa Fe's rights to production and production revenues from the Royalty Properties, they have been taken into account in calculating the Royalty Interests and in estimating the size and value of the Trust's reserves attributable to the Royalty Interests. It is not entirely clear that all of the Royalty Interests would be treated as fully conveyed real or personal property interests under the laws of each of the states in which the Royalty Properties are located. The Conveyances (other than the Louisiana Conveyance) state that the Royalty Interests constitute real property interests and Santa Fe has recorded the Conveyances (other than the Louisiana Conveyance) in the appropriate real property records of the states in which the Royalty Properties are located in accordance with local recordation provisions. If during the term of the Trust, Santa Fe becomes involved as a debtor in bankruptcy proceedings, it is not entirely clear that all of the Royalty Interests would be treated as fully conveyed property interests under the laws of each of the states in which the Royalty Properties are located. If in such a proceeding a determination were made that a Royalty Interest (or a portion thereof) did not constitute fully conveyed property interests under applicable state law, the Conveyance related to such Royalty Interest (or a portion thereof) could be subject to rejection as an executory contract (a term used in the Federal Bankruptcy Code to refer to a contract under which the obligations of both the debtor and the other party to the contract are so unsatisfied that the failure of either to complete performance would constitute a material breach excusing performance of the other) in a bankruptcy proceeding involving Santa Fe. In such event, the Trust would be treated as an unsecured creditor of Santa Fe with respect to such Royalty Interest in the pending bankruptcy. Under Louisiana law, the Louisiana Conveyance constitutes personal property that could be rejected as an executory contract in a bankruptcy proceeding involving Santa Fe, although the mortgage on the Royalty Properties that is burdened by the Louisiana Conveyance and which secures the Trust's interests in such Royalty Properties should enhance the Trust's position in the event of such a proceeding. No assurance can be given that the Royalty Interests would not be subject to rejection in a bankruptcy proceeding as executory contracts. RESERVES A study of the proved oil and gas reserves attributable to the Trust as of December 31, 1993 has been made by Ryder Scott Company, independent petroleum consultants. The following letter (Reserve Report) summarized such reserve study. The Trust has not filed reserve estimates covering the Royalty Properties with any other Federal authority or agency. (RYDER SCOTT LETTERHEAD) February 1, 1994 Santa Fe Energy Resources, Inc. 1616 South Voss Road Houston, Texas 77057-2696 Gentlemen: Pursuant to your request, we present below our estimates of the net proved reserves attributable to the interests of the Santa Fe Energy Trust (Trust) as of December 31, 1993. The Trust is a grantor trust formed to hold interests in certain domestic oil and gas properties owned by Santa Fe Energy Resources, Inc. (Santa Fe). The interests conveyed to the Trust consist of royalty interests in the Wasson Field, Texas (Wasson Royalties) and a net profits interest derived from working and royalty interests in numerous other properties (Net Profits Royalties). The properties included in the Trust are located in the states of Alabama, Arkansas, California, Colorado, Kansas, Louisiana, Mississippi, New Mexico, North Dakota, Oklahoma, Texas, Wyoming, and in state waters offshore Louisiana and Texas. The estimated reserve quantities and future income quantities presented in this report are related to a large extent to hydrocarbon prices. Hydrocarbon prices in effect as December 31, 1993 were used in the preparation of this report as required by Securities and Exchange Commission (SEC) and Financial Accounting Standards Bulletin No. 69 (FASB 69) guidelines; however, actual future prices may vary significantly from December 31, 1993 prices for reasons discussed in more detail in other sections of this report. Therefore, quantities of reserves actually recovered and quantities of income actually received may differ significantly from the estimated quantities presented in this report. The estimated proved reserves and income quantities for the Wasson Royalties presented in this report are calculated by multiplying the net revenue interest attributable to each of the Wasson Royalties by the total amount of oil estimated to be economically recoverable from the respective productive units, subject to production limitations applicable to the Wasson Royalties and an additional royalty to provide Support Payments, which have been described to us by Santa Fe. Reserve quantities are calculated differently for the Net Profits Royalties because such interests do not entitle the Trust to a specific quantity of oil or gas but to 90 percent of the Net Proceeds derived therefrom. Accordingly, there is no precise method of allocating estimates of the quantities of proved reserves attributable to the Net Profits Royalties between the interest held by the Trust and the interests to be retained by Santa Fe. For purposes of this presentation, the proved reserves attributable to the Net Profits Royalties have been proportionately reduced to reflect the future estimated costs and expenses deducted in the calculation of Net Proceeds with respect to the Net Profits Royalties. Accordingly, the reserves presented for the Net Profits Royalties reflect quantities of oil and gas that are free of future costs or expenses based on the price and cost assumptions utilized in this report. The allocation of proved reserves of the Net Profits Properties between the Trust and Santa Fe will vary in the future as relative estimates of future gross revenues and future net incomes vary. Furthermore, Santa Fe requested that for purposes of our report the Net Profits Royalties be calculated beyond the Liquidation Date of December 31, 2007, even though by the terms of the Trust Agreement the Net Profits Royalties will be sold by the Trustee on or about this date and a liquidating distribution of the sales proceeds from such sale would be made to holders of Trust Units. The 'Liquid' reserves shown above are comprised of crude oil, condensate and natural gas liquids. Natural gas liquids comprise 0.7 percent of the Trust's developed liquid reserves and 0.7 percent of the Trust's developed and undeveloped liquid reserves. All hydrocarbon liquid reserves are expressed in standard 42 gallon barrels. All gas volumes are sales gas expressed in MMCF at the pressure and temperature bases of the area where the gas reserves are located. The estimated future net cash inflows are described later in this report. Santa Fe has indicated that the conveyance of the Wasson Royalties to the Trust provides that the Trust will receive an additional royalty interest in the Wasson ODC Unit which could be available for Support Payments. Payment of this additional royalty is subject to numerous limitations which are detailed in the Conveyance. The tables shown on Pages A-1 and A-4 include 1,890,522 barrels of oil, $20,000,000 of estimated future net revenue, and $12,662,967 of discounted estimated future net revenue attributable to an additional royalty in respect of Support Payments which have been described to us by Santa Fe. In accordance with information provided by Santa Fe, proved reserves and revenues attributable to Santa Fe's remaining royalty interest in the Wasson ODC Unit available for Support Payments, which includes the above mentioned reserves and revenues, are presented below. ESTIMATED FUTURE NET PROVED OIL ESTIMATED REVENUES RESERVES FUTURE NET DISCOUNTED (BBLS) REVENUES -- $ AT 10% -- $ 3,272,552 $ 34,558,352 $ 23,815,495 The Support Payments are limited to $20,000,000 in the aggregate. As a result, even though we have calculated total estimated future net revenues of $34,558,352 available for Support Payments and $20,000,000 of such amount has been included in our estimate of the future net cash inflow for the Wasson ODC Royalty attributable to the Trust, no additional Support Payment would be allowed due to the $20,000,000 limitation. The proved reserves presented in this report comply with the Securities and Exchange Commission's Regulation S-X Part 210.4-10 Sec. (a) as clarified by subsequent Commission Staff Accounting Bulletins, and are based on the following definitions and criteria: Proved reserves of crude oil, condensate, natural gas, and natural gas liquids are estimated quantities that geological and engineering data demonstrate with reasonable certainty to be recoverable in the future from known reservoirs under existing conditions. Reservoirs are considered proved if economic producibility is supported by actual production or formation RYDER SCOTT COMPANY PETROLEUM ENGINEERS tests. In certain instances, proved reserves are assigned on the basis of a combination of core analysis and other type logs which indicate the reservoirs are analogous to reservoirs in the same field which are producing or have demonstrated the ability to produce on a formation test. The area of a reservoir considered proved includes (1) that portion delineated by drilling and defined by fluid contacts, if any, and (2) the adjoining portions not yet drilled that can be reasonably judged as economically productive on the basis of available geological and engineering data. In the absence of data on fluid contacts, the lowest known structural occurrence of hydrocarbons controls the lower proved limit of the reservoir. Proved reserves are estimates of hydrocarbons to be recovered from a given date forward. They may be revised as hydrocarbons are produced and additional data become available. Proved natural gas reserves are comprised of nonassociated, associated, and dissolved gas. An appropriate reduction in gas reserves has been made for the expected removal of natural gas liquids, for lease and plant fuel and the exclusion of non-hydrocarbon gases if they occur in significant quantities and are removed prior to sale. Reserves that can be produced economically through the application of improved recovery techniques are included in the proved classification when these qualifications are met: (1) successful testing by a pilot project or the operation of an installed program in the reservoir provides support for the engineering analysis on which the project or program was based, and (2) it is reasonably certain the project will proceed. Improved recovery includes all methods for supplementing natural reservoir forces and energy, or otherwise increasing ultimate recovery from a reservoir, including (1) pressure maintenance, (2) cycling, and (3) secondary recovery in its original sense. Improved recovery also includes the enhanced recovery methods of thermal, chemical flooding, and the use of miscible and immiscible displacement fluids. Estimates of proved reserves do not include crude oil, natural gas, or natural gas liquids being held in underground storage. Depending on the status of development, these proved reserves are further subdivided into: (i) 'developed reserves' which are those proved reserves reasonably expected to be recovered through existing wells with existing equipment and operating methods, including (a) 'developed producing reserves' which are those proved developed reserves reasonably expected to be produced from existing completion intervals now open for production in existing wells, and (b) 'developed non-producing reserves' which are those proved developed reserves which exit behind the casing of existing wells which are reasonably expected to be produced through these wells in the predictable future where the cost of making such hydrocarbons available for production should be relatively small compared to the cost of a new well; and (ii) 'undeveloped reserves' which are those proved reserves reasonably expected to be recovered from new wells on undrilled acreage, from existing wells where a relatively large expenditure is required and from acreage for which an application of fluid injection or other improved recovery technique is contemplated where the technique has been proved effective by actual tests in the area in the same reservoir. Reserves from undrilled acreage are limited to those drilling units offsetting productive units that are reasonably certain of production when drilled. Proved reserves for other undrilled units are included only where it can be demonstrated with reasonable certainty that there is continuity of production from the existing productive formation. Because of the direct relationship between quantities of proved undeveloped reserves and development plans, we include in the proved undeveloped category only reserves assigned to undeveloped locations that we have been assured will definitely be drilled and reserves assigned to the undeveloped portions of secondary or tertiary projects which we have been assured will definitely be developed. RYDER SCOTT COMPANY PETROLEUM ENGINEERS In accordance with the requirements of FASB 69, our estimates of future cash inflows, future costs and future net cash inflows before income tax, as well as our estimated reserve quantities, as of December 31, 1993 from this report presented below. In the case of the Wasson Royalties, the future cash inflows are gross revenues after gathering and transportation costs where applicable, but before any other deductions. The production costs are based on current data and include production taxes and ad valorem taxes provided by Santa Fe. In the case of the Net Profits Royalties, the future cash inflows are, as described previously, after consideration of future costs or expenses based on the price and cost assumptions utilized in this report. Therefore, the future cash inflows are the same as the future net cash inflows. Included in these future cash inflows is an estimated amount attributable to the sale of sulphur in certain Gulf Coast properties. Santa Fe furnished us gas prices in effect at December 31, 1993 and with its forecasts of future gas prices which take into account Securities and Exchange Commission guidelines, current market prices, regulations under the Natural Gas Policy Act of 1978 and the Gas Decontrol Act of 1989, contract prices and fixed and determinable price escalations where applicable. In accordance with Securities and Exchange Commission guidelines, the future gas prices used in this report make no allowances for future gas price increases which may occur as a result of inflation nor do they account for seasonal variations in gas prices which are likely to cause future yearly average gas prices to be somewhat lower than December gas prices. In those cases where contract market-out has occurred, the current market price was held constant to depletion of the reserves. In those cases where market-out has not occurred, contract gas prices including fixed and determinable escalations, exclusive of inflation adjustments, were used until the contract expires and then reduced to the current market price for similar gas in the area and held at this reduced price to depletion of the reserves. Santa Fe furnished us with liquid prices in effect at December 31, 1993 and these prices were held constant to depletion of the properties. In accordance with Securities and Exchange Commission RYDER SCOTT COMPANY PETROLEUM ENGINEERS guidelines, changes in liquid prices subsequent to December 31, 1993 were not considered in this report. Operating costs for the leases and wells in this report were provided by Santa Fe and include only those costs directly applicable to the leases or wells. When applicable, the operating costs include a portion of general and administrative costs allocated directly to the leases and wells under terms of operating agreements. Development costs were furnished to us by Santa Fe and are based on authorizations for expenditure for the proposed work or actual costs for similar projects. The current operating and development costs were held constant throughout the life of the properties. For properties located onshore, this study does not consider the salvage value of the lease equipment or the abandonment cost since both are relatively insignificant and tend to offset each other. The estimated net cost of abandonment after salvage was considered for offshore properties where abandonment costs net of salvage are significant. The estimates of the offshore net abandonment costs furnished by Santa Fe were accepted without independent verification. No deduction was made for indirect costs such as general administration and overhead expenses, loan repayments, interest expenses, and exploration and development prepayments. No attempt has been made to quantify or otherwise account for any accumulated gas production imbalances that may exist. Our reserve estimates are based upon a study of the properties in which the Trust has interests; however, we have not made any field examination of the properties. No consideration was given in this report to potential environmental liabilities which may exist nor were any costs included for potential liability to restore and clean up damages, if any, caused by past operating practices. Santa Fe informed us that it has furnished us all of the accounts, records, geological and engineering data and reports and other data required for our investigation. The ownership interests, terms of the Trust, prices, taxes, and other factual data furnished to us in connection with our investigation were accepted as represented. The estimates presented in this report are based on data available through July, 1993. The reserves included in this report are estimates only and should not be construed as being exact quantities. They may or may not be actually recovered. Estimates of proved reserves may increase or decrease as a result of future operations of Santa Fe. Moreover, due to the nature of the Net Profits Royalties, a change in the future costs, or prices, or capital expenditures different from those projected herein may result in a change in the computed reserves and the Net Proceeds to the Trust even if there are no revisions or additions to the gross reserves attributed to the property. The future production rates from properties now on production may be more or less than estimated because of changes in market demand or allowables set by regulatory bodies. In general, we estimate that gas production rates will continue to be the same as the average rate for the latest available 12 months of actual production until such time that the well or wells are incapable of producing at this rate. The well or wells are then projected to decline at their decreasing delivery capacity rate. Our general policy on estimates of future gas production rates is adjusted when necessary to reflect actual gas market conditions in specific cases. Properties which are not currently producing may start producing earlier or later than anticipated in our estimates of their future production rates. The future prices received for the sale of the production may be higher or lower than the prices used in this report as described above, and the operating costs and other costs relating to such production may also increase or decrease from existing levels; however, such possible changes in prices and costs were, in accordance with rules adopted by the Securities and Exchange Commission, omitted from consideration in preparing this report. RYDER SCOTT COMPANY PETROLEUM ENGINEERS Neither Ryder Scott Company nor any of its employees has any interest in the subject properties and neither the employment to make this study nor the compensation is contingent on our estimates of reserves and future cash inflows for the subject properties. Very truly yours, RYDER SCOTT COMPANY PETROLEUM ENGINEERS /s/ Fred W. Ziehe Fred W. Ziehe, P.E. Group Vice President FWZ/db RYDER SCOTT COMPANY PETROLEUM ENGINEERS The value of the Depositary Units and the Trust Units evidenced thereby are substantially dependent upon the proved reserves and production levels attributable to the Royalty Interests. There are many uncertainties inherent in estimating quantities and values of proved reserves and in projecting future rates of production and the timing of development expenditures. The reserve data set forth herein, although prepared by independent engineers in a manner customary in the industry, are estimates only, and actual quantities and values of oil and gas are likely to differ from the estimated amounts set forth herein. In addition, the discounted present values shown herein were prepared using guidelines established by the Commission for disclosure of reserves and should not be considered representative of the market value of such reserves or the Depositary Units or the Trust Units evidenced thereby. A market value determination would include many additional factors. Distributions to Holders could be adversely affected if any of the hazards typically associated with the development, production and transportation of oil and gas were to occur, including personal injuries, property damage, damage to productive formations or equipment and environmental damages. Uninsured costs for damages from any of the foregoing will directly reduce payments to the Trust from those Royalty Properties that are working interests, and will reduce payments to the Trust from those Royalty Properties that are royalties and overriding royalties to the extent such damages reduce the volumes of oil and gas produced. In contrast to the Net Profits Royalties, which have no contractually imposed production limitations, the Wasson Royalties have been structured with quarterly production limitations. Thus, the Trust and Holders will not receive cash distributions from oil production from the two Wasson production units burdened by the Wasson Royalties in excess of such amounts. While the Wasson ODC Unit is expected to produce at levels substantially in excess of the applicable production limitations, failure of actual production from either of the two Wasson production units to meet or exceed the applicable quarterly production limitations will reduce amounts payable in respect of the Wasson Royalties. GAS PRODUCTION At December 31, 1993, approximately 25 percent of the estimated future net revenues from proved reserves of the Royalty Interests, on an equivalent basis, was attributable to gas. Thus, the revenues of the Trust and the amount of cash distributions to Holders will be dependent upon, among other things, the volume of gas produced and the price at which such gas is sold. Since the early 1980s, the available gas production capacity nationwide has exceeded the demand by users of such gas, resulting in demand-related production curtailments. No assurances can be made that curtailments will not continue to exist. In addition, excess gas production capacity in the United States has generally resulted in downward pressure on gas prices. The effect of any excess production capacity which exists in the future cannot be predicted with certainty; however, any such excess capacity may have a material adverse effect on Trust distributions through its impact on prices and production volumes. Due to the seasonal nature of demand for gas and its effect on sales prices and production volumes, the amount of cash distributions by the Trust that is attributable to gas production may vary substantially on a seasonal basis. Generally, gas production volumes and prices tend to be higher during the first and fourth quarters of the calendar year. Because of the lag between Santa Fe's receipt of revenues related to the Net Profits Properties and the dates on which distributions are made to Holders, however, any seasonality that affects production and prices generally should be reflected in distributions to Holders in later periods. PROCEEDS, PRODUCTION AND AVERAGE PRICES Reference is made to 'Results of Operations' under Item 7 of this Form 10-K. ASSETS Reference is made to Item 6 of this Form 10-K for information relating to the assets of the Trust. DEFINITIONS As used herein, the following terms have the meanings indicated: 'Mcf' means thousand cubic feet, 'MMcf' means million cubic feet, 'Bbl' means barrel (approximately 42 U.S. gallons), and 'MBbl' means thousand barrels. COMPETITION AND MARKETS COMPETITION. The oil and gas industry is highly competitive in all of its phases. Santa Fe and the other operators of the Royalty Properties will encounter competition from major oil and gas companies, international energy organizations, independent oil and gas concerns, and individual producers and operators. Many of these competitors have greater financial and other resources than Santa Fe and the other operators of the Royalty Properties. Competition may also be presented by alternative fuel sources, including heating oil and other fossil fuels. MARKETS. Production attributable to Santa Fe's royalty interests in the Wasson ODC Unit and the Wasson Willard Unit is marketed by Santa Fe and is in some cases sold at the wellhead at market responsive prices that approximate spot oil prices for West Texas sour crude, and in other cases is sold at points within common carrier pipeline systems on terms whereby Santa Fe pays the cost of transporting same to such points. With respect to the Net Profits Properties, where such properties consist of royalty interests, the operators of the properties will make all decisions regarding the marketing and sale of oil and gas production. Although Santa Fe generally has the right to market oil and gas produced from the Royalty Properties that are working interests, Santa Fe generally relies on the operators of the properties to market the production. The ability of the operators to market the oil and gas produced from the Royalty Properties will depend upon numerous factors beyond their control, including the extent of domestic production and imports of oil and gas, the proximity of the gas production to gas pipelines, the availability of capacity in such pipelines, the demand for oil and gas by utilities and other end-users, the effects of inclement weather, state and Federal regulation of oil and gas production and Federal regulation of gas sold or transported in interstate commerce. There is no assurance that such operators will be able to market all of the oil or gas produced from the Royalty Properties or that favorable prices can be obtained for the oil and gas produced. The supply of gas capable of being produced in the United States has exceeded demand in recent years as a result of decreased demand for gas in response to economic factors, conservation, lower prices for alternative energy sources and other factors. As a result of this excess supply of gas, gas producers have experienced increased competitive pressure and significantly lower prices. Many gas pipelines have reduced their takes from producers below the amounts they were contractually obligated to take or pay at fixed prices in excess of spot prices or have renegotiated their obligations to reflect more market responsive terms. The decline in demand for gas has resulted in many pipelines reducing or ceasing altogether their purchase of new gas. Substantially all of the gas production from the Net Profits Properties is sold at market responsive prices. Demand for gas production has historically been seasonal in nature. Due to unseasonably warm weather over the last several years, the demand for gas has decreased, resulting in lower prices received by producers during the winter months than in prior years. Consequently, on an energy equivalent basis, gas has been sold at a discount to oil for the past several years. Such price fluctuations will directly impact Trust distributions, estimates of Trust reserves and estimated future net revenues from Trust reserves. In view of the many uncertainties affecting the supply and demand for oil, gas and refined petroleum products, Santa Fe is unable to make reliable predictions of future oil and gas prices and demand or the overall effect they will have on the Trust. Santa Fe does not believe that the loss of any of its purchasers would have a material adverse effect on the Trust, since substantially all of the oil and gas sales from the Royalty Properties are made on the spot market at market responsive prices. GOVERNMENTAL REGULATION OIL AND GAS REGULATION The production, transportation and sale of oil and gas from the Royalty Properties are subject to Federal and state governmental regulation, including regulations concerning maximum allowable rates of production, regulation of tariffs charged by pipelines, taxes, the prevention of waste, the conservation of oil and gas, pollution controls and various other matters. The United States has governmental power to permit increases in the amount of oil imported from other countries and to impose pollution control measures. FEDERAL REGULATION OF GAS. The Net Profits Properties are subject to the jurisdiction of the Federal Energy Regulatory Commission (FERC) and the Department of Energy with respect to various aspects of oil and gas operations including marketing and production of oil and gas. The Natural Gas Act and the Natural Gas Policy Act of 1978 (Policy Act) mandate Federal regulation of interstate transportation of gas and of wellhead pricing of certain domestic gas, depending on the category of the gas and the nature of the sale. In July 1989, however, Congress enacted the Natural Gas Wellhead Decontrol Act of 1989 that eliminated wellhead price controls on all domestic gas effective January 1, 1993. In 1992, FERC issued Orders Nos. 636 and 636-A which generally opened access to interstate pipelines by requiring the operators of such pipelines to unbundle their transportation services which historically were combined with their sales services and allow customers to choose and pay for only the services they require, regardless of whether the customer purchases gas from such pipelines or from other suppliers. The orders also require upstream pipelines to permit downstream pipelines to assign upstream capacity to their shippers, and place analogous, unbundled access requirements on the downstream pipelines. Although these regulations should generally facilitate the transportation of gas produced from the Net Profits Properties and the direct access to end user markets, the impact of FERC Order Nos. 636 and 636-A on marketing production from the Net Profits Properties cannot be predicted at this time. A number of parties which are aggrieved by the FERC's Order No. 636 program have filed petitions for review of these orders which are now pending in various U.S. Courts of Appeal. Numerous questions have been raised concerning the interpretation and implementation of several significant provisions of the Natural Gas Act and the Policy Act (collectively, Acts), and of the regulations and policies promulgated by FERC thereunder. A number of lawsuits and administrative proceedings have been instituted which challenge the validity of regulations implementing the Acts. In addition, FERC currently has under consideration various policies and proposals in addition to those discussed above that may affect the marketing of gas under new and existing contracts. Accordingly, Santa Fe is unable to estimate the full impact that the Acts and the regulations issued thereunder by FERC may have on the Net Profits Properties. LEGISLATIVE PROPOSALS. In the past, Congress has been very active in the area of gas regulation. Recently enacted legislation repeals incremental pricing requirements and gas use restraints previously applicable. There are other legislative proposals pending in the Federal and state legislatures which, if enacted, would significantly affect the petroleum industry. At the present time, it is impossible to predict what proposals, if any, might actually be enacted by Congress or the various state legislatures and what effect, if any, such proposals might have on the Royalty Properties and the Trust. STATE REGULATION. Many state jurisdictions have at times imposed limitations on the production of gas by restricting the rate of flow for gas wells below their actual capacity to produce and by imposing acreage limitations for the drilling of a well. States may also impose additional regulation of these matters. Most states regulate the production and sale of oil and gas, including requirements for obtaining drilling permits, the method of developing new fields, provisions for the unitization or pooling of oil and gas properties, the spacing, operation, plugging and abandonment of wells and the prevention of waste of oil and gas resources. The rate of production may be regulated and the maximum daily production allowable from oil and gas wells may be established on a market demand or conservation basis or both. ENVIRONMENTAL REGULATION GENERAL. Activities on the Royalty Properties are subject to existing Federal, state and local laws and regulations governing environmental quality and pollution control. It is anticipated that, absent the occurrence of an extraordinary event, compliance with existing Federal, state and local laws, rules and regulations regulating the discharge of materials into the environment or otherwise relating to the protection of the environment will not have a material effect upon the Trust. Santa Fe cannot predict what effect additional regulation or legislation, enforcement policies thereunder, and claims for damages to property, employees, other persons and the environment resulting from operations on the Royalty Properties could have on the Trust. SOLID AND HAZARDOUS WASTE. The Royalty Properties include numerous properties that have produced oil and gas for many years and that have been owned by Santa Fe for only a relatively short time. Although, to Santa Fe's knowledge, the operators have utilized operating and disposal practices that were standard in the industry at the time, hydrocarbons or other solid wastes may have been disposed or released on or under the Royalty Properties by the current or previous operator. State and Federal laws applicable to oil and gas wastes and properties have become increasingly more stringent. Under these new laws, Santa Fe or an operator of the Royalty Properties could be required to remove or remediate previously disposed wastes or property contamination (including groundwater contamination) or to perform remedial plugging operations to prevent future contamination. The operators of the Royalty Properties may generate wastes that are subject to the Federal Resource Conservation and Recovery Act and comparable state statutes. The Environmental Protection Agency (EPA) has limited the disposal options for certain hazardous wastes and is considering the adoption of more stringent disposal standards for nonhazardous wastes. Furthermore, it is anticipated that additional wastes (which could include certain wastes generated by oil and gas operations) will be designated as 'hazardous wastes', which are subject to more rigorous and costly disposal requirements. SUPERFUND. The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), also known as the 'superfund' law, imposes liability, without regard to fault or the legality of the original conduct, on certain classes of persons that contributed to the release of a 'hazardous substance' into the environment. These persons include the owner and operator of a site and companies that disposed or arranged for the disposal of the hazardous substance found at a site. CERCLA also authorizes the EPA and, in some cases, third parties to take actions in response to threats to the public health or the environment and to seek to recover from the responsible classes of persons the costs of such action. In the course of their operations, the operators of the Royalty Properties have generated and will generate wastes that may fall within CERCLA's definition of 'hazardous substances.' Santa Fe or the operators of the Royalty Properties may be responsible under CERCLA for all or part of the costs to clean up sites at which such wastes have been disposed. AIR EMISSIONS. The operators of the Royalty Properties are subject to Federal, state and local regulations concerning the control of emissions from sources of air pollution. Administrative enforcement actions for failure to comply strictly with air regulations or permits are generally resolved by payment of a monetary penalty and correction of any identified deficiencies. Alternatively, regulatory agencies could require the operators to forego construction or operation of certain air pollution emission sources. OSHA. The operators of the Royalty Properties are subject to the requirements of the Federal Occupational Safety and Health Act (OSHA) and comparable state statutes. The OSHA hazard communication standard, the EPA community right-to-know regulations under Title III of the Federal Superfund Amendment and Reauthorization Act and similar state statutes require an operator to organize information about hazardous materials used or produced in its operations. Certain of this information must be provided to employees, state and local government authorities and local citizens. ITEM 2. ITEM 2. PROPERTIES. Reference is made to Item 1 of this Form 10-K. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are no pending legal proceedings to which the Trust is a party. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders during the year ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED HOLDER MATTERS. The Depositary Units are traded on the New York Stock Exchange -- ticker symbol SFF. The high and low closing sales prices and distributions for the quarter ended December 31, 1992 and each quarter in the year ended December 31, 1993 were as follows (in dollars): CLOSING SALES PRICES DISTRIBUTION LOW HIGH PAID Fourth Quarter (beginning November 13) 17.875 19.875 -- First Quarter---------------------- 18.00 19.75 0.30753 Second Quarter--------------------- 19.375 20.875 0.46660 Third Quarter---------------------- 19.625 22.00 0.49485 Fourth Quarter--------------------- 19.625 23.625 0.44218 At March 25, 1994, the 6,300,000 Depositary Units outstanding were held by 480 Holders of record. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. 1993 1992 (THOUSANDS OF DOLLARS, EXCEPT AS NOTED) Period Ended December 31: Distributable Cash----------------- 10,781 -- Distributable Cash per Trust Unit (in dollars)--------------------- 1.71116 -- At December 31: Investment in Royalty Interests, net------------------------------ 77,356 87,276 Trust Corpus----------------------- 77,301 87,277 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL; LIQUIDITY AND CAPITAL RESOURCES The Trust is a passive entity with the Trustee's primary responsibility being the collection and distribution of proceeds from the Wasson Royalties and the Net Profits Royalties and the payment of Trust liabilities and expenses (see Note 1 to the financial statements of the Trust). The Trust's results of operations are dependent upon the difference between the prices received for oil and gas and the costs of producing such resources. Since, on an equivalent basis, approximately eighty percent of the Trust's proved reserves are crude oil, even relatively modest changes in crude oil prices may significantly affect the Trust's revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the world supply, economic conditions in the United States and elsewhere, the world political situation as it affects OPEC, the Middle East (including the current embargo of Iraqi crude oil from worldwide markets) and other producing countries, the actions of OPEC and governmental regulation. In addition, a substantial portion of the Trust's revenues come from properties which produce sour (i.e. high sulfur content) crude oil which sells at prices lower than sweeter (i.e. low sulfur) crude oils. The sales price of crude oil dropped significantly in the fourth quarter of 1993, as reflected in the average prices with respect to the royalty payment received in the first quarter of 1994 (see Results of Operations). For factors affecting the sale of natural gas see Item 1. Business--Gas Production. Cash proceeds from the Royalty Properties in the first quarter of 1994 included a Support Payment of $362,000, primarily due to lower realized oil prices and capital expenditures incurred with respect to certain Royalty Properties, a substantial portion of which relates to the drilling of new wells. Based on current prices, it is expected that cash proceeds from the Royalty Properties in the second quarter of 1994, which relates to operations of the Royalty Properties in the first quarter of 1994, will include a Support Payment, the amount of which has not been determined. In addition to costs and expenses related to the Royalty Properties, Trust administrative expenses are estimated to be approximately $450,000 annually, including approximately $250,000 for legal, accounting, engineering, trustee and other administrative fees and a $200,000 annual fee to Santa Fe, which will increase by 3.5 percent per year. In addition, Santa Fe paid approximately $379,000 in Trust formation costs of which $271,000 was recovered in 1993 and $108,000 was recovered in the first quarter of 1994. RESULTS OF OPERATIONS The following table reflects pertinent information with respect to the cash proceeds from the Royalty Properties and the net distributable cash of the Trust for the year 1993 and the first quarter of 1994 (in thousands of dollars, except as noted): Volumes with respect to the Wasson ODC Royalty and the Wasson Willard Royalty increased in periods subsequent to the first quarter of 1993 because (i) the first quarter of 1993 represented the initial quarter of operations of the Trust and included only two months of operations with respect to such royalties and (ii) there was an increase in the maximum net quarterly production in accordance with the royalty conveyance beginning in the second quarter of 1993. Volumes increased from the first quarter of 1993 with respect to the Net Profits Royalties generally reflecting that the first quarter of 1993 included only two months of operations with respect to such properties. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. PAGE IN THIS FORM 10-K Audited Financial Statements Report of Independent Accountants-------------------- 34 Statement of Cash Proceeds and Distributable Cash for the Year Ended December 31, 1993---------------------------- 35 Statement of Assets, Liabilities and Trust Corpus as of December 31, 1993 and 1992---------------------------------- 35 Statement of Changes in Trust Corpus for the Year Ended December 31, 1993 and the Period from Inception (October 22, 1992) to December 31, 1992--------------------- 36 Notes to Financial Statements------------------------ 37 Unaudited Financial Information Supplemental Information to the Financial Statements------------------------------- 39 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. There are no directors or executive officers of the Registrant. The Trustee is a corporate trustee which may be removed by the affirmative vote of Holders of a majority of the Trust Units then outstanding at a meeting of the Holders of the Trust at which a quorum is present. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Not applicable. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) Security Ownership of Certain Beneficial Owners. Not Applicable. (b) Security Ownership of Management. Not applicable. (c) Changes in Control. The Registrant knows of no arrangements, including the pledge of securities of the Registrant, the operation of which may at a subsequent date result in a change in control of the Registrant. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Marc J. Shapiro, a director of Santa Fe, is Chairman and Chief Executive Officer of the Trustee. The Trustee is the Agent and a principal lender to Santa Fe under an Amended and Restated Revolving Credit Agreement (the Credit Agreement). As of March 31, 1994 approximately $70 million was outstanding under the Credit Agreement. In the opinion of Santa Fe, the terms of the Credit Agreement and the fees and interest rates thereunder are within the range of normal and customary bank credit transactions involving energy borrowers of similar size and credit. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A)(1) FINANCIAL STATEMENTS The following financial statements are included in this Annual Report on Form 10-K on the pages as indicated: PAGE IN THIS FORM 10-K Report of Independent Accountants--------------------------- 34 Statement of Cash Proceeds and Distributable Cash for the Year Ended December 31, 1993----------------------------------- 35 Statement of Assets, Liabilities and Trust Corpus as of December 31, 1993 and 1992--------------------------------------------- 35 Statement of Changes in Trust Corpus for the Year Ended December 31, 1993 and the Period from Inception (October 22, 1992) to December 31, 1992------------------ 36 Notes to Financial Statements------------------------------ 37 (A)(2) SCHEDULES Schedules have been omitted because they are not required, not applicable or the information required has been included elsewhere herein. (A)(3) EXHIBITS (Asterisk indicates exhibit previously filed with the Securities and Exchange Commission and incorporated herein by reference.) SEC FILE OR REGISTRATION EXHIBIT NUMBER NUMBER 3(a)* Form of Trust Agreement of Santa Fe Energy Trust------------------------- 33-51760 3.1 4(a)* Form of Custodial Deposit Agreement---------------------------- 33-51760 4.2 4(b)* Form of Secure Principal Energy Receipt (included as Exhibit A to Exhibit 4(a))----------- 33-51760 4.1 10(a)* Form of Net Profits Conveyance (Multi-State)------------------------ 33-51760 10.1 10(b)* Form of Wasson Conveyance------------ 33-51760 10.2 10(c)* Form of Louisiana Mortgage----------- 33-51760 10.3 (B) REPORTS ON FORM 8-K No reports on Form 8-K were filed with the Securities and Exchange Commission during the year ended December 31, 1993. REPORT OF INDEPENDENT ACCOUNTANTS To the Unitholders and Trustee of the Santa Fe Energy Trust We have audited the financial statements listed in the index appearing under Item 14(a)(1) on page 33. These financial statements are the responsibility of the Trustee. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the Trustee, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 2, these financial statements have been prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, the financial statements audited by us present fairly, in all material respects, the financial position of the Santa Fe Energy Trust at December 31, 1993 and 1992, the cash proceeds and distributable cash for the year ended December 31, 1993 and the changes in trust corpus for the year ended December 31, 1993 and the period from inception (October 22, 1992) to December 31, 1992, on the basis of accounting described in Note 2. PRICE WATERHOUSE Houston, Texas March 25, 1994 SANTA FE ENERGY TRUST STATEMENT OF CASH PROCEEDS AND DISTRIBUTABLE CASH (DOLLARS IN THOUSANDS, EXCEPT AS NOTED) YEAR ENDED DECEMBER 31, 1993 Royalty Income ODC Royalty---------------------- $ 1,802 Willard Royalty------------------ 1,881 Net Profits Royalty-------------- 7,677 Total Royalties---------------------- 11,360 Administrative Fee to Santa Fe------- (183) Trust Formation Costs---------------- (271) Advance from Santa Fe Energy Resources, Inc.-------------------- 55 Cash Withheld for Trust Expenses----- (180) Distributable Cash------------------- $ 10,781 Distributable Cash per Trust Unit (in dollars)--------------------------- $ 1.71116 Trust Units Outstanding (thousands)-------------------------- 6,300 STATEMENT OF ASSETS, LIABILITIES AND TRUST CORPUS (DOLLARS IN THOUSANDS) ASSETS DECEMBER 31, DECEMBER 31, 1993 1992 Current Assets Cash----------------------------- $ -- $ 1 Investment in Royalty Interests, at cost------------------------------- 87,276 87,276 Less: Accumulated Amortization------- (9,920) -- 77,356 87,276 $ 77,356 $ 87,277 LIABILITIES AND TRUST CORPUS Advance from Santa Fe Energy Resources, Inc.-------------------- $ 55 $ -- Trust Corpus (6,300,000 Trust Units issued and outstanding)------------ 77,301 87,277 $ 77,356 $ 87,277 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY TRUST STATEMENT OF CHANGES IN TRUST CORPUS (IN THOUSANDS OF DOLLARS) Balance at Inception (October 22, 1992)------ $ 1 Issuance of Trust Units for Royalty Interests-------------------------------- 87,276 Balance at December 31, 1992----------------- 87,277 Cash Proceeds------------------------------ 10,906 Cash Distributions------------------------- (10,781) Trust Expenses----------------------------- (181) Amortization of Royalty Interests---------- (9,920) Balance at December 31, 1993----------------- $ 77,301 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY TRUST NOTES TO FINANCIAL STATEMENTS (1) THE TRUST Santa Fe Energy Trust (the 'Trust') was formed on October 22, 1992, with Texas Commerce Bank National Association as trustee (the 'Trustee'), to acquire and hold certain royalty interests (the 'Royalty Interests') in certain properties (the 'Royalty Properties') conveyed to the Trust by Santa Fe Energy Resources, Inc. ('Santa Fe'). The Royalty Interests consist of two term royalty interests in two production units in the Wasson field in west Texas (the 'Wasson Royalties') and a net profits royalty interest in certain royalty and working interests in a diversified portfolio of properties located in twelve states (the 'Net Profits Royalties'). The Royalty Interests are passive in nature and the Trustee has no control over or responsibility relating to the operation of the Royalty Properties. The Trust will be liquidated on February 15, 2008 (the 'Liquidation Date'). In November 1992, 5,725,000 Depositary Units, each consisting of beneficial ownership of one unit of undivided beneficial interest in the Trust ('Trust Units') and a $20 face amount beneficial ownership interest in a $1,000 face amount zero coupon United States Treasury obligation maturing on or about February 15, 2008, were sold in a public offering for $20 per Depositary Unit. A total of $114.5 million was recieved from public investors, of which $38.7 million was used to purchase the Treasury obligations and $5.7 million was used to pay underwriting commissions and discounts. Santa Fe received the remaining $70.1 million and 575,000 Depositary Units. In the first quarter of 1994 Santa Fe sold in a public offering the 575,000 Depositary Units which it held. The trust agreement under which the Trust was formed (the 'Trust Agreement') provides, among other things, that: * the Trustee shall not engage in any business or commercial activity or acquire any asset other than the Royalty Interests initially conveyed to the Trust; * the Trustee may not sell all or any portion of the Wasson Royalties or substantially all of the Net Profits Royalties without the prior consent of Santa Fe; * Santa Fe may sell the Royalty Properties, subject to and burdened by the Royalty Interests, without consent of the holders of the Trust Units; following any such transfer, the Royalty Properties will continue to be burdened by the Royalty Interests and after any such transfer the royalty payment attributable to the transferred property will be calculated separately and paid by the transferee; * the Trustee may establish a cash reserve for the payment of any liability which is contingent, uncertain in amount or that is not currently due and payable; * the Trustee is authorized to borrow funds required to pay liabilities of the Trust, provided that such borrowings are repaid in full prior to further distributions to the holders of the Trust Units; * the Trustee will make quarterly cash distributions to the holders of the Trust Units. (2) BASIS OF ACCOUNTING The financial statements of the Trust are prepared on the cash basis of accounting for revenues and expenses. Royalty income is recorded when received (generally during the quarter following the end of the quarter in which the income from the Royalty Properties is received by Santa Fe) and is net of any cash basis exploration and development expenditures. Expenses of the Trust, which will include accounting, engineering, legal, and other professional fees, Trustee fees, an administrative fee paid to Santa Fe and out-of-pocket expenses, are recognized when paid. Under generally accepted accounting principles, revenues and expenses would be recognized on an accrual basis. Amortization of the Trust's investment in Royalty Interests is recorded using the unit-of-production method in the period in which the cash is received with respect to such production. No royalty income was received and no Trust expenses were paid during the period from inception (October 22, 1992) through December 31, 1992 (see Note 4). SANTA FE ENERGY TRUST NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The conveyance of the Royalty Interests to the Trust was accounted for as a purchase transaction. The $87,276,000 reflected in the Statement of Assets and Trust Corpus as Investment in Royalty Interests represents 6,300,000 Trust Units valued at $20 per unit less the $38,724,000 paid for the Treasury obligations. The carrying value of the Trust's investment in the Royalty Interests is not necessarily indicative of the fair value of such Royalty Interests. The Trust is a grantor trust and as such is not subject to income taxes and accordingly no recognition has been given to income taxes in the Trust's financial statements. The tax consequences of owning Trust Units are included in the income tax returns of the individual Trust Unit holders. During 1993 net cash proceeds (before deducting Trust expenses) exceeded cash distributions by $125,000. In order to pay current Trust expenses Santa Fe advanced the Trust $55,000, which amount was due to Santa Fe at December 31, 1993. (3) THE ROYALTY INTERESTS The Wasson Royalties consist of interests conveyed out of Santa Fe's royalty interest in the Wasson ODC Unit (the 'ODC Royalty') and the Wasson Willard Unit (the 'Willard Royalty'). The ODC Royalty entitles the Trust to receive quarterly royalty payments with respect to 12.3934% of the actual gross oil production from the Wasson ODC Unit, subject to certain quarterly limitations set forth in the conveyance agreement, for the period from November 1, 1992 to December 31, 2007. The Willard Royalty entitles the Trust to receive quarterly royalty payments with respect to 6.8355% of the actual gross oil production from the Wasson Willard Unit, subject to certain quarterly limitations set forth in the conveyance agreement, for the period from November 1, 1992 to December 31, 2003. The Net Profits Royalties entitle the Trust to receive, on a quarterly basis, 90% of the net proceeds, as defined in the conveyance agreement, from the sale of production from the properties subject to the conveyance agreement. The Net Profits Royalties are not limited in term, although the Trustee is required to sell such royalties prior to the Liquidation Date. For any calendar quarter ending on or prior to December 31, 2002, the Trust will receive additional royalty payments ('Support Payments') to the extent it needs such payments to distribute $0.40 per Trust Unit per quarter (two-thirds of such amount for the period ended December 31, 1992). Such Support Payments are limited to Santa Fe's remaining royalty interest in the Wasson ODC Unit. If such Support Payments are received, certain proceeds otherwise payable to the Trust in subsequent quarters may be reduced to recoup the amount of such Support Payments. The aggregate of the Support Payments, net of any amounts recouped, will be limited to $20,000,000 on a revolving basis. The royalty payment received by the Trust in the first quarter of 1994 included a Support Payment of $362,000, or $0.0575 per Trust Unit. (4) DISTRIBUTIONS TO TRUST UNIT HOLDERS The Trust has received royalty payments and made distributions as follows (in thousands of dollars, except as noted): ROYALTY DISTRIBUTIONS PAYMENT PER TRUST UNIT RECEIVED AMOUNT (IN DOLLARS) First quarter-------------------- 1,937 1,937 0.30753 Second quarter------------------- 2,990 2,940 0.46660 Third quarter-------------------- 3,193 3,118 0.49485 Fourth quarter------------------- 2,786 2,786 0.44218 Total year------------------- 10,906 10,781 1.71116 First quarter (a)---------------- 2,575 2,520 0.40000 (a) Includes a Support Payment of $362,000, or $0.0575 per Trust Unit. SUPPLEMENTAL INFORMATION TO FINANCIAL STATEMENTS (UNAUDITED) OIL AND GAS RESERVES The following table sets forth the Royalty Interests' proved oil and gas reserves (all located in the United States) at December 31, 1993 and 1992 prepared by Ryder Scott Company, independent petroleum consultants. Proved reserve quantities for each of the Wasson Royalties are calculated by multiplying the net revenue interest attributable to each of the Wasson Royalties in effect for a given year by the total amount of oil estimated to be economically recoverable from the respective production units (subject to limitation by applicable maximum quarterly production amounts). Reserve quantities are calculated differently for the Net Profits Royalties because such interests do not entitle the Trust to a specific quantity of oil or gas but to the Net Proceeds derived therefrom. Proved reserves attributable to the Net Profits Royalties are calculated by deducting from estimated quantities of oil and gas reserves an amount of oil and gas sufficient, if sold at the prices used in preparing the reserve estimates for the Net Profits Royalties, to pay the future estimated costs and expenses deducted in the calculation of Net Proceeds with respect to the Net Profits Royalties. Accordingly, the reserves presented for the Net Profits Royalties reflect quantities of oil and gas that are free of future costs or expenses if the price and cost assumptions set forth in the applicable reserve report occur. CRUDE OIL AND NATURAL GAS LIQUIDS (MBBLS) (MMCF) Proved reserves at December 31, 1992------------------------------- 7,258 12,638 Revisions to previous estimates---------------------- 1,169 1,351 Extensions, discoveries and other additions 9 230 Production----------------------- (667) (3,098) Proved reserves at December 31, 1993------------------------------- 7,769 11,121 Proved developed reserves at December 31, 1992----------------------------- 7,169 12,500 1993----------------------------- 7,765 10,900 Proved reserves are estimated quantities of crude oil and natural gas which geological and engineering data indicate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are proved reserves which can be expected to be recovered through existing wells with existing equipment and operating methods. ESTIMATED PRESENT VALUE OF FUTURE NET CASH FLOWS Estimated future net cash flows from the Royalty Interests' proved oil and gas reserves at December 31, 1993 and 1992 are presented in the following table (in thousands of dollars): DECEMBER 31, 1993 1992 Net future cash flows---------------- 107,544 138,005 Discount at 10% for timing of cash flows-------------------------------- (42,228) (59,503) Present value of future net cash flows for proved reserves------------ 65,316 78,502 The following table sets forth the changes in the present value of estimated future net cash flows from proved reserves during the year ended December 31, 1993 (in thousands of dollars): Balance at December 31, 1992-------------------------- 78,502 Royalties, net of related property taxes (a)------ (12,123) Extensions, discoveries and other additions------- 733 Net changes in prices and costs------------------- (19,307) Changes in estimated volumes---------------------- 9,866 Interest factor -- accretion of discount---------- 7,645 (13,186) Balance at December 31, 1993-------------------------- 65,316 (a) Relates to the operations of the Royalty Properties for the year ended December 31, 1993, the proceeds from which were received by the Trust during the second, third and fourth quarters of 1993 and the first quarter of 1994. Estimated future cash flows represent an estimate of future net revenues from the production of proved reserves using estimated sales prices and estimates of the production costs, ad valorem and production taxes, and future development costs necessary to produce such reserves. No deduction has been made for depletion, depreciation or any indirect costs such as professional and administrative fees. The sales prices used in the calculation of estimated future net cash flows are based on the prices in effect at year end. Such prices have been held constant except for known and determinable escalations. Operating costs and ad valorem and production taxes are estimated based on current costs with respect to producing oil and gas properties. Future development costs are based on the best estimate of such costs assuming current economic and operating conditions. The information presented with respect to estimated future net revenues and cash flows and the present value thereof is not intended to represent the fair value of oil and gas reserves. Actual future sales prices and production and development costs may vary significantly from those in effect at December 31, 1993 and 1992 and actual future production may not occur in the periods or amounts projected. This information is presented to allow a reasonable comparison of reserve values prepared using standardized measurement criteria and should be used only for that purpose. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR L5(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 ON THIS 30TH DAY OF MARCH, 1994. SANTA FE ENERGY TRUST By TEXAS COMMERCE BANK NATIONAL ASSOCIATION, TRUSTEE By /s/ RICHARD L. MELTON RICHARD L. MELTON EXECUTIVE VICE PRESIDENT & TRUST OFFICER The Registrant, Santa Fe Energy Trust, has no principal executive officer, principal financial officer, controller or principal accounting officer, board of directors or persons performing similar functions. Accordingly, no additional signatures are available and none have been provided. THIS ANNUAL REPORT ON FORM 10-K WAS DISTRIBUTED TO HOLDERS AS AN ANNUAL REPORT. ADDITIONAL COPIES OF THIS ANNUAL REPORT WILL BE PROVIDED, WITHOUT CHARGE, AND COPIES OF EXHIBITS HERETO WILL BE PROVIDED, UPON PAYMENT OF A REASONABLE FEE, UPON WRITTEN REQUEST FROM ANY HOLDER TO: Santa Fe Energy Trust Texas Commerce Bank National Association, Trustee Attention: David Snyder, Corporate Trust Department P.O. Box 4717 Houston, Texas 77210-4717 INDEPENDENT ACCOUNTANTS COUNSEL TRANSFER AGENT AND REGISTRAR Price Waterhouse Baker & Botts, L.L.P. Texas Commerce Bank, N.A. Houston, Texas Houston, Texas Houston, Texas SANTA FE ENERGY TRUST P.O. Box 4717 Houston, Texas 77210-4717

821130_1993.txt

821130_1993

1993

821130

ITEM 1. BUSINESS THE COMPANY United States Cellular Corporation (the "Company") is engaged through subsidiaries and joint ventures primarily in the development and operation of and in the acquisition of interests in cellular telephone markets ("cellular markets"). The Company is a majority-owned subsidiary of Telephone and Data Systems, Inc. ("TDS"), an Iowa corporation. The Company acquires, manages, owns, operates and invests in cellular systems throughout the United States. As of December 31, 1993, the Company owned or had the right to acquire interests in Metropolitan Statistical Areas ("MSAs") and Rural Service Areas ("RSAs") representing approximately 23.7 million population equivalents in a total of 205 markets. The Company is the seventh largest cellular telephone company in the United States, based on the aggregate number of population equivalents it owns or has the right to acquire. The Company's corporate development strategy is to acquire controlling interests in MSA and RSA licensees in areas adjacent to or in proximity to its other markets in order to build clusters. The Company anticipates that clustering markets will expand its cellular service areas while enabling it to achieve marketing and advertising benefits and to achieve economies in certain capital and operating costs. The following table summarizes the status of the Company's interests in cellular markets at December 31, 1993. The Company served 293,000 customers at December 31, 1993, through 614 cells in 136 managed markets. The average penetration rate (i.e., the percentage of total population of a market represented by customers) in the Company-managed markets was 1.33% at December 31, 1993. The churn rate, or the portion of the Company's customers discontinuing service each month, averaged 2.3% per month during the twelve months ended December 31, 1993. The Company's 116 majority-owned and managed ("consolidated") markets served 261,000 customers at December 31, 1993, through 522 cells. The average penetration rate in the consolidated markets was 1.35% at December 31, 1993, and the churn rate in all consolidated markets averaged 2.3% per month for the twelve months ended December 31, 1993. The Company, or TDS for the benefit of the Company, has entered into agreements with third parties to acquire cellular interests which generally require the issuance of securities of the Company or TDS securities. In connection with agreements that require the delivery of TDS securities, the Company reimburses TDS for TDS securities issued to third parties as consideration for the acquisitions. If all acquisitions pending at December 31, 1993, are completed as planned, the Company will issue approximately 3.7 million Common Shares to TDS at or near the respective closing dates of each of these acquisitions and approximately 49,000 Common Shares to third parties. In addition, approximately 5.0 million Common Shares are issuable to third parties at December 31, 1993, in connection with completed acquisitions. At December 31, 1993, the Company also had 197,000 outstanding shares of Preferred Stock, all held by TDS, which are redeemable by the delivery of 1.2 million Common Shares between 1994 and 1996. Certain TDS Preferred Shares delivered in connection with the Company's acquisitions are also redeemable by the delivery of an additional 1.1 million USM Common Shares between 1994 and 1996. The aggregate of 11.0 million Common Shares committed for issuance in future years are scheduled to be issued as follows: approximately 6.8 million shares by March 21, 1994, 1.2 million shares in the remainder of 1994, 1.6 million shares in 1995 and 1.4 million shares in 1996. TDS owned an aggregate of 59,548,450 shares of common stock of the Company at December 31, 1993, representing over 85% of the combined total of the Company's outstanding Common and Series A Common Shares and over 97% of their combined voting power. Assuming the Company's Common Shares are issued in all instances in which the Company has the choice to issue its Common Shares or other consideration and assuming all other issuances of the Company's common stock to TDS and third parties for completed and pending acquisitions and redemptions of the Company's Preferred Stock and TDS's Preferred Shares had been completed at December 31, 1993, TDS would have owned approximately 79.5% of the total outstanding common stock of the Company and controlled over 95% of the combined voting power of both classes of its common stock. In the event TDS's ownership of the Company falls below 80% of the total value of all of the outstanding shares of the Company's stock, TDS and the Company would be deconsolidated for federal income tax purposes. TDS and the Company have the ability to defer or prevent deconsolidation, if deferring or preventing deconsolidation would be advantageous, by delivering TDS Common Shares and/or cash, in lieu of the Company's Common Shares in connection with certain acquisitions. The Company was incorporated in Delaware in 1983. The Company's executive offices are located at 8410 West Bryn Mawr, Chicago, Illinois 60631. Its telephone number is 312-399-8900. The Common Shares of the Company are listed on the American Stock Exchange under the symbol "USM." Unless the context indicates otherwise: (i) references to the "Company" refer to United States Cellular Corporation and its subsidiaries; (ii) references to "MSA" or to a particular city refer to the Metropolitan Statistical Area, as designated by the U.S. Office of Management and Budget and used by the Federal Communications Commission ("FCC") in designating metropolitan cellular market areas; (iii) references to "RSA" refer to the Rural Service Area, as used by the FCC in designating non-MSA cellular market areas; (iv) references to cellular "markets" or "systems" refer to MSAs, RSAs or both; (v) references to "population equivalents" mean the population of a market, based on 1993 Donnelley Marketing Service Estimates, multiplied by the percentage interests that the Company owns or has the right to acquire in an entity licensed, designated to receive a license or expected to receive a construction permit ("licensee") by the FCC to construct or operate a cellular system in such market. REGULATORY DEVELOPMENTS The operations of the Company are subject to FCC and state regulation. The licenses held by the Company which are granted by the FCC for the use of radio frequencies are an important component of the overall value of the assets of the Company. As discussed here, recent Congressional legislation and related FCC regulatory proceedings may have significant impact on some or all of its operations by altering FCC and state regulatory responsibilities for mobile service, the procedures for the award by the FCC of licenses to conduct existing and new mobile services, the terms and conditions of business relationships between mobile service providers and Local Exchange Carriers ("LECs") and the scope of the competitive opportunities available to mobile service providers. The Omnibus Reconciliation Act of 1993 (the "Budget Act"), which became effective in August 1993, amended the Communications Act of 1934 (the "Communications Act") by eliminating legislatively enacted distinctions affecting FCC and state regulation of common carrier and private carrier mobile operations and directed the FCC to classify all mobile services, including cellular, paging, Specialized Mobile Radio ("SMR") and other services under two categories: Commercial Mobile Radio Services ("CMRS"), subject to common carrier regulation; or Private Mobile Radio Services ("PMRS"), not subject to common carrier regulation. At its February 3, 1994 public meeting, the FCC adopted a decision classifying mobile service offerings as CMRS operations if they include a service offering to the public, for a fee, which is interconnected to the public switched network. Cellular, SMR and paging, among other services, will be classified as CMRS if they fit this definition. In addition, the FCC decision establishes a regulatory precedent for hybrid CMRS/PMRS regulation of mobile operations which offer both CMRS service and PMRS service. The Company anticipates that its service offerings will be classified as CMRS. The FCC decision also states that it would forebear from requiring that CMRS providers comply with a number of statutory provisions, otherwise applicable to common carriers, such as the filing of tariffs. It requires LECs to provide reasonable and fair interconnection to all CMRS providers, subject to mutual compensation, reasonable charges for interstate interconnection and reasonable forms of interconnection. Because the text of the FCC's decision has only recently been released and addresses many complex and interrelated aspects of regulatory policy, the impact of these aspects of the FCC proceedings on the Company cannot be predicted with certainty. The Budget Act also amended the Communications Act to authorize the FCC to use a system of competitive bidding to issue initial licenses for the use of radio frequencies for which there are mutually exclusive applications and where the principal use of the license will be to offer service in return for compensation from customers. At its March 8, 1994 public meeting, the FCC adopted a decision, the text of which has not yet been released, that establishes generic rules for competitive bidding, defines eligibility criteria for small businesses, minority-and female-owned businesses and rural telephone companies which qualify for preferential bidding treatment, as required under the Budget Act, and describes the bidding mechanisms to be used by businesses qualifying for preferential treatment in future spectrum auctions. The FCC deferred adoption of the competitive bidding rules for specific licensing situations. Under other amendments to the Communications Act included in the Budget Act, states will generally be prohibited from regulating the entry of, or the rates charged by, any CMRS provider. The new law does not, however, prohibit a state from regulating other terms and conditions of CMRS offerings and permits states to petition the FCC for authority to continue rate regulation. These new statutory provisions will take effect in August 1994. On September 23, 1993, the FCC decided to allocate seven Personal Communications Services ("PCS") frequency blocks for licensing, in the aggregate 120 Megahertz ("MHz") of spectrum for licensed operations, and an additional 40 MHz for unlicensed operations, including uses such as telephone PBX and wireless local area network operations. Two 30 MHz frequency blocks will be awarded for each of the 51 Rand McNally Major Trading Areas, while one 20 MHz and four 10 MHz frequency blocks will be awarded for each of the 492 Rand McNally Basic Trading Areas. Cellular operators will be permitted to participate in the award of these new PCS licenses, which will be made via a yet-to-be-defined auction process, except for licenses reserved for rural, small, minority-and female- owned businesses and licenses for markets in which such cellular operator owns a 20% or greater interest in a cellular licensee which holds a license covering 10% or more of the population of the respective PCS licensed area. In the latter case, the cellular licensee is limited to one 10 MHz PCS channel block. Numerous requests for reconsideration of the FCC's decision have been filed and remain pending before the FCC. In its March 8, 1994 decision referenced above, the FCC presumptively classified PCS as CMRS. The FCC has not adopted specific competitive bidding rules for the initial licensing of PCS spectrum or established a schedule for the commencement of PCS auctions. PCS technology is currently under development and is expected to be similar in some respects to cellular technology. When offered commercially, this technology is expected to offer increased capacity for wireless two-way and one-way voice, data and multimedia communications services and is expected to result in increased competition in the Company's operations. The ability of these future PCS licensees to complement or compete with existing cellular licensees is uncertain and may be affected by future FCC rule-making. These and other future technological developments in the wireless telecommunications industry and the enhancement of current technologies will likely create new products and services that are competitive with the services currently offered by the Company. There can be no assurance that the Company will not be adversely affected by such technological developments. CELLULAR TELEPHONE OPERATIONS THE CELLULAR TELEPHONE INDUSTRY. The cellular telephone industry has been in existence for approximately eleven years in the United States. Although the industry is still relatively new, it has grown significantly during this period. According to the Cellular Telecommunications Industry Association, at December 31, 1993, there were estimated to be over 16 million cellular customer units in service in the United States, generating nearly $11 billion of revenue per year. Cellular service is now available throughout the United States. The commercial feasibility of cellular systems in the United States has not, however, been proven over a long period of time. Cellular telephone technology provides high-quality, high-capacity communications services to in-vehicle cellular telephones and hand-held portable cellular telephones. Cellular technology is a major improvement over earlier mobile telephone technologies. Cellular telephone systems are designed to allow for maximum mobility of the customer. In addition to mobility, cellular telephone systems provide access through system interconnections to local, regional, national and world-wide telecommunications networks. Cellular telephone systems also offer a full range of ancillary services such as conference calling, call-waiting, call-forwarding, voice mail, facsimile and data transmission. Cellular telephone systems divide each service area into smaller geographic areas or "cells." Each cell is served by radio transmitters and receivers operating on discrete radio frequencies licensed by the FCC. All of the cells in a system are connected to a computer-controlled Mobile Telephone Switching Office ("MTSO"). The MTSO is connected to the conventional ("landline") telephone network. Each conversation on a cellular phone involves a transmission over a specific range of radio frequencies from the cellular phone to a transmitter/receiver at a cell site. The transmission is forwarded from the cell site to the MTSO and from there may be forwarded to the landline telephone network to complete the call. As the cellular telephone moves from one cell to another, the MTSO determines radio signal strength and transfers ("hands off") the call from one cell to the next. This hand-off is not noticeable to either party on the phone call. The Company provides cellular telephone service under licenses granted by the FCC. The FCC grants only two licenses to provide cellular telephone service in each market. However, competition for customers includes competing communications technologies such as conventional landline and mobile telephone, SMR systems and radio paging. In addition, emerging technologies such as Enhanced Specialized Mobile Radio ("ESMR"), mobile satellite communication systems, second generation cordless telephones ("CT-2") and PCS may prove to be competitive with cellular service in the future in some or all of the markets where the Company has operations. The services available to cellular customers and the sources of revenue available to cellular system operators are similar to those provided by conventional landline telephone companies. Customers are charged a separate fee for system access, airtime, long-distance calls, and ancillary services. Technical standards require that analog cellular telephones be compatible with all cellular systems in all market areas in the United States. Because of this compatibility feature, cellular system operators often provide service to customers of other operators' cellular systems while the customers are temporarily located within the operators' service areas. Customers using service away from their home system are called "roamers." The system that provides the service to these roamers will generate usage revenue. Many operators, including the Company, charge premium rates for this roaming service. There are a number of recent technical developments in the cellular industry. Currently, while most of the MTSOs process information digitally, most of the radio transmission is done on an analog basis. Digital radio technology offers advantages, including less transmission noise, greater system capacity, and potentially lower incremental costs for additional customers. The conversion from analog to digital radio technology is expected to be an industry-wide process that will take a number of years. During 1992, a new transmission technique was approved for implementation by the cellular industry. Time Division Multiple Access ("TDMA") technology was selected as one industry standard by the cellular industry and has been deployed in several markets, including the Company's operations in Tulsa, Oklahoma. However, another digital technology, Code Division Multiple Access ("CDMA"), is expected to be in a commercial trial by the end of 1994. The Company expects to deploy some digital radio channels in other markets in the near future. The cellular telephone industry is characterized by high initial fixed costs. Accordingly, if and when revenues less variable costs exceed fixed costs, incremental revenues should yield an operating profit. The amount of profit, if any, under such circumstances is dependent on, among other things, prices and variable marketing costs which in turn are affected by the amount and extent of competition. Until technological limitations on total capacity are approached, additional cellular system capacity can normally be added in increments that closely match demand and at less than the proportionate cost of the initial capacity. THE COMPANY'S OPERATIONS. The Company is building a substantial presence in selected geographic areas throughout the United States where it can efficiently integrate and manage cellular telephone systems. Its cellular interests include market clusters in the Northern Florida, Eastern Tennessee/Western North Carolina, Eastern North Carolina/Virginia, Maine/New Hampshire/Vermont, West Virginia/Pennsylvania/Maryland, Indiana/Kentucky, Iowa, Wisconsin/Illinois/Minnesota, Oklahoma, Missouri, Southwestern Texas, Texas/Oklahoma, Oregon/California and Washington/Idaho areas. See "The Company's Cellular Interests." The Company has acquired its cellular interests through the wireline application process (22%), including settlements and exchanges with other applicants, and through acquisitions (78%), including acquisitions from TDS and third parties. Management plans to retain minority interests in certain cellular markets which it believes will earn a favorable return on investment. Other minority interests may be traded for interests in markets which enhance the Company's market clusters or may be sold for cash or other consideration. CERTAIN CONSIDERATIONS REGARDING CELLULAR TELEPHONE OPERATIONS Since its inception in 1983, the Company has principally been in a start-up phase in which its activities have been concentrated significantly on the acquisition of interests in entities licensed or designated to receive a license ("licensees") from the FCC to provide cellular service and on the construction and initial operation of cellular systems. The development of a cellular system is capital-intensive and requires substantial investment prior to and subsequent to initial operation. The Company has experienced operating losses and net losses in all but a few quarters since its inception. The Company may incur operating losses for the next few quarters, and there is no assurance that future operations, individually or in the aggregate, will be profitable. The licensing (including renewal of licenses), construction, operation, sale, interconnection arrangements and acquisition of cellular systems are regulated by the FCC and various state public utility commissions. Changes in the regulation of cellular operators or their activities and of other mobile service providers (such as the decision by the FCC to permit PCS licensees) could have a material adverse effect on the Company's operations. See "Legal Proceedings -- La Star Application" for a discussion of certain FCC proceedings which have suspended the Company's and TDS's licensing authority in a Wisconsin market pending the outcome of an FCC hearing. The number of population equivalents represented by the Company's cellular interests bears no direct relationship to the number of potential cellular customers or the revenues that may be realized from the operation of the related cellular systems. The fair market value of the Company's cellular interests will ultimately depend on the success of its operations. There is no assurance that the value of cellular interests will not be significantly lower in the future than at present. While there are numerous cellular systems operating in the United States and other countries, the industry has only a limited operating history. As a result, there is uncertainty regarding its future, including, among other factors: (i) the growth in customers; (ii) the usage and pricing of cellular services; (iii) the percentage of customers who terminate service each month (the "churn rate"); (iv) the cost of providing cellular services, including the cost of attracting new customers; and (v) continuing technological advances which may provide competitive alternatives. Media reports have suggested that certain radiofrequency ("RF") emissions from portable cellular telephones might be linked to cancer. The Company has reviewed relevant scientific information and, based on such information, is not aware of any credible evidence linking the usage of portable cellular telephones with cancer. The FCC currently has a rulemaking proceeding pending to update the guidlines and methods it uses for evaluating RF emissions in radio equipment, including cellular telephones. While the proposal would impose more restrictive standards on RF emissions from low-power devices such as portable cellular telphones, it is anticipated that all cellular telephones currently marketed and in use will comply with those standards. CELLULAR SYSTEMS DEVELOPMENT ACQUISITIONS. During the last three years, the Company has aggressively expanded its size, particularly in markets which share adjacency, through an ongoing acquisition program aimed at strengthening the Company's position in the cellular industry. This growth has resulted primarily from acquisitions of interests in RSAs and has been based on obtaining interests with rights to manage the underlying market. Including transfers of RSA interests from TDS, the Company has nearly tripled its population equivalents from approximately 8.0 million at December 31, 1988, to approximately 23.7 million at December 31, 1993. Similarly, markets managed or to be managed by the Company have increased from 33 markets at December 31, 1988, to 144 markets at December 31, 1993. As of December 31, 1993, almost 86% of the Company's population equivalents represented interests in markets the Company manages or expects to manage, compared to 62% at December 31, 1988. The Company seeks and is currently negotiating for the acquisition of additional cellular interests and plans to acquire significant additional cellular interests in markets that complement its developing market clusters and in other attractive markets. The Company also seeks to acquire minority interests in markets where it already owns (or has the right to acquire) the majority interest. At the same time the Company continues to evaluate the disposition of interests which are not essential to its corporate development strategy. The Company will ordinarily make acquisitions using securities or cash or by exchanging cellular interests it already owns. There is no assurance that the Company will be able to purchase any additional interests, or that any such additional interests, if purchased, will be purchased on terms that are favorable to the Company. The Company, or TDS for the benefit of the Company, has negotiated acquisitions of cellular interests from third parties primarily in consideration for the Company's Common Shares or TDS's Common or Preferred Shares. Cellular interests acquired by TDS are generally assigned to the Company. At that time, the Company reimburses TDS for the value of TDS securities issued in such transactions, generally by issuing Common Shares and Preferred Stock (redeemable by the delivery of Common Shares) to TDS or by increases to the balance due TDS under the Company's Revolving Credit Agreement in amounts equal to the value of TDS capital stock at the time the acquisitions are closed. The fair market value of the Common Shares and Preferred Stock issued to TDS in connection with these transactions is equal to the fair market value of the TDS securities issued in the transactions and is determined at the time the transactions are closed. In cases where the Company's Common Shares are used as consideration in connection with acquisitions, most of the agreements call for such shares to be delivered in 1994 and later years. In a limited number of transactions, the Company has agreed to pay some portion of the purchase price in cash. COMPLETED ACQUISITIONS. During 1993, the Company completed the acquisition of controlling interests in 25 markets and several additional minority interests representing approximately 3.8 million population equivalents for an aggregate consideration of $284.6 million. The consideration consisted of 5.7 million of the Company's Common Shares, 75,000 of the Company's Series A Common Shares, an increase in the debt to TDS under the Revolving Credit Agreement of $101.5 million, $12.7 million in cash, cash paid by TDS of $9.4 million (treated as an equity contribution to the Company), and the obligation to deliver approximately 140,000 of the Company's Common Shares to third parties in 1994. The debt under the Revolving Credit Agreement and 5.5 million of the Company's Common Shares were issued to TDS to reimburse TDS for TDS Common Shares issued and cash paid to third parties in connection with these acquisitions. Included in the above transactions is the transfer of a minority interest in one RSA from TDS, representing 35,000 population equivalents. The consideration consisted of the issuance of 31,000 of the Company's Common Shares and 75,000 of the Company's Series A Common Shares to TDS. The Company's Common and Series A Common Shares have been recorded at TDS's book value of the RSA interests transferred, rather than the fair market value of the shares, due to the intercompany nature of the transaction. PENDING ACQUISITIONS. At December 31, 1993, the Company, or TDS for the benefit of the Company, had entered into agreements to acquire controlling interests in nine markets and a minority interest representing approximately 1.2 million population equivalents for an aggregate consideration estimated to be approximately $128.4 million. If all of the pending acquisitions are completed as planned, the Company will issue approximately 49,000 of its Common Shares and will pay approximately $4.5 million in cash. TDS will pay approximately $123.0 million in TDS Common Shares and cash. Any interests acquired by TDS in these transactions are expected to be assigned to the Company and at that time, the Company will reimburse TDS for TDS's consideration delivered and costs incurred in such acquisitions in the form of Common Shares of the Company or increases in the balance under the Revolving Credit Agreement. Based on the estimated value of the consideration at the time the agreements were entered into, the Company expects to reimburse TDS by issuing 3.7 million of the Company's Common Shares to TDS and by increasing the balance due TDS under the Revolving Credit Agreement by $400,000. In addition to the agreements discussed above, the Company has agreements to acquire interests representing 302,000 population equivalents in three markets. The consideration for these acquisitions will be determined based on future appraisals of the fair market values of the interests to be acquired. All population equivalents acquirable pursuant to these agreements and the agreements in the previous paragraph are included in the table on pages 11 to 14. In addition to the acquisitions completed in 1993 and the pending acquisitions discussed above, the Company had commitments at December 31, 1993 to issue 4.8 million Common Shares in connection with acquisitions completed prior to 1993. Approximately 3.8 million of these shares were issued in early 1994. The Company also had Preferred Stock outstanding (all of which is held by TDS) which is redeemable into 1.2 million of the Company's Common Shares in 1994 through 1996. Certain series of TDS Preferred Shares are redeemable into an additional 1.1 million of the Company's Common Shares in 1994 through 1996. The Company maintains shelf registration of its Common Shares and Preferred Stock under the Securities Act of 1933 for issuance specifically in connection with acquisitions. CELLULAR INTERESTS AND CLUSTERS The Company operates clusters of adjacent cellular systems, enabling its customers to benefit from a larger service area than otherwise possible. The Company's strategy was initially implemented by filing for licenses to operate cellular systems in MSAs. Following the MSA lotteries and settlements, the Company acquired interests in certain additional MSAs through purchases. The Company has acquired substantial additional population equivalents through the purchase of interests in RSAs. The Company plans to continue to acquire controlling interests in cellular licenses to provide service in systems that complement its developing market clusters and in other attractive systems. The Company anticipates that clustering markets will expand its cellular service areas and provide certain economies in its capital and operating costs. In areas where the Company has clusters of contiguous markets it may offer wide-area coverage. This would allow uninterrupted service within the area and allow the customer to make outgoing and receive incoming calls without special roamer arrangements. Clustering also makes possible greater sharing of facilities, personnel and other costs and may thereby reduce the costs of serving each customer. The extent to which these revenue enhancements and economies of operation will be realized through clustering is dependent upon market conditions, population sizes of the clusters and engineering considerations. The Company's market clusters have grown rapidly. At December 31, 1993, approximately 87%, or 17.7 million, of the Company's managed population equivalents were in contiguous markets within market clusters. Additionally, 92% of the Company's managed markets were adjacent to another Company-managed market at that time. The Company anticipates continuing to pursue strategic acquisitions and trades in order to complement its developing market clusters. The Company has also acquired minority interests in markets where it already owns, or has the right to acquire, a majority interest. From time to time, the Company may consider trading or selling some of its cellular interests which do not fit well with its long-term strategies. The Company owned or had the right to acquire interests in cellular telephone systems in 205 markets at December 31, 1993. At December 31, 1993, approximately 86%, or 20.4 million, of the Company's population equivalents were in markets that the Company manages or expects to manage. At that date, approximately 95% of the Company's managed population equivalents were in markets where cellular service has been initiated and where the Company is currently operating the system. The following table summarizes the growth in the Company's population equivalents in recent years and the development status of these population equivalents. The following section details the Company's cellular interests, including those it owned or had the right to acquire as of December 31, 1993. The table presented therein lists clusters of markets, including both MSAs and RSAs, that the Company operates or anticipates operating. The Company's market clusters show the areas in which the Company is currently focusing its development efforts. These clusters have been devised with a long-term goal of allowing delivery of cellular service to areas of economic interest and along corridors of economic activity. THE COMPANY'S CELLULAR INTERESTS The table below sets forth certain information with respect to the interests in cellular markets which the Company owned or had the right to acquire pursuant to definitive agreements as of December 31, 1993. SYSTEM DESIGN AND CONSTRUCTION. The Company designs and constructs its systems in a manner it believes will permit it to provide high-quality service to mobile, transportable and portable cellular telephones, generally based on market and engineering studies which relate to specific markets. Engineering studies are performed by Company personnel or independent engineering firms. The Company's switching equipment is digital, which reduces noise and crosstalk and is capable of interconnecting in a manner which reduces costs of operation. While digital microwave interconnections are typically made between the MTSO and cell sites, primarily analog radio transmission is used between cell sites and the cellular telephones themselves. In accordance with its strategy of building and strengthening market clusters, the Company has selected high capacity with service-upgraded digital cellular switching systems that are capable of serving multiple markets via a single MTSO. The Company's cellular systems are designed to facilitate the installation of equipment which will permit microwave interconnection between the MTSO and each cell site. The Company has implemented such microwave interconnection in most of the cellular systems it manages. In other systems in which the Company owns or has an option to purchase a majority interest and where it is believed to be cost-efficient, such microwave technology will also be implemented. Otherwise, such systems will rely upon landline telephone connections or microwave links owned by others to link cell sites with the MTSO. Although the installation of microwave network interconnection equipment requires a greater initial capital investment, a microwave network enables a system operator to avoid the current and future charges associated with leasing telephone lines from the landline telephone company, while generally improving system reliability. In addition, microwave facilities can be used to connect separate cellular systems to allow shared switching, which reduces the aggregate cost of the equipment necessary to operate both systems. The Company has continued to expand its internal, nationwide seamless network in 1993 to encompass over 100 markets in the United States. This network provides automatic call delivery for the Company's customers and handoff between adjacent markets. The seamless network has also been extended, using IS-41 technology, via links with certain systems operated by several other carriers, including GTE, US West, Ameritech, BellSouth, Centennial Cellular Corp., Southwestern Bell, McCaw Cellular Communications, Vanguard Cellular Systems, Inc. and others. Additionally, the Company has conducted Signaling System 7 field trials with AT&T and with Independent Telephone Network to determine the most viable approach to establish a backbone network that will enable the Company to interface with other national networks. During 1994, the Company expects to significantly extend the seamless network for its customers into additional areas in Texas, Arkansas, Indiana, Idaho, Utah, California, Louisiana, Massachusetts, Washington, Florida and several other states. Not only will this expanded network increase the area in which customers can automatically receive incoming calls, but it will also reduce the incidence of fraud due to the pre-call validation feature of the IS-41 technology. Management believes that currently available technologies will allow sufficient capacity on the Company's networks to meet anticipated demand over the next few years. COSTS OF SYSTEM CONSTRUCTION AND FINANCING Construction of cellular systems is capital-intensive, requiring substantial investment for land and improvements, buildings, towers, MTSOs, cell site equipment, microwave equipment, customer equipment, engineering and installation. The Company, consistent with FCC control requirements, uses primarily its own personnel to engineer and oversee construction of each cellular system where it owns or has the right to acquire a controlling interest. In so doing, the Company expects to improve the overall quality of its systems and to reduce the expense and time required to make them operational. The costs (exclusive of license costs) of the operational systems in which the Company owns or has the right to acquire an interest are generally financed through capital contributions or intercompany loans to the partnerships or subsidiaries owning the systems, and through certain vendor financing. MARKETING AND CUSTOMER SERVICE The Company's marketing plan is designed to capitalize on its clustering strategy and to increase revenue by growing the Company's customer base, increasing customers' usage of cellular service and reducing churn or customer disconnects. The marketing plan stresses service quality and incorporates programs aimed at developing and expanding new and existing distribution channels, stimulating customer usage by offering new and enhanced services and by increasing the public's awareness and understanding of the cellular services offered by the Company. Most of the Company's operations market cellular service under the "United States Cellular"-TM- name and service mark. The Company's marketing strategy is to develop a local, customer-oriented operation, the primary goal of which is to provide quality cellular service to its customers. The Company's marketing program focuses on obtaining customers who need cellular service, such as business people who, while out of their offices, need to be in contact with others. The Company plans to follow the same marketing program in the other systems it expects to manage. The Company manages each cellular cluster, and in some cases individual markets, with a local staff, including a manager and customer service representatives. Sales consultants are typically maintained in each market within the clusters. Customers are able to report cellular service problems or concerns 24 hours a day. It is the Company's goal to respond to customers' concerns and to correct reported service deficiencies within 24 hours of notification. The Company has established local service centers in order to repair and maintain most major brands of user equipment. The Company has relied primarily on its own direct and retail sales channels to obtain customers for the cellular markets it manages. The Company maintains an ongoing training program to improve the effectiveness of the sales consultants and retail associates in obtaining customers as well as maximizing the sale of high-user packages. These packages commit customers to pay for a minimum amount of usage at discounted rates per minute, even if usage falls below the monthly minimum amount. The Company also uses agents, dealers and retailers to obtain customers. Agents and dealers are independent business people who sell to customers on a commission basis for the Company. The Company's agents are in the business of selling cellular telephones, cellular service packages and other related products to customers. The Company's dealers include car stereo companies and other companies whose customers are also potential cellular customers. The Company's retailers include car dealers, major appliance dealers, office supply dealers and mass merchants. The Company began to specifically address the fast-growing consumer market by opening its own retail stores in late 1993. These small facilities are located in high-traffic areas and are designed to cater to walk-in customers. The Company plans to open more locations in 1994 to further its presence in the local markets. The Company also actively pursues national retail accounts which may potentially yield new customer additions in multiple markets. The national account effort is expected to enable the Company to reach segments of the market other than those accessed by the local sales force. Agreements have been entered into with such national distributors as Chrysler Corporation, Ford Motor Company, General Motors, Honda, AT&T, Radio Shack, Best Buy, and Sears, Roebuck & Co. for certain of the Company's markets. Upon the sale of a cellular telephone by one of these national distributors, the Company receives, often exclusively within the territories served, the resulting cellular customer. In recognition of the needs of these national accounts, the Company initiated a centralized customer support program. This program allows for customer activation during peak retail business hours (weekends and evenings) when the Company's local office might otherwise be closed. The Company uses a variety of direct mail, billboard, radio, television and newspaper advertising to stimulate interest by prospective customers in cellular service and to establish familiarity with the Company's name. Advertising is directed at gaining customers, increasing usage by existing customers and increasing the public awareness and understanding of the cellular services offered by the Company. The Company attempts to select the advertising and promotion media that are most appealing to the targeted groups of potential customers in each local market. The Company utilizes local advertising media and public relations activities and establishes programs to enhance public awareness of the Company, such as providing telephones and service for public events and emergency uses. CUSTOMERS AND SYSTEM USAGE Company data for 1993 indicate that 52% of the Company's customers use their cellular telephones primarily for business. Cellular customers come from a wide range of occupations. They typically include a large proportion of individuals who work outside of their offices such as people in the construction, real estate, wholesale and retail distribution businesses, and professionals. Most of the Company's customers use in-vehicle cellular telephones. However, more customers (71% of new customers in 1993 compared to 21% in 1988) are selecting portable and other transportable cellular telephones as these units become more compact and fully featured as well as more attractively priced. The Company's cellular systems are used most extensively during normal business hours between 7:00 am and 6:00 pm. On average, the local retail customers in the Company's majority-owned and managed systems used their cellular systems approximately 103 minutes per unit each month and generated retail revenue of approximately $49 per month during 1993, compared to 121 minutes and $52 per month in 1992. Revenue generated by roamers, together with local, toll and other revenues, brought the Company's total average monthly service revenue per customer unit in majority-owned and managed markets to $99 during 1993. Average monthly service revenue per customer unit decreased approximately 6% during 1993, reflecting primarily the decline in average local minutes per customer unit. The Company anticipates that average monthly service revenue per customer unit may continue to decline as retail distribution channels provide additional consumer customers who generate fewer local minutes of use and as roamer revenues grow more slowly. Roaming is a service offered by the Company which allows a customer to place or receive a call in a cellular service area away from the customer's home market area. The Company has entered into "roaming agreements" with operators of other cellular systems covering virtually all systems in the United States and Canada. These agreements offer customers the opportunity to roam in these systems. These reciprocal agreements automatically pre-register the customers of the Company's systems in the other carriers' systems. Also, a customer of a participating system roaming (i.e. travelling) in a Company market where this arrangement is in effect is able to automatically make and receive calls on the Company's system. The charge for this service is typically at premium rates and is billed by the Company to the customer's home system, which then bills the customer. The Company has entered into agreements with other cellular carriers to transfer roaming usage at agreed-upon rates. In some instances, based on competitive factors, the Company may charge a lower amount to its customers than the amount actually charged to the Company by another cellular carrier for roaming; however, these services include call delivery and call handoff. The following table summarizes certain information about customers and market penetration in the Company's managed operations. The following table summarizes, by cluster, the total population, the Company's customer units and penetration for the Company's majority-owned and managed markets that were operational as of December 31, 1993. CELLULAR TELEPHONES AND INSTALLATION There are a number of different types of cellular telephones, all of which are currently compatible with cellular systems nationwide. The Company offers a full range of vehicle-mounted, transportable, and hand-held portable cellular telephones. Features offered in some of the cellular telephones include hands-free calling, repeat dialing, horn alert and others. The Company has established service and/or installation facilities in many of its local markets to ensure quality installation and service of the cellular telephones it sells. These facilities allow the Company to improve its service by promptly assisting customers who experience equipment problems. The Company negotiates volume discounts from its cellular telephone suppliers. The Company discounts cellular telephones in most markets to meet competition or to stimulate sales by reducing the cost of becoming a cellular customer. In these instances, where permitted by law, customers are generally required to sign an extended service contract with the Company. The Company also cooperates with cellular equipment manufacturers in local advertising and promotion of cellular equipment. PRODUCTS AND SERVICES The Company's customers are able to choose from a variety of packaged pricing plans which are designed to fit different calling patterns. The Company's customer bills typically show separate charges for custom-calling features, airtime in excess of the packaged amount, and toll calls. Custom-calling features provided by the Company include wide-area call delivery, call forwarding, call waiting, three-way calling and no-answer transfer. The Company also offers a voice message service in many of its markets. This service, which functions like a sophisticated answering machine, allows customers to receive messages from callers when they are not available to take calls. REGULATION The construction, operation and transfer of cellular systems in the United States are regulated to varying degrees by the FCC pursuant to the Communications Act. The FCC has promulgated regulations governing construction and operation of cellular systems, and licensing and technical standards for the provision of cellular telephone service. For licensing purposes, the FCC divided the United States into separate geographic markets (MSAs and RSAs). In each market, the allocated cellular frequencies are divided into two equal blocks. During the application process, the FCC reserved one block of frequencies for nonwireline applicants and another block for wireline applicants. Subject to FCC approval, a cellular system may be sold to either a wireline or nonwireline entity, but no entity which controls a cellular system may own an interest in another cellular system in the same MSA or RSA. The completion of acquisitions involving the transfer of control of a cellular system requires prior FCC approval. Acquisitions of minority interests generally do not require FCC approval. Whenever FCC approval is required, any interested party may file a petition to dismiss or deny the Company's application for approval of the proposed transfer. When the first cell of a cellular system has been constructed, the licensee is required to notify the FCC that construction has been completed. Immediately upon this notification, but not before, FCC rules authorize the licensee to offer commercial service to the public. The licensee is then said to have "operating authority." Initial operating licenses are granted for ten-year periods. The FCC must be notified each time an additional cell is constructed. The FCC's rules also generally require persons or entities holding cellular construction permits or licenses to coordinate their proposed frequency usage with other cellular users and licensees in order to avoid electrical interference between adjacent systems. The height and power of base stations in the cellular system are regulated by FCC rules, as are the types of signals emitted by these stations. In addition to regulation by the FCC, cellular systems are subject to certain Federal Aviation Administration regulations respecting the siting and construction of cellular transmitter towers and antennas. On January 9, 1992, the FCC adopted a Report and Order ("R&O") which establishes standards for conducting comparative renewal proceedings between a cellular licensee seeking renewal of its license and challengers filing competing applications. In the R&O, the FCC: (i) established criteria for comparing the renewal applicant to challengers, including the standards under which a "renewal expectancy" will be granted to the applicant seeking license renewal; (ii) established basic qualifications standards for challengers; and (iii) provided procedures for preventing possible abuses in the comparative renewal process. The FCC has concluded that it will award a renewal expectancy if the licensee has (i) substantially used its spectrum for its intended purposes; (ii) complied with FCC rules, policies and the Communications Act, as amended; and (iii) not engaged in substantial relevant misconduct. If a renewal expectancy is awarded to an existing licensee, that expectancy will be more significant in the renewal proceeding than any other criterion used to compare the licensee to challengers. Licenses of the Company's affiliates in Knoxville and Tulsa will be its first to come up for renewal in 1994. See "Legal Proceedings -- La Star Application" for a discussion of certain FCC proceedings which have suspended the Company's and TDS's licensing authority in a Wisconsin market pending the outcome of an FCC hearing. The Company conducts and plans to conduct its operations in accordance with all relevant FCC rules and regulations and would anticipate being able to qualify for a renewal expectancy. Accordingly, the Company believes that the regulations will have no significant effect on its operations and financial condition. The FCC has also provided that five years after the initial licenses are granted, unserved areas within markets previously granted to licensees may be applied for by both wireline and nonwireline entities and by third parties. The FCC established 1993 filing dates for filing "unserved area" applications in MSAs in which the five-year period had expired and many unserved area applications were filed in certain MSAs. The Company's strategy with respect to system construction in its markets has been and will be to build cells covering every area within such markets that the Company considers economically feasible to serve or might conceivably wish to serve and to do so within the five-year period following issuance of the license. The Company is also subject to state and local regulation in some instances. In 1981, the FCC preempted the states from exercising jurisdiction in the areas of licensing, technical standards and market structure. However, certain states require cellular system operators to go through a state certification process to serve communities within their borders. All such certificates can be revoked for cause. In addition, certain state authorities regulate several aspects of a cellular operator's business, including the rates it charges its customers and cellular resellers, the resale of long-distance service to its customers, the technical arrangements and charges for interconnection with the landline network and the transfer of interests in cellular systems. The siting and construction of the cellular facilities, including transmitter towers, antennas and equipment shelters may also be subject to state or local zoning, land use and other local regulations. Public utility or public service commissions (or certain of the commissioners) in several states have expressed an interest in examining whether the cellular industry should be more closely regulated by such states. COMPETITION The Company's only facilities-based competitor for cellular telephone service in each market is the licensee of the second cellular system in that market. Competition for customers between the two systems in each market is principally on the basis of quality of service, price, size of area covered, services offered, and responsiveness of customer service. The competing entities in many of the markets in which the Company has an interest have financial resources which are substantially greater than those of the Company and its partners in such markets. The FCC's rules require all operational cellular systems to provide, on a nondiscriminatory basis, cellular service to resellers which purchase blocks of mobile telephone numbers from an operational system and then resell them to the public. In addition to competition from the other cellular licensee in each market, there is also competition from, among other technologies, conventional mobile telephone and SMR systems, both of which are able to connect with the landline telephone network. The Company believes that conventional mobile telephone systems and conventional SMR systems are competitively disadvantaged because of technological limitations on the capacity of such systems. The FCC has recently given approval, via waivers of its rules, to ESMR, an enhanced SMR system. ESMR systems may have cells and frequency reuse like cellular, thereby potentially eliminating any current technological limitation. The first ESMR systems were implemented in 1993 in Los Angeles. Although less directly a substitute for cellular service, wireless data services and one-way paging service (and in the future, two-way paging services) may be adequate for those who do not need full two-way voice service. Continuing technological advances in the communications field make it impossible to predict the extent of additional future competition for cellular systems. For example, the FCC has allocated radio channels to a mobile satellite system in which transmissions from mobile units to satellites would augment or replace transmissions to cell sites, and a consortium to provide such service has been formed. Such a system is designed primarily to serve the communications needs of remote locations and a mobile satellite system could provide viable competition for land-based cellular systems in such areas. It is also possible that the FCC may in the future assign additional frequencies to cellular telephone service to provide for more than two cellular telephone systems per market. CT-2, second generation cordless telephones, and PCS, personal communications network services, may prove to be competitive with cellular service in the future. CT-2 will allow a customer to make a call from a personal phone as long as the person is within range of a telepoint base station which connects the call to the public switched telephone network. PCS will be digital, wireless communications systems which currently are primarily targeted for use in very densely populated areas. Various CT-2 and PCS trials are in process throughout the United States. CT-2 and PCS are not anticipated to be significant sources of competition in the Company's markets in the near future. Similar technological advances or regulatory changes in the future may make available other alternatives to cellular service, thereby creating additional sources of competition. EMPLOYEES The Company had 1,785 employees as of February 28, 1994. Of these, 1,491 were based at the various cellular markets operated or managed by the Company with only 294 based at its corporate office in Chicago, Illinois. None of the Company's employees is represented by a labor organization. The Company considers its relationship with its employees to be good. - -------------------------------------------------------------------------------- ITEM 2. ITEM 2. PROPERTIES The property for mobile telephone switching offices and cell sites are either owned or leased under long-term leases by the Company, one of its subsidiaries or the partnership or corporation which holds the construction permit or license. The Company has not experienced major problems with obtaining zoning approval for cell sites or operating facilities and does not anticipate any such problems in the future which are or will be material to the Company and its subsidiaries as a whole. The Company's investment in property is small compared to its investment in licenses and equipment. The Company leases approximately 39,000 square feet of office space for its headquarters in Chicago, Illinois. The Company considers the properties owned or leased by it and its subsidiaries to be suitable and adequate for their respective business operations. - -------------------------------------------------------------------------------- ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in a number of legal proceedings before the FCC and various state and federal courts. In some cases, the litigation involves disputes regarding rights to certain cellular telephone markets. The more significant proceedings affecting the Company are described in the following paragraphs. LA STAR APPLICATION. Star Cellular Telephone Company, Inc. ("Star Cellular"), an indirect, wholly owned subsidiary of the Company, is a 49% owner of La Star Cellular Telephone Company ("La Star"), an applicant for a construction permit for a cellular system in St. Tammany Parish in the New Orleans MSA. In June 1992, the FCC affirmed an Administrative Law Judge's order which had granted the mutually exclusive application of New Orleans CGSA, Inc. ("NOCGSA") and dismissed La Star's application. The ground for the FCC's action was its finding that Star Cellular, and not the 51% owner, SJI Cellular, Inc. ("SJI"), in fact controlled La Star. La Star, TDS and the Company have appealed that order to the United States Court of Appeals of the District of Columbia Circuit and those appeals are pending. In a footnote to its decision, the FCC stated, in part, that "Questions regarding the conduct of SJI and [the Company] in this case may be revisited in light of the relevant findings and conclusions here in future proceedings where the other interests of these parties have decisional significance." Certain adverse parties have attempted to use the footnote in the LA STAR decision in a number of unrelated, contested proceedings which TDS and the Company have pending before the FCC. In addition, since the LA STAR proceeding, FCC authorizations in uncontested FCC proceedings have been granted subject to any subsequent action the FCC may take concerning the LA STAR footnote. On February 1, 1994, in a proceeding involving a license originally issued to TDS for a rural service area in Wisconsin, the FCC instituted a hearing to determine whether in the La Star case the Company had misrepresented facts to, lacked candor in its dealings with or attempted to mislead the FCC and, if so, whether TDS possesses the requisite character qualifications to hold that Wisconsin license. The FCC stated that, pending resolution of the issues in the Wisconsin proceeding, further grants to TDS and its subsidiaries will be conditioned on the outcome of that proceeding. TDS was granted interim authority to continue to operate the Wisconsin system pending completion of the hearing. An adverse finding in the Wisconsin hearing could result in a variety of possible sanctions, ranging from a fine to loss of the Wisconsin license, and could, as stated in the FCC order, be raised and considered in other proceedings involving TDS and its subsidiaries. TDS and the Company believe they acted properly in connection with the La Star application and that the findings and record in the La Star proceeding are not relevant in any other proceeding involving their FCC license qualifications. TOWNES TELECOMMUNICATIONS, INC., ET. AL. V. TDS, ET. AL. Plaintiffs Townes Telecommunications, Inc. ("Townes"), Tatum Telephone Company ("Tatum Telephone") and Tatum Cellular Telephone Company ("Tatum Cellular") filed a suit in the District Court of Rusk County, Texas, against both TDS and the Company as defendants. Plaintiff Townes alleges that it entered into an oral agreement with defendants which established a joint venture to develop cellular business in certain markets. Townes alleges that defendants usurped a joint venture opportunity and breached fiduciary duties to Townes by purchasing interests in nonwireline markets in Texas RSA #11 and the Tyler (Texas) MSA on their own behalf rather than on behalf of the alleged joint venture. In its Fifth Amended Original Petition, Townes seeks unspecified damages not to exceed $33 million for usurpation, breach of fiduciary duty, civil conspiracy, breach of contract and tortious interference. Townes also seeks imposition of a constructive trust on defendants' profits from Texas RSA #11 and the Tyler (Texas) MSA and transfer of those interests to the alleged joint venture. In addition Townes seeks reasonable attorneys' fees equal to one-third of the judgment, along with the prejudgment interest. Plaintiffs Tatum Telephone and Tatum Cellular seek a declaration that transfers by defendants of a 49% interest in Tatum Cellular violated a five-year restriction on alienation of Tatum Cellular shares contained in a written shareholders' agreement. Tatum Telephone and Tatum Cellular seek to void the transfers. All plaintiffs together seek as much as $200 million in punitive damages. Defendants have asserted meritorious defenses to each of the plaintiffs' claims and are vigorously defending this case. Discovery is ongoing. A jury trial in this case is set to commence on April 25, 1994. - -------------------------------------------------------------------------------- ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of securities holders during the fourth quarter of 1993. - -------------------------------------------------------------------------------- PART II - -------------------------------------------------------------------------------- ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Incorporated by reference from Exhibit 13, Annual Report section entitled "United States Cellular Stock and Dividend Information." - -------------------------------------------------------------------------------- ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Incorporated by reference from Exhibit 13, Annual Report section entitled "Selected Consolidated Financial Data," except for ratios of earnings to fixed charges, which are incorporated herein by reference from Exhibit 12 to this Annual Report on Form 10-K. - -------------------------------------------------------------------------------- ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated by reference from Exhibit 13, Annual Report section entitled "Management's Discussion and Analysis of Results of Operations and Financial Condition." - -------------------------------------------------------------------------------- ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Incorporated by reference from Exhibit 13, Annual Report sections entitled "Consolidated Statements of Operations," "Consolidated Statements of Cash Flows," "Consolidated Balance Sheets," "Consolidated Statements of Changes in Common Shareholders' Equity," "Notes to Consolidated Financial Statements," "Report of Independent Public Accountants," and "Consolidated Quarterly Income Information (Unaudited)." - -------------------------------------------------------------------------------- ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. - -------------------------------------------------------------------------------- PART III - -------------------------------------------------------------------------------- ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference from Proxy Statement sections entitled "Election of Directors" and "Executive Officers." - -------------------------------------------------------------------------------- ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from Proxy Statement section entitled "Executive Compensation," except for the information specified in Item 402(a)(8) of Regulation S-K under the Securities Exchange Act of 1934, as amended. - -------------------------------------------------------------------------------- ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from Proxy Statement section entitled "Security Ownership of Certain Beneficial Owners and Management." - -------------------------------------------------------------------------------- ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from Proxy Statement section entitled "Certain Relationships and Related Transactions." - -------------------------------------------------------------------------------- PART IV - -------------------------------------------------------------------------------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K The following documents are filed as a part of this report: (a)(1) Financial Statements All other schedules have been omitted because they are not applicable or not required or because the required information is shown in the financial statements or notes thereto. (3) Exhibits The exhibits set forth in the accompanying Index to Exhibits are filed as a part of this Report. The following is a list of each management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c) of this Report. (b) Reports on Form 8-K filed during the quarter ended December 31, 1993. The Company filed a Report on Form 8-K dated November 17, 1993, which included as an exhibit a Press Release discussing the Company's completion of its rights offering. No other reports on Form 8-K were filed during the quarter ended December 31, 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Shareholders and Board of Directors of UNITED STATES CELLULAR CORPORATION: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in United States Cellular Corporation and Subsidiaries Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 7, 1994. Our report on the consolidated financial statements includes explanatory paragraphs with respect to the change in the method of accounting for cellular sales commissions and with respect to the change in the method of accounting for income taxes as discussed in Note 1 and Note 10, respectively, of the Notes to Consolidated Financial Statements and the uncertainties discussed in Note 3 of the Notes to Consolidated Financial Statements; and an explanatory paragraph calling attention to certain litigation as discussed in Note 15 of the Notes to Consolidated Financial Statements. Our audits were made for the purpose of forming an opinion on those financial statements taken as a whole. The financial statement schedules listed in Item 14(a)(2) are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These financial statement schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois February 7, 1994 UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE IV--INDEBTEDNESS OF AND TO RELATED PARTIES--NOT CURRENT UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- DEPRECIATION The Company and its subsidiaries provide depreciation for book purposes on a straight-line basis over the useful lives of the property ranging from three to twenty-five years. The composite depreciation rate, as applied to the average cost of depreciable property, was 10.5%. UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 - -------------------------------------------------------------------------------- DEPRECIATION The Company and its subsidiaries provide depreciation for book purposes on a straight-line basis over the useful lives of the property ranging from three to twenty-five years. The composite depreciation rate, as applied to the average cost of depreciable property, was 10.5%. UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 - -------------------------------------------------------------------------------- DEPRECIATION The Company and its subsidiaries provide depreciation for book purposes on a straight-line basis over the useful lives of the property ranging from three to twenty-five years. The composite depreciation rate, as applied to the average cost of depreciable property, was 10.4%. UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE VI--RESERVE FOR DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE VI--RESERVE FOR DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1992 - -------------------------------------------------------------------------------- UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE VI--RESERVE FOR DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1991 - -------------------------------------------------------------------------------- UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS UNITED STATES CELLULAR CORPORATION AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 - -------------------------------------------------------------------------------- LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP COMBINED FINANCIAL STATEMENTS The following financial statements are the combined financial statements of the cellular system partnerships listed below which are accounted for by the Company following the equity method. The combined financial statements were compiled from financial statements and other information obtained by the Company as a noncontrolling limited partner of the cellular limited partnerships listed below. The cellular system partnerships included in the combined financial statements, the periods each partnership is included, and the Company's ownership percentage of each cellular system partnership at December 31, 1993 are set forth in the following table. COMPILATION REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of UNITED STATES CELLULAR CORPORATION: The accompanying combined balance sheets of the Los Angeles SMSA Limited Partnership, the Nashville/Clarksville MSA Limited Partnership and the Baton Rouge MSA Limited Partnership as of December 31, 1993 and 1992 and the related combined statements of operations, changes in partners' capital, and cash flows for each of the three years in the period ended December 31, 1993, have been prepared from the separate financial statements, which are not presented separately herein, of the Los Angeles SMSA, Nashville/Clarksville MSA and Baton Rouge MSA limited partnerships, as described in Note 1. We have reviewed for compilation only the accompanying combined financial statements, and, in our opinion, those statements have been properly compiled from the amounts and notes of the underlying separate financial statements of the Los Angeles SMSA, Nashville/Clarksville MSA and Baton Rouge MSA limited partnerships, on the basis described in Note 1. The statements for the Los Angeles SMSA, Nashville/Clarksville MSA and Baton Rouge MSA limited partnerships were audited by other auditors as set forth in their reports included on pages 40 through 43. The report of the other auditors of the Los Angeles SMSA Limited Partnership contains explanatory paragraphs with respect to the uncertainties discussed in the fourth and fifth paragraphs of Note 7. We have not been engaged to audit either the separate financial statements of the aforementioned limited partnerships or the related combined financial statements in accordance with generally accepted auditing standards and to render an opinion as to the fair presentation of such financial statements in accordance with generally accepted accounting principles. As discussed in "Change in Accounting Principle" in Note 2, the method of accounting for cellular sales commissions was changed effective January 1, 1991, for the Nashville/Clarksville MSA Limited Partnership and the Baton Rouge MSA Limited Partnership. ARTHUR ANDERSEN & CO. Chicago, Illinois February 11, 1994 REPORTS OF OTHER INDEPENDENT ACCOUNTANTS To The Partners of LOS ANGELES SMSA LIMITED PARTNERSHIP: We have audited the balance sheets of Los Angeles SMSA Limited Partnership as of December 31, 1993 and 1992, and the related statements of operations, partners' capital and cash flows for each of the three years in the period ended December 31, 1993; such financial statements are not included separately herein. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Los Angeles SMSA Limited Partnership as of December 31, 1993 and 1992, and results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 9 to the financial statements, two cellular agents filed complaints against the Partnership. The outcome of these matters is uncertain and, accordingly, no accrual for these matters has been made in the financial statements. In addition, as discussed in Note 9, a class action suit was filed against the Partnership alleging violations of state and federal antitrust laws. The outcome of this matter is uncertain and, accordingly, no accrual for this matter has been made in the financial statements. COOPERS & LYBRAND Newport Beach, California February 4, 1994 To The Partners of NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP: We have audited the balance sheet of Nashville/Clarksville MSA Limited Partnership as of December 31, 1993, and the related statements of income, changes in partners' capital and cash flows for the year then ended; such financial statements are not included separately herein. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Nashville/Clarksville MSA Limited Partnership as of December 31, 1993, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. COOPERS & LYBRAND Atlanta, Georgia February 11, 1994 REPORTS OF OTHER INDEPENDENT ACCOUNTANTS To The Partners of NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP: We have audited the balance sheet of Nashville/Clarksville MSA Limited Partnership as of December 31, 1992, and the related statements of income, changes in partners' capital and cash flows for the year then ended; such financial statements are not included separately herein. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Nashville/Clarksville MSA Limited Partnership as of December 31, 1992, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. COOPERS & LYBRAND Atlanta, Georgia February 11, 1993 To The Partners of NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP: We have audited the balance sheet of Nashville/Clarksville MSA Limited Partnership as of December 31, 1991, and the related statements of operations, changes in partners' capital and cash flows for the year then ended; such financial statements are not included separately herein. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Nashville/Clarksville MSA Limited Partnership as of December 31, 1991, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. As discussed in Note 2 to the financial statements, the Partnership changed its method of accounting for commissions in 1991. COOPERS & LYBRAND Atlanta, Georgia February 10, 1992 REPORTS OF OTHER INDEPENDENT ACCOUNTANTS To The Partners of BATON ROUGE MSA LIMITED PARTNERSHIP: We have audited the balance sheet of Baton Rouge MSA Limited Partnership as of December 31, 1993, and the related statements of income, changes in partners' capital and cash flows for the year then ended; such financial statements are not included separately herein. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Baton Rouge MSA Limited Partnership as of December 31, 1993, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. COOPERS & LYBRAND Atlanta, Georgia February 11, 1994 To The Partners of BATON ROUGE MSA LIMITED PARTNERSHIP: We have audited the balance sheet of Baton Rouge MSA Limited Partnership as of December 31, 1992, and the related statements of income, changes in partners' capital and cash flows for the year then ended; such financial statements are not included separately herein. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Baton Rouge MSA Limited Partnership as of December 31, 1992, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. COOPERS & LYBRAND Atlanta, Georgia February 11, 1993 REPORTS OF OTHER INDEPENDENT ACCOUNTANTS To The Partners of BATON ROUGE MSA LIMITED PARTNERSHIP: We have audited the balance sheet of Baton Rouge MSA Limited Partnership as of December 31, 1991, and the related statements of income, changes in partners' capital and cash flows for the year then ended; such financial statements are not included separately herein. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Baton Rouge MSA Limited Partnership as of December 31, 1991, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. As discussed in Note 2 to the financial statements, the Partnership changed its method of accounting for commissions in 1991. COOPERS & LYBRAND Atlanta, Georgia February 10, 1992 LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP COMBINED STATEMENTS OF OPERATIONS (UNAUDITED) The accompanying notes are an integral part of these combined financial statements. LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP COMBINED BALANCE SHEETS (UNAUDITED) ASSETS The accompanying notes are an integral part of these combined financial statements. LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP COMBINED STATEMENTS OF CASH FLOWS (UNAUDITED) The accompanying notes are an integral part of these combined financial statements. LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP COMBINED STATEMENTS OF CHANGES IN PARTNERS' CAPITAL (UNAUDITED) The accompanying notes are an integral part of these combined financial statements. LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP NOTES TO UNAUDITED COMBINED FINANCIAL STATEMENTS 1. BASIS OF COMBINATION: The combined financial statements and notes thereto were compiled from the individual financial statements of cellular limited partnerships listed below in which United States Cellular Corporation (AMEX symbol "USM") has a noncontrolling ownership interest and which it accounts for using the equity method. The cellular partnerships, the period each partnership is included in the combined financial statements and USM's ownership interest in each partnership are set forth in the table below. The combined financial statements and notes thereto present 100% of each partnership whereas USM's ownership interest is shown in the table. Profits, losses and distributable cash are allocated to the partners based upon respective partnership interests. Distributions are made quarterly at the discretion of the General Partner for one of the Partnerships. Of the partnerships included in the combined financial statements, the Los Angeles SMSA Limited Partnership is the most significant, accounting for approximately 89% of the combined total assets at December 31, 1993, and substantially all of the combined net income for the year then ended. USM's investment in and advances to Los Angeles SMSA Limited Partnership totalled $15,212,000 as of December 31, 1993, of which $17,398,000 represents its proportionate share of net assets of the Partnership. USM's investment in and advances to the Nashville/Clarksville MSA Limited Partnership totalled $14,300,000 as of December 31, 1993, which represents its proportionate share of net assets. USM's investment in and advances to the Baton Rouge MSA Limited Partnership totalled $8,935,000 as of December 31, 1993, $6,207,000 of which represents its proportionate share of net assets. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES FOR COMBINED ENTITIES: PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is stated at cost. Depreciation is computed using the straight-line method over the following estimated lives: LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP NOTES TO UNAUDITED COMBINED FINANCIAL STATEMENTS--(CONTINUED) Property, Plant and Equipment consists of: Included in buildings are costs relating to the acquisition of cell site leases; such as legal, consulting, and title fees. Lease acquisition costs are capitalized when incurred and amortized over the period of the lease. Costs related to unsuccessful negotiations are expensed in the period the negotiations are terminated. Gains and losses on disposals are included in income at amounts equal to the difference between net book value and proceeds received upon disposal. During 1993 and 1992, one of the Partnerships recorded capital lease additions of $827,000 and $513,000, respectively. Commitments for future equipment acquisitions amounted to $22,734,000 at December 31, 1993. On January 10, 1994, one of the Partnerships entered into an agreement with its major supplier to purchase $77 million in equipment. OTHER ASSETS Other assets consist primarily of the costs of acquiring the right to serve certain customers previously served by resellers and are being amortized over three years using the straight-line method. Accumulated amortization was $4,806,000 and $2,797,000 at December 31, 1993 and 1992, respectively. CHANGE IN ACCOUNTING PRINCIPLE In the third quarter of 1991, the General Partner of two of the Partnerships changed its policy of capitalizing certain third party sales commissions and amortizing them over the average customer life. The General Partner's parent effected this change to standardize the accounting treatment of sales commissions throughout its consolidated cellular operations. These amounts will be expensed in the period in which they are incurred by the agent. In 1991, this change in accounting principle was retroactively applied as of January 1, 1991. Had the change not been made, 1991 net income before the cumulative effect of a change in accounting principle would have increased $1,838,000. REVENUE RECOGNITION Revenues from operations primarily consist of charges to customers for monthly access charges, cellular airtime usage, and roamer charges. Revenues are recognized as services are rendered. Unbilled revenues, resulting from cellular service provided from the billing cycle date to the end of each month and from other cellular carriers' customers using the partnership's cellular systems for the last half of each month, are estimated and recorded as receivables. Unearned monthly access charges relating to the periods after month-end are deferred and netted against accounts receivable. LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP NOTES TO UNAUDITED COMBINED FINANCIAL STATEMENTS--(CONTINUED) INCOME TAXES No provisions have been made for federal or state income taxes since such taxes, if any, are the responsibility of the individual partners. 3. LEASE COMMITMENTS: Future minimum rental payments required under operating leases for real estate that have initial or remaining noncancellable lease terms in excess of one year as of December 31, 1993, are as follows: The initial lease terms generally range from 5 to 25 years with the majority of them having initial terms of 10 years and providing for one renewal option of 5 years and for rental escalation. Included in selling, general and administrative expense are rental costs of $7,897,000, $5,996,000 and $4,463,000 for the years ended December 31, 1993, 1992 and 1991, respectively. One of the Partnerships leases office facilities under a ten-year lease agreement which provides for free rent incentives for six months and rent escalation over the ten-year period. The Partnership recognizes rent expense on a straight-line basis and recorded the related deferred rent as a noncurrent liability to be amortized as an adjustment to rental costs over the life of the lease. 4. CAPITAL LEASE OBLIGATION: One of the Partnerships leases equipment under capital lease agreements. At December 31, 1993 and 1992, respectively, the amount of such equipment included in property, plant and equipment is $3,324,000 and $2,638,000 less accumulated amortization of $1,914,000 and $1,451,000. Future minimum annual lease payments on noncancellable capital leases are as follows: 5. RELATED PARTY TRANSACTIONS: Certain affiliates of these cellular limited partnerships provide services for the system operations, legal, financial, management and administration of these entities. These affiliates are reimbursed for both direct and allocated costs (totaling $57.1 million in 1993 $52.2 million in 1992 and $50.0 million in 1991) related to providing these services. In addition, certain affiliates have established a credit facility with certain partnerships to provide working capital to the partnership. One of the partnerships participates in a centralized cash management arrangement with its general partner. At December 31, 1993 LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP NOTES TO UNAUDITED COMBINED FINANCIAL STATEMENTS--(CONTINUED) and 1992, the interest-bearing balance amounted to $29,981,000 and $16,074,000, respectively. Effective January 1, 1989, the general partner pays or charges the Partnership monthly interest, computed using the general partner's average borrowing rate, on the amounts due to or from the Partnership. Interest earned in 1993, 1992 and 1991 was $1,294,000, $1,396,000 and $675,000, respectively. 6. REGULATORY INVESTIGATIONS: The California Public Utilities Commission (CPUC) has issued an Order Instituting Investigation of the regulation of cellular radiotelephone utilities operating in the State of California under Order Number I.88-11-040. The intent of the investigation was to determine the appropriate regulatory objectives for the cellular industry, and whether current regulations applicable to the cellular industry and its operators meet those objectives or should be modified. On October 6, 1992, the CPUC adopted an Order which, among other things, imposes an accounting methodology on cellular utilities to separate wholesale and retail costs, permits resellers to operate a reseller switch interconnected to the cellular carrier's facilities, and requires the unbundling of certain wholesale rates to the resellers. On May 19, 1993, the CPUC granted limited rehearing of the decision. In addition, the CPUC rescinded its order to modify the method for allocating costs between wholesale and retail operations. On December 17, 1993, the CPUC adopted a new Order Instituting Investigation into the regulation of mobile telephone service and wireless communications, Order Number I.93-12-007. The investigation proposes a regulatory program which would encompass all forms of mobile telephone service. Currently, one of the Partnerships affected is unable to quantify the precise impact of these Orders on its future operations, but that impact may be material to the Partnership under certain circumstances. In January 1992, the CPUC commenced a separate investigation of all cellular companies operating in the State to determine their compliance with General Order number 159 (G.O. 159). The investigation will address whether cellular utilities have complied with local, state or federal regulations governing the approval and construction of cellular sites in the State. The CPUC may advise other agencies of violations in their jurisdictions. One of the Partnerships affected has prepared and filed the information requested by the CPUC. The CPUC will review the information provided by the Partnership and, if violations of G.O. 159 are found, it may assess penalties against the Partnership. The outcome of this investigation is uncertain and accordingly, no accrual for this matter has been made. 7. CONTINGENCIES AND COMMITMENTS: On June 28, 1993, an applicant for an unserved area license in the Los Angeles market filed an informal objection with the FCC to one of the Partnerships' System Information Update map. The applicant claims the Partnership was not legally authorized to provide service in parts of its described service area. The applicant requests that the FCC correct the Partnership's service area to eliminate such areas and suggests the FCC impose "such sanctions as it deems appropriate." The Partnership filed a response with the FCC in which it reported that, in its review of the applicant's allegations, it found certain errors that were made in its filings but disputed any of these were intentional. The FCC could assess penalties against the Partnership for nonconformance with its license. The outcome of this matter remains uncertain and, accordingly, the Partnership has not recorded an accrual. The Partnership intends to defend its position vigorously. The Partnership filed for its 10-year license renewal for the Los Angeles market on August 30, 1993. The Partnership is currently operating with FCC authority while the renewal application is pending resolution of the FCC's decision on claims mentioned above. The Partnership fully expects that its license will be renewed. LOS ANGELES SMSA LIMITED PARTNERSHIP NASHVILLE/CLARKSVILLE MSA LIMITED PARTNERSHIP BATON ROUGE MSA LIMITED PARTNERSHIP NOTES TO UNAUDITED COMBINED FINANCIAL STATEMENTS--(CONTINUED) Two agents of a competing carrier have named one of the Partnerships in several complaints against the carrier. The general allegations include violations of California Unfair Practices Act and price fixing. The ultimate outcome of both these actions is uncertain at this time. Accordingly, no accrual for these contingencies has been made. The Partnership intends to defend its position vigorously. On November 24, 1993, a class action suit was filed against one of the Partnerships and another cellular carrier alleging conspiracy to fix the price of cellular service in violation of state and federal antitrust laws. The plaintiffs are seeking substantial monetary damages and injunctive relief in excess of $100 million. The outcome of this matter is uncertain and, accordingly, the Partnership has not recorded an accrual. The Partnership intends to defend its position vigorously. One of the Partnerships is a party to various other lawsuits arising in the ordinary course of business. In the opinion of management, based on a review of such litigation with legal counsel, any losses resulting from these actions are not expected to materially impact the financial condition of the Partnership. Two of the Partnerships provide cellular service and sell cellular telephones to diversified groups of consumers within concentrated geographical areas. The general partner performs credit evaluations of the Partnerships' customers and generally does not require collateral. Receivables are generally due within 30 days. Credit losses related to customers have been within management's expectations. One of the Partnerships purchases substantially all of its equipment from one supplier. The General Partner of two of the Partnerships entered into agreements with an equipment vendor on behalf of the Partnerships to replace the Partnerships' cellular equipment with new cellular technology which will support both analog and digital voice transmissions. 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. UNITED STATES CELLULAR CORPORATION By: /S/ H. DONALD NELSON ----------------------------------- H. Donald Nelson PRESIDENT (CHIEF EXECUTIVE OFFICER) By: /S/ K. R. MEYERS ----------------------------------- K. R. Meyers VICE PRESIDENT--FINANCE AND TREASURER (PRINCIPAL FINANCIAL OFFICER) By: /S/ PHILLIP A. LORENZINI ----------------------------------- Phillip A. Lorenzini CONTROLLER (PRINCIPAL ACCOUNTING OFFICER) Dated March 28, 1994 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. - -------------------------------------------------------------------------------- INDEX TO EXHIBITS - --------------------------------------------------------------------------------

55373_1993.txt

55373_1993

1993

55373

Item 1.BUSINESS - -------------------------------------------------------------------------------- GENERAL AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company which owns, directly or indirectly, all of the outstanding common stock of its operating electric utility subsidiaries. Substantially all of the operating revenues of AEP and its subsidiaries are derived from the furnishing of electric service. The service area of AEP's electric utility subsidiaries covers portions of the states of Indiana, Kentucky, Michigan, Ohio, Tennessee, Virginia and West Virginia. The generating and transmission facilities of AEP's subsidiaries are physically interconnected, and their operations are coordinated, as a single integrated electric utility system. Transmission networks are interconnected with extensive distribution facilities in the territories served. At December 31, 1993, the subsidiaries of AEP had a total of 20,007 employees. AEP, as such, has no employees. The principal operating subsidiaries of AEP are: APCo (organized in Virginia in 1926), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 838,000 customers in the southwestern portion of Virginia and southern West Virginia, and in supplying electric power at wholesale to other electric utility companies and municipalities in those states and in Tennessee. At December 31, 1993, APCo and its wholly owned subsidiaries had 4,587 employees. A generating subsidiary of APCo, Kanawha Valley Power Company, which owns and operates under Federal license three hydroelectric generating stations located on Government lands adjacent to Government- owned navigation dams on the Kanawha River in West Virginia, sells its net output to APCo. Among the principal industries served by APCo are coal mining, primary metals, chemicals, textiles, paper, stone, clay, glass and concrete products and furniture. In addition to its AEP System interconnection, APCo also is interconnected with the following unaffiliated utility companies: Carolina Power & Light Company, Duke Power Company and VEPCo. A comparatively small part of the properties and business of APCo is located in the northeastern end of the Tennessee Valley. APCo has several points of interconnection with TVA and has entered into agreements with TVA under which APCo and TVA interchange and transfer electric power over portions of their respective systems. CSPCo (organized in Ohio in 1937, the earliest direct predecessor company having been organized in 1883), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 578,000 customers in Ohio, and in supplying electric power at wholesale to other electric utilities and to municipally owned distribution systems within its service area. At December 31, 1993, CSPCo had 2,143 employees. CSPCo's service area is comprised of two areas in Ohio, which include portions of twenty-five counties. One area includes the City of Columbus and the other is a predominantly rural area in south central Ohio. Approximately 80% of CSPCo's retail revenues are derived from the Columbus area. Among the principal industries served are food processing, chemicals, primary metals, electronic machinery and paper products. In addition to its AEP System interconnection, CSPCo also is interconnected with the following unaffiliated utility companies: CG&E, DP&L and Ohio Edison Company. I&M (organized in Indiana in 1925), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 525,000 customers in northern and eastern Indiana and southwestern Michigan, and in supplying electric power at wholesale to other electric utility companies, rural electric cooperatives and municipalities. At December 31, 1993, I&M had 3,944 employees. Among the principal industries served are transportation equipment, primary metals, fabricated metal products, electrical and electronic machinery, rubber and miscellaneous plastic products and chemicals and allied products. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana. In addition to its AEP System interconnection, I&M also is interconnected with the following unaffiliated utility companies: Central Illinois Public Service Company, CG&E, Commonwealth Edison Company, Consumers Power Company, Illinois Power Company, Indianapolis Power & Light Company, Louisville Gas and Electric Company, Northern Indiana Public Service Company, PSI Energy Inc. and Richmond Power & Light Company. KEPCo (organized in Kentucky in 1919), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 161,000 customers in an area in eastern Kentucky, and in supplying electric power at wholesale to other utilities and municipalities in Kentucky. At December 31, 1993, KEPCo had 842 employees. In addition to its AEP System interconnection, KEPCo also is interconnected with the following unaffiliated utility companies: Kentucky Utilities Company and East Kentucky Power Cooperative Inc. KEPCo is also interconnected with TVA. Kingsport Power Company (organized in Virginia in 1917), which provides electric service to approximately 41,000 customers in Kingsport and eight neighboring communities in northeastern Tennessee. Kingsport Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from APCo. At December 31, 1993, Kingsport Power Company had 102 employees. OPCo (organized in Ohio in 1907 and reincorporated in 1924), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 657,000 customers in the northwestern, east central, eastern and southern sections of Ohio, and in supplying electric power at wholesale to other electric utility companies and municipalities. At December 31, 1993, OPCo and its wholly owned subsidiaries had 5,749 employees. Among the principal industries served by OPCo are primary metals, stone, clay, glass and concrete products, rubber and plastic products, petroleum refining, chemicals and metal and wire products. In addition to its AEP System interconnection, OPCo also is interconnected with the following unaffiliated utility companies: CG&E, The Cleveland Electric Illuminating Company, DP&L, Duquesne Light Company, Kentucky Utilities Company, Monongahela Power Company, Ohio Edison Company, The Toledo Edison Company and West Penn Power Company. Wheeling Power Company (organized in West Virginia in 1883 and reincorporated in 1911), which provides electric service to approximately 41,000 customers in northern West Virginia. Wheeling Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from OPCo. At December 31, 1993, Wheeling Power Company had 143 employees. Another principal electric utility subsidiary of AEP is AEGCo, which was organized in Ohio in 1982 as an electric generating company. AEGCo sells power at wholesale to I&M, KEPCo and VEPCo. AEGCo has no employees. See Item 2 Item 2.PROPERTIES - -------------------------------------------------------------------------------- At December 31, 1993, subsidiaries of AEP owned (or leased where indicated) generating plants with the net power capabilities (winter rating) shown in the following table: - -------- (a) Unit 1 of the Rockport Plant is owned one-half by AEGCo and one-half by I&M. Unit 2 of the Rockport Plant is leased one-half by AEGCo and one-half by I&M. The leases terminate in 2022 unless extended. (b) Unit 3 of the John E. Amos Plant is owned one-third by APCo and two-thirds by OPCo. (c) Represents CSPCo's ownership interest in generating units owned in common with CG&E and DP&L. (d) I&M plans to close the Breed Plant on March 31, 1994. (e) Leased from the City of Fort Wayne. Indiana. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana under a 35-year lease with a provision for an additional 15-year extension at the election of I&M. See Item 1 under Fuel Supply, for information concerning coal reserves owned or controlled by subsidiaries of AEP. The following table sets forth the total circuit miles of transmission and distribution lines of the AEP System, APCo, CSPCo, I&M, KEPCo and OPCo and that portion of the total representing 765,000-volt lines: - -------- (a)Includes jointly owned lines. (b)Includes lines of other AEP System companies not shown. TITLES The AEP System's electric generating stations are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the System has been constructed over lands of private owners pursuant to easements or along public highways and streets pursuant to appropriate statutory authority. The rights of the System in the realty on which its facilities are located are considered by it to be adequate for its use in the conduct of its business. Minor defects and irregularities customarily found in title to properties of like size and character may exist, but such defects and irregularities do not materially impair the use of the properties affected thereby. System companies generally have the right of eminent domain whereby they may, if necessary, acquire, perfect or secure titles to or easements on privately-held lands used or to be used in their utility operations. Substantially all the physical properties of APCo, CSPCo, I&M, KEPCo and OPCo are subject to the lien of the mortgage and deed of trust securing the first mortgage bonds of each such company. SYSTEM TRANSMISSION LINES AND FACILITY SITING Legislation in the states of Indiana, Kentucky, Michigan, Ohio, Virginia, and West Virginia requires prior approval of sites of generating facilities and/or routes of high-voltage transmission lines. Delays and additional costs in constructing facilities have been experienced as a result of proceedings conducted pursuant to such statutes, as well as in proceedings in which operating companies have sought to acquire rights-of-way through condemnation, and such proceedings may result in additional delays and costs in future years. PEAK DEMAND The AEP System is interconnected through 119 high-voltage transmission interconnections with 29 neighboring electric utility systems. The all-time and 1993 one-hour peak demands were 25,174,000 and 22,142,000 kilowatts, respectively, (including 6,459,000 and 4,043,000 kilowatts, respectively, of scheduled deliveries to unaffiliated systems which the System might, on appropriate notice, have elected not to schedule for delivery) and occurred on January 18, 1994 and July 26, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual obligations, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time and 1993 one-hour internal peak demands were 19,236,000 and 18,085,000 kilowatts, respectively, and occurred on January 19, 1994 and July 28, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual arrangements, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time one-hour integrated and internal net system peak demands and 1993 peak demands for AEP's generating subsidiaries are shown in the following tabulation: HYDROELECTRIC PLANTS Licenses for hydroelectric plants, issued under the Federal Power Act, reserve to the United States the right to take over the project at the expiration of the license term, to issue a new license to another entity, or to relicense the project to the existing licensee. In the event that a project is taken over by the United States or licensed to a new licensee, the Federal Power Act provides for payment to the existing licensee of its "net investment" plus severance damages. Licenses for six System hydroelectric plants expired in 1993 and applications for new licenses for these plants were filed in 1991. The existing licenses for these plants were extended on an annual basis and will be renewed automatically until new licenses are issued. No competing license applications were filed. One new license was issued in March 1994. COOK NUCLEAR PLANT Unit 1 of the Cook Plant, which was placed in commercial operation in 1975, has a nominal net electric rating of 1,020,000 kilowatts. Unit 1's availability factor was 100% during 1993 and 64.8% during 1992. Unit 2, of slightly different design, has a nominal net electrical rating of 1,090,000 kilowatts and was placed in commercial operation in 1978. Unit 2's availability factor was 96.6% during 1993 and 19.5% during 1992. The availability of Units 1 and 2 was affected in 1992 by outages to refuel and Unit 2 main turbine/generator vibrational problems. Units 1 and 2 are licensed by the NRC to operate at 100% of rated thermal power to October 25, 2014 and December 23, 2017, respectively. NUCLEAR INSURANCE The Price-Anderson Act limits public liability for a nuclear incident at any nuclear plant in the United States to $9.4 billion. I&M has insurance coverage for liability from a nuclear incident at its Cook Plant. Such coverage is provided through a combination of private liability insurance, with the maximum amount available of $200,000,000, and mandatory participation for the remainder of the $9.4 billion liability, in an industry retrospective deferred premium plan which would, in case of a nuclear incident, assess all licensees of nuclear plants in the U.S. Under the deferred premium plan, I&M could be assessed up to $158,600,000 payable in annual installments of $20,000,000 in the event of a nuclear incident at Cook or any other nuclear plant in the U.S. There is no limit on the number of incidents for which I&M could be assessed these sums. I&M also has property damage, decontamination and decommissioning insurance for loss resulting from damage to the Cook Plant facilities in the amount of $2.75 billion. Nuclear insurance pools provide $1.265 billion of coverage and Nuclear Electric Insurance Limited (NEIL) and Energy Insurance Bermuda (EIB) provide the remainder. If NEIL's and EIB's losses exceed their available resources, I&M would be subject to a total retrospective premium assessment of up to $15,327,023. NRC regulations require that, in the event of an accident, whenever the estimated costs of reactor stabilization and site decontamination exceed $100,000,000, the insurance proceeds must be used, first, to return the reactor to, and maintain it in, a safe and stable condition and, second, to decontaminate the reactor and reactor station site in accordance with a plan approved by the NRC. The insurers then would indemnify I&M for property damage up to $2.5 billion less any amounts used for stabilization and decontamination. The remaining $250,000,000, as provided by NEIL (reduced by any stabilization and decontamination expenditures over $2.5 billion), would cover decommissioning costs in excess of funds already collected for decommissioning. See Fuel Supply--Nuclear Waste. NEIL's extra-expense program provides insurance to cover extra costs resulting from a prolonged accidental outage of a nuclear unit. I&M's policy insures against such increased costs up to approximately $3,500,000 per week (starting 21 weeks after the outage) for one year, $2,350,000 per week for the second and third years, or 80% of those amounts per unit if both units are down for the same reason. If NEIL's losses exceed its available resources, I&M would be subject to a total retrospective premium assessment of up to $8,929,456. POTENTIAL UNINSURED LOSSES Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including liabilities relating to damage to the Cook Plant and costs of replacement power in the event of a nuclear incident at the Cook Plant. Future losses or liabilities which are not completely insured, unless allowed to be recovered through rates, could have a material adverse effect on results of operation and the financial condition of AEP, I&M and other AEP System companies. Item 3. Item 3.LEGAL PROCEEDINGS - -------------------------------------------------------------------------------- In February 1990 the Supreme Court of Indiana overturned an order of the IURC, affirmed by the Indiana Court of Appeals, which had awarded I&M the right to serve a General Motors Corporation light truck manufacturing facility located in Fort Wayne. In August 1990 the IURC issued an order transferring the right to serve the GM facility to an unaffiliated local distribution utility. In October 1990 the local distribution utility sued I&M in Indiana under a provision of Indiana law that allows the local distribution utility to seek damages equal to the gross revenues received by a utility that renders retail service in the designated service territory of another utility. On November 30, 1992, the DeKalb Circuit Court granted I&M's motion for summary judgment to dismiss the local distribution utility's complaint. The local distribution utility has begun an appeal to the Indiana Court of Appeals. I&M received revenues of approximately $29,000,000 from serving the GM facility. It is not clear whether the plaintiffs claim will be upheld on appeal because the service was rendered in accordance with an IURC order I&M believed in good faith to be valid. On April 4, 1991, then Secretary of Labor Lynn Martin announced that the U.S. Department of Labor ("DOL") had issued a total of 4,710 citations to operators of 847 coal mines who allegedly submitted respirable dust sampling cassettes that had been altered so as to remove a portion of the dust. The cassettes were submitted in compliance with DOL regulations which require systematic sampling of airborne dust in coal mines and submission of the entire cassettes (which include filters for collecting dust particulates) to the Mine Safety and Health Administration ("MSHA") for analysis. The amount of dust contained on the cassette's filter determines an operator's compliance with respirable dust standards under the law. OPCo's Meigs No. 2, Meigs No. 31, Martinka, and Windsor Coal mines received 16, 3, 15 and 2 citations, respectively. MSHA has assessed civil penalties totalling $56,900 for all these citations. OPCo's samples in question involve about 1 percent of the 2,500 air samples that OPCo submitted over a 20-month period from 1989 through 1991 to the DOL. OPCo is contesting the citations before the Federal Mine Safety and Health Review Commission. An administrative hearing was held before an administrative law judge with respect to all affected coal operators. On July 20, 1993, the administrative law judge rendered a decision in this case holding that the Secretary of Labor failed to establish that the presence of a "white center" on the dust sampling filter indicated intentional alteration. The administrative law judge has set for trial the case of an unaffiliated mine to determine if there was an intentional alteration of the dust sampling filter. All remaining cases, including the citations involving OPCo's mines, have been stayed. On September 21, 1993, CSPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Conesville Plant of the Toxic Substances Control Act and proposed a penalty of $41,000. On October 4, 1993, I&M was served with a complaint issued by Region V, Federal EPA which alleged violations by Breed Plant of the Clean Water Act and proposed a penalty of $70,000. On October 4, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by OPCo's General Service Center (Canton, Ohio) of the Toxic Substances Control Act and proposed a penalty of $24,000. Settlement discussions have been held in each of these cases and it is expected that these matters will be resolved shortly. On June 18, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Muskingum River Plant of the Toxic Substances Control Act and proposed a penalty of $87,000. In February 1994, OPCo paid a penalty of $12,185 and agreed to undertake supplemental environmental projects in 1994 valued at $61,547. On February 28, 1994, Ormet Corporation filed a complaint in the U.S. District Court, Northern District of West Virginia, against AEP, OPCo, the Service Corporation and two of its employees, Federal EPA and the Administrator of Federal EPA. Ormet is the operator of a major aluminum reduction plant in Ohio and is a customer of OPCo. See Certain Industrial Contracts. Pursuant to the Clean Air Act Amendments of 1990, OPCo received sulfur dioxide emission allowances for its Kammer Plant. See Environmental and Other Matters. Ormet's complaint seeks a declaration that it is the owner of approximately 89% of the Phase I and Phase II allowances issued for use by the Kammer Plant. OPCo believes that since it is the owner and operator of Kammer Plant and Ormet is a contract power customer, Ormet is not entitled to any of the allowances attributable to the Kammer Plant. See Item 1 for a discussion of certain environmental and rate matters. Meigs Mine--On July 11, 1993, water from an adjoining sealed and abandoned mine owned by Southern Ohio Coal Company ("SOCCo"), a mining subsidiary of OPCo, entered Meigs 31 mine, one of two mines currently being operated by SOCCo. Ohio EPA approved a plan to pump water from the mine to certain Ohio River tributaries under stringent conditions for biological and water quality monitoring and restoring the streams after pumping. On July 30, pumping commenced in accordance with the Ohio EPA approved plan. Since September 16, 1993, SOCCo has processed all water removed from the mine through its expanded treatment system and is in compliance with the effluent limitations in its water discharge permit. Pumping has removed most of the water that entered the mine on July 11 and the mine was returned to service in February 1994. On July 26, 1993, the Ohio Department of Natural Resources Division of Reclamation issued an administrative order directing SOCCo to cease pumping due to that agency's concern over possible environmental harm. On July 26, 1993, following SOCCo's appeal of the cessation order, the chairman of the Reclamation Board of Review issued a temporary stay pending a hearing by the full Reclamation Board. On January 14, 1994, the administrative proceeding was settled on the basis of agreements by the Division of Reclamation to dismiss the administrative order and by SOCCo to treat all water removed from the mine in accordance with its discharge permit and to pay certain expenses of the Division of Reclamation. On August 19, 1993, the U.S. District Court for the Southern District of Ohio granted SOCCo's motion for a preliminary injunction against the Federal Office of Surface Mining Reclamation and Enforcement ("OSM") and Federal EPA preventing them from exercising jurisdiction to issue orders to cease pumping. On August 30, 1993, the U.S. Court of Appeals for the Sixth Circuit denied OSM's motion for a stay of the District Court's preliminary injunction but granted Federal EPA's motion for a stay in part which allowed Federal EPA to investigate and make findings with respect to alleged violations of the Clean Water Act and thereafter to exercise its enforcement authority under the Clean Water Act if a violation was identified. On September 2, 1993, Federal EPA issued an administrative order requiring a partial cessation of pumping, the effect of which was delayed by Federal EPA until September 8, 1993. On September 8, 1993, the District Court granted SOCCo's motion requesting that enforcement of the Federal EPA order be stayed. On September 23, 1993, the Court of Appeals ruled that the District Court could not review the Federal EPA order in the absence of a civil enforcement action and lifted the stay. A further decision of the Court of Appeals with respect to the appeal of the preliminary injunction is pending. On January 3, 1994, the District Court held that the complaint filed by SOCCo should not be dismissed and concluded that sufficient legal and factual grounds existed for the court to consider SOCCo's claim that Federal EPA could not override Ohio EPA's authorization for SOCCo to bypass its water treatment system on an emergency basis during pumping activities. In a separate opinion, the District Court denied Federal EPA's request that the District Court defer consideration of SOCCo's motion involving a request for a Declaration of Rights with respect to the mine water releases into area streams. The West Virginia Division of Environmental Protection ("West Virginia DEP") has proposed fining SOCCo $1,800,000 for violations of West Virginia Water Quality Standards and permitting requirements alleged to have resulted from the release of mine water into the Ohio River. SOCCo is meeting with the West Virginia DEP in an attempt to resolve this matter. Although management is unable to predict what enforcement action Federal EPA or OSM may take, the resolution of the aforementioned litigation, environmental mitigation costs and mine restoration costs are not expected to have a material adverse impact on results of operations or financial condition. Item 4. Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - -------------------------------------------------------------------------------- AEP, APCO, I&M AND OPCO. None. AEGCO, CSPCO AND KEPCO. Omitted pursuant to Instruction J(2)(c). ---------------- EXECUTIVE OFFICERS OF THE REGISTRANTS AEP The following persons are, or may be deemed, executive officers of AEP. Their ages are given as of March 15, 1994. - -------- (a) All of the executive officers listed above have been employed by the Service Corporation or System companies in various capacities (AEP, as such, has no employees) during the past five years, except E. Linn Draper, Jr. who was Chairman of the Board, President and Chief Executive Officer of Gulf States Utilities Company from 1987 until 1992 when he joined AEP and the Service Corporation. All of the above officers are appointed annually for a one-year term by the board of directors of AEP, the board of directors of the Service Corporation, or both, as the case may be. APCO The names of the executive officers of APCo, the positions they hold with APCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appears below. The directors and executive officers of APCo are elected annually to serve a one-year term. - -------- (a)Positions are with APCo unless otherwise indicated. OPCO The names of the executive officers of OPCo, the positions they hold with OPCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of OPCo are elected annually to serve a one-year term. - -------- (a)Positions are with OPCo unless otherwise indicated. PART II --------------------------------------------------------------------- Item 5. Item 5.MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - -------------------------------------------------------------------------------- AEP. AEP Common Stock is traded principally on the New York Stock Exchange. The following table sets forth for the calendar periods indicated the high and low sales prices for the Common Stock as reported on the New York Stock Exchange Composite Tape and the amount of cash dividends paid per share of Common Stock. - -------- (1) See Note 5 of the Notes to the Consolidated Financial Statements of AEP for information regarding restrictions on payment of dividends. At December 31, 1993, AEP had approximately 194,000 shareholders of record. AEGCO, APCO, CSPCO, I&M, KEPCO AND OPCO. The information required by this item is not applicable as the common stock of all these companies is held solely by AEP. Item 6. Item 6.SELECTED FINANCIAL DATA - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). AEP. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). I&M. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). OPCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the AEGCo 1993 Annual Report (for the fiscal year ended December 31, 1993). AEP. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the CSPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). I&M. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the KEPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). OPCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 8. Item 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - -------------------------------------------------------------------------------- AEGCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. AEP. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. APCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. CSPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. I&M. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. KEPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. OPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. Item 9. Item 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - -------------------------------------------------------------------------------- AEGCO, AEP, APCO, CSPCO, I&M, KEPCO AND OPCO. None. PART III -------------------------------------------------------------------- Item 10. Item 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Nominees for Director and Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. APCO. The information required by this item is incorporated herein by reference to the material under Election of Directors of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. The names of the directors and executive officers of I&M, the positions they hold with I&M, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of I&M are elected annually to serve a one- year term. - -------- (a)Positions are with I&M unless otherwise indicated. (b)Dr. Draper is a director of Pacific Nuclear Systems, Inc. and Mr. Lhota is a director of Huntington Bancshares Incorporated. (c)Messrs. DeMaria, Dowd, Draper, Lhota and Maloney are directors of AEGCo, APCo, CSPCo, KEPCo and OPCo. Messrs. DeMaria, Dowd, Draper and Maloney are also directors of AEP. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under the heading Election of Directors of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. Item 11. Item 11.EXECUTIVE COMPENSATION - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Compensation of Directors, Executive Compensation and the performance graph of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. I&M Certain executive officers of I&M are employees of the Service Corporation. The salaries of these executive officers are paid by the Service Corporation and a portion of their salaries has been allocated and charged to I&M. The following table shows for 1993, 1992 and 1991 the compensation earned from all AEP System companies by (i) the chief executive officer and four other most highly compensated executive officers (as defined by regulations of the SEC) of I&M at December 31, 1993 and (ii) a chief executive officer and executive officer, both of whom retired in 1993. Summary Compensation Table - -------- (1) Reflects payments under the AEP Management Incentive Compensation Plan ("MICP") in which individuals in key management positions with AEP System companies participate. Amounts for 1993 are estimates but should not change significantly. For 1991 and 1993, these amounts included both cash paid and a portion deferred in the form of restricted stock units. These units are paid out in cash after three years based on the price of AEP Common Stock at that time. Dividend equivalents are paid during the three- year period. At December 31, 1993, Dr. Draper and Messrs. DeMaria, Maloney, Dowd and Lhota held 813, 746, 715, 593 and 639 units having a value of $30,177, $27,701, $26,526, $22,020 and $23,730, respectively, based upon a $37 1/8 per share closing price of AEP's Common Stock as reported on the New York Stock Exchange. For 1992, MICP payments were made entirely in cash. (2) Includes amounts contributed by AEP System companies under the American Electric Power System Employees Savings Plan on behalf of their employee participants. For 1993 this amount was $7,075 for Dr. Draper and Messrs. Katlic, Maloney, Dowd and Lhota and $6,000 for Mr. Disbrow and $7,006 for Mr. DeMaria. The AEP System Savings Plan is available to all employees of AEP System companies (except for employees covered by certain collective bargaining agreements) who have met minimum service requirements. Includes director's fees for AEP System companies. For 1993 these fees were: Dr. Draper, $11,105; Mr. Disbrow, $3,580; Mr. DeMaria, $10,805; Mr. Katlic, $2,300; Mr. Maloney, $10,925; Mr. Dowd, $8,685; and Mr. Lhota, $10,085. Includes payments of $93,173 and $36,077 for unused accrued vacation which Messrs. Disbrow and Katlic, respectively, received upon their retirement. (3) Dr. Draper was elected chairman of the board and chief executive officer of I&M and other AEP System companies and chairman of the board, president and chief executive officer of AEP and the Service Corporation, succeeding Mr. Disbrow, who retired, effective April 28, 1993. Retirement Benefits The American Electric Power System Retirement Plan provides pensions for all employees of AEP System companies (except for employees covered by certain collective bargaining agreements), including the executive officers of I&M. The Retirement Plan is a noncontributory defined benefit plan. The following table shows the approximate annual annuities under the Retirement Plan that would be payable to employees in certain higher salary classifications, assuming retirement at age 65 after various periods of service. The amounts shown in the table are the straight life annuities payable under the Plan without reduction for the joint and survivor annuity. Retirement benefits listed in the table are not subject to any deduction for Social Security or other offset amounts. The retirement annuity is reduced 3% per year in the case of retirement between ages 60 and 62 and further reduced 6% per year in the case of retirement between ages 55 and 60. If an employee retires after age 62, there is no reduction in the retirement annuity. PENSION PLAN TABLE Compensation upon which retirement benefits are based consists of the average of the 36 consecutive months of the employee's highest salary, as listed in the Summary Compensation Table, out of the employee's most recent 10 years of service. With respect to Messrs. Disbrow and Katlic, since they retired in 1993, the amounts of $600,000 and $316,944, respectively, are the actual salaries upon which their retirement benefits are based. Mr. Disbrow's retirement benefit was enhanced by computing his benefit based on his 1992 base salary. As of December 31, 1993, the number of full years of service credited under the Retirement Plan to each of the executive officers of I&M named in the Summary Compensation Table were as follows: Dr. Draper, 1 year; Mr. Disbrow, 39 years; Mr. DeMaria, 34 years; Mr. Katlic, 10 years; Mr. Maloney, 38 years; Mr. Dowd, 31 years; and Mr. Lhota, 29 years. Dr. Draper's employment agreement described below provides him with a supplemental retirement annuity that credits him with 24 years of service in addition to his years of service credited under the Retirement Plan less his actual pension entitlement under the Retirement Plan and any pension entitlements from prior employers. Mr. Katlic has a contract with the Service Corporation under which the Service Corporation agrees to provide him with a supplemental retirement annuity equal to the annual pension that Mr. Katlic would have received with service of 30 years under the AEP System Retirement Plan as then in effect, less his actual annual pension entitlement under the Retirement Plan. Mr. Katlic commenced receiving his supplemental annuity upon his retirement effective October 31, 1993. AEP has determined to pay supplemental retirement benefits to 23 AEP System employees (including Messrs. Disbrow, DeMaria, Maloney and Lhota) whose pensions may be adversely affected by amendments to the Retirement Plan made as a result of the Tax Reform Act of 1986. Such payments, if any, will be equal to any reduction occurring because of such amendments. Upon his retirement on April 28, 1993, Mr. Disbrow began receiving an annual supplemental benefit of $2,642. Assuming retirement of the remaining eligible employees in 1994, none would be eligible to receive supplemental benefits. AEP made available a voluntary deferred-compensation program in 1982 and 1986, which permitted certain executive employees of AEP System companies to defer receipt of a portion of their salaries. Under this program, an executive was able to defer up to 10% or 15% annually (depending on the terms of the program offered), over a four-year period, of his or her salary, and receive supplemental retirement or survivor benefit payments over a 15-year period. The amount of supplemental retirement payments received is dependent upon the amount deferred, age at the time the deferral election was made, and number of years until the executive retires. The following table sets forth, for the executive officers named in the Summary Compensation Table, the amounts of annual deferrals and, assuming retirement at age 65, annual supplemental retirement payments under the 1982 and 1986 programs. Employment Agreement Dr. Draper has a contract with AEP and the Service Corporation which provides for his employment for an initial term from no later than March 15, 1992 until March 15, 1997. Dr. Draper commenced his employment with AEP and the Service Corporation on March 1, 1992. AEP or the Service Corporation may terminate the contract at any time and, if this is done for reasons other than cause and other than as a result of Dr. Draper's death or permanent disability, the Service Corporation must pay Dr. Draper's then base salary through March 15, 1997, less any amounts received by Dr. Draper from other employment. -------------- Directors of I&M receive a fee of $100 for each meeting of the Board of Directors attended in addition to their salaries. -------------- The AEP System is an integrated electric utility system and, as a result, the member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity, transportation and handling of fuel, sales or rentals of property and interest or dividend payments on the securities held by the companies' respective parents. Item 12. Item 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. All 1,400,000 outstanding shares of Common Stock, no par value, of I&M are directly and beneficially held by AEP. Holders of the Cumulative Preferred Stock of I&M generally have no voting rights, except with respect to certain corporate actions and in the event of certain defaults in the payment of dividends on such shares. The table below shows the number of shares of AEP Common Stock that were beneficially owned, directly or indirectly, as of December 31, 1993, by each director and nominee of I&M and each of the executive officers of I&M named in the summary compensation table, and by all directors and executive officers of I&M as a group. It is based on information provided to I&M by such persons. No such person owns any shares of any series of the Cumulative Preferred Stock of I&M. Unless otherwise noted, each person has sole voting power and investment power over the number of shares of AEP Common Stock set forth opposite his name. Fractions of shares have been rounded to the nearest whole share. - -------- (a) The amounts include shares held by the trustee of the AEP Employees Savings Plan, over which directors, nominees and executive officers have voting power, but the investment/disposition power is subject to the terms of such Plan, as follows: Mr. Bailey, 550 shares; Mr. DeMaria, 2,081 shares; Mr. Disbrow, 4,027 shares; Mr. D'Onofrio, 2,889 shares; Mr. Katlic, 2,230 shares; Mr. Lhota, 5,245 shares; Mr. Maloney, 2,142 shares; Mr. Menge, 2,566 shares; Mr. Prater, 1,561 shares; Mr. Synowiec, 1,754 shares; Mr. Walters, 3,685 shares; and all directors and executive officers as a group, 33,806 shares. Messrs. Disbrow's, Dowd's and Maloney's holdings include 85 shares each; Messrs. Bailey's, DeMaria's, D'Onofrio's, Katlic's, Lhota's, Menge's, Prater's, Synowiec's, and Walter's holdings include 44, 83, 59, 60, 60, 62, 48, 53 and 45 shares, respectively; and the holdings of all directors and executive officers as a group include 738 shares, each held by the trustee of the AEP Employee Stock Ownership Plan, over which shares such persons have sole voting power, but the investment/disposition power is subject to the terms of such Plan. (b) Includes shares with respect to which such directors, nominees and executive officers share voting and investment power as follows: Mr. DeMaria, 3,624 shares; Mr. Disbrow, 283 shares; Mr. Draper, 115 shares; Mr. Lhota, 1,368 shares; Mr. Maloney, 2,000 shares; Mr. Menge, 24 shares; and all directors and executive officers as a group, 7,883 shares. Mr. DeMaria disclaims beneficial ownership of 807 shares. (c) 85,231 shares in the American Electric Power System Educational Trust Fund, over which Messrs. DeMaria, Lhota and Maloney share voting and investment power as trustees (they disclaim beneficial ownership of such shares), are not included in their individual totals, but are included in the group total. (d) Represents less than 1 percent of the total number of shares outstanding on December 31, 1993. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Item 13. Item 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------------------------------- AEP. The information required by this item is incorporated herein by reference to the material under Transactions With Management of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO, I&M AND OPCO. None. AEGCO, CSPCO, AND KEPCO. Omitted pursuant to Instruction J(2)(c). PART IV ------------------------------------------------------------------- Item 14. Item 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------------- (a) The following documents are filed as a part of this report: (b) No Reports on Form 8-K were filed during the quarter ended December 31, 1993. 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. AEP Generating Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Henry Fayne *John R. Jones, III *Wm. J. Lhota *James J. Markowsky /s/ G. P. Maloney *By: ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. American Electric Power Company, Inc. By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Treasurer and March 23, 1994 - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Robert M. Duncan *Arthur G. Hansen *Lester A. Hudson, Jr. *Angus E. Peyton *Toy F. Reid *W. Ann Reynolds *Linda Gillespie Stuntz *Morris Tanenbaum *Ann Haymond Zwinger *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Appalachian Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Luke M. Feck *Wm. J. Lhota *James J. Markowsky *J. H. Vipperman *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Columbus Southern Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: Vice President, March 23, 1994 /s/ P. J. DeMaria Treasurer and - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Indiana Michigan Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *Mark A. Bailey *W. N. D'Onofrio *A. Joseph Dowd *Wm. J. Lhota *Richard C. Menge *R. E. Prater *D. B. Synowiec *W. E. Walters *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Kentucky Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *C. R. Boyle, III *A. Joseph Dowd *Wm. J. Lhota *Ronald A. Petti *By: /s/ G. P. Maloney --------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Ohio Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURES TITLE DATE ---------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) INDEX TO FINANCIAL STATEMENT SCHEDULES S-1 INDEPENDENT AUDITORS' REPORT American Electric Power Company, Inc. and Subsidiaries: We have audited the consolidated financial statements of American Electric Power Company, Inc. and its subsidiaries and the financial statements of certain of its subsidiaries, listed in Item 14 herein, as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our reports thereon dated February 22, 1994; such financial statements and reports are included in your respective 1993 Annual Report to Shareowners and are incorporated herein by reference. Our audits also included the financial statement schedules of American Electric Power Company, Inc. and its subsidiaries and of certain of its subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the respective Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the corresponding basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche Columbus, Ohio February 22, 1994 S-2 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $676,404,000 in 1993, $718,154,000 in 1992 and $733,909,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $278,435,000 in 1993, $297,460,000 in 1992 and $198,352,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 3 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-3 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-4 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Recoveries on accounts previously written off. (b)Uncollectible accounts written off. (c)Billings to others. (d)Payments and accrual adjustments. (e)Includes interest on trust funds. (f)Adjust royalty provision. S-5 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-6 AEP GENERATING COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $4,089,000 in 1993, $4,512,000 in 1992 and $3,796,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $1,038,000 in 1993, $1,830,000 in 1992 and $1,450,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-7 AEP GENERATING COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-8 AEP GENERATING COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-9 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $201,169,000 in 1993, $198,116,000 in 1992 and $196,937,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $47,254,000 in 1993, $42,926,000 in 1992 and $32,428,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-10 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-11 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments and transfers. S-12 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-13 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $97,455,000 in 1993, $80,279,000 in 1992 and $111,856,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $18,161,000 in 1993, $21,999,000 in 1992 and $19,773,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 2 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-14 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Reflects the write-off of accumulated depreciation related to a portion of the Zimmer Plant investment that was disallowed by the PUCO as discussed in Note 2 of the Notes to Consolidated Financial Statements. S-15 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-16 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-17 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $125,247,000 in 1993, $175,728,000 in 1992 and $149,187,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $61,586,000 in 1993, $25,301,000 in 1992 and $40,396,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-18 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-19 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments and accrual adjustments. (e) Includes interest on trust funds. (f) Adjust Royalty Provision. S-20 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-21 KENTUCKY POWER COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $37,808,000 in 1993, $35,203,000 in 1992 and $31,369,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $12,000,000 in 1993, $11,352,000 in 1992 and $8,092,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-22 KENTUCKY POWER COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-23 KENTUCKY POWER COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-24 KENTUCKY POWER COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-25 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $197,089,000 in 1993, $201,737,000 in 1992 and $228,500,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $128,775,000 in 1993, $191,662,000 in 1992 and $90,472,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions for other than mining assets were determined using the following composite rates for functional classes of property: The current provisions for mining assets were calculated by use of the following methods: S-26 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-27 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments. S-28 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-29 EXHIBIT INDEX Certain of the following exhibits, designated with an asterisk(*), are filed herewith. The exhibits not so designated have heretofore been filed with the Commission and, pursuant to 17 C.F.R. (S)201.24 and (S)240.12b-32, are incorporated herein by reference to the documents indicated in brackets following the descriptions of such exhibits. Exhibits, designated with a dagger (+), are management contracts or compensatory plans or arrangements required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. AEGCO E-1 AEGCO (continued) E-2 AEP++ (continued) E-3 AEP++ (continued) E-4 APCO++ (continued) E-5 APCO++ (continued) E-6 CSPCO++ (continued) E-7 I&M++ (continued) E-8 I&M++ (continued) E-9 KEPCO (continued) E-10 OPCO++ (continued) E-11 OPCO++ (continued) -------------- ++Certain instruments defining the rights of holders of long-term debt of the registrants included in the financial statements of registrants filed herewith have been omitted because the total amount of securities authorized thereunder does not exceed 10% of the total assets of registrants. The registrants hereby agree to furnish a copy of any such omitted instrument to the SEC upon request. E-12

18366_1993.txt

18366_1993

1993

18366

Item 1. Business. The registrant, CBS Inc. ("CBS")*, conducts its domestic and international operations either directly or through subsidiaries and joint ventures. The operations of CBS are carried out primarily by the CBS/Broadcast Group. Other activities of CBS include various activities not directly associated with the Group, i.e., The CBS/FOX Company, Radford Studio Center Inc. and other non-material miscellaneous activities. CBS/Broadcast Group The CBS/Broadcast Group, through the CBS Television Network, distributes a comprehensive schedule of news and public affairs broadcasts, entertainment and sports programming and feature films to 206 independently owned affiliated stations and the seven CBS owned and operated television stations, which in the aggregate serve the 50 states and the District of Columbia, and to certain overseas affiliated stations. The CBS Operations and Administration Division operates the technical facilities used to produce and distribute programs of the CBS News, Sports and Entertainment Divisions. This division is also responsible for providing facilities management, personnel services, management information systems and administrative support services to CBS, including the CBS/Broadcast Group, and to unaffiliated companies for a fee. The CBS/Broadcast Group consists of eight divisions, whose operations are briefly described below: The CBS Entertainment Division produces and otherwise acquires entertainment series and other programs, and acquires feature films, for distribution by the CBS Television Network for broadcast. The CBS Marketing Division is responsible for sales of advertising time for CBS Television Network broadcasts and related marketing research, merchandising and sales promotion activities. The CBS Enterprises Division, operating primarily through the CBS Broadcast International and CBS Video units, is responsible for the worldwide distribution of CBS-owned news and public affairs broadcasts, sports and entertainment programming and feature films to broadcast and other media (including cable, airlines and home video, in the latter case through The CBS/Fox Company) and the acquisition of broadcast and non- broadcast rights in independently produced programs where permitted by law. The CBS Affiliate Relations Division is responsible for the full range of ongoing activities and mutual concerns between the CBS Television Network and the 206 independently owned affiliated stations. The CBS News Division operates a worldwide news organization which produces regularly scheduled news and public affairs broadcasts and special reports for the CBS Television and Radio Networks. This division also produces certain news- _______________ * Except as the context otherwise requires, references to CBS in this Annual Report mean CBS Inc. and include its subsidiaries. - 2 - oriented programming for broadcast in the early morning daypart and in designated hours during prime time. The CBS Sports Division produces and otherwise acquires sports programs for distribution by the CBS Television Network for broadcast. The CBS Television Stations Division operates and serves as sales representative for the seven CBS owned television stations (serving New York, Chicago, Los Angeles, Philadelphia, Minneapolis-St. Paul (which includes two satellite stations), Green Bay-Appleton (which includes a satellite station) and Miami). The division also owns and operates Midwest Sports Channel, a supplier of regional sports programming to cable subscribers in Minnesota, North Dakota, South Dakota, northern Iowa and western Wisconsin, and Teleport Minnesota, which provides programming and technical services to cable operators in the upper Midwest and operates a service enabling broadcast companies and other clients to transmit video signals into and out of Minnesota. The CBS Radio Division operates the eight CBS owned AM radio stations (serving New York, Chicago, Detroit, Los Angeles, Philadelphia, Minneapolis- St. Paul, St. Louis and San Francisco) and 13 CBS owned FM radio stations (serving the same cities named above, as well as Boston, Dallas/Fort Worth (two stations), Houston and Washington, D.C.); serves as broadcast sales representative for the CBS owned radio stations, 14 independently owned AM and 24 independently owned FM radio stations; and operates the CBS Radio Networks, which serve approximately 585 affiliated stations nationwide. Other Activities The CBS/FOX Company is a partnership in which CBS and a wholly-owned subsidiary of Twentieth Century-Fox Film Corporation ("Fox") each own a 50% interest. This partnership is engaged in the acquisition from unrelated third parties of the videocassette rights to feature films and other, non-theatrical product, and provides marketing activities relating to the videocassette distribution (by a subsidiary of Fox) of products produced by CBS and the partnership. It also engages in selling activities to specialized accounts of product of CBS and the partnership. The related partnership agreement expires February 28, 1997. Radford Studio Center Inc., a wholly owned subsidiary of CBS ("Radford"), owns and operates television and film production facilities at its Studio Center facility in Studio City, California. CBS, through Radford, became the sole owner of the Studio Center business and facilities in March 1992 when it acquired the 50 percent partnership interest of MTM Studios, Ltd. in The CBS/MTM Company. Industry Segment Information Since January 1988, CBS has operated predominantly in a single industry - -- broadcasting. Accordingly, there is no requirement for segment reporting. Competition The CBS Television Network and CBS owned television stations compete for audiences with other television networks and television stations, as well as with other video media, including cable television, multipoint distribution services, low power television stations, satellite television services and video cassettes. In the sale of advertising, the CBS Television Network competes with other networks, - 3 - television stations, cable television programmers, and other advertising media. The CBS owned television stations compete for advertising with other television stations and cable television systems, as well as with newspapers, magazines and billboards. The CBS Television Network and CBS owned television stations also compete with other video media for distribution rights to television programming. The CBS owned television stations compete primarily in their individual markets. In addition to competing television broadcast stations, cable television systems and program services represent a significant source of competition for audiences, advertising and program rights to CBS. In individual markets, cable systems provide competition by offering audiences additional signals and by supplying a broad array of advertiser- and subscription-supported video programming not available on conventional stations. Current and future technological developments may affect competition within the television field. Developments in advanced digital technology may enable competitors to provide "high definition" pictures and sound qualitatively superior to what television stations now provide. Development of the technology to compress digital signals may also permit the same broadcast or cable channel or satellite transponder to carry multiple video and data services, and could result in an expanded field of competing services. CBS cannot predict when and to what extent digital technology will be implemented in the various television services, and whether and how television stations will be able to make use of the improvements inherent in it. The Federal Communications Commission (FCC) has initiated proceedings having the ultimate goal of adopting a standard for the use of advanced digital technology in terrestrial television broadcast service. Recent statutory, judicial and regulatory actions may also affect competition. The Cable Consumer Protection and Competition Act of 1992 ("1992 Cable Act") for the first time required cable systems to obtain broadcast stations' consent to retransmit the stations' signals, thereby providing television stations the opportunity to negotiate a fee or other compensation for such retransmission. (In September 1993 CBS granted cable systems carrying the signals of its owned television stations consent to continue to carry those signals, without compensation, until October 6, 1994.) As an alternative, the Cable Act allowed television stations to require cable systems to carry their signals within their television markets without compensation. The cable industry has brought legal challenges to the latter provisions of the 1992 Cable Act (commonly referred to as the "must carry" provisions), and a split lower court decision upholding them has been appealed to the United States Supreme Court, which is expected to render its decision by the end of June 1994. Telephone companies represent another source of potential competition in the television field through their efforts to provide both video services and data transmission services directly to their subscribers' homes. While the Cable Communications Policy Act of 1984 ("1984 Cable Act") prohibits regional Bell operating companies ("RBOCs") from providing video programming directly to subscribers' homes, several recent developments may affect competition. In 1992, the FCC permitted telephone companies, without the necessity of obtaining a municipal cable franchise, to offer "video dialtone" distribution services to programmers on a common carrier basis. In 1993, a federal district court in Virginia ruled that the 1984 Cable Act's prohibition on telephone companies' provision of video programming to subscribers is unconstitutional as applied to the Bell Atlantic Corporation. Other RBOCs have sought similar rulings, and the Bell Atlantic ruling is on appeal. Currently, there are a number of legislative - 4 - proposals that would provide a regulatory framework for telephone company entry into the cable television business and into the provision of future broadband video services in the companies' service areas. Network regulations may also affect competition. In 1991, the FCC modified its Financial Interest and Syndication ("Fin/Syn") rules, which had limited the ability of television networks to acquire any financial interest or syndication rights in television programs and prohibited the networks from themselves syndicating television programs. CBS and other television networks appealed this decision to the United States Court of Appeals for the Seventh Circuit, contending that the rules should have been eliminated rather than modified. The Court affirmed the FCC's decision to abrogate the pre-existing rules, but vacated the FCC's modification of those rules as arbitrary and capricious and remanded the matter to the FCC. In April 1993, the FCC announced new rules which eliminate all restrictions on network acquisition of financial interests and syndication rights in network programming and retain most restrictions on syndication by the networks themselves. Petitions to review the new rules are before the Seventh Circuit Court of Appeals. The television network operations of CBS and other television networks are subject to consent decrees entered by the United States District Court for the Central District of California in 1980. In November 1993, the court modified the consent decrees to eliminate restrictions parallel to the FCC's old Fin/Syn rules, thereby permitting the networks to act to the extent permitted by the FCC's 1993 rules. The FCC has provided that all its Fin/Syn restrictions are to "sunset" two years from the date of the November 1993 modification of the consent decrees. It has also determined that it will review the rules six months before they expire and that the burden of proof in this review will rest on those favoring retention of the rules. The CBS Radio Network and CBS's owned radio stations compete with other radio networks, independent radio stations, suppliers of radio programming, and other advertising media. Competition with CBS's owned radio stations occurs primarily in their individual market areas, although on occasion stations outside a market place signals within that area. While such outside stations may obtain an audience share, they generally do not obtain any significant share of the advertising within the market. Developments in radio technology could affect competition in the radio field. New radio technology, known as "digital audio broadcasting" (DAB), can provide sound of the quality of compact discs, which is significantly higher than that now provided by radio networks and stations using analog technology. CBS, among others, is actively involved in the study and development of this digital technology, but cannot predict when and to what extent existing radio networks and stations will be in a position to utilize it. The FCC has initiated proceedings to consider the development and implementation of DAB services. The FCC is also currently considering an application to establish a nationwide, satellite-delivered DAB service, which, if approved, could constitute an additional source of competition to conventional radio stations and networks. CBS cannot predict the effect on its business or earnings of possible future competitive, economic, technological, international or industrial changes. Nor can CBS generally predict the outcome of administrative and judicial procedures or whether new legislation may be enacted or new regulations adopted that might bear on the broadcast industry or affect CBS's business. - 5 - Material Licenses and Federal Regulation Except as indicated below, all of CBS's television and radio stations operate under currently effective licenses from the Federal Communications Commission ("FCC"), which is empowered by the Communications Act of 1934, as amended, to, inter alia, license and regulate television and radio broadcasting stations. The FCC has authority to grant or renew broadcast licenses for a maximum term of five years for television and seven years for radio if it determines that the "public convenience, interest or necessity" will be served thereby. During a specified period after an application for renewal of a broadcast station license has been filed, competing applications seeking a license to broadcast on the same frequency may be filed with the FCC, and are entitled to consideration by the FCC in a hearing to evaluate the comparative merits of the applications. Persons objecting to the license renewal application may also file petitions to deny during this period. In Item 1 of CBS's Form 10-K for 1992 (under the caption "Material Licenses and Federal Regulation"), CBS reported that, on August 3, 1992, it had filed with the FCC timely applications to renew the television broadcast licenses for WBBM-TV, Chicago, Illinois; WFRV-TV, Green Bay, Wisconsin; and WJMN-TV, Escanaba, Michigan. The applications to renew such licenses for WFRV-TV and WJMN-TV were granted on November 23, 1993. There is no change in the status of CBS's application to renew the license for WBBM-TV. CBS believes that the station has been operated in accordance with all requirements. In Item 1 of Part II of CBS's Form 10-Q for the quarter ended September 30, 1993, CBS reported that, on August 2, 1993, CBS filed with the FCC a timely application to renew the television broadcast license for KCBS-TV, Los Angeles, California. On November 17, 1993, Mark McDermott and Americans for Responsible Media filed with the FCC a petition to deny the KCBS-TV application, to which CBS responded on December 14, 1993. CBS believes that the station has been operated in accordance with all requirements. On February 1, 1994 CBS filed with the FCC a timely application to renew the television license for WCBS-TV, New York, New York. The date by which oppositions or competing applications may be filed is May 2, 1994. The FCC has adopted rules prohibiting common ownership in the same market of radio and VHF television stations and prohibiting common ownership of stations with certain overlapping signals ("duopoly"). When those rules were adopted, existing commonly owned stations, including the VHF/radio combinations and a television duopoly then owned by CBS, were "grandfathered". In addition, in February 1992, CBS acquired from Midwest Communications, Inc., a VHF television station and AM and FM radio stations in Minneapolis, Minnesota, pursuant to an FCC waiver of its rules relating to VHF/radio combinations. As a result, absent an FCC waiver, a transfer of CBS licenses to a third party or a change in control of CBS could result in the loss of the license of either the television station or the radio stations in New York, Philadelphia, Chicago, Los Angeles and Minneapolis, and (as a result of overlapping television signals) the television station in either New York or Philadelphia. Under the FCC's waiver policy, however, the FCC will generally look favorably on waiver applications relating to radio-television station combinations in the top 25 television markets where there would be at least 30 separately owned broadcast stations after the proposed combination. Employees As of December 31, 1993, CBS had approximately 6,500 full-time employees. - 6 - Executive Officers of the Registrant (as of March 1, 1994) Date of Commencement of Service as Executive Officer in Present Position; Other Positions Since Name Age Present Positions January 1, 1989 ____ ___ _________________ ______________________ Laurence A. Tisch 71 Chairman of the Board, December 12, 1990; President President and Chief Exe- and Chief Executive Officer cutive Officer, CBS Inc. since January 1987; Chairman of the Board and Co-chief Executive Officer, Loews Corporation (Chief Executive Officer from August 1986 to February 1988 and a Director since 1959) (insurance, tobacco products, hotels, watches) Edward Grebow 44 Senior Vice President, February 8, 1988; executive Administration, CBS Inc. in charge of CBS Operations and Administration Division since June 1988 Ellen Oran Kaden 42 Senior Vice President, October 13, 1993; Vice General Counsel and President, General Counsel Secretary, CBS Inc. and Secretary, from July 1991 to October 1993; Vice President, Deputy General Counsel and Secretary (Acting General Counsel), from May to July 1991; Deputy General Counsel, from April 1989 to July 1991; Associate General Counsel, from September 1986 to April Peter W. Keegan 49 Senior Vice President, March 9, 1988 Finance, CBS Inc. Howard Stringer 52 Vice President, CBS Inc.; August 1, 1988 President, CBS/Broadcast Group Peter A. Lund 53 Executive Vice President, January 3, 1994; President, CBS/Broadcast Group; CBS Marketing Division, from President, CBS Television October 9, 1990 to December Network 1993; President, Multimedia Entertainment, from March 1987 to October 1990 Anthony C. Malara 57 President, CBS Affiliate May 31, 1988 Relations, a Division of CBS Inc. - 7 - Eric W. Ober 52 President, CBS News, a September 1, 1990; Division of CBS Inc. President, CBS Television Stations Division, from March 1987 to August 1990 Neal H. Pilson 53 President, CBS Sports, December 15, 1986 a Division of CBS Inc. Johnathan Rodgers 48 President, CBS Television September 1, 1990; Vice Stations, a Division of President and General CBS Inc. Manager, WBBM-TV, from March 1986 to August 1990 Jeffrey F. Sagansky 42 President, CBS January 1, 1990; President, Entertainment, a Tri-Star Pictures Inc., Division of from March to December CBS Inc. 1989; President, Production, Tri-Star Pictures Inc., from February 1985 to March James A. Warner 40 President, CBS December 4, 1989; Vice Enterprises, a Division President, HBO Enterprises, of CBS Inc. Home Box Office, Inc., from April 1986 to November 1989 Nancy C. Widmann 51 President, CBS Radio, a August 1, 1988 Division of CBS Inc. - 8 - Item 2. Item 2. Properties. The principal executive offices of CBS are located in its headquarters building at 51 West 52 Street, New York, NY 10019. Major CBS television and/or radio facilities are located at the CBS Broadcast Center at 524 West 57 Street, New York, NY and the headquarters building in New York, NY; CBS Television City and Columbia Square in Los Angeles, CA; and in Chicago, IL; Philadelphia, PA; St. Louis, MO; Boston, MA; San Francisco, CA; a suburb of Washington, D.C.; Miami, FL; Detroit, MI; St. Petersburg, FL; Dallas/Fort Worth and Houston, TX; Minneapolis, MN; and Green Bay, WI. Of the foregoing real estate properties, all are owned by CBS except as described below: CBS Radio Division occupies radio studios and offices in St. Louis, MO (leases expire December 31, 2002); Boston, MA (lease expires December 31, 2006); San Francisco, CA (lease expires December 31, 1995); Dallas, TX (lease expires December 31, 1996); Houston, TX (lease expires March 25, 1994); Detroit, MI (lease expires April 30, 1998); and Minneapolis, MN (month-to-month). Radford owns and operates a television and film production facility lot in Studio City, CA which includes 17 sound stages. Some of these facilities are made available to the CBS Entertainment Division, and the balance is leased to third parties. CBS owns and leases other domestic real properties (including transmitter sites), and leases foreign real properties, used in connection with its business activities. In October 1993, CBS and the City of New York consummated a previously- announced agreement whereby, for a 15-year period, CBS agreed to maintain current principal operations and specified levels of employment in New York City, and in consideration thereof the City of New York granted to CBS annual tax abatements, investment incentives, and certain other concessions. Over such period, the abatements and concessions are expected to aggregate approximately $48.5 million, and will reduce CBS's annual operating costs accordingly. Included among a series of interrelated transactions among CBS, the City and certain of its administrative units, and the New York State Power Authority, was CBS's conveyance of fee title to its Broadcast Center properties, located on West 57th Street in Manhattan, to the New York City Industrial Development Agency for a period of 15 years with a lease of those properties back to CBS. Such conveyance is expressly subject to CBS's retaining a reversionary interest in the properties, so that title in fee will revert to CBS at the end of the 15-year term, or prior thereto in the event of the occurrence of certain contingencies. Also, on March 15, 1993, CBS acquired the Ed Sullivan Theater and an adjacent 13-story office building in New York City. The Ed Sullivan Theater has been designated a landmark theater by the New York City Landmark Preservation Commission. CBS has renovated the theater for use as a television production facility, and the Landmark Commission has granted its approval of the renovation. The Ed Sullivan Theater currently serves as the home of the LATE SHOW with DAVID LETTERMAN, which commenced broadcasting on the CBS Television Network in August, 1993. - 9 - Item 3. Item 3. Legal Proceedings. There are no active pending legal proceedings to which CBS is a party, or to which any of its property is subject, other than (a) routine litigation incidental to the business, and (b) proceedings before the FCC with respect to the renewal of certain radio broadcast and television broadcast licenses reported in Item 1 under the caption "Material Licenses and Federal Regulation". In addition, various other legal actions, governmental proceedings and other claims (including those relating to environmental investigations and remediation resulting from the operations of discontinued businesses) are pending or, with respect to certain claims, unasserted. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Inapplicable. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. Incorporated herein by this reference and made a part of this Item 5 are the materials included under the captions "Stock Data" and "Dividends" at page 41 of Item 8 of this Report. There were approximately 11,584 holders of CBS common stock as of February 28, 1994. In May 1993, CBS converted $389.6 million of its outstanding 5% Convertible Subordinated Debentures Due 2002 for 1,947,975 shares of its common stock, issued from its treasury shares. The remaining Debentures of $.9 million were redeemed. In November 1993, CBS issued $100,000,000 of 7-1/8% Senior Notes that are due on November 1, 2023 and may not be redeemed prior to maturity. The net proceeds from the sale of those debt securities were used to fund the cost of implementing a related transaction with the New York City Industrial Development Agency, referred to in Item 2 of this Report. Item 6. Item 6. Selected Financial Data. Incorporated herein by this reference and made a part of this Item 6 is the information set forth for the years 1989 through 1993 in Item 7 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Incorporated herein by this reference and made a part of this Item 7 are the materials included under the caption "Management's Financial Commentary" at pages 15 through 20 of this Report. Item 8. Item 8. Financial Statements and Supplementary Data. Incorporated herein by this reference and made a part of this Item 8 are the Consolidated Statements of Income, Retained Earnings, Additional Paid-In Capital and Cash Flows for the years ended December 31, 1993, 1992, and 1991; the Consolidated Balance Sheets as of December 31, 1993, 1992, and 1991; the Notes to Consolidated Financial Statements; the Report of Independent Certified Public Accountants thereon; the material set forth under "Quarterly Results of Operations (Unaudited)"; and the material set forth under "Shareholder Reference Information"; all of which are set forth at pages 21 through 41 of this Report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Inapplicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Incorporated herein by this reference and made a part of this Item 10 are the materials included in CBS's Proxy Statement relating to the 1994 Annual Meeting of Shareholders (the "1994 Proxy Statement") under the captions "Information Concerning the Director-Nominees" and "Board of Directors and Its Committees". Definitive copies of the 1994 Proxy Statement are to be filed with the Commission on or about April 8, 1994. See also, "Executive Officers of the Registrant", included in Item 1 hereof pursuant to Instruction 3 to Item 401(b) of Regulation S-K. Item 11. Item 11. Executive Compensation. Incorporated herein by this reference and made a part of this Item 11 are the materials included under the caption "Executive Compensation" and the sub-headings thereunder, as set forth in the 1994 Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated herein by this reference and made a part of this Item 12 are the materials included under the caption "Principal Stockholders and Management Ownership of Equity Securities", as set forth in the 1994 Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. Incorporated herein by this reference and made a part of this Item 13 are the materials included under the caption "Certain Relationships and Related Transactions", as set forth in the 1994 Proxy Statement. - 11 - PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The Index to Financial Statements and Schedules filed as a part of this Report appears on page 14 and the report and consent of the independent certified public accountants thereon appears on page 22. The following compensatory plans and management contracts have been filed (or incorporated by reference) as Exhibits hereunder. (i) Compensatory Plans: CBS Additional Compensation Plan, CBS Stock Rights Plan, CBS Pension Plan, CBS Supplemental Executive Retirement Plan, CBS Supplemental Executive Retirement Plan #2, CBS Excess Benefits Plan, CBS Senior Executive Life Insurance Plan, CBS Deferred Compensation Plan, CBS Employee Investment Fund, CBS Retirement Plan for Outside Directors, Restricted Stock Plan for Eligible Directors. (ii) Management Contracts: The following executive officers of CBS are the only executive officers of CBS who have employment agreements: Messrs. Stringer, Lund, Ober, Sagansky, Grebow, Warner and Rodgers. (b) No reports on Form 8-K were filed during the fourth quarter of 1993. (c) The Index to Exhibits begins on page 46. (d) Not applicable. - 12 - 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. Dated: March 9, 1994 (Registrant) CBS Inc. Peter W. Keegan By:________________________________ Peter W. Keegan Senior Vice President, Finance 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. Laurence A. Tisch Henry B. Schacht _______________________________ _____________________________ Laurence A. Tisch Henry B. Schacht, Director Chairman of the Board, Dated: March 7, 1994 President and Chief Executive Officer (principal executive officer) Dated: March 9, 1994 Peter W. Keegan Edson W. Spencer ________________________________ ______________________________ Peter W. Keegan Edson W. Spencer, Director Senior Vice President, Finance Dated: March 9, 1994 (principal financial and accounting officer) Dated: March 9, 1994 Michel C. Bergerac Franklin A. Thomas ________________________________ ______________________________ Michel C. Bergerac, Director Franklin A. Thomas, Director Dated: March 9, 1994 Dated: March 9, 1994 Harold Brown Preston R. Tisch ________________________________ _____________________________ Harold Brown, Director Preston R. Tisch, Director Dated: March 9, 1994 Dated: March 9, 1994 Ellen V. Futter James D. Wolfensohn ________________________________ _____________________________ Ellen V. Futter, Director James D. Wolfensohn, Director Dated: March 9, 1994 Dated: March 9, 1994 Henry A. Kissinger ________________________________ Henry A. Kissinger, Director Dated: March 9, 1994 - 13 - INDEX TO FINANCIAL STATEMENTS AND SCHEDULES PAGE NO. DESCRIPTION IN 10-K ___________ _______ Management's Financial Commentary 15 Consolidated Financial Statements Management's Responsibility for Financial Statements 21 Report and Consent of Independent Certified Public Accountants 22 Statements of Income 23 Balance Sheets 24 Statements of Retained Earnings and Additional Paid-In Capital 25 Statements of Cash Flows 26 Notes to Financial Statements 27 Quarterly Results of Operations (unaudited) 40 Shareholder Reference Information 41 Schedules Schedule I - Marketable Securities - Other Investments 42 Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties 44 Schedule X - Supplementary Income Statement Information 45 Schedules other than those listed above have been omitted since they are either not required or not applicable. Financial statements of 50% or less owned persons, the investments in which are carried on an equity basis, are omitted because such persons are not "significant subsidiaries" within the meaning of Rule 1-02(v) of Regulation S-X. - 14 - MANAGEMENT'S FINANCIAL COMMENTARY In 1993, the Company's operating results improved significantly, reflecting both its ratings strength and higher unit pricing. Earnings in 1993 were also enhanced by several special items as well as by capital gains from the sale of marketable securities. The special items, which are not expected to recur in 1994, included a legal settlement with Viacom International Inc. (Viacom), an insurance settlement for hurricane damage to the Company's television station in Miami, a favorable Federal income tax audit settlement, and deferred tax benefits resulting from new Federal tax law. Excluding the effect of the above noted special items and capital gains, the Company anticipates improved operating results in 1994 based on continuing solid audience ratings, improving advertiser demand and active cost control. The Company continually updates its evaluations of environmental liabilities and the adequacy of the provisions made in prior years to cover asserted and unasserted environmental claims arising from the operations of its discontinued businesses. (There are no significant environmental claims known to the Company arising from its continuing operations.) In the Company's opinion, any additional liabilities that may result from such claims are not reasonably likely to have a material adverse effect on its consolidated financial position, results of operations, or liquidity. The impact of inflation on the Company's financial statements in 1993 was not considered sufficient to warrant the inclusion of any additional current cost disclosures in these statements. This Financial Commentary should be read in conjunction with the consolidated financial statements and notes to these financial statements. In addition, although the Commentary's Liquidity and Capital Resources section is based upon the Consolidated Statements of Cash Flows, certain data have been rearranged for purposes of clarification and, therefore, it should be read in conjunction with the Consolidated Statements of Cash Flows. RESULTS OF OPERATIONS Income from Continuing Operations and Net Income The Company's sales in 1993 were essentially the same as in 1992. The Television Network's strong household ratings and better unit prices resulted in increased sales in 1993 from its regularly scheduled programming which largely compensated for the absence of the sales generated from the broadcasts of the Olympic Winter Games and the Super Bowl in 1992. As a result, the Company's operating income improved significantly in 1993 over 1992 from the Television Network's more profitable entertainment and news programs. The Television Stations Division recorded increased sales and profits at all stations except Los Angeles. The Radio Division experienced a significant improvement in earnings, attributable to sales increases at most of its stations and to lower operating costs. Also, in 1993, earnings benefited from a legal settlement with Viacom and an insurance settlement for hurricane damage to the Company's television station in Miami (both of which were included in other income, net); capital gains from the sale of marketable securities; a favorable Federal income tax audit settlement; and deferred tax benefits resulting from new Federal tax law-all of which contributed $5.33 to earnings per share. The Company's sales and operating income improved significantly in 1992. The Television Network's stronger primetime program schedule, as well as the sales generated by the acquisition of Midwest Communications, Inc. (Midwest) (note 2), contributed to the sales and operating income increases. The sales increases due to the broadcasts of the Olympic Winter Games and the Super Bowl were largely offset by their related costs. In 1991 and 1990, the Company recorded operating losses due mainly to the provisions for losses on its Major League Baseball and National Football League television contracts (note 3). Interest income increased slightly in 1993. In 1992 and 1991, it decreased from previous years, largely as a result of the sale of marketable securities to fund the Company's $2 billion repurchase of its common stock in February 1991 (note 12). The decrease in interest expense in 1993 resulted mainly from the conversion of the 5% convertible debt into common stock in 1993 and the refinancing of the 10 7/8% senior notes in 1992. The increase in interest expense in 1992 was due mainly to the issuance of $150.0 million of debt related to the acquisition of Midwest. The decrease in interest expense in 1991 and 1990 was due primarily to the retirement of debt in 1990 and 1989. In 1993, the effective income tax expense rate was reduced by deferred tax benefits of $11.2 million resulting from new Federal tax law and by a favorable Federal tax audit settlement for the years 1988-1990 of $23.0 million. The 1992 effective income tax expense rate was reduced by a favorable Federal tax audit settlement of $17.9 million for the years 1985-1987. Income from tax preference securities increased the effective tax benefit rate in 1991 and reduced the effective tax expense rate in 1990. The Company recorded additional gains in 1991 and 1990 as a result of the final settlement of all disputed items in arbitration related to the sale of its Records Group in 1988. In 1992, the Company adopted certain accounting standards (note 1) that resulted in a one-time charge to net income, shown as cumulative effects of changes in accounting principles. The decreases in 1992 and 1991 of the adjusted weighted average shares outstanding were related mainly to the Company's repurchase of 10.5 million shares of its common stock in February 1991. In connection with this repurchase, the Company reduced its quarterly dividend per share in the first quarter of 1991 from $1.10 to $.25. Based on the Company's improved financial condition, it raised its quarterly dividend per share to $.50 in the fourth quarter of 1993. -16 (Page 1 of 2)- Year ended December 31 1993 1992 1991 1990 1989 (In millions, except per share amounts) Net sales $3,510.1 $3,503.0 $3,035.0 $3,261.2 $2,961.5 Cost of sales (2,688.8) (2,906.5) (2,938.0)(2,925.6) (2,313.2) Selling, general and administrative expenses (461.3) (422.9) (384.6) (409.3) (384.1) Other income, net 51.2 6.5 16.3 23.9 9.6 Operating income (loss) 411.2 180.1 (271.3) (49.8) 273.8 Interest income on investments, net 110.4 107.6 140.1 210.1 246.7 Interest expense on debt, net (42.3) (60.7) (47.4) (57.9) (64.8) Interest, net 68.1 46.9 92.7 152.2 181.9 Income (loss) from continuing operations before income taxes 479.3 227.0 (178.6) 102.4 455.7 Income tax (expense) benefit (153.1) (64.5) 79.9 (10.9) (158.6) Income (loss) from continuing operations 326.2 162.5 (98.7) 91.5 297.1 Discontinued operations 12.9 20.0 Extraordinary items (.7) (.8) Cumulative effects of changes in accounting principles (81.5) Net income (loss) $326.2 $81.0 $(85.8) $110.8 $296.3 Per share of common stock: Continuing operations $20.39 $10.51 $(6.11) $3.55 $11.54 Discontinued operations .79 .78 Extraordinary items (.03) (.03) Cumulative effects of changes in accounting principles (5.28) Net income (loss) $20.39 $5.23 $(5.32) $4.30 $11.51 Dividends per common share $1.25 $1.00 $1.00 $4.40 $4.40 Adjusted weighted average shares outstanding 15.5 15.4 16.2 25.7 25.7 -16 (Page 2 of 2)- LIQUIDITY AND CAPITAL RESOURCES Cash Flows The Company's liquid assets include its cash and cash equivalents and readily marketable securities held in its short-term and long-term portfolios. In 1993, the increase in liquid assets of $123.8 million was attributable primarily to cash flows from operating activities, gain on sale of marketable securities and the issuance of $100.0 million of debt, partially offset by capital expenditures. In 1992, the increase of $46.7 million was due mainly to cash flows from operating activities, partially offset by capital expenditures. The issuance of $150.0 million of debt in 1992 was used to fund major acquisitions. The decrease in liquid assets in 1991 was related principally to the Company's $2 billion repurchase of its common stock (note 12). In 1990, the combination of capital expenditures, retirement of debt and the payment of dividends to shareholders moderately exceeded the Company's cash flows from operating activities. In 1989, the Company retired debt, acquired a television station and two radio stations, and made substantial investments in broadcasting assets. These expenditures more than offset cash flows from operations, after dividend payments, and resulted in negative cash flows. The positive cash flows from asset dispositions in the 1985-1988 period and from normal operations have enabled the Company to accumulate a substantial amount of cash and marketable securities while allowing it to repurchase its common stock and make major investments in program rights, broadcasting assets, and television and radio stations. Additional details on specific cash flows are provided in subsequent sections of this Commentary. Year ended December 31 1993 1992 1991 1990 1989 (In millions) Cash flows: Operating activities $117.6 $144.2 $97.8 $217.7 $180.7 Investing activities (163.0) (374.1) 1,484.3 103.5 203.8 Financing activities 73.4 105.3 (2,033.2) (198.6) (192.1) Net change in cash and cash equivalents 28.0 (124.6) (451.1) 122.6 192.4 Remove net investment in marketable securities (included above)* 95.8 171.3 (1,456.2) (147.6) (404.8) Cash flows before investment in marketable securities** 123.8 46.7 (1,907.3) (25.0) (212.4) Cash and marketable securities at beginning of year** 921.6 874.9 2,782.2 2,807.2 3,019.6 Cash and marketable securities at end of year** $1,045.4 $921.6 $874.9 $2,782.2 $2,807.2 *Includes liabilities for securities sold subject to repurchase agreements (note 1). **Includes cash and cash equivalents and readily marketable securites held in the Company's short-term and long-term portfolios as well as liabilities for securities sold under repurchase agreements. Cash Flows from Operating Activities In accordance with Statement of Financial Accounting Standards (SFAS) No. 95, "Statement of Cash Flows," all cash flows not classified as investing or financing activities, and all interest and income taxes including those related to investing and financing activities, are classified as operating activities. In 1993, cash flows from operating activities were lower than in 1992. This was primarily caused by the excess of payments for baseball and football program rights over their related revenues, the rights fee paid for the 1994 Olympic Winter Games, and a higher level of year-end accounts receivable, due to increased sales in the fourth quarter. In 1992, cash flows from operating activities increased over the preceding year due to improved operating results. The main reasons for this increase were the sales due to the improved primetime ratings and unit pricing, and the operating cash flows related to the acquisition of Midwest (note 2). In 1991, cash flows from operating activities declined from 1990's level, principally as a result of a decline in sales which more than offset cost reductions, and also because of reduced interest income resulting from the sale of marketable securities in February 1991 to fund the Company's $2 billion repurchase of its common stock (note 12). Cash flows from operating activities in 1990 rose over 1989's level, despite a signficant reduction in income in 1990, because of lower year-end accounts receivable in 1990 and the absence of 1989's buildup of program rights. Interest, net, increased in 1993, mainly because of the conversion of the 5% convertible debt into common stock in 1993 and the refinancing of the 10 7/8% senior notes in 1992. In the preceding two years, interest, net, had declined, due primarily to the issuance of debt in 1992 related to the acquisition of Midwest and to the sale of securities in February 1991 to fund the Company's $2 billion repurchase of its common stock. The significant taxes paid in 1993 related primarily to the Company's improved operating results. The small positive cash flows from taxes in 1992 and 1991 were attributable principally to refunds related to prior years, offsetting the current years'tax payments which were small due to tax deductions for timing items. These timing items arose mainly from baseball and football losses (note 3) which were accrued in 1990 and 1991 but which were deducted for tax purposes in 1991, 1992 and 1993. From an overall standpoint, the fluctuations in cash flows from operating activities, over the period covered by the table, were due largely to changes in operating income (exclusive of noncash items) and investments in program rights. Additionally, there were period-to-period changes in year-end levels of accounts receivable and various other assets and liabilities, due largely to the timing of transactions. -18 (Page 1 of 2)- Year ended December 31 1993 1992 1991 1990 1989 (In millions) Net income (loss) $326.2 $81.0 $(85.8) $110.8 $296.3 Adjustments: Depreciation and amortization 71.0 66.7 59.9 58.7 63.6 Gain on sale of marketable securities, net (39.6) (28.9) (38.1) (12.4) (10.5) Cumulative effects of changes in accounting principles 81.5 Gain on discontinued operations (21.2) (33.0) Changes in assets and liabilities: Accounts receivable (37.1) 7.8 (2.7) 32.4 (46.9) Program rights, net (26.0) 23.3 .9 8.1 (160.5) Accounts payable (2.3) (18.1) 4.7 (5.0) 6.6 Accrual on baseball and football television contracts (242.0) (160.0) 233.0 190.0 Recoverable income taxes 88.3 (9.6) (2.6) (88.5) (4.0) Deferred income taxes (27.8) 79.4 (61.9) (26.2) 27.4 Other, net 6.9 21.1 11.6 (17.2) 8.7 Cash flows from operating activities $117.6 $144.2 $97.8 $217.7 $180.7 Cash flows from interest and income taxes included above: Interest, net* $28.5 $18.0 $54.6 $139.8 $171.4 Income taxes (94.2) 2.6 2.4 (143.4) (144.4) *Excludes gain on sale of marketable securities, which was included in cash flows from investing activities. -18 (Page 2 of 2)- Cash Flows from Investing Activities The cash flows from marketable securities in 1991 were used mainly to fund the Company's $2 billion repurchase of shares of its common stock (note 12). Other changes in net investment in marketable securities were due essentially to the cash requirements of the Company. In addition, the increases and decreases in the sales and purchases of these securities, as presented in the Statements of Cash Flows, reflected activity stimulated by market conditions. In 1992, the Company acquired Midwest and the remaining 50 percent interest in television and film production facilities in Los Angeles (note 2). In 1989, it acquired a television station in Miami and two radio stations in Detroit. The Company's principal capital expenditures in 1993, as in previous years, were for broadcasting assets. In 1993, they also included the acquisition and renovation of the Ed Sullivan Theater in New York City from which the Late Show with David Letterman is broadcast. In 1989, the Company also acquired satellite capacity for the distribution of Television Network programs to affiliated stations. The asset dispositions in 1991 represent the cash receipt of the final settlement of all disputed items in arbitration related to the 1988 sale of the Company's Records Group. Interest income on investments, net, excluding gain on sale of marketable securities, was included in operating activities and is presented for informational purposes. -19 (Page 1 of 4)- Year ended December 31 1993 1992 1991 1990 1989 (In millions) Marketable securities: Gain on sale $ 39.6 $ 28.9 $ 38.1 $ 12.4 $ 10.5 Net investment (95.8) (171.3) 1,456.2 147.6 404.8 Cash flows from marketable securities* (56.2) (142.4) 1,494.3 160.0 415.3 Major acquisitions** (160.2) (117.0) Capital expenditures (106.8) (71.5) (64.2) (60.4) (98.7) Asset dispositions 54.2 3.9 4.2 Cash flows from investing activities*** $(163.0) $(374.1) $1,484.3 $ 103.5 $ 203.8 Interest income on investments, net (not included above)*** $ 70.8 $ 78.7 $ 102.0 $ 197.7 $ 236.2 *Includes liabilities for securities sold subject to repurchase agreements (note 1). **The table excludes the noncash items indicated in the footnotes to the Statements of Cash Flows. ***Cash flows related to interest (excluding gain on sale of marketable securities) and taxes are included in operating activities in accordance with SFAS No. 95. -19 (Page 2 of 4)- Cash Flows from Financing Activities In 1993, the Company issued $100.0 million of senior notes. The proceeds from the issuance of these debt securities were used to purchase New York City Industrial Development Agency (IDA) bonds, which were issued by the IDA to establish a trust fund to implement the Company's agreement with the IDA. Under this agreement, the Company is required to invest in production facilities and develop new broadcasting and production technologies in New York City in return for certain tax incentives and low-cost energy. In 1992, the Company issued $150.0 million of senior notes in connection with the acquisition of Midwest. In addition, it issued $125.0 million of senior notes and $125.0 million of senior debentures to refinance the $263.0 million of 10 7/8% senior notes due 1995. During the period 1989-1991, the Company retired debt of $171.5 million. In 1991, the Company repurchased 10.5 million shares of its common stock at a cost of approximately $2 billion. In connection with this repurchase of shares, the Company reduced its quarterly dividend per share in the first quarter of 1991 from $1.10 to $.25. In the fourth quarter of 1993, based on its improved financial condition, the Company increased its quarterly dividend per share to $.50. Interest expense on debt, net, was included in operating activities and is presented for informational purposes. -19 (Page 3 of 4)- Year ended December 31 1993 1992 1991 1990 1989 (In millions) 7 1/8% senior notes due 2023 $100.0 7 5/8% senior notes due 2002 $ 150.0 7 3/4% senior notes due 1999 125.0 8 7/8% senior debentures due 2022 125.0 10 7/8% senior notes due 1995 (263.0) $(3.0) $ (7.7) $ (26.7) 11 3/8% notes due 1992 (75.6) (1.0) 14 1/2% notes due 1992 (50.0) Other debt (.9) (2.5) (2.5) (2.3) (2.7) Debt issued (retired)* 99.1 134.5 (5.5) (85.6) (80.4) Repurchases of common stock (3.0) (2,005.1) Dividends to shareholders (31.3) (25.9) (25.7) (116.6) (116.5) Other, net 5.6 (.3) 3.1 3.6 4.8 Cash flows from financing activities** $ 73.4 $105.3 $(2,033.2) $(198.6) $(192.1) Interest expense on debt, net (not included above)** $(42.3) $(60.7) $ (47.4) $ (57.9) $ (64.8) *The table excludes the noncash items indicated in the footnotes to the Statements of Cash Flows. **Cash flows related to interest and taxes are included in operating activities in accordance with SFAS No. 95. -19 (Page 4 of 4)- Working Capital In 1993, the increase in working capital was due largely to the decrease in other current liabilities caused by the reversal of accrued losses recorded in prior years related to the baseball and football television contracts (note 3), partially offset by the realization of tax benefits related to these losses. The increase in accounts receivable, due to increased sales in the fourth quarter, and the increase in net program rights, due primarily to the 1994 Olympic Winter Games, contributed to the increase in working capital. In 1992, the decrease in working capital was due primarily to the reclassification of certain marketable securities to the Company's long-term portfolio, and to a reclassification from long-term to other current liabilities for the accrued losses related to the baseball and football television contracts. The main reason for the decrease in working capital in 1991 related to the Company's cash outlay for its $2 billion common stock repurchase (note 12). In addition, the increase in other current liabilities was due mainly to accrued losses on the baseball and football television contracts. In 1990, the primary reason for the increased working capital was the reclassification of marketable securities from long-term to short-term in anticipation of their sale to fund the $2 billion common stock repurchase. -20 (Page 1 of 4)- December 31 1993 1992 1991 1990 1989 (In millions) Current assets: Cash and marketable securities* $ 219.4 $169.0 $272.5 $2,318.8 $755.8 Accounts receivable 454.5 417.4 420.3 417.6 450.0 Program rights 581.9 447.4 505.5 403.3 353.5 Recoverable income taxes** 28.8 117.1 90.2 87.6 Other 18.2 20.9 18.2 17.8 19.8 Total current assets 1,302.8 1,171.8 1,306.7 3,245.1 1,579.1 Current liabilities: Accounts payable 33.4 35.7 48.1 43.4 48.4 Liabilities for talent and program rights 317.4 245.5 276.3 236.4 183.9 Debt .9 13.0 3.5 3.4 3.3 Other 312.5 514.4 410.0 251.7 263.1 Total current liabilities 664.2 808.6 737.9 534.9 498.7 Working capital $ 638.6 $363.2 $ 568.8 $2,710.2 $1,080.4 Ratio of current assets to current liabilities 1.96:1 1.45:1 1.77:1 6.07:1 3.17:1 *Includes cash and cash equivalents and liabilities related to securities sold subject to repurchase agreements (note 1). **Primarily related to temporary differences attributable to the Major League Baseball and National Football League television contracts (note 3). -20 (Page 2 of 4)- Capital Structure and Total Assets In 1993, the Company's total debt as a percentage of total capitalization improved, mainly because of the conversion of $389.6 million of the 5% convertible debentures into common stock, and net income $326.2 million. The percentage remained essentially unchanged in 1992 compared with 1991, due mainly to the higher level of debt largely offset by the increase in shareholders' equity. The percentage rose in 1991, primarily as a result of the Company's repurchase of common stock, which reduced shareholders' equity by $2 billion in 1991. The higher level of debt in 1992 was due primarily to the issuance of $150.0 million of senior notes in connection with the acquisition of Midwest (note 2). Also, in 1992, the Company retired its 10 7/8% senior notes due 1995 by refinancing debt with lower interest rates and lengthened maturities. The Company believes that, with a substantial amount of highly liquid assets and a low debt-to-total capitalization ratio, it remains fully capable of funding its current operations and sufficiently flexible with respect to the acquisition of additional broadcast properties should suitable opportunities arise. The principal changes in total assets over the five-year period were related to the Company's $2 billion common stock repurchase in 1991, the acquisitions of Midwest and television and film production facilities in 1992, and increased investment in marketable securities from the issuance of debt and increased program rights in 1993. -20 (Page 3 of 4)- December 31 1993 1992 1991 1990 1989 (In millions) Current debt $ .9 $ 13.0 $ 3.5 $ 3.4 $ 3.3 Long-term debt 590.3 870.0 696.5 712.4 795.5 Total debt 591.2 883.0 700.0 715.8 798.8 Common stock subject to redemption 65.2 65.2 Preference stock subject to redemption 124.7 124.5 124.4 124.2 124.0 Shareholders' equity 1,138.0 446.8 354.8 2,392.7 2,394.0 Total capitalization $1,853.9 $1,454.3 $1,179.2 $3,297.9 $3,382.0 Total debt as a percentage of total capitalization 31.9% 60.7% 59.4% 21.7% 23.6% Total assets $3,418.7 $3,175.0 $2,798.6 $4,691.8 $4,637.9 -20 (Page 4 of 4)- FINANCIAL STATEMENTS Management's Responsibility for Financial Statements The consolidated financial statements presented on the following pages have been prepared by management in conformity with generally accepted accounting principles. The reliability of the financial information, which includes amounts based on judgment, is the responsibility of management. The Company uses systems and procedures for handling routine business activities which seek to prevent or detect unauthorized transactions. The Company's internal control system envisages a segregation of duties among the Company's personnel, a wide dissemination to these personnel of the Company's written policies and procedures, the use of formal approval authorities and the selection and training of qualified people. The design of internal control systems involves a balancing of estimated benefits against estimated costs. The system is monitored by an internal audit program. The scope and results of the internal audit function and the adequacy of the system of internal accounting controls are reviewed regularly by the Audit Committee of the Board of Directors. Management believes that the Company's system provides reasonable assurance that assets are safeguarded against material loss and that the Company's financial records permit the preparation of financial statements that are fairly presented in accordance with generally accepted accounting principles. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ____________________ To the Shareholders of CBS Inc.: We have audited the consolidated financial statements and the financial statement schedules of CBS Inc. and subsidiaries listed in the index on page 14 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of CBS Inc. and subsidiaries as of December 31, 1993, 1992, and 1991, and the consolidated results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in note 1 to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions, postemployment benefits and income taxes. COOPERS & LYBRAND New York, New York February 9, 1994 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ____________________ We consent to the incorporation by reference in the registration statements of CBS Inc. and subsidiaries on Form S-8 (File Nos. 2-87270, 2-58540, and 2- 33-2098) and the registration statement of CBS Inc. on Form S-3 (File No. 33- 59462) of our report dated February 9, 1994, on our audits of the consolidated financial statements and financial statement schedules of CBS Inc. and subsidiaries as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, which report appears above. COOPERS & LYBRAND New York, New York March 9, 1994 CONSOLIDATED STATEMENTS OF INCOME CBS Inc. and subsidiaries (Dollars in millions, except per share amounts) Year ended December 31 1993 1992 1991 Net sales. . . . . . . . . . . . . . . . . . $3,510.1 $3,503.0 $3,035.0 Cost of sales (note 3) . . . . . . . . . . . (2,688.8) (2,906.5) (2,938.0) Selling, general and administrative expenses . . . . . . . . . . . . . . . . . (461.3) (422.9) (384.6) Other income, net (note 4) . . . . . . . . . 51.2 6.5 16.3 Operating income (loss). . . . . . . . . . . 411.2 180.1 (271.3) Interest income on investments, net. . . . . . . . . . . . . . . . . . . . 110.4 107.6 140.1 Interest expense on debt, net. . . . . . . . (42.3) (60.7) (47.4) Interest, net (note 4) . . . . . . . . . . . 68.1 46.9 92.7 Income (loss) from continuing operations before income taxes . . . . . . . . . . . . 479.3 227.0 (178.6) Income tax (expense) benefit (note 5). . . . (153.1) (64.5) 79.9 Income (loss) from continuing operations . . 326.2 162.5 (98.7) Discontinued operations (note 7) . . . . . . 12.9 Income (loss) before cumulative effects of changes in accounting principles . . . . . 326.2 162.5 (85.8) Cumulative effects of changes in accounting principles (note 1) . . . . . . (81.5) Net income (loss). . . . . . . . . . . . . . $ 326.2 $ 81.0 $ (85.8) Per share of common stock (note 6): Continuing operations . . . . . . . . . . . $ 20.39 $ 10.51 $ (6.11) Discontinued operations . . . . . . . . . . .79 Cumulative effects of changes in accounting principles (note 1) . . . . . (5.28) Net income (loss) . . . . . . . . . . . . . $ 20.39 $ 5.23 $ (5.32) See notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS CBS Inc. and subsidiaries (Dollars in millions, except per share amounts) ASSETS December 31 1993 1992 1991 Current assets: Cash and cash equivalents (note 1). . . . . . . . $ 173.4 $ 145.4 $ 270.0 Marketable securities (note 1). . . . . . . . . . 420.7 332.3 215.7 Accounts receivable, less allowance for doubtful accounts: 1993, $9.1; 1992, $9.7; 1991, $9.0 . . 454.5 417.4 420.3 Program rights. . . . . . . . . . . . . . . . . . 581.9 447.4 505.5 Recoverable income taxes (note 5) . . . . . . . . 28.8 117.1 90.2 Other . . . . . . . . . . . . . . . . . . . . . . 18.2 20.9 18.2 Total current assets. . . . . . . . . . . . . . . 1,677.5 1,480.5 1,519.9 Marketable securities (note 1). . . . . . . . . . 826.0 752.6 602.4 Property, plant and equipment (note 2): Land. . . . . . . . . . . . . . . . . . . . . . . 81.4 76.8 32.5 Buildings . . . . . . . . . . . . . . . . . . . . 319.0 297.2 218.0 Machinery and equipment . . . . . . . . . . . . . 556.9 542.0 544.2 Leasehold improvements. . . . . . . . . . . . . . 20.8 21.3 21.4 978.1 937.3 816.1 Less accumulated depreciation . . . . . . . . . . 459.0 451.9 437.5 Net property, plant and equipment . . . . . . . . 519.1 485.4 378.6 Other assets: Program rights. . . . . . . . . . . . . . . . . . 90.9 154.1 131.9 Goodwill, less accumulated amortization (note 1): 1993, $33.0; 1992, $28.0; 1991, $20.4; . . . . . 280.6 283.8 144.6 Other . . . . . . . . . . . . . . . . . . . . . . 24.6 18.6 21.2 Total other assets. . . . . . . . . . . . . . . . 396.1 456.5 297.7 $3,418.7 $3,175.0 $2,798.6 -24 (Page 1 of 2)- LIABILITIES AND SHAREHOLDERS' EQUITY December 31 1993 1992 1991 Current liabilities: Accounts payable . . . . . . . . . . . . . . . $ 33.4 $ 35.7 $ 48.1 Accrued salaries, wages and benefits . . . . . 72.6 61.4 53.5 Liabilities for talent and program rights. . . 317.4 245.5 276.3 Liabilities for securities sold under repurchase agreements (note 1). . . . . . . . 374.7 308.7 213.2 Debt (note 8). . . . . . . . . . . . . . . . . .9 13.0 3.5 Other (note 3) . . . . . . . . . . . . . . . . 239.9 453.0 356.5 Total current liabilities. . . . . . . . . . . 1,038.9 1,117.3 951.1 Long-term debt (note 8). . . . . . . . . . . . 590.3 870.0 696.5 Other liabilities (notes 3, 9 and 11). . . . . 406.0 467.8 554.3 Deferred income taxes (note 5) . . . . . . . . 120.8 148.6 117.5 Commitments and contingent liabilities (notes 10 and 16) . . . . . . . . . . . . . . Preference stock, Series B, par value $1.00 per share, subject to redemption (note 14). . 124.7 124.5 124.4 Shareholders' equity (notes 12, 13 and 14): Common stock, par value $2.50 per share; authorized 100,000,000 shares; issued 24,816,623 shares . . . . . . . . . . . . . . 62.0 61.8 61.8 Additional paid-in capital . . . . . . . . . . 318.6 274.7 277.7 Retained earnings. . . . . . . . . . . . . . . 2,441.9 2,147.2 2,092.3 2,822.5 2,483.7 2,431.8 Less shares of common stock in treasury, at cost: 9,332,916 in 1993; 11,284,669 in 1992; 11,504,270 in 1991 . . . . . . . . . . . . . 1,684.5 2,036.9 2,077.0 Total shareholders' equity . . . . . . . . . . 1,138.0 446.8 354.8 $3,418.7 $3,175.0 $2,798.6 See notes to consolidated financial statements. -24 (Page 2 of 2)- CONSOLIDATED STATEMENTS OF RETAINED EARNINGS AND ADDITIONAL PAID-IN CAPITAL CBS Inc. and subsidiaries (Dollars in millions, except per share amounts) Year ended December 31 1993 1992 1991 RETAINED EARNINGS Balance at beginning of year. . . . . . . . $2,147.2 $2,092.3 $2,143.9 Net income (loss) . . . . . . . . . . . . . 326.2 81.0 (85.8) Cash dividends: Common stock (per share - 1993, $1.25; 1992 and 1991, $1.00) . . . . . . . . . (18.8) (13.4) (13.2) Preference stock, Series B ($10.00 per share) . . . . . . . . . . . (12.5) (12.5) (12.5) Accretion of preference stock, Series B (note 14). . . . . . . . . . . . (.2) (.2) (.2) Reclassification of common stock subject to redemption (note 13). . . . . . 60.1 Balance at end of year. . . . . . . . . . . $2,441.9 $2,147.2 $2,092.3 ADDITIONAL PAID-IN CAPITAL Balance at beginning of year. . . . . . . . $ 274.7 $ 277.7 $ 260.9 Exercise of stock options and other items . 12.5 1.8 3.3 Conversion of convertible debentures (note 8) . . . . . . . . . . . 31.4 9.5 Acquisition of Midwest (note 2) . . . . . . (4.8) Reclassification of common stock subject to redemption (note 13). . . . . . 4.0 Balance at end of year. . . . . . . . . . . $ 318.6 $ 274.7 $ 277.7 See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS CBS Inc. and subsidiaries (Dollars in millions) Year ended December 31 1993 1992 1991 Operating activities: Net income (loss). . . . . . . . . . . . . . . $ 326.2 $ 81.0 $ (85.8) Adjustments: Depreciation and amortization. . . . . . . . 71.0 66.7 59.9 Gain on sale of marketable securities, net . (39.6) (28.9) (38.1) Cumulative effects of changes in accounting principles. . . . . . . . . . . 81.5 Gain on discontinued operations. . . . . . . (21.2) Changes in assets and liabilities*: Accounts receivable. . . . . . . . . . . . . (37.1) 7.8 (2.7) Program rights, net. . . . . . . . . . . . . (26.0) 23.3 .9 Accounts payable . . . . . . . . . . . . . . (2.3) (18.1) 4.7 Accrual on baseball and football television contracts . . . . . . . . . . . (242.0) (160.0) 233.0 Recoverable income taxes . . . . . . . . . . 88.3 (9.6) (2.6) Deferred income taxes. . . . . . . . . . . . (27.8) 79.4 (61.9) Other, net . . . . . . . . . . . . . . . . . 6.9 21.1 11.6 117.6 144.2 97.8 Investing activities**: Marketable securities Gross sales . . . . . . . . . . . . . . . . . 2,521.3 1,495.0 3,536.4 Gross purchases . . . . . . . . . . . . . . . (2,643.5) (1,732.9)(1,975.3) Liabilities for securities sold under repurchase agreements . . . . . . . . . . . 66.0 95.5 (66.8) Capital expenditures . . . . . . . . . . . . . (106.8) (71.5) (64.2) Major acquisitions . . . . . . . . . . . . . . (160.2) Discontinued operations. . . . . . . . . . . . 54.2 (163.0) (374.1) 1,484.3 Financing activities**: Issuance of debt . . . . . . . . . . . . . . . 124.0 422.5 Extinguishment of debt . . . . . . . . . . . . (24.9) (288.0) (5.5) Dividends to shareholders. . . . . . . . . . . (31.3) (25.9) (25.7) Repurchases of common stock. . . . . . . . . . (3.0)(2,005.1) Other, net . . . . . . . . . . . . . . . . . . 5.6 (.3) 3.1 73.4 105.3 (2,033.2) Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . 28.0 (124.6) (451.1) Cash and cash equivalents at beginning of year. 145.4 270.0 721.1 Cash and cash equivalents at end of year. . . . $ 173.4 $ 145.4 $ 270.0 See notes to consolidated financial statements. *Excludes effect of major acquisitions and items included in Adjustments. **Excludes the following noncash items: a) In 1993 and 1991, the conversion of $389.6 and $9.5, respectively, of the Company's 5% convertible debentures into common stock (note 8). b) In 1992, the issuance of $36.8 of the Company's common stock re: Midwest, and the consolidation of a mortgage obligation of $51.0 re: CBS/MTM Partnership (note 2). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Statement of Significant Accounting Policies Basis of presentation. The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been excluded from the consolidated financial statements. All notes relate to continuing operations unless otherwise indicated. Revenue recognition. The Company's practice is to record revenues from services when performed. Income taxes. The Company provides deferred income taxes for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities. Cash equivalents and marketable securities. The Company considers all highly liquid debt instruments purchased with a maturity of three months or less, including accrued interest thereon, to be cash equivalents. Marketable securities include U.S. Treasury notes, money market instruments, tax-exempt securities and corporate securities. The Company also enters into agreements to sell and repurchase certain of these securities. Due to the agreements to repurchase, the sales of these securities are not recorded. Instead, the liabilities to repurchase securities sold under these agreements are reported as current liabilities and the investments acquired with the funds received are included in cash equivalents and/or short-term marketable securities. Marketable securities managed for long-term yield and not required for working capital are classified as long-term investments and are carried at cost. At December 31, 1993, these long-term investments included $94.0 million in a trust fund to implement the Company's agreement with the New York City Industrial Development Agency. (Under this agreement, the Company is required to invest in production facilities and develop new broadcasting and production technologies in New York City in return for certain tax incentives and low-cost energy.) Other marketable securities are classified as current assets and are carried at the aggregate of the lower of cost or market value. Marketable securities, in current assets, also included accrued interest on short-term and long-term marketable securities at December 31, 1993, 1992 and 1991 of $20.4 million, $20.1 million and $19.3 million, respectively. The market values of these securities were as follows (in millions): December 31 1993 1992 1991 Marketable securities (current) . . . . . $405.0 $317.4 $198.7 Marketable securities (noncurrent). . . . 878.5 811.2 660.3 -27 (Page 1 of 2)- As of December 31, 1993, securities sold and the corresponding liabilities (both including accrued interest) under repurchase agreements were as follows (in millions): Maturity Carrying Market Repurchase Term Amount Value Liabilities U.S. Treasury notes up to 30 days $281.6 $302.4 $301.4 U.S. Government agency notes up to 30 days 73.0 73.7 73.3 $354.6 $376.1 $374.7 The loan rates on the repurchase liabilities varied between 2.75% and 3.32% for U.S. Treasury notes and between 3.30% and 3.35% for U.S. Government agency notes. Program rights. Costs incurred in connection with the production of, or the purchase of rights to, programs to be broadcast within one year are classified as current assets while costs of those programs to be broadcast subsequently are considered noncurrent. Program costs are charged to expense as the respective programs are broadcast. -27 (Page 2 of 2)- 1. Statement of Significant Accounting Policies (continued) Property, plant and equipment. Land, buildings, machinery and equipment are stated at cost. Major improvements to existing plant and equipment are capitalized. Expenditures for maintenance and repairs which do not extend the life of the assets are charged to expense as incurred. The cost of properties retired or otherwise disposed of and any related accumulated depreciation are generally removed from the accounts and the resulting gain or loss is reflected in income currently. Depreciation is computed using principally the straight-line method over the estimated useful lives of the assets. Depreciation expense, in millions, for 1993, 1992 and 1991 was $63.1, $58.9 and $53.9, respectively. Goodwill. The goodwill at the date of acquisition of net assets of businesses acquired is amortized over 40 years on a straight-line basis. The increase in 1992 was attributable primarily to the acquisition of Midwest (note 2). Other. In 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (note 11); SFAS No. 109, "Accounting for Income Taxes"; and SFAS No. 112, "Employers' Accounting for Postemployment Benefits." In accordance with the provisions of SFAS No. 112, the Company recorded a one-time pretax charge of $9.9 million for severance and long-term disability-related benefits. These adoptions resulted in a one-time post-tax charge to net income as follows: (In Millions) Per Share Postretirement benefits other than pensions $(76.1) $(4.94) Postemployment benefits . . . . . . . . (6.1) (.39) Income taxes. . . . . . . . . . . . . . .7 .05 $(81.5) $(5.28) The ongoing costs related to these adoptions do not have a material effect on continuing operations. On January 1, 1994, the Company adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." It classified its marketable securities as available-for-sale and recorded an unrealized post- tax holding gain of $34.2 million, net of a tax effect of $23.0 million, in a separate component of shareholders' equity. There was no effect on net income as a result of this adoption. -28 (Page 1 of 2)- 2. Business Acquisitions (Dollars in millions, except per share amounts) In February 1992, the Company acquired substantially all of the assets of Midwest Communications, Inc. (Midwest), including a television station (with two satellite stations) located in Minneapolis, Minnesota (WCCO-TV); a television station (with one satellite station) located in Green Bay, Wisconsin (WFRV-TV); two radio stations located in Minneapolis, Minnesota (WCCO-AM and WLTE-FM); and Midwest Cable & Satellite, which operates Midwest Sports Channel, a supplier of regional sports programming. This transaction was consummated at a price of $177.0 through the issuance of $36.8 of the Company's common stock, valued at an exchange price of $160 per share (the market value of the Company's common stock on the closing date was $144 per share), and the assumption and immediate pay-down of $140.2 of Midwest's debt and other liabilities. In March 1992, the Company acquired for $27.0 the 50 percent interest of MTM Studios, Ltd. in the CBS/MTM Partnership, which operated television and film production facilities in Los Angeles, California. The acquisition of this interest also included the assumption of MTM's partnership mortgage indebtedness. The Company is the sole owner of these television and film production facilities and is obligated for the entire mortgage indebtedness (note 8). These acquisitions were accounted for by the purchase method and the results of their operations from the respective dates of acquisition are included in the accompanying financial statements. Had the acquisitions occurred on January 1, 1991, consolidated results of operations for 1992 and 1991 would not have been materially different. -28 (Page 2 of 2)- 3. Major League Baseball and National Football League Television Contracts (Dollars in millions) In 1991, the Company recorded a $322.0 pretax provision, reflected in cost of sales, for losses over the remaining lives of its Major League Baseball and National Football League television contracts. This provision was in addition to a $282.0 pretax loss on the baseball contract recorded in 1990 and reflected the severely depressed condition of the television sports marketplace. The remaining balances of the loss accruals, recorded to reduce these contracts to their net realizable value, were as follows: December 31 1993 1992 1991 Included in: Other current liabilities . . $ 21.0 $242.0 $160.0 Other liabilities . . . . . . 21.0 263.0 $ 21.0 $263.0 $423.0 -29 (Page 1 of 2)- 4. Interest and Other Income, net (Dollars in millions) Interest income on investments, net, consisted of the following: Year ended December 31 1993 1992 1991 Interest income. . . . . . . . . . . . . . . .$ 75.6 $ 82.1 $103.6 Dividend income. . . . . . . . . . . . . . . . 6.6 8.7 10.4 Interest expense on repurchase agreements. . . (11.4) (12.1) (12.0) Gain on sale of marketable securities, net: Equity securities. . . . . . . . . . . . . . 8.0 10.5 2.1 Other securities . . . . . . . . . . . . . . 31.6 18.4 36.0 $110.4 $107.6 $140.1 The cost of marketable securities sold was determined by specific identification. As of December 31, 1993, gross unrealized gains and gross unrealized losses on equity securities were $18.1 and $.2, respectively. The aggregate cost and market value of the Company's equity securities, all of which were noncurrent, were as follows: December 31 1993 1992 1991 Aggregate cost . . . . . . . . . . . . . . . $74.2 $70.7 $78.1 Aggregate market value . . . . . . . . . . . 92.1 89.0 92.8 Interest expense on debt, net, was net of amounts capitalized in 1993, 1992 and 1991 of $6.4, $10.2 and $8.4, respectively, as part of the cost of investments in property, plant and equipment, made-for-television movies and mini-series. Interest paid on debt in 1993, 1992 and 1991 was $59.6, $76.3 and $56.3, respectively. Other income, net, in 1993, included a pretax gain of $29.5 from a legal settlement with Viacom International Inc., a portion of which constituted payment for rights granted to Viacom to distribute in the United States and abroad certain television programs owned by the Company, and a pretax gain of $12.4 from insurance settlements for hurricane damage to the Company's television station in Miami. It also included other miscellaneous items of income and expense. -29 (Page 2 of 2)- 5. Income Taxes (Dollars in millions) Income tax expense (benefit) consisted of the following: Year ended December 31 1993 1992 1991 Federal: Current . . . . . . . . . . . . . . . . . . $ 60.0 $ 5.2 $ 14.9 Deferred* . . . . . . . . . . . . . . . . . 54.3 40.4 (81.2) Other: Current . . . . . . . . . . . . . . . . . . 9.3 1.8 2.9 Deferred* . . . . . . . . . . . . . . . . . 29.5 17.1 (16.5) $153.1 $64.5 $(79.9) *Deferred taxes: Accrual on baseball and football television contracts. . . . . . . . . . $ 97.3 $62.9 $(91.6) Federal tax audit settlement. . . . . . . . (23.0) (17.9) Federal tax law changes . . . . . . . . . . (11.2) Write-down of marketable securities . . . . 6.6 11.9 1.4 Amortization of intangibles . . . . . . . . (1.3) 13.9 .4 Other state and local taxes . . . . . . . . 7.9 11.9 (11.9) Other, net. . . . . . . . . . . . . . . . . 7.5 (25.2) 4.0 $ 83.8 $57.5 $(97.7) Income taxes of $94.2 were paid in 1993. In 1992 and 1991, there were net income tax refunds of $2.6 and $2.4, respectively. In 1991, the Company's loss from continuing operations before income taxes reflected significant provisions for future losses over the remaining lives of its Major League Baseball and National Football League television contracts, as explained in note 3. The tax benefits attributable to these charges were included in deferred taxes and are realized as the transactions provided for become taxable events. Reconciliations between the statutory Federal income tax expense (benefit) rate and the Company's effective income tax expense (benefit) rate as a percentage of income (loss) from continuing operations before income taxes were as follows: Year ended December 31 1993 1992 1991 Statutory Federal income tax expense (benefit) rate. . . . . . . . . . . . . . . 35.1% 34.1% (34.1)% Federal tax audit settlement. . . . . . . . (4.8) (7.9) Federal tax law changes . . . . . . . . . . (2.3) Income from tax preference securities . . . (1.9) (4.2) (5.6) State and local taxes . . . . . . . . . . . 5.2 5.3 (5.2) Other, net. . . . . . . . . . . . . . . . . .6 1.1 .1 Effective income tax expense (benefit) rate. 31.9% 28.4% (44.8)% 5. Income Taxes (continued) Deferred tax assets and liabilities consisted of the following*: December 31 1993 1992 Deferred tax assets: Accrual on baseball and football television contracts. . . . . . . . . . . . . . $ 9.0 $110.2 Postretirement benefits other than pensions. . . 67.5 65.0 Employee benefits. . . . . . . . . . . . . . . . 21.6 19.6 Other. . . . . . . . . . . . . . . . . . . . . . 76.3 50.7 $174.4 $245.5 Deferred tax liabilities: Property, plant and equipment. . . . . . . . . . $ 89.6 $ 90.0 Safe harbor leases . . . . . . . . . . . . . . . 97.6 96.5 Other. . . . . . . . . . . . . . . . . . . . . . 79.2 90.5 $266.4 $277.0 *Recoverable income taxes, reflected in the balance sheet at December 31, 1993 and 1992, include current deferred tax assets of $41.2 and $147.1, respectively, reduced by current deferred tax liabilities of $12.4 and $30.0, respectively. The remaining deferred tax liabilities, net of deferred tax assets, were reflected in the balance sheet as deferred income taxes. -31 (Page 1 of 2)- 6. Earnings Per Share Data (In thousands) The data used in the computation of earnings per share were as follows: Year ended December 31 1993 1992 1991 Earnings: Income (loss) from continuing operations . $326,188 $162,479 $(98,634) Add post-tax interest on convertible debentures*. . . . . . . . . . . . . . . 3,288 12,259 12,277 Less dividends on preference stock . . . . (12,688) (12,688) (12,688) Income (loss) from continuing operations applicable to common shares. . . . . . . 316,788 162,050 (99,045) Discontinued operations. . . . . . . . . . 12,871 Cumulative effects of changes in accounting principles. . . . . . . . . . (81,472) Net income (loss) applicable to common shares. . . . . . . . . . . . . . $316,788 $ 80,578 $(86,174) Shares: Weighted average shares outstanding. . . . 14,797 13,423 14,217 Add common stock equivalents: Convertible debentures*. . . . . . . . . 649 1,953 1,953 Other. . . . . . . . . . . . . . . . . . 92 40 35 Adjusted weighted average shares outstanding. . . . . . . . . . . . 15,538 15,416 16,205 *The debentures were converted in May 1993. Conversion was assumed for all prior periods. In 1993, fully diluted earnings per share was considered equal to primary earnings per share because the addition of potentially dilutive securities that were not common stock equivalents would have resulted in immaterial dilution. In 1992 and 1991, the fully diluted earnings per share calculation produced an antidilutive effect. - 31 (Page 2 of 2)- 7. Discontinued Operations As a result of the final settlement of all disputed items in arbitration, the Company recorded an additional gain in 1991 related to the 1988 sale of its Records Group. Income tax expense applicable to this additional gain was $8.3 million. -32 (Page 1 of 2)- 8. Long-Term Debt (Dollars in millions) Long-term debt consisted of the following: December 31 1993 1992 1991 7 5/8% senior notes due 2002. . . . . . . . . $150.0 $150.0 7 3/4% senior notes due 1999. . . . . . . . . 125.0 125.0 8 7/8% senior debentures due 2022 . . . . . . 125.0 125.0 7 1/8% senior notes due 2023. . . . . . . . . 100.0 9.03% mortgage due 1998 . . . . . . . . . . . 27.0 51.0 5% convertible debentures due 2002. . . . . . 390.5 $390.5 10 7/8% senior notes due 1995 . . . . . . . . 263.0 7.85% debentures due 2001 . . . . . . . . . . 25.0 Capital lease obligations . . . . . . . . . . 19.4 20.4 21.5 Other debt. . . . . . . . . . . . . . . . . . 44.8 21.1 Reclassified to current debt. . . . . . . . . (.9) (13.0) (3.5) $590.3 $870.0 $696.5 During 1993, 1992 and 1991, debt was repurchased, redeemed or converted as follows: Year ended December 31 1993 1992 1991 5% convertible debentures due 2002. . . . . . $390.5 $ 9.5 9.03% mortgage due 1998 . . . . . . . . . . . 24.0 10 7/8% senior notes due 1995 . . . . . . . . $263.0 3.0 7.85% debentures due 2001 . . . . . . . . . . 25.0 2.5 $414.5 $288.0 $15.0 In May 1993, the Company converted $389.6 of its 5% convertible debentures into 1,947,975 shares of its common stock, issued from its treasury shares (note 12). The difference between the amount of debt converted, net of unamortized issue costs, and the average cost of the treasury shares issued was credited to additional paid-in-capital. The remaining debentures of $.9 were redeemed. The principal terms of the various long-term issues are as follows: The 7 5/8% senior notes, issued in connection with the acquisition of Midwest (note 2), are due January 1, 2002 and may not be redeemed prior to maturity. The 7 3/4% senior notes are due June 1, 1999 and may not be redeemed prior to maturity. The 8 7/8% senior debentures are due June 1, 2022 and may not be redeemed prior to June 1, 2002. On and after that date they may be redeemed, at the option of the Company, as a whole at any time, or in part from time to time, at specified redemption prices. The net proceeds from the issuance of the 7 3/4% senior notes due June 1, 1999 and the 8 7/8% senior debentures due June 1, 2022 were used to retire the 10 7/8% senior notes due August 1, 1995. -32 (Page 2 of 2)- 8. Long-Term Debt (continued) The 7 1/8% senior notes are due on November 1, 2023 and may not be redeemed prior to maturity. The proceeds from the issuance of these debt securities were used to purchase New York City Industrial Development Agency (IDA) bonds, which were issued by the IDA to establish a trust fund to implement the Company's agreement with the IDA. Under this agreement, the Company is required to invest in production facilities and develop new broadcasting and production technologies in New York City in return for certain tax incentives and low-cost energy. The 9.03% mortgage, which was recorded as a result of the Company's acquisition of the remaining 50 percent interest in the CBS/MTM Partnership (note 2), is due $12.0 on July 15, 1996 and $15.0 on July 15, 1998. The aggregate amounts of maturities of the Company's long-term debt for each of the five years subsequent to December 31, 1993 are as follows: 1994. . . . . . . . . . . . . . . $ .9 1995. . . . . . . . . . . . . . . .6 1996. . . . . . . . . . . . . . . 12.7 1997. . . . . . . . . . . . . . . 23.3 1998. . . . . . . . . . . . . . . 40.2 To meet the disclosure requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," the Company estimated that, based primarily on quoted market prices for its traded issues, the fair value of its long- term debt at December 31, 1993 exceeded its book value by approximately $38.0. It is anticipated, however, that the debt ultimately will be redeemed at amounts approximating its book value. -33 (Page 1 of 3)- 9. Environmental Liabilities The Company continually evaluates its environmental liabilities and has determined that, as of December 31, 1993, 1992, and 1991, its recorded liabilities were adequate to cover asserted and unasserted claims arising from the operations of its discontinued businesses. These liabilities were not reduced by any potential recoveries from insurance companies or others. There are no significant environmental claims known to the Company arising from its continuing operations. -33 (Page 2 of 3)- 10. Commitments and Contingent Liabilities (Dollars in millions) The Company routinely enters into commitments to purchase the rights to broadcast programs, including feature films and sports events. These contracts permit the broadcast of such properties for various periods ending no later than September 1999. As of December 31, 1993, the Company was committed to make payments of $1,451.5 under such broadcasting contracts. Rent expense, excluding payments of real estate taxes, insurance and other expenses required under some leases, amounted to $50.3, $53.6 and $57.8 in 1993, 1992 and 1991, respectively. At December 31, 1993, minimum future rental payments and receipts under noncancelable leases (including capital leases and subleases, which were not significant) were as follows: Payments Receipts 1994. . . . . . . . . . . $18.4 $ 10.1 1995. . . . . . . . . . . 13.3 9.7 1996. . . . . . . . . . . 11.2 9.6 1997. . . . . . . . . . . 8.1 9.5 1998. . . . . . . . . . . 6.4 9.4 1999 and thereafter . . . 30.0 58.7 $87.4 $107.0 The Company did not have any significant concentrations of credit risk at December 31, 1993. -33 (Page 3 of 3)- 11. Retirement Plans (Dollars in millions) The Company has pension plans covering substantially all of its employees. Benefits are based on formulas that consider years of service and average compensation. The Company's general policy is to fund pension costs accrued over the lives of the plans to the extent the contributions will be tax- deductible. At December 31, 1993, the aggregate market value of all plan assets exceeded the projected benefit obligations of all plans by $91.3. This net amount consisted of $145.8 related to plans whose assets exceeded their projected benefit obligations and $54.5 related to plans whose projected benefit obligations exceeded their assets. Those plans whose projected benefit obligations exceeded their assets are excluded from coverage under Section 4021(b) of the Employee Retirement Income Security Act of 1974 (ERISA). The assets of the funded plans consisted primarily of interest-bearing securities. The net pension costs for 1993, 1992 and 1991 were as follows: Year ended December 31 1993 1992 1991 Service cost . . . . . . . . . . . . $16.8 $ 15.9 $ 15.4 Interest cost. . . . . . . . . . . . 41.6 39.3 38.4 Net amortization and deferral. . . . (2.6) (25.1) 29.4 55.8 30.1 83.2 Less return on plan assets . . . . . 55.5 33.8 84.2 Net pension cost (credit). . . . . . $ .3 $ (3.7) $ (1.0) Reconciliations of the funded status of these plans were as follows: December 31 1993 1992 1991 Plans whose assets exceed accumulated benefits Accumulated pension benefit obligation: Vested . . . . . . . . . . . . . . . . . $391.7 $352.5 $336.0 Nonvested. . . . . . . . . . . . . . . . 20.4 18.0 22.3 $412.1 $370.5 $358.3 Market value of plan assets. . . . . . . . $669.1 $637.4 $636.5 Less projected pension benefit obligation . . . . . . . . . . . . . . . 523.3 473.2 455.0 Assets exceed projected benefit obligation . . . . . . . . . . . . . . . 145.8 164.2 181.5 Less items not yet recognized in net periodic pension cost: Unrecognized net asset . . . . . . . . . 84.3 94.6 105.3 Unrecognized net gain. . . . . . . . . . 31.1 55.6 73.0 Unrecognized prior service cost. . . . . 1.1 (10.0) (10.8) Pension asset excluding unrecognized items*. . . . . . . . . . . . . . . . . $ 29.3 $ 24.0 $ 14.0 * Amounts recognized in the Consolidated Balance Sheets. Unrecognized items, in the aggregate, will be recognized in future years as a net reduction in pension expense and pension liability under the provisions of SFAS No. 87, "Employers' Accounting for Pensions." 11. Retirement Plans (continued) December 31 1993 1992 1991 Plans whose accumulated benefits exceed assets Accumulated pension benefit obligation: Vested . . . . . . . . . . . . . . . . . $ 26.3 $ 20.0 $ 17.4 Nonvested. . . . . . . . . . . . . . . . 2.9 2.3 2.3 $ 29.2 $ 22.3 $ 19.7 Market value of plan assets. . . . . . . . $ - $ - $ - Less projected pension benefit obligation . . . . . . . . . . . . . . 54.5 34.4 31.0 Assets (are less than) projected benefit obligation. . . . . . . . . . . . . . . (54.5) (34.4) (31.0) Additional minimum (liability) . . . . . . (.6) (.6) (.9) (55.1) (35.0) (31.9) Less items not yet recognized in net periodic pension cost: Unrecognized net (liability). . . . . . (5.1) (5.7) (6.4) Unrecognized net (loss) . . . . . . . . (8.7) (1.9) (.9) Unrecognized prior service cost . . . . (10.0) (.3) (.5) Pension (liability) excluding unrecognized items* . . . . . . . . . $(31.3) $(27.1) $(24.1) *Amounts recognized in the Consolidated Balance Sheets. Unrecognized items, in the aggregate, will be recognized in future years as a net increase in pension expense and pension liability under the provisions of SFAS No. 87, "Employers' Accounting for Pensions." The Company also participates in various multi-employer union-administered defined benefit pension plans that cover certain broadcast employees. Pension expense under these plans for 1993, 1992 and 1991 was $10.2, $9.2 and $7.9, respectively. In addition to providing pension benefits, the Company provides medical and life insurance benefits for its retired employees. Substantially all of the Company's nonunion employees may become eligible for these benefits when they retire from the Company. Also included are those union employees covered by a collective bargaining agreement that provides for such benefits. During 1991, the Company made certain revisions to its retiree medical insurance program. Effective January 1, 1992, most current retirees and all future retirees were required to contribute to the cost of this coverage, and a maximum outlay by the Company for this cost was established. In addition, all retirees whose employment started after March 31, 1991 may maintain their coverage only if they pay its full cost. In 1992, the Company implemented, on the immediate recognition basis, SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and recorded a transition obligation that resulted in a charge to net income of $76.1, net of an income tax benefit of $49.3. 11. Retirement Plans (continued) Under the new guidelines, the costs of the benefits are accrued over a period ending with the date that the qualified employees become eligible to retire, and future inflation of medical costs is considered in the determination of these costs. As a result, the costs of providing these benefits were as follows: Year ended December 31 1993 1992 Service cost . . . . . . . . . . . . . . . . $ 1.9 $ 1.9 Interest cost. . . . . . . . . . . . . . . . 14.1 14.6 Net amortization and deferral. . . . . . . . 1.9 17.9 16.5 Less return on plan assets . . . . . . . . . 5.5 3.4 Net periodic postretirement benefit cost . . $12.4 $13.1 Prior to the implementation of SFAS No. 106, the Company's practice was to determine the costs of these benefits actuarially, without considering future inflation of medical costs, and to accrue these costs over the working lives of those employees expected to qualify for the benefits. The costs of providing these benefits under this method in 1991 were $5.1. The Company's general policy is to fund accrued postretirement medical and life insurance costs to the extent the contributions will be tax- deductible. The funded assets consisted primarily of interest-bearing securities. The funded status of the postretirement medical and life insurance plans were as follows: December 31 1993 1992 Accumulated postretirement benefit obligation (APBO): Retirees. . . . . . . . . . . . . . . . . . . $141.1 $152.6 Fully eligible active plan participants . . . 17.1 16.0 Other active plan participants. . . . . . . . 34.1 30.2 192.3 198.8 Less market value of plan assets . . . . . . . 52.0 46.4 Assets are less than accumulated postretirement benefit obligation . . . . . . 140.3 152.4 Add unrecognized net gain. . . . . . . . . . . 16.9 Postretirement benefit liability recognized in the balance sheet. . . . . . . . . . . . . $157.2 $152.4 The calculations for the postretirement medical and life insurance plans were based on an actuarial assumption of a medical inflation rate of 14.0 percent in 1993, grading down to 7.0 percent in the year 2000. The effect of a one- percentage-point annual increase in the assumed medical inflation rates would increase the APBO by approximately $1.7; the annual service cost would not be materially affected. -36 (Page 1 of 2)- The actuarial assumptions used in computing the funded status of the pension plans and the postretirement medical and life insurance plans were as follows: 1993 1992 1991 Weighted average discount rate . . . . 7.5% 8.0% 8.0% Rate of compensation increase. . . . . 6.0% 6.5% 6.5% Weighted average long-term rate of return on plan assets . . . . . . 8.0% 8.0% 8.0% All costs in this note relate to the covered employees of both the continuing and discontinued operations of the Company. -36 (Page 2 of 2)- 12. Common Stock (Dollars in millions, except per share amounts) As a result of a tender offer in December 1990, the Company purchased 10.5 million of its shares, at $190 per share, in February 1991 and funded the purchase from available cash and the sale of marketable securities. In 1993, the Company converted $389.6 of its 5% convertible debentures into 1,947,975 shares of its common stock, issued from its treasury shares (note 8). Changes in common stock during 1991, 1992 and 1993 were as follows: Issued Treasury Shares Amount Shares Amount (Shares in thousands) Balance - December 31, 1990 . . . . . . . 24,644 $60.5 960 $ 72.6 Conversions of preference stock . . . . . (4) (.3) Issuances under employee benefit plans. . 31 .1 (8) (.4) Repurchases of common stock . . . . . . . 10,556 2,005.1 Conversions of convertible debentures . . 47 .1 Reclassification of common stock subject to redemption (note 13). . . . . . . . . 1.1 Balance - December 31, 1991 . . . . . . . 24,722 61.8 11,504 2,077.0 Conversions of preference stock . . . . . (7) (1.3) Issuances under employee benefit plans. . 17 (4) (.2) Repurchases of common stock . . . . . . . 22 3.0 Acquisition of Midwest (note 2) . . . . . (230) (41.6) Balance - December 31, 1992 . . . . . . . 24,739 61.8 11,285 2,036.9 Issuances under employee benefit plans. . 78 .2 (4) (.2) Conversions of convertible debentures . . (1,948) (352.2) Balance - December 31, 1993 . . . . . . . 24,817 $62.0 9,333 $1,684.5 See notes 8 and 15 for additional information about the Company's common stock. -37 (Page 1 of 2)- 13. Common Stock Subject to Redemption In July 1985, the Company offered to repurchase 6.365 million shares of its common stock. In consideration for not tendering their shares pursuant to the offer, William S. Paley, certain members of his family and other related entities received the right to sell to the Company a maximum of 434,489 shares at $150 per share. Certain of these rights were relinquished in connection with the Company's December 1990 tender offer (note 12) and the remaining rights expired in October 1991. The common stock subject to redemption was therefore reclassified to the appropriate components of shareholders' equity, as indicated in the Consolidated Statements of Retained Earnings and Additional Paid-In Capital and in note 12. -37 (Page 2 of 2)- 14. Preference Stock The Company's certificate of incorporation provides authority for the issuance of 6.0 million shares of preference stock, $1 par value. In 1985, the Company issued 1.25 million shares of preference stock, specifically authorized and designated as $10 Convertible Series B preference stock. The net proceeds of the issuance was $123.1 million. The issue has an aggregate liquidation preference of $125.0 million. The difference between the redemption value and the net proceeds from the issue is being amortized to retained earnings over 10 years. Each share is entitled to receive cumulative cash dividends at the rate of $10 per year, payable in equal quarterly installments, is subject to mandatory redemption on August 1, 1995, and is convertible, at the option of the holder, into .6915 of a share of common stock. At December 31, 1993 there were 1.25 million shares of Series B preference stock outstanding, for which there were 864,375 common shares reserved for issuance upon conversion. Upon redemption, or in the event of voluntary or involuntary liquidation, each shareholder will be entitled to $l00 per share plus any accrued or unpaid dividends. The terms of the Series B preference stock provide that the Company may not take any action that would result in the Company's ratio of total debt to total capitalization exceeding .75 to 1. As of December 31, 1993, this ratio was .32 to 1. -38 (Page 1 of 2)- 15. Stock Rights Plan The Company's 1983 Stock Rights Plan (as amended) has been approved by the Company's shareholders. It is administered by the Compensation Committee of the Board of Directors (the "Committee"), consisting entirely of outside directors, and under the terms of the plan certain key employees (including officers, who may also be directors) of the Company may be granted nonqualified stock options at an exercise price not less than 100 percent of the closing market price of a share of common stock on the date of the grant. These are ten-year options that become exercisable in installments of 25 percent per year, with the first installment commencing one year following the date of grant. The plan also provides that option grants to any one participant in a calendar year may not exceed 15,000 underlying shares of common stock. Prior to May 7, 1991, options granted to officers subject to the "short swing" profit provisions of Section 16 of the Securities and Exchange Act of 1934 (as amended) were coupled with alternative stock appreciation rights (SAR's) which enabled such holder to receive in cash or shares the excess of the common stock price on the date of exercise over the option price (the "spread"). Due to the manner in which the grant of an option to a person subject to the provisions of Section 16 is now treated by the Securities and Exchange Commission, the Committee has taken action to provide that options granted after May 7, 1991 would not be coupled with SAR's. In November 1985, the Plan was amended to provide that then outstanding options not coupled with SAR's would be subject to limited SAR's. (Such limited SAR's provided for treatment of the spread similar to that of alternative SAR's and became exercisable only if certain defined changes in control or concentration of equity ownership of the Company occurred.) The limited SAR feature was not extended to any option grants subsequent to 1986. The Plan provides that the Committee can authorize dividend share credits on outstanding options and on previously issued dividend share credits. Such credits are recorded in shares of common stock based on cash dividends paid to holders of common stock. In 1986, the Committee permanently suspended granting dividend share credits. The Plan provides that a maximum of 1.5 million shares in the aggregate are available for option grants and dividend share credits. Options granted to purchase 171,376 shares of common stock were exercisable at December 31, 1993. The number of shares available for option grants and dividend share credits, should the Committee choose to reintroduce the granting of such credits, was 369,200 shares, 550,745 shares and 634,945 shares at December 31, 1993, 1992 and 1991, respectively. To record the estimated cost of the Plan, in 1993 and 1992, $6.1 and $.7 million, respectively, were charged to income and, in 1991, $.5 million was credited to income (to adjust prior accruals). The Plan also provides that, absent shareholder approval, options may not be granted after 2001, options for more than 15,000 underlying shares may not be granted to any one participant in any calendar year, and options for an aggregate of 1.5 million underlying shares may not be granted. -38 (Page 2 of 2)- 15. Stock Rights Plan (continued) The following table summarizes the activity under the Plan during the years ended December 31, 1991, 1992 and 1993: Options With Stock Appreciation Rights Other* Dividend Common Common Share Shares Exercise Price Shares Exercise Price Credits Outstanding - December 31, 1990 68,050 $72 -$191 1/2 219,618 $56 1/4-$191 1/2 3,201 Granted. . . 85,600 159 7/8 Exercised. . ( 700) 118 3/4 (30,781) 56 1/4- 163 5/8 (1,678) Cancelled. . (4,500) 163 5/8- 191 1/2 (18,450) 159 7/8- 191 1/2 _____ Outstanding - December 31, 1991 62,850 72 - 191 1/2 255,987 56 1/4- 191 1/2 1,523 Granted. . . 91,600 191 1/2 Exercised. . (2,000) 118 3/4- 163 5/8 (16,762) 56 1/4- 191 1/2 (325) Cancelled. . ______ (8,400) 159 7/8- 191 1/2 Outstanding - December 31, 1992 60,850 72 - 191 1/2 322,425 56 1/4- 191 1/2 1,198 Granted. . . 93,000 237 1/8 Exercised. . (20,500) 72 - 191 1/2 (77,550) 56 1/4- 191 1/2 (883) Cancelled. . ______ (5,750) 159 7/8- 237 1/8 _____ Outstanding - December 31, 1993 40,350 $163 5/8-$191 1/2 332,125 $76 3/4-$237 1/8 315 *All grants outstanding which were issued prior to January 1, 1987 contain limited stock appreciation rights as explained above. At December 31, 1993, there were 12,450 options of this type outstanding with exercise prices between $76 3/4 and $136 5/8. -39 (Page 1 of 2)- 16. Litigation Various legal actions, governmental proceedings and other claims (including those relating to environmental investigations and remediation resulting from the operations of discontinued businesses) are pending or, with respect to certain claims, unasserted. The Company believes that the liabilities, if any, which may result from such litigation, proceedings or claims are not reasonably likely to have a material adverse effect on its consolidated financial position, results of operations, or liquidity. -39 (Page 2 of 2)- OTHER FINANCIAL INFORMATION QUARTERLY RESULTS OF OPERATIONS (Unaudited) (Dollars in millions, except per share amounts) The quarterly results of operations for the years ended December 31, 1993 and 1992 were as follows: 1993 1992 1993 1992 Net Sales Operating Income 1st Quarter . . . . . . . $ 878.7 $1,082.6 $ 62.5 $ 17.6 2nd Quarter . . . . . . . 835.7 779.9 153.2 83.7 3rd Quarter . . . . . . . 752.9 672.2 132.8 39.0 4th Quarter . . . . . . . 1,042.8 968.3 62.7 39.8 $3,510.1 $3,503.0 $411.2 $180.1 Income from Continuing Operations Net Income (Loss) 1st Quarter . . . . . . . $ 54.2 $ 17.5 $ 54.2 $(64.0) 2nd Quarter . . . . . . . 107.4 69.0 107.4 69.0 3rd Quarter . . . . . . . 118.2 42.7 118.2 42.7 4th Quarter . . . . . . . 46.4 33.3 46.4 33.3 $ 326.2 $162.5 $326.2 $ 81.0 Income from Continuing Operations Net Income (Loss) Per Common Share Per Common Share 1st Quarter . . . . . . . $ 3.50 $ 1.14 $ 3.50 $(4.18) 2nd Quarter . . . . . . . 6.73 4.46 6.73 4.46 3rd Quarter . . . . . . . 7.39 2.76 7.39 2.76 4th Quarter . . . . . . . 2.77 2.14 2.77 2.14 $20.39 $10.51 $20.39 $ 5.23 The first quarter of 1992 included a net charge of $81.5 ($5.32 per share) to net income for the adoption of SFAS No. 106, SFAS No. 109 and SFAS No. 112 (note 1). Quarterly and full year per share amounts are calculated independently based on the adjusted weighted average number of outstanding common shares applicable to each period. In 1992, because of the issuance of shares in connection with the acquisition of Midwest (note 2), the sum of the four quarters per common share does not equal the full year. SHAREHOLDER REFERENCE INFORMATION Stock Data The principal market for CBS common stock is the New York Stock Exchange. It is also traded on the Pacific Stock Exchange. There were 11,629 holders of record of CBS common stock as of December 31, 1993. The following table indicates the quarterly high and low prices for CBS common stock as reported in the quotations of consolidated trading for issues on the New York Stock Exchange during the past two years: 1993 1992 1993 1992 High Low 1st Quarter . . . . . . . $217 3/4 $176 7/8 $186 1/8 $136 2nd Quarter . . . . . . . 250 1/2 209 7/8 214 164 5/8 3rd Quarter . . . . . . . 277 7/8 217 228 182 1/4 4th Quarter . . . . . . . 326 1/2 220 1/2 268 5/8 176 Dividends Dividends on CBS common stock were paid quarterly at $.25 per share in 1992 and for the first three quarters of 1993, and at $.50 per share for the fourth quarter of 1993. In 1993 and 1992, dividends were paid quarterly at $2.50 per share on CBS Series B preference stock. Transfer Agent and Registrar Independent Certified Public Accountants First Chicago Trust Company Coopers & Lybrand of New York 1301 Avenue of the Americas P.O. Box 2500 New York, New York 10019 Jersey City, New Jersey 07303-2500 Annual Meeting The 1994 annual meeting of shareholders of CBS Inc. will be held at 11 A.M., Wednesday, May 11, 1994, at The Museum of Modern Art, 11 West 53 Street, New York, New York. Form 10-K Annual Report The Form 10-K Annual Report for the Company's 1993 fiscal year, filed with the Securities and Exchange Commission, contains certain financial information and, when appropriate, other matters concerning the Company which are required to be reported to the SEC. Shareholders who wish a copy of this report may obtain one, without charge, upon request to the CBS Shareholder Relations Department, 51 West 52 Street, New York, New York 10019. Schedule I (Page 1 of 4) CBS INC. and SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS As of December 31, 1993 (In Thousands) ____________________ Col. A Col. B Number of Shares or Units - Principal Name of Issuer and Amount of Title of Each Issue Bonds and Notes U.S. Government and its Agencies $122,430 States and their Agencies 2,140 Corporations Bonds: Time Warner 23,985 Other 52,656 Money Markets: Bank of America 18,000 Other 60,478 Asset Backed Securities 41,880 Notes 41,300 Other 36,250 -42 (Page 1 of 2)- Schedule I (Page 2 of 4) CBS INC. and SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS As of December 31, 1993 (In Thousands) ____________________ Col. A Col. C Col. D Col. E Amount at Which Each Portfolio of Equity Security Issues and Each Market Value of Other Security Name of Issuer and Cost of Each Issue at Issue is Carried in Title of Each Issue Each Issue Balance Sheet Date the Balance Sheet U.S. Government and its Agencies $121,998 $123,715 $121,998 States and their Agencies 2,140 2,140 2,140 Corporations Bonds: Time Warner 23,209 24,714 23,209 Other 53,420 54,023 53,420 Money Markets: Bank of America 18,006 18,045 18,006 Other 60,458 60,633 60,458 Asset Backed Securities 41,945 41,967 41,945 Notes 42,921 43,198 42,921 Other 36,221 36,522 36,221 $400,318 $404,957 400,318 Accrued Interest on Short-Term and Long-Term Securities 20,406 TOTAL SHORT-TERM MARKETABLE SECURITIES $420,724 -42 (Page 2 of 2)- Schedule I (Page 3 of 4) CBS INC. and SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS As of December 31, 1993 (In Thousands) ____________________ Col. A Col. B Number of Shares or Units - Principal Name of Issuer and Amount of Title of Each Issue Bonds and Notes Amount Shares U.S. Government and its Agencies $296,000 States and their Agencies 61,365 Political Subdivisions of States, and their Agencies Utah 40,070 Florida 23,675 Georgia 21,525 Washington 20,975 New Mexico 18,395 California 17,530 New York 13,575 Alabama 13,515 Texas 13,495 Illinois 12,935 Other 52,390 Corporations Preferred Stock Banks 1,108 Other 1,326 Time Warner Convertible Bonds 21,592 Asset Backed Securities 30,382 Other 64,657 -43 (Page 1 of 2)- Schedule I (Page 4 of 4) CBS INC. and SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS As of December 31, 1993 (In Thousands) ____________________ Col. A Col. C Col. D Col. E Amount at Which Each Portfolio of Equity Security Issues and Each Market Value of Other Security Name of Issuer and Cost of Each Issue at Issue is Carried in Title of Each Issue Each Issue Balance Sheet Date the Balance Sheet U.S. Government and its Agencies $286,914 $308,306 $286,914 States and their Agencies 66,324 68,324 66,324 (a) Political Subdivisions of States, and their Agencies Utah 42,332 44,400 42,332 Florida 25,708 26,795 25,708 (b) Georgia 22,966 23,887 22,966 Washington 23,384 24,477 23,384 New Mexico 21,005 20,897 21,005 California 19,955 20,441 19,955 (c) New York 14,572 15,434 14,572 (d) Alabama 15,268 15,211 15,268 Texas 14,247 14,762 14,247 (e) Illinois 14,265 14,921 14,265 (f) Other 56,069 59,030 56,069 (g) Corporations Preferred Stock Banks 38,915 53,025 38,915 Other 45,215 49,352 45,215 Time Warner Convertible Bonds 22,475 22,726 22,475 Asset Backed Securities 30,475 30,466 30,475 Other 65,915 66,093 65,915 TOTAL LONG-TERM MARKETABLE SECURITIES $826,004 $878,547 $826,004 (a) Includes $18,596 (Maryland $8,335, New York $5,561, and Massachusetts $4,700) for which insurance exists if the issuer defaults. (b) Includes $16,502 for which insurance exists if the issuer defaults. (c) Includes $7,785 for which insurance exists if the issuer defaults. (d) Includes $4,455 for which insurance exists if the issuer defaults. (e) Includes $14,247 for which insurance exists if the issuer defaults. (f) Includes $2,120 for which insurance exists if the issuer defaults. (g) Includes $7,654 (Maryland $4,000, Washington, D.C. $2,160 and Minnesota $1,494) for which insurance exists if the issuer defaults. -43 (Page 2 of 2)- Schedule II CBS INC. and SUBSIDIARIES AMOUNTS RECEIVABLE from RELATED PARTIES and UNDERWRITERS, PROMOTERS, and EMPLOYEES other than RELATED PARTIES for the years ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) ____________________ Col. A Col. B Col. C Balance at Beginning Name of Debtor of Period Additions Year ended December 31, 1993: Peter Tortorici - $350 (A) Martin Franks $243 $ 19 Year ended December 31, 1992: Martin Franks $ 61 $183 (B) Year ended December 31, 1991: Martin Franks - $ 61 (B) Col. A Col. D Col. E Deductions Amounts Amounts Balance at End of Period Name of Debtor Collected Written Off Current Not Current Year ended December 31, 1993: Peter Tortorici - - $350 - Martin Franks - - $ 87 $175 Year ended December 31, 1992: Martin Franks $ 1 - $ 68 $175 Year ended December 31, 1991: Martin Franks - - $ 61 - (A) A note receivable for $350.0 at 8% dated 12/1/93 and due 11/30/94. (B) Includes a note receivable for $60.0 at 8% dated 9/25/91, a note receivable for $175.0 at 8% dated 10/13/92, and related accrued interest. By agreement dated January 3, 1994, Registrant will forgive 25% of these loans (and accrued interest) in each of January 1994, 1995, 1996 and 1997. Schedule X CBS INC. and SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION For the years ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) ____________________ Col. A Col. B Item Charged to Costs and Expenses 1993 1992 1991 Advertising costs $107,129 $98,781 $93,957 Depreciation and amortization $70,983 $66,689 $59,882 INDEX TO EXHIBITS Number Description ______ ___________ 3-A Restated Certificate of Incorporation of registrant, as amended May 13, 1988 and filed as Exhibit 3 to Form 10-Q for the quarter ended June 30, 1988.* 3-B By-Laws of registrant, as amended to March 11, 1994, is filed herewith. 4-A See Article 3 of Restated Certificate of Incorporation, as amended, filed as Exhibit 3-A to Form 10-K for 1992.* 4-B(i) Indenture dated as of January 2, 1992 between Registrant and The Chase Manhattan Bank (National Association), as Trustee, filed as Exhibit 4-F(i) to Form 10-K for 1991.* (ii) Specimen Form of 7-5/8% Senior Note Due 2002, filed as Exhibit 4-F(ii) to Form 10-K for 1991.* (iii) Specimen Form of 8-7/8% Senior Debenture Due 2022, issued May 21, 1992, filed as Exhibit 4-D(iii) to Form 10-K for 1992.* (iv) Specimen Form of 7-3/4% Senior Note Due 1999, issued May 21, 1992, filed as Exhibit 4-D(iv) to Form 10-K for 1992.* (v) Specimen Form of 7-1/8% Senior Note Due 2023, issued October 28, 1993, is filed herewith. 4-C Pursuant to Regulation S-K Item 601(b)(4), CBS agrees to furnish to the Securities and Exchange Commission, upon request, a copy of other instruments defining the rights of holders of long-term debt of CBS. 10-A CBS Additional Compensation Plan, filed as Exhibit 10-A to Form 10-K for 1980.* 10-B CBS Stock Rights Plan, as amended effective March 13, 1991, filed as Exhibit 10-B to Form 10-K for 1991.* 10-C CBS Pension Plan, dated as of October 1, 1969, and all amendments through March 11, 1992, filed as Exhibit 10-C to Form 10-K for 1992.* Amendment No. 13 to such Plan, dated July 14, 1993 and effective as of April 1, 1992, is filed herewith. 10-D(i) CBS Supplemental Executive Retirement Plan, as amended October 14, 1987, filed as Exhibit 10-C to Registrant's Form 10-K for 1987.* (ii) CBS Supplemental Executive Retirement Plan #2, dated as of January 1, 1989, as amended January 1, 1993, filed as Exhibit 10-D(ii) to Form 10-K for 1992.* 10-E CBS Excess Benefit Plan, dated as of March 9, 1976, effective January 1, 1976, filed as Exhibit 10-E to Form 10-K for 1992.* ____________ * Previously filed as indicated and incorporated herein by reference. - 46 - 10-F Senior Executive Life Insurance Plan, dated July 9, 1990, filed as Exhibit 10-D to Registrant's Form 10-K for 1990.* 10-G CBS Deferred Compensation Plan for Non-Employee Directors, dated as of November 2, 1981, filed as Exhibit 10-G to Form 10-K for 1992.* 10-H CBS Employee Investment Fund, dated as of June 29, 1969, restated to include all amendments through December 30, 1993, is filed herewith. 10-I CBS Retirement Plan for Outside Directors, as amended May 9,1990, filed as Exhibit 10-E to Registrant's Form 10-K for 1990.* 10-J Restricted Stock Plan for Eligible Directors is filed herewith. 10-K Employment Agreement between CBS Inc. and Howard Stringer, dated December 27, 1992, filed as Exhibit 10-J to Form 10-K for 1992.* 10-L Employment Agreement between CBS Inc. and Edward Grebow, dated as of November 8, 1993, is filed herewith. 10-M Employment Agreement between CBS Inc. and Eric W. Ober, dated as of September 1, 1990, filed as Exhibit 10-H to Form 10-K for 1990.* 10-N Employment Agreement between CBS Inc. and Jeffrey F. Sagansky, dated as of July 1, 1992, filed as Exhibit 10-M to Form 10-K for 1992.* 10-O Employment Agreement between CBS Inc. and James A. Warner, dated January 28, 1992, filed as Exhibit 10-J to Form 10-K for 1991.* 10-P Employment Agreement between CBS Inc. and Peter A. Lund, dated as of January 31, 1994, is filed herewith. 10-Q Employment Agreement between CBS Inc. and Johnathan Rodgers, dated as of September 1, 1990, filed as Exhibit 10-O to Form 10-K for 1990.* 11 Computation of per share income is filed herewith. 12 Computation of ratios is filed herewith. 13 Registrant's 1994 Notice of Annual Meeting and Proxy Statement (to be filed on or about April 8, 1994), which except for those portions thereof expressly incorporated by reference elsewhere in this Form 10-K is furnished for the information of the Securities and Exchange Commission and is not to be deemed "filed" as part of the filing. 21 List of registrant's subsidiaries is filed herewith. 23 Consent of Independent Certified Public Accountants is filed herewith (p. 22). 99 Form S-8 Undertakings pursuant to Item 512 of Regulation S-K is filed herewith. ___________________ * Previously filed as indicated and incorporated herein by reference. - 47 - NOTE Copies of the Exhibits filed may be inspected at the Library of the New York Stock Exchange, 11 Wall Street, New York, NY 10005; at the Pacific Stock Exchange, 301 Pine Street, San Francisco, CA 94104; or at the Public Reference Room of the Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. - 48 -

830260_1993.txt

830260_1993

1993

830260

ITEM 1. BUSINESS GENERAL Oregon Steel Mills, Inc. (the "Company" or the "Registrant") was founded in 1926 by William G. Gilmore and was incorporated in California in 1928. The Company reincorporated in Delaware in 1974. The Company changed its name in December 1987 from Gilmore Steel Corporation to Oregon Steel Mills, Inc. The Company has five plant locations, which include two steel mills. During 1993 the Company established the Portland steel and CF&I steel mills and the related downstream finishing facilities as separate business units to be known as the Oregon Steel Division and the CF&I Steel Division. The Oregon Steel Division is centered on the Company's Portland, Oregon steel minimill (the "Portland Steel Mill"), which supplies steel for the Company's steel plate and large diameter pipe finishing facilities. The Portland Steel Mill operates under the name of Oregon Steel Mills, Inc. The wholly-owned and majority-owned operating divisions, which are included in the Oregon Steel Division, are: Oregon Steel Mills -- Fontana Division, Inc., a steel plate rolling mill in Fontana, California (the "Fontana Plate Mill"); Napa Pipe Corporation, a large diameter steel pipe mill and fabrication facility in Napa, California (the "Napa Facility"); and Camrose Pipe Corporation ("CPC") which owns a 60% interest in Camrose Pipe Company, a large diameter pipe and electric resistance welded ("ERW") pipe facility in Camrose, Alberta, Canada (the "Camrose Facility"). The CF&I Steel Division consists of the steelmaking and finishing facilities of CF&I Steel, L.P. ("CF&I") located in Pueblo, Colorado (the "Pueblo Steel Mill"). The Company, through a wholly-owned subsidiary, owns a 95.2 percent general partnership interest in CF&I. The Pueblo Steel Mill is a steel minimill which produces long-length and standard steel rails, seamless oil country tubular goods ("OCTG"), wire rod and wire products, and reinforcing bar. The Company produces eight steel products which include most standard grades of steel plate, a wide range of higher margin specialty steel plate, large diameter steel pipe, ERW pipe, longlength and standard rails, OCTG, wire rod, wire and bar products. The steel industry, including the steel products manufactured by the Company, has been highly cyclical and is currently characterized by overcapacity, both domestically and internationally. The Portland Steel Mill is the only hot-rolled steel plate minimill and one of two steel plate producers located in the eleven western states. The start-up of a ladle metallurgy furnace in November 1990 at the Portland Steel Mill increased the Portland Steel Mill's melting and casting capacity from approximately 640,000 tons to 800,000 tons of steel per year. The Portland Steel Mill produces slab thicknesses of 6, 7 and 8 inches and has an annual rolling mill capacity, depending on product mix, of up to 450,000 tons of finished steel plate in widths of up to 103 inches. The Company's Napa Facility produces large diameter steel pipe of a quality suitable for use in high pressure oil and gas transmission pipelines. The Napa Facility can produce pipe with an outside diameter ranging from 16 to 42 inches, with wall thicknesses of up to 1-1/16 inches and in lengths of up to 80 feet, and can process two different sizes of pipe simultaneously in its two finishing sections. Depending on product mix, the Napa Facility has an annual capacity in excess of 350,000 tons of pipe. Substantially all of the Napa Facility's requirements for specialty steel plate, which is fabricated into steel pipe, are currently supplied by the Portland Steel Mill and the Fontana Plate Mill. The Company expanded its plate rolling capacity by commencing operations at the Fontana Plate Mill in December 1989. Depending on product mix, the Fontana Plate Mill has an annual rolling mill capacity of up to 750,000 tons of finished steel plate, bringing the Company's total plate rolling capacity to approximately 1.2 million tons per year. The Fontana Plate Mill can roll plate up to 136 inches wide, which is sufficient for fabricating the Napa and Camrose Facilities' largest diameter pipe products. The Company acquired the rolling mill machinery used at the Fontana Plate Mill in November 1989 for approximately $7.5 million. The land and buildings at the Fontana Plate Mill are leased by the Company. The lease of the Fontana Plate Mill expires in 2002 but is subject to earlier termination by the Company or lessor upon certain terms and conditions. See Properties. The Company acquired a 60% interest in the Camrose Facility in June 1992 for approximately $18 million from Stelco, Inc., a large Canadian steel producer. The Camrose Facility has two pipe manufacturing mills. One is a large diameter pipe mill similar to that of the Napa Facility, and the other is an ERW pipe mill which produces steel pipe used in the oil and gas industry for drilling and distribution. The large diameter pipe mill produces pipe with a diameter ranging from 20 to 42 inches with maximum wall thickness limited to about 70% of the Napa Facility in lengths of up to 80 feet. Depending upon the product mix, the annual capacity for large diameter pipe is up to 184,000 tons. The ERW mill produces pipe in sizes ranging from 4.5 to 16 inches in diameter and has an annual nominal capacity of up to 142,000 tons depending upon product mix. On March 3, 1993, New CF&I, Inc., a wholly-owned subsidiary of the Company, acquired for $22.2 million a 95.2 percent interest in a newly formed limited partnership, CF&I. The remaining 4.8 percent interest is owned by the Pension Benefit Guaranty Corporation. CF&I purchased substantially all of the steelmaking, fabricating, metals and railroad business assets of CF&I Steel Corporation for $113.1 million. The Pueblo Steel Mill has melting capacity in excess of 1 million tons and a finished ton capacity of approximately 1.5 million tons. In February 1991 the Company sold 2,875,000 shares of common stock in a public stock offering. Proceeds to the Company from the offering were approximately $77.6 million. PRODUCTS Oregon Steel Division The Company's steel plate products consist of hot-rolled carbon, high-strength low alloy, heat treated and alloy plate up to 136 inches wide. In addition to commodity grades of steel plate, the Company produces a wide range of specialty steel plate. Commodity steel plate is used in a variety of applications, such as the manufacture of storage tanks, machinery parts, barges and ships. Specialty steel plate, such as high strength low alloy, heat treated, and alloy plate, has superior strength and performance characteristics for particular applications, such as the manufacture of construction, mining and logging equipment, pressure vessels, and oil and gas transmission pipe, and the fabrication of bridges and high-rise buildings. At the request of a customer, the Company can vary the properties of steel plate products, including the plate's malleability, hardness or abrasion resistance, impact resistance or toughness, strength and ability to be machined or welded. These variations are achieved by chemically altering the steel through the addition of elements such as carbon, manganese, chromium, molybdenum, nickel, boron, aluminum, and titanium and through the removal of elements such as phosphorous and sulfur. Different steel properties are required for specialized applications: high strength steel is required for construction and logging equipment; a combination of high strength and toughness steel is required for bridges and oil and gas transmission pipe; and steel with high abrasion resistance and hardness is required for the manufacture of mining equipment and armor for military ordinance. The Company's heat treating facility produces steel plate that has been normalized or quenched and tempered. The heat treating process of normalizing increases the toughness and impact resistance of plate, and is especially useful for low temperature applications. The heat treating process of quenching and tempering improves the strength and hardness of the plate. Quenched and tempered steel is used extensively in the mining industry, the manufacture of heavy transportation equipment, and military armor. The Company also offers customers the option of surface processing steel plate, which includes descaling (the removal of oxides from the surface of the plate) and painting. This process provides a more efficient and economical means of cleaning and coating steel products than the traditional sandblasting or hand cleaning methods. The Company's Portland Steel Mill, on the basis of an audit conducted in 1992, has received registration under ISO-9002. This registration is the emerging international designation for demonstrating that the Company systems support the production of quality products. This was one of the first ISO-9002 registrations of a steel mill in the United States. The Napa Facility pipe mill is one of the most versatile pipe mills in the industry. The mill can produce large diameter steel pipe ranging from 16 to 42 inches in diameter with wall thicknesses of up to 1-1/16 inches and lengths of up to 80 feet. In addition, the mill can process two different sizes of pipe simultaneously in its two finishing sections. Moreover, the Company can vary the pipe's hardness, impact resistance, strength and ability to be welded to meet the customers' specifications. The Company offers customers the option of surface processing the steel pipe, which includes descaling and internal and external coating on-site. The external coating facility was acquired by Napa in 1993. During 1989, the Company completed the construction of a full body ultrasonic inspection facility at the Napa Facility. If requested by the customer, this facility inspects the ends, long seam welds and entire body for all types of steelmaking and pipemaking imperfections and records the results for a permanent record. The Camrose Facility produces large diameter steel pipe ranging from 20 to 42 inches with maximum wall thickness limited to about 70% of that produced at the Napa Pipe Mill. The pipe can be produced in lengths up to 80 feet. Unlike the Napa Pipe Mill, this mill has one finishing section and can produce one size pipe at a time. The Company's large diameter pipe is used primarily in pressurized underground or underwater oil and gas pipelines where quality is critical. The Camrose Facility also produces ERW pipe in sizes 4.5 inches through 16 inches outside diameter. The pipe is manufactured using coiled skelp rolled on a high frequency electric resistance weld mill. The principal customers for this product are oil and gas companies for gathering lines to supply product to feed larger pipeline systems. CF&I Steel Division The Pueblo Steel Mill produces carbon, head hardened and alloy premium rail in accordance with the latest specifications of the American Railway Engineering Association. Rails are manufactured in the five most popular rail weights (115 lb/yard through 136 lb/yard), in all lengths as well as quarter mile welded strings. The Pueblo Steel Mill is the sole manufacturer of rails west of the Mississippi River. OCTG is produced at the Pueblo Steel Mill and consists of seamless casing, coupling stock, standard and line pipe. Oil country casing is used as a structural retainer for the walls of oil or gas wells. Standard and line pipe are used to conduct liquids and gasses above ground. The Company's seamless tube mill is equipped to produce the most widely used sizes of OCTG (2-3/8 inches outside diameter through 10-3/4 inches outside diameter) in all lengths according to the latest specifications of the American Petroleum Institute ("API"). The Company's production capability includes both carbon and high strength (quench and tempered) tubular products. The Pueblo Steel Mill also sells semi-finished OCTG ("green tubes") for processing and finishing by third parties. The rolled products produced at the Pueblo Steel Mill consist of concrete reinforcing bar, hot-rolled bar, bar size shapes, special sections and semi-finished billets. CF&I can produce rebar in sizes of 1/2" to 1-3/8" diameter; 2,250 pound coils can be made up to 1-1/2" diameter. Rebar is produced in grade 40 tensile strength for normal applications and grade 60 tensile strength for more severe applications. Rod products produced at the Pueblo Steel Mill are for industrial rod consumption. Generally, the rods are produced in diameters ranging from 7/32" to 9/16." The Pueblo Steel Mill is one of the few manufacturers which produce a wide variety of wire products. The wire produced consists primarily of fencing, barbed wire, nails, staples, bailing wire, welded wire fabric, merchant wire, rebar tie wire, high carbon special purpose wire and low carbon manufacturer's wire. RAW MATERIALS The Company's principal raw material for the Portland and Pueblo Steel Mills is ferrous scrap metal derived from, among other sources, junked automobiles, railroad cars and railroad track materials, and demolition scrap from obsolete structures, containers and machines. The purchase price for scrap is subject to market forces largely beyond the control of the Company, including demand by foreign steel producers for steel scrap (which is in turn influenced by currency exchange rates) and domestic demand from other steel companies. The cost of scrap to the Company can vary significantly, and product prices cannot always be adjusted, especially in the short-term, to recover the costs of large increases in scrap costs. During 1993 the average cost of purchased scrap at the Portland Steel Mill was $117 per ton compared to $91 per ton in 1992. The average cost of scrap at the Pueblo Steel Mill was $121 during 1993, compared to $96 during 1992. The Company maintains a 30 to 45 day supply of scrap to insulate itself to some extent against possible short-term price fluctuations. The Company purchases scrap through many outside dealers and is not dependent on any single supplier or group of suppliers at its Portland Steel Mill. The Pueblo Steel Mill purchases scrap through a broker. The Company believes that adequate supplies of scrap are readily available from a number of sources, but that current demand will keep pricing relatively high. The Company also purchases a quantity of directly reduced iron in briquetted form ("HBI") for use as a substitute for steel scrap. The successful integration of this material into the steelmaking process provides the Company with an alternate source of low residual material. Because this material is purchased on a contract basis it provides some insulation from the price fluctuations experienced in the scrap market. During 1993 the Company also purchased pig iron as a scrap substitute and believes it can be used successfully in limited quantities. With the shift in the Company's product mix from carbon grades to higher quality grades of steel, the need for higher quality scrap must be assured. The availability of higher grades of scrap in sufficient quantities may not be available in the Company's traditional scrap markets, which will require the use of an alternate source of metallics. The Company is participating in a joint venture project to construct an HBI plant in Venezuela. The plant is expected to have a capacity of one million metric tons and a capital cost of approximately $245 million. As the project is currently structured, the Company will own an equity interest in the facility and will have committed off-take requirements of 200,000 tons. It is anticipated that there will be several other joint venture partners and the Company expects its cash investment to be approximately $15 million. The project is expected to obtain non-recourse debt financing for 60% of the capital needs. In addition to the Venezuelan project, the Company is pursuing other metallic technologies, such as iron carbide and fastmet. The Company anticipates it will participate in one or more joint ventures for these processes. The Company purchases semi-finished steel slab from third parties for finishing at the Fontana Plate Mill and to supplement steel production capacity and enable the Portland Steel Mill to produce steel plate in thicknesses greater than 3 inches. Generally, the Company has been able to adjust product prices in response to increases in slab prices. The world demand for slab can, however, significantly affect its purchase price. The Company expects to purchase significant quantities of slabs in 1994. MARKETING AND CUSTOMERS Steel products are sold by the Company principally through its own sales organizations, which have sales offices at various locations in the United States and Canada and, as appropriate, through foreign sales agents. In addition to selling to customers who consume steel products directly, the Company sells steel products to steel service centers, distributors, processors and converters. In 1993 the Company derived 11.8 percent of its sales from one customer. Most of the Company's sales are initiated by contacts between sales representatives and customers. Accordingly, the Company does not incur substantial advertising or other promotional expenses for the sale of its products. The Company does not have any significant ongoing contracts with customers to purchase steel products, and orders placed with the Company generally are cancelable by the customer. The Company does not have a general policy permitting return of purchased steel products except for product defects. The Company does not routinely offer extended payment terms to its customers. The business is generally not subject to significant seasonal trends. The Company does not have material contracts with the United States Government and does not have any contracts subject to renegotiation. Oregon Steel Division Customers for commodity steel plate typically are located in the western United States, primarily in the northwest and California. Customers for specialty steel are located throughout the United States, but the Company is most competitive in the west, southwest and midwest. Incremental transportation costs for steel plate limit the Company's ability to compete in the eastern states' market. Large diameter steel pipe is marketed on a global basis. During 1993 the Company began to market large diameter pipe internationally and believes this will become a viable market for its pipe products. The Company believes that the quality of its pipe enables it to compete effectively in this market. Domestically the Company is most competitive in the steel pipe market west of the Mississippi River. The Camrose Facility is most competitive in western Canada. Sales of large diameter pipe generally consist of a small number of large orders and generally involve the Company responding to requests to submit bids. The principal customers for ERW pipe produced at the Camrose Facility are in the provinces of Alberta and British Columbia, where most of Canada's natural gas and oil is located, as well as the northwestern United States. The primary customers for this product are oil and natural gas companies who utilize ERW for gathering lines to supply their product to feed the larger distribution pipelines. CF&I Steel Division Rail is sold directly to major railroads, rail contractors, transit districts and short-line railroads. The primary market for the Pueblo Steel Mill's rail is the major western railroads. The Company estimates its share of the domestic rail market in 1993 was 43%. OCTG is sold primarily through distributors to a large number of oil exploration and production companies. Sales of standard and line pipe are made both through distributors and directly to oil and gas transmission and production companies. The market for the Company's OCTG product is primarily domestic and focused in the western and southwestern United States. The demand for this product is determined by the number of oil and gas drilling rigs working in the United States. The rig count in the United States (and, consequently, the consumption of OCTG) has been depressed in recent years. During 1993 the Company sold its bar products to more than 300 customers, most of which were fabricators and distributors. The majority of its customers are regional, located primarily within the state of Colorado. Incremental costs for transportation limit the Company's ability to ship the product out of the region and surrounding states. Sales of wire products are made to a large number and wide variety of customers in the western United States. The customers are primarily in the agricultural and construction segments. The agricultural market remains constant but the construction market is cyclical and has been depressed. The Company's wire rod products are sold primarily to wire drawers and consist of a number of customers, primarily in the western United States. The demand for wire rod is driven by wire demand and is dependent upon agricultural, construction and to a lesser degree, the durable goods segments. COMPETITION AND OTHER MARKET FACTORS The Company competes in its product markets primarily on the basis of product quality, price, and responsiveness to customer needs. Competition within the domestic steel industry is driven by overcapacity in most products and is intense. Domestic steel producers face significant competition from foreign producers. The highly competitive nature of the industry, combined with overcapacity in most products, has exerted downward pressure on the pricing of plate, large diameter line pipe, and OCTG; the Company expects this to continue into 1994. Oregon Steel Division Some of the Company's steel plate competitors are larger, have greater capital resources than the Company and have modern technology and relatively low labor and raw material costs. Principal competitors in the commodity steel plate market include Geneva Steel Corporation, located in Utah, IPSCO, located in Saskatchewan, Canada, and several other foreign producers. Principal competitors in the market for specialty steel plate include Lukens Steel Company, U.S. Steel Corporation and several foreign producers. Steel plate producers in the western United States have faced competition in past years from foreign producers, including producers in Japan, certain members of the European Economic Community, Korea, Brazil and Canada. The effects of foreign competition were mitigated in recent years by the decline and continued weakness of the U.S. dollar relative to several foreign currencies and strong demand for steel plate in foreign countries, particularly the Far East. The Company believes that its efforts in increasing productivity, reducing production costs and shifting into higher margin product niches should enable the Company to compete effectively with both foreign and domestic producers even if the dollar strengthens relative to foreign currencies. The Company believes that competition in the market for large diameter steel pipe is based primarily on quality, price and responsiveness to customer needs. The Company competes on a global basis and believes its ability to manufacture pipe of sufficiently high quality will enable it to compete effectively. Principal domestic competitors in the large diameter steel pipe market at this time are Berg Steel Pipe Corporation, located in Florida, and Bethlehem Steel Corporation, located in Pennsylvania. International competitors consist primarily of Japanese and European pipe producers. The principal Canadian competitor is IPSCO, located in Regina, Saskatchewan. Demand for the Company's pipe in recent years is primarily a function of new construction of oil and gas transportation pipelines and to a lesser extent maintenance and replacement of existing pipelines. Construction of new pipelines domestically depends to some degree on the level of oil and gas exploration and drilling activity, which has declined in recent years. The competition in the market for ERW pipe is based on price, product quality and responsiveness to customers. The need for this product has a direct correlation to the drilling rig count in the United States and Canada. In recent years, the drilling rig count has been at a low level and consequently the demand for ERW pipe has also been low. The Company believes that, as the need for natural gas increases, the rig count will also begin to increase. Principal competitors in the ERW product in western Canada are IPSCO located in Regina, Saskatchewan and Prudential located in Calgary, Alberta. CF&I Steel Division The majority of current rail requirements in the United States revolves around replacement rail for existing rail lines. Consequently, domestic rail demand is projected to be stable for the next several years. Imports have been a significant factor in the domestic premium rail market in recent years. Premium rail represents approximately 25 percent of the domestic market and is expected to increase over the next few years. The Company's capital expenditure program at CF&I will give the rail production facilities the continuous cast steel and in-line head hardening rail capabilities necessary to compete with the level of cost and quality available from other producers. Bethlehem Steel Corporation is the only other domestic rail producer. The Company's primary competitors in OCTG include a number of domestic and foreign manufacturers, some of which have significantly greater resources than the Company. Competition is based primarily on price and quality. The Company enjoys a freight advantage over eastern producers in shipping to some of the major oil drilling areas. The Company also has the flexibility to produce relatively small volumes of specified products on short notice in response to customer requirements. Principal domestic competitors include U.S. Steel Corporation, Lone Star Steel and Maverick Steel. The competition in bar products include a group of minimills that have a geographical location close to the intermountain market. Most of these mills utilize reinforcing bar as an incremental product to keep mills operating at capacity. Market expansion into other geographical locations is not feasible since freight is a significant factor. The Company's market area on wire and wire rod products is considered to be west of the Mississippi River with a primary market of the intermountain states. The Company presently manufactures rod using an antiquated mill with a coil size that is small compared to that of competitors. The Company will complete construction of a new rod/bar mill during the second half of 1994 which will produce substantially larger coils and reduce manufacturing costs. The domestic producers range from "rod only" producers, such as Armco Steel and North Star Steel, to dual producers of rod and wire, such as Keystone Steel and Wire and Northwestern Steel & Wire. There are also "wire only" producers, the largest in the western United States being Davis Wire Corporation and Tree Island Steel. ENVIRONMENTAL MATTERS The Company is subject to federal, state and local environmental laws and regulations concerning, among other things, wastewater, air emissions, toxic use reduction and hazardous material disposal. The Portland and Pueblo Steel Mills are classified in the same manner as other similar steel mills in the industry, as generating hazardous waste materials because the melting operation produces dust that contains heavy metals ("EAF" dust). This dust, which constitutes the largest waste stream generated at these facilities, has been disposed of at substantial expense in order to comply with applicable laws and regulations. In 1993 the Company began processing EAF dust in its Glassification(trademark) facility at the Portland Steel Mill. It is anticipated that in the second quarter of 1994, the Company will be recycling 100 percent of the EAF dust produced at the Portland Steel Mill. In 1993 the Environmental Protection Agency (EPA) concluded a site assessment of the Portland Steel Mill. The review concluded with ranking the facility as a medium/low corrective action priority for identified Solid Waste Management Units. The Company intends to proceed with an internal corrective action schedule. This schedule will include making portions of the Company's property useable for future development. Cost of these corrective action improvements is estimated at $1.5 million. The Portland Steel Mill received a renewed air discharge permit in 1993 which will require additional monitoring and reporting obligations. Some enhancements to pollution control equipment may be required. The full scope of these expenditures, however, has yet to be determined but is not believed to be material. The property and building at which the Fontana Plate Mill is located are leased to the Company (see "Properties"). The Fontana Plate Mill was formerly part of a larger integrated steel plant (the "Mill") operated on property (the "Mill Property") surrounding the Fontana Plate Mill. Prior to the termination of steel production at the Mill in 1983, the Mill operator produced substances that currently are defined as hazardous by federal and California regulations. Hazardous substances have been detected in the soil and groundwater at a number of specific areas within the Mill Property on the basis of inspections done by the prior operator and by the EPA. The testing program carried out by the prior operator and the EPA at the Mill Property has not included sampling at the Fontana Plate Mill site. On the basis of limited testing on behalf of the Company at the Fontana Plate Mill site, the levels of hazardous substances in the subsurface soils and groundwater at the Fontana Plate Mill site appear to be within permissible limits, although there can be no absolute assurance that this is, in fact, the case. The successor to the former operator of the Mill currently is carrying out site investigations at the Mill Property that may lead to the identification of needed remedial action. The successor is taking these actions pursuant to a consent order with the State of California Department of Health Services as required by corrective action provisions of the federal Resource Conservation and Recovery Act. The lessor of the land and building at the Fontana Plate Mill has agreed to indemnify the Company for certain expenses (excluding consequential damages, but including cost of clean-up and remediation required by governmental agencies) resulting from the presence of hazardous substances at the Fontana Plate Mill site other than as a result of the actions or negligence of the Company; and the Company has agreed to indemnify such lessor for similar expenses resulting from the presence of hazardous substances at the Fontana Plate Mill site as a result of actions or negligence of the Company. The Fontana Plate Mill discharges wastewater to treatment systems. The Company recently took over management of the water pre-treatment system from its lessor. The system will undergo improvements to enhance its operational efficiency and prevent discharges of water. This will result in an expected cost of $400,000. The Fontana Plate Mill is located within the South Coast Air Quality District and has been identified as a significant source of air emissions. A local emissions credit trading market has established additional rules to ensure reduction in emissions, establishment of a trading market for excess emission credits and continuous monitoring of these emissions. Fontana Plate Mill will be installing equipment to meet these new requirements as well as prepare application for a new air permit. The cost of this equipment is not expected to exceed $200,000. Prior to the acquisition of the Napa Facility by the Company, the prior owner of the Napa Facility disposed of certain waste materials, including spent sandblast materials, mill scale and welding flux, on-site. As a result of these matters and other actions prior to the acquisition, certain metals were released into the ground, and certain petroleum based compounds have seeped into the ground and groundwater at the Napa Facility. The prior owner of the Napa Facility entered into a stipulated judgment with the County of Napa which required a site investigation of the Napa Facility and remediation (to the satisfaction of local, regional and state environmental authorities) of soil and groundwater contamination associated with activities conducted at the site prior to its acquisition by the Company. As a result of the acquisition of the Napa Facility, the Company's subsidiary, Napa Pipe Corporation, is obligated by contract to comply with the terms and requirements of the stipulated judgment. Proposed plans for investigating the soil and water conditions at the Napa Facility were submitted to local, regional and state environmental authorities in February 1988. The Company is continuing to negotiate certain terms of these proposed plans with such environmental authorities. In addition to local, regional and state environmental authorities, the EPA conducted an investigation of the Napa Facility and has taken soil and water samples at the Napa Facility. The Company's proposed plans for investigating the soil and water conditions at the Napa Facility were furnished to the EPA in March 1988. While awaiting possible further response from the EPA, the Company is proceeding with its remediation plans as described in the preceding paragraph. In April 1992, the State of California Environmental Protection Agency, Department of Toxic Substances Control completed a Site Screening and recommended a low priority preliminary endangerment assessment for the Napa Facility. The total cost of the remedial action that may be required to correct existing environmental problems at the Napa Facility, including remediation of contaminants in the soil and groundwater, depends on the eventual requirements of the relevant regulatory authorities. As of December 31, 1993, the Company has expended $6.4 million and has reserved an additional $3.1 million to cover future costs arising from environmental issues relating to the site. CF&I has accrued a reserve of $36.7 million for environmental remediation at the Pueblo Steel Mill site. CF&I's estimate of this environmental reserve was based on two separate remediation investigations and feasibility studies conducted by independent environmental engineering consultants. The estimated costs were based on current technologies and presently enacted laws and regulations. The reserve includes costs for RCRA (Resource Conservation and Recovery Act) facility investigation, corrective measures study, remedial action, and operation and maintenance of the remedial actions taken. CF&I has an agreement with the State of Colorado for the remediation of environmental issues. The agreement specifies a schedule for corrective action and a yearly expenditure amount. The State of Colorado anticipated that the schedule would be reflective of a straight line rate of expenditures over 30 years. The State of Colorado stated the schedule for corrective action could be accelerated if new data indicated a greater threat to the environment than is currently known to exist. In November 1990 the President signed into law the Clean Air Act Amendments of 1990. This law has imposed new responsibilities on many industrial sources of air emissions, including plants owned by the Company. The Company cannot determine at this time the financial impact of the new law. The impact will depend on a number of site-specific factors, including the quality of the air in the geographical area in which a plant is located, rules to be adopted by each state to implement the law, and future EPA rules specifying the content of state implementation plans. The Company anticipates that it will be required to make additional expenditures, and will be required to pay higher fees to governmental agencies, as a result of the new law and future state laws regulating air emissions. In addition, the monitoring and reporting requirements of the new law will subject all air emissions to increased regulatory scrutiny. The Company's future expenditures for installation of environmental control facilities, remediation of environmental conditions existing at its properties and other similar matters are difficult to predict. Environmental legislation and regulations and related administrative policies, have changed rapidly in recent years. It is likely that the Company will be subject to increasingly stringent environmental standards in the future (including those under the Clean Water Act Amendments of 1990 stormwater permit program, and toxic use reduction programs), and will be required to make additional expenditures, which could be significant, relating to environmental matters on an ongoing basis. EMPLOYEES As of December 31, 1993, the Company had 3,060 full-time employees. At the Pueblo Steel Mill, 1,360 employees work under a collective bargaining agreement with the United Steelworkers of America. The contract was negotiated in March of 1993 and will expire in September of 1997. The remainder of the Company's domestic employees, approximately 1,450, are paid on a salary basis and are not represented by a union. Approximately 225 employees of the Camrose Facility are members of the Canadian Autoworkers Union. The contract was renegotiated in January of 1994 and expires on January 31, 1997. The Company believes it has a good relationship with its employees. The domestic employees of the Oregon Steel Division participate in an Employee Stock Ownership Plan ("ESOP") program. The ESOP currently owns 14% of the Company's Common Stock. Stock is contributed to the ESOP, as decided annually by the Board of Directors. The Company also has a profit participation plan for its domestic employees which permits eligible employees to share in the pre-tax profits of their division unit. ITEM 2. ITEM 2. PROPERTIES Oregon Steel Division The Portland Steel Mill is located on approximately 147 acres owned by the Company in the Rivergate Industrial Park in Portland, Oregon, near the confluence of the Columbia and Willamette rivers. The operating facilities principally consist of one electric arc furnace and ladle metallurgy stations, slab casting equipment and a plate rolling mill. The Company's 24,500 square foot office building and its steel mill facilities occupy approximately 84 acres of the site. The remaining 63 acres consist of two waterfront sites totaling 59 acres and a four acre site. The adjacent water channel accommodates ocean-going vessels. The Company's heat treating facilities are located near its principal facilities on a five acre site owned by the Company. In addition, the Company owns 74 acres of industrial property nearby, of which 44 acres are leased. The Company owns approximately 152 acres in Napa, California. The Company's pipe mill occupies approximately 92 of these acres. The Company also owns a steel fabricating facility located adjacent to the pipe mill on this site. The fabricating facility is not currently used by the Company and consists of approximately 325,000 square feet of industrial buildings containing equipment for the production and assembly of large steel products or components and is partially leased on a short-term basis. Camrose Pipe Company owns approximately 67 acres in Camrose, Alberta, Canada. The large diameter pipe mill occupies approximately 4 acres and the ERW pipe mill occupies approximately 3 acres of the site. In addition, there is a 3,600 square foot office building on the site. The sales staff is located in Calgary, Alberta in leased space. The land and buildings at the Fontana Plate Mill are leased to the Company under a net lease (the "Lease"). The Company entered into the Lease in November 1989, and concurrently purchased from the lessor the machinery comprising the steel plate rolling mill for a purchase price of approximately $7.5 million. The lessor also owns certain property and buildings adjacent to the Fontana Plate Mill (which, together with the property leased to the Company, is referred to as the "Lessor Property") where it conducts steel slab processing operations. The Fontana Plate Mill and the Lessor Property are surrounded by the Mill Property, which is owned by the successor to the former operator of the Mill. The Lease is for a ten-year term ending on December 31, 1999, and provides for an extension of up to three years at the Company's option if, before November 16, 1992, the Company incurs costs in excess of $5.0 million in connection with the construction of new slab reheating furnaces at the Fontana Plate Mill. This requirement was met and the Company extended its lease for an additional three year period until December 31, 2002. The Lease permits either the Company or the lessor to terminate the Lease if at any time: (i) the lessor terminates substantially all of its slab processing operations at the Lessor Property; (ii) the lessor is no longer the beneficial owner of a controlling interest in the Lessor Property or the buildings and improvements thereon; or (iii) either of two specified foreign affiliates of the lessor shall no longer beneficially own an equity interest in the lessor; provided that, if terminated by the lessor, the termination date will be on the first anniversary of the date of lessor's exercise of the termination option but in no event prior to November 16, 1999. The Lease also permits either the Company or the lessor to terminate the Lease if (i) the lessor terminates substantially all of its slab processing operations on the Lessor Property, (ii) neither the lessor nor any person who manufactures any product manufactured by the Company or any of its subsidiaries beneficially owns any interest in the Lessor Property and (iii) neither the lessor nor any person who manufactures any product manufactured by the Company or any of its subsidiaries beneficially owns any interest in the buildings or improvements located on the Lessor Property; provided that, if terminated by the lessor, the termination date will be on the first anniversary of the date of the lessor's exercise of the termination option but in no event prior to November 16, 1994, and provided further that the Company will be entitled to payment from the Lessor of certain unamortized capital improvement costs if such termination occurs prior to November 16, 1999. The Lease also permits termination by either the Company or the lessor, effective on the first anniversary of the date of exercise of the termination option (notwithstanding any extension of the term of the lease by the Company), if the Company discontinues substantially all its operations at, or no longer holds a controlling interest in, either the Napa Facility or the rolling mill machinery at the Fontana Plate Mill. The lessor also may terminate the Lease upon 30 days' written notice, if the Company removes the rolling mill machinery from the Fontana Plate Mill site. The lease payment is subject to annual increases based on increases in the consumer price index. The rental payment under the lease during 1993 was $1.3 million. CF&I Steel Division The Pueblo Steel Mill is located in Pueblo, Colorado on approximately 574 acres. The operating facilities principally consist of two electric arc furnaces for production of all raw steel, a 6-strand continuous billet caster and a 6-strand continuous round caster for producing semi-finished steel, and five finishing mills for conversion of semi-finished steel to a finished steel product. These finishing mills consist of a rail mill, seamless tube mill, an 11" bar mill, rod mill and a wire mill. During 1993 the Company began a major capital improvement program of CF&I. This program includes the installation of a new bar mill reheat furnace, new rod mill, a continuous caster and the upgrading of the steelmaking facilities with a new arc furnace, ladle furnace and vacuum degassing system. See Management Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources. The production capacities at the Company's facilities are effected by product mix. At December 31, 1993, the Company had the following nominal capacities: CAPACITY PRODUCTION (TONS) (TONS) --------- ---------- Portland Steel Mill: Melting ......................... 800,000 800,000 Rolling ......................... 450,000 372,200 Fontana Plate Mill: Rolling ......................... 750,000 331,600 Napa Facility: Steel Pipe ...................... 350,000 133,700 Camrose Facility: Steel Pipe ...................... 326,000 154,000 Pueblo Steel Mill: Melting ......................... 1,000,000 913,500 Finishing Mill .................. 1,500,000 828,800 At December 31, 1993, all properties of the Company except for those of Camrose Pipe Company are free of any major encumbrances, liens or mortgages. The assets of Camrose are subject to a bank lien securing the operating credit facility. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is party to various claims, disputes, legal actions and other proceedings involving contracts, employment and various other matters. In the opinion of management, the outcome of these matters should not have a material adverse effect on the consolidated financial condition of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were voted upon during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Officers are elected by the Board of Directors of the Company to serve for a period ending with the next succeeding annual meeting of the Board of Directors held immediately after the annual meeting of stockholders. The name of each executive officer of the Company, his age as of February 24, 1994, and position(s) and office(s) and all other positions and offices held by each executive officer are as follows: ASSUMED PRESENT EXECUTIVE NAME AGE POSITIONS POSITION - ---- --- --------- -------------- Thomas B. Boklund 54 Chairman of the Board of Directors and Chief Executive Officer July 1985 Robert J. Sikora 51 President and Chief Operating Officer February 1992 L. Ray Adams 43 Vice President of Finance and Secretary March 1991 Christopher D. Cassard 40 Treasurer January 1994 Joe E. Corvin 49 Vice President and General Manager of Portland Steel Mill February 1992 Edward J. Hepp 48 Vice President of Marketing September 1991 Richard J. Kasten 49 Vice President of Quality and Metallurgy February 1992 Jack C. Longbine 47 Vice President of Employee Resources February 1992 Robert R. Mausshardt 61 Vice President of Marketing, Tubular Products March 1984 James R. McCaughey 64 Vice President and General Manager of Napa Facility April 1989 Steven M. Rowan 48 Vice President of Materials and Transportation February 1992 Each of the executive officers named above has been employed by the Company in an executive or managerial role for at least five years, except Edward J. Hepp and Christopher D. Cassard. Mr. Hepp joined the Company in September of 1991. From 1972 until 1991 he was with Lukens Steel Company where his last position was Manager of Product Sales. Mr. Cassard joined the Company in August of 1992 as Assistant Treasurer. From 1990 to 1992 he was a consultant on various finance projects for privately-held companies and from 1989 to 1990 was Chief Financial Officer for Columbia Vista Corporation. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the New York Stock Exchange. At December 31, 1993, the number of common stockholders of record was 951. Information on quarterly dividends and common stock prices is shown on page 19 and incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table sets forth for the periods indicated the percentages of sales represented by selected income statement items and information regarding selected balance sheet data: YEARS ENDED DECEMBER 31, ---------------------------- 1993 1992 1991 ---- ---- ---- INCOME STATEMENT DATA: Sales ........................................ 100.0% 100.0% 100.0% Cost of sales ................................ 89.4 79.6 79.0 Selling, general and administrative expenses . 6.1 7.5 5.9 Contribution to employee stock ownership plan .1 .9 1.0 Profit participation ......................... .7 2.6 2.9 ---- ----- ----- Operating income ........................... 3.7 9.4 11.2 Interest and dividend income ................. .1 .2 .4 Interest expense ............................. (.6) -- -- Other income (expense), net .................. -- -- (.1) Settlement of litigation ..................... .4 (1.3) -- Minority interest ............................ (.3) .3 -- ---- ---- ---- Pretax income .............................. 3.3 8.6 11.5 Income tax expense ........................... (1.1) (3.6) (4.3) ---- ---- ---- Net income ................................. 2.2% 5.0% 7.2% ==== ==== ==== BALANCE SHEET DATA (AT DECEMBER 31): Current ratio ................................ 2.2:1 2.8:1 3.8:1 Long-term debt as a percent of capitalization 21.7% -- 1.4% Net book value per share ..................... $14.23 $13.41 $12.90 The following table sets forth by division for the periods indicated tonnage sold, revenues and average selling price per ton: TOTAL TONNAGE SOLD: Oregon Steel Division Plate products ............................. 436,200 379,700 344,100 Pipe products .............................. 323,700 285,600 418,600 Semi-finished products ..................... 18,400 -- -- --------- ------- ------- 778,300 665,300 762,700 CF&I Steel Division .......................... 624,700 -- -- --------- ------- ------- 1,403,000 665,300 762,700 ========= ======= ======= REVENUES (IN THOUSANDS): Oregon Steel Division ........................ $415,165 $397,722 $489,357 CF&I Steel Division .......................... 264,658 -- -- -------- -------- -------- Total ...................................... $679,823 $397,722 $489,357 ======== ======== ======== AVERAGE SELLING PRICE PER TON: Oregon Steel Division $533 $598 $642 CF&I Steel Division $424 -- -- Average $485 $598 $642 The Company's long-range strategic plan has been to provide stability for its operating facilities through expanding its product mix and markets to minimize the impact of product cycles in the domestic large diameter pipe product produced at the Napa Facility. The domestic market for large diameter pipe declined significantly during 1993 from that experienced in prior years. The Napa Facility shipped 168,300 tons in 1993 compared to 255,100 tons in 1992 and 418,600 tons in 1991; domestic shipments will decline further in 1994. The Company believes that the decline in the domestic large diameter pipe market will continue beyond 1994, quite possibly to the end of the decade. In an effort to decrease the Company's reliance on the domestic large diameter steel pipe market and provide additional end uses for its steel plate, the Company purchased an interest in the Camrose Facility. During the last six months of 1992 and for all of 1993, the Camrose Facility shipped 30,000 tons and 155,400 tons respectively of steel pipe. The Company believes there will continue to be opportunities in Canada for steel pipe as the large reserves of natural gas in western Canada continue to be developed during the next several years. To expand the Company's steel product lines and enter new geographic areas, the Company purchased its 95.2 percent interest in CF&I. During 1993, CF&I shipped 624,700 tons and generated $264.7 million in revenue. In November of 1993 the Company's Napa Facility was awarded a contract from the Petroleum Authority of Thailand to produce and ship 133,000 tons of large diameter pipe during 1994. The Company has also been awarded a contract from British Gas to provide large diameter pipe for a severe sour gas service pipeline offshore in Tunisia. The Company believes the international market for large diameter oil and gas transmission pipe could provide signficant opportunities over the next few years. The Company's capital expenditures at the Portland Steel Mill over the last five years have been committed to increasing the Company's ability to produce high quality, specialty steel plate. In 1993 the Company installed a vacuum degassing unit at the Portland Steel Mill which will enable it to produce the highest quality steel plate and line pipe steels. The installation of this technology will also enable the Company to be a viable supplier to the international large diameter pipe market. In addition, the Company expanded the capacity of the heat treating facility at the Portland Steel Mill from 60,000 to 90,000 tons and completed installation of a new leveler in February of 1994. The Company believes these capital expenditures will further enhance its ability to produce high quality, specialty steel plate and focus on increasing its share of this market. The capital expenditure program at CF&I began in November of 1993 with the ground breaking for the rod/bar mill modernization. This modernization is expected to be completed during the third quarter of 1994. During 1994 the steel making facilities at CF&I will be upgraded with the installation of a ladle metallurgy station, a vacuum degassing unit, elimination of ingot casting for the rail mill, and conversion of existing casters to provide continuous cast steel for all products. These upgrades are expected to be completed and operational at the end of 1994. The Company believes it will realize significant yield improvements and cost reduction when this phase of the capital expenditure plan is completed. Future expenditures at CF&I will include modifications to the rail mill and installation of in-line head hardening for rails. The Company expects raw material costs such as scrap and alloys to remain high during 1994. The Company implemented price increases on most of its products in the fourth quarter of 1993 and the first quarter of 1994 to partially offset increased raw material costs. The Company does not expect that the pricing environment for steel plate, large diameter pipe and steel rail products will improve significantly from current levels during 1994. Pricing in the Company's other steel products will be affected by the competitive environment in the respective product markets. COMPARISON OF 1993 TO 1992 Sales. Sales in 1993 of $679.8 million increased 70.9 percent from sales of $397.7 million in 1992. Tonnage shipments increased 110.9 percent to 1.4 million tons in 1993 from 665,300 tons in 1992. Selling prices in 1993 averaged $485 per ton versus $598 in 1992. Of the $282.1 million sales increase, $441 million was the result of volume increase offset by $158.9 million of lower average selling prices. The increase in sales and shipments was primarily due to the inclusion of the operations of CF&I and a full year contribution from 60 percent owned Camrose Facility which was formed on June 30, 1992. The decrease in selling price was primarily due to a decline in large diameter steel pipe shipments from the Napa Facility (168,300 tons in 1993 versus 255,100 tons in 1992) and a larger percentage of CF&I's product mix to total sales and shipments. On average CF&I's products have a lower selling price than steel plate and large diameter pipe products. Gross Profits. Gross profits as a percentage of sales for 1993 were 10.6 percent compared to 20.4 percent for 1992. The gross profit margin decline year to year is due to higher raw material costs, principally scrap, which could not be completely recovered through sales price increases. During 1993 the Company experienced an average increase of $26 per ton in scrap cost over the average 1992 cost per ton. This increase reversed the downward spiral in costs experienced for certain raw materials during the previous two years. In addition, the reduction of pipe production and pipe shipments in 1993 at the Company's Napa Facility negatively impacted the Company's ability to absorb fixed costs at both the Napa Facility and the Fontana Plate Mill, since a majority of the Fontana Plate Mill production is shipped to the Napa Facility for conversion into steel pipe. Decreased Napa Facility shipments also required the Company to increase its sales of lower margin commodity steel plate products in order to sustain the operating efficiency of the Portland Steel Mill. Production began on a number of large pipe orders during the fourth quarter of 1993; however, the revenues related to these orders will not be recognized until shipments begin in the first quarter of 1994. The Company implemented price increases of $20 a ton on its steel plate shipments, effective November 1, 1993, on all new orders and January 3, 1994 for all tons shipped. During fourth quarter 1993, price increases of $15 a ton were announced on bar, wire rod and certain wire products, and OCTG and line pipe products manufactured at CF&I. Selling, General and Administrative. Selling, general and administrative expenses for 1993 increased $11.7 million or 39.2 percent compared with 1992 but decreased as a percentage of sales from 7.5 percent in 1992 to 6.1 percent in 1993. The dollar amount increase is primarily a result of the Company's acquisitions of Camrose and CF&I ($11.5 million), increased expenses related to increased support required by the Company's growth and general inflation ($2.3 million), offset by decreased shipping costs due to reduced pipe shipments from the Company's Napa Facility ($2.1 million). The percentage decrease is due primarily to the increased sales volume in 1993. Contribution to ESOP and Profit Participation. The contribution to the ESOP was $753,000 in 1993 compared with $3.5 million in 1992. Profit Participation Plan expense was $4.5 million for 1993 compared with $10.5 million for 1992. These reductions are a result of the decreased profitability of the Company in 1993 versus 1992. Interest and Dividend Income. Interest and dividend income on investments was $.9 million in 1993 compared with $.7 million in 1992. This increase was primarily the result of an increase in average cash and cash equivalent balances available for investment and an increase in average interest rates during 1993 compared with 1992. Interest Expense. Total interest cost for 1993 was $5.7 million, an increase of $5.4 million compared to 1992. This increase was primarily related to interest cost incurred on debt issued by CF&I for its purchase of substantially all the assets of CF&I Steel Corporation. Of the $5.7 million of interest cost, $1.7 million was capitalized as part of construction in progress. Settlement of Litigation. The $2.8 million recovery from settlement of litigation was received from the Company's excess liability insurance carrier in the second quarter of 1993 and related to former employee lawsuits which were settled in the fourth quarter of 1992 (see Note 9 to the consolidated financial statements). Income Tax Expense. The Company's effective income tax rate for state and federal taxes was 33.3 percent for 1993 compared to 42.1 percent for 1992. The effective income tax rate for both periods varied from the combined state and federal statutory rates due to utilization of carryforward tax credits against state income taxes and deductible dividends paid on stock held by the ESOP and paid to ESOP participants. The higher effective income tax rate in 1992 resulted primarily because the litigation settlement expense of $5 million was treated as a nondeductible item for tax purposes. In 1993 the insurance recovery of $2.8 million related to the 1992 litigation settlement was treated as a nontaxable item (see Note 6 to the consolidated financial statements). COMPARISON OF 1992 TO 1991 Sales. Sales in 1992 of $397.7 million declined 18.7 percent from sales of $489.4 million in 1991. Tonnage shipments decreased 12.8 percent to 665,300 tons in 1992 from 762,700 tons in 1991. Selling prices in 1992 averaged $598 per ton versus $642 in 1991. Of the $91.7 million sales decrease, 32 percent was the result of lower selling prices and 68 percent was the result of volume decreases. The decrease in tonnage sold is the result of the decline in large diameter pipe shipments from the Company's Napa Facility (255,100 tons in 1992 versus 418,600 tons in 1991). The decline in pipe sales was also partially the result of the Company not being able to ship at December 31, 1992, 39,400 tons of large diameter steel pipe that had been produced under contract at the Napa Facility. Because the steel pipe had not been shipped, revenue of $36.5 million associated with the production was not recognized until fiscal 1993 when the steel pipe was shipped. In 1991 this facility produced a greater tonnage volume of large diameter pipe than at any time in its history. The decrease in average sales price was primarily the result of a decrease in the proportion of higher priced large diameter pipe products in the Company sales mix in 1992 compared to 1991. Gross Profits. Gross profits as a percentage of sales for 1992 were 20.4 percent compared to 21 percent for 1991. These margins were approximately the same year to year despite a decline in the average per ton sales price in 1992 ($598) versus 1991 ($642). This is a result of a decline in per ton production costs in 1992 at the Portland Steel Mill (principally because of lower scrap costs) and the Napa Facility from those costs experienced in 1991. In 1991 the Napa Facility experienced production problems associated with certain pipeline projects, which resulted in higher than normal reworked and downgraded steel pipe. These production problems were corrected during 1991. In addition, during 1991, the Company purchased substantial quantities of steel plate for forming into steel pipe from outside suppliers at a cost significantly above its internal cost of production. No significant quantities of plate were purchased from outside suppliers during 1992. The Company estimated the reworking and downgrading of the steel pipe and purchased plate decreased the Company's gross profit margin in 1991 by approximately $10 million from what it otherwise would have been. Margins for 1992 were also negatively impacted due to limited pipe shipments from the Camrose Facility, whose results of operations were included beginning on June 30, 1992. Selling, General and Administrative. Selling, general and administrative expenses for 1992 increased $.9 million or 3 percent compared with 1991 and increased as a percentage of sales from 5.9 percent in 1991 to 7.5 percent in 1992. The dollar amount increase is primarily a result of an increase in legal expense relating to litigation, the inclusion of expenses from the newly acquired Camrose Facility and general inflation. The percentage increase is due primarily to the decreased sales volume in 1992. Contribution to ESOP and Profit Participation. The contribution to the ESOP was $3.5 million in 1992, compared to $5 million in 1991. Profit Participation Plan expense was $10.5 million for 1992 compared with $14.3 million for 1991. These reductions are a result of the decreased profitability of the Company in 1992 versus 1991. Interest and Dividend Income. Interest and dividend income on investments was $.7 million in 1992 compared with $1.9 million in 1991. This decrease was primarily the result of a decline in average cash and cash equivalent balances available for investment and a decline in average interest rates during 1992 compared with 1991. Interest Expense. Total interest cost for 1992 was $.3 million, a decrease of $1.1 million compared to the comparable period in 1991. This decrease was due to a reduction in the amount of short-term borrowings and lower interest rates. All interest costs incurred in 1992 were capitalized as part of construction in progress. Settlement of Litigation. During the fourth quarter of 1992, the Company recorded a net charge of $5 million related to the settlement of former employee lawsuits (see Note 9 to the consolidated financial statements). Income Tax Expense. The Company's effective income tax rate for state and federal taxes was 42.1 percent for 1992 compared with 37 percent for 1991. The effective income tax rate for both periods varied from the combined state and federal statutory rates due to utilization of carryforward tax credits against state income taxes and deductible dividends paid on stock held by the ESOP and paid to ESOP participants. The increased effective income tax rate in 1992 resulted because the $5 million litigation settlement expense was treated as a nondeductible item (see Note 6 to the consolidated financial statements). LIQUIDITY AND CAPITAL RESOURCES Positive cash flow from 1993 operations was $44.5 million compared to a positive cash flow of $48.4 million in the corresponding 1992 period. The major items affecting this $3.9 million decrease were positive cash flows from increased depreciation and amortization ($5.1 million), increased minority interest earnings ($2 million), less funds required for payment of income and other taxes ($7.3 million), and less payments made on trade accounts payable and accrued expenses ($34.7 million). These positive cash flows were offset by reduced net income ($5.2 million), reduced ESOP contributions ($2.8 million), increased trade accounts receivable ($34.2 million), and increased inventories ($12.4 million). Net working capital at December 31, 1993 increased $40 million from December 31, 1992 due to a $100.8 million increase in current assets offset by a $60.8 million increase in current liabilities. Trade accounts receivable increased from $23.9 million at the end of 1992 to $71.6 million at December 31, 1993. The increase is primarily a result of the inclusion of CF&I sales for the first time in 1993. The December 31, 1993 inventory increase and the increase in current liabilities are primarily due to the addition of inventories, accounts payable and current portion of long-term debt as a result of the CF&I acquisition. The Company maintains an unsecured revolving credit and term loan agreement (Credit Agreement) with two banks which enables the Company to borrow up to $75 million. The use of the proceeds from borrowings under this Credit Agreement is restricted to (1) investing in businesses and related equipment in the steel industry and certain other industries, and (2) working capital and general corporate purposes. On July 1, 1996, the outstanding balance will be converted, unless prepaid, to a term loan payable in sixteen equal quarterly installments through June 30, 2000. Annual commitment fees during the revolving loan period are 1/8 of 1 percent of the average daily unused portion of the available credit payable on a quarterly basis. Depending on the Company's election at the time of borrowing, interest will be payable based on either (1) the prime rate, (2) the certificate of deposit rate, (3) the federal funds rate or (4) the Eurodollar rate as specified in the Credit Agreement. At December 31, 1993, $16.7 million was outstanding under this credit facility and classified as noncurrent. The Company has a $15 million unsecured revolving line of credit facility with a bank which matures May 31, 1994. Depending on the Company's election at the time of borrowing, interest will be payable based on either the prime rate or the federal funds rate, fully floating in either case. At December 31, 1993, there were no amounts outstanding under this credit facility. However, $15 million was restricted under outstanding letters of credit. In addition, the Company has a $5 million unsecured revolving credit line with a bank which is restricted to use for letter of credit obligations and cash advances for up to 90 days.Interest rates applicable to such advances, if any, will be set at the time of borrowing. At December 31, 1993, $3.2 million was restricted under outstanding standby letters of credit, and there were no loan amounts outstanding. Camrose Pipe Company (a 60 percent owned subsidiary) maintains a $10 million revolving credit facility with a bank, the proceeds of which may be used for working capital and general corporate purposes. The facility is collateralized by the assets of Camrose Pipe Company and expires on October 31, 1994. Depending on Camrose Pipe Company's election at the time of borrowing, interest will be payable based on (1) the bank's Canadian dollar prime rate, (2) the bank's United States dollar prime rate, or (3) the London Interbank Borrowing Rates ("LIBOR"). As of December 31, 1993, Camrose Pipe Company had $4.2 million outstanding under the facility. CF&I maintains a $15 million revolving credit facility with a bank, the proceeds of which may be used for working capital and general corporate purposes. The facility is collateralized by the accounts receivables of CF&I and expires on May 24, 1994. Depending on CF&I's election at the time of borrowing, interest will be payable based on either the bank prime rate or LIBOR. As of December 31, 1993, CF&I had $10 million outstanding under this facility. CF&I issued a $67.5 million term note as part of the purchase price of the assets of CF&I Steel Corporation on March 3, 1993. This debt, which is unsecured, is payable over ten years, plus interest at 9.5 percent. The Company has agreed to guarantee the payment of the first 25 months' installment cash payments. At December 31, 1993, the Company's remaining commitment under this guarantee is $13.1 million. As of December 31, 1993, the outstanding balance on this debt is $64.5 million, of which $59.8 million is classified as noncurrent. The Company has started a $180 million capital spending program at its CF&I Steel Division. In 1993 approximately $20 million was expended as progress payments on the major components of the project including the installation of a new bar mill reheat furnace, new rod mill, a continuous caster and the upgrading of the steelmaking facilities with a new ladle furnace and vacuum degassing system. The Company expects to expend $110 million on the capital program at CF&I in 1994. The Company has also budgeted approximately $21 million for capital expenditures at its Oregon Steel Division manufacturing facilities. The Company expects to spend approximately $1 million at the Portland Steel Mill to complete its vacuum degassing and heat treating facility projects. The remaining Portland Steel Mill and Fontana Plate Mill $12 million capital budget will be used for several recurring upgrade projects to the present facilities and equipment. The Company's capital budget for the Napa Facility was increased to $8 million to prepare the pipe mill for anticipated increased production. Approximately $17 million of the total $21 million budget is planned to be expended in 1994. About $20 million was expended on capital projects such as vacuum degassing, heat treat leveler, and baghouse dust recycling plant at the Company's Oregon Steel Division in 1993. The Company's total capitalization at December 31, 1993 of $351.7 million consisted of $76.5 million in long-term debt and $275.2 million in stockholders' equity, for a long-term debt-to-capitalization ratio of .22 to 1. Net book value per share of common stock at December 31, 1993 was $14.23 per share versus $13.41 per share at December 31, 1992. The Company believes that anticipated needs for working capital and capital expenditures through 1994 will be met from existing cash balances, funds generated by operations, borrowings pursuant to the Company's revolving credit facility and short-term borrowing. Impact of Inflation. Inflation can be expected to have an effect on many of the Company's operating costs and expenses. Due to worldwide competition in the steel industry, the Company may not be able to pass through such increased cost to its customers. Property, plant facilities and equipment purchased by the Company in prior years have been subject to inflation; consequently, current charges to depreciation are smaller than would be required if such assets were valued at replacement cost. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Directors of Oregon Steel Mills, Inc. We have audited the accompanying consolidated balance sheets of Oregon Steel Mills, Inc. and Subsidiaries as of December 31, 1993, 1992 and 1991 and the related consolidated statements of income, changes in stockholders' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards required that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Oregon Steel Mills, Inc. and Subsidiaries as of December 31, 1993, 1992 and 1991, and the consolidated results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. As discussed in Note 6 and 7 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992 and postretirement benefits in 1991. COOPERS & LYBRAND Portland, Oregon February 11, 1994 OREGON STEEL MILLS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of all wholly owned and majority owned subsidiaries. Affiliates which are 20 percent to 50 percent owned are accounted for using the equity method. All material intercompany transactions and account balances have been eliminated upon consolidation. Operations of purchased businesses are included in the consolidated financial statements from the date of acquisition (see Note 11). CASH AND CASH EQUIVALENTS The Company invests excess cash balances in short-term securities, including corporate and municipal obligations, bank repurchase agreements, commercial paper, remarketed preferred stock, and similar instruments which are readily converted to known amounts of cash and are so near to maturity that they present insignificant risk in changes in value because of changes in interest rates. The carrying amounts approximate fair value because of the short maturity of these instruments. INVENTORIES Inventories are stated at the lower of average cost or market. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are recorded at historical costs, including all costs directly related to the acquisition or construction of, and the preparation for, the assets' intended use, such as interest capitalized on funds borrowed to finance the major capital additions. Such capitalized interest amounted to $1.7 million, $318,000 and $1.4 million in 1993, 1992 and 1991, respectively. Depreciation is determined utilizing principally the straightline method over the estimated useful lives of the individual items. Maintenance and repairs are expensed as incurred and costs of improvements are capitalized. Upon disposal, related costs and accumulated depreciation are removed from the accounts and resulting gains or losses are reflected in income. EXCESS OF COST OVER NET ASSETS ACQUIRED Excess of cost over net assets acquired, principally from the acquisition of CF&I Steel, L.P. ("CF&I"), is being amortized over 40 years using the straight-line method. REVENUE RECOGNITION Revenue is recognized when the earning process is complete and an exchange has taken place. The earning process is not considered complete until collection of the sales price is reasonably assured. TAXES ON INCOME Deferred income taxes are recorded to reflect the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at year end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Tax credits are accounted for using the flow through method which recognizes such credits in the year in which the credit arises by a reduction to income tax expense. As of January 1, 1992, the Company adopted the Statement of Financial Accounting Standards No. 109, (FAS No. 109) "Accounting for Income Taxes." This Statement supersedes existing accounting standards for income taxes which the Company adopted in 1988 (see Note 6). FOREIGN CURRENCY TRANSLATION Assets and liabilities of subsidiaries are translated at the rate of exchange in effect as of the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the year. The related translation adjustments are reflected in the cumulative foreign currency translation adjustment section of the consolidated balance sheet. NET INCOME PER SHARE The computation of earnings per common and common equivalent share is based upon the weighted average number of common shares outstanding during each period plus (in periods in which they have a dilutive effect) the effect of common shares contingently issuable. The weighted average number of common shares and equivalents outstanding was 19.8 million, 19.2 million and 18.7 million, respectively, in 1993, 1992 and 1991. There were no dilutive common share equivalents outstanding in any years presented. CONCENTRATIONS OF CREDIT RISK Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, investments and trade receivables. The Company places its cash and cash equivalents and investments with high-credit-quality financial institutions and limits the amount of credit exposure by any one financial institution. At times temporary cash investments may be in excess of the Federal Deposit Insurance Corporation insurance limit. The Company's trade receivables are derived from sales to customers. Management believes that any risk of loss is significantly reduced by its ongoing credit evaluations of its customers' financial condition and its requirement of collateral, such as letters of credit and bank guarantees, whenever deemed necessary. ENVIRONMENTAL EXPENDITURES All material environmental remediation liabilities which are probable and estimable are recorded in the financial statements based on current technologies and current environmental standards with adjustments made later if additional sources of contaminants are discovered that may require different remediation methods and a longer remediation period, and ultimately increase the total cost. The best estimate of the probable loss within a range is recorded. If there is no best estimate, the low end of the range is recorded, and the range is disclosed. In general, environmental remediation costs are charged to operating expenses with certain limited exceptions which meet generally accepted accounting principles' criteria for capitalization. RECLASSIFICATIONS Certain amounts in the 1992 financial statements have been reclassified. The reclassifications do not affect previously reported net income. 2. BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION The Company operates in one business segment in two geographical locations, the United States and Canada. Geographical area information is as follows: 1993 1992 -------- -------- (IN THOUSANDS) SALES TO UNAFFILIATED CUSTOMERS United States.........................................$587,247 $379,714 Canada................................................ 92,576 18,008 -------- -------- $679,823 $397,722 ======== ======== OPERATING INCOME (LOSS) BY GEOGRAPHIC LOCATION United States.........................................$ 19,645 $ 39,917 Canada................................................ 5,215 (2,446) -------- -------- $ 24,860 $ 37,471 ======== ======== INCOME (LOSS) BEFORE INCOME TAXES BY GEOGRAPHIC LOCATION United States.........................................$ 19,192 $ 36,068 Canada................................................ 3,001 (1,585) -------- -------- $ 22,193 $ 34,483 ======== ======== IDENTIFIABLE ASSETS BY GEOGRAPHIC AREAS United States.........................................$508,084 $314,273 Canada..................................................41,586 39,979 -------- -------- $549,670 $354,252 ======== ======== The major industries to which the Company sells steel products are fabricators, manufacturers, steel service centers and natural gas pipeline companies. In 1993 the Company derived 11.8 percent of its sales from one customer. In 1992 and 1991, the Company derived 44.9 percent and 45 percent, respectively, of its sales from one customer. These sales were to the same customer for 1993 and 1992, but to a different customer for 1991. Operating income is total revenues less operating expenses. In determining operating income, none of the following items have been included: Investment income, interest expense, other nonoperating income (expense), settlement of litigation, provision for income taxes and equity in income or loss from minority interest. 3. INVENTORIES Inventories at December 31 consist of: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Raw materials...................................$ 26,242 $ 8,326 $ 5,868 Semi-finished product........................... 51,759 29,280 41,986 Finished product................................ 62,104 61,557 39,448 Stores and operating supplies................... 20,399 14,090 14,130 -------- -------- -------- $160,504 $113,253 $101,432 ======== ======== ======== 4. LONG-TERM DEBT AND FINANCING ARRANGEMENTS Long-term debt at December 31 is summarized as follows: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Revolving credit and term loan..................$ 16,700 $ -- $ -- CF&I term loan.................................. 64,467 -- -- Other term loans -- -- 5,125 -------- -------- -------- 81,167 -- 5,125 Less current maturities 4,680 -- 1,708 -------- -------- -------- $76,487 $ -- $ 3,417 ======== ======== ======== In June 1993 the Company entered into an unsecured revolving credit and term loan agreement (Credit Agreement) with two banks which enables the Company to borrow up to $75 million. The use of the proceeds from borrowings under this Credit Agreement is restricted to (1) investing in businesses and related equipment in the steel industry and certain other industries, and (2) working capital and general corporate purposes. On July 1, 1996, the outstanding balance will be converted, unless prepaid, to a term loan payable in sixteen equal quarterly installments through June 30, 2000. Annual commitment fees during the revolving loan period are 1/8 of 1 percent of the average daily unused portion of the available credit payable on a quarterly basis. Depending on the Company's election at the time of borrowing, interest will be payable based on either (1) the prime rate, (2) the certificate of deposit rate, (3) the federal funds rate, or (4) the Eurodollar rate as specified in the Credit Agreement. At December 31, 1993, $16.7 million was outstanding under the Credit Agreement and classified as noncurrent. Term debt of $67.5 million was incurred by CF&I as part of the purchase price of the assets of CF&I Steel Corporation on March 3, 1993. This debt is without stated collateral and is payable over ten years with interest at 9.5 percent. The Company has agreed to guarantee the payment of the first 25 months installment cash payments. At December 31, 1993, the Company's remaining commitment under this agreement is $13.1 million. As of December 31, 1993, the outstanding balance on this debt is $64.5 million, of which $59.8 million is classified as noncurrent. As of December 31 1993, principal payments on long-term debt are payable in annual installments of: 1994................................................................. $ 4,680 1995................................................................. 5,016 1996................................................................. 6,193 1997................................................................. 10,126 1998................................................................. 10,704 Balance due in installments through 2003............................. 44,448 ------- $81,167 ======= SHORT-TERM DEBT The Company has a $15 million unsecured revolving line of credit facility with a bank which matures May 31, 1994. Depending on the Company's election at the time of borrowing, interest will be payable based on either the prime rate or the federal funds rate, fully floating in either case. At December 31, 1993, there were no amounts outstanding under this credit facility. However, $15 million was restricted under outstanding letters of credit. In addition, the Company has a $5 million unsecured revolving credit line with a bank which is restricted to use for letter of credit obligations and cash advances for up to 90 days. Interest rates applicable to such advances, if any, will be set at the time of borrowing. At December 31, 1993, $3.2 million was restricted under outstanding standby letters of credit, and there were no loan amounts outstanding. Camrose Pipe Company (a 60 percent owned subsidiary) maintains a $10 million revolving credit facility with a bank, the proceeds of which may be used for working capital and general corporate purposes. The facility is collateralized by the assets of Camrose Pipe Company and expires on October 31, 1994. Depending on Camrose Pipe Company's election at the time of borrowing, interest will be payable based on (1) the bank's Canadian dollar prime rate, (2) the bank's United States dollar prime rate, or (3) the London Interbank Borrowing Rates ("LIBOR"). As of December 31, 1993, Camrose Pipe Company had $4.2 million outstanding under the facility. CF&I maintains a $15 million revolving credit facility with a bank, the proceeds of which may be used for working capital and general corporate purposes. The facility is collateralized by the accounts receivables of CF&I and expires on May 24, 1994. Depending on CF&I's election at the time of borrowing, interest will be payable based on either the bank prime rate or LIBOR. As of December 31, 1993, CF&I had $10 million outstanding under this facility. The Company's revolving credit and term loan agreements contain various restrictive covenants which include, among other things, a minimum current assets to current liabilities ratio, a minimum interest coverage ratio, a minimum ratio of cash flow to scheduled maturities of long-term debt, a minimum tangible net worth, a maximum ratio of long-term debt to total capitalization, and restrictions on liens, investments and additional indebtedness. The Company's short-term debt and revolving long-term credit facility are considered to be carried at fair value due to interest being paid at current market rates. Long-term debt is considered to be carried at fair value because its rate of interest is based on the Company's incremental borrowing rates for the same or similar types of borrowing arrangements. 5. ACCRUED EXPENSES Accrued expenses at December 31 are as follows: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Accrued profit participation....................$ -- $ 1,749 $ 2,949 Other........................................... 19,091 7,557 6,946 -------- -------- -------- $ 19,091 $ 9,306 $ 9,895 ======== ======== ======== 6. INCOME TAXES The Company has adopted Statement of Financial Accounting Standards No. 109 (FAS No. 109), "Accounting for Income Taxes," as of January 1, 1992. The accounting change had no effect on 1992 or previously reported net income. The provision for income taxes consists of the following: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Current: Federal......................................$ 5,287 $ 9,162 $ 16,293 State........................................ 984 2,082 2,512 Foreign...................................... 19 -- -- -------- -------- -------- 6,290 11,244 18,805 -------- -------- -------- Deferred: Federal...................................... 124 3,932 1,372 State........................................ 163 (670) 593 Foreign...................................... 811 -- -- -------- -------- -------- 1,098 3,262 1,965 -------- -------- -------- Provision for income taxes......................$ 7,388 $ 14,506 $ 20,770 ======== ======== ======== The components of the deferred income tax provision are as follows: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Difference between tax and financial statement accounting for: Depreciation and amortization................$ 4,707 $ 2,673 $ 2,969 Inventories.................................. (239) 447 (934) Unfunded pension liability................... (100) 126 90 Accrued vacation liability................... (1,091) -- -- Alternative minimum tax...................... (1,665) -- -- Other........................................ (514) 16 (160) -------- -------- -------- $ 1,098 $ 3,262 $ 1,965 ======== ======== ======== The components of the net deferred tax liability as of December 31 are as follows: 1993 1992 -------- -------- (IN THOUSANDS) Current deferred tax asset: Assets Inventories..........................................$ 2,268 $ 2,029 Accrued vacation liability........................... 1,920 829 Accounts receivable.................................. 597 384 State tax credits.................................... 196 196 Other................................................ 920 366 -------- -------- 5,901 3,804 Liabilities Other................................................ 1,097 171 -------- -------- Net current deferred tax asset...........................$ 4,804 $ 3,633 ======== ======== Noncurrent deferred income taxes: Assets Postretirement benefits other than pensions......... $ 2,009 $ 1,124 State tax credits................................... 207 403 Alternative minimum tax............................. 1,665 -- Excess of cost over net assets acquired............. 13,282 -- Water rights........................................ 4,247 -- Other............................................... 1,076 488 -------- -------- 22,486 2,015 Liabilities Property, plant and equipment....................... 19,015 14,308 Unfunded pension liability.......................... 615 715 Environmental liability............................. 13,282 -- Other............................................... 6,088 1,237 -------- -------- 39,000 16,260 -------- -------- Net deferred income taxes............................... $ 16,514 $ 14,245 ======== ======== A reconciliation of the statutory tax rate to the effective tax rate on income before income taxes is as follows: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) U.S. statutory income tax rate ................. 35.0% 34.0% 34.0% Tax credits..................................... (1.4) (1.8) (.5) Deduction for dividends to ESOP participants.... (2.6) (2.1) (1.3) State income taxes.............................. 6.6 5.2 4.5 Settlement of litigation........................ (4.3) 6.1 -- Rate changes on beginning deferred taxes........ 1.8 -- -- Other........................................... (1.8) .7 .3 -------- -------- -------- 33.3% 42.1% 37.0% ======== ======== ======== At December 31, 1993, the Company has available state tax credits of $403,000 for income tax purposes which expire in 1994 through 2002. 7. EMPLOYEE BENEFIT PLANS U.S. PENSION PLANS The Company has noncontributory defined benefit retirement plans covering all of its eligible domestic employees. The plans provide benefits based on participants' years of service and compensation. The Company funds at least the minimum annual contribution required by ERISA. Pension cost included the following components: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Service cost -- benefits earned during the year $ 3,857 $ 1,703 $ 1,185 Interest cost on projected benefit obligations.. 1,714 1,528 1,370 Actual return on plan assets.................... (4,002) (2,256) (1,831) Net amortization and deferral................... 2,423 1,002 668 -------- -------- -------- $ 3,992 $ 1,977 $ 1,392 ======== ======== ======== The following table sets forth the funded status of the plans and amount recognized in the Company's consolidated balance sheet at December 31: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Accumulated benefit obligations, including vested benefits of $23,589 in 1993, $17,781 in 1992, and $15,562 in 1991..................$ 26,543 $ 19,918 $ 17,629 ======== ======== ======== Projected benefit obligations for participants' service rendered to date......................$ 28,413 $ 21,987 $ 19,627 Plan assets at fair value....................... 27,380 20,464 17,031 -------- -------- -------- Projected benefit obligation in excess of plan assets (1,033) (1,523) (2,596) Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions .................... 428 2,165 2,842 Unrecognized prior service cost................. 1,156 413 471 Unrecognized net obligation at January 1, 1987 being recognized over 15 years................ 1,271 681 757 Adjustment required to recognize minimum liability..................................... (297) -- (2,072) -------- -------- -------- Pension asset (liability) recognized in consolidated balance sheet....................$ 1,525 $ 1,736 $ (598) ======== ======== ======== The following table sets forth the significant actuarial assumptions as of December 31: 1993 1992 1991 -------- -------- -------- Discount rate................................... 7.3% 8.0% 8.0% Rate of increase in future compensation levels.. 4.5% 4.5% 4.5% Expected long-term rate of return on plan assets 8.0% 8.0% 8.0% Plan assets are invested in common stock and bond funds (62 percent), marketable fixed income securities (23 percent) and insurance company contracts (15 percent) at December 31, 1993. The plans do not invest in the stock of the Company. CANADIAN PENSION PLANS The Company has noncontributory defined benefit retirement plans covering all of its eligible Camrose Pipe Company employees. The plans provide benefits based on participants' years of service and compensation. Pension costs for 1993 and 1992 were $295,000 and $146,000, respectively, for service cost benefits earned during the year. The Canadian pension plan assets acquired with the Company's 60 percent interest in Camrose Pipe Company are held by Stelco Inc. until such time as the transfer is approved by Canadian regulatory authorities. The present value of those pension assets and liabilities to be transferred as of December 31 was approximately: 1993 1992 -------- -------- (IN THOUSANDS) Assets...................................................$ 6,337 $ 5,253 Liabilities.............................................. 5,870 5,700 -------- -------- Overfunded (underfunded) amount....................... $ 467 $ (447) ======== ======== The following table sets forth the significant actuarial assumptions as of December 31: 1993 1992 -------- -------- Discount rate............................................ 7.3% 8.0% Rate of increase in future compensation levels........... 5.0% 5.0% Expected long-term rate of return on plan assets......... 8.0% 8.0% EMPLOYEE STOCK OWNERSHIP PLAN (ESOP) The Company has an ESOP for eligible domestic employees which enables an employee to own stock in the Company. This plan is a noncontributory qualified stock bonus plan. Contributions to the plan are made at the discretion of the Board of Directors. Company contributions in 1993, 1992 and 1991 were $753,000, $3.5 million and $5 million, respectively. Shares are allocated to eligible employees' accounts based on annual compensation. At December 31, 1993, the ESOP held 2.8 million shares of Company common stock. PROFIT PARTICIPATION PLANS The Company has profit participation plans under which it distributes quarterly 12 percent to 20 percent, depending on operating division, of its domestic pre-tax earnings to its eligible domestic employees. The plans define profits as pre-tax earnings from divisional operations after adjustments for certain non-operating items. Each eligible employee receives a share of the distribution based upon the level of the eligible employee's base compensation compared with the total base compensation of all eligible employees of the division. THRIFT PLAN The Company has a qualified Thrift Plan (401-K) for all of its eligible domestic employees that is designed to receive and invest their deferred compensation as provided by current laws. The Company currently matches 25 percent of the first 4 percent of the participant's deferred compensation. Company contributions in 1993, 1992 and 1991 were $461,000, $424,000 and $388,000, respectively. POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS In December 1990 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106 (FAS No. 106), "Employers' Accounting for Postretirement Benefits Other than Pensions." This statement requires the accrual of benefits during the years the employee provides services to the Company. The Company adopted this statement during the quarter ended March 31, 1991 and elected to recognize the initial postretirement benefit obligation (i.e., the "transition obligation") of approximately $7.8 million over a period of twenty years. The Company provides certain health care and life insurance benefits for substantially all of its retired employees. Employees are generally eligible for benefits upon retirement and completion of a specified number of years of service. The benefit plans are unfunded. The following table sets forth the health care plans' status at December 31: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Accumulated postretirement benefit obligation: Retirees......................................$ 8,240 $ 7,155 $ 7,279 Fully eligible plan participants.............. 1,294 786 269 Other active plan participants................ 5,050 1,728 481 -------- -------- -------- $ 14,584 $ 9,669 $ 8,029 ======== ======== ======== Accumulated postretirement benefit obligation in excess of plan assets......................$(14,584) $ (9,669) $ (8,029) Unrecognized net (gain) loss.................... 34 (450) 25 Accrued postretirement benefit cost............. 7,557 2,716 566 -------- -------- -------- Postretirement asset recognized in consolidated balance sheet.................................$ 6,993 $ 7,403 $ 7,438 ======== ======== ======== Net periodic postretirement benefit cost include the following components: Service cost attributed to service during the year...........................$ 395 $ 196 $ 86 Interest cost on accumulated postretirement benefit obligation........................ 1,017 733 665 Amortization of transition obligation....... 410 410 392 -------- -------- -------- Net periodic postretirement benefit cost........$ 1,822 $ 1,339 $ 1,143 ======== ======== ======== For measurement purposes, a long-term inflation rate of 6 percent is assumed for health care cost trend rates. However, a higher inflation rate (12 percent in 1994) has been assumed over the next five years, based on trends related to health care costs. The effect of a one percentage point increase in the assumed health care cost trend rate for 1994 would increase the accumulated postretirement benefit obligation by $610,000; the aggregate service and interest cost would increase $65,000. The discount rate used in determining the accumulated postretirement benefit obligation was 7.3 percent. 8. RELATED PARTY TRANSACTIONS The Company's 60 percent owned Camrose Pipe Company purchases steel coil and plate under a steel supply agreement from Stelco Inc. whose wholly owned subsidiary, Stelcam Holdings Inc., owns 40 percent of Camrose Pipe Company. Transactions under the agreement are at negotiated market prices. The following table summarizes the transactions among Camrose Pipe Company, Stelco Inc., and Stelcam Holdings Inc.: 1993 1992 -------- -------- (IN THOUSANDS) Purchases from Stelco....................................$ 59,019 $ 17,000 Accounts payable to Stelco at December 31............... 6,755 7,100 Note payable to Stelcam at December 31 (interest at Canadian prime rate plus 2 percent)....... -- 2,200 9. COMMITMENTS AND CONTINGENCIES ENVIRONMENTAL The Company's Napa Pipe Corporation subsidiary has a reserve of $3.1 million at December 31, 1993 for environmental remediation relating to the Napa facility. The Company's estimate of this environmental reserve was based on several remedial investigations and feasibility studies performed by an independent engineering consultant. The estimated costs were based on current technologies and presently enacted laws and regulations. The reserve includes costs for remedial action and monitoring, and operations and maintenance of the remedial action taken. Corrective action is scheduled to be completed in 1997. An environmental reserve of $36.7 million was accrued as part of the CF&I Pueblo, Colorado steel mill acquisition (see Note 11). FORMER EMPLOYEE LAWSUITS In 1992 the Company settled for $6.2 million certain litigation in the United States District Court of Oregon ("District Court Cases") relating to claims filed by former employee participants in the Company's ESOP and Tax Credit Employee Stock Ownership Plan ("TCESOP") in connection with claims and/or rescission of certain transactions which occurred during the period August 1985 through March 1987. This litigation involved the purchase by the Company of 1.5 million shares of its common stock which had been held by the ESOP and TCESOP. The Company also settled its claim against the primary insurance company which provided the Company's officers and directors liability insurance for the above claim for $1.2 million. As a result of these settlements, the Company recorded a $5 million charge to income in the fourth quarter of 1992. The Company's pursuit of its claim against its excess liability insurance carrier for the balance of the settlement amount and legal costs paid in connection with the District Court Cases was settled for $2.8 million and collected in the second quarter of 1993. CONTRACTS WITH KEY EMPLOYEES The Company has employment agreements with certain of its officers which provide for severance compensation to such employees in the event their employment with the Company is terminated subsequent to a change in control (as defined) of the Company under the circumstances set forth in the agreements. Each agreement has automatic annual extensions until the employee reaches the age of 65, unless either the Company or the employee gives notice that the agreement shall not be extended. In the event of a change in control while the agreements are in effect, the agreements are automatically extended for 36 months from the date the change in control occurs. The agreements will generally terminate upon termination of employment prior to a change in control of the Company. If, within 36 months following a change in control, the employee's employment with the Company is terminated by the Company without cause (as defined) or by the employee with good reason (as defined), then the Company will pay to the employee his full base salary through the date of termination at the rate in effect on the date the change in control occurred, plus three times his annual base salary at the above-specified rate, the four most recent quarterly cash distributions from the Company's profit participation plan and certain postretirement benefits as specified in the agreement. The employee is also entitled to be reimbursed for any reasonable legal fees and expenses he may incur in enforcing his rights under the agreement. 10. CAPITAL STOCK The Board of Directors has the authority to issue shares of preferred stock from time to time in one or more series and to fix the number of shares to be included in such a series, the designation, powers, preferences and rights of the shares of each such series and any qualifications, limitations or restrictions of such series, including but not limited to dividend rights, dividend rates, conversion rights, voting rights, rights and terms of redemption (including sinking fund provisions) and liquidation preferences, all without any vote or action by the stockholders. In connection with the acquisition of substantially all of the assets of CF&I Steel Corporation, the Company, through its ownership interest in CF&I Steel, L. P., agreed to issue 598,400 shares of its common stock in March 2003 to specified creditors of CF&I Steel Corporation. The stock was valued at $11.2 million using the Black-Scholes valuation method. The common stock has no voting rights or rights to receive dividends until it is issued. In connection with the acquisition, the Company also delivered warrants to CF&I Steel Corporation to purchase for five years, expiring March 3, 1998, 100,000 shares of the Company's common stock at $35 per share. The warrants were valued at $556,000 using the Black-Scholes method (see Note 11). 11. BUSINESS ACQUISITIONS CF&I STEEL, L. P. On March 3, 1993, New CF&I, Inc. ("General Partner"), a wholly-owned subsidiary of the Company, acquired for $22.2 million a 95.2 percent interest in a newly formed limited partnership, CF&I Steel, L.P. ("CF&I"). The remaining 4.8 percent interest is owned by the Pension Benefit Guaranty Corporation ("Limited Partner"). Concurrent with the formation of CF&I and the acquisition of the partnership interest by the General Partner, CF&I purchased from CF&I Steel Corporation substantially all of the assets of its steelmaking, fabricating, metals and railroad business ("Business"). The purchase price for the Business was $113.1 million paid by the General Partner's capital contribution of $22.2 million (consisting of $7.3 million cash, $3.1 million capitalized direct acquisition costs, 598,400 shares of Company common stock valued at $11.2 million to be issued ten years from March 3, 1993, and by the delivery of warrants to purchase 100,000 shares of Company common stock at $35 per share for five years valued at $556,000), by the Limited Partner's capital contribution of an asset valued at $1.2 million, by installment payments to be paid by CF&I totalling $67.5 million in principal plus interest at 9.5 percent over a period of 10 years, by the assumption of non contingent liabilities of CF&I Steel Corporation in the aggregate amount of $18.5 million, and by the assumption of a liability for postretirement health care benefits of $3.7 million. The Company has guaranteed the payment of the first 25 months of cash installment payments on the $67.5 million note (a total of approximately $13.1 million of principal and interest at December 31, 1993), and the performance of certain capital expenditures for improvements at the facilities being acquired in the aggregate amount of $40 million. As part of the acquisition, CF&I accrued a reserve of $36.7 million for environmental remediation at CF&I's Pueblo, Colorado steel mill. CF&I believes $36.7 million is the best estimate from a range of $23.1 to $43.6 million. CF&I's estimate of this environmental reserve was based on two separate remediation investigations and feasibility studies conducted by independent environmental engineering consultants. The estimated costs were based on current technologies and presently enacted laws and regulations. The reserve includes costs for RCRA (Resource Conservation and Recovery Act) facility investigation, a corrective measures study, remedial action, and operation and maintenance of the proposed remedial actions. The State of Colorado is reviewing a permit application and will issue a permit to CF&I with a schedule for corrective action specifying activities to be completed by certain dates. The State of Colorado anticipated that the schedule would be reflective of a straight line rate of expenditure over 30 years. The State of Colorado stated the schedule for corrective action could be accelerated if new data indicated a greater threat to the environment than is currently known to exist. Any adjustment to the environmental liability as a result of new technologies, new laws, or new facts after the purchase price allocation period will be generally recognized as an element of income with certain limited exceptions which meet generally accepted accounting principles' criteria for capitalization. For financial statement reporting purposes only, the acquisition has been treated as a business combination using the purchase method of accounting. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on the estimated fair values at the date of acquisition. The operating results of this acquisition are included in the Company's consolidated results of operations from the date of acquisition. The estimated fair values of assets acquired and liabilities assumed are summarized as follows: (IN THOUSANDS) ---------- Accounts receivable................................................ $ 40,167 Inventories........................................................ 28,527 Other current assets............................................... 490 Property, plant and equipment...................................... 28,518 Investments and other assets....................................... 52,136 Current portion of long-term debt.................................. (4,251) Accounts payable................................................... (18,500) Other accured expenses............................................. (2,000) Long-term debt..................................................... (63,249) Deferred employee benefits......................................... (3,680) Other deferred liabilities......................................... (34,716) Minority interest.................................................. (1,200) -------- $ 22,242 ======== Investments and other assets include excess of cost over net assets acquired ($40.4 million) and water rights ($11.7 million). Other deferred liabilities represent an accrued liability for environmental remediation less the current year portion of $2 million which is included in other accrued expenses. The following unaudited pro forma summary presents the Company's consolidated results of operations as if the acquisition had occurred as of January 1, 1992, after giving effect to adjustments for salaries and wages, fringe benefits, depreciation and amortization, interest expense, reversal of reorganization costs, and extraordinary loss from termination of pension plans by CF&I Steel Corporation. The pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisition been made as of January 1, 1992, or of results which may occur in the future. YEAR ENDED DECEMBER 31 ---------------------- (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) 1993 1992 -------- -------- Net sales................................................$729,604 $638,343 Net Income...............................................$ 16,922 $ 24,871 Primary and fully diluted net income per common and common equivalent share.................$ .85 $ 1.26 CAMROSE PIPE COMPANY On June 30, 1992, Camrose Pipe Corporation, a wholly-owned subsidiary of the Company, acquired for $18 million a 60 percent interest in a newly formed Canadian general partnership, Camrose Pipe Company ("Camrose"). The remaining 40 percent interest is owned by Stelcam Holdings Inc., a wholly-owned subsidiary of Stelco Inc ("Stelco"). Concurrent with the formation of Camrose and the purchase of the partnership interest by Camrose Pipe Corporation, Camrose purchased from Stelco, Stelco's steel pipemaking facility in Camrose, Alberta, Canada and related receivables, inventories and other current assets. The purchase price for the Camrose assets may increase or decrease based upon an annual performance adjustment over a five-year period as described in the Asset Purchase Agreement. Since additional consideration is contingent on achieving specified earnings levels in future periods, the Company will record the current fair value of the consideration as additional cost of the acquired company. The additional cost would be assigned to the tangible assets acquired or excess of cost over net assets acquired depending on an independent appraisal of the fair value of the assets acquired. For financial statement reporting purposes only, the acquisition has been treated as a business combination using the purchase method of accounting. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on the estimated fair values at the date of acquisition (June 30, 1992). The operating results of this acquisition are included in the Company's consolidated results of operations from the date of acquisition. The estimated fair values of assets acquired and liabilities assumed are summarized as follows: (IN THOUSANDS) ---------- Accounts receivable................................................ $ 8,107 Inventories........................................................ 5,491 Other current assets............................................... 302 Property, plant and equipment...................................... 26,545 Investment and other assets........................................ 615 Accounts payable and accrued liabilities........................... (3,208) Due to partners.................................................... (5,650) Other liabilities.................................................. (2,234) Minority interest.................................................. (11,996) -------- $ 17,972 ======== ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEMS 10 and 11. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT AND EXECUTIVE COMPENSATION A definitive proxy statement of Oregon Steel Mills, Inc. will be filed not later than 120 days after the end of the fiscal year with the Securities and Exchange Commission. The information set forth therein under "Election of Directors" and "Executive Compensation" is incorporated herein by reference. Executive Officers of Oregon Steel Mills, Inc. and principal subsidiaries are listed on page 11 of this Form 10-K. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required is set forth under the caption "Principal Stockholders" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required is set forth under the caption "Executive Compensation" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K PAGE (A) (i) FINANCIAL STATEMENTS: Report of Independent Accountants............................. 20 Consolidated Financial Statements: Balance Sheets at December 31, 1993, 1992 and 1991.......... 21 Statements of Income for each of the three years in the period ended December 31, 1993..................... 22 Statements of Changes in Stockholders' Equity for the three years ended December 31, 1993............... 23 Statements of Cash Flows for each of three years in the period ended December 31, 1993..................... 24 Notes to Consolidated Financial Statements.................. 25 (ii) Financial Statement Schedules: All required schedules will be filed by amendment to this Form 10-K. (iii) Exhibits: References made to the list on page 3 of the exhibits filed with this report. (B) No reports on Form 8-K were required to be filed by the Registrant during the fourth quarter of the fiscal year ended December 31, 1993. LIST OF EXHIBITS* 2.0 Asset Purchase Agreement dated as of January 2, 1992, by and between Camrose Pipe Company (a partnership) and Stelco Inc. (Filed as exhibit 2.0 to Form 8-K dated June 30, 1992 and incorporated by reference herein.) 2.1 Asset Purchase Agreement dated as of March 3, 1993, among CF&I Steel Corporation, Denver Metals Company, Albuquerque Metals Company, CF&I Fabricators of Colorado, Inc., CF&I Fabricators of Utah, Inc., Pueblo Railroad Service Company, Pueblo Metals Company, Colorado & Utah Land Company, the Colorado and Wyoming Railway Company, William J. Westmark as trustee for the estate of The Colorado and Wyoming Railway Company, CF&I Steel, L.P., New CF&I, Inc. and Oregon Steel Mills, Inc. (Filed as exhibit 2.1 to Form 8-K dated March 3, 1993, and incorporated by reference herein.) 3.1 Restated Certificate of Incorporation of the Company. (Filed as exhibit 3.1 to Form 10-K for the year ended December 31, 1992, and incorporated by reference herein.) 3.2 Bylaws of the Company. (Filed as exhibit 3.2 to Form 10-Q dated March 31, 1993, and incorporated by reference herein.) 4.1 Specimen Common Stock Certificate. (Filed as exhibit 4.1 to Form S-1 Registration Statement 33-38379 and incorporated by reference herein.) 4.2 Form of Oregon Steel Mills, Inc. -- Five-Year Common Stock Purchase Warrant. (Filed as exhibit 4.2 to Form 8-K dated March 3, 1993, and incorporated by reference herein.) 10.1 Employee Stock Ownership Plan, as amended. (Filed as exhibit 10.1 to Form S-1 Registration Statement 33-38379 and incorporated by reference herein.) 10.2 Employee Stock Ownership Plan Trust Agreements. (Filed as exhibit 10.2 to Form 10-K for the year ended December 31, 1990 and incorporated by reference herein.) 10.3 Profit Participation Plan. (Filed as exhibit 10.5 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.4 Form of Indemnification Agreement between the Company and its directors. (Filed as exhibit 10.6 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.5 Form of Indemnification Agreement between the Company and its executive officers. (Filed on exhibit 10.7 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.6 Agreement for Electric Power Service between registrant and Portland General Electric Company. (Filed as exhibit 10.20 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.9 Key employee contracts for Thomas B. Boklund, Robert R. Mausshardt and Robert J. Sikora. (Filed as exhibit 10.11 to Form 10-K for the year ended December 31, 1988, and incorporated by reference herein.) 10.10 Key employee contracts for L. Ray Adams and James R. McCaughey. (Filed as exhibit 10.10 to Form 10-K for the year ended December 31, 1990 and incorporated by reference herein.) 10.11 Key employee contract for Edward J. Hepp. (Filed as exhibit 10.11 to Form 10-K for the year ended December 31, 1991, and incorporated by reference herein.) 10.12 Net lease between Oregon Steel Mills-Fontana Division Inc. and California Steel Industries. (Filed as exhibit 10.16 to Form S-1 Registration Statement 33-38379 and incorporated by reference herein.) 11.0 Statement re computation of per share earnings. 21.0 Subsidiaries of registrant. (Filed as exhibit 22.1 to Form 10-K for the year ended December 31, 1992, and incorporated by reference herein.) - ---------- *The Company will furnish to stockholders a copy of the exhibit upon payment of $.25 per page to cover the expense of furnishing such copies. Requests should be directed to Vicki A. Tagliafico, Investor Relations Contact, Oregon Steel Mills, Inc., PO Box 5368, Portland, Oregon 97228. 28.0 Partnership Agreement dated as of January 2, 1992, by and between Camrose Pipe Corporation and Stelcam Holding, Inc. (Filed as exhibit 28.0 to Form 8-K dated June 30, 1992, and incorporated by reference herein.) 28.1 Amended and Restated Agreement of Limited Partnership of CF&I Steel, L.P. dated as of March 3, 1993 by and between New CF&I, Inc. and the Pension Benefit Guaranty Corporation. (Filed as exhibit 28.1 to Form 8-K dated March 3, 1993, and incorporated by reference herein.) 99.0 Oregon Steel Mills, Inc. Pension Plan, as amended. SIGNATURES REQUIRED FOR FORM 10-K Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Oregon Steel Mills, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. OREGON STEEL MILLS, INC. (Registrant) By /s/ Thomas B. Boklund ------------------------ Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Oregon Steel Mills, Inc. and in the capacities and on the date indicated. SIGNATURE TITLE DATE --------- ----- ---- /s/ THOMAS B. BOKLUND Chairman of the Board - ----------------------- Chief Executive Officer (Thomas B. Boklund) (Principal Executive Officer) March 1, 1994 /s/ L. RAY ADAMS Vice President of Finance, - ----------------------- and Secretary (L. Ray Adams) (Principal Financial Officer) March 1, 1994 /s/ JACKIE L. WILLIAMS Controller - ----------------------- (Principal Accounting Officer) March 1, 1994 (Jackie L. Williams) /s/ C. LEE EMERSON Director March 1, 1994 - ----------------------- (C. Lee Emerson) /s/ V. NEIL FULTON Director March 1, 1994 - ----------------------- (V. Neil Fulton) /s/ EDWARD C. GENDRON Director March 1, 1994 - ----------------------- (Edward C. Gendron) /s/ RICHARD G. LANDIS Director March 1, 1994 - ---------------------- (Richard G. Landis) /s/ JAMES A. MAGGETTI Director March 1, 1994 - ---------------------- (James A. Maggetti) /s/ JOHN A. SPROUL - ---------------------- (John A. Sproul) Director March 1, 1994 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table sets forth for the periods indicated the percentages of sales represented by selected income statement items and information regarding selected balance sheet data: YEARS ENDED DECEMBER 31, ---------------------------- 1993 1992 1991 ---- ---- ---- INCOME STATEMENT DATA: Sales ........................................ 100.0% 100.0% 100.0% Cost of sales ................................ 89.4 79.6 79.0 Selling, general and administrative expenses . 6.1 7.5 5.9 Contribution to employee stock ownership plan .1 .9 1.0 Profit participation ......................... .7 2.6 2.9 ---- ----- ----- Operating income ........................... 3.7 9.4 11.2 Interest and dividend income ................. .1 .2 .4 Interest expense ............................. (.6) -- -- Other income (expense), net .................. -- -- (.1) Settlement of litigation ..................... .4 (1.3) -- Minority interest ............................ (.3) .3 -- ---- ---- ---- Pretax income .............................. 3.3 8.6 11.5 Income tax expense ........................... (1.1) (3.6) (4.3) ---- ---- ---- Net income ................................. 2.2% 5.0% 7.2% ==== ==== ==== BALANCE SHEET DATA (AT DECEMBER 31): Current ratio ................................ 2.2:1 2.8:1 3.8:1 Long-term debt as a percent of capitalization 21.7% -- 1.4% Net book value per share ..................... $14.23 $13.41 $12.90 The following table sets forth by division for the periods indicated tonnage sold, revenues and average selling price per ton: TOTAL TONNAGE SOLD: Oregon Steel Division Plate products ............................. 436,200 379,700 344,100 Pipe products .............................. 323,700 285,600 418,600 Semi-finished products ..................... 18,400 -- -- --------- ------- ------- 778,300 665,300 762,700 CF&I Steel Division .......................... 624,700 -- -- --------- ------- ------- 1,403,000 665,300 762,700 ========= ======= ======= REVENUES (IN THOUSANDS): Oregon Steel Division ........................ $415,165 $397,722 $489,357 CF&I Steel Division .......................... 264,658 -- -- -------- -------- -------- Total ...................................... $679,823 $397,722 $489,357 ======== ======== ======== AVERAGE SELLING PRICE PER TON: Oregon Steel Division $533 $598 $642 CF&I Steel Division $424 -- -- Average $485 $598 $642 The Company's long-range strategic plan has been to provide stability for its operating facilities through expanding its product mix and markets to minimize the impact of product cycles in the domestic large diameter pipe product produced at the Napa Facility. The domestic market for large diameter pipe declined significantly during 1993 from that experienced in prior years. The Napa Facility shipped 168,300 tons in 1993 compared to 255,100 tons in 1992 and 418,600 tons in 1991; domestic shipments will decline further in 1994. The Company believes that the decline in the domestic large diameter pipe market will continue beyond 1994, quite possibly to the end of the decade. In an effort to decrease the Company's reliance on the domestic large diameter steel pipe market and provide additional end uses for its steel plate, the Company purchased an interest in the Camrose Facility. During the last six months of 1992 and for all of 1993, the Camrose Facility shipped 30,000 tons and 155,400 tons respectively of steel pipe. The Company believes there will continue to be opportunities in Canada for steel pipe as the large reserves of natural gas in western Canada continue to be developed during the next several years. To expand the Company's steel product lines and enter new geographic areas, the Company purchased its 95.2 percent interest in CF&I. During 1993, CF&I shipped 624,700 tons and generated $264.7 million in revenue. In November of 1993 the Company's Napa Facility was awarded a contract from the Petroleum Authority of Thailand to produce and ship 133,000 tons of large diameter pipe during 1994. The Company has also been awarded a contract from British Gas to provide large diameter pipe for a severe sour gas service pipeline offshore in Tunisia. The Company believes the international market for large diameter oil and gas transmission pipe could provide signficant opportunities over the next few years. The Company's capital expenditures at the Portland Steel Mill over the last five years have been committed to increasing the Company's ability to produce high quality, specialty steel plate. In 1993 the Company installed a vacuum degassing unit at the Portland Steel Mill which will enable it to produce the highest quality steel plate and line pipe steels. The installation of this technology will also enable the Company to be a viable supplier to the international large diameter pipe market. In addition, the Company expanded the capacity of the heat treating facility at the Portland Steel Mill from 60,000 to 90,000 tons and completed installation of a new leveler in February of 1994. The Company believes these capital expenditures will further enhance its ability to produce high quality, specialty steel plate and focus on increasing its share of this market. The capital expenditure program at CF&I began in November of 1993 with the ground breaking for the rod/bar mill modernization. This modernization is expected to be completed during the third quarter of 1994. During 1994 the steel making facilities at CF&I will be upgraded with the installation of a ladle metallurgy station, a vacuum degassing unit, elimination of ingot casting for the rail mill, and conversion of existing casters to provide continuous cast steel for all products. These upgrades are expected to be completed and operational at the end of 1994. The Company believes it will realize significant yield improvements and cost reduction when this phase of the capital expenditure plan is completed. Future expenditures at CF&I will include modifications to the rail mill and installation of in-line head hardening for rails. The Company expects raw material costs such as scrap and alloys to remain high during 1994. The Company implemented price increases on most of its products in the fourth quarter of 1993 and the first quarter of 1994 to partially offset increased raw material costs. The Company does not expect that the pricing environment for steel plate, large diameter pipe and steel rail products will improve significantly from current levels during 1994. Pricing in the Company's other steel products will be affected by the competitive environment in the respective product markets. COMPARISON OF 1993 TO 1992 Sales. Sales in 1993 of $679.8 million increased 70.9 percent from sales of $397.7 million in 1992. Tonnage shipments increased 110.9 percent to 1.4 million tons in 1993 from 665,300 tons in 1992. Selling prices in 1993 averaged $485 per ton versus $598 in 1992. Of the $282.1 million sales increase, $441 million was the result of volume increase offset by $158.9 million of lower average selling prices. The increase in sales and shipments was primarily due to the inclusion of the operations of CF&I and a full year contribution from 60 percent owned Camrose Facility which was formed on June 30, 1992. The decrease in selling price was primarily due to a decline in large diameter steel pipe shipments from the Napa Facility (168,300 tons in 1993 versus 255,100 tons in 1992) and a larger percentage of CF&I's product mix to total sales and shipments. On average CF&I's products have a lower selling price than steel plate and large diameter pipe products. Gross Profits. Gross profits as a percentage of sales for 1993 were 10.6 percent compared to 20.4 percent for 1992. The gross profit margin decline year to year is due to higher raw material costs, principally scrap, which could not be completely recovered through sales price increases. During 1993 the Company experienced an average increase of $26 per ton in scrap cost over the average 1992 cost per ton. This increase reversed the downward spiral in costs experienced for certain raw materials during the previous two years. In addition, the reduction of pipe production and pipe shipments in 1993 at the Company's Napa Facility negatively impacted the Company's ability to absorb fixed costs at both the Napa Facility and the Fontana Plate Mill, since a majority of the Fontana Plate Mill production is shipped to the Napa Facility for conversion into steel pipe. Decreased Napa Facility shipments also required the Company to increase its sales of lower margin commodity steel plate products in order to sustain the operating efficiency of the Portland Steel Mill. Production began on a number of large pipe orders during the fourth quarter of 1993; however, the revenues related to these orders will not be recognized until shipments begin in the first quarter of 1994. The Company implemented price increases of $20 a ton on its steel plate shipments, effective November 1, 1993, on all new orders and January 3, 1994 for all tons shipped. During fourth quarter 1993, price increases of $15 a ton were announced on bar, wire rod and certain wire products, and OCTG and line pipe products manufactured at CF&I. Selling, General and Administrative. Selling, general and administrative expenses for 1993 increased $11.7 million or 39.2 percent compared with 1992 but decreased as a percentage of sales from 7.5 percent in 1992 to 6.1 percent in 1993. The dollar amount increase is primarily a result of the Company's acquisitions of Camrose and CF&I ($11.5 million), increased expenses related to increased support required by the Company's growth and general inflation ($2.3 million), offset by decreased shipping costs due to reduced pipe shipments from the Company's Napa Facility ($2.1 million). The percentage decrease is due primarily to the increased sales volume in 1993. Contribution to ESOP and Profit Participation. The contribution to the ESOP was $753,000 in 1993 compared with $3.5 million in 1992. Profit Participation Plan expense was $4.5 million for 1993 compared with $10.5 million for 1992. These reductions are a result of the decreased profitability of the Company in 1993 versus 1992. Interest and Dividend Income. Interest and dividend income on investments was $.9 million in 1993 compared with $.7 million in 1992. This increase was primarily the result of an increase in average cash and cash equivalent balances available for investment and an increase in average interest rates during 1993 compared with 1992. Interest Expense. Total interest cost for 1993 was $5.7 million, an increase of $5.4 million compared to 1992. This increase was primarily related to interest cost incurred on debt issued by CF&I for its purchase of substantially all the assets of CF&I Steel Corporation. Of the $5.7 million of interest cost, $1.7 million was capitalized as part of construction in progress. Settlement of Litigation. The $2.8 million recovery from settlement of litigation was received from the Company's excess liability insurance carrier in the second quarter of 1993 and related to former employee lawsuits which were settled in the fourth quarter of 1992 (see Note 9 to the consolidated financial statements). Income Tax Expense. The Company's effective income tax rate for state and federal taxes was 33.3 percent for 1993 compared to 42.1 percent for 1992. The effective income tax rate for both periods varied from the combined state and federal statutory rates due to utilization of carryforward tax credits against state income taxes and deductible dividends paid on stock held by the ESOP and paid to ESOP participants. The higher effective income tax rate in 1992 resulted primarily because the litigation settlement expense of $5 million was treated as a nondeductible item for tax purposes. In 1993 the insurance recovery of $2.8 million related to the 1992 litigation settlement was treated as a nontaxable item (see Note 6 to the consolidated financial statements). COMPARISON OF 1992 TO 1991 Sales. Sales in 1992 of $397.7 million declined 18.7 percent from sales of $489.4 million in 1991. Tonnage shipments decreased 12.8 percent to 665,300 tons in 1992 from 762,700 tons in 1991. Selling prices in 1992 averaged $598 per ton versus $642 in 1991. Of the $91.7 million sales decrease, 32 percent was the result of lower selling prices and 68 percent was the result of volume decreases. The decrease in tonnage sold is the result of the decline in large diameter pipe shipments from the Company's Napa Facility (255,100 tons in 1992 versus 418,600 tons in 1991). The decline in pipe sales was also partially the result of the Company not being able to ship at December 31, 1992, 39,400 tons of large diameter steel pipe that had been produced under contract at the Napa Facility. Because the steel pipe had not been shipped, revenue of $36.5 million associated with the production was not recognized until fiscal 1993 when the steel pipe was shipped. In 1991 this facility produced a greater tonnage volume of large diameter pipe than at any time in its history. The decrease in average sales price was primarily the result of a decrease in the proportion of higher priced large diameter pipe products in the Company sales mix in 1992 compared to 1991. Gross Profits. Gross profits as a percentage of sales for 1992 were 20.4 percent compared to 21 percent for 1991. These margins were approximately the same year to year despite a decline in the average per ton sales price in 1992 ($598) versus 1991 ($642). This is a result of a decline in per ton production costs in 1992 at the Portland Steel Mill (principally because of lower scrap costs) and the Napa Facility from those costs experienced in 1991. In 1991 the Napa Facility experienced production problems associated with certain pipeline projects, which resulted in higher than normal reworked and downgraded steel pipe. These production problems were corrected during 1991. In addition, during 1991, the Company purchased substantial quantities of steel plate for forming into steel pipe from outside suppliers at a cost significantly above its internal cost of production. No significant quantities of plate were purchased from outside suppliers during 1992. The Company estimated the reworking and downgrading of the steel pipe and purchased plate decreased the Company's gross profit margin in 1991 by approximately $10 million from what it otherwise would have been. Margins for 1992 were also negatively impacted due to limited pipe shipments from the Camrose Facility, whose results of operations were included beginning on June 30, 1992. Selling, General and Administrative. Selling, general and administrative expenses for 1992 increased $.9 million or 3 percent compared with 1991 and increased as a percentage of sales from 5.9 percent in 1991 to 7.5 percent in 1992. The dollar amount increase is primarily a result of an increase in legal expense relating to litigation, the inclusion of expenses from the newly acquired Camrose Facility and general inflation. The percentage increase is due primarily to the decreased sales volume in 1992. Contribution to ESOP and Profit Participation. The contribution to the ESOP was $3.5 million in 1992, compared to $5 million in 1991. Profit Participation Plan expense was $10.5 million for 1992 compared with $14.3 million for 1991. These reductions are a result of the decreased profitability of the Company in 1992 versus 1991. Interest and Dividend Income. Interest and dividend income on investments was $.7 million in 1992 compared with $1.9 million in 1991. This decrease was primarily the result of a decline in average cash and cash equivalent balances available for investment and a decline in average interest rates during 1992 compared with 1991. Interest Expense. Total interest cost for 1992 was $.3 million, a decrease of $1.1 million compared to the comparable period in 1991. This decrease was due to a reduction in the amount of short-term borrowings and lower interest rates. All interest costs incurred in 1992 were capitalized as part of construction in progress. Settlement of Litigation. During the fourth quarter of 1992, the Company recorded a net charge of $5 million related to the settlement of former employee lawsuits (see Note 9 to the consolidated financial statements). Income Tax Expense. The Company's effective income tax rate for state and federal taxes was 42.1 percent for 1992 compared with 37 percent for 1991. The effective income tax rate for both periods varied from the combined state and federal statutory rates due to utilization of carryforward tax credits against state income taxes and deductible dividends paid on stock held by the ESOP and paid to ESOP participants. The increased effective income tax rate in 1992 resulted because the $5 million litigation settlement expense was treated as a nondeductible item (see Note 6 to the consolidated financial statements). LIQUIDITY AND CAPITAL RESOURCES Positive cash flow from 1993 operations was $44.5 million compared to a positive cash flow of $48.4 million in the corresponding 1992 period. The major items affecting this $3.9 million decrease were positive cash flows from increased depreciation and amortization ($5.1 million), increased minority interest earnings ($2 million), less funds required for payment of income and other taxes ($7.3 million), and less payments made on trade accounts payable and accrued expenses ($34.7 million). These positive cash flows were offset by reduced net income ($5.2 million), reduced ESOP contributions ($2.8 million), increased trade accounts receivable ($34.2 million), and increased inventories ($12.4 million). Net working capital at December 31, 1993 increased $40 million from December 31, 1992 due to a $100.8 million increase in current assets offset by a $60.8 million increase in current liabilities. Trade accounts receivable increased from $23.9 million at the end of 1992 to $71.6 million at December 31, 1993. The increase is primarily a result of the inclusion of CF&I sales for the first time in 1993. The December 31, 1993 inventory increase and the increase in current liabilities are primarily due to the addition of inventories, accounts payable and current portion of long-term debt as a result of the CF&I acquisition. The Company maintains an unsecured revolving credit and term loan agreement (Credit Agreement) with two banks which enables the Company to borrow up to $75 million. The use of the proceeds from borrowings under this Credit Agreement is restricted to (1) investing in businesses and related equipment in the steel industry and certain other industries, and (2) working capital and general corporate purposes. On July 1, 1996, the outstanding balance will be converted, unless prepaid, to a term loan payable in sixteen equal quarterly installments through June 30, 2000. Annual commitment fees during the revolving loan period are 1/8 of 1 percent of the average daily unused portion of the available credit payable on a quarterly basis. Depending on the Company's election at the time of borrowing, interest will be payable based on either (1) the prime rate, (2) the certificate of deposit rate, (3) the federal funds rate or (4) the Eurodollar rate as specified in the Credit Agreement. At December 31, 1993, $16.7 million was outstanding under this credit facility and classified as noncurrent. The Company has a $15 million unsecured revolving line of credit facility with a bank which matures May 31, 1994. Depending on the Company's election at the time of borrowing, interest will be payable based on either the prime rate or the federal funds rate, fully floating in either case. At December 31, 1993, there were no amounts outstanding under this credit facility. However, $15 million was restricted under outstanding letters of credit. In addition, the Company has a $5 million unsecured revolving credit line with a bank which is restricted to use for letter of credit obligations and cash advances for up to 90 days.Interest rates applicable to such advances, if any, will be set at the time of borrowing. At December 31, 1993, $3.2 million was restricted under outstanding standby letters of credit, and there were no loan amounts outstanding. Camrose Pipe Company (a 60 percent owned subsidiary) maintains a $10 million revolving credit facility with a bank, the proceeds of which may be used for working capital and general corporate purposes. The facility is collateralized by the assets of Camrose Pipe Company and expires on October 31, 1994. Depending on Camrose Pipe Company's election at the time of borrowing, interest will be payable based on (1) the bank's Canadian dollar prime rate, (2) the bank's United States dollar prime rate, or (3) the London Interbank Borrowing Rates ("LIBOR"). As of December 31, 1993, Camrose Pipe Company had $4.2 million outstanding under the facility. CF&I maintains a $15 million revolving credit facility with a bank, the proceeds of which may be used for working capital and general corporate purposes. The facility is collateralized by the accounts receivables of CF&I and expires on May 24, 1994. Depending on CF&I's election at the time of borrowing, interest will be payable based on either the bank prime rate or LIBOR. As of December 31, 1993, CF&I had $10 million outstanding under this facility. CF&I issued a $67.5 million term note as part of the purchase price of the assets of CF&I Steel Corporation on March 3, 1993. This debt, which is unsecured, is payable over ten years, plus interest at 9.5 percent. The Company has agreed to guarantee the payment of the first 25 months' installment cash payments. At December 31, 1993, the Company's remaining commitment under this guarantee is $13.1 million. As of December 31, 1993, the outstanding balance on this debt is $64.5 million, of which $59.8 million is classified as noncurrent. The Company has started a $180 million capital spending program at its CF&I Steel Division. In 1993 approximately $20 million was expended as progress payments on the major components of the project including the installation of a new bar mill reheat furnace, new rod mill, a continuous caster and the upgrading of the steelmaking facilities with a new ladle furnace and vacuum degassing system. The Company expects to expend $110 million on the capital program at CF&I in 1994. The Company has also budgeted approximately $21 million for capital expenditures at its Oregon Steel Division manufacturing facilities. The Company expects to spend approximately $1 million at the Portland Steel Mill to complete its vacuum degassing and heat treating facility projects. The remaining Portland Steel Mill and Fontana Plate Mill $12 million capital budget will be used for several recurring upgrade projects to the present facilities and equipment. The Company's capital budget for the Napa Facility was increased to $8 million to prepare the pipe mill for anticipated increased production. Approximately $17 million of the total $21 million budget is planned to be expended in 1994. About $20 million was expended on capital projects such as vacuum degassing, heat treat leveler, and baghouse dust recycling plant at the Company's Oregon Steel Division in 1993. The Company's total capitalization at December 31, 1993 of $351.7 million consisted of $76.5 million in long-term debt and $275.2 million in stockholders' equity, for a long-term debt-to-capitalization ratio of .22 to 1. Net book value per share of common stock at December 31, 1993 was $14.23 per share versus $13.41 per share at December 31, 1992. The Company believes that anticipated needs for working capital and capital expenditures through 1994 will be met from existing cash balances, funds generated by operations, borrowings pursuant to the Company's revolving credit facility and short-term borrowing. Impact of Inflation. Inflation can be expected to have an effect on many of the Company's operating costs and expenses. Due to worldwide competition in the steel industry, the Company may not be able to pass through such increased cost to its customers. Property, plant facilities and equipment purchased by the Company in prior years have been subject to inflation; consequently, current charges to depreciation are smaller than would be required if such assets were valued at replacement cost. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Directors of Oregon Steel Mills, Inc. We have audited the accompanying consolidated balance sheets of Oregon Steel Mills, Inc. and Subsidiaries as of December 31, 1993, 1992 and 1991 and the related consolidated statements of income, changes in stockholders' equity and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards required that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Oregon Steel Mills, Inc. and Subsidiaries as of December 31, 1993, 1992 and 1991, and the consolidated results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. As discussed in Note 6 and 7 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992 and postretirement benefits in 1991. COOPERS & LYBRAND Portland, Oregon February 11, 1994 OREGON STEEL MILLS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of all wholly owned and majority owned subsidiaries. Affiliates which are 20 percent to 50 percent owned are accounted for using the equity method. All material intercompany transactions and account balances have been eliminated upon consolidation. Operations of purchased businesses are included in the consolidated financial statements from the date of acquisition (see Note 11). CASH AND CASH EQUIVALENTS The Company invests excess cash balances in short-term securities, including corporate and municipal obligations, bank repurchase agreements, commercial paper, remarketed preferred stock, and similar instruments which are readily converted to known amounts of cash and are so near to maturity that they present insignificant risk in changes in value because of changes in interest rates. The carrying amounts approximate fair value because of the short maturity of these instruments. INVENTORIES Inventories are stated at the lower of average cost or market. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are recorded at historical costs, including all costs directly related to the acquisition or construction of, and the preparation for, the assets' intended use, such as interest capitalized on funds borrowed to finance the major capital additions. Such capitalized interest amounted to $1.7 million, $318,000 and $1.4 million in 1993, 1992 and 1991, respectively. Depreciation is determined utilizing principally the straightline method over the estimated useful lives of the individual items. Maintenance and repairs are expensed as incurred and costs of improvements are capitalized. Upon disposal, related costs and accumulated depreciation are removed from the accounts and resulting gains or losses are reflected in income. EXCESS OF COST OVER NET ASSETS ACQUIRED Excess of cost over net assets acquired, principally from the acquisition of CF&I Steel, L.P. ("CF&I"), is being amortized over 40 years using the straight-line method. REVENUE RECOGNITION Revenue is recognized when the earning process is complete and an exchange has taken place. The earning process is not considered complete until collection of the sales price is reasonably assured. TAXES ON INCOME Deferred income taxes are recorded to reflect the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at year end based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Tax credits are accounted for using the flow through method which recognizes such credits in the year in which the credit arises by a reduction to income tax expense. As of January 1, 1992, the Company adopted the Statement of Financial Accounting Standards No. 109, (FAS No. 109) "Accounting for Income Taxes." This Statement supersedes existing accounting standards for income taxes which the Company adopted in 1988 (see Note 6). FOREIGN CURRENCY TRANSLATION Assets and liabilities of subsidiaries are translated at the rate of exchange in effect as of the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the year. The related translation adjustments are reflected in the cumulative foreign currency translation adjustment section of the consolidated balance sheet. NET INCOME PER SHARE The computation of earnings per common and common equivalent share is based upon the weighted average number of common shares outstanding during each period plus (in periods in which they have a dilutive effect) the effect of common shares contingently issuable. The weighted average number of common shares and equivalents outstanding was 19.8 million, 19.2 million and 18.7 million, respectively, in 1993, 1992 and 1991. There were no dilutive common share equivalents outstanding in any years presented. CONCENTRATIONS OF CREDIT RISK Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, investments and trade receivables. The Company places its cash and cash equivalents and investments with high-credit-quality financial institutions and limits the amount of credit exposure by any one financial institution. At times temporary cash investments may be in excess of the Federal Deposit Insurance Corporation insurance limit. The Company's trade receivables are derived from sales to customers. Management believes that any risk of loss is significantly reduced by its ongoing credit evaluations of its customers' financial condition and its requirement of collateral, such as letters of credit and bank guarantees, whenever deemed necessary. ENVIRONMENTAL EXPENDITURES All material environmental remediation liabilities which are probable and estimable are recorded in the financial statements based on current technologies and current environmental standards with adjustments made later if additional sources of contaminants are discovered that may require different remediation methods and a longer remediation period, and ultimately increase the total cost. The best estimate of the probable loss within a range is recorded. If there is no best estimate, the low end of the range is recorded, and the range is disclosed. In general, environmental remediation costs are charged to operating expenses with certain limited exceptions which meet generally accepted accounting principles' criteria for capitalization. RECLASSIFICATIONS Certain amounts in the 1992 financial statements have been reclassified. The reclassifications do not affect previously reported net income. 2. BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION The Company operates in one business segment in two geographical locations, the United States and Canada. Geographical area information is as follows: 1993 1992 -------- -------- (IN THOUSANDS) SALES TO UNAFFILIATED CUSTOMERS United States.........................................$587,247 $379,714 Canada................................................ 92,576 18,008 -------- -------- $679,823 $397,722 ======== ======== OPERATING INCOME (LOSS) BY GEOGRAPHIC LOCATION United States.........................................$ 19,645 $ 39,917 Canada................................................ 5,215 (2,446) -------- -------- $ 24,860 $ 37,471 ======== ======== INCOME (LOSS) BEFORE INCOME TAXES BY GEOGRAPHIC LOCATION United States.........................................$ 19,192 $ 36,068 Canada................................................ 3,001 (1,585) -------- -------- $ 22,193 $ 34,483 ======== ======== IDENTIFIABLE ASSETS BY GEOGRAPHIC AREAS United States.........................................$508,084 $314,273 Canada..................................................41,586 39,979 -------- -------- $549,670 $354,252 ======== ======== The major industries to which the Company sells steel products are fabricators, manufacturers, steel service centers and natural gas pipeline companies. In 1993 the Company derived 11.8 percent of its sales from one customer. In 1992 and 1991, the Company derived 44.9 percent and 45 percent, respectively, of its sales from one customer. These sales were to the same customer for 1993 and 1992, but to a different customer for 1991. Operating income is total revenues less operating expenses. In determining operating income, none of the following items have been included: Investment income, interest expense, other nonoperating income (expense), settlement of litigation, provision for income taxes and equity in income or loss from minority interest. 3. INVENTORIES Inventories at December 31 consist of: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Raw materials...................................$ 26,242 $ 8,326 $ 5,868 Semi-finished product........................... 51,759 29,280 41,986 Finished product................................ 62,104 61,557 39,448 Stores and operating supplies................... 20,399 14,090 14,130 -------- -------- -------- $160,504 $113,253 $101,432 ======== ======== ======== 4. LONG-TERM DEBT AND FINANCING ARRANGEMENTS Long-term debt at December 31 is summarized as follows: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Revolving credit and term loan..................$ 16,700 $ -- $ -- CF&I term loan.................................. 64,467 -- -- Other term loans -- -- 5,125 -------- -------- -------- 81,167 -- 5,125 Less current maturities 4,680 -- 1,708 -------- -------- -------- $76,487 $ -- $ 3,417 ======== ======== ======== In June 1993 the Company entered into an unsecured revolving credit and term loan agreement (Credit Agreement) with two banks which enables the Company to borrow up to $75 million. The use of the proceeds from borrowings under this Credit Agreement is restricted to (1) investing in businesses and related equipment in the steel industry and certain other industries, and (2) working capital and general corporate purposes. On July 1, 1996, the outstanding balance will be converted, unless prepaid, to a term loan payable in sixteen equal quarterly installments through June 30, 2000. Annual commitment fees during the revolving loan period are 1/8 of 1 percent of the average daily unused portion of the available credit payable on a quarterly basis. Depending on the Company's election at the time of borrowing, interest will be payable based on either (1) the prime rate, (2) the certificate of deposit rate, (3) the federal funds rate, or (4) the Eurodollar rate as specified in the Credit Agreement. At December 31, 1993, $16.7 million was outstanding under the Credit Agreement and classified as noncurrent. Term debt of $67.5 million was incurred by CF&I as part of the purchase price of the assets of CF&I Steel Corporation on March 3, 1993. This debt is without stated collateral and is payable over ten years with interest at 9.5 percent. The Company has agreed to guarantee the payment of the first 25 months installment cash payments. At December 31, 1993, the Company's remaining commitment under this agreement is $13.1 million. As of December 31, 1993, the outstanding balance on this debt is $64.5 million, of which $59.8 million is classified as noncurrent. As of December 31 1993, principal payments on long-term debt are payable in annual installments of: 1994................................................................. $ 4,680 1995................................................................. 5,016 1996................................................................. 6,193 1997................................................................. 10,126 1998................................................................. 10,704 Balance due in installments through 2003............................. 44,448 ------- $81,167 ======= SHORT-TERM DEBT The Company has a $15 million unsecured revolving line of credit facility with a bank which matures May 31, 1994. Depending on the Company's election at the time of borrowing, interest will be payable based on either the prime rate or the federal funds rate, fully floating in either case. At December 31, 1993, there were no amounts outstanding under this credit facility. However, $15 million was restricted under outstanding letters of credit. In addition, the Company has a $5 million unsecured revolving credit line with a bank which is restricted to use for letter of credit obligations and cash advances for up to 90 days. Interest rates applicable to such advances, if any, will be set at the time of borrowing. At December 31, 1993, $3.2 million was restricted under outstanding standby letters of credit, and there were no loan amounts outstanding. Camrose Pipe Company (a 60 percent owned subsidiary) maintains a $10 million revolving credit facility with a bank, the proceeds of which may be used for working capital and general corporate purposes. The facility is collateralized by the assets of Camrose Pipe Company and expires on October 31, 1994. Depending on Camrose Pipe Company's election at the time of borrowing, interest will be payable based on (1) the bank's Canadian dollar prime rate, (2) the bank's United States dollar prime rate, or (3) the London Interbank Borrowing Rates ("LIBOR"). As of December 31, 1993, Camrose Pipe Company had $4.2 million outstanding under the facility. CF&I maintains a $15 million revolving credit facility with a bank, the proceeds of which may be used for working capital and general corporate purposes. The facility is collateralized by the accounts receivables of CF&I and expires on May 24, 1994. Depending on CF&I's election at the time of borrowing, interest will be payable based on either the bank prime rate or LIBOR. As of December 31, 1993, CF&I had $10 million outstanding under this facility. The Company's revolving credit and term loan agreements contain various restrictive covenants which include, among other things, a minimum current assets to current liabilities ratio, a minimum interest coverage ratio, a minimum ratio of cash flow to scheduled maturities of long-term debt, a minimum tangible net worth, a maximum ratio of long-term debt to total capitalization, and restrictions on liens, investments and additional indebtedness. The Company's short-term debt and revolving long-term credit facility are considered to be carried at fair value due to interest being paid at current market rates. Long-term debt is considered to be carried at fair value because its rate of interest is based on the Company's incremental borrowing rates for the same or similar types of borrowing arrangements. 5. ACCRUED EXPENSES Accrued expenses at December 31 are as follows: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Accrued profit participation....................$ -- $ 1,749 $ 2,949 Other........................................... 19,091 7,557 6,946 -------- -------- -------- $ 19,091 $ 9,306 $ 9,895 ======== ======== ======== 6. INCOME TAXES The Company has adopted Statement of Financial Accounting Standards No. 109 (FAS No. 109), "Accounting for Income Taxes," as of January 1, 1992. The accounting change had no effect on 1992 or previously reported net income. The provision for income taxes consists of the following: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Current: Federal......................................$ 5,287 $ 9,162 $ 16,293 State........................................ 984 2,082 2,512 Foreign...................................... 19 -- -- -------- -------- -------- 6,290 11,244 18,805 -------- -------- -------- Deferred: Federal...................................... 124 3,932 1,372 State........................................ 163 (670) 593 Foreign...................................... 811 -- -- -------- -------- -------- 1,098 3,262 1,965 -------- -------- -------- Provision for income taxes......................$ 7,388 $ 14,506 $ 20,770 ======== ======== ======== The components of the deferred income tax provision are as follows: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Difference between tax and financial statement accounting for: Depreciation and amortization................$ 4,707 $ 2,673 $ 2,969 Inventories.................................. (239) 447 (934) Unfunded pension liability................... (100) 126 90 Accrued vacation liability................... (1,091) -- -- Alternative minimum tax...................... (1,665) -- -- Other........................................ (514) 16 (160) -------- -------- -------- $ 1,098 $ 3,262 $ 1,965 ======== ======== ======== The components of the net deferred tax liability as of December 31 are as follows: 1993 1992 -------- -------- (IN THOUSANDS) Current deferred tax asset: Assets Inventories..........................................$ 2,268 $ 2,029 Accrued vacation liability........................... 1,920 829 Accounts receivable.................................. 597 384 State tax credits.................................... 196 196 Other................................................ 920 366 -------- -------- 5,901 3,804 Liabilities Other................................................ 1,097 171 -------- -------- Net current deferred tax asset...........................$ 4,804 $ 3,633 ======== ======== Noncurrent deferred income taxes: Assets Postretirement benefits other than pensions......... $ 2,009 $ 1,124 State tax credits................................... 207 403 Alternative minimum tax............................. 1,665 -- Excess of cost over net assets acquired............. 13,282 -- Water rights........................................ 4,247 -- Other............................................... 1,076 488 -------- -------- 22,486 2,015 Liabilities Property, plant and equipment....................... 19,015 14,308 Unfunded pension liability.......................... 615 715 Environmental liability............................. 13,282 -- Other............................................... 6,088 1,237 -------- -------- 39,000 16,260 -------- -------- Net deferred income taxes............................... $ 16,514 $ 14,245 ======== ======== A reconciliation of the statutory tax rate to the effective tax rate on income before income taxes is as follows: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) U.S. statutory income tax rate ................. 35.0% 34.0% 34.0% Tax credits..................................... (1.4) (1.8) (.5) Deduction for dividends to ESOP participants.... (2.6) (2.1) (1.3) State income taxes.............................. 6.6 5.2 4.5 Settlement of litigation........................ (4.3) 6.1 -- Rate changes on beginning deferred taxes........ 1.8 -- -- Other........................................... (1.8) .7 .3 -------- -------- -------- 33.3% 42.1% 37.0% ======== ======== ======== At December 31, 1993, the Company has available state tax credits of $403,000 for income tax purposes which expire in 1994 through 2002. 7. EMPLOYEE BENEFIT PLANS U.S. PENSION PLANS The Company has noncontributory defined benefit retirement plans covering all of its eligible domestic employees. The plans provide benefits based on participants' years of service and compensation. The Company funds at least the minimum annual contribution required by ERISA. Pension cost included the following components: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Service cost -- benefits earned during the year $ 3,857 $ 1,703 $ 1,185 Interest cost on projected benefit obligations.. 1,714 1,528 1,370 Actual return on plan assets.................... (4,002) (2,256) (1,831) Net amortization and deferral................... 2,423 1,002 668 -------- -------- -------- $ 3,992 $ 1,977 $ 1,392 ======== ======== ======== The following table sets forth the funded status of the plans and amount recognized in the Company's consolidated balance sheet at December 31: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Accumulated benefit obligations, including vested benefits of $23,589 in 1993, $17,781 in 1992, and $15,562 in 1991..................$ 26,543 $ 19,918 $ 17,629 ======== ======== ======== Projected benefit obligations for participants' service rendered to date......................$ 28,413 $ 21,987 $ 19,627 Plan assets at fair value....................... 27,380 20,464 17,031 -------- -------- -------- Projected benefit obligation in excess of plan assets (1,033) (1,523) (2,596) Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions .................... 428 2,165 2,842 Unrecognized prior service cost................. 1,156 413 471 Unrecognized net obligation at January 1, 1987 being recognized over 15 years................ 1,271 681 757 Adjustment required to recognize minimum liability..................................... (297) -- (2,072) -------- -------- -------- Pension asset (liability) recognized in consolidated balance sheet....................$ 1,525 $ 1,736 $ (598) ======== ======== ======== The following table sets forth the significant actuarial assumptions as of December 31: 1993 1992 1991 -------- -------- -------- Discount rate................................... 7.3% 8.0% 8.0% Rate of increase in future compensation levels.. 4.5% 4.5% 4.5% Expected long-term rate of return on plan assets 8.0% 8.0% 8.0% Plan assets are invested in common stock and bond funds (62 percent), marketable fixed income securities (23 percent) and insurance company contracts (15 percent) at December 31, 1993. The plans do not invest in the stock of the Company. CANADIAN PENSION PLANS The Company has noncontributory defined benefit retirement plans covering all of its eligible Camrose Pipe Company employees. The plans provide benefits based on participants' years of service and compensation. Pension costs for 1993 and 1992 were $295,000 and $146,000, respectively, for service cost benefits earned during the year. The Canadian pension plan assets acquired with the Company's 60 percent interest in Camrose Pipe Company are held by Stelco Inc. until such time as the transfer is approved by Canadian regulatory authorities. The present value of those pension assets and liabilities to be transferred as of December 31 was approximately: 1993 1992 -------- -------- (IN THOUSANDS) Assets...................................................$ 6,337 $ 5,253 Liabilities.............................................. 5,870 5,700 -------- -------- Overfunded (underfunded) amount....................... $ 467 $ (447) ======== ======== The following table sets forth the significant actuarial assumptions as of December 31: 1993 1992 -------- -------- Discount rate............................................ 7.3% 8.0% Rate of increase in future compensation levels........... 5.0% 5.0% Expected long-term rate of return on plan assets......... 8.0% 8.0% EMPLOYEE STOCK OWNERSHIP PLAN (ESOP) The Company has an ESOP for eligible domestic employees which enables an employee to own stock in the Company. This plan is a noncontributory qualified stock bonus plan. Contributions to the plan are made at the discretion of the Board of Directors. Company contributions in 1993, 1992 and 1991 were $753,000, $3.5 million and $5 million, respectively. Shares are allocated to eligible employees' accounts based on annual compensation. At December 31, 1993, the ESOP held 2.8 million shares of Company common stock. PROFIT PARTICIPATION PLANS The Company has profit participation plans under which it distributes quarterly 12 percent to 20 percent, depending on operating division, of its domestic pre-tax earnings to its eligible domestic employees. The plans define profits as pre-tax earnings from divisional operations after adjustments for certain non-operating items. Each eligible employee receives a share of the distribution based upon the level of the eligible employee's base compensation compared with the total base compensation of all eligible employees of the division. THRIFT PLAN The Company has a qualified Thrift Plan (401-K) for all of its eligible domestic employees that is designed to receive and invest their deferred compensation as provided by current laws. The Company currently matches 25 percent of the first 4 percent of the participant's deferred compensation. Company contributions in 1993, 1992 and 1991 were $461,000, $424,000 and $388,000, respectively. POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS In December 1990 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106 (FAS No. 106), "Employers' Accounting for Postretirement Benefits Other than Pensions." This statement requires the accrual of benefits during the years the employee provides services to the Company. The Company adopted this statement during the quarter ended March 31, 1991 and elected to recognize the initial postretirement benefit obligation (i.e., the "transition obligation") of approximately $7.8 million over a period of twenty years. The Company provides certain health care and life insurance benefits for substantially all of its retired employees. Employees are generally eligible for benefits upon retirement and completion of a specified number of years of service. The benefit plans are unfunded. The following table sets forth the health care plans' status at December 31: 1993 1992 1991 -------- -------- -------- (IN THOUSANDS) Accumulated postretirement benefit obligation: Retirees......................................$ 8,240 $ 7,155 $ 7,279 Fully eligible plan participants.............. 1,294 786 269 Other active plan participants................ 5,050 1,728 481 -------- -------- -------- $ 14,584 $ 9,669 $ 8,029 ======== ======== ======== Accumulated postretirement benefit obligation in excess of plan assets......................$(14,584) $ (9,669) $ (8,029) Unrecognized net (gain) loss.................... 34 (450) 25 Accrued postretirement benefit cost............. 7,557 2,716 566 -------- -------- -------- Postretirement asset recognized in consolidated balance sheet.................................$ 6,993 $ 7,403 $ 7,438 ======== ======== ======== Net periodic postretirement benefit cost include the following components: Service cost attributed to service during the year...........................$ 395 $ 196 $ 86 Interest cost on accumulated postretirement benefit obligation........................ 1,017 733 665 Amortization of transition obligation....... 410 410 392 -------- -------- -------- Net periodic postretirement benefit cost........$ 1,822 $ 1,339 $ 1,143 ======== ======== ======== For measurement purposes, a long-term inflation rate of 6 percent is assumed for health care cost trend rates. However, a higher inflation rate (12 percent in 1994) has been assumed over the next five years, based on trends related to health care costs. The effect of a one percentage point increase in the assumed health care cost trend rate for 1994 would increase the accumulated postretirement benefit obligation by $610,000; the aggregate service and interest cost would increase $65,000. The discount rate used in determining the accumulated postretirement benefit obligation was 7.3 percent. 8. RELATED PARTY TRANSACTIONS The Company's 60 percent owned Camrose Pipe Company purchases steel coil and plate under a steel supply agreement from Stelco Inc. whose wholly owned subsidiary, Stelcam Holdings Inc., owns 40 percent of Camrose Pipe Company. Transactions under the agreement are at negotiated market prices. The following table summarizes the transactions among Camrose Pipe Company, Stelco Inc., and Stelcam Holdings Inc.: 1993 1992 -------- -------- (IN THOUSANDS) Purchases from Stelco....................................$ 59,019 $ 17,000 Accounts payable to Stelco at December 31............... 6,755 7,100 Note payable to Stelcam at December 31 (interest at Canadian prime rate plus 2 percent)....... -- 2,200 9. COMMITMENTS AND CONTINGENCIES ENVIRONMENTAL The Company's Napa Pipe Corporation subsidiary has a reserve of $3.1 million at December 31, 1993 for environmental remediation relating to the Napa facility. The Company's estimate of this environmental reserve was based on several remedial investigations and feasibility studies performed by an independent engineering consultant. The estimated costs were based on current technologies and presently enacted laws and regulations. The reserve includes costs for remedial action and monitoring, and operations and maintenance of the remedial action taken. Corrective action is scheduled to be completed in 1997. An environmental reserve of $36.7 million was accrued as part of the CF&I Pueblo, Colorado steel mill acquisition (see Note 11). FORMER EMPLOYEE LAWSUITS In 1992 the Company settled for $6.2 million certain litigation in the United States District Court of Oregon ("District Court Cases") relating to claims filed by former employee participants in the Company's ESOP and Tax Credit Employee Stock Ownership Plan ("TCESOP") in connection with claims and/or rescission of certain transactions which occurred during the period August 1985 through March 1987. This litigation involved the purchase by the Company of 1.5 million shares of its common stock which had been held by the ESOP and TCESOP. The Company also settled its claim against the primary insurance company which provided the Company's officers and directors liability insurance for the above claim for $1.2 million. As a result of these settlements, the Company recorded a $5 million charge to income in the fourth quarter of 1992. The Company's pursuit of its claim against its excess liability insurance carrier for the balance of the settlement amount and legal costs paid in connection with the District Court Cases was settled for $2.8 million and collected in the second quarter of 1993. CONTRACTS WITH KEY EMPLOYEES The Company has employment agreements with certain of its officers which provide for severance compensation to such employees in the event their employment with the Company is terminated subsequent to a change in control (as defined) of the Company under the circumstances set forth in the agreements. Each agreement has automatic annual extensions until the employee reaches the age of 65, unless either the Company or the employee gives notice that the agreement shall not be extended. In the event of a change in control while the agreements are in effect, the agreements are automatically extended for 36 months from the date the change in control occurs. The agreements will generally terminate upon termination of employment prior to a change in control of the Company. If, within 36 months following a change in control, the employee's employment with the Company is terminated by the Company without cause (as defined) or by the employee with good reason (as defined), then the Company will pay to the employee his full base salary through the date of termination at the rate in effect on the date the change in control occurred, plus three times his annual base salary at the above-specified rate, the four most recent quarterly cash distributions from the Company's profit participation plan and certain postretirement benefits as specified in the agreement. The employee is also entitled to be reimbursed for any reasonable legal fees and expenses he may incur in enforcing his rights under the agreement. 10. CAPITAL STOCK The Board of Directors has the authority to issue shares of preferred stock from time to time in one or more series and to fix the number of shares to be included in such a series, the designation, powers, preferences and rights of the shares of each such series and any qualifications, limitations or restrictions of such series, including but not limited to dividend rights, dividend rates, conversion rights, voting rights, rights and terms of redemption (including sinking fund provisions) and liquidation preferences, all without any vote or action by the stockholders. In connection with the acquisition of substantially all of the assets of CF&I Steel Corporation, the Company, through its ownership interest in CF&I Steel, L. P., agreed to issue 598,400 shares of its common stock in March 2003 to specified creditors of CF&I Steel Corporation. The stock was valued at $11.2 million using the Black-Scholes valuation method. The common stock has no voting rights or rights to receive dividends until it is issued. In connection with the acquisition, the Company also delivered warrants to CF&I Steel Corporation to purchase for five years, expiring March 3, 1998, 100,000 shares of the Company's common stock at $35 per share. The warrants were valued at $556,000 using the Black-Scholes method (see Note 11). 11. BUSINESS ACQUISITIONS CF&I STEEL, L. P. On March 3, 1993, New CF&I, Inc. ("General Partner"), a wholly-owned subsidiary of the Company, acquired for $22.2 million a 95.2 percent interest in a newly formed limited partnership, CF&I Steel, L.P. ("CF&I"). The remaining 4.8 percent interest is owned by the Pension Benefit Guaranty Corporation ("Limited Partner"). Concurrent with the formation of CF&I and the acquisition of the partnership interest by the General Partner, CF&I purchased from CF&I Steel Corporation substantially all of the assets of its steelmaking, fabricating, metals and railroad business ("Business"). The purchase price for the Business was $113.1 million paid by the General Partner's capital contribution of $22.2 million (consisting of $7.3 million cash, $3.1 million capitalized direct acquisition costs, 598,400 shares of Company common stock valued at $11.2 million to be issued ten years from March 3, 1993, and by the delivery of warrants to purchase 100,000 shares of Company common stock at $35 per share for five years valued at $556,000), by the Limited Partner's capital contribution of an asset valued at $1.2 million, by installment payments to be paid by CF&I totalling $67.5 million in principal plus interest at 9.5 percent over a period of 10 years, by the assumption of non contingent liabilities of CF&I Steel Corporation in the aggregate amount of $18.5 million, and by the assumption of a liability for postretirement health care benefits of $3.7 million. The Company has guaranteed the payment of the first 25 months of cash installment payments on the $67.5 million note (a total of approximately $13.1 million of principal and interest at December 31, 1993), and the performance of certain capital expenditures for improvements at the facilities being acquired in the aggregate amount of $40 million. As part of the acquisition, CF&I accrued a reserve of $36.7 million for environmental remediation at CF&I's Pueblo, Colorado steel mill. CF&I believes $36.7 million is the best estimate from a range of $23.1 to $43.6 million. CF&I's estimate of this environmental reserve was based on two separate remediation investigations and feasibility studies conducted by independent environmental engineering consultants. The estimated costs were based on current technologies and presently enacted laws and regulations. The reserve includes costs for RCRA (Resource Conservation and Recovery Act) facility investigation, a corrective measures study, remedial action, and operation and maintenance of the proposed remedial actions. The State of Colorado is reviewing a permit application and will issue a permit to CF&I with a schedule for corrective action specifying activities to be completed by certain dates. The State of Colorado anticipated that the schedule would be reflective of a straight line rate of expenditure over 30 years. The State of Colorado stated the schedule for corrective action could be accelerated if new data indicated a greater threat to the environment than is currently known to exist. Any adjustment to the environmental liability as a result of new technologies, new laws, or new facts after the purchase price allocation period will be generally recognized as an element of income with certain limited exceptions which meet generally accepted accounting principles' criteria for capitalization. For financial statement reporting purposes only, the acquisition has been treated as a business combination using the purchase method of accounting. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on the estimated fair values at the date of acquisition. The operating results of this acquisition are included in the Company's consolidated results of operations from the date of acquisition. The estimated fair values of assets acquired and liabilities assumed are summarized as follows: (IN THOUSANDS) ---------- Accounts receivable................................................ $ 40,167 Inventories........................................................ 28,527 Other current assets............................................... 490 Property, plant and equipment...................................... 28,518 Investments and other assets....................................... 52,136 Current portion of long-term debt.................................. (4,251) Accounts payable................................................... (18,500) Other accured expenses............................................. (2,000) Long-term debt..................................................... (63,249) Deferred employee benefits......................................... (3,680) Other deferred liabilities......................................... (34,716) Minority interest.................................................. (1,200) -------- $ 22,242 ======== Investments and other assets include excess of cost over net assets acquired ($40.4 million) and water rights ($11.7 million). Other deferred liabilities represent an accrued liability for environmental remediation less the current year portion of $2 million which is included in other accrued expenses. The following unaudited pro forma summary presents the Company's consolidated results of operations as if the acquisition had occurred as of January 1, 1992, after giving effect to adjustments for salaries and wages, fringe benefits, depreciation and amortization, interest expense, reversal of reorganization costs, and extraordinary loss from termination of pension plans by CF&I Steel Corporation. The pro forma results have been prepared for comparative purposes only and do not purport to be indicative of what would have occurred had the acquisition been made as of January 1, 1992, or of results which may occur in the future. YEAR ENDED DECEMBER 31 ---------------------- (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) 1993 1992 -------- -------- Net sales................................................$729,604 $638,343 Net Income...............................................$ 16,922 $ 24,871 Primary and fully diluted net income per common and common equivalent share.................$ .85 $ 1.26 CAMROSE PIPE COMPANY On June 30, 1992, Camrose Pipe Corporation, a wholly-owned subsidiary of the Company, acquired for $18 million a 60 percent interest in a newly formed Canadian general partnership, Camrose Pipe Company ("Camrose"). The remaining 40 percent interest is owned by Stelcam Holdings Inc., a wholly-owned subsidiary of Stelco Inc ("Stelco"). Concurrent with the formation of Camrose and the purchase of the partnership interest by Camrose Pipe Corporation, Camrose purchased from Stelco, Stelco's steel pipemaking facility in Camrose, Alberta, Canada and related receivables, inventories and other current assets. The purchase price for the Camrose assets may increase or decrease based upon an annual performance adjustment over a five-year period as described in the Asset Purchase Agreement. Since additional consideration is contingent on achieving specified earnings levels in future periods, the Company will record the current fair value of the consideration as additional cost of the acquired company. The additional cost would be assigned to the tangible assets acquired or excess of cost over net assets acquired depending on an independent appraisal of the fair value of the assets acquired. For financial statement reporting purposes only, the acquisition has been treated as a business combination using the purchase method of accounting. Accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on the estimated fair values at the date of acquisition (June 30, 1992). The operating results of this acquisition are included in the Company's consolidated results of operations from the date of acquisition. The estimated fair values of assets acquired and liabilities assumed are summarized as follows: (IN THOUSANDS) ---------- Accounts receivable................................................ $ 8,107 Inventories........................................................ 5,491 Other current assets............................................... 302 Property, plant and equipment...................................... 26,545 Investment and other assets........................................ 615 Accounts payable and accrued liabilities........................... (3,208) Due to partners.................................................... (5,650) Other liabilities.................................................. (2,234) Minority interest.................................................. (11,996) -------- $ 17,972 ======== ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEMS 10 and 11. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT AND EXECUTIVE COMPENSATION A definitive proxy statement of Oregon Steel Mills, Inc. will be filed not later than 120 days after the end of the fiscal year with the Securities and Exchange Commission. The information set forth therein under "Election of Directors" and "Executive Compensation" is incorporated herein by reference. Executive Officers of Oregon Steel Mills, Inc. and principal subsidiaries are listed on page 11 of this Form 10-K. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required is set forth under the caption "Principal Stockholders" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required is set forth under the caption "Executive Compensation" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K PAGE (A) (i) FINANCIAL STATEMENTS: Report of Independent Accountants............................. 20 Consolidated Financial Statements: Balance Sheets at December 31, 1993, 1992 and 1991.......... 21 Statements of Income for each of the three years in the period ended December 31, 1993..................... 22 Statements of Changes in Stockholders' Equity for the three years ended December 31, 1993............... 23 Statements of Cash Flows for each of three years in the period ended December 31, 1993..................... 24 Notes to Consolidated Financial Statements.................. 25 (ii) Financial Statement Schedules: All required schedules will be filed by amendment to this Form 10-K. (iii) Exhibits: References made to the list on page 3 of the exhibits filed with this report. (B) No reports on Form 8-K were required to be filed by the Registrant during the fourth quarter of the fiscal year ended December 31, 1993. LIST OF EXHIBITS* 2.0 Asset Purchase Agreement dated as of January 2, 1992, by and between Camrose Pipe Company (a partnership) and Stelco Inc. (Filed as exhibit 2.0 to Form 8-K dated June 30, 1992 and incorporated by reference herein.) 2.1 Asset Purchase Agreement dated as of March 3, 1993, among CF&I Steel Corporation, Denver Metals Company, Albuquerque Metals Company, CF&I Fabricators of Colorado, Inc., CF&I Fabricators of Utah, Inc., Pueblo Railroad Service Company, Pueblo Metals Company, Colorado & Utah Land Company, the Colorado and Wyoming Railway Company, William J. Westmark as trustee for the estate of The Colorado and Wyoming Railway Company, CF&I Steel, L.P., New CF&I, Inc. and Oregon Steel Mills, Inc. (Filed as exhibit 2.1 to Form 8-K dated March 3, 1993, and incorporated by reference herein.) 3.1 Restated Certificate of Incorporation of the Company. (Filed as exhibit 3.1 to Form 10-K for the year ended December 31, 1992, and incorporated by reference herein.) 3.2 Bylaws of the Company. (Filed as exhibit 3.2 to Form 10-Q dated March 31, 1993, and incorporated by reference herein.) 4.1 Specimen Common Stock Certificate. (Filed as exhibit 4.1 to Form S-1 Registration Statement 33-38379 and incorporated by reference herein.) 4.2 Form of Oregon Steel Mills, Inc. -- Five-Year Common Stock Purchase Warrant. (Filed as exhibit 4.2 to Form 8-K dated March 3, 1993, and incorporated by reference herein.) 10.1 Employee Stock Ownership Plan, as amended. (Filed as exhibit 10.1 to Form S-1 Registration Statement 33-38379 and incorporated by reference herein.) 10.2 Employee Stock Ownership Plan Trust Agreements. (Filed as exhibit 10.2 to Form 10-K for the year ended December 31, 1990 and incorporated by reference herein.) 10.3 Profit Participation Plan. (Filed as exhibit 10.5 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.4 Form of Indemnification Agreement between the Company and its directors. (Filed as exhibit 10.6 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.5 Form of Indemnification Agreement between the Company and its executive officers. (Filed on exhibit 10.7 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.6 Agreement for Electric Power Service between registrant and Portland General Electric Company. (Filed as exhibit 10.20 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.9 Key employee contracts for Thomas B. Boklund, Robert R. Mausshardt and Robert J. Sikora. (Filed as exhibit 10.11 to Form 10-K for the year ended December 31, 1988, and incorporated by reference herein.) 10.10 Key employee contracts for L. Ray Adams and James R. McCaughey. (Filed as exhibit 10.10 to Form 10-K for the year ended December 31, 1990 and incorporated by reference herein.) 10.11 Key employee contract for Edward J. Hepp. (Filed as exhibit 10.11 to Form 10-K for the year ended December 31, 1991, and incorporated by reference herein.) 10.12 Net lease between Oregon Steel Mills-Fontana Division Inc. and California Steel Industries. (Filed as exhibit 10.16 to Form S-1 Registration Statement 33-38379 and incorporated by reference herein.) 11.0 Statement re computation of per share earnings. 21.0 Subsidiaries of registrant. (Filed as exhibit 22.1 to Form 10-K for the year ended December 31, 1992, and incorporated by reference herein.) - ---------- *The Company will furnish to stockholders a copy of the exhibit upon payment of $.25 per page to cover the expense of furnishing such copies. Requests should be directed to Vicki A. Tagliafico, Investor Relations Contact, Oregon Steel Mills, Inc., PO Box 5368, Portland, Oregon 97228. 28.0 Partnership Agreement dated as of January 2, 1992, by and between Camrose Pipe Corporation and Stelcam Holding, Inc. (Filed as exhibit 28.0 to Form 8-K dated June 30, 1992, and incorporated by reference herein.) 28.1 Amended and Restated Agreement of Limited Partnership of CF&I Steel, L.P. dated as of March 3, 1993 by and between New CF&I, Inc. and the Pension Benefit Guaranty Corporation. (Filed as exhibit 28.1 to Form 8-K dated March 3, 1993, and incorporated by reference herein.) 99.0 Oregon Steel Mills, Inc. Pension Plan, as amended. SIGNATURES REQUIRED FOR FORM 10-K Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Oregon Steel Mills, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. OREGON STEEL MILLS, INC. (Registrant) By /s/ Thomas B. Boklund ------------------------ Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Oregon Steel Mills, Inc. and in the capacities and on the date indicated. SIGNATURE TITLE DATE --------- ----- ---- /s/ THOMAS B. BOKLUND Chairman of the Board - ----------------------- Chief Executive Officer (Thomas B. Boklund) (Principal Executive Officer) March 1, 1994 /s/ L. RAY ADAMS Vice President of Finance, - ----------------------- and Secretary (L. Ray Adams) (Principal Financial Officer) March 1, 1994 /s/ JACKIE L. WILLIAMS Controller - ----------------------- (Principal Accounting Officer) March 1, 1994 (Jackie L. Williams) /s/ C. LEE EMERSON Director March 1, 1994 - ----------------------- (C. Lee Emerson) /s/ V. NEIL FULTON Director March 1, 1994 - ----------------------- (V. Neil Fulton) /s/ EDWARD C. GENDRON Director March 1, 1994 - ----------------------- (Edward C. Gendron) /s/ RICHARD G. LANDIS Director March 1, 1994 - ---------------------- (Richard G. Landis) /s/ JAMES A. MAGGETTI Director March 1, 1994 - ---------------------- (James A. Maggetti) /s/ JOHN A. SPROUL - ---------------------- (John A. Sproul) Director March 1, 1994 ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEMS 10 and 11. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT AND EXECUTIVE COMPENSATION A definitive proxy statement of Oregon Steel Mills, Inc. will be filed not later than 120 days after the end of the fiscal year with the Securities and Exchange Commission. The information set forth therein under "Election of Directors" and "Executive Compensation" is incorporated herein by reference. Executive Officers of Oregon Steel Mills, Inc. and principal subsidiaries are listed on page 11 of this Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required is set forth under the caption "Principal Stockholders" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required is set forth under the caption "Executive Compensation" in the Proxy Statement for the 1994 Annual Meeting of Stockholders and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K PAGE (A) (i) FINANCIAL STATEMENTS: Report of Independent Accountants............................. 20 Consolidated Financial Statements: Balance Sheets at December 31, 1993, 1992 and 1991.......... 21 Statements of Income for each of the three years in the period ended December 31, 1993..................... 22 Statements of Changes in Stockholders' Equity for the three years ended December 31, 1993............... 23 Statements of Cash Flows for each of three years in the period ended December 31, 1993..................... 24 Notes to Consolidated Financial Statements.................. 25 (ii) Financial Statement Schedules: All required schedules will be filed by amendment to this Form 10-K. (iii) Exhibits: References made to the list on page 3 of the exhibits filed with this report. (B) No reports on Form 8-K were required to be filed by the Registrant during the fourth quarter of the fiscal year ended December 31, 1993. LIST OF EXHIBITS* 2.0 Asset Purchase Agreement dated as of January 2, 1992, by and between Camrose Pipe Company (a partnership) and Stelco Inc. (Filed as exhibit 2.0 to Form 8-K dated June 30, 1992 and incorporated by reference herein.) 2.1 Asset Purchase Agreement dated as of March 3, 1993, among CF&I Steel Corporation, Denver Metals Company, Albuquerque Metals Company, CF&I Fabricators of Colorado, Inc., CF&I Fabricators of Utah, Inc., Pueblo Railroad Service Company, Pueblo Metals Company, Colorado & Utah Land Company, the Colorado and Wyoming Railway Company, William J. Westmark as trustee for the estate of The Colorado and Wyoming Railway Company, CF&I Steel, L.P., New CF&I, Inc. and Oregon Steel Mills, Inc. (Filed as exhibit 2.1 to Form 8-K dated March 3, 1993, and incorporated by reference herein.) 3.1 Restated Certificate of Incorporation of the Company. (Filed as exhibit 3.1 to Form 10-K for the year ended December 31, 1992, and incorporated by reference herein.) 3.2 Bylaws of the Company. (Filed as exhibit 3.2 to Form 10-Q dated March 31, 1993, and incorporated by reference herein.) 4.1 Specimen Common Stock Certificate. (Filed as exhibit 4.1 to Form S-1 Registration Statement 33-38379 and incorporated by reference herein.) 4.2 Form of Oregon Steel Mills, Inc. -- Five-Year Common Stock Purchase Warrant. (Filed as exhibit 4.2 to Form 8-K dated March 3, 1993, and incorporated by reference herein.) 10.1 Employee Stock Ownership Plan, as amended. (Filed as exhibit 10.1 to Form S-1 Registration Statement 33-38379 and incorporated by reference herein.) 10.2 Employee Stock Ownership Plan Trust Agreements. (Filed as exhibit 10.2 to Form 10-K for the year ended December 31, 1990 and incorporated by reference herein.) 10.3 Profit Participation Plan. (Filed as exhibit 10.5 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.4 Form of Indemnification Agreement between the Company and its directors. (Filed as exhibit 10.6 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.5 Form of Indemnification Agreement between the Company and its executive officers. (Filed on exhibit 10.7 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.6 Agreement for Electric Power Service between registrant and Portland General Electric Company. (Filed as exhibit 10.20 to Form S-1 Registration Statement 33-20407 and incorporated by reference herein.) 10.9 Key employee contracts for Thomas B. Boklund, Robert R. Mausshardt and Robert J. Sikora. (Filed as exhibit 10.11 to Form 10-K for the year ended December 31, 1988, and incorporated by reference herein.) 10.10 Key employee contracts for L. Ray Adams and James R. McCaughey. (Filed as exhibit 10.10 to Form 10-K for the year ended December 31, 1990 and incorporated by reference herein.) 10.11 Key employee contract for Edward J. Hepp. (Filed as exhibit 10.11 to Form 10-K for the year ended December 31, 1991, and incorporated by reference herein.) 10.12 Net lease between Oregon Steel Mills-Fontana Division Inc. and California Steel Industries. (Filed as exhibit 10.16 to Form S-1 Registration Statement 33-38379 and incorporated by reference herein.) 11.0 Statement re computation of per share earnings. 21.0 Subsidiaries of registrant. (Filed as exhibit 22.1 to Form 10-K for the year ended December 31, 1992, and incorporated by reference herein.) - ---------- *The Company will furnish to stockholders a copy of the exhibit upon payment of $.25 per page to cover the expense of furnishing such copies. Requests should be directed to Vicki A. Tagliafico, Investor Relations Contact, Oregon Steel Mills, Inc., PO Box 5368, Portland, Oregon 97228. 28.0 Partnership Agreement dated as of January 2, 1992, by and between Camrose Pipe Corporation and Stelcam Holding, Inc. (Filed as exhibit 28.0 to Form 8-K dated June 30, 1992, and incorporated by reference herein.) 28.1 Amended and Restated Agreement of Limited Partnership of CF&I Steel, L.P. dated as of March 3, 1993 by and between New CF&I, Inc. and the Pension Benefit Guaranty Corporation. (Filed as exhibit 28.1 to Form 8-K dated March 3, 1993, and incorporated by reference herein.) 99.0 Oregon Steel Mills, Inc. Pension Plan, as amended. SIGNATURES REQUIRED FOR FORM 10-K Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Oregon Steel Mills, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. OREGON STEEL MILLS, INC. (Registrant) By /s/ Thomas B. Boklund ------------------------ Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Oregon Steel Mills, Inc. and in the capacities and on the date indicated. SIGNATURE TITLE DATE --------- ----- ---- /s/ THOMAS B. BOKLUND Chairman of the Board - ----------------------- Chief Executive Officer (Thomas B. Boklund) (Principal Executive Officer) March 1, 1994 /s/ L. RAY ADAMS Vice President of Finance, - ----------------------- and Secretary (L. Ray Adams) (Principal Financial Officer) March 1, 1994 /s/ JACKIE L. WILLIAMS Controller - ----------------------- (Principal Accounting Officer) March 1, 1994 (Jackie L. Williams) /s/ C. LEE EMERSON Director March 1, 1994 - ----------------------- (C. Lee Emerson) /s/ V. NEIL FULTON Director March 1, 1994 - ----------------------- (V. Neil Fulton) /s/ EDWARD C. GENDRON Director March 1, 1994 - ----------------------- (Edward C. Gendron) /s/ RICHARD G. LANDIS Director March 1, 1994 - ---------------------- (Richard G. Landis) /s/ JAMES A. MAGGETTI Director March 1, 1994 - ---------------------- (James A. Maggetti) /s/ JOHN A. SPROUL - ---------------------- (John A. Sproul) Director March 1, 1994

45919_1993.txt

45919_1993

1993

45919

Item 1. Business 3 Item 2. Item 2. Properties 3 Item 3. ITEM 3. LEGAL PROCEEDINGS The Company from time to time becomes involved in various claims and lawsuits incidental to its businesses, including defamation actions. In the opinion of management, after consultation with counsel, any ultimate liability arising out of currently pending claims and lawsuits will not have a material effect on the financial condition or operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Incorporated herein by reference from the Company's Annual Report to Stockholders for the year ended December 31, 1993 at pages 24 and 37. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Incorporated herein by reference from the Company's Annual Report to Stockholders for the year ended December 31, 1993 at pages 32 and 33. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated herein by reference from the Company's Annual Report to Stockholders for the year ended December 31, 1993 at pages 13 through 17. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following information is set forth in the Company's Annual Report to Stockholders for the year ended December 31, 1993, which is incorporated herein by reference: All Consolidated Financial Statements (pages 18 through 21); all Notes to Consolidated Financial Statements (pages 22 through 31); and the "Independent Auditors' Report" (page 34). With the exception of the information herein expressly incorporated by reference, the Company's Annual Report to Stockholders for the year ended December 31, 1993 is not deemed filed as part of this Annual Report on Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 10. ITEM 10. MANAGEMENT Incorporated herein by reference from the information the Company's definitive proxy statement dated March 30, 1994 for the May 6, 1994 Annual Meeting of Stockholders under the caption "Management -- Directors and Executive Officers" on pages 5 and 6. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference from the information the Company's definitive proxy statement dated March 30, 1994 for the May 6, 1994 Annual Meeting of Stockholders under the caption "Executive Compensation and Other Information" on pages 7 through 14. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference from the information the Company's definitive proxy statement dated March 30, 1994 for the May 6, 1994 Annual Meeting of Stockholders under the caption "Security Ownership of Management and Principal Stockholders" on pages 4 and 5. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) The following consolidated financial statements are incorporated by reference from the Company's Annual Report to Stockholders for the year ended December 31, 1993 attached hereto: Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholder's Equity, Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Independent Auditors' Report (a)(2) The following accountants' report and financial schedules for years ending December 31, 1993, 1992 and 1991 are submitted herewith: Independent Auditors' Report 10-K Schedules Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule X - Supplementary Income Statement Information All other schedules are omitted as the required information is inapplicable. (a)(3) Exhibits (continued). EXHIBIT NO. DESCRIPTION OF EXHIBIT PAGE NO. 2(a) Certificate of Ownership and Merger (filed as Exhibit 2(a) to the Company's Registration Statement No. 33-69202 and incorporated by reference herein). * 3(a) Amended and Restated Certificate of Incorporation. 30 3(b) Amended and Restated Bylaws (filed as Exhibit 3(b) to the Company's Registration Statement No. 33-69202 and incorporated by reference herein). 4(a) Long term debt instruments are not being filed pursuant to Section (b)(4)(iii) of Item 601 of Regulation S-K. Copies of such instruments will be furnished to the Commission upon request. 10(a) 1984 Stock Option Plan (filed as Exhibit 10(d) to the Company's Form 10-K for the year ended December 31, 1984 and incorporated herein by reference). *10(b) Registration Rights Agreement dated as of 38 September 11, 1984 among HHC Holding Inc. and its stockholders. 10(c) HHC Holding Inc. 1991 Stock Option Plan (filed as Exhibit 10(l) to the Company's Form 10-K for the year ended December 31, 1991 and incorporated by reference herein). 10(d) Amendment to HHC Holding Inc. 1991 Stock Option Plan (filed as Exhibit 10(l) to the Company's Form 10-K for the year ended December 31, 1992 and incorporated by reference herein). 10(e) Third Amended and Restated Loan Agreement dated May 19, 1993 among the Company, The Toronto-Dominion Bank, NationsBank of Texas, N.A., National Westminster Bank USA, The First National Bank of Boston, Bank of Hawaii, Corestates Bank, N.A., The Bank of Nova Scotia, CIBC Inc., and National Bank of Canada; and Toronto-Dominion (Texas), Inc., as agent (filed as Exhibit 10(l) to the Company's 10-Q for the quarter ended June 30, 1993 and incorporated by reference herein). (a)(3) Exhibits (continued). EXHIBIT NO. DESCRIPTION OF EXHIBIT PAGE NO. 10(f) Note Purchase Agreement by and between HHC Holding Inc. and The Goldman Sachs Group, L.P. (filed as Exhibit 10(f) to the Company's Registration Statement No. 33-69202 and incorporated by reference herein). 10(g) Severance Agreement between Harte-Hanks Communications, Inc. and Larry Franklin, dated as of July 23, 1993 (filed as Exhibit 10(f) to the Company's Registration Statement No. 33-69202 and incorporated by reference herein). 10(h) Form of Severance Agreement between Harte-Hanks Communications, Inc. and certain Executive Officers of the Company, dated as of July 23, 1993 (filed as Exhibit 10(h) to the Company's Registration Statement No. 33-69202 and incorporated by reference herein). 10(i) Amendment No. 2 to HHC Holding Inc. 1991 Stock Option Plan (filed as Exhibit 10(l) to the Company's Registration Statement No. 33-69202 and incorporated by reference herein). 10(j) Harte-Hanks Communications, Inc. Pension Restoration Plan (filed as Exhibit 10(j) to the Company's Registration Statement No. 33-69202 and incorporated by reference herein). 10(k) First Amendment, dated as of November 3, 1993 to Third Amended and Restated Loan Agreement dated May 19, 1993 among the Company, The Toronto-Dominion Bank, NationsBank of Texas, N.A., National Westminster Bank USA, The First National Bank of Boston, Bank of Hawaii, Corestates Bank, N.A., The Bank of Nova Scotia, CIBC Inc., and National Bank of Canada; and Toronto- Dominion (Texas), Inc., as agent (filed as Exhibit 10(l) to the Company's Form 10-Q for the quarter ended September 30, 1993 and incorporated by reference herein). (a)(3) Exhibits (continued). EXHIBIT NO. DESCRIPTION OF EXHIBIT PAGE NO. 10(l) Amendment No. 1, dated as of November 10, 1993 to Note Purchase Agreement by and between Harte-Hanks Communications, Inc. and GS Capital Partners, L.P., Stone Street Fund 1992, L.P. and Bridge Street Fund 1992, L.P. (filed as Exhibit 10(l) to the Company's Form 10-Q for the quarter ended September 30, 1993 and incorporated by reference herein). *10(m) Harte-Hanks Communications, Inc. Incentive Bonus Plan. 62 *11 Statement Regarding Computation of Net Income (Loss) 63 Per Common Share. *13 Annual Report to Securityholders (only those portions 64 incorporated by reference into the Form 10-K are filed herewith). *21 Subsidiaries of the Company. 91 *23 Consent of KPMG Peat Marwick. 92 24 Power of Attorney (included on the signature page of the Registration Statement on Form S-2 filed with the Commission on September 23, 1993). *Filed herewith. (b) Reports on Form 8-K No reports on Form 8-K have been filed during the fourth quarter of 1993. (c) Exhibits -- The response to this portion of Item 14 is submitted as separate section of this report on pages 30 to 92. (d) Financial Statement Schedules -- The response to this portion of Item 14 is submitted as a separate section of this report on pages 25 to 29. The agreements set forth above describe the contents of certain exhibits thereunto which are not included. However, such exhibits will be furnished to the Commission upon request. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Harte-Hanks Communications, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HARTE-HANKS COMMUNICATIONS, INC. By: /s/ LARRY D. FRANKLIN Larry D. Franklin President & Chief Executive Officer By: /s/ RICHARD L. RITCHIE Richard L. Ritchie Senior Vice President, Finance & Chief Financial and Accounting Officer Date: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities indicated. /s/ HOUSTON H. HARTE /s/ DR. PETER T. FLAWN Houston H. Harte, Chairman Dr. Peter T. Flawn, Director /s/ LARRY D. FRANKLIN /s/ CHRISTOPHER M. HARTE Larry D. Franklin, Director Christopher M. Harte, Director /s/ EDWARD H. HARTE /s/ JAMES L. JOHNSON Edward H. Harte, Director James L. Johnson, Director /s/ ANDREW B. SHELTON Andrew B. Shelton, Director INDEPENDENT AUDITORS' REPORT 10-K SCHEDULES The Board of Directors and Stockholders Harte-Hanks Communications, Inc.: Under date of January 28, 1994, we reported on the consolidated balance sheets of Harte-Hanks Communications, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and stockholders' equity for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in Item 14(a)(2). These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG Peat Marwick San Antonio, Texas January 28, 1994

778437_1993.txt

778437_1993

1993

778437

ITEM 1. BUSINESS. GENERAL American Industrial Properties REIT (the "Trust"), a Texas equity real estate investment trust, was organized as Trammell Crow Real Estate Investors on September 26, 1985. On November 27, 1985, the Trust issued 9,062,000 Shares of Beneficial Interest (the "Shares") and commenced operations. The Trust's investment objective is to maximize the total return to its Shareholders through the acquisition, leasing, management and disposition of industrial and retail properties. The Trust's original Declaration of Trust provided for a maximum term of 15 years from inception. The Trust is engaged in a single industry segment -- operation of developed industrial and retail real estate properties. The Trust leases space in its properties to a variety of tenants. The industrial properties are leased for office, office-showroom, storage, distribution, research and development, and light assembly purposes. The retail property is leased to retail merchandise establishments, restaurants, and a cinema. No single tenant accounts for more than 10% of the Trust's consolidated gross revenue. However, Tamarac Square, the Trust's only retail property, has rental revenues in excess of 10% of the total revenues of the Trust. The Trust initially acquired from entities engaged in the commercial real estate business under the name "Trammell Crow Company" (the "TCC Entities") 19 commercial real estate properties, consisting of 18 industrial properties located in California, Florida, Maryland, Minnesota, North Carolina, Texas, Washington and Wisconsin, and one retail mall located in Colorado. Since 1985, the Trust has sold five of its original real estate assets: two of the California properties were sold in 1990, the North Carolina property was sold in two separate transactions in 1992, one of the Houston, Texas properties was sold in 1992, and one of the Dallas, Texas properties was sold in early 1993. A property in Dallas, Texas was acquired by the Trust in December 1993. As a result of these transactions, the Trust currently owns a total of fifteen properties, consisting of fourteen industrial properties and one retail property. From November 1985 through June 1993, the Trust was advised by Trammell Crow Ventures, Ltd. (the "Advisor"), an affiliate of Trammell Crow Company, under an advisory agreement that provided for the payment of an annual advisory fee and reimbursements for certain expenses as well as transaction fees for asset acquisitions and dispositions. In June 1993, the Trust terminated its agreement with the Advisor and converted to self-administration. The name of the Trust was changed to American Industrial Properties REIT and its ticker symbol on the New York Stock Exchange was changed to "IND" to reflect the Trust's industrial property focus. In October 1993, the Shareholders of the Trust approved a proposal to remove the Trust's limited term restriction, thus making the life of the Trust perpetual. As part of its initial capitalization, the Trust also issued $179,698,000 in Zero Coupon Notes due 1997. In 1991, the Trust began to repurchase these Zero Coupon Notes as part of its financial plan. Since that time, the Trust has utilized the net proceeds from property sales and issuance of unsecured notes to repurchase a total of $160,207,000 principal amount at stated maturity ("Face Amount") of the Zero Coupon Notes, as described below. - In March 1991, the Trust used the net proceeds from property sales and cash on hand to repurchase an aggregate of $31,297,000 Face Amount of the Zero Coupon Notes which had an accreted balance of approximately $14,415,000, net of unamortized original issue discount. Pursuant to the terms of the Indenture, $24,800,000 Face Amount of the repurchased Zero Coupon Notes remains pledged to the Indenture trustee for the security of the remaining Noteholders. The remaining repurchased Zero Coupon Notes were surrendered to the Indenture trustee for cancellation. - In connection with the repurchases discussed above, the Trust also obtained an option to repurchase an additional $21,371,000 Face Amount of Zero Coupon Notes at a discount rate of 17.75% compounded semiannually, exercisable in whole or in part prior to December 31, 1992. In May 1991, the Trust repurchased an additional $3,000,000 Face Amount of Zero Coupon Notes having an accreted value of $1,407,000 for an aggregate purchase price of $993,000, pursuant to the option. - On February 27, 1992, the Trust repurchased an aggregate of $106,322,000 Face Amount of Zero Coupon Notes for a purchase price of $53,234,000. The accreted balance of these Zero Coupon Notes was approximately $54,401.000. The entire purchase price was financed by issuing new unsecured notes bearing interest at a rate of 8.8% (the "8.8% Notes") to the seller of the Zero Coupon Notes. Interest on the 8.8% Notes was deferred initially and is payable semiannually commencing May 1993. The 8.8% Notes, which are unsecured, can be prepaid at any time prior to maturity without penalty. An $8,000,000 mandatory principal repayment was required in November 1993, with the balance due in November 1997. Pursuant to the terms of the Indenture, approximately $21,629,000 Face Amount of these repurchased Zero Coupon Notes are also pledged to the Indenture trustee for the security of the remaining Noteholders. Additionally, in four other separate transactions during February and April of 1992, the Trust used cash on hand to repurchase $697,000 Face Amount of Zero Coupon Notes having an accreted value of $356,000 for an aggregate purchase price of $237,000. - On December 30, 1992, the Trust exercised its remaining option to repurchase an additional $18,371,000 Face Amount of Zero Coupon Notes at a semiannual discount rate of 17.75%. These Zero Coupon Notes, having an accreted value of $10,341,000, were repurchased for an aggregate purchase price of $7,968,000. Pursuant to the terms of the Indenture, these Zero Coupon Notes are also pledged to the Indenture trustee for the security of the remaining Noteholders. After the 1992 repurchases, the total Face Amount of the Zero Coupon Notes still outstanding was $20,011,000. - On December 31, 1992, the Trust used $11,648,000 of the net sales proceeds from its 1992 sales of real estate to make a principal and interest payment on the 8.8% Notes. This payment included the $8,000,000 mandatory repayment which was due in November 1993. - During 1993, the Trust purchased $520,000 Face Amount of Zero Coupon Notes at approximately their accreted value. Pursuant to the terms of the Indenture related to the Zero Coupon Notes, the Trust is required to deposit certain amounts, including funds from sales of properties, into a Property Acquisition Account administered by the Trustee. According to the Indenture, amounts in this account could be used to make additional investments in accordance with the Trust's By-Laws until November 27, 1993. At that date, any amounts remaining in this account were to be used to defease the holders of the remaining Zero Coupon Notes. The approximate balance at November 27, 1993 was $13.6 million. In accordance with a court order directing the Trustee to release certain funds from the Property Acquisition Account, the Trust purchased the Northview Distribution Center in Dallas, Texas for total consideration of approximately $3.4 million on December 10, 1993. On December 15, 1993, the Trust announced its intent to redirect its cash resources to the ultimate elimination of the operating restrictions imposed on the Trust by the terms of the Zero Coupon Notes through a complete defeasance of the outstanding Notes. This would require the Trust to deposit approximately $16,289,000 with the Trustee. For this reason, the Trust determined that it was in the best interest of the Trust and its Shareholders to suspend quarterly distributions (which had been at $.04 per quarter) until such time as the remaining Notes are fully defeased and distributions can be supported from the positive cash flow of the Trust, as measured by its Funds from Operations. In accordance with this policy and with terms of the Indenture, the balance of funds held by the Trustee (approximately $10.2 million) will be used to partially defease the remaining Zero Coupon Notes. The Trust has historically qualified as a Real Estate Investment Trust ("REIT") for federal income tax purposes and intends to maintain its REIT qualification in the future. In order to preserve its REIT status, the Trust must meet certain criteria with respect to assets, income, and shareholder ownership. In addition, the Trust is required to distribute at least 95% of taxable income (as defined) to the shareholders. Pursuant to proxy materials dated March 25, 1994, the Trust has submitted for Shareholder approval a proposal to merge the Trust into American Industrial Properties REIT, Inc., a Maryland corporation and wholly owned subsidiary of the Trust (the "Company"), at a Special Meeting of Shareholders to be held on May 10, 1994. Under the proposal (a) every five Shares will be converted into one share of Common Stock of the Company, par value $0.01 per share ("Common Stock"); (b) persons that will hold a fractional share in the Company after the merger must either (i) pay to the Company an amount equal to the fraction necessary to round upward to a whole share of Common Stock times the opening price of the Company's Common Stock on the first trading date after the consummation of the merger (the "Opening Price") and the fractional share shall be rounded upward to the nearest whole share of Common Stock or (ii) permit the Company to purchase the fractional share at a price equal to the fraction owned times the Opening Price; (c) all rights and obligations of the Trust will be assumed by the Company; and (d) the executive officers of the Trust immediately prior to the merger shall become the executive officers of the Company and Messrs. Bricker and Wolcott will serve as directors of the Company. Only Shareholders of record on March 4, 1994 are entitled to notice of and to vote at the Special Meeting. The consummation of the merger is subject to receipt of the approval of holders of 66 2/3% of the outstanding Shares. REVENUE AND LOSSES FROM REAL ESTATE OPERATIONS The breakdown of revenue and loss from real estate operations for the fiscal years ended December 31, 1993, 1992, and 1991 is as follows ($ in thousands): GEOGRAPHIC ANALYSIS OF REVENUE The geographic breakdown of the Trust's rents and tenant reimbursements for the fiscal years ended December 31, 1993, 1992, and 1991 is as follows ($ in thousands): - --------------- (*) The Charlotte property was sold during the fourth quarter of 1992. COMPETITION AND CONFLICTS OF INTEREST The Trust owns industrial properties in Baltimore, Dallas, Ft. Lauderdale, Houston, Los Angeles, Milwaukee, Minneapolis, and Seattle, and one retail property in Denver. The principal methods of competition in these markets are price, location, quality of space, and amenities. In each case, the Trust owns a small portion of the total similar space in the market and competes with owners of other space for tenants. Each of these markets is highly competitive, and other owners of property may have competitive advantages not enjoyed by the Trust. TCC Entities, which provide leasing and management services for most of the Trust's properties, also own and/or manage space in each market in which the Trust owns property. The Trust has access to the managerial skills, experience, and relationships of TCC Entities in the markets where TCC Entities provide such services. Although the Trust Managers currently believe that this access will benefit the Trust, TCC Property Managers also have relationships and interests that may conflict with the interest of, and may have an adverse impact on, the Trust in certain circumstances. Various steps have been taken in structuring the Trust to ameliorate the effect of these potential conflicts of interest while at the same time preserving the Trust's access to the benefits provided by the relationship with TCC Entities. In general, the steps taken are: (i) a requirement that all agreements and other transactions in which TCC Entities have an interest be approved by the Trust Managers, and (ii) a compensation system tying the incentives of the TCC Property Managers to the performance of the properties. There can be no assurance, however, that any potential conflict between the interests of the Trust and any TCC Entity having a relationship with the Trust will be resolved in favor of the Trust. EMPLOYEES The Trust currently employs six people on a full-time basis. Information regarding executive officers of the Trust is set forth in Item 10 of Part III of this Form 10-K and is incorporated in this Item 1 by reference. ITEM 2. ITEM 2. PROPERTIES As of December 31, 1993, the Trust owned fifteen real estate properties consisting of fourteen industrial developments and one enclosed specialty retail mall. The Trust sold a total of three properties during December 1992 and January 1993 and purchased one property in December 1993. Information related to the properties owned by the Trust as of December 31, 1993, physical occupancy, leased occupancy, and related mortgage indebtedness is presented below. Physical occupancy differs from leased occupancy primarily in that leased occupancy includes space in the property for which leases have been signed, but the lease term has not yet commenced. PROPERTY DESCRIPTIONS Baltimore Industrial Patapsco Industrial Center Patapsco Industrial Center is a five-building, two phase industrial park located in Linthicum Heights, Maryland, a suburb of Baltimore. The project comprises approximately 95,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 86%. As of March 25, 1994, the property was 87% occupied and 89% leased. The Trust is the 99.99% general partner of the limited partnership that currently owns Patapsco Industrial Center. This interest entitles the Trust to 100% of the income generated by the project, 100% of any appreciation in the value of the project, and 99.99% of the return of capital in any sale of the project. The remaining interest in the limited partnership is a limited partner's interest. The limited partner has no rights to participate in the management of Patapsco Industrial Center. Patapsco Industrial Center is subject to a first mortgage with a principal amount outstanding of $1,429,000 as of December 31, 1993. Dallas Industrial Beltline Business Center Beltline Business Center consists of three industrial buildings located in Irving, Texas, a suburb of Dallas, that are 100% finished for office space and that together comprise approximately 60,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 75%. As of March 25, 1994, the property was 77% occupied and 77% leased. Gateway 5 and 6 Gateway 5 and 6 consists of two industrial buildings located in Irving, Texas comprising approximately 79,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 79%. As of March 25, 1994, the property was 72% occupied and 89% leased. Northgate II Northgate II consists of four industrial buildings located within a 21-building industrial park in Dallas, Texas. The project consists of approximately 236,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 94%. As of March 25, 1994, the property was 100% occupied and 100% leased. Northview Distribution Center Northview Distribution Center consists of two industrial buildings located in Dallas, Texas. The project consists of approximately 175,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 100%. As of March 25, 1994, the property was 100% occupied and 100% leased. Denver Retail Tamarac Square Tamarac Square, located in Denver, Colorado, consists of an enclosed specialty retail mall of approximately 139,000 net rentable square feet with an adjacent convenience center of approximately 33,000 net rentable square feet, two free-standing buildings of approximately 8,000 net rentable square feet each, a separate free-standing building of approximately 9,000 net rentable square feet and two ground leases comprising approximately 4.91 acres. During 1993, the Trust completed a $2 million renovation of Tamarac Square. As of December 31, 1993, physical occupancy was 88%. As of March 25, 1994, the property was 88% occupied and 89% leased. Tamarac Square is subject to a mortgage with a principal amount outstanding of $1,213,000 as of December 31, 1993. The mortgage encumbers only the convenience center. Ft. Lauderdale Industrial Quadrant Center Quadrant Center consists of two industrial buildings situated on approximately 5.4 acres of land located in Deerfield Beach, a suburb of Ft. Lauderdale, Florida. The project comprises approximately 73,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 100%. As of March 25, 1994, the property was 92% occupied and 92% leased. Quadrant is subject to a mortgage with a principal amount outstanding of $1,200,000 as of December 31, 1993. Houston Industrial Plaza Southwest Plaza Southwest consists of five industrial buildings in Houston, Texas comprising approximately 149,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 91%. As of March 25, 1994, the property was 83% occupied and 83% leased. Commerce Park Commerce Park consists of two industrial buildings in Houston, Texas comprising approximately 87,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 61%. As of March 25, 1994, the property was 61% occupied and 61% leased. Westchase Park Westchase Park consists of two industrial buildings in Houston, Texas comprising approximately 47,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 100%. As of March 25, 1994, the property was 77% occupied and 100% leased. Los Angeles Industrial Huntington Drive Center Huntington Drive Center consists of a two-story office building and an industrial building comprising approximately 62,000 square feet of net rentable space located in Monrovia, California, a suburb of Los Angeles. As of December 31, 1993, physical occupancy was 83%. As of March 25, 1994, the property was 94% occupied and 94% leased. Milwaukee Industrial Northwest Business Park Northwest Business Park consists of three industrial buildings comprising approximately 143,000 square feet of net rentable space located in Menomonee Falls, Wisconsin, a suburb of Milwaukee. As of December 31, 1993, physical occupancy was 98%. As of March 25, 1994, the property was 98% occupied and 98% leased. Phase I of Northwest Business Park is subject to a first mortgage with a principal amount outstanding of $1,342,000 as of December 31, 1993. Minneapolis Industrial Burnsville Burnsville consists of one industrial building comprising approximately 46,000 square feet of net rentable space in a three-building industrial and office park located in Burnsville, Minnesota, a suburb of Minneapolis. As of December 31, 1993, physical occupancy was 68%. As of March 25, 1994, the property was 86% occupied and 86% leased. Burnsville is subject to a first mortgage with a principal amount outstanding of $1,973,000 as of December 31, 1993. This mortgage is recourse to the Trust. The mortgage matured in 1992, and the Trust exercised its option to renew the mortgage for three additional years by making certain payments to the lender and fulfilling certain other conditions. Cahill Cahill consists of one industrial building comprising approximately 60,000 square feet of net rentable space located in Edina, Minnesota, a suburb of Minneapolis. As of December 31, 1993, physical occupancy was 100%. As of March 25, 1994, the property was 100% occupied and 100% leased. Seattle Industrial Springbrook Business Park Springbrook Business Park consists of one industrial building located in Kent, Washington, a suburb of Seattle, comprising approximately 81,000 square feet of net rentable space. As of December 31, 1993, physical occupancy was 85%. As of March 25, 1994, the property was 91% occupied and 91% leased. OTHER ENCUMBRANCES ON THE PROPERTIES Each of the properties is subject to a mortgage securing the Zero Coupon Notes (a "Mortgage"), as required by the Indenture. In the case of Tamarac Square, Burnsville, Northwest Business Park, and Quadrant Center, the Mortgage is a second lien. In the case of Patapsco Industrial Center, the Mortgage is a lien on the Trust's partnership interest. For all other properties, the Mortgage is a first lien. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Trust is not a party to, nor is any of its property the subject of, any material pending legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS. No matters were submitted to a vote of the Shareholders of the Trust, through the solicitation of proxies or otherwise, in the fourth quarter of the fiscal year ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR SHARES AND RELATED SHAREHOLDER MATTERS The Trust's Shares are listed and traded on the New York Stock Exchange (the "NYSE") under the symbol IND. The following table sets forth for the periods indicated the high and low per Share closing sale price of the Trust's Shares, and the cash distributions declared per Share: As of March 25, 1994, the closing sale price per Share on the New York Stock Exchange was $2.125. On such date, there were 9,075,400 outstanding Shares held by approximately 2,308 Shareholders of record. In December 1993, the Trust announced a suspension of quarterly distributions to Shareholders pending the completion of certain refinancing transactions (see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.) ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth historical financial information for the Trust and should be read in conjunction with the Financial Statements of the Trust and the Notes thereto. - --------------- (a) The Trust sold one of its properties in the first quarter of 1993, thus operating with only 14 properties until the acquisition of the Northview Distribution Center in December 1993. (b) The Trust sold two of its properties in the fourth quarter of 1992, thus operating with only 15 properties for the remainder of the year. (c) On December 30, 1990, the Trust sold two of its 19 original properties, thus operating with only 17 properties during 1991. (d) Loss from real estate operations and net loss for 1992 and 1991 include provisions for possible losses on real estate of $14,094,000 and $9,371,000, respectively. (e) Funds from (used by) Operations is computed based on the definition adopted by the National Association of Real Estate Investment Trusts, which is net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from debt restructuring and sales of property, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Funds from (used by) Operations should not be considered by the reader as an alternative to net income as an indicator of the Trust's operating performance or to cash flows from operations as a measure of liquidity. The 1991-1992 changes in the Trust's debt structure from primarily zero coupon debt to current pay debt negatively impacts Funds from (used by) Operations as the amortization of the zero coupon debt has been previously added back to net income in computing Funds from (used by) Operations, whereas the current pay interest incurred on the notes replacing the zero coupon debt is not added back. The two properties sold during the fourth quarter of 1992 contributed a total of $2,111,000 to the Trust's 1992 Funds from Operations. The property sold in January of 1993 contributed a total of $815,000 to the Trust's 1992 Funds from Operations. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Below is a summary of net income and funds from operations for the Trust for the years ended December 31, 1993, 1992 and 1991. Management believes that the presentation of Funds from Operations will enhance the reader's understanding of the Trust's financial condition because it provides the reader with an additional measure of the Trust's operating performance which excludes nonrecurring activities (i.e., gains or losses from debt restructuring and sales of property) as well as certain non-cash items (i.e., depreciation and amortization). Funds from Operations is disclosed for the purpose of providing readers with additional information with which to compare performance. Funds from Operations, however, should not be considered an alternative to net income as an indicator of the Trust's operating performance or to cash flows from operations as a measure of liquidity. The determination of Funds from Operations is based on the definition adopted by the National Association of Real Estate Investment Trusts which is net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from debt restructuring and sales of property, plus depreciation and amortization (the Trust adds back the amortization of the original issue discount on its Zero Coupon Notes due 1997), and after adjustments for unconsolidated partnerships and joint ventures ("Funds from Operations"). Comparison of 1993 to 1992 The net loss in 1993 declined to $7,867,000 from $17,593,000 in 1992 due in part to provisions for possible losses on real estate recognized in 1992 in the amount of $14,094,000. The benefit from the absence of these provisions in 1993 was partially offset by the extraordinary loss recognized by the Trust in 1993 in the amount of $2,530,000 as a result of a partial in-substance defeasance of the Trust's Zero Coupon Notes (see discussion under Liquidity and Capital Resources). In addition, the Trust recognized extraordinary gains in 1992 in the amount of $1,910,000 related to the repurchase of Zero Coupon Notes which caused a favorable impact to 1992 net loss when compared to 1993. The remaining variance in net loss between 1993 and 1992 of approximately $2.5 million (greater loss in 1993 than 1992 after considering the previous items) can be attributed to the sales of the Woodland Industrial Park in Charlotte, North Carolina and the Southland industrial property in Houston, Texas, at the end of 1992, and the sale of the Royal Lane Business Park in Dallas, Texas in January, 1993, as well as the incremental administrative costs attributable to the termination fee paid to the Advisor in the amount of $435,000 as further discussed below and the proxy solicitation effort to remove the finite life restriction of the Trust in the amount of approximately $250,000. On a same property basis, rental revenues remained flat during the year, although in the third and fourth quarter, the Trust began to see some strengthening in the leasing markets in most of the areas in which the Trust operates in terms of both traffic and rental rates (other than in Southern California). Same property occupancy improved to 89% at December 31, 1993 from 88% at December 31, 1992. The Trust terminated its Advisory Agreement with the Advisor effective June 12, 1993. In accordance with the terms of the Advisory Agreement, a one-time termination fee of $435,000 was paid to the Advisor on June 12, 1993. The Trust is now self-administered and employs six full-time employees to conduct and administer the business affairs of the Trust. The overall costs to the Trust over time under self-administration related to managerial, administrative and other services are expected to be lower than fees previously paid to the Advisor under the Advisory Agreement. For example, under self-administration, the Trust will be able to provide, through its management group, certain services, including restructuring activities and certain transaction services, without the need to pay the fees previously provided for in the Advisory Agreement. Comparison of 1992 to 1991 The Trust had a net loss of $17,593,000 in 1992 compared to a net loss of $9,162,000 in 1991. The 1992 net loss included provisions for possible losses in value of real estate of $14,094,000, an extraordinary gain from partial repurchases of Zero Coupon Notes of $1,910,000 and a net loss on sales of real estate of $784,000. Excluding the 1992 and 1991 provisions for possible losses, the extraordinary gains, and the gain or loss on sales of real estate, the net loss would have been $4,625,000 and $4,415,000 in 1992 and 1991, respectively. Net loss before extraordinary gain and gain or loss on sales of real estate was $18,719,000 in 1992 and $13,786,000 in 1991. In 1992 and 1991, the Trust recorded provisions for possible losses on real estate of $14,094,000 and $9,371,000, respectively, to reflect the Trust's assets at the lower of depreciated cost or net realizable value, as defined by the Trust's accounting policies. Declines in estimated market values were primarily attributable to declines in rents from several of the Trust's properties. The decline in rents was attributed to general economic conditions affecting markets in which the properties owned by the Trust are located. It is management's belief that such rents have stabilized and that continuing declines in the near future are unlikely. Total revenue decreased to $15,139,000 in 1992 from $16,488,000 in 1991. Average occupancy levels were the same in both years, at 89%; however, the sales of the Southland and Woodland properties negatively impacted revenue and earnings. Total real estate expenses, excluding $14,094,000 and $9,371,000 of provisions for possible losses on real estate, in 1992 and 1991, respectively, decreased to $19,764,000 in 1992 from $20,903,000 in 1991 primarily as a result of the sales of the Southland and Woodland properties. LIQUIDITY AND CAPITAL RESOURCES The principal source of funds for the Trust's liquidity requirements is funds generated from operations of the Trust's real estate assets and unrestricted cash reserves. As of December 31, 1993, the Trust had $1,119,000 in unrestricted cash on hand. The Trust presently anticipates that cash on hand and Funds from Operations will provide sufficient funds for all known liabilities and commitments relating to the Trust's operations during 1994. However, certain discretionary uses of the Trust's cash, including: (i) the costs of the Trust's reorganization into a Maryland corporation via merger (estimated at approximately $400,000, see below); (ii) the loss of the income producing ability of the $10.2 million expected to be used to defease Zero Coupon Notes (see discussion below); and (iii) certain capitalized leasing costs (such as leasing commissions and tenant improvements), will likely require that the Trust seek alternative sources of financing in 1994. Management is currently negotiating with lenders in an effort to obtain debt to refinance the first and second mortgage liens presently encumbering the Trust's Properties and incremental financing to pursue additional property acquisitions. Presently, no firm commitments to provide additional capital have been obtained from these lenders. If successful, management intends to use the cash to fund current operations and pursue potential debt or equity capital. Presently, the Trust must seek a waiver from the lender under its 8.8% Notes Payable in order to borrow funds in excess of those necessary to retire the principal amount of outstanding secured debt. There can be no assurance that management will be able to obtain such debt financing and if successful, that the lender on the 8.8% Notes Payable would consent to the borrowing of funds in excess of the amount necessary to retire the principal amount of outstanding secured debt. The retirement of all secured debt (inclusive of the Zero Coupon Notes due 1997) would make available to the Trust a portion of the cash presently held in the Defeasance Account by the Indenture Trustee, estimated to be at least $6 million, without requiring the consent of the lender on the 8.8% Notes Payable. Management may seek the 8.8% Notes Payable lender's consent in order to borrow additional funds with which to acquire property. There can be no assurance that the lender would grant such consent. Based on its current liquidity position, the Trust currently intends to make the semi-annual interest payment due in May 1994 to the lender on the 8.8% Notes Payable. In the event the Trust is forced to default on the unsecured debt obligation, the Trust expects to continue to operate and will continue to seek to: (a) restructure the terms of the unsecured debt obligation; (b) generate sufficient funds from operations in order to bring the Trust current on the unsecured debt obligation; or (c) obtain financing to fund the deficiency in the debt service on the unsecured obligation. In the event of a default, the lender on the 8.8% Notes Payable may declare the entire balance of the 8.8% Notes due and payable and could seek a judgment against the Trust to enforce such a claim. Distributions made and declared during 1993 in the amount of $1,453,000 ($.16 per share), have been paid out of cash reserves of the Trust. In December, 1993, the Trust Managers announced the suspension of the Trust's quarterly dividend in order to redirect the Trust's resources to the ultimate defeasance of the Trust's Zero Coupon Notes due in 1997 (see discussion below). The initial capitalization of the Trust included $179,698,000 face amount of Zero Coupon Notes due November 27, 1997 secured by first liens on all of the Trust's initial investments. Amortization of the original issue discount on the Zero Coupon Notes is a non-cash charge against net income of the Trust, compounding semiannually at 12% (see the Notes to Financial Statements for additional detail concerning the Zero Coupon Notes). During 1991 and 1992, the Trust repurchased a substantial amount of the Zero Coupon Notes, decreasing the remaining face amount outstanding to a total of $20,011,000. Subsequent to September 30, 1993, the Trust Managers authorized management to utilize the Trust's available cash reserves to provide liquidity for the repurchase of outstanding Zero Coupon Notes at their accreted value from Noteholders desiring to sell their Notes and unable to find a market for them. In 1993, the Trust acquired $520,000 face amount of the Zero Coupon Notes at their accreted value. No other purchases of significance are planned at this time, however, should the Trust identify an opportunity to purchase significant amounts of the Zero Coupon Notes at a discount to their defeasance amount (the amount that would be required to Defease the Notes under the Indenture), additional purchases may be made out of cash reserves of the Trust. Pursuant to the terms of the Indenture covering the Trust's Zero Coupon Notes due 1997, prior to November 27, 1993 (the "Defeasance Commencement Date"), the Trust was required to deposit the net proceeds of any property sale or refinancing into a Property Acquisition Account administered by the Trustee to the extent deemed necessary or appropriate by the Trust Managers to secure the interests of the Noteholders. Prior to the Defeasance Commencement Date, funds in the Property Acquisition Account could be used to make additional investments as allowed under the Trust's By-Laws. After the Defeasance Commencement Date, any remaining funds in the Property Acquisition Account must be used to defease the holders of the remaining Zero Coupon Notes. Subsequent to September 30, 1993, the Trust reinvested all of the funds held in the Property Acquisition Account (approximately $13.6 million) into short-term commercial paper and Treasury Notes which are pledged as additional collateral to the Noteholders. Of these invested funds, which matured in February 1994, approximately $10.2 million will be used to partially defease the Zero Coupon Notes. The result of a partial defeasance of the Zero Coupon Notes would be a reduction in the accreted value of the Zero Coupon debt on the Trust's balance sheet from approximately $13.0 million to approximately $4.7 million, with a loss of approximately $2.5 million being recognized by the Trust. As previously discussed above, it is the Trust's intent to seek additional debt or equity capital to defease the remaining Zero Coupon Notes (approximately $6,100,000) in 1994. There can be no assurance, however, that the Trust will be able to raise such debt or equity capital and, if so, on what terms. On December 10, 1993, pursuant to a court order directing the Indenture Trustee to release certain of these funds, the Trust acquired a 175,000 square foot multi-tenant distribution center in Dallas for a purchase price of approximately $3,400,000. Consistent with all of the properties owned by the Trust, the acquired property is pledged under a first mortgage lien and Deed of Trust to the Noteholders. Management believes the acquisition will further enhance Funds from Operations of the Trust in fiscal 1994. The property is 100% occupied and expected 1994 rental revenues are approximately $450,000. In acquiring its existing Properties, the Trust assumed a total of $8,075,000 in mortgage debt, of which $7,157,000 remained outstanding as of December 31, 1993. The debt service on the Trust's mortgages amounts to approximately $800,000 annually (see the Notes to Financial Statements for additional detail concerning the terms of the mortgage notes payable). In accordance with the terms of the Trust's 8.8% Notes payable due 1997, the Trust paid its first installment of accrued interest on the 8.8% Notes on May 27, 1993 in the amount of $1,974,000 (see the Notes to Financial Statements for additional discussion regarding the terms of the 8.8% Notes). Accrued interest in the amount of approximately $1,990,000 will be payable each May and November until these 8.8% Notes become due in November 1997. Tenant and capital improvements were $1,414,000 for the year ended December 31, 1993 as compared to $3,379,000 for the same period of 1992. The improvements during 1992 primarily related to renovations under way at the Trust's Tamarac Square retail property in Denver, Colorado. Current year capital expenditures relate primarily to leasing activity, including tenant improvements and lease commissions arising from the new lease with The GAP at Tamarac Square. The nature of the Trust's operating Properties, which generally provide for leases with a term of between three and seven years, results in an approximate turnover rate of 20% of the Trust's tenants annually (generally representing a similar proportion of the Trust's rental revenues). This requires capital outlays for re-leasing related to tenant improvements and leasing commissions in an amount of approximately $1.3 million annually in order to maintain the Trust's occupancy at or above historical levels. These costs have historically been funded out of the Trust's operating cash flow, however, should cash generated from operations be insufficient to provide the funds necessary to lease and re-lease the Trust's Properties in 1994, the Trust may seek to obtain financing for a portion of these costs. The Trust has made no commitments for additional capital expenditures beyond those related to normal leasing and re- leasing activity. No capital improvements or renovations of significance are anticipated in the near future for any of the Trust's Properties. Management believes that the Trust's successful conversion from a finite-life entity required to liquidate in 1997 to a perpetual-life entity (which was announced after the Trust received in excess of the required 80% positive vote of all Shareholders on October 22, 1993) should enhance the Trust's ability to take advantage of the capital and investment markets available to real estate investment trusts. Management intends to pursue a strategy which should lower the Trust's cost of capital and enable the Trust to make additional investments in industrial real estate. This can be accomplished through raising additional equity and/or obtaining financing from various sources, including the public or private markets. At this time, however, management has obtained no commitments for funding or underwriting additional equity or debt financing and there can be no assurances that these sources of capital will become available in the future. Management believes that the reorganization of the Trust into a Maryland corporation is a necessary step towards a future financial restructuring because it removes existing barriers of the Trust's organization to obtaining additional capital by increasing the authorized shares and allowing for different classes of equity capital, among other things. Concurrent with this reorganization, management will continue to pursue capital raising opportunities. However, there can be no assurances that such equity capital or debt financing will be available to the Company upon its reorganization into a Maryland corporation or if available, whether the terms of such equity capital or debt financing will be acceptable. On January 12, 1994, the Trust incorporated American Industrial Properties REIT, Inc. (the "Company"), a Maryland corporation as its wholly owned subsidiary. The Trust intends to seek the approval of the required 66 2/3% of its Shareholders to merge with and into the Company (the "Merger"). Management has estimated the cost of completing the Merger at approximately $400,000. The Trust Managers have determined that it is in the best interest of the Trust and its Shareholders to suspend quarterly distributions to Shareholders until such time as the remaining Zero Coupon Notes are fully defeased and distributions can be supported from the available Funds from Operations of the Trust. OTHER MATTERS On January 8, 1993, the Trust sold its Royal Lane Business Park in Dallas, Texas. The sales price was $7,500,000, and the net proceeds of approximately $1,800,000, after reduction for the existing first mortgage loan and the related sales costs, were deposited into the Property Acquisition Account under the terms of the Zero Coupon Note Indenture. In 1992, Royal Lane contributed approximately $200,000 to the net cash flow of the Trust. As discussed above, the Trust has suspended quarterly distributions to Shareholders until such time as the remaining Notes are fully defeased and distributions can be supported from the available Funds from Operations of the Trust. In the event that the Trust does not refinance its existing debt or raise additional equity capital, it is unlikely that the Trust will make any distributions to Shareholders during 1994. Distributions to Shareholders are charges against Shareholders' equity, and therefore, Shareholders' equity will continue to decrease due to distributions made and net losses incurred by the Trust. Distributions in excess of taxable net income, or to the extent of net loss, constitute a return of capital to Shareholders. For federal income tax purposes, the taxable portion of distributions is determined on a calendar year basis, and is computed based on actual distributions for the year. It is presently estimated that the entire amount of the distributions paid by the Trust in 1993 will constitute a return of capital. Management has been notified of the possible existence of underground contamination at Tamarac Square, the Trust's Denver retail Property. The source of the possible contamination is apparently related to petroleum underground storage tanks located on an adjacent property. This adjacent property was placed on Colorado's list of leaking underground storage tanks. A second potential source of contamination is a nearby tract on which a service station was formerly operated. The owner of the adjacent property is currently conducting studies under the direction of the Colorado Department of Health in an attempt to define the contamination and institute an appropriate plan to address the situation. At this time, management does not anticipate any exposure to the Trust relative to this issue. RECENT DEVELOPMENTS Effective February 7, 1994, the Board of Directors of the Company authorized, contingent upon approval of the Merger, the issuance of rights ("Rights") to each Stockholder following the Merger. As currently contemplated, each Stockholder will be entitled to receive one Right for each share of Common Stock owned on a record date to be determined by the Board of Directors. The Rights, if issued, will entitle the Stockholders to purchase additional shares of Common Stock at a price below the then-current market price, such price to be set by the Board of Directors at the time of issuance. Such Rights would be exercisable for a fixed period of time that has yet to be determined. Although the Board of Directors has authorized the issuance of the Rights, the Board of Directors may, in its sole discretion, determine in the future not to issue the Rights based upon current or anticipated market and economic conditions or other factors. Pursuant to proxy materials dated March 25, 1994, the Trust has submitted for Shareholder approval a proposal to merge the Trust into American Industrial Properties REIT, Inc., a Maryland corporation and wholly owned subsidiary of the Trust (the "Company"), at a Special Meeting of Shareholders to be held on May 10, 1994. Under the proposal (a) every five Shares will be converted into one share of Common Stock of the Company, par value $0.01 per share ("Common Stock"); (b) persons that will hold a fractional share in the Company after the merger must either (i) pay to the Company an amount equal to the fraction necessary to round upward to a whole share of Common Stock times the opening price of the Company's Common Stock on the first trading date after the consummation of the merger (the "Opening Price") and the fractional share shall be rounded upward to the nearest whole share of Common Stock or (ii) permit the Company to purchase the fractional share at a price equal to the fraction owned times the Opening Price; (c) all rights and obligations of the Trust will be assumed by the Company; and (d) the executive officers of the Trust immediately prior to the merger shall become the executive officers of the Company and Messrs. Bricker and Wolcott will serve as directors of the Company. Only Shareholders of record on March 4, 1994 are entitled to notice of and to vote at the Special Meeting. The consummation of the merger is subject to receipt of the approval of holders of 66 2/3% of the outstanding Shares. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data are listed in the Index to Financial Statements and Financial Statement Schedules appearing on Page of this Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE During the two most recent fiscal years of the Trust and subsequent thereto, the Trust has not experienced any changes in or disagreements with its independent auditors. PART III. ITEM 10. ITEM 10. TRUST MANAGERS AND EXECUTIVE OFFICERS OF THE TRUST The persons who serve as Trust Managers and executive officers of the Trust, their ages and their respective positions are as follows: WILLIAM H. BRICKER, Trust Manager. Mr. Bricker has served as President of D.S. Energy Services Incorporated and has consulted in the energy field and international trade since 1987. In May 1987, Mr. Bricker retired as the Chairman and Chief Executive Officer of Diamond Shamrock Corporation where he held various management positions from 1969 through May, 1987. Mr. Bricker is a director of the LTV Corporation, the Eltech Systems Corporation and the National Paralysis Foundation. He received his Bachelor of Science and Masters of Science degrees from Michigan State University. GEORGE P. JENKINS, Trust Manager. Mr. Jenkins is a consultant to W.R. Grace and Co. In 1980, Mr. Jenkins retired as chairman of Metropolitan Life Insurance Company. Mr. Jenkins is a director of W.R. Grace and Co. CHARLES W. WOLCOTT, Trust Manager, President and Chief Executive Officer. Mr. Wolcott was hired as the President and Chief Executive Officer of the Trust on May 4, 1993. For the six months immediately prior to his election as President of the Trust, Mr. Wolcott was engaged in developing various personal business enterprises. Mr. Wolcott was President and Chief Executive Officer of Trammell Crow Asset Services, a real estate asset and portfolio management affiliate of Trammel Crow Company, from 1990 to 1992. He served as Vice President and Chief Financial and Operating Officer of the Trust from 1988 to 1991. From 1988 to 1990, Mr. Wolcott was a partner in Trammell Crow Ventures Operating Partnership. Prior to joining the Trammell Crow Company in 1984, Mr. Wolcott was President of Wolcott Corporation, a firm engaged in the development and management of commercial real estate properties. Mr. Wolcott graduated from the University of Texas at Austin in 1975 with a Bachelor of Science degree and received a Masters of Business Administration degree from Harvard University in 1977. DAVID B. WARNER, Vice President and Chief Operating Officer. Mr. Warner was hired as Vice President and Chief Operating Officer of the Trust on May 24, 1993. From 1989 through the date of his accepting a position with the Trust, Mr. Warner was Director of the Equity Investment Group for The Prudential Realty Group. From 1985 to 1989, he served in the Real Estate Banking Group of NCNB Texas National Bank. Mr. Warner graduated from the University of Texas at Austin in 1981 with a degree in Finance and received a Masters of Business Administration from the same institution in 1984. MARC A. SIMPSON, Vice President and Chief Financial Officer, Secretary and Treasurer. Mr. Simpson was hired as the Vice President and Chief Financial Officer, Secretary and Treasurer of the Company and the Trust on March 7, 1994. From November 1989 through March 4, 1994, Mr. Simpson was a Manager in the Financial Advisory Services Group of Coopers & Lybrand. Prior to that time, he served as Controller of Pacific Realty Corp., a real estate development company. Mr. Simpson graduated with a Bachelor of Business Administration from Midwestern State University in 1978, and received a Masters of Business Administration from Southern Methodist University in 1990. The Trust Managers have two committees, the Audit Committee and the Compensation Committee. Messrs. Bricker and Jenkins are the sole members of each committee. Both the Audit and Compensation Committees include only members independent of management who are free from any relationship that, in the opinion of the Trust Managers, would interfere with the exercise of their independent judgment. The Audit Committee appoints the independent public accountants for the Trust subject to the approval of the Shareholders at the Annual Meeting and consults with the accountants on the Trust's audited financial statements and on the efficacy of the Trust's internal control systems. The Compensation Committee establishes guidelines for compensation and benefits of the executive officers of the Trust based upon achievement of objectives and other factors, including review of compensation to executive officers of comparable entities. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION In fiscal 1993, the Trust paid each of the Trust Managers a fee of $15,000 per year for services as a Trust Manager plus $1,000 for each meeting of the Trust Managers or a committee of the Trust Managers attended in person. In addition, the Trust Managers were reimbursed for their expenses incurred in connection with their duties as Trust Managers. Mr. Wolcott did not receive any compensation for his services as a Trust Manager. The following table sets forth certain information regarding the compensation paid to the Trust's Chief Executive Officer since the commencement of his employment with the Trust on March 23, 1993 through December 31, 1993: SUMMARY COMPENSATION TABLE - --------------- (1) Mr. Wolcott's annualized salary for 1993 was $150,000. No other executive officer's salary and bonus exceeded $100,000 for fiscal 1993. No executive officers or Trust Managers were granted Share options by the Trust. The Trust has adopted a Retirement and Profit Sharing Plan (the "Profit Sharing Plan") for the benefit of employees of the Trust. Employees who were employed by the Trust on November 1, 1993, and who have attained the age of 21 are immediately eligible to participate in the Profit Sharing Plan. All other employees of the Trust are eligible to participate in the Plan after they have completed one year of service with the Trust and attained the age of 21. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth certain information as to the number of Trust Shares beneficially owned by (a) each person (including any "group" as that term is used in Section 13(d) of the Exchange Act) who is known by the Trust to own beneficially 5% or more of the Shares, (b) each Trust Manager, (c) each executive officer of the Trust, and (d) all executive officers of the Trust and Trust Managers as a group. - --------------- * Ownership is less than 1% of the outstanding Shares. (1) This information was obtained from Amendment No. 2 to the Schedule 13D of American Holdings, Inc. dated March 16, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Trust acquired fourteen of its properties from various TCC Entities during 1985 and 1986. The Trust hires third party property managers to manage the operations of its properties. Most of the properties owned by the Trust are managed by TCC Entities. Pursuant to the property management agreements, the property managers are paid a base management fee, leasing commissions, compensation for certain other services provided, and incentive fees. In 1993, the aggregate payments made to TCC Entities pursuant to such property management agreements totaled approximately $835,000. In its capacity as the former Advisor to the Trust, a TCC entity was paid $716,000 in advisory fees in 1993, including a one-time termination fee of $435,000. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) and (2) Financial Statements and Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules appearing on page of this Form 10-K. (b) Reports on Form 8-K: The following is the date and description of the events reported on Form 8-K during the quarter ended December 31, 1993: AMERICAN INDUSTRIAL PROPERTIES REIT INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES All other financial statements and schedules not listed have been omitted since the required information is either included in the Financial Statements and the Notes thereto as included herein or is not applicable or required. INDEPENDENT AUDITORS' REPORT To the Trust Managers and Shareholders of American Industrial Properties REIT: We have audited the Financial Statements and the Financial Statement Schedule of American Industrial Properties REIT (formerly Trammell Crow Real Estate Investors) (the "Trust"), listed in the Index on page of this Form 10-K. These financial statements and schedule are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and schedule are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedule. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement and schedule presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of American Industrial Properties REIT as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the years ended December 31, 1993, 1992 and 1991 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the financial statements taken as a whole, presents fairly in all material respects, the information required to be set forth therein. KENNETH LEVENTHAL & COMPANY Dallas, Texas February 15, 1994 AMERICAN INDUSTRIAL PROPERTIES REIT STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying notes are an integral part of these financial statements. AMERICAN INDUSTRIAL PROPERTIES REIT BALANCE SHEETS (DOLLARS IN THOUSANDS) ASSETS The accompanying notes are an integral part of these financial statements. AMERICAN INDUSTRIAL PROPERTIES REIT STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. AMERICAN INDUSTRIAL PROPERTIES REIT STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of these financial statements. AMERICAN INDUSTRIAL PROPERTIES REIT NOTES TO FINANCIAL STATEMENTS NOTE 1 -- SIGNIFICANT ACCOUNTING POLICIES: General. American Industrial Properties REIT (formerly Trammell Crow Real Estate Investors) (the "Trust") is an equity real estate investment trust which, as of December 31, 1993, owned and operated 15 commercial real estate properties consisting of 14 industrial properties and one retail property. The Trust was formed September 26, 1985, by issuing 13,400 shares to Trammell Crow Company, Inc. for $201,000. On November 27, 1985, the Trust issued 9,062,000 Shares of Beneficial Interest (the "Shares") and commenced operations. On April 13, 1993, the Independent Trust Managers gave formal notice of the Trust's intent to terminate the Advisory Agreement with Trammell Crow Ventures, Ltd. (the "Advisor", see Note 2). The Trust converted to self-administration effective June 13, 1993 and began operating under the name American Industrial Properties REIT. Pursuant to the Trust's 1993 Annual Meeting of Shareholders, the Trust's Shareholders approved amendments to the Trust's Declaration of Trust and By-Laws which, amongst other things, officially changed the name of the Trust from Trammell Crow Real Estate Investors to American Industrial Properties REIT and removed the Trust's limited term restriction, converting the Trust from a finite life entity scheduled to liquidate in 1997, to a perpetual life entity. Real Estate and Provisions for Possible Losses on Real Estate. The Trust carries its real estate at lower of depreciated cost or net realizable value, as defined. Management defines net realizable value for assets held for sale as estimated market value. In determining estimated market value, management considers numerous factors, including market evaluations, the cost of capital, operating cash flows from the property during the projected holding period, and an expected capitalization rate applied to the estimated stabilized net operating income of the specific property. The carrying amount of real estate held for investment is reduced when management believes the carrying amount is less than net realizable value, as defined. Management defines net realizable value for assets held for investment as the total of the estimated undiscounted future cash flows from the property. These writedowns are reviewed periodically and any additional writedown determined to be necessary is recorded in the period in which it becomes reasonably estimable. Real estate held for investment is reclassified to real estate held for sale when management determines that there is a reasonable probability that the asset will no longer be held for long-term investment and activities begin to offer the property for sale. During 1993, certain properties classified as being held for sale at December 31, 1992 were reclassified to held for investment, consistent with management's intent to continue to hold the properties for investment rather than for sale. Property improvements are capitalized while maintenance and repairs are expensed as incurred. Depreciation of buildings and capital improvements is computed using the straight-line method over forty years. Depreciation of tenant improvements is computed using the straight-line method over ten years. Cash and Cash Equivalents and Restricted Cash. Cash equivalents include demand deposits and all highly liquid debt instruments purchased with an original maturity of three months or less. According to the terms of the Indenture (the "Indenture") securing the Trust's Zero Coupon Notes due 1997 (the "Zero Coupon Notes"), upon the sale or refinancing of any property prior to the defeasance commencement date (November 27, 1993), the Trust was required to deposit into a Property Acquisition Account such portion of the net proceeds received by the Trust that the Trust Managers deemed necessary or appropriate to protect the interests of the Holders of the Zero Coupon Notes (see Notes 5 and 6). Such AMERICAN INDUSTRIAL PROPERTIES REIT NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) deposits are shown as restricted cash on the accompanying balance sheet. After November 27, 1993, any proceeds held in the Property Acquisition Account must be placed in another restricted account and be used solely to defease the holders of the remaining Zero Coupon Notes. Subsequent to September 30, 1993, the funds held in the Property Acquisition Account were reinvested by the Trust into short-term commercial paper and Treasury Bills which are pledged as collateral to the Zero Coupon Noteholders. In December 1993, management announced its intent to use the remaining pledged short-term commercial paper and Treasury Bills upon their maturity in 1994 for the partial defeasance of the Zero Coupon Noteholders (see Note 6). Issuance Costs of Zero Coupon Notes Payable. The issuance costs of the outstanding Zero Coupon Notes are being amortized over 12 years (the life of the Zero Coupon Notes) and include the difference between the proceeds received by the Company from the underwriters and the subsequent offering price to the public for the Zero Coupon Notes. Rents and Tenant Reimbursements. The Trust leases its retail and industrial properties to tenants under operating leases with expiration dates ranging from 1994 to 2005. Several tenants in the retail property are also required to pay as rent a percentage of their gross sales volume, to the extent such percentage exceeds their base rents. In addition to paying base and percentage rents, most tenants are required to reimburse the Trust for operating expenses in excess of a negotiated base. Contractual rent increases or delayed rent starts are recognized ratably over the lease term. Tamarac Square, the Trust's only retail property, has rental revenues in excess of 10% of the total revenues of the Trust. Rental revenues and tenant reimbursements from Tamarac totaled $3,182,000, $3,126,000 and $3,320,000 in 1993, 1992 and 1991, respectively. Income Tax Matters. The Trust operates as a real estate investment trust ("REIT") for federal income tax purposes. Under the REIT provisions the Trust is required to distribute 95% of REIT taxable income and is allowed a deduction for dividends paid during the year. The Trust made distributions in 1993, 1992 and 1991, which were all years in which the Trust incurred a taxable loss. Accordingly, no provision for income taxes has been reflected in the financial statements. For the year ended December 31, 1993 the Trust has adopted Statement of Financial Accounting Standards ("FAS") No. 109, Accounting For Income Taxes. Since, as discussed above, no tax provision is necessary, the adoption of FAS No. 109 does not affect the Trust's results from operations or financial position in the current or prior years. The Trust has a net operating loss carryforward from 1993 and prior years of approximately $22,700,000. The losses may be carried forward for up to 15 years. The present losses will expire beginning in the year 2004. Management intends to operate the Trust in such a manner as to continue to qualify as a REIT and to continue to distribute cash flow in excess of taxable income. Therefore, no tax benefit related to the potential utilization of the net operating loss has been reflected in the financial statements. Earnings and profits, which will determine the taxability of dividends to shareholders, will differ from that reported for financial reporting purposes due primarily to differences in the basis of the assets and the estimated useful lives used to compute depreciation. Reclassification. The Trust has reclassified certain items in the accompanying financial statements in order to (i) present amounts paid directly to the Advisor separately from Trust administration and overhead costs and general and AMERICAN INDUSTRIAL PROPERTIES REIT NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) administrative costs related to property operations, (ii) separately present accrued interest on the 8.8% Notes payable, and (iii) reflect the portion of the principal paydown related to deferred interest on the 8.8% Notes payable as an interest payment rather than a principal reduction in the 1992 statement of cash flows. NOTE 2 -- TRANSACTIONS WITH PARTIES IN INTEREST: Parties in Interest. Trammell Crow Ventures, Ltd. acted as advisor (the "Advisor") to the Trust through June 13, 1993 (see Termination of Advisory Agreement below). Owners of the Advisor are associated with a group of entities engaged in various real estate businesses under the name "Trammell Crow Company" (collectively, the "TCC Entities"). Termination of Advisory Agreement. Effective June 13, 1993, the Trust terminated the Advisory Agreement with the Advisor. Pursuant to the terms of the Advisory Agreement, the Trust paid to the Advisor a one-time termination fee of $435,000 in the second quarter. No additional amounts are due the Advisor. Certain TCC Entities continue to manage twelve of the Trust's fifteen properties, however, these are no longer considered to be related party or party in interest relationships by the Trust. Advisory Fees. For its services under an advisory agreement, in 1992 and 1991, the Advisor received an annual advisory fee equal to .4375% of the sum of (1) the estimated value of the Trust's real estate investments, as reviewed by an independent appraiser, less the original mortgage balances upon acquisition, and (2) the proceeds from the sale of real estate pending reinvestment. Through December 31, 1992, the Advisor was also entitled to an incentive advisory fee in varying degrees if distributable cash exceeded $11,600,000. For the year commencing January 1, 1993, the Trust Managers established an advisory fee of $500,000 per year. As in previous years, the Advisor was also entitled to reimbursement for costs of providing legal, accounting and financial reporting services. Disposition Fees. The Trust paid the Advisor a real estate disposition fee equal to 2% of net cash proceeds realized by the Trust from the sale or disposition of any Trust real estate asset, after deduction for any real estate commission paid by the Trust. Disposition fees paid to the Advisor and charged against the gain or loss on sales of real estate were $144,500 in 1993, $711,000 in 1992, and $8,000 in 1991. Management Fees. Most of the Trust's real estate assets are managed by various TCC Entities (the "TCC Property Managers"). For their services, the TCC Property Managers receive base management fees of approximately 4% of gross income, as defined in the Property Management Agreements, from industrial properties and approximately 5% of gross income, as defined, from the retail property. The TCC Property Managers also receive leasing commissions based on prevailing market rates of 2% to 5% of future rentals to be collected from new tenants and 1% to 4.5% of future rentals from renewal tenants. Other Fees. The Advisor also received fees for services provided to the Trust that were not required pursuant to the terms of the Advisory Agreement. For its services rendered in connection with the acquisition and refinancing of the Zero Coupon Notes on February 27, 1992 (see Note 4), the Trust Managers approved and the Trust AMERICAN INDUSTRIAL PROPERTIES REIT NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) paid to the Advisor a fee equal to 1% of the amount paid for the Zero Coupon Notes. This amount, $532,340, was charged against the extraordinary gain from partial repurchase of the Zero Coupon Notes. NOTE 3 -- REAL ESTATE AND PROVISIONS FOR POSSIBLE LOSSES ON REAL ESTATE: The Trust has previously recorded provisions for possible losses on real estate of $14,094,000 and $9,371,000 in 1992 and 1991, respectively. In accordance with the accounting policies of the Trust, such provisions included a reduction of the depreciated cost of real estate held for sale as well as real estate held for investment. At December 31, 1993, all of the Trust's properties were held for investment. If unforeseen factors should cause a reclassification of the Trust's real estate to held for sale, significant adjustments to reduce the depreciated cost of the real estate to net realizable value, as defined, for such assets could be required. NOTE 4 --8.8% NOTES PAYABLE: To finance the February 27, 1992 repurchase of $106,322,000 principal amount at stated maturity ("Face Amount") of Zero Coupon Notes (see Note 5), the Trust issued $53,234,000 of unsecured notes payable due November 1997 (the "8.8% Notes Payable"). These notes bear interest at 8.8% per annum, payable semiannually commencing May 27, 1993. The terms of the 8.8% Notes Payable allow for prepayment, in full or in part, at any time prior to maturity without penalty. On December 31, 1992, the Trust used $11,648,000 of the net sales proceeds from the 1992 sales of real estate (see Note 11) to repay $11,553,000 principal amount of the 8.8% Notes Payable. This repayment included the $8,000,000 mandatory repayment which was due in November 1993, and $3,648,000 of accrued interest. NOTE 5 --ZERO COUPON NOTES PAYABLE: The balance of the Zero Coupon Notes due November 27, 1997 increases annually in an amount equal to the amortization of the original issue discount, which is computed at 12% compounding semiannually; the balance is reduced for any Zero Coupon Note repurchases. The Zero Coupon Notes are collateralized by first and second mortgages on the Trust's properties and a security interest in the Trust's partnership interest in one property as well as by certain short-term investments pledged to the Noteholders (see discussion below) as of December 31, 1993. The issuance costs of the outstanding Zero Coupon Notes are amortized over 12 years (the life of the Zero Coupon Notes). On March 18, 1991, in two separate transactions, the Trust repurchased an aggregate of $31,297,000 Face Amount of Zero Coupon Notes having an accreted value of $14,415,000 for an aggregate purchase price of $10,060,000. The Trust also acquired an option to repurchase an additional $21,371,000 Face Amount of Zero Coupon Notes at a discount rate of 17.75% compounded semiannually, exercisable in whole or in part prior to December 31, 1992. On May 30, 1991, the Trust repurchased $3,000,000 Face Amount of Zero Coupon Notes having an accreted value of $1,407,000 for an aggregate purchase price of $993,000, pursuant to the option. AMERICAN INDUSTRIAL PROPERTIES REIT NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The Trust recognized extraordinary gains in 1991 of $4,320,000 from the repurchases of Zero Coupon Notes, determined as follows ($ in thousands): On February 27, 1992, the Trust repurchased an aggregate of $106,322,000 Face Amount of Zero Coupon Notes for a purchase price of $53,234,000. The accreted balance of the Zero Coupon Notes was approximately $54,401,000. The entire purchase price was financed by issuing new 8.8% Notes Payable (see Note 4) to the seller of the Zero Coupon Notes. Pursuant to the terms of the Indenture, approximately $21,629,000 Face Amount of these repurchased Zero Coupon Notes are also pledged to the Indenture trustee for the security of the remaining Noteholders. Additionally, in four other separate transactions during February and April 1992, the Trust used cash on hand to repurchase $697,000 Face Amount of Zero Coupon Notes having an accreted value of $356,000 for an aggregate purchase price of $237,000. On December 30, 1992, the Trust exercised its remaining option to repurchase an additional $18,371,000 Face Amount of Zero Coupon Notes ($10,341,000 accreted balance) for an aggregate purchase price of $7,968,000. Pursuant to the terms of the Indenture, these Zero Coupon Notes are also pledged to the Indenture trustee for the security of the remaining Noteholders. The Trust recognized extraordinary gains totalling $1,910,000 from the 1992 repurchases of the Zero Coupon Notes, determined as follows ($ in thousands): During 1993 the Trust repurchased $520,000 face amount of Zero Coupon Notes for approximately their accreted amounts of $316,000. No gain or loss was recognized on the transaction. The By-laws of the Trust, the Indenture, and the Note Purchase Agreement related to the 8.8% Notes Payable contain various borrowing restrictions and operating performance covenants. As of December 31, 1993, the Trust is in compliance with all of these restrictions and covenants. NOTE 6 -- PARTIAL DEFEASANCE OF ZERO COUPON NOTES: Due to the restrictions contained in the Zero Coupon Indenture on the use of the approximately $10,189,000 in short-term investments pledged to the Zero Coupon Noteholders, the Trust has announced its intent to utilize these funds to partially defease the Zero Coupon Notes upon maturity of the short-term investments at the end of February, 1994. This has been recognized as an in-substance partial defeasance of the Zero Coupon Notes in the accompanying financial statements as of December 31, 1993, by offsetting the AMERICAN INDUSTRIAL PROPERTIES REIT NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) restricted cash balance to be used for the defeasance against the related Zero Coupon Notes and by recognizing a loss on the partial defeasance of $2,530,000. It is estimated that an additional $6,100,000 in cash will be required to defease the remaining recorded amount of Zero Coupon Notes as of December 31, 1993. Upon a full defeasance of the Zero Coupon Notes, the Trust will be released from most of the restrictive covenants of the Indenture, including the Zero Coupon Note mortgage liens encumbering substantially all of the Trust's assets. NOTE 7 -- MORTGAGES PAYABLE: Certain of the Trust's properties are subject to first mortgage notes bearing interest at annual rates of 8% to 11%, requiring monthly payments of principal and interest aggregating $67,000 in 1993, and coming due in various years through 2010. Principal payments due for the next five years are $124,000 in 1994, $137,000 in 1995, $1,351,000 in 1996, $166,000 in 1997 and $2,053,000 in 1998. Effective April 30, 1992, the Trust extended, for three years, the maturity date of the loan on one of its Minneapolis properties. In accordance with the applicable loan agreement, the Trust paid to the Lender $92,000 of deferred accrued interest at the date of the Note extension. The principal amount of this mortgage as of December 31, 1992 was $2,141,000. This Note may be extended, subject to certain conditions, by the Trust for one additional three year period. The payoff of this Note in the amount of $1,894,000 is included in the total principal payments due in 1998. In addition to being collateralized by a mortgage on the property, this Note is recourse to the Trust. NOTE 8 -- COMMITMENTS AND CONTINGENCIES: Environmental Matters. The Trust has been notified of the possible existence of underground contamination at Tamarac Square, the Trust's Denver retail property. The source of the possible contamination is apparently related to underground storage tanks located on an adjacent property. This adjacent property was placed on Colorado's list of leaking underground storage tanks. A second potential source of contamination is a nearby tract on which a service station was formerly operated. The owner of the adjacent property is currently conducting studies under the direction of the Colorado Department of Health in an attempt to define the contamination and institute an appropriate plan to address the situation. At this time, the Trust does not anticipate any exposure relative to this issue. The Trust has not been notified (except with respect to Tamarac Square), and is not otherwise aware of any material non-compliance, liability or claim relating to hazardous or toxic substances in connection with any of its properties. Litigation. The Trust is involved in a property lawsuit arising in the normal course of business. In management's opinion, the Trust maintains adequate insurance to cover any potential loss from this suit. NOTE 9 -- RETIREMENT AND PROFIT SHARING PLAN: During 1993, the Trust adopted a retirement and profit sharing plan which qualifies under section 401(k) of the Internal Revenue Code. All existing Trust employees at adoption and subsequent employees who have completed one year of service are eligible to participate in the plan. The Trust may make annual discretionary contributions to the plan. Plan contributions by the Trust in 1993 were $12,000. AMERICAN INDUSTRIAL PROPERTIES REIT NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 10 -- RENTAL INCOME: Minimum future rentals on noncancellable leases at December 31, 1993 were as follows ($ in thousands): NOTE 11 -- GAIN (LOSS) ON SALES OF REAL ESTATE: In 1991, $355,000 of a $732,000 escrow established in connection with the sales of two of the Trust's California properties in 1990 was released to the Trust since a portion of the required leasing objectives were achieved. An additional $51,000 in selling expenses was recognized in 1991 associated with these 1990 sales. In the second quarter of 1992, the Trust sold one of the 13 buildings in the Woodland Industrial Park in Charlotte, North Carolina. In the fourth quarter of 1992, the Trust sold its Southland Industrial property located in Houston, Texas and the remaining 12 buildings in the Woodland Industrial Park. The net loss recognized in 1992 on these sales is summarized below ($ in thousands): The total net sales proceeds after repayment of the $1,800,000 first mortgage on the Southland property and the related transaction costs were approximately $32,000,000. Pursuant to the terms of the Indenture, these proceeds were deposited in the Trust's Property Acquisition Account. A portion of the proceeds were subsequently used to repurchase a portion of the Trust's Zero Coupon Notes through the exercise of the remaining repurchase option (see Note 5) and to repay a portion of the 8.8% Notes Payable (see Note 4). On January 8, 1993, the Trust sold the Royal Lane Business Park property (one of its real estate assets Held for Sale) located in Dallas, Texas. The net sales proceeds totalled approximately $1,800,000 after repayment of approximately $4,650,000 of first mortgages on the property and the related transaction costs. Pursuant to the Indenture, these net proceeds were deposited in the Trust's Property Acquisition Account. The estimated net loss on the sale of Royal Lane Business Park of $931,000 was reflected in the December 31, 1992 financial statements. NOTE 12 -- DISTRIBUTIONS: The Trust's distributions of $1,453,000 ($.16 per Share) in 1993 and $1,815,000 ($.20 per Share) in 1992 represented a return of capital to Shareholders, to the extent of the Shareholder's basis in the Shares. Of the Trust's total distributions of $3,766,000 ($.42 per Share) in 1991, $122,000 ($.02 per Share) represented taxable income to Shareholders and $3,644,000 ($.40 per Share) represented a return of capital to Shareholders, to the extent of a Shareholder's basis in the shares. AMERICAN INDUSTRIAL PROPERTIES REIT NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 13 -- PER SHARE DATA: Net income per Share is based on 9,075,400 Shares outstanding during all years presented. NOTE 14 -- PROPERTY ACQUISITION: On December 10, 1993, the Trust purchased a 175,000 square foot multi-tenant industrial distribution property in Dallas, Texas for a purchase price and related expenses of $3,400,000 in cash (the "Northview Distribution Center"). The property is encumbered by a first mortgage lien for the benefit of the Zero Coupon Noteholders. NOTE 15 -- SUBSEQUENT EVENT: On January 12, 1994, the Trust incorporated American Industrial Properties REIT, Inc., a Maryland corporation (the "Company") as its wholly owned subsidiary through the purchase of 100 shares of stock for $1,000. The Trust intends to seek the approval of the requisite 66 2/3% of all Shareholders to merge the Trust into the Company through an exchange of the Trust's Shares of Beneficial Interest for the Common Stock of the Company. SCHEDULE XI AMERICAN INDUSTRIAL PROPERTIES REIT REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 ($ IN THOUSANDS) The accompanying notes are an integral part of this schedule. AMERICAN INDUSTRIAL PROPERTIES REIT NOTES TO SCHEDULE XI DECEMBER 31, 1993 (1) ACQUISITIONS: All of the real estate on Schedule XI was acquired for cash, subject to certain encumbrances shown therein, from TCC Entities, except for the Northview property acquired in 1993. (2) RECONCILIATION OF REAL ESTATE: The following table reconciles the Trust's real estate for the years ended December 31, 1993 and 1992. (4) RECONCILIATION OF ACCUMULATED DEPRECIATION: The following table reconciles the accumulated depreciation for the years ended December 31, 1993 and 1992. (5) TAX BASIS: The cost basis of the Trust's real estate for tax purposes at December 31, 1993 is $128,585,000. The basis reported under generally accepted accounting principles has been reduced by the aggregate amounts collected under developers' leases, less management fees paid on such developers' leases, and by reductions for the impairments in value of real estate. 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, on March 31, 1994. AMERICAN INDUSTRIAL PROPERTIES REIT /s/ CHARLES W. WOLCOTT Charles W. Wolcott, Trust Manager, President and Chief Executive Officer 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.

764764_1993.txt

764764_1993

1993

764764

Item 1. Business General Caterpillar Financial Services Corporation (the "Company") is a wholly owned finance subsidiary of Caterpillar Inc. ("Caterpillar"). The Company and its wholly owned subsidiaries in North America, Australia, and Europe are principally engaged in the business of financing sales and leases of Caterpillar products and non-competitive related equipment through Caterpillar dealers and is also engaged in extending loans to Caterpillar customers and dealers. Unless the context otherwise requires, the term "Company" includes subsidiary companies. The Company's business is largely dependent upon the ability of Caterpillar dealers to generate sales and leasing activity, the willingness of the customers and the dealers to enter into financing transactions with the Company, and the availability of funds to the Company to finance such transactions. Additionally, the Company's business is affected by changes in market interest rates, which, in turn, are related to general economic conditions, demand for credit, inflation, governmental policies, and other factors. The Company's retail financing business is highly competitive. Financing for users of Caterpillar products is available through a variety of competitive sources, principally commercial banks and finance and leasing companies. The Company emphasizes prompt and responsive service to meet customer requirements and offers various financing plans designed to increase the opportunity for sales of Caterpillar products and financing income for the Company. In addition, the Company's competitive position is improved by merchandising programs of Caterpillar, its subsidiaries, and/or Caterpillar dealers. The following types of retail financing plans are currently offered: Installment sale contracts. The Company finances retail sales of equipment under installment sale contracts with terms generally from one to five years. Such contracts may be entered into (i) by dealers with their customers and assigned to the Company, or (ii) by the Company directly with equipment users. Tax-oriented leases. Under these leases, the Company is considered to be the owner of the equipment for tax purposes during the term of the lease (generally from two to seven years, except for special engine or turbine applications which may range up to 15 years). For financial accounting purposes, these leases are classified as either financing or operating leases depending upon the specific characteristics of the lease. The Company establishes a specific residual value on each product leased based on various factors including the use and application, price, product type, and lease term. Generally, the lessee, at the end of the lease term, may continue to lease the product or purchase the product for its fair market value. The profitability of these leases is affected by the Company's ability to realize estimated residual values upon selling or re-leasing the equipment at the termination of the leases. Non-tax (financing) leases. Under these leases, the lessee is considered to be the owner of the equipment for tax and financial accounting purposes during the term of the lease (generally from one to six years). For financial accounting purposes, these leases are classified as financing leases. The lessee customarily has a fixed price purchase option exercisable upon expiration of the lease term or will be required to purchase the equipment at the end of the lease term. Customer and dealer loans. The Company offers loans for working capital and other business purposes to Caterpillar customers and dealers meeting the Company's credit requirements. The loans may be secured or unsecured and are repayable over terms generally ranging from two to five years. Governmental lease-purchase contracts. The Company finances sales of products to cities, counties, states, and other qualified governmental bodies for terms generally from two to seven years. In general, this form of financing is subject to termination if the governmental body does not appropriate funds for future payments. The reduced interest rate in these transactions reflects the fact that interest income is not subject to federal income tax. The Company also provides wholesale financing of Caterpillar dealer inventory in Germany and Caterpillar dealer rental fleets in the United States. These receivables are secured by the respective product which is fully insured against physical damage. The amount of credit extended by the Company for each machine is generally limited to the invoice price of the new equipment. Maturities in Germany generally range from one to three months and in the United States from six to twelve months. The percentages of the total value of the Company's portfolio represented by these financing plans at December 31 of the past three years were as follows: 1993 1992 Retail Financing: Installment sale contracts 25% 25% 27% Tax-oriented leases 20% 20% 21% Non-tax (financing) leases 19% 19% 22% Customer loans 19% 18% 13% Dealer loans 10% 12% 12% Governmental lease-purchase contracts 3% 4% 5% Wholesale Financing 4% 2% - The Company periodically offers below-market-rate financing to customers which is subsidized by Caterpillar, its subsidiaries, and/or Caterpillar dealers. In all such cases, the cost of such subsidies is borne totally by Caterpillar, its subsidiaries, and/or the dealer (and not by the Company) and is settled at the time each transaction is executed. Tax-oriented leases and governmental lease-purchase contracts are currently offered at fixed interest rates and fixed rental payments. Non-tax (financing) leases, installment sale contracts, and customer and dealer loans are offered at either fixed or floating interest rates. Approximately 80% of the Company's portfolio involves financing with fixed interest rates and fixed payments. In order to reduce the impact of interest rate fluctuations on its operations, the Company has a match funding policy of structuring the maturities of a substantial percentage of its borrowed funds over periods which closely correspond to the maturities of its portfolio. The Company provides financing only when acceptable credit standards and criteria are met. Decisions regarding credit applications are based upon the customer's credit history and financial strength, the intended use of the equipment being financed, and other considerations. In general, the Company obtains a security interest in the equipment being financed. Less than five percent of the total value of the Company's portfolio (excluding loans to dealers) is comprised of transactions in which the Company has recourse to a dealer. Management closely monitors past due accounts and regularly evaluates the collectibility of receivable balances. The Company maintains an allowance for credit losses which it believes is sufficient to cover uncollectible accounts. Company policy is to write off against such allowance that portion of the outstanding receivable which cannot be recovered by leasing or selling the related equipment. Management believes the allowance for credit losses at December 31, 1993, is sufficient to provide for any losses which may be sustained on outstanding receivables. For more information on receivables and the allowance for credit losses, see Note 2 of the Notes to the Consolidated Financial Statements. The following table summarizes the Company's delinquency experience showing past-due receivables as a percentage of total receivables: Delinquency Experience Decem ber 31, 1992 1991 Past due 31 to 60 days ..................... .7% 0.6% 1.6% Past due over 60 days ..................... 1.2% 1.9% 2.4% At December 31, 1993, the largest single customer/dealer account represented 3.5% of the Company's portfolio and the five largest such customer/dealer accounts represented 11.1% of the portfolio. With respect to dealer financing, at December 31, 1993, the largest single dealer account represented 3.5% of the Company's portfolio and the five largest such dealer accounts collectively represented 8.8% of the portfolio. In the opinion of the Company, the loss of the business represented by any one of these accounts would not have a material adverse effect on the Company's overall business. Relationship with Caterpillar Caterpillar provides the Company with certain operational and financial support which is integral to the conduct of the Company's business. The employees of the Company are covered by various benefit plans, including pension/post-retirement plans, administered by Caterpillar. The Company reimburses Caterpillar for certain corporate services and pays rent for space occupied on Caterpillar premises. For more information on payments for services, see Note 10 of the Notes to the Consolidated Financial Statements. The Company, in conjunction with Caterpillar and its subsidiaries, periodically offers below-market-rate financing to customers under merchandising programs. Caterpillar, at the outset of the transaction, remits to the Company an amount equal to the interest differential which is recognized as income over the term of the contracts. For more information on the interest differential payments, see Note 10 of the Notes to the Consolidated Financial Statements. The Company entered into agreements with a subsidiary of Caterpillar to purchase, at a discount, some or all of the subsidiary's receivables generated by sales of products to Caterpillar dealers in Germany, Austria, and the Czech Republic. These purchases (wholesale financing) in 1993 and 1992 totaled $210.2 million and $201.7 million, respectively. Through December 31, 1993, Caterpillar had invested a total of $250.0 million in the equity of the Company. The Company and Caterpillar have also entered into an agreement (the "Support Agreement") which provides, among other things, that Caterpillar will (i) remain, directly or indirectly, the sole owner of the Company, (ii) ensure that the Company will maintain a tangible net worth of at least $20.0 million, and (iii) permit the Company to use (and the Company is required to use) the name "Caterpillar" in the conduct of its business. The Support Agreement provides that it may be modified, amended, or terminated by either party. However, no such modification or amendment, which adversely affects the holders of any debt outstanding at the execution thereof, is binding on or in any manner becomes effective with respect to (i) any then outstanding commercial paper, or (ii) any other debt then outstanding unless such modification or amendment is approved in writing by the holders of 66-2/3% of the aggregate principal amount of such other debt. The obligations of Caterpillar under the Support Agreement are to the Company only and are not directly enforceable by any creditor of the Company, nor do such obligations constitute a guarantee by Caterpillar of the payment of any debt or obligation of the Company. To supplement external debt financing sources, the Company has variable amount lending agreements with Caterpillar (including one of its subsidiaries). Under these agreements, which may be amended from time to time, the Company may borrow up to $53.8 million from Caterpillar, and Caterpillar may borrow up to $83.8 million from the Company. All of the variable amount lending agreements are effective for indefinite terms and may be terminated by either party upon 30 days' notice. At December 31, 1993, the Company had no outstanding borrowings or loans receivable under these agreements. To hedge the U.S. dollar denominated borrowings in Australia against currency fluctuations, the Company has entered into forward exchange contracts with Caterpillar. All of these contracts generally have maturities not exceeding 90 days. At December 31, 1993, the Company had contracts with Caterpillar totaling $143.1 million. The Company has an agreement (the "Tax Sharing Agreement") with Caterpillar in which the Company consented to the filing of consolidated income tax returns with Caterpillar, and Caterpillar agreed, among other things, to collect from or pay to the Company, within 45 days of realization, its allocated share of any consolidated income tax liability or credit applicable to any period for which the Company is included in Caterpillar's consolidated federal income tax return. The Tax Sharing Agreement sets forth the method by which the Company's allocated share shall be determined and provides that Caterpillar will indemnify the Company for any related tax liability in excess of that amount. Similar agreements were executed between Caterpillar Financial Australia Limited and Caterpillar of Australia Ltd. with respect to taxes payable in Australia, and between the Company and Caterpillar with respect to taxes payable in Germany. Item 2. Item 2. Properties The Company does not own any real estate. Its principal executive offices are comprised of approximately 49,000 square feet of office space at 3322 West End Avenue, Nashville, Tennessee. As of December 31, 1993, the Company had additional offices in or near Phoenix, Arizona; Dallas, Texas; Atlanta, Georgia; Baltimore, Maryland; Chicago, Illinois; Melbourne, Australia; Calgary, Alberta; Toronto, Ontario; Munich, Germany; Leipzig, Germany; Stockholm, Sweden; Oslo, Norway; Arhus, Denmark; Paris, France; London, England; and Madrid, Spain. For more information on leases, see Note 11 of the Notes to the Consolidated Financial Statements. Item 3. Item 3. Legal Proceedings The Company is a party to various litigation matters and claims, and, while the results of litigation and claims cannot be predicted with certainty, management believes the final outcome of such matters and claims will not have a material adverse effect on the consolidated financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Information for this Item 4 is not required. See General Instruction J. PART II. Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The Company's common stock is owned entirely by Caterpillar and is not publicly traded. In its three most recent fiscal years, the Company has not declared or paid cash dividends on its common stock. Item 6. Item 6. Selected Financial Data Information on this Item 6 is not required. See General Instruction J. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations The Company derives its earnings primarily from financing sales and leases of Caterpillar products and from loans extended to Caterpillar customers and dealers. New retail financing during 1993 totaled $1,967.4 million, a 28% increase over the $1,531.8 million financed in 1992 and a 59% increase over the 1991 new business of $1,240.0 million. New retail financing volume for 1993 exceeded 1992 and 1991 levels due to increased machine financing in the United States and Europe. New business volume for 1992 exceeded the 1991 level primarily as the result of financing activity in Germany. The Company had wholesale financing during 1993 of $228.2 million. New retail financing in 1994 is expected to remain at about 1993 levels. Wholesale financing in 1994 is expected to exceed 1993 levels due to expansion of the Caterpillar dealer rental fleet financing program in the United States. In 1994, the Company will offer financial services to the customers of the Caterpillar dealer in Spain through a new subsidiary, Alquiler de Equipos Industriales, S.A. Revenues from operations in the United States were more than 80% of total revenues in 1993, 1992, and 1991. Net income from operations in the United States was more than 90% of total net income in 1993, 1992, and 1991. For more geographic segment information, see Note 12 of the Notes to the Consolidated Financial Statements. Past due percentages decreased in 1993 primarily as a result of an improving U.S. economy and collection efforts. The allowance for credit losses will continue to be monitored to provide for an amount which, in management's judgement, will be adequate to cover uncollectible receivables. The composition of the Company's portfolio (see "Item 1. Business") by financing plans did not change significantly from 1992 to 1993. The Company's wholesale financing increased due to a higher floor planning receivable balance in Germany and the addition of receivables from dealers under the inventory rental assistance program in the United States. 1993 Compared With 1992 Total revenues for 1993 were $363.6 million, a 6% increase over 1992 revenues of $342.4 million. The increase in revenues, limited by a low interest rate environment, was primarily the result of earnings from the larger portfolio which increased to $3,522.1 million at December 31, 1993 from $2,812.7 million at December 31, 1992. The annualized interest rate on finance receivables (computed by dividing finance income by the average monthly finance receivable balances) was 9.1% for 1993 compared with 10.3% for 1992. Tax benefits associated with governmental lease- purchase contracts and a portion of tax benefits associated with long-term tax-oriented leases are not reflected in such annualized interest rates. The decrease in the annualized interest rate reflected a decrease in the interest rates charged to customers. Other income, net, of $15.7 million for 1993 included fees, gains on sales of equipment returned from lease, and other miscellaneous income. The increase of $1.3 million for 1993 was primarily due to a higher amount of fees collected and earned. Interest expense for 1993 was $173.1 million, $1.3 million less than 1992. Although there were increased borrowings to support the larger portfolio, interest expense decreased due to lower borrowing rates as the average cost of borrowed funds was 6.5% in 1993 compared with 7.8% in 1992. Depreciation expense increased from $63.1 million in 1992 to $69.6 million in 1993 due to the increase in equipment on operating leases which, computed as a monthly average balance, increased 9%. General, operating, and administrative expenses increased $8.8 million over 1992 primarily due to staff-related and other expenses required to service the larger portfolio and expansion into Europe. The Company's full-time employment increased from 324 at the end of 1992 to 361 at December 31, 1993. Provision for credit losses during 1993 increased from $20.4 million in 1992 to $20.8 million in 1993. This increase, partially offset by a higher provision taken in 1992 for the U.S., Australian, and Canadian companies, reflected increased levels of new business for 1993. Receivables, net of recoveries, of $18.8 million were written off against the allowance for credit losses during 1993 compared with $14.3 million during 1992 due to an acceleration of write-offs from point of sale to point of repossession. Receivables past due over 30 days were 1.9% of total receivables at December 31, 1993 compared with 2.5% at December 31, 1992. Past due percentages decreased primarily as a result of an improving U.S. economy and collection efforts. The allowance for credit losses is monitored to provide for an amount which, in management's judgment, will be adequate to cover uncollectible receivables. At December 31, 1993, the allowance for credit losses was $41.5 million which was 1.3% of finance receivables, net of unearned income, compared with $36.5 million and 1.4% at December 31, 1992, respectively. The effective income tax rate for 1993 was 36% compared with 34% for 1992. For information on this change, see Note 8 of the Notes to the Consolidated Financial Statements. Consolidated net income in 1993 was $37.8 million, compared with $34.0 million, excluding the cumulative effect of the change in accounting for income taxes in 1992. The increase in net income generally reflected the increased revenues from a larger portfolio and lower cost of borrowed funds, partially offset by increased costs to support the larger portfolio and European expansion. 1992 Compared With 1991 Total revenues for 1992 were $342.4 million, an 8% increase over 1991 revenues of $316.4 million. The increase in revenues, limited by a low interest rate environment, was primarily the result of earnings from the larger portfolio, which increased to $2,812.7 million at December 31, 1992 from $2,437.1 million at December 31, 1991. The annualized interest rate on finance receivables (computed by dividing finance income by the average monthly finance receivable balances) was 10.3% for 1992 compared with 11.1% for 1991. Tax benefits associated with governmental lease- purchase contracts and a portion of tax benefits associated with long-term tax-oriented leases are not reflected in such annualized interest rates. The decrease in the annualized interest rate reflected a decrease in interest rates charged to customers. Other income, net, of $14.4 million for 1992 included fees, gains on sales of equipment returned from lease, and other miscellaneous income. The increase of $3.7 million for 1992 was primarily due to larger gains on sales of equipment returned from lease, more commitment fees earned, and more late charge fees collected. Interest expense for 1992 was $174.4 million, $1.9 million less than 1991. Although there were increased borrowings to support the larger portfolio, interest expense decreased due to lower borrowing rates as the average cost of borrowed funds was 7.8% in 1992 compared with 8.9% in 1991. Depreciation expense increased from $54.4 million in 1991 to $63.1 million in 1992 due to the increase in equipment on operating leases which, computed as a monthly average balance, increased 12%. General, operating, and administrative expenses increased 11% over 1991 primarily due to staff-related and other expenses required to service the larger portfolio and expansion into Europe. The Company's full-time employment increased from 310 at the end of 1991 to 324 at December 31, 1992. Provision for credit losses during 1992 increased from $13.2 million in 1991 to $20.4 million in 1992. This increase reflected increased levels of new business and a higher provision taken for the U.S., Australian, and Canadian companies. Receivables, net of recoveries, of $14.3 million were written off against the allowance for credit losses during 1992 compared with $13.0 million during 1991. Receivables past due over 30 days were 2.5% of total receivables at December 31, 1992, compared with 4.0% at December 31, 1991. Past due percentages decreased primarily as a result of increased collection efforts. The allowance for credit losses is monitored to provide for an amount which, in management's judgement, will be adequate to cover uncollectible receivables. At December 31, 1992, the allowance for credit losses was $36.5 million which was 1.4% of finance receivables, net of unearned income, compared with $31.0 million and 1.4% at December 31, 1991, respectively. The effective income tax rate for 1992 and 1991 was 34%. In the fourth quarter of 1992, effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes." SFAS 109 requires changing the method of accounting for income taxes from the deferred method to the liability method. The effect of adopting SFAS 109, as of January 1, 1992, was a benefit of $2.6 million and is excluded from the effective income tax rate calculation. For more information on this accounting change, see Note 8 of the Notes to the Consolidated Financial Statements. Consolidated net income in 1992, excluding the cumulative effect of the change in accounting for income taxes, was $34.0 million, compared with $28.5 million in 1991. The increase in net income generally reflected the increased revenues from a larger portfolio and lower cost of borrowed funds, partially offset by the increase in the provision for credit losses. Capital Resources and Liquidity The Company's operations were primarily funded with a combination of medium-term notes, commercial paper, bank borrowings, retained earnings, and additional equity capital of $30.0 million invested by Caterpillar. Additional short-term funding was available from Caterpillar (see Note 10 of the Notes to the Consolidated Financial Statements); however, no intercompany borrowings were outstanding at December 31, 1993. Total debt outstanding as of December 31, 1993, was $3,041.1 million, an increase of $639.7 million over that at December 31, 1992, and was primarily comprised of $1,854.8 million of medium- term notes, $797.2 million of commercial paper, and $335.7 million of notes payable to banks. Interest rate swaps were contracted in the United States, Australia, Canada, and Germany to reduce the exposure to interest rate fluctuations. See Notes 6 and 7 of the Notes to the Consolidated Financial Statements for more information on short-term and long-term debt. At December 31, 1993, the Company had available in the United States, Australia, Canada, Germany, Sweden, and the United Kingdom a total of $990.7 million of short-term credit lines, which expire at various dates in 1994, and $64.7 million of long- term credit lines, which expire at various dates from January 1996 to May 1996. These credit lines are with a number of banks and are considered support for the Company's outstanding commercial paper, commercial paper guarantees, the discounting of bank and trade bills, and bank borrowings at various interest rates. At December 31, 1993, there were $326.1 million of these lines utilized for bank borrowings in Australia, Germany, Sweden, and the United Kingdom. The Company also has a $455.0 million revolving credit agreement with a group of banks. This agreement is also considered support for the Company's outstanding commercial paper and commercial paper guarantees. The agreement terminates in 1996 and provides for borrowings at interest rates which vary according to LIBOR or money market rates. At December 31, 1993, there were no borrowings under this agreement. The above-mentioned credit agreements require the Company to maintain its consolidated ratio of profit before taxes plus fixed charges to fixed charges at no less than 1.1 to 1 for each quarter; the Company's total liabilities to total stockholder's equity may not exceed 8.0 to 1; and the Company's tangible net worth must be at least $20.0 million. The Company's funding requirements were met primarily through the sale of commercial paper and medium-term notes, discounting of bank and trade bills, and through bank borrowings. During 1993, the average outstanding commercial paper balance, net of discount, was $782.3 million at an average interest rate of 3.7%. At year-end 1993, the face value of commercial paper outstanding was $798.6 million. During 1993, $417.1 million of fixed-rate medium-term notes were sold at an average interest rate of 4.9% and $475.2 million of floating-rate medium-term notes were sold at rates indexed to LIBOR, prime, or commercial paper rates. Medium-term notes outstanding at year-end 1993 were $1,854.8 million. During the year, bank bills totaling $154.4 million and trade bills totaling $184.2 million were discounted at an average interest rate of 5.6% and 8.0%, respectivly. In connection with its match funding objectives, the Company entered into a variety of interest rate contracts including interest rate swap and cap agreements. Interest rate swap agreements totaled $2,047.3 million and interest rate cap agreements totaled $500.0 million at year-end 1993. The Company has entered into forward exchange contracts to hedge its U.S. dollar denominated obligations in Australia and Canada against currency fluctuations. At December 31, 1993, the outstanding forward exchange contracts totaled $146.6 million. On a consolidated basis, equity capital at the end of 1993 was $418.0 million, an increase of $64.0 million during the year. This increase included $30.0 million of additional equity investment made by Caterpillar and $37.8 million of retained earnings from operations. The increase in debt, the equity investment from Caterpillar, and the funds provided by operations were used to finance the increase in the portfolio. The ratio of debt to equity at December 31, 1993 was 7.3 to 1, compared with 6.8 to 1 for 1992 and 6.7 to 1 for 1991. Item 8. Item 8. Financial Statements and Supplementary Data The information required by Item 8 is included as a part of this report on pages 16 through 29. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III. Item 10. Item 10. Directors and Executive Officers of the Registrant Information for Item 10 is not required. See General Instruction J. Item 11. Item 11. Executive Compensation Information for Item 11 is not required. See General Instruction J. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information for Item 12 is not required. See General Instruction J. Item 13. Item 13. Certain Relationships and Related Transactions Information for Item 13 is not required. See General Instruction J. PART IV. Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) The following documents are filed as part of this report: 1. Financial Statements Report of Independent Accountants Consolidated Statement of Financial Position at December 31, 1993, 1992, and 1991 Consolidated Statement of Income and Retained Earnings for the Years Ended December 31, 1993, 1992, and 1991 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992, and Notes to Consolidated Financial Statements 2. Financial Statement Schedules Schedule IX - Short-term Borrowings All other schedules are omitted because they are not applicable or required information is shown in the financial statements or the notes thereto. (b) Reports on Form 8-K None (c) Exhibits 3.1 Certificate of Incorporation of the Company (incorporated by reference from Exhibit 3.1 to the Company's Form 10, as amended, Commission File No. 0-13295). 3.2 Bylaws of the Company (incorporated by reference from Exhibit 3.2 to the Company's Annual Report on Form 10-K, for the year ended December 31, 1990, Commission File No. 0-13295). 4.1 Indenture, dated as of April 15, 1985, between the Company and Morgan Guaranty Trust Company of New York, as Trustee, including form of Debt Security (see Table of Contents to Indenture)(incorporated by reference from Exhibit 4.1 to the Company's Registration Statement on Form S-3, Commission File No. 33- 2246). 4.2 First Supplemental Indenture, dated as of May 22, 1986, amending the Indenture dated as of April 15, 1985 between the Company and Morgan Guaranty Trust Company of New York, as Trustee (incorporated by reference from Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 20, 1986, Commission File No. 0-13295). 4.3 Second Supplemental Indenture, dated as of March 15, 1987, amending the Indenture dated as of April 15, 1985 between the Company and Morgan Guaranty Trust Company of New York, as Trustee (incorporated by reference from Exhibit 4.3 to the Company's Current Report on Form 8-K dated April 24, 1987, Commission File No. 0-13295). 4.4 Third Supplemental Indenture, dated as of October 2, 1989, amending the Indenture dated as of April 15, 1985, between the Company and Morgan Guaranty Trust Company of New York, as Trustee (incorporated by reference from Exhibit 4.3 to the Company's Current Report on Form 8-K, dated October 16, 1989, Commission File No. 0-13295). 4.5 Fourth Supplemental Indenture, dated as of October 1, 1990, amending the Indenture dated April 15, 1985, between the Company and Morgan Guaranty Trust Company of New York, as Trustee (incorporated by reference from Exhibit 4.3 to the Company's Current Report on Form 8-K, dated October 29, 1990, Commission File No. 0-13295). 4.6 Indenture, dated as of July 15, 1991, between the Company and Continental Bank, National Association, as Trustee (incorporated by reference from Exhibit 4.1 to the Company's Current Report on Form 8-K, dated July 25, 1991, Commission File No. 0-13295). 4.7 Support Agreement, dated as of December 21, 1984, between the Company and Caterpillar (incorporated by reference from Exhibit 4.2 to the Company's Form 10, as amended, Commission File No. 0-13295). 10.1 Tax Sharing Agreement, dated as of June 21, 1984, between the Company and Caterpillar (incorporated by reference from Exhibit 10.3 to the Company's Form 10, as amended, Commission File No. 0-13295). 10.2 Revolving Credit Agreement, dated as of February 22, 1991, among the Company, as the Borrower, the several financial institutions parties thereto (the "Banks"), and The First National Bank of Chicago, as agent for the Banks (incorporated by reference from Exhibit 10.2 to the Company's Annual Report on Form 10-K, for the year ended December 31, 1990, Commission File No. 0-13295). 10.3 Amendment to the Revolving Credit Agreement, described in Exhibit 10.2 of the Company's Annual Report on Form 10-K for the year ending December 31, 1990, extending the Termination Date from February 20, 1994 to February 20, 1995 (incorporated by reference from Exhibit 10.3 to the Company's Annual Report on Form 10-K, for the year ended December 31, 1991, Commission File No. 0-13295). 10.4 Amendment to the Revolving Credit Agreement, described in Exhibit 10.2 of the Company's Annual Report on Form 10-K for the year ending December 31, 1990, extending the Termination Date from February 20, 1995 as amended by Exhibit 10.3 of the Company's Annual Report on Form 10-K for the year ending December 31, 1991, to February 20, 1996 (incorporated by reference from Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, Commission File No. 013295). 12 Statement Setting Forth Computation of Ratio of Profit to Fixed Charges. (The ratios of profit to fixed charges for the years ending December 31, 1993, 1992, and 1991 were 1.33, 1.28, and 1.23, respectively.) 23 Consent of Price Waterhouse 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. Caterpillar Financial Services Corporation (Registrant) Dated: March 4, 1994 By: /s/ Nancy L. Snowden Nancy L. Snowden, Secretary 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 Company and in the capacities and on the dates indicated. Date Signature Title March 4, 1994 /s/ James S. Beard President, Director and (James S. Beard) Principal Executive Officer March 4, 1994 /S/ F. Lynn McPheeters Executive Vice President (F. Lynn McPheeters) and Director March 4, 1994 /s/ James W. Wogsland Director (James W. Wogsland) March 4, 1994 /s/ Kenneth C. Springer Controller and Principal (Kenneth C. Springer) Accounting Officer March 4, 1994 /s/ Frank C. Carder Treasurer and Principal (Frank C. Carder) Financial Officer REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholder of Caterpillar Financial Services Corporation In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on page 11 present fairly, in all material respects, the financial position of Caterpillar Financial Services Corporation and its subsidiaries at December 31, 1993, 1992, and 1991, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 8 to the consolidated financial statements, in 1992 the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes." PRICE WATERHOUSE Peoria, Illinois January 21, 1994 CATERPILLAR FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENT OF FINANCIAL POSITION (Millions of dollars) December 31, 1993 1992 Assets: Cash and cash equivalents $ 15.6 $ 11.5 $ 20.4 Finance receivables (Notes 2,3, and 5): Wholesale notes receivable 142.8 49.3 - Retail notes receivable 1,035.5 858.5 623.9 Investment in finance receivables 2,350.8 1,970.1 1,840.8 3,529.1 2,877.9 2,464.7 Less: Unearned income 348.2 315.8 288.7 Allowance for credit losses 41.5 36.5 31.0 3,139.4 2,525.6 2,145.0 Equipment on operating leases, less accumulated depreciation (Note 4) 364.6 276.7 283.0 Other assets 45.1 29.5 40.6 Total assets $3,564.7 $2,843.3 $2,489.0 Liabilities and stockholder's equity: Payable to dealers and customers $ 13.7 $ 11.1 $ 1.5 Payable to Caterpillar Inc. (Note 10) 3.9 2.9 3.5 Accrued interest payable 33.6 28.0 27.4 Income tax payable (Note 8) 36.0 30.0 8.8 Other liabilities 5.4 3.2 1.1 Short-term borrowings (Note 6) 1,138.2 913.1 672.5 Current maturities of long-term debt (Note 7) 492.5 492.4 562.7 Long-term debt (Note 7) 1,410.4 995.9 876.3 Deferred income taxes (Note 8) 13.0 12.7 22.3 Total liabilities 3,146.7 2,489.3 2,176.1 Commitments and contingent liabilities (Note 7) Common stock - $1 par value Authorized: 2,000 shares Issued and outstanding: one share 250.0 220.0 210.0 Profit employed in the business 175.5 137.7 101.1 Foreign currency translation adjustment (Note 1G) (7.5) (3.7) 1.8 Total stockholder's equity 418.0 354.0 312.9 Total liabilities and stockholder's equity $3,564.7 $2,843.3 $2,489.0 (See Notes to Consolidated Financial Statements) CATERPILLAR FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENT OF INCOME AND RETAINED EARNINGS FOR THE YEARS ENDED DECEMBER 31, (Millions of dollars) 1993 1992 Revenues: Wholesale finance income $ 5.8 $ 4.1 $ - Retail finance income 246.4 235.2 227.7 Rental income 95.7 88.7 78.0 Other income, net 15.7 14.4 10.7 Total revenues 363.6 342.4 316.4 Expenses: Interest (Notes 6 & 7) 173.1 174.4 176.3 Depreciation 69.6 63.1 54.4 General, operating, and administrative 41.7 32.9 29.6 Provision for credit losses 20.8 20.4 13.2 Total expenses 305.2 290.8 273.5 Income before income taxes, minority interest, and cumulative effect of change in accounting for income taxes 58.4 51.6 42.9 Provision for income taxes (Note 8) 21.3 17.6 14.4 Minority interest in earnings (losses) of subsidiary (0.7) - - Income before cumulative effect of change in accounting for income taxes 37.8 34.0 28.5 Cumulative effect of change in accounting for income taxes - 2.6 - Net income 37.8 36.6 28.5 Retained earnings - beginning of year 137.7 101.1 72.6 Retained earnings - end of year $175.5 $137.7 $101.1 (See Notes to Consolidated Financial Statements) CATERPILLAR FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, (Millions of dollars) 1993 1992 Cash flows from operating activities: Net income $ 37.8 $ 36.6 $ 28.5 Adjustments for noncash items: Depreciation 69.6 63.1 54.4 Provision for credit losses 20.8 20.4 13.2 Other (4.4) (6.1) (5.7) Change in assets and liabilities: Receivables from customers and others (15.3) 14.9 (14.6) Deferred and refundable income taxes - (9.5) 2.2 Payable to dealers and customers 2.8 10.1 (2.0) Payable to Caterpillar Inc. 1.0 (.6) (7.0) Accrued interest payable 5.5 .7 9.5 Income tax payable 6.0 21.4 (2.6) Other, net 2.1 2.1 (2.5) Net cash provided by operating activities 125.9 153.1 73.4 Cash flows from investing activities: Additions to equipment (204.1) (121.2) (118.7) Disposals of equipment 32.6 31.2 19.5 Additions to finance receivables (2,023.0) (1,601.5) (1,268.6) Collections of finance receivables 1,388.8 1,197.8 999.3 Other, net .2 (.3) .2 Net cash used for investing activities (805.5) (494.0) (368.3) Cash flows from financing activities: Additional paid in capital 30.0 10.0 10.0 Proceeds from long-term debt issues 918.4 617.0 691.3 Payments on long-term debt (517.4) (567.7) (410.7) Short-term borrowings, net 253.5 275.0 2.8 Net cash provided by financing activities 684.5 334.3 293.4 Effect of exchange rate changes on cash (.8) (2.3) (.4) Net change in cash and cash equivalents 4.1 (8.9) (1.9) Cash and cash equivalents at beginning of year 11.5 20.4 22.3 Cash and cash equivalents at end of year $ 15.6 $ 11.5 $ 20.4 (See Notes to Consolidated Financial Statements) CATERPILLAR FINANCIAL SERVICES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar amounts in millions) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. Operations and basis of consolidation Caterpillar Financial Services Corporation (the "Company") is a wholly owned finance subsidiary of Caterpillar Inc. ("Caterpillar"). The Company provides financing of earthmoving, construction, and materials handling machinery and engines sold by Caterpillar dealers, and turbine engines sold by Solar Turbines Incorporated through offices located in North America, Australia, and Europe. The Company also provides customer and dealer loans for various business purposes. The accompanying financial statements include the accounts of Caterpillar Financial Services Corporation and its foreign subsidiaries. Certain amounts in the prior period financial statements have been reclassified to conform to the 1993 presentation. B. Recognition of earned income Retail finance income - Income on retail finance receivables (financing leases, installment sale contracts, and customer and dealer loans) is recognized over the term of the contract at a constant rate of return on the scheduled uncollected principal balance. Wholesale finance income - Income on wholesale finance receivables (dealer floor planning in Germany and rental fleet financing in the United States) is recognized based on the daily balance of wholesale receivables outstanding and the applicable effective interest rate. Rental income - Income on operating leases is reported over the life of the operating lease in the period earned. Fee income - Loan origination fees are amortized to finance income using the interest method over the contractual terms of the finance receivables. Commitments fees are amortized to other income using the straight-line method over the commitment period. Recognition of income is suspended when management determines that collection of future income is not probable. Accrual is resumed if the receivable becomes contractually current and collection doubts are removed; previously suspended income is recognized at that time. C. Depreciation Depreciation on operating leases is recognized using the straight-line method over the lease term. The depreciable basis is the original cost of the equipment less the estimated residual value of the equipment at the end of the lease term. Depreciation on property and equipment, other than equipment on operating leases, that the Company owns, was less than $1.3 million for 1993. D. Cash and cash equivalents Cash and cash equivalents include cash on hand or on deposit with banks and highly liquid short-term investments with maturities of three months or less at the time of purchase. E. Allowance for credit losses Management regularly evaluates factors affecting the collectibility of receivable balances and maintains an allowance for credit losses, which it believes is sufficient to cover uncollectible accounts. Uncollectible receivable balances are written off against the allowance for credit losses when the underlying collateral is repossessed. Prior to 1993, uncollectible receivable balances were written off when the underlying collateral was sold. F. Income taxes The Company has a tax sharing agreement with Caterpillar in which the Company consents to the filing of consolidated income tax returns with Caterpillar, and Caterpillar agrees, among other things, to collect from or pay to the Company its allocated share of any consolidated income tax liability or credit applicable to any period for which the Company is included as a member of the consolidated group in a manner determined as if each company in the consolidated group had computed its tax on a separate return basis. Similar agreements exist between Caterpillar Financial Australia Limited and Caterpillar of Australia Ltd. with respect to taxes payable in Australia, and between the Company and Caterpillar with respect to taxes payable in Germany. G. Foreign currency translation Assets and liabilities of foreign subsidiaries are translated at current exchange rates, and the effects of translation adjustments are reported as a separate component of stockholder's equity entitled "Foreign currency translation adjustment." NOTE 2 - RECEIVABLES AND ALLOWANCE FOR CREDIT LOSSES The contractual maturities of outstanding receivables at December 31, 1993, were: Installment Financing Amounts due in contracts leases Notes Total 1994 $ 415.9 $ 392.5 $ 362.2 $1,170.6 1995 304.1 296.6 288.1 888.8 1996 189.7 198.5 219.6 607.8 1997 70.8 116.7 115.2 302.7 1998 14.0 56.4 123.2 193.6 Thereafter 1.0 74.7 70.0 145.7 995.5 1,135.4 1,178.3 3,309.2 Residual Value - 219.9 - 219.9 Total $ 995.5 $1,355.3 $1,178.3 $3,529.1 Receivables generally may be repaid or refinanced without penalty prior to contractual maturity. Accordingly, this presentation should not be regarded as a forecast of future cash collections. At December 31, 1993, the recognition of finance income had been suspended on $20.1 million of finance receivables compared with $23.4 million at December 31, 1992, and $40.4 million at December 31, 1991. Activity relating to the allowance for credit losses is shown below: 1993 1992 Balance at beginning of year $36.5 $31.0 $30.8 Provision for credit losses 20.8 20.4 13.2 Aquisition of Spanish subsidiary 3.5 - - Less: Receivables written off, net of recoveries 18.8 14.3 13.0 Foreign currency translation adjustment .5 .6 - Balance at end of year $41.5 $36.5 $31.0 NOTE 3 - INVESTMENT IN FINANCING LEASES 1993 1992 Total minimum lease payments receivable $1,135.4 $ 982.3 $ 893.3 Estimated residual value of leased assets: Guaranteed 71.4 55.1 65.1 Unguaranteed 148.5 123.7 97.7 1,355.3 1,161.1 1,056.1 Less: Unearned income 229.5 212.2 182.0 Net investment in financing leases $1,125.8 $ 948.9 $ 874.1 NOTE 4 - EQUIPMENT ON OPERATING LEASES Components of the Company's investment in equipment on operating leases, less accumulated depreciation, at December 31 were as follows: 1993 1992 Equipment on operating leases, at cost $503.5 $402.0 $402.5 Less: Accumulated depreciation 138.9 125.2 119.2 Unearned investment tax credits - .1 .3 Equipment on operating leases, net $364.6 $276.7 $283.0 At December 31, 1993, scheduled minimum rental payments for operating leases were as follows: Amounts due in: 1994 $103.1 1995 83.2 1996 55.5 1997 29.2 1998 15.0 Thereafter 8.5 Total $294.5 NOTE 5 - CONCENTRATION OF CREDIT RISK The Company's receivables are primarily composed of receivables under installment sale contracts, receivables arising from leasing transactions, and notes receivable. The Company generally maintains a secured interest in equipment financed, and a substantial portion of its business activity is with customers located within the United States. Receivables from customers in construction-related industries made up approximately one-third of total finance receivables as of December 31, 1993, 1992 and 1991, respectively. However, no single customer or region represents a significant concentration of credit risk. NOTE 6 - SHORT-TERM BORROWINGS Total average short-term borrowings during 1993, 1992, and 1991 were $1,038.3 million, $776.9 million, and $662.8 million, respectively. Commercial paper and bank borrowings outstanding at December 31, 1993, generally had maturities not exceeding 90 days with average discount rates of 3.6% and 7.0%, respectively. The approximate weighted average interest rate on short-term borrowings was 4.8%, 5.2%, and 7.2% for 1993, 1992, and 1991, respectively. Interest paid on short-term borrowings was $58.3 million in 1993, $60.3 million in 1992, and $62.3 million in 1991. Short-term borrowings at December 31, consisted of the following: 1993 1992 Notes payable to banks, net $ 335.7 $195.5 $ 32.3 Commercial paper, net 797.2 714.0 638.8 Other 5.3 3.6 1.4 Total $1,138.2 $913.1 $672.5 At December 31, 1993, the Company had available in the United States, Australia, Canada, Germany, Sweden, and the United Kingdom, a total of $990.7 million of short-term credit lines which expire at various dates in 1994, and $64.7 million of long- term credit lines which expire at various dates from January 1996 to May 1996. These credit lines are with a number of banks and are considered support for the Company's outstanding commercial paper, commercial paper guarantees, the discounting of bank and trade bills, and bank borrowings at various interest rates. At December 31, 1993, there were $326.1 million of these lines utilized for bank borrowings in Australia, Germany, Sweden, and the United Kingdom. The Company also has a $455.0 million revolving credit agreement with a group of banks. This agreement is also considered support for the Company's outstanding commercial paper and commercial paper guarantees. The agreement terminates in 1996 and provides for borrowings at interest rates which vary according to LIBOR or money market rates. At December 31, 1993, there were no borrowings under this agreement. The above-mentioned credit agreements require the Company to maintain its consolidated ratio of profit before taxes plus fixed charges to fixed charges at no less than 1.1 to 1 for each quarter; the Company's total liabilities to total stockholder's equity may not exceed 8.0 to 1; and the Company's tangible net worth must be at least $20.0 million. In connection with its match funding objectives, the Company entered into a variety of interest rate contracts including interest rate swap and cap agreements, options, and forward rate agreements. These agreements are entered into with major financial institutions to reduce the Company's exposure to changes in interest rates by matching the maturities of interest- earning assets with comparable maturities of long-term and short-term funding. The interest differentials to be paid or received are accrued as interest rates change and are recognized over the lives of the agreements. As of December 31, 1993, there were outstanding swap and cap agreements with notional amounts totaling $2,047.3 million and $500.0 million, respectively. These agreements have terms generally ranging up to five years, which effectively changed $1,050.6 million of floating rate debt to fixed rate debt, $629.1 million of fixed rate debt to floating rate debt, and $867.6 million of floating rate debt to floating rate debt having different conditions. In connection with swap agreements having a total notional amount of $95.1 million, the Company entered into option agreements which would allow the counterparty to enter into swap agreements at some future date or alter the conditions of certain swap agreements. The Company's outstanding forward rate agreements totaled $246.0 million at year end, and the premiums paid or received on these agreements have been deferred and are being recognized over the lives of the agreements. The Company is exposed to possible credit loss in the event of nonperformance by the counterparties to these above-mentioned swap and cap agreements. The notional amounts of these agreements are significantly greater than the amount subject to credit risk. As of December 31, 1993, there was an accrued receivable of $2.8 million relating to these contracts. In addition, the Company may incur additional costs in replacing at current market rates any contracts for which a counterparty fails to perform. The Company has entered into forward exchange contracts to hedge its U.S. dollar denominated obligations in Australia and Canada against currency fluctuations. These contracts have terms generally ranging up to three months and do not subject the Company to risk due to exchange rate movements, because the gains and losses on the contracts offset the losses and gains on the liabilities being hedged. At December 31, 1993, the Company had forward exchange contracts totaling $146.6 million of which $143.1 million represent contracts with Caterpillar. NOTE 7 - LONG-TERM DEBT During 1993, the Company publicly issued $892.3 million of medium-term notes, of which $417.1 million were at fixed interest rates and $475.2 million were at floating interest rates indexed to LIBOR, prime, or commercial paper rates. Interest rates on fixed-rate medium-term notes are established by the Company as of the date of issuance. The notes are offered on a continuous basis through agents and have maturities ranging from nine months to 15 years. The weighted average interest rate on all outstanding medium-term notes was 6.1% at December 31, 1993. Interest paid on long-term debt in 1993, 1992, and 1991 was $102.1 million, $107.8 million, and $98.5 million, respectively. Long-term debt outstanding at December 31, 1993, matures as follows: 1994 $ 492.5 1995 486.8 1996 247.2 1997 240.2 1998 216.3 Thereafter 219.9 Total $1,902.9 At December 31, 1993, the Company was also contingently liable under guarantees of securities of certain Caterpillar dealers totaling $249.6 million of which $173.5 million was outstanding. These guarantees have terms ranging up to two years. At December 31, 1992, the Company was contingently liable for $48.1 million. No loss is anticipated under these guarantees. NOTE 8 - INCOME TAXES Effective January 1, 1992, the Company adopted SFAS 109, "Accounting for Income Taxes." Prior years' financial statements have not been restated. For years prior to 1992, income taxes were computed based on Accounting Principles Board Opinion (APB) 11. Net deferred tax liabilities as of January 1, 1992, were reduced by $2.6 million as a result of the adoption of SFAS 109. The 1992 tax provision was not materially different from the amount which would have resulted from applying APB 11. The components of the provision for income taxes were as follows for the years ended December 31: 1993 1992 Current tax provision (credit): U.S. federal taxes $17.4 $13.6 $ 9.4 Foreign taxes 2.9 4.8 1.6 U.S. state taxes 2.5 2.8 1.5 22.8 21.2 12.5 Deferred tax provision (credit): U.S. federal taxes (1.2) (.1) - Foreign taxes (.6) (3.8) .7 U.S. state taxes .3 .3 1.2 (1.5) (3.6) 1.9 Total provision for income taxes $21.3 $17.6 $14.4 Current tax provision (credit) is the amount of income taxes reported or expected to be reported on the Company's tax returns. Income taxes paid in 1993, 1992, and 1991 totaled $14.8 million, $2.2 million, and $14.8 million, respectively. In August 1993, the U.S. federal income tax rate for corporations was increased from 34% to 35% effective January 1, 1993. As a result of the rate increase, net U.S. deferred tax liabilities and the 1993 provision for income taxes were increased $0.9 million. Differences between accounting rules and tax laws cause differences between the bases of certain assets and liabilities for financial reporting and tax purposes. The tax effects of these differences, to the extent they are temporary, are recorded as deferred tax assets and liabilities under SFAS 109 and consisted of the following components at December 31: 1993 1992 U.S. federal, U.S. state, and foreign taxes: Deferred tax assets: Minimum tax credit carryforwards $ 22.0 $ 24.7 General business credit carryforwards - .2 22.0 24.9 Deferred tax liabilities - primarily capital assets (35.0) (37.6) Valuation allowance for deferred tax assets - - Deferred taxes - net $(13.0) $(12.7) No valuation allowance for the Company's deferred tax assets was necessary at December 31, 1993. The Company's tax credit carryforwards may be carried forward indefinitely. For 1991 under APB 11, the tax effect of timing differences, net of alternative minimum tax, represented deferred income tax provision reported in the financial statements because the following items were recognized in the results of operations in different years than in the tax returns: U.S. federal, U.S. state, and foreign taxes: Finance lease income and depreciation $ 1.5 Provision for credit losses - Other - net .4 Deferred tax provision $ 1.9 The provision for income taxes was different than would result from applying the U.S. statutory rate to income before income taxes and minority interest for the reasons set forth in the following reconciliation: 1993 1992 Taxes computed at U.S. statutory rates $20.4 $17.5 $14.6 Increases (decreases) in taxes resulting from: Finance income not subject to federal taxation (2.5) (2.7) (2.6) State income taxes - net of federal taxes 1.8 2.0 1.8 Subsidiaries' results subject to tax rates other than U.S. statutory rates .9 .8 .6 Change in U.S. federal tax rate .9 - - Other, net (.2) - - Provision for income taxes $21.3 $17.6 $14.4 The domestic and foreign components of income before income taxes and minority interest of consolidated companies were as follows: 1993 1992 Domestic $54.4 $51.0 $38.4 Foreign 4.0 .6 4.5 Total $58.4 $51.6 $42.9 The foreign component of income before taxes and minority interest is comprised of the profit of all consolidated subsidiaries located outside the United States. NOTE 9 - FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and cash equivalents, Other assets, Liabilities other than long-term debt and deferred income taxes, Forward exchange contracts, and Guarantees of securities. For these items, the carrying amount is a reasonable estimate of fair value. Finance receivables - net. Fair value of the outstanding receivables (excluding tax-oriented leases) is estimated by discounting the future cash flows using the Company's current rates for new receivables with similar remaining maturities. Historical experience of bad debts is also factored into the calculation. Long-term debt. Fair value is estimated by discounting the future cash flows using the Company's current borrowing rates for similar types and maturities of debt. Interest rate swaps and options. Fair value is estimated based upon the amount that the Company would receive or pay to terminate the agreements as of the reporting date. The estimated fair values of the Company's financial instruments are as follows: Carrying Fair Carrying Fair Amount Value Amount Value Cash and cash equivalents $ 15.6 $ 15.6 $ 11.5 $ 11.5 Finance receivables - net (excluding tax-oriented leases) 2,806.2 2,821.5 2,253.1 2,275.4 Other assets 45.1 45.1 29.5 29.5 Liabilities other than long-term debt and deferred income taxes 1,230.8 1,230.8 988.3 988.3 Long-term debt 1,902.9 1,941.6 1,488.3 1,520.3 Off-balance-sheet financial instruments: Interest rate swaps/caps/options: In a net receivable position* 2.8 7.9 1.2 2.7 In a net payable position* (7.3) (24.1) (6.6) (22.4) Forward exchange contracts* (1.5) (1.5) .1 .1 Guarantees of securities (173.5) (173.5) (48.1) (48.1) *The amounts shown under "Carrying amount" represent accruals or deferred income (fees) arising from these off-balance-sheet financial instruments. NOTE 10 - TRANSACTIONS WITH RELATED PARTIES Caterpillar has made capital contributions to the Company of $250.0 million. The Company has also entered into a support agreement with Caterpillar whereby the parent will cause the Company to have at all times a net worth of at least $20.0 million. To supplement external debt financing sources, the Company has variable amount lending agreements with Caterpillar (including one of its subsidiaries). Under these agreements, which may be amended from time to time, the Company may borrow up to $53.8 million from Caterpillar, and Caterpillar may borrow up to $83.8 million from the Company. All of the variable amount lending agreements are effective for indefinite terms and may be terminated by either party upon 30 days' notice. At December 31, 1993, 1992, and 1991, the Company had no outstanding borrowings or loans receivable under these agreements. The Company has also entered into forward exchange contracts with Caterpillar to hedge the U.S. dollar denominated borrowings in Australia against currency fluctuations. All of these contracts generally have maturities not exceeding 90 days. At December 31, 1993, 1992, and 1991, the Company had contracts with Caterpillar totaling $143.1 million, $116.4 million, and $119.9 million, respectively. The Company entered into agreements with a subsidiary of Caterpillar to purchase, at a discount, some or all of this subsidiary's receivables generated by sales of products to Caterpillar dealers in Germany, Austria, and the Czech Republic. The total purchases (dealer floor planning) in 1993 and 1992 amounted to $210.2 million and $201.7 million, respectively, and the cash discount earned was $4.4 million and $3.4 million, respectively. At December 31, 1993, wholesale notes receivable balances related to floor planning were $124.1 million compared with $49.3 million at December 31, 1992. Periodically, the Company offers below-market-rate financing to customers under merchandising programs. When such terms provide less than the Company's standard interest rates, Caterpillar and its subsidiaries remit an amount equal to the interest differential to the Company which is recognized as income over the term of the contract. During 1993, the Company received $7.9 million from Caterpillar and its subsidiaries relative to such programs, compared with $5.7 million in 1992 and $9.6 million in 1991. The Company reimburses Caterpillar and its subsidiaries for services provided. The amount of such charges was $4.2 million, $3.9 million, and $3.7 million for the years ended December 31, 1993, 1992, and 1991, respectively. NOTE 11 - LEASES The Company leases certain offices and other property through operating leases. Lease expense on these leases is charged to operations as incurred. Total rental expense for operating leases was $3.7 million, $3.1 million, and $2.4 million for 1993, 1992, and 1991, respectively. Minimum payments for operating leases having initial or remaining noncancelable terms in excess of one year are: 1994 $ 1.8 1995 1.7 1996 1.4 1997 1.4 1998 1.1 Thereafter 2.7 Total $10.1 NOTE 12 - SEGMENT INFORMATION Although the majority of its business is done in the United States, the Company also conducts its operations through foreign subsidiaries in Australia, Canada, and Europe. Total assets, revenues, and net income applicable to operations by geographic segments were as follows: 1993 1992 Assets: Domestic $2,878.1 $2,401.4 $2,186.0 Foreign 779.9 507.9 354.3 3,658.0 2,909.3 2,540.3 Less: Investment in subsidiaries 93.1 63.0 50.3 Intercompany balances .2 3.0 1.0 Total assets $3,564.7 $2,843.3 $2,489.0 Revenues: Domestic $ 293.0 $ 286.5 $ 265.0 Foreign 70.7 55.9 51.4 363.7 342.4 316.4 Less intercompany interest .1 - - Total revenues $ 363.6 $ 342.4 $ 316.4 Net income: Domestic $ 35.4 $ 36.9 $ 26.3 Foreign 2.4 (.3) 2.2 Total net income $ 37.8 $ 36.6* $ 28.5 *After restatement for the cumulative effect of $2.6 million ($2.5 million domestic) which resulted from the change in accounting for income taxes. NOTE 13 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Financial data for the interim periods were as follows: QUARTERS FIRST SECOND THIRD FOURTH 1993 1992 1993 1992 1993 1992 1993 1992 Total revenues $86.4 $82.4 $90.1 $84.7 $91.5 $87.5 $95.6 $87.8 Income before income taxes, minority interest, and cumulative effect of change in accounting for income taxes 15.3 11.0 14.6 13.4 15.9 14.9 12.6 12.3 Net income 10.1 9.8* 9.4 8.8 9.0 9.9 9.3 8.1 *After restatement for the cumulative effect of $2.6 million which resulted from the change in accounting for income taxes. CATERPILLAR FINANCIAL SERVICE CORPORATION Schedule IX - Short-Term Borrowings (Dollars in millions) At Dec 31, Average for Year Weighted Maximum Amount Average Outstanding Outstanding Weighted Interest During the During the Interest Description Balance Rate Period Period Rate 1993: Notes payable to banks $336.0 7.0% $336.0 $251.8 8.1% Commercial paper 798.6 3.6 821.8 782.3 3.7 The Caterpillar Money Market Account 5.3 3.6 5.3 4.2 3.6 1992: Notes Payable to banks $195.5 8.6% $195.5 $ 97.1 9.1% Commercial paper 717.0 4.7 735.4 677.1 4.6 The Caterpillar Money Market Account 3.6 3.8 3.6 2.7 4.2 1991: Notes payable to banks $ 32.3 8.1% $ 34.0 $ 29.6 11.2% Commercial paper 642.0 6.4 691.1 633.0 7.0 The Caterpillar Money Market Account 1.4 5.6 1.4 .2 6.3 The weighted average interest rates were computed by relating interest for the year to average daily borrowings. Commercial paper and notes payable to banks balances represent the face amount. Unamortized discounts at December 31, 1993, 1992, and 1991 were $1.7 million, $3.0 million, and $3.2 million, respectively. Commercial paper balances represent proceeds (face amount less discount). The rate does not reflect issue costs of the money market account which was started in the third quarter of 1991. The rate reflecting issue costs was 8.2%, 11.8%, and 46.9% for 1993, 1992, and 1991, respectively.

11884_1993.txt

11884_1993

1993

11884

ITEM 1 - BUSINESS GENERAL Betz Laboratories, Inc. and its subsidiaries ("Registrant"), is engaged in the engineered chemical treatment of water, wastewater and process systems operating in a wide variety of industrial and commercial applications, with particular emphasis on the chemical, petroleum refining, paper, automotive, electrical utility and steel industries. Registrant produces and markets a wide range of specialty chemical products, including the technical and laboratory services necessary to utilize these products effectively. Chemical treatment programs are developed and marketed for use in boilers, cooling systems, heat exchangers, paper and process streams and both influent and effluent systems. Registrant monitors changing water, process and plant operating conditions so as to prescribe the appropriate treatment programs to solve problems such as corrosion, scale, deposit formation and a variety of process problems. Registrant has thirteen (13) production plants in the United States and eight (8) in foreign countries. Operations are conducted primarily in the United States and Canada, and also in Europe, Southeast Asia and the Caribbean area. Registrant employs approximately 4,115 people worldwide. MARKETING During 1993, the Registrant undertook a reorganization of its marketing strategies on a global basis. Pursuant to this globalization initiative, Registrant's foreign paper and refinery process sales and marketing organizations will report to Registrant's domestic operations along technology lines. This should result in faster overseas growth, where Registrant presently has a very small market share. Domestically, Registrant continued to organize into separate marketing units along technology lines in order to be more responsive to customer needs. As part of this strategy, Registrant has further decentralized into nine autonomous domestic marketing units, four of which are wholly-owned subsidiaries and five of which are groups or divisions of the Registrant. Each unit operates as a separate profit center with its own sales staff and specific programs for the market it serves. Effective January 1, 1994, Betz Industrial was decentralized into four separate operating units: the Refining and Chemical Division; the Pulp and Paper Division; the Power Industry Division; and the Manufacturing Industries Division. These four divisions along with Betz Entec, Inc. became the Betz Water Management Group which markets all of Registrant's water treatment programs to customers within the United States. Betz Water Management Group, which accounted for approximately 50.1% of Registrant's 1993 sales, will continue to provide specialty chemicals and value added treatment programs to basic domestic industries, such as petroleum, refining, chemical, paper, electric utility and food processing industries. Betz Entec, Inc., a subsidiary, specializes in the treatment of boilers, cooling systems, air conditioning systems and wastewater for mid- sized industrial plants, hospitals, government buildings, institutions and commercial facilities. Its customized treatment programs are designed to control scale, corrosion and microbiological growth. As an adjunct to the sale of its specialty chemical products, Betz Entec, Inc. markets laboratory reagents and chemical test kits for use in analyzing water. Betz Process Chemicals, Inc., a subsidiary, develops specific products used in process streams in the refining, petrochemical and steel industries. These products are "process-side" treatments as compared to "water-side" treatments and are formulated to reduce production inefficiencies in large industrial plants. This technology is applied in many ways including controlling corrosion with effective inhibitors and controlling fouling in heat exchangers through trace metal deactivation, polymer retardants and oxidation control. A related market is served by Betz Energy Chemicals, Inc. This subsidiary serves the oil production markets by providing products and programs used in extracting crude oil from deposits in the earth. The pulp and paper industry is served by another subsidiary, Betz PaperChem, Inc. It formulates custom engineered programs for the process related problems associated with paper production. As a consumer of large amounts of water in the production process, the pulp and paper industry's efforts to reuse water and conserve energy have increased the need for water treatment chemicals. Recirculating water systems build up organic and inorganic deposits which must be controlled. Deposition, corrosion, pulp bleaching, foam control, de-inking and felt conditioning are other problems associated with pulp and paper production that are treated by Betz PaperChem, Inc.'s products and programs. The Betz MetChem Division serves steel, aluminum and plastic producers, and the related automotive, machinery, appliances, fabricated parts and coil industries. Its products and treatment programs are designed to increase productivity, improve quality and reduce overall operating expenses through specific process chemicals aimed at the respective markets. Technical specialists working in each of the Registrant's nine marketing units assist in the development of engineered programs to meet a customer's needs. Such programs are custom designed to conserve energy, minimize corrosion and deposits, control microbiological fouling, reduce waste generation, improve process efficiency or any combination of the above, depending on the customer's requirements. Technical specialists also train customer operating personnel in the controlling, testing and chemical feeding required in applying Registrant's treatment programs. Since plant operating conditions and intake water characteristics do not remain static, the technical specialists make regular, scheduled plant follow-up visits to monitor the treatment program results and help customer operating personnel. To ensure treatment effectiveness, Registrant may also provide additional technical services from its mobile water treatment TravelLabs (registered trademark) which conduct tests on customer water systems. In the United States and other countries, Registrant has approximately 1,495 Regional Managers, District Managers and technical specialists selling and servicing its chemical products. Registrant's worldwide sales of specialty chemicals and the above related products during 1993 amounted to $684,872,000, as compared to $706,972,000 in 1992 and $665,565,000 in 1991, and in each case constituted 100% of Registrant's consolidated net sales. Consolidated net earnings for 1993 were $65,520,000, as compared to $82,047,000 in 1992 and $75,524,000 in 1991. INTERNATIONAL OPERATIONS Registrant's international activities are conducted through foreign subsidiaries operating in fourteen foreign locations. Betz International, Inc., a wholly-owned domestic subsidiary of Registrant, manages Registrant's U.S. based international sales effort and holds substantially all of the stock in Registrant's Singapore, Australian, Korean and Venezuelan subsidiaries. Betz International markets to customers outside of the U.S., Canada, and Europe which are located primarily in the Caribbean, Central America, South America, Saudi Arabia, India, Korea, Singapore, Malaysia, Indonesia, Thailand, Australia and New Zealand. Betz Europe, Inc., a wholly-owned domestic subsidiary of Registrant, holds directly or indirectly all of the stock in Registrant's Belgian, Austrian, German, Finnish, Swedish, French, Italian and United Kingdom subsidiaries. Registrant's Canadian subsidiary, Betz Inc., operates independently of Betz International and Betz Europe. Although Registrant does not believe that its foreign operations are presently subject to a materially greater risk than its domestic operations, Registrant's foreign operations may at any time be adversely affected by conditions outside its control including economic and political conditions. See Notes 1, 2 and 4 to Consolidated Financial Statements for certain additional information pertaining to foreign operations. The range of products sold by Registrant to customers located outside of the United States is substantially similar to, although not as broad in scope as, those sold in the United States. Products and services sold to foreign markets during 1993 accounted for approximately $153,592,000 or 22.4% of Registrant's consolidated net sales as compared to $160,484,000 (22.7%) in 1992 and $142,042,000 (21.3%) in 1991. Of these amounts, direct exports by Betz International from the United States to foreign markets accounted for approximately $11,981,000 or 1.7% of Registrant's consolidated net sales in 1993, as compared to $10,913,000 (1.5%) in 1992 and $9,989,000 (1.5%) in 1991. Excluding products and services exported directly by Betz International, sales for 1993 by foreign subsidiaries were approximately $141,611,000 or 20.7% of the Registrant's consolidated net sales. Foreign subsidiary sales in 1992 and 1991, and their percentage of Registrant's consolidated net sales were $149,571,000 (21.2%) and $132,053,000 (19.8%) respectively. Of these amounts, sales by Registrant's Canadian subsidiary amounted to $36,171,000 (5.3%) in 1993; $34,361,000 (4.9%) in 1992; and, $33,893,000 (5.1%) in 1991. The operating earnings of Registrant's foreign subsidiaries in 1993 were $18,988,000 or 2.8% of Registrant's consolidated net sales as compared to $27,069,000 (3.8%) in 1992, and $23,963,000 (3.6%) in 1991. Approximately $399,927,000 or 76.7% of Registrant's identifiable assets are attributable to its domestic operations and $121,202,000 or 23.3% are attributable to its foreign operations. PRODUCTION AND DISTRIBUTION Many of Registrant's products are produced at more than one of the twenty-one (21) production plants referred to under Item 2 ITEM 2 - PROPERTIES The Registrant's principal facilities are at the following locations: DOMESTIC FACILITIES Square Owned Footage or of Location Leased Facility General Character -------- ------ -------- ----------------- Bakersfield, California Owned 55,000 Office, Plant and Warehouse Cerritos, California Leased 28,480 Office and Warehouse Compton, California Owned 36,600 Plant and Warehouse Ventura, California Leased 10,000 Office and Laboratory Jacksonville, Florida Owned 117,000 Office and Laboratory Macon, Georgia Owned 71,000 Plant and Warehouse Addison, Illinois Owned 56,800 Plant and Warehouse Leased 16,000 Warehouse Reserve, Louisiana Owned 24,000 Plant and Warehouse New Philadelphia, Ohio Owned 108,000 Plant and Warehouse Cornwells Heights, Pennsylvania Owned 40,834 Office, Laboratory Supply and Limited Production Trevose, Pennsylvania Owned 198,000 Headquarters Owned 46,500 W. H. and L. D. Betz Research Center Owned 50,000 Training Center, Warehouse and Maintenance Bldg. Owned 81,000 J. D. Betz Engineering Laboratory and Betz Industrial Laboratory Langhorne, Pennsylvania Owned 134,000 Plant and Warehouse Horsham, Pennsylvania Owned 32,500 Office and Laboratory Horsham, Pennsylvania Owned 126,000 Office and Limited Production Horsham, Pennsylvania Owned 100,000 Office and Laboratory Square Owned Footage or of Location Leased Facility General Character -------- ------ -------- ----------------- Puerto Rico Leased 12,000 Office and Warehouse Beaumont, Texas Owned 82,000 Plant, Warehouse and Office The Woodlands, Texas Owned 120,000 Laboratory and Office Garland, Texas Owned 45,000 Plant and Warehouse Orange, Texas Owned 53,000 Plant and Warehouse South Houston, Texas Owned 25,000 Plant and Warehouse Washougal, Washington Owned 46,000 Plant and Warehouse Cheyenne, Wyoming Owned 35,800 Plant and Warehouse FOREIGN FACILITIES Ingleburn, New South Wales, Australia Owned 31,895 Office, Plant, Warehouse and Laboratory Haasrode, Belgium Owned 38,500 Office and Laboratory Herentals, Belgium Owned 43,800 Office, Plant and Laboratory Herentals, Belgium Owned 11,500 Office Edmonton, Alberta, Canada Owned 59,800 Plant, Warehouse and Laboratory Pointe Claire, Quebec, Canada Owned 90,000 Office and Plant Kanata, Ontario, Canada Owned 24,400 Office and Laboratory Winsford, England Owned 49,000 Office, Plant and Laboratory Crissey, France Owned 48,000 Office and Plant Marne la Vallee, France Owned 21,000 Office and Laboratory Willich, Germany Owned 15,000 Office and Laboratory Ferentino, Italy Owned 35,721 Office, Plant and Laboratory Square Owned Footage or of Location Leased Facility General Character -------- ------ -------- ----------------- Rome, Italy Owned 18,200 Office Iri, Korea Owned 22,700 Office, Plant (under construction) and Laboratory Singapore(1) Owned/ 26,320 Office, Plant, Lease Warehouse and Laboratory The Registrant believes that the present production capacity of its plants is adequate to meet its present and reasonably anticipated domestic and foreign needs. In addition to owned facilities, the Registrant leases numerous office facilities throughout the world from which its local sales efforts are conducted. See Note 7 to the Consolidated Financial Statements comprising Item 8 hereof for information concerning lease obligations. - - ------------------------- (1) In accordance with local law and custom, Registrant owns the Singapore facility but presently holds the land upon which the facility is situated under a 30 year lease, which expires in August, 2009. At such time as the lease lapses without being renewed, the office, plant and warehouse would become the property of the Singapore government. Registrant would receive no compensation therefor. ITEM 3 ITEM 3 - PENDING LEGAL PROCEEDINGS There are no material pending legal proceedings other than ordinary routine litigation incidental to the business of the Registrant to which the Registrant or any of its subsidiaries is a party or of which any of their property is the subject. The Registrant is a "Potentially Responsible Party" ("PRP") under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") as amended by the Superfund Amendments and Reauthorization Act ("SARA") with respect to thirteen (13) sites at which alleged releases or threatened releases of hazardous substances into the environment may have occurred. In response, the Registrant has been voluntarily participating with other PRPs at each of these sites to familiarize itself with site conditions, determine the nature and extent of contamination, analyze alternatives for remediation and develop a plan for clean-up. In each instance, the Registrant has participated in discussions with representatives of the EPA and other PRPs to determine its potential liability for financing necessary response actions. Although it is impossible to determine the exact cost of response activities, present information and the likelihood of contributions from other PRPs at each site indicates that the Registrant's ultimate share of remediation costs at eleven (11) of the thirteen (13) sites will be less than $100,000 of the total anticipated response cost. At the Operating Industries, Inc. site, Monterey Park, California (the "Site"), the Registrant is a signatory to two Partial Consent Decrees among the United States of America, the State of California, the California Hazardous Substance Account and approximately three hundred (300) other parties entered in the United States District Court for the Central District of California in 1989 and 1992 respectively. Pursuant to such Partial Consent Decrees, the parties are performing remedial activities at the Site in response to alleged releases and threatened releases of hazardous substances into the environment. The Registrant, without admitting liability, agreed to an allocation of costs of approximately $279,000 to be paid over a period of three (3) to five (5) years pursuant to the 1989 Partial Consent Decree. Pursuant to the 1992 Partial Consent Decree, the Registrant agreed to pay a portion of state and federal past costs and perform necessary remedial work, and pay for oversight of such work. Although Registrant's share of such costs has not been finally determined among the parties, it is estimated that Registrant's future allocation will be approximately $180,000 payable over the next eight to ten years. Such amount, if ultimately assessed and paid, would not be material to the business of the Registrant. The Registrant is a third party defendant in two federal court actions in the State of New Jersey involving the Helen Kramer Landfill site in Mantua Township, New Jersey. It is alleged that the Registrant's wastes were shipped to the site from 1968 to 1971 and that two loads of municipal solid waste were sent to the site in 1981. In September, 1988 EPA estimated the chosen remedy to have a present worth cost of approximately $44 million. Actual costs have been higher; press releases issued in January, 1993 indicated costs were in the range of $90-100 million. However, in overall settlement discussions, EPA and New Jersey Department of Environmental Protection have demanded over $200 million to end the litigation. The defendants and third-party defendants await documentation of this later sum. If remedial costs exceed $100 million, the Registrant's allocation may exceed $100,000; however, such allocation is speculative and would most likely not materially affect the Registrant's financial condition or results of operations. Presently, no allocation of costs has been determined among the PRPs, and the Registrant's ultimate allocation is still speculative. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Registrant's security holders through the solicitation of proxies or otherwise during the fourth quarter of the fiscal year to which this report relates. PART II ITEM 5 ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS Pursuant to General Instruction G(2) to Form 10-K, in response to Item 5, Registrant hereby incorporates by reference the information contained in Note 10 to the Consolidated Financial Statements, "Quarterly Financial Information (Unaudited)", under the captions "Cash Dividends Declared Per Common Share" and "Common Stock Market Prices" on page 26 of Registrant's 1993 Annual Report to its Shareholders. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA Pursuant to General Instruction G(2) to Form 10-K, in response to Item 6, Registrant hereby incorporates by reference the following information contained under the heading "Consolidated Summary of Operations" on pages 30 and 31, of Registrant's 1993 Annual Report to its Shareholders: For Fiscal Years 1989 through 1993, both inclusive, the information under the headings "Net Sales", "Net Earnings", "Earnings per Common Share", "Cash dividends declared per Common Share", "Total assets", and "ESOP debt". ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pursuant to General Instruction G(2) to Form 10-K, in response to Item 7, Registrant hereby incorporates by reference the information contained under the heading "Management's Discussion And Analysis Of Financial Condition And Results Of Operations" on pages 27 through 29 of Registrant's 1993 Annual Report to its Shareholders. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pursuant to General Instruction G(2) to Form 10-K, in response to Item 8, Registrant hereby incorporates by reference the consolidated financial statements included on pages 17 through 26, both inclusive, of Registrant's 1993 Annual Report to its Shareholders. ITEM 9 ITEM 9 - DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT Pursuant to General Instruction G(3) to Form 10-K, in response to Item 10, Registrant hereby incorporates by reference the information contained under the heading "Directors and Executive Officers" on pages 2 through 6, both inclusive, of Registrant's definitive proxy statement to be used in connection with Registrant's 1994 Annual Meeting of Shareholders, as filed with the Securities and Exchange Commission on or about March 11, 1994. ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION AND TRANSACTIONS Pursuant to General Instruction G(3) to Form 10-K, in response to Item 11, Registrant hereby incorporates by reference the information contained under the headings "Executive Compensation" on pages 8 through 15, both inclusive, of Registrant's definitive proxy statement to be used in connection with Registrant's 1994 Annual Meeting of Shareholders, as filed with the Securities and Exchange Commission on or about March 11, 1994. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G(3) to Form 10-K, in response to Item 12, Registrant hereby incorporates by reference the information contained under the heading "Ownership of Company Shares" on pages 7 and 8 of Registrant's definitive proxy statement to be used in connection with Registrant's 1994 Annual Meeting of Shareholders, as filed with the Securities and Exchange Commission on or about March 11, 1994. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K a. 1. and 2. The following consolidated financial statements of Betz Laboratories, Inc. and subsidiaries, included in the Annual Report of Registrant to its shareholders for the year ended December 31, 1993, are incorporated by reference in Item 8: Annual Report Page(s) ------- Consolidated Statements of Operations--Years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . 17 Consolidated Balance Sheets--December 31, 1993 and 1992 . 18-19 Consolidated Statements of Cash Flows--Years ended December 31, 1993, 1992 and 1991 . . . . . . . . . 20 Consolidated Statements of Common Shareholders' Equity-- Years ended December 31, 1993, 1992 and 1991 . . . . . . 21 Notes to Consolidated Financial Statements . . . . . . . . 22-26 The following consolidated financial statement schedules of Betz Laboratories, Inc. and subsidiaries are included in Item 14(d): Form 10-K Page(s) -------- Schedule V -- Property, Plant and Equipment . . . . 16 (F-1) Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment . . . . . . . . . . . 17 (F-2) Schedule VIII -- Valuation and Qualifying Accounts . . . 18 (F-3) Schedule X -- Supplementary Income Statement Information . . . . . . . . . . . . 19 (F-4) All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. 3. LISTING OF EXHIBITS. Form 10-K Exhibit Number Description Page ------- ----------- ---- 3 Articles of Incorporation and Bylaws . . . . * * The items designated Exhibit 3 to Registrant's Annual Report on Form 10-K for fiscal year 1988, (Restated Articles of Incorporation and Bylaws of Betz Laboratories, Inc.) as heretofore filed with the Securities and Exchange Commis- sion are hereby incorporated by reference as Exhibit 3 hereto. 4 Instruments defining the rights of Security Holders . . . . . . . . . . . . . . . . . . . * See Exhibit 3 hereto. Page ---- 10 Material Contracts . . . . . . . . . . . . * *The items designated Exhibit 10 to Registrant's Annual Report on Form 10-K for fiscal year 1992, ("Guidelines For Betz Laboratories, Inc. Corporate Discretionary Senior Executive Officer Bonus Plan; Corporate Discretionary Executive Officer Bonus Plan; Corporate Discretionary Officer Plan; and Corporate Discretionary Key Employee Bonus Plan"; the item designated as Exhibit A to Registrant's definitive Proxy Statement dated March 7, 1991, ("Employee Stock Incentive Plan"); the item designated Exhibit A to Registrant's definitive Proxy Statement dated March 5, 1982, ("Stock Option Plan"); and the item designated Exhibit A to Registrant's definitive Proxy Statement dated March 7, 1991 ("Stock Option Plan of 1987"); all as heretofore filed with the Securities and Exchange Commission are hereby incorporated by reference as Exhibit 10 hereto. 11 Statement Re: Computation of Per Share Earnings 20 13 Registrant's 1993 Annual Report to Shareholders 21 18 Letter Re: Change in Accounting Principles. . . . . . 57 21 Subsidiaries of Registrant . . . . . . . . . . . . 58 23 Consent of Independent Auditors . . . . . . . . . 59 b. REPORTS ON FORM 8K None 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. BETZ LABORATORIES, INC. By: s/ William R. Cook Date: March 11, 1994 --------------------------------- ----------------- William R. Cook, President and Chief Executive Officer By: s/ R. Dale Voncannon Date:March 14, 1994 --------------------------------- ----------------- R. Dale Voncanon, Vice President - Finance and Treasurer (Principal Financial and Accounting Officer) 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. By: s/ John F. McCaughan Date: March 14, 1994 --------------------------------- ----------------- John F. McCaughan, Director By: s/ John W. Boyer, Jr. Date: March 15, 1994 --------------------------------- ----------------- John W. Boyer, Jr., Director By: s/ Patrick F.Brennan Date: March 15, 1994 --------------------------------- ----------------- Patrick F. Brennan, Director By: s/ Carolyn S. Burger Date: March 18, 1994 --------------------------------- ----------------- Carolyn S. Burger Director By: s/ George R. Butler Date: March 14, 1994 --------------------------------- ----------------- George A. Butler, Director By: s/ William R. Cook Date: March 11, 1994 --------------------------------- ----------------- William R. Cook, Director By: s/ John A. Miller Date: March 14, 1994 --------------------------------- ----------------- John A. Miller, Director By: s/ Theodore B. Palmer, 3rd Date: March 14, 1994 --------------------------------- ----------------- Theodore B. Palmer, 3rd, Director By: s/ John R. Quarles Date: March 17, 1994 --------------------------------- ----------------- John R. Quarles, Director By: s/ John A. H. Shober Date: March 14, 1994 --------------------------------- ----------------- John A. H. Shober, Director By: s/ Geoffrey Stengel, Jr. Date: March 14, 1994 --------------------------------- ----------------- Geoffrey Stengel, Jr., Director By: s/ Robert L. Yohe Date: March 18, 1994 --------------------------------- ----------------- Robert L. Yohe Director

87949_1993.txt

87949_1993

1993

87949

ITEM 1. BUSINESS. Scott Paper Company continues a business established in 1879. It was incorporated in Pennsylvania in 1922 as the successor to a company of the same name incorporated in Pennsylvania in 1905. Its executive offices are located at Scott Plaza, Philadelphia, Pennsylvania 19113-1585 (tel. 610/522-5000). As used herein, the terms "Scott" and "Company" refer to Scott Paper Company and its consolidated domestic and international subsidiaries unless the context otherwise indicates. Information contained herein is for 1993 or as of December 25, 1993, except as otherwise specified. The Company's business consists of: (1) worldwide personal care and cleaning, which includes products (primarily tissue products) for personal care, environmental cleaning and wiping, health care and foodservice, manufactured and marketed by the Company and its unconsolidated international affiliates; and (2) printing and publishing papers, which principally consist of coated papers and include uncoated and specialty papers. Pages 34 and 35 of the Company's 1993 Annual Report to Shareholders show, for 1993, 1992 and 1991, the sales, income before taxes, identifiable assets, capital expenditures and depreciation and cost of timber harvested of the two segments which comprise the Company's consolidated operations and show the sales, income before taxes, and identifiable assets of these operations by geographic area. The discussions under the heading "Printing and Publishing Papers" on pages 14 and 17 of the Company's 1993 Annual Report to Shareholders show the sales by product class of this segment for 1993, 1992 and 1991. These pages are incorporated herein by reference. PRODUCTIVITY IMPROVEMENT ACTIONS In January 1994 the Company announced significant actions in support of its ongoing productivity improvement efforts, including plans to reduce the number of persons employed by the Company and its unconsolidated international affiliates, approximately 33,000 persons, by about 8,300. See "Employees" below. As a part of these actions, the Company will realign and shut down some older and inefficient tissue producing and converting assets in the United States and Europe, as well as consolidate and simplify S.D. Warren Company's coated paper business. In addition, the Company's Mexican affiliate is restructuring its operations. See the Management's Discussion and Analysis incorporated by reference in Item 7. WORLDWIDE PERSONAL CARE AND CLEANING The Company's personal care and cleaning business, including the Company's unconsolidated international affiliates, is the world's largest manufacturer of sanitary tissue paper products. Page 26 of the Company's 1993 Annual Report to Shareholders contains information on those unconsolidated international affiliates which are reported on the equity method, including the combined sales, assets and net income (loss), and Scott's share of the net income (loss), of such affiliates. This page is incorporated herein by reference. OPERATIONS IN THE AMERICAS Scott's U.S. personal care and cleaning operations manufacture and market products for personal care, environmental cleaning and wiping, health care and foodservice. The principal consumer and away-from-home products marketed in the United States are listed in the following table: CONSUMER PRODUCTS BATHROOM TISSUE - --------------- Cottonelle, Family Scott, ScotTissue, Waldorf DISPOSABLE TOWELS - ----------------- Job Squad, ScotTowels, Viva FACIAL TISSUE - ------------- Scotties, Scotties Accents BABY WIPES - ---------- Baby Fresh, Wash a-bye Baby PREMOISTENED CLEANSING CLOTHS - ----------------------------- Sofkins, KidFresh TABLETOP PRODUCTS - ----------------- Scott, Viva and Viva Accents napkins; Viva Designer Collection tabletop ensembles, including napkins, table covers, plates, plastic cutlery and cups "DO-IT-YOURSELF" PRODUCTS - ------------------------- Shop Towels on a Roll; Rags in a Box; Gotcha Covered drop cloths; Ultra Scrub cloths AWAY-FROM-HOME PRODUCTS ----------------------- PERSONAL CARE PRODUCTS - ----------------------- Bathroom Tissue--Cottonelle, Scott Select, ScotTissue, Soft-Weve, Soft Blend, Waldorf, JRT and JRT, Jr. jumbo roll tissue Facial Tissue--Scotties, Scotties Accents Folded Towels--Scottfold, Scott Select Roll Towels--Scott Select, Sequel Perforated Roll Towels--ScotTowels, Premiere Soap Dispensing Systems--EuroBath, Sani-Fresh, Sani-Tuff, SureTouch Toilet Seat Covers--P.S. Personal Seats Industrial Garments--Durafab ENVIRONMENTAL CLEANING AND WIPING PRODUCTS - ------------------------------------------ Critical Task Wipers--Micro-Wipes, Precision Wipes, Scottpure, Soft- cote General Purpose Light Duty Wipers-- Utility Wipes, Sturdi-Wipes, EconoMizer General Purpose Medium Duty Wipers--WypAll, WypAll Plus, Grab- a-Rag General Purpose Heavy Duty Wipers-- Scottcloth, Shop and Service Towels, Autoshop Towels Custom Wipers--Sani-Prep dairy towels, Dri-Tones windshield towels, Professional Towel, Dry-Up bath towels, Scottcloth and Heftlon foodservice towels Special Task Systems--Sani-Qwik toilet bowl cleaning system, Cleanworks modular dispensing system, WetTask system FOODSERVICE PRODUCTS - -------------------- Cellutex, Craftmaster, Mealmates, Scottex and Softees and other napkins; Hoffmaster placemats, tray covers, table covers; American doilies, portion products, fluted containers; Cater Cloth table covers and napkins FIXTURES - -------- Dispensers for bathroom tissue, towels, facial tissue, napkins, toilet seat covers, cups, wiping products and soaps The Company's consumer products are marketed principally through supermarkets, drug stores, warehouse clubs, convenience stores and mass merchandisers. The principal methods of competition in consumer sanitary paper markets include product quality, price, design, packaging, advertising and promotion. ScotTissue bathroom tissue, ScotTowels paper towels, Scotties facial tissue, Scott napkins and Wash a-bye Baby baby wipes are the Company's principal brands in the value segment of the consumer market. In the premium segment of the consumer market, Scott's principal brands include Cottonelle bathroom tissue, Job Squad and Viva disposable towels and Baby Fresh baby wipes. In addition, the Company sells a modest amount of private label bathroom tissue, towels and facial tissue in certain areas of the country, and sells a "Do-It-Yourself" line of disposable auto care and home maintenance products. The Company's away-from-home products and product systems are sold through a selective distribution network primarily to manufacturing, lodging, office building, foodservice and health care establishments and high volume public facilities. The away-from-home market has generally grown more rapidly than the consumer market for sanitary paper products, and is expected to continue to do so. Competition in away-from-home markets is primarily on the basis of price, product utility, product quality and service. The Company's away-from-home business continues to aggressively pursue its strategy of meeting the needs of key end-user markets with distinctive products and product systems. The Company is a leading U.S. producer of disposable towels, bathroom tissue, baby wipes, consumer napkins, away-from-home cloth-replacement wipers and away- from-home product systems. In the sale of all of its principal products, the Company faces strong competition from other manufacturers, some of which are substantially larger and more diversified than the Company. The Company's principal competitive strengths are believed to include the Scott name and reputation for quality and value, strong market positions, strong sales forces and capabilities in managing the sale of products through distributor organizations, innovative away-from-home product systems and services and the Company's natural resources asset base. However, the Company continues to have high labor density at numerous sites, and several of its production facilities have relatively complex process flows and older equipment. The actions described above under "Productivity Improvement Actions" are designed to reduce labor density and streamline and simplify the Company's operations. See the "Trends" section of the Management's Discussion and Analysis incorporated by reference in Item 7. Scott Health Care, a 50% joint venture between the Company and Molnlycke AB, a Swedish company, manufactures and markets Promise adult incontinence products and a chronic wound care system to nursing homes, home health care dealers and hospitals in the United States and Canada. In February 1994, the Company divested its polystyrene bead operations, which manufacture expandable polystyrene beads and crystal and modified polystyrene beads for sale to third parties. The Company's personal care and cleaning business in the Americas outside the United States is conducted by the consolidated subsidiaries in Costa Rica and Honduras, and the unconsolidated affiliates in Canada and Mexico, which, together with Scott's direct or indirect ownership interest therein, are listed below. CANADA -- Scott Paper Limited (50% owned) COSTA RICA -- Scott Paper Company de Costa Rica, S.A. (51% owned) HONDURAS -- Scott Paper Company-Honduras, S.A. de C.V.(/1/) MEXICO -- Compania Industrial de San Cristobal, S.A. (48.8% owned)(/2/) - -------- (/1/) This subsidiary is 100% owned by Scott Paper Company de Costa Rica, S.A. (/2/) An additional 3.1% of this affiliate is owned by a 40%-owned Mexican affiliate of the Company. Scott Paper Limited manufactures and markets consumer and away-from-home sanitary paper products and systems similar to those marketed by the Company in the U.S., including Cottonelle, Purex and White Swan bathroom tissue, ScotTowels, Viva and White Swan disposable towels, Scotties and White Swan facial tissue and Scott Family napkins, and markets Baby Fresh baby wipes. Scott Paper Limited is the largest producer of sanitary tissue products in Canada. Compania Industrial de San Cristobal, S.A., through its subsidiaries and affiliates, manufactures and markets consumer sanitary tissue products, including Petalo bathroom tissue, towels and napkins, Confort and Saba sanitary protection products and Baby Fresh baby wipes, as well as away-from-home sanitary paper and cleaning products and systems. This affiliate also produces coated and uncoated printing and writing papers for the Mexican market. The Costa Rican subsidiary and its subsidiary in Honduras produce consumer sanitary tissue products, principally Natural bathroom tissue for Central American and Caribbean markets. EUROPEAN OPERATIONS Scott's European personal care and cleaning business is conducted by the following consolidated subsidiaries and in certain cases by their wholly-owned subsidiaries, all of which are wholly-owned directly or indirectly by Scott unless otherwise noted. BELGIUM -- Scott Continental N.V., Scott Paper International Trade Venture (Europe) B.V. FRANCE -- Scott S.N.C. GERMANY -- Scott Paper GmbH, Scott GmbH ITALY -- Scott S.p.A. THE NETHERLANDS -- Scott Page N.V. PORTUGAL -- Scott Paper Portugal Lda. SPAIN -- Scott Iberica, S.A. (99.7% owned) UNITED KINGDOM -- Scott Limited, Cross Paperware Limited The Company's European subsidiaries generally market sanitary tissue products in their own countries, and the products are manufactured either by the same subsidiaries or by others under arrangements designed to optimize use of the Company's manufacturing facilities across Europe. The Company's principal consumer products which are marketed in several European countries include Scottex bathroom tissue, disposable towels, napkins and facial tissue, Baby Fresh baby wipes and Cotonelle bathroom tissue and facial tissue. Similar products are sold under the Andrex trademark in the United Kingdom, the Le Trefle trademark in France, the Cel trademark in Spain, the Servus and Pro Natur trademarks in Germany and the Page and Popla trademarks in the Netherlands and Belgium. The Company's away-from-home products and product systems are also sold in several European countries. The Company's European subsidiaries, which face competition from several multi-national and regional companies, together constitute the largest marketers of sanitary tissue products in the European Union. The subsidiaries in Belgium, Italy, The Netherlands, Spain and the United Kingdom are the largest marketers of sanitary tissue products in their respective countries; those in France and Portugal are the second largest; and the German subsidiary is one of the four largest. The Company's principal competitive strengths in Europe generally include strong market positions, brand names common to several countries, certain manufacturing technologies and an increasingly integrated management and manufacturing system. However, the Company faces the challenges of implementing its market growth strategies and lowering its costs and, in particular, its labor density at several sites. See Item 7. PACIFIC OPERATIONS The Company's personal care and cleaning business in the Pacific region is conducted by the consolidated subsidiaries in Hong Kong, Japan, Malaysia, Singapore, Taiwan and Thailand and the unconsolidated affiliate in Korea listed below. Scott's direct or indirect ownership interest is 100% unless otherwise noted. HONG KONG -- Scott Paper (Hong Kong) Limited JAPAN -- Scott Japan Limited KOREA -- Ssangyong Paper Co., Ltd. (23.8% owned) MALAYSIA -- Scott Paper (Malaysia) Sdn. Bhd. SINGAPORE -- Scott Paper (Singapore) Pte. Ltd. TAIWAN -- Taiwan Scott Paper Corporation (66.7% owned) THAILAND -- Scott Trading Limited; Thai-Scott Paper Company Limited (99.6% owned) The Company's Pacific subsidiaries and affiliates generally market sanitary tissue products in their own countries, and the products are manufactured either by the same subsidiaries or by other Company operations. The consumer products sold in this region include bathroom tissue, disposable towels, napkins, facial tissue and baby wipes under a variety of trademarks, including Scott, Scottex, Cottonelle, Baby Fresh, Sujay (in Taiwan) and Andrex and Purex (in Hong Kong). In 1993 the Company began moving toward common branding of its products sold in this region. The Company's away-from-home products and product systems are also sold in several countries in this region. The subsidiaries in Malaysia, Singapore, Taiwan and Thailand are the largest marketers of sanitary tissue products in their respective countries. Sanitary tissue markets in this region are growing more rapidly than in the United States and Europe. GENERAL The Company generally maintains sanitary paper products inventories to meet the delivery requirements of its customers, and in most cases the backlog of customer orders is not significant in relation to sales. The Company has patents and patent applications which cover some of its sanitary paper products or the processes or equipment used in manufacturing them. The Company believes that the most significant of these patents and patent applications relate to certain processes for manufacturing its higher quality products and pulp. The trademarks for all major products are federally registered. The Company believes that such trademarks, as a whole, are material to its business. PRINTING AND PUBLISHING PAPERS S. D. Warren Company, a wholly-owned subsidiary of the Company, manufactures commercial printing, publishing and specialty papers. Its principal products are high quality coated printing papers used for print advertising, annual reports, specialty magazines, catalogs and other printed communications; uncoated printing papers of various grades and qualities used for a wide range of printing purposes; coated and uncoated publishing papers used for textbooks, illustrated books and trade books; and specialty products, including pressure sensitive base material sold to EDP label manufacturers and an extensive line of flat and embossed release papers used in the production of man-made leather and other synthetic materials which are sold worldwide. The subsidiary's printing and publishing papers are distributed mainly through selected independent wholesale paper distributors throughout the United States. Its specialty papers are for the most part sold directly to converters. The subsidiary does not maintain significant finished goods inventories and the backlog of customer orders is not significant in relation to sales. The subsidiary competes in several markets against a large number of companies which vary substantially in size. It is one of the largest U.S. producers of high quality coated papers, release papers and pressure sensitive base material. In the subsidiary's markets the principal methods of competition generally include price, product quality and customer service. In many of these markets the subsidiary is believed to be helped by the Warren name and reputation, its coated paper manufacturing technology, strong market positions and a strong sales force with the ability to market products through selective distribution. The Company and the subsidiary have patents and patent applications covering some of the subsidiary's products or the processes or equipment used in manufacturing them. Most of these patents or patent applications relate to release papers, paper coating and finishing methods. The trademarks for all of the subsidiary's major products are federally registered. The Company does not view such trademarks, except Warren and Somerset, as material to the subsidiary's business due to the nature of the markets in which its products are sold. The S. D. Warren International Division of Scott Continental is a specialty papers business which sells electrophotographic offset masters, other reprographic products and release papers manufactured in the United States. SUPPLY OF RAW MATERIAL The Company's paper products are manufactured principally from wood pulp. The pulp mills and recycled fiber facilities of the Company's consolidated North American operations produce approximately 85% of the amount of pulp used by its U.S. paper manufacturing operations, and the pulp mills and recycled fiber facilities of the Company's consolidated international subsidiaries produce somewhat less than one-half of the pulp used in their operations. The Company's unconsolidated affiliates in Canada and Mexico produce approximately one-half of their own pulp. Recycled fiber provides approximately 20% to 25% of the pulp used by the Company's consolidated personal care and cleaning manufacturing operations. Market pulp is a commodity product available from a large number of suppliers around the world. The Company purchases pulp at market-related prices from numerous suppliers under contracts which generally extend automatically unless terminated by either party. In addition, the Company has entered into long term contracts with Millar Western Pulp Limited of Canada and an affiliate of Millar Western to purchase approximately 210,000 metric tons per year of chemi- thermomechanical pulp. The Company owns 20% of Forestal e Industrial Santa Fe, S.A., which owns and operates a 240,000 metric ton per year eucalyptus pulp mill in Chile. Under a long term contract with this company, Scott is entitled to purchase up to 80% of the pulp mill's output and is required to purchase at least 40% of the output. Each of these long term contracts provides for pricing which tends to reduce the effect of pulp market fluctuations on the Company. The Company's annual harvest of pulpwood from its U.S. and Nova Scotia timberlands, which constitutes approximately 60% of the total annual harvest from such timberlands, equals approximately 30% of the pulp manufacturing requirements of the consolidated North American operations. Substantially all of the remainder of the timber harvest is sold as logs in international and U.S. markets. The estimated annual growth of such timber, in the aggregate, exceeds the annual harvest. The Company is continually implementing programs to enhance growth rates on its land. Standing timber is subject to various hazards, including forest fires, windstorms and various types of infestations. The Company employs active salvage and forest management programs to minimize their economic impact. Subject to these hazards, it is believed that the timber available from the Company's own resources, plus purchases of wood and wood chips in the open market, should provide its pulp mills with an adequate supply of raw materials for the foreseeable future. None of the Company's consolidated international subsidiaries has significant timberlands. ENERGY SOURCES The Company's consolidated North American pulp and paper operations generate approximately 75% of their energy requirements by burning spent pulping liquor, process wastes, biomass and wood residuals (including purchased biomass and wood residuals) and anthracite culm and from their own hydroelectric plants. The remaining 25% of such energy requirements is provided by purchased coal, oil, natural gas and electricity. Several facilities have the capacity to alternate between oil and natural gas to take advantage of differences in their relative prices and availability. In addition, several U.S. facilities generate electricity for their own use and for sale to electric utilities. Substantially all of the energy requirements of the Company's consolidated international subsidiaries are provided by purchased electricity, natural gas and oil. RESEARCH AND DEVELOPMENT The Company's research and development programs are principally conducted at the facilities located at Philadelphia, Pennsylvania and Westbrook, Maine. During 1993, 1992 and 1991, the Company expended approximately $62.3 million, $61.2 million and $64.4 million, respectively, for research and development activities. The personal care and cleaning business' programs, some of which are conducted jointly with other organizations, support the development of new and improved products and product systems and the supporting packaging, converting, process control, and paper web process development; chemical, high- yield and recycled pulp processes; and the transmission of the results of these programs among the Company and its consolidated subsidiaries and unconsolidated affiliates. S. D. Warren conducts research in fiber optimization and paper making, coating and finishing. These programs also support the Company's ongoing efforts to reduce costs and to ensure employee safety, product safety and environmental protection. EMPLOYEES As of December 25, 1993, the Company employed approximately 25,900 persons and its unconsolidated affiliates in Canada and Mexico employed approximately 6,600 persons. Of the 15,700 persons employed in the consolidated North American operations, approximately 8,900 are hourly paid employees represented by collective bargaining units affiliated with regional, national or international unions. Of these union employees, approximately 28%, 41% and 31% are members of collective bargaining units whose agreements with the Company expire in 1994, 1997 and 1998, respectively. Of the 10,200 persons employed by the Company's consolidated international subsidiaries, a significant proportion of the manufacturing employees are represented by labor unions. As noted in "Productivity Improvement Actions" on page 2, the Company intends to reduce the number of persons employed by it and its unconsolidated subsidiaries by approximately 8,300. Of these, 3,800 are employed in the United States, 2,600 are employed by the Company's consolidated international subsidiaries and 1,900 are employed by the Company's Mexican affiliate. See the "Trends" section of the Management's Discussion and Analysis incorporated by reference in Item 7. ENVIRONMENTAL MATTERS The paper industry is subject to a wide variety of laws relating to the environment in the countries in which the Company operates. The Company believes it is currently in substantial compliance with these laws in all of its U.S. operations and in substantially all of its operations outside the United States. The Company and other manufacturers of pulp in the United States face proposed regulations imposing stringent limits on chlorinated organics, including dioxin and chloroform, which arise from the process of manufacturing bleached pulp. In late 1993, the Environmental Protection Agency (EPA) released its proposed regulations, which also include limitations on other discharges and emissions. After evaluation of these proposed regulations, the Company believes that the additional capital expenditures required to comply with them at its existing sites would be between $250 million and $300 million in the 1996-1998 period. These estimates could change further depending on several factors, including additional evaluation of the proposed regulations, changes in the proposed regulations, new developments in control and process technology, and inflation. It is also possible that limitations contained in permits currently being appealed by the Company and laws or regulations which may be adopted by states where Scott pulp mills are located could cause an acceleration of these expenditures (see the following paragraph and Item 3). The State of Maine has enacted legislation limiting effluent color arising from the manufacture of pulp beginning in late 1996 or, if certain events occur, 1998. Compliance with this legislation would probably involve most of the same steps which are expected to be required by EPA, as described above. S.D. Warren Company has received NPDES permits from EPA which would limit dioxin discharges from its Skowhegan, Maine and Westbrook, Maine mills to less than the level of detectability. The Company understands that the New England region of EPA has issued similar permits to certain other pulp manufacturers. The Company is vigorously pursuing efforts to have the limits for these Company facilities revised. See Item 3. If such limits are not revised, these facilities could be placed at a competitive disadvantage compared to other pulp and paper manufacturers. In 1993, the Company's capital spending for environmental improvements to existing facilities was approximately $25 million. It is currently estimated that the capital spending necessary for such improvements will be approximately $25 million in 1994 and $40 million in 1995, excluding any expenditures that may be required by the matters discussed in the second and third paragraphs above. These amounts do not include the environmental portion of capital expenditures on new projects. Actual expenditures may vary from these dollar estimates due to inflation, additional changes in regulatory requirements or new developments in control technology. As is the case with other companies, capital expenditures on environmental improvements are in addition to the Company's normal expenditures for maintenance and replacement of its plant, and generally result in increased operating costs. The Company believes that its environmental improvement costs are of the same general magnitude as those of comparable pulp and paper companies. Except as noted in the third paragraph of this section, the more significant environmental regulations appear to be applied more or less uniformly throughout the industry. Assuming that such regulations are applied uniformly in the future, the Company believes that its environmental improvement costs will not have a material adverse impact on its relative competitive position. See Item 3 for a description of litigation with respect to environmental matters. CAPITAL EXPENDITURES The Company's capital expenditures (excluding acquisitions and equity investments in unconsolidated international affiliates) during the past five years were as follows: The Company expects to spend a total of $800 to $900 million on capital projects during the 1994-1995 period. These projects include: approximately $200 million of spending related to the Company's productivity improvement program; the continuation of four projects underway--a converting and distribution facility for S.D. Warren in Allentown, Pennsylvania, modernization of the pulp mill in Mobile, Alabama, capacity expansion for the wet wipes business in Dover, Delaware and continued construction of a state-of-the-art tissue paper mill in Owensboro, Kentucky; and other projects designed to sustain existing operations and reduce costs. The Company expects to finance this spending primarily from internally generated funds. ITEM 2. ITEM 2. PROPERTIES The location of the manufacturing facilities of the Company (including its consolidated subsidiaries) and the types of products produced at each facility are shown below. WORLDWIDE PERSONAL CARE AND CLEANING AMERICAS Chester, Pennsylvania--sanitary Durafab, Inc. tissue paper products Cleburne, Texas--industrial garments Dover, Delaware--wet wipe products Italy, Texas--industrial garments Everett, Washington--sanitary Scott Maritimes Limited tissue paper products and pulp New Glasgow, Nova Scotia--pulp Ft. Edward, New York--sanitary Scott Paper Company de Costa Rica, tissue paper products S.A. San Jose, Costa Rica--sanitary Hattiesburg, Mississippi--sanitary tissue paper products tissue paper products Scott Paper Company-Honduras, S.A. Marinette, Wisconsin--sanitary de C. V. tissue paper products San Pedro, Honduras--sanitary tissue paper products Mobile, Alabama--sanitary tissue paper products and pulp(/1/) Scott Polymers, Inc.(/3/) Fort Worth, Texas (two Oconto Falls, Wisconsin--sanitary locations)--polystyrene beads tissue paper products Saginaw, Texas--polystyrene beads Oshkosh, Wisconsin--tabletop Scott Polymers, Ltd.(/3/) products Baie d'Urfe, Quebec--polystyrene beads Owensboro, Kentucky--sanitary tissue paper products San Antonio, Texas--personal cleansing products and systems Winslow, Maine--sanitary tissue paper products(/2/) EUROPE Cross Paperware Limited Dunstable, United Kingdom-- foodservice products Scott Continental, N.V. Duffel, Belgium--sanitary tissue paper products Scott GmbH Neunkirchen, Germany--wet wipe products Scott Iberica, S.A. Aranguren, Spain--sanitary base paper Arceniaga, Spain--sanitary tissue paper products and personal cleansing prod- ucts and systems Canarias, Canary Islands--sanitary tissue paper products Hernani, Spain--sanitary tissue paper products Miranda del Ebro, Spain--pulp Salamanca, Spain--sanitary tissue paper products Scott Limited Barrow, United Kingdom--sanitary tissue paper products Northfleet, United Kingdom--sanitary tissue paper products Scott Page N.V. Gennep, The Netherlands--sanitary tissue paper products Scott Paper GmbH Flensburg, Germany--sanitary tissue paper products Dusseldorf-Reisholz, Germany--sanitary tissue paper products Scott S.N.C. Orleans, France--sanitary tissue paper products Scott S.p.A. Alanno, Italy--sanitary tissue paper products Romagnano, Italy--sanitary tissue paper products Villanovetta, Italy--sanitary tissue paper products PACIFIC Scott Paper (Hong Kong) Limited Hong Kong--sanitary tissue paper products(/4/) Scott Paper (Malaysia) Sdn. Bhd. Kluang, Malaysia--sanitary tissue paper products Kuala Lumpur, Malaysia--foodservice products Taiwan Scott Paper Corporation Hsin Ying, Taiwan--sanitary tissue paper products(/5/) Tayaun, Taiwan--sanitary tissue paper products Thai-Scott Paper Company Limited Samut Prakan, Thailand--sanitary tissue paper products PRINTING AND PUBLISHING PAPERS S. D. Warren Company Muskegon, Michigan--paper and pulp Skowhegan, Maine--paper and pulp Westbrook, Maine--paper and pulp(/6/) Scott Continental, S. D. Warren International Division Bornem, Belgium--specialty papers Mobile, Alabama--paper and pulp(/1/) - -------- (/1/) Land under this facility is held under two long-term operating leases with options to purchase the land at the end of the respective lease terms. (/2/) The fiber recycling facility at this mill is held under an operating lease expiring in 2008 under which the Company has the option of renewing the lease for terms not exceeding nine additional years or purchasing the facility for its then fair market value. (/3/) The Company sold these subsidiaries in February 1994. (/4/) This facility is held under a short-term renewable lease. (/5/) The land and a portion of this facility are subject to a mortgage. (/6/) Part of the cogeneration facility at this mill is owned by a party with whom the Company has separate agreements expiring in 2008 to operate the facility and to purchase its output of steam and electricity on a take-or- pay basis. After such period, the Company has the option of renewing these agreements or purchasing the facility for its then fair market value. The largest papermaking facilities of the Company (including its consolidated subsidiaries) are located at Chester, Everett, Mobile, Muskegon, Skowhegan and Westbrook. The largest pulp making facilities listed above are located at Everett, Mobile, New Glasgow and Skowhegan. A substantial portion of the Company's corporate headquarters near Philadelphia and certain warehouses are held under long-term capital leases. Various Company plants contain equipment, pollution control facilities and solid waste disposal facilities which have been financed by issuance of industrial revenue bonds and are held by the Company under lease or installment purchase agreements. During 1993 the Company's rate of utilizing its papermaking capacity was approximately 92%. The Company's consolidated North American timber resources total approximately 2.8 million acres, including approximately 2.5 million acres owned in fee and approximately 366,000 acres on which the Company has long-term cutting rights or lease or purchase rights. In the United States, such timber resources include approximately 657,000 acres in Alabama and Mississippi, 910,000 acres in Maine, and 3,800 acres in Washington. In Canada, the Company's timber resources include approximately 1,217,000 acres (including long-term cutting rights on 214,000 acres of government lands) in Nova Scotia. The Company has mineral rights pertaining to substantially all of its U.S. timberlands but has no mineral rights pertaining to its Canadian timberlands. Scott Paper Limited in Canada operates four manufacturing facilities, Compania Industrial de San Cristobal, S.A. in Mexico operates five manufacturing facilities and Ssangyong Paper Co., Ltd. in Korea operates four manufacturing facilities. Scott Health Care operates two manufacturing facilities in the United States and one in Canada. Forestal e Industrial Santa Fe, S.A. owns a pulp mill in Chile and Forestal y Agricola Monte Aguila, S.A. (of which the Company also owns 20%) owns 120,000 acres of forestland in Chile. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and two of its senior officers, Chairman and Chief Executive Officer Philip E. Lippincott and Senior Vice President Ashok N. Bakhru, were defendants in In Re Scott Paper Securities Litigation, a consolidated class action in the U.S. District Court, Eastern District of Pennsylvania on behalf of a class of purchasers of the Company's common shares in 1990. In July 1993, attorneys for the plaintiff class and the defendants entered into a settlement stipulation under which the plaintiffs agreed to dismiss the action with prejudice and stipulated that they were unaware of any evidence that deliberate or intentional wrongdoing was involved, and under which the Company agreed to pay $2,999,999 and its insurance carrier agreed to pay $5 million. In November 1993, the Court issued a final order approving the settlement. The Company is a defendant in numerous actions in state and federal courts seeking damages relating to breast implants. The actions allege that the plaintiffs' breast implants were covered by polyurethane foam manufactured by the Company's former Foam Division, which was sold in 1983, and that the foam caused physical or psychological harm to the plaintiffs. In each of these actions the Company is one of several defendants, including the Foam Division's successor and the manufacturers of the implants. The Company believes that only a small percentage of breast implants were covered by polyurethane foam manufactured by the Company's Foam Division prior to its sale. The Company believes that it has meritorious defenses against these claims and intends to conduct a vigorous defense and to seek insurance recovery to the extent provided under its insurance policies, if necessary. In June 1990 S. D. Warren Company filed a request for an evidentiary hearing with the Environmental Protection Agency (EPA) challenging EPA's modification of the NPDES permit for the Skowhegan, Maine mill. In January 1994 EPA reissued the permit with additional limitations and the Company again filed a request for an evidentiary hearing. The modifications being challenged include limitations on the discharge of dioxin and absorbable organic halogens (AOX) and related monitoring requirements, as well as limitations on the discharge of conventional pollutants. See "Environmental Matters" on page 8. In October 1992 S. D. Warren Company filed a request for an evidentiary hearing with EPA challenging EPA's modification of the NPDES permit for the Westbrook, Maine mill. The modifications being challenged include limitations on water temperature and the discharge of dioxin. While Warren's request has been granted, no hearing has been scheduled. See "Environmental Matters" on page 8. The Company is involved in a number of administrative and judicial proceedings under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) and comparable state laws. Most of these proceedings involve the cleanup of hazardous substances at commercial landfills which receive waste from many different sources. While joint and several liability is authorized under CERCLA, as a practical matter, liability for CERCLA cleanups is generally allocated among many waste generators. The range of reasonably possible losses in these proceedings, to the extent not already provided for, is not significant. In addition, the Company is involved in lawsuits and state and Federal administrative proceedings under the environmental and equal employment opportunity laws, among others. The relief sought in such lawsuits and proceedings includes injunctions, damages and penalties. Although the final results in these suits and proceedings cannot be predicted with certainty, it is the present opinion of the Company, after consulting with counsel, that they will not have a material adverse effect on the Company's financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS This item is inapplicable because no matter was submitted during the fourth quarter of 1993 to a vote of the Company's security holders. EXECUTIVE OFFICERS OF THE REGISTRANT The following chart shows, as of March 10, 1994, the names, ages, current positions and areas of responsibility, and the dates applicable to such positions and areas of responsibility, for the Company's executive officers. Previous positions and areas of responsibility over the past five years, where applicable, are included in footnotes for all persons listed. There is no "family relationship" between any of these officers or between any such officer and any Director of the Company. Each officer is elected at the regular meeting of the Board of Directors next following the Annual Meeting of Shareholders to serve for one year and until his or her successor is duly elected and qualified. - ------- (/1/) In November 1993, Mr. Lippincott announced his plan to retire as the Company's Chairman and Chief Executive Officer and as a Director on April 1, 1994. As stated in the Company's Proxy Statement, the relevant pages of which are incorporated in Item 10, upon the request of the Board of Directors, Mr. Lippincott has agreed to stand for election as a Director at the Company's 1994 Annual Meeting of Shareholders and to serve as a Director and as Chairman and Chief Executive Officer until his successor has been duly elected and qualified. (/2/) Mr. Leaman served as President of Scott Worldwide since November 1986. (/3/) Mr. Andes served as Managing Director of Scott Limited since January 1988. (/4/) Mr. Bakhru served as the Company's Chief Financial Officer since April 1985. (/5/) Mr. Butler served as Senior Vice President in charge of Scott Worldwide's European Operations since January 1989 and as Vice President in charge of Scott Worldwide's Pacific Operations since November 1986. (/6/) Mr. Schregel served as Senior Vice President in charge of the Americas Region since April 1991 and as Senior Vice President in charge of Scott Worldwide's North American Operations since November 1986. (/7/) Mr. White served as Senior Vice President in charge of Scott Worldwide's Pacific Operations since April 1991, as Vice President of Scott Worldwide's Pacific Operations since February 1989, and as Vice President in charge of Scott Worldwide's North American Commercial Business since November 1986. (/8/) Mr. Anderson served as Vice President since February 1988 and as Treasurer since January 1987. (/9/) Mr. Horwitz served as Vice President and General Counsel--North American Operations since August 1987. (/10/) Mr. Salvucci served as Division Vice President of Scott Worldwide in charge of papermaking technologies since January 1987. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. See the text under the heading "Stock Exchange Listings" on page 37 of the Company's 1993 Annual Report to Shareholders, the market price and dividend information under the heading "Quarterly Highlights" on page 35 thereof, and the row "Number of common shareholders" on page 36 thereof, which portions of said pages are incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. See page 36 of the Company's 1993 Annual Report to Shareholders, which page is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See the text under the heading "Management's Discussion and Analysis" on pages 13-18 of the Company's 1993 Annual Report to Shareholders and the portions of pages 23 and 24 thereof which are referred to in said "Management's Discussion and Analysis," all of which pages or portions thereof, as the case may be, are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See the financial statements on pages 19-35 and the information under "Quarterly Highlights" on page 35 of the Company's 1993 Annual Report to Shareholders, all of which pages or portions thereof, as the case may be, are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. This item is inapplicable to the Company. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. For information with respect to the Company's Directors and Director nominees, see the information under the heading "Election of Directors" on pages 3-7 of the Company's Proxy Statement dated March 11, 1994, which pages are incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. See pages 8-19 of the Company's Proxy Statement dated March 11, 1994, which pages are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. See the information under the headings "Ownership of Shares" on pages 2 and 7-8 of the Company's Proxy Statement dated March 11, 1994, which information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. This item is inapplicable to the Company. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) FINANCIAL STATEMENTS: The financial statements, including the financial statement schedules, are listed in the Index to Financial Statements on page 17 hereof. (b) REPORTS ON FORM 8-K: A report on Form 8-K, with disclosure under Item 5, was filed November 29, 1993. (c) EXHIBITS: - -------- * These items are management contracts or compensatory plans or arrangements required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. 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. Scott Paper Company ___________________________________ (REGISTRANT) /s/ Philip E. Lippincott By_________________________________ PHILIP E. LIPPINCOTT CHAIRMAN AND CHIEF EXECUTIVE OFFICER Date: March 23, 1994 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. SIGNATURE AND TITLE DATE /s/ Philip E. Lippincott March 23, 1994 By_________________________________ PHILIP E. LIPPINCOTT CHAIRMAN AND CHIEF EXECUTIVE OFFICER /s/ Basil L. Anderson March 23, 1994 By_________________________________ BASIL L. ANDERSON VICE PRESIDENT, TREASURER AND CHIEF FINANCIAL OFFICER /s/ Edward B. Betz March 23, 1994 By_________________________________ EDWARD B. BETZ VICE PRESIDENT AND CONTROLLER PURSUANT TO GENERAL INSTRUCTION D TO FORM 10-K, THIS REPORT HAS BEEN SIGNED BELOW BY A MAJORITY OF THE BOARD OF DIRECTORS: Jack J. Crocker Philip E. Lippincott Pierre J. Everaert Richard K. Lochridge John F. Fort, III Bruce K. MacLaury William H. Gray, III Claudine B. Malone Peter Harf Gary L. Roubos J. Richard Leaman, Jr. Paula Stern A majority of the Board of Directors /s/ Frank W. Bubb, III By______________________________________ FRANK W. BUBB, III ATTORNEY-IN-FACT Date: March 23, 1994 The consolidated financial statements, together with the report thereon of Price Waterhouse dated January 25, 1994, appearing on pages 19 through 35 of the accompanying 1993 Annual Report to Shareholders, are incorporated by reference in this Annual Report on Form 10-K as Exhibit 13. With the exception of the aforementioned information and the information incorporated by reference in Items 1, 5, 6, 7 and 8, the 1993 Annual Report to Shareholders is not to be deemed filed as part of this report. The following Financial Statement Schedules should be read in conjunction with the consolidated financial statements in such 1993 Annual Report to Shareholders: Financial statement schedules other than those listed above are omitted because they are not applicable or the required information is shown in the consolidated financial statements or the related financial review. Columns omitted from schedules filed have been omitted because the information is not applicable. Separate financial statements for each 50% or less owned affiliate have been omitted because the registrant's proportionate share of each such company's profit before income taxes and total assets is less than 20% of the respective consolidated amounts and the registrant's investment in and advances to each such company are less than 20% of the consolidated total assets of the registrant. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors Scott Paper Company Our audits of the consolidated financial statements referred to in our report dated January 25, 1994 appearing on page 19 of the 1993 Annual Report to Shareholders of Scott Paper Company (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed on page 17 of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Price Waterhouse Philadelphia, Pennsylvania January 25, 1994 SCOTT PAPER COMPANY SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND EMPLOYEES OTHER THAN RELATED PARTIES (THOUSANDS OF DOLLARS) - -------- (/1/)Note for house loan due April 6, 1994; interest rate 3.62%. SCOTT PAPER COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (MILLIONS OF DOLLARS) - -------- *Includes foreign currency translation adjustments in accordance with FAS No. 52. (/1/) Includes activities related to businesses divested as part of the Company's business improvement program. (/2/) Primarily includes cost of timber harvested and amortization of logging roads which are credited directly to the asset. SCOTT PAPER COMPANY SCHEDULE VI--ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (MILLIONS OF DOLLARS) - -------- * Includes foreign currency translation adjustments in accordance with FAS No. 52. (/1/)Includes activities related to businesses to be divested as part of the Company's business improvement program. SCOTT PAPER COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS (MILLIONS OF DOLLARS) - -------- *Applied as deductions from the receivables account. (/1/) Consists of writeoffs, net of recoveries, and foreign currency translation adjustments in accordance with FAS No. 52. - -------- (/1/) Includes $92.7 million due to the adoption of FAS No. 109 in the first quarter. SCOTT PAPER COMPANY SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION (MILLIONS OF DOLLARS) - -------- (/1/) These results exclude activities related to businesses divested as part of the Company's business improvement program. (/2/) Revised to reflect the inclusion of costs related to the specialty papers business. EXHIBIT INDEX

761023_1993.txt

761023_1993

1993

761023

ITEM 1. BUSINESS Unless otherwise indicated, all references to "Notes" are to Notes to Consolidated Financial Statements contained in this report. The registrant, Carlyle Real Estate Limited Partnership-XV (the "Partnership"), is a limited partnership formed in August of 1984 and currently governed by the Revised Uniform Limited Partnership Act of the State of Illinois to invest in income-producing commercial and residential real property. On July 5, 1985, the Partnership commenced an offering to the public of $250,000,000 (subject to increase by up to $250,000,000) in Limited Partnership Interests and assigned interests therein ("Interests") pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (No. 2-95382). A total of 443,711.76 Interests were sold to the public at $1,000 per Interest. The holders of 224,569.10 Interests were admitted to the Partnership in 1985; the holders of 219,142.66 Interests were admitted to the Partnership in 1986. The offering closed on July 31, 1986. Subsequent to admittance to the Partnership, no holder of Interests (hereinafter, a "Limited Partner") has made any additional capital contribution. The Limited Partners of the Partnership share in their portion of the benefits of ownership of the Partnership's real property investments according to the number of Interests held. The Partnership is engaged solely in the business of the acquisition, operation and sale and disposition of equity real estate investments. Such equity investments are held by fee title, leasehold estates and/or through joint venture partnership interests. The Partnership's real property investments are located throughout the nation and it has no real estate investments located outside of the United States. A presentation of information about industry segments, geographic regions, raw materials or seasonality is not applicable and would not be material to an understanding of the Partnership's business taken as a whole. Pursuant to the Partnership Agreement, the Partnership is required to terminate on or before December 31, 2035. Accordingly, the Partnership intends to hold the real properties it acquires for investment purposes until such time as sale or other disposition appears to be advantageous. Unless otherwise described, the Partnership expects to hold its properties for long-term investment. Due to current market conditions, the Partnership is not able to determine the holding period for its remaining properties. At sale of a particular property, the proceeds, if any, are generally distributed or reinvested in existing properties rather than invested in acquiring additional properties. The Partnership has made the real property investments set forth in the following table: The Partnership's real property investments are subject to competition from similar types of properties (including in certain areas properties owned or advised by affiliates of the General Partners or properties owned by venture partners or their affiliates) in the respective vicinities in which they are located. Such competition is generally for the retention of existing tenants. Additionally, the Partnership is in competition for new tenants in markets where significant vacancies are present. Reference is made to Item 7 below for a discussion of competitive conditions and future renovation and capital improvement plans of the Partnership and certain of its significant investment properties. Approximate occupancy levels for the properties are in the table in Item 2 ITEM 2. PROPERTIES The Partnership owned or owns directly or through joint venture partnerships the properties or interests in the properties referred to under Item 1 above to which reference is hereby made for a description of said properties. The following is a listing of principal businesses or occupations carried on in and approximate occupancy levels by quarter during fiscal years 1993 and 1992 for the Partnership's investment properties owned during 1993: ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Partnership is not subject to any material pending legal proceedings. Reference is made to Note 3(c)(ii) for a discussion of certain litigation involving the Partnership. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during 1993 and 1992. PART II ITEM 5. ITEM 5. MARKET FOR THE PARTNERSHIP'S LIMITED PARTNERSHIP INTERESTS AND RELATED SECURITY HOLDER MATTERS As of December 31, 1993, there were 40,382 record holders of Interests in the Partnership. There is no public market for Interests, and it is not anticipated that a public market for Interests will develop. Upon request, the Corporate General Partner may provide information relating to a prospective transfer of Interests to an investor desiring to transfer his Interests. The price to be paid for the Interests, as well as any other economic aspect of the transaction, will be subject to negotiation by the investor. Reference is made to Article XVI of the Partnership Agreement and Sections 3 and 4 of the Assignment Agreement, (included as Exhibits 3 and 4-A, respectively, filed with the Partnership's report on Form 10-K for December 31, 1992 (File No. 0-16111) dated March 19, 1993) for provisions governing the transferability of Interests, which provisions are hereby incorporated herein by reference. Reference is made to Note 5 for a discussion of the provisions of the Partnership Agreement relating to cash distributions. Reference is made to Item 6 Item 6 below for a discussion of cash distributions made to the Limited Partners. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On July 5, 1985, the Partnership commenced an offering of $250,000,000 (subject to increase by up to $250,000,000) of Limited partnership interests and assignee interests therein pursuant to a Registration Statement on Form S-11 (File No. 2-95382) under the Securities Act of 1933. A total of 443,711.76 Interests were sold to the public at $1,000 per Interest (fractional interests are due to a Distribution Reinvestment Program). The holders of such Interests were admitted to the Partnership in 1985 and 1986. After deducting selling expenses and other offering costs, the Partner- ship had approximately $385,000,000 with which to make investments in income-producing commercial and residential real property, to pay legal fees and other costs (including acquisition fees) related to such investments and to satisfy working capital requirements. A portion of the proceeds has been utilized to acquire the properties described in Item 1 above. At December 31, 1993, the Partnership and its consolidated ventures had cash and cash equivalents of approximately $5,020,000. Such funds and short- term investments of approximately $10,167,000 are available for the Partnership's share of leasing costs and capital improvements at 9701 Wilshire Building, 160 Spear Street Building, Springbrook Shopping Center, Eastridge Mall and 260 Franklin Street Building, and the Partnership's share of operating deficits currently being incurred at 260 Franklin Street Building (to the extent not funded from escrowed reserves for 260 Franklin as discussed below) and 9701 Wilshire Building as well as distributions to partners as discussed below and working capital requirements, including the Partnership's share of potential future deficits and financing costs at these and certain other of the Partnership's investment properties. The Partnership currently has adequate cash and cash equivalents to maintain the operations of the Partnership. However, the Partnership has taken steps to preserve its working capital by deciding to suspend distributions (except for certain withholding requirements) to the Limited and General Partners effective as of the first quarter of 1992. In addition, the General Partners and their affiliates have deferred cash distributions, management and leasing fees and reimbursements payable to them in an aggregate amount of approximately $6,811,566 (approximately $15 per interest) through December 31, 1993. These amounts, which do not bear interest, are expected to be paid in future periods. Effective October 1, 1993, the Partnership began paying property management and leasing fees on a current basis. Reference is made to Note 11 relating to this deferral of distributions, fees and reimbursements. The Partnership and its consolidated ventures have currently budgeted in 1994 approximately $4,328,000 for leasing costs and other capital expenditures. The Partnership's share of such items and its share of such similar items for its unconsolidated ventures in 1994 is currently budgeted to be $6,419,000. Actual amounts expended in 1994 may vary depending on a number of factors including actual leasing activity, results of property operations, liquidity considerations and other market conditions over the course of the year. The source of capital for such items and for both short-term and long- term future liquidity requirements and distributions is expected to be primarily through net cash generated by the Partnership's investment properties, through an existing obligation of a seller (or its affiliate) to fund deficits at one property and through the sale or refinancing of such investments. A number of mortgage loans secured by the Partnership's investment properties will mature in 1994 and will need to be extended or refinanced, including the mortgage loans related to the Wells Fargo Center, 900 Third Avenue, 9701 Wilshire Building and the Dunwoody Apartments (Phase I and III). In addition, certain other mortgage loans secured by the Partnership's investment properties are the subject of discussions with lenders for debt modifications or restructurings, including the mortgage loans related to 125 Broad and RiverEdge Plaza. The current status of the a refinance, modify or restructure these loans, as well as other possible mortgage loan modifications, are discussed below. The mortgage note secured by the Villa Solana Apartments matured on November 1, 1993. The venture had obtained extensions of this note from the existing lender until August 1, 1994. The venture paid the lender $125,000 in extension fees in connection with these extensions. The monthly principal and interest payment, and the interest rate remain the same on the loan as prior to the original maturity date. The unpaid principal and accrued interest were to mature on August 1, 1994, however, the venture sold the investment property on March 23, 1994 as described in Note 13. The loan has been classified at December 31, 1993 and December 31, 1992 as a current liability in the accompanying consolidated financial statements. As a matter of prudent accounting practice, the Partnership made a provision for value impairment of $916,309 at September 30, 1993 for Villa Solana Apartments. Such provision reduced the net carrying value of the investment property to an amount not in excess of the proposed selling price of the investment property. Reference is made to Note 1. The mortgage notes secured by the Woodland Hills Apartments are scheduled to mature on June 1, 1994. The Partnership plans to refinance these notes when they mature, although there is no assurance the Partnership will be able to obtain such financing. The loans have been classified at December 31, 1993 as current liabilities in the accompanying consolidated financial statements. Reference is made to Notes 2(f) and 4(c). In October 1993, the joint venture ceased making the required debt service payments on the mortgage note secured by Park at Countryside Apartments, and commenced discussions with the lender regarding an additional modification of the loan. However, the venture was unable to secure an additional modification of the loan. Therefore, as of the date of this report, the loan is in default and the lender has initiated procedures to obtain title to the property. The loan has been classified at December 31, 1993 as a current liability in the accompanying consolidated financial statements. Based on current and anticipated market conditions, the Partnership and the joint venture partners are unwilling to commit any additional amounts to the property since the likelihood of recovering any such amounts is remote. This will result in the Partnership no longer having an ownership interest in the property and would result in a gain to the Partnership for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. The first mortgage loan secured by the Dunwoody Crossing Phase I and III Apartments is scheduled to mature in October 1994. The Partnership plans to refinance this note when it matures, although there can be no assurance the Partnership will be able to obtain such financing. In June 1993, JMB/Owings sold its interest in the Owings Mills Shopping Center for $9,416,000 represented by a purchase price note. Reference is made to Note 7. The borrowings of the Partnership and its ventures consist of separate non-recourse mortgage loans secured by the investment properties and individually are not obligations of the entire investment portfolio. However, for any particular investment property incurring deficits, the Partnership or its ventures, if deemed appropriate, may seek a modification or refinancing of existing indebtedness and, in the absence of a satisfactory debt modification or refinancing, may decide, in light of then existing and expected future market conditions for such investment property, not to commit additional funds to such investment property. This would result in the Partnership no longer having an ownership interest in such property and would result in a gain to the Partnership for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. Certain of the Partnership's investments have been made through joint ventures. There are certain risks associated with the Partnership's investments including the possibility that the Partnership's joint venture partner(s) in an investment might become unable or unwilling to fulfill its (their) financial or other obligations, or that such joint venture partner(s) may have economic or business interests or goals that are inconsistent with those of the Partnership. In response to the weakness of the economy and the limited amount of available real estate financing in particular, the Partnership is taking steps to preserve its working capital during the current economic slowdown. Therefore, the Partnership is carefully scrutinizing the appropriateness of any possibly discretionary expenditures, particularly in relation to the amount of working capital it has available to it and its ventures. By conserving working capital, the Partnership will be in a better position to meet future needs of its properties without having to rely on external financing sources. Piper Jaffray Tower The Minneapolis office market remains competitive due to the significant amount of new office building developments, which has caused effective rental rates achieved at Piper Jaffray Tower to be below expectations. During the fourth quarter 1991, Larkins, Hoffman, Daly & Lindgren, Ltd. (23,344 square feet) approached the joint venture indicating that it was experiencing financial difficulties and desired to give back a portion or all of its leased space. Larkin's lease was scheduled to expire in January 2005 and provided for annual rental payments which were significantly higher than current market rental rates. Larkin was also an owner with partial interests in the building and the land under the building. After substantive review of Larkin's financial condition, on January 15, 1992, the joint venture signed an agreement with Larkin to terminate its lease in return for its partial interest (4%) in the land under the building and a $1,011,798 note payable to the joint venture. The note payable provides for monthly payments of principal and interest at 8% per annum with full repayment over ten years. Larkin may prepay all or a portion of the note payable at any time. During the fourth quarter of 1993, the joint venture finalized a lease amendment with Popham Haik, Schnobrich & Kaufman, Ltd. (104,843 square feet). The amendment provides for the extension of the lease term from February 1, 1997 to January 31, 2003 in exchange for a rent reduction effective February 1, 1994. In addition, the tenant will lease an additional 10,670 square feet effective August 1, 1995. The rental rate on the expansion space approximates market which is significantly lower than the reduced rental rate on the tenant's current occupied space. In August 1992, the venture signed an agreement with the lender, effective April 1, 1991, to modify the terms of the mortgage notes which are secured by the investment property. The principal balance of the mortgage notes has been consolidated into one note in the amount of $100,000,000. Under the terms of the modification, commencing on April 1, 1991 and continuing through and including January 30, 2020, fixed interest will accrue and is payable on a monthly basis at a $10,250,000 per annum level. Contingent interest is payable in annual installments on April 1 and is computed at 50% of gross receipts, as defined, for each fiscal year in excess of $15,200,000; none was due for 1992 or 1993. In addition, to the extent the investment property generates cash flow after leasing and capital costs, and 29% of the ground rent (25% after January 15, 1992 as a result of the Larkin, Hoffman, Daly & Lindgren, Ltd. settlement discussed above), such amount will be paid to the lender as a reduction of the principal balance of the mortgage loan. The excess cash flow generated by the property in 1992 totalled $923,362 and was remitted to the lender during the third quarter of 1993. During 1993, the excess cash flow generated under this agreement was $1,390,910 and will be remitted to the lender during the second quarter in 1994. The mortgage note provides for the lender to earn a minimum internal rate of return which increases over the term of the note. Accordingly, for financial reporting purposes, interest expense has been accrued at a rate of 13.59% per annum which is the estimated minimum interna annum assuming the note is held to maturity. On a monthly basis, the venture deposits the property management fee into an escrow account to be used for future leasing costs to the extent cash flow is not sufficient to cover such items. The manager of the property (which is an affiliate of the Corporate General Partner) has agreed to defer receipt of its management fee until a later date. As of December 31, 1993, the manager has deferred approximately $1,792,000 of management fees. If upon sale of the property or refinancing as discussed below, there are funds remaining in this escrow after repayments of amounts owed the lender, such funds will be paid to the manager to the extent of its deferred and unpaid management fees. Any remaining unpaid management fees would be payable out of the venture's share of sale or refinancing proceeds. Additionally, pursuant to the terms of the loan modification, effective January 1992, an affiliate of the joint venture, as majority owner of the underlying land, began deferring receipt of its share of land rent. These deferrals will be repaid from potential net sale or refinancing proceeds. In order for the Partnership to share in future net sale or refinancing proceeds, there must be a significant improvement in current market and property operating conditions resulting in a significant increase in value of the property. Reference is made to Note 3(c)(i). 160 Spear Street Building Due to the rental concessions granted to facilitate leasing, the property operated at an approximate break-even level in 1993. As more fully discussed in Note 4(b)(iii), effective February 1992, the Partnership reached an agreement with the lender to reduce the current debt service payments and to extend the loan, which was scheduled to mature on December 10, 1992, to February 10, 1999. Additionally, tenant leases comprising approximately 69% of the building are scheduled to expire in 1995. It is anticipated that there will be significant costs related to releasing this space. The venture expects to approach the lender regarding an additional modification to the loan due to the increased deficits anticipated in connection with the re- leasing costs. Should the venture not be successful in obtaining an additional loan modification or alternative financing, or, should the Partnership decide not to commit any significant additional funds for the anticipated re-leasing costs, this may result in the Partnership no longer having an ownership interest in the property. This would likely result in the Partnership recognizing a gain for financial reporting and Federal income tax purposes with no corresponding distributable proceeds. 125 Broad Street Building Vacancy rates in the downtown Manhattan office market have increased significantly over the last few years. As vacancy rates rise, competition for tenants increases, which results in lower effective rental rates. The increased vacancy rate in the downtown Manhattan office market has resulted primarily from layoffs, cutbacks and consolidations by many of the financial service companies which, along with related businesses, dominate this submarket. The Partnership believes that these adverse market conditions and the negative impact on effective rental rates will continue over the next few years. The depressed market in downtown Manhattan has significantly affected the 125 Broad Street Building as the occupancy has decreased to 54% at December 31, 1993 partially as a result of a major tenant vacating 395,000 square feet (30% of the building) at the expiration of its lease during 1991. Additionally, in October 1993, the joint venture owning the building, 125 Broad Street Company ("125 Broad") entered into an agreement with Salomon Brothers, Inc. to terminate its lease covering approximately 231,000 square feet (17% of the building) at the property on December 31, 1993 rather than its scheduled termination in January 1997. In consideration for the early termination of the lease, Salomon Brothers, Inc. paid 125 Broad approximately $26,500,000 plus interest thereon of approximately $200,000, which 125 Broad in turn paid its lender to reduce amounts outstanding under the mortgage loan. In addition, Salomon Brothers, Inc. paid JMB/125 $1,000,000 in consideration of JMB/125's consent to the lease termination. The property will be adversely affected by lower than originally expected effective rental rates to be achieved upon releasing of the space. The low effective rental rates coupled with the lower occupancy during the releasing period are expected to result in the property operating at a significant deficit in 1994 and for several years. The unaffiliated venture partners (the "O&Y partners"), who are affiliates of Olympia & York Developments, Ltd. ("O&Y"), are obligated to fund (in the form of interest-bearing loans) operating deficits and costs of lease-up and capital improvements through the end of 1995. However, as discussed below, the O&Y partners are in default in respect to certain of their funding obligations, and it appears unlikely that the O&Y partners will fulfill their obligation to 125 Broad and JMB/125. Releasing of the vacant space will depend upon, among other things, the O&Y partners advancing the costs associated with such releasing since JMB/125 does not intend to contribute funds to the joint venture to pay such costs. The O&Y partners have made outstanding loans to the joint venture of approximately $14,650,000 as of December 31, 1993. Such loans, which are non-recourse to JMB/125, are payable out of cash flow from property operations or sale or refinancing proceeds. Based on the facts discussed above and as described more fully in Note 3(c)(iv), the joint venture recorded a provision for value impairment as of December 31, 1991 to reduce the net book value of the 125 Broad Street Building to the then outstanding balance of the related non-recourse financing and O&Y partner loans due to the uncertainty of the joint venture's ability to recover the net carrying value of the investment property through future operations or sale. O & Y and certain of its affiliates have been involved in bankruptcy proceedings in the United States and Canada and similar proceedings in England. Subsequent to December 31, 1992, O & Y emerged from bankruptcy protection in Canada. In addition, a reorganization of the management of the company's United States operations has been completed, and certain O&Y affiliates are in the process of renegotiating or restructuring various loans affecting properties in the United States in which they have an interest. In view of the present financial condition of O&Y and its affiliates and the anticipated deficits for the property as well as the existing defaults of the O&Y partners, it appears unlikely that the O&Y partners will meet their financial and other obligations to JMB/125 and 125 Broad. The O&Y partners have failed to advance necessary funds to 125 Broad as required under the joint venture agreement, and as a result, the joint venture defaulted on its mortgage loan which has an outstanding principal balance of approximately $277,000,000 in June 1992 by failing to pay approximately $4,722,000 of the semi-annual interest payment due on the loan. In addition, during 1992 affiliates of O&Y defaulted on a "takeover space" agreement with Johnson & Higgins, Inc. ("J&H"), one of the major tenants at the 125 Broad Street Building, whereby such affiliates of O&Y agreed to assume certain lease obligations of J&H at another office building in consideration of J&H's leasing space in the 125 Broad Street Building. As a result of this default, J&H has offset rent payable to 125 Broad for its lease at the 125 Broad Street Building in the amount of approximately $28,600,000 through December 31, 1993, and it is expected that J&H will continue to offset amounts due under its lease corresponding to amounts by which the affiliates of O&Y are in default under the "takeover space" agreement. As a result of the O&Y affiliates' default under the "takeover space" agreement and the continuing defaults of the O&Y partners to advance funds to cover operating deficits, as of the end of 1993, the arrearage under the mortgage loan had increased to approximately $48,180,000. However, as discussed above, approximately $26,700,000 was remitted to the lender in October 1993 in connection with the early termination of the Salomon Brothers lease, and was applied towards the mortgage principal for financial reporting purposes. Due to their obligations relating to the "takeover space" agreement, the affiliates of O&Y are obligated for the payment of the rent receivable associated with the J&H lease at the 125 Broad Street Building. Based on the continuing defaults of the O&Y partners, the joint venture has reserved the entire rent offset by J&H, $19,300,000 and $9,300,000 in 1993 and 1992, respectively, and has also reserved approximately $32,600,000 of accrued rents receivable relating to such J&H lease, since the ultimate collectability of such amounts depends upon the O&Y partners' and the O&Y affiliates' performance of their obligations. The Partnership's share of such losses was approximately $5,587,000 and $12,159,000 for 1993 and 1992, respectively, and is included in the Partnership's share of loss from operations of unconsolidated ventures. The O&Y partners have attempted to negotiate a restructuring of the mortgage loan with the lender in order to reduce operating deficits view of, among other things, the significant operating deficits which the property is expected to incur during 1994 and for the next several years, it is unlikely that a restructuring of the mortgage loan will be obtained. The loan restructuring is part of a larger restructuring with the lender involving a number of loans secured by various properties in which O&Y affiliates have an interest. JMB/125 has notified the O&Y partners that their failure to advance funds to cover the operating deficits constitutes a default under the joint venture agreement. Accordingly, it appears unlikely the O&Y partners will fulfill their obligations to 125 Broad and JMB/125. Therefore, it appears unlikely that 125 Broad will be able to restructure the mortgage loan, and JMB/125 is not likely to commit any significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property. If this event were to occur, the Partnership would recognize a net gain for financial reporting and Federal income tax purposes without any corresponding distributable proceeds. In addition, under certain circumstances JMB/125 may be required to make an additional capital contribution to 125 Broad in order to make up a deficit balance in its capital account. Reference is made to Note 3(c)(iv). 260 Franklin Street Building The office market in the Financial District of Boston remains competitive due to new office building developments and layoffs, cutbacks and consolidations by financial service companies. The effective rental rates achieved upon releasing have been substantially below the rates which were received under the previous leases for the same space. In December 1991, 260 Franklin, the affiliated joint venture, reached an agreement with the lender to modify the long-term mortgage note secured by the 260 Franklin Street Building. The property is currently expected to operate at a deficit for 1994 and for several years thereafter. The loan modification required that the affiliated joint venture establish an escrow account for excess cash flow from the property's operations (computed without a deduction for property management fees and leasing commissions to an affiliate) to be used to cover the cost of capital and tenant improvements and lease inducements, which are the primary components of the anticipated operating deficits noted above, as defined, with the balance, if any, of such escrowed funds available at the scheduled or accelerated maturity to be used for the payment of principal and interest due to the lender. Beginning January 1, 1992, 260 Franklin began escrowing the payment of property management fees and lease commissions owed to an affiliate of the Corporate General Partner pursuant to the terms of the debt modification, which is more fully described in Note 4(b), and accordingly, such fees and commissions remained unpaid. The Partnership's share of such fees and lease commissions is approximately $523,615 at December 31, 1993. In 1995, the leases of tenants occupying approximately 107,000 square feet (approximately 31% of the property) at the 260 Franklin Street Building expire. It is anticipated that there will be significant cost related to releasing this space. In addition, the long-term mortgage loan matures January 1, 1996. If the Partnership is unable to refinance or extend the mortgage loan, the Partnership may decide not to commit any significant additional funds. This may result in the Partnership no longer having an ownership interest in the property. This would result in the Partnership recognizing a gain for financial reporting purposes. 900 Third Avenue Building During the year, occupancy of this building increased to 95%, up from 92% in the previous year primarily due to Investment Technology Group, Inc. occupying 15,636 square feet (approximately 3% of the building's leasable space) in the second quarter of 1993. The midtown Manhattan market remains very competitive. Although, the joint venture is in discussions with the existing lender for a possible refinancing and extension of its mortgage loan which matures in December 1994, there can be no assurance that the Partnership will be successful in such discussions. The Partnership and affiliated partner have filed a lawsuit against the former manager and one of the unaffiliated venture partners to recover the amounts advanced and certain other joint venture obligations on which the unaffiliated partner has defaulted. This lawsuit has been dismissed on jurisdictional grounds. Subsequently, however, the Federal Deposit Insurance Corp. ("FDIC") filed a complaint, since amended, in a lawsuit against the joint venture partner, the Partnership and affiliated partner and the joint venture, which has enabled the Partnership and affiliated partner to refile its previously asserted claims against the joint venture partner as part of that lawsuit in Federal court. There is no assurance that the Partnership and affiliated partner will recover the amounts of its claims as a result of the litigation. Due to the uncertainty, no amounts in addition to the amounts advanced to date, noted above, have been recorded in the accompanying consolidated financial statements. Settlement discussions with one of the venture partners and the FDIC continue. The FDIC has, in the past, been unwilling to consider a settlement until certain other issues it has with one of the unaffiliated venture partners are resolved. It appears that a resolution of those other issues may be near. There are no assurances that a settlement will be finalized and that the Partnership and affiliated partner will be able to recover any amounts from the unaffiliated venture partners. 300 East Lombard Building Effective September 30, 1991, the Partnership sold, to an affiliate of the joint venture partners, 62% of its interest in a joint venture that owns a 55% interest in the 300 East Lombard investment property. In conjunction with the sale, the Partnership and buyer established a put-call option on the Partnership's remaining interest in the joint venture. In January 1993, the Partnership sold its remaining interest in accordance with the terms of the option. Reference is made to Note 7. Wells Fargo Center The Wells Fargo Center operates in the Downtown Los Angeles office market, which has become extremely competitive over the last several years with the addition of several new buildings that has resulted in a high vacancy rate of approximately 25% in the marketplace. In 1992, two major law firm tenants occupying approximately 11% of the building's space approached the joint venture indicating that they were experiencing financial difficulties and desired to give back a portion of their leased space in lieu of ceasing business altogether. The joint venture reached agreements which resulted in a reduction of the space leased by each of these tenants. The Partnership is also aware that a major tenant, IBM, leasing approximately 58% of the tenant space in the Wells Fargo Building is sub-leasing or attempting to sub-lease approximately one-fourth of its space, which is scheduled to expire in December 1998. The Partnership expects that the competitive market conditions will have an adverse affect on the building through lower effective rental rates achieved on releasing of existing tenant space which expires or is given back over the next several years. The property operated at deficits in 1992 and 1993 due to rental concessions granted to facilitate leasing of space taken back from the two tenants noted above and the expansion of one of the other major tenants in the building. The property is expected to produce cash flow in 1994. The mortgage note secured by the property, as well as the promissory note secured by the Partnership's interest in the joint venture are scheduled to mature in December 1994. The promissory note secured by the Partnership's interest in the joint venture is classified at December 31, 1993 as a current liability in the accompanying consolidated financial statements. In view of, among other things, current and anticipated market and leasing conditions affecting the property, including uncertainty regarding the amount of space, if any, which IBM will renew when its lease expires in December 1998, the South Tower Venture, as a matter of prudent accounting practice, recorded a provision for value impairment of $67,479,871 (of which $20,035,181 has been allocated to the Partnership and is reflected in the Partnership's share of operations of unconsolidated ventures in the accompanying consolidated financial statements). Such provision, made as of August 31, 1993, is recorded to reduce the net carrying value of the Wells Fargo Center to the then outstanding balance of the related non-recourse debt. Further, there is no assurance that the joint venture or the Partnership will be able to refinance these notes when they mature in December o Partnership may then decide not to commit any significant additional amounts to the property. This may result in the Partnership no longer having an ownership interest in the property, and would result in a gain for financial reporting and for Federal income tax purposes with no corresponding distributable proceeds. The property did not sustain any significant damage as a result of the January 1994 earthquake in southern California. Reference is made to Notes 1 and 3(c)(iii). RiverEdge Place Building The RiverEdge Place Building was 100% leased to an affiliate of the major tenant, First American Bank, under a long-term over-lease executed in connection with the purchase of the property. The Bank and its affiliate approached the Partnership indicating that they were experiencing significant financial difficulties. On June 23, 1992, the Partnership reached an agreement with the Bank and received cash and U.S. Government Securities valued at $9,325,000 for the buy-out of the Bank's over-lease obligations. The termination of the Bank's over-lease obligation yielded an approximately $1,591,000 reduction in accrued rents receivable. The Partnership took these courses of action due to the First American Bank's deteriorating financial condition and the Federal Deposit Insurance Corporation's ability to assume control of the Bank and to terminate the over-lease obligation. The $9,325,000 buy-out was concurrently remitted to the lender to reduce the mortgage secured by the RiverEdge Place Building and the Partnership continues to negotiate with the lender to restructure the mortgage note in order to reduce operating deficits anticipated as a result of the over-lease buy-out. In connection with the Partnership's negotiations with the lender, the Partnership ceased making debt service payments effective July 1, 1992. If the Partnership's negotiations for mortgage note restructuring are not successful, the Partnership would likely decide, based upon current market conditions and other considerations relating to the property and the Partnership's portfolio, not to commit significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property and would result in a gain for financial reporting and Federal income tax purposes without any corresponding distributable proceeds. Accordingly, the mortgage note has been classified as a current liability in the accompanying consolidated financial statements. Additionally, the tenant lease with First American Bank for approximately 120,000 square feet has been assigned to and assumed by SouthTrust Bank of Georgia in connection with that bank's acquisition of most of the remaining assets of First American Bank. Effective August 1, 1992, the Partnership restructured the lease with SouthTrust Bank of Georgia reducing the tenant's space to approximately 92,000 square feet, as well as reducing the effective rent on the retained space in exchange for an extension of the lease term from April, 1994 to July, 2002. The restructuring of SouthTrust Bank's lease reduced the occupied space of the RiverEdge Place Building from 96% to 85% at that time. The Partnership is actively pursuing replacement tenants for the building's vacant space including the space taken back from the SouthTrust lease restructuring. Due to the uncertainty as to the Partnership's ability to recover the net carrying value of the investment property through future operations and sale, as a matter of prudent accounting practice, the Partnership made a provision for value impairment of $6,149,632 recorded as of September 30, 1992. Such provision was recorded to reduce the net carrying value of the investment property to the September 30, 1992 outstanding balance of the related non-recourse financing. Reference is made to Notes 1, 2(b) and 4(b)(iv). 21900 Burbank Building The 21900 Burbank Building sustained some damage as a result of the earthquakes that occurred in January 1994 in southern California. Preliminary estimates of the damage range from $200,000 to $500,000. Much of this damage occurred within tenant premises in the building. The Partnership does not believe it has any significant obligations to reimburse tenants for such repairs. While the Partnership carried earthquake insurance on this property, it is anticipated that the total damages will not exceed the deductible amount. Although the property produced cash flow to the Partnership in 1993, there is uncertainty as to the Partnership's ability to recover the net carrying value of the investment property through future operations and sale as a result of the substantial amount of tenant space (approximately 83% of the building) under leases that are scheduled to expire during 1995 and 1996. As a matter of prudent accounting practice, the Partnership made a provision for value impairment of such investment property of $1,740,533 recorded as of June 30, 1992. Such provision was recorded to reduce the net carrying value of the investment property to the June 30, 1992 outstanding balance of the related non-recourse financing. Reference is made to Notes 1 and 2(c). NewPark Associates In December 1992, NewPark Associates refinanced the existing indebtedness related to its shopping center with a new mortgage loan as described in Note 3(c)(v). In addition to retiring the prior mortgage loan and the notes payable to the unaffiliated joint venture partner, the new mortgage loan, which is in the principal amount of approximately $51,000,000 and bears interest at 8.75% per annum, has provided approximately $14,000,000 of additional proceeds, a major portion of which were used to pay the costs of the renovation work described below and to provide a reserve for future tenant improvement costs at the property. The new mortgage loan matures in November 1995, subject to the right of the joint venture to extend the maturity date to November 2000 upon payment of a $250,000 fee and satisfaction of certain conditions. NewPark Associates commenced a renovation of NewPark Mall in early 1993 and such renovation was substantially complete as of September 30, 1993. NewPark Mall may be subject to increased competition from a new mall that is expected to open in the vicinity in late 1994. California Plaza The property operated at a deficit in 1993 due to the costs incurred in connection with the leasing of space which was vacant or under leases that expired in 1993. Effective March 1, 1993, the joint venture ceased making the scheduled debt service payments on the mortgage loan secured by the property which was scheduled to mature on January 1, 1997. Subsequently, the Partnership made partial debt service payments based on net cash flow of the property through December, 1993 when an agreement was reached with the lender to modify the loan on December 22, 1993. As more fully discussed in Note 4(b)(vi), the loan modification reduced the pay rate of monthly interest only payments to 8% per annum, effective February 1993, extended the loan maturity date to January 1, 2000, and requires the net cash flow of the property to be escrowed (as defined). The venture also funded $500,000 into a reserve account as required by the modification agreement. This reserve account is to be used to fund future costs, including tenant improvements, leasing commissions and capital improvements, approved by the lender. Additionally, due to the uncertainty of the Partnership's ability to recover the net carrying value of the California investment property, the Partnership made, as a matter of prudent accounting practice, a provision for value impairment of California Plaza at June 30, 1993 of $2,166,799 (which included $1,558,492 relating to the venture partner's deficit investment balance at that date). Such provision reduced the net carrying value of the investment property to the June 30, 1993 outstanding balance of the related non-recourse mortgage note. Reference is made to Notes 1 and 4(b)(vi). Erie-McClurg Parking Facility On September 25, 1992, the Partnership, through Erie-McClurg Associates, sold the Erie-McClurg Parking Facility located in Chicago, Illinois. A portion of the cash proceeds was used to retire the first mortgage note secured by the property. Additionally, a portion of the proceeds was used to retire the Partnership's unsecured, non-revolving line of credit. Reference is made to Notes 2(e) and 7. Concurrently, with the sale of the Erie-McClurg Parking Facility, the Partnership entered into an agreement with the unaffiliated manager of the parking facility to induce the manager to re-write the existing long-term management agreement at less favorable terms to the manager. This agreement guarantees the manager 100% of the compensation which would have been earned under the agreement prior to the sale in years one through five and 50% of any potential difference between the management fee under the agreement prior to the sale and the renegotiated agreement with the purchaser (as defined) in years six through eighteen. Reference is made to Note 7. In connection with this agreement, at closing the Partnership paid the unaffiliated manager a partial settlement of $400,000 and has estimated the present value of the remaining contingent liability to be $360,000. This contingent liability is recorded as a long-term liability in the accompanying consolidated financial statements. Reference is made to Note 7. Springbrook Shopping Center In October 1993, a tenant occupying 20% of the space at the Springbrook Shopping Center vacated upon expiration of its lease. The Partnership is actively pursuing replacement tenants for the vacant space, but there is no assurance that any leases will be consummated. Due to the uncertainty of re- leasing this space, and due to the property being expected to operate at a deficit in 1994, there is uncertainty as to the Partnership's ability to recover the net carrying value of the investment property through future operations or sale. Thus, as a matter of prudent accounting practice, the Partnership made a provision for value impairment of such investment property of $7,534,763 at December 31, 1993. Such provision is recorded to reduce the net carrying value of the investment property to the December 31, 1993 outstanding balance of the related non-recourse financing. Reference is made to Note 1. Other The mortgage note secured by Eastridge Mall is scheduled to mature on October 1, 1995. There is no assurance that the venture will be able to refinance or obtain alternative financing when the note matures. Due to the uncertainty of the Partnership's ability to recover the net carrying value of the Eastridge Mall investment property, the Partnership has made, as a matter of prudent accounting practice, a provision at June 30, 1992 for value impairment of Eastridge Mall of $5,752,710. Such provision reduced the net carrying value of the investment property to the then outstanding balance of the related non-recourse mortgage note. Due to the uncertainty of the Partnership's ability to recover the net carrying value of the 9701 Wilshire Building investment property, the Partnership has made, as a matter of prudent accounting practice, a provision at September 30, 1992 for value impairment of 9701 Wilshire Building of $12,504,079. Such provision reduced the net carrying value of the investment property to the then outstanding balance of the related non-recourse mortgage note. The property operated at a slight deficit in 1993 due to the costs incurred in connection with the re-leasing of the vacant space in the building. The mortgage note secured by the property matured on January 1, 1994. The Partnership obtained extensions of this note from the existing lender until August 1, 1994. The Partnership paid the lender $110,000 in extension fees in connection with these extensions. The monthly principal and interest payment, and the interest rate remain the same on the loan as prior to the original maturity date. The unpaid principal and interest matures on August 1, 1994, and thus, the loan has been classified at December 31, 1993 as a current liability in the accompanying consolidated financial statements. The Partnership is pursuing a sale or alternative financing of the property, however, there is no assurance that the Partnership will be successful in either refinancing or selling the property. The property did not sustain any significant damage as a result of the January 1994 earthquake in southern California. Due to the factors discussed above and the general lack of buyers of real estate today, it is likely that the Partnership may hold some of its investment properties longer than originally anticipated in order to maximize Partnership's recovery of its investments and any potential return thereon. In light of the current severely depressed real estate markets, it currently appears that the Partnership's goal of capital appreciation will not be achieved. Although some portion of the Limited Partners' original capital is expected to be distributed from sales proceeds, without a dramatic improvement in market conditions the Limited Partners will not receive a full return of their original investment. In addition, in connection with sales or other dispositions (including transfers to lenders) of properties (or interests therein) owned by the Partnership or its joint ventures, the Limited Partners may be allocated substantial gain for Federal income tax purposes. RESULTS OF OPERATIONS The decrease in current portion of notes receivable at December 31, 1993 as compared to December 31, 1992 is primarily due to the receipt by the Partnership in June 1993 of $165,625 of the Boatman's settlement. Reference is made to Note 3(b)(i). The increase in escrow deposits and restricted securities at December 31, 1993 as compared to December 31, 1992 is primarily due to an increase in the escrow balance at the 260 Franklin Street Building and an increase in the escrow balance at Cal Plaza due to the loan modification in December 1993, offset by the return of reserves to the venture partner related to Cal Plaza as required by the 1991 settlement. Reference is made to Notes 3(b)(iii) and 4(b). The decrease in land and buildings and improvements at December 31, 1993 as compared to December 31, 1992 is primarily due to the Partnership's decision to establish provisions for value impairment in connection with the Cal Plaza, Villa Solana Apartments and Springbrook Shopping Center investment properties. The decrease in buildings and improvements is partially offset by additions of buildings and improvements at certain of the Partnership's investment properties. Reference is made to Note 1. The decrease in investment in unconsolidated ventures, at equity at December 31, 1993 as compared to December 31, 1992 is primarily due to the provision for value impairment recorded at Wells Fargo Center at August 31, 1993, of which the Partnership's share was $20,035,181, as more fully discussed in Note 1, and in the Liquidity and Capital Resources section above. The increase in the balance of the current portion of long-term debt and corresponding decrease in the balance of long-term debt at December 31, 1993 as compared to December 31, 1992 is primarily due to 9701 Wilshire's debt, which matured January 1, 1994 and for which the Partnership obtained extensions until August 1, 1994, Woodland Hills debt, which is scheduled to mature June 1, 1994, Dunwoody Crossings (Phase I and III) Apartment's debt, which is scheduled to mature on October 1, 1994, Park at Countryside Apartment's debt which has been in default since October 1993, and for which the lender has initiated foreclosure proceedings, and the Wells Fargo promissory note which is secured by the Partnership's interest in the South Tower joint venture, which is scheduled to mature on December 31, 1994, being classified as current liabilities at December 31, 1993. Reference is made to Note 4. The increase in amounts due affiliates at December 31, 1993 as compared to December 31, 1992 is primarily due to the additional deferrals by the Partnership's General Partners and their affiliates of certain property management and leasing fees and reimbursements. Reference is made to Note 11. The increase in the balance of accrued interest payable at December 31, 1993 as compared to December 31, 1992 is primarily due to the accrual of approximately $2,611,000 in 1993 of unpaid interest on the mortgage loan secured by the RiverEdge Place investment property. Reference is made to Note 4(b)(iv). The decrease in deposits and advances at December 31, 1993 as compared to December 31, 1992 is due to the return of reserves to the venture partner related to the California Plaza investment property as required by the 1991 settlement agreement. Reference is made to Note 3(b)(iii). Decreases in rental income for the year ended December 31, 1993 as compared to the same period in 1992 is primarily due to the June 30, 1992 buy- out of the First American Bank's over-lease obligations at RiverEdge Place, and the sale of the Erie-McClurg Parking Facility in September 1992. Reference is made to Notes 2(b) and 7. Increases in rental income for the year ended December 31, 1992 as compared to the same period in 1991 are primarily due to the June 1992 buy-out of the First American Bank's over-lease obligations (as discussed above) offset, in part, by lower effective rental rates on tenant space that expired in 1991 and was re-leased in 1992 at the 260 Franklin Street investment property and the September 1992 sale of the Erie-McClurg Parking Facility. The decrease in interest income for the year ended December 31, 1993 as compared to the same period in 1992 is primarily due to lower interest rates earned on the Partnership's short-term investments. The increase in interest income for the year ended December 31, 1992 as compared to same period in 1991 is primarily due to an increase in the average balance of short-term investments in 1992 as compared to 1991. The decrease in mortgage and other interest for the year ended December 31, 1993 as compared to the same period in 1992 is primarily due to the sale of the Erie-McClurg Parking Facility in September, 1992, a reduction of the debt balance of RiverEdge Place investment property by $9,325,000 in June 1992 and the modification of the loan at Cal Plaza which decreased the effective interest rate. Reference is made to Notes 2(b), 4(b)(vi) and 7. The decrease in mortgage and other interest for the year ended December 31, 1992 as compared to the same period in 1991 is primarily due to the February 1992 modification (effecting a lower average interest rate) of the debt secured by the 160 Spear Street investment property, the June 1992 $9,325,000 principal reduction of the debt secured by the RiverEdge Place investment property and the September 1992 sale and simultaneous retirement of debt of the Erie- McClurg Parking Facility. The decrease in depreciation expense for the year ended December 31, 1993 as compared to the same period in 1992, and the decrease for the year and December 31, 1992 as compared to the same period in 1991 is primarily due to the provisions for value impairment recorded at several of the Partnership's investment properties in 1993 and 1992, which resulted in a lower basis of assets to be depreciated in 1993 and 1992, and due to the sale in September 1992 of the Erie-McClurg Parking Facility. Reference is made to Notes 1 and 7. The decrease in professional services for the years ended December 31, 1993 as compared to the same period in 1992 and the decrease for the year ended December 31, 1992 as compared to the same period in 1991 is primarily due to Partnership's 1991 and 1992 legal fees relating to the lawsuit against the joint venture partner of the C-C California Plaza venture. Reference is made to Note 3(b)(iii). The decrease in management fees to corporate general partner for the year ended December 31, 1993 as compared to the same period in 1992 and, the decrease for the year ended December 31, 1992 as compared to the same period in 1991 is due to the decreases in the Partnership's distributions in 1992, and suspension of distributions in 1992, a portion of which is earned by the Corporate General Partner as a partnership management fee. Reference is made to Note 11 relating to the deferral of these fees. The provisions for value impairment for the year ended December 31, 1993 relate to provisions recorded for Cal Plaza, Villa Solana Apartments, and Springbrook Shopping Center of $2,166,799, $916,309 and $7,534,763, respectively. The provisions for value impairment for the year ended December 31, 1992 relate to provisions recorded for Eastridge Mall, 21900 Burbank Boulevard Building, 9701 Wilshire Building and RiverEdge Plaza properties of $5,752,710, $1,740,533, $12,504,079 and $6,149,632, respectively. Reference is made to Note 1. The increase in Partnership's share of loss from operations of unconsolidated ventures for the year ended December 31, 1993 as compared to the same period in 1992 is primarily due to the provision for value impairment recorded at August 31, 1993 at Wells Fargo Center (of which the Partnership's share is $20,035,181), offset by a decrease in the Partnership's share of losses of JMB/125 due to the receipt of the Salomon Brothers lease termination fee payment in 1993. The increase in the Partnership's share of losses from operations of unconsolidated ventures for the year ended December 31, 1992 as compared to the same period in 1991 is primarily due to activity at the 125 Broad Street office building, including (i) the recognition of losses relating to Johnson and Higgins receivables in 1992 and (ii) a decrease in rental income as a result of a major tenant vacating a large portion of its space during 1991. The Partnership's share of loss from operations of unconsolidated ventures for 1991 includes a provision for value impairment recorded on the books of the 125 Broad Street Building as of December 31, 1991 to reduce the net book value of the 125 Broad Street Building to the then outstanding balance of related non-recourse financing. Reference is made to Notes 3(c)(iii) and 3(c)(iv). The gain on sale of investment property in 1992 relates to the sale of the Erie-McClurg Parking Facility in September 1992. Reference is made to Note 7. The gain on sale of interests in unconsolidated ventures for the year ended December 31, 1993 relates to JMB/Owning's sale of its interest in Owings Mills Limited Partnership ("OMLP") in June 1993, and the Partnership's sale of the remaining interest in Harbor Overlook Limited Partnership in January 1993. The gain on sale of interest in unconsolidated ventures for the year ended December 31, 1991 relates to the Partnership's sale of 62% of its general partnership interest in Harbor Overlook Limited Partnership in 1991. Reference is made to Note 7. The $1,014,538 extraordinary item for the year ended December 31, 1991 relates to the cancellation in February 1991, of the wrap-around mortgage note secured by the Woodland Hills apartment complex. Reference is made to Note 4(c). INFLATION Due to the decrease in the level of inflation in recent years, inflation generally has not had a material effect on rental income or property operating expenses. To the extent that inflation in future periods does have an adverse impact on property operating expenses, the effect will generally be offset by amounts recovered from tenants as many of the long-term leases at the Partnership's commercial and retail properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, there should be little effect on net operating earnings if the properties remain substantially occupied. In addition, substantially all of the leases at the Partnership's shopping center investments contain provisions which entitle the property owner to participate in gross receipts of tenants above fixed minimum amounts. Future inflation may also cause capital appreciation of the Partnership's investment properties over a period of time to the extent that rental rates and replacement costs of properties increase. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES INDEX Independent Auditors' Report Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Partners' Capital Accounts (Deficits), years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI Schedules not filed: All schedules other than those indicated in the indices have been omitted as the required information is inapplicable or the information is presented in the consolidated or combined financial statements or related notes. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV CERTAIN UNCONSOLIDATED VENTURES INDEX Independent Auditors' Report Combined Balance Sheets, December 31, 1993 and 1992 Combined Statements of Operations, years ended December 31, 1993, 1992 and 1991 Combined Statements of Partners' Capital Accounts (Deficits), years ended December 31, 1993, 1992 and 1991 Combined Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Combined Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Combined Real Estate and Accumulated Depreciation XI Schedules not filed: All schedules other than those indicated in the indices have been omitted as the required information is inapplicable or the information is presented in the consolidated or combined financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV: We have audited the consolidated financial statements of Carlyle Real Estate Limited Partnership - XV (a limited partnership) and Consolidated Ventures as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Carlyle Real Estate Limited Partnership - XV and Consolidated Ventures at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As described in Note 3 (c)(iv) of notes to consolidated financial statements, the property owned by 125 Broad Street Company (125 Broad), in which the Partnership has an interest through 125 Broad Building Associates (JMB/125), has suffered losses and cash flow deficits from operations and expects to incur significant cash flow deficits in the future that are required to be funded by the unaffiliated venture partners through 1995 pursuant to the 125 Broad joint venture agreement. In 1992, the unaffiliated venture partners failed to advance necessary funds to 125 Broad and, as a result, 125 Broad defaulted on its mortgage loan. JMB/125 has notified the unaffiliated joint venture partners that their failure to advance funds to cover operating deficits constitutes a default under the 125 Broad joint venture agreement. The 125 Broad joint venture partners have been negotiating with the property's lender to restructure the mortgage loan; however, there can be no assurances that negotiations to restructure the loan will be successful. The Partnership believes it is unlikely that the unaffiliated joint venture partners will fulfill their funding obligations to 125 Broad and JMB/125. As a result, it appears unlikely that 125 Broad will be able to restructure the mortgage loan. In the event that 125 Broad is unable to restructure the mortgage loan, JMB/125 would likely decide not to commit additional funds to 125 Broad. These circumstances could result in the Partnership no longer having an ownership interest in the investment property. The ultimate outcome of these circumstances cannot presently be determined. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties. Additionally, as discussed in Notes 3 and 4 of notes to consolidated financial statements, a number of mortgage loans secured by the Partnership's investment properties or investment properties owned by ventures in which the Partnership has an interest, mature in 1994. The Partnership has commenced or intends to commence discussions with the mortgage lenders in order to extend and/or modify such mortgage loans. In the event that discussions with lenders are unsuccessful, the Partnership and its venture partners may be unable or unwilling to commit additional amounts to the investment properties. These circumstances could result in the Partnership no longer having an ownership interest in certain investment properties. The ultimate outcome of these circumstances cannot presently be determined. The Partnership and ventures have recorded provisions for value impairment, where applicable, to reduce the net book value of such properties to the outstanding balance of the related non-recourse financing (Notes 1 and 3 of notes to consolidated financial statements). KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying consolidated financial statements include the accounts of the Partnership and its consolidated ventures, Eastridge Development Company ("Eastridge"); Daytona Park Associates ("Park"); JMB/160 Spear Street Associates ("160 Spear"); Villa Solana Associates ("Villa Solana"); 260 Franklin Street Associates ("260 Franklin"); C-C California Plaza Partnership ("Cal Plaza"); Villages Northeast Associates ("Villages Northeast") and VNE Partners, Ltd. ("VNE Partners"). The effect of all transactions between the Partnership and the consolidated ventures has been eliminated. The equity method of accounting has been applied in the accompanying consolidated financial statements with respect to the Partnership's interests in JMB/Piper Jaffray Tower Associates ("JMB/Piper") and JMB/Piper Jaffray Tower Associates II ("JMB/Piper II"); 900 Third Avenue Associates ("JMB/900"); Maguire/Thomas Partners-South Tower ("South Tower"); Harbor Overlook Limited Partnership ("Harbor"); JMB/Owings Mills Associates ("JMB/Owings"); Carlyle-XV Associates, L.P., which owns an interest in JMB/125 Broad Building Associates, L.P. ("JMB/125") and JMB/NewPark Associates, L.P. ("JMB/NewPark"). The Partnership's records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying consolidated financial statements have been prepared from such records after making appropriate adjustments to present the Partnership's accounts in accordance with generally accepted accounting principles ("GAAP") and to consolidate the accounts of certain ventures as described above. Such adjustments are not recorded on the records of the Partnership. The effect of these items is summarized as follows for the years ended December 31, 1993 and 1992: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net loss per limited partnership interest is based upon the limited partnership interests outstanding at the end of the period (443,717). Deficit capital accounts will result, through the duration of the Partnership, in the recognition of net gain for financial reporting and income tax purposes. Statement of Financial Accounting Standards No. 95 requires the Partnership to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. Partnership distributions from unconsolidated ventures are considered cash flow from operating activities only to the extent of the Partnership's cumulative share of net earnings. In addition, the Partnership records amounts held in U.S. Government obligations and other securities at cost which approximates market. For the purposes of these statements, the Partnership's policy is to consider all such amounts held with original maturities of three months or less (none at December 31, 1993 and 1992) as cash equivalents with any remaining amounts reflected as short-term investments. Escrow deposits and restricted securities primarily represent cash and investments restricted as to their use by the Partnership. Due to the uncertainty of the Partnership's ability to recover the net carrying value of the 125 Broad Street Building (note 3(c)(iv), 260 Franklin Street Building, Eastridge Mall, 21900 Burbank Boulevard Building, 9701 Wilshire Building, RiverEdge Place, California Plaza, Wells Fargo Center - IBM Tower, Villa Solana Apartments and Springbrook Shopping Center investment properties, the Partnership, or ventures, as the case may be, made, as a matter of prudent accounting practice, provisions for value impairment. A provision for value impairment was recorded at June 30, 1992 of $5,752,710 and $1,740,533 for Eastridge Mall and 21900 Burbank Boulevard Building, respectively, at September 30, 1992 of $12,504,079 and $6,149,632 for 9701 Wilshire Building and RiverEdge Place, respectively, at June 30, 1993, of $2,166,799 for California Plaza, which included $1,558,492 relating to the venture partner's deficit investment balance at that date, at August 31, 1993, of $67,479,871 (of which, the Partnership's share is $20,035,181) at Wells Fargo Center - IBM Tower, at September 30, 1993, of $916,309 at Villa Solana Apartments, and at December 31, 1993 of $7,534,763 at Springbrook Shopping Center. Such provisions generally reduce the net carrying values of the investment properties to the then outstanding balance of the related non- recourse mortgage notes. Deferred expenses are comprised principally of deferred financing fees which are amortized over the related debt term and deferred leasing fees which are amortized over the related lease term. Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due and/or increases in minimum lease payments over the term of the lease, the Partnership accrues prorated rental income for the full period of occupancy on a straight-line basis. Statement of Financial Accounting Standards No. 107 ("SFAS 107"), "Disclosures about Fair Value of Financial Instruments", requires entities with total assets exceeding $150 million at December 31, 1993 to disclose the SFAS 107 value of all financial assets and liabilities for which it is practicable to estimate. Value is defined in the Statement as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The Partnership believes the carrying amount of its current assets and liabilities (excluding current portion of long-term debt) approximates SFAS 107 value due to the relatively short maturity of these instruments. There is no quoted market value available for any of the Partnership's other instruments. As the debt secured by the RiverEdge Place Building and Park at Countryside Apartments investment properties has been classified by the Partnership as a current CARLYLE REAL ESTATE LIMITED PARTNERSHIP - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED liability at December 31, 1993 as a result of defaults (see notes 4(b)(i) and 4(b)(iv)), and because the resolution of such defaults is uncertain, the Partnership considers the disclosure of the SFAS 107 value of such long-term debt to be impracticable. The remaining debt, with a carrying balance of $319,790,235, has been calculated to have a SFAS 107 value of $311,472,146 by discounting the scheduled loan payments to maturity. Due to restrictions on transferability and prepayment, and the inability to obtain comparable financing due to previously modified debt terms or other property specific competitive conditions, the Partnership would be unable to refinance these properties to obtain such calculated debt amounts reported (see note 4). The Partnership has no other significant financial instruments. Certain reclassifications have been made to the 1992 and 1991 consolidated financial statements to conform with the 1993 presentation. No provision for State or Federal income taxes has been made as the liability for such taxes is that of the partners rather than the Partnership. However, in certain instances, the Partnership has been required under applicable law to remit directly to the tax authorities amounts representing withholding from distributions paid to partners. (2) INVESTMENT PROPERTIES (a) General The Partnership has acquired, either directly or through joint ventures, interests in four apartment complexes, twelve office buildings, four shopping centers and one parking facility. The Partnership's aggregate cash investment, excluding certain related acquisition costs, was $299,637,926. During 1989, the Partnership disposed of its interest in the investment property owned by CBC Investment Company ("Boatmen's") (note 3(b)(i)). During 1991, the Partnership sold 62% of its interest in Harbor and in 1993 sold its remaining 38% interest in Harbor (note 7). In September 1992, the Partnership sold the Erie-McClurg Parking Facility (note 7). In June 1993, the Partnership sold its interest in Owings Mills Shopping Center (note 7). All of the properties owned at December 31, 1993 were completed and operating. The cost of the investment properties represents the total cost to the Partnership or its ventures plus miscellaneous acquisition costs. Deprecia- tion on the operating properties has been provided over the estimated useful lives of 5-30 years using the straight-line method. All investment properties are pledged as security for the long-term debt, for which generally there is no recourse to the Partnership. Maintenance and repair expenses are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. (b) RiverEdge Place Building The RiverEdge Place Building (formerly the First American Bank Building) was 100% leased to an affiliate of the major tenant, First American Bank, under a long-term over-lease executed in connection with the purchase of the property. The Bank and its affiliate approached the Partnership and indicated that they were experiencing significant financial difficulties. On June 23, 1992, the Partnership reached an agreement with the Bank and received cash and U.S. Government securities valued at $9,325,000 for the buy-out of the Bank's over-lease obligations. The termination of the Bank's over-lease obligations yielded an approximately $1,591,000 reduction in accrued rents receivable. The Partnership took these courses of action due to the First American Bank's CARLYLE REAL ESTATE LIMITED PARTNERSHIP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED deteriorating financial condition and the Federal Deposit Insurance Corporation's ability to assume control of the Bank and to terminate the over- lease obligation. The $9,325,000 buy-out was concurrently remitted to the lender to reduce the mortgage note secured by the RiverEdge Place Building and the Partnership continues to negotiate with the lender to restructure the mortgage note in order to reduce operating deficits anticipated as a result of the over-lease buy-out (see note 4(b)(iv)). Additionally, the tenant lease with First American Bank for approximately 120,000 square feet of space was assigned to and assumed by SouthTrust Bank of Georgia in connection with that bank's acquisition of most of the remaining assets of First American Bank. Effective August 1, 1992, the Partnership restructured the lease with SouthTrust Bank of Georgia reducing the tenant's space to approximately 92,000 square feet, as well as, reducing the effective rent on the retained space in exchange for an extension of the lease term from April 1994 to July 2002. The restructuring of SouthTrust Bank's lease reduced the occupied space of the RiverEdge Place Building from 96% to 85% at that time. The Partnership is actively pursuing replacement tenants for the building's vacant space including the space taken back from the SouthTrust lease restructuring. (c) 21900 Burbank Boulevard Building The 21900 Burbank Building sustained some damage as a result of the earthquakes that occurred in January 1994 in southern California. Preliminary estimates of the damage range from $200,000 to $500,000. Much of this damage occurred within tenant premises in the building. The Partnership does not believe it has any significant obligations to reimburse tenants for such repairs. While the Partnership carried earthquake insurance on this property, it is anticipated that the total damages will not exceed the policy's deductible amount. (d) Springbrook Shopping Center In October 1993, a tenant occupying 20% of the space at the Springbrook Shopping Center vacated upon expiration of its lease. The Partnership is actively pursuing replacement tenants for the vacant space. (e) Erie-McClurg Parking Facility The mortgage note secured by the Erie-McClurg Parking Facility was scheduled to mature May 1, 1992. The Partnership negotiated with the underlying lender and received an extension of the note's maturity to September 30, 1992. On September 25, 1992, the Partnership sold the Erie- McClurg Parking Facility to an unaffiliated third party for a price of $18,700,000 (before selling costs and prorations) (note 7). (f) Woodland Hills Apartments Effective February 1, 1991, the seller/manager has agreed to guarantee a level of cash flow from the property equal to the underlying debt service in return for a subordinated level of cash flow (payable as an incentive management fee) from operations and sale or refinancing of the property. The underlying debt which consists of first and second mortgage notes secured by the property is scheduled to mature in June 1994. The Partnership plans to refinance the notes when they mature, although there is no assurance the Partnership will be able to obtain such financing (see note 4(c)). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (3) VENTURE AGREEMENTS (a) Introduction The Partnership (or Carlyle-XV Associates, L.P., in which the Partnership holds a limited partnership interest) has entered into eight joint venture agreements (JMB/Piper, JMB/Piper II, JMB/900, JMB/Owings, JMB/125, 260 Franklin, Villages Northeast and JMB/NewPark) with Carlyle Real Estate Limited Partnership-XIV ("Carlyle-XIV") or Carlyle Real Estate Limited Partnership-XVI (or Carlyle-XVI Associates, L.P., in which Carlyle Real Estate Limited Partnership-XVI holds a limited partnership interest) ("Carlyle-XVI"), partnerships sponsored by the Corporate General Partner, and eight joint venture agreements with unaffiliated venture partners. Pursuant to such agreements, the Partnership made initial capital contributions of approximately $247,300,000 (before legal and other acquisition costs and its share of operating deficits as discussed below). The terms of these affiliated partnerships provide, in general, that the benefits of ownership, including tax effects, net cash receipts and sale and refinancing proceeds, are allocated between or distributed to, as the case may be, the Partnership and the affiliated partner in proportion to their respective capital contributions to the affiliated venture. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partner(s) in an investment might become unable or unwilling to fulfill its (their) financial or other obligations, or that such joint venture partner(s) may have economic or business interests or goals that are inconsistent with those of the Partnership. Under certain circumstances, either pursuant to the venture agreements or due to the Partnership's obligations as a general partner, the Partnership may be required to contribute additional amounts to the venture. During 1989, the Partnership disposed of its interest in the Boatmen's venture (note 3(b)(i)). During 1991, the Partnership sold a portion of its interest in the Harbor venture (note 7). In January 1993, the Partnership sold the remaining portion of its interest in the Harbor venture and in June 1993, the Partnership sold its interest in the JMB/Owings Mills joint venture (note 7). (b) Consolidated Ventures The terms of the 260 Franklin venture have been described, in general, above (note 3(a)). The terms of the Eastridge, Park, 160 Spear, Villa Solana, Cal Plaza and VNE Partners ventures can be described in general, as follows: In most instances, these properties were acquired (as completed) for a fixed purchase price; however, certain properties were developed by the ventures and in those instances, the contributions of the Partnership are generally fixed. The joint venture partner was required to contribute any excess of cost over the aggregate amount available from Partnership contributions and financing. To the extent such funds exceed the aggregate costs, the venture partner was entitled to retain such excesses. The venture properties have been financed under various long-term debt arrangements as described in note 4. The Partnership generally has a cumulative preferred interest in net cash receipts (as defined) from the properties. Such preferential interest relates to a negotiated rate of return on contributions made by the Partnership. After the Partnership receives its preferential return, the venture partner is generally entitled to a non-cumulative return on its interest in the venture; additional net cash receipts are generally shared in a ratio relating to the CARLYLE REAL ESTATE LIMITED PARTNERSHI NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED various ownership interests of the Partnership and its venture partners. During 1993, 1992 and 1991, three, four and four, respectively, of the ventures' properties produced net cash receipts. The Partnership also has preferred positions (related to the Partnership's cash investment in the ventures) with respect to distribution of net sale or refinancing proceeds from the ventures. In general, operating profits and losses are shared in the same ratio as net cash receipts; however, if there are no net cash receipts, substantially all profits or losses are allocated to the Partnership. In addition, generally amounts equal to certain expenses paid from capital contributions by the Partnership or venture partners are allocated to the contributing partner or partners. (i) Boatmen's During 1989 the joint venture defaulted on the mortgage loan secured by the property, and the lender obtained title to the property. As a result, the Partnership has no further ownership interest in the property. On May 31, 1990, the Partnership entered into an agreement with the joint venture partners to settle certain claims against the joint venture partners. The settlement provided that the Partnership would receive payments totalling $2,325,000. As of December 31, 1993 the Partnership has received cash payments totalling $1,910,937. Two of the venture partners were delinquent under the scheduled payments in the amount of $414,063 as of December 31, 1993. These joint venture partners had requested extensions of the promissory notes and the Partnership is currently considering their requests. To preserve its legal rights, the Partnership served the delinquent partners with notices of default. The Partnership has recognized revenue on the settlement to the extent of the cash collected. There is no assurance that the remaining delinquent payments will be collected. (ii) Park In November 1991, Park modified the mortgage note secured by Park at Countryside Apartments effective January 1, 1990 (note 4(b)). In October 1993, the joint venture ceased making the required debt service payments, and commenced discussions with the lender regarding an additional modification of the loan. However, the venture was unable to secure an additional modification of the loan. Therefore, as of the date of this report, the loan is in default and the lender has initiated procedures to obtain title to the property. As a result of an amendment to the joint venture agreement, an affiliate of the joint venture partners agreed to manage the property without compensation from January 1, 1990 through December 31, 1995. (iii) Cal Plaza In August 1990, the joint venture partner filed a lawsuit against the Partnership, the General Partners of the Partnership and certain of their affiliates, alleging, among other things, breaches of the joint venture agreement and fraud. The Partnership filed a counter claim against the joint venture partner for breaches of the joint venture agreement and property management agreement. In November 1991, the Partnership and the joint venture partner reached a settlement resolving certain claims between the two parties. Under the terms of the settlement agreement, the obligation of the venture partner to indemnify Cal Plaza for payment on promissory notes issued to a tenant was revised (see note 10) and previously escrowed amounts were made available for 1991 cash flow requirements. In December 1993, the venture reached an agreement with the lender to modify the mortgage note, effective February 1993. The accrual rate of the note remains at 10.375%, but the interest only monthly payments are based on CARLYLE REAL ESTATE LIMITED PARTNERSHIP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED an interest rate of 8% per annum. The maturity date of the note has been extended from January 1, 1997 to January 1, 2000, and property cash flows are required to be escrowed as more fully described in note 4(b)(vi). (c) Significant Unconsolidated Ventures (i) JMB/Piper In 1984, the Partnership acquired, through a joint venture partnership ("JMB/Piper") with Carlyle-XIV, an interest in three existing joint ventures (OB Joint Venture, OB Joint Venture II and 222 South Ninth Street Limited Partnership, together "Piper") with the developer and certain limited partners which own a 42-story office building known as the Piper Jaffray Tower in Minneapolis, Minnesota. As of December 31, 1993, two of the limited partners are primary tenants in the office building and hold a 25% interest in the land and building ventures. The third limited partner holds a 4% interest in the building venture; however, on January 15, 1992, it returned its 4% interest in the land venture to 222 South Ninth Street Limited Partnership (as discussed below). In April 1986, JMB/Piper II, a joint venture partnership between the Partnership and Carlyle-XIV, acquired the developer's interest in the OB Joint Venture as discussed below. The terms of the JMB/Piper and JMB/Piper II venture agreements generally provide that JMB/Piper's and JMB Piper II's respective shares of Piper's annual cash flow, sale or refinancing proceeds and profits and losses will be distributed or allocated to the Partnership in proportion to its 50% share of capital contributions. JMB/Piper invested approximately $19,915,000 for its 71% interest in Piper. JMB/Piper is obligated to loan amounts to Piper to fund operating deficits (as defined). The loans bear interest at a rate of not more than 14.36% per annum, provide for payments of interest only from net cash flow, if any, and are repayable from net sale or refinancing proceeds. Such loans and accrued interest was approximately $63,214,000 and $53,729,000 at December 31, 1993 and 1992, respectively. The Partnership and the affiliated partner, Carlyle-XIV, have contributed to JMB/Piper the funds required for such loans. In August 1992, the venture signed an agreement with the lender, effective April 1, 1991, to modify the terms of the mortgage notes which are secured by the investment property. The principal balance of the mortgage notes has been consolidated into one note in the amount of $100,000,000. Under the terms of the modification, commencing on April 1, 1991 and continuing through and including January 30, 2020, fixed interest will accrue and is payable on a monthly basis at a $10,250,000 per annum level. Contingent interest is payable in annual installments on April 1 and is computed at 50% of gross receipts, as defined, for each fiscal year in excess of $15,200,000; none was due for 1991, 1992 or 1993. In addition, to the extent the investment property generates cash flow after payment of the fixed interest on the mortgage, contingent interest, leasing and capital costs, and 29% of the ground rent (25% after January 15, 1992 as a result of the Larkin, Hoffman, Daly & Lindgren, Ltd. settlement discussed below), such amount will be paid to the lender as a reduction of the principal balance of the mortgage loan. The excess cash flow generated by the property in 1992 totalled $923,362 and was remitted to the lender during the third quarter of 1993. During 1993, the excess cash flow generated under this agreement was $1,390,910 and will be remitted to the lender during the second quarter of 1994. On a monthly basis, the venture deposits the property management fee into an escrow account to be used for future leasing costs to the extent cash flow is not sufficient to cover such items. The manager of the property (which is an affiliate of the Corporate General Partner) has agreed to defer receipt of its management fee until a later date. As of December 31, 1993, the manager has deferred approximately $1,792,000 of management fees. If upon sale or refinancing as discussed below, there are funds remaining in this escrow after payment of amounts owed to the lender, such funds will be paid to the manager to the extent of its deferred and unpaid management fees. Any CARLYLE REAL ESTATE LIMITED PARTNERSHIP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED remaining unpaid management fees would be payable out of the venture's share of sale of refinancing proceeds. Additionally, pursuant to the terms of the loan modification, effective January 1992, OB Joint Venture, as majority owner of the underlying land, began deferring receipt of it share of land rent. These deferrals will be payable from potential net sale or refinancing proceeds, if any. Furthermore, pursuant to the loan modification, the venture can prepay the mortgage note beginning February 1, 1996. The prepayment fee is equal to the sum of (i) 6% of the amount prepaid declining 1/2 of 1% per annum to a minimum of 1%; (ii) from the greatest of: (1) net sale proceeds or (2) net refinance proceeds or (3) the net appraised value (all as defined), an amount until the lender has received an internal rate of return of 12% per annum if prepayment occurs between February 1, 1996 and February 1, 1997; 12 3/4% if prepayment occurs between February 1, 1997 and February 1, 1998; and 13.59% per annum thereafter; and (iii) after the lender has received the internal rate of return as noted above, the next $10,000,000 of net proceeds (as determined in (ii) above) will be distributed 50% to the lender and 50% to the venture, the next $10,000,000 - 40% to the lender and 60% to the venture, the next $10,000,000 - 30% to the lender and 70% to the venture, the next $10,000,000 - 20% to the lender and 80% to the venture, and the remaining proceeds - 10% to the lender and 90% to the venture. For financial reporting purposes, interest expense has been accrued at a rate of 13.59% per annum which is the estimated minimum internal rate of return assuming the note is held to maturity. In order for the venture to share in future net sale or refinancing proceeds, there must be a significant improvement in current market and property operating conditions resulting in a significant increase in value of the property. The Piper venture agreements provide that any net cash flow, as defined, will be used to pay interest on any operating deficit loans (as described above) with any excess generally distributable 71% to JMB/Piper and 29% to the venture partners, subject to certain adjustments (as defined). In general, operating profits or losses are allocated in relation to the economic interests of the venture partners. Accordingly, operating profits and losses (excluding depreciation and amortization) were allocated 71% to the General Partner and 29% to limited partners during 1993 and 100% to the General Partner during 1992. The Piper venture agreements further provide that, in general, upon any sale or refinancing of the property, the principal and any accrued interest outstanding on any operating deficit loans will be repaid. Any remaining proceeds will be distributable 71% to JMB/Piper and 29% to the joint venture partners, subject to certain adjustments, as defined. During the fourth quarter 1991, Larkin, Hoffman, Daly & Lindgren, Ltd. (23,344 square feet) approached the joint venture indicating that it was experiencing financial difficulties and desired to give back a portion or all of its leased space. Larkin's lease was scheduled to expire in January 2005 and provided for annual rental payments which were significantly higher than current market rental rates. Larkin was also an owner with partial interests in the building and the land under the building. After substantive review of Larkin's financial condition, on January 15, 1992, the joint venture signed an agreement with Larkin to terminate its lease in return for its partial interest (4%) in the land under the building and a $1,011,798 note payable to the joint venture. The note payable provides for monthly payments of principal and interest at 8% per annum with full repayment over ten years. Larkin may prepay all or a portion of the note payable at any time. During the third quarter of 1992, the joint venture executed a lease amendment with a major tenant and joint venture partner, Piper Jaffray Inc., which provides for (i) deletion of the tenant's option to terminate in March 1994 its leases on 21,508 square feet of space and 18,288 square feet of space which leases were to expire on March 2000 and March 1995, respectively, (ii) CARLYLE REAL ESTATE LIMITED PARTNERSH NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED extension of the lease term on its 18,288 square foot space to March 2000, (iii) rent reductions on the aggregate 39,796 square feet of space, (iv) lease expansions through March 2000 of 23,344 square feet (the former Larkin, Hoffman space) and 19,350 square feet on November 1992 and February 1993, respectively, at rental rates significantly below market, and (v) additional expansion options to lease up to an additional 94,210 square feet of space throughout the term of the lease. During the fourth quarter of 1993, the joint venture finalized a lease amendment with Popham, Haik, Schnobrich & Kaufman, Ltd. (104,843 square feet). The amendment provides for the extension of the lease term from February 1, 1997 to January 31, 2003 in exchange for a rent reduction effective February 1, 1994. In addition, the tenant will lease an additional 10,670 square feet effective August 1, 1995. The rental rate on the expansion space approximates market which is significantly lower than the reduced rental rate on the tenant's current occupied space. (ii) JMB/900 In 1984, the Partnership acquired, through JMB/900, an interest in an existing joint venture ("Progress Partners") which owns a 36-story office building known as the 900 Third Avenue Building in New York, New York. The partners of Progress Partners are the developer of the property and an affiliate of the developer (the "Venture Partners") and JMB/900. The terms of the JMB/900 venture agreement generally provide that JMB/900's share of Progress Partners' cash flow, sale or refinancing proceeds and profits and losses will be distributed or allocated to the Partnership in proportion to its 66-2/3% share of capital contributions. JMB/900 has made capital contributions to Progress Partners and certain payments to an affiliate of the developer, in the aggregate amount of $17,200,000, subject to the obligation to make additional capital contributions as described below. JMB/900 has also made a loan to the developer in the amount of $20,000,000 which is secured by the Venture Partners' interest in Progress Partners. The loan bears interest at the rate of 16.4% per annum and is payable in monthly installments of interest only until maturity on the earlier of the sale or refinancing of the property or August 2004. For financial reporting purposes, the loan is classified as an additional investment in Progress Partners and any related interest received would be accounted for as distributions (none in 1991, 1992 and 1993). To the extent that JMB/900 has not received annual distributions equal to the interest payable on such loan, the deficiency becomes a cumulative preferred return payable out of future net cash flow or net sale or refinancing proceeds. The Progress Partners venture agreement provides that the venture is required to pay the Venture Partners a stated return of $3,285,000 per annum. Generally, JMB/900 is required to contribute funds to the venture, to the extent net cash flow is not sufficient, to enable the venture to make this payment. Such amounts have not been paid as interest has not been received on the $20,000,000 loan discussed above. Under the terms of the Progress Partners' venture agreement, the Venture Partners are generally entitled to receive a non-cumulative preferred return of net cash flow of approximately $3,414,000 per annum, with any remaining net cash flow distributable 49% to JMB/900 and 51% to the Venture Partners. The Progress Partners venture agreement further provides that net sale or refinancing proceeds are distributable to JMB/900 and the Venture Partners, on a pro rata basis, in an amount equal to the sum of any deficiencies in the receipt of their respective cumulative preferred returns of net cash flow plus certain contributions to the venture made by JMB/900. Next, proceeds will be distributable to the Venture Partners in an amount equal to $20,000,000. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED JMB/900 is entitled to receive the next $21,000,000 and the Venture Partners will receive the next $42,700,000. Any remaining net proceeds are to be distributed 49% to JMB/900 and 51% to the Venture Partners. Operating profits, in general, are allocated 49% to JMB/900 and 51% to the Venture Partners. Operating losses, in general, are allocated 90% to JMB/900 and 10% to the venture partners. As a result of certain defaults by one of the unaffiliated joint venture partners, an affiliate of the General Partners assumed management responsibility for the property as of August 1987 for a fee computed as a percentage of certain revenues. Through December 31, 1991, it was necessary for JMB/900 to contribute approximately $4,364,000 ($2,909,000 of which was contributed by the Partnership) to pay past due property real estate taxes and to pay certain costs, including litigation settlement costs, which were the responsibility of one of the unaffiliated joint venture partners under the terms of the joint venture agreement to the extent such funds were not available from the investment property. In July 1989, JMB/900 filed a lawsuit in federal court against the former manager and one of the unaffiliated venture partners to recover the amounts contributed and to recover for certain other joint venture obligations on which the unaffiliated partner has defaulted. This lawsuit was dismissed on jurisdictional grounds. Subsequently, however, the Federal Deposit Insurance Corporation ("FDIC") filed a complaint, since amended, in a lawsuit against the joint venture partner, the Partnership and affiliated partner and the joint venture, which has enabled the Partnership and affiliated partner to refile its previously asserted claims against the joint venture partner as part of that lawsuit in Federal Court. There is no assurance that JMB/900 will recover the amounts of its claims as a result of the litigation. Due to the uncertainty, no amounts in addition to the amounts advanced to date, noted above, have been recorded in the financial statements. Settlement discussions with one of the venture partners and the FDIC continue. The FDIC has, in the past, been unwilling to consider a settlement until certain other issues it has with one of the unaffiliated venture partners are resolved. It appears that a resolution of those other issues may be near. There are no assurances that a settlement will be finalized and that the Partnership and affiliated partner will be able to recover any amounts from the unaffiliated venture partners. The joint venture negotiated an early lease termination agreement with a major tenant that vacated its space in June 1992. The joint venture terminated the lease (which was to expire in November 2000) for a fee of approximately $1.2 million (including arrearages). The Partnership is currently seeking a replacement tenant for the vacated space (14,700 square feet). The Midtown Manhattan office rental market remains very competitive. (iii) South Tower In June 1985, the Partnership acquired an interest in a joint venture partnership ("South Tower") which owns a 44-story office building in Los Angeles, California. The joint venture partners of the Partnership include Carlyle Real Estate Limited Partnership-XIV ("Affiliated Partner"), one of the sellers of the interests in South Tower, and another unaffiliated venture partner. The Partnership and the Affiliated Partner purchased their interests for $61,592,000. In addition, the Partnership and the Affiliated Partner made capital contributions to South Tower totaling $48,400,000 for general working capital requirements and certain other obligations of South Tower. The Partnership's share of the purchase price, capital contributions (net of additional financing) and interest thereon totaled $53,179,000. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The terms of the South Tower agreement generally provide that the Partnership and Affiliated Partner's aggregate share of the South Tower's annual cash flow, net sale or refinancing proceeds, and profits and losses are to be distributed or allocated to the Partnership and the Affiliated Partner in proportion to their aggregate capital contributions. Annual cash flow will be distributed 80% to the Partnership and Affiliated Partner and 20% to another partner until the Partnership and the Affiliated Partner have received, in the aggregate, a cumulative preferred return of $8,050,000 per annum. The remaining cash flow is to be distributable 49.99% to the Partnership and the Affiliated Partner, and the balance to the other joint venture partners. Additional contributions to South Tower were contributed 49.99% by the Partnership and the Affiliated Partner until all partners had contributed $10,000,000 in aggregate. Operating profits and losses, in general, are to be allocated 49.99% to the Partnership and the Affiliated Partner and the balance to the other joint venture partners. Substantially all depreciation and certain expenses paid from the Partnership's and Affiliated Partner's capital contributions are to be allocated to the Partnership and Affiliated Partner. In addition, operating profits, up to the amount of any annual cash flow distribution, are allocated to all partners in proportion to such distributions of annual cash flow. In general, upon sale or refinancing of the property, net sale or refinancing proceeds will be distributed 80% to the Partnership and the Affiliated Partner and 20% to another partner until the Partnership and the Affiliated Partner have received the amount of any deficiency in their preferred cash flow distributions described above plus an amount equal to their "Disposition Preference" (which, in general, begins at $120,000,000 and increases annually by $8,000,000 to a maximum of $200,000,000). Any remaining net sale or refinancing proceeds will be distributed 49.99% to the Partnership and the Affiliated Partner and the remainder to the other partners. The office building is being managed by an affiliate of one of the venture partners under a long-term agreement pursuant to which the affiliate is entitled to receive a monthly management fee of 2-1/2% of gross project income, a tenant improvement fee of 10% of the cost of tenant improvements, and commissions on new leases. The mortgage note secured by the property, as well as the promissory note secured by the Partnership's interest in the joint venture are scheduled to mature in December 1994. The promissory note secured by the Partnership's interest in the joint venture is classified at December 31, 1993 as a current liability in the accompanying consolidated financial statements. In view of, among other things, current and anticipated market and leasing conditions affecting the property including uncertainty regarding the amount of space, if any, which IBM will renew when its lease expires in December 1998, there is no assurance that the joint venture or the Partnership will be able to refinance these notes when they mature, the Partnership may then decide not to commit any significant amounts to the property. This may result in the Partnership no longer having an ownership interest in the property, and would result in a gain for financial reporting and for Federal income tax purposes with no corresponding distributable proceeds. (iv) JMB/125 In December 1985, the Partnership, through the JMB/125 joint venture partnership, acquired an interest in an existing joint venture partnership ("125 Broad") which owns a 40-story office building, together with a leasehold interest in the underlying land, located at 125 Broad Street in New York, New York. In addition to JMB/125, the other partners (the "O&Y partners") of 125 Broad include O&Y 25 Realty Company L.P., Olympia & York Broad Street Holding Company L.P. (USA) and certain other affiliates of Olympia & York Development, Ltd. ("O&Y"). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED JMB/125 is a joint venture between Carlyle-XV Associates, L.P. (in which the Partnership holds a 99% limited partnership interest), Carlyle-XVI Associates, L.P. and Carlyle Advisors, Inc. The terms of the JMB/125 venture agreement generally provide that JMB/125's share of 125 Broad's annual cash flow and sale or refinancing proceeds will be distributed or allocated to the Partnership in proportion to its (indirect) approximate 60% share of capital contributions to JMB/125. In April 1993 JMB/125, originally a general partnership, was converted to a limited partnership, and the Partnership's interest in JMB/125, which previously has been held directly, was converted to a limited partnership interest and was contributed to Carlyle-XV Associates, L.P. in exchange for a limited partnership interest in Carlyle-XV Associates, L.P. As a result of these transactions, the Partnership currently holds, indirectly through Carlyle-XV Associates, L.P., an approximate 60% limited partnership interest in JMB/125. The general partner in each of JMB/125 and Carlyle-XV Associates, L.P. is an affiliate of the Partnership. For financial reporting purposes, profits and losses of JMB/125 are generally allocated 60% to the Partnership. JMB/125 acquired an approximately 48.25% interest in 125 Broad for a purchase price of $16,000,000, subject to a first mortgage loan of $260,000,000 and a note payable to an affiliate of the joint venture partners in the amount of $17,410,516 originally due September 30, 1989. In June 1987, the note payable was consolidated with the first mortgage loan forming a single consolidated note in the principal amount of $277,410,516. The consolidated note bears interest at a rate of 10-1/8% per annum payable in semi-annual interest only payments and matures on December 27, 1995. JMB/125 has also contributed $14,055,500 to 125 Broad to be used for working capital purposes and to pay an affiliate of O&Y for its assumption of JMB/125's share of the obligations incurred by 125 Broad under the "takeover space" agreement described below. In addition, JMB/125 contributed $24,222,042, plus interest thereon of approximately $1,089,992 on June 30, 1986 for working capital purposes. Thus, JMB/125's original cash investment, exclusive of acquisition costs, was $55,367,534, of which the Partnership's share was approximately $33,220,000. The land underlying the office building is subject to a ground lease which has a term through June 2067 and provides for annual rental payments of $1,075,000. The terms of the ground lease grant 125 Broad a right of first refusal to acquire the fee interest in the land in the event of any proposed sale of the land during the term of the lease and an option to purchase the fee interest in the land for $15,000,000 at 10-year intervals (the next option date occurring in 1994). The partnership agreement of 125 Broad, as amended, provides that the O&Y partners are obligated to make advances to pay operating deficits incurred by 125 Broad from the earlier of 1991 or the achievement of a 95% occupancy rate of the office building through 1995. In addition, from closing through 1995, the O&Y partners are required to make capital contributions to 125 Broad for the cost of tenant improvements and leasing expenses up to certain specified amounts and to make advances to 125 Broad to the extent such costs exceed such specified amounts and such costs are not paid for by the working capital provided by JMB/125 or the cash flow of 125 Broad. The amount of all costs for such tenant improvements and leasing expenses over the specified amounts and the advances for operating deficits from the earlier of the achievement of a 95% occupancy rate of the office building or 1991 will be treated by 125 Broad as non-recourse loans bearing interest, payable monthly, at the floating prime rate of an institutional lender. The interest rate in effect at December 31, 1993 was 6%. The amount of such outstanding O&Y partner non- recourse loans was approximately $14,650,000 at December 31, 1993. Due to a major tenant vacating in 1991 and the O&Y affiliates' default under the "takeover space" agreement, the property operated at a deficit in 1993 and is expected to operate at a deficit for the next several years. Such deficits are required to be funded by additional loans from the O&Y partners, although as discussed below the O&Y partners have been in default of such funding obligation since June 1992. The outstanding principal balance and any accrued CARLYLE REAL ESTATE LIMITED PARTNERS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED and unpaid interest of such loans will be payable from 125 Broad's annual cash flow or net sale or refinancing proceeds, as described below. Any unpaid principal of such loans and any accrued and unpaid interest thereon will be due and payable on December 31, 2000. JMB/125 and the O&Y partners are obligated to make capital contributions, in proportion to their respective interests in 125 Broad, in amounts sufficient to enable 125 Broad to pay any excess expenditures not covered by the capital contributions or advances of the O&Y partners described above. The 125 Broad partnership agreement also provides that beginning in 1991 annual cash flow, if any, is distributable first to JMB/125 and to the O&Y partners in certain proportions up to certain specified amounts. Next, the O&Y partners are entitled to repayment of principal and any accrued but unpaid interest on the loans for certain tenant improvements, leasing expenses and operating deficits described above, and remaining annual cash flow, if any, is distributable approximately 48.25% to JMB/125 and approximately 51.75% to the O&Y partners. In general, operating profits or losses are allocable approximately 48.25% to JMB/125 and approximately 51.75% to the O&Y partners, except for certain specified items of profits or losses which are allocable to JMB/125 or the O&Y partners. The 125 Broad partnership agreement further provides that, in general, upon sale or refinancing of the property, net sale or refinancing proceeds (after repayment of the outstanding principal balance and any accrued and unpaid interest on any loans from the O&Y partners described above) are distributable approximately 48.25% to JMB/125 and approximately 51.75% to the O&Y partners. In the event of a dissolution and liquidation of the joint venture, the terms of the joint venture agreement between the O&Y partners and JMB/125 provide that if there is a deficit balance in the tax basis capital account of JMB/125, after the allocation of profits or losses and the distribution of all liquidation proceeds, then JMB/125 generally would be required to contribute cash to the joint venture in the amount of its deficit capital account balance. Taxable gain arising from the sale or other disposition of the joint venture's property would be allocated to the joint venture partner or partners then having a deficit balance in its or their respective capital accounts in accordance with the terms of the joint venture agreement. However, if such taxable gain is insufficient to eliminate the deficit balance in its account in connection with a liquidation of the joint venture, JMB/125 would be required to contribute funds to the joint venture (regardless of whether any proceeds were received by JMB/125 from the disposition of the joint venture's property) to eliminate any remaining deficit account balance. The Partnership's liability for such contribution, if any, would be its share, if any, of the liability of JMB/125 and would depend upon, among other things, the amounts of JMB/125's and the O&Y partners' respective capital accounts at the time of a sale or other disposition of 125 Broad's property, the amount of JMB/125's share of the taxable gain attributable to such sale or other disposition of 125 Broad's property and the timing of the dissolution and liquidation of 125 Broad. In such event, the Partnership could be required to sell or dispose of other assets in order to satisfy any obligation attributable to it as a partner of JMB/125 to make such contribution. Although the amount of such liability may be material, the Limited Partners of the Partnership would not be required to make additional contributions of capital to satisfy the obligation, if any, of the Partnership. As described above, the terms of the joint venture agreement provide that the O&Y partners are obligated to advance to the joint venture, in the form of interest-bearing loans, amounts required to pay operating deficits and capital improvement costs incurred during 1991 through 1995. O&Y and certain of its affiliates have been involved in bankruptcy proceedings in the United States and Canada and similar proceedings in England. During 1993, O & Y emerged from bankruptcy protection in Canada. In addition, a reorganization of the CARLYLE REAL ESTATE LIMITED PARTNERSHIP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED management of the company's United States operations has been completed, and certain O&Y affiliates are in the process of renegotiating or restructuring various loans affecting properties in the United States in which they have an interest. In view of the present financial conditions of O&Y and its affiliates and the anticipated deficits for the property, as well as the existing defaults of the O&Y partners, it appears unlikely that the O&Y partners will meet their financial and other obligations to JMB/125 and 125 Broad. In October 1993, 125 Broad entered into an agreement with Salomon Brothers, Inc. to terminate its lease covering approximately 231,000 square feet (17% of the building) at the property on December 31, 1993 rather than its scheduled termination in January 1997. In consideration for the early termination of the lease, Salomon Brothers, Inc. paid 125 Broad approximately $26,500,000, plus interest thereon of approximately $200,000, which 125 Broad in turn paid its lender to reduce amounts outstanding under the mortgage loan. In addition, Salomon Brothers, Inc. paid JMB/125 $1,000,000 in consideration of JMB/125's consent to the lease termination. Due to the O&Y partners' failure to advance necessary funds to 125 Broad as required under the joint venture agreement, 125 Broad defaulted on its mortgage loan in June 1992 by failing to pay approximately $4,722,000 of the semi-annual interest payment due on the loan. As a result of this default, the loan agreement provides for a default interest rate of 13-1/8% per annum on the unpaid principal amount. In addition, during 1992 affiliates of O&Y defaulted on a "takeover space" agreement with Johnson & Higgins, Inc. ("J&H"), one of the major tenants at the 125 Broad Street Building, whereby such affiliates of O&Y agreed to assume certain lease obligations of J&H at another office building in consideration of J&H's leasing space in the 125 Broad Street Building. As a result of this default, J&H has offset rent payable to 125 Broad for its lease at the 125 Broad Street Building in the amount of approximately $28,600,000 through December 31, 1993, and it is expected that J&H will continue to offset amounts due under its lease corresponding to amounts by which the affiliates of O&Y are in default under the "takeover space" agreement. As a result of the O&Y affiliates' default under the "takeover space" agreement and the continuing defaults of the O&Y partners to advance funds to cover operating deficits, as of the end of 1993, the arrearage under the mortgage loan had increased to approximately $48,180,000. As discussed above, approximately $26,700,000 was remitted to the lender in October 1993 in connection with the early termination of the Salomon Brothers lease, and was applied towards mortgage principal for financial reporting purposes. Due to their obligations relating to the "takeover space" agreement, the affiliates of O&Y are obligated for the payment of the rent receivable associated with the J&H lease at the 125 Broad Street Building. Based on the continuing defaults of the O&Y partners, 125 Broad has provided loss reserves for the entire rent offset by J&H, $19,300,000 and $9,300,000 in 1993 and 1992, respectively, and has also reserved approximately $32,600,000 of accrued rents receivable relating to such J&H lease, since the ultimate collectability of such amounts depends upon the O&Y partners' and the O&Y affiliates' performance of their obligations. The Partnership's share of such losses was approximately $5,587,000 and $12,159,000 for the years ended December 31, 1993 and 1992, respectively, and is included in the Partnership's share of loss from operations of unconsolidated venture. The O&Y partners have attempted to negotiate a restructuring of the mortgage loan with the lender in order to reduce operating deficits of the property. In view of, among other things, the significant operating deficits which the property is expected to incur during 1994 and for the next several years, it is unlikely that a restructuring of the mortgage will be obtained. The loan restructuring is part of a larger restructuring with the lender involving a number of loans secured by various properties in which O&Y affiliates have an interest. JMB/125 has notified the O&Y partners that their failure to advance funds to cover the operating deficits constitutes a default under the joint venture agreement. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Accordingly, it appears unlikely the O&Y partners will fulfill their obligations to 125 Broad and JMB/125. As a result, as discussed above, it appears unlikely that 125 Broad will be able to restructure the mortgage loan and JMB/125 is not likely to commit any significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property. If this event were to occur, the Partnership would recognize a net gain for financial reporting and Federal income tax purposes without any corresponding distributable proceeds. In addition, under certain circumstances, as discussed above, JMB/125 may be required to make an additional capital contribution to 125 Broad in order to make up a deficit balance in its capital account. The O&Y partners and certain other O&Y affiliates reached an agreement with the City of New York to defer the payment of real estate taxes owed in July 1992 on properties in which O&Y affiliates have an ownership interest, including the 125 Broad Street Building. Payment of the real estate taxes was made in six equal monthly installments from July through December, 1992. Interest on the deferred amounts was paid in July 1992. A similar agreement to defer payment of real estate taxes owed in January, 1993 was entered into for the first six months of 1993. Interest on the deferred amounts was paid in January, 1993. Vacancy rates in the downtown Manhattan office market have increased substantially over the last several years. As a result, competition for tenants has increased, which has resulted in lower effective rents. The increased vacancy in the downtown Manhattan office market has resulted primarily from layoffs, cutbacks and consolidations by many financial service companies which, along with related businesses, dominate the submarket. This has resulted in uncertainty as to the joint venture partnership's ability to recover the net carrying value of the investment property through future operations and sales. As a matter of prudent accounting practice, a provision for value impairment of such investment property of $14,844,420 was recorded as of December 31, 1991. The Partnership's share of such provision was $4,841,800 and was included in the Partnership's share of operations of unconsolidated ventures. Such provision was recorded to reduce the net book value of the investment property to the then outstanding balance of the related non-recourse financing and O&Y partner loans. The office building is being managed pursuant to a long-term agreement with an affiliate of the O&Y partners. Under the terms of the management agreement, the manager is obligated to manage the office building, collect all receipts from operations and to the extent available from such receipts pay all expenses of the office building. The manager is entitled to receive a management fee equal to 1% of gross receipts of the property. (v) JMB/NewPark In December 1986, the Partnership, through a joint venture partnership ("JMB/NewPark"), acquired an interest in an existing joint venture partnership ("NewPark Associates") with the developer which owns an interest in an existing enclosed regional shopping center in Newark, California known as NewPark Mall. JMB/NewPark acquired its 50% interest in NewPark Associates for a purchase price of $32,500,000 paid in cash at closing, subject to an existing first mortgage loan of approximately $23,556,000 and certain loans from the joint venture partner of approximately $6,300,000. In 1990, NewPark Associates reached an agreement with J.C. Penney to open an anchor store at NewPark Mall which opened in November 1991. Under the terms of the agreement, J.C. Penney built its own store and NewPark Associates constructed a parking deck to accommodate the addition of J.C. Penney to the center. NewPark Associates incurred costs of approximately $10,400,000 related to this addition, of which $2,000,000 was reimbursed by J.C. Penney. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The unaffiliated joint venture partner loaned NewPark Associates all of the funds to cover the costs incurred related to the addition. In December 1992, proceeds from the refinancing described below were used to repay all amounts due to the unaffiliated joint venture partner. On December 31, 1992, NewPark Associates refinanced the shopping center with an institutional lender. The new mortgage note payable in the principal amount of $50,620,219 is due on November 1, 1995. Monthly payments of interest only of $369,106 are due through November 30, 1993. Commencing on December 1, 1993 through October 30, 1995, principal and interest are due in monthly payments of $416,351 with a final balloon payment due November 1, 1995. Interest on the note payable accrues at 8.75% per annum. The joint venture has an option to extend the term of the mortgage note payable to November 1, 2000 upon payment of a $250,000 option fee and satisfaction of certain conditions as specified in the mortgage note. A portion of the proceeds from the note payable were used to pay the outstanding balance including accrued interest, under the previous mortgage note payable and the notes payable to the unaffiliated joint venture partner. NewPark Associates commenced a renovation that was substantially complete as of September 30, 1993. The NewPark Associates partnership agreement provides that JMB/NewPark and the joint venture partner are each entitled to receive 50% of profits and losses, net cash flow and net sale or refinancing proceeds of NewPark Associates and are each obligated to advance 50% of any additional funds equired under the terms of the NewPark Associates partnership agreement. The portion of the shopping center owned by NewPark Associates is managed by the unaffiliated joint venture partner under a long-term agreement pursuant to which it is obligated to manage the property and collect all receipts from operations of the property. The joint venture partner is paid a management fee equal to 4% of the fixed and percentage rent. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Included in the above total long-term debt is $10,411,883 and $6,868,462 for 1993 and 1992, respectively, which represents mortgage interest accrued but not currently payable pursuant to the terms of the notes. Five year maturities of long-term debt are as follows: 1994. . . . . . . . $103,244,992 1995. . . . . . . . 23,874,541 1996. . . . . . . . 87,025,453 1997. . . . . . . . 11,352,285 1998. . . . . . . . 504,393 ============ (b) Debt Modifications (i) Park In March 1988, the mortgage note secured by Park at Countryside Apartments located in Daytona Beach, Florida was modified to reduce the monthly installments payable and in November 1991, the mortgage note was further modified effective January 1, 1990 through December 31, 1995. The new agreement provides for minimum monthly interest payments of $18,033 (7.0% per annum) through 1991, $19,375 (7.5% per annum) for 1992, $20,667 (8.0% per annum) for 1993, $21,958 (8.5% per annum) for 1994 and $23,250 (9.0% per annum) for 1995. The contract rate on the loan will remain at 11.25% per annum. The deferrals, along with interest thereon, and the outstanding principal balance were to become due and payable at maturity on January 1, 1996. In October 1993, the joint venture ceased making the required debt service payments, and commenced discussions with the lender regarding an additional modification of the loan. However, the venture was unable to secure an additional modification of the loan. Therefore, as of the date of this report, the loan is in default and the lender has initiated procedures to obtain title to the property. (ii) 260 Franklin In December 1991, the affiliated joint venture reached an agreement with the lender to modify the terms of the long-term mortgage note secured by the 260 Franklin Street Building. During 1991, the affiliated joint venture made monthly payments of principal and interest, in the amount of $714,375, which reduced the outstanding balance to $74,891,013 as of April 30, 1991. The modified terms of the mortgage note provide for payments made relating to 1991, which were paid through April 1991, to be amortized based upon an accrued interest rate of 6%. Beginning May 1991, the modified mortgage note provides for monthly payments of interest only based upon the then outstanding balance at a rate of 6% per annum through January 1992 and 8% per annum thereafter. Upon the scheduled or accelerated maturity, or prepayment of the mortgage loan, the affiliated joint venture shall be obligated to pay an amount sufficient to provide the lender with an 11% per annum yield on the mortgage note from January 1, 1991 through the date of maturity or prepayment. In addition, upon maturity or prepayment, the affiliated joint venture is obligated to pay to the lender a residual interest amount equal to 60% of the CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED highest amount, if any, of (i) net sales proceeds, (ii) net refinancing proceeds, or (iii) net appraisal value, as defined. The affiliated joint venture is required to (i) escrow excess cash flow from operations, beginning in 1991, to cover future cash flow deficits (ii) make an initial contribution to the escrow account of $250,000, of which the Partnership's share was $175,000, and (iii) make annual escrow contributions through January 1995, of $150,000, of which the Partnership's share is $105,000. The escrow account is to be used to cover the costs of capital and tenant improvement and lease inducements which are the primary components of the anticipated operating deficits noted above ($726,983 as of December 31, 1993), as defined, with the balance, if any, of such escrowed funds available at the scheduled or accelerated maturity to be used for the payment of principal and interest due to the lender as described above. (iii) 160 Spear Street Building The Partnership reached an agreement, effective February 10, 1992, with the first mortgage lender to modify the mortgage note secured by the 160 Spear Street investment property, which was scheduled to mature on December 10, 1992. Under the terms of the agreement, the modified first mortgage note of approximately $33,750,000 and the second mortgage note of $5,435,000 require monthly debt service (reduced to interest only payments) of approximately $279,000 (9.3% per annum) and $58,000 (12.55% per annum), respectively, through February 10, 1995. Beginning March 10, 1995, monthly payments of principal and interest of approximately $337,000 are required through maturity of the loan, which is extended to February 10, 1999. Additionally, the Partnership is required to escrow net cash flow (as defined) thirty days following each quarter end which can be withdrawn for expenditures approved by the lender, by the lender upon default of the note or by the Partnership on February 10, 1997 when the escrow agreement terminates. As of December 31, 1993, $62,000 has been placed in, and withdrawn for expenditures approved by the lender, from the escrow account. (iv) RiverEdge Place Building On June 23, 1992, in connection with the buy-out of the over-lease (see note 2(b)), the Partnership remitted cash and U.S. Government securities valued at $9,325,000 to the lender reducing the balance of the mortgage note secured by the RiverEdge Place Building (formerly the First American Bank Building) to approximately $18,166,000. The Partnership ceased making its monthly debt service payments effective July 1, 1992. The Partnership is currently negotiating with the lender to restructure the mortgage note in order to reduce operating deficits anticipated as a result of the over-lease buy-out. If the Partnership's negotiations for mortgage note restructuring are not successful, the Partnership would likely decide, based upon current market conditions and other considerations relating to the property and the Partnership's portfolio, not to commit significant additional amounts to the property. This would result in the Partnership no longer having an ownership interest in the property and would result in the recognition of a gain for financial statement and Federal income tax purposes without any corresponding distributable proceeds. As of December 31, 1993, the amount of such principal and interest payments in arrears is approximately $5,451,000. Therefore, the loan has been classified at December 31, 1993 as a current liability in the accompanying consolidated financial statements. (v) Villages Northeast Effective October 6, 1992, the Villages Northeast joint venture, through a joint venture ("Post Associates") refinanced the first mortgage loan secured by the Dunwoody (Phase II) Apartments which had a principal balance at the date of refinancing of approximately $9,467,000. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The new first mortgage loan of $9,800,000 (from an institutional lender) bears interest of 7.64% per annum, is collateralized by the property and requires monthly payments of principal and interest of $73,316 beginning November 1, 1992 and continuing through November 1, 1997, when the remaining balance is payable. (vi) Cal Plaza Effective March 1, 1993, the joint venture ceased making the scheduled debt service payments on the mortgage loan secured by the property which was scheduled to mature on January 1, 1997. Subsequently, the Partnership made partial debt service payments based on net cash flow of the property through December 1993 when an agreement was reached with the lender to modify the loan. The accrual rate of the modified loan remains at 10.375% per annum while the pay rate is reduced to 8% per annum. The loan modification reduced the monthly payments to $384,505, effective with the March 1, 1993 payment. The maturity date is extended, as a result of this modification, to January 1, 2000 when the unpaid balance of principal and interest is due. Additionally, the joint venture entered into a cash management agreement which requires monthly net cash flow to be escrowed (as defined). The excess of the monthly cash flow paid from March 1993 to December 1993 above the 8% interest pay rate was put into escrow for the future payment of insurance premiums, real estate taxes, and to fund a reserve account to be used to cover future costs, including tenant improvements, lease commissions, and capital improvements, approved by the lender. The joint venture also was required to fund $500,000 into the reserve account. (c) Cancellation of Wrap Note In February 1991, the Partnership entered into an agreement with the seller of Woodland Hills Apartments. Under the terms of this agreement, the seller canceled its wrap-around mortgage note receivable from the Partnership and assumed management of the property (see notes 2(f) and 6). The obligations to make payments on the two underlying mortgage loans have been assumed by the Partnership. The mortgage note receivable wrapped around and was subordinate to a first and a second mortgage loan in the principal amounts of $6,800,000 and $1,256,667, respectively. The first mortgage loan bears interest at the rate of 12.8% per annum and requires monthly payments of interest only in arrears through June 1, 1994 when the entire principal balance and any accrued interest will be due and payable. The second mortgage loan bears interest at 11.7% per annum and requires monthly payments of interest only in arrears until June 1, 1994 when the entire principal balance and any accrued interest will be due and payable. The Partnership plans to refinance these notes when they mature, although there is no assurance the Partnership will be able to obtain such financing. The loans have been classified as current liabilities at December 31, 1993 in the accompanying consolidated financial statements. As a result of the seller's cancellation of the wrap-around mortgage note, an extraordinary gain totalling $1,014,538 was recognized in the 1991 consolidated financial statements. (5) PARTNERSHIP AGREEMENT Pursuant to the terms of the Partnership Agreement, net profits and losses of the Partnership from operations are allocated 96% to the Limited Partners and 4% to the General Partners. Profits from the sale or other dispositions of investment properties will be allocated first to the General Partners in an amount equal to the greater of the General Partners' share of cash distributions from the proceeds of any such sale or other dispositions (as described below) or 1% of the total profits from any such sales or other CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED dispositions, plus an amount which will reduce deficits (if any) in the General Partners' capital accounts to a level consistent with the gain anticipated to be realized from the sale of investment properties. Losses from the sale or other disposition of investment properties will be allocated 1% to the General Partners. The remaining sale or other disposition profit and losses will be allocated to the Limited Partners. The General Partners are not required to make any additional capital contributions except under certain limited circumstances upon dissolution and termination of the Partnership. "Net cash receipts" from operations of the Partnership will be allocated 90% to the Limited Partners and 10% to the General Partners (of which 6.25% constitutes a management fee to the Corporate General Partner for services in managing the Partnership). The Partnership Agreement provides that subject to certain conditions, the General Partners shall receive as a distribution from the sale of a real property by the Partnership up to 3% of the selling price, and that the remaining proceeds (net after expenses and retained working capital) be distributed 85% to the Limited Partners and 15% to the General Partners. However, prior to such distribution being made, the Limited Partners are entitled to receive 99% and the General Partners l% of net sale or refinancing proceeds until the Limited Partners (i) have received cash distributions of "sale proceeds" or "refinancing proceeds" in an amount equal to the Limited Partners' aggregate initial capital investment in the Partnership and (ii) have received cumulative cash distributions from the Partnership's operations which, when combined with "sale proceeds" or "refinancing proceeds" previously distributed, equal a 6% annual return on the Limited Partners' average capital investment for each year (their initial capital investment as reduced by "sale proceeds" or "refinancing proceeds" previously distributed) commencing with the first fiscal quarter of 1990. Accordingly, up to $561,000 of sale proceeds from Erie-McClurg Parking Facility for the General Partners has been deferred (see note 7). (6) MANAGEMENT AGREEMENTS The Partnership has entered into agreements for the operation and management of the properties. Such agreements are summarized as follows: At acquisition, management of the 9701 Wilshire Building and the Springbrook Shopping Center was assumed by affiliates of the Corporate General Partner. For a fee computed as a percentage of rental income, an affiliate of the Corporate General Partner assumed management of the 21900 Burbank Boulevard Building, the 260 Franklin Street Building, the Woodland Hills Apartments, the Villa Solana Apartments, the RiverEdge Place Building and Village Northeast Apartments in January 1988, May 1988, September 1989, December 1989, September 1992 and August 1993, respectively. The Partnership has also entered into agreements with certain joint venture partners or affiliates of the joint venture partners for the operation and management of properties owned by Eastridge, 160 Spear, Park, Boatmen's, Cal Plaza and VNE Partners. Certain of these agreements have been terminated. Reference is made to note 3(b). Such agreements generally provided for initial terms during which the managers or their affiliates pay all expenses of the properties and retain the excess, if any, of the cash revenues from operations over costs and expenses, as defined (including debt service requirements), as a management fee. Upon termination of the agreements, the properties are expected to be managed by an affiliate of the Corporate General Partner. In February 1991, management of the Woodland Hills Apartments was reassumed by the seller of this property (see notes 2(f) and 4(c)). CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (7) SALE OF INVESTMENT PROPERTIES (a) Erie-McClurg Parking Facility On September 25, 1992, the Partnership, through Erie-McClurg Associates, sold the Erie-McClurg Parking Facility located in Chicago, Illinois. The sale price was $18,700,000 (before selling costs and prorations), all of which was paid in cash at closing. A portion of the cash proceeds (approximately $7,612,000) was used to retire the first mortgage note secured by the property. An additional $6,335,000 of the proceeds was used to retire the Partnership's unsecured, non-revolving line of credit. Concurrently, with the sale of the Erie-McClurg Parking Facility, the Partnership entered into an agreement with the unaffiliated manager of the parking facility to induce the manager to re-write the existing long-term management agreement at less favorable terms to the manager (see note 2(e)). This agreement guarantees the manager 100% of the compensation which would have been earned under the agreement prior to the sale in years one through five and 50% of any potential difference between the management fee under the agreement prior to the sale and the re- negotiated agreement with the purchaser (as defined) in years six through eighteen. In connection with this agreement, at closing the Partnership paid the unaffiliated manager a partial settlement of $400,000 and has estimated the remaining contingent liability to be $360,000. This contingent liability is recorded as a long-term liability in the accompanying consolidated financial statements. The sale of the property has resulted in the Partnership's recognition of a gain of $506,446 for financial reporting purposes and $1,296,367 for Federal income tax purposes in 1992. (b) Owings Mills On June 30, 1993, JMB/Owings sold its partnership interest in Owings Mills Limited Partnership ("OMLP"), which owns an allocated portion of the land, building and related improvements of the Owings Mills Mall located in Owings Mills, Maryland. The purchaser, O.M. Investment II Limited Partnership, is an affiliate of the Partnership's joint venture partner in OMLP. The sale price of the interest in OMLP was $9,416,000, all of which was received in the form of a promissory note. In addition, the Partnership and Carlyle-XVI were relieved of their allocated portion of the debt secured by the property. The promissory note (which is secured by a guaranty from an affiliate of the purchaser and of the Partnership's joint venture partner in OMLP) bears interest at a rate of 7% per annum unless a certain specified event occurs, in which event the rate would increase to 8% per annum for the remainder of the term of the note. The promissory note requires principal and interest payments of approximately $109,000 per month with the remaining principal balance of approximately $5,500,000 due and payable on June 30, 1998. The monthly installment of principal and interest would be adjusted for the increase in the interest rate if applicable. Early prepayment of the promissory note may be required under certain circumstances, including the sale or further encumbrance of Owings Mills Mall. The net cash proceeds and gain from sale of the interest in OMLP was allocated 50% to the Partnership and 50% to Carlyle-XVI in accordance to the JMB/Owings Mills Associates partnership agreement. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED For financial reporting purposes, JMB/Owings recognized, on the date of sale, gain of $5,254,855, of which the Partnership's share is $2,627,427, attributable to JMB/Owings being relieved of its obligations under the OMLP partnership agreement pursuant to the terms of the sale agreement. The Partnership has adopted the cost recovery method until such time as the purchaser's initial investment is sufficient in order to recognize gain under Statement of Financial Accounting Standards No. #66. At December 31, 1993, the total deferred gain of JMB/Owings including principal and interest payments of $546,639 received through December 31, 1993 is $9,687,441 of which the Partnership's share is $4,843,720. (c) Harbor During 1991, the Partnership sold, 62% of its general partnership interest in Harbor, to an affiliate of the Harbor unaffiliated joint venture partners. The Partnership owned an 80% interest in Harbor prior to sale. Harbor owned a 55% general partnership interest in a joint venture which owned the leasehold interest on the land and owned the building and related improvements of the 300 East Lombard office building located in Baltimore, Maryland. The sale price for 62% of the Partnership's general partnership interest was $383,244, all of which was received in cash at closing. As of the date of the initial sale, the Partnership had a deficit capital account balance in the Harbor venture resulting from losses and distributions from the joint venture in an amount in excess of its original cash investment in the joint venture. As a result of the Partnership's initial sale of 62% of its interest and its simultaneous conversion to a limited partner, the Partnership eliminated its remaining deficit capital balance and recognized a total gain of $9,041,533 in 1991 for financial reporting purposes. In conjunction with the sale, the Partnership established a put-call option with the buyer on the Partnership's remaining interest in Harbor. On January 19, 1993, the Partnership sold the remaining 38% of its limited partnership interest in Harbor based on the buyer's exercise of the put-call option. The sale price for the Partnership's remaining interest was $229,140, plus $24,294 of interest accrued at 10% per annum from September 30, 1991 through the closing date, all of which was received in cash at closing. For financial reporting purposes in 1993, the Partnership recognized a gain on sale of the remaining interest of $229,140, which is included in gain on sale of interests in unconsolidated ventures in the accompanying financial statements. (8) NOTES RECEIVABLE In 1987 and 1988, the Partnership advanced funds to pay for certain deficits at the 21900 Burbank Boulevard Building which were the obligation of an affiliate of the seller. Such advances, including unpaid interest, were approximately $2,004,000 as of the date of this report. The Partnership received demand notes from the seller which are personally guaranteed by certain of its principals. The seller had been paying interest on the note at a rate equal to 3% over the prime rate. In February 1991, the seller ceased paying monthly interest required under terms of the note. The Partnership has put the seller in default and effective October 31, 1991, the note began accruing interest at the default rate. The Partnership is pursuing its legal remedies against the seller and certain of its principals. The collectibility of the amounts discussed above is uncertain. For financial reporting purposes, the Partnership ceased accruing interest on the note receivable as of February 1991. As a matter of prudent accounting policy, a reserve for uncollectibility for the entire amount recorded for financial reporting purposes ($1,466,051) has been reflected in the accompanying consolidated financial statements. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (9) LEASES (a) As Property Lessor At December 31, 1993, the Partnership and its consolidated ventures' principal assets are six office buildings, four apartment complexes and two shopping centers. The Partnership has determined that all leases relating to these properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of each of the properties, excluding cost of land, is depreciated over the estimated useful lives. Leases with commercial tenants range in term from one to 30 years and provide for fixed minimum rent and partial to full reimbursement of operating costs. In addition, substantially all leases with shopping center tenants provide for additional rent based upon percentages of tenant sales volume. With respect to the Partnership's shopping center investments, a substantial portion of the ability of retail tenants to honor their leases is dependent upon the retail economic sector. Apartment complex leases in effect at December 31, 1993 are generally for a term of one year or less and provide for annual rents of approximately $11,925,695. Cost and accumulated depreciation of the leased assets are summarized as follows at December 31, 1993: Office buildings: Cost. . . . . . . . . . . . . . . . . $278,922,521 Accumulated depreciation. . . . . . . 72,739,876 ------------ 206,182,645 ------------ Shopping centers: Cost. . . . . . . . . . . . . . . . . 46,856,107 Accumulated depreciation. . . . . . . 13,230,510 ------------ 33,625,597 ------------ Apartment complexes: Cost. . . . . . . . . . . . . . . . . 87,360,949 Accumulated depreciation. . . . . . . 22,026,935 ------------ 65,334,014 ------------ Total . . . . . . . . . . . . $305,142,256 ============ Minimum lease payments including amounts representing executory costs (e.g., taxes, maintenance, insurance), and any related profit in excess of specific reimbursements, to be received in the future under the above operating commercial lease agreements, are as follows: 1994. . . . . . . . . . . $ 35,330,429 1995. . . . . . . . . . . 28,530,858 1996. . . . . . . . . . . 18,689,562 1997. . . . . . . . . . . 13,786,253 1998. . . . . . . . . . . 11,363,918 Thereafter. . . . . . . . 31,075,046 ------------ Total . . . . . . . . $138,776,066 ============ CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (b) As Property Lessee The following lease agreement has been determined to be an operating lease: The Partnership owns through 160 Spear, a leasehold interest which expires in 2033 in the land underlying the 160 Spear Street Building. The ground lease provides that through the end of the lease term and each of the two ten-year renewal option periods, the rental payments will increase annually to equal the lesser of (i) 105-1/2% of $252,000, compounded annually, or (ii) $252,000 increased by the increase in a price index from August 1, 1987 through the commencement date of each subsequent lease year. Future minimum rental commitments under the lease are as follows: 1994. . . . . . . . . . . $ 374,724 1995. . . . . . . . . . . 374,724 1996. . . . . . . . . . . 374,724 1997. . . . . . . . . . . 374,724 1998. . . . . . . . . . . 374,724 Thereafter. . . . . . . . 13,115,340 ----------- Total. . . . . . . . $14,988,960 =========== (10) NOTES PAYABLE Pursuant to the terms of a tenant lease at Cal Plaza, promissory notes (for certain sub-leasing costs) aggregating $707,009 have been issued by the Cal Plaza joint venture to a tenant of the investment property. Commencing on July 1, 1990 and on each July 1st thereafter until the notes are paid in full, one tenth of the original principal balance together with 12% annual interest on the outstanding balance of the notes shall be payable. As the result of a settlement agreement between the Partnership and its joint venture partner, the joint venture partner is obligated to pay 40% of the amounts owed under the promissory notes and the Partnership is obligated to pay 60% of such amounts (see note 3(b)(iii)). During July 1991, principal of $70,701 and interest of $71,724 was paid to the tenant from cash flow generated from operations of the property. During July 1992, principal of $70,701 and interest of $68,788 was paid to the tenant from cash flow generated from operations of the property. During July 1993, principal of $70,701 and interest of $60,304 was paid to the tenant from cash flow generated from operations of the property. As of December 31, 1993, the outstanding balance of the notes was $431,836. (11) TRANSACTIONS WITH AFFILIATES The Corporate General Partner and its affiliates are entitled to reimbursement for salaries and direct expenses of officers and employees of the Corporate General Partner and its affiliates relating to the administration of the Partnership and the operation of the Partnership's properties. Fees, commissions and other expenses required to be paid by the Partnership (or in the case of property management and leasing fees, by the Partnership's consolidated ventures) to the General Partners and their affiliates as of December 31, 1993 and for the years ended December 31, 1993, 1992 and 1991 are as follows: CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV KPMG PEAT MARWICK Chicago, Illinois March 28, 1994 See accompanying notes to combined financial statements. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV CERTAIN UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 (1) ORGANIZATION AND BASIS OF ACCOUNTING The accompanying combined financial statements have been prepared for the purpose of complying with Rule 3.09 of Regulation S-X of the Securities and Exchange Commission. They include the accounts of certain of the unconsolidated joint ventures in which Carlyle Real Estate Limited Partnership-XV ("Carlyle-XV") owns a direct interest. Also included are the accounts of one of the joint venture partnerships (underlying ventures) in which Carlyle-XV owns an indirect interest through one of the unconsolidated joint ventures. The entities included in the combined financial statements are as follows: DATE VENTURE ACQUIRED ------- -------- 1. Maguire/Thomas Partners - South Tower ("South Tower") (a) 06/28/85 2. Carlyle - XV Associates, L.P. (a) - JMB/125 Broad Building Associates, L.P. 12/31/85 ("JMB/125") (a) - 125 Broad Street Company (b) Five year maturities of long-term debt are as follows: 1994 . . . . . . . . . $447,216,935 1995 . . . . . . . . . -- 1996 . . . . . . . . . -- 1997 . . . . . . . . . -- 1998 . . . . . . . . . -- ============ 1994 . . . . . . . . . . . $ 56,853,468 1995 . . . . . . . . . . . 57,634,891 1996 . . . . . . . . . . . 60,566,341 1997 . . . . . . . . . . . 57,362,986 1998 . . . . . . . . . . . 51,203,800 Thereafter . . . . . . . . 354,036,341 ------------ Total. . . . . . $637,657,827 ============ CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV CERTAIN UNCONSOLIDATED VENTURES NOTES TO COMBINED FINANCIAL STATEMENTS - CONCLUDED (b) As Property Lessee The 125 Broad Street Building is currently subject to a ground lease which has a term through June 2067. The future minimum rental commitments under these leases are as follows: 1994 . . . . . . . . . $ 1,075,000 1995 . . . . . . . . . 1,075,000 1996 . . . . . . . . . 1,075,000 1997 . . . . . . . . . 1,075,000 1998 . . . . . . . . . 1,075,000 Thereafter . . . . . . 74,175,000 ----------- Total. . . . $79,550,000 =========== The terms of the ground lease grant 125 Broad Street Company a right of first refusal to acquire the fee interest in the land in the event of any proposed sale of the land during the term of the lease and an option to purchase the fee interest in the land for $15,000,000 at ten-year intervals (the next option date occurring in 1994). SCHEDULE X CARLYLE REAL ESTATE LIMITED PARTNERSHIP CERTAIN UNCONSOLIDATED VENTURES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ---------------------------------------------- 1993 1992 1991 ----------- ---------- ---------- Depreciation . . . . . . . . $21,023,113 22,625,958 22,233,706 Repairs and maintenance. . . 5,968,953 6,291,955 6,490,736 Real estate taxes. . . . . . 14,578,166 15,863,796 14,635,888 Amortization of deferred expenses. . . . . 4,007,632 3,367,762 3,829,014 =========== ========== ========== ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes of or disagreements with accountants during fiscal year 1993 and 1992. PART III SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV By: JMB Realty Corporation Corporate General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date: March 28, 1994 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. By: JMB Realty Corporation Corporate General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date: March 28, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date: March 28, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date: March 28, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date: March 28, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date: March 28, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date: March 28, 1994 STUART C. NATHAN* By: Stuart C. Nathan, Executive Vice President and Director Date: March 28, 1994 *By: GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date: March 28, 1994 CARLYLE REAL ESTATE LIMITED PARTNERSHIP - XV EXHIBIT INDEX Document Incorporated By Reference Page ------------ ---- 3. Amended and Restated Agreement Yes of Limited Partnership of the Partnership, included as Exhibit A to the Partnership's Prospectus dated July 5, 1985. 4-A. Assignment Agreement, included as Yes Exhibit B to the Partnership's Prospectus dated July 5, 1985. 4-B. Documents relating to the modification of the mortgage loan secured by the 260 Franklin Street Building Yes 4-C. Documents relating to the modification of the mortgage loans secured by the 160 Spear Street Building Yes 4-D. Documents relating to the refinancing of the mortgage loan secured by the Post Crest Apartments Yes 10-A. through 10-R. * Exhibits 10.A through 10.R Yes are hereby incorporated herein by reference. 10-S. through 10-W. Exhibits 10-S. through 10-W. are hereby incorporated herein by reference. Yes 10-X. Agreement of Limited Partnership of Carlyle-XV Associates, L.P., dated April 19, 1993 between the Partnership and Carlyle Partners, Inc. relating to the 125 Broad Street Building is filed herewith. No 10-Y. Documents relating to the modification of the mortgage loan secured by California Plaza are filed herewith. No 21. List of Subsidiaries No 24. Powers of Attorney No - - -------------------- * Previously filed as Exhibits to the Partnership's Registration Statement (as amended) on Form S-11 (Filed No. 2-95382) of the Securities Act of 1933. AMENDED AND RESTATED ARTICLES OF PARTNERSHIP OF JMB/125 BROAD BUILDING ASSOCIATES These Amended and Restated Articles of Partnership made and entered into as of April 21, 1993, by and between Carlyle Advisors, Inc., a Delaware corporation (hereinafter referred to as "General Partner"), and Carlyle-XV Associates, L.P., an Delaware limited partnership, and Carlyle-XVI Associates, L.P., a Delaware limited partnership, as the limited partners (hereinafter collectively referred to as the "Limited Partners"). W I T N E S S E T H THAT WHEREAS, this partnership (hereinafter referred to as the "Partnership") was heretofore formed pursuant to the Uniform Partnership Act of the State of Illinois by Carlyle Real Estate Limited Partnership-XV, an Illinois limited partnership, and Carlyle Real Estate Limited Partnership-XVI, an Illinois limited partnership (hereinafter collectively referred to as the "Original Partners"); and THAT WHEREAS, the Original Partners have each individually assigned their respective partnership interests to the Limited Partners pursuant to that certain Amendment No. 1 to the Articles of Partnership of the Partnership (the "Agreement"); and THAT WHEREAS, the parties hereto desire to continue the partnership as a limited partnership pursuant to the Revised Uniform Limited Partnership Act as in effect in the State of Illinois, as amended (the "Act"), for the purposes and on the terms and conditions hereinafter set forth; and THAT WHEREAS, the General Partner desires to: (i) be admitted into the Partnership as a general partner, (ii) perform all of the duties and responsibilities of a general partner under the Act, and (iii) acquire a general partnership interest in the Partnership, and the Limited Partners, by their execution hereof, desire to evidence their consent to said admission and to the continuance of the Partnership as a limited partnership; and THAT WHEREAS, the parties hereto desire to amend and restate the partnership so that it appears in its entirety as follows. NOW THEREFORE, the undersigned hereby continue the partnership as a limited partnership under the provisions of the Act, except as hereinafter provided, for the purposes and on the terms and conditions as hereinafter set forth, and do hereby agree: 1. Name of Partnership. The name of the Partnership shall be "JMB/125 Broad Building Associates, L.P." 2. Character of the Partnership's Business. The character of the business of the Partnership will be to acquire, hold, and otherwise use for profit , either directly or indirectly, an interest in 125 Broad Street Company, a limited partnership formed pursuant to the Uniform Limited Partnership Act as in effect in the State of New York, which partnership owns the improvements on, together with a leasehold interest in, the land more particularly described on Exhibit A attached hereto, and to engage in any and all activities related or incidental thereto. Whenever the term "Property" appears in these Articles such term shall mean any property, real or personal, tangible or intangible, at any time owned by the Partnership, including the Partnership's interest in 125 Broad Street Company, and any property at any time owned by 125 Broad Street Company. 3. Location of the Principal Place of Business. The location of the principal place of business of the Partnership shall be 900 North Michigan Avenue, Chicago, Illinois 60611 or such other location as shall be designated by the Partners. 4. Names and Places of Residence of Partners. The names of the Partners of the Partnership and their respective addresse after each respective name as follows: General Partner Residence Carlyle Advisors, Inc. 900 North Michigan Chicago, IL 60611 Limited Partners Residence Carlyle-XV Associates, L.P. 900 North Michigan Chicago, IL 60611 Carlyle-XVI Associates, L.P. 900 North Michigan Chicago,IL 60611 As used herein, the term "Partner" shall refer to any of the General Partner or Limited Partners and the term "Partners" shall refer to the General Partner and the Limited Partners collectively and shall include their respective successors and assigns, as the case may be. 5. Term of Partnership. The term for which the Partnership shall exist shall be until December 31, 2035 unless sooner terminated as hereinafter provided. 6. Contributions of the Members of the Partnership. A. Contributions. The Original Partners have contributed the sums set forth opposite each Partner's name on the attached Exhibit B. Each of the Limited Partners have contributed hereto the partnership interests in the Partnership assigned to them by each of the Original Partners, respectively. In the event that any Partner makes an additional contributions to the Partnership or receives a return of all or part of its contributions to the Partnership, Exhibit B shall be promptly and appropriately amended to reflect such additional or returned contribution. B. Withdrawals of Capital. Except as otherwise herein provided, no Partner shall be entitled to withdraw capital or to receive distributions of or against capital without the prior written consent of, and upon the terms and conditions specified by, the General Partner. C. Capital Accounts. The Partnership shall maintain for each of the Partners a Capital Account, which shall be the aggregate amount of the contributions to the Partnership made by such Partner, as set forth in Exhibit B, reduced by the aggregate amount of any losses allocated, and any distributions of cash or the fair market value of other assets of the Partnership made, to such Partner and increased by the aggregate amount of any profits allocated to such Partner. D. Loans. Except as provided in Section 8D hereof, all advances or payments to the Partnership by any Partner shall be deemed to be loans by such Partner to the Partnership, and the Partner shall be entitled to interest thereon at such rates per annum as the General Partner may determine, and the same, together with interest as aforesaid, shall be repaid before any distribution shall be made hereunder to the other Partners. No such loan to the Partnership shall be made without the prior written consent of the General Partner and, unless all of the Partners otherwise agree, shall be required to be made by all of the Partners in proportion to their respective Partnership Shares (as hereinafter defined). 7. Partnership Shares. A. As used herein, "profits and losses" include, without limitation, each item of Partnership income, gain, loss and deduction as determined for Federal income tax purposes, and "Partnership Share" means the proportion which the aggregate capital contributions to the Partnership of a Partner bear to the aggregate capital contributions to the Partnership of all of the Partners as set forth in Exhibit B. All net profits or losses from the operations of the Partnership for a fiscal year or part thereof shall be allocated to the Partners based upon their respective Partnership Shares. Any credits of the Partnership for a fiscal year shall be allocated in the same manner as are profits of the Partnership pursuant to this Section 7A (without regard to Section 7B), except that any investment tax credit shall be allocated only among those Partners who were partners (for Federal income tax purposes) on the date the property with respect to which such credit is earned was placed in service. B. There shall be allocated to each Partner (i) the amount of any profits attributable to interest, "points", financing fees and other amounts paid by such Partner to the Partnership with respect to loans made by the Partnership to such Partner and (ii) the amount of any losses attributable to interest, "points", financing fees and other amounts paid by the Partnership to a third party lender with respect to borrowings incurred by the Partnership to make loans by the Partnership to such Partner. C. (i) All net profits or losses from the sale or other disposition of all or any substantial portion of the Property shall be allocated to the Partners in accordance with their respective Partnership Shares on the date on which the Partnership recognized such profits or losses for Federal income tax purposes. Notwithstanding allocations in the first sentence of this Section 7C(i) if, at any time profit or loss, as the case may be, is realized by the Partnership on the sale or other disposition of all or any substantial portion of the Property, the Capital Account balances of the Partners are not in the ratio of their respective Partnership Shares (the "Equalization Ratio"), then gain shall be allocated to those Partners whose Capital Account balances are less than they would be if they were in the Equalization Ratio (or loss shall be allocated to those Partners whose Capital Account balances are greater than they would be if they were in the Equalization Ratio), in either case up to and in proportion to the amount necessary to cause the Capital Account balances of the Partners to be in the Equalization Ratio and then in accordance with the first sentence in this Section 7C(i). Notwithstanding any adjustment of the allocation of profits or losses provided in this Agreement by any judicial body or governmental agency, the allocations of profits of losses provided in this Agreement shall control for purposes of this Agreement (or any amendment hereto pursuant to Section 12B), including without limitation, the determination of the Partners' Capital Accounts. (ii) The portion of any gain allocated under Section 7C(i) above that represents ordinary income attributable to "Unrealized Receivables" and "Substantially Appreciated Inventory Items", as such terms are defined in Section 751(c) and (d), respectively, of the Internal Revenue Code of 1954, as amended (the "Code"), shall be allocated among the Partners in the proportions in which depreciation deductions on the Partnership Property sold, or tax benefits attributable to or giving rise to such Unrealized Receivables or Substantially Appreciated Inventory Items, were originally allocated to their Partnership interests. No Partner shall relinquish such Partner's share of "Unrealized Receivables" (as such term is defined in Section 751(c) of the Code) attributable to depreciation recapture in the case of a distribution or constructive distribution of property arising in connection with admission to the Partnership of another person as Person. D. Each distribution to the Partners of cash or other assets of the Partnership made prior to the dissolution of the Partnership, including, but not limited to, each distribution of net proceeds received by the Partnership from the sale or refinancing of all or any substantial portion of the Property, shall be made to the Partners in accordance with their respective Partnership Shares owned on the date of such distribution; provided, however, that if, at the time of any such distribution, the Capital Account balances of the Partners are not in the Equalization Ratio, then the proceeds of any such distribution shall be distributed first to the Partners having Capital Account balances greater than they would be if the Capital Account balances of all Partners were in the Equalization Ratio, up to and in proportion to the amount necessary to cause the Capital Account balances of all Partners to be in the Equalization Ratio, and then in accordance with the respective Partnership Shares of the Partners on the date of such distribution. Each distribution of cash or other assets of the Partnership made after dissolution of the Partnership shall be made in accordance with Section 11C. Distributions to the Partners will be made in such amounts and at such times as shall be determined by the General Partner. E. The Partnership Shares of each of the Partners are as follows: 1% to the General Partner, 58.712% to Carlyle-XV Associates, L.P., and 40.288% to Carlyle-XVI Associates, L.P. 8. Powers, Rights and Duties of the Partners. A. Except as otherwise provided herein, the General Partner alone shall have the full, exclusive and complete power, authority and responsibility to manage and control the affairs and funds of the Partnership in the ordinary course of its activities for the purposes herein stated, including the power to take (or omit) all or any such action as he may from time to time deem appropriate or desirable in connection therewith. In furtherance of the powers granted to the General Partner herein, and in no way in limitation thereof, the General Partner, for and on behalf of the Partnership, shall have full, exclusive and complete power and responsibility to enter into agreements of whatever nature necessary to effect the acquisition of the Partnership's assets, and such amendments and restatements thereof and supplements and modifications thereto as it amy consider to be in the best interests of the Partnership to perform all duties and obligations, and exercise all rights, as provided under such agreements in such manner as it may determine; to act on behalf of the Partnership in dealing with third parties and to manage, operate and undertake the funds and affairs of the Partnership for the purposes of conducting its business and of making, holding, conducting and disposing of assets and investments. The president or any vice president of the General Partner may act for and in the name of the Partnership in the exercise by the Partnership of any of its rights and powers hereunder. In dealing with the president or any vice president of the General Partner, no person shall be required to inquire into the authority of such individual acting on behalf of the Partnership to bind the Partnership. Persons dealing with the Partnership are entitled to rely conclusively on the power and authority of the president or any vice president of the General Partner as set forth in this Agreement. B. Notwithstanding any provision of this Agreement to the contrary, in the event that the Partners cannot reach unanimous agreement concerning a decision regarding the sale of all or any substantial portion of the Property (other than any property owned by a partnership or joint venture, directly or indirectly through another partnership or joint venture, in which the Partnership is a partner), the Partner or Partners desiring a sale thereof (the "Notifying Party") shall give notice to the other Partner or Partners (the "Notified Party") of the proposed transaction and shall deliver to the Notified Party with such notice a copy of the bona fide written offer from the prospective purchaser setting forth the name of the prospective purchaser and all of the material terms and conditions on which it is intended that the Property, or specified portion thereof, be sold. The Notified Party shall then have 30 days after receiving such notice to elect (by giving notice of the same to the Notifying Party) either (a) to purchase the specified Property (other than any property owned by a partnership or joint venture, in which the Partnership is a partner) for the purchase price and on the terms and conditions as set forth in such offer or (b) to acquire a proportionate share of the Notifying Party's interest in the Partnership for an amount equal to the amount which the Notifying Party would have received as its share of the net proceeds from the sale of the specified Property. In the event that the Notified Party makes either such election, the Partners shall close on the transaction as elected by the Notified Party within a period equal to the later of 90 days after the making of such election or the closing date specified in such written offer, with the time, place and date (within such period) as specified by the Notified Party by notice to the Notifying Party within 30 days after the making of such election. If the Notified Party does not make either election, then the Notifying Party may conclude a sale of such specified Property, without the agreement of the Notified Party, at any time or times within 180 days after the giving of notice of the proposed sale thereof, for a purchase price and on terms which are at least as favorable to the Partnership as those contained in the written offer and only to the purchaser identified in such written offer or to an "Affiliate" (as hereinafter defined) of such purchaser, if the Affiliate is specified in such written offer or such notice, but if a sale is not consummated within such period, then the right of the Notified Party to receive notice and to purchase or to acquire as aforesaid will continue as to any future proposed sale. In the event that the Notified Party includes more than one Partner, the election made by the Notified Party must be consented to by each such Partner and the purchase from the Notifying Party shall be made by the Partners comprising the Notified Partner based upon their respective Partnership Shares at the time of such election; provided, however, that if one such Partner fails or refuses to consent to either election, the other such Partner may, at its option, make the election of its choice and undertake the entire purchase or acquisition from the Notifying Party. C. Neither the General Partner nor any of its Affiliates shall be required to manage the Partnership as its sole and exclusive function and it may have other business interests and may engage in other activities in addition to those relating to the Partnership, including the making or management of other investments. Without limitation on the generality of the foregoing, each Partner recognizes that each Partner was formed for the purpose of investing in, operating, transferring, leasing and otherwise using real property and interests therein for profit and engaging in any and all activities related or incidental thereto and that each Partner will or may make other investments consistent with such purpose. Neither the Partnership nor any Partner shall have any right by virtue of this Agreement or the Partnership relationship created hereby in or to such other ventures or activities or to the income or proceeds derived therefrom, and the pursuit of such other ventures or activities by each Partner or any of their Affiliates, even if competitive with the business of the Partnership, is hereby consented to by all Partners and shall not be deemed wrongful or improper. Except as otherwise permitted in this Agreement or in any agreement among the Partners, no Partner or any Affiliate of a Partner shall be obligated to present any particular investment opportunity to the Partnership even if such opportunity is of a character which, if presented to the Partnership, could be taken by the Partnership, and each Partner or any Affiliate of a Partner shall have the right to take for its own account, or to recommend to others, any such particular investment opportunity. D. "Affiliate(s)" of a person means (i) any officer, director, employee, shareholder, partner or relative within the third degree of kindred of such person: (ii) any corporation, partnership, trust or other entity controlling, controlled by or under common control with such person or any such relative of such person; and (iii) any officer, director, trustee, general partner or employee of any entity described in (ii) above. Affiliates of a Partner may receive commissions when the Partnership buys or sells the Property or any portion thereof and may be employed to provide property management for the Partnership or any of the Property, but no commissions or compensation payable to such Affiliate for the same may exceed the normal and competitive rates for similar services in the locality where provided. The Partnership may borrow funds for the purpose of lending such funds to all or any of its Partners; provided, however, that the cost of such funds charged to the Partnership (including financing fees, "points" and interest charged with respect to such funds) by a third party shall not exceed the amount charged by the Partnership to such Partner or Partners for the use of such funds. The Partnership may enter into agreements with Affiliates of a Partner to provide insurance brokerage or similar services to the Partnership or any of the Property; provided that any such services by Affiliates shall be at rates at least as favorable to the Partnership as those available from unaffiliated parties. The validity of any transaction, agreement or payment involving the Partnership and any Affiliate of a Partner shall not be affected by reason of the relationship between the Partner and such Affiliate or the approval of said transaction, agreement or payment by officers, directors or partners of such Affiliate all or some of whom are also Affiliates of a Partner or are officers, directors or partners or are otherwise interested in or related to such Partner or its Affiliates. E. No Partner nor any Affiliate of any Partner nor any officer, director, shareholder, employee or partner of any such Affiliate shall be liable, responsible or accountable in damages or otherwise to the Partnership or to any other Partner for any action taken or failure to act on behalf of the Partnership within the scope of the authority conferred on such Partner or such Affiliate or such other person by this Agreement or by law unless such action or omission was performed or omitted fraudulently or in bad faith or constituted wanton and willful misconduct. F. The Partnership shall indemnify and hold harmless each Partner, any Affiliate of any Partner and any officer, director, shareholder, employee or partner of any such Affiliate (the "Indemnified Parties") from and against any loss, expense, damage or injury suffered or sustained by any Indemnified Party by reason of any acts, omissions or alleged acts or omissions arising out of its activities on behalf of the Partnership or in furtherance of the interest of the Partnership, including, but not limited to, any judgment, award, settlement, reasonable attorneys' fees and other costs and expenses incurred in connection with the defense of any actual or threatened action, proceeding or claim; provided that the acts or omissions or alleged acts or omissions upon which such actual or threatened action, proceeding or claim are based were performed or omitted in good faith and were not performed or omitted fraudulently or in bad faith or as a result of wanton and willful misconduct. G. The Limited Partners shall not participate in the management or control of the Partnership's business, nor shall they transact any business for the Partnership, nor shall they have the power to act for or bind the Partnership, said powers being vested solely and exclusively in the General Partner as provided herein (and except as provided herein). The Limited Partners shall not have any personal liability whatever, whether to the Partnership, to any Partner or to the creditors of the Partnership, for the debts of the Partnership or any of its losses once it has paid to the Partnership the amount of its capital contribution set forth in Exhibit B. The partnership interest of the Limited Partners in the Partnership shall be fully paid and non-assessable. H. The General Partner may in its sole discretion, make or seek to revoke the election referred to in Section 745 of the Internal Revenue Code of 1986, as amended, (herein the "Code") or any similar provision exacted in lieu thereof. Each of the Partners will upon request supply the information necessary to properly give effect to any such election. I. The General Partner shall, at the Partnership's expense and within a reasonable time after the close of each fiscal year, cause each Partner to be furnished with such statements of the Partnership's assets and liabilities as of the close of such year (if any), such profit and loss statement for such year (if any), such statement of the capital and profit account of each Partner (if any), and such other reports (if any), all as the General Partner may deem appropriate. J. The General Partner shall, at the Partnership's expense, cause the Partnership's Federal and state income and other tax returns to be prepared and filed and shall furnish copies to each Partner of any information on such returns needed for the preparation of each Partner's own tax returns. 9. Books and Records of the Partnership; Fiscal Year. The General Partner shall keep and maintain the books and records of the Partnership at the principal place of business of the Partnership. The fiscal year of the Partnership shall end on the 31st day of December in each year. The books of the Partnership shall be kept on the cash or accrual basis, and the Partnership shall be on the cash or accrual basis for tax purposes, as determined by the General Partner. The books and records of the Partnership shall be audited at such times and by such accountants as shall be determined from time to time by the General Partner. The funds of the Partnership shall be deposited in such bank accounts or invested in such interest-bearing or non-interest-bearing investments as shall be determined by Partner. 10. Transfer of Partnership Interest. A. No Partner may sell, assign, transfer, encumber or hypothecate the whole or any part of its Partnership interest (including, but not limited to, its interest in the capital or profits of the Partnership) without prior written consent of the General Partner. B. Any party or person admitted to the Partnership as a substituted Partner shall be subject to and bound by all of the provisions of this Agreement as if originally a party to this Agreement and as a condition to such admission shall be required to execute a copy of this Agreement as amended to the date of such admission. C. A Partner shall have no liability hereunder (including, but not limited to, any liability as a surety but excluding the repayment of any outstanding principal and interest on loans made by the Partnership to such Partner) for any obligations accruing under or in connection with the Partnership and relating to events occurring after such Partner shall have sold, assigned or transferred its entire Partnership interest. 11. Dissolution of the Partnership. A. No act, thing, occurrence, event or circumstances shall cause or result in the dissolution of the Partnership except the matters specified in subsection B below. B. The happening of any one of the following events shall work a dissolution of the Partnership: (1) The bankruptcy, resignation, legal incapacity, dissolution, termination, or expulsion of the General Partner; provided, however, that in such event the remaining Partners shall have the right to elect to continue the Partnership's business by depositing at the office of the Partnership a writing evidencing such an election. No other act shall be required to effect such continuation; (2) The sale of all or substantially all of the assets of the Partnership; (3) The unanimous agreement in writing by all of the Partners to dissolve the Partnership; or (4) The termination of the term of the Partnership pursuant to Section 5 hereof. Without limitation on the other provisions hereof, the admission of a new Partner shall not work a dissolution of the Partnership. Except as otherwise provided in this Agreement, each Partner agrees that, without the consent of the General Partner, a Partner may not withdraw from or cause a voluntary dissolution of the Partnership. C. Upon the occurrence of any of the events specified in subsection B above causing a dissolution of the Partnership and except as otherwise provided in subsection B above, the remaining Partner or Partners shall commence to wind up the affairs of the Partnership and to liquidate its investments (and in this connection shall have full right and unlimited discretion to determine in good faith the time, manner and terms of any sale or sales of Partnership Property). The Partner or Partners obligated to wind up the affairs of the Partnership as aforesaid shall herein be called the "Winding-Up Party". The Partners and their legal representatives, successors and assignees shall continue to share in profits and losses during the period of liquidation in the same manner and proportion as immediately before the dissolution. Following the payment of all debts and liabilities of the Partnership and all expenses of liquidation and subject to the right of the Winding-Up Party to set up such cash reserves as, and for so long as, it may deem reasonably necessary, the proceeds of the liquidation and any other funds of the Partnership shall be distributed to the Partners (after deducting from the distributive share of a Partner any sum such Partner owes the Partnership) in accordance with Section 7 hereof. No Partner shall have any right to demand or receive property other than cash upon dissolution or termination of the Partnership. Upon the completion of the liquidation of the Partnership and of the distribution of all Partnership funds, the Partnership shall terminate and the Winding-Up Party shall have the authority to execute any and all documents required in its judgment to effectuate the dissolution and termination of the Partnership. Each Partners shall look solely to the assets of the Partnership for all distributions with respect to the Partnership and its capital contributions thereto and share of profits or losses therefrom, and shall have no recourse therefor against any Partner; provided that nothing herein contained shall relieve any Partner of such Partner's obligation to pay any liability or indebtedness owing to the Partnership by such Partner. 12. Notices; Amendment. A. Any notice which a Partner is required or may desire to give any other Partner shall be in writing, and may be given by personal delivery or by mailing the same by United States registered or certified mail, return receipt required, to the Partner to whom such notice is directed at the address of such Partner as hereinabove set forth, subject to the right of a Partner to designate a different address for itself by notice similarly given. Any notice so given by United States mail shall be deemed to have been given on the second day after the same is deposited in the United States mail as registered or certified mail, addressed as above provided, with postage thereon fully prepaid. Any such notice not given by registered or certified mail as aforesaid shall be deemed to be given upon receipt of the same by the party to whom the same is to be given. B. This Agreement may be amended by written agreement of amendment executed by all the Partners, but not otherwise. 13. New General Partner. All of the Partners may agree in writing from time to time to admit to the Partnership one or more new General Partners. The General Partner may, on behalf of all Partners, cause Exhibit B hereto and the Partnership's Certificate of Limited Partnership to be appropriately amended and cause the same to be recorded in the event of each such appointment. No such addition or substitution of a new General Partner shall work a dissolution of the Partnership or otherwise affect the continuity of the Partnership. 14. Miscellaneous. Each Partner hereby irrevocably waives any and all rights that it may have to maintain any action for partition of any of the Partnership Property. This Agreement constitutes the entire agreement between the parties. This Agreement supersedes any prior agreement or understanding between the parties. This Agreement and the rights of the parties hereunder shall be governed by and interpreted in accordance with the laws of the State of Illinois. Except as herein otherwise specifically provided, this Agreement shall be binding upon and inure to the benefit of the parties and their legal representatives, successors and assignees. Captions contained in the Agreement in no way define, limit or extend the scope or intent of this Agreement. If any provision of this Agreement, or the application of such provision to any person or circumstance shall be held invalid, the remainder of this Agreement, or the application of such provision to other persons or circumstances, shall not be affected thereby. This Agreement may be executed in several counterparts, each of which shall be deemed an original but all of which shall constitute one and the same instrument. The opinion of the independent certified public accountants retained by the Partnership from time to time shall be final and binding with respect to all computations and determinations required to be made under Section 7 hereof (including computations and determinations in connection with any distribution following or in connection with dissolution of the Partnership). If the Partnership or any Partner obtains a judgment against any other party by reason of breach of this Agreement or failure to comply with the provisions hereof, a reasonable attorneys' fee as fixed by the court shall be included in such judgment. Any Partner shall be entitled to maintain, on its own behalf or on behalf of the Partnership, any action or proceeding against any other Partner or the Partnership (including, without limitation, any action for damages, specific performance or declaratory relief) for or by reason of breach by such party of this Agreement, notwithstanding the fact that any or all of the parties to such proceeding may then be a partner in the Partnership, and without dissolving the Partnership as a partnership. No remedy conferred upon the Partnership or any partner in this Agreement is intended to be exclusive of any other remedy herein or by law provided or permitted, but each shall be cumulative and shall be in addition to every other remedy given hereunder or now or hereafter existing at law or in equity or by stature (subject, however, to the limitations expressly herein set forth). No waiver by a Partner or the Partnership of any breach of this Agreement shall be deemed to be a waiver of any other breach of any kind or nature and no acceptance of payment or performance by a Partner of the Partnership after any such breach shall be deemed to be a waiver of any breach of this Agreement whether or not such Partner or the Partnership knows of such breach at the time it accepts such payment or performance. No failure or delay on the part of a Partner or the Partnership to exercise any right it may have shall prevent the exercise thereof by such Partner or the Partnership at any time such other Partner may continue to be so in default, and no such failure or delay shall operate as a waiver of any default. Power of Attorney The undersigned Partners of JMB/125 Broad Building Associates, L.P., a limited partnership pursuant to the laws of the State of Illinois, hereby jointly and severally irrevocably constitute and appoint the General Partner with full power of substitution, their true and lawful attorney-in-fact, in their name, place and stead to make, execute, sign, acknowledge, record and file, on behalf of them and on behalf of the Partnership the following: (i) A Certificate of Limited Partnership and any other certificates or instruments which may be required to be filed by the Partnership or the Partners under the laws of the State of Illinois and any other jurisdiction whose laws may be applicable; (ii) Such instruments or documents as may be deemed necessary or desirable by the General Partner in connection with the termination of the Partnership's business; (iii) Any and all amendments of the instruments described in clauses (i) and (ii) above, provided such amendments either are required by law to be filed or are consistent with the Agreement of Limited Partnership of the Partnership as it may exist from time to time, or have been authorized by the particular Partner or Partners; and (iv) Any amendment of this Agreement authorized to be made by the General Partner under this Agreement. The foregoing grant of authority: (i) Is a Special Power of Attorney coupled with an interest, is irrevocable and shall survive the death or incapacity of the Partner granting the power; (ii) May be exercised by the General Partner on behalf of each Partner by a facsimile signature or by listing all of the Partners executing any instrument with a single signature as attorney-in-fact for all of them; and (iii) Shall survive the withdrawal, dissolution, legal incapacity, bankruptcy or resignation of a Partner from the Partnership or the delivery of an assignment by a Partner of the whole or any portion of his interest in the Partnership. IN WITNESS WHEREOF, the undersigned have executed these Amended and Restated Articles of Limited Partnership of JMB/125 Broad Building Associates, L.P. as of the day and year first above written. General Partner Limited Partners CARLYLE ADVISORS, INC., CARLYLE-XV ASSOCIATES, L.P., a Delaware corporation a Delaware limited partnership By: CARLYLE PARTNERS, INC., By: a Delaware corporation, Brian Ellison General Partner Vice President By: Brian Ellison Vice President CARLYLE-XVI ASSOCIATES, L.P., a Delaware limited partnership By: CARLYLE PARTNERS, INC., a Delaware corporation, General Partner By: Brian Ellison Vice President EXHIBIT A A 40-story office building containing approximately 1,336,000 rentable square feet of space and located at 125 Broad Street in New York, New York, together with a leasehold interest in the underlying land. EXHIBIT B CAPITAL CONTRIBUTIONS DECEMBER, 1985 PARTNER Carlyle Real Estate Limited Partnership-XV $27,138,800 Carlyle Real Estate Limited Partnership-XVI $ 274,129 ----------- $27,412,929 =========== EXHIBIT B (con't) ADDITIONAL CAPITAL CONTRIBUTIONS AS OF SEPTEMBER 29, 1986 EXHIBIT B TOTAL CAPITAL CONTRIBUTIONS GENERAL PARTNER CONTRIBUTION TOTAL Carlyle Advisors, Inc. $ 00000000100 000001% LIMITED PARTNERS Carlyle-XV Associates, L.P. $ 33,792.885.73 58.712% Carlyle-XVI Associates, L.P. $ 23,188,462.03 40.288% AGREEMENT OF LIMITED PARTNERSHIP OF CARLYLE-XV ASSOCIATES, L.P. This Agreement of Limited Partnership (the "Agreement") made and entered into as Apr.il_19 993 by and between Carlyle Partners, Inc., a Delaware corporation, as general partner (hereinafter the "General Partners) and Carlyle Real Estate Limited Partnership-XV, an Illinois limited partnership, as limited partner (hereinafter the "Limited Partner" and, together with the General Partner, sometimes hereinafter collectively referred to as the "Partners"). WITNESSETH THAT WHEREAS, the parties hereto desire to form a limited partnership, (hereinafter the "Partnerships) pursuant to the Revised Uniform Limited Partnership Act as in effect in the State of Delaware (hereinafter the "Act"), except as hereinafter provided, for the purposes and term as hereinafter provided; NOW, THEREFORE, in consideration of the mutual promises and agreements herein made and intending to be legally bound thereby, the parties hereto hereby agree as follows: 1. Name of Partnership. The name of the Partnership shall be "Carlyle-XV Associates, L.P." 2. Character of the Partnership's Business. The character of the business of the Partnership will be to acquire, hold and otherwise use for profit, either directly or indirectly, a limited partnership interest in IMB/125 Broad Building Associates, L.P., an Illinois limited partnership, and to engage in any and all activities related or incidental thereto. Whenever the term "Property" appears in this Agreement, such term shall mean any property, real or personal, tangible or intangible, at any time owned by the Partnership, including the Partnership's respective interests in the aforementioned limited partnership and any property at any time owned by a partnership or other enterprise in which the Partnership is a partner. 3. Location of the Principal Place of Business. The location of the principal place of business of the Partnership is 900 North Michigan Avenue, Chicago, Illinois 60611-1575 or such other location as shall be designated by the General Partner. 4. Names and Addresses of Partners. The names of the Partners of the Partnership and their respective addresses are as set forth on exhibit A attached hereto. 5. Term of Partnership. The term for which the Partnership shall exist shall be until December 31, 2043, unless earlier dissolved as provided in Section 11 hereof. 6. Partner's Capital. A. Capital Contributions. (i) The capital contribution of each Partner to the Partnership is set forth opposite such Partner's name on Exhibit A hereto. The Partners shall bc obligated to make their capital contributions as reflected in Exhibit A hereto at such times as the General Partner may determine. (ii) Except as provided in Section 6A(i) above, no Partner shall have any obligation to make any additional capital contribution to the Partnership. In the event that, as provided in this Agreement, all or any part of the capital contribution of any Partner is withdrawn, any Partner makes an additional capital contribution, additional Partners are admitted to the Partnership, the Partnership purchases the interest of a Partner, or some similar change occurs, the General Partner shall promptly, when required, amend Exhibit A and prepare an amendment to this Agreement and the Certificate of Limited Partnership to reflect such change. The term "capital contribution" when used herein, shall mean the capital contribution of each Partner as set forth on Exhibit A hereto, plus any additional capital contributions which arc made to the Partnership as permitted under Section 6C hereof. B. No Right to Return of Contributions. No interest shall be paid or shall accrue on the capital contribution of any Partner. No Partner shall be personally liable for the return of the capital contributions of the other Partners, nor for the return of any Partnership assets. Notwithstanding the Act or any other provision of law, no Partner shall bc entitled to withdraw or obtain a return of all or any part of his capital contribution other than as expressly provided in this Agreement. It is the intent of the Partners that, unless expressly stated otherwise in a writing furnished to all the Partners by the Partnership, no distribution (or any part of any distribution) made to any Partner pursuant to this Agreement shall bc deemed a return or withdrawal of capital, even if such distribution represents (in full or in part) an allocation of depreciation or of any other non-cash item accounted for as a loss or deduction from or offset to income. C. Additional Contributions of Partners: Admission of Additional Partners. Any Partner or Partners may make additional contributions to the capital of the Partnership only with the consent of the General Partner. The General Partner may admit persons as additional Partners only (i) upon cecution by such persons of a copy of this Agreement, as it may have been amended or supplemented and be in effect immediately prior to the time of such admission and (ii) upon payment by such person(s) of a capital contribution, whether in cash or Property, which, along with the agreed value thereof, has been determined by agreement of all of the Partners. D. Capital Accounts. The Partnership shall maintain a capital account for each of the Partners which shall be the aggregate amount of the contributions to the Partnership made by such Partner, as set forth in Exhibit A hereto, reduced by the aggregate amount of any losses allocated, and any distributions of cash or the fair market value of other assets of the Partnership made to such Partner, and increased by the aggregate amount of any profits allocated to such Partner. E. Loans. Except as provided in Section 8C hereof, all advances or payments to the Partnership by any Partner other than the contributions required or made under Sections 6 or 7 hereof, shall be deemed to be loans by such Partner to the Partnership, and the Partner making the same shall be entitled to interest thereon at such rates per annum as the Partners may agree, and the same, together with interest as aforesaid, shall be repaid before any distribution shall be made hereunder to the Partners. No such loan to the Partnership shall be made without the prior written consent of the Partners and, unless all Partners otherwise agree, shall be required to be made by all Partners in proportion to their respective Partnership Shares (as hereinafter defined). With respect to any borrowings by the Partnership for which there is recourse to the Partners or any of their respective assets, the Partners shall be liable for such borrowings in proportion to their respective Partnership Shares (as hereinafter defined) as determined from time to time. 7. Partnership Shares. A. As used herein, "profits" or "losses" include, without limitation, each item of Partnership income, gain, loss and deduction as determined for Federal income tax purposes, and "Partnership Share" means 99% to the Limited Partner and 1% to the General Partner. Except as otherwise provided in this Section 7, all profits or losses from the operations of the Partnership for a fiscal year or part thereof shall be allocated to the Partners based upon their respective Partnership Shares. Notwithstanding the foregoing, to the extent required by Section 704(c) of the Code (as hereinafter defined) and the regulations promulgated thereunder, income, gain, loss and deduction with respect to the Property then owned by the Partnership shall be shared among the Partners so as to take account of the variation between the basis of the Property to the Partnership and its fair market value at the time of contribution. B. Each distribution to the Partners of cash or other assets of the Partnership (exclusive of cash or other assets relating to a sale or other disposition of the assets of the Partnership) made prior to the dissolution of the Partnership, including, but not limited to, each distribution of net cash flow from the operations of the Partnership shall be made to the Partners in accordance with their respective Partnership Shares owned on the date of such distribution. Each distribution of cash or other assets of the Partnership made after dissolution of the Partnership shall be made in accordance with Section II.E. hereof. Distributions to the Partners will be made in such amounts and at such times as shall be determined by the General Partner, or in the event of the dissolution and liquidation of the Partnership, by the Winding-Up Party (as hereinafter defined). 8. Powers. Rights and Duties of the Partners. A. The General Partner alone shall have the full, exclusive and complete power, authority and responsibility to manage and control the affairs and funds of the Partnership in the ordinary course of its activities for the purposes herein stated, including the power to take (or omit) all or any such action as he may from time to time deem appropriate or desirable in connection therewith. In furtherance of the powers granted to the General Partner herein, and in no way in limitation thereof, the General Partner, for and on behalf of the Partnership, shall have full, exclusive and complete power and responsibility to enter into agreements of whatever nature necessary to effect the acquisition of the Partnership's assets, and such amendments and restatements thereof and supplements and modifications thereto as it may consider to be in the best interests of the Partnership to perform all duties and obligations, and exercise all rights, as provided under such agreements in such manner as it may determine; to act of behalf of the Partnership in dealing with third parties and to manage, operate and undertake the funds and affairs of the Partnership for the purposes of conducting its business and of making, holding, conducting and disposing of assets and investments. The president or any vice president of the General Partner may act for and in the name of the Partnership in the exercise by the Partnership of any of its rights and powers hereunder. In dealing with the president or any vice president of the General Partner, no person shall be required to inquire into the authority of such individual acting on behalf of the partnership to bind the Partnership. Persons dealing with the Partnership are entitled to rely conclusively on the power and authority of the president or any vice president of the General Partner as set forth in this Agreement. B. Neither the General Partner nor any of its Affiliates (as hereinafter defined) shall be required to manage the Partnership as its sole and exclusive function and it may have other business interests and may engage in other activities in addition to those relating to the Partnership, including the making or management of other investments or businesses. Without limitation on the generality of the foregoing, each Partner recognizes that each other Partner was formed for the purpose of investing in, operating, transferring, leasing and otherwise using real property and interests therein for profit and engaging in any and all activities related or incidental thereto and that each Partner will make other investments consistent with such purpose. Neither the Partnership nor any Partner shall have any right by virtue of this Agreement or the Partnership relationship created hereby in or to such other ventures or activities conducted by each Partner or its Affiliates or to the income or proceeds derived therefrom, and the pursuit of such other ventures or activities by each Partner or any of its Affiliates, even if competitive with the business of the Partnership, is hereby consented to by all Partners and shall not be deemed wrongful or improper. Except as otherwise provided in this Agreement or in any agreement between the Partners, no Partner nor any Affiliate of a Partner shall be obligated to present any particular business or investment opportunity to the Partnership even if such opportunity is of a character which, if presented to the Partnership, could be taken by the Partnership, and each Partner and any Affiliate of a Partner shall have the right to take for its own account, or to recommend to others, any such particular investment opportunity. C. "Affiliate(s)" of a Partner means (i) any officer, director, employee, shareholder, trustee, partner or relative within the third degree of kindred of such Partner or any other interest in or relation to such Partner; (ii) any corporation, partnership, trust or other entity controlling, controlled by or under common control with such Partner or any such relative of such Partner; and (iii) any officer, director, trustee, shareholder, partner or employee of any entity described in (ii) above. Affiliates of a Partner may receive commissions when the Partnership buys and sells the Partnership's Property or any portion thereof or any real property acquired or owned by a partnership in which the Partnership is a partner and may be employed to provide property management for the Partnership or any of the Property, but no commissions or compensation payable to such Affiliate for the same may exceed the normal and competitive rates for similar services in the locality where provided. The Partnership may borrow funds for the purpose of lending such funds to all or any of its Partners; provided, however, that the cost of such funds charged to the Partnership (including financing fees, "points" and interest and other amounts charged with respect to such funds) by a third party shall not exceed the amount charged by the Partnership to such Partner or Partners for the use of such funds. The Partnership may enter into agreements with Affiliates of a Partner to provide insurance brokerage or similar services to the Partnership or with respect to any of the Partnership's property; provided that any such services by Affiliates shall be at rates at least as favorable to the Partnership as those available from unaffiliated parties. The validity of any transaction, agreement or payment involving the Partnership and any Affiliate of a Partner shall not be affected by reason of the relationship between the Partner and such Affiliate or the approval of said transaction, agreement or payment by officers, directors or partners of such Affiliate all or some of whom are also Affiliates of a Partner or are officers, directors or partners or are otherwise interested in or related to such Partner or its Affiliates. D. No Partner, employee nor any Affiliate of any Partner shall bc liable, responsible or accountable in damages or otherwise to the Partnership or the other Partner for any action taken or failure to act on behalf of the Partnership within the scope of the authority conferred on such Partner or such Affiliate or such other person by this Agreement or by law unless such action or omission was performed or omitted fraudulently or in bad faith or constituted misconduct or negligence (gross or ordinary). E. The Partnership shall indemnify and hold harmless each of its Partners, employees, and any Affiliate of any Partner (the "Indemnified Parties") from and against any loss, expense, damage or injury suffered or sustained by any Indemnified Partyby reason of any acts, omissions or alleged acts or omissions arising out of is activities on behalf of the Partnership or in furtherance of the interest of the Partnership, including, but not limited to, any judgment, award, settlement, reasonable attorneys' fees and other costs and expenses incurred in connection with the defense of any actual or threatened action, proceeding or claim and including any payments made by the General Partner to any of its officers or directors pursuant to an indemnification agreement no broader than this Section 8E; provided that the acts or omissions or alleged acts or omissions upon which such actual or threatened action, proceeding or claim is based were taken or omitted in good faith and were not performed or omitted fraudulently or in bad faith or as a result of misconduct or negligence (gross or ordinary) by such Indemnified Party. F. The Limited Partner shall not participate in the management or control of the Partnership's business, nor shall it transact any business for the Partnership, nor shall it have the power to act for or bind the Partnership, said powers being vested solely and exclusively in the General Partner as provided herein (and except as provided herein). The Limited Partner shall not have any personal liability whatever, whether to the Partnership, to any Partner or to the creditors of the Partnership, for the debts of the Partnership or any of its losses once it has paid to the Partnership the amount of its capital contribution set forth in Exhibit A. The partnership interest of the Limited Partner in the Partnership shall be fully paid and non-assessable. G. The General Partner may in its sole discretion, make or seek to revoke the election referred to in Section 754 of the Internal Revenue Code of 1986, as amended, (herein the "Code") or any similar provision enacted in lieu thereof. Each of the Partners will upon request supply the information necessary to properly give effect to any such election. H. The General Partner shall, at the Partnership's expense and within a reasonable time after the close of each fiscal year, cause each Partner to be furnished with such statements of the Partnership's assets and liabilities as of the close of such year (if any), such profit and loss statement for such year (if any), such statement of the capital and profit account of each Partner (if any), and such other reports (if any), all as the General Partner may deem appropriate. 1. The General Partner shall, at the Partnership's expense, cause the Partnership's Federal and state income and other tax returns to be prepared and filed and shall furnish copies to each Partner of any information on such returns needed for the preparation of each Partner's own tax returns. 9. Books and Records of the Partnership: Fiscal Year. The General Partner shall keep and maintain the books and records of the Partnership at the principal place of business of the Partnership. The books of the Partnership shall be kept on the cash or accrual basis, and the Partnership shall be on the cash or accrual basis for tax purposes and the Partnership shall have a fiscal or calendar year, all as determined by the General Partner. The books and records of the Partnership shall be audited at such times and by such accountants as shall be determined from time to time by the General Partner. The funds of the Partnership shall be deposited in such bank accounts or invested in such interest-bearing or non-interest-bearing investments, as shall be determined by the General Partner. 10. Transfer of Partnership Interest. A. No Partner may sell, assign, transfer, encumber or hypothecate the whole or any part of its Partnership interest (including, but not limited to, its interest in the capital or profits of the Partnership) without prior written consent of all of the other Partners. The assignee of all or any portion of a Partner's interest so assigned shall be admitted to the Partnership as a substituted Partner only upon the consent of all of the Partners. B. Any party or person admitted to the Partnership as a substituted Partner shall be subject to and bound by all of the provisions of this Agreement as if originally a party to this Agreement and, as a condition to such admission, shall be required to execute a copy of this Agreement as amended or supplemented to the date of such admission. C. A Partner shall have no liability hereunder (including, but not limited to, any liability as a surety but excluding liability for the repayment of any outstanding principal and interest on loans made by the Partnership to such Partner) for any obligations accruing under or in connection with the Partnership and relating to events occurring after such Partner shall have sold, assigned or transferred its entire Partnership interest. 11. Dissolution of the Partnership. A. No act, thing, occurrence, event or circumstance shall cause or result in the dissolution of the Partnership, except the matters specified in subsection B below. Without limitation on the other provisions hereof, the admission of a new Partner shall not work a dissolution of the Partnership. Except as otherwise provided in this Agreement, each Partner agrees that, without the consent of the other Partner, a Partner may not withdraw from or cause a voluntary dissolution of the Partnership. B. The happening of any one of the following events shall work a dissolution of the Partnership: (I) The death, bankruptcy, resignation, retirement, legal incapacity, dissolution, termination or withdrawal of the last remaining General Partner; (2) The sale or other disposition of all of the Partnership's assets (including purchase money security interest), all liabilities and obligations of the Partnership have been paid and satisfied and the purposes of the Partnership have been completed; reduction to cash or cash equivalents of all of the assets of the Partnership; (3) The unanimous agreement, in writing, of all of the Partners to dissolve the Partnership; (4) The termination of the term of the Partnership pursuant to Section 5 of this Agreement; or (5) The happening of any other event causing a dissolution of the Partnership under the Act (other than an event of withdrawal of the General Partner as set forth in Section 17-402(5) of the Act or any similar or successor provision enacted in lieu thereof ). C. In the event of the dissolution of the Partnership for any reason, the Partners shall have the option, upon the consent of all of them (other than any Partner which may have become bankrupt or incompetent, dissolved, terminated or withdrawn from the Partnership), to form a new (or reform the existing) partnership, on such terms and conditions as may be agreed upon, for the purpose of continuing the Partnership business. Unless the Partners so agree, the Partnership shall be liquidated and shall immediately commence to wind up its affairs as provided in subsection E below. D. Each Partner shall look solely to the assets of the Partnership for all distributions with respect to the Partnership and for the return, if any, of his capital contribution and his share of profits or losses thereof, and shall have no recourse therefore (upon dissolution or otherwise) against the General Partner or any other Partner. No Partner shall have any right to demand or receive Property other than cash at any time, including dissolution and termination of the Partnership; provided that nothing herein contained shall relieve any Partner of such Partner's obligation to pay any liability or indebtedness owing the Partnership by such Partner. E. Upon the occurrence of any of the events specified in subsection B above causing a dissolution of the Partnership and except as otherwise provided in this Section 11, the remaining Partner or Partners shall commence to wind up the affairs of the Partnership and to liquidate its assets (and in this connection shall have full right and unlimited discretion to determine in good faith the time, manner and terms of any sale or sales of the Partnership's Property). The Partner or Partners obligated to wind up the affairs of the Partnership as aforesaid are herein called the "Winding-Up Party. The Partners and their legal representatives, successors and assignees shall continue to share profits and losses during the period of liquidation in the same manner and proportion as immediately before the dissolution. Following the payment of all debts and liabilities of the Partnership and all expenses of liquidation and subject to the right of the Winding-Up Party to set up such cash reserves as, and for so long as, it may deem reasonably necessary, the proceeds of the liquidation and any other funds and assets of the Partnership shall be distributed to the Partners (after deducting from the distributive share of a Partner any sum such Partner owes the Partnership) in accordance with Capital Account balances and Partnership Shares as provided in Section 7A hereof. Upon the completion of the liquidation of the Partnership and of the distribution of all Partnership assets, the Partnership shall terminate and the Winding-Up Party shall have the authority to execute any and all documents required in its judgment to effectuate the dissolution and termination of the Partnership. 12. Personal Property. A. A Partner's interest in the Partnership shall be personal property for all purposes. All real and other Property owned by the Partnership shall be deemed to be owned by the Partnership as an entity (and may be held in the name of a nominee for the Partnership), and no Partner, individually, shall have any ownership of such Property. The Partners agree that the Property of the Partnership is not and will not be suitable for partition. Accordingly, each of the Partners hereby irrevocably waives any and all rights he may have to maintain any action for partition of any Property of the Partnership. B. Whenever, either under this Agreement or under applicable law, it is provided that there shall be voting or approval by all Partners, each Partner shall vote in Partnership matters, insofar as is necessary, according to the ratio which his capital contribution to the Partnership as set forth on Exhibit A hereto bears to the combined capital contributions of all Partners to the Partnership as set forth on Exhibit A hereto. 13. New General Partner. A. All the Partners may agree in writing from time to time to admit to the Partnership one or more new General Partners. The General Partner may, on behalf of all Partners, cause Exhibit A hereto and the Partnership's Certificate of Limited Partnership to be appropriately amended and cause the same to be recorded in the event of each such appointment. No such addition or substitution of a new General Partner shall work a dissolution of the Partnership or otherwise affect the continuity of the Partnership. B. The death, resignation, withdrawal, bankruptcy, incompetence or legal incapacity of a General Partner shall not cause a dissolution of the Partnership (unless such General Partner is the last remaining General Partner) but the rights of such former General Partner or his personal representative, or other successor, to share in the profits or losses in the Partnership, to receive distributions from the Partnership and otherwise to receive the benefit of his interest in the Partnership shall be treated as if such former General Partner or his personal representative or other successor had received his interest in the Partnership from a Limited Partner, and, with the consent of the General Partner, such former General Partner or his personal representative or other successor shall become a Limited Partner in the Partnership being deemed to have made the same capital contribution to the Partnership as such former General Partner, and this Agreement and the Certificate of Limited Partnership shall be amended to reflect the capital contribution deemed made by such person or successor as a Limited Partner, subject to the terms and conditions of this Agreement. Any such General Partner, or the estate of a deceased General Partner, shall remain liable for all debts and obligations of such General Partner prior to the date of death, withdrawal or removal. 14. Notices: Amendment. A. Any notice which a Partner is required or may desire to give any other Partner shall be in writing, and may be given by personal delivery or by mailing the same by United States registered or certified mail, return receipt requested, to the Partner to whom such notice is directed at the address of such Partner as set forth on Exhibit A hereto, subject to the right of a Partner to designate a different address for itself by notice similarly given. Any notice so given by United States mail shall be deemed to have been given on the second day after the same is deposited in the United States mail as registered or certified mail, addressed as above provided, with postage thereon fully prepaid. Any such notice not given by registered or certified mail as aforesaid shall be deemed to be given upon receipt of the same by the party to whom the same is to be given. B. This Agreement may be amended by written agreement of amendment executed by all of the Partners, but not otherwise. 15. Miscellaneous. This Agreement constitutes the entire agreement between the Partners concerning the subject matter hereof. This Agreement supersedes any prior agreement or understanding between the Partners regarding the subject matter hereof. This Agreement and the rights of the Partners hereunder shall be governed by and interpreted in accordance with the laws of the State of Delaware. Except as herein otherwise specifically provided, this Agreement shall be binding upon and inure to the benefit of the Partners and their legal representatives, successors and assignees. Captions contained in this Agreement in no way define, limit or extend the scope or intent of this Agreement. If any provision of this Agreement, or the application of such provision to any person or circumstance, shall be held invalid, the remainder of this Agreement, or application of such provision to other persons or circumstances, shall not be affected thereby. This Agreement may be executed in several counterparts, each of which shall be deemed an original but all of which shall constitute one and the same instrument. The opinion of the independent certified public accountants retained by the Partnership from time to time shall be final and binding with respect to all computations and determinations required to be made under Section 7 hereof (including computations and determinations in connection with any distribution following or in connection with the dissolution of the Partnership). If the Partnership or any Partner obtains a judgment against any other party by reason of breach of this Agreement or failure to comply with the provisions hereof, a reasonable attorneys' fee as fixed by the court shall be included in such judgment. Any Partner shall be entitled to maintain, on its own behalf or on behalf of the Partnership, any action or proceeding against any other Partner or the Partnership (including, without limitation, any action for damages, specific performance or declaratory relief) for or by reason of breach by such party of this Agreement, notwithstanding the fact that any or all of the parties to such proceeding may then be a Partner in the Partnership, and without dissolving the Partnership as a partnership. No remedy conferred upon the Partnership or either Partner in this Agreement is intended to be exclusive of any other remedy herein or by law provided or permitted, but each shall be cumulative and shall be in addition to every other remedy given hereunder or now or hereafter existing at law or in equity or by statute (subject, however, to the limitations expressly herein set forth). No waiver by a Partner or the Partnership of any breach of this Agreement shall be deemed to be a waiver of any other breach of any kind or nature and no acceptance of payment or performance by a Partner of the Partnership after any such breach shall be deemed to be a waiver of any breach of this Agreement whether or not such Partner or the Partnership knows of such breach at the time it accepts such payment or performance. No failure or delay on the part of a Partner or the Partnership to exercise any right it may have shall prevent the exercise thereof by such Partner or the Partnership at any time such other Partner may continue to be in default hereunder, and no such failure or delay shall operate as a waiver of any breach or default. mjs.agreemts.carlyle. 1 4 Power of Attorney. The undersigned Partners of Carlyle-XV Associates, L.P., a limited partnership formed under the laws of the State of Delaware, hereby jointly and severally irrevocably constitute and appoint the General Partner with full power of substitution, their true and lawful attorney-in-fact, in their name, place and stead to make, execute, sign, acknowledge, record and file, on behalf of them and on behalf of the Partnership the following: (i) A Certificate of Limited Partnership and any other certificates or instruments which may be required to be filed by the Partnership or the Partners under the laws of the State of Delaware and any other jurisdiction whose laws may be applicable; (ii) Such instruments or documents as may be deemed necessary or desirable by the General Partner in connection with the termination of the Partnership business; (iii) Any and all amendments of the instruments described in clauses (i) and (ii) above, provided such amendments either are required by law to be filed or are consistent with the Agreement of Limited Partnership of the Partnership as it may exist from time to time, or have been authorized by the particular Partner or Partners; and (iv) Any amendment of this Agreement authorized to be made by the General Partner under this Agreement. The foregoing grant of authority: (i) Is a Special Power of Attorney coupled with an interest, is irrevocable and shall survive the death or incapacity of the Partner granting the power; (ii) May be exercised by the General Partner or any of them on behalf of each Partner by a facsimile signature or by listing all of the Partners executing any instrument with a single signature as attorney-in-fact for all of them; and (iii) Shall survive the withdrawal, dissolution, legal incapacity, bankruptcy or resignation of a Partner from the Partnership or the delivery of an assignment by a Partner of the whole or any portion of his interest in the Partnership. IN WITNESS WHEREOF, the undersigned have executed this Agreement of Limited Partnership of Carlyle-XV Associates, L.P. as of this l9th day of April, 1993. General Partner Limited Partner Carlyle Partners, Inc. Carlyle Real Estate Limited Partnership-XV a Delaware corporation an Illinois limited partnership By: JMB Realty Corporation a Delaware corporation NEIL G. BLUHM Corporate General Partner ------------- Neil G. Bluhm President NEIL G. BLUHM ------------- Neil G. Bluhm President EXHIBIT A Partner Name and Address Capital Contribution Carlyle Partners, Inc. $ 10.00 900 North Michigan Avenue Chicago, Illinois 60611-1575 Carlyle Real Estate Limited Partnership-XV $ 990.00 900 North Michigan Avenue Chicago, Illinois 60611-1575 $ 1 ,000.00 Travelers Loan No. 204366 CASH MANAGEMENT AGREEMENT THIS CASH MANAGEMENT AGREEMENT (this "AGREEMENT") is made as of the 22nd day of December, 1993, by and among C-C CALIFORNIA PLAZA PARTNERSHIP, a California general partnership having an office at 2121 North California Boulevard, Suite 230, Walnut Creek, California 94596 ("BORROWER"), THE TRAVELERS LIFE AND ANNUITY COMPANY, having an office at 2215 York Road, Suite 504, Oak Brook, Illinois 60521, Attention: Managing Director ("LENDER") and CYGNA DEVELOPMENT SERVICES, INC., a California corporation, having an office at 2121 North California Boulevard, Suite 230, Walnut Creek, California 94596 ("MANAGER"). RECITALS: This Agreement is based upon the following recitals: (a) Borrower is indebted to Lender for certain deed of trust obligations in the aggregate outstanding principal amount of $57,675,704.31 (the "LOAN"), which Loan is evidenced by the Note and secured by the Deed of Trust, which documents are described on EXHIBIT A attached hereto. The Deed of Trust grants to Lender a first priority security interest in the property commonly known as California Plaza, 2121 North California Boulevard, Walnut Creek, California (the "PROPERTY"). Pursuant to the Deed of Trust, among other things, Borrower assigned to Lender Borrower's interest in all leases and occupancy agreements of whatever form then or thereafter affecting all or any part of the Property and any and all guarantees, extensions and modifications thereof (the "LEASES") and all deposits, rents, issues, profits, revenues, royalties, benefits and income of every nature of and from the Property (the "RENTS"). The Note and the Deed of Trust, together with all other documents and instruments originally executed and delivered in connection with the Loan, as described more fully in EXHIBIT A attached hereto, are hereinafter called the "ORIGINAL LOAN DOCUMENTS". (b) Borrower failed to pay when due (after expiration of applicable grace periods, if any) the full installment in the amount of $525,136.08 representing principal and interest due under the Note on March 1, 1993. (c) Borrower has proposed that such default and certain other subsequent defaults be resolved through a modification of the Loan pursuant to which payment of a portion of the interest due would be deferred and the maturity date extended. (d) Lender is willing to enter into such a modification only if, among other things, Borrower executes and delivers to Lender (i) this Cash Management Agreement and (ii) the Modification Agreement and certain other documents amending and restating the Original Loan Documents (the "MODIFICATION DOCUMENTS"), which documents are described more fully in EXHIBIT B attached hereto (the Original Loan Documents, as so amended and restated by the Modification Documents, are hereinafter collectively referred to as the "LOAN DOCUMENTS"). (e) Borrower and Manager have entered into a certain Management and Leasing Agreement dated as of June 30, 1986, as amended by agreements dated as of July 30, 1986, November 26, 1991 and December 21, 1993 (as so amended, the "MANAGEMENT AGREEMENT") pursuant to which Manager is managing the operation and leasing of the Property. NOW, THEREFORE, in consideration of the above recitals and for other good and valuable consideration, the receipt and adequacy of which are hereby mutually acknowledged, the parties hereto do hereby agree as follows: 1. Affirmation of Recitals. The recitals set forth above are true and correct and are incorporated herein by this reference. 2. Cash Collateral. (a) Borrower hereby affirms that all Rents and the other payments, if any, assigned to Lender under the Loan Documents (collectively, the "ASSIGNED PAYMENTS"), all deposits to the Cash Collateral Disbursement Account, the Reserve Account, the Security Deposits Account (as such terms are hereinafter defined) and all proceeds of such accounts and interest on the proceeds of such accounts (hereinafter collectively referred to as the "CASH COLLATERAL") are subject to the existing first priority lien and security interest of Lender as created by the Original Loan Documents and continued by the Loan Documents. In addition to, and without limitation of, any such continuing security interest, Borrower hereby affirms Lender's security interest in and to all Cash Collateral as security for the obligations to Lender under the Loan Documents and Borrower acknowledges and agrees that Lender has an absolute, present, possessory and "choate" perfected security interest in and to the Rents and the other Assigned Payments. On demand, from time to time, Borrower agrees to execute and deliver to Lender and hereby authorizes Lender to execute in the name of Borrower to the extent Lender may lawfully do so, financing statements, chattel mortgages or comparable security instruments as may reasonably be requested or required by Lender to perfect or continue the satisfaction of its security interest in the Cash Collateral Disbursement Account, the Reserve Account, the Security Deposits Account and all other accounts provided for herein. (b) The $4,271,000.00 of cash flow from the Property for the calendar years 1992 and 1993 currently held by Travelers shall be applied as follows: (i) $30,000 shall be transferred to the Cash Collateral Disbursement Account in order to establish a minimum account balance to be used by Borrower and Manager from time to time as necessary to fund short-term shortfalls of Assigned Payments to pay Operating Expenses without resorting to the formal procedure set forth in subparagraph 3(c) hereof for larger and longer-term shortfalls, and to be replenished by deposit of the Assigned Payments collected during the next subsequent calendar month in accordance with subparagraph 3(d) hereof (such minimum account balance, the "WORKING CAPITAL BALANCE"), (ii) $3,845,046.95 shall be paid to Lender as interest payable under the Note (as modified and amended by the Modification Agreement) on the first day of each month commencing March 1, 1993 through December 1, 1993, (iii) $149,753.79 shall be transferred to the real estate tax escrow described in subparagraph 3(d)(i) of this Agreement (iv) $78,665.00 shall be transferred to the insurance escrow described in subparagraph 3(d)(ii) of this Agreement and (v) the remaining $167,534.26 shall be placed into the Reserve Account. 3. Application of Assigned Payments. (a) From and after the date hereof, Manager shall collect all Rents and the other Assigned Payments as agent of and in trust for Lender, and upon collection, will deposit all Rents and other Assigned Payments into Account No. 0585-107212 with Wells Fargo Bank (the "CASH COLLATERAL DISBURSEMENT ACCOUNT"), which Cash Collateral Disbursement Account has been established in a depositary institution to be approved by, and in the name of Manager as trustee for the benefit of Lender and will be held by Manager in such institution as agent of and in trust for Lender. Borrower and Manager shall take all reasonably necessary actions and shall otherwise reasonably cooperate to ensure that all the Assigned Payments are promptly deposited in the Cash Collateral Disbursement Account, including without limitation immediately depositing any such amounts inadvertently held by Borrower or Manager and not deposited in the Cash Collateral Disbursement Account as provided in this paragraph. Lender shall have the absolute and unconditional right, at any time (and regardless of whether a default has occurred under this Agreement or the Loan Documents), to modify the arrangements for the collection and application of Cash Collateral under this Agreement by giving written notice to the tenants at the Property (the "TENANTS") in the form of EXHIBIT C attached hereto (which notices will, at Lender's request, be joined by Borrower and Manager), whereby the Tenants will be required to pay all Rents directly to an account maintained by and in the name of Lender. Upon such modification, and provided that no default beyond applicable notice and cure periods then exists by Manager under this Agreement or by Borrower under this Agreement or any of the Loan Documents, this Agreement will be modified as necessary to reflect that (i) all Rents and other Assigned Payments are to be sent directly by Tenants to such account and (ii) Lender will make available to Manager that portion of the Rents and the other Assigned Payments as provided in this Agreement, but subject to all of the limitations and restrictions set forth in this Agreement as well as all of the rights of Lender under this Agreement. (b) During each calendar month during the term hereof, Manager shall pay from the Cash Collateral Disbursement Account those expenses relating to the operation and maintenance of the Property (the "OPERATING EXPENSES") as more particularly set forth in the annual operating budget for the Property prepared by Borrower for such calendar year and approved by Lender (the "OPERATING BUDGET") or as otherwise approved by Lender in writing. The approved form of Operating Budget for each calendar year during the term of the Loan is attached hereto as EXHIBIT D. In addition, Manager may disburse monies in the Cash Collateral Disbursement Account for emergency expenses relating to the Property required to prevent or limit damage or injury to persons or property, provided that Manager notifies both Borrower and Lender of such disbursements no later than the first business day thereafter and provides to Lender a complete accounting of such expenses within five (5) business days of such disbursements. Notwithstanding any contrary provision hereof, in no event or under any circumstance (other than as set forth in the preceding sentence) shall Manager, without having received the prior written approval of Lender, which approval will be granted or withheld promptly (but may be withheld in Lender's sole and absolute discretion), disburse monies from the Cash Collateral Disbursement Account for payment of: (i) an Operating Expense in a particular category (as such categories are set forth in the form of Attachment 1 to the Operating Budget attached hereto as Exhibit D) (A) for a given calendar month in an amount in excess of one hundred ten percent (110%) of the amount allocated for such category of Operating Expense in the Operating Budget for such calendar month plus the amount by which the aggregate amount allocated for such category of Operating Expense for all prior months of said calendar year exceeds the amount actually disbursed by Manager for each category of Operating Expense for such prior calendar months, or (B) in any particular calendar year in an amount in excess of one hundred five percent (105%) of the amount allocated for such category of Operating Expense in the Operating Budget for such calendar year (provided, however, that with respect to current utilities, real estate taxes, expenses for insurance provided on a competitively bid basis, the full amount of such Operating Expenses may be disbursed from the Cash Collateral Disbursement Account regardless of the amount allocated for such categories of Operating Expenses in the Operating Budget); and provided further, with respect to any repairs and maintenance categories that appear on the Operating Budget or any approved leasing costs, an amount up to the full amount allocated to such category on the Operating Budget (or such approved leasing costs) for the calendar year may be disbursed from the Cash Collateral Disbursement Account in any calendar month provided the aggregate amount disbursed from the Cash Collateral Disbursement Account for such category over the calendar year does not exceed one hundred five percent (105%) of the amount allocated for such category of Operating Expense in the Operating Budget for such calendar year; (ii) expenses, including those for capital expenditures, not identified in the Operating Budget; or (iii) any category of Operating Expense unless such expense is actually incurred prior to the Termination Date (as hereinafter defined). Furthermore, Manager shall in no event or under any circumstance make any further disbursements from the Cash Collateral Disbursement Account after the tenth (10th) day of any calendar month unless, on or before such date (i) Borrower has delivered to Lender the accountings and statements with respect to the Property that are required to be delivered in such month to Lender pursuant to the provisions of subparagraphs 4(a) and 4(c) of this Agreement; (ii) Manager has furnished Lender with (A) an aging report for accounts receivable and payable for the Property and (B) a certified statement in the form of EXHIBIT E attached hereto from Manager, certifying that all payroll and other taxes required by applicable law to be withheld for the preceding month with respect to the Property have been so withheld, and will be delivered in good and sufficient funds to the appropriate taxing authorities on or prior to the date established by law for such delivery; and (iii) Manager has remitted to Lender all Excess Cash Collateral for the prior month, as required by subpara- graph 3(d) of this Agreement. In addition, Lender shall have the right to request that Manager furnish Lender with evidence of payment of all or certain of the Operating Expenses for a prior calendar month or months for the Property, which evidence shall be in the form of invoices marked "paid-in- full" or such other evidence of payment reasonably satisfactory to Lender including, without limitation, copies of checks accompanied by the invoices paid by said checks. (c) In the event that the available balance in the Cash Collateral Disbursement Account (inclusive of the Working Capital Balance) is insufficient to pay a particular Operating Expense set forth in the Operating Budget (such an event, a "SHORTFALL"), then, in such case, Borrower may issue to Lender a written request to disburse Cash Collateral for payment of such Operating Expense from the Reserve Account (as hereinafter defined) (each such request, a "REQUEST"). Provided that no default shall exist and be continuing under this Agreement and provided that Borrower complies with all of the provisions of this subparagraph 3(c), within ten (10) business days from the receipt of such Request, Lender shall disburse payment of any Shortfall from the Reserve Account. The following additional conditions shall apply to any Requests made by Borrower seeking Lender's approval for the use of Cash Collateral in the Reserve Account for payment of Operating Expenses: (i) Each Request shall be in the form of EXHIBIT F attached hereto, shall specify the amount and payee of each item of Operating Expense and shall be accompanied by evidence reasonably satisfactory to Lender of the incurrence of such expense by Borrower; (ii) If the Request is to pay for Capital Expenditures, it shall be accompanied by (w) invoices or other evidence substantiating the actual incurrence of items of Capital Expenditures which are covered in the Request, (x) if required by Lender and if the Capital Expenditure involves a physical improvement to the Property, a certificate of a consultant to Lender (based upon an on-site inspection) in which such consultant shall verify that any work for which payment is sought under the Request has actually been performed, (y) evidence that all work for which payment is sought under the Request shall comply with all applicable laws, rules, restrictions, orders and regulations of governmental authorities, and that all necessary permits, certificates, licenses and other approvals relating to such work have been obtained and are in full force and effect, and (z) lien waivers (which may be conditional with respect to payments not yet received) and other documents required under applicable law or reasonably required by Lender; (iii) No more than one (1) Request may be made in any calendar month; (iv) Notwithstanding any contrary provision hereof, in no event or under any circumstance shall Lender be required to pay from the Reserve Account, (A) any item of any Request unless such expense is actually incurred by Borrower prior to the Termination Date (as hereinafter defined) and the Request for such item is received by Lender not later than thirty (30) days subsequent to the Termination Date, (B) unless otherwise included within clause (A), any item of any Request which is properly payable after the date of such Request, (C) any Request which is not accompanied by evidence satisfactory to Lender of the incurrence of such expense by Borrower and the insufficiency of funds in the Cash Collateral Disbursement Account, (D) any Request for funds in excess of available Cash Collateral in the Reserve Account or (E) any item of any Request that is over thirty (30) days past due (other than with respect to items subject to a bona fide dispute which are less than sixty (60) days past due); (v) Borrower and Manager shall not have defaulted (beyond the expiration of applicable grace and cure periods, if any) in any of their respective obligations under this Agreement; and (vi) Borrower shall not have defaulted (beyond the expiration of applicable grace and cure periods, if any) in any of its obligations under any of the Loan Documents. Simultaneously with the execution of this Agreement and as described in subparagraph 2(b) of this Agreement, Lender is depositing $167,534.26 of cash flow from the Property into the Reserve Account and Borrower is depositing an additional $500,000.00 into the Reserve Account, all of which monies are to be held and disbursed pursuant to the provisions of this Agreement. (d) On the last business day of December, 1993, and on the last business day of each calendar month thereafter, Manager shall remit to Lender from the Cash Collateral Disbursement Account an amount equal to the amount by which the Rents and other Assigned Payments deposited in the Cash Collateral Disbursement Account during the calendar month exceeds the aggregate of (x) the Operating Expenses paid from the Cash Collateral Disbursement Account in such calendar month, including any amounts represented by any checks written for Operating Expenses for such calendar month which have not yet cleared through the Cash Collateral Disbursement Account and (y) an amount, if any, necessary to restore the Working Capital Balance in the Cash Collateral Disbursement Account back to $30,000 (such excess amounts are herein referred to as "EXCESS CASH COLLATERAL"), which remittance will be done by wire transfer made in accordance with the instructions set forth on EXHIBIT G attached hereto or as otherwise directed by Lender. Simultaneously with the delivery of any Excess Cash Collateral to Lender as aforesaid, Manager shall furnish Lender and Borrower with a complete accounting of all Cash Collateral received by Manager and all expenditures of Cash Collateral made during such month. Excess Cash Collateral payable to Lender on the last business day of each calendar month shall be applied by Lender on or about the first business day of the following calendar month in the following order and priority: (i) An amount equal to one-twelfth of the amount sufficient to pay real property taxes payable for the Property, or estimated by Lender to be payable, by Borrower for the ensuing twelve (12) months shall be deposited by Lender into a real property tax escrow account maintained by Lender. The monies in the real property tax escrow account shall be held and disbursed by Lender as provided in paragraph 3 of the Deed of Trust (as modified and amended by the Modification Agreement); (ii) An amount equal to one-twelfth of the amount sufficient to pay all premiums and other charges for the insurance required to be maintained under the Deed of Trust (as modified and amended by the Modification Agreement), or estimated by Lender to be payable, for the ensuing twelve (12) months shall be deposited by Lender into an insurance escrow account maintained by Lender. The monies in the insurance escrow account shall be held and disbursed by Lender toward the payment of insurance premiums and charges; (iii) Towards the payment of interest that is due and payable under the Note (as modified and amended by the Modification Agreement); (iv) Lender shall deposit into an interest bearing account established by and in the name of First National Bank of Chicago (the "ACCOUNT AGENT"), as trustee for the benefit of Lender (the "RESERVE ACCOUNT") an amount that is necessary to bring (or replenish, as the case may be) the balance of the Reserve Account to $2,120,000.00; (v) Toward all "Deferred Interest" accrued under the Note (as modified and amended by the Modification Agreement); and (vi) Toward the repayment of the outstanding principal balance of the Note (as modified and amended by this Agreement). (e) Account Agent shall have sole control and responsibility for management of the Reserve Account and all monies deposited into such account. At any time and from time to time Lender may redesignate the name or title of or the manner in which the Reserve Account is held, but in each instance otherwise subject to the terms and provisions of this Agreement. The Reserve Account shall be at all times maintained with financial institutions chosen by Lender and shall bear interest initially at a rate equal to the then current yield on three-month U.S. Treasury bills less seventy (70) basis points. The monies contained in the Reserve Account may be transferred by Account Agent from time to time to any other account chosen by Lender, provided that the monies shall remain subject to the terms and provisions of this Agreement. The Reserve Account shall without further act or instrument be deemed to be assigned to Lender and shall constitute additional security for the payment of the Debt. The Reserve Account shall be administered by Account Agent, with any disbursements to Manager to be made in accordance with subparagraph 3(c) of this Agreement. Lender shall have the sole, absolute and unconditional right, at any time after the date hereof, without notice, to designate a third party attorney, accountant or property manager acceptable to Lender to administer the Reserve Account on its behalf in accordance with the provisions of this Agreement, which shall by instrument in form and substance satisfactory to Lender in all respects, be assumed by any such third party attorney, accountant or property manager. Borrower agrees that the reasonable fees of Lender (including the fee of Account Agent), and the reasonable fees of such other attorney, accountant or property manager incurred in establishing and administering the Reserve Account, which fees shall be equal to $10,000 per year in the aggregate, shall be payable on January 1 of each calendar year out of the Cash Collateral. Borrower acknowledges that any third party attorney, accountant or property manager designated subsequent to the execution hereof to administer the Reserve Account shall hold the proceeds thereof as agent of and in trust for the use and benefit of Lender and for application in accordance with the terms of this Agreement. (f) Lender may from time to time, at its sole option and in its sole and absolute discretion, upon the written petition of Borrower, authorize in writing the expenditure of Cash Collateral from the Cash Collateral Disbursement Account or the Reserve Account for expenses not identified in the Operating Budget or for purposes not otherwise authorized herein and Lender agrees to respond to any such request for an expenditure in a prompt fashion. Lender and Borrower acknowledge that in lieu of Borrower paying the following costs incurred in connection with the modification of the Loan out of pocket (i.e., not from the cash flow generated by the Property), Lender shall pay out of the proceeds of the Reserve Account: the reasonable attorneys' fees and disbursements of Borrower and Lender's counsel for legal services rendered in connection with the modification of the Loan, any title premium or charges incurred in connection with the issuance of endorsements to the title policies issued in connection with the Loan, any recording charges with respect to the recording of any of the Modification Documents and the reasonable fees charged by the escrow agent pursuant to the Escrow Agreement described on Exhibit B attached hereto. (g) Except as otherwise expressly set forth herein, Borrower and Manager acknowledge and agree that no disbursements shall be made from the Cash Collateral Disbursement Account unless such disbursements are consistent with the Operating Budget then in effect (subject to the permitted variances as set forth in subparagraph 3(b) of this Agreement) or are otherwise approved in writing by Lender. Borrower and Manager further acknowledge and covenant that all Rents and other Assigned Payments and all funds deposited in the Cash Collateral Disbursement Account shall be used solely for the payment of approved Operating Expenses and the use of such funds for any other purpose shall constitute a default under this Agreement and an event of default under the Loan Documents. (h) Borrower and Manager agree that should any account payable relating to the Property remain unpaid for a period in excess of sixty (60) days, such occurrence shall constitute a default under this Agreement and an event of default under the Loan Documents (other than with respect to any bona fide dispute, provided Manager has escrowed from the Cash Collateral pursuant to an arrangement satisfactory to Lender an amount sufficient to include any attorneys' fees incurred with respect to such dispute and otherwise satisfactory to Lender, in its reasonable discretion, to pay such bona fide dispute; it being agreed, however, that (i) the rights of the party seeking payment from the escrowed funds will not be affected by the occurrence of the Termination Date and (ii) upon the occurrence of the Termination Date all rights of Borrower under such escrow arrangement shall automatically and without further act or notice required, be assigned over to Lender). In no event or under any circumstances whatsoever (and notwithstanding anything to the contrary which may be contained in or implied in this Agreement to the contrary) shall Lender be required to make any advances for any expenses relating to the operation, maintenance, management or marketing of the Property. The foregoing sentence shall not constitute a waiver by Borrower or Manager of their right to use amounts deposited in the Cash Collateral Disbursement Account or to make a Request for the disbursal of monies by Lender from the Reserve Account in accordance with the terms of this Agreement. (i) Lender reserves the right to approve and to change the depository banks holding the Cash Collateral Disbursement Account, the Reserve Account, the Security Deposits Account or any other account maintained under this Agreement, and Borrower and Manager agree to cooperate with Lender to promptly effect any such transfer. (j) Manager shall submit to Borrower and Lender (i) on or before November 15, 1994 and on or before November 15 of each subsequent year, a comprehensive preliminary proposed Operating Budget (containing full and complete breakdowns of all categories of expense, as such categories are set forth in the form of Attachment 1 to the Operating Budget attached hereto as Exhibit D, including, without limitation, Capital Expenditures, as defined below and rebates to then-existing tenants) for the ensuing calendar year for Borrower's and Lender's review; and (ii) on or before December 15, 1993 and on or before December 15 of each subsequent year, Borrower shall submit the final comprehensive proposed Operating Budget (containing full and complete breakdowns of all categories of expenses, including, without limitation, Capital Expenditures, as defined below, and rebates to then-existing tenants) for the ensuing calendar year for review by Borrower and Lender. Provided Manager has delivered the preliminary and final proposed Operating Budgets on or before the dates set forth above, Lender shall notify Borrower as to whether Lender approves such final comprehensive proposed Operating Budget within thirty (30) days of receipt by Lender. Such proposed annual Operating Budget shall be in the form attached hereto as EXHIBIT D and shall include comparative figures for amounts actually spent for each expense listed therein for the calendar year in which the Operating Budget is delivered for review. In addition to the foregoing, each proposed annual Operating Budget shall specify parameters for the leasing of any space at the Property, which parameters shall include, among other things, the following information, broken down by size and/or location of the space to be leased at the Property: lease term, gross fixed and additional rent, effective rent (net of any tenant concessions), rental or other concessions to be granted prospective tenants (including rental abatements) and a description and the cost of any improvements to be performed on behalf of prospective tenants. If a proposed Operating Budget has not been approved prior to January 1 of the calendar year covered by such Operating Budget, the most recently approved Operating Budget will remain in effect and be utilized until agreement is reached on a new budget, provided that current utilities, real estate taxes and insurance expenses (if the insurance is provided on a competitively bid basis) may be paid as Operating Expenses regardless of the budget allocations set forth on the most recently approved Operating Budget. Furthermore, no monies will be applied towards capital improvement items regardless of whether the most recently approved Operating Budget contains line items for Capital Expenditures (other than for ongoing multi-year capital repair projects or leasing costs which have received the prior approval of Lender). The term "CAPITAL EXPENDITURES" as used in this Agreement shall mean any and all expenditures (i) with respect to the Property which would be capitalized instead of expensed in accordance with generally accepted accounting principles consistently applied, (ii) for an addition or replacement to the Property with a useful life of more than one (1) year, (iii) for an improvement that prolongs the useful life of the Property, and (iv) for reimbursement of the costs of tenant improvements and leasing commissions pursuant to Leases which meet the leasing parameters set forth in an approved Operating Budget or otherwise have been approved in writing by Lender, and such other capital and tenant expenditures as may be approved by Lender in writing, in Lender's sole and absolute discretion. (k) Nothing contained in this Agreement (including, without limitation, the provisions of paragraph 3 of this Agreement regarding the application of Excess Cash Collateral) shall limit or qualify in any manner (i) the obligations of Borrower under the Loan Documents, including without limitation, the obligation of Borrower to make all principal, interest and other payments at the time and manner required under the Note (as modified and amended by the Modification Agreement), or (ii) the right of Lender to pursue all rights and remedies available under the Loan Documents, at law, equity or otherwise in the event of the occurrence of any default under the Loan Documents. (l) Notwithstanding anything to the contrary contained in this Agreement, in the event an insured loss occurs with respect to the Property, Lender confirms that the insurance proceeds shall be applied in the manner provided in paragraph 6 of the Deed of Trust. 4. Reporting. (a) Borrower shall deliver to Lender or cause Manager to deliver to Lender, not later than the tenth (10th) day of each month following any month (or portion thereof) during the term hereof, (x) a detailed accounting of the cash income from the Property for the preceding calendar month and a detailed accounting of the cash expenses for the Property for the preceding calendar month, which accountings shall include, without limitation, a monthly balance sheet, a profit and loss statement (cash basis), a schedule of all accounts receivable and accounts payable (to the extent ascertainable by the date such report is required and including whether any rents or other charges are delinquent), a bank statement and bank reconciliation for the Cash Collateral Disbursement Account and such other statements and information as Lender shall reasonably request, (y) a certified current rent roll of the Property identifying therein all current Tenants (with appropriate contact persons), the spaces they use or occupy, their monthly rental and other obligations, the commencement and termination dates of all Leases in effect at the Property, and (z) a schedule of the security deposits held pursuant to such Leases and such other information as Lender shall reasonably request. (b) If the reports delivered under clause (x) of subparagraph 4(a) above reveal an underpayment of Excess Cash Collateral with respect to the period covered by such reports, simultaneously with the sending of such reports, the underpayment will be sent to Lender from the Cash Collateral Disbursement Account by wire transfer in accordance with the instructions set forth on EXHIBIT G attached hereto or as otherwise directed by Lender, which amount will be applied by Lender in the manner that such underpayment would have been applied had such underpayment been received with the prior monthly payment to Lender of Excess Cash Collateral. If the reports delivered under clause (x) of subparagraph 4(a) above reveal an overpayment of Excess Cash Collateral with respect to the period covered by such reports, and Lender confirms in writing such overpayment to Borrower and Manager, Manager shall be entitled to reduce the next payment of Excess Cash Collateral by an amount equal to such overpayment. (c) Whenever any action, suit or proceeding is commenced against the Borrower or the Property or is threatened in writing to be commenced against the Borrower or the Property, the Borrower shall (or shall cause Manager to), within five (5) business days of such commencement or receipt of such threat, as the case may be, notify Lender of such action, suit or proceeding or of such threatened action, suit or proceeding, as the case may be (which notice will include, without limitation, a description of the amount and nature of the claim), and as long as such action, suit or proceeding or such threatened action, suit or proceeding, as the case may be, is continuing, Borrower will update Lender on a monthly basis on the status of such action, suit or proceeding or of such threatened action, suit or proceeding, as the case may be. (d) All accounts, reports and statements delivered to Lender pursuant to subparagraphs 4(a) and (c) above shall be certified by Manager or by the Chief Financial Officer of Borrower or, if none, its managing general partner as being true, complete and correct in all material respects as of the date of such certification, and shall be accompanied by all invoices and such other documentation as Lender may reasonably request to substantiate and verify the actual incurrence of such expenses by Borrower identified therein. (e) Borrower and Manager agree that Lender and its agents and employees shall at all times have the right upon reasonable notice and during normal business hours to inspect, audit and make copies of the books, records, reports and financial and accounting information relating to the Property maintained by Borrower or Manager. In addition, in the event that Lender determines from any such inspection or audit that Borrower or Manager failed to pay over to Lender any net cash flow from the Property, for the period of February 1, 1993 through November 30, 1993, Borrower or Manager, as the case may be, shall reimburse Lender for such net cash flow immediately upon written notice of such failure, it being understood that Manager shall only be liable for the obligation set forth in the sentence up to the amount of such net cash flow which Manager did not pay over to Borrower or Lender. Such net cash flow shall be deposited in the Reserve Account. 5. Waiver of Management Fees. Neither Borrower nor Manager will pay Borrower or any entity or person affiliated with Borrower (including Borrower's partners) any management fees, commissions or other compensation of any kind or nature with respect to the management, leasing, development or administration of the Property during the term of this Agreement, other than fees due to Manager under the Management Agreement; it being agreed, however, that the foregoing shall not preclude Cash Collateral being applied by Borrower or Manager toward payment of the usual and customary insurance commissions obtained by Borrower, provided that the insurance is provided on a competitively-bid basis and provided that such payments are otherwise made in accordance with the terms of this Agreement. Furthermore, neither Borrower nor Manager shall enter into any agreement amending, modifying, restating, replacing, extending, renewing or terminating the Management Agreement without the prior written consent of Lender. 6. Termination and Default. (a) At any time upon the occurrence of any default beyond applicable grace and cure periods by Borrower or Manager under this Agreement or by Borrower under the Loan Documents, Lender may, in addition to electing to exercise any and all of its rights and remedies under the Loan Documents or at law or in equity, by written notice to Borrower and Manager, elect to terminate this Agreement, in which event (and notwith- standing anything to the contrary which may be contained or implied in this Agreement) the terms of the Deed of Trust shall govern the application of Rents and other Assigned Payments, it being expressly acknowledged that upon any such termination Lender shall have the absolute and unconditional right either to: (i) direct Manager, with respect to the Cash Collateral Disbursement Account, and/or Account Agent, with respect to the Reserve Account, to maintain the account balances then existing in said accounts plus any new monies subsequently deposited therein and to enjoin said parties from disbursing any amounts from said accounts for any purpose whatsoever or (ii) to apply all Rents and other Assigned Payments (then held or thereafter received, but subject, with respect to security deposits, to the rights of Tenants) to the payment of principal, interest and other sums due under the Loan in such order and priority as Lender, in its sole and absolute discretion, shall elect. Termination of this Agreement shall not affect the right of Lender to collect the Rents should Lender elect to exercise its rights under the Deed of Trust. The date that Lender gives a notice to terminate this Agreement as described above is herein referred to as the "TERMINATION DATE". Upon the occurrence of the Termination Date, Lender expressly reserves the right (i) to enjoin the disbursement of any amounts held in the Cash Collateral Disbursement Account, Reserve Account or any other account maintained in connection with the Loan for whatever purpose, by notice to Manager, Account Agent or the holder of any other such accounts as set forth above; (ii) to notify the bank holding the Cash Collateral Disbursement Account and/or the Reserve Account that Lender shall have the sole, exclusive and absolute authority to make disbursements or transfers from such accounts or (iii) to withdraw all monies contained in the Cash Collateral Disbursement Account, the Reserve Account and any other accounts maintained in connection with the Loan (irrespective of whether such monies constitute Excess Cash Collateral), or alternatively, with respect to the Cash Collateral Disbursement Account, to require Manager and/or Account Agent to immediately remit to Lender on demand all sums in the Cash Collateral Disbursement Account and/or the Reserve Account. Lender shall apply all such monies received from Manager and Account Agent under clause (iii) above against the Borrower's obligations under the Loan Documents (but subject, with respect to security deposits, to the rights of Tenants), including without limitation, the payment of principal, interest and other sums evidenced and secured by the Loan Documents (all said principal, interest and other sums being herein referred to as the "DEBT"), whether or not then due and payable and in such order, priority and proportions as Lender shall determine in its sole and absolute discretion; provided, however, that Lender will leave in the Cash Collateral Disbursement Account an amount sufficient to pay Operating Expenses (including any leasing commissions owing to the Manager under the terms of the Management Agreement) which have been incurred prior to the Termination Date (but not with respect to any accounts payable which are more than thirty (30) days past due, except for (i) items subject to a bona fide dispute which are less than sixty (60) days past due and (ii) items for which monies have been reserved in accordance with the provisions of subparagraph 3(h) of this Agreement), or which otherwise relate to Operating Expenses incurred no more than thirty (30) days prior to the Termination Date (but only if Lender has not made other arrangements for the payment of such Operating Expenses). In no event shall such Operating Expenses to be so paid from the Cash Collateral Disbursement Account following the Termination Date be in excess of amounts permitted to be paid by Manager under this Agreement for such Operating Expenses and in no event shall such Operating Expenses be incurred subsequent to Lender (other than as approved by Lender) having commenced a foreclosure action against the Property or having obtained the appointment of a receiver for the Property and Borrower having received notice of such commencement or such appointment or Lender (or its assignee, designee or nominee) having taken title to the Property pursuant to the terms of the Modification Agreement and Borrower having received notice of such transfer of title. In addition to the foregoing, at any time on or after the Termination Date, Lender shall have the right to terminate the Management Agreement with or without cause on fifteen (15) days' notice to Manager and Borrower. (b) No failure to exercise or delay by Lender in exercising any right, power or privilege under the Loan Documents, at law or in equity shall preclude any other or further exercise thereof, or the exercise of any other right, power or privilege. The rights and remedies provided in this Agreement and the Loan Documents are cumulative and not exclusive of each other or of any right or remedy provided by law or in equity. Lender expressly reserves any and all rights and remedies available to it under the Loan Documents, at law or in equity, including, without limitation, the right to accelerate the Loan and to commence an action to foreclose the Deed of Trust (judicially or by power of sale) or petition for the appointment of a receiver, irrespective of whether this Agreement is in effect or has been terminated in accordance with the provisions contained in this paragraph 6, it being expressly agreed that the termination of this Agreement shall in no event or under any circumstances be a condition precedent to the exercise by Lender of any of such rights and remedies. (c) Simultaneously with the execution of this Agreement, Borrower and Manager have executed and delivered to Lender undated written notices (collectively, the "NOTICES") instructing each Tenant and future tenant to pay Rents to Lender in the manner more particularly set forth in such Notices. Borrower acknowledges and agrees that Lender shall have the absolute and unconditional right to send the Notices to the Tenants and future tenants upon the occurrence of any event which would permit Lender to terminate this Agreement in accordance with the terms of this paragraph 6. Borrower hereby grants to Lender (and all persons designated by Lender including, without limitation, First National Bank of Chicago or any other financial institution designated by Lender) the full right, power and authority, which shall be deemed to be coupled with an interest, to endorse and deposit all checks pertaining to the Property delivered for deposit into the account described in the Notices, whether or not made payable to Borrower, Lender, Manager or otherwise, and Borrower agrees to execute all necessary or appropriate documentation confirming the authority granted hereby. Neither Borrower nor Manager shall hereafter deliver any notice or other written communication containing contrary payment instructions for the Rents or any other Assigned Payments to any Tenant or future tenant of the Property unless such notice or communication shall have been approved by Lender in writing, which approval may be withheld by Lender in its sole and absolute discretion. 7. Security Deposits Account. As of the date hereof, Borrower has deposited $192,237.26 representing all amounts being held as security deposits under the Leases into a separate interest-bearing escrow account (which interest shall periodically be paid into the Reserve Account, unless the terms of a Lease or applicable state law require otherwise, in which event such escrow account shall retain such interest or such interest shall be paid as required by applicable law or such Lease) in Lender's exclusive possession and control (the "SECURITY DEPOSITS ACCOUNT") which monies represent all security deposits under existing Leases. Lender shall furnish Borrower account statements with respect to the Security Deposits Account not more than quarterly during any calendar year. In addition, Borrower has furnished Lender with a complete accounting of all security deposits required to be held by Borrower under the Leases presently in effect. Borrower or Manager, as the case may be, shall remit to Lender all future security deposits from Tenants of the Property for deposit into the Security Deposits Account. Neither Borrower nor Manager shall have any right to withdraw or otherwise use, apply or credit such funds (except as provided in the next sentence or to return same to a Tenant in accordance with the provisions of a Lease) without the prior written consent of Lender. Borrower or Manager shall notify Lender in writing in advance of the need to return a particular security deposit to a Tenant or of the right of Borrower to retain the security deposit under the terms of the applicable Lease, and if Borrower is entitled to retain a security deposit, then all such amounts shall be transferred by Lender promptly into the Cash Collateral Disbursement Account to be treated as Cash Collateral and applied in accordance with the provisions of paragraph 3 of this Agreement. Borrower hereby grants to Lender a security interest in Borrower's interest, if any, in the Security Deposits Account and this Agreement shall constitute a security agreement upon said account. On demand, Borrower agrees to execute and deliver to Lender and hereby authorizes Lender to execute in the name of Borrower to the extent Lender may lawfully do so, financing statements, chattel mortgages or comparable security instruments as may be requested or required by Lender to perfect its security interest in the Security Deposits Account and Borrower's interest in the monies held in the Security Deposits Account. The foregoing provisions shall not constitute a waiver of any claim Lender may have against Borrower or Manager, if any, by reason of any misapplication and/or misrepresentation by Borrower, Manager or their respective agents or employees of security deposits and Borrower and Manager hereby indemnify and hold Lender harmless from and against any loss, liability, damage or expense in connection with any such misapplication and/or misrepresentation by Borrower, Manager or their respective agents or employees. 8. Leases. Borrower has delivered to Lender original or certified copies (as amended and modified) of (i) all Leases and (ii) all other contracts and agreements which currently affect the use, operation, maintenance or occupancy of the Property. Manager, for itself and its agents and employees, shall agree at all times to maintain, operate and endeavor to lease-up the Property in a professional and diligent manner. 9. No Waiver. Upon the occurrence of the Termination Date and subject to the provisions of the last sentence of subparagraph 6(a) of this Agreement, Lender expressly reserves the right to withdraw and apply all monies contained in the Cash Collateral Disbursement Account, the Reserve Account and any other escrow accounts maintained by Lender in connection with the Loans (irrespective of whether such monies constitute Excess Cash Collateral) against the Debt whether or not then due and payable and in such order, priority and proportions as Lender shall determine in its sole and absolute discretion. No failure to exercise or delay by Lender in exercising any right, power or privilege under the Loan Documents, at law or in equity shall preclude any other or further exercise thereof, or the exercise of any other right, power or privilege. The rights and remedies provided in this Agreement and the Loan Documents are cumulative and not exclusive of each other or of any right or remedy provided by law or in equity. Except as otherwise expressly provided in the Loan Documents, no notice to or demand upon Borrower in any instance shall, in itself, entitle Borrower to any other or further notice or demand in similar or other circumstances or constitute a waiver of the right of Lender to any other or further action in any circumstances without notice or demand. 10. Expenses, Attorneys' Fees. Lender is hereby authorized to reimburse itself from the Reserve Account or to direct Manager to reimburse Lender from the Cash Collateral Disbursement Account for all amounts reasonably incurred by or on behalf of Lender from and after the date hereof for attorneys' fees and all other expenses reasonably incurred by or on behalf of Lender in connection with the enforcement of this Agreement following the occurrence of a default hereunder. In the event any dispute shall arise concerning the subject matter of this Agreement and the Lender prevails in such dispute, Lender shall be entitled to recover its reasonable attorneys' fees and costs incurred in connection therewith, including without limitation, all costs of trial, appellate and bankruptcy proceedings. The rights and remedies of Lender contained in this paragraph shall be in addition to, and not in lieu of, the rights and remedies contained in the Loan Documents and as otherwise provided by law or in equity. 11. Borrower to Encourage Payment, Collections. Borrower and Manager will use their usual and customary procedures to collect Rents up to the institution of suit, including sending delinquency notices and phone calls. At such time as Borrower or Manager would ordinarily take action to collect past-due accounts, Borrower or Manager, as the case may be, shall notify Lender that it recommends that a collection action be instituted. Lender shall then have the option, with respect to any leases covering more than 10,000 square feet of the Property, of authorizing Borrower or Manager, or both, to take such action, either on Borrower's name or its own name, as Lender deems appropriate to collect the delinquent Rents or Lender shall undertake on behalf of Borrower to take such action as Lender deems appropriate to collect the delinquent Rents; provided, however, that with respect to leases covering less than 10,000 square feet of the Property, Borrower or Manager shall take such actions to collect past due accounts as Borrower deems appropriate in its sole discretion. All reasonable attorneys' fees and costs incurred by Borrower in the collection of delinquent Rents shall be approved by Lender for payment from the Cash Collateral Disbursement Account or the Reserve Account in accordance with subparagraphs 3(a) or 3(c) hereof, respectively. 12. Carryover of this Agreement in the Event of Bankruptcy. In the event either Borrower or any general partner of Borrower ("GENERAL PARTNERS") files for relief under Title 11 of the United States Code, as amended (the "BANKRUPTCY CODE"), or an order of relief is granted as to any of them under the Bankruptcy Code, the following provisions shall be applicable. Notwithstanding anything in this paragraph 12 to the contrary, however, neither Borrower nor any of the General Partners shall have Lender's consent to use the Cash Collateral until a Cash Collateral Order or Stipulation incorporating the following provisions has been signed by Lender and entered and approved by a bankruptcy court under Section 363 of the Bankruptcy Code. Borrower and General Partners (on behalf of themselves and each of their prospective bankruptcy estates) enter into the following provisions in consideration of the procedures provided in this Agreement and other good and valuable consideration, the receipt and sufficiency of which Borrower and General Partners acknowledge: This Agreement to be a Cash Collateral Order. Borrower and General Partners agree that, in the event Borrower or any of the General Partners files a petition for relief under the Bankruptcy Code with any bankruptcy court, or is subjected to any petition under the Bankruptcy Code which results in any order of relief under the Bankruptcy Code, and the debtor in that proceeding wishes to use Cash Collateral as defined in the Bankruptcy Code and/or this Agreement, then this Agreement shall without modification be deemed to be a stipulation between Lender and Borrower and/or any of the General Partners, as applicable, for a Cash Collateral Order pursuant to Section 363 of the Bankruptcy Code. Borrower, General Partners (on behalf of themselves and each of their prospective bankruptcy estates) and Lender hereby agree that they shall cooperate in and shall not in any way resist having this Agreement become and be fully incorporated in, without change or modification, a Cash Collateral Order or Stipulation immediately entered, subject to court approval, by a bankruptcy court under Section 363 of the Bankruptcy Code and before any use of Cash Collateral as defined in Section 363 of the Bankruptcy Code and/or this Agreement and that Cash Collateral shall only be used as provided in this Agreement. Such order shall permit the use of Cash Collateral only until the end of the exclusive period under Section 1121(b) of the Bankruptcy Code, and no longer, and shall incorporate all of the other terms provided by this Agreement, and specifically Sections 12(ii) through 12(vi) below; provided, however, that nothing herein shall be deemed to restrict Lender's absolute right, at any time, to seek to limit or terminate the exclusive period under Section 1121(b) of the Bankruptcy Code or any of Lender's other rights or remedies under the Loan Documents, the Bankruptcy Code or otherwise; and provided, further, that Borrower does not represent, warrant or guarantee that any creditor, committee or trustee acting in the bankruptcy case, or the bankruptcy court, sua sponte, will not object to one or more of the terms or conditions in Section 12(ii) through 12 (vi) below provided that this provision shall not be deemed an admission by Lender that any such party has any right or cause to make any such objection. Borrower and General Partners also agree and acknowledge that the Rents and the other Assigned Payments are and shall be deemed to be in any such proceeding "Cash Collateral" as that term is defined in Section 363 of the Bankruptcy Code. (i) Adequate Protection. As adequate protection for the use of Cash Collateral, Borrower and General Partners agree that Lender shall be deemed in the proceeding, to the extent it is determined that Section 552(a) of the Bankruptcy Code applies to limit Lender's interest under the Loan Documents and this Agreement, to have a continuing perfected post- bankruptcy interest and pledge in all Leases and all Rents and other Assigned Payments whether entered into or derived from the Property prior or subsequent to the later to occur of the filing of the petition or the order for relief. As further adequate protection for Borrower's use of the Rents and the other Assigned Payments, Borrower agrees to maintain at all times an adequate and appropriate amount and coverage of insurance covering its assets in amounts not less than that required under the Loan Documents, naming Lender as a loss payee as its interest may appear, provided a sufficient portion of the Rents is made available for such purpose. (ii) Priority Claim To The Extent Lender's Security Decreased. All Rents and the other Assigned Payments are Cash Collateral, and to the extent they are used and consumed after filing or entry of any Cash Collateral Order, Borrower and General Partners specifically agree that they are collateral for a secured claim under Section 506 of the Bankruptcy Code in the amount so used. To the extent the collateral securing Lender's claim in the bankruptcy proceeding is thereafter deemed or proves to be insufficient to pay Lender's claim in full, Lender's secured claim shall be deemed to have been inadequately protected by the provisions of the Cash Collateral Order, and it shall therefore have an administrative expense claim in the proceeding with super priority over any and all administrative expenses of the kind specified in Section 503(b) and 507(b) of the Bankruptcy Code, which super priority shall be equal to the priority provided under the provisions of Section 364(c)(1) of the Bankruptcy Code over all other costs and administrative expenses incurred in the case of the kind specified in, or ordered pursuant to, Section 105, 326, 330, 331, 503(b), 506(c), 507(a), 507(b) or 726 of the Bankruptcy Code and shall at all times be senior to the rights of Borrower, General Partners or any successor trustee in the resulting bankruptcy proceeding or any subsequent proceeding under the Bankruptcy Code. (iii) No Renewal of Exclusive Period, Relief from Automatic Stay. Borrower and General Partners agree that if it or any of them is a debtor in a proceeding under the Bankruptcy Code, and the bankruptcy court enters a Cash Collateral Order, then, subject to the approval of the bankruptcy court, such Cash Collateral Order shall provide that if Borrower or any of the General Partners, as the case may be, does not file a Plan within the exclusive period provided by Section 1121(b) of the Bankruptcy Code, Lender shall, without the necessity of any additional notice to the debtor or to other creditors, or any hearing or any further order of the bankruptcy court, have immediate relief from stay under Bankruptcy Code Section 362 to commence and complete foreclosure on the Property, conduct and complete sale thereunder, and either purchase itself or sell to a third party under the provisions of the Loan Documents and according to applicable non-bankruptcy laws, and to take any other action permitted under the Loan Documents and applicable non-bankruptcy law. Nothing in this subsection 12(iii) shall be deemed to in any way limit Lender's right, at any time, to limit or terminate the exclusive period under Section 1121 of the Bankruptcy Code. (iv) Further Relief From Automatic Stay. Borrower and General Partners specifically agree that, for valuable consideration as stated herein, subject to bankruptcy court approval, Lender shall be deemed to have the relief from the automatic stay under Section 362 of the Bankruptcy Code in order to effectuate the provisions of this Section 12. As an alternative, if Lender requests such relief, Borrower or General Partners, as the case may be, shall not object to or oppose Lender from having immediate relief, subject to bankruptcy court approval, from the automatic stay under Section 362 of the Bankruptcy Code, such relief being limited to modification of the stay (i) to implement the provisions of this Agreement permitting the use of Cash Collateral, (ii) to permit the filing of financing statements or other instruments and documents evidencing Lender's interests in the Rents, the other Assigned Payments and the Leases after the filing of the petition or order for relief, whichever is later, (iii) to permit Lender's application of the Rents and the other Assigned Payments as provided herein, and (iv) to permit the relief provided for in subsection 12(iii). (v) Perfection. During the pendency of the case, any of the rights granted hereunder or by the Deed of Trust shall be confirmed as security interests or liens, and shall be deemed present, "choate", fully perfected and presently fully enforceable without the necessity of the filing of any additional documents or commencement of proceedings otherwise required under non-bankruptcy law for the perfection or enforcement of security interests, with such perfection and enforcement being binding upon Borrower, General Partners and any subsequently appointed trustee, either in Chapter 11 or under any other Chapter of the Bankruptcy Code, and upon other creditors of Borrower or General Partners, as the case may be, who have or who may hereafter extend secured or unsecured credit to Borrower or General Partners. (vi) Nothing in this Section 12 shall be deemed in any way to limit or restrict any of Lender's rights to seek in the bankruptcy court any relief that Lender, in its sole discretion, may deem appropriate, in the event that a case under the Bankruptcy Code is commenced by or against Borrower or any of the General Partners, and in particular, Lender shall be free to move for an immediate vacation of the automatic stay under Section 362 of the Bankruptcy Code, to terminate the exclusive period under Section 1121 of the Bankruptcy Code, and/or to dismiss the filed bankruptcy case. 13. Lender Not Liable for Expenses. Nothing in this Agreement shall be intended or construed to hold Lender liable or responsible for any expense, disbursement, liability or obligation of any kind or nature whatsoever, including, but not limited to, wages, salaries, payroll taxes, withholding, benefits or other amounts payable to or on behalf of Borrower or General Partners, whether or not there is sufficient money in the Cash Collateral Disbursement Account and/or the Reserve Account to pay such expenses or costs and whether any present or future creditor attempts to assert a claim against Lender or the Property, including, but not limited to, any attempt in any bankruptcy proceeding to assert a claim under Section 506(c) of the Bankruptcy Code, or any other provision of the Bankruptcy Code. Nothing contained in the preceding sentence shall be construed as relieving Lender of its obligations to comply with the express provisions of this Agreement. In any case commenced under any provision of the Bankruptcy Code by or against Borrower, Lender does not consent to any "carve-out", nor shall the Borrower nor any of the General Partners seek the imposition of any "carve-out" for any costs, fees or expenses of any kind or nature of the Borrower's bankruptcy estate, as against either (x) any of Borrower's past, present or future property together with any proceeds or products of the same (and whether or not any of such property together with the proceeds or products thereof is Lender's collateral) or (y) as against Lender, its collateral or its indebtedness. 14. Management Agreement. In the event and to the extent that the terms and provisions of the Management Agreement conflict with those of this Agreement, the terms and provisions of this Agreement shall override those of the Management Agreement. Manager acknowledges and agrees that amendments and modifications of the Management Agreement will be binding on Lender only to the extent such amendments and modifications have been approved in writing by Lender. Lender may terminate the Management Agreement upon termination of this Agreement as set forth in subparagraph 6(a) hereof. 15. No Joint Venture. This Agreement shall not constitute a joint venture or partnership agreement of any kind between the parties hereto or otherwise create the relationship of joint venturers or partners among the parties hereto. Nothing contained herein shall characterize or be deemed to characterize Lender as a "mortgagee-in-possession". 16. Modifications. If any or all of the provisions of this Agreement are hereafter modified, vacated or stayed by subsequent order of any court, such stay, modification or vacation shall not affect the validity and enforceability of any contractual right, property right, lien, security interest or priority authorized hereby with respect to any of the Rents or the other Assigned Payments which are deemed by this Agreement to be Cash Collateral and which have been used pursuant to this Agreement and the Loan Documents. Notwithstanding such stay, modification or vacation, any uses of Rents or the other Assigned Payments after the effective date of such modification, stay or vacation, shall be governed in all respects by the original provisions of this Agreement, and Lender shall be entitled to all of the rights, privileges and benefits, including any interest, liens, security interests, priorities and collection rights granted herein, with respect to all Rents and other Assigned Payments which are used thereafter. Unless it explicitly consents in writing at the time of such modification, stay or vacation, Lender does not by the terms hereof consent to any modifications of this Agreement. 17. Governing Law. This Agreement shall be construed in accordance with the laws of the State of California without regard to its conflict of laws principles. 18. Benefit. This Agreement shall to the extent legally permissible be binding upon and shall inure to the benefit of Lender, Borrower, Manager and their respective successors and assigns, including, but not limited to, any trustee that may be appointed under the Bankruptcy Code or any state court receiver. The provisions of paragraph 12 of this Agreement shall be binding upon General Partners and their respective successors, assigns, heirs, estates and representatives. In no event or under any circumstances shall any third party be deemed a third party beneficiary of this Agreement. 19. Consent to Agreement. Borrower and each General Partner acknowledges for itself that it has thoroughly read and reviewed the terms and provisions of this Agreement and is familiar with same, that the terms and provisions contained herein are clearly understood by it and have been fully and unconditionally consented to by it and that Borrower and each General Partner has had full benefit and advice of counsel of its own selection, or the opportunity to obtain the benefit and advice of counsel of its own selection, in regard to understanding the terms, meaning and effect of this Agreement, and that this Agreement has been entered into by Borrower and each General Partner freely, voluntarily, with full knowledge and without duress, and that in executing this Agreement, Borrower and each General Partner are relying on no other representations, either written or oral, express or implied, made by Lender, or by any other party hereto, and that the consideration received by Borrower and each General Partner hereunder has been actual and adequate. 20. Miscellaneous. This Agreement is made for the sole protection of Lender, Borrower, Manager and their respective successors and assigns. No other person shall have any right whatsoever hereunder. Any notice, demand or other communication which any party hereto may desire or may be required to give to any other party hereto shall be in writing, and shall be deemed given (a) if and when personally delivered, (b) upon receipt if sent by a nationally recognized overnight courier addressed to a party at its address set forth below, or (c) on the third (3rd) business day after being deposited in United States registered or certified mail, postage prepaid, addressed to a party at its address set forth below, or to such other address as the party to receive such notice may have designated to all other parties by notice in writing in accordance herewith: If to Lender: The Travelers Life and Annuity Company 2215 York Road Suite 504 Oak Brook, Illinois 60521 Attention: Managing Director General Counsel With copies to: The Travelers Insurance Company One Tower Square Hartford, Connecticut 06183 Attention: Travelers Realty Investment Company and Battle Fowler 280 Park Avenue New York, New York 10017 Attention: Lawrence Mittman, Esq. Dean A. Stiffle, Esq. If to Borrower: C-C California Plaza Partnership c/o Carlyle Real Estate Limited Partnership-XV c/o JMB Realty Corporation 900 North Michigan Avenue Chicago, Illinois 60611-1575 Attention: Robert J. Chapman With copies to: Pircher, Nichols & Meeks 1999 Avenue of the Stars Los Angeles, California 90067-6077 Attention: Real Estate Notices (P.G.N.) Cygna Limited One c/o Cygna Development Corporation 2121 North California Boulevard - Suite 230 Walnut Creek, California 94596 Attention: Ben Kacyra and Greene, Radovsky, Maloney & Share Spear Street Tower - Suite 4200 1 Market Plaza San Francisco, California 94105 Attention: Russell Pollock, Esq. If to Manager: Cygna Development Services, Inc. 2121 North California Boulevard Suite 230 Walnut Creek, California 94596 With copies to: Greene, Radovsky, Maloney & Share Spear Street Tower - Suite 4200 1 Market Plaza San Francisco, California 94105 Attention: Russell Pollock, Esq. Each party entitled to receive notice under this Agreement may designate a change of address by notice given to the other parties at least ten (10) days prior to the date such change of address is to become effective. Time shall be of the strictest essence in the performance of each and every one of the provisions hereof. If any of the provisions of this Agreement is held to be invalid or unenforceable, the remaining provisions shall remain in effect without impairment. This Agreement may not be modified, amended or terminated except by an agreement in writing executed by all of the parties hereto. 21. Counterparts. It is understood and agreed that this Agreement may be executed in telecopied or original counterparts, each of which shall, for all purposes, be deemed an original and all of such counterparts, taken together, shall constitute one and the same Agreement, even though all of the parties hereto may not have executed the same counterpart of this Agreement. 22. Recourse Obligations. Borrower and its general partner, Carlyle Real Estate Limited Partnership-XV, an Illinois limited partnership ("CARLYLE") (but none of the partners of Carlyle, including, without limitation, JMB Realty Corporation ("JMB"), a Delaware corporation, nor any of Carlyle's partners' respective successors and assigns), respectively, shall be liable personally and on a full recourse basis to Lender for any and all losses, costs, expenses and liabilities of any kind or nature whatsoever incurred by Lender as a result of any act of Borrower or Carlyle which knowingly or intentionally prevents or materially impedes or hinders the collection or application of the Rents and the other Assigned Payments as provided in this Agreement; provided, however, that Carlyle shall only be liable with respect to acts of Borrower directly caused by Carlyle (and not by any other person or entity, including any other partner in Borrower). Borrower and Borrower's general partner, Cygna Limited One, a California limited partnership ("CL1"), respectively, shall also be liable personally and on a full recourse basis to Lender for any and all such losses, costs, expenses, and liabilities incurred by Lender as a result of any act of Borrower or CL1 which knowingly or intentionally prevents or materially impedes or hinders the collection or application of the Rents and the other Assigned Payments as provided in this Agreement; provided however, that CL1 shall only be liable with respect to acts of Borrower directly caused by CL1 (and not by any other person or entity, including any other partner or Borrower). In addition, CL1 shall be liable as set forth above with respect to any acts of Manager, for which acts Manager also shall be personally liable to Lender on a full recourse basis. The provisions of the foregoing sentence shall be limited to the circumstances described in such sentence and shall not otherwise affect the exculpatory provisions of the Loan Documents as they relate to the payment of the Debt. 23. Signatories. Each undersigned general partner signatory of Borrower represents that it is a general partner of Borrower and that it is executing this Agreement on behalf of Borrower and, with respect to paragraphs 12, 13, 18, 19 and 22 of this Agreement, also in its separate capacity as a general partner of Borrower, and that such execution has been duly authorized by all necessary partnership action. 24. Exculpation. Notwithstanding anything in this Agreement to the contrary, but subject to the provisions of this paragraph 24, without in any manner releasing, impairing or otherwise affecting the Note, the Deed of Trust or any other instrument securing the Note or the validity thereof or hereof or the lien of the Deed of Trust, there is no personal liability of Borrower or any partner in Borrower hereunder or under any of the Loan Documents, and no monetary or deficiency judgment shall be sought or enforced against Borrower; provided, however, that a judgment may be sought against Borrower to the extent necessary to enforce the right of Lender in, to or against the Property securing the indebtedness evidenced by the Note and covered by the Deed of Trust and the other Loan Documents. Notwithstanding any of the foregoing, nothing contained in this paragraph shall be deemed to prejudice the rights of Lender: (i) to recover any fraudulently misapplied Restoration Funds, Insurance Proceeds or Condemnation Proceeds (all as defined in the Deed of Trust) as well as any expenditures, damages or costs (including without limitation reasonable attorneys' fees) incurred by Lender as a result of such fraudulent misapplication, (ii) to recover any expenditures, damages or costs (including without limitation reasonable attorneys' fees) incurred by Lender as a result of Borrower's fraud, material and intentional misrepresentation or intentional destruction of the Property or (iii) to enforce the personal recourse obligations set forth in paragraph 22 of this Agreement. All references in this paragraph to the Note, Deed of Trust and Loan Documents shall be deemed to mean the Note, Deed of Trust and Loan Documents as modified and amended by the Modification Agreement. 25. Waiver of California Statutes. Borrower acknowledges that it is in default under the terms and conditions of the Loan Documents as of the execution hereof, that Lender presently has the right to enforce the terms of the Loan Documents, and that this Agreement is being entered into pursuant to the request of Borrower. Borrower further acknowledges that all of the terms and conditions of this Agreement have been carefully negotiated between Borrower and Lender and that Borrower has been fully represented during those negotiations by competent legal counsel of Borrower's choosing, including counsel licensed to practice in the state of California. Borrower understands that Lender is entering into this Agreement in reliance upon, and in consideration of, among other things, the following waiver by Borrower of various provisions of California law. Accordingly, Borrower hereby waives, to the fullest extent permitted by law, the protections of (i) Section 726 of the California Code of Civil Procedure (providing that a creditor has only one form of action to enforce a debt secured by real property) and (ii) Sections 580a and 580d of the California Code of Civil Procedure (providing for the limitation of deficiency judgments), but only for the purpose of allowing Lender to foreclose on any collateral expressly pledged to Lender under the Loan Documents (and, without limitation to the foregoing, no deficiency judgment following a foreclosure sale may be enforced personally against Borrower or its partners, but rather may be enforced solely against such other collateral as may be expressed pledged to Lender under the Loan Documents). Borrower represents and warrants to Lender that Borrower has discussed the meaning and effect of the foregoing waivers with Borrower's legal counsel and that Borrower understands fully the legal consequence of Borrower's providing such waivers to Lender. Borrower covenants to Lender not to assert any rights under any of the foregoing statutes in opposition to any action taken by Lender to enforce Lender's rights under this Agreement or any other Loan Document. [THE REMAINDER OF THIS PAGE IS INTENTIONALLY LEFT BLANK.] IN WITNESS WHEREOF, this Agreement has been executed by the parties hereto in manner and form sufficient to bind them, as of the day and year first set forth above. THE TRAVELERS LIFE AND ANNUITY COMPANY, a Connecticut corporation By: _________________________________ Name: Title: C-C CALIFORNIA PLAZA PARTNERSHIP a California general partnership By: Carlyle Real Estate Limited Partnership-XV, an Illinois limited partnership, General Partner By: JMB Realty Corporation, a Delaware corporation, General Partner By: _______________________ Name: Title: By: Cygna Limited One, a California limited partnership, General Partner By: Cygna Development Corporation, a California corporation, General Partner By: _______________________ Name: Title: CYGNA DEVELOPMENT SERVICES, INC., a California corporation By: _________________________________ Name: Title: EXHIBIT A [ORIGINAL LOAN DOCUMENTS] NOTE: The term "Note" as used herein shall mean that certain Note Secured by Deed of Trust dated December 18, 1986 in the principal amount of $58,000,000 given by Borrower to Lender. DEED OF TRUST: The term "Deed of Trust" as used herein shall mean that certain First Deed of Trust and Security Agreement With Assignment of Rents and Leases and Fixture Filing dated as of December 18, 1986 in the principal amount of $58,000,000 given by Borrower to First American Title Insurance Company and Lender and recorded on December 18, 1986 as Document Number 86-229768 in Book 13327, Page 243, Contra Costa County Records, California. The Original Loan Documents also include all filings made in accordance with the Uniform Commercial Code with respect to the documents listed on this Exhibit A as well as all other documents or instruments evidencing, securing or relating to the indebtedness of the Note. EXHIBIT B [MODIFICATION DOCUMENTS] MODIFICATION AGREEMENT: The term "Modification Agreement" as used herein shall mean that certain Agreement of Modification of Note, Deed of Trust, and other Loan Documents dated as of the date hereof between Borrower and Lender. The Modification Documents also include the following additional documents: (i) This Agreement; (ii) that certain Escrow Agreement among Borrower, Lender and Chicago Title and Trust Company, as escrow agent; and (iii)all filings made in accordance with the Uniform Commercial Code with respect to the documents listed on this Exhibit B. EXHIBIT C [NOTICE TO TENANTS] Tenant's Name: Tenant's Address: Attention: General Manager Re: [Lease or License] dated _______________ between (C-C California Plaza Partnership), as landlord, and __________________, as tenant, [as amended] [such lease or license, as amended,] the ["Lease" or "License"] Gentlemen: This Letter shall confirm to you that notwithstanding any previous communications received by you from either or both of the undersigned and notwithstanding anything to the contrary contained in the Lease [or License], you are hereby directed by the undersigned to make your check payable to ___________________ _____ and to send all payments of rents, additional rents and all other payments due or to become due under the Lease [or License] as follows: __________________________ __________________________ __________________________ Each check should include the notation: Account No. _______________. You are also hereby notified that the terms of this letter are irrevocable and cannot be terminated, modified, abrogated or vitiated in any respect whatsoever except by a writing signed by _________________ ____________________________________________________. Sincerely yours, _____________________________________ ________________________ By:________________________________ Name: Title: C-C CALIFORNIA PLAZA PARTNERSHIP, a California general partnership By: Carlyle Real Estate Limited Partnership-XV, an Illinois limited partnership, General Partner By: JMB Realty Corporation, a Delaware corporation, General Partner By:___________________________ Name: Title: By: Cygna Limited One, a California limited partnership, General Partner By: Cygna Development Corporation, a California corporation, General Partner By:___________________________ Name: Title: CYGNA DEVELOPMENT SERVICES, INC. a California corporation By:_____________________________________ Name: Title: EXHIBIT D [OPERATING BUDGET] To Be Attached EXHIBIT E [CERTIFICATION OF MANAGER] The undersigned, _________________________, hereby certifies to you that on behalf of C-C California Plaza Partnership, a California general partnership ("BORROWER") he has paid all federal, state and local income taxes, FICA taxes, FUTA taxes, federal and state unemployment taxes and any and all other taxes required to be withheld by Borrower from its employee payroll to date as referenced in that certain Budget dated ______________ delivered to you for Borrower's operating period from ________________________ to ___________________________. The undersigned further certifies that he has withheld and paid over to the appropriate taxing authorities, any and all state and local sales and use taxes due on goods sold or services rendered during such operating period. IN WITNESS WHEREOF, the undersigned has executed and delivered this certification as of this ___ day of __________, 199_. By: ___________________________ Title: ________________________ Witness: _____________________________________ EXHIBIT F [FORM OF REQUEST] ___________________, 199_ The Travelers Life and Annuity Company 2215 York Road Suite 504 Oak Brook, Illinois 60521 Re: Request No._______ for Cash Collateral in the Amount of $________________ Travelers Loan No. 204366-0 Gentlemen: This request refers to that certain Cash Management Agreement ("AGREEMENT") dated ________________________, 1993, among The Travelers Life and Annuity Company ("LENDER"), C-C California Plaza Partnership ("BORROWER") and Cygna Development Services, Inc. ("MANAGER"). All capitalized terms which are not otherwise defined herein shall have the meaning given to such term in the Agreement. This certifies that pursuant to paragraph 3(c) of the Agreement, Borrower is entitled to request, and hereby does request, disbursement from available funds in the Reserve Account, of the amounts listed on Schedule I hereto, each of which is required to pay ordinary, necessary and reasonable operating expenses of the Property. Attached are invoices and other substantiation for the amounts requested. The exculpation provisions set forth in paragraph 24 of the Agreement are incorporated herein by reference as if set forth in their entirety. Very truly yours, C-C CALIFORNIA PLAZA PARTNERSHIP, a California general partnership By: Carlyle Real Estate Limited Partnership-XV, an Illinois limited partnership, General Partner By: JMB Realty Corporation, a Delaware corporation, General Partner By: ___________________________ Name: Title: By: Cygna Limited One, a California limited partnership, General Partner By: Cygna Development Corporation, a California corporation, General Partner By: __________________________ Name: Title: EXHIBIT G (Wiring Instructions) The Travelers Life and Annuity Company Chase Manhattan Bank New York, New York 10005 ABA No.: 021-000-021 Acct. No.: 910-2-524155 Attn.: Investment Administration Ref.: TIC Loan No. 204366-0 Travelers Loan No. 204366 ESCROW AGREEMENT AGREEMENT dated as of December 22, 1993 entered into among C-C CALIFORNIA PLAZA PARTNERSHIP, a California general partnership having an office at 2121 North California Boulevard, Suite 230, Walnut Creek, California 94596 (hereinafter referred to as Borrower); THE TRAVELERS LIFE AND ANNUITY COMPANY, a Connecticut corporation, having an address at 2215 York Road, Suite 504, Oak Brook, Illinois 60521 (hereinafter referred to as Lender); and CHICAGO TITLE AND TRUST COMPANY, having an office at 171 North Clark Street, Chicago, Illinois 60601 (hereinafter referred to as Escrow Agent); W I T N E S S E T H: WHEREAS, Borrower has borrowed from Lender the original principal sum of $58,000,000.00 (the "LOAN"), the indebtedness of which Loan is evidenced by the Note and secured by the Deed of Trust (as such terms are defined in Exhibit A attached hereto) encumbering Borrower's fee estate in the real property and improvements more particularly described in the Deed of Trust (the "PROPERTY"); WHEREAS, Borrower has permitted certain defaults to occur under the Loan and as of the date hereof Lender is entitled to foreclose its interest in the Property; WHEREAS, Borrower has requested that for the time being Lender refrain from foreclosing its interest in the Property and has requested that Lender enter into among other agreements, that certain Agreement of Modification of Note, Deed and Trust and Other Loan Documents (the "MODIFICATION AGREEMENT") amending the Note and the Deed of Trust and extending the maturity date of the Loan; WHEREAS, Lender has refused to refrain from foreclosing its interest in the Property for the time being or to execute and deliver the Modification Agreement unless Borrower executes this Agreement and delivers a deed to the Property and various other documents in escrow pursuant hereto; and WHEREAS, in consideration of Lender's agreement to refrain from foreclosing its interest in the Property for the time being, to extend the maturity of the Loan and to execute and deliver the Modification Agreement, Borrower and Lender have executed various documents which are to be deposited into escrow and held in escrow pursuant to the provisions of this Agreement. NOW, THEREFORE, in consideration of ten dollars ($10) and other good and valuable consideration, the receipt of which is hereby acknowledged, Borrower, Lender and Escrow Agent hereby covenant and agree as follows: 1. Transfer Documents. Borrower acknowledges and agrees that in order to enable Lender to avoid the time and expense of pursuing a foreclosure upon the occurrence of a default beyond applicable grace and cure periods, if any, under the Loan Documents (as defined in Exhibit A), on the date hereof, original copies of the documents and instruments described in Exhibit B attached hereto (hereinafter referred to as the Transfer Documents) executed by Borrower have been delivered to Escrow Agent. 2. Receipt by Escrow Agent. Escrow Agent acknowledges receipt of the Transfer Documents and agrees to establish an escrow (hereinafter referred to as the Escrow) and hold the Transfer Documents in escrow pursuant to the provisions of this Agreement. 3. Breaking of Escrow. Upon the receipt by Escrow Agent of a certification in the form of Exhibit C attached hereto (the "TRANSFER DIRECTION NOTICE"), Escrow Agent shall immediately complete, by dating and filling in all blanks as appropriate, and deliver to Lender or Lender's nominee, designee or assignee the Transfer Documents, it being understood that the Property may be transferred to Lender, its nominee, designee or assignee, as directed by Lender. Borrower hereby authorizes and empowers Lender as attorney-in-fact of Borrower, to complete the Transfer Documents as described above and to execute any such further documentation as is reasonably necessary to effectuate any such transfer; provided, however, that Lender shall not execute pursuant to said power of attorney any further documentation that would create any recourse liability on behalf of Borrower or any of its partners. The power of attorney granted to Lender pursuant to this paragraph shall be deemed coupled with an interest and shall be irrevocable. Notwithstanding anything to the contrary contained in this Agreement, it is expressly understood that (i) Borrower shall not be responsible for the payment of any deed tax, sales tax or similar tax imposed as a result of the execution, delivery and recordation of the Transfer Documents, (ii) Borrower shall not be responsible for the payment of any title premiums or other title charges with respect to the issuance of the owner's title policy insuring the Transfer Documents and (iii) all documents and instruments required to be delivered by Borrower or actions required to be taken by Borrower pursuant to this Agreement shall be without recourse, cost or liability of any sort whatsoever to Borrower or any of its direct or indirect present or future partners. 4. Transfer Absolute. Borrower acknowledges and agrees that at the time the Transfer Documents and all additional documents and actions contemplated by this Agreement are properly delivered to Lender pursuant to the provisions hereof (a) they are intended to effect a present and absolute conveyance and unconditional transfer of the Property, the Account Proceeds, the leases affecting the Property and all income and revenue therefrom, furniture, fixtures and equipment and all licenses, rights and privileges associated therewith, to the extent assignable, and are not given as security, (b) Borrower will deliver to Lender, its nominee, designee or assignee possession (subject to the rights of tenants, occupants and licensees) and enjoyment of the Property and the other property transferred pursuant to the Transfer Documents concurrently with the delivery to Lender of the Transfer Documents and Lender, its nominee, designee or assignee shall thereafter have the immediate right to occupy, operate, use, sell and transfer the same or any part thereof for its own account, at its sole and absolute discretion and (c) title to the Property shall remain subject to the Deed of Trust to the full extent of the indebtedness secured thereby, and recording of the Deed (described in Exhibit B attached hereto) shall not result in a merger of Lender's interest as beneficiary under the Deed of Trust with Lender's interest as fee title holder pursuant to the Deed. 5. Cumulative Remedies. Nothing contained in this Agreement shall preclude Lender from pursuing foreclosure of the Deed of Trust upon an Event of Default or failure to pay the Debt upon maturity, or any other rights and remedies under the Deed of Trust or the other Loan Documents (as defined in the Deed of Trust), instead of or in addition to directing the Escrow Agent to deliver the Transfer Documents to Lender in accordance with the provisions of this Agreement and effectuating a transfer to Lender, its nominee, designee or assignee, pursuant to the Transfer Documents. Upon a default under the Loan Documents beyond applicable notice and cure periods, if any, or failure to pay the Debt in full on the maturity, Borrower shall within five (5) days of demand by Lender (unless the Debt shall have been paid in full within such five (5) day period) deliver to Lender, in a form and content acceptable to Lender, a stipulation of the facts, necessary to obtain a judgment of foreclosure uncontested by Borrower and a quitclaim deed of Borrower's redemption rights and Lender shall have the absolute right to file the same and complete a foreclosure of the Deed of Trust and a transfer of the Property pursuant to the terms thereof. Any documents or instrument required to be delivered under this paragraph shall be without recourse, cost or liability of any sort whatsoever to Borrower. 6. Specific Performance. The provisions of this Agreement shall be enforceable by an action for specific performance. 7. Termination of Escrow. Upon payment in full to Lender of the Debt, Lender shall by written notice to Escrow Agent terminate the Escrow and deliver the Transfer Documents to Borrower whereupon the Transfer Documents shall be deemed cancelled and null and void. Except as to deposits of funds for which Escrow Agent has received express written direction concerning investment or other handling, the parties hereto agree that the Escrow Agent shall be under no duty to invest or reinvest any deposits at any time held by it hereunder; and, further, that Escrow Agent may commingle such deposits with other deposits or with its own funds in the manner provided for the administration of funds under Section 2-8 of the Corporate Fiduciary Act (Ill. Rev. Stat. 1989, Ch 17, Par. 1552-8) and may use any part or all such funds for its own benefit without obligation of any party for interest or earnings derived thereby, if any. Provided, however, nothing herein shall diminish Escrow Agent's obligation to apply the full amount of the deposits in accordance with the terms of these escrow trust instructions. In the event the Escrow Agent is requested to invest deposits hereunder, Escrow Agent is not to be held responsible for any loss of principal or interest which may be incurred as a result of making the investments or redeeming said investment for the purposes of these escrow trust instructions. 8. Provisions Regarding Escrow Agent. (a) Escrow Agent shall have no duties or responsibilities other than those expressly set forth herein. Escrow Agent shall have no duty to enforce any obligation of any person to make any delivery or to enforce any obligation of any person to perform any other act. Escrow Agent shall be under no liability to the other parties hereto or to anyone else by reason of any failure on the part of any party hereto or any maker, guarantor, endorser or other signatory of any document or any other person to perform such person's obligations under any such document. Except for amendments to this Agreement hereinafter referred to and except for joint instructions given to Escrow Agent by Borrower and Lender relating to the Transfer Documents, Escrow Agent shall not be obligated to recognize any agreement between any or all of the persons referred to herein. (b) In its capacity as Escrow Agent, Escrow Agent shall not be responsible for the genuineness or validity of any security, instrument, document or item deposited with it and shall have no responsibility other than to faithfully follow the instructions contained herein, and shall not be responsible for the validity or enforceability of any security interest of any party and it is fully protected in acting in accordance with any written instrument given to it hereunder by any of the parties hereto and reasonably believed by Escrow Agent to have been signed by the proper person. Escrow Agent may assume that any person purporting to give any notice hereunder has been duly authorized to do so. (c) It is understood and agreed that the duties of Escrow Agent are purely ministerial in nature. Escrow Agent shall not be liable to the other parties hereto or to anyone else for any action taken or omitted by it, or any action suffered by it to be taken or omitted, in good faith and in the exercise of reasonable judgment, except for acts of willful misconduct or gross negligence. Escrow Agent may rely conclusively and shall be protected in acting upon any order, notice, demand, certificate, opinion or advice of counsel (including counsel chosen by Escrow Agent), statement, instrument, report or other paper or document (not only as to its due execution and the validity and effectiveness of its provisions, but also as to the truth and acceptability of any information therein contained) which is reasonably believed by Escrow Agent to be genuine and to be signed or presented by the proper person or persons. Except as set forth in paragraphs 3 and 7 of this Agreement, Escrow Agent shall not be bound by any notice or demand, or any waiver, modification, termination or rescission of this Agreement or any of the terms hereof, unless evidenced by a final judgment or decree of a court of competent jurisdiction in the State of California or a Federal court in such State, or a writing delivered to Escrow Agent signed by the proper party or parties and, if the duties or rights of Escrow Agent are affected, unless it shall give its prior written consent thereto. (d) Escrow Agent shall have the right to assume in the absence of written notice to the contrary from the proper person or persons that a fact or an event by reason of which an action would or might be taken by Escrow Agent does not exist or has not occurred, without incurring liability to the other parties hereto or to anyone else for any action taken or omitted, or any action suffered by it to be taken or omitted, in good faith and in the exercise of reasonable judgment, in reliance upon such assumption. (e) Escrow Agent may resign as Escrow Agent hereunder upon giving five (5) days' prior written notice to that effect to each of the parties to this Agreement. In such event, the successor Escrow Agent shall be a reputable law firm or a nationally recognized title insurance company, selected by Lender and approved by Borrower, which approval will not be unreasonably withheld or unduly delayed. Such party that will no longer be serving as Escrow Agent shall deliver, against receipt, to such successor Escrow Agent, the Transfer Documents, if any, held by such party, to be held by such successor Escrow Agent pursuant to the terms and provisions of this Agreement. If no such successor has been designated on or before the effective date of such party's resignation, its obligations as Escrow Agent shall continue until such successor is appointed; provided, however, its sole obligation thereafter shall be to safely keep all documents and instruments then held by it and to deliver the same to the person, firm or corporation designated as its successor or until directed by a final order or judgment of a court of competent jurisdiction in the State of California or a Federal Court in such State, whereupon Escrow Agent shall make disposition thereof in accordance with such order or judgment. If no successor Escrow Agent is designated and qualified within five (5) days after Escrow Agent's resignation is effective, such party that will no longer be serving as Escrow Agent may apply to any court of competent jurisdiction for the appointment of a successor Escrow Agent. (f) In the event Escrow Agent is the attorney for any party hereto, Escrow Agent shall be entitled to represent such party in any matter, including any litigation in connection herewith. 9. Miscellaneous Provisions. (a) No failure or delay on the part of a party to this Agreement in exercising any power or right hereunder shall operate as a waiver thereof, nor shall any single or partial exercise of any such right or power preclude any other or further exercise thereof or the exercise of any other right or power hereunder. No modification or waiver of any provision of this Agreement and no consent to any departure by any party to this Agreement therefrom shall be effective unless the same shall be in writing and signed by the party against whom such modification, waiver or consent is being sought to be enforced against, and then such waiver, modification or consent shall be effective only in the specific instance and for the purpose for which given. No notice to or demand on any party to this Agreement in any case shall, of itself, entitle such party to any other or further notice or demand in similar or other circumstances. (b) This Agreement may only be modified, amended, changed, discharged or terminated by an agreement in writing signed by all of the parties hereto. (c) Each of the parties to this Agreement (and the undersigned representatives of such parties, if any) has the full power, authority and legal right to execute this Agreement and to keep and observe all of the terms, covenants and provisions of this Agreement on such parties' respective parts to be performed or observed. (d) Any notice, request, direction or demand given or made under this Agreement shall be in writing and shall be hand delivered or sent by Federal Express or other reputable overnight national courier service, and shall be deemed given when received at the following addresses whether hand delivered or sent by Federal Express or other reputable overnight national courier service: If to Borrower: C-C California Plaza Partnership c/o Carlyle Real Estate Limited Partnership-XV c/o JMB Realty Corporation 900 North Michigan Avenue Chicago, Illinois 60611-1575 Attention: Robert J. Chapman With copies to: Pircher, Nichols & Meeks 1999 Avenue of the Stars Los Angeles, California 90067-6077 Attention: Real Estate Notices (P.G.N.) Cygna Limited One c/o Cygna Development Corporation 2121 North California Boulevard - Suite 230 Walnut Creek, California 94596 Attention: Ben Kacyra and Greene, Radovsky, Maloney & Share Spear Street Tower Suite 4200 1 Market Plaza San Francisco, California 94105 Attention: Russell Pollock, Esq. If to Lender: The Travelers Life and Annuity Company 2215 York Road, Suite 504 Oak Brook, Illinois 60521 Attention: Managing Director General Counsel and The Travelers Insurance Company One Tower Square, 13 SHS Hartford, Connecticut 06183-2020 Attention: Travelers Realty Investment Company With a copy to: Battle Fowler 280 Park Avenue New York, New York 10017 Attention: Lawrence Mittman, Esq. Dean A. Stiffle, Esq. If to Escrow Agent: Chicago Title and Trust Company 171 North Clark Street Chicago, Illinois 60601 Attention: Ms. Nancy Castro Each party to this Agreement may designate a change of address by notice given to the other party fifteen (15) days prior to the date such change of address is to become effective. (e) If any term, covenant or provision of this Agreement shall be held to be invalid, illegal or unenforceable in any respect, this Agreement shall be construed without such term, covenant or provision. (f) This Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns. (g) This Agreement sets forth the entire agreement and understanding of the parties hereto with respect to the specific matters agreed to herein and the parties hereto acknowledge that no oral or other agreements, understandings, representations or warranties exist with respect to this Agreement or with respect to the obligations of the parties hereto under this Agreement, except those specifically set forth in this Agreement. (h) This Agreement is, and shall be deemed to be, a contract entered into under and pursuant to the laws of the State of Illinois and shall be in all respects governed, construed, applied and enforced in accordance with the laws of the State of Illinois. No defense given or allowed by the laws of any other state or country shall be interposed in any action or proceeding hereon unless such defense is also given or allowed by the laws of the State of Illinois. (i) The parties hereto agree to submit to personal jurisdiction in the State of Illinois in any action or proceeding arising out of this Agreement. (j) Paragraph 21 of the Modification Agreement ("Exculpation") is hereby incorporated by reference with the same force and effect as if such paragraph appeared in this Agreement. (k) This Agreement may be executed in one or more counterparts by some or all of the parties hereto, each of which counterparts shall be an original and all of which together shall constitute a single agreement. 10. Waiver of California Statutes. Borrower acknowledges that it is in default under the terms and conditions of the documents evidencing and securing the Loan (the "Loan Documents") as of the execution hereof, that Lender presently has the right to enforce the terms of the Loan Documents, and that this Agreement is being done pursuant to the request of Borrower. Borrower further acknowledges that all of the terms and conditions of this Agreement have been carefully negotiated between Borrower and Lender and that Borrower has been fully represented during those negotiations by competent legal counsel of Borrower's choosing, including counsel licensed to practice in the state of California. Borrower understands that Lender is entering into this Agreement in reliance upon, and in consideration of, among other things, the following waiver by Borrower of various provisions of California law. Accordingly, Borrower hereby waives, to the fullest extent permitted by law, the protections of (i) Section 726 of the California Code of Civil Procedure (providing that a creditor has only one form of action to enforce a debt secured by real property) and (ii) Sections 580a and 580d of the California Code of Civil Procedure (providing for the limitation of deficiency judgments), but only for the purpose of allowing Lender to foreclose on any collateral expressly pledged to Lender under the Loan Documents (and, without limitation to the foregoing, no deficiency judgment following a foreclosure sale may be enforced personally against Borrower or its partners, but rather may be enforced solely against such other collateral as may be expressed pledged to Lender under the Loan Documents). Borrower represents and warrants to Lender that Borrower has discussed the meaning and effect of the foregoing waivers with Borrower's legal counsel and that Borrower understands fully the legal consequence of Borrower's providing such waivers to Lender. Borrower covenants to Lender not to assert any rights under any of the foregoing statutes in opposition to any action taken by Lender to enforce Lender's rights under this Agreement or any other Loan Document. [THE REMAINDER OF THIS PAGE IS INTENTIONALLY BLANK.] IN WITNESS WHEREOF, Borrower, Lender and Escrow Agent have duly executed this Agreement the day and year first above written. C-C CALIFORNIA PLAZA PARTNERSHIP, a California general partnership By: Carlyle Real Estate Limited Partnership-XV, an Illinois limited partnership, General Partner By: JMB Realty Corporation, a Delaware corporation, General Partner By: ________________________ Name: Title: By: Cygna Limited One, a California limited partnership, General Partner By: Cygna Development Corporation, a California corporation, General Partner By: ________________________ Name: Title: THE TRAVELERS LIFE AND ANNUITY COMPANY, a Connecticut corporation By: ___________________________________ Name: Title: CHICAGO TITLE AND TRUST COMPANY, as Escrow Agent By: ____________________________________ Name: Title: Exhibit A (DEFINITIONS) Deed of Trust: Deed of Trust and Security Agreement with Assignment of Rents and Leases and Fixture Filing dated as of December 18, 1986 in the principal amount of $58,000,000 given by Borrower to First American Title Insurance Company and Lender and recorded as Document No. 86- 229768 in Book 13327, Page 243, Contra Costa County Records, California. Note: Note Secured by Deed of Trust dated December 18, 1986 in the principal amount of $58,000,000 given by Borrower to Lender. Property: The real property and all improvements located thereon encumbered by the Deed of Trust. Debt: All principal, interest, contingent interest and other sums of any nature whatsoever which may or shall become due and owing under the Note or Deed of Trust, as each may have been modified by the Modification Agreement, or the other documents evidencing or securing the Loan. Loan Documents: The term "Loan Documents" shall mean all documents and instruments executed and delivered by Borrower, Carlyle Real Estate Limited Partnership-XV or Cygna Limited One in connection with the Loan, as modified and amended from time to time. Exhibit B (Transfer Documents) Transfer Documents: 1. Deed executed by Borrower 2. Bill of Sale executed by Borrower 3. Omnibus Assignment executed by Borrower 4. FIRPTA Certificate executed by Borrower Exhibit C (Letterhead of Travelers) Transfer Direction Notice __________ __, 199_ Chicago Title and Trust Company 111 West Washington Avenue Chicago, Illinois 60602 Attn: Ms. Nancy Castro Dear Sirs: Reference is made to that certain Escrow Agreement dated as of __________ __, 1993 entered into among C-C California Plaza Partnership, The Travelers Life and Annuity Company ("Lender") and First American Title Insurance Company (the "Escrow Agreement"). Lender hereby directs you to release from the Escrow and deliver to Lender the Transfer Documents. All terms not otherwise specifically defined in this Transfer Direction Notice shall have the meaning given to such terms in the Escrow Agreement. The undersigned hereby certifies to you that (i) he/she is a representative of Lender, (ii) he/she has the full power and authority to sign and deliver this Transfer Direction Notice, (iii) a default occurred under the Deed of Trust, the Modification Agreement or one of the other Loan Documents and continued beyond the expiration of applicable notice and cure periods, if any and (iv) Lender has the right to receive the Transfer Documents under the terms of the Escrow Agreement and the Modification Agreement. THE TRAVELERS LIFE AND ANNUITY COMPANY By: __________________________________ Name: Title: AGREEMENT OF MODIFICATION OF NOTE, DEED OF TRUST AND OTHER LOAN DOCUMENTS THIS AGREEMENT made as of the 22nd day of December, 1993, between C-C CALIFORNIA PLAZA PARTNERSHIP, a California general partnership having an office at 2121 North California Boulevard, Suite 230, Walnut Creek, California 94596 (hereinafter referred to as "BORROWER"); and THE TRAVELERS LIFE AND ANNUITY COMPANY, a Connecticut corporation having an office at 2215 York Road, Suite 504, Oak Brook, Illinois 60521 (hereinafter referred to as "LENDER"); W I T N E S S E T H : WHEREAS, Lender has previously made a loan of up to $58,000,000 (hereinafter referred to as the "LOAN") to Borrower, which Loan is (i) evidenced by the NOTE (as defined in Exhibit A attached hereto) and (ii) secured by, inter alia, the DEED OF TRUST (as defined in Exhibit A attached hereto) covering the fee interest of Borrower in the PROPERTY (as defined in Exhibit A attached hereto); WHEREAS, Borrower committed the Prior Defaults (as defined in Exhibit A attached hereto), and as a result thereof, Lender declared Borrower in default under the Loan; WHEREAS, Borrower has proposed that such Prior Defaults be addressed through a modification of the Loan pursuant to which payment of a portion of the interest due would be deferred and the maturity date extended; WHEREAS, Lender is willing to enter into such modification of the Loan so as to defer a portion of the interest due and to extend the maturity date only if, among other things, Borrower agrees to modify and amend the terms of the Loan Documents (as defined in Exhibit A attached hereto) executed and delivered prior to the date hereof on the terms and conditions set forth herein; NOW, THEREFORE, in consideration of the premises and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Borrower hereby represents and warrants to and covenants and agrees with Lender as follows: 1. Modification and Amendment of the Note. As of the date hereof, the Note, without further act or instrument, shall be deemed modified and amended in the following respects: (i) The address of Lender, as it appears in the first paragraph of the Note, is hereby deleted and the following address inserted in its place: "2215 York Road, Suite 504, Oak Brook, Illinois 60521." (ii) From and after February 1, 1993 interest shall accrue on the outstanding principal balance of the Note at a per annum rate equal to 10.375% (hereinafter referred to as the "CONTRACT RATE"), which interest will be payable on March 1, 1993 and on the first day of each calendar month thereafter through and including January 1, 2000. All accrued and unpaid interest (including, without limitation, any Deferred Interest, as hereinafter defined), principal and any other amounts evidenced by the Note shall be due and payable on January 1, 2000 (subject to Lender's right to accelerate the indebtedness evidenced by the Note, as expressly set forth therein). Notwithstanding anything to the contrary contained in this subparagraph (ii), for the period commencing on February 1, 1993 and ending on the date that all Deferred Interest has been repaid in full in accordance with the provisions of subparagraph 3(d)(v) of the Cash Management Agreement (such period herein referred to as the "DEFERRAL PERIOD"), interest will accrue at the Contract Rate on the outstanding principal balance of the Note, and interest will be payable under the Note at a per annum rate of 8% (hereinafter referred to as the "DEFERRAL PERIOD PAYMENT RATE"). The difference between (i) the amount of interest accruing at the Contract Rate on the outstanding principal balance of the Note during each one month period of time during the Deferral Period and (ii) the amount of interest payable at the Deferral Period Payment Rate on the outstanding principal balance of the Note during each one month period of time during the Deferral Period (herein referred to as "DEFERRED INTEREST") shall accrue and be payable on January 1, 2000 (as such date of payment may be accelerated as described above) subject to the prior application of any amounts under subparagraph 3(d)(v) of the Cash Management Agreement, it being understood and agreed that no interest shall accrue on the Deferred Interest (other than interest at the Default Rate, as defined in the Note, following an acceleration of the indebtedness following a default). The outstanding principal balance of the Note as of February 1, 1993 is $57,675,704.31. (iii) The term "Deed of Trust" as used in the Note shall be deemed to refer to the Deed of Trust, as modified and amended by this Agreement. (iv) The term "Loan Documents" as used in the Note shall be deemed to refer to the Loan Documents, as modified and amended by this Agreement. (v) The following subparagraph 3(a)(i) is hereby added to the Note between subparagraphs 3(a) and 3(b) of the Note: "(a)(i) if the Termination Date shall occur under that certain Cash Management Agreement dated as of December 22, 1993 entered into among Maker, Holder and Cygna Development Services (the "Cash Management Agreement")." (vi) The third and fourth paragraphs (not counting the preamble paragraphs) of paragraph 4 of the Note are hereby deleted and shall be deemed of no further force and effect. (vii) Nothing contained in paragraph 5 of the Note shall be deemed to prejudice the rights of Lender to enforce the personal recourse obligations created under paragraph 22 of the Cash Management Agreement. (viii) Paragraph 6 of the Note is hereby deleted and shall be deemed of no further force and effect. (ix) Paragraph 12 of the Note is deleted in its entirety and the following is inserted in its place: "12. Notices. Any notice, demand or other communication which any party hereto may desire or may be required to give to any other party hereto shall be in writing, and shall be deemed given (a) if and when personally delivered, (b) upon receipt if sent by a nationally recognized overnight courier addressed to a party at its address set forth below, or (c) on the third (3rd) business day after being deposited in United States registered or certified mail, postage prepaid, addressed to a party at its address set forth below, or to such other address as the party to receive such notice may have designated to all other parties by notice in writing in accordance herewith: If to Holder: The Travelers Life and Annuity Company 2215 York Road Suite 504 Oak Brook, Illinois 60521 Attention: Managing Director General Counsel With copies to: The Travelers Insurance Company One Tower Square Hartford, Connecticut 06183 Attention: Travelers Realty Investment Company and Battle Fowler 280 Park Avenue New York, New York 10017 Attention: Lawrence Mittman, Esq. Dean A. Stiffle, Esq. If to Maker: C-C California Plaza Partnership c/o Carlyle Real Estate Limited Partnership-XV c/o JMB Realty Corporation 900 North Michigan Avenue Chicago, Illinois 60611-1575 Attention: Robert J. Chapman With copies to: Pircher, Nichols & Meeks 1999 Avenue of the Stars Los Angeles, California 90067-6077 Attention: Real Estate Notices (P.G.N.) Cygna Limited One c/o Cygna Development Corporation 2121 North California Boulevard - Suite 230 Walnut Creek, California 94596 Attention: Ben Kacyra and Greene, Radovsky, Maloney & Share Spear Street Tower Suite 4200 1 Market Plaza San Francisco, California 94105 Attention: Russell Pollock, Esq. Each party entitled to receive notice under this Note may designate a change of address by notice given to the other parties at least ten (10) days prior to the date such change of address is to become effective." 2. Modification and Amendment of the Deed of Trust. As of the date hereof, the Deed of Trust, without further act or instrument, shall be deemed modified and amended in the following respects: (i) The address of Lender, as it appears in the first paragraph of page one of the Deed of Trust, is hereby deleted and the following address inserted in its place: "2215 York Road, Suite 504, Oak Brook, Illinois 60521." (ii) The term "Note" as used in the Deed of Trust shall be deemed to refer to the Note, as modified and amended by this Agreement. (iii) The following subparagraph 12(a)(i) is hereby added to paragraph 12 of the Deed of Trust between subparagraphs 12(a) and 12(b): "(a)(i) if the Termination Date shall occur under that certain Cash Management Agreement dated as of December 22, 1993 entered into among Trustor, Beneficiary and Cygna Development Services (the "Cash Management Agreement")." (iv) Paragraph 31 of the Deed of Trust is deleted in its entirety and the following is inserted in its place: "31. Addresses for Notices. Any notice, demand or other communication which any party hereto may desire or may be required to give to any other party hereto shall be in writing, and shall be deemed given (a) if and when personally delivered, (b) upon receipt if sent by a nationally recognized overnight courier addressed to a party at its address set forth below, or (c) on the third (3rd) business day after being deposited in United States registered or certified mail, postage prepaid, addressed to a party at its address set forth below, or to such other address as the party to receive such notice may have designated to all other parties by notice in writing in accordance herewith: If to Beneficiary: The Travelers Life and Annuity Company 2215 York Road Suite 504 Oak Brook, Illinois 60521 Attention: Managing Director General Counsel With copies to: The Travelers Insurance Company One Tower Square Hartford, Connecticut 06183 Attention: Travelers Realty Investment Company and Battle Fowler 280 Park Avenue New York, New York 10017 Attention: Lawrence Mittman, Esq. Dean A. Stiffle, Esq. If to Trustor: C-C California Plaza Partnership c/o Carlyle Real Estate Limited Partnership-XV c/o JMB Realty Corporation 900 North Michigan Avenue Chicago, Illinois 60611-1575 Attention: Robert J. Chapman With copies to: Pircher, Nichols & Meeks 1999 Avenue of the Stars Los Angeles, California 90067-6077 Attention: Real Estate Notices (P.G.N.) Cygna Limited One c/o Cygna Development Corporation 2121 North California Boulevard - Suite 230 Walnut Creek, California 94596 Attention: Ben Kacyra and Greene, Radovsky, Maloney & Share Spear Street Tower Suite 4200 1 Market Plaza San Francisco, California 94105 Attention: Russell Pollock, Esq. Each party entitled to receive notice under this Deed of Trust may designate a change of address by notice given to the other parties at least ten (10) days prior to the date such change of address is to become effective." (v) The third and fourth paragraphs of paragraph 34 of the Deed of Trust are hereby deleted and shall be deemed of no further force and effect. (vi) Paragraph 35 of the Deed of Trust is hereby deleted and shall be deemed of no further force and effect. (vii) Nothing contained in paragraph 37 of the Deed of Trust shall be deemed to prejudice the rights of Lender to enforce the personal recourse obligations created under paragraph 22 of the Cash Management Agreement. 3. Deed In Escrow. (a) Borrower acknowledges and agrees that in order to avoid the time and expense of pursuing a foreclosure of the Deed of Trust, in consideration of Lender's agreement to enter into this Agreement and to modify the Loan, Borrower has delivered the TRANSFER DOCUMENTS (as defined in Exhibit A attached hereto) to the ESCROW AGENT (as defined in Exhibit A attached hereto). Upon the occurrence of a default under and as defined in the Note or the Deed of Trust (both as modified and amended by this Agreement), this Agreement or any other document or instrument executed or delivered in connection with the Loan or its modification (such other documents are hereinafter collectively referred to as, the "OTHER LOAN DOCUMENTS") which continues beyond the expiration of applicable notice and cure periods, if any, or upon failure to pay all principal, interest and other sums due under the Note (as modified and amended by this Agreement) upon maturity, Lender or Lender's nominee, designee or assignee shall have the absolute and unconditional right, at its option, without further notice required to be given to Borrower or any other persons, parties or entities, to remove the Transfer Documents from escrow and record the deed which constitutes one of the Transfer Documents (hereinafter referred to as the "DEED"). Borrower shall, within three (3) business days of request by Lender or Lender's nominee, designee or assignee, sign and deliver to Lender upon demand an updated affidavit required for purposes of Section 1445 of the Internal Revenue Code, and, to the extent required by Lender's counsel to consummate the transactions described in this sentence, such other documents necessary or required to effect a full and complete transfer of Borrower's title to the Property and all income and revenue therefrom and all licenses, rights and privileges associated therewith pursuant to the provisions of this paragraph, and to enable Lender or Lender's nominee, designee or assignee to obtain an owner's policy of title insurance (or "open" commitment for an owner's policy of title insurance) containing an anti-merger endorsement, if available, and any such other endorsements as may be reasonably requested by Lender or Lender's nominee, designee or assignee (provided that such policy, commitment or endorsements are available in the marketplace). In no event shall any such additional or updated documents impose any personal liability upon Borrower or its direct and indirect or future constituent partners. In the event the Transfer Documents are removed from escrow in accordance with the provisions of this Agreement and the Escrow Agreement, at Lender's election, title to the Property shall remain subject to the lien of the Deed of Trust (as modified and amended by this Agreement) to the full extent of the indebtedness secured thereby, and recording of the Deed or any of the other Transfer Documents shall not result in a merger of the Lender's interest as beneficiary under the Deed of Trust (as modified and amended by this Agreement) with that of it as fee title holder. (b) A transfer pursuant to the terms of the preceding subparagraph (a) is referred to herein as a "DEED IN LIEU TRANSFER". At the option of Lender, any such Deed in Lieu Transfer may be made to Lender or its nominee, designee or assignee. Borrower further acknowledges and agrees: (i) that at the time the Transfer Documents and all additional documents and actions contemplated by this paragraph (the "ADDITIONAL REQUIREMENTS") are properly delivered to Lender out of escrow pursuant to the terms of this paragraph 3, they are intended to effect a present and absolute conveyance and unconditional transfer of Borrower's interest in the Property, and all Borrower's right, title, interest, income, revenues, receipts, rents, royalties and profits in connection therewith, and are not given as security; and (ii) Lender has advised Borrower and Borrower confirms that, upon proper delivery of and compliance with the Transfer Documents and the Additional Requirements in accordance with this paragraph 3, Lender does not intend to purchase or continue the business of Borrower at the Property, to be a successor to any such business or to have any liability for the debts, acts or omissions of Borrower, its employees or agents, and Lender intends only to be liable for its own debts, acts or omissions which take place from and after the date of recording of the Deed or any of the other Transfer Documents; and (iii) Borrower will deliver Borrower's right to possession and enjoyment of the Property concurrently with the recording of the Deed and Lender shall thereafter have the immediate right to operate, use, sell and/or transfer the Property or any part thereof for its own account, at its sole and absolute discretion. (c) Nothing contained in this paragraph 3 shall preclude Lender from pursuing foreclosure of the Deed of Trust (as modified and amended by this Agreement) or any other rights and remedies under any of the Loan Documents (as modified and amended by this Agreement), instead of or in addition to removing the Transfer Documents from escrow and recording the Deed, and in such event, Borrower agrees to sign and deliver to Lender (at Lender's cost and expense), in a form and content reasonably acceptable to Lender, a stipulation of the facts necessary to obtain a judgment of foreclosure uncontested by Borrower and a quitclaim deed of Borrower's redemption rights and Borrower agrees not to impede, hinder or delay any foreclosure by power of sale; provided, however, that such stipulation does not impose any personal liability upon Borrower or its direct and indirect present or future constituent partners. If and when Lender completes a foreclosure (through recording of a deed) of the Deed of Trust (as modified and amended by this Agreement) or when all principal, interest and other sums due under the Note and the other Loan Documents (all as modified and amended by this Agreement) are paid in full or otherwise satisfied, Lender shall cause the Transfer Documents to be cancelled and returned to Borrower for destruction, and they shall be of no force and effect. The provisions of this paragraph 3 shall be enforceable by an action for specific performance. 4. Cash Management Agreement. Simultaneously with the execution of this Agreement, and in consideration of Lender entering into this Agreement, Borrower, Cygna Development Services and Lender are executing and delivering a Cash Management Agreement dated as of the date hereof (the "CASH MANAGEMENT AGREEMENT") governing the collection and application of rents, revenues, income, profits and proceeds of the Property. In the event of any conflict or ambiguity between the terms, covenants and conditions of the Note, the Deed of Trust or any of the Other Loan Documents, all as modified and amended by this Agreement, and the terms, covenants and conditions of the Cash Management Agreement, the terms, covenants and conditions which shall enlarge the rights and remedies of Lender and the interest of Lender in the Property and the rents, revenues, income, profits and proceeds of the Property, afford Lender greater financial security in the Property and the rents, revenues, income, profits and proceeds of the Property and better assure payment of the Loan in full, shall govern and control. 5. Representations and Warranties. Borrower represents and warrants to Lender as follows: (a) Borrower has all requisite partnership power and authority to execute and deliver this Agreement and the documents contemplated hereby and to carry out its obligations hereunder and the transactions contemplated hereby. This Agreement has been, and the documents contemplated hereby or otherwise executed and delivered in connection herewith, have been duly executed and delivered by Borrower and constitute the legal, valid and binding obligations enforceable against Borrower in accordance with their respective terms subject to the application of bankruptcy, insolvency, moratorium and similar laws affecting rights of creditors and principles of equity, and are not in violation of or in conflict with, nor do they constitute a default under, any term or provision of the organizational documents of Borrower or any of its general partners, or any of the terms of any agreement or instrument to which Borrower or any of its general partners is or may be bound, or any agreement or instrument affecting the Property, or to the best of Borrower's knowledge, any provision of any applicable law, ordinance, rule or regulation of any governmental authority or of any provision of any applicable order, judgment or decree of any court, arbitrator or governmental authority. (b) Except as set forth in Exhibit B attached hereto and made a part hereof, Borrower has no knowledge, nor has Borrower received any written notice of any action, proceeding or litigation, or proceeding by any organization, person, individual or governmental agency (including, without limitation, any employee or former employee, tenant, lessee, contractor, subcontractor, mechanic, materialmen or laborer, architect, engineer, managing agent, leasing agent, real estate broker or similar party) against or specifically relating to the Property or any portion of the Property. (c) To the best of Borrower's knowledge, there is no pending or threatened condemnation of the Property or of any building or other improvement located on any portion of the Property. (d) Lender may be required, under Section 6050J of the Internal Revenue Code, to submit to the Internal Revenue Service Borrower's taxpayer identification number in connection with the transactions contemplated hereby. Borrower hereby warrants and represents that its taxpayer identification number is 36-3450380. (e) To Borrower's actual knowledge, (i) no Hazardous Materials (as hereinafter defined) are currently present at the Property (or have been present at the Property at anytime in the past) other than those used, stored and contained in quantities, and in such manner, that do not violate any law or regulation relating thereto (including, without limitation, heating oil, cleaning fluids and supplies, refrigerants and paint), and (ii) the Property is in compliance with all applicable local, state or federal environmental laws, rules, ordinances and regulations ("ENVIRONMENTAL REGULATIONS"). As used in this Agreement, "HAZARDOUS MATERIALS" means any dangerous, toxic or hazardous pollutants, contaminants, chemicals, wastes, materials or substances, as defined in or governed by the provisions of any Environmental Regulations, including, without limitation, urea-formaldehyde, polychlorinated biphenyls, asbestos, asbestos-containing materials, nuclear fuel or waste and petroleum products, or any other waste, material, substance, pollutant or contaminant which would subject the owner of the Property to any damages, penalties or liabilities under any applicable Environmental Regulation. Lender acknowledges that Borrower has informed Lender that Borrower has not ordered or received any report as to the presence of Hazardous Materials at the Property or compliance with Environmental Regulations in connection with this Agreement or the modification of the Loan or the Loan Documents. (f) Borrower (i) has sufficient knowledge and experience in financial and business matters so as to enable it to evaluate the merits and risks of transactions like the transactions contemplated hereby, and (ii) by virtue of its sufficient knowledge and experience in financial and business matters in transactions such as the transactions contemplated hereby, Borrower is not in a significantly disparate bargaining position with respect to such transactions. 6. Release of Lender. (a) Borrower hereby releases and forever discharges Lender, its agents, servants, employees, directors, officers, attorneys, branches, affiliates, subsidiaries, successors and assigns and all persons, firms, corporations and organizations in its behalf of and from all damage, loss, claims, demands, liabilities, obligations, actions and causes of action whatsoever which Borrower may now have or claim to have against Lender, as of the date hereof, whether presently known or unknown, and of every nature and extent whatsoever on account of or in any way touching, concerning, arising out of or founded upon the Loan Documents, as herein or concurrently herewith modified, including but not limited to, all such loss or damage of any kind heretofore sustained, or that may arise as a consequence of the dealings between the parties up to and including the date hereof with respect to the Note, the Deed of Trust, this Agreement, the Other Loan Documents or the Property. Borrower expressly waives any rights or benefits available under Section 1542 of the Civil Code of the State of California which provides as follows: "A general release does not extend to claims which a creditor does not know or suspect to exist in his favor at the time of executing the release, which if known by him must have materially affected his settlement with the debtor." (b) By entering into this Agreement, the Cash Management Agreement and by otherwise effecting the modification of the Loan described in this Agreement, Lender is not, and shall not be deemed to be, participating in, directing, or influencing in any manner whatsoever the management of Borrower's business, including, without limitation, the operation of the Property or improvements located thereon. Borrower hereby acknowledges and agrees that Lender is not participating in the management of Borrower's business. 7. References. All references in the Loan Documents to (i) the Loan shall be deemed to refer to the Loan as amended and modified pursuant to the terms of this Agreement, and (ii) the Loan Documents shall be deemed to refer to the Loan Documents as modified and amended pursuant to the terms of this Agreement. All references in the Other Loan Documents to (i) the Note shall be deemed to refer to the Note, as amended and modified by this Agreement, (ii) the Deed of Trust shall be deemed to refer to the Deed of Trust, as amended and modified pursuant to the provisions of this Agreement, and (iii) the Other Loan Documents shall be deemed to refer to the Other Loan Documents as amended and modified pursuant to the provisions of this Agreement. 8. Ratification. Borrower hereby acknowledges and agrees that the Loan, as amended pursuant to the terms of this Agreement, shall be secured by, among other things, the Deed of Trust, as modified and amended pursuant to the provisions of this Agreement, and shall be evidenced by the Note, as modified and amended pursuant to the provisions of this Agreement. Borrower hereby assumes and agrees to perform all of the terms, covenants and provisions contained in the Note, the Deed of Trust and the Other Loan Documents, all as modified and amended pursuant to the provisions of this Agreement. Borrower and Lender agree that all of the terms, covenants and conditions of the Note, the Deed of Trust and the Other Loan Documents, except as expressly amended and modified pursuant to the provisions of this Agreement, remain in full force and effect. 9. No Defenses. Borrower acknowledges and agrees that there are no offsets, defenses or counterclaims of any nature whatsoever with respect to (i) the Note, the Deed of Trust or any of the Other Loan Documents or (ii) the payment of the indebtedness evidenced by the Note and secured by, among other things, the Deed of Trust (hereinafter referred to as the "DEBT"). Borrower acknowledges that Borrower's obligation to pay the Debt in accordance with the provisions of the Note, the Deed of Trust and the Other Loan Documents is and shall at all times continue to be absolute and unconditional in all respects, and shall at all times be valid and enforceable irrespective of any other agreements or circumstances of any nature whatsoever which might otherwise constitute a defense to (i) the Note, the Deed of Trust or the Other Loan Documents or the respective obligations of Borrower under such documents and instruments (including, without limitation, the obligation to pay the Debt) or (ii) the obligations of any other person relating to the Note, the Deed of Trust and the Other Loan Documents or the obligations of Borrower under such documents and instruments or otherwise with respect to the Loan, and Borrower absolutely, unconditionally and irrevocably waives any and all right to assert any defense, setoff, counterclaim (other than compulsory counterclaims) or crossclaim of any nature whatsoever with respect to the obligation to pay the Debt in accordance with the provisions of the Note, the Deed of Trust and the Other Loan Documents or the obligations of any other person relating to the Note, the Deed of Trust and the Other Loan Documents or the obligations of Borrower under such documents and instruments or otherwise with respect to the Loan in any action or proceeding brought by Lender to collect the Debt, or any portion thereof, or to enforce, foreclose and realize upon the liens and security interests created by the Deed of Trust or any other document or instrument securing repayment of the Debt, in whole or in part. Notwithstanding the foregoing to the contrary, nothing herein shall limit Borrower's right to bring a separate cause of action against Lender, provided that such action would not (i) seek to preclude Lender from exercising its remedies under the Note, the Deed of Trust or the Other Loan Documents or (ii) if raised, upon motion of Borrower be consolidated with any prior action brought by Lender under the Note, the Deed of Trust or the Other Loan Documents unless a failure to so consolidate said action would result in the inability to prosecute the claim upon which such action is based because such claim would be deemed to be a compulsory counterclaim. All references in this paragraph to the Note, the Deed of Trust, and the Other Loan Documents shall mean the Note, the Deed of Trust and the Other Loan Documents as amended and modified by this Agreement. 10. Waiver by Borrower. Borrower hereby waives for itself and its partners (i) to the extent permitted by applicable law, all rights to exercise or to attempt to exercise any right of redemption with respect to the Property, or if such waivers are not permitted by applicable law, Borrower hereby agrees to reduce the time period for redemption to the shortest period of time permitted by applicable law and Borrower hereby agrees that it shall not, nor shall any person or entity acting on its behalf or upon its (or any of its partners') instigation, exercise or attempt to exercise any right of redemption with respect to the Property or bid or cause any other person or entity to bid at a foreclosure sale of the Property; and (ii) all rights to contest the validity, binding effect or enforceability of this Agreement or of the provisions hereof and Borrower hereby agrees that it shall not, nor shall any person or entity acting on its behalf or upon its (or any of its partners') instigation, directly or indirectly, contest the validity, binding effect or enforceability of this Agreement or any of the provisions hereof. The foregoing shall not be deemed a waiver by Borrower of any claim or right to take action or bring a compulsory counterclaim against Lender for any default or breach of its obligations under this Agreement or the other Loan Documents (as modified and amended by this Agreement). 11. Lift Stay Agreement. Borrower hereby agrees that, in consideration of the recitals and mutual covenants contained herein, and for other good and valuable consideration (including the agreement of Lender to modify the Loan pursuant to this Agreement), the receipt and sufficiency of which are hereby acknowledged, in the event (a) Borrower or any of its general partners shall (i) file with any bankruptcy court of competent jurisdiction or be the subject of any petition under Title 11 of the United States Code, as amended, (ii) be the subject of any order for relief issued under such Title 11 of the United States Code, as amended, (iii) file or be the subject of any petition seeking any reorganization, arrangement, composition, readjustment, liquidation, dissolution or similar relief under any present or future federal or state act or law relating to bankruptcy, insolvency or other relief for debtors, (iv) have sought or consented to or acquiesced in the appointment of any trustee, receiver or liquidator for itself or for any substantial portion of its assets, (v) be the subject of any order, judgment or decree entered by any court of competent jurisdiction approving a petition filed against such party for any reorganization, arrangement, composition, readjustment, liquidation, dissolution or similar relief under any present or future federal or state act or law relating to bankruptcy, insolvency or relief for debtors, and as a result of any of the matters set forth in (a) above, (b) Lender's ability to complete a sale at foreclosure or other conveyance of the Property or to exercise or enforce any of Lender's other rights or remedies under the Note, the Deed of Trust or the Other Loan Documents (all as modified and amended pursuant to the provisions of this Agreement) at law or in equity is interfered with, impeded or otherwise impaired because of a stay of such sale or conveyance in such proceeding, then in any such event Borrower agrees that any such action described in clause (i) through (v) above shall have been filed to frustrate or delay a foreclosure proceeding, in bad faith, and in abrogation of this Agreement and should be deemed to have been so filed by the Bankruptcy Court, and Lender shall thereupon be automatically entitled to relief from any automatic stay imposed by Section 362 of Title 11 of the United States Code, as amended, or otherwise (provided that Borrower's agreement that any such action shall have been taken in bad faith shall be solely for the purpose of determining whether Lender is entitled to relief from the automatic stay and shall not be used against Borrower for any other purpose), on or against the exercise of the rights and remedies otherwise available to Lender as provided in the Loan Documents (as modified and amended pursuant to the provisions of this Agreement) or as otherwise provided by law and, in the event of the occurrence of any of the events described in clauses (i) through (v) above, neither Borrower nor any of its general partners will take any action to impede, restrain or restrict Lender's rights and remedies under this Agreement or otherwise, whether under Sections 105 or 362 of Title 11 of the United States Code or otherwise. In addition, Borrower waives the right to extend the one hundred twenty (120) day period under which the debtor has the exclusive right to file a plan of reorganization in any case involving Borrower as debtor under Title 11 of the United States Code. 12. WAIVER OF TRIAL BY JURY. TO THE EXTENT PERMITTED BY LAW, THE PARTIES HERETO EACH IRREVOCABLY AND UNCONDITIONALLY WAIVE THE RIGHT TO TRIAL BY JURY IN ANY ACTION, SUIT OR COUNTERCLAIM ARISING IN CONNECTION WITH, OUT OF OR OTHERWISE RELATING TO THE NOTE, THE DEED OF TRUST OR ANY OF THE OTHER LOAN DOCUMENTS (ALL AS AMENDED AND MODIFIED BY THIS AGREEMENT). 13. Further Modifications. This Agreement may not be modified, amended or terminated, except by an agreement in writing signed by the parties hereto. 14. Successors and Assigns. This Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns. 15. Counterparts. This Agreement may be executed in one or more counterparts by some or all of the parties hereto, each of which counterparts shall be an original and all of which together shall constitute a single agreement. 16. Not a Novation. This Agreement constitutes a modification of the Loan Documents, and is not intended to and shall not terminate or extinguish any of the indebtedness or obligations under the Note, the Deed of Trust or any of the Other Loan Documents in such a manner as would constitute a novation of the original indebtedness or obligations under the Note, the Deed of Trust, or any of the Other Loan Documents, nor shall this Agreement affect or impair the priority of any liens created thereby, it being the intention of the parties hereto to carry forward all liens and security interests securing payment of the Note, which liens and interests are acknowledged by Borrower to be valid and subsisting against the Property, and any other collateral for the Loan. 17. Severability. If any term, covenant or provision of this Agreement shall be held to be invalid, illegal or unenforceable in any respect, this Agreement shall, at Lender's option, be construed without such term, covenant or provision. 18. Construction. This Agreement has been negotiated at arms' length between persons knowledgeable in the matters dealt with herein. Each party has been represented by experienced and knowledgeable counsel. Accordingly, any rule of law or any other statutes, legal decisions or common law principles of similar effect that would require interpretation of any ambiguities in this Agreement against the party that has drafted it are of no application and are hereby expressly waived. 19. Further Assurances. Borrower shall execute and deliver or cause to be executed and delivered such assignments, agreements, partnership authorization and other documentation as Lender shall reasonably require to create, evidence and assure the modifications and agreements herein contained and the rights conferred upon the parties hereby. \EL Waiver of Prior Defaults. In consideration of this Agreement and the modification of the Loan, Lender hereby waives its rights with respect to enforcement against Borrower of the Prior Defaults and all other defaults, known or unknown, which occurred prior to the date hereof but which are not continuing or in existence today. This waiver shall not be a waiver of any default under the Loan Documents prior to the date hereof which continues or is in existence as of the date hereof nor a waiver of any default, monetary or non-monetary, subsequent to the date hereof, to which Lender expressly reserves all rights to which it is entitled under law and under the Loan Documents, as amended and restated by this Agreement. Lender hereby waives as a default Borrower's failure to make the debt service payments under the Note that were due and payable on the first day of March, 1993 and the first day of each month thereafter through December 1, 1993 which payments are being replaced by the interest payments due under the Note as amended and modified by this Agreement. 21. Exculpation. Without in any manner releasing, impairing or otherwise affecting the Note, the Deed of Trust or any other instrument securing the Note or the validity thereof or hereof or the lien of the Deed of Trust, there is no personal liability of Borrower or any partner in Borrower hereunder or under any of the Loan Documents, and no monetary or deficiency judgment shall be sought or enforced against Borrower; provided, however, that a judgment may be sought against Borrower to the extent necessary to enforce the right of Lender in, to or against the Property securing the indebtedness evidenced by the Note and covered by the Deed of Trust and the other Loan Documents. Notwithstanding any of the foregoing, nothing contained in this paragraph shall be deemed to prejudice the rights of Lender: (i) to recover any fraudulently misapplied Restoration Funds, Insurance Proceeds or Condemnation Proceeds (all as defined in the Deed of Trust) as well as any expenditures, damages or costs (including without limitation reasonable attorneys' fees) incurred by Lender as a result of such fraudulent misapplication, (ii) to recover any expenditures, damages or costs (including without limitation reasonable attorneys' fees) incurred by Lender as a result of Borrower's fraud, material and intentional misrepresentation or intentional destruction of the Property or (iii) to enforce the personal recourse obligations set forth in paragraph 22 of the Cash Management Agreement. All references in this paragraph to the Note, Deed of Trust and Loan Documents shall be deemed to mean the Note, Deed of Trust and Loan Documents as modified and amended by this Agreement. Notwithstanding anything in this paragraph 21 to the contrary, neither general partner of Borrower shall have any personal liability hereunder or under any of the Loan Documents with respect to a material and intentional misrepresentation by Borrower concerning the matters set forth in paragraph 5(e) hereof unless such general partner had actual knowledge of the matters constituting such misrepresentation. 22. Leasing. Notwithstanding anything to the contrary which may be contained in the Note, the Deed of Trust or any of the Other Loan Documents (as each of the foregoing is amended and modified by this Agreement), Borrower shall not enter into any lease, or permit any party to enter into any lease on its behalf, with respect to the Property or any portion thereof without having received the prior written consent of Lender (which consent may be withheld by Lender in the exercise of its sole and absolute discretion) in the event that such lease does not comply with the leasing parameters set forth in the annual Operating Budget for the Property submitted in accordance with, and more particularly described in, subparagraph 3(j) of the Cash Management Agreement as defined in Exhibit A attached hereto. Lender shall have no obligation to consider a request to approve a lease for space at the Property unless Lender has been provided with a complete copy of the Lease, comprehensive financial information on the prospective tenant and a comprehensive summary of the costs and expenses that will be incurred by Borrower in connection with the lease. 23. Waiver of California Statutes. Borrower acknowledges that it is in default under the terms and conditions of the Loan Documents as of the execution hereof, that Lender presently has the right to enforce the terms of the Loan Documents, and that this Agreement is being entered into pursuant to the request of Borrower. Borrower further acknowledges that all of the terms and conditions of this Agreement have been carefully negotiated between Borrower and Lender and that Borrower has been fully represented during those negotiations by competent legal counsel of Borrower's choosing, including counsel licensed to practice in the state of California. Borrower understands that Lender is entering into this Agreement in reliance upon, and in consideration of, among other things, the following waiver by Borrower of various provisions of California law. Accordingly, Borrower hereby waives, to the fullest extent permitted by law, the protections of (i) Section 726 of the California Code of Civil Procedure (providing that a creditor has only one form of action to enforce a debt secured by real property) and (ii) Sections 580a and 580d of the California Code of Civil Procedure (providing for the limitation of deficiency judgments), but only for the purpose of allowing Lender to foreclose on any collateral expressly pledged to Lender under the Loan Documents (and, without limitation to the foregoing, no deficiency judgment following a foreclosure sale may be enforced personally against Borrower or its partners, but rather may be enforced solely against such other collateral as may be expressed pledged to Lender under the Loan Documents). Borrower represents and warrants to Lender that Borrower has discussed the meaning and effect of the foregoing waivers with Borrower's legal counsel and that Borrower understands fully the legal consequence of Borrower's providing such waivers to Lender. Borrower covenants to Lender not to assert any rights under any of the foregoing statutes in opposition to any action taken by Lender to enforce Lender's rights under this Agreement or any other Loan Document. 24. Assignment of Loan. Notwithstanding anything in the Loan Documents (as amended and modified by this Agreement) to the contrary, Lender shall have the absolute and unconditional right to assign, sell or otherwise transfer all or any portion of its interest in the Loan, any security given therefor, or its interest under the Loan Documents (as amended and modified by this Agreement). [THE REMAINDER OF THIS PAGE IS INTENTIONALLY LEFT BLANK.] IN WITNESS WHEREOF, Borrower and Lender have duly executed this Agreement as of the day and year first above written. C-C CALIFORNIA PLAZA PARTNERSHIP, a California general partnership By: Carlyle Real Estate Limited Partnership-XV, an Illinois limited partnership, General Partner By: JMB Realty Corporation, a Delaware corporation, General Partner By: ____________________________ Name: Title: By: Cygna Limited One, a California limited partnership, General Partner By: Cygna Development Corporation, a California corporation, General Partner By: ____________________________ Name: Title: THE TRAVELERS LIFE AND ANNUITY COMPANY By: _______________________________________ Name: Title: The undersigned parties are joining this Agreement to acknowledge and confirm their agreement to paragraphs 11 and 21 of this Agreement. CARLYLE REAL ESTATE LIMITED PARTNERSHIP- XV, an Illinois limited partnership By: JMB Realty Corporation, a Delaware corporation, General Partner By: __________________________________ Name: Title: CYGNA LIMITED ONE, a California limited partnership By: Cygna Development Corporation, a California corporation By:__________________________________ Name: Title: State of _______________) County of ______________) ss. On ________________ before me, _____________________ personally appeared ____________________ personally known to me (or proved to me on the basis of satisfactory evidence) to be the person(s) whose name(s) is/are subscribed to the within instrument and acknowledged to me that he/she/they executed the same in his/her/their authorized capacity(ies), and that by his/her/their signature(s) on the instrument the person(s) or the entity upon behalf of which the person(s) acted, executed the instrument. WITNESS my hand and official seal. Signature__________________________________ (This area for official seal.) State of _______________) County of ______________) ss. On ________________ before me, _____________________ personally appeared ____________________ personally known to me (or proved to me on the basis of satisfactory evidence) to be the person(s) whose name(s) is/are subscribed to the within instrument and acknowledged to me that he/she/they executed the same in his/her/their authorized capacity(ies), and that by his/her/their signature(s) on the instrument the person(s) or the entity upon behalf of which the person(s) acted, executed the instrument. WITNESS my hand and official seal. Signature__________________________________ (This area for official seal.) State of _______________) County of ______________) ss. On ________________ before me, _____________________ personally appeared ____________________ personally known to me (or proved to me on the basis of satisfactory evidence) to be the person(s) whose name(s) is/are subscribed to the within instrument and acknowledged to me that he/she/they executed the same in his/her/their authorized capacity(ies), and that by his/her/their signature(s) on the instrument the person(s) or the entity upon behalf of which the person(s) acted, executed the instrument. WITNESS my hand and official seal. Signature__________________________________ (This area for official seal.) State of _______________) County of ______________) ss. On ________________ before me, _____________________ personally appeared ____________________ personally known to me (or proved to me on the basis of satisfactory evidence) to be the person(s) whose name(s) is/are subscribed to the within instrument and acknowledged to me that he/she/they executed the same in his/her/their authorized capacity(ies), and that by his/her/their signature(s) on the instrument the person(s) or the entity upon behalf of which the person(s) acted, executed the instrument. WITNESS my hand and official seal. Signature__________________________________ (This area for official seal.) State of _______________) County of ______________) ss. On ________________ before me, _____________________ personally appeared ____________________ personally known to me (or proved to me on the basis of satisfactory evidence) to be the person(s) whose name(s) is/are subscribed to the within instrument and acknowledged to me that he/she/they executed the same in his/her/their authorized capacity(ies), and that by his/her/their signature(s) on the instrument the person(s) or the entity upon behalf of which the person(s) acted, executed the instrument. WITNESS my hand and official seal. Signature__________________________________ (This area for official seal.) EXHIBIT A (Certain Definitions) Cash Management Agreement: The term "Cash Management Agreement" as used in this Agreement shall mean the Cash Management Agreement dated the date hereof by and among Borrower, Lender and Cygna Development Services, as manager of the Property. Deed of Trust: The term "Deed of Trust" as used in this Agreement shall mean that certain Deed of Trust and Security Agreement with Assignment of Rents and Leases and Fixture Filing dated as of December 18, 1986 in the principal amount of $58,000,000 given by Borrower to First American Title Insurance Company and Lender and recorded on December 18, 1986 as Document No. 86-229768 in Book 13327, Page 243, Contra Costa County Records, California. Escrow Agent: The term "Escrow Agent" as used in this Agreement shall mean Chicago Title and Trust Company. Loan Documents: The term "Loan Documents" as used in this Agreement shall mean the Note, the Deed of Trust and any other document or instrument executed and delivered in connection with the Loan. Note: The term "Note" as used in this Agreement shall mean that certain Note Secured by Deed of Trust dated December 18, 1986 in the principal amount of $58,000,000 given by Borrower to Lender. Prior Defaults: The term "Prior Defaults" as used in this Agreement shall mean those certain defaults committed by Borrower prior to the date hereof and declared by Lender under the Loan Documents, including, without limitation, Borrower's failure to pay when due (after expiration of applicable grace periods, if any) the full installment in the amount of $525,136.08 representing principal and interest due under the Note on March 1, 1993). Property: The term "Property" as used in this Agreement shall mean the land and improvements known as California Plaza and located at 2121 North California Boulevard, Walnut Creek, California as more particularly described on Schedule A attached hereto. Transfer Documents: The term "Transfer Documents" as used in this Agreement shall mean that certain Escrow Agreement dated as of the date hereof by and among Borrower, Lender and Escrow Agent and the Deed, Bill of Sale, Assignment, Section 1445 (FIRPTA) Affidavit and any other document and instrument delivered into escrow pursuant thereto. SCHEDULE A (Description of Premises) EXHIBIT B (Description of Litigation) C-C California Plaza Associates v. Dillingham Construction N.A., Inc., Case No. C91-03449 filed in Superior Court, Contra Costa County, California. Travelers Loan No. 204366 C-C CALIFORNIA PLAZA PARTNERSHIP and THE TRAVELERS LIFE AND ANNUITY COMPANY _________________________________________ AGREEMENT OF MODIFICATION OF NOTE, DEED OF TRUST AND OTHER LOAN DOCUMENTS _________________________________________ Dated: As of December 22, 1993 Location: 2121 North California Boulevard Walnut Creek, California RECORD AND RETURN TO: Battle Fowler 280 Park Avenue New York, New York 10017 Attention: Steven Koch, Esq. POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned officers and directors of JMB Realty Corporation, the managing general partner of JMB Income Properties, Ltd. - XV, do hereby nominate, constitute and appoint GARY NICKELE, GAILEN J. HULL, DENNIS M. QUINN or any of them, attorneys and agents of the undersigned with full power of authority to sign in the name and on behalf of the undersigned officer or directors a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, hereby ratifying and confirming all that said attorneys and agents and any of them may do by virtue hereof. IN WITNESS WHEREOF, the undersigned have executed this Power of Attorney the 23rd day of March, 1994. JUDD D. MALKIN - - ------------------- Chairman and Director Judd D. Malkin NEIL G. BLUHM - - ------------------- President and Director Neil G. Bluhm H. RIGEL BARBER - - ------------------- Chief Executive Officer H. Rigel Barber JEFFREY R. ROSENTHAL - - ----------------------- Chief Financial Officer Jeffrey R. Rosenthal The undersigned hereby acknowledge and accept such power of authority to sign, in the name and on behalf of the above named officer and directors, a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, the 23rd day of March, 1994. GARY NICKELE ------------ Gary Nickele GAILEN J. HULL --------------- Gailen J. Hull DENNIS M. QUINN --------------- Dennis M. Quinn POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, that the undersigned officer and directors of JMB Realty Corporation, the managing general partner of JMB Income Properties, Ltd. - XV, do hereby nominate, constitute and appoint GARY NICKELE, GAILEN J. HULL, DENNIS M. QUINN or any of them, attorneys and agents of the undersigned with full power of authority to sign in the name and on behalf of the undersigned officer or directors a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, hereby ratifying and confirming all that said attorneys and agents and any of them may do by virtue hereof. IN WITNESS WHEREOF, the undersigned have executed this Power of Attorney the 26th day of January, 1994. STUART C. NATHAN _________________________ Executive Vice President and Director of Stuart C. Nathan General Partner A. LEE SACKS _________________________ Director of General Partner A. Lee Sacks The undersigned hereby acknowledge and accept such power of authority to sign, in the name on behalf of the above named officer and directors, a Report on Form 10-K of said partnership for the fiscal year ended December 31, 1993, and any and all amendments thereto, the 26th day of January, 1994. GARY NICKELE ______________________ Gary Nickele GAILEN J. HULL ______________________ Gailen J. Hull DENNIS M. QUINN ___________________________ Dennis M. Quinn

863517_1993.txt

863517_1993

1993

863517

ITEM 1. BUSINESS GENERAL Northeast Federal Corp. (the Company), a Delaware corporation incorporated in January 1990, is a unitary savings association holding company engaged in the financial services industry through its wholly-owned subsidiary, Northeast Savings, F.A. (Northeast Savings or the Association). Northeast Savings, one of the largest thrift institutions based in New England with total assets of $3.9 billion, is a federally-chartered savings and loan association headquartered in Hartford, Connecticut with 49 retail branch offices in California, Connecticut, Massachusetts, New York, and Rhode Island. Through these retail branch offices, Northeast Savings offers a wide range of mortgage loan and deposit products. In addition, Northeast Savings operates residential mortgage loan origination offices in Connecticut and, through a subsidiary, in Colorado. The financial statements and the related information included in this document reflect the consolidated balances of Northeast Federal Corp. and its subsidiaries. Principal Business and Operating Strategy. The business of the Company, conducted through the Association, is providing traditional thrift banking services to the general public. These services include a range of deposit products such as checking accounts, savings accounts, retirement accounts, and certificates of deposit; a wide range of residential mortgage loan programs including both fixed and adjustable rate first mortgage loans and home equity loans and credit lines; and ancillary banking services such as safe deposit boxes and travelers checks. The Association's primary source of income is the net interest income generated through raising deposits from the general public and investing those deposits in residential mortgage loans. Additional sources of revenue are the interest earned on securities, the fees earned in connection with loans, deposits and other banking services, and gains realized on the sales of loans and securities. Other expenses besides the interest incurred on deposits and other borrowed funds are the provision for loan losses and other non-interest expenses including general and administrative costs and expenses on real estate and other assets acquired in settlement of loans. Since 1989, the Company has pursued the operating strategy of providing traditional thrift banking services, namely gathering retail deposits and investing those deposits in adjustable rate residential mortgages. In 1993, however, the Company adjusted this strategy in consideration of the prevailing interest rate and economic environment. The low interest rate environment of 1993 brought with it high prepayments on existing mortgages, extremely competitive rates on adjustable rate mortgages in some markets, and deposit disintermediation as bank deposits were transferred into alternative investments such as mutual funds. The regional recessions in New England and in California increased the credit costs associated with lending in those regions, particularly in California. As a result of these factors, in the third quarter of 1993, the Company modified its operating strategy both with regard to lending and to balance sheet structure. For example, adjustable rate mortgages originated in markets where start rates are extremely low are not retained for portfolio. In place of this adjustable rate mortgage production that had been retained for portfolio under the previous operating strategy, the Company is originating 10 and 15 year fixed rate mortgages for portfolio and is purchasing intermediate term mortgage-backed securities (MBSs). Further, in February 1994, the Company closed its loan origination office in California. This modified strategy is intended to reduce the Company's loan concentration in California, to reduce credit costs, and to increase the net interest margin. Background. Northeast Savings was formed in March 1982 when The Schenectady Savings Bank, F.S.B., operating in the Albany-Schenectady area in upstate New York, acquired Hartford Federal Savings and Loan Association in Connecticut. Schenectady Savings was organized in 1834 as a New York state-chartered mutual savings bank. Northeast Savings further expanded into Massachusetts in October when it acquired Freedom Federal Savings and Loan Association of Worcester (Freedom Federal) with branch offices in Springfield, Worcester, Greater Boston, and Cape Cod, and the First Federal Savings and Loan Association of Boston. These acquisitions were Federal Savings and Loan Insurance Corporation (FSLIC)-assisted supervisory mergers induced by the Federal Home Loan Bank Board (FHLBB). As an integral part of the Freedom Federal acquisition, the FSLIC purchased a $50,000,000 income capital certificate from the Association. In exchange for the Association's agreement to acquire these troubled institutions, the FSLIC and the FHLBB also agreed that the Association could account for the mergers under the purchase method of accounting and that the resultant supervisory goodwill would be included in regulatory capital. On September 22, 1983, the Association converted from a mutual to a stock association through the sale of 5,060,765 shares of common stock, which generated net proceeds of $52,767,000. In October 1985, the Association issued 1,610,000 shares of $2.25 Cumulative Convertible Preferred Stock, Series A (the convertible preferred stock), which generated net proceeds of $38,341,000. Additionally, in March 1987, Northeast Savings issued 1,202,916 shares of Adjustable Rate Cumulative Preferred Stock, Series A (the adjustable rate preferred stock), valued at $60,145,000 to the FSLIC in exchange for the FSLIC's cancellation of the income capital certificate and a portion of the accumulated income payments on the certificate. On July 6, 1990, at a Special Meeting of Stockholders, the holders of voting stock of Northeast Savings approved a Plan of Reorganization whereby Northeast Savings became the wholly-owned subsidiary of a Delaware holding company, Northeast Federal Corp. Under the reorganization plan, Northeast Savings' capital stock was exchanged for capital stock of Northeast Federal Corp. and the capital of Northeast Federal Corp. was downstreamed to Northeast Savings in the form of common stock which qualified as core capital. As a result, on July 6, 1990, Northeast Savings came into compliance with all of the then-applicable Office of Thrift Supervision (OTS) capital requirements. Since that time, Northeast Savings has remained in compliance with all current capital requirements and, as of June 30, 1992, met all of its fully phased-in capital requirements. On June 19, 1991, the Association acquired $10.5 million of deposits of Financial of Hartford, F.S.B. from the Resolution Trust Corporation (RTC). On September 13, 1991, the Association acquired $210.9 million in insured deposits of eight branches of ComFed Savings Bank, F.A. (ComFed), from the RTC. In addition, on March 20, 1992, Northeast Savings acquired approximately $183.2 million in insured deposits of four southern California branches of FarWest Savings and Loan Association, F.A. from the RTC. On May 8, 1992, the Association acquired certain assets of four Rhode Island financial institutions (the Rhode Island acquisition) which were in receivership proceedings under the jurisdiction of the Superior Court of Providence County, Rhode Island. In addition, deposits in the Association were issued to former depositors in the Rhode Island institutions. As a result, the Association acquired seven branches in Rhode Island which, at the time of acquisition, had total deposits of $315.0 million. In conjunction with the Rhode Island acquisition, the Company repurchased from the FSLIC Resolution Fund (FRF) the Company's adjustable rate preferred stock for $28.0 million in cash and $7.0 million of the Company's 9% Sinking Fund Uncertificated Debentures, due 2012 (the 9% Debentures) for a total fair value of $32.5 million. The 9% Debentures had a fair value of $4.5 million, based on the value attributable to those debentures by the FRF, as determined by its investment banker. The cash used for the repurchase of the adjustable rate preferred stock was obtained by the sale of $28.95 million of 9% Debentures to the receivers for the Rhode Island institutions, who distributed those 9% Debentures to certain depositors in those institutions in partial settlement of their claims against the receiverships. Also, the Company issued and sold 351,700 shares of a new class of preferred stock, its $8.50 Cumulative Preferred Stock, Series B, (the Series B preferred stock) plus warrants to purchase an aggregate of 800,000 shares of the Company's common stock to the Rhode Island Depositors Economic Protection Corporation (DEPCO) for $35.17 million. The net proceeds from the sale of the Series B preferred stock were used by the Company to increase the equity capital of the Association. The Rhode Island acquisition and its impact on the Company are discussed more thoroughly in Item 7: Management's Discussion and Analysis of the Results of Operations and Financial Condition. On May 7, 1993, at a Special Meeting of Stockholders, the Company's stockholders approved a reclassification of the Company's convertible preferred stock into common stock at the ratio of 4.75 shares of common stock for each share of convertible preferred stock. Effective May 14, 1993, the 1,610,000 outstanding shares of convertible preferred stock were converted into an aggregate of 7,647,500 shares of common stock. At such time, in the aggregate, $12.2 million of accumulated and unpaid dividends on the convertible preferred stock were eliminated. On February 9, 1994, Shawmut National Corporation and the Company signed a definitive agreement for the acquisition by Shawmut of ten Northeast Savings branches located in Eastern Massachusetts and in Rhode Island. Five of the branches to be purchased are in Massachusetts and five are in Rhode Island. Deposits held in these branches totaled approximately $427 million as of December 31, 1993. Shawmut will pay a premium of three percent to Northeast Savings for deposits on hand in these branches at the time of closing. The transaction is expected to close by the end of the second quarter, and is subject to regulatory approval. The sale will permit Northeast Savings to focus its resources on its four significant deposit markets: the capital region of New York State; Hartford, Connecticut; and Springfield and Worcester, Massachusetts. The sale of the branches will also strengthen the Company's financial position and enhance its profitability. When the transaction is finalized, Northeast Savings will operate thirty-eight branches, thirty-two of which are in those markets. Supervisory Goodwill. Management believes that, based on the Association's constitutional rights and legal rights under its 1982 contracts with the FSLIC and the FHLBB, the supervisory goodwill generated by the 1982 acquisitions was includable for purposes of all regulatory capital requirements. However, as discussed in the Regulations section, current regulatory capital requirements of the OTS, the successor agency to the FHLBB, exclude supervisory goodwill from regulatory capital to the extent that such supervisory goodwill is in excess of a specified allowed amount, which was initially 1.5% of tangible assets but which declines to zero after December 31, 1994. As a result of the impact of the OTS regulations on its regulatory capital position, Northeast Savings asserted its constitutional rights and its contractual rights to the inclusion in capital of the then remaining balance of the supervisory goodwill in a complaint filed on December 6, 1989 in the United States District Court for the District of Columbia (the district court). On July 16, 1991, the district court dismissed the lawsuit, ruling that it lacked jurisdiction over the action, but that Northeast Savings could bring a damages action against the government in the United States Claims Court. On July 8, 1992, the Association moved to voluntarily dismiss its appeal of the district court's decision. The United States Court of Appeals for the District of Columbia Circuit granted the Association's motion on July 9, 1992. On August 12, 1992, Northeast Savings refiled its action in the United States Claims Court. Note that, effective October 29, 1992, the United States Claims Court was renamed the United States Court of Federal Claims. The complaint is discussed further in Item 3: Legal Proceedings. Subsequent to the initial complaint filed in 1989, the Association has recorded two significant reductions in the value of its supervisory goodwill. The first reduction of $109.4 million took place in the year ended March 31, 1990. The second reduction occurred in September 1992 and is explained in more detail in Item 7: Management's Discussion and Analysis of the Results of Operations and Financial Condition. The reduction in supervisory goodwill should not affect the Association's claim, described above, pending in the United States Court of Federal Claims. The Association's remaining supervisory goodwill was eliminated in the quarter ended December 31, 1992 as a result of normal amortization and the utilization of net operating loss carryforwards. Competitive and Regulatory Environment. Northeast Savings faces strong competition both in attracting retail deposits and in making residential real estate loans. Its most direct competition for deposits has historically come from savings banks, other savings and loan associations, commercial banks, and credit unions. The Association faces additional competition for retail depositors' funds from financial intermediaries offering money market and mutual funds and corporate and government securities. Additionally, Northeast Savings competes with mortgage banking companies, finance companies, and other institutional lenders for residential real estate loans. The Association competes by supplying efficient and quality service, offering and charging competitive interest rates and fees, and providing convenient branch locations with extended banking hours and 24 hour automated teller service. Northeast Savings' operations, like those of other financial institutions, are significantly influenced by general economic conditions. Deposit flows and the cost of funds to the Association are influenced by interest rates on competing investments and general market interest rates. The Association's loan volume, loan yields, and loan prepayments are also impacted by market interest rates on loans and other factors which affect the supply of and demand for housing and the availability of funds. In the past several years, a weak economy and real estate market have impacted the ability of borrowers to repay their loans which, in turn, affects the Association's overall level of nonperforming assets. Northeast Savings' operations are further influenced by the policies and regulations of financial institution regulatory authorities such as the Board of Governors of the Federal Reserve System (Federal Reserve Board), the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the OTS, and by the other monetary, fiscal, legislative, and regulatory policies of the United States government and various state governments. Most states have adopted legislation which would permit, subject to various conditions and restrictions, banking on an interstate basis. The right to engage in banking on an interstate basis is often restricted to specific states or regions and often includes reciprocity provisions. The location of the financial institution's home office is also generally a factor in determining the extent of the right. In some instances, the legislation applies only to banks and not to savings institutions. With the advent of regional and interstate branching, competitors of the Association may be able to conduct extensive interstate banking operations and thereby gain competitive advantages. In addition, an OTS regulation, which states that it preempts any state law purporting to address the subject of branching by a federal savings institution, generally allows federal savings institutions, including Northeast Savings, to branch freely throughout the United States to the extent allowed by federal statutes. The Association is subject to the supervision and regulation of the OTS and, secondarily, the FDIC. During the year ended December 31, 1993, the Company and the Association were examined by both the OTS and FDIC. Management believes that these examinations were routine in nature and part of the normal supervisory examination process. Management is not aware of any current directive by either the OTS or the FDIC, specific to Northeast Federal Corp. or Northeast Savings that, if implemented, would have a significant material effect on the Company's liquidity, capital resources, or operations. The Association's deposits are insured up to applicable limits by the Savings Association Insurance Fund (SAIF) which is administered by the FDIC, the successor agency to the FSLIC. Northeast Savings is further subject to regulations of the Federal Reserve Board with respect to reserves required to be maintained against deposits and certain other matters. For further discussion, see the Regulations section. The Association underwent an OTS consumer compliance examination as of September 28, 1992. The OTS has a specialized group of examiners that focuses on consumer regulations, including non-discrimination regulations, such as the Equal Credit Opportunity Act and the Home Mortgage Disclosure Act; the Truth- in- Lending Act and the Bank Secrecy Act. The consumer compliance examination revealed no significant items of concern. In conjunction with the consumer compliance examination, a separate Community Reinvestment Act (CRA) evaluation and rating were provided. The CRA evaluation and rating process assesses and ranks the overall performance of federally regulated depository institutions in helping to meet community credit needs, including those of low and moderate income neighborhoods. The evaluation and ratings are narrative and are public information; institutions are given ratings as follows: Outstanding, Satisfactory, Needs to Improve, or Substantial Noncompliance. The Association received a Satisfactory rating. An institution in this group has a satisfactory record of ascertaining and helping to meet community credit needs consistent with its resources and capabilities. The management of the CRA process is satisfactory and includes adequate documentation of CRA related activities and demonstrates regular involvement by the Board of Directors and senior management in the institution's CRA planning, implementation, and monitoring process. An institution's CRA rating is taken into consideration by the OTS when it reviews applications to open or relocate a branch facility or to acquire assets and assume liabilities. Generally, institutions that receive a satisfactory rating are placed on an eighteen month review cycle by the OTS. Reregulation, increased competition, and a weakened economy have adversely impacted the asset quality of a significant number of the institutions in the thrift industry, including the Association. The effects of the lingering recession have caused real estate values to continue to decline in many parts of the country. Until signs of stabilization or improvement are prevalent in the markets in which the Association operates, future effects of the economy and industry regulation will continue to impact the asset quality of the Association. LENDING ACTIVITIES Northeast Savings' primary business is receiving deposits from the public and investing those funds in single-family residential mortgage loans. Prior to fiscal year 1989, Northeast Savings substantially increased its total assets primarily through the purchase of mortgage-backed securities and investment securities in the secondary markets. However, in October 1988, under the direction of its new chairman and chief executive officer, Northeast Savings announced its intention to return to more traditional thrift activities and de- emphasize its wholesale activities. Northeast Savings also announced it would substantially stop the growth in its balance sheet and more fully utilize its retail branch network as a low cost delivery system for deposit gathering and single-family residential mortgage loan origination. A singularly important element of this strategy was the strengthening of Northeast Savings' residential mortgage loan origination network within its then-existing three- state branch market as well as the expansion into selected geographic markets. Currently, Northeast Savings originates its residential mortgage loans through its five-state branch system and its residential mortgage loan origination offices in Connecticut and, through a subsidiary, in Colorado. Previously, Northeast Savings also operated a loan origination office in California. This office was closed in early February 1994. Northeast Savings' primary lending activities consist of originating single- family residential mortgage loans and, to a small extent, consumer loans such as equity loans and lines of credit, checking account overdraft protection, and loans collateralized by deposit accounts, and income property loans secured by commercial real estate and guaranteed by the United States Small Business Administration (SBA). Northeast Savings' lending objective is to meet its customers' needs while managing the amount of credit and interest rate risk exposure in its loan portfolio. To accomplish this goal, significant attention is directed toward designing appropriate types of loans to be offered and the proper pricing of each type of loan. Northeast Savings reviews its loan volume capacity as compared with its asset growth projection and capital ratios on a regular basis. Loan volume in excess of the desired growth capacity is available for sale in public and private markets either in a securitized or non-securitized form. Loans which are originated with the intention to sell are carried at the lower of cost or fair value. The environment for the sale of loans in the secondary market is dependent upon market conditions. When the market is restricted, the effect is to reduce loan sales and loans serviced for others. When this occurs, it may be necessary to restrict loan originations to maintain targeted asset growth and capital levels. Single-Family Residential Mortgage Loans. Single-family residential first mortgage loans were $1.8 billion or 96.0% of Northeast Savings' total loan portfolio at December 31, 1993 and included $46.1 million in the available-for-sale portfolio which is carried at the lower of cost or fair value. The following table shows the geographic distribution of the Association's single-family residential mortgage loan portfolio at the dates indicated: The Association offers a variety of adjustable rate residential mortgage loan products, all of which conform to secondary mortgage market requirements. The Association's primary adjustable rate product is a one-year adjustable rate loan, which is tied to the Weekly Average Yield on U.S. Treasury Securities adjusted to a constant maturity of one year (One-Year Treasury Constant Maturity Index). Payments and interest rates change annually with an interest rate cap of 2%. Northeast Savings also offers a selection of fixed rate mortgage loans. Generally, both adjustable and fixed rate loans originated by Association are based on underwriting standards such that the loans may be sold or securitized in the secondary mortgage market. Depending upon the underlying index, adjustable rate loans are offered at terms ranging from 25 to 30 years. All adjustable rate loan products include a lifetime cap and some contain options to convert to a fixed rate loan. A lifetime cap on loans is determined by the Association at the inception of a loan. For borrowers whose initial down payments are less than 20%, Northeast Savings offers adjustable rate loans covered by private mortgage insurance which insures that the Association's exposure is no greater than approximately 75% of the appraised value of the property at the time the loan was originated. Northeast Savings also originates 10, 15, 20, and 30 year, conforming and non-conforming, fully amortizing fixed rate residential mortgage loans, some of which are sold in the secondary mortgage market as whole loans or, with conforming loans, in the form of securities issued by the Federal Home Loan Mortgage Corporation (FHLMC) or the Federal National Mortgage Association (FNMA). Single-family residential conforming loans are those loans which are equal to or less than FNMA or FHLMC loan limits, which was $203,150 as of January 1, 1994. Generally, when conforming loans are sold to FHLMC or FNMA, Northeast Savings collects fees for continuing to service the loans. In addition, the Association originates loans for private investors based on their underwriting standards and sells these loans to the investors, servicing released. All residential mortgage loans originated by the Association contain due-on-sale clauses which provide that the Association may, subject to certain regulatory restrictions, declare the unpaid principal amount due and payable upon the resale of the mortgaged property. The Association also originates a variety of other single-family residential mortgage loan products including loans with fixed interest rates for the first three years after origination which convert to adjustable rate mortgages at the end of the fixed rate period. The adjustable rates are generally tied to the One-Year Treasury Constant Maturity Index. Originations of single-family residential mortgage loans by product type and by geographic area during the year ended December 31, 1993 were as follows: Northeast Savings' single-family residential loan portfolio at December 31, 1993 by product type and geographic area is as follows: Included in the single-family residential loan portfolio are $226.1 million of loans which were purchased prior to 1991 in the secondary market and are serviced by FNMA/FHLMC approved servicers. At the time of purchase, the underwriting guidelines for purchased loans met or exceeded the credit standards established by the Board of Directors. Purchased loans cannot exceed $600,000 and loan-to-value ratios cannot exceed 80% without acceptable private mortgage insurance. Properties collateralizing purchased loans are geographically dispersed to limit the Association's exposure to unfavorable economic changes in any one area of the country. Under federal regulations, with some limited exceptions, a residential mortgage loan may not exceed 100% of the appraised value of the collateralized property at the time of origination. Under policies adopted by its Board of Directors, Northeast Savings limits the loan-to-value ratio to 80% on single- family residential mortgage loans, and, with private mortgage insurance, up to 90% on adjustable rate single-family residential mortgage loans and 95% on fixed rate single-family residential mortgage loans. In certain geographic areas of the country, Northeast Savings has limited the loan-to-value ratio to even less than 80%. In certain cases, prior to 1990, the Association's policies allowed originations of single-family residential mortgage loans with loan-to- value ratios greater than 80% without private mortgage insurance. Such loans originated after 1990 were on an exception basis only and required the approval of the Chairman of the Board or the President. The following table shows certain information with respect to the original loan-to-value ratios of single-family residential loans originated during the periods indicated: The following table shows originations of single-family residential loans during the year ended December 31, 1993 by state and by original loan-to-value ratios: The following table presents the Association's single-family residential loans, which are both originated and serviced by the Association, by state at December 31, 1993 based on original loan-to-value ratios: The remaining $243.8 million in the Association's single-family residential loan portfolio consists primarily of purchased loans for which the above breakdown is not available. The Association originates, reviews, and approves loans in accordance with written, nondiscriminatory underwriting guidelines established by the Board of Directors and requires property appraisals on all real estate loans. Pursuant to federal regulations, Northeast Savings has developed and adopted a written appraisal policy that meets certain minimum standards, including guidelines pertaining to the hiring of the Chief Appraiser, who reports directly to the Chairman, and the use of other independent fee appraisers. Licensed or certified independent fee appraisers must be approved by the Chief Appraiser and reviewed and affirmed by the Board of Directors and all appraisals must meet FNMA/FHLMC guidelines. Approximately 70% of the Association's appraisals are performed by internal state-certified staff appraisers. Detailed loan applications and credit reports are obtained to determine the borrower's ability to repay and the significant items on the applications are verified through the use of financial statements and deposit and employment verifications. Since the beginning of calendar year 1992, the Association has required full or standardized documentation on all portfolio loans. Northeast Savings requires borrowers to maintain fire and casualty insurance for the greater of the insurable value of the property or the amount of the mortgage. Consumer Loans. Federal laws and regulations permit federally-chartered savings institutions to make secured and unsecured consumer loans of up to 35% of the institution's total assets. In addition, federally-chartered savings institutions have lending authority above the 35% limit for certain consumer loans such as home equity loans. In the past several years, Northeast Savings' consumer lending activities have been directed almost exclusively towards loans associated with deposit products, such as loans collateralized by deposit accounts and overdraft protection on checking accounts. However, beginning in late 1993, the Association also began offering equity lines of credit. The equity lines of credit provide for an interest rate that is 1 1/2% above the Wall Street Journal prime rate with a corresponding maximum lifetime interest rate cap of 14.9%. The rate is adjusted monthly, based on changes in the index. The equity line of credit remains open with a revolving feature for ten years and requires the payment of interest only during that time, after which the principal balance fully amortizes over a twenty year period. The maximum amount on these loans is $100,000 and the maximum combined loan-to-value ratio is 75%. In addition, the Association originates a small number of fixed rate, closed- end equity loans. The maximum amount on the fixed rate equity loans is also $100,000 and the maximum combined loan-to-value ratio is 75%. Deposit account loans have no set repayment date, are collateralized by deposit accounts maintained at Northeast Savings, and provide for a rate of interest that is 3% above the rate on the deposit account collateralizing the loan. The overdraft protection associated with checking accounts is a revolving credit line which is currently limited to a maximum of $1,000 and is restricted to depositors who maintain a household deposit balance of at least $5,000 with Northeast Savings. This product carries an interest rate of 15.75%. Consumer loans are approved in accordance with written, non-discriminatory underwriting guidelines established by the Board of Directors. Consumer loans were $34.7 million or 1.8% of the total loan portfolio at December 31, 1993. Consumer loans at December 31, 1993 included $5.9 million in equity credit lines and $15.5 million in fixed rate equity loans. Income Property Loans. At December 31, 1993, the income property loan portfolio totaled $79.3 million or 4.1% of total loans. Income property loans include loans on income-producing properties and single-family residential construction. At December 31, 1993, loans on income-producing properties totaled $69.2 million. Approximately 78.3% of Northeast Savings' income property loans are located within its primary market areas of New York, Massachusetts, Connecticut, and California. Of the total income property loan portfolio, $377,000 or approximately 0.5%, was classified as non-accrual at December 31, 1993. Income property loans are collateralized by the underlying real estate, may be supported by additional personal guarantees, and conform to all federal regulations. Restrictions under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) limit income property loans to 400% of an institution's capital. This limitation is discussed further in the Regulations section. Northeast Savings offers single-family residential construction loans to stable developers, since the construction of single-family residences is so closely tied to the Association's primary lending activity. Specific loan structure and pricing on single-family residential construction loans are consistent with Association objectives. At December 31, 1993, single-family residential construction loans totaled $10.1 million or less than 1% of total loans. None of these loans was classified as non-accrual or delinquent at December 31, 1993. During the year ended December 31, 1993, the Association originated $7.1 million in single-family residential construction loans. Northeast Savings offers loans secured by owner occupied commercial real estate to established and expanding businesses. Such loans are generally guaranteed by the SBA. Origination of these loans is consistent with the objectives of the CRA. Commercial Loans. The Association had $77,000 of commercial loans outstanding at December 31, 1993. Northeast Savings does not intend to originate any new commercial loans during 1994 or future years because these loans do not conform to the Association's strategy of being a traditional thrift single-family residential lender. Federal regulations limit the amount of commercial, corporate, or business loans a federal savings association may make to 10% of total assets and further limit the aggregate amount of loans that Northeast Savings may make to any one borrower. These limitations are discussed further in the Regulations section. The composition of Northeast Savings' loan portfolio is set forth in the following table at the dates indicated: - -------- * Available-for-sale loans include $39.6 million of fixed rate loans and $6.5 million of adjustable rate loans. The table below shows the geographic distribution of the Association's gross loans at the dates indicated: The following table shows the composition of Northeast Savings' gross portfolio of loans by state and loan type at December 31, 1993: The following table shows changes in Northeast Savings' loan portfolio for the periods indicated: - -------- (1) Loans repurchased from prior sales. Such loans were adjustable rate loans which were convertible into fixed rate loans. Upon conversion, the Association was required to repurchase the loans. (2) Consists of a purchase from the RTC of a portion of a loan participation in which the Association was already a co-participant. (3) Consists primarily of loans which were securitized and simultaneously sold. In addition, $7.4 million resulted from the sale of California adjustable rate mortgages. (4) Sale of a loan participation to the servicer at the request of the servicer in order to facilitate a pool sale. (5) Sale of an income property participation loan in which the lead lender elected to repurchase the Association's share of the loan. (6) Represents a whole loan participation which was serviced by another financial institution. This participation was sold because of management's concerns over the creditworthiness of that servicer. (7) Loans repurchased from prior sales due to documentation deficiencies. (8) Acquired as part of the acquisitions of Financial of Hartford, ComFed, and FarWest from the RTC and consists primarily of loans collateralized by deposit accounts. Scheduled fixed rate and adjustable rate loan maturities of the Association's gross loan portfolio at December 31, 1993 are as follows. Actual maturities may be significantly shorter due to market conditions on interest rates. Sales of Loans and Loan Servicing Activities. Northeast Savings sells loans primarily in order to manage interest rate risk and to maintain targeted asset growth and capital levels. In addition, other factors such as origination volume and mix as well as mortgage prepayment rates enter into the determination of the amount of fixed and adjustable rate loans originated for sale. Northeast Savings' portfolio of loans originated for sale totaled $46.1 million and $32.2 million at December 31, 1993 and 1992, respectively. In most cases when loans are sold, Northeast Savings retains the servicing of the loans. Northeast Savings sells loans and retains the related servicing in order to increase income while fully utilizing the capacity of its loan servicing systems. Northeast Savings records gains or losses from the sale of loans that it continues to service for others by computing the present value of the difference between the yield on the loans sold and the yield to be paid to the buyer, reduced by normal servicing and guarantee fees, over the estimated remaining life of the loans. The present value gain or loss is based upon market prepayment and discount rate assumptions. An asset, known as excess servicing, which is equal to the present value gain, is recorded at the time a loan is sold and is amortized over the estimated remaining life of the loans. Northeast Savings monitors actual prepayments on the related loans and reduces the balance of the asset by a charge to earnings if actual and/or projected prepayments exceed the Association's original estimate. In addition, prior to fiscal 1990, Northeast Savings purchased rights to service loans. At December 31, 1993 and 1992, purchased mortgage servicing rights and deferred excess servicing, as well as the principal balance of loans serviced for others in connection with those assets, were as follows: Current capital regulations which limit the inclusion of purchased mortgage servicing rights in regulatory capital are discussed in "Regulations-- Regulatory Capital and Other Requirements." The following table summarizes loans serviced for others, by investor, at the dates indicated: Northeast Savings earns an annual servicing fee for servicing loans for others. The servicing fee typically ranges from approximately twenty-five basis points for fixed rate loans to thirty-eight basis points for adjustable rate loans. Fees generated from servicing loans for others are included with non- interest income in the Consolidated Statement of Operations. The following table details fee income earned by the Association on loans serviced for others for the periods indicated. Adjustments to value due to prepayments resulted from the availability of substantially lower interest rates on mortgage loans. Reflecting the overall level of interest rates in the economy, mortgage rates were particularly low during the year ended December 31, 1993. Interest losses on payoffs occur because, although a borrower may pay off a mortgage early in the month, the Association must still remit an entire month's interest to the investor. Securitization. During the fiscal years ended December 31, 1993, the nine months ended December 31, 1992, and the years ended March 31, 1992, 1991, and 1990 the Association securitized residential mortgage loans totaling $376.6 million, $2.6 million, $14.5 million, $365.6 million and $402.5 million, respectively. These securitizations were transacted for a number of reasons. First, the Association needed to enhance its risk-based capital ratios. The high quality of the mortgage-backed securities received in exchange for the mortgage loans require a risk-based capital weighting of only 20% whereas the underlying mortgage loans would have required a risk-based capital weighting of 50%. Second, none of the mortgage-backed securities created have recourse provisions. As a result, these securities mitigate the credit risk inherent in the underlying loans. Third, at times the Association securitizes mortgage loans to balance the diversification of its mortgage loan portfolio, thereby reducing the concentration of loans in any one state or region of the country. And finally, mortgage-backed securities are more readily accepted as collateral for wholesale-type borrowings than whole loans and thus have the effect of enhancing funding flexibility on a cost-effective basis. Allowance For Loan Losses. As a result of certain credit, appraisal, and underwriting risks and uncertainties, potential credit losses are implicit in the business of originating or investing in single-family residential real estate, consumer, income property, and commercial loans. Accordingly, management determines a provision necessary to maintain an allowance for loan losses which it believes is adequate for potential losses at each period end. The evaluation of the loan portfolio for potential losses includes a review on a periodic basis of the financial status and credit standing of certain individual borrowers and/or, an evaluation of available collateral. In addition, management's judgment regarding prevailing and anticipated economic conditions, the impact of those conditions on property values, historical loan loss experience in relation to outstanding loans, the diversification and size of the loan portfolio, the results of the most recent regulatory examinations available to Northeast Savings, the overall loan portfolio quality and the level of loan charge-offs are considered in evaluating the adequacy of the allowance for loan losses. Although management believes that the allowance is adequate, if events or economic conditions change, there can be no assurance that losses, which could be substantial in relation to the size of the allowance, will not be sustained in any given year. Further, no assurance can be given that future increases to the allowance might not result because of the economy for a particular region or the financial difficulties of a particular borrower. Management has established a monitoring system for its loan portfolio to identify potential problem loans and to permit periodic evaluations of the adequacy of the allowance for loan losses in a timely manner. The loan portfolio is comprised of the following major categories: single-family residential real estate loans, consumer loans, income property loans, and commercial loans. In analyzing these categories, management has established specific monitoring policies and procedures which it believes are suitable for the relative risk profile and other characteristics of the loans within the various portfolios. The Association's single-family residential real estate and consumer loans are relatively homogeneous. Therefore, in general, management reviews its residential and consumer portfolios by analyzing their performance and the composition of their collateral for the portfolios as a whole. Loans originated since 1989 which are more than 30 days past due are reviewed on a monthly basis by a product performance committee comprised of senior officers, which assesses both the product type and the individual originators for potential trends. Also on a monthly basis, all residential loans greater than $1,000,000 are reviewed by the Board of Directors. Additionally, all loans greater than $1,000,000 which are more than sixty days past due are reviewed quarterly by the Association's Asset Classification Committee (see below). Since Northeast Savings originates primarily adjustable rate mortgage loans, management regularly monitors the status of this portfolio as compared with its total portfolio and reviews the corresponding loss experience. The impact of negative amortization type loans is considered in the review as well, although the Association has not originated any of these loans since July 1991. Trends are being closely monitored in the current recessionary environment, particularly in the Northeast and California, the Association's two primary market areas, to determine if any additional changes need to be made to either underwriting standards or to the allowance for loan losses. Northeast Savings' monitoring process for the income property and commercial portfolios includes an annual review by loan personnel of all loans greater than $100,000, regardless of performance. In addition, on a monthly basis, the Board of Directors and senior management review specific loans and detailed delinquency information, including a review of loans which are less than $100,000 about which management has particular concerns and a review of loans to related parties. As a result of this monitoring process, approximately 97% of the income property loan portfolio is reviewed on a regular basis. Finally, Northeast Savings has an Asset Classification Committee comprised of senior executive officers which meets quarterly to determine which loans should be classified as Pass, Special Mention, Substandard, Doubtful, or Loss. A brief description of these classifications follows: A Pass loan is considered of sufficient quality to preclude a Special Mention or an adverse rating. Pass loans generally are well protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral. A Special Mention loan does not currently expose the Association to a sufficient degree of risk to warrant an adverse classification. However, it does possess potential weaknesses deserving management's close attention. If left uncorrected, these potential weaknesses may result in a deterioration of the repayment prospects for the loan or in the institution's credit position at some future date. Special mention loans are not adversely classified since they do not expose an institution to sufficient risk to warrant adverse classification. A loan classified Substandard is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses. They are characterized by the distinct possibility that the Association will sustain some loss if the deficiencies are not corrected. Substandard loans totaled $76.4 million at December 31, 1993. Loans classified as Doubtful have the weaknesses of those classified as Substandard, with the added characteristic that the weaknesses make collection or liquidation in full highly questionable or improbable, based on currently existing facts, conditions, and values. The Association views the Doubtful classification as a temporary category. The Association had no loans classified as Doubtful at December 31, 1993. Loans classified as Loss are considered uncollectible and of such little value that their continuance as assets without establishment of a specific valuation allowance or charge-off is not warranted. A Loss classification does not necessarily mean that a loan has absolutely no recovery or salvage value; rather, it is not practical or desirable to defer writing off a basically worthless loan even though partial recovery may occur in the future. The Association had no loans classified as Loss at December 31, 1993. In addition to the aforementioned procedures, the results of the Asset Classification Committee are reviewed quarterly by the Audit Committee of the Board of Directors. See the Regulations section for a further discussion of classification of loans. The following table presents a reconciliation of the Association's classified loans to its non-accrual loans, restructured loans, and real estate and other assets acquired in settlement of loans (REO) at December 31, 1993 and 1992. Further information regarding non-accrual loans, restructured loans, and REO may be found in the following pages. - -------- * At December 31, 1993 and 1992, respectively, $2.9 million and $4.6 million of non-accrual loans were not classified. These loans identified as non-accrual but not classified were primarily single-family residential loans which were guaranteed through government programs or which have full recourse against the servicer. Potential problem loans amounted to approximately $10.2 million at December 31, 1993. Potential problem loans are currently performing and have not been restructured but compliance with the present loan repayment terms is doubtful based on management's assessment of possible credit problems of the borrowers. These potential problem loans have been included above as substandard loans. The following table reflects the activity in the allowance for loan losses for the periods indicated: The following table summarizes net charge-offs/(recoveries) by state for the year ended December 31, 1993: The following table summarizes the Association's net charge-offs to average loans outstanding for the periods indicated. The increases in the ratio of single-family residential real estate loan net charge-offs to average loans for the periods ended December 31, 1993 and 1992, and March 31, 1992 were due to general economic conditions, particularly the recessions in New England and California. The lingering recessionary environment caused high rates of unemployment and reduced family income levels which resulted in declining real estate values and increased delinquencies and foreclosures. Net charge-offs due to losses on single-family residential loans in California totaled $9.8 million, $6.2 million, and $2.2 million for the year ended December 31, 1993, the nine months ended December 31, 1992, and the year ended March 31, 1992, respectively. These charge-offs were due largely to the severity of the recession in California which resulted from several factors, including the deterioration of the California real estate market. In the single-family residential sector of this market, existing home sales and property values have continued to decline, particularly with respect to homes with original values greater than $500,000. The increase in single-family residential charge-offs, which began in late 1992 and continued into 1993, indicated that the risk in the single-family residential loan portfolio was higher than indicated by previous analysis. As a result, management increased the provision for loan losses to $23.3 million for the year ended December 31, 1993. Net charge-offs on income property loans for the year ended December 31, 1993 resulted from charge-offs of $1.1 million and $300,000 on two income property loans in New Hampshire and Massachusetts, respectively. Both loans were collateralized by office buildings. The increase in net charge-offs on income property loans for the year ended March 31, 1992 was due primarily to net charge-offs of $280,000 on two residential subdivision loans originated in 1989 and $220,000 on an industrial warehouse loan. A further discussion of loan charge-offs may be found in Item 7: Management's Discussion and Analysis of the Results of Operations and Financial Condition. The nature of the allowance for loan losses is such that it is not possible to allocate it to specific loans with a high degree of precision. However, the allowance has been allocated for the periods indicated in the following table to broad categories of loans to indicate management's assessment of the relative risk characteristics of those types of loans and consideration of other factors. This allocation is based not only on an evaluation of specifically identified loans, but also includes considerations of historical loan losses, levels of non-accrual and restructured loans, if any, and an assessment of local and regional economic conditions and other factors which may influence risk. Activity in the allowance for loan losses is also discussed in Item 7: Management's Discussion and Analysis of the Results of Operations and Financial Condition. The following table shows the allocation of the allowance for loan losses to the various loan types at the dates indicated: - -------- * The gross loan portfolio balances used in the calculations are net of unearned discounts, deferred origination fees, and the undisbursed portion of loans in process. At the dates indicated, the percentage distribution of the allowance for loan losses was as follows: - -------- * The gross loan portfolio balance is net of unearned discounts, deferred origination fees, and the undisbursed portion of loans in process. ** For purposes of this analysis, the unallocated portion of the allowance for loan losses has been included in the single-family residential allocation. The allowance for loan losses as a percentage of non-accrual loans by loan category was as follows: - -------- * There were no non-accrual commercial loans at the dates indicated. ** For purposes of this analysis, the unallocated portion of the allowance for loan losses has been included in the single-family residential real estate allocation. The ratios of the allowance for loan losses to non-accrual loans since 1990 reflect a change in composition of the allowance which corresponds to the change in the composition of the Association's non-accrual loans, specifically the increase in single-family residential non-accrual loans as a percentage of total non-accrual loans. At December 31, 1993 and 1992, and March 31, 1992 and 1991, single-family residential non-accrual loans were 97.5%, 92.6%, 96.2%, and 85.6%, respectively, of non-accrual loans. At March 31, 1990, the percentage was only 71.1%. At December 31, 1993 and 1992, the decreased ratios of the allowance for loan losses to non-accrual consumer loans reflect significant charge-offs made during the years ended March 31, 1992 and 1991, which resulted in a portfolio with generally lower risk. The Association's consumer loans, which totaled 1.8% of the total loan portfolio at December 31, 1993, consist primarily of well- seasoned loans collateralized by deposit accounts or real estate. At December 31, 1993, 25.1% of the Association's consumer loans were collateralized by deposit accounts, while 61.7% consisted of loans collateralized by real estate. The non-accrual income property loans at December 31, 1993 consist primarily of loans which have been reserved to their estimated fair values based on current appraisals. The Association's income property loan portfolio, totaling 4.1% of the total loan portfolio at December 31, 1993, consists of well- seasoned loans, most of which were originated prior to 1986. Non-Accrual Loans. Non-accrual loans are loans on which the accrual of interest has been discontinued. Northeast Savings' policy is to discontinue the accrual of interest on loans and to reverse previously accrued interest when there is reasonable doubt as to its collectibility. Interest accruals on loans are normally discontinued and previously accrued interest is reversed whenever the payment of interest or principal is more than ninety days past due, or earlier when conditions warrant it. For example, although a loan may be current, the Association discontinues accruing interest on that loan when foreclosure is brought about by other owner defaults. When the interest accrual on a loan is discontinued, any previously accrued interest is reversed. A non-accrual loan may be restored to an accrual basis when principal and interest payments are current and full payment of principal and interest is expected. For all of the periods noted below, Northeast Savings had no loans more than ninety days past due on which interest was still accruing. The total interest income that would have been recorded for the year ended December 31, 1993 on non-accrual loans, had these loans been current in accordance with their original terms, or since the date of origination if outstanding for only part of the year, was $4.8 million. The amount of interest income which was included in net income for the year ended December 31, 1993 on those loans was $1.3 million. The following is a table of non-accrual loans along with the percentage to total gross loans and total assets as of the dates indicated. The high levels of non-accrual loans as a percentage of total loans in recent years is primarily a result of general economic conditions in the Association's primary markets, particularly the recessions in New England and California. The decreases in non-accrual loans at December 31, 1993 and 1992 from March 31, 1992 were primarily due to increased foreclosures of the underlying collateral securing the loans. The following table presents the Association's gross non- accrual loans by state at the dates indicated. Complete state-by-state information for the year ended March 31, 1990 is not available. The following table presents the Association's non-accrual loans by state and property type at December 31, 1993: The table which follows shows the loan-to-value ratios based on the original appraisal and the current loan balance of the Association's single-family residential non-accrual loans at the dates indicated. The remaining $7.0 million, $13.7 million, and $19.3 million of single-family residential non-accrual loans at December 31, 1993 and 1992, and March 31, 1992, respectively, was serviced by other servicers. As a result, the above information is not available for these loans. In addition, information regarding loan-to-value ratios for years prior to the year ended March 31, 1992 is not available. Loan-to-value ratios for income property non-accrual loans are based on 1993 appraisals and current loan balances. At December 31, 1993 and 1992, all of the income property non-accrual loans were in the 85-90% category. At March 31, 1992, all of the income property non-accrual loans were in the 80-85% category. Non-accrual loans are discussed further in Item 7: Management's Discussion and Analysis of the Results of Operations and Financial Condition. Delinquent Loans. While non-accrual loans are generally loans which are more than ninety days past due, delinquent loans are all loans more than thirty days past due, including non-accrual loans. The following table presents the principal amount of the Association's delinquencies by loan types at the dates indicated: The following table presents the principal amount of the Association's loan delinquencies and delinquency ratios by state as of the dates indicated: - -------- * State-by-state information is not available for certain purchased loans serviced by others which were 30-59 days delinquent at the dates indicated. These loans, which are included in "other" loans, totaled $9.4 million, $11.7 million, and $17.2 million at December 31, 1993 and 1992, and March 31, 1992, respectively. Real Estate and Other Assets Acquired in Settlement of Loans. REO results when property collateralizing a loan is foreclosed upon or otherwise acquired in satisfaction of the loan. REO is recorded by the Association at the lower of the recorded investment in the loan or fair value less estimated costs to sell. When a borrower fails to make required payments on a loan and does not cure the delinquency promptly, the Association takes the steps required under applicable law to foreclose upon the property collateralizing the loan. If a delinquency is not cured, the property is generally acquired by the Association in a foreclosure sale or by taking a deed in lieu of foreclosure. If the applicable period of redemption by the borrower (which varies from state to state and by method of foreclosure pursued) has expired, the Association is free to sell the property. The remedies available to lenders when a residential mortgage borrower is in default vary from state to state. Certain states have antideficiency and homeowner provisions which limit the Association's ability to foreclose upon, or otherwise obtain ownership of, the property collateralizing the loan and which prevent the Association from recovering from the borrower any deficiency realized from the sale of such property. In these states the Association generally has an option to sue on the note in lieu of a judicial foreclosure. The activity in the Association's REO is presented in the following table: - -------- * During the quarter ended September 30, 1993, $30.3 million of REO was sold in a single transaction. The total loss on the sale was $6.8 million, including a provision of $6.0 million recorded in June in anticipation of the sale. Excluding this sale, sales of REO for the year ended December 31, 1993 totaled $52.8 million. The following table presents Northeast Savings' REO by property type at the dates indicated. The following table shows the detail of Northeast Savings' REO by state: The following table details the Association's REO by state and property type at December 31, 1993: The $24.4 million decrease in REO at December 31, 1993 from a year earlier was due primarily to the sale in a single transaction of $30.3 million of the Company's portfolio of single-family residential REO. The turnover of single- family residential REO has been relatively rapid. Of the $57.2 million of single-family residential REO at December 31, 1993, only thirty-four properties totaling $17.3 million were in the portfolio for longer than one year. The table below presents the aging of foreclosed properties at the dates indicated: During the year ended December 31, 1993, 281 REO properties with a book value of $77.1 million, net of a $6.0 million provision on the single transaction sale noted above, were disposed of. Excluding the total loss of $6.8 million on the single transaction sale, net gains of $318,000 were recorded on the sale of all other REO properties. Additional discussion of REO may be found in Item 7: Management's Discussion and Analysis of the Results of Operations and Financial Condition. INVESTMENT ACTIVITIES Northeast Savings engages in investment activities for both investment and liquidity purposes. Northeast Savings maintains an investment securities portfolio, which consists primarily of U.S. government and agency securities, corporate obligations, bank and finance securities, asset-backed securities, collateralized mortgage obligations, Federal Home Loan Bank stock, and marketable equity securities. Other short-term investments held by Northeast Savings from time-to-time include interest-bearing deposits and federal funds sold. Northeast Savings also maintains a mortgage-backed securities portfolio consisting of securities issued and guaranteed by Government National Mortgage Association (GNMA), FHLMC, and FNMA in addition to publicly traded and rated mortgage-backed securities issued by private financial intermediaries. U.S. government and agency securities, corporate obligations, bank and finance securities, collateralized mortgage obligations, and mortgage-backed securities, which the Association has the intent and ability to hold until maturity, are classified as held-to-maturity and are carried at amortized cost; however, those securities which have been identified as assets which will be sold prior to maturity or assets for which there is not a positive intent to hold to maturity are classified as available-for-sale and are carried at fair value, with unrealized gains and losses excluded from earnings and, reflecting the adoption of Statement of Financial Accounting Standards (SFAS) 115, "Accounting for Certain Investments in Debt and Equity Securities," reported as a separate component of stockholders' equity. In addition, when management determines that a security has been impaired by a loss which is other than temporary, the Association writes the security down in accordance with its accounting policies as outlined in Note 1 to the Consolidated Financial Statements and ceases to accrue interest on it. At December 31, 1993, the Association had no investments which were deemed to have been impaired by an other than temporary loss. Northeast Savings is required by federal regulations to maintain a specified minimum amount of liquid assets which must be invested in certain securities. Management maintains liquidity at a level to assure adequate funds, taking into account anticipated cash flows and available sources of credit, and to afford future flexibility to meet deposit withdrawal requests and loan commitments. Northeast Savings' liquidity portfolio is carried in the available-for-sale portfolio at fair value. As required by federal regulations, Northeast Savings maintains its liquidity ratio above 5%, and its short term liquid asset ratio above 1% of net withdrawable deposits and borrowings payable in one year or less. For the year ended December 31, 1993, Northeast Savings' liquidity ratio averaged 5.67%, compared to 9.88% for the nine months ended December 31, 1992 and 5.83% and for the year ended March 31, 1992. For the same respective periods, the Association's short term liquid asset ratio averaged 2.34%, 5.00%, and 3.31%. The following tables reflect the carrying value of the Association's investment securities and the weighted average yield based on the amortized cost for each category at the dates indicated. Both the amortized cost and the fair value of these securities may be found in Note 5 to the Consolidated Financial Statements. The following table shows the maturity distribution of the amortized cost and the weighted average yields based on amortized cost of Northeast Savings' investment securities at December 31, 1993. The carrying value of these securities may be found in a previous table. Changes in interest rates will affect the actual maturity. The following table details the Standard and Poor's ratings for each major category of the Association's investments at December 31, 1993: - -------- *Of this amount, $1.6 million has been translated from Moody's rating of Aaa. **All obligations of states and political subdivisions are current. The carrying value of the Association's mortgage-backed securities and the weighted average yield based on amortized cost for each category at the dates indicated is detailed in the following tables. Both the amortized cost and the fair value of these mortgage-backed securities may be found in Note 6 and Note 21 to the Consolidated Financial Statements. The following table shows the maturity distribution of the amortized cost and the weighted average yields of Northeast Savings' mortgage-backed securities at December 31, 1993. The carrying value of these mortgage-backed securities may be found in a previous table. Changes in interest rates will affect the actual maturity. The following table details the Standard and Poor's ratings for each major category of the Association's mortgage-backed securities at December 31, 1993: - -------- * Of these amounts, $317.7 million of AAA-rated securities, and $326.2 million of AA-rated securities, have been translated from Moody's ratings of Aaa and Aa2, respectively. SOURCES OF FUNDS DEPOSITS. The principal source of funds for the Association is retail customer deposits. Northeast Savings offers a variety of deposit products ranging from transaction accounts to certificate and retirement accounts with maturities from 30 days to seven years. Northeast Savings' deposits are derived primarily from its five-state branch system area. In previous years, wholesale funding sources, including brokered deposits and capital market borrowings, were used to fund the Association's wholesale banking activities in the secondary markets. However, with the return to more traditional thrift activities, brokered deposits were reduced to less than 1% of Northeast Savings' total deposits at December 31, 1993 and 1992 and March 31, 1992. Brokered deposits totaled $25.1 million at both December 31, 1993 and 1992 and $25.7 million at March 31, 1992, compared to $113.5 million at March 31, 1991. However, the decrease in retail deposits over the past several years has caused management to replace those deposits with increased wholesale borrowings in order to maintain the asset size of the Association. At December 31, 1993, Northeast Savings was 81.0% funded by retail deposits, compared to 87.5% at December 31, 1992 and 97.7% at March 31, 1992. Northeast Savings' other income from deposit accounts consists primarily of monthly service charges, charges for insufficient or uncollected funds, stop payment fees, check printing charges, retirement account fees, and automated teller machine transaction fees. Fees from deposit accounts totaled $4.9 million for the year ended December 31, 1993, compared to $3.9 million and $4.8 million for the nine months ended December 31, 1992 and the year ended March 31, 1992, respectively. The following table sets forth information relating to the Association's deposit flows for each of the periods indicated: The following tables, which include both retail customer deposits and brokered deposits, set forth the amounts of deposits in the various types of accounts offered by Northeast Savings, the amounts of those deposits as a percentage of total deposits, and the weighted average interest rates at the dates indicated, as well as the contractual maturities of deposits at December 31, 1993: - -------- * Certificates mature in the applicable year ending December 31, rather than March 31. - -------- * Certificates mature in the applicable year ending December 31, rather than March 31. The following table, which includes both retail customer and brokered certificates of deposit, provides information by interest rate ranges at each of the dates indicated: The following table sets forth the weighted average interest rates and amount of deposits by original term for certificate accounts at December 31, 1993: At December 31, 1993, deposits had the following remaining contractual maturities: While non-certificate accounts have no contractual maturities, they are reported in the above table as though they mature within three months. Certificates of deposit included above, which are equal to or in excess of $100,000, had the following remaining contractual maturities at December 31, 1993: The following table sets forth certain information relating to the Association's concentration of deposits by state in which the Association's branches are located: Borrowings. Northeast Savings' borrowing sources consist primarily of Federal Home Loan Bank (FHLB) advances and securities sold under agreements to repurchase. The Association borrows funds from the FHLB from time to time, pledging certain of its mortgage loans as collateral. Such borrowings may be obtained pursuant to several different credit programs, and each credit program has its own rate and range of maturities up to a maximum of twenty years. Prepayment fees are charged on fixed rate advances if paid prior to maturity. The FHLB is required to review its credit programs at least once every six months and such programs are subject to change. The Federal Housing Finance Board (FHFB) also has established standards for community investment or service for members of FHLBs to maintain continued access to long-term advances. Each member institution must submit to its FHLB a community support statement evidencing assistance to first-time homebuyers such as special credit programs or participation in governmental homeownership programs and any additional evidence of community support. A member institution's access to long term advances could be restricted if it fails to comply with the FHFB community support requirements. In addition, the FHLB of Boston limits additional advances to a member institution that is approaching insolvency on a tangible capital basis to certain short term advances. The FHLB of Boston also may determine not to extend new credit to a member institution that is insolvent on a regulatory capital basis. For further information, see Note 12 of the Notes to the Consolidated Financial Statements. Northeast Savings enters into repurchase agreements whereby it sells marketable mortgage-backed securities with a simultaneous commitment to repurchase the same securities at a specified price at a specified later date. Securities sold under agreements to repurchase are subject to risks relating to the financial strength of the counterparty to the transaction, the nature of the lien against the securities subject to the transaction, and the disparity between the book value of the securities sold and the amount of funds obtained. In order to reduce these risks, the Association deals only with national investment banking firms which are primary dealers in United States government securities. For further information, see Note 12 of the Notes to the Consolidated Financial Statements. In addition, at December 31, 1993, the Company had outstanding $38.4 million of 9% Uncertificated Debentures, Due in 2012. These debentures were issued in May 1992 to the receivers of four failed Rhode Island financial institutions and the FSLIC Resolution Fund in connection with the aforementioned acquisition of four Rhode Island financial institutions and the repurchase of the Company's adjustable rate preferred stock. For further information on the issuance and terms of the debentures, see Note 12 of the Notes to the Consolidated Financial Statements. Selected information relating to borrowings for the dates and periods indicated is as follows: Additional information regarding the Association's business activities can be found in Item 7: Management's Discussion and Analysis of the Results of Operations and Financial Condition and in the Notes to the Consolidated Financial Statements. SUBSIDIARIES Northeast Savings is permitted by current OTS regulations to invest up to 3% of its assets in service corporations whose operations are authorized by the OTS, provided that any investment in excess of 2% must serve primarily community or inner-city purposes. In addition, so long as the OTS continues to permit any such investments, under its grandfathered savings bank investment authority, Northeast Savings may invest up to the lesser of 2% of its assets or 20% of its net worth in any type of investment, subject to certain limitations. Investments in subsidiaries and investments made pursuant to its grandfathered savings bank authority are subject to review by the FDIC to ensure that such investments do not pose a serious threat to the SAIF. OTS regulations also permit federal associations to establish operating subsidiaries in any geographic location. Unlike a service corporation, an operating subsidiary may engage only in such activities as a federal savings association could engage in directly and would not be subject to the percentage of assets limitation imposed on service corporations. To establish an operating subsidiary, a federal savings association must either notify or obtain prior approval of the OTS, depending on the association's capital level and MACRO rating, the OTS internal rating system used for supervisory and examination purposes. All of Northeast Savings' subsidiaries have been redesignated as operating subsidiaries with the exception of: NEMAC Escrow Corp; Hillshire House, Incorporated; Real Estate Referral, Inc.; First Service Corporation of New England; First Service Insurance Agency, Inc.; and Family Security Corp. Northeast Savings has twenty-eight subsidiaries, twenty of which are active. The businesses in which the twenty active subsidiaries are engaged are as follows. NEMAC, INC. is the Association's subsidiary which originates residential loans in Colorado. NFRC VIII, Inc. holds all of the stock of Northeast Custody Corp., a California corporation engaged in trustee services. Through Hillshire House, Incorporated, the Association acquired certain assets of Westledge Real Estate, Inc. and Westledge Real Estate II Corporation in settlement of loans made by the Association to those two corporations. Hillshire House, Incorporated continues to operate the real estate brokerage business under the name Westledge Real Estate. Real Estate Referral, Inc., is a wholly-owned subsidiary of Hillshire House, Incorporated. NFRC II, Inc. holds an REO residential subdivision in Tolland, Connecticut. NFRC III, Inc. holds an REO warehouse in Chelmsford, Massachusetts. NFRC IV, Inc. holds an apartment building in West Hartford, Connecticut. NFRC V, Inc. holds an REO parcel of land in Wethersfield, Connecticut. NFRC VI, Inc. holds an REO office building in Lowell, Massachusetts. NFRC VII, Inc. holds an REO residential subdivision in East Granby, Connecticut. NFRC IX, Inc. owns all of the stock of Connecticut Realty Corp., Connecticut Realty Corp. II, Connecticut Realty Corp. III, Connecticut Realty Corp. IV, Connecticut Realty Corp. V, and Nutmeg Realty Corp., which are all Rhode Island corporations currently holding several commercial REO properties. Northeast Charleston Corp. holds a hotel in Charleston, South Carolina. Northeast New Britain Corp. holds a hotel in New Britain, Connecticut. EMPLOYEES Northeast Savings had 999 employees (901 full-time equivalents) at December 31, 1993, compared to 1,171 (1,036 full-time equivalents) at December 31, 1992. Management considers its relations with its employees to be good. Northeast Savings employees are not represented by any collective bargaining group. Northeast Savings maintains a comprehensive employee benefits program providing, among other benefits, a retirement plan, medical and dental insurance, long-term and short-term disability insurance, life insurance, a thrift and profit sharing plan, an employee stock ownership plan, and educational assistance. REGULATIONS General. The Association is a member of the FHLB System and its deposit accounts are insured up to applicable limits by the FDIC under the SAIF. The Association is subject to extensive regulation by the OTS, as its chartering agency, and the FDIC, as the deposit insurer. The Association must file reports with the OTS and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with or acquisitions of other savings institutions. Periodic examinations by the OTS and the FDIC test the Association's compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulation, whether by the OTS, the FDIC, or the Congress, could have a material adverse impact on the Company, the Association, and their operations. The OTS, an agency established pursuant to FIRREA, is the primary regulator for federally chartered savings associations such as the Association, as well as savings and loan holding companies. The OTS is an office of the Department of Treasury under the general oversight of the Secretary of Treasury. Due to its ownership and control of Northeast Savings, Northeast Federal Corp. is a savings and loan holding company within the meaning of the Home Owners' Loan Act of 1933, as amended, and thus is subject to that Act's regulation, examination, supervision, and reporting requirements imposed on savings association holding companies. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), which was signed into law on December 19, 1991, also included numerous mandatory measures which affect all depository institutions, including savings associations such as Northeast Savings, and which are designed to reduce the cost to the deposit funds of resolving problems presented by undercapitalized institutions. FDICIA significantly increases the supervision and enforcement powers of bank regulatory agencies, particularly the FDIC. In addition to recapitalizing the Bank Insurance Fund (BIF), FDICIA includes a number of provisions relating to annual onsite regulatory examinations of depository institutions, accounting reforms, prompt regulatory action for institutions that fail to satisfy capital requirements, least cost resolution for troubled or failing or failed depository institutions, various truth-in-savings provisions, limitations on the acceptance of brokered deposits by undercapitalized depository institutions, risk-based deposit insurance premiums, limitations on pass-through insurance on qualified retirement accounts and deposit insurance for certain investment contracts, amendments to the Qualified Thrift Lender test for thrift institutions, new restrictions on loans to officers, directors, and controlling shareholders of depository institutions, and a variety of other provisions including authorizing various studies by the regulatory agencies of deposit insurance and customer and consumer issues. As discussed below, the banking agencies have adopted or proposed various rules pursuant to FDICIA. In addition, the federal regulatory agencies were also required to adopt and enforce final regulations to be effective by December 1, 1993 prescribing standards relating to a variety of operating matters such as internal controls, information systems and external audit systems, loan documentation and credit underwriting, interest rate exposure, asset growth and quality, and employee compensation; such standards were published in proposed form on November 18, 1993. Since they are not yet final, it is not possible to assess their impact on the Association. Recent legislation has amended certain FDICIA provisions regarding compensation standards. Additional legislation could be proposed and enacted. No representation can be made as to the possible effects of legislation or regulations which may be adopted in the future. Insurance of Deposits. The FDIC is the federal deposit insurance administrator for both banks and savings associations. The FDIC administers separate insurance funds, the SAIF and the BIF for thrifts and banks respectively, and assessment rates are set independently. The FDIC has the specified authority to prescribe and enforce such regulations and issue such orders as it deems necessary to prevent actions or practices by savings associations that pose a serious threat to the SAIF. In addition, FDICIA required that the FDIC establish a risk-based deposit insurance premium system which would be effective as of January 1, 1994. In establishing such a system, the FDIC was required by FDICIA to take into consideration the risks attributable to different categories and concentrations of assets and liabilities and the revenue needs of the deposit insurance funds. On October 1, 1992, the FDIC published final rules increasing the deposit insurance assessment rate to be paid by BIF and SAIF insured institutions during two semiannual periods in 1993 and thereafter and adopting a transitional risk-based deposit insurance assessment system. The transitional system became effective January 1, 1993 and remained in effect until implementation of the permanent risk-based assessment system one year later. Under the transitional rule, the annual assessment rate for each SAIF insured institution was determined on the basis of capital and supervisory measures. For the capital measure, institutions were assigned to one of three capital groups: well-capitalized, adequately capitalized, or undercapitalized. The first two groups were defined by application of the capital ratio standards imposed under the prompt corrective action rule (discussed below). The third group consisted of those institutions not qualifying as well capitalized or adequately capitalized. Within each group, institutions were assigned to one of three supervisory subgroups: healthy, supervisory concern, or substantial supervisory concern. The FDIC assigned institutions to supervisory subgroups on the basis of supervisory evaluations provided by the institution's primary federal regulator and such other information as the FDIC determined to be relevant to the institution's financial condition and the risk posed to the insurance fund. The supervisory subgroup to which an institution was assigned by the FDIC is confidential and may not be disclosed. Under the final rule, there were nine combinations of groups with assessments ranging from 23 cents for each $100 of insured deposits to 31 cents for each $100 of insured deposits depending upon the risk group to which a savings association was assigned. A savings association's capital group was determined on the basis of data reported in its thrift financial report as of the date closest to June 30 or December 31 that included the necessary capital data. Northeast Savings is deemed to be an adequately capitalized association. The impact of this final rule increased the Association's deposit insurance premium expense between 13% and 26% for 1993. For the year ended December 31, 1993, SAIF deposit insurance premium expense for the Association totaled $7.8 million. On June 17, 1993, the FDIC adopted a final rule establishing a risk-based deposit insurance premium assessment system which was implemented with the semi-annual assessment period commencing January 1, 1994. Except for limited changes, the structure of the permanent system is substantially the same as the structure of the transitional system it replaced. The FDIC is authorized to raise insurance premiums for SAIF members in certain circumstances. If the FDIC determined to increase the assessment rate for all SAIF institutions, institutions in all risk categories could be affected. Any increase in premiums could have an adverse effect on the Association's earnings. The FDIC has authority to terminate the insurance of deposits of savings associations upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. In addition, the FDIC has power to suspend temporarily a savings association's insurance on deposits received after the issuance of a suspension order in the event that the savings association has no tangible capital. Savings associations are allowed to include certain goodwill in tangible capital for this requirement; however, any savings association with no tangible capital prior to including goodwill would be considered a "special supervisory savings association." Assessments. Savings institutions are required by OTS regulation to pay assessments to the OTS to fund the operations of the OTS. The general assessment, to be paid on a semiannual basis, is computed upon the savings institution's total assets, including consolidated subsidiaries, as reported in the institution's latest quarterly thrift financial report. The Association's total expense for assessments for the year ended December 31, 1993 was $590,000. Federal Home Loan Bank System. The Federal Housing Finance Board was established by FIRREA as an independent agency to oversee and supervise the credit functions of the Federal Home Loan Banks. The FHFB ensures that the Federal Home Loan Banks carry out their housing finance mission, remain adequately capitalized, and operate in a safe and sound manner. FIRREA also broadened membership in the Federal Home Loan Banks to include insured banks and credit unions in addition to savings associations. Financial institutions which maintain FHLB membership must hold stock in the FHLB within certain guidelines. As a result of membership, an institution can secure FHLB advances in accordance with the requirements of the FHLB. However, members who do not meet the Qualified Thrift Lender test discussed below have reduced access to advances. Northeast Savings is a member of the FHLB of Boston and as such is required to maintain an investment in capital stock of the FHLB of Boston in an amount equal to the greater of one percent of its outstanding residential mortgage loans and similar obligations, one-twentieth of its outstanding advances, or .3% of total assets. Northeast Savings was in compliance with this requirement with an investment in the FHLB of Boston stock at December 31, 1993 of $31.8 million. The Association may borrow from the FHLB of Boston pursuant to several different credit programs upon the security of certain home mortgages and other assets assuming certain standards of credit worthiness have been met. The FHLB may limit the uses and amount of borrowings under different programs. FIRREA requires the FHLB of Boston to contribute a significant amount of its reserves and annual earnings to fund the principal and a portion of the interest payable on bonds issued to fund the resolution of failed savings associations. In addition, the statute provides that each FHLB must transfer a percentage of its annual net earnings to a specified affordable housing program. As a result of these requirements, it is anticipated that the FHLB of Boston may pay reduced dividends on their stock in the future. As of December 31, 1993 and 1992, respectively, Northeast Savings held $31.8 million and $32.4 million of FHLB of Boston stock. During the year ended December 31, 1993 and the nine months ended December 31, 1992, respectively, Northeast Savings recorded dividend income on its FHLB investment in an aggregate amount of $2.4 million and $1.9 million for a yield of 7.58% and 7.72%, respectively. Regulatory Capital and Other Requirements: Current Capital Regulations. The current OTS regulatory capital regulations require savings associations to meet three capital standards: (1) tangible core capital of 1.5% of adjusted total assets, (2) core capital (leverage ratio) of 3% of adjusted total assets, and (3) risk-based capital of 8% of risk-weighted assets. See "Proposed Leverage Ratio Requirement," "Final OTS Interest Rate Risk Component," and "Prompt Corrective Action." In calculating tangible core capital, a savings association must deduct from capital most intangible assets. Core capital consists of tangible core capital plus certain intangible assets such as qualifying purchased mortgage servicing rights and certain qualifying supervisory goodwill which meets the requirements of FIRREA. Other than qualifying purchased mortgage servicing rights and certain qualifying supervisory goodwill as described below, intangible assets must be deducted from core capital unless they meet a three-part test relating to identifiability, marketability, and liquidity in which event they may be included in an amount up to 25% of core capital. On February 2, 1994, the OTS issued a final rule, effective March 4, 1994, which would permit the inclusion of purchased mortgage servicing rights in capital provided that those rights, in the aggregate, do not exceed 50% of core capital. This rule requires that all other intangibles, including core deposit intangibles with certain limited exceptions, be deducted from capital. This rule will have minimal impact on the Association since the Association's purchased mortgage servicing rights comprise less than 1.8% of core capital. In addition, the OTS will grandfather core deposit intangibles resulting from prior transactions or transactions under firm control as of March 4, 1994. As of December 31, 1993, the Association had only $551,000 of core deposit intangibles which will be so grandfathered. Supervisory goodwill includable in core capital initially could be used to satisfy up to one-half of the 3% core capital requirement and is being phased out over five years, with all goodwill completely excluded from capital after December 31, 1994. At December 31, 1993, supervisory goodwill could be used to satisfy one fourth of the three percent core capital requirement. The allowable percentages of adjusted total assets during the phaseout period are as follows: Since, as discussed in Item 7: Management's Discussion and Analysis of the Results of Operations and Financial Condition, the Company has eliminated all of its supervisory goodwill through valuation adjustments and the utilization of net operating loss carryforwards, the phaseout of supervisory goodwill from capital will have no impact on the Company in the future. The risk-based capital requirement for savings associations of 8% of risk- weighted assets was phased in over three years. Thrifts were required to meet 100% of the requirement, or 8%, on December 31, 1992. The risk-based capital requirement includes core capital plus supplementary capital to the extent that supplementary capital does not exceed 100% of core capital. Supplementary capital includes certain capital instruments which are not included in core capital and general loan loss allowances. Risk-weighted assets equal total assets plus consolidated off-balance sheet items where each asset or item is multiplied by the appropriate risk-weighting applicable to the asset category. The capital regulations assign each asset held by a savings association to one of four risk-weighting categories, based upon the credit risk associated with each asset or item. The risk-weighting categories range from 0% for low-risk assets (such as U.S. Treasury securities and Government National Mortgage Association securities) to 100% for assets deemed to be of higher risk (such as repossessed assets and certain equity investments). Effective December 31, 1993, the OTS requires all savings associations to use fair value for valuation of foreclosed assets including repossessed assets. Previously, foreclosed assets could be carried at the lower of cost or net realizable value. Under this new rule, after foreclosure, foreclosed assets must be carried at the lower of cost or fair value based on an assumption that such assets are available for sale. Since 1989, the Association has carried its foreclosed assets at fair value, rather than at net realizable value. As of December 31, 1992, the OTS also removed the 200 percent risk-weight category which was previously imposed. As a result, foreclosed assets are assigned a risk- weighting of 100 percent. On March 19, 1993, the OTS issued a final rule changing the risk-based capital treatment of certain equity investments to parallel the capital treatment of those investments under the rules applicable to national banks. Effective April 13, 1993, savings associations were required to place these investments in the 100% risk-weight category. The OTS capital regulation further provides that a savings association will be deemed to be in compliance with the OTS capital requirements if it is operating under an approved capital plan and it is not critically undercapitalized as that term is defined by the prompt corrective action rule. FDICIA required the federal banking agencies to review their risk-based capital standards to ensure that those standards take adequate account of: (1) interest rate risk; (2) concentration of credit risks; and (3) the risks of nontraditional activities. FDICIA also mandated that the federal banking agencies publish final regulations no later than 18 months after the enactment of FDICIA or June 18, 1993, as well as establish reasonable transition rules to facilitate compliance with those rules. In addition, the OTS is also soliciting comments on a proposed regulation to take adequate account of credit concentration risk and the risk of non-traditional activities. Since, with the exception of the OTS interest rate risk component discussed below, these proposed rules are not yet final, it is not possible to assess their impact on the Association. Proposed Leverage Ratio Requirement. On April 22, 1991, the OTS issued a notice of proposed rulemaking to establish a new minimum leverage ratio of 3% of adjusted total assets for savings associations without any supervisory, financial, or operational deficiencies, that is, associations receiving a composite rating of 1 on their regulatory examinations under the OTS MACRO system. The leverage ratio is the ratio of core capital to adjusted total assets. Higher leverage ratios, generally 100 to 200 basis points higher, would be required for all other associations, as warranted by particular circumstances or risk profiles. Thus, for all but the most highly rated institutions meeting the conditions set forth in the OTS notice, the minimum leverage ratio would be 3% plus an additional 100 to 200 basis points determined on a case-by-case basis. In all cases, savings institutions would be required to hold capital commensurate with the quality of risk management systems and the level of overall risk in each individual savings association as determined through the supervisory process on a case-by-case basis. Savings associations that no longer pass the minimum capital standards because of the new core capital leverage ratio requirements would be subject to certain restrictions and a limitation on distributions and would be required to submit capital plans that detail the steps they will take to reach compliance with the fully phased-in capital standards by December 31, 1994. These capital plans would be due within 60 days of the effective date of the rule. The Association continues to exceed all current capital requirements including the anticipated increased leverage ratio requirement. Although the proposed leverage requirement is not yet final, under the prompt corrective action rules discussed below, which became effective December 19, 1992, an institution must have a leverage ratio of 4% or greater in order to be considered adequately capitalized. Final OTS Interest Rate Risk Component. On August 31, 1993, the OTS adopted final rules adding an interest rate risk component to its risk-based capital requirement. This rule became effective January 1, 1994. Under the rule, savings associations are divided into two groups, those with "normal" levels of interest rate risk and those with greater than "normal" levels of interest rate risk. Associations with greater than normal levels are subject to a deduction from total capital for purposes of calculating risk-based capital. Interest rate risk is measured by the change in Net Portfolio Value under a 2.0% change in market value of an association's assets less the economic value of its liabilities adjusted for the economic value of off-balance-sheet contracts. If an association's change in Net Portfolio Value under a 2.0% change in market interest rates exceeds 2.0% of the estimated economic value of its assets, it will be considered to have greater than normal interest rate risk, and its total capital for risk-based capital purposes will be reduced by one-half of the difference between its measured interest rate risk and the normal level of 2.0%. The rule adjusts the interest rate risk measurement methodology when interest rates are low. In the event that the 3-month Treasury rate is below 4.0%, interest rate risk will be measured under a 2.0% increase in interest rates and under a decrease in interest rates equal to one-half the value of the 3-month Treasury rate. According to the most recent OTS measurements, Northeast Savings' interest rate risk is within the normal range. The Association's regulatory capital position at December 31, 1993 is presented in Item 7: Management's Discussion and Analysis of the Results of Operations and Financial Condition. Prompt Corrective Action. Under the prompt corrective action provisions of FDICIA, regulations were implemented on December 19, 1992 whereby all financial institutions are placed in one of five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The federal banking agencies are required to take certain supervisory actions against undercapitalized institutions. The severity of such actions depends upon the degree of undercapitalization. Undercapitalized thrifts will be required to submit a capital restoration plan for OTS approval. This capital restoration plan may be approved by the OTS only if the parent holding company of the undercapitalized institution guarantees that the institution will comply with the plan and provides appropriate assurances of performance. Aggregate liability for the holding company under such guarantee is the lesser of five percent (5%) of the institution's assets at the time it became undercapitalized or the amount necessary to bring the institution into compliance with all capital standards applicable at the time the institution fails to comply with the capital restoration plan. In addition, undercapitalized institutions are subject to increased monitoring and restrictions on capital distributions, asset growth and acquisitions, branching, and new activities. Significantly undercapitalized institutions (or undercapitalized institutions that fail to submit a capital plan) are subject to a number of additional measures including restrictions on deposit interest rates, forced sale of stock or merger, changes in management, forced divestitures of affiliates or subsidiaries by the institution or its holding company, and restrictions on compensation. The relevant capital measures for the categories of well-capitalized, adequately capitalized, undercapitalized, and significantly undercapitalized, are defined to be the ratio of total capital to risk-weighted assets (i.e., the OTS risk-based capital requirement), the ratio of core capital to risk-weighted assets (i.e., the OTS Tier I risk-based capital requirement), and the ratio of core capital to adjusted total assets (i.e., the OTS core or leverage capital requirement). Under the rules, an institution will be deemed to be well capitalized if the institution has a total risk-based capital ratio of 10% or greater, a core capital to risk-weighted assets capital ratio of 6% or greater and a ratio of core capital to adjusted total assets of 5% or greater and the institution is not subject to any order, written agreement or prompt corrective action directive. An institution is deemed to be adequately capitalized if it has total risk-based capital of 8% or greater, core capital to risk-weighted assets capital ratio of 4% or greater and a ratio of core capital to total assets of 4% or greater (unless it has a composite one MACRO rating). An institution is deemed to be undercapitalized if it fails to meet any of the relevant capital measures to be considered adequately capitalized, and significantly undercapitalized if it has a total risk-based capital ratio of less than 6% or a core capital to risk-weighted assets capital ratio of less than 3% or a leverage ratio of less than 3%. An institution with a ratio of tangible equity to total assets of 2% or less is deemed to be critically undercapitalized. FDICIA and the prompt corrective action rule require, with very limited exception, that an insured depository institution that is critically undercapitalized be placed in conservatorship within 90 days unless the OTS and the FDIC concur that other action would better achieve the purpose of the regulation. Such determination to defer placing an institution in receivership must be reissued every 90 days up to 270 days after the institution becomes "undercapitalized" and must document the reasons the OTS and FDIC believe action other than conservatorship would be more appropriate. In addition to establishing a system of prompt corrective action based on the capital level of an institution, the prompt corrective action rule also permits the OTS to reclassify a well-capitalized institution as an adequately capitalized institution or to require an adequately capitalized institution to comply with supervisory provisions as if the institution were in the next lower category based on supervisory information other than capital levels of the institution. The rules provide that an institution may be reclassified if the appropriate federal banking agency determines it is in an unsafe and unsound condition or engages in an unsafe or unsound practice. An institution may be deemed to be in an unsafe and unsound condition if (1) the institution receives a less than satisfactory rating in its most recent examination report and (2) the institution has not corrected the deficiency. The rule provides procedures for notice and a hearing in connection with a reclassification based on supervisory information about the institution. Based on the Association's capital position at December 31, 1993, Northeast Savings is an adequately capitalized institution and will not be subject to any of the restrictions imposed by the prompt corrective action rule on institutions that are less than adequately capitalized. However, should the Association receive a less than satisfactory rating for asset quality, earnings, liquidity, or management in a regulatory examination, the OTS could impose restrictions upon Northeast Savings as if it were a less than adequately capitalized institution until such time as the less than satisfactory rating is corrected. Limitation on Capital Distributions. The ability of the Company to pay dividends for the foreseeable future is restricted by its receipt of dividends from the Association and by regulatory and financial limitations on the Association's payment of dividends. The prompt corrective action regulation provides that a financial institution may not make a capital distribution if the institution would be undercapitalized after making the capital distribution. Also, the Company and the OTS entered into a Dividend Limitation Agreement as a part of the holding company approval process which prohibited the payment of dividends to the holding company without prior written OTS approval if the Association's capital is below its fully phased-in capital requirement or if the payment of such dividends would cause its capital to fall below its fully phased-in capital requirement. The OTS Capital Distribution Regulation differentiates among savings institutions primarily by their capital levels. Associations which meet their fully phased-in capital requirements are considered Tier 1 associations and require only normal OTS supervision. A Tier 1 association may make capital distributions during a calendar year up to the higher of: (1) 100% of its net income to date during the calendar year plus the amount that would reduce by one-half its surplus capital ratio of the beginning of the calendar year; or (2) 75% of its net income over the most recent four- quarter period. A Tier 1 association would not be permitted to make capital distributions in excess of the foregoing limit without prior OTS approval. Capital surplus is defined as the amount of capital over an association's fully phased-in capital requirement. Tier 2 institutions meet current capital requirements and are authorized to make some capital distributions without prior permission. The amount of such capital distribution is limited to between 25% and 75% of current earnings, depending on how close the institution is to meeting its fully phased-in capital requirement. Tier 3 institutions do not meet their current capital requirements and are prohibited from making any capital distributions without OTS permission except where such distribution is consistent with an approved capital plan. The Association meets its fully phased-in regulatory capital requirements and is a Tier 1 association. A savings association permitted to make a capital distribution under the prompt corrective action regulations may do so if the amount and type of distribution would be permitted under the Capital Distribution Regulation. New Safety and Soundness Standards. FDICIA also requires the federal banking agencies to prescribe by regulation certain safety and soundness standards for insured depository institutions and depository institution holding companies. Three types of standards must be prescribed: (1) operational and managerial; (2) asset quality and earnings; and (3) compensation. On November 18, 1993, the federal banking agencies published proposed safety and soundness standards to implement this provision of FDICIA. The proposed operational and managerial standards relate to: (1) internal controls, information systems, and internal audit systems; (2) loan documentation; (3) credit underwriting; (4) interest rate exposure; (5) asset growth; (6) compensation, fees, and benefits. In addition, the proposed standards would establish a maximum ratio of classified assets to total capital of 1.0. The federal banking agencies have also proposed minimum earnings standards which require that an institution continue to meet minimum capital standards assuming that any losses experienced over the past four quarters were to continue over the next four quarters. Finally, each federal banking agency is required to prescribe standards for the employment contracts and other compensation of executive officers, employees, directors, and principal stockholders of insured institutions that would prohibit compensation and benefit arrangements that are excessive or that could lead to material financial loss for the institution. If an insured depository institution or its holding company fails to meet any of the standards described above, it would be required to submit a plan describing the steps the institution will take to correct the deficiency. If an institution fails to submit or to implement an acceptable plan, the appropriate federal banking agency may impose restrictions on the institution's holding company including any of the restrictions applicable under the prompt corrective action provision of FDICIA. Liquidity Requirements. OTS regulations require savings associations to maintain for each calendar month an average daily balance of liquid assets (including cash and certain time deposits, bankers' acceptances, specified corporate obligations and specified United States government, state, and federal agency obligations) of not less than five percent of the average daily balance of its net withdrawable deposit accounts (the amount of all deposit accounts less the unpaid balance of all loans made on the security of such accounts) and borrowings payable on demand or in one year or less. OTS regulations also require each savings association to maintain for each calendar month an average daily balance of short-term liquid assets (generally those having maturities of twelve months or less) at an amount not less than one percent of the average daily balance of its net withdrawable accounts plus such short-term debt during the preceding calendar month. The OTS may impose monetary penalties for failure to meet the liquidity requirement. The average liquidity and average short-term liquidity ratios of Northeast Savings for the year ended December 31, 1993, were 5.67% and 2.34%, respectively, which exceeded the applicable requirements. Interstate Branching Regulation. Under OTS regulations, federal savings associations are authorized to branch interstate to the full extent permitted by federal statute. An institution which makes application to branch interstate would be required to meet or exceed applicable minimum capital standards, demonstrate compliance with and commitment to the requirements of the Community Reinvestment Act and to comply with the remaining statutory limitations on branching. Grandfathered Savings Bank Authority. Northeast Savings' predecessor, The Schenectady Savings Bank was a New York state-chartered savings bank with investment powers conferred by New York law. The Garn-St Germain Depository Institutions Act of 1982 and the implementing regulations empower savings and loan associations such as Northeast Savings to exercise all the powers that the predecessor state-chartered savings bank possessed under state law, whether or not such powers had been exercised. These powers are in addition to the powers the Association possesses as a federally-chartered savings and loan association. These powers allow Northeast Savings to pursue diversified acquisition opportunities and provide the Association with flexibility in structuring its investment portfolio. These powers are, however, subject to limitation by both the OTS and the FDIC. Pursuant to authority granted to it by FIRREA, the FDIC may determine, by regulation or by order, that an association may not engage in any specific activity that poses a serious risk to the SAIF. Qualified Thrift Lender. The Qualified Thrift Lender (QTL) test generally requires savings associations to concentrate a significant majority of their assets in housing-related investments. Under the QTL test, qualified thrift investments must equal 65% of portfolio assets on a monthly basis; a qualified thrift lender must meet the 65% test in nine out of every twelve months. Portfolio assets are defined as total assets minus supervisory goodwill and other intangible assets, premises and equipment, and certain liquid assets up to 20% of assets. The Association is in compliance with the QTL test. As of December 31, 1993, 92.3% of the Association's portfolio assets under the OTS QTL definition consisted of qualified thrift assets. An institution that fails the QTL test is subject to severe restrictions on its activities and a holding company of such an institution would also be subject to restrictions on its activities. Penalties for failure to meet the QTL test may result in: (1) required conversion of the savings association's charter to a bank charter; (2) limitation on new investments and activities to those permissible for national banks; (3) branching restrictions similar to those imposed on national banks; (4) prohibitions on obtaining new advances from the savings association's Federal Home Loan Bank; and (5) dividend restrictions. Non QTL institutions may obtain FHLB advances only to fund housing finance and only if they meet certain minimum FHLB stock purchase requirements. Federal Home Loan Banks may not allocate more than 30% of advances to non QTL institutions and must allocate scarce credit to QTL institutions first. Classification of Assets. Insured institutions are required to classify their own assets on a regular basis and establish prudent valuation allowances in accordance with generally accepted accounting principles (GAAP). The classification of assets system provides that certain assets which pose credit deficiencies or potential or well defined weaknesses be classified as assets deserving Special Mention, Substandard, Doubtful, or Loss. Please refer to the earlier section, "Allowance for Loan Losses," for a description of these classifications. As part of its regulatory oversight, the OTS requires each savings institution to reflect its self-classification of assets in aggregate totals in its quarterly reports to the OTS. In addition, the asset classification regulation requires OTS examiners to consider the institution's system of internal controls employed in classifying its assets, and to examine both the assets classified and the allowances for loan losses established by the institution pursuant to the self-classification procedure. The OTS has the authority to approve, disapprove, or modify any asset classification and any amounts established as allowances for loan losses. Allowance for Loan and Lease Losses. On December 21, 1993, the OCC, the FDIC, the Federal Reserve Board and the OTS (the agencies) issued an interagency policy statement on the allowance for loan and lease losses (ALLL). The policy statement provides guidance for financial institutions on the responsibilities of management for the assessment and establishment of adequate allowances for loan and lease losses and also provides guidance for the banking agencies' examiners to use in determining the adequacy of general valuation allowances. Generally, the policy statement requires that institutions have effective systems and controls to identify, monitor and address asset quality problems; have analyzed all significant factors that affect the collectibility of the portfolio in a reasonable manner; and have established acceptable allowance evaluation processes that meet the objectives set forth in the policy statement. Loans-to-One Borrower Limitation. With certain limited exceptions, the statutory provision limiting the ability of national banks to make loans to a single borrower is applicable to savings associations in the same manner and to the same extent as it applies to national banks. A savings association may make loans to one borrower equal to 15% of the savings association's unimpaired capital and unimpaired surplus, plus an additional 10% of capital for loans secured by readily marketable collateral. Real estate is not considered readily marketable collateral. The OTS may impose more stringent requirements on a savings association to protect its safety and soundness. At December 31, 1993, the maximum amount that Northeast Savings could loan to one borrower and the borrower's related entities was $29.7 million. At December 31, 1993, the largest aggregate amount of loans that Northeast Savings had committed and/or outstanding to one borrower and its related entities was $6.6 million. Hence, Northeast Savings is in compliance with this limitation. Loan-to-Value Requirements. On December 31, 1992, the federal banking agencies, including the OTS, issued final rules establishing loan-to-value (LTV) ratio limits on real estate lending by insured depository institutions. As mandated by FDICIA, these rules became effective March 19, 1993. Real estate loans originated after that date which are in excess of the supervisory LTV limits for the particular loan type must be identified in the institution's records and their aggregate amount must be reported to the Board of Directors at least quarterly. In addition, the aggregate amount of loans in excess of the supervisory LTV limits may not exceed 100% of total capital. Within the aggregate limit, total loans for commercial multifamily or other non one-to- four family residential properties may not exceed 30% of total capital. The rule excludes from the supervisory LTV limits permanent mortgages on owner- occupied one-to-four family residential properties provided that residential mortgage loans originated with an LTV in excess of 90% have mortgage insurance coverage for the amount of the loan in excess of 80% LTV ratio. The rule also excludes from the LTV limits loans guaranteed by the federal government or a state government, loans to facilitate the sale of real estate owned, and loans that are refinanced without an advancement of new funds. The Association has reviewed its lending policies and practices for uniformity with the new LTV limits. The impact of the real estate lending standards on the Association has been minimal. Real Estate Appraisal Regulations. The OTS and other federal banking agencies adopted regulations in 1990 to implement Title XI of FIRREA. These regulations are applicable to all federally related transactions defined as any real estate related transaction entered into by a federally regulated institution which requires an appraiser. The regulations identify which real estate related transactions require an appraiser, set forth minimum standards for performing appraisals, and distinguishes those transactions requiring the services of a state-certified appraiser from those requiring the services of a state-licensed appraiser. Certain real estate-related transactions are exempt from the requirements of the regulations including real estate-related financial transactions that do not require an appraisal including loans of $100,000 or less. Consistent with the regulation, however, those transactions that do not receive an appraisal must receive an evaluation of the real estate collateral that reflects present lending practices and OTS policies and guidelines. Like appraisals, evaluations are used to validate real estate values and to determine an appropriate carrying value and probable sales price for foreclosed properties. An appraisal contains certain formal elements recognized by industry practices and must conform to generally accepted appraisal practices endorsed by the Uniform Standards of Professional Appraisal Practice, developed by the Appraisal Standards Board of the Appraisal Foundation. An appraisal estimates a property's value under three approaches (the cost, income, and comparable sales approaches) and reconciles the values of every approach. An appraisal typically contains a description of the property, a disclosure of sales history, and an opinion as to the highest and best use of the property. The appraiser certifies the appraisal as to content, independence, property inspection, compensation, and opinions. An evaluation, by contrast, need not meet all of the detailed requirements of an appraisal. File documentation, however, should support the estimate of value and include sufficient information for an individual to understand the evaluation conclusion. Management, including the Board of Directors, is responsible for developing written appraisal policies to ensure that adequate appraisals and evaluations are obtained consistent with OTS regulation and to institute procedures pertaining to the hiring of qualified appraisers. At a minimum, such policies should: (1) incorporate prudent standards and procedures for obtaining initial and subsequent appraisals and evaluations; (2) be appropriate to the size of the institution and nature of its real estate related activities; (3) establish a method to monitor the value of real estate collateral securing an institution's real estate loans; and (4) establish the manner in which an institution selects, monitors, and renews annually individuals who perform or review real estate appraisals or evaluations. The Association's appraisal policy has been prepared in accordance with the OTS appraisal regulations and imposes more stringent requirements for appraisals than are included in the regulation. Growth Restrictions. The liability growth regulation, which was promulgated prior to FIRREA but remains in effect until amended or rescinded by the OTS, requires a savings institution, unless exempted by the regulation, to obtain the prior approval of its District Director to increase its total liabilities within any two-quarter period at a rate greater than 12.5%. A savings institution is exempted from the foregoing requirement (as defined prior to FIRREA) if it has regulatory capital equal to the greater of (1) its fully phased-in capital requirement or (2) 6% of total liabilities. If exempted from the prior approval requirement, an institution is required to notify its District Director of its intention to grow in excess of 12.5% within any two- quarter period. In addition, under OTS Regulatory Bulletin 3a-1, "Policy Statement on Growth for Savings Associations," the District Director has the authority to impose restrictions on asset growth for associations which have received a rating of 4 or 5 under the OTS MACRO system or which fail to meet any one of their minimum regulatory capital requirements. Such associations may not increase their total assets during any quarter in excess of an amount equal to net interest credited or deposits during the quarter. On a case-by-case basis, where appropriate, District Directors retain the authority to impose more stringent growth restrictions on associations that are required to submit a capital plan or that are otherwise of supervisory concern. The OTS has verbally informed Northeast Savings that, inasmuch as Northeast Savings had recently achieved compliance with its fully phased-in capital standards, under OTS Regulatory Bulletin 3a-1, Northeast Savings may not grow its assets if such growth would cause it to fall below its fully phased-in capital requirements, even if the Company continued to exceed the applicable minimum capital standards previously established for the duration of the FIRREA phase-in period. Brokered Deposits. Brokered deposits include any funds that are obtained directly or indirectly, by or through any deposit broker for deposit into one or more deposit accounts. FDICIA imposes certain restrictions on the acceptance of brokered deposits by savings associations. The FDIC has issued regulations implementing these restrictions. Under those regulations, "well-capitalized" institutions may accept brokered deposits without restriction, "adequately capitalized" institutions may accept brokered deposits with a waiver from the FDIC, while "undercapitalized" institutions may not accept any brokered deposits. These capital categories are defined earlier under "Prompt Corrective Action." Even with the waiver, however, an adequately capitalized institution is prohibited from paying above market rates on any deposits. These regulations became effective June 16, 1992. Under the regulations, Northeast Savings is considered an adequately capitalized institution and has applied for and received a waiver from the FDIC. In accordance with the waiver, the Association may accept up to $300.0 million in brokered deposits. Other Restrictions. Other restrictions under FIRREA limit the permissible amount of income property loans that a federal association may make to 400% of an association's capital. Under FIRREA, federal regulations also limit the amount of commercial, corporate, or business loans a federal savings association may make to 10% of assets. Effective upon its enactment, the FDICIA increased the overall percentage of assets limit for consumer loans and high grade corporate debt from 30% to 35%. Annual Independent Audits and Reporting Requirements. On June 2, 1993, the FDIC published final regulations and related guidelines implementing the management reporting, audit committee, and independent audit requirements of Section 112 of FDICIA. Under the final regulations and guidelines, all insured depository institutions with total assets at or above $500 million at the beginning of the fiscal year after December 31, 1992 must file an annual report with the FDIC, and the OTS as in the case of a federally chartered savings association such as Northeast Savings. The annual report would include financial statements prepared in accordance with generally accepted accounting principles that are audited by the institution's independent accountant. The report would also include a statement of management's responsibilities for establishing and maintaining an adequate internal control structure and procedures for financial reporting and for complying with laws and regulations relating to safety and soundness, including capital distribution restrictions and loans to insiders. In addition, insured depository institutions with total assets at or above $500 million are required to establish an independent audit committee comprised of outside directors. Further, at least two audit committee members of institutions with total assets at or above $3 billion must have banking or related financial management expertise, and its audit committee must have access to outside counsel. The Association has surveyed the members of the audit committee and determined that all members are qualified under the rule. Community Reinvestment Act. The CRA is intended to encourage financial institutions to help meet the credit needs of their entire communities, including low and moderate income areas, consistent with safe and sound operations. CRA regulations provide for three disclosure obligations. First, each institution must prepare and make available a CRA Statement for each of its local communities that includes a delineation of the community served and a list of specified types of credit offered to the community. Second, each lending institution must maintain a public comment file for public inspection that includes written comments from the public on its CRA Statement or its performance in meeting community credit needs. Third, public disclosure of written CRA evaluations of financial institutions made by regulatory agencies is required under the CRA to promote enforcement of CRA requirements by providing the public with the status of a particular institution's community reinvestment record. The regulatory agencies are required to include, in the written evaluation, an institution's record of meeting the credit needs of its local community including low and moderate income neighborhoods. Each written evaluation required under CRA is required to have a public and confidential section addressing the association's CRA performance. In connection with the CRA examination, the federal banking agencies are required to assess each institution's record of helping to meet the credit needs of its entire community. The Association received a satisfactory rating in its written evaluation as a result of its last CRA examination performed in September 1992. Evaluations under the Community Reinvestment Act are taken into account in determining whether to grant branch and merger applications as well as other regulatory applications. Transactions with Related Parties. The Association's authority to engage in transactions with related parties or "affiliates" (i.e., any company that controls, is controlled by, or is under common control with the Association, including the Company and its non-savings institution subsidiaries), or to make loans to certain insiders, is limited by Sections 23A and 23B of the Federal Reserve Act (FRA). Section 23A limits the aggregate amount of transactions with any individual affiliate to 10% of the capital and surplus of the savings institution and also limits the aggregate amount of transactions with all affiliates to 20% of the savings institution's capital and surplus. Certain transactions with affiliates are required to be secured by collateral in an amount and of a type described in the FRA and the purchase of low quality assets from affiliates is generally prohibited. Section 23B provides that certain transactions with affiliates, including loans and asset purchases, must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to the institution as those prevailing at the time for comparable transactions with nonaffiliated individuals or entities. In the absence of comparable transactions, such transactions may only occur under terms and circumstances, including credit standards, that in good faith would be offered to or would apply to individuals or entities. Notwithstanding Sections 23A and 23B, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies under Section 4(c) of the Bank Holding Company Act. Further, no savings institution may invest in the securities of any affiliate other than a subsidiary. In addition, Sections 22(g) and 22(h) of the FRA, which relate to limits on loans and extensions of credit to executive officers, directors, and 10% shareholders, as well as companies which such persons control, apply to savings institutions. Among other things, such loans must be made on terms, including interest rates, substantially the same as loans to unaffiliated individuals or entities. Effective November 5, 1992, the OTS amended its regulations governing extensions of credit to executive officers, directors, and principal shareholders and to the related interests of such persons. OTS regulations implementing the provisions of 22(g) and 22(h) of the FRA which govern extensions of credit to insiders, incorporate by means of crossreference the provisions of Federal Reserve Regulation O. Savings and Loan Holding Company Regulations. As a result of the reorganization into a holding company form of organization, the Company is subject to applicable OTS regulations regarding the activities of the savings and loan holding company and the savings institution. Northeast Federal Corp. is prohibited, either directly or indirectly, from acquiring control of any savings association or savings and loan holding company without prior OTS approval and from acquiring more than 5% of any voting stock of any savings association or savings and loan holding company which is not a subsidiary of Northeast Federal Corp. In addition, under the terms of the OTS approval of the Company's application to reorganize to form a holding company, the Company may not at any time, absent prior written approval by the Regional Director, engage in any activity other than activities incident to holding the stock of the Association. Federal Reserve System Requirements. The Federal Reserve Board requires savings institutions to maintain non-interest-earning reserves against certain of their transaction accounts. The regulations generally require a reserve of 3% against total transaction accounts up to $51.9 million and a reserve of 10% (subject to adjustment by the Federal Reserve Board to an amount between 8% and 14%) against transaction accounts in excess of $51.9 million. The first $4.0 million of otherwise reservable balances are exempt from the reserve requirement. As of December 31, 1993, Northeast Savings was in compliance with all reserve requirements of the Federal Reserve Board. The balances used to meet these reserve requirements imposed by the Federal Reserve Board may also be used to satisfy the Association's liquidity requirements discussed above. As a creditor and a financial institution, Northeast Savings is subject to various regulations promulgated by the Federal Reserve Board, including, but not limited to Regulation B (Equal Credit Opportunity); Regulation D (Reserve Requirements); Regulation E (Electronic Funds Transfers); Regulation Z (Truth- in-Lending); and Regulation CC (Availability of Funds); and Regulation DD (Truth-In-Savings). Additionally, as creditors of loans secured by real property, and as owners of real property, financial institutions, including Northeast Savings, may be subject to potential liability under various statutes and regulations applicable to property owners, generally including statutes and regulations relating to the environmental condition of a property. Interbank Liabilities. Effective December 19, 1992, the Federal Reserve Board prescribed standards to limit the risk posed by an insured depository institution's exposure to a correspondent institution. All insured institutions were required to have policies in place by June 19, 1993 which set limits on credit and liquidity risks in dealing with other depository institutions. The rule includes a regulatory limit for exposure to correspondents that are less than adequately capitalized. ENFORCEMENT The OTS, as primary regulator of savings associations, has primary responsibility for enforcement actions concerning savings associations and their affiliates, but the FDIC also has authority to impose enforcement actions independently after following certain procedures. The sanctions which may be imposed include cease and desist orders, civil monetary penalties, and also removal and prohibition orders against an institution's affiliated persons. FIRREA confers on the OTS oversight authority for all holding company affiliates, not just savings associations. Among other restrictions, the OTS may impose: (1) limitations on the payment of dividends by savings associations and (2) limitations on transactions between a savings association and its holding company and subsidiaries or affiliates of either. Such limitations would be issued in the form of a directive having the effect of a cease and desist order. FIRREA utilizes a three tier system for the imposition of civil money penalties. For a violation of law, regulation, written condition, or any final or temporary order, a penalty of $5,000 per day may be assessed for each violation. A maximum penalty of $25,000 per day may be assessed for an activity which evidences reckless disregard for the safety or soundness of the depository institution's fiduciary duty or is part of a pattern of misconduct; or the activity is likely to cause more than a minimal loss to the depository institution. A maximum penalty of $1,000,000 per violation for each day of violation may be assessed for knowingly and recklessly causing substantial loss to an institution or for taking actions that result in a substantial pecuniary gain to an institution- affiliated person including, in some cases, its attorneys and independent accountants. In addition, the prompt corrective action rules prescribe a number of restrictions on depository institutions and individuals. If an institution fails to meet applicable capital standards or to meet a measure for safety and soundness, federal regulators could require, among other things, (1) the filing of a capital plan; (2) the filing of the plan to correct any safety and soundness violation; (3) restrictions on interest rates; (4) restrictions on growth; (5) forced sale or merger or divestiture of the institution; (6) dismissal of directors and executive officers. Under the FDI Act, the FDIC has the authority to recommend to the Director of the OTS that enforcement actions be taken with respect to a particular savings institution. If action is not taken by the Director, the FDIC has authority to take action under certain circumstances. TAXATION For tax purposes, Northeast Federal Corp. files a consolidated tax return with its subsidiaries on a calendar year-end basis. Northeast Savings, F.A., a subsidiary of Northeast Federal Corp., conducts its business primarily in Connecticut, New York, Massachusetts, California, and Rhode Island and, accordingly, is subject to taxation in those jurisdictions. Taxes paid to such jurisdictions are deductible in determining federal taxable income. Northeast Savings has been audited by the Internal Revenue Service with respect to tax returns through 1979. Savings and loan associations are generally subject to federal income taxation in the same manner as regular corporations. However, under applicable provisions of the Internal Revenue Code, savings and loan associations that meet certain definitional and other tests are generally permitted to claim a deduction for additions to their bad debt reserves computed as a percentage of taxable income before such deduction. Alternatively, a qualifying association may elect to utilize its own bad debt loss experience to compute its additions to its bad debt reserves. At December 31, 1993, Northeast Savings' tax bad debt reserve totaled approximately $2.0 million. If in the future, earnings allocated to this bad debt reserve and deducted for federal income tax purposes are used for payment of cash dividends or other distributions to stockholders, including distributions in redemption or in dissolution or liquidation, an amount up to approximately one and three-quarters times the amount actually distributed to the stockholders will be includable in the consolidated taxable income of Northeast Federal Corp. and be subject to tax. However, such taxable income could be reduced by any net operating loss carryforwards available to Northeast Federal Corp. Earnings and profits include taxable income net of federal income taxes and adjustments for items of income which are not taxable and expenses which are not deductible. For the tax year ended December 31, 1993, Northeast Federal Corp. had current earnings and profits. Any dividends paid with respect to Northeast Savings' stock in excess of current or accumulated earnings and profits at year-end for federal tax purposes or any other stockholder distribution will be treated as made out of the tax bad debt reserves and will increase taxable income as noted in the preceding paragraph. In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." See "Results of Operations" in Item 7: Management's Discussion and Analysis of Results of Operations and Financial Condition for a discussion of the impact of SFAS 109 on the Company. ITEM 2. ITEM 2. PROPERTIES Northeast Federal Corp.'s corporate headquarters are located at 50 State House Square, Hartford, Connecticut 06103. Northeast Savings operates twelve branch banking offices in the Hartford-Springfield market, seventeen in the Albany-Schenectady and Pittsfield areas, nine in the Boston-Worcester markets, one on Cape Cod, four in the San Diego area, and six in the Providence area. Northeast Savings also operates separate residential mortgage loan origination offices in Connecticut and through the Association's subsidiary, NEMAC, INC., in Colorado. All of Northeast Savings' facilities are leased except for twelve branch offices and an office building in Farmington, Connecticut. The aggregate net book value of office buildings and leasehold improvements at December 31, 1993 was $22.1 million. Northeast Savings' office locations by state are as follows: Retail branch banking offices: Connecticut: 782 Park Avenue Bloomfield 940 Silver Lane East Hartford 1105 New Britain Avenue Elmwood 50 State House Square Hartford (Home Office) 1147 Tolland Turnpike Manchester 530 Bushy Hill Road Simsbury 29 South Main Street West Hartford 38 Wells Road Wethersfield New York: 900 Central Avenue Albany Amsterdam Mall Amsterdam 15 Park Avenue Clifton Park 98 Wolf Road Colonie 579 Troy-Schenectady Road Colonie 501 Columbia Turnpike East Greenbush Route 9W Glenmont 14 La Rose Street Glens Falls 200 Saratoga Road Glenville 475 Albany Shaker Road Loudonville 211 Park Avenue Mechanicville 420 Balltown Road Niskayuna 189 Ballston Avenue Saratoga Springs 500 State Street Schenectady 2525 Broadway Schenectady 13 Maple Road Voorheesville Massachusetts: 56 Auburn Street Auburn 50 Franklin Street Boston 160 Reservoir Street Holden 31 Austin Street Newtonville 609 Merrill Road Pittsfield 101 Memorial Parkway Randolph 110 Boston Turnpike Shrewsbury 1029 Route 28 South Yarmouth 1724 Boston Road Springfield 1243 Main Street Springfield 560 Sumner Avenue Springfield 87-95 Sharon Street Stoughton 75 Main Street Watertown 453 East Main Street Westfield 22 Elm Street Worcester California: 2570-B El Camino Real Carlsbad 353 Felicita Road Escondido 4250 Executive Square La Jolla 9025 Mira Mesa Boulevard Mira Mesa Rhode Island: 1047 Park Avenue Cranston 383 Atwood Avenue Cranston 999 South Broadway East Providence 1926 Smith Street North Providence 3 Crescent View Avenue Riverside 1062 Centreville Road Warwick Mortgage origination offices: Connecticut: 1111 East Putnam Avenue Greenwich Colorado (through a subsidiary of the Association, NEMAC, INC.): 101 University Boulevard Denver ITEM 3. ITEM 3. LEGAL PROCEEDINGS On December 6, 1989, Northeast Savings filed a complaint in the United States District Court for the District of Columbia against the FDIC and the OTS, as successor regulatory agencies to the FSLIC and the FHLBB. It was the position of the Association in the litigation that the denial by the OTS and the FDIC of core capital treatment of the adjustable rate preferred stock and the elimination from capital, subject to limited inclusion during a phaseout period, of supervisory goodwill constitutes a breach of contract, as well as a taking of the Association's property without just compensation or due process of law in violation of the Fifth Amendment to the United States Constitution. The Association sought a determination by the court to this effect and to enjoin the defendants and their officers, agents, employees and attorneys, and those persons in active concert or participation with them, from enforcing the provisions of FIRREA and the OTS regulations or from taking other actions that are inconsistent with their contractual obligations to Northeast Savings. The suit sought an injunction requiring the OTS and FDIC to abide by their contractual agreements to recognize as regulatory capital the supervisory goodwill booked by Northeast Savings as a result of its 1982 acquisition from the FSLIC of three insolvent thrifts. On July 16, 1991, the district court ruled that it lacked jurisdiction over the action but that Northeast Savings could bring a damages action against the government in the United States Claims Court. On July 8, 1992, the Association moved to voluntarily dismiss its appeal of the district court decision dismissing its action seeking injunctive relief. This motion was made with a view toward refiling the Association's lawsuit against the government in the United States Claims Court, so as to seek damages against the United States rather than injunctive relief against the OTS and FDIC. This motion was made for two reasons. First, by virtue of the Association's greatly improved financial and regulatory capital condition, including its compliance with all fully phased-in capital requirements, and its tangible capital position exceeding four percent, the Association determined that it was no longer in need of injunctive relief. Rather, the Association determined that it was now in its best interest to pursue a damages claim against the United States in the Claims Court. Second, the Association sought to dismiss its appeal and refile in the Claims Court because of the adverse decision of the Court of Appeals for the D.C. Circuit in another "supervisory goodwill" case, TransOhio Savings Bank, et al. v. Director, OTS, et al. 967 F.2d 598 (June 12, 1992). Neither the OTS nor the FDIC opposed the Association's motion. The D.C. Circuit granted the Association's motion to voluntarily dismiss its appeal on July 9, 1992. On August 12, 1992, Northeast Savings refiled its action in the United States Claims Court, Northeast Savings, F.A. v. United States, No. 92-550c. Note that, effective October 29, 1992, the United States Claims Court was renamed the United States Court of Federal Claims. Northeast Savings' complaint seeks monetary relief against the United States on theories of breach of contract, taking of property without just compensation, and deprivation of property without due process of law. The United States has not yet filed an answer to the Complaint. On May 25, 1993, a three-judge panel of the Federal Circuit Court of Appeals ruled against the plaintiffs in three other consolidated "supervisory goodwill" cases, holding that the thrift institutions had not obtained an "unmistakable" promise from the government that it would not change the law in such a manner as to abrogate its contractual obligations and that the plaintiffs therefore bore the risk of such a change in the law. Winstar Corp. v. United States, No. 92-5164. On August 18, 1993, however, the full Federal Circuit, acting in response to a Petition for Rehearing with Suggestion for Rehearing In Banc filed by two of the three plaintiffs in these cases, vacated the May 25 panel decision, ordered the panel opinion withdrawn, and ordered that the case be reheard by the full Court. Oral argument in the Winstar case was held on February 10, 1994. On June 3, 1993, the Court of Federal Claims entered an order staying proceedings in Northeast Savings' case pending further action by the Federal Circuit in the Winstar case or any action taken by the Supreme Court on any petition for a writ of certiorari in that case. In connection with the formation of Northeast Federal Corp. as the holding company of the Association, the Association sought the consent of the FDIC to exchange the Adjustable Rate Preferred Stock, Series A, of the Association, then owned by the FDIC as administrator of the FSLIC Resolution Fund, for Adjustable Rate Preferred Stock, Series A of Northeast Federal Corp. As a condition to its consent of the exchange of the adjustable rate preferred stock, the FDIC required Northeast Savings to agree not to seek monetary damages or any other form of monetary relief from the FDIC arising out of or relating to the claims asserted in the complaint for declaratory judgment and injunctive relief filed against the FDIC and the OTS and to moot certain issues related to the adjustable rate preferred stock. The release of the FDIC, however, does not restrict Northeast Savings' ability to pursue its claim for injunctive relief in the action or to seek any other equitable remedy in connection with the claims asserted in the litigation, provided that such remedy would not involve the payment of money by the FDIC. Further, the execution of the release did not alter or otherwise affect the positions that the parties to the litigation have taken or may take. Issues related to the adjustable rate preferred stock issued by Northeast Savings to the FSLIC Resolution Fund are mooted, as provided in a Mootness Agreement executed concurrently with the release. The release is exclusive to the FDIC and is not extended to any other governmental agency, including but not limited to the OTS. The execution of the release does not prejudice any new claims that may arise with respect to the FDIC or the OTS regarding the capital treatment of Northeast Savings' equity. Finally, the release is null and void in the event that the OTS refuses to permit Northeast Federal Corp.'s Adjustable Rate Preferred Stock, Series A, to be treated as core capital by Northeast Savings. As discussed previously, in conjunction with the acquisition of four Rhode Island financial institutions, on May 8, 1992, the Company repurchased all of the adjustable rate preferred stock from the FSLIC Resolution Fund, administered by the FDIC. Nothing in the agreement to repurchase the adjustable rate preferred stock alters, impairs, or otherwise affects the validity or enforceability of the Mootness Agreement or the Release and the parties have agreed that the Mootness Agreement and the Release remain in full force and effect. The Association is also involved in litigation arising in the normal course of business. Although the legal responsibility and financial impact with respect to such litigation cannot presently be ascertained, the Association does not anticipate that any of these matters will result in the payment by the Association of damages that, in the aggregate, would be material in relation to the consolidated financial position or operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. SUPPLEMENTARY ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT At December 31, 1993, the following persons were executive officers of the Company as defined by Rule 405 of Regulation C of the Securities and Exchange Commission. Effective January 1, 1994, Kirk W. Walters assumed the positions of Chief Executive Officer of the Company and the Association from George P. Rutland. GEORGE P. RUTLAND, Director, Chairman of the Board and Chief Executive Officer KIRK W. WALTERS, Director, President, Chief Operating Officer, and Chief Financial Officer LYNNE M. CARCIA, Senior Vice President, Controller and Principal Accounting Officer of the Company and the Association JOANN DOLAN, Executive Vice President--Loan Administration and Operations of the Association TAMI W. KASCHULUK, Executive Vice President and Chief Appraiser of the Association DANIEL J. STEINMETZ, Executive Vice President--Commercial Lending of the Association VICTOR VRIGIAN, Executive Vice President--Marketing and Retail Banking of the Association The following information concerns the executive officers of the Company: GEORGE P. RUTLAND (age 61), was elected to the positions of Chairman of the Board, President, and Chief Executive Officer of the Company in April 1990 in connection with the holding company reorganization. He joined Northeast Savings as Chairman, President, and Chief Executive Officer in July 1988. He held the positions of President of both Northeast Federal Corp. and Northeast Savings until Mr. Walters was elected to those positions in September 1991. He held the position of Chief Executive Officer until Mr. Walters was elected to that position in November 1993, effective January 1, 1994. Mr. Rutland was President and Chief Executive Officer of Calfed, Inc. in California from 1985 to May 1988. Prior to that, he had served as President and Chief Operating Officer at Calfed, and before that as Executive Vice President. He joined Calfed, Inc. in 1982 from Crocker Bank, where he had served as Senior Executive Vice President. He entered the financial services industry in 1954 at Citibank, where he held a variety of positions, including Executive Vice President of their Advance Mortgage Company and Senior Vice President of Corporate Services. KIRK W. WALTERS (age 38), was elected Chief Executive Officer in November 1993, effective January 1, 1994 and President and Chief Operating Officer of the Company in September 1991. In connection with the holding company reorganization in April 1990, he was elected Senior Executive Vice President and Chief Financial Officer of the Company. He joined Northeast Savings in April 1989 as Executive Vice President and Controller. He was elected Senior Executive Vice President and Chief Financial Officer of Northeast Savings in September 1989, and was elected to the position of President and Chief Operating Officer of Northeast Savings in September 1991 and Chief Executive Officer of Northeast Savings in November 1993, effective January 1, 1994. He joined Northeast Savings from California Federal Bank, a subsidiary of Calfed, Inc., where he was Senior Vice President and Controller. Prior to that, he worked for Atlantic Richfield Company (ARCO) and prior to that, he served on the audit staff of Coopers & Lybrand. He was elected to the Board of Directors in 1990. LYNNE M. CARCIA (age 31), was elected Senior Vice President, Controller and Principal Accounting Officer of the Company and the Association in April 1993. She was formerly Senior Vice President and Controller and Vice President--Loan Accounting, of the Association. She joined the Association in 1989. Previously, she was an audit manager with Ernst & Young. JOANN DOLAN (age 42) was elected Executive Vice President--Loan Administration and Operations of the Association in May 1993. She joined the Association in 1987 as Vice President of Planning Administration and was elected to the position of Senior Vice President of Consumer Lending in October of 1989. She was elected to the position of Executive Vice President, Consumer Lending and Loan Administration in March of 1990. TAMI W. KASCHULUK (age 36) was elected Executive Vice President & Chief Appraiser for the Association in December 1992. Formerly, she was Senior Vice President and Chief Appraiser of the Association. Prior to joining the Association in April 1989, she was manager of the Appraisal Division at Cushman and Wakefield. DANIEL J. STEINMETZ (age 41) was elected Executive Vice President-- Commercial Lending of the Association in December 1993. He formerly served as Senior Vice President of Commercial Lending. He joined the Association in November 1988. Prior to that time, he was Vice President and Regional Manager at Bank of Boston, Connecticut. VICTOR VRIGIAN (age 37) was elected Executive Vice President--Marketing and Retail Banking of the Association in April 1993. He served as Vice President of Deposit Products from February of 1987 through June of 1990, at which time he was elected Senior Vice President of Marketing. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Northeast Federal Corp.'s common stock is traded on the New York Stock Exchange under the symbol NSB. Information concerning the prices paid per common share of Northeast Federal Corp.'s common stock appears in Note 25 of the Notes to the Consolidated Financial Statements. On February 4, 1994, 13,507,945 shares of Northeast Federal Corp.'s common stock were issued and outstanding and held by approximately 5,100 holders of record. See item 6: ITEM 6. SELECTED FINANCIAL DATA - -------- * Antidilutive (1) Per share amounts have been restated to give effect to the two 2% stock dividends declared in fiscal 1990. (2) For comparative purposes, ratios for the nine months ended December 31, 1992 have been annualized to reflect twelve months of activity. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION OVERVIEW Northeast Federal Corp. reported a net loss of $14.1 million for 1993. The year was a difficult one for the Company as the continuing recessions in New England and California increased credit costs through higher loan loss provisions and higher REO operations expenses while low interest rates reduced the Company's net interest margin. Higher credit costs and a lower net interest margin resulted in the substantial operating loss for the year. The economies of Connecticut, Massachusetts, and New York, which began to contract in early 1989, continued to contract throughout 1993. California entered its recession later, in 1990, and its economy also continued to contract throughout 1993. As a consequence, the Company's provision for loan losses totaled $23.3 million in 1993 compared to $16.3 million for the nine months ended December 31, 1992 and $10.2 million for the twelve months ended March 31, 1992. REO operations expenses totalled $17.6 million for the twelve months ended December 31, 1993 compared to $9.7 million for the nine months ended December 31, 1992 and $5.7 million for the twelve months ended March 31, 1992. Interest rates reached their lowest level in thirty years in 1993, prompting many borrowers to refinance their loans and leading to exceptionally high prepayments of existing mortgage loans. At the same time, the Company's portfolio of adjustable rate mortgage loans was repricing to lower rates. As a consequence, the Company's interest rate spread was 1.97% for 1993 compared to 2.38% for the nine months ended December 31, 1992 and 2.21% for the twelve months ended March 31, 1992. Despite the continuing recessions, however, asset quality improved throughout 1993 as delinquencies and non-performing assets both decreased throughout the year. Total non-performing assets were 3.63% of total assets at December 31, 1993, compared to 4.97% at December 31, 1992, and 4.54% at March 31, 1992. In August, the Company accelerated the reduction in non-performing assets by selling $30.3 million of REO in a single transaction. The Company recorded a $6.0 million provision for loss during the quarter ended June 30, 1993 in anticipation of the sale. That provision and an adjustment of $777,000 are included in REO operations expense for 1993. Total REO at December 31, 1993 was $75.0 million compared to $99.4 million at December 31, 1992 and $61.2 million at March 31, 1992. Non-accrual loans were $67.5 million at December 31, 1993 compared to $95.0 million at December 31, 1992 and $112.1 million at March 31, 1992. The Company also took significant steps during 1993 to reduce its concentration of loans in California. The Company securitized approximately $350 million of California mortgage loans in 1993, effectively eliminating the credit risk on those loans while retaining the loans in portfolio in securitized form. The Company changed its capital structure in May of 1993. On May 7, 1993, at a Special Meeting of Stockholders, the Company's stockholders approved a reclassification of the Company's $2.25 Cumulative Convertible Preferred Stock, Series A into common stock at the ratio of 4.75 shares of common stock for each share of convertible preferred stock. Effective May 14, 1993, the 1,610,000 outstanding shares of convertible preferred stock were converted into an aggregate of 7,647,500 shares of common stock. At such time, in the aggregate, $12.2 million of accumulated and unpaid dividends on the convertible preferred stock were eliminated. Although the reclassification did not change the regulatory capital of the Association, it eliminated a possible future need for the Company to seek dividends from the Association for the purpose of paying dividends on the convertible preferred stock. The results of operations for 1993 and changes in the Company's financial condition in 1993 are discussed in more detail in the sections that follow. On February 9, 1994, Shawmut National Corporation and the Company signed a definitive agreement for the acquisition by Shawmut of ten Northeast Savings branches located in Eastern Massachusetts and in Rhode Island. Five of the branches to be purchased are in Massachusetts and five are in Rhode Island. Deposits held in these branches totaled approximately $427 million as of December 31, 1993. Shawmut will pay a premium of three percent to Northeast Savings for deposits on hand in these branches at the time of closing. The transaction is expected to close by the end of the second quarter, and is subject to regulatory approval. The sale will permit Northeast Savings to focus its resources on its four significant deposit markets: the capital region of New York State; Hartford, Connecticut; and Springfield and Worcester, Massachusetts. The sale of the branches will also strengthen the Company's financial position and enhance its profitability. When the transaction is finalized, Northeast Savings will operate thirty-eight branches, thirty-two of which are in those markets. At the July 24, 1992 meetings of the Boards of Directors of Northeast Federal Corp. and Northeast Savings, the Boards voted to change the fiscal year end of the Company and the Association from March 31 to December 31. In general, the discussions which follow compare the year ended December 31, 1993 to the nine months ended December 31, 1992 and to the year ended March 31, 1992. Also, for certain areas of income and expense, comparisons are made between the fiscal year ended December 31, 1993, the twelve month period ended December 31, 1992 (unaudited), and the fiscal year ended March 31, 1992. A further comparison which presents the unaudited statement of operations for the nine months ended December 31, 1993 compared to statements of operations for the same nine months in 1992 (audited) and 1991 (unaudited) may be found in Note 2 to the Consolidated Financial Statements: Change in Fiscal Year. RESULTS OF OPERATIONS Northeast Federal Corp. and consolidated subsidiaries reported a net loss of $14.1 million for the year ended December 31, 1993 and a primary and fully diluted net loss per common share of $1.75 after preferred stock dividend requirements. For the nine months ended December 31, 1992, the Company reported a net loss of $59.2 million and a primary and fully diluted net loss per common share of $11.16 after preferred stock dividend requirements, which compared to net income of $5.6 million and a primary and fully diluted net loss per common share of $.51 after preferred stock dividend requirements for the year ended March 31, 1992. The net loss of $59.2 million for the nine months ended December 31, 1992 was substantially due to the Company's $56.6 million reduction in the value of its supervisory goodwill. For the periods ended December 31, 1993 and 1992 other factors contributing to the losses include decreases in average earning assets, and substantially higher expenses on real estate and other assets acquired in settlement of loans. The loss for the nine- month period ended December 31, 1992 was also affected by decreased mortgage servicing fees attributable to a high level of prepayments and proportionately higher general and administrative expenses due principally to a twelve branch increase in the Association's branching network between March 20, 1992 and December 31, 1992. Interest Income and Expense Northeast Savings' principal source of earnings is its net interest income. Net interest income depends primarily upon the difference, or interest rate spread, between the combined weighted average yield the Association earns from its net loans, mortgage-backed securities, and investment portfolio (together, the interest-earning assets) and the combined weighted average rate paid on deposits and borrowings (together, the interest-bearing liabilities). Interest rate spread is affected by changes in the level of non-performing loans and foreclosed real estate, as well as by various external factors, including national and regional economic trends governing general interest rates, changes in accounting rules, changes in federal legislation, loan demand, deposit flows, and competition for deposit funds and mortgage loans. When the balance of interest-earning assets equals or exceeds the balance of interest-bearing liabilities, net interest income as a percent of interest-earning assets will equal or exceed the interest rate spread. When the balance of the interest- earning assets is less than the balance of the interest-bearing liabilities, net interest income as a percentage of interest-earning assets will be less than the interest rate spread. For the year ended December 31, 1993, the nine months ended December 31, 1992, and the year ended March 31, 1992, average interest-bearing liabilities exceeded average interest-earning assets by $42.9 million, $34.7 million, and $6.4 million, respectively. Total interest income was $220.4 million, $266.3 million, and $326.9 million for the years ended December 31, 1993 and 1992 and March 31, 1992, respectively. For the nine-month periods ended December 31, 1993 and 1992, respectively, total interest income was $163.1 million and $196.3 million. The increase in total interest income for the year ended December 31, 1993 when compared to the nine months ended December 31, 1992, was due primarily to a longer reporting period, which increased total interest income by $65.4 million. However, primarily as a result of a 128 basis point decrease in the weighted average yield on interest-earning assets, total interest income increased by only $24.0 million. Weighted average yields were 5.88% and 7.16% for the year ended December 31, 1993 and the nine months ended December 31, 1992, respectively. The $130.6 million decrease in total interest income for the nine months ended December 31, 1992 when compared to the year ended March 31, 1992, was due primarily to a shorter reporting period, which decreased total interest income by $62.1 million, and to lower yields on interest-earning assets. Primarily as a result of a 153 basis point decrease in the weighted average yield on interest-earning assets, total interest income decreased $53.3 million. Weighted average yields were 7.16% and 8.69% for the nine months ended December 31, 1992 and the year ended March 31, 1992, respectively. In addition, the decrease in total interest income for the nine months ended December 31, 1992 was also impacted by a $104.3 million decrease in average interest-earning assets, which reduced interest income by $15.2 million. The weighted average yields on the Association's principal categories of interest-earning assets were as follows for the periods indicated. The table below presents the Association's loans, before consideration of allowances for losses, deferred fees, discounts, and other items, and mortgage- backed securities at December 31, 1993 and the primary indexes which dictate their repricing: A portion of the Association's loans and mortgage-backed securities are tied to indexes other than the primary ones noted above. However, no significant portion of the Association's portfolios is tied to any one of these other individual indexes. The following table presents the primary indexes to which the Association's loans are tied and the corresponding interest rates of those indexes at the dates indicated: The lower yields earned by the Association on its interest-earning assets were due to several factors. First, the Association has experienced a high level of prepayments on its loans and mortgage-backed securities. Such prepayments have resulted from low interest rates due to extremely poor economic conditions and the continuing recession. In this current low interest rate environment, many borrowers are refinancing their existing mortgage loans in order to reduce their payment obligations through lower mortgage interest rates. This increase in prepayments, coupled with the fact that approximately 84.6% of Northeast Savings' interest-earning assets are either short-term in nature or tied to an adjustable rate index, has resulted in an overall lower level of interest rates earned by the Association. Finally, lower yields have resulted from the Association's recent high levels of non-performing assets which consist of non-accrual loans and REO. Average non-performing assets were $172.1 million, $215.7 million, and $149.7 million for the year ended December 31, 1993, the nine months ended December 31, 1992, and the year ended March 31, 1992, respectively. Non-performing assets totaled $142.4 million, or 3.6% of total assets at December 31, 1993, compared to $194.4 million, or 5.0% of assets at December 31, 1992, and $173.3 million or 4.5% of assets at March 31, 1992. The level of non-performing assets has negatively impacted the Company's net interest income and operating results. Management believes that the high level of non-performing assets will continue to negatively impact net interest income in 1994. As a result of an overall lower level of interest rates, both total interest expense and the Association's cost of funds were lower in the year ended December 31, 1993 and the nine months ended December 31, 1992 than for the previous comparable periods. In addition, total interest expense was higher for the year ended December 31, 1993 versus the nine months ended December 31, 1992 due to the difference in the length of the reporting period. Total interest expense was $148.0 million, $182.2 million, and $244.1 million for the years ended December 31, 1993 and 1992 and March 31, 1992, respectively. For the nine months ended December 31, 1993 and 1992, respectively, total interest expense was $110.3 million and $132.9 million. During the year ended December 31, 1993, the cost of funds decreased 87 basis points to 3.91%, while during the nine months ended December 31, 1992, the cost of funds decreased to 4.78%, 170 basis points lower than in the year ended March 31, 1992. Average interest-bearing liabilities were $3.8 billion, $3.7 billion and $3.8 billion for the year ended December 31, 1993, the nine months ended December 31, 1992, and the year ended March 31, 1992, respectively. Net interest income totaled $72.4 million, $84.1 million, and $82.8 million for the years ended December 31, 1993 and 1992, and March 31, 1992, respectively. For the nine months ended December 31, 1993 and 1992, respectively, net interest income was $52.8 million and $63.4 million. The following table presents the primary determinants of the Company's net interest income for the periods presented: The decreases in the interest rate spread and margin were due primarily to the recent high level of refinancing in the current low interest rate environment. As refinanced loans with relatively higher rates were replaced by loans whose initial coupon rate was often lower than 4%, the Association's yield on interest-earning assets decreased. For the year ended December 31, 1993, the average rate on single-family residential real estate loans was 6.15%, compared to 7.33% for the nine months ended December 31, 1992. For the nine months ended December 31, 1992, the interest rate spread increased to 2.38%, compared to 2.21% for the year ended March 31, 1992. The net interest rate margins for the same respective periods were 2.34% and 2.20%. The increase in the interest rate spread for the nine months ended December 31, 1992 resulted because the decrease in the cost of funds for the period was more rapid than the decrease in the yields earned. The interest rate spread is calculated by subtracting the average rate paid for average total interest- bearing liabilities from the average rate earned on average total earning assets. The interest rate margin is calculated by dividing annualized net interest income by average total earning assets. In addition, the high average level of non-performing loans during recent years has had a negative impact on the interest spread, lowering the spread by 14 basis points for the year ended December 31, 1993, and 26 basis points for both the nine months ended December 31, 1992 and the year ended March 31, 1992. The table below summarizes the degree to which changes in the Association's interest income, interest expense, and net interest income are due to changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities. The tables above indicate that total interest income during the year ended December 31, 1993 versus the nine months ended December 31, 1992 was positively affected by $6.2 million from the increase in the average level of interest- earning assets, primarily mortgage-backed securities, and negatively impacted by $45.2 million from the reduction in the average yield realized on interest- earning assets. Total interest expense was negatively impacted by $10.0 million from the increases in the level of average interest-bearing liabilities, particularly the increase in FHLB advances, and favorably impacted by $30.4 million from a reduction in the average cost of interest-bearing liabilities. Net interest income was negatively impacted by $3.8 million due to changes in the levels of interest-earning assets and interest-bearing liabilities and by $14.8 million from a decline in market rates that continued throughout 1993 versus 1992. Provision for Loan Losses The provision for loan losses for the year ended December 31, 1993 was $23.3 million compared to $16.3 million for the nine months ended December 31, 1992 and $10.2 million for the year ended March 31, 1992. The continuing high levels of provisions reflect the effects of the ongoing recessions in New England and California and the impact of such recessions on borrowers' abilities to repay loans and the value of homes collateralizing these loans. The allowance for loan losses at December 31, 1993 was $7.3 million higher than at December 31, 1992, while the Association's net loan portfolio was $388.9 million lower. The factors considered in determining the adequacy of the allowance for loan losses on the Association's loan portfolio are management's judgment regarding prevailing and anticipated economic conditions, historical loan loss experience in relation to outstanding loans, the diversification and size of the loan portfolio, the results of the most recent regulatory examinations available to the Association, the overall loan portfolio quality, and the level of loan charge-offs. The most recent examination of the Association by the OTS was completed in the fourth quarter of 1993. The activity in the allowance for loan losses for the year ended December 31, 1993, the nine months ended December 31, 1992, and the year ended March 31, 1992 can be found in Note 7 to the Consolidated Financial Statements. Although management believes that the allowance for loan losses is adequate at December 31, 1993, based on the quality of the loan portfolio at that date, further additions to the allowance may be necessary if market conditions continue to deteriorate. Net charge-offs for the periods indicated by type of loan were: The increases in single-family residential real estate loan net charge-offs were due to general economic conditions, particularly the recessions in New England and California which continued into 1993. The lingering recessionary environment has caused high rates of unemployment and reduced family income levels and has resulted in declining real estate values, increased delinquencies, and foreclosures. The increase in residential charge-offs, which began in late 1992 and continued into 1993, indicated that the risk in the residential loan portfolio was higher than indicated by previous analysis. As a result, management increased the provision for loan losses to $23.3 million for the year ended December 31, 1993. The increase in charge-offs on income property loans for the year ended December 31, 1993 resulted from the sale in April 1993 of the Association's portion of an income property loan participation. The Association's portion of this participation had been included in non-accrual loans since March 15, 1992. Non-performing assets. The risks and uncertainties involved in originating loans may result in loans becoming non-performing assets. Non-performing assets include non-accrual loans and real estate and other assets acquired in settlement of loans. The following table presents the Association's non-performing assets and restructured loans at the dates indicated. Activity within the non-performing asset portfolio was as follows: The above information is not available for the nine months ended December 31, 1992 or the year ended March 31, 1992. The following table sets forth the effect of non-performing and restructured loans on interest income for the periods indicated. As the level of non-performing assets has risen, the Association has increased its efforts to reduce the amount of such assets. The Association seeks to reduce nonperforming assets by aggressively pursuing loan delinquencies through collection and foreclosure processes and, if foreclosed, disposing rapidly of the acquired real estate. Management believes that disposal of REO is handled most efficiently through its area managers who have greater knowledge of their neighborhoods than do the personnel at Company headquarters. Thus, California REO is generally disposed of through the Association's West Coast offices. In August 1993, as part of its efforts to dispose of foreclosed real estate more rapidly, the Association sold fifty-seven single-family residential REO properties in a single transaction. The sale is discussed further in "Real estate and other assets acquired in settlement of loans." Including this sale, the Association sold approximately $76.7 million in foreclosed single-family residential real estate in 1993, compared to $22.2 million for the nine months ended December 31, 1992. Another key to reducing the level of non-performing assets is the continuing goal to improve underwriting standards. For example, in certain cases prior to 1990, the Association's policies allowed originations of single-family residential mortgages with loan-to-value ratios greater than 80% without private mortgage insurance. Such loans originated after 1990 were on an exception basis only and required the approval of the Chairman of the Board or the President. Also in 1989, the average loan-to-value ratio on loans originated that year was 74.6%. By 1993, the average loan-to-value ratio had decreased to 66.0%. Non-accrual loans. Non-accrual loans are loans on which the accrual of interest has been discontinued. The Association's policy is to discontinue the accrual of interest on loans when there is reasonable doubt as to its collectibility. Interest accruals on loans are normally discontinued whenever the payment of interest or principal is more than ninety days past due, or earlier when conditions warrant it. For example, although a loan may be current, the Association discontinues accruing interest on that loan when a foreclosure is brought about by other owner defaults. When interest accrual on a loan is discontinued, any previously accrued interest is reversed. A non- accrual loan may be restored to an accrual basis when principal and interest payments are current and full payment of principal and interest is expected. Non-accrual loans at December 31, 1993 were $67.5 million, compared to $95.0 million and $112.1 million at December 31, 1992 and March 31, 1992, respectively. At December 31, 1993 and 1992 and March 31, 1992, the Association had no loans more than ninety days past due on which it was accruing interest. The decreases in non-accrual loans were due to foreclosures of the underlying collateral securing the loans, which resulted in transfers to the REO balance, and to payoffs and reinstatements of non-accrual loans. Below is a table which summarizes Northeast Savings' gross loan portfolio and non-accrual loans as a percentage of gross loans by state and property type at December 31, 1993. Although Northeast Savings' single-family residential non-accrual loans have decreased by approximately 25.2% since December 31, 1992, they remain at a high level due to continuing weak economic conditions, particularly the recessions in New England and California. Virtually all of these residential mortgage non- accrual loans are collateralized by properties with an original loan-to-value ratio of 80% or less. At December 31, 1993 and 1992 and March 31, 1992, single- family residential non-accrual loans were 97.5%, 92.6%, and 96.2%, respectively, of non-accrual loans. The ratio of the allowance, including the unallocated portion, attributed to single-family residential loans as a percentage of total single-family residential non-accrual loans was 41.3%, 21.2%, and 11.4%, at December 31, 1993 and 1992 and March 31, 1992, respectively. The low levels in the allowance for loan losses as a percentage of non- accrual consumer loans reflect significant charge-offs made during the years ended March 31, 1992 and 1991, which resulted in a portfolio with substantially lower risk. The Association's consumer loans, which totaled only 1.8% of the total loan portfolio at December 31, 1993, consist primarily of well-seasoned loans collateralized by deposits or real estate. At December 31, 1993, 25.1% of the Association's consumer loans were collateralized by deposits, while 61.7% consisted of loans collateralized by real estate. The non-accrual income property loans at December 31, 1993 primarily represent three loans which have been reserved to their estimated fair values based on current appraisals. The Association's income property loan portfolio, totaling 4.1% of the total loan portfolio at December 31, 1993, consists of well-seasoned loans, most of which were originated prior to 1986. Real estate and other assets acquired in settlement of loans. The $24.4 million decrease in REO at December 31, 1993 from December 31, 1992 was due primarily to the August 27, 1993 sale in a single transaction of a portion of the Company's portfolio of single-family residential REO. The fifty-seven REO properties sold had a book value of $30.3 million at the time of the sale. Of the fifty-seven properties, thirty-four properties, totaling 88.9% of the book value of the sale, were in California and thirty of the properties, with a total book value of $18.3 million, were in the REO portfolio for greater than one year. The Company recorded a $6.0 million provision for loss during the quarter ended June 30, 1993 in anticipation of the sale. An adjustment of $777,000, which is included in expense on REO on the statement of operations, was recorded at the time the properties were sold. After giving effect to the sale, the Company's REO at December 31, 1993 was $21.5 million lower than at June 30, 1993. The turnover of single-family residential REO has been relatively rapid. Of the $57.2 million of single-family residential REO at December 31, 1993, only 34 properties totaling $17.3 million were in the portfolio for longer than one year. Included in income property REO of $16.0 million at December 31, 1993 were two hotels, an industrial building, one retail office, two single-family residential subdivisions, two apartment buildings, and one property zoned for residential development. Also included in income property REO were a residential subdivision and an apartment building purchased as part of the Rhode Island acquisition. If the recessions in New England and California continue, the amount of non- accrual loans and real estate owned may increase. Management believes that the single-family residential real estate market has stabilized in New England. However, management also expects that California single-family residential non- accrual loans could increase due to the poor economic environment. Non-Interest Income Non-interest income, which is comprised primarily of fees for services and net gains or losses on the sales of securities and loans, totaled $17.7 million, $16.7 million, and $16.1 million for the years ended December 31, 1993 and 1992 and March 31, 1992, respectively, compared to $10.7 million and $13.0 million for the nine months ended December 31, 1993 and 1992, respectively. Fees for services result principally from fees received for servicing loans and fees charged to customers. When compared to prior periods, fee income was lower for the years ended December 31, 1993 and 1992 than for the year ended March 31, 1992. Fees for services totaled $10.2 million, $9.7 million, and $12.8 million for the years ended December 31, 1993 and 1992, and March 31, 1992, respectively, and $7.3 million and $7.1 million for the nine months ended December 31, 1993 and 1992, respectively. Total fees for services are affected by the level of loans serviced for others and by the level of savings deposits. For the year ended December 31, 1993 and the nine months ended December 31, 1992, loan servicing fees were impacted by higher adjustments to value and to increased amortization of the Association's purchased mortgage servicing rights and deferred excess servicing resulting from higher prepayments on underlying mortgage loans. Such prepayments have occurred primarily as a result of the low interest rate levels which have been experienced in the economy over recent months. The following table details fee income earned by the Association on loans serviced for others for the periods indicated. Adjustments to value due to prepayments resulted from the availability of substantially lower interest rates on mortgage loans. Reflecting the overall level of interest rates in the economy, mortgage rates were particularly low during the year ended December 31, 1993. Interest losses on payoffs occur because, although a borrower may pay off a mortgage early in the month, the Association must still remit an entire month's interest to the investor. Fees charged to customers were $7.6 million, $8.4 million, and $7.9 million for the years ended December 31, 1993 and 1992 and March 31, 1992, respectively. For the nine months ended December 31, 1993 and 1992, fees charged to customers totaled $5.7 million and $6.3 million. Non-interest income for the year ended December 31, 1993, the nine months ended December 31, 1992 and the year ended March 31, 1992 included net gains of $5.6 million, $4.1 million and $2.0 million, respectively, on sales of securities. For the year ended December 31, 1993 and nine months ended December 31, 1992 net gains included $3.6 million and $1.9 million, respectively, on investment securities and $2.0 million and $2.2 million, respectively, on mortgage-backed securities. For the year ended March 31, 1992, net losses of $2.8 million on investment securities were offset by net gains of $4.7 million on mortgage-backed securities. Sales of the investment securities and the mortgage-backed securities for the year ended March 31, 1992 were made in accordance with the Association's objectives of downsizing and of remaining in compliance with anticipated higher core capital requirements. Net gains on sales of securities for the year ended December 31, 1993, the nine month period ended December 31, 1992, and the year ended March 31, 1992 included $2.9 million, $880,000, and $566,000, respectively, of realized capital gains allocated to the Association by two limited partnerships in which the Association invested and which, during the quarter ended June 30, 1993, were transferred from the held-to-maturity portfolio to the available-for-sale portfolio in anticipation of compliance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The remaining net gains on investment securities for the same respective periods resulted primarily from the sale of fixed-rate securities from the available-for-sale portfolio. Included in net losses on investment securities for the year ended March 31, 1992 were net realized losses of $2.8 million which included losses of $371,000 on the FIRREA-mandated sale of the Association's last non-investment grade corporate debt security, $572,000 on the sale of all of the Association's remaining collateralized mortgage obligation residuals, and $6.2 million on the sales of corporate debt securities. These losses were partly offset by gains on sales of other investment securities from the available-for-sale portfolio. For further information related to sales of investment securities and mortgage- backed securities, see Notes 5 and 6 to the Consolidated Financial Statements. Non-interest income for the year ended December 31, 1993, the nine months ended December 31, 1992, and the year ended March 31, 1992, respectively, also included net gains on sales of loans of $1.9 million, $1.9 million, and $2.5 million. For the year ended December 31, 1993, total proceeds from sales of loans totaled $279.7 million, $231.2 million of which was due to sales of loans from the available-for-sale portfolio. In addition, $33.7 million resulted from the securitization of loans into mortgage-backed securities and their simultaneous sale. The remaining proceeds resulted primarily from the sale of seasoned California adjustable rate mortgages. For the nine months ended December 31, 1992, proceeds from sales of loans totaled $192.4 million, $184.3 million of which was from the available-for-sale portfolio. The remaining $8.1 million in proceeds resulted from the sale of a whole loan participation which was serviced by another financial institution. The participation was sold because of management's concern over the creditworthiness of that servicer. For the year ended March 31, 1992, proceeds from sales of loans totaled $151.7 million. Of the total proceeds for the year ended March 31, 1992, $135.1 million resulted from sales of loans from the available-for-sale portfolio, while the remaining proceeds were due principally to the sale of a fixed rate commercial mortgage loan participation. The sale of this participation resulted in a gain of $856,000. Non-Interest Expense Total non-interest expense totaled $93.2 million, $145.6 million, and $79.3 million for the years ended December 31, 1993 and 1992 and March 31, 1992, respectively, compared to $71.6 million and $124.5 million for the nine months ended December 31, 1993 and 1992, respectively. As discussed below, the substantial increase in non-interest expense for the nine months ended December 31, 1992 was due to a $56.6 million reduction of supervisory goodwill. As a result of an analysis of the value of its remaining supervisory goodwill, Northeast Savings reduced supervisory goodwill by $56.6 million in the quarter ended September 30, 1992. This reduction was precipitated by several factors that had diminished the value of the Association's Connecticut and Massachusetts franchises. Accordingly, the Company hired Kaplan Associates, Inc. to perform an independent valuation of the Association's franchise rights in Connecticut and Massachusetts. This study was completed during the quarter ended September 30, 1992 and supported the value of the Company's remaining supervisory goodwill at September 30, 1992. The reduction in supervisory goodwill had no effect on Northeast Savings' fully phased-in regulatory tangible, core, or risk-based capital. General and administrative expenses (compensation and benefits, occupancy and equipment, and other general and administrative expenses) have increased slightly, totaling $67.2 million, $65.6 million and $61.5 million for the years ended December 31, 1993 and 1992 and March 31, 1992, respectively. General and administrative expenses were $50.0 million and $50.1 million for the nine months ended December 31, 1993 and 1992, respectively. Although management has streamlined operations over the last several years, the cost benefits resulting from this streamlining have been offset by expenses related to the Association's increased number of branches as well as other management costs due to the acquisitions of financial institutions and higher costs related to delinquent loans and REO. The following table summarizes general and administrative expense for the periods indicated: - -------- * In accordance with generally accepted accounting principles, certain loan origination costs are deferred and amortized as an adjustment of yield over the life of the loans closed. As a result of the previously discussed $56.6 million reduction of supervisory goodwill, amortization of supervisory goodwill was zero for the year ended December 31, 1993 and was proportionately lower for the nine months ended December 31, 1992 than for the year ended March 31, 1992. Expenses relating to real estate and other assets acquired in settlement of loans increased to $17.6 million for the year ended December 31, 1993, compared to $11.7 million and $5.7 million for the years ended December 31, 1992 and March 31, 1992, respectively. These expenses totaled $15.0 million and $9.7 million for the nine months ended December 31, 1993 and 1992, respectively. REO expenses increased in the year ended December 31, 1993 due primarily to a loss of $6.8 million on the sale in a single transaction of a portion of the Company's residential REO portfolio. The increased expenses for the periods ended December 31 and March 31, 1992 were primarily a result of increased foreclosures on residential real estate. Also included in REO expense for the nine months ended December 31, 1992 were writedowns of $1.0 million on a real estate brokerage operation and $1.5 million on a hotel in Connecticut. Total REO expenses may remain at a high level in the coming year since, based on present economic conditions, management anticipates that the portfolio of real estate and other assets acquired in settlement of loans may increase. Income Taxes/Cumulative Effect of a Change in Accounting for Income Taxes Income tax benefit for the year ended December 31, 1993 and the nine months ended December 31, 1992 and income tax expense for the year ended March 31, 1992 represent federal and state taxes or benefits. For the December 31 and March 31, 1992 periods, respectively, the effective tax rates of (7.9)% and 52.25% differ from the combined federal and state statutory rates primarily as a result of permanent differences, such as the amortization of supervisory goodwill (See Note 15: Income Taxes). In February 1992, the FASB issued SFAS 109, "Accounting for Income Taxes," which established financial accounting and reporting standards for the effects of income taxes that result from an enterprise's activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting for income taxes. The Company implemented SFAS 109 for the fiscal year ended March 31, 1992. In accordance with this implementation, the Company recorded $21.1 million in deferred tax assets and $3.6 million in deferred tax liabilities, as well as an additional $1.0 million in income. The additional income is reported separately in the Consolidated Statement of Operations as the cumulative effect of a change in accounting principle. In addition, a valuation allowance was established which reduced the deferred tax assets as of April 1, 1991. Due to the Company's utilization of all remaining net operating loss carryforwards, the valuation reserve was eliminated as of December 31, 1992. Also in accordance with SFAS 109, the Company applied tax benefits of approximately $20.9 million at April 1, 1991 and another $1.0 million at December 31, 1992 to reduce its supervisory goodwill. At December 31, 1993, the Company's deferred tax asset totaled $41.7 million and the deferred tax liability was $3.2 million. Also recorded was a valuation allowance of $4.0 million. On January 20, 1993, the OTS issued Thrift Bulletin No. 56 (TB 56) entitled "Regulatory Reporting of Net Deferred Tax Assets." In TB 56, the OTS adopted the Federal Financial Institutions Examination Council (FFIEC) recommendations with respect to SFAS No. 109 and the resulting deferred tax assets that may be included in regulatory capital. Deferred tax assets that are unlimited in the computation of regulatory capital are those tax assets that can be realized from taxes paid in prior carryback years and future reversal of existing taxable temporary differences. Conversely, to the extent that the realization of deferred tax assets depends on an institution's future taxable income or its tax planning strategies, such deferred tax assets are limited for regulatory capital purposes to the lesser of: (1) the amount of future taxable income that can be realized within one year of the quarter-end report date, or (2) ten percent (10%) of core capital. In addition, TB 56 adopted transitional provisions which allow regulatory capital to include deferred tax assets that would be reportable under Accounting Principle Board Opinion No. 11 (APB 11) or SFAS No. 96 as of December 31, 1992. Accordingly, at December 31, 1993 and 1992, the deferred tax assets included in the Association's regulatory capital ratios were calculated in accordance with this transitional guidance. Extraordinary Items There were no extraordinary items for the year ended December 31, 1993 or the nine months ended December 31, 1992. Extraordinary items for the fiscal year ended March 31, 1992 included realized gains of $95,000, net of income taxes, on the early retirement of the Association's 8% Convertible Subordinated Debentures, due 2011 (the convertible subordinated debentures). Quarter Ended December 31, 1993 The net loss for the quarter ended December 31, 1993 totaled $2.9 million, which resulted in a primary and fully diluted net loss per common share of $.28 after preferred stock dividend requirements. This compares with net income of $398,000 for the quarter ended December 31, 1992, which resulted in a primary and fully diluted net loss per common share of $.22 after preferred stock dividend requirements. Net interest income totaled $15.7 million, compared with $21.8 million for the quarter ended December 31, 1992. Reflecting the low interest rate environment which led to an exceptionally high volume of prepayments of existing mortgages, the interest rate spread decreased to 1.75% for the quarter ended December 31, 1993 from 2.48% for the same quarter last year. During the quarter ended December 31, 1993, the Association securitized approximately $350 million of mortgage loans originated in California. By securitizing these loans, the Association improved the geographic distribution of its loan portfolio, reduced its credit risk by exchanging the loans for high quality mortgage-backed securities, and increased its risk-based capital ratio. Loan charge-offs for the quarter ended December 31, 1993 were $3.0 million, down from $6.4 million for the quarter ended December 31, 1992. The quarterly provision for loan losses was also down, $3.0 million for the quarter ended December 31, 1993, compared to $7.5 million for the same quarter last year. However, although the loan portfolio was $388.9 million lower, management increased the allowance for loan losses at December 31, 1993 to $28.3 million, compared to $21.0 million at December 31, 1992, reflecting the effects of the ongoing recession in New England and California. REGULATORY CAPITAL The OTS capital requirements have three separate measures of capital adequacy: the first is a tangible core capital requirement of 1.5% of tangible assets; the second is a core capital requirement of 3% of adjusted total assets; and the third is a risk-based capital requirement that is 8% of risk- weighted assets. On April 22, 1991, the OTS issued a notice of proposed rulemaking which would establish a minimum leverage ratio of 3% of adjusted total assets, plus an additional 100 to 200 basis points, determined on a case-by-case basis for all but the most highly-rated thrift institutions. The OTS has proposed this requirement in order to fulfill its obligation pursuant to FIRREA to adopt capital requirements no less stringent than those required for national banks by the OCC, which adopted a similar increased leverage requirement effective December 31, 1990. Although the April 22, 1991 proposed leverage requirement is not yet final, under the prompt corrective action rule which was issued by the federal banking agencies on September 29, 1992 and which became final on December 19, 1992, an institution must have a leverage ratio of 4% or greater in order to be considered adequately capitalized. The OTS final rule adding an interest rate risk component to its risk-based capital rule became effective January 1, 1994. Under the rule, savings associations are divided into two groups, those with "normal" levels of interest rate risk and those with greater than "normal" levels of interest rate risk. Associations with greater than normal levels are subject to a deduction from total capital for purposes of calculating risk-based capital. Interest rate risk is measured by the change in Net Portfolio Value under a 2.0% change in market value of an association's assets less the economic value of its liabilities adjusted for the economic value of off-balance-sheet contracts. If an association's change in Net Portfolio Value under a 2.0% change in market interest rates exceeds 2.0% of the estimated economic value of its assets, it will be considered to have greater than normal interest rate risk, and its total capital for risk-based capital purposes will be reduced by one-half of the difference between its measured interest rate risk and the normal level of 2.0%. The rule adjusts the interest rate risk measurement methodology when interest rates are low. In the event that the 3-month Treasury rate is below 4.0%, interest rate risk will be measured under a 2.0% increase in interest rates and under a decrease in interest rates equal to one-half the value of the 3-month Treasury rate. According to the most recent OTS measurements, Northeast Savings' interest rate risk is within the normal range. The following table reflects the regulatory capital position of the Association as well as the current regulatory capital requirements at December 31, 1993 and 1992: The following table reconciles the Association's capital as calculated in accordance with generally accepted accounting principles to tangible, core, and risk-based capital as calculated in accordance with OTS regulations in effect at December 31, 1993. - -------- * Total assets as reported to the OTS ** Subject to risk-based capital limitations of 1.25% of risk-based assets before general valuation allowance adjustment FINANCIAL CONDITION Total assets were $3.9 billion at both December 31, 1993 and 1992 and $3.8 billion at March 31, 1992. When compared to earlier years, the reduced asset size at these dates is consistent with the Association's business plan to meet the current and anticipated capital requirements mandated by FIRREA and subsequent proposed regulations. During the year ended March 31, 1990, the Association reduced its mortgage-backed securities portfolio, its high-yield corporate debt securities portfolio, and other investment securities. The Association continued downsizing during 1991 primarily by reducing its portfolio of purchased loans. In the year ended March 31, 1992, the Association also continued its downsizing by reducing its loan portfolio by $222.0 million to $2.4 billion, its mortgage-backed securities portfolio by $689.9 million to $680.8 million and its investment portfolio by $87.7 million to $229.9 million. As a part of its dispositions during the year ended March 31, 1992, the Association sold the last of its high-yield corporate debt securities and its CMO residuals from the available-for-sale portfolios. Principal reductions resulting from the normal amortization and payoffs on loans and mortgage-backed securities were approximately $649.5 million, $535.5 million, and $691.3 million during the year ended December 31, 1993, the nine months ended December 31, 1992, and the year ended March 31, 1992, respectively. Funds received from the disposition of assets as well as from the acquisitions of branches of other financial institutions were used to reduce wholesale liabilities which include all borrowed and brokered funds. These liabilities are generally more rate-sensitive and a more costly source of funds for the Association than retail deposits. Wholesale liabilities were $4.1 billion or 53% of total liabilities at March 31, 1989. In the years that followed, the Association reduced these liabilities to $731.4 million or 19.3% of total liabilities at December 31, 1993. At December 31, 1992, wholesale liabilities comprised 13.0% of total liabilities. The increase in wholesale liabilities at December 31, 1993 was necessary for the Association to offset the decrease in retail deposits, as discussed below. During the year ended March 31, 1990, the Association reduced its brokered deposits by $693.2 million. Since then, brokered deposits have been reduced to only $25.1 million at December 31, 1993. Securities sold under agreements to repurchase also experienced a decline, totaling $294.8 million at December 31, 1993, down from approximately $2.3 billion at March 31, 1989. In spite of the recent acquisitions of financial institutions, retail deposits, the Association's least expensive source of funds, decreased to $3.0 billion at December 31, 1993, compared to $3.2 billion and $3.5 billion at December 31, and March 31, 1992, respectively. Following the trend of low interest rates in the economy due to the continuing recession, the Association has experienced a significant reduction in its cost of retail deposits. These lower rates have caused some depositors who are struggling to preserve their former level of income to seek higher yields through alternative investments, and others to reduce their outstanding high interest rate liabilities. Others have withdrawn funds to meet their financial obligations due to a loss in personal income. Another large component of the deposit decrease relates to the Rhode Island acquisition. The depositors in this acquisition had been blocked from accessing their funds for over 16 months. Once the funds were made available to them, many of these depositors withdrew a portion of their deposits to meet financial obligations they incurred while their funds were frozen. The following table shows the components of change in customer account balances: Transaction accounts (regular savings, NOWs, Super NOWs and money market savings) comprised 40.9% of total customer account balances at December 31, 1993, compared to 43.0% at December 31, 1992 and 34.6% at March 31, 1992. In the current low interest-rate environment, transaction accounts tend to be more popular than certificates of deposit. CAPITAL RESOURCES AND LIQUIDITY The primary source of funds for the Association is retail deposits, while secondary sources include FHLB advances, repurchase agreements, debentures, and internally-generated cash flows resulting from the maturity, amortization, and prepayment of assets as well as sales of loans and securities from the available-for-sale portfolios. The Association's ongoing principal use of capital resources remains the origination of single-family residential mortgage loans. The following table sets forth the composition of the Association's single-family residential mortgage loan originations for the periods indicated: The composition of the Association's residential mortgage loan portfolio at December 31, 1993 and 1992 was as follows: Total loans originated during the year ended December 31, 1993 were $758.6 million compared to $614.2 million and $474.6 million for the nine months ended December 31, 1992 and the year ended March 31, 1992, respectively. At December 31, 1993, the Association was committed to fund mortgage loans totaling $49.1 million, including $15.4 million in adjustable rate mortgages. The Association expects to fund such loans from its liquidity sources in 1994. Net cash provided by operations during the year ended December 31, 1993 totaled $18.0 million. Adjustments to the net loss of $14.1 million provided $32.2 million of net cash, including proceeds from sales of loans available- for-sale of $231.2 million. These proceeds resulted principally from the sale of fixed rate loans which were originated by the Association with the intent to sell in the secondary market. Net cash provided by investing activities during the year totaled $36.6 million. Loans originated and purchased used $513.2 million of cash, while purchases of mortgage-backed securities and investment securities used cash of $361.5 million and $239.4 million, respectively. Principal collected on loans and mortgage-backed securities generated cash of $412.2 million and $237.3 million, respectively, while maturities of investment securities provided $133.9 million in cash. Proceeds from sales of loans were $48.5 million, while proceeds from sales of investment securities and mortgage-backed securities available-for-sale totaled $158.9 million and $39.8 million, respectively. Included in proceeds on the sale of investment securities was $16.3 million which resulted from the sale of two bonds due to credit concerns. These bonds had been classified as held-to-maturity. Proceeds from REO sales generated $76.5 million in cash. All other investing activities provided net cash of $43.6 million. Net cash used in financing activities during the years ended December 31, 1993 totaled $10.0 million and resulted primarily from a decrease of $252.5 million in retail deposits. As noted previously, this decrease in deposits was a consequence of the low interest rates in the economy due to the continuing recession. Net increases in FHLB advances generated $233.0 million in cash. Remaining financing activities provided $9.5 million in cash. The Association has pledged certain of its assets as collateral for certain borrowings. By utilizing collateralized funding sources, the Association is able to access a variety of cost effective sources of funds. The assets pledged consist of investment securities, mortgage-backed securities, and loans. Management monitors its liquidity requirements by assessing assets pledged, the level of assets available for sale, additional borrowing capacity and other factors. Management does not anticipate any negative impact to its liquidity from its pledging activities. Assets pledged totaled $902.7 million at December 31, 1993, compared to $903.0 million and $785.8 million at December 31 and March 31, 1992, respectively. The following table details assets pledged by the Association at December 31, 1993: The liquidity of the Association is measured by the ratio of its liquid assets to the net withdrawable deposits and borrowings payable in one year or less. A portion of these liquid assets are in the form of non-interest bearing reserves required by Federal Reserve Board regulations. For total transaction account deposits of $51.9 million or less, regulations require a reserve of 3%. For total transaction account deposits in excess of $51.9 million, a 10% reserve is required. The Federal Reserve Board may adjust the latter reserve percentage within a range of 8-14%. The Association is also subject to OTS regulations which require the maintenance of a daily average balance of liquid assets equal to 5%. The ratio averaged 5.67% for the year ended December 31, 1993, compared to 9.88% for the nine months ended December 31, 1992 and 5.83% for the year ended March 31, 1992. In addition to the regulatory requirements, the average liquidity ratio reflects management's expectations of future loan fundings, operating needs, and the general economic and regulatory climate. In addition, the Association is required by OTS regulations to maintain a daily average balance of short-term liquid assets of 1%. The ratio averaged 2.34%, 5.00%, and 3.31% for the year ended December 31, 1993, the nine months ended December 31, 1992, and the year ended March 31, 1992, respectively. Each of the Company's sources of liquidity is vulnerable to various uncertainties beyond the control of the Company. Scheduled loan payments are a relatively stable source of funds, while loan prepayments and deposit flows vary widely in reaction to market conditions, primarily prevailing interest rates. Asset sales are influenced by general market interest rates and other unforeseen market conditions. The Company's ability to borrow at attractive rates is affected by its credit rating and other market conditions. Increased capital remains a significant focus for the Association because, notwithstanding that it has achieved compliance with its fully phased in regulatory capital requirements, the Association does not meet the standards for a well-capitalized institution promulgated pursuant to FDICIA. The ability of the Company to make capital distributions is restricted by the limited cash resources of the Company and the ability of the Company to receive dividends from the Association. The Association's payment of dividends is subject to regulatory limitations, particularly the prompt corrective action regulation, which prohibits the payment of a dividend if such payment would cause the Association to become undercapitalized. Also, the Company and the OTS entered into a Dividend Limitation Agreement as a part of the holding company approval process which prohibited the payment of dividends to the holding company without prior written OTS approval if the Association's capital is below its fully phased-in capital requirement or if the payment of such dividends would cause its capital to fall below its fully phased-in capital requirement. On May 21, 1993, the Company's Board of Directors voted to declare a stock dividend payable on July 1, 1993 on the Company's Series B preferred stock of one share of Series B preferred stock for each $100 of the amount of dividends payable on July 1, 1993, and accumulated and unpaid as of that date, to holders of record on June 14, 1993. On July 1, 1993, the Company paid all then- accumulated and payable dividends on the Series B preferred stock, an aggregate of $3.4 million, through the issuance of an additional 34, 296 shares of Series B preferred stock. On September 24, 1993, the Company's Board of Directors voted to declare a stock dividend payable on October 1, 1993 on the Series B preferred stock of one share of Series B preferred stock for each $100 of the amount of dividends payable on October 1, 1993, and accumulated and unpaid as of that date, to holders of record on September 24, 1993. On October 1, 1993, the Company paid the $820,000 of dividends then payable on the Series B preferred stock through the issuance of an additional 8,203 shares of Series B preferred stock. On December 17, 1993, the Company's Board of Directors voted to declare a stock dividend payable on January 1, 1994 on the Series B preferred stock of one share of Series B preferred stock for each $100 of the amount of dividends payable on January 1, 1994 and accumulated and unpaid as of that date, to holders of record on December 17, 1993. On January 1, 1994, the Company paid $838,000 of dividends then payable on the Series B preferred stock through the issuance of an additional 8,377 shares of Series B preferred stock. In addition, the interest and principal repayment obligations on the 9% Debentures constitute an impediment to the Company's ability to pay cash dividends. The $38.4 million net balance of 9% Debentures at December 31, 1993 require annual interest payments of $3.7 million. In addition, the Company is required to repurchase 6 2/3% of the 9% Debentures outstanding as of March 1, 1998 in each year commencing on May 1, 1998. Prior to May 1, 1997, the Company may fulfill its interest payment obligation by the issuance of additional 9% Debentures. In meeting this interest obligation, the Company has issued an additional $5.0 million in 9% Debentures, which are included in the outstanding principal at December 31, 1993. Any such issuance, however, increases the aggregate annual interest obligation and also the amount of 9% Debentures required to be repurchased annually commencing May 1, 1998. INTEREST RATE RISK MANAGEMENT Northeast Savings' net interest income is the difference between interest earned on its loans and investment securities and interest paid on its deposits and borrowings. Net interest income is subject to fluctuations due to changes in interest rates. Such changes can affect the Association's net interest income in several ways. First, the cost of interest-bearing liabilities may respond more or less quickly than the yield on earning assets to changes in interest rates if the volume of liabilities maturing or repricing in any period is greater or less than the volume of earning assets maturing or repricing in the same period. To the extent that the volume of liabilities maturing or repricing in any period is not matched by a corresponding volume of assets, the Association has a repricing gap or mismatch, and net interest income is subject to change as interest rates change. The Association's maturity and repricing mismatches are measured by the asset/liability gap report. Unlike the traditional position of many thrift institutions which have a larger volume of liabilities maturing or repricing within one year than assets maturing or repricing, Northeast Savings has a larger volume of assets maturing or repricing than liabilities for all time frames from one to ten years on a cumulative basis. As a consequence, excluding all other factors, the Association's interest-earning assets can be expected to respond more quickly to changes in interest rates than its interest-bearing liabilities resulting in an increase in net interest income when interest rates rise and a decrease when interest rates fall. The Company's gap results at December 31, 1993, are reported in the following table. The one year gap as a percentage of total assets was a positive 13.06% at December 31, 1993, compared to a positive 10.54% and 10.72% at December 31 and March 31, 1992, respectively. - -------- For purposes of the above Interest Rate Sensitivity Analysis: . Fixed rate assets are scheduled by contractual maturity; adjustable rate assets are scheduled by the next repricing date; in both cases, assets that have prepayment options are adjusted for the Company's estimate of prepayments. . NOW accounts are assumed to decay at a rate of 5% per year. . Regular savings account decay assumptions used have the effect of repricing $288.0 million funds in excess of the historical average balance within six months. The historical average balance is assumed to decay at a rate of 5% per year. . Loans do not include the allowance for loan loss of $28.3 million. . Loans do not include non-accrual loans of $67.5 million. Second, net interest income is also subject to fluctuations due to changes in interest rates if asset yields and liability costs are tied to different indexes and the relationship or basis between the indexes changes. Since the large majority of the Association's earning assets are indexed to United States treasury rates, the Association relies predominantly on retail deposits for a funding source and minimizes its reliance on wholesale funding sources tied to the London Interbank Offered Rate in order to minimize basis risk. Although retail deposit costs are not directly tied to treasury rates, retail deposit costs bear a generally predictable relationship to treasury rates. The proportion of total funding provided by retail deposits was 81.0% at December 31, 1993 compared to 87.5% and 97.7% at December 31 and March 31, 1992, respectively. Third, net interest income may also fluctuate if asset yields and liability costs are not equally responsive to changes in interest rates as a result of pricing by competitors. Competition for deposits and loans from other financial institutions may require the Association to respond more quickly to changes in interest rates on new loans and more slowly to changes in interest rates on new deposits or vice versa. Typically, market competition has been slow to respond to changing rates on deposit products and fast to respond to changing rates on loan products. This difference in responsiveness can cause an expansion or contraction of the interest rate spread between loans and deposits and a change in net interest income. During 1993, competitors in several markets lowered the initial rate on one year adjustable rate mortgages to levels that represented discounts relative to the fully indexed rate on such loans larger than had been offered in the past five years. The effect of such aggressive pricing on some new loans adversely impacted the Association's net interest income in 1993 and increased the Association's exposure to interest rate increases due to the effect of the annual interest rate caps on loans with larger initial rate discounts than has been typical. In addition to maturity/repricing mismatch risk, basis risk, and competitive pricing risk, Northeast Savings' net interest income is also subject to fluctuations due to changes in asset and liability cash flows resulting from changes in interest rates. Significant increases or decreases in interest rates will change the rate at which current borrowers prepay their loans which will result in higher rate loans prepaying more rapidly in low rate environments and lower rate loans prepaying more slowly in high rate environments. These changes in prepayments will generally affect the Association's net interest income in an adverse fashion. Deposit cash flows may also be affected by changes in interest rates. Significant increases in interest rates can induce depositors to make premature withdrawals from certificates of deposit in order to receive the higher current interest rate. Higher interest rates can also induce depositors to shift funds from more liquid core deposit accounts into higher paying alternatives. These changes in deposit cash flows when interest rates increase generally have an adverse effect on the Association's net interest income although the magnitude of the impact can be wholly or partially offset by premature withdrawal penalties. Since 1992, deposit cash flows have been impacted by the lowest level of market interest rates in thirty years. Depositors who had been accustomed to receiving a higher level of interest income than has been available on Northeast Savings' deposit products have withdrawn their funds and sought higher yields in alternative investments such as mutual funds. The outflow of depositor funds has been made up by borrowings, although retail deposits still provided 81.0% of total funding at December 31, 1993 as noted above. The disintermediation resulting from the unusually low level of interest rates has not had a material impact on the Association's interest rate risk exposure. Significant changes in interest rates can also affect the Association's net interest income due to the effect of interest rate caps on adjustable rate loans. Interest rate caps which may be either period caps (such as annual or semiannual) or lifetime caps limit the amount by which the interest rate may change on a loan. If interest rates change in such a way that interest rate caps prevent a loan from repricing to the fully indexed rate, net interest income may be favorably or unfavorably impacted depending upon whether interest rates have declined or increased. In order to measure the effects of changes in cash flows and the impact of interest rate caps and also to measure the full effects of all of the other factors on net interest income, the Association performs a set of simulations each quarter in order to quantify the effects of a wide range of interest rate changes on the Association's net interest income. The effect of instantaneous and sustained rate shocks of +/-1%, +/-2%, +/-3%, and +/-4% are simulated along with the effects of quarterly rate changes of +/-0.25%, +/-0.50%, +/-0.75%, +/- 1.00% and the effects of changes in the slope of the yield curve of +/-1.50%. The results of these simulations at December 31, 1993 show that the Association's net interest income decreases when rates decrease, increases marginally when rates increase modestly, and decreases when rates increase significantly. In general, the Association's interest rate risk exposure is asset sensitive. The decreases in net interest income under rate shocks of two percent or more is due to the combined effect of annual rate caps on adjustable rate mortgages and the potential impact of premature withdrawals from certificates of deposit and the transfer of those funds into higher rate certificates. Since the simulations on which these results are based assume instantaneous and sustained rate changes, the results exaggerate the impact of rate changes on net interest income since interest rates do not typically increase or decrease by such magnitudes instantaneously. A comparison of these results at December 31, 1993 with the results of simulations at December 31 and March 31, 1992 (see the table that follows) shows that the Association's interest rate risk exposure has shifted from being significantly asset sensitive at March 31, 1992 to being marginally asset sensitive at December 31, 1993. There was little change in the Association's interest rate risk exposure between December 31, 1992 and December 31, 1993. This overall reduction in asset sensitivity from March 31, 1992 has been due to the effects of the sustained low interest rates which have prevailed since 1992. The sustained low interest rate environment has caused deposit disintermediation and a decrease in funding sources. The sustained low rate environment has also reduced the volume of loans with above market rates through the repricing or refinancing of existing loans and has thereby exacerbated the effect of periodic interest rate caps in a sharply rising interest rate environment. NORTHEAST SAVINGS, F.A. SIMULATED CHANGES IN NET INTEREST INCOME - -------- * Rate changes of this magnitude result in negative short term rates and simulated results that are not meaningful. The Association also performs an analysis of the sensitivity of its portfolio equity to changes in interest rates. Simulations on the effect of instantaneous rate shocks of +/-1%, +/-2%, +/-3%, and +/-4% are performed and the results are used to evaluate the long-term impact of interest rate changes on the theoretical market value of the Association and its financial performance. The results of the portfolio equity analyses indicate that the Association is more asset sensitive than indicated by the net interest income analysis. Since the portfolio equity analyses are static analyses and do not take into account the effect of projected changes in the balance sheet such as some continued deposit disintermediation, the portfolio equity analyses indicate that Northeast Savings' interest rate risk exposure is more strongly asset sensitive. The results of the simulations just noted are also used to measure compliance with Northeast Savings' stated interest rate risk management policy. The Association has a stated policy of limiting its exposure to interest rate changes. Should the Association's exposure to plausible changes in interest rates exceed the limits set by policy, the Association would be required to hedge its exposure in such a way as to reduce it to less than the stated limits. In general, the Association has relied on the implementation of its overall strategy to manage interest rate risk rather than relying on the use of financial hedging vehicles. The Association's investment and interest rate risk management policies do permit the use of vehicles such as standard interest rate swaps and interest rate caps to manage its interest rate risk exposure. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS In December 1990, the FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS 106 focuses principally on postretirement health care benefits and significantly changes the prevalent current practice of accounting for postretirement benefits on a pay-as-you-go (cash) basis by requiring accrual of the expected cost of providing those benefits. SFAS 106 is effective for fiscal years beginning after December 15, 1992. The impact of the adoption of SFAS 106 on the financial condition and results of operations of the Company is approximately $444,000. The Company implemented SFAS 106 during the quarter ended March 31, 1993 and is amortizing the expense over the twelve year life expectancy of the participants. In November 1992, the FASB issued SFAS 112, "Employers' Accounting for Postemployment Benefits." SFAS 112 establishes accounting standards for employers who provide benefits to former or inactive employees after employment but before retirement (postemployment benefits). Postemployment benefits are all types of benefits provided to former or inactive employees, their beneficiaries, and covered dependents. Those benefits include, but are not limited to, salary continuation, supplemental unemployment benefits, severance benefits, disability-related benefits (including worker's compensation), job training and counseling, and continuation of benefits such as health care benefits and life insurance coverage. SFAS 112 requires employers to recognize the obligation to provide postemployment benefits in accordance with SFAS 43, "Accounting for Compensated Absences," if the obligation is attributable to employees' services already rendered, employees' rights to those benefits accumulate or vest, payment of the benefits is probable, and the amount of the benefits can be reasonably estimated. If those four conditions are not met, the employer should account for postemployment benefits when it is probable that a liability has been incurred and the amount can be reasonably estimated in accordance with SFAS 5, "Accounting for Contingencies." If an obligation for postemployment benefits is not accrued in accordance with SFAS 5 or 43 only because the amount cannot be reasonably estimated, the financial statements shall disclose that fact. SFAS 112 is effective for fiscal years beginning after December 15, 1993. Generally, the Association does not provide benefits to its former or inactive employees after employment but before retirement. Therefore, SFAS 112 is expected to have minimal impact on the Company. At the urging of the auditing profession, the Securities and Exchange Commission, bank regulators, and some preparers of financial statements, in 1986, the FASB added the financial instruments project to its agenda in order to address numerous questions resulting from the use of innovative financial instruments. Thus far, the project has resulted in the issuance of four Statements of Financial Accounting Standards: SFAS 105, "Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk," issued in March 1990, SFAS 107, "Disclosures about Fair Value of Financial Instruments," issued in December 1991, SFAS 114, "Accounting by Creditors for Impairment of a Loan," and SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities." Both SFAS 114 and SFAS 115, issued in May 1993, are discussed below. The Company has previously implemented SFAS 105 and SFAS 107. As a part of this project, the FASB has also issued two Discussion Memorandums, "Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both" in August 1990 and "Recognition and Measurement of Financial Instruments" in November 1991. SFAS 114 addresses the accounting by creditors for impairment of certain loans. It is applicable to all creditors and to all loans, uncollateralized as well as collateralized, except large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment, loans that are measured at fair value or at the lower of cost or fair value, leases, and debt securities as defined in SFAS 115. It applies to all loans that are restructured in a troubled debt restructuring involving a modification of terms. SFAS 114 requires that impaired loans that are within its scope be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. SFAS 114 amends SFAS 5, "Accounting for Contingencies," to clarify that a creditor should evaluate the collectibility of both contractual interest and contractual principal of all receivables when assessing the need for a loss accrual. SFAS 114 also amends SFAS 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings," to require a creditor to measure all loans that are restructured in a troubled debt restructuring involving a modification of terms in accordance with SFAS 114. SFAS 114 applies to financial statements for fiscal years beginning after December 15, 1994. Earlier application is encouraged. Management implemented SFAS 114 for the year ended December 31, 1993. Since the Company was previously in compliance with SFAS 114, the statement did not impact the Company's results of operations or financial condition. SFAS 115 addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows: . Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. . Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. . Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity. SFAS 115 does not apply to unsecuritized loans. However, after mortgage loans are converted to mortgage-backed securities, they are subject to its provisions. SFAS 115 supersedes SFAS 12, "Accounting for Certain Marketable Securities," and related Interpretations and amends SFAS 65, "Accounting for Certain Mortgage Banking Activities," to eliminate mortgage-backed securities from its scope. SFAS 115 is effective for fiscal years beginning after December 15, 1993. It is to be initially applied as of the beginning of an enterprise's fiscal year and cannot be applied retroactively to prior years' financial statements. However, an enterprise may elect to initially apply SFAS 115 as of the end of an earlier fiscal year for which annual financial statements have not previously been issued. Correspondingly, the Company adopted SFAS 115 as of the end of the year ended December 31, 1993. As a result, unrealized gains of $9.5 million, net of tax effect, were recognized in stockholders' equity and increased the Association's core capital by 22 basis points. On June 30, 1993, the FASB issued a proposed Statement of Financial Accounting Standards, "Accounting for Stock-based Compensation" (the proposed Statement). The proposed Statement would establish financial accounting and reporting standards for stock-based compensation paid to employees. It would supersede APB Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees." The proposed requirements also would apply to other transactions in which equity instruments are issued to suppliers of goods or services. The proposed Statement would require recognition of compensation cost for the fair value of stock-based compensation paid to employees for their services. Although this proposed Statement would apply to all forms of stock-based compensation, its most notable effect would be to significantly reduce the anomalous results of the current accounting for fixed and performance stock options under APB 25. Performance stock options usually are less valuable than fixed stock options, but application of the requirements of APB 25 typically results in recognition of compensation cost for performance stock options and none for fixed stock options. The proposed Statement would recognize the fair value of an award of equity instruments to employees as additional equity at the date the award is granted. Amounts attributable to future service would be recognized as an asset, prepaid compensation, and would be amortized ratably over the period(s) that the related employee services are rendered. If an award is for past services, the related compensation cost would be recognized in the period in which the award is granted. The final measurement date for equity instruments granted to employees as compensation is the date at which the stock price that enters into the measurement of the transaction is fixed. Stock price changes after that date have no effect on measuring the value of the equity instrument issued or the related compensation cost. This proposed Statement would require that restricted stock, stock options, and other equity instruments issued to employees as compensation, and the related compensation cost, be measured based on the stock price at the date an award is granted. Accounting for the cost of employees services is based on the value of compensation paid, which is presumed to be a measure of the value of services received. Accordingly, the compensation cost stemming from employee stock options is measured based on the fair value of stock options granted. This proposed Statement would require that the fair value of a stock option (or its equivalent) granted by a public entity be estimated using a pricing model, such as the Black-Scholes or binomial option-pricing models, that takes into account the exercise price and expected term of the option, the current price of the underlying stock, its expected volatility, the expected dividend yield on the stock, and the risk-free interest rate during the expected term of the option. The proposed requirements provide for reducing the estimated value of employees stock options below that produced by an option-pricing model for nonforfeitable, tradable options issued to third parties. Under this proposed Statement, the value of an employee stock option that does not vest is zero, and the value of an employee stock option that does vest is based on the length of time it remains outstanding rather than on the maximum term of the option, which may be considerably longer. The proposed Statement has two effective dates. Its disclosure provisions would be effective for years beginning after December 31, 1993. Pro forma disclosure of the effects on net income and earnings per share of recognizing compensation cost for awards granted after December 31, 1993 would be required. The recognition provisions would be effective for awards granted after December 31, 1996. Until the FASB has issued a final Statement, management cannot determine the impact that implementation of such final Statement would have on the results of operations or financial condition of the Company. On November 22, 1993, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position 93-6 (SOP 93-6), "Employers' Accounting for Employee Stock Ownership Plans." This SOP supersedes AICPA SOP 76-3, "Accounting Practices for Certain Employee Stock Ownership Plans," which was issued in December 1976. SOP 93-6 applies to all employers with ESOPs, both leveraged and nonleveraged and requires the following: . Employers should report the issuance of new shares or the sale of treasury shares to the ESOP when the issuance or sale occurs and should report a corresponding charge to unearned ESOP shares, a contra-equity account. . For ESOP shares committed to be released in a period to compensate employees directly, employers should recognize compensation cost equal to the fair value of the shares committed to be released. . For ESOP shares committed to be released in a period to settle or fund liabilities for other employee benefits, such as an employer's match of employees' 401(k) contributions or an employer's obligation under a formula profit-sharing plan, employers should report satisfaction of the liabilities when the shares are committed to be released to settle the liabilities. Compensation cost and liabilities associated with providing such benefits to employees should be recognized the way they would be if an ESOP had not been used to fund the benefit. . For ESOP shares committed to be released to replace dividends on allocated shares used for debt service, employers should report satisfaction of the liability to pay dividends when the shares are committed to be released for that purpose. . Employers should credit unearned ESOP shares as the shares are committed to be released based on the cost of the shares to the ESOP. The difference between the fair value of the shares committed to be released and the cost of those shares to the ESOP should be charged or credited to additional paid-in capital. . Employers should charge dividends on allocated ESOP shares to retained earnings. Employers should report dividends on unallocated shares as a reduction of debt or accrued interest or as compensation cost, depending on whether the dividends are used for debt service or paid to participants. . Employers should report redemptions of ESOP shares as purchases of treasury stock. . Employers should report loans from outside lenders to ESOPs as liabilities in their balance sheets and should report interest cost on the debt. Employers with internally leveraged ESOPs should not report the loan receivable from the ESOP as an asset and should not report the ESOP's debt from the employer as a liability. . For earnings-per-share (EPS) computations, ESOP shares that have been committed to be released should be considered outstanding. ESOP shares that have not been committed to be released should not be considered outstanding. SOP 93-6, although it does not change the existing accounting for nonleveraged ESOPs, contains guidance for nonleveraged ESOPs. SOP 93-6 also addresses issues concerning pension reversion ESOPs, ESOPs that hold convertible preferred stock, and terminations, as well as issues related to accounting for income taxes. SOP 93-6 also contains disclosure requirements for all employers with ESOPs, including those that account for ESOP shares under the grandfathering provisions. SOP 93-6 is effective for fiscal years beginning after December 15, 1993. Employers are required to apply the provisions of SOP 93-6 to shares purchased by ESOPs after December 31, 1992, that have not been committed to be released as of the beginning of the year of adoption. Employers are permitted, but not required, to apply the provisions of ESOP 93-6 to shares purchased by ESOPs on or before December 31, 1992, that have not been committed to be released as of the beginning of the year of adoption. The Company adopted SOP 93-6 as of January 1, 1994. On March 31, 1993, the Accounting Standards Executive Committee of the AICPA issued a proposed statement of position (SOP) which would require all reporting entities (including business enterprises, non-for-profit organizations, and state and local governments) that prepare financial statements in conformity with generally accepted accounting principles to include in their financial statements disclosures about the nature of their operations and use of estimates in the preparation of financial statements. In addition, if specified disclosure criteria are met, it would require such entities to include in their financial statements disclosures about certain significant estimates, current vulnerability due to concentrations, and financial flexibility. The provisions of this proposed SOP would be effective for financial statements issued for fiscal years ending after December 15, 1994, and for financial statements for interim periods in fiscal years subsequent to the year for which the proposed SOP is first applied. Early application is encouraged but not required. Since the proposed SOP is a disclosure document only, the final SOP, if issued as proposed, would have no impact on the Company's results of operations or financial position. CONSOLIDATED AVERAGE BALANCE SHEETS The following tables reflect the Company's consolidated average balance sheets for the periods indicated as well as interest income and expense and average rates earned and paid on each major category of interest-earning assets and interest-bearing liabilities. Average balances are calculated predominantly on a daily basis. Average balances of loans include non-accrual loans. The interest rate spread is calculated as the average rate earned on total interest-earning assets less the average rate paid on total interest-bearing liabilities. The interest rate margin is calculated by dividing net interest income by total interest-earning assets. CONSOLIDATED RATE/VOLUME TABLES The following tables present the degree to which changes in the Association's interest income, interest expense, and net interest income are due to changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities. The change due to average balance or volume is computed by multiplying the change in the average balance of funds employed in the current period by the interest rate for the prior period. The change due to average rate is computed by multiplying the change in interest rates by the average balance of funds in the prior period. The change due to rate/volume is computed by multiplying the change in the average balance by the change in the interest rate. The change due to timing results from the difference in the length of the reporting periods. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA MANAGEMENT'S REPORT To the Stockholders: Financial Statements The management of Northeast Federal Corp. (the Company) is responsible for the preparation, integrity, and fair presentation of its published financial statements and all other information presented in this annual report. The financial statements have been prepared in accordance with generally accepted accounting principles and, as such, include amounts based on informed judgments and estimates made by management. The financial statements have been audited by an independent accounting firm, which was given unrestricted access to all financial records and related data, including minutes of all meetings of stockholders, the board of directors and committees of the board. Management believes that all representations made to the independent auditors during their audit were valid and appropriate. The independent auditors' report is presented on page 93. Internal Control Management is responsible for establishing and maintaining an effective internal control structure over financial reporting presented in conformity with both generally accepted accounting principles and, as pertaining to Northeast Savings, F.A., the Office of Thrift Supervision Instructions for Thrift Financial Reports (TFR instructions). The structure contains monitoring mechanisms, and actions are taken to correct deficiencies identified. There are inherent limitations in the effectiveness of any structure of internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even an effective internal control structure can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of an internal control structure may vary over time. Management assessed the institution's internal control structure over financial reporting presented in conformity with both generally accepted accounting principles and TFR instructions as of December 31, 1993. This assessment was based on criteria for effective internal control over financial reporting described in "Internal Control-Integrated Framework," issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that the Company maintained an effective internal control structure over financial reporting presented in conformity with both generally accepted accounting principles and TFR instructions, as of December 31, 1993. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of the Company's management; it includes members with banking or related management experience, has access to its own outside counsel, and does not include any large customers of the institution. The Audit Committee is responsible for recommending to the Board of Directors the selection of independent auditors. It meets periodically with management, the independent auditors, and the internal auditors to ensure that they are carrying out their responsibilities. The Committee is also responsible for performing an oversight role by reviewing and monitoring the financial accounting and auditing procedures of the Company in addition to reviewing the Company's financial reports. The independent auditors and the internal auditors have full and free access to the Audit Committee, with or without the presence of management, to discuss the adequacy of the internal control structure for financial reporting and any other matters which they believe should be brought to the attention of the Committee. MANAGEMENT'S REPORT (CONTINUED) Compliance with Laws and Regulations Management is also responsible for ensuring compliance with the federal laws and regulations concerning loans to insiders and the federal and state laws and regulations concerning dividend restrictions, both of which are designated by the FDIC as safety and soundness standards. Management assessed its compliance with the designated safety and soundness laws and regulations and has maintained records of its determinations and assessments as required by the FDIC. Based on this assessment, management believes that the Company has complied, in all material respects, with the designated safety and soundness laws and regulations for the year ended December 31, 1993. /s/ Kirk W. Walters - ------------------------------------- January 21, 1994 Kirk W. Walters President and Chief Executive Officer /s/ Lynne M. Carcia - ------------------------------------- January 21, 1994 Lynne M. Carcia Controller and Chief Accounting Officer REPORT OF INDEPENDENT ACCOUNTANTS The Board of Directors and Stockholders of Northeast Federal Corp.: We have audited the accompanying consolidated statement of financial condition of Northeast Federal Corp. and subsidiaries (the Company) as of December 31, 1993, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Northeast Federal Corp. and subsidiaries at December 31, 1993 and the consolidated results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. As described in Note 1, the Company changed its method of accounting for securities as of December 31, 1993. Deloitte & Touche Hartford, Connecticut January 21, 1994 (February 9, 1994 as to Note 26) REPORT OF INDEPENDENT ACCOUNTANTS The Board of Directors and Stockholders of Northeast Federal Corp. We have audited the accompanying consolidated statements of financial condition of Northeast Federal Corp. as of December 31 and March 31, 1992, and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the nine months ended December 31, 1992 and each of the two years in the period ended March 31, 1992. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Northeast Federal Corp. as of December 31 and March 31, 1992 and the consolidated results of its operations and its cash flows for the nine months ended December 31, 1992 and each of the two years in the period ended March 31, 1992 in conformity with generally accepted accounting principles. As discussed in Note 1 to the Consolidated Financial Statements, the Company changed its method of accounting for income taxes for the fiscal year ended March 31, 1992. Coopers & Lybrand Hartford, Connecticut January 18, 1993 NORTHEAST FEDERAL CORP. CONSOLIDATED STATEMENT OF OPERATIONS (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) See accompanying Notes to the Consolidated Financial Statements NORTHEAST FEDERAL CORP. CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (IN THOUSANDS EXCEPT SHARE AMOUNTS) See accompanying Notes to the Consolidated Financial Statements NORTHEAST FEDERAL CORP. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS) *Changes during the year ended December 31, 1993 reflect the Company's implementation of SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities." See accompanying Notes to the Consolidated Financial Statements NORTHEAST FEDERAL CORP. CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) See accompanying Notes to the Consolidated Financial Statements NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The accompanying consolidated financial statements include the accounts of Northeast Federal Corp. and its wholly-owned subsidiary, Northeast Savings, F.A. All significant intercompany balances and transactions have been eliminated in consolidation. Certain reclassifications have been made to prior years' financial statements to conform to the 1993 presentation. Cash and Cash Equivalents For purposes of the Consolidated Statement of Cash Flows, cash and due from banks, interest-bearing deposits with original maturities of ninety days or less, and federal funds sold are considered as cash and cash equivalents. Federal Reserve Board regulations require the Association to maintain non- interest-bearing reserves against certain of its transaction accounts. For total transaction account deposits of $51.9 million or less, regulations require a reserve of 3%. For total transaction account deposits in excess of $51.9 million, a 10% reserve is required. Securities Purchased Under Agreements to Resell The Association invests in securities purchased under agreements to resell (repurchase agreements) for short-term cash management. The Association takes physical possession of the collateral for these agreements, which normally consists of U.S. Treasury securities, collateralized mortgage obligations, or mortgage-backed securities guaranteed by agencies of the U.S. government. Investment Securities Investment securities include U.S. Government, agency, and corporate bonds, collateralized mortgage obligations, and asset-backed securities. Those securities which management has the intent and ability to hold until maturity are classified as held-to-maturity and are carried at amortized cost, adjusted for amortization of premiums and accretion of discounts into interest income using the level-yield method. Premiums are amortized to the earlier of the call or maturity date and discounts are accreted to the maturity date. Investment securities which have been identified as assets for which there is not a positive intent to hold to maturity, including all marketable equity securities, are classified as available-for-sale. SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities," requires that available- for-sale securities be reported at fair value with unrealized gains and losses excluded from earnings and reported in a separate component of stockholders' equity. The Company implemented SFAS 115 as of December 31, 1993. SFAS 115 may not be applied retroactively. Gains and losses on sales of investment securities are computed on a specific identification cost basis. Investment securities which have experienced an other than temporary decline are written down to fair value as a new cost basis with the amount of the writedown included in earnings as a realized loss. The new cost basis is not changed for subsequent recoveries in fair value. Factors which management considers in determining whether an impairment in value of an investment is other than temporary include the issuer's financial performance and near term prospects, the financial conditions and prospects of the issuer's geographic region and industry, and recoveries in market value subsequent to the balance sheet date. Mortgage-Backed Securities Mortgage-backed securities which management has the intent and ability to hold until maturity are classified as held-to-maturity, and are carried at amortized cost, adjusted for premiums and discounts which NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) are amortized or accreted into interest income using the level-yield method over the remaining contractual life of the securities, adjusted for actual prepayments. Mortgage-backed securities for which there is not a positive intent to hold to maturity are classified as available-for-sale. As indicated above, SFAS 115, implemented by the Company as of the end of the year ended December 31, 1993, requires that available-for-sale securities be reported at fair value with unrealized gains and losses excluded from earnings and reported in a separate component of stockholders' equity. Gains and losses on sales of mortgage-backed securities are computed on a specific identification cost basis. Loans Loans are generally recorded at the contractual amounts owed by borrowers, less unearned discounts, deferred origination fees, the undisbursed portion of any loans in process, and the allowance for loan losses. Interest on loans is credited to income as earned to the extent it is deemed collectible. Discounts on loans purchased are accreted into interest income using the level-yield method over the contractual lives of the loans, adjusted for actual prepayments. Single-family residential real estate loans that were originated with the intent to sell in the secondary mortgage market or those loans which have been identified as assets for which there is not a positive intent to hold to maturity are classified as available-for-sale and carried at the lower of cost or fair value. The amount by which the aggregate cost of loans available-for- sale exceeds market value is charged to gain (loss) on sale of loans, net. The Company adopted SFAS 114, "Accounting by Creditors for Impairment of a Loan," as of January 1, 1993. Loans which are identified for evaluation and which are deemed to be impaired under the guidance of SFAS 114 are measured at the fair value of the collateral. Substantially all of the Association's loans are collateral dependent. If the fair value of the collateral is less than the recorded investment in the loan, the allowance for loan losses is adjusted with a corresponding charge to the provision for loan losses. The fair value of the collateral, based on a current appraisal, often changes from one reporting period to the next. If the fair value of the collateral decreases, such decrease is reported as a charge to the provision for loan losses. If the fair value increases, the provision for loan losses is reduced. Impaired loans are included in nonperforming assets as non-accrual loans or troubled debt restructurings, as appropriate. The Company had previously measured loan impairment pursuant to the methods prescribed in SFAS 114. As a result, no additional reserves were required by early adoption of the pronouncement. Loan Fees Loan origination fees, commitment fees, and certain direct loan origination costs are deferred and recognized over the lives of the related loans as an adjustment of the loans' yields using the level-yield method. Calculation of the level-yield is based upon weighted average contractual payment terms which are adjusted for actual prepayments. Amortization of deferred fees is discontinued for non-accrual loans. Loans Serviced for Others Northeast Savings services real estate and consumer loans for others which are not included in the accompanying consolidated financial statements. Fees earned for servicing loans owned by others are reported as income when the related mortgage loan payments are collected. Loan servicing costs are charged to expense as incurred. Costs associated with acquiring the right to service certain loans are capitalized and amortized in proportion to and deducted from the estimated future net servicing income. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Prior to 1986, the Association sold certain loans with limited recourse requirements. In addition, in the normal course of business, loans are sold to various agencies which have recourse on standard documentation representations and warranties. Such loans are included in loans serviced for others. Estimated probable loan losses and related costs of collection and repossession are provided for at the time of such sales and are periodically reevaluated. The Company evaluates the credit risk of loans sold with recourse in conjunction with its evaluation of the adequacy of allowance for loan losses. Allowance for Loan Losses The allowance for loan losses is established and maintained through a periodic review and evaluation of various factors which affect the loans' collectibility and results in provisions for loan losses which are charged to expense. Numerous factors are considered in the evaluation, including a review of certain borrowers' current financial status, credit standing, available collateral, management's judgment regarding economic conditions, the impact of those conditions on property values, historical loan loss experience in relation to outstanding loans, the diversification and size of the loan portfolio, the results of the most recent regulatory examinations available to the Association, the overall loan portfolio quality, and other relevant factors. Non-Accrual Loans Interest accruals on loans are normally discontinued and previously accrued interest is reversed whenever the payment of interest or principal is more than 90 days past due, or earlier when conditions warrant it. A non-accrual loan may be restored to an accrual basis when principal and interest payments are current and full payment of principal and interest is expected. Real Estate and Other Assets Acquired in Settlement of Loans Real estate and other assets acquired in settlement of loans is recorded at the lower of the recorded investment in the loan or fair value minus estimated costs to sell. The lower of the recorded investment in the loan or fair value less estimated costs to sell becomes the new cost basis for REO. Any excess of the recorded investment over the fair value less estimated costs to sell is charged off. Subsequent valuations of REO are at the lower of the new cost basis or fair value less estimated costs to sell. Premises and Equipment Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the respective lease terms or the estimated useful life, whichever is shorter. Interest Rate Swap Agreements Northeast Savings is a party to interest rate swap agreements in managing its interest rate exposure. The net amounts received or paid in accordance with the interest rate swap agreements are charged or credited to interest expense on other borrowings. Generally, gains and losses on terminated interest rate swap agreements are amortized over the lesser of the remaining terms of the agreements or the remaining lives of the assets or liabilities hedged. Pension Plan Pension costs are funded on a current basis in compliance with the requirements of the Employee Retirement Income Security Act and are accounted for in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions." NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Retirement Benefits Other Than Pensions SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," focuses principally on postretirement health care benefits and significantly changed the practice of accounting for postretirement benefits on a pay-as-you-go (cash) basis by requiring accrual of the expected cost of providing those benefits to an employee and the employee's beneficiaries and covered dependents during the years that the employee renders the necessary service. SFAS 106 became effective for the Association in 1993. The Company implemented SFAS 106 during the quarter ended March 31, 1993 and is amortizing the estimated $444,000 expense over the twelve year life expectancy of the participants. Income Taxes Northeast Federal Corp. and subsidiaries file a federal consolidated income tax return. In February 1992, the FASB issued SFAS 109, "Accounting For Income Taxes," which requires an asset and liability approach for financial accounting and reporting for income taxes. One requirement of SFAS 109 is that the tax benefit related to acquired deductible temporary differences and pre- acquisition net operating loss carryforwards shall first be applied to reduce to zero goodwill related to that acquisition. Accordingly, goodwill has been reduced as a result of the tax benefits related to these items. The Company elected to adopt SFAS 109 effective April 1, 1991. The effect of initially applying the new standard was reported as the effect of a change in accounting principle. The cumulative effect of this change is reported separately in the Consolidated Statement of Operations for the year ended March 31, 1992. As required, first, second, and third quarters of the year ended March 31, 1992 were restated for the effect of this change. Income (Loss) Per Common Share Income (loss) per common share is based on the weighted average number of common shares outstanding and (if dilutive) common stock equivalents (i.e., stock options and warrants) outstanding in each year. The 8% Convertible Subordinated Debentures do not meet the criteria for a common stock equivalent. Income (loss) per common share has been restated to give effect to the two 2% common stock dividends declared in fiscal 1990. Net income (loss) applicable to common stockholders and income (loss) per common share are calculated after deducting preferred stock dividend requirements which include $4,652,000 and $8,506,000 of accumulated and unpaid preferred dividends for the nine-month period ended December 31, 1992 and the year ended March 31, 1992, respectively. There were no accumulated and unpaid preferred dividends at December 31, 1993. Accumulated and unpaid dividends totaled $12,802,000 and $19,364,000 at December 31, 1992 and March 31, 1992, respectively. On May 8, 1992, $11.2 million of accumulated and unpaid dividends were eliminated as a result of the Company's repurchase of its adjustable rate preferred stock plus accumulated dividends from the FRF administered by the FDIC. On May 14, 1993, $12.2 million of accumulated and unpaid dividends were eliminated as a result of the conversion of 1,610,000 of $2.25 Cumulative Convertible Preferred Stock, Series A into 7,647,500 shares of common stock. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 2: CHANGE IN FISCAL YEAR In July 1992, the Company changed its reporting period from a fiscal year ended March 31 to a calendar year. Accordingly, results of operations for the transition period ended December 31, 1992 cover a nine-month period. The following statements of operations present financial data for the nine months ended December 31, 1993 and the comparable nine months of the prior years. These statements are for comparative purposes only. NORTHEAST FEDERAL CORP. CONSOLIDATED STATEMENT OF OPERATIONS (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 3: SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION For purposes of the Consolidated Statement of Cash Flows, cash and due from banks, interest-bearing deposits with original maturities of ninety days or less, and federal funds sold are considered as cash and cash equivalents. NOTE 4: SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL The securities purchased under agreements to resell at December 31, 1993 were collateralized by federal agency mortgage-backed securities. There were no securities purchased under agreements to resell at December 31, 1992. The following table provides additional information on the agreements. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) At December 31, 1993, the Association held only securities purchased under agreements to resell identical securities. The securities underlying the agreements were physically held by the Association until the maturity of the agreements. NOTE 5: INVESTMENT SECURITIES Investment securities consisted of the following: At December 31, 1993, the net unrealized holding gain, net of tax effect, on available-for-sale securities that was included in the separate component of stockholders' equity was $8,978,000 exclusive of mortgage-backed securities available-for-sale. Proceeds, gains, and losses from sales of investment securities were as follows: - -------- * Sales were due to credit concerns. For the periods ended December 31, 1993 and 1992, gains and losses on investment securities which management has the positive intent and ability to hold until maturity resulted primarily from the recognition NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) of realized capital gains and losses allocated to the Association by two limited partnerships in which the Association has invested. In addition, for the year ended March 31, 1992, $5.8 million of these losses resulted from sales of corporate debt securities due to credit concerns. The weighted average interest yields on investment securities were 5.13% and 6.09% at December 31, 1993 and 1992, respectively. Accrued interest and dividends receivable related to investment securities outstanding at December 31, 1993 and 1992 were $1,680,000 and $1,718,000, respectively. The contractual maturities of Northeast Savings' held-to-maturity investment securities are summarized in the following table. Actual maturities may differ from contractual maturities because certain issuers have the right to call or prepay obligations with or without call premiums. The contractual maturities of the Association's available-for-sale investment securities are summarized below. Actual maturities may differ from contractual maturities because certain issues have the right to call or prepay obligations with or without call premiums. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 6: MORTGAGE-BACKED SECURITIES Mortgage-backed securities consisted of the following: At December 31, 1993, the net unrealized holding gain on available-for-sale mortgage-backed securities that was included in the separate section of stockholders' equity was $484,000, net of tax effect, exclusive of investment securities available-for-sale. Proceeds, gains, and losses from sales of mortgage-backed securities were as follows: Included in results of operations for the year ended March 31, 1992 are gains of approximately $107,000 on sales of mortgage-backed securities acquired in savings and loan association acquisitions accounted for under the purchase method of accounting. The weighted average yields on mortgage-backed securities were 5.30% and 6.27% at December 31, 1993 and 1992, respectively. Accrued interest receivable related to mortgage-backed securities outstanding at December 31, 1993 and 1992 was $6,783,000, and $5,597,000, respectively. At December 31, 1993, mortgage-backed securities having a carrying value of $306,344,000 and a market value of $308,839,000 were pledged to collateralize securities sold under agreements to repurchase and other items. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 7: LOANS The Association's primary lending business is the origination of single- family residential mortgage loans in the northeastern United States and Colorado. These loans are collateralized by residential properties and are made with strict adherence to Association policy which limits the loan-to-value ratio on residential mortgage loans to 80%, or 95% with private mortgage insurance. In certain geographic areas of the country, the Association has limited the loan-to-value ratio to even less than 80%. Loans consisted of the following: Accrued interest receivable related to loans outstanding at December 31, 1993 and 1992 was $9,076,000 and $12,652,000, respectively. For the year ended December 31, 1993, the nine months ended December 31, 1992 and the year ended March 31, 1992, the Association recognized net gains on sales of loans of $1,939,000, $1,870,000 and $2,532,000, respectively. At December 31, 1993, the recorded investment in loans for which impairment has been recognized under the guidance of SFAS 114 totaled $1.6 million. There was no specific reserve on these loans at December 31, 1993. However, their impairment was considered in the allowance for loan losses at December 31, 1993. Such loans are included in non-accrual loans (see below) or troubled debt restructurings, as appropriate. At December 31, 1993 and 1992, loans totaling $67,462,000 and $94,989,000, respectively, were contractually delinquent ninety days or more. Interest accruals on loans are discontinued whenever the payment of interest or principal is more than 90 days past due or earlier when conditions warrant it and any previously accrued interest is reversed. The total interest income that would have been recorded for the year ended December 31, 1993, had these loans been current in accordance with their original terms, or since the date of origination if outstanding for only part of the year, was $4,810,000. The amount of interest income which was included in net income for the year ended December 31, 1993 on those loans was $1,341,000. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table summarizes the Association's gross loan portfolio and non-accrual loans as a percentage of gross loans by state and property type at December 31, 1993: The level of single-family residential non-accrual loans is due primarily to continuing poor general economic conditions in the Association's primary market areas, particularly the recessions in New England and California. Loans serviced for others by Northeast Savings totaled approximately $1,888,863,000 and $1,783,365,000 at December 31, 1993 and 1992, respectively, which includes loans serviced with recourse to Northeast Savings of $69,124,000 and $6,371,000 at the same respective dates. In connection with loans serviced for others, at December 31, 1993 and 1992, respectively, Northeast Savings had $3,623,000 and $4,389,000 in excess servicing assets and $5,794,000 and $7,903,000 in capitalized purchased mortgage servicing. Loan servicing fees totaled $2,627,000, $793,000, and $4,928,000 for the year ended December 31, 1993, the nine months ended December 31, 1992 and the year ended March 31, 1992, respectively. The following summarizes activity in the allowance for loan losses. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 8: RHODE ISLAND COVERED ASSETS As discussed in Note 23: Acquisitions, on May 8, 1992, the Association acquired certain assets of four Rhode Island financial institutions which were in receivership proceedings. The Association is protected against losses relative to all loans acquired from the institutions, including loans foreclosed upon by the Association subsequent to acquisition. Accordingly, as discussed below, these covered assets have been segregated from the Association's remaining portfolios of loans and REO. At December 31, 1993, total Rhode Island covered assets and non-accrual Rhode Island covered assets as a percentage of gross covered assets were as follows: In the above table, the principal balance of individual loans for which a specific credit adjustment has been determined by independent valuators has been reduced by the amount of that credit adjustment. The unallocated credit adjustment represents amounts applied to pools of loans. In connection with the acquisition of the Rhode Island assets, the Association entered into an Acquisition Agreement with the receivers of the Rhode Island financial institutions. Pursuant to this agreement, DEPCO was required to pay a balancing consideration to the Association. The balancing consideration was the amount by which the deposits issued by the Association plus other assumed liabilities NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) exceeded the fair value of the acquired assets. The estimate of the fair value of the acquired assets (the valuation) was determined by independent valuators in accordance with a detailed methodology outlined in the Acquisition Agreement. The balancing consideration of $59.0 million was paid to the Association in the quarter ended December 31, 1992. As part of the valuation process in determining the balancing consideration, a credit adjustment was made which was specifically related to the Rhode Island covered assets and which was intended to establish the amount by which the value of the loans must be adjusted in determining their fair value for reasons of collectibility. This initial credit adjustment was determined by the valuators pursuant to the methodology for credit adjustments set forth in the Acquisition Agreement. The methodology required the reappraisal of underlying collateral and/or an individual evaluation of loans meeting specific delinquency and/or size criteria as well as the application of credit adjustment percentages to loans which were not individually reviewed. In general, for purposes of loan valuation, residential and consumer loans were valued in pools and commercial loans were valued individually. With the exception of certain adjustable rate consumer, commercial, and delinquent loans, all acquired loans were also subject to an interest rate adjustment in order to adjust the yield on those loans to a market rate of interest as of the closing date. Subsequent to the initial valuation and payment of the balancing consideration, the credit adjustment account will be adjusted for all charge- offs and recoveries on acquired loans and gains and losses from the disposition of assets received in lieu of repayment which occur prior to the seventh anniversary of the closing date, at which time the remaining balance in the credit adjustment account will be reevaluated for adequacy and adjusted accordingly, utilizing the same criteria as the initial valuation methodology. On the seventh anniversary, if there is a negative balance in the credit adjustment account, the Association can claim the amount of such balance from an escrow established by DEPCO. To the extent escrow funds are not available, DEPCO is required to pay the amount of any negative remaining balance to the Company. Conversely, if there is a positive balance in the credit adjustment account, Northeast Savings will be required to pay that balance to DEPCO. The terms of the Acquisition Agreement also provide the Association with the right to put back loans to DEPCO for a period of one year from the date of acquisition if the Association determines that the property securing any loan has an environmentally hazardous condition. In addition, for a period of seven years, Northeast Savings is indemnified against losses resulting from environmentally hazardous materials deposited on the security property prior to the closing date, as well as against losses suffered on account of breaches in the representations and warranties provided by the receivers and DEPCO with regard to the acquired assets. Northeast Savings is also indemnified against claims, damages, losses, costs, and expenses that may arise from a variety of conditions related to the acquisition including claims against the former institutions, their officers, agents, or employees. As security for the obligations of DEPCO to pay the balancing consideration, to repurchase certain loans, and to indemnify the Association for certain matters, DEPCO placed $59 million in treasury securities in escrow and granted to the Association a first priority security interest in such funds. Of such $59 million, $49 million was essentially placed in escrow for a one-year period to cover the balancing consideration and the repurchase of loans based on environmentally hazardous conditions. The remaining $10 million is in a seven-year escrow to cover the general indemnification obligations and the credit adjustment obligation. As of December 31, 1992, the $49 million in the one-year escrow account had been used totally in connection with payment of the $59 million balancing consideration. The seven-year escrow retains its $10 million. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 9: REAL ESTATE AND OTHER ASSETS ACQUIRED IN SETTLEMENT OF LOANS The following table presents Northeast Savings' REO by property type at the dates indicated. The activity in the Association's REO is presented in the following table: - -------- * During the quarter ended September 30, 1993, $30.3 million of REO was sold in a single transaction. The total loss on the sale was $6.8 million, including a provision of $6.0 million recorded in June in anticipation of the sale. Excluding this sale, sales of REO for the year ended December 31, 1993 totaled $52.8 million. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10: PREMISES AND EQUIPMENT Premises and equipment consisted of the following: At December 31, 1993, Northeast Savings was obligated under various non- cancelable leases for premises and equipment. The leases generally contain renewal options and escalation clauses providing for increased rent expense in future periods. Rent expense for the year ended December 31, 1993, the nine months ended December 31, 1992 and the year ended March 31, 1992 was $7,717,000, $5,440,000 and $6,681,000, respectively. Northeast Savings leases certain office space for its headquarters and three of its branch banking offices from corporations or partnerships in which Directors of the Company or their immediate families are the principal beneficial owners. The leases were entered into either prior to the nomination and election to the position of director or with the written approval of the Association's OTS District Director. Virtually all lease terms end by 1996 and rents paid for such leases were $3,319,000 for the year ended December 31, 1993, $2,555,000 for the nine months ended December 31, 1992, and $3,426,000 for the year ended March 31, 1992. All future minimum rental payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year at December 31, 1993 are as follows: In February 1992, the Association purchased an office building for $9.6 million in cash in Farmington, Connecticut and leased it back to the previous owners until 1994. Management anticipates moving a significant portion of the Association's operations to that facility in 1995. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 11: DEPOSITS Deposits consisted of the following: At both December 31, 1993 and 1992, certificates include brokered deposits of approximately $25,135,000. Included in deposits is accrued interest payable of $1,965,000 and $3,043,000 at December 31, 1993 and 1992, respectively. Interest expense on deposits consisted of the following: NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 12: FEDERAL HOME LOAN BANK ADVANCES AND OTHER BORROWINGS FHLB advances and other borrowings are summarized as follows: Federal Home Loan Bank Advances FHLB advances consisted of the following: At December 31, 1993, all of the outstanding advances were fixed rate advances. Accrued interest payable on advances outstanding at December 31, 1993 and 1992 was $1,135,000 and $485,000, respectively. At December 31, 1993, Northeast Savings' ability to borrow from the Federal Home Loan Bank of Boston under its Advances Program was limited to the value of qualified collateral that had not been pledged to outside sources. At December 31, 1993, mortgage loans having a carrying value of $568,139,000 and a collateral value of $426,104,000 were pledged to collateralize the above advances. Based on the Federal Home Loan Bank of Boston's Credit Policy, mortgage loans are assigned a collateral value equal to 75% of the current unpaid principal balance. At December 31, 1993, the Association's remaining borrowing capacity from the FHLB totaled $1.8 billion. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Securities Sold Under Agreements to Repurchase Securities sold under agreements to repurchase were wholesale repurchase agreements and consisted of the following: * Book value includes accrued interest of $2,126,000 and $2,441,000 at December 31, 1993 and 1992, respectively. Wholesale repurchase agreements mature or reprice on average every 33 days and were collateralized at December 31, 1993 and 1992 by mortgage-backed securities. All wholesale repurchase agreements were to repurchase the same securities. Securities sold under agreements to repurchase are considered short-term borrowings. The average balance of repurchase agreements outstanding during the year ended December 31, 1993 and the nine months ended December 31, 1992 was $290,112,000 and $153,150,000, respectively. The maximum amount outstanding at any month-end was $311,385,000 for the year ended December 31, 1993 and $330,317,000 for the nine months ended December 31, 1992. Interest expense on repurchase agreements totaled $9,866,000 for the year ended December 31, 1993, $4,111,000 for the nine months ended December 31, 1992, and $12,395,000 for the year ended March 31, 1992, respectively. Accrued interest payable on repurchase agreements outstanding at December 31, 1993 and 1992 was $3,693,000 and $1,384,000, respectively. The weighted average interest rates during the year ended December 31, 1993 and the nine months ended December 31, 1992 were 3.40% and 3.56%, respectively. Uncertificated Debentures In conjunction with the Association's acquisition of $315.0 million in assets from four Rhode Island financial institutions and the issuance of deposit accounts in the Association to depositors in those institutions, the Company issued and sold $28.95 million of 9% Sinking Fund Uncertificated Debentures, due in 2012 to the receivers for the four institutions. These debentures have been transferred from the receivers to certain of the depositors in the Rhode Island institutions in consideration of a portion of their deposit claims against the receiverships. The Company has the right to pay the first five years of interest on the 9% Debentures by the issuance of additional 9% Debentures (a payment in kind). For further information on the Association's acquisition of the Rhode Island institutions, see Note 23: Acquisitions. In addition, in connection with the repurchase of its adjustable rate preferred stock, the Company issued $7.0 million in 9% Debentures to the FRF. The debentures issued to the FRF have a market value of $4.5 million, based on the value attributable to the debentures by the FRF, as determined by its investment bankers. Implicit in the $4.5 million valuation is a discount rate of 14.4%, which was consistent with market yields on high-yield securities at the time. These debentures have the same terms as those transferred to the depositors in the Rhode Island institutions. In meeting its interest obligation on all of the 9% Debentures, NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) the Company has issued an additional $5.0 million of 9% Debentures, which are included in the debentures outstanding at December 31, 1993. For additional information on the Company's repurchase of its adjustable rate preferred stock, and the conversion of its convertible preferred stock into common stock, see Note 13: Stockholders' Equity. Convertible Subordinated Debentures The 8% Convertible Subordinated Debentures were due on February 15, 2011, and were convertible at any time into shares of the Company's common stock at a conversion price of $20.79 per share. The total Debentures originally issued amounted to $57.5 million, of which none were outstanding at December 31, 1993 and $560,000 were outstanding at December 31, 1992. Realized gains, net of income taxes, on the repurchase and retirement of $470,000 of 8% Debentures for the year ended March 31, 1992 are reflected as extraordinary items in the Consolidated Statement of Operations. See Note 17: Extraordinary Items. Other Borrowings Other borrowings, when outstanding, consist of Tax Advantaged Variable Rate ESOP Notes, Series 1987, which were issued by the Association's ESOP and guaranteed by Northeast Savings. Initially, the notes were subject to mandatory redemption through the operation of a sinking fund commencing on the interest payment date originally beginning September 1988 and on each September thereafter to 1997. Effective August 31, 1992, the mandatory redemption of the notes was extended an additional three years. The notes may be redeemed earlier under certain circumstances. The interest rate on the notes at December 31, 1993 and 1992 was 3.40% and 3.98%, respectively. The proceeds of this issue were used by the Association's ESOP to purchase 1,010,326 outstanding shares of the Company's common stock, adjusted for stock dividends. As of December 31, 1993 and 1992, Northeast Savings had invested in the ESOP notes at an amount equal to the principal outstanding, thus acquiring all outstanding notes. Correspondingly, the notes were not reported as other borrowings at either December 31, 1993 or 1992. Mandatory redemptions of the ESOP notes in the amounts of $1,110,000 are due each fiscal year from 1994 through 2000. At December 31, 1993, mortgage-backed securities having a carrying value of $13,846,000 and a market value of $13,800,000 were pledged to collateralize a Letter of Credit supporting the ESOP notes, which honors demands for payment by the Note Trustee presented in accordance with the terms of the Letter of Credit. Also, the Association had an available, but unused, line of credit in the amount of $25,000,000 at December 31, 1993. NOTE 13: STOCKHOLDERS' EQUITY Regulatory Matters The Financial Institutions Reform, Recovery and Enforcement Act of 1989, which was signed into law on August 9, 1989, provided for a comprehensive reorganization of the regulatory structure of the thrift industry. Northeast Savings is required to maintain certain levels of capital in accordance with FIRREA and OTS regulations. In addition, on November 7, 1991, the United States Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991, which became effective on December 19, 1991. While the primary focus of the legislation is to recapitalize the Bank Insurance Fund, FDICIA also adopted numerous mandatory measures which affect all depository institutions, including savings associations such as Northeast Savings, and which are designed to reduce the cost to the deposit funds of resolving problems presented by undercapitalized institutions. The OTS regulations implementing the FIRREA capital standards established three measures of capital compliance: tangible core capital, core capital, and risk-based capital. Associations which failed to meet any NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) of the three capital standards on December 7, 1989, were subject to certain restrictions which included growth restrictions and a limitation on capital distributions. These thrifts were also required to develop and submit to the OTS by January 8, 1990, acceptable capital restoration plans which demonstrate the strategies to be utilized to meet the capital standards. At December 7, 1989, Northeast Savings did not meet the capital standards set forth in FIRREA and the OTS regulations implementing the FIRREA capital standards. Northeast Savings filed its capital restoration plan with the OTS, as required by FIRREA, which was approved and accepted by the OTS on March 9, 1990. On March 23, 1990, the Association accepted the conditions imposed upon it by the OTS approval of its capital plan. Northeast Savings also filed an application to form a holding company, Northeast Federal Corp., which was approved by the OTS on April 16, 1990. The holding company reorganization was completed in July 1990, upon approval of the holders of voting stock of Northeast Savings. Under this reorganization Northeast Savings' capital stock was exchanged for capital stock of Northeast Federal Corp. and the capital of Northeast Federal Corp. was downstreamed to Northeast Savings in the form of common stock which qualified as regulatory capital. At such time, the Association came into compliance with all then-applicable regulatory capital requirements. The Association subsequently met all of the conditions of the capital plan and has been released from it by the OTS. Although Northeast Savings is in compliance with all fully phased-in regulatory capital requirements, the ability of the Company to make capital distributions is restricted by the limited cash resources of the Company and the ability of the Company to receive a dividend from the Association. The Association's payment of dividends is subject to regulatory limitations, particularly the prompt corrective action regulation which prohibits the payment of a dividend if such payment would cause the Association to become undercapitalized. In addition, the Company and the OTS entered into a Dividend Limitation Agreement as part of the holding company approval process which prohibits the payment of dividends to the holding company without prior written OTS approval if the Association's capital is below its fully phased-in capital requirement or if the payment of such dividends would cause its capital to fall below its fully phased-in capital requirement. The OTS Capital Distribution Regulation also restricts the amount of capital distributions that an association may make without obtaining prior OTS approval. Consequently, the Company anticipates that it will not pay any cash dividends on its Series B preferred stock or common stock for the foreseeable future. Due to the restrictions of the Dividend Limitation Agreement and the Capital Distribution Regulation combined with management's decision in 1990 to suspend cash dividend payments in order to preserve capital, management considers that essentially all of the Company's net assets are restricted from dividend payments. The following table reflects the regulatory capital requirements and the Association's regulatory capital. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Conversion to Stock Association On September 22, 1983, Northeast Savings converted from a mutual to a stock association. At the time of the conversion, eligible deposit account holders were granted priority in the event of future liquidation by the establishment of a "liquidation account" equal to net worth at June 30, 1983. No dividends may be paid to stockholders if such dividends reduce stockholders' equity below the amount required for the liquidation account, which was approximately $13.0 million at December 31, 1993. $2.25 Cumulative Convertible Preferred Stock, Series A In October 1985, Northeast Savings issued 1,610,000 shares of $2.25 Cumulative Convertible Preferred Stock, Series A (the convertible preferred stock) at $25 per share, par value $.01 per share which generated net proceeds of $38,341,000. Dividends on the convertible preferred stock were payable quarterly and were cumulative from the date of issue. Each share of the convertible preferred stock was convertible into 1.473 shares of common stock at any time at the conversion price of $16.97. The convertible preferred stock was redeemable at any time, at the option of the Company, at $26.35 per share prior to October 1, 1990 and at prices declining annually thereafter to $25.00 per share on and after October 1, 1995. In February 1990, the Board of Directors suspended the quarterly cash dividend on the convertible preferred stock. At January 1, 1993, accumulated and unpaid quarterly dividends on the convertible preferred stock were $.56 per share or $906,000, while total dividends were $6.75 per share or $10.9 million in the aggregate. On May 7, 1993, at a Special Meeting of Stockholders, the Company's stockholders approved a reclassification of the convertible preferred stock into common stock at a ratio of 4.75 shares of common stock for each share of convertible preferred stock. Effective May 14, 1993, the 1,610,000 shares of convertible preferred stock were converted into 7,647,500 shares of common stock. As a result, all of the powers, privileges and special and relative rights of the convertible preferred stock were eliminated including the then accumulated and unpaid dividends, the liquidation priority, the right, at the option of the holder, to convert each share of convertible preferred stock into 1.473 shares of common stock (and retain the right to receive, when as, and if, declared and paid by the Company, the accumulated and unpaid dividends at the time of such conversion on each such share of convertible preferred stock) and the right to elect two directors to the Company's Board so long as six full quarterly dividends are in arrears. $8.50 Cumulative Preferred Stock, Series B. In connection with the Association's acquisition of assets of four Rhode Island financial institutions, and the issuance of deposit accounts in the Association to depositors in those institutions, the Company issued and sold to the Rhode Island Depositors Economic Protection Corporation, 351,700 shares of a new class of preferred stock, the $8.50 Cumulative Preferred Stock, Series B. Accordingly, the Certificate of Incorporation of the Company was amended by adding a new Certificate of Designation for the Series B preferred stock. The Certificate of Designation authorizes the issuance of a total of 540,000 shares of the Series B preferred stock. Under the Stock and Warrant Purchase Agreement (the Stock Purchase Agreement) entered into with DEPCO in connection with the acquisition, DEPCO has the right to transfer its interest in the Series B preferred stock to another instrumentality or agency of the State of Rhode Island and such entity would be a "Nominee" within the meaning of the Stock Purchase Agreement. On June 24, 1992, the Company was advised by DEPCO that it had transferred its interest in the Series B preferred stock to the Rhode Island State Investment Commission (RISIC). On September 28, 1993, RISIC transferred its interest in the Series B preferred stock to DEPCO. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Certificate of Designation for the Series B preferred stock increases the Company's Board of Directors by two and gives DEPCO or any Nominee as defined in the Stock Purchase Agreement the right to elect two directors so long as DEPCO or a Nominee holds at least 211,020 shares of the Series B preferred stock (one director if DEPCO or the Nominee holds less than that number but at least 105,510 of the Series B preferred stock). Two directors were elected by the RISIC and seated at the meeting of the directors on July 24, 1992. The same two individuals continue to serve as directors. So long as DEPCO or its Nominee beneficially owns the requisite number of shares such that, pursuant to the Series B preferred stock Certificate of Designation, DEPCO or such Nominee is entitled to elect one director of the Company, then, in the event of a change in control of the Company, the Company agrees to and shall, not less than forty-five days after such change in control, make an offer to redeem or repurchase all of the shares of the Series B preferred stock then outstanding at the Redemption Price plus accumulated and unpaid dividends thereon (whether or not declared) through the date fixed for such repurchase. Such repurchase obligation of the Company is limited to the extent the Company has available funds which, in general, are funds of the Company which can be obtained by a permissible dividend from the Association and which are not required for the payment of debt or senior obligations and the payment of which would not violate Delaware law or any regulatory obligation. A Change in Control shall be deemed to have occurred under the terms of the Stock Purchase Agreement in the event that any person acquires the right to vote or dispose of 25% or greater of the Company's then-outstanding common stock or such amount of securities of the Company as shall enable such person to exercise, or acquire securities and thereupon exercise rights to vote 25% or greater of the total outstanding voting rights in the Company or to elect more than 25% of the directors of the Company. Dividends on the Series B preferred stock payable on or prior to July 1, 1997, whether or not paid on or prior to that date shall be paid at the election of the Company in cash or in shares of Series B preferred stock. No dividends or other distribution shall be paid or declared or set aside for the common stock of the Company nor may any shares of common stock be purchased or redeemed by the Company or any subsidiary thereof unless all cumulative dividends on all outstanding shares of the Series B preferred stock have been paid in full to the holders of the shares of Series B preferred stock. On May 21, 1993, the Company's Board of Directors voted to declare a stock dividend payable on July 1, 1993 on the Series B preferred stock of one share of Series B Preferred stock for each $100 of the amount of dividends payable on July 1, 1993 and accumulated and unpaid as of that date, to holders of record on June 14, 1993. On July 1, 1993, the Company paid all then accumulated and payable dividends on the Series B preferred stock, an aggregate of $3.4 million, through the issuance of 34,296 shares of Series B preferred stock. On September 24, 1993, the Company's Board of Directors voted to declare a quarterly stock dividend on the Series B preferred stock payable on October 1, 1993 to holders of record on September 24, 1993. On October 1, 1993, the Company paid $820,000 of dividends payable on the Series B preferred stock through the issuance of an additional 8,203 shares of Series B preferred stock. On December 17, 1993, the Company's Board of Directors voted to declare a quarterly stock dividend on the Series B preferred stock payable on January 1, 1994 to holders of record on December 17, 1993. On January 1, 1994, the Company paid $838,000 of dividends payable on the Series B preferred stock through the issuance of an additional 8,377 shares of Series B preferred stock. The Company also issued to DEPCO a warrant to purchase 600,000 shares of the Company's common stock exercisable at $2.50 per share and a warrant to purchase 200,000 shares of the Company's common stock exercisable at $4.25 per share. These warrants may be exercised by DEPCO (or by any Rhode Island state agency to which DEPCO may transfer the warrants) as to all, but not less than all, of the applicable shares during the period beginning ninety days from the closing date of May 8, 1992 and ending ten years NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) from May 8, 1992. Common stock received by DEPCO upon the exercise of such warrants is restricted as to its sale. During each twelve month period beginning upon the exercise of the warrants and expiring on May 8, 1997, DEPCO is entitled to sell 120,000 shares of common stock acquired from the exercise of the warrants. Adjustable Rate Cumulative Preferred Stock, Series A In March 1987, Northeast Savings issued 1,202,916 shares of Adjustable Rate Cumulative Preferred Stock, Series A, at a stated value of $50 per share, par value $.01 per share, to the FSLIC in exchange for the FSLIC's cancellation of a $50,000,000 income capital certificate and a portion of the related accumulated income payments, the sum of which totaled $60,145,000. When the FSLIC was terminated, the adjustable rate preferred stock was transferred to the FSLIC Resolution Fund which is administered by the FDIC. Dividends on the adjustable rate preferred stock were cumulative and payable quarterly based on the highest of the Treasury Bill Rate, the Ten Year Constant Maturity Rate or the Thirty Year Constant Maturity Rate. The dividend rate at March 31, 1992 was 7.75%. In February 1990, the Board of Directors suspended the quarterly cash dividend on the adjustable rate preferred stock. Thus, the quarterly dividend of $1.2 million or $.97 per share which normally would have been payable April 1, 1992, was not declared by the Board of Directors of the Company and was in arrears at March 31, 1992. At March 31, 1992, total accumulated dividends on the adjustable rate preferred stock were $9.32 per share or $11.2 million. On May 8, 1992, also in conjunction with the aforementioned acquisition of assets of the Rhode Island financial institutions, the Company repurchased the adjustable rate preferred stock plus accumulated dividends from the FSLIC Resolution Fund for $28.0 million in cash and $7.0 million in 9% Sinking Fund Uncertificated Debentures, due 2012 for a total fair value of $32.5 million. The 9% Debentures issued to the FRF had a market value of $4.5 million based on the value attributable to those debentures by the FRF, as determined by its investment banker. Unallocated Employee Stock Ownership Plan Shares In connection with the funding of the ESOP, stockholders' equity has been reduced net of tax to reflect the guarantee of Northeast Savings. See Note 12: Federal Home Loan Bank Advances and Other Borrowings. NOTE 14: EMPLOYEE BENEFIT PLANS Retirement Plan The Retirement Plan for Employees of Northeast Savings, F.A. and Subsidiaries (the Plan) is a defined benefit plan which covers substantially all employees of Northeast Savings. Employees are vested in the Plan after seven years of service and benefits are based on a percentage of each year's compensation. Plan assets are under the control of a trustee and invested in pooled funds. Net pension expense consisted of the following: NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) According to the Association's actuary, the following table sets forth the Plan's funded status at the dates indicated. Assumptions used in actuarial computations were: 401(k) Thrift and Profit Sharing Plan Northeast Savings maintains a 401(k) thrift and profit sharing plan to encourage systematic savings by employees. Substantially all employees are eligible and can contribute up to 6% of their base salary, on a tax-deferred basis, 50% of which is matched by Northeast Savings. Employees are vested in this plan after five years of service. Thrift plan expense amounted to $524,000, $318,000 and $396,000 for the year ended December 31, 1993, the nine months ended December 31, 1992, and the year ended March 31, 1992, respectively. Employee Stock Ownership Plan Northeast Savings also maintains an employee stock ownership plan to provide the opportunity for substantially all employees of Northeast Savings to also become stockholders. The ESOP was funded through the issuance of Tax Advantaged Variable Rate ESOP Notes, Series 1987. The proceeds of the notes were used to purchase outstanding shares of Northeast Savings' common stock and the notes are guaranteed by Northeast Savings. When Northeast Savings was reorganized into the holding company, Northeast Federal Corp., the common stock of the Association was exchanged for the common stock of the holding company. The ESOP requires Northeast Savings to contribute the amount necessary for the ESOP to discharge its current obligations which include principal and interest payments on the notes. For the year ended December 31, 1993 and the nine months ended December 31, 1992, respectively, Northeast Savings' contribution to the ESOP amounted to $1,512,000 and $383,000, of which $267,000 and $260,000 was interest expense on the ESOP notes. For the year ended March 31, 1992, the contribution totaled $2,108,000 of which $561,000 was interest expense. Further information regarding these notes may be found in Note 12: Federal Home Loan Bank Advances and Other Borrowings. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Stock Option Plans The stock option plans provide for the granting of options to Directors, officers, and other key employees to purchase common stock of Northeast Federal Corp. at a price not less than the fair market value of the Company's stock on the date of grant. The stock option plans provide for the option and sale in the aggregate of 2,250,000 shares of the Company's common stock. The maximum option term is 10 years. At December 31, 1993 and 1992, respectively, there were 571,613 and 352,676 shares which were fully vested and exercisable. Changes in the status of stock options are summarized as follows: Deferred Compensation Plan The Deferred Compensation Plan allows key executives to defer receipt of compensation otherwise currently payable to them by the Association or any subsidiary of the Association for a period of two to ten years. The Association will match 60% of the first 5% an executive elects to defer. The deferred funds will be invested during the deferral period in either a Guaranteed Rate Investment Account or in common stock of Northeast Federal Corp. at a price not less than the monthly average fair market value of the Company's stock for the last ten days of each month. Directors' Deferred Fee Plan The Deferred Fee Plan provides the members of the Board of Directors of the Association the opportunity to defer receipt of fees otherwise currently payable to them by the Association for a period up to ten years. The deferred fees will be invested during the deferral period in either the Guaranteed Rate Investment Account or in common stock of Northeast Federal Corp. at a price not less than the monthly average fair market value of the Company's stock. The Deferred Compensation Plan and the Deferred Fee Plan provide for a total of 250,000 shares of company stock to be purchased. NOTE 15: INCOME TAXES As discussed in Note 1, the Company adopted SFAS 109 as of April 1, 1991. SFAS 109 establishes financial accounting and reporting standards for the effects of income taxes that result from an enterprise's activities during the current and preceding years. It requires an asset and liability approach for financial accounting and reporting for income taxes. In accordance with this implementation, the Company recorded an additional $1.0 million in income as the cumulative effect of a change in accounting principle for the year ended March 31, 1992. In addition, a valuation allowance of $3.7 million was established which reduced the deferred tax assets as of April 1, 1991. Due to the Company's utilization of all net operating loss NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) carryforwards, the valuation reserve, which was related to those carryforwards, was eliminated as of December 31, 1992. Also in accordance with the implementation of SFAS 109, the Company applied $20.9 million at April 1, 1991 and another $1.0 million at December 31, 1992 to reduce the balance of its supervisory goodwill. The cumulative effect of this change is reported separately in the March 31, 1992 Consolidated Statement of Income and prior years' financial statements have not been restated. In accordance with SFAS 109, deferred income tax assets and liabilities at December 31, 1993 and 1992 reflect the impact of temporary differences between values recorded as assets and liabilities for financial reporting purposes and values utilized for remeasurement in accordance with tax laws. A reconciliation of the statutory income tax rate to the consolidated effective income tax rate as well as a reconciliation of the recorded income tax expense (benefit) and the amount of income tax expense (benefit) computed by applying the statutory federal corporate tax rate to income (loss) before income taxes and extraordinary items follow: The components of the income tax expense (benefit) are as follows: NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The tax effect of the temporary differences giving rise to the Company's deferred tax assets and liabilities are as follows: In addition, as of December 31, 1993, a valuation allowance of $4.0 million was established which reduced the deferred tax assets, since it is more likely than not that a portion of these assets will not be realized. Also, the Company has recorded deferred tax assets at December 31, 1993 related to alternative minimum tax credit carryforwards and the ESOP guarantee of $3.3 million and $3.1 million, respectively. For federal tax return purposes, Northeast Federal Corp. files a consolidated tax return with its subsidiaries on a calendar year-end basis. Northeast Savings, a subsidiary of Northeast Federal Corp., has been audited by the Internal Revenue Service with respect to tax returns through 1979. Under the Internal Revenue Code (the Code), Northeast Savings is allowed a special bad debt deduction based on a percentage of taxable income (8%) before such deduction, or based on specified experience formulas. Through 1979, Northeast Savings consistently computed its annual addition to the tax bad debt reserve using the percentage of taxable income method. Subsequent to 1979, such annual addition has been computed under an experience formula because of operating losses incurred for federal income tax purposes. At December 31, 1993, Northeast Savings' base year tax bad debt reserve totaled approximately $2.0 million for which a deferred tax liability is not required to be recognized under SFAS 109. If in the future, earnings allocated to this bad debt reserve and deducted for federal income tax purposes are used for payment of cash dividends or other distributions to stockholders, including distributions in redemption or in dissolution or liquidation, an amount up to approximately 1 3/4 times the amount actually distributed to the stockholders will be includable in Northeast Federal Corp.'s taxable income and be subject to tax. Earnings and profits include taxable income net of federal income taxes and adjustments for items of income which are not taxable and expenses which are not deductible. For the tax year ended December 31, 1993, Northeast Federal Corp. and subsidiaries had current earnings and profits. Any dividends paid with respect to Northeast Savings, F.A.'s stock in excess of current or accumulated earnings and profits at year-end for federal tax purposes or any other stockholder distribution will be treated as paid out of the tax bad debt reserves and will increase taxable income as noted in the preceding paragraph. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 16: GAIN (LOSS) ON SALE OF INTEREST-EARNING ASSETS, NET Gains (losses) are summarized in the following table. For the year ended December 31, 1993 and the nine months ended December 31, 1992, virtually all sales of investments and mortgage-backed securities were either from the available-for-sale portfolios or were due to credit concerns. NOTE 17: EXTRAORDINARY ITEMS A summary of extraordinary items follows: Extraordinary items presented above are net of applicable taxes of $109,000 for the year ended March 31, 1992. All federal income taxes were offset by the utilization of existing operating loss carryforwards. NOTE 18: SUPPLEMENTARY EARNINGS PER SHARE As required by Accounting Principles Board Opinion No. 15, "Earnings Per Share," supplementary earnings per share information is presented as if the conversion of the Company's $2.25 Convertible Cumulative Preferred Stock, Series A, into common stock, which occurred on May 14, 1993, had taken place at the beginning of the period. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table shows the computation of the weighted average shares used in the calculation of supplementary earnings per share: NOTE 19: COMMITMENTS AND CONTINGENCIES Outstanding commitments to originate adjustable rate and fixed rate mortgage loans amounted to $15,429,000 and $33,649,000, respectively, at December 31, 1993. With respect to residential mortgage loans, commitments generally expire within 10 to 180 days, depending upon the type and purpose of the loan. Also at December 31, 1993, commitments of $3,497,000 were outstanding on existing single-family residential construction loans. In addition, at December 31, 1993, the Association had outstanding commitments of $10,125,000 on consumer loans, which consisted primarily of available lines of credit. At December 31, 1993, the Association had entered into firm commitments to sell $44,510,000 of mortgage loans from the available-for-sale portfolio. Finally, at December 31, 1993, the Association had entered into firm commitments to purchase $76,689,000 of mortgage-backed securities. On December 6, 1989, the Association filed a complaint in the United States District Court for the District of Columbia against the FDIC and the OTS, as successor regulatory agencies to the FSLIC and the Federal Home Loan Bank Board. It was the position of the Association in the litigation that the denial by the OTS and the FDIC of core capital treatment to the adjustable rate preferred stock and the elimination from capital, subject to limited inclusion during a phase-out period, of supervisory goodwill, constitutes a breach of contract, as well as a taking of the Association's property without just compensation or due process of law in violation of the Fifth Amendment to the United States Constitution. The Association sought a determination by the Court to this effect and the Association further sought to enjoin the defendants and their officers, agents, employees and attorneys and those persons in active concert or participation with them from enforcing the provisions of FIRREA and the OTS regulations or from taking other actions that are inconsistent with their contractual obligations to Northeast Savings. The suit sought an injunction requiring the OTS and FDIC to abide by their contractual agreements to recognize as regulatory capital the supervisory goodwill booked by Northeast Savings as a result of its 1982 acquisition from the FSLIC of three insolvent thrifts. On July 16, 1991, the district court ruled that it lacked jurisdiction over the action but that Northeast could bring a damages action against the government in the United States Claims Court. On July 8, 1992, the Association moved to voluntarily dismiss its appeal of the July 16, 1991 district court decision dismissing its action seeking injunctive relief. This motion was made with a view toward refiling the Association's lawsuit against the government in the United States Claims Court, so as to seek damages against the United States rather than injunctive relief against the OTS and FDIC. This motion was made for two reasons. First, by virtue of the Association's improved financial and regulatory capital condition, including its compliance with all fully phased-in capital requirements, and its tangible capital position exceeding four percent, the Association determined that it was no longer in need of injunctive relief. Rather, the Association determined that it was now in its best interest to pursue a damages claim against the United States in the Claims Court. Second, the Association sought to dismiss its appeal and refile in the Claims Court because of the adverse decision of the Court of Appeals for the D.C. Circuit in another "supervisory goodwill" NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) case, TransOhio Savings Bank, et al. v. Director, OTS, et al. 967 F.2d 598 (June 12, 1992). Neither the OTS nor the FDIC opposed the Association's motion. The D.C. Circuit granted the Association's motion to voluntarily dismiss its appeal on July 9, 1992. On August 12, 1992, Northeast Savings refiled its action in the United States Claims Court, Northeast Savings, F.A. v. United States, No. 92-550c. Note that, effective October 29, 1992, the United States Claims Court was renamed the United States Court of Federal Claims. Northeast Savings' complaint seeks monetary relief against the United States on theories of breach of contract, taking of property without just compensation, and deprivation of property without due process of law. The United States has not yet filed an answer to the Complaint. On May 25, 1993, a three-judge panel of the Federal Circuit Court of Appeals ruled against the plaintiffs in three other consolidated "supervisory goodwill" cases, holding that the thrift institutions had not obtained an "unmistakable" promise from the government that it would not change the law in such a manner as to abrogate its contractual obligations and that the plaintiffs therefore bore the risk of such a change in the law. Winstar Corp. v. United States, No. 92-5164. On August 18, 1993, however, the full Federal Circuit, acting in response to a Petition for Rehearing with Suggestion for Rehearing In Banc filed by two of the three plaintiffs in these cases, vacated the May 25 panel decision, ordered the panel opinion withdrawn, and ordered that the case be reheard by the full Court. Oral argument in the Winstar case was held on February 10, 1994. On June 3, 1993, the Court of Federal Claims entered an order staying proceedings in Northeast Savings' case pending further action by the Federal Circuit in the Winstar case or any action taken by the Supreme Court on any petition for a writ of certiorari in that case. The Association is also involved in litigation arising in the normal course of business. Although the legal responsibility and financial impact with respect to such litigation cannot presently be ascertained, the Association does not anticipate that any of these matters will result in the payment by the Association of damages that, in the aggregate, would be material in relation to the consolidated results of operations or financial position of the Company. NOTE 20: FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATION OF CREDIT RISK In the normal course of business, Northeast Savings is a party to various financial instruments with off-balance-sheet risk. These financial instruments include commitments to extend credit to meet the financing needs of customers, as well as interest rate swaps entered into as a means of reducing the Association's exposure to changes in interest rates. To varying degrees, these instruments involve elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Statement of Financial Condition. The following table shows the contract or notional amount of these instruments held by the Association. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Commitments to extend credit are agreements to lend to a customer and are entered into in accordance with written, nondiscriminatory, underwriting guidelines established by the Board of Directors. Prior to extending credit, the Association appraises any property which will collateralize the loan and determines the borrower's ability to repay through review of detailed loan applications and credit reports. These commitments have fixed expiration dates or other termination clauses and may require payment of a fee. The total commitment amounts do not necessarily represent future cash requirements since some commitments may expire without being drawn upon. The increase in loans serviced with recourse resulted from management's decision in 1993 to eliminate pool insurance on these loans. In reviewing the delinquency history of the loans, management determined that it was more costly to maintain insurance than to assume the credit risk directly. The loans are well-seasoned and generally have a loan-to-value ratio of 65% or less. At December 31, 1993, $2.1 million were contractually delinquent. Of that amount, $540,000 were delinquent for over 90 days. The risk of these loans is evaluated in conjunction with the evaluation of the adequacy of the allowance for loan losses. At December 31, 1993, the Association's interest rate swap agreements on a market value basis were in a net loss position of $231,000. Interest rate swaps involve the exchange of rates on interest payment obligations without the exchange of the underlying principal amounts. The primary risk associated with interest rate swaps is not credit risk but risk associated with movements in interest rates. While notional principal amounts express the volume of the interest rate swaps, the amounts potentially subject to credit risk are much smaller. At December 31, 1993 and 1992, outstanding interest rate swaps totaled $15,739,000 and $46,080,000, respectively. During the year ended March 31, 1992, the Association voluntarily terminated $275,000,000 of interest rate swap agreements. Interest payments related to interest rate swaps and caps are charged or credited to interest expense on other borrowings. Accrued interest receivable on swaps outstanding at December 31, 1993 and 1992, respectively, was $70,000 and $264,000. The Association grants residential loans to customers primarily in the Northeast. In 1992, the Association also began originating loans through its recently-opened office in Colorado. In early 1994, the Association closed its loan origination office in California. Although the Association has a diversified portfolio, the ability of its borrowers to repay their loans is substantially dependent upon the general economic conditions of the region. NOTE 21: DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other estimation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Such techniques and assumptions, as they apply to individual categories of the Company's financial instruments, are as follows: . Cash and short-term investments: The carrying amounts for cash and short- term investments is a reasonable estimate of those assets' fair value. . Investment securities, including mortgage-backed securities: Fair values for these securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices for similar securities. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) . Loans receivable: For adjustable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on the market prices for securities collateralized by similar loans. For certain homogeneous categories of loans, such as some residential fixed rate mortgages, fair value is estimated using the quoted market price for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. For the income property loan portfolio, due to its immateriality, i.e. approximately 2.0% of total assets, management concluded that it was not practicable to estimate its fair value and, accordingly, has valued it at its carrying amount. . Rhode Island covered assets: Since, relative to these assets, the Association is protected against credit losses, their carrying value is a reasonable estimate of their fair value. . Accrued interest receivable: The carrying amount of accrued interest approximates its fair value. . Deposit liabilities: The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date, that is, the carrying value. Fair values for fixed rate certificates of deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered for deposits of similar remaining maturities. SFAS 107 defines the fair value of demand deposits as the amount payable on demand, and prohibits adjusting fair value for any value derived from retaining those deposits for an expected future period of time. That component, commonly referred to as a deposit base intangible, is estimated to be between zero and 4.0% of total demand deposits at December 31, 1993 and is neither considered in the following fair value amounts nor recorded as an intangible asset in the balance sheet. . Federal Home Loan Bank advances: The fair value of these liabilities is estimated using the rates currently offered for liabilities of similar remaining maturities or, when available, quoted market prices. . Securities sold under agreements to repurchase: Securities sold under agreements to repurchase generally have an original term to maturity of less than thirty days and thus are considered short-term borrowings. Consequently, their carrying value is a reasonable estimate of fair value. . Long-term borrowings: The fair values of the Company's long-term borrowings are estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. . Interest rate swap agreements: The fair value of the interest rate swaps is the estimated amount that would be received or paid to terminate the swap agreements at the reporting date, taking into account current interest rates and the current creditworthiness of the swap counterparties. . Commitments to extend credit consist primarily of commitments to originate adjustable rate mortgage loans and generally expire within 10 to 180 days, depending upon the type and purpose of the loan. Due to the current nature of the commitments, management concluded that the contractual amount of the commitments is a reasonable estimate of their fair value. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The following table presents the Company's assets, liabilities, and unrecognized financial instruments at both their respective carrying amounts and fair value. The Company's non-financial assets and liabilities are presented in both columns at their carrying amount. - -------- (1) Excludes $70,000 and $264,000 at December 31, 1993 and 1992, respectively, of accrued interest receivable on interest rate swaps. (2) Represents the fair value of uncapitalized servicing rights on loans serviced for others by Northeast Savings. * Fair value at December 31, 1992 is not available. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) As discussed earlier, the fair value estimate of financial instruments for which quoted market prices are unavailable is dependent upon the assumptions used. Consequently, those estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Accordingly, the aggregate fair value amounts presented in the above fair value table do not necessarily represent the underlying value of the Company. NOTE 22: RECONCILIATION OF REGULATORY REPORTS TO ACCOMPANYING CONSOLIDATED FINANCIAL STATEMENTS The following is a reconciliation of stockholders' equity and net income (loss) from regulatory reports furnished to the OTS to the accompanying consolidated financial statements: NOTE 23: ACQUISITIONS During fiscal 1982 and fiscal 1983, Northeast Savings acquired three savings and loan associations in FSLIC-assisted supervisory mergers accounted for using the purchase method of accounting. Supervisory goodwill, the excess of cost over net assets acquired, related to these acquisitions totaled $290,019,000. In 1988, a portion of the supervisory goodwill related to 17 branch banking offices which were sold was eliminated and all goodwill related to Northeast Savings' 1987 non-supervisory acquisitions was eliminated in 1989 as a result of sales. In fiscal 1990, as a result of an analysis of the value of its remaining supervisory goodwill, Northeast Savings reduced supervisory goodwill by $109.4 million. This reduction was precipitated by several factors that had diminished the value of the Association's Connecticut and Massachusetts franchises. The primary factor was the impact of OTS regulations promulgated pursuant to FIRREA which require the deduction of a substantial portion of goodwill in calculating regulatory capital. Other factors included the passage of the Connecticut Interstate Banking Law which was enacted March 14, 1990 and which greatly increased the opportunities for out-of-state banks to enter the state. Accordingly, Northeast Savings hired Kaplan, Smith & Associates, then a subsidiary of The First Boston Corporation, to perform an independent valuation of the Association's franchise rights in Connecticut and Massachusetts. This study was completed in May 1990 and supported the value of Northeast Savings' remaining goodwill at March 31, 1990. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The reduction in supervisory goodwill had no effect on Northeast Savings' regulatory capital or the treatment of the goodwill for regulatory accounting purposes. A further analysis of the value of the Company's remaining supervisory goodwill completed in September 1992, resulted in an additional $56.6 million reduction of supervisory goodwill. This reduction was also brought about by factors which had diminished the value of the Association's Connecticut and Massachusetts franchises. The principal factor was the adverse effect on the value of the Association's Connecticut and Massachusetts franchise rights of OTS regulations promulgated pursuant to FIRREA and the FDICIA as well as other positions taken by the OTS regarding regulatory capital requirements. For example, the prompt corrective action regulation issued by the federal banking agencies on September 29, 1992 finalized the 4% core capital requirement for institutions that are not rated MACRO 1, which thereby reduced prospective earnings which the Association could expect to realize from its Connecticut and Massachusetts franchise rights. Moreover, the OTS has verbally informed Northeast Savings that, inasmuch as Northeast Savings had recently achieved compliance with its fully phased-in capital standards, under OTS Regulatory Bulletin 3a-1, "Policy Statement on Growth for Savings Associations" (RB 3a-1), Northeast Savings may not grow its assets if such growth would cause it to fall below its fully phased-in capital requirements, even if the Company continued to exceed the applicable minimum capital standards previously established for the duration of the FIRREA phase-in period. This OTS position regarding the effect of RB 3a-1 further decreased the prospective earnings that Northeast had expected to realize from its Connecticut and Massachusetts franchise rights. Another significant factor included the implementation of the final rule issued by the OTS which permits federal savings associations to branch interstate to the full extent permitted by federal statute and which greatly increased opportunities for out-of-state institutions to enter these states. Thus, the Company again hired Kaplan Associates, Inc. to perform an independent valuation of the Association's franchise rights in Connecticut and Massachusetts. This study was completed during the quarter ended September 30, 1992 and supported the value of the Company's remaining supervisory goodwill at September 30, 1992. The reduction in supervisory goodwill had no effect on Northeast Savings' fully phased-in regulatory tangible, core, or risk-based capital. The following summarizes transactions relating to the supervisory goodwill. During the year ended March 31, 1992, the Association acquired a total of $404.6 million in deposits from the RTC. All of the acquired deposits were in institutions which had been placed into receivership by the RTC. Financial of Hartford On June 19, 1991, Northeast Savings assumed the deposits of Financial of Hartford, F.S.B. from the RTC. Northeast Savings assumed $10.5 million in deposits and accrued interest and received $7.9 million in cash, $2.6 million in securities, and $70,000 in passbook secured loans. Northeast Savings closed the branch and now services the deposits through the eight branches in the Hartford area. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) ComFed Savings Bank On September 13, 1991, Northeast Savings assumed the insured deposits of eight branches of ComFed Savings Bank, F.A. from the RTC. Northeast Savings assumed $210.9 million in deposits and accrued interest, at a premium of $406,000, and received $209 million in cash and $567,000 in passbook secured loans. The branches acquired were located in the Springfield, Massachusetts area and in Pittsfield, Massachusetts. Northeast Savings closed four of the branches, keeping two open in Springfield and two open in Pittsfield. FarWest Savings and Loan On March 20, 1992, Northeast Savings assumed the insured deposits of four branches of FarWest Savings and Loan Association, F.A. from the RTC. Northeast Savings assumed $183.2 million in deposits and accrued interest, at a premium of $610,000, and received $182 million in cash and $176,000 in passbook secured loans. The four branches are in the San Diego, California area. Northeast Savings now operates the four branches as full service banking offices. Rhode Island Acquisition On May 8, 1992, the Association acquired $315.0 million in assets of four Rhode Island financial institutions which were in receivership proceedings under the jurisdiction of the Superior Court of Providence County, Rhode Island. The following transactions were completed in conjunction with the acquisition of the assets of the Rhode Island institutions. . The Association issued $315.0 million of insured deposit accounts in the Association to depositors in the Rhode Island institutions. . The Company issued and sold to the Rhode Island Depositors Economic Protection Corporation approximately $35.2 million of a new class of preferred stock, the $8.50 Cumulative Preferred Stock, Series B as well as warrants to purchase 600,000 shares of common stock of the Company at $2.50 per share and 200,000 shares of common stock of the Company at $4.25 per share. The Company contributed the net proceeds from this issuance to the Association. The Company has the right to pay the first five years of dividends on the new preferred stock by the issuance of additional new preferred stock (a payment in kind). . The Company issued and sold $28.95 million of 9% Debentures to the receivers for the four institutions. These debentures have been distributed to certain of the depositors in the Rhode Island institutions in consideration of a portion of their deposit claims against the receiverships for the Rhode Island institutions. The Company has the right to pay the first five years of interest on the 9% Debentures by the issuance of additional 9% Debentures (a payment in kind). . The Company repurchased its adjustable rate preferred stock plus accumulated dividends from the FRF for $28.0 million in cash and $7.0 million in 9% Debentures, for a total fair value of $32.5 million. The 9% Debentures had a fair market value of $4.5 million, which was based on the value attributed to those debentures by the FRF, as determined by its investment banker. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 24: PARENT COMPANY FINANCIAL INFORMATION The condensed parent company Statement of Operations, Statement of Financial Condition, and Statement of Cash Flows are as follows: STATEMENT OF OPERATIONS (IN THOUSANDS) STATEMENT OF FINANCIAL CONDITION (IN THOUSANDS) NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) STATEMENT OF CASH FLOWS (IN THOUSANDS) This information should be read in conjunction with other Notes to the Consolidated Financial Statements. NORTHEAST FEDERAL CORP. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 25: QUARTERLY FINANCIAL INFORMATION (UNAUDITED) NOTE 26: SUBSEQUENT EVENT On February 9, 1994, the Company and another financial institution signed a definitive agreement for the sale by the Company of ten Northeast Savings branches located in eastern Massachusetts and in Rhode Island. Deposits held in these branches totaled approximately $427 million as of December 31, 1993. The purchasing institution will pay a premium of three percent to Northeast Savings for deposits on hand at the time of closing. The transaction is expected to close by the end of the second quarter, and is subject to regulatory approval. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES Northeast Federal Corp. has engaged Deloitte & Touche as its new independent accountants. Deloitte & Touche will serve as the independent accountants for both Northeast Federal and its savings and loan association subsidiary, Northeast Savings, F.A. The decision to hire new independent accountants was recommended by the Audit Committees of both Northeast Federal and Northeast Savings and approved by the Board of Directors on September 24, 1993. Coopers & Lybrand, who previously served as the independent accountants for Northeast Federal and Northeast Savings, were dismissed on the same day. On September 24, 1993, the date on which the Board of Directors approved the hiring of Deloitte & Touche as the new independent accountants for Northeast Federal and Northeast Savings, F.A., subject to compliance with requisite regulatory requirements, Northeast Savings, the Rhode Island Depositors Economic Protection Corporation and the trustees of certain Rhode Island financial institutions had an outstanding balance due to Deloitte & Touche for professional services performed in conjunction with the 1992 acquisition of certain assets of four Rhode Island institutions by Northeast Savings, F.A. Fees for the services rendered were paid prior to the commencement of the current audit engagement. In connection with the audits of the two fiscal years ended March 31, 1992 and December 31, 1992 and the subsequent interim period through September 24, 1993, there were no disagreements with Coopers & Lybrand on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedures, which disagreements if not resolved to their satisfaction would have caused them to make reference in connection with their opinion to the subject matter of the disagreement. In accordance with Item 304(a)(1)(v) of Regulation S-K, during the two most recent fiscal years and the subsequent interim period, Northeast Federal has not been advised by Coopers & Lybrand of any of the reportable events listed in Item 304(a)(1)(v) (A) through (D). The audit reports of Coopers & Lybrand on the consolidated financial statements of Northeast Savings, F.A. and subsidiaries as of and for the fiscal years ended December 31, 1992 and March 31, 1992 did not contain any adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope, or accounting principles, except for an explanatory paragraph noting the Company changed its method of accounting for income taxes for the fiscal year ended March 31, 1992. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding directors of the Company will appear in the Proxy Statement for the Annual Meeting of Stockholders, May 20, 1994, and is incorporated herein by this reference. In addition, information required by Item 405 of Regulation S-K disclosing any delinquent filing required under Section 16(a) of the Securities Exchange Act of 1934 by any of the Company's directors, executive officers or any person holding ten percent or more of the Company's common or convertible preferred stock will appear in the Proxy Statement for the Annual Meeting of Stockholders and is incorporated herein by reference. The Proxy Statement will be filed with the SEC within 120 days of December 31, 1993. As required by Instruction 3 to Item 401(b) of Regulation S- K, information regarding executive officers of the Company is contained in Part I of this report under Supplementary Item, Executive Officers of the Registrant. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation will appear in the Proxy Statement for the Annual Meeting of Stockholders, May 20, 1994, and is incorporated herein by this reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding security ownership of certain beneficial owners and management will appear in the Proxy Statement for the Annual Meeting of Stockholders, May 20, 1994, and is incorporated herein by this reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relations and related transactions will appear in the Proxy Statement for the Annual Meeting of Stockholders, May 20, 1994, and is incorporated herein by this reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)1. FINANCIAL STATEMENTS These documents are listed in the Index to Consolidated Financial Statements under Item 8. 2. FINANCIAL STATEMENT SCHEDULES Financial Statement Schedules have been omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto. (b)REPORTS ON FORM 8-K FILED DURING THE QUARTER ENDED DECEMBER 31, 1993 None (c)EXHIBITS REQUIRED BY SECURITIES AND EXCHANGE COMMISSION REGULATION S-K - -------- (a) Incorporated by reference to Northeast Federal Corp. Annual Report on Form 10-K for the fiscal year ended March 31, 1992. (b) Incorporated herein by reference to such plan in Exhibit 4.3 of Form S-8 Registration as filed with the SEC on September 19, 1990, Registration Number 33-36907. (c) Incorporated herein by reference to such plan in Exhibit 4.4 of Form S-8 Registration Statement as filed with the SEC on September 19, 1990, Registration Number 33-36907. (d) Incorporated by reference to such plan in Exhibit 4.3 of Form S-8 Registration Statement as filed with the SEC on December 21, 1993, Registration Number 33-51641. (e) Incorporated by reference to such plan in Exhibit 4.3 of Form S-8 Registration Statement as filed with the SEC on December 21, 1993, Registration Number 33-51643. 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. NORTHEAST FEDERAL CORP. ------------------------------------- (Registrant) March 4, 1994 By: /s/ George P. Rutland --------------------------------- George P. Rutland Chairman of the Board 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 INDICATED ON FEBRUARY 25, 1993. By: /s/ George P. Rutland --------------------------------- George P. Rutland Chairman of the Board By: /s/ Kirk W. Walters --------------------------------- Kirk W. Walters Chief Executive Officer, President, Chief Operating Officer, and Chief Financial Officer By: /s/ Lynne M. Carcia --------------------------------- Lynne M. Carcia Senior Vice President, Controller, and Principal Accounting Officer DIRECTORS Gerald P. Carmen David W. Clark, Jr. George J. Fantini, Jr. Richard H. Gaskill Richard H. Gordon Beverly L. Hamilton Barbara C. Lawrence Thomas P. O'Neill, III George P. Rutland George W. Sarney Raymond T. Schuler John R. Silber Kirk W. Walters Jerome F. Williams Frederick W. Zuckerman By: /s/ George P. Rutland --------------------------------- George P. Rutland Attorney-in-Fact

66025_1993.txt

66025_1993

1993

66025

ITEM 1. Business. Incorporated by reference in pages 2 through 11 and 26 of the Registrant's 1993 Annual Report to Shareholders. The number of persons employed by the Registrant was approximately 980 at December 31, 1993. ITEM 2. ITEM 2. Properties. Incorporated by reference in pages 2 through 11 of the Registrant's 1993 Annual Report to Shareholders. ITEM 3. ITEM 3. Legal Proceedings. None other than ordinary routine litigation incidental to the business of the Company and its subsidiaries. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders. None during the fourth quarter. PART II ITEM 5. ITEM 5. Market for the Registrant's Common Stock and Related Security Holder Matters. Incorporated by reference to pages 25 and 26 (Note 13), and 28 and 29 of the Registrant's 1993 Annual Report to Shareholders. ITEM 6. ITEM 6. Selected Financial Data. Incorporated by reference to page 13 of the Registrant's 1993 Annual Report to Shareholders. ITEM 7. ITEM 7. Management's Discussion And Analysis of Financial Condition And Results of Operations. Incorporated by reference to pages 14 and 15 of the Registrant's 1993 Annual Report to Shareholders. ITEM 8. ITEM 8. Financial Statements and Supplementary Data. Incorporated by reference to pages 16 through 28 of the Registrant's 1993 Annual Report to Shareholders. ITEM 9. ITEM 9. Disagreements on Accounting and Financial Disclosures. None. PART III ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant. Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. PART III (Continued) Executive Officers Of The Company- J. P. Hayden, Jr. - Age 64 - Chairman and Chief Executive Officer Michael J. Conaton - Age 60 - President and Chief Operating Officer John R. LaBar - Age 62 - Vice President and Secretary Robert W. Hayden - Age 55 - Vice President John I. Von Lehman - Age 41 - Vice President, Treasurer and Chief Financial Officer Thomas J. Rohs - Age 52 - Vice President J. P. Hayden III - Age 41 - Vice President John W. Hayden - Age 36 - Vice President Robert N. Thornbladh - Age 41 - Vice President Michael L. Flowers - Age 42 - Vice President, Assistant Secretary and Chief In-House Counsel J. P. Hayden, Jr. and Robert W. Hayden are brothers. J. P. Hayden, III and John W. Hayden are sons of J. P. Hayden, Jr. During 1988, Michael J. Conaton was elected President and Chief Operating Officer (formerly Executive Vice President and Chief Financial Officer). During 1988, John I. Von Lehman was elected Vice President and Chief Financial Officer and retained the title of Treasurer (formerly Treasurer and Chief Accounting Officer). During 1990, Robert N. Thornbladh joined the Company as Vice President. He was formerly employed by Nutmeg Industries. During 1991, Michael L. Flowers (formerly Assistant Secretary) was elected Vice President. The officers listed above have served in the positions indicated for the past five years (except as noted above). ITEM 11. ITEM 11. Executive Compensation. Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. ITEM 13. ITEM 13. Certain Relationships and Related Transactions. Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1. Financial Statements. Incorporated by reference in Part II of this report: PART IV (Continued) Data pertaining to The Midland Company and Subsidiaries - Report of Independent Public Accountants. Consolidated Balance Sheets, December 31, 1993 and 1992. Consolidated Statements of Income and Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. (a) 2. Financial Statement Schedules. Included in Part IV of this report: Data pertaining to The Midland Company and Subsidiaries - Page Independent Auditors' Consent and Report on Schedules 7 Schedule I - Marketable Securities - Other Investments, December 31, 1993 8 Schedule V - Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 9 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991 10 Schedule VIII - Allowance for Losses for the Years Ended December 31, 1993, 1992 and 1991 11 Schedule IX - Short-Term Borrowings for the Years Ended December 31, 1993, 1992 and 1991 12 Schedule X - Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991 13 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (a) 3. Exhibits. 3. Articles of Incorporation and By-Laws - Filed as Exhibit 3 to the Registrant's 1980 Annual Report on Form 10-K, and incorporated herein by reference. 10. A description of the Company's Stock Option Plan and Profit Sharing Plan - Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. 11. Computation of Consolidated Net Income Per Share for the years ended December 31, 1993, 1992 and 1991 13. Annual Report to security holders - Incorporated by reference to the Registrant's 1993 Annual Report to Shareholders 21. Subsidiaries of the Registrant 22. Registrant's Proxy Statement dated - Incorporated by reference to the Registrant's Proxy Statement dated March 18, 1994. (b) Reports on Form 8-K. None. SIGNATURES 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. THE MIDLAND COMPANY Signature Title Date S/ George R. Baker Director March 3, 1994 (George R. Baker) S/ James H. Carey Director and Member March 3, 1994 (James H. Carey) of Audit Committee S/ Michael J. Conaton President, Chief Operating March 3, 1994 (Michael J. Conaton) Officer and Director S/ J. P. Hayden, Jr. Chairman, Chief Executive March 3, 1994 (J. P. Hayden, Jr.) Officer and Director S/ J. P. Hayden, III Vice President and Director March 3, 1994 (J. P. Hayden, III) S/ John W. Hayden Vice President and Director March 3, 1994 (John W. Hayden) S/ Robert W. Hayden Vice President and Director March 3, 1994 (Robert W. Hayden) S/ William J. Keating Director March 3, 1994 (William J. Keating) S/ William McD. Kite Director March 3, 1994 (William McD. Kite) S/ John R. LaBar Vice President, Secretary March 3, 1994 (John R. LaBar) and Director S/ John M. O'Mara Director and Member March 3, 1994 (John M. O'Mara) of Audit Committee S/ John R. Orther Director and Member March 3, 1994 (John R. Orther) of Audit Committee S/ William F. Plettner Director March 3, 1994 (William F. Plettner) S/ Glenn E. Schembechler Director and Member March 3, 1994 (Glenn E. Schembechler) of Audit Committee S/ John I. Von Lehman Vice President, Treasurer, March 3, 1994 (John I. Von Lehman) Chief Financial Officer, Chief Accounting Officer and Director SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has dully caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE MIDLAND COMPANY Signature Title Date S/ J. P. Hayden, Jr. Chairman and Chief Executive March 3, 1994 (J. P. Hayden, Jr.) Officer S/ John I. Von Lehman Vice President, Treasurer, March 3, 1994 (John I. Von Lehman) Chief Financial Officer and Chief Accounting Officer INDEPENDENT AUDITORS' CONSENT AND REPORT ON SCHEDULES ----------------------------------------------------- To the Shareholders of The Midland Company: We consent to the incorporation by reference in Registration Statement No. 33-48511 of The Midland Company on Form S-8 of our report dated February 10, 1994, incorporated by reference in this Annual Report on Form 10-K and our report (appearing below) on the financial statement schedules of The Midland Company for the year ended December 31, 1993. Our audits of the consolidated financial statements referred to in our aforementioned report also included the financial statement schedules of The Midland Company and its subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. March 14, 1994 SCHEDULE I THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 . . . . . . .December 31, 1993. . . . . . . - -------------------------------------------------------------------------------- Column A Column C Column D Column E - ------------------------------------------------------------------------------- Amount at which shown Market in the Type of Investment Cost Value balance sheet - -------------------------------------------------------------------------------- Bonds and notes: United States Government and government agencies and authorities $ 69,482,000 $ 72,477,000 $ 72,477,000 States, municipalities and political subdivisions 61,642,000 64,998,000 64,998,000 All other corporate 56,479,000 56,942,000 56,942,000 -------------------------------------------- Total bonds and notes 187,603,000 194,417,000 194,417,000 -------------------------------------------- Preferred stocks 294,000 419,000 419,000 -------------------------------------------- Common stocks: Star Banc Corporation 2,073,000 9,457,000 9,457,000 All other common stocks 14,497,000 17,466,000 17,466,000 -------------------------------------------- Total common stocks 16,570,000 26,923,000 26,923,000 -------------------------------------------- Accrued investment income 2,855,000 2,855,000 2,855,000 -------------------------------------------- Total investments $207,322,000 $224,614,000 $224,614,000 ============================================ NOTE: The individual issue disclosed above is the only individual issue requiring separate disclosure. SCHEDULE V THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 COLUMN A COLUMN B COLUMN C COLUMN D COLUMN F BALANCE AT BALANCE BEGINNING ADDITIONS AT END CLASSIFICATION OF PERIOD AT COST RETIREMENTS OF PERIOD - -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993: Land $ 488,000 $ 813,000 $ 45,000 $ 1,256,000 Buildings, improvements, fixtures, etc. 27,516,000 17,028,000 3,378,000 41,166,000 Vessels and barges 122,193,000 14,394,000 1,988,000 134,599,000 River transportation equipment under capital leases 8,143,000 -- -- 8,143,000 Construction-in-progress 4,881,000 (4,881,000) -- -- ---------------------------------------------------- TOTAL $163,221,000 $27,354,000 $5,411,000 $185,164,000 ==================================================== YEAR ENDED DECEMBER 31, 1992: Land $ 488,000 $ -- $ -- $ 488,000 Buildings, improvements, fixtures, etc. 23,754,000 5,240,000 1,478,000 27,516,000 Vessels and barges 115,578,000 7,487,000 872,000 122,193,000 River transportation equipment under capital leases 8,143,000 -- -- 8,143,000 Construction-in-progress -- 4,881,000 -- 4,881,000 ---------------------------------------------------- TOTAL $147,963,000 $17,608,000 $2,350,000 $163,221,000 ==================================================== YEAR ENDED DECEMBER 31, 1991: Land $ 488,000 $ -- $ -- $ 488,000 Buildings, improvements, fixtures, etc. 22,119,000 2,676,000 1,041,000 23,754,000 Vessels and barges 105,389,000 10,285,000 96,000 115,578,000 River transportation equipment under capital leases 8,143,000 -- -- 8,143,000 ---------------------------------------------------- TOTAL $136,139,000 $12,961,000 $1,137,000 $147,963,000 ==================================================== SCHEDULE VI THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 COLUMN A COLUMN B COLUMN C COLUMN D COLUMN F ADDITIONS BALANCE AT CHARGED TO BALANCE BEGINNING COSTS AND AT END CLASSIFICATION OF PERIOD EXPENSES RETIREMENTS OF PERIOD - -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993: Buildings, improvements, fixtures, etc. $ 9,756,000 $ 3,699,000 $1,145,000 $12,310,000 Vessels and barges 54,574,000 5,778,000 1,763,000 58,589,000 River transportation equipment under capital leases 5,849,000 524,000 -- 6,373,000 ---------------------------------------------------- TOTAL $70,179,000 $10,001,000 $2,908,000 $77,272,000 ==================================================== YEAR ENDED DECEMBER 31, 1992: Buildings, improvements, fixtures, etc. $ 7,883,000 $ 2,839,000 $ 966,000 $ 9,756,000 Vessels and barges 49,356,000 5,787,000 569,000 54,574,000 River transportation equipment under capital leases 5,325,000 524,000 -- 5,849,000 ---------------------------------------------------- TOTAL $ 62,564,000 $ 9,150,000 $1,535,000 $70,179,000 ==================================================== YEAR ENDED DECEMBER 31, 1991: Buildings, improvements, fixtures, etc. $ 6,028,000 $ 2,417,000 $ 562,000 $ 7,883,000 Vessels and barges 44,129,000 5,301,000 74,000 49,356,000 River transportation equipment under capital leases 4,801,000 524,000 -- 5,325,000 ---------------------------------------------------- TOTAL $ 54,958,000 $ 8,242,000 $ 636,000 $62,564,000 ==================================================== SCHEDULE VIII THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE VIII - ALLOWANCE FOR LOSSES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 ADDITIONS BALANCE AT CHARGED TO BALANCE BEGINNING COSTS AND DEDUCTIONS AT END DESCRIPTION OF PERIOD EXPENSES (ADDITIONS) OF PERIOD - -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993: Allowance For Losses $1,192,000 $357,000 $432,000 (1) $1,117,000 YEAR ENDED DECEMBER 31, 1992: Allowance For Losses $1,133,000 $297,000 $238,000 (1) $1,192,000 YEAR ENDED DECEMBER 31, 1991: Allowance For Losses $ 943,000 $195,000 $ 5,000 (1) $1,133,000 NOTES: (1) Accounts written off are net of recoveries. SCHEDULE IX THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 -- END OF PERIOD --- ------ DURING THE PERIOD ---------- WEIGHTED WEIGHTED CATEGORY OF AVERAGE MAXIMUM AVERAGE AVERAGE SHORT-TERM INTEREST AMOUNT AMOUNT INTEREST BORROWINGS BALANCE RATE OUTSTANDING OUTSTANDING RATE - -------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993: Bank Borrowings $22,000,000 3.5% $27,000,000 $13,583,000 3.5% Commercial Paper 14,302,000 3.3% 15,129,000 11,096,000 3.7% YEAR ENDED DECEMBER 31, 1992: Bank Borrowings $27,000,000 4.1% $27,000,000 $ 2,669,000 3.8% Commercial Paper 8,866,000 4.1% 10,208,000 9,135,000 4.7% YEAR ENDED DECEMBER 31, 1991: Bank Borrowings $12,000,000 5.2% $12,000,000 $ 323,000 7.7% Commercial Paper 8,568,000 5.1% 9,686,000 8,097,000 6.5% NOTE: The weighted average interest rate is computed by dividing actual interest expense on borrowings by the average amount of such borrowings during the year. SCHEDULE X THE MIDLAND COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES 1993 1992 1991 ---------------------------------- Maintenance and repairs $4,972,000 $5,662,000 $3,015,000 ================================== Taxes, other than payroll and income taxes: Insurance premium taxes $5,971,000 $4,766,000 $3,995,000 Other 2,742,000 2,060,000 2,056,000 ---------------------------------- Total $8,713,000 $6,826,000 $6,051,000 ==================================

27984_1993.txt

27984_1993

1993

27984

ITEM 3 LEGAL PROCEEDINGS In the action styled GARCIA V. DELTONA ET. AL, Case No. 86-03542, filed in the Circuit Court for Dade County, Florida, on January 30, 1986, the plaintiff had sought to recover $2,000,000 allegedly paid to the Company on four installment land sales contracts, claiming fraud and misrepresentation on the part of one of the Company's independent sales representatives and other violations of law. The Company had cancelled the contracts in question according to their terms for default of the payment obligations by the purchaser. Although the Company negotiated a settlement of this action which provides for the Company to convey to the plaintiff property which has a value equivalent to the monies paid by the plaintiff to the Company under the cancelled contracts, the plaintiff has asserted that the Company has breached the settlement agreement by failing to convey sufficient property which meets the criteria of the settlement agreement. The Company is of the belief that the property conveyed complies with such criteria. The parties are currently attempting to resolve the dispute by reaching an agreement as to alternative property that may be used for settlement purposes. In the action styled FIVE POINTS LIMITED V. THE DELTONA CORPORATION, Case No. 93-22877, filed in the Circuit Court for Dade County, Florida and served upon the Company on December 8, 1993, the plaintiff is seeking damages against the Company for an alleged breach of the lease for its office building. The complaint alleges that the Company has defaulted in its obligation to make payments under the lease and seeks damages in excess of $272,000 for additional past due rent, plus damages for acceleration of lease payments in excess of $4,000,000. On February 17, 1994 the Court entered an Order requiring the Company to pay uncontested back rent of approximately $240,000, plus uncontested monthly rents of approximately $48,000, commencing on March 1, 1994. As of August 31, 1994, approximately $41,500 had been garnished by the Court under this Order. The Plaintiff has obtained multiple judgments in the amount of $647,000 as of August 31, 1994. These judgments have been recorded in certain of the Company's communities. On September 1, 1994 the Company entered into a settlement agreement with plaintiff to be consummated on or before October 17, 1994. New financing is essential for the Company to consummate the settlement agreement. Failure to fund this agreement will result in continued litigation and a likely substantial judgment against the Company. As part of the settlement agreement, the Company will be evicted from the premises and must vacate its occupancy by January 6, 1995. In the action styled LEE, ET.AL. V. THE DELTONA CORPORATION, Case No. 94-3808, filed in the Circuit Court for Dade County, Florida and served upon the Company on February 28, 1994, the plaintiff had alleged that the liquidated damages provision in the Company's contracts for the sale of its properties is unenforceable under Florida law and contests the method utilized by the Company to calculate actual damages in the event of contract cancellations. As part of its complaint, the plaintiff was seeking certification as a class action, as well as unspecified compensatory damages, together with interest, costs and fees. The Company has reached a settlement with the plaintiff and proceedings have been dismissed. In the action styled BRUCE WEINER V. THE DELTONA CORPORATION, the plaintiff, Bruce Weiner, prior Executive Vice President of the Company, has sued the Company on April 28, 1994 for alleged breach of employment contract seeking damages of approximately $750,000.00 and unspecified employee benefits. The proceeding is pending in the Circuit Court of Dade County, Florida, Case No. 94-7825-04. The Company has filed a response to the plaintiff's complaint and discovery is pending. No final hearing has been set. The Company believes that it has defenses to the claim. In the event that the Company is not successful in its defenses or a settlement is not reached, a substantial judgment may be entered against the Company in favor of the plaintiff. The Company at the present time is unable to predict the ultimate outcome of the litigation. Although settlement discussions have commenced, no resolution of the matter has been consummated. Any ultimate settlement will require the Company to obtain financing for payment. In the action styled JOSEPH MANCILLA, JR. V. THE DELTONA CORPORATION, the plaintiff, Joseph Mancilla, Jr., prior Senior Vice President of the Company, has sued the Company on May 17, 1994 for alleged breach of employment contract seeking damages in excess of $391,000,000 plus unspecified employee benefits, costs and other claims. The proceeding is pending in the Circuit Court of Dade County, Florida, Case No. 94-09116. The Company has filed a responsive pleading and no final hearing has been set. If a settlement is not reached and the Company is not successful in its defenses, a substantial portion of the plaintiff's claim may be entered as a judgment against the Company. The Company at the present time is unable to predict the ultimate outcome. The Company intends to begin settlement discussions with plaintiff. Any settlement funding would require the Company to obtain financing to meet settlement commitment. In the action styled MICHELLE GARBIS V. THE DELTONA CORPORATION, the plaintiff, Michelle Garbis, prior Senior Vice President and Corporate Secretary of the Company, has sued the Company on August 18, 1994 for alleged breach of employment contract seeking damages of approximately $280,000.00. The Company disputes the plaintiff's claim which is pending in the Circuit Court of Dade County, Florida, Case No. 94-15531 CA (11). The Company and plaintiff have reached a resolution and settlement of the claim and have entered into a stipulation requiring installment payments through December 1994. Failure of the Company to obtain financing and perform under the stipulation, would result in continued litigation and potential judgment against the Company for the unpaid portion of the settlement amount. The Company is subject to various litigation involving claims by certain trade creditors. The Company has entered into individual compromise and settlement agreements or stipulations, for payments at discounted amounts on or before September 30, 1994. Failure to obtain financing to make the committed payments may result in judgments of up to $500,000.00. The Company is also a party to certain other legal and administrative proceedings arising in the ordinary course of its business. The outcome will not, in the opinion of the Company, have a material adverse effect on the business or financial condition of the Company. ITEM 5 ITEM 5 PRICE RANGE OF COMMON STOCK AND DIVIDENDS The Company's Common Stock was traded on the New York and Pacific Stock Exchanges under the ticker symbol DLT until trading was suspended on April 6, 1994. The following table sets forth the reported high and low sales prices for the Company's Common Stock during the periods indicated as reported in the record of composite transactions for NYSE listed securities. QUARTER HIGH LOW - - ------- ------ ----- 1992 - First Quarter........................................ 1-1/2 5/8 Second Quarter....................................... 2-3/4 7/8 Third Quarter........................................ 2-1/4 1-7/8 Fourth Quarter....................................... 4-1/8 1-3/4 1993 - First Quarter........................................ 3-3/8 2-1/2 Second Quarter....................................... 3-1/2 1-7/8 Third Quarter........................................ 2-7/8 1-7/8 Fourth Quarter....................................... 3 1-7/8 On March 18, 1994 the last reported sales price of the shares of Common Stock on the NYSE was 1-1/4. There were 1,704 holders of record of the Company's Common Stock. On April 6, 1994, both the New York and Pacific Stock Exchanges suspended the Company's Common Stock from trading and instituted procedures to delist the Company's Common Stock. On June 16, 1994, the Company's Common Stock was formally removed from listing and registration on the New York Stock Exchange. As of August 31, 1994, the Company's Common Stock was traded on a limited basis in the over-the-counter markets. The high bid was 12-1/2(cent) and the low ask price was 50(cent) at September 6, 1994 on the over-the-counter markets. The Company has never paid any cash dividends on its Common Stock. The Company's loan agreements contain certain restrictions which currently prohibit the Company from paying dividends on its Common Stock. ITEM 6 ITEM 6 SELECTED CONSOLIDATED FINANCIAL INFORMATION The following table summarizes selected consolidated financial information and should be read in conjunction with the Consolidated Financial Statements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations". CONSOLIDATED INCOME STATEMENT DATA (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) CONSOLIDATED BALANCE SHEET DATA (IN THOUSANDS) ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS On June 19, 1992, the Company completed a transaction with Selex, which resulted in a change in control of the Company. Under the transaction, Selex loaned the Company $3,000,000 collateralized by a first mortgage on certain of the Company's property in its St. Augustine Shores, Florida community (the "First Selex Loan"). The First Selex Loan initially bears interest at the rate of 10% per annum with a term of four years and payment of interest deferred for the first 18 months. Accrued interest due under the First Selex Loan in the amount of $604,312 (including $463,562 due December 31, 1993) was unpaid and in default as of August 31, 1994. In conjunction with the First Selex Loan: (i) Empire sold Selex its 2,220,066 shares of the Company's Common Stock and assigned Selex its $1,000,000 Note from the Company, with $225,000 of interest accrued thereon; (ii) Maurice A. Halperin, Chairman of the Board of Empire and former Chairman of the Board of the Company, forgave payment of the $200,000 salary due him for the period of April, 1990 through April, 1991, which was in arrears; and (iii) certain changes occurred in the composition of the Company's Board of Directors. Namely, the six directors serving on the Company's Board who were previously designated by Empire resigned and four Selex designees (Messrs. Marcellus H.B. Muyres, Antony Gram, Cornelis van de Peppel and Cornelis L.J.J. Zwaans) were elected to serve as directors in their stead. Marcellus H.B. Muyres was appointed Chairman of the Board and Chief Executive Officer of the Company. These directors, as well as Leonardus G.M. Nipshagen, a Selex designee, were then elected as directors at the Company's 1992 Annual Meeting and re-elected at the Company's 1993 Annual Meeting. As part of the Selex transaction, Selex was granted an option, approved by the holders of a majority of the outstanding shares of the Company's Common Stock at the Company's 1992 Annual Meeting, to convert the Selex Loan, or any portion thereof, into a maximum of 850,000 shares of the Company's Common Stock at a per share conversion price equal to the greater of (i) $1.25 or (ii) 95% of the market price of the Company's Common Stock at the time of conversion, but in no event greater than $4.50 per share (the "Option"). However, on September 14, 1992, Selex formally waived and relinquished its right to exercise the Option as to 250,000 shares of the Company's Common Stock to enable the Company to settle certain litigation involving the Company through the issuance of approximately 250,000 shares of the Company's Common Stock to the claimants, without jeopardizing the utilization of the Company's net operating loss carryforward. On February 17, 1994, Selex exercised the remaining full 600,000 share Option at a conversion price of $1.90 per share, such that $1,140,000 in principal was repaid under the First Selex Loan through such conversion. As a consequence of such conversion, Selex holds 2,820,066 shares of the Company's Common Stock (43.1% of the outstanding shares of Common Stock of the Company based upon the number of shares of the Company's Common Stock outstanding as of March 18, 1994. Pursuant to the Selex transaction, $1,000,000 of the proceeds from the First Selex Loan was used by the Company to acquire certain commercial and multi-family properties at the Company's St. Augustine Shores community at their net appraised value, from Mr. Muyres and certain entities affiliated with Messrs. Zwaans and Muyres. Namely, (i) $416,000 was used to acquire 48 undeveloped condominium units (twelve 4 unit building sites) and 4 completed (and rented) condominium units from Conquistador, in which Messrs. Zwaans and Muyres serve as directors, as well as President and Secretary/Treasurer, respectively; (ii) $485,000 was used to acquire 4 commercial lots from Swan, in which Messrs. Zwaans and Muyres also serve as directors, as well as President and Secretary, respectively; and (iii) approximately $99,000 was used to reacquire, from Mr. Muyres, all of his rights, title and interest in that certain contract with the Company for the purchase of a commercial tract in St. Augustine Shores, Florida. None of the commercial land and multi-family property acquired by the Company from Mr. Muyres and certain entities affiliated with Messrs. Zwaans and Muyres collateralizes the First Selex Loan. In March, 1994, Conquistador exercised its right to repurchase certain of the multi-family property from the Company (which right had been granted in connection with the June, 1992 transaction) at a price of $312,000, of which $260,000 was paid in cash to the Company and $52,000 was applied to reduce interest due to Selex under the Third Selex Loan. In December, 1992, Mr. Gram, a director of the Company and beneficial owner of the Common Stock of the Company held by Selex, acquired all of the Company's outstanding bank debt and then assigned same to Yasawa, of which Mr. Gram is also the beneficial owner. Yasawa simultaneously completed a series of transactions with the Company which involved the transfer of certain assets to Yasawa or its affiliated companies, the acquisition by Yasawa of 289,637 shares of the Company's Common Stock through the exercise of warrants previously held by the banks, the provision of a $1,500,000 line of credit to the Company and the restructuring of the remaining debt as a $5,106,000 Yasawa Loan. Principal repayments aggregating $341,000 were made in 1993 and 1994 to reduce the Yasawa Loan to $4,765,000. On April 30, 1993, Selex loaned the Company an additional amount of $1,000,000 pursuant to the Second Selex Loan and since July 1, 1993 made further loans to the Company aggregating $4,400,000 under the Third Selex Loan. Principal of $33,000 had been repaid under the Second Selex Loan through August 31, 1994. As of August 31, 1994, Yasawa has loaned the Company an additional sum of $l,200,000 pursuant to the Second Yasawa Loan. As a consequence of these transactions, the Company had loans outstanding from Selex, Yasawa and their affiliates on August 31, 1994 in the aggregate amount of approximately $17,976,000, including interest. The loans from Selex, Yasawa and their affiliates are secured by substantially all of the assets of the Company. See Note 5 to Consolidated Financial Statements. The Company has stated in previous filings with the Commission that the obtainment of additional funds to implement its marketing program and achieve the objectives of its business plan is essential to enable the Company to maintain operations and continue as a going concern. Since December, 1992, the Company has been dependent on loans and advances from Selex, Yasawa and their affiliates in order to implement its marketing program and assist in meeting its working capital requirements. As stated above, during the last six months of 1993, Selex, Yasawa and their affiliates loaned the Company an aggregate of $4,400,000 pursuant to Third Selex Loan. Funds advanced under the Third Selex Loan enabled the Company to commence implementation of the majority of its marketing program in the third quarter of 1993. The full benefits were not realized in 1993 and the Company was unable to secure financing in 1994 to meet its working capital requirements. On March 10, 1994, the Company was advised that Selex filed Amendment No. 2 dated February 17, 1994 to its Schedule 13D (the "Amendment") with the Commission. In the Amendment, Selex reported that it, together with Yasawa and their affiliates were uncertain as to whether they would provide any further funds to the Company. The Amendment further stated that Selex, Yasawa and their affiliates, were seeking third parties to provide financing for the Company and that as part of any such transaction, they would be willing to sell or restructure all or a portion of their loans and Common Stock in the Company. Inasmuch as funding is not presently available to the Company from external sources and, as stated in their Amendment, Selex, Yasawa and their affiliates have not determined whether they will provide any further funds to the Company, the Company is facing a severe cash shortfall. As a consequence of its liquidity position, the Company has defaulted on certain obligations, including its escrow obligations to the Division pursuant to the Company's 1992 Consent Order, its obligation under its lease for its corporate offices and its obligation to make required interest payments under loans from Selex, Yasawa and their affiliates. Furthermore, the Company has not paid certain real estate taxes which are approximately $1,549,000 at August 31, 1994 and is also subject to certain pending litigation by former employees and others, which may adversely affect the financial condition of the Company. See "Legal Proceedings." The Company is continuing to seek third parties to provide financing. As part of any such transaction, Selex, Yasawa and their affiliates have indicated that they are willing to sell or restructure all or a portion of their loans and Common Stock in the Company. They have also indicated that they are willing to sell their interests in the Company at a significant discount. Consummation of any such transaction may result in a change in control of the Company. There can be no assurance, however, that any such transaction will result or that any financing will be obtained. Accordingly, the Company's Board of Directors is also considering other appropriate action given the severity of the Company's liquidity position including but not limited to filing under the federal bankruptcy laws. Alternatively, the Company could be subject to the filing of an involuntary bankruptcy proceeding in the event it is unable to resolve and settle pending litigation, satisfy settlement commitments and other unpaid creditor claims. See "Business: Recent Developments", "Legal Proceedings" and Notes 1, 5 and 8 to Consolidated Financial Statements. RESULTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993 AND DECEMBER 25, 1992 REVENUES Total revenues were $12,099,000 for 1993 compared to $12,217,000 for 1992. Included in 1992 revenues is a third quarter gain of $448,000 from the sale of the administration building at the Company's Citrus Springs community. Gross land sales were $3,170,000 for 1993 versus $2,515,000 for 1992. Net land sales (gross land sales less estimated uncollectible installment sales and contract valuation discount) increased to $2,432,000 for 1993 from $2,092,000 for 1992. The modest increase in sales reflects the introduction of the Company's marketing program which was delayed until the third quarter of the year. Retail land sales increased to $3,057,000 from $2,289,000, a 33.5% increase. The Company had a 90.6% increase in retail land sales contracts entered into in 1993 over 1992. This increase was due to the third quarter introduction of the Company's marketing program and reflects increased spending on advertising and promotional programs to strengthen the Company's marketing organization, rebuild its retail land sales business and re-enter the single-family home business. Bulk land sales were $113,000 in 1993 as compared to bulk land sales of $226,000 in 1992. In light of the Company's diminished bulk land sales inventory and the properties transferred to the Company's lenders on October 11, 1991, it is anticipated that 1994 will also produce a low volume of bulk land sales. See "Liquidity and Capital Resources: Mortgages and Similar Debt". The Company re-entered the single-family housing business in December, 1992. Since revenues are not recognized from housing sales until the completion of construction and passage of title, no significant housing revenues will be recognized in 1994. The Company recognized revenues from housing sales of $344,000 for 1993, primarily during the fourth quarter of the year, and had a backlog of housing sales of $899,000 as of December 31, 1993. The following table reflects the Company's real estate product mix for 1993 and 1992 (in thousands): - - -------------------- * New retail land sales contracts entered into, including deposit sales on which the Company has received less than 20% of the sales price, net of cancellations, for the years ended December 31, 1993 and December 25, 1992 were $4,106,000 and $2,154,000, respectively. Such contracts are not included in retail land sales until the applicable rescission period has expired and the Company has received payments totalling 20% of the contract sales prices. See Note 1 to the Consolidated Financial Statements. Improvement revenues result from the recognition of revenue deferred from prior period sales. Recognition occurs as development work proceeds on previously sold property. Improvement revenues totalled $4,725,000 in 1993 as compared to $2,404,000 for 1992. The increase was due to the Company's resumption of development work in the third quarter of 1992. Interest income was $1,197,000 for 1993 compared to $3,584,000 for 1992. This decrease is the result of lower contracts receivable balances. Other revenues were $3,401,000 for 1993 compared to $4,137,000 in 1992. Included in other revenues for 1992 is the previously mentioned gain of $448,000 on the sale of the administration building at the Company's Citrus Springs community, as well as revenues from the Company's Sunny Hills golf and country club which was sold in the first quarter of 1993. COSTS AND EXPENSES Costs and expenses were $20,871,000 for 1993 compared to $18,935,000 in 1992. Cost of sales totalled $6,441,000 for 1993 versus $4,605,000 for 1992, primarily due to the resumption of development work in the third quarter of 1992. Gross profit margins decreased from 46.7% to 40.9% The 1993 results include a provision for contract cancellations of $2,400,000. Included in the provision is $1,400,000 for contracts sold in prior years to third parties which the Company is obligated to repurchase. Commissions, advertising and other selling expenses totalled $6,008,000 for 1993 versus $3,917,000 for 1992. Advertising and promotional expenditures increased from $580,000 in 1992 to $1,521,000 in 1993, reflecting the Company's implementation of its marketing program. General and administrative expenses were $3,790,000 in 1993 versus $5,844,000 for 1992. General and administrative expenses have decreased primarily due to overhead reductions, as part of the Company's efforts to stabilize its liquidity situation. Interest expense was $1,257,000 for 1993, as compared to $3,356,000 for 1992, or a 62.5% decrease. Total interest costs (including capitalized interest) were $1,421,000 and $3,456,000 for 1993 and 1992, respectively. The decrease in interest cost is due to lower debt balances. NET INCOME The Company reported a net loss of $8,772,000 for 1993, compared to a net income of $7,336,000 for 1992. The 1993 results include a provision for contract cancellations of $2,400,000. The 1992 results include a gain of $448,000 on the sale of the administration building at the Company's Citrus Springs community, as well as a $10,161,000 extraordinary gain from debt restructuring and a $3,983,000 extraordinary gain from the settlement related to the Company's Marco refund obligation. RESULTS OF OPERATIONS YEARS ENDED DECEMBER 25, 1992 AND DECEMBER 27, 1991 REVENUES Total revenues were $12,217,000 for 1992 compared to $10,784,000 for 1991. Included in 1992 revenues is a third quarter gain of $448,000 from the sale of the administration building at the Company's Citrus Springs community. Gross land sales were $2,515,000 for 1992 versus $1,539,000 for 1991. Net land sales (gross land sales less estimated uncollectible installment sales and contract valuation discount) increased to $2,092,000 for 1992 from $1,154,000 for 1991. Retail land sales contracts written increased $851,000 from $1,438,000 in 1991 to $2,289,000 in 1992, a 60% increase. The increase in sales is primarily due to the resale, during the first quarter of 1992, of property which was the subject of a previously cancelled contract; however, sales for the year reflected the economic slowdown and the Company's inability to bolster marketing efforts due to its liquidity situation. Bulk land sales were $226,000 in 1992 as compared to bulk land sales of $101,000 in 1991. See "Liquidity and Capital Resources: Mortgages and Similar Debt". Although the Company re-entered the single-family housing business in December, 1992, since revenues are not recognized from housing sales until the completion of construction and passage of title, no housing revenues were expected to be recognized until late 1993. The following table reflects the Company's real estate product mix for 1992 and 1991 (in thousands): Improvement revenues result from the recognition of revenue deferred from prior period sales. Recognition occurs as development work proceeds on previously sold property. Improvement revenues totalled $2,404,000 in 1992 as compared to $-0- for 1991. The increase was due to the Company's resumption of development work in the third quarter of 1992. Interest income was $3,584,000 for 1992 compared to $5,270,000 for 1991. This decrease is the result of lower contracts receivable balances. Other revenues were $4,137,000 for 1992 compared to $4,240,000 in 1991. Included in other revenues is the previously mentioned gain of $448,000 on the sale of the administration building at the Company's Citrus Springs community. COSTS AND EXPENSES Costs and expenses were $18,935,000 for 1992 compared to $30,313,000 in 1991. Included in costs and expenses for 1991 was a provision of $8,900,000 caused by an addition to the allowance for uncollectible contracts for previously recognized sales of $12,200,000. Cost of sales totalled $4,605,000 for 1992 versus $2,599,000 for 1991, primarily due to the resumption of development work in the third quarter of 1992. Gross profit margins decreased from 53.1% to 46.7%. Commissions, advertising and other selling expenses totalled $3,917,000 for 1992 versus $4,107,000 for 1991. Advertising expenditures increased from $259,000 in 1991 to $580,000 in 1992, reflecting the Company's efforts to stimulate sales and implement its marketing program. Additional working capital was expected to be allocated during the year for advertising and promotional purposes to strengthen the Company's marketing organization, rebuild its retail land sales business and re-enter the single-family home business. General and administrative expenses were $5,844,000 in 1992 versus $6,165,000 for 1991. General and administrative expenses decreased primarily due to overhead reductions, as part of the Company's efforts to stabilize its liquidity situation. Interest expense was $3,356,000 for 1992, as compared to $6,896,000 for 1991, or a 51% decrease. Total interest costs (including capitalized interest) were $3,456,000 and $6,896,000 for 1992 and 1991, respectively. The decrease in interest cost is due to substantially lower debt balances, as well as lower prime rates of interest charged by the Company's lenders. NET INCOME The Company reported net income of $7,336,000 for 1992, compared to a net loss of $26,629,000 for 1991. The 1992 results include a gain of $448,000 on the sale of the administration building at the Company's Citrus Springs community, as well as a $10,161,000 extraordinary gain from debt restructuring and a $3,983,000 extraordinary gain from the settlement related to the Company's Marco refund obligation. The 1991 results included a provision of approximately $8,900,000 related to a $12,200,000 addition to the allowance for uncollectible contracts, as well as a $7,100,000 extraordinary loss from debt restructuring related to the Sixth Restatement. Exclusive of the extraordinary items, the loss from operations for 1992 was $6,808,000, as compared to the prior year's loss of $19,529,000. REGULATORY DEVELOPMENTS WHICH MAY AFFECT FUTURE OPERATIONS In Florida, as in many growth areas, local governments have sought to limit or control population growth in their communities through restrictive zoning, density reduction, the imposition of impact fees and more stringent development requirements. Although the Company has taken such factors into consideration in its master plans, the increased regulation has lengthened the development process and added to development costs. On a statewide level, the Florida Legislature adopted and implemented the Florida Growth Management Act of 1985 (the "Act") to aid local governments efforts to discourage uncontrolled growth in Florida. The Act precludes the issuance of development orders or permits if public facilities such as transportation, water and sewer services will not be available concurrent with development. Development orders have been issued for, and development has commenced in, the Company's existing communities (with development being virtually completed in certain of these communities). Thus, such communities are less likely to be affected by the new growth management policies than future communities. Any future communities developed by the Company will be strongly impacted by new growth management policies. Since the Act and its implications are consistently being re-examined by the State, together with local governments and various state and local governmental agencies, the Company cannot further predict the timing or the effect of new growth management policies, but anticipates that such policies may increase the Company's permitting and development costs. In addition to Florida, other jurisdictions in which the Company's properties are offered for sale have recently strengthened, or are considering strengthening, their regulation of subdividers and subdivided lands in order to provide further assurances to the public, particularly given the adverse publicity surrounding the industry which existed in 1990. The Company has attempted to take appropriate steps to modify its marketing programs and registration applications in the face of such increased regulation, but has incurred additional costs and delays in the marketing of certain of its properties in certain states and countries. For example, the Company has complied with regulations of certain states which require that the Company sell its properties to residents of those states pursuant to a deed and mortgage transaction, regardless of the amount of the down payment. The Company intends to continue to monitor any changes in statutes or regulations affecting, or anticipated to affect, the sale of its properties and intends to take all necessary and reasonable action to assure that its properties and its proposed marketing programs are in compliance with such regulations, but there can be no assurance that the Company will be able to timely comply with all regulatory changes in all jurisdictions in which the Company's properties are presently offered for sale to the public. LIQUIDITY AND CAPITAL RESOURCES MORTGAGES AND SIMILAR DEBT Indebtedness under various purchase money mortgages and loan agreements is collateralized by substantially all of the Company's assets, including stock of certain wholly-owned subsidiaries. The following table presents information with respect to mortgages and similar debt (in thousands): Included in Mortgage Notes Payable is the $3,000,000 First Selex Loan ($1,860,000 as of August 31, 1994), the $1,000,000 Second Selex Loan ($967,000 as of August 31, 1994) the $4,384,000 Third Selex Loan and the $4,900,000 Yasawa Loan ($4,765,000 as of August 31, 1994). Other loans include the $1,000,000 Empire note and the $1,500,000 Scafholding Loan. These mortgage notes payable and other loans are in default as of August 31, 1994 due to the non-payment of interest and principal. The lenders have not taken any action as a result of these defaults. On June 19, 1992, the Company completed a transaction with Selex whereby, among other things, Selex loaned the Company $3,000,000 (the First Selex Loan). The First Selex Loan is collateralized by a first mortgage on certain of the Company's property in its St. Augustine Shores, Florida community. The Loan matures on June 15, 1996 and provides for principal to be repaid at 50% of the net proceeds per lot for lots requiring release from the mortgage, with the entire unpaid balance becoming due and payable at the end of the four year term. It initially bears interest at the rate of 10% per annum, with payment of interest deferred for the initial eighteen months of the Loan and interest payments due quarterly thereafter. On February 17, 1994, principal in the amount of $1,140,000 was repaid under the First Selex Loan when Selex exercised its previously described Option to convert a portion of the Loan into 600,000 shares of the Company's Common Stock at a conversion price of $1.90 per share. Accrued interest in the amount of $604,300 (including $463,600 due December 31, 1993) was unpaid and in default under the First Selex Loan as of August 31, 1994. The Company had defaulted on its bank debt in the third quarter of 1990, and was engaged in negotiating the repayment and restructuring of such debt through 1991 and the first half of 1992. As of December 27, 1991, the Company's bank debt had been reduced by the assignment of mortgages receivables and, on October 11, 1991, the transfer of certain properties to its principal lending banks pursuant to a Conveyance Agreement with such lenders. The Conveyance Agreement not only provided for the partial repayment of the bank debt, but also encompassed an agreement in principle providing for the restructuring and repayment of the remaining bank debt. On June 18, 1992, the Company completed the restructuring of its bank debt by entering into the Sixth Amended and Restated Credit and Security Agreement (the "Sixth Restatement") with its lenders. The terms of the Sixth Restatement provided for the Company's remaining debt in the principal amount of approximately $25,300,000 to be repaid by June 30, 1997, with specified interim repayments and benchmarks to be achieved. Among other things, the Sixth Restatement provided for: (i) interest to accrue on the remaining debt at Citibank's alternate base rate ("ABR") plus 4% per annum, subject to a minimum interest rate of 11% per annum and a maximum interest rate of 14% per annum, with no interest payments due until June 30, 1996; (ii) accrued, but unpaid interest on $10,000,000 of the restructured debt to be forgiven provided that the principal balance outstanding on the restructured debt as of June 30, 1996 was less than $9,000,000; and (iii) the issuance to the lenders of warrants to acquire up to 277,387 shares of the Company's Common Stock at a price of $1.00 per share. In conjunction with the completion of the Sixth Restatement, the lenders released or subordinated their lien on certain assets of the Company, to enable the Company to complete the First Selex Loan, to complete the $13,500,000 sale of contracts receivable described below, to enter into the 1992 Consent Order with the Division, and to secure working capital needed to pay real estate taxes which were, at the time, delinquent and meet its customer obligations for improvement work at certain of the Company's communities. During the third quarter of 1992, the lenders also released their lien on certain other contracts receivable to allow the Company to complete a sale of such receivables, which generated $600,000 in proceeds. These proceeds were, in turn, paid to the lenders, with the lenders allowing the Company $1,000,000 in debt reduction credit, and resulting in an extraordinary gain of $400,000. During the 1991 second quarter, the Company incurred extraordinary expenses of $3,500,000 for debt restructuring, based upon the transfer value of the assets involved in the first phase of its debt restructuring. During the fourth quarter of 1991, the Company provided for an additional $3,600,000 of extraordinary expenses for debt restructuring based upon the Company's assessment of the ultimate costs that would result from the restructuring of its debt pursuant to the Sixth Restatement. The fourth quarter addition included the anticipated professional fees, bank charges and other costs related to the Sixth Restatement, as well as the loss on the sale of contracts receivable discussed below. The completion of the Sixth Restatement was dependent upon the completion of the sale of contracts receivable; therefore, the loss on such sale was included as an extraordinary item. On December 2, 1992 the Company entered into various agreements relating to certain of its assets and the restructuring of its debt with Yasawa. The consummation of these agreements was conditioned upon the acquisition by Mr. Gram of the bank debt under the Sixth Restatement (the "Bank Loan") described above. On December 4, 1992, Gram acquired the Bank Loan of approximately $25,150,000 (including interest and fees) for a price of $10,750,000, as well as the warrants which the lenders held. Immediately thereafter, Gram transferred all of his interest in the Bank Loan, including the warrants, to Yasawa. See Notes 5 and 10 to Consolidated Financial Statements. On December 11, 1992 the Company consummated the December 2, 1992 agreements with Yasawa. Under these agreements, Yasawa, its affiliates and the Company agreed as follows: (i) the Company sold certain property at its Citrus Springs community to an affiliate of Yasawa in exchange for approximately $6,500,000 of debt reduction credit; (ii) an affiliate of Yasawa and the Company entered into a joint venture agreement with respect to the Citrus Springs property, providing for the Company to market such property and receive an administration fee from the venture (in March, 1994, the Company and the affiliate agreed to terminate the venture); (iii) the Company sold certain contracts receivable at face value to an affiliate of Yasawa for debt reduction credit of approximately $10,800,000; (iv) the Company sold the Marco Shores Country Club and Golf Course to an affiliate of Yasawa for an aggregate sales price of $5,500,000, with the affiliate assuming an existing first mortgage of approximately $1,100,000 and the Company receiving debt reduction credit of $2,400,000, such that the Company obtained cash proceeds from this transaction of $2,000,000, which amount was used for working capital; (v) an affiliate of Yasawa agreed to lease the Marco Shores Country Club and Golf Course to the Company for a period of approximately one year; (vi) an affiliate of Yasawa and the Company agreed to amend the terms of the warrants to increase the number of shares issuable upon their exercise from 277,387 shares to 289,637 shares and to adjust the exercise price to an aggregate of approximately $314,000; (vii) Yasawa exercised the warrants in exchange for debt reduction credit of approximately $314,000; (viii) Yasawa released certain collateral held for the Bank Loan; (ix) an affiliate of Yasawa agreed to make an additional loan of up to $1,500,000 to the Company, thus providing the Company with a future line of credit (all of which was drawn and outstanding as of August 31, 1994); and (x) Yasawa agreed to restructure the payment terms of the remaining $5,106,000 of the Bank Loan as a loan from Yasawa. The Yasawa Loan bears interest at the rate of 11% per annum, with payment of interest deferred until December 31, 1993, at which time only accrued interest became payable. Commencing January 31, 1994, principal and interest became payable monthly, with all unpaid principal and accrued interest being due and payable on December 31, 1997. A portion of the proceeds from a March, 1993 sale of contracts receivable was applied to reduce the Yasawa Loan to $4,900,000 during the first quarter of 1993 and the assignment of a mortgage receivable to Yasawa reduced the Yasawa Loan to $4,764,000 as of August 31, 1994. Accrued interest due under the Yasawa Loan in the amount of $355,196 was unpaid and in default as of August 31, 1994. In February, 1994, Yasawa loaned the Company an additional amount of $437,500 at an interest rate of 8% per annum (the "Second Yasawa Loan"). As of August 31, 1994, a total of $1,200,000 had been advanced under the Loan. On April 30, 1993 Selex loaned the Company an additional $1,000,000 collateralized by a first mortgage on certain of the Company's property in its Marion Oaks, Florida community (the "Second Selex Loan"). The Second Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. The Second Selex Loan provides for principal to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 to be due and payable on April 30, 1994. Although Selex had certain conversion rights under the Second Selex Loan in the event the Company sold any Common Stock or Preferred Stock prior to payment in full of all amounts due to Selex under the Second Selex Loan, such rights were voided as of December 31, 1993 since the regulations set forth in proposed Treasury Decision CO-18-90 relative to Section 382 of the Internal Revenue Code were not adopted by such date. As of August 31, 1994, $33,000 in principal had been repaid under the Second Selex Loan, but accrued interest of $93,344 due under the Loan as of August 31, 1993 remained unpaid and in default. From July 9, 1993 through December 31, 1993, Selex loaned the Company an additional $4,400,000 collateralized by a second mortgage on certain of the Company's property on which Selex and/or Yasawa hold a first mortgage pursuant to a Loan Agreement dated July 14, 1993 and amendments thereto (the "Third Selex Loan"). The Third Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. Principal is to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 becoming due and payable on April 30, 1994. As of August 31, 1994 accrued interest of $466,837 due under the Third Selex Loan was unpaid and in default. Interest due to Selex, Yasawa and their affiliates in the aggregate amount of $2,300,000 remained unpaid and in default as of August 31, 1994. From January 1, 1994 through August 31, 1994, $24,000 in principal was repaid under the Second Selex Loan and $1,140,000 in principal was repaid under the First Selex Loan through the exercise of the above described Option. After giving effect to such repayments of principal, the Company had loans outstanding from Selex, Yasawa and their affiliates on August 31, 1994 in the amount of approximately $17,976,000 including interest, of which approximately $9,867,000 is owed to Selex, (10% per annum on the First Selex Loan, 11% per annum on the Second and Third Selex Loans and 12% per annum on the $1,000,000 Empire Note assigned to Selex); approximately $6,349,000 is owed to Yasawa, including accrued and unpaid interest of approximately $384,500 (11% per annum on the Yasawa Loan and 8% per annum on the Second Yasawa Loan); and approximately $1,759,000 is owed to an affiliate of Yasawa, including accrued and unpaid interest of approximately $259,500 (12% per annum). The loans from Selex, Yasawa and their affiliates are secured by substantially all of the assets of the Company. On March 10, 1994, the Company was advised that Selex filed an Amendment to its Schedule 13D filed with the Commission. In the Amendment, Selex reported that it, together with Yasawa and their affiliates, were uncertain as to whether they would provide any further funds to the Company. The Amendment further stated that Selex, Yasawa and their affiliates were seeking third parties to provide financing for the Company and that as part of any such transaction, they would be willing to sell or restructure all or a portion of their loans and Common Stock in the Company. The Company has stated in previous filings with the Commission that the obtainment of additional funds to implement its marketing program and achieve the objectives of its business plan is essential to enable the Company to maintain operations and continue as a going concern. Since December, 1992, the Company has been dependent on loans and advances from Selex, Yasawa and their affiliates in order to implement its marketing program and assist in meeting its working capital requirements. As stated above, during the last six months of 1993, Selex, Yasawa and their affiliates loaned the Company an aggregate of $4,400,000 pursuant to Third Selex Loan. Funds advanced under the Third Selex Loan enabled the Company to commence implementation of the majority of its marketing program in the third quarter of 1993. The full benefits of the program could not be realized in 1993 and the Company was unable to secure financing in 1994 to meet its ongoing working capital requirements. Inasmuch as funding is not presently available to the Company from external sources and, as stated in their Amendment, Selex, Yasawa and their affiliates have not determined whether they will provide any further funds to the Company, the Company is facing a severe cash shortfall. As a consequence of its liquidity position, the Company has defaulted on certain obligations, including its escrow obligations to the Division pursuant to the Company's 1992 Consent Order, its obligation under its lease for its corporate offices and its obligation to make required interest payments under loans from Selex, Yasawa and their affiliates. Furthermore, the Company has not paid certain real estate taxes which aggregate approximately $1,549,000 as of August 31, 1994 and is also subject to certain pending litigation from former employees and others, which may adversely affect the financial condition of the Company. See "Legal Proceedings." The Company is continuing to seek third parties to provide financing. As part of any such transaction, Selex, Yasawa and their affiliates have indicated that they are willing to sell or restructure all or a portion of their loans and Common Stock in the Company. They have also indicated that they are willing to sell their interests in the Company at a significant discount. Consummation of any such transaction may result in a change in control of the Company. There can be no assurance, however, that any such transaction will result or that any financing will be obtained. Accordingly, the Company's Board of Directors is also considering other appropriate action given the severity of the Company's liquidity position including but not limited to protection under federal bankruptcy laws. Alternatively, the Company could be subject to the filing of an involuntary bankruptcy proceeding in the event it is unable to resolve and settle pending litigation, satisfy settlement commitments and other unpaid creditor claims. See "Business: Recent Developments", "Legal Proceedings" and Notes 1, 5 and 8 to Consolidated Financial Statements. CONTRACTS AND MORTGAGES RECEIVABLE SALES In December, 1992, as described above, the Company sold $10,800,000 of contracts and mortgages receivable to an affiliate of Yasawa at face value, applying the proceeds therefrom to reduce the Bank Loan acquired by Yasawa. In June, 1992, the Company completed a new financing through a $13,500,000 sale of contracts and mortgages receivable which generated approximately $8,000,000 in net proceeds to the Company and the creation of a holdback account in the amount of $3,100,000. The anticipated costs of this transaction were included in the extraordinary loss from debt restructuring for 1991. In conjunction with this sale, the February, 1990 sale described below and certain prior sales of receivables, the Company granted the purchaser a security interest in certain additional contracts receivable of approximately $2,700,000 and conveyed all of its rights, title and interest in the property underlying such contracts to a collateral trustee. Upon compliance with the conditions of the agreement with the purchaser, funds from the holdback account and property held by the collateral trustee will be released to the Company. In February, 1990, the Company completed a sale of $17,000,000 of receivables, generating approximately $13,900,000 in net proceeds and a loss of approximately $600,000. This transaction, as well as the June, 1992 sale described above, among other things, requires that the Company replace or repurchase any receivable that becomes 90 days delinquent upon the request of the purchaser. Such requirement can be satisfied from contracts in which the purchaser holds a security interest (approximately $1,200,000 as of August 31, 1993). The Company believes that it has established adequate reserves and guarantees in the event such replacement or repurchase becomes necessary. In addition to the above, the Company transferred $1,600,000 in contracts and mortgages receivable in March, 1993, to a third party generating $1,100,000 in proceeds to the Company and the creation of a holdback account in the amount $150,000. The Company was the guarantor of approximately $29,265,000 of contracts receivable sold or transferred as of December 31, 1993 and had $1,992,000 on deposit with the purchaser of the receivables as security to assure collectibility as of such date. The Company has been in compliance with all receivable transactions since the consummation of the June, 1992 sale. The Company anticipates that it will be necessary to complete additional sales and financings of a portion of its receivables in 1994 and 1995. There can be no assurance, however, that such sales and/or financings can be accomplished. OTHER OBLIGATIONS As a result of the delays in completing the land improvements to certain property sold in certain of its Central and North Florida communities, the Company fell behind in meeting its contractual obligations to its customers. In connection with these delays, the Company, in February, 1980, entered into a Consent Order with the Division which provided a program for notifying affected customers. The Consent Order, which was restated and amended, provided a program for notifying affected customers of the anticipated delays in the completion of improvements (or, in the case of purchasers of unbuildable lots in certain areas of the Company's Sunny Hills community, the transfer of development obligations to core growth areas of the community); various options which may be selected by affected purchasers; a schedule for completing certain improvements; and a deferral of the obligation to install water mains until requested by the purchaser. Under an agreement with Topeka, Topeka's utility companies have agreed to furnish utility service to the future residents of the Company's communities on substantially the same basis as such services were provided by the Company. The Consent Order also required the establishment of an improvement escrow account as assurance for completing such improvement obligations. In June, 1992, the Company entered into the 1992 Consent Order with the Division, which replaced and superseded the original Consent Order, as amended and restated. Among other things, the 1992 Consent Order consolidated the Company's development obligations and provided for a reduction in its required monthly escrow obligation to $175,000 from September, 1992 through December, 1993. Beginning January, 1994 and until development is completed or the 1992 Consent Order is amended, the Company is required to deposit $430,000 per month into the escrow account. To meet its current escrow and development obligations under the 1992 Consent Order, the Company is required to deposit into escrow $5,160,000 in 1994 and $3,519,000 in 1995. As part of the assurance program under the 1992 Consent Order, the Company and its lenders granted the Division a lien on certain contracts receivable (approximately $8,915,000 as of December 31, 1993) and future receivables. As previously stated, the Company is in default of its escrow obligations, and in accordance with the 1992 Consent Order, the collections on such receivables have been escrowed for the benefit of purchasers since March 1, 1994. At August 31, 1994, the amount collected on fully paid-for lots was approximately $1,340,000. Pursuant to the 1992 Consent Order, the Company has limited the sale of single-family lots to lots which front on a paved street and are ready for immediate building. Because of the Company's default, the Division could also exercise other available remedies under the 1992 Consent Order, which remedies entitle the Division, among other things, to halt all sales of registered property. As of December 31, 1993, the Company had estimated development obligations of approximately $2,825,000 on sold property, an estimated liability to provide title insurance costing $951,000 and an estimated cost of street maintenance, prior to assumption of such obligations by local governments, of $3,852,000, all of which are included in deferred revenue. The total cost, including the previously mentioned obligations, to complete improvements at December 31, 1993 to lots subject to the 1992 Consent Order and to lots in the St. Augustine Shores community was estimated to be approximately $18,574,000. The Company has in escrow approximately $1,664,000 specifically for land improvements at certain of its Central and North Florida communities. The Company's continuing liquidity problems have precluded the timely payment of the full amount of its 1992 and 1993 real estate taxes. The Company has paid real estate taxes on all properties sold on which it is solely obligated to pay real estate taxes and on all properties which are presently available for sale. On properties where customers have contractually assumed the obligation to pay into a tax escrow maintained by the Company, the Company has and will continue to pay real estate taxes as monies are collected from customers. Delinquent real estate taxes on certain of the Company's properties, none of which are presently being marketed, aggregated approximately $1,549,000 as of August 31, 1994. The Company's corporate performance bonds to assure the completion of development at its St. Augustine Shores community expired in March and June, 1993. Such bonds cannot be renewed due to a change in the policy of the Board of County Commissioners of St. Johns County which precludes allowing any developer to secure the performance of development obligations by the issuance of corporate bonds. In the event that St. Johns County elects to undertake and complete such development work, the Company would be obligated with respect to 1,000 improved lots at St. Augustine Shores in the amount of approximately $6,200,000. The Company intends to submit an alternative assurance program for the completion of such development and improvements to the County for its approval. On September 30, 1988, the Company entered into an agreement with Citrus County, Florida to establish the procedure for transferring final maintenance responsibilities for roads in the Company's Citrus Springs subdivision to Citrus County. The agreement obligated the Company to complete certain remedial work on previously completed improvements within the Citrus Springs subdivision by June 1, 1991. The Company was unable to complete this work by the specified date and is negotiating with Citrus County for the transfer of final maintenance responsibility for the roads to the County. Following the consummation of the Sixth Restatement, the Company conveyed certain properties to the landlord in satisfaction of its outstanding lease obligations for its executive office building in Miami, Florida. The Company also entered into a modification of its lease agreement, providing for a reduction of its rental expenses through June 30, 1994, at which time the Company would have the option of acquiring the leased premises or reinstating the lease according to its original terms. Should the landlord sell the leased premises to a third party at any time that the lease, or any modification thereof, is in effect, then the lease with the Company would be cancelled. In December, 1993, the landlord filed suit against the Company alleging that the Company defaulted in its obligation to make rental payments under the lease and seeking to accelerate lease payments. See "Business: Recent Developments" and "Legal Proceedings". The Company had placed certain properties in trust to meet its refund obligations to customers affected by the 1976 denial by the U.S. Army Corps of Engineers of permits to complete the development of the Company's Marco Island community and had provided in its financial statements for such obligations. Following the September, 1992 court approval of a settlement of certain class action litigation instituted by customers affected by the Marco permit denials, the Company, among other things, conveyed more than 120 acres of multi-family and commercial land that had been placed in trust to the trustee of the 809 member class, and listed 250,000 shares of restricted Common Stock of the Company to be issued to the class members. At December 31, 1993, $2,886,000 remained in the allowance for Marco permit costs, including $554,000 relating to interest accrued on such obligations. Based upon the Company's experience with affected customers, the Company believes that its total obligations to the remaining 1.3% of its affected customers will not materially exceed the amount provided for in its financial statements. See Note 9 to Consolidated Financial Statements. LIQUIDITY Since 1986, the Company has directed its marketing efforts to rebuilding retail land sales in an attempt to obtain a more stable income stream and achieve a balanced growth of retail land sales and bulk land sales. Retail land sales typically have a higher gross profit margin than bulk land sales and the contracts receivable generated from retail land sales provide a continuing source of income. However, retail land sales also have traditionally produced negative cash flow through the point of sale. This is because the marketing and selling expenses have generally been paid prior to or shortly after the point of sale, while the land is generally paid for in installments. The Company's ability to rebuild retail land sales has been substantially dependent on its ability to sell or otherwise finance contracts receivable and/or secure other financing sources to meet its cash requirements. To alleviate the negative cash flow impact arising from retail land sales while attempting to rebuild its sales volume, the Company implemented several new marketing programs which, among other things, adjusted the method of commission payments and required larger down payments. However, the nationwide economic recession, which has been especially pronounced in the real estate industry, adverse publicity surrounding the industry which existed in 1990, the resulting, more stringent regulatory climate, and worldwide economic uncertainties have severely depressed retail land sales beginning in mid-1990 and continuing thereafter, resulting in a continuing liquidity crisis. Because of this severe liquidity crisis, the Company ceased development work late in the third quarter of 1990 and did not resume development work until the third quarter of 1992. From September 29, 1990 through the fourth quarter of 1991, when the Company ceased selling undeveloped lots, sales of undeveloped lots were accounted for using the deposit method. Under this method, all payments were recorded as a customer deposit liability. In addition, because of the increasing trend in delinquencies during 1990, since the beginning of 1991, the Company has not recognized any sale until 20% of the contract sales price has been received. As a result, the reporting and recognition of revenues and profits on a portion of the Company's retail land sales contracts is being delayed. See Note 1 to Consolidated Financial Statements. The continued economic recession and the increasing adverse effects of such recession on the Florida real estate industry not only resulted in the Company's sales remaining at depressed levels, but caused greater contract cancellations in 1991, particularly in the second half of the year, than were anticipated. Such cancellations required the Company to record an additional provision to its allowance for uncollectible sales of approximately $12,200,000 in the 1991 third quarter, impacting net income by approximately $8,900,000. While the Company is making every effort to reduce its cancellations, should this trend continue, the Company could be required to record additional provisions in the future. The Company had defaulted on its bank debt in the third quarter of 1990, and was engaged in negotiating the repayment and restructuring of such debt through 1991 and the first half of 1992. On October 11, 1991, as described above, the Company completed the first phase of the restructuring of its bank debt by conveying to the lenders certain real estate assets which had been held for future development or bulk sales purposes, and on June 18, 1992, the Company finalized the restructuring of its remaining bank debt by entering into the Sixth Restatement. In December, 1992, such bank debt was acquired by Mr. Gram and assigned to Yasawa. Through the sale of certain assets to Yasawa and its affiliates, including certain contracts receivable, and the exercise of the warrants by Yasawa, the Company was able to reduce such remaining debt from approximately $25,150,000 (including interest and fees) to approximately $5,106,000. During 1993, the Yasawa Loan was reduced to $4,900,000. The agreement with Yasawa also provided the Company with a future line of credit of $1,500,000, all of which was drawn and outstanding as of August 31, 1994. During 1993, Selex loaned the Company an additional $5,400,000 pursuant to the Second and Third Selex Loans, of which $5,351,000 was outstanding as of August 31, 1994, and Yasawa loaned the Company an additional $1,200,000 in 1994 pursuant to the Second Yasawa Loan. The loans from Selex, Yasawa and their affiliates are collateralized by substantially all of the Company's assets. On March 10, 1994, the Company was advised that Selex filed an Amendment to its Schedule 13D with the Commission. In the Amendment, Selex reported that it, together with Yasawa and their affiliates, were uncertain as to whether they would provide any further funds to the Company. The Amendment further stated that Selex, Yasawa and their affiliates were seeking third parties to provide financing for the Company and that as part of any such transaction, they would be willing to sell or restructure all or a portion of their loans and Common Stock in the Company. The Company has stated in previous filings with the Commission and elsewhere herein that the obtainment of additional funds to implement its marketing program and achieve the objectives of its business plan is essential to enable the Company to maintain operations and continue as a going concern. Since December, 1992, the Company has been dependent on loans and advances from Selex, Yasawa and their affiliates in order to implement its marketing program and assist in meeting its working capital requirements. As previously stated, during the last six months of 1993, Selex, Yasawa and their affiliates loaned the Company an aggregate of $4,400,000 pursuant to Third Selex Loan. Funds advanced under the Third Selex Loan enabled the Company to commence implementation of the majority of its marketing program in the third quarter of 1993. The full benefits of the program were not realized in 1993 and the Company was unable to secure financing in 1994 to meet its working capital requirements. Inasmuch as funding is not presently available to the Company from external sources and, as stated in their Amendment, Selex, Yasawa and their affiliates have not determined whether they will provide any further funds to the Company, the Company is facing a severe cash shortfall. As a consequence of its liquidity position, the Company has defaulted on certain obligations, including its previously described escrow obligations to the Division pursuant to the Company's 1992 Consent Order, its obligation under its lease for its corporate offices and its obligation to make required interest payments under loans from Selex, Yasawa and their affiliates. Furthermore, the Company has not paid certain real estate taxes which aggregate approximately $1,549,000 as of August 31, 1994 and is also subject to certain pending litigation from former employees and others, which may adversely affect the financial condition of the Company. See "Legal Proceedings." The Company is continuing to seek third parties to provide financing. As part of any such transaction, Selex, Yasawa and their affiliates have indicated that they are willing to sell or restructure all or a portion of their loans and Common Stock in the Company. They have also indicated that they are willing to sell their interests in the Company at a significant discount. Consummation of any such transaction may result in a change in control of the Company. There can be no assurance, however, that such transaction will result or that any financing will be obtained. Accordingly, the Company's Board of Directors is also considering other appropriate action given the severity of the Company's liquidity position. Alternatively, the Company could be subject to the filing of an involuntary bankruptcy proceeding in the event it is unable to resolve and settle pending litigation, satisfy settlement commitments and other unpaid creditor claims. See "Business: Recent Developments", "Legal Proceedings" and Notes 1, 5 and 8 to Consolidated Financial Statements. ITEM 8 ITEM 8 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA INDEPENDENT AUDITORS' REPORT TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF THE DELTONA CORPORATION: We have audited the consolidated balance sheets of The Deltona Corporation and subsidiaries (the "Company") as of December 31, 1993 and December 25, 1992 and the related statements of consolidated operations, consolidated stockholders' equity (deficiency) and consolidated cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company at December 31, 1993 and December 25, 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company incurred substantial operating losses during 1993, 1992 and 1991, has continued to experience severe liquidity crises, causing the Company to be unable to meet certain contractual obligations, in some cases resulting in litigation that may have a substantial impact on the Company, and has a stockholders' deficiency at December 31, 1993. These matters raise substantial doubt about the Company's ability to continue as a going concern. Management's plans concerning these matters are described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. DELOITTE & TOUCHE LLP Certified Public Accountants Miami, Florida September 5, 1994 CONSOLIDATED BALANCE SHEETS THE DELTONA CORPORATION AND SUBSIDIARIES ASSETS (IN THOUSANDS) The accompanying notes are an integral part of the consolidated financial statements. CONSOLIDATED BALANCE SHEETS THE DELTONA CORPORATION AND SUBSIDIARIES LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY) (IN THOUSANDS EXCEPT SHARE DATA) The accompanying notes are an integral part of the consolidated financial statements. STATEMENTS OF CONSOLIDATED OPERATIONS THE DELTONA CORPORATION AND SUBSIDIARIES (IN THOUSANDS EXCEPT SHARE DATA) The accompanying notes are an integral part of the consolidated financial statements. STATEMENTS OF CONSOLIDATED STOCKHOLDERS' EQUITY (DEFICIENCY) THE DELTONA CORPORATION AND SUBSIDIARIES (IN THOUSANDS) FOR THE YEARS ENDED DECEMBER 31, 1993, DECEMBER 25, 1992 AND DECEMBER 27, 1991 The accompanying notes are an integral part of the consolidated financial statements. STATEMENTS OF CONSOLIDATED CASH FLOWS THE DELTONA CORPORATION AND SUBSIDIARIES (IN THOUSANDS) The accompanying notes are an integral part of the consolidated financial statements. STATEMENTS OF CONSOLIDATED CASH FLOWS - (CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES (IN THOUSANDS) RECONCILIATION OF NET INCOME (LOSS) TO NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES: The accompanying notes are an integral part of the consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE DELTONA CORPORATION AND SUBSIDIARIES 1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION - GOING CONCERN The accompanying financial statements of The Deltona Corporation and subsidiaries (the "Company") have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. During 1990, as a result of adverse publicity surrounding the Florida real estate industry, the Company could not complete the sale of $7,000,000 of contracts receivable. This created a severe liquidity crisis for the Company. The liquidity crisis was further impacted by declining sales and increasing delinquencies in the Company's contracts receivable portfolio caused by such adverse publicity and the national economic slowdown which was particularly severe in the real estate industry. These factors caused the Company to incur a loss from operations of $19,529,000 during 1991, to default on its bank debt and to defer development work at its communities. As a result of its 1991 loss, the Company had a stockholders' deficiency of $13,169,000 for the year ended December 27, 1991. Although the Company reported net income of $7,336,000 for 1992, primarily due to extraordinary gains of $10,161,000 from debt restructuring and $3,983,000 from a settlement related to the Marco refund obligation, such that it was able to reduce the stockholders' deficiency to $5,519,000 as of December 25, 1992, the Company incurred a loss from operations for 1992 of $6,808,000 and for 1993 of $8,772,000, resulting in a stockholders' deficiency of $14,291,000 as of December 31, 1993. The Company has continued to experience liquidity problems, causing it to be unable to fully implement its marketing program and to meet certain contractual obligations, primarily relating to the repayment of debt and the completion of improvements. The Company must obtain additional financing to accomplish the objectives of satisfying or substantially reducing its current debt obligations and provide the financial stability that will allow the Company to accomplish the objectives of a successful business plan. These matters raise substantial doubt about the Company's ability to continue as a going concern. Following the completion of the restructuring of its bank debt in 1992 (see Note 5), the Company commenced the implementation of its business plan by undertaking a new marketing program which included the Company's re-entry into the single-family housing business. To accomplish the objectives of its business plan required the Company to obtain financing during 1993 and will require the Company to obtain additional financing in 1994 and 1995. The transactions described in Note 5 with Selex International B.V., a Netherlands corporation ("Selex"), Yasawa Holding, N.V., a Netherlands Antilles corporation ("Yasawa"), and their affiliates provided the Company with a portion of its financing requirements enabling the Company to commence implementation of the marketing program and attempt to accomplish the objectives of its business plan, but additional financing will be required in 1994 and 1995. Selex, Yasawa and their affiliates are uncertain as to whether they will provide any further funds to the Company. While the Company, together with Selex, Yasawa and their affiliates, is seeking third parties to provide financing for the Company and, as part of any such transaction, Selex, Yasawa and their affiliates have indicated their willingness to sell or restructure all or a portion of their loans and Common Stock in the Company, such financing has not yet become available. As a consequence of its liquidity position, the Company has defaulted on certain obligations, including its escrow account obligations to the State of Florida, Department of Business Regulation, Division of Land Sales, Condominiums and Mobile Homes (the "Division") pursuant to the Company's 1992 Consent Order with the Division (the "1992 Consent Order"), its obligation under its lease for its corporate offices, its obligation to pay certain real estate taxes, and its obligation to make required interest payments under loans from Selex, Yasawa and their affiliates. Additionally, the Company is subject to certain pending litigation by former employees and NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES - (CONTINUED) others, which may adversely affect the financial condition of the Company (See Note 5 and 8). There can be no assurance that the Company will be able to timely secure the necessary financing to resolve its present liquidity situation, that the pending litigation will be favorably concluded, or that a new business plan will be successfully implemented. Consequently, there can be no assurance that the Company can continue as a going concern. In the event that these matters are not successfully addressed, the Company's Board of Directors will consider other appropriate action given the severity of the Company's liquidity position, including, but not limited to, filing for protection under the federal bankruptcy laws. Alternatively, the Company could be subject to the filing of an involuntary bankruptcy proceeding in the event it is unable to resolve and settle pending litigation, satisfy settlement commitments and other unpaid creditor claims. See "Legal Proceedings", "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes 5 and 8 to Consolidated Financial Statements. The consolidated financial statements do not include any adjustments relating to the recoverability of asset amounts or the amounts of liabilities should the Company be unable to continue as a going concern. Significant Accounting Policies The Company's consolidated financial statements are prepared in accordance with generally accepted accounting principles. Material intercompany accounts and transactions are eliminated. Since 1986, the Company has used a 52-53 week fiscal year ending on the last Friday of the year. The year ended December 31, 1993 contained 53 weeks, and the years ended December 25, 1992 and December 27, 1991 contained 52 weeks. Commencing in 1994, the Company will return to a fiscal year ended December 31. The Company sells homesites under installment contracts which provide for payments over periods ranging from 2 to 10 years. Sales of homesites are recorded under the percentage-of-completion method in accordance with Statement of Financial Accounting Standards No. 66, "Accounting for Sales of Real Estate" ("FASB No. 66"). Since 1991, the Company has not recognized a sale until it has received 20% of the contract sales price. Because of the severe liquidity crisis faced by the Company as discussed above, the Company ceased development work late in the third quarter of 1990. From September 29, 1990 through the fourth quarter of 1991, all sales of undeveloped lots were accounted for using the deposit method. Since the fourth quarter of 1991 and in compliance with the 1992 Consent Order, the Company has been offering only developed lots for sale (see Note 8). At the time of recording a sale the Company records an allowance for the estimated cost to cancel the related contracts receivable through a charge to the provision for uncollectible sales. The amount of this provision and the adequacy of the allowance is determined by the Company's continuing evaluation of the portfolio and past cancellation experience. While the Company uses the best information available to make such evaluations, future adjustments to the allowance may be necessary as a result of future national and international economic and other conditions that may be beyond the Company's control. Changes in the Company's estimate of the allowance for previously recognized sales will be reported in earnings in the period in which they become NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES-(CONTINUED) estimable and are charged to the provision for uncollectible contracts. Land improvement costs are allocated to individual homesites based upon the relationship that the homesite's sales price bears to the total sales price of all homesites in the community. The estimated costs of improving homesites are based upon independent engineering estimates made in accordance with sound cost estimation and provide for anticipated cost-inflation factors. The estimates are systematically reviewed. When cost estimates are revised, the percentage relationship they bear to deferred revenues is recalculated on a cumulative basis to determine future income recognition as performance takes place. Bulk land sales are recorded and profit is recognized in accordance with FASB No. 66. Bulk land sales of approximately $113,000, $226,000 and $101,000 are included in gross land sales for the years ended December 31, 1993, December 25, 1992 and December 27, 1991, respectively. Sales of houses and vacation ownership units, as well as all related costs and expenses, are recorded at the time of closing. Interest costs directly related to, and incurred during, a project's construction period are capitalized. Such capitalized interest amounted to $164,000, $100,000 and $-0- for the years ended December 31, 1993, December 25, 1992 and December 27, 1991, respectively. Property, plant and equipment is stated at cost. Depreciation is provided by the straight-line method over the estimated useful lives of the respective assets. Additions and betterments are capitalized, and maintenance and repairs are charged to income as incurred. Generally, upon the sale or retirement of assets, the accounts are relieved of the costs and related accumulated depreciation and any gain or loss is reflected in income. When property exchanges and refund transactions are consummated under the Company's Marco Island-Marco Shores customer programs (see Note 9), any resulting loss is charged to the allowance for Marco permit costs. When property exchanges and refund transactions are consummated under the Consent Order (see Note 8), any resulting loss is charged against the allowance included in accrued expenses and other. The Company accrues interest on its refund obligations in accordance with the various customer refund programs. For the purposes of the statements of cash flows, the Company considers its investments, which are comprised of short term, highly liquid investments purchased with a maturity of three months or less, to be cash equivalents. Certain amounts in the 1991 and 1992 financial statements have been reclassified for comparative purposes to the 1993 presentation. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 2. CONTRACTS AND MORTGAGES RECEIVABLE At December 31, 1993, interest rates on contracts receivable outstanding ranged from 6.0% to 12.0% per annum (weighted average approximately 8.4%). The approximate principal maturities of contracts receivable (including $65,000 restricted for use in the Marco refund program, see Note 9) were: DECEMBER 31, -------------- (IN THOUSANDS) 1994........................................................... $ 942 1995........................................................... 1,011 1996........................................................... 1,077 1997........................................................... 1,125 1998........................................................... 1,156 1999 and thereafter............................................ 2,570 ------- Total.................................................. $ 7,881 ======= If a regularly scheduled payment on a contract remains unpaid 30 days after its due date, the contract is considered delinquent. Aggregate delinquent contracts receivable at December 31, 1993 and December 25, 1992 approximate $1,717,000 and $2,104,000, respectively. Information with respect to interest rates and average contract lives used in valuing new contracts receivable generated from sales follows: AVERAGE AVERAGE STATED DISCOUNTED YEARS ENDED TERM INTEREST RATE TO YIELD ----------- ---------- -------------- ---------- December 31, 1993.................... 98 months 7.8% 13.5% December 25, 1992.................... 111 months 8.4% 13.5% December 27, 1991.................... 108 months 7.8% 13.5% In March, 1993 the Company transferred $1,600,000 of contracts and mortgages receivable, generating approximately $1,059,000 in proceeds to the Company, which was used for working capital, and the creation of a holdback account in the amount of $150,000. As of December 31, 1993, the balance of the holdback account was $126,000. In December, 1992 the Company sold $10,800,000 of contracts and mortgages receivable to an affiliate of Yasawa at face value, applying the proceeds therefrom to reduce the debt under the Sixth Amended and Restated Credit and Security Agreement (the "Sixth Restatement") which had been acquired by Yasawa (see Note 5). In June, 1992, the Company completed a $13,500,000 sale of contracts and mortgages receivable which generated approximately $8,000,000 in net proceeds to the Company and the creation of a holdback account in the amount of $3,100,000. The anticipated costs of this transaction were included in the extraordinary loss from debt restructuring for 1991 since the restructuring was dependent on the sale. In conjunction with this sale, the February, 1990 sale described below and certain prior sales of receivables, the Company granted the purchaser a security interest in certain additional contracts and mortgages receivable of approximately $2,700,000 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 2. CONTRACTS AND MORTGAGES RECEIVABLE - (CONTINUED) and conveyed all of its rights, title and interest in the property underlying such contracts to a collateral trustee. Upon compliance with the conditions of the agreement with the purchaser, funds from the holdback account and property held by the collateral trustee will be released to the Company. The Company sold approximately $17,000,000 of contracts and mortgages receivable in February, 1990. Net proceeds from the sale were approximately $13,900,000 (see Note 8). The Company recorded a loss of $600,000 on the 1990 sale (see Note 12). This transaction, as well as the June, 1992 sale described above, among other things, requires that the Company replace or repurchase any receivable that becomes 90 days delinquent upon the request of the purchaser. Such requirement can be satisfied from contracts in which the purchaser holds a security interest (approximately $1,419,000 as of December 31, 1993). Since the sale of receivables in 1992, the Company has been in compliance with the requirements of its prior receivables transactions and believes that it has established adequate reserves in the event such replacement or repurchase becomes necessary. The Company was unable, however, to replace or repurchase approximately $1,946,000 of delinquent contracts in 1993, which amount was deducted from the deposit held by the purchaser of the receivables as security. The Company was the guarantor of approximately $29,265,000 of contracts receivable sold or transferred as of December 31, 1993 and had $1,992,000 on deposit with the purchasers of the receivables as security to assure collectibility as of such date. The Company has been in compliance with all receivable transactions since the consummation sales. On July 24, 1991, the Company assigned mortgages receivable, including accrued interest and payments collected thereon from December 1990 through July 1991, of approximately $6,400,000, to its principal lending banks to be applied to reduce its outstanding bank debt (see Note 5). At December 31, 1993, mortgages receivable were collectible over periods ranging from one to seven years at stated interest rates of 7% to 10%. Principal maturities (including approximately $619,000 restricted for use in the Marco refund program, see Note 9) were approximately: DECEMBER 31, -------------- (IN THOUSANDS) 1994......................................................... $ 1,139 1995......................................................... 5 1996......................................................... 4 1997......................................................... 3 1998......................................................... 3 1999 and thereafter.......................................... 8 ------- Total (included in mortgages and other receivables)...... $ 1,162 ======= NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 3. INVENTORIES Information with respect to the classification of inventory of land and improvements including land held for sale or transfer is as follows: DECEMBER 31, DECEMBER 25, 1993 1992 ------------ ------------ (IN THOUSANDS) Unimproved land...................................... $ 444 $ 444 Land in various stages of development................ 4,888 7,168 Fully improved land.................................. 7,111 4,806 -------- -------- Total.................................... $ 12,443 $ 12,418 ======== ======== Land and land improvements include approximately $202,000 and $406,000 of land placed in the Marco Island and Marco Shores trusts for the Marco refund program as of December 31, 1993 and December 25, 1992, respectively (see Note 9). Other inventories consists primarily of multi-family units completed, as well as approximately $900,000 in 1992 of land assets previously classified as being held for sale or transfer to lenders. Land held for sale or transfer to lenders consists of land and land assets which were transferred to the Company's lenders or sold by the Company with proceeds therefrom used in repayment of outstanding debt (see Note 5). 4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment and accumulated depreciation consist of the following: DECEMBER 31, 1993 DECEMBER 25, 1992 --------------------- ---------------------- ACCUMULATED ACCUMULATED COST DEPRECIATION COST DEPRECIATION ------ ------------ ------ ------------ (IN THOUSANDS) Land and land improvements...... $ 143 $ - $ 157 $ - Other buildings, improvements and furnishings.............. 1,954 1,250 2,223 1,414 Construction and other equipment.............. 1,661 1,543 1,654 1,496 Construction work in progress... 43 - 34 - ------- ------- ------- ------- Total...................... $ 3,801 $ 2,793 $ 4,068 $ 2,910 ======= ======= ======= ======= NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 4. PROPERTY, PLANT AND EQUIPMENT - (CONTINUED) Depreciation charged to operations for the years ended December 31, 1993, December 25, 1992 and December 27, 1991 was approximately $104,000, $175,000 and $292,000, respectively. 5. MORTGAGES AND SIMILAR DEBT Indebtedness under various purchase money mortgages and loan agreements is collateralized by substantially all of the Company's assets, including stock of certain wholly-owned subsidiaries. The following table presents information with respect to mortgages and similar debt (in thousands): DECEMBER 31, DECEMBER 25, 1993 1992 ------------ ------------ Mortgage Notes Payable ........................ $ 13,284 $ 8,165 Other Loans.................................... 2,500 1,000 -------- -------- Total Mortgages and Similar Debt....... $ 15,784 $ 9,165 ======== ======== Included in Mortgage Notes Payable is the $3,000,000 First Selex Loan ($1,860,000 as of August 31, 1994), the $1,000,000 Second Selex Loan ($967,000 as of August 31, 1994) the $4,384,000 Third Selex Loan and the $4,900,000 Yasawa Loan ($4,765,000 as of August 31, 1994). Other loans include the $1,000,000 Empire note and the $1,500,000 Scafholding Loan. These mortgage notes payable and other loans are in default as of August 31, 1994 due to the non-payment of interest and principal. The lenders have not taken any action as a result of these defaults. On June 19, 1992, the Company completed a transaction with Selex whereby, among other things, Selex loaned the Company $3,000,000 (the "First Selex Loan"). The First Selex Loan is collateralized by a first mortgage on certain of the Company's property in its St. Augustine Shores, Florida community. The Loan matures on June 15, 1996 and provides for principal to be repaid at 50% of the net proceeds per lot for lots requiring release from the mortgage, with the entire unpaid balance becoming due and payable at the end of the four year term. It initially bears interest at the rate of 10% per annum, with payment of interest deferred for the initial eighteen months of the Loan and interest payments due quarterly thereafter. As discussed in Note 10, Selex was granted an Option to convert the First Selex Loan, or any portion thereof, into up to 600,000 shares of the Company's Common Stock. On February 17, 1994, principal in the amount of $1,140,000 was repaid under the First Selex Loan when Selex exercised such Option at a conversion price of $1.90 per share. Accrued interest in the amount of $604,300 (including $463,600 due December 31, 1993) was unpaid and in default under the First Selex Loan as of August 31, 1994. The Company had defaulted on its bank debt in the third quarter of 1990, and was engaged in negotiating the repayment and restructuring of such debt through 1991 and the first half of 1992. As of December 27, 1991, the Company's bank debt had been reduced by the assignment of mortgages receivables and, on October 11, 1991, the transfer of certain properties to its principal lending banks pursuant to a Conveyance Agreement with such lenders. The Conveyance Agreement not only provided for the partial repayment of the bank debt, but also encompassed an agreement in principle providing for the restructuring and repayment of the remaining bank debt. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 5. MORTGAGES AND SIMILAR DEBT - (CONTINUED) On June 18, 1992, the Company completed the restructuring of its bank debt by entering into the Sixth Amended and Restated Credit and Security Agreement (the "Sixth Restatement") with its lenders. The terms of the Sixth Restatement provided for the Company's remaining debt in the principal amount of approximately $25,300,000 to be repaid by June 30, 1997, with specified interim repayments and benchmarks to be achieved. Among other things, the Sixth Restatement provided for: (i) interest to accrue on the remaining debt at Citibank's alternate base rate ("ABR") plus 4% per annum, subject to a minimum interest rate of 11% per annum and a maximum interest rate of 14% per annum, with no interest payments due until June 30, 1996; (ii) accrued, but unpaid interest on $10,000,000 of the restructured debt to be forgiven provided that the principal balance outstanding on the restructured debt as of June 30, 1996 was less than $9,000,000; and (iii) the issuance to the lenders of warrants to acquire up to 277,387 shares of the Company's Common Stock at a price of $1.00 per share. In conjunction with the completion of the Sixth Restatement, the lenders released or subordinated their lien on certain assets of the Company, to enable the Company to complete the First Selex Loan, to complete the $13,500,000 sale of contracts receivable described below, to enter into the 1992 Consent Order with the Division, and to secure working capital needed to pay real estate taxes which were, at the time, delinquent and meet its customer obligations for improvement work at certain of the Company's communities. During the third quarter of 1992, the lenders also released their lien on certain other contracts receivable to allow the Company to complete a sale of such receivables, which generated $600,000 in proceeds. These proceeds were, in turn, paid to the lenders, with the lenders allowing the Company $1,000,000 in debt reduction credit, and resulting in an extraordinary gain of $400,000. During the 1991 second quarter, the Company incurred extraordinary expenses of $3,500,000 for debt restructuring, based upon the transfer value of the assets involved in the first phase of its debt restructuring. During the fourth quarter of 1991, the Company provided for an additional $3,600,000 of extraordinary expenses for debt restructuring based upon the Company's assessment of the ultimate costs that would result from the restructuring of its debt pursuant to the Sixth Restatement. The fourth quarter addition included the anticipated professional fees, bank charges and other costs related to the Sixth Restatement, as well as the loss on the sale of contracts receivable discussed below. The completion of the Sixth Restatement was dependent upon the completion of the sale of contracts receivable; therefore, the loss on such sale was included as an extraordinary item. On December 2, 1992 the Company entered into various agreements relating to certain of its assets and the restructuring of its debt with Yasawa. The consummation of these agreements was conditioned upon the acquisition by Mr. Gram of the bank debt under the Sixth Restatement as described above. On December 4, 1992, Gram acquired the Bank Loan of approximately $25,150,000 (including interest and fees) for a price of $10,750,000, as well as the warrants which the lenders held. Immediately thereafter, Gram transferred all of his interest in the Bank Loan, including the warrants, to Yasawa. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 5. MORTGAGES AND SIMILAR DEBT - (CONTINUED) On December 11, 1992, the Company consummated the December 2, 1992 agreements with Yasawa. Under these agreements, Yasawa, its affiliates and the Company agreed as follows: (i) the Company sold certain property at its Citrus Springs community to an affiliate of Yasawa in exchange for approximately $6,500,000 of debt reduction credit; (ii) an affiliate of Yasawa and the Company entered into a joint venture agreement with respect to the Citrus Springs property, providing for the Company to market such property and receive an administration fee from the venture (in March, 1994, the Company and the affiliate agreed to terminate the venture); (iii) the Company sold certain contracts receivable at face value to an affiliate of Yasawa for debt reduction credit of approximately $10,800,000; (iv) the Company sold the Marco Shores Country Club and Golf Course to an affiliate of Yasawa for an aggregate sales price of $5,500,000, with the affiliate assuming an existing first mortgage of approximately $1,100,000 and the Company receiving debt reduction credit of $2,400,000, such that the Company obtained cash proceeds from this transaction of $2,000,000, which amount was used for working capital; (v) an affiliate of Yasawa agreed to lease the Marco Shores Country Club and Golf Course to the Company for a period of approximately one year; (vi) an affiliate of Yasawa and the Company agreed to amend the terms of the warrants to increase the number of shares issuable upon their exercise from 277,387 shares to 289,637 shares and to adjust the exercise price to an aggregate of approximately $314,000; (vii) Yasawa exercised the warrants in exchange for debt reduction credit of approximately $314,000; (viii) Yasawa released certain collateral held for the bank loan; (ix) an affiliate of Yasawa agreed to make an additional loan of up to $1,500,000 to the Company, thus providing the Company with a future line of credit (all of which was drawn and outstanding as of August 31, 1994); and (x) Yasawa agreed to restructure the payment terms of the remaining $5,106,000 of the bank loan as a loan from Yasawa (the "Yasawa Loan"). The Yasawa Loan bears interest at the rate of 11% per annum, with payment of interest deferred until December 31, 1993, at which time only accrued interest became payable. Commencing January 31, 1994, principal and interest became payable monthly, with all unpaid principal and accrued interest being due and payable on December 31, 1997. A portion of the proceeds from a March, 1993 sale of contracts receivable was applied to reduce the Yasawa Loan to $4,900,000 during the first quarter of 1993 and the assignment of a mortgage receivable to Yasawa reduced the Yasawa Loan to $4,771,000 as of February 17, 1994. Accrued interest due under the Yasawa Loan in the amount of $355,200 was unpaid and in default as of August 31, 1994. In February, 1994, Yasawa loaned the Company an additional amount of $437,500 at an interest rate of 8% per annum (the "Second Yasawa Loan"). As of August 31, 1994 a total of $1,200,000 had been advanced under this loan. On April 30, 1993 Selex loaned the Company an additional $1,000,000 collateralized by a first mortgage on certain of the Company's property in its Marion Oaks, Florida community (the "Second Selex Loan"). The Second Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. The Second Selex Loan provides for principal to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 to be due and payable on April 30, 1994. Although Selex had certain conversion rights under the Second Selex Loan in the event the Company sold any Common Stock or Preferred Stock prior to payment in full of all NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 5. MORTGAGES AND SIMILAR DEBT - (CONTINUED) amounts due to Selex under the Second Selex Loan, such rights were voided as of December 31, 1993 since the regulations set forth in proposed Treasury Decision CO-18-90 relative to Section 382 of the Internal Revenue Code were not adopted by such date. As of August 31, 1994, $33,000 in principal had been repaid under the Second Selex Loan. Accrued interest of $93,300 due under the Loan as of August 31, 1993 remained unpaid and in default. From July 9, 1993 through December 31, 1993, Selex loaned the Company an additional $4,400,000 collateralized by a second mortgage on certain of the Company's property on which Selex and/or Yasawa hold a first mortgage pursuant to a Loan Agreement dated July 14, 1993 and amendments thereto (the "Third Selex Loan"). The Third Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. Principal is to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 becoming due and payable on April 30, 1994. As of August 31, 1994 accrued interest of $466,800 due under the Third Selex Loan was unpaid and in default. Interest due to Selex, Yasawa and their affiliates in the aggregate amount of $2,300,000 remained unpaid and in default as of August 31, 1994. From January 1, 1994 through August 31, 1994, $24,000 in principal was repaid under the Second Selex Loan and $1,140,000 in principal was repaid under the First Selex Loan through the exercise of the above described Option. After giving effect to such repayments of principal, the Company had loans outstanding from Selex, Yasawa and their affiliates on August 31, 1994 in the amount of approximately $17,976,000 including interest, of which approximately $9,867,000 is owed to Selex, (10% per annum on the First Selex Loan, 11% per annum on the Second and Third Selex Loans and 12% per annum on the $1,000,000 Empire Note assigned to Selex); approximately $6,349,000 is owed to Yasawa, including accrued and unpaid interest of approximately $384,500 (11% per annum on the Yasawa Loan and 8% per annum on the Second Yasawa Loan); and approximately $1,759,000 is owed to an affiliate of Yasawa, including accrued and unpaid interest of approximately $259,500 (12% per annum). The loans from Selex, Yasawa and their affiliates are secured by substantially all of the assets of the Company. 6. INCOME TAXES Because the Company incurred a net loss for 1991 and is in a carryforward position for both book and tax purposes for such year, no tax provision was recorded for 1991. Since the Company had income before consideration of any net operating loss carryforwards for book purposes for 1992, deferred taxes were provided for alternative minimum tax. The deferred provision for 1992 for alternative minimum tax resulted from the enactment of the alternative minimum tax provisions under the Tax Reform Act of 1986. Under these federal income tax provisions, a corporation may offset only 90% of its alternative minimum taxable income with net operating loss carryovers. Prior to December 26, 1992, the Company accounted for income taxes in accordance with Accounting Principles Board Opinion No. 11. Effective December 26, 1992, the Company adopted Statement of Accounting Standard No. 109 "Accounting for Income Taxes." There was no effect from the adoption of this standard. Under this standard deferred income assets and liabilities are computed annually for the difference between financial statements and the tax bases of assets and liabilities that will result in taxable or deductible amounts in the future bases on enacted tax laws and rates applicable to periods in which the differences are expected to affect taxable NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 6. INCOME TAXES - (CONTINUED) income. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred assets and liabilities. For the year ended December 31, 1993, the Company had a net loss for tax purposes and, as a result, there was no tax payable or refundable and there was no change in the net deferred tax asset. Accordingly, there was no tax provision for the year ended December 31, 1993. As of December 31, 1993, the Company had a net deferred tax asset of approximately $25,564,000 which primarily resulted from the tax effect of the Company's net operating loss carryforward of $21,719,000 and losses on subsidiaries sold in prior years of $3,944,000. A valuation allowance of $25,564,000 has been established against the net deferred tax asset. The Company's regular net operating loss carryover for tax purposes is estimated to be $51,813,000 at December 31, 1993, of which $6,555,000 will be available through 1995, $4,733,000 through 1996, $11,022,000 through 1997, $364,000 through 2002, $9,189,000 through 2003, $9,780,000 through 2006, and the remainder through 2007. In addition to the net operating loss carryover, investment tax credit carryovers of approximately $259,000, which expire from 1994 through 2001, are available to reduce federal income tax liabilities only after the net operating loss carryovers have been utilized. The utilization of the Company's net operating loss and tax credit carryforwards would be impaired or reduced under certain circumstances, pursuant to changes in the federal income tax laws effected by the Tax Reform Act of 1986. Events which affect these carryforwards include, but are not limited to, cumulative stock ownership changes of 50% or more over a three-year period, as defined, and the timing of the utilization of the tax benefit carryforwards. 7. LIABILITY FOR IMPROVEMENTS The Company has an obligation to complete land improvements upon deeding which, depending on contractual provisions, typically occurs within 90 to 120 days after the completion of payments by the customer. The estimated cost to complete improvements to lots and tracts at December 31, 1993 and December 25, 1992 was approximately $18,574,000 and $24,600,000 (as adjusted for the 1992 Consent Order), respectively. The foregoing estimates reflect the Company's current development plans at its communities (see Note 8). These estimates include estimated development obligations applicable to sold lots of approximately $2,825,000 and $10,700,000, respectively, a liability to provide title insurance, costing $951,000 and $900,000, respectively, and an estimated cost of street maintenance, prior to assumption of such obligations by local governments, of $3,852,000 and $2,800,000, respectively, all of which are included in deferred revenue. Included in cash at December 31, 1993 and December 25, 1992, are escrow deposits of $1,664,000 and $4,998,000, respectively, restricted for completion of improvements in certain of the Company's communities. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 7. LIABILITY FOR IMPROVEMENTS - (CONTINUED) The anticipated expenditures for land improvements to complete areas from which sales have been made through December 31, 1993 are as follows: DECEMBER 31, 1993 ----------------- (In Thousands) 1994.......................................... $ 1,000 1995.......................................... 5,200 1996.......................................... 5,200 1997.......................................... 5,200 1998.......................................... 1,974 ------- Total..................................... $18,574 ======= 8. COMMITMENTS AND CONTINGENT LIABILITIES Total rental expense for the years ended December 31, 1993, December 25, 1992 and December 27, 1991 was approximately $808,000, $1,164,000 and $1,684,000, respectively. Following is a schedule of future minimum rental payments required under operating leases that have initial or remaining noncancellable lease terms in excess of one year: DECEMBER 31, 1993 ----------------------------------- TOTAL REAL ESTATE EQUIPMENT ----- ----------- --------- (IN THOUSANDS) 1994.................... $ 982 $ 916 $ 66 1995.................... 1,305 1,236 69 1996.................... 1,258 1,227 31 1997.................... 1,276 1,276 - 1998.................... 322 322 - 1999 and thereafter..... - - - ------ ------ ---- Total............... $5,143 $4,977 $166 ====== ====== ==== The above commitments are not a forecast of future rental expenses and may not necessarily be the amount payable in the event of default and do not encompass the terms of the proposed settlement of the corporate office lease (see discussion below). During 1983 the Company entered into a sale-leaseback agreement on its executive office building. Included in the above schedule in the real estate category is approximately $5,860,000 in future minimum rental payments to be paid over the term of the lease which expires March 31, 1998. The profit on this agreement is included in deferred revenue and is being amortized as a reduction in rent expense over the term of the lease. At December 31, 1993 and December 25, 1992, $1,205,000 and $1,544,000, respectively, of the profit remained in deferred revenue. Following the consummation of the Sixth Restatement, the Company conveyed certain properties to the landlord in satisfaction of its outstanding lease obligations for its executive office building in Miami, Florida. The Company also entered into a modification of its lease agreement, providing for a reduction of its rental expenses through June 30, 1994, at which time the Company would have the option of acquiring the leased premises or NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 8. COMMITMENTS AND CONTINGENT LIABILITIES - (CONTINUED) reinstating the lease according to its original terms. Should the landlord sell the leased premises to a third party at any time that the lease, or any modification thereof, is in effect, then the lease with the Company would be cancelled. In the action styled FIVE POINTS LIMITED V. THE DELTONA CORPORATION, Case No. 93-22877, filed in the Circuit Court for Dade County, Florida and served upon the Company on December 8, 1993, the plaintiff is seeking damages against the Company for an alleged breach of the lease for its office building. The complaint alleges that the Company has defaulted in its obligation to make payments under the lease and seeks damages in excess of $272,000 for additional past due rent, plus damages for acceleration of lease payments in excess of $4,000,000. On February 17, 1994 the Court entered an Order requiring the Company to pay uncontested back rent of approximately $240,000, plus uncontested monthly rents of approximately $48,000, commencing on March 1, 1994. As of August 31, 1994, the Company had paid approximately $41,500 to the Court under this Order. The plaintiff has obtained judgments in the amount of $647,000 as of August 31, 1994. These judgments have been recorded in certain of the Company's communities. On September 1, 1994 the Company entered into a Settlement Agreement with plaintiff to be consummated on or before October 17, 1994. New financing is essential for the Company to fund the settlement agreement. Failure to fund this agreement will result in continued litigation and a likely substantial judgment against the Company. As part of the settlement agreement, the Company will be evicted from the premises and must vacate its occupancy by January 6, 1995. Homesite sales contracts provide for the return of all monies paid in (including paid-in interest) should the Company be unable to meet its contractual obligations after the use of reasonable diligence. If a refund is made, the Company will recover the related homesite and any improvement thereto. The aggregate amount of all monies paid in (including paid-in interest) on all homesite contracts having outstanding contractual obligations (primarily to complete improvements) at December 31, 1993 was approximately $11,422,000. As a result of the delays in completing the land improvements to certain property sold in certain of its Central and North Florida communities, the Company fell behind in meeting its contractual obligations to its customers. In connection with these delays, the Company, in February, 1980, entered into a Consent Order with the Division which provided a program for notifying affected customers. The Consent Order, which was restated and amended, provided a program for notifying affected customers of the anticipated delays in the completion of improvements (or, in the case of purchasers of unbuildable lots in certain areas of the Company's Sunny Hills community, the transfer of development obligations to core growth areas of the community); various options which may be selected by affected purchasers; a schedule for completing certain improvements; and a deferral of the obligation to install water mains until requested by the purchaser. Under an agreement with Topeka, Topeka's utility companies have agreed to furnish utility service to the future residents of the Company's communities on substantially the same basis as such services were provided by the Company. The Consent Order also required the establishment of an improvement escrow account as assurance for completing such improvement obligations. In June, 1992, the Company entered into the 1992 Consent Order with the Division, which replaced and superseded the original Consent Order, as amended and restated. Among other things, the 1992 Consent Order consolidated the Company's development obligations and provided for a reduction in its required monthly escrow obligation to $175,000 from September, 1992 through December, 1993. Beginning January, 1994 and until development is completed or the 1992 Consent Order is amended, the Company is required to deposit $430,000 per month into the escrow account. To meet its current escrow and development obligations under the 1992 Consent Order, the Company is required to deposit into escrow $5,160,000 in 1994 and $3,519,000 in 1995. As part of the assurance program under the 1992 Consent Order, the Company and its lenders granted the Division a lien on certain contracts receivable (approximately $8,915,000 as of December 31, 1993) and future receivables. As previously stated, the Company is in default of its escrow obligations, and in NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 8. COMMITMENTS AND CONTINGENT LIABILITIES - (CONTINUED) accordance with the 1992 Consent Order, the collections on such receivables have been escrowed for the benefit of purchasers since March 1, 1994. At December 31, 1993, the liability to complete improvements to fully paid-for lots was approximately $774,000. Pursuant to the 1992 Consent Order, the Company has limited the sale of single-family lots to lots which front on a paved street and are ready for immediate building. Because of the Company's default, the Division could also exercise other available remedies under the 1992 Consent Order, which remedies entitle the Division, among other things, to halt all sales of registered property. Based upon the Company's experience with affected customers, the Company believes that the total refunds arising from delays in completing such improvements will not materially exceed the amount provided for in the consolidated financial statements. Approximately $64,000 and $133,300 of the provision for the total refunds relating to the delays of improvements remained in accrued expenses and other at December 31, 1993 and December 25, 1992, respectively. The Company's corporate performance bonds to assure the completion of development at its St. Augustine Shores community expire in March and June, 1993. Such bonds cannot be renewed due to a change in the policy of the Board of County Commissioners of St. Johns County which precludes allowing any developer to secure the performance of development obligations by the issuance of corporate bonds. In the event that St. Johns County elects to undertake the completion of such development work, the Company would be obligated with respect to 1,000 improved lots at St. Augustine Shores in the amount of approximately $6,200,000. The Company intends to submit an alternative assurance program for the completion of such development and improvements to the County for its approval. In addition to the matters discussed above and in Note 9, the Company is a party to other litigation relating to the conduct of its business which is routine in nature and, in the opinion of management, should have no material effect upon the Company's operation. 9. MARCO ISLAND-MARCO SHORES PERMITS On April 16, 1976, the U.S. Army Corps of Engineers (the "Corps") denied the Company's application for dredge and fill permits required to complete development of the Marco Island community. These denials adversely affected the Company's ability to obtain the required permits for the Marco Shores community as originally platted. Following the denials, the Company instituted legal proceedings, implemented various programs to assist its customers affected by the Corps' action, and applied for permits from certain administrative agencies for other areas of the Company's Marco ownership. On July 20, 1982, the Company entered into an agreement with the State of Florida and various state and local agencies (the "Settlement Agreement"), endorsed by various environmental interest groups, to resolve pending litigation and administrative proceedings relative to the Marco permitting issues. The Settlement Agreement became effective when, pursuant thereto, approximately 12,400 acres of the Company's Marco wetlands were conveyed to the State in exchange for approximately 50 acres of State-owned property in Dade County, Florida. In October, 1987, the Company sold the Dade County property for $9,000,000. The Settlement Agreement also allowed the Company to develop as many as 14,500 additional dwelling units in the Marco vicinity. On October 11, 1991, 1,300 acres of Marco property (7,000 dwelling units) were conveyed to the Company's lenders pursuant to the Conveyance Agreement. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 9. MARCO ISLAND-MARCO SHORES PERMITS - (CONTINUED) The Company had placed certain properties in trust to meet its refund obligation to affected customers. On September 14, 1992, the Circuit Court of Dade County, Florida approved a settlement of certain class action litigation instituted by customers affected by the Marco permit denials, under the terms of which the Company was required, among other things, to convey more than 120 acres of multi-family and commercial land that had been placed in trust to the trustee of the 809 member class. As part of the settlement, the Company guaranteed the amount to be realized from the sale of the conveyed property. This guaranteed amount shall not exceed $2,000,000. Such settlement enabled the Company to resolve the claims of an additional 12.7% of its affected customers and re-evaluate the allowance for Marco permit costs. As a result of such analysis, the Company was able to reduce such allowance by $12,200,000, resulting in a $3,983,000 extraordinary gain and a $500,000 credit to accrued expenses to be credited to paid-in capital following issuance of 250,000 shares of restricted Common Stock of the Company to the class members. At December 31, 1993, $2,886,000 remained in the allowance for Marco permit costs. Based upon the Company's experience with affected customers, the Company believes that its total obligations to the remaining 1.3% of its affected customers will not materially exceed the amount provided for in the accompanying Consolidated Financial Statements. Information with respect to the allowance for Marco permit costs follows: DECEMBER 31, DECEMBER 25, 1993 1992 ------------ ------------ (IN THOUSANDS) Refunds requested by affected customers............ $ 332 $ 905 Reserve for settlement guarantee................... 2,000 2,000 Accrued interest on actual and estimated refund obligation............................... 554 944 ------- ------- Total..................................... $ 2,886 $ 3,849 ======= ======= 10. COMMON STOCK AND EARNINGS PER SHARE INFORMATION Options to purchase Common Stock of the Company had been granted to employees of the Company under an incentive stock option plan. Such shares could be treasury or authorized but unissued shares, and were subject to adjustment resulting from stock dividends, splits, reorganizations, or other substitutions of securities for the present Common Stock of the Company. The option price could not be less than the market value of the Company's Common Stock on the date of the grant. All options were exercisable for a period of up to five years from the date of grant at an annual cumulative rate of 20%, except that no option could be exercised for a period of 60 days from grant. Since options could not be granted after ten years from the date the plan was adopted, options were not available for grant under the plan after March 1, 1992, and options to purchase an aggregate of 26,800 shares which were outstanding as of December 27, 1991 expired unexercised on December 9, 1992. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 10. COMMON STOCK AND EARNINGS PER SHARE INFORMATION - (CONTINUED) Under the Company's 1987 Stock Incentive Plan (the "Stock Plan"), an aggregate of 500,000 shares of Common Stock have been reserved for the granting of non-qualified stock options and the award of incentive shares to such executive officers and other key employees of the Company as may be determined by the Committee administering the Stock Plan. The extent to which incentive shares are earned and charged to expense will be determined at the end of the three-year award cycle, based on the achievement of the Company' s net income goal for the award cycle. Payment of incentive shares earned may be made in shares of the Company's Common Stock and/or cash. If paid in cash, such payment will be based on the average daily closing price of the Company's Common Stock during the last month of the award cycle. The option features of the Stock Plan are substantially the same as the Company's incentive stock option plan described above. A total of 79,940 shares were issued and $233,412 was paid with respect to awards earned under the Stock Plan as of December 29, 1989. In March, 1993 an option to acquire 20,000 shares of the Company's Common Stock at an exercise price of $4.00 per share was granted under the Stock Plan; the 20,000 share option remained outstanding as of December 31, 1993. On June 18, 1992, in conjunction with the Sixth Restatement, the Company issued warrants to its lenders for the purchase of 277,387 shares of Common Stock at $1.00 per share (the Warrants"). The Warrants became exercisable on June 18, 1992, were subject to mandatory repurchase by the Company at the request of the holder at any time after December 18, 1993 at 75% of the market price of the Company's Common Stock (unless such repurchase would cause a default under the Sixth Restatement or unless the Company elected to effect an underwritten public offering on a firm commitment basis), and expired on the later of: (i) 30 days after payment in full of all debt under the Sixth Restatement; (ii) July 31, 1997, or (iii) such later date as to which the expiration date had been extended to implement the provisions applicable to the mandatory repurchase option. On December 2, 1992, the Company entered into a Warrant Exercise and Debt Reduction Agreement with Yasawa, providing for the number of shares issuable upon acquisition of the Warrants by Yasawa and the exercise of such Warrants by Yasawa to be increased from 277,387 shares of Common Stock to 289,637 shares of Common Stock, and adjusting the exercise price to an aggregate of approximately $314,000. On December 11, 1992, following the acquisition of the Bank Loan and the Warrants by Gram and the immediate transfer of the Bank Loan and the Warrants by Gram to Yasawa, Yasawa exercised the Warrants in exchange for debt reduction credit to the Company of approximately $314,000. As part of the Selex transaction, Selex was granted an option which was approved by the holders of a majority of the outstanding shares of the Company's Common Stock at the Company's 1992 Annual Meeting, to convert the Selex Loan, or any portion thereof, into a maximum of 850,000 shares of the Company's Common Stock at a per share conversion price equal to the greater of (i) $1.25 or (ii) 95% of the market price of the Company's Common Stock at the time of conversion, but in no event greater than $4.50 per share (the "Option"). However, on September 14, 1992, Selex formally waived and relinquished its right to exercise the Option as to 250,000 shares of the Company's Common Stock to enable the Company to settle certain litigation involving the Company through the issuance of approximately 250,000 shares of the Company's Common Stock to the claimants, without jeopardizing the utilization of the Company's net operating loss carryforward. On February 17, 1994, Selex exercised the remaining full 600,000 share Option at a conversion price of $1.90 per share, such that $1,140,000 in principal was repaid under the First Selex Loan through such conversion. As a consequence of such conversion, Selex holds 2,820,066 shares of the Company's Common Stock (43.1% of the outstanding shares of Common Stock of the Company based upon the number of shares of the Company's Common Stock outstanding as of March 18, 1994. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 10. COMMON STOCK AND EARNINGS PER SHARE INFORMATION -(CONTINUED) Earnings (loss) per common and common equivalent share were computed by dividing net income (loss) by the weighted average number of shares of Common Stock and common stock equivalents outstanding during each period. The earnings (loss) and average number of shares of Common Stock and common stock equivalents used to calculate earnings per share for 1993, 1992 and 1991 were ($8,772,000) and 6,056,743, $7,336,000 and 5,694,236 and ($26,629,000) and 5,660,967, respectively. 11. OTHER OPERATIONS Through December 31, 1993, the Company operated country clubs and golf courses at certain of its communities. All such operations have been sold as of December 31, 1993. The following is a summary of its operations: YEARS ENDED ------------------------------------------ DECEMBER 31, DECEMBER 25, DECEMBER 27, 1993 1992 1991 ------------ ------------ ------------ (IN THOUSANDS) Revenues........................ $1,820 $1,823 $2,375 Costs of sales.................. 1,527 1,638 1,948 ------ ------ ------ Gross profit............... $ 293 $ 185 $ 427 ====== ====== ====== NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED) THE DELTONA CORPORATION AND SUBSIDIARIES 12. BUSINESS SEGMENTS SUPPLEMENTAL UNAUDITED QUARTERLY FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ITEM 10, 11 AND 13 DIRECTORS AND EXECUTIVE OFFICERS DIRECTORS OF THE COMPANY The Board of Directors of the Company presently consists of eight individuals: Antony Gram, Chairman of the Board and Chief Executive Officer, and Neil E. Bahr, George W. Fischer, Marcellus M. B. Muyres, Thomas B. McNeill, Leonardus G.M. Nipshagen, Cornelis van de Peppel and Cornelis L.J.J. Zwaans. As previously discussed, in June, 1992, the Company completed a transaction with Selex, which resulted in the infusion of additional funds into the Company and in a change in control of the Company. In conjunction with the transaction with Selex, Messrs. Muyres, Gram, Nipshagen, Peppel and Zwaans were designated by Selex for election as directors of the Company. See "Business: Recent Developments" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The table below sets forth the names of the present directors of the Company, together with certain information with respect to each of them. Unless otherwise indicated, each such person has held the position shown, or has been associated with the named employer in the executive capacity shown, for more than the past five years. The entire Board of Directors is elected annually to hold office until the next Annual Meeting of Stockholders and until their respective successors are duly elected and qualified. Messrs. Bahr, Fischer and McNeill (Audit Committee) receive a fee of $1,000 per month for services as a Director of the Company and are reimbursed for travel and related costs incurred with respect to committee and board meetings. Messrs. Gram, Muyres, Nipshagen, van de Peppel and Zwaans do not receive a monthly Directors fee, however are reimbursed for travel and related costs incurred with respect to committee and board meetings and other Company business activities. In August 1994, the Directors with outstanding fees and/or expenses agreed to forgive 50% of the amounts due them. The following sets forth the amounts due those Directors at August 31, 1994 after the forgiveness. Neil E. Bahr $ 6,500 George Fischer 6,500 Thomas B. McNeill 6,500 Marcellus H.B. Muyres 9,585 Cornelis L.J.J. Zwaans 4,981 ------- Total $34,066 ======= Cornelis van de Peppel provided the Company consulting services periodically during the months of August 1993 through November 1993. Mr. van de Peppel was paid $22,500 in consulting fees for his services as well as $11,862 in expense reimbursement in conjunction with those services. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Executive Compensation Committee (the "Committee") is comprised of Mr. Bahr, Chairman, and three of the Selex directors, namely, Messrs. Gram, Muyres and Zwaans. Mr. Bahr, Chairman of the Committee and Vice Chairman of the Board, retired from the Company in December, 1985. From the Company's incorporation in September, 1962 until his retirement, Mr. Bahr served as an officer of the Company and/or its subsidiaries. He presently does not serve as a director or as a member of the compensation committee of any other company. Mr. Gram, a member of the Committee, has served as Chairman of the Board and Chief Executive Officer of the Company, and thus, as an executive officer of the Company, since July 13, 1994. Additionally, Mr. Gram is deemed to be the beneficial owner of 46.7% of the Company's Common Stock since he is the beneficial owner of Yasawa (which holds 4.4% of the Common Stock of the Company as of August 19, 1994), as well as the holder of a seventy-four percent equity interest in Wilbury International N.V., a Netherlands Antilles corporation ("Wilbury"), which owns all of the issued and outstanding stock of Selex (which holds 42.3% of the Common Stock of the Company as of August 19, 1994). See "Ownership of Voting Securities of the Company." Mr. Muyres, Vice Chairman of the Board of the Company, and a member of the Committee, served as Chairman of the Board and Chief Executive Officer, and thus, as an officer of the Company, from June 19, 1992 through July 12, 1994. As previously stated, Mr. Muyres serves as a director and executive officer of Swan, Conquistador and M&M, companies of which Mr. Zwaans, also a member of the Committee, serves as a director and executive officer. Mr. Zwaans also serves as a Managing Director of Selex. As previously stated, all of the issued and outstanding stock of Selex is owned by Wilbury. Wilbury is, in turn, owned by Messrs. Gram and Muyres, with Mr. Gram, as the largest shareholder of Wilbury, being treated as the beneficial owner of all of the Company's Common Stock held by Selex. See "Ownership of Voting Securities of the Company." On June 19, 1992, Selex loaned the Company the sum of $3,000,000 pursuant to the First Selex Loan. The First Selex Loan is collateralized by a first mortgage on certain of the Company's unsold, undeveloped property in its St. Augustine Shores, Florida community. The Loan matures on June 15, 1996 and provides for principal to be repaid at 50% of the net proceeds per lot for lots requiring release from the mortgage, with the entire unpaid balance becoming due and payable at the end of the four year term. It initially bears interest at the rate of 10% per annum, with payment of interest deferred for the initial 18 months of the Loan and interest payments due quarterly thereafter. As part of the Selex transaction, Selex was granted an option, approved by the holders of a majority of the outstanding shares of the Company's Common Stock at the Company's 1992 Annual Meeting, which, as modified, enabled Selex to convert the First Selex Loan, or any portion thereof, into a maximum of 600,000 shares of the Company's Common Stock at a per share conversion price equal to the greater of (i) $1.25 or (ii) 95% of the market price of the Company's Common Stock at the time of conversion, but in no event greater than $4.50 per share (the "Option"). On February 17, 1994, Selex exercised the Option, in full, at a conversion price of $1.90 per share, such that $1,140,000 in principal was repaid under the First Selex Loan through such conversion. As of August 31, 1994, the Company was in default of the First Selex Loan inasmuch as accrued interest in the amount of $604,300 (including $463,500 due December 31, 1993) remained unpaid. One million dollars of the proceeds from the First Selex Loan was used by the Company to acquire certain commercial and multi-family properties at the Company's St. Augustine Shores community at their net appraised value, from Mr. Muyres and certain entities affiliated with Messrs. Zwaans and Muyres. Namely, (i) $416,000 was used to acquire 48 undeveloped condominium units (twelve 4 unit building sites) and 4 completed and rented) condominium units from Conquistador, in which Messrs. Zwaans and Muyres serve as directors, as well as President and Secretary/Treasurer, respectively; (ii) $485,000 was used to acquire 4 commercial lots from Swan, in which Messrs. Zwaans and Muyres also serve as directors, as well as President and Secretary, respectively; and (iii) approximately $99,000 was used to reacquire, from Mr. Muyres, all of his rights, title and interest in that certain contracts with the Company for the purchase of a commercial tract in St. Augustine Shores, Florida. None of the commercial and multi-family property acquired by the Company from Mr. Muyres and certain entities affiliated with Messrs. Zwaans and Muyres collateralizes the First Selex Loan. In March, 1994, Conquistador exercised its right to repurchase certain multi-family property from the Company (which right had been granted in connection with the June, 1992 Selex transaction) at a price of $312,000, of which $260,000 was paid in cash to the Company and $52,000 was applied to reduce interest due to Selex under the third Selex Loan. As previously stated, Messrs. Muyres and Zwaans also serve as directors and executive officers of M&M. The Company has leased certain office space to M&M at its St. Augustine Shores community pursuant to a Lease Agreement dated August 10, 1990. The aggregate annual rental payments under such Lease are less than $60,000. On December 2, 1992, the Company entered into various agreements relating to certain of its assets and the restructuring of its debt with Yasawa, which is beneficially owned by Mr. Gram. The consummation of these agreements, which are further described below, was conditioned upon the acquisition by Gram of the Company's outstanding bank loan. On December 4, 1992, Gram entered into an agreement with the lenders, pursuant to which he acquired the bank loan of approximately $25,150,000 (including interest and fees) for a price of $10,750,000. In conjunction with such transaction, the lenders transferred to Gram the warrants which they held that entitled the holder to purchase an aggregate of 277,387 shares of the Company's Common Stock at an exercise price of $1.00 per share. Immediately after the acquisition of the bank loan, Gram transferred all of his interest in the bank loan, including the warrants, to Yasawa. On December 11, 1992, the Company consummated the December 2, 1992 agreements with Yasawa. Under these agreements, Yasawa, its affiliates and the Company agreed as follows: (i) the Company sold certain property at its Citrus Springs community to an affiliate of Yasawa in exchange for approximately $6,500,000 of debt reduction credit; (ii) an affiliate of Yasawa and the Company entered into a joint venture agreement with respect to the Citrus Springs property, providing for the Company to market such property and receive an administration fee from the venture (in March, 1994, the Company and the affiliate agreed to terminate the venture); (iii) the Company sold certain contracts receivable at face value to an affiliate of Yasawa for debt reduction credit of approximately $10,800,000; (iv) the Company sold the Marco Shores Country Club and Golf Course to an affiliate of Yasawa for an aggregate sales price of $5,500,000, with the affiliate assuming an existing first mortgage of approximately $1,100,000 and the Company receiving debt reduction credit of $2,400,000, such that the Company obtained cash proceeds from this transaction of $2,000,000, which amount was used for working capital; (v) an affiliate of Yasawa agreed to lease the Marco Shores Country Club and Golf Course to the Company for a period of approximately one year; (vi) an affiliate of Yasawa and the Company agreed to amend the terms of the warrants to increase the number of shares issuable upon their exercise from 277,387 shares to 289,637 shares and to adjust the exercise price to an aggregate of approximately $314,000; (vii) Yasawa exercised the warrants in exchange for debt reduction credit of approximately $314,000; (viii) Yasawa released certain collateral held for the bank loan; (ix) an affiliate of Yasawa agreed to make an additional loan of up to $1,500,000 to the Company, thus providing the Company with a future line of credit (all of which was drawn and outstanding as of August 19, 1994); and (x) Yasawa agreed to restructure the payment terms of the remaining $5,106,000 of the bank loan as a loan from Yasawa (the "Yasawa Loan"). The Yasawa Loan bears interest at the rate of 11% per annum, with payment of interest deferred until December 31, 1993, at which time only accrued interest became payable. Commencing January 31, 1994, principal and interest became payable monthly, with all unpaid principal and accrued interest being due and payable on December 31, 1997. A portion of the proceeds from a March, 1993 sale of contracts receivable was applied to reduce the Yasawa Loan to $4,900,000 during the first quarter of 1993 and the assignment of a mortgage receivable to Yasawa reduced the Yasawa Loan to $4,771,600 as of December 31, 1993. Accrued interest due under the Yasawa Loan in the amount of $355,200 were unpaid and in default as of August 31, 1994. In February, 1994, Yasawa loaned the Company an additional amount of approximately $514,900 at an interest rate of 8% per annum (the "Second Yasawa Loan"). Since May, 1994, additional amounts were advanced to the Company under the Second Yasawa Loan to enable the Company to pay certain essential expenses and effectuate settlements with the Company's principal creditors. As of August 31, 1994, an aggregate amount of $1,200,000 had been advanced to the Company under the Second Yasawa Loan. On April 30, 1993 Selex loaned the Company an additional $1,000,000 collateralized by a first mortgage on certain of the Company's property in its Marion Oaks, Florida community (the "Second Selex Loan"). The Second Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. The Second Selex Loan provides for principal to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 to be due and payable on April 30, 1994. Although Selex had certain conversion rights under the Second Selex Loan in the event the Company sold any Common Stock or Preferred Stock prior to payment in full of all amounts due to Selex under the Second Selex Loan, such rights were voided as of December 31, 1993 since the regulations set forth in proposed Treasury Decision CO-18-90 relative to Section 382 of the Internal Revenue Code were not adopted by such date. As of August 31, 1994, $33,000 in principal had been repaid under the Second Selex Loan, but accrued interest of 93,300 due under the Loan as of August 31, 1994, as well as the principal balance of $967,000, remained unpaid and in default. From July 9, 1993 through December 31, 1993, Selex loaned the Company an additional $4,400,000 collateralized by a second mortgage on certain of the Company's property on which Selex and/or Yasawa hold a first mortgage pursuant to a Loan Agreement dated July 14, 1993 and amendments thereto (the "Third Selex Loan"). The Third Selex Loan bears interest at 11% per annum, with interest deferred until December 31, 1993. Principal is to be repaid at $3,000 per lot for lots requiring release from the mortgage, with the entire unpaid principal balance and interest accruing from January 1, 1994 to April 30, 1994 becoming due and payable on April 30, 1994. As of August 31, 1994, accrued interest of $466,800 due under the Third Selex Loan as well as the principal balance of $4,384,200 remained unpaid and in default. Interest due to Selex, Yasawa and their affiliates in the aggregate amount of $2,300,000 remained unpaid and in default as of August 31, 1994. Through August 31, 1994 $33,000 in principal was repaid under the Second Selex Loan and $1,140,000 in principal was repaid under the First Selex Loan through the exercise of the above described Option; however, Selex, Yasawa and their affiliates were unpaid and in default as of August 31, 1994. Consequently, as of August 31, 1994, the Company had loans outstanding from Selex, Yasawa and their affiliates in the aggregate amount of approximately $17,976,000, including interest, of which approximately $9,867,000 is owed to Selex, including accrued and unpaid interest of approximately $1,656,000 (10% per annum on the First Selex Loan, 11% per annum on the Second and Third Selex Loans and 12% per annum on the $1,000,000 Empire Note assigned to Selex); approximately $6,349,200 is owed to Yasawa, including accrued and unpaid interest of approximately $384,500 (11% per annum on the Yasawa Loan and 8% per annum on the Second Yasawa Loan); and approximately $1,759,000 is owed to an affiliate of Yasawa, including accrued and unpaid interest of approximately $259,500 (12% per annum). The loans from Selex, Yasawa and their affiliates are secured by substantially all of the assets of the Company. See "Business: Recent Developments", "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 5 to Consolidated Financial Statements. The lease between an affiliate of Yasawa and the Company with respect to the Marco Shores Country Club and Gold Course was terminated in December 31, 1993. At the time of termination, an amount of approximately $34,200 was due to the Company from the Yasawa affiliate, which amount was paid in 1994. In December 1992, the Company and Citony (an affiliate of Yasawa) entered into a joint venture agreement with respect to Citony's Citrus Springs property, providing for the Company to market the property and receive an administration fee from the venture. The Company and Citony agreed to terminate the joint venture agreement in March, 1994, however, the Company is providing certain assistance to Citony during the transition period. At the time of termination $265,000 was due to the Company by Citony for marketing costs incurred as well as administrative services provided, which amount was paid in 1994. M&M First Coast Realty, of which Messrs. Muyres and Zwaans are Directors leased office facilities from the Company in its St. Augustine Shores community. At December 31, 1993 $16,600 was due the Company for past rents, which amount was paid in 1994. Messrs. Muyres and Zwaans serve as officers and directors of Conquistador Development Corporation, which the Company owed $11,583 at December 31, 1993, principally for condominium fees advanced on behalf of the Company. This amount was paid in 1994. EXECUTIVE OFFICERS OF THE COMPANY The table below sets forth the executive officers of the Company as of August 19, 1994, their ages and their principal occupations during the past five years; they have been appointed to serve in the capacities indicated until their successors are appointed and qualified, subject to their earlier resignation or removal by the Board of Directors. On July 13, 1994, Marcellus H.B. Muyres, who had served as Chairman of the Board and Chief Executive Officer of the Company since June 19, 1992, agreed to serve, instead, as a Vice Chairman of the Board to facilitate the appointment of Antony Gram as Chairman and Chief Executive Officer. Additionally, since December 31, 1993, one executive officer (Stephen J. Diamond) resigned his position and four executive officers (Michelle R. Garbis, Joseph Mancilla, Jr., Theodore J. Maureau, III and Bruce M. Weiner) were removed from the positions in which they served. EXECUTIVE COMPENSATION Due to the Company's liquidity situation, Antony Gram has served as Chairman of the Board and Chief Executive since July 13, 1994 without compensation. Likewise, Marcellus H.B. Muyres served as Chairman of the Board and Chief Executive Officer without compensation from June, 1992 through July 12, 1994. The Commission's rules on executive compensation disclosure require, however, that the Summary Compensation Table which appears below, depict the compensation for the past three years of the Company's chief executive officer and its four most highly compensated executive officers whose annual salary and bonuses exceed $100,000. During the fiscal year ended December 31, 1993, four executive officers of the Company were paid an annual salary and bonus in excess of $100,000, with one of such officers not being employed by the Company until March 15, 1993 and one not being employed until July 15, 1992. Accordingly, the table set forth below discloses compensation paid to Mr. Weiner for the year ended December 31, 1993, to Mr. Muyres and Mr. Mancilla for the two years ended December 31, 1993 and to Mr. Cortright and Mrs. Garbis for the three years ended December 31, 1993. SUMMARY COMPENSATION TABLE -------------------------- OPTION/SAR GRANTS IN LAST FISCAL YEAR The only option granted during 1993 was the grant of an option to Mr. Weiner to acquire 20,000 shares under the provisions of the Stock Plan. The exercise price of $4.00 per share was above the market price of the Company's Common Stock (2 7/8) on the March 15, 1993 grant date. The option was not awarded with tandem stock appreciation rights, and it expired unexercised following Mr. Weiner's removal as an officer of the Company. EMPLOYMENT CONTRACTS In 1993, the Company recruited Bruce M. Weiner, an individual with over twenty years of experience in the sale and marketing of Florida real estate, to develop, implement and oversee a marketing program which would strengthen the Company's marketing organization, rebuild its retail land sales business and provide for the Company's successful re-entry into the single family housing business. Effective March 15, 1993, the Company entered into a three-year employment agreement with Mr. Weiner. The agreement provided for Mr. Weiner to be paid an annual salary of $350,000 (subject to reduction or repayment, as discussed below, in the event that the overall annual objectives of the Company's marketing program were not substantially achieved) and for the furnishing of certain benefits, such as payment of an automobile allowance. The agreement further provided for Mr. Weiner to be paid an annual bonus if the annual overall objectives of the marketing program were met in an amount equal to the greater of: (i) one half of one percent of the Company's net retail land sales were met in an amount equal to the greater of: (i) one half of one percent of the Company's net retail land sales revenue for the preceding fiscal year (pro-rated for the Company's 1993 fiscal year) and one quarter of one percent of revenues from house sale closings during the Company's preceding fiscal year; or (ii) five percent of the annual pre-tax profits of the Company for the preceding fiscal year. Such bonus was to have been payable, net of applicable taxes, in incentive shares or other form of stock equivalents as may be determined, valued at a price of $4.00 per share unit. On the other hand, if the annual overall objectives of the marketing program were not met by Mr. Weiner in any given year, he was responsible for either repaying to the Company an amount equal to five percent of the operating losses of the Company for the preceding year or subject to a fifty percent reduction in salary until an amount equal to five percent of the operating loss had been recovered by the Company. In the event, however, that Mr. Weiner was precluded from meeting the annual overall objectives due to strikes, unforeseen governmental action or intervention, war, hurricane striking employer's communities or other similar acts of God, or the failure of the Company to fund or otherwise fulfill its obligations under the marketing program, then no such repayment or salary adjustment would be required. Additionally, the maximum amount of salary repayment or adjustment was limited to $50,000 per year (pro-rated to $39,584 for the Company's 1993 fiscal year, based upon the salary payments made to Mr. Weiner during 1993). In conjunction with Mr. Weiner's employment and his agreement, Mr. Weiner was awarded an option to purchase 20,000 shares of the Company's Common Stock under the provisions of the 1987 Stock Incentive Plan described below. See "Compensation Committee Report." In the event that Mr. Weiner earned the bonus provided for in his agreement with respect to the Company's 1994 fiscal year, it was anticipated that any net bonus payable would first be applied by the Company to exercise the shares in respect of which Mr. Weiner was granted said option. Mr. Weiner's agreement further provided that if his employment were terminated without cause (defined as gross misconduct or the failure to achieve certain specific objectives set forth in his agreement), he would be entitled to receive a lump-sum payment upon termination equal to the salary remaining to be paid him for the term of his agreement, unless termination was due to death, in which case his beneficiary would be entitled to receive a sum equal to one month's salary for each month of his employment during the first twelve months of employment, and thereafter, a sum equal to the aggregate of one year's salary. Mr. Weiner failed to achieve both the specific objectives set forth in his agreement for 1993 and the annual overall objectives of the marketing program during 1993. Due to the Company's liquidity situation, the Company was unable to pay its executive officers the compensation due them for the months of March, 1994 and April, 1994. The executive officers employed pursuant to an employment agreement notified the Chairman of the Board, the Vice Chairmen of the Board and the Chairman of the Executive Compensation Committee, on April 1, 1994, that the Company's failure to remit the compensation due constituted a breach of their respective agreements and that while they were willing to continue their efforts, for a limited time, to assist the Company in resolving its problems, they were not waiving their rights to enforce any remedies available under their respective agreements. On April 28, 1994, Mr. Weiner filed suit against the Company for breach of his agreement by reason of non-payment of compensation, seeking damages under the agreement in excess of $744,000. He was subsequently removed as an officer of the Company and his employment was terminated for non-performance. See "Legal Proceedings." Mr. Mancilla, Jr., who was appointed Senior Vice President and General Counsel of the Company, effective July 15, 1992, was employed pursuant to an employment agreement with the Company which continued through July 15, 1994 (the initial term), was to be automatically renewed at that time for an additional year (the initial renewal term), and thereafter was subject to automatic renewal for successive one-year periods (subsequent renewal terms) unless notice of intent not to renew was given by the Company sixty days prior to the applicable expiration date. The agreement provided for Mr. Mancilla to be paid an annual salary of $150,000 (subject to such increases as might be mutually agreed upon), for the furnishing of certain benefits, such as payment of an automobile allowance, and for payment of a bonus (the "Bonus") of $50,000 upon the settlement of certain litigation. The Bonus was paid in 1992 following court approval of the settlement of such litigation, and is included in the Summary Compensation Table set forth above. The agreement further provided that if Mr. Mancilla's employment were terminated or constructively terminated by the Company, without cause (defined as gross misconduct), he would be entitled to receive a lump-sum payment at termination equal to two years' salary (one year's salary if termination occurred during the initial renewal term or any subsequent renewal term), together with any salary remaining to be paid for the contract term (but, in no event, more than for an additional year); he would also be entitled to payment of an automobile allowance and certain insurance benefits for a period of not less than one year. For the purposes of Mr. Mancilla's agreement, "constructive termination" was defined as the assignment of duties inconsistent with his status as Senior Vice President and General Counsel or a substantial alteration in his responsibilities. Mr. Mancilla's agreement with the Company further provided that if his employment were terminated due to death, his beneficiary would be entitled to receive a sum equal to the aggregate of one year's salary. In May, 1994, Mr. Mancilla filed suit against the Company for breach of his employment agreement by reason of non-payment of compensation, seeking damages under the agreement in excess of $391,500. He was subsequently removed as an officer of the Company and his employment was terminated for non-performance. See "Legal Proceedings." In June, 1992, the Company obtained $8,000,000 additional financing through a $13,500,000 sale of certain of the Company's contracts receivable. The agreement with respect to such sale requires that the Company maintain, in effect, certain employment agreements with Mr. Cortright, Mrs. Garbis, and certain other executive officers of the Company. Pursuant to the requirements of such agreement, Mr. Cortright entered into a five-year employment agreement which continues through June 19, 1997. Such agreement is subject to automatic renewal for successive one-year periods unless notice of intent not to renew is given by the Company 60 days prior to the end of the applicable contract term. The agreement provides for Mr. Cortright to be paid his current annual salary of $200,000 (subject to such increases as may be mutually agreed upon) and for the furnishing of certain benefits, such as payment of an automobile allowance. The agreement contains "non compete" provisions which preclude Mr. Cortright from engaging, in any manner, or from being employed, in any capacity, in any business which could be deemed to be competitive with the Company in Florida, New York, New Jersey and Ohio during the five year term of his agreement, if his employment is terminated or constructively terminated by the Company or if he resigns his employment from the Company. Because of such non-compete provisions and to compensate Mr. Cortright for his exceptional services in conjunction with the completion of the restructuring of the Company's bank debt and the securing of financing for the Company through the above-mentioned contracts receivable sale and the Selex Loan, Mr. Cortright's agreement also provides for the payment of a $200,000 bonus, $50,000 of which was paid upon the signing of his agreement and the completion of the foregoing transactions, $50,000 of which was paid in June, 1993 (and is included in the Summary Compensation Table set forth above), $50,000 of which was due in June, 1994, the payment of which is in default, and $50,000 being payable on June, 1995 so long as he continues to serve as President and Chief Operating Officer of the Company (the "Special Bonus"), with payment of the unpaid portion of the Special Bonus accelerated in the event of the termination or constructive termination of his employment or the agreement without cause or due to his death or medical disability. Additionally and as a consequence of such non-compete provisions, Mr Cortright's employment agreement provides that if his employment is terminated or constructively terminated by the Company, without cause (defined as gross misconduct), during its initial term or any renewal term, he is entitled to receive a lump sum payment at termination equal to any salary remaining to be paid him for the contract term (but, in no event, less than for an additional two years); in addition, he is entitled to payment of an automobile allowance and certain insurance benefits for such period. For purposes of Mr. Cortright's agreement, "constructive termination" includes, among other things: (i) the assignment of duties inconsistent with Mr. Cortright's status as President and Chief Operating Officer or a substantial alteration in his responsibilities if such assignment and/or alteration is not acceptable to him, (ii) relocation of the Company's principal place of business to a location other than Orlando, Florida (unless such other location is mutually agreed upon), (iii) failure of the Company to maintain compensation plans in which Mr. Cortright participates or to continue providing certain other existing employee benefits, or (iv) any disability commencing after a "change in control" which is continuous for six months. Mr. Cortright's agreement with the Company further provides that if his employment is terminated due to death or medical disability (as distinguished from a disability following a change in control), payment of salary to him or his beneficiary shall continue for two years following termination. Under this agreement, the agreement with Mrs. Garbis described below, and the benefit plans described in the Compensation Committee Report, a "change in control" is (a) an acquisition of 35% of the voting securities of the Company if the Board of Directors determines that a change in control has occurred or is likely to occur; or (b) a change in the majority of the Board of Directors of the Company which is not recommended or approved by the incumbent Board. On June 11, 1992, the Board determined that the acquisition by Selex of more than 35% of the Company's Common Stock from Empire, accompanied by its control of the Board, would constitute a change in control of the Company. Mrs. Garbis was employed pursuant to a renewal of her employment agreement with the Company which, as renewed, continues through December 31, 1994. Such agreement was subject to automatic renewal for successive one-year periods unless notice of intent not to renew is given by the Company sixty days prior to the end of each year. The agreement provides for Mrs. Garbis to be paid her current annual salary of $115,000 (subject to such increases as the Company may determine) and for the furnishing of certain benefits, such as payment of an automobile allowance. The agreement provided that if employment is terminated due to death, payment of salary to her beneficiary continues for one year following termination. In addition, if employment is terminated by the Company without cause, regardless of whether or not the agreement itself is effect, she is entitled to receive a lump sum payment at termination equal to two years' salary; she is also entitled to payment of an automobile allowance and certain insurance benefits for one year. Such payments and benefits would be due if employment is terminated by the Company at any time within a two-year period following a change in control of the Company (unless termination is due to gross misconduct). In August, 1994 Mrs. Garbis filed suit against the Company for breach of her employment agreement by reason of non-payment of compensation, seeking damages under the agreement in excess of $280,000. Mrs. Garbis and the Company have reached a resolution and settlement of the claim. Mrs. Garbis has been removed as an officer of the Company and her employment was terminated. See "Legal Proceedings." Two other executive officers, Mr. Harden and Mrs. Hummerhielm, are employed pursuant to employment agreements which provide that if their employment is terminated due to death, payment of salary to their beneficiary continues for six months and, if employment is otherwise terminated by the Company without cause (defined as gross misconduct), they are entitled to receive one year's salary, payable in twenty-four equal semi-monthly installments. Although, as discussed above, the Company is in default of certain compensation due Mr. Cortright, Mrs. Garbis, Mr. Harden and Mrs. Hummerhielm, none of such officers has, as of August 19, 1994, instituted legal action with respect to such defaults. Since May 1, 1994, the Company has, with the exception of the $50,000 installment payment of the Special Bonus due Mr. Cortright, met all compensation obligations on a current basis. Nevertheless, should the employment of Mr. Cortright, Mr. Harden and Mrs. Hummerhielm be determined to have been terminated without cause, then the amounts that would be payable, as of August 19, 1994 under the agreements described above, inclusive of compensation in default and certain benefits, but exclusive of insurance benefits, would be $804,166, $101,337, and $101,337, respectively. COMPENSATION COMMITTEE REPORT COMPENSATION PHILOSOPHY It is the goal of the Company and the Executive Compensation Committee (the "Committee") to align all compensation, including executive compensation, with business objectives and both individual and corporate performance, while simultaneously attracting and retaining employees who contribute to the long-term success of the Company. The Company attempts, within its resources, to pay competitively and for performance and management initiative, while striving for fairness in the administration of its compensation program. EXECUTIVE COMPENSATION PROGRAM Since it has been the policy of the Company to encourage and enable employees upon whom it principally depends to acquire a personal proprietary interest in the Company, the total executive compensation program of the Company historically, consisted of both cash and equity-based compensation, and has been comprised of three key elements: salary, an annual bonus and a long term incentive plan that provides for both incentive awards and stock options. While each of these elements is discussed below, it is important to note that due to the financial performance of the Company during the past four years and the fact that the Company has undergone two changes in control since January 1, 1990, no awards have been made under the Annual Executive Bonus Plan (the "Bonus Plan") since 1990 and, with the exception of one stock option grant in 1993, no awards have been made under the long term incentive program other than the initial awards which were fully earned at the end of 1989. In particular, the Committee has been reticent to grant additional equity-based awards, lest it jeopardize the utilization of the Company's net operating loss carryforward for federal income tax purposes. This situation is re-examined annually and the 1993 review made it feasible for the Committee to grant Mr. Weiner, the Company's newly recruited executive vice president, an option to acquire 20,000 shares of the Company's Common Stock. SALARY Salaries paid to executive officers (other than the Chief Executive Officer and the President) are based upon the recommendations of the President, derived from his subjective assessment of the nature of the position, competitive salaries and the contribution, experience and Company tenure of the executive officer. The President reviews all salary recommendations with the Committee, which is responsible for approving or disapproving such recommendations. Salaries paid to the Chief Executive Officer (if any) and the President are determined by the Committee, subject to ratification by the Board of Directors, and are based upon the Committee's subjective evaluation of their contribution to the Company, their performance, and salaries paid by competitors to their chief executive officer and chief operating officer. Prior to January 1, 1990, the President's assessment and the Committee's subsequent approval or disapproval also took into consideration data from comparable industry salary surveys, such as that prepared by Stephens & Associates. From 1990 through March 31, 1994, the only salary increases which were granted occurred in June, 1992, at which time Mr. Cortright, Mrs. Garbis and two other executive officers of the Company were granted salary increases. Such increases were granted in connection with the efforts of these officers in securing over $10,000,000 in new financing for the Company and resolving various regulatory matters with the State of Florida. ANNUAL INCENTIVE PROGRAM Although business exigencies and the Company's liquidity situation have required the Company to suspend the granting of awards under the Bonus Plan, and to award bonuses only in certain limited instances where the bonus directly relates to the accomplishment of certain specified corporate and financial objectives, it is the intention of the Committee that an executive's annual compensation consist of a base salary and an annual bonus such as that provided under the Bonus Plan. All executive officers of the Company (except those officers who are otherwise entitled to receive additional compensation) and all managerial employees who meet certain eligibility criteria determined by their level of responsibility are eligible to participate in the Bonus Plan. The Bonus Plan provides for executives to earn bonuses of up to 150% of the base bonus for which they are eligible (which generally ranges from 10% to 75% of annual salary, depending upon their position and anticipated contribution to the Company), with the maximum bonus payable to the President being limited to 100% of his annual salary. Such bonuses are earned based upon the success of the Company, or of the subsidiary or division for which the individual is responsible, in achieving its debt-to-equity and/or net income goals. Typically, under the Bonus Plan, awards are determined in advance of a fiscal year, at which time the net income and/or debt-to-equity goals for the year are also established. Thereafter, at the conclusion of the year, the awards are adjusted up or down and paid, based upon the achievements of the specified objectives and individual job performance. The Bonus Plan provides for the acceleration of the determination and payment of bonuses thereunder in the event of the termination of employment of a participant following a change in control of the Company. No bonuses were awarded, earned by, or paid to, any executive officer of the Company under the Bonus Plan during or in respect of 1993; further, since no bonus awards have been outstanding to any executive officer of the Company for the past three years, the change in control resulting from the Selex transaction did not result in the acceleration of the determination and payment of bonuses under the Bonus Plan. The only bonus paid in 1993 was to Mr. Cortright pursuant to his employment agreement described above. In 1992, Mr. Cortright was instrumental in securing over $10,000,000 in new financing for the Company through the sale of contracts receivable and the Selex transaction, as well as for resolving certain regulatory matters with the State of Florida. His contribution was recognized through the award of a $200,000 bonus (an amount equal to one year's salary). To avoid straining the Company's liquidity situation, it was determined that his employment agreement would provide for that bonus to be paid in four annual installments, the second of which was paid in 1993. The installment due to have been paid in June, 1994 is currently in default and the final remaining installment is due to be paid in June, 1995. See "Employment Contracts." LONG TERM INCENTIVE PROGRAM Additional long-term cash and equity incentives has been provided through the 1987 Stock Incentive Plan (the "Stock Plan"). The Stock Plan combines the features of a stock option plan and a performance unit plan by providing for the issuance of up to 500,000 shares of Common Stock through the granting of stock options and the award of incentive shares. Under the Stock Plan, incentive shares are awarded to those executive officers and other key employees who, in the opinion of the Committee, are in positions which enable them to make significant contributions to the long-term performance and growth of the Company. The extent to which incentive share awards are earned is determined at the end of the three-year award cycle, based upon the achievement of a net income goal set forth in the three-year business plan adopted by the Board of Directors of the Company prior to or during the first year of the cycle. Awards are paid, in the discretion of the Committee, in cash or in shares of Common Stock of the Company, on or before the May 1st following the end of the three-year cycle. The Stock Plan provides for the acceleration of the determination and payment of awards thereunder in the event of a change of control of the Company. Incentive shares awarded in November, 1986 were fully earned as of the end of 1989, and 79,940 shares were issued under the Stock Plan. Inasmuch as no additional awards have been granted or are outstanding under the Stock Plan, the change in control resulting from the Selex transaction did not result in the acceleration of the determination and payment of awards thereunder. The Stock Plan also provides for the granting of non-qualified stock options, such that the Committee has available a further vehicle for compensating executives through equity participation. The exercise price of options granted under the Stock Plan cannot be less than the fair market value of the Company's Common Stock on the date of the grant. Options are granted under the Stock Plan for periods of up to five years and become exercisable in 20% cumulative annual increments (but no option may be exercised within 60 days of its grant). The only option granted in 1993, as indicated above, was an option to Mr. Weiner to acquire 20,000 shares of Common Stock at a price of $4.00 per share, which was in excess of the market value of the Company's Common Stock on the grant date. Such option expired unexercised following Mr. Weiner's removal as an officer of the Company. CHIEF EXECUTIVE OFFICER COMPENSATION Marcellus H.B. Muyres, who served as Chairman of the Board and Chief Executive Officer of the Company from June 19, 1992 through July 12, 1994, served without compensation in accordance with his representation to the Committee and the Board that he would not draw a salary until the Company's liquidity situation permitted the payment of appropriate compensation. To date, Mr. Muyres has received no compensation for his services as Chairman of the Board and Chief Executive Officer. As a director and executive officer of the Company, Mr. Muyres is entitled to reimbursement of expenses, including travel and transportation expenses, incurred on the Company's behalf. From June, 1992 through August 19, 1994, Mr. Muyres incurred expenses aggregating approximately $39,112, none of which has been reimbursed, but which is being carried as a liability of the Company. On July 13, 1994, Antony Gram was appointed Chairman of the Board and Chief Executive Officer of the Company, with Mr. Muyres agreeing to serve as a Vice Chairman of the Board. As Chairman and Chief Executive Officer, Mr. Gram has been given the responsibility of resolving the financial and legal difficulties facing the Company and developing an alternative business plan to enable the Company to continue as a going concern. During the process of resolving such difficulties and developing such plan, Mr. Gram has agreed to serve without compensation, with the understanding that all ordinary, necessary and reasonable expenses incurred by him in the performance of his duties, including travel and temporary living expenses, will be reimbursed by the Company and with the further understanding that the Committee and the Board will thereafter consider establishing an appropriate salary to be paid him for his services. COMPLIANCE WITH INTERNAL REVENUE CODE SECTION 162(M) Section 162(m) of the Internal Revenue Code, enacted in 1993, generally disallows a tax deduction to public companies for compensation over $1,000,0000 paid to the corporation's Chief Executive Officer and four other mostly highly compensated executives officers. Qualifying performance-based compensation will not be subject to the deduction limit if certain requirements are met. The compensation currently paid to the Company's Chief Executive Officer and highly compensated executive officers does not approach the $1,000,000 threshold, and the Company does not anticipate approaching such threshold in the foreseeable future. Nevertheless, the Company intends to take the necessary action to comply with the Code limitations. FUTURE COMPENSATION TRENDS The Committee anticipates undertaking a review of all compensation programs and policies of the Company, and making appropriate modifications and revisions, in conjunction with the development of an alternative business plan for the Company. Executive Compensation Committee Neil E. Bahr, Chairperson Antony Gram Marcellus H.B. Muyres Cornelis L.J.J. Zwaans ITEM 12 ITEM 12 OWNERSHIP OF VOTING SECURITIES OF THE COMPANY Based upon information furnished to the Company or contained in filings made with the Commission, the Company believes that the only persons who beneficially own more than five percent (5%) of the Common Stock the Common Stock of the Company are Dimensional Fund Advisors Inc. (5.7%), Selex (42.3%), and Antony Gram, through his holdings in Selex and Yasawa (46.7%). Dimensional Fund Advisors Inc. ("Dimensional"), 1299 Ocean Avenue, 11th Floor, Santa Monica, California 90401, a registered investment advisor, is deemed to have beneficial ownership of 380,300 shares of the Company's Common Stock as of December 31, 1993, with sole dispositive power as to all of such shares and sole voting power as to 216,100 of such shares. All of such shares are held in portfolios of DFA Investment Dimensions Group Inc., a registered open-end investment company (the "Fund"), or in series of The DFA Investment Trust Company, a Delaware business trust, or the DFA Group Trust and the DFA Participating Group Trust, investment vehicles for qualified employee benefit plans, as to all of which Dimensional serves as investment manager. Dimensional disclaims beneficial ownership of all such shares. Persons who are officers of Dimensional also serve as officers of the Fund. In their capacity as officers of the Fund, these persons vote the 164,200 additional shares which are owned by the Fund. All of the issued and outstanding stock of Selex, Gerrit Van Den Veenstraat 70, Amsterdam, the Netherlands, is owned by Wilbury which is, in turn, owned by Messrs. Muyres and Gram. Antony Gram, Chairman of the Board of Directors and Chief Executive Officer of the Company, as the largest shareholder of Wilbury, holding a seventy-four percent equity interest in that corporation, is treated as the beneficial owner of all of the Company's Common Stock held by Selex. In addition, Mr. Gram beneficially owns Yasawa. Since Yasawa is the direct owner of 289,637 shares of the Common Stock of the Company, Mr. Gram is deemed to be the beneficial owner of an aggregate of 3,109,703 shares of Common Stock of the Company. The following table sets forth information, as of August 19, 1994, concerning the beneficial ownership by all directors, by each of the executive officers named in the Summary Compensation Table beginning on Page 69 (the "Summary Compensation Table") and by all directors and executive officers as a group. The number of shares beneficially owned by each director or executive officer is determined under the rules of the Commission, and the information is not necessarily indicative of beneficial ownership for any other purpose. COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934 The Securities Exchange Act of 1934 requires the Company's directors, its executive officers and any persons holding more than ten percent of the Company's Common Stock to report their initial ownership of the Company's Common Stock and any subsequent changes in that ownership to the Commission and the New York Stock Exchange. Under the Section 16(a) rules, the Company is required to disclose in this Annual Report on Form 10-K any failure to file such required reports by their prescribed due dates. To the Company's knowledge, based solely on a review of the copies of such reports furnished to the Company and written representations that no other reports were required during the fiscal year ended December 31, 1993, all Section 16(a) filing requirements were satisfied, except that Mr. Gram, as beneficial owner of Selex, failed to file a Form 4 with respect to the conversion rights in the Second Selex Loan, which rights lapsed unexercised, Mr. Fischer filed one Form 4 approximately one week late, and Messrs. Muyres, Nipshagen, van de Peppel and Zwaans have neither filed a Form 5 nor acknowledged that such filing was not necessary. PERFORMANCE GRAPH Set forth below is a line graph comparing the cumulative total shareholder return on the Company's Common Stock, based on the market price of the Common Stock, with the cumulative total return of companies on the Media General Financial Services Composite Index and the Media General Peer Group (real estate subdividers and developers) Index. COMPARE 5-YEAR CUMULATIVE TOTAL RETURN AMONG THE DELTONA CORPORATION, MEDIA GENERAL INDEX AND PEER GROUP INDEX [INSERT GRAPH] ITEM 14 ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) 1 FINANCIAL STATEMENTS See Item 8, Index to Consolidated Financial Statements and Supplemental Data. (A) 2 FINANCIAL STATEMENT SCHEDULES PAGE ---- Independent Auditors' Report...................................... 81 Schedule IV - Indebtedness to related parties - non current as of December 31, 1993............................. 82 Schedule VIII - Valuation and qualifying accounts for the three years ended December 31, 1993.................... 83 Schedule X - Supplementary income statement information for the three years ended December 31, 1993.......... 84 All other schedules are omitted because they are not applicable or not required, or because the required information is included in the Consolidated Financial Statements or Notes thereto. (A) 3 EXHIBITS See the Exhibit Index included herewith. (B) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the year ended December 31, 1993; however, a report on Form 8-K dated February 17, 1994 responding to Item 5 "Other Events" was filed on March 14, 1994. INDEPENDENT AUDITORS' REPORT TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF THE DELTONA CORPORATION: We have audited the consolidated financial statements of The Deltona Corporation and subsidiaries (the "Company") as of December 31, 1993 and December 25, 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated September 5, 1994, included elsewhere in this Annual Report on Form 10-K. Our audits also included the financial statement schedules listed in Item 14(a)2 of this Annual Report on Form 10-K. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE LLP Certified Public Accountants Miami, Florida September 5, 1994 SCHEDULE IV THE DELTONA CORPORATION AND SUBSIDIARIES INDEBTEDNESS TO RELATED PARTIES - NON CURRENT SCHEDULE VIII THE DELTONA CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) SCHEDULE X THE DELTONA CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION CHARGES (IN THOUSANDS) TO COSTS AND EXPENSES SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE DELTONA CORPORATION (Company) By /S/ EARLE D. CORTRIGHT, JR. DATE: August 30, 1994 --------------------------------------- Earle D. Cortright, Jr., PRESIDENT & CHIEF OPERATING OFFICER Pursuant to the requirements of the Securities Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the date indicated. /S/ ANTONY GRAM /S/ CORNELIS VAN DE PEPPEL - - ---------------------------------- -------------------------------- Antony Gram, CHIEF EXECUTIVE Cornelis van de Peppel, DIRECTOR OFFICER & DIRECTOR /S/ EARLE D. CORTRIGHT, JR. /S/ CORNELIS L.J.J. ZWAANS - - ---------------------------------- -------------------------------- Earle D. Cortright, Jr., PRESIDENT Cornelis L.J.J. Zwaans, DIRECTOR & CHIEF OPERATING OFFICER (PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER) /S/ NEIL E. BAHR - - ---------------------------------- Neil E. Bahr, DIRECTOR /S/ GEORGE W. FISCHER - - ---------------------------------- George W. Fischer, DIRECTOR /S/ THOMAS B. MCNEILL - - ---------------------------------- Thomas B. McNeill, DIRECTOR /S/ MARCELLUS H.B. MUYRES - - ---------------------------------- Marcellus H.B. Muyres, DIRECTOR /S/ LEONARDUS G.M. NIPSHAGEN - - ---------------------------------- Leonardus G.M. Nipshagen, DIRECTOR DATE: August 30, 1994

68330_1993.txt

68330_1993

1993

68330

Item 1. Business - ------ -------- General - ------- MGI Properties (the "Trust" or "MGI") is an unincorporated business trust organized under the laws of the Commonwealth of Massachusetts. MGI commenced operations in 1971 as a real estate investment trust. Since that time, the Trust has elected to be treated as a real estate investment trust (a "REIT") under Sections 856-860 of the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"), and expects to continue to operate in a manner which will entitle the Trust to be so treated. For each taxable year in which the Trust qualifies as a REIT under the Internal Revenue Code, taxable income distributed to the holders of its shares will not be taxable to the Trust (other than certain items of tax preference which are subject to minimum tax in the hands of the Trust). See "Investment and Operating Policies" and "Portfolio" below and the description of dividend policy included under Item 5 of this Annual Report on Form 10-K for the year ended November 30, 1993 (the "Report"). References herein to the Trust include its wholly-owned subsidiaries. Narrative Description of Business - --------------------------------- The Trust, which is a self-administered and self-managed equity REIT, owns and manages a diversified portfolio of income-producing real estate assets. The Trust's portfolio consists of investments in apartment complexes, multi-use industrial facilities (such as warehouses and research and development buildings), shopping centers and office buildings. The primary investment objective of the Trust is to make diversified equity and equity-oriented investments in existing properties believed to be capable of producing stable and rising income streams and having long-term capital appreciation potential. The Trust also believes that its active managing and leasing practices can enhance rental income, funds from operations and long-term capital appreciation. These investments have typically taken the form in recent years of a direct equity ownership interest. The Trust employs ten persons. Investment and Operating Policies - --------------------------------- The investment policy of the Trust in its broadest aspect is to seek income of the types permitted to a REIT under Section 856 of the Internal Revenue Code, consistent with its Declaration of Trust. Under its Declaration of Trust, the Trust is permitted to invest in a broad range of real estate and mortgage investments, including among other things equity interests, full or participating interests in securities, whether or not secured by mortgages, interests in rents and any other interests related to real property. The Trust's policies are subject to ongoing review by the Board of Trustees and may be modified from time to time to take into consideration changes in business or economic conditions or otherwise as circumstances warrant. The Trust's investment focus with respect to type of property has, during the last several years, been directed to equity and equity-oriented investments in existing income-producing properties, principally apartment complexes, multi-use industrial facilities, shopping centers and office buildings. MGI continues to believe it is beneficial to diversify its assets by location and type of real estate, although it periodically changes its emphasis from one sector to another in accordance with its perception of market opportunities. Over the past several years MGI, has increased its emphasis on acquisitions in the northeastern region of the United States, including industrial and office properties. Although the principal investment emphasis is on the direct ownership of income-producing equity real estate, MGI was historically an equity-oriented or "hybrid" (equity and mortgage) trust. MGI's focus turned from mortgage loans with equity participations toward equity investments in which the Trust becomes the sole owner of the property and realizes all of the property's future benefits and risks. Management believes that this evolution has given the Trust greater control over the direction of its portfolio and the opportunity to increase its capital gains potential. Previously, when operating as a hybrid trust, the investments financed as mortgages (first mortgage loans, junior liens, including wrap- around mortgages, or purchase-money mortgages taken back on the sale of former equity investments) have in many instances included an option to acquire, or a provision for the conversion of such mortgage into, a material equity position at a cost believed by management to be favorable, and in some instances, a participation in the earnings from the property over a base amount or a percentage of the proceeds from the sale of the property. In making new investments, MGI's investment focus has been primarily directed to acquiring quality income-producing properties. Over the last several years, MGI's investment philosophy has been to seek what management believes to be value- creating opportunities by acquiring quality properties that have not met their full potential at a cost believed to be below or near replacement value. Management believes that its investments can be managed to create a total return which includes current income and appreciation. The Trust seeks to implement its investment objectives through selective acquisitions of quality properties, leasing and property management in accordance with its defined long term goals, investment in property improvements and periodic sales of selected properties. The Trust has recently operated with an individual investment parameter of below $20,000,000, but has exceeded and may occasionally exceed this parameter. The decision to sell specific properties or investments involves a number of factors, including the economic climate (giving effect also to the impact of tax laws and other regulatory factors), future potential and reinvestment alternatives. As indicated above, the investment focus may change, based upon the ongoing review of the Trust's policies by the Board of Trustees. As is common with any real estate owner or lender investing in equity real estate, partnerships, mortgage loans and other investments, the Trust from time to time may restructure its financial arrangements with partners, tenants or borrowers who encounter financial or other difficulties. Accordingly, the Trust, as circumstances warrant, has modified and will modify a lease, partnership, loan or other agreement if, after investigation, it is established that such modification would be economically feasible and in the best interests of the Trust. Protection of the Trust's investments may require foreclosure or other action leading to acquisition of title to properties underlying its mortgage loans or investments. The Trust's business is limited to investments in real estate, direct or indirect, including investments in and possible future acquisitions of real estate companies. To the extent that the Trust has assets not otherwise invested in real estate, the Trust may invest such assets in other securities, including United States government obligations and commercial paper, so long as, in the opinion of the Trustees, such securities may be held without jeopardizing the Trust's qualification as a REIT under the Internal Revenue Code. Funds necessary to conduct operations are provided from rental and interest income, mortgaging of equity investments, lines of credit, corporate borrowings, sale of marketable securities and loan repayments and amortization. Such operations include the Trust's continuous incurrence of costs, reimbursed and unreimbursed, for improvements and renovations of its existing properties in order to maintain and enhance their value. From time to time, as conditions warrant, the Trust may operate on a leveraged basis by incurring indebtedness in order to increase its capital available for investment when, in the Trustees' judgment, the Trust will benefit thereby. There is no assurance at any given time that borrowed funds will be available or that the terms and conditions of such borrowings will be acceptable. The Trust may employ short-term borrowings to fund some of its investments. Reference is made to Note 4 of the Notes to Consolidated Financial Statements included in Item 14 below. Portfolio - --------- The Trust's real estate portfolio as of November 30, 1993 consisted of interests in fifty properties, forty-five of which are wholly- owned, three are owned by partnerships in which the Trust has an equity interest, one is a property sold by the Trust in a prior year transaction which did not meet the conditions for a completed sale and is still carried as a real estate investment for financial accounting purposes and one is a mortgage loan that is accounted for as real estate owned. For tax purposes, the property sold and the property accounted for as real estate owned are treated as mortgage loans receivable. The Trust's real estate investments can be classified by type of property and market region. As of November 30, 1993, the Trust's real estate investments were diversified by type of property as follows: Number of Percent of Type Of Property Properties Cost Total ---------------- ---------- ------------- ---------- Apartments 10 $ 78,955,000 30.5% Retail 5 53,198,000 20.6 Office 9 65,230,000 25.2 Industrial 25 61,255,000 23.7 Land 1 25,000 * -- ------------ ------ Total 50 $ 258,663,000 100.0% -- ------------ ------ - ---------- * Less than 1% As of November 30, 1993, the Trust's real estate investments were diversified by geographic region as follows: Percent of Number of Portfolio Based Region Properties Cost on Cost ------ ---------- ----------- --------------- Midwest 22 $ 99,726,000 38.5% Southeast 13 74,408,000 28.8 Mid-Atlantic 4 23,129,000 8.9 Northeast 10 61,175,000 23.7 Other 1 225,000 .1 -- ----------- ------ Total 50 $258,663,000 100.0% -- ----------- ------ Terms under leases to tenants at the Trust's properties range from tenancies-at-will up to eighteen years. The Trust leases commercial space to approximately 260 commercial tenants, including 130 office tenants, 71 retail tenants and 59 industrial tenants. Additional information concerning the Trust's mortgage and real estate investments is set forth under Item 2 Item 2. Properties. - ------ ---------- The following table sets forth certain information concerning the Trust's properties. SUMMARY OF PROPERTIES AT NOVEMBER 30, 1993 Note: (a) See Note 2 of the Notes to Consolidated Financial Statements included under Item 14 of this Report. (continued) Item 2. Properties. (cont'd) - ------ ---------- Reference is made to Notes 1, 2 and 3 in the Notes to the Consolidated Financial Statement and Schedules XI and XII of the Financial Statement Schedules for descriptions of the Trust's investments and properties. Executive Office. - ---------------- The Trust's headquarters, at 30 Rowes Wharf, Boston, Massachusetts, includes approximately 5,400 square feet and is occupied under a lease expiring November 30, 1994. Item 3. Item 3. Legal Proceedings. - ------ ----------------- The Trust is not a party to any material legal proceedings as to which it does not have adequate insurance coverage. Item 4. Item 4. Submission of Matters to a - ------ Vote of Security Holders. ------------------------ Not applicable. PART II ------- Item 5. Item 5. Market for Registrant's Common Equity - ------ and Related Stockholder Matters. ------------------------------- (a) Market Information and Dividends. The principal market on which the Trust's common shares are traded is the New York Stock Exchange, under the symbol MGI. The table below sets forth, for the fiscal quarters indicated, the high and low sales prices on the New York Stock Exchange of the Trust's common shares and dividends paid per common share. Fiscal Sales Price -------------------------- 1993 High Low Dividends ------ ---- --- --------- First Quarter 15 3/4 11 $.20 Second Quarter 16 1/2 13 $.20 Third Quarter 13 3/8 12 $.20 Fourth Quarter 15 1/8 12 3/4 $.21 Fiscal Sales Price -------------------------- 1992 High Low Dividends ------ ---- --- --------- First Quarter 12 1/2 9 5/8 $.20 Second Quarter 12 10 7/8 $.20 Third Quarter 12 1/8 11 1/8 $.20 Fourth Quarter 12 1/8 11 1/8 $.20 Future dividends will be determined by the Trust's Board of Trustees and will be dependent upon the earnings, financial position and cash requirements of the Trust and other relevant factors existing at the time. The Trust must distribute at least 95% of the Trust's taxable income in order to enable it to qualify as a real estate investment trust for tax purposes. So long as the Trust continues to qualify as a REIT, shareholders will, therefore, receive in the form of dividends at least 95% of the taxable income of the Trust. (b) Approximate Number of Holders of Common Shares. Approximate Number of Holders (as of Title of Class February 8, 1994) - ----------------------------------------------------- Common Shares, $1.00 3,219 par value Item 6. Item 6. Selected Financial Data (a) - ------ ----------------------- (Not covered by Independent Auditors' Report) Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. --------------------------------------------- Liquidity and Capital Resources - ------------------------------- At November 30, 1993 financial liquidity was provided by $12.7 million in cash and investment securities and by an unused $10.0 million line of credit. Shareholders' equity of $171.0 million at November 30, 1993, when compared to $145.7 million at November 30, 1992, reflects net proceeds of $25.6 million received in connection with the May 6, 1993 public offering of 2,000,000 common shares, dividends of $0.5 million paid in excess of net income and, to a lesser extent, treasury stock issued in connection with stock options exercised. Sources of funds in 1993 included the public sale of common shares, operations, interest income and the Trust's portfolio of investment securities. In 1993, these resources were used to: (i) acquire ten industrial properties and two office buildings, totaling 950,300 square feet and 215,000 square feet of space, respectively, for an aggregate of $41.1 million cash and a $6.6 million wrap-around mortgage loan of which MGI had been the lender, (ii) pay dividends of $8.5 million, (iii) repay debt of $7.7 million, and (iv) fund $2.7 million of tenant and capital improvements. Total mortgage and other loans payable aggregated $66.9 million at November 30, 1993, a net increase of $6.3 million compared to $60.6 million at November 30, 1992. The increase resulted from the addition of $14.0 million of debt (which included $0.7 million of debt in connection with the acquisition of four industrial buildings), offset by scheduled amortization payments of $0.9 million, a $5.6 million repayment of a maturing loan and prepayments of $1.1 million (which included $0.7 million in connection with the amendment and assignment of a lease at Yorkshire Plaza located in Aurora, Illinois and $0.4 million related to three first mortgages acquired in connection with three industrial buildings). Mortgage and other loans payable are collateralized by sixteen of MGI's properties having an aggregate carrying value of $115.8 million, $3.2 million of investment securities and MGI's guarantees of $9.2 million. Subsequent to November 30, 1993, mortgage loans payable increased by $2.2 million as MGI received the balance of the proceeds of a loan which closed in November 1993. Loans payable due within twelve months of November 30, 1993 totaled $18.7 million, including a $6.3 million 12.75% loan with an April 1994 maturity and a $11.2 million floating rate loan with a September 1994 maturity. MGI has commenced, on a preliminary basis, several mortgage financing initiatives. If MGI proceeds with all of these borrowing initiatives a net increase in outstanding debt of approximately $30,000,000 may result. Despite the generally reduced availability of real estate financing, MGI believes it will be successful extending or refinancing maturing mortgage loans upon satisfactory terms although there can be no assurance thereof. In December 1993, MGI acquired two industrial/research and development buildings, one totaling 100,000 square feet and the other 56,300 square feet, located in suburban Boston, Massachusetts for an aggregate price of $6.3 million cash. Both buildings are 100% occupied by the same publicly- traded tenant with leases that expire in June 1998 and December 1999. Other cash requirements in 1994 are distributions to shareholders, capital and tenant improvements and other leasing expenditures required to maintain MGI's occupancy levels and other investment undertakings. During the period 1990 through 1993, annual expenditures for capital and tenant improvements averaged approximately 1.2% of real estate investments. In 1994 budgeted capital and tenant improvements which are based on assumed leasing activity, completion of discretionary capital projects and estimated costs, approximates 1.7% of real estate investments. Principal sources of funds in the future are expected to be from operations of properties including those acquired in the future, mortgaging or refinancing existing mortgages on properties and MGI's portfolio of investment securities. Other potential sources of funds may include the proceeds of offerings of additional equity or debt securities or the sale of real estate investments. The cost of new borrowings or issuances of equity capital will be measured against the anticipated yields of investments to be acquired with such funds. Following the December 1993 acquisition of two buildings, the purchase of additional properties in 1994 may require the use of funds from MGI's line of credit, new borrowings, the sale of properties currently owned or the issuance of equity securities. MGI believes the combination, at November 30, 1993, of cash and investment securities, the value of MGI's unencumbered properties, and other resources are sufficient to meet its short and long term liquidity requirements. Results of Operations - --------------------- Net income for 1993 of $8.0 million, or $0.75 per share on the greater number of shares outstanding, exceeded net income of $7.2 million, or $0.77 per share, in 1992. Included in net income in 1992 was a net gain of $1.6 million, or $.17 per share. Funds from operations in 1993 totaled $15.0 million, or $1.42 per share on the greater number of shares outstanding, compared to $11.7 million, or $1.24 per share, in 1992. MGI defines funds from operations as net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from debt restructuring, sales of property and similar non-cash items, depreciation and amortization charges, and equity method partnership losses. MGI believes funds from operations is an appropriate supplemental measure of operating performance. The change in funds from operations is attributable to the same factors that affected income before net gains, with the exception of depreciation and amortization expense. The increase in income before net gains when comparing 1993 to 1992 resulted principally from the increase in properties owned and the receipt of a non-recurring fee. As a result, rental and other income, property operating expenses, real estate tax expense, depreciation and amortization expense increased and mortgage interest income decreased in 1993. The $8.2 million increase in rental and other income in 1993 compared to 1992 was principally the result of (i) $3.6 million from the properties acquired in 1993, (ii) $2.4 million related to the reclassification of MGI's investment in a Metairie, Louisiana apartment complex to owned real estate from a mortgage receivable, (iii) $1.0 million of non-recurring income received in connection with the assignment and amendment of a lease at Yorkshire Plaza, Aurora, Illinois, (iv) $0.8 million due to the partial year ownership of properties acquired in 1992 and (v) the $0.4 million increase from the balance of the portfolio. The $2.4 million increase in property operating expenses and the $0.9 million increase in real estate taxes in 1993 as compared to 1992, reflect primarily (i) $1.0 million and $0.1 million, respectively, related to the Metairie, Louisiana apartment complex, (ii) $0.8 million and $0.6 million, respectively, from the properties acquired in 1993, (iii) $0.2 million and $0.1 million, respectively, due to the buildings acquired in 1992 and (iv) $0.4 million and $0.1 million, respectively, from the balance of the portfolio. The $1.0 million increase in depreciation and amortization expense for 1993 when compared to 1992 was mostly due to partial year ownership of the properties acquired in 1993 and 1992 ($0.4 million) and the Louisiana apartment complex ($0.5 million). The $1.6 million decrease in mortgage interest income in 1993 is due to the reclassification of the Metairie, Louisiana investment to real estate owned and the acquisition by MGI of the four properties that secured a $6.6 million MGI wrap-around mortgage loan. Three additional factors also contributed to the increase in income before net gains and funds from operations when 1993 is compared to 1992. Interest income in 1993 reflects a decrease in the average outstanding balance of short-term investments and lower interest rates. General and administrative expenses increased in 1993 primarily reflecting an increase in personnel. Lower average levels of debt outstanding, combined with lower interest rates on variable rate debt, resulted in decreased interest expense of $0.5 million when 1993 is compared to 1992. Average occupancy levels of 94% in 1993 were higher than the level achieved in 1992. Average occupancy of MGI's industrial properties was 96% in 1993 compared to 92% for 1992. Average occupancy of MGI's office buildings was 94% in 1993 and 91% in 1992. Retail average occupancy during 1993 was 92% compared to 90% in 1992. Average residential occupancy at 94% in 1993 was comparable to 1992. At November 30, 1993, scheduled 1994 lease expirations for non- residential space approximates 426,000 square feet, or 11% of the entire commercial portfolio. Of the scheduled 1994 expirations, 275,000 square feet is industrial space, 128,000 square feet is office and 23,000 is retail. During the second half of 1993, MGI was notified that a 40,000 square-foot tenant in a suburban Chicago, Illinois office building was not renewing its lease upon its December 31, 1993 expiration. This tenant contributed annual rental revenues of approximately $0.6 million. Although MGI believes that the rental rates for this tenant's lease is at or below current market rents, rents paid by replacement tenants for this space could be modestly below the existing rent, depending on length of vacancy, tenant size and other market factors. Net income for 1992 of $7.2 million, or $.77 per share, exceeded net income of $6.2 million, or $.66 per share, for 1991. Net income in 1992 included net gains of $1.6 million. Funds from operations totaled $11.7 million, or $1.24 per share, in 1992 compared to $12.2 million, or $1.30 per share, in 1991. The changes in 1992 income before net gains when compared to 1991 were the result of various factors. The principal factors were the sale of an interest in a California apartment complex ("the San Bruno Transaction"), the acquisitions of two industrial properties and lower interest expense. The $2.7 million decline in rental and other income was the result of a $3.3 million decrease in rental income from the San Bruno Transaction offset by the increase of $0.3 million from the partial-year ownership of the 1992 acquisitions and $0.3 million of increased revenues from the other properties. Property operating expenses, including real estate taxes, decreased $1.0 million as a result of a $1.4 million decrease in operating expenses from the San Bruno Transaction, an increase of $0.1 million in such expenses from the properties acquired in 1992 and an increase of $0.3 million from other properties. Depreciation and amortization expense was $6.0 million in both 1992 and 1991. A decrease in depreciation and amortization expense related to the San Bruno Transaction was offset by an increase related to the 1992 acquisitions and increased amortization expense related to tenant improvements. The $0.9 million decrease in interest expense for 1992 when compared to 1991 was the result of the decrease in debt outstanding combined with lower interest rates on variable rate debt. Increased levels of funds available to invest in 1992, due to the San Bruno Transaction, produced an increase in interest income on investment securities for 1992 when compared to 1991, which offset the lower interest rates generally available in 1992 for short- term investments. Net gains in 1992 included a $3.7 million gain related to the repayment of approximately $18.8 million of the outstanding financing provided to the partnership owning a San Bruno, California apartment complex. This repayment effected the partial sale of the Trust's interest for financial accounting purposes. Previously this property was carried as a real estate investment since a 1976 sale had not met the financial accounting conditions for a completed sale. In addition, MGI deferred $3.7 million of gain related to this property. Partially offsetting this gain was a $2.1 million write-down recorded in connection with the reclassification of the Trust's mortgage loan receivable on a Metairie, Louisiana apartment complex to owned real estate at November 30, 1992. Real estate investments and operations are subject to a number of factors including changes in general economic climate, local conditions (such as an oversupply of space, a decline in effective rents or a reduction in the demand for real estate), competition from other available space, the ability of the owner to provide adequate maintenance, to fund capital and tenant improvements required to maintain market position and control of operating costs. In certain markets in which the Trust owns real estate, overbuilding and local or national economic conditions have combined to produce lower effective rents and/or longer absorption periods for vacant space. As the Trust re-leases space, certain effective rents may be less than those earned previously. Management believes its diversification by region and property type reduces the risks associated with these factors and enhances opportunities for cash flow growth and capital gains potential, although there can be no assurance thereof. During the past three fiscal years, the impact of inflation on MGI's operations and investment activity has not been significant. Item 8. Item 8. Financial Statements and Supplementary Data. - ------ ------------------------------------------- The financial statements and supplementary data are included under Item 14 of this Report. Item 9. Item 9. Changes in and Disagreements with Accountants on - ------ Accounting and Financial Disclosure. ----------------------------------- None. PART III -------- The information required by Items 10, 11, 12 and 13 of this Part III has been omitted from this Report since the Registrant intends to file with the Securities and Exchange Commission a definitive proxy statement which involves the election of Trustees not later than 120 days after the close of the Registrant's last fiscal year. PART IV ------- Item 14. Item 14. Exhibits, Financial Statement Schedules - ------- and Reports on Form 8-K. --------------------------------------- (a) 1. CONSOLIDATED FINANCIAL STATEMENTS INDEX - ----- Independent Auditors' Report Financial Statements: Consolidated Balance Sheets, November 30, 1993 and 1992 Consolidated Statements of Earnings, Years ended November 30, 1993, 1992 and 1991 Consolidated Statements of Changes in Shareholders' Equity, Years ended November 30, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, Years ended November 30, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. CONSOLIDATED FINANCIAL STATEMENT SCHEDULES Schedules (as of or for the year ended November 30, 1993): Schedule X, Supplementary Income Statement Information Schedule XI, Real Estate and Accumulated Depreciation Schedule XII, Mortgage Loans on Real Estate Exhibit XI - Computation of Net Income Per Share, Assuming Full Dilution Other schedules are omitted for the reasons that they are not required, are not applicable, or the required information is set forth in the financial statements or notes thereto. 3. EXHIBITS* Sequentially Numbered Page ------------- 3(a) Second Amended and Restated Declaration of Trust, incorporated by reference to Exhibit 3 of the Trust's Annual Report on Form 10-K for the fiscal year ended November 30, 1981 (the "1981 10-K"). (b) Certificate of First Amendment of Second Amended and Restated Declaration of Trust, incorporated by reference to Exhibit 3 of the 1981 10-K. (c) Certificate of Second Amendment of Second Amended and Restated Declaration of Trust, incorporated by reference to the Trust's Report on Form 8-K, filed on January 13, 1983. (d) Certificate of Third Amendment of Second Amended and Restated Declaration of Trust, incorporated by reference to Exhibit 3(d) to Amendment No. 1 to the Trust's Registration Statement on Form S-2 filed on June 7, 1985. (e) Certificate of Fourth Amendment of Second Amended and Restated Declaration of Trust, dated October 17, 1986, incorporated by reference to the Trust's Annual Report on Form 10-K for the year ended November 30, 1986. (f) Certificate of Fifth Amendment of Second Amended and Restated Declaration of Trust, dated March 25, 1987, incorporated by reference to Exhibit 3(f) of the Trust's Annual Report on Form 10-K for the fiscal year ended November 30, 1987. (g) Certificate of Sixth Amendment of Second Amended and Restated Declaration of Trust, dated February 10, 1988, incorporated by reference to Exhibit 4(g) of the Trust's Registration Statement on Form S-8 filed on May 3, 1988. (h) Certificate of Seventh Amendment of Second Amended and Restated Declaration of Trust, dated June 30, 1988, incorporated by reference to Exhibit 4.8 of the Trust's Registration Statement on Form S-4 filed on November 10, 1988 (Reg. No. 33-25495). (i) Certificate of Eighth Amendment of Second Amended and Restated Declaration of Trust, dated March 27, 1989, incorporated by reference to Exhibit 3(i) of the Trust's Annual Report on Form 10-K for the fiscal year ended November 30, 1989 (the "1989 10- K"). (j) By-Laws, incorporated by reference to the Trust's Report on Form 8-K, filed on January 12, 1983. (k) Certificate of Amendment of By-Laws, dated March 21, 1989, incorporated by reference to the Trust's Report on Form 8-K dated March 21, 1989. (l) Rights Agreement, dated as of June 21, 1989 between the Trust and The First National Bank of Boston as Rights Agent, incorporated by reference to Exhibit 1 to the Trust's Registration Statement on Form 8-A, filed on June 27, 1989. (m) Certificate of Vote of the Trustees Designating a Series of Preferred Shares, dated June 21, 1989, incorporated by reference to Exhibit 3(m) of the 1989 10-K. 10(a) Mortgage Growth Investors Incentive Stock Option Plan for Key Employees, incorporated by reference to the Trust's Definitive Proxy Statement dated March 15, 1982. (b) Mortgage Growth Investors Stock 1982 Option Plan For Trustees, incorporated by reference to the Trust's Definitive Proxy Statement dated March 15, 1982. (c) MGI Properties 1988 Stock Option and Stock Appreciation Rights Plans for Key Employees and Trustees, incorporated by reference to the Trust's Definitive Proxy Statement, dated February 19, 1988. (d) Amendment to MGI Properties' 1982 Incentive Stock Option Plan for Key Employees, dated as of December 19, 1989, incorporated by reference to Exhibit 10(d) of the 1989 10- K. (e) Amendment to MGI Properties' 1982 Stock Option Plan for Trustees, dated as of December 19, 1989, incorporated by reference to Exhibit 10(e) of the 1989 10- K. (f) Amendment to MGI Properties' 1988 Stock Option and Stock Appreciation Rights Plan for Key Employees, dated as of December 19, 1989, incorporated by reference to Exhibit 10(f) of the 1989 10-K. (g) Amendment to MGI Properties' 1988 Stock Option Plan for Trustees, dated as of December 19, 1989, incorporated by reference to Exhibit 10(g) of the 1989 10- K. (h) Amended and Restated Severance Compensation Plan, dated as of December 19, 1989, incorporated by reference to Exhibit 10(i) of the 1989 10-K. (i) Amended and Restated MGI Properties Long Term Share Bonus Plan, dated December 18, 1991, incorporated by reference to Exhibit 10(i) of the 1991 10-K. (j) Purchase Agreement, dated December 29, 1992, among West Port Park, Inc., a Massachusetts corporation, those persons named on Schedule A thereto, MGI Properties and MGI West Port, Inc., a Delaware corporation, incorporated by reference to the Trust's Report on Form 8-K, filed on February 14, 1994 (the "1994 8-K") (k) Agreement of Sale, dated as of May 7, 1993, among MGI Properties and Continental Bank, National Association, as successor trustee, and Jesse B. Morgan and Thomas E. Meador, as co-trustees, incorporated by reference to the Trust's 1994 8-K. (l) Agreement of Purchase and Sale, dated as of April 6, 1993, between MGI Properties and Hexalon Real Estate, Inc., incorporated by reference to the Trust's 1994 8-K. (m) Contract of Sale, effective June 1, 1993, between Nationwide Life Insurance Company and MGI Properties, incorporated by reference to the Trust's 1994 8-K. (n) Real Estate Sale Agreement, dated as of July 16, 1993, between The Travelers Insurance Company and MGI Properties, incorporated by reference to the Trust's 1994 8-K. (o) Agreement to Purchase Real Property, dated July 23, 1993, between Bedford Property Investors, Inc. and MGI Properties, incorporated by reference to the Trust's 1994 8-K. (p) Agreement for Purchase and Sale of Property, dated as of October 21, 1993, between New York Life Insurance Company, MGI Properties and Sherburne, Powers & Needham, P.C., as escrow agent, incorporated by reference to the Trust's 1994 8-K. (q) Purchase and Sale Agreement, dated as of October 1, 1993, between The Boston Finance Company and MGI Properties, incorporated by reference to the Trust's 1994 8-K. (r) Real Estate Sale Contract, dated as of November 1993, between The Prudential Insurance Company of America and MGI Properties, incorporated by reference to the Trust's 1994 8-K. 11 Computation of Net Income Per Share, Assuming Full Dilution, included under Item 14 of this Report. 24 Auditors' consent to the incorporation by reference in the Trust's Registration Statements on Form S-8 of the independent auditor's report included herein. * On file at Securities and Exchange Commission as indicated. (b) REPORTS ON FORM 8-K: No reports on Form 8-K were filed during the fourth quarter of the fiscal year ended November 30, 1993. ------------------------- MGI Properties (the "Trust") is a Massachusetts business trust and all persons dealing with the Trust must look solely to the property of the Trust for the enforcement of any claims against the Trust. Neither the Trustees, officers, agents nor shareholders of the Trust assume any personal liability in connection with its business or assume any personal liability for obligations entered into in its behalf. POWER OF ATTORNEY ----------------- MGI Properties and each of the undersigned do hereby appoint W. Pearce Coues and Phillip C. Vitali and each of them severally, its or his true and lawful attorneys to execute on behalf of MGI Properties and the undersigned any and all amendments to this Report and to file the same with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission. Each of such attorneys shall have the power to act hereunder with or without the other. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: February 17, 1994 MGI PROPERTIES (Registrant) By: /s/ W. Pearce Coues ---------------------------- W. Pearce Coues, Chairman of the Board of Trustees 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 date indicated. Signature Title Date - --------- ----- ---- /s/ W. Pearce Coues Chairman of the Board February 17, 1994 - ------------------------- of Trustees and Chief W. Pearce Coues Executive Officer /s/ Phillip C. Vitali Principal Financial Officer February 17, 1994 - ------------------------- and Principal Accounting Phillip C. Vitali Officer /s/ Herbert D. Conant Trustee February 17, 1994 - ------------------------- Herbert D. Conant /s/ Francis P. Gunning Trustee February 17, 1994 - ------------------------- Francis P. Gunning /s/ Colin C. Hampton Trustee February 17, 1994 - ------------------------- Colin C. Hampton /s/ George M. Lovejoy, Jr. Trustee February 17, 1994 - -------------------------- George M. Lovejoy, Jr. /s/ Rodger P. Nordblom Trustee February 17, 1994 - ------------------------- Rodger P. Nordblom /s/ John R. White Trustee February 17, 1994 - ------------------------- John R. White UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ITEM 8 - CONSOLIDATED FINANCIAL STATEMENTS November 30, 1993 MGI PROPERTIES MGI PROPERTIES Index to Consolidated Financial Statements and Schedules Page Independent Auditors' Report 1 Financial Statements: Consolidated Balance Sheets, November 30, 1993 and 1992 2 Consolidated Statements of Earnings, Years ended November 30, 1993, 1992 and 1991 3 Consolidated Statements of Cash Flows, Years ended November 30, 1993, 1992 and 1991 4 Consolidated Statements of Changes in Shareholders' Equity, Years ended November 30, 1993, 1992 and 1991 5 Notes to Consolidated Financial Statements 6-11 Schedules (as of or for the year ended November 30, 1993): Schedule X - Supplementary Income Statement Information Schedule XI - Real Estate and Accumulated Depreciation Schedule XII - Mortgage and Other Loans on Real Estate Exhibit XI - Computation of Net Income Per Share, Assuming Full Dilution Other schedules are omitted as they are not required, are not applicable, or the required information is set forth in the consolidated financial statements or notes thereto. Independent Auditors' Report The Board of Trustees and Shareholders MGI Properties: We have audited the consolidated financial statements of MGI Properties and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Trust's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MGI Properties and subsidiaries as of November 30, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended November 30, 1993 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Boston, Massachusetts January 6, 1994 MGI PROPERTIES Consolidated Balance Sheets November 30, 1993 and 1992 See accompanying notes to consolidated financial statements. MGI PROPERTIES Consolidated Statements of Earnings See accompanying notes to consolidated financial statements. MGI PROPERTIES Consolidated Statements of Cash Flows See accompanying notes to consolidated financial statements. MGI PROPERTIES Consolidated Statements of Changes in Shareholders' Equity See accompanying notes to consolidated financial statements. MGI PROPERTIES Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies (a) Consolidation The consolidated financial statements of the Trust include the accounts of its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. (b) Income Taxes The Trust intends to continue to qualify to be taxed as a real estate investment trust under Sections 856-860 of the Internal Revenue Code of 1986 and the related regulations. In order to qualify as a real estate investment trust for tax purposes, the Trust, among other things, must distribute to shareholders at least 95% of its taxable income. It has been the Trust's policy to distribute 100% of its taxable income to shareholders; accordingly, no provision has been made for Federal income taxes. (c) Income and Expense Recognition Income and expenses are recorded using the accrual method of accounting for financial reporting and tax purposes. Income or loss from real estate partnerships is accounted for according to generally accepted accounting principles using either the cost method or the equity method. (d) Depreciation and Amortization Real estate investments, excluding land costs, are depreciated using the straight-line method over estimated useful lives of 20 to 40 years. Tenant improvements are amortized over the shorter of their estimated useful lives or lease terms ranging from 2 to 10 years. Equipment is depreciated over 5, 10 or 20 years. Maintenance and repairs are charged to expense as incurred; major improvements are capitalized. (e) Statements of Cash Flows For purposes of the statements of cash flows, all short-term investments with a maturity, at date of purchase, of three months or less are considered to be cash equivalents. During 1993, the Trust purchased four industrial properties for $6.8 million. The purchase price consisted of cash and a $6.6 million mortgage loan receivable. Only the cash portion of the purchase price is reflected in the accompanying consolidated statement of cash flows. Mortgage loans payable assumed with the acquisition of real estate investments amounted to $.7 million for the year ended November 30, 1993. Cash interest payments of $5.3 million, $5.5 million and $6.5 million were made for the years ended November 30, 1993, 1992 and 1991, respectively. (f) Fair Value of Financial Instruments The Trust estimated the fair values of its financial instruments at November 30, 1993 using discounted cash flow analysis and quoted market prices. Such financial instruments include short-term investments, U.S. Government securities, mortgage and other loans payable and mortgage notes receivable which were received in connection with transactions not qualifying as sales for financial accounting purposes and accordingly not reflected in the Trust's consolidated balance sheet. The excess of the aggregate fair value of the Trust's financial instruments over their aggregate carrying amounts is not material. (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements (g) Net Income Per Share Net income per share is computed based on the weighted average number of common shares outstanding. (2) Investments (a) Real Estate A summary of real estate investments follows: A discussion of certain real estate investments follows: In 1982, the Trust sold its investment in a Michigan apartment complex and received a $15.5 million purchase money mortgage in a transaction that did not meet the conditions for a completed sale for financial accounting purposes. The loan, which matures in February 1995, has an interest rate of 7% and provides for the Trust to receive at least 50% but not more than 60% of the shared appreciation value in excess of the outstanding note balance. In addition, the Trust has a 35% ownership interest, direct and indirect, in the partnership owning this complex. The Trust's purchase option expires in February 1995 and allows it to obtain a maximum equity interest of 67.5%. At November 30, 1993, the Trust carried this asset as a real estate investment at a net carrying value of $7.5 million, which excludes the gain from the sale. At November 30, 1992, the Trust began to account for its loan on a Metairie, Louisiana apartment complex as real estate owned. The Trust had been recognizing interest income ($1.1 million in 1992 and 1991) on the related mortgage loan as received. During 1993, the Trust has recognized property income and expenses as if it owned the property. For tax purposes, this investment is reflected as a $14.1 million, 8.5% mortgage loan receivable at November 30, 1993. With respect to a California partnership investment, the Trust is entitled to receive 50% of property cash flow and residuals through a 2% limited partnership interest (carrying value of $225,000) and has an option to increase its equity interest. In addition, the Trust has a loan receivable from the partnership with a $3.1 million tax basis. Such loan is not recorded in the accompanying financial statements. (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements (b) Mortgage Loan At November 30, 1992, the Trust had reached agreement with the borrower to purchase the four industrial properties securing this $5.9 million wrap-around mortgage loan for a price of $225,000 over the mortgage face value (face value $6.6 million). The acquisition of these buildings was completed December 31, 1992. This loan was subordinate to prior liens which aggregated $.7 million. (c) Other Gains In 1992, the Trust recognized a gain of $3.7 million and deferred an additional gain of $3.7 million, which was effectuated by the December 1991 repayment of approximately $18.8 million of financing it had provided to the partnership owning a San Bruno, California apartment complex. Prior to the completion of the December 1991 transaction, a 1976 sale had not met the conditions for a completed sale and the Trust carried this property as a real estate investment for financial accounting purposes. In addition, in 1992, the Trust recognized a $2.1 million write-down of the Metairie, Louisiana investment discussed above. (3) Leases All leases relating to real estate investments are operating leases; accordingly, rental income is reported when earned. Future minimum lease payments on noncancelable operating leases at commercial properties at November 30, 1993 are: $23.0 million in 1994, $19.5 million in 1995, $16.4 million in 1996, $12.4 million in 1997, $9.1 million in 1998, and $22.2 million thereafter. The above amounts do not include contingent rental income which is received under certain leases based upon tenant sales, ad valorem taxes, property operating expenses and/or costs to maintain common areas. Contingent rental income was $3.4 million in 1993 and $2.6 million in 1992 and 1991. Operating leases on apartments generally have a term of one year or less. (4) Mortgage and Other Loans Payable (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements Mortgage loans payable are nonrecourse and are collateralized by certain real estate investments having a net carrying value of $115.8 million and the Trust's guarantee of $6.2 million. Loans require monthly principal amortization and/or a balloon payment at maturity. The mortgage loan maturing in September 1994 and a $10.0 million line of credit are part of a credit agreement which requires the Trust to maintain compensating balances of 4% of the outstanding loan balance in non-interest bearing accounts with the lender or pay a deficiency fee. The credit agreement contains restrictive covenants which, among other things, require the Trust to maintain certain financial ratios and restricts the incurrence of certain additional indebtedness and the making of certain investments. No borrowing under this line of credit was outstanding during the fiscal year. In connection with this line, a fee is charged on the unused amount. The housing revenue bond is tax exempt and is secured by real estate having a net carrying value of $5.1 million. The bond is also secured by a letter of credit which is collateralized by $3.2 million of short-term investments and U.S. Government securities. The Trust has also guaranteed $3.0 million of the debt. The base interest rate floats weekly and was 2.35% at November 30, 1993 (an effective interest rate of 4.28% due to the payment of fees). Principal payments on mortgage and other loans payable due in the next five years and thereafter are as follows: $18.7 million in 1994, $1.3 million in 1995, $13.4 million in 1996, $16.8 million in 1997, $0.8 million in 1998, and $16.0 million thereafter. (5) Shareholders' Equity (a) Stock Option Plans Under the Trust's 1988 stock option plans for key employees and Trustees (the "Plans"), incentive stock options with or without stock appreciation rights or nonqualified options and related stock appreciation rights may be granted to employees, and nonqualified options may be granted to Trustees. Under the Plans, options may be granted at an exercise price not less than fair market value of the Trust's common shares on the date of grant. Changes in options outstanding during the years ended November 30 were as follows: The weighted average exercise price per option at November 30, 1993, 1992 and 1991 was $12.16, $11.88 and $11.81, respectively. The shares reserved expire by April 1998 and all outstanding options expire by March, 2003. Subsequent to November 30, 1993, 61,000 options were granted. All options outstanding are currently exercisable. (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements (b) Shareholder Rights Plan On June 21, 1989, the Board of Trustees adopted a shareholder rights plan. Under this plan, one right was attached to each outstanding common share on July 5, 1989, and one right will be attached to each share issued in the future. Each right entitles the holder to purchase, under certain conditions, one one-hundredth of a share of Series A participating preferred stock for $60. The rights may also, under certain conditions, entitle the holders to receive common shares of the Trust, common shares of an entity acquiring the Trust, or other consideration, each having a value equal to twice the exercise price of each right ($120). One hundred fifty thousand preferred shares have been designated as Series A participating preferred shares and are reserved for issuance under the shareholder rights plan. The rights are redeemable by the Trust at a price of $.01 per right. If not exercised or redeemed, all rights expire on July 5, 1999. (c) Common Stock Offering In May 1993 the Trust sold 2,000,000 shares of common stock in a public offering for a price of $13.785 per share. The Trust received net proceeds of $25.6 million after the underwriting discount and offering costs. (6) Cash Distributions and Federal Income Taxes The difference between taxable income and net income reported in the consolidated financial statements is due principally to reporting certain gains for tax purposes under the installment method, use of net operating loss carryforwards available and differences in depreciation and in the basis of real estate sold as reported for tax and financial statement purposes. The Trust made cash distributions of ordinary income of $.81 per share ($8,460,000) in 1993, and cash distributions of ordinary income and capital gains of $.80 per share is 1992 ($7,523,000) and in 1991 ($7,518,000). On December 15, 1993, the Trust declared a dividend of $.21 per share payable on January 11, 1994 to shareholders of record on January 3, 1994. (7) Commitments In November 1993, the Trust agreed to acquire two industrial research and development buildings totaling 156,000 sq. ft. for an aggregate price of approximately $6.3 million. The purchase transaction closed in December 1993. (8) Quarterly Financial Information (Unaudited) Quarterly results of operations for the years ending November 30, 1993 and 1992 follow: (Continued) MGI PROPERTIES Notes to Consolidated Financial Statements Schedule X MGI PROPERTIES Supplementary Income Statement Information Charged to Costs and Expenses Schedule XI MGI PROPERTIES Real Estate and Accumulated Depreciation November 30, 1993 Schedule XI (Continued) MGI PROPERTIES Real Estate and Accumulated Depreciation A summary of real estate investments and accumulated depreciation and amortization for the three years ended November 30 follows: The aggregate cost for Federal income tax purposes of the above investments is approximately $215.0 million. Refer to Note 1 regarding the Trust's accounting policies on real estate investments and depreciation and amortization. Schedule XII MGI PROPERTIES Mortgage and Other Loans on Real Estate November 30, 1993 A summary of mortgage and other loan activity for the years ended November 30 follows: Exhibit XI MGI PROPERTIES Computation of Net Income Per Share Assuming Full Dilution Consent of Independent Auditors The Board of Trustees MGI Properties: We consent to incorporation by reference in the registration statements (Nos. 33-21584, 2-97270 and 33-65844) on Form S-8 of MGI Properties and subsidiaries of our report dated January 6, 1994, relating to the consolidated balance sheets of MGI Properties and subsidiaries as of November 30, 1993 and 1992, and the related consolidated statements of earnings, changes in shareholders' equity, and cash flows and related schedules for each of the years in the three-year period ended November 30, 1993, which report appears in the November 30, 1993 annual report on Form 10-K of MGI Properties and subsidiaries. KPMG PEAT MARWICK Boston, Massachusetts February 15, 1994

711404_1993.txt

711404_1993

1993

711404

ITEM 1. BUSINESS. INTRODUCTION The Cooper Companies, Inc. ('TCC' or the 'Company'), through its subsidiaries, develops, manufactures and markets healthcare products, including a range of contact lenses, ophthalmic pharmaceutical products and diagnostic and surgical instruments and accessories, and provides healthcare services through the ownership and operation of certain psychiatric facilities and the management of other such facilities. TCC is a Delaware corporation which was organized on March 4, 1980. BUSINESS EXPANSION TCC disposed of a number of businesses during the 1980s, and by 1989 all of its revenues were derived from the sale of contact lenses. Since that time, the Company has pursued a strategy of diversification into other businesses. As a result, total operating revenues have grown significantly and for fiscal 1993 can be allocated among the Company's businesses as follows: Hospital Group of America, Inc. (including PSG Management, Inc.) -- $45,283,000, CooperVision, Inc. -- $32,120,000, CooperSurgical, Inc. -- $14,679,000 and CooperVision Pharmaceuticals, Inc. -- $570,000. During fiscal 1990, TCC, through various subsidiaries, acquired rights to (i) certain materials used to manufacture contact lenses, (ii) cryosurgical instruments and diagnostic devices, (iii) manufacture, distribute and sell a hard and soft intraocular lens and the injector used to insert the soft intraocular lens (which rights were subsequently sold), and (iv) two ophthalmic products. Early in fiscal 1991, a newly-formed subsidiary, CooperVision Pharmaceuticals, Inc., obtained an exclusive license for the ophthalmic use of Verapamil, a Class I calcium channel blocker being developed as a topical therapeutic to treat ocular hypertension, or glaucoma, which could lead to damaged eye tissue and loss of vision. At about the same time, CooperSurgical, Inc., another newly-formed subsidiary, purchased a company whose primary product is an office hysteroscopy system. Shortly thereafter, CooperSurgical, Inc. acquired another company, which develops and markets surgical instruments principally used for performing gynecologic procedures. In May 1992, another newly-formed subsidiary of TCC acquired all of the issued and outstanding capital stock of Hospital Group of America, Inc. ('Original HGA'), a corporation indirectly owned by Nu-Med, Inc. ('Nu-Med'). In June 1992, Original HGA was merged with and into TCC's subsidiary, with that subsidiary surviving such merger and changing its name to Hospital Group of America, Inc. ('HGA'). Pursuant to the acquisition, HGA acquired facilities providing both psychiatric and substance abuse treatment for children, adolescents and adults. In addition, PSG Management, Inc., another newly-formed subsidiary of TCC ('PSG Management'), entered into a three-year management services agreement (the 'Management Services Agreement') in May 1992, pursuant to which it provides management and administrative services to three facilities still owned by Nu-Med subsidiaries. Those facilities provide a range of specialized treatments for children, adolescents and adults, including programs for women, older adults, survivors of psychological trauma and alcohol and drug abusers. Treatments at both the owned and managed facilities are provided on an inpatient, outpatient and partial hospitalization basis. In April 1993, CooperVision, Inc. acquired all of the stock of CoastVision, Inc., which manufactures and markets soft toric contact lenses designed to correct astigmatism. INVESTMENT COMPANY ACT The Investment Company Act of 1940, as amended (the 'Investment Company Act'), places restrictions on the capital structure of, and the business activities that may be undertaken by, investment companies. The Investment Company Act defines an investment company as, among other things and subject to certain exceptions, an issuer that is engaged in the business of investing or trading in securities and which owns 'investment securities' (as such term is defined in the Investment Company Act) having a value exceeding 40% of the 'value' (as such term is defined in the Investment Company Act) of such company's total assets (exclusive of government securities and cash items) on an unconsolidated basis. Following the completion in 1989 of the Company's divestiture program, a substantial percentage of the Company's assets consisted of cash, cash equivalents and marketable securities, which the Company used or intended to be used primarily for working capital purposes, to reduce further the Company's debt and to fund acquisitions. The Division of Investment Management of the Securities and Exchange Commission (the 'SEC') has raised an issue as to whether the Company may be an investment company under the above definition. The Company has advised the SEC that its consolidated balance sheets at July 31, 1992 and at the last day of each fiscal quarter thereafter demonstrate that less than 40% of the value of the Company's total assets (exclusive of government securities and cash items) consists of investment securities, and that, if such balance sheets had been presented on an unconsolidated basis, the value (for purposes of the Investment Company Act) of the Company's investments in and advances to its subsidiaries that are actively engaged in various aspects of the healthcare business would have been significantly in excess of the carrying value of the underlying assets of those subsidiaries that was included in the consolidated balance sheets. The Company has provided the SEC with information regarding the Company's unconsolidated balance sheets at April 30 and July 31, 1993. The Company believes that this information also demonstrates that the Company is not an investment company within the meaning of the Investment Company Act. As of the date hereof, the Company is continuing to work with the SEC to clarify the Company's status under the Investment Company Act. If the Company were found to be an investment company, the Company believes that such status would have a materially adverse effect upon the Company due to the restrictions which would be placed on its capital structure and business activities. COOPERVISION The Company, through its CooperVision, Inc. subsidiary ('CooperVision'), develops, manufactures and markets a range of hard and soft contact lenses in the United States and Canada. Sales of soft contact lenses represent 98% of CooperVision's total lens sales. Of CooperVision's line of soft contact lenses, approximately 75% of the lenses sold are conventional daily or flexible wear lenses and approximately 25% constitute frequent replacement lenses. CooperVision's major brand name lenses are Preference'r', Vantage'r', Permaflex'r', Permalens'r', Cooper Clear'tm' and Hydrasoft'r'. These and other products enable CooperVision to fit the needs of a diverse group of wearers by offering lenses formulated from a variety of polymers containing varying amounts of water, having different design parameters, diameters, base curves and lens edges and different degrees of oxygen permeability. Certain lenses offer special features such as protection against ultraviolet light, color tint or aphakic correction. Lenses are also available in a wide range of prices. Preference'r' is a frequent replacement product developed using the Tetrafilcon A polymer. When Preference'r' was compared to other leading planned replacement contact lenses, in two studies conducted at an aggregate of 22 investigative sites using 505 patients, Tetrafilcon A demonstrated superior resistance to the formation of deposits on lens surfaces. Preference'r' was test marketed during the fourth quarter of fiscal 1991 and introduced in fiscal 1992. CooperVision acquired CoastVision, Inc. ('CoastVision'), a contact lens company which designs, manufactures and markets high quality soft toric lenses (the majority of which are custom made) designed to correct astigmatism. The acquisition enables CooperVision to expand into an additional niche in the contact lens market and to enlarge its customer base. CooperVision is continuing to explore opportunities to expand and diversify its business into additional niche markets. COOPERVISION PHARMACEUTICALS CooperVision Pharmaceuticals, Inc. ('CVP'), a development stage business, develops and markets ophthalmic pharmaceuticals. In February 1993, CVP sold its EYEscrub'tm' product line while retaining the right to market two medical product kits which include EYEscrub'tm'. Several other products discussed below are in various stages of clinical development. In 1993, CVP continued the clinical development of Verapamil, a Class I calcium channel blocker, as a potential anti-glaucoma compound. CVP received U.S. Food and Drug Administration ('FDA') clearance to begin human clinical trials in June 1991. Phase I clinical trials were initiated in 1991 and completed in 1992. Phase II clinical trials were initiated in 1992 and have been completed. Phase III clinical trials commenced during 1993. Rose Bengal, Phenyltrope'r' and other products are being developed as diagnostic aids for use by eye-care professionals. During 1993, a filing was made with the FDA seeking clearance to begin marketing Rose Bengal. A New Drug Application for Phenyltrope'r' will be submitted to the FDA in fiscal 1994. In 1993, CVP began to market a line of prescription and over-the-counter ophthalmic pharmaceuticals. The prescription line consists of antibacterial products, anti-inflammatory products, glaucoma treatment products and diagnostic dilating agents. The non-prescription offerings are intended to be used as tear replacements. COOPERSURGICAL CooperSurgical, Inc. ('CooperSurgical') was established in November 1990 to compete in niche segments of the rapidly expanding worldwide market for diagnostic and surgical instruments and accessories. Its business is developing, manufacturing and distributing electrosurgical, cryosurgical and general application diagnostic and surgical instruments and equipment used selectively in both traditional and minimally invasive surgical procedures. Unlike traditional surgical instruments, electrosurgical instruments, which operate by means of high radio frequency, dissect and cause coagulation, making them useful in surgical procedures to minimize blood loss. Cryosurgical equipment is differentiated by its ability to apply cold or sub-zero temperatures to the body in order to cause adhesion, provoke an inflammatory response or destroy diseased tissue. CooperSurgical's loop electrosurgical excision procedure products, marketed under the LEEP'tm' brand name, are viewed as an improvement over existing laser treatments for primary use in the removal of cervical and vaginal pre-cancerous tissue and benign external lesions. Unlike laser ablation which tends to destroy tissue, the electrosurgery procedure removes affected tissue with minimal charring, thereby improving the opportunity to obtain an accurate histological analysis of the patient's condition by producing a viable tissue specimen for biopsy purposes. In addition, the loop electrosurgical excision procedure is less painful than laser ablation and is easily learned by practitioners. Because this procedure enables a gynecologist to both diagnose and treat a patient in one office visit, patients incur lower costs. CooperSurgical's LEEP System 6000'tm' branded products include an electrosurgical generator, sterile single application LEEP Electrodes'tm', the CooperSurgical Smoke Evacuation System 6080, a single application LEEP RediKit'r', a series of educational video tapes and a line of coated LEEP'tm' surgical instruments. CooperSurgical's Euro-Med mail order business offers over 400 products for use in gynecologic and general surgical procedures. Over 60% of these products are exclusive to Euro-Med, including its 'signature' instrument series, cervical biopsy punches, clear plastic instruments used for unobstructed viewing, titanium instruments used in laser surgeries, colposcopy procedure kits and instrument care and sterilization systems. Euro-Med recently introduced its FNA 21'tm' for fine needle aspiration from the breast, thyroid and salivary glands of lymphoma and other tumors. The CooperSurgical Diagnostic Office Hysteroscopy System 3000'tm' is designed for in-office use by gynecologists. The system includes a hysteroscope, light source, monitor, solid state video camera and the Diagnostic Hysteroscopy RediKit'r', a prepackaged, disposable procedure kit. CooperSurgical's Frigitronics'r' instruments for cryosurgery are used primarily in dermatologic procedures to treat skin cancers, in ophthalmic procedures to treat retinal detachments and remove cataracts, and in certain gynecologic, cardiovascular and general surgical procedures. The primary products bearing the Frigitronics brand name are the Model 310 Zoom Colposcope, the CCS-200 Cardiac Cryosurgical System, the Model 2000 Ophthalmic Cryosurgical System and the Cryo-Plus System. Since October 1992, CooperSurgical has also offered its CooperEndoscopy line of endoscopic instruments which enable physicians to conduct abdominal and thoracic exploration using minimally invasive procedures. Included in that line are the LSS'tm' 500 Electronic Laparoscopic Insufflator, the LSS'tm' 600 Electronic Auto Shutter Endoscopic Camera System and the LSS'tm' 700 High Intensity Xenon Light Source. HOSPITAL GROUP OF AMERICA On May 29, 1992, HGA acquired three psychiatric facilities through the acquisition of Original HGA: Hartgrove Hospital in Chicago, Illinois (119 licensed beds), Hampton Hospital in Rancocas, New Jersey (100 licensed beds), and MeadowWood Hospital in New Castle, Delaware (50 licensed beds). In addition, the Company, through its subsidiary, PSG Management, entered into the Management Services Agreement with three indirectly owned subsidiaries of Nu-Med under which it assumed the management of three psychiatric facilities owned by such subsidiaries: Northwestern Institute of Psychiatry in Fort Washington, Pennsylvania (146 licensed beds), Malvern Institute for Psychiatric and Alcohol Studies in Malvern, Pennsylvania (36 licensed beds), and Pinelands Hospital in Nacogdoches, Texas (40 licensed beds). The HGA facilities provide intensive and structured treatment for children, adolescents and adults suffering from a variety of mental illnesses and/or chemical dependencies. Services include comprehensive psychiatric and chemical dependency evaluations, inpatient and outpatient treatment and partial hospitalization. In response to market demands for an expanded continuum of care, HGA is in the process of expanding its outpatient and partial hospitalization programs. The following is a comparison of certain statistical data relating to inpatient treatment for fiscal years 1991, 1992 and 1993 for the psychiatric facilities owned by HGA: - ------------ (1) Reflects operations of HGA when owned by Nu-Med and, after May 29, 1992, by TCC. Each psychiatric facility is accredited by the Joint Commission of Accreditation of Healthcare Organizations (JCAHO), a voluntary national organization which periodically undertakes a comprehensive review of a facility's staff, programs, physical plant and policies and procedures for purposes of accreditation of such healthcare facility. Accreditation generally is required for patients to receive insurance company reimbursement and for participation by the facility in government sponsored provider programs. HGA periodically conducts audits of the facilities of its subsidiaries to ensure compliance with applicable practices, procedures and regulations. In the course of an ongoing audit that was recently commenced, HGA has learned that there may be certain irregularities at Hampton Hospital (the primary facility operated by HGA's subsidiary, Hospital Group of New Jersey, Inc.) with respect to certain billings for clinical services. The provision of clinical services at Hampton Hospital, as well as the billing for such services, are the responsibility of an independent medical group under contract to Hampton Hospital. Consequently, HGA has not yet been able to determine if any billing irregularities have occurred. It is, however, currently investigating this matter and has requested the production of the billing records. To date, the independent medical group has refused to cooperate. HGA considers this refusal to be a breach of the contract between the parties and is in the process of evaluating its options. The Management Services Agreement provides for the contracting subsidiaries to pay to PSG Management a $6,000,000 fee (the 'Management Fee') in equal monthly installments over the three- year term (subject to prior termination in accordance with its terms, upon which termination all or a portion of such Management Fee becomes immediately due and payable). Payments of the Management Fee are jointly and severally guaranteed by Nu-Med and its subsidiary PsychGroup, Inc., the parent of the contracting subsidiaries. On January 6, 1993, Nu-Med (but not any of its direct or indirect subsidiaries) filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code. Neither the Company nor any of its subsidiaries filed a proof of claim in the Nu-Med Chapter 11 proceeding, and the bar date (the time for filing proofs of claim) has past. None of the Nu-Med subsidiaries have filed under Chapter 11 and, to date, they have paid the Management Fee on a timely basis, although representatives of Nu-Med and its subsidiaries have alleged in writing that PSG Management has breached the Management Services Agreement (which contention PSG Management vigorously disputes). Moreover, Nu-Med's Proposed Disclosure Statement to accompany its Second Amended Plan of Reorganization, filed with the United States Bankruptcy Court for the Central District of California, indicates that PsychGroup, Inc. is commencing performance of certain administrative functions performed by PSG Management on a parallel basis. On October 9, 1992, HGA filed a complaint against Nu-Med and several of its subsidiaries asserting claims in excess of $4 million and asserted additional claims against the same defendants in excess of an additional $6 million that are to be resolved by an independent auditor. In both instances, HGA's claims arose from the defendants' alleged breaches of certain provisions in the acquisition agreement pursuant to which the HGA facilities were acquired. As indicated, the Company and its subsidiaries did not file a proof of claim against Nu-Med, and the bar date has passed. Since Nu-Med's subsidiaries have not filed under Chapter 11, the bar date is not applicable with respect to the Company's claims against Nu-Med's subsidiaries and those claims are still pending. Patient and Third Party Payments. HGA receives payment for its psychiatric services either from patients, from their health insurers or through the Medicare, Medicaid and Civilian Health and Medical Program of Uniformed Services ('CHAMPUS') governmental programs. Medicare is a federal program which entitles persons 65 and over to a lifetime benefit of up to 190 days as an inpatient in an acute psychiatric facility. Persons defined as disabled, regardless of age, also receive this benefit. Medicaid is a joint federal and state program available to persons with limited financial resources. CHAMPUS is a federal program which provides health insurance for active and retired military personnel and their dependents. While other programs may exist or be adopted in different jurisdictions, the following four categories include all methods by which HGA's three owned facilities receive payment for services: (a) Standard reimbursement, consisting of payment by patients and their health insurers, is based on a facility's schedule of rates and is not subject to negotiation with insurance companies, competitive bidding or governmental limitation. (b) Negotiated rate reimbursement is at prices established in advance by negotiation or competitive bidding for contracts with insurers and other payors such as managed care companies, health maintenance organizations ('HMO'), preferred provider organizations ('PPO') and similar organizations which can provide a reasonable number of referrals. (c) Cost-based reimbursement is predicated on the allowable cost of services, plus, in certain cases, an incentive payment where costs fall below a target rate. It is used by Medicare, Medicaid and certain Blue Cross insurance programs to provide reimbursement in amounts lower than the schedule of rates in effect at an HGA facility. (d) CHAMPUS reimbursement is at either (1) regionally set rates, (2) a national rate adjusted upward periodically on the basis of the Medicare Market Basket Index or (3) a fixed discount rate per day at certain facilities where CHAMPUS contracts with a benefit administration group. The approximate percentages of HGA's net patient revenue by payment source are as follows: - ------------ (1) Reflects operations of HGA when owned by Nu-Med and, after May 29, 1992, by TCC. (2) Consists of self-payors and other miscellaneous payors. The Medicare, Medicaid and CHAMPUS programs are subject to statutory and regulatory changes and interpretations, utilization reviews and governmental funding restrictions, all of which may materially increase or decrease program payments and the cost of providing services, as well as the timing of payments to the facilities. Existing and Proposed Legislation. In recent years, forms of prospective reimbursement legislation have been proposed in various states but have not been enacted into law. If legislation based on the budgeted costs of individual hospitals were to be enacted in the future in one or more of the states in which HGA operates psychiatric facilities, it could have an adverse effect on HGA's business and earnings. In addition, the enactment of such legislation in states where HGA does not now operate could have a deterrent effect on the decision to acquire or establish facilities in such states. RESEARCH AND DEVELOPMENT During the fiscal years ended October 31, 1993, 1992 and 1991, expenditures for Company-sponsored research and development were $3,209,000, $3,267,000 and $2,268,000, respectively. During fiscal 1993, approximately 51% of those expenditures was incurred by CVP, 24% was incurred by CooperVision and the balance was incurred by CooperSurgical. No customer-sponsored research and development has been conducted. The Company employs 14 people in its research and development and manufacturing engineering departments. Product development and clinical research for CooperVision products are supported by outside specialists in lens design, formulation science, polymer chemistry, microbiology and biochemistry. At CooperVision, experienced employees work with outside consultants. Product research and development for CooperSurgical is conducted in-house and by outside surgical specialists, including members of both the CooperSurgical and Euro-Med surgical advisory boards. GOVERNMENT REGULATION Healthcare Products. The development, testing, production and marketing of the Company's healthcare products is subject to the authority of the FDA and other federal agencies as well as foreign ministries of health. The Federal Food, Drug and Cosmetic Act and other statutes and regulations govern the testing, manufacturing, labeling, storage, advertising and promotion of such products. Noncompliance with applicable regulations can result in fines, product recall or seizure, suspension of production and criminal prosecution. The Company is currently developing and marketing both medical devices and drug products. Medical devices are subject to different levels of FDA regulation depending upon the classification of the device. Class III devices, such as contact lenses, require extensive premarket testing and approval procedures, while Class I and II devices are subject to substantially lower levels of regulation. A multi-step procedure must be completed before a new contact lens can be sold commercially. Data must be compiled on the chemistry and toxicology of the lens, its microbiological profile and the proposed manufacturing process. All data generated must be submitted to the FDA in support of an application for an Investigational Device Exemption. Once granted, clinical trials may be initiated subject to the review and approval of an Institutional Review Board and, where a lens is determined to be a significant risk device, the FDA. Upon completion of clinical trials, a Premarket Approval Application must be submitted and approved by the FDA before commercialization may begin. The ophthalmic pharmaceutical products under development by the Company require extensive testing before marketing approval may be obtained. Preclinical laboratory studies are conducted to determine the safety and efficacy of a new drug. The results of these studies are submitted to the FDA in an Investigational New Drug Application under which the Company seeks clearance to commence human clinical trials. The initial clinical evaluation, Phase I, consists of administering the drug and evaluating its safety and tolerance levels. Phase II involves studies to evaluate the effectiveness of the drug for a particular indication, to determine optimal dosage and to identify possible side effects. If the new drug is found to be potentially effective, Phase III studies, which consist of additional testing for safety and efficacy with an expanded patient group, are undertaken. If results of the studies demonstrate safety and efficacy, marketing approval is sought from the FDA by means of filing a New Drug Application. The Company, in connection with some of its new surgical products, can submit premarket notification to the FDA under an expedited procedure known as a 510(k) application, which is available for any product that is substantially equivalent to a device marketed prior to May 28, 1976. If the new product is not substantially equivalent to a pre-existing device or if the FDA were to reject a claim of substantial equivalence, extensive preclinical and clinical testing would be required, additional costs would be incurred and a substantial delay would occur before the product could be brought to market. FDA and state regulations also require adherence to applicable 'good manufacturing practices' ('GMP'), which mandate detailed quality assurance and record-keeping procedures. In conjunction therewith, the Company is subject to unscheduled periodic regulatory inspections. The Company believes it is in substantial compliance with GMP regulations. The Company also is subject to foreign regulatory authorities governing human clinical trials and pharmaceutical/medical device sales that vary widely from country to country. Whether or not FDA approval has been obtained, approval of a product by comparable regulatory authorities of foreign countries must be obtained before products may be marketed in those countries. The approval process varies from country to country, and the time required may be longer or shorter than that required for FDA approval. The procedures described above involve expenditures of considerable resources and usually result in a substantial time lag between the development of a new product and its introduction into the marketplace. There can be no assurance that all necessary approvals will be obtained, or that they will be obtained in a time frame that allows the product to be introduced for commercial sale in a timely manner. Furthermore, product approvals may be withdrawn if compliance with regulatory standards is not maintained or if problems occur after marketing has begun. Healthcare Facilities. The healthcare services industry is subject to substantial federal, state and local regulation. Government regulation affects the Company's business by controlling the use of its properties and controlling reimbursement for services provided. Licensing, certification and other applicable governmental regulations vary from jurisdiction to jurisdiction and are revised periodically. The Company's facilities must comply with the licensing requirements of federal, state and local health agencies and with the requirements of municipal building codes, health codes and local fire department codes. In granting and renewing a facility's license, a state health agency considers, among other things, the condition of the physical buildings and equipment, the qualifications of the administrative personnel and professional staff, the quality of professional and other services and the continuing compliance of such facility with applicable laws and regulations. Most states in which the Company operates or manages facilities have in effect certificate of need statutes. State certificate of need statutes provide, generally, that prior to the construction of new healthcare facilities, the addition of new beds or the introduction of a new service, a state agency must determine that a need exists for those facilities, beds or services. A certificate of need is generally issued for a specific maximum amount of expenditures or number of beds or types of services to be provided, and the holder is generally required to implement the approved project within a specific time period. Certificate of need issuances for new facilities are extremely competitive, often with several applicants for a single certificate of need. Each Company owned or managed facility that is eligible (five of the six) is certified or approved as a provider under one or more of the Medicaid or Medicare programs. In order to receive Medicare reimbursement, each facility must meet the applicable conditions promulgated by the United States Department of Health and Human Services relating to the type of facility, its equipment, its personnel and its standards of patient care. The Social Security Act contains a number of provisions designed to ensure that services rendered to Medicare and Medicaid patients are medically necessary and meet professionally recognized standards. Those provisions include a requirement that admissions of Medicare and Medicaid patients to healthcare facilities must be reviewed in a timely manner to determine the medical necessity of the admissions. In addition, the Peer Review Improvement Act of 1982 provides that a healthcare facility may be required by the federal government to reimburse the government for the cost of Medicare-paid services determined by a peer review organization to have been medically unnecessary. Various state and federal laws regulate the relationships between providers of healthcare services and physicians. Among these laws are the Medicare and Medicaid Anti-Fraud and Abuse Amendments to the Social Security Act, which prohibit individuals or entities participating in the Medicare or Medicaid programs from knowingly and willfully offering, paying, soliciting or receiving remuneration in order to induce referrals for items or services reimbursed under those programs. In addition, specific laws exist that regulate certain aspects of the Company's business, such as the commitment of patients to psychiatric hospitals and disclosure of information regarding patients being treated for chemical dependency. Many states have adopted a 'patient's bill of rights' which sets forth standards for dealing with issues such as use of the least restrictive treatment, patient confidentiality, patient access to telephones, mail and legal counsel and requiring the patient to be treated with dignity. Healthcare Reform. On October 27, 1993, President Clinton delivered his Administration's proposal for national health care reform to Congress. This complex proposal contains provisions designed to control and reduce growth in public and private spending on health care and to reform the payment methodology for health care goods and services by both the public (Medicare and Medicaid) and private sectors, including overall limitations on future growth in spending for health care benefits and the provision of universal access to health care. Currently, there are pending before Congress several competing health care reform proposals which, through varying mechanisms and methodologies, are also intended to control or reduce public and private spending on health care. It is uncertain which, if any, of these proposals will be adopted by Congress or what actions federal, state or private payors for health care goods and services may take in response thereto. The Company cannot yet predict the effect such reforms or the prospect of their enactment may have on the business of the Company and its subsidiaries. Accordingly, no assurance can be given that the same will not have a material adverse effect on the Company's revenues, earnings or cash flows. RAW MATERIALS In general, raw materials required by CooperVision consist of various polymers as well as packaging materials. Alternative sources of all of these materials are available. Raw materials used by CooperSurgical or its suppliers are generally available from a variety of sources. Products manufactured for CooperSurgical are generally available from more than one source. However, because some products require specialized manufacturing procedures, CooperSurgical could experience inventory shortages if an alternative manufacturer had to be secured on short notice. MANUFACTURING CooperVision manufactures products in the United States and Canada. CooperSurgical manufactures products in the United States and Europe. Pursuant to a supply agreement entered into in May 1989 and subsequently amended between the Company and Pilkington plc, the buyer of the Company's contact lens business outside of the United States and Canada, CooperVision purchases certain of its product lines from Pilkington plc (see Note 14)(1). These purchased lenses represented approximately 28%, 31% and 40% of the total number of lenses sold by the Company in fiscal 1993, 1992 and 1991, respectively. MARKETING AND DISTRIBUTION Healthcare Products. In the United States and Canada, CooperVision markets its products through its field sales representatives, who call on ophthalmologists, optometrists, opticians and optical chains. In the United States, field sales representatives also call on distributors. CVP's line of generic pharmaceuticals is sold directly to wholesalers and distributors through an independent contract sales force and by the sales forces of CooperVision and CoastVision. CooperSurgical's LEEP'tm', Frigitronics'r', hysteroscopy and endoscopy products are marketed worldwide by a network of independent sales representatives and distributors. In the United States, CooperSurgical, as a principal method of increasing physician awareness of its products, conducted teaching seminars in fiscal 1993. Euro-Med instruments and systems, as well as certain LEEP'tm' disposable products, are marketed through direct mail catalog programs. Healthcare Facilities. HGA's marketing concept aims to position each psychiatric facility as the provider of the highest quality mental health services in its marketplace. HGA employs a combination of general advertising, toll-free 'help lines', community education programs and facility-based continuing education programs to underscore the facility's value as a mental health resource center. HGA's marketing emphasizes discrete programs for select illnesses or disorders because of its belief that marketing a generic product without program differentiation will not generate the interest of, or be of value to, a referral source seeking treatment for specific disorders. Referral sources include psychiatrists, other physicians, psychologists, social workers, school guidance counselors and the police, courts, clergy, care-provider organizations and former patients. PATENTS, TRADEMARKS AND LICENSING AGREEMENTS TCC owns or licenses a variety of domestic and foreign patents which, in the aggregate, are material to its businesses. CooperVision is a party to a licensing agreement under which it holds a perpetual, royalty free, nonexclusive right to make, have made and sell contact lenses utilizing a polymer owned by a third party. CooperVision's ability to utilize that polymer is material to its business. Unexpired terms of TCC's United States patents range from less than one year to a maximum of 17 years. CVP has the exclusive license to the U.S. patent for the use of Class I calcium channel blockers as agents to reduce intraocular pressure in ocular hypertensive conditions including glaucoma. In addition, CVP has filed and/or is in the process of filing additional U.S. and international patent applications. As indicated in the references to such products in this Item 1, the names of certain of TCC's products are protected by trademark registration in the United States Patent and Trademark Office and, in some instances, in foreign trademark offices as well. Applications are pending for additional trademark registrations. TCC considers these trademarks to be valuable because of their contribution to the market identification of its various products. DEPENDENCE UPON CUSTOMERS At this time, no material portion of TCC's businesses is dependent upon any one customer or upon any one affiliated group of customers. - ------------ (1) All references to Note numbers shall constitute the incorporation by reference of the text of the specific Note contained in the Notes to Consolidated Financial Statements of the Company located in Item 8 into the Item number in which it appears. GOVERNMENT CONTRACTS No material portion of TCC's businesses is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the United States government. COMPETITION No single company competes with the Company in all of its industry segments; however, each of TCC's business segments operates within a highly competitive environment. Competition in the healthcare industry revolves around the search for technological and therapeutic innovations in the prevention, diagnosis and treatment of illness or disease. TCC competes primarily on the basis of product quality, technological benefit, service and reliability, as perceived by medical professionals. Healthcare Products. Numerous companies are engaged in the development and manufacture of contact lenses and ophthalmic pharmaceuticals. CooperVision competes primarily on the basis of product quality, service and reputation among medical professionals and by its participation in specialty niche markets. It has been, and continues to be, the sponsor of clinical lens studies intended to generate information leading to the improvement of CooperVision's lenses from a medical point of view. Major competitors have greater financial resources and larger research and development and sales forces than CooperVision. Furthermore, many of these competitors offer a greater range of contact lenses, plus a variety of other eye care products, which gives them a competitive advantage in marketing their lenses. In the surgical segment, competitive factors are technological and scientific advances, product quality, price and effective communication of product information to physicians and hospitals. CooperSurgical believes that it benefits, in part, from the technological advantages of certain of its products and from the ongoing development of new medical procedures, which creates a market for equipment and instruments specifically tailored for use in such new procedures. CooperSurgical competes by focusing on distinct niche markets and supplying medical personnel working in those markets with equipment, instruments and disposable products that are high in quality and that, with respect to certain procedures, enable a medical practitioner to obtain from one source all of the equipment, instruments and disposable products required to perform such procedure. As CooperSurgical develops products to be used in the performance of new medical procedures, it offers training to medical professionals in the performance of such procedures. CooperSurgical competes with a number of manufacturers in each of its niche markets, including larger manufacturers that have greater financial and personnel resources and sell a substantially larger number of product lines. Healthcare Facilities. In most areas in which HGA operates, there are other psychiatric facilities that provide services comparable to those offered by HGA's facilities. Some of those facilities are owned by governmental organizations, not-for-profit organizations or investor-owned companies having substantially greater resources than HGA and, in some cases, tax-exempt status. Psychiatric facilities frequently draw patients from areas outside their immediate locale, therefore, HGA's psychiatric facilities compete with both local and distant facilities. In addition, psychiatric facilities also compete with psychiatric units in acute care hospitals. HGA's strategy is to develop high quality programs designed to target specific disorders and to retain a highly qualified professional staff. BACKLOG TCC does not consider backlog to be a material factor in its businesses. SEASONALITY HGA's psychiatric facilities experience a decline in occupancy rates during the summer months when school is not in session and during the year-end holiday season. No other material portion of TCC's businesses is seasonal. COMPLIANCE WITH ENVIRONMENTAL LAWS Federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, do not currently have a material effect upon TCC's capital expenditures, earnings or competitive position. WORKING CAPITAL TCC's businesses have not required any material working capital arrangements in the past five years. In light of the substantial reduction in TCC's cash items and temporary investments and the net cash outflow still anticipated by the Company, the Company is considering a variety of alternatives to obtain funds through borrowings or other financings or sales of assets. See Item 7 'Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capital Resources and Liquidity.' FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS, GEOGRAPHIC AREAS, FOREIGN OPERATIONS AND EXPORT SALES Note 16 sets forth financial information with respect to TCC's business segments and sales in different geographic areas. EMPLOYEES On October 31, 1993, TCC and its subsidiaries employed approximately 970 persons. In addition, HGA's psychiatric facilities are staffed by licensed physicians who have been admitted to the medical staff of an individual facility. Certain of those physicians are not employees of HGA. TCC believes that its relations with its employees are good. ITEM 2. ITEM 2. PROPERTIES. The following are TCC's principal facilities as of December 31, 1993: (table continued on next page) (table continued from previous page) - ------------ (1) Outstanding loans totaling $13,718,000 as of October 31, 1993, were secured by these properties. (2) Does not include optional renewal periods. The Company believes its properties are suitable and adequate for its businesses. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is a defendant in a number of legal actions relating to its past or present businesses in which plaintiffs are seeking damages. On November 10, 1992, the Company was charged in an indictment (the 'Indictment'), filed in the United States District Court for the Southern District of New York, with violating federal criminal laws relating to a 'trading scheme' by Gary A. Singer, a former Co-Chairman of the Company (who went on a leave of absence on May 28, 1992, begun at the Company's request, and who subsequently resigned on January 20, 1994), and others, including G. Albert Griggs, Jr., a former analyst with The Keystone Group, Inc., and John D. Collins II, to 'frontrun' high yield bond purchases by the Keystone Custodian Funds, Inc., a group of mutual funds. The Company was named as a defendant in 10 counts. Gary Singer was named as a defendant in 24 counts, including violations of the Racketeer Influenced and Corrupt Organizations Act and the mail and wire fraud statutes (including defrauding the Company by virtue of the 'trading scheme,' by, among other things, transferring profits on trades of DR Holdings, Inc. 15.5% bonds (the 'DR Holdings Bonds') from the Company to members of his family during fiscal 1991), money laundering, conspiracy, and aiding and abetting violations of the Investment Advisers Act of 1940, as amended (the 'Investment Advisers Act'), by an investment advisor. On January 13, 1994, the Company was found guilty on six counts of mail fraud and one count of wire fraud based upon Mr. Singer's conduct, but acquitted of charges of conspiracy and aiding and abetting violations of the Investment Advisers Act. Mr. Singer was found guilty on 21 counts. One count against Mr. Singer and the Company was dismissed at trial and two counts against Mr. Singer relating to forfeiture penalties were resolved by stipulation between the government and Mr. Singer. Sentencing is scheduled for March 25, 1994. The maximum penalty which could be imposed on the Company is the greater of (i) $500,000 per count, (ii) twice the gross gain derived from the offense or (iii) twice the gross loss suffered by the victim of the offense, and a $200 special assessment. In addition to the penalties described in (i), (ii) or (iii), the Court could order the Company to make restitution. The Company is considering its options, including filing an appeal of its conviction. Mr. Singer's attorney has advised the Company that Mr. Singer intends to appeal his conviction. Although the Company may be obligated under its Certificate of Incorporation to advance the costs of such appeal, the Company and Mr. Singer have agreed that Mr. Singer will not request such advances, but that he will reserve his rights to indemnification in the event of a successful appeal. Also on November 10, 1992, the SEC filed a civil Complaint for Permanent Injunction and Other Equitable Relief (the 'SEC Complaint') in the United States District Court for the Southern District of New York against the Company, Gary A. Singer, Steven G. Singer (the Company's Executive Vice President and Chief Operating Officer and Gary Singer's brother), and, as relief defendants, certain persons related to Gary and Steven Singer and certain entities in which they and/or those related persons have an interest. The SEC Complaint alleges that the Company and Gary and Steven Singer violated various provisions of the Securities Exchange Act of 1934, as amended (the 'Securities Exchange Act'), including certain of its antifraud and periodic reporting provisions, and aided and abetted violations of the Investment Company Act, and the Investment Advisors Act, in connection with the 'trading scheme' described in the preceding paragraphs. The SEC Complaint further alleges, among other things, federal securities law violations (i) by the Company and Gary Singer in connection with an alleged manipulation of the trading price of the Company's 10 5/8% Convertible Subordinated Reset Debentures due 2005 (the 'Debentures') to avoid an interest rate reset allegedly required on June 15, 1991 under the terms of the Indenture governing the Debentures, (ii) by Gary Singer in allegedly transferring profits on trades of high yield bonds (including those trades in the DR Holdings Bonds which were the subject of certain counts of the Indictment of which Mr. Singer was found guilty) from the Company to members of his family and failing to disclose such transactions to the Company and (iii) by the Company in failing to disclose publicly on a timely basis such transactions by Gary Singer. The SEC Complaint asks that the Company and Gary and Steven Singer be enjoined permanently from violating the antifraud, periodic reporting and other provisions of the federal securities laws, that they disgorge the amounts of the alleged profits received by them pursuant to the alleged frauds (stated in the SEC's Litigation Release No. 13432 announcing the filing of the SEC Complaint as being $1,296,406, $2,323,180 and $174,705, respectively), plus interest, and that they each pay appropriate civil monetary penalties. The SEC Complaint also seeks orders permanently prohibiting Gary and Steven Singer from serving as officers or directors of any public company and disgorgement from certain Singer family members and entities of amounts representing the alleged profits received by such defendants pursuant to the alleged frauds. In February 1993, the court granted a motion staying all proceedings in connection with this matter pending completion of the criminal case. On January 24, 1994, the Court lifted the stay and directed the defendants to file answers to the SEC Complaint within 30 days. The Company is currently involved in settlement negotiations with the SEC. At this time, there can be no assurances these negotiations will be successfully concluded. The imposition of monetary penalties upon the Company as a result of the criminal convictions or in connection with the matters alleged in the SEC Complaint, as well as the incurrence of any additional defense costs, could exacerbate, possibly materially, the Company's liquidity problems and its need to raise funds. See Item 7 -- 'Management's Discussion and Analysis of Financial Condition and Results of Operations.' Copies of the Indictment and the SEC Complaint were attached as exhibits to the Company's Current Report on Form 8-K, dated November 16, 1992, filed with the SEC. The Company is named as a nominal defendant in a shareholder derivative action entitled Harry Lewis and Gary Goldberg v. Gary A. Singer, Steven G. Singer, Arthur C. Bass, Joseph C. Feghali, Warren J. Keegan, Robert S. Holcombe and Robert S. Weiss, which was filed on May 27, 1992 in the Court of Chancery, State of Delaware, New Castle County. On May 29, 1992, another plaintiff, Alfred Schecter, separately filed a derivative complaint in Delaware Chancery Court that was essentially identical to the Lewis and Goldberg complaint. Lewis and Goldberg later amended their complaint, and the Delaware Chancery Court thereafter consolidated the Lewis and Goldberg and Schecter actions as In re The Cooper Companies, Inc. Litigation, Consolidated C.A. 12584, and designated Lewis and Goldberg's amended complaint as the operative complaint (the 'First Amended Derivative Complaint'). The First Amended Derivative Complaint alleges that certain directors of the Company and Gary A. Singer, as Co-Chairman of the Board of Directors, caused or allowed the Company to be a party to the 'trading scheme' that was the subject of the Indictment. The First Amended Derivative Complaint also alleges that the defendants violated their fiduciary duties to the Company by not vigorously investigating the allegations of securities fraud. The First Amended Derivative Complaint requests that the Court order the defendants (other than the Company) to pay damages and expenses to the Company and certain of the defendants to disgorge their profits to the Company. On October 16, 1992, the defendants moved to dismiss the First Amended Derivative Complaint on grounds that such Complaint fails to comply with Delaware Chancery Court Rule 23.1 and that Count III of the First Amended Derivative Complaint fails to state a claim. The Company has been advised by the individual directors named as defendants that they believe they have meritorious defenses to this lawsuit and intend vigorously to defend against the allegations in the First Amended Derivative Complaint. The Company was named as a nominal defendant in a purported shareholder derivative action entitled Bruce D. Sturman v. Gary A. Singer, Steven G. Singer, Brad C. Singer, Martin Singer, John D. Collins II, Back Bay Capital, Inc., G. Albert Griggs, Jr., John and Jane Does 1-10 and The Cooper Companies, Inc., which was filed on May 26, 1992 in the Supreme Court of the State of New York, County of New York. The plaintiff, Bruce D. Sturman, a former officer and director of the Company, alleged that Gary A. Singer, as Co-Chairman of the Board of Directors, and various members of the Singer family caused the Company to make improper payments to alleged third-party co-conspirators, Messrs. Griggs and Collins, as part of the 'trading scheme' that was the subject of the Indictment. The complaint requested that the Court order the defendants (other than the Company) to pay damages and expenses to the Company, including reimbursement of payments made by the Company to Messrs. Collins and Griggs, and to disgorge their profits to the Company. Pursuant to its decision and order, filed August 17, 1993, the Court dismissed this action under New York Civil Practice Rule 327(a). On September 22, 1993, the plaintiff filed a Notice of Appeal. The Company was named in an action entitled Bruce D. Sturman v. The Cooper Companies, Inc. and Does 1-100, Inclusive, first brought on July 24, 1992 in the Superior Court of the State of California, Los Angeles, County. Mr. Sturman alleged that his suspension from his position as Co-Chairman of the Board of Directors constituted, among other things, an anticipatory breach of his employment agreement. On May 14, 1993, Mr. Sturman filed a First Amended Complaint in the Superior Court of the State of California, County of Alameda, Eastern Division, the jurisdiction to which the original case had been transferred. In the Amended Complaint, Mr. Sturman alleged that by first suspending and then terminating him from his position as Co-Chairman, the Company breached his employment agreement, violated provisions of the California Labor Code, wrongfully terminated him in violation of public policy, breached its implied covenant of good faith and fair dealing, defamed him, invaded his privacy and intentionally inflicted emotional distress, and was otherwise fraudulent, deceitful and negligent. The Amended Complaint seeks declaratory relief, damages in the amount of $5,000, treble and punitive damages in an unspecified amount, and general, special and consequential damages in the amount of at least $5,000,000. In March 1993, the Court ordered a stay of all discovery in this action until further order of the Court and thereafter scheduled a conference for January 14, 1994 to review the status of the stay. The Court subsequently modified the stay to permit the taking of the deposition of one witness who will not be available to testify at trial. On September 24, 1993, Mr. Sturman filed a Second Amended Complaint, setting forth the same material allegations and seeking the same relief and damages as set forth in the First Amended Complaint. On January 7, 1994, the Company filed an Answer, generally denying all of the allegations in the Second Amended Complaint, and also filed a Cross-Complaint against Mr. Sturman. In the Cross-Complaint, the Company alleges that Mr. Sturman's conduct constituted a breach of his employment agreement with the Company as well as a breach of his fiduciary duty to the Company, that Mr. Sturman misrepresented and failed to disclose certain material facts to the Company and converted certain assets of the Company to his personal use and benefit. The Cross-Complaint seeks compensatory and punitive damages in an unspecified amount. On January 14, 1994, the Court continued in place the stay on all discovery and scheduled a case management conference for February 10, 1994 to review the status of the stay. Based on management's current knowledge of the facts and circumstances surrounding Mr. Sturman's termination, the Company believes that it has meritorious defenses to this lawsuit and intends to defend vigorously against the allegations in the Second Amended Complaint. In two virtually identical actions, Frank H. Cobb, Inc. v. The Cooper Companies, Inc., et al., and Arthur J. Korf v. The Cooper Companies, Inc., et al., class action complaints were filed in the United States District Court for the Southern District of New York in August 1989, against the Company and certain individuals who served as officers and/or directors of the Company after June 1987. In their Fourth Amended Complaint filed in September 1992, the plaintiffs allege that they are bringing the actions on their own behalf and as class actions on behalf of a class consisting of all persons who purchased or otherwise acquired shares of the Company's common stock during the period May 26, 1988 through February 13, 1989. The amended complaints seek an undetermined amount of compensatory damages jointly and severally against all defendants. The complaints, as amended, allege that the defendants knew or recklessly disregarded and failed to disclose to the investing public material adverse information about the Company. Defendants are accused of having allegedly failed to disclose, or delayed in disclosing, among other things: (a) that the allegedly real reason the Company announced on May 26, 1988 that it was dropping a proposed merger with Cooper Development Company, Inc. was because the Company's banks were opposed to the merger; (b) that the proposed sale of Cooper Technicon, Inc., a former subsidiary of the Company, was not pursuant to a definitive sales agreement but merely an option; (c) that such option required the approval of the Company's debentureholders and preferred stockholders; (d) that the approval of such sale by the Company's debentureholders and preferred stockholders would not have been forthcoming absent extraordinary expenditures by the Company; and (e) that the purchase agreement between the Company and Miles, Inc. for the sale of Cooper Technicon, Inc. included substantial penalties to be paid by the Company if the sale was not consummated within certain time limits and that the sale could not be consummated within those time limits. The amended complaints further allege that the defendants are liable for having violated Section 10(b) of the Securities Exchange Act and Rule 10(b)-5 thereunder and having engaged in common law fraud. Based on management's current knowledge of the facts and circumstances surrounding the events alleged by plaintiffs as giving rise to their claims, the Company believes that it has meritorious defenses to these lawsuits and intends vigorously to defend against the allegations in the amended complaints. The parties have engaged in preliminary settlement negotiations; however, there can be no assurances that these discussions will be successfully concluded. On September 2, 1993, a patent infringement complaint was filed against the Company in the United States District Court for the District of Nevada captioned Steven P. Shearing v. The Cooper Companies, Inc. On or about that same day, the plaintiff filed twelve additional complaints, accusing at least fourteen other defendants of infringing the same patent. The patent in these suits covers a specific method of implanting an intraocular lens into the eye. Until February 1989, the Company manufactured intraocular lenses and ophthalmic instruments, but did not engage in the implantation of such lenses. Subsequent to February 1989, the Company was not involved in the manufacture, marketing or sale of intraocular lenses. The Company denies the material allegations of Shearing's complaint and will vigorously defend itself. The Company is a defendant in more than 2,600 breast implant lawsuits pending in federal district courts and state courts, some of which purport to be class actions, relating to the mammary prosthesis (breast implant) business of its former wholly-owned subsidiaries, Aesthetech Corporation ('Aesthetech'), the manufacturer, and Natural Y Surgical Specialities, Inc. ('Natural Y'), the distributor, of polyurethane foam covered, silicone gel-filled breast implants, which subsidiaries were sold to Medical Engineering Corporation ('MEC'), a wholly-owned subsidiary of Bristol-Myers Squibb Company ('BMS') on December 14, 1988. The plaintiffs in the breast implant lawsuits generally claim to have been injured by breast implants allegedly manufactured and/or sold by Aesthetech, Natural Y or MEC. The ailments typically alleged include autoimmune disorders, scleroderma, chronic fatigue syndrome and vascular and neurological complications, as well as, in some cases, a fear of cancer. A small percentage of lawsuits allege that plaintiffs are suffering from cancer, allegedly caused by the component parts of the implants, including the alleged breakdown of polyurethane foam used to cover the implants. In most cases, other defendants are named in addition to the Company, Aesthetech, Natural Y, MEC and BMS, including, in many cases, implanting surgeons and the suppliers of the silicone and polyurethane products used in the manufacture of the breast implants. On October 29, 1992, the Delaware Chancery Court in Medical Engineering Corporation and Bristol-Myers Squibb Company v. The Cooper Companies, Inc. ruled that, as between BMS and MEC, on the one hand, and the Company, on the other, the Company is responsible for product liability claims and obligations relating to breast implants sold by Natural Y before December 14, 1988, irrespective of when the claims are brought. On September 28, 1993, the Company entered into an agreement with MEC (the 'MEC Agreement') settling this litigation between the Company and BMS and MEC. Pursuant to the MEC Agreement, MEC has agreed, subject to limited exceptions, to take responsibility for all legal fees and other costs, and to pay all judgments and settlements, resulting from all pending and future claims in respect of breast implants sold by Aesthetech and Natural Y prior to their acquisition by MEC (including the above-mentioned lawsuits), and the Company has withdrawn its appeal of the Delaware Chancery Court decision and agreed, among other things, to make certain payments to MEC. Pursuant to the terms of the MEC Agreement, MEC could have terminated the agreement if the exchange offer and consent solicitation (the 'Exchange Offer and Solicitation') relating to its Debentures (or an alternative restructuring of the Debentures or other amendment, forebearance or waiver with respect to the Debentures) was not completed on terms satisfactory to the Company by February 1, 1994. The Exchange Offer and Solicitation was completed on January 6, 1994. See Item 7 -- 'Management's Discussion and Analysis of Financial Condition and Results of Operations, Capital Resources and Liquidity' and Notes 14 and 19. The Company was named as a defendant in a civil action entitled Site Microsurgical Systems v. The Cooper Companies, Inc. filed in the United States District Court of Delaware on November 13, 1990. The plaintiff alleged that the Company infringed one of its U.S. patents through sales by the CooperVision Surgical Division ('CVS') of certain cassettes and systems utilizing such cassettes prior to the sale of CVS in February, 1989. The Company denied the plaintiff's allegations and counterclaimed for a Declaratory Judgment of non-infringement and invalidity of the plaintiff's patent-in-suit. This lawsuit was settled in October 1993. Pursuant to the settlement, the Company made a cash payment to the plaintiff and the parties terminated a generic ophthalmic pharmaceutical supply agreement. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. The 1993 Annual Meeting of Stockholders was held on September 14, 1993. Eight individuals were nominated to serve as directors of the Company. Information with respect to votes cast for or against such nominees is set forth below: On June 14, 1993, the Company acquired from Cooper Life Sciences, Inc. ('CLS') 160,600 shares of its Senior Exchangeable Redeemable Restricted Voting Preferred Stock ('SERPS'), constituting all of the Company's then outstanding SERPS, together with all rights to any dividends thereon, in exchange for 345 shares of a newly created series of preferred stock of the Company, designated Series B Preferred Stock (the 'Series B Preferred Stock'), having a par value of $.10 per share and a liquidation preference of $10,000 per share. The stockholders of the Company were asked to approve conversion rights on such Series B Preferred Stock, whereby such shares would be convertible, at the option of CLS, into an aggregate of 3,450,000 shares of common stock of the Company (subject to customary antidilution adjustments). The proposal to approve conversion rights of the Series B Preferred Stock was approved by a vote of 17,741,096 shares in favor, with 600,364 shares voted against and 409,155 shares abstaining. 9,315,119 shares present at the meeting for the purpose of establishing a quorum were ineligible to vote on the proposal. The shares of Series B Preferred Stock, if any, issued in payment of dividends on the Series B Preferred Stock will be convertible into one share of common stock for each $1.00 of liquidation preference of such Series B Preferred Stock (subject to customary antidilution adjustments). The Company also has the right to compel conversion of Series B Preferred Stock at any time after (i) the average of the closing sale prices for the common stock on its principal trading market on the trading days during any period of 90 consecutive calendar days is at least $1.375 and (ii) on at least 80% of the trading days during such period, the closing sale price is at least $1.375. Stockholders were also asked to ratify the appointment of KPMG Peat Marwick as independent certified public accountants for the Company for the fiscal year which ended October 31, 1993. A total of 27,694,165 shares were voted in favor of the ratification, 291,596 shares were voted against it and 79,973 shares abstained. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is traded on The New York Stock Exchange, Inc. and the Pacific Stock Exchange Incorporated. No cash dividends were paid with respect to the common stock in fiscal 1993 or 1992. The Certificate of Designations, Preferences and Relative Rights, Qualifications, Limitations and Restrictions of the Company's SERPS, which were retired in exchange for the Series B Preferred Stock on June 14, 1993, as indicated in Item 4 above, prohibited the payment of cash dividends on the Company's common stock unless certain conditions, which the Company did not meet, were met. The Certificate of Designations, Preferences and Relative Rights, Qualifications, Limitations and Restrictions of the Series B Preferred Stock prohibits the payment of cash dividends on the Company's common stock unless the full amount of cumulative dividends on the Series B Preferred Stock have been declared and paid in full or contemporaneously are paid through the most recent dividend payment date. Dividends on the Series B Preferred Stock do not begin to accrue until June 14, 1994. The Indenture, dated as of March 1, 1985, governing the Company's Debentures, as amended by the First Supplemental Indenture dated as of June 29, 1989 and the Second Supplemental Indenture dated as of January 6, 1994, and the Indenture dated as of January 6, 1994 governing the Company's 10% Senior Subordinated Secured Notes due 2003 (collectively, the 'Indentures'), permit the payment of cash dividends on the Series B Preferred Stock but prohibit the payment of cash dividends on the Company's common stock unless (i) no defaults exist or would exist under the Indentures, (ii) the Company's Cash Flow Coverage Ratio (as defined in the Indentures) for the most recently ended four full fiscal quarters has been at least 1.5 to 1, and (iii) such cash dividend, together with the aggregate of all other Restricted Payments (as defined in the Indentures), is less than the sum of 50% of the Company's cumulative net income plus the proceeds of certain sales of the Company's or its subsidiaries' capital stock subsequent to February 1, 1994. The Company does not anticipate, in the foreseeable future, being able to satisfy the foregoing test and, therefore, does not anticipate being able to pay cash dividends on its common stock in the foreseeable future. The ability of the Company to declare and pay dividends is also subject to restrictions set forth in the Delaware General Corporation Law (the 'Delaware GCL'). As a general rule, a Delaware corporation may pay dividends under the Delaware GCL either out of its 'surplus,' as defined in the Delaware GCL, or, subject to certain exceptions, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Even if the Company were to satisfy the requirements in the Indentures for the payment of cash dividends on the Company's common stock, the Company's ability to pay cash dividends will depend upon whether the Company satisfies the requirements of the Delaware GCL at the time any such proposed dividend is declared. CLS filed Amendment No. 2 to its Schedule 13D stating that it owns and has sole voting and dispositive power with respect to 4,850,000 shares of the Company's common stock as of June 12, 1992. On June 14, 1993, CLS acquired 345 shares of Series B Preferred Stock which are convertible into 3,450,000 shares of common stock. In addition, the Company had been advised that, as of December 15, 1993, Moses Marx, the beneficial owner of approximately 22% of the outstanding stock of CLS, beneficially owned 1,126,000 shares (or approximately 3.7%) of the Company's common stock and $4,500,000 principal amount of Debentures, or approximately 11.4% of the aggregate principal amount thereof, and that United Equities Company ('United Equities'), a brokerage firm owned by Mr. Marx, held approximately $3,706,000 principal amount of Debentures or approximately 9.4% of the aggregate principal amount of Debentures outstanding, in its trading account. Mr. Marx and United Equities tendered all of their Debentures in the Exchange Offer and Solicitation (although not all of their Debentures were accepted, due to proration), and the Company is not aware of either Mr. Marx's or United Equities' current holdings of the Company's securities. Although the Company takes no position as to whether Mr. Marx and United Equities are 'affiliates' of the Company, the Company has not treated Mr. Marx or United Equities as affiliates for purposes of the Company's Form 10-K. Other information called for by this Item is set forth in Note 17. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA THE COOPER COMPANIES, INC. AND SUBSIDIARIES FIVE YEAR FINANCIAL HIGHLIGHTS THE COOPER COMPANIES, INC. AND SUBSIDIARIES FIVE YEAR FINANCIAL HIGHLIGHTS ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. References to Note numbers herein are references to 'Notes to Consolidated Financial Statements' of the Company located in Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA THE COOPER COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES STATEMENT OF CONSOLIDATED OPERATIONS See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS -- (CONTINUED) During the three years ended October 31, 1993, the Company acquired businesses and entered into certain licensing and distribution agreements. In connection with these acquisitions and agreements were assumed liabilities as follows: On June 12, 1992, the Company consummated a transaction with Cooper Life Sciences, Inc. ('CLS') which eliminated approximately 80% of the Company's $100 per share liquidation preference Senior Exchangeable Redeemable Restricted Voting Preferred Stock ('SERPS') and resulted in the issuance of 4,850,000 shares of the Company's common stock. On June 14, 1993, the Company acquired from CLS all of the remaining outstanding SERPS of the Company in exchange for a newly created series of preferred stock of the Company ('Series B Preferred Stock'). See Note 15, 'Agreements with CLS,' for a further discussion of these transactions. See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES STATEMENT OF CONSOLIDATED STOCKHOLDERS' EQUITY YEARS ENDED OCTOBER 31, 1993, 1992, AND 1991 (IN THOUSANDS) See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Cooper Companies, Inc. and its subsidiaries (the 'Company') develop, manufacture and market healthcare products, including a range of hard and soft contact lenses, ophthalmic pharmaceutical products and diagnostic and surgical instruments. On May 29, 1992, with the acquisition of Hospital Group of America, Inc. ('HGA')(see Note 2), the Company began to provide healthcare services through the ownership and operation of certain psychiatric facilities and management of other such facilities. With the acquisition of HGA, the Company has adopted certain financial accounting and reporting practices which are specific to the healthcare service industry. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company. Intercompany transactions and accounts are eliminated in consolidation. Also, certain reclassifications have been applied to prior years' financial statements to conform such statements to the current year's presentation. None of these reclassifications had any impact on net loss. FOREIGN CURRENCY TRANSLATION Assets and liabilities of the Company's operations located outside the United States (primarily Canada) are translated at prevailing year-end rates of exchange. Related income and expense accounts are translated at weighted average rates for each year. Gains and losses resulting from the translation of financial statements in foreign currencies into U. S. dollars are recorded in the equity section of the consolidated balance sheet. Gains and losses resulting from the impact of changes in exchange rates on transactions denominated in foreign currencies are included in the determination of net loss for each period. Foreign exchange losses included in the Company's consolidated statement of operations for each of the years ended October 31, 1993, 1992 and 1991 were ($550,000), ($769,000) and ($49,000), respectively. NET SERVICE REVENUE Net service revenue consists primarily of net patient service revenue, which is based on the HGA hospitals' established billing rates less allowances and discounts principally for patients covered by Medicare, Medicaid, Blue Cross and other contractual programs. Payments under these programs are based on either predetermined rates or the cost of services. Settlements for retrospectively determined rates are estimated in the period the related services are rendered and are adjusted in future periods as final settlements are determined. Management believes that adequate provision has been made for adjustments that may result from final determination of amounts earned under these programs. Approximately 38% and 41%, respectively, of 1993 and 1992 net service revenues are from participation of hospitals in Medicare and Medicaid programs and Blue Cross. With respect to net service revenue, receivables from government programs and Blue Cross represent the only concentrated group of credit risk for the Company, and management does not believe that there are any credit risks associated with these governmental agencies or Blue Cross. Negotiated and private receivables consist of receivables from various payors, including individuals involved in diverse activities, subject to differing economic conditions, and do not represent any concentrated credit risks to the Company. Furthermore, management continually monitors and adjusts its reserves and allowances associated with these receivables. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NET SALES OF PRODUCTS Net sales of products consists of sales from the Company's CooperVision and CooperSurgical businesses. The Company recognizes product revenue when risk of ownership has transferred to the buyer, with appropriate provisions for sales returns and uncollectible accounts. With respect to net sales of products, management believes trade receivables do not include any concentrated groups of credit risk. CASH AND CASH EQUIVALENTS Cash and cash equivalents includes commercial paper and other short-term income producing securities with a maturity date at purchase of three months or less. These investments are readily convertible to cash, and are carried at cost which approximates market. RESTRICTED CASH Restricted cash represents collateral for expiring insurance policies for a discontinued contact lens insurance program. TEMPORARY INVESTMENTS Temporary investments are primarily current marketable equity and debt securities. Current marketable debt and equity securities are carried at the lower of aggregate cost or market at the balance sheet date with unrealized losses included in investment income, net in the statement of consolidated operations. Other securities and investments are carried at cost. Gains or losses realized upon sale (based on the first-in, first-out method) and write-downs necessitated by other than temporary declines in value for all securities and investments are also reflected in investment income, net. As of October 31, 1993 and October 31, 1992, aggregate cost and market value, and gross unrealized gains and losses for current marketable securities are as follows: In addition, the Company carried certain non-marketable equity and debt securities at October 31, 1992, at cost in the amounts of $4,068,000 and $2,100,000, respectively, in its temporary investments. Unrealized gains and losses on marketable securities included in the table above compare the market value of the Company's investment in securities as of October 31, 1993 and 1992 versus the cost of such securities. The unrealized gains and losses do not indicate the actual gains or losses that will be realized by the Company upon the disposition of such marketable securities. The net unrealized loss on the current marketable securities portfolio was increased from approximately $1,150,000 at October 31, 1993, to approximately $1,842,000 at December 31, 1993. For the two months ended December 31, 1993, the Company had net realized gains on investments of $191,000. Included in the Company's marketable debt securities portfolio at October 31, 1993 and 1992 are debt securities whose issuers are currently in default of interest payments and/or in bankruptcy reorganization. Total debt securities in default of interest payments and in bankruptcy at October 31, 1993 have an adjusted carrying amount of approximately $2,651,000 on which the Company has recorded an aggregate unrealized loss of $641,000. The maximum additional accounting loss the THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company would incur if these securities become worthless would be an additional $2,010,000 (i.e. $2,651,000 less $641,000) because the Company does not accrue interest income on such issues. Included in the statement of consolidated operations in investment income, net for each of the years ended October 31, 1993, 1992 and 1991 are unrealized gains (losses) of $6,532,000, ($6,244,000) and $2,797,000, respectively, on current marketable securities. Also included in investment income, net for the years ended October 31, 1993, 1992, and 1991 are net realized gains (losses) of ($7,356,000), $13,538,000 and ($2,586,000), respectively, on marketable equities, debt securities and option contracts. The combined impact of the aforementioned net unrealized and realized gains (losses) for each of the years ended October 31, 1993, 1992 and 1991 was a net gain (loss) of ($824,000), $7,294,000 and $211,000, respectively. Interest income for each of the years ended October 31, 1993, 1992 and 1991 was $2,439,000, $6,960,000 and $12,057,000, respectively, and is included in investment income, net. Dividend income in any reported year was de minimis. A former Co-Chairman of the Company and, by reason of his actions, the Company, have been convicted of violations of federal criminal laws, and the Securities and Exchange Commission (the 'SEC') has initiated an action with respect to, among other things, trading in certain marketable debt securities previously owned by the Company. For a further discussion, see Note 18. LOANS AND ADVANCES Loans and advances were made by the Company to certain of its officers and employees at interest rates ranging from 9.0% to 9.5% per annum. The principal amount of loans and advances outstanding at October 31, 1993 and 1992 was $65,000 and $902,000, respectively. INVENTORIES Inventories are stated at the lower of cost, determined on a first-in, first-out or average cost basis, or market. UNAMORTIZED BOND DISCOUNT The difference between the carrying amount and the principal amount of the Company's 10 5/8% Convertible Subordinated Reset Debentures due 2005 (the 'Debentures') represents unamortized discount which is being charged to expense over the life of the issue. As of October 31, 1993, the amount of unamortized discount was $387,000. DEPRECIATION AND LEASEHOLD AMORTIZATION Depreciation is computed on the straight-line method in amounts sufficient to write-off the cost or carrying amount of depreciable assets over their estimated useful lives. Leasehold improvements are amortized over the shorter of their estimated useful lives or the period of the related lease. EXPENDITURES FOR MAINTENANCE AND REPAIRS Expenditures for maintenance and repairs are expensed; major replacements, renewals and betterments are capitalized. The cost and accumulated depreciation of assets retired or otherwise disposed of are eliminated from the asset and accumulated depreciation accounts, and any gains or losses are reflected in operations for the period. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) AMORTIZATION OF INTANGIBLES Amortization is currently provided for on all intangible assets (primarily goodwill, which represents the excess of purchase price over fair value of net assets acquired) on a straight-line basis over periods of up to thirty years. Accumulated amortization at October 31, 1993 and 1992 was approximately $3,059,000 and $2,155,000, respectively. The Company assesses the recoverability of goodwill by determining whether the amortization of goodwill balance over its remaining life can be recovered through reasonably expected future results. RESTRICTED STOCK AND COMPENSATION EXPENSE Under the Company's 1988 Long Term Incentive Plan, its 1990 Non-Employee Directors' Restricted Stock Plan and its predecessor Restricted Stock Plans (see Note 12), certain officers and key employees designated by the Board of Directors or a committee thereof have purchased, for par value, shares of the Company's common stock restricted as to resale ('Restricted Shares') unless or until certain prescribed objectives are met or certain events occur. The difference between market value and par value of the Restricted Shares on the date of grant is recorded as unamortized restricted stock award compensation and shown as a component of stockholders' equity. This compensation is charged to operations as earned. INCOME TAXES Income taxes are provided for in the period in which the related transactions enter into the determination of net income. No provisions have been made for taxes which may become payable should income of subsidiaries outside the United States be remitted to the Company (see Note 9). Investment tax credits and other credits are applied as a reduction of the provision for United States federal income taxes on the flow-through method. EARNINGS PER COMMON SHARE Net income (loss) per common share is determined by using the weighted average number of common shares and common share equivalents (stock warrants) outstanding during each year. Stock options have not been included in the determination of earnings per common share for any period as they are anti-dilutive or resulted in dilution of less than 3%. NOTE 2. ACQUISITIONS AND DISPOSITIONS ACQUISITIONS On April 1, 1993, CooperVision, Inc., a subsidiary of the Company, acquired via a purchase transaction the stock of CoastVision for approximately $9,800,000 cash. CoastVision manufactures and markets a range of contact lens products, primarily custom soft toric contact lenses, which are designed to correct astigmatism. The purchase of CoastVision expands CooperVision's customer base for its existing product lines. CoastVision had net sales of $9,600,000 in its fiscal year ended October 31, 1992. Excess cost over net assets acquired recorded on the purchase was $7,500,000, which is being amortized over 30 years. On May 29, 1992, the Company acquired all of the common stock of Hospital Group of America, Inc. ('HGA') from its ultimate parent, Nu-Med Inc. ('NuMed') for a total consideration of approximately $50,000,000 including $15,898,000 in cash, the assumption of approximately $22,000,000 of third party debt of HGA and the delivery of $21,685,000 principal amount of Nu-Med debentures owned by the Company (including $3,525,000 principal amount of 'Affiliate debentures,' defined and described below), in which the Company had a cost basis of approximately $12,322,000. The Company THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) used available cash to purchase the Nu-Med debentures and to make the $15,898,000 payment at closing. Except for the 'Affiliate debentures' defined and described below, the Company acquired the Nu-Med debentures in open market transactions for a total cost of approximately $10,374,000. On April 13, 1992, the Company acquired, for a total cost of approximately $1,948,000, an additional $3,525,000 principal amount of Nu-Med debentures (the 'Affiliate debentures') from an individual and a corporation (together, the 'Affiliates') related to or affiliated with Messrs. Gary, Steven and Brad Singer. The Affiliate debentures were tendered to Nu-Med at the same price paid by the Company. At the time of the transaction, Gary and Steven Singer were each officers and directors of the Company, and Brad Singer was a director of the Company. The Affiliate debentures were purchased by the Company at the cost paid by the Affiliates plus accrued interest thereon, following the approval of the majority of the disinterested members of the Board of Directors of the Company. To protect the Company against any potential loss, it acquired the Affiliate debentures pursuant to an agreement that would have allowed the Company to 'put' the Affiliate debentures back to the Affiliates at the Company's cost if the acquisition of HGA had not occurred. HGA provides psychiatric and substance abuse treatment through three hospitals with a total of 259 beds at the time of the acquisition, which was subsequently increased to 269. Concurrently, PSG Management, Inc. ('PSG Management'), a subsidiary of the Company, entered into a management agreement with three indirect subsidiaries of Nu-Med under which PSG Management is managing three additional hospitals owned by such subsidiaries which have a total of 220 licensed beds. Under the management agreement, PSG Management is entitled to receive a management fee of $6,000,000 payable in equal monthly installments over the three year term of the agreement. The management agreement is jointly and severally guaranteed by Nu-Med and its wholly-owned subsidiary, PsychGroup, Inc. the parent of the contracting subsidiaries which own the managed facilities. On January 6, 1993, Nu-Med (but not any of its direct or indirect subsidiaries) filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code. Neither the Company nor any of its affiliates filed a proof of claim in the Nu-Med Chapter 11 proceeding, and the bar date (the time for filing proofs of claims) has past. However, none of the Nu-Med subsidiaries has filed under Chapter 11, and the Nu-Med subsidiaries have paid the management fee on a timely basis, although representatives of Nu-Med and its subsidiaries have alleged in writing that PSG Management has breached the Management Services Agreement (which contention PSG Management vigorously disputes). Moreover, Nu-Med's Proposed Disclosure Statement to accompany its Second Amended Plan of Reorganization, filed with the United States Bankruptcy Court for the Central District of California, indicates that PsychGroup, Inc. is commencing performance of certain administrative functions performed by PSG Management on a parallel basis. The acquisition of HGA was accounted for as a purchase. Accordingly, the results of HGA's operations were included in the Company's consolidated results from acquisition date. Excess of cost over net assets acquired has initially been estimated to be $6,155,000, subject to purchase price adjustments per the sales agreement, and is being amortized over 30 years. Had the acquisition of HGA occurred on November 1, 1991, the Company's unaudited pro forma combined net revenue, loss from continuing operations and loss from continuing operations per share would have been $95,320,000, ($15,586,000) and ($.56), respectively, for the twelve months ended October 31, 1992. Had such acquisition occurred on November 1, 1990, the comparable unaudited pro forma combined figures for the twelve months ended October 31, 1991 would have been $82,951,000, ($19,394,000) and ($.84), respectively. During 1992, the Company acquired two parcels of land having an aggregate cost of $3,149,000. The land is carried at cost in property, plant and equipment. Concurrently, the Company entered into two lease agreements under which the Company is entitled to receive rental payments amounting to THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) approximately $22,000,000 over the next 48 years. The subject parcels of land were sold in fiscal 1994 for cash and notes aggregating the approximate original purchase price. In December 1990 and January 1991, the Company acquired Euro-Med Endoscope and Euro-Med, Inc., for cash and notes in the aggregate amount of $3,250,000. The two companies offer a line of surgical instruments and diagnostic hysteroscopy equipment for use in gynecologic and minimally invasive surgical procedures. Excess cost over net assets acquired for these two businesses was $2,082,000. In November 1990, the Company entered into a license agreement under which the Company will support the licensor's efforts to obtain FDA approvals so that the Company may manufacture, market and sell Verapamil for ophthalmic applications. DISPOSITIONS On February 12, 1993, the Company sold its EYEscrub'tm' product line for $1,400,000 cash which resulted in a $620,000 gain. The Company retains the right to market certain ophthalmic pharmaceutical surgical kits containing EYEscrub'tm' once certain regulatory requirements are met. On January 31, 1992, the Company assigned its license to manufacture, have manufactured, sell, distribute and market certain intraocular lens products and disposed of certain other related rights and assets. Total cash consideration received by the Company for such assignment was approximately $5,200,000, which resulted in a pretax gain of $1,030,000. On June 29, 1989, the Company completed the sale of Cooper Technicon, Inc. ('CTI'), the Company's former automated medical diagnostic and industrial analytical systems business, to Miles Inc. ('Miles'), a subsidiary of Bayer USA Inc., a subsidiary of Bayer A G, West Germany, in a transaction involving approximately $477,000,000, consisting of cash and the elimination of CTI's debt of approximately $290,000,000 from the Company's consolidated financial statements. Pursuant to the terms of the sale, the Company sold all of CTI's capital stock for approximately $191,000,000 reduced by $4,000,000 for certain adjustments, resulting in a net cash receipt of approximately $187,000,000, of which $10,000,000 was placed in escrow to secure certain post-closing indemnity obligations of the Company. During 1990, $150,000 of the escrow principal was released to Miles. As of October 31, 1992, $9,850,000 of the escrow was included in 'Other receivables' in the Company's consolidated balance sheet. During 1993 $7,550,000 of such funds were collected by the Company, with the balance being released to Miles. The funds released to Miles were charged against an accrual for such purpose. NOTE 3. DISCONTINUED OPERATIONS In 1993, the Company recorded a charge of $14,000,000 to increase the Company's accrual (the 'Breast Implant Accrual') for contingent liabilities associated with breast implant litigation involving the plastic and reconstructive surgical division of the Company's former Cooper Surgical business segment which was sold in fiscal 1989. See Note 18 for a discussion of breast implant litigation. The Breast Implant Accrual will be charged for payments made and to be made to MEC under the MEC Agreement (see Note 14 for a discussion of the schedule of payments) as well as certain related charges. In October 1993 the Company made the initial payment of $3,000,000 to MEC. At October 31, 1993 the Company is carrying $9,000,000 of the Breast Implant Accrual in 'Deferred income taxes and other non current liabilities' on the Company's Consolidated Balance Sheet for future payments to MEC, none of which is due for repayment in one year or less from October 31, 1993. The Company also recorded a reversal of $343,000 of accruals no longer necessary related to another discontinued business. In 1992, the Company recorded a charge of $9,300,000 to discontinued operations. A charge of $7,000,000 represents an increase to the Company's Breast Implant Accrual. See Note 18 for a discussion of breast implant litigation. The balance of the charge reflects a $2,000,000 settlement of a THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) dispute involving the Company's former Surgical business segment, and a $300,000 adjustment to the loss on the sale of the Company's former Cooper Technicon business segment. No tax benefit has been applied against the above figures, as the Company was not profitable in either year. NOTE 4. EXTRAORDINARY ITEMS The extraordinary gain of $924,000, or $.03 per share, in 1993 represents gains on the Company's purchases of $4,846,000 principal amount of its Debentures. The purchases were privately negotiated and executed at prevailing market prices. The extraordinary gain of $640,000, or $.02 per share, in 1992 represents gains on the Company's purchases of $5,031,000 principal amount of its Debentures. Substantially all of the purchases were privately negotiated and executed at prevailing market prices. The extraordinary gain of $5,428,000, or $.21 per share, in 1991 represents gains on the Company's purchases of $23,166,000 principal amount of its Debentures, including $8,518,000 owned by Brad, Gary and Steven Singer (each of whom was an officer and/or director of the Company at the time of the transaction) or their relatives, $7,656,000 owned by Moses Marx (a former director of the Company) and $2,115,000 owned by Mel Schnell, currently a director of the Company and a director and President and Chief Executive Officer of Cooper Life Sciences, Inc. ('CLS'). See Note 7. Substantially all of the purchases were privately negotiated and executed at or slightly below prevailing market prices. NOTE 5. STOCKHOLDERS RIGHTS PLAN On October 29, 1987, the Board of Directors of the Company declared a dividend distribution of one right for each outstanding share of the Company's common stock, par value $.10 per share (a 'Right'). Each Right entitles the registered holder of an outstanding share of the Company's common stock to initially purchase from the Company a unit consisting of one one-hundredth of a share of Series A Junior Participating Preferred Stock (a 'Unit'), par value $.10 per share, at a purchase price of $60.00 per Unit, subject to adjustment. The Rights are exercisable only if a person or group acquires (an 'Acquiring Person'), or generally obtains the right to acquire beneficial ownership of 20% or more of the Company's common stock, or commences a tender or exchange offer which would result in such person or group beneficially owning 30% or more of the Company's common stock. If, following the acquisition of 20% or more of the Company's common stock, (i) the Company is the surviving corporation in a merger with an Acquiring Person and its common stock is not changed, (ii) a person or entity becomes the beneficial owner of more than 30% of the Company's common stock, except in certain circumstances such as through a tender or exchange offer for all the Company's common stock which the Board of Directors determines to be fair and otherwise in the best interests of the Company and its stockholders, (iii) an Acquiring Person engages in certain self-dealing transactions or (iv) an event occurs which results in such Acquiring Person's ownership interest being increased by more than 1%, each holder of a Right, other than an Acquiring Person, will thereafter have the right to receive, upon exercise, the Company's common stock (or, in certain circumstances, cash, property or other securities of the Company) having a value equal to two times the exercise price of the Right. The Board of Directors amended the Rights Agreement dated as of October 29, 1987, between the Company and The First National Bank of Boston, as Rights Agent, so that Cooper Life Sciences, Inc. ('CLS') and its affiliates and associates would not be Acquiring Persons thereunder as a result of CLS's beneficial ownership of more than 20% of the outstanding common stock of the Company by reason of its ownership of Series B Preferred Stock or common stock issued upon conversion thereof. See Note 15 under 'Agreements With CLS.' Under certain circumstances, if (i) the Company is acquired in a merger or other business combination transaction in which the Company is not the surviving corporation, unless (a) the THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) transaction occurs pursuant to a transaction which the Board of Directors determines to be fair and in the best interests of the Company and its stockholders (b) the price per share of Common Stock offered in the transaction is not less than the price per share of common stock paid to all holders pursuant to the tender or exchange offer, and (c) the consideration used in the transaction is the same as that paid pursuant to the offer, or (ii) 50% or more of the Company's assets or earning power is sold or transferred, each holder of a Right, other than an Acquiring Person, shall thereafter have the right to receive, upon exercise, common stock of the acquiring company having a value equal to two times the exercise price of the Right. At any time until the close of business on the tenth day following a public announcement that an Acquiring Person has acquired, or generally obtained the right to acquire beneficial ownership of 20% or more of the Company's common stock, the Company will generally be entitled to redeem the Rights in whole, but not in part, at a price of $.05 per Right. After the redemption period has expired, the Company's right of redemption may be reinstated if an Acquiring Person reduces his beneficial ownership to 10% or less of the outstanding shares of common stock in a transaction or series of transactions not involving the Company. Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends. The Rights expire on October 29, 1997. NOTE 6. COSTS ASSOCIATED WITH RESTRUCTURING OPERATIONS In the second quarter of 1993, the Company recorded a restructuring charge of $451,000 for consolidation of CooperSurgical facilities and related reorganization and relocation costs. NOTE 7. SETTLEMENT OF DISPUTES The Company and CLS entered into a settlement agreement, dated July 14, 1993, pursuant to which CLS delivered a general release of claims against the Company, subject to exceptions for specified on-going contractual obligations, and agreed to certain restrictions on its acquisitions, voting and transfer of securities of the Company, in exchange for the Company's payment of $4,000,000 in cash and delivery of 200,000 shares of common stock of CLS owned by the Company and a general release of claims against CLS, subject to similar exceptions. See Note 15 for a discussion of the settlement terms. The cash paid and fair value of CLS shares returned to CLS were charged to the Company's statement of operations for 1993 as settlement of disputes. In addition, the Company charged $1,500,000 to the statement of operations for certain other disputes. Included in fiscal 1992 is a charge for settlement of disputes which includes 1) a $650,000 charge related to a transaction with CLS, 2) a payment to Mr. Frederick R. Adler and 3) provisions for several ongoing litigations and disputes including the tentative settlement of Guenther v. Cooper Life Sciences, Inc. et. al. In April 1992, Frederick R. Adler, a former director of the Company at that time, notified the Company that he would solicit proxies to elect his own slate of nominees at the 1992 Annual Meeting of Shareholders (the 'Annual Meeting'), in opposition to the Board's nominees to the Board of Directors (the 'Proxy Contest'). On June 15, 1992, Mr. Adler and the Company entered into a settlement agreement with respect to the Proxy Contest pursuant to which the Board of Directors set the size of the Board at nine members, effective as of the Annual Meeting, and nominated Mr. Adler and Louis A. Craco, a partner in the law firm of Willkie, Farr & Gallagher, for election to the Board together with the Board's seven other nominees, Arthur C. Bass, Allen H. Collins, M.D., Joseph C. Feghali, Mark A. Filler, Michael H. Kalkstein, Allan E. Rubenstein, M.D., and Robert S. Weiss. The settlement agreement provided for the replacement of Mr. Adler by one of three designated persons if he was unable or unwilling to serve as a director following his election at the Annual Meeting. In December THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 1992, Mr. Adler resigned from the Company's Board of Directors and designated Michael R. Golding, M.D., as his replacement. As part of the settlement, in which the parties exchanged mutual releases of claims arising out of the Proxy Contest and litigation brought in connection therewith, Mr. Adler agreed, among other things, not to solicit proxies in opposition to the election of the Board's nine nominees at the Annual Meeting and not to take any action to call a special meeting of stockholders or solicit stockholder consents with respect to the election or removal of directors prior to the 1993 annual meeting of stockholders of the Company. The Company also reimbursed Mr. Adler for $348,000 of expenses actually incurred by him in connection with the Proxy Contest and negotiation of the settlement agreement. In 1992 the Company reached an agreement involving the settlement of Guenther v. Cooper Life Sciences, et. al., a class and shareholder derivative action filed against CLS, the Company, Cooper Development Company, a Delaware corporation ('CDC'), Parker G. Montgomery, A. Kenneth Nilsson, Charles Crocker, Robert W. Jamplis, Barbara Foster as executrix of the Estate of Hugh K. Foster, Michael Mitzmacher, Joseph A. Dornig, Martin M. Koffel, Richard W. Turner, John Vuko, Randolph Stockwell, Hambrecht & Quist, Incorporated, Peat Marwick Main & Co., Gryphon Associates, L.P. and The Gryphon Management Group, Ltd. in June 1988 in the United States District Court for the District of Minnesota and transferred in December 1988 to the District Court for the Northern District of California. As amended, the action alleged various securities law violations and shareholder derivative claims in connection with the public disclosures by, and management of, CLS from 1985 to 1988. The Company formerly shared certain officers and directors with CLS and is alleged to have controlled CLS. The settlement resolved all claims asserted against the Company and its former officers and directors. On April 30, 1993, the court approved the settlement after notice to the plaintiff class and a court hearing. In accordance with the settlement, the case has been dismissed as to the Company and all other defendants. The settlement provided for a payment by Optics Cayman Islands Insurance Ltd., a subsidiary of the Company (which provided directors' and officers' liability insurance to some of the above-named individuals), in the amount of $2,200,000 on behalf of the directors and officers of CLS, as well as a payment of $1,800,000 by the Company. The settlement amount was fully reserved in the books of the Company at July 31, 1992 and paid into escrow by October 31, 1992. NOTE 8. PREFERRED STOCK On June 14, 1993, the Company acquired from CLS all of the remaining outstanding shares of the Company's SERPS, having an aggregate liquidation preference of $16,060,000, together with all rights to any dividends or distributions thereon, in exchange for shares of Series B Preferred Stock having an aggregate liquidation preference of $3,450,000 and a par value of $.10 per share. The 345 shares of Series B Preferred Stock, and any shares of Series B Preferred Stock issued as dividends, are convertible into one share of common stock of the Company for each $1.00 of liquidation preference, subject to customary antidilution adjustments. The Company also has the right to compel conversion of Series B Preferred Stock at any time after the market price of the common stock on its principal trading market averages at least $1.375 for 90 consecutive calendar days and closes at not less than $1.375 on at least 80% of the trading days during such period. CLS currently owns 4,850,000 shares of common stock, or approximately 16.2% of the Company's outstanding common stock. See Note 15. Dividends will accrue on the Series B Preferred Stock commencing June 14, 1994, and will be payable quarterly in cash at the rate of 9% (of liquidation preference) per annum or, if the Company is restricted by applicable law or certain debt agreements from paying cash dividends, in additional shares of Series B Preferred Stock at the rate of 12% (of liquidation preference) per annum. The Series B Preferred Stock is redeemable, in whole or in part, at the option of the Company, at any time at a redemption price equal to its then applicable liquidation preference, plus accrued and unpaid dividends. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9. INCOME TAXES The components of income (loss) from continuing operations before income taxes and extraordinary items and the provision for income taxes are as follows: A reconciliation of the provision for (benefit of) income taxes included in the Company's statement of consolidated operations and the amount computed by applying the United States statutory federal income tax rate to income (loss) from continuing operations before extraordinary items and income taxes follows: At October 31, 1993, the Company had net operating loss carryforwards of approximately $224,000,000 for financial statement purposes and approximately $243,000,000 for income tax purposes, and investment tax, research and development and job tax credit carryforwards of approximately $2,455,000 all of which will expire in varying amounts beginning in the year ending October 31, 1999. Income taxes have not been provided for the undistributed earnings of subsidiaries operating outside the United States. There were no such earnings of the Company at October 31, 1993. During 1992 and 1991, the Company repatriated $3,655,000 and $1,713,000, respectively, of earnings of the Company's selected subsidiaries. Such repatriations did not result in a material increase in income taxes. Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes' ('FAS 109') was issued by the Financial Accounting Standards Board in February 1992. FAS 109 requires a THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) change from the deferred method under APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of FAS 109, deferred income taxes are recognized for the future tax consequences attributable to differences between bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under FAS 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. FAS 109 must be adopted for years beginning after December 15, 1992. Upon adoption, the provisions of FAS 109 may be applied without restating prior years' financial statements or may be applied retroactively by restating any number of consecutive prior years' financial statements. Upon adoption in the 1994 fiscal year, the Company plans to apply the provisions of FAS 109 without restating prior years' financial statements. The Company anticipates that the adoption of FAS 109 will not have a material impact on the financial statements. No benefit will be recognized for operating loss and tax credit carryforwards since the deferred tax asset will be offset by a valuation reserve. NOTE 10. PROPERTY, PLANT AND EQUIPMENT A summary of property, plant and equipment follows: - ------------ * Includes approximately $3,000,000 for two parcels of land sold in fiscal 1994. See Note 2. Depreciation and leasehold amortization expense amounted to $2,624,000, $1,537,000 and $1,039,000 for the years ended October 31, 1993, 1992 and 1991, respectively. NOTE 11. LONG-TERM DEBT, NOTES PAYABLE AND WARRANTS LONG-TERM DEBT As used herein, the term 'Indenture' means the indenture governing the Company's Debentures. The Indenture has been amended twice (and unless specified herein or the context requires otherwise, references to the Indenture are to the Indenture as so amended): first, pursuant to a First Supplemental Indenture dated as of June 29, 1989, and second, pursuant to a Second Supplemental Indenture dated as of January 6, 1994. During the year ended October 31, 1989, in order to consummate the sale of CTI (see Note 2), the Company was required to obtain the approval of the sale by the holders of a majority of the Company's Debentures which were then 8 5/8% Convertible Subordinated Debentures due 2005 (the '8 5/8% Debentures'). The Company's Consent Solicitation and Offer to Purchase sought consents for: the sale of CTI the sale of the Optometrics business the adoption of the First Supplemental Indenture. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company received the requisite consents and, in connection therewith, upon consummating the CTI sale, purchased approximately $70,000,000 principal amount of the 8 5/8% Debentures, and entered into the First Supplemental Indenture, which amended certain terms of the Indenture. Under these amended terms, the interest rate on the 8 5/8% Debentures was increased from 8 5/8% to 10 5/8% per annum, effective June 29, 1989. Reflecting this change, the 8 5/8% Debentures were retitled the '10 5/8% Convertible Subordinated Reset Debentures due 2005'. In addition, under the terms of the Indenture as then amended, the Company was required to reset the interest rate on the Debentures on June 15, 1991, to a rate per annum, as determined by two nationally recognized investment banking firms selected by the Company, such that the Debentures would have a market value equal to 75% of their principal amount on such date. The market value of the Debentures was 75% of principal value as of June 15, 1991; therefore, no interest rate reset was necessary. The SEC has filed a complaint for Permanent Injunction and Other Equitable Relief (the 'SEC Complaint') alleging, among other things, federal securities laws violations by the Company and Gary Singer, a former Co-Chairman of the Company, in connection with an alleged manipulation of the price and demand of the Debentures to avoid an allegedly required reset. The SEC Complaint alleges that Gary Singer and the Company manipulated the trading price of the Debentures, and that Gary Singer obtained allegedly false opinion letters from two firms, which letters failed to meet the Indenture requirements to avoid such reset. See Note 18. As a result of the losses experienced by the Company, the Company's Adjusted Net Worth, as defined in the Indenture (as in effect after adoption of the First Supplemental Indenture but prior to consummation of the Exchange Offer and Solicitation more fully discussed in Note 19), was $24,580,000 at April 30, 1993, $10,965,000 at July 31, 1993 and $452,000 at October 31, 1993. As a result of the Company's Adjusted Net Worth remaining below $41,500,000 for two consecutive fiscal quarters, the Company was required, pursuant to Section 4.09 of the Indenture (as then in effect), to purchase $15,000,000 principal amount of Debentures in the open market or through private transactions or to make an offer to all holders to purchase $15,000,000 principal amount of Debentures (less the principal amount of any Debentures purchased after July 31, 1993 through market or private purchases) at the optional redemption price then in effect, plus accrued and unpaid interest. The maximum purchases that the Company was required to make to comply with the covenant would have been $15,000,000 principal amount of Debentures every six months, beginning October 25, 1993. In addition, pursuant to Section 4.14 of the Indenture (as in effect after adoption of the First Supplemental Indenture but prior to consummation of the Exchange Offer and Solicitation), if all of the outstanding Debentures were not repurchased in connection with the covenant described above and if the Company had an Adjusted Net Worth of less than $350,000,000 at January 31, 1995 or a Cash Flow Coverage Ratio of less than 5 to 1 for the fiscal quarter then ended, the Company would have been required to purchase, in June of 1995, all Debentures then outstanding at 100% of principal amount plus accrued and unpaid interest. In its Annual Report on Form 10-K for the fiscal year ended October 31, 1991, as amended, the Company disclosed the following transactions: On July 11, 1991, the Company purchased $450,000 principal amount of Bally's Grand Inc. 11 1/2% bonds (the 'Bally's Grand Bonds') for $301,500. On July 16, 1991, Gary Singer purchased $500,000 principal amount of Bally's Grand Bonds for his wife's account for $340,000. On August 7, 1991, the Company purchased the Bally's Grand Bonds held in his wife's account for $345,000. The Company has been advised by counsel for Mr. Singer that in transactions such as this transaction and the transactions described below, because prices for these bonds are not widely quoted, it was Mr. Singer's practice to confirm the market price by requesting market price information from brokers. Mr. Singer's wife received net proceeds on such sale of $344,470.50. On September 5, 1992, the Company sold its entire position of Bally's Grand Bonds for $656,687.50. On July 23, July 26 and August 5, 1991, the Company purchased an aggregate of $9,500,000 principal amount of Petrolane Gas 13 1/4% bonds (the 'Petrolane Bonds') for an aggregate of $3,361,875. On September 17, 1991, the Company sold $6,000,000 principal amount of its Petrolane THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Bonds, for an aggregate of $2,520,000. On September 19, 1991, it sold its remaining $3,500,000 principal amount of bonds to a relative of Mr. Singer for $1,400,000. Mr. Singer's relative purchased such bonds for $1,404,375 (including broker mark-up) and sold a portion of them on September 30, and the balance on October 2, 1991, receiving aggregate proceeds of $1,469,375. On September 24 and 26, 1991, the Company purchased an aggregate of $4,887,000 principal amount of DR Holdings Bonds for an aggregate of $2,385,195. On October 1, 1991, the Company sold its DR Holdings Bonds to the same relative of Mr. Singer for $2,565,675. Mr. Singer's relative purchased such bonds for $2,571,783.75 (including broker mark-up) and sold them on October 2, 1991, for $2,907,765. On or about September 27, 1991, the Company purchased $2,213,000 principal amount of DR Holdings Bonds for $1,156,292.50. On or about October 4, 1991, the DR Holdings Bonds were transferred to a securities brokerage account in the name of the wife of Gary Singer, and, on or about October 7, 1991, a payment of $1,156,292.50 was made by Mr. Singer's wife to the Company. Counsel for Mr. Singer has advised the Company that Mr. Singer intended to purchase the DR Holdings Bonds for his wife's account, that the transaction was executed in a Company account as the result of a broker's error, and that the subsequent transfer of the DR Holdings Bonds from a Company account to his wife's account and payment by his wife to the Company, as described above, were undertaken to correct the broker's error. Counsel for Mr. Singer has further advised the Company that, on October 2, 1991, Mr. Singer's wife sold the $2,213,000 principal amount of DR Holdings Bonds for $1,316,735. Gary Singer was convicted of violations of federal criminal laws in connection with certain of the foregoing transactions, and certain of such transactions are also the subject of allegations in the SEC Complaint that, among other things, Gary Singer entered into such trades for the purpose of diverting profits from the Company to such relatives. See Note 18. Section 4.12 of the Indenture (as in effect prior to consummation of the Exchange Offer and Solicitation) contained a covenant limiting the Company's ability to, among other things, sell any of its property or assets to, or purchase any property or assets from, any Affiliate of the Company (as defined in the Indenture as then in effect). Section 4.18 of the Indenture (as in effect after adoption of the First Supplemental Indenture but prior to consummation of the Exchange Offer and Solicitation) contained a covenant prohibiting the Company from maintaining an equity interest for more than eighteen months in, and making any direct or indirect advances, loans or other extensions of credit to, any person that is not consolidated with the Company. From time to time, the Company has maintained an equity interest in unconsolidated persons for more than the permitted period and may have engaged in transactions that could be construed to be a direct or indirect advance, loan or other extension of credit in violation of the Indenture as then in effect. Breach of the covenants contained in Section 4.09, 4.12 or 4.18 of the Indenture or the reset obligation contained in the Debentures (in each case, as in effect after adoption of the First Supplemental Indenture but prior to consummation of the Exchange Offer and Solicitation) was a Default under the Indenture, which would have led to an Event of Default under the Indenture (providing grounds for the Trustee or the holders ('Holders') of at least 25% in principal amount of the Debentures then outstanding to declare the principal and accrued interest on the outstanding Debentures immediately due and payable) if such Default was not cured within 60 days of the Company's receipt of notice of the Default from the Trustee or such Holders. The Company did not have the necessary cash resources to pay the principal and accrued interest on the outstanding Debentures (totalling approximately $40,000,000 at October 31, 1993) in the event that the Debentures were successfully accelerated and such acceleration were not rescinded. Consummation of the Exchange Offer and Solicitation in January 1994 and the execution of the Second Supplemental Indenture pursuant thereto eliminated the requirement that the Company purchase Debentures by reason of Section 4.09 of the Indenture and eliminated the risk that the Company would be required to purchase Debentures by reason of Section 4.14 of the Indenture. In addition, the Company obtained, pursuant to the Exchange Offer and Solicitation, the waiver (the 'Waiver') of any and all Defaults and Events of Default and their consequences under the Debentures THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and the Indenture arising out of any actions, omissions or events occurring on or prior to 5:00 p.m. New York City time, January 6, 1994, the expiration date of the Exchange Offer and Solicitation (the 'Expiration Date'), including any Defaults or Events of Default arising out of the matters described above. The Debentures mature on March 1, 2005 and, as a result of amendments approved by the holders of the Debentures in connection with the Exchange Offer and Solicitation and set forth in the Second Supplemental Indenture, are convertible into common stock at a conversion price of $5.00 per share, subject to adjustment under certain conditions to prevent dilution to the holders. On October 31, 1993, the aggregate principal amount of Debentures then outstanding were convertible into an aggregate of 1,434,754 shares of common stock at a conversion price of $27.45. Interest is payable semiannually on March 1st and September 1st of each year. As of October 31, 1993, $39,384,000 principal amount of the Debentures remained outstanding, the market value of which was approximately $26,584,000. The difference between the principal amount and carrying value on the Company's consolidated balance sheet of $387,000 represents unamortized discount which is being charged to expense. Following consummation of the Exchange Offer and Solicitation approximately $9,400,000 principal amount of the Debentures remain outstanding, convertible into shares of common stock at a conversion price of $5.00, and approximately $22,000,000 principal amount of Notes (as defined in Note 19) were outstanding. During 1993, 1992 and 1991, the Company purchased $4,846,000, $5,031,000 and $23,166,000, respectively, principal amount of its Debentures, all of which have been retired. See Note 4 for a discussion of extraordinary gains which resulted from these purchases. Other long-term debt consists of the following: The HGA Term Loan and HGA IRB contain several covenants, including the maintenance of certain ratios and levels of net worth (as defined), restrictions with respect to the payments of cash dividends on common stock and on the levels of capital expenditures, interest and debt payments. In addition, the holders of the HGA IRB have the right to accelerate all outstanding principal at December 31, 1995 upon notification one year prior to that date. Substantially all of the property and equipment and accounts receivable of HGA collateralize its outstanding debt. Aggregate annual maturities of other long-term debt, including the current installments thereof, during the five years subsequent to October 31, 1993, are as follows: THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTES PAYABLE AND WARRANTS In connection with agreements to extend the due date on certain of the Company's outstanding debt in 1988, the Company issued warrants to a group of its lenders. Warrants to purchase 658,950 shares of the Company's common stock vested in December 1988 and currently have an expiration date of December 29, 1995. All other warrants related to the agreements expired. The terms of the warrants provide that the exercise price is to be reset every six months to the lower of the then current exercise price or 80% of the market value as defined in the warrant agreement. As of January 12, 1994, the most recent reset date, the exercise price was $.37 per share. NOTE 12. STOCK OPTIONS, STOCK APPRECIATION RIGHTS, RESTRICTED STOCK, DEFERRED STOCK, STOCK PURCHASE RIGHTS AND LONG TERM PERFORMANCE AWARDS 1988 Long-Term Incentive Plan The 1988 Long Term Incentive Plan, as amended (the 'LTIP') provides the Company with opportunities to attract, retain and motivate key employees and consultants to the Company and its subsidiaries and affiliates, and enables the Company to provide incentives to key employees and consultants who are directly linked to the profitability of the Company and to increasing stockholder value. The LTIP authorizes a committee consisting of three or more individuals not eligible to participate in the LTIP or, if no committee is appointed, the Company's Board of Directors, to grant to eligible individuals during a period of ten years from September 15, 1988, stock options, stock appreciation rights, restricted stock, deferred stock, stock purchase rights, phantom stock units and long term performance awards for up to 6,376,710 shares of common stock, subject to adjustment for future stock splits, stock dividends and similar events. As of October 31, 1993, 4,008,943 shares remained available under the LTIP for future grants. Since the approval of the LTIP by the Company's stockholders, no further grants have been, and none will be, made under predecessor stock option and restricted stock plans. However, grants made under the prior plans before approval of the LTIP remain in effect. In February 1989, Gary Singer, Steven Singer, Bruce Sturman, Howard Sturman, Wayne Sturman, Kenneth Nilsson, Peter Riepenhausen and Martin Singer were granted the right to purchase 25,000, 25,000, 25,000, 25,000, 25,000, 5,000, 5,000 and 25,000 shares of restricted stock, respectively, pursuant to the LTIP. At the same time, options to purchase 313,170 shares were granted to each of Gary Singer, Steven Singer, Bruce Sturman, Howard Sturman, Wayne Sturman and Martin Singer, and options to purchase 25,000 shares were granted to each of Kenneth Nilsson and Peter Riepenhausen. The exercise price of such options was $3.75 per share. In March 1989, Arthur Bass, the former President and Chief Executive Officer of the Company at that time, was granted the right to purchase 50,000 shares of restricted stock pursuant to the LTIP. The purchase price for all such restricted stock awards was $.10 per share. Restrictions were removed from 10% of all of the aforementioned restricted shares in 1989 according to the restricted share release formula and 90% of the grants of Howard Sturman, Wayne Sturman, Kenneth Nilsson and Peter Riepenhausen were forfeited by each of the foregoing upon the termination of his employment. Martin Singer's restricted shares as to which restrictions had not been removed (22,500 shares) were relinquished as described more fully below. In April 1990 and April 1991, in accordance with the revised vesting schedule described below, the first two Price Levels (i.e. $4.43 THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and $5.22, respectively) were achieved and, accordingly, restrictions were removed from 40% of the restricted shares still outstanding on each of such dates from which restrictions had not been removed previously. In March 1989, Arthur Bass also received an option to purchase 737,690 shares of the Company's common stock at an exercise price of $3.75 per share. In accordance with a renegotiation of his compensation, Mr. Bass waived that option in return for 150,000 shares of restricted stock, of which 31,317 shares were immediately free of restrictions. Restrictions were removed from another 23,736 of those shares in April 1990 upon satisfaction of the first Price Level. When Mr. Bass resigned as President and Chief Executive Officer of the Company in September 1990, he forfeited his remaining restricted shares. Pursuant to employment agreements between the Company and each of Gary Singer, Steven Singer and Bruce Sturman, which became effective as of March 9, 1990, each of the aforementioned individuals received a grant of the right to purchase 313,170 shares of restricted stock (the 'March Restricted Shares'), of which 31,317 shares were immediately free of restrictions. Restrictions on the remainder of the March Restricted Shares were to be removed in 20% increments when the average closing price of the Company's common stock on the New York Stock Exchange (composite quotations) over any consecutive period of 30 days (the 'Average Price') next equals or exceeds $4.43, $5.22, $6.16, $7.27 and $8.58 (individually, a 'Price Level') or, if not previously removed, at the end of ten years. Pursuant to other provisions in the aforementioned employment agreements, the formula for removing restrictions from the restricted shares granted in February and March 1989 was amended to conform to that of the March Restricted Shares and each of Gary Singer, Steven Singer and Bruce Sturman relinquished their 313,170 options. The issuance of the March Restricted Shares was effected pursuant to Board authorization given in connection with the adoption of a series of proposals designed to reduce the cash compensation of senior management. Bruce Sturman, Gary Singer and Steven Singer each relinquished their rights to cash severance in exchange for the March Restricted Shares. That compensation adjustment reflects some of the terms contained in a subsequently approved stipulation of settlement (the 'Settlement Agreement') in a derivative suit entitled In Re The Cooper Companies, Inc. Shareholders' Litigation in which Bruce Sturman, Gary Singer and Steven Singer and certain former officers of the Company were named defendants. Also pursuant to the aforementioned Board authorization and in contemplation of the effectiveness of the Settlement Agreement, 281,853 stock options of Martin Singer which had not yet become exercisable and 22,500 restricted shares as to which the restrictions had not yet been removed were relinquished in exchange for the right to purchase for par value 272,500 restricted shares as to which all restrictions were to be removed 18 months following the date of issuance (the 'Special Restricted Shares'). On March 9, 1990, the Executive Committee of the Board of Directors authorized additional grants totalling 457,500 restricted shares to various other employees and consultants of the Company, with restrictions to be removed in 20% increments or at the end of ten years as described above. All of the aforementioned grants were also ratified and approved by the Compensation Committee and by the full Board of Directors. When the first and second Price Levels were achieved in April 1990 and April 1991, restrictions were removed from 40% of the aforementioned restricted shares, other than the Special Restricted Shares of Martin Singer. In July 1990, the Compensation Committee of the Board of Directors authorized several grants covering an aggregate of 383,000 restricted shares (the 'July Restricted Shares') to be issued pursuant to the LTIP. Restrictions on 20% of the July Restricted Shares were removed pursuant to the terms of individual restricted share agreements upon issuance of those shares. Restrictions on the remaining 80% of the July Restricted Shares were to be removed in 25% increments when the Average Price of the Company's common stock next equals or exceeds for the first time $5.22, $6.16, $7.27 and $8.58, or, if THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) not previously removed, at the end of ten years. In April 1991, the $5.22 Price Level was achieved and, accordingly, restrictions were removed from 25% of the restricted shares. All remaining restrictions on the aforementioned restricted shares, except for restricted shares of Steven Singer as a result of a modification to his employment agreement, were removed in September 1993 as a result of a 'Change in Control' as defined by the LTIP in connection with the issuance by the Company of Series B Preferred Stock. In January and June 1991, the Administrative Committee of the LTIP authorized grants to employees and consultants of the Company covering an aggregate of 101,500 restricted shares. Those restricted shares were to have restrictions removed in 20% increments at the various Price Levels or at the end of ten years, as described above. As of October 31, 1992, restrictions on 13,450 of these shares were removed, and during 1993 the remainder of restrictions were removed as a result of a 'Change in Control' as defined by the LTIP in connection with the issuance by the Company of Series B Preferred Stock. In October 1991, the Administrative Committee of the LTIP made a grant to Bruce Sturman of 100,000 restricted shares. Of those 100,000 shares, 46,000 shares had restrictions removed upon purchase and the remaining restricted shares would have been released in 33.33% increments at Price Levels of $6.16, $7.27 and $8.58. With the termination of Bruce Sturman's employment with the Company on July 27, 1992, the remaining restricted shares granted in October 1991 (54,000 shares) and his remaining restricted shares granted in March 1990 (182,611 shares) were purchased by the Company for $.10 per share. In October 1991, the Administrative Committee of the LTIP made grants of 25,000 phantom stock units ('PSUs') to each of Gary Singer, Steven Singer and Bruce Sturman which were immediately vested to the individuals. Gary and Steven Singer each surrendered their 25,000 PSUs to the Company in October 1991, whereupon they received an amount of cash ($98,450 each) equal to the fair market value of 25,000 shares of common stock as specified by the grant. Bruce Sturman's PSUs expired with his termination of employment with the Company on July 27, 1992. In February and June 1992, the Administrative Committee of the LTIP authorized grants to employees and consultants covering an aggregate of 223,250 restricted shares. These restricted shares were to have restrictions removed in 20% increments at the various Price Levels (as described above), or have restrictions removed based on performance criteria or at the end of ten years. Of these grants, restrictions were removed from a total of 12,300 shares in 1992, and the remainder, not otherwise forfeited, had restrictions removed during 1993 as a result of a 'Change in Control' as defined by the LTIP in connection with the issuance by the Company of Series B Preferred Stock. (See Note 8.) In June 1993, the Administrative Committee of the LTIP authorized a grant to a consultant covering an aggregate of 125,000 restricted shares. These restricted shares had all restrictions removed in 1993. As of August 1, 1993, there were options to purchase an aggregate of 1,102,500 shares of common stock granted to, and not subsequently forfeited by, optionholders at exercise prices ranging from $.69 to $4.25 per share. The Company offered each employee who held options granted under the LTIP an opportunity to exchange those options for a smaller number of substitute options. Each new option is exercisable at $.56 per share. The number of shares each employee was entitled to purchase pursuant to such option was computed by the Company's independent nationally recognized compensation consulting firm using an option exchange ratio derived under the Black-Scholes option pricing model which takes into account the number of shares which could be acquired pursuant to outstanding options, the exercise price of the options, the current market of the Company's common stock and the option expiration date. Each person who elected to participate received an option to purchase an individually calculated percentage of the shares covered by his outstanding option, ranging from 21% to 70% of the shares such person was entitled to purchase. A percentage of the new option, equal to the percentage of the outstanding option that was already exercisable, was immediately exercisable. The remainder of the new option will vest and become exercisable in 25% tranches if and when the trading THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) price of the Company's common stock over 30 days averages, $1.00, $1.50, $2.00 and $2.50 per share, respectively. The option exchange program provided optionholders the opportunity to exchange options with exercise prices well in excess of the current market price of the Company's common stock with a lesser number of options that are exercisable at a price that, while still above current market price, is lower than the exercise price on the surrendered options. Under the terms of the option exchange offer, each person who elected to participate waived the vesting of options that otherwise would have resulted from the Change in Control (as such term is defined in the LTIP) that occurred when stockholders approved the conversion rights of the Series B Preferred Stock on September 14, 1993. 1990 Non-Employee Directors Restricted Stock Plan On April 26, 1990, the Company's Board of Directors adopted the 1990 Non-Employee Directors Restricted Stock Plan (the 'NEDRSP'), subject to the approval of such plan by the stockholders of the Company. Such approval was received July 12, 1990, at the Annual Meeting of Stockholders. The NEDRSP, by its terms, grants to each current and future director of the Company who is not also an employee or a consultant to the Company or any subsidiary of the Company ('Non-Employee Director') the right to purchase for $.10 per share, shares of the Company's common stock, subject to certain restrictions. One hundred thousand shares of such common stock were authorized and reserved for issuance under the NEDRSP. Shares which are forfeited become available for new awards under such plan. On July 12, 1990, upon approval of the NEDRSP by the stockholders of the Company, three Non-Employee Directors received grants for 10,000 restricted shares each. Each grant provided that the restrictions will be removed from 20% of such shares upon issuance. Restrictions shall lapse in 25% increments for the remaining 8,000 shares each time the Average Price next equals or exceeds $5.22, $6.16, $7.27 and $8.58. Restricted shares acquired under any award made after July 12, 1990 shall be in awards of 5,000 shares and shall have restrictions lapse with respect to 20% of such shares, and the shares subject thereto shall become nonforfeitable and freely transferable, each time, after the date of grant of the award, the Average Price equals or exceeds for the first time each of the following percentages of increase over the Average Price on the date of grant of the award: 18%, 36%, 54%, 72% and 90%. Transactions involving options to purchase the Company's common stock in connection with the LTIP and NEDRSP during each of the three years ended October 31, 1993 are summarized below: Options issued and outstanding have option prices ranging from $.56 to $2.625 per share. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The excess of market value over $.10 per share of LTIP and NEDRSP restricted shares on respective dates of grant is recorded as unamortized restricted stock award compensation and shown as a separate component of stockholders' equity. Restricted shares and other stock compensation charged (credited) to selling, general and administrative expense for the twelve months ended October 31, 1993, 1992 and 1991 was approximately $1,084,000, ($33,000) and $1,734,000, respectively. Prior Stock Option Plans Prior to the implementation of the LTIP, the Company had two stock option plans, the 1982 Stock Option Plan and the 1985 Stock Option Plan (collectively referred to as the 'Stock Option Plans'). With the adoption of the LTIP, effective September 15, 1988, all authorized but unallocated options of the Stock Option Plans (approximately 430,500 options) were transferred to the LTIP and no further grants were allowed from the Stock Option Plans. Previously existing grants, however, remained in effect. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Options granted under the Stock Option Plans could not be granted at less than 85% of the market value on the date of grant, could not have terms exceeding ten years and were generally exercisable in four equal annual installments commencing on the first anniversary of the date of the grant. The maximum number of shares authorized to be granted under the Stock Option Plans was 2,150,000 shares. Transactions in the Company's common stock during each of the three years ended October 31, 1993 in connection with the Company's Stock Option Plans are summarized below: NOTE 13. EMPLOYEE BENEFITS THE COMPANY'S RETIREMENT INCOME PLAN The Company adopted The Cooper Companies, Inc. Retirement Income Plan (the 'Retirement Plan') in December 1983. The Retirement Plan is a non-contributory pension plan covering substantially all full-time United States employees of CVI, CVP and the Company's Corporate Headquarters. The Company's customary contributions are designed to fund normal cost on a current basis and to fund over thirty years the estimated prior service cost of benefit improvements (fifteen years for annual gains and losses). The unit credit actuarial cost method is used to determine the annual cost. The Company pays the entire cost of the Retirement Plan and funds such costs as they accrue. Retirement costs applicable to continuing and discontinued operations of the Company for the years ended October 31, 1993, 1992 and 1991 were approximately $181,000, $265,000 and $351,000, respectively. Virtually all of the assets of the Retirement Plan are comprised of participations in equity and fixed income funds. Based on the latest actuarial information available, the following tables set forth the net periodic pension costs, funded status and amounts recognized in the Company's consolidated financial statements for the Retirement Plan: THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NET PERIODIC PENSION COST SCHEDULE RECONCILING THE FUNDED STATUS OF THE PLAN WITH PROJECTED AMOUNTS FOR THE FINANCIAL STATEMENTS ACTUARIAL PRESENT VALUE OF BENEFIT OBLIGATIONS THE COMPANY'S 401(K) SAVINGS PLAN The Company adopted its Stock Purchase Savings Plan (the 'Stock Plan') on December 1, 1983. Effective July 1, 1990, the Company froze the Stock Plan and implemented The Cooper Companies, Inc. 401(k) Savings Plan (the '401(k) Plan'), a revision of the Stock Plan. Both plans provide for a deferred compensation arrangement as described in section 401(k) of the Internal Revenue Code. The 401(k) Plan is a contributory plan and is available to substantially all full-time United States employees of the Company. United States resident employees of the Company who participate in the 401(k) Plan may elect to have from 2% to 10% of their pre-tax salary or wages (but not more than $8,994 for the calendar year ended December 31, 1993) deferred and contributed to the trust established under the 401(k) Plan. The Company's contributions to the Stock Plan or the 401(k) Plan on account of the THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company's participating employees, net of forfeiture credits, were $90,000, $72,000 and $54,000 for the years ended October 31, 1993, 1992 and 1991, respectively. THE COMPANY'S BONUS PLAN The Company adopted its Incentive Payment Plan (the 'IPP') available to key executives and certain other personnel on November 1, 1982 pursuant to which such persons may in certain years receive cash bonuses based on Company and subsidiary performance. Total payments earned under the IPP for the years ended October 31, 1993, 1992 and 1991, were approximately $439,000, $456,000 and $125,000, respectively. The Board of Directors of the Company also approved discretionary bonuses outside of the IPP for the years ended October 31, 1993 and October 31, 1992 of approximately $124,000 and $343,000, respectively. THE COMPANY'S TURN-AROUND INCENTIVE PLAN The Company adopted its Turn-Around Incentive Plan (the 'TIP') on May 18, 1993 pursuant to which certain designated employees are eligible to receive awards, payable over time in a combination of cash and restricted stock issued if the Company achieves a global resolution acceptable to the Board of Directors of all breast implant matters and if the price of the Company's common stock reaches certain designated price levels. No payments have been made under the TIP to date. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In December 1990, the Financial Accounting Standards Board issued Statement No. 106, Employer's Accounting for Postretirement Benefits Other Than Pensions ('FAS 106'), which required adoption of a new method of accounting for postretirement benefits. FAS 106 establishes standards for providing an obligation for future postretirement benefits due employees over the service period of such employees. FAS 106 is effective for fiscal years beginning after December 15, 1992. The Company will adopt FAS 106 as required and believes the adoption will have no material impact on its consolidated financial statements. NOTE 14. LEASE AND OTHER COMMITMENTS Total minimum annual rental obligations under noncancelable operating leases (substantially all real property and equipment) in force at October 31, 1993 are payable in subsequent years as follows: Aggregate rental expense for both cancelable and noncancelable contracts amounted to $2,105,000, $2,828,000 and $2,869,000 in 1993, 1992 and 1991, respectively. Commitments under capitalized leases are not significant. Under the terms of a supply agreement most recently modified in 1993, the Company agreed to purchase by December 31, 1997, certain contact lenses from a British manufacturer with an aggregate cost of approximately `L'4,063,000. As of December 31, 1993, there remained a commitment of `L'3,835,116. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The $9,000,000 liability recorded for payments to be made to MEC under the MEC Agreement described in Notes 3, 18 and 19 will become due as follows: Additional payments to be made to MEC beginning December 31, 1999 are contingent upon the Company's earning net income before taxes in each fiscal year, and are, therefore, not recorded in the Company's financial statements. Such payments are limited to the smaller of 50% of the Company's net income before taxes in each such fiscal year on a noncumulative basis or the amounts shown below: NOTE 15. RELATIONSHIPS AND TRANSACTIONS BETWEEN THE COMPANY CLS, COOPER DEVELOPMENT COMPANY ('CDC') AND THE COOPER LABORATORIES, INC. STOCKHOLDERS' LIQUIDATING TRUST (THE 'TRUST') ADMINISTRATIVE SERVICES Pursuant to separate agreements between the Company and CDC, CLS and the Trust, which was formed in connection with the liquidation of the Company's former parent, Cooper Laboratories, Inc., the Company provided certain administrative services to CDC, CLS and the Trust, including the services of the Company's treasury, legal, tax, data processing, corporate development, investor relations and accounting staff. Expenses are charged on the basis of specific utilization or allocated based on personnel, space, percent of assets used or other appropriate bases. The agreements relating to the provision of administrative services to CDC and CLS terminated on September 17, 1988. The Company has not performed any services for CDC and CLS since September 17, 1988, other than historic tax services pursuant to the Trust. Combined corporate administrative expenses charged to the Trust by the Company were $213,000 in 1992 and $560,000 in 1991. On July 9, 1992, the Trust filed a petition in Bankruptcy under Chapter 7 of the Bankruptcy Code; and, effective July 31, 1992, the Company ceased providing services to the Trust. The Company has asserted a claim for approximately $740,000 in the Trust's bankruptcy proceedings, primarily representing unpaid administrative service fees and expenses and legal fees advanced by the Company on behalf of the Trust. AGREEMENTS WITH CLS On October 21, 1988, the Company and CLS entered into a settlement agreement (the '1988 CLS Settlement Agreement') pursuant to which certain claims between the two corporations were settled. Among other things, the 1988 CLS Settlement Agreement provided that (a) the discovery period under the directors and officers liability insurance policy issued by the Company covering directors and officers of CLS would be extended pursuant to an option contained in the insurance policy (see 'Liability Insurance', below), (b) CLS would indemnify the Company for certain claims made by a former consultant to the Company (c) CLS would have no further liability to the Company with respect to the termination of the contract pursuant to which the Company had agreed to purchase ophthalmic THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) laser systems from CLS, (d) CLS would pay the Company $2,750,000 and (e) CLS, in its capacity as a holder of the SERPS, would consent to the Company's proposed sales of its CTI business and its Cooper Surgical business and to the proposed deletion of the mandatory redemption provision of the Senior Preferred Stock. The 1988 CLS Settlement Agreement did not allocate the $2,750,000 settlement amount among the various items contained therein. The $2,750,000 was paid in full by CLS in December 1988. On November 27, 1989, the Company and CLS entered into another separate settlement agreement (the '1989 CLS Settlement Agreement'). Pursuant to the 1989 CLS Settlement Agreement, among other things, the Company and CLS (i) entered into a mutual standstill arrangement precluding each party from acquiring each other's common stock and precluding CLS from acquiring additional shares of the SERPS, (ii) dismissed most of the outstanding litigations among the Company and CLS, (iii) reaffirmed the Company's obligation to register the SERPS, and (iv) obtained the consent of CLS, as a holder of outstanding SERPS, to any future sale of all or any portion of the Company's remaining contact lens business, subject to the receipt of a fairness opinion and following a 90-day period (since expired) in which the Company would negotiate the sale of the business exclusively with CLS and CDC. On June 12, 1992, the Company consummated a transaction with CLS, which eliminated approximately 80% of the SERPS (the '1992 CLS Transaction'). Pursuant to an Exchange Agreement between the Company and CLS dated as of June 12, 1992 (the '1992 Exchange Agreement'), the Company acquired from CLS 488,004 shares of SERPS owned by CLS, and all of CLS's right to receive, by way of dividends pursuant to the terms of SERPS, an additional 11,996 shares of SERPS (such 11,996 shares together with the 488,004 shares being referred to collectively as the 'Exchanged SERPS') in exchange for 4,850,000 newly issued shares of the Company common stock (the 'Company Shares'). In addition, the Company purchased 200,000 unregistered shares of CLS common stock (the 'CLS Shares'), for a purchase price of $1,500,000 in cash (carried at October 31, 1992, at cost in 'Other assets' of the Company's consolidated balance sheet) and entered into a settlement agreement with CLS dated as of June 12, 1992 (the '1992 CLS Settlement Agreement'), with respect to certain litigation and administrative proceedings in which the Company and CLS were involved. Pursuant to the 1992 Settlement Agreement, CLS, among other things, released its claim against the Company for unliquidated damages arising from the Company's failure to register the SERPS, in return for the Company's payment of $500,000, the reimbursement of certain legal fees and expenses in the amount of $650,000 incurred by CLS in connection with certain litigation and administrative proceedings, and the payment of $709,000 owed by the Company to CLS pursuant to tax sharing agreements between them. The Company also agreed to reimburse CLS for up to $250,000 of legal and other fees and expenses incurred by CLS in connection with the 1992 CLS Transaction and, if requested by CLS, to use its reasonable best efforts to cause the election to the Company's Board of Directors of one or two designees of CLS, reasonably acceptable to the Company (the number of designees depending, respectively, on whether CLS owns more than 1,000,000 but less than 2,400,000 shares, or more than 2,400,000 shares of the Company's common stock). As part of the 1992 CLS Transaction, pursuant to Registration Rights Agreements, dated as of June 12, 1992, each between the Company and CLS (the 'Registration Rights Agreements'), the Company and CLS each agreed to use its reasonable best efforts to register, respectively, the Company Shares and the CLS Shares. On July 27, 1992, the Company filed with the SEC a registration statement for the Company Shares which became effective November 20, 1992. If a registration statement covering the Company Shares had not been declared effective within 180 days following June 12, 1992, the Company had agreed to pay $1,250,000 in cash (an amount equal to the value of 'pay-in-kind' dividends it would have accrued on the Exchanged SERPS but for the exchange). CLS agreed that if CLS had not registered the CLS Shares within 17 months from the closing date, the Company could require CLS to repurchase the CLS Shares, at the Company's cost of $1,500,000, by either, at CLS's option, (a) payment of cash, (b) delivery of shares of Senior Preferred Stock, valued at $39 per share, or (c) delivery of THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) shares of the Company's common stock, valued at $3 per share The CLS Shares were delivered to CLS as part of 1993 CLS Settlement Agreement (as defined and described below). On June 14, 1993, the Company acquired from CLS, all of the remaining outstanding SERPS of the Company, having an aggregate liquidation preference of $16,060,000, together with all rights to any dividends or distributions thereon, in exchange for shares of Series B Preferred Stock having an aggregate liquidation preference of $3,450,000 and a par value of $.10 per share (the '1993 CLS Exchange Agreement'). Such shares, and any shares of Series B Preferred Stock issued as dividends, are convertible into one share of common stock of the Company for each $1.00 of liquidation preference, subject to customary antidilution adjustments. The Company also has the right to compel conversion of Series B Preferred Stock at any time after the market price of the common stock on its principal trading market averages at least $1.375 for 90 consecutive calendar days and closes at not less than $1.375 on at least 80% of the trading days during such period. CLS currently owns 4,850,000 shares of Common Stock, or approximately 16.2% of the outstanding common stock. Dividends will accrue on the Series B Preferred Stock commencing June 14, 1994, and will be payable quarterly in cash at the rate of 9% (of liquidation preference) per annum or, if the Company is restricted by applicable law or certain debt agreements from paying cash dividends, in additional shares of Series B Preferred Stock at the rate of 12% (of liquidation preference) per annum. The Series B Preferred Stock is redeemable, in whole or in part, at the option of the Company, at any time at a redemption price equal to its then applicable liquidation preference, plus accrued and unpaid dividends. The Company and CLS also entered into a Registration Rights Agreement, dated June 14, 1993, providing for the registration under the Securities Act of the shares of common stock issued upon such conversion of any of the Series B Preferred Stock and any of the 4,850,000 shares of common stock currently owned by CLS which have not been sold prior thereto. The Board of Directors amended the Rights Agreement dated as of October 29, 1987, between the Company and The First National Bank of Boston, as Rights Agent, so that CLS and its affiliates and associates would not be Acquiring Persons thereunder as a result of CLS's beneficial ownership of more than 20% of the outstanding Common Stock of the Company by reason of its ownership of Series B Preferred Stock or Common Stock issued upon conversion thereof. See Note 5. CLS obtained the 4,850,000 shares of Common Stock it currently owns pursuant to the 1992 CLS Exchange Agreement described above. In Amendment No. 1 to its Schedule 13D, filed with the SEC on November 12, 1992, CLS disclosed that 'in light of the recent public disclosures relating to the Company and the recent significant decline in the public trading price of the Common Stock, CLS is presently considering various courses of action which it may determine to be necessary or appropriate in order to maintain and restore the value of the Common Stock. Included among the actions which CLS is considering pursuing are the initiation of litigation against the Company and the replacement of management and at least a majority of the members of the Board of Directors of the Company.' On June 14, 1993, in order to resolve all disputes with CLS, the Company and CLS entered into a Settlement Agreement (the '1993 CLS Settlement Agreement'), pursuant to which CLS delivered a general release of claims against the Company, subject to exceptions for specified on-going contractual obligations, and agreed to certain restrictions on its voting and transfer of securities of the Company, in exchange for the Company's payment of $4,000,000 in cash and delivery of 200,000 shares of common stock of CLS owned by the Company and a general release of claims against CLS, subject to similar exceptions. The cash paid and fair value of CLS shares returned have been charged to the Company's statement of operations as settlement of disputes. See Note 7. Pursuant to the 1993 CLS Settlement Agreement, the Company agreed to nominate, and CLS agreed to vote all of its shares of common stock of the Company in favor of the election of, a Board of Directors of the Company consisting of eight members, up to three of whom will, at CLS's request, be THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) designated by CLS (such designees to be officers or more than 5% stockholders of CLS as of June 14, 1993 or otherwise be reasonably acceptable to the Company). The number of CLS designees will decline as CLS's ownership of common stock (including shares of common stock into which the shares of Series B Preferred Stock owned by CLS are or may become convertible) declines. A majority of the Board members (other than CLS designees) will be individuals who are not officers or employees of the Company. Pursuant to the 1993 CLS Settlement Agreement, CLS designated, and on August 10, 1993 the Board of Directors elected, one person to serve as a director of the Company until the 1993 Annual Meeting. CLS also designated that individual along with two other people as its three designees to the eight-member Board of Directors that was elected at the 1993 Annual Meeting. CLS also agreed in the 1993 Settlement Agreement not to acquire any additional securities of the Company (except shares of Series B Preferred Stock issued as dividends or common stock issued upon conversion, if any, of Series B Preferred Stock) and to certain limitations on its transfer of securities of the Company. In addition, CLS agreed, among other things, not to seek control of the Company or the Board or otherwise take any action contrary to the 1993 CLS Settlement Agreement. CLS is free, however, to vote all voting securities owned by it as it deems appropriate on any matter before the Company's stockholders. The agreements with respect to Board representation and voting, and the restrictions on CLS's acquisition and transfer of securities of the Company, will terminate on June 14, 1995, or earlier if CLS beneficially owns less than 1,000,000 shares of common stock (including as owned any common stock into which shares of Series B Preferred Stock owned by CLS are convertible). The agreements will be extended if the market price of the common stock increases to specified levels prior to each of June 12, 1995, and June 12, 1996, or the Company agrees to nominate one CLS designee, who is independent of CLS and reasonably acceptable to the Company, in addition to that number of designees to which CLS is then entitled on each such date, which could result in such agreements continuing through October 31, 1996, and CLS having up to five designees on the Board (which would then have a total of ten members, or eleven members if a new chairman or chief executive officer is then serving on the Board). Following termination of such agreements and through June 12, 2002, CLS will continue to have the contractual right that it had pursuant to the 1992 CLS Settlement Agreement to designate two directors of the Company, so long as CLS continues to own at least 2,400,000 shares of common stock, or one director, so long as it continues to own at least 1,000,000 shares of common stock. LIABILITY INSURANCE Prior to fiscal 1988, a subsidiary of the Company that is engaged in the insurance underwriting business issued a directors and officers liability policy to CLS and a former affiliate of the Company covering its directors and officers for certain liabilities. Each policy had a maximum aggregate coverage of $5,000,000. On September 2, 1988, the Company terminated the insurance policies. As described above, the discovery periods for claims under such policies were extended pursuant to the terms of such policies. The Company had pledged $7,750,000 of cash (included in restricted cash at October 31, 1991 in the Company's consolidated balance sheet) to collateralize the contingent obligation. On April 30, 1993, the civil action entitled Guenther v. Cooper Life Sciences, Inc. et. al. filed in 1988 was settled. With such settlement, the Company was released from any future potential director and officer liability relating to coverage under the aforementioned policies and, therefore, the restricted cash which collateralized contingent liabilities was released. For a further discussion of the action see Note 7 'Settlement of Disputes.' OTHER CLS was formerly an 89.5% owned subsidiary of the Company's former parent, Cooper Laboratories, Inc. ('Labs'). THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CLS filed Amendment No. 2 to its Schedule 13D stating that it owns and has sole voting and dispositive power with respect to 4,850,000 shares of the Company's common stock as of June 12, 1992. On June 14, 1993, CLS acquired 345 shares of Series B Preferred Stock which are convertible into 3,450,000 shares of common stock. In addition, the Company had been advised that, as of December 15, 1993, Moses Marx, the beneficial owner of approximately 22% of the outstanding stock of CLS, beneficially owned 1,126,000 shares (or approximately 3.7%) of the Company's common stock and $4,500,000 principal amount of Debentures, or approximately 11.4% of the aggregate principal amount thereof, and that United Equities Company ('United Equities'), a brokerage firm owned by Mr. Marx, held approximately $3,706,000 principal amount of Debentures or approximately 9.4% of the aggregate principal amount of Debentures outstanding, in its trading account. Mr. Marx and United Equities tendered all of their Debentures in the Exchange Offer and Solicitation (although not all of their Debentures were accepted due to proration), and the Company is not aware of Mr. Marx's or United Equities' current holdings of the Company's securities. NOTE 16. BUSINESS AND GEOGRAPHIC SEGMENT INFORMATION The Company's operations are attributable to four business segments: HGA (including PSG Management) which provides psychiatric healthcare services, and CooperVision, CooperVision Pharmaceuticals and CooperSurgical which develop, manufacture and market healthcare products. Total revenues by business segment represent service and sales revenue as reported in the Company's statement of consolidated operations. Total net sales revenue by geographic area include intercompany sales which are priced at terms that allow for a reasonable profit for the seller. Operating income (loss) is total revenue less cost of products sold, research and development expenses, selling, general and administrative expenses, costs of restructuring and amortization of intangible assets. Corporate operating loss is principally corporate headquarters expense. Investment income, net, settlement of disputes, debt restructuring costs, gain on sales of assets and businesses, net, other income (expense), net, and interest expense were not allocated to individual businesses and geographic segments. Identifiable assets are those assets used in continuing operations (exclusive of cash and cash equivalents) or which are allocated thereto when used jointly. Corporate assets are principally cash and cash equivalents, restricted cash and temporary investments. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Information by business segment for each of the years in the three year period ended October 31, 1993 follows: - ------------ (1) Results from May 29, 1992. (2) Includes $3,149,000 for two real estate investments made by Cooper Real Estate Group. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Information by geographic area for each of the years in the three year period ended October 31, 1993 follows: THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 17. QUARTERLY FINANCIAL DATA (UNAUDITED) - ------------ * The sum of income (loss) per common share for the four quarters is different from the full year net income (loss) per common share as a result of computing the quarterly and full year amounts on the weighted average number of common shares outstanding in the respective periods. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) - ------------ At December 31, 1993 and 1992 there were 4,550 and 4,902 common stockholders of record, respectively. ITEM 18. LEGAL PROCEEDINGS. The Company is a defendant in a number of legal actions relating to its past or present businesses in which plaintiffs are seeking damages. On November 10, 1992, the Company was charged in an indictment (the 'Indictment'), filed in the United States District Court for the Southern District of New York, with violating federal criminal laws relating to a 'trading scheme' by Gary A. Singer, a former Co-Chairman of the Company (who went on a leave of absence on May 28, 1992, begun at the Company's request, and who subsequently resigned on January 20, 1994), and others, including G. Albert Griggs, Jr., a former analyst with The Keystone Group, Inc., and John D. Collins II, to 'frontrun' high yield bond purchases by the Keystone Custodian Funds, Inc., a group of mutual funds. The Company was named as a defendant in 10 counts. Gary Singer was named as a defendant in 24 counts, including violations of the Racketeer Influenced and Corrupt Organizations Act and the mail and wire fraud statutes (including defrauding the Company by virtue of the 'trading scheme', by, among other things, transferring profits on trades of DR Holdings, Inc. 15.5% bonds (the 'DR Holdings Bonds') from the Company to members of his family during fiscal 1991), money laundering, conspiracy, and aiding and abetting violations of the Investment Advisers Act of 1940, as amended (the 'Investment Advisers Act'), by an investment advisor. On January 13, 1994, the Company was found guilty on six counts of mail fraud and one count of wire fraud based upon Mr. Singer's conduct, but acquitted of charges of conspiracy and aiding and abetting violations of the Investment Advisers Act. Mr. Singer was found guilty on 21 counts. One count THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) against Mr. Singer and the Company was dismissed at trial and two counts against Mr. Singer relating to forfeiture penalties were resolved by stipulation between the government and Mr. Singer. Sentencing is scheduled for March 25, 1994. The maximum penalty which could be imposed on the Company is the greater of (i) $500,000 per count, (ii) twice the gross gain derived from the offense or (iii) twice the gross loss suffered by the victim of the offense, and a $200 special assessment. In addition to the penalties described in (i), (ii) or (iii), the Court could order the Company to make restitution. The Company is considering its options, including filing an appeal of its conviction. Mr. Singer's attorney has advised the Company that Mr. Singer intends to appeal his conviction. Although the Company may be obligated under its Certificate of Incorporation to advance the costs of such appeal, the Company and Mr. Singer have agreed that Mr. Singer will not request such advances, but that he will reserve his rights to indemnification in the event of a successful appeal. Also on November 10, 1992, the SEC filed a civil Complaint for Permanent Injunction and Other Equitable Relief (the 'SEC Complaint') in the United States District Court for the Southern District of New York against the Company, Gary A. Singer, Steven G. Singer (the Company's Executive Vice President and Chief Operating Officer and Gary Singer's brother), and, as relief defendants, certain persons related to Gary and Steven Singer and certain entities in which they and/or those related persons have an interest. The SEC Complaint alleges that the Company and Gary and Steven Singer violated various provisions of the Securities Exchange Act of 1934, as amended (the 'Securities Exchange Act'), including certain of its antifraud and periodic reporting provisions, and aided and abetted violations of the Investment Company Act, and the Investment Advisors Act , in connection with the 'trading scheme' described in the preceding paragraphs. The SEC Complaint further alleges, among other things, federal securities law violations (i) by the Company and Gary Singer in connection with an alleged manipulation of the trading price of the Company's 10 5/8% Convertible Subordinated Reset Debentures due 2005 (the 'Debentures') to avoid an interest rate reset allegedly required on June 15, 1991 under the terms of the Indenture governing the Debentures, (ii) by Gary Singer in allegedly transferring profits on trades of high yield bonds (including those trades in the DR Holdings Bonds which were the subject of certain counts of the Indictment of which Mr. Singer was found guilty) from the Company to members of his family and failing to disclose such transactions to the Company and (iii) by the Company in failing to disclose publicly on a timely basis such transactions by Gary Singer. The SEC Complaint asks that the Company and Gary and Steven Singer be enjoined permanently from violating the antifraud, periodic reporting and other provisions of the federal securities laws, that they disgorge the amounts of the alleged profits received by them pursuant to the alleged frauds (stated in the SEC's Litigation Release No. 13432 announcing the filing of the SEC Complaint as being $1,296,406, $2,323,180 and $174,705, respectively), plus interest, and that they each pay appropriate civil monetary penalties. The SEC Complaint also seeks orders permanently prohibiting Gary and Steven Singer from serving as officers or directors of any public company and disgorgement from certain Singer family members and entities of amounts representing the alleged profits received by such defendants pursuant to the alleged frauds. In February 1993, the court granted a motion staying all proceedings in connection with this matter pending completion of the criminal case. On January 24, 1994, the Court lifted the stay and directed the defendants to file answers to the SEC Complaint within 30 days. The Company is currently involved in settlement negotiations with the SEC. At this time, there can be no assurance these negotiations will be successfully concluded. The imposition of monetary penalties upon the Company as a result of the criminal convictions or in connection with the matters alleged in the SEC Complaint, as well as the incurrence of any additional defense costs, could exacerbate, possibly materially, the Company's liquidity problems and its need to raise funds. Copies of the Indictment and the SEC Complaint were attached as exhibits to the Company's Current Report on Form 8-K, dated November 16, 1992, filed with the SEC. The Company is named as a nominal defendant in a shareholder derivative action entitled Harry Lewis and Gary Goldberg v. Gary A. Singer, Steven G. Singer, Arthur C. Bass, Joseph C. Feghali, Warren THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) J. Keegan, Robert S. Holcombe and Robert S. Weiss, which was filed on May 27, 1992 in the Court of Chancery, State of Delaware, New Castle County. On May 29, 1992, another plaintiff, Alfred Schecter, separately filed a derivative complaint in Delaware Chancery Court that was essentially identical to the Lewis and Goldberg complaint. Lewis and Goldberg later amended their complaint, and the Delaware Chancery Court thereafter consolidated the Lewis and Goldberg and Schecter actions as In re The Cooper Companies, Inc. Litigation, Consolidated C.A. 12584, and designated Lewis and Goldberg's amended complaint as the operative complaint (the 'First Amended Derivative Complaint'). The First Amended Derivative Complaint alleges that certain directors of the Company and Gary A. Singer, as Co-Chairman of the Board of Directors, caused or allowed the Company to be a party to the 'trading scheme' that was the subject of the Indictment. The First Amended Derivative Complaint also alleges that the defendants violated their fiduciary duties to the Company by not vigorously investigating the allegations of securities fraud. The First Amended Derivative Complaint requests that the Court order the defendants (other than the Company) to pay damages and expenses to the Company and certain of the defendants to disgorge their profits to the Company. On October 16, 1992, the defendants moved to dismiss the First Amended Derivative Complaint on grounds that such Complaint fails to comply with Delaware Chancery Court Rule 23.1 and that Count III of the First Amended Derivative Complaint fails to state a claim. The Company has been advised by the individual directors named as defendants that they believe they have meritorious defenses to this lawsuit and intend vigorously to defend against the allegations in the First Amended Derivative complaint. The Company was named as a nominal defendant in a purported shareholder derivative action entitled Bruce D. Sturman v. Gary A. Singer, Steven G. Singer, Brad C. Singer, Martin Singer, John D. Collins II, Back Bay Capital, Inc., G. Albert Griggs, Jr., John and Jane Does 1-10 and The Cooper Companies, Inc., which was filed on May 26, 1992 in the Supreme Court of the State of New York, County of New York. The plaintiff, Bruce D. Sturman, a former officer and director of the Company, alleged that Gary A. Singer, as Co-Chairman of the Board of Directors, and various members of the Singer family caused the Company to make improper payments to alleged third-party co-conspirators, Messrs. Griggs and Collins, as part of the 'trading scheme' that was the subject of the Indictment. The complaint requested that the Court order the defendants (other than the Company) to pay damages and expenses to the Company, including reimbursement of payments made by the Company to Messrs. Collins and Griggs, and to disgorge their profits to the Company. Pursuant to its decision and order, filed August 17, 1993, the Court dismissed this action under New York Civil Practice Rule 327(a). On September 22, 1993, the plaintiff filed a Notice of Appeal. The Company was named in an action entitled Bruce D. Sturman v. The Cooper Companies, Inc. and Does 1-100, Inclusive, first brought on July 24, 1992 in the Superior Court of the State of California, Los Angeles, County. Mr. Sturman alleged that his suspension from his position as Co-Chairman of the Board of Directors constituted, among other things, an anticipatory breach of his employment agreement. On May 14, 1993, Mr. Sturman filed a First Amended Complaint in the Superior Court of the State of California, County of Alameda, Eastern Division, the jurisdiction to which the original case had been transferred. In the Amended Complaint, Mr. Sturman alleged that by first suspending and then terminating him from his position as Co-Chairman, the Company breached his employment agreement, violated provisions of the California Labor Code, wrongfully terminated him in violation of public policy, breached its implied covenant of good faith and fair dealing, defamed him, invaded his privacy and intentionally inflicted emotional distress, and was otherwise fraudulent, deceitful and negligent. The Amended Complaint seeks declaratory relief, damages in the amount of $5,000, treble and punitive damages in an unspecified amount, and general, special and consequential damages in the amount of at least $5,000,000. In March 1993, the Court ordered a stay of all discovery in this action until further order of the Court and thereafter scheduled a conference for January 14, 1994 to review the status of the stay. The Court subsequently modified the stay to permit the taking of the deposition of one witness who will not be available to testify at trial. On September 24, 1993, Mr. Sturman filed a Second Amended Complaint, setting forth the same material allegations and seeking the same relief THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and damages as set forth in the First Amended Complaint. On January 7, 1994, the Company filed an Answer, generally denying all of the allegations in the Second Amended Complaint, and also filed a Cross-Complaint against Mr. Sturman. In the Cross-Complaint, the Company alleges that Mr. Sturman's conduct constituted a breach of his employment agreement with the Company as well as a breach of his fiduciary duty to the Company, that Mr. Sturman misrepresented and failed to disclose certain material facts to the Company and converted certain assets of the Company to his personal use and benefit. The Cross-Complaint seeks compensatory and punitive damages in an unspecified amount. On January 14, 1994, the Court continued in place the stay on all discovery and scheduled a case management conference for February 10, 1994 to review the status of the stay. Based on management's current knowledge of the facts and circumstances surrounding Mr. Sturman's termination, the Company believes that it has meritorious defenses to this lawsuit and intends to defend vigorously against the allegations in the Second Amended Complaint. In two virtually identical actions, Frank H. Cobb, Inc. v. The Cooper Companies, Inc., et al., and Arthur J. Korf v. The Cooper Companies, Inc., et al., class action complaints were filed in the United States District Court for the Southern District of New York in August 1989, against the Company and certain individuals who served as officers and/or directors of the Company after June 1987. In their Fourth Amended Complaint filed in September 1992, the plaintiffs allege that they are bringing the actions on their own behalf and as class actions on behalf of a class consisting of all persons who purchased or otherwise acquired shares of the Company's common stock during the period May 26, 1988 through February 13, 1989. The amended complaints seek an undetermined amount of compensatory damages jointly and severally against all defendants. The complaints, as amended, allege that the defendants knew or recklessly disregarded and failed to disclose to the investing public material adverse information about the Company. Defendants are accused of having allegedly failed to disclose, or delayed in disclosing, among other things: (a) that the allegedly real reason the Company announced on May 26, 1988 that it was dropping a proposed merger with Cooper Development Company, Inc. was because the Company's banks were opposed to the merger; (b) that the proposed sale of Cooper Technicon, Inc., a former subsidiary of the Company, was not pursuant to a definitive sales agreement but merely an option; (c) that such option required the approval of the Company's debentureholders and preferred stockholders; (d) that the approval of such sale by the Company's debentureholders and preferred stockholders would not have been forthcoming absent extraordinary expenditures by the Company; and (e) that the purchase agreement between the Company and Miles, Inc. for the sale of Cooper Technicon, Inc. included substantial penalties to be paid by the Company if the sale was not consummated within certain time limits and that the sale could not be consummated within those time limits. The amended complaints further allege that the defendants are liable for having violated Section 10(b) of the Securities Exchange Act and Rule 10(b)-5 thereunder and having engaged in common law fraud. Based on management's current knowledge of the facts and circumstances surrounding the events alleged by plaintiffs as giving rise to their claims, the Company believes that it has meritorious defenses to these lawsuits and intends vigorously to defend against the allegations in the amended complaints. The parties have engaged in preliminary settlement negotiations; however, there can be no assurances that these discussions will be successfully concluded. On September 2, 1993, a patent infringement complaint was filed against the Company in the United States District Court for the District of Nevada captioned Steven P. Shearing v. The Cooper Companies, Inc. On or about that same day, the plaintiff filed twelve additional complaints, accusing at least fourteen other defendants of infringing the same patent. The patent in these suits covers a specific method of implanting an intraocular lens into the eye. Until February 1989, the Company manufactured intraocular lenses and ophthalmic instruments, but did not engage in the implantation of such lenses. Subsequent to February 1989, the Company was not involved in the manufacture, marketing or sale of intraocular lenses. The Company denies the material allegations of Shearing's complaint and will vigorously defend itself. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company is a defendant in more than 2,600 breast implant lawsuits pending in federal district courts and state courts, some of which purport to be class actions, relating to the mammary prosthesis (breast implant) business of its former wholly-owned subsidiaries, Aesthetech Corporation ('Aesthetech'), the manufacturer, and Natural Y Surgical Specialities, Inc. ('Natural Y'), the distributor, of polyurethane foam covered, silicone gel-filled breast implants, which subsidiaries were sold to Medical Engineering Corporation ('MEC'), a wholly-owned subsidiary of Bristol-Myers Squibb Company ('BMS') on December 14, 1988. The plaintiffs in the breast implant lawsuits generally claim to have been injured by breast implants allegedly manufactured and/or sold by Aesthetech, Natural Y or MEC. The ailments typically alleged include autoimmune disorders, scleroderma, chronic fatigue syndrome and vascular and neurological complications, as well as, in some cases, a fear of cancer. A small percentage of lawsuits allege that plaintiffs are suffering from cancer, allegedly caused by the component parts of the implants, including the alleged breakdown of polyurethane foam used to cover the implants. In most cases, other defendants are named in addition to the Company, Aesthetech, Natural Y, MEC and BMS, including, in many cases, implanting surgeons and the suppliers of the silicone and polyurethane products used in the manufacture of the breast implants. On October 29, 1992, the Delaware Chancery Court in Medical Engineering Corporation and Bristol-Myers Squibb Company v. The Cooper Companies, Inc. ruled that, as between BMS and MEC, on the one hand, and the Company, on the other, the Company is responsible for product liability claims and obligations relating to breast implants sold by Natural Y before December 14, 1988, irrespective of when the claims are brought. On September 28, 1993, the Company announced that it had entered into an agreement with MEC (the 'MEC Agreement') settling this litigation between the Company and BMS and MEC. Pursuant to the MEC Agreement, MEC has agreed, subject to limited exceptions, to take responsibility for all legal fees and other costs, and to pay all judgments and settlements, resulting from all pending and future claims in respect of breast implants sold by Aesthetech and Natural Y prior to their acquisition by MEC (including the above-mentioned lawsuits), and the Company has withdrawn its appeal of the Delaware Chancery Court decision and agreed, among other things, to make certain payments to MEC. Pursuant to the terms of the MEC Agreement, MEC could have terminated the agreement if the Exchange Offer and Solicitation relating to its Debentures (or an alternative restructuring of the Debentures or other amendment, forebearance or waiver with respect to the Debentures) was not completed on terms satisfactory to the Company by February 1, 1994. The Exchange Offer and Solicitation was completed on January 6, 1994. See Notes 14 and 19. The Company was named as a defendant in a civil action entitled Site Microsurgical Systems v. The Cooper Companies, Inc. filed in the United States District Court of Delaware on November 13, 1990. The plaintiff alleged that the Company infringed one of its U.S. patents through sales by the CooperVision Surgical Division ('CVS') of certain cassettes and systems utilizing such cassettes prior to the sale of CVS in February, 1989. The Company denied the plaintiff's allegations and counterclaimed for a Declaratory Judgment of non-infringement and invalidity of the plaintiff's patent-in-suit. This lawsuit was settled in October 1993. Pursuant to the settlement, the Company made a cash payment to the plaintiff and the parties terminated a generic ophthalmic pharmaceutical supply agreement. NOTE 19. SUBSEQUENT EVENT On January 6, 1994, the Company consummated the Exchange Offer and Solicitation in which it issued approximately $22,000,000 of 10% Senior Subordinated Secured Notes due 2003 (the 'Notes') and paid approximately $4,350,000 in cash ($725 principal amount of Notes and $145 in cash for each $1,000 principal amount of Debentures) in exchange for approximately $30,000,000 aggregate principal amount of Debentures (out of $39,384,000 aggregate principal amount then outstanding). The Company also obtained, pursuant to the Exchange Offer and Solicitation, consents of the holders of Debentures THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) to (i) certain proposed amendments to the Indenture and (ii) the Waiver. See Note 11. Following the exchange, approximately $9,400,000 aggregate principal amount of Debentures remain outstanding. On January 6, 1994, after receiving consents from holders of a majority of the outstanding principal amount of Debentures not owned by the Company or its affiliates, the Waiver was effected and the Company and the Trustee under the Indenture executed the Second Supplemental Indenture effecting the proposed amendments, which eliminated or modified various covenants in the Indenture. The consummation of the Exchange Offer and Solicitation also satisfied a condition of the MEC Agreement, described in Note 18, limiting the Company's liability with respect to breast implant litigation. The Notes bear interest from September 1, 1993 at a rate equal to 10% per annum. (Interest accrued from September 1, 1993 will not be paid on Debentures tendered and accepted pursuant to the Exchange Offer and Solicitation.) Interest on the Notes is payable quarterly on each March 1, June 1, September 1 and December 1, commencing March 1, 1994. The Notes are redeemable solely at the option of the Company, in whole or in part, at any time, at a redemption price equal to 100% of their principal amount, together with accrued and unpaid interest thereon to the redemption date. The Company will not be required to effect any mandatory redemptions or make any sinking fund payments with respect to the Notes, except in connection with certain sales or other dispositions of, or certain financings secured by, the collateral securing the Notes. Pursuant to a pledge agreement dated as of January 6, 1994, between the Company and the trustee for the holders of the Notes, the Company has pledged a first priority security interest in all of its right, title and interest in stock of HGA and CooperSurgical, all additional shares of stock of, or other equity interests in HGA and CooperSurgical from time to time acquired by the Company, all intercompany indebtedness of HGA and CooperSurgical from time to time held by the Company and, except as set forth in the indenture governing the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture governing the Notes is included in the Company's Amended and Restated Offer to Exchange and Consent Solicitation filed with SEC on December 15, 1993. The Exchange Offer and Solicitation has been accounted for in accordance with Statement of Financial Accounting Standards No. 15 'Accounting by Debtors and Creditors for Troubled Debt Restructurings.' Consequently, the difference between the carrying value of the Debentures exchanged less the face value of the Notes issued and the aggregate cash payment for the Debentures is recorded as a deferred premium. The Company will recognize the benefit of the deferred premium prospectively as a reduction to the effective interest rate on the Notes over the life of the issue. In addition, the Company recorded a charge of $2,131,000 in 1993 for the estimated debt restructuring costs related to the Exchange Offer and Solicitation. SCHEDULE II THE COOPER COMPANIES, INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED OCTOBER 31, 1993 All outstanding loans are due on demand under certain conditions. The following footnotes address original loan amounts and do not reflect interest accrued or collected. - ------------ (A) Represents a 9% term loan of $900,000 granted pursuant to an employment agreement dated October 31, 1989, secured by a lien on real estate. (B) Represents a 9.5% temporary housing loan of $200,000 secured by a lien on real estate. SCHEDULE V THE COOPER COMPANIES, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT THREE YEARS ENDED OCTOBER 31, 1993 - ------------ (A) Represents reclassification of an addition in 1992. (B) Represents acquired assets of CoastVision, Inc. and other items. (C) Represents write-off of leaseholds upon relocation of executive office. (D) Represents acquired assets of Hospital Group of America, Inc. (E) Represents write-off of machinery and equipment resulting from a fire. (F) Represents acquired assets of Euro-Med, Inc. and other items. SCHEDULE VI THE COOPER COMPANIES, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT THREE YEARS ENDED OCTOBER 31, 1993 - ------------ (A) Represents write-off of leaseholds upon relocation of executive office. (B) Represents write-off of machinery and equipment resulting from a fire. SCHEDULE VIII THE COOPER COMPANIES, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED OCTOBER 31, 1993 - ------------ (A) Represents acquired reserve of CoastVision, Inc. (B) Represents acquired reserve of Hospital Group of America, Inc. (C) Uncollectible accounts written off, recovered accounts receivable previously written off and other items. (D) Recorded in Stockholders' Equity. SCHEDULE X THE COOPER COMPANIES, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED OCTOBER 31, 1993 Royalties, maintenance and repairs and taxes other than payroll and income taxes are omitted as each item does not exceed 1% of net operating revenue as reported in the Statement of Consolidated Operations. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as part of this report: 1. Financial Statements of the Company. The Consolidated Financial Statements and the Notes thereto, the Financial Statement Schedules identified in (2) below and the Accountants' Report on the foregoing are included in Part II, Item 8 of this report. 2. Financial Statement Schedules of the Company. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable and, therefore, have been omitted. Also included herein are separate company Financial Statements and the Notes thereto, the Accountants' Report thereon and required Financial Statement Schedules of: Hospital Group of America, Inc. and Subsidiaries CooperSurgical, Inc. INDEPENDENT AUDITORS' REPORT Board of Directors HOSPITAL GROUP OF AMERICA, INC.: We have audited the accompanying consolidated balance sheets of Hospital Group of America, Inc. and subsidiaries as of October 31, 1993, October 31, 1992, May 29, 1992 and April 30, 1991 and the related consolidated statements of operations, stockholder's equity and cash flows for the year ended October 31, 1993, for the period from May 30, 1992 to October 31, 1992, for the period from June 1, 1991 to May 29, 1992, for the period from May 1, 1991 to May 31, 1991 and for the year ended April 30, 1991. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules V, VI, VIII and X. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hospital Group of America, Inc. and subsidiaries at October 31, 1993, October 31, 1992, May 29, 1992 and April 30, 1991 and the results of their operations and their cash flows for the year ended October 31, 1993, for the period from May 30, 1992 to October 31, 1992, for the period from June 1, 1991 to May 29, 1992, for the period from May 1, 1991 to May 31, 1991, and for the year ended April 30, 1991 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. The accompanying financial statements have been prepared assuming Hospital Group of America, Inc. will continue as a going concern. As discussed in Note H to the consolidated financial statements, the Company's losses, negative cash flows, working capital deficiency, and dependence upon the Parent raise substantial doubt about the Company's ability to continue as a going concern. Additionally, the independent auditors' report dated January 24, 1994 on the Parent's financial statements as of October 31, 1993 includes an explanatory paragraph describing a substantial doubt about the Parent's ability to continue as a going concern. The accompanying financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties. KPMG PEAT MARWICK Philadelphia, Pennsylvania January 24, 1994 HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) CONSOLIDATED BALANCE SHEETS OCTOBER 31, 1993 AND 1992 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) CONSOLIDATED STATEMENTS OF OPERATIONS YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) CONSOLIDATED STATEMENTS OF CASH FLOWS YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting -- On May 29, 1992, The Cooper Companies, Inc. ('Cooper' or 'Parent') acquired all of the common stock of Hospital Group of America, Inc. (HGA) from its ultimate parent, Nu-Med, Inc. (Nu-Med). The acquisition of HGA was accounted for as a purchase and the purchase adjustments were 'pushed-down' to the separate financial statements of HGA resulting in a new basis of accounting as of May 30, 1992. The Parent's cost of the acquisition was approximately $50 million, including the assumption of approximately $22 million of third-party debt of HGA. The purchase price was allocated to assets and liabilities based on their estimated fair values as of the acquisition date. The purchase price exceeded the estimated fair value of the identifiable net assets acquired resulting in goodwill. The estimated goodwill amount of $6,155,000 was recorded as of May 30, 1992 and is being amortized over 30 years on a straight-line basis. Business -- The accompanying consolidated financial statements include the accounts of HGA and its wholly owned subsidiaries (the 'Company'). All intercompany balances and transactions have been eliminated. The Company owns and operates the following psychiatric facilities: Effective May 30, 1992, PSG Management, Inc. (PSG), a sister company to HGA and a wholly-owned subsidiary of Cooper, entered into a three year agreement with the following subsidiaries to manage the two psychiatric hospitals and the substance abuse treatment center owned by the subsidiaries of Nu-Med, Inc. The management fee earned by PSG from the subsidiaries of Nu-Med, Inc. related to this agreement is $2,000,000 annually, payable in equal monthly installments. The management agreement is jointly and severally guaranteed by Nu-Med and a wholly owned subsidiary of Nu-Med, Inc. HGA is not a party to this agreement and therefore the management fee earned by PSG from the subsidiaries of Nu-Med, Inc. is not recognized in the accompanying financial statements. However, in connection with this agreement, HGA performs services on behalf of PSG for which it earns a fee of 25% of certain of its corporate headquarters' cost plus a 20% mark-up. Such fees earned by HGA from PSG amounted to $691,000 for the year ended October 31, 1993 and $260,000 for the period from May 30, 1992 to October 31, 1992. On January 6, 1993, Nu-Med (but not any of its direct or indirect subsidiaries) filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code. Neither Cooper nor any of its subsidiaries filed a Proof of Claim in the Nu-Med Chapter 11 proceeding, and the bar date (the time for filing proofs of claim) has past. However, none of the Nu-Med subsidiaries have filed under Chapter 11, and the Nu-Med subsidiaries have paid the management fee on a timely basis, although representatives of Nu-Med and its subsidiaries have alleged in writing that PSG Management has breached the management services agreement (which contention PSG Management vigorously disputes). Moreover, Nu-Med's Proposed Disclosure Statement to accompany its Second Amended Plan of Reorganization, filed with the United States Bankruptcy Court for the Central District of California, indicates that PsychGroup is commencing, performance of certain administrative functions performed by PSG Management on a parallel basis. The following are subsidiaries of Nu-Med which own the facilities managed by PSG: HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 Net Patient Service Revenue -- Net patient service revenue is recorded at the estimated net realizable amounts from patients, third-party payors, and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. Retroactive adjustments are accrued on an estimated basis in the period the related services are rendered and adjusted in the period as final settlements are determined. Charity Care -- The Company provides care to indigent patients who meet certain criteria under its charity care policy without charge or at amounts less than its established rates. Because the Company does not pursue collection of amounts determined to qualify as charity care, they are not reported as revenue. The Company maintains records to identify and monitor the level of charity care it provides. These records include the amount of charges foregone for services and supplies furnished under its charity care policy. Charges at the Company's established rates forgone for charity care provided by the Company amounted to $3,220,000 during the year ended October 31, 1993 and $1,597,000 during the period May 30, 1992 to October 31, 1992. Hampton Hospital is required by its Certificate of Need to incur not less than 10% of total patient days as free care. Health Insurance Coverage -- The Company is self-insured for the health insurance coverage offered to its employees. The provision for estimated self-insured health insurance costs includes management's estimates of the ultimate costs for both reported claims and claims incurred but not reported. Supplies -- Supplies consist principally of medical supplies and are stated at the lower of cost (first-in, first-out method) or market. Property and Equipment -- Property and equipment are stated at fair value as of May 29, 1992, the date of the acquisition of HGA by Cooper. Depreciation is computed on the straight-line method over the estimated useful lives of the respective assets, which range from 20 to 40 years for buildings and improvements, and 5 to 10 years for equipment, furniture and fixtures. Other Assets -- Loan fees incurred in obtaining long-term financing are deferred and recorded as other assets. Loan fees are amortized over the terms of the related loans. The balance of unamortized loan fees amounted to $540,000 and $727,000, respectively, at October 31, 1993 and 1992. Income Taxes -- The Company is included in the consolidated tax returns of Cooper. The Company computes a tax provision as if it were a stand alone entity. Cash and Cash Equivalents -- Cash and cash equivalents include investments in highly liquid debt instruments with a maturity of three months or less. B. NET PATIENT SERVICE REVENUE The Company has agreements with third-party payors that provide for payments to the Company at amounts different from its established rates. A summary of the payment arrangements with major third-party payors follows: Commercial Insurance -- Most commercial insurance carriers reimburse the Company on the basis of the hospitals' charges, subject to the rates and limits specified in their policies. Patients covered by commercial insurance generally remain responsible for any differences between insurance proceeds and total charges. Blue Cross -- Reimbursement under Blue Cross plans varies depending on the areas in which the Company presently operates facilities. Benefits paid to the Company can be charge-based, cost-based, negotiated per diem rates or approved through a state rate setting process. Medicare -- Services rendered to Medicare program beneficiaries are reimbursed under a retrospectively determined reasonable cost system with final settlement determined after HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 submission of annual cost reports by the Company and audits thereof by the Medicare fiscal intermediary. Managed Care -- Services rendered to subscribers of health maintenance organizations, preferred provider organizations and similar organizations are reimbursed based on prospective negotiated rates. The Company's business activities are primarily with large insurance companies and federal and state agencies or their intermediaries. Other than adjustments arising from audits by certain of these agencies, the risk of loss arising from the failure of these entities to perform according to the terms of their respective contracts is considered remote. During the period ended October 31, 1992, the Company received and recognized as net patient service revenue, approximately $465,000 related to the settlement of prior year cost reports. C. RELATED PARTY TRANSACTIONS The current portion of Due to Parent at October 31, 1993 consists of amounts due under a demand note ('Demand Note') for costs incurred or paid by the Parent in connection with the acquisition, cash advances from the Parent, interest payable on the Subordinated Promissory Note (as defined below) in the amount of $2,680,000, and an allocation of Cooper corporate services amounting to $623,000, net of payments to the Parent. All current and future borrowings under the terms of the Demand Note bear interest, payable monthly, commencing on December 1, 1993 at the rate of 15% per annum (17% in the event principal and interest is not paid when due), and all principal and all accrued and unpaid interest under the Demand Note shall be completely due and payable on demand. Prior to December 1, 1993, the Parent did not charge the Company for amounts due to it except for amounts due under the Subordinated Promissory Note. The non-current portion of Due to Parent consists of a $16,000,000 subordinated promissory note (the 'Subordinated Promissory Note'). The annual interest rate on the Subordinated Promissory Note is 12%. The principal amount of this Subordinated Promissory Note shall be due and payable on May 29, 2002 unless payable sooner pursuant to its terms. HGA allocates interest expense to PSG to reflect an estimate of the interest cost on debt incurred by HGA in connection with the May 29, 1992 acquisition which relates to the PSG management agreement with Nu-Med. Such allocations amounted to $194,000 and 106,000 for the year ended October 31, 1993 and the period from May 30, 1992 to October 31, 1992, respectively and are recorded as reductions of interest on long-term debt and interest on due to Parent note. D. EMPLOYEE BENEFITS The Company participates in Cooper's 401(k) plan (the 'Plan'), which covers substantially all full-time employees with more than 60 days of service. The Company matches employee contributions up to certain limits. These costs were $40,000 for the year ended October 31, 1993 and $26,000 for the period from May 30, 1992 to October 31, 1992. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 E. LONG TERM DEBT Long-term debt at October 31, 1993 and 1992 consists of the following: Annual maturities of long-term debt are as follows: The long-term debt agreements contain several covenants, including the maintenance of certain ratios and levels of net worth (as defined), restrictions with respect to the payments of cash dividends on common stock and on the levels of capital expenditures, interest and debt payments. In addition, the Industrial Revenue Bonds give the holders the right to accelerate all outstanding principal at December 31, 1995 upon notification one year prior to that date. Substantially all of the property and equipment and accounts receivable of the Company collateralize the debt outstanding. F. COMMITMENTS AND CONTINGENCIES In the normal course of business, the Company is involved in various litigation cases. In the opinion of management, the disposition of such litigation will not have a material adverse effect on the Company's consolidated financial position. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 The Company leases certain space and equipment under operating lease agreements. The following is a schedule of estimated minimum payments due under such leases with an initial term of more than one year as of October 31, 1993: Some of the operating leases contain provisions for renewal or increased rental (based upon increases in the Consumer Price Index), none of which are taken into account in the above table. Rental expense under all operating leases amounted to $736,000 and $340,000, respectively, for the year ended October 31, 1993, and the period from May 30, 1992 to October 31, 1992. G. INCOME TAXES The Company is included in the consolidated tax returns of Cooper. The Company and Cooper have incurred operating losses and accordingly the Company has not recognized any income tax benefit in the accompanying financial statements. In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes.' Cooper and the Company are required to adopt the new method of accounting for income taxes no later than the fiscal year ending October 31, 1994. Neither the Company nor Cooper has completed an analysis to estimate the impact of the statement on the Company's consolidated financial statements. H. DEPENDENCE UPON COOPER The Company has incurred losses and negative cash flows since May 30, 1992, and has a working capital deficiency at October 31, 1993 which includes a liability to the Parent of $6,082,000. The Parent has provided the Company with cash advances to meet its cash needs. The independent auditors' report dated January 24, 1994 on the Parent's October 31, 1993 consolidated financial statements includes the following explanatory paragraph: The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. During the past three fiscal years, the Company has suffered significant losses and negative cash flows. In addition, as discussed in Note 18 to the financial statements the Company is exposed to contingent liabilities related to a criminal conviction and a Securities and Exchange Commission action. Such losses, negative cash flows, and contingent liabilities raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties. The Company is unable to predict the effect, if any, of the uncertainty concerning the Parent's ability to continue as a going concern on its financial condition or results of operations. The aforementioned factors raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if the Company or its Parent is unable to continue as a going concern. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 I. Subsequent Event Pursuant to a pledge agreement dated as of January 6, 1994, between the Parent and the trustee for the holders of a new class of debt issued by the Parent (the 'Notes'), the Parent has pledged a first priority security interest in all of its right, title and interest in stock of the Company, all additional shares of stock of, or other equity interest in, the Company from time to time acquired by the Parent, all intercompany indebtedness of the Company from time to time held by the Parent and except as set forth in the indenture governing the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture governing the Notes is included in the Parent's Amended and Restated Offer to Exchange and Consent Solicitation filed with the Securities and Exchange Commission on December 15, 1993. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET MAY 29, 1992 (IN THOUSANDS OF DOLLARS) See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 (IN THOUSANDS OF DOLLARS) See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY PERIOD FROM MAY 1, 1991 TO MAY 31 1991 AND JUNE 1, 1991 TO MAY 29, 1992 (IN THOUSANDS OF DOLLARS) See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 (IN THOUSANDS OF DOLLARS) See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS The accompanying consolidated financial statements include the accounts of Hospital Group of America (HGA) and its wholly owned subsidiaries (the 'Company') and certain other assets and operations owned by an entity affiliated through common ownership. HGA was a wholly owned subsidiary of PsychGroup, Inc. which in turn is wholly owned by Nu-Med, Inc. The financial position and results of operations of Hospital Group of America and its subsidiaries may not necessarily be indicative of conditions that may have existed or the results of operations if the Company had been operated as an unaffiliated entity. All intercompany balances and transactions have been eliminated. The Company owns and operates the following psychiatric facilities: BASIS OF PRESENTATION On May 29, 1992, PSG Acquisition, Inc., a wholly owned subsidiary of The Cooper Companies, Inc. ('Cooper'), acquired all of the issued and outstanding capital stock of HGA from PsychGroup, Inc. Concurrent with the acquisition, all due from related parties balances as of May 29, 1992 were forgiven. The accompanying financial statements represent the financial position and results of operations of the Company as of May 29, 1992 immediately prior to the acquisition and the periods from May 1, 1991 to May 31, 1991 and June 1, 1991 to May 29, 1992 just prior to the acquisition and reflect the elimination of the due from related parties balances as of May 29, 1992 with a corresponding charge to retained earnings in the amount of $20,595,000. NET PATIENT SERVICE REVENUE Net patient service revenue is recorded at the estimated net realizable amounts from patients, third-party payors, and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. Retroactive adjustments are accrued on an estimated basis in the period the related services are rendered and adjusted in the period as final settlements are determined. CHARITY CARE The Company provides care to indigent patient who meet certain criteria under its charity care policy without charge or at amounts less than its established rates. Because the Company does not pursue collection of amount determined to qualify as charity care, they are not reported as revenue. The HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 Company maintains records to identify and monitor the level of charity care it provides. These records include the amount of charges foregone for services and supplies furnished under its charity care policy. Charges at the Company's established rates foregone for charity care provided by the Company amounted to $326,000 during the month of May 1991 and $4,768,000 for the period from June 1, 1991 to May 29, 1992. Hampton Hospital is required by its Certificate of Need to incur not less than 10% of total patient days as free care. HEALTH INSURANCE COVERAGE Effective October 1, 1991, the Company is self-insured for the health insurance coverage offered to its employees. The provision for estimated self-insured health insurance costs includes management's estimates of the ultimate costs for both reported claims and claims incurred but not reported. SUPPLIES Supplies consist principally of medical supplies and are stated at the lower of cost (first-in, first-out method) or market. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Depreciation is computed on the straight-line method over the estimated useful lives of the respective assets, which range from 20 to 40 years for buildings and improvements, and 5 to 10 years for equipment, furniture and fixtures. OTHER ASSETS Pre-opening costs incurred in new facilities and loan fees incurred in obtaining long-term financing are deferred and recorded as other assets. Pre-opening costs are amortized on a straight-line basis over five years. The unamortized portion of pre-opening costs was $21,000 at May 29, 1992. Loan fees are amortized over the terms of the related loans. The balance of unamortized loan fees amounted to $802,000 at May 29, 1992. INCOME TAXES The Company was included in the consolidated tax returns of Nu-Med. The Company computes a tax provision as if it were a stand-alone entity. The corresponding liability for such taxes is included in the net amount Due from Related Parties. CASH AND CASH EQUIVALENTS Cash and cash equivalents include investments in highly liquid debt instruments with a maturity of three months or less. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 B. NET PATIENT SERVICE REVENUE The Company has agreements with third-party payors that provide for payments to the Company at amounts different from its established rates. A summary of the payment arrangements with major third-party payors follows: Commercial Insurance -- Most commercial insurance carriers reimburse the Company on the basis of the hospitals' charges, subject to the rates and limits specified in their policies. Patients covered by commercial insurance generally remain responsible for any differences between insurance proceeds and total charges. Blue Cross -- Reimbursement under Blue Cross plans varies depending on the areas in which the Company presently operates facilities. Benefits paid to the Company can be charge-based, cost-based, negotiated per diem rates or approved through a state rate setting process. Medicare -- Services rendered to Medicare program beneficiaries are reimbursed under a retrospectively determined reasonable cost system with final settlement determined after submission of annual cost reports by the Company and audits thereof by the Medicare fiscal intermediary. Managed Care -- Services rendered to subscribers of health maintenance organizations, preferred provider organizations and similar organizations are reimbursed based on prospective negotiated rates. The Company's business activities are primarily with large insurance companies and federal and state agencies or their intermediaries. Other than adjustments arising from audits by certain of these agencies, the risk of loss arising from the failure of these entities to perform according to the terms of their respective contracts is considered remote. C. RELATED PARTY TRANSACTIONS Due from related parties consisted primarily of cash advances to Nu-Med and income tax obligations. Included in the Other Operating Revenue are management fees of $320,000 for the month of May 1991 and $3,557,000 for the period from June 1, 1991 to May 29, 1992 charged to other affiliated entities which are under common ownership. In connection with the acquisition of HGA, all due from related parties balances as of May 29, 1992 were forgiven and the balance of $20,595,000 as of that date was eliminated with a corresponding charge to retained earnings. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 D. EMPLOYEE BENEFITS The Company participated in the Nu-Med Combined Savings Plan, (the 'Plan'), which covers substantially all full-time employees with more than one year of service. Nu-Med may make annual contributions to the Plan based upon earnings, which the Plan may utilize to acquire Nu-Med common stock. In addition, Nu-Med may make contributions to the Plan in the form of Nu-Med common stock. No such contributions were made during the periods ended May 31, 1991 and May 29, 1992. The Company does not provide post-retirement benefits to its employees. Hartgrove had a defined benefit pension plan, which was terminated during the period ended May 29, 1992, at which time all benefits became fully vested. The excess of plan assets over vested benefits amounted to approximately $94,000. Such amount has been recorded as other operating revenue in the accompanying statement of earnings. E. LONG TERM DEBT Long-term debt at May 29, 1992 consists of the following: HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 Annual maturities of long-term debt are as follows: The long-term debt agreements contain several covenants, including the maintenance of certain ratios and levels of net worth (as defined), restrictions with respect to the payments of cash dividends on common stock and on the levels of capital expenditures, interest and debt payments. In addition, the Industrial Revenue Bonds give the holders the right to accelerate all outstanding principal at December 31, 1995 upon notification one year prior to that date. Substantially all of the property and equipment and accounts receivable of the Company collateralize the debt outstanding. F. COMMITMENTS AND CONTINGENCIES In the normal course of business, the Company is involved in various litigation cases. In the opinion of management, the disposition of such litigation will not have a material adverse effect on the Company's consolidated financial position. The Company leases certain space and equipment under operating lease agreements. The following is a schedule of estimated minimum payments due under such leases with an initial term of more than one year as of May 29, 1992: Some of the operating leases contain provisions for renewal or increased rental (based upon increases in the Consumer Price Index), none of which are taken into account in the above table. Rental expense under all operating leases amounted to $37,000 and HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 $619,000 for the periods from May 1, 1991 to May 31, 1991 and June 1, 1991 to May 29, 1992. G. INCOME TAXES The provision for income taxes for the following periods are composed of the following: The provision for income taxes included in the consolidated statements of earnings differs from the amount computed by applying the statutory federal income tax rate of 34% to earnings before taxes due to the effect of the state franchise taxes, net of federal benefit. This amounted to 6% for the periods presented. In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes.' Cooper and the Company are required to adopt the new method of accounting for income taxes no later than the fiscal year ending October 31, 1994. Neither the Company nor Cooper has completed an analysis to estimate the impact of the statement on the Company's consolidated financial statements. H. DEPENDENCE UPON COOPER The Company has incurred losses and negative cash flows since May 30, 1992, and has a working capital deficiency at October 31, 1993 which includes a liability to Cooper of $6,082,000. Cooper has provided the Company with cash advances to meet its cash needs. The independent auditors, report dated January 24, 1994 on Cooper's October 31, 1993 consolidated financial statements includes the following explanatory paragraph: 'The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. During the past three fiscal years, the Company has suffered significant losses and negative cash flows. In addition, as discussed in Note 18 to the financial statements the Company is exposed to contingent liabilities relatated to a criminal conviction and a Securities and Exchange Commission action. Such losses, negative cash flows and contingent liabilities raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties.' HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 The Company is unable to predict the effect, if any, of the uncertainty concerning Cooper's ability to continue as a going concern on its financial condition or results of operations. The aforementioned factors raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if the Company or Cooper is unable to continue as a going concern. I. Subsequent Event Pursuant to a pledge agreement dated as of January 6, 1994, between the Parent and the trustee for the holders of a new class of debt issued by the Parent (the 'Notes'), the Parent has pledged a first priority security interest in all of its right, title and interest in stock of the Company, all additional shares of stock of, or other equity interest in, the Company from time to time acquired by the Parent, all intercompany indebtedness of the Company from time to time held by the Parent and except as set forth in the indenture to the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture to the Notes is included in the Parent's Amended and Restated Offer to Exchange and Consent Solicitation filed with the Securities and Exchange Commission on December 15, 1993. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET APRIL 30, 1991 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS YEAR ENDED APRIL 30, 1991 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY YEAR ENDED APRIL 30, 1991 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS YEAR ENDED APRIL 30, 1991 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED APRIL 30, 1991 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Business -- The accompanying consolidated financial statements include the accounts of Hospital Group of America, Inc., (HGA) and its wholly owned subsidiaries (the 'Company') and certain other assets and operations owned by an entity affiliated through common ownership. HGA was a wholly owned subsidiary of PsychGroup, Inc. which in turn is wholly-owned by Nu-Med, Inc. ('Nu-Med'). The financial position and results of operations of HGA and its subsidiaries may not necessarily be indicative of conditions that may have existed or the results of operations if the Company had been operated as an unaffiliated entity. All intercompany balances and transactions have been eliminated. The Company owns and operates the following psychiatric facilities: Basis of Presentation -- On May 29, 1992, PSG Acquisition, Inc., a wholly owned subsidiary of The Cooper Companies, Inc. ('Cooper'), acquired all of the issued and outstanding capital stock of HGA from PsychGroup, Inc. Concurrent with the acquisition, all due from related parties balances as of May 29, 1992 were forgiven. The accompanying financial statements represent the historical position and results of operations of the Company as of April 30, 1991 and for the year then ended. The accompanying financial statements do not reflect the elimination of the due from related parties balances with a corresponding charge to retained earnings which as of May 29, 1992 amounted to $20,595,000. Net Patient Service Revenue -- Net patient service revenue is recorded at the estimated net realizable amounts from patients, third-party payors, and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. Retroactive adjustments are accrued on an estimated basis in the period the related services are rendered and adjusted in the period as final settlements are determined. Charity Care -- The Company provides care to indigent patients who meet certain criteria under its charity care policy without charge or at amounts less than its established rates. Because the Company does not pursue collection of amounts determined to qualify as charity care, they are not reported as revenue. The Company maintains records to identify and monitor the level of charity care it provides. These records include the amount of charges foregone for services and supplies furnished under its charity care policy. Charges at the Company's established rates foregone for charity care provided by the Company amounted to $3,457,000 for the year ended April 30, 1991. Hampton Hospital is required by its Certificate of Need to incur not less than 10% of total patient days as free care. Supplies -- Supplies consist principally of medical supplies and are stated at the lower of cost (first-in, first-out method) or market. Property and Equipment -- Property and equipment are stated at cost. Depreciation is computed on the straight-line method over the estimated useful lives of the respective assets, which range from 20 to 40 years for buildings and improvements, and 5 to 10 years for equipment, furniture and fixtures. Other Assets -- Pre-opening costs incurred in new facilities and loan fees incurred in obtaining long-term financing are deferred and recorded as other assets. Pre-opening costs are amortized on a straight-line basis over five years. Loan fees are amortized over the terms of the related loans. The balance of unamortized loan fees was $896,000 as of April 30, 1991. Income Taxes -- The Company was included in the consolidated tax returns of Nu-Med. The Company computes a tax provision as if it were a stand alone entity. The corresponding liability for such taxes is included in the net amount Due from Related Parties. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED APRIL 30, 1991 Malpractice Insurance Coverage -- Medical malpractice claims were covered by an occurrence-basis medical malpractice insurance policy. In the opinion of management, sufficient reserves have been established for any potential deductible to be paid by the Company. These reserves are maintained upon Nu-Med's financial statements and are not allocated to individual subsidiaries. The costs and deductibles associated with the policy are allocated to the Company and are included in operating expenses. Subsequent to October 1, 1991, the Company became directly responsible for its own malpractice insurance, with Nu-Med being responsible for any tail coverage through May 29, 1992. B. NET PATIENT SERVICE REVENUE The Company has agreements with third-party payors that provide for payments to the Company at amounts different from its established rates. A summary of the payment arrangements with major third-party payors follows: Commercial Insurance -- Most commercial insurance carriers reimburse the Company on the basis of the hospitals' charges, subject to the rates and limits specified in their policies. Patients covered by commercial insurance generally remain responsible for any differences between insurance proceeds and total charges. Blue Cross -- Reimbursement under Blue Cross plans varies depending on the areas in which the Company presently operates facilities. Benefits paid to the Company can be charge-based, cost-based, negotiated per diem rates or approved through a state rate setting process. Medicare -- Services rendered to Medicare program beneficiaries are reimbursed under a retrospectively determined reasonable cost system with final settlement determined after submission of annual cost reports by the Company and audits thereof by the Medicare fiscal intermediary. Managed Care -- Services rendered to subscribers of health maintenance organizations, preferred provider organizations and similar organizations are reimbursed based on prospective negotiated rates. The Company's business activities are primarily with large insurance companies and federal and state agencies or their intermediaries. Other than adjustments arising from audits by certain of these agencies, the risk of loss arising from the failure of these entities to perform according to the terms of their respective contracts is considered remote. C. RELATED PARTY TRANSACTIONS Amounts due from (to) related parties at April 30, 1991 were composed of the following (in thousands of dollars): Due from Nu-Med, Inc. consists primarily of cash advances, transfers of certain assets and income tax obligations. The repayment of this obligation was not expected to commence within 12 months and was to be repaid over a period of years. Therefore, this amount was classified as a long-term receivable at April 30, 1991. In connection with the acquisition of HGA, all due from related parties balances as of May 29, 1992 were forgiven and the balance of $20,595,000 as of that date was eliminated with a corresponding charge to retained earnings. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED APRIL 30, 1991 Included in Other Operating Revenue are management fees charged to other affiliated entities which are under common ownership. Such fees amounted to $3,172,000 for 1991. D. LONG TERM DEBT Long-term debt consists of the following: Scheduled annual maturities of long-term debt as of April 30, 1991 are as follows: The long-term debt agreements contain several covenants, including the maintenance of certain ratios and levels of net worth (as defined), restrictions with respect to the payments of cash dividends on common stock and on the levels of capital expenditures, interest and debt payments. In addition, the Industrial Revenue Bonds give the holders the right to accelerate all outstanding principal at December 31, 1995 upon notification one year prior to that date. Substantially all of the property and equipment and accounts receivable of the Company collateralize the debt outstanding. E. EMPLOYEE BENEFITS The Company participated in the Nu-Med Combined Savings Plan, (the 'Plan'), which covers substantially all full-time employees with more than one year of service. Nu-Med may make annual contributions to the Plan based upon earnings, which the Plan may utilize to acquire Nu-Med common stock. In addition, Nu-Med may make contributions to the Plan in the form of Nu-Med common stock. No such contributions were made during the year ended April 30, 1991. The Company does not provide postretirement benefits to its employees. F. COMMITMENTS AND CONTINGENCIES In the normal course of business, the Company is involved in various litigation. In the opinion of management, the disposition of such litigation will not have a material adverse effect on the Company's consolidated financial position. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED APRIL 30, 1991 The Company leases certain space and equipment under operating lease agreements. The following is a schedule of estimated minimum payments due under such leases with an initial term of more than one year as of April 30, 1991 (in thousands of dollars): Some of the operating leases contain provisions for renewal or increased rental (based upon increases in the Consumer Price Index), none of which are taken into account in the above table. Rental expense under all operating leases amounted to $357,000 in 1991. G. INCOME TAXES The provision for income taxes is composed of the following (in thousands of dollars): The provision for income taxes included in the consolidated statements of earnings differs from the amount computed by applying the statutory federal income tax rate of 34% to earnings before taxes due to the effect of the state franchise taxes, net of federal benefit. This amounted to 5% for the year ended April 30, 1991. In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 109. 'Accounting for Income Taxes'. Cooper and the Company are required to adopt the new method of accounting for income taxes no later than the fiscal year ending October 31, 1994. Neither the Company nor Cooper has completed an analysis to estimate the impact of the statement on the Company's consolidated financial statements. H. DEPENDENCE UPON COOPER The Company has incurred losses and negative cash flows since May 30, 1992, and has a working capital deficiency at October 31, 1993 which includes a liability to Cooper of $6,082,000. Cooper has provided the Company with cash advances to meet its cash needs. The independent auditors' report dated January 24, 1994 on Cooper's October 31, 1993 consolidated financial statements includes the following explanatory paragraph: 'The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. During the past three fiscal years, the Company has suffered significant losses and negative cash flows. In addition, as discussed in Note 18 to the financial statements the Company is exposed to contingent liabilities related to a criminal conviction and a Securities and Exchange Commission motion. Such losses, negative cash flows, and contingent liabilities raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties.' HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED APRIL 30, 1991 The Company is unable to predict the effect, if any, of the uncertainty concerning Cooper's ability to continue as a going concern on its financial condition or results of operations. The aforementioned factors raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if the Company or Cooper is unable to continue as a going concern. I. SUBSEQUENT EVENT Pursuant to a pledge agreement dated as of January 6, 1994, between the Parent and the trustee for the holders of a new class of debt issued by the Parent (the 'Notes'), the Parent has pledged a first priority security interest in all of its right, title and interest in stock of the Company, all additional shares of stock of, or other equity interest in, the Company from time to time acquired by the Parent, all intercompany indebtedness of the Company from time to time held by the Parent and except as set forth in the indenture to the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture governing the Notes is included in the Parent's Amended and Restated Offer to Exchange and Consent Solicitation filed with the Securities and Exchange Commission on December 15, 1993. SCHEDULE V HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES PROPERTY AND EQUIPMENT YEAR ENDED OCTOBER 31, 1993 PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 PERIOD FROM JUNE 1, 1991 TO MAY 29, 1992 PERIOD FROM MAY 1, 1991 TO MAY 31, 1991 YEAR ENDED APRIL 30, 1991 - ------------ (A) Includes adjustment of accounts to fair value pursuant to the implementation of purchase accounting. SCHEDULE VI HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT YEAR ENDED OCTOBER 31, 1993 PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 PERIOD FROM JUNE 1, 1991 TO MAY 29, 1992 PERIOD FROM MAY 1, 1991 TO MAY 31, 1991 YEAR ENDED APRIL 30, 1991 - ------------ (A) Write-off of accumulated depreciation pursuant to the implementation of purchase accounting. SCHEDULE VIII HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS YEAR ENDED OCTOBER 31, 1993 PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 PERIOD FROM JUNE 1, 1991 TO MAY 29, 1992 PERIOD FROM MAY 1, 1991 TO MAY 31, 1991 YEAR ENDED APRIL 30, 1991 SCHEDULE X HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEAR ENDED OCTOBER 31, 1993 PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 PERIOD FROM JUNE 1, 1991 TO MAY 29, 1992 PERIOD FROM MAY 1, 1991 TO MAY 31, 1991 YEAR ENDED APRIL 30, 1991 - ------------ Royalties, maintenance and repairs and taxes other than payroll and income taxes are omitted as each item does not exceed 1% of net operating revenue as reported in the statement of consolidated operations. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders COOPERSURGICAL, INC. We have audited the accompanying balance sheets of CooperSurgical, Inc. as of October 31, 1993 and 1992, and the related statements of operations, stockholders' deficit, and cash flows for each of the years in the three-year period ended October 31, 1993. In connection with our audits of the financial statements, we also have audited financial statement schedules IV, VIII and X. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CooperSurgical, Inc. as of October 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended October 31,1993 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. The accompanying financial statements have been prepared assuming CooperSurgical, Inc. will continue as a going concern. As discussed in Note 1 to the financial statements, the Company's recurring losses and negative cash flows from operations raise substantial doubt about the Company's ability to continue as a going concern. Additionally, the independent auditors' report dated January 24, 1994 on the parent's financial statements as of October 31, 1993 included an explanatory paragraph describing a substantial doubt about the parent's ability to continue as a going concern. The accompanying financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties. KPMG PEAT MARWICK Stamford, Connecticut January 24, 1994 COOPERSURGICAL, INC. BALANCE SHEET See accompanying notes to financial statements. COOPERSURGICAL, INC. STATEMENTS OF OPERATIONS See accompanying notes to financial statements. COOPERSURGICAL, INC. STATEMENT OF STOCKHOLDERS' DEFICIT YEARS ENDED OCTOBER 31, 1993, 1992, 1991 AND 1990 See accompanying notes to financial statements. COOPERSURGICAL, INC. STATEMENTS OF CASH FLOWS During Fiscal 1993, furniture and equipment with a net book value of $56 were transferred to CooperSurgical from the Parent. This non-cash transaction was recorded as an increase to Parent advances. During Fiscal 1991, CooperSurgical assumed notes payable of $1,525 with the acquisition of Euro-Med Endoscope and Euro-Med, Inc., see Note 2. Also during fiscal 1991, CooperSurgical assumed promissory notes, due to its Parent, as a result of a $450 non-cash equity transfer to its Parent. See accompanying notes to financial statements. COOPERSURGICAL, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL CooperSurgical, Inc. ('CooperSurgical' or the 'Company'), a Delaware corporation, develops, manufactures and distributes electrosurgical, cryosurgical and general application diagnostic surgical instruments and equipment. The Cooper Companies, Inc. ('Parent'), a Delaware corporation, owns 100% of CooperSurgical's Series A preferred stock. CooperSurgical's outstanding common stock is 100% owned by individuals on the CooperSurgical Advisory Board which provides counsel and management of clinical trials in the area of minimally invasive surgery. The accompanying financial statements have been prepared from the separate records of CooperSurgical and may not be indicative of conditions which would have existed or the results of its operations if CooperSurgical operated autonomously (see Note 4). Foreign exchange translation and transactions are immaterial. DEPENDENCE UPON PARENT CooperSurgical has incurred substantial losses and has not generated positive cash flows from operations. The Company is, therefore, dependent upon its Parent for financing to meet its cash obligations. The Company's Parent issued its October 31, 1993 consolidated financial statements on or about January 24, 1994. The independent accountants' report thereon included the following explanatory paragraph: The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. During the past three fiscal years, the Company has suffered significant losses and negative cash flows. In addition, as discussed in Note 18 to the financial statements the Company is exposed to contingent liabilities related to a criminal conviction and a Securities and Exchange Commission action. Such losses, negative cash flows, and contingent liabilities raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties. The Company is unable to predict the effect, if any, of this uncertainty on its financial condition or results of operations. These factors raise substantial doubt about CooperSurgical's ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if CooperSurgical or its Parent is unable to continue as a going concern. REVENUE RECOGNITION CooperSurgical recognizes product revenue when risk of ownership has transferred to the buyer, net of appropriate provisions for sales returns and bad debts. PROVISION FOR INCOME TAXES CooperSurgical is included in the consolidated federal income tax return of the Parent pursuant to a tax-sharing agreement. CooperSurgical state and franchise taxes are de minimis. In February 1992, the Financial Accounting Standards Board ('FASB') issued Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes.' The Parent and CooperSurgical are required to adopt this method of accounting for income taxes no later than the fiscal year ending October 31, 1994. The Parent anticipates that the adoption of the statement will not have a material impact on CooperSurgical's balance sheet. COOPERSURGICAL, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) INVENTORIES Inventories are carried at the lower of cost, determined on an average cost basis, or market. FURNITURE AND EQUIPMENT Furniture and equipment are carried at cost. Depreciation is computed on the straight line method over the estimated useful lives of depreciable assets. AMORTIZATION OF INTANGIBLES Amortization is currently provided on all intangible assets on a straight line basis over periods up to 20 years. Accumulated amortization at October 31, 1993 and 1992 was $831,000 and $541,000, respectively. NOTE 2. ACQUISITIONS In December 1990 and January 1991, CooperSurgical acquired Euro-Med Endoscope and Euro-Med, Inc. for cash and notes in the amount of $3,250,000. The acquisitions were recorded using the purchase method of accounting. The two companies offer a line of surgical instruments and diagnostic hysteroscopy equipment for use in gynecologic and minimally invasive surgical procedures. Goodwill for these two businesses was $2,082,000 and is being amortized over 20 years. On a pro forma basis, if Euro-Med, Inc. results had been included in CooperSurgical's results beginning November 1, 1990, the pro forma net sales would have been approximately $8,460,000 and loss before provision of income taxes would have been approximately $3,406,000. In a separate transaction, CooperSurgical purchased distribution rights associated with the aforementioned surgical instruments and diagnostic hysteroscopy equipment from the previous owners of Euro-Med Endoscope and Euro-Med, Inc. for $256,000. NOTE 3. ACCOUNTS PAYABLE CooperSurgical utilized a cash concentration account with the Parent whereby approximately $131,000 and $293,000 of checks issued and outstanding at October 31, 1993 and 1992, respectively, in excess of related bank cash balances were reclassified to accounts payable. Sufficient funds were available from the Parent to cover these checks. NOTE 4. RELATED PARTY TRANSACTIONS Included in CooperSurgical's selling, general and administrative expense are Parent allocations for technical service fees of $1,312,000, $341,000 and $279,000 for the three years ended October 31, 1993, 1992 and 1991 respectively. 1993 technical service fees include $134,000 relating to redetermination of appropriate amount for the year ended October 31, 1992. These costs are charges from the Parent for accounting, legal, tax and other services provided to CooperSurgical. COOPERSURGICAL, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) Amounts due to the parent at October 31, 1993 and 1992 were composed of the following: NOTE 5. LONG TERM DEBT Long term debt consists of the following: Annual maturities of long-term debt, including current installments thereof, are as follows: NOTE 6. COMMITMENTS AND CONTINGENCIES In the normal course of its business, CooperSurgical is involved in various litigation cases. In the opinion of management, the disposition of such litigation will not have a materially adverse effect on CooperSurgical's financial condition. CooperSurgical leases certain property and equipment under operating lease agreements. The following is a schedule of the estimated minimum payment due under such leases with an initial term of more than one year as of October 31, 1993: Rental expense for all leases amounted to approximately $340,000 and $322,000 for the years ended October 31, 1993 and 1992, respectively. NOTE 7. EMPLOYEE BENEFITS CooperSurgical employees are eligible to participate in the Parent's 401(k) Savings Plan, a defined contribution plan and the Parent's Retirement Income Plan, a defined benefit plan. As of October 31, COOPERSURGICAL, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) 1993, CooperSurgical has not elected to participate in the Parent's Retirement Income Plan. Costs and expenses of administration of the Parent's 401(k) Savings Plan are allocated to CooperSurgical as appropriate. These costs were not significant for the years ended October 31, 1993, 1992 and 1991. NOTE 8. SERIES A CONVERTIBLE PREFERRED STOCK The Series A Convertible Preferred Stock is convertible into Common Stock on a one-to-one basis, subject to adjustment for stock splits, dividends and certain other distributions of Common Stock and has voting rights equal to the number of shares of Common Stock into which it is convertible. The Preferred Stock has a liquidation preference of $1.940625 per share and accrues cumulative dividends of $0.1940625 per share per annum. The aggregate liquidation preference of the Preferred Stock at October 31, 1993 is $1,242,000, plus cumulative dividends of $248,000. The Preferred Stock participates ratably with the Common Stock in any additional dividends declared beyond the cumulative dividends and in any remaining assets beyond the liquidation preference. The Series A Convertible Preferred Stock represents 96.5% of the total voting rights of all outstanding CooperSurgical stock. NOTE 9. INCOME TAXES As of October 31, 1993, CooperSurgical, Inc. had federal tax net operating loss carryforwards of $12,611,000 expiring as follows: 2006 -- $3,260,000, 2007 -- $3,083,000, and 2008 -- $6,268,000. The tax benefits attributable to the net operating loss carryforwards have not been recognized in the statements of operations for each of the years in the three year period ended October 31, 1993 due to the uncertainty of future taxable income. NOTE 10. SUBSEQUENT EVENT Pursuant to a pledge agreement dated as of January 6, 1994, between the Parent and the trustee for the holders of a new class of debt issued by the Parent (the 'Notes'), the Parent has pledged a first priority security interest in all of its right, title and interest in stock of CooperSurgical, all additional shares of stock of, or other equity interests in, CooperSurgical from time to time acquired by the Parent, all intercompany indebtedness of CooperSurgical from time to time held by the Parent and, except as set forth in the indenture governing the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture governing the Notes is included in the Parent's Amended and Restated Offer to Exchange and Consent Solicitation filed with The Securities and Exchange Commission on December 15, 1993. On January 24, 1994, the Company's Parent converted $19,012,000 of outstanding Parent advances into 9,796,660 shares of the Company's Series A preferred stock and converted the remaining $3,313,000 balance of CooperSurgical's liability to its Parent into a promissory note due January 24, 1996. As a result of this transaction, advances due to Parent have been classified as long-term. SCHEDULE IV COOPERSURGICAL, INC. INDEBTEDNESS OF AND TO RELATED PARTIES -- NOT CURRENT THREE YEARS ENDED OCTOBER 31, 1993 SCHEDULE VIII COOPERSURGICAL, INC. VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED OCTOBER 31, 1993 SCHEDULE X COOPERSURGICAL, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED OCTOBER 31, 1993 - ------------ * Royalties, maintenance and repairs, and taxes other than payroll are omitted as each item does not exceed 1% of net operating revenue as reported in the statement of operations. 3. Exhibits. (b) Reports on Form 8-K. 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, on January 26, 1994. THE COOPER COMPANIES, INC. By: /s/ ALLAN E. RUBENSTEIN ... ALLAN E. RUBENSTEIN ACTING CHAIRMAN OF THE BOARD OF DIRECTORS 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 indicated on January 26, 1994. STATEMENT OF DIFFERENCES

79731_1993.txt

79731_1993

1993

79731

ITEM 1. BUSINESS Allegheny Power System, Inc. (APS), incorporated in Maryland in 1925, is an electric utility holding company that derives substantially all of its income from the electric utility operations of its direct and indirect subsidiaries (Subsidiaries), Monongahela Power Company (Monongahela), The Potomac Edison Company (Potomac Edison), West Penn Power Company (West Penn), and Allegheny Generating Company (AGC). The properties of the Subsidiaries are located in Maryland, Ohio, Pennsylvania, Virginia, and West Virginia, are interconnected, and are operated as a single integrated electric utility system (System), which is interconnected with all neighboring utility systems. The three electric utility operating Subsidiaries are Monongahela, Potomac Edison, and West Penn (Operating Subsidiaries). Monongahela, incorporated in Ohio in 1924, operates in northern West Virginia and an adjacent portion of Ohio. It also owns generating capacity in Pennsylvania. Monongahela serves about 340,700 customers in a service area of about 11,900 square miles with a population of about 710,000. The seven largest communities served have populations ranging from 10,900 to 33,900. On December 31, 1993, Monongahela had 1,962 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, glass sand, natural gas, rock salt, and other natural resources. Its service area's principal industries produce coal, chemicals, iron and steel, fabricated products, wood products, and glass. There are two municipal electric distribution systems and two rural electric cooperative associations in its service area. Except for one of the cooperatives, they purchase all of their power from Monongahela. Potomac Edison, incorporated in Maryland in 1923 and in Virginia in 1974, operates in portions of Maryland, Virginia, and West Virginia. It also owns generating capacity in Pennsylvania. Potomac Edison serves about 354,300 customers in a service area of about 7,300 square miles with a population of about 782,000. The six largest communities served have populations ranging from 11,900 to 40,100. On December 31, 1993, Potomac Edison had 1,152 employees. Its service area is generally rural. Its service area's principal industries produce aluminum, cement, fabricated products, rubber products, sand, stone, and gravel. There are four municipal electric distribution systems in its service area, all of which purchase power from Potomac Edison, and six rural electric cooperatives, one of which purchases power from Potomac Edison. There are also several large federal government installations served by Potomac Edison. - 2 - West Penn, incorporated in Pennsylvania in 1916, operates in southwestern and north and south central Pennsylvania. It also owns generating capacity in West Virginia. West Penn serves about 646,700 customers in a service area of about 9,900 square miles with a population of about 1,399,000. The 10 largest communities served have populations ranging from 11,200 to 38,900. On December 31, 1993, West Penn had 2,043 employees. Its service area has navigable waterways and substantial deposits of bituminous coal, limestone, and other natural resources. Its service area's principal industries produce steel, coal, fabricated products, and glass. There are two municipal electric distribution systems in its service area, which purchase their power requirements from West Penn, and five rural electric cooperative associations, located partly within the area, which purchase virtually all of their power through a pool supplied by West Penn and other nonaffiliated utilities. AGC, organized in 1981 under the laws of Virginia, is jointly owned by the Operating Subsidiaries as follows: Monongahela, 27%; Potomac Edison, 28%; and West Penn, 45%. AGC has no employees, and its only operating assets are a 40% undivided interest in the Bath County (Virginia) pumped- storage hydroelectric station, which was placed in commercial operation in December 1985, and its connecting transmission facilities. AGC's 840-megawatt (MW) share of capacity of the station is sold to its three parents. The remaining 60% interest in the Bath County Station is owned by Virginia Electric and Power Company (Virginia Power). APS has no employees. Its officers are employed by Allegheny Power Service Corporation (APSC), a wholly-owned subsidiary of APS. On December 31, 1993, the Subsidiaries and APSC had 6,025 employees. The Subsidiaries in the past have experienced and in the future may experience some of the more significant problems common to electric utilities in general. These include increases in operating and other expenses, difficulties in obtaining adequate and timely rate relief, restrictions on construction and operation of facilities due to regulatory requirements and environmental and health considerations, including the requirements of the Clean Air Act Amendments of 1990 (CAAA), which among other things, require a substantial annual reduction in utility emissions of sulfur dioxides and nitrogen oxides. Additional concerns include proposals to restructure and, to some extent, deregulate portions of the industry and increase competition, particularly as a result of the National Energy Policy Act of 1992 (EPACT). EPACT may increase competition by allowing the formation of Exempt Wholesale Generators (EWGs), with the approval of the FERC, and providing mandatory access to the interconnected electric grid for wholesale transactions. It further provides for expansion of the grid where constraints are determined to exist - at the expense of the requestor of such transmission service and provided necessary authority to construct such facilities can be obtained. EPACT permits utility generation facilities to qualify as EWGs and allows sales to nonaffiliated and to affiliated utilities provided state commissions approve such transactions. (See ITEM 1. SALES, ELECTRIC FACILITIES and REGULATION for a further discussion of the impact of EPACT.) - 3 - In an effort to meet the challenges of the new competitive environment in the industry, APS is considering forming a new nonutility subsidiary, subject to regulatory approval, to pursue new business opportunities which have a meaningful relationship to the core utility business. APS would also consider establishing or acquiring its own EWGs, if that is feasible, particularly in view of the possible constraints imposed by regulations under the Public Utility Holding Company Act of 1935 (PUHCA) on nonexempt public utility holding companies such as APS and its Subsidiaries. Further concerns of the industry include possible restrictions on carbon dioxide emissions, uncertainties in demand due to economic conditions, energy conservation, market competition, weather, and interruptions in fuel supply because of weather and strikes. (See ITEM 1. CONSTRUCTION AND FINANCING, RATE MATTERS, and ENVIRONMENTAL MATTERS for information concerning the effect on the Subsidiaries of the CAAA.) SALES In 1993, consolidated kilowatthour (kWh) sales to the Operating Subsidiaries' retail customers increased 3.3% from those of 1992, as a result of increases of 6.5%, 5.2% and 0.3% in residential, commercial and industrial sales, respectively. The increased Kwh sales in 1993 reflect both growth in number of customers and higher use. Consolidated revenues from residential, commercial, and industrial sales increased 11.4%, 9.8%, and 5.6%, respectively, primarily because of several rate increases effective in 1993 as described in ITEM 1. RATE MATTERS, increases in fuel and energy cost adjustment clause revenues, and increased kWh sales. Consolidated kWh sales to and revenues from nonaffiliated utilities decreased 30.2% and 25.5%, respectively, due to increased native load, decreased demand, and price competition. The System's all-time peak load of 7,153 MW occurred on January 18, 1994. The peak loads in 1993 and 1992 were 6,678 MW and 6,530 MW, respectively. The increased 1994 peak was due in part to record cold temperatures throughout the Operating Subsidiaries' service areas and would have been higher except for voluntary curtailments. The average System load (Yearly Net Power Supply divided by number of hours in the year) was 4,674 megawatthours (MWh) and 4,526 MWh in 1993 and 1992, respectively. More information concerning sales may be found in the statistical sections and ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Consolidated electric operating revenues for 1993 were derived as follows: Pennsylvania, 44.8%; West Virginia, 28.4%; Maryland, 20.2%; Virginia, 5.0%; Ohio, 1.6% (residential, 35.1%; commercial, 18.4%; industrial, 28.9%; nonaffiliated utilities, 14.9%; and other, 2.7%). The following percentages of such revenues were derived from these industries: iron and steel, 6.0%; chemicals, 3.3%; fabricated products, 3.3%; aluminum and other nonferrous metals, 3.2%; coal mines, 3.1%; cement, 1.8%; and all other industries, 8.2%. The coal mine percentage decreased in 1993 principally due to the coal strike. More information concerning the coal strike may be found in ITEM 1. FUEL SUPPLY. Revenues from each of 16 industrial customers exceeded $5 million, including one coal customer of both Monongahela and West Penn with total revenues exceeding $15 million, three steel customers with revenues exceeding $26 million each, and one aluminum customer with revenues exceeding $63 million. - 4 - During 1993, Monongahela's kWh sales to retail customers increased 0.3% as a result of increases of 6.4% and 4.7% in residential and commercial sales, respectively, and a decrease of 4.4% in industrial sales, primarily due to the coal strike and lower sales to one iron and steel customer because of increased use of its own generation. Revenues from such customers increased 9.2%, 7.8% and 0.7%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 7.8%. Monongahela's all- time peak load of 1,667 MW occurred on December 21, 1989. (For a discussion of the coal strike, See ITEM 1. FUEL SUPPLY.) Monongahela's electric operating revenues were derived as follows: West Virginia, 94.0% and Ohio, 6.0% (residential, 28.8%; commercial, 17.3%; industrial, 29.2%; nonaffiliated utilities, 13.4 %; and other, 11.3%). Revenues from each of five industrial customers exceeded $8 million, including one coal customer with revenues exceeding $13 million and one steel customer with revenues exceeding $26 million. The decreases in the revenues of these customers from 1992 levels were primarily due to the coal strike. During 1993, Potomac Edison's kWh sales to retail customers increased 6.3% as a result of increases of 8.4%, 7.1%, and 4.3% in residential, commercial, and industrial sales, respectively. Revenues from such customers increased 12.7%, 11.8%, and 11.8%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 23.1%. Potomac Edison's all-time peak load of 2,595 MW occurred on January 19, 1994. Potomac Edison's electric operating revenues were derived as follows: Maryland, 66.6%; West Virginia, 16.8%; and Virginia 16.6% (residential, 38.5%; commercial, 17.5%; industrial, 24.7%; nonaffiliated utilities, 15.2%; and other, 4.1%). Revenues from one industrial customer, the Eastalco aluminum reduction plant near Frederick, Maryland, amounted to $63.4 million (8.9% of total electric operating revenues). Minimum annual charges to Eastalco under an electric service agreement which continues through March 31, 2000, with automatic extensions thereafter unless terminated on notice by either party, were $19.3 million in 1993. Said agreement may be canceled before the year 2000 upon 90 days notice of a governmental decision resulting in a material modification of the agreement. During 1993, West Penn's kWh sales to retail customers increased 3.1% as a result of increases of 5.2%, 4.4% and 0.8% in residential, commercial, and industrial sales, respectively. Revenues from residential, commercial, and industrial customers increased 11.5%, 9.6%, and 5.4%, respectively, and revenues from kWh sales to affiliated and nonaffiliated utilities decreased 24.3%. West Penn's all- time peak load of 3,068 MW occurred on January 18, 1994. - 5 - West Penn's electric operating revenues were derived as follows: Pennsylvania, 100% (residential, 33.1%; commercial, 18.0%; industrial, 28.5%; nonaffiliated utilities, 14.1%; and other, 6.3%). Revenues from each of three steel customers exceeded $10 million, including two with revenues exceeding $31 million each. On average, the Operating Subsidiaries are the lowest or among the lowest cost producers of electricity in their regions and therefore the Operating Subsidiaries' delivered power prices should compete favorably with those of potential alternate suppliers who use cost-based pricing. However, the Operating Subsidiaries are experiencing cost increases due to compliance with the CAAA and purchases from Public Utility Regulatory Policies Act of 1978 (PURPA) projects. (See page 7 for a discussion of PURPA projects, and ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings concerning PURPA capacity.) In 1993, the Operating Subsidiaries provided approximately 13.3 billion kWh of energy to nonaffiliated utility companies, of which 1.5 billion kWh were generated by the Subsidiaries and the rest were transmitted from electric systems located primarily to the west. These sales included a long-term transaction under which the Operating Subsidiaries purchased 450 MW of firm capacity and its associated energy from Ohio Edison Company for resale to Potomac Electric Power Company, both nonaffiliated utilities. The transaction began in mid-1987 and will continue through 2005, unless terminated earlier. Sales to nonaffiliated utility companies vary with the needs of those companies for imported power; the availability of System generating facilities, fuel, and regional transmission facilities; and the availability and price of competitive sources of power. System sales decreased in 1993 relative to 1992 primarily because of continued decreased demand, increased Operating Subsidiaries' native load, coal conservation because of the coal strike, and increased willingness of other suppliers to make sales at lower prices. Further decreases in kWh sales to nonaffiliated utilities are expected in 1994 and beyond. Substantially all of the revenues from kWh sales to nonaffiliated utilities are passed on to retail customers and as a result have little effect on net income. The Operating Subsidiaries reactivated a peak diversity exchange arrangement with Virginia Power effective June 1993 which continues indefinitely. The Operating Subsidiaries will annually supply Virginia Power with 200 MW during each June, July, and August, in return for which Virginia Power will supply the Operating Subsidiaries with 200 MW during each December, January, and February, at least through February 1997. Thereafter, specific amounts of annual diversity exchanges beyond those currently established are to be mutually determined no less than 34 months prior to each year for which an exchange is to take place. The total number of MWh to be delivered by each to the other over the term of the arrangement is expected to be equal. - 6 - The Operating Subsidiaries and Duquesne Light Company (Duquesne Light) in 1991 entered into an exchange arrangement under which the Operating Subsidiaries will supply Duquesne Light with up to 200 MW for a specified number of weeks, generally during each March, April, May, September, October, and November. In return, Duquesne Light will supply the Operating Subsidiaries with up to 100 MW, generally during each December, January, and February. The total number of MWh delivered by each utility to the other over the term of the arrangement is expected to be the same. West Penn supplies power to the Borough of Tarentum (Tarentum) using in part leased distribution facilities from Tarentum under a 30 year lease agreement terminating in 1996. In June 1993, Tarentum, which in that year had a load of 6.5 MW and revenues of $1.8 million, notified West Penn of its intention to exercise its option to end the lease agreement. The termination of the lease agreement and resulting transfer and sale of electric facilities will result in Tarentum becoming a municipal customer which will purchase electricity on a wholesale basis from West Penn or another supplier. The sale of electric facilities will require Pennsylvania Public Utility Commission approval. The System provides wholesale transmission services to applicants under its Federal Energy Regulatory Commission (FERC) approved Standard Transmission Service tariff. The tariff provides that such service is subordinate in priority to native load and reliability requirements of interconnected systems to avoid adverse effects on regional reliability in general and on the reliability of the Operating Subsidiaries' service to their retail and full- requirements wholesale customers in particular. (See ITEM 1. ELECTRIC FACILITIES for a discussion of stress on the System's transmission system.) Transmission services requiring special arrangements or long-term commitments have been and continue to be negotiated through mutually acceptable bilateral agreements. Substantially all of the revenues from transmission service sales are passed on to retail customers and as a result have little effect on net income. EPACT permits wholesale generators, utility-owned and otherwise, and wholesale consumers to request from System and other owners of bulk power transmission facilities a commitment to supply transmission services. Generators include nonaffiliated utilities and nonutility generators (NUG) of electricity (including classifications of generators known as Independent Power Producers (IPP) and EWGs). Consumers of wholesale power include qualifying nonaffiliated utilities or groups of utilities including the many small electric systems owned by municipalities and rural electric cooperative associations in the service areas of the Operating Subsidiaries. Many of these small systems currently purchase substantially all of their power from the Operating Subsidiaries. Under EPACT, these small systems may now seek an order from the FERC to force the Operating Subsidiaries to wheel power over the System to them from sources outside the System service area. All of the small electric wholesale customers in the Operating Subsidiaries' service areas which might avail themselves of this opportunity produced $42 million of total revenues in 1993. - 7 - Under PURPA, certain municipalities and private developers have installed, are installing or are proposing to install hydroelectric and other generating facilities at various locations in or near the Operating Subsidiaries' service areas with the intent of selling some or all of the electric capacity and energy to the Operating Subsidiaries at rates provided under PURPA and approved by appropriate state commissions. The System's total generation capacity includes 292 MW of on-line PURPA capacity. Payments for PURPA capacity and energy in 1993 totaled approximately $105 million at an average cost to the System of 5.04 cents per kWh. The System projects an additional 180 MW of PURPA capacity to come on-line in future years. In addition, lapsed purchase agreements totaling 203 MW and other PURPA complaints totaling 520 MW (none of which are included in the System's integrated resource plan as of August 20, 1993), are the subject of pending litigation. (See ITEM 3. LEGAL PROCEEDINGS for a description of litigation and regulatory proceedings in Pennsylvania, Maryland, and West Virginia affecting PURPA capacity.) In the future, ratings of the Operating Subsidiaries' first mortgage bonds and preferred stock may be affected by increased concern of rating agencies that purchased power contracts are a risk factor deserving consideration in assessing the credit- worthiness of electric utilities. ELECTRIC FACILITIES The following table shows the System's December 31, 1993, generating capacity, based on the maximum monthly normal seasonal operating capacity of each unit. The System-owned capacity totaled 7,991 MW, of which 7,089 MW (88.7%) are coal-fired, 840 MW (10.5%) are pumped-storage, and 62 MW (0.8%) are hydroelectric. The term "pumped-storage" refers to the Bath County station which stores energy for use principally during peak load hours by pumping water from a lower to an upper reservoir, using the most economic available electricity, generally during off-peak hours. During the generating cycle, power is produced by water falling from the upper to the lower reservoir through turbine generators. The average age of the System-owned coal-fired stations shown below, based on generating capacity at December 31, 1993, was about 23.6 years. In 1993, their average heat rate was 10,020 Btu's/kWh, and their availability factor was 87.0%. - 8 - - 9 - (a) Excludes 361 MW of West Penn oil-fired capacity, which was placed on cold reserve status as of June 1, 1983. Current plans call for the reactivation of these units within the next five years. (b) Where more than one year is listed as a commencement date for a particular source, the dates refer to the years in which operations commenced for the different units at that source. (c) The installation of flue-gas desulfurization equipment (See ITEM 1. ENVIRONMENTAL MATTERS) is expected to reduce the net generating capacity of each unit by about 3%. (d) Capacity entitlement through percentage ownership of AGC. (e) The FERC issued an annual license to West Penn for Lake Lynn for 1994. A relicensing application has been filed with the FERC for Lake Lynn and a license with a 30 to 50 year term is expected to be issued in late 1994. Potomac Edison's license for hydroelectric facilities, Dam #4 and Dam #5 will expire in 2003. Potomac Edison has received 30 year licenses, effective January 1994, for the Shenandoah, Warren, Luray and Newport projects. (f) Nonutility generating capacity available through contractual arrangements pursuant to PURPA. - 10 - SYSTEM MAP The Allegheny Power System Map (System Map), which has been omitted, provides a broad illustration of the names and approximate locations of the System's major generation and transmission facilities, both existing and under construction, in a five state region which includes portions of Pennsylvania, Ohio, West Virginia, Maryland and Virginia. Additionally, Extra High Voltage substations are displayed. By use of shading, the System Map also provides a general representation of the service areas of Monongahela (portions of West Virginia and Ohio), Potomac Edison (portions of Maryland, Virginia and West Virginia), and West Penn (portions of Pennsylvania). Power Stations shown on the System Map which appear within the Monongahela service area are Willow Island, Pleasants, Harrison, Rivesville, Albright, and Fort Martin. The single Power Station appearing within the Potomac Edison service area is R. Paul Smith. The Bath County Power Station appears on the map just south of the westernmost portion of Potomac Edison's service area formed by the borders of Virginia and West Virginia. Power Stations appearing within the West Penn service area are Armstrong, Mitchell, Hatfield's Ferry, Springdale and Lake Lynn. The System Map also depicts transmission facilities which are (i) owned solely by the Operating Subsidiaries; (ii) owned by the Operating Subsidiaries in conjunction with other utilities; or (iii) owned solely by other utilities. The transmission facilities portrayed range in capacity from 138kV to 765kV. Additionally, interconnections with other utilities are displayed. - 11 - The following table sets forth the existing miles of tower and pole transmission and distribution lines and the number of substations of the Subsidiaries as of December 31, 1993: (a) The System has a total of 5,203 miles of underground distribution lines. (b) The substations have an aggregate transformer capacity of 37,512,771 kilovoltamperes. (c) Total Bath County transmission lines, of which AGC owns an undivided 40% interest and Virginia Power owns the remainder. The System has 11 extra-high-voltage (345 kV and above) (EHV) and 29 lower-voltage interconnections with neighboring utility systems. The interregional EHV transmission system, including System facilities, continues to experience periods of heavy loading in a west-to-east direction. Increases in customer load, power transfers by the Subsidiaries and by nonaffiliated entities, and parallel flows caused by transactions to which the Operating Subsidiaries are not a party, all contribute to the heavy west-to-east power flows. In late 1992 and early 1993, a substantial amount of reactive power sources (shunt capacitors) were added to neighboring eastern utilities' EHV systems. These capacitors complement the capacitors added in 1991 and 1992 on the System and together they serve to increase transfer capability by improving voltage on the transmission system during heavy loading periods. While the additional capacitors installed by the Subsidiaries' eastern neighbors have enhanced transfer capability, the interregional transmission facilities are still expected periodically to operate up to their reliability limits; therefore, restrictions on transfers may still be necessary at times as was the case in recent years. Under certain provisions of EPACT, wholesale generators, utility-owned or otherwise, may seek from System and other owners of bulk power transmission facilities a commitment to supply power transmission services, so long as the FERC finds reliability and native load and existing contractual customers are not adversely affected (See discussion under ITEM 1. SALES and REGULATION). Such demand on the System for transmission service may add periodically to heavy power flows on the System's facilities. - 12 - The Operating Subsidiaries have, to date, provided managed contractual access to the System's transmission facilities via the provisions of their Standard Transmission Service tariff, or the terms and conditions of bilateral contracts with purchasers of transmission service. As a result of EPACT, the FERC is investigating the continued desirability of traditional methods of pricing and providing transmission service. The FERC may choose to maintain existing methods, implement new methodologies which the Operating Subsidiaries and their ratepayers may or may not find to be beneficial, or a combination thereof. The Operating Subsidiaries are participating fully in the FERC proceedings with the principal intent of safeguarding the reliability of the System's transmission facilities, and the rights and interests of its native load customers. The outcome of those deliberations cannot be predicted. RESEARCH AND DEVELOPMENT The Operating Subsidiaries spent $4.6 million, $2.7 million, and $2.8 million in 1993, 1992, and 1991, respectively, for research programs. Of these amounts, $3.2 million and $0.6 million were for Electric Power Research Institute (EPRI) dues in 1993 and 1992, respectively. The Operating Subsidiaries plan to spend approximately $7.5 million for research in 1994, with EPRI dues representing $5.9 million of that total. The Operating Subsidiaries joined EPRI, an industry- sponsored research and development institution, effective October 1, 1992, contingent upon the approval by state commissions of recovery of the dues in rates, which approval was subsequently received in all jurisdictions except Ohio and West Virginia, where the matter is pending. Ongoing participation in EPRI depends upon continued approval by state commissions of recovery of dues in rates. Dues are based on a three-year, new-member ramping formula. Independent research conducted by the Operating Subsidiaries in 1993, which will be completed or continued in 1994, concentrated on environmental protection, generating unit performance, future generating technologies, delivery systems, and customer-related research. Two U.S. Department of Energy Clean Coal Technology nitrogen oxide control projects, which the Operating Subsidiaries cofounded, have recently been completed. Based upon the results of one of the projects, retrofitting of low nitrogen oxide cell burners at the Hatfield's Ferry Power Station units has been undertaken at much lower costs than would otherwise have been required. - 13 - Research is also being directed to help address major issues facing the Operating Subsidiaries including electric and magnetic field (EMF) risk, waste disposal, greenhouse gas, client-server information system prospects, renewable resources, fuel cells, new combustion turbines and other cogeneration technologies. In addition, evaluation of technical proposals for business opportunities is also ongoing. EMF research includes monitoring work done by EPRI, Department of Energy (DOE), the Environmental Protection Agency (EPA) and other government researchers. It also includes monitoring literature, law and litigation, and standards as developed. This research enables the Operating Subsidiaries to evaluate any potential health risks to employees and customers which may exist. Research activities related to alleged global climate change include monitoring government activity, studying possible joint implementation activities in connection with the Clinton Climate Change Action Plan, and studying demand- side management, electro- technologies and possible joint implementation plans. The Operating Subsidiaries also made research grants to regional colleges and universities to encourage the development of technical resources related to current and future utility problems. CONSTRUCTION AND FINANCING Construction expenditures by the Subsidiaries in 1993 amounted to $574 million and for 1994 and 1995 are expected to aggregate $500 million and $400 million, respectively. In 1993, these expenditures included $240 million for compliance with the CAAA. The 1994 and 1995 estimated expenditures include $161 million and $53 million, respectively, to cover the costs of compliance with the CAAA. (See ITEM 1. ENVIRONMENTAL MATTERS.) Allowance for funds used during construction (AFUDC) (shown below) has been reduced for carrying charges on CAAA expenditures that are being collected through currently approved surcharges or in base rates. - 14 - * Includes allowance for funds used during construction for 1993, 1994 and 1995 of: Monongahela $5.8, $4.1 and $1.9; Potomac Edison $7.1, $5.7 and $2.7; and West Penn $8.6, $12.7 and $6.2. These construction expenditures include major capital projects at existing generating stations, including the construction of flue-gas desulfurization equipment (scrubbers) at the Harrison Power Station, upgrading distribution lines and substations, and the strengthening of the transmission and subtransmission systems. It is anticipated that the Harrison scrubber project will be completed on schedule and that the final costs will be approximately 24% below the original budget. Primary factors contributing to the reduced cost are: a) the absence of any major construction problems to date; b) financing and material and equipment costs lower than expected; and c) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. In order to avoid unnecessary and uneconomic additional outages, power station construction and long-range maintenance schedules and the expenditures associated therewith will have to be coordinated over the next several years with outages to meet the in-service dates of the new emission control facilities. - 15 - On a System basis, total expenditures for 1993, 1994, and 1995 include $270 million, $191 million, and $93 million, respectively, for construction of environmental control technology. The Operating Subsidiaries continue to study ways to reduce or meet future increases in customer demand, including aggressive demand- side management programs, new and efficient electric technologies, construction of various types and sizes of generating units and increasing the efficiency and availability of System generating facilities, reducing company electrical use and transmission and distribution losses, and where feasible and economical, acquisition of reliable long- term capacity from other electric systems and from nonutility developers. The Operating Subsidiaries are implementing demand-side management activities. Potomac Edison and West Penn are engaged in state commission supported or ordered evaluations of demand-side management programs (See ITEM 1. REGULATION for a further discussion of these programs). Several jurisdictions have adopted mechanisms which provide for recovery of the costs of such activities, some return on the related investment, the associated revenue reductions and a performance incentive, either on a current basis or through deferral to a base rate case. Current forecasts, which reflect demand-side management efforts and other considerations and assume normal weather conditions, project average annual winter and summer peak load growth rates of 1.47% and 1.28%, respectively, in the period 1994-2004. After giving effect to the reactivation of West Penn capacity in cold reserve (see page 9), peak diversity exchange arrangements described in ITEM 1. SALES above, demand- side management and conservation programs, and the capacity of an anticipated new PURPA plant, the System's integrated resource plan indicates that new System-owned generating capacity will not be required until the year 2000 or beyond. If future customer demand materially exceeds that forecast or anticipated supply-side resources do not become available or demand-side management efforts do not succeed, or under extremely adverse weather conditions, the Operating Subsidiaries may be unable at times to meet all of their customers' requirements for electric service. In connection with their construction and demand- side management programs, the Operating Subsidiaries must make estimates of the availability and cost of capital as well as the future demands of their customers that are necessarily subject to regional, national, and international developments, changing business conditions, and other factors. The construction of facilities and their cost are affected by laws and regulations, lead times in manufacturing, availability of labor, materials and supplies, inflation, interest rates, and licensing, rate, environmental, and other proceedings before regulatory authorities. As a result, future plans of the Operating Subsidiaries, as well as their projected ownership of future generating stations, are subject to continuing review and substantial change. - 16 - The Subsidiaries have financed their construction programs through internally generated funds, first mortgage bond, debenture, medium-term note and preferred stock issues, pollution control and solid waste disposal notes, instalment loans, long-term lease arrangements, equity investments by APS (or, in the case of AGC, by the Operating Subsidiaries), and, where necessary, interim short-term debt. Effective January 1994, the Operating Subsidiaries also have available a $300 million multi-year credit facility. The future ability of the Subsidiaries to finance their construction programs by these means depends on many factors, including rate levels sufficient to provide internally generated funds and adequate revenues to produce a satisfactory return on the common equity portion of the Subsidiaries' capital structures and to support their issuance of senior and other securities. APS obtains most of the funds for equity investments in the Operating Subsidiaries through the issuance and sale of its common stock publicly and through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In May 1993, Monongahela, Potomac Edison, and West Penn issued $10.68 million, $13.99 million, and $18.04 million, respectively, in solid waste disposal notes to Harrison County, West Virginia. Harrison County in turn issued $24.67 million of 6-1/4% and $18.04 million of 6.3% tax-exempt 30-year solid waste disposal revenue bonds. The Operating Subsidiaries are using the proceeds from the issuance to finance certain solid waste disposal facilities which comprise a portion of the scrubbers located at the Harrison Power Station. On November 3, 1993, the holders of more than two-thirds of the shares of APS common stock voted to split the common stock by amending the charter to reclassify each share of common stock, par value $2.50, issued or unissued, into two shares of common stock, par value $1.25 each. The stock split became effective on November 4, 1993. All references to APS common stock herein reflect the two-for-one stock split. On October 14, 1993, APS issued and sold 2,400,000 shares of its common stock in an underwritten offering with net proceeds to APS of $64.1 million, and in 1993 sold 1,364,846 shares of its common stock for $36.1 million through its Dividend Reinvestment and Stock Purchase Plan and its Employee Stock Ownership and Savings Plan. In October 1993, Potomac Edison and West Penn issued and sold to APS 2,500,000 and 5,000,000 additional shares of each of their common stock, respectively, at a price of $20 per share. During 1993, the rate for West Penn's 400,000 shares of market auction preferred stock, par value $100 per share, reset approximately every 90 days at 2.62%, 2.55%, 2.595% and 2.7%. The rate set at auction on January 14, 1994, was 2.52%. In August 1993, Potomac Edison redeemed the remaining $404,600 of 4.70% Series B Preferred Stock outstanding. - 17 - In 1993, the Subsidiaries issued $651.9 million of securities having interest rates between 4.95% and 7.75%, to refund outstanding debt with rates of 7.0% to 9.75%, with an annual after-tax savings in interest cost of almost $9 million. In February 1993, Potomac Edison issued $45 million of 7-3/4%, 30-year first mortgage bonds to refund $25 million, 8-5/8% series due 2007 and $15 million, 8-5/8% series due 2003. In March 1993, West Penn issued $61.5 million of 10-year, 4.95% Pollution Control Revenue Notes to refund $30 million, 9-3/4% series due 2003 and $31.5 million, 9-1/2% series due 2003. In March 1993, AGC issued $50 million of 5- 3/4% medium-term notes due in 1998 to refund $50 million, 8% debentures due in 1997. In March 1993, Potomac Edison issued $75 million of 5-7/8% first mortgage bonds due 2000 to refund $72 million of four series due 1998-2002 with rates ranging from 7% to 8- 3/8%. In April 1993, Monongahela, Potomac Edison and West Penn issued $7.05 million, $8.6 million, and $7.75 million, respectively, in 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia. Monongalia County, in turn issued $23.4 million of 5.95%, 20-year Pollution Control Revenue Bonds to refund $23.4 million of three series due in 2013 with rates ranging from 9.375% to 9.5%. In April 1993, Monongahela issued $65 million of 5-5/8% first mortgage bonds due in 2000 to refund $60 million of three series due 1998-2002 with rates ranging from 7.5% to 8.125%. In June 1993, West Penn issued $102 million of 5-1/2% first mortgage bonds due in 1998 to refund $102 million of three series due 1997-1999 with rates ranging from 7% to 7-7/8%. Also in June 1993, West Penn issued $80 million of 6-3/8% first mortgage bonds due 2003 to refund $75 million of two series due 2001-2002 with rates of 7-5/8% and 8-1/8%. In September 1993, AGC issued $50 million of 5-5/8% debentures due 2003 and $100 million of 6-7/8% debentures due 2023 to refund $50 million, 8-3/4% debentures due 2017 and $100 million, 9-1/8% debentures due 2016. At December 31, 1993, APS had $67.5 million and Monongahela had $63.1 million outstanding in short-term debt, and AGC had $50.87 million outstanding in commercial paper and notes payable to affiliates, while Potomac Edison and West Penn had short-term investments of $4.6 million and $24.9 million, respectively. The Subsidiaries' ratios of earnings to fixed charges for the year ended December 31, 1993, were as follows: Monongahela, 3.49; Potomac Edison, 3.34; West Penn, 3.49; and AGC, 2.88. APS and the Subsidiaries' consolidated capitalization ratios as of December 31, 1993, were: common equity, 46.1%; preferred stock, 6.5%; and long- term debt, 47.4%. APS and the Subsidiaries' long-term objective is to maintain the common equity portion above 45%, reduce the long-term debt portion toward 45%, and maintain the preferred stock ratio for the balance of the capital structure. In January 1994, the Operating Subsidiaries jointly entered into an aggregate $300 million multi- year credit agreement with eighteen lenders. Each Operating Subsidiary's borrowings under the agreement are limited to its pro rata share of the stock of AGC, which stock was pledged to secure the credit agreement. The Operating Subsidiaries' percentage ownership of AGC and resulting borrowing limitations are: Monongahela 27%, $81,000,000; Potomac Edison 28%, $84,000,000; and West Penn 45%, $135,000,000. The agreement may be used as a supplement to or in lieu of public financings and short-term debt programs. - 18 - During 1994, Monongahela, Potomac Edison and West Penn plan to issue up to $50 million, $75 million, and $105 million, respectively, of new securities, consisting of both debt and preferred and common equity, for general corporate purposes, including their construction programs. In addition, the Operating Subsidiaries may engage in tax-exempt solid waste disposal financings to the extent funds are available to Harrison County from the West Virginia cap allocation. APS plans to fund Operating Subsidiaries' sales of common stock to it through the issuance of short-term debt and the sale of APS' common stock through its Dividend Reinvestment and Stock Purchase Plan and Employee Stock Ownership and Savings Plan. The Operating Subsidiaries, if economic and market conditions make it desirable, may refund during 1994 up to $550 million of first mortgage bonds, up to $100 million of preferred stock, and up to $78 million of pollution control revenue notes through tender offers or optional redemptions. FUEL SUPPLY System-operated stations burned approximately 15.7 million tons of coal in 1993. Of that amount, 67% was cleaned (6.7 million tons) or used in stations equipped with scrubbers (3.9 million tons). Use of desulfurization equipment and cleaning and blending of coal make burning local higher-sulfur coal practical, and in 1993 about 96% of the coal received at System stations came from mines in West Virginia, Pennsylvania, Maryland, and Ohio. The Operating Subsidiaries do not mine or clean any coal. All raw, clean or washed coal is purchased from various suppliers as necessary to meet station requirements. Long-term arrangements, subject to price change, are in effect and will provide for approximately 12 million tons of coal in 1994. The System depends on short-term arrangements and spot purchases for its remaining requirements. Through the year 1999, the total coal requirements of present System-operated stations are expected to be met with coal acquired under existing contracts or from known suppliers. The Operating Subsidiaries will meet the requirements of Phase I of the CAAA by installing scrubbers at Harrison Power Station. This will allow the continued use of local, high-sulfur coal there. A long-term contract for the supply of lime for use in the scrubber operation and for fixation of the scrubber byproduct has been negotiated and is expected to be signed in early 1994. It is expected that the use of lime will increase the costs of operating the station. For each of the years 1989 through 1992, the average cost per ton of coal burned was, respectively, $34.64, $35.97, $36.74 and $36.31. For the year 1993, the cost per ton decreased to $36.19, and in December 1993 the cost per ton was $36.45. - 19 - The labor agreement between the United Mine Workers of America (UMWA) and the Bituminous Coal Operators' Association (BCOA) expired on February 1, 1993. As a result, the UMWA initiated selective strikes against BCOA member companies on February 2, 1993. In late May and early June, numerous mines which serve the Operating Subsidiaries' power stations were closed down to various degrees. The UMWA and BCOA agreed to a new five year contract on December 14, 1993, and mining operations resumed at most mines during the week of December 20, 1993. The Operating Subsidiaries continued to meet customer needs during this approximately seven-month period through the use of existing low cost inventories, additional spot and substitute contract coal purchases, and some conservation measures, primarily at the Harrison Power Station. The Operating Subsidiaries own coal reserves estimated to contain about 125 million tons of high- sulfur coal recoverable by deep mining. There are no present plans to mine these reserves and, in view of economic conditions now prevailing in the coal market, the Operating Subsidiaries plan to hold the reserves as a long-term resource. RATE MATTERS Rate case decisions in Pennsylvania and Maryland were issued for West Penn and Potomac Edison in May and February, 1993. West Penn On May 14, 1993, the Pennsylvania Public Utility Commission (PUC) issued an order in West Penn's base rate case effective May 18, 1993, authorizing an increase in revenues of $61.6 million, of which $26.1 million was for recovery of carrying charges (return on investment and taxes) associated with West Penn's CAAA compliance plan through June 30, 1993. West Penn had originally filed for a base rate increase designed to produce $101.4 million. West Penn received all maintenance expenses that it had requested, and a return on equity (ROE) of 11.5%. West Penn filed a petition on January 12, 1994 with the PUC requesting authorization to accrue post in-service carrying charges on the Harrison scrubbers and to defer related depreciation and operating and maintenance expenses until they are recognized in rates. West Penn cannot predict the outcome of this proceeding. West Penn plans to file an application with the PUC on or about March 31, 1994, for a base rate increase to recover the remaining carrying charges on investment, depreciation and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the new rates will become effective on or about December 31, 1994. West Penn cannot predict the precise amount to be requested or the outcome of this proceeding. On February 20, 1992, the Commonwealth Court of Pennsylvania affirmed the PUC's December 13, 1990, decision relating to West Penn's challenge to the PUC's methodology for calculation of ROE. Three industrial customers also appealed to the Commonwealth Court that part of the PUC order which failed to allocate capacity costs of PURPA projects on a demand basis in West Penn's Energy Cost Rate. On June 25, 1992, the Commonwealth Court reversed the PUC's decision on this issue and remanded the case to the PUC for further proceedings. West Penn and other parties have negotiated a settlement on capacity costs of PURPA projects and other demand-related costs in West Penn's Energy Cost Rate, which settlement does not affect West Penn's revenues. The settlement agreement was approved by the PUC and was implemented in 1993. - 20 - Monongahela On January 18, 1994, Monongahela filed an application with the West Virginia Public Service Commission (West Virginia PSC) for a base rate increase designed to produce $61.3 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Monongahela cannot predict the outcome of this proceeding. Monongahela filed a petition on January 11, 1994, with the Public Utilities Commission of Ohio (PUCO) requesting authorization to accrue post-in-service carrying charges on the Harrison scrubbers until its investment in such scrubbers is recognized in rates. The petition also requested authorization for Monongahela to defer depreciation, and operating and maintenance expenses, including property taxes (but not including fuel costs) with respect to the scrubbers until the recovery of the deferrals can be addressed in Monongahela's next base rate case or otherwise, as the PUCO may deem appropriate. Monongahela is currently awaiting a decision on this petition. If the petition is approved, Monongahela will file its Ohio base rate case in early 1995. Potomac Edison The Maryland Public Service Commission (Maryland PSC) issued a final order in Potomac Edison's base rate case on February 24, 1993, authorizing an annual increase of $11.3 million, effective February 25, 1993, which included CAAA carrying charges through February 28, 1993. The original filing in July of 1992 was designed to produce approximately $23.0 million in additional annual revenues. Subsequent adjustments reduced this request to $17.6 million. Potomac Edison received most of the maintenance expenses that it had requested and a ROE of 11.9%. On April 30, 1993, Potomac Edison filed with the Virginia State Corporation Commission (SCC) for a rate increase designed to produce $10.0 million in additional annual revenues. The new rates went into effect on September 28, 1993, subject to refund. Hearings have been held and a final SCC decision is expected by April 1994. Potomac Edison cannot predict the outcome of this proceeding. - 21 - On January 14, 1994, Potomac Edison filed an application with the West Virginia PSC for a base rate increase designed to produce $12.2 million in additional annual revenues which includes recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that a decision will be rendered about November 15, 1994, with increases to be effective immediately. Potomac Edison cannot predict the outcome of this proceeding. On or about April 15, 1994, and June 30, 1994, Potomac Edison plans to file new rate cases in Maryland and Virginia, respectively. The amounts of the requested increases have not yet been determined, but they will include recovery of the remaining carrying charges on investment, depreciation, and all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense. It is expected that the Maryland decision will be rendered in late 1994, and the Virginia decision in mid-1995. However, in both jurisdictions, it is expected that increases will be effective in late 1994. Monongahela and Potomac Edison Pursuant to its order of December 12, 1991, approving Monongahela and Potomac Edison's plan for compliance with Phase I of the CAAA, the West Virginia PSC authorized recovery by Monongahela and Potomac Edison of $5.6 million and $1.4 million, respectively, of carrying charges on Phase I CAAA compliance costs through March 31, 1993, effective July 1, 1993. This brings the annual Phase I CAAA recovery for Monongahela and Potomac Edison to $8.7 million and $2.2 million, respectively. Pursuant to the order, Monongahela and Potomac Edison will submit requests for recovery of carrying charges through March 31, 1994, on Phase I CAAA compliance costs in the annual energy cost review proceedings with any increase to be effective July 1, 1994. The annual values of all CAAA revenues authorized in these proceedings will be removed from this collection process effective when full Phase I CAAA costs are included in base rates as a result of the 1994 rate case filings. AGC Through February 29, 1992, AGC's ROE was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties filed to reduce the ROE to 10%. Hearings were completed in June 1992, and a recommendation has been issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the other parties argue should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate filed a joint complaint with the FERC against AGC claiming that both the existing ROE of 11.53% and the ROE recommended by the ALJ of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53% with rates subject to refund beginning April 1, 1994. AGC cannot predict the outcome of these proceedings. - 22 - FERC West Penn, Potomac Edison, and Monongahela implemented settlement agreements in 1993 covering wholesale rates in effect for their municipal, co-op, and borderline agreement customers subject to the jurisdiction of the FERC. Each included carrying charges for work in progress on the scrubbers at the Harrison Power Station, additional expenses for postretirement benefits other than pensions (see below), and future automatic rate changes resulting from changes to taxes or tax rates (federal, state and local for Monongahela and West Penn, and federal for Potomac Edison). The amounts of the increases and the effective dates for West Penn, Potomac Edison, and Monongahela were $1.6 million on June 15, 1993; $1.5 million on September 15, 1993; and $0.6 million on December 1, 1993, respectively. It is anticipated that additional filings to include recovery of the remaining carrying charges on investment, depreciation, as well as all operating costs required to comply with Phase I of the CAAA, and other increasing levels of expense for each Operating Subsidiary will be made in 1994 with increases to be effective around the end of 1994. Postretirement Benefits Other Than Pensions (SFAS No. 106) The Operating Subsidiaries and APSC adopted SFAS No. 106 as of January 1, 1993. This requires all companies to accrue for the cost of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years that the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Operating Subsidiaries and APSC for retired employees and their dependents were recovered in rates on a pay-as-you-go basis. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for FERC wholesale customers effective on the rate case effective date described above under ITEM 1. RATE MATTERS, FERC. Regulatory actions have been taken by the PUCO and Virginia PSC, which indicate that substantial recovery is probable. The West Virginia PSC considers recovery of SFAS No. 106 costs on a case- by-case basis and therefore Monongahela and Potomac Edison cannot predict the outcome of such proceedings. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. Recovery of these costs in Ohio will be requested in the next base rate case which is expected to be filed in early 1995. The Operating Subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. The Operating Subsidiaries have recorded regulatory assets relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates. The Operating Subsidiaries do not anticipate that SFAS No. 106 will have a substantial effect on consolidated net income. - 23 - ENVIRONMENTAL MATTERS The operations of the Subsidiaries are subject to regulation as to air and water quality, hazardous and solid waste disposal, and other environmental matters by various federal, state, and local authorities. Meeting known environmental standards is estimated to cost the Subsidiaries about $361 million in capital expenditures over the next three years, including $254 million for compliance with Phase I of the CAAA, described below, and initial cost for anticipated compliance with Phase II. The full costs of compliance with Phase II cannot be estimated at this time, but may be substantial. Additional legislation or regulatory control requirements, if enacted, may well require modifying, supplementing, or replacing equipment at existing stations at substantial additional cost. Air Standards The Operating Subsidiaries meet applicable standards as to particulates and opacity at major stations with high-efficiency electrostatic precipitators, cleaned coal, flue-gas conditioning, and, at times, reduction of output. From time to time minor excursions of opacity normal to fossil fuel operations are experienced and are accommodated by the regulatory process. In February 1994, three notices of violation were received by the Operating Subsidiaries from the West Virginia Division of Environmental Protection (WVDEP) regarding opacity excursions for three power stations in West Virginia. The Operating Subsidiaries are working with the WVDEP to resolve the alleged violations. It is not anticipated that the alleged violations will result in substantial penalties. At the major stations (other than Mitchell Unit No. 3 and Pleasants, which have scrubbers), the Operating Subsidiaries meet current emission standards as to sulfur dioxide by using low-sulfur coal, by purchasing cleaned coal to lower the sulfur content, or by blending low-sulfur with higher sulfur coal. The CAAA, among other things, require an annual reduction in total utility emissions within the United States of 10 million tons of sulfur dioxide and two million tons of nitrogen oxides from 1980 emission levels, to be completed in two phases, Phase I and Phase II. Five coal-fired System plants are affected in Phase I and the remaining five coal-fired plants and any coal-fired plants or units reactivated in the future will be affected in Phase II. Installation of scrubbers at the Harrison Power Station is the strategy undertaken by the Operating Subsidiaries to meet the required sulfur dioxide emission reductions for Phase I (1995). Continuing studies will determine the compliance strategy for Phase II (2000). It is expected that burner modifications at all power stations will satisfy the nitrogen oxide emission reduction requirements for the acid rain (Title IV) provisions of the CAAA. Additional post-combustion controls may be mandated in Maryland and Pennsylvania for ozone nonattainment (Title I) reasons. Continuous emission monitoring equipment has been installed on all Phase I units and is being installed on Phase II units. Studies to evaluate cost effective options to comply with Phase II of the CAAA, including those which may be available from the use of Operating Subsidiaries' banked emission allowances and from the emission allowance trading market, are continuing. - 24 - In an effort to introduce market forces into pollution control, the CAAA created sulfur dioxide emission allowances. An allowance is defined as an authorization for an owner to emit one ton of sulfur dioxide into the atmosphere during or following a specified calendar year. Subject to regulatory limitations, allowances (including bonus and extension allowances) not used by an owner for its own compliance may be sold or "banked" for future use or sale. Through an industry allowance pooling agreement, the Operating Subsidiaries will receive a total of approximately 570,000 bonus and extension allowances during Phase I. These allowances are in addition to the Table A allowances of approximately 356,000 per year. As a result of EPA's 1993 auctioning of a number of Table A allowances retained from each utility's annual allotment, approximately 16,000 allowances were sold for the Operating Subsidiaries. Such auctions will be held every year for the foreseeable future and allowances sold thereby will result in a prorational allocation of revenues back to the Operating Subsidiaries. If some allowances offered at auction remain unsold, the balance will also be prorationally rebated to the utilities which contributed them. The proceeds from these auctions are expected to be relatively minimal and the Operating Subsidiaries plan to credit these proceeds against the capital cost of emission compliance activities, subject to regulatory approval. Other allowance trading activities may be undertaken by the Operating Subsidiaries once certain tax questions are answered and once studies to determine Phase II compliance strategy are completed. In 1989, the West Virginia Air Pollution Control Commission approved the construction of a cogeneration facility in the vicinity of Rivesville, West Virginia. Emissions impact modeling for that facility raised concerns about the compliance status of Monongahela's Rivesville Station with the National Ambient Air Quality Standards (NAAQS) for sulfur dioxide. Pursuant to a consent order, Monongahela agreed to collect on- site meteorological data and conduct additional dispersion modeling in order to demonstrate compliance. The modeling study and a compliance strategy recommending construction of a new "good engineering practices" (GEP) stack was submitted to the WVDEP in June 1993. Costs associated with the GEP stack are approximately $7 million. Monongahela is awaiting action by the WVDEP. - 25 - Under an EPA-approved consent order with Pennsylvania, West Penn completed construction of a GEP stack at the Armstrong Station in 1982 at a cost of over $13 million with the expectation that EPA's reclassification of Armstrong County to "attainment status" under NAAQS for sulfur dioxide would follow. As a result of the 1985 revision of its stack height rules, EPA refused to reclassify the area to attainment status. West Penn appealed the EPA's decision. In 1988, the U. S. Court of Appeals for the Third Circuit dismissed West Penn's appeal for lack of jurisdiction, stating that West Penn's request for reconsideration before EPA made EPA's denial a non-final agency action. West Penn's request for reconsideration before EPA remains pending. West Penn cannot predict the outcome of this proceeding. Water Standards Under the National Pollutant Discharge Elimination System (NPDES) permitting procedures, permits for all System-owned stations are in place. However, in proposed NPDES renewal permits for some stations which are currently being sought, some conditions are being appealed through the regulatory process since the Operating Subsidiaries believe the effluent limitations being applied are overly stringent. The Operating Subsidiaries continue to work with the appropriate state agencies to resolve these issues. In the meantime, the existing permits remain in effect during the appeal process. The EPA and states are now implementing stormwater runoff regulations for controlling discharges from industrial and municipal sources as well as construction sites. Stormwater discharges have been identified and included in NPDES renewals, but controls have not yet been required. Since the current round of permit renewals began in 1993, monitoring requirements have been imposed, with pollution reduction plans and additional control of some discharges anticipated. Pursuant to the National Groundwater Protection Strategy, which supplements existing West Virginia groundwater protection policy, West Virginia has adopted a Groundwater Protection Act. This law establishes a statewide antidegradation policy which could require the Operating Subsidiaries to undertake reconstruction of existing landfills and surface impoundments as well as groundwater remediation, and may affect herbicide use for right-of-way maintenance in West Virginia. Groundwater protection standards were approved and implemented in 1993 (based on EPA drinking water criteria) which established compliance limits which cannot be exceeded. The Operating Subsidiaries anticipate that some facilities will not be able to meet the new compliance limits. Variance requests and requests for stays of implementation have been made for all affected facilities. However, variance rules have not yet been promulgated and action on the requests has not been taken. Therefore, it is not possible to predict the difficulty and costs associated with obtaining variances. If variances are not granted, costs may be incurred by the Operating Subsidiaries for groundwater remediation. Such costs, if any, cannot be predicted at this time. - 26 - The Pennsylvania Department of Environmental Resources (PADER) developed a Groundwater Quality Protection Strategy which established a goal of nondegradation of groundwater quality. However, the strategy recognizes that there are technical and economic limitations to immediately achieving the goal and further recognizes that some groundwaters need greater protection than others. The PADER is beginning to implement the strategy by promulgating changes to the existing rules that heretofore did not consider the nondegradation goal. The full extent of the impact of the strategy on the Operating Subsidiaries cannot be anticipated at this time. In 1993, two notices of violation were received by the Operating Subsidiaries from the WVDEP regarding excursions above limits contained in NPDES permits for discharge of leachate from fly ash landfills in West Virginia. One violation notice was withdrawn by the state agency and the other was resolved without payment of substantial penalty. On January 27, 1994 and February 9, 1994, the Operating Subsidiaries received two separate notices of violation from PADER regarding excursions above limits contained in the NPDES permit for discharge of leachate from Hatfield's Ferry Power Station fly ash landfill. One violation notice was resolved without payment of substantial penalty. The Operating Subsidiaries are working with the PADER to resolve the other alleged violation. It is not anticipated that the alleged violation will result in substantial penalties. Hazardous and Solid Wastes Pursuant to the Resource Conservation and Recovery Act of 1976 and the Hazardous and Solid Waste Management Amendments of 1984 (RCRA), EPA regulates the disposal of hazardous and solid waste materials. Pennsylvania, West Virginia, Maryland, Ohio, and Virginia have also enacted hazardous and solid waste management legislation. With the installation of the scrubbers at the Harrison Power Station, approximately 2.8 million tons per year of scrubber sludge, consisting principally of limestone and ash, will be generated and disposed of in a disposal facility owned and operated by the Operating Subsidiaries. The expected capacity of the site is 30 years. Pleasants Power Station processes its scrubber sludge using a wet-fixation and slurry system, with the treated sludge disposed of in a properly permitted sludge pond. Mitchell and Harrison Power Stations process their scrubber sludge by a dry-fixation process with the stabilized sludge disposed of in a properly permitted landfill. Coal combustion byproducts from all other facilities are either sold for beneficial reuse or landfilled in properly permitted and currently adequate disposal facilities owned and operated by the Operating Subsidiaries. The Operating Subsidiaries are in the process of permitting additional capacity to meet future disposal needs. - 27 - Costs are being incurred as the Operating Subsidiaries progress with implementation of both West Virginia's and Pennsylvania's 1992 solid waste regulatory changes. A predominant portion of the costs are attributable to two major factors: 1) liner systems for new disposal sites and the expansion portion of existing disposal sites, and 2) the assessment of groundwater impacts via monitoring wells. Because past operating practices, while in compliance with then existing regulations, may not meet the current criteria, as measured by new standards, it is possible that groundwater remediation may be required at some of the Operating Subsidiaries' facilities. In addition, under West Virginia's Solid Waste Rules, it is possible that certain active disposal sites may have to be retrofitted with liner systems to address potential groundwater degradation. The draft permit renewal from WVDEP for the currently active disposal site at Albright Power Station requires, on a portion of the site, retrofitting with a new liner system with possible removal of already placed coal combustion byproducts. The Operating Subsidiaries are working to have this proposed permit condition removed; however if it is not, it is anticipated that this condition will be appealed. EPA regulations on the burning of hazardous waste in utility boilers are expected to be amended in 1994 making the practice cost prohibitive for the Operating Subsidiaries. Until such time as the regulations are amended, the Operating Subsidiaries will continue to minimize their hazardous waste and to burn small quantities of hazardous waste generated in accordance with EPA boiler and industrial furnace disposal rules. Once such regulations are amended, the low volume wastes will be disposed of in incinerators or landfills which are owned by third parties. None of the Operating Subsidiaries are required to obtain hazardous waste treatment, storage or disposal permits under RCRA. With a continued effort to reduce hazardous waste, disposal costs and potential environmental liability should be minimized. Potomac Edison has received a notice from the Maryland Department of the Environment (MDE) regarding a remediation ordered under Maryland law at a facility previously owned by Potomac Edison. The MDE has identified Potomac Edison as a potentially responsible party under Maryland law. Remediation is currently being implemented by the current owner of the facility in Frederick, Maryland. It is not anticipated that Potomac Edison's share of remediation costs, if any, will be substantial. Emerging Environmental Issues Title I of the CAAA establishes an ozone transport region consisting of 11 northeast states including Maryland and Pennsylvania. Sources within the region will be required to reduce nitrogen oxide emissions, a precursor of ozone, to a level conducive to attainment of the ambient ozone standard. The first step for Title I compliance will result in the installation of low nitrogen oxide burners and potentially overfire air at all Pennsylvania and Maryland stations by 1995. This is compatible with Title IV nitrogen oxide reduction requirements. Modeling studies being conducted by the states will determine if a second step of reductions will be necessary which could require installation of post- combustion control technologies. - 28 - Title III of the CAAA requires EPA to conduct studies of toxic air pollutants from utility plants to determine if emission controls are necessary. EPA's reports are expected to be submitted to Congress in late 1995. The impact of Titles I and III on the Operating Subsidiaries is unknown at this time. Both the CWA and the RCRA are expected to be reauthorized in 1994. It is anticipated that coal combustion byproducts will continue to be regulated as nonhazardous waste, minimizing the Operating Subsidiaries' disposal costs. An additional issue which could impact the Operating Subsidiaries and which is undergoing intense study, is the effect, if any, of electric and magnetic fields. The financial impact of this issue on the Operating Subsidiaries, if any, cannot be assessed at this time. In connection with President Clinton's Climate Change Action Plan concerning greenhouse gases, the Operating Subsidiaries expressed by letter to the DOE in August 1993, their willingness to work with the DOE on implementing voluntary, cost-effective courses of action that reduce or avoid emission of greenhouse gases. Such courses of action must take into account the unique circumstances of each participating company, such as growth requirements, fuel mix and other circumstances. Furthermore, they must be consistent with the Operating Subsidiaries' integrated resource planning process and must not have an adverse effect on competitive position in terms of costs and rates or be unacceptable to their regulators. Some 63 other utility systems submitted similar letters. REGULATION APS and the Subsidiaries are subject to the broad jurisdiction of the Securities and Exchange Commission (SEC) under the Public Utility Holding Company Act of 1935 (PUHCA). APS is also subject to the jurisdiction of the Maryland PSC as to certain of its activities. The Subsidiaries are regulated as to substantially all of their operations by regulatory commissions in the states in which they operate and also by the DOE and the FERC. In addition, they are subject to numerous other city, county, state, and federal laws, regulations, and rules. EPACT became law on October 24, 1992. This broad legislation, among other things, amends PUHCA to permit utilities subject to PUHCA to compete in the wholesale generation business with other wholesale generators which it exempts from PUHCA; to ease restrictions on financing for that purpose; and to permit investment in foreign utilities. EPACT also amends the Federal Power Act to permit the FERC to order, under specified circumstances, access to transmission systems (including those of the System) so long as it would not unreasonably impair reliability nor adversely affect its existing wholesale, retail and transmission customers. It also amends PURPA to encourage states to study and regulate various matters, including the capital structures of EWGs, integrated resource planning, and the amount of purchased power that electric utilities should have in their generation mix. EPACT also sets forth waste disposal standards, new nuclear licensing procedures, and contains provisions promoting alternate transportation fuels, research on environmental issues, and increased energy from renewables (See discussion of EPACT in ITEM 1. BUSINESS, SALES and ELECTRIC FACILITIES). - 29 - Pursuant to the requirements of Section 712 of EPACT, the Maryland, Ohio, Pennsylvania, Virginia, and West Virginia commissions issued orders regarding four broad economic and regulatory policy issues related to the purchase of wholesale power. All of the commissions decided to evaluate these issues on a case- by-case basis or within their existing regulatory framework, instead of establishing generic standards. On January 24, 1994, the Maryland PSC issued an order which instituted a proceeding for the purpose of determining whether to implement standards which, under EPACT, a state commission must consider in order to encourage integrated resource planning and investments in conservation and energy efficiency by electric utilities. The order provides for the filing of initial and reply comments and for a hearing on May 3, 1994. Potomac Edison intervened and will be submitting comments in this proceeding. Under EPACT, the FERC has initiated several proceedings, one of the most significant being the request for comments on transmission pricing, including pricing as it may apply to parallel power flows. The Operating Subsidiaries have developed and submitted a pricing philosophy intended to meet certain goals, including reliable operation of the transmission system and protection of native load customers, while promoting accurate price signals and offering third- party transmission service at the lowest reasonable rates. Other FERC initiatives included the issuance of guidelines governing open access transmission requests and rules governing the establishment of Regional Transmission Groups. The Operating Subsidiaries founded and continue to participate in, along with other utilities, an organization whose primary purpose is to develop a mutually acceptable method of resolving the inequities imposed on transmission network owners by parallel power flows. The SEC has also issued regulations and proposed regulations to implement EPACT, including the integration of EPACT with PUCHA and the effect of EPACT on nonexempt PUCHA companies such as APS and its Subsidiaries. In July 1993, the PUC directed the Bureau of Conservation, Economics and Energy Planning to develop competitive bidding regulations to replace, at least in part, the existing state PURPA regulations. In November 1993, West Penn filed a petition with the PUC requesting an Order that, pending the revision and replacement of the existing state PURPA regulations, any proceedings or orders regarding purchase by West Penn of capacity from a qualifying facility under PURPA shall be based on competitive bidding. The Office of Consumer Advocate, the Office of Small Business Advocate, the West Penn Power Industrial Intervenors, and West Penn's two largest industrial customers have intervened in support of West Penn's position. Several PURPA developers and a group purporting to represent PURPA interests have filed in opposition to certain parts of the petition. West Penn cannot predict the outcome of this proceeding. - 30 - On October 8, 1993, the West Virginia PSC issued proposed regulations concerning bidding procedures for capacity additions for electric utilities and invited comment by December 7, 1993. A number of interested parties, including Monongahela and Potomac Edison, filed comments. The West Virginia PSC has taken no further action since the filing of comments. On December 17, 1992, the PUCO issued proposed rules concerning competitive bidding for supply-side resources, transmission access for winning bidders and incentives for the recovery of the cost of purchased power. The PUCO invited comments by March 3, 1993 and reply comments by March 24, 1993. A number of interested parties, including Monongahela, submitted comments. The PUCO has taken no further action following the filing of comments. Maryland and Virginia have not mandated compulsory competitive bidding at this date. The Omnibus Budget Reconciliation Act of 1993 increased the marginal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. As a result, the Operating Subsidiaries' income tax expense for 1993 increased by about $3 million. On June 13, 1990, the Maryland PSC began an investigation to determine whether Potomac Edison's methodology for calculating avoided costs under PURPA is appropriate. On October 11, 1991, the Maryland PSC incorporated this review of avoided costs into a collaborative process already formed between its Staff, the Maryland Department of Natural Resources, Potomac Edison, Eastalco Aluminum, the Maryland Energy Administration, and the Office of People's Counsel. Although the group's primary mission was to avoid litigation by working cooperatively to develop demand- side management programs, the issue of avoided costs was addressed because avoided costs are needed for determining the cost-effectiveness of programs. These negotiations culminated in a Settlement Agreement which was signed by the six parties and filed with the Maryland PSC on October 14, 1993. The Hearing Examiner issued a proposed order accepting the Settlement Agreement on November 17, 1993. The proposed order became final on December 17, 1993, thereby concluding this proceeding. In October 1990, the PUC ordered Pennsylvania's major electric utilities, including West Penn, to file programs for demand-side management designed to reduce customer demand for electricity and to reduce the need for additional generating capacity. The PUC's order proposed that the affected utilities receive full recovery of the costs of approved programs, as well as financial incentives for implementing such programs, including recovery of lost revenues. West Penn filed its proposed programs with the PUC. On December 13, 1993, the PUC entered an order which provides for the recovery of program costs either through a surcharge or deferral to a base rate case; the recovery of revenues lost due to the implementation of demand-side management programs through a base rate case; and the award of incentives for good program performance or the assessment of penalties for poor performance. Two parties to this proceeding have petitioned the PUC for reconsideration and clarification and the Pennsylvania Industrial Energy Coalition has filed an appeal with the Commonwealth Court of Pennsylvania. West Penn cannot predict the final outcome of this proceeding. - 31 - During 1993, Potomac Edison continued its participation in the Collaborative Process for demand- side management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and Potomac Edison's largest industrial customer. Potomac Edison received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993 Potomac Edison had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. ITEM 2. ITEM 2. PROPERTIES Substantially all of the properties of the Operating Subsidiaries are held subject to the lien securing each company's first mortgage bonds and, in many cases, subject to certain reservations, minor encumbrances, and title defects which do not materially interfere with their use. Some properties are also subject to a second lien securing certain solid waste disposal and pollution control notes. The indenture under which AGC's unsecured debentures and medium-term notes are issued, prohibits AGC, with certain limited exceptions, from incurring or permitting liens to exist on any of its properties or assets unless the debentures and medium-term notes are contemporaneously secured equally and ratably with all other indebtedness secured by such lien. Transmission and distribution lines, in substantial part, some substations and switching stations, and some ancillary facilities at power stations are on lands of others, in some cases by sufferance, but in most instances pursuant to leases, easements, permits or other arrangements, many of which have not been recorded and some of which are not evidenced by formal grants. In some cases no examination of titles has been made as to lands on which transmission and distribution lines and substations are located. Each of the Operating Subsidiaries possesses the power of eminent domain with respect to its public utility operations. (See also ITEM 1. BUSINESS and SYSTEM MAP.) - 32 - ITEM 3. ITEM 3. LEGAL PROCEEDINGS In 1979, National Steel Corporation (National Steel) filed suit against certain Subsidiaries in the Circuit Court of Hancock County, West Virginia, alleging damages of approximately $7.9 million as a result of an order issued by the West Virginia PSC requiring curtailment of the plaintiff's use of electric power during the United Mine Workers' strike of 1977-8. A jury verdict in favor of the defendants was rendered in June 1991. National Steel has filed a motion for a new trial, which is still pending before the Circuit Court of Hancock County. The Subsidiaries believe the motion is without merit; however, they cannot predict the outcome of this case. In 1987, West Penn entered into separate agreements with developers of four PURPA projects: Milesburg (43 MW), Burgettstown (80 MW), Shannopin (80 MW) and Point Marion (2 MW). The agreements provided for the purchase of each project's power over 30 years or more at rates generally approximating West Penn's avoided costs at the time the agreements were negotiated, as defined by PURPA. Yearly capacity payments under the four agreements would total in excess of $50 million. Each agreement was subject to prior PUC approval of the pass-through to West Penn's customers of the total cost incurred under each agreement, on a current basis. In 1987 and 1988, West Penn filed a separate petition with the PUC for each agreement requesting an appropriate PUC order, and various parties intervened. Since that time, all four agreements have been, in varying degrees, the subject of complex and continuing regulatory and judicial proceedings. During 1993, West Penn entered into a settlement agreement with Point Marion and that project has been terminated. On November 24, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Milesburg project which upheld the decision of the Commonwealth Court concerning the time frame for the calculation of avoided cost and upheld the decision that the PUC had the authority under PURPA to revise and reinstate a lapsed power purchase contract. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. On December 30, 1993, the Pennsylvania Supreme Court issued a per curiam opinion regarding the Shannopin project which upheld the decision of the Commonwealth Court affirming the PUC's authority under PURPA to revise voluntarily negotiated power purchase contracts. West Penn is considering its options as a result of this ruling, including a petition for certiorari to the United States Supreme Court. As of December 31, 1993, petitions for allowance of an appeal of the decision of the Pennsylvania Commonwealth Court on the Burgettstown project were pending before the Pennsylvania Supreme Court. West Penn cannot predict the outcome of these proceedings. On October 28, 1993, South River Power Partners, L.P. ("South River") filed a complaint against West Penn with the PUC. The complaint seeks to require West Penn to purchase 240 MW from a proposed coal-fired PURPA project which South River proposes to build in Fayette County, Pennsylvania. South River's proposed initial price for this power would be over $0.09 per kWh. West Penn is opposing this complaint as the power is not needed and the price is in excess of avoided cost. The Pennsylvania Consumer Advocate, the Small Business Advocate, the PUC Trial Staff and various industrial customers have also intervened in opposition to the complaint. West Penn cannot predict the outcome of this proceeding. - 33 - Two previously reported complaints had been filed with the West Virginia PSC by developers of cogeneration projects in Marshall and Barbour Counties, West Virginia to require Monongahela and Potomac Edison to purchase capacity from the projects. These two cases were consolidated. The West Virginia PSC on March 5, 1993, found that: Monongahela had no need for additional capacity; Potomac Edison will need new combustion turbine generating capacity beginning in 1996; and Potomac Edison's avoided cost estimate, which is substantially below the costs sought by the developers of the projects, is reasonable. The developers have asked the West Virginia PSC to consider issues not resolved in the March 5, 1993 order. On June 25, 1993 the West Virginia PSC found that Potomac Edison had a PURPA obligation to purchase power from qualifying facilities properly interconnected to the System in Monongahela's service territory and ordered negotiations by Monongahela and Potomac Edison with the two PURPA developers. On August 9, 1993, the West Virginia PSC deconsolidated the two cases. Following the West Virginia Supreme Court's denial of a petition for review of this order, both developers requested the start of negotiations. Monongahela and Potomac Edison cannot predict the outcome of these proceedings. On November 16, 1992, Potomac Edison and the developer of a proposed cogeneration project located in Cumberland, Maryland, requested that the Maryland PSC approve an amendment to a previously approved agreement for the sale of 180 MW of capacity and associated energy from the project to Potomac Edison. The amendment provides for the relocation of the proposed project within the Cumberland area; a delay of one year in the project's earliest in-service date to October 1, 1996, without increase in the initial capacity rate (which otherwise escalates annually at one-half the rate of actual inflation); and other changes consistent with the site and in-service date modifications. The Maryland PSC commenced an investigation of the amendment in December 1992. After hearings, the parties reached a settlement which was approved by the Maryland PSC on March 17, 1993. The settlement agreement resulted in a further delay of the project's in-service date to October 1, 1999, modified the initial capacity rate with only a slight escalation, and provided that Potomac Edison would pay, and recover from customers by a surcharge, a portion of the project's costs resulting from the delay. On December 22, 1993, the Maryland PSC approved the surcharge and these costs are being recovered from customers effective January 1, 1994. As previously reported, effective March 1, 1989, West Virginia enacted a new method for calculating the Business and Occupation Tax (B & O Tax) on electricity generated in that state, which disproportionately increased the B & O Tax on shipments of electricity to other states. In 1989, West Penn, the Pennsylvania Consumer Advocate, and several West Penn industrial customers filed a joint complaint in the Circuit Court of Kanawha County, West Virginia seeking to have the B & O Tax declared illegal and unconstitutional on the grounds that it violates the Interstate Commerce Clause and the Equal Protection Clause of the federal Constitution and certain provisions of federal law that bar the states from imposing or assessing taxes on the generation or transmission of electricity that discriminate against out-of-state entities. In 1991, West Penn amended the complaint to include a 1990 increase in the rate of the B & O Tax. The trial was held in July 1993 and briefs have been filed. West Penn cannot predict the outcome of this litigation. - 34 - As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shot- gun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Operating Subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the Operating Subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at Subsidiary-operated stations were employed by third- party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Operating Subsidiaries believe potential liability of the Operating Subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the Operating Subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. On March 4, 1994, the Operating Subsidiaries received notice that the EPA had identified them as potentially responsible parties ("PRPs") under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"), with respect to the Jack's Creek/Sitkin Smelting Superfund Site ("Site"). The Operating Subsidiaries are among some 880 PRPs that have been identified at the Site. EPA is planning to issue a Proposed Plan and Record of Decision in September 1994 delineating the remedy selected for the Site. At this time it is not possible to determine what liability, if any, the Operating Subsidiaries may have regarding the Site. - 35 - In 1970, the Operating Subsidiaries filed with the Federal Power Commission (FPC) an application for a license to build a 1,000-MW energy-storage facility near Davis, West Virginia. In 1977, FPC issued a license for the project, but various parties, including the State of West Virginia and the U.S. Department of Interior, filed appeals, which are now pending before the U.S. Court of Appeals for the District of Columbia. The U.S. Army Corps of Engineers (Corps) denied a dredge and fill permit for the project, which decision was appealed. The U.S. District Court for the District of Columbia decided that the Corps had no jurisdiction in the matter. The Corps filed an appeal with the U.S. Court of Appeals for the District of Columbia. In 1987, the appellate Court decided that the Corps did have jurisdiction and remanded the case to the U.S. District Court for further consideration of the Corps' denial of the permit. The U. S. Supreme Court refused to review that decision. In 1988, the U.S. District Court reversed the Corps' denial of the dredge and fill permit. The District Court's decision, which has now been appealed, found, among other things, that the Operating Subsidiaries were denied an opportunity to review and comment upon written materials and other communications used by the Corps in making its decision, and as a result the Court remanded the matter to the Corps for further proceedings. Negotiations are ongoing to settle this matter. The Operating Subsidiaries cannot predict the outcome of these proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The holders of 46,537,924 shares of common stock of APS voted at a special meeting held on November 3, 1993 to amend APS' charter to reclassify each share of common stock, par value $2.50 per share, issued or unissued, into two shares of common stock, par value $1.25 each. The holder of 259,451 shares voted against the proposal and the holders of 296,598 shares abstained. The charter amendment became effective at the close of business on November 4, 1993. The amount of APS' stated capital was not changed as a result of the amendment. The holder of the common stock of Monongahela on December 13, 1993, waived the holding of a meeting and consented in writing to the amendment of its Charter to reflect the redemption of 50,000 shares of $9.64 series cumulative preferred stock. No other company submitted matters to a vote of shareholders during the fourth quarter. - 36 - Executive Officers of the Registrants The names of the executive officers of each company, their ages, the positions they hold and their business experience during the past five years appears below: (a) All officers and directors are elected annually. - 37 - (a) All officers and directors are elected annually. - 48 - (a) All officers and directors are elected annually. - 39 - PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS APS. AYP is the trading symbol of the common stock of APS on the New York, Chicago, and Pacific Stock Exchanges. The stock is also traded on the Amsterdam (Netherlands) and other stock exchanges. As of December 31, 1993, there were 63,396 holders of record of APS' common stock. The tables below show the dividends paid and the high and low sale prices of the common stock for the periods indicated: The high and low prices in 1994 were 26-1/2 and 24-1/8 through February 3. The last reported sale on that date was at 25. Monongahela, Potomac Edison, and West Penn. The information required by this Item is not applicable as all the common stock of these Subsidiaries is held by APS. AGC. The information required by this Item is not applicable as all the common stock of AGC is held by Monongahela, Potomac Edison, and West Penn. - 40 - ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Page No. APS D-1 Monongahela D-3 Potomac D-5 West Penn D-7 AGC D-9 D-1 D-2 (a) Reflects a two-for-one common stock split effective November 4, 1993. (b) Capability available through contractual arrangements with nonutility generators. (c) Preliminary. D-3 D-3 (a) Capability available through contractual arrangements with nonutility generators. D-5 D-6 D-7 D-8 (a) Capability available through contractual arrangements with nonutility generators. D-9 - 41 - ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Page No. APS M-1 Monongahela M-9 Potomac M-18 West Penn M-27 AGC M-36 M-1 APS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONSOLIDATED NET INCOME Earnings per share were $1.88 in 1993 and were $1.83 and $1.80 in 1992 and 1991. Consolidated net income was $215.8 million, $203.5 million, and $194.0 million. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. All per share amounts have been adjusted to reflect the November 4, 1993, two-for-one stock split (See Note F to the consolidated financial statements). SALES AND REVENUES KWh sales to and revenues from residential, commercial, and industrial customers are shown on page D-2. Such kWh sales increased 3.3% and 1.5% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $ 46.6 $ 9.1 Fuel and energy cost adjustment clauses (a) 57.0 37.9 Rate increases (b): Pennsylvania 25.2 5.8 Maryland 12.7 11.7 West Virginia 5.3 12.4 Virginia 2.5 1.8 Ohio 2.1 1.7 47.8 33.4 Other 6.2 .1 $157.6 $80.5 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) See ITEM 1. RATE MATTERS for further information on rate changes. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were approximately normal, cooling degree days increased 69% over 1992 and were 25% over normal, contributing to the 1993 kWh sales increases. The subsidiaries experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M -2 KWh sales to industrial customers increased .3% in 1993 and 2.9% in 1992. The relatively flat industrial sales growth in 1993 followed record industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From subsidiaries' generation 1.2 3.2 5.8 From purchased power 11.2 14.6 12.4 12.4 17.8 18.2 Revenues (in millions): From subsidiaries' generation $ 28.5 $ 91.7 $158.5 From sales of purchased power 318.2 373.8 366.5 $346.7 $465.5 $525.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by subsidiaries' generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the subsidiaries' ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989--a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $14 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M -3 OPERATING EXPENSES Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with other utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA) and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Purchased power: For resale to other utilities $280.9 $344.0 $332.7 From PURPA generation 105.2 94.0 68.9 Other 33.8 12.7 29.0 Total power purchased 419.9 450.7 430.6 Power exchanges, net (2.5) .7 (1.4) $417.4 $451.4 $429.2 The amount of power purchased from other utilities for use by subsidiaries and for resale to other utilities depends upon the availability of the subsidiaries' generating equipment, transmission capacity, and fuel, and their cost of generation and the cost of operations of other utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to other utilities is described under SALES AND REVENUES above. The cost of power purchased for use by the subsidiaries, including power from PURPA generation, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the subsidiaries' regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net income. The increases in purchases from PURPA generation reflect additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $5 million. The subsidiaries are currently recovering approximately 85% of SFAS No. 106 expenses in rates and will be requesting recovery of substantially all of the remainder in 1994 rate cases. During 1992, the subsidiaries implemented significant changes to their benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 20% greater than 1993 amounts. M-4 Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other postemployment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The subsidiaries currently accrue for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The subsidiaries are also experiencing, and expect to continue to experience, increased expenditures due to the aging of their power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the Clean Air Act Amendments of 1990 (CAAA). Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note I to the consolidated financial statements) and the replacement of aging equipment at the subsidiaries' power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $4 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($5 million) and increased property taxes ($2 million). These increases were offset by decreased West Virginia Business and Occupation taxes (B&O taxes) due to decreased generation in that state. The 1992 increase resulted from increased property taxes ($4 million), increases in gross receipts taxes ($3 million), and increased capital stock taxes ($2 million), offset by decreased B&O taxes ($2 million). The net increase of $13 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($9 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($3 million). The net decrease in 1992 of $4 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the consolidated financial statements provides a further analysis of income tax expenses. M-5 The combined increase of $4 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. Fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the levels of short-term debt maintained by the companies. The decrease in dividends on preferred stock of subsidiaries reflects the 1992 redemption of three series totaling $25 million with dividend rates of 9.4% to 9.64% and the 1993 redemption of an additional $2 million of 4.7% to $7.16 series, offset by the 1992 sale of $40 million of market auction preferred stock with an average dividend rate of 2.6%. LIQUIDITY AND CAPITAL RESOURCES SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". System companies need cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stocks, and for their construction programs. To meet these needs, the companies have used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the companies' cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. CAPITAL REQUIREMENTS Construction expenditures for 1993 were $574 million and for 1994 and 1995 are estimated at $500 million and $400 million, respectively. These estimates include $161 million and $53 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA discussed under ITEM 1. ENVIRONMENTAL MATTERS. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for M-6 compliance with both Phase I and Phase II of the CAAA. The subsidiaries are estimating amounts of approximately $1.4 billion, which includes $482 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the subsidiaries have additional capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note G to the consolidated financial statements). INTERNAL CASH FLOWS Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $270 million in 1993. Regulatory commission orders received in Maryland, Pennsylvania, Virginia, and West Virginia provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and requested and new rate cases planned in 1994, internal generation of cash can be expected to increase. The increase in other investments reflects the 1993 cash surrender values for secured benefit plans and a related prepayment. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($54 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the subsidiaries' regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. FINANCINGS In October 1993, the Company issued 2,400,000 shares of its common stock for $64.1 million. Also during 1993, the Company issued 1,364,846 shares of common stock under its Dividend Reinvestment and Stock Purchase Plan (DRISP), and Employee Stock Ownership and Savings Plan (ESOP) for $36.1 million. During 1993 the subsidiaries issued $43 million of 6.25% to 6.3% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $634 million of debt securities having interest rates of 7% to 9.75% through the issuance of $652 million of securities having interest rates of 4.95% to 7.75%. The costs M-7 associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $44 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long-term securities. Short-term debt increased from $11.2 million in 1992 to $130.6 million in 1993. The subsidiaries canceled or postponed approximately $152 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its subsidiaries established an internal money pool whereby surplus funds of the Company and certain subsidiaries may be borrowed on a short-term basis by the Company's subsidiaries. This has contributed to the decrease in the 1993 temporary cash investment amounts. Allegheny Generating Company in 1992 replaced its $65.7 million of commercial paper with $50.9 million of money pool borrowings and $2.4 million of four-year, 6.05%-6.10% medium-term notes. Allegheny Generating Company has available an established program to replace money pool borrowings with medium-term notes or commercial paper. At December 31, 1993, unused lines of credit with banks were $149 million. In addition, a multi-year credit program was established in January 1994, which provides that the subsidiaries may borrow on a standby revolving credit basis up to $300 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the subsidiaries plan to issue about $230 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $728 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The subsidiaries may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company plans to fund the subsidiaries' sale of common stock through the issuance of short-term debt and DRISP/ESOP common stock sales. The subsidiaries anticipate that they will be able to meet their future cash needs through internal cash generation and external financings as they have in the past and possibly through alternative financing procedures. M-8 ENVIRONMENTAL MATTERS AND OTHER CONTINGENCIES In the normal course of business, the subsidiaries are subject to various contingencies and uncertainties relating to their operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note I to the consolidated financial statements. All of the state jurisdictions in which the subsidiaries operate have enacted hazardous and solid waste management legislation. While the subsidiaries do not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The subsidiaries are incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the subsidiaries. As of January 1994, Monongahela has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and Monongahela, Potomac Edison, and West Penn have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the subsidiaries. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against any or all of the subsidiaries. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at subsidiary-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of Monongahela. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the subsidiaries believe potential liability of the subsidiaries is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by Monongahela for an amount substantially less than the anticipated cost of defense. While the subsidiaries believe that all of these cases are without merit, they cannot predict the outcome of these cases or whether other cases will be filed. M-9 Monongahela MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $61.7 million, $58.3 million, and $54.1 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-3 and D-4 Such kWh sales increased .3% in 1993 and decreased 1.0% in 1992. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase (Decrease) from Prior Year 1993 1992 (Millions of Dollars) Increased (decreased) kWh sales $ 6.6 $(5.3) Fuel and energy cost adjustment clauses (a) 11.8 12.3 Rate increases (b): West Virginia 4.1 12.1 Ohio 2.1 1.6 6.2 13.7 Other .2 (1.3) $24.8 $19.4 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a surcharge in West Virginia for recovery of carrying charges on expenditures to comply with the Clean Air Act Amendments of 1990 (CAAA), designed to produce $3.1 million on an annual basis effective on July 1, 1992, which was increased to $8.7 million on an annual basis effective on July 1, 1993, and a rate increase in Ohio, designed to produce $3.3 million on an annual basis, which became effective on July 21, 1992. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days showed only a slight increase over 1992, and were only 6% above normal, cooling degree days increased 54% over 1992, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-10 KWh sales to industrial customers decreased 4.4% in 1993 and .7% in 1992. The 1993 decrease was primarily due to continuing declines in sales to coal and primary metals customers. Coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. Lower sales to primary metals customers was due in part to one iron and steel customer's increased use of its own generation. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .3 1.0 1.8 From purchased power 2.8 3.6 3.1 3.1 4.6 4.9 Revenues (in millions): From Company generation $ 8.4 $ 26.7 $ 48.5 From sales of purchased power 77.6 92.9 91.5 $86.0 $119.6 $140.0 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWH) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The increase in other revenues in 1993 and 1992 resulted from continued increases in sales of capacity, energy, and spinning reserve to other affiliated companies because of additional capacity and energy available from new PURPA projects in both years. This increase was offset in part in 1993 by an agreement with the Federal Energy Regulatory Commission to record in 1993 about $3 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. About 90% of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on net income. M-11 Operating Expenses Fuel expenses decreased 3% in 1993 and 9% in 1992. Both decreases were primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $ 68.6 $ 85.5 $ 83.0 From PURPA generation 55.7 37.4 13.2 Other 8.1 3.1 7.2 Power exchanges, net (.6) .3 (.5) Affiliated transactions: AGC capacity charges 23.3 24.2 25.1 Energy and spinning reserve charges .5 2.8 5.3 $155.6 $153.3 $133.3 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The increases in purchases from PURPA generation reflects additional generation from new PURPA projects. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. Energy and spinning reserve charges decreased in 1993 and 1992 primarily because of additional generation available from new PURPA projects. M-12 The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, will increase future employee benefit costs for postretirement benefit expenses. The Company is currently recovering approximately 50% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 and early 1995 rate cases. This reflects for West Virginia and Ohio only the recovery of the previously authorized pay-as-you-go component. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-13 Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes (B&O taxes) ($1 million) due to decreased generation in that state. The 1992 decrease resulted from decreased B&O taxes ($2 million) and prior period B&O tax adjustments ($2 million), offset somewhat by increases in gross receipts and property taxes ($2 million). The net increase of $6 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($4 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $3 million resulted primarily from plant removal and certain bond refinancing cost tax deductions for which deferred taxes were not provided. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures primarily associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to decrease as the Company completes its Phase I compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used M-14 internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $141 million and for 1994 and 1995 are estimated at $103 million and $83 million, respectively. These estimates include $39 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $400 million, which includes $122 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, was about $69 million for 1993. A regulatory commission order has been received in West Virginia authorizing procedures to provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and new rate cases planned in 1994 and early 1995, internal generation of cash can be expected to increase. M-15 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($13 million). The five- year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $10.68 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $67 million of debt securities having interest rates of 7.5% to 9.5% through the issuance of $72 million of securities having interest rates of 5.625% to 5.95%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. Short-term debt, including notes payable to affiliates under the money pool, increased from $8.0 million in 1992 to $63.1 million in 1993. The Company canceled or postponed approximately $69 million of debt and equity financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $100 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $81 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $50 million of new equity securities and, if economic and market conditions make it desirable, may refinance up to $285 million of first M-16 mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. As of January 1994, the Company has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the M-17 Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of the Company. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by the Company for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-18 Potomac MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net Income Net income was $73.5 million, $67.5 million, and $58.2 million in 1993, 1992, and 1991, respectively. The increase in net income in 1993 resulted primarily from kWh sales and retail rate increases. The increase in 1992 resulted primarily from retail rate increases. These revenue increases, in both years, were offset in part by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-5 and D-6. Such kWh sales increased 6.3% and 2.0% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $24.4 $ 7.7 Fuel and energy cost adjustment clauses (a) 19.1 10.4 Rate increases (b): Maryland 12.7 11.7 Virginia 2.5 1.8 West Virginia 1.1 .3 16.3 13.8 Other 2.9 .2 $62.7 $32.1 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on net income. (b) Reflects a rate increase in Maryland, designed to produce $11.3 million on an annual basis, which became effective on February 25, 1993, and a rate increase in Virginia, designed to produce $10.0 million on an annual basis, which became effective on September 28, 1993, subject to refund. The Maryland surcharge for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance investment of $1.7 million effective on June 4, 1992, which was increased to $3.9 million effective on December 3, 1992, was rolled into base rates effective with the February 1993 increase. Rate increases also include a CAAA surcharge in West Virginia designed to produce $.8 million on an annual basis effective July 1, 1992, which was increased to $2.2 million on an annual basis effective July 1, 1993. The increased kWh sales to residential and commercial customers in 1993 reflect both higher use and growth in number of customers. While 1993 heating degree days showed only a slight increase over 1992, and were only 7% M-19 above normal, cooling degree days increased 82% over 1992 and were 12% over normal, contributing to the 1993 kWh sales increases. The Company experienced a normal winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. KWh sales to industrial customers increased 4.3% in 1993 and 2.0% in 1992. The increase in both years occurred in almost all industrial groups, the most significant of which in 1993 was from sales to cement customers. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.0 1.8 From purchased power 3.5 4.4 3.8 3.9 5.4 5.6 Revenues (in millions): From Company generation $8.6 $27.5 $47.4 From sales of purchased power 99.5 113.6 114.3 $108.1 $141.1 $161.7 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. About 95% of the aggregate benefits from sales to nonaffiliated utilities is passed on to retail customers and has little effect on net income. The decrease in other revenues in 1993 resulted from an agreement with the Federal Energy Regulatory Commission to record in 1993 about $4 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. M-20 Operating Expenses Fuel expenses decreased 4% in 1993 and 6% in 1992. Both decreases were primarily due to decreases in kWh generated. The 1992 decrease also included a 1% decrease in average coal prices. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the financial statements, with the result that changes in fuel expenses have little effect on net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities, capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $87.9 $104.6 $103.7 Other 10.5 3.7 8.9 Power exchanges, net (.8) .2 (.4) Affiliated transactions: AGC capacity charges 28.0 29.6 31.3 Other affiliated capacity charges 28.4 21.9 23.4 Energy and spinning reserve charges 51.1 41.2 37.6 $205.1 $201.2 $204.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power purchased from nonaffiliates for use by the Company and affiliated energy and spinning reserve charges are mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on net income. The 1993 increase in other purchased power reflects efforts to conserve coal because of selective work stoppages by the United Mine Workers of America for most of the year. M-21 While the Company does not currently purchase generation from qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), several projects have been proposed, and an agreement has been reached with one facility to commence purchasing generation in 1999. This project and others may significantly increase the cost of power purchases passed on to customers. The increase in affiliated capacity and energy and spinning reserve charges in 1993 was due to growth of kWh sales to retail customers and an increase in affiliated energy available because of energy purchased by an affiliate from new PURPA projects in 1992 and 1993. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in employee benefit costs and salaries and wages. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $1.5 million. The Company is currently recovering approximately 90% of SFAS No. 106 expenses in rates and will be requesting recovery of the remainder in 1994 rate cases. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 25% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. M-22 The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. Depreciation expense increases resulted primarily from additions to electric plant. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $1 million in 1993 due to increases in gross receipts taxes resulting from higher revenues from retail customers ($1 million) and increased property taxes ($1 million), offset by decreased West Virginia Business and Occupation taxes due to decreased generation in that state ($1 million). The 1992 increase was due to increased property ($1 million) and gross receipts ($1 million) taxes. The net increase of $2 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($3 million) and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million), offset by plant removal tax deductions for which deferred taxes were not provided ($1 million). The net increase in 1992 was primarily due to an increase in income before taxes. Note B to the financial statements provides a further analysis of income tax expenses. The combined increase of $2 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt and certain preferred stock, M-23 and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. During 1993, the Company continued its participation in the Collaborative Process for Demand-Side Management in Maryland with the Maryland PSC Staff, Office of People's Counsel, the Department of Natural Resources, Maryland Energy Administration, and the Company's largest industrial customer. The Company received the Maryland PSC's approval to implement a Commercial and Industrial Lighting Rebate Program as of July 1, 1993. Through December 31, 1993, the Company had received applications for $7.5 million in rebates related to the commercial lighting program. Program costs, including rebates and lost revenues, are deferred and are to be recovered through an energy conservation surcharge over a five-year period. Capital Requirements Construction expenditures for 1993 were $179 million and for 1994 and 1995 are estimated at $136 million and $106 million, respectively. These estimates include $40 million and $10 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable rulings of state commissions allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $350 million, which includes $153 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has M-24 additional annual capital requirements of an annual preferred stock sinking fund ($1.2 million) and debt maturities (see Note H to the financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $75 million in 1993. Regulatory commission orders received in all of the state jurisdictions and the FERC provide for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with various amounts of lag. Based upon the authorizations received and new rate cases planned in 1994, internal generation of cash can be expected to increase. Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($14 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $13.99 million of 6.25% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $121 million of debt securities having interest rates of 7% to 9.5% through the issuance of $129 million of securities having interest rates of 5.875% to 7.75%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $9 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $36 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. M-25 At December 31, 1993, the Company had SEC authorization to issue up to $115 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $84 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $75 million of new debt securities and, if economic and market conditions make it desirable, may refinance up to $231 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction programs, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the financial statements. All of the state jurisdictions in which the Company operates have enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-26 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System-operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in five generating plants, including four operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-27 West Penn MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Net Income Consolidated net income was $102.1 million, $98.2 million, and $101.2 million in 1993, 1992, and 1991, respectively. The increase in consolidated net income in 1993 resulted primarily from kWh sales and retail rate increases, offset in part by higher expenses. Higher retail revenues in 1992 from a surcharge to recover increases in various state taxes and greater kWh sales were more than offset by higher expenses. Sales and Revenues KWh sales to and revenues from residential, commercial, and industrial customers are shown on pages D-7 and D-8. Such kWh sales increased 3.1% and 2.7% in 1993 and 1992, respectively. The increases in revenues from sales to residential, commercial, and industrial customers resulted from the following: Increase from Prior Year 1993 1992 (Millions of Dollars) Increased kWh sales $15.5 $ 6.7 Fuel and energy cost adjustment clauses (a) 26.2 15.2 Rate increases (b) 25.2 5.8 Other 3.1 1.3 $70.0 $29.0 (a) Changes in revenues from fuel and energy cost adjustment clauses have little effect on consolidated net income. (b) Reflects a base rate increase on an annual basis of about $61.6 million in Pennsylvania effective May 18, 1993, including $26.1 million for recovery of carrying charges on Clean Air Act Amendments of 1990 (CAAA) compliance costs, and in 1992 also reflects a surcharge effective August 24, 1991, to recover Pennsylvania tax increases. The increased kWh sales to residential and commercial customers in 1993 reflect both growth in number of customers and higher use. While 1993 heating degree days remained about the same as 1992, and were only 6% below normal, cooling degree days increased 70% over 1992 and were 46% over normal, contributing to the 1993 kWh sales increases. The Company experienced a mild winter in the first quarter of 1992 followed by a much cooler than normal summer and early fall. As a result, weather had a negative impact on 1992 sales to retail customers. M-28 KWh sales to industrial customers increased .8% in 1993 and 6.3% in 1992. The relatively flat industrial sales growth in 1993 followed increases in industrial sales in 1992 which occurred in almost all industrial groups. One particular group, coal mines staffed by union personnel, recorded reduced usage because of selective work stoppages by the United Mine Workers of America (UMWA) for most of the year prior to the settling of the dispute in December 1993. KWh sales to and revenues from nonaffiliated utilities are comprised of the following items: 1993 1992 1991 KWh sales (in billions): From Company generation .4 1.3 2.3 From purchased power 5.0 6.5 5.4 5.4 7.8 7.7 Revenues (in millions): From Company generation $11.5 $37.5 $62.5 From sales of purchased power 141.0 167.2 160.7 $152.5 $204.7 $223.2 Decreased sales to nonaffiliated utilities resulted primarily from decreased demand and continuing price competition. Sales supplied by the Company's generation in 1993 decreased to less than 15% of 1988 levels because of continuing growth of kWh sales to retail customers, which reduces the amount available for sale, and because other suppliers were willing or able to make the sales at lower prices. A significant factor affecting the Company's ability to compete in the market for sales to nonaffiliated utilities has been the approximate 290% increase (from about 67 cents per MWh to $2.60 per MWh) in taxes on generation in West Virginia since March 1989 - a significant cost not experienced by utilities not generating in West Virginia. Further decreases in these sales are anticipated in 1994 before leveling off. The decrease in other revenues in 1993 and 1992 resulted from continued decreases in sales of energy and spinning reserve to an affiliated company because of additional energy available to it from new PURPA projects commencing in both years. The 1993 decrease was also due in part to an agreement with the Federal Energy Regulatory Commission to record in 1993 about $6 million of revenues as sales to nonaffiliated utilities. Similar transactions were recorded as other revenues in prior years. Most of the aggregate benefits from sales to affiliated and nonaffiliated utilities is passed on to retail customers and has little effect on consolidated net income. M-29 Operating Expenses Fuel expenses decreased 4% in each of the years of 1993 and 1992 primarily due to decreases in kWh generated. Fuel expenses are primarily subject to deferred power cost accounting procedures, as described in Note A to the consolidated financial statements, with the result that changes in fuel expenses have little effect on consolidated net income. "Purchased power and exchanges, net" represents power purchases from and exchanges with nonaffiliated utilities and qualified facilities under the Public Utility Regulatory Policies Act of 1978 (PURPA), capacity charges paid to AGC, and other transactions with affiliates made pursuant to a power supply agreement whereby each company uses the most economical generation available in the System at any given time, and is comprised of the following items: 1993 1992 1991 (Millions of Dollars) Nonaffiliated transactions: Purchased power: For resale to other utilities $124.5 $153.9 $146.0 From PURPA generation 49.6 56.5 55.6 Other 15.2 5.9 12.9 Power exchanges, net (1.2) .3 (.5) Affiliated transactions: AGC capacity charges 42.3 43.5 44.1 Energy and spinning reserve charges 4.7 3.5 3.8 Other affiliated capacity charges .7 .6 .6 $235.8 $264.2 $262.5 The amount of power purchased from nonaffiliated utilities for use by the Company and for resale to nonaffiliated utilities depends upon the availability of the Company's generating equipment, transmission capacity, and fuel, and its cost of generation and the cost of operations of nonaffiliated utilities from which such purchases are made. The primary reason for the fluctuations in purchases for resale to nonaffiliated utilities is described under Sales and Revenues above. The cost of power and capacity purchased for use by the Company, including power from PURPA generation and affiliated transactions, is mostly recovered from customers currently through the regular fuel and energy cost recovery procedures followed by the Company's regulatory commissions and is primarily subject to deferred power cost procedures with the result that changes in such costs have little effect on consolidated net M-30 income. The decrease in purchases from PURPA generation in 1993 was due to a planned generating outage at one PURPA project. The 1993 increase in other purchased power reflects efforts to conserve coal during the UMWA dispute. The increase in other operation expense for 1993 and 1992 resulted primarily from increases in salaries and wages and in 1993 also from employee benefit costs. The Financial Accounting Standards Board's (FASB) standard, SFAS No. 106, increased 1993 postretirement benefit expense by approximately $3.1 million. The Company is currently recovering all of SFAS No. 106 expenses in rates. During 1992, the Company implemented significant changes to its benefits plans, including cost caps, in an effort to both control and reduce employee benefits costs. The cost caps provide for future postretirement medical benefit costs to be capped at two times 1993 levels. Because 1993 medical costs were more than actuarially projected, SFAS No. 106 costs for 1994 are expected to be approximately 5% greater than 1993 amounts. Another FASB standard, SFAS No. 112, "Employers' Accounting for Postemployment Benefits", effective in 1994, requires companies to accrue for other post- employment benefits such as disability benefits, health care benefits for disabled employees, severance pay, and workers' compensation claims. The Company currently accrues for workers' compensation claims and the estimated liability for the other benefits is not expected to be material. Maintenance expenses represent costs incurred to maintain the power stations, the transmission and distribution (T&D) system, and general plant, and reflect routine maintenance of equipment and rights-of-way as well as planned major repairs and unplanned expenditures, primarily from forced outages at the power stations and periodic storm damage on the T&D system. Maintenance expense in 1993 includes the effects of an ice storm and blizzard in March 1993. The Company is also experiencing, and expects to continue to experience, increased expenditures due to the aging of its power stations. Variations in maintenance expense result primarily from unplanned events and planned major projects, which vary in timing and magnitude depending upon the length of time equipment has been in service without a major overhaul, the amount of work found necessary when the equipment is dismantled, and outage requirements to comply with the CAAA. M-31 Depreciation expense increases resulted primarily from additions to electric plant and in 1993 also from a change in depreciation rates and net salvage amortization as a result of the May 1993 rate order. Because of the increased levels of capital expenditures as a result of the CAAA (see Note J to the consolidated financial statements) and the replacement of aging equipment at the Company's power stations, depreciation expense is expected to increase significantly over the next few years. Taxes other than income increased $2 million in 1993 primarily due to increases in gross receipts taxes resulting from higher revenues from retail customers ($3 million) offset in part by decreased West Virginia Business and Occupation taxes (B&O taxes) ($2 million) due to decreased generation in that state. The 1992 increase resulted from increased property and capital stock taxes ($4 million), increased B&O taxes ($1 million), and increases in gross receipts taxes ($1 million). The net increase of $7 million in federal and state income taxes in 1993 resulted primarily from an increase in income before taxes ($6 million), and an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($1 million). The net decrease in 1992 of $4 million resulted primarily from a decrease in income before taxes. Note B to the consolidated financial statements provides a further analysis of income tax expenses. The combined increase of $.3 million in allowances for funds used during construction (AFUDC) in 1993 reflects increased construction expenditures including those associated with the CAAA, net of CAAA amounts included in rate base and earning a cash return. Future levels of AFUDC can be expected to increase slightly with increasing levels of CAAA expenditures until late 1994 upon substantial completion of Phase I of the CAAA compliance program. The decrease in other income, net, in 1993 resulted primarily from the Company's share of decreases in the earnings of AGC (see Note D to the consolidated financial statements). Other fluctuations in other income, net, were individually insignificant. Other interest expense reflects changes in the level of short-term debt maintained by the Company. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company needs cash for operating expenses, the payment of interest and dividends, retirement of debt, and for its construction program. To meet these needs, the Company has used internally generated funds and external financings, such M-32 as the sale of common and preferred stock, debt instruments, instalment loans, and lease arrangements. The timing and amount of external financings depend primarily upon economic and financial market conditions, the Company's cash needs, and capitalization ratio objectives. The availability and cost of external financing depend upon the financial health of the companies seeking those funds. Capital Requirements Construction expenditures for 1993 were $251 million and for 1994 and 1995 are estimated at $258 million and $208 million, respectively. These estimates include $82 million and $33 million, respectively, for substantial completion of the program of complying with Phase I of the CAAA. It is anticipated that the Harrison Scrubber Project will be completed on schedule (late 1994) and that the final cost will be approximately 24% below the original budget. Primary factors contributing to the reduced cost include: 1) the absence of any major construction problems to date; 2) financing and material and equipment costs lower than expected; and 3) favorable ruling of the Pennsylvania PUC allowing the inclusion of carrying costs of construction in rates in lieu of AFUDC. Construction expenditures through the year 2000 may include substantial amounts for compliance with both Phase I and Phase II of the CAAA. The Company is estimating amounts of approximately $700 million, which includes $207 million expended through 1993, depending upon the strategy eventually selected for complying with Phase II. The mere possibility of new legislation which restricts or discourages carbon dioxide emissions, either through taxation or caps, further complicates the CAAA Phase II planning process. The remaining amount of this CAAA construction estimate, together with normal construction activity assures that continuing external financings will be required. In addition, the Company has additional capital requirements of debt maturities (see Note H to the consolidated financial statements). Internal Cash Flows Internal generation of cash, consisting of cash flows from operations reduced by dividends, increased to $119 million in 1993. A regulatory commission order has been received from the PUC which provides for current cash recovery of the carrying costs of CAAA expenditures in rates, albeit with a certain amount of lag. Based upon the authorization received and a new rate case planned in 1994, internal generation of cash can be expected to increase. M-33 Materials and supplies, primarily fuel, constituted a significant source of cash in 1993 ($27 million). The five-year National Bituminous Coal Wage Agreement terminated on February 1, 1993. Coal inventories (fuel) as of December 31, 1992, were increased over 1991 amounts to provide an increased coal supply in the event of a strike. The union chose a strategy of selective shutdowns including mines that accounted for approximately 60% of the System's regular coal supply. The union signed a new five-year contract in December 1993. System coal inventory, which declined during the dispute, and which is somewhat lower than the seasonal norm, is considered adequate. Financings During 1993 the Company issued $18.04 million of 6.30% tax-exempt solid waste disposal notes to Harrison County, West Virginia, and refunded an aggregate of $246 million of debt securities having interest rates of 7% to 9.75% through the issuance of $251 million of securities having interest rates of 4.95% to 6.375%. The costs associated with the debt redemptions are being amortized over the life of the new bonds. Due to the significant number of refinancings which have occurred over the past two years, this balance is now about $12 million. Reduced future interest expense will more than offset these expenses. Short-term debt is used to meet temporary cash needs until the timing is considered appropriate to issue long- term securities. The Company canceled or postponed approximately $47 million of debt financings in 1993 due to favorable short-term alternatives. In 1992, the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At December 31, 1993, the Company had SEC authorization to issue up to $170 million of short-term debt. In addition, a multi-year credit program was established in January 1994, which provides that the Company may borrow on a standby revolving credit basis up to $135 million. After the initial three-year term, the program agreement provides that the maturity date may be extended in one-year increments. The borrowings have the support of a long-term credit facility. During 1994, the Company plans to issue about $105 million of new securities, consisting of both debt and equity issues and, if economic and market conditions make it desirable, may refinance up to $212 million of first mortgage bonds, preferred stock, and pollution control revenue notes. The Company may also engage in additional Harrison County tax-exempt solid waste disposal financings to the extent that funds are available. The Company anticipates that it will be able to meet its future cash needs through internal cash generation and external financings as it has in the past and possibly through alternative financing procedures. Environmental Matters and Other Contingencies In the normal course of business, the Company is subject to various contingencies and uncertainties relating to its operations and construction program, including cost recovery in the regulatory process, laws, regulations and uncertainties related to environmental matters, and legal actions. Contingencies and uncertainties related to the CAAA are discussed above and under Note J to the consolidated financial statements. Pennsylvania has enacted hazardous and solid waste management legislation. While the Company does not have significant hazardous waste concerns, solid wastes, such as fly ash and other coal by-products generated from power stations, must be disposed in accordance with the state requirements. The Company is incurring various costs, which are recoverable in rates, to comply with these and other environmental matters. The level of future expenditures for environmental matters is impossible to determine with any degree of certainty. It is management's opinion that the ultimate costs will not have a material effect on the financial position of the Company. M-35 As of January 1994, Monongahela Power Company (MP), an affiliated company, has been named as a defendant along with multiple other defendants in 1,429 pending asbestos cases involving multiple plaintiffs and the Company and its affiliates have been named as defendants along with multiple defendants in an additional 626 cases by multiple plaintiffs. Because these cases are filed by "shotgun" complaints naming many plaintiffs and many defendants, it is presently impossible to determine the actual number of claims against the Company and its affiliates. However, based on past experience and data available to date, it is estimated that less than 600 cases actually involve claims against the Company or its affiliates. All complaints allege that the plaintiffs sustained unspecified injuries resulting from claimed exposure to asbestos in various generating plants and other industrial facilities operated by the various defendants, although all plaintiffs do not claim exposure at facilities operated by all defendants. All plaintiffs claiming exposure at System- operated stations were employed by third-party contractors, with the exception of three who claim to have been employees of MP. The Company is joint owner with MP in four generating plants, including three operated by MP in West Virginia. Each plaintiff generally seeks compensatory and punitive damages against all defendants in amounts of up to $1 million and $3 million, respectively; in those cases that include a spousal claim for loss of consortium, damages are generally sought against all defendants in an amount of up to $1 million for the loss of consortium claim. Therefore, because of the multiple defendants, the Company believes its potential liability is a very small percentage of the total amount of the damages sought. A total of 94 cases have been previously settled by MP for an amount substantially less than the anticipated cost of defense. While the Company believes that all of these cases are without merit, it cannot predict the outcome of these cases or whether other cases will be filed. M-36 AGC MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations As described under Liquidity and Capital Resources, revenues are determined under a cost of service formula rate schedule. Therefore, if all other factors remain equal, revenues are expected to decrease each year due to a normal continuing reduction in the Company's net investment in the Bath County station and its connecting transmission facilities upon which the return on investment is determined. Revenues for 1993 and 1992 decreased due to a reduction in interest charges and net investment, and reduced operating expenses which are described below. Additionally, revenues for 1993 and 1992 were reduced by the recording of estimated liabilities for possible refunds pending final Federal Energy Regulatory Commission (FERC) decisions in rate case proceedings (see Liquidity and Capital Resources). The net investment (primarily net plant less deferred income taxes) decreases to the extent that provisions for depreciation and deferred income taxes exceed net plant additions. The decrease in operating expenses in 1993 resulted from a decrease in federal income taxes due to a decrease in income before taxes ($1.9 million) offset by an increase in the tax rate due to the Revenue Reconciliation Act of 1993 ($.5 million), partially offset by an increase in operation and maintenance expense. The decrease in operating expenses in 1992 resulted primarily from reduced federal income taxes because of a decrease in income before taxes, partially offset by increases in taxes other than income. The increase in taxes other than income in 1992 was due to increased property taxes. The decreases in interest on long-term debt in 1993 and 1992 were the combined result of decreases in the average amount of and interest rates on long-term debt outstanding. Liquidity and Capital Resources SEC regulations define "liquidity" as "the ability of an enterprise to generate adequate amounts of cash to meet the enterprise's need for cash". The Company's only operating assets are an undivided 40% interest in the Bath County (Virginia) pumped-storage hydroelectric station and its connecting transmission facilities. The Company has no present plans for construction of any other major facilities. M-37 Pursuant to an agreement, the Parents buy all of the Company's capacity in the station priced under a "cost of service formula" wholesale rate schedule approved by the FERC. Under this arrangement, the Company recovers in revenues all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment. Through February 29, 1992, the Company's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. On March 1, 1990, the ROE decreased from 12% to 11.25%, and on March 1, 1991, it was increased to 11.53%. In December 1991, the Company filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. In 1993, the Company issued $50 million of 5.75% medium-term notes due 1998, $50 million of 5.625% debentures due 2003, and $100 million of 6.875% debentures due 2023 to refund $50 million 8% debentures due 1997, $50 million 8.75% debentures due 2017, and $100 million 9.125% debentures due 2016. The Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short- term borrowing needs, to the extent that certain of the companies have funds available. - 42 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Financial Statement Schedules - All other schedules are omitted because they are not applicable or the required information is shown in the Financial Statements or Notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Power System, Inc. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Power System, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and E to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 APS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) NOTE A--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The Company and its subsidiaries (companies) are subject to regulation by the Securities and Exchange Commission. The subsidiaries are subject to regulation by various state bodies having jurisdiction and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company and its subsidiaries are summarized below. CONSOLIDATION: The Company owns all of the outstanding common stock of its subsidiaries. The consolidated financial statements include the accounts of the Company and all subsidiary companies after elimination of intercompany transactions. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures followed by Monongahela Power Company in West Virginia, revenues include service rendered but unbilled at year end. Certain increases in rates being collected by subsidiaries are subject to final commission approvals, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used by the subsidiaries for computing AFUDC in 1993, 1992, and 1991 averaged 9.37%, 9.19%, and 8.84%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4% of average depreciable property in 1993 and 3.3% in each of the years 1992 and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INVESTMENTS: The investment in subsidiaries consolidated represents the excess of acquisition cost over book equity (goodwill) prior to 1966. Goodwill is not being amortized because, in management's opinion, there has been no reduction in its value. Other investments primarily represent the cash surrender values and prepayments of purchased life insurance contracts on certain qualifying management employees under an executive life insurance plan and a supplemental executive retirement plan (Secured Benefit Plan). Payment of future premiums will fully fund these benefits. INCOME TAXES: Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The subsidiaries have a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The subsidiaries also provide partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the subsidiaries adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the subsidiaries adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before preferred dividends and income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the subsidiaries recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $ 105 289 Unbilled revenue 38 363 Tax interest capitalized 22 236 Contributions in aid of construction 17 176 State tax loss carryback/carryforward 14 560 Other 21 658 219 282 Deferred tax liabilities: Book vs. tax plant basis differences, net 1 051 500 Other 42 122 1 093 622 Total net deferred tax liabilities 874 340 Less portion above included in current liabilities 645 Total long-term net deferred tax liabilities $ 873 695 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the subsidiaries have recorded regulatory assets for an amount equal to the $562 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $108 million increase in deferred tax assets to reflect the subsidiaries' obligation to pass such tax benefits on to their customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. NOTE C--DIVIDEND RESTRICTION: Supplemental indentures relating to most outstanding bonds of subsidiaries contain dividend restrictions under the most restrictive of which $461,539,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on their common stocks, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by a subsidiary as a capital contribution or as the proceeds of the issue and sale of shares of such subsidiary's common stock. The benefits earned to date and funded status at December 31 using a measurement date of September 30 were as follows: In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. NOTE E--POSTRETIREMENT BENEFITS OTHER THAN PENSIONS: The subsidiaries adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the subsidiaries for retired employees and their dependents were recorded in expense in the period in which they were paid and were $6,553,000 and $5,691,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost--benefits earned $ 2 000 Interest cost on accumulated postretirement benefit obligation 11 300 Actual return on plan assets (24) Amortization of unrecognized transition obligation 7 300 Other net amortization and deferral 24 SFAS No. 106 postretirement cost 20 600 Regulatory deferral (4 790) Net postretirement cost $15 810 The benefits earned to date and funded status at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $115 019 Fully eligible employees 24 135 Other employees 55 255 Total obligation 194 409 Plan assets at market value in short-term investment fund 4 646 Accumulated postretirement benefit obligation in excess of plan assets 189 763 Less: Unrecognized cumulative net loss from past experience different from that assumed 41 450 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 138 200 Postretirement benefit liability at September 30, 1993 10 113 Fourth quarter 1993 contributions and benefit payments 4 549 Postretirement benefit liability at December 31, 1993 $ 5 564 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $145,500,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $13.4 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $1.0 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993, in Pennsylvania effective in May 1993, and for the FERC wholesale customers effective in mid-to-late 1993. Regulatory actions have been taken by the Virginia and Ohio regulatory commissions which provide support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The subsidiaries have recorded regulatory assets at December 31, 1993, of $4.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. NOTE F--STOCKHOLDERS' EQUITY: COMMON STOCK: In November 1993, the common shareholders approved a two-for-one split of the Company's common stock which was effective November 4, 1993. The stock split reduced the par value of the common stock from $2.50 per share to $1.25 per share and increased the number of authorized shares of common stock from 130,000,000 to 260,000,000. The number of common stock shares outstanding and per share information for all periods reflect the two-for-one split. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. The holders of West Penn Power Company's auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. MANDATORILY REDEEMABLE PREFERRED STOCK: The Potomac Edison Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. That subsidiary has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, The Potomac Edison Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. NOTE G--LONG-TERM DEBT: Maturities for long-term debt for the next five years are: 1994, $26,000,000; 1995, $28,000,000; 1996, $43,575,000; 1997, $48,262,000; and 1998, $185,400,000. Substantially all of the properties of the subsidiaries are held subject to the lien securing each subsidiary's first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Commercial paper borrowings issuable by Allegheny Generating Company are backed by a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. However, to the extent that funds are available from the companies, Allegheny Generating Company borrowings are made through an internal money pool as described in Note H. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $2,129,923,000 and $2,033,103,000, respectively, based on actual market prices or market prices of similar issues. NOTE H--SHORT-TERM DEBT: To provide interim financing and support for outstanding commercial paper, lines of credit have been established with several banks. The companies have fee arrangements on all of their lines of credit and no compensating balance requirements. At December 31, 1993, unused lines of credit with banks were $149,175,000. In addition to bank lines of credit, in 1992 the companies established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, a multi-year credit program was established which provides that the subsidiaries may borrow up to $300 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of notes payable to banks ($75,825,000) and commercial paper ($54,811,000) and at the end of 1992 consisted of a note payable to a bank ($11,205,000). The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. NOTE I--COMMITMENTS AND CONTINGENCIES: CONSTRUCTION PROGRAM: The subsidiaries have entered into commitments for their construction programs, for which expenditures are estimated to be $500 million for 1994 and $400 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: The companies are subject to laws, regulations, and uncertainties as to environmental matters discussed under ITEM 1. ENVIRONMENTAL MATTERS. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The subsidiaries are estimating expenditures of approximately $1.4 billion, which includes $482 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $161 million and $53 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the subsidiaries will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION: In the normal course of business, the companies become involved in various legal proceedings. The companies do not believe that the ultimate outcome of these proceedings will have a material effect on their financial position. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Monongahela Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Monongahela Power Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 1,500,000 shares, outstanding as follows (Note G): Monongahela NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are generally recorded when billed. In accordance with ratemaking procedures in West Virginia, revenues include service rendered but unbilled at year end. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 8.69%, 8.23%, and 6.17%, respectively. In accordance with FERC guidelines, the 1991 rate was based solely on borrowed funds because the Company's average outstanding short-term debt was greater than the average construction work in progress balance. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.8% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is different than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $18 043 Unbilled revenue 4 181 Tax interest capitalized 2 430 Contributions in aid of construction 2 058 Vacation pay 1 958 Advances for construction 1 601 Other 4 455 34 726 Deferred tax liabilities: Book vs. tax plant basis differences, net 205 829 Other 23 411 229 240 Total net deferred tax liabilities 194 514 Less portion above included in current liabilities 2 048 Total long-term net deferred tax liabilities $192 466 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $158 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,482,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 27% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.3 million, $8.3 million, and $8.9 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 30%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $2,390,000 and $2,029,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 30%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 478 Interest cost on accumulated postretirement benefit obligation 2 819 Actual return on plan assets (5) Amortization of unrecognized transition obligation 1 772 Other net amortization and deferral 5 SFAS No. 106 postretirement cost 5 069 Regulatory deferral (1 981) Net postretirement cost $3 088 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $32 469 Fully eligible employees 4 348 Other employees 14 664 Total obligation 51 481 Plan assets at market value in short-term investment fund 1 230 Accumulated postretirement benefit obligation in excess of plan assets 50 251 Less: Unrecognized cumulative net loss from past experience different from that assumed 14 161 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 34 059 Postretirement benefit liability at September 30, 1993 2 031 Fourth quarter 1993 contributions and benefit payments 997 Postretirement benefit liability at December 31, 1993 $ 1 034 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $35,800,000 (transition obligation), is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $3.5 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.2 million. Recovery of SFAS No. 106 costs has been authorized for FERC wholesale customers effective in December 1993. Recovery has been requested in a rate case filed in West Virginia for which a final commission decision is expected in 1994. Regulatory action has been taken by the Ohio regulatory commission which provides support that substantial recovery is probable. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million for West Virginia and Ohio where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: In September 1992, the Company issued and sold to its parent, 800,000 shares of its common stock at $50 per share. Other paid-in capital decreased $4,000 in 1992 as a result of a preferred stock redemption. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994 and 1995, none; 1996, $18,500,000; 1997, $15,500,000; and 1998, $20,100,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $65 million of 5-5/8% 7-year first mortgage bonds to refund a $10 million 8-1/8% issue due in 1999, a $30 million 7-7/8% issue due in 2002, and a $20 million 7-1/2% issue due in 1998. The Company also issued $7.05 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund a $7.05 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $485,713,000 and $461,663,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Debt: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $100 million including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $81 million on a standby revolving credit basis. Short-term debt outstanding at the end of 1993 consisted of $63.1 million of notes payable to banks and at the end of 1992 consisted of money pool borrowings from affiliates of $8.03 million. The carrying amount of short-term debt approximates the fair value because of the short-term maturity of those instruments. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $103 million for 1994 and $83 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $400 million, which includes $122 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $39 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 27% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of The Potomac Edison Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The Potomac Edison Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Potomac NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. Revenues of $63.4 million from one industrial customer, Eastalco Aluminum Company, were 8.9% of total electric operating revenues in 1993. Certain increases in rates being collected by the Company in Virginia are subject to final commission approval, and possible refunds, for which estimated liabilities have been recorded. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.97%, 9.92%, and 9.93%, respectively. AFUDC is not recorded for construction applicable to the state of Virginia, where construction work in progress is included in rate base. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.6% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The Company joins with its parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $17 922 Unbilled revenue 12 556 Contributions in aid of construction 10 530 Tax interest capitalized 9 056 State tax loss carryback/carryforward 5 770 Advances for construction 1 303 Other 3 279 60 416 Deferred tax liabilities: Book vs. tax plant basis differences, net 183 892 Other 10 122 194 014 Total net deferred tax liabilities 133 598 Less portion above included in current liabilities 571 Total long-term net deferred tax liabilities $133 027 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $74 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $19 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $103,730,000 of retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 28% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the West Virginia PSC, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $7.6 million, $8.6 million, and $9.2 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 35%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long- term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,790,000 and $1,564,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 35%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 383 Interest cost on accumulated postretirement benefit obligation 3 042 Actual return on plan assets (7) Amortization of unrecognized transition obligation 1 986 Other net amortization and deferral 7 SFAS No. 106 postretirement cost 5 411 Regulatory deferral (846) Net postretirement cost $4 565 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 189 Fully eligible employees 7 741 Other employees 14 635 Total obligation 57 565 Plan assets at market value in short-term investment fund 1 375 Accumulated postretirement benefit obligation in excess of plan assets 56 190 Less: Unrecognized cumulative net loss from past experience different from that assumed 15 695 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 37 995 Postretirement benefit liability at September 30, 1993 2 500 Fourth quarter 1993 contributions and benefit payments 1 132 Postretirement benefit liability at December 31, 1993 $1 368 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $40,000,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.0 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.3 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Maryland effective in February 1993 and for the FERC wholesale customers effective in September 1993. Regulatory action has been taken by the Virginia regulatory commission which provides support that substantial recovery is probable. Recovery has been requested in rate cases filed in Virginia and West Virginia for which final commission decisions are expected in 1994. The Company has recorded regulatory assets at December 31, 1993, of $.8 million relating to those regulatory jurisdictions where full recovery of SFAS No. 106 level of expenses has not yet been granted recovery in rates, with the result that adoption of SFAS No. 106 has had no effect on net income. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL The Company issued and sold common stock to its parent, at $20 per share, 2,500,000 shares in October 1993, 4,000,000 shares in September 1992, and 1,250,000 shares in September 1991. Other paid-in capital decreased $2,000 in 1992 as a result of preferred stock transactions. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 a share. MANDATORILY REDEEMABLE PREFERRED STOCK: The Company's $7.16 preferred stock is entitled to a cumulative sinking fund sufficient to retire 12,000 shares each year, commencing in 1992, at $100 a share plus accrued dividends. The Company has the noncumulative option in each year to retire up to an additional 12,000 shares at the same price. The estimated fair value of this series of preferred stock at December 31, 1993 and 1992, was $28,566,000 and $28,944,000, respectively, based on quoted market prices. The call price declines in future years. In August 1993, the Company redeemed the remaining 4,046 outstanding shares of Series B, 4.70% preferred stock. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, $16,000,000; 1995, none; 1996, $18,700,000; 1997, $800,000; and 1998, $1,800,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $45 million of 7-3/4% 30-year first mortgage bonds and $75 million of 5-7/8% 7-year first mortgage bonds to refund a $25 million 8-5/8% issue due in 2007, a $15 million 8-5/8% issue due in 2003, a $20 million 8-3/8% issue due in 2001, a $15 million 7-5/8% issue due in 1999, a $12 million 7-1/2% issue due in 2002, and a $25 million 7% issue due in 1998. The Company also issued $8.6 million of 5.95% 20-year Pollution Control Revenue Notes to Monongalia County, West Virginia to refund an $8.6 million 9.5% issue due in 2013. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $566,070,000 and $538,211,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $115 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $84 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $4.6 million and $38 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $136 million for 1994 and $106 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $350 million, which includes $153 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $40 million and $10 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 28% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of West Penn Power Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of West Penn Power Company (a subsidiary of Allegheny Power System, Inc.) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, B and F to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 Preferred Stock of the Company (not subject to mandatory redemption): Cumulative preferred stock - par value $100 per share, authorized 3,097,077 shares, outstanding as follows (Note G): West Penn NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (These notes are an integral part of the consolidated financial statements.) Note A - Summary of Significant Accounting Policies: The Company is a wholly-owned subsidiary of Allegheny Power System, Inc. and is a part of the Allegheny Power integrated electric utility system (the System). The Company is subject to regulation by the Securities and Exchange Commission (SEC), by various state bodies having jurisdiction, and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries (the companies). REVENUES: Customers are billed on a cycle basis, and revenues, including amounts resulting from the application of fuel and energy cost adjustment clauses, are recorded when billed. DEFERRED POWER COSTS, NET: The costs of fuel, purchased power, and certain other costs, and revenues from sales and transmission services to other utilities, are deferred until they are either recovered from or credited to customers under fuel and energy cost recovery procedures. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment, including facilities owned with affiliates in the System, are stated at original cost, less contributions in aid of construction, except for capital leases which are recorded at present value. Cost includes direct labor and material, allowance for funds used during construction (AFUDC) on property for which construction work in progress is not included in rate base, and such indirect costs as administration, maintenance, and depreciation of transportation and construction equipment, and pensions, taxes, and other fringe benefits related to employees engaged in construction. The cost of depreciable property units retired, plus removal costs less salvage, are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION: AFUDC, an item that does not represent current cash income, is defined in applicable regulatory systems of accounts as including "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used". AFUDC is recognized as a cost of property, plant, and equipment with offsetting credits to other income and interest charges. Rates used for computing AFUDC in 1993, 1992, and 1991 were 9.40%, 9.25%, and 9.46%, respectively. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined generally on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 3.4%, 3.3%, and 3.2% of average depreciable property in 1993, 1992, and 1991, respectively. The cost of maintenance and of certain replacements of property, plant, and equipment is charged principally to operating expenses. INCOME TAXES: The companies join with the parent and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are accounted for substantially in accordance with the accounting procedures followed for ratemaking purposes. Provisions for federal income tax were reduced in previous years by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. POSTRETIREMENT BENEFITS: The Company participates with affiliated companies in the System in a noncontributory, defined benefit pension plan covering substantially all employees, including officers. Benefits are based on the employee's years of service and compensation. The funding policy is to contribute annually at least the minimum amount required under the Employee Retirement Income Security Act and not more than can be deducted for federal income tax purposes. The Company also provides partially contributory medical and life insurance plans for eligible retirees and dependents. Medical benefits, which comprise the largest component of the plans, are based upon an age and years-of-service vesting schedule and other plan provisions. The funding plan for these costs is to contribute to Voluntary Employee Beneficiary Association (VEBA) trust funds an amount equal to the annual cost as determined by Statement of Financial Accounting Standards (SFAS) No. 106 (described below). Medical benefits are self-insured; the life insurance plan is paid through insurance premiums. The Financial Accounting Standards Board (FASB) has prescribed the determination of annual pension and other postretirement benefits expenses in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", respectively. Pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation", regulatory deferrals of these benefit expenses are recorded for those jurisdictions which reflect as net expense the funding of pensions and cash payment of other benefits in the ratemaking process. TEMPORARY CASH INVESTMENTS: For purposes of the Consolidated Statement of Cash Flows, temporary cash investments with original maturities of three months or less, generally in the form of commercial paper, certificates of deposit, and repurchase agreements, are considered to be the equivalent of cash. The carrying amount of temporary cash investments approximates the fair value because of the short-term maturity of those instruments. ACCOUNTING CHANGES: Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Post- retirement Benefits Other Than Pensions". This statement requires the costs of providing postretirement benefits, such as medical and life insurance, to be accrued over the applicable employees' service periods. Prior to 1993, medical expenses and life insurance premiums paid for retired employees and their dependents were recorded as expense in the period they were paid. Also effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes as further described in Note B. The total provision for income taxes is less than the amount produced by applying the federal income statutory tax rate to financial accounting income before income taxes, as set forth below: Federal income tax returns through 1989 have been examined and substantially settled. In adopting SFAS No. 109, the Company recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets: Unamortized investment tax credit $40 455 Unbilled revenue 21 626 Tax interest capitalized 10 750 State tax loss carryback/carryforward 8 790 Contributions in aid of construction 4 588 Other 7 416 93 625 Deferred tax liabilities: Book vs. tax plant basis differences, net 507 214 Other 8 437 515 651 Total net deferred tax liabilities 422 026 Add portion above included in current assets 1 974 Total long-term net deferred tax liabilities $424 000 It is expected that regulatory commissions will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $326 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $41 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on consolidated net income resulting from adoption of the standard. Note C - Dividend Restriction: Supplemental indentures relating to most outstanding bonds of the Company contain dividend restrictions under the most restrictive of which $285,914,000 of consolidated retained earnings at December 31, 1993, is not available for cash dividends on common stock, except that a portion thereof may be paid as cash dividends where concurrently an equivalent amount of cash is received by the Company as a capital contribution or as the proceeds of the issue and sale of shares of its common stock. Note D - Allegheny Generating Company: The Company owns 45% of the common stock of Allegheny Generating Company (AGC), and affiliates of the Company own the remainder. AGC owns an undivided 40% interest, 840 MW, in the 2,100-MW pumped-storage hydroelectric station in Bath County, Virginia operated by the 60% owner, Virginia Power Company, an unaffiliated utility. AGC recovers from the Company and its affiliates all of its operation and maintenance expenses, depreciation, taxes, and a return on its investment under a wholesale rate schedule approved by the FERC. Through February 29, 1992, AGC's return on equity (ROE) was adjusted annually pursuant to a settlement agreement approved by the FERC. In December 1991, AGC filed for a continuation of the existing ROE of 11.53% and other parties (the Consumer Advocate Division of the Public Service Commission of West Virginia, Maryland People's Counsel, and Pennsylvania Office of Consumer Advocate, collectively referred to as the joint consumer advocates or JCA) filed to reduce the ROE, with any resultant rate decreases subject to refund from March 1, 1992 through May 31, 1993. Hearings were completed in June 1992, and a recommendation was issued by an Administrative Law Judge (ALJ) on December 21, 1993, for an ROE of 10.83%, which the JCA argues should be further adjusted to reflect changes in capital market conditions since the hearings. Exceptions to this recommendation have been filed by all parties for consideration by the full Commission. On January 28, 1994, the JCA filed a joint complaint claiming that both the existing ROE of 11.53% and the ALJ's recommended ROE of 10.83% are unjust and unreasonable. This new complaint requests an ROE of 8.53%, with rates subject to refund beginning April 1, 1994. Following is a summary of financial information for AGC: The Company's share of the equity in earnings above was $12.2 million, $13.8 million, and $14.8 million for 1993, 1992, and 1991, respectively, and was included in other income, net, on the Consolidated Statement of Income. Note E - Pension Benefits: The Company's share of net pension costs under the System's pension plan, a portion of which (about 25%) was charged to plant construction, included the following components: The benefits earned to date and funded status of the Company's share of the System plan at December 31 using a measurement date of September 30 were as follows: The foregoing includes the Company's portion of amounts applicable to employees at power stations which are owned jointly with affiliates. In determining the actuarial present value of the projected benefit obligation at December 31, 1993, 1992, and 1991, the discount rates used were 7.25%, 7.75%, and 8%, and the rates of increase in future compensation levels were 4.75%, 5.25%, and 5.5%, respectively. The expected long-term rate of return on assets was 9% in each of the years 1993, 1992, and 1991. Note F - Postretirement Benefits Other Than Pensions: The Company adopted SFAS No. 106 as of January 1, 1993, which requires accrual of postretirement benefits other than pensions (principally health care and life insurance) for the employee and covered dependents during the years the employee renders the necessary service to receive such benefits. Prior to 1993, medical expenses and life insurance premiums paid by the Company for retired employees and their dependents were recorded in expense in the period in which they were paid and were $1,907,000 and $1,721,000 in 1992 and 1991, respectively. SFAS No. 106 postretirement cost in 1993, a portion of which (about 25%) was charged to plant construction, included the following components: (Thousands of Dollars) Service cost - benefits earned $ 939 Interest cost on accumulated postretirement benefit obligation 4 389 Actual return on plan assets (9) Amortization of unrecognized transition obligation 2 817 Other net amortization and deferral 9 SFAS No. 106 postretirement cost 8 145 Regulatory deferral (1 963) Net postretirement cost $6 182 The benefits earned to date and funded status of the Company's share of the System plan at December 31, 1993, using a measurement date of September 30 were as follows: (Thousands of Dollars) Accumulated postretirement benefit obligation: Retirees $35 748 Fully eligible employees 9 030 Other employees 18 378 Total obligation 63 156 Plan assets at market value in short-term investment fund 1 510 Accumulated postretirement benefit obligation in excess of plan assets 61 646 Less: Unrecognized cumulative net loss from past experience different from that assumed 3 362 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993 53 746 Postretirement benefit liability at September 30, 1993 4 538 Fourth quarter 1993 contributions and benefit payments 1 960 Postretirement benefit liability at December 31, 1993 $2 578 The unfunded accumulated postretirement benefit obligation (APBO) at January 1, 1993, of $56,600,000 (transition obligation) is being amortized prospectively over 20 years as permitted by the standard. In determining the APBO at January 1 and December 31, 1993, the discount rates used were 8% and 7.25%, and the rates of increase in future compensation levels were 5.5% and 4.75%, respectively. For measurement purposes, a health care trend rate of 14% for 1993, declining 1% each year thereafter to 7% in the year 2000 and beyond, and plan provisions which limit future medical and life insurance benefits were assumed. Increasing the assumed health care trend rate by 1% in each year would increase the APBO at December 31, 1993, by $4.3 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.4 million. Recovery of SFAS No. 106 costs has been authorized for retail customers in Pennsylvania effective in May 1993 and for the FERC wholesale customers effective in June 1993. The Company has recorded regulatory assets at December 31, 1993, of $2.0 million relating to SFAS No. 106 costs in Pennsylvania incurred prior to the May rate order, with the result that adoption of SFAS No. 106 has had no effect on consolidated net income. The Company will seek to recover these costs in its next base rate case. Note G - Stockholders' Equity: COMMON STOCK AND OTHER PAID-IN CAPITAL: The Company issued and sold common stock to its parent, at $20 per share, 5,000,000 shares in October 1993, and 1,750,000 shares in December 1991. Other paid-in capital decreased $145,000 in 1993 and $550,000 in 1992 as a result of the underwriting fees and commissions and miscellaneous expenses associated with the Company's sale of $40 million of preferred stock in 1992. PREFERRED STOCK: All of the preferred stock is entitled on voluntary liquidation to its then current call price and on involuntary liquidation to $100 per share. The holders of the Company's market auction preferred stock are entitled to dividends at a rate determined by an auction held the business day preceding each quarterly dividend payment date. Note H - Long-Term Debt: Maturities for long-term debt for the next five years are: 1994, none; 1995, $27,000,000; 1996 and 1997, none; and 1998, $103,500,000. Substantially all of the properties of the Company are held subject to the lien securing its first mortgage bonds. Some properties are also subject to a second lien securing certain pollution control and solid waste disposal notes. Certain first mortgage bond series are not redeemable by certain refunding until dates established in the respective supplemental indentures. In 1993, the Company sold $102 million of 5-1/2% 5-year first mortgage bonds to refund a $25 million 7% issue due in 1997, a $25 million 7-7/8% issue due in 1999, and a $52 million 7-1/8% issue due in 1998, and sold $80 million of 6-3/8% 10-year first mortgage bonds to refund a $35 million 7-5/8% issue due in 2002 and a $40 million 8-1/8% issue due in 2001. The Company also issued $7.75 million of 5.95% 20-year Pollution Control Revenue Notes to refund a $7.75 million 9-3/8% issue due in 2013, and issued $61.5 million of 10-year 4.95% Pollution Control Revenue Notes to refund a $30 million 9-3/4% series and a $31.5 million 9-1/2% series due in 2003. The estimated fair value of long-term debt at December 31, 1993 and 1992, was $823,333,000 and $783,379,000, respectively, based on actual market prices or market prices of similar issues. Note I - Short-Term Financing: To provide interim financing and support for outstanding commercial paper, the System companies have established lines of credit with several banks. The Company has SEC authorization for total short-term borrowings of $170 million, including money pool borrowings described below. The Company has fee arrangements on all of its lines of credit and no compensating balance requirements. In addition to bank lines of credit, in 1992 the Company and its affiliates established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. In January 1994, the Company and its affiliates jointly established an aggregate $300 million multi-year credit program which provides that the Company may borrow up to $135 million on a standby revolving credit basis. There was no short-term debt outstanding at the end of 1993 or 1992. The Company had outstanding at the end of 1993 and 1992, $24.9 million and $20.9 million, respectively, of notes receivable from affiliates in the money pool. Note J - Commitments and Contingencies: CONSTRUCTION PROGRAM: The Company has entered into commitments for its construction program, for which expenditures are estimated to be $258 million for 1994 and $208 million for 1995. These estimates include expenditures for the program of complying with the Clean Air Act Amendments of 1990 (CAAA) as discussed below. ENVIRONMENTAL MATTERS: System companies are subject to laws, regulations, and uncertainties with respect to air and water quality, land use, and other environmental matters. Compliance may require them to incur substantial additional costs to modify or replace existing and proposed equipment and facilities and may affect adversely the lead time, size, and siting of future generating stations, increase the complexity and cost of pollution control equipment, and otherwise add to the cost of future operations. Construction expenditures through the year 2000 will include substantial amounts for compliance with Phase I and Phase II of the CAAA. The Company is estimating expenditures of approximately $700 million, which includes $207 million expended through 1993, depending on the strategy eventually selected for complying with Phase II. Construction estimates for 1994 and 1995 include $82 million and $33 million, respectively, for the program of complying with the CAAA. In complying with the CAAA, the Company will face uncertainties, including regulatory administrative interpretations and contingencies, such as potential cost overruns, equipment performance, and cost recovery in rates. LITIGATION AND OTHER: In the normal course of business, the Company becomes involved in various legal proceedings. The Company does not believe that the ultimate outcome of these proceedings will have a material effect on its financial position. The Company is guarantor as to 45% of a $75 million revolving credit agreement of AGC, which in 1993 was used by AGC solely as support for its indebtedness for commercial paper outstanding. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Allegheny Generating Company In our opinion, the financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Allegheny Generating Company (an Allegheny Power System, Inc. affiliate) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A and B to the financial statements, the Company changed its method of accounting for income taxes in 1993. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York February 3, 1994 AGC NOTES TO FINANCIAL STATEMENTS (These notes are an integral part of the financial statements.) Note A - Summary of Significant Accounting Policies: The Company was incorporated in Virginia in 1981. Its common stock is owned by Monongahela Power Company - 27%, The Potomac Edison Company - 28%, and West Penn Power Company - 45% (the Parents). The Parents are wholly-owned subsidiaries of Allegheny Power System, Inc. and are a part of the Allegheny Power integrated electric utility system. The Company is subject to regulation by the Securities and Exchange Commission (SEC) and by the Federal Energy Regulatory Commission (FERC). Significant accounting policies of the Company are summarized below. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment are stated at original cost, and consist of a 40% undivided interest in the Bath County pumped-storage hydroelectric station and its connecting transmission facilities. The cost of depreciable property units retired plus removal costs less salvage are charged to accumulated depreciation. DEPRECIATION AND MAINTENANCE: Provisions for depreciation are determined on a straight-line method based on estimated service lives of depreciable properties and amounted to approximately 2.1% of average depreciable property in each of the years 1993, 1992, and 1991. The cost of maintenance and of certain replacements of property, plant, and equipment is charged to operating expenses. INCOME TAXES: The Company joins with its parents and affiliates in filing a consolidated federal income tax return. The consolidated tax liability is allocated among the participants generally in proportion to the taxable income of each participant, except that no subsidiary pays tax in excess of its separate return tax liability. Financial accounting income before income taxes differs from taxable income principally because certain income and deductions for tax purposes are recorded in the financial income statement in another period. Differences between income tax that would be paid if taxes were computed on the basis of financial accounting income instead of taxable income are deferred. Prior to 1987, provisions for federal income tax were reduced by investment credits, and amounts equivalent to such credits were charged to income with concurrent credits to a deferred account, balances in which are being amortized over estimated service lives of the related properties. ACCOUNTING CHANGE: Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". This standard mandated a change from the previous income-based deferral approach to a balance sheet-based liability approach for computing deferred income taxes. Note B - Income Taxes: Details of federal income tax provisions are: In 1993, the total provision for income taxes ($13,262,000) was less than the amount produced by applying the federal income tax statutory rate to financial accounting income before income taxes ($14,155,000), due primarily to amortization of deferred investment credit ($1,316,000). Federal income tax returns through 1989 have been examined and substantially settled. The Company adopted SFAS No. 109 as of January 1, 1993, and in doing so recognized a significant increase in both deferred tax assets and liabilities. At December 31, 1993, the deferred tax assets and liabilities were comprised of the following: (Thousands of Dollars) Deferred tax assets Unamortized investment tax credit $ 28 869 Deferred tax liabilities Book vs. tax plant basis differences, net 154 565 Other 152 154 717 Total net deferred tax liabilities $125 848 It is expected the FERC will allow recovery of the deferred tax liabilities in future years as they are paid, and accordingly, the Company has recorded regulatory assets for an amount equal to the $4 million increase in deferred tax liabilities. Regulatory liabilities were recorded in an amount equal to the $29 million increase in deferred tax assets to reflect the Company's obligation to pass such tax benefits on to its customers as the benefits are realized in cash in future years. Based on the provisions in the standard for recording these regulatory assets and liabilities on the balance sheet, there was no effect on net income resulting from adoption of the standard. Note C - Long-Term Debt: The Company had long-term debt outstanding as follows: The Company has a revolving credit agreement with a group of seven banks which provides for loans of up to $75 million at any one time outstanding through 1997. Each bank has the option to discontinue its loans after 1997 upon three years' prior written notice. Without such notice, the loans are automatically extended for one year. Amounts borrowed are guaranteed by the Parents in proportion to their equity interest. Interest rates are determined at the time of each borrowing. The revolving credit agreement serves as support for the Company's commercial paper. In addition to bank lines of credit, the Company and its affiliates in 1992 established an internal money pool as a facility to accommodate intercompany short-term borrowing needs, to the extent that certain of the companies have funds available. At the end of 1993, the Company had outstanding $29,500,000 of money pool borrowings from affiliates. Maturities for long-term debt for the next five years are: 1994, 10,000,000; 1995, $1,000,000; 1996, $6,375,000; 1997, $61,462,000; and 1998, $60,000,000. The estimated fair value of debentures and medium- term notes at December 31, 1993 and 1992, was $233,445,000 and $249,850,000 respectively, based on actual market prices or market prices of similar issues. The carrying amount of commercial paper and notes payable to affiliates approximates their fair value because of the short maturity of those instruments. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Classified as long-term debt by Allegheny Generating Company (AGC). Charges for maintenance and depreciation other than amounts shown in the consolidated statement of income were not material. Charges for maintenance and depreciation other than amounts shown in the statement of income were not material. (A) The maximum amount outstanding at any month end during the year. (B) Computed by multiplying the principal amounts of short-term debt by the days outstanding, and dividing the sum of the products by the number of days in the year. (C) Computed by dividing total interest accrued for the year by the average principal amount outstanding for the year. (D) Unsecured promissory notes issued under informal credit arrangements with various banks with terms of 270 days or less. (E) Unsecured bearer promissory notes sold to dealers at a discount with a term of 270 days or less. (F) Internal arrangement for borrowing funds on a short-term basis. - 43 - - 44 - ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE For APS and the Subsidiaries, none. - 45 - PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS APS, Monongahela, Potomac Edison, West Penn, and AGC. Reference is made to the Executive Officers of the Registrants in Part I of this report. The names, ages, and the business experience during the past five years of the directors of the System companies are set forth below: (1) See Executive Officers of the Registrants in Part I of this report for further details. (a) Eleanor Baum. Dean of the Albert Nerken School of Engineering of The Cooper Union for the Advancement of Science and Art. Director of United States Trust Company, Commissioner of the Engineering Manpower Commission, and a fellow of the Institute of Electrical and Electronic Engineers and the Society of Women Engineers. Ms. Baum filed one late report on Form 4 concerning one purchase transaction in 1993. (b) William L. Bennett. Co-Chairman, Director and Chief Executive Officer of Noel Group, Inc. Formerly, General partner, Discovery Funds, a venture capital affiliate of Rockefeller & Company, Inc. Chairman of the Board of TDX Corporation. Director of Forschner Group, Inc., Global Natural Resources Inc., Lincoln Snacks Company, Simmons Outdoor Corporation and VISX, Inc. (c) Phillip E. Lint. Retired. Formerly, partner, Price Waterhouse. (d) Edward H. Malone. Retired. Formerly, Vice President of General Electric Company and Chairman, General Electric Investment Corporation. Director of Fidelity Group of Mutual Funds, General Re Corporation, Mattel, Inc., and Corporate Property Investors, a real estate investment trust. (e) Frank A. Metz, Jr. Retired. Formerly, Senior Vice President, Finance and Planning, and Director, International Business Machines Corporation. Director of Monsanto Company and Norrell Corporation. (f) Clarence F. Michalis. Chairman of the Board of Directors of Josiah Macy, Jr. Foundation, a tax-exempt foundation for medical research and education. Director of Schroder Capital Funds Inc. (g) Steven H. Rice. Business consultant and attorney-at-law. Formerly, President and Chief Operating Officer and Director of The Seamen's Bank for Savings. Director and member of the Investment and Audit Committees of Royal Group, Inc. (The Royal Insurance Companies). Director and Vice Chairman of the Board of The Stamford (CT) Federal Savings Bank. (h) Gunnar E. Sarsten. President and Chief Operating Officer of Morrison Knudsen Corporation. Formerly, President and Chief Executive Officer of United Engineers & Constructors International, Inc., a subsidiary of the Raytheon Company, and Deputy Chairman of the Third District Federal Reserve Bank in Philadelphia. (i) Peter L. Shea. Managing director of Hydrocarbon Energy, Inc., a privately owned oil and gas development drilling and production company. - 46 - ITEM 11. ITEM 11. EXECUTIVE COMPENSATION During 1993, and for 1992 and 1991, the annual compensation paid by each of the System companies, APS, APSC, Monongahela, Potomac Edison, West Penn, and AGC directly or indirectly for services in all capacities to such companies to their Chief Executive Officer and each of the four most highly paid executive officers of each such company whose cash compensation exceeded $100,000 was as follows: (a) APS has no paid employees. All salaries and bonuses are paid by APSC. (b) Bonus amounts are determined and paid in April of the year in which the figure appears and are based upon performance in the prior year. (c) Amounts constituting less than 10% of the total annual salary and bonus are not disclosed. All officers did receive miscellaneous other items amounting to less than 10% of total annual salary and bonus. (d) Effective January 1, 1992, the basic group life insurance provided employees was reduced from two times salary during employment, which reduced to one times salary after 5 years in retirement, to a new plan which provides one times salary until retirement and $25,000 thereafter. Executive officers and other senior managers remain under the prior plan. In order to pay for this insurance for these executives, during 1992 insurance was purchased on the lives of each of them. Effective January 1, 1993, APS started to provide funds to pay for the future benefits due under the supplemental retirement plan (Secured Benefit Plan) as described in note (a) on p. 53. To do this, APS purchased, during 1993, life insurance on the lives of the covered executives. The premium costs of both the 1992 and 1993 policies plus a factor for the use of the money are returned to APS at the earlier of (a) death of the insured or (b) the later of age 65 or 10 years from the date of the policy's inception. The figures in this column include the present value of the executives' cash value at retirement attributable to the current year's premium payment for both the Executive Life Insurance and Secured Benefit Plans (based upon the premium, future valued to retirement, using the policy internal rate of return minus the corporation's premium payment), as well as the premium paid for the basic Group Life Insurance program plan and the contribution for the 401(k) plan. For 1993, the figure shown includes amounts representing (a) the aggregate of life insurance premiums and dollar value of the benefit to the executive officer of the remainder of the premium paid on the Group Life Insurance program and the Executive Life Insurance and Secured Benefit Plans and (b) 401(k) contributions as follows: Mr. Bergman $42,392 and $4,497; Mr. Garnett $19,509 and $4,497; Mr. Skrgic $14,181 and $4,497; Ms. Gormley $11,152 and $4,294; and Mr. Jones $8,382 and $4,497, respectively. (e) These amounts as previously reported did not include the following amounts representing the dollar value of the benefit to the executive officer of the remainder of the premium paid on the Executive Life Insurance Plan: Mr. Bergman $786; Mr. Garnett $210; Mr. Skrgic $218; Ms. Gormley $232; and Mr. Jones $519. (f) See Executive Officers of the Registrants for other positions held. (g) Although less than 10% of total annual salary and bonus, Mr. Skrgic received a $15,000 housing allowance in 1993, 1992 and 1991. (h) The incentive plan was not in effect for these officers in 1991. (i) Includes $15,000 housing allowance for both 1993 and 1992 and miscellaneous other items totaling $2,423 and $2,457 for 1993 and 1992, respectively. - 47 - - 48 - - 49 - - 50 - Summary Compensation Tables AGC Annual Compensation (a) Name All Other and Compen- Principal sation Position Year Salary($) Bonus($) ($) (a) AGC has no paid employees. - 51 - DEFINED BENEFIT OR ACTUARIAL PLAN DISCLOSURE Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) APS (b) Klaus Bergman, President* $235,270 and Chief Executive Officer (c) Stanley I. Garnett, II, 112,320 Vice President, Finance (c) Peter J. Skrgic, 126,000 Vice President (c) Kenneth M. Jones, 90,004 Vice President and Comptroller (c) Nancy H. Gormley, 78,404 Vice President (c) Monongahela Klaus Bergman, $ Chief Executive Officer (c)(d) Benjamin H. Hayes, 113,364 President Thomas A. Barlow, 70,788 Vice President Robert R. Winter, 67,896 Vice President Richard E. Myers, 67,200 Comptroller * Elected Chairman of the Board effective January 1, 1994. - 52 - Estimated Name and Capacities Annual Benefits Company in Which Served on Retirement (a) Potomac Edison Klaus Bergman, $ Chief Executive Officer (c)(d) Alan J. Noia, 133,200 President Robert B. Murdock, 80,677 Vice President James D. Latimer, 75,298 Vice President Thomas J. Kloc, 68,591 Comptroller West Penn Klaus Bergman, $ Chief Executive Officer (c)(d) Jay S. Pifer, 111,463 President Thomas K. Henderson, 73,127 Vice President Charles S. Ault, 71,100 Vice President Charles V. Burkley, 66,442 Comptroller Allegheny Generating Company No paid employees. - 53 - (a) Assumes present insured benefit plan and salary continue and retirement at age 65 with single life annuity. Under plan provisions, the annual rate of benefits payable at the normal retirement age of 65 are computed by adding (i) 1% of final average pay up to covered compensation times years of service up to 35 years, plus (ii) 1.5% of final average pay in excess of covered compensation times years of service up to 35 years, plus (iii) 1.3% of final average pay times years of service in excess of 35 years. Covered compensation is the average of the maximum taxable Social Security wage bases during the 35 years preceding the member's retirement, except that years before 1959 are not taken into account for purposes of this average. The final average pay benefit is based on the member's average total earnings during the highest-paid 60 consecutive calendar months or, if smaller, the member's highest rate of pay as of any July 1st. Effective July 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. The maximum amount will be reduced to $150,000 effective July 1, 1994 as a result of The Omnibus Budget Reconciliation Act of 1993. Benefits for employees retiring between 55 and 62 differ from the foregoing. Pursuant to a supplemental plan (Secured Benefit Plan), senior executives of Allegheny Power System companies who retire at age 60 or over with 40 or more years of service are entitled to a supplemental retirement benefit in an amount that, together with the benefits under the basic plan and from other employment, will equal 60% of the executive's highest average monthly earnings for any 36 consecutive months. The supplemental benefit is reduced for less than 40 years service and for retirement age from 60 to 55. It is included in the amounts shown where applicable. In order to provide funds to pay such benefits, effective January 1, 1993 the Company purchased insurance on the lives of the plan participants. The Secured Benefit Plan has been designed that if the assumptions made as to mortality experience, policy dividends, and other factors are realized, the Company will recover all premium payments, plus a factor for the use of the Company's money. All executive officers are participants in the Secured Benefit Plan. This does not include benefits from an Employee Stock Ownership and Savings Plan (ESOSP) established as a non-contributory stock ownership plan for all eligible employees effective January 1, 1976, and amended in 1984 to include a savings program. Under the ESOSP for 1993, all eligible employees may elect to have from 2% to 7% of their compensation contributed to the Plan as pre-tax contributions and an additional 1% to 6% as post-tax contributions. Employees direct the investment of these contributions into one or more of five available funds. Each System company matches 50% of the pre-tax contributions up to 6% of compensation with common stock of Allegheny Power System, Inc. Effective January 1, 1993 the maximum amount of any employee's compensation that may be used in these computations is $235,840. Effective January 1, 1994, the amount was reduced to $150,000 as a result of The Omnibus Budget Reconciliation Act of 1993. Employees' interests in the ESOSP vest immediately. Their pre-tax contributions may be withdrawn only upon meeting certain financial hardship requirements or upon termination of employment. (b) APS has no paid employees. These executives are employees of APSC. (c) See Executive Officers of the Registrants for other positions held. (d) The total estimated annual benefits on retirement payable to Mr. Bergman for services in all capacities to APS, APSC and the Subsidiaries is set forth in the table for APS. Compensation of Directors In 1993, APS directors who were not officers or employees of System companies received for all services to System companies (a) $16,000 in retainer fees, (b) $800 for each committee meeting attended, except Executive Committee meetings which are $200, and (c) $250 for each Board meeting of each company attended. Under an unfunded deferred compensation plan, a director may elect to defer receipt of all or part of his or her director's fees for succeeding calendar years to be payable with accumulated interest when the director ceases to be such, in equal annual installments, or, upon authorization by the Board of Directors, in a lump sum. - 55 - ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - 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. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 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. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: *Eleanor Baum *Edward H. Malone *William L. Bennett *Frank A. Metz, Jr. *Klaus Bergman *Clarence F. Michalis *Stanley I. Garnett, II *Steven H. Rice *Benjamin H. Hayes *Gunnar E. Sarsten *Phillip E. Lint *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Alan J. Noia *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Jay S. Pifer *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: *Klaus Bergman *Kenneth M. Jones *Stanley I. Garnett, II *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. *Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders.* S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. ** Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). *** Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For APS and the Subsidiaries, none. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The financial statements and financial statement schedules filed as part of this Report are set forth under ITEM 8. and reference is made to the index on page 42. (b) APS filed a report on Form 8-K on November 5, 1993 concerning the two-for-one stock split. No other reports on Form 8-K were filed by System companies during the quarter ended December 31, 1993. (c) Exhibits for APS, Monongahela, Potomac Edison, West Penn, and AGC are listed in the Exhibit Index beginning on page E-1 and are incorporated herein by reference. Graphics Appendix Page System Map . . . . . . . . . . . . . . . . . . . . . . . 10 - 56 - 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. ALLEGHENY POWER SYSTEM, INC. By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 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. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: STANLEY I. GARNETT, II Vice President, 2/3/94 (Stanley I. Garnett, II) Finance (iii) Principal Accounting Officer: KENNETH M. JONES Vice President 2/3/94 (Kenneth M. Jones) and Comptroller (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 57 - 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MONONGAHELA POWER COMPANY By: BENJAMIN H. HAYES (Benjamin H. Hayes, President) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: CHARLES S. MULLETT Secretary and 2/3/94 (Charles S. Mullett) Treasurer (iii) Principal Accounting Officer: RICHARD E. MYERS Comptroller 2/3/94 (Richard E. Myers) (iv) A Majority of the Directors: *Eleanor Baum *Edward H. Malone *William L. Bennett *Frank A. Metz, Jr. *Klaus Bergman *Clarence F. Michalis *Stanley I. Garnett, II *Steven H. Rice *Benjamin H. Hayes *Gunnar E. Sarsten *Phillip E. Lint *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 58 - 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. THE POTOMAC EDISON COMPANY By: ALAN J. NOIA (Alan J. Noia, President) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: DALE F. ZIMMERMAN Secretary and 2/3/94 (Dale F. Zimmerman) Treasurer (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (THOMAS J. KLOC) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Alan J. Noia *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 59 - 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. WEST PENN POWER COMPANY By: JAY S. PIFER (Jay S. Pifer, President) Date: February 3, 1994 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: KENNETH D. MOWL Secretary and 2/3/94 (Kenneth D. Mowl) Treasurer (iii) Principal Accounting Officer: CHARLES V. BURKLEY Comptroller 2/3/94 (Charles V. Burkley) (iv) A Majority of the Directors: *Eleanor Baum *Frank A. Metz, Jr. *William L. Bennett *Clarence F. Michalis *Klaus Bergman *Jay S. Pifer *Stanley I. Garnett, II *Steven H. Rice *Phillip E. Lint *Gunnar E. Sarsten *Edward H. Malone *Peter L. Shea *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 60 - 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ALLEGHENY GENERATING COMPANY By: KLAUS BERGMAN (Klaus Bergman, President and Chief Executive Officer) Date: February 3, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date (i) Principal Executive Officer: Chairman of 2/3/94 of the Board, KLAUS BERGMAN President, Chief (Klaus Bergman) Executive Officer, and Director (ii) Principal Financial Officer: NANCY L. CAMPBELL Treasurer and 2/3/94 (Nancy L. Campbell Assistant Secretary (iii) Principal Accounting Officer: THOMAS J. KLOC Comptroller 2/3/94 (Thomas J. Kloc) (iv) A Majority of the Directors: *Klaus Bergman *Kenneth M. Jones *Stanley I. Garnett, II *Peter J. Skrgic *By: NANCY H. GORMLEY 2/3/94 (Nancy H. Gormley) - 61 - CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-36716) relating to the Dividend Reinvestment and Stock Purchase Plan of Allegheny Power System, Inc.; in the Prospectus constituting part of Allegheny Power System, Inc.'s Registration Statement on Form S-3 (No. 33-49791) relating to the common stock shelf registration; in the Prospectus constituting part of Monongahela Power Company's Registration Statement on Form S-3 (No. 33-51301); in the Prospectus constituting part of The Potomac Edison Company's Registration Statement on Form S-3 (No. 33-51305); and in the Prospectus constituting part of West Penn Power Company's Registration Statement on Form S-3 (No. 33-51303); of our reports dated February 3, 1994 included in ITEM 8 of this Form 10-K. We also consent to the references to us under the heading "Experts" in such Prospectuses. PRICE WATERHOUSE PRICE WATERHOUSE New York, New York March 11, 1994 - 62 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Power System, Inc., a Maryland corporation, Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to Annual Reports on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ELEANOR BAUM FRANK A. METZ, JR. (Eleanor Baum) (Frank A. Metz, Jr.) WILLIAM L. BENNETT CLARENCE F. MICHALIS (William L. Bennett) (Clarence F. Michalis) KLAUS BERGMAN STEVEN H. RICE (Klaus Bergman) (Steven H. Rice) PHILLIP E. LINT GUNNAR E. SARSTEN (Phillip E. Lint) (Gunnar E. Sarsten) EDWARD H. MALONE PETER L. SHEA (Edward H. Malone) (Peter L. Shea) - 63 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of The Potomac Edison Company, a Maryland and Virginia corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 ALAN J. NOIA (Alan J. Noia) - 64 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 JAY S. PIFER (Jay S. Pifer) - 65 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 BENJAMIN H. HAYES (Benjamin H. Hayes) - 66 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned directors of Allegheny Generating Company, a Virginia corporation, do hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Company, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 KLAUS BERGMAN (Klaus Bergman) KENNETH M. JONES (Kenneth M. Jones) PETER J. SKRGIC (Peter J. Skrgic) - 67 - POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS THAT the undersigned director of Monongahela Power Company, an Ohio corporation, The Potomac Edison Company, a Maryland and Virginia corporation, and West Penn Power Company, a Pennsylvania corporation, does hereby constitute and appoint NANCY H. GORMLEY and STANLEY I. GARNETT, II and each of them a true and lawful attorney in his or her name, place and stead, in any and all capacities, to sign his or her name to the Annual Report on Form 10-K for the year ended December 31, 1993 under the Securities Exchange Act of 1934, as amended, and to any and all amendments, of said Companies, and to cause the same to be filed with the Securities and Exchange Commission, granting unto said attorneys and each of them full power and authority to do and perform any act and thing necessary and proper to be done in the premises, as fully and to all intents and purposes as the undersigned could do if personally present, and the undersigned hereby ratifies and confirms all that said attorneys or any one of them shall lawfully do or cause to be done by virtue hereof. Dated: February 3, 1994 PETER J. SKRGIC (Peter J. Skrgic) E-1 EXHIBIT INDEX (Rule 601(a)) Allegheny Power System, Inc. Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-267), September 1993, exh. (a)(3) 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-267), June 1990, exh. (a)(3) 4 Subsidiaries' Indentures described below. 10.1 Directors' Deferred Compensation Plan 10.2 Executive Compensation Plan 10.3 Allegheny Power System Incentive Compensation Plan 10.4 Allegheny Power System Supplemental Executive Retirement Plan 10.5 Executive Life Insurance Program and Collateral Assignment Agreement 10.6 Secured Benefit Plan and Collateral Assignment Agreement 11 Statement re computation of per share earnings: Clearly determinable from the financial statements contained in Item 8. 21 Subsidiaries of APS: Name of Company State of Organization Allegheny Generating Company (a) Virginia Allegheny Power Service Corporation Maryland Monongahela Power Company Ohio The Potomac Edison Company Maryland and Virginia West Penn Power Company Pennsylvania (a) Owned directly by Monongahela, Potomac Edison, and West Penn. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. Exhibit 10.1 Election to Defer Receipt of Directors Fees Under the Directors Elective Deferred Fees Plan of Allegheny Power System Pursuant to Section 4 of the captioned Plan, I hereby elect to defer receipt of ________% of all retainer and attendance fees payable to me on and after January 1, 19__. I elect to have my deferred account, with accumulated interest, paid as follows, commencing with the 2nd day of January following the termination of my service as a member of the Board of Directors of Allegheny: In a single lump sum, to be paid within 60 days after such January 2. In annual installment payments of equal amounts (adjusted for interest credits) over _______ years (at least 3) with such installment payments to be made on January 2 of each year. In annual installments of equal amounts (adjusted for interest credits) on January 2 of each year, such annual payments to be equal in number to the number of years of service. In the event of my death prior to receipt of all amounts I have deferred under this Plan, including interest credits, the balance of such deferred funds shall be paid in a lump sum to the following designees who survive me or to my estate in proportion to the percentage shares indicated, and, if I have indicated no designees or if all indicated designees predecease me, entirely to my estate. Designee Address Percentage Share Dated: Signature Exhibit 10.2 CONFIDENTIAL EXECUTIVE COMPENSATION PLAN OBJECTIVES To attract, hold, and motivate executive personnel. Prior approval of the chief executive officer is required for inclusion in the Plan. QUALIFICATIONS An employee becomes eligible for inclusion when 1. the employee has held a position with a salary grade of 28 or above for at least one year, is assuming the full responsibility of the position, is achieving satisfactory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28, or 2. the employee has held the position of operating division manager with a salary grade of 18 or above for at least one year, is assuming the full responsibility of the position, is achieving satis- factory results and has a salary which exceeds the mid point between the minimum and standard amounts of salary grade 28. COMPENSATION 1. Life insurance 2. Dependent medical insurance 3. Dependent dental insurance 4. Annual physical examination during employment 5. Five weeks vacation, unless length of service would warrant more.* Participants in the Plan are not entitled to pay for accrued vacation (or to vacation in lieu of such pay) in excess of what they would receive if they were not par- ticipants. *Language clarified. Exhibit 10.2 (Cont'd) 6. Sick pay allowance of one year at full pay and one year at half pay, regardless of length of service. PROCEDURE 1. The president of each of the operating companies, the Executive Director, Central Services and the APS, Inc. vice presidents shall submit to the chief executive officer the names of all eligible employees or reasons why an employee, otherwise eligible, should not be included, not less than 30 days prior to the employee's eligibility date. 2. The Vice President, Employee and Consumer Relations maintains an official list of employees included in the Executive Compensation Plan for all companies. January 1, 1987 Exhibit 10.3 ALLEGHENY POWER SYSTEM, INC. 1993 ANNUAL INCENTIVE PLAN I. PURPOSE OF THE INCENTIVE PLAN To attract and retain first quality managers in a com- petitive job market and to reward superior performance. II. ELIGIBILITY The annual incentive plan is designed to reward participating executives for achieving key goals for the System and for the units for which they are responsible. A prerequisite for participation in the plan shall be an understanding of and commitment to -- The System Management Plan and Policies -- The System's expectation that employees will observe the highest ethical standards in their conduct of System business and stewardship of its property. Eligibility will be determined by the Management Review Committee upon the recommendation of the CEO from among executives whose responsibilities can affect System performance. III. AWARDS Awards will reflect the importance of the participants to the System and the units for which they are responsible. Awards will be paid for the achievement of specific measurable goals set for the System, including goals set the individual and the units for which he or she is responsible. The plan's goals will be: -- Determined and communicated annually -- A reasonable number for each participant The types of goals which the Board will set with the help of the Management Review Committee include: -- Financial performance (return on equity, earnings, dividends) -- Customer satisfaction (cost, quality, and reliability of service) -- Cost and environmental consciousness (productivity, efficiency, availability and utilization of equipment) and conservation of resources -- Safety -- Development of personnel for management positions, including women and minorities IV. OVERALL LIMITATIONS ON AWARDS The Board of Directors shall not authorize any incentivepayment if, in the Board's opinion, the System's financial performance is less than satisfactory from the perspective of its stockholders. V. PERFORMANCE MEASURES Each year measures to evaluate participants' performance will be determined. They may vary among participants according to whether their principal responsibilities are to: -- The System as a whole -- An Operating Company -- Bulk Power Supply or Central Services. Each category of performance measure will carry appropriate weightings as shown on 1993 Participant Performance Schedule. Examples of possible measures include: For System as a whole -- Quantity and quality of earnings: return on equity, measured against previous year, authorized return on equity and as appropriate peer companies; financial ratings; capital structure, dividend payout ratios and total return -- Productivity, cost control, efficient use of equipment, natural resources, and other environmental considerations -- Quality and reliability of customer service -- Safety -- Attainment of reasonable rates and maintenance of competitive position For Operating Companies -- Balance for common stock: return on equity -- Safety -- Productivity and efficiency: revenues from regular customers, and administrative, operating, and maintenance expenditures - Per employee, customer, and kwh - Measured against previous year and peer companies -- Customer satisfaction (quality of service): outage rates, speedy restoration of service, customer complaints, employee courtesy, conservation and demand- side management programs -- Cost of service: rate per kwh measured against past period, economic indices, and peer companies -- Community relations and relations with state and local governments and their agencies -- Completion of construction projects on time and within budget -- Adequacy of management development programs For Bulk Power Supply and Central Services -- Adequacy of planning and accuracy of forecasts -- Completion of assignments and projects on time and within budget -- Availability, efficiency, and reliability of generating units and transmission systems -- Safety -- Cost consciousness (avoidance of excessive staffing and waste of work space and receptivity to cost saving techniques) -- Minimizing adverse effects in the environment -- User satisfaction -- Adherence to System Purchasing Policy and success in buying material, equipment, and supplies at the best possible price. For Individual Performance -- Initiative -- Resourcefulness -- Responsiveness -- Identifiable results -- Other VI. CALCULATION OF AWARDS Target Incentive Awards and Total Estimated Cost -- No awards will be paid for any year unless the Board of Directors finds that the System's financial performance is satisfactory from the perspective of its stockholders -- 100% of a target incentive award will be paid to a participant only if System, Responsibility Unit, and Individual target performance measures are fully achieved Performance Schedules -- The Performance Schedule describes ratings and weightings for each performance measure at all levels of performance -- As soon as practicable each year, Participant Performance Schedules for that year will be issued Performance Ratings -- Target performance represents the full and complete attainment of expectations in the performance area; it is rated 1.0 -- Performance that is acceptable but does not fully meet expectations can earn a rating but, of course, less than 1.0 -- Exceeding expectations can result in a performance rating as high as 1.25 -- Unacceptable individual performance will result in no award regardless of System or Unit Performance. Weightings -- Weightings will be established each year for System, Unit and Individual performance measures. Calculation of Award -- A participant's award, if any, will be determined by multiplying the participant's assigned incentive percentage times his/her rounded total performance rating times his/her salary at the close of the year prior to the year for which the award is to be made. The Management Review Committee or the Board of Directors,at its discretion, may supplement or decrease any partici-pant's calculated award to reflect extraordinary circumstances provided that it records its reason for doing so. VII. FORM AND TIMING OF PAYOUT Calculation of awards will be made as soon as practicable after the close of books for the year measured, but no award will be paid until it has been approved by the Management Review Committee or the Board of Directors, as appropriate. Payment will be in current cash unless the Management Review Committee or the Board at its discretion provides for deferral. VIII. TERMINATION AND TRANSFER PROVISIONS Termination Provisions -- Awards may at the discretion of the Management Review Committee or the Board be calculated on the basis of a full year's performance and prorated to the number of whole months actually served, except in the case of voluntary termination (other than retirement after the second quarter of the year) or termination by the company (with or without cause), in which case no award is made for year of termination. Designation of "Unit" in cases of transfer among Operating Companies, Central Services, Bulk Power Supply, and New York -- Weighting will be based on the number of months participant was in each unit. IX. PLAN ADMINISTRATION Administration of the plan is the responsibility of the Management Review Committee of the Board of Directors. -- The Committee is responsible for review and administration of all Systemwide goals and has final approval over these and other matters involving the plan, including eligibility. Exhibit 10.4 ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN (Effective July 1, 1990) ALLEGHENY POWER SYSTEM SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN 1. Purpose of the Plan: The purpose of the Plan, the "Allegheny Power System Supplemental Executive Retirement Plan" (hereinafter referred to as the "Plan") is to provide for the payment of supplemental retirement benefits to or in respect of senior executives of Allegheny Power System companies (hereinafter sometimes referred to as a "Company" or the "Companies") as part of an integrated executive compensation program which is intended to assist the Companies in attracting, motivating and retaining executives of superior ability, industry, and loyalty. 2. Eligibility to Participate in the Plan: Each employee of a Company who was a participant in the Predecessor Plan or who on or after the Effective Date is assigned 1990 salary grade 28 or higher shall be a participant in the Plan. 3. Definitions: A. Average Compensation - shall mean 12 times the highest average monthly earnings (including overtime and other salary payments actually earned, whether or not payment thereof is deferred) for any 36 consecutive months. B. Committee - shall mean the Finance Committee of the Board of Directors of Allegheny Power System, Inc. C. Effective Date - shall mean July 1, 1990. D. Participant - shall mean an employee who meets the eligibility requirements of Section 2. Retired Participant shall mean a Participant who has retired from service after at least 10 years of service with one or more Companies and on or after his/her 55th birthday. E. Plan Year - shall mean the 12-month period on which the fiscal records of the Plan are kept, which is now the period from July 1st to June 30th. F. Predecessor Plan - shall mean the Allegheny Power System Supplemental Executive Retirement Plans effective July 1, 1982 and July 1, 1988. G. Supplemental Retirement Benefit Reduction - shall mean the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired. H. Years of Service - shall mean the Participant's Years of Service, and fractional parts thereof, as computed under the terms of the Allegheny Power System Retirement Plan. 4. Supplemental Retirement Benefits: A. Eligibility for Benefits - A Participant shall be eligible for a benefit from this Plan only (a) if he/she has at least 10 Years of Service with one or more of the Companies and (b) on or after his/her 55th birthday: provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan. A Participant who dies in active employment on or after his/her 55th birthday shall be deemed to have retired one day before his/her death. B. Amount of Benefits - (1) Subject to paragraph (2) of this Subsection, an eligible Participant will be entitled to receive a supplemental retirement benefit under this Plan equal to his/her Average Compensation multiplied by the sum of: (a) 2% times his/her number of Years of Service up to 25 years, (b) 1% times his/her number of Years of Service from 25 to 30 years, and (c) 1/2% times his/her number of Years of Service from 30 to 40 years less (x) such Participant's Supplemental Retirement Benefit Reduction and (y) 2% per year for each year that a Participant retires prior to his/her 60th birthday. (2) The supplemental retirement benefits contemplated by paragraph (1) of this Subsection shall be payable only to the extent such benefits, together with (i) all retirement benefits payable to the Participant by reason of employment with another employer (other than a benefit payable under the Federal Social Security Act) converted to the same form as the benefit paid under this Plan by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan and (ii) the retirement benefit payable to the Participant under the Allegheny Power System Retirement Plan excluding any increases in this benefit which become effective after the Participant has retired do not exceed sixty percent (60%) of his/her Average Compensation, less 2% per year for each year the Participant retires prior to his/her 60th birthday. C. Form and Time of Payment - A benefit payable under this Plan shall be paid in such form as the Participant shall elect from those available, and at the same time as the retirement benefit payable to the Retired Participant, under the Allegheny Power System Retirement Plan. If the Benefit payable under this Plan is paid other than as a life annuity, the amount of the benefit when paid in such other form shall be determined by using the actuarial equivalence factors of the Allegheny Power System Retirement Plan. 5. Vesting: A Participant shall have no vested interest in the Plan until he/she becomes eligible to receive benefits under Section 4A. In the event such eligible Participant is discharged from employment for cause or terminates employment, other than by death or retirement under the Allegheny Power System Retirement Plan, any such interest which may have vested shall be discontinued and forfeited. 6. Funding: The Plan shall be unfunded. Benefits of a Participant shall be paid from the general assets of the Company employing the Participant at the time of his/her retirement and a Participant shall have no interest in any such assets under the terms of this Plan until he/she becomes a Retired Participant. An eligible Participant shall be an unsecured creditor of the Company as to the payment of any benefit under this plan. 7. Administration and Governing Law: This Plan will be administered by and under the direction of the Committee. The Committee shall adopt, and may from time to time modify or amend, such rules and guidelines consistent herewith as it may deem necessary or appropriate for carrying out the provisions and purposes of the Plan, which, upon their adoption and so long as in effect, shall be deemed a part hereof to the same extent as if set forth in the Plan (hereinafter referred to as the "Rules and Guidelines"). Any interpretation and construction by the Committee of any provision of, and the determination of any question arising under, the Plan or the Rules and Guidelines shall be final, conclusive, and binding upon the Participant, his/her surviving spouse and all other persons. The provisions of the Plan shall be construed, administered, and enforced according to and governed by the laws of the United States and the State of New York. 8. Entire Agreement: This Plan shall not be deemed to constitute a contract between any Company and any employee or other person in the employ of any Company, nor shall anything herein contained be deemed to give any employee or other person in the employ of any Company any right to be retained in the employ of any Company or to interfere with the right of any Company to discharge any employee or such other person at any time and to treat an employee without regard to the effect which such treatment might have upon such employee as a Participant in the Plan. 9. Non-Assignability: Neither a Participant, nor his beneficiary or any other person, shall have any right to commute, sell, assign, transfer, or otherwise convey the right to receive any payments hereunder; which payments and the right thereto are expressly declared to be nonassignable and nontransferable. In the event of any attempted assignment or transfer, the Companies shall have no further liability hereunder. Nor shall any payments be subject to attachment, garnishment, or execution, or be transferable by operation of law in the event of bankruptcy or insolvency, except to the extent otherwise provided by applicable law. 10. Termination or Amendment: This Plan may be terminated as to any Company at any time and amended from time to time by the Board of Directors of that Company; provided that neither termination nor amendment of the Plan may reduce or terminate any benefit to or in respect of a Participant eligible to receive benefits under Section 4A. Exhibit 10.5 AGREEMENT EXECUTIVE LIFE INSURANCE PROGRAM AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this day of , 19 , by and between Allegheny Power System, Inc., (hereinafter called "the Employer" in Part I or "Assignee" in Part II), and (hereinafter called "the Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; Whereas the Employer wishes to assist the Employee with his (or her) personal life insurance program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Assignee agreeing to pay all of the premiums, the Owner agrees to grant the Assignee a security for the recovery of the Assignee's premium outlay. NOW, THEREFORE for value received, the Employer and the Employee agree as follows: PART I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, The Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. issued by Security Life of Denver Insurance Company. Said policy is hereinafter called "the Policy" and said life insurance company is hereinafter called "the Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by the Employer provided for in Section B, above, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the Policy to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section F and there has been a default in Employee's obligation under Section G of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all such payments are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the Collateral Assignment provisions hereof. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy equal to one (1) times his base salary, excluding bonuses, until his retirement. At retirement, his death benefit shall increase to two (2) times salary for the next 12 months, then shall decrease by 20% of final salary each year until the earlier of the fifth anniversary of retirement or age 70, at which time it will be one (1) times salary. The Employee shall have the right to name the Policy beneficiary. However, in the event of the Employee's death, the Employer shall have an interest in the Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section above. E. Procedure at Employee's Death Upon the death of the Employee while the policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required by the Employee's beneficiary, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. F. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the Policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement; G. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph G. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made, from time to time, greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value under the policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such Transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. H. Employee's Right to Assign His/Her Interest The Employee shall have the right to transfer his/her entire interest in the Policy (other than rights assigned to the Employer pursuant to this Agreement and subject to the obligations of any outstanding Collateral Assignment). If the Employee makes such a transfer, all his/her rights shall be vested in the Transferee and the Employee shall have no further interest in the Policy and Agreement. Any assignee shall be subject to all obligations of the Employee under both Parts I and II of this Agreement. I. Insurer's Obligations The Insurer is not party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at its Home Office and in Section J of this Agreement. Except as set forth in Section J, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such Policy. Upon the death of the Insured and payment of the proceeds in accordance with Section J of this Agreement, the insurer shall be discharged of all liability. J. Claims Procedure The following claims procedure shall apply to the Policy and the Executive Life Insurance Program: 1. Filing of a claim for benefits. The Employee or the beneficiary of the Policy shall make a claim for the benefits provided under the Policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section J4, following shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The Insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of which such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections J5 and J6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter; a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than on hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section J. PART II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein in this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to collect and receive all distributions or share of surplus, dividend deposits or additions to he Policy now or hereafter made or apportioned thereto, and to exercise any and all options contained in the Policy with respect thereto; provided, that unless and until the Assignee shall notify the Insurer in writing to the contrary, the distributions or share of surplus, dividend deposits and additions shall continue on the Policy in force at the time of this assignment; and 5. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Agreement and Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made and the Policy is to be held as collateral security for any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured to or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not been executed: 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of Part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without reasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against him/her and that his/her property is not subject to any assignment for the benefit of creditors. PART III - Provisions Applicable to Parts I an II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This agreement shall be subject to, and construed according to, the laws of the State of . C. A Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Provision The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of this Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. Witness Employee Address Employer (Title) Exhibit 10.6 AGREEMENT SECURED BENEFIT PLAN AND COLLATERAL ASSIGNMENT THIS AGREEMENT is entered into this _____ day of __________, 1992 by and between Allegheny Power Service Corporation (hereinafter called the "Employer" in Part I or "Assignee" in Part II), and ___________________________ (hereinafter called the "Employee"). WHEREAS the Employee is currently a valued employee and Executive of Employer; WHEREAS the Employer wishes to assist the Employee with his (or her) personal future financial program and the Employee desires to accept such assistance; and WHEREAS in consideration of the Employer agreeing to pay all of the premiums, the Employee agrees to grant the Employer security for the recovery of the Employer's premium outlay and the excess, if any, over the amounts due the Employee under Part I of this Agreement. NOW, THEREFORE, for value received, the Employer and the Employee agree as follows: Part I - Individual Life Insurance Agreement A. Description of Policy - Policy Ownership In furtherance of the purposes of the Agreement, the Employee will purchase and own a certain policy of life insurance on his own life, being Policy No. _____, issued by Pacific Mutual Life Insurance Co. Said policy is hereinafter called the "Policy" and said life insurance company is hereinafter called the "Insurer". The Employee's ownership of the Policy shall be subject to all the terms and conditions set forth in this Agreement. B. Payment of Premiums The Employer shall pay the entire annual premium for the Policy directly to the Insurer. C. Collateral Assignment and Possession of Policy To secure repayment of premiums paid by and amounts due to the Employer provided for in Section B, above, and Sections D and E, below, Part II of this Agreement includes an assignment of the policy or the Employee's interest therein (hereinafter called "Collateral Assignment") and provides for the transfer of possession of the policy, and the right to receive from the carrier and possess billings and policy statements, to the Employer during the term specified in Part II of this Agreement. Except as provided in or as otherwise consistent with the provisions of this Agreement, the Employer covenants that it will not exercise its rights under the Collateral Assignment provisions of this Agreement in such a manner as to defeat the rights of the Employee or the policy beneficiary under this Agreement. Specifically, the Employer covenants that it will not surrender the Policy unless Part I of the Agreement has terminated as provided in Section G and there has been a default in Employee's obligation under Section H of this Part I. The Employer shall have possession of the Policy during the period that the Employer makes premium payments and until all amounts due the Employer are repaid. The Employer shall make the Policy available to the Insurer in order to make any change desired by the Employee as to the designation of beneficiary or the selection of a settlement option, subject, however, to the provisions of this Agreement and the Collateral Assignment. D. Beneficiary Designation and Payment of Policy Proceeds The Employee shall be entitled to a death benefit from the Policy in the amount required to provide an annuity equal to (under then current annuity settlement rates from the Insurer) the supplemental retirement benefit that would be provided under Sections 4A and 4B of the Allegheny Power System Supplemental Executive Retirement Plan effective July 1, 1990, attached hereto as Appendix I, excluding the provision in Section 4A that states, "...provided that, if a Participant is discharged from employment for cause or terminates employment with the Companies prior to retirement under the Allegheny Power System Retirement Plan for any reason whatsoever, other than death, such eligibility will terminate and no benefit shall be payable to such Participant from this Plan." The Employer shall be the sole beneficiary of the policy until such time as the Employee has at least 10 years of service and is at least 55 years old. After that time and while this Agreement is in force, the following shall occur: 1. the beneficiary of the Employee's death benefit shall be the employee's spouse; 2. in the event of the Employee's death, the Employer shall be entitled to Policy proceeds equal to the total Policy proceeds in excess of the amount due to the Employee pursuant to this Section, above; and 3. if the employee is not married, he/she is entitled to no death benefit while this agreement is in force. E. Policy Cash Values The Employee shall be entitled to cash values of the Policy in excess of the premiums paid by the Employer pursuant to Section B, Above, but not to exceed the death benefits to which he/she is entitled under Section D, above. If the Employee is not married, he/she shall be entitled to cash values determined as if he/she were married. The Employer shall be entitled to Policy cash values in excess of the amount due to the Employee under this Section, above. F. Procedure at Employee's Death Upon the death of the Employee while the Policy and this Agreement are in force and subject to the provisions of Parts I and II hereof, the Employer shall promptly take all necessary steps, including rendering of such assistance as may reasonably be required, to obtain payment from the Insurer of the amounts payable under the Policy to the respective parties, as provided under Section D, above. G. Termination of Agreement Part I of this Agreement shall terminate when the first of any of the following events occur: 1. Termination of the Employee's employment with the Employer prior to retirement; 2. The later of the Employee's actual retirement or ten years from the date of issuance of the policy; 3. Performance of the Agreement's terms following the death of the Employee; 4. Failure by the Employer, for any reason, to make the premium contributions required under Section B of this Agreement. H. Disposition of Policy Upon Termination of Agreement Upon the termination of Part I of this Agreement for any reason other than Section G3 above, the Employee shall have a thirty (30) day option to satisfy the Collateral Assignment regarding the policy held by the Employer in accordance with the terms of this Paragraph H. The amount necessary to satisfy such Collateral Assignment shall be an amount equal to the total premium payments made by the Employer, plus any excess amounts as determined in Section E, above, but no greater than the amount of cash value under the Policy and, at the option of the Employee, either shall be paid directly by the Employee or through the Employer's collection from the cash value of the Policy. If the Policy shall then be encumbered by assignment, policy loan, or other means which have been the result of the Employer's actions, the Employer shall either remove such encumbrance, or reduce the amount necessary to satisfy the Collateral Assignment by the total amount of indebtedness outstanding against the Policy. If the Employee exercises his option to satisfy the Collateral Assignment, the Employer shall execute all necessary documents required by the Insurer to remove and satisfy the Collateral Assignment outstanding on the Policy. If the Employee does not exercise his option to satisfy the Collateral Assignment outstanding on the Policy, the Employee shall execute all documents necessary to transfer ownership of the Policy to the Employer. Such transfer shall constitute satisfaction of any obligation the Employee has to the Employer with respect to this Agreement. The Employer shall then pay to the Employee the amount, if any, by which the cash surrender value of the Policy exceeds the amount necessary to satisfy the Collateral Assignment. I. Employee's Right to Assign His/Her Interest Employee agrees not to sell, assign, surrender or otherwise terminate the policy while this Agreement is in effect without the consent of the Employer. J. Insurer's Obligations The Insurer is not a party to this Agreement. It is understood by the parties hereto that in issuing such Policy of insurance, the Insurer shall have no liability except as set forth in the Policy and except as set forth in any assignment of the Policy filed at it Home Office and in Section K of this Agreement. Except as set forth in Section K, the Insurer shall not be bound to inquire into, or take notice of, any of the covenants herein contained as to the Policy of insurance or as to application of proceeds of such policy. Upon the death of the Insured and payment of the proceeds in accordance with Section K of this Agreement, the Insurer shall be discharged of all liability. K. Claims Procedure The following claims procedure shall apply to the Policy and the Secured Benefit Plan: 1. Filing of a claim for benefits. The Employee or the Beneficiary shall make a claim for the benefits provided under the policy in the manner provided in the Policy. 2. Claim denial. With respect to a claim for benefits under said Policy, the Insurer shall be the entity which reviews and makes decisions on claim denials according to the terms of the Policy. 3. Notification to claimant of decision. If a claim is wholly or partially denied, notice of the decision, meeting the requirements of Section K4, following, shall be furnished to the claimant within a reasonable period of time after a claim has been filed. 4. Content of notice. The insurer shall provide, to any claimant who is denied a claim for benefits, written notice setting forth in a manner calculated to be understood by the claimant, the following: a. The specific reason or reasons for the denial; b. Specific reference to pertinent Policy provisions or provisions of this Agreement on which the denial is based; c. A description of any additional material or information necessary for the claimant to perfect the claim and an explanation of why such material or information is necessary; and d. An explanation of this Agreement's claim review procedure, as set forth in Sections K5 and K6. 5. Review procedure. The purpose of the review procedure set forth in this subsection and subsection 6, following, is to provide a method by which a claimant under the Policy may have a reasonable opportunity to appeal a denial of claim for a full and fair review. To accomplish that purpose, the claimant or his/her duly authorized representative: a. May request a review upon written application to the Insurer; b. May review the Policy; and c. May submit issues and comments in writing. A claimant, (or his/her duly authorized representative), shall request a review by filing a written application of review at any time within sixty (60) days after receipt by the claimant of written notice of the denial of the claim. 6. Decision on review. A decision on review of a denial of a claim shall be made in the following matter: a. The decision on review shall be made by the Insurer which may, at its discretion, hold a hearing on the denied claim. The Insurer shall make its decision promptly, unless special circumstances (such as the need to hold a hearing) require an extension of time for processing, in which case a decision shall be rendered as soon as possible, but not later than one hundred twenty (120) days after receipt of the request for review. b. The decision on review shall be in writing and shall include specific reasons for the decision, written in a manner calculated to be understood by the claimant, and specific references to the pertinent Policy provision or provision of this Agreement on which the decision is based. Notwithstanding any provision of the Agreement or the Policy, no Employee, assignee or beneficiary may commence any action in any court regarding the Policy prior to pursuing all rights of an Employee under this Section K. END OF PART I Part II - Assignment of Life Insurance Policy as Collateral A. For value received and in specific consideration of the premium payments made by the Employer as set forth in Section B of Part I hereof, the Employee hereby assigns, transfers and sets over to the Employer (herein this Part II called the "Assignee"), its successors and assigns, the Policy issued by the Insurer upon the life of Employee and all claims, options, privileges, rights, titles and interest therein and thereunder (except as provided in Paragraph C hereof), subject to all terms and conditions of the Policy and to all superior liens, if any, which the Insurer may have against the Policy. The Employee by this instrument agrees and the Assignee by the acceptance of this Assignment agrees to the conditions and provisions herein set forth. B. It is expressly agreed that, without detracting from the generality of the foregoing, the following specific rights are included in this Agreement and Collateral Assignment and inure to the Assignee by virtue hereof: 1. The sole right to collect from the Insurer the net proceeds of the Policy in excess of the proceeds due the Employee under Part I, Section D, when it becomes a claim by death or maturity; 2. The sole right to surrender the Policy and receive the surrender value thereof at any time provided by the terms of the Policy and at such other times as the Insurer may allow; 3. The sole right to obtain one or more loans or advances on the policy, either from the Insurer or, at any time, from other persons, and to pledge or assign the Policy as security for such loans or advances; 4. The sole right to exercise all nonforfeiture rights permitted by the terms of the Policy or allowed by the Insurer and to receive all benefits and advantages derived therefrom; 5. The sole right to direct investment of cash values as provided under the insurance contract, and to make changes and transfers in such fund allocations. C. It is expressly agreed that the following specific rights, so long as the Policy has not been surrendered, are reserved and excluded from this Collateral Assignment and do not pass by virtue hereof: 1. The right to designate and change the beneficiary; 2. The right to elect any optional mode of settlement permitted by the Policy or allowed by the Insurer; provided, however, that the reservation of these rights shall in no way impair the right of the Assignee to surrender the Policy completely with all its incidents or impair any other right of the Assignee hereunder, and any designation or change of beneficiary or election of a mode of settlement shall be made subject to this Agreement and Collateral Assignment and to the rights of the Assignee hereunder. D. This Collateral Assignment is made, and the Policy is to be held as collateral security for, any and all liabilities of the Employee to the Assignee arising under this Agreement (all of which liabilities secured or to become secured are herein called "Liabilities"). It is expressly agreed that all sums received by the Assignee hereunder either in the event of death of the Insured, the maturity or surrender of the Policy, the obtaining of a loan or advance on the Policy, or otherwise, shall first be applied to the payment of the liability for premiums paid by the Assignee on the Policy and other amounts due to Assignee under Part I of this Agreement. E. The Assignee covenants and agrees with the Employee as follows: 1. That any balance of sums, if any, received hereunder from the Insurer remaining after payment of the existing Liabilities, matured or unmatured, shall be paid by the Assignee to the persons entitled thereto under the terms of the policy had this Collateral Assignment not be executed; 2. That the Assignee will not exercise either the right to surrender the Policy or the right to obtain policy loans from the Insurer, until there has been either default in any of the Liabilities pursuant to this Agreement or termination of part I of said Agreement as therein provided; and 3. That the Assignee will, upon request, forward without unreasonable delay to the Insurer the Policy for endorsement of any designation or change of beneficiary or any election of an optional mode of settlement. F. The Employee declares that no proceedings in bankruptcy are pending against, him/her and that his/her property is not subject to any assignment for the benefit of creditors. Part III - Provisions Applicable to Parts I and II A. Amendments Amendments may be added to this Agreement by a written agreement signed by each of the parties and attached hereto. B. Choice of Law This Agreement shall be subject to, and construed according to, the laws of the State of Maryland. C. Binding Agreement This Agreement shall bind the Employer and the Employer's successors and assigns, the Employee and his/her heirs, executors, administrators, and assigns, and any Policy beneficiary. D. Validity of Provisions The Employer and the Employee agree that if any provision of this Agreement is determined to be invalid or unenforceable, in whole or part, then all remaining provisions of the Agreement and, to the extent valid or enforceable, the provision in question shall remain valid, binding and fully enforceable as if the invalid or unenforceable provisions, to the extent necessary, was not a part of this Agreement. IN WITNESS WHEREOF, parties hereto have executed this Agreement, including the provisions regarding Collateral Assignment, on the day and year first above written. ________________________ __________________________ Witness Employee ____________________________ _____________________________ Address Allegheny Power Service Corporation By: ____________________________ Richard J. Gagliardi Vice President E-2 Monongahela Power Company Incorporation Documents by Reference 3.1 Charter of the Company, as amended Form S-3, 33-51301, exh. 4(a) 3.2 Code of Regulations, Form 10-Q of the Company as amended (1-268-2), September 1993, exh. (a)(3) 4 Indenture, dated as S 2-5819, exh. 7(f) of August 1, 1945, S 2-8782, exh. 7(f) (1) and certain S 2-8881, exh. 7(b) Supplemental S 2-9355, exh.4(h) (1) Indentures of the S 2-9979, exh. 4(h)(1) Company defining S 2-10548, exh. 4(b) rights of security S 2-14763, exh. 2(b) (i) holders.* S 2-24404, exh. 2(c); S 2-26806, exh. 4(d); Forms 8-K of the Company (1-268-2) dated August 8, 1989, November 21, 1991, June 4, 1992, July 15, 1992, September 1, 1992 and April 29, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: Monongahela Power Company has a 27% equity ownership in Allegheny Generating Company, incorporated in Virginia; and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent Accountants See page 61 herein. 24 Powers of Attorney See pages 62-67 herein. E-3 The Potomac Edison Company Incorporation Documents by Reference 3.1 Charter of the Company, Form 10-Q of the Company as amended (1-3376-2), September 1993, exh. (a)3 3.2 By-laws of the Company, Form 10-Q of the Company as amended (1-3376-2), June 1990, exh. (a)3 4 Indenture, dated as of S 2-5473, exh. 7(b); Form October 1, 1944, and S-3, 33-51305, exh. 4(d) certain Supplemental Forms 8-K of the Company (1- Indentures of the 33-76-2) dated June 14, 1989, Company defining rights June 25, 1990, August 21, Company defining rights 1991, December 11, 1991, of security holders* December 15, 1992, February 17, 1993 and March 30, 1993 * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: The Potomac Edison Company has a 28% equity ownership in Allegheny Generating Company, incorporated in Virginia and a 25% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-4 West Penn Power Company Incorporation Documents by Reference 3.1 Charter of the Company, Form S-3, 33-51303, exh. 4(a) as amended 3.2 By-laws of the Company, Form 8-K of the Company as amended (1-255-2), dated June 9, 1993, exh. (a)(3) 4 Indenture, dated as of S-3, 33-51303, exh. 4(d) March 1, 1916, and certain S 2-1835, exh. B(1), B(6) Supplemental Indentures of S 2-4099, exh. B(6), B(7) the Company defining rights S 2-4322, exh. B(5) of security holders.* S 2-5362, exh. B(2), B(5) S 2-7422, exh. 7(c), 7(i) S 2-7840, exh. 7(d), 7(k) S 2-8782, exh. 7(e) (1) S 2-9477, exh. 4(c), 4(d) S 2-10802, exh. 4(b), 4(c) S 2-13400, exh. 2(c), 2(d) Form 10-Q of the Company (1-255-2), June 1980, exh. D Forms 8-K of the Company (1-255-2) dated June 1989, February 1991, December 1991, August 13, 1993, September 15, 1992, June 9, 1993 and June * There are omitted the Supplemental Indentures which do no more than subject property to the lien of the above Indentures since they are not considered constituent instruments defining the rights of the holders of the securities. The Company agrees to furnish the Commission on its request with copies of such Supplemental Indentures. 12 Computation of ratio of earnings to fixed charges 21 Subsidiaries: West Penn Power Company has a 45% equity ownership in Allegheny Generating Company, incorporated in Virginia; a 50% equity ownership in Allegheny Pittsburgh Coal Company, incorporated in Pennsylvania; and a 100% equity ownership in West Virginia Power and Transmission Company, incorporated in West Virginia, which owns a 100% equity ownership in West Penn West Virginia Water Power Company, incorporated in Pennsylvania. 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. E-5 Allegheny Generating Company Documents 3.1(a) Charter of the Company, as amended* 3.1(b) Certificate of Amendment to Charter, effective July 14, 1989.** 3.2 By-laws of the Company, as amended* 4 Indenture, dated as of December 1, 1986, and Supplemental Indenture, dated as of December 15, 1988, of the Company defining rights of security holders.*** 10.1 APS Power Agreement-Bath County Pumped Storage Project, as amended, dated as of August 14, 1981, among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Allegheny Generating Company.* 10.2 Operating Agreement, dated as of June 17, 1981, among Virginia Electric and Power Company, Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.3 Equity Agreement, dated June 17, 1981, between and among Allegheny Generating Company, Monongahela Power Company, West Penn Power Company and The Potomac Edison Company.* 10.4 United States of America Before The Federal Energy Regulatory Commission, Allegheny Generating Company, Docket No. ER84-504-000, Settlement Agreement effective October 1, 1985.* 12 Computation of ratio of earnings to fixed charges 23 Consent of Independent See page 61 herein. Accountants 24 Powers of Attorney See pages 62-67 herein. * Incorporated by reference to the designated exhibit to AGC's registration statement on Form 10, File No. 0-14688. ** Incorporated by reference to Form 10-Q of the Company (0-14688) for June 1989, exh. (a). *** Incorporated by reference to Forms 8-K of the Company (0-14688) for December 1986, exh. 4(A), and December 1988, exh. 4.1.

314485_1993.txt

314485_1993

1993

314485

ITEM 1. BUSINESS (A) GENERAL Commonwealth Equity Trust ("Trust") was formed as a real estate investment trust ("REIT") on July 31, 1973 for the primary purpose of acquiring, owning and financing real property and mortgage investments. The Trust provides investors with the opportunity to own, through transferable shares, an interest in diversified real estate investments. The Trust invested primarily in income-producing real property (as opposed to property investments acquired primarily for possible capital gain) and in loans secured by mortgages on real property in accordance with investment objectives and policies. Most of the investments in mortgage loans were in connection with the disposition of The Trust's real properties. In addition, the Trust also acquired unimproved real property with little current income for the propose of constructing buildings or other improvements thereon or for capital appreciation. Through these investments, The Trust has provided investors with the opportunity to participate in a portfolio of professionally managed real estate assets in much the same way that a mutual fund affords investors an opportunity to invest in a professionally managed portfolio of stocks, bonds and other securities. A REIT is not, however, a mutual fund, and is not subject to the same regulations as a mutual fund. In 1977, the Trust elected to be and was taxed as a REIT through the year ended September 30, 1992. Under the Internal Revenue Code, a qualified REIT is relieved, in part, of federal income taxes on ordinary income and capital gains distributed to shareholders. State tax benefits may also accrue to a qualified REIT. The Trust maintained a general policy of distributing cash to its shareholders that approximated taxable income plus noncash charges such as depreciated and amortization. As a result, distributions to shareholders often exceeded cumulative net income. During the year ended September 30, 1993, the Trust did not qualify to be taxed as a REIT. The termination of its REIT status will be effective as of the beginning of that fiscal year. Furthermore, the circumstances of that termination were such that it is unlikely that the Trust will be eligible to re-elect to be taxed as a REIT prior to its taxable year ending September 30, 1998. July 21, 1994 The Trust operates pursuant to a Declaration of Trust which sets forth the powers of the Board of Trustees with regard to management and investment activities of the Trust. The Declaration of Trust gives the Board of Trustees the power to borrow money on the Trust's behalf; to make loans to other persons; to invest in the securities of other issuers under certain circumstances; to make investments in property; to purchase outstanding shares of the Trust for such consideration as they deem advisable; to issue an annual report to shareholders; to issue debt securities; to allocate investments between direct and indirect ownership; and to exercise other powers in connection with the Trust's operation. Pursuant to the Declaration of Trust, the Trustees make decisions regarding the Trust's investment and sales activities without the prior approval of shareholders. CURRENT DEVELOPMENTS CHAPTER 11 PROCEEDINGS. On August 2, 1993, the Trust filed a petition for reorganization under Chapter 11 of the United States Bankruptcy Code. The bankruptcy case is currently pending in the United States Bankruptcy Court for the Eastern District of California, Sacramento Division and is entitled In re Commonwealth Equity Trust Case No. 93-26727-C-11. The proximate cause of the Trust's filing a petition for reorganization was its falling out of compliance with a restructuring agreement entered into on July 17, 1992 with a lender group for which Pacific Mutual Life Insurance Company ("Pacific Mutual Lenders") acted as agent. The Trust was unable to meet payment dates on the Pacific Mutual Lenders' restructured debt. The Pacific Mutual Lenders noticed the Trust's default, but attempted to negotiate a further restructuring and resolve claims by the Trust against the Pacific Mutual Lenders. Finally, on August 2, 1993, the Trust filed its petition for reorganization under Chapter 11 of the U. S. Bankruptcy Code. In September 1993 the United States Trustee ("UST") appointed an Official Committee of Holders of Equity Interests ("Equity Holders Committee") and an Official Committee of Creditors Holding Unsecured Claims ("Creditors Committee"). Both the Equity Holders Committee and the Creditors Committee have undertaken significant involvement in many aspects of the Chapter 11 case, including evaluation of the Trust's business operations and of reorganization alternatives. On March 30, 1994, the Trust filed with the Court a Plan of Reorganization and Disclosure Statement. Thereafter, there were a number of further discussions and negotiations between the Trust and the Pacific Mutual Lenders regarding settlement. On May 13, 1994, the Trust, together with the Equity Holders' Committee and the Pacific Mutual Lenders (collectively, together with the Trust, the "Plan Proponents") filed with the Court a First Amended Plan of Reorganization and a Disclosure Statement with respect thereto. July 21, 1994 On June 3, 1994, the Plan Proponents filed with the Court a Second Amended Plan of Reorganization and a Disclosure Statement with respect thereto. On June 9, 1994, the Plan Proponents and the Creditors Committee as an additional proponent filed with the Court a Third Amended Plan and related Disclosure Statement. The Third Amended Plan provided for, inter alia: (a) the restructuring of virtually all of the Trust's secured and unsecured debt; (b) the reduction in the number of Common Shares held by current shareholders from approximately 25,100,000 shares to approximately 2,450,000 shares (effectively, a reverse stock split); and the issuance of approximately 2,550,000 new Common Shares, as well as a new class of Preferred Shares, of the Trust to the Pacific Mutual Lenders. After the restructuring, the Pacific Mutual Lenders will own a majority of the new Common Shares. The Disclosure Statement was approved by the Court after a hearing on June 8 and 9, 1994. The Disclosure Statement was mailed to the Trust's creditors and equity security holders on or about June 21, 1994, with ballots to be returned by July 18, 1994. A hearing to confirm the Plan is tentatively scheduled from July 27 through August 8, 1994. EFFECT OF ECONOMIC DOWNTURN ON DISPOSITIONS. Overall recessionary factors and depressed conditions in the real estate industry, which result in part from the contraction of available financing to the commercial real estate industry, have restricted the Trust's ability to generate liquidity through the sale of its properties because potential buyers have been unable to obtain the necessary financing to consummate transactions. VALUATION LOSSES. The Trust recorded $53,089,000 in 1993 as an allowance for possible investment losses. The valuation loss provision was recorded based on appraisals and management's estimate of net realizable values of certain real properties owned by the Trust, notes receivable secured by real properties and Partnership interests, and after consideration of various market factors adversely affecting real estate at the present time, particularly the lack of credit available to purchasers of commercial real estate and overbuilt commercial real estate markets. Gain or loss will be recorded in the future to the extent that amounts realized from sale of these properties differ from the appraised or estimated net realizable values. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Since its inception in 1973, the Trust has sought to acquire a diversified portfolio of income producing real property and mortgage investments (as opposed to investment acquired primarily for possible capital gain), primarily in California. The Trust does not intend to actively invest additional significant amounts at the present time. It is anticipated that the terms of the new notes to be issued to the Pacific Mutual Lenders will severely limit the Trust's ability to make acquisitions. However, the Trust will continue to make investment to the extent necessary to preserve or to develop existing assets, including acquisitions and dispositions to provide additional diversity, flexibility and liquidity to the portfolio. To the extent that the Trust continues to invest, the Declaration of Trust grants broad discretion to the Trustees to allocate the Trust's assets without prior approval of shareholders between real property (both improved and unimproved) and mortgage loans and between direct and indirect ownership interest. July 21, 1994 During the last three fiscal years, the following sources have contributed to the Trust's total income: The Declaration of Trust permits the Trust to leverage its investments, that is, the Trust may finance or refinance its properties by borrowings. The level of leverage of the Trust at September 30, 1993, which level will likely change as a result of the Chapter 11 Case, is 1 to 1. The Trust generally has made significant cash investments in any properties it acquires. Historically, the Trust has invested primarily in properties which show income in excess of expenses. During the last several years, the ability of the Trust's properties to produce positive cash flow has been negatively impacted by the current economic downturn. The real estate market is highly competitive. Although the Trust is not currently competing for investment opportunities, the pool of available financing for real estate investments has diminished and the Trust competes for such financing with an indeterminate number of individuals, both foreign and domestic, including other REITs, life insurance companies, pension funds, trust funds and private sources of investment capital. (C) SELECTION, MANAGEMENT AND CUSTODY OF THE TRUST'S INVESTMENTS. The Declaration of Trust authorized the Trustees to seek advice from time to time on the values and suitability of prospective investments and dispositions. The Trust's management at the time of its bankruptcy filing was subject to considerable controversy and dispute. The Trust filed an application (the "B&B Employment Application") seeking authority to employ its prepetition advisor and property manager, B&B I and B&B II, respectively. The UST and the Pacific Mutual Lenders, among others, raised numerous questions regarding the employment and compensation of B&B I and B&B II in the Chapter 11 Case, which objections were scheduled for a hearing and cross-examination testimony. Following numerous and lengthy discussions with the UST, in particular, as well as other parties, regarding the Trust's post-petition operations and management, the Trust withdrew the B&B Employment Application. For two decades the Trust had no employees and managed and operated its properties through outside entities. Pursuant to a consensual agreement with the UST, the Trust won court approval of and implemented a sweeping change in its management structure. In October 1993, the Trust changed to a self-administration management structure. This involved: July 21, 1994 1. Hiring a number of employees of B&B I and B&B II who were knowledgeable regarding the Trust's properties, operations and financial affairs; 2. Expanding the duties of Doris Alexis, chairperson of the Trust's Board of Trustees, including significantly enlarging her day to day responsibilities and involvement; 3. Other management and administration changes, including changes in responsibilities; physical relocation of personnel, records and equipment; activation of new telephone numbers; computer system realignments; and construction of walls physically segregating remaining B&B I and B&B II personnel pending the relocation of B&B I and B&B II; 4. Engaging in arranging and negotiating the relicensing of the Trust's hotel operations and the proposed terms of continued affiliation with national hotel franchisors who had previously dealt directly with B&B I and B&B II and related outside management companies; and 5. Formulating and implementing plans for realignment of the Trust's property lease-up and property management functions, including parameters for use of in-house brokers and outside tenant brokers. NEW CEO. An additional change in the Trust management was implemented in March, 1994, when the Trust hired Frank A. Morrow, through his corporation FAMA Management, Inc. as chief executive officer pending Bankruptcy Court approval of a services and confidentiality agreement, which agreement was approved by the Court following a hearing held on March 31, 1994. Mr. Morrow was not previously affiliated with the Trust, but has a range of real estate and management experience, having served as Director of Real Estate for Stanford University, Senior Vice President/Regional Manager of Bedford Properties, Senior Vice President of Boise Cascade Urban Development Corporation and Assistant to the Chairman for Hawaiian Airlines, among other experience. As CEO, he will exercise "hands-on" oversight of business operations and advise the Board of Trustees. The term of the agreement is from March 8, 1994 through September 30, 1994, subject to the Trust's right to terminate upon thirty (30) days advance notice. NEW PROPERTY MANAGEMENT COMPANY. The Trust has searched for and obtained the services of a property management company to assist in the management of the Trust's commercial real estate portfolio. On June 15, 1994 the court approved the contract for services with United Property Services. (D) OTHER INFORMATION During its last three fiscal years, the Trust has been involved in only one industry segment: the acquisition, operation and holding for investment of income producing real properties, the making of loans secured by real property and improvements in connection with those activities. Revenues, net income and assets concerning this industry segment are set forth in the Trust's financial statements. July 21, 1994 The rules and regulations adopted by various agencies of federal, state or local government relating to environmental controls in the development and operation of real property may operate to reduce the number of available investment opportunities or may adversely affect existing properties. While the Trust does not believe that environmental controls have had a material impact on its activities to date, there can be no assurance that the Trust will not be adversely affected in the future. The Trust does not engage in research and development activities nor is it involved in any foreign operations. The Trust does not derive income from foreign sources. ITEM 2: ITEM 2: PROPERTIES The following table sets forth certain information relating to properties owned by the Trust at September 30, 1993. All of the properties are suitable for the purpose for which they are designed and are being used. ITEM 2: PROPERTIES (continued) (1) Total cost before any reduction for valuation allowance related to investments and accumulated depreciation. (2) All of the above properties are pledged as collateral, subject to existing liens, for the restructured debt. July 21, 1994 ITEM 3. ITEM 3. LEGAL PROCEEDINGS At the time its Chapter 11 petition was filed in August 1993, the Trust was party to a number of lawsuits. Most involved ordinary disputes common to the real property management business, and amounts immaterial to the Trust's overall financial condition. In addition, the Trust was party to the lawsuits described below. SHAREHOLDER B&B LITIGATION. In December, 1991, the Trust received notice of a pending action (the "Luebkeman Litigation") filed by a shareholder in the Superior Court of the State of California, County of Sacramento ("Sacramento Superior Court") and seeking to maintain (a) a class action on behalf of all shareholders, and (b) a derivative action on the Trust's behalf. The action named as defendants B&B II, the individual Trustees of the Trust, and Merrill Lynch Business, Brokerage and Valuation, Inc. The Trust was named as a nominal defendant. The action sought, among other things, a declaration that the Trust's management agreement with B&B II was invalid; imposition of a constructive trust on and recovery of $7,195,000 received by B&B II in December, 1989, in connection with the Second Amendment to the B&B Management Agreement; attorneys' fees, costs of suit; and other damages according to proof. The Trust appointed a committee of independent Trustees who are not defendants to engage counsel to represent the Trust's interests in the action. On April 30, 1992, the Sacramento Superior Court sustained the defendants' demurrer to the class action causes of action, but authorized the plaintiffs to proceed with the case as a derivative action. The Sacramento Superior Court also ruled that, in light of the terms of the Declaration of Trust, the Trustees would no be held liable to the Trust based upon simple negligence. On July 16, 1992, the Sacramento Superior Court sustained the defendants' demurrer to the derivative action, with leave to amend. This ruling was based on the plaintiffs' failure to make demand on the Trustees to take the action requested in the complaint or to allege with sufficient particularity the reasons why such a demand would be futile. The Sacramento Superior Court also stayed the action for all other purposes for 60 days, except to allow plaintiffs to amend their complaint. On March 30, 1993, the plaintiffs filed and served a second amended complaint, which names as additional defendants Joyce Berger and the law firm of Nossaman, Guthner, Knox and Elliott. Upon dissolution of the stay, the parties actively engaged in settlement negotiations. Prior to bankruptcy, settlement negotiations were progressing toward a payment to the Trust of over $1 million. Since the bankruptcy and the involvement of creditor constituencies, the parties have sought to broaden negotiations to encompass a global settlement of disputes involving the B&B entities. If Lubekeman is not settled, the current plaintiffs' counsel will continue prosecution of the action on a contingency fee basis. Due to settlement negotiations, there has been little discovery and, therefore, the likelihood of success on the merits is uncertain. July 21, 1994 FORMER SHAREHOLDER LITIGATION. On April 27, 1993, the Trust received notice that it had been named as a defendant in a complaint filed in the United States District Court for the Eastern District of California (the "Aizuss Action"). The complaint was filed by about 130 former Commonwealth Equity Trust shareholders and named defendants the Trust, current and former Trustees, B&B II and its shareholders, and various current and former professional advisors and consultants to the Trust. The plaintiffs allege breach of fiduciary duty, violation of federal and state securities laws, violation of civil RICO, fraud, negligent misrepresentation, negligence and civil conspiracy. The non-Debtor defendants to this litigation filed a motion to dismiss the plaintiffs' complaint and a request for sanctions. The district court granted the motion, and assessed sanctions against the plaintiffs' attorneys. Subsequently, pursuant to a stipulation by and between the Trust and the plaintiffs, the action was dismissed without prejudice as to the Trust. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No annual meeting of the Trust's shareholders was held during 1993. No matters were put to a vote of the shareholders. July 21, 1994 PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS The Trust has one class of authorized and outstanding equity consisting of common shares of beneficial interest, par value $1.00 per share. Historical Pricing of and Market for Shares From its inception through April 4, 1982, the Trust sold its shares at $10 per share regardless of the value of its investment portfolio. The equity interests in real estate owned by the Trust are carried on its financial statements at the lower of (a) cost less accumulated depreciation, or (b) net realizable value, rather than at current fair market values. Accordingly, any increase or decrease in portfolio value is reflected in the Trust's financial statements only upon the sale of a property or upon a determination by the Trust that the value of a property has been impaired by economic circumstances. Historically, the Trustees from time to time adjusted the offering price of the Trust's shares to reflect appreciation of the Trust's portfolio. The first such adjustment was made on April 4, 1982, when the price per share was raised to $11.50. On June 9, 1983, the Trustees revalued the Trust portfolio, raising the price per share to $12.00. There is no established market for the Trust's Shares. From July 1973 until July 5, 1989, the Trust engaged in a continuous intrastate offering of its securities pursuant to permits issued by the California Commissioner of Corporations. In May 1989, the Trust advised its shareholders that (a) the offering would terminate as of July 5, 1989 and (b) shareholders desiring to purchase or sell shares pursuant to the "crossing" arrangement described below would have to submit their purchase orders or shares prior to that date. Although the shares of the Trust are not traded on any exchange or on the NASDAQ System, several registered broker-dealers from time to time have matched orders to purchase and sell outstanding shares. Status of Liquidation The Trust terminated the continuous offering and the crossing arrangement effective July 5, 1989. The Trust determined that it would arrange for the purchase at $10.80 per share ($12 per share less commissions) of all shares properly submitted to the designated crossing agent prior to the termination date. To the extent that account "liquidation" requests could not be matched with new purchase orders, the Board of Trustees authorized redemption of the shares by the Trust using proceeds from the sale of shares from January 1, 1989 to the termination date to fund the redemption. At June 30, 1994, 29,691 shares, had been tendered and not redeemed. Holders of these shares will receive the same treatment as all other shareholders under the Amended Plan of Reorganization. July 21, 1994 Distributions Until recent years, it was the Trust's policy to declare quarterly distributions and to declare special distributions from time to time, usually to distribute gains realized on the sale or refinancing of Trust property. Because of the financial difficulties, the Trust made only one distribution during fiscal 1991 ($.20 per share on October 3, 1990) and no distributions during 1992 or 1993. It is not anticipated that any distributions will be made in the foreseable future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." At June 30, 1994, there were 28,832 shareholders of record of the Trust. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (1) Included net (losses) gains from sales of rental properties, note receivable and partnership interests of $($7,130), $539, $203, $616, and $5,692 for the years 1993, 1992, 1991, 1990 and 1989, respectively. (2) Includes valuation losses of $53,089, $48,130, $28,298, $7,408 and $1,840 for 1993, 1992, 1991, 1990 and 1989, respectively. See note 7 of the Notes to Consolidated Financial Statements for further discussion. (3) Includes $29,000 of short-term notes payable to bank in 1991 which had been renegotiated in 1992 as secured long-term debt. July 21, 1994 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAPITAL RESOURCES AND LIQUIDITY. The Trust anticipates that its principal source of funds during 1994 will be operating income. Because the Trust will be under the protection of Chapter 11 during the year, the payment of certain liabilities has been stayed. It is a condition to confirmation of the Amended Plan, that the Trust obtain a working capital loan of approximately ten million dollars to meet capital needs in excess of available income. However, capital resources and the amount and timing of Trust liabilities cannot be finally determined until the status of the Amended Plan is finally determined. RESULTS OF OPERATIONS 1993 vs. 1992 Results of operations for 1993 were affected principally by the continuing downturn in the general economy, as reflected in the commercial real estate market, through California and Arizona and especially in Southern California. Approximately 74% of the year's net loss was effected by the total valuation loss of $53,089,000, as applied to the Trust's real properties, notes receivable and partnership interests. The provision for valuation loss reflects recent independent appraisals and managements's estimates of net realizable value on the Trust's real properties, notes receivable secured by real properties and partnership interests compared with book value. Factors considered include increased capitalization rates, decreased rental rates and decreased occupancy rates for many of the Trust's properties. The largest valuation losses recorded against real properties aggregated $25,183,000 on the following properties: Redding Park Holiday Inn (Redding, CA), Pacific Palisades Office Building (Pacific Palisades, CA), Sacramento Holiday Inn (Sacramento, CA), Chico Holiday Inn (Chico, CA), Town Center Garden Office Park (Long Beach, CA) Trade Center A (Rancho Cordova, CA), Florin Perkins land (Sacramento, CA), Parthenia land (Northridge, CA) and Casa Grande Motor Inn (Arroyo Grande, CA). The largest valuation loss recorded against notes receivable collateralized by real properties was $2,400,000 on a note secured by Southcoast Commerce (Fountain Valley, CA). Total valuation losses of $12,472,000 were recorded against the Trust's partnership interest in CR Properties and Placer Ranch Partners. CR Properties, which interest has been written down to zero, is a limited partner in Sacramento Renaissance, a limited partnership, which owns the Renaissance Tower office building (Sacramento, CA). The independent appraisal has determined that the value of the property does not exceed the related debts. Placer Ranch Partners' indirectly owned land has been written down to its value as agricultural land, as development of the property is not ascertained at this point. Gain or loss will be recorded in the future to the extent that amounts July 21, 1994 realized from the sale of these assets differ from the appraised or estimated net realizable values. In the event economic conditions for real estate continue to decline, additional valuation losses will be recognized. Losses and gains are realized only on the sale of the underlying assets. From August 2, 1993 through September 30, 1993, the Trust operated as debtor-in-possession and incurred net reorganization expenses of $679,000. For the year total revenues (excluding reorganized revenue items, which equaled $27,000 or 0.1% of prior year's revenue) decreased by 14.9%. Rental revenues declined by $2,862,000 (10.4%), and interest income declined by $1,809,000 (46.7%). Total expenses (excluding reorganization expense items, which equaled $706,000 or 1.6% of prior year's expenses) decreased by $3,772,000 (8.7%) from 1992 to 1993. Loss on foreclosure or sale of investments totaled $7,130,000 and reflects net loss derived from the sale of Pavilions, 20 Bicentennial Drive, Denny's, Florin/Perkins, Dunlap, Northern, Park West, Sizzler, West Southern, Corona and six notes receivable and the foreclosure of Howe Avenue & Cottage Way, Arbor Plaza, Huntington and Hookston Square. 1992 vs. 1991 Results of operations for 1992 were affected principally by the continuing downturn in the general economy, as reflected in the commercial real estate market, throughout California and Arizona and especially in Southern California. Although the net loss during the year was attributable in part to decreased revenues, as discussed below, the bulk of the net loss results from $48,130,000 in valuation losses relating to the Trust's real properties, notes receivable and partnership interests. The provision for valuation loss reflects recent independent appraisals and management's estimates of net realizable value on the Trust's real properties, notes receivable secured by real properties and partnership interests compared with book value. Factors considered include increased capitalization rates, decreased rental rates and decreased occupancy rates for many of the Trust's real properties. The most extreme valuation reserves were recorded against real properties and notes receivable collateralized by real properties located in Southern California and Arizona including Town Center, Villa Del Sol, Imperial Canyon and Southcoast Commerce Center, which together accounted for $14,138,000 of total valuation writedowns. Properties located in Sacramento were not immune from the continuing impact of the economy on commercial real estate. A provision from valuation loss of $4,957,000 was made against the Trust's investment in CR Properties (formerly CET/RJB), a limited partner in Sacramento Renaissance, owner of the Renaissance Towers property, reflecting substantial loans for tenant improvements and other leasing and marketing expenses made to Sacramento Renaissance by its general partner which must be repaid before returns are paid to the Trust. A valuation allowance of $1,910,000 was recorded as to the Florin Perkins lots reflecting the decrease in the value of raw land and reduced prospects for development over the medium term. Writedowns on thirteen additional properties located in the Sacramento area accounted for $7,592,000 of the allowance. July 21, 1994 In addition to valuation reserves, total revenues decreased $3,242,000 (9.4%) in 1992 as compared with 1991. While aggregate interest income remained relatively unchanged, rental revenues decreased $3,329,000 (10.8%) reflecting sale of four properties during 1992 and disposition of an additional property by voluntary foreclosure. In addition, the Trust experienced a substantial decrease in aggregate rental revenue of $708,000 at Imperial Canyon, Arbor Plaza and 515 S. Fair Oaks Avenue, all properties located in Southern California as a result of greater vacancy and lower lease renewal rates. The Trust's rental income relating to its hotel properties also reflected a $1,200,000 decrease as a result of partial closures and reduced occupancy during renovations required by the franchisor. Notwithstanding the foregoing, several Trust properties showed increased revenues during 1992 including Totem Square, with increased revenues of $300,000 and higher occupancy rates, the Fulton Square, a property acquired in 1991 which accounted for $375,000 in increased rental income. Total expenses increased by $828,000 (2%) from 1991 to 1992. While property management and depreciation and amortization expense decreased by $179,000 (10.4%) and $1,527,000 (15.2%), respectively, reflecting property dispositions during the year, general and administrative expenses showed an increase of $2,817,000 (90.4%). The increase resulted principally from (i) $1,000,000 in professional services (including lender legal fees, appraisal costs and accounting fees) related to restructuring of the Trust's debt with its Senior Lenders and (ii) $1,100,000 in legal fees and costs arising from the shareholder litigation described in Item 3 of this report and in fees incurred by the Trust in the restructuring of debt with the Senior Lenders. The increase in general and administrative expense also reflects fees for consultants to the Independent Trustees. Net gain on sale of rental properties totalling $539,000 reflects net gain derived from the sale of F Street Professional Building, 190 Otis, 1227 Chester Avenue and Fountain View Office Plaza. 1991 vs. 1990 Results of operations in 1991 showed the impact of overall recessionary factors and highly competitive market conditions in many real estate markets. Rental revenue decreased $1,777,000 (5.5%) in 1991 as compared with 1990. Two-thirds of the decrease is attributable to property sales in 1990 and 1991. In addition, properties held by the Trust during both 1991 and 1990 generally showed lower revenues in 1991, accounting for one-third of the total decrease in rental revenues. Lower average note receivable balances in 1991 led to a decrease of $1,999,000 (34.6%) in interest revenue from the 1990 level. The lower balances were a result of collections, sale of participation interests and conversion of a note into a partnership interest. Overall, revenues decreased $3,776,000 (9.8%) in 1991 as compared with 1990. Expenses increased 1.6% in 1991 as compared with 1990. Decreases in property management and general and administrative expenses of $312,000 (15.4%) and $788,000 (20.2%), respectively, resulting from property sales were offset by increases in depreciation and amortization of $958,000 (10.5%) and in interest expense of $788,000 (4.7%). The increased depreciation and amortization reflects amortization for a full twelve month period in 1991 (as compared with a partial year in 1990) of the $7,195,000 paid to the Adviser in connection with the Second Amendment to Management Agreement, as discussed above. Increased interest expense reflects higher average note payable balances outstanding in 1991 as compared with 1990. July 21, 1994 Shareholder's equity was $138,559,000 at September 30, 1991 compared with $180,946,000 at September 30, 1990. The decrease from 1990 to 1991 was the result of the net loss incurred in 1991, the October 1990 distribution to shareholders and the Trust's repurchase in 1991 of shares submitted for redemption prior to termination of the Trust's offering on July 5, 1989. The bulk of the loss results from provision for valuation losses of $28,298,000 recorded in 1991. The provision reflects the Trust's estimation of the net realizable values of its real estate investments as compared with the book value of such investments. The valuation loss provision was recorded after consideration of various market factors adversely affecting real estate at the present time. particularly the lack of credit available to purchasers of commercial real estate and overbuilt and overinvested commercial real estate markets. Thus, $12,800,000 of the valuation losses arise from properties owned in the Phoenix metropolitan area, which has experienced a lengthy period of oversaturation of retail and office properties. An additional $14,800,000 of the valuation losses relate to hotel properties and reflect increased competition arising from a general overinvestment in the hotel industry by developers and banks during the latter part of the 1980's. Gain or loss will be recorded in the future to the extent that amounts realized from sale of these properties differ from the estimated net realizable values. Losses and gains are realized only on sale of the underlying real property. Net gain on sale of rental properties totalling $203,000 reflects net gain derived from the sale of 87 Scripps Drive, El Torito, National University and Vacation Special Apartments. The decrease in gain from 1990 reflects the continued slowdown in the commercial real estate market; current economic conditions have severely restricted credit availability to prospective buyers of Trust properties. IMPACT OF INFLATION. The effect of inflation on the Trust's operations and properties is varied. Revenues have not recently been affected by inflation as highly competitive market conditions have prevented increases in rental rates for most of the Trust's properties and, in some cases, have caused rental rates to decrease. Although operating expenses are impacted by inflation, inflation related increases in operating expenses have not been material during the past year. July 21, 1994 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES (a) As of November 3, 1993, KPMG Peat Marwick was terminated as the Trust's independent accountant. The Trust's financial statements for its fiscal year ended September 30, 1992 contained a report of KPMG Peat Marwick which included an explanatory paragraph regarding substantial doubt about the Trust's ability to continue as a going concern because of the Trust's recurring losses, non-compliance with certain loan covenants and significant loan repayments due in fiscal 1993 on its long term notes payable. Similarly, the Trust's financial statements for its fiscal year ended September 30, 1991 contained a report of KPMG Peat Marwick which included an explanatory paragraph regarding substantial doubt about the Trust's ability to continue as a going concern because of the Trust's recurring losses, non- compliance with certain loan covenants and significant loan repayments due in fiscal 1992 under its bank debt and debenture agreements. The Board of Trustees of the Trust decided to solicit bids from independent accountants, including KPMG Peat Marwick, for accounting services to be provided to the Trust. KPMG Peat Marwick submitted a bid but was not the winning bidder and thus has been terminated. The winning bidder was Coopers & Lybrand. The decision to change independent accountants was approved by the Board of Trustees. During the two most recent fiscal years preceding KPMG Peat Marwick's termination, there were no disagreements with KPMG Peat Marwick on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which would have caused it to make a reference to the subject July 21, 1994 matter of the disagreement in connection with its report. Furthermore, there were no reportable events during the two most recent fiscal years preceding KPMG Peat Marwick's termination arising from KPMG Peat Marwick having advised the company (a) that the internal controls necessary for the Trust to develop reliable financial statements did not exist; (b) that information had come to its attention that led it to no longer be able to rely on management's representations or that made it unwilling to be associated with financial statements prepared by management; (c) (1) of the need to expand significantly the scope of its audit or that information had come to its attention that if further investigated might either (i) materially impact the fairness or reliability of a previously issued audit report or underlying financial statements or the financial statements issued or to be issued to cover the fiscal period subsequent to the date of the most recent financial statements covered by an audit report or (ii) cause it to be unwilling to rely on management's representations or be associated with the Trust's financial statements and (2) due to KPMG Peat Marwick's termination, it did not so expand the scope of its audit or conduct such further investigations; and (d) (1) information had come to its attention that it concluded materially impacts the fairness or reliability of either (i) a previously issued audit report or the underlying financial statements, (ii) the financial statements issued or to be issued covering the fiscal period subsequent to the date of the most recent financial statement covered by an audit report (including information that, unless resolved to its satisfaction, would prevent it from rendering an unqualified audit report on those financial statements) and (2) due to KPMG Peat Marwick's termination, the issue has not been resolved to its satisfaction prior to its termination. (e) Coopers & Lybrand was appointed by the Board of Trustees as the new independent accountant for the Trust effective November 3, 1993. During the Trust's two most recent fiscal years and the subsequent interim period prior to KPMG Peat Marwick's termination, the Trust did not consult with Coopers & Lybrand regarding the application of accounting principles to a specified transaction or the type of audit opinion that might be rendered on the Trust's financial statements. Independent Auditors' Report The Board of Trustees Commonwealth Equity Trust We have audited the consolidated balance sheet of Commonwealth Equity Trust and Affiliates (Trust) as of September 30, 1993, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for the year then ended. In connection with our audit of the consolidated financial statements, we have also audited the financial statement schedules as listed in the accompanying index for the year ended September 30, 1993. These consolidated financial statements and financial statement schedules are the responsibility of the Trust's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audit. The consolidated financial statements and financial statement schedules of the Trust for the years ended September 30, 1992 and 1991, were audited by other auditors, whose report dated February 5, 1993, on those statements included an explanatory paragraph that described substantial doubt about the Trust's ability to continue as a going concern, which is discussed in Note 14 to those financial statements. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Commonwealth Equity Trust and Affiliates at September 30, 1993, and the consolidated results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules for the year ended September 30, 1993, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects, the information set forth therein. The Board of Trustees Commonwealth Equity Trust The accompanying consolidated financial statements have been prepared assuming that the Trust will continue as a going concern. As discussed in Notes 1 and 13 to the consolidated financial statements, the Trust's Chapter 11 bankruptcy proceedings and related litigation raise substantial doubt about the Trust's ability to continue as a going concern. Management's Plan of Reorganization and Disclosure Statement that have been submitted to the Court is described in Note 1, which includes the Equity Security Holders' Committee and the Pacific Mutual Lenders as coproponents. The consolidated financial statements do not include any adjustment that might result from the outcome of these uncertainties. COOPERS & LYBRAND Sacramento, California May 26, 1994 except for Note 1, as to which the date is June 3, 1994 KPMG Peat Marwick Certified Public Accountants 2495 Natomas Park Drive Sacramento, CA 95833-2936 INDEPENDENT AUDITORS' REPORT The Board of Trustees Commonwealth Equity Trust: We have audited the consolidated balance sheets of Commonwealth Equity Trust and affiliates as of September 30, 1992, and the related consolidated statements of loss, changes in shareholders' equity, and cash flows for each of the years in the two-year period ended September 30, 1992. In connection with our audits of the consolidated financial statements, we also have audited the, financial statement schedules for the periods ended September 30, 1992. These consolidated financial statements and financial statement schedules are the responsibility of the Trust's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Commonwealth Equity Trust and affiliates at September 30, 1992, and the results of their operations and their cash flows for each of the years in the two-year period ended September 30, 1992, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects, the information set forth therein. The accompanying consolidated financial statements have been prepared assuming that the Trust will continue as a going concern. As discussed in Note 14 to the financial statements, the Trust's recurring losses, noncompliance with certain loan covenants and significant loan repayments due in fiscal 1993 on its long-term notes payable, raise substantial doubt about the Trust's ability to continue as a going concern, Management's plans in regards to these matters are also described in Note 14. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. KPMG Peat Marwick February 5, 1993 COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES CONSOLIDATED BALANCE SHEETS September 30 ____________ See accompanying notes to consolidated financial statements. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES CONSOLIDATED STATEMENTS OF OPERATIONS for the years ended September 30 ______________ See accompanying notes to consolidated financial statements. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY for the years ended September 30, 1993, 1992 and 1991 ______________ See accompanying notes to consolidated financial statements. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES CONSOLIDATED STATEMENTS OF CASH FLOWS for the years ended September 30 ______________ See accompanying notes to consolidated financial statements. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ______________ 1. Organization, Summary of Significant Accounting Policies and Chapter 11 Proceedings: Organization Commonwealth Equity Trust (the Trust) was organized under the laws of the State of California pursuant to a Declaration of Trust dated July 31, 1973. From July 1973 until July 1989, the Trust engaged in a continuous intrastate offering of its securities pursuant to permits issued by the California Department of Corporations. Commencing September 1, 1993, the Trust became self-administered. Principles of Consolidation At September 30, 1993, the consolidated financial statements include the accounts of the Trust and its majority-owned affiliates: 3604 Fair Oaks Boulevard (3604) and California Real Estate Investment Trust (CalREIT). Majority-owned affiliates consist of a general partnership and a real estate investment trust engaged in real estate activities in which the Trust owns a greater than 50% interest. Plan of Reorganization Under Chapter 11 Proceedings On August 2, 1993, the Trust filed a petition for reorganization under Chapter 11 of the United States Bankruptcy Code. The bankruptcy case is currently pending in the United States Bankruptcy Court for the Eastern District of California, Sacramento Division and is entitled In re Commonwealth Equity Trust, Case No. 93-26727-C-11. On March 30, 1994, the Trust filed with the Court a Plan of Reorganization and Disclosure Statement. On May 13, 1994, the Trust, together with the Equity Security Holders' Committee and the Pacific Mutual Lenders (collectively, together with the Trust, the "Plan Proponents"), filed with the Court a First Amended Plan of Reorganization and a Disclosure Statement with Respect to First Amended Plan of Reorganization. On June 3, 1994, the Plan Proponents filed with the Court a Second Amended Plan of Reorganization and Disclosure Statement with Respect to Second Amended Plan of Reorganization. The Second Amended Plan provides for, inter alia: (a) the restructuring of virtually all of the Trust's secured and unsecured debt; (b) the issuance of new common stock of the Trust to current equity security holders; (c) the issuance of new common stock of the Trust to the Pacific Mutual Lenders; and (d) the issuance of preferred stock of the Trust to the Pacific Mutual Lenders and other creditors of the Trust will result in a dilution of the current equity. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 1. Organization, Summary of Significant Accounting Policies and Chapter 11 Proceedings, continued: A hearing to approve the Disclosure Statement is scheduled for June 8, 1994. Neither the Disclosure Statement nor the Second Amended Plan will be distributed to the Trust's equity security holders and creditors for voting until the Court has approved the contents of the Disclosure Statement. Accordingly, both the Second Amended Plan and Disclosure Statement are subject to further revisions and modifications. After the Disclosure Statement is approved, the Trust will transmit same to the Trust's creditors and equity security holders for voting and request that the Court confirm the Plan in accordance with the provisions of the United States Bankruptcy Code. On July 17, 1992, the Trust completed a restructuring of $78,445,000 in unsecured obligations (see Note 9). The terms of the restructuring agreement allowed for an extension of maturity dates for 5 1/2 years, provided that certain conditions were met. Pursuant to the agreement, if these conditions were not met, new secured notes (bearing interest at 9.5%) came due as follows: $3,445,000 on December 31, 1992; $2,500,000 on March 31, 1993, and $72,600,000 on June 30, 1993. The Trust defaulted under the terms of the restructuring agreement and was unable to meet its payment dates. After attempting to negotiate a further restructuring, the Trust filed the aforementioned petition for reorganization. In the Trust's Chapter 11 case, all litigation and claims against the Trust at the date of filing were automatically stayed, and the Trust continues business operations as a debtor-in-possession. (See Note 8 for a description of debt in process of foreclosure and other matters). The Bankruptcy Code prohibits creditors who are subject to the jurisdiction of the Bankruptcy Court from attempting to collect their pre-petition debts from the Trust, either by commencement or continuation of a lawsuit or otherwise, unless the Bankruptcy terminates or modifies the stay. During the Chapter 11 proceedings, interest expense is recorded at contractually stated amounts as the related debt is not in excess of aggregate assets. Neither of the Trust's majority owned affiliates, 3604 or CalREIT, filed for protection under Chapter 11. However, 3604 is under a court appointed receiver. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 1. Organization, Summary of Significant Accounting Policies and Chapter 11 Proceedings, continued: Partnership Interests Partnership investments of 20% to 50% are accounted for by the equity method. Under this method, the investments are recorded at initial cost and increased for partnership income and decreased for partnership losses and distributions. During the year ended September 30, 1990, the Trust entered into Placer Ranch Partners, a limited partnership in which the Trust owns a 31% interest. CR Properties, formerly CET/RJB, is a general partnership, in which the Trust owns a 50% interest. Income Taxes In 1977, the Trust elected to be and was taxed as a real estate investment trust (REIT) through the year ended September 30, 1992. A REIT is not taxed on that portion of its taxable income which is distributed to shareholders, provided that at least 95% of its real estate investment trust taxable income is distributed. During the year ended September 30, 1993, the Trust did not qualify to be taxed as a REIT. The termination of its REIT status is effective as of October 1, 1992. Furthermore, the circumstances of that termination were such that the Trust will not be eligible to re- elect to be taxed as a REIT prior to its fifth taxable year which begins after its taxable year ended September 30, 1992. Rental Properties Rental properties are carried at cost, net of accumulated depreciation and less a valuation allowance for possible investment losses. The Trust's valuation allowance for possible investment losses represents the excess of the carrying value of individual properties over their appraised or estimated net realizable value. The additions to the valuation allowance for possible investment losses are recorded after consideration of various external factors, particularly the lack of credit available to purchasers of real estate and overbuilt real estate markets, both of which adversely affect real estate. A gain or loss will be recorded to the extent that the amounts ultimately realized from property sales differ from those currently estimated. In the event economic conditions for real estate continue to decline, additional valuation losses may be recognized. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 1. Organization, Summary of Significant Accounting Policies and Chapter 11 Proceedings, continued: The allowance for depreciation and amortization has been calculated under the straight-line method, based upon the estimated useful lives of the properties which range from 30 to 40 years. Expenditures for maintenance, repairs and betterments which do not materially prolong the normal useful life of an asset are charged to operations as incurred. Contract termination costs described in Note 2 have been capitalized as a carrying cost of the properties and are being amortized over one to four years. Real estate acquired by cancellation of indebtedness or foreclosure is recorded at current fair market value at the date of acquisition, but not in excess of the unpaid balance of the related loan plus costs of securing title to and possession of the property. Cash The Trust invests its cash and restricted cash in demand deposits with banks with strong credit ratings. Cash at September 30, 1993, in excess of federally insured amounts was $4,951,000. The Trust has not experienced any losses on these deposits. Distributions in Excess of Cumulative Net Income The Trust, in the past, maintained a general policy of distributing cash to its shareholders in an amount that approximated taxable income plus noncash charges such as depreciation and amortization. As a result, distributions to shareholders exceeded cumulative net income. Sales of Real Estate The Trust complies with the provisions of Statement of Financial Accounting Standards No. 66 (SFAS 66), "Accounting for Sales of Real Estate." Accordingly, the recognition of gains on certain transactions are deferred until such transactions have complied with the criteria for full profit recognition under the Statement. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 1. Organization, Summary of Significant Accounting Policies and Chapter 11 Proceedings, continued: Adoption of Authoritative Statement In fiscal 1993, the Trust adopted Statement of Financial Accounting Standards No. 107 (SFAS 107), "Disclosure About Fair Value of Financial Instruments." This statement requires disclosure of the fair value of all financial instruments, both assets and liabilities recognized and not recognized in the balance sheet. The adoption of SFAS 107 resulted only in additional disclosure requirements and had no effect on the Trust's financial position or results of operations. Net Loss Per Share Net loss per share of beneficial interest has been computed based on the weighted-average number of shares outstanding during the year of 25,093,000 in 1993, 25,095,000 in 1992 and 25,138,000 in 1991. Reclassifications Certain reclassifications have been made in the presentation of the 1992 and 1991 financial statements to conform to the 1993 presentation. 2. Related-Party Transactions: Until September 1, 1993, administrative services were provided to the Trust by B&B Property Investment, Development and Management Company, Inc. (B&B). B&B's compensation consisted of 5% of the gross proceeds from the sale of shares of beneficial interest, as well as a reimbursement of certain expenses incurred in performing services for the Trust. B&B earned real estate commissions in connection with purchases and sales of Trust properties handled by B&B, as well as leasing commissions. The agreement also provided that B&B reimburse the Trust for any promotional or annual expenses which exceed the statutory allowable limits established by the State of California. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 2. Related-Party Transactions, continued: On December 27, 1989, the Trust and B&B terminated the portion of the Advisory Agreement relating to CET which granted B&B an exclusive authorization to act as a real estate broker in connection with the sale of Trust properties owned at August 31, 1989. In consideration of this termination, B&B received $595,000 in cash and two promissory notes totalling $6,600,000 which have subsequently been paid. The $7,195,000 of consideration was capitalized as a carrying cost of the properties and is fully amortized as of September 30, 1993. Until September 1, 1993, property management responsibilities of the Trust were assigned to B&B Property Investments, Inc. (B&B Property), a wholly-owned subsidiary of B&B. The compensation for property management services was negotiated by B&B Property and the Trustees for each property when acquired. Compensation, leasing commissions and expense reimbursements to B&B and B&B Property were $2,826,000, $3,341,000 and $3,330,000 for the years ended September 30, 1993, 1992 and 1991, respectively. The commissions paid are included in other assets and amortized over the term of the leases, typically five years. The Trust entered into certain leasing transactions with North Main Street Company (North Main), a company owned by the President and Chairman of the Board of the Trust's former advisor, B & B. Until July 20, 1993, North Main leased the Trust's hotels under triple net leases, which leases generated revenue to the Trust of $1,854,000 during the year ended September 30, 1993. Generally such leases provided for payment of the greater of a minimum rent or specified percentages of preestablished revenue categories as stated in each hotel's lease. An amount of $70,000 was owed by North Main to the Trust as of September 30, 1992. The Trust terminated its lease arrangement with North Main on or about July 20, 1993. North Main has asserted a claim under the Chapter 11 proceedings against the Trust arising out of that termination, which claim the Trust disputes. In addition, North Main left unpaid certain payables in connection with the hotels' operations, for which the Trust disputes liability and which may be offset against any North Main claim. At September 30, 1993 and 1992, the Trust has amounts due to CalREIT aggregating $597,000 and $539,000, respectively. Such amounts bear interest at 10% and are due on demand, without collateral, and are eliminated in consolidation. During the year ended September 30, 1993, the Trust paid fees of $93,000, primarily for consulting, to a company owned by one of the Trustees. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 3. Restricted Cash: At September 30, 1993 and 1992, cash of $111,000 and $584,000, respectively, is restricted under the terms of the agreement with Sun Life Insurance Company of America in connection with their purchase of senior participation interests in notes receivable (Note 6). 4. Rental Properties: At September 30, 1993 and 1992, the Trust's rental property portfolio at cost included office buildings, $86,931,000 and $142,622,000; commercial buildings, $83,426,000 and $110,075,000; hotels, $64,787,000 and $62,393,000 and land, $8,253,000 and $10,165,000, respectively. Noncancellable operating leases at September 30, 1993, provide for minimum rental income during each of the next five years of $10,702,000, $9,902,000, $8,229,000, $5,876,000 and $4,284,000, respectively, and $11,854,000 thereafter. Certain of the leases increase periodically based on changes in the Consumer Price Index. In March 1989, the Trust sold its Milpitas, California office building for $10,000,000, comprised of a $5,000,000 promissory note collateralized by the property and a $5,000,000 credit towards the purchase of 680 acres in Roseville, California. Under the terms of the sale agreement, the Trust agreed to lease the entire building for one year and received an option to repurchase the property for $5,000,000. The transaction was recorded as a financing arrangement for financial accounting purposes and no gain or loss was recognized in accordance with generally accepted accounting principles. In August 1990, the Trust exercised its option to repurchase the property for $5,000,000 by canceling the $5,000,000 promissory note collateralized by the property. For income tax purposes, this transaction was accounted for as a sale and subsequent repurchase of $5,000,000. Based on the different tax and financial accounting treatments accorded this transaction, the Trust's tax basis in the Milpitas, California office building is $5,000,000 less than the financial accounting basis and the tax basis of the 680 acres is $5,000,000 more than the financial accounting basis. In February 1990, the Trust contributed the 680 acres in Roseville, California to Placer Ranch Partners, a limited partnership. Rental properties with costs of $9,583,000 are subject to purchase options exercisable on the part of the lessees. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 5. Partnership Interests: As discussed in Notes 1 and 4, the Trust is a partner in Placer Ranch Partners, a limited partnership in which the Trust owns a 31% limited partnership interest. No income has been recognized in the Trust's financial statements for 1993, 1992 and 1991 related to the Placer Ranch Partners partnership as payment of such income is contingent upon the future sale of land. The following represents an unaudited summary balance sheet and operational information of the partnership for the years ended September 30: COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 5. Partnership Interests, continued: The Trust is also a partner in CR Properties, a general partnership, in which the Trust owns a 50% interest. CR Properties is a limited partner in a partnership which owns an office building in Sacramento, California. No portion of the CR Properties partnership loss has been recognized in the Trust's financial statements for 1993, 1992 and 1991 as the partnership agreement specifies that net losses shall be allocated 100% to the other partner. As CR Properties has a limited partnership interest, it has no contingent liability with respect to the office building debt. 6. Notes Receivable: In order to facilitate sales of real estate, the Trust has accepted partial payment in the form of notes receivable collateralized by deeds of trust. Additionally, the Trust has invested in a variety of loans collateralized by deeds of trust. As of September 30, 1993 and 1992, the Trust had long-term notes receivable, collateralized by deeds of trust, of (before valuation allowance and unaccreted discount) $27,692,000 and $38,349,000, respectively. Generally the notes are collateralized by real estate properties in California. The notes are to be repaid from the cash flow of the property or proceeds from the sale or refinancing of the property. At September 30, 1993, $2,448,000 of such notes were delinquent. Contractually scheduled principal collections over the next five years, excluding delinquent notes, are as follows: $1,129,000, $2,055,000, $7,349,000, $2,860,000, $815,000, respectively, and $11,036,000 thereafter. The notes bear interest at rates ranging from 8% to 13% as of September 30, 1993. For the year ended September 30, 1993, the overall effective rate was 8.2%. During the year ended September 30, 1990, the Trust sold $13,753,000 in senior participation interests in certain notes receivable to Sun Life Insurance Company of America, a Maryland corporation. The participation agreement specifies that upon default of any note receivable covered by the agreement, Sun Life will have priority in any proceeds before the Trust. Total participation outstanding at September 30, 1993 and 1992, was $1,194,000 and $11,812,000, respectively. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 7. Allowance for Valuation Losses: In connection with preparing its plan or reorganization, as described in Note 1, the Trust engaged outside professionals to assist in developing the plan related to its real estate investments. Based on this review of the real estate investments, the Trust does not expect losses in excess of the valuation allowances established. Adverse economic factors, particularly the lack of credit available to purchasers of real estate and overbuilt real estate markets resulting in declining lease renewal rates, necessitated a provision for valuation losses. If such adverse economic factors continue, additional valuation loss provisions may be required. Analysis of changes in the allowance for possible losses on real estate investments, partnership interests, notes receivable, and rents and interest receivable for fiscal years ended September 30, 1993, 1992 and 1991 follow: COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 7. Allowance for Valuation Losses, continued: In addition, the Trust has established an allowance for valuation losses on other assets in the amounts of $590,000 and $330,000 at September 30, 1993 and 1992, respectively. 8. Long-Term Notes Payable: As of September 30, 1993 and 1992, the Trust had long-term notes payable, most of which are collateralized by deeds of trust on rental properties and are subject to compromise, due in installments extending to the year 2008, with interest rates ranging from 7.5% to 18.0% for the years ended September 30, 1993 and 1992. Contractually scheduled principal payments during each of the next five years are $19,282,000, $11,556,000, $27,178,000, $477,000 and $3,641,000, respectively, and $5,439,000 thereafter. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 8. Long-Term Notes Payable, continued: The Trust is in default under the notes, due to, among other factors, its filing a petition under Chapter 11 (see Note 1). As a result of reorganization proceedings described in Note 1, the amount and/or timing of these future payments may change. Long-term notes payable, mostly collateralized by deeds of trust on rental properties, in the amount of $15,874,000 are collateralized by CalREIT properties and 3604 and, therefore, are not subject to compromise. Two rental properties collateralizing debt of $11,272,000 at September 30, 1993, are in the hands of receivers and are in the process of foreclosure. The assets have been valued in the financial statements equal to the nonrecourse deeds of trust debt. Subsequent to September 30, 1993, a senior mortgage holder filed an action with the Bankruptcy Court for relief from stay with regard to its indebtedness which totaled $28,859,000 at September 30, 1993, and which is collateralized by rental properties with a carrying value of $35,830,000 at September 30, 1993. This action is currently scheduled for trial in June 1994. 9. Principal and Deferred Interest Notes: On July 17, 1992, the Trust completed a restructuring of $46,000,000 in debentures outstanding with interest rates ranging from 9% to 9.94%, and a bank loan of $29,000,000 at 9%, along with unpaid interest to July 31, 1992, aggregating $3,445,000. Under that restructuring agreement, substantially all of the Trust's assets, subject to previously existing liens, were pledged as collateral for the restructured debt. All sales, refinancings or other disposition of such pledged assets were subject to review by the secured lenders prior to completion. These secured notes bear contractual interest at 9.5% and were due $3,445,000 on December 31, 1992, and additional amounts of $2,500,000 on March 31, 1993 and $72,600,000 on June 30, 1993 (which date could have been extended if certain conditions which were not met had been met). At September 30, 1993, the balance was $72,600,000. The terms of the debt restructuring prohibit the Trust from making distributions to shareholders until all principal and capitalized interest scheduled for payment through December 31, 1993, have been paid. No distributions were made by the Trust for the fiscal years ended September 30, 1993 and 1992. The Trust is in default under the debt restructuring agreement due to, among other factors, its filing a petition under Chapter 11 (see Note 1). COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 10. Distributions: No cash distributions were made to holders of shares of beneficial interest for the fiscal years ended September 30, 1993 and 1992. A cash distribution (which was entirely return of capital) of $.20 per share of beneficial interest was made for the fiscal year ended September 30, 1991. 11. Statements of Cash Flows Supplemental Information: In connection with the purchase of property and improvements, the Trust entered into various noncash transactions as follows: The property cost additions of $7,225,000 during 1992 resulted from recognition of in-substance foreclosures on two properties securing notes receivable and related interest aggregating $8,790,000, resulting in a valuation loss of $1,565,000. In 1991, the Trust was allocated an additional capital contribution of $166,000 in the CR Properties Partnership in conjunction with the purchase of property. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 11. Statements of Cash Flows Supplemental Information, continued: In connection with the sale of property, the Trust entered into various noncash transactions as follows: Four properties which collateralized notes payable in the aggregate amount of $29,845,000 were foreclosed upon during the year ended September 30, 1993, causing a net loss of $4,783,000 to be recorded. During the year ended September 30, 1993, the Trust sold six notes receivable for net proceeds of $11,538,000, reduced by other costs (including delinquent taxes, fees and closing costs) of $1,297,000, producing net cash proceeds to the Trust of $10,241,000, resulting in a loss of $662,000. Two of the six notes were treated differently than the other four. The Trust sold a partial interest in those notes for $4,968,000 in cash (resulting in a loss of $204,000). The Trust's retained interest in those two notes amounts to $3,047,000 and is noninterest bearing. A discount of $1,189,000 was recorded on the Trust's portion of the notes as of September 30, 1992, using an imputed interest rate of 15%. The agreement provides for the purchaser to receive interest of 18%, representing all interest on the total balance of such notes. In addition, the purchaser will receive all payments on the notes until interest and principal is paid in full. In the event the notes go into default, the Trust must cure such default or lose its remaining interest of $3,047,000 in the notes. In 1992, CalREIT modified the terms of a note receivable collateralized by rental property. As a provision of the modification, $1,275,000 of deferred interest and $214,000 of accrued interest was added to the principal amount of the note. Interest paid on the Trust's outstanding debt for the years ended September 30, 1993, 1992, and 1991 was $12,579,000, $16,762,000 and $17,987,000, respectively. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 12. Commitments and Contingencies: Leases The Trust is obligated under land leases to the year 2033. The minimum annual payment under the leases for each of the next five years are $121,000, $121,000, $121,000, $104,000, $104,000, respectively, and $3,324,000 thereafter. Litigation At the time the Trust filed its Chapter 11 petition in August 1993, it was party to a number of lawsuits. Most involved ordinary disputes common in the real property management business, and amounts immaterial to the Trust's overall financial situation. Other lawsuits involved the following matters: . Claims filed by the Pacific Mutual Lenders, Senior Mortgage Holders and other Claim Holders as summarized in Notes 1, 2 and 8. . Litigation filed in 1991 naming the individual Trustees of the Trust and B & B, among others, as defendants, and the Trust as a nominal defendant. It sought, among other things, a declaration that the Trust's management agreement with B & B was invalid and imposition of a constructive trust on and recovery of $7,195,000 by B&B in 1989. (See Note 2). This case had been in settlement discussions prior to the filing of the Chapter 11 petition. . A complaint filed by about 130 former Trust shareholders in 1993 naming the Trust, current and former Trustees, B & B and its shareholders and various current and former professional advisors and consultants to the Trust as defendants. The complaint alleged breach of fiduciary duty, violation of federal and state securities laws, violation of civil RICO, fraud, negligent misrepresentation, negligence and civil conspiracy. Subsequently, the action was dismissed without prejudice as to the Trust. . A complaint was filed in April 1994 by the franchisor of most of the Trust's hotels, alleging trademark infringement and unfair business practices. Following extensive negotiations, the parties entered into a settlement agreement approved by the Bankruptcy Court which involved ongoing licensing arrangements for the hotels. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 12. Commitments and Contingencies, continued: Other In accordance with bankruptcy proceedings, claims are filed with the Court by specified dates. At September 30, 1993, the Trust recorded its estimate of valid claims. The Trust believes, based on the supporting documentation that it has, that the remaining excess claims will ultimately be determined not to be valid. However, there is no assurance that the Court will not hold additional claims from the remaining excess claims to be valid; and, if the Court does so hold, there is no practical way of estimating what the total amount of additional claims would be. 13. Basis of Presentation: The financial statements have been presented on a going concern basis which contemplates the realization of assets and satisfaction of liabilities in the normal course of business; however, as a result of the Chapter 11 proceedings and related litigation, such realization of assets and satisfaction of liabilities are subject to significant uncertainties. These financial statements include adjustments and reclassifications that have been made to reflect indebtedness as extended under the Plan of Reorganization, as described in Note 1. Such indebtedness is included in "Liabilities Subject to Compromise." These financial statements do not include any adjustments that would be required should the Trust be unable to continue as a going concern or as a result of the finalization of the Chapter 11 proceedings. 14. Liabilities Subject to Compromise: The Trust has $133,065,000 of liabilities which are subject to compromise in Chapter 11 proceedings as follows: COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 15. Reorganization Items: Reorganization items are calculated from August 2, 1993, the date on which the Trust filed its petition for reorganization, and consist of the following: 16. Fair Value of Financial Instruments: SFAS 107 requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. SFAS 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Trust. The estimated fair value of the Trust's financial instruments at September 30, 1993, is as follows: (1) It was not practical to value notes payable due to the reorganization proceedings described in Note 1. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 17. Subsequent Event - CalREIT Board of Trustees: Effective April 14, 1994, CalREIT elected a new Board of Trustees, comprising Frank Morrow, Howard Cohn and Mark Bennett, all of whom are key management personnel of the Trust. CalREIT also terminated certain management and advisory agreements with B & B and B & B Property. Certain disputes with B & B and B & B Property in connection with that termination were settled in May 1994. 18. Income Taxes: At September 30, 1993, the Trust had tax net operating loss carryforwards (NOL) which may be applied against future taxable income and which expire as follows: The Trust's alternative minimum tax operating loss carryforwards are substantially the same as its NOLs at September 30, 1993. The Trust's ability to use its NOLs to offset future income is subject to restrictions enacted in the Internal Revenue Code (Code). These restrictions limit the Trust's future use of its NOLs if certain stock ownership changes described in the Code (referred to herein as an Ownership Change) occur. The Trust does not believe that any recent or historical changes in stock ownership have resulted in an Ownership Change through the date of these financial statements. However, depending on final approval of a Plan of Reorganization and other events as described in Note 1, changes in stock ownership which would limit the Trust's future use of its NOLs may occur. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 18. Income Taxes, continued: As stated in Note 1, during the year ended September 30, 1993, the Trust failed to qualify under the Internal Revenue Code to be taxed as a REIT. The lack of a need for a provision for income taxes has been calculated for fiscal 1993 according to the precepts of Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes." The Trust plans to adopt Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes," beginning with the fiscal year ending September 30, 1994. The Trust estimates that the impact on the financial statements as a result of the application of SFAS 109 will not be material. COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 19. Condensed Financial Statements of Commonwealth Equity Trust (CET) Only: Condensed financial statements as of and for the year ended September 30, 1993, for CET only are as follows: Commonwealth Equity Trust (Debtor-in-Possession) Condensed Balance Sheet September 30, 1993 __________ ASSETS COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 19. Condensed Financial Statements of Commonwealth Equity Trust (CET) Only, continued: Commonwealth Equity Trust (Debtor-in-Possession) Condensed Statement of Operations for the year ended September 30, 1993 __________ COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 19. Condensed Financial Statements of Commonwealth Equity Trust (CET) Only, continued: Commonwealth Equity Trust (Debtor-in-Possession) Condensed Statement of Cash Flows for the year ended September 30, 1993 __________ COMMONWEALTH EQUITY TRUST (Debtor-in-Possession) AND AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued ______________ 20. Selected Quarterly Financial Data (Unaudited): (1) Includes $53,089,000 in valuation losses. (2) Includes $48,130,000 in valuation losses. July 21, 1994 PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Board of Trustees was composed of five and six persons during the year ended September 30, 1993. Two positions on the Board are currently vacant. The following table sets forth certain information as of June 30, 1994 with respect to each of the Trustees of The Trust and the Trust's single officer. There are no arrangements or understandings between any trustee and any other person pursuant to which the trustee was or is to be selected as a trustee. There are no family relationships between any trustees. Until September 1, 1993, Jeffrey B. Berger served as Secretary of the Trust. William Gallagher served as a Trustee from April 28, 1993 until he resigned on August 9, 1993. The principal occupations and affiliations of the Trustees and Chief Executive Officer as of June 30, 1994 were as follows: DORIS V. ALEXIS, President of the Board of Trustees, formerly served as the Director of the California Department of Motor Vehicles. She was appointed to that position by the Governor in 1977 after 23 years of service with the Department of Motor Vehicles. She has experience in management, planning and budgeting and is currently a senior consultant to the National Traffic Safety Institute and a member of the Advisory Council to Californians for Drug Free Youth. She is the past President of the Board of Directors of the YWCA. HOWARD E. COHN serves in the capacity of Operations Manager for the Trust. He has specialized in general real estate law and real estate, personal injury and insurance defense litigation since 1980. Mr. Cohn received a B.S. degree in business administration from Menlo College in 1974 and a Juris Doctor degree from Western State University College of Law in 1976. Mr Cohn is also a Trustee and Secretary of the Trust's 77% owned subsidiary California Real Estate Investment Trust. STEVEN H. GOLD is Chairman and Chief Financial Officer of Center Financial Group, which arranges debt and equity financing. Mr. Gold specializes in financing major real estate developments including income and residential properties. he also originates joint ventures for developers with institutional partners. Mr. Gold writes regularly for real estate publications on real estate investment and financing. he has lectured at major universities and has given seminars throughout the United States, Canada and Western Europe on these topics. Mr. Gold earned a Master's Degree in Business Administration from the University of California, Los Angeles. He is a Chairman of the Real Estate Advisory Board of UCLA and is a member of the Dean's Council of the UCLA School of Architecture and Urban Planning. He is listed in Who's Who in Real Estate and is a director of numerous civic organizations, including the Anti-Defamation League, The United Jewish Appeal and the Guardians. RICHARD RATHFON, now retired, was the Sacramento City Manager from 1968 to 1976. He has over 31 years of diversified experience in housing, architecture and urban planning. He is currently Chairman of the Capital Area Development Authority. ALBERT S. RODDA, A.B., M.A. AND Ph.D. from Stanford University, taught American History and Principles of Economics for 20 years at Sacramento City College. He served as Senator in the California State Senate for 22 years and is an Executive Secretary of the California Commission on State Finance for two years. During World War II he served in the Pacific as a gunnery officer with the U.S. Navy. FRANK A. MORROW is Chief Executive Officer of the Trust. He received a B.S. from the U.S. Naval Academy in 1961 and an M.B.A. from Stanford University in 1971. He has a range of real estate and management experience, having served as Director of Real Estate for Stanford University, Senior Vice President/Regional Manager of Bedford Properties, Senior Vice President of Boise Cascade Urban Development Corporation and assistant to the Chairman of Hawaiian Airlines, among other experience. POST-REORGANIZATION MANAGEMENT. The Amended Plan or Reorganization provides that, on the plan effective date, the Board of Trustees will consist of five persons, one of whom shall be designated by the Trust, provided that the Trust's designee is Mr. Morrow; and three of whom shall be designated by a majority vote of an election committee consisting of two Pacific Mutual Lender designees and one Equity Committee designee. The Trustees shall serve for an initial one year period. The Plan Proponents have reached an agreement with Frank Morrow on the terms of his continued management services after the plan effective date. The agreement will provide that Morrow will act as Chief Executive Officer for a term of one year, for monthly compensation of $25,000, commencing on the effective date, and terminable at any date with or without cause by the Trustees. If the contract is terminated before the first anniversary date or not renewed at the first anniversary, Mr. Morrow will be entitled to receive a termination payment equal to one year's salary ($300,000). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table lists the cash compensation of the Trustees and the officers of the Trust for the fiscal year ended September 30, 1993: (1) Includes compensation paid to Jeffrey B. Berger as Secretary of the Trust from October 1, 1992 through August 31, 1993. (2) Does not include amounts paid to Center Financial Group, a company owned by Mr. Gold, a trustee. Also does not include amounts paid to Howard Cohn, a trustee, for legal services. See "Certain Relationships and Related Transactions." Trustees and Officer Each Trustee is paid $2,000 for each Trustees' meeting attended. During the fiscal year ended September 30, 1993, 8 regular meetings and 3 special meetings for the Trustees were held. In August 1992, the Trust established a policy pursuant to which Trustees who are requested to render extraordinary service to the Trust receive $2,000 per full day, or a pro rata amount for less than a full day, plus expenses incurred in performing such services. If any Trustee receives a transaction fee in connection with any services performed for the Trust, expenses and extraordinary compensation paid or payable will be credited against the amount of the transaction fee. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Following is the beneficial security ownership of the trustees of the Trust and all trustees, officers and former officers as a Group who owned Shares at June 30, 1994. Except as otherwise indicated, all securities are directly or beneficially owned by the named trustee. No person is known to the Trust to own beneficially more than 5% of the outstanding Shares. * Ownership represents less than 1% of the total outstanding Shares. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Jeffrey B. Berger, former Secretary and a former Trustee of the Trust, is Chairman of the Board, President and a shareholder of B&B Property Investment, Development and Management Company, Inc., which was financial advisor to the Trust until September 1, 1993. An Advisory Agreement between the Trust and B&B provided for compensating for various types of services at such rates as may be agreed upon and reimbursement of expenses incurred in performing such services. The agreement provided that B&B would reimburse the Trust for any promotional or annual expenses which exceeded the statutory allowable limits established by the Stated of California. The portion of the Advisory Agreement which related to property management services was transferred by the Trust and B&B to B&B's wholly owned subsidiary, B&B Property Investments, Inc. ("B&B Property") on December 20, 1979. During the fiscal year ended September 30, 1993, B&B and B&B property received $2,826,000 as compensation, leasing commissions, and expense reimbursements. In addition, Mr. Berger is sole shareholder of North Main St. Co., which managed the Trust's hotel properties pursuant to leases, each with a primary term expiring December 31, 1998, which provide (subject to reduction during scheduled capital improvements projects) for annual rent of the greater of $2,520,000 or a percentage rent based on certain revenue categories from the hotels. CET received $1,854,000 from North Main St. Co pursuant to such leases in 1993 before terminating the lease arrangement on or about July 20, 1993. In October 1992, the Trust entered into an Exchange Agreement with California Real Estate Investment Trust ("Cal REIT"), its 77% owned subsidiary, pursuant to which the Pavillions at Mesa property in Mesa, Arizona was exchanged for notes receivable collateralized by deeds of trust owned by Cal REIT. The value of the transaction was estimated at the time to be approximately $6,300,000. Each party paid one-half of the expenses of the exchange. Thereafter, the Trust sold $1,084,000 of the notes for $920,000 in cash. Howard E. Cohn, a Trustee of the Trust, received $252,219 fees for legal from the Trust in Fiscal 1993. During the year ended September 30, 1993, the Trust paid fees of $93,000 to a company owned by Mr. Gold, a Trustee, for consulting services in connection with obtaining debt for the Trust. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K (a) (2) CONSOLIDATED FINANCIAL STATEMENT SCHEDULES AND EXHIBITS FILED The statements and schedules referred to above should be read in conjunction with the financial statements with notes thereto included in Part II of this Form 10-K. Schedules not included in this item have been omitted because they are not applicable or because the required information is presented in the consolidated financial statements or notes thereto. (b) Reports on Form 8-K The Trust filed three reports on Form 8-K during the quarter ended September 30, 1993 as follows: (c) Exhibits 3.1 Declaration of Trust, filed as Exhibit A to the Trust's Form 10, filed on December 31, 1979, and incorporated herein by reference. 10.1 Services and Confidentiality Agreement dated as of March 8, 1994, between the Trust and FAMA Management, Inc. 16. Letter dated November 15, 1993 from KPMG Peat Marwick to Securities and Exchange Commission, filed as Exhibit A to the Trust's Form 8-K/A Report dated November 3, 1993 and incorporated herein by reference. COMMONWEALTH EQUITY TRUST AND AFFILIATES SCHEDULE IX - SHORT-TERM BORROWINGS Years ended September 30, 1993, 1992 and 1991 * Average borrowings were computed by dividing the borrowed amounts, which were weighted on the basis of the number of days outstanding, by 365 days for 1991 and by 259 days for 1992. ** The weighted average interest rate during the year was determined by dividing total interest expense related to short-term borrowings by average borrowings outstanding during the year. *** As a result of the July 17, 1992 debt restructuring agreement, the note payable to bank is currently secured and included as part of the principal and deferred interest notes. - - -------------------------------------------------------------------------------- COMMONWEALTH EQUITY TRUST AND AFFILIATES SCHEDULE XI - REAL ESTATE AND ACCUMULATED DEPRECIATION SEPTEMBER 30, 1993 Page 1 Part A - - -------------------------------------------------------------------------------- - - -------------------------------------------------------------------------------- COMMONWEALTH EQUITY TRUST AND AFFILIATES SCHEDULE XI - REAL ESTATE AND ACCUMULATED DEPRECIATION SEPTEMBER 30, 1993 Page 2 Part A - - -------------------------------------------------------------------------------- (1) The reduction in basis resulted from a judgment against the original seller of the property. (2) Represents total cost of assets after valuation allowance. (3) The Trust establishes allowances for possible investment losses which represent the excess of the carrying value of individual properties over their appraised or estimated net realizable value. Various external factors, particularly the lack of credit available to purchasers of real estate and overbuilt real estate markets have adversely affected real estate and necessitated the allowance. - - -------------------------------------------------------------------------------- COMMONWEALTH EQUITY TRUST AND AFFILIATES SCHEDULE XI - REAL ESTATE AND ACCUMULATED DEPRECIATION SEPTEMBER 30, 1993 Page 1 Part B - - -------------------------------------------------------------------------------- COMMONWEALTH EQUITY TRUST AND AFFILIATES SCHEDULE XI - REAL ESTATE AND ACCUMULATED DEPRECIATION SEPTEMBER 30, 1993 Page 2 Part B - - ------------------------------------------------------------------------------ COMMONWEALTH EQUITY TRUST AND AFFILIATES SCHEDULE XI - REAL ESTATE AND ACCUMULATED DEPRECIATION - - ------------------------------------------------------------------------------ Reconciliation of total real estate carrying values for the three years ended September 30, 1993, 1992 and 1991 are as follows: - - ------------------------------------------------------------------------------ COMMONWEALTH EQUITY TRUST AND AFFILIATES SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE (Notes Receivable Collateralized by Deeds of Trust) SEPTEMBER 30, 1993 - - ----------------------------------------------------------------------------- - - ------------------------------------------------------------------------------ COMMONWEALTH EQUITY TRUST AND AFFILIATES SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE (Notes Receivable Collateralized by Deeds of Trust) SEPTEMBER 30, 1993 - - ------------------------------------------------------------------------------ (1) Represents carrying amount of notes after valuation allowance. (2) The Trust establishes allowances for possible investment losses which represent the excess of the face amount of the note over the appraised or estimated net realizable value of the property securing the note. In addition, discounts on the Trust's remaining interest in note sold has been recognized to reflect a market rate of interest. Such write downs in no way limit the obligation of the borrower to comply with the terms of the note. - - ------------------------------------------------------------------------ COMMONWEALTH EQUITY TRUST AND AFFILIATES SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE - - ------------------------------------------------------------------------ July 21, 1994 SIGNATURES Pursuant to the requirements of Section 13 or Section 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 requirement 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. July 21, 1994 EXHIBIT INDEX

92476_1993.txt

92476_1993

1993

92476

Item 1. Business. The Company Southwestern Bell Telephone Company (Telephone Company) was incorporated in 1882 under the laws of the State of Missouri. The Telephone Company is a wholly-owned subsidiary of Southwestern Bell Corporation (Corporation) which was incorporated in 1983 under the laws of the State of Delaware. The Telephone Company was a wholly-owned subsidiary of AT&T until January 1, 1984, when it was divested by AT&T pursuant to a court-ordered reorganization of the Bell System (divestiture). AT&T accomplished the divestiture by contributing its 100 percent interest in the Telephone Company to the Corporation and then distributing its ownership in the Corporation to its shareowners effective January 1, 1984. Operations Under the Modification of Final Judgment (MFJ) The MFJ, as originally approved by the United States District Court for the District of Columbia (Court) in 1982, placed restrictions on the types of businesses in which the Corporation could engage. The principal restriction prohibits the Corporation from providing interexchange telecommunications services. An exchange in this context refers to a Local Access and Transport Area (LATA), which is generally centered on a standard metropolitan service area or other identifiable community of interest. Interexchange service refers to the provision of telecommunications services between exchanges. The MFJ initially restricted the Corporation from providing information services and from manufacturing or providing telecommunications products, other than the provision of customer premises equipment (CPE) manufactured by others. CPE, as defined in the MFJ, represents equipment used on customers' premises to originate, route or terminate telecommunications. The MFJ also initially restricted the Corporation from engaging in nontelecommunications lines of business. These services and products are collectively known as "restricted lines of business". The MFJ permits the Corporation to obtain relief from these restrictions upon a showing that there is no substantial possibility that it could use its monopoly power to impede competition in the specific market it seeks to enter (waiver standard). The Department of Justice (DOJ) initiated a review of the MFJ's line of business restrictions in 1987. After that review, the Court removed the restriction against entry into nontelecommunications lines of business, as well as that portion of the information services restriction which prohibited voice messaging services (VMS), electronic mail, electronic White Pages services and certain gateway functions (i.e., a telecommunications arrangement, either by video or audio, in which customers can communicate with many different information service providers). In April 1990, the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit Court) affirmed the Court's decision not to remove the interexchange and manufacturing restrictions, but clarified the waiver standard in a manner beneficial to future waiver requests by the Corporation. The D.C. Circuit Court also reversed the decision not to lift the information services restriction in its entirety, and remanded the issue to the Court for reconsideration under a more lenient public interest standard which is to apply when AT&T and the DOJ, the original parties to the MFJ, do not oppose relief. In July 1991, the Court applied this public interest standard and issued an order which removed the information services restriction in its entirety, but stayed the effectiveness of the relief it granted the regional holding companies (RHCs), pending appeals. The D.C. Circuit Court has affirmed the order and the United States Supreme Court (Supreme Court) has refused to review the matter. Thus, the removal of the information services restriction on an intraexchange basis (within the LATA) has become final. Also as a result of proceedings before the Court since divestiture, the Corporation has been authorized to engage in the restricted lines of business outside the United States, subject to certain conditions designed to prevent an impact on United States markets. The Corporation has also obtained relief from the Court to provide interexchange cellular services in various markets throughout the United States, as well as intersystem handoff and automatic call delivery capabilities. Recent Waivers Denied The Corporation, jointly with the other RHCs, had appealed a July 1990 order of the Court holding that the RHCs were not permitted to transport common channel signaling 7 (CCS7) information across LATA boundaries for handoff to interexchange carriers at centralized signal transport points (STPs). CCS7 is the AT&T version of the internationally standardized signaling system which transmits signaling and service definition information between components of the telephone network. The STP is a type of switch which routes the signaling messages within the signaling network. The Court held that the MFJ requires that signaling information be given to the interexchange carriers in the LATA where the call originated, and also denied the RHCs' requests for waivers to establish the centralized STP service arrangement. The order was affirmed by the D.C. Circuit Court, and in February 1993 the Supreme Court refused to review the decision. Pending Waiver Requests and Appeals The Corporation has initiated other requests with the Court which seek the removal of some of the remaining restrictions. This includes a generic request, filed jointly by all the RHCs, seeking relief from the interexchange prohibition to provide wireless services without regard to geographic boundaries. In addition, the Corporation has also requested relief to provide interexchange cellular services in certain of its own regional markets. The Corporation has also filed waiver requests seeking relief from the manufacturing restriction, to permit the design and development of CPE, and the provision of telecommunications equipment to third parties. All of these requests are pending. In June 1993, the Corporation, along with the other RHCs, filed a joint request for a waiver to provide information services on an interLATA basis. A condition of the request is that the RHCs lease the interLATA transport from independent interexchange carriers. Opposition briefs were filed in October 1993. In January 1992, the Court denied a waiver to allow Ameritech Corporation (Ameritech), an RHC, to receive royalties from the sale to third parties of telecommunication equipment designed, developed and/or manufactured by the unaffiliated party with the financial assistance of Ameritech. The Court also denied the DOJ's request for a declaratory ruling that a funding/royalty agreement with a firm in which an RHC has neither a significant equity interest nor influence over operations does not constitute manufacturing. The ruling was appealed to determine the issue of whether an otherwise independent company over which an RHC has no operating control and only a minimal ownership interest, may be labelled an "affiliated enterprise" of the RHC under the MFJ, and whether a funding/royalty relationship such as that proposed by Ameritech is permissible under the MFJ. In December 1993, the D.C. Circuit Court ruled that the MFJ bans all arrangements in which RHCs have a direct and continuing share in the revenues of entities engaged in restricted activities. However, Ameritech's waiver request was remanded to the Court for further consideration and is pending. The Corporation has requested relief with regard to certain paging services, as described below. Although the Corporation recently sold its paging services subsidiary, these requests are being pursued as they may have relevance to other aspects of the Corporation's business. In February 1989, the Court granted a waiver permitting the RHCs to provide multi-LATA one-way paging services regardless of geographic scope, but included a condition requiring the interexchange links for multi-LATA paging services to be obtained from unaffiliated interexchange carriers. The Corporation appealed that portion of the order which prohibited it from owning the interexchange links outside the service territory of the Telephone Company. In October 1990, the D.C. Circuit Court reversed the Court's decision and remanded the matter to the Court for reconsideration. This matter is still pending. In January 1993, the Corporation filed a request for a waiver to provide interLATA paging origination and access to voice storage and retrieval services. This waiver would permit the origination of pages from outside of LATA boundaries and permit paging subscribers to access their voice-mail messages from outside of a LATA. This request is pending with the Court. Principal Services The Telephone Company's principal services include local services, network access and long-distance (i.e., toll) services, which are provided in the states of Arkansas, Kansas, Missouri, Oklahoma and Texas (five-state area). Local services involve the transport of telecommunications traffic between telephones and other CPE located within the same local service calling area. Local services include: basic local exchange service, extended area service, dedicated private line services for voice and special services, directory assistance and various vertical services. Vertical services represent discretionary, generally nonregulated, services which a customer may choose to supplement his/her basic line, such as: call waiting, call forwarding, call blocking, etc. Toll services involve the transport of traffic between local calling areas within the same LATA, and include such services as Wide Area Telecommunications Service (WATS or 800 services) and other special services. Network access services link a subscriber's telephone or other equipment to the transmission facilities of other non-Telephone Company carriers which, in turn, provide long-distance and other communications services. Network access is either switched, which uses a switched communications path between the carrier and the customer, or special, which uses a direct nonswitched path. The following table sets forth for the Telephone Company the percentage of total operating revenues by any class of service which accounted for 10 percent or more of total operating revenues in any of the last three fiscal years. Percentage of Total Operating Revenues 1993 1992 1991 Charges for local service 48% 48% 48% Charges to interexchange carriers for network access 26% 26% 25% Charges for long- distance (i.e., toll service) 12% 13% 14% Major Customer See Note 10, "Segment and Major Customer Information", on page 38 of this report. Government Regulation In the five-state area, the Telephone Company is subject to regulation by state commissions which have the power to regulate intrastate rates and services, including local, toll, private line and network access (both intraLATA and interLATA access within the state) services. The Telephone Company is also subject to the jurisdiction of the Federal Communications Commission (FCC) with respect to foreign and interstate rates and services, including interstate access charges. Access charges are designed to compensate the Telephone Company for the use of its facilities for the origination or termination of long- distance and other communications by non-Telephone Company carriers. Additional information relating to federal and state regulation of the Telephone Company is contained in Item 7, Management's Discussion and Analysis of Results of Operations of this report under the heading "Regulatory Environment" beginning on page 17 of this report. Principal Markets The Telephone Company provides its services along approximately 9 million residential and 4 million business access lines in the five-state area. During 1993, more than half of the Telephone Company's access line growth occurred in Texas. In 1993, 1992 and 1991, approximately 73 percent of the Telephone Company's total operating revenues were attributable to intrastate operations. Status of New Services During 1993, the Telephone Company continued to expand its offering of optional services, known as Easy Options. These options include, among others: Caller ID, a feature which displays the telephone number of the person calling and, by next year, will also display the caller's name in certain markets; Call Return, a feature that redials the number of the last incoming call; and Call Blocker, a feature which allows customers to automatically reject calls from a designated list of telephone numbers. Recent changes in Texas law will allow the Telephone Company to introduce Caller ID in its largest markets during 1994 and 1995. Caller ID is now being offered in certain markets in all of the states in the Telephone Company's five-state area. The FCC has promulgated certain rules that impact the manner in which the Telephone Company may offer enhanced services, which generally include services which are more than basic transmission services. Under FCC decisions known as Computer Inquiry III, the Telephone Company is permitted to offer enhanced services either on its own or jointly with its affiliates, subject to nonstructural safeguards, designed to permit the Telephone Company's competitors to acquire needed network services on an efficient, non-discriminatory basis and to reduce the risk of cross-subsidization. These safeguards include accounting and reporting procedures, and Open Network Architecture (ONA) requirements, which represent the Telephone Company's plan essentially to provide equal access to its network to all enhanced service providers. Enhanced services are deregulated at the federal level, and none of the Telephone Company's state commissions have, as yet, asserted jurisdiction over intrastate enhanced services. In December 1991, after various court proceedings, the FCC slightly modified the original Computer Inquiry III nonstructural competitive safeguards. The Telephone Company received FCC acknowledgement of its initial ONA implementation in November 1992. However, the current modified Computer Inquiry III nonstructural safeguards are subject to an appeal now pending at the U.S. Court of Appeals for the Ninth Circuit. Competition Competition is growing in the telecommunications industry. Regulatory and court decisions have expanded the number of alternative service providers offering telecommunications services. Technological advances have expanded the types and uses of services and products available. Accordingly, the Corporation faces increasing competition in significant portions of its business. The Telephone Company currently faces competition from, but not limited to, competitive access providers (CAPs), private networks, residential multi-tenant services, interexchange carriers, cellular providers, resellers and providers of telecommunications equipment. CAPs typically build fiber optic "rings" throughout large metropolitan areas to provide transport services (generally high-speed data) for large business customers and interexchange carriers. Also, an increasing number of individual firms, particularly large business customers, have established their own private network systems to transmit voice and data, bypassing Telephone Company facilities. The extent of the economic incentive to bypass the local exchange network depends upon local exchange prices, access charges, regulatory policy and other factors. End user charges ordered by the FCC are designed to mitigate the effect of system bypass. Recent regulatory rulings have sought to expand competition for special and switched access services. Special access refers to a dedicated transmission path, used primarily by large business customers and long-distance carriers, which does not involve switching at the local exchange carrier central office. Switched access refers to the link between local exchange carriers' switching facilities and long-distance carriers' networks; switched access transport is one component of this process. In October 1992, the FCC released an order requiring large local exchange carriers, including the Telephone Company, to file tariffs permitting independent parties to physically collocate (i.e., locate) their equipment within local exchange carrier central offices for purposes of providing certain special access services. Local exchange carriers were also required to work out virtual collocation agreements for central offices where there is insufficient space for physical collocation. Virtual collocation involves a set of technical and pricing rules intended to position the interconnector as if its equipment were located in the central office. Tariffs were filed in February 1993, and became effective in June 1993. In November 1992, the Telephone Company joined with 11 local exchange carriers in a petition filed with the FCC to stay the physical collocation requirement, and also filed a separate petition to stay the virtual collocation requirement. After denial of the petitions, the Telephone Company and several other local exchange carriers filed an appeal with the D.C. Circuit Court. Oral arguments were presented in February 1994. In September 1993, the FCC released an order essentially imposing the same collocation requirements for switched access transport services as for special access services. In November 1993, the Telephone Company and other local exchange carriers filed an appeal of that order as well. Switched access transport collocation tariffs were filed in November 1993, and became effective in February 1994. State regulatory commissions are also addressing issues pertaining to CAPs. In Texas, the Texas Public Utility Commission (TPUC) was asked to determine whether CAPs must first obtain a certificate of convenience and necessity before providing certain intrastate services. In response, the TPUC adopted a change to the definition of local exchange service that would allow CAPs to provide certain intrastate services without specific TPUC approval. The Telephone Company is appealing this decision. In February 1993, the TPUC denied a petition filed by a CAP seeking intrastate collocation, rate unbundling and the elimination of resale restrictions in Telephone Company tariffs, and indicated it would address these issues in separate proceedings. In Missouri, CAPs are permitted to provide certain services, including special access and interexchange and intraexchange private line services, upon a showing of financial viability and authorization from the Missouri Public Service Commission (MPSC). In Missouri, a number of CAPs are presently certified to offer services. The MPSC, in December 1992, granted the Telephone Company transitionally competitive status for toll, WATS, 800, operator and private line services, which has been appealed by several parties. This decision permits the Telephone Company to file minimum and maximum rates for those services, within which it can change rates without prior MPSC approval once enabling tariffs are approved. The Telephone Company plans to file for these rates in early 1994. In February 1993, the Arkansas Public Service Commission issued an order granting Tier 1 local exchange carriers, including the Telephone Company, the choice between physical and virtual collocation. The Telephone Company has appealed that decision to the Arkansas Court of Appeals. The Oklahoma Corporation Commission (OCC) issued an order in February 1993, adopting a policy of local exchange carriers discretion to choose between physical and virtual collocation. In Texas, the TPUC adopted a rule in January 1994, requiring expanded interconnection for special access services on terms similar to the interstate tariffs. The rule also requires the Telephone Company to provide expanded interconnection for private line services, and to unbundle special access and private line services. In Missouri, the MPSC has initiated preliminary discussions on expanded interconnection. The Kansas Corporation Commission (KCC) presently does not authorize intrastate collocation. The Telephone Company faces increasing competition in its intraLATA toll markets, primarily from interexchange carriers and resellers. IntraLATA toll competition currently exists in various forms in Arkansas, Missouri and Texas. In Kansas, certain types of intraLATA toll competition went into effect in November 1993. And in Oklahoma, the OCC is currently considering an Administrative Law Judge's recommendation to allow certain types of intraLATA toll competition. In the future, it is likely that additional competitors will emerge in the telecommunications industry. Cable television companies and electric utilities have expressed an interest in providing telecommunications services. Interexchange carriers have also expressed interest in providing local service, either directly or through alternative wireless networks, and one carrier has publicly announced its intent to provide local service in certain markets, some of which may be in the Telephone Company's five-state area. During 1993, several RHCs announced mergers, acquisitions, or investments in domestic cable companies, subject to court and regulatory approval. As a result of these mergers and acquisitions, the Corporation may face competition from entities offering both cable and telephone services over their transport mediums in the Telephone Company's operating territory. In September 1993, the FCC adopted an order allocating radio spectrum and outlining development of licenses for new personal communications services (PCS). PCS utilizes wireless telecommunications technology, using different radio spectrum than cellular, and, like cellular, is designed to permit access to a variety of communications services regardless of subscriber location. Under an auction process scheduled to begin in May 1994, up to seven new licenses could be awarded in each of 51 geographic areas. Licenses may be combined by spectrum amounts and geographically, including creation of a nationwide service. The Telephone Company will monitor the auction of PCS licenses within its operating area to assess competitive impacts. Competitive opportunities may arise as a result of pending legislative and legal proceedings. Legislation has recently been introduced in the United States Congress which, if adopted, could allow the Corporation to enter previously restricted lines of business. Specifically, provisions of certain of these bills seek to eliminate or modify restrictions imposed at divestiture by the MFJ related to electronic publishing, telecommunications equipment manufacturing and interLATA telecommunications services, and would allow local exchange carriers to compete in the cable television business in their own areas. In addition, pricing flexibility could be granted for services subject to competition. In February 1994, the Corporation filed a lawsuit in the U.S. District Court in Dallas, seeking to overturn provisions of the Cable Communications Policy Act of 1984, in order to provide cable television service in the Telephone Company's five-state area. The outcome of these proceedings cannot be predicted at this time. The Corporation is aggressively representing its interests regarding competition before federal and state regulatory bodies and courts, and before Congress and state legislatures, and will continue to evaluate the increasingly competitive nature of its business and the appropriate regulatory, legislative and industry solutions needed to respond effectively to competition. The Telephone Company currently accounts for the economic effects of regulation in accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). Continued application of Statement No. 71 is appropriate only if it is reasonable to assume that rates designed to recover costs can be charged to and collected from customers. This assumption requires, among other things, consideration of anticipated changes in levels of demand or competition during the recovery period for any capitalized costs. It is management's opinion that application of Statement No. 71 to the Telephone Company is appropriate at this time. If, as a result of actual and anticipated increases in competition and other changes in the telecommunications industry, including the manner of determining rates, the Telephone Company determines that it no longer qualifies for the provisions of Statement No. 71, management expects that the resulting non-cash extraordinary charge would be material. Research and Development The majority of company-sponsored basic and applied research activities are conducted at Bell Communications Research, Inc. (Bellcore). The Telephone Company owns a one-seventh interest in Bellcore along with the other six RHCs. Bellcore is also the coordinator for the Federal government's telecommunications requirements on national security and emergency preparedness. Basic and applied research is also conducted at Southwestern Bell Technology Resources, Inc. (TRI), a subsidiary of the Corporation. TRI provides technology planning and assessment services to the Telephone Company. Employees As of January 31, 1994, the Telephone Company employed 49,370 persons. Approximately 76 percent of the employees are represented by the Communications Workers of America (CWA). Effective in August 1992, a three-year contract was negotiated between the CWA and the Telephone Company. This contract will be subject to renegotiation in mid-1995. Item 2. Item 2. Properties. The properties of the Telephone Company do not lend themselves to description by character and location of principal units. At December 31, 1993, network access lines represented 45 percent of the Telephone Company's investment in telephone plant; central office equipment represented 36 percent; land and buildings represented 10 percent; other miscellaneous property, comprised principally of furniture and office equipment and vehicles and other work equipment, represented 7 percent; and information origination/termination equipment represented 2 percent. Item 3. Item 3. Legal Proceedings. Not applicable PART II Item 6. Item 6. SOUTHWESTERN BELL TELEPHONE COMPANY SELECTED FINANCIAL AND OPERATING DATA At December 31, or for the year ended 1993 1992 Return on Weighted Average 12.48%* 10.71% Total Capital Debt Ratio (debt, including 48.58%** 41.31% current maturities, as a percentage of total capital) Network access lines in 13,238 12,803 service (000) Access minutes of use 43,767 41,235 (000,000) Long-distance messages 1,093 1,057 (000,000) Number of employees 49,320 49,960 * Calculated using income before extraordinary loss and cumulative effect of changes in accounting principles. These impacts are included in shareowner's equity. ** Shareowner's equity used in debt ratio calculation includes extraordinary loss and cumulative effect of changes in accounting principles. Item 7. Item 7. Management's Discussion and Analysis of Results of Operations. Dollars in Millions Southwestern Bell Telephone Company (Telephone Company) provides telecommunications services through approximately 13.2 million access lines in Arkansas, Kansas, Missouri, Oklahoma and Texas (five-state area). The Telephone Company is a public utility subject to regulation by each of the state jurisdictions in which it operates and by the Federal Communications Commission (FCC). The Telephone Company is a wholly-owned subsidiary of Southwestern Bell Corporation (Corporation). This discussion should be read in conjunction with the financial statements and the accompanying notes. Results of Operations Summary Financial results, including changes from the prior year, are summarized as follows: Percent change 1992 vs. 1993 1992 1993 Operating revenues $ 8,072.9 $7,744.0 4.2% Operating expenses $ 6,240.9 $6,040.0 3.3% Income before extraordinary loss and accounting changes $ 1,015.0 $ 964.1 5.3% Extraordinary loss $ (153.2) - - Accounting changes $(1,849.4) - - Net income (loss) $ (987.6) $ 964.1 (202.4)% The Telephone Company reported income before extraordinary loss and cumulative effect of changes in accounting principles of $1,015.0. Extraordinary loss associated with early extinguishment of debt was $153.2. The adoption of financial accounting standards relating to postretirement benefits, postemployment benefits and income taxes resulted in one-time charges of $1,849.4 in the first quarter of 1993. As a result, net loss for the year was $987.6. The primary factors contributing to the increase in income before extraordinary loss and cumulative effect of changes in accounting principles in 1993 were the growth in demand for services and products and the decrease in license fees for switching system software. These factors were partially offset by increased postretirement benefit and depreciation expenses, accruals for potential rate reductions, and a one-time charge for restructuring. Items affecting the comparison of the operating results between 1993 and 1992 are discussed in the following sections. Operating Revenues Total operating revenues increased $328.9, or 4.2 percent, in 1993. Revenue components of total operating revenues, including changes from the prior year, are as follows: Percent change 1993 vs. 1993 1992 1992 Local service $ 3,898.3 $ 3,727.3 4.6% Network access Interstate 1,804.7 1,710.3 5.5 Intrastate 880.7 837.5 5.2 Long-distance service 965.7 1,003.4 (3.8) Other 523.5 465.5 12.5 $ 8,072.9 $ 7,744.0 4.2% Local Service revenues increased in 1993 due primarily to increases in demand, including growth in the number of access lines of 3.4 percent. Nearly two-thirds of the access line growth occurred in Texas. Local service revenues for the period also increased as a result of extended area service plans which expand the area defined as local service. Network Access Interstate network access revenues increased in 1993 due primarily to increases in demand for access services and growth in revenues from end user charges attributable to an increasing access line base. These increases were partially offset by decreases in recognized interstate rates. Intrastate network access revenues increased in 1993 due primarily to increases in demand. These increases were partially offset by previously ordered rate reductions, primarily in Texas. Long-Distance Service revenues decreased in 1993 due mainly to accruals for potential rate reductions in Oklahoma and the impact of extended area service plans. These decreases were partially offset by increases in demand for long-distance services. Although extended area service plans have had a negative effect on long-distance service revenues, this effect is partially offset by related increases in local service revenues, as noted in the discussion of local service revenues. Other revenues increased in 1993 due primarily to increases in demand for the Telephone Company's nonregulated services and products. Operating Expenses Total operating expenses increased $200.9, or 3.3 percent, in 1993. Expense components of total operating expenses, including changes from the prior year, are as follows: Percent change 1993 vs. 1993 1992 1992 Cost of services and products $ 2,519.1 $ 2,594.3 (2.9)% Selling, general and administrative 2,022.2 1,830.7 10.5 Depreciation and amortization 1,699.6 1,615.0 5.2 $ 6,240.9 $ 6,040.0 3.3% Cost of Services and Products decreased in 1993 due primarily to a decrease in license fees for switching system software. Increased switching system software expenses in 1992 were associated with advanced calling features and an accelerated implementation of a single national database of 800 numbers as mandated by the FCC. This decrease was partially offset by costs related to increased demand for services and products, and annual compensation increases. Selling, General and Administrative expenses increased in 1993 due primarily to the increase of approximately $110 in postretirement benefits expense required by the adoption of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (Statement No. 106) as discussed in Note 2 to the financial statements. The increased expenses also reflect a one-time charge for restructuring, as further discussed in "Other Business Matters," as well as increases in property and other taxes and annual compensation increases. Depreciation and Amortization increased in 1993 mainly due to changes in plant level and composition. This increase was partially offset by a decrease in reserve deficiency amortization. Interest Expense decreased $23.5, or 5.7 percent, in 1993. The decrease was due primarily to lower interest rates on long-term debt refinanced during 1993. Other Income - Net decreased $52.0 in 1993. The decrease was due primarily to the absence of interest income associated with the settlement of federal income tax audit issues in 1992 and to increases in legislative advocacy expenses in Texas. Federal Income Tax expense increased $47.7, or 15.1 percent, in 1993, primarily due to higher income before income taxes. Based on comparable results, management estimates that the change in tax rates and other provisions of the Omnibus Budget Reconciliation Act will decrease net income in 1994 by approximately $25-$30. Extraordinary Item The Telephone Company recorded an extraordinary charge of $153.2 in 1993 as a result of refinancing $2,100 of long-term debt. See Note 7 to the financial statements for additional information. Operating Environment and Trends of the Business Regulatory Environment The Telephone Company operates in a five-state area comprised of Arkansas, Kansas, Missouri, Oklahoma and Texas. The intrastate telecommunications operations of Arkansas, Missouri and Oklahoma are currently regulated under traditional rate-of-return methodology. Since 1990, Kansas and Texas intrastate telecommunications operations have been governed by alternative forms of regulation. The Telephone Company's interstate telecommunications operations in the five states are regulated by the FCC, using, since 1991, a price-cap methodology. The Texas Public Utility Commission (TPUC) requires that certain ratemaking adjustments be made to the Telephone Company's reported earnings in order to compute earnings subject to sharing according to its regulatory plan. These adjustments, however, are not used in preparing the published financial statements. Similarly, other jurisdictions may require that adjustments be made to reported earnings in order to compute regulatory returns. As a result, differences may exist between the returns reported to these regulatory bodies and those computed from Telephone Company financial information included in the financial statements. Following is a summary of significant regulatory proceedings. Missouri Missouri has completed its fourth and final year under an incentive regulation plan (Missouri Plan), formed as part of a September 1989 agreement among the Missouri Public Service Commission (MPSC), Office of Public Counsel (OPC) and the Telephone Company. Under its terms, the Telephone Company was required to reduce annual revenues, effective October 1989, by approximately $82, and upgrade its network in Missouri between 1990 and 1997 at an estimated cost of $180. The Missouri Plan also provided for a sharing of earnings between the Telephone Company and its customers at certain rate-of-return thresholds. Revenue sharing amounts for 1990 and 1991 were refunded to customers in June 1991 and June 1992, respectively, with no material impact on financial results. The Telephone Company was not required to share revenues for 1992, and expects that sharing for 1993, if any, will be minimal. In October 1992, the Telephone Company, the MPSC staff and OPC filed separate recommendations to the MPSC concerning the success of the Missouri Plan and proposing changes in procedures and parameters. The Missouri Plan, originally scheduled to expire on December 31, 1992, was ordered extended until December 31, 1993, to allow for consideration of the various proposals. The MPSC staff filed a complaint with the MPSC in January 1993 alleging that, under traditional rate-of-return methods, the Telephone Company's intrastate rates should be reduced by $150 annually. In December 1993, the MPSC issued an order requiring rate reductions of $84.6 annually, beginning January 1, 1994. The order also offered the Telephone Company the option of participating in a five-year Accelerated Modernization Plan (AMP). The AMP would have required annual revenue reductions of $84.6, a five-year rate freeze, as well as continued revenue sharing and accelerated network modernization. In December 1993, the Telephone Company declined the AMP offer on the basis that it would be detrimental to the Telephone Company, and obtained a temporary restraining order from the Cole County Circuit Court (Circuit Court), temporarily preventing enforcement of the ordered rate reductions. In February 1994, the Circuit Court granted a stay of the ordered rate reductions, pending disposition on appeal. All revenues in excess of the MPSC proposed reduced rates are being paid to the Circuit Court at this time and will not be reflected in 1994 operating revenues. The MPSC order did not impact 1993 financial results. The final impact of the order on future financial results cannot be determined until all issues are resolved. Oklahoma In January 1989, the Oklahoma Corporation Commission (OCC) ordered an investigation into the reasonableness of the Telephone Company's intrastate rates. A final order was issued in August 1992, requiring the Telephone Company to refund revenues in excess of 11.41 percent return on equity, effective April 1991 through the date of the final order. The ordered refund obligation is $148.4. The OCC order also would reduce annual revenues by $100.6 effective September 1992 (of which $24.5 relates to wide-area calling plans which had already been implemented when the order was issued, and $7.4 relates to expanded wide-area calling plans implemented during 1993 through March 1994), partially offset by a positive annual revenue adjustment of $7.8 to compensate the Telephone Company for its investment of $84 over five years for network modernization. The order would also lower the allowed return on equity from 14.25 percent to 12.20 percent. In addition, the order denies recovery of depreciation expense associated with certain network assets and changes the regulatory method of accounting for pension expense. These actions could result in a maximum one-time reduction in net income of approximately $36. In September 1992, the Telephone Company appealed to the Oklahoma Supreme Court which suspended the effectiveness of the entire order pending final disposition. This appeal is still pending. The Telephone Company is contesting all aspects of the OCC's actions. Although it is unable to predict the outcome of the proceeding at this time, management believes that the OCC-ordered refund of revenues collected before the date of the OCC's August 1992 order is illegal under Oklahoma law, and will be overturned by the Court. The Court may require the Telephone Company to implement some portion of the annual rate reductions indicated in the OCC order. Management is unable to determine the outcome of the remaining portions of the OCC order. Ultimate resolution of the entire OCC order is not expected to have a material impact on financial results. In 1986, the OCC made an inquiry into the effects of the Tax Reform Act of 1986 on the Telephone Company. As a result, in October 1989, the OCC concluded that the Telephone Company had a revenue surplus of $27.5, and required the Telephone Company to invest this surplus, together with interest, to upgrade its network in Oklahoma rather than refund it to customers. In addition, prospective annual rate reductions totaling $7.8 were ordered, effective October 1989. In October 1989, the OCC order was appealed to the Oklahoma Supreme Court by various parties, including the Telephone Company. In December 1991, the Court upheld the portion of the OCC's decision that required the Telephone Company to invest the revenue surplus in network upgrades. The Court also determined that the OCC's finding of a depreciation reserve deficiency was not supported by substantial evidence and that the OCC's treatment of employee severance payments and cash working capital analysis was inappropriate. The OCC has not reconsidered the remand issues. A prehearing conference has been scheduled for April 1994. Although the final outcome of the OCC's reconsideration is uncertain at this time, management does not expect the decision to have a material future impact on financial results. Texas The Telephone Company has completed the third year of its four-year incentive regulation agreement (the Agreement), which was approved by the TPUC in November 1990. Under the terms of the Agreement the Telephone Company has agreed, over a four-year period ending November 29, 1994, to cap certain local rates, provide annual rate reductions and other benefits to customers in Texas, and upgrade the network at a cost of approximately $329. Rate reductions and customer benefits for 1991 were approximately $246. Additional rate reductions of $34 and $21 were implemented in 1992 and 1993, respectively, and additional rate reductions of approximately $146 will be implemented in 1994. The Agreement also provides an earnings-sharing mechanism designed to encourage efficiency and innovation by the Telephone Company. Revenue sharing amounts for 1991 and 1992 were refunded to customers in 1993, with no material impact on financial results. Management expects that sharing for 1993, if any, will be minimal. In 1991, the Agreement was appealed through the courts, and, in February 1993, the Texas Court of Appeals (Appeals Court) upheld the Agreement, but found that the TPUC incorrectly applied laws on the treatment of federal income tax benefits related to disallowed expenses and directed the matter back to the TPUC for resolution. In August 1993, the Telephone Company and opposing intervenors filed appeals in the Texas Supreme Court, and the matter is pending. In October 1992, the Office of Public Utility Counsel (OPUC) filed a petition for inquiry into the rates of the Telephone Company, alleging that the Telephone Company had realized excess annual earnings of approximately $234, which the sharing mechanism failed to capture. The Telephone Company filed a motion to dismiss in November 1992. In July 1993, TPUC granted the Telephone Company's motion to dismiss. Postretirement Benefits Other Than Pensions The adoption of Statement No. 106 for ratemaking purposes has been addressed by regulatory authorities in most of the Telephone Company's state jurisdictions. See Note 2 to the financial statements for additional information on Statement No. 106. Texas and Arkansas, through commission order, and Kansas, through stipulation and commission order, have agreed to accrual accounting for postretirement benefit expenses, with some funding requirements. In Missouri, the MPSC has ordered continued pay-as-you-go treatment for postretirement benefit expenses. The Telephone Company intends to appeal this order. In Oklahoma, the OCC has not ruled on the issue, although OCC staff has recommended accrual accounting for postretirement benefit expenses, with some funding requirements. An FCC order issued in December 1991 required all local exchange carriers to use the amortization method for recognition of the transition benefit obligation. In June 1992, the Telephone Company asked the FCC for the ability to increase its price caps to take into account the incremental interstate costs resulting from the accrual accounting required by Statement No. 106 (referred to as exogenous treatment). In January 1993, the FCC issued an order denying exogenous treatment for these incremental costs, but did not preclude the seeking of exogenous treatment of the transition benefit obligation in a separate filing in 1993. In February 1993, the Telephone Company joined with other local exchange carriers in an appeal of the January 1993 FCC order. In April 1993, the Telephone Company filed tariffs with the FCC requesting exogenous treatment of the transition benefit obligation. In June 1993, the FCC allowed the proposed rates to go into effect on July 1, 1993, subject to further investigation which could result in future refunds for all or part of the amount attributable to the transition benfit obligation. Potential refunds are currently being accrued by the Telephone Company; however, any future refunds are not expected to have a material impact on financial results. Competition Information relating to actual and potential competition impacting the Telephone Company's local exchange, vertical services, access and intraLATA toll revenues is included under the heading "Competition" in Item 1 on page 8 of this report. Other Business Matters Operational Restructuring During the third quarter of 1993, the Telephone Company announced a restructuring of its operations. The restructuring realigns the Telephone Company into two operating divisions, Customer Services, comprised of nine geographic market areas, and Network Services, which focuses on technology planning and deployment. As part of the restructuring, approximately 800 management positions were eliminated during 1993. Costs for severance, relocation and benefits associated with the positions currently eliminated were accrued during 1993, reducing net income by approximately $35. Over the next 18 to 24 months, approximately 700 additional management positions will be eliminated. Pending Litigation The Telephone Company is presently engaged in litigation with four Texas cities arising from the Telephone Company's alleged breach of certain ordinances relating to the Telephone Company's use of, and work activities in, streets and other public ways. The cases are entitled City of Mesquite v. Southwestern Bell Telephone Company, et al., and City of Harlingen and City of Brownsville v. Southwestern Bell Telephone Company, et al., in the U.S. District Court for the Northern District of Texas, and City of Port Arthur, et al., v. Southwestern Bell Telephone Company, et al., in the 136th Judicial District Court of Jefferson County, Texas. The City of Port Arthur action was certified as a class action on November 20, 1992. The certification order has been appealed by the Telephone Company. If the class certification is affirmed, the class could include approximately 110 Texas cities. The ordinances provide for the payment of a percentage of the gross receipts received by the Telephone Company from the provision of certain services within the cities. While the particular claims of the cities vary, they all allege that the Telephone Company should have included revenues received from other services in calculating the compensation described in the ordinances. The cities have demanded general unspecified actual and exemplary damages or have not specifically alleged the amount of damages resulting from the gross receipts claims. The Telephone Company believes it has several meritorious defenses to the claims and intends to vigorously pursue these defenses. Although the outcomes of these cases are uncertain, the Telephone Company believes that it will either be successful on the merits of the cases or that any unfavorable result will not have a material impact on the financial results. Item 8. Item 8. Financial Statements and Supplementary Data. Report of Independent Auditors The Board of Directors Southwestern Bell Telephone Company We have audited the accompanying balance sheets of Southwestern Bell Telephone Company as of December 31, 1993 and 1992, and the related statements of income, shareowner's equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14 (a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Southwestern Bell Telephone Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 2 and 3 to the financial statements, in 1993 the Company changed its method of accounting for postretirement benefits other than pensions, postemployment benefits and income taxes. /s/ Ernst & Young San Antonio, Texas February 11, 1994 Southwestern Bell Telephone Company Statements of Income (Dollars in millions) 1993 1992 1991 Operating Revenues Local service $ 3,898.3 $ 3,727.3 $ 3,527.9 Network access 2,685.4 2,547.8 2,440.8 Long-distance service 965.7 1,003.4 1,020.4 Other 523.5 465.5 435.0 Total operating revenues 8,072.9 7,744.0 7,424.1 Operating Expenses Cost of services and products 2,519.1 2,594.3 2,433.5 Selling, general and administrative 2,022.2 1,830.7 1,719.4 Depreciation and amortization 1,699.6 1,615.0 1,555.5 Total operating expenses 6,240.9 6,040.0 5,708.4 Operating Income 1,832.0 1,704.0 1,715.7 Other Income (Expense) Interest expense (385.2) (408.7) (456.3) Other income (expense) - net (22.6) 29.4 26.9 Total other income (expense) (407.8) (379.3) (429.4) Income Before Income Taxes, Extraordinary Loss and Cumulative Effect of Changes in Accounting Principles 1,424.2 1,324.7 1,286.3 Income Taxes Federal 364.4 316.7 316.6 State and local 44.8 43.9 33.7 Total income taxes 409.2 360.6 350.3 Income Before Extraordinary Loss and Cumulative Effect of Changes in Accounting Principles 1,015.0 964.1 936.0 Extraordinary Loss on Early Extinguishment of Debt, net of tax (153.2) - (80.7) Cumulative Effect of Changes in Accounting Principles, net of tax (1,849.4) - - Net Income (Loss) $ (987.6) $ 964.1 $ 855.3 The accompanying notes are an integral part of the financial statements. Southwestern Bell Telephone Company Balance Sheets (Dollars in millions) December 31, 1993 1992 Assets Current Assets Cash and cash equivalents $ 37.8 $ 44.9 Accounts receivable - net of allowances for uncollectibles of $14.2 and $11.3 1,375.0 1,259.6 Material and supplies 129.0 121.5 Deferred charges 46.8 53.4 Deferred income taxes 152.4 79.5 Prepaid expenses and other current assets 56.6 63.0 Total current assets 1,797.6 1,621.9 Property, Plant and Equipment - Net 15,699.1 15,666.1 Other Assets 401.7 570.6 Total Assets $17,898.4 $17,858.6 Liabilities and Shareowner's Equity Current Liabilities Debt maturing within one year $ 663.0 $ 466.5 Accounts payable and accrued liabilities 2,160.0 2,002.8 Total current liabilities 2,823.0 2,469.3 Long-Term Debt 4,383.0 4,524.5 Deferred Credits and Other Noncurrent Liabilities Deferred income taxes 1,746.7 3,162.2 Postemployment benefit obligation 2,817.7 - Unamortized investment tax credits 429.8 495.3 Other noncurrent liabilities 356.7 116.2 Total deferred credits and other noncurrent liabilities 5,350.9 3,773.7 Commitments (Note 5) Shareowner's Equity Common stock - one share, without par value, owned by parent 1.0 6,469.9 Paid-in surplus 5,706.9 - Retained earnings (deficit) (366.4) 621.2 Total shareowner's equity 5,341.5 7,091.1 Total Liabilities and Shareowner's Equity $17,898.4 $17,858.6 The accompanying notes are an integral part of the financial statements. Southwestern Bell Telephone Company Statements of Cash Flows (Dollars in millions, increase (decrease) in cash and cash equivalents) 1993 1992 1991 Operating Activities Net income (loss) $ (987.6) $ 964.1 $ 855.3 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 1,699.6 1,615.0 1,555.5 Provision for uncollectible accounts 66.0 62.6 67.3 Amortization of investment tax credits (65.5) (72.0) (86.7) Pensions and other postemployment expenses 262.2 66.3 (55.2) Deferred income tax expense (163.8) (99.0) (70.0) Extraordinary loss, net of tax 153.2 - 80.7 Cumulative effect of accounting changes, net of tax 1,849.4 - - Changes in operating assets and liabilities: Accounts receivable (176.7) (145.5) (72.0) Other current assets (36.9) (37.2) (7.4) Accounts payable and accrued liabilities 245.3 104.4 126.3 Other - net (220.5) 256.1 43.4 Total adjustments 3,612.3 1,750.7 1,581.9 Net Cash Provided by Operating Activities 2,624.7 2,714.8 2,437.2 Investing Activities Construction and capital expenditures (1,667.8) (1,617.4) (1,475.3) Net Cash Used in Investing Activities (1,667.8) (1,617.4) (1,475.3) Financing Activities Net change in short-term borrowings with original maturities of three months or less 38.1 (189.9) 318.8 Issuance of other short-term borrowings 16.0 521.4 - Repayment of other short-term borrowings (137.6) (394.8) - Issuance of long-term debt 2,086.1 284.3 397.4 Repayment of long-term debt (10.7) (11.1) (7.8) Early extinguishment of debt and related call premiums (2,190.3) (355.6) (799.5) Dividends paid (865.6) (960.6) (855.4) Equity from parent 100.0 - - Net Cash Used in Financing Activities (964.0) (1,106.3) (946.5) Net increase (decrease) in cash and cash equivalents (7.1) (8.9) 15.4 Cash and cash equivalents beginning of year 44.9 53.8 38.4 Cash and Cash Equivalents End of Year $ 37.8 $ 44.9 $ 53.8 The accompanying notes are an integral part of the financial statements. Southwestern Bell Telephone Company Statements of Shareowner's Equity (Dollars in Millions) Retained Common Paid-in Earnings Stock Surplus (Deficit) Balance, December 31, 1991 $ 6,469.9 $ - $ 621.2 Net income - - 964.1 Dividend to shareowner - - (964.1) Balance, December 31, 1992 6,469.9 - 621.2 Net income (loss) - - (987.6) Dividend to shareowner - (862.0) - Equity from parent - 100.0 - Transfer of equity (6,468.9) 6,468.9 - Balance, December 31, 1993 $ 1.0 $ 5,706.9 $ (366.4) The accompanying notes are an integral part of the financial statements. 1. Summary of Significant Accounting Policies Southwestern Bell Telephone Company (Telephone Company) is a regulated utility which provides telecommunications services to customers in Arkansas, Kansas, Missouri, Oklahoma and Texas. The Telephone Company is a wholly-owned subsidiary of Southwestern Bell Corporation (Corporation). Regulatory Accounting The Telephone Company prepares its financial statements in accordance with the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). The provisions of Statement No. 71 require, among other things, that regulated enterprises reflect rate actions of regulators in their financial statements, when appropriate. These rate actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset, or impose a liability on a regulated enterprise. Allowance for Funds Used During Construction Where capital invested by the Telephone Company in construction projects is not allowed in the rate base upon which revenue requirements are determined, it is the practice of regulatory authorities to allow, in lieu thereof, a capitalization of interest and equity costs during periods of construction. These capitalized costs are reflected as income during the construction period and as an addition to the cost of plant constructed, and are included in other income (expense)-net on the Telephone Company's Statements of Income. Income Taxes The Telephone Company is included in the Corporation's consolidated federal income tax return. Federal income taxes are provided for in accordance with the provisions of the Tax Allocation Agreement (Agreement) between the Telephone Company and the Corporation. In general, the Telephone Company's income tax provision under the Agreement reflects the financial consequences of income, deductions and credits which can be utilized on a separate return basis or in consolidation with the Corporation and which are assured of realization. Deferred income taxes are provided for certain temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for tax purposes. Investment tax credits resulted from federal tax law provisions that allowed for a reduction in income tax liability based on certain construction and capital expenditures. Corresponding income tax expense reductions were deferred and are being amortized as reductions in income tax expense over the life of the property, plant and equipment that gave rise to the credits. Effective January 1, 1993, the Telephone Company adopted a new accounting standard for accounting for income taxes. See Note 3. Cash Equivalents Cash equivalents include all highly liquid investments with an original maturity of three months or less. The carrying amount of cash equivalents approximates fair value. Material and Supplies New and reusable materials are carried principally at average original cost. Specific costs are used for large individual items. Nonreusable material is carried at estimated salvage value. Property, Plant and Equipment The cost of additions and substantial betterments of property, plant and equipment is capitalized. Cost includes salaries and wages, material, applicable taxes, pensions and other benefits, allowance for funds used during construction and certain other items. The Telephone Company computes depreciation using certain straight-line methods as prescribed by the FCC and the applicable state regulatory authorities. The Telephone Company's provision for depreciation includes the amortization of interstate and certain intrastate accumulated depreciation deficiencies (reserve deficiency amortization). Reserve deficiency amortization allows additional depreciation to be recognized currently in an attempt to reflect more accurately prior years' actual consumption of telephone plant. When a portion of the Telephone Company's depreciable property, plant and equipment is retired, the gross book value is charged to accumulated depreciation. The cost of maintenance and repairs of property, plant and equipment,including the cost of replacing minor items not constituting substantial betterments, is charged to operating expenses. 2. Employee Retirement Benefits Pensions Substantially all employees of the Telephone Company are covered by noncontributory pension and death benefit plans sponsored by the Corporation. The pension benefit formula used in the determination of pension cost is based on a flat dollar amount per year of service according to job classification for nonmanagement employees, and a stated percentage of adjusted career income for management employees. The Corporation's objective in funding the plans, in combination with the standards of the Employee Retirement Income Security Act of 1974 (as amended), is to accumulate funds sufficient to meet its benefit obligations to employees upon their retirement. Contributions to the plans are made to a trust for the benefit of plan participants. Plan assets consist primarily of stocks, U.S. government and domestic corporate bonds and real estate. The following data relate to plan costs: 1993 1992 1991 Pension cost (credit) $ 21.6 $ 61.5 $ (57.5) Amount capitalized in property, plant and equipment $ 1.5 $ 11.5 $ (5.5) Assumed discount rate for determining projected benefit obligation 7.25% 7.5% 7.5% Assumed long-term rate of return on plan assets 8.0% 8.0% 7.75% Assumed composite rate of compensation increase 4.6% 4.6% 4.6% Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions", requires certain disclosures to be made of components of net periodic pension cost for the period and a reconciliation of the funded status of the plans with amounts reported in the balance sheets. Since the funded status of plan assets and obligations relates to the plans as a whole, which are sponsored by the Corporation, this information is not presented for the Telephone Company. As of December 31, 1993 and 1992, the amount of the Telephone Company's cumulative contributions made to the pension trust in excess of its cumulative amount of pension cost recognized was $251.8 and $396.6, respectively. Based on the actuarial valuations of each plan, the fair value of each plan's assets exceeded the estimated actuarial projected benefit obligation at December 31, 1993 and 1992. Savings Plans Substantially all employees are eligible to participate in contributory savings plans sponsored by the Corporation. Under the savings plans, the Telephone Company matches a stated percentage of eligible employee contributions, subject to a specified ceiling. Since 1990, the Telephone Company's match of employee contributions to the savings plans has been fulfilled with the Corporation's common stock allocated from two leveraged Employee Stock Ownership Plans and with purchases of the Corporation's stock in the open market. The costs relating to these savings plans were $43.5, $48.6 and $53.5 in 1993, 1992 and 1991, respectively. Voluntary Retirement Programs As a result of a March 1992 agreement with the Communications Workers of America (CWA), the Telephone Company offered a limited early retirement plan to designated nonmanagement employees which included incentives affecting service pension eligibility and amounts. Approximately 1,200 nonmanagement employees participated in this offer. The plan resulted in a charge to 1992 net income of approximately $24. In 1991, the Corporation amended the pension plan for management employees and offered incentives for managers of selected subsidiaries, including the Telephone Company, to retire or resign effective December 30, 1991. Approximately 3,500 managers participated in the program in 1991. The voluntary management retirement program resulted in a charge to 1991 net income of approximately $28 for the Telephone Company. Postretirement Benefits The Telephone Company provides certain medical, dental and life insurance benefits to substantially all retired employees. Effective January 1, 1993, the Telephone Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (Statement No. 106), which requires accrual of actuarially determined postretirement benefit costs as active employees earn these benefits. Prior to the adoption of Statement No. 106, the Telephone Company expensed retiree medical benefits when claims were incurred. In implementing Statement No. 106, the Telephone Company immediately recognized an accumulated obligation for postretirement benefits (transition obligation) in the amount of $2,756.9 and a related deferred income tax benefit of $976.2. The resulting 1993 charge to net income of $1,780.7 is included in the cumulative effect of changes in accounting principles in the Statement of Income. In accordance with Statement No. 71, a regulatory asset associated with the transition obligation was not recorded by the Telephone Company. In connection with the 1992 collective bargaining agreements negotiated between subsidiaries of the Corporation and the CWA, the Corporation established collectively bargained Voluntary Employee Beneficiary Association (CBVEBA) trusts to fund postretirement benefits. In March 1993, the Telephone Company contributed $132.3 into the CBVEBA trusts to be ultimately used for the payment of postretirement benefits. The Telephone Company also funds postretirement life insurance benefits at an actuarially determined rate. Assets consist principally of stocks and U.S. government and corporate bonds. Statement No. 106 requires certain disclosures to be made of components of net periodic postretirement benefit cost and a reconciliation of the funded status of the plans to amounts reported in the balance sheets. Since the funded status of assets and obligations relates to the plans as a whole, this information is not presented for the Telephone Company. The Telephone Company recognized postretirement benefit cost for 1993 of $238.8. Under the claims incurred method, expense would have been approximately $126.6. In 1992 and 1991, the cost of providing these postretirement benefits was $102.6 and $95.1, respectively. At December 31, 1993, the amount included in postemployment benefit obligation for postretirement benefits was $2,722.6. Certain actuarial assumptions were used by the Corporation to calculate postretirement costs under Statement No. 106. The accumulated postretirement benefit obligation (APBO) was determined using an assumed discount rate of 7.25 percent, a rate of future compensation increases of 4.6 percent, and an expected long-term rate of return on assets of 8.0 percent. The assumed medical cost trend rate in 1994 is approximately 10.5 percent, decreasing gradually to 5.5 percent in 2004, prior to adjustment of cost- sharing provisions of the plan for active and certain recently retired employees. The assumed dental cost rate in 1994 is 7.0 percent reducing to 5.0 percent in 2002. The discount rate used in determining the postretirement benefit cost is 7.5 percent. Raising the annual medical and dental cost trend rates by one percentage point increases the net periodic postretirement benefit cost for the year ended December 31, 1993 by approximately 7.5 percent. Postemployment Benefits Effective January 1, 1993, the Telephone Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112). Statement No. 112 requires accrual of disability pay, workers' compensation and medical benefits at the occurrence of an event that renders an employee inactive or, if the benefits ratably vest, over the vesting period. These expenses were previously recognized as the claims were incurred. A charge to net income of $60.1, after a deferred tax benefit of $32.9, is included in the cumulative effect of changes in accounting principles in the 1993 Statement of Income. Management does not anticipate that Statement No. 112 will materially affect ongoing postemployment benefit expense. 3. Income Taxes The Telephone Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109) effective January 1, 1993. In adopting Statement No. 109, the Telephone Company adjusted its net deferred income tax liability for all temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, computed based on provisions of the enacted tax law on a separate company basis. Financial statements prior to January 1, 1993, have not been restated to apply the provisions of Statement No. 109. The cumulative effect of adopting Statement No. 109 as of January 1, 1993 was to decrease net income for 1993 by $8.6. The adoption of Statement No. 109 had no material effect on pre-tax income. As a result of implementing Statement No. 109, the Telephone Company recorded a $431.4 net reduction in its deferred tax liability. The reduction in the deferred tax liability was caused primarily by deferred tax benefits provided for excess deferred taxes (arising from reduced tax rates, which are returned to customers through rates), and unamortized investment tax credits, partially offset by deferred taxes provided for temporary differences previously flowed through the ratepayers. This reduction was substantially offset by the establishment of a net regulatory liability in accordance with Statement No. 71, with minimal effect on net income. The net regulatory liability recognizes the differences between the recording of income taxes for financial reporting purposes and recovery of those taxes through telephone service rates. Amounts comprising the net liability will be amortized over the regulatory lives of the associated assets. Future regulatory proceedings may affect the period in which these amounts are recognized in net income. Significant components of deferred tax liabilities and assets as of December 31, 1993 are as follows: Depreciation $ 2,893.5 Employee benefits 116.3 Other 105.0 Gross deferred tax liabilities 3,114.8 Employee benefits 1,091.9 Unamortized investment tax credits 156.9 Other 271.7 Gross deferred tax assets 1,520.5 Net deferred tax liabilities $ 1,594.3 The components of income tax expense are as follows: 1993 1992 1991 Federal: Current $ 568.9 $ 489.4 $ 472.8 Deferred - net (139.0) (100.7) (69.5) Amortization of investment tax (65.5) (72.0) (86.7) credits 364.4 316.7 316.6 State and local: Current 69.6 42.2 34.2 Deferred - net (24.8) 1.7 (.5) 44.8 43.9 33.7 Total $ 409.2 $ 360.6 $ 350.3 The components of deferred federal income tax expense for 1992 and 1991 as reported prior to the adoption of Statement No. 109 are as follows: 1992 1991 Depreciation $ (23.7) $ (62.5) Employee benefits (70.0) 3.8 Other - net (7.0) (10.8) Total $ (100.7) $ (69.5) A reconciliation of income tax expense and the amount computed by applying the statutory federal income tax rate (35 percent for 1993, 34 percent for 1992 and 1991) to income before income taxes and extraordinary loss and cumulative effect of changes in accounting principals is as follows: 1993 1992 1991 Taxes computed at federal $ 498.5 $ 450.4 $ 437.4 statutory rate Increases (decreases) in taxes resulting from: Amortization of investment tax credits over the life of the plant that gave rise to the credits (65.5) (72.0) (86.7) Excess deferred taxes due to rate (43.2) (74.3) (55.8) change Depreciation of telephone plant construction costs previously deducted for tax purposes - net 22.5 21.7 23.2 State and local income taxes - net of federal tax benefit 29.1 29.0 22.3 Other - net (32.2) 5.8 9.9 Total $ 409.2 $ 360.6 $ 350.3 On August 10, 1993, the Omnibus Budget Reconciliation Act was signed into law. Among other provisions, the top corporate tax rate was raised to 35 percent, effective January 1, 1993. The effect on net income was not material, as the increase in taxes on operating income was offset by an increase in deferred tax assets associated with the postemployment benefit obligation. Increases in previously recorded deferred tax liabilities were offset by decreases in the net regulatory liability. 4. Property, Plant and Equipment Property, plant and equipment, which is stated at cost, is summarized as follows at December 31: 1993 1992 Telephone plant: In service $ 25,970.0 $ 25,005.4 Under construction 261.3 265.5 26,231.3 25,270.9 Accumulated depreciation and amortization (10,532.2) (9,604.8) Property, plant and equipment - net $ 15,699.1 $ 15,666.1 5. Leases Certain facilities and equipment used in operations are under capital or operating leases. Rental expenses under operating leases were $68.3, $82.8 and $68.2 for 1993, 1992 and 1991, respectively. At December 31, 1993, the aggregate minimum rental commitments under noncancelable leases were as follows: Operating Capital Year Leases Leases 1994 $ 30.9 $ 5.3 1995 23.2 2.4 1996 11.2 1.6 1997 6.8 1.0 1998 4.3 1.3 Thereafter 26.7 3.4 Total minimum lease payments $ 103.1 15.0 Amount representing executory costs (0.9) Amount representing interest (4.1) Present value of minimum lease payments $ 10.0 6. Debt Maturing Within One Year Debt maturing within one year consists of the following at December 31: 1993 1992 1991 Commercial paper $ 375.0 $ 458.6 $ 521.9 Current maturities of long-term debt 288.0 7.9 107.4 Total $ 663.0 $ 466.5 $ 629.3 Commercial paper: Average amount outstanding during the year * $ 671.1 $ 676.3 $ 496.6 Maximum amount at any month end during the year $ 808.7 $ 808.1 $ 813.7 Weighted average interest rate at December 31, 3.3% 3.5% 4.8% Weighted average interest rate on average commercial paper ** 3.2% 3.8% 5.9% * Amounts represent average daily face amount. ** Computed by dividing the average daily face amount of commercial paper into the aggregate related interest expense. At December 31, 1993 and 1992, the carrying amount of commercial paper approximates fair value. The Telephone Company has entered into agreements with several banks for lines of credit totaling $270.0, all of which may be used to support commercial paper borrowings. All of these lines are on an informal basis, with interest rates determined at time of borrowing. There were no borrowings outstanding under these lines of credit at December 31, 1993. 7. Long-Term Debt Long-term debt, including interest rates and maturities, is summarized as follows at December 31: Maturities 1993 1992 Debentures 4.50%-5.88% 1995-2006 $ 700.0 $ 500.0 6.12%-6.88% 2000-2024 1,050.0 350.0 7.00%-7.75% 1994-2025 1,400.0 800.0 8.25%-9.63% 1996-2024 650.0 2,750.0 3,800.0 4,400.0 Unamortized discount-net of premium (34.2) (168.9) Total debentures (Fair value of $3,830.8 and $4,427.0) 3,765.8 4,231.1 Notes 5.04%-7.35% 1994-2010 900.0 285.0 Unamortized discount (4.8) (1.3) Total notes (Fair value of $915.1 and $288.3) 895.2 283.7 Capitalized leases 10.0 17.6 Total long-term debt, including current maturities 4,671.0 4,532.4 Current maturities (288.0) (7.9) Total long-term debt $ 4,383.0 $4,524.5 The fair value of the debentures was based on quoted market prices. The fair values of the notes were estimated using a discounted cash flow analysis based on the yield to maturity of each issue. The Telephone Company recorded extraordinary losses on the refinancing of long-term bonds of $153.2 and $80.7 in 1993 and 1991 respectively, net of related income tax benefits of $92.2 and $48.6, respectively. The aggregate principal amounts of long-term debt scheduled for repayment for the years 1994 through 1998 are $288.0, $117.5, $201.1, $120.7 and $172.9, respectively. As of December 31, 1993, the Telephone Company was in compliance with all covenants and conditions of the indenture relating to its debt. 8. Reallocation of Shareowner's Equity On March 25, 1993, the Board of Directors of the Telephone Company approved the reduction of Common Stock to $1.0 and the reallocation of all amounts in excess of $1.0 to Paid-in Surplus. Any dividends to the Corporation declared subsequent to January 1, 1993, which are in excess of Retained Earnings will be considered a return of equity and be paid as liquidating dividends out of Paid-in Surplus. All future equity contributions made by the Corporation will be allocated to Paid-in Surplus. 9. Additional Financial Information December 31, Balance Sheets 1993 1992 Accounts payable and accrued liabilities: Accounts payable $ 748.7 $ 826.0 Accrued taxes 379.9 296.9 Advance billing and customer deposits 222.2 208.7 Compensated future absences 182.8 179.6 Accrued interest 86.8 91.3 Accrued payroll 91.0 90.4 Other 448.6 309.9 Total $ 2,160.0 $ 2,002.8 Statements of Income 1993 1992 1991 Interest expense: Long-term debt $ 354.8 $ 381.0 $ 414.4 Notes payable 21.3 25.9 29.3 Other 9.1 1.8 12.6 Total $ 385.2 $ 408.7 $ 456.3 Allowance for funds used during construction $ 20.7 $ 30.1 $ 33.8 Statements of Cash Flows 1993 1992 1991 Cash paid during the year for: Interest $ 389.6 $ 416.3 $ 471.5 Income taxes $ 477.8 $ 563.5 $ 383.9 10. Segment and Major Customer Information The Telephone Company operates predominantly in the communications service industry. Approximately 15 percent in 1993, 16 percent in 1992 and 17 percent in 1991 of the Telephone Company's revenues were from services provided to AT&T. No other customer accounted for more than 10 percent of total revenues. 11. Quarterly Financial Information (Unaudited) Calendar Total Operating Quarter Revenues Operating Income Net Income (Loss) 1993 1992 1993 1992 1993 1992 First $ 1,960.5 $ 1,863.9 $ 470.3 $ 393.4 $(1,682.7)#$ 225.6 Second 1,999.2 1,923.9 487.9 451.9 222.2 # 256.7 Third 2,060.6 1,974.7 428.9 463.4 232.1 # 264.3 Fourth 2,052.6 1,981.5 444.9 395.3 240.8 217.5 Total $ 8,072.9 $ 7,744.0 $ 1,832.0 $ 1,704.0 $ (987.6) $ 964.1 # Includes extraordinary losses of $89.4, $43.6 and $20.2 for the first, second and third quarter of 1993, respectively. The first quarter also includes a charge of $1,849.4 for cumulative effect of changes in accounting principles. Item 9. Item 9. Changes in and disagreements With Accountants on Accounting and Financial Disclosure. No changes in accountants or disagreements with accountants on any accounting or financial disclosure matters occurred during the period covered by this report. Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Documents filed as a part of the report: Page (1) Report of Independent Auditors . . . . . 22 Financial Statements Covered by Report of Independent Auditors: Statements of Income . . . . . . . 23 Balance Sheets . . . . . . . . . . . 24 Statements of Cash Flows . . . . . . 25 Statements of Shareowner's Equity . 26 Notes to Financial Statements . . . 27 (2) Financial Statement Schedules Covered by Report of Independent Auditors: V-Property, Plant and Equipment . . . . . 41 VI-Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment . . . . . . . . . . . . 45 VIII-Valuation and Qualifying Accounts 46 X-Supplementary Income Statement Information 47 Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto, or because such schedules are not required or applicable. (3) Exhibits: Exhibits identified in parentheses below, on file with the SEC, are incorporated by reference as exhibits hereto. 4 Pursuant to Regulation S-K, Item 601(b)(4)(iii)(A), no instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith. Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 12 Computation of Ratios of Earnings to Fixed Charges. 23 Consent of Ernst & Young. 24 Powers of Attorney. (b) Reports on Form 8-K: No report on Form 8-K was filed by the Registrant during the last quarter of the year covered by this report. Schedule V - Sheet 4 (a) Includes allowance for funds used during construction and additions to capitalized leases. (b) Items of telephone plant, when retired or sold are deducted from the property accounts at the amount of cost originally recorded. Amounts are estimated if original historical cost is not known. (c) Primarily includes transfers to and from Material and Supplies for reused material. The 1993 amounts include certain reclassifications. SOUTHWESTERN BELL TELEPHONE COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Dollars in Millions Column B - Charged to Column A - Item Expense Year 1993 1. Maintenance and repairs . . . . . $1,506.3 2. Taxes, other than payroll and income taxes Property . . . . . . . $ 292.8 Gross receipts . . . $ 179.0 Year 1992 1. Maintenance and repairs . . . . . $1,655.8 2. Taxes, other than payroll and income taxes Property . . . . . . $ 272.2 Gross receipts . . . . $ 147.9 Year 1991 1. Maintenance and repairs . . . . . $1,515.2 2. Taxes, other than payroll and income taxes Property . . . . . . . $ 265.1 Gross receipts . . . . $ 130.6 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, on the 18th day of March, 1994. SOUTHWESTERN BELL TELEPHONE COMPANY By /s/ Charles J. Roesslein (Charles. J. Roesslein Vice President-Chief Financial Officer and Treasurer) 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 date indicated. Principal Executive Officer: Robert G. Pope* President and Chief Executive Officer Principal Financial and Accounting Officer: Charles J. Roesslein Vice President-Chief Financial Officer and Treasurer /s/Charles J. Roesslein (Charles J. Roesslein, as attorney-in-fact and on his own behalf as Principal Financial Officer and Principal Accounting Officer) Directors: Robert G. Pope* Royce S. Caldwell* William E. Dreyer* J. Cliff Eason* James D. Ellis* March 18, 1994 Richard A. Harris* Donald E. Kiernan* _________ * by power of attorney EXHIBIT INDEX Exhibits identified in parentheses below, on file with the SEC, are incorporated by reference as exhibits hereto. 4 Pursuant to Regulation S-K, Item 601(b)(4)(iii)(A), no instrument which defines the reghts of holders of long and intermediate term debt of the registrant is filed herewith. Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 12 Computation of Ratios of Earnings to Fixed Charges. 23 Consent of Ernst & Young. 24 Powers of Attorney.

798905_1993.txt

798905_1993

1993

798905

Item 1. Business. General Development of Business. Phoenix Leasing Cash Distribution Fund II, a California limited partnership (the "Partnership"), was organized on June 28, 1984. The Partnership was registered with the Securities and Exchange Commission with an effective date of November 20, 1986 and shall continue to operate until its termination date unless dissolved sooner due to the sale of substantially all of the assets of the Partnership or a vote of the Limited Partners. The Partnership will terminate on December 31, 1997. The General Partner is Phoenix Leasing Incorporated, a California corporation. The General Partner or its affiliates also is or has been a general partner in several other limited partnerships formed to invest in capital equipment and other assets. The initial registration was for 300,000 units of limited partnership interest at a price of $250 per unit with an option of increasing the public offering up to a maximum of 400,000 units. The Partnership sold 386,308 units for a total capitalization of $96,577,000. Of the proceeds received through the offering, the Partnership has incurred $11,540,000 in organizational and offering expenses. The Partnership concluded its public offering on February 4, 1988. From the initial formation of the Partnership through December 31, 1993, the total investments in equipment leases and financing transactions (loans), including the Partnership's pro rata interest in investments made by joint ventures, approximate $174,034,000. The average initial firm term of contractual payments from equipment subject to lease was 32.20 months, and the average initial net monthly payment rate as a percentage of the original purchase price was 2.24%. The average initial firm term of contractual payments from loans was 82.01 months. Narrative Description of Business. The Partnership's principal objective is to produce cash flow to the investors on a continuing basis over the life of the Partnership. To achieve this objective, the Partnership has invested in various types of capital equipment and other assets to provide leasing or financing of the same to third parties, including Fortune 1000 companies and their subsidiaries, middle-market companies, emerging growth companies, cable television operators and others, on either a long-term or short-term basis. The types of equipment that the Partnership has invested in includes computer peripherals, terminal systems, small computer systems, communications equipment, IBM mainframes, IBM-software compatible mainframes, office systems, CAE/CAD/CAM equipment, telecommunications equipment, cable television equipment, medical equipment, production and manufacturing equipment and software products. The Partnership has made secured loans to cable television systems, emerging growth companies, security monitoring companies and other businesses. These loans are asset-based and the Partnership receives a security interest in the assets financed. Page 4 of 36 Item 1. Business (continued): Narrative Description of Business (continued). The Partnership's financing activities have been concentrated in the cable television industry. The Partnership has made secured loans (notes receivable) to operators of cable television systems for the acquisition, refinancing, construction, upgrade and extension of such systems located throughout the United States. The loans to cable television system operators are secured by a senior or subordinated interest in the assets of the cable television system, its franchise agreements, subscriber lists, material contracts and other related assets. In some cases the Partnership has also received personal guarantees from the owners of the systems. At December 31, 1993, the Partnership's investments in notes receivable primarily consist of notes receivable from four cable television system operators. The Partnership's net investment in notes receivable (including notes receivable reclassified to in-substance foreclosed cable systems) of $2,740,000 approximate 40% of the total assets of the Partnership at December 31, 1993. Several of the cable television system operators the Partnership provided financing to have experienced financial difficulties. These difficulties are believed to have been caused by several factors such as: a significant reduction in the availability of debt from banks and other financial institutions to finance acquisitions and operations, uncertainties related to future government regulation in the cable television industry and the economic recession in the United States. These factors have resulted in a significant decline in the demand for the acquisition of cable systems and have further caused an overall decrease in the value of many cable television systems. The Partnership has acquired equipment pursuant to either "Operating" leases or "Full Payout" leases. The Partnership has also provided and intends to provide financing secured by assets in the form of notes receivable. Operating leases are generally short-term leases under which the lessor will receive aggregate rental payments in an amount that is less than the purchase price of the equipment. Full Payout leases are generally for a longer term under which the non-cancellable rental payments due during the initial term of the lease are at least sufficient to recover the purchase price of the equipment. The General Partner has concentrated the Partnership's activities in the equipment leasing and financing industry, an area in which the General Partner has developed an expertise. The computer equipment leasing industry is extremely competitive. The Partnership competes with many well established companies having substantially greater financial resources. Competitive factors include pricing, technological innovation and methods of financing (including use of various short-term and long-term financing plans, as well as the outright purchase of equipment). Although IBM is still a dominant factor in the computer equipment marketplace, even IBM has been adversely affected by wide-spread competition in this industry. Given the high degree of competition and rapid pace of technological development in the computer equipment industry, revolutionary changes with respect to pricing, marketing practices, technological innovation and the availability of new and attractive financing plans could occur at almost any time. Significant action in any of these areas might materially and adversely affect the remarketability of equipment owned by the Partnership. Any such adverse effect on remarketability could also be reflected in the overall return realized by the Partnership. The General Partner believes that IBM and its competitors will continue to make significant Page 5 of 36 Item 1. Business (continued): Narrative Description of Business (continued): advances in the computer equipment industry, some of which may result in revolutionary changes with respect to small, medium and large computer systems. The Partnership will maintain working capital reserves in an amount which will fluctuate from time to time depending upon the needs of the Partnership, but which will be at least one percent of the gross offering proceeds. Other. A brief description of the type of assets in which the Partnership has invested as of December 31, 1993, together with information concerning the uses of assets is set forth in Item 2. Item 2. Properties. The Partnership is engaged in the equipment leasing and financing industry and as such, does not own or operate any principal plants, mines or real property. The primary assets held by the Partnership are its investments in leases and loans. As of December 31, 1993, the Partnership owns equipment and has outstanding loans to borrowers with an aggregate original cost of $44,250,000. The equipment and loans have been made to customers located throughout the United States. The following table summarizes the type of equipment owned or financed by the Partnership, including its pro rata interest in joint ventures, at December 31, 1993. Percentage of Asset Types Purchase Price(1) Total Assets (Amounts in Thousands) Reproduction Equipment $14,636 33% Computer Peripherals 12,701 29 Mainframes 9,126 21 Financing Related to Cable Television Systems 4,157 9 Capital Equipment Leased to Emerging Growth Companies 1,880 4 Telecommunications 1,350 3 Small Computer Systems 344 1 Financing of Security Monitoring System Companies 56 - TOTAL $44,250 100% (1) These amounts include the Partnership's pro rata interest in equipment joint ventures of $945,000, cost of equipment on financing leases of $1,898,000 and original cost of outstanding loans of $4,213,000 at December 31, 1993. Page 6 of 36 Item 3. Item 3. Legal Proceedings. On July 1, 1991, Phoenix Leasing Incorporated, as General Partner to the Partnership and sixteen other affiliated partnerships, filed suit in the Superior Court for the County of Marin, Case No. 150016, against Xerox Corporation, a corporation in which the General Partner had entered into a contractual agreement for the acquisition and administration of leased equipment. Phoenix Leasing Incorporated alleges on behalf of the Partnership that Xerox Corporation breached certain agreements when it failed to remit and account for certain funds due as adjustments to purchase prices, failed to properly refurbish and remarket certain equipment, and failed to properly administer the Partnership's portfolio of equipment. The suit seeks recovery of damages and attorney costs of a yet to be determined amount. Discovery in the case is currently in process. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of Limited Partners, through the solicitation of proxies or otherwise, during the year covered by this report. Item 5. Item 5. Market for the Registrant's Securities and Related Security Holder Matters. (a) The Registrant's limited partnership interests are not publicly traded. There is no market for the Registrant's limited partnership interests and it is unlikely that any will develop. (b) Approximate number of equity security investments: Number of Unit Holders Title of Class as of December 31, 1993 Limited Partners 9,316 General Partner 1 Page 7 of 36 PART II Item 6. Item 6. Selected Financial Data. Amounts in Thousands Except for Per Unit Amounts 1993 1992 1991 1990 1989 Total Income $5,613 $10,706 $14,290 $27,016 $42,644 Net Income (Loss) 1,570 (1,540) (5,429) (2,969) 4,149 Total Assets 6,922 10,168 24,728 45,925 83,935 Long-term Debt Obligations - - - - 405 Distributions to Partners 3,794 14,269 14,623 14,119 13,896 Net Income (Loss) per Limited Partnership Unit 4 (4) (14) (8) 9 Distributions per Limited Partnership Unit 10 38 37 35 34 The above selected financial data should be read in conjunction with the financial statements and related notes appearing elsewhere in this report. Page 8 of 36 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations =============================================================================== For the years ended December 31, Description 1993 1992 1991 (Amounts in Thousands) - ------------------------------------------------------------------------------ Net income (loss) $1,570 $(1,540) $(5,429) Rental income 3,779 7,072 12,077 Gain from equipment insurance settlement - 1,235 - Depreciation expense 1,888 8,471 13,630 Lease related operating expenses 1,081 2,116 3,853 =============================================================================== Phoenix Leasing Cash Distribution Fund II (the Partnership) reported net income of $1,570,000 during the year ended December 31, 1993, as compared to net losses of $1,540,000 and $5,429,000 during 1992 and 1991, respectively. The improvement in earnings during 1993 is attributable to a substantial decrease of $6,583,000 in depreciation expense. As of December 31, 1992, a majority of the Partnership's reproduction equipment had become fully depreciated, causing a major portion of the decrease in depreciation expense during 1993. The decreased net loss during 1992 was primarily attributable to an equipment insurance settlement received by the Partnership of $1,235,000 and a decrease in lease-related operating expenses of $1,737,000. The equipment insurance settlement received during 1992 was for the full replacement value of certain capital equipment owned by the Partnership and is not a recurring event. The decrease in rental income of $3,293,000 and $5,005,000 during 1993 and 1992, respectively, is attributable to a decrease in the size of the equipment portfolio due to equipment sales. At December 31, 1993, the Partnership owned equipment with an aggregate original cost of $40 million as compared to $58 million and $79 million at December 31, 1992 and 1991, respectively. As the Partnership continues to sell equipment upon expiration of the lease terms, it is anticipated that the equipment portfolio and rental income will continue to decrease. Total expenses decreased by $8,203,000 and $7,473,000 during 1993 and 1992, respectively, as compared to the same period in the preceding year due primarily to the decrease in depreciation of $6,583,000 and $5,159,000 during 1993 and 1992, respectively. The decrease in depreciation expense is attributable to the decrease in the size of the equipment portfolio due to the sale of equipment and a large portion of the equipment having been fully depreciated. The Partnership sold equipment with an aggregate original cost of $18,149,000, $20,744,000 and $26,074,000 during the years ended December 31, 1993, 1992 and 1991, respectively. During 1993 and 1992, the Partnership also experienced a decrease in lease related operating expenses of $1,035,000 and $1,737,000, respectively, due to a decrease in maintenance, remarketing and refurbishing expenses incurred on a portion of the Partnership's reproduction equipment purchased pursuant to a vendor lease and remarketing agreement. In accordance with the agreement, these expenses are deducted from the rents and sales proceeds received from such leases. Page 9 of 36 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Results of Operations (continued) The Partnership has been impacted by the recession through an increase in the number of lessee and borrower defaults. This has caused an increase in delinquent lease and loan payments from customers, and the Partnership has seen an increase in lessees and borrowers filing for protection under the bankruptcy laws. This has caused the Partnership a loss of revenues from such delinquent or defaulted leases and has also forced the Partnership to renegotiate its leases on far less favorable terms. These defaults and delinquencies have also resulted in an increase in legal and collection related expenses. The recession has also caused manufacturers of newer computer equipment to engage in highly aggressive sales practices by discounting new products by as much as 50-60%. The effects of this practice have been lower re-leasing and resale revenues on the equipment owned by the Partnership, thereby earning lower returns than originally anticipated as reflected by the decrease in rental income. Inflation affects the Partnership in relation to the current cost of equipment placed on lease and the residual values realized when the equipment comes off-lease and is sold. During the last several years inflation has been low, thereby having very little impact upon the Partnership. Liquidity and Capital Resources =============================================================================== For the years ended December 31, Description 1993 1992 1991 (Amounts in Thousands) - ------------------------------------------------------------------------------ MAJOR CASH SOURCES: Net cash from equipment leasing and financing operations (1) $ 3,003 $ 5,270 $10,707 Proceeds from sale of equipment 1,857 3,520 6,328 Proceeds from equipment insurance settlement - 1,273 - Proceeds from payoff of notes receivable - - 543 MAJOR CASH USES: Cost of equipment acquired 192 221 2,704 Investment in notes receivable - - 166 Principal payments, notes payable 291 - 156 Cash distributions to partners 3,794 14,269 14,623 (1) Includes a per copy charge from the Partnership's reproduction equipment of $640,000, $978,000 and $1,370,000 during 1993, 1992 and 1991, respectively. =============================================================================== The Partnership's primary source of liquidity comes from equipment leasing and financing activities. The Partnership has contractual obligations with a diversified group of lessees for fixed lease terms at fixed rental amounts and will also receive payments on its outstanding notes receivable. The Partnership's future liquidity is dependent upon its receiving payment of such contractual obligations. As the initial lease terms expire, the Partnership will continue to renew, remarket or sell the equipment. The future liquidity in excess of the remaining contractual obligations will depend upon the General Partner's success in re-leasing and selling the Partnership's equipment as it comes off lease. Page 10 of 36 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Liquidity and Capital Resources (continued) During the fourth quarter of 1992, the Partnership borrowed an additional $465,000 from a bank. The Partnership repaid $291,000 of its outstanding debt during 1993. Proceeds from sale of equipment decreased due to a decrease in the amount of equipment sold of $1,663,000 and $2,808,000 during 1993 and 1992, respectively, as well as a decrease in the market value of such equipment. During 1993, the Partnership purchased $192,000 in equipment subject to operating and financing type leases, compared to the $221,000 and $2,704,000 in equipment acquired during 1992 and 1991, respectively. As a result, the aggregate original cost of equipment owned by the Partnership at December 31, 1993 approximates $40 million, as compared to the $58 million and $79 million at December 31, 1992 and 1991, respectively. The $40 million of equipment owned at December 31, 1993 is classified as follows: 36% reproduction equipment, 32% computer peripheral equipment, 23% computer mainframes, 5% capital equipment leased to emerging growth companies, 3% telecommunications equipment and 1% small computer systems. The $58 million of equipment owned at December 31, 1992 was classified as follows: 58% computer peripheral equipment, 31% reproduction equipment, 6% capital equipment leased to emerging growth companies, 2% telecommunications equipment, 1% small computer systems, 1% computer mainframes and 1% miscellaneous, as compared to $79 million of equipment owned at December 31, 1991 which was classified as follows: 58% computer peripheral equipment, 28% reproduction equipment, 9% capital equipment leased to emerging growth companies, 2% small computer systems, 2% telecommunications equipment and 1% computer mainframes. The Partnership is currently in its liquidation stage and accordingly has no obligations or commitments to purchase additional equipment. In addition to acquiring equipment for lease to third parties, the Partnership has provided financing to cable television system operators, emerging growth companies, security monitoring system companies, and other businesses. The Partnership maintains a security interest in the equipment financed. Such security interest will give the Partnership the right, upon default, to obtain possession of the assets. The Partnership provided financing of $0, $0, and $166,000 during 1993, 1992 and 1991, respectively. As a result, the aggregate original amount of outstanding financing provided by the Partnership approximates $4.2 million at December 31, 1993, as compared to $4.2 million and $4.6 million at December 31, 1992 and 1991, respectively. The $4.2 million of financing as of December 31, 1993 is classified as follows: 99% financing to cable television systems and 1% financing to security monitoring companies. The Partnership has equipment held for lease with a purchase price of $13,484,000, $16,645,000 and $22,535,000 with a net book value of $40,000, $549,000 and $4,098,000 at December 31, 1993, 1992 and 1991, respectively. The General Partner is actively engaged, on behalf of the Partnership, in remarketing and selling the Partnership's off-lease equipment portfolio. The cash distributed to partners for the years ended December 31, 1993, 1992 and 1991 are $3,794,000, $14,269,000 and $14,623,000, respectively. In accordance with the Limited Partnership Agreement, the limited partners are entitled to 95% of the cash available for distribution and the General Partner Page 11 of 36 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations (continued) Liquidity and Capital Resources (continued) is entitled to 5%. As a result, the limited partners received distributions of $3,794,000, $14,269,000 and $14,071,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The cumulative distributions to Limited Partners are $75,219,000, $71,425,000 and $57,156,000 at December 31, 1993, 1992 and 1991, respectively. The General Partner received $0, $0 and $741,000 in cash distributions for the year ended December 31, 1993, 1992 and 1991, respectively. In accordance with the partnership agreement, upon termination of the Partnership, the General Partner is required to restore any deficit balance in its capital account. During 1992, the General Partner elected to make an early contribution for such deficit capital balance. In addition, the General Partner is no longer receiving payment for its share of the cash available for distribution. The Partnership's asset portfolio continues to decline as a result of the ongoing liquidation of assets, and therefore it is expected that the cash generated from operations will also decline. As the cash generated by Partnership operations continues to decline, the rate of cash distributions made to limited partners will also decline. During 1993, the Partnership reduced the cash distributions to partners due to such decline in the cash available for distribution. It is anticipated that the Partnership will make distributions to partners during 1994 at approximately the same rate as those made during 1993. The Partnership has been adversely impacted by several factors that have caused them to achieve returns and recovery of investment in lower than anticipated amounts. The factors impacting the Partnership have been, the economic recession in the United States, the rate of obsolescence of computer equipment, the market demand and remarketability for equipment owned by the Partnership, aggressive manufacturer sales practices and a general unavailability of debt to companies. All of these factors have resulted in the decline in revenues and the reduced distributions to partners. Cash generated from leasing and financing operations has been and is anticipated to continue to be sufficient to meet the Partnership's ongoing operational expenses and debt service. Page 12 of 36 Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PHOENIX LEASING CASH DISTRIBUTION FUND II YEAR ENDED DECEMBER 31, 1993 Page 13 of 36 REPORT OF INDEPENDENT AUDITORS The Partners Phoenix Leasing Cash Distribution Fund II We have audited the financial statements of Phoenix Leasing Cash Distribution Fund II (a California limited partnership) listed in the accompanying index to financial statements (Item 14(a)). These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements listed in the accompanying index to financial statements (Item 14(a)) present fairly, in all material respects the financial position of Phoenix Leasing Cash Distribution Fund II at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. San Francisco, California ERNST & YOUNG January 20, 1994 Page 14 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II BALANCE SHEETS (Amounts in Thousands Except for Unit Amounts) December 31, 1993 1992 ASSETS Cash and cash equivalents $2,032 $ 1,459 Accounts receivable (net of allowance for losses on accounts receivable of $453 and $468 at December 31, 1993 and 1992, respectively) 262 623 Notes receivable (net of allowance for losses on notes receivable of $368 and $253 at December 31, 1993 and 1992, respectively) 1,960 2,972 Equipment on operating leases and held for lease (net of accumulated depreciation of $34,365 and $47,638 at December 31, 1993 and 1992, respectively) 641 2,890 Net investment in financing leases (net of allowance for early terminations of $0 and $4 at December 31, 1993 and 1992, respectively) 998 1,367 Capitalized acquisition fees (net of accumulated amortization of $6,681 and $6,559 at December 31, 1993 and 1992, respectively) 191 305 In-substance foreclosed cable systems 780 - Other assets 58 552 Total Assets $6,922 $10,168 LIABILITIES AND PARTNERS' CAPITAL Liabilities: Accounts payable and accrued expenses $1,093 $ 1,824 Notes payable 174 465 Total Liabilities 1,267 2,289 Partners' Capital: General Partner 63 47 Limited Partners, 400,000 units authorized, 386,308 units issued and 379,583 units outstanding at December 31, 1993 and 1992 5,592 7,832 Total Partners' Capital 5,655 7,879 Total Liabilities and Partners' Capital $6,922 $10,168 [FN] The accompanying notes are an integral part of these statements. Page 15 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II STATEMENTS OF OPERATIONS (Amounts in Thousands Except for Per Unit Amounts) For the Years Ended December 31, 1993 1992 1991 INCOME Rental income $3,779 $ 7,072 $12,077 Gain on sale of equipment 1,450 1,804 1,641 Interest income, notes receivable 294 451 163 Equipment insurance settlement - 1,235 - Other income 90 144 409 Total Income 5,613 10,706 14,290 EXPENSES Depreciation 1,888 8,471 13,630 Amortization of acquisition fees 122 445 858 Lease related operating expenses 1,081 2,116 3,853 Management fees to General Partner 230 459 646 Interest expense 18 - 1 Provision for losses on receivables 111 111 71 Reimbursed administrative costs to General partner 133 174 289 Other expenses 460 470 371 Total Expenses 4,043 12,246 19,719 NET INCOME (LOSS) $1,570 $(1,540) $(5,429) NET INCOME (LOSS) PER LIMITED PARTNERSHIP UNIT $ 4 $ (4) $ (14) NET INCOME (LOSS) General Partner $ 16 $ (15) $ (54) Limited Partners 1,554 (1,525) (5,375) $1,570 $(1,540) $(5,429) [FN] The accompanying notes are an integral part of these statements. Page 16 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II STATEMENTS OF PARTNERS' CAPITAL (Amounts in Thousands Except for Unit Amounts) General Partner's Limited Partners' Total Amount Units Amount Amount Balance, December 31, 1990 $ (736) 382,384 $ 43,272 $ 42,536 Distributions to partners ($37 per limited partnership unit) (741) - (14,071) (14,812) Redemptions of capital - (2,010) (174) (174) Net loss (54) - (5,375) (5,429) Balance, December 31, 1991 (1,531) 380,374 23,652 22,121 Partners' contributions 1,404 - - 1,404 Distributions to partners ($38 per limited partnership unit) - - (14,269) (14,269) Redemptions of capital - (791) (26) (26) Reversal of 1991 General Partner distributions accrued but not paid 189 - - 189 Net loss (15) - (1,525) (1,540) Balance, December 31, 1992 47 379,583 7,832 7,879 Distributions to partners ($10 per limited partnership unit) - - (3,794) (3,794) Net income 16 - 1,554 1,570 Balance, December 31, 1993 $ 63 379,583 $ 5,592 $ 5,655 [FN] The accompanying notes are an integral part of these statements. Page 17 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II STATEMENTS OF CASH FLOWS (Amounts in Thousands) For the Years Ended December 31, 1993 1992 1991 Operating Activities: Net income (loss) $ 1,570 $ (1,540) $ (5,429) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 1,888 8,471 13,630 Amortization of acquisition fees 122 445 858 Gain on sale of equipment (1,450) (1,804) (1,641) Gain on equipment insurance settlement - (1,235) - Provision for early termination, financing leases (4) 1 7 Provision for losses on notes receivable 115 110 64 Gain on sale of marketable securities - (2) (196) Decrease in accounts receivable 361 296 1,543 Decrease in accounts payable and accrued expenses (729) (590) (821) Decrease in other assets 494 314 166 Interest income added to principal on notes receivable - (97) (133) Net cash provided by operating activities 2,367 4,369 8,048 Investing Activities: Principal payments, financing leases 519 875 2,115 Principal payments, notes receivable 117 26 544 Proceeds from sale of equipment 1,857 3,520 6,328 Proceeds from equipment insurance settlement - 1,273 - Proceeds from payoff of notes receivable - - 543 Proceeds from sale of marketable securities - 44 196 Purchase of equipment (7) - (1,681) Investment in financing leases (185) (221) (1,023) Investment in notes receivable - - (166) Investment in marketable securities - (42) - Payment of acquisition fees (10) (12) (109) Net cash provided by investing activities 2,291 5,463 6,747 Financing Activities: Partners' contributions - 1,404 - Payments of principal, notes payable (291) - (156) Proceeds from notes payable - 465 - Redemptions of capital - (26) (174) Distributions to partners (3,794) (14,269) (14,623) Net cash used by financing activities (4,085) (12,426) (14,953) [FN] The accompanying notes are an integral part of these statements. Page 18 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II STATEMENTS OF CASH FLOWS (continued) (Amounts in Thousands) For the Years Ended December 31, 1993 1992 1991 Increase (decrease) in cash and cash equivalents $ 573 $ (2,594) $ (158) Cash and cash equivalents, beginning of period 1,459 4,053 4,211 Cash and cash equivalents, end of period $ 2,032 $ 1,459 $ 4,053 Supplemental Cash Flow Information: Cash paid for interest expense $ 18 $ - $ 1 [FN] The accompanying notes are an integral part of these statements. Page 19 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 Note 1. Organization and Partnership Matters. Phoenix Leasing Cash Distribution Fund II, a California limited partnership (the "Partnership"), was formed on June 28, 1984, to invest in capital equipment of various types and to lease such equipment to third parties on either a long- term or short-term basis, and to provide financing to emerging growth companies and cable television system operators. The Partnership's minimum investment requirements were met November 24, 1986. The Partnership's termination date is December 31, 1997. For financial reporting purposes, Partnership income shall be allocated as follows: (a) first, to the General Partner until the cumulative income so allocated is equal to the cumulative distributions to the General Partner, (b) second, before redemption fees, 1% to the General Partner and 99% to the Limited Partners until the cumulative income so allocated is equal to any cumulative Partnership loss and syndication expenses for the current and all prior accounting periods, and (c) the balance, if any, to the Unit Holders. All Partnership losses shall be allocated, before redemption fees, 1% to the General Partner and 99% to the Unit Holders. The General Partner is entitled to receive 5% of all cash distributions until the Limited Partners have recovered their initial capital contributions plus a cumulative return of 12% per annum. Thereafter, the General Partner will receive 15% of all cash distributions. In the event the General Partner has a deficit balance in its capital account at the time of partnership liquidation, it will be required to contribute the amount of such deficit to the Partnership. During the year ended December 31, 1992, the General Partner elected to make an early contribution of $1,404,000, and the $189,000 in accrued distributions to the General Partner at December 31, 1991 was reversed. In addition, the General Partner did not draw its share of the 1993 and 1992 cash available for distribution. As compensation for management services, the General Partner receives a fee payable quarterly, in an amount equal to 3.5%, subject to certain limitations, of the Partnership's gross revenues for the quarter from which such payment is being made, which revenues shall include, but are not limited to, rental receipts, maintenance fees, proceeds from the sale of equipment and interest income. The General Partner will be compensated for services performed in connection with the analysis of assets available to the Partnership, the selection of such assets and the acquisition thereof, including obtaining lessees for the equipment, negotiating and concluding master lease agreements with certain lessees. As compensation for such acquisition services, the General Partner will receive a fee equal to 4%, subject to certain limitations, of (a) the purchase price of equipment acquired by the Partnership, or equipment leased to customers Page 20 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 1. Organization and Partnership Matters (continued). by manufacturers, the financing for which is provided by the Partnership, or (b) financing provided to businesses such as cable operators, emerging growth companies, or security monitoring system companies, payable upon such acquisition or financing, as the case may be. As of December 31, 1993, $6,872,000 had been paid or accrued to the General Partner for its acquisition fee. Acquisition fees are amortized over the life of the assets principally on a straight-line basis. Phoenix Securities, Inc., an affiliate of the General Partner, has contracted with or employs certain persons who have performed wholesaling activities in connection with the offering of the units through broker-dealers. As of December 31, 1993, $1,336,000 has been paid or accrued to Phoenix Securities, Inc. Note 2. Summary of Significant Accounting Policies. Leasing Operations. The Partnership's leasing operations consist of both financing and operating leases. The financing method of accounting for leases records as unearned income at the inception of the lease, the excess of net rentals receivable and estimated residual value at the end of the lease term, over the cost of equipment leased. Unearned income is credited to income monthly over the term of the lease on a declining basis to provide an approximate level rate of return on the unrecovered cost of the investment. Initial direct costs of consummating new leases are capitalized and included in the cost of equipment. Under the operating method of accounting for leases, the leased equipment is recorded as an asset at cost and depreciated primarily on an accelerated depreciation method over the estimated useful life of six years, except for equipment leased under vendor agreements, which is depreciated on a straight-line basis over the estimated useful life, ranging up to six years. The Partnership's policy is to review periodically the expected economic life of its rental equipment in order to determine the probability of recovering its undepreciated cost. Such reviews address, among other things, recent and anticipated technological developments affecting computer equipment and competitive factors within the computer marketplace. Although remarketing rental rates are expected to decline in the future with respect to some of the Partnership's rental equipment, such rentals are expected to exceed projected expenses and depreciation. Where reviews of the equipment portfolio indicate that rentals plus anticipated sales proceeds will not exceed expenses in any future period, the Partnership revises its depreciation policy and accelerates depreciation as appropriate. As a result of such periodic Page 21 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 2. Summary of Significant Accounting Policies (continued). reviews, the Partnership recognized additional depreciation expense of $0, $12,000 and $1,812,000 ($0, $.03 and $4.75 per limited partnership unit) for the years ended December 31, 1993, 1992 and 1991, respectively. Rental income for the year is determined on the basis of rental payments due for the period under the terms of the lease. Maintenance, repairs and minor renewals of the leased equipment are charged to expense. Non Cash Investing Activities. During the year ended December 31, 1993, the Partnership reclassified two foreclosed notes receivable from Notes Receivable to Investment in Foreclosed Cable Systems on the balance sheet. The amount of such reclassification was $780,000. Reclassification. Certain 1992 and 1991 amounts have been reclassified to conform to the 1993 presentation. Cash and Cash Equivalents. This includes deposits at banks, investments in money market funds and other highly liquid short-term investments with original maturities of less than 90 days. Credit and Collateral. The Partnership's activities have been concentrated in the equipment leasing and financing industry. A credit evaluation is performed by the General Partner for all leases and loans made, with the collateral requirements determined on a case-by-case basis. The Partnership's loans are generally secured by the equipment or assets financed and, in some cases, other collateral of the borrower. In the event of default, the Partnership has the right to foreclose upon the collateral used to secure such loans. Note 3. Accounts Receivable. Accounts receivable consist of the following at December 31: 1993 1992 (Amounts in Thousands) Lease payments $ 636 $ 920 Other 79 168 Interest - 3 715 1,091 Less: allowance for doubtful accounts receivable (453) (468) Total $ 262 $ 623 Page 22 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 4. Notes Receivable. Notes receivable consist of the following at December 31: 1993 1992 (Amounts in Thousands) Notes receivable from cable television system operators with stated interest ranging from 17% to 19% per annum, receivable in installments ranging from 60 to 108 months, collateralized by a security interest in the cable system assets. These notes have a graduated repayment schedule followed by a balloon payment. $2,282 $3,176 Notes receivable from security monitoring companies with stated interest at 16% per annum, with payments to be taken out of the monthly payments received from assigned contracts, collateralized by all assets of the borrower. At the end of 48 months, the remaining balance, if any, is due and payable. 46 49 2,328 3,225 Less: allowance for losses on notes receivable (368) (253) Total $1,960 $2,972 The Partnership's notes receivable to cable television system operators provide a payment rate in an amount that is usually less than the contractual interest rate. The difference between the payment rate and the contractual interest rate is added to the principal and therefore deferred until the maturity date of the note. Upon maturity of the note, the original principal and deferred interest is due and payable in full. Although the contractual interest rates may be higher, effective January 1, 1993, the amount of interest being recognized on the Partnership's outstanding notes receivable to cable television system operators is being limited to the amount of the payments received, thereby deferring the recognition of a portion of the deferred interest until the loan is paid off. During 1992 and 1991, the Partnership had been limiting the amount of interest income to 16% on these notes receivable. Page 23 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 5. Equipment on Operating Leases and Investment in Financing Leases. Equipment on lease consists primarily of computer peripheral equipment, computer mainframes and reproduction equipment. The Partnership's operating leases are for initial lease terms of approximately 12 to 48 months. During the remaining terms of existing operating leases, the Partnership will not recover all of the undepreciated cost and related expenses of its rental equipment, and therefore must remarket a portion of its equipment in future years. The Partnership has agreements with some of the manufacturers of its equipment, whereby such manufacturers will undertake to remarket off-lease equipment on a best-efforts basis. This agreement permits the Partnership to assume the remarketing function directly if certain conditions contained in the agreements are not met. For their remarketing services, the manufacturers are paid a percentage of net monthly rentals. The Partnership has entered into direct lease arrangements with lessees consisting of Fortune 1000 companies and other businesses in different industries located throughout the United States. Generally, it is the responsibility of the lessee to provide maintenance on leased equipment. The General Partner administers the equipment portfolio of leases acquired through the direct leasing program. Administration includes the collection of rents from the lessees and remarketing of the equipment. The net investment in financing leases consists of the following at December 31: 1993 1992 (Amounts in Thousands) Minimum lease payments to be received $ 959 $1,380 Estimated residual value of leased equipment (unguaranteed) 140 175 Less: unearned income (101) (184) allowance for early termination - (4) Net investment in financing leases $ 998 $1,367 Minimum rentals to be received on noncancellable operating and financing leases for the years ended December 31 are as follows: Page 24 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 5. Equipment on Operating Leases and Investment in Financing Leases (continued). Operating Financing (Amounts in Thousands) 1994 . . . . . . . . . . . . . . . . . . $ 862 $451 1995 . . . . . . . . . . . . . . . . . . 171 349 1996 . . . . . . . . . . . . . . . . . 136 159 1997 . . . . . . . . . . . . . . . . . . 32 - 1998 and future . . . . . . . . . . . . 16 - Total $1,217 $959 The Partnership receives contingent monthly rental payments on its reproduction equipment that is not included in the minimum rentals to be received. The contingent monthly rentals consist of a monthly rental payment that is based upon actual machine usage. The monthly usage charge included in income for the years ended December 31, 1993, 1992 and 1991 was $640,000, $978,000 and $1,370,000, respectively. The net book value of equipment held for lease at December 31, 1993 and 1992 amounted to $40,000 and $549,000, respectively. The General Partner, on behalf of the Partnership and sixteen other affiliated partnerships, filed suit against one manufacturer of its equipment. The partnerships allege that this manufacturer breached certain agreements with respect to the equipment portfolios. The suit seeks damages and attorney's fees in unspecified amounts. The Partnership will recognize any such amounts in income when received. Note 6. In-Substance Foreclosed Cable Systems. The Partnership has reclassified two nonperforming outstanding notes receivable from cable television system operators to In-Substance Foreclosed Cable Systems where in-substance foreclosure has occurred. Upon reclassification, these notes are recorded at the lower of their carrying value or estimated fair market value of the cable system. The Partnership, along with other affiliated partnerships managed by the General Partner, has a total carrying value in these cable systems of $1,399,000. The net carrying value of the Partnership's investment is $780,000 which represents a 56% pro rata interest in the total investment. In order to maximize the recovery of the Partnership's investment, the General Partner anticipates that upon foreclosure, it will hold and manage the operations of the foreclosed cable systems, on behalf of the partnerships, until such time that the General Partner can sell the cable television systems. Page 25 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 7. Accounts Payable and Accrued Expenses. Accounts payable and accrued expenses consist of the following at December 31: 1993 1992 (Amounts in Thousands) Equipment lease operations $ 732 $1,173 Sales tax 257 268 General Partner and affiliates 38 228 Security deposits 8 82 Other 57 73 Accrued interest 1 - Total $1,093 $1,824 Note 8. Notes Payable. Notes payable consist of the following at December 31: 1993 1992 (Amounts in Thousands) Note payable to a bank, collateralized by leased equipment, non-recourse to the other assets of the Partnership, with interest of 4.75% per annum, payable in 22 monthly installments through August 1, 1994 $174 $465 Principal payments of $174,000 are due in 1994. Note 9. Income Taxes. Federal and state income tax regulations provide that taxes on the income or loss of the Partnership are reportable by the partners in their individual income tax returns. Accordingly, no provision for such taxes has been made in the accompanying financial statements. In 1993, the Partnership adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). One of the requirements of SFAS 109 is for a public enterprise that is not subject to income taxes, because its income is taxed directly to its owners, to disclose the net difference between the tax basis and the reported amounts of the enterprise's assets and liabilities. Page 26 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 9. Income Taxes (continued). The net differences between the tax basis and the reported amounts of the Partnership's assets and liabilities at December 31, 1993 are as follows: Reported Amounts Tax Basis Net Difference Assets $6,922,000 $7,966,000 $(1,044,000) Liabilities 1,267,000 1,267,000 0 Note 10. Related Entities. The General Partner and its affiliates serves in the capacity of general partner in other partnerships, all of which are engaged in the equipment leasing and financing business. Note 11. Reimbursed Costs to the General Partner. The General Partner incurs certain administrative costs, such as data processing, investor and lessee communications, lease administration, accounting, equipment storage and equipment remarketing, for which it is reimbursed by the Partnership. These expenses incurred by the General Partner are to be reimbursed at the lower of the actual costs or an amount equal to 90% of the fair market value for such services. The reimbursed costs to the General Partner for the years ended December 31 are as follows: 1993 1992 1991 (Amounts in Thousands) General administration $139 $179 $289 Equipment remarketing and administrative 81 168 565 Data processing 14 20 43 Totals $234 $367 $897 In addition, the General Partner receives a management fee and an acquisition fee (see Note 1). Page 27 of 36 PHOENIX LEASING CASH DISTRIBUTION FUND II NOTES TO FINANCIAL STATEMENTS (Continued) DECEMBER 31, 1993 Note 12. Net Income (Loss) and Distributions per Limited Partnership Unit. Net income (loss) and distributions per limited partnership unit were based on the Limited Partners' share of net income (loss) and distributions, and the weighted average number of units outstanding of 379,583, 380,133 and 381,453 for the years ended December 31, 1993, 1992 and 1991, respectively. For the purposes of allocating income (loss) and distributions to each individual Limited Partner, the Partnership allocates net income (loss) and distributions based upon each respective Limited Partner's ending capital account balance. Note 13. Subsequent Events. In January 1994, cash distributions of $957,000 were made to the Limited Partners. Page 28 of 36 Item 9. Item 9. Disagreements on Accounting and Financial Disclosure Matters. None. Page 29 of 36 PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The registrant is a limited partnership and, therefore, has no executive officers or directors. The general partner of the registrant is Phoenix Leasing Incorporated, a California corporation. The directors and executive officers of Phoenix Leasing Incorporated (PLI) are as follows: GUS CONSTANTIN, age 56, is President, Chief Executive Officer and a Director of PLI. Mr. Constantin received a B.S. degree in Engineering from the University of Michigan and a Master's Degree in Management Science from Columbia University. From 1969 to 1972, he served as Director, Computer and Technical Equipment of DCL Incorporated (formerly Diebold Computer Leasing Incorporated), a corporation formerly listed on the American Stock Exchange, and as Vice President and General Manager of DCL Capital Corporation, a wholly-owned subsidiary of DCL Incorporated. Mr. Constantin was actively engaged in marketing manufacturer leasing programs to computer and medical equipment manufacturers and in directing DCL Incorporated's IBM System/370 marketing activities. Prior to 1969, Mr. Constantin was employed by IBM as a data processing systems engineer for four years. Mr. Constantin is an individual general partner in four active partnerships and is an NASD registered principal. Mr. Constantin is the founder of PLI and the beneficial owner of all of the common stock of Phoenix American Incorporated. PARITOSH K. CHOKSI, age 40, is Senior Vice President, Chief Financial Officer, Treasurer and a Director of PLI. He has been associated with PLI since 1977. Mr. Choksi oversees the finance, accounting, information services and systems development departments of the General Partner and its Affiliates and oversees the structuring, planning and monitoring of the partnerships sponsored by the General Partner and its Affiliates. Mr. Choksi graduated from the Indian Institute of Technology, Bombay, India with a degree in Engineering. He holds an M.B.A. degree from the University of California, Berkeley. GARY W. MARTINEZ, age 43, is Senior Vice President and a Director of PLI. He has been associated with PLI since 1976. He manages the Asset Management Department, which is responsible for lease and loan portfolio management. This includes credit analysis, contract terms, documentation and funding; remittance application, change processing and maintenance of customer accounts; customer service, invoicing, collection, settlements and litigation; negotiating lease renewals, extensions, sales and buyouts; and management information reporting. From 1973 to 1976, Mr. Martinez was a Loan Officer with Crocker National Bank, San Francisco. Prior to 1973, he was an Area Manager with Pennsylvania Life Insurance Company. Mr. Martinez is a graduate of California State University, Chico. BRYANT J. TONG, age 39, is Senior Vice President, Financial Operations of PLI. He has been with PLI since 1982. Mr. Tong is responsible for investor services and overall company financial operations. He is also responsible for the technical and administrative operations of the cash management, corporate accounting, partnership accounting, accounting systems, internal controls and tax departments, in addition to Securities and Exchange Commission and other regulatory agency reporting. Prior to his association with PLI, Mr. Tong was Controller-Partnership Accounting with the Robert A. McNeil Corporation for two years and was an auditor with Ernst & Whinney (succeeded by Ernst & Young) from 1977 through 1980. Mr. Tong holds a B.S. in Accounting from the University of California, Berkeley, and is a Certified Public Accountant. Page 30 of 36 Item 10. Directors and Executive Officers of the Registrant (continued). Neither the General Partner nor any Executive Officer of the General Partner has any family relationship with the others. Phoenix Leasing Incorporated or its affiliates and the executive officers of the General Partner serve in a similar capacity to the following affiliated limited partnerships: Phoenix Leasing American Business Fund, L.P. Phoenix Leasing Cash Distribution Fund V, L.P. Phoenix Income Fund, L.P. Phoenix High Tech/High Yield Fund Phoenix Leasing Cash Distribution Fund IV Phoenix Leasing Cash Distribution Fund III Phoenix Leasing Cash Distribution Fund Phoenix Leasing Capital Assurance Fund Phoenix Leasing Income Fund VII Phoenix Leasing Income Fund VI Phoenix Leasing Growth Fund 1982 Phoenix Leasing Income Fund 1982-4 Phoenix Leasing Income Fund 1982-3 Phoenix Leasing Income Fund 1982-2 Phoenix Leasing Income Fund 1982-1 Phoenix Leasing Income Fund 1981 Phoenix Leasing Income Fund 1980 Phoenix Leasing Income Fund 1977 and Phoenix Leasing Income Fund 1975 Item 11. Item 11. Executive Compensation. Set forth is the information relating to all direct remuneration paid or accrued by the Registrant during the last year to the General Partner. (A) (B) (C) (D) Aggregate of Name of Capacities Cash and cash- contingent Individual or in which equivalent forms forms of persons in group served of remuneration remuneration (C1) (C2) Securities or Salaries, fees, property insurance directors' fees, benefits or reim- commissions and bursement, personal bonuses benefits (Amounts in Thousands) Phoenix Leasing Incorporated General Partner $238(1) $0 $0 (1) consists of management and acquisition fees. Page 31 of 36 Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. (a) No person owns of record, or is known by the Registrant to own beneficially, more than five percent of any class of voting securities of the Registrant. (b) The General Partner of the Registrant owns the equity securities of the Registrant set forth in the following table: (1) (2) (3) Title of Class Amount Beneficially Owned Percent of Class General Partner Represents a 5% interest in the 100% Interest Registrant's profits and distributions, until the Limited Partners have recovered their capital contributions plus a cumulative return of 12% per annum, compounded quarterly, on the unrecovered portion thereof. Thereafter, the General Partner will receive 15% interest in the Registrant's profits and distributions. Item 13. Item 13. Certain Relationships and Related Transactions. None. Page 32 of 36 PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. Page No. (a) 1. Financial Statements for the year ended December 31, 1993: Balance Sheets as of December 31, 1993 and 1992 14 Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 15 Statements of Partners' Capital for the Years Ended December 31, 1993, 1992 and 1991 16 Statements of Cash Flows for the Years ended December 31, 1993, 1992 and 1991 17 Notes to Financial Statements 19 - 27 2. Financial Statement Schedules: Schedule V - Property, Plant, and Equipment 34 Schedule VI - Accumulated Depreciation and Amortizable Costs of Equipment 35 Schedule VIII - Valuation and Qualifying Accounts and Reserves 36 All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the financial statements or notes thereto. Page 33 of 36 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. PHOENIX LEASING CASH DISTRIBUTION FUND II (Registrant) BY: PHOENIX LEASING INCORPORATED, A CALIFORNIA CORPORATION GENERAL PARTNER Date: March 29, 1994 BY: /S/ GUS CONSTANTIN, President Gus Constantin, President 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. Signature Title Date /S/ GUS CONSTANTIN President, Chief Executive March 29, 1994 (Gus Constantin) Officer and a Director of Phoenix Leasing Incorporated, General Partner /S/ PARITOSH K. CHOKSI Chief Financial Officer March 29, 1994 (Paritosh K. Choksi) Senior Vice President Treasurer and a Director of Phoenix Leasing Incorporated General Partner /S/ BRYANT J. TONG Senior Vice President, March 29, 1994 (Bryant J. Tong) Financial Operations (Principal Accounting Officer) Phoenix Leasing Incorporated General Partner /S/ GARY W. MARTINEZ Senior Vice President and March 29, 1994 (Gary W. Martinez) a Director of Phoenix Leasing Incorporated General Partner /S/ MICHAEL K. ULYATT Partnership Controller March 29, 1994 (Michael K. Ulyatt) Phoenix Leasing Incorporated General Partner

276283_1993.txt

276283_1993

1993

276283

ITEM 1. BUSINESS -------- GENERAL: - ------- Evans & Sutherland Computer Corporation (herein called the Company or E&S) designs, manufactures, sells and services interactive computing systems and software for such systems. The Company's products are widely used for providing simulated visual scenes for vehicle operator training and engineering design, and for various other modeling and visualization applications. E&S has historically designed and manufactured equipment used for these modeling, visualization, and simulation applications and has maintained a leading position in the simulation business. The Company's current products are of three basic types: 1. Visual systems which generate and display computed images of stored -------------- digital models of various real-world environments. Such systems allow exploration of the stored data base, generally through the operation of a flight training simulator, a weapons training system, a whole-vehicle engineering simulator, or an entertainment application. 2. Graphics accelerators which can be used as a component in high --------------------- performance interactive graphics display systems of a workstation. These machines allow users to make line drawings of the edges and vertices of models of three-dimensional objects and will also generate shaded images of such models stored in computer memory. These products allow for easy interaction with, and manipulation and alteration of, mathematical models and are useful tools for computer-aided design, analysis, research, and simulation. These products also support standard application programs generally available on workstations. 3. Software systems which are used with interactive graphics systems for ---------------- the creation of mathematically precise digital models of various objects for use in design and analysis. Evans & Sutherland was incorporated under the laws of the State of Utah on May 10, 1968. The Company, including subsidiaries, currently employs approximately 1,100 people and has its principal executive and operations facilities in Salt Lake City, Utah. The Company also has software design and production facilities in St. Louis, Missouri, and has several sales and service offices at various locations around the world. RECENT DEVELOPMENTS: - ------------------- 1. OEM agreement with IBM. In April of 1993, the Company signed an ---------------------- agreement with IBM under which IBM will re-market selected E&S high-end graphics accelerators to customers and distributors of IBM's RISC System/6000/TM/(1) workstation worldwide. The products will retain the E&S logo and will support IBM's AIX/TM/6000/(1)Operating System as well as selected IBM graphics application programming interfaces (API's). The new graphics accelerators developed by E&S will be available in the first half of 1994. - ---------- (1) RISC System/6000/TM/ and AIX/TM/6000 are trademarks of IBM. 2. Investment in Iwerks Entertainment, Inc. In August, 1993, the Company --------------------------------------- made an equity investment in Iwerks Entertainment, Inc. (Iwerks) with the purchase of 210,526 shares of Iwerks preferred stock for the total purchase price of $2,000,000 or $9.50 a share. The preferred shares converted into the same number of common shares when Iwerks subsequently went public. At December 31, 1993, the shares were trading at $26.75 a share. E&S and Iwerks had previously joined forces to develop a new virtual reality product, Virtual Adventures, scheduled for completion in 1994. Virtual Adventures is a high-capacity virtual reality attraction geared toward the out- of-home entertainment market. 3. Purchase of Hughes Rediffusion by Thomson-CSF. Since November of 1975, --------------------------------------------- the Company has had a special working relationship with Hughes Rediffusion Simulation Ltd. (hereinafter "Rediffusion") of Crawley, England. The relationship was first covered by a collaboration agreement which was replaced October 11, 1986 by a working agreement which runs until October, 1997. The working agreement provides for an exclusive marketing and selling arrangement in the worldwide civil aviation market and in specific segments of the United Kingdom military market. On December 31, 1993, Thomson-CSF (hereinafter "Thomson"), of Paris, France, acquired Rediffusion from Hughes Aircraft. Discussions are being held with Thomson personnel regarding the terms and conditions of the working agreement which Thomson has said are not acceptable to them. Thomson recently invoked an 18 month cancellation provision based on decreased market share. Evans & Sutherland disputes the availability of the cancellation provision. The parties are continuing to seek a mutually acceptable ongoing relationship which may result in significant changes in the way the Company serves these two markets. 4. Restructuring of E&S operations. Pursuant to a Board of Directors ------------------------------- decision in December, 1993, E&S implemented a restructuring of its operations that are expected to result in reduced costs and operating expenses of approximately $14,000,000 annually. The restructuring eliminated about 170 jobs worldwide (approximately 13% of the workforce) and entailed a one-time restructuring charge of $7,900,000 against operating earnings in the fourth quarter of 1993. The purpose of the restructuring was to respond to significant changes occurring within the traditional and highly competitive markets served by the Company enabling it to more effectively and efficiently focus appropriate resources in serving these markets as well as new emerging opportunities. 5. TRIPOS spin-off. On March 16, 1994, the Company and its wholly-owned --------------- subsidiary TRIPOS, Inc. filed with the Securities and Exchange Commission (SEC) a preliminary Information Statement and a Form 10 Registration Statement pertaining to the spin-off of TRIPOS to the stockholders of Evans & Sutherland in the form of a special dividend of TRIPOS stock. Significant costs of the spin-off were included in the $7,900,000 restructuring charge described in paragraph 3 above. The spin-off is subject to continuing review and approval by the Board of Directors and SEC review. PRODUCTS AND MARKETS: - -------------------- 1. Visual Systems. The Company produces visual systems that cover a broad -------------- range of price and performance. These visual systems include Computer Image Generator (CIG) Systems, display systems, models and other components used in training and engineering simulators and in entertainment and education. The Company's image generator products are given the designation ESIG(R)(2)followed by a number. A brief description of the products follow: ESIG 200: Primarily a dusk/night system meeting all of the requirements -------- for Federal Aviation Agency (FAA) Phase II training. The ESIG 200 displays 225 textured polygons and 4800 full color calligraphic light points per channel. An optional mode provides low-visibility daylight operation. ESIG 500: A day/dusk/night system meeting all of the requirements for FAA -------- Phase III training. Used for civil aviation training as well as military tactical and operational flight training, the ESIG 500 displays 500 textured polygons and 5000 calligraphic light points per channel. ESIG 600: A day/dusk/night system which includes all of the basic -------- performance factors of the ESIG 500 as well as significant enhancements. The ESIG 600 displays 1000 textured polygons and 5000 calligraphic light points per channel. Contour texture and photographic texture capability are available along with an increased number and size of texture maps. Non-linear image mapping is also available for compatibility with a large range of dome displays. ESIG 2000: During 1991, the Company introduced the ESIG 2000, one of the --------- most cost-effective system produced for simulation applications. Both initial orders and deliveries of these systems were achieved during that year. Systems have been installed in gunnery and battlefield simulation applications, and systems have been sold overseas. During the fourth quarter of 1992, the ESIG 2000 was selected as the visual image generator system for the U.S. Army's Close Combat Tactical Trainer (CCTT) ground forces training system. This long-term contract is one of the largest secured in the history of the Company. LIBERTY/TM/(3): A very low-cost image generator, compatible with ESIG 2000 -------------- models and selling for under $100,000, was announced at SIGGRAPH in July of 1993. Shipments of this new system are expected by mid-1994. ESIG 3000: The ESIG 3000 is a moderately priced, high-performance system --------- which is expected to serve customer requirements across a broad range of applications. It serves mid-range and high-performance requirements for military training and forms the basis for our civil airline image generation product line. ESIG 4000: The ESIG 4000 is a very high-performance system which is --------- expected to fill the most demanding requirements for military tactical training, including mission rehearsal and other applications where only highest performance will serve the customer's needs. The ESIG 4000 is especially designed to facilitate the rapid development of terrain and feature models using the latest in satellite and photographic data. Projectors, Domes, and Software: E&S supplies other components required in ------------------------------- the high-performance simulation market, including processors for infrared and radar simulation. Projector systems, helmet displays, dome structures, screen materials, and high-speed projectors for area-of-interest and target-display applications round out the hardware offerings to the simulation market. Modeling software and system integration is often a key element of the system solutions provided by the Company. - ---------- (2) ESIG(R) is a registered trademark of the Company. (3) Liberty/TM/ is a trademark of the Company. This broad range of capabilities provides solutions to virtually every visual system requirement. All ESIG family image generators are modular and expandable with the user's requirements. Extensive use of custom VLSI technology throughout the product line has been made to improve reliability, maintainability, and cost/performance ratio. E&S CIG products range in price from $100,000 to $10,000,000. 2. Graphics Accelerators. In January, 1992, the Company entered into an --------------------- agreement with Sun Microsystems Computer Corporation (SMCC) for the development of a line of high-performance interactive graphics accelerators to operate with Sun SPARCstation/TM/(4) products. The graphics accelerator products were introduced to the market in the fourth quarter of 1992 under the E&S trade name, Freedom Series/TM/(5), and have graphics functionality and performance starting above that of the current top-of-the-line Sun products. These accelerator products allow users of Sun machines to achieve graphics performance equal to or higher than that available on any other systems on the market. The arrangement with Sun is non-exclusive. The OEM agreement between the Company and IBM, as disclosed in the Recent Development portion of this report, provides a new business model for the graphics accelerator business and further provides new market access through the strong market presence of the Company's OEM partner. 3. Software Systems. The Company's software systems used for the design ---------------- of industrial products, the Conceptual Design and Rendering System (CDRS), continues to be well accepted in the automobile industry. There has been some penetration into the large, non-automotive market. CDRS is an integrated product, with both general-purpose and special-purpose hardware and application software, that allows stylists to use familiar techniques to build accurate mathematical models of aesthetic shapes, such as auto bodies, and to generate very high-quality renderings of the shapes so designed. During 1992, the CDRS software was ported to workstation platforms manufactured by IBM, and during 1993 it was ported to hardware platforms manufactured by Silicon Graphics. The CDRS systems also works efficiently on Sun machines with the Company's Freedom Series graphics accelerator and is expected to run on IBM and any other workstations equipped with the Company's accelerators as they are introduced to the market. TRIPOS Associates, Inc. of St. Louis, Missouri, the Company's wholly-owned subsidiary, had a 20% increase in revenues during 1993, which was aided by the introduction of several new software products. TRIPOS acts as a Value Added Reseller (VAR) for several engineering workstation vendors. MARKETING: - --------- 1. Visual Systems. Visual systems are primarily marketed by E&S or its -------------- agents, directly to end-users, sub-contractors, and prime contractors on a world-wide basis. In the civil airline market and specific segments of the British military market, the Company has had an exclusive working agreement with Rediffusion of Crawley, England. Rediffusion has recently been acquired by Thomson, which has indicated that the terms and conditions of the working agreement are unacceptable to it. Discussions are ongoing with respect to the continued relationship between the parties. These ongoing discussions may result in significant changes in the way in which the Company serves these markets (see Recent Developments). The Company has developed and continues to form marketing alliances in international markets. Such alliances are proving to be an effective method of reaching specific foreign markets. - ---------- (4) SPARCstation/TM/ is a trademark of Sun Microsystems, Inc. (5) Freedom Series/TM/is a trademark of the Company. It is expected that other marketing alliances will be formed as new markets develop. 2. Graphics Accelerators and Software Systems. Graphics accelerator ------------------------------------------ products were sold directly by the Company through its own specialist sales force during 1993. In the future such products will be sold OEM by the sales and marketing staffs of OEM customers. The IBM arrangement for such sales is in place with product deliveries expected in the first half of 1994, and all other graphics accelerator products, including those for Sun workstations, are expected to be sold through a similar OEM arrangement beginning early in 1994. Chemistry software products and industrial design products (CDRS) each have specialist sales people. Service for the installed base of E&S graphics accelerator products is provided through a customer engineering group which is organized along geographic lines similar to the sales organization. In the future, product support will be provided by OEM customers except for second level support to the OEM customer which will be provided by the Company from its Salt Lake City headquarters. Support for the chemistry software products is provided directly from TRIPOS in St. Louis. SIGNIFICANT CUSTOMERS: - --------------------- Sales through Rediffusion accounted for $21.0 million (15% of total sales) during 1993, $25.0 million (17% of total sales) during 1992, and $39.3 million (27% of total sales) during 1991. Value added resales of the Company's visual systems by Rediffusion have been made primarily to civil airlines and, to a lesser extent, to the United States and United Kingdom governments. Sales to the United States government and to prime contractors under government contracts were $47.1 million (33% of total sales) during 1993, $47.5 million (32% of total sales) during 1992, and $45.0 million (31% of total sales) during 1991. A portion of these sales are included in the sales to Rediffusion. The only customers accounting for more than 10% of the total sales during 1993 were Rediffusion and the United States government. The loss of any of these customers could have a material adverse effect on the revenues of the Company. Note the Rediffusion change of ownership described in the Recent Developments section, page 4, of this report. COMPETITION: - ----------- Primary competitive factors for the Company's products are performance and price. Because competitors are constantly striving to improve their products, E&S must assure that it continues to offer products with the best technical capability at a competitive price. The Company believes that it is able to compete well in this environment and that it will continue to be able to do so. Evans & Sutherland's line of graphics accelerators for use with Sun and IBM workstations sells into the competitive market for high-performance engineering workstations. The sale of these products through a strong OEM partner should enhance the Company's competitive ability. The Company believes it can compete successfully under these conditions. Evans & Sutherland has been a major supplier of visual systems to the civil airlines market worldwide. It has marketed its products through Rediffusion, now owned by Thomson. Thomson, which is a competitor of the Company, has indicated that the terms and conditions of the Rediffusion working agreement are unacceptable to it. Discussions between the parties, for the purpose of developing a suitable ongoing relationship, are continuing (see Recent Developments). Flight Safety, Link Miles (also owned by Thomson), and CAE (the Canadian parent of CAE Link) are the main competitors in this market. E&S has continued to gain market share in visual systems in the U.S. military simulation market. CAE Link and Martin Marietta (the latter through the recently acquired General Electric division) are the major competitors in this market. The Company's sales of military and tactical training visual systems have remained in the mid-$40 million range for the past several years. While sales are not expected to change significantly in the coming year, the level of new orders that are being received is expected to bring future growth in revenues. The awarding of the U.S. Army's large CCTT program (which uses the Company's ESIG 2000 image generator systems) to a team headed by Loral Federal Systems (formerly a unit of IBM) should result in revenues through the end of the decade. The Company has been successful in winning a number of related ground warfare programs throughout the world. The Company has continued to be successful in the international (non-civil) simulation business. Sales in 1993 increased to $38.0 million. Significant competitors include the previously mentioned simulation companies. E&S is a significant factor in the chemistry information software market, where the total market is small, but growing, and where the Company is a principal supplier among several relatively small vendors. BACKLOG: - ------- The Company's backlog was $68,685,000 on December 31, 1993, compared with $75,900,000 on December 25, 1992, and $74,700,000 on December 27, 1991. The predominant portion of the backlog as of December 31, 1993, is for visual simulation products. Approximately 72% of the backlog will be delivered during fiscal 1994. It is the Company's normal practice to book backlog only upon receipt and acceptance of purchase orders and contracts. It should be recognized that booked orders may be changed or canceled; however, the historical effect of such changes and cancellations has been minimal. INTERNATIONAL SALES: - ------------------- A significant amount of the Company's sales volume is for international end-users. Sales made to Rediffusion and known by E&S to be ultimately installed outside the United States are considered as international sales by the Company. In order to take full advantage of this sales pattern, the Company operated a wholly-owned Foreign Sales Corporation (FSC) subsidiary through fiscal year 1993, the use of which resulted in tax benefits in 1993 amounting to approximately $343,000. Rediffusion sales classified as international sales, plus direct sales by E&S to international customers, comprised 49% of the Company's 1993 sales volume. DEPENDENCE ON SUPPLIERS: - ----------------------- Most parts and assemblies used by E&S are readily available in the open market; however, a limited number are available only from a single vendor. In these instances the Company stocks a substantial inventory and attempts to develop alternative components or sources where appropriate. PATENTS: - ------- Evans & Sutherland owns a number of patents and is a licensee under several others developed principally at the University of Utah. Several patent applications are presently pending in the United States, Japan, and several European countries. E&S is continuing the practice, begun in 1985, of copyrighting chip masks designed by the Company and has instituted copyright procedures for these masks in Japan. E&S does not rely on, and is not dependent on, patent ownership for its competitive position. Rather, the Company relies on its depth of technological expertise. Were any or all patents held to be invalid, management believes that the Company would not suffer significant damage. However, E&S actively pursues patents on its new technology. RESEARCH & DEVELOPMENT: - ---------------------- Expenses for company-funded research and development increased 1% during 1993, and the Company continues to fund almost all R&D efforts internally. It is anticipated that high levels of R&D will continue in support of essential product development and research efforts to ensure the Company maintains technical excellence, leadership, and market competitiveness. However, it is further anticipated that R&D, as a percentage of sales, will decline over the next few years. ENVIRONMENTAL STANDARDS: - ----------------------- The Company believes that its facilities and operations are within standards fully acceptable to the Environmental Protection Agency and that all facilities and procedures are in accord with environmental rules and regulations, as well as federal, state and local laws. SEASONALITY: - ----------- The Company believes that there is no inherent seasonal pattern to its business. However, sales volume continues to fluctuate month-to-month or quarter-to-quarter due to relatively large individual sales and the random nature of customer-established shipping dates. Although the Company's volume has been skewed toward the fourth quarter in the past few years the Company knows of no reason for such a sales pattern and does not know if it will continue. ITEM 2. ITEM 2. PROPERTIES ---------- Evans & Sutherland's principal operations are located in the University of Utah Research Park, in Salt Lake City, Utah, where it owns and occupies six buildings totaling approximately 442,000 square feet. These buildings are located on land leased from the University of Utah on 40 year land leases. Two of the buildings have options to renew for an additional 40 years, and four have options to renew for 10 years. The Company's chemistry software subsidiary, TRIPOS Associates, Inc. in St. Louis, Missouri, is housed in 22,200 square feet of leased space. E&S also leases 22,000 square feet of warehouse space in Salt Lake City and holds leases on several sales and service facilities located throughout the U. S. and in Europe. Evans & Sutherland owns 46 acres of land in North Salt Lake in an undeveloped industrial area. This land was acquired for possible future expansion. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ----------------- Neither the Company, nor any of its subsidiaries, is a party to any material legal proceeding other than ordinary routine litigation incidental to its business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- Not Applicable FORM 10-K PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON ---------------------------------- STOCK AND RELATED SECURITY HOLDER MATTERS ----------------------------------------- (A) Price Range of Common Stock: --------------------------- The Company's Common Stock is traded in the over-the-counter market. Prices are quoted in the National Market System of the National Association of Security Dealers Automated Quotation System ("NASDAQ") under the symbol ESCC. The following table sets forth the range of the closing prices of the stock for the calendar quarters indicated, as reported by NASDAQ. Quotations represent actual transactions in NASDAQ'S quotation system but do not include retail markup, markdown or commission. (B) Approximate Number of Equity Security Holders: --------------------------------------------- - ---------- (1) Included in the number of stockholders of record are shares held in "nominee" or "street" names. (C),(D) Dividends: ---------- Evans & Sutherland has never paid a cash dividend on its Common Stock, retaining its earnings for the operation and expansion of its business. The Company intends for the foreseeable future to continue the policy of retaining its earnings to finance the development and growth of its business. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA (Dollars in thousands except per share amounts) QUARTERLY FINANCIAL DATA: (UNAUDITED) QUARTERLY FINANCIAL DATA--CONTINUED: (UNAUDITED) [THIS SPACE INTENTIONALLY LEFT BLANK] ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF --------------------------------------- FINANCIAL CONDITION AND RESULTS OF OPERATIONS --------------------------------------------- (Dollars In Thousands) SUMMARY - ------- The following table sets forth, for the periods indicated, the percentages which selected items in the Statements of Earnings bear to total sales of the Company and the percentage increase or decrease in such items as compared to the indicated prior period: RESULTS OF OPERATIONS - --------------------- Evans & Sutherland's domestic and international businesses operate in highly competitive markets. The business of the Company is subject to national and worldwide economic and political influences such as recession, political instability, the economic strength of governments, and rapid changes in technology. Evans & Sutherland will continue to mitigate these factors by expanding its markets, building strategic alliances both domestically and internationally, and providing lower-priced products. Costs are being controlled through strict budgetary reviews, cost effective product design, and efficient and effective purchasing and manufacturing. Sales: The following table summarizes sales for the three years of 1991 through - ----- 1993 in the five market sectors served by the Company. Sales in 1993 declined 4% from 1992, compared to a 3% increase from 1991 to 1992. U.S. government engineering sales decreased 6% from 1992 to 1993, compared to the 7% increase experienced from 1991 to 1992. Orders from the U.S. government, with some deliveries extending beyond 1993, were significantly above those for the prior year and were driven by a dramatic increase in the use of simulation by the Army for ground combat. The Company's ESIG 2000 has proven to be an ideal product to serve this market, where high volume and low cost are required. The U.S. military services and intelligence agencies are becoming increasingly interested in mission planning and rehearsal where very rapid production of complex, mission-specific databases are a critical requirement. The Company's ESIG 4000 is a well-positioned product to meet this need. Sales increased 36% in the international government and engineering sector from 1992 to 1993, compared to a 73% increase from 1991 to 1992. Growth continues to be strong, but the rate of growth has moderated, reflecting an unsettled political and business environment which is currently fueled by the cold war demise, the worldwide recession, and low oil prices. However, as with the U.S. military, the international military community is increasingly recognizing the use and value of simulation capability as a cost and performance effective solution to the accomplishment of its mission in a reduced budget environment. This is particularly evident in the rapidly growing ground warfare sector, where the Company succeeded in winning the highly sought after British Challenger Main Battle Tank Training Program. In Europe, lower-priced product offerings by the Company have also spurred interest in the commercial market. Design systems sales declined 6% in 1993 from 1992 and were flat from 1991 to 1992. Revenues from the Freedom Series graphics accelerators used with Sun Microsystems workstations, were well below expectations throughout 1993. The principal detractors to achieving anticipated sales levels were the lack of ported and validated third-party software and an inadequate commission incentive for Sun salesmen. Sun and E&S support teams, working together with the third-party suppliers have now made significant progress in alleviating much of the porting and validation bottleneck. Also, in a Company-wide restructuring announcement January 12, 1994, it was announced that the Design Systems Division was reorganizing to serve the graphics accelerator market entirely as an OEM supplier. On October 19, the Company announced an important OEM agreement with IBM, where IBM will market selected E&S high-end graphics accelerators that support IBM's RISC System/6000 workstations. IBM will use its worldwide sales force to re- sell the E&S product to its customers and will provide full service and support for these products. This combination is expected to provide new business for E&S beginning in 1994. Molecular Design (TRIPOS) sales for 1993 were nearly 20% above the 1992 sales level. Software license, support, and systems sales each contributed to the overall sales gain in 1993. The business group presently offers three software product lines for use with workstations, integrated by the molecular spreadsheet, a unique software integration tool. Please refer to the Recent Development section of this report for the announced SEC filing March 16, 1994 for the proposed spin-off of TRIPOS. Design Software (CDRS) sales were significantly higher in 1993 compared to 1992. The CDRS software offerings, the Freedom Series graphic accelerator, and the Sun Microsystems workstation are providing a winning combination as tools for styling and design. The CDRS products are now available on more platforms than any competitive products and will support the IBM/E&S platform at introduction in 1994. Ford Motor Company has renewed its commitment to CDRS with additional R&D funding, reaffirming CDRS as the leading product in the automotive styling market. The total number of civil airline visual systems ordered throughout the world declined markedly during the period 1991 through 1993. The Company's world civil pilot training business declined 37% in each of the periods 1992 to 1993 and 1991 to 1992, reflecting this continuing severe downturn. In 1993 the Company's share of new order placements dropped dramatically. The Company believes this drop, from a historically dominant position to approximately a 25% share of the new order business, was due to the failure of Rediffusion to appropriately focus its efforts on the independent visual business as it had in the past. Rediffusion made organizational changes in 1993 which included disbanding the business unit which had accounted for the bulk of the sales of the Company's products to the civil airline market. On December 31, 1993, Thomson purchased Rediffusion from Hughes Aircraft, including the responsibilities under the working agreement between Evans & Sutherland and Rediffusion. This agreement, which runs through October, 1997, covers the marketing of the Company's products to the civil airlines and to specific segments of the United Kingdom military market. Discussions between Thomson and the Company, with regard to the nature of the ongoing relationship, are being conducted. Thomson has invoked an 18 month cancellation provision based on decreased market share; however, Evans & Sutherland disputes the availability of the cancellation provision. Both parties continue to seek a suitable solution. The Company intends to continue to participate successfully in the civil airline market. Based on projected growth in air traffic miles and orders for new equipment this market is expected to experience some recovery, but not in 1994. Education and entertainment sales declined 39% in 1993 from 1992 compared to a 119% increase from 1991 to 1992. The decline principally reflected a higher than usual number of sales, in 1992, of Digistar planetarium projector units. In the latter half of 1993 the Company announced an agreement to develop interactive entertainment systems with Iwerks Entertainment, Inc. positioning it to participate in the emerging and exciting "Virtual Reality" entertainment market. This new business, however, had negligible contribution to 1993 sales results. Cost of Sales: As a percent of sales, cost of sales were 46%, 46%, and 45%, - ------------- respectively, in 1993, 1992, and 1991. Enhanced competition for nearly all of the Company's products are putting added pressure on prices and margins. Thus, the cost of sales percentage is anticipated to rise slightly in 1994. Expenses: Total expenses as a percent of sales, excluding the restructuring - -------- expenses in 1993, were 51%, 47%, and 46%, respectively, for 1993, 1992, and 1991. Marketing, General, and Administrative: Marketing, general, and -------------------------------------- administrative expenses were 5% higher in 1993 compared to 1992 and, as a percent of sales, were slightly higher than 2% above the expense level of 1992. The total increase came from the Graphics and TRIPOS business groups and was predominantly marketing related. The Simulation Division and the Design Software business groups actually experienced reductions in their marketing expenses. Expense rose 13% in 1992 from 1991. As a percent of sales, expenses were 2% above the 1991 level. Strong marketing activities for the ESIG 2000 and ESIG 3000 in the Simulation Division and expenses surrounding the introduction and initial selling of the Freedom Series accounted for a substantial portion of the increase. The Company believes future sales opportunities in these areas justified increased expense. Research and Development: Company-funded research and development ------------------------ increased 1% in 1993 from 1992, compared to a 2% decrease from 1991 to 1992. As a percent of sales, there was a 1% increase from 1992 to 1993. Management continues to practice stringent expense controls with the intent of reducing research and development expense, as a percent of revenues, over the next few years. However, high levels of R&D will continue in support of essential product development to ensure that the Company maintains technical excellence and market competitiveness. The Company continues to fund almost all R&D costs internally. Restructuring Expense: As stated elsewhere in this report, the markets --------------------- served by the Company are undergoing significant changes presenting particular challenges and opportunities. For the Company to effectively meet the needs of its customers, major reorganization was essential. This restructuring, essentially completed in January, 1994, affected every business group in the Company. The graphics accelerator business group has been reorganized to serve its market sector entirely as an OEM supplier. The Simulation Division has been reorganized to focus its enterprise on the applications of its two major customer groups. The government sector, serving mainly domestic and international military training needs, is growing in importance to the Company and has generally lower margins and specialized service requirements. The commercial business sector serves the civil airline business which continues in a cyclical downturn. This sector also includes the emerging opportunities in the fields of entertainment and education which share the same commercial nature and margin structure. The final changes and adjustments are incident to the probable spin-off of the Company's TRIPOS subsidiary to the Company's stockholders. The Company-wide restructuring expense, as recognized in the fourth quarter of 1993, was comprised of the following general expense elements: * Estimated to be cash expenditures except for $600,000 asset write-off in Item no. 4 (TRIPOS spin-off expense). The total estimated cash outlay is $4,600,000. Other Income (Expense), Net: Other income (expense), net, increased 7074% in - --------------------------- 1993 from 1992, compared to a 104% decline from 1991 to 1992. Interest income declined 19% and 27% respectively in 1993 from 1992 and in 1992 from 1991 due to lower interest rates. Some offset occurred in 1992 due to higher balances of cash and cash equivalents and temporary cash investments. Interest expense declined 15% and 21% respectively in 1993 from 1992 and in 1992 from 1991 due to a lower balance of the Company's outstanding convertible debentures during both 1993 and 1992 and also due to the payoff of 8.5% and 10.125% mortgages in early 1992. Sales of appreciated assets during 1993 and 1991 resulted in net realized gains of $6,238 and $2,315 respectively. The underlying marketable securities comprising these sales were 510,000 shares of VLSI common stock, sold in 1993, and 50,000 shares of Adobe common stock, sold in 1991. There were no sales of appreciated assets in 1992. Extraordinary Gain: The Company realized extraordinary gains of $709 and $1,252 - ------------------ in 1992 and 1991, respectively, but no extraordinary activity occurred in 1993. The gains resulted from repurchase by the Company of its 6% Subordinated Convertible Debentures at less than par. Provision for Income Taxes: Provision for income taxes was 36%, 38%, and 38% of - -------------------------- pre-tax earnings, respectively, for 1993, 1992, and 1991. The rate decline in 1993 tax provisions results from reserve reductions due to favorable settlement of tax audits. The Company adopted FASB 109 in the first quarter of 1993 as described in Note (1) (l) to the Consolidated Financial Statements with the resulting tax effects shown as a separate line item in the Consolidated Financial Statements of Earnings. LIQUIDITY AND CAPITAL COMMITMENTS - --------------------------------- Funds to support the Company's operations come mainly from: Net cash provided by operating activities, sales of marketable securities, and proceeds from employee stock purchase and option plans. The Company also has cash equivalents and temporary cash investments which can be used as needed for operating funds. During 1993, operating activities provided $28,092, proceeds from the sale of marketable securities added $7,089, and employee stock purchases contributed $2,084. The major use of cash in investing activities was to purchase $8,265 of capital equipment, and an investment of $2,000 in marketable securities. The net result was an increase in cash and temporary cash investments from $52,023 in 1992 to $78,536 at the end of 1993. At the end of 1993, the Company owned marketable securities with a market value of approximately $14,207. As of February 18, 1994, the value of the assets had increased to $14,860. There were no material capital commitments at the end of 1993. The Company believes that, through internal cash generation, plus the cash investments and marketable securities identified above, it has sufficient resources to cover its cash needs during fiscal year 1994. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- Financial statements included in Part II of this report are as follows: . Independent Auditors' Report . Consolidated Statements of Earnings - Years ended December 31, 1993, December 25, 1992, and December 27, 1991. . Consolidated Balance Sheets - December 31, 1993 and December 25, 1992. . Consolidated Statements of Stockholders' Equity - Years ended December 31, 1993, December 25, 1992, and December 27, 1991. . Consolidated Statements of Cash Flows - Years ended December 31, 1993, December 25, 1992, and December 27, 1991. . Notes to Consolidated Financial Statements - Years ended December 31, 1993, December 25, 1992, and December 27, 1991. Financial statements schedules included in Part IV of this report are as follows: . Schedule V - Property, Plant and Equipment . Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment . Schedule VIII - Valuation and Qualifying Accounts . Schedule X - Supplementary Income Statement Information Schedules other than those listed above are omitted because of the absence of conditions under which they are required or because the required information is presented in the Financial Statements or Notes thereto. Independent Auditors' Report ---------------------------- The Board of Directors and Stockholders Evans & Sutherland Computer Corporation: We have audited the consolidated financial statements of Evans & Sutherland Computer Corporation and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Evans & Sutherland Computer Corporation and subsidiaries as of December 31, 1993 and December 25, 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG Peat Marwick Salt Lake City, Utah February 18, 1994 EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Consolidated Statements of Earnings Years ended December 31, 1993, December 25, 1992, and December 27, 1991 (In thousands except per share amounts) See accompanying notes to consolidated financial statements. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Consolidated Balance Sheets December 31, 1993 and December 25, 1992 (Dollars in thousands except share amounts) See accompanying notes to consolidated financial statements. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity Years ended December 31, 1993, December 25, 1992, and December 27, 1991 (Dollars in thousands) See accompanying notes to consolidated financial statements. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows Years ended December 31, 1993, December 25, 1992, and December 27, 1991 (In thousands) EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Consolidated Statements of Cash Flows (continued) Years ended December 31, 1993, December 25, 1992, and December 27, 1991 (In thousands) See accompanying notes to consolidated financial statements. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1993, December 25, 1992, and December 27, 1991 (Dollars in thousands except per share amounts) (1) Summary of Significant Accounting Policies ------------------------------------------ (a) Fiscal Year ----------- The Company's fiscal year ends the last Friday in December. The fiscal year- ends for the years included in the accompanying consolidated financial statements are the periods ended December 31, 1993, December 25, 1992, and December 27, 1991. Unless otherwise specified, all references to a year are to the fiscal year ending in the year stated. (b) Principles of Consolidation --------------------------- The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. (c) Revenue Recognition ------------------- Sales of products and services to customers are generally recorded when the products are shipped to the customer or the service has been completed. The Company records income from long-term contracts using the percentage-of- completion method, determined by the ratio of costs incurred to management's estimate of total anticipated costs. If estimated total costs on any contract indicate a loss, the Company provides currently for the total anticipated loss on the contract. Billings on uncompleted long-term contracts may be greater than or less than incurred costs and estimated earnings and are recorded as a net asset in the accompanying consolidated balance sheets. (d) Cash Equivalents ---------------- For purposes of reporting cash flows, the Company considers all highly liquid financial instruments purchased with an original maturity to the Company of three months or less to be cash equivalents. (e) Temporary Cash Investments -------------------------- Temporary cash investments, consisting of U.S. government securities, are stated at cost, which approximates market value. All such investments have original maturities to the Company of greater than three months. (f) Inventories ----------- Raw materials and supplies inventories are stated at the lower of weighted average cost or market. Work-in-process and finished goods are stated on the basis of accumulated manufacturing costs, but not in excess of market (net realizable value). EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (g) Property, Plant, and Equipment ------------------------------ Property, plant, and equipment are stated at cost. Depreciation and amortization are computed using the straight-line and double-declining balance methods based on the estimated useful lives of the related assets. (h) Other Assets ------------ Other assets include deferred bond offering costs, capitalized software development costs, and goodwill, and are being amortized on a straight- line basis over the bond term, estimated useful lives, and twelve years, respectively. (i) Marketable Equity Securities ---------------------------- Marketable equity securities are stated at the lower of cost or market. Market is determined using the closing published market price at year-end. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities. The Company is required to adopt provisions of Statement 115 beginning January 1, 1994, prospectively. Statement 115 requires that debt and equity securities be grouped into one of three categories; (i) held-to-maturity, (ii) available-for-sale, or (iii) trading. Financial accounting treatment of the various categories is as follows: (i) held-to-maturity securities will be accounted for using amortized book value similar to current standards; (ii) changes in the unrealized gain or loss on securities in the available-for-sale category will be reflected as an adjustment to stockholders' equity; (iii) unrealized gains or losses on trading securities will flow through the consolidated statements of earnings. The Company will classify all marketable equity securities as available-for- sale. If Statement 115 had been adopted on December 31, 1993, marketable equity securities and stockholders' equity would have been increased by $11,029. (j) Warranty Reserve ---------------- The Company provides a warranty reserve for estimated future costs of servicing products under warranty agreements. Anticipated costs for product warranty are based upon estimates derived from experience factors and are recorded at the time of sale or over the contract period for long-term contracts. (k) Earnings Per Common and Common Equivalent Shares ------------------------------------------------ Earnings per common and common equivalent shares have been computed based on the weighted average number of shares outstanding during the year, after giving effect, if necessary, to the assumption that all dilutive stock options were exercised at the beginning of the year or date of grant with the proceeds therefrom being used to acquire treasury shares. Earnings per common and common equivalent shares are based on 8,256,331, 8,780,051, and 8,863,075 shares outstanding for 1993, 1992, and 1991, respectively. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (l) Income Taxes ------------ In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. Statement 109 requires a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of Statement 109, 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 and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective December 26, 1992, the Company adopted Statement 109 and it has reported the cumulative effect of the change in the method of accounting for income taxes in the 1993 consolidated statement of income. Pursuant to the deferred method under APB Opinion 11, which was applied in 1992 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable in the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. (m) Research and Development Costs ------------------------------ Research and development costs are expensed as incurred. (n) Foreign Currency Translation ---------------------------- The local foreign currency is the functional currency for the Company's foreign subsidiaries. Assets and liabilities of foreign operations are translated to U.S. dollars at the current exchange rates as of the applicable balance sheet date. Revenues and expenses are translated at the average exchange rates prevailing during the period. Adjustments resulting from translation are reported as a separate component of stockholders' equity. Certain transactions of the foreign subsidiaries are denominated in currencies other than the functional currency, including transactions with the parent company. Transaction gains and losses are included in miscellaneous income (expense) for the period in which exchange rates change and amounted to net losses of $291 in 1993, $56 in 1992, and $831 in 1991. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (2) Inventories ----------- Inventories are summarized as follows: (3) Long-term Contracts ------------------- Comparative information with respect to uncompleted contracts follows: (4) Property, Plant, and Equipment ------------------------------ The cost and estimated useful lives of property, plant, and equipment are summarized as follows: EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (4) Property, Plant, and Equipment (continued) ------------------------------------------ All buildings and improvements owned by the Company are constructed on land leased from an unrelated third party. Such leases extend for a term of 40 years from 1986, with options to extend two of the leases for an additional 40 years and the remaining four leases for an additional 10 years. At the end of the lease term, including any extension, the buildings and improvements revert to the lessor. (5) Long-term Investments --------------------- Long-term investments, stated at cost, are summarized as follows: Iwerks - The Company purchased 210,526 shares of common stock of Iwerks ------ during 1993. The Company's investment in Iwerks represents less than a three percent ownership. Gross unrealized gains on the Iwerks investment amount to approximately $3,632 at December 31, 1993. As of February 18, 1994, gross unrealized gains amounted to approximately $3,105. VLSI - The Company owned 694,500 and 1,204,500 voting common shares of VLSI ---- at December 31, 1993 and December 25, 1992, respectively. The Company's investment in VLSI, an electronics manufacturing company, represents less than a two percent ownership. A realized gain of $6,238 on the sale of 510,000 shares was recognized in 1993. Gross unrealized gains on the VLSI investment amounted to approximately $6,306, $6,872, and $7,100 at December 31, 1993, December 25, 1992, and December 27, 1991, respectively. As of February 18, 1994, gross unrealized gains on the investment amounted to approximately $7,087. Adobe - The Company owned 49,864 shares of Adobe common stock at December 31, ----- 1993, December 25, 1992, and December 27, 1991. The number of shares owned reflect an adjustment to 1992 and 1991 amounts for a two for one stock split declared in 1993. The Company's investment in Adobe represents less than a one percent ownership. A realized gain of $2,315 on the sale of 50,000 (pre- split) shares of Adobe stock was recognized in 1991. Gross unrealized gains on the Adobe investment amounted to approximately $1,091, $752, and $1,500 at December 31, 1993, December 25, 1992, and December 27, 1991, respectively. As of February 18, 1994, gross unrealized gains on the investment amounted to approximately $1,490. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (6) Notes Payable to Banks ---------------------- The following is a summary of notes payable to banks: The average balance outstanding and weighted average interest rate are computed based on the outstanding balances and interest rates at month-end during each year. The Company has unsecured revolving line of credit agreements totaling $4,319 at December 31, 1993, of which approximately $1,634 was unused and available. At December 31, 1993, the Company also had standby letters of credit outstanding totaling approximately $1,436 relating to performance obligations under long-term contracts. (7) Long-term Debt -------------- Long-term debt is summarized as follows: The six percent convertible subordinated debentures are due in 2012 and are convertible at any time prior to maturity into the Company's common stock at $48.50 per share, subject to adjustments in certain events. The debentures are redeemable at the Company's option, in whole or in part, at declining redemption premiums until March 1, 1997, and at par on and after such date. The Company is required to provide a sinking fund balance of five percent of the applicable principal amount of the debentures annually beginning March 1, 1998. The debentures are subordinated to all existing and future superior indebtedness. During 1992 and 1991, the Company repurchased $4,369 and $5,785, respectively, of convertible debentures on the open market. These purchases resulted in extraordinary gains of approximately $1,144 and $2,019, respectively. These extraordinary gains are shown net of income taxes in the accompanying consolidated statements of earnings. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (8) Accrued Expenses ---------------- Accrued expenses consist of the following: (9) Income Taxes ------------ Components of income tax expense (benefit) follow, allocated to income from continuing operations: EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (9) Income Taxes (continued) ------------------------ The actual tax expense allocated to income from continuing operations differs from the "expected" tax expense for the three years shown (computed by applying the U.S. corporate tax rate of 34 percent) as follows: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 in accordance with Statement 109 are presented below: The valuation allowance for deferred tax assets as of December 26, 1992 was $560. There was no net change in the total valuation allowance for the year ended December 31, 1993. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (9) Income Taxes (continued) ------------------------ Deferred income taxes result from timing differences in the recognition of income and expense for tax and financial statement purposes. The sources of these timing differences and their tax effects for the years ended December 25, 1992 and December 27, 1991 in accordance with APB Opinion 11 which was in effect for these years as follows: Management believes the existing net deductible temporary differences will reverse during the periods in which the Company generates net taxable income. The Company has a strong taxable earnings history. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The Company has established a valuation allowance primarily for net operating loss and tax credit carryforwards from an acquired subsidiary as a result of the uncertainty of realization. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (10) Stock Option, Purchase, and Bonus Plans --------------------------------------- Stock Option Plans - The Company has granted options to officers, directors, ------------------ and employees to acquire shares of the Company's common stock. Substantially all options so granted provide for purchase prices equal to the fair market value on the date of grant. A summary of activity follows: Under the terms of the stock option plan, 522,305, 438,799, and 389,971 shares of common stock were authorized and reserved for issuance, but were not granted at December 31, 1993, December 25, 1992, and December 27, 1991, respectively. Stock Purchase Plan - The Company has an employee stock purchase plan ------------------- whereby qualified employees are allowed to purchase limited amounts of the Company's common stock at 85 percent of the market value of the stock at the time of the sale. Stock Bonus Plan - The Company has authorized a total of 200,000 shares of ---------------- common stock for an executive stock bonus plan under which officers and key employees may be granted stock bonuses. No shares were issued under this plan in 1993, 1992, or 1991. (11) Lease Commitments ----------------- The Company occupies real property and uses certain equipment under lease arrangements, which are accounted for primarily as operating leases. A summary of lease expense under such arrangements follows: EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (11) Lease Commitments (continued) ----------------------------- A summary of noncancelable long-term operating lease commitments follows: (12) Industry Segment and Foreign Operations --------------------------------------- The Company's operations consist of a single line of business composed of designing, manufacturing, selling, and servicing interactive computing systems for pilot training and for general engineering and scientific applications. A summary of operations by geographic area follows: EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (12) Industry Segment and Foreign Operations (continued) --------------------------------------------------- Transfers between geographic areas are accounted for at market price, and intercompany profit is eliminated in consolidation. Operating earnings (loss) are total sales less operating expenses. Identifiable assets are those assets of the Company that are identified with the operations in each geographic area. Corporate assets are principally temporary cash investments and long-term investments. (13) Sales to Foreign and Major Customers ------------------------------------ A summary of sales to foreign and major customers follows: (14) Employee Benefit Plans ---------------------- Pension Plan - The Company has a defined benefit pension plan covering ------------ substantially all employees who have attained age 21 with service in excess of one year. Benefits at normal retirement age (65) are based upon the employee's years of service and the employee's highest compensation for any consecutive five of the last ten years of employment. The Company's funding policy is to contribute annually the maximum amount that can be deducted for federal income tax purposes. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (14) Employee Benefit Plans (continued) ---------------------------------- Net annual pension expense of the plan is summarized as follows: The following assumptions were used in accounting for the pension plan: The following summarizes the plan's funded status and amounts recognized in the Company's consolidated financial statements: Deferred Savings Plan - The Company has a deferred savings plan which --------------------- qualifies under Section 401(k) of the Internal Revenue Code. The plan covers all employees of the Company who have at least one year of service and who are age 18 or older. The Company makes matching contributions of 50 percent of each employee's contribution not to exceed six percent of the employee's compensation. The Company's contributions to this plan for 1993, 1992, and 1991 were $1,025, $1,022, and $900, respectively. EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (15) Preferred Stock --------------- The Company has both Class A and Class B Preferred Stock with 5,000,000 shares authorized for each class. The Company has reserved 300,000 shares of the Class A Preferred Stock as Series A Junior Preferred Stock under a shareholder rights plan. This preferred stock entitles holders to 100 votes per share and to receive the greater of $2.00 per share or 100 times the common dividend declared. Upon voluntary or involuntary liquidation, dissolution, or winding up of the Company, holders of the preferred stock would be entitled to be paid, to the extent assets are available for distribution, an amount of $100 per share plus any accrued and unpaid dividends before payment is made to common stockholders. In connection with this preferred stock, the Company issued warrants to each common stockholder that would be exercisable contingent upon certain conditions and would allow the holder to purchase 1/100th of a preferred share per warrant. At December 31, 1993 and December 25, 1992, the warrants were not exercisable, and no shares of preferred stock have been issued. (16) Disclosures About the Fair Value of Financial Instruments --------------------------------------------------------- The carrying amount approximates fair value because of the short maturity of the following financial instruments: cash and cash equivalents, temporary cash investments, receivables, notes payable to banks, accounts payable, and accrued expenses. The fair value of the Company's marketable equity securities ($14,207 at December 31, 1993) is based on quoted market prices (note 5). The fair value of the Company's long-term debt instruments ($30,765 at December 31, 1993) is based on quoted market prices (note 7). (17) Commitments and Contingencies ----------------------------- In the normal course of business, the Company has various claims and other contingent matters, including items raised by government contracting officers and auditors. Although the final outcome of such matters cannot be predicted, the Company believes the ultimate disposition of these matters will not have a material adverse effect on the Company's consolidated financial condition. (18) Restructuring Charge -------------------- In the fourth quarter of 1993, the Company incurred $7,900 of nonrecurring restructuring charges. This restructuring eliminated approximately 170 jobs worldwide or about 13 percent of the work force. This charge was incurred to help the Company better serve its changing markets and focus more appropriately its resources on profitable opportunities. Approximately $7,313 of these charges were included in accrued expenses at December 31, 1993 (note 8). EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements (18) Restructuring Charge (continued) -------------------------------- On March 16, 1994, the Company and its wholly-owned subsidiary Tripos, Inc. filed with the Securities and Exchange Commission (SEC) a preliminary Information Statement and a Form 10 Registration Statement pertaining to the spin-off of Tripos, Inc. to the stockholders of Evans & Sutherland in the form of a special dividend of Tripos common stock. Estimated costs of the spin-off were included in the $7,900 restructuring charge described above. The spin-off is subject to continuing review and approval by the Board of Directors and SEC review. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ---------------------------------------------------- "None" [THIS SPACE INTENTIONALLY LEFT BLANK] FORM 10-K PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY: ----------------------------------------------- ITEM 11. ITEM 11. MANAGEMENT REMUNERATION: ----------------------- ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT: -------------------------------------------------------------- ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS: ---------------------------------------------- Part III of this Annual Report on Form 10-K, comprised of the foregoing Items 10 - 13, has been omitted in reliance upon the provisions of Instruction G (3) to Form 10-K. The Company will file a definitive Proxy Statement with the Securities and Exchange Commission, pursuant to Regulation 14A, within 120 days after the close of its last fiscal year. Such Proxy Statement is specifically incorporated herein by this reference. [THIS SPACE INTENTIONALLY LEFT BLANK] FORM 10-K PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K --------------------------------------------------------------- (A) The following constitutes a list of Financial Statements, Financial Statement Schedules and Exhibits required to be included in this report: 1. Financial Statements - Included in Part II, Item 8 of this report: -------------------- . Independent Auditors' Report . Consolidated Statements of Earnings - Years ended December 31, 1993, December 25, 1992, and December 27, 1991. . Consolidated Balance Sheets - December 31, 1993 and December 25, 1992. . Consolidated Statements of Stockholders' Equity - Years ended December 31, 1993, December 25, 1992, and December 27, 1991. . Consolidated Statements of Cash Flows - Years ended December 31, 1993, December 25, 1992, and December 27, 1991. . Notes to Consolidated Financial Statements - Years ended December 31, 1993, December 25, 1992, and December 27, 1991. 2. Financial Statements Schedules - included in Part IV of this report ------------------------------ are as follows: . Schedule V - Property, Plant and Equipment . Schedule VI - Accumulated Depreciation Amortization of Property, Plant and Equipment . Schedule VIII - Valuation and Qualifying Accounts . Schedule X - Supplementary Income Statement Information Schedules other than those listed above are omitted because of the absence of conditions under which they are required or because of the required information is presented in the Financial Statements or Notes thereto. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON ------------------------------------------------------ FORM 8-K (CONTINUED) -------------------- 3. Exhibits -------- 3.1 Articles of Incorporation, as amended, filed as Exhibit 3.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 25, 1987, and incorporated herein by this reference. Amendments to Articles of Incorporation filed as Exhibit 3.1.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 1988, and incorporated herein by this reference. 3.2 By-laws, as amended, filed as Exhibit 3.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 25, 1987, and incorporated herein by this reference. 10.1 Working Agreement dated October 11, 1986, between the Company and Rediffusion Simulation Ltd. filed as Exhibit 10.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 1986, and incorporated herein by this reference. 10.1.1 Amendment Number 1 to the October 11, 1986 Working Agreement between the Company and Rediffusion Simulation Ltd. effective June 7, 1988, and filed as Exhibit 10.1.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 30, 1988, and incorporated herein by this reference. 10.1.2 Amendment Number 2 to the October 11, 1986 Working Agreement between the Company and Rediffusion Simulation Ltd. effective January 15, 1991, and filed as Exhibit 10.1.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1990, and incorporated herein by this reference. 10.2 1985 Stock Option Plan, filed as Exhibit 1 to the Company's Post-effective Amendment No. 1 to Registration Statement on Form S-8, SEC File No. 2-76027, and incorporated herein by this reference. 10.3 1989 Stock Option Plan for Non-employee Directors, filed as Exhibit 10.5 to the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1989, and incorporated herein by this reference. 10.5 The Company's 1981 Executive Stock Bonus Plan, filed as Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1982, and incorporated herein by this reference. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON ------------------------------------------------------ FORM 8-K (CONTINUED) -------------------- 10.6 The Company's 1991 Employee Stock Purchase Plan, filed as Exhibit 4.1 to the Company's Registration Statement on Form S-8, SEC File No. 33-39632, and incorporated herein by this reference. 11.1 Statement re: Computation of Weighted Average Number of Shares used in computing Earnings per Share. 23.1 Consent of Accountants to Incorporation of Financial Statements by reference to Form S-8's. 24.1 Powers of Attorney for Messrs. Stewart Carrell, Henry N. Christiansen, Peter O. Crisp, Rodney S. Rougelot, Ivan E. Sutherland, and John E. Warnock. (B) No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. Schedule V ---------- EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Property, Plant, and Equipment Years ended December 31, 1993, December 25, 1992, and December 27, 1991 (In thousands) Note: These adjustments result from the effects of changes in foreign currency exchange rates on beginning of year asset balances, from transfers among categories, and from assets acquired in purchase business combinations. Schedule VI ----------- EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Accumulated Depreciation and Amortization of Property, Plant, and Equipment Years ended December 31, 1993, December 25, 1992, and December 27, 1991 (In thousands) Note: These adjustments result from the effects of changes in foreign currency exchange rates on beginning of year asset balances and from transfers among categories. Schedule VIII ------------- EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Valuation and Qualifying Accounts Years ended December 31, 1993, December 25, 1992, and December 27, 1991 (In thousands) Schedule X ---------- EVANS & SUTHERLAND COMPUTER CORPORATION AND SUBSIDIARIES Supplementary Income Statement Information Years ended December 31, 1993, December 25, 1992, and December 27, 1991 (In thousands) 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. EVANS & SUTHERLAND COMPUTER CORPORATION March 30, 1994 By: /S/ ------------------------------------------- RODNEY S. ROUGELOT, PRESIDENT Pursuant to the requirements of the Securities and Exchange Act of 1934, this report signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /S/ * Chairman of the March 30, 1994 - -------------------------- Board of Directors STEWART CARRELL /S/ Director and President March 30, 1994 - -------------------------- (Chief Executive Officer) RODNEY S. ROUGELOT /S/ Vice President and Chief March 30, 1994 - -------------------------- Financial Officer GARY E. MEREDITH (Principal Financial and Accounting Officer) /S/ * Director March 30, 1994 - -------------------------- HENRY N. CHRISTIANSEN /S/ * Director March 30, 1994 - -------------------------- PETER O. CRISP /S/ * Director March 30, 1994 - -------------------------- IVAN E. SUTHERLAND /S/ * Director March 30, 1994 - -------------------------- JOHN E. WARNOCK By: /S/ * March 30, 1994 ----------------------- RICHARD F. LEAHY Attorney-in-Fact EXHIBITS TO THE ANNUAL REPORT OF FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 OF EVANS & SUTHERLAND COMPUTER CORPORATION

101001_1993.txt

101001_1993

1993

101001

Item 1. Business Introduction United Air Lines, Inc. ("United" or the "Company") was incorporated under the laws of the State of Delaware on December 30, 1968. The executive offices of the Company are located at 1200 Algonquin Road, Elk Grove Township, Illinois 60007. The Company's mailing address is P.O. Box 66100, Chicago, Illinois 60666. The telephone number for the Company is (708) 952-4000. United is the principal subsidiary of UAL Corporation ("UAL"), and is wholly-owned by UAL. United accounted for virtually all of UAL's revenues and expenses in 1993. United is a major commercial air transportation company. Proposed Employee Investment Transaction On December 22, 1993, the Board of Directors of UAL approved an agreement in principle (as amended, the "Agreement in Principle") with the Air Line Pilots Association ("ALPA") and the International Association of Machinists ("IAM") concerning a proposed transaction (the "Employee Investment Transaction") that would provide a majority equity interest in UAL to certain of the employees of United in exchange for wage and benefit concessions and work-rule changes. In January 1994, ALPA and the IAM ratified the Agreement in Principle. The Employee Investment Transaction is subject to, among other conditions, execution of definitive documentation and approval by UAL's stockholders. The proposed Employee Investment Transaction is intended to put in place a lower cost structure that allows United to compete effectively in domestic markets and improve its long-term financial competitiveness. The concessions would come from three of United's employee groups: employees represented by ALPA, employees represented by the IAM, and the salaried and management employees. Employees represented by the Association of Flight Attendants ("AFA") have been invited to participate in the transaction, and representatives of UAL have engaged in discussions with AFA representatives concerning such participation but the transaction does not require their participation to proceed. In the proposed transaction, an employee stock ownership plan ("ESOP") would be created to provide United employees with a minimum of a 53% equity interest in UAL in exchange for wage and benefit concessions and work-rule changes. The employee interest could increase to up to 63%, depending on the average market value of UAL's common stock in the year after the transaction closes. The transaction would not be dependent on external financing. Pursuant to the terms of the Agreement In Principle, current stockholders of UAL would receive the remaining 37% to 47% of the new common stock and $88 per share of cash and face amount of debt and preferred stock. The transaction would provide for the creation of a low-cost short-haul operation to compete in domestic markets. For additional information concerning the Agreement in Principle and the proposed Employee Investment Transaction, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operation". Recent Developments In January 1994, United entered into an agreement with The Boeing Company ("Boeing") to acquire two new B747-400 aircraft in 1994, in place of options for two similar aircraft (see "Flight Equipment" in Item 2, Properties). In March 1994, United opened a new major aircraft maintenance and overhaul facility ("MOC-II") in Indianapolis. Operating under a lease with the Indianapolis Airport Authority which expires November 30, 2031, when all phases of the construction work are completed United will occupy approximately 300 acres of land and up to three million square feet of space, including 15 aircraft dock positions. MOC-II will be used for maintenance of Boeing 737 aircraft, engine repair, spare parts storage, ground equipment maintenance, technical support and administrative functions. Airline Operations United has been engaged in the air transportation of persons, property and mail since 1934, and certain of its predecessors began operations as early as 1926. United is one of the world's largest investor-owned airlines as measured by operating revenues, revenue passengers and revenue passenger miles flown. At the end of 1993, United served 159 airports in the United States and 32 foreign countries. During 1993, United averaged 2,040 departures daily, flew a total of 101 billion revenue passenger miles, and carried an average of 191,000 passengers per day. United provides service to its domestic and international markets principally through a system of hub airports at major cities. Each hub provides United flights to a network of spoke destinations as well as flights to other United hubs. This arrangement permits travelers to fly from point of origin to more destinations without switching carriers. Currently, United flies from four U.S. hubs - Chicago-O'Hare International ("O'Hare"), Denver, San Francisco International, and Dulles International near Washington, D.C. ("Dulles") - and is the principal carrier at each of these hubs. United also has a Pacific hub operation at Tokyo Narita airport, and an Atlantic hub operation at London Heathrow Airport. During the last several years, United has strengthened the revenue-generating capability of the hub airports by: (1) adding new spokes (new cities and airports); (2) adding frequency on previously operated route segments; and (3) entering into marketing agreements with smaller U.S. air carriers which serve less populated destinations and with foreign carriers which serve destinations that United could not serve economically itself. United has developed a route system covering North America, Asia, the South Pacific, Europe and Latin America. Within North America, East-West traffic is served by nonstop Transcontinental flights and by the hubs at Chicago O'Hare and Denver, while North-South traffic on the West Coast is served by the San Francisco hub. Within North America, United has a marketing program with selected independent regional air carriers, known as the United Express ("UE") program, which allows United to increase the number of destinations served by its hub-and-spoke network. Six regional carriers currently participate in the UE marketing program providing connecting schedules to ten major cities also served by United: Air Wisconsin Airlines Corporation to Chicago and Denver; UFS, Inc. to Chicago; Mesa Airlines, Inc. to Denver and Los Angeles; WestAir Commuter Airlines, Inc. to San Francisco, Los Angeles, Seattle and Portland, Oregon; Great Lakes Aviation to Chicago, Denver and Minneapolis; and Atlantic Coast Airlines, Inc. to Washington-Dulles, Newark and Orlando. Connecting schedules of three of these carriers result in part from separate transfers to them in 1993 of operating assets of Air Wisconsin, Inc., which is an indirect subsidiary of UAL Corporation. Within North America, United also has marketing agreements that provide for sharing of the "UA" code on certain routes with two other domestic air carriers, Trans World Express ("TWE") and Aloha Airlines. Code-sharing allows an airline to expand the marketing of its service brand by using its two-letter designator code to designate in computerized reservations systems a connecting flight operated by another airline on the itinerary. Under these agreements, the UA designator code is reflected on TWE flights between approximately 20 cities in the Northeast U.S. which connect with United's international flights in and out of New York John F. Kennedy International Airport ("Kennedy"), and on Aloha Airlines' flights between and among the Hawaiian Islands in connection with United's flights in and out of Hawaii. Finally, North American traffic is also served by code-sharing agreements United has with two Caribbean air carriers, ALM and Sunaire, under which each reflects the United designator code on its flights. Asian traffic is served from six U.S. cities via the Tokyo hub and with nonstop flights from San Francisco to Hong Kong, Osaka, Seoul and Taipei; from Honolulu to Osaka; and, beginning in 1993, from Los Angeles to Hong Kong, and from Chicago to Seoul. Effective October 1994, United plans to offer nonstop service between Los Angeles and Osaka and, as soon as government approvals are received, service between Los Angeles and Ho Chi Minh City, Vietnam, via Taipei. South Pacific traffic to Auckland, Melbourne and Sydney is served from Los Angeles. United plans to begin nonstop service between San Francisco and Sydney beginning in June 1994 (subject to the approval of the Australian government), further strengthening United's San Francisco international hub and supplementing United's Los Angeles to Sydney service. United also has code-sharing agreements with two South Pacific air carriers, Ansett Australia and Ansett New Zealand. Based on reports filed with the Department of Transportation, United was the leading U.S. carrier in the Pacific in 1993 in terms of revenue passenger miles. During 1993, United's Pacific Division accounted for 25% of United's revenues. Service between the U.S. and Europe is provided by: flights from six U.S. cities to the London hub, with connecting service at London to several European cities; flights from four U.S. cities to Paris, with connecting service to two European cities; and nonstop service from Dulles to Brussels, Frankfurt, Madrid, Milan/Rome and, beginning in 1993, to Amsterdam, Glasgow and Zurich; and from Chicago to Frankfurt. European traffic is also served by United's code-sharing agreements with British Midland and Emirates. In addition, in 1993 a comprehensive marketing agreement was signed with Germany's flag carrier, Lufthansa, and is awaiting governmental approvals. If approved, this worldwide alliance would, among other things, allow code-sharing between the two airlines on Transatlantic route segments, and would permit United to code-share on Lufthansa flights to eight cities in Germany beyond Frankfurt (Berlin, Cologne, Dusseldorf, Hanover, Hamburg, Munich, Nuremberg and Stuttgart), as well as Vienna. Similarly, the agreement would permit Lufthansa to code- share on United flights to eleven cities in the U.S. -- five beyond Chicago, five beyond Washington, D.C., and one beyond San Francisco. A 1993 agreement to acquire USAir's Philadelphia- London route was terminated due to the transaction's failure to receive the requisite governmental approvals. Service between the U.S. and Latin America is provided by flights to 14 Latin American cities in 11 countries from a number of cities in the U.S. Ten Latin American cities are served nonstop from Miami, three nonstop from Los Angeles and four from New York-Kennedy. United also has a code-sharing agreement with Transbrasil. Operating revenues attributed to United's foreign operations were approximately $5.6 billion in 1993, $4.9 billion in 1992 and $3.9 billion in 1991. Selected Operating Statistics The following table sets forth certain selected operating data for United: Year Ended December 31 1993 1992 1991 1990 1989 Revenue Aircraft Miles (millions)(a) 756 695 635 597 552 Revenue Aircraft Departures 746,665 721,504 691,402 654,555 621,113 Available Seat Miles (millions)(b) 150,728 137,491 124,100 114,995 104,547 Revenue Passenger Miles (millions)(c) 101,258 92,690 82,290 76,137 69,639 Revenue Passengers (thousands) 69,814 66,692 62,003 57,598 54,859 Average Passenger Journey (miles) 1,450 1,390 1,327 1,322 1,269 Average Flight Length (miles) 1,013 964 918 912 888 Passenger Load Factor(d) 67.2% 67.4% 66.3% 66.2% 66.6% Break-even Load Factor(e) 65.6% 70.4% 69.5% 66.5% 63.0% Average Yield Per Revenue Passenger Mile (in cents)(f) 12.5 12.2 12.5 12.6 12.2 Cost Per Available Seat Mile (in cents)(g) 9.3 9.6 9.8 9.6 8.9 Average Fare Per Revenue Passenger $181.65 $169.87 $166.05 $167.26 $155.60 Average Daily Utilization of each Aircraft (hours:minutes)(h) 8:30 8:19 8:13 8:14 8:09 (a) "Revenue aircraft miles" means the number of miles flown in revenue producing service. (b) "Available seat miles" represents the number of seats available for passengers multiplied by the number of miles those seats are flown. (c) "Revenue passenger miles" represents the number of miles flown by revenue passengers. (d) "Passenger load factor" represents revenue passenger miles divided by available seat miles. (e) "Break-even load factor" represents the number of revenue passenger miles at which operating earnings would have been zero (based on the actual average yield) divided by available seat miles. (f) "Average yield per revenue passenger mile" represents the average revenue received for each mile a revenue passenger is carried. (g) "Cost per available seat mile" represents operating expenses divided by available seat miles. (h) "Average daily utilization of each aircraft" means the average air hours flown in service per day per aircraft for the total fleet of aircraft. Industry Conditions Seasonal and Other Factors. United's results of operations for interim periods are not necessarily indicative of those for an entire year, since the air travel business is subject to seasonal fluctuations. United's first and fourth quarter results normally are affected by reduced travel demand in the fall and winter, and United's operations, particularly at its O'Hare and Denver hubs, are often affected adversely by winter weather. In the past, these fluctuations have generally resulted in better operating results for United in the second and third quarters. See Item 8, "Financial Statements and Supplementary Data," for summarized unaudited financial data for the four quarters of 1993 and 1992 incorporated by reference therein. The results of operations in the air travel business have also fluctuated significantly in the past in response to general economic conditions. In addition, the airline business is characterized by a high degree of operating leverage. As a result, the economic environment and small fluctuations in United's yield per revenue passenger mile and cost per available seat mile can have a significant impact on operating results. The Company anticipates that seasonal factors and general economic conditions, in addition to industrywide fare levels, labor and fuel costs, the competition from other airlines with lower operating costs than United's international government policies, and other factors, will continue to impact United's operations. Competition and Fares. The airline industry is highly competitive. In domestic markets, new and existing carriers are free to initiate service on any route. United faces competition from other carriers on virtually every route it serves. In United's domestic markets, these competitors include all of the other major U.S. airlines as well as smaller carriers. United's marketing strategy is driven by four principal competitive factors: schedule convenience, overall customer service, frequent flyer programs and price. United seeks to attract travelers through convenient scheduling (particularly during peak demand periods), high quality service, frequent flyer programs designed to reward customer loyalty, and competitive pricing. During 1993, certain domestic carriers, both in and out of bankruptcy proceedings, reorganized their operating cost structures. These carriers, together with more recent entrants to the airline business, and a select number of established domestic carriers, currently have cost structures significantly lower than United's, and therefore may be able to operate profitably at lower fare levels. Furthermore, certain carriers in the short-to-medium distance domestic markets have been able to compete against major air carriers, including United, by operating without as great a reliance upon a hub-and-spoke system. These airlines operate efficiently through strategies such as rapid turnaround of flights on a point-to-point basis. The success of these carriers and such strategies has led certain major carriers, including United, to consider ways in which to reorganize their short-haul operations to allow them to compete more effectively in domestic markets. From time to time, excess aircraft capacity and other factors such as the cash needs of financially distressed carriers induce airlines to engage in "fare wars." Such factors can have a material adverse impact on the Company's revenues. The Company maintains yield and inventory management programs designed to manage the number of seats offered in various fare categories in order to enhance the effectiveness of fare promotions and maximize revenue production on each flight. In order to improve its ability to compete effectively in the markets that it serves, United has taken several steps to reduce its costs and capital expenditures. In January 1993, United announced a cost reduction program, which included the layoff of 2,800 employees in February 1993. In 1993 United reached agreement with Boeing to convert 49 Boeing aircraft orders into options and delay delivery of certain of the Boeing aircraft. United also reached agreement with Airbus Industrie ("Airbus") to delay delivery of 14 A320s originally scheduled for delivery after 1994. In addition, United announced in 1993 that it would accelerate the retirement of 25 widebody aircraft. United also negotiated over $100 million in annual savings from suppliers. Finally, in 1993 United reached agreements to sell assets related to the operation of 16 of its flight kitchens to Dobbs International Services, Inc. and Caterair International Corp. for $119 million in a series of phased closings which are expected to be completed by mid-1994. The Employee Investment Transaction, if consummated, contemplates the creation of a low-cost, short-haul operation within United to compete more effectively in domestic markets and improve its long-term financial competitive position. In its international markets, United competes with major U.S. carriers as well as investor-owned and national flag carriers of foreign countries. Competition in certain international markets is subject to varying degrees of governmental regulation (see "Government Regulation"), and in certain instances United's foreign competitors enjoy subsidies and other forms of governmental support which are not available to U.S. carriers. United and other U.S. carriers have certain advantages over foreign air carriers in their ability to generate U.S.-origin- destination traffic from their integrated domestic route systems. However, the U.S. carriers are in many cases constrained from carrying passengers to points beyond designated gateway cities in foreign countries due to limitations in the bilateral air service agreements with such countries or restrictions imposed unilaterally by the foreign governments. To the extent that foreign competitors can offer more connecting services to points beyond these gateway cities, they have an advantage in attracting traffic moving between these foreign points and in attracting traffic moving between such cities and points in the United States. Also, several foreign air carriers have sought and obtained access to the U.S. domestic market through substantial equity investments and code sharing arrangements with U.S. airlines. The comprehensive marketing agreement signed in 1993 with Germany's flag carrier, Lufthansa, if approved, is also expected to enhance the Company's competitive position in international markets. No material part of the business of United and its subsidiaries is dependent upon a single customer or very few customers. Consequently, the loss of the few largest customers of United would not have a material adverse effect on the Company. Airport Access. United's operations at its principal domestic hub, Chicago-O'Hare International Airport ("O'Hare"), as well as at three other airports, Kennedy, New York LaGuardia ("LaGuardia"), and Washington National ("National"), are limited by the "high density traffic airports rule" administered by the Federal Aviation Administration ("FAA"). Under this rule, take- off and landing rights ("slots") required for the conduct of domestic flight operations may be bought, sold or traded. As of December 31, 1993, United held 753 domestic air carrier slots at O'Hare, 43 at National, 65 at LaGuardia and 11 at Kennedy. In addition, Air Wisconsin, Inc. held (or owned the beneficial interest in) 38 air carrier slots and 118 commuter slots at O'Hare which are either operated by United or leased to United Express carriers serving O'Hare. Under the high density rule carriers are required to relinquish slots to the FAA for reallocation if they fail to meet certain minimum use standards. Slots for international services at O'Hare are allocated by the FAA seasonally to both U.S. and foreign carriers based upon the carriers' historical operations and requests for additional capacity. The FAA holds a certain number of slots in reserve for this purpose. Slots over that number are provided through the withdrawal of domestic slots from carriers at O'Hare and the reallocation of those slots for international operations of requesting carriers. United has lost as many as 33 daily slots - that is, slots that were being used by United three days or more per week - during a single operating season. During 1993, Congress amended the U.S. Department of Transportation ("DOT") appropriations bill for fiscal year 1994. This legislation capped for that fiscal year the number of slots that could be withdrawn from U.S. carriers for allocation to international operations. Also, in November 1991, United petitioned the FAA for a repeal of the international slot withdrawal provisions of the regulations. This petition has not, however, been acted upon by the agency. United believes that the number and distribution of slots it holds at the airports subject to the high density rule are sufficient to support its current operations. There can be no assurance, however, that additional slots sufficient to accommodate otherwise desirable service expansions will be available to United on satisfactory terms in the future. There is also no assurance that the current slot regulations will remain in effect. If an alternative to the current system were to be adopted, no assurance can be given that such alternative would preserve United's investment in slots already acquired or that slots adequate for future operations would be available. United believes that, at present, it has a sufficient number of leased gates and other airport facilities at the cities it serves to meet its current and near term needs. From time to time, expansion by United at certain airports may be constrained by insufficient availability of gates on attractive terms. United's ability to expand its international operations in Asia, the South Pacific, Europe and Latin America is subject to restrictions at many of the airports in these regions, including noise curfews, slot controls and absence of adequate airport facilities. At Los Angeles and elsewhere, United and other airlines face continuing disputes as to the level of landing fee rates and other charges for airport operations. Recently, some of these rates and charges have escalated rapidly. Mileage Plus Program. United operates a frequent flyer marketing program known as "Mileage Plus" wherein credits are earned by flying on United or using the services of one of the other airlines, credit card companies, car rental agencies and hotels (the "Partners") participating in the Mileage Plus program. The program is designed to enable United to retain and increase the business of frequent travelers. Credits earned under the program may be exchanged at certain plateaus for free travel or service upgrades on United or for use with one or more of the Partners. When an award level is attained, United records a liability for the incremental costs of accrued credits under the Mileage Plus program based on the expected redemptions. United's incre mental costs include the costs of providing service for an other wise vacant seat including fuel, meals, certain incremental personnel and ticketing costs. The incremental costs do not include any contribution to overhead or profit. Awards earned after July 1989 have an expiration date three years from date earned. The program also contains certain restrictive provisions, including blackout dates and capacity controlled bookings, which substantially limit the use of the awards on certain flights. In 1993 United announced that the mileage levels for Mileage Plus domestic award travel would be increased on a prospective basis. As revised in January 1994, the Mileage Plus rules will require 25,000 miles, instead of the 20,000 miles now required, for award tickets issued for economy class travel within the continental United States. Other mileage award level changes were also announced, as was a change to a bank-account type of system to track mileage; all changes are scheduled to take effect February 1, 1995. Lawsuits challenging these changes and changes to American Airlines' frequent flyer program are pending in Illinois. While United believes that it has the right to make the aforementioned changes to its program, and is defending itself vigorously in the pending litigation, an adverse court decision could restrict United's ability to alter award levels now or in the future. At December 31, 1993 and 1992, United estimated that the total number of outstanding awards was approximately 7.7 million and 7.4 million, respectively. United estimated that 5.8 million and 5.5 million, respectively, of such awards could be expected to be redeemed and, accordingly, had recorded a liability amounting to $205 million and $207 million, respectively, at December 31, 1993 and 1992. The difference between the awards expected to be redeemed and the total awards outstanding is the estimate, based on historical data, of awards (1) which will never be redeemed, (2) which will be redeemed for other than free trips, or (3) which will be redeemed on partner carriers. The number of awards used on United were 1.6 million, 1.4 million and 1.6 million for the years 1993, 1992 and 1991, respectively. Such awards represented 7.5%, 6.7% and 6.7% of United's total revenue passenger miles for each period, res pectively. With these low percentages, seat availability and restrictions on the use of free travel awards, United believes that the displacement, if any, of revenue passengers by users of Mileage Plus awards is minimal. United has agreements with certain air carriers and other parties to utilize the Mileage Plus program and receives and makes payments based on the earning and redemption of awards by Mileage Plus participants with such parties. Computer Reservations Systems. Travel agents account for a substantial percentage of United's sales. The complexity of the various schedules and fares offered by air carriers has fostered the development of electronic distribution systems that display information relating the fares and schedules of United and other airlines to travel agents and others. United believes that the use of such systems has been a key factor in the marketing and distribution of airlines' products. Before September 1993, United had an ownership interest in two general partnerships which owned and marketed computer reservation system ("CRS") products and services. In September 1993, The Covia Partnership ("Covia"), a 50%-owned affiliate of United, and The Galileo Company Limited, a 25.6%-owned affiliate of United, combined. In the combination Covia was renamed as "Galileo International Partnership" ("Galileo"), and a second entity, the Apollo Travel Services Partnership ("ATS"), was formed. These two general partnerships are owned 38% and 77%, respectively, by United through a wholly-owned subsidiary. Galileo is held 50% by European carriers and 50% by North American carriers. It owns the Apollo and Galileo CRSs and markets CRS services worldwide through a system of national distribution companies located in countries in which Galileo operates and which are usually owned by the Galileo partner airline resident in a particular country, or if there is none, by Galileo or a local contractor. Galileo is used by approximately 30% of the travel agent locations outside North America, where it has over 42,000 terminals at more than 14,000 locations. ATS, which is held solely by the North American carriers, is responsible for marketing, sales and support of Apollo CRS products and services in the United States, Mexico and the Caribbean. A third entity, Galileo Japan Partnership, a 50%- owned affiliate of United, was also formed in September 1993 for the purpose of distributing CRS services in Japan. In Canada, Apollo is distributed as the "Apollo by Gemini" product sold by the Gemini Group Limited Partnership ("Gemini"),in which Galileo owned a one-third interest. Gemini is under a court order to dissolve by November 1994, and Air Canada has agreed to acquire Galileo's interest in Gemini. Galileo is in discussions concerning an alternative distribution of its CRS products and services in Canada. Competition among CRS vendors is intense, and services similar to these offered by Galileo are marketed by several air carriers and other concerns, both in the United States and worldwide. In the European and Pacific CRS markets, various consortia of foreign carriers have formed CRSs to be marketed in countries in which the owning carriers have a substantial presence. Government Regulation General. All carriers engaged in air transportation in the United States, including United, are subject to regulation by the DOT and the FAA under the Federal Aviation Act of 1958, as amended (the "Aviation Act"). The DOT has authority to regulate certain economic and consumer protection aspects of air transportation. It is empowered to issue certificates of public convenience and necessity for domestic air transportation upon a carrier's showing of fitness; to prohibit unjust discrimination; to prescribe forms of accounts and require reports from air carriers; to regulate methods of competition, including the provision and use of computerized reservation systems; and to administer regulations providing for consumer protection, including regulations governing the accessibility of air transportation facilities for handicapped individuals. United's operations require certificates of public convenience and necessity issued by the DOT, an air carrier operating certificate and related operations specifications issued by the FAA. United's operations also require licenses issued by the aviation authorities of the foreign countries United serves. Foreign aviation authorities may from time to time impose a greater degree of economic regulation than exists with respect to United domestic operations. In international markets, United competes against foreign investor-owned and national flag carriers and U.S. carriers that have been granted authority to provide scheduled passenger and freight service between points in the United States and various overseas destinations. In connection with its international services, United is required to file with the DOT and observe tariffs establishing the fares and rates charged and the rules governing the transportation provided. In addition, United's operating authorities in international markets are governed by the aviation agreements between the United States and foreign countries. In certain cases, fares, rates and schedules require the approval of the DOT and the relevant foreign governments. United has recommended to the U.S. Congress that it consider developing an international aviation policy that seeks enhanced access to international markets for U.S. carriers in return for access to U.S. markets by foreign carriers. Shifts in United States or foreign government aviation policies can lead to the alteration or termination of existing air service agreements that the U.S. has with other governments, which could diminish the value of United's international routes. For example, in 1993 the DOT determined that the Government of Japan violated its aviation agreement with the U.S. when it prevented United from implementing service between Tokyo and Sydney as part of United's New York-Tokyo-Sydney schedule. The DOT is considering various actions against Japan. While such disputes are generally the subject of inter-governmental negotiations, there are no assurances that United's operating rights under the bilateral aviation agreements and DOT-issued certificates of public convenience and necessity can be preserved in such cases. The DOT and the U.S. Congress have engaged from time to time in various regulatory and legislative initiatives, respectively, with respect to CRS activities and issues, such as the level of booking fees, host versus non-host functionality, mandatory dehosting, travel agency connection of third-party hardware and software to a CRS, terms of the contracts between CRS vendors and travel agencies, continued airline ownership of CRS vendors, and the ability to access multiple CRS systems from a single computer terminal. New regulatory or legislative initiatives in many of these areas, if enacted, could have a material adverse effect upon CRS vendors in general and ATS and United in particular. Safety. The FAA has regulatory jurisdiction over flight operations generally, including equipment, ground facilities, maintenance, communications and other matters. In order to ensure compliance with its operational and safety standards, the FAA requires air carriers to obtain operating, airworthiness and other certificates. United's aircraft and engines are maintained in accordance with the standards and procedures recommended and approved by the manufacturers and the FAA. For all of its engines, United utilizes a "condition monitoring" maintenance program so that the schedule for engine removals and overhauls is based on performance trend monitoring of engine operating data. In addition, all engines contain time-limited components, each of which has a maximum amount of time (measured by operating hours) or a maximum number of operating cycles (measured by takeoffs and landings) after which the component must be removed from the engine assembly and overhauled or scrapped. Similarly, United's FAA-approved maintenance program specifies the number of hours or operating cycles between inspections and overhauls of the airframes and their component parts. The nature and extent of each inspection and overhaul is specifically prescribed by the approved maintenance program. From time to time, the FAA issues airworthiness directives ("ADs") which require air carriers to undertake inspections and to make unscheduled modifications and improvements on aircraft, engines and related components and parts. The ADs sometimes cause United to incur substantial, unplanned expense and occasionally aircraft or engines must be removed from service prematurely in order to undergo mandated inspections or modifications on an accelerated basis. The issuance of any particular AD may have a greater or lesser impact on United compared to its competitors depending upon the equipment covered by the directive. Since 1988 the airlines, in cooperation with the FAA, have been engaged in an in-depth review of the adequacy of existing maintenance procedures applicable to older versions of most of the aircraft types in general use in the airline industry. These include certain of the Boeing and Douglas aircraft used by United. As a part of this program, the FAA has issued ADs requiring interim inspections and remedial maintenance procedures. While certain of these aging aircraft ADs have necessitated unscheduled removals from service and increased maintenance costs, compliance is not expected to have a material adverse impact on United's costs or operations. Legislation enacted by the U.S. Congress required the installation, in all types of aircraft operated by United, of a traffic collision avoidance system (TCAS) by November 30, 1993, and a windshear detection system by December 30, 1993. United completed the installations of both systems prior to their respective mandated deadline dates on all aircraft operated by it. Both the DOT and the FAA have authority to institute administrative and judicial proceedings to enforce the Aviation Act and their own regulations, rules and orders. Both civil and criminal sanctions may be assessed for violations. The Aviation Act provides for the assessment of civil penalties in amounts of up to $10,000 per violation which are applicable to most cases involving the safety of commercial aircraft operations, including the airport security responsibilities of air carriers. Environmental Regulations. The Airport Noise and Capacity Act of 1990 ("ANCA") requires the phase-out by December 31, 1999 of Stage 2 aircraft operations, subject to certain waivers. The FAA has issued final regulations which would require carriers to modify or reduce the number of Stage 2 aircraft operated by 25% by December 31, 1994, 50% by December 31, 1996, 75% by December 31, 1998 and 100% by December 31, 1999. Alternatively, a carrier could satisfy compliance requirements by operating a fleet that is at least 55% Stage 3 by December 31, 1994, 65% Stage 3 by December 31, 1996, 75% Stage 3 by December 31, 1998 and 100% Stage 3 by December 31, 1999. At December 31, 1993, United operated 371 Stage 3 aircraft representing 70% of United's total fleet, and thus is in compliance with these regulations. The ANCA recognizes the rights of operators of airports with noise problems to implement local noise abatement procedures so long as such procedures do not interfere unreasonably with inter state or foreign commerce or the national air transportation system. ANCA generally requires FAA approval of local noise restrictions on Stage 3 aircraft first effective after October 1990, and establishes a regulatory notice and review process for local restrictions on Stage 2 aircraft first proposed after October 1990. While United has had sufficient scheduling flexibility to accommodate local noise restrictions imposed to the present, United's operations could be adversely affected if locally-imposed regulations become more restrictive or widespread. Federal Aviation Regulation Part 150, which was issued pursuant to Title I of the Aviation Safety and Noise Abatement Act of 1979, provides limited funding to airport operators to formulate noise compatibility programs, and established procedures through which such programs may be approved by the FAA. This rule may encourage the consideration of additional local aircraft and airport usage restrictions. The Environmental Protection Agency regulates operations, including air carrier operations, which affect the quality of air in the United States. United has made all necessary modifications to its operating fleet to meet emission standards issued by the Environmental Protection Agency ("EPA"). Federal and state environmental laws require that underground storage tanks (USTs) be upgraded to new construction standards and equipped with leak detection by December 22, 1998. These requirements are phased into effect based on the age, construction and use of existing tanks. United operates a number of underground and above ground storage tanks throughout its system, primarily used for the storage of fuels and deicing fluids. A program for the removal or upgrading of USTs and remediation of any related contamination has been ongoing since 1987. Compliance with these federal and state UST regulations is not expected to have a material adverse effect on United's financial condition. United has been identified by the EPA as a potentially responsible party with respect to Superfund sites involving soil and groundwater contamination at the Bay Area Drum Site in San Francisco, California, the Chemsol, Inc. Site in Piscataway, New Jersey, the Petrochem/Ekotek Site in Salt Lake City, Utah, the Monterey Park Site at Monterey Park, California, the West Contra Costa Sanitary Landfill Site in Richmond, California, and the Douglasville Site in Berks County, Pennsylvania. Because of the limited nature of the volume of pollutants allegedly contributed by United to the above Superfund sites, the outcome of these matters is not expected to have a material adverse effect on United's financial condition. United is aware of soil and groundwater contamination present on its leaseholds at several U.S. airports, with the most significant locations being San Francisco International Airport, Kennedy, Seattle Tacoma International Airport, Spokane International Airport, and Stapleton International Airport in Denver (which is expected to close in the Spring of 1994 due to the opening of a new airport for Denver). United is investigating these sites, assessing its obligations under applicable environmental regulations and lease agreements, and where appropriate remediating these sites. Remediation of these sites, for which United may be responsible, is not expected to have a material adverse effect on United's financial condition. Other Government Matters. Besides the DOT and the FAA, other federal agencies with jurisdiction over certain aspects of United's operations are the Department of Justice (Antitrust Division and Immigration and Naturalization Service), the Equal Employment Opportunity Commission, the Occupational Safety and Health Administration, the Department of Labor (the Office of Federal Contract Compliance Programs of the Employment Standards Administration), the National Labor Relations Board, the National Mediation Board, the National Transportation Safety Board, the Treasury Department (U.S. Customs Service), the Federal Communications Commission (due to use of radio facilities by aircraft), and the United States Postal Service (carriage of domestic mail). In connection with its service to cities in other countries, United is subject to varying degrees of regulation by foreign governments. United has no existing obligation to the Civil Reserve Air Fleet. Fuel United's results of operations are significantly affected by the price and availability of jet fuel. Based on 1993 fuel consumption, every $.01 change in the average annual price-per-gallon of jet fuel caused a change of approximately $27 million in United's annual fuel costs. The table below shows United's fuel expenses, fuel consumption, average price per gallon and fuel as a percent of total operating expenses for annual periods from 1989 through 1993: 1993 1992 1991 1990 1989 Fuel expense, including tax (in millions) $1,718 $1,679 $1,674 $1,811 $1,353 Gallons consumed (in millions) 2,699 2,529 2,338 2,253 2,128 Average cost per gallon (in cents) 63.6 66.4 71.6 80.4 63.6 % of total operating expenses 12% 13% 14% 16% 15% United's average fuel cost per gallon in 1993 was 4.2% lower than in 1992. Changes in fuel prices are industry-wide occurrences that benefit or harm United's competitors as well as United. Accordingly, lower fuel prices may be offset by increased price competition and lower revenues for all air carriers, including United. There can be no assurance that United will be able to increase its fares in response to any increases in fuel prices in the future. In order to assure adequate supplies of fuel and to provide a measure of control over fuel costs, United continues to ship fuel on major pipelines, maintains fuel storage facilities, and trades fuel to locations where it is needed. In 1993, almost all of United's fuel was purchased under contracts with major U.S. and international oil companies. Most of these contracts are terminable by either party on short notice. United also purchases minor volumes of fuel on the spot market at some domestic locations. In addition, United purchases foreign fuel on a spot basis from the Middle East, Caribbean and Far East. Although United has not experienced any problem with fuel availability in the past few years and does not anticipate any in the near future, it is impossible to predict the future availability of jet fuel. If there were major reductions in the availability of jet fuel, United's business would be adversely affected. Insurance United carries liability insurance of a type customary in the air transportation industry, in amounts which it deems adequate, covering passenger liability, public liability and property damage liability. Insurance is subject to price fluctuations from time to time. The amount recoverable by United under aircraft hull insurance covering all damage to its aircraft is not subject to any deductible amount in the event of a total loss. In the event of a partial loss, however, such recovery is subject to a per-occurrence deductible of $1,000,000 for B747s, B757s, B767s and DC10s, $750,000 for B737-300s, and B737-500s, and $500,000 for all other aircraft except commuter aircraft, for which the deductible is $100,000. Employees - Labor Matters On December 31, 1993, United had 81,511 employees (approximately ten percent of whom are part-time employees). Approximately 64% of United's employees were represented by various labor organizations. The employee groups, number of employees, labor organization and current contract status for each of United's major collective bargaining groups as of December 31, 1993 are as follows: Number of Contract Open Employee Group Employees* Union For Amendment Mechanics, ramp servicemen & other ground employees 26,984 IAM December 1, 1994** Flight attendants 17,330 AFA April 1, 1996 Pilots 8,022 ALPA December 1, 1994** *The flight kitchen sales (see Item 2, Properties, "Transfers of Assets") occurring in 1994 are expected to reduce United's number of total employees by more than 4,000 from December 31, 1993 levels. **If the proposed Employee Investment Transaction is consummated, the IAM and the ALPA contracts each will not be open for amendment until the year 1999 or 2000, depending on when the transaction closes and whether the AFA participates in the transaction. United's relations with these labor organizations are governed by the Railway Labor Act. Under this Act, collective bargaining agreements between United and these organizations become amendable upon the expiration of their stated term. If either party wishes to modify the terms of any such agreement, it must notify the other party before the contract becomes amendable. After receipt of such notice, the parties must meet for direct negotiations and, if no agreement is reached, either party may request that a mediator be appointed. If no agreement is reached, the National Mediation Board may determine, at any time, that an impasse exists and may proffer arbitration. Either party may decline to submit to arbitration. If arbitration is rejected, a 30-day "cooling off" period commences, following which the labor organization may strike and the airline may resort to "self-help," including the imposition of its proposed amendments and the hiring of replacement workers. United's wage and related costs accounted for 33% of its total operating expenses for the twelve months ended December 31, 1993. In order to enhance its competitive position, United has taken various steps to reduce its unit costs, including the layoffs of 2,800 employees in February 1993, the reduction in force which is resulting from the flight kitchen sales, reductions in non-personnel expenses and the redeployment of certain aircraft to more profitable airports. The long-term competitiveness of United's labor costs, and the long-term financial stability and profitability of United, is expected to be improve if the proposed Employee Investment Transaction is consummated. Item 2. Item 2. Properties Flight Equipment As of December 31, 1993, United's aircraft fleet totaled 544 jet aircraft, of which 246 were owned and 298 were leased. These aircraft are listed below: Average Average Aircraft Type No. of Seats Owned Leased* Total Age (Years) B727-222A 147 50 25 75 15 B737-200 109 45 - 45 25 B737-200A 109 -- 24 24 14 B737-300 128 14 87 101 5 B737-500 108 28 29 57 2 B747-100 393 18 -- 18 22 B747-SP 244 2 7 9 17 B747-200 369 2 7 9 15 B747-400 398 3 19 22 2 B757-200 188 34 54 88 2 B767-200 179 19 -- 19 11 B767-300ER 206 3 20 23 1 DC10-10 287 28 13 41 19 DC10-30 298 -- 8 8 14 A320-200 144 -- 5 5 1 TOTAL OPERATING FLEET 246 298 544 10 === === === == ________________ * United' s aircraft leases have initial terms of 4 to 26 years, and expiration dates range from 1994 through 2018. Under the terms of leases for 287 of the aircraft in the operating fleet, United has the right to purchase the aircraft at the end of the lease term, in some cases at fair market value and in others at fair market value or a percentage of cost. As of December 31, 1993, 78 of the 246 aircraft owned by United were encumbered under transaction agreements. In 1993 United took delivery of 43 new aircraft. United acquired ten B737-500s, four B747-400s, 16 B757-200s, eight B767-300ERs, and five A320-200s. In early 1993, United revised its capital spending plan based on reductions in its capacity requirements for the next several years. Consistent with this reduced capital spending plan, United reached agreement with Boeing to convert 49 firm aircraft orders into options, and to delay delivery of certain aircraft originally scheduled for delivery between 1993 and 1996 into the 1996-1999 period. Under the terms of the agreement, if United does not elect to confirm the delivery of these option aircraft, it will forfeit significant deposits. United also reached agreement with Airbus to delay delivery of 14 A320s originally scheduled for delivery after 1994. In addition, United announced in 1993 that it would accelerate the retirement of 25 widebody aircraft, including 15 DC10-10s and ten B747-SPs, retiring them prior to the end of 1994; six of these 25 widebody aircraft (five DC10-10s and one B747-SP) were retired in 1993. As a result of these new agreements, as of December 31, 1993, United had taken delivery of all aircraft on order, with the exception of 34 B777-200 aircraft, which are scheduled to be delivered between 1995 and 1999. In addition to the B777- 200 order, United has arrangements with Airbus and A320 engine manufacturer International Aero Engines to lease an additional 45 A320-200 aircraft, which are scheduled for delivery through 1998. At December 31, 1993, United also had purchase options for 186 B737 aircraft, 54 B757-200 aircraft, 34 B777-200 aircraft, 52 B747-400 aircraft, 8 B767-300ER aircraft and 50 A320-200. In January 1994, United entered into an agreement with Boeing to acquire two new B747-400 aircraft in 1994, in place of options for two similar aircraft. These two aircraft orders fulfill part of United's obligation to Boeing under the 1993 restructuring agreement described above. The following table sets forth United's firm aircraft orders, options and expected delivery schedules as of December 31, 1993: Order Status Aircraft Type Number To Be Delivered Delivery Rate Firm Orders B777-200 34 1995-1999 0-3 per month Total-Firms 34* Options** B737*** 186 1996-2002 0-5 per month B747-400* 52 1996-2003 2-10 per year B757-200 54 1996-1999 0-2 per month B767-300ER 8 1997-1999 0-1 per month B777-200 34 1998-2000 1 per month A320-200 50 1996-2001 1-3 per month Total-Options384 ________________ * In addition, United has agreed to lease an additional 45 A320-200 aircraft. Deliveries of these aircraft are expected to occur between 1994 and 1998. Also, in January 1994, United entered into an agreement with Boeing to acquire two new B747-400 aircraft in 1994, in place of options for two similar aircraft. ** Rate of deliveries with respect to option aircraft assumes that all options are exercised and that all orders subject to reconfirmation are confirmed by United. *** Models 300, 400 and 500, at United's discretion. Ground Facilities In the vicinity of O'Hare, United owns a 106 acre complex consisting of over one million square feet of office space for its executive headquarters, a computer facility, and a training center. United operates reservation centers in or near eight U.S. cities - Chicago, Denver, Detroit, Honolulu, Los Angeles, San Francisco, Seattle and Washington, D.C. United also operates 133 city ticket offices in the U.S., plus offices in the Pacific and European countries served by United. United's Maintenance Operation Center ("MOC") at San Francisco International Airport occupies 144 acres of land, three million square feet of floor space and 12 aircraft hangar docks, under leases expiring in 2013. Virtually all major aircraft and component maintenance for United's fleet occurs at the MOC, including aircraft acceptance and flight testing, and the installation, testing and repairing of engines, electronics, and interior fittings. United also has a major facility at the Oakland, California airport which is dedicated to airframe maintenance and which includes a hangar with sufficient space to accommodate maintenance work on four wide-bodied aircraft simultaneously. As of December 31, 1993, United employed more than 11,970 mechanics, inspectors, engineers, and maintenance support personnel at the MOC and over 1,660 at the Oakland facility. United also has line aircraft maintenance employees and facilities at 36 domestic and 18 international locations. In March 1994, United opened a new major aircraft maintenance and overhaul facility ("MOC-II") in Indianapolis. Operating under a lease with the Indianapolis Airport Authority which expires November 30, 2031. When all phases of the construction work are completed, as scheduled, in 2004, United will employ 6,300 people at MOC-II, and will occupy approximately 300 acres of land and up to three million square feet of space, including 15 aircraft dock positions. MOC-II will be used for maintenance of Boeing 737 aircraft, engine repair, spare parts storage, ground equipment maintenance, technical support and administrative functions. In Spring 1994 United expects to relocate its Denver hub operations to the new Denver International Airport. Under a new 30-year lease and use agreement, expiring in 2023, United eventually will occupy 44 gates and over one million square feet of exclusive terminal building space. The new airport is located northeast of Stapleton International Airport and approximately 25 miles from downtown Denver. Upon the opening of the new airport, Stapleton will be closed to all aircraft operations. United's flight training center will continue to be located near Stapleton and is under lease, including options to extend, until 2018. This flight training center consists of four buildings with a total of 300,000 square feet located on 22 acres of land adjoining Stapleton. The flight training center accommodates 26 flight simulators and over 90 computer-based training stations, as well as cockpit procedures trainers, autoflight system trainers and emergency evacuation trainers. United has entered into various leases relating to its use of airport landing areas, gates, hangar sites, terminal buildings and other airport facilities in most of the municipalities it serves. In many cases United has constructed, at its expense, the buildings it occupies on its leased properties. In general, buildings and fixtures constructed by United on leased land are the property of the lessor upon the expiration of such leases. United also has leased and improved ticketing, sales and general office space in the downtown and outlying areas of most of the larger cities in its system. United believes its facilities are suitable and adequate for its current requirements. United will continue to acquire equipment and facilities as necessary to support its airline operations. Transfers of Assets In third quarter of 1993, United reached agreements to sell, lease or otherwise transfer assets related to the operation of 16 of its 17 domestic flight kitchens to Dobbs International services, Inc. and Caterair International Corp. for $119 million in a series of phased closings that commenced in December 1993 and are expected scheduled to continue through mid-1994. Under the agreements, the purchasers will provide catering services for United at the airports served by the flight kitchens for seven years. Item 3. Item 3. Legal Proceedings The Company is involved from time to time in legal proceedings incidental to the ordinary course of its business. Such proceedings include claims brought by and against the Company or its subsidiaries including claims seeking substantial compensatory and punitive damages. Such claims arise from routine commercial disputes as well as incidents resulting in bodily injury and damage to property. The Company believes that the potential liabilities in all of bodily injury and property damage actions are adequately insured and none of the other actions are expected to have any material adverse effect on the Company or its subsidiaries. Noise Proceedings United may be affected by legal proceedings brought by owners of property located near certain airports. Plaintiffs generally seek to enjoin certain aircraft operations and/or to obtain damages against airport operators and air carriers as a result of alleged aircraft noise or air pollution. Any liability or injunctive relief imposed against airport operations or air carriers could result in higher costs to United and other air carriers. The ultimate disposition of the matters discussed in Item 3 hereof, and other claims affecting the Company, are not expected to have a material adverse effect on the Company's financial condition. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Omitted pursuant to General Instruction J (2) (c) of Form 10- K. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Shareholder Matters United is a wholly-owned subsidiary of UAL Corporation. Item 6. Item 6. Selected Financial Data Year Ended December 31 1993 1992 1991 1990 1989 (In Millions) Operating revenues $14,354 $12,725 $11,660 $11,023 $9,773 Earnings (loss) before extraordinary item and cumulative effect of accounting changes (17) (386) (335) 96 358 Extraordinary loss on early extinguishment of debt, net of tax (19) - - - - Cumulative effect of accounting changes - (547) - - - Net earnings (loss) (36) (933) (335) 96 358 Total assets at year end 12,153 12,067 9,907 8,001 7,217 Long-term debt and capital lease obligations, including current portion at year end 3,614 3,628 2,531 1,326 1,404 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Proposed Employee Investment Transaction On December 22, 1993, the Board of Directors of UAL Corporation ("UAL"), parent company of United Air Lines, Inc. ("United"), approved a non-binding agreement in principle that would provide a majority equity interest in UAL to the employees of United in exchange for wage concessions and work-rule changes. In January 1994, the agreement was ratified by the Air Line Pilots Association ("ALPA") and the International Association of Machinists ("IAM"). The transaction is subject to, among other things, approval by UAL stockholders. The employee investment plan is intended to put in place a lower cost structure that allows United to compete effectively in the aviation marketplace and address its long-term financial viability. The concessions will come from three of United's employee groups: employees represented by ALPA, employees represented by the IAM and the salaried and management employees. Employees represented by the Association of Flight Attendants ("AFA") have been invited to participate in the plan and UAL has engaged in discussions with the AFA concerning such participation. In the transaction, an Employee Stock Ownership Plan will be created to provide United employees with a minimum of a 53% equity interest in UAL in exchange for wage concessions and work-rule changes. The employee interest may increase to up to 63%, depending on the average market value of UAL common stock in the year after the transaction closes. The transaction is not dependent on external financing. Pursuant to the terms of the agreement in principle, current UAL stockholders would receive the remaining 37 to 47% of the common stock and $88 per share in cash and face amount of debt and preferred stock. The non-common stock consideration is expected to aggregate approximately $743 million of cash, $900 million face amount of senior unsecured debentures and $900 million face amount of preferred stock depending on the number of common shares on which the distribution is made. While the agreement in principle contemplates that the debentures would be issued by UAL, such debentures could be issued by United. The agreement includes terms for the creation of a low-cost short-haul operation to compete in domestic markets. This short-haul operation, in combination with the other wage and work-rule concessions, is expected to increase United's cash flows from operating activities. UAL agreed that if the transaction closes prior to August 31, 1994, severance payments and employee benefits coverage approximating $50 million would be provided by United to IAM employees being terminated from United as a result of the recent sale of flight kitchens (see Sale of Flight Kitchens), in addition to payments required under United's labor contracts. Certain of the severance payments, which are to be made on a monthly basis, became payable in January 1994 after the unions ratified the agreement; however, these monthly payments terminate but are not refunded if the transaction does not close before August 31, 1994 or certain other conditions are not met. Other lump-sum severance amounts are payable only if the transaction closes prior to the required date. UAL has also agreed to pay up to $45 million of transaction fees and expenses incurred by ALPA and the IAM if the transaction is closed by August 31, 1994. If the transaction does not close by the required date but certain conditions are met, UAL will pay up to $12.5 million of ALPA and IAM transaction expenses. Under the terms of the agreement in principle, United may not, among other things, incur incremental debt or other obligations, or sell certain assets, other than in the ordinary course of business, prior to the consummation of the transaction. In addition, after consummation of the transaction, certain activities, including certain asset dispositions, may require a different approval process by the UAL Board of Directors, and in some cases the shareholders, than is currently required. Liquidity and Capital Resources During 1993, United's total cash, cash equivalents and short-term investments decreased $266 million to a balance of $966 million at December 31, 1993. Operating activities generated $818 million. Cash was used primarily to repay long-term debt, reduce short-term borrowings and to fund net additions to property and equipment. Repayments of long-term debt amounted to $664 million, including the early extinguishment of $500 million of senior subordinated notes in June 1993. In addition, $55 million was used for capital lease payments during the period. Long-term debt and capital lease obligations incurred in connection with aircraft financings during 1993 amounted to $557 million. As a result of the year's financing activities, United's debt:equity ratio was 85:15 at December 31, 1993, unchanged from December 31, 1992. During 1993, United placed 43 new aircraft in service. These aircraft were financed primarily with long-term debt, capital leases and operating leases. United acquired 10 B737-500 aircraft, 16 B757-200 aircraft, four B747-400 aircraft, eight B767-300ER aircraft and five A320-200 aircraft during 1993. Of these, 16 aircraft were purchased, 18 were purchased and then sold and leased back, seven were acquired under operating leases and two were acquired in capital lease transactions. Aircraft purchases and other property additions, including aircraft modification projects and aircraft spare parts, amounted to $1.484 billion. Property dispositions, which included sale and leaseback transactions and the sales of five B727 aircraft, provided $1.156 billion. In early 1993, United revised its capital spending plan based on reductions in its capacity requirements for the next several years. United reached agreement with The Boeing Company ("Boeing") to convert certain aircraft orders into options. Under the terms of the agreement, if United does not elect to confirm the delivery of these option aircraft before 1998, it will forfeit significant deposits. United also announced an agreement with Airbus Industrie ("Airbus") to delay from 1995 and 1996 to 1997 and 1998 delivery of 14 leased A320 aircraft. In addition, United announced that it would accelerate the retirement of 25 widebody aircraft, including 15 DC10-10s and ten B747-SPs, retiring them prior to the end of 1994. In 1993, United recorded a $59 million charge to reduce the net book value of the DC-10 aircraft to estimated net realizable value. As a result of these new agreements, as of December 31, 1993, United had taken delivery of all aircraft on order, with the exception of 34 B777 aircraft, which are expected to be delivered between 1995 and 1999. In addition to the B777 order, United has arrangements with Airbus and International Aero Engines to lease an additional 45 A320 aircraft, which are scheduled for delivery through 1998. At December 31, 1993, United also had options for 186 B737 aircraft, 54 B757 aircraft, 34 B777 aircraft, 52 B747 aircraft, eight B767 aircraft and 50 A320 aircraft. In January 1994, United entered into an agreement with Boeing to acquire two B747-400 aircraft in 1994 in place of options for two similar aircraft. United continually reviews its fleet to determine whether aircraft acquisitions will be used to expand the fleet or to replace older aircraft, depending on market and regulatory conditions at the time of delivery. Commitments for the purchase of aircraft and other property at December 31, 1993 approximated $4.3 billion, after deducting advance payments. An estimated $0.6 billion will be spent in 1994, $1.1 billion in 1995, $0.8 billion in 1996, $1.2 billion in 1997, $0.4 billion in 1998, and $0.2 billion after 1998. These amounts do not include the two B747-400 aircraft to be acquired under the January 1994 agreement referred to above. Funds necessary to finance aircraft acquisitions are expected to be obtained from internally generated funds, irrevocable external financing arrangements or other external sources. In 1993, UAL and United filed a shelf registration statement with the Securities and Exchange Commission for up to $1.5 billion of securities, including secured and unsecured debt, equipment trust certificates, equity or a combination of both. Under the terms of this shelf registration statement, a 1992 shelf and a 1991 shelf were combined with the 1993 shelf statement. In December 1993, United issued $100 million of debentures under the shelf registration statement. In May and November 1993, United issued $176 million and $118 million, respectively, of pass through certificates under the shelf registration to refinance aircraft under operating leases. On a combined basis, up to $1.776 billion of additional securities may be offered at December 31, 1993. The shelf registration statement may be utilized for purposes of registering securities to be issued in the employee investment transaction. United's senior unsecured debt is rated BB by Standard & Poor's Corporation ("S & P") and Baa3 by Moody's Investors Service Inc. ("Moody's"). These ratings reflect an October 1993 downgrade by Moody's. On December 17, 1993, Moody's announced that it was placing United's securities under review for possible downgrade citing reports about the potential for the employee investment transaction. On December 20, 1993, S & P announced that it was placing the securities on CreditWatch with developing implications, meaning the ratings may be raised or lowered. United is in the process of constructing a maintenance facility in Indianapolis, which begins operation in 1994. The facility is being financed primarily with tax-exempt bonds and other capital sources. As of December 31, 1993, United had a working capital deficit of $1.608 billion. Historically, United has operated with a working capital deficit and, as in the past, United expects to meet all of its obligations as they become due. Operating and financing activities in 1992 generated cash flows of $287 million and $127 million, respectively, which more than offset cash used for net additions to property, resulting in a $96 million increase in cash, cash equivalents and short-term investments. During the year, $2.458 billion was spent on property additions, principally aircraft. United acquired 25 B737-500 aircraft, 25 B757-200 aircraft, 10 B767-300ER aircraft and six B747-400 aircraft in 1992. Of these, 18 aircraft were purchased, 38 were purchased and then sold and leased back and 10 were acquired in capital lease transactions. Property dispositions provided cash proceeds of $2.363 billion. In 1992, United also acquired certain Latin American route authorities and other related assets from Pan American World Airways, Inc. ("Pan Am"). During 1991, operating property additions amounted to $2.122 billion and included the acquisition of 23 B757-200 aircraft, 18 B737-500 aircraft, five B767-300ER aircraft, four B747-400 aircraft and seven used B747-200 aircraft. Dispositions of property, including the sale and leaseback of 15 aircraft and the sales of two DC8-71 aircraft and four B727-100 aircraft, provided $1.281 billion. United also acquired international route authorities and other assets from Pan Am, which was the primary cause of a $358 million increase in intangibles. However, cash provided by operating activities of $355 million and financing activities of $827 million allowed United to maintain a relatively stable balance of cash, cash equivalents and short-term investments, which amounted to $1.136 billion at December 31, 1991. Results of Operations United's results of operations in 1993 improved considerably as compared to 1992. In 1993, United recorded a net loss of $36 million, compared to a 1992 net loss of $933 million. The 1993 results include an extraordinary loss of $19 million on the early extinguishment of debt. The 1992 results include a $547 million cumulative effect of adopting Statement of Financial Accounting Standard ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" and SFAS No. 109, "Accounting for Income Taxes." The 1993 loss before extraordinary item was $17 million, compared to a 1992 loss before cumulative effect of accounting changes of $386 million. United recorded operating earnings in 1993 of $295 million compared to an operating loss in 1992 of $496 million. The improved performance in 1993 was benefitted by the cost reduction program implemented in 1993, the realignment of domestic schedules to eliminate unprofitable routes in an effort to enhance revenue performance and the impact of a labor union strike on a competing air carrier. United's 1992 losses were significantly affected by uneconomic fare actions initiated by other carriers that increased traffic and load factors to unprecedented levels, but resulted in substantially reduced yield (passenger revenue per revenue passenger mile). While United's results showed improvement in 1993, the results of operations in the airline business can fluctuate significantly in response to general economic conditions. This is because small fluctuations in yield and cost per available seat mile can have a significant effect on operating results. Thus, United believes that industrywide fare levels, increasing low-cost competition, prolonged operations of carriers under bankruptcy protection, general economic conditions, fuel costs, international governmental policies and other factors over which it has limited control, will continue to affect its operating results. In addition, United expects its 1994 operating results to be impacted by increases in operating expenses of approximately $100 million related to operations at the new Denver International Airport, and approximately $70 million related to employee pension costs as a result of lowering the assumed discount rate from 8.75% to 7.5%. 1993 Compared with 1992 Operating Revenues Operating revenues increased $1.629 billion (13%). Passenger revenues increased $1.353 billion (12%) due to a 9% increase in revenue passenger miles and a 2% increase in yield to 12.48 cents. Domestic revenue passenger miles increased 6% on an increase of 8% in domestic available seat miles, resulting in a decrease of 1.0 point in domestic passenger load factor to 65.2%. International revenue passenger miles increased 14%. Passenger traffic increased in substantially all international markets, especially in Latin America, where United began service in the first quarter of 1992. Passenger load factors increased in Latin America, the Atlantic and the Pacific. On a system basis, available seat miles increased 10% and passenger load factor decreased 0.2 points to 67.2%. Cargo revenues increased $167 million (21%), due to increases of $144 million in freight revenues and $23 million in mail revenues. The freight revenue increase reflects both volume and unit revenue increases largely attributable to increased international operations. Contract services and other revenues increased $109 million (18%) primarily as a result of revenues generated by Apollo Travel Services Partnership ("ATS"), a consolidated general partnership 77% owned by United, that was formed by the 1993 merger of two affiliates of United. (see Note 3 of the Notes to Consolidated Financial Statements) Operating Expenses Operating expenses increased $838 million (6%). United's cost per available seat mile decreased 3% to 9.33 cents. The decrease in unit cost was largely due to the implementation of a cost reduction program in early 1993. Commissions increased $288 million (13%) due to increased revenues and slightly higher cargo commission rates. Salaries and related costs increased $208 million (5%) primarily due to higher average wage rates and higher costs associated with pensions and health insurance. Rentals and landing fees increased $169 million (13%) primarily reflecting rent associated with a larger number of aircraft on operating leases. Aircraft maintenance increased $60 million (20%) due principally to higher outside maintenance costs. Purchased services increased $48 million (5%) due principally to higher computer reservations fees and higher costs associated with international operations, such as communications, navigation charges and security. Depreciation and amortization increased $27 million (4%) due principally to newly acquired aircraft. Aircraft fuel expense increased $39 million, as a 7% increase in fuel consumption was partially offset by a 4% decrease in the average price per gallon of fuel to 63.6 cents. Other operating expenses increased $80 million (10%) due principally to the consolidation of ATS after the merger. Advertising and promotion decreased $51 million (24%) and food and beverages decreased $24 million (7%) due to cost reduction efforts. Other Income and Expense Other expense amounted to $321 million in 1993 compared to $106 million in 1992. Interest expense increased $31 million due primarily to increased debt and capital lease obligations incurred in connection with aircraft financings. Interest capitalized decreased $41 million (45%) due to lower advance payments on new aircraft. United's equity in the results of affiliates shifted from income of $42 million in 1992, representing United's share of Covia Partnership ("Covia") earnings, to losses of $30 million in 1993, primarily due to a charge recorded by Galileo International for the cost of eliminating duplicate facilities and operations after the merger of Covia and the Galileo Company. Included in "Miscellaneous, net" were foreign exchange losses of $20 million in 1993 compared to gains of $2 million in 1992. Also included in 1993 was a charge of $59 million to reduce the net book value of 15 DC-10 aircraft to estimated net realizable value and a $17 million gain resulting from the final settlement for overpayment of annuities purchased in 1985 to cover certain vested pension benefits. Interest income increased $11 million due principally to interest received in connection with the same settlement. In 1992, "Miscellaneous, net" also included gains on disposition of property of $32 million, a charge of $13 million to record the cash settlement of class action claims resulting from litigation relating to the use of airline fare data. 1992 Compared with 1991 In 1992, United recorded a net loss of $933 million, compared to the 1991 net loss of $335 million. The 1992 loss before the cumulative effect of adoption of SFAS No. 106 and SFAS No. 109 was $386 million. Operating Revenues Operating revenues increased $1.065 billion (9%). Passenger revenues increased $1.033 billion (10%) due to a 13% increase in revenue passenger miles partially offset by a 2% decrease in yield to 12.19 cents. The increase in passenger traffic was largely attributable to United's international operations. European operations increased significantly with the April 1991 acquisition of route authorities from Pan Am. Latin American operations began in January 1992 as United started serving certain former Pan Am destinations. Pacific air travel demand also improved compared to 1991, which was adversely impacted by the Gulf war. Domestic traffic increased primarily as a result of fare reductions initiated by other carriers. Domestic revenue passenger miles increased 5% and available seat miles increased 2%, resulting in a 2.0 point increase in domestic load factor to 66.2%. On a system basis, United's revenue passenger miles increased 13% and available seat miles increased 11%, resulting in a 1.1 point increase in passenger load factor to 67.4%. Cargo revenues increased $89 million (13%), primarily due to increased freight revenues, reflecting both volume and unit revenue increases as a result of expanded international operations. Contract services and other revenues decreased $57 million (9%) primarily as a result of a decrease in fuel sales. Operating Expenses Operating expenses increased $1.070 billion (9%). United's cost per available seat mile decreased 2% to 9.6 cents. Salaries and related costs increased $430 million (11%) primarily due to increased flight crew and customer service personnel, higher average wage rates and higher costs associated with pensions and health insurance. The increase in salaries and related costs included $75 million related to SFAS No. 106, which was adopted effective January 1, 1992. Rentals and landing fees increased $212 million (20%) reflecting rent associated with an increasing number of aircraft on operating leases and higher airport facilities rent and landing fees, primarily related to international operations. Commissions increased $166 million (8%) due to increased revenues, as average commission rates remained relatively unchanged. Purchased services increased $142 million (18%) due principally to higher computer reservations fees and higher costs associated with international operations, such as communications, navigation charges and security. Depreciation and amortization increased $91 million (15%) due principally to newly acquired aircraft. Food and beverages increased $49 million (17%) due to a higher per passenger cost, reflecting a passenger mix more heavily weighted by international passengers. Aircraft fuel expense increased $5 million, as an 8% increase United's in fuel consumption was partially offset by a 7% decrease in the average price per gallon of fuel to 66.4 cents. Aircraft maintenance decreased $57 million (16%) due principally to lower outside maintenance costs and the retirement of the B727-100 fleet. Other operating expenses decreased $2 million due to selling less fuel to third parties. Other Income and Expense Other expense amounted to $106 million in 1992 compared to $22 million in 1991. Interest expense increased $106 million due primarily to increased debt and capital lease obligations incurred in connection with 1991 and 1992 aircraft financings. Interest income decreased $19 million due to lower interest rates. Equity in the earnings of affiliates increased $35 million as a result of higher Covia booking revenues and the settlement of certain partner accounts in 1991. "Other income (expense) - Miscellaneous, net" included foreign exchange gains of $2 million in 1992 compared to losses of $20 million in 1991. Also included in 1992 was a charge of $13 million to record the cash settlement of class action claims resulting from litigation relating to the use of airline fare data and gains of $32 million on the disposition of property, primarily one B747-SP aircraft, seventeen B727 aircraft and four B737-200 aircraft. In 1991, gains on the disposition of property amounted to $49 million, which reflected sales of two DC8-71s and four B727-100s. Other Information Deferred Tax Asset United's consolidated balance sheet at December 31, 1993 includes a net cumulative deferred tax asset of $697 million. The net deferred tax asset is composed of approximately $1.9 billion of deferred tax assets and approximately $1.2 billion of deferred tax liabilities. The deferred tax assets include, among other things, $598 million related to obligations for postretirement and other employee benefits, $480 million related to gains on sales and leasebacks and $202 million related to alternative minimum tax ("AMT") credit carryforwards which do not expire. The majority of the deferred tax assets will be realized through reversals of existing deferred tax liabilities with similar reversal patterns. To realize the benefits of the remaining deferred tax assets relating to temporary differences, United needs to generate approximately $1.2 billion in future taxable income. Based on the expectations for future taxable income, the extended period over which postretirement benefits will be recognized, and the indefinite carryforward period for AMT credits, management believes it is more likely than not that the deferred tax assets will be realized. Although United has experienced both book and tax losses in the past three years, in the ten years prior to these losses, United reported cumulative taxable income of $2.8 billion (including $400 million of gains on dispositions of businesses). Following is a summary of United's pretax book income and taxable income for the last five years: (In Millions) 1993 1992 1991 1990 1989 Pretax book income (loss) $ (26) $(602) $(513) $167 $595 Taxable income (loss) $(156) $(502) $(784) $274 $638 The losses in the past three years were largely attributable to certain events beyond management control, including the Gulf war, the unanticipated duration of the recession in both the U. S. and other areas of the world and the proliferation of numerous low-cost air carriers resulting in severe competition in the airline industry. While the economic outlook in Japan and Europe could continue to negatively affect United's operating results, management believes that these economies will begin to improve, and when combined with certain cost containment strategies, United's financial results should improve. Management has already taken several steps to reduce costs and capital expenditures. United's improved operating results in 1993 versus 1992 are principally attributable to these actions, as highlighted below: o Implemented a program in January 1993 to reduce planned 1993 operating expenses by $400 million, including the furlough of 2,800 employees in February 1993. o Reached agreement with Boeing, its principal supplier, to convert 49 aircraft orders into options and defer their scheduled delivery dates. o Reduced 1993 to 1996 capital spending by $6 billion. o Agreed to sell flight kitchens which will result in the avoidance of an estimated $70 million of capital expenditures and estimated cost savings of more than $320 million over the seven year catering contract with the purchaser, before taking into account the severance payments resulting from the employee investment transaction. o Accelerated the retirement of 25 older aircraft to reduce costs and improve operating efficiencies. o Negotiated over $100 million in annual savings from suppliers. o Reduced domestic capacity by eliminating certain unprofitable routes and reducing capacity in certain markets to better match demand. o Increased the use of cooperative arrangements with domestic and international carriers resulting in increased revenue opportunities through code-sharing. The long-term financial stability and profitability of the company is expected to be further enhanced through the proposed employee investment transaction. However, in the event the proposed employee investment transaction does not occur, United is prepared to make additional structural changes to return to profitablilty. United's ability to generate sufficient amounts of taxable income from future operations is dependent upon numerous factors, including general economic conditions, inflation, oil prices, the state of the industry and other factors beyond management's control. In the event that future taxable income is inadequate to realize the benefits of the remaining deferred tax assets, United has identified certain tax planning strategies that would significantly contribute to the utilization of these assets. These strategies include, among other things, eliminating the prefunding of certain employee benefits and the sale of unused route authorities. There can be no assurances that United will meet its expectation of future taxable income. However, based on the above factors, management believes it is more likely than not that future taxable income will be sufficient to utilize the cumulative deferred tax assets at December 31, 1993. Contingencies During 1992, United recorded a $13 million charge representing its share of the cash component of a settlement of certain class action claims. Under the settlement, which has been approved by the U.S. District Court, six airlines paid approximately $45 million in cash and will issue $397 million in face amount of certificates affording discounts of up to approximately 10% on future air travel on any of the six carriers. No liability was established for the certificate portion of the settlement since United expects that in the aggregate, future revenues associated with certificate redemption will exceed the cost of providing the related air service. United anticipates that the portion of the total issued certificates that may be redeemed on United will approximate United's 22% market share among the six carriers, but actual redemption may be greater or lesser. The ultimate impact of the settlement on United's future revenues, operating margins and earnings is not reasonably estimable since neither the portion of the certificates to be redeemed on United nor the generative or dilutive revenue effect of certificate redemption is known. United has been named as a Potentially Responsible Party at certain Environmental Protection Agency ("EPA") cleanup sites which have been designated as Superfund Sites. At sites where the EPA has commenced remedial litigation, potential liability is joint and several. United's alleged proportionate contributions at the sites are minimal. Additionally, United has participated and is participating in remediation actions at certain other sites, primarily airports. The estimated cost of these actions is accrued when it is determined that it is probable that United is liable. Such accruals have not been material. United has certain other contingencies resulting from litigation and claims incident to the ordinary course of business. Although the ultimate outcome of these matters could have a material effect on United's financial condition, operating results or liquidity, management believes, after considering a number of factors, including (but not limited to) the views of legal counsel, the nature of such contingencies and prior experience, that the ultimate disposition of these contingencies is not likely to materially affect United's financial condition, operating results or liquidity. New Accounting Standards In November 1992, the Financial Accounting Standards Board ("FASB") issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which requires recognition of the liability for postemployment benefits during the period of employment. Such benefits include company paid continuation of group life insurance and medical and dental coverage for certain employees after employment but before retirement. United will adopt the new standard in the first quarter of 1994. Based on preliminary estimates, United currently expects to record a transition obligation, which will result in a cumulative charge of $26 million, net of tax. Prior years' financial statements will not be restated. Ongoing expenses will vary based on actual claims experience. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires fair value accounting for certain investments. United is required to adopt the new standard in 1994 and the standard is not to be applied retroactively. Upon adoption, United will record a periodic charge or credit to adjust the carrying value of certain investments to fair value. The adjustment will be recorded in earnings or as a separate component of equity, depending on the type of investment. United does not expect a material impact on either earnings or equity as a result of adopting SFAS No. 115. Energy Tax The Omnibus Budget Reconciliation Act of 1993 signed into law on August 10, 1993, imposes a 4.3 cent per gallon tax on commercial aviation jet fuel purchased for use in domestic operations. This new fuel tax will become effective October 1, 1995, and is scheduled to continue until October 1, 1998. Based on United's 1993 domestic fuel consumption of 1.7 billion gallons, the new fuel tax, when effective, is expected to increase United's operating expenses by approximately $75 million annually. Foreign Currency Transactions United generates revenues and incurs expenses in numerous foreign currencies; however, United has limited exposure to foreign exchange rate fluctuations due to its ability to convert excess local currencies generated to U.S. dollars. In addition, United has exposure to transaction gains and losses resulting from rate fluctuation. The foreign exchange gains and losses recorded in recent years, including losses recorded in early 1993, were primarily the result of the impact of exchange rate changes on unhedged Japanese yen-denominated long-term debt, lease obligations and current liabilities, since the aggregate balance of such liabilities exceeded United's yen-denominated assets. During 1993, United increased the amount of its yen-denominated assets to minimize the impact of foreign exchange rate changes on reported financial results. Sale of Flight Kitchens In the third quarter of 1993, United reached agreements to sell assets related to the operation of 16 of its flight kitchens to Dobbs International Services, Inc. and Caterair International Corp. for $119 million. Under the agreements, the purchasers will provide catering services for United at the airports served by the flight kitchens for seven years. United expects the catering agreement to result in savings of approximately $320 million over its term, before taking into account the severance payments resulting from the employee investment transaction. The asset sales for most, if not all, of the flight kitchens are expected to be completed in the second quarter of 1994. The asset sales result in an insignificant gain. Item 8. Item 8. Financial Statements and Supplementary Data Page Number Report of independent public accountants 41 Consolidated financial statements - Statement of consolidated operations for the years ended December 31, 1993, 1992 and 1991 42 Statement of consolidated financial position as of December 31, 1993 and 1992 43-44 Statement of consolidated cash flows for the years ended December 31, 1993, 1992 and 1991 45 Statement of consolidated shareholder's equity for the years ended December 31, 1993, 1992 and 1991 46 Notes to consolidated financial statements 47-66 Reference is made to Item 14(a)(2), page 68, for the Financial Statements Schedules included in this report. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors, United Air Lines, Inc.: We have audited the accompanying statement of consolidated financial position of United Air Lines, Inc. (a Delaware corporation) and subsidiary companies as of December 31, 1993 and 1992, and the related statements of consolidated operations, consolidated cash flows and consolidated shareholder's equity for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of United Air Lines, Inc. and subsidiary companies as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in notes 5 and 11 to the consolidated financial statements, effective January 1, 1992, the Company changed its methods of accounting for income taxes and postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules referenced in Item 14(a)(2) herein are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois February 23, 1994 UNITED AIR LINES, INC. AND SUBSIDIARY COMPANIES STATEMENT OF CONSOLIDATED OPERATIONS (In Millions) Year Ended December 31 1993 1992 1991 Operating revenues: Passenger $12,682 $11,329 $10,296 Cargo 960 793 704 Contract services and other 712 603 660 14,354 12,725 11,660 Operating expenses: Salaries and related costs 4,695 4,487 4,057 Commissions 2,500 2,212 2,046 Aircraft fuel 1,718 1,679 1,674 Rentals and landing fees 1,466 1,297 1,085 Purchased services 974 926 784 Depreciation and amortization 722 695 604 Aircraft maintenance 366 306 363 Food and beverages 317 341 292 Personnel expenses 260 266 239 Advertising and promotion 163 214 207 Other 878 798 800 14,059 13,221 12,151 Earnings (loss) from operations 295 (496) (491) Other income (expense): Interest expense (347) (316) (210) Interest capitalized 51 92 91 Interest income 75 64 83 Equity in earnings (loss) of affiliates (30) 42 7 Miscellaneous, net (70) 12 7 (321) (106) (22) Loss before extraordinary item, income taxes and cumulative effect of accounting changes (26) (602) (513) Provision (credit) for income taxes (9) (216) (178) Loss before extraordinary item and cumulative effect of accounting changes (17) (386) (335) Extraordinary loss on early extinguishment of debt, net of tax (19) - - Cumulative effect of accounting changes: Accounting for postretirement benefits, net of tax - (580) - Accounting for income taxes - 33 - Net loss $ (36) $ (933) $ (335) The accompanying notes to consolidated financial statements are an integral part of these statements. UNITED AIR LINES, INC. AND SUBSIDIARY COMPANIES STATEMENT OF CONSOLIDATED FINANCIAL POSITION (In Millions) December 31 Assets 1993 1992 Current assets: Cash and cash equivalents $ 285 $ 454 Short-term investments 681 778 Receivables, less allowance for doubtful accounts (1993 - $22; 1992 - $12) 1,092 1,064 Related party receivables 397 311 Aircraft fuel, spare parts and supplies, less obsolescence allowance (1993 - $69; 1992 - $46) 277 314 Refundable income taxes 47 109 Deferred income taxes 127 34 Prepaid expenses 361 328 3,267 3,392 Operating property and equipment: Owned - Flight equipment 7,899 7,604 Advances on flight equipment 589 706 Other property and equipment 2,658 2,077 11,146 10,387 Less - Accumulated depreciation and amortization 4,678 4,183 6,468 6,204 Capital leases - Flight equipment 1,027 958 Other property and equipment 104 100 1,131 1,058 Less - Accumulated amortization 395 343 736 715 7,204 6,919 Other assets: Intangibles, less accumulated amortization (1993 - $165; 1992 - $129) 789 800 Deferred income taxes 570 579 Other 323 377 1,682 1,756 $12,153 $12,067 The accompanying notes to consolidated financial statements are an integral part of these statements. UNITED AIR LINES, INC. AND SUBSIDIARY COMPANIES STATEMENT OF CONSOLIDATED FINANCIAL POSITION (In Millions, Except Share Data) December 31 Liabilities and Shareholder's Equity 1993 1992 Current liabilities: Short-term borrowings $ 315 $ 450 Long-term debt maturing within one year 125 73 Current obligations under capital leases 62 53 Advance ticket sales 1,036 1,066 Accounts payable 632 649 Accrued salaries, wages and benefits 941 903 Accrued aircraft rent 886 708 Other accrued liabilities 878 858 4,875 4,760 Long-term debt 2,603 2,694 Long-term obligations under capital leases 824 808 Other liabilities and deferred credits: Deferred pension liability 571 576 Postretirement benefit liability 1,058 960 Deferred gains 1,400 1,430 Other 113 101 3,142 3,067 Minority interest 35 - Shareholder's equity: Common stock, $5 par value; authorized, 1,000 shares; outstanding 200 shares - - Additional capital invested 839 816 Retained earnings (deficit) (95) (59) Unearned compensation (17) (11) Pension liability adjustment (53) (8) 674 738 Commitments and contingent liabilities (Note 13) $12,153 $12,067 The accompanying notes to consolidated financial statements are an integral part of these statements. UNITED AIR LINES, INC. AND SUBSIDIARY COMPANIES STATEMENT OF CONSOLIDATED CASH FLOWS (In Millions) The accompanying notes to consolidated financial statements are an integral part of these statements. UNITED AIR LINES, INC. AND SUBSIDIARY COMPANIES STATEMENT OF CONSOLIDATED SHAREHOLDER'S EQUITY (In Millions) The accompanying notes to consolidated financial statements are an integral part of these statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies (a) Consolidation- United Air Lines, Inc. ("United") is a wholly-owned subsidiary of UAL Corporation ("UAL"). The consolidated financial statements include the accounts of United and all of its subsidiaries. All significant intercompany transactions are eliminated. Investments in affiliates are carried on the equity basis. (b) Accounting Changes- Effective January 1, 1992, United adopted Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (see Note 11) and SFAS No. 109, "Accounting for Income Taxes" (see Note 5). (c) Airline Revenues- Passenger fares and cargo revenues are recorded as operating revenues when the transportation is furnished. The value of unused passenger tickets is included in current liabilities. (d) Foreign Currency Transactions- Monetary assets and liabilities denominated in foreign currencies are converted at exchange rates in effect at the balance sheet date. The resulting foreign exchange gains and losses, and gains and losses on foreign currency call options used to hedge foreign currency obligations, are charged or credited directly to income. (e) Cash and Cash Equivalents and Short-term Investments- Cash in excess of operating requirements is pooled with funds from UAL and its subsidiary companies and invested in short-term, highly liquid, income-producing investments. Investments with an original maturity of three months or less on their acquisition date are classified as cash and cash equivalents. Cash and cash equivalents and short-term investments are stated at cost, which approximates market value. Due to the short maturity of these instruments, their carrying amount is a reasonable estimate of fair value. (f) Aircraft Fuel, Spare Parts and Supplies- Aircraft fuel and maintenance and operating supplies are stated at average cost. Flight equipment spare parts are stated at average cost less an obsolescence allowance. (g) Operating Property and Equipment- Owned operating property and equipment is stated at cost. Property under capital leases, and the related obligation for future minimum lease payments, are initially recorded at an amount equal to the then present value of those lease payments. Depreciation and amortization of owned depreciable assets is based on the straight-line method over their estimated service lives. Leasehold improvements are amortized over the remaining period of the lease or the estimated service life of the related asset, whichever is less. Aircraft are depreciated to estimated salvage values, generally over lives of 10 to 25 years; buildings are depreciated over lives of 25 to 45 years; and other property and equipment are depreciated over lives of three to 15 years. Properties under capital leases are amortized on the straight-line method over the life of the lease, or in the case of certain aircraft, over their estimated service lives. Lease terms are 10 to 19 years for aircraft and flight simulators and 25 years to 40 years for buildings. Amortization of capital leases is included in depreciation and amortization expense. Gains or losses on dispositions of individual units of owned property and equipment are reflected in earnings. Maintenance and repairs, including the cost of minor replacements, are charged to maintenance expense accounts. Costs of additions to and renewals of units of property are charged to property and equipment accounts. (h) Intangibles- Intangibles consist primarily of route acquisition costs, slots and intangible pension assets (see Note 10). Route acquisition costs and slots are amortized over 40 years and 5 years, respectively. (i) Mileage Plus Awards- United accrues the estimated incremental cost of providing free travel awards earned under its Mileage Plus frequent flyer program when such award levels are reached. (j) Deferred Gains- Gains on aircraft sale and leaseback transactions are deferred and amortized over the lives of the leases as a reduction of rental expense. (k) Interest Rate Swap Agreements- United enters into interest rate swap agreements to hedge certain interest rate exposure. The differential to be paid or received under the swap agreements is accrued and included in interest expense or rental expense. (2) Proposed Employee Investment Transaction On December 22, 1993, the Board of Directors of UAL approved a non-binding agreement in principle that would provide a majority equity interest in UAL to the employees of United in exchange for wage concessions and work-rule changes. In January 1994, the agreement was ratified by the Air Line Pilots Association ("ALPA") and the International Association of Machinists ("IAM"). The transaction is subject to, among other things, approval by UAL stockholders. In the transaction, an Employee Stock Ownership Plan will be created to provide United employees with a minimum of a 53% equity interest in UAL in exchange for wage concessions and work-rule changes. The employee interest may increase to up to 63%, depending on the average market value of UAL common stock in the year after the transaction closes. The transaction is not dependent on external financing. Pursuant to the terms of the agreement in principle, current UAL stockholders would receive the remaining 37 to 47% of the common stock and $88 per share in cash and face amount of debt and preferred stock. The non-common stock consideration is expected to aggregate approximately $743 million of cash, $900 million face amount of senior unsecured debentures and $900 million face amount of preferred stock depending on the number of common shares on which the distribution is made. While the agreement in principle contemplates that the debentures would be issued by UAL, such debentures could be issued by United. UAL agreed that if the transaction closes prior to August 31, 1994, severance payments and employee benefits coverage approximating $50 million would be provided by United to IAM employees being terminated from United as a result of the recent sale of flight kitchens (see Note 16), in addition to payments required under United's labor contracts. Certain of the severance payments, which are to be made on a monthly basis, became payable in January 1994 after the unions ratified the agreement; however, these monthly payments terminate but are not refunded if the transaction does not close before August 31, 1994 or certain other conditions are not met. Other lump-sum severance amounts are payable only if the transaction closes prior to the required date. UAL has also agreed to pay up to $45 million of transaction fees and expenses incurred by ALPA and the IAM if the transaction is closed by August 31, 1994. If the transaction does not close by the required date but certain conditions are met, UAL will pay up to $12.5 million of ALPA and IAM transaction expenses. (3) Merger of Affiliates In September 1993, the Covia Partnership ("Covia"), a 50% owned affiliate of United, and The Galileo Company Limited, a 25.9% owned affiliate of United, merged. The merger resulted in the formation of the Apollo Travel Services Partnership ("ATS") and the Galileo International Partnership ("Galileo"), two general partnerships that are owned 77% and 38%, respectively, by United through a wholly-owned subsidiary. Galileo owns the Apollo and Galileo computer reservations systems. ATS is responsible for marketing, sales and support of Apollo in the United States, Mexico and the Caribbean. Prior to the merger, United's investments in these companies were carried on the equity basis. As a result of the merger and United's majority ownership of ATS, the accounts of ATS are consolidated, resulting in non-cash increases of $78 million in assets, $46 million in liabilities and $34 million in minority interests as of the date of the merger. United's investment in Galileo is carried on the equity basis. The accounting for the merger resulted in no change in the book value of the assets and liabilities of the companies combined. During the fourth quarter, Galileo recorded a charge for the cost of eliminating duplicate facilities and operations. United's share of this charge was recorded in "Equity in earnings (loss) of affiliates." The merger is expected to create operating efficiencies by eliminating duplication. Under operating agreements with Covia prior to the merger, United provided certain computer support services for, and purchased computer reservation services, communications and other information from Covia. Revenues derived from the sale of services to Covia amounted to approximately $21 million, $22 million and $31 million in 1993, 1992 and 1991, respectively. The cost to United of services purchased from the Covia Partnership amounted to approximately $168 million, $219 million, and $191 million in 1993, 1992 and 1991, respectively. Under operating agreements with Galileo subsequent to the merger, United purchases computer reservation services from Galileo and ATS provides marketing, sales and communication services for Galileo. Revenues derived from the sale of services to Galileo amounted to approximately $58 million and the cost of services purchased from Galileo amounted to approximately $47 million in 1993. Summarized financial information for the significant entities accounted for on the equity basis, follows. Covia - Summarized financial information as of September 15, 1993 and December 31, 1992 and for the period from January 1, 1993 through September 15, 1993 and the years ended December 31, 1992 and 1991 (in millions): September 15, December 31, 1993 1992 Current assets $168 $132 Non-current assets 312 322 Total assets 480 454 Current liabilities 83 98 Long-term liabilities 44 13 Total liabilities 127 111 Net assets $353 $343 1993 1992 1991 Net services revenues $398 $527 $451 Costs and expenses 334 444 436 Income before cumulative effect of change in accounting 64 83 15 Net income 47 83 15 Effective January 1, 1993, Covia adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" which resulted in a cumulative charge of $17 million. Galileo - Summarized financial information as of December 31, 1993 and for the period from September 16, 1993 through December 31, 1993 (in millions): December 31, Current assets $141 Non-current assets 467 Total assets 608 Current liabilities 173 Long-term liabilities 440 Total liabilities 613 Net assets $ (5) Services revenues $186 Costs and expenses 327 Net loss (141) During 1993, Galileo recorded $114 million of charges which included the cost of eliminating duplicate facilities and operations. (4) Other Income (Expense) - Miscellaneous Other income (expense) - miscellaneous, net consisted of the following: 1993 1992 1991 (In Millions) Foreign exchange gains or losses $(20) $ 2 $(20) Amortization of hedge transaction costs (6) (4) (8) Write down of aircraft to net realizable value (59) - - Gain on settlement of 1985 annuity purchases 17 - - Net gains on disposition of property 2 32 49 Gain on sale of certain property rights - 9 15 Settlement of class action claims regarding airline fare data - (13) - Other (4) (14) (29) $(70) $ 12 $ 7 (5) Income Taxes United, its subsidiaries and other affiliated companies file a consolidated federal income tax return with UAL. Under an intercompany tax allocation policy, United and its subsidiaries compute, record, and pay UAL for their own tax liability as if they were separate companies filing separate tax returns. In determining their own tax liabilities, United and each of its subsidiaries take into account all tax credits or benefits generated and utilized as separate companies, and they are compensated for the aforementioned tax benefits only if they would be able to use those benefits on separate company bases. In 1993, United incurred a regular tax loss but had an alternative minimum tax ("AMT") liability. The regular tax loss will be carried back to reduce taxable income generated in previous years resulting in federal and state refunds and additional AMT credits. Certain preferences, mainly depreciation adjustments, have caused alternative minimum taxable income to exceed regular taxable income, resulting in the AMT liability. The provision (credit) for income taxes is summarized as follows: 1993 1992 1991 (In Millions) Current- Federal $ 50 $ (85) $(198) State - (3) 2 50 (88) (196) Deferred- Federal (68) (114) 24 State 9 (14) (6) (59) (128) 18 $ (9) $(216) $(178) The income tax provision (credit) differed from amounts computed at the statutory federal income tax rate, as follows: 1993 1992 1991 (In Millions) Income tax provision (credit) at statutory rate $ (9) $(205) $(174) State income taxes, net of federal income tax benefit 6 (11) (3) Nondeductible employee meals 8 8 6 Foreign sales corporation benefit (1) (6) (6) Rate change effect (9) - - Foreign tax credits (3) (2) (2) Losses of foreign affiliate - - 1 Other, net (1) - - Income tax provision (credit) as reported $ (9) $(216) $(178) United adopted SFAS No. 109 "Accounting for Income Taxes," effective January 1, 1992. This statement provides for an asset and liability approach to accounting for income taxes. United recognized a tax benefit of $33 million for the cumulative effect of adopting SFAS No. 109. Deferred income taxes (credit) for 1993 and 1992 reflect the impact of "temporary differences" between amounts of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws. These temporary differences are determined in accordance with SFAS No. 109 and are more inclusive in nature than "timing differences" as determined under previously applicable accounting principles. During 1991, deferred income taxes were provided for significant timing differences in the recognition of revenue and expenses for tax and financial statement purposes. Principally, these items consisted of the following: $81 million for depreciation and capitalized interest, $(62) million for gains on sale and leaseback transactions, $32 million for gains on asset dispositions, $(24) million for rent expense, $(31) for pension expense, $16 million for other employee benefits and $12 million for prepaid commissions. Temporary differences and carryforwards which give rise to a significant portion of deferred tax assets and liabilities for 1993 and 1992 are as follows: 1993 1992 Deferred Deferred Deferred Deferred Tax Tax Tax Tax Assets Liabilities Assets Liabilities (In Millions) Employee benefits, including postretirement medical $ 598 $ 31 $ 657 $ 119 Prepaid commissions - 49 - 51 Depreciation, capitalized interest and transfers of tax benefits - 1,105 - 1,013 Gains on sale and leasebacks 480 - 479 - Rent expense 207 - 169 - AMT credit carryforward 202 - 132 - Foreign exchange gains and losses 84 - 102 - Frequent flyer accrual 72 - 72 - Other 295 56 385 200 $1,938 $1,241 $1,996 $1,383 United has determined, based on its history of operating earnings, available carrybacks, expectations for the future and potential tax planning strategies, that it is more likely than not that the deferred tax assets at December 31, 1993 will be realized before expiration. The significant differences between pretax book losses and taxable losses for the last three years were as follows (in millions): 1993 1992 1991 Pretax book loss $ (26) $(602) $(513) Gains on sale and leasebacks 17 304 171 Depreciation, capitalized interest and transfers of tax benefits (370) (278) (218) Rent expense 139 127 93 Pension expense (3) (95) (194) Other employee benefits 47 36 (67) Gains on asset dispositions (41) (3) (110) Other, net 81 9 54 Taxable loss $(156) $(502) $(784) At December 31, 1993, United and its subsidiaries had $202 million of federal AMT credit carryforwards available for an indefinite period and $27 million of state tax benefit from net operating loss carryforwards expiring between 1997 and 2009. (6) Short-Term Borrowings At December 31, 1993, United had outstanding $315 million in short-term borrowings, bearing an average interest rate of 3.34%. Receivables amounting to $367 million were pledged by United to secure repayment of such outstanding borrowings. Due to the short maturity of these borrowings, their carrying amount is a reasonable estimate of fair value. In February 1993, United entered agreements to increase the maximum available amount of borrowings under this arrangement from $450 million to $500 million. Pursuant to the terms of this agreement, in the event of a change in control of United or UAL, such as the proposed employee investment transaction, the lenders under this agreement may decline to make new loans to United. (7) Long-Term Debt A summary of long-term debt, excluding current maturities, as of December 31 is as follows (interest rates are as of December 31, 1993): 1993 1992 (In Millions) Secured notes, 4.2125% to 11.54%, averaging 7.41%, due 1994 to 2014 $ 1,399 $ 1,057 Deferred purchase certificates, Japanese yen- denominated, 7.75%, due 1994 to 1998 178 183 Debentures, 6.75% to 10.25%, averaging 9.36%, due 1997 to 2021 1,000 900 Promissory notes, 3.72% to 4.38%, averaging 4.07%, due 1994 through 1998 41 76 Senior subordinated notes - 500 2,618 2,716 Unamortized discount on debt (15) (22) $ 2,603 $ 2,694 The fair value of long-term debt, including current maturities, at December 31, 1993 and 1992 were estimated to be $2.928 billion and $2.893 billion, respectively, based on the quoted market prices for the same or similar issues or on the then current rates offered for debt of the same remaining maturities. In the second quarter of 1993, United retired $500 million of senior subordinated notes. The notes, bearing interest at 12.5% and 13%, were scheduled to mature in 1995 and 1998 for $150 and $350 million, respectively. An extraordinary loss of $19 million, net of tax benefits of $8 million, was recorded in the first quarter of 1993, based on United's stated intention to retire the notes. In May 1993, United issued $176 million of pass through certificates under a 1992 shelf registration to refinance aircraft under operating leases. In June 1993, a new shelf registration filed by UAL and United for up to $1.5 billion of securities, including secured and unsecured debt, equipment trust and pass through certificates, equity or a combination thereof, was declared effective. Under the terms of the 1993 shelf registration statement, the 1992 shelf and a 1991 shelf, under which $394 million and $100 million, respectively, of securities remained, were combined with the 1993 shelf. In November 1993, United issued $118 million of pass through certificates under the shelf registration to refinance aircraft under operating leases. In December 1993, United issued $100 million of 6.75% debentures due 1997 under the shelf. On a combined basis, up to $1.776 billion of additional securities may be offered at December 31, 1993. In connection with 1993 aircraft financings, United issued $470 million of secured notes due through 2013. Interest rates were fixed between 7.53% and 8.99% on $270 million of principal amount. Initial interest rates on the remaining notes were 166 and 176 basis points over the London interbank offered rate ("LIBOR") and will be 650 basis points over LIBOR after nine months. In addition, during 1993, United retired $74 million of principal amount of secured notes in connection with sale and leaseback transactions. At December 31, 1993, United had outstanding a total of $544 million of long-term debt bearing interest at rates 85 to 176 basis points over LIBOR. In connection with certain of these debt financings, United has entered interest rate swap agreements to effectively fix interest rates at December 31, 1993 between 8.554% and 8.6% on $73 million of notional amount. The swap agreements have terms of 18.5 years, corresponding to the terms of the related debt obligations. Under the agreements, United makes payments to counterparties at fixed rates and in return receives payments based on LIBOR. In the event of default by the counterparties, United is exposed to credit risk for periodic settlements due under the swap agreements; however, United does not anticipate such default. The fair values of these swap agreements at December 31, 1993 and 1992 were $8 million and $3 million, respectively, representing the estimated amount that United would pay to terminate the swap agreements, based on interest rates in effect at the time. Maturities of long-term debt for each of the four years after 1994 are: 1995 -- $107 million; 1996 -- $112 million; 1997 -- $114 million; and 1998 -- $175 million. Various assets, principally aircraft, having an aggregate book value of $1.634 billion at December 31, 1993, were pledged under various loan agreements. (8) Lease Obligations United leases aircraft, airport passenger terminal space, aircraft hangars and related maintenance facilities, cargo terminals, flight kitchens, real estate, office and computer equipment and vehicles. Future minimum lease payments as of December 31, 1993, under capital leases and operating leases having initial or remaining noncancelable lease terms of more than one year are as follows: Operating Capital Leases Leases (In Millions) Payable during- 1994 $ 1,255 $ 144 1995 1,268 144 1996 1,249 146 1997 1,230 141 1998 1,273 145 After 1998 19,639 548 Total minimum lease payments $25,914 1,268 Imputed interest (at rates of 5.3% to 12.2%) (382) Present value of minimum lease payments 886 Current portion (62) Long-term obligations under capital leases $ 824 As of December 31, 1993, United leased 298 aircraft, 45 of which were under capital leases. These leases have terms of four to 26 years, and expiration dates range from 1994 through 2017. Under the terms of leases for 287 of the aircraft, United has the right of first refusal to purchase, at the end of the lease term, certain aircraft at fair market value and others at either fair market value or a percentage of cost. United has five Airbus A320-200 aircraft under 24-year operating leases which are cancelable upon eleven months notice during the initial 10 years of the leases. Amounts charged to rent expense, net of minor amounts of sublease rentals, were $1.176 billion in 1993, $1.021 billion in 1992, and $854 million in 1991. Included in rent expense for 1993 and 1992 were insignificant amounts of contingent rentals, resulting from changes in interest rates for operating leases under which the rent payments are based on variable interest rates. In connection with certain of these leases, United has entered interest rate swap agreements, with terms similar to those discussed in Note 7 - Long-Term Debt. At December 31, 1993, a notional amount of $415 million of interest rate swap agreements effectively fixed interest rates between 8.02% and 8.65% on such leases. The fair values of these swap agreements at December 31, 1993 and 1992 were $34 million and $8 million, respectively. (9) Foreign Operations United conducts operations in various foreign countries, principally in the Pacific, Europe and Latin America. Operating revenues from foreign operations were approximately $5.560 billion in 1993, $4.863 billion in 1992 and $3.870 billion in 1991. (10) Retirement Plans United has various retirement plans which cover substantially all employees. Defined benefit plans covering certain employees (primarily union ground employees) provide a stated benefit for specified periods of service, while defined benefit plans for other employees provide benefits based on employees' years of service and average compensation for a specified period of time before retirement. Pension costs are funded to at least the minimum level required by the Employee Retirement Income Security Act of 1974. The company also provides several defined contribution plans which cover substantially all U. S. employees who have completed one year of service. For certain groups of employees (primarily pilots), the company contributes an annual amount on behalf of each participant, calculated as a percentage of the participants' earnings or a percentage of the participants' contributions. The following table sets forth the defined benefit plans' funded status and amounts recognized in the statement of consolidated financial position as of December 31: 1993 1992 Accumulated Assets Accumulated Benefits Exceed Benefits Exceed Accumulated Exceed Assets Benefits Assets (In Millions) Actuarial present value of accumulated benefit obligation $4,200 $2,179 $1,088 Actuarial present value of projected benefit obligation $5,025 $2,705 $1,356 Plan assets at fair value 3,589 2,290 762 Projected benefit obligation in excess of plan assets 1,436 415 594 Unrecognized net gain (loss) (624) (27) (28) Prior service cost not yet recognized in net periodic pension cost (455) (122) (435) Remaining unrecognized net asset 16 70 3 Adjustment required to recognize minimum liability 346 - 255 Pension liability recognized in the statement of consolidated financial position $ 719 $ 336 $ 389 For the valuation of pension obligations as of December 31, 1993 and 1992, the weighted average discount rates used were 7.5% and 8.75%, respectively, and the rates of increase in compensation were 4.0% and 4.3%, respectively. Substantially all of the accumulated benefit obligation is vested. Total pension expense for all retirement plans (including defined contribution plans) was $346 million in 1993, $324 million in 1992, and $252 million in 1991. Plan assets are invested primarily in governmental and corporate debt instruments and corporate equity securities. The expected average long-term rate of return on plan assets at December 31 was 9.75% for 1993, 10.25% for 1992 and 11.25% for 1991. The net periodic pension cost of defined benefit plans included the following components: 1993 1992 1991 (In Millions) Service cost - benefits earned during the year $ 186 $ 180 $ 144 Interest cost on projected benefit obligation 356 320 257 Actual return on plan assets (310) (289) (237) Net amortization and deferral 19 24 6 Net periodic pension cost $ 251 $ 235 $ 170 (11) Postretirement Benefits United provides certain life insurance and health care benefits for substantially all retired employees. The estimated cost of life insurance benefits is accrued and funded over the years of service of those employees expected to qualify for such benefits. United provides various defined benefit postretirement health care plans which pay stated percentages of most necessary medical expenses incurred by retirees, after subtracting payments by Medicare or other providers and after a stated deductible has been met. United funds this plan as medical claims are paid. Effective January 1, 1992, United adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". This standard requires that the expected cost of postretirement benefits be charged to expense during the years in which employees render service. Upon adoption, United elected to record the transition obligation of $925 million as a one-time charge against earnings. Prior to 1992, the cost of health care benefits was recognized as expense as claims were paid. The total cost of these postretirement benefits was $33 million in 1991. Information on the plans' funded status, on an aggregate basis at December 31, follows (in millions): 1993 1992 Accumulated postretirement benefit obligation: Retirees $ 416 $ 442 Other fully eligible participants 236 277 Other active participants 679 416 Total accumulated postretirement benefit obligation 1,331 1,135 Unrecognized net loss (149) (49) Fair value of plan assets (91) (86) Accrued postretirement benefit obligation $1,091 $1,000 Net postretirement benefit costs included the following components (in millions): 1993 1992 Service cost - benefits attributed to service during the period $ 38 $ 28 Amortization of unrecognized net loss 3 - Interest cost on benefit obligation 92 83 Net postretirement benefit costs $133 $111 For the valuation of the accumulated postretirement benefit obligation as of December 31, 1993 and 1992, the discount rate was 7.5% and 8.75%, respectively. An 11% and 12% annual rate of increase in the per capita cost of covered health care was assumed for 1993 and 1992, respectively; the rate is assumed to decrease annually to a rate of 4% by the year 2001, remaining level thereafter. The effect of a 1% increase in the assumed health care cost trend rate would increase the accumulated postretirement benefit obligation at December 31, 1993, by $175 million and the aggregate of the service and interest cost components of net postretirement benefit cost for 1993 by $21 million. (12) Related Party Transactions In 1992 and 1991, UAL made capital contributions of $60 million and $192 million, respectively, to United. In 1991, UAL also made a capital contribution to United of its investment in United Vacations, Inc., a wholly-owned subsidiary. At December 31, 1993 and 1992, United had accounts receivable from UAL of $361 million and $288 million, respectively. Certain officers and key employees of United participate in UAL stock award plans. Under UAL's incentive stock option program, stock appreciation rights ("SARs") were granted in tandem with certain stock options prior to 1992. On exercise of these SARs, holders would receive in cash 100% of the appreciation in fair market value of the UAL shares subject to the SAR. The estimated payment value of SARs, net of market value adjustments, was charged to United's earnings over the vesting period. In 1992, all active officers relinquished their SARs but retained the tandem stock options. The expense (credit) recorded for SARs was $1 million in 1993, $(1) million in 1992 and $18 million in 1991. In February 1994, UAL reinstated the use of SARs and 818,370 SARs were authorized in tandem with existing options with an outstanding average option price of $128.50. The SARs are not exercisable until September 1, 1994, and will expire if the employee investment transaction is consummated. Under UAL's restricted stock plan, 138,500 and 101,750 shares of UAL common stock were awarded to officers and key employees of United in 1993 and 1991, respectively. No shares were issued under this plan in 1992. In 1993, 1992 and 1991, 9,000, 6,500 and 4,200 shares, respectively, were forfeited under this plan. Unearned compensation, representing the fair market value of the stock on the date of award, is being amortized to salaries and related costs over the vesting period. Air Wis Services, Inc. ("Air Wis") became a wholly-owned subsidiary of UAL in January 1992. Air Wis owns Air Wisconsin, Inc. In April 1993, UAL transferred the Air Wisconsin, Inc. operations at Dulles to Atlantic Coast Airlines. In September 1993, UAL transferred certain Air Wisconsin, Inc. operations at O'Hare to United Feeder Services. In December 1993, UAL transferred the jet operations of Air Wisconsin, Inc. to CJT Holdings. These operations are being conducted by the counterparties in these agreements under the United Express trade name. These actions are not expected to have a material effect on United's results of operations or financial position. At December 31, 1993 and 1992, United had outstanding loans to Air Wisconsin, Inc. in the amount of $80 million and $58 million, respectively, bearing interest at market rates. (13) Commitments and Contingencies United has certain contingencies resulting from litigation and claims (including environmental issues) incident to the ordinary course of business. Management believes, after considering a number of factors, including (but not limited to) the views of legal counsel, the nature of contingencies to which United is subject and its prior experience, that the ultimate disposition of these contingencies is not expected to materially affect United's consolidated financial position or results of operations. At December 31, 1993, commitments for the purchase of property and equipment, principally aircraft, approximated $4.3 billion after deducting advance payments. An estimated $0.6 billion is expected to be expended during 1994, $1.1 billion in 1995, $0.8 billion in 1996, $1.2 billion in 1997, $0.4 billion in 1998, and $0.2 billion after 1998. The major commitments are for the purchase of thirty-four B777 aircraft, which are expected to be delivered between 1995 and 1999. These amounts reflect United's revised capital spending plan and agreements with The Boeing Company, to convert certain aircraft orders into options. Under the terms of the agreements, if United does not elect to confirm the delivery of these option aircraft before 1998, it will forfeit significant deposits. In addition to the B777 order, United has arrangements with Airbus and International Aero Engines to lease an additional 45 A320 aircraft, which are scheduled for delivery through 1998. Under the agreement, United is making advance payments through 1996 which are refundable upon delivery of each aircraft. At December 31, 1993, United also had purchase options for 186 B737 aircraft, 54 B757 aircraft, 34 B777 aircraft, 52 B747 aircraft, eight B767 aircraft and 50 A320 aircraft. Consistent with its revised capital spending plan, United has recently cancelled options on certain aircraft. In January 1994, United entered an agreement with Boeing to acquire two B747-400 aircraft in 1994 and cancelled options for two B747 aircraft. These aircraft are not included in the commitment amounts above. As of December 31, 1993, United had guaranteed $97 million of indebtedness of affiliates. Special facility revenue bonds have been issued by certain municipalities to build or improve airport facilities leased by United. Under the lease agreements, United is required to make rental payments in amounts sufficient to pay the maturing principal and interest payments on the bonds. At December 31, 1993, $907 million principal amount of such bonds was outstanding. Payment of United's obligations with respect to $40 million of this amount is secured through standby letters of credit. As of December 31, 1993, UAL and United had jointly guaranteed $35 million of such bonds and United had guaranteed $841 million of such bonds, including accrued interest. Included in this amount are bonds issued by the City of Denver in connection with the construction of certain United facilities at Denver International Airport, which will replace Stapleton International Airport ("Stapleton"). Denver has agreed to retire the outstanding special facility revenue bonds related to United's Stapleton facilities. The new airport is expected to open in 1994. Transfers of the tax benefits of accelerated depreciation and investment tax credits associated with the acquisition of certain equipment have been made previously by United to various tax lessors through tax lease transactions. Proceeds from tax benefit transfers were recognized as income in the year the lease transactions were consummated. The subject equipment is being depreciated for book purposes. United has agreed to indemnify (guaranteed in some cases by UAL) the tax lessors against loss of such benefits in certain circumstances and has agreed to indemnify others for loss of tax benefits in limited circumstances for certain used aircraft purchased by United subject to previous tax lease transactions. Certain tax lessors have required that letters of credit be issued in their favor by financial institutions as security for United's indemnity obligations under the leases. The outstanding balance of such letters of credit totaled $68 million at December 31, 1993. At that date, United had granted mortgages on aircraft and engines having a total book value of $252 million as security for indemnity obligations under tax leases and letters of credit. United is in the process of constructing a maintenance facility in Indianapolis, which begins operation in 1994. The facility is being financed primarily with tax-exempt bonds and other capital sources. In connection with incentives received, United has agreed to reach an $800 million capital spending target and employ at least 6,300 individuals. United does not believe it is subject to any significant concentration of credit risk. Most of United's receivables result from sales of tickets to individuals through travel agents, company outlets or other airlines, often through the use of major credit cards. These receivables are short term, generally being settled shortly after the sale. (14) New Accounting Standards In November 1992, the Financial Accounting Standards Board ("FASB") issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which requires recognition of the liability for postemployment benefits during the period of employment. Such benefits include company paid continuation of group life insurance and medical and dental coverage for certain employees after employment but before retirement. United will adopt the new standard in the first quarter of 1994. Based on preliminary estimates, United currently expects to record a transition obligation which will result in a cumulative charge of $26 million, net of tax. Prior years' financial statements will not be restated. Ongoing expenses will vary based on actual claims experience. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires fair value accounting for certain investments. United is required to adopt the new standard in 1994 and the standard is not to be applied retroactively. Upon adoption, United will record a periodic charge or credit to adjust the carrying value of certain investments to fair value. The adjustment will be recorded in earnings or as a separate component of equity, depending on the type of investment. United does not expect a material impact on either earnings or equity as a result of adopting SFAS No. 115. (15) Statement of Consolidated Cash Flows - Supplemental Disclosures Supplemental disclosures of cash flow information and non-cash investing and financing activities were as follows: 1993 1992 1991 (In Millions) Cash paid during the year for: Interest (net of amounts capitalized) $319 $188 $ 87 Income taxes $ 43 $ 6 $ 62 Non-cash transactions: Capital lease obligations incurred $ 70 $276 $277 Long-term debt incurred in connection with additions to equipment $487 $755 $318 Increase in pension intangible $ 19 $ 8 $192 (16) Other Matters In the third quarter of 1993, United reached agreements to sell assets related to the operation of 16 of its flight kitchens to Dobbs International Services, Inc. and Caterair International Corp. for $119 million. Under the agreements, the purchasers will provide catering services for United at the airports served by the flight kitchens for seven years. The asset sales for most, if not all, of the flight kitchens are expected to be finalized in the second quarter of 1994. The asset sales result in an insignificant gain. (17) Selected Quarterly Financial Data (Unaudited) In the second quarter of 1993, United retired $500 million of senior subordinated notes. An extraordinary loss of $19 million, net of tax benefits of $8 million, was recorded in the first quarter of 1993, based on United's stated intention to retire the notes. In the third quarter of 1993, United recorded a charge of $59 million to reduce the net book value of 15 DC-10 aircraft to estimated net realizable value. In addition, third quarter earnings included a $17 million gain and interest income of $27 million resulting from the final settlement for overpayment of annuities purchased in 1985 to cover certain vested pension benefits. The 1993 fourth quarter included $53 million of equity in the loss of Galileo, which primarily reflects United's share of a charge recorded by Galileo for the cost of eliminating duplicate facilities and operations. Effective January 1, 1992, United adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" and SFAS No. 109, "Accounting for Income Taxes." The effect of adopting SFAS No. 106 was a cumulative charge of $580 million, net of tax benefits of $345 million. The effect of adopting SFAS No. 109 was a cumulative benefit of $33 million. In the 1992 fourth quarter, operating expenses included charges of $18 million for certain foreign employee benefits and certain taxes. In addition, operating expenses included charges of $25 million related to the announced cost reduction program. The 1992 second quarter included a $13 million non-operating charge to record the cash settlement of class action claims resulting from litigation relating to the use of airline fare data. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure No reportable event has occurred. PART III Item 10. Item 10. Directors and Executive Officers of the Company Omitted pursuant to General Instruction J (2) (c) of Form 10-K. Item 11. Item 11. Executive Compensation Omitted pursuant to General Instruction J (2) (c) of Form 10-K. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Omitted pursuant to General Instruction J (2) (c) of Form 10-K. Item 13. Item 13. Certain Relationships and Related Transactions Omitted pursuant to General Instruction J (2) (c) of Form 10-K. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. The financial statements required by this item are listed in Item 8, "Financial Statements and Supplementary Data" on page 40 herein. 2. The financial statements schedules required by this item are listed below: Page Financial statement schedules: Number Schedules - As of December 31, 1993: I--Marketable securities 70 VII--Guarantees of securities of other issuers 77 For the years ended December 31, 1993, 1992 and 1991: V--Property, plant and equipment 71-73 VI--Accumulated deprecia- tion, depletion and amortization of property, plant and equipment 74-76 VIII--Valuation and qualifying accounts 78-80 IX--Short-term borrowing 81 X--Supplementary income statement information 82 All other schedules are omitted because they are not applicable, not required or the required information is shown in the consolidated financial statements or notes thereto. Columns omitted from schedules filed have been omitted because the information is not applicable. 3. The exhibits required by this item are listed in "Index to Exhibits" on pages 83 through 87 herein. The financial statements of the Covia Partnership and the Galileo International Partnership are included herein as exhibits. (b) Reports on Form 8-K On October 28, 1993, United filed a report on Form 8-K dated October 28, 1993 to include a press release issued by UAL reporting UAL's financial results for the third quarter of 1993 and certain financial information for United. On November 19, 1993, United filed a report on Form 8-K dated November 17, 1993 to include exhibits relating to an offering covered by the Registration Statement on Form S-3 (File No. 33-57192) included as Exhibit 4.1 hereto. On December 1, 1993, United filed a report on Form 8-K dated November 30, 1993 to include a press release issued by UAL on its discussions with union representatives. On December 23, 1993, United filed a report on Form 8-K to report the execution of an agreement in principle dated December 22, 1993 among UAL, ALPA and the IAM concerning the proposed Employee Investment Transaction. On February 4, 1994, United filed a report on Form 8-K to report the execution of an amendment, dated February 3, 1994, among UAL, ALPA and the IAM to the agreement in principle dated December 22, 1993 among the parties concerning the proposed Employee Investment Transaction. On February 4, 1994, United filed a report on Form 8-K to include the text of a speech concerning the proposed Employee Investment Transaction delivered by Stephen M. Wolf, the Chairman and Chief Executive Officer of the Company. United Air Lines, Inc. and Subsidiary Companies Schedule I -- Marketable Securities As of December 31, 1993 (1) No individual security issue exceeds 2% of total assets. United Air Lines, Inc. and Subsidiary Companies Schedule V - Property, Plant and Equipment For the Year Ended December 31, 1993 United Air Lines, Inc. and Subsidiary Companies Schedule V - Property, Plant and Equipment For the Year Ended December 31, 1992 United Air Lines, Inc. and Subsidiary Companies Schedule V - Property, Plant and Equipment For the Year Ended December 31, 1991 United Air Lines, Inc. and Subsidiary Companies Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment For the Year Ended December 31, 1993 United Air Lines, Inc. and Subsidiary Companies Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment For the Year Ended December 31, 1992 United Air Lines, Inc. and Subsidiary Companies Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment For the Year Ended December 31, 1991 United Air Lines, Inc. and Subsidiary Companies Schedule VIII--Valuation and Qualifying Accounts For the Year Ended December 31, 1993 United Air Lines, Inc. and Subsidiary Companies Schedule VIII--Valuation and Qualifying Accounts For the Year Ended December 31, 1992 United Air Lines, Inc. and Subsidiary Companies Schedule VIII--Valuation and Qualifying Accounts For the Year Ended December 31, 1991 United Air Lines, Inc. and Subsidiary Companies Schedule IX - Short-Term Borrowings For the Years Ended December 31, 1993, 1992 and 1991 United Air Lines, Inc. and Subsidiary Companies Schedule VII--Guarantees of Securities of Other Issuers As of December 31, 1993 United Air Lines, Inc. and Subsidiary Companies Schedule X--Supplementary Income Statement Information For the Years Ended December 31, 1993, 1992 and 1991 Charged to Costs and Expenses Item 1993 1992 1991 (In Millions) Maintenance and repairs $1,516 $1,397 $1,423 Taxes other than payroll and income taxes $ 198 $ 178 $ 139 Amortization of intangibles $ 53 $ 47 $ 48 INDEX TO EXHIBITS Exhibit Number Description 3.1 Registrant's Restated Certificate of Incorporation, as amended March 13, 1992 (filed as Exhibit 3.1 of Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference). 3.2 Registrant's By-laws, as amended on June 25, 1987 (filed as Exhibit 3(b) to Registrant's S-1 Registration Statement (Nos. 33-21220 and 22-18246) effective June 3, 1988, and incorporated herein by reference). 4.1 Registrant's Registration Statement Form S-3 (No. 33-46033) filed on January 21, 1993, relating to the offer of $1,500,000,000 Debt Securities, Warrants to Purchase Debt Securities, Equipment Trust Certificates and/or Pass-Through Certificates, and incorporated herein by reference; Amendment Nos. 1, 2, 3 and 4 to UAL's (File No. 1-6033) Registration Statement Form S-3 (No. 33- 46033) filed on January 21, March 19, May 7 and May 28, 1993, respectively, and each incorporated herein by reference. Registrant's indebtedness under any single instrument, or any potential indebtedness under any instruments except as described in Exhibit 4.1, does not exceed 10% of Registrant's total assets on a consolidated basis. Copies of such instruments will be furnished to the Commission upon request. 10.1 Letter Agreement, dated December 22, 1993, among UAL Corporation, Air Line Pilots Association, International UAL-MEC and the International Association of Machinists and Aerospace Workers (filed as Exhibit 10.1 to UAL Corporation's Form 8-K dated December 22, 1993 and incorporated herein by reference; amendment thereto filed as Exhibit 10.1 to UAL's (File No. 1-6033) Form 8-K dated February 4, 1994 and incorporated herein by reference). 10.2 Letter Agreement No. 6-1162-DLJ-1193 dated January 25, 1994 to Agreement dated December 18, 1990 between The Boeing Company, as seller, and United Air Lines, Inc., and United Worldwide Corporation, as buyer, for the acquisition of Boeing 777-200 aircraft (as previously amended and supplemented, "777-200 Purchase Agreement" (filed as Exhibit 10.7 to UAL's Annual Report on Form 10-K for the year ended December 31, 1990 and incorporated herein by reference; supplements thereto filed as Exhibits 10.1, 10.2 and 10.22 to UAL's (File No. 1-6033) Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference)). (Filed as Exhibit 10.2 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1993, with a request for confidential treatment of certain portions and incorporated herein by reference.) 10.3 Supplemental Agreement No. 5 dated January 17, 1994 to Agreement dated December 18, 1990 between The Boeing Company, as seller, and United Air Lines, Inc., and United Worldwide Corporation, as buyer, for the acquisition of Boeing 747-400 aircraft (as previously amended and supplemented, "747-400 Purchase Agreement" (filed as Exhibit 10.8 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated herein by reference; supplements thereto filed as (i) Exhibits 10.4 and 10.5 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1991 and (ii) Exhibits 10.3, 10.4, 10.5, 10.6 and 10.22 to UAL's (File No. 1-6033) Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 and incorporated herein by reference)). (Filed as Exhibit 10.3 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1993, with a request for confidential treatment of certain portions and incorporated herein by reference.) 10.4 Amendment No. 1 dated as of November 24, 1993 to A320 Purchase Agreement dated August 10, 1992 between AVSA, S.A.R.L., as seller, and United Air Lines, Inc., as buyer, for the acquisition of Airbus Industrie A320-200 model aircraft (as previously amended and supplemented, "A320-200 Purchase Agreement" (filed as Exhibit 10.14 to UAL's (File No. 1- 6033) Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference)). (Filed as Exhibit 10.4 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1993, with a request for confidential treatment of certain portions and incorporated herein by reference). 10.5 Amendment No. 1 dated as of November 24, 1993 to Letter Agreement No. 8 dated as of August 10, 1992 to A320-200 Purchase Agreement (filed as Exhibit 10.5 to UAL's (File No. 1- 6033) Annual Report on Form 10-K for the year ended December 31, 1993, with a request for confidential treatment of certain portions and incorporated herein by reference). 10.6 Agreement dated March 1, 1990 between The Boeing Company and United Air Lines, Inc., as amended and supplemented, for the acquisition of Boeing 767-300ER aircraft (filed as Exhibit (10)L to UAL's (File No. 1- 6033) Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference; supplements thereto filed as (i) Exhibits 10.7, 10.8, 10.9 and 10.10 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1991, and (ii) Exhibits 10.7, 10.8, 10.9, 10.10, 10.11, 10.12, 10.13 and 10.22 to UAL's (File No. 1-6033) Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference). 10.7 Agreement dated April 26, 1989 between The Boeing Company and United Air Lines, Inc., as amended and supplemented, for the acquisition of Boeing 757-200 and 737 aircraft (filed as Exhibit (10)K to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference; supplements thereto filed as (i) Exhibits 10.12 and 10.13 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1991, and (ii) Exhibits 10.14, 10.15, 10.16, 10.17, 10.18, 10.19 and 10.22 to UAL's (File No. 1-6033) Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference). 10.8 An amended and restated agreement, dated March 19, 1992, between The Boeing Company and United Air Lines, Inc., for the acquisition of Boeing 737 aircraft (filed as Exhibit 10.15 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference; supplements thereto filed as Exhibits 10.20, 10.21 and 10.22 to UAL's (File No. 1-6033) Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, and incorporated herein by reference). 10.9 Letter Agreement among the State of Indiana, the City of Indianapolis, the Indianapolis Airport Authority and United Air Lines, Inc. dated June 15, 1992, amending the Agreement dated November 21, 1991, concerning United's aircraft maintenance facility ("MOC II Agreement" (filed as Exhibit 10.29 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference)). (Filed as Exhibit 10.9 to UAL's (File No. 1- 6033) Annual Report on Form 10-K for the year ended December 31, 1993 and incorporated herein by reference.) 10.10 Letter Agreement among the State of Indiana, the City of Indianapolis, the Indianapolis Airport Authority and United Air Lines, Inc. dated December 23, 1993, amending the MOC II Agreement (filed as Exhibit 10.10 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1993 and incorporated herein by reference). 12 Computation of Ratio of Earnings to Fixed Charges. 24.1 Consent of Independent Public Accountants. 24.2 Consent of Independent Public Accountants. 99.1 Financial Statements of the Covia Partnership (filed as Exhibit 99.1 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1993 and incorporated herein by reference). 99.2 Financial Statements of the Galileo International Partnership together with the report and consent of its independent public accountants (filed as Exhibit 99.2 to UAL's (File No. 1-6033) Annual Report on Form 10-K for the year ended December 31, 1993 and incorporated herein by reference). 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. UNITED AIR LINES, INC. By: /s/ STEPHEN M. WOLF Stephen M. Wolf Chairman and Chief Executive Officer and a Director (Principal Executive Officer) By: /s/ JOHN C. POPE John C. Pope President and Chief Operating Officer and a Director (Principal Financial Officer) By: /s/ FREDERIC F. BRACE Frederic F. Brace Vice President - Corporate Development and Controller (Principal Accounting Officer) March 11, 1994 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 as Directors on March 11, 1994. /s/ PAUL G. GEORGE Paul G. George /s/ JAMES M. GUYETTE James M. Guyette /s/ LAWRENCE M. NAGIN Lawrence M. Nagin /s/ JOSEPH R. O'GORMAN Joseph R. O'Gorman

203248_1993.txt

203248_1993

1993

203248

ITEM 1. BUSINESS. INTRODUCTION Southern Union Company ("Southern Union" and, together with its subsidiaries, the "Company") was incorporated under the laws of the State of Delaware in 1932. The Company's principal line of business is the distribution of natural gas as a public utility through Southern Union Gas Company ("Southern Union Gas") and Missouri Gas Energy, each of which is a division of the Company. Southern Union Gas serves approximately 483,000 residential, commercial, industrial, agricultural and other customers in the States of Texas (including the cities of Austin, Brownsville, El Paso, Galveston and Port Arthur) and Oklahoma. Missouri Gas Energy, acquired on January 31, 1994, serves approximately 472,000 customers in central and western Missouri (including the cities of Kansas City, St. Joseph, Joplin and Monett). See "Missouri Acquisition." Subsidiaries of Southern Union have been established to support and expand natural gas sales and to capitalize on the Company's gas energy expertise. These subsidiaries market natural gas to end-users, sell natural gas as a vehicular fuel, convert vehicles to operate on natural gas, operate intrastate and interstate natural gas pipeline systems, and sell commercial gas air conditioning and other gas-fired engine-driven applications. By providing "one-stop shopping," the Company can serve its various customers' particular energy needs, which encompass substantially all of the natural gas distribution and sales businesses from natural gas sales to specialized energy consulting services. A subsidiary also holds investments in real estate which are used primarily in the Company's utility business. See "Company Operations." The Company is a sales and market-driven energy company whose management is committed to achieving profitable growth of its natural gas energy businesses in an increasingly competitive business environment. Management's strategies for achieving these objectives principally consist of: (i) promoting new sales opportunities and markets for natural gas; (ii) enhancing financial and operating performance; and (iii) expanding the Company through developing existing systems and selectively acquiring new systems. Management developed and continually evaluates these strategies and the Company's implementation of them by applying their experience and expertise in analyzing the energy industry, technological advances, market opportunities and general business trends. Each of these strategies, as implemented throughout the Company's businesses, reflects the Company's commitment to its core natural gas utility business. Central to all of the Company's businesses and strategies is the sale and transportation of natural gas. The Company has a goal of selected growth and expansion, primarily in the natural gas industry. To that extent, the Company intends to consider, when appropriate, and if financially practicable to pursue, the acquisition of other natural gas distribution or transmission businesses. The nature and location of any such properties, the structure for any such acquisitions, and the method of financing any such expansion or growth will be determined by management and the Southern Union Board of Directors. MISSOURI ACQUISITION On July 9, 1993, Southern Union entered into an Agreement for the Purchase of Assets (the "Missouri Asset Purchase Agreement") with Western Resources, Inc. ("Western Resources"), pursuant to which Southern Union purchased from Western Resources (the "Missouri Acquisition") certain Missouri natural gas distribution operations (the "Missouri Business"). The purchase was consummated on January 31, 1994. Southern Union paid Western Resources approximately $400,300,000 in cash for the Missouri Business. The final determination of the purchase price and all prorations and adjustments is expected to be finalized by May 30, 1994. Southern Union operates the Missouri Business as Missouri Gas Energy, which is headquartered in Kansas City, Missouri. As a result of the Missouri Acquisition, the Company nearly doubled the number of customers served by its natural gas distribution system and became one of the top 15 gas utilities in the United States, as measured by number of customers. In addition, the Missouri Acquisition lessens the sensitivity of the Company's operations to weather risk and local economic conditions by diversifying operations into a different geographic area. The incurrence of additional debt and issuance of new equity in connection with the Missouri Acquisition also significantly changed the Company's capital structure. See "Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") -- Investing Activities" and "Subsequent Events" in the Notes to the Consolidated Financial Statements for the year ended December 31, 1993. The approval of the Missouri Acquisition by the Missouri Public Service Commission ("MPSC") was subject to the terms of a stipulation and settlement agreement (the "MPSC Stipulation") among Southern Union, Western Resources, the MPSC staff and all intervenors in the MPSC proceeding. Among other things, the MPSC Stipulation: (i) provides that the Company attain a total debt to total capital ratio that does not exceed Standard and Poor's Corporation's Utility Financial Benchmark ratio for the lowest investment grade investor-owned natural gas distribution company (which, at January 31, 1994, would be approximately 58%) in order to implement any general rate increase with respect to the Missouri Business; (ii) prohibits Southern Union from implementing a general rate increase in Missouri before January 31, 1997 except in certain unusual events; (iii) required Western Resources to contribute an additional $9,000,000 to the Missouri Business' employees' and retirees' qualified defined benefit plan assets transferred to the Company; and (iv) requires the Company to contribute an additional $3,000,000 to the Company's qualified defined benefit plan applicable to the Missouri Business' employees and retirees; and (v) requires the Company to reduce rate base by $30,000,000 (to be amortized over a ten year period) to compensate rate payers for rate base reductions that were eliminated as a result of the acquisition. The Missouri Acquisition was funded through a $50,000,000 subscription rights offering of Common Stock (the "Rights Offering") completed in December 1993 and the sale of $475,000,000 of 7.60% Senior Notes due 2024 (the "Senior Debt Securities") in January 1994. The net proceeds from the Rights Offering, together with the net proceeds from the sale of the Senior Debt Securities and working capital from operations, have been or will be used to: (i) fund the Missouri Acquisition; (ii) refinance $20,000,000 aggregate principal amount of 10 1/8% Notes due May 15, 1994; (iii) repay approximately $59,300,000 of borrowings under the Company's $100,000,000 revolving credit facility, used to fund the acquisition of the Rio Grande Valley Gas Company and to repurchase all of Southern Union's outstanding preferred stock; (iv) refinance $10,000,000 aggregate principal amount of 9.45% Senior Notes due January 31, 2004 and $25,000,000 aggregate principal amount of 10% Senior Notes due January 31, 2012, and the related premium of $10,400,000 resulting from the early extinguishment of the 9.45% and 10% Senior Notes; and (v) refinance $50,000,000 aggregate principal amount of 10.5% Sinking Fund Debentures due May 15, 2017, and the premium of $3,300,000 resulting from the early extinguishment of such debentures. See Business -- "Other Acquisitions and Divestitures" and "MD&A -- Liquidity and Capital Resources." Southern Union assumed certain liabilities of Western Resources with respect to the Missouri Business, including liabilities arising from certain specified contracts assigned to Southern Union at closing, including gas supply and transportation contracts, office equipment leases and real estate leases, liabilities arising from certain contracts entered into by Western Resources in the ordinary course of business, certain liabilities that have arisen or may arise from the operation of the Missouri Business, and liabilities for certain accounts payable of Western Resources pertaining to the Missouri Business. Southern Union and Western Resources also entered into an Environmental Liability Agreement at closing. Subject to the accuracy of certain representations made by Western Resources in the Missouri Asset Purchase Agreement, the agreement provides for a tiered approach to the allocation of substantially all liabilities under environmental laws that may exist or arise with respect to the Missouri Business. The agreement contemplates Southern Union first seeking reimbursement from other potentially responsible parties, or recovery of such costs under insurance or through rates charged to customers. To the extent certain environmental liabilities are discovered by Southern Union prior to July 9, 1995, and are not so reimbursed or recovered, Southern Union will be responsible for the first $3,000,000, if any, of out of pocket costs and expenses incurred to respond to and remediate any such environmental claim. Thereafter, Western Resources would share one-half of the next $15,000,000 of any such costs and expenses, and Southern Union would be solely liable for any such costs and expenses in excess of $18,000,000. The Company believes that it will be able to obtain substantial reimbursement or recovery for any such environmental liabilities from other potentially responsible third parties, under insurance or through rates charged to customers. Pursuant to the terms of an Employee Agreement with Western Resources entered into on July 9, 1993, after the closing of the Missouri Acquisition, Southern Union employed certain employees of Western Resources involved in the operation of the Missouri Business ("Continuing Employees"). Under the terms of the Employee Agreement, the assets and liabilities attributable to Continuing Employees and retired employees who had been necessary to the operation of the Missouri Business ("Retired Employees") under Western Resources' qualified defined benefit plans were transferred to a qualified defined benefit plan of Southern Union that will provide benefits to Continuing Employees and Retired Employees substantially similar to those provided for under Western Resources' defined benefit plans. Southern Union amended its defined benefit plan to cover the Continuing Employees and Retired Employees and provide Continuing Employees and Retired Employees with certain welfare, separation and other benefits and arrangements. OTHER ACQUISITIONS AND DIVESTITURES In September 1993, the Company acquired the Rio Grande Valley Gas Company ("Rio Grande"), a subsidiary of Valero Energy Corporation, for approximately $30,500,000 (the "Rio Grande Acquisition"). Rio Grande serves approximately 76,000 customers in the south Texas counties of Willacy, Cameron and Hidalgo which includes 32 towns and cities along the Mexico border, including Harlingen, McAllen and Brownsville (the southernmost city in the U.S.). The Company initially funded the purchase with borrowings from its revolving credit facility, which was subsequently paid down out of the net proceeds from the Rights Offering and the sale of the Senior Debt Securities. See MD&A -- "Liquidity and Capital Resources." During May 1993, the Company acquired the natural gas distribution facilities of Berry Gas Company (the "Berry Gas Acquisition") which serves the Texas cities and towns of Nome, Raywood, Hull and Devers for approximately $274,000. In July 1993, the Company acquired the natural gas distribution facilities serving the city of Eagle Pass, Texas (the "Eagle Pass Acquisition"), for approximately $2,000,000. Combined, these operations collectively serve approximately 4,600 customers. In February 1993, Southern Union Exploration Company ("SX"), a wholly owned subsidiary of Southern Union, entered into a purchase and sale agreement pursuant to which it sold substantially all of its oil and gas leasehold interests and associated production for approximately $22,000,000, effective January 1, 1993. The Company estimated and recorded a book loss on the sale of approximately $4,400,000 as of December 31, 1992. In connection with the sale, the Company recorded an income tax liability of approximately $6,960,000 resulting from the recognition of a tax basis gain of approximately $18,800,000. During 1992, the Company acquired the natural gas distribution facilities of Nixon, Texas (the "Nixon Acquisition"). Also, the Company added approximately 12 miles of pipeline which transports gas to the community of Sabine Pass, Texas. During 1991, the Company acquired the natural gas distribution and transmission facilities serving an area in south Texas that includes the cities of Luling, Lockhart, Cuero, Yoakum, Shiner and Gonzales (the "South Texas Acquisition") and the natural gas distribution facilities serving the city of Andrews, Texas (the "Andrews Acquisition"). Also in 1991, Southern Union acquired Brazos River Gas Company (the "Brazos River Acquisition"), a natural gas distribution company serving the north Texas cities of Mineral Wells, Weatherford, Graham, Breckenridge, Millsap, Jacksboro and surrounding communities. These distribution operations collectively serve approximately 35,000 customers. In November 1991, the Company sold the assets of its Arizona gas utility operations for approximately $46,000,000, including cash of $40,400,000 and assumed liabilities of $5,600,000 (the "Arizona Sale"). Cash proceeds after taxes approximated $32,800,000. The Arizona gas operations served approximately 62,000 customers. COMPANY OPERATIONS The Company's principal line of business is the distribution of natural gas through its Southern Union Gas and Missouri Gas Energy divisions. Southern Union Gas provides service to a number of communities and rural areas in Texas, including the municipalities of Austin, Brownsville, El Paso, Galveston, Harlingen, McAllen and Port Arthur, as well as several communities in the Oklahoma panhandle. Missouri Gas Energy provides service to various cities and communities in central and western Missouri including Kansas City, St. Joseph, Joplin and Monett. The Company's gas utility operations are generally seasonal in nature, with a significant percentage of its annual revenues and earnings occurring in the traditional heating-load months. Western Gas Interstate Company ("WGI"), a wholly owned subsidiary of Southern Union, operates interstate pipeline systems principally serving the Company's gas distribution properties in the El Paso, Texas area and in the Texas and Oklahoma panhandles. During 1993 WGI received approval in its restructuring and rate case dockets from the Federal Energy Regulatory Commission (FERC) which allowed WGI to implement services pursuant to FERC Order No. 636. WGI is now providing unbundled transportation service for those gas volumes entering the pipeline's transportation system. WGI also completed its second year of exports to Mexico, transporting approximately 8,500 million cubic feet (MMcf) to the city of Juarez and the Samalayuca Power Plant. Southern Transmission Company ("Southern"), a wholly owned subsidiary of Southern Union, owns and operates approximately 123 miles of intrastate pipeline. Southern's system connects the cities of Lockhart, Luling, Cuero, Shiner, Yoakum, and Gonzales, Texas, as well as an industrial customer in Port Arthur, Texas. Southern also owns a transmission line which supplies gas to the community of Sabine Pass, Texas. Mercado Gas Services Inc. ("Mercado"), a wholly owned subsidiary of Southern Union, markets natural gas to various large volume customers. Mercado's sales and purchase activities are made through short-term contracts. These contracts and business activities are not subject to direct rate regulation. Southern Union Econofuel Company ("Econofuel"), a wholly owned subsidiary of Southern Union, was formed in 1990 to market and sell natural gas for natural gas vehicles ("NGVs") as an alternative fuel to gasoline. Econofuel owns fuel dispensing equipment in Austin, El Paso, Port Arthur, and Galveston, Texas located at independent retail fuel stations for NGVs. These stations serve fleet and other public vehicles which have been manufactured or converted to operate on natural gas. In 1991, Econofuel and Natural Gas Development Company, Inc. of California, formed a joint venture that, in 1992 opened the Natural Gas Vehicle Technology Centers, L.L.P. (the "Tech Center") in Austin, Texas. The Tech Center converts gasoline-driven vehicles to operate using natural gas. Since its opening, the Tech Center has converted about 1,200 fleet vehicles and buses to operate on natural gas. Southern Union Energy Products and Services Company ("SUEPASCO"), a wholly owned subsidiary of the Company, was formed during 1992 to market and sell commercial gas air conditioning, irrigation pumps and other gas-fired engine driven applications and related services. Southern Union Energy International, Inc. ("International"), a wholly owned subsidiary of the Company, was also formed during 1992 to participate in energy related projects internationally. In addition, the Company holds investments in commercially developed real estate as well as undeveloped tracts of land through its wholly owned subsidiary, Lavaca Realty Company ("Lavaca Realty"). COMPETITION Southern Union Gas and Missouri Gas Energy are not currently in significant direct competition with any other distributors of natural gas to residential and small commercial customers within their service areas. In recent years, certain large volume customers, primarily industrial and significant commercial customers, have had opportunities to access alternative natural gas supplies and, in some instances, delivery service from pipeline systems. The Company has offered transportation arrangements to customers who secure their own gas supplies. These transportation arrangements, coupled with the efforts of the Company's marketing subsidiary, Mercado, enable the Company to provide competitively priced gas service to these large volume customers. In addition, the Company has successfully used flexible rate provisions, when needed, to prevent by-pass of the Company's distribution system. As energy providers, Southern Union Gas and Missouri Gas Energy have historically competed with alternative energy sources, particularly electricity and also propane, coal, natural gas liquids and other refined products available in the Company's service areas. At present rates, the cost of electricity to residential and commercial customers in the Company's service areas generally is higher than the effective cost of its natural gas service. There can be no assurances, however, that future fluctuations in gas and electric costs will not reduce the cost advantage of natural gas service. The following operating cost analysis provides a comparison of annual gas and electric costs for three typical residential energy applications in the three largest cities (which represent approximately 72% of the present customers) served by Southern Union Gas and Missouri Gas Energy: The Company believes that similar gas price advantages exist for commercial and industrial applications. In addition, the cost of expansion for peak load requirements of electricity in some of Southern Union Gas' service areas has historically provided opportunities to allow energy switching to natural gas pursuant to integrated resource planning techniques. Electric competition has responded by offering equipment rebates and incentive rates. Competition between the use of fuel oil and natural gas, particularly by industrial, electric generation and agricultural customers, has increased as oil prices have decreased. While competition between such fuels is generally more intense outside the Company's service areas, this competition affects the nationwide market for natural gas. Additionally, the general economic conditions in its service areas continue to affect certain customers and market areas, thus impacting the results of the Company's operations. GAS SUPPLY The low cost for natural gas service is attributable to efficient operations and the Company's ability to contract for natural gas using favorable mixes of long-term and short-term supply arrangements and favorable transportation contracts. The Company has been directly acquiring its gas supplies since the mid 1980s when interstate pipeline systems opened their systems for transportation service. The Company has the organization, personnel and equipment necessary to dispatch and monitor gas volumes on a daily and even hourly basis to ensure reliable service to customers. This experience will be of major significance in the post FERC Order 636 procurement environment. FERC Order 636 promotes the "unbundling" of services offered by interstate pipeline companies. As a result, gas purchasing and transportation decisions and associated risks now shift from the pipeline companies to the gas distributors. The increased demands on distributors to effectively manage their gas supply in an environment of volatile gas prices will provide an advantage to distribution companies such as Southern Union that have demonstrated a history of contracting favorable and efficient gas supply arrangements in an open market system. The majority of Southern Union Gas' 1993 gas requirements for utility operations were delivered under long-term transportation contracts through five major pipeline companies. These contracts have various expiration dates ranging from 1995 through 2011. Southern Union Gas also purchases significant volumes of gas under long-term and short-term arrangements with suppliers. The amounts of such short-term purchases are contingent upon price. Southern Union Gas and Missouri Gas Energy both have firm supply commitments for all areas that are supplied with gas purchased under short-term arrangements. Gas sales and/or transportation contracts with interruption provisions, whereby large volume users purchase gas with the understanding that they may be forced to shut down or switch to alternate sources of energy at times when the gas is needed for higher priority customers, have been utilized for load management by Southern Union and the gas industry as a whole for many years. In addition, during times of special supply problems, curtailments of deliveries to customers with firm contracts may be made in accordance with guidelines established by appropriate federal and state regulatory agencies. There have been no supply-related curtailments of deliveries to Southern Union Gas or Missouri Gas Energy utility sales customers during the last ten years. The following table shows, for each of Southern Union Gas' principal service areas, the percentage of gas utility revenues and sales volume for 1993, the average cost per Mcf of gas in 1993, and the primary delivery systems: Missouri Gas Energy provides gas service to Kansas City, St. Joseph, Joplin, Monett and surrounding communities in central and western Missouri. The average cost per Mcf of gas supplied to Missouri Gas Energy in 1993 was $3.04. The primary source of supply to Missouri Gas Energy's service areas is Williams Natural Gas Company. UTILITY REGULATION AND RATES The Company's rates and operations are subject to regulation by federal, state and local authorities. In Texas, municipalities have primary jurisdiction over rates within their respective incorporated areas. Rates in adjacent environs areas and appellate matters are the responsibility of the Railroad Commission of Texas. Rates in Oklahoma are subject to regulation by the Oklahoma Corporation Commission. In Missouri, rates are established by the MPSC on a system wide basis. The FERC and the Railroad Commission of Texas have jurisdiction over rates, facilities and services of WGI and Southern, respectively. The Company holds non-exclusive franchises with varying expiration dates in all incorporated communities where it is necessary to do so to carry on its business as it is now being conducted. In the five largest cities in which the Company's utility customers are located, such franchises expire as follows: Kansas City, Missouri in 1997; El Paso, Texas in 2000; Austin, Texas in 2006; and Port Arthur, Texas in 2013. The franchise in St. Joseph, Missouri is perpetual. Gas service rates are established by regulatory authorities to collectively permit utilities to recover operating, administrative and finance costs, and to earn a return on equity. Gas costs are billed to customers through purchase gas adjustment clauses which permit the Company to adjust its sales price as the cost of purchased gas changes. The appropriate regulatory authority must receive notice of such adjustments prior to billing implementation. This is important because the cost of natural gas accounts for a significant portion of the Company's total expenses. The Company must support any service rate changes to its regulators using an historic test year of operating results adjusted to normal conditions and for any known and measurable revenue or expense changes. Because the rate regulatory process has certain inherent time delays, rate orders may not reflect the operating costs at the time new rates are put into effect. The monthly customer bill contains a fixed service charge, a usage charge for service to deliver gas, and a charge for the amount of natural gas used. While the monthly fixed charge provides an even revenue stream, the usage charge increases the Company's annual revenue and earnings in the traditional heating load months when usage of natural gas increases. The majority of the Company's rate increases in Texas and Oklahoma in recent years have been reflected in increased monthly fixed charges which help stabilize earnings. Weather normalization clauses, now in place in Austin and three other service areas in Texas, also help stabilize earnings. On February 10, 1993, the Company's South Texas service area received an annualized rate increase of $777,000. On June 10, 1993, the Austin City Council approved an ordinance reflecting (i) an approximate $1,700,000 base revenue increase, (ii) new and increased fees that will add approximately $250,000 annually, and (iii) weather normalization clause revisions. The Austin rate increase became effective as of July 1, 1993. On October 5, 1993, the MPSC approved an order reflecting a $9,750,000 revenue increase to Missouri Gas Energy. The Missouri rate increase became effective October 15, 1993. On October 12, 1993, the El Paso City Council approved an ordinance reflecting an approximate revenue increase of $463,000. The El Paso rate increase became effective November 1, 1993. These rate increases should contribute significantly to the Company's earnings in 1994. The following table summarizes the rate increases that have been granted over the last three years: In addition to the regulation of its utility and pipeline businesses, the Company is affected by numerous other regulatory controls, including, among others, pipeline safety requirements of the Department of Transportation, safety regulations under the Occupational Safety and Health Act, and various state and federal environmental statutes and regulations. The Company believes that its operations are in compliance with applicable safety and environmental statutes and regulations. STATISTICS OF GAS UTILITY AND RELATED OPERATIONS The following table provides by division and/or region the number of gas utility customers served: STATISTICS OF GAS UTILITY AND RELATED OPERATIONS. The following table shows certain operating statistics of Southern Union Gas' utility business for the periods indicated: The following table shows certain operating statistics of Missouri Gas Energy for the periods indicated: INVESTMENTS IN REAL ESTATE In February 1993, Southern Union entered into a settlement agreement with the Resolution Trust Corporation ("RTC") with respect to Southern Union's former subsidiary, First Bankers Trust & Savings Association. As part of the settlement, in return for payment by the Company of $4,792,000, the RTC dismissed a $6,174,000 judgment for specific performance of a contract to purchase real estate; canceled notes in the principal amount of $1,600,000; permitted the Company to terminate a $2,000,000 letter of credit; deeded the Company a 21-acre tract in Austin, Texas; and released certain other claims asserted in the settled litigation. This settlement had no impact on earnings since the Company had previously recorded a reserve for the related loss contingency. In December 1993, Lavaca Realty sold this land for approximately $794,000, resulting in an after tax gain of approximately $321,000. See "Real Estate" in the Notes to the Consolidated Financial Statements for the year ended December 31, 1993. Lavaca Realty owns a commercially developed tract of land in the central business district of Austin, Texas, containing a combined 11-story office building, parking garage, a drive-through bank and a mini-bank facility ("Lavaca Plaza"). Approximately 49% of the office space at Lavaca Plaza is used in the Company's business while 51% is leased, or under option to lease, to non-affiliated entities. Lavaca Realty also owns a commercially developed tract of land in Austin, Texas that is used exclusively in the Company's business. Other real estate investments held at December 31, 1993 include 12 acres of undeveloped land in Dallas, Texas and 42 acres of undeveloped land in Denton, Texas. The Company is attempting to sell all undeveloped real estate. BUSINESS HELD FOR SALE In February 1993, SX entered into a purchase and sales agreement with certain limited partnerships affiliated with a Dallas-based company to sell all of its oil and gas leasehold interests and associated production for approximately $22,000,000, effective as of January 1, 1993. SX, which was engaged in the development and production of oil and gas, held varying interests in producing oil and gas wells located primarily in New Mexico and Texas. The Company accounted for SX as a business held for sale wherein adjustments were made to reflect the valuation of this business to an estimated net realizable value. At December 31, 1992 and 1991, the Company estimated and recorded a book loss on future disposal of $4,400,000 and $2,250,000, respectively. In addition, at the time of the sale the Company incurred a tax liability of approximately $6,960,000 resulting from the recognition of a tax basis gain of approximately $18,800,000. The sale closed on March 31, 1993. EMPLOYEES As of February 28, 1994, the Company had 1,923 employees, of whom 1,488 were paid on an hourly basis, 419 were paid on a salary basis and 16 were paid on a commission basis. Of the 1,488 hourly paid employees, approximately 57% were represented by unions. Of those employees represented by unions, 78% are employed by Missouri Gas Energy. In December 1992, the Company announced an early retirement program available to certain of the Company's employees with an election period from January to March 1993. Approximately 75 of an eligible 109 employees accepted the early retirement program. From time to time the Company may be subject to labor disputes; however, such disputes have not previously disrupted its business. The Company believes that its relations with its employees are good. ITEM 2. ITEM 2. PROPERTIES. See Item 1, "Business," for information concerning the general location and characteristics of the important physical properties and assets of the Company. Southern Union Gas' system consists of 8,452 miles of mains, 3,601 miles of service lines and 307 miles of transmission lines. Missouri Gas Energy's system consists of 6,930 miles of mains, 3,333 miles of service lines and 71 miles of transmission lines. WGI's system consists of 219 miles of transmission lines and 50 miles of gathering lines and Southern's system consists of 123 miles of transmission lines. The Company considers the systems to be in good condition and to be well maintained, and it has a continuing replacement program based on historical performance and system surveillance. Missouri Gas Energy is required, pursuant to an MPSC order, to replace certain service and main lines. This has amounted to an annual capital expenditure of approximately $20,000,000. In addition, the MPSC has issued accounting orders in the past to allow the deferral for future recovery in rates of related financing costs, depreciation and property taxes incurred in the periods between rate filings. The Company believes the MPSC will allow Missouri Gas Energy to continue such deferral and recovery. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. See "Commitments and Contingencies" and "Subsequent Events -- Missouri Acquisition" in the Notes to Consolidated Financial Statements for the year ended December 31, 1993 for discussions of the Company's legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders of Southern Union during the quarter ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. MARKET INFORMATION Southern Union's common stock is traded on the American Stock Exchange under the symbol "SUG". On February 11, 1994 the Company's Board of Directors declared a three for two stock split distributed in the form of a 50% stock dividend on March 9, 1994 to stockholders of record on February 23, 1994. The high and low sales prices (adjusted for the March 9, 1994 distribution) for shares of Southern Union common stock for the period January 1, 1994 through March 21, 1994 and for each quarter in 1993 and 1992 are set forth below: HOLDERS As of March 21, 1994, there were 272 holders of record of the registrants' common stock. This number does not include persons whose shares are held of record by a bank, brokerage house, or clearing agency, but does include any such bank, brokerage house or clearing agency. There were 10,900,586 shares of the registrants' common stock outstanding on March 21, 1994 of which 6,496,772 shares were held by non-affiliates. DIVIDENDS Southern Union paid no dividends on its common stock in 1993, 1992 or 1991. Provisions in certain of Southern Union's long-term notes and its bank revolving credit facility limit the payment of cash or asset dividends on capital stock. Under the most restrictive provisions in effect, as a result of the January 1994 sale of Senior Debt Securities, Southern Union may not declare or pay any cash or asset dividend on its common stock (other than dividends and distributions payable solely in shares of its common stock or in rights to acquire its common stock) or acquire or retire any of Southern Union's common stock, unless no event of default exists and the Company meets certain financial ratio requirements. On February 11, 1994, Southern Union's Board of Directors also approved the commencement of regular stock dividends of approximately 5% annually. The first such dividend is expected to be a 5% stock dividend to be declared in connection with the Company's annual meeting of stockholders to be held on May 25, 1994. The specific declaration, record and distribution dates for each stock dividend will be determined by the Board and announced at a date no later than the annual stockholders meeting each year. A portion of the 5% stock dividend expected to be distributed in 1994 may be characterized as a distribution of capital depending upon the level of the Company's retained earnings available as of the record date of that distribution. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. INTRODUCTION The Company's principal line of business is the distribution of natural gas as a public utility through Southern Union Gas and, subsequent to January 31, 1994, Missouri Gas Energy, each of which is a division of the Company. Missouri Gas Energy was acquired in a transaction accounted for as a purchase on January 31, 1994 and, therefore, its results of operations are not consolidated with those of the Company until after that date. Accordingly, the following discussion of results of operations does not include Missouri Gas Energy. See "Item I: Business -- Missouri Acquisition." In 1993 the Company completed the Rio Grande, Eagle Pass and Berry Gas Acquisitions. In 1992 the Company completed the Nixon Acquisition and in 1991 the Company completed the South Texas, Brazos River and Andrews Acquisitions and the Arizona Sale. See "Acquisitions and Divestitures" in the Notes to Consolidated Financial Statements for the year ended December 31, 1993. For these reasons, the results of operations of the Company for the periods presented are not comparable. On February 11, 1994, the Company's Board of Directors declared a three for two stock split distributed in the form of a 50% stock dividend on March 9, 1994 to stockholders of record on February 23, 1994. Effective March 9, 1994 the Company gave retroactive recognition to the equivalent change in capital structure for all periods presented. Consequently, earnings per share for 1993, 1992 and 1991 have been recomputed based on the weighted average number of shares outstanding during each year, adjusted for the stock split. Southern Union Gas, which accounted for approximately 86% of the Company's total revenues for the year ended December 31, 1993, serves approximately 483,000 residential, commercial, industrial, agricultural and other customers in the States of Texas (including the cities of Austin, Brownsville, El Paso, Galveston and Port Arthur) and Oklahoma. In addition, the Company operates interstate and intrastate natural gas pipeline systems, markets natural gas to end users and markets and sells natural gas for natural gas vehicles. The Company also holds investments in real estate. Several of the Company's business activities are subject to regulation by federal, state or local authorities where the Company operates. Thus, the Company's financial condition and results of operations have been dependent upon the receipt of adequate and timely adjustments in rates. In addition, the Company's business is affected by seasonal weather impacts, competitive factors within the energy industry and economic development and residential growth in its service areas. The Company's revenues and earnings are primarily dependent upon gas sales volumes and gas service rates. Gas purchase costs generally do not affect the Company's earnings because such costs are passed through to customers pursuant to purchase gas adjustment clauses. Accordingly, while changes in the cost of gas may cause the Company's operating revenues to fluctuate, operating margin (defined as operating revenues less gas purchase costs) is generally not affected by gas purchase cost increases or decreases. Gas sales volumes fluctuate as a function of seasonal weather impact and the size of the Company's customer base, which is affected by competitive factors in the industry as well as economic development and residential growth in its service areas. The primary factors that affect the distribution and sale of natural gas are the seasonal nature of gas use, adequate and timely rate relief from regulatory authorities, competition from alternative fuels, competition within the gas business for industrial customers and volatility in the supply and price of natural gas. Gas service rates, which consist of a monthly fixed charge and a gas usage charge, are established by regulatory authorities and are intended to permit utilities to recover operating, administrative and financing costs and to earn a return on equity. The monthly fixed charge provides a base revenue stream while the usage charge increases the Company's revenues and earnings in colder weather when natural gas usage increases. In recent years weather variances experienced during the traditional heating load months have significantly impacted the Company's results of operations. The average temperatures in Southern Union Gas' service areas during the past several winter seasons have been much warmer than the 30 year normal temperature. To mitigate the impact of these seasonal variances, Southern Union Gas has requested and received approval for weather normalization clauses in Austin and Galveston and in two other service areas in Texas. These clauses allow for rate adjustments that help stabilize the utility's customers' monthly bills and the Company's earnings from the varying effects of weather. Over the last three years, an average of 59% of the Company's revenues came from sales to Southern Union Gas' residential customers. Revenues from residential customers have grown as a result of the Company's acquisitions. The growth of its residential base combined with marketing efforts aimed at large volume users have provided overall gains in sales volumes in recent years. The Company plans to continue these marketing efforts. RESULTS OF OPERATIONS NET EARNINGS AVAILABLE FOR COMMON STOCK The Company recorded net earnings available for common stock of $6,890,000 for the year ended December 31, 1993 compared to net earnings of $1,445,000 for the year ended December 31, 1992, an increase of $5,445,000. Net earnings per common share, based on weighted average shares outstanding were $.87 in 1993 compared to $.18 in 1992 and $.12 in 1991. (Prior to the March 1994 stock split, discussed above, earnings per share in 1993, 1992 and 1991 were $1.31, $.27 and $.19, respectively.) Earnings from continuing operations available for common stock, net of preferred dividends, were $6,890,000 for the year ended December 31, 1993 compared to $3,891,000 for the year ended December 31, 1992, an increase of $2,999,000. Earnings from continuing operations per common share for the year ended December 31, 1993 were $.87 compared to $.49 in 1992 and $.27 in 1991. Net earnings for the year ended December 31, 1993 were positively impacted by the receipt of several rate increases during the past year including: a $777,000 annualized increase in the Company's South Texas service area effective February 10, 1993; a $1,950,000 annualized increase in Austin effective July 1, 1993; and a $463,000 annualized increase in El Paso effective November 1, 1993. The Company also recorded a non-recurring accounting adjustment of approximately $2,345,000 to reverse a tax reserve upon the final settlement of prior period federal income tax audits and the filing of amended federal income tax returns. Other factors which positively impacted net earnings for the year ended December 31, 1993 included the reduction in payroll expenses of approximately $1,525,000 resulting from the Company's 1993 early retirement program which was finalized during the second quarter of 1993 and the reduction of approximately $1,657,000 of preferred dividends due to the retirement of the Company's Series A 10% Cumulative Preferred Stock in March and June 1993. Net earnings for the year ended December 31, 1993 were negatively impacted by warmer than normal weather during 1993, which was 89% of normal, and by an increase in operating maintenance and general expense associated with severance costs of approximately $1,298,000 resulting from the early retirement program. The Company's net earnings available for common stock for the year ended December 31, 1992 were $1,445,000 compared to $987,000 in 1991. The increase in 1992 net earnings available for common stock was primarily due to reductions in operating costs, which significantly impacted net operating revenues. Other positive factors affecting net earnings in 1992 included increases in rates and changes in rate designs effected during 1992 and subsequent to the winter heating season of 1991, the reversal of certain contingency accruals of $2,200,000 recorded in 1990 related to the February 1990 cash merger between the Company and Metro Mobile CTS, Inc., and the recognition of a gain of approximately $950,000 resulting from a litigation settlement. These increases in earnings were partially offset by warmer weather in 1992, approximately 4% warmer than 1991 and 9% warmer than normal. In addition, the Company recorded a loss on the disposal of a discontinued operation of $4,400,000. The assets of the discontinued operation were sold effective January 1, 1993. See "Business Held For Sale" in the Notes to the Consolidated Financial Statements for the year ended December 31, 1993. OPERATING REVENUES Total operating revenues in 1993, 1992 and 1991 were $209,005,000, $192,445,000 and $200,261,000, respectively. Revenues are affected by the level of sales volumes and by the pass-through of increases or decreases in the Company's gas purchase costs through its purchase gas adjustment clauses. Operating revenues increased $16,560,000, or approximately 9%, for the year ended December 31, 1993, primarily from an increase in the customer base resulting from the Rio Grande Valley, Berry Gas and Eagle Pass Acquisitions as well as the receipt of rate increases in 1993, described above. These acquisitions increased revenues by approximately $8,085,000 in 1993. Operating revenues also increased due to a 24% increase in the average cost of gas from $2.01 per Mcf in 1992 to $2.50 in 1993, which was partially offset by a 12% decrease in gas sales volumes from 51,104 MMcf in 1992 to 44,859 MMcf in 1993. The decline in gas sales volumes reflected a decrease of 7,831 MMcf in gas sales by Mercado, the Company's marketing subsidiary, resulting from the Company's decision in early 1993 to reduce sales to off system markets. Operating revenues decreased in 1992 compared to 1991 due to the Arizona Sale in November 1991, warmer than normal weather in 1992, and a 19% decrease in gas costs billed to residential customers. These factors were partially offset by an increase in sales of approximately $16,400,000 due to Mercado's expanding markets, an increase in rates, described above, and the first full year of operations provided by the Brazos River and Andrews Acquisitions which increased revenues by approximately $6,400,000. The Arizona Sale decreased operating revenues by approximately $29,000,000 in 1992 as compared to 1991. Weather during 1992 was 91% of normal with one of the warmest winter seasons in the Company's history. GAS SALES AND TRANSPORTATION VOLUMES Gas sales volumes billed in 1993, 1992 and 1991 totaled 44,203 MMcf, 51,147 MMcf and 44,942 MMcf, respectively, at an average Mcf sales price of $4.42, $3.58 and $4.39, respectively. Gas sales volumes fluctuate as a function of weather and customer base. The decrease in gas sales volumes is due to the weather patterns in the Company's service areas which averaged 11% warmer than normal in 1993 and 9% warmer than normal in 1992. Gas sales volumes also decreased due to a substantial reduction in gas sales for resale by Mercado, as previously discussed. The average customer bases served in 1993, 1992 and 1991 were approximately 421,000, 394,000 and 428,000, respectively. The average sales price per Mcf varied between periods as a result of variations in the average spot market price of natural gas. Gas transportation volumes in 1993, 1992, and 1991 totaled 22,750 MMcf, 25,438 MMcf and 8,608 MMcf, respectively, at an average transportation rate per Mcf of $.29, $.23 and $.66, respectively. Transportation volumes decreased in 1993 as compared to 1992 as a result of a 6,500 MMcf reduction in volume transported into Mexico by WGI which was partially offset by an increase in transport volumes to several new customers. In addition, the average transportation rate per Mcf increased in 1993 as compared to 1992. Transportation volumes increased in 1992 as compared to 1991 as a result of WGI's transported volumes into Mexico of approximately 15,000 MMcf during 1992. GAS PURCHASE COSTS Gas purchase costs in 1993, 1992 and 1991 were $110,384,000, $102,918,000 and $109,238,000, respectively. The increase in costs in 1993 was due to a 16% increase in the average spot market price of natural gas from $1.69 per MMbtu in 1992 to $1.96 per MMbtu in 1993 and an increase in the average customer base resulting from acquisitions of gas distribution systems, previously discussed. These factors were partially offset by a substantial reduction in gas sales for resale by Mercado, also previously discussed. The average gas purchase cost incurred by the Company was $2.50 per Mcf in 1993, $2.01 in 1992 and $2.43 in 1991. The decrease in gas purchase costs in 1992 was due to a decrease in the average spot market price of natural gas and a decrease in the average customer base resulting from the Arizona Sale in November 1991. The impact of the decrease in 1992 and 1991 gas prices was partially offset by an increase in volumes. OPERATING, MAINTENANCE AND GENERAL EXPENSES Operating, maintenance and general expenses were $50,076,000, $46,313,000 and $49,022,000 in 1993, 1992 and 1991, respectively. During 1993 these expenses increased $3,763,000 or 8% due principally to increased operating costs of approximately $1,800,000 associated with acquisitions as well as severance costs of approximately $1,298,000 resulting from the early retirement program, each previously discussed. Partially offsetting the overall increase was a reduction in payroll expenses of $1,525,000 as a result of the Company's early retirement program. During 1992 operating, maintenance and general expenses decreased $2,709,000 compared to 1991 due to the cost containment efforts implemented by the Company throughout 1992 as well as the reductions resulting from the Arizona Sale in November 1991. These factors were partially offset by increases in medical and hospitalization expenses. TAXES Federal and state income tax expense in 1993, 1992 and 1991 was $3,855,000, $4,440,000, and $6,635,000, respectively. The decrease in taxes in 1993 as compared to 1992 is due principally to reductions related to amended prior year federal income tax returns and non-taxable income items included with "other income" related to the reversal of a tax reserve as discussed below. In July 1993 the Company paid the Internal Revenue Service ("IRS") approximately $1,266,000 in settlement for federal income taxes and interest related to the tax years 1984 through 1989. The Company had previously estimated and accrued an amount for the tax deficiencies and related interest and, as a result of the settlement with the IRS for a lesser amount, a non-recurring adjustment was recorded to reverse the tax reserve in excess of the payment made. The reversal of the reserve had no impact on liquidity or cash flows due to the non-cash impact of this adjustment. See "Taxes on Income" in the Notes to Consolidated Financial Statements for the year ended December 31, 1993 for further analysis of the Company's federal and state income tax expense. Taxes other than income taxes reflect various state and local business and payroll related taxes. The state and local business taxes are generally based on gross receipts and investments in property, plant and equipment and fluctuate accordingly. DEPRECIATION AND AMORTIZATION EXPENSE Depreciation and amortization expense in 1993, 1992 and 1991 was $14,416,000, $12,737,000 and $13,317,000, respectively. The increase in depreciation and amortization expense of $1,679,000 in 1993 compared to 1992 was primarily attributable to acquisitions of gas distribution systems, previously discussed. The decrease in depreciation expense of $580,000 in 1992 compared to 1991 was principally due to the Arizona Sale in November 1991 and was partially offset by a full year of depreciation on the acquired gas distribution systems. The Company has requested recovery of the amortization of additional purchase cost assigned to utility plant in recent rate filings. At this time, recovery has not been included in gas distribution rates in the Company's major rate jurisdictions. However, during 1993 the Federal Energy Regulatory Commission issued a rate order approving the recovery of additional purchase costs assigned to utility plant associated with WGI, which amount is not material to the consolidated financial statements. OTHER INCOME AND EXPENSES, NET Other income and expenses, net in 1993, 1992 and 1991 were $8,176,000, $6,531,000 and $2,536,000, respectively. During 1993 the Company recorded a non-recurring adjustment of approximately $2,345,000 to reverse a tax reserve upon the final settlement of prior period federal income tax audits as previously discussed. The reversal of the reserve had no impact on liquidity or cash flows due to the non-cash impact of this adjustment. Other income items recorded in 1993 also included interest income on notes receivable of approximately $830,000; rental income from Lavaca Realty, Southern Union's real estate subsidiary, of approximately $1,835,000; and a pre-tax gain of approximately $494,000 on the sale of undeveloped real estate. Other income in 1992 included a $2,200,000 reversal of certain contingency reserves recorded at the time of the 1990 merger that were subsequently resolved or settled and a $950,000 gain resulting from a litigation settlement, each previously discussed. The reversal of these reserves had no impact on liquidity or cash flows due to the non-cash impact of the adjustment. Other income in 1991 also included the recognition of a gain on the Arizona Sale of $4,782,000, to the extent of tax expense incurred, interest income on notes receivable of approximately $528,000 and the recognition of gains on litigation settlements of approximately $1,792,000. Interest expense on short-term debt was $1,836,000, $384,000 and $697,000 in 1993, 1992 and 1991, respectively. Average short-term debt outstanding during 1993, 1992 and 1991 of $33,021,000, $5,912,000 and $9,184,000 was at an average interest rate of 5.3%, 6.3% and 8.1%, respectively. The variance in the average amounts outstanding coupled with a general reduction in interest rates resulted in the change in other interest expense in each of the years. BUSINESS HELD FOR SALE The loss from discontinued operation of $2,446,000 for the year ended December 31, 1992 includes net earnings from oil and gas operations of $1,954,000 which were offset by the estimated loss on disposal of $4,400,000. Similarly, the 1991 loss from discontinued operation of $1,186,000 included net earnings from operations of $1,064,000 and a valuation adjustment of $2,250,000. Increased production volumes in 1992 contributed to an increase in net earnings from operations. See "Business Held for Sale" in the Notes to Consolidated Financial Statements for the year ended December 31, 1993. LIQUIDITY AND CAPITAL RESOURCES The Company's liquidity is impacted by its ability to generate funds from operations and to access capital markets. The gas utility operations are seasonal in nature with a significant percentage of the Company's annual revenues and earnings occurring in the traditional heating-load months. This seasonality results in a high level of cash flow needs during the peak winter heating-load months, resulting from the required payments to natural gas suppliers in advance of the receipt of cash payments from the Company's customers. FINANCING ACTIVITIES On December 31, 1993 Southern Union completed a $50,000,000 Rights Offering (the "Rights Offering") to its existing stockholders to subscribe for and purchase 3,000,000 shares of the Company's common stock, par value $1.00 per share, at $16.67 per share, as adjusted for the three for two stock split, for net proceeds of $49,351,000. In addition, on January 31, 1994, the Company completed the sale of $475,000,000 of 7.60% Senior Notes due 2024 (the "Senior Debt Securities"). The net proceeds from the sale of the Senior Debt Securities, together with the net proceeds from the Rights Offering and working capital from operations, have been or will be used to: (i) fund the purchase price of the Missouri Acquisition; (ii) refinance the $20,000,000 aggregate principal amount of the 10 1/8% Notes due May 15, 1994; (iii) repay approximately $59,300,000 of borrowings under the $100,000,000 revolving credit facility, which borrowings were used to fund the Rio Grande Acquisition and repurchase all of the outstanding preferred stock; (iv) refinance the $10,000,000 aggregate principal amount of 9.45% Senior Notes due January 31, 2004, and $25,000,000 aggregate principal amount of 10% Senior Notes due January 31, 2012 and the related premium of $10,400,000 resulting from the early extinguishment of such notes; and (v) refinance $50,000,000 aggregate principal amount of the 10.5% Sinking Fund Debentures due May 15, 2017 and the premium of $3,300,000 resulting from the early extinguishment of such debentures. On September 30, 1993, Southern Union entered into a new revolving credit facility with a three year term (the "Revolving Credit Facility") initially underwritten by Texas Commerce Bank, N.A. for $80,000,000. On November 15, 1993, the Revolving Credit Facility was syndicated to five additional banks and the aggregate amount available to be borrowed was increased to $100,000,000. Borrowings under the Revolving Credit Facility are available for Southern Union's working capital and letter of credit requirements. The Revolving Credit Facility can also be used in part, but not to exceed $40,000,000, to fund acquisitions and capital expenditures and it provided the funds to complete the Rio Grande Acquisition. The Revolving Credit Facility contains certain financial covenants that, among other things, restrict cash or asset dividends, share repurchases, certain investments and additional debt. The Revolving Credit Facility is currently uncollaterized. Under certain conditions involving the issuance of collateralized debt of Southern Union, the Revolving Credit Facility automatically would become collateralized by a first priority security interest on substantially all of the accounts receivable, inventory and certain related contract rights of the Company. The amount outstanding under the Revolving Credit Facility at March 21, 1994 was zero. During March 1993 the Company retired 68,000 shares of the Series A 10% Cumulative Preferred Stock ("Preferred Stock") at $103 per share for $7,004,000. In April 1993, the Company retired 77,000 shares of Preferred Stock at $102 per share for $7,854,000. In June 1993, the Company retired 4,000 shares of Preferred Stock at $103.50 per share for $414,000 and the remaining outstanding 100,000 shares at par for $10,000,000. In February 1992 the Company repurchased 77,438 shares of common stock at $10.25, as adjusted for the stock split. INVESTING ACTIVITIES The Company has used its revolving loan and credit facilities, internally generated funds and long-term debt to provide funding for its seasonal working capital, continuing construction programs, operational requirements, preferred dividend requirements and acquisitions. During the three years ended December 31, 1993, Southern Union spent approximately $112,000,000 on capital projects. Of that total, $58,000,000 was incurred on normal expansion of its distribution system as well as relocation and replacement, and $54,000,000 was incurred for the acquisition of distribution properties. In addition, during the last three years, approximately $6,500,000 was incurred for the purchase of real estate. For the year ended December 31, 1993, the Company spent approximately $19,000,000 for capital expenditures, exclusive of the acquisitions of natural gas distribution properties, which was used for normal distribution system replacement and expansion. On July 9, 1993, the Company entered into the Missouri Asset Purchase Agreement pursuant to which the Company on January 31, 1994 purchased certain natural gas distribution operations in central and western Missouri. The estimated purchase price paid at closing was $400,300,000 in cash. The Missouri Acquisition was accounted for as a purchase, as previously discussed. Pursuant to the MPSC Stipulation, the additional purchase cost assigned to utility plant may not be included in rate base nor amortized in cost of service. See "Subsequent Events -- Missouri Acquisition" in the Notes to the Consolidated Financial Statements for the year ended December 31, 1993. On September 30, 1993, the Company completed the Rio Grande Acquisition for approximately $30,500,000. Rio Grande presently serves approximately 76,000 customers in the south Texas counties of Willacy, Cameron and Hidalgo, including the cities of Harlingen, McAllen and Brownsville (the southernmost city in the U.S.). The Company initially funded the purchase with borrowings from its Revolving Credit Facility. The Rio Grande Acquisition was accounted for as a purchase. In July 1993, the Company completed the Eagle Pass Acquisition for approximately $2,000,000. During May 1993, the Company completed the Berry Gas Acquisition which system serves the Texas cities and towns of Nome, Raywood, Hull and Devers for approximately $274,000. Combined, these operations collectively serve approximately 4,600 customers. These acquisitions were also accounted for as purchases. In October 1992, the Company completed the Nixon Acquisition for approximately $415,000. This system serves approximately 650 customers. In January 1991 the Company completed the South Texas Acquisition consisting of the natural gas distribution and transmission facilities that serve approximately 12,000 customers in several communities. The purchase price for these facilities was approximately $10,200,000. In August 1991, the Company completed the Andrews Acquisition for $1,000,000. This system serves approximately 3,000 customers. In September 1991 the Company completed the Brazos River Acquisition which provides distribution services to approximately 18,000 customers in several communities in north-central Texas. The purchase price for these facilities approximated $7,000,000 of cash and assumption of $3,500,000 of mortgage bond debt. Also in September 1991 the Company purchased a commercially developed tract of land in the central business district of Austin, Texas containing a combined 11-story office building, parking garage, a drive-through bank and a mini-bank facility for $5,300,000. In December 1991, the Company also purchased a commercially developed tract of land in Austin, Texas for $1,100,000. Each of these acquisitions and purchases was initially funded under the Company's revolving loan or credit facilities. In March 1993, Southern Union Exploration Company ("SX"), pursuant to a purchase and sale agreement entered into in February 1993, sold substantially all of its oil and gas leasehold interests and associated production, for $22,000,000 effective January 1, 1993. The Company recorded a book loss on the sale of approximately $4,400,000 as of December 31, 1992. In November 1991, the Company completed the Arizona Sale for approximately $46,000,000, representing cash of $40,400,000 and assumed liabilities of $5,600,000. The cash proceeds were used to retire the short-term debt which funded the 1991 acquisitions described above. In addition, during 1991 the Company sold a three acre office park project in Dallas, Texas for $1,600,000 and a 120 unit apartment project in Nacogdoches, Texas for cash of $500,000 and a note receivable for $600,000. As a result of these sales, the Company has divested itself of all developed real estate not otherwise used at least partially in the Company's business. OTHER MATTERS CONTINGENCIES The Company has been named as a potentially responsible party in a special notice letter from the United States Environmental Protection Agency for costs associated with removing hazardous substances from the site of a former coal gasification plant in Vermont. The Company also assumed responsibility for certain environmental matters in connection with the Missouri Acquisition. See "Commitments and Contingencies" and "Subsequent Events -- Missouri Acquisition" in the Notes to Consolidated Financial Statements for the year ended December 31, 1993. In 1993 the Internal Revenue Service completed its audit of the Company's federal income tax return for 1984 through 1989. The Internal Revenue Service proposed and the Company agreed to deficiencies and related interest of approximately $1,266,000. The Company had fully accrued for such tax deficiencies and related interest. REGULATORY The Company is continuing to pursue certain changes to rates and rate structures that are intended to reduce the sensitivity of earnings to weather including weather normalization clauses and higher minimum monthly service charges. On February 10, 1993, the Company's South Texas service area received an annualized rate increase of $777,000. On June 10, 1993, the Austin City Council approved an ordinance reflecting (i) an approximate $1,700,000 base revenue increase, (ii) new and increased fees that will add approximately $250,000 annually and (iii) weather normalization clause revisions. The Austin rate increase became effective as of July 1, 1993. On October 12, 1993, the El Paso City Council approved an ordinance reflecting an approximate revenue increase of $463,000. The El Paso rate increase became effective November 1, 1993. These rate increases should contribute significantly to Southern Union Gas' earnings in 1994. During 1992, the Company's rate cases continued to focus upon the receipt of timely and adequate revenue increases and on various measures designed to stabilize earnings. Rate cases resolved in El Paso, South Texas, Dell City, Port Arthur, Borger, Galveston, Pecos and Monahans resulted in revenue increases of $2,742,000. The Galveston rate case also provided for an increase in the minimum residential monthly service charge from $7.50 to $10 and the implementation of a weather normalization clause. ACCOUNTING PRONOUNCEMENTS The Company adopted the provisions of Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective as of January 1, 1993. SFAS No. 109 provides for the replacement of the "deferred method" of interperiod income tax allocation with the "liability method" which bases the amounts of current and future tax assets and liabilities on events recognized in the financial statements and on income tax laws and rates existing at the balance sheet date. The adoption of SFAS No. 109 resulted in the recording of an insignificant amount in 1993. The Company also adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective as of January 1, 1993. SFAS No. 106 requires an accrual of postretirement medical and other benefit liabilities on an actuarial basis during the years an employee provides services as compared to the current pay-as-you-go method. The Company records a regulatory asset for the difference between the postretirement costs currently included in rates and SFAS No. 106 expense to the extent the Company files, or intends to file, a rate application to include SFAS No. 106 expense in rates. It is probable that the regulator will allow such expense in future rates. Consequently, earnings were not adversely impacted by the adoption of this statement. The Company's adoption of the provisions of SFAS No. 106 resulted in a transition obligation of approximately $9,328,000 which was subsequently reduced in 1993 to $4,257,000 primarily as a result of certain plan amendments. The Company will amortize the remaining transition obligation over the allowed 20-year period. SFAS No. 112, "Employees Accounting for Postemployment Benefits," is required to be adopted effective for fiscal years beginning after December 15, 1993. SFAS No. 112 provides standards for employers who grant benefits to employees after employment but before retirement. The Company anticipates the recovery of the periodic expense through rates and the recording of the future benefits to be paid as a regulatory asset. The Company plans to adopt the provisions of SFAS No.112 effective as of January 1, 1994. The impact of the adoption of SFAS No. 112 is not expected to be material to the financial condition or results of operations of the Company. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Reference is made to the Consolidated Financial Statements of Southern Union and its consolidated subsidiaries listed on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT. The information required is incorporated herein by reference from Southern Union's definitive Proxy Statement for the annual meeting of stockholders to be held on May 25, 1994, which will be filed on or before April 4, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required is incorporated herein by reference from Southern Union's definitive Proxy Statement for the annual meeting of stockholders to be held on May 25, 1994, which will be filed on or before April 4, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required is incorporated herein by reference from Southern Union's definitive Proxy Statement for the annual meeting of stockholders to be held on May 25, 1994, which will be filed on or before April 4, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required is incorporated herein by reference from Southern Union's definitive Proxy Statement for the annual meeting of stockholders to be held on May 25, 1994, which will be filed on or before April 4, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a)(1) FINANCIAL STATEMENTS. Reference is made to the Index on page for a list of all financial statements filed as part of this Report. (a)(2) FINANCIAL STATEMENT SCHEDULES. Reference is made to the Index on page for a list of all financial statement schedules filed as a part of this Report. (a)(3) EXHIBITS. Reference is made to the Exhibit Index on pages E-1 and E-2 for a list of all exhibits filed as a part of this Report. (b) REPORTS ON FORM 8-K. A Current Report on Form 8-K was filed on October 13, 1993. Events reported included: (i) the Corpus Christi, Texas, City Council voted not to hold a referendum on selling the city's gas system to the Company; (ii) the Company entered into a new Revolving Credit Agreement with Texas Commerce Bank, N.A., as agent, for an $80,000,000 Revolving Credit Facility, as amended on November 15 to increase the facility to $100,000,000; and (iii) the Company entered into a Purchase Agreement pursuant to which it simultaneously purchased Rio Grande Valley Gas Company for approximately $30,500,000. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Southern Union has duly caused this report to be signed by the undersigned, thereunto duly authorized on March 28, 1994. SOUTHERN UNION COMPANY By /s/ PETER H. KELLEY ----------------------------------- Peter H. Kelley, PRESIDENT AND CHIEF OPERATING OFFICER Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of Southern Union and in the capacities indicated as of March 28, 1994. SOUTHERN UNION COMPANY INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES All other schedules are omitted as the required information is not applicable or the information is presented in the consolidated financial statements, related notes or other schedules. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Southern Union Company: We have audited the consolidated financial statements and financial statement schedules of Southern Union Company and Subsidiaries listed in the index on page of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Southern Union Company and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in the Summary of Significant Accounting Policies note to the consolidated financial statements, effective January 1, 1993 the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. COOPERS & LYBRAND Austin, Texas March 11, 1994 SOUTHERN UNION COMPANY AND SUBSIDIARIES STATEMENT OF CONSOLIDATED OPERATIONS See accompanying notes to the consolidated financial statements. SOUTHERN UNION COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET ASSETS See accompanying notes to the consolidated financial statements. SOUTHERN UNION COMPANY AND SUBSIDIARIES STATEMENT OF CONSOLIDATED CASH FLOWS See accompanying notes to the consolidated financial statements. SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES OPERATIONS AND PRINCIPLES OF CONSOLIDATION Southern Union Company ("Southern Union" and, together with its wholly owned subsidiaries, the "Company"), is an investor-owned public utility primarily engaged in the distribution and sale of natural gas to residential, commercial, industrial, agricultural and other customers as a public utility in the states of Texas, Oklahoma and Missouri. See "Subsequent Events -- Missouri Acquisition." Subsidiaries of Southern Union also market natural gas to end-users, sell natural gas as a vehicular fuel, convert vehicles to operate on natural gas, operate intrastate and interstate natural gas pipeline systems, and sell commercial gas air conditioning and other gas-fired engine-driven applications. A subsidiary also holds investments in real estate. Substantial operations of the Company are subject to regulation. The consolidated financial statements include the accounts of Southern Union and its wholly owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. All dollar amounts in the tabulations in the notes to consolidated financial statements, except per share amounts, are stated in thousands unless otherwise indicated. Certain reclassifications have been made to the prior years' financial statements to conform with the current year presentation. PROPERTY, PLANT AND EQUIPMENT Utility plant in-service and construction work in progress are stated at original cost of construction, less contributions in aid of construction, which includes, where appropriate, payroll related costs such as taxes, pensions, other employee benefits, general and administrative costs and an allowance for funds used during construction. Gain or loss is recognized upon the disposition of significant utility properties and other property constituting operating units. Gain or loss from minor dispositions of property is charged or credited to accumulated depreciation and amortization. The Company capitalizes the cost of significant internally developed computer software systems. Acquisitions are recorded at the historical book carrying value of utility plant. Additional purchase cost assigned to utility plant is the excess of the purchase price over the book carrying value of utility plant purchased. In general, the Company has not been allowed direct recovery of additional purchase cost assigned to utility plant in rates. Periodically, the Company evaluates the carrying value of its additional purchase cost assigned to utility plant by comparing the anticipated future operating income from the businesses giving rise to the additional purchase cost with the unamortized balance. DEPRECIATION AND AMORTIZATION Depreciation of utility plant is provided at an average straight-line rate of approximately 3% per annum of the cost of such depreciable properties less applicable salvage. Franchises are being amortized over their respective lives. Depreciation and amortization of other property is provided at straight-line rates estimated to recover the costs of the properties, after allowance for salvage, over their respective lives. Amortization of the additional purchase cost assigned to utility plant is provided on a straight-line basis over thirty years. BUSINESS HELD FOR SALE Business held for sale is stated at estimated net after-tax sales proceeds. LONG-TERM DEBT Debt issuance costs are amortized over the lives of the related debt issues. SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) GAS UTILITY REVENUES AND GAS PURCHASE COSTS Gas utility customers are billed on a monthly-cycle basis. The related cost of gas is matched with cycle-billed revenues through operation of purchased gas adjustment provisions in tariffs approved by the regulatory agencies having jurisdiction. The Company recognizes an estimate of unbilled revenues on a monthly-cycle basis which include sales from the cycle-billing dates to the end of the month, unbilled gas purchase costs and revenue related taxes. The accrual for unbilled revenues is included in operating revenues in the statement of consolidated earnings. EMPLOYEE RETIREMENT PLAN AND POSTRETIREMENT BENEFITS The Company adopted the provisions of Statement of Financial Accounting Standard ("SFAS") No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," effective as of January 1, 1993. This statement requires an accrual of postretirement medical and other benefit liabilities on an actuarial basis during the years an employee provides services. The Company records a regulatory asset for the difference between the postretirement costs currently included in rates and SFAS 106 expense to the extent the Company has filed, or intends to file, a rate application to include SFAS 106 expense in rates and it is probable that the regulator will allow such expense in future rates. TAXES ON INCOME The Company adopted the provisions of SFAS No. 109, "Accounting for Income Taxes," effective as of January 1, 1993. SFAS No. 109 provides for the replacement of the "deferred method" of interperiod income tax allocation with the liability method which bases the amounts of current and future tax assets and liabilities on events recognized in the financial statements and on income tax laws and rates existing at the balance sheet date. Prior to the adoption of SFAS No. 109, the Company followed the provisions of Accounting Principles Board ("APB") No. 11, "Accounting for Income Taxes." For the years ended December 31, 1992 and 1991, the interperiod allocation of federal income taxes resulted in the provision of deferred income taxes provided for timing differences between financial and taxable income, principally attributable to accelerated tax depreciation. Investment tax credits allowed on certain qualified properties were deferred and are amortized to income over the estimated life of the related property. CASH FLOWS AND CREDIT RISK The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. The Company places its temporary cash investments with a high credit quality financial institution which, in turn, invests the temporary funds in a variety of high-quality financial securities. Concentrations of credit risk in trade receivables are limited due to the large customer base with relatively small individual account balances. EARNINGS PER SHARE Earnings per common share is based on net earnings available for common stock using the weighted average shares outstanding during each period. Fully diluted earnings per share is not presented because the relevant stock options are not significant. ACQUISITIONS AND DIVESTITURES In September 1993, the Company acquired the Rio Grande Valley Gas Company ("Rio Grande") for approximately $30,500,000. Rio Grande serves approximately 76,000 customers in the south Texas counties of Willacy, Cameron and Hidalgo which includes 32 towns and cities along the Mexico border, including Harlingen, McAllen and Brownsville (the southernmost city in the U.S.). The Company initially funded the purchase with borrowings from its revolving credit facility which were subsequently paid down out of the net proceeds from the sale of a $50,000,000 Rights Offering completed on SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) December 31, 1993 (the "Rights Offering") and the sale of $475,000,000 of 7.60% Senior Notes due 2024 (the "Senior Debt Securities") completed on January 31, 1994. See "Stockholders' Equity -- Rights Offering" and "Long-Term Debt." The acquisition of Rio Grande was accounted for using the purchase method of accounting. Rio Grande was merged into Southern Union on the date of the acquisition and has been integrated into its Southern Union Gas utility division. The additional purchase cost assigned to utility plant of approximately $11,644,000 reflects the excess of the purchase price over the historical book carrying value of the utility plant purchased. The following unaudited pro forma financial information for the years ended December 31, 1993 and 1992 is presented as though the acquisition of Rio Grande had been consummated at the beginning of 1993 and 1992, respectively. The pro forma financial information, adjusted for the stock split on March 9, 1994, is not necessarily indicative of the results which would have actually been obtained had the acquisition been completed as of the assumed date for the periods presented or which may be obtained in the future. In July 1993, the Company acquired the natural gas distribution facilities serving the city of Eagle Pass, Texas for approximately $2,000,000. In May 1993, the Company acquired the natural gas distribution facilities of Berry Gas Company which serves the Texas cities and towns of Nome, Raywood, Hull and Devers for approximately $274,000. Combined, these operations collectively serve approximately 4,600 customers. These acquisitions were also accounted for as purchases. During 1992, the Company acquired the natural gas distribution facilities in Nixon, Texas for $415,000. Also, the Company added approximately 12 miles of pipeline which transports gas to the community of Sabine Pass, Texas. During 1991, the Company acquired the natural gas distribution and transmission facilities serving an area in south Texas, including the cities of Lockhart, Luling, Cuero, Shiner, Yoakum and Gonzales, and the natural gas distribution facilities serving the city of Andrews, Texas. Also, in 1991, Southern Union acquired Brazos River Gas Company, a natural gas distribution company serving the north Texas cities of Mineral Wells, Weatherford, Graham, Breckenridge, Millsap, Jacksboro and surrounding communities. The purchase price for the 1991 acquisitions was $18,200,000 in cash and assumption of $3,500,000 of mortgage bonds. The distribution operations acquired in 1992 and 1991 collectively serve approximately 35,000 customers. In February 1993, Southern Union Exploration Company ("SX"), a wholly owned subsidiary of Southern Union, entered into a purchase and sale agreement to sell substantially all of its oil and gas leasehold interests and associated production for approximately $22,000,000, which sale was completed in March 1993, effective January 1, 1993. See "Business Held For Sale". In November 1991, the Company sold the assets of its Arizona gas utility operations (the "Arizona Sale") for approximately $46,000,000, including cash of $40,400,000 and assumed liabilities of $5,600,000. Cash proceeds approximated $32,800,000, net of applicable taxes. The Company recognized a gain of approximately $4,800,000 on the Arizona Sale to the extent of the tax expense incurred on the transaction. The remaining amount in excess of assets sold of approximately $11,400,000 was credited to additional purchase cost assigned to utility plant recorded in February 1990 at the time of the merger of an acquiring company into Southern Union. SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Because of the aforementioned acquisitions and divestitures in 1993, 1992 and 1991, the results of operations of the Company for the years ended December 31, 1993, 1992 and 1991 are not comparable. OTHER INCOME During 1993, the Company recorded a non-recurring accounting adjustment of approximately $2,345,000 to reverse a tax reserve upon the final settlement of prior period federal income tax audits and the filing of amended federal income tax returns. In July 1993, the Company paid the Internal Revenue Service ("IRS") approximately $1,266,000 in settlement for federal income taxes and interest related to the tax years 1984 through 1989. The Company had previously estimated and accrued an amount for the tax deficiencies and related interest and, as a result of the settlement with the IRS for a lesser amount, a non-recurring adjustment was recorded to reverse the tax reserve in excess of the payment made. The reversal of the reserve had no impact on liquidity or cash flows due to the non-cash impact of this adjustment. Other income items recorded in 1993 also included: interest income on notes receivable of approximately $830,000; rental income from Lavaca Realty Company ("Lavaca Realty"), the Company's real estate subsidiary, of approximately $1,835,000; and a pre-tax gain of approximately $494,000 on the sale of undeveloped real estate. During 1992, the Company resolved certain other contingent matters and reversed approximately $2,200,000 of certain contingency reserves, recorded when an acquiring company completed a cash merger into Southern Union during February 1990. The reversal of those reserves had no impact on liquidity or cash flows due to the non-cash impact of this adjustment. In addition, a $950,000 gain resulting from a litigation settlement was recorded in 1992. Other income in 1991 included approximately $1,792,000 in gains resulting from litigation settlements and interest income on notes receivable of approximately $528,000. CASH FLOW INFORMATION SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Excluded from the statement of consolidated cash flows were the following effects of non-cash investing and financing activities: REAL ESTATE In February 1993, Southern Union entered into a settlement agreement with the Resolution Trust Corporation ("RTC") with respect to Southern Union's former subsidiary, First Bankers Trust & Savings Association. As part of the settlement, in return for payment by the Company of $4,792,000, the RTC: dismissed a $6,174,000 judgment for specific performance of a contract to purchase real estate; canceled notes in the principal amount of $1,600,000; permitted the Company to terminate a $2,000,000 letter of credit; deeded the Company a 21-acre tract in Austin, Texas; and released certain other claims asserted in the settled litigation. This settlement had no impact on earnings since the Company had previously recorded a reserve for the related loss contingency. In December 1993, Lavaca Realty sold this land for approximately $794,000 resulting in an after tax gain of approximately $321,000. In 1991, Lavaca Realty purchased a commercially developed tract of land in the central business district of Austin, Texas containing a combined 11-story office building, parking garage, drive-through bank and mini-bank facility ("Lavaca Plaza") for $5,300,000. Approximately 49% of the office space at Lavaca Plaza is used in the Company's business while 51% is leased, or is under option to lease, to non-affiliated entities. During 1991, Lavaca Realty sold a three-acre office park project in Dallas, Texas for $1,600,000 and a 120 unit apartment project in Nacogdoches, Texas for cash of $500,000 and a note receivable for $600,000 and, in 1992, sold 11 acres of undeveloped land in Austin, Texas for $335,000. The 1991 sales transactions resulted in the recognition of a tax benefit of approximately $1,300,000. SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) STOCKHOLDERS' EQUITY The changes in common stockholders' equity and cumulative preferred stock were as follows: STOCK SPLIT On February 11, 1994 Southern Union's Board of Directors declared a three for two stock split in the form of a 50% stock dividend which was distributed on March 9, 1994 to stockholders of record on February 23, 1994. Effective March 9, 1994 the Company gave retroactive recognition to the equivalent change in capital structure for all periods presented. Consequently, earnings per share in 1993, 1992 and 1991 were recomputed based on the weighted average number of shares outstanding during each year adjusted for the stock split. RIGHTS OFFERING On December 31, 1993, Southern Union consummated a Rights Offering to its existing stockholders to subscribe for and purchase 3,000,000 shares of the Company's common stock, par value $1.00 per share, at $16.67 per share, as adjusted for the March 9, 1994 three for two stock split, for net proceeds of $49,351,000. The proceeds from the Rights Offering, together with the proceeds from the sale of $475,000,000 of 7.60% of Senior Notes due 2024 on January 31, 1994, were used to fund the acquisitions of Rio Grande and certain gas distribution assets in Missouri and to retire certain outstanding debt. See "Acquisitions and Divestitures," "Long-Term Debt" and "Subsequent Events." SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) COMMON STOCK The Company had an incentive stock option plan (the "1982 Plan") which terminated on December 31, 1991. Under the terms of the 1982 Plan, options to purchase up to an aggregate of 750,000 shares of common stock could have been granted to officers and key employees at prices not less than fair market value on the date of grant. Options granted under the 1982 Plan are exercisable for periods of ten years from the date of grant or such lesser period as may be designated for particular options, and become exercisable after a specified time from the date of grant in cumulative annual installments. Upon exercise of an option, the 1982 Plan permitted the Company to elect, instead of issuing shares, to make a cash payment equal to the difference at the date of exercise between the option price and the market price of the shares as to which option is being exercised. Options under the 1982 Plan for 19,500 shares at $8.17 were exercised in 1993 and options under the 1982 Plan for 13,500 shares at $8.17 were canceled in 1993. No options under the 1982 Plan were exercised in 1992. Options under the 1982 Plan for 15,000 shares at $8.17 per share were canceled in 1992 due to employee terminations in 1992. Options under the 1982 Plan for 4,500 shares at $8.33 were exercised in 1991. No options under the 1982 Plan were granted during the year ended December 31, 1991. At December 31, 1993, 1992 and 1991, options under the 1982 Plan for 195,000, 142,500 and 78,000 shares were exercisable at prices ranging from $8.17 to $9.17. The 1992 Long-Term Stock Incentive Plan (the "1992 Long-Term Plan") was approved at the annual meeting of stockholders held on May 12, 1993. Under the 1992 Long-Term Plan options to purchase 780,000 shares may be granted to officers and key employees at prices not less than the market value on the date of grant. Options granted under the 1992 Long-Term Plan are exercisable for periods of ten years from the date of grant or such lesser period as may be designated for particular options, and become exercisable after a specified period of time from the date of grant in cumulative annual installments. The 1992 Long-Term Plan also allows for the granting of stock appreciation rights, dividend equivalents, performance shares and restricted stock. No options under the 1992 Long-Term Plan were granted during 1993. Options under the 1992 Long-Term Plan for 5,250 shares at $10.67 were exercised in 1993 and options under the 1992 Long-Term Plan for 6,000 shares at $10.67 were canceled in 1993. There are 588,000 shares available for future option grants under the 1992 Long-Term Plan at December 31, 1993. Options for 203,250 shares at $10.67 per share, along with dividend equivalents, were granted in October 1992 under the 1992 Long-Term Plan. No options under the 1992 Long-Term Plan were exercised during 1992 and none under the 1992 Long-Term Plan were exercisable at December 31, 1992. At December 31, 1993, options for 38,400 shares at $10.67 were exercisable under the 1992 Long-Term Plan. In 1992 the Company purchased 77,438 shares of its common stock at $10.25, adjusted for the stock split, from a company whose Chairman, Chief Executive Officer and President, at that time, were also executive officers, directors and stockholders of Southern Union. RETAINED EARNINGS Provisions in certain of Southern Union's long-term notes and Southern Union's charter relating to the issuance of preferred stock limit the payment of cash or asset dividends on capital stock. Under the most restrictive provisions in effect, as a result of the sale of Senior Debt Securities, Southern Union will not declare or pay any cash or asset dividends on common stock (other than dividends and distributions payable solely in shares of its common stock or in rights to acquire its common stock) or acquire or retire any shares of Southern Union's common stock, unless no event of default exists and the Company meets certain financial ratio requirements. SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) CUMULATIVE PREFERRED STOCK During March 1993, Southern Union retired 68,000 shares of the Series A 10% Cumulative Preferred Stock ("Preferred Stock") at $103 per share for $7,004,000. In April 1993, Southern Union retired 77,000 shares of Preferred Stock at $102 per share for $7,854,000. In June 1993, Southern Union retired 4,000 shares of Preferred Stock at $103.50 per share for $414,000 and the remaining outstanding 100,000 shares at par for $10,000,000. LONG-TERM DEBT First mortgage bonds, debentures and other long-term debt outstanding, including current maturities, were as follows: The maturities of long-term debt for each of the next five years are: 1994 - -- $20,555,000; 1995 -- $516,000; 1996 -- $545,000; 1997 -- $559,000 and 1998 -- $243,000. On January 31, 1994, Southern Union completed the sale of the Senior Debt Securities. The net proceeds from the sale of the Senior Debt Securities, together with the net proceeds from the Rights Offering and working capital from operations, have been or will be used to: (i) fund the purchase price of the Missouri Acquisition; (ii) refinance the $20,000,000 aggregate principal amount of the 10 1/8% Notes due May 15, 1994; (iii) repay approximately $59,300,000 of borrowings under the $100,000,000 revolving credit facility, which borrowings were used to fund the acquisition of Rio Grande and repurchase all of the outstanding preferred stock; (iv) refinance the $10,000,000 aggregate principal amount of 9.45% Senior Notes due January 31, 2004, and $25,000,000 aggregate principal amount of 10% Senior Notes due January 31, 2012 and the related premium of $10,400,000 resulting from the early extinguishment of such notes; and (v) refinance $50,000,000 aggregate principal amount of the 10.5% Sinking Fund Debentures due May 15, 2017 and the premium of $3,300,000 resulting from the early extinguishment of such debentures. See "Subsequent Events. NOTES PAYABLE On September 30, 1993, Southern Union entered into an $80,000,000 revolving credit facility with one bank to provide its seasonal working capital and letters of credit requirements. The revolving credit facility was amended on November 15, 1993 to syndicate it to five additional banks and to increase the facility to $100,000,000. The Company may use up to $40,000,000 of this facility to finance future acquisitions. This facility contains covenants with respect to financial parameters and ratios, total debt limitations, borrowing base limitations, restrictions as to dividend payments, stock reacquisitions, certain investments and additional liens. Further, this revolving credit facility is initially uncollaterized; however, it would become collaterized by a first priority security interest in substantially all of the Company's accounts receivable, inventory and certain related contract rights SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) in the event that Southern Union issues debt collaterized by 20% or more of the property, plant and equipment of Southern Union. The facility expires on December 31, 1996, but may be extended annually for periods of one year beginning on September 30, 1994 with the consent of each of the banks. The revolving credit facility is subject to a commitment fee of an annualized .25% on the unused balance. The interest rate on borrowings on the revolving credit facility is calculated based on a formula using the LIBOR and prime interest rates. The average interest rate under the revolving credit facility was 4.7% for the year ended December 31, 1993. EMPLOYEE RETIREMENT PLAN AND POSTRETIREMENT BENEFITS DEFINED BENEFIT PLAN The Company maintains a trusteed non-contributory defined benefit retirement plan which covers substantially all employees. Benefits are based on years of service and the employee's compensation during the last ten years of employment. The Company funds plan costs in accordance with federal regulations, not to exceed the amounts deductible for income tax purposes. The plan's assets are invested in a cash fund, bond funds and stock funds. During 1993, the Company completed an early retirement program for certain of the Company's employees. Approximately 75 of an eligible 109 employees accepted the early retirement program. As a result, the Company recognized expenses of approximately $702,000 associated with special termination benefits. The components of net pension expense for the year ended December 31, 1993, 1992 and 1991 consisted of the following: The actuarial computations for the determination of accumulated and projected benefit obligations using the projected unit credit actuarial cost method, assumed a discount rate of 7.5% and a weighted average annual salary increase of 5.8% over the average remaining service lives of employees under the plan as of December 31, 1993. A discount rate of 9% and a weighted average annual salary increase of 6.6% were assumed as of December 31, 1992 and 1991. An expected long-term rate of return on plan assets of 8% was assumed in 1993, 1992 and 1991. As a result of decreasing the discount rate effective January 1, 1994, the provisions of SFAS No. 87, "Employers Accounting for Pensions" required the recognition in the balance sheet of an additional minimum liability representing the excess of accumulated benefits over plan assets. A corresponding amount is recognized as an intangible asset to the extent of any unrecognized prior service cost and any remainder as a reduction of stockholders' equity. At December 31, 1993, the Company recorded an additional liability of $4,917,000, an intangible asset of $1,809,000 and a reduction in stockholders' equity of $2,051,000, net of an income tax benefit of $1,057,000. SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following is a reconciliation of the funded status of the pension plan and accrued retirement plan liabilities as of December 31, 1993, and 1992: Prior service cost is being amortized on a straight line basis over the average remaining expected future service of participants present at the time of amendment. The Company also maintains a supplemental non-contributory defined benefit retirement plan which covers certain employees whose annual earnings exceed $50,000. The purpose of the supplemental plan is to provide part or all of those defined benefit plan benefits which are not payable to certain employees under the primary plan. The Company does not currently fund the supplemental plan. The net pension cost of the supplemental plan for the years ended December 31, 1993, 1992 and 1991 was not significant. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company adopted the provision of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective as of January 1, 1993 which resulted in a transition obligation of approximately $9,328,000 which was subsequently reduced in 1993 to $4,257,000 primarily as a result of certain plan amendments. The Company will amortize the remaining transition obligation over an allowed 20-year period. This statement requires an accrual of postretirement medical and other benefit liabilities on an actuarial basis during the years an employee provides services. The Company records a regulatory asset for the difference between the postretirement cost currently included in rates and the SFAS No. 106 expense to the extent the Company has filed, or intends to file, a rate application to include SFAS No. 106 expense in rates and it is probable that the regulator will allow such expense in future rates. The total postretirement costs deferred and recorded as a regulatory asset at December 31, 1993 were approximately $501,000. The postretirement costs recognized as expense in 1993 were $489,000. Prior years' costs of $155,000 and $270,000 in 1992 and 1991, respectively, were recognized as expense when claims were paid. The significant features of the substantive plan include the payment for life of a portion of the medical benefit costs for individuals (and their dependents) who retired prior to January 1, 1993 and for certain individuals (and their dependents) who elected to retire during the first quarter of 1993 and for active employees hired prior to January 1, 1993 benefits are provided only to retirees and only until eligibility for Medicare (age 65). The cost-sharing provisions for medical care benefits include an escalation in the retirees share of claims obligations that is expected to follow the trend of claims net of Medicare reimbursements. The substantive plan was amended during 1993 to substantially modify SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) the cost-sharing provisions to decrease the employer's share of expected future claims and make certain other plan changes. During 1992, the Company discontinued offering postretirement medical benefits to dependents to the future retirees after age 65 and employees hired after December 31, 1992. The funding policy is to pay claims as they arise from a tax-exempt trust through 1999. In addition, contributions are currently being made to a separate account within the pension plan to accumulate assets sufficient to fund claims arising after 1999. Assets held in the tax-exempt trust include primarily short-term obligations. Assets held in the separate account within the retirement plan include cash funds, bond funds and stock funds. Non-benefit liabilities are limited to expenses associated with plan operation and administration. The components of net postretirement benefit cost for the year ended December 31, 1993 consisted of the following: The following is a reconciliation of the funded status of the postretirement benefit plan and accrued postretirement liabilities as of December 31, 1993. For purposes of computing the 1993 net periodic cost and transition obligation, the assumed health care cost trend rate used to measure expected cost benefits covered by the plan was 13.7%, gradually decreasing to 7% in year 17 of the projection. For purposes of the December 31, 1993 benefit obligations, the health care cost trend rate was 10% for the first seven years of the projection, thereafter decreasing by .25% per year, reaching 7% in year 18 of the projection. The weighted average assumed discount rate was 9% for purposes of the 1993 net periodic cost and transition obligation and 7.5% for purposes of the December 31, 1993 computation of the accumulated postretirement benefit obligation. The weighted average expected long-term rate of return on plan assets is assumed to be 8% on an after tax basis. In addition, prior service cost is amortized on a straight line basis over the average remaining years of service to full eligibility for benefits of the active plan participants. SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) A one percentage point increase in the assumed health care cost trend rates for each future year would increase the aggregate of the service and interest cost components of the net periodic postretirement health care benefit cost by approximately $50,000 and would increase the accumulated postretirement benefit obligation for health care benefits by approximately $500,000. TAXES ON INCOME The Company adopted SFAS No. 109 effective January 1, 1993. The effect of this change was not material. Prior to that date, the Company applied the provisions of APB No. 11, "Accounting for Income Taxes". The components of taxes on income relating to continuing operations were as follows: Deferred credits include $755,000 and $791,000 of unamortized deferred investment tax credit as of December 31, 1993 and 1992, respectively. SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Deferred income taxes result from temporary differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. The source of these differences and tax effect of each is as follows: The sources of timing differences and the related deferred tax effect for the years ended December 31, 1992 and 1991, pursuant to APB No. 11 were as follows: On August 10, 1993, the United States Congress passed and the President signed into law, the Omnibus Budget Reconciliation Act of 1993 (the "Act"). Among other provisions in the Act, effective January 1, 1993, the corporate federal income tax rate was increased to 35% on corporate taxable income in excess of $10,000,000. Total income tax expense differed from the amount computed by SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) applying the applicable federal income tax rate of 35% in 1993 and 34% in 1992 and 1991 to earnings from continuing operations before taxes on income. The reasons for the differences for each of the years were as follows: BUSINESS HELD FOR SALE In February 1993, SX entered into a purchase and sale agreement to sell substantially all of its oil and gas leasehold interests and associated production for approximately $22,000,000, which sale was completed in March 1993 effective as of January 1, 1993. SX, engaged in the development and production of oil and gas, held varying interests in producing oil and gas wells located primarily in New Mexico and Texas. The Company accounted for SX as a business held for sale wherein adjustments were made to reflect the valuation of this business to an estimated net realizable value. At December 31, 1992 and 1991, the Company estimated and recorded a book loss on future disposal of $4,400,000 and $2,250,000, respectively. In addition, the Company recorded a tax liability of approximately $6,960,000 resulting from the recognition of a tax basis gain of approximately $18,800,000. The sale closed on March 31, 1993. SX also disposed of various oil and gas properties during 1992 and 1991 for a total of approximately $800,000 and $2,600,000, respectively. LEASES The Company leases certain facilities, equipment and office space under cancelable and noncancelable operating leases. The minimum annual rentals under operating leases for the next five years are as follows: 1994 -- $2,325,000; 1995 -- $1,819,000; 1996 -- $1,384,000; 1997 -- $1,113,000; and 1998 -- $900,000; and thereafter $938,000. Rental expense was approximately $2,061,000, $2,372,000 and $1,881,000 in 1993, 1992 and 1991, respectively. RELATED PARTIES In April 1992, Southern Union advanced $375,980 to Peter H. Kelley, President, Chief Operating Officer and a Director of Southern Union, to enable him to repay certain funds borrowed by him from his previous employer in connection with his departure from his previous employer to become an executive officer of the Company. The advance is evidenced by a note, payable on demand, bearing an annual percentage interest rate of 6.5% which was equal to the prime rate announced by Texas Commerce Bank, N.A. on the date the advance was made, plus one-half percent. As of December 31, 1993, Mr. Kelley's outstanding principal and accrued but unpaid interest balance was $355,428. This loan is being repaid on schedule. In October 1993, Southern Union's Board of Directors approved and ratified payments by the Company to Activated Communications, Inc. ("Activated") for use by the Company of Activated's office space in New York City. Activated is controlled and operated by Company Chairman George L. Lindemann and Vice Chairman John E. Brennan, who, along with Director Adam M. Lindemann, did SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) not participate in such Board action. Monthly rental payments commenced effective as of August 1992 for approximately half of Activated's base lease payments before certain adjustments. Total payments to Activated in 1993 and 1992 were $187,000 and $104,000, respectively. Fleischman and Walsh, of which Southern Union Director Aaron Fleischman is Senior Partner, provides legal services to the Company. In 1993, 1992 and 1991 the total value of legal services provided by Fleischman and Walsh to the Company was approximately $980,000, $503,000 and $624,000, respectively. On February 10, 1994, Southern Union's Board of Directors granted to Fleischman and Walsh a warrant to purchase up to 37,500 shares of Common Stock, $1 par value per share, at an exercise price of $23.00, as adjusted for the stock split. The warrant expires on February 10, 2004. COMMITMENTS AND CONTINGENCIES The Company is aware of the possibility that it may become a defendant in an action brought by the United States Environmental Protection Agency ("EPA") under 42 U.S.C. Section 9607(a) for reimbursement of costs associated with removing hazardous substances from the site of a former coal gasification plant (the "Pine Street Canal Site") in Burlington, Vermont. This knowledge arises out of the existence of a prior action, UNITED STATES V. GREEN MOUNTAIN POWER CORP., ET AL, Civil No. 88-307 (D. Vt.) in which the Company became involved as a third-party defendant in January 1989. Green Mountain Power was an action under 42 U.S.C. Section 9607(a) by the federal government to recover clean-up costs associated with the "Maltex Pond", which is part of the Pine Street Canal Site. Two defendants in Green Mountain Power, Vermont Gas Systems and Green Mountain Power Corp., claimed that the Company is the corporate successor to People's Light and Power Corporation, an upstream corporate parent of Green Mountain Power Corp. during the years 1928-1931. Green Mountain Power was settled without admission or determination of liability with respect to the Company by order dated December 26, 1990. The EPA has since conducted studies of the clean-up costs for the remainder of the Pine Street Canal Site, but the ultimate costs are unknown at this time. On November 30, 1992, the Company was named as a potentially responsible party in a special notice letter from the EPA. On August 16, 1993, the Company's participation in settlement discussions on technical and allocation issues with the EPA was requested by Green Mountain Power Corp., Vermont Gas Systems, Inc. and New England Electric System (the "Gas Plant PRPs"). By letter dated September 20, 1993, the Company informed the Gas Plant PRPs of its reasons for its belief that it has no liability for the site, including (1) that it is not a corporate successor to any entity that owned or was responsible for the Pine Street Canal Site during the period the coal gasification plant was in operation, (2) that any claims against Peoples Light and Power Corporation were discharged in that company's 1936 Plan of Reorganization, and (3) that the Company merged with a successor to People's Light and Power Company, Inc., a separate company incorporated following the bankruptcy of Peoples Light and Power Corporation. Should the Company be made party to any action seeking recovery of remaining clean-up costs, it intends to assert the foregoing defenses and to otherwise vigorously defend against such an action. The Company has made demands of the appropriate insurers that they assume the defense of and liability for any such claim that may be asserted. In 1993, the Internal Revenue Service completed its audit of the Company's federal income tax return for 1984 through 1989. The Internal Revenue Service proposed, and the Company agreed to the deficiencies and related interest of approximately $1,266,000. The Company had fully accrued for the tax deficiencies and interest. Southern Union and its subsidiaries are parties to other legal proceedings that its management considers to be the normal kinds of actions to which an enterprise of its size and nature might be subject. Management believes the outcome of these legal proceedings will not have a material impact on the Company's results of operations or consolidated financial position. The Company has commitments under gas purchase contracts which contain certain minimum purchase provisions for the firm supply of quantities of natural gas. The Company's minimum SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) provisions in its gas supply contracts do not exceed fifty percent of its supply requirements in its service areas. In addition, the Company manages its gas supply purchases to ensure it meets the minimum purchase provisions of its gas purchase contracts. As such, management of the Company believes that take-or-pay provisions within its contracts will not have a material adverse impact on the Company's results of operations or consolidated financial position. SUBSEQUENT EVENTS MISSOURI ACQUISITION On July 9, 1993, Southern Union entered into an Agreement for the Purchase of Assets (the "Missouri Asset Purchase Agreement") with Western Resources, Inc. ("Western Resources"), pursuant to which Southern Union purchased from Western Resources (the "Missouri Acquisition") certain Missouri natural gas distribution operations (the "Missouri Business"). The acquisition was consummated on January 31, 1994 and will be accounted for as a purchase. Southern Union paid approximately $400,300,000 in cash for the Missouri Business. The final determination of the purchase price and all prorations and adjustments are expected to be completed by May 30, 1994. Southern Union operates the Missouri Business as Missouri Gas Energy, a division of Southern Union which is headquartered in Kansas City, Missouri. As of January 31, 1994, Missouri Gas Energy served approximately 472,000 customers in 147 communities in central and western Missouri, including the cities of Kansas City, St. Joseph, Joplin and Monett. The approval of the Missouri Acquisition by the Missouri Public Service Commission (the "MPSC") was subject to the terms of a stipulation and settlement agreement (the "MPSC Stipulation") among Southern Union, Western Resources, the MPSC staff and all intervenors in the MPSC proceeding. Among other things, the MPSC Stipulation: (i) provides that the Company attain a total debt to total capital ratio that does not exceed Standard and Poor's Corporation's Utility Financial Benchmark ratio for the lowest investment grade investor-owned natural gas distribution company (which, at January 31, 1994, would have been approximately 58%) in order to implement any general rate increase with respect to the Missouri Business; (ii) prohibits Southern Union from implementing a general rate increase in Missouri before January 31, 1997 except in certain unusual events; (iii) required Western Resources to contribute an additional $9,000,000 to the Missouri Business' employees' and retirees' qualified defined benefit plans transferred to the Company; (iv) requires the Company to contribute an additional $3,000,000 to the Company's qualified defined benefit plan applicable to the Missouri Business' employees and retirees; and (v) requires the Company to reduce rate base by $30,000,000 (to be amortized over a ten year period) to compensate rate payers for rate base reductions that were eliminated as a result of the acquisition. Southern Union assumed certain liabilities of Western Resources with respect to the Missouri Business, including liabilities arising from certain specified contracts assigned to Southern Union at closing, including gas supply and transportation contracts, office equipment leases and real estate leases, liabilities arising from certain contracts entered into by Western Resources in the ordinary course of business, certain liabilities that have arisen or may arise from the operation of the Missouri Business, and liabilities for certain accounts payable of Western Resources pertaining to the Missouri Business. Southern Union and Western Resources also entered into an Environmental Liability Agreement at closing. Subject to the accuracy of certain representations made by Western Resources in the Missouri Asset Purchase Agreement, the agreement provides for a tiered approach to the allocation of substantially all liabilities under environmental laws that may exist or arise with respect to the Missouri Business. The agreement contemplates Southern Union first seeking reimbursement from other potentially responsible parties, or recovery of such costs under insurance or through rates charged to customers. To the extent certain environmental liabilities are discovered by Southern SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Union prior to July 9, 1995, and are not so reimbursed or recovered, Southern Union will be responsible for the first $3,000,000, if any, of out of pocket costs and expenses incurred to respond to and remediate any such environmental claim. Thereafter, Western Resources would share one-half of the next $15,000,000 of any such costs and expenses, and Southern Union would be solely liable for any such costs and expenses in excess of $18,000,000. The Missouri Business owns or is otherwise associated with a number of sites where manufactured gas plants were previousy operated. These plants were commonly used to supply gas service in the late 19th and early 20th centuries, in certain cases by corporate predecessors to Western Resources. By-products and residues from manufactured gas could be located at these sites and at some time in the future may require remediation by the EPA or delegated state regulatory authority. By virtue of notice under the Missouri Asset Purchase Agreement and its preliminary, non-invasive review, the Company is aware of eleven such sites in the service territory of the Missouri Business. Based on information reviewed thus far, it appears that neither Western Resources nor any predecessor in interest ever owned or operated at least three of those sites. Western Resources has informed the Company that it was notified in 1991 by the EPA that the EPA was evaluating one of the sites (in St. Joseph, Missouri) for any potential threat to human health and the environment. Western Resources has also advised the Company that to date, the EPA has not notified it that any further action may be required. Evaluation of the remainder of the sites by appropriate federal and state regulatory authorities may occur in the future. At the present time and based upon the preliminary information available to it, the Company believes that the costs of any remediation efforts that may be required for these sites for which it may ultimately have responsibility will not exceed the aggregate amount subject to substantial sharing by Western Resources. Pursuant to the terms of an Employee Agreement with Western Resources entered into on July 9, 1993, after the closing of the Missouri Acquisition, Southern Union employed certain employees of Western Resources involved in the operation of the Missouri Business ("Continuing Employees"). Under the terms of the Employee Agreement, the assets and liabilities under Western Resources' qualified defined benefit plans attributable to Continuing Employees and retired employees who had been necessary to the operation of the Missouri Business ("Retired Employees") were transferred to a qualified defined benefit plan of Southern Union that will provide benefits to Continuing Employees and Retired Employees substantially similar to those provided for under Western Resources' qualified defined benefit plans. Southern Union amended its qualified defined benefit plan to cover the Continuing Employees and Retired Employees and provide Continuing Employees and Retired Employees with certain welfare, separation and other benefits and arrangements. In connection with the Missouri Acquisition, on January 31, 1994 Southern Union completed the sale of the Senior Debt Securities. See "Long-Term Debt." PRO FORMA FINANCIAL INFORMATION The following unaudited pro forma financial information for the years ended December 31, 1993 and 1992 is presented to give effect to: the funding of the Missouri Acquisition; the completion of the Rights Offering; the sale of Senior Debt Securities; and the refinancing of certain short-term debt, current maturities of long-term debt and certain long-term debt outstanding at December 31, 1993, as if such transactions had been consummated at the beginning of 1993 and 1992, respectively. The pro forma financial information, adjusted for the stock split, is not necessarily indicative of the results SOUTHERN UNION COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) which would have actually been obtained had the Missouri Acquisition, the Rights Offering, the sale of Senior Debt Securities or the refinancings been completed as of the assumed date for the periods presented or which may be obtained in the future. OTHER EVENT On February 11, 1994, Southern Union's Board of Directors declared a three for two stock split in the form of a 50% stock dividend which was distributed on March 9, 1994 to stockholders of record on February 23, 1994. See "Stockholder's Equity." QUARTERLY OPERATIONS (UNAUDITED) SCHEDULE V SOUTHERN UNION COMPANY AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT THREE YEARS ENDED DECEMBER 31, 1993 S-1 SCHEDULE VI SOUTHERN UNION COMPANY AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT THREE YEARS ENDED DECEMBER 31, 1993 S-2 SCHEDULE IX SOUTHERN UNION COMPANY AND SUBSIDIARIES SHORT-TERM BORROWINGS THREE YEARS ENDED DECEMBER 31, 1993 S-3 SCHEDULE X SOUTHERN UNION COMPANY AND SUBSIDIARIES SUPPLEMENTARY STATEMENT OF OPERATIONS INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 S-4 EXHIBIT INDEX E-1 E-2

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1993

852807

ITEM 1. BUSINESS - ----------------- Aztar Corporation ("Aztar" or the "Company") was incorporated in Delaware in June 1989 to operate the gaming business of Ramada Inc. ("Ramada") after the restructuring of Ramada (the "Restructuring"). The Restructuring,which was approved by Ramada's board of directors in October 1988 and substantially completed December 20, 1989, involved the disposition of Ramada's hotel and restaurant businesses with Ramada's shareholders retaining their interest in the gaming business. As part of the Restructuring, the gaming business and certain other assets and liabilities of Ramada were transferred to Aztar, and a wholly-owned subsidiary of New World Hotels (U.S.A.), Inc. was merged with Ramada (the "Merger"). In the Merger, each share of Ramada common stock was converted into the right to receive $1.00 and one share of Aztar common stock. For accounting purposes Aztar is treated as the continuing accounting entity that is the successor to the historical Ramada and that has discontinued the hotel and restaurant businesses. The Company operates in major domestic gaming markets with casino hotel facilities in Atlantic City, New Jersey, and in Las Vegas and Laughlin, Nevada. The strategy of the Company has been to develop facilities with distinctive themes that are "must-see" attractions in their respective gaming markets and provide a full entertainment experience to attract gaming patrons. The Company believes that as the gaming industry becomes increasingly competitive, casino operators that can best provide a broad entertainment experience will be most successful. The Company targets gaming customers in the high end of the middle market, with particular emphasis on slot customers. The Company has been pursuing the development of its business in various gaming jurisdictions. An agreement was executed in September 1993 with the City of Caruthersville, Missouri, to operate a casino riverboat there, and an application was filed with the Missouri Gaming Commission for a gaming license to operate the Caruthersville facility. In January 1994, the Company took delivery of a vessel and began renovation with the intent for it to be used in Caruthersville. The Company hopes to begin operations in Caruthersville in 1994. However, the timing of this is dependent on several factors that are beyond the Company's control. One of these factors is the granting of a gaming license by the Missouri Gaming Commission. Another possible factor is a ruling by the Missouri Supreme Court holding unconstitutional some portions of the Missouri gaming law. A statewide election to amend the constitution was scheduled to be held April 5, 1994. During 1993, a proposal was submitted to the City of Evansville, Indiana, for a casino riverboat there and an application was filed for a riverboat gaming license with the Indiana Gaming Commission. In 1994, the Company plans to continue to explore opportunities in new jurisdictions as they become interested in gaming. The TropWorld complex encompasses 10 acres and has 220 yards of ocean beach frontage along the Boardwalk in Atlantic City. In July 1993, the TropWorld building became wholly-owned by the Company upon the acquisition by the Company of the partnership interests in Ambassador Real Estate Investors, L.P. ("AREI") and Ambassador General Partnership ("AGP"). AREI owned a 99.9 percent general partnership interest in AGP, which acquired a substantial interest in TropWorld in a sale-leaseback transaction in 1984. TropWorld's 92,191 square foot casino (the second largest in Atlantic City) contains 2,780 slot machines, including a wide variety of progressive jackpot machines and video poker machines, and contains 95 table games, including blackjack, craps, roulette, baccarat, pai gow poker, big six, sic bo and red dog. The TropWorld complex contains 1,020 hotel rooms, 80,000 square feet of meeting, convention and banquet space, a 1,700 seat theatrical showroom, the largest in Atlantic City, and parking facilities for over 2,700 vehicles. There is a wide variety of food and beverage facilities at TropWorld, including gourmet restaurants, several medium- priced restaurants and a food court offering a large choice of convenient and moderately priced items. Recreational facilities at TropWorld include indoor and outdoor swimming pools, tennis courts, a health and fitness club and a jogging track. TropWorld operates the casino 24 hours a day, seven days a week. The theme of TropWorld recalls the heyday of the Atlantic City Boardwalk Piers with their amusement rides, carnival games and strolling entertainers. TropWorld offers daily live musical entertainment in its atrium, which contains a spectacular four-story-high operating ferris wheel. TropWorld boasts an indoor roller coaster, bumper cars, and other attractions reminiscent of the old Boardwalk in Atlantic City. Tropicana is located on a 34-acre site on the southeast corner of the Strip and Tropicana Avenue in Las Vegas, Nevada. The Tropicana casino occupies 45,000 square feet and contains 1,510 slot machines and 52 table games. Tropicana has a tropical island theme and is promoted as "The Island of Las Vegas." It has one of the world's largest swimming pools and a five-acre water park and tropical garden area. Tropicana has 1,907 hotel rooms and suites and approximately 100,000 square feet of convention and exhibit space. The tropical theme is apparent in the decor of the property, which includes a large collection of tropical birds and fish. Tropicana offers its guests a variety of entertainment including laser light shows, a comedy club, lounge shows and the Folies Bergere revue, which is the longest- running production show in Las Vegas. At the end of 1993, the Company was in the process of constructing at Tropicana a new main entrance and a new building facade that will create a colorful Caribbean Village motif. The Company expects to complete construction of these enhancements during the first quarter of 1994. Throughout most of its history, Tropicana, with its upscale decor and location as the sole major casino hotel on the southern end of the Strip, catered to high end table games customers with particular emphasis on baccarat. This strategy allowed for significant gaming revenues without substantial walk-in traffic. However, beginning in late 1989 with the opening of the Mirage, competition for this small group of premium table games customers, dominated by players from the Far East, increased significantly. The center portion of the Strip, highlighted by Ceasars Palace and the Mirage, became the focal point of the high end table games market. As heavy promotion and complimentary expenditures ensued, profit margins in this segment declined. As a result, management decided to curtail its emphasis on premium table games and focus on slot revenue from the high end of the middle market. Tropicana is located at an intersection which is now referred to as "The New Four Corners" of Las Vegas. There are three other major casino hotel properties located at this intersection, two of which, Luxor and MGM Grand, opened during the fourth quarter of 1993, and the other, Excalibur, opened June 1990. The increase in total casino and hotel capacity with the opening of Luxor and MGM Grand has increased the level of activity and visitor traffic around Tropicana. Pedestrian traffic around "The New Four Corners" will be made faster, safer and more convenient upon completion of an elevated pedestrian bridge system under construction by the State of Nevada. The bridge system will connect the four corners of the intersection and will have elevators and escalators set back from all four corners. The Company is funding a portion of the construction costs for this project which is scheduled for completion in early 1994. Upon completion of this project, the Company plans to construct a connecting bridge into the Tropicana casino in order to facilitate access from the MGM Grand. Management believes that the new properties located at "The New Four Corners" have stimulated and will continue to stimulate additional walk-in traffic that provides increased opportunities for Tropicana to attract its target customers and retain them through the Company's proprietary database marketing system. There can be no assurance, however, that the increased competition from these new properties will not have an adverse effect on Tropicana. Ramada Express is located on 28 acres in Laughlin, Nevada. Laughlin is situated on the Colorado River at Nevada's southern tip. The facility features a Victorian-era railroad theme, including a train that carries guests between the parking areas and the casino hotel. In September 1993, the Company completed a $75 million expansion of Ramada Express, on schedule and within budget. The expansion was financed primarily out of the Company's cash and cash flow. During the fourth quarter 1993, the Company borrowed $25 million against its $50 million construction and term loan credit facility which was converted into a $50 million revolving line of credit in December 1993. The expansion of Ramada Express included a new 1,100-room tower, increasing the property to a total of 1,500 rooms; a casino expansion of 20,000 square feet, bringing the total to 50,000 square feet; a 1,100-vehicle parking garage, bringing the total parking capacity to 2,300 vehicles; and additional restaurant, special event and retail space. The expanded casino contains 33 gaming tables and 1,545 slot machines and is utilized 24 hours a day, seven days a week. COMPETITION AND SEASONALITY Competition Although the Company has been able to compete successfully in its gaming markets in the past, there can be no assurance that the Company will be able to continue to compete successfully in these markets. The Company faces intense competition in each of the markets in which its gaming facilities are located from other companies in the gaming industry, some of which have significantly greater financial resources than the Company. Such competition results, in part, from the geographic concentration of competitors. All of the Company's casinos primarily compete with other casinos in their immediate geographic area and, to a lesser extent, with casinos in other locations, including Native American lands, and on cruise ships and riverboats, and with other forms of legalized gaming in the United States, including state-sponsored lotteries, off-track wagering and card parlors. Certain states have recently legalized, and several other states are currently considering legalizing, casino gaming in specific geographic areas within those states. Legalization of large-scale, unlimited casino gaming in or near any major metropolitan area or increased gaming in other areas could have an adverse economic impact on the business of any or all of the Company's gaming facilities. As of December 30, 1993, there were 11 casino hotel facilities operating in Atlantic City in competition with TropWorld. Presently, there is no new casino hotel supply anticipated in the Atlantic City market for the next several years. During 1993, three major casino hotels opened in the Las Vegas market, two of which, Luxor and MGM Grand, are located adjacent to the Tropicana near the intersection of Tropicana Avenue and the Strip, which is now referred to as "The New Four Corners". Circus Circus opened its 2,500-room Luxor in October 1993. The 5,000-room MGM Grand opened in December 1993. The third casino, Mirage's 3,000-room Treasure Island, also opened in October 1993 and is located in the middle of the Strip. These newly opened casinos added a total of approximately 10,500 rooms to an existing Las Vegas market base of approximately 77,000 rooms, representing an increase of 14%. In addition, there has been a significant increase in room supply and casino space in recent years, including the opening of the 3,000-room Mirage in November 1989 and the 4,000-room Excalibur in June 1990. Management believes that the MGM Grand and the Luxor have stimulated and will continue to stimulate additional walk-in traffic that provides increased opportunities for Tropicana to attract its target customers and retain them through the Company's proprietary database marketing system. There can be no assurance, however, that the increased competition from the new casinos will not have an adverse effect on Tropicana. In the Laughlin market, in addition to the Company's expansion completed in September 1993, the Riverside is in the process of obtaining building permits for its 792-room tower expansion which it expects to open in December 1994, and has announced a management agreement with the Mohave Indian Tribe to build and operate a small facility (approximately 250 gaming positions) in Arizona roughly twenty-five miles south of Laughlin to open in the fall of 1994. Separately, the Golden Nugget is reportedly planning to add several hundred additional hotel rooms. Another entity is reportedly planning two projects in Laughlin consisting of 1,800 rooms and 70,000 square feet of casino space north of Ramada Express and 1,000 rooms and 50,000 square feet of casino space south of Ramada Express. Sewer permits are available for new sewer capacity that was recently completed and is currently in a test phase. The new sewer capacity is expected to be available for use in the summer of 1994. Competition involves not only the quality of casino, room, restaurant, entertainment and convention facilities, but also room, food and beverage prices. The level of gaming activity also varies significantly from time to time depending on general economic conditions, marketing efforts, hotel occupancies and the offering of special events and promotions. The extent and quality of complimentary services to attract high-stakes players and, in Atlantic City, casino customers arriving under bus programs, the personal attention offered to guests and casino customers, advertising, entertainment, slot machine pay-out rates and credit policies with respect to high-stakes players are also important competitive factors. As a result, operating results can be adversely affected by significant cash outlays for advertising and promotion and complimentary services to patrons, the amount and timing of which are partially dictated by the policies of competitors. If operating revenues are insufficient to allow management the flexibility to match the promotions of competitors, the number of the Company's casino patrons may decline, with an adverse effect on its financial performance. Seasonality TropWorld experiences seasonal fluctuations in casino play that management believes are typical of casino hotel operations in Atlantic City. Operating results indicate that casino play is seasonally higher during the months of May through October; consequently the Company's revenues during the first and fourth quarters have generally been lower than for the second and third quarters and from time to time the Company has experienced losses in the first and fourth quarters. Because TropWorld's operating results are especially dependent upon operations in the summer months, any event that adversely affects the operating results of TropWorld during such period could have a material adverse effect on the Company's operations and financial condition. Given Atlantic City's location, it is also subject to occasional adverse weather conditions such as storms and hurricanes that would impede access to Atlantic City, thus adversely impacting operations. The gaming markets in Las Vegas and Laughlin experience a slight decrease in gaming activity in the hot summer months and during the holiday period between Thanksgiving and Christmas. CREDIT POLICY AND CONTROL PROCEDURES As is customary in the gaming industry and necessitated by competitive factors, the Company's gaming activities are conducted on a credit as well as a cash basis. Credit policies vary widely from one operator to another and are largely dependent on the profile of the targeted customers. Table games players, for example, are typically extended more credit than slot players, and high-stakes players are typically extended more credit than patrons who tend to wager lower amounts. The Company currently markets to customers in all gaming segments; however, its credit policy will vary from facility to facility based upon the various types of customers at each facility. Gaming debts are legally enforceable under the current laws of both New Jersey and Nevada; it is not clear, however, that all other states will honor these policies. The uncollectibility of gaming receivables could have a material adverse effect on results of operations. Provisions for estimated uncollectible gaming receivables have been made in order to reduce gaming receivables to amounts deemed to be collectible. Gaming operations at the casinos are subject to risk of substantial loss as a result of employee or patron dishonesty, credit fraud or illegal slot machine manipulation. The Company has in place stringent control procedures to minimize such risks; however, there can be no assurance that losses will not occur. Current controls include supervision of employees, monitoring by electronic surveillance equipment and use of two-way mirrors and overhead catwalks. In New Jersey, the Company's activities are observed and monitored on an ongoing basis by agents of both the New Jersey Casino Control Commission (the "New Jersey Commission") and the New Jersey Division of Gaming Enforcement (the "New Jersey Division"), each of which maintains a staff on the premises of TropWorld. Similarly, in Nevada the Company's gaming subsidiaries must comply with certain regulatory requirements concerning casino and game security and surveillance, and the gaming operations of Tropicana and Ramada Express are subject to routine audit and supervision by agents of the Nevada State Gaming Control Board (the "Nevada Board"). REGULATION General Regulatory aspects of the gaming business in both Nevada and New Jersey are pervasive in nature and the following description should not be construed as a complete summary of all the regulatory requirements faced by the Company. In both states, gaming authorizations, once obtained, can be suspended or revoked for a variety of reasons. If the Company were ever precluded from operating one of its gaming facilities, it would, to the extent permitted by law, seek to recover its investment by sale of the property affected, but there can be no assurance that the Company would recover its full investment. In addition, the Nevada Gaming Commission (the "Nevada Commission") and the New Jersey Commission have the authority to require a holder or beneficial owner of the Company's securities to be found to be suitable or to qualify under applicable laws or regulations. From time to time, legislative and regulatory changes are proposed that could be adverse to the Company. In addition, from time to time, investigations are conducted relating to the gaming industry. TropWorld is required to report certain cash transactions to the U.S. Department of the Treasury pursuant to the Bank Secrecy Act. Violation of the reporting requirements of the Bank Secrecy Act could result in civil as well as criminal penalties including fines and/or imprisonment. The State of Nevada has adopted a regulation similar to the Bank Secrecy Act which requires the Nevada facilities to document and/or report certain currency transactions to the Nevada Board. Violation of this regulation could result in action by the Nevada authorities to fine or revoke, suspend, condition or fail to renew the Nevada facilities' licenses and/or the Company's licensing approval. These reporting requirements are not expected to have any adverse effects on the Company's casino operations. Regulation and Licensing - Nevada The ownership and operation of casino gaming facilities in Nevada are subject to: (i) the Nevada Gaming Control Act and the regulations promulgated thereunder (collectively, "Nevada Act"); and (ii) various local regulation. The gaming operations of Tropicana and Ramada Express are subject to the licensing and regulatory control of the Nevada Commission, the Nevada Board and the Clark County Liquor and Gaming Licensing Board (the "Clark County Board") (collectively, the "Nevada Gaming Authorities"). The laws, regulations and supervisory procedures of the Nevada Gaming Authorities are based upon declarations of public policy which are concerned with, among other things; (i) the prevention of unsavory or unsuitable persons from having a direct or indirect involvement with gaming at any time or in any capacity; (ii) the establishment and maintenance of responsible accounting practices and procedures; (iii) the maintenance of effective controls over the financial practices of licensees, including the establishment of minimum procedures for internal fiscal affairs and the safeguarding of assets and revenues, providing reliable record keeping and requiring the filing of periodic reports with the Nevada Gaming Authorities; (iv) the prevention of cheating and fraudulent practices; and (v) the provision of a source of state and local revenues though taxation and licensing fees. Change in such laws, regulations and procedures could have an adverse effect on the Company. Hotel Ramada of Nevada ("HRN") is the Company's wholly-owned subsidiary which operates the casino at Tropicana and Ramada Express, Inc. ("Express") is the Company's wholly-owned subsidiary which operates the casino at Ramada Express. HRN and Express are both required to be licensed by the Nevada Gaming Authorities. The gaming license requires the periodic payment of fees and taxes and is not transferable. The Company is registered by the Nevada Commission as a publicly traded corporation ("Registered Corporation") and as such, it is required periodically to submit detailed financial and operating reports to the Nevada Commission and furnish any other information which the Nevada Commission may require. No person may become a stockholder of, or receive any percentage of profits from HRN or Express without first obtaining licenses and approvals from the Nevada Gaming Authorities. The Company, HRN and Express have obtained from the Nevada Gaming Authorities the various registrations, approvals, permits and licenses required in order to engage in gaming activities in Nevada. The Nevada Gaming Authorities may investigate any individual who has a material relationship to, or material involvement with, the Company, HRN or Express in order to determine whether such individual is suitable or should be licensed as a business associate of a gaming licensee. Officers, directors and certain key employees of HRN and Express must file applications with the Nevada Gaming Authorities and may be required to be licensed or found suitable by the Nevada Gaming Authorities. Officers, directors and key employees of the Company who are actively and directly involved in gaming activities of HRN and Express may be required to be licensed or found suitable by the Nevada Gaming Authorities. The Nevada Gaming Authorities may deny an application for licensing for any cause which they deem reasonable. A finding of suitability is comparable to licensing, and both require submission of detailed personal and financial information followed by a thorough investigation. The applicant for licensing or a finding of suitability must pay all the costs of the investigation. Changes in licensed positions must be reported to the Nevada Gaming Authorities and in addition to their authority to deny an application for a finding of suitability or licensure, the Nevada Gaming Authorities have jurisdiction to disapprove a change in a corporate position. If the Nevada Gaming Authorities were to find an officer, director or key employee unsuitable for licensing or unsuitable to continue having a relationship with the Company, HRN or Express the companies involved would have to sever all relationships with such person. In addition, the Nevada Commission may require the Company, HRN or Express to terminate the employment of any person who refuses to file appropriate applications. Determinations of suitability or of questions pertaining to licensing are not subject to judicial review in Nevada. The Company, HRN and Express are required to submit detailed financial and operating reports to the Nevada Commission. Substantially all material loans, leases, sales of securities and similar financing transactions by HRN and Express must be reported to, or approved by, the Nevada Commission. If it were determined that the Nevada Act was violated by HRN or Express, the gaming licenses held by HRN or Express could be limited, conditioned, suspended or revoked, subject to compliance with certain statutory and regulatory procedures. In addition, HRN, Express, the Company and the persons involved could be subject to substantial fines for each separate violation of the Nevada Act at the discretion of the Nevada Commission. Further, a supervisor could be appointed by the Nevada Commission to operate the Company's Nevada gaming properties and, under certain circumstances, earnings generated during the supervisor's appointment (except for the reasonable rental value of the Company's Nevada gaming properties) could be forfeited to the State of Nevada. Limitation, conditioning or suspension of any gaming license or the appointment of a supervisor could (and revocation of any gaming license would) materially adversely affect the Company. Any beneficial holder of the Company's voting securities, regardless of the number of shares owned, may be required to file an application, be investigated, and have his suitability as a beneficial holder of the Company's voting securities determined if the Nevada Commission has reason to believe that such ownership would otherwise be inconsistent with the declared policies of the State of Nevada. The applicant must pay all costs of investigation incurred by the Nevada Gaming Authorities in conducting any such investigation. The Nevada Act requires any person who acquires more than 5% of the Company's voting securities to report the acquisition to the Nevada Commission. The Nevada Act requires that beneficial owners of more than 10% of the Company's voting securities apply to the Nevada Commission for a finding of suitability within thirty days after the Chairman of the Nevada Board mails the written notice requiring such filing. Under certain circumstances, an "institutional investor," as defined in the Nevada Act, which acquires more than 10%, but not more than 15%, of the Company's voting securities may apply to the Nevada Commission for a waiver of such finding of suitability if such institutional investor holds the voting securities for investment purposes only. An institutional investor shall not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of business as an institutional investor and not for the purpose of causing, directly or indirectly, the election of a majority of the members of the board of directors of the Company, any change in the Company's corporate charter, bylaws, management, policies or operations of the Company, or any of its gaming affiliates, or any other action which the Nevada Commission finds to be inconsistent with holding the Company's voting securities for investment purposes only. Activities which are not deemed to be inconsistent with holding voting securities for investment purposes only include: (i) voting on all matters voted on by stockholders; (ii) making financial and other inquiries of management of the type normally made by securities analysts for informational purposes and not to cause a change in its management, policies or operations; and (iii) such other activities as the Nevada Commission may determine to be consistent with such investment intent. If the beneficial holder of voting securities who must be found suitable is a corporation, partnership or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant is required to pay all costs of investigation. Any person who fails or refuses to apply for a finding of suitability or a license within thirty days after being ordered to do so by the Nevada Commission or the Chairman of the Nevada Board, may be found unsuitable. The same restrictions apply to a record owner if the record owner, after request, fails to identify the beneficial owner. Any stockholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of the common stock of a Registered Corporation beyond such period of time as may be prescribed by the Nevada Commission may be guilty of a criminal offense. The Company is subject to disciplinary action if, after it receives notice that a person is unsuitable to be a stockholder or to have any other relationship with the Company, HRN or Express, the Company (i) pays that person any dividend or interest upon voting securities of the Company, (ii) allows that person to exercise, directly or indirectly, any voting right conferred through securities held by that person, (iii) pays remuneration in any form to that person for services rendered or otherwise, or (iv) fails to pursue all lawful efforts to require such unsuitable person to relinquish his voting securities for cash at fair market value. Additionally, the Clark County Board has taken the position that it has the authority to approve all persons owning or controlling the stock of any corporation controlling a gaming license. The Nevada Commission may, in its discretion, require the holder of any debt security of a Registered Corporation to file applications, be investigated and be found suitable to own the debt security of a Registered Corporation. If the Nevada Commission determines that a person is unsuitable to own such security, then pursuant to the Nevada Act, the Registered Corporation can be sanctioned, including the loss of its approvals, if without the prior approval of the Nevada Commission, it: (i) pays to the unsuitable person any dividend, interest, or any distribution whatsoever; (ii) recognizes any voting right by such unsuitable person in connection with such securities; (iii) pays the unsuitable person remuneration in any form; or (iv) makes any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation, or similar transaction. The Company is required to maintain a current stock ledger in Nevada which may be examined by the Nevada Gaming Authorities at any time. If any securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada Gaming Authorities. A failure to make such disclosure may be grounds for finding the record holder unsuitable. The Company is also required to render maximum assistance in determining the identity of the beneficial owner. The Nevada Commission has the power to require the Company's stock certificates to bear a legend indicating that the securities are subject to the Nevada Act. However, to date, the Nevada Commission has not imposed such a requirement on the Company. The Company may not make a public offering of its securities without the prior approval of the Nevada Commission if the securities or the proceeds therefrom are intended to be used to construct, acquire or finance gaming facilities in Nevada, or to retire or extend obligations incurred for such purposes. On June 24, 1993, the Nevada Commission granted the Company prior approval to make public offerings for a period of one year, subject to certain conditions ("Shelf Approval"). However, the Shelf Approval may be rescinded for good cause without prior notice upon the issuance of an interlocutory stop order by the Chairman of the Nevada Board. The Shelf Approval does not constitute a finding, recommendation or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the prospectus or the investment merits of the securities. Any representation to the contrary is unlawful. Changes in control of the Company through merger, consolidation, stock or asset acquisitions, management or consulting agreements, or any act or conduct by a person whereby he obtains control, may not occur without the prior approval of the Nevada Commission. Entities seeking to acquire control of a Registered Corporation must satisfy the Nevada Board and Nevada Commission in a variety of stringent standards prior to assuming control of such Registered Corporation. The Nevada Commission may also require controlling stockholders, officers, directors and other persons having a material relationship or involvement with the entity proposing to acquire control, to be investigated and licensed as part of the approval process relating to the transaction. The Nevada legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and corporate defense tactics affecting Nevada gaming licensees, and Registered Corporation, that are affiliated with those operations, may be injurious to stable and productive corporate gaming. The Nevada Commission has established a regulatory scheme to ameliorate the potentially adverse effects of these business practices upon Nevada's gaming industry and to further Nevada's policy to: (i) assure the financial stability of corporate gaming operators and their affiliates; (ii) preserve the beneficial aspects of conducting business in the corporate form; and (iii) promote a neutral environmental for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Nevada Commission before the Company can make exceptional repurchases of voting securities above the current market price thereof and before a corporate acquisition opposed by management can be consummated. The Nevada Act also requires prior approval of a plan of recapitalization proposed by the Company's Board of Directors in response to a tender offer made directly to the Registered Corporation's stockholders for the purposes of acquiring control of the Registered Corporation. License fees and taxes, computed in various ways depending on the type of gaming or activity involved, are payable to the State of Nevada and to the counties and cities in which the Nevada licensee's respective operations are conducted. Depending upon the particular fee or tax involved, these fees and taxes are payable either monthly, quarterly or annually and are based upon either: (i) a percentage of the gross revenues received; (ii) the number of gaming devices operated; or (iii) the number of table games operated. A casino entertainment tax is also paid by casino operations where entertainment is furnished in connection with the selling of food or refreshments. Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such persons (collectively, "Licensees"), and who proposes to become involved in a gaming venture outside of Nevada is required to deposit with the Nevada Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation of the Nevada Board of their participation in such foreign gaming. The revolving fund is subject to increase or decrease in the discretion of the Nevada Commission. Thereafter, Licensees are required to comply with certain reporting requirements imposed by the Nevada Act. Licensees are also subject to disciplinary action by the Nevada Commission if it knowingly violates any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fails to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required of Nevada gaming operations, engages in activities that are harmful to the State of Nevada or its ability to collect gaming taxes and fees, or employs a person in the foreign operation who has been denied a license or finding of suitability in Nevada on the ground of personal unsuitability. The sale of alcoholic beverages is also subject to licensing, control and regulation by the Clark County Board. All licenses are revokable and are not transferable. The Clark County Board has full power to limit, condition, suspend or revoke any such license and any such disciplinary action could (and revocation would) have a material adverse effect upon the operations of the Company. Regulation and Licensing - New Jersey Regulation. The ownership and operation of casino hotel facilities and gaming activities in Atlantic City, New Jersey, are subject to extensive state regulation under the New Jersey Casino Control Act (the "New Jersey Act") and the regulations of the New Jersey Commission. In general, the New Jersey Act and regulations provide for more extensive controls over a broader scope of gaming-related activities than does the Nevada regulatory system. The New Jersey Act and regulations concern primarily the financial stability and character of casino licensees, their intermediary and holding companies, their employees, their security holders and others financially interested in casino operations, the nature of hotel and casino facilities and a wide range of gaming and non-gaming related operations. The New Jersey Act and regulations include detailed provisions concerning, among other things, financial and accounting practices used in connection with casino operations, residence and equal employment opportunities for employees of casino operators, contractors for casino facilities and others; rules of games, levels of supervision of games and methods of selling and redeeming chips; manner of granting credit, duration of credit and enforceability of gaming debts; manufacture, distribution and sale of gaming equipment; security standards, management control procedures, accounting and cash control methods and reports to gaming authorities; advertising of casinos and standards for entertainment and distribution of alcoholic beverages in casinos. A number of these provisions require practices which are different from those in Nevada and some of them result in casino operating costs being higher than those in comparable facilities in Nevada. The New Jersey Act also established the New Jersey Division to investigate all license applications, enforce the provisions of the New Jersey Act and attendant regulations and prosecute all proceedings for violations of the New Jersey Act and regulations before the New Jersey Commission. The New Jersey Division also conducts audits and continuing reviews of all casino operations. Licensing. Adamar of New Jersey, Inc. ("Adamar"), the Company's New Jersey gaming subsidiary, has been licensed (subject to biennial renewal) by the New Jersey Commission to operate TropWorld. In November 1982, the New Jersey Commission granted a plenary license to Adamar. In November 1993, the license was renewed for a period of two years. The Company and Ramada New Jersey Holdings Corporation ("Holdings"), another of the Company's New Jersey gaming subsidiaries, have been approved as qualified holding companies for Adamar's casino license. Officers and directors of the Company and Adamar and employees who work at casino hotel facilities operated by Adamar also have been or must be approved or licensed. In addition, all contracts affecting the facilities have been or must be approved, and all enterprises that conduct business with Adamar must register with the New Jersey Commission and those enterprises that conduct gaming related businesses or that conduct business on a regular and continuing basis, as defined by the regulations under the New Jersey Act, must be licensed by the New Jersey Commission. The New Jersey Commission has broad discretion regarding the issuance, renewal, revocation and suspension of casino licenses. Casino licenses are not transferable. A casino hotel facility must also continually satisfy certain requirements concerning, among other things, the number of qualifying sleeping units and the relationship between the number of qualifying sleeping units and the square footage of casino space. The Company believes that TropWorld continues to meet such requirements. The New Jersey Act further provides that each person who directly or indirectly holds any beneficial interest or ownership of the securities issued by a casino licensee or any of its intermediary or holding companies, those persons who, in the opinion of the New Jersey Commission, have the ability to control the casino licensee or its intermediary or holding companies or elect a majority of the board of directors of said companies, other than a banking or other licensed lending institution which makes a loan or holds a mortgage or other lien acquired in the ordinary course of business, lenders and underwriters of said companies may be required to seek qualification from the New Jersey Commission. However, because the Company is a publicly traded holding company, in accordance with the provisions of the New Jersey Act, a waiver of qualification may be granted by the New Jersey Commission, with the concurrence of the Director of the Division, if it is determined that said persons or entities are not significantly involved in the activities of Adamar and, in the case of security holders, do not have the ability to control the Company or elect one or more of its directors. There exists a rebuttable presumption that any person holding 5% or more of the equity securities of a casino licensee's intermediary or holding company or a person having the ability to elect one or more of the directors of such a company has the ability to control the company and thus must obtain qualification from the New Jersey Commission. Notwithstanding this presumption of control, the New Jersey Act provides for a waiver of qualification for passive "institutional investors," as defined by the New Jersey Act, if the institutional investor purchased the securities for investment purposes only and where such securities constitute (i) less than 10% of the equity securities of a casino licensee's holding or intermediary company or (ii) debt securities of a casino licensee's holding or intermediary company representing a percentage of the outstanding debt of such company not exceeding 20% or a percentage of any issue of the outstanding debt of such company not exceeding 50%. The waiver of qualification is subject to certain conditions including, upon request of the New Jersey Commission, filing a certified statement that the institutional investor has no intention of influencing or affecting the affairs of the issuer. Additionally, a waiver of qualification may also be granted to institutional investors holding a higher percentage of securities of a casino licensee's holding or intermediary company upon a showing of good cause. If the institutional investor is granted such a waiver and subsequently determines to influence or affect the affairs of the issuer, it must provide not less than 30 days notice of such intent and file with the New Jersey Commission an application for qualification before taking any action which may influence or affect the affairs of the issuer, except that an institutional investor holding voting securities shall be permitted to vote on matters put to the vote of the holders of outstanding voting securities. If an institutional investor that has been granted a waiver subsequently changes its investment intent, or if the New Jersey Commission finds reasonable cause to believe that the institutional investor may be found unqualified, no action other than divestiture shall be taken by the investor with respect to the security holdings until there has been compliance with the provisions of the New Jersey Act concerning Interim Casino Authorization. The provisions of the New Jersey Act concerning Interim Casino Authorization provide that whenever a security holder of either equity or debt is required to qualify pursuant to the New Jersey Act, the security holder shall, within 30 days after the New Jersey Commission determines that qualification is required or declines to waive qualification, (i) file a completed application for qualification, along with an executed and approved Trust Agreement, wherein all securities of the holding or intermediary company held by that security holder are placed in trust pending qualification, or (ii) file a notice of intent to divest itself of such securities as the New Jersey Commission may require so as to remove the need for qualification, which securities must be divested within 120 days from the date such determination was made. The New Jersey Act further requires that corporate licensees and their subsidiaries, intermediaries and holding companies adopt certain provisions in their certificates of incorporation that require certain remedial action in the event that an individual owner of any security of such company is found disqualified under the New Jersey Act. The required certificate of incorporation provisions vary depending on whether the stock of the company subject to the requirements of the New Jersey Act is publicly or privately traded. Pursuant to the New Jersey Act, the certificate of incorporation of a publicly held company must provide that any securities of such corporation are held subject to the condition that if a holder is found to be disqualified by the New Jersey Commission pursuant to the New Jersey Act such holder shall dispose of his interest in such company. The certificate of incorporation of a privately held company must create the absolute right of the company to repurchase at the market price or purchase price, whichever is the lesser, any security, share or other interest in the company in the event the New Jersey Commission disapproves a transfer in accordance with the provisions of the New Jersey Act. The Company is a publicly held company and, accordingly, a provision has been placed in the Company's Restated Certificate of Incorporation which provides that a holder of the Company's securities must dispose of such securities if the holder is found disqualified under the New Jersey Act. In addition, the Restated Certificate of Incorporation for the Company provides that the Company may redeem the stock of any holder found to be disqualified. If, at any time, it is determined that Adamar has violated the New Jersey Act or regulations, or if any security holder of the Company, Adamar or Holdings who is required to be qualified under the New Jersey Act is found disqualified but does not dispose of the securities, Adamar could be subject to fines or its license could be suspended or revoked. If Adamar's license is revoked, the New Jersey Commission could appoint a conservator to operate and to dispose of any casino hotel facilities of Adamar. Net proceeds of a sale by a conservator and net profits of operations by a conservator (at least up to an amount equal to a fair return on Adamar's investment which is reasonable for casinos or hotels) would be paid to Adamar. The subsidiaries which conduct the Company's gaming operations in Las Vegas and Laughlin are not required to apply for licensure or qualification under the New Jersey Act, but their certificates of incorporation are required under the New Jersey Act to contain a provision granting them an absolute right to repurchase at the market price or purchase price, whichever is less, any of their respective securities in the event that the New Jersey Commission disapproves a transfer of any such securities. In addition to compliance with the New Jersey Act and regulations relating to gaming, any facility built in Atlantic City by Adamar or any other subsidiary of the Company must comply with the New Jersey and Atlantic City laws and regulations relating to, among other things, the Coastal Area Facilities Review Act, construction of buildings, environmental considerations, operation of hotels and the sale of alcoholic beverages. Gaming Fees and Taxes. The New Jersey Commission is authorized to establish fees for the issuance or renewal of casino licenses. Yearly casino hotel alcoholic beverage license fees are payable for each facility in any of five specified categories in any licensed casino hotel. There is also an annual license fee on each slot machine. The New Jersey Commission is also authorized by regulation to establish annual fees for the issuance and renewal of licenses other than casino licenses. The New Jersey Act imposes an annual tax of eight percent on gross revenues (as defined in the New Jersey Act). In addition, casino licensees are required to invest one and one-quarter percent of gross revenues for the purchase of bonds to be issued by the Casino Reinvestment Development Authority or make other approved investments equal to that amount; in the event the investment requirement is not met, the casino licensee is subject to a tax in the amount of two and one-half percent on gross revenues. EMPLOYEES The Company employs approximately 8,200 people of which approximately 2,700 employees are represented by unions. Of the approximately 4,300 employees at TropWorld, approximately 1,300 are covered by collective bargaining contracts. Substantially all of such employees are covered by a contract that expires in 1994 and the remainder are covered by contracts that expire in 1996. At Tropicana, approximately 1,400 of the 2,400 employees are covered by collective bargaining contracts. Substantially all of such employees are covered by contracts that expire in 1994 and the remainder are covered by contracts that expire in 1995. TRADEMARKS The Company and Adamar of Nevada are the beneficiaries of an agreement with Tropicana Enterprises, the owner of certain properties related to Tropicana, and the Jaffe family regarding the use of the name "Tropicana" for the operation of a casino hotel in Atlantic City and in connection with the operation of a casino hotel in New York State (if gaming were to be authorized in New York State). Pursuant to such agreement, the Company has registered the name under the Lanham Act. Upon the occurrence of certain events, the right to use the name reverts to Tropicana Enterprises. Ramada has licensed the Company to use the name "Ramada" in conjunction with the operation of Ramada Express, and will not use or permit the use of the name "Ramada" in Laughlin, Nevada by any other person or entity. The following trademarks are important to the Company: Aztar, Trop, TropWorld, Trop Park, Tropicana, Tivoli Pier, TropWorld Casino and Entertainment Resort, Ramada Express and Express. There are no other trademarks the use of which is material to the conduct of the Company's business as a whole. ITEM 2. ITEM 2. PROPERTIES - ------------------- TROPWORLD. TropWorld is located on a 10-acre site in Atlantic City, New Jersey. In July 1993, the TropWorld building became wholly-owned by the Company upon the acquisition by the Company of the partnership interests in AREI and AGP. AREI owned a 99.9 percent general partnership interest in AGP, which acquired a substantial interest in TropWorld in a sale-leaseback transaction in 1984. Adamar owns the land on which the TropWorld facilities prior to a 1988 expansion are located, and Atlantic-Deauville owns the land under the expanded facilities. TROPICANA. Tropicana is located on a 34-acre site in Las Vegas, Nevada. Tropicana is owned by Tropicana Enterprises and is leased to HRN, which operates the casino and hotel under the lease ( the "Tropicana Lease") that expires in 2011. The Company, through its wholly-owned subsidiary, Adamar of Nevada, owns a noncontrolling 50% general partnership interest in Tropicana Enterprises. The remaining 50% general partnership interest in Tropicana Enterprises is held by various individuals and trusts associated with the Jaffe family and is entitled to certain preferences on distributions and liquidations. The Company does not have the right to purchase Tropicana from Tropicana Enterprises and does not have the right to purchase the remaining partnership interest in Tropicana Enterprises that is not owned by Adamar of Nevada. RAMADA EXPRESS. Ramada Express is located on a 28-acre site in Laughlin, Nevada. The Company completed in September 1993 a $75 million expansion of Ramada Express. NEW GAMING JURISDICTIONS In connection with the Company's development of its business in new gaming jurisdictions, the Company has options to purchase various parcels of land in Caruthersville, Missouri and Evansville, Indiana. GENERAL. The Company leases its corporate headquarters located in Phoenix, Arizona and owns or leases certain other facilities which are not material to the Company's operations. Substantially all land, casino hotel buildings, furnishings and equipment owned by the Company are pledged as collateral under long-term debt agreements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - -------------------------- The Company is a party to various claims, legal actions and complaints arising in the ordinary course of business or asserted by way of defense or counterclaim in actions filed by the Company. Management believes that its defenses are substantial in each of these matters and that the legal posture of the Company can be successfully defended or satisfactorily settled without material adverse effect on its consolidated financial statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ None EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------ The registrant has elected not to include information concerning its executive officers in its 1993 Proxy Statement, as allowed by the Proxy Statement instructions. The registrant relies on General Instruction G(3) of this report on Form 10-K in presenting the following information on its executive officers. Tenure ----------------- With Present Name Office Age Company Position - ------------------- ---------------------------- --- -------- -------- Paul E. Rubeli Chairman of the Board, 50 15 years 2 years President and Chief Executive Officer Robert M. Haddock Executive Vice President 49 13 years 7 years and Chief Financial Officer Nelson W. Armstrong, Jr. Vice President, 52 21 years 4 years Administration and Secretary Joe C. Cole Vice President, 55 6 years 6 years Corporate Communications Meridith P. Sipek Controller 47 16 years 4 years Craig F. Sullivan Treasurer 47 16 years 4 years Paul E. Rubeli. Mr. Rubeli joined Ramada in 1979 as Group Vice President, Industrial Operations. He served as Executive Vice President, Gaming, of Ramada from 1982 to December 1989, when he was appointed President and Chief Operating Officer of the Company in the Restructuring. He was appointed Chief Executive Officer in February 1990 and Chairman of the Board in addition to his other positions in February 1992. Robert M. Haddock. Mr. Haddock joined Ramada in 1980 and held various positions before becoming Executive Vice President and Chief Financial Officer in March 1987, serving in that capacity until the Restructuring, when he assumed the same position with the Company. Nelson W. Armstrong, Jr. Mr. Armstrong joined Ramada in 1973 as an accounting supervisor and held various positions on the corporate accounting staff, serving as Vice President and Controller of Ramada and then of the Company after the Restructuring until he was appointed Vice President, Administration and Secretary of the Company in March 1990. Joe C. Cole. Mr. Cole joined Ramada in March 1988 as Vice President, Corporate Communications after having been affiliated with Phoenix Newspapers Inc. for 26 years as a reporter, columnist and editor. He became Vice President, Corporate Communications, of the Company in the Restructuring. EXECUTIVE OFFICERS OF THE REGISTRANT (continued) - ------------------------------------------------ Meridith P. Sipek. Mr. Sipek joined Ramada's corporate accounting staff in 1977 as a manager and held various positions in corporate and hotel accounting, serving as Hotel Group Controller before being named Assistant Corporate Controller of Ramada and then of the Company after the Restructuring until he was appointed Controller of the Company in March 1990. Craig F. Sullivan. Mr. Sullivan joined Ramada in 1978 as a treasury analyst and held various Treasury Department positions before being named Assistant Treasurer in May 1982, serving in that capacity in Ramada and in the Company after the Restructuring until he was appointed Treasurer of the Company in March 1990. PART II ------- ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - ------------------------------------------------------------------------------ Aztar had 12,588 shareholders of record as of February 18, 1994. The additional information required by this Item 5 is included in this report on, and. ITEMS 6, 7, and 8 - ----------------- The information required by Item 6 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------------------------------------------------------------------------ FINANCIAL DISCLOSURE - -------------------- None. PART III ITEMS 10, 11, 12 and 13 -------- - ----------------------- The information required by Items 10, 11, 12 and 13 is incorporated by reference to the registrant's definitive Proxy Statement to be filed with the Commission. A cross-referenced index is located on the facing page of this report. Information concerning the registrant's executive officers is presented above under a separate caption in Part I of this report. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------- Page No. (a) 1. Financial Statements: -------- Report of Independent Accountants Consolidated Balance Sheets, December 30, 1993 and December 31, 1992 Consolidated Statements of Operations for the years ended December 30, 1993, December 31, 1992 and January 2, 1992 Consolidated Statements of Cash Flows for the years ended December 30, 1993, December 31, 1992 and January 2, 1992 Consolidated Statements of Shareholders' Equity for the years ended December 30, 1993, December 31, 1992 and January 2, 1992 Notes to Consolidated Financial Statements ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------- (Continued) - ----------- Page No. -------- 2. Financial Statement Schedules: Report of Independent Accountants S-1 V - Property, Plant and Equipment S-2 VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment S-3 VIII - Valuation and Qualifying Accounts S-4 X - Supplementary Income Statement Information S-5 All other schedules are omitted because the required information is either presented in the financial statements or notes thereto, or is not present in amounts sufficient to require submission of the schedules. 3. Exhibits: 3 Articles of Incorporation and By-Laws * 4 Instruments Defining the Rights of Security Holders, Including Indentures * 10 Material Contracts * 11 Statement Regarding Computation of Per Share Earnings * 21 Subsidiaries of the Registrant * 23 Consents of Experts and Counsel * * See exhibit index at page E-1 of this report for a listing of exhibits filed with this report and those incorporated by reference. All other exhibits have been omitted because the information is not required or is not applicable. (b) Reports on Form 8-K: The Company did not file any report on Form 8-K during the quarter ended December 30, 1993. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 No. 33-32399 and No. 33-44794 (filed January 5, 1990 and December 24, 1991, respectively): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. 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. AZTAR CORPORATION By /s/ Robert M. Haddock March 11, 1994 ----------------- ------------------------- ------------------ Registrant Robert M. Haddock Date Executive Vice President (Chief Financial Officer) 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. /s/ Paul E. Rubeli Chairman of the Board, March 11, 1994 - ------------------------- President and Chief ---------------- Paul E. Rubeli Executive Officer /s/ Robert M. Haddock Executive Vice President, March 11, 1994 - ------------------------- Chief Financial Officer ---------------- Robert M. Haddock and Director /s/ Meridith P. Sipek Controller March 11, 1994 - ------------------------- ---------------- Meridith P. Sipek /s/ John B. Bohle Director March 11, 1994 - ------------------------- ---------------- John B. Bohle /s/ E. M. Carson Director March 11, 1994 - ------------------------- ---------------- Edward M. Carson /s/ A. S. Gittlin Director March 11, 1994 - ------------------------- ---------------- A. Sam Gittlin /s/ John R. Norton, III Director March 11, 1994 - ------------------------- ---------------- John R. Norton, III /s/ Robert S. Rosow Director March 11, 1994 - ------------------------- ---------------- Robert S. Rosow /s/ R. Snell Director March 11, 1994 - ------------------------- ---------------- Richard Snell /s/ Terence W. Thomas Director March 11, 1994 - ------------------------- ---------------- Terence W. Thomas /s/ Carroll V. Willoughby Director March 11, 1994 - ------------------------- ---------------- Carroll V. Willoughby REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors Aztar Corporation We have audited the consolidated balance sheets of Aztar Corporation and Subsidiaries as of December 30, 1993 and December 31, 1992, and the related consolidated statements of operations, cash flows and shareholders' equity for each of the three years in the period ended December 30, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Aztar Corporation and Subsidiaries as of December 30, 1993 and December 31, 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 30, 1993 in conformity with generally accepted accounting principles. As discussed in Note 16 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992. COOPERS & LYBRAND Phoenix, Arizona February 11, 1994 AZTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 30, 1993 and December 31, 1992 ---------------------------------------- (in thousands, except share data) 1993 1992 --------- --------- Assets Current assets: Cash and cash equivalents $ 39,551 $ 100,403 Accounts and notes receivable, net 19,170 28,601 Refundable income taxes 2,062 2,062 Inventories 5,564 5,144 Prepaid expenses 9,206 8,208 Deferred income taxes 6,566 13,353 --------- --------- Total current assets 82,119 157,771 Investments in and advances to unconsolidated partnership 13,776 15,225 Other investments 22,131 19,250 Notes receivable -- 246,310 Property and equipment: Buildings and equipment, net 648,139 287,228 Land 81,795 78,853 Construction in progress 6,701 15,718 Leased under capital leases, net 1,043 9,262 --------- --------- 737,678 391,061 Other assets 21,467 19,948 --------- --------- $ 877,171 $ 849,565 ========= ========= The accompanying notes are an integral part of these financial statements. AZTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (continued) December 30, 1993 and December 31, 1992 ---------------------------------------- (in thousands, except share data) 1993 1992 --------- --------- Liabilities and Shareholders' Equity Current liabilities: Accounts payable and accruals $ 39,515 $ 39,749 Accrued payroll and employee benefits 15,823 17,854 Accrued interest payable 13,714 13,365 Income taxes payable 2,633 2,757 Current portion of long-term debt 2,499 3,508 --------- --------- Total current liabilities 74,184 77,233 Long-term debt 404,086 378,058 Other long-term liabilities 21,882 23,334 Deferred income taxes 26,126 34,193 Contingencies and commitments Series B ESOP convertible preferred stock (redemption value $4,295 and $3,118) 3,905 2,998 Shareholders' equity: Common stock, $.01 par value (37,359,011 and 36,977,662 shares outstanding) 414 410 Paid-in capital 346,965 344,574 Retained earnings 16,559 5,787 Less: Treasury stock (16,885) (16,885) Unearned compensation (65) (137) --------- --------- Total shareholders' equity 346,988 333,749 --------- --------- $ 877,171 $ 849,565 ========= ========= The accompanying notes are an integral part of these financial statements. AZTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 30, 1993, December 31, 1992 and January 2, 1992 ----------------------------------- (in thousands, except per share data) 1993 1992 1991 Revenues --------- --------- --------- Casino $439,294 $431,831 $392,917 Rooms 32,248 32,651 36,577 Food and beverage 36,357 37,519 42,040 Other 10,863 10,044 9,751 -------- -------- -------- 518,762 512,045 481,285 Costs and expenses Casino 217,087 202,747 187,189 Rooms 19,495 19,527 21,598 Food and beverage 34,773 35,008 39,229 Other 6,737 6,827 7,211 Marketing 45,427 45,705 41,385 General and administrative 46,849 46,399 46,190 Utilities 12,328 11,617 11,227 Repairs and maintenance 19,953 18,544 18,064 Provision for doubtful accounts 1,566 2,622 4,763 Property taxes and insurance 16,729 16,108 15,391 Net rent 27,747 45,653 47,193 Depreciation and amortization 32,652 28,679 28,191 -------- -------- -------- 481,343 479,436 467,631 -------- -------- -------- Operating income 37,419 32,609 13,654 Interest income 24,172 28,655 26,245 Interest expense (45,363) (31,132) (32,101) -------- -------- -------- Income from continuing operations before other items, income taxes, extraordinary items and cumulative effect of accounting change 16,228 30,132 7,798 Equity in unconsolidated partnership's loss (3,822) (4,125) (5,030) -------- -------- -------- Income from continuing operations before income taxes, extraordinary items and cumulative effect of accounting change 12,406 26,007 2,768 Income taxes (1,024) (9,629) (60) -------- -------- -------- Income from continuing operations before extraordinary items and cumulative effect of accounting change 11,382 16,378 2,708 Discontinued operations -- 1,262 2,553 Extraordinary items -- (5,335) 1,237 Cumulative effect of accounting change -- 7,500 -- -------- -------- -------- Net income $ 11,382 $ 19,805 $ 6,498 ======== ======== ======== The accompanying notes are an integral part of these financial statements. AZTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (continued) For the Years Ended December 30, 1993, December 31, 1992 and January 2, 1992 ----------------------------------- (in thousands, except per share data) 1993 1992 1991 -------- -------- -------- Earnings per common and common equivalent share: Income from continuing operations before extraordinary items and cumulative effect of accounting change $ .28 $ .41 $ .05 Discontinued operations -- .03 .07 Extraordinary items -- (.14) .03 Cumulative effect of accounting change -- .20 -- -------- -------- -------- Net income $ .28 $ .50 $ .15 ======== ======== ======== Earnings per common share assuming full dilution: Income from continuing operations before extraordinary items and cumulative effect of accounting change $ .27 $ .40 $ .05 Discontinued operations -- .03 .06 Extraordinary items -- (.13) .03 Cumulative effect of accounting change -- .19 -- -------- -------- -------- Net income $ .27 $ .49 $ .14 ======== ======== ======== Weighted average common shares applicable to: Earnings per common and common equivalent share 38,367 38,212 38,782 Earnings per common share assuming full dilution 39,429 39,311 39,939 The accompanying notes are an integral part of these financial statements. AZTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 30, 1993, December 31, 1992 and January 2, 1992 -------------- (in thousands) 1993 1992 1991 ---------- ---------- ---------- Cash Flows from Operating Activities Net income $ 11,382 $ 19,805 $ 6,498 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 34,577 30,639 31,048 Provision for losses on accounts receivable 1,566 2,622 4,763 Loss on reinvestment obligation 991 1,103 1,060 Interest income 1,889 (4,389) (2,144) Rent expense (880) (2,537) (2,527) Distribution in excess of equity in income of partnership 1,449 1,355 1,393 Deferred income taxes (1,280) (1,556) (41) Change in assets and liabilities: (Increase) decrease in accounts receivable (1,442) (1,372) (15) (Increase) decrease in refundable income taxes -- (2,062) -- (Increase) decrease in inventories and prepaid expenses (1,969) (1,582) (1,332) Increase (decrease) in accounts payable, accrued expenses and income taxes payable 1,955 (12,745) (2,776) Other items, net 2,087 2,502 3,245 --------- --------- --------- Net cash provided by (used in) operating activities 50,325 31,783 39,172 --------- --------- --------- Cash Flows from Investing Activities Reduction (increase) in invested funds -- 5,075 (5,075) Payments received on TropWorld second mortgage 24,400 51,450 45,900 Payments received on other notes receivable 2,191 2,383 3,075 Increase in TropWorld second mortgage (24,400) (51,450) (45,900) Increase in other notes receivable (419) (174,678) (3,252) Purchases of property and equipment (77,804) (20,607) (18,400) Acquisition of AREI/AGP partnership interests, net of cash acquired (61,859) -- -- Additions to other long-term assets (7,360) (10,893) (3,489) --------- --------- --------- Net cash provided by (used in) investing activities $(145,251) $(198,720) $ (27,141) -------- -------- -------- The accompanying notes are an integral part of these financial statements. AZTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) For the Years Ended December 30, 1993, December 31, 1992 and January 2, 1992 -------------- (in thousands) 1993 1992 1991 Cash Flows from Financing Activities --------- --------- --------- Proceeds from issuance of long-term debt $ 35,000 $200,000 -- Proceeds from issuance of common stock 2,149 261 $ 35 Principal payments on long-term debt (2,157) (3,787) (3,902) Repurchase of common stock -- (5,364) (224) Preferred stock dividend (787) (797) (800) Redemption of preferred stock (131) (90) (24) Redemption of Holdings preferred stock -- -- (4,131) -------- -------- -------- Net cash provided by (used in) financing activities 34,074 190,223 (9,046) -------- -------- -------- Net increase (decrease) in cash and cash equivalents (60,852) 23,286 2,985 Cash and cash equivalents at beginning of year 100,403 77,117 74,132 -------- -------- -------- Cash and cash equivalents at end of year $ 39,551 $100,403 $ 77,117 ======== ======== ======== Supplemental Cash Flow Disclosures Acquisition of AREI/AGP partnership interests: Working capital, other than cash $ 3,370 $ -- $ -- Notes receivable 242,605 -- -- Building and equipment (307,582) -- -- Capital lease assets, net 6,703 -- -- Long-term debt (5,682) -- -- Other long-term liabilities (1,273) -- -- -------- -------- -------- Net cash used in acquisition (61,859) -- -- Summary of non-cash investing and financing activities: Capital lease obligations incurred for property and equipment $ 385 $ 3,687 $ 3,282 Note received in sale of property and equipment -- 225 -- Tax benefit from stock options and preferred stock dividend 431 290 -- Issuance of restricted stock -- -- 210 Forfeiture of restricted stock -- 30 -- Cash paid (refunded) during the year for the following for continuing and discontinued operations: Interest, net of amount capitalized $ 43,160 $ 31,905 $ 28,883 Income taxes 1,997 8,165 (408) The accompanying notes are an integral part of these financial statements. AZTAR CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY For the Years Ended December 30, 1993, December 31, 1992 and January 2, 1992 ------------- (in thousands) Retained Unearned Common Paid-in Earnings Treasury Compen- Stock Capital (Deficit) Stock sation Total Balance, -------- -------- --------- --------- --------- -------- January 3, 1991 $ 409 $343,990 $(19,130) $(11,267) $(1,231) $312,771 Stock options exercised 35 35 Issuance of restricted stock 210 (210) -- Repurchase of common stock (224) (224) Preferred stock dividend (800) (800) Amortization of unearned compensation 620 620 Net income 6,498 6,498 Balance, -------- -------- -------- -------- -------- -------- January 2, 1992 409 344,235 (13,432) (11,491) (821) 318,900 Stock options exercised 1 260 261 Tax benefit from stock options exercised 79 79 Repurchase of common stock (5,364) (5,364) Preferred stock dividend, net of income tax benefit (586) (586) Forfeitures of restricted stock (30) 30 -- Amortization of unearned compensation 654 654 Net income 19,805 19,805 Balance, -------- -------- -------- -------- -------- -------- December 31, 1992 410 344,574 5,787 (16,885) (137) 333,749 Stock options exercised 4 2,145 2,149 Tax benefit from stock options exercised 246 246 Preferred stock dividend, net of income tax benefit (610) (610) Amortization of unearned compensation 72 72 Net income 11,382 11,382 Balance, -------- -------- -------- -------- -------- -------- December 30, 1993 $ 414 $346,965 $ 16,559 $(16,885) $ (65) $346,988 ======== ======== ======== ======== ======== ======== The accompanying notes are an integral part of these financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidated Statements Aztar Corporation ("Aztar" or the "Company") was incorporated in Delaware in June 1989 to operate the gaming business of Ramada Inc. ("Ramada") after the restructuring of Ramada (the "Restructuring"). The Restructuring involved the disposition of Ramada's hotel and restaurant businesses with Ramada's shareholders retaining their interest in the gaming business. As part of the Restructuring, the gaming business and certain other assets and liabilities of Ramada were transferred to Aztar, and a wholly-owned subsidiary of New World Hotels (U.S.A.), Inc. was merged with Ramada (the "Merger"). In the Merger, each share of Ramada common stock was converted into the right to receive $1.00 and one share of Aztar common stock. For accounting purposes Aztar is treated as the continuing accounting entity that is the successor to the historical Ramada and that has discontinued the hotel and restaurant businesses. The consolidated financial statements include the accounts of Aztar and all of its controlled subsidiaries and partnerships. All subsidiary companies are wholly owned. Ramada New Jersey Holdings Corporation ("Holdings") was majority owned until January 4, 1991, when it redeemed its outstanding shares of Convertible Class A Preferred Stock and became wholly owned. In consolidating, all material intercompany transactions are eliminated. The Company uses a 52/53 week fiscal year ending on the Thursday nearest December 31, which includes 52 weeks in 1993, 1992 and 1991. Cash and Cash Equivalents Highly liquid investments purchased with an original maturity of three months or less are classified as cash equivalents. These instruments are stated at cost, which approximates fair value because of their short maturity. Inventories Inventories, which consist primarily of food, beverage and operating supplies, are stated at the lower of cost or market value. Costs are determined using the first-in, first-out method. Property and Equipment Property and equipment are stated at cost. During construction, the Company capitalizes interest and other direct and indirect development costs. Interest is capitalized monthly by applying the effective interest rate on certain borrowings to the average balance of expenditures. Capitalized interest was $3,491,000 in 1993, $1,061,000 in 1992 and $253,000 in 1991. Depreciation and amortization are computed by the straight-line method based upon the following useful lives: buildings and improvements, 3-40 years; furniture and equipment, 3-15 years; and leasehold improvements, shorter of lease term or asset useful life. Accumulated depreciation and amortization on buildings and equipment was $139,690,000 at December 30, 1993 and $112,442,000 at December 31, 1992. Improvements, renewals and extraordinary repairs that extend the life of the asset are capitalized; other repairs and maintenance are expensed. The cost and accumulated depreciation applicable to assets retired are removed from the accounts and the gain or loss, if any, on disposition is recognized in income as realized. Deferred Charges Note and loan issuance costs are amortized using the interest method. Costs incurred to obtain initial gaming licenses to operate a casino are capitalized and amortized over ten years; subsequent renewal costs are amortized over the renewal period. Preopening costs directly related to the opening of a gaming operation or major addition to a gaming operation are capitalized as incurred and expensed in the period the related facility commences operations. Revenue Recognition Casino revenue consists of gaming win net of losses. Revenues exclude the retail value of complimentary food and beverage, accommodations and other goods and services provided to customers. The estimated costs of providing such complimentaries have been classified as casino expenses through interdepartmental allocations as follows (in thousands): 1993 1992 1991 -------- -------- -------- Rooms $ 18,992 $ 14,930 $ 12,130 Food and beverage 33,287 30,568 26,795 Other 6,666 6,509 6,033 -------- -------- -------- $ 58,945 $ 52,007 $ 44,958 ======== ======== ======== Interest Rate Swap Agreement The differential to be paid or received is recognized in interest expense as incurred. Income Taxes Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been included in the financial statements or income tax returns. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted rates expected to apply to taxable income in the years in which those 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 income in the period that includes the enactment date. Earnings Per Share Earnings per common and common equivalent share are computed based on the weighted average number of common shares outstanding after consideration of the dilutive effect of stock options. Earnings per common share, assuming full dilution, are computed based on the weighted average number of common shares outstanding after consideration of the dilutive effect of stock options and the assumed conversion of the preferred stock at the stated rate. In calculating the 1993, 1992 and 1991 earnings per share for both computations, dividends of $610,000, $586,000 and $800,000, respectively, on the Series B ESOP Convertible Preferred Stock are deducted in arriving at income applicable to the common stock. The 1993 and 1992 dividends are net of income tax benefits of $185,000 and $211,000, respectively. Reclassifications Certain reclassifications have been made in the 1992 Consolidated Balance Sheet in order to be comparable with the 1993 presentation. NOTE 2. ACCOUNTS RECEIVABLE The Company's principal operations are conducted in Atlantic City, New Jersey, at TropWorld and in Las Vegas and Laughlin, Nevada, at Tropicana and Ramada Express. TropWorld has a concentration of credit risk in the northeast region of the U.S. Approximately 50% of the receivables at the Nevada operations are concentrated in Asian and Latin American customers and the remainder of their receivables are concentrated in California and the southwest region of the U.S. As a general policy, the Company does not require collateral for these receivables. At December 30, 1993 and December 31, 1992, the net receivables at TropWorld were $8,948,000 and $10,372,000, respectively, and the net receivables at Tropicana and Ramada Express combined were $10,175,000 and $10,575,000, respectively. An allowance for doubtful accounts is maintained at a level considered adequate to provide for possible future losses. At December 30, 1993 and December 31, 1992, the allowance for doubtful accounts was $9,908,000 and $13,124,000, respectively. NOTE 3. INVESTMENTS IN AND ADVANCES TO UNCONSOLIDATED PARTNERSHIP The Company's investment in unconsolidated partnership is a noncontrolling partnership interest of 50% in Tropicana Enterprises, a Nevada general partnership that owns the real property and certain personal property that the Company leases in the operation of Tropicana. The Company uses the equity method of accounting for this investment and in connection with the lease expensed rents of $12,684,000 in 1993, $12,815,000 in 1992 and $14,545,000 in 1991, of which 50% was eliminated in consolidation. Summarized balance sheet information and operating results for the unconsolidated partnership are as follows (in thousands): 1993 1992 -------- -------- Current assets $ 270 $ 272 Noncurrent assets 81,220 83,504 Current liabilities 1,516 1,320 Noncurrent liabilities 73,033 73,713 1993 1992 1991 -------- -------- -------- Revenues $ 12,815 $ 12,980 $ 14,717 Operating expenses (2,755) (2,836) (2,837) -------- -------- -------- Operating income 10,060 10,144 11,880 Interest expense (3,793) (4,318) (6,129) -------- -------- -------- Net income $ 6,267 $ 5,826 $ 5,751 ======== ======== ======== The Company's share of the above operating results, after intercompany eliminations, is as follows (in thousands): 1993 1992 1991 -------- -------- -------- Equity in unconsolidated partnership's loss $ (3,822) $ (4,125) $ (5,030) NOTE 4. OTHER INVESTMENTS The Company satisfies a New Jersey assessment based upon its casino revenues by purchasing bonds issued by the Casino Reinvestment Development Authority ("CRDA"). Deposits with the CRDA bear interest at two-thirds of market rates resulting in a fair value lower than cost. At December 30, 1993 and December 31, 1992, other investments consisted of the Company's deposit with the CRDA of $31,726,000 and $27,853,000, respectively, net of a valuation allowance of $9,595,000 and $8,603,000, respectively. NOTE 5. NOTES RECEIVABLE At December 30, 1993 and December 31, 1992, notes receivable consisted of (in thousands): 1993 1992 -------- -------- First Mortgage $ -- $171,000 Second Mortgage -- 69,859 FF&E Mortgage -- 24,855 -------- -------- -- 265,714 Less: Deferred gain -- (12,966) Current portion -- (6,438) -------- -------- $ -- $246,310 ======== ======== In July 1993, the Company acquired the partnership interests in Ambassador Real Estate Investors, L.P. ("AREI") and Ambassador General Partnership ("AGP"). AREI owned a 99.9% general partnership interest in AGP, which acquired a substantial interest in TropWorld in a sale-leaseback transaction in 1984. The above notes receivable from AGP together with the cash paid by Aztar were replaced on Aztar's balance sheet by the assets acquired. In November 1992, the Company loaned $171,000,000 principal amount (the "First Mortgage") to AGP. AGP used the funds to redeem $171,000,000 of its outstanding 12% First Mortgage Notes Due 1996. As modified by another agreement, the First Mortgage bore interest at a rate of 16% and was payable quarterly. The Second Mortgage bore interest at 16 1/2% payable annually. Under the terms of the Second Mortgage, the Company advanced funds to AGP and AREI for cash flow shortfalls, including any unpaid interest on the Second Mortgage. The Company funded AGP's purchase of replacement furniture, fixtures and equipment by 5-year loans collateralized by the FF&E Mortgage from AGP. Each loan accrued interest at the rate of 16 1/2% compounded annually. No principal or interest payments were made on such loans until maturity. The furniture, fixtures and equipment were leased back to the Company by AGP under 5-year leases. At December 31, 1992, the estimated cost for AGP to raise debt in the public bond markets was approximately 13%. Based on a 13% interest rate, the approximate fair values as of December 31, 1992 were $179,326,000 for the First Mortgage, $81,129,000 for the Second Mortgage and $26,274,000 for the FF&E Mortgage. NOTE 6. LONG-TERM DEBT At December 30, 1993 and December 31, 1992, long-term debt included (in thousands): 1993 1992 13 1/2% First Mortgage Notes Due 1996 ($170,000 -------- -------- principal amount, 13.7% effective interest rate); redeemable beginning September 15, 1994 at 100.00%; net of unamortized discount $169,133 $168,882 11% Senior Subordinated Notes Due 2002; redeemable beginning October 1, 1997 at 103.143% 200,000 200,000 $50 million revolving credit note; floating rate, 6.44% at December 30, 1993; matures June 30, 1996 25,000 -- $10 million revolving credit note; floating rate, 6 1/4 % at December 30, 1993; matures December 31, 1994 10,000 -- Other mortgage loans; 7%; maturities to 1999 907 1,037 Notes payable, other; 7%; maturities to 1999 168 196 Obligations under capital leases 1,377 11,451 -------- -------- 406,585 381,566 Less current portion (2,499) (3,508) -------- -------- $404,086 $378,058 ======== ======== Maturities of long-term debt for the five years subsequent to December 30, 1993 are as follows (in thousands): Year 1994 $ 2,499 1995 12,527 1996 191,357 1997 311 1998 331 On December 20, 1989, the Company, through a wholly-owned, special-purpose subsidiary, issued $170,000,000 principal amount of 13 1/2% First Mortgage Notes Due September 15, 1996 (the "First Mortgage Notes"). Interest on the First Mortgage Notes is payable semiannually on March 15 and September 15. The First Mortgage Notes are redeemable at par at the option of the Company, in whole or in part, on or after September 15, 1994. Mandatory annual sinking fund payments of $2,000,000, commencing September 15, 1994, are calculated to retire $4,000,000 principal amount of the First Mortgage Notes prior to maturity. Upon change of control of the Company, the holders of the First Mortgage Notes would have the right to require the First Mortgage Notes to be repurchased at par plus accrued interest. Payment of principal and interest on the First Mortgage Notes is unconditionally guaranteed by the Company and is collateralized by TropWorld. On October 8, 1992, the Company issued $200,000,000 principal amount of 11% Senior Subordinated Notes Due October 1, 2002 (the "Subordinated Notes"). Interest on the Subordinated Notes is payable semiannually on April 1 and October 1. The Subordinated Notes are redeemable at the option of the Company, in whole or in part, on or after October 1, 1997, at prices from 103.143% of the principal amount plus interest declining to 100% plus interest beginning October 1, 1999. The Subordinated Notes are general unsecured obligations of the Company and are subordinated in right of payment to all present and future Senior indebtedness (as defined) of the Company. Upon change of control of the Company, the holders of the Subordinated Notes would have the right to require repurchase of the Subordinated Notes at par plus accrued interest but their rights would be subordinated to the right of the holders of the First Mortgage Notes to receive payment if the holders of the First Mortgage Notes exercise their right to require repurchase. In connection with an expansion of Ramada Express that was completed in September 1993, the Company converted its construction and term loan credit facility into a $50 Million Revolving Credit Note pursuant to the terms of the First Amended and Restated Credit Agreement, dated December 28, 1993 (the "$50 Million Credit Facility"). The maximum principal amount that can be outstanding may not exceed $50,000,000 at any one time. Interest is payable monthly on the outstanding principal balance at a rate of prime plus 1/2 %. The Company may elect to pay interest based on a one, two or three month LIBOR rate plus 2 1/4%. The Company incurs a commitment fee of 0.5% per annum on the unused portion of this credit facility. The $50 Million Credit Facility matures on June 30, 1996 and is collateralized by Ramada Express. The Company may request that the maturity date be extended for one-year periods at the lenders' discretion. At the Company's option, the credit facility can be converted to a three-year reducing revolving credit facility whereby the maximum principal amount that can be outstanding will be reduced by 1/12 each quarter. In connection with the AREI/AGP acquisition, the Company borrowed $10,000,000 under a $10 million Revolving Credit Note pursuant to the Revolving Credit Loan Agreement, dated July 29, 1993 (the "$10 Million Credit Facility"). Borrowings under the $10 Million Credit Facility may not exceed $10,000,000 principal amount at any one time. Interest is payable monthly on the unpaid principal balance at a rate of prime plus 1/4%. The $10 Million Credit Facility matures on December 31, 1994. Certain covenants in the First Mortgage Notes and the Subordinated Notes limit the ability of the Company to incur indebtedness, sell or encumber any of the applicable collateral or engage in mergers, consolidations or sales of assets. A covenant related to the First Mortgage Notes limits the amount of cash dividends that the Company may pay to $3,814,000 as of December 30, 1993. At December 30, 1993 and December 31, 1992, based on the bid prices in the public bond markets, the fair value of the First Mortgage Notes was 105.125% and 107.25%, respectively, of the principal amount and the fair value of the Subordinated Notes was 101.75% and 100%, respectively, of the principal amount. The estimated fair value of both revolving credit notes approximates the carrying amount due to the short maturity of these notes. Substantially all of the Company's properties are pledged as collateral under long-term debt agreements. NOTE 7. INTEREST RATE SWAP AGREEMENT The Company had outstanding an interest rate swap agreement with a commercial bank. This agreement had a notional principal amount of $50,000,000 and matured on December 31, 1991. Under the terms of the agreement, the Company made annual interest payments to the bank based on a fixed rate of 12.41%, and the bank made quarterly interest payments to the Company based on the LIBOR rate. NOTE 8. LEASE OBLIGATIONS The Company is a lessee under a number of noncancelable lease agreements involving land, buildings, leasehold improvements and equipment, some of which provide for contingent rentals based on the consumer price index and/or interest rate fluctuations. The leases extend for various periods up to 18 years and generally provide for the payment of executory costs (taxes, insurance and maintenance) by the Company. Certain of these leases have provisions for renewal options ranging from 3 to 10 years, primarily under similar terms, and/or options to purchase at various dates. Properties leased under capital leases are as follows (in thousands): 1993 1992 -------- -------- Furniture and equipment $ 9,410 $ 54,751 Less accumulated amortization (8,367) (45,489) -------- -------- $ 1,043 $ 9,262 ======== ======== Amortization of furniture and equipment leased under capital leases, computed on a straight-line basis, was $1,899,000 in 1993, $3,533,000 in 1992 and $3,667,000 in 1991. Minimum future lease obligations on long-term, noncancelable leases in effect at December 30, 1993 are as follows (in thousands): Year Capital Operating ---- -------- --------- 1994 $ 425 $ 8,147 1995 417 8,000 1996 214 7,856 1997 146 7,469 1998 146 7,347 Thereafter 330 87,086 -------- -------- 1,678 $125,905 ======== Amount representing interest (301) -------- Net present value 1,377 Less current portion (331) -------- Long-term portion $ 1,046 ======== The above net present value is computed based on specific interest rates determined at the inception of the leases. Net rent expense is detailed as follows (in thousands): 1993 1992 1991 -------- -------- -------- Minimum rentals $ 30,565 $ 51,647 $ 51,133 Contingent rentals 7,512 12,377 14,118 Less: Minimum lease income (2,773) (5,544) (5,544) Maintenance reimbursement (7,557) (12,827) (12,514) -------- -------- -------- $ 27,747 $ 45,653 $ 47,193 ======== ======== ======== NOTE 9. OTHER LONG-TERM LIABILITIES At December 30, 1993 and December 31, 1992, other long-term liabilities consisted of (in thousands): 1993 1992 -------- -------- Accrued rent expense $ 13,684 $ 15,837 Deferred compensation and retirement plans 8,044 7,343 Deferred income 154 154 -------- -------- $ 21,882 $ 23,334 ======== ======== NOTE 10. REDEEMABLE PREFERRED STOCK A series of preferred stock consisting of 100,000 shares has been designated Series B ESOP Convertible Preferred Stock (the "ESOP Stock") and those shares were issued on December 20, 1989, to the Company's Employee Stock Ownership Plan (the "ESOP"). The ESOP purchased the shares for $10,000,000 with funds borrowed from a subsidiary of the Company. These funds are repayable in even semiannual payments of principal and interest at 13 1/2% per year over a 10-year term. During 1993, 1992 and 1991, respectively, 1,203 shares, 878 shares and 239 shares were redeemed primarily in connection with employee terminations. The ESOP Stock has an annual dividend rate of $8.00 per share per annum payable semiannually in arrears. These shares have no voting rights except under certain limited, specified conditions. Shares not allocated to participant accounts and those shares not vested may be redeemed at $100 per share. Shares may be converted into common stock at $9.46 and have a liquidation preference of $100 per share. The shares that have been allocated to the ESOP participant accounts and have vested are redeemable at the higher of appraised value, conversion value or $100 per share, by the participant upon termination. The excess of the redemption value of the ESOP Stock over the carrying value is charged to retained earnings upon redemption. In the event of default in the payment of dividends on the ESOP Stock for six consecutive semiannual periods, each outstanding share would have one vote per share of common stock into which the preferred stock is convertible. NOTE 11. CAPITAL STOCK The Company is authorized to issue 10,000,000 shares of preferred stock, par value $.01 per share, issuable in series as the Board of Directors may designate. Approximately 40,000 shares of preferred stock have been designated Series A Junior Participating Preferred Stock but none have been issued. The Company is authorized to issue 100,000,000 shares of common stock with a par value of $.01 per share. Shares issued were 41,351,153 at December 30, 1993 and 41,012,323 at December 31, 1992. Common stock outstanding was net of 3,992,142 and 4,034,661 treasury shares at December 30, 1993 and December 31, 1992, respectively. One preferred stock purchase right (a "Right") is attached to each share of the Company's common stock. Each Right will entitle the holder, subject to the occurrence of certain events, to purchase a unit with no par value (a "Unit") consisting of one one-thousandth of a share of Series A Junior Participating Preferred Stock at a purchase price of $40.00 per Unit subject to adjustment. The Rights will expire in December 1999 if not earlier redeemed by the Company at $.01 per Right. The Company issued 42,000 shares of restricted stock in 1991, on which the restrictions will lapse over a three-year period, commencing on the date of issuance, to certain executive officers and key employees. Compensation expense in connection with these and prior issuances, recognized in 1993, 1992 and 1991, respectively, was $72,000, $654,000 and $620,000. In accordance with the Merger agreement, 666,572 shares of common stock that had not been claimed by the shareholders of Ramada were returned to the Company in December 1990 to be held as treasury shares until claimed. During 1993, 1992 and 1991, respectively, 42,519, 60,179 and 117,117 shares were claimed; the balance of unclaimed shares was 446,757 as of December 30, 1993. During 1990, the Board of Directors authorized the Company to make discretionary repurchases of up to 4,000,000 shares of its common stock from time to time in the open market or otherwise and at December 30, 1993, there remains 591,900 shares that could be repurchased under this authority. During 1992 the Company repurchased 1,025,100 shares of common stock. None were repurchased under this program in 1993 or 1991. During 1991, under a separate odd-lot buyback program, the Company repurchased 49,857 shares of common stock. During 1992, 3,779 shares of restricted stock that were issued in 1989 were forfeited. Repurchased and forfeited shares are stated at cost and held as treasury shares to be used for general corporate purposes. Effective July 18, 1990, the Company adopted a stock option plan for directors who are not employees of the Company ("Nonemployee Director Stock Option Plan"). As of December 30, 1993, 71,000 common shares were reserved under the Nonemployee Director Stock Option Plan. During 1993, options were granted for 9,000 shares at $6.75 per share; during 1992, options were granted for 5,000 shares at $6.75 per share and 9,000 shares at $5.50 per share; during 1991, options were granted for 8,000 shares at $6.50 per share. All options granted under the Nonemployee Director Stock Option Plan are immediately exercisable on the date of grant and expire ten years from the date of grant. At December 30, 1993, December 31, 1992 and January 2, 1992, common shares reserved for future grants of options under this plan were 179,000, 188,000 and 202,000, respectively. Changes in the number of common shares reserved under the Company's employee stock option plans are as follows (in thousands of shares): Number of Price Range Shares of Options --------- ----------- Balance, January 3, 1991 2,992 $3.19-$8.15 Granted 900 $5.00 Exercised (11) $3.19 Cancelled, expired or surrendered (14) $5.83 -------- Balance, January 2, 1992 3,867 $3.19-$8.15 Granted 135 $6.88 Exercised (82) $3.19 Cancelled, expired or surrendered (87) $3.19-$8.15 -------- Balance, December 31, 1992 3,833 $3.19-$8.15 Granted 50 $7.63 Exercised (339) $3.19-$8.15 Cancelled, expired or surrendered (42) $6.49-$8.15 -------- Balance, December 30, 1993 3,502 $3.19-$8.15 ======== At December 30, 1993, December 31, 1992 and January 2, 1992, options exercisable under the Company's employee stock option plans were 3,077,000, 3,118,000 and 2,238,000, respectively; shares reserved for future grants were 1,797,000, 1,805,000 and 1,849,000, respectively. In addition to the common shares reserved under stock option plans at December 30, 1993, the Company has 1,033,000 common shares reserved for the conversion of the ESOP Stock. The Company also has 40,563 shares of preferred stock reserved for exercise of the Rights. NOTE 12. BENEFIT PLANS The Company has a pension plan, which is not currently funded, for certain former executive employees. The Company has a nonqualified retirement plan, which is not required to be funded by the Company, for certain senior executives. The Company has a savings plan that covers substantially all employees who are not covered by a collective bargaining unit. Contributions to the savings plan are discretionary. Total pension and savings plan expense was $689,000 for 1993, $662,000 for 1992 and $900,000 for 1991. The Company also contributed $1,990,000, $1,834,000 and $1,881,000 in 1993, 1992 and 1991, respectively, to trusteed pension plans under various collective bargaining agreements. The Company has a deferred compensation plan for designated executives and a similar plan for outside directors. The plans provide for the payment of benefits commencing at retirement. The Company is substantially funding the plans through the purchase of life insurance. Net expense recognized in 1993, 1992 and 1991 was $180,000, $184,000 and $103,000, respectively. In connection with Restructuring, the Company adopted the ESOP that covers substantially all non-union employees. The Company will make contributions to the ESOP so that, after the dividends are paid on the Company's ESOP Stock, the ESOP can make its debt service payments to the Company. Cash dividends and contributions, respectively, paid to the ESOP were $787,000 and $1,088,000 in 1993, $797,000 and $1,078,000 in 1992, and $800,000 and $1,076,000 in 1991. Compensation expense recognized in 1993, 1992 and 1991, respectively, was $1,311,000, $1,400,000 and $1,482,000. NOTE 13. INCOME TAXES The (provision) benefit for income taxes for continuing operations before extraordinary items and cumulative effect of accounting change is comprised of (in thousands): 1993 1992 1991 Current: -------- -------- -------- Federal $ (2,231) $ (3,685) $ 1,136 State (73) -- -- --------- -------- -------- (2,304) (3,685) 1,136 Deferred: -------- -------- -------- Federal 378 (5,303) 41 State 902 (641) -- -------- -------- -------- 1,280 (5,944) 41 -------- -------- -------- Charge in lieu of income taxes -- -- (1,237) -------- -------- -------- $ (1,024) $ (9,629) $ (60) ======== ======== ======== The Company is responsible, with certain exceptions, for the taxes of Ramada through December 20, 1989. In 1991, the Company settled the Internal Revenue Service's examination of Ramada's income tax returns for the years 1984 and 1985 and paid taxes and interest of $17,495,000 in January 1992. The tax liability was less than that provided and the Company recorded a continuing operations benefit of $1,264,000 in 1991. The Internal Revenue Service is examining the income tax returns for the years 1986 through 1991. The New Jersey Division of Taxation is examining the income tax returns for the years 1983 through 1988. Management believes that adequate provision for income taxes and interest has been made in the financial statements. General business credits are taken as a reduction of the provision for federal income taxes during the year such credits become available. The following table provides a reconciliation between the federal statutory rates and the (provision) benefit for income taxes when both are expressed as a percentage of pretax income. 1993 1992 1991 -------- -------- -------- Tax (provision) benefit at statutory rate (35.0)% (34.0)% (34.0)% (Increase) decrease in tax resulting from: State income taxes 4.3 (6.1) -- Contributions and gifts (.6) (.5) (6.1) Disallowance of business meals (4.1) (2.2) (11.1) Capitalized restructuring costs .8 2.3 13.5 Restricted stock and non-qualified stock options .7 -- (3.1) Casino license amortization -- -- (3.1) IRS examination (7.9) 3.6 42.2 Targeted jobs tax credit 4.2 1.5 -- Change in valuation allowance 30.3 -- -- Other, net (1.0) (1.6) (.5) ------- ------- ------- (8.3)% (37.0)% (2.2)% ======= ======= ======= The income tax effects of loss carryforwards, tax credit carryforwards and temporary differences between financial and income tax reporting that give rise to the deferred income tax assets and liabilities at December 30, 1993 and December 31, 1992, are as follows (in thousands): 1993 1992 --------- --------- Net operating loss carryforward $ 21,902 $ 26,505 Accrued rent expense 4,818 11,856 Accrued bad debt expense 3,972 6,081 Accrued compensation 5,030 4,737 Accrued liabilities 2,396 1,205 General business credit carryforward 2,887 2,066 -------- -------- Gross deferred tax assets 41,005 52,450 -------- -------- Deferred tax asset valuation allowance (20,974) (24,732) -------- -------- Other (1,528) (1,195) Partnership investment (5,328) (4,704) Depreciation and amortization (12,199) (20,544) Ramada tax sharing agreement (20,536) (22,115) -------- --------- Gross deferred tax liabilities (39,591) (48,558) -------- -------- Net deferred tax liabilities $(19,560) $(20,840) ======== ======== Included in the valuation allowance is $520,000 that will be allocated to shareholders' equity when recognized. The deferred tax amounts were adjusted in 1993 for the effect of legislation that increased the federal income tax rate from 34% to 35%. The net effect of this change was not significant. The December 31, 1992 valuation allowance was reduced during 1993 due to the generation of taxable income that resulted in the utilization of a portion of the net operating loss carryforward. The effect of this reduction was to decrease the 1993 income tax expense by $3,878,000. At December 30, 1993, tax benefits are available for federal income tax purposes as follows (in thousands): Net operating losses $ 40,466 General business credits 2,121 These tax benefits will expire in the years 2003 through 2008 if not used. The Company also has alternative minimum tax credit carryforwards of $766,000 that can be carried forward indefinitely and offset against the regular federal income tax liability. In addition, the Company has net operating loss carryforwards for state income tax purposes that will expire in the following years if not used (in thousands): 1994 $13,705 1995 26,377 1996 13,300 1997 15,962 1998 6,334 2000 10,307 A valuation allowance has been established for those federal and state tax benefits which are not expected to be realized. NOTE 14. DISCONTINUED OPERATIONS In 1989, the Company disposed of its hotel business and the following items are related to this discontinued operation. In 1992, the Company reached a settlement with Canadian tax authorities in relation to the 1988 and 1989 income tax returns of Ramada Inc. and received a refund of $1,262,000. In 1991, the Company recorded a tax benefit of $1,861,000 in connection with the settlement discussed in "Note 13. Income Taxes". In another matter, but also in 1991, the Company reached a settlement with Canadian tax authorities and received a refund of $692,000. NOTE 15. EXTRAORDINARY ITEMS A substantial portion of the proceeds from the issuance of the Subordinated Notes were loaned to AGP to redeem its 12% First Mortgage Notes Due 1996. In connection with the debt redemption, the Company paid a prepayment premium and expensed its remaining deferred financing costs. These items were reflected in the 1992 Consolidated Statement of Operations as an extraordinary loss of $5,335,000, net of an income tax benefit of $2,749,000. The Company has a net operating loss carryforward from 1989. A portion of the tax benefit of the 1989 loss was offset against the 1991 provision for income taxes as an extraordinary item because the tax benefit of the 1989 loss could not have been recorded previously. NOTE 16. CUMULATIVE EFFECT OF ACCOUNTING CHANGE In February 1992, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS 109"), which superseded Statement of Financial Accounting Standards No. 96 with the same title ("SFAS 96"). SFAS 96 was never adopted by the Company. The Company adopted the provisions of SFAS 109 in the first quarter of 1992 and elected not to restate prior year financial statements. The effect from prior years of adopting SFAS 109 as of the beginning of fiscal 1992 was a net deferred income tax benefit of $7,500,000 and it was reflected in the 1992 Consolidated Statement of Operations as the Cumulative effect of accounting change. The income tax effects of loss carryforwards, tax credit carryforwards and temporary differences between financial and income tax reporting that give rise to the deferred income tax assets and liabilities at January 2, 1992, under the provisions of SFAS 109, are as follows (in thousands): Deferred Income Tax -------------------------- Assets Liabilities --------- ------------ Net operating loss carryforward $ 26,058 Accrued rent expense 12,914 Accrued bad debt expense 5,770 Accrued compensation 3,572 Accrued liabilities 2,199 General business credit carryforward 1,407 Other 618 Partnership investment $ 4,963 Depreciation and amortization 14,472 Ramada tax sharing agreement 22,437 -------- --------- 52,538 $ 41,872 ========= Valuation allowance (25,562) -------- $ 26,976 ======== Included in the valuation allowance is $505,000 that will be allocated to shareholders' equity when recognized. NOTE 17. CONTINGENCIES AND COMMITMENTS The Company agreed to indemnify Ramada against all monetary judgments in lawsuits pending against Ramada and its subsidiaries as of the conclusion of the Restructuring on December 20, 1989, as well as all related attorneys' fees and expenses not paid at that time, except for any judgments, fees or expenses accrued on the hotel business balance sheet and except for any unaccrued and unreserved aggregate amount up to $5,000,000 of judgments, fees or expenses related exclusively to the hotel business. Aztar is entitled to the benefit of any crossclaims or counterclaims related to such lawsuits and of any insurance proceeds received. In addition, the Company agreed to indemnify Ramada for various lease guarantees made by Ramada relating to the restaurant business conducted through its Marie Callender Pie Shops, Inc. ("MCPSI") subsidiary. In connection with these matters the Company has an accrued liability of $3,980,000 and $4,256,000 at December 30, 1993 and December 31, 1992, respectively. The Company is a party to various other claims, legal actions and complaints arising in the ordinary course of business or asserted by way of defense or counterclaim in actions filed by the Company. Management believes that its defenses are substantial in each of these matters and that the Company's legal posture can be successfully defended without material adverse effect on its consolidated financial statements. The Company had commitments for capital expenditures of approximately $13,000,000 at December 30, 1993. NOTE 18. ACQUISITION In July 1993, the Company acquired the partnership interests in Ambassador Real Estate Investors, L.P. ("AREI") and Ambassador General Partnership ("AGP"). AREI owned a 99.9% general partnership interest in AGP, which acquired a substantial interest in TropWorld in a sale-leaseback transaction in 1984. The acquisition has been accounted for as a purchase by the Company. The aggregate consideration, including costs incurred to complete the transaction, was approximately $62,000,000 in cash. The Company obtained the $10 million Credit Facility to fund a portion of the purchase price. This acquisition did not significantly change Aztar's total assets. The cash paid by Aztar and notes receivable from AGP were replaced on Aztar's balance sheet by the assets acquired, which consisted primarily of building and equipment. The additional $10,000,000 of indebtedness incurred by Aztar was more than offset by a reduction of indebtedness to AGP. The Company's consolidated statement of operations for the year ended December 30, 1993 includes the results of AGP since its acquisition. After intercompany eliminations, the acquisition has the following effects on consolidated results: Most of the reduction in Aztar interest income from the replacement of the AGP notes receivable is offset by a reduction in rent expense. Aztar's net income is affected negatively primarily by an increase in depreciation expense. If the acquisition had occurred at the beginning of each of the years ended December 30, 1993 and December 31, 1992, the Company's results of operations would have been as follows (in thousands, except per share data): 1993 1992 -------- -------- (unaudited) Revenues $518,762 $512,045 Income from continuing operations before extraordinary item and cumulative effect of accounting change 7,846 8,332 Net income 7,846 11,759 Earnings per common and common equivalent share: Income from continuing operations before extraordinary item and cumulative effect of accounting change $ .19 $ .20 Net income .19 .29 Earnings per common share assuming full dilution: Income from continuing operations before extraordinary item and cumulative effect of accounting change $ .18 $ .20 Net income .18 .28 NOTE 19. UNAUDITED QUARTERLY RESULTS/COMMON STOCK PRICES The following unaudited information shows selected items in thousands, except per share data, for each quarter in the years ended December 30, 1993 and December 31, 1992. The Company's common stock is listed on the New York Stock Exchange. First Second Third Fourth 1993 -------- -------- -------- -------- - ---- Revenues $122,322 $130,781 $144,038 $121,621 Operating income 3,517 6,869 19,576 7,457 Income (loss) before income taxes 2,542 6,078 8,859 (5,073) Income taxes (958) (2,172) (3,526) 5,632 Net income 1,584 3,906 5,333 559 Earnings per common and common equivalent share: Net income .04 .10 .13 .01 Earnings per common share assuming full dilution: Net income .04 .09 .13 .01 - ---- Revenues $117,669 $131,646 $141,225 $121,505 Operating income 2,995 10,400 15,147 4,067 Income from continuing operations before income taxes, extraordinary item and cumulative effect of accounting change 1,549 9,210 13,888 1,360 Income taxes (629) (3,158) (5,382) (460) Discontinued operations -- -- -- 1,262 Extraordinary item -- -- -- (5,335) Cumulative effect of accounting change 7,500 -- -- -- Net income (loss) 8,420 6,052 8,506 (3,173) Earnings per common and common equivalent share: Income from continuing operations before extraordinary item and cumulative effect of accounting change .02 .16 .22 .02 Net income (loss) .21 .16 .22 (.09) Earnings per common share assuming full dilution: Income from continuing operations before extraordinary item and cumulative effect of accounting change .02 .15 .22 .02 Net income (loss) .21 .15 .22 (.09) Common Stock Prices - ------------------- 1993 - High $ 8.88 $10.13 $ 9.63 $ 7.88 - Low 6.63 6.25 7.00 6.00 1992 - High 7.50 6.50 7.13 7.63 - Low 5.00 4.63 5.00 6.13 MANAGEMENT'S DISCUSSION AND ANALYSIS Financial Condition-Liquidity and Capital Resources CASH FLOW AND COVERAGE The company's operating cash flow (measured by adding net rent and depreciation and amortization to operating income) was $97.8 million in 1993 compared to $106.9 million in 1992. Net financing charges were $48.9 million in 1993 compared to $48.1 million in 1992. Even with a decrease in operating cash flow, as defined, the company's coverage of its net financing charges was 2.0 times. RAMADA EXPRESS EXPANSION AND FINANCING One of the company's three major capital expenditures in 1993 was the expansion of Ramada Express, which was completed in September, on schedule and within budget. The expansion included a new 1,100-room tower; 20,000 square feet of casino space, bringing the total to 50,000 square feet; a 1,100-vehicle parking garage; additional restaurant and event space; and other amenities. The company spent $60.0 million on this project in 1993 for a total cost of $74.7 million. Financing was provided primarily out of cash and cash flow. In the fourth quarter 1993, the company borrowed $25 million under its $50 million construction and term loan credit facility that is collateralized by Ramada Express. In December 1993, the company entered into the First Amended and Restated Credit Agreement, which converted the construction and term loan into a $50 million revolving line of credit that matures in June 1996. This new credit agreement can be used for general corporate purposes and may be converted into a three-year reducing revolving line of credit. PURCHASE OF THIRD PARTY PARTIAL INTEREST IN TROPWORLD A second major capital expenditure in 1993 was the purchase in July of the partnership interests in Ambassador Real Estate Investors, L.P. ("AREI") and Ambassador General Partnership ("AGP"). AREI owned a 99.9% general partnership interest in AGP, which acquired a substantial interest in TropWorld in a sale-leaseback transaction in 1984. The aggregate consideration, including costs incurred to complete the transaction, was approximately $62 million. The company funded the AREI/AGP acquisition using cash and a $10 million revolving credit loan obtained in July 1993. This acquisition did not significantly change Aztar's total assets. The cash paid by Aztar and notes receivable from AGP were replaced on Aztar's balance sheet by the assets acquired. The additional $10 million of indebtedness incurred by Aztar was more than offset by a reduction of indebtedness to AGP. TROPICANA PROJECT At the end of 1993 at Tropicana, the company was in the process of constructing a new main entrance, adding a new building facade that will create a colorful Caribbean Village motif facing "The New Four Corners" of Las Vegas and funding a portion of the construction by the State of Nevada of a four-way pedestrian skywalk system at the intersection of Las Vegas Boulevard and Tropicana Avenue. Expenditures in 1993 were approximately $5 million on this project and will be approximately $6 million in 1994. Funding for this project was and will be from available cash balances and cash flow. STOCK OPTIONS An additional source of funds in 1993 was $2.1 million from the exercise of stock options for approximately 339,000 shares of common stock. DEBT PAYMENTS AND FUTURE REFINANCINGS The company's maturities of long-term debt were $2.2 million in 1993 and are $2.5 million and $12.5 million for 1994 and 1995, respectively. The 1994 and 1995 maturities of long-term debt include $2 million each year for mandatory sinking fund payments on the 13 1/2% First Mortgage Notes Due 1996 ("13 1/2% Notes"). These notes are redeemable at par at the option of the company, in whole or in part, on or after September 15, 1994. Also included in the 1995 maturities is the $10 million revolving credit loan obtained in connection with the AREI/AGP acquisition. If favorable interest rates continue, the company intends to call the 13 1/2% Notes in 1994 and obtain a new loan or loans secured by TropWorld that would provide sufficient funds to pay off the 13 1/2% Notes, to pay off the $10 million revolving credit loan and to provide some additional funds for riverboat facilities or general corporate purposes. If the 13 1/2% notes are redeemed in 1994, the company will expense the remaining unamortized deferred financing costs and unamortized discount. This expense would be presented as an extraordinary charge and shown net of an income tax benefit. These unamortized items totaled $4.8 million at December 30, 1993. In October 1996, a balloon payment of $71.3 million is due on Tropicana Enterprises' bank loan. This loan is serviced through rent payments made by the Tropicana operation. The company is a noncontrolling 50% partner in Tropicana Enterprises. FUTURE DEVELOPMENTS AND FINANCING The company has been pursuing the development of its business in various gaming jurisdictions. An agreement was executed in September 1993 with the City of Caruthersville, Missouri, to operate a casino riverboat there, and an application was filed with the Missouri Gaming Commission for a gaming license to operate the Caruthersville facility. In January 1994, the company took delivery of a vessel and began renovation with the intent for it to be used in Caruthersville. On another front, a proposal was submitted to the City of Evansville, Indiana, for a casino riverboat there and an application was filed for a riverboat gaming license with the Indiana Gaming Commission. In the event that the company is granted approval by the applicable jurisdictions to proceed with one or both of these riverboat projects, financing may be required to fund the related capital expenditures. One source of financing could come under the $50 million First Amended and Restated Credit Agreement discussed previously, which provides a structure for an additional borrowing capacity of $25 million for a total of $75 million. Under this structure, the maximum amount of additional borrowing that could be outstanding would be tied to the cash flows of Ramada Express. Any additional capacity will require additional lenders that may be sought by the agent bank and the company. COMMITMENTS AND ON-GOING CAPITAL EXPENDITURES At December 30, 1993, the company had commitments of approximately $13 million for the purchase of fixed assets. In 1994, including the remaining expenditures on the Tropicana project, the company plans to spend approximately $33 million on routine capital expenditures at its three land-based properties and the purchase and renovation of the vessel acquired in January. In addition to this, expenditures will be required for the Caruthersville facility; however, the timing of these expenditures is uncertain. We believe that the company's existing credit facilities, along with continuing cash flow from operations and cash balances, will be sufficient to meet any anticipated obligations as well as any working capital and liquidity requirements. Results of Operations - 1993 versus 1992 REVENUES AND OPERATING INCOME Aztar's consolidated revenues were $518.8 million for 1993, an increase of 1% from $512.0 million in 1992. The increase came primarily from an increase in casino revenue resulting from the expansion at Ramada Express and improved market share in the slot segment at Tropicana. Casino revenue at TropWorld was lower in 1993 than in 1992, partially resulting from a $5.3 million year-over-year decrease in the reversal of progressive jackpot accruals. The trend in the mix of consolidated casino revenue that existed in 1992 continued into 1993 whereby the table games revenue is decreasing and the slot revenue is increasing. Rooms revenue and food and beverage revenue continued to decline in 1993 as a result of a continuing strategy of using rooms and food and beverage service as a means of promoting casino activity. However, the expansion at Ramada Express caused consolidated rooms revenue for 1993 to finish approximately even with 1992. Consolidated operating income was $37.4 million in 1993 compared with $32.6 million in 1992. The primary reason for the increase in consolidated operating income is the reduction in net rent. This reduction was principally caused by the purchase of the AREI/AGP partnership interests in July 1993, which eliminated the rent we incurred for the portion of TropWorld that was owned by AREI/AGP. The net rent reduction was partially offset by the increase in depreciation and amortization that was caused primarily by this purchase. Consolidated casino costs are higher because of the increased use of rooms and food and beverage service as a means of promoting casino activity and increased coin redemptions at TropWorld. Since there is more credit business associated with table games revenue than with slot revenue, the decrease in table games revenue has allowed for a decrease of $1.1 million or 40% in the provision for doubtful accounts. Additional analysis of the performance of each of Aztar's three properties follows. TROPICANA Tropicana Resort and Casino in Las Vegas, Nevada, continued to improve in 1993. Once again, an increase in revenue contributed to improved operating income as Tropicana held the increase in total operating costs to 1% or less. Total revenues for Tropicana were up 3% to $134.9 million in 1993 compared to $130.9 million in 1992 and operating income improved 68% to $7.2 million from $4.3 million. Operating income is after net rent of $6.8 million in 1993 compared to $7.1 million in 1992 and depreciation and amortization of $6.5 million in 1993 compared to $7.1 million in 1992. Casino revenue was up 7% in 1993 as Tropicana continued its shift in the mix of table games revenue and slot revenue. The table games revenue was down 8% in 1993 on top of a 7% decrease in 1992. Table games revenue has been declining as a result of lower baccarat revenue as we shift from a historical dependence on premium table games to the slot segment of the business. Baccarat revenue amounted to only 3% of casino revenue in 1993 compared to 7% in 1992 and 10% in 1991. Slot revenue, on the other hand, increased 19% in 1993 on top of a 25% increase in 1992. The mix of slot revenue to total casino revenue was 63% in 1993 compared to 56% in 1992 and 49% in 1991. This shift in the revenue mix allows Tropicana to be a steady producer of operating income and less subject to the volatility associated with baccarat revenue. The number of rooms occupied in 1993 increased 6% over 1992 but the revenues from rooms and food and beverage decreased in 1993 from 1992. This situation is a result of increased complimentaries as we make greater use of our database targeted marketing strategy and as our database increases. The increased complimentaries result in higher casino costs since we charge the cost of complimentaries to the casino department. Major cost savings in 1993 compared to 1992 occurred in two categories. One reduction was $1.1 million in marketing costs due to less television advertising. The other reduction was also $1.1 million and it occurred in the provision for doubtful accounts. This reduction is a benefit associated with the mix in revenue toward more slot revenue and less table games revenue. With regard to staffing, we operated in 1993 at about the same level as in 1992. However, our payroll and related taxes and benefits went up about 4% in 1993 compared to 1992 primarily from a 9% increase in taxes and benefits. As we look to 1994, we continue to be optimistic about Tropicana's prospects. With the opening of the approximate 2,500-room Luxor resort in October 1993 and the approximate 5,000-room MGM Grand resort in December 1993 on corners of the Las Vegas Strip and Tropicana Avenue adjacent to our corner, "The New Four Corners" of Las Vegas has become a reality. During the first quarter of 1994, we plan to complete the colorful Caribbean Village motif enhancement to Tropicana's facade that faces these two corners. Customer access to Tropicana will be facilitated by an elevated pedestrian crosswalk system under construction by the State of Nevada. This pedestrian bridge system, with elevators and escalators set back from all four corners, will make pedestrian traffic faster, safer and more convenient. Upon completion of this project, we plan to construct a connecting bridge into the Tropicana casino in order to facilitate access from the MGM Grand resort. We believe that most visitors to Las Vegas will go to one or more casinos besides the one where they are staying. Since we believe this has been true of our customers all along, we welcome the opportunity of having other casino customers so close to our facility, especially those customers that are in the high end of the middle market, which we believe to be the market targeted by these two new resorts. TROPWORLD TropWorld Casino and Entertainment Resort in Atlantic City, New Jersey, had a difficult year in 1993 with the continuing poor economic conditions in the Northeast, a very competitive local market and increased competition from other gaming jurisdictions. The rate of growth for casino revenue in the Atlantic City market was anemic for the year. As participants in the market try to maintain or increase market share in this environment, the costs associated with attracting revenue go up, which causes pressure on margins and profits. TropWorld's revenues decreased 2% to $327.7 million in 1993 from $334.3 million in 1992 while operating income increased 21% to $33.5 million from $27.7 million. Casino revenue was down $5.1 million or 2% in 1993 compared to 1992. Continuing the trend from prior years, table games revenue in 1993 was down $10.4 million from 1992 while slot revenue was up $5.3 million in spite of a year-over-year $5.3 million decrease in the reversal of slot machine progressive jackpot accruals. The slot revenue percentage of total casino revenue increased again in 1993 to 76% from 73% in 1992 and 69% in 1991. While the slot segment of the casino business has a higher gross operating margin than the table games segment, we believe the customers' desired casino experience includes a certain level of tables games activity. We therefore anticipate the slot revenue percentage of total casino revenue to be maintained rather than to continue to increase. The increase in slot revenue came at a high cost. We increased promotional programs in anticipation of a greater market growth rate than what actually occurred. Specifically, we increased the number of rooms occupied on a complimentary basis by 11%. There was also an increase in coin redemptions of $4.7 million in 1993 compared to 1992. These two items were the primary causes of a $4.8 million or 3% increase in casino costs for 1993 compared to 1992. Since payroll and related taxes and benefits are our largest cost item, we continue to monitor the level of full-time equivalent headcounts. These costs in 1993 were $0.3 million less than in 1992. Net rent in 1993 was $20.4 million compared to $38.2 million in 1992 and depreciation and amortization in 1993 was $20.4 million compared to $17.3 million in 1992. The primary cause of both the decrease in net rent and the increase in depreciation and amortization was the purchase of the AREI/AGP partnership interests as mentioned in the discussion of financial condition. While the current slow growth in the Atlantic City market is a cause for concern, we believe that infrastructure improvements underway will boost Atlantic City's attractiveness as a destination. Since TropWorld has substantial untapped capacity and there is no significant new casino supply in sight in Atlantic City, the improving economy and increased consumer confidence cause us to be optimistic. RAMADA EXPRESS Ramada Express Hotel and Casino in Laughlin, Nevada started 1993 with approximately 400 hotel rooms, 30,000 square feet of casino space and surface parking for 1,500 vehicles. The facility ended 1993 with approximately 1,500 hotel rooms, 50,000 square feet of casino space, parking for 2,300 vehicles with about one-half in a garage, additional food and beverage facilities, and additional special event and retail space. The expansion began in September 1992 and was completed in September 1993. Because of this expansion, the operating results for 1993 are not comparable to 1992. Ramada Express revenues were $56.2 million in 1993 compared to $46.8 million in 1992. Operating income was $5.5 million in 1993 compared to $8.7 million in 1992. Operating income is after depreciation and amortization of $5.4 million in 1993 compared to $3.9 million in 1992. Net rent was not significant in either year. All significant revenue components were higher in 1993 than in 1992 and all significant cost components were higher in 1993 than in 1992. Ramada Express operating income was lower in 1993 than in 1992 as a result of the disruption to its operations associated with the construction activities and additional costs incurred so as to minimize that disruption. In the third quarter 1993, we expensed $1.4 million of costs associated with the opening of the expanded facilities. During December 1993, we lowered the Ramada Express room rates in order to increase occupancy and to build our customer database. This approach was successful as the Ramada Express occupied room nights more than tripled in December 1993 compared to December 1992. Now that the expansion is completed and we have one full quarter of operating the expanded facility behind us, we expect improvements in Ramada Express operating income in 1994. NEW GAMING JURISDICTIONS In mid-1993, the company began pursuing the development of its business in various gaming jurisdictions. In addition to those jurisdictions mentioned in the analysis of financial condition, the company was one of four finalists but unsuccessful in its proposal to develop and operate a casino complex in Windsor, Ontario. We also investigated several other locations in Missouri and Indiana. In connection with these efforts, we expensed approximately $1.3 million in development costs in 1993. In 1994, we hope to begin the operation of a casino riverboat in Caruthersville, Missouri. However, the timing of this is dependent on several factors that are beyond our control. One of these factors is the granting of a gaming license by the Missouri Gaming Commission. The company applied for this license when the Missouri Gaming Commission began taking applications. Another possible factor is a ruling by the Missouri Supreme Court holding unconstitutional some portions of the Missouri gaming law. A statewide election to amend the constitution was scheduled to be held April 5, 1994. We also plan to continue to explore opportunities in new jurisdictions as they become interested in gaming. INTEREST INCOME AND EXPENSE Interest income declined by $4.5 million in 1993 compared to 1992. The replacement of the AGP notes receivable on Aztar's balance sheet with the assets acquired in the acquisition of the AREI/AGP partnership interests in July 1993 caused a net decrease of $2.9 million in 1993. Included in this $2.9 million net decrease was an increase of $7.4 million as a result of a $171 million 12 1/4% First Mortgage note receivable from AGP. The company loaned AGP the $171 million in November 1992 so that AGP could redeem its outstanding 12% First Mortgage Notes Due 1996. This note was one of the notes receivable that were replaced in the AREI/AGP acquisition. Interest expense increased by $14.2 million in 1993 compared to 1992. Interest incurred on the $200 million 11% Senior Subordinated Notes Due 2002 that were issued in October 1992 was $17.2 million higher in 1993 than in 1992. This increase in interest expense was offset by $2.4 million of increased interest being capitalized in 1993 in association with construction projects. DISCONTINUED OPERATIONS The company received a refund of $1.2 million in a settlement in 1992 with Canadian tax authorities related to the 1988 and 1989 income tax returns of Ramada Inc. involving the discontinued hotel business. EXTRAORDINARY ITEMS The company had an extraordinary loss in 1992 of $5.3 million, net of an income tax benefit of $2.8 million, related to the payment of a redemption premium and the writeoff of deferred financing costs associated with the redemption of the $171 million outstanding of 12% First Mortgage Notes Due 1996 of AGP. ACCOUNTING CHANGE In 1992, the company adopted Statement of Financial Accounting Standards No. 109 related to the reporting of income taxes. The effect of this action and the company's election not to restate prior-year financial statements resulted in a net deferred income tax benefit of $7.5 million. Results of Operations - 1992 versus 1991 Aztar's consolidated revenues were $512.0 million for 1992, an increase of 6% from $481.3 million in 1991, reflecting higher revenues from all three properties. The increase in revenues was primarily as a result of increases in casino revenue at all three properties resulting from market growth in the slot segment, added slot machine capacity, improved market shares and the reversal of $6.0 million of progressive jackpot accruals at TropWorld. Rooms and food and beverage revenue declined at all three properties, reflecting a continuing strategy of using rooms and food and beverage service as a means of promoting casino activity. Aztar's consolidated operating costs and expenses were $479.4 million in 1992, a 3% increase from $467.6 million in 1991. The increase primarily reflects a larger volume of business. Consolidated marketing expenses were higher, reflecting increased marketing expenses at all three properties, as a result of increased staffing, higher levels of expenses for entertainers, and special promotions to stimulate incremental revenue. Consolidated operating income was $32.6 million in 1992, a 138% improvement over $13.7 million in 1991, reflecting improved operating results at all three properties. Increased revenues from the more profitable slot segment combined with relatively lower increases in costs and expenses resulted in operating efficiencies that led to higher operating margins at all three properties. Operating income is after net rent of $45.7 million in 1992, down $1.5 million from 1991 principally as a result of a $0.9 million decline in the interest factor at Tropicana due to an overall decline in interest rates in 1992. TROPWORLD TropWorld had a successful year in 1992 despite continuing poor economic conditions in the Northeast and a very competitive market. TropWorld revenues rose 8% to $334.3 million in 1992 from $310.3 million in 1991, while the increase in costs and expenses was proportionally less, 3% to $306.6 million from $298.1 million. The most important source of the resulting excellent operating flow-throughs was in the casino, where total revenues increased 9% while associated casino and marketing expenses increased 7%. TropWorld's use of rooms and food and beverage services as a way to promote casino activity resulted in a 10% decrease in revenue in those categories, with a corresponding 9% decrease in rooms and food and beverage costs. The Atlantic City market recorded strong growth in 1992 with $3.2 billion of casino win*, an increase of 7.5% from 1991. TropWorld's growth exceeded the market's with casino revenue up 8% to $310 million, its highest ever, from $287 million in 1991. Slot operations were the driving force at TropWorld in 1992. Slot win for 1992 was $227.5 million, a 15% increase over $198.4 million in 1991 due to a targeted marketing and product strategy and growth in * Market comparisons are stated on a calendar basis for the market and the property. the market. The Atlantic City slot market grew 14% during 1992, reaching $2.114 billion in slot win, up from $1.851 billion in 1991. TropWorld captured 10.8% of the slot market in 1992, compared with a 10.7% share in 1991 and 10.3% in 1990. Atlantic City market-wide table games revenue declined approximately 3% in 1992, to $1.102 billion from $1.140 billion in 1991. TropWorld's table games revenue dropped to $83 million in 1992, a 7% decrease. The decline in table games revenue in 1992 was the fourth consecutive year of decline in the Atlantic City market and the third consecutive year of decline at TropWorld, in both cases somewhat by design. With the easing of restrictions on the allocation of casino floor space, operators are dedicating more floor space to the more profitable slot segment, thereby reducing the number of table games units. TropWorld's improvements in operating efficiencies, partially a result of the change in the mix of revenue toward higher-margin slots from table games, were reflected in a 127% improvement in operating income, to $27.7 million from $12.2 million. The decrease in table games revenue together with the issuance of less credit has allowed for a decrease in the provision for doubtful accounts of 75% to $0.5 million in 1992 from $2.0 million in 1991. Operating income is after net rent of $38.2 million in 1992, down from $38.6 million in 1991. Depreciation and amortization was $17.3 million in both years. To some extent the year-over-year comparison favors 1992 because of the negative effects the Persian Gulf War had on operations at TropWorld in the first quarter of 1991. TROPICANA Tropicana reported improved results for 1992 despite external factors including a highly competitive market due to unabsorbed capacity and to negative economic conditions, particularly in southern California. The Las Vegas market in 1992 experienced visitor growth that was weak by Las Vegas standards early in the year, countered in part by a boost due to deep air fare discounting during the summer. Tropicana revenues for 1992 were $130.9 million, a gain of 1% from $129.4 million in 1991. Casino revenue was 8% higher in 1992 than in 1991. Tropicana made significant progress in 1992 in the continuing shift from its historical dependence on premium table games to the slot segment, which has higher growth rates and better profit margins. Slot revenue growth at Tropicana was significantly higher than growth in the market as a result of increased slot machine capacity and improved slot machine product in the casino, coupled with increased slot marketing efforts. Slot revenue at Tropicana rose 27%* in 1992 while Las Vegas market slot revenues rose 9%. Tropicana win from games excluding baccarat was down 3% in 1992. Total games revenue, including baccarat, was down 7%. The games hold percentage was basically unchanged in 1992 from 1991. The decrease in games revenue allowed for a decrease in the provision for doubtful accounts of 25%, to $2.1 million in 1992 from $2.8 million in 1991. * Market comparisons are stated on calendar basis for the market and the property. Occupancy at Tropicana was higher in 1992 than in 1991 by more than two occupancy points. But continuing pressure on room rates in Las Vegas and greater utilization of Tropicana's rooms to promote its casino games resulted in an 8% reduction in rooms revenue. Food and beverage revenue was also lower, by 13%, because of lower demand for banquets and the closing of Tropicana's buffet. Food and beverage costs were correspondingly 14% lower in 1992 than in 1991. Cost and expenses were $126.6 million in 1992, less than 1% higher than the level of $126.2 million in 1991. Costs and expenses in 1992 included $7.1 million of net rent, compared with $8.0 million in 1991, and depreciation and amortization of $7.1 million in 1992, compared with $6.9 million in 1991. Operating income was $4.3 million in 1992, an increase of 34% from $3.2 million in 1991. RAMADA EXPRESS Ramada Express revenues for 1992 were $46.8 million, a 13% increase from $41.6 million in 1991. Costs and expenses rose less than half of the revenue increase, creating good flow-through to profit and higher overall operating margins. Costs and expenses included $3.9 million of depreciation and amortization in 1992, compared with $3.7 million in 1991. Net rent was not significant in either year. Operating income was $8.7 million in 1992, an increase of 45% from $6.0 million in 1991. Ramada Express turned in a strong operating performance in 1992, improving its market position in a highly competitive atmosphere even as the company commenced in September a $75 million expansion of the property. Despite some negative impact from the woes of the southern California economy, the Laughlin market grew strongly in 1992. Casino revenues* for the market were $506.9 million for 1992, a 9% increase from $463.4 million in 1991. Slot revenue growth for the Laughlin market was particularly strong, with slot revenues growing 12% during 1992, while Ramada Express slot revenue grew 22% in the same period. Rooms occupancy for the Laughlin market was 91% for 1992 compared with 90% in 1991. Occupancy at Ramada Express was 90% in 1992, 2.5 occupancy points higher than the previous year. INTEREST INCOME AND EXPENSE Interest income increased $2.5 million in 1992 from 1991, due principally to the $171 million note receivable from AGP. Consolidated interest expense in 1992 was $31.1 million, down $1.0 million from the prior year. The company incurred $5.2 million of interest expense in 1992 in connection with the $200 million 11% Senior Subordinated Notes Due 2002 issued in October 1992. That increase was offset by decreases in interest expense that occurred principally as a result of three factors, the primary factor being the expiration on December 31, 1991 of an interest rate swap agreement. The other factors were the payment in January 1992 of a settlement with the Internal Revenue Service on which interest had been accrued in 1991 and the capitalization of interest on the Ramada Express expansion. * Market comparisons are stated on a calendar basis for the market and the property. UNCONSOLIDATED PARTNERSHIP The company's loss on its equity share in Tropicana Enterprises, the partnership that owns the Tropicana land and improvements, declined as a result of lower interest expense due to an overall decline in interest rates in 1992 on the floating rate bank financing of Tropicana Enterprises. Aztar is a noncontrolling 50% partner in Tropicana Enterprises. SUMMARY OF SELECTED FINANCIAL DATA Aztar Corporation and Subsidiaries For the Five Years Ended December 30, 1993 1993 1992 1991 1990 1989 -------- -------- -------- -------- -------- Statement of Operations Data (in thousands) Revenues $518,762 $512,045 $481,285 $515,060 $522,255 Operating income (loss)(a) 37,419 32,609 13,654 (3,574) (33,812) Net interest income and expense (a) (21,191) (2,477) (5,856) (4,480) (20,950) Other, net (3,822) (4,125) (5,030) (6,905) (7,422) Income (loss) from continuing operations before extraordinary items and cumulative effect of accounting change 11,382 16,378 2,708 (15,922) (47,689) Discontinued operations -- 1,262 2,553 -- 127,130 Extraordinary items -- (5,335) 1,237 963 -- Cumulative effect of accounting change (b) -- 7,500 -- -- -- Net income (loss) 11,382 19,805 6,498 (14,959) 79,441 Common Stock Data (per share) Income (loss) from continuing operations before extraordinary items and cumulative effect of accounting change: Earnings per common and common equivalent share $ .28 $ .41 $ .05 $ (.42) $ (1.17) Earnings per common share assuming full dilution .27 .40 .05 * (1.15) Cash dividends declared -- -- -- -- 1.00 Equity 9.29 9.03 8.42 8.29 8.28 * Anti-dilutive Balance Sheet Data (in thousands at year end) Total assets $877,171 $849,565 $638,474 $641,905 $678,476 Long-term debt 404,086 378,058 176,693 180,391 181,102 Series B ESOP convertible preferred stock 3,905 2,998 2,059 1,056 -- Shareholders' equity 346,988 333,749 318,900 312,771 338,528 (a) See "Note 18. Acquisition" of the Notes to Consolidated Financial Statements. (b) See "Note 16. Cumulative Effect of Accounting Change" of the Notes to Consolidated Financial Statements. REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Shareholders and Board of Directors Aztar Corporation Our report on the consolidated financial statements of Aztar Corporation and Subsidiaries is included in this report on Form 10-K on page. In connection with our audits of such consolidated financial statements, we have also audited the related financial statement schedules listed in the index on page 21 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Phoenix, Arizona February 11, 1994 S-1 SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT AZTAR CORPORATION AND SUBSIDIARIES For the Years Ended December 30, 1993, December 31, 1992 and January 2, 1992 (in thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F - -------------- -------- -------- -------- -------- -------- Balance at Retire- Balance Beginning Additions ments or Other at End of Description of Year at Cost Sales Changes Year - -------------- --------- --------- -------- --------- --------- - ---- Buildings and equipment $399,670 $ 83,851 $ 3,352 $306,841 (a) 819 (b) $787,829 Land 78,853 2,942 -- -- 81,795 Leased under capital leases 54,751 385 459 (45,267)(a) 9,410 Construction in progress 15,718 (8,989) -- 741 (a) (769)(b) 6,701 -------- -------- -------- -------- -------- $548,992 $ 78,189 $ 3,811 $262,365 $885,735 ======== ======== ======== ======== ======== - ---- Buildings and equipment $394,035 $ 11,339 $ 5,704 $ -- $399,670 Land 78,735 118 -- -- 78,853 Leased under capital leases 51,727 3,687 663 -- 54,751 Construction in progress 6,568 9,150 -- -- 15,718 -------- -------- -------- -------- -------- $531,065 $ 24,294 $ 6,367 $ -- $548,992 ======== ======== ======== ======== ======== - ---- Buildings and equipment $385,096 $ 20,071 $ 9,082 $ (2,050)(b) $394,035 Land 76,181 2,554 -- -- 78,735 Leased under capital leases 50,276 3,282 1,684 (147)(b) 51,727 Construction in progress 10,883 (4,225) 90 -- 6,568 -------- -------- -------- -------- -------- $522,436 $ 21,682 $ 10,856 $ (2,197) $531,065 ======== ======== ======== ======== ======== (a) Acquisition of AREI/AGP partnership interests. (b) Primarily transfers and reclassifications. S-2 SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT AZTAR CORPORATION AND SUBSIDIARIES For the Years Ended December 30, 1993, December 31, 1992 and January 2, 1992 (in thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F - ------------------ ---------- ---------- ---------- ---------- ---------- Balance at Additions Retire- Balance at Beginning Charged to ments or Other End of Description of Year Expense Sales Changes Year - ------------------ ---------- ---------- ---------- ---------- ---------- - ---- Buildings and equipment $112,442 $ 29,672 $ 2,424 $ -- $139,690 Leased under capital leases 45,489 1,899 457 (38,564)(a) 8,367 -------- -------- -------- -------- -------- $157,931 $ 31,571 $ 2,881 $(38,564) $148,057 ======== ======== ======== ======== ======== - ---- Buildings and equipment $ 93,689 $ 24,111 $ 5,358 $ -- $112,442 Leased under capital leases 42,524 3,533 568 -- 45,489 -------- -------- -------- -------- -------- $136,213 $ 27,644 $ 5,926 $ -- $157,931 -------- -------- -------- -------- -------- - ---- Buildings and equipment $ 78,072 $ 23,282 $ 6,496 $ (1,169)(b) $ 93,689 Leased under capital leases 39,671 3,668 668 (147)(b) 42,524 -------- -------- -------- -------- -------- $117,743 $ 26,950 $ 7,164 $ (1,316) $136,213 ======== ======== ======== ======== ======== (a) Acquisition of AREI/AGP partnership interests. (b) Primarily transfers and reclassifications. S-3 SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AZTAR CORPORATION AND SUBSIDIARIES For the Years Ended December 30, 1993, December 31, 1992 and January 2, 1992 (in thousands) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E - ------------------ ------------ ------------ ------------ ------------ Balance at Balance at Beginning End of Description of Year Additions Deductions Year - ------------------- ------------ ------------ ---------- ------------ Allowance for doubtful accounts receivable: 1993 $ 13,124 $ 1,566(a) $ 4,782(d) $ 9,908 1992 14,349 2,622(a) 3,847(d) 13,124 1991 15,126 4,763(a) 5,540(d) 14,349 Deferred income tax asset valuation allowance: 1993 $ 24,732 $ 479(b) $ 4,237(e) $ 20,974 1992 -- 25,562(a)(c) 830(d) 24,732 (a) Charged to costs or expenses. (b) Reflects an adjustment to the deferred income tax asset account for the effect of legislation that increased the federal income tax rate from 34% to 35%. (c) Allowance established in 1992 in connection with the adoption of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. (d) Related assets charged against allowance account. (e) Reflects a reduction of $3,878,000, with a corresponding decrease to the 1993 income tax expense, due to the generation of taxable income that resulted in the utilization of a portion of a net operating loss carryforward. The remainder of the reduction represented charges of deferred tax assets against the valuation allowance account. S-4 SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION AZTAR CORPORATION AND SUBSIDIARIES For the Years Ended December 30, 1993, December 31, 1992 and January 2, 1992 (in thousands) COLUMN A COLUMN B ------------------------------------- ------------------ Charged to Item Costs and Expenses ------------------------------------- ------------------ ---- Advertising $ 5,714 (a) Property taxes 14,183 Gaming revenue taxes 34,758 ---- Advertising $ 7,484 (a) Property taxes 13,692 Gaming revenue taxes 33,647 ---- Advertising $ 7,082 (a) Property taxes 12,905 Gaming revenue taxes 30,493 (a) Includes only direct media costs paid by the Company. S-5 EXHIBIT INDEX - ------------- 3.1 Restated Certificate of Incorporation, filed as Exhibit 3.1 to Aztar Corporation's Registration Statement No. 33-32009 and incorporated herein by reference. 3.2 By-Laws, as amended and restated May 9, 1991, filed as Exhibit 1 to Aztar Corporation's Form 8-K dated May 9, 1991 and incorporated herein by reference. 4.1 Rights Agreement between Aztar Corporation and First Interstate Bank of Arizona, N.A. as Rights Agent, filed as Exhibit 4.1 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 4.2(a) Indenture, dated as of December 15, 1989, among Aztar Mortgage Funding, Inc., Ramada Inc., as guarantor, and First Interstate Bank of Arizona, N.A., as Trustee, relating to the First Mortgage Notes Due 1996, filed as Exhibit 4.2 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 4.2(b) Instrument of Appointment and Acceptance of Successor Trustee dated as of January 26, 1993, among Aztar Mortgage Funding, Inc., as Issuer, Aztar Corporation, as Guarantor, First Interstate Bank of Arizona N.A., as resigning Trustee, and First Bank National Association, as successor Trustee. 4.3 Indenture, dated as of October 8, 1992, between Aztar Corporation and Bank of America National Trust & Savings Association, as Trustee, relating to the Senior Subordinated Notes due 2002 of Aztar Corporation, filed as Exhibit 4.1 to Aztar Corporation's Form 10-Q for the quarter ended October 1, 1992 and incorporated herein by reference. 10.1 Amended and Restated Lease (Tropicana Hotel/Casino) between Tropicana Enterprises and Hotel Ramada of Nevada, dated November 1, 1984, filed as Exhibit 10.20 to Ramada Inc.'s 1984 Form 10-K (Commission File Reference Number 1-5440) and incorporated herein by reference. 10.2 Amended and Restated Partnership Agreement by and between the Jaffe Group and Adamar of Nevada, entered into as of November 1, 1984, filed as Exhibit 10.22 to Ramada Inc.'s 1984 Form 10-K (Commission File Reference Number 1-5440) and incorporated herein by reference. *10.3(a) Management (Severance) Agreement, dated December 30, 1981, by and between Ramada Inc. and Paul E. Rubeli, filed as Exhibit 10(l) to Ramada Inc.'s 1981 Form 10-K (Commission File Number 1-5440) and incorporated herein by reference. *10.3(b) Management (Severance) Agreement, dated October 30, 1985, by and between Ramada Inc. and Robert M. Haddock, filed as Exhibit 10.29 to Ramada Inc.'s 1985 Form 10-K (Commission File Number 1-5440) and incorporated herein by reference. *Indicates a management contract or compensatory plan or arrangement. E-1 EXHIBIT INDEX - ------------- *10.3(c) Severance Agreements by and between Ramada Inc. and 2 executives of Ramada Inc. prior to the Restructuring, filed as Exhibit 10.18(a) and (b) to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. *10.3(d) Severance Agreements by and between Ramada Inc. and certain executives of Ramada Inc. prior to the Restructuring, filed as Exhibit 10.18(c),(d),(e),(f),(g),(h) and (i) to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. *10.3(e) Amendment to Severance Agreement by and between Ramada Inc. and Paul E. Rubeli prior to the Restructuring, filed as Exhibit 10.18(j) to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. *10.3(f) Amendment to Severance Agreements by and between Ramada Inc. and certain executives of Ramada Inc. prior to the Restructuring, filed as Exhibit 10.18(k),(l),(m),(n) and (o) to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.4 Ramada Express Expansion Design-Build Construction Agreement, dated as of August 24, 1992, by and between Mardian Construction Company and Ramada Express, Inc., filed as Exhibit 10.32 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. *10.5 Aztar Corporation 1989 Stock Option and Incentive Plan filed as Exhibit 4 to Aztar Corporation's Registration Statement No. 33-32399 and incorporated herein by reference. 10.6 Master Consent Agreement, dated July 18, 1989, by and among Ramada Inc., Adamar of Nevada, Hotel Ramada of Nevada, Adamar of New Jersey, Inc., Aztar Corporation, Tropicana Enterprises, Trop C.C. and the Jaffe Group, with attached exhibits, filed as Exhibit 10.50 to Aztar Corporation's Registration Statement No. 33-29562 and incorporated herein by reference. 10.7 Mortgage and Fixture Security Agreement, dated December 15, 1989, made by Ambassador General Partnership, Adamar of New Jersey, Inc., Atlantic-Deauville Inc. and Aztar Mortgage Funding, Inc., covering TropWorld, filed as Exhibit 10.38 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.8 Mortgage and Fixture Security Agreement, dated December 15, 1989, made by Adamar of New Jersey, Inc., Atlantic-Deauville Inc., Adamar Garage Corporation and Aztar Mortgage Funding, Inc., covering the Barbun Parking Garage, filed as Exhibit 10.39 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. *Indicates a management contract or compensatory plan or arrangement. E-2 EXHIBIT INDEX - ------------- 10.9 Mortgage and Fixture Security Agreement, dated December 15, 1989, made by Adamar of New Jersey, Inc., Atlantic-Deauville Inc., Adamar Garage Corporation and Aztar Mortgage Funding, Inc., covering the Transportation Center, filed as Exhibit 10.40 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.10 Mortgage and Collateral Assignment, dated December 15, 1989, made by Adamar of New Jersey, Inc., Adamar Garage Corporation and First Fidelity Bank of New Jersey, National Association, as Trustee, covering the Barbun Parking Garage, filed as Exhibit 10.41 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.11 Security Agreement and Assignment of Contracts, dated December 15, 1989, by and among Adamar of New Jersey, Inc., Ambassador General Partnership, Atlantic-Deauville Inc. and Aztar Mortgage Funding, Inc., covering TropWorld, filed as Exhibit 10.44 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.12 Collateral Assignment of Commercial Leases, dated December 15, 1989, made by Adamar of New Jersey, Inc. and Aztar Mortgage Funding, Inc., covering the Expansion, filed as Exhibit 10.46 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.13 Collateral Assignment of Option to Purchase, dated December 19, 1989, made by Ambassador General Partnership to Aztar Mortgage Funding, Inc., covering the Transportation Center Air Space Parcel and the Barbun Parking Garage, filed as Exhibit 10.47 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.14 Assignment and Agreement, dated December 15, 1989, made by Adamar of New Jersey, Inc., Ambassador General Partnership, Atlantic- Deauville Inc., Adamar Garage Corporation and First Interstate Bank of Arizona, N.A., filed as Exhibit 10.48 to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.15 Subordination Agreement, among Aztar Corporation, Adamar of New Jersey, Inc., Aztar Mortgage Funding, Inc. and Ambassador General Partnership, filed as Exhibit 4.15 to Aztar Mortgage Funding, Inc. and Aztar Corporation's Registration Statement No. 33-29701 and incorporated herein by reference. *10.16(a) Employee Stock Ownership Plan of Aztar Corporation, as amended and restated effective December 19, 1989, dated December 12, 1990, filed as Exhibit 10.60(a) to Aztar Corporation's 1990 Form 10-K and incorporated herein by reference. *Indicates a management contract or compensatory plan or arrangement. E-3 EXHIBIT INDEX - ------------- 10.16(b) Term Loan Agreement, dated as of December 19, 1989, by and among State Street Bank and Trust Company, as Trustee, Adamar Garage Corporation, as lender, and Aztar Corporation, filed as Exhibit 10.50(b) to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.16(c) Preferred Stock Purchase Agreement, dated as of December 19, 1989, between Ramada Inc. and State Street Bank and Trust Company, as Trustee, filed as Exhibit 10.50(c) to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.16(d) Letter Agreement, dated as of December 19, 1989, between Aztar Corporation and State Street Bank and Trust Company, as Trustee, relating to the Employee Stock Ownership Plan of Aztar Corporation, filed as Exhibit 10.50(d) to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 10.17(a) Agreement and Plan of Merger, dated as of April 17, 1989, among New World Hotels (U.S.A.), Inc., RI Acquiring Corp. and Ramada Inc., as amended and Restated as of October 23, 1989, filed as Exhibit 2.1 to Aztar Corporation's Registration Statement No. 33-32009 and incorporated herein by reference. 10.17(b) Letter, dated as of October 23, 1989, from Ramada Inc. to New World Hotels (U.S.A.), Inc. regarding "Net Cash Flows from Investing Activities", filed as Exhibit 2.1(a) to Aztar Corporation's Registration Statement No. 33-32009 and incorporated herein by reference. 10.17(c) Letter, dated as of October 23, 1989, from Ramada Inc. to New World Hotels (U.S.A.), Inc. regarding certain franchising matters and hotel projects, filed as Exhibit 2.1(b) to Aztar Corporation's Registration Statement No. 33-32009 and incorporated herein by reference. 10.18 Reorganization Agreement, dated as of April 17, 1989, between Ramada Inc. and Aztar Corporation, as amended and restated as of October 23, 1989, filed as Exhibit 2.2 to Aztar Corporation's Registration Statement No. 33-32009 and incorporated herein by reference. 10.19 Tax Sharing Agreement, dated as of April 17, 1989, among New World Hotels (U.S.A), Inc., Ramada Inc. and Aztar Corporation, as amended and restated as of October 23, 1989, filed as Exhibit 2.3 to Aztar Corporation's Registration Statement No. 33-32009 and incorporated herein by reference. 10.20 Guaranty and Acknowledgement Agreement, dated as of April 17, 1989, among New World Development Company Limited, New World Hotels (Holdings) Limited, New World Hotels (U.S.A.), Inc. and RI Acquiring Corp., filed as Exhibit 2.4 to Aztar Corporation's Registration Statement No. 33-29562 and incorporated herein by reference. E-4 EXHIBIT INDEX - ------------- *10.21 Aztar Corporation 1990 Nonemployee Directors Stock Option Plan, as amended and restated effective March 15, 1991, filed as Exhibit A to Aztar Corporation's 1991 definitive Proxy Statement and incorporated herein by reference. *10.22 Aztar Corporation Nonqualified Retirement Plan for Senior Executives, dated September 5, 1990, filed as Exhibit 10.2 to Aztar Corporation's Form 10-Q for the quarter ended September 27, 1990 and incorporated herein by reference. 10.23 First Amended and Restated Credit Agreement, dated December 28, 1993, by and among Ramada Express, Inc., Aztar Corporation, First Interstate Bank of Nevada, N.A., as agent, Midlantic National Bank, The Daiwa Bank, Limited, NBD Bank, N.A. and First Security Bank of Idaho, N.A., and the Lenders listed therein. 10.24 Loan Agreement by and between Tropicana Enterprises, Hotel Ramada of Nevada, Ramada Inc. and Lenders made and entered into November 19, 1984, as amended, filed as Exhibit 10.23 to Ramada Inc.'s 1984 Form 10-K (Commission File Reference Number 1-5440) and incorporated herein by reference. *10.25 Summary of deferred compensation program for designated executives of Ramada, dated November 10, 1983, filed as Exhibit 10(r) to Ramada Inc.'s 1983 Form 10-K (Commission File Reference Number 1-5440) and incorporated herein by reference. *10.26 Deferred Compensation Agreements entered into by and between Ramada and designated executives (including each Executive Officer), dated December 1, 1983, 1984 or 1985, filed as Exhibits 10.60(a) through (w) to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. *10.27 Deferred Compensation Plan for Directors, dated December 1, 1983, filed as Exhibit 10(t) to Ramada Inc.'s 1983 Form 10-K (Commission File Reference Number 1-5440) and incorporated herein by reference. *10.28 Deferred Compensation Agreements entered into by and between Ramada and certain outside Directors as of December 1, 1983, filed as Exhibits 10.62(a),(b),(c) and (d) to Aztar Corporation's Registration Statement No. 33-51008 and incorporated herein by reference. 11. Statement Regarding Computation of Per Share Earnings. 21. Subsidiaries of Aztar Corporation. 23. Consent of Coopers & Lybrand. *Indicates a management contract or compensatory plan or arrangement. E-5

23910_1993.txt

23910_1993

1993

23910

Item 1. Business. Consumers Water Company (Consumers or the Company) is a holding and management company whose principal business is the ownership and operation of water utility subsidiaries. Consumers owns directly or indirectly at least 90% of the voting stock of 11 water companies (the Consumers Water Subsidiaries) which operate 28 separate systems providing water service to approximately 218,000 customers in six states. It also owns 100% of C/P Utility Services (C/P), a provider of technical services to utilities and other enterprises. C/P, headquartered in Hamden, Connecticut, provides services in the areas of meter services, contract operations, mechanical engineering services, corrosion engineering services, environmental engineering services and water conservation to the utility industry and certain industrial clients primarily in the northeastern United States. Consumers also owns Burlington Homes of New England (Burlington), a manufactured housing company located in Oxford, Maine, that formerly sold manufactured housing through developers and an independent dealer network throughout New England and eastern New York. On October 6, 1993, The Company announced its decision to discontinue the operations of Burlington, to offer the Company for sale and to concentrate its efforts on its water resource management business. To date, efforts to sell Burlington have been unsuccessful. The plant has been closed and Burlington has begun the liquidation of its assets. Consumers was incorporated under the laws of Maine in 1926. The address of its executive offices is Three Canal Plaza, Portland, Maine 04101, and the Company's telephone number is (207) 773-6438. The Company had at December 31, 1993, subsidiaries as noted on Exhibit 22 attached hereto, the accounts of which are included in the consolidated financial statements in this report. Consumers Water Subsidiaries The Consumers Water Subsidiaries operate 28 primary systems in six states for the collection, treatment and distribution of water for public use to residential, commercial and industrial customers, to other water utilities for resale and for private and municipal fire protection purposes. In 1993, 65% of the revenue of the Consumers Water Subsidiaries was generated from residential accounts, while sales for commercial users, industrial users and fire protection and miscellaneous uses accounted for 13%, 9% and 13% of revenues, respectively. Water utility revenues for the three years ended December 31, 1993, 1992 and 1991 were $78,171,000, $74,637,000, and $72,427,000, respectively. At December 31, 1993, the Consumers Water Subsidiaries owned in the aggregate 3,084 miles of main line pipe, of which approximately 84% was six inches or larger in diameter. Of the 28 primary systems, twelve have surface supplies (lakes, ponds and streams) as their source of supply; twelve obtain water principally or entirely from wells; two obtain their water supplies from adjacent systems through wells and surface supplies; and two purchase their supplies from adjacent systems, one of which is an affiliated utility. Less than 5% of the Consumers Water Subsidiaries' water usage is purchased from other systems. In general, the Company considers the surface and well supplies at the Consumers Water Subsidiaries to be adequate for anticipated average daily demand and normal peak day demand for the next five years. One division of Garden State Water Company, Blackwood, serving approximately 11,000 customers has water supplies that will need to be supplemented. This work of developing an additional water supply is underway and anticipated to be completed within the next year. All of the systems (except one system serving solely industrial users) provide customers with water which has been subjected to disinfection treatment and some of which has been subjected to additional treatment, such as softening, sedimentation, filtration, chemical stabilization, iron and/or manganese removal and taste and odor control. Eight systems own and operate full scale water treatment plants. In addition, Consumers Illinois Water Company operates four wastewater treatment facilities. The water treatment, pumping and distribution capacities of the systems are generally considered by management to be adequate to meet the present requirements of their residential, commercial and industrial customers. On a continuing basis, the Consumers Water Subsidiaries make system improvements and additions to capacity in response to changing regulatory standards, changing patterns of consumption and increases in the number of customers. See "Environmental Regulation." Operating and capital costs associated with these improvements are normally recognized by the various state regulatory commissions in setting rates. See "Rate Regulation." Consumers' water utility business is seasonal because the demand for water during the warmer months is generally greater than during the cooler months due to additional requirements for industrial and residential cooling systems, private and public swimming pools and lawn sprinklers. The following table indicates, for each of the Consumers Water Subsidiaries, the number of customers at year-end, 1993 revenues and net utility plant as of December 31, 1993: (Dollars in Thousands) Number Number of Utility Net Utility Subsidiary of Systems Customers Revenue Plant (1) Ohio Water Service Company (2) 5 70,020 $27,144 $95,840 Consumers Illinois Water Company 5 42,260 10,741 45,731 Inter-State Water Company 1 16,799 7,055 32,167 Shenango Valley Water Company (3) 2 17,044 6,335 22,544 Roaring Creek Water Company 1 16,671 5,260 21,405 Pennsylvania Water Company 1 4,451 1,370 3,872 Garden State Water Company (4) 4 28,374 9,452 40,345 Southern New Hampshire Water Company 1 7,416 5,273 30,188 Camden and Rockland Water Company 1 7,109 2,879 14,053 Maine Water Company 4 2,732 1,125 4,816 Wanakah Water Company 3 4,903 1,606 6,118 Inter-Company Eliminations - (69) ( 363) ------- ------- -------- 28 217,779 $78,171 $316,716 ======= ======= ======== _________________________________ (1) Includes construction work in progress. (2) Includes the revenue from the Washington Court House Division which was sold on December 16, 1993. (3) Includes Masury Water Company, a wholly-owned subsidiary. (4) Includes Califon Water Company, a 93.2% owned subsidiary. The properties of the Consumers Water Subsidiaries consist of transmission and distribution mains and conduits, purification plants, pumping facilities, wells, tanks, meters, supply lines, dams, reservoirs, buildings, land, easements, rights and other facilities and equipment used for the collection, purification, storage and distribution of water. Substantially all of the property and all rights and franchises of the Consumers Water Subsidiaries are owned by the subsidiaries and are subject to liens of mortgages or indentures. For the most part, such liens are imposed to secure bonds, notes and/or other evidences of long-term indebtedness of the respective companies. Management considers that its water collection, treatment and distribution systems, facilities and properties are well maintained and structurally sound. In addition, Consumers carries replacement cost insurance coverage on substantially all of its and its subsidiaries' above-ground properties, as well as liability coverages for risks incident to their ownership and use, including consequential damage coverage. Rate Regulation The Consumers Water Subsidiaries are subject to regulation by their respective state regulatory bodies. The state regulatory bodies have broad administrative power and authority to regulate water and other public utilities, including the power to regulate rates and charges, service and the issuance of securities. They also establish uniform systems of accounts, develop standards with respect to groundwater withdrawal rights, surface water supply, potability and adequacy of treatment, and approve the terms of contracts and relations with affiliates and customers, purchases and sales of property and loans. Maine and Illinois have laws regulating reorganizations of water and other utilities. The profitability of the operations of the Consumers Water Subsidiaries is influenced to a great extent by the timeliness and magnitude of rate allowances by regulatory authorities in various states. Accordingly, Consumers maintains a rate case management capability to ensure that the tariffs of the Consumers Water Subsidiaries reflect, to the extent possible, current costs of operations, capital, taxes, energy, materials and compliance with environmental regulations. This process also addresses other factors bearing on rate determinations, such as the quantity of rainfall and temperature in a given period of time, system expansion and industrial demand. The approximate amount of annual rate increases allowed for the last three years was $2,880,000 for 1991, $4,698,000 for 1992, and $1,945,000 for 1993 represented by ten, eight, and five rate decisions, respectively. Included in the 1992 total is a $2.2 million rate allowance for Inter-State Water Company, received on January 8, 1992. This increase was due primarily to recovery of, and an allowance of a return on, its new $14 million water treatment plant. The Company currently has five rate filings pending totalling $7.3 million of requested annualized new revenue. Decisions on these cases are expected in 1994. The number and magnitude of rate increases for the next three years is expected to increase due to the large capital expenditure program for the period 1994 to 1996. Rates for some divisions of Ohio Water are fixed by negotiated agreements with the political subdivisions that are served, instead of through a filing with the Public Utility Commission of Ohio. Currently, two of the five regulated divisions of Ohio Water are operating under rate ordinances. Water Utility Competition In general, the Company believes that the Consumers Water Subsidiaries have valid operating rights, free from unduly burdensome restrictions, sufficient to enable them to carry on their businesses as presently conducted. They derive their rights to install and maintain mains in streets, highways and other public places from the acts under which they were incorporated, municipal consents and ordinances, permits granted for an indefinite period of time by states and permits from state highway departments and county and township authorities. In most instances, such operating rights are non-exclusive. In certain cases, permits from state highway departments and county and township authorities have not been received for service in unincorporated areas, but service is being rendered without assertion or lack of authority by the governmental body concerned. Each of the Consumers Water Subsidiaries serves an area or areas in which it is sole operator of the public water supply system. In some instances another water utility provides service to a separate and sometimes contiguous area within the same township or other political subdivision served by one of the Consumers Water Subsidiaries. In the states in which the operations of the Consumers Water Subsidiaries are carried on, there exists the right of municipal acquisition by one or more of the following methods: eminent domain, the right of purchase given or reserved by a municipality or other political subdivision in granting a franchise, and the right of purchase given or reserved under the law of the state in which the subsidiary was incorporated or from which it received its permit. The price to be paid upon acquisition is usually determined in accordance with both federal law and the laws of the state governing the taking of lands or other property under eminent domain statutes; in other instances, the price may be negotiated, fixed by appraisers selected by the parties or computed in accordance with a formula prescribed in the law of the state or in the particular franchise or special charter. Certain communities in areas served by the Consumers Water Subsidiaries have, from time to time, expressed an interest in acquiring the water utility serving those communities. Environmental Regulation The primary federal laws affecting the provision of water and wastewater treatment services by the Consumers Water Subsidiaries are the Clean Water Act (the CWA) and the Safe Drinking Water Act (the SDWA), and the regulations promulgated pursuant thereto by the United States Environmental Protection Agency (the EPA). These laws and regulations establish criteria and standards, including those for drinking water and for discharges into waters of the United States. States have the right to establish criteria and standards stricter than those established by the EPA, and some of the states in which the Consumers Water Subsidiaries operate have done so. The CWA regulates the discharge of effluents from the drinking water and wastewater treatment processes into the lakes, rivers, streams, and ground water. Seven of the systems owned by the Consumers Water Subsidiaries generate water treatment precipitate from operating conventional filtration facilities used for producing drinking water. The water treatment precipitate is a combination of silt and chemicals used in the treatment process and chemicals removed from the raw water. For each of the seven facilities, the water treatment precipitate generated from the treatment facilities is disposed of either in a storage facility such as a lagoon owned by the subsidiary, an off-site facility not owned by the subsidiary, a State approved landfill, municipal sewer system or it is used for agricultural land application. Wastewater precipitate generated from small wastewater treatment facilities in Illinois is used as a solid additive. Additional capital expenditures and operating costs in connection with the management and ultimate disposal of effluent from water and wastewater facilities may be required in the future, particularly if changes are made in the requirements of the CWA or other applicable federal or state laws. A small wastewater plant owned by Consumers Illinois serving the University Park area will require approximately $2.0 to $3.0 million of capital investment over the next three years to correct periodic excursions in discharge permit requirements. A consent decree addressing these excursions and the alleged resulting stream bed contamination is being negotiated with the Illinois Environmental Protection Agency (the IEPA). At Consumers Illinois, a small wastewater plant serving the Candlewick area will require approximately $2.2 to $3.0 million of capital investment due to periodic excursions in discharge permit requirements. The IEPA has restricted Consumers Illinois from extending its sewer lines in the Candlewick service area until the plant capital program is complete. The Poland Filtration Plant, which is operated by Ohio Water, has been disposing of treatment precipitate at an abandoned strip mine. The Ohio Environmental Protection Agency has informed Ohio Water that it must find an alternative method of disposal for the treatment precipitate. This issue is being studied and the cost for the alternative disposal method is estimated at $500,000 to $1.0 million. The SDWA established uniform minimum national quality standards for drinking water. The EPA regulations, promulgated pursuant to the SDWA, set standards on the amount of certain inorganic and organic chemical contaminants, microbials and radionuclides in drinking water. The 1986 amendments to the SDWA require that the EPA promulgate new primary water standards for 83 contaminants. The EPA has not met the timetable established in the amendments but is developing new water quality standards and, to date, has issued regulations on volatile synthetic organic chemicals, inorganic chemicals, surface water treatment, microbials, lead and copper. Reauthorization of the SDWA is scheduled to be taken up by Congress in 1994. Stricter drinking water standards currently under consideration may result in additional capital expenditures being required of the Company. The implications of the 1986 amendments to the SDWA and the EPA regulations for the Company can be analyzed by grouping contaminants into four categories: (i) microbials, (ii) inorganics, (iii) radionuclides and (iv) volatile organics. With respect to microbials, improved disinfection and/or filtration is required under the EPA Surface Water Treatment Rule adopted pursuant to the SDWA. Necessary improvements to comply with the Surface Water Treatment Rule have been completed or are under way at a number of Consumers Water Subsidiaries. The estimated cost for 1994 and beyond for these improvements is $20 million. Other major improvements at two water treatment plants designed to increase capacity and upgrade facilities are estimated to cost $11 million. In addition, open water storage reservoirs may have to be covered or replaced at three subsidiaries at an approximate cost of $4 million. Testing for lead and copper in finished water supplies, as required by the SDWA provisions dealing with inorganics, has been undertaken at a number of Consumers Water Subsidiaries. The most recent test results show that copper and lead levels meet the applicable standards at most of the Consumers Water Subsidiaries. The EPA has not yet established the Maximum Contaminant Level (MCL) for radon gas in drinking water pursuant to the SDWA provisions applicable to radiouclides. The Company anticipates that the EPA will set those levels at not less than 300 pico curies/liter and has budgeted for capital expenditures of $5 million during the 1994 through 1998 period to treat groundwater supplies to comply with this anticipated radon standard. If the standard is set at 1,000 pico curies/liter, as proposed by an industry group, the necessary capital expenditures would be reduced to approximately $1 million. The Consumers Water Subsidiaries have surveillance programs in place to provide early warning of a possible contamination threat to their water supplies from volatile organics and other potential contaminants. Each of the Consumers Water Subsidiaries has adopted contingency plans to respond to such contamination, should it occur. In 1992, Inter-State executed a Consent Decree with the Illinois Environmental Protection Agency to comply with the MCL for nitrates by 1997 and to take additional interim steps to address the problem. Inter-State will be required to add treatment facilities and/or new sources of supply to reduce the level of nitrates in its finished water at certain times of the year for an estimated project cost of $5 million. A small satellite system owned by Consumers Illinois Water Company has identified an organic contaminant in its groundwater supply. The problem can be resolved by interconnecting the system to the core system at a cost of approximately $1 million. It is felt costs associated with this problem will be recovered from a third party. A contractor working at the Lake Erie West water treatment facility, which is operated by Ohio Water, caused the release of a relatively small amount of mercury within a building at the facility. Workers tracked the mercury to various areas of the building, necessitating the clean-up of a relatively large area in and around the building at a cost of approximately $900,000. Clean-up has been completed and Ohio Water is looking to the responsible parties for reimbursement of its costs. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations - Liquidity and Capital Resources." The Consumers Water Subsidiaries own 12 major dams that are subject to the requirements of the Federal Dam Safety Act of 1986. The dams normally undergo a comprehensive engineering evaluation annually. The Company believes the dams are structurally sound and well maintained. One of the dams owned by Ohio Water will require structural improvements which are currently estimated to cost $2.7 million. In addition to the SDWA, the CWA and Federal Dam Safety Act of 1986, numerous federal and state environmental laws affect the operations of the Consumers Water Subsidiaries. In addition to the capital expenditures and costs currently anticipated, changes in environmental regulation, enforcement policies and practices or related matters may result in additional capital expenditures and costs. Capital expenditures and costs required as a result of water quality standards and environmental requirements are normally recognized by state public utility commissions as appropriate plant additions in established rates. Water Subsidiary Information Consumers' five largest water subsidiaries, Ohio Water Service Company (Ohio Water), Consumers Illinois Water Company (Consumers Illinois), Garden State Water Company (Garden State), Shenango Valley Water Company, (Shenango), and Inter-State Water Company (Inter-State) accounted for approximately 78% of consolidated operating revenues of the water subsidiaries in 1993 and 75% of consolidated water utility net property, plant and equipment at December 31, 1993. Consumers' five largest water subsidiaries are discussed separately below. Ohio Water Service Company Ohio Water is the largest of the Consumers Water Subsidiaries, accounting for approximately 35% of the operating revenues of the water subsidiaries in 1993. As of December 31, 1993, Ohio Water operates five separate systems, five of which deliver treated water and one of which delivers partially treated water primarily to industrial customers. Ohio Water serves a number of communities in northeastern and central Ohio. The following indicates the distribution of 1993 year-end customers, revenues and net utility plant among the five districts of Ohio Water. (Dollars in Thousands) Number of Utility Net Utility Customers Revenues Plant Lake Erie East District 7,516 $ 3,211 $ 8,789 Lake Erie West District 25,254 7,098 35,239 Massillon District 23,039 8,330 31,237 Struthers District 14,201 5,640 18,067 Washington Court House District 0 2,326 0 Mahoning Valley District 10 539 2,508 ------- -------- --------- Total 70,020 $ 27,144 $ 95,840 ======= ======== ========= Consumers Illinois Water Company Consumers Illinois serves 32,218 water customers in the City of Kankakee, Village of Bourbonnais, and a portion of the Village of Bradley, as well as unincorporated areas of Kankakee, Bourbonnais, Aroma, Limestone, and Manteno Townships, all in Kankakee County; as well as the Village of University Park and unincorporated areas of Crete and Monee Townships in Will County, and portions of Lee, Boone and Knox Counties, all in the state of Illinois. The Company also serves 10,042 sewer customers in the Village of University Park, portions of Crete and Monee Townships in Will County, and portions of Lee and Boone Counties, all in the state of Illinois. The company sold its Bourbonnais wastewater collection operation on January 13, 1993, for a gain, net of taxes, of approximately $847,000. The operation generated $1.1 million in revenues and had 5,007 customers in 1992. Consumers Illinois obtains its water supply for its customers in Kankakee County from the Kankakee River and satellite wells. In Will, Lee, Boone and Knox counties, its customers are supplied from deep well systems. The economy of the Company's service areas is based on agriculture and diverse light industries. Consumers Illinois' net utility plant at December 31, 1993, and utility revenues for 1993 were $45,731,000 and $10,741,000, respectively. Garden State Water Company Garden State (and its 93.2% owned subsidiary, Califon Water Company) operates three districts in New Jersey which serve 28,374 customers in territories which are not contiguous. Each district draws its water from deep high capacity wells. The Blackwood District serves a growing residential area, primarily in Camden County. The Hamilton District serves a growing residential area that also includes a small amount of light industry and agriculture, primarily in Mercer County. The Phillipsburg District serves an industrial and agricultural community and outlying municipalities, primarily in Warren County, that are experiencing modest growth. Garden State's net utility plant at December 31, 1993, and utility revenues for 1993 were $40,345,000 and $9,452,000 respectively. Shenango Valley Water Company Shenango, which draws its water from the Shenango River, and its wholly-owned Ohio subsidiary, Masury Water Company, serve 17,044 residential, commercial, industrial and wholesale customers in the cities of Sharon and Farrell, the boroughs of Wheatland, New Wilmington and West Middlesex, and portions of Hermitage, Mercer, Pulaski and Shenango Townships, all in Pennsylvania, and Trumbull County, Ohio. The economy of the area is largely based on heavy industrial manufacturing. Shenango's net utility plant at December 31, 1993, and utility revenue for 1993 were $22,544,000 and $6,335,000 respectively. Inter-State Water Company Inter-State serves 16,799 residential, commercial, industrial and wholesale customers in the cities of Danville, Tilton, Westville and Catlin and the Lake Boulevard and Hooton areas in Illinois. Inter-State draws its water from Lake Vermilion. Inter-State's corporate offices are located in Danville, Illinois, a city of approximately 34,000 residents, with an economy based on agriculture and heavy industrial manufacturing. Inter-State's net utility plant at December 31, 1993 and utility revenue for 1993 were $32,167,000 and $7,055,000 respectively. Utility Services C/P Utility Services, Inc. (C/P) provides services primarily in the area of meter services, contract operations, corrosion engineering services, environmental engineering services, and water conservation to the utility industry and certain industrial clients, primarily in the northeastern United States. In 1992, C/P began offering its services in the southeastern United States from a regional office in Orlando, Florida. On December 7, 1993, C/P Utilities acquired the assets of EnviroAudit, an environmental services company, for $260,000. C/P's services in the areas of environmental engineering and contract operations subject it to possible liability in environmentally sensitive areas such as the removal of underground storage tanks, site remediation, and environmental assessments of sites and facilities. C/P maintains professional liability insurance with respect to the services it provides in amounts and subject to deductibles and exclusions believed by C/P's management to be appropriate. Since September of 1987, C/P has managed the operation of the Merrill Creek Reservoir, a pumped storage facility owned by several power companies, for the purpose of augmenting flows in the Delaware River during periods of low flow or to replace water used by the owners for cooling purposes. C/P's contract for the operation of this facility was renewed for an additional five-year period at the end of 1992. In June, 1993, C/P was awarded three contracts to install new water meters in New York City. The total award for these three contracts is $10.7 million. C/P began work on these projects in December. C/P's total revenues for the years ended December 31, 1993, 1992 and 1991 were $11 million, $9.7 million, and $7.6 million, respectively. Approximately $117,000, or approximately 1%, of C/P's 1993 revenue was derived from services provided to the Consumers Water Subsidiaries. Discontinued Operations On October 6, 1993, the Company announced its intention to dispose of its manufactured housing business, Burlington Homes of New England, Inc., and to concentrate its effort on its water resource management business. Burlington was offered for sale. It has had losses aggregating $1.8 million from December 31, 1989, through September 30, 1993, and estimated losses under the disposal equal $4.2 million, net of taxes. To date, efforts to sell Burlington have been unsuccessful, therefore, an additional $1.1 million reserve was recorded in the fourth quarter. The plant has been closed and Burlington has begun the liquidation of its assets. Please see Note 13 to the consolidated Financial Statements for further detail. In 1990, the Company decided to discontinue the operations of The Dartmouth Company. As of this date, Dartmouth has sold, or otherwise disposed of, all of its properties. As a result of the successful resolution of material uncertainties related to the disposition of the Company's real estate operations, the Company reversed a total of $1.8 million of its reserve for losses from discontinued operations during 1991. Please see Note 12 to the Consolidated Financial Statements for further detail. Employees Consumers Water Company and its subsidiaries employed 693 people as of December 31, 1993, of which 504 are employed by the Consumers Water Subsidiaries. Non-supervisory personnel at Ohio, Shenango Valley, Consumers Illinois, Roaring Creek, Inter-State and Pennsylvania water companies were covered by collective bargaining agreements. Employee relations are considered by management to be satisfactory throughout the Company. Foreign Operations The Company had no foreign operations or export sales in 1993. Item 2. Item 2. Properties. (a)Description See Item 1. "Consumers Water Subsidiaries" for description of Consumers' principal properties, and encumbrances thereon. Consumers' properties are located as follows: Illinois (1) Consumers Illinois Water Company with five divisions in Kankakee, University Park, Sublette, Oak Run and Candlewick, Illinois. (2) Inter-State Water Company located in Danville, Illinois. Ohio (3) Ohio Water Service Company with corporate offices in Poland and five operating districts located in Massillon, Struthers, Mahoning Valley, Geneva and Mentor, Ohio. (4) Masury Water Company located in Trumbull County, Ohio. Pennsylvania (5) Pennsylvania Water Company located in Sayre, Pennsylvania (6) Shenango Valley Water Company located in Sharon, Pennsylvania. (7) Roaring Creek Water Company located in Shamokin, Pennsylvania. New Jersey (8) Garden State Water Company with corporate offices in Hamilton and operating districts in Blackwood, Hamilton Square and Phillipsburg, New Jersey. (9) Califon Water Company located in Califon, New Jersey. Connecticut (10) C/P Utility Services Company located in Hamden, Connecticut and Orlando, Florida. (11) EnviroAudit, Ltd. located in Centerbrook, Connecticut. New Hampshire (11) Southern New Hampshire Water Company located in Londonderry, New Hampshire. Maine (12) Maine Water Company with four divisions located in Kezar Falls, Freeport, Damariscotta and Oakland, Maine. (13) Camden and Rockland Water Company located in Rockland, Maine. (14) Wanakah Water Company with three divisions in Skowhegan, Greenville and Millinocket, Maine. (15) Burlington Homes of New England located in Oxford, Maine. (16) Consumers' corporate headquarters located in Portland, Maine. Item 3. Item 3. Legal Proceedings. Various environmental orders and policies affecting the Consumers Water Subsidiaries are described above under the caption "Environmental Regulation." In March, 1993, an outside contractor spilled a small amount of mercury while working one of Ohio Water's water treatment plants. Several areas in and around the plant were contaminated by the spill. Although no mercury has contaminated Ohio Water's water supply, Ohio Water is continuously monitoring the situation to maintain water quality. Ohio Water contacted all appropriate regulatory agencies and the clean up has been completed. The total cost to clean up the spill was approximately $900,000. Ohio Water has received $100,000 from its insurer and is currently seeking recovery of all the clean up costs from the contractor. While there can be no assurance as to the ultimate outcome of Ohio Water's efforts to obtain such recovery, management believes it is probable that Ohio Water will recover clean up costs from the contractor and/or the contractor's insurers and, therefore, has deferred the cost incurred in connection with the spill. On December 20, 1993, A.P. O'Horo Company filed a complaint against Ohio Water in Lake County Court of Common Pleas seeking recovery of the retainage of $250,000 that Ohio is withholding on this project. On December 30, 1993, Ohio Water filed a counter claim against A.P. O'Horo Company seeking recovery of all past and future costs relating to the spill. Ohio Water is also asking the court to dismiss A.P. O'Horo's complaint. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters. (a) Market Information The common shares of Consumers are listed on the National Market System of NASDAQ (symbol: CONW). The following table sets forth the high and low last sale prices for the common shares for the periods indicated, as reported by NASDAQ, together with cash dividends declared per common share. DIVIDENDS Calendar Year HIGH LOW DECLARED First Quarter 19 17 $0.285 Second Quarter 19 3/4 17 1/4 0.285 Third Quarter 21 1/4 18 1/2 0.29 Fourth Quarter 21 1/4 17 1/4 0.29 ------ $1.15 First Quarter 18 1/2 15 1/2 0.28 Second Quarter 19 3/4 14 1/4 0.28 Third Quarter 19 1/2 16 1/4 0.285 Fourth Quarter 19 1/4 17 1/2 0.285 ----- $1.13 (b) Holders As of March 22, 1994, there were approximately 5,900 shareholders of record of the Registrant's common stock. Item 6. Item 6. Selected Financial Data. (Dollars in Thousands Except Per Share Amounts) 1993 1992 1991 1990 1989 Operating Revenue $ 89,084 $ 84,245 $ 79,965 $75,296 $ 71,574 Net Income from Continuing Operations $ 12,003 $ 8,501 $ 9,791 $ 7,488 $ 7,212 Earnings Per Common Share: Continuing Operations $ 1.63 $ 1.21 $ 1.52 $ 1.23 $ 1.21 Total $ .80 $ 1.14 $ 1.74 $( 0.33) $ 1.15 Dividends Declared Per Common Share $ 1.15 $ 1.13 $ 1.11 $ 1.09 $ 1.06 Total Assets $371,657 $343,033 $315,124 $302,220 $287,404 Long-Term Debt of Continuing Operations (including current maturities, sinking fund requirements and redeemable preferred stock) $ 125,080 $ 131,667 $ 106,666 $ 113,875 $ 93,964 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis sets forth certain factors relative to the financial condition of the Company at December 31, 1993, and the results of its operations for the three years ended December 31, 1993, as compared to the same period of the prior year. LIQUIDITY AND CAPITAL RESOURCES CONSTRUCTION PROGRAM Capital expenditures for the year ended December 31, 1993, totaled $30.8 million, net of contributions and advances, the majority of which relates to the Consumers Utility subsidiaries. Projects include $2.9 million spent on a water treatment plant expansion in Ohio, $4.9 million on a new water treatment plant in Pennsylvania, $2.0 million spent on a disinfection facility in Maine and other smaller projects throughout the Company. The Company expects capital expenditures for 1994 through 1996 to be approximately $116 million, net of contributions and advances. The high level of expected capital expenditures is in large part due to the Safe Drinking Water Act (SDWA), the Clean Water Act (CWA) and other regulations. Construction has begun for a $16 million water treatment plant and transmission main in Pennsylvania required by state regulations under the SDWA to be completed by the end of 1995. The Company's utility subsidiaries plan to file for recovery of, and return on, capital used to fund their capital expenditure programs. While costs which have been prudently incurred in the judgment of the appropriate public utility commission have been, and are expected to continue to be, recognized in rate setting, no assurance can be given that requested rate increases or any portion thereof will be approved. To support these capital requirements over the next three years, some subsidiaries will be required to file for large percentage rate increases, in large part due to the significant capital expenditures resulting from compliance with the SDWA and the CWA. FINANCING AND CAPITALIZATION The table below shows the cash generated and used by the Company during 1993. Cash was generated from: (Dollars in millions) Operating activities $17.3 Net increase in short-term debt 10.3 Long-term debt issued 19.4 Common stock issued 15.4 Sale of properties including the Bourbonnais wastewater system and the Washington Court House Division of Ohio Water Service 10.2 ------- Total cash generated $ 72.6 ======= Cash was used: Repay long-term debt $26.0 Pay dividends 8.4 Capital expenditures net of CIAC 30.8 Increase in funds restricted for capital projects 4.4 ------ Total cash used $69.6 ====== At December 31, 1993, approximately $9.5 million of tax exempt financing proceeds remained on the balance sheet as restricted funds for specific capital projects including $8.9 million to be used for the $16 million water treatment plant and transmission main in Pennsylvania. Common stock issued includes proceeds from the issuance of 690,000 shares through a public offering in the fourth quarter of 1993. Water utilities will require higher equity ratios to maintain current debt ratings due to recognition by Standard & Poors' rating system of additional risk of the SDWA requirements and uncertainty of future regulatory treatment of the cost of these requirements. This, coupled with the size of the 1994 - 1996 capital expenditure program, makes it likely that the Company will again return to the equity market in the next three years. Any cash flow needs not provided through stock issuance will, as usual, be financed with short-term lines of credit until each subsidiary's short-term debt level is high enough to warrant a placement of long-term debt, generally in the $4-$6 million range. As of December 31, 1993, the Company had unused lines of credit available of over $82 million. In addition, the Company plans to continue to use tax exempt long-term debt financing in appropriate situations. The $16 million project in Pennsylvania mentioned above is being financed, in large part, with $14 million of 6.375% tax exempt bonds issued on behalf of Roaring Creek Water Company in October, 1993. The Company plans to continue to take advantage of the current low interest rates by refinancing long-term debt whenever appropriate. DISCONTINUED OPERATIONS On October 6, 1993, the Company announced its intention to dispose of its manufactured housing business, Burlington Homes of New England, Inc., and to concentrate its effort on its water resource management business. A reserve of $4.2 million was established in the third quarter. Burlington was offered for sale. It had losses aggregating $1.8 million from December 31, 1989, through September 30, 1993. To date, efforts to sell Burlington have been unsuccessful, and an additional $1.1 million reserve was recorded in the fourth quarter. The plant has been closed and Burlington has begun the liquidation of its assets. The operating results of Burlington prior to the date of discontinuance is shown under "Discontinued Operations" in the Company Consolidated Statements of Income. All of the financial statements of prior periods have been restated to reflect the discontinuance of Burlington's operations. ACQUISITIONS AND DISPOSITIONS On December 7, 1993, C/P Utilities acquired the assets of EnviroAudit Ltd., an environmental services company, for $260,000. On January 13, 1993, the Company sold the Bourbonnais wastewater collection operation of Consumers Illinois Water Company to the village of Bourbonnais for a gain, net of taxes, of approximately $847,000. The operation generated approximately $1.1 million in revenues and had 5,007 customers in 1992. On December 16, 1993, the Company sold the Washington Court House Division of Ohio Water Service Company to the City for a gain, net of taxes, of approximately $3.0 million. The Washington Court House Division served approximately 6,000 customers and generated approximately $2.3 million in revenue in 1993. Over the past five years, the Company has acquired eight water systems. Although the Company currently has no material acquisitions pending, management anticipates continuing the acquisition policy of recent years. OTHER In March, 1993, an outside contractor spilled a small amount of mercury while working at one of Ohio Water's water treatment plants. Several areas in and around the plant were contaminated by the spill. Although no mercury has contaminated Ohio Water's water supply, Ohio Water is continuously monitoring the situation to maintain water quality. Ohio Water contacted all appropriate regulatory agencies and the cleanup has been completed. The total cost to cleanup the spill was approximately $900,000. Ohio Water has received $100,000 from its insurer and is currently seeking recovery of all the cleanup costs from the contractor. While there can be no assurance as to the ultimate outcome of Ohio Water's efforts to obtain such recovery, management believes it is probable that Ohio Water will recover cleanup costs from the contractor and/or the contractor's insurers and, therefore, has deferred the cost incurred in connection with the spill. The Company adopted Statement of Financial Accounting Standards (SFAS) 106, Employer's Post Retirement Benefits (other than Pensions), and SFAS 109, Accounting for Income Taxes, in the first quarter, 1993. SFAS 106 requires the expected cost of Post Retirement Benefits (other than Pensions) be expensed in the years employees render service. This is a significant change in the Company's previous policy of recording these costs on a cash basis. The annual expense under the new method was $584,200 compared to $75,000 under the old method in 1992. The Public Utilities Commissions have ruled in generic proceedings in each of the states which the Company operates except Illinois, that they will allow full accrual of SFAS 106 costs. They also ordered that the Company's subsidiaries in those states record the costs as regulatory assets until the next rate case. The Illinois Commerce Commission has concluded that any costs associated with this statement must be expensed until the Company's first rate proceeding. Of the $584,200 total expected 1993 cost, $136,000 is related to the Illinois' utilities. SFAS 109, Accounting for Income Taxes, required the Consumers Water subsidiaries to increase deferred taxes by approximately $2.8 million. This is offset by a corresponding increase in deferred charges. There is no material impact on the income statement. The effect of the new standard on C/P and Consumers Parent is not material to the Consolidated Financial Statements. RESULTS OF OPERATIONS 1993 Compared to 1992 UTILITY REVENUE Utility revenues increased $3.5 million or 4.7% in 1993 compared to 1992 due primarily to $2 million in rate increases, $2.1 million from the inclusion of revenues from the properties acquired in Maine and Pennsylvania in 1992, and increased consumption due to dry weather in some areas served by Consumers Water subsidiaries. These increases were partially offset by the revenue impact of the sale of the Bourbonnais wastewater system, which had revenue in 1992 of $1.1 million. Currently, there are five rate cases pending in which approximately $7.3 million in additional revenues is sought. These cases are timed to seek recovery of, and a return on, funds used to finance the large capital expenditure program. UTILITY OPERATING EXPENSES Water utility operating expenses increased approximately $4.1 million in 1993 compared to 1992. Increased expenses associated with the new acquisitions, increased depreciation and property tax expense due to increased plant balances and normal increases in labor costs accounted for most of the increase. OTHER OPERATIONS - REVENUE AND EXPENSE Other operating revenue increased $1.3 million in 1993 or 13.6% over 1992, while other operating expenses increased by $1.7 million or 17.5%. The revenue increase is due primarily to revenue of C/P's New York City meter installation projects. Expenses are up more than revenue due to a health insurance adjustment recorded at the Parent company and lower profit margins at C/P Utility Services. The Company's self insured health insurance plan incurred an unusual amount of claims and required an additional accrual of $500,000 in 1993 compared to $300,000 in 1992. At C/P, meter installation sales, traditionally a low margin field, increased in 1993 over 1992, while demand for underground storage tank testing, a high margin area, decreased. In June, 1993, C/P was awarded contracts for $10.7 million in additional meter installation projects in New York City. C/P began work on these projects in December 1993. The New York City meter installation projects that C/P was awarded in 1992 are nearing completion. OTHER Interest expense was up $435,000 in 1993 compared to 1992, due primarily to increased debt balances offset by lower interest rates in 1993. Income taxes were down $239,000 due to lower pretax income. Congress recently passed a bill to increase corporate income taxes from a top rate of 34% to 35% for taxable income in excess of $10 million. Management does not expect this increase to have a material impact on the Company's financial results. 1992 Compared to 1991 UTILITY REVENUE Utility revenues for 1992 increased $2.2 million or 3.1% over 1991, due primarily to $4.7 million in rate increases offset by decreased consumption and the revenue impact of the sale of the Marysville Division of Ohio Water Service in June, 1991. At the end of 1992, there were three rate cases pending in which over $2 million in additional revenue was sought. Consumption was down compared to 1991 due to a wetter summer in 1992. UTILITY OPERATING EXPENSES Water utility operating expenses in 1992 showed a nominal increase of approximately $200,000. Increased depreciation and property tax expense associated with higher plant balances were offset by lower operating costs, including a lower pension expense due to favorable investment performance and a change in one subsidiary's vacation policy. OTHER OPERATIONS - REVENUE AND EXPENSE Other operating revenue increased $2.1 million or 27.5%, due primarily to revenue of C/P from two additional New York City meter installation projects. Interest expense was down $905,000 in 1992 compared to 1991, due primarily to lower interest rates in 1992. This reduction was offset by $727,000 less capitalized interest in 1992 due to the completion of the new water treatment plant in Illinois in early 1992. Income taxes were up $1.1 million in 1992 over 1991 due to higher pretax income. The effective rate was 34.1% in 1992 and 34.3% in 1991. In 1992, the Company had a small loss on the sale of a satellite of its New Hampshire subsidiary, which was partially offset by gains from the sale of land in Ohio and Illinois. In 1991, gains from the sales of properties included a gain of $3.1 million (after tax) from the sale of the Marysville Division of Ohio Water, and a net gain of $207,000 (after tax) from the sale of land owned by the Company or its subsidiaries in Ohio, Pennsylvania, and Illinois. Item 8. Item 8. Financial Statements and Supplementary Data. Page Reference Report of Management Report of Independent Public Accountants Consolidated Statements of Income for Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Capitalization and Interim Financing at December 31, 1993 and 1992 Consolidated Statements of Cash Flow for Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Change in Common Shareholders' Investment for Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Quarterly Information Pertaining to the Results of Operations for the Years Ended December 31, 1993 and 1992 Item 9. Item 9. Disagreements on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Incorporated by reference are the "Nominees for Election as Directors," "Other Executive Officers" and "Compliance with Beneficial Ownership Reporting Rules" sections of the Company's Definitive Proxy Statement filed pursuant to Regulation 14A. Item 11. Item 11. Executive Compensation. Incorporated by reference is the "Executive Compensation" section of the Company's Definitive Proxy Statement filed pursuant to Regulation 14A. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated by reference is the "Common Stock Ownership of Certain Beneficial Owners and Management" section of the Company's Definitive Proxy Statement filed pursuant to Regulation 14A. Item 13. Item 13. Certain Relationships and Related Transactions. Incorporated by reference is the "Executive Compensation" section of the Company's Definitive Proxy Statement filed pursuant to Regulation 14A. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) List of financial statements, schedules and exhibits. (1) Consolidated financial statements and notes thereto of Consumers Water Company and its subsidiaries together with the Report of Independent Public Accountants, are listed as part of Item 8 of this Form 10-K. (2) Schedules V Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991. VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991. VIII Valuation and Qualifying Accounts for the Years Ended December 31, 1993, 1992 and 1991. X Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991. All other schedules have been omitted, since they are not required, not applicable or the information is included in the consolidated financial statements or notes thereto. (3) Exhibits Exhibit 2.1 Assets Purchase and Sale Agreement between Ohio Water Service and the City of Washington, Ohio dated October 28, 1993 is submitted herewith as Exhibit 2.1. 3.1 Conformed Copy of Restated Articles of Incorporation of Consumers Water Company, as amended, incorporated by reference to Exhibit 4.1.6 to Consumers Water Company's Registration Statement on Form S-2 (No. 33-41113), filed with the Securities and Exchange Commission on June 11, 1991. 3.2 Bylaws of Consumers Water Company, as amended March 2, 1994, are submitted herewith as Exhibit 3.2. 4.1 Instruments defining the rights of security holders, including Indentures. The registrant agrees to furnish copies of instruments with respect to long-term debt to the Commission upon request. 10.1 Noncompetition and Consulting Agreement between Consumers Water Company and John H. Schiavi incorporated by reference to Exhibit 10.2 of Consumers Water Company's Annual Report on form 10-K for the year ended December 31, 1992. 10.2* Consumers Water Company 1988 Incentive Stock Option Plan is submitted herewith as Exhibit 10.2. 10.3* Consumers Water Company 1993 Incentive Stock Option Plan is incorporated by reference to Appendix B to definitive proxy statement dated April 5, 1993. 10.4* Consumers Water Company 1992 Deferred Compensation Plan for Directors, Plan A, incorporated by reference to Exhibit 10.5.2 to Consumers Water Company's Annual Report on Form 10K for the year ended December 31, 1991. 10.5* Consumers Water Company 1992 Deferred Compensation Plan for Directors, Plan B, incorporated by reference to Exhibit 10.5.3 to Consumers Water Company's Annual Report on Form 10-K for the year ended December 31, 1991. 10.6 Letter Agreement between Consumers Water Company and Anjou International Company dated February 7, 1986, incorporated by reference to Exhibit 10.6 to Consumers Water Company's Registration Statement on Form S-2 (No. 33-41113), filed with the Securities and Exchange Commission on June 11, 1991. 10.7 Assignment of Rights under February 7, 1986 Agreement between Consumers Water Company and Anjou International Company to Compagnie Generale des Eaux, dated November 12, 1987, incorporated by reference to Exhibit 10.7 to Consumers Water Company's Annual Report on Form 10k for the year ended December 31, 1992. 10.8 Form of Indemnification Agreement entered into between Consumers Water Company and each of its current directors and executive officers, incorporated by reference to Exhibit 10.8 to Consumers Water Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. 10.9* Employment Agreement between Peter L. Haynes and Consumers Water Company incorporated by reference to Exhibit 10.11 to Consumers Water Company's Annual Report on Form 10-K for the year ended December 31, 1992. 11. Statement of Computation of Per Share Earnings is submitted herewith as Exhibit 11. 22. List of Subsidiaries of the Registrant is submitted herewith as Exhibit 22. 23. Consent of Arthur Andersen & Co is submitted herewith as Exhibit 23. (b)Reports on Form 8K On November 24, 1993, Consumers Water Company filed a Form 8-K with the Securities and Exchange Commission reporting, under Item 5 thereof, the effectiveness of the Company's Registration Statement on Form S-3, File No. 33-71318, in connection with the public offering of its common shares and incorporating therein the final Prospectus distributed in connection with the offering. - ------------------------------------------ * Management contract or compensatory plan or arrangement required to be filed as an Exhibit pursuant to Item 14(c) of Form 10-K. CONSUMERS WATER COMPANY 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. By: /s/ Peter L. Haynes 03/28/94 _______________________________ _________ Peter L. Haynes Date President and Director (Chief Executive Officer) 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. By: /s/ John F. Isacke 03/28/94 _____________________________ _________ John F. Isacke Date Senior Vice President - Development and Administration (Chief Financial Officer) By: /s/ Gary E. Wardwell 03/28/94 _______________________________ _________ Gary E. Wardwell Date Controller (Chief Accounting Officer) By: /s/ David R. Hastings, II 03/28/94 ______________________________ _________ David R. Hastings, II Date Chairman and Director By: /s/ Jack S. Ketchum 03/28/94 ______________________________ _________ Jack S. Ketchum Date Director By: /s/ John E. Menario 03/28/94 ______________________________ _________ John E. Menario Date Director By: /s/ J. Bonnie Newman 03/28/94 ________________________________ _________ J. Bonnie Newman Date Director By: /s/ John E. Palmer, Jr. 03/28/94 ________________________________ _________ John E. Palmer, Jr. Date Director CONSUMERS WATER COMPANY 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. By: /s/ Eliot B. Payson 03/28/94 ________________________________ _________ Eliot B. Payson Date Director By: /s/ Elaine D. Rosen 03/28/94 _______________________________ _________ Elaine D. Rosen Date Director By: -------------------------------- --------- William B. Russell Date Director By: /s/ John H. Schiavi 03/28/94 _______________________________ _________ John H. Schiavi Date Director By: /s/ John W. L. White 03/28/94 _______________________________ _________ John W. L. White Date Director By: /s/ Claudio Elia 03/28/43 _______________________________ _________ Claudio Elia Date Director By: /s/ Peter L. Haynes 03/28/94 ________________________________ _________ Peter L. Haynes Date President and Director (Chief Executive Officer) Consumers Water Company and Subsidiaries Report of Management The accompanying consolidated financial statements of Consumers Water Company and its subsidiaries were prepared by management, which is responsible for the integrity and objectivity of the data presented, including amounts that must necessarily be based on judgments or estimates. The consolidated financial statements were prepared in conformity with generally accepted accounting principles and financial information appearing throughout this annual report is consistent with these statements. In recognition of its responsibility, management maintains and relies upon systems of internal accounting controls, which are reviewed and evaluated on an ongoing basis. The systems are designed to provide reasonable assurance that transactions are executed in accordance with management's authorization and properly recorded to permit preparation of reliable financial statements, and that assets are safeguarded. Management must assess and balance the relative cost and expected benefits of these controls. These financial statements have been audited by Arthur Andersen & Co., the Company's independent public accountants. Their audit, in accordance with generally accepted auditing standards, resulted in the expression of their opinion. Arthur Andersen & Co.'s audit does not limit management's responsibility for the fair presentation of the financial statements and all other information in this annual report. The Audit Committee of the Board of Directors, composed solely of outside directors, meets periodically with management, internal audit, and Arthur Andersen & Co. to review the work of each and to discuss areas relating to internal accounting controls, audits, and financial reporting. Arthur Andersen & Co. and the Company's internal audit personnel have free access to meet individually with the Committee, without management present, at any time, and they periodically do so. /s/ John F. Isacke - -------------------- John F. Isacke Senior Vice President Chief Financial Officer Arthur Andersen & Co. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Shareholders and Board of Directors of Consumers Water Company: We have audited the accompanying consolidated balance sheets and the consolidated statements of capitalization and interim financing of CONSUMERS WATER COMPANY (a Maine corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, change in common shareholders' investment and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Consumers Water Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in notes 2 and 9 to the Consolidated Financial Statements, effective January 1, 1993, the Company changed its method of accounting for income taxes and other post-retirement benefits. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opionion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. -------------------------- ARTHUR ANDERSEN & CO. Boston, Massachusetts February 9, 1994 Consumers Water Company and Subsidiaries Consolidated Statements of Income For the years ended December 31, (In Thousands Except Per Share Amounts) 1993 1992 1991 Revenue and Sales: Water utility operations $78,171 $74,637 $72,427 Other operations 10,913 9,608 7,538 - ------------------------------------------------------------------ Operating revenue 89,084 84,245 79,965 - ------------------------------------------------------------------ Costs and Expenses: Water utility operations 55,127 50,996 50,795 Other operations 11,112 9,454 8,158 - ------------------------------------------------------------------ Operating expenses 66,239 60,450 58,953 - ------------------------------------------------------------------ Operating Income 22,845 23,795 21,012 - ------------------------------------------------------------------ Other Income and (Expense): Interest expense (11,905) (11,470)(12,375) Construction interest capitalized 778 367 1,094 Preferred dividends and minority interest of subsidiaries (147) (143) (146) Other, net (Notes 3 and 11) 692 344 116 - ------------------------------------------------------------------ (10,582) (10,902)(11,311) - ------------------------------------------------------------------ Earnings from Continuing Operations Before Income Taxes and Gains (Losses) from Sales of Properties 12,263 12,893 9,701 Income Taxes (Note 2) 4,128 4,367 3,212 - ------------------------------------------------------------------ Earnings from Continuing Operations: Before Gains (Losses) from Sales of Properties 8,135 8,526 6,489 Gains (Losses) from Sales of Properties, Net (Note 7) 3,868 (25) 3,302 - ------------------------------------------------------------------ Income from Continuing Operations 12,003 8,501 9,791 - ------------------------------------------------------------------ Income (Loss) from Discontinued Operations: Before Discontinuance (784) (479) (373) Provision for Loss on Disposal of Discontinued Operations (5,300) - 1,800 - ------------------------------------------------------------------ Total from Discontinued Operations (Notes 12 and 13) (6,084) (479) 1,427 - ------------------------------------------------------------------ Net Income $5,919 $8,022 $11,218 ================================================================== Weighted Average Shares Outstanding 7,320 7,007 6,429 Earning (Loss) per Common Share: Continuing Operations- Before Gains (Losses) from Sales $1.10 $1.21 $1.00 Total $1.63 $1.21 $1.52 - ------------------------------------------------------------------ Discontinued Operations- Before Discontinuance ($0.11) ($0.07) ($0.06) Earnings (Loss) on Disposal of Discontinued Operations ($0.72) - $0.28 - ------------------------------------------------------------------ Total ($0.83) ($0.07) $0.22 - ------------------------------------------------------------------ Total $0.80 $1.14 $1.74 ================================================================== The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiarie Consolidated Balance Sheets December 31, (Dollars in Thousands) 1993 1992 Assets Property, Plant and Equipment, at cost: Water utility plant, in service $360,115 $349,156 Less - Accumulated depreciation 63,579 59,705 --------------------- 296,536 289,451 --------------------- Other subsidiaries 1,710 1,482 Less - Accumulated depreciation 881 820 --------------------- 829 662 --------------------- Construction work in progress 20,180 10,252 --------------------- Net property, plant and equipment 317,545 300,365 - -------------------------------------------------------------------- Assets of Discontinued Operations, Net (Notes 12 and 13) 1,308 5,180 Investments, at cost 2,044 1,918 - --------------------------------------------------------------------- Current Assets: Cash and cash equivalents (Note 4) 4,993 1,768 Accounts receivable, net of reserves of $798 in 1993 and $702 in 1992 10,171 7,548 Unbilled revenue 6,649 8,169 Inventories (Note 1) 1,793 1,863 Prepayments and other 6,524 5,311 - -------------------------------------------------------------------- Total current assets 30,130 24,659 - -------------------------------------------------------------------- Other Assets: Funds restricted for construction activity (Note 3) 9,508 5,093 Deferred charges and other assets 11,122 5,818 - -------------------------------------------------------------------- 20,630 10,911 - -------------------------------------------------------------------- $371,657 $343,033 ==================================================================== Shareholders' Investment and Liabilities: Capitalization (See Separate Statement) Common shareholders' investment $96,938 $84,243 Preferred shareholders' investment 1,069 1,078 Minority interest 2,240 2,247 Long-term debt 124,050 119,832 - -------------------------------------------------------------------- Total capitalization 224,297 207,400 - -------------------------------------------------------------------- Contributions in Aid of Construction 54,045 50,064 - -------------------------------------------------------------------- Current Liabilities: Interim Financing (See Separate Statement) 20,606 21,071 Accounts payable 6,052 3,364 Accrued taxes (Note 2) 6,662 6,530 Accrued interest 3,318 2,992 Accrued expenses and other 11,011 8,829 - -------------------------------------------------------------------- Total current liabilities 47,649 42,786 - -------------------------------------------------------------------- Commitments and Contingencies (Note 10) - -------------------------------------------------------------------- Deferred Credits: Customers' advances for construction 21,338 24,544 Deferred income taxes (Note 2) 19,183 12,803 Unamortized investment tax credits 5,145 5,436 - -------------------------------------------------------------------- 45,666 42,783 - -------------------------------------------------------------------- $371,657 $343,033 ==================================================================== The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiaries Consolidated Statements of Capitalization and Interim Financing December 31, (Dollars in Thousands) 1993 1992 Capitalization (Notes 3 and 5) Common shareholders' investment: Common stock, $1 par value Authorized: 15,000,000 shares in 1993 and 10,000,000 shares in 1992 Issued: 8,041,369 shares in 1993 and 7,129,639 shares in 1992 $8,041 $7,130 Amounts in excess of par value 64,662 50,157 Reinvested earnings 24,235 26,956 - ------------------------------------------------------------------- 96,938 84,243 - ------------------------------------------------------------------- Preferred shareholders' investment: Preferred stock, $100 par value 1,069 1,078 - ------------------------------------------------------------------- Minority interest: Common stock, at equity 562 469 Preferred stock 1,678 1,778 - ------------------------------------------------------------------- 2,240 2,247 - ------------------------------------------------------------------- Long-term debt: First mortgage bonds, debentures and promissory notes- Maturities Interest Rate Range 1993 1.00% to 13.00% - 10,358 1994 69% of Prime to 10.50% 14 710 1995 9.00% to 13.88% 1,624 2,738 1996 6.10% to 11.00% 228 757 1997 5.94% to 7.50% 1,452 3,865 1998 5.94% to 9.38% 573 1,656 1999-2003 70% of Prime to 8.75% 5,637 7,018 2004-2008 8.00% to 10.55% 15,646 17,995 2009-2013 1.00% to 10.54% 14,135 14,193 THEREAFTER 6.10% to 10.40% 85,671 72,277 -------------------- Total first mortgage bonds, debentures and notes 124,980 131,567 Less - Sinking fund requirements and current maturities 930 11,735 -------------------- 124,050 119,832 - ------------------------------------------------------------------- Total capitalization 224,297 207,400 - ------------------------------------------------------------------- Interim financing (Note 4): Notes payable 19,676 9,336 Sinking fund requirements and current maturities 930 11,735 - ------------------------------------------------------------------- Total interim financing 20,606 21,071 - ------------------------------------------------------------------- Total capitalization and interim financing $244,903 $228,471 =================================================================== The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiaries Consolidated Statements of Cash Flows For the years ended December 31, (Dollars in Thousands) 1993 1992 1991 Operating activities: Net income 5,919 $8,022 $11,218 --------------------------- Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 7,994 7,432 6,125 Deferred income taxes and investment tax credits 6,417 1,072 1,475 (Gains) losses on sales of properties (3,869) 25 (3,302) Changes in assets and liabilities: Increase in accounts receivable and unbilled revenue (1,202) (1,695) (1,027) (Increase) decrease in inventories 70 63 (27) (Increase) decrease in prepaid expenses (1,203) 432 (998) Increase (decrease) in accounts payable and accrued expenses 4,134 (236) 4,821 Change in other assets, net of change in other liabilities of continuing operations (4,847) (1,263) 337 Change in assets, net of change in liabilities of discontinued operations (1,428) 257 (7) (Income) loss on disposal of discontinued operations (Notes 12 and 13) 5,300 (1,800) ----------------------------- Total adjustments 11,366 6,087 5,597 ----------------------------- Net cash provided by operating activities 17,285 14,109 16,815 ----------------------------- Investing activities: Capital expenditures (34,655) (21,877) (30,175) Funds restricted for construction activity (4,415) (5,093) 8,271 Increase (decrease) in construction accounts payable 911 (1,092) 829 Net cash cost of acquisitions (Note 6) (260) (3,524) - Net proceeds from sales of properties (Note 7) 10,239 8 8,494 ----------------------------- Net cash used in investing activities (28,180) (31,578) (12,581) ----------------------------- Financing activities: Net borrowing (repayment) of short-term debt 10,340 (7,673) (2,464) Proceeds from issuance of long-term debt 19,429 39,902 6,429 Repayment of long-term debt (25,989) (15,084) (13,619) Proceeds from issuance of stock 15,408 3,570 12,328 Advances and contributions in aid of construction, net of repayments 3,879 3,070 2,868 Taxes paid by developers on advances and contributions in aid of construction (583) (364) (150) Cash dividends paid (8,364) (7,932) (7,202) ----------------------------- Net cash provided by (used in) financing activities 14,120 15,489 (1,810) ----------------------------- Net increase (decrease) in cash and cash equivalents 3,225 (1,980) 2,424 Cash and cash equivalents at beginning of year 1,768 3,748 1,324 ----------------------------- Cash and cash equivalents at end of year $4,993 $1,768 $3,748 ============================= Supplemental disclosures of cash flow information from continuing operations Cash paid during the year for: Interest (net of amounts capitalized) $10,540 $10,612 $11,123 Income taxes $ 3,570 $ 3,713 $ 2,412 Noncash investing and financing activities for the year: Assets acquired by stock issuance and/or assumption of debt of acquired company - $ 998 - Property advanced or contributed $ 855 $ 3,910 $ 455 Note receivable and water rights in exchange for utility assets - $ 2,085 - The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiaries Consolidated Statements of Change in Common Shareholders' Investment Number of Shares, $1 par value, (Dollars in Thousands) Issued and Excess of Reinvested For the years ended Outstanding Par Value Earnings December 31, 1993, 1992 and 1991 Balance, December 31, 1990 6,059,761 $34,744 $23,217 Net income 11,218 Cash dividends: Common shares (7,410) Preferred shares (57) Dividend Reinvestment Plan 116,656 1,802 Employee benefit plans 25,116 349 Stock Issue 690,000 9,345 Other (5) - ----------------------------------------------------------------------------- Balance, December 31, 1991 6,891,533 46,235 26,968 Net income 8,022 Cash dividends: Common shares (7,977) Preferred shares (57) Dividend Reinvestment Plan 170,823 2,823 Employee benefit plans 32,957 542 Other 34,326 557 - ----------------------------------------------------------------------------- Balance, December 31, 1992 7,129,639 50,157 26,956 Net income 5,919 Cash dividends: Common shares (8,584) Preferred shares (56) Dividend Reinvestment Plan 187,679 3,280 Employee benefit plans 34,051 569 Stock Issue 690,000 10,652 Other 4 - ----------------------------------------------------------------------------- Balance, December 31, 1993 8,041,369 $64,662 $24,235 ============================================================================= The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiaries Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of Consumers Water Company (the Company) and its water utility and utility services subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements and related footnote information have been restated to reflect the Company's real estate subsidiary, The Dartmouth Company, and its manufactured housing subsidiary, Burlington Homes of New England, as discontinued operations. See Notes 12 and 13. Regulation The rates, operations, accounting and certain other practices of the Company's utility subsidiaries are subject to the regulatory authority of state public utility commissions. Property, Plant and Equipment The utility subsidiaries generally capitalize interest at current rates on short-term notes payable used to finance major construction projects. Utility plant construction costs also include payroll, related fringe benefits and other overhead costs associated with construction activity. Depreciation is provided principally at straight-line composite rates. consolidated provision, based on average amounts of depreciable utility plant (which excludes contributions in aid of construction and customers' advances for construction for most subsidiaries), approximated 2.4% in 1993, 2.3% in 1992 and 2.1% in 1991. Under composite depreciation, when property is retired or sold in the normal course of business, the entire cost, including net cost of removal, is charged to accumulated depreciation and no gain or loss is recognized. The utility services subsidiary depreciates property and equipment using the straight-line method over the estimated useful lives of the assets, generally 5 to 10 years. Revenue Recognition All of the utility subsidiaries accrue estimated revenue for water distributed but not yet billed as of the balance sheet date. Unbilled revenue also includes amounts for work performed but not yet billed for C/P Utility Services Company, Inc. C/P accounts for contracts using the percentage-of-completion method for long-term contracts and the completed contract method for short-term contracts. Cash Flows For purposes of the Consolidated Statements of Cash Flows, the Company considers all highly liquid instruments with an original maturity of three months or less, which are not restricted for construction activity to be cash equivalents. Consumers Water Company and Subsidiaries Notes to Consolidated Financial Statements Disclosures about Fair Value of Financial Instruments The carrying amount of cash, temporary investments, notes receivable, and preferred stock approximate their fair value. The fair value of long-term debt based on borrowing rates currently available for loans with similar terms and maturities is approximately $139 million. Inventories Inventories generally consist of materials and supplies. They are stated at the lower of cost (average cost method) or market. Other Assets Deferred charges consist primarily of financing charges, rate case and other expenses, a note receivable of $1,330,000 and the net excess of acquisition cost over book value of the net assets for the utility subsidiaries. Deferred rate case expenses are amortized over periods allowed by the governing regulatory authorities, generally one to three years. The net excess of the acquisition cost over book value or market value of the net assets of subsidiaries acquired is being amortized principally over a period of 40 years. Other assets also include preliminary survey and investigation costs and certain items amortized, subject to regulatory approval, over their anticipated period of recovery. Deferred financing charges are amortized over the lives of the related debt issues. Customers' Advances/Contributions in Aid of Construction The water subsidiaries receive contributions and advances for construction from or on behalf of customers. Advances received are refundable, under certain circumstances, either wholly or in part, over varying periods of time. Amounts no longer refundable are reclassified to contributions in aid of construction. Contributions and advances received after 1986 are treated as taxable income. Amounts that customers are required to contribute to offset the income taxes payable by the Company are normally included in contributions or advances. Income Taxes The Company and its subsidiaries file a consolidated federal income tax return. The rate-making practices followed by most regulatory agencies allow the utility subsidiaries to recover, through customer rates, federal and state income taxes payable currently and deferred taxes related to certain timing differences between pretax accounting income and taxable income. The income tax effects of other timing differences are flowed through for rate-making and accounting purposes. The Company expects that deferred taxes not collected will be recovered through customer rates in the future when such taxes become payable. Investment Tax Credits Investment tax credits of utility subsidiaries are deferred and amortized over the estimated useful lives of the related properties. Effective January 1, 1986, investment tax credits were eliminated by the Tax Reform Act of 1986 except for property meeting the transitional rules. Consumers Water Company and Subsidiaries Notes to Consolidated Financial Statements Earnings (Loss) Per Common Share Earnings (loss) per common share are based on the annual weighted average number of shares outstanding and common share equivalents. The effect of employee stock options, which are included as common share equivalents, is not significant. (2) Income Tax Expense Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, which requires the use of the liability method in accounting for income taxes. Under the liability method, deferred income taxes are recognized at currently enacted income tax rates to reflect the tax effect of temporary differences between the financial reporting and tax bases of assets and liabilities. Such temporary differences are the result of provisions in the income tax law that either require or permit certain items to be reported on the income tax return in a different period than they are reported in the financial statements. To implement SFAS 109, certain adjustments were made to accumulated deferred income taxes. To the extent such income taxes are recoverable or payable through future rates, regulatory assets and liabilities have been recorded in the accompanying Consolidated Balance Sheets. The adoption of SFAS 109 resulted in the recognition of a net regulatory asset of approximately $2.8 million and had no material impact on the Company's results of operations. At December 31, 1993, accumulated deferred taxes consisted of tax assets of $893,000 related to alternative minimum tax offset by liabilities of $19,665,000, which are predominanty related to accumulated depreciation and other plant related differences. The Company believes that all deferred income tax assets will be realized in the future; therefore, a valuation allowance has not been recorded. The net regulatory asset was approximately $3.1 million at December 31, 1993. The components of income tax expense from continuing operations reflected in the Consolidated Statements of Income are as follows: For the Years Ended December 31, (Dollars in Thousands) 1993 1992 1991 Federal: Currently payable $3,077 $3,255 $ 3,345 Deferred 2,827 668 1,566 Investment tax credit, net of amortization ( 291) ( 183) ( 246) -------- -------- -------- $5,613 3,740 4,665 -------- -------- -------- State: Currently payable 134 589 493 Deferred 195 ( 21) ( 63) -------- -------- -------- 329 568 430 -------- -------- -------- Total provision $5,942 $ 4,308 $ 5,095 ======== ======== ======== The provision for income tax expense is reflected in: Income taxes $4,128 $ 4,367 $ 3,212 Gains (Losses) from sales of properties 1,735 ( 89) 1,808 Other income 79 30 75 ------- -------- -------- Total provision $5,942 $ 4,308 $ 5,095 ======= ========= ========= The table below reconciles the federal statutory rate to a rate computed by dividing income tax expense, as shown in the previous table, by income from continuing operations before income tax expense. 1993 1992 1991 Statutory rate 34.0% 34.0% 34.0% State taxes, net of federal benefit 1.2 3.0 1.9 Effect of decrease in statutory rate on reversing timing items (0.1) (0.2) (0.2) Investment tax credit (0.8) (1.6) (1.8) Other (1.2) (1.1) 0.4 ------- ------- ------ 33.1% 34.1% 34.3% ======= ======= ====== The table below was required prior to the adoption of SFAS 109, therefore, it is only presented for years prior to 1993. The major differences in the timing of recognition of income and expense for tax and accounting purposes, for which deferred income taxes are provided, are as follows: (Dollars in Thousands) 1992 1991 Accelerated depreciation $ 2,896 $ 2,565 Contributions and advances ( 2,570) ( 1,151) Gains from sales of properties - 1,893 Alternative minimum tax 526 ( 1,307) Other, net ( 205) ( 497) -------- -------- $ 647 $ 1,503 ======== ======== (3) Long-Term Debt Maturities and sinking fund requirements of the first mortgage bonds, debentures and notes including capitalized leases are $930,000 in 1994, $2,516,000 in 1995, $883,000 in 1996, $2,219,000 in 1997, $812,000 in 1998, and $117,620,000 thereafter. Substantially all of the Company's water utility plant is pledged as security under various indentures or mortgages. The indentures restrict cash dividends and purchases of the companies' common stocks. The various water utility subsidiaries' indentures generally prohibit the payment of dividends on common shares in excess of retained earnings plus a stated dollar amount. Approximately $26.6 million of reinvested earnings were not so restricted at December 31, 1993. In 1993, funds restricted for construction activity of $9.5 million was obtained through the issuance of tax exempt bonds, the use of which is restricted for utility plant construction. Interest income earned is included in Other, net in the accompanying Consolidated Statements of Income. (4) Notes Payable Notes payable are incurred primarily for temporary financing of plant expansion. It is the subsidiaries' intent to repay these borrowings with the proceeds from the issuance of long-term debt or equity securities. Certain information related to the borrowings of the continuing operations is as follows: (Dollars in Thousands) 1993 1992 1991 Unused lines of bank credit $ 82,574 $47,314 $38,566 Borrowings outstanding at year-end 19,676 9,336 16,809 -------- ------- ------- Total lines of bank credit $102,250 $56,650 $55,375 ======== ======= ======= Monthly average borrowings during the year $ 20,660 $17,310 $20,774 ======== ======= ======= Maximum borrowings at any month-end during the year $ 34,619 $21,612 $26,223 ======== ======= ======= Weighted average annual interest rate during the year 4.5% 6.0% 8.5% ======== ======= ======= Weighted average interest rate on borrowings outstanding at year-end 4.7% 5.1% 6.8% ======== ======= ======= The Company and its subsidiaries are required to maintain compensating balances with several banks holding notes. As of December 31, 1992, cash balances of approximately $50,000 were on deposit representing compensating balances. There were no compensating balances in 1993. There are no legal restrictions on the withdrawal of these funds. (5) Shareholders' Investment As of December 31, 1993, the Company reserved issuable common shares for the following purposes: Dividend Reinvestment Plan 317,728 401(k) Savings Plan 243,685 Stock Option Plans 278,377 Employee Stock Bonus Plan 64,019 --------- 903,809 ========= The stock option plans approved by stockholders in 1988 and 1993 provide for the sale of shares to eligible key employees of the Company and its subsidiaries. The plans provide that option prices shall not be less than 100% of the fair market value on the date of the grant. The options expire after five years. During 1993, 34,500 options were granted, 13,091 options were exercised and 13,445 options lapsed and were cancelled. During 1992, 30,700 options were granted, 12,767 options were exercised, and 25,613 options lapsed and were cancelled. During 1991, 30,700 options were granted, no options were excercised, and 12,877 options lapsed and were cancelled. At December 31, 1993, options for 108,739 shares were exercisable at prices of $18.25, $18.50, $17.75, $16.50 and $19.25 per share. 13,091 stock options were exercised in 1993 at $18.25, $17.75, $16.50, $19.25, and $16.75. 12,767 stock options were excercised in 1992 at $16.50 and $16.75. No stock options were exercised in 1991. Information regarding outstanding preferred stock ($100 par value) of the Company and its subsidiaries is as follows: Of the total 30,000 Consumers Water Company preferred shares authorized with voting rights, 15,925 shares have been designated 5-1/4% Cumulative Preferred Stock Series A. The remaining 14,075 shares are undesignated. The difference between par value and acquisition price was credited to amounts in excess of par value. (6) Acquisitions On December 7, 1993, the Company, through its subsidiary C/P Utilities acquired the assets of EnviroAudit, an environmental services company, for $260,000. On December 31, 1992, the Company, through its subsidiary, Roaring Creek Water Company, acquired the assets of Northumberland Utilities in exchange for $590,000 of the Company's common stock and the assumption of $408,000 in debt. On December 31, 1992, the Company, through its subsidiary Wanakah Water Company, acquired the assets of Greenville, Millinocket and Skowhegan Water Companies for $3.5 million. All of these acquisitions were accounted for using the purchase method of accounting, and the results of their operations have been included in the consolidated financial statements since the date of acquisition. (7) Dispositions On December 16, 1993, the Company sold the Washington Court House Division of Ohio Water Service Company to the City of Washington resulting in a gain, net of taxes, of $3.0 million. In 1993, Washington Court House Division generated $2.3 million in revenue and had 6,000 customers. On January 13, 1993, the Company sold the Bourbonnais wastewater collection system of Consumers Illinois Water Company to the Village of Bourbonnais for a gain, net of taxes, of approximately $847,000. The operation generated $1.1 million in revenues and had 5,007 customers in 1992. On December 31, 1992, Southern New Hampshire Water Company sold its Amherst Division for $2.1 million resulting in a loss, net of taxes, of $27,000. On December 30, 1991, the Company closed on the sale of 389 acres of land in University Park, Illinois, for $1.1 million. This sale generated a loss, net of taxes, of approximately $98,000. On October 1, 1991, Roaring Creek Water Company closed on the sale of 220 acres of land to Northumberland County, Pennsylvania, for $550,000. This sale generated a gain, net of taxes, of approximately $294,000. On June 27, 1991, the Company sold the Marysville Division of Ohio Water Service Company to the City of Marysville for $9.5 million resulting in a gain, net of taxes, of $3.1 million. The Marysville Division generated $1.9 million of revenue during 1990 and served 3,328 customers. (8) Retirement Plan The Company has a defined benefit pension plan covering substantially all of its employees. Pension benefits are based on years of service and the employee's average salary during the last five years of employment. The Company's funding policy is to contribute an amount that will provide for benefits attributed to service to date and for those expected to be earned in the future by current participants, to the extent deductible for income tax purposes. Net pension cost for the years ended December 31, 1993, 1992, and 1991, was $501,000, $30,000, and $582,000, respectively. The funded status of the Plan as of December 31 is as follows: (Dollars in Thousands) 1993 1992 Actuarial present value of benefit obligations: Accumulated benefit obligations Vested $20,448 $17,350 Nonvested 2,132 1,809 ------- ------- Total 22,580 19,159 Effect of future salary increases 7,361 7,502 ------- ------- Projected benefit obligations for services provided to date 29,941 26,661 Market value of plan assets, primarily invested in stocks, bonds and short-term funds 30,067 28,395 ------- ------- Plan assets in excess of projected benefit obligations 126 1,734 Unrecognized net asset existing as of January 1, 1987, being amortized over 22 years (3,317) ( 3,526) Unrecognized prior service cost 2,601 2,814 Unrecognized net gain ( 865) (1,975) -------- ------- Accrued pension cost at year-end $(1,455) $( 953) ======== ======== Net pension cost included the following items: (Dollars in Thousands) 1993 1992 1991 Service cost-benefits earned during the year $ 977 $ 934 $ 941 Interest cost on projected benefit obligations 2,022 1,860 1,740 Actual return on plan assets (2,502) (1,955) (6,549) Net amortization and deferral 4 ( 809) 4,450 --------- ------- -------- Net periodic pension cost $ 501 $ 30 $ 582 ========= ======= ======== The expected long-term rate of return on plan assets was 9.0% in 1993 and 9.5% in 1992 and 1991 and the salary increase assumption was 5.0% in 1993 and 6% in 1992 and 1991. The discount rate used to determine the actuarial present value of the projected benefit obligations was 7.5% in 1993, 8.0% in 1992 and 8.5% in 1991. (9) Postretirement Benefits Employees retiring from the Company in accordance with the retirement plan provisions are entitled to postretirement health care and life insurance coverage. These benefits are subject to deductibles, co-payment provisions and other limitations. The Company may amend or change the plan periodically. In December, 1990, the Financial Accounting Standards Board issued Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (SFAS 106). This new standard, which the Company adopted in the first quarter of 1993, requires that the expected cost of postretirement benefits (other than pensions) be expensed during the years that the employees render service. This is a significant change from the Company's previous policy of recognizing these costs on a cash basis. The Company adopted the new standard using the delayed recognition method. Under this method, the unrecorded SFAS 106 liability as of January 1, 1993, will be amortized to expense on a straight-line basis over a 20-year period. The Company estimates that its SFAS 106 liability related to prior years of service, based upon the current level of benefits, is approximately $3,048,000. The annual expense is $584,200. The utility subsidiaries generally will record some portion of the annual expense as a regulatory asset if full SFAS 106 expense is not included in rates currently and appropriate approval is received from their respective regulators. The public utility commissions have ruled in generic proceedings in each of the states in which the Company operates except Illinois that they will allow full accrual of SFAS 106 costs. They also ordered that the Company's subsidiaries in those states record the costs as regulatory assets until the next rate case. The Illinois Commerce Commission has concluded that any costs associated with this statement must be expensed until the Company's first rate proceeding. Of the $584,200 total 1993 costs, $136,000 is related to the Illinois utilities. The following table sets forth the postretirement health and life insurance plans' combined funded status. (Dollars in Thousands) 1993 Accumulated postretirement benefit obligation ($3,873) Plan assets at fair value - Accumulated postretirement benefit --------- obligation in excess of plan assets ($3,873) Unrecognized net gain from past experience different from that assumed and from changes in assumptions 323 Unrecognized transition obligation 3,048 -------- Accrued postretirement benefit cost $(502) ======== The Company's postretirement health and life insurance plans are unfunded; there are no assets for either plan and the accumulated postretirement benefit obligation for health insurance is $3,371,961 and for life insurance is $501,110. Net periodic postretirement benefit cost for fiscal 1993 included the following components; (Dollars in Thousands) 1993 Service cost-benefits attributed to service during the period $155 Interest cost on accumulated postretirement benefit obligation 269 Amortization of transition obligation over 20 years 160 ------ Net periodic postretirement benefit cost $584 ====== The weighted average discount rate used in determining the accumulated postretirement benefit obligation is 7.5%. A 15% annual rate of increase in the per capita cost of covered health care benefits is assumed for 1993. The health care cost trend rate is assumed to decrease annually through the year 2002 to an ultimate rate of 6%. Increasing the assumed health care cost trend rates by 1% would increase the accumulated postretirement benefit obligation as of December 31, 1993, by $300,000. (10) Commitments and Contingencies The Company is a party in or may be affected by various matters under litigation. The Company expects that some of its operating subsidiaries, in order to comply with the requirements of the Safe Drinking Water Act, may have to invest in significant improvements or additions including, but not limited to, the construction of treatment plants and the modification or replacement of open reservoirs. Management believes that the ultimate treatment of these expenditures and the various matters under litigation will not have a significant adverse effect on either the Company's future results of operations or financial position. The Company has operating leases for buildings, vehicles, water meters and office equipment. Rental expenses relating to these leases for the years ended December 31, 1993, 1992 and 1991 were approximately $1,612,000, $1,684,000 and $1,448,000,respectively. At December 31, 1993, minimum future lease payments under noncancelable operating leases are $1,386,000 in 1994, $916,000 in 1995, $683,000 in 1996, $467,000 in 1997, $127,000 in 1998 and $706,000 thereafter. In March, 1993, an outside contractor spilled a small amount of mercury while working at the Company's subsidiary, Ohio Water Service's (OWS) water treatment plant. Several areas in and around the plant were contaminated by the spill, although no mercury has contaminated OWS's water supply. OWS is continuously monitoring the situation to maintain water quality. The OWS has contacted all the appropriate regulatory agencies and the cleanup has been completed. The total cost to clean up the spill was approximately $900,000. The OWS is currently seeking recovery of these costs from the contractor. Management believes that OWS has a high probability of recovering damages from the contractor and, therefore, has recorded no expenses related to the spill. (11) Other, net In the second quarter of 1991, the Company's New Hampshire utility, Southern New Hampshire Water Company, received a decision and order on its pending rate request, requiring that Southern New Hampshire Water Company reduce its rate base by approximately $616,000. Accordingly, the Company has recorded a write-off of $616,000 ($374,000 after taxes). This write-off is included in Other, net as of December 31, 1991. (12) Discontinuance of Real Estate Operations On July 11, 1990, the Company announced its intention to discontinue and dispose of its real estate business, which includes The Dartmouth Company (Dartmouth) and its wholly owned subsidiary, Arcadia Company (Arcadia). In February 1991, the Company decided to cease any further investment in Dartmouth. This action was in response to increasingly stringent financing requirements for real estate investors, recent bank failures creating a considerable inventory of properties on the market at distressed prices and the inability to forecast a near bottom to the New England real estate market decline. Dartmouth had notes payable to financial institutions aggregating $14.2 million at December 31, 1990, which were secured by its real estate assets and other liabilities of $420,000, consisting primarily of current liabilities. As of December 31, 1991, Dartmouth had sold, or otherwise disposed of, all of its properties. As a result of the successful resolution of material uncertainties related to the disposition of the Company's real estate operations the Company reversed $1.8 million of its reserve for loss on disposal of discontinued operations during 1991. The Dartmouth Company's business is being accounted for as a discontinued operation, and accordingly, operating results to the date of discontinuance are shown separately in the accompanying Consolidated Statements of Income, and all financial statements presented for prior periods have been restated. Total sales for the discontinued real estate operations were $1.7 million in 1991. (13) Discontinuance of Manufactured Housing Operations On October 6, 1993, the Company announced its intention to dispose of its manufactured housing business, Burlington Homes of New England. The business was offered for sale. The estimated loss on the disposal of $4.2 million was recorded in the third quarter of 1993. To date, efforts to sell Burlington have been unsuccessful, and an additional $1.1 million reserve was recorded in the fourth quarter for a total reserve of $5.3 million, net of taxes, of approximately $600,000. The operating results of Burlington Homes prior to the date of discontinuance are shown separately on the accompanying consolidated statements of income, and all financial statements for prior periods have been restated. Total sales for Burlington Homes were $5,486,000, $5,370,000, and $5,240,000 in 1993, 1992, and 1991, respectively. Consumers Water Company and Subsidiaries Unaudited Financial Information Quarterly Financial Data Unaudited quarterly financial data pertaining to the results of operations for 1993 and 1992 are as follows: (Dollars in Thousands Except Per Share Amounts) 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Operating Revenue --- Continuing Operations $20,937 $22,503 $24,521 $21,123 Operating Income --- Continuing Operations $4,662 $5,444 $8,026 $4,713 Net Income(Loss): Continuing Operations $2,111 $1,738 $3,613 $4,541 Discontinued Operations($ 274) ($ 293) ($4,417) ($1,100) Total $1,837 $1,445 ($ 804) $3,441 Earnings(Loss) Per Share: Continuing Operations $0.29 $0.24 $0.50 $0.60 Discontinued Operations($0.04) ($0.04) ($0.61) ($0.14) Total $0.25 $0.20 ($0.11) $0.46 Operating Revenue --- Continuing Operations $19,195 $21,142 $22,725 $21,183 Operating Income --- Continuing Operations $4,628 $6,367 $7,132 $5,668 Net Income(Loss): Continuing Operations $1,255 $2,331 $2,818 $2,097 Discontinued Operations($ 156) ($ 66) ($ 62) ($ 195) Total $1,099 $2,265 $2,756 $1,902 Earnings Per Share(Loss): Continuing Operations $0.18 $0.33 $0.40 $0.30 Discontinued Operations($0.02) ($0.01) ($0.01) ($0.03) Total $0.16 $0.32 $0.39 $0.27 The fluctuations in revenue and operating income between quarters reflect the seasonal nature of the water utility business, changes in industrial usage and the timing of rate relief. Gains from the sales of properties of continuing operations, net of taxes, were $867,000, $6,000, $(5,000), and $2,999,000 in the four quarters of 1993 as compared with $2,000, $0, $0, and $(27,000) in 1992. Schedule X CONSUMERS WATER COMPANY AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR CONTINUING OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) Column A Column B Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $4,806 $5,275 $5,696 ========================= Depreciation and amortization $7,994 $7,432 $6,125 ========================= Taxes other than payroll and income taxes: Municipal property $4,983 $4,521 $4,137 State, franchise and excise $3,098 $2,902 $2,730 Other $291 $298 $281 Total taxes other than payroll and ------------------------- income taxes $8,372 $7,721 $7,148 ========================= The amounts of royalties and advertising expenses are not presented as such amounts are less than one percent of total revenues and sales.

37931_1993.txt

37931_1993

1993

37931

ITEM 1. BUSINESS: GENERAL Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for fiscal year ended December 31, 1993 on page 8. REVENUES Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for fiscal year ended December 31, 1993 on page 8. CLIENTS The Registrant and its subsidiaries (the Company) consider their relations with their clients to be satisfactory. Due to the nature of the business, however, any client could at some time in the future reduce its advertising budget, or transfer to another agency all or part of its advertising presently placed through the Company. Representation of a client does not necessarily mean that all advertising for such clients is handled by the Company exclusively. In many cases, the Company handles the advertising of only a portion of a client's products or services or only the advertising in particular geographic areas. COMPETITION The advertising agency business is highly competitive, with agencies of all sizes competing primarily on the basis of quality of service to attract and retain clients and personnel. Advertisers are able to move from one agency to another with relative ease, in part because accounts are terminable on short notice, usually90-180 days. Competition for clients by large agencies is limited somewhat because many advertisers prefer not to be represented by an agency which handles competing products or services for other advertisers. REGULATION Federal, state and local governments and governmental agencies in recent years have adopted statutes and regulations affecting the advertising activities of advertising agencies and their clients. For example, statutes and regulations have prohibited television advertising for certain products and have regulated the form and content of certain types of advertising for many consumer products. The Federal Trade Commission ("FTC") has also required proof of accuracy of advertising claims with respect to various products and, in its enforcement policies, is seeking to establish more stringent standards with respect to advertising practices. The FTC has the authority to investigate and to institute proceedings against advertisers and their advertising agencies for deceptive advertising. Proposals have also been made for the adoption of additional statutes and regulations which would further restrict the advertising activities of advertising agencies and their clients. The effect on the advertising business of future application of existing statutes or regulations, or the extent, nature or effect of future legislation or regulatory activity with respect to advertising, cannot be predicted. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 on page 21. ITEM 2. ITEM 2. PROPERTIES Virtually all of the Company's operations are conducted in leased premises. The Company's physical property consists primarily of leasehold improvements, furniture, fixtures and equipment. However, the Company does own office buildings in Puerto Rico and the Dominican Republic, neither of which are material to the Company's consolidated financial statements. Further information regarding the Company's leased premises, which it considers to be adequate for its current operations, is contained in note 12 of the Registrant's Annual Report to Shareholders (page 23). ITEM 3. ITEM 3. PENDING LEGAL PROCEEDINGS Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 note 5 on page 19. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 on page 9. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 on page 11. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Response to this item is incorporated by reference to the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 on pages 10 and 11. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA The following consolidated financial statements of the Registrant and its subsidiaries, included in the Registrant's Annual Report to shareholders for the fiscal year ended December 31, 1993 are incorporated by reference: Consolidated Balance Sheets--December 31, 1992 and 1993 Consolidated Statements of Income--Years ended December 31, 1991, 1992 and Consolidated Statements of Stockholders' Equity--Years ended December 31, 1991, 1992 and 1993 Consolidated Statements of Cash Flows--Years ended December 31, 1991, 1992 and 1993 Notes to Consolidated Financial Statements--December 31, 1993 Quarterly Financial Data--Years ended December 31, 1992 and 1993 ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to the Directors of the Registrant is incorporated by reference to the Proxy Statement for the Annual Meeting of Stockholders filed with the Commission prior to April 1, 1994 pursuant to Regulation 14A. Information with respect to executive officers of the Registrant who are not also Directors or nominees to the Board of Directors is included below. JACK J. BOLAND (37) --Executive Vice President, North American Finance Director MARY A. CARRAGHER (34) --Vice President, General Counsel and Assistant Secretary MICHAEL S. DUFFEY (39) --Vice President, Treasurer and Assistant Secretary --Vice President, DALE F. PERONA (48) Controller and Secretary Mr. Duffey and Ms. Carragher joined the Company and became officers during 1992. Previous to that time, Mr. Duffey held various executive positions at Outboard Marine Corporation, and Ms. Carragher held various positions at Sidley & Austin. No officer of the Registrant is related to any other officer. All other officers have been officers of the Registrant or have held senior executive positions with the Company for the past five years, except as otherwise disclosed in Registrant's Proxy Statement. ITEMS 11. EXECUTIVE COMPENSATION The Registrant has filed with the Commission, prior to April 1, 1994, a definitive proxy statement pursuant to Regulation 14A. Information required under this item with respect to Directors and Officers is incorporated by reference to said Proxy Statement. ITEMS 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Persons or "groups" (as that term is used in Section 13(d)(3) of the Securities and Exchange Act of 1934) known by the Registrant to beneficially own more than five percent of any class of the Registrant's voting securities, included in the Proxy Statement for the Annual Meeting of Stockholders, is incorporated herein by reference. (b) Security ownership of management included in the Proxy Statement for the Annual Meeting of Stockholders is incorporated herein by reference. (c) There are no arrangements known to the Registrant the operation of which may at a subsequent date result in change in control of the Registrant. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information with respect to certain transactions with directors of the Registrant, see the Proxy Statement for the Annual Meeting of Stockholders which is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K FORM 10-K--ITEM 14(A) FOOTE, CONE & BELDING COMMUNICATIONS, INC. AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of Foote, Cone & Belding Communications, Inc. and Subsidiaries, and the Independent Public Accountant's Report covering these financial statements, appearing in the Registrant's Annual Report to shareholders on pages 12 through 26 for the year ended December 31, 1993, are incorporated by reference in Item 8: Consolidated Balance Sheets--December 31, 1992 and 1993 Consolidated Statements of Income--Years ended December 31, 1991, 1992 and Consolidated Statements of Stockholders' Equity--Years ended December 31, 1991, 1992 and 1993 Consolidated Statements of Cash Flows--Years ended December 31, 1991, 1992 and 1993 Notes to Consolidated Financial Statements--December 31, 1993 The following consolidated financial statements (numbered in accordance with Regulation S-X) of Publicis Communication (a 26% owned unconsolidated affiliate of the Registrant) and Subsidiaries, and Auditors' Report with respect thereto, are included in this Report. Consolidated Income Statements--Years ended December 31, 1992 and 1993, page 10 of this Report. Consolidated Balance Sheet--December 31, 1992 and 1993, page 9 of this Report. Consolidated Statement of Change in Financial Position--Year ended December 31, 1992 and 1993, pages 11 and 12 of this Report. Notes to the Consolidated Financial Statements--December 31, 1993, pages 13 through 18 of this Report. Auditors' Report, page 19 of this Report. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions, or are inapplicable, or the information called for therein is included elsewhere in the financial statements or related notes thereto contained in or incorporated by reference into this Report. Accordingly, such schedules have been omitted. Publicis Communication owns 51% of Publicis.FCB BV. Accordingly, the consolidated financial statements of Publicis Communication and Subsidiaries include the results of operations and financial position of Publicis.FCB BV. These financial statements have been prepared and audited based upon accounting and auditing standards and practices acceptable for external reporting purposes in France. These practices and standards can vary from U.S. accounting practices. Following is a reconciliation, prepared by Registrant, of reported net income to net income which would be reported under U.S. generally accepted accounting principles (amounts in thousands). - - - - - -------- Notes: (1) Net income as reported was computed using the average exchange rates for the year. (2) Goodwill is charged directly to retained earnings or income in the year it arises for French financial reporting purposes. The goodwill amortization expense adjustment was computed using forty years as the estimated useful life for each of the related goodwill components. All calculations have been made by Registrant based upon assumptions deemed appropriate by Registrant. PUBLICIS COMMUNICATION CONSOLIDATED FINANCIAL STATEMENTS 31/12/1993 PUBLICIS COMMUNICATION 31/12/1993 PAGE 9: Comparative Consolidated Balance Sheet : Comparative Consolidated Income Statement PAGES 11-12 : Consolidated Statement of Change in Financial Statements. PAGES 13-18 : Notes to the Consolidated Financial Statements PUBLICIS COMMUNICATION GROUP CONSOLIDATED BALANCE SHEET (IN THOUSANDS OF FRENCH FRANCS) PUBLICIS COMMUNICATION GROUP CONSOLIDATED INCOME STATEMENTS (IN THOUSANDS OF FRENCH FRANCS) PUBLICIS COMMUNICATION GROUP CONSOLIDATED STATEMENT OF CHANGE IN FINANCIAL POSITION (US GAAP--IN THOUSAND FRF) PUBLICIS COMMUNICATION GROUP CONSOLIDATED STATEMENT OF CHANGE IN FINANCIAL POSITION (US GAAP--IN THOUSAND FRF) PUBLICIS COMMUNICATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS AS OF 31/12/1993. I. CONSOLIDATED PRINCIPLES. PUBLICIS COMMUNICATION GROUP'S consolidated financial statements as at December 31, 1993 have been prepared in accordance with the French legislation and are in conformity with generally accepted international accounting principles. The consolidated financial statements include the accounts of the Company's wholly owned and majority owned domestic and international subsidiaries. The subsidiary companies with less than 50% ownership are consolidated on an equity basis. The company translates the financial statements of its international subsidiaries into French Francs using official exchange rates as of December 31. II. SUMMARY OF MAJOR ACCOUNTING POLICIES. Companies Consolidated: No material changes are noted in the scope of the consolidation as compared to last year. The FCA! Group accounts will only be consolidated within Publicis Communication as at January 1st 1994. General: The accounting policies used as at December 31, 1993 are identical to those used in preparing the consolidated financial statements of the Publicis Group. Tangible and Intangible Assets: Tangible assets are valued at cost and the depreciation is calculated according to the most suitable method in order to take into account the economical criteria. Listed below are the methods most currently used within the Publicis Communication Group: Building : 20 years straightline Leasehold property and improvements : 10 years straightline Furniture and Equipment : 5-10 years straightline Motor Vehicles : 4 years straightline Premiums paid to acquire marketable leasehold property and the cost of acquired goodwill are not amortized except in cases where the estimated market value is considered to be inferior to the acquisition cost. To comply with the regulation, goodwill generated through the legal reevaluation of 1976 have been fully written off against net equity 1993. Goodwill: The excess costs over the net book value of subsidiaries, after reallocating potential capital gains to the assets concerned, by their nature, are considered to be intangible assets, justified by elements such as: market shares, trade marks, clients' lists, brands . . . Usually they are not amortized. However, each year, a careful examination is made to determine their market value. If their market value is inferior to their acquisition cost, a provision for depreciation is made. The excess costs referring to unidentified elements are amortized over a maximum period of 40 years. In any case, all goodwill of small value are immediately depreciated at 100%. PUBLICIS COMMUNICATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) As at December 31, 1993, considering the economic background (pooling of interest) of FCA! Group, the goodwill has been exceptionally written off against net equity. Work in Progress: Work in progress is valued at the lower of cost and net realisable value. Billings: Since March 31, 1993, the Sapin law has been changing the accounting principles applicable to Media Buying activities. In order to be able to show comparable Billings with last year and to be in line with the principles applied by our foreign competitors, our consolidated Media Revenues raised in France have been capitalised using the international multiple of 6,67. Retirement Indemnities: French Subsidiaries: Potential and probable retirement indemnities including social security charges appear either on the Balance Sheet or are shown in the Contingent Liabilities. The criteria for choosing the treatment is the age of the employees concerned. The yearly movements in the provision for the retirement indemnities shown on the Balance Sheet are accounted for in the expenses of the year. Foreign Subsidiaries: Retirement indemnities are accrued for in accordance with the laws and regulations specific to each country. Statutory Profit Sharing: The Statutory Profit Sharing related to the 1993 fiscal year and payable to the employees is accounted for on a consistent basis with last year. Income Tax: All actual and deferred Income Taxes payable are accounted for. Deferred Income Tax assets or potential fiscal credits are not recognised with the exception of a latent fiscal credit of 33 1/3% calculated on the provision for the French statutory profit sharing. III. COMMENTS ON THE CONSOLIDATED ACCOUNTS. Foreign Subsidiaries' Contribution in Group Activities: Foreign subsidiaries account for 64% of the total billings and 62% of the total consolidated net income. Intangible Assets: In addition to lease rights and softwares, intangible assets include KF 21,379 of acquired goodwill and KF 468,409 related to the excess of cost over the underlying book value of subsidiaries. PUBLICIS COMMUNICATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED) As of December 31, 1993 accumulated depreciation and amortization on Intangible Assets is KF 23,916 versus KF 24,666 as of December 31, 1992. Variation in Stockholders' Equity: The variation of the stockholders' equity between December 31, 1992 and December 31, 1993 is as follows: (in thousands of FF) NET EQUITY OF THE GROUP The Net Equity of the Group is as follows: (in thousands of FF) - - - - - -------- (1) After a deduction of the excess of cost over the underlying book value of subsidiaries amounting to KF 569 961 CONSOLIDATED CASH FLOW CONTINGENT LIABILITIES PRINCIPALES SOCIETES CONSOLIDEES AU 31 DECEMBRE 1993 A/ SOCIETES CONSOLIDEES PAR INTEGRATION GLOBALE CABINET ROBERT MAZARS We have examined the consolidated balance sheet of PUBLICIS COMMUNICATION and Subsidiaries as of December 31, 1993 and the related consolidated statements of income, stockholders' equity and changes in financial position for the year in the period ended December 31, 1993. These statements present a net equity (group share) of 369,647,000 FF and a net income (group share) of 131,659,000 FF. Our examination was made in accordance with generally accepted auditing standards and, accordingly, include such test of the accounting records and other auditing procedures that we considered necessary in the circumstances. In our opinion, the financial statements referred to above present fairly the financial position of PUBLICIS COMMUNICATION and Subsidiaries as of December 31, 1993, and the result of their operations and the changes in their financial position for the year in the period ended December 31, 1993, in conformity with generally accepted accounting principles applied on a consistent basis. Paris, 16th March 1994 Frederic ALLILAIRE Jose MARETTE (This page left blank intentionally) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL NOTES We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Foote, Cone & Belding Communications, Inc.'s Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 15, 1994 (except with respect to the matter discussed in Note 10, as to which the date is March 16, 1994). Our report on the consolidated financial statements includes an explanatory paragraph with respect to the change in the method of accounting for income taxes, effective January 1, 1992, as discussed in Note 1 to the consolidated financial statements, and the change in the method of accounting for post-retirement benefits other than pensions, effective January 1, 1993, as discussed in Note 4 to the consolidated financial statements. Our audits were made for the purpose of forming an opinion on those financial statements taken as a whole. Supplemental Notes A through C are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. The Supplemental Notes have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. Arthur Andersen & Co. Chicago, Illinois, February 15, 1994. FORM 10-K -- ITEM 14(A)(1) NOTE A--VALUATION ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992, AND 1993 - - - - - -------- NOTES: (1) Account consists of currency translation adjustment and adjustments made as a result of subsidiaries acquired and sold during the year. NOTE B--SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992, AND 1993 - - - - - -------- NOTES: (1) The average amount outstanding during the period was computed by dividing the total of month-end outstanding principal balances by 12. (2) The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. NOTE C--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES - - - - - -------- (1) Note (represents relocation loan) due on demand. SIGNATURES PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934 AND TO THE POWER OF ATTORNEY FILED WITH THE SECURITIES AND EXCHANGE COMMISSION, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS (CONSTITUTING, AMONG OTHERS, A MAJORITY OF THE MEMBERS OF THE BOARD OF DIRECTORS OF THE REGISTRANT) ON BEHALF OF THE REGISTRANT. /s/ Bruce Mason By: _________________________________ Bruce Mason as Attorney-in-Fact /s/ Terry M. Ashwill By: _________________________________ Terry M. Ashwill as Attorney-in-Fact Date: March 29, 1994 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. Date: March 29, 1994 Foote, Cone & Belding Communications, Inc. /s/ Bruce Mason By: _________________________________ Bruce Mason Chairman of the Board of Directors and Chief Executive Officer (Principal Executive Officer) /s/ Terry M. Ashwill By: _________________________________ Terry M. Ashwill Executive Vice President, Chief Financial Officer and Director FORM 10-K--ITEM 14(a)(3) INDEX OF EXHIBITS EXHIBIT NO. DESCRIPTION Page - - - - - ----------- ----------- ---- 3(i) Amended Certificate of Incorporation. 28-35 11 Summary of Calculations of Earnings Per Share. 36 13 Portions of the Company's 1993 Annual Report to Shareholders Incorporated by Reference to this Form 10-K. 37-55 21 Parent and Significant Subsidiaries of Registrant. 56 23 Consent of Independent Public Accountants 57 24 Power of Attorney 58

7323_1993.txt

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1993

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Item 1. Business BUSINESS OF ENTERGY General Entergy Corporation was originally incorporated under the laws of the State of Florida on May 27, 1949. On December 31, 1993, in connection with the Merger (see "Entergy Corporation-GSU Merger," below), Entergy Corporation merged with and into Entergy-GSU Holdings, Inc., a Delaware corporation (Holdings), and Holdings was renamed Entergy Corporation. Entergy Corporation is a holding company registered under the Holding Company Act and does not own or operate any physical properties. Entergy Corporation owns all of the outstanding common stock of five retail operating electric utility subsidiaries, AP&L, GSU, LP&L, MP&L, and NOPSI. AP&L was incorporated under the laws of the State of Arkansas in 1926; GSU was incorporated under the laws of the State of Texas in 1925; LP&L and NOPSI were incorporated under the laws of the State of Louisiana in 1974 and 1926, respectively; and MP&L was incorporated under the laws of the State of Mississippi in 1963. As of December 31, 1993, these operating companies provided electric service to approximately 2.3 million customers in the States of Arkansas, Louisiana, Mississippi, Missouri, and Texas. In addition, GSU furnished gas service in the Baton Rouge, Louisiana area, and NOPSI furnished gas service in the City of New Orleans. GSU's steam products department produces and sells, on an unregulated basis, process steam and by- product electricity supplied from its steam electric extraction plant to a large industrial customer. The business of the System is subject to seasonal fluctuations with the peak period occurring during the third quarter. During 1993, the System's (excluding GSU) electricity sales as a percentage of total System energy sales were: residential - 28.1%; commercial - 19.9%; and industrial - 36.9%. Electric revenues from these sectors as a percentage of total System electric revenues were: 36.3% - residential; 24.4% - commercial; and 27.3% - industrial. Sales to governmental and municipal sectors and to nonaffiliated utilities accounted for the balance of energy sales. During 1993, GSU's electric department sales as a percentage of total GSU energy sales were: residential - 25.5%; commercial - 20.3%; and industrial - 50.8%. Electric revenues from these sectors as a percentage of total GSU electric revenues were: 33.5% - residential; 23.8% - commercial; and 37.2% - industrial. Sales to governmental and municipal sectors and to nonaffiliated utilities accounted for the balance of GSU's energy sales. The System's major industrial customers are in the chemical processing, petroleum refining, paper products, and food products industries. Entergy Corporation also owns all of the outstanding common stock of System Energy, Entergy Services, Entergy Operations, Entergy Power, and Entergy Enterprises. System Energy is a nuclear generating company that was incorporated under the laws of the State of Arkansas in 1974. System Energy sells the capacity and energy at wholesale from its 90% interest in Grand Gulf 1 to its only customers, AP&L, LP&L, MP&L, and NOPSI (see "Capital Requirements and Future Financing - - Certain System Financial and Support Agreements - Unit Power Sales Agreement," below). System Energy has approximately a 78.5% ownership interest and an 11.5% leasehold interest in Grand Gulf 1. Entergy Services provides general executive and advisory services, and accounting, engineering, and other technical services to certain of the System companies, generally at cost. Entergy Operations is a nuclear management company that operates ANO, River Bend, Waterford 3, and Grand Gulf 1, subject to the owner oversight of AP&L, GSU, LP&L, and System Energy, respectively. Entergy Power, an independent power producer, owns 809 MW of generating capacity and markets its capacity and energy in the wholesale market outside Arkansas and Missouri and in markets not otherwise presently served by the System. (For further information on regulatory proceedings related to Entergy Power, see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Entergy Power," below). Entergy Enterprises is a nonutility company that invests in businesses whose products and activities are of benefit to the System's utility business (see "Corporate Development," below). Entergy Enterprises also markets technical expertise developed by the System companies when it is not required in the System's operations. Entergy Enterprises has received SEC approval to provide services to certain nonutility companies in the System. In 1992 and 1993, several new Entergy Corporation subsidiaries were formed to participate in utility projects located outside the System's retail service territory, both domestically and in foreign countries (see "Corporate Development," below). AP&L, LP&L, MP&L, and NOPSI own, in ownership percentages of 35%, 33%, 19%, and 13%, respectively, all of the common stock of System Fuels, a non-profit subsidiary, that implements and/or maintains certain programs to procure, deliver, and store fuel supplies for the System. GSU has four wholly-owned subsidiaries: Varibus Corporation, GSG&T, Inc., Southern Gulf Railway Company, and Prudential Oil & Gas, Inc. Varibus Corporation operates intrastate gas pipelines in Louisiana, which are used primarily to transport fuel to two of GSU's generating stations, and has marketed computer-aided engineering and drafting technologies and related computer equipment and services. GSG&T, Inc. owns the Lewis Creek Station, a 532 MW (as of December 31, 1993) gas-fired generating plant, which is leased and operated by GSU. Southern Gulf Railway Company will own and operate several miles of rail track being constructed in Louisiana for the purpose of transporting coal for use as a boiler fuel at Nelson Unit 6. Prudential Oil & Gas, Inc., which was formerly in the business of exploring, developing, and operating oil and gas properties in Texas and Louisiana, is presently inactive. Entergy Corporation-GSU Merger On December 31, 1993, Entergy Corporation consummated its acquisition of GSU. Entergy Corporation merged with and into Holdings, and Holdings was renamed Entergy Corporation. GSU became a wholly-owned subsidiary of Entergy Corporation and continues to operate as a public utility under the regulation of the PUCT and the LPSC. As consideration to GSU's shareholders, Entergy Corporation paid $250 million in cash and issued 56,667,726 shares of its common stock at a price of $35.8417 per share, in exchange for outstanding shares of GSU common stock. In addition, $33.5 million of transaction costs were capitalized in connection with the Merger. See "Rate Matters and Regulation - Regulation - Other Regulation and Litigation," for, information on requests for rehearing and appeals of certain regulatory approvals of the Merger. The information contained in this Form 10-K is filed on behalf of all the registrants of Entergy, including GSU. Unless otherwise noted, consolidated financial and statistical information contained in this report that is stated as of December 31, 1993 (such as assets, liabilities, and property), includes the associated GSU amounts, and consolidated financial and statistical information for periods ending before January 1, 1994 (such as revenues, sales, and expenses), does not include GSU amounts; those amounts are presented separately for GSU herein. Certain Industry and System Challenges The System's business is affected by various challenges and issues including those that confront the electric utility industry in general. These issues and challenges include: - an increasingly competitive environment (see "Competition," below); - compliance with regulatory requirements with respect to nuclear operations (see "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry," below) and environmental matters (see "Rate Matters and Regulation - Regulation - Environmental Regulation," below); - adaptation to structural changes in the electric utility industry, including increased emphasis on least cost planning and changes in the regulation of generation and transmission of electricity (see "Competition - General" and "Competition - Least Cost Planning," below); - continued cost management (particularly in the area of operation and maintenance costs at nuclear units) to improve financial results and to delay or to minimize the need for rate increase requests in light of current rate freezes and rate caps at the System operating companies (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," below); - integrating GSU into the System's operations and achieving cost savings (see "Entergy Corporation-GSU Merger," above); - achieving enhanced earnings in light of lower returns and slow growth in the domestic utility business (see "Corporate Development," below); and - resolving GSU's major contingencies, including potential write- offs and refunds related to River Bend (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU," below) and litigation with Cajun relating to its ownership interest in River Bend (see "Rate Matters and Regulation - Regulation - Other Regulation and Litigation - GSU," below). Corporate Development Entergy continues to consider new opportunities to expand its regulated electric utility business, as well as to expand into utility and utility-related businesses that are not regulated by state and local regulatory authorities (nonregulated businesses). Investments in nonregulated businesses are likely to draw upon the System's skills in power generation and customer service as well as its strengths in the fuels area. Entergy Corporation's investment strategy with respect to nonregulated businesses is to invest in nonregulated business opportunities wherein Entergy Corporation has the potential to earn a greater rate of return compared to its regulated utility operations. Entergy Corporation's nonregulated businesses fall into two broad categories: overseas power development and new electro- technologies. Entergy Corporation has made investments in Argentina's electric energy infrastructure, as described below, and is pursuing additional projects in Central America, South America, South Africa, and Asia. Entergy Corporation will also open offices in Buenos Aires, Argentina and Hong Kong in 1994. In addition, Entergy Corporation is seeking to provide telecommunications services based upon its experience with interactive communications systems that allow customers to control energy usage. Entergy Corporation expects to invest approximately $150 million per year in nonregulated businesses. Current investments in nonregulated businesses include the following: (1) Entergy Corporation's subsidiary, Entergy Power Development Corporation (an EWG under the provisions of the Energy Act), through its subsidiary (which is also an EWG) Entergy Richmond Power Corporation, owns a 50% interest in an independent power plant in Richmond, Virginia. The power plant is jointly-owned and operated by the Enron Power Corporation, a developer of independent power projects. The plant owners have a 25-year contract to sell electricity to Virginia Electric & Power Company. Entergy Corporation's investment in the project totals approximately $12.5 million. (2) Entergy Enterprises has a 9.95% equity interest in First Pacific Networks, Inc. (FPN), a communications company, and a license from FPN in connection with utility applications, being jointly developed by Entergy Enterprises and FPN, for FPN's patented communications technology. Entergy Enterprises' investment in FPN is approximately $20.1 million, of which $9.7 million is equity investment. (3) Entergy Enterprises' subsidiary, Entergy Systems and Service, Inc. (Entergy SASI), holds a 9.95% equity interest in Systems and Service International, Inc. (SASI), a manufacturer of efficient lighting products. This subsidiary also made a loan to SASI, acquired the business and assets of SASI's distribution subsidiary, and entered into an agreement to distribute SASI's products. Entergy Enterprises' initial investment in this business was approximately $11 million (of which $2.3 million is invested in SASI common stock). Entergy Corporation has provided to Entergy SASI $6.0 million in loans, as of December 31, 1993, to fund Entergy SASI's installment sale agreements with its customers. (4) Entergy Corporation's subsidiary, Entergy, S.A., participated in a consortium with other nonaffiliated companies that acquired a 60% interest in Argentina's Costanera steam electric generating facility consisting of seven natural gas- and oil-fired generating units, with a total installed capacity of 1,260 MW. Entergy Corporation's initial investment to acquire its 10% interest in the consortium was approximately $11 million and its maximum financial obligation currently authorized by the SEC in connection with this investment is $22.5 million. (5) In January 1993, Entergy Corporation, through a new subsidiary, Entergy Argentina, S.A., participated in a consortium with other nonaffiliated companies that acquired a 51% interest in a foreign electric distribution company providing service to Buenos Aires, Argentina. Entergy Corporation's initial investment to acquire its 10% interest in the consortium was approximately $58 million and its maximum financial obligation currently authorized by the SEC in connection with this investment is $77.5 million. (6) In July 1993, Entergy Corporation, through a new subsidiary, Entergy Transener, S.A., participated in a consortium with other nonaffiliated companies that acquired a 65% interest in a foreign transmission system providing service in the country of Argentina. Entergy Corporation's initial investment to acquire its 15% interest in the consortium was $18.5 million. In the near term, these investments are likely to have a minimal effect on earnings; but the possibility exists that they could contribute to future earnings growth. However, due to the absence of an allowed rate of return, these investments involve a higher degree of risk. International operations are subject to certain risks that are inherent in conducting business abroad, including possible nationalization or expropriation, price and exchange controls, limitations on foreign participation in local governmental enterprises, and other restrictive actions. Changes in the relative value of currencies take place from time to time and their effects may be favorable or unfavorable on results of operations. In addition, there are exchange control restrictions in certain countries relating to repatriation of earnings. Selected Data Selected customer and sales data for 1993 are summarized in the following tables: 1993 - Selected Customer Data Customers as of December 31, 1993 ------------------ Area Served Electric Gas ----------- -------- --- AP&L Portions of State of Arkansas 590,862 - GSU Portions of the States of Texas 593,975 85,040 and Louisiana LP&L Portions of State of Louisiana 599,991 - MP&L Portions of State of Mississippi 361,692 - NOPSI City of New Orleans, except Algiers, is provided electric service by LP&L 190,613 154,251 --------- ------- System 2,337,133 239,291 ========= ======= NOPSI sold 17,437,292 MCF of natural gas to retail customers in 1993. Revenues from natural gas operations for each of the three years in the period ended December 31, 1993, were material for NOPSI, but not material for the System (see "Industry Segments," below, for a description of NOPSI's business segments). GSU sold 6,786,794 MCF of natural gas to retail customers in 1993. Revenues from natural gas operations for each of the three years in the period ended December 31, 1993, were not material for GSU. See "Entergy Corporation and Subsidiaries Selected Financial Data - - Five-Year Comparison," "AP&L Selected Financial Data - Five-Year Comparison," "GSU Selected Financial Data - Five-Year Comparison," "LP&L Selected Financial Data - Five-Year Comparison," "MP&L Selected Financial Data - Five-Year Comparison," "NOPSI Selected Financial Data - - Five-Year Comparison," and "System Energy Selected Financial Data - Five-Year Comparison," (which follow each company's notes to financial statements herein) incorporated herein by reference, for further information with respect to operating statistics of the System and of AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy, respectively. Employees As of December 31, 1993, Entergy had 16,679 employees as follows: Full-time: Entergy Corporation 6 AP&L 2,557 GSU (1) 4,765 LP&L 1,727 MP&L 1,236 NOPSI 716 System Energy - Entergy Operations 3,508 Entergy Services (2) 1,986 Other Subsidiaries 24 ------ Total Full-time 16,525 Part-time 154 ------ Total Entergy System 16,679 ====== __________________ (1) As of December 31, 1993, GSU had not been functionally aligned into Entergy. In December 1993, GSU recorded $17 million for an announced early retirement program in connection with the Merger. Of the 503 employees eligible, 369 employees elected to participate in the program. (2) As a result of System realignment of operations along functional lines, certain employees of AP&L, LP&L, MP&L, and NOPSI transferred to Entergy Services during 1993. Competition General. Entergy and the electric utility industry are experiencing increased competitive pressures both in the retail and wholesale markets. The economic, social, and political forces behind these competitive pressures are numerous and complex. They include legislative and regulatory changes, technological advances, consumer demands, greater availability of natural gas, environmental needs, and others. Entergy looks at these competitive pressures both as opportunities to compete for new customers and as risks for loss of customers. On October 24, 1992, Congress passed the Energy Act. The Energy Act addresses a wide range of energy issues and alters the way Entergy and the rest of the electric utility industry will operate in the future. The Energy Act creates exemptions from regulation under the Holding Company Act and creates a class of EWG's consisting of utility affiliates and nonutilities that are owners and operators of facilities for the generation and transmission of power for sales at wholesale. These exemptions offer an incentive for Entergy to participate in the development of wholesale power generation. In addition, the Holding Company Act has been amended to allow utilities to compete on a global scale with foreign entities to own and operate generation, transmission, and distribution facilities. The Energy Act also gives FERC the authority to order investor-owned utilities, including the System operating companies, to transmit power and energy to or for wholesale purchasers and sellers. The law creates the potential for electric utilities and other power producers to gain increased access to the transmission systems of other entities to facilitate wholesale sales. FERC may also require electric utilities to increase their transmission capacity to provide these services. The impact of this provision on the System operating companies should be lessened by their joint filing of open access transmission service tariffs with FERC in 1991 (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters," below). The Energy Act also amends PURPA by requiring states to consider (1) new regulatory standards that would require electric utilities to undertake integrated resource planning, and (2) allowing energy efficiency programs to be at least as profitable as new energy supply options. Entergy is unable to predict the ultimate impact the Energy Act will have on its operations. Wholesale Competition. Entergy has, like other utility systems, generating capacity (most of which is owned by Entergy Power) and energy available for a period of time for sale to other utility systems. The System is in competition with neighboring systems, as well as EWG's, to sell such capacity and energy. Given this competition, the ability of the System to sell this capacity and energy is limited. However, in 1993, the System sold 8,291 million KWH of energy (compared to 7,979 million KWH in 1992) to nonaffiliated utilities. The System also sold 1,234 MW of long-term capacity (compared to 1,048 MW in 1992) to nonaffiliated utilities outside of the System's service area. These capacity sales represent 8% of the System's net capability (excluding GSU) at year-end 1993. Under AP&L's and LP&L's Grand Gulf 1 rate orders, and under GSU's River Bend rate order in Louisiana, a portion of the capacity of Grand Gulf 1 and River Bend represents capacity that is available for sale, subject to regulatory approval, to nonaffiliated parties. In some cases, profits from such sales must be shared between ratepayers and shareholders. As discussed in "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Open Access Transmission," below, Entergy Power and the System operating companies will be permitted by FERC to make wholesale capacity sales in bulk power markets at rates based primarily upon negotiation and market conditions rather than cost of service. In order to receive authorization to make such sales, AP&L, LP&L, MP&L, and NOPSI also filed with FERC open access transmission service tariffs. FERC has approved this filing, subject to certain modifications. Revisions to the tariffs were filed in December 1993 to recognize GSU's inclusion in the Entergy System. When the modified tariffs are made effective, Entergy Power and the System operating companies may engage in sales at market prices. It is anticipated that these tariffs will enable any electric utility (as defined in such tariffs) to use Entergy 's integrated transmission system for the transmission of capacity and energy produced and sold by such electric utility or by third parties. Other similar open access transmission tariffs have also been filed with FERC for several large utility companies or systems and more open access transmission tariffs are anticipated. Concurrently, capacity resources are being developed and used to make wholesale sales from a range of non-traditional sources, including nonutility generators as well as cogenerators and small power producers qualifying under PURPA. These developments simultaneously produce increased marketing opportunities for utility systems such as Entergy and expose the System to loss of load or reduced sales revenues due to displacement of System sales by alternative suppliers with access to the System's primary areas of service. Entergy Power, which owns 809 MW of capacity, was formed to compete with other utilities and independent power producers in the bulk power market. As of December 31, 1993, Entergy Power has accumulated total losses from operations of $52.5 million. Entergy Power has entered into several long-term contracts for the sale of capacity and associated energy from its resources and has also made short-term capacity and energy sales. Entergy Power continues to actively market its capacity and energy in the bulk power market. (See "Corporate Development," above, for information with respect to a wholly-owned subsidiary of Entergy, Entergy Power Development Corporation, organized as an EWG to compete in the wholesale power market.) Retail Competition. Scheduled increases in the price of power sold by the System pursuant to the operation of phase-in plans (see "Rate Matters and Regulation - Rate matters - Retail Rate Matters," below) will affect the competitiveness of certain classes of industrial customers whose costs of production are energy-sensitive. Entergy is constantly working with these customers to address their concerns. It is the practice of the System operating companies to negotiate the renewal of contracts with large industrial customers prior to their expiration. In certain cases (particularly for GSU), contracts or special tariffs that use incentive pricing below total cost have been negotiated with industrial customers to keep these customers on the System. These contracts and tariffs have generally resulted in increased KWH sales at lower margins over incremental cost. While the System operating companies anticipate they will be successful in renegotiating such contracts, they cannot assure that they will be successful or that future revenues will not be lost to other forms of generation. To date, through these efforts, Entergy has been largely successful in retaining its industrial load. This competitive challenge could increase. Cogeneration is generally defined as the combined production of electricity and steam. Cogenerated power may be either sold by its producer to the local utility at its avoided cost under PURPA, or utilized by the cogenerator to displace purchases from the utility. To the extent that cogeneration is used by industrial customers to meet their own power requirements, the System may suffer loss of industrial load. Cogenerated power delivered to the System would be purchased at avoided cost, which for a number of years is expected to be equivalent to avoided energy cost, and as such, the cost of these purchases would not impact earnings. To date, only a few cogeneration facilities have been installed in areas served by the System, excluding GSU. The primary purpose of these facilities is to displace power that was purchased from the System. The economic advantage to the customer is generally due to the customer having waste products that can be used as fuel. Presently, the loss of load to cogeneration and the amount of cogenerated power delivered under PURPA to the System (excluding GSU) is not significant. The System is prepared to participate (subject to regulatory approval) in various phases of the design, construction, procurement, and ownership of cogeneration facilities. The System has entered into several cogeneration deferral agreements with certain of its retail customers, which give the System the right of first refusal to participate in any of such customers' cogeneration activities. Such participation could occur in the event there are individual customers whose long-term interests, along with Entergy's, can best be served by installing cogeneration facilities. No such participation has occurred to date, except by GSU. Existing qualifying facilities in the GSU service territory are estimated to total approximately 2,400 MW's or over 10% of Entergy's total owned and leased generating capability as of December 31, 1993. GSU currently believes that no significant load will be lost to cogeneration projects during the next several years; however, GSU is currently negotiating a contract with a large industrial customer, which is scheduled to expire in 1996. If the contract is not renewed, GSU would lose approximately $40 million in base revenues. Although GSU has competed in the past for various retail and wholesale customers, the System (excluding GSU) generally is not in direct competition with privately-owned or municipally-owned electric utilities for retail sales. However, a few municipalities distribute electricity within their corporate limits and some of these generate all or a portion of their requirements. A number of electric cooperative associations or corporations serve a substantial number of retail customers in or adjacent to areas served by the System . Sales of energy by the System to privately- or municipally-owned utilities amounted to approximately 4.6% of total System energy sales in 1993 (excluding GSU). Legislatures and regulatory commissions in several states have considered, or are considering, retail wheeling, which is the transmission by an electric utility of energy produced by another entity over the utility's transmission and distribution system to a retail customer in the electric utility's service territory. Retail wheeling would permit retail customers to elect to purchase electric capacity and/or energy from the electric utility in whose service area they are located or from any other electric utility or independent power producer. Retail wheeling is not currently required within the Entergy System service area. See "Rate Matters and Regulation - Regulation - Other Regulation and Litigation," below for information on proceedings brought by Cajun seeking transmission access to certain of GSU's industrial customers. Least Cost Planning. The System continues to pursue least cost planning, also known as integrated resource planning, in order to compete more effectively in both retail and wholesale markets. Least cost planning is the development of strategies to add resources to meet future electricity demands reliably and at the lowest possible cost. The least cost planning process includes the study of electric supply- and demand-side options. The resultant plan uses demand-side options, such as changing customer consumption patterns, to limit electricity usage during times of peak demand, thus delaying the need for new capacity resources. Least cost planning offers the potential for the System to minimize customer costs, while providing an opportunity to earn a return. On December 1, 1992, AP&L, LP&L, MP&L, and NOPSI each filed a Least Cost Plan with its respective regulator, and on July 1, 1993, each company filed a near-term revision to such plan. Each Least Cost Plan details the resources that the System intends to use to provide reasonably priced, reliable electric service to its customers over the next 20 years. Such plan includes 925 MW of DSM resources, such as programs for efficient air conditioning and heating, high efficiency lighting, and CCLM. CCLM is the subject of recent Entergy proposals (filed, or to be filed, by AP&L, LP&L, MP&L, and NOPSI with their respective regulators) requesting the CCLM pilot be withdrawn from consideration in the existing Least Cost Plan dockets on the basis of a new proposal by Entergy to undertake the initial pilot development of CCLM at Entergy stockholder expense. To date, the Council and the LPSC are the only regulators that have addressed the proposal. The System expects to spend a total of approximately $800 million for DSM resources over the next 20 years. Such plan also includes significant resource additions, but does not contemplate construction of any generating facilities at new sites. All incremental supply-side resources will come from either delayed retirements or repowering of existing generating units. The System estimates that, over the next 20 years, least cost planning, if implemented in accordance with the terms of each filed Least Cost Plan, will reduce revenue requirements by approximately $2.3 billion ($600 million on a net present value basis), thereby avoiding the need for related rate increase requests. Each Least Cost Plan includes specific actions that the System will undertake pursuant to regulatory approval, including the recovery of costs associated with DSM (for further information, see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," below). CAPITAL REQUIREMENTS AND FUTURE FINANCING Construction expenditures for the System are estimated to aggregate $586 million, $560 million, and $550 million for the years 1994, 1995, and 1996, respectively. No significant costs are expected in connection with the System's generating facilities. Actual construction costs may vary from these estimates because of a number of factors, including changes in load growth estimates, changes in environmental regulations, modifications to nuclear units to meet regulatory requirements, increasing costs of labor, equipment and materials, and cost of capital. Construction expenditures by company (including immaterial environmental expenditures and AFUDC, but excluding nuclear fuel and the impact of the ice storm that occurred in February 1994) for the period 1994-1996 are estimated as follows: 1994 1995 1996 Total ---- ---- ---- ----- (In Millions) AP&L $181 $172 $175 $528 GSU 134 128 119 381 LP&L 156 143 142 441 MP&L 61 63 63 187 NOPSI 26 26 26 78 System Energy 26 22 23 71 Entergy Power 2 6 2 10 System $586 $560 $550 $1,696 In addition to construction expenditure requirements, the estimated amounts required during 1994-1996 to meet scheduled long- term debt and preferred stock maturities and cash sinking fund requirements are: AP&L - $83 million; GSU - $214 million; LP&L - $158 million; MP&L - $212 million; NOPSI - $80 million; and System Energy - $615 million. A substantial portion of the above capital and refinancing requirements is expected to be satisfied from internally generated funds and cash on hand supplemented by the issuance of debt and preferred stock. Certain System companies may also continue with the acquisition or refinancing of all, or a portion of, certain outstanding series of preferred stock and long-term debt. In early February 1994, an ice storm left more than 221,000 Entergy customers without electric power across the System's four- state service area. The storm was the most severe natural disaster ever to affect the System, causing damage to transmission and distribution lines, equipment, poles, and facilities in certain areas, particularly in Mississippi. A substantial portion of the related costs, which are estimated to be $110 million - $140 million, are expected to be capitalized. The MPSC acknowledged that there is precedent in Mississippi for recovery of certain costs associated with storms and natural disasters and the restoration of service resulting from such events. MP&L plans to immediately file for rate recovery of the costs related to the ice storm (see "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - MP&L," below). Entergy Corporation's current primary capital requirements are to periodically invest in, or make loans to, its subsidiaries. Entergy Corporation has SEC authorization to make additional investments in Entergy Power, Entergy S.A., Entergy Argentina, S.A., Entergy Transener, S.A., Entergy SASI, and FPN. Entergy Corporation expects to meet these requirements in 1994-1996 with internally generated funds and cash on hand. Entergy receives funds through dividend payments from its subsidiaries. Certain restrictions may limit the amount of these distributions. See Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, Note 2, "Rate and Regulatory Matters" and Note 8, "Commitments and Contingencies," incorporated herein by reference, regarding River Bend rate appeals and pending litigation with Cajun. Substantial write- offs or charges resulting from adverse rulings in these matters could adversely affect GSU's ability to continue to pay dividends. Entergy Corporation continues to consider new opportunities to expand its electric energy business, including expansion into related nonregulated businesses. Entergy Corporation expects to invest up to approximately $150 million per year over the next three years in nonregulated business opportunities. Entergy Corporation may finance any such expansion with cash on hand. Further, shareholder and/or regulatory approvals may be required for such acquisitions to take place. Also, Entergy Corporation has SEC authorization to repurchase shares of its outstanding common stock. Market conditions and board authorization determine the amount of repurchases. Entergy Corporation has requested SEC authorization for a $300 million bank line of credit, the proceeds of which are expected to be used for common stock repurchases and other optional activities. (For further information on the capital and refinancing requirements, capital resources, and short-term borrowing arrangements of AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy, respectively, refer in each case to AP&L's, GSU's, LP&L's, MP&L's, NOPSI's, and System Energy's "Management's Financial Discussion and Analysis - Liquidity and Capital Resources," Note 4 of AP&L's, GSU's, LP&L's, MP&L's, NOPSI's, and System Energy's Notes to Financial Statements, "Lines of Credit and Related Borrowings," Note 5 of AP&L's and NOPSI's Notes to Financial Statements, "Preferred Stock", Note 5 of GSU's Notes to Financial Statements, "Preferred, Preference and Common Stock", Note 5 of LP&L's and MP&L's Notes to Financial Statements, "Preferred and Common Stock," Note 6 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's and Note 5 of System Energy's Notes to Financial Statements, "Long-Term Debt," and Note 8 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's and Note 7 of System Energy's Notes to Financial Statements, "Commitments and Contingencies - Capital Requirements and Financing," each incorporated herein by reference. For further information concerning Entergy Corporation's capital requirements and resources, refer to Entergy Corporation and Subsidiaries' "Management's Financial Discussion and Analysis - Liquidity and Capital Resources," and Note 4 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Lines of Credit and Related Borrowings," incorporated herein by reference. For further information on the subsequent event, see Note 12 of AP&L's and Note 11 of MP&L's Notes to Financial Statements, "Subsequent Event (Unaudited)," incorporated herein by reference.) Certain System Financial and Support Agreements Unit Power Sales Agreement. The Unit Power Sales Agreement allocates capacity and energy from System Energy's 90% ownership and leasehold interest in Grand Gulf 1 (and the costs related thereto) to AP&L (36%), LP&L (14%), MP&L (33%), and NOPSI (17%). AP&L, LP&L, MP&L, and NOPSI pay rates to System Energy for their respective entitlements of capacity and energy on a full cost-of-service basis regardless of the quantity of energy delivered, so long as Grand Gulf 1 remains in commercial operation. Payments under the Unit Power Sales Agreement are System Energy's only source of operating revenues. The financial condition of System Energy depends upon the continued commercial operation of Grand Gulf 1 and upon the receipt of payments from AP&L, LP&L, MP&L, and NOPSI. (See "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - System Energy," below for further information with respect to proceedings relating to the Unit Power Sales Agreement.) Availability Agreement. The Availability Agreement was entered into among System Energy and AP&L, LP&L, MP&L, and NOPSI in 1974 in connection with the financing by System Energy of the Grand Gulf Station. The agreement provided that System Energy would join in the agreement among AP&L, LP&L, MP&L, and NOPSI for the sharing of generating capacity and other capacity and energy resources on or before the date on which Grand Gulf 1 was placed in commercial operation. It also provided that System Energy would make available to AP&L, LP&L, MP&L, and NOPSI all capacity and energy available from System Energy's share of the Grand Gulf Station. System Energy and AP&L, LP&L, MP&L, and NOPSI further agreed that if this agreement were terminated, or if any of the parties thereto withdrew from it, then System Energy would enter into a separate agreement with all of such parties or the withdrawing party, as the case may be, with respect to the purchase of capacity and energy on the same terms as if this agreement were still controlling. AP&L, LP&L, MP&L, and NOPSI also agreed severally to pay System Energy monthly for the right to receive capacity and energy available from the Grand Gulf Station in amounts that (when added to any amounts received by System Energy under the Unit Power Sales Agreement, or otherwise) would be at least equal to System Energy's total operating expenses for the Grand Gulf Station (including depreciation at a specified rate) and interest charges. As amended to date, the Availability Agreement provides that: - the obligation of AP&L, LP&L, MP&L, and NOPSI for payments for Grand Gulf 1 became effective upon commercial operation of Grand Gulf 1 on July 1, 1985; - the sale of capacity and energy generated by the Grand Gulf Station may be governed by a separate power purchase agreement among System Energy and AP&L, LP&L, MP&L, and NOPSI; - the September 1989 write-off of System Energy's investment in Grand Gulf 2, amounting to approximately $900 million, will be amortized for Availability Agreement purposes over 27 years rather than in the month the write-off was recognized on System Energy's books; and - the allocation percentages under the Availability Agreement are fixed as follows: AP&L - 17.1%; LP&L - 26.9%; MP&L - 31.3%; and NOPSI - 24.7%. As noted above, the Unit Power Sales Agreement provides for different allocation percentages for sales of capacity and energy from Grand Gulf 1. However, the allocation percentages under the Availability Agreement remain in effect and would govern payments made thereunder in the event of a shortfall of funds available to System Energy from other sources, including payments by AP&L, LP&L, MP&L, and NOPSI to System Energy under the Unit Power Sales Agreement. System Energy has assigned its rights to payments and advances from AP&L, LP&L, MP&L, and NOPSI under the Availability Agreement as security for its first mortgage bonds and reimbursement obligations to certain banks providing the letters of credit in connection with the equity funding of the sale and leaseback transactions described under "Sale and Leaseback Arrangements - System Energy," below. In these assignments, AP&L, LP&L, MP&L, and NOPSI further agreed that in the event they were prohibited by governmental action from making payments under the Availability Agreement (if, for example, FERC reduced or disallowed such payments as constituting excessive rates; see the second succeeding paragraph), they would then make subordinated advances to System Energy in the same amounts and at the same times as the prohibited payments. System Energy would not be allowed to repay these subordinated advances so long as it remained in default under the related indebtedness or in other similar circumstances. Each of the assignment agreements relating to the Availability Agreement provides that AP&L, LP&L, MP&L, and NOPSI shall make payments directly to System Energy. However, if there is an event of default, AP&L, LP&L, MP&L, and NOPSI shall make those payments directly to the holders of indebtedness secured by such assignment agreements. The payments shall be made pro rata according to the amount of the respective obligations secured. The obligations of AP&L, LP&L, MP&L, and NOPSI to make payments under the Availability Agreement are subject to receipt and continued effectiveness of all necessary regulatory approvals. Sales of capacity and energy under the Availability Agreement would require that the Availability Agreement be submitted to FERC for approval with respect to the terms of such sale. No filing with FERC has been required because sales of capacity and energy from the Grand Gulf Station are being made under the Unit Power Sales Agreement. Other aspects of the Availability Agreement, including the obligations of AP&L, LP&L, MP&L, and NOPSI to make subordinated advances, are subject to the jurisdiction of the SEC under the Holding Company Act, which approval has been obtained. If, for any reason, sales of capacity and energy are made in the future pursuant to the Availability Agreement, the jurisdictional portions of the Availability Agreement would be submitted to FERC for approval. (Refer to the second preceding paragraph.) Amounts that have been received by System Energy under the Unit Power Sales Agreement have exceeded the amounts payable under the Availability Agreement. Consequently, no payments under the Availability Agreement by AP&L, LP&L, MP&L, and NOPSI have ever been required. If AP&L, LP&L, MP&L, or NOPSI became unable in whole or in part to continue making payments to System Energy under the Unit Power Sales Agreement, and System Energy were unable to procure funds from other sources sufficient to cover any potential shortfall between the amount owing under the Availability Agreement and the amount of continuing payments under the Unit Power Sales Agreement plus other funds then available to System Energy, LP&L and NOPSI could become subject to claims or demands by System Energy or its creditors for payments or advances under the Availability Agreement or the assignments thereof for the difference between their required Unit Power Sales Agreement payments and their required Availability Agreement payments. The amount, if any, which these companies would become liable to pay or advance, over and above amounts they would be paying under the Unit Power Sales Agreement for capacity and energy from Grand Gulf 1, would depend on a variety of factors (especially the degree of any such shortfall and System Energy's access to other funds). It cannot be predicted whether any such claims or demands, if made and upheld, could be satisfied. In NOPSI's case, if any such claims or demands were upheld, the holders of certain of NOPSI's outstanding general and refunding mortgage bonds could require redemption of their bonds at par. The ability of AP&L, LP&L, MP&L, and NOPSI to sustain payments under the Availability Agreement and the assignments thereof in material amounts without substantially equivalent recovery from their customers would be limited by their respective available cash resources and financing capabilities at the time. The ability of AP&L, LP&L, MP&L, and NOPSI to recover from their customers payments made under the Availability Agreement, or under the assignments thereof, would depend upon the outcome of regulatory proceedings before the state and local regulatory authorities having jurisdiction. In view of the controversies that arose over the allocation of capacity and energy from Grand Gulf 1 pursuant to the Unit Power Sales Agreement, opposition to recovery would be likely and the outcome of such proceedings, should they occur, is not predictable. Reallocation Agreement. On November 18, 1981, the SEC authorized LP&L, MP&L, and NOPSI to indemnify AP&L against principally its responsibilities and obligations with respect to the Grand Gulf Station contained in the Availability Agreement and the assignments thereof. The revised percentages of allocated capacity of System Energy's share of Grand Gulf 1 and Grand Gulf 2 were, respectively: LP&L - 38.57% and 26.23%; MP&L - 31.63% and 43.97%; and NOPSI - 29.80% and 29.80%. FERC's decision allocating the capacity and energy of Grand Gulf 1 to AP&L, LP&L, MP&L, and NOPSI supersedes the Reallocation Agreement insofar as it relates to Grand Gulf 1. However, responsibility for any Grand Gulf 2 amortization amounts (see "Availability Agreement," above) has been allocated to LP&L - 26.23%, MP&L - 43.97%, and NOPSI - 29.80% under the terms of the Reallocation Agreement. The Reallocation Agreement does not affect the obligation of AP&L to System Energy's lenders under the assignments referred to in the fifth preceding paragraph, and AP&L would be liable for its share of such amounts if LP&L, MP&L, and NOPSI were unable to meet their contractual obligations. No payments of any amortization amounts will be required as long as amounts paid to System Energy under the Unit Power Sales Agreement, together with other funds available to System Energy, exceed amounts required under the Availability Agreement, which is expected to be the case for the foreseeable future. Capital Funds Agreement. System Energy and Entergy Corporation have entered into the Capital Funds Agreement whereby Entergy Corporation has agreed to supply to System Energy sufficient capital to (1) maintain System Energy's equity capital at an amount equal to a minimum of 35% of its total capitalization (excluding short-term debt), and (2) permit the continuation of commercial operation of Grand Gulf 1 and to pay in full all indebtedness for borrowed money of System Energy when due under any circumstances. Entergy Corporation has entered into various supplements to the Capital Funds Agreement, and System Energy has assigned its rights thereunder as security for its first mortgage bonds and reimbursement obligations to certain banks providing letters of credit in connection with the equity funding of the sale and leaseback transactions described under "Sale and Leaseback Arrangements - System Energy," below. Each such supplement provides that permitted indebtedness for borrowed money incurred by System Energy in connection with the financing of the Grand Gulf Station may be secured by System Energy's rights under the Capital Funds Agreement on a pro rata basis (except for the Specific Payments, as hereinafter defined). In addition, in the particular supplements to the Capital Funds Agreement relating to the specific indebtedness being secured, Entergy Corporation has agreed to make cash capital contributions to System Energy sufficient to enable System Energy to make payments when due on such indebtedness (Specific Payments). Except with respect to the Specific Payments, which have been approved by the SEC under the Holding Company Act, the performance by both Entergy Corporation and System Energy of their obligations under the Capital Funds Agreement, as supplemented, is subject to the receipt and continued effectiveness of all governmental authorizations necessary to permit such performance, including approval by the SEC under the Holding Company Act. Each of the supplemental agreements provides that Entergy Corporation shall make its payments directly to System Energy. However, if there is an event of default, Entergy Corporation shall make those payments directly to the holders of indebtedness secured by the supplemental agreements. The payments (other than the Specific Payments) shall be made pro rata according to the amount of the respective obligations secured by the supplemental agreements. Sale and Leaseback Arrangements LP&L. On September 28, 1989, LP&L entered into arrangements for the sale and leaseback of an approximate aggregate 9.3% ownership interest in Waterford 3. LP&L has options to terminate the leases and to repurchase the sold interests in Waterford 3 at certain intervals during the basic terms of the leases. Further, at the end of the terms of the leases, LP&L has options to renew the leases or to repurchase the interests in Waterford 3. If LP&L does not exercise its options to repurchase the interests in Waterford 3 on the fifth anniversary (September 28, 1994) of the closing date of the sale and leaseback transactions, LP&L will be required to provide collateral to the owner participants for the equity portion of certain amounts payable by LP&L under the lease. The required collateral is either a bank letter or letters of credit or the pledging of new series of first mortgage bonds issued by LP&L under its first mortgage bond indenture. (For further information on LP&L's sale and leaseback arrangements, including the required maintenance by LP&L of specified capitalization and fixed charge coverage ratios, see Note 9 of LP&L's Notes to Financial Statements, "Leases - Waterford 3 Lease Obligations," incorporated herein by reference.) System Energy. On December 28, 1988, System Energy entered into arrangements for the sale and leaseback of an 11.5% ownership interest in Grand Gulf 1. System Energy has options to terminate the leases and to repurchase the undivided interest in Grand Gulf 1 at certain intervals during the basic lease term. Further, System Energy has an option at the end of the basic lease term to renew the leases or to repurchase the undivided interest in Grand Gulf 1. In connection with the equity funding of the sale and leaseback arrangements, letters of credit are required to be maintained by System Energy under the leases to secure certain amounts payable for the benefit of the equity investors. The letters of credit currently maintained are effective until January 15, 1997. Under the provisions of a reimbursement agreement, dated December 1, 1988, as amended, entered into by System Energy and various banks in connection with the sale and leaseback arrangements related to the letters of credit, System Energy has agreed to a number of covenants relating to, among other things, the maintenance of certain capitalization and fixed charge ratios. In connection with an audit of System Energy by FERC, if a decision of FERC issued on August 4, 1992 (August 4 Order) is ultimately sustained and implemented, System Energy would need to obtain the consent of certain banks to waive the capitalization and fixed charge coverage covenants for a limited period of time in order to avoid violation of such covenants. System Energy has obtained the consent of the banks to waive these covenants for the twelve-month period beginning with the earlier of the write-off or the first refund, if the August 4 Order is implemented prior to December 31, 1994. Absent a waiver, failure by System Energy to perform these covenants could give rise to a draw under the letters of credit and/or an early termination of the letters of credit, and, if such letters of credit were not replaced in a timely manner, could result in a default under, or other early termination of, System Energy's leases. (For further information on the potential effects of the August 4 Order on System Energy's financial condition, see Note 2 of System Energy's Notes to Financial Statements, "Rate and Regulatory Matters - FERC Audit," incorporated herein by reference, and for a further discussion of the provisions of System Energy's Reimbursement Agreement, see System Energy's Notes to Financial Statements, Note 6, "Dividend Restrictions" and Note 7, "Commitments and Contingencies - Reimbursement Agreement," incorporated herein by reference.) RATE MATTERS AND REGULATION RATE MATTERS The System operating companies' retail rates are regulated by their respective state and/or local regulatory authorities, as described below, and their rates for wholesale sales (including intrasystem sales pursuant to the System Agreement) and interstate transmission of electricity are regulated by FERC. Rates for System Energy's sales of capacity and energy from Grand Gulf 1 to AP&L, LP&L, MP&L, and NOPSI pursuant to the Unit Power Sales Agreement are also regulated by FERC. Wholesale Rate Matters GSU. For information, see "Retail Rate Matters - GSU," below and "Regulation - Other Regulation and Litigation - GSU," below. System Energy. As described above under "Certain System Financial and Support Agreements," System Energy recovers costs related to its interest in Grand Gulf 1 through rates charged to AP&L, LP&L, MP&L, and NOPSI for Grand Gulf 1 capacity and energy under the Unit Power Sales Agreement. Several proceedings currently pending or recently concluded at FERC affect these rates. In connection with an audit report covering a review of System Energy's books and records for the years 1986-1988, on August 4, 1992, FERC issued an opinion and order (1) finding that System Energy overstated its Grand Gulf 1 utility plant by approximately $95 million for costs included in utility plant that are related to the System's income tax allocation procedures, and (2) requiring System Energy to make adjusting accounting entries and refunds, with interest, to AP&L, LP&L, MP&L, and NOPSI within 90 days from the date of the order. System Energy requested a rehearing of the order, and on October 5, 1992, FERC issued an order allowing additional time for its consideration of such request and deferring System Energy's refund obligation until 30 days following issuance of FERC's order on rehearing. (For further information on FERC's order and its potential effect on System Energy's and Entergy's consolidated financial position, see Note 2 of System Energy's Notes to Financial Statements and Note 2 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Rate and Regulatory Matters - FERC Audit," incorporated herein by reference.) In a separate proceeding, on August 24, 1992, FERC instituted an investigation of the justness and reasonableness of certain of Entergy's formula wholesale rates, including System Energy's rates under the Unit Power Sales Agreement. Various regulatory authorities intervened in the proceeding. On August 2, 1993, Entergy and the intervenors settled the proceeding and agreed that System Energy's rate of return on equity would be reduced from 13% to 11%, and such rate would remain in effect until at least August 1995. Refunds were payable by System Energy with respect to the period from November 2, 1992, through the effective date of the settlement. FERC approved the settlement on October 25, 1993, and System Energy credited AP&L, LP&L, MP&L, and NOPSI with an aggregate of $29.6 million on their October 1993 bills. This matter is now final. (See Note 2 of System Energy's Notes to Financial Statements, "Rate and Regulatory Matters - FERC Return on Equity Case," incorporated herein by reference.) Entergy Power. In 1990, authorizations were obtained from the SEC, FERC, the APSC, and the Public Service Commission of Missouri for Entergy Power to purchase AP&L's interests in Independence 2 and Ritchie 2, and to begin marketing the capacity and energy from the units in certain wholesale markets. The SEC order approving various aspects of the transaction was appealed by various intervenors in the proceeding to the D.C. Circuit, which reversed a portion of the order and remanded the case to the SEC for consideration of the effect of the transfers on the System's future costs of replacement generating capacity and fuel. In response to a June 24, 1993 SEC order setting a procedural schedule for the filing of further pleadings in the proceeding, in July 1993, the Entergy parties filed a post-effective amendment to their application addressing the issues specified in the SEC order. On September 9, 1993, the City of New Orleans and the LPSC each requested a hearing. However, on January 5, 1994, the City of New Orleans withdrew from the proceeding, as agreed in its settlement with NOPSI of various issues related to the Merger. System Agreement. AP&L, LP&L, MP&L, and NOPSI engage in the coordinated planning, construction, and operation of generation and transmission facilities pursuant to the terms of the System Agreement (described under "Property - Generating Stations," below). GSU became a party to the System Agreement upon consummation of the merger of Entergy's and GSU's electric systems, and GSU now participates in this System-wide coordination. For further information, see Note 2 of GSU's Notes to Financial Statements and Note 2 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Rate and Regulatory Matters - Merger-Related Rate Agreements." In connection with the Merger, FERC approved certain rate schedule changes to integrate GSU into the System Agreement. Certain commitments were adopted to provide reasonable assurance that the ratepayers of the existing Entergy operating companies will not be allocated higher costs, including, among other things: (1) a tracking mechanism to protect operating companies from certain unexpected increases in fuel costs; (2) excluding GSU from the distribution of profits from power sales contracts entered into prior to the Merger; (3) a methodology to estimate the cost of capital in future FERC proceedings; and (4) a stipulation that the operating companies will be insulated from certain direct effects on capacity equalization payments should GSU, due to a finding of imprudent GSU management prior to the Merger, be required to purchase Cajun's 30% share in River Bend. See "Regulation - Other Regulation and Litigation," for information on requests for rehearing of FERC's approval. On August 20, l990, the City of New Orleans filed a complaint against Entergy Corporation, AP&L, LP&L, MP&L, NOPSI, and System Energy requesting that FERC investigate AP&L's transfer of its interest in Independence 2 and Ritchie 2 to Entergy Power (see "Entergy Power," above) and the effect of the transfer on AP&L, LP&L, MP&L, and NOPSI and their ratepayers. Various parties, including certain of the System's state regulators, intervened in the proceeding. FERC issued an order on March 19, 1991, setting for investigation (l) the question of whether overall billings under the System Agreement will increase as a result of the transfer to Entergy Power, and (2) if so, whether such increased billings reflect prudently incurred costs that may reasonably be charged under the System Agreement. In two separate decisions with respect to these issues, the FERC ALJ assigned to the matter ruled on May 14, l992 and October 30, 1992, respectively, that there was sufficient evidence to show that overall billings would increase as a result of the transfer, but that the transfer was prudent. On December 15, 1993, FERC issued an opinion declining to address the prudence issue until a future time when replacement capacity has been added or planned and finding that, until such time, billings under the System Agreement as affected by the transfer of the two units are reasonable. The Entergy parties and the City of New Orleans each filed a request for rehearing of this order. If FERC's decision were reversed and any refunds were ordered, they would be retroactive to October 19, 1990. Open Access Transmission. On August 2, 1991, Entergy Services, as agent for AP&L, LP&L, MP&L, NOPSI, and Entergy Power, submitted to FERC (1) proposed tariffs that, subject to certain conditions, would provide to electric utilities "open access" to the System's integrated transmission system, and (2) rate schedules providing for sales of wholesale power at market-based rates. Under FERC policy, sales of power at market-based rates would be permitted only if FERC found, among other things, that Entergy did not have market power over transmission. Permitting "open access" to the System's transmission system helps support such a finding. Various parties, including the Council, the APSC, the MPSC, and the LPSC, intervened in the proceeding. On March 3, 1992, FERC approved the filing, with some modifications, and on August 7, l992, FERC denied rehearing of its March 1992 order. On August 24, l992, various parties filed petitions with the D.C. Circuit for review of FERC's 1992 orders, and these petitions have been consolidated. The revised tariffs, submitted by Entergy Services in response to FERC's 1992 orders, were accepted for filing and made effective, subject to further modifications, by order dated April 5, l993. Entergy Services made a further compliance filing on May 5, l993, reflecting these modifications and requesting reconsideration of certain limited matters, which is subject to approval by FERC. On December 31, 1993, Entergy Services filed revisions to the transmission service tariff to recognize GSU's inclusion in the Entergy System. These matters are pending. Retail Rate Matters General. AP&L, LP&L, MP&L, and NOPSI currently have retail rate structures sufficient to recover their costs, including costs associated with their allocated shares of capacity and energy from Grand Gulf 1 under the Unit Power Sales Agreement, and a return on equity. Certain costs related to Grand Gulf 1 (and in LP&L's case, Waterford 3 are being phased-into retail rates over a period of time, in order to avoid the "rate shock" associated with increasing rates to reflect all of such costs at once. The deferral period in which costs are incurred but not currently recovered has expired for all of these programs, and AP&L, LP&L, MP&L, and NOPSI are now recovering those costs that were previously deferred. Also, AP&L and LP&L have retained a portion of their shares of Grand Gulf 1 capacity and GSU is operating under a deregulated asset plan for a portion of its share of River Bend. GSU is involved in several rate proceedings involving recovery, among other things, of costs associated with River Bend. Some rate relief has been received, but GSU has been unable to obtain recognition in rates for a substantial portion of its River Bend investment. Recovery of certain costs has been disallowed, while other costs are being deferred for future recovery, held in abeyance pending further regulatory action, or treated as investments in deregulated assets. There are ongoing rate proceedings and appeals relating to these issues (see "GSU," below). The System is committed to taking actions that will stabilize retail rates and avoid the need for future rate increases. In the short-term, this involves containing costs to the greatest degree practicable, thereby avoiding erosion of earnings and delaying for as long as possible the need for general rate increases. In accordance with this retail rate policy, the System operating companies have agreed to retail rate caps and/or rate freezes for specified periods of time. In the longer term, as discussed in "Business of Entergy - Competition - Least Cost Planning" above, and also as discussed specifically for each applicable company below, the System is pursuing implementation of least cost planning to minimize the cost of future sources of energy. Effective January 1, 1993, the System adopted SFAS No. 106 (SFAS 106), an accounting standard that requires accrual of the costs of postretirement benefits other than pensions prior to the time these costs are actually incurred. In 1992, the System operating companies requested from their retail rate regulators authorization to recognize in rates the costs associated with implementation of SFAS 106. For further information, see Note 10 of Entergy Corporation and Subsidiaries', Note 9 of MP&L's and NOPSI's, and Note 10 of AP&L's, GSU's, and LP&L's Notes to Financial Statements, "Postretirement and Postemployment Benefits," incorporated herein by reference. AP&L Rate Freeze. In connection with the settlement of various issues related to the Merger, AP&L agreed that it will not request any general retail rate increase that would take effect before November 3, 1998, except, among other things, for increases associated with the Least Cost Plan (discussed below); recovery of certain Grand Gulf 1- related costs, excess capacity costs, and costs related to the adoption of SFAS 106 that were previously deferred; recovery of certain taxes; fuel adjustment recoveries; recovery of nuclear decommissioning costs; and force majeure (defined to include, among other things, war, natural catastrophes, and high inflation). Recovery of Grand Gulf 1 Costs. Under the settlement agreement entered into with the APSC in 1985 and amended in 1988, AP&L agreed to retain a portion of its Grand Gulf l-related costs, recover a portion of such costs currently, and defer a portion of such costs for future recovery. In 1994 and subsequent years, AP&L will retain 7.92% of such costs (stated as a percentage of System Energy's 90% share of the unit) and will recover 28.08% currently. Deferrals ceased in l990, and AP&L is recovering a portion of the previously deferred costs each year through l998. As of December 31, l993, the balance of deferred uncollected costs was $568.0 million. AP&L is permitted to recover on a current basis the incremental costs of financing the unrecovered deferrals. AP&L has the right to sell capacity and energy from its retained share of Grand Gulf 1 to third parties and to sell such energy to its retail customers at a price equal to AP&L's avoided energy cost. Proceeds of sales to third parties of AP&L's retained share of Grand Gulf l capacity and energy generally accrue to the benefit of AP&L's stockholder; however, half of the proceeds of such sales to third parties prior to January 1, 1996, are used to reduce the balance of uncollected deferrals and thus accrue to the benefit of retail ratepayers. If AP&L makes sales to third parties prior to that date in excess of the retained share, the proceeds of such excess are also split between the stockholder and the ratepayers, except that the portion of the sale that accrues to the stockholder's benefit cannot exceed the retained share. Least Cost Planning. On December 1, 1992 and July 1, 1993, AP&L filed with the APSC the Least Cost Plan described in "Business of Entergy - Competition - Least Cost Planning," above. AP&L also requested authorization to recover development and implementation costs and costs and incentives related to the DSM aspects of the plan. On October 13, 1993, the APSC found AP&L's plan to be complete and directed the APSC staff to conduct a series of public forums in late 1993, including focus groups, town meetings, and collaborative workshops, before it would establish a procedural schedule that would include evidentiary hearings and the issuance of a Least Cost Plan order. Several of these meetings were delayed into 1994, but are expected to be completed by March 1994. At or before that time, AP&L expects the APSC to issue a procedural schedule that will allow the APSC to issue an order before the end of 1994. On January 19, 1994, AP&L filed a request with the APSC for permission to withdraw the CCLM portion of the filing and to continue such programs on a pilot basis at shareholder expense. The APSC has not yet ruled on AP&L's request. Fuel Adjustment Clause. AP&L's retail rate schedules have a fuel adjustment clause that provides for recovery of the excess cost of fuel and purchased power incurred in the second preceding month. The fuel adjustment clause also contains a nuclear reserve fund designed to cover the cost of replacement energy during scheduled maintenance and refueling outages at ANO, and an incentive provision that permits over- or under-recovery of the excess cost of replacement energy when ANO is operating or down for reasons other than refueling. GSU Rate Cap and Other Merger-Related Rate Agreements. The LPSC and the PUCT approved separate regulatory proposals that include the following elements: (1) a five-year rate cap on GSU's retail electric base rates in the respective states, except for force majeure (defined to include, among other things, war, natural catastrophes, and high inflation); (2) a provision for passing through to retail customers in the respective states the jurisdictional portion of the fuel savings created by the Merger; and (3) a mechanism for tracking nonfuel operation and maintenance savings created by the Merger. The LPSC regulatory plan provides that such nonfuel savings will be shared 60% by the shareholder and 40% by ratepayers during the eight years following the Merger. The LPSC plan requires regulatory filings each year by the end of May through 2001. The PUCT regulatory plan provides that such savings will be shared equally by the shareholder and ratepayers, except that the shareholder's portion will be reduced by $2.6 million per year on a total company basis in years four through eight. The PUCT plan also requires a series of regulatory filings, currently anticipated to be in June 1994, and February 1996, 1998, and 2001, to ensure that the ratepayers' share of such savings be reflected in rates on a timely basis and requires Entergy Corporation to hold GSU's Texas retail customers harmless from the effects of the removal by FERC of a 40% cap on the amount of fuel savings GSU may be required to transfer to other Entergy operating companies under the FERC tracking mechanism (see "Rate Matters - Wholesale Rate Matters - System Agreement," above). On January 14, 1994, Entergy Corporation filed a request for rehearing of FERC's December 15, 1993 order approving the Merger, requesting that FERC restore the 40% cap provision in the fuel cost protection mechanism (see "Regulation - Other Litigation and Regulation," below). The matter is pending. Recovery of River Bend Costs. GSU deferred approximately $369 million of River Bend operating costs, purchased power costs, and accrued carrying charges pursuant to a 1986 PUCT accounting order. Approximately $182 million of these costs are being amortized over a 20-year period, and the remaining $187 million are not being amortized pending the ultimate outcome of the Rate Appeal (see "Texas Jurisdiction - River Bend," below). As of December 31, 1993, the unamortized balance of these costs was $330.3 million. Further, GSU deferred approximately $400.4 million of similar costs pursuant to a 1986 LPSC accounting order. These costs, of which approximately $160.4 million are unamortized as of December 31, 1993, are being amortized over a 10-year period. In accordance with a phase-in plan approved by the LPSC, GSU deferred $324.7 million of its River Bend costs related to the period December 1987 through February 1991. GSU has amortized $86.6 million through December 31, 1993, and the remainder of $238.1 million will be recovered over approximately 3.8 years. Texas Jurisdiction - River Bend. In May 1988, the PUCT granted GSU a permanent increase in annual revenues of $59.9 million resulting from the inclusion in rate base of approximately $1.6 billion of company-wide River Bend plant investment and approximately $182 million of related Texas retail jurisdiction deferred River Bend costs (Allowed Deferrals). In addition, the PUCT disallowed as imprudent $63.5 million of company-wide River Bend plant costs and placed in abeyance, with no finding of prudency, approximately $1.4 billion of company-wide River Bend plant investment and approximately $157 million of Texas retail jurisdiction deferred River Bend operating and carrying costs. The PUCT affirmed that the ultimate rate treatment of such amounts would be subject to future demonstration of the prudency of such costs. GSU and intervening parties appealed this order (Rate Appeal) and GSU filed a separate rate case asking that the abeyed River Bend plant costs be found prudent (Separate Rate Case). Intervening parties filed suit in district court to prohibit the Separate Rate Case. The district court's decision was ultimately appealed to the Texas Supreme Court which ruled in 1990 that the prudence of the purported abeyed costs could not be relitigated in a separate rate proceeding. Further, the Texas Supreme Court's decision stated that all issues relating to the merits of the original order of the PUCT, including the prudence of all River Bend-related costs, should be addressed in the Rate Appeal. In October 1991, the district court in the Rate Appeal issued an order holding that, while it was clear the PUCT made an error in assuming it could set aside $1.4 billion of the total costs of River Bend and consider them in a later proceeding, the PUCT, nevertheless, found that GSU had not met its burden of proof related to the amounts placed in abeyance. The court also ruled that the Allowed Deferrals should not be included in rate base under a 1991 decision regarding El Paso Electric Company's similar deferred costs (El Paso Case). The court further stated that the PUCT erred in reducing GSU's deferred costs by $1.50 for each $1.00 of revenue collected under the interim rate increases authorized in 1987 and 1988. The court remanded the case to the PUCT with instructions as to the proper handling of the Allowed Deferrals. GSU's motion for rehearing was denied, and in December 1991, GSU filed an appeal of the October 1991 district court order. The PUCT also appealed the October 1991 district court order, which served to supersede the district court's judgment, rendering it unenforceable under Texas law. In August 1992, the court of appeals in the El Paso Case handed down its second opinion on rehearing modifying its previous opinion on deferred accounting. The court's second opinion concluded that the PUCT may lawfully defer operating and maintenance costs and subsequently include them in rate base, but that the Public Utility Regulatory Act prohibits such rate base treatment for deferred carrying costs. The court stated, however, its opinion would not preclude the recovery of deferred carrying costs. The August 1992 court of appeals opinion was appealed to the Texas Supreme Court where arguments were heard in September 1993. The matter is still pending. In September 1993, the Texas Third District Court of Appeals (the Third District Court) remanded the October 1991 district court decision to the PUCT "to reexamine the record evidence to whatever extent necessary to render a final order supported by substantial evidence and not inconsistent with our opinion." The Third District Court specifically addressed the PUCT's treatment of certain costs, stating that the PUCT's order was not based on substantial evidence. The Third District Court also applied its most recent ruling in the El Paso Case to the deferred costs associated with River Bend. However, the Third District Court cautioned the PUCT to confine its deliberations to the evidence addressed in the original rate case. Certain parties to the case have indicated their position that, on remand, the PUCT may change its original order only with respect to matters specifically discussed by the Third District Court which, if allowed, would increase GSU's allowed River Bend investment, net of accumulated depreciation and related taxes, by approximately $48 million as of December 31, 1993. GSU believes that under the Third District Court's decision, the PUCT would be free to reconsider any aspect of its order concerning the abeyed $1.4 billion River Bend investment. GSU has filed a motion for rehearing asking the Third District Court to modify its order so as to permit the PUCT to take additional evidence on remand. The PUCT and other parties have also moved for rehearing on various grounds. The Third District Court has not yet ruled on any of these motions. As of December 31, 1993, the River Bend plant costs disallowed for retail ratemaking purposes in Texas, and the River Bend plant costs held in abeyance and the related cost deferrals totaled (net of taxes) approximately $14 million, $300 million (both net of depreciation), and $171 million, respectively. Allowed Deferrals were approximately $95 million, net of taxes and amortization, as of December 31, 1993. GSU estimates it has collected approximately $139 million of revenues as of December 31, 1993, as a result of the originally ordered rate treatment of these deferred costs. However, if the PUCT adopts the most recent decision in the El Paso Case, the possible refunds approximate $28 million as a result of the inclusion of deferred carrying costs in rate base for the period July 1988 through December 1990. However, if the PUCT reverses its decision to reduce GSU's deferred costs by $1.50 for each $1.00 of revenue collected under the interim rate increases authorized in 1987 and 1988, the potential refund of amounts described above could be reduced by an amount ranging from $7 million to $19 million. No assurance can be given as to the timing or outcome of the remands or appeals described above. Pending further developments in these cases, GSU has made no write-offs for the River Bend related costs. Management believes, based on advice from Clark, Thomas & Winters, a Professional Corporation, legal counsel of record in the Rate Appeal, that it is reasonably possible that the case will be remanded to the PUCT, and the PUCT will be allowed to rule on the prudence of the abeyed River Bend plant costs. Rate caps imposed by the PUCT's regulatory approval of the Merger could result in GSU being unable to use the full amount of a favorable decision to immediately increase rates; however, a favorable decision could permit some increases and/or limit or prevent decreases during the period the rate caps are in effect. At this time, management and legal counsel are unable to predict the amount, if any, of the abeyed and previously disallowed River Bend plant costs that ultimately may be disallowed by the PUCT. A net of tax write-off as of December 31, 1993, of up to $314 million could be required based on the PUCT's ultimate ruling. In prior proceedings, the PUCT has held that the original cost of nuclear power plants will be included in rates to the extent those costs were prudently incurred. Based upon the PUCT's prior decisions, management believes that its River Bend construction costs were prudently incurred and that it is reasonably possible that it will recover in rate base, or otherwise through means such as a deregulated asset plan, all or substantially all of the abeyed River Bend plant costs. However, management also recognizes that it is reasonably possible that not all of the abeyed River Bend plant costs may ultimately be recovered. As part of its direct case in the Separate Rate Case, GSU filed a cost reconciliation study prepared by Sandlin Associates, management consultants with expertise in the cost analysis of nuclear power plants, which supports the reasonableness of the River Bend costs held in abeyance by the PUCT. This reconciliation study determined that approximately 82% of the River Bend cost increase above the amount included by the PUCT in rate base was a result of changes in federal nuclear safety requirements and provided other support for the remainder of the abeyed amounts. There have been four other rate proceedings in Texas involving nuclear power plants. Investment in the plants ultimately disallowed ranged from 0% to 15%. Each case was unique, and the disallowances in each were made on a case-by-case basis for different reasons. Appeals of most, if not all, of these PUCT decisions are currently pending. The following factors support management's position that a loss contingency requiring accrual has not occurred, and its belief that all, or substantially all, of the abeyed plant costs will ultimately be recovered: 1. The $1.4 billion of abeyed River Bend plant costs have never been ruled imprudent and disallowed by the PUCT. 2. Sandlin Associates' analysis which supports the prudence of substantially all of the abeyed construction costs. 3. Historical inclusion by the PUCT of prudent construction costs in rate base. 4. The analysis of GSU's internal legal staff, which has considerable experience in Texas rate case litigation. Additionally, management believes, based on advice from Clark, Thomas & Winters, a Professional Corporation, legal counsel of record in the Rate Appeal, that it is probable that the deferred costs will be allowed. However, assuming the August 1992 court of appeals' opinion in the El Paso Case is upheld and applied to GSU and the deferred River Bend costs currently held in abeyance are not allowed to be recovered in rates as allowable costs, a net-of-tax write-off of up to $171 million could be required. In addition, future revenues based upon the deferred costs previously allowed in rate base could also be lost and no assurance can be given as to whether or not refunds (up to $28 million as of December 31, 1993) of revenue received based upon such deferred costs previously recorded will be required. See Note 12 of GSU's Notes to Financial Statements, "Entergy Corporation-GSU Merger," for the accounting treatment of preacquistion contingencies, including a River Bend write-down. Texas Jurisdiction - Fuel Reconciliation. In January 1992, GSU applied with the PUCT for a new fixed fuel factor and requested a final reconciliation of fuel and purchased power costs incurred between December 1, 1986 and September 30, 1991. GSU proposed to recover net underrecoveries and interest (including underrecoveries related to NISCO, discussed below) over a twelve month period. In April 1993, the presiding PUCT ALJ issued a report which concluded that GSU incurred approximately $117 million of nonreimbursable fuel costs on a company-wide basis (approximately $50 million on a Texas retail jurisdictional basis) during the reconciliation period. Included in the nonreimbursable fuel costs were payments above GSU's avoided cost rate for power purchased from NISCO. The PUCT ordered in 1986 that the purchased power costs from NISCO in excess of GSU's avoided costs be disallowed. The PUCT disallowance resulted in approximately $12 million to $15 million of unrecovered purchased power costs on an annual basis, which GSU continued to expense as the costs were incurred. In April 1991, the Texas Supreme Court, in the appeal of such order, ordered the PUCT to allow GSU to recover purchased power payments in excess of its avoided cost in future proceedings, if GSU established to the PUCT's satisfaction that the payments were reasonable and necessary expenses. In June 1993, the PUCT, in the fuel reconciliation case, concluded that the purchased power payments made to NISCO in excess of GSU's avoided cost were not reasonably incurred. As a result of the order, GSU recorded additional fuel expenses (including interest) of $2.8 million for non-NISCO related items. The PUCT's order resulted in no additional expenses related to the NISCO issue, or for overcollections related to the fixed fuel factor, as those charges were expensed by GSU as they were incurred. The PUCT concluded that GSU had over-collected its fuel costs in Texas and ordered GSU to refund approximately $33.8 million to its Texas retail customers, including approximately $7.5 million of interest. The PUCT reduced GSU's fixed fuel factor in Texas from about 2.1 cents per KWH to approximately 1.84 cents per KWH. GSU had requested a new fixed fuel factor of about 2.02 cents per KWH. Based on current sales forecasts, adoption of the PUCT's recommended fixed fuel factor would reduce GSU's revenues by approximately $34 million annually. In October 1993, GSU appealed the PUCT's order to the Travis County District Court. No assurance can be given as to the timing or outcome of the appeal. Texas - Cities Rate Settlement. In June 1993, thirteen cities within GSU's Texas service area instituted an investigation to determine whether GSU's current rates were justified. In October 1993, the general counsel of the PUCT instituted an inquiry into the reasonableness of GSU's rates. In November 1993, a settlement agreement was filed with the PUCT which provides for an initial reduction in annual retail base revenues in Texas of approximately $22.5 million effective for electric usage on or after November 1, 1993, and a second reduction of $20 million to be effective September 1994. Further, the settlement provided for GSU to reduce rates with a $20 million one-time bill credit in December 1993, and to refund approximately $3 million to Texas retail customers on bills rendered in December 1993. The cities rate inquiries had been settled earlier on the same terms. In November 1993, in association with the settlement of the above- described rate inquiries, GSU entered into a settlement covering issues related to a March 1991 non-unanimous settlement in another proceeding. Under this settlement, a $30 million rate increase approved by the PUCT in March 1991, became final and the PUCT's treatment of GSU's federal tax expense was settled, eliminating the possibility of refunds associated with amounts collected resulting from the disputed tax calculation. In December 1993, a large industrial customer of GSU announced its intention to oppose the settlement of the PUCT rate inquiry. The customer's opposition does not affect the cities' rate settlement. The customer's opposition requires the PUCT to conduct a hearing concerning GSU's rates charged in areas outside the corporate limits of the cities in its Texas service territory to determine whether the settlement's rates are just and reasonable. A hearing has been set for July 8, 1994. GSU believes that the PUCT will ultimately approve the settlement, but no assurance can be provided in this regard. Louisiana Jurisdiction - River Bend. Previous rate orders of the LPSC have been appealed, and pending resolution of various appellate proceedings, GSU has made no write-off for the disallowance of $30.6 million of deferred revenue requirement that GSU recorded for the period December 16, 1987 through February 18, 1988. In January 1992, the LPSC ordered a deregulated asset plan for $1.4 billion of River Bend plant costs not allowed in rates. The plan allows GSU to sell the generation from the approximately 22% of River Bend to Louisiana customers at 4.6 cents per KWH, or off-system at higher prices. Incremental revenues from off-system sales above 4.6 cents per KWH will be shared 60% by shareholders and 40% by ratepayers (see GSU's "Management's Financial Discussion and Analysis," incorporated herein by reference, for the effects of the plan on GSU's 1993 results of operations). LPSC - Return on Equity Review. In the June 1993 open session, a preliminary report was made comparing the authorized and actual earned rates of return for electric and gas utilities subject to the LPSC's jurisdiction. The preliminary report indicated that several electric utilities, including GSU, may be over-earning based on current estimated costs of equity. The LPSC requested those utilities to file responses indicating whether they agreed with the preliminary report, and to provide their reasons if they did not agree. GSU provided the LPSC with information that GSU believes supports the current rate level. The LPSC decided at its September 7, 1993 open session to defer review of GSU's base rates until the first earnings analysis after the Merger, scheduled for mid-1994. LPSC Fuel Cost Review. In November 1993, the LPSC ordered a review of GSU's fuel costs. The LPSC stated that fuel costs for the period October 1988 through September 1991 would be reviewed based on the number of outages at River Bend and the findings in the June 1993 PUCT fuel reconciliation case. Hearings are scheduled to begin in March 1994. Least Cost Planning. Currently, the PUCT does not have least cost planning rules in place, and GSU has not filed a Least Cost Plan with the PUCT. However, the PUCT staff has begun a rulemaking process for such rules, and GSU is actively participating in this process. GSU has not yet filed a Least Cost Plan with the LPSC. Fuel Recovery. In January 1993, the PUCT adopted a new rule for setting a fixed fuel factor that is intended to recover projected allowable fuel and purchased power costs not covered by base rates. To the extent actual costs vary from the fixed factor, the PUCT may require refunds of overcharges or permit recovery of undercharges. Under the new rule, fuel factors are to be revised every six months, and GSU is on a schedule providing for revision each March and September. The PUCT is required to act within 60 or 90 days, depending on whether or not a hearing is required, and refunds and surcharges will be required based upon a materiality threshold of 4% of Texas retail fuel revenues. Fuel charges will also be subject to reconciliation proceedings every three years, at which time additional adjustments may be required (see "Texas Jurisdiction - Fuel Reconciliation," above). All of GSU's rate schedules in Louisiana include a fuel adjustment clause to recover the cost of fuel and purchased power energy costs. The fuel adjustment reflects the delivered cost of fuel for the second preceding month. LP&L LPSC Jurisdiction. In a series of LPSC orders, court decisions, and agreements from late 1985 to mid-1988, LP&L was granted rate relief with respect to costs associated with Waterford 3 and LP&L's share of capacity and energy from Grand Gulf l, subject to certain terms and conditions. With respect to Waterford 3, LP&L was granted an increase aggregating $170.9 million over the period 1985-1988, and LP&L agreed to permanently absorb, and not recover from retail ratepayers, $284 million of its investment in the unit and to defer $266 million of its costs related to the years 1985-1988 to be recovered over approximately 8.6 years beginning in April 1988. As of December 31, 1993, LP&L's unrecovered deferral balance was $82.5 million. With respect to Grand Gulf l, LP&L agreed to absorb, and not recover from retail ratepayers, 18% of its 14% share (approximately 2.52%) of the costs of Grand Gulf l capacity and energy. LP&L is allowed to recover, through the fuel adjustment clause, 4.6 cents per KWH (currently 2.55 cents per KWH through May 1994) for the energy related to the permanently absorbed percentage, with LP&L's permanently absorbed retained percentage to be available for sale to non-affiliated parties, subject to LPSC approval. (See Note 2 of LP&L's Notes to Financial Statements, "Rate and Regulatory Matters - Waterford 3 and Grand Gulf 1," incorporated herein by reference, for further information on LP&L's Grand Gulf 1 and Waterford 3-related rates.) In a subsequent rate proceeding, on March 1, l989, the LPSC issued an order providing that, in effect, LP&L was entitled to an approximately $45.9 million annual retail rate increase, but that, in lieu of a rate increase, LP&L would be permitted to retain $188.6 million of the proceeds of a 1988 settlement of litigation with a gas supplier, and to amortize such proceeds into revenues over a period of approximately 5.3 years. The amortization of the proceeds will expire in mid-1994 and this source of revenue will no longer be available to LP&L. LP&L believes that the amortization has resulted in approximately the same amount of additional net income as an annual rate increase of $45.9 million would have provided over the same period. In connection with this order, LP&L agreed to a five-year base rate freeze scheduled to expire in March 1994 at then current levels subject to certain conditions. (See Note 2 of LP&L's Notes to Financial Statements, "Rate and Regulatory Matters - March 1989 Order," incorporated herein by reference, for further information on the terms of this order.) By letter dated July 27, 1993, the LPSC requested LP&L to explain its "relatively high cost of debt" compared to other electric utilities subject to LPSC jurisdiction. LP&L responded to the request on August 11, 1993. On August 14, 1993, the LPSC's consultants acknowledged LP&L's rationale for its cost of debt and suggested that certain aspects of LP&L's cost of debt could be taken up in rate proceedings after the expiration of LP&L's rate freeze. On October 7, 1993, the LPSC approved a schedule to conduct a review of LP&L's rates and rate structure upon the expiration of the rate freeze in March 1994. Council Jurisdiction. Under the Algiers rate settlement entered into with the Council in l989, LP&L was granted rate relief with respect to its Grand Gulf l and Waterford 3-related costs, subject to certain terms and conditions. LP&L was granted an annual rate increase of $9.5 million that was phased-in over the two-year period beginning in July 1989, and was permitted to retain $4.2 million (the Council's jurisdictional portion) of the proceeds of litigation with a gas supplier and to amortize such proceeds plus interest into revenues over the same two-year period. LP&L agreed to absorb and not recover from Algiers retail ratepayers $17 million of fixed costs associated with Grand Gulf l and Waterford 3 incurred prior to the date of the settlement, $5.9 million of its investment in Waterford 3, and 18% of the Algiers portion of LP&L's Grand Gulf l-related costs incurred after the settlement. However, LP&L is allowed to recover 4.6 cents per KWH or the avoided cost, whichever is higher, for the energy related to the permanently absorbed percentage through the fuel adjustment clause, with the permanently absorbed percentage to be available for sale to non-affiliated parties, subject to the Council's right of first refusal. LP&L also agreed to a rate freeze for Algiers customers until July 6, l994, except in the case of catastrophic events, changes in federal tax laws, or changes in LP&L's Grand Gulf l costs resulting from FERC proceedings. Least Cost Planning. On December l, l992, and July 1, l993, LP&L filed with the LPSC and the Council the Least Cost Plan described under "Business of Entergy - Competition - Least Cost Planning," above. LP&L also requested authorization to recover development and implementation costs and costs and incentives related to the DSM aspects of the plan. Discovery in the LPSC review of LP&L's Least Cost Plan filing is continuing, and the current procedural schedule (which maybe extended) contemplates that, after hearings and briefings, a report of the LPSC special counsel will be issued on June 14, 1994. The LPSC could render a decision on the basis of this report. On January 19, 1994, LP&L filed a motion with the LPSC to dismiss or withdraw without prejudice the CCLM and to proceed with a pilot CCLM at shareholder expense. The LPSC granted LP&L's motion on February 2, 1994, subject to LP&L, among other things, keeping the LPSC timely informed as to LP&L's CCLM activities. (See "NOPSI - Least Cost Planning," below, for further information on LP&L's and NOPSI's proceedings pending before the Council.) Fuel Adjustment Clause. LP&L's rate schedules include a fuel adjustment clause to reflect the delivered cost of fuel in the second preceding month and purchased power energy costs. The fuel adjustment also reflects a surcharge for deferred fuel expense arising from the monthly reconciliation of actual fuel cost incurred with fuel cost revenues billed to customers. LP&L defers on its books fuel costs that will be reflected in customer billings in the future under the fuel adjustment clause. MP&L Rate Freeze. In a stipulation entered into by MP&L in connection with the settlement of various issues related to the Merger, MP&L agreed that (1) for a period of five years beginning on November 9, 1993, retail base rates under the FRP (see "Incentive Rate Plan," below) would not be increased above the level of rates in effect on November 1, 1993, and (2) MP&L would not request any general retail rate increase that would increase retail rates above the level of MP&L's rates in effect as of November l, 1993, and that would become effective in such five-year period except, among other things, for increases associated with the Least Cost Plan (discussed below), recovery of deferred Grand Gulf 1-related costs, recovery under the fuel adjustment clause, adjustments for certain taxes, and force majeure (defined to include, among other things, war, natural catastrophes, and high inflation). Recovery of Grand Gulf 1 Costs. The MPSC's Final Order on Rehearing, issued in 1985, affirmed by the United States Supreme Court in 1988, and subsequently revised in 1988, granted MP&L an annual base rate increase of approximately $326.5 million in connection with its allocated share of Grand Gulf 1 costs. The Final Order on Rehearing also provided for the deferral of a portion of such costs that were incurred each year through 1992, and recovery of these deferrals over a period of six years ending in 1998. As of December 31, 1993, the uncollected balance of MP&L's deferred costs was approximately $601.4 million. MP&L is permitted to recover the carrying charges on all deferred amounts on a current basis. Incentive Rate Plan. In July 1993, the MPSC ordered MP&L to file a formulary incentive rate plan designed to allow for periodic small adjustments in rates based upon a comparison of earned to benchmark returns and upon performance factors incorporated in the plan. Pursuant to this order, on November 1, 1993, MP&L filed a proposed formula rate plan. MPSC was also expected to conduct a general review of MP&L's current rates in the course of approving an incentive rate plan. On January 28, 1994, MP&L and the Mississippi Public Utilities Staff (MPUS) entered into a Joint Stipulation in this proceeding. Under the Joint Stipulation, MP&L and the MPUS agreed on a number of accounting adjustments for the test year ending June 30, 1993, (June 30 Test Year) that resulted in a reduction to MP&L's base rate revenues in the June 30 Test Year of approximately 4.3%, or $28.1 million. This translates into approximately a 3.7% decrease in overall revenues from sales to retail customers, which include revenues related to fuel, taxes, and Grand Gulf. MP&L and the MPUS agreed on a required return on equity of 11% for the June 30 Test Year. MP&L and the MPUS also stipulated to a revised Formula Rate Plan (FRP). The stipulated FRP is essentially the same as the proposed plan filed by MP&L on November 1, 1993. Certain of the accounting changes agreed to by the MPUS and MP&L for the June 30 Test Year are incorporated into the stipulated FRP. Also, the formula in the stipulated FRP for determining required return on equity would have produced a required return on equity for MP&L of 11.07% for the June 30 Test Year. The stipulated return on equity formula will be applied for the first time in the first Evaluation Report under the stipulated FRP. The first Evaluation Report will be filed in March 1995 for the Evaluation Period ending December 31, 1994. On February 10, 1994, MP&L, the Mississippi Industrial Energy Group (MIEG), and the MPUS entered into and filed with the MPUS, a Joint Stipulation (MIEG Joint Stipulation) resolving the issues raised by the MIEG in the docket. On February 16, 1994, MP&L and the Mississippi Attorney General entered into a Joint Stipulation that resolved the issues raised by the Mississippi Attorney General in the docket. Other parties in the case, including two gas utility intervenors, were not parties to the Joint Stipulations. In late February 1994, the MPSC conducted a general review of MP&L's current rates and on March 1, 1994, issued a final order in which the MPSC approved each of the Joint Stipulations. The MPSC ordered MP&L to file rates designed to provide a reduction of $28.1 million in operating revenues for the June 30 Test Year on or before March 18, 1994, to become effective for service rendered on and after March 25, 1994. The FRP also was approved and will be effective on March 25, 1994, with any initial adjustment to base rates, if any, in May 1995. Under the FRP, a formula will be established under which MP&L's earned rate of return will be calculated automatically every 12 months and compared to a benchmark rate of return calculated under a separate formula within the FRP. If MP&L's earned rate of return falls within a bandwidth around the benchmark rate of return, there will be no adjustment in rates. If MP&L's earnings are above the bandwidth, the FRP will automatically reduce MP&L's base rates. Alternatively, if MP&L's earnings are below the bandwidth, the FRP will automatically increase MP&L's base rates (see "Rate Freeze" above for information on a cap on base rates at November 1993 levels for a period of five years). The reduction or increase in base rates will be an amount representing 50% of the difference between the earned rate of return and the nearest limit of the bandwidth. In no event will the annual adjustment in rates exceed the lesser of 2% of MP&L's aggregate annual retail revenues, or $14.5 million. Under the FRP the benchmark rate of return, and consequently the bandwidth, will be adjusted slightly upward or downward based upon MP&L's performance on three performance factors: customer reliability, customer satisfaction, and customer price. In its Final Order, the MPSC also recognized that on February 9 and 10, 1994, a severe ice storm struck northern Mississippi causing extensive and widespread damage to MP&L's transmission and distribution facilities in approximately 15 counties. Although the MPSC made no findings in the final order as to MP&L's costs associated with the ice storm and restoration of service, the MPSC acknowledged that there is precedent in Mississippi for recovery of certain costs associated with storms and natural disasters and restoration of service. The MPSC stated the recovery of MP&L's ice storm costs should be addressed in a separate docket. MP&L plans to immediately file for rate recovery of the costs related to the ice storm. Least Cost Planning. On December 1, 1992 and July 1, 1993, MP&L filed with the MPSC the Least Cost Plan described in "Business of Entergy - Competition - Least Cost Planning," above. MP&L also requested a finding by the MPSC that the plan's cost recovery methodology is reasonable and appropriate. MP&L will request approval of cost recovery mechanisms after the plan has been approved by the MPSC. On October 6, 1993, the MPSC, on its own motion, stayed all proceedings in this docket. The MPSC stay order regarding MP&L's Least Cost Plan filing remains in effect even though MP&L and the MPUS have stipulated to an FRP (see "Incentive Rate Plan," above). Because the stay order remains in effect, MP&L has not yet filed a request that the CCLM portion of the filing be withdrawn and that a pilot CCLM program be implemented. Fuel Adjustment Clause. MP&L's rate schedules include a fuel adjustment clause that permits recovery from customers of changes in the cost of fuel and purchased power. The monthly fuel adjustment rate is based on projected sales and costs for the month, adjusted for differences between actual and estimated costs for the second prior month. NOPSI Electric Retail Rate Reduction. On November 18, 1993, in connection with the settlement of various issues related to the Merger, the Council adopted a resolution requiring NOPSI to reduce its annual electric base rates by $4.8 million on bills rendered on or after November 1, 1993. Recovery of Grand Gulf 1 Costs. Under NOPSI's various Rate Settlements with the Council (which include the 1986 NOPSI Settlement, the February 4 Resolution relating to prudence issues, and the 1991 NOPSI Settlement of the issues raised in the February 4 Resolution), NOPSI agreed to absorb and not recover from ratepayers a total of $186.2 million of its Grand Gulf 1 costs. NOPSI was permitted to implement annual rate increases in decreasing amounts each year through 1995, and to defer certain costs, and related carrying charges, for recovery on a schedule extending from 1991 through 2001. As of December 31, 1993, the uncollected balance of NOPSI's deferred costs was $228.8 million. NOPSI also agreed to a base rate freeze through October 31, 1996, excluding the scheduled increases, certain changes in tax rates, and increases related to catastrophic events. (See Note 2 of NOPSI's Notes to Financial Statements, "Rate and Regulatory Matters - Prudence Settlement and Finalized Phase-In Plan," incorporated herein by reference, for further information.) Gas Rates. In May 1992, NOPSI and the Council settled a pending application for gas rate increases. The settlement provided for annual rate increases of approximately $3.8 million in May 1992 and 1993, and the deferral of an additional $3 million for recovery in the years beginning in May 1993 through May 1996. NOPSI also agreed to a base rate freeze, except for the scheduled increases and certain other exceptions, through October 31, 1996. Least Cost Planning. On December 1, 1992, and July 1, 1993, NOPSI filed with the Council the Least Cost Plan described under "Business of Entergy - Competition - Least Cost Planning," above. NOPSI also requested authorization to recover development and implementation costs and costs and incentives related to DSM aspects of the plan. After hearings and briefings, the Council issued, on November 22, 1993, a resolution that requires NOPSI and LP&L to provide, within certain time frames, additional information, among other things, on how the seven full scale DSM programs approved by the Council in the resolution will be implemented. Such programs are estimated to cost approximately $13 million over the next three years. The Council provided in the resolution certain assurances regarding recovery of costs associated with these programs. Discovery is proceeding and testimony is being filed, with the second round of hearings to begin in February 1994. After the hearings are concluded and briefs have been filed, the Council will address the second round issues in early April 1994. On February 3, 1994, the Council issued a resolution and order granting the motions of NOPSI and LP&L to dismiss without prejudice the CCLM portion of the filing, authorizing NOPSI and LP&L to proceed with a pilot CCLM (other than the construction of a fiber optics/coaxial cable network) in New Orleans at shareholder expense (subject to certain conditions). The Council also opened a new docket to expeditiously address issues related to the CCLM pilot, and directing NOPSI and LP&L to obtain Council authorization in the new docket before constructing such a fiber optics/coaxial cable network. In connection with the settlement of various issues related to the Merger, the Council adopted a resolution on November 18, 1993, that provides that the Council will not disallow the first $3.5 million of costs incurred by NOPSI through October 31, 1993, in connection with the Least Cost Plan. Fuel Adjustment Clause. NOPSI's electric rate schedules include a fuel adjustment clause to reflect the delivered cost of fuel in the second preceding month, adjusted by a surcharge for deferred fuel expense arising from the monthly reconciliation of actual fuel cost incurred with fuel cost revenues billed to customers. The adjustment clause, on a monthly basis, also reflects the difference between nonfuel Grand Gulf 1 costs paid by NOPSI and the estimate of such costs provided in NOPSI's Grand Gulf 1 Rate Settlements. NOPSI's gas rate schedules include a gas cost adjustment to reflect gas costs in excess of those collected in rates, adjusted by a surcharge similar to that included in the electric adjustment clause. NOPSI defers on its books fuel and purchased gas costs to be reflected in billings to customers in the future under the fuel adjustment clause. REGULATION Federal Regulation Holding Company Act. Entergy Corporation is a registered public utility holding company under the Holding Company Act. As such, Entergy Corporation and its various direct and indirect subsidiaries (with the exception of its independent power/EWG subsidiaries) are subject to the broad regulatory provisions of that Act. Except with respect to investments in certain EWG projects and foreign utility company projects (see "Business of Entergy - Competition - General," above for a discussion of the Energy Act), Section 11(b)(1) of the Holding Company Act limits the operations of a registered holding company system to a single, integrated public utility system, plus additional systems and businesses as provided by that section. Federal Power Act. The System operating companies, System Energy, and Entergy Power are subject to the Federal Power Act as administered by FERC and the DOE. The Federal Power Act provides for regulatory jurisdiction over the licensing of certain hydroelectric projects, the business of, and facilities for, the transmission and sale at wholesale of electric energy in interstate commerce and certain other activities of the System operating companies, System Energy, and Entergy Power as interstate electric utilities, including accounting policies and practices. Such regulation includes jurisdiction over the rates charged by System Energy for capacity and energy provided to AP&L, LP&L, MP&L, and NOPSI, or others, from Grand Gulf 1. AP&L holds a license for two hydroelectric projects (70 MW) that was renewed on July 2, 1980. This license, granted by FERC, will expire in February 2003. Regulation of the Nuclear Power Industry General. Under the Atomic Energy Act of 1954 and Energy Reorganization Act of 1974, operation of nuclear plants is intensively regulated by the NRC, which has broad power to impose licensing and safety-related requirements. In the event of non-compliance, the NRC has the authority to impose fines or shut down a unit, or both, depending upon its assessment of the severity of the situation, until compliance is achieved. AP&L, GSU, LP&L, and System Energy, as owners of all or a portion of ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively, and Entergy Operations, as the operator of these units, are subject to the jurisdiction of the NRC. Revised safety requirements promulgated by the NRC have, in the past, necessitated substantial capital expenditures at System nuclear plants and additional such expenditures could be required in the future. The nuclear power industry faces uncertainties with respect to the cost and availability of long-term arrangements for disposal of spent nuclear fuel and other radioactive waste, nuclear plant operational issues, the technological and financial aspects of decommissioning plants at the end of their licensed lives, and the effect of certain requirements relating to nuclear insurance. These matters are briefly discussed below. Spent Fuel and Other High-Level Radioactive Waste. Under the Nuclear Waste Policy Act of 1982, the DOE is required, for a specified fee, to construct storage facilities for, and to dispose of, all spent nuclear fuel and other high-level radioactive waste generated by domestic nuclear power reactors. The NRC, pursuant to this Act, also requires operators of nuclear power reactors to enter into spent fuel disposal contracts with the DOE, and the affected System companies have entered into such disposal contracts. However, the DOE has not yet identified a permanent storage repository and, as a result, future expenditures may be required to increase spent fuel storage capacity at the plant sites. (For further information concerning spent fuel disposal contracts with the DOE, schedules for initial shipments of spent nuclear fuel, current on-site storage capacity, and costs of providing additional on-site storage capacity, with respect to AP&L, GSU, LP&L, and System Energy, respectively, see Note 8 of AP&L's, GSU's, and LP&L's, and Note 7 of System Energy's, Notes to Financial Statements, "Commitments and Contingencies - Spent Nuclear Fuel and Decommissioning Costs," incorporated herein by reference.) Low-Level Radioactive Waste. The availability and cost of disposal facilities for low-level radioactive waste resulting from normal operation of nuclear units are subject to a number of uncertainties. Under the Low-Level Radioactive Waste Policy Act of 1980, as amended, each state is responsible for disposal of its own waste, and states may join in regional compacts to jointly fulfill their responsibilities. The States of Arkansas and Louisiana participate in the Central States Compact, and the State of Mississippi participates in the Southeast Compact. Two disposal sites are currently operating in the United States, and one of them, which is located in Washington, is closed to out-of-region generators. The second site, the Barnwell Disposal Facility (Barnwell) located in South Carolina, is operated by the Southeast Compact and the State of Mississippi is expected to have access to this site through December 1995. Barnwell had been open to out-of-region generators (including generators in Arkansas and Louisiana) in the past; however, on April 14, 1993, the Southeast Compact voted to deny access to Barnwell to members of the Central States Compact. Such access was reinstated for the period from October 1993 through June 1994, at which time legislative action by the State of South Carolina would be required to permit further access to out-of-region generators. Beginning in July 1994, low-level radioactive waste generators in the Central States Compact, including AP&L, GSU, and LP&L, will be required to store such waste on-site until a Central States Compact facility becomes operational or another site becomes accessible. Both the Central States Compact and the Southeast Compact are working to establish additional disposal sites. The System, along with other waste generators, funds the development costs for new disposal facilities. The System's expenditures to date are approximately $30 million; and future levels of expenditures cannot be predicted. Until such facilities are established, the System will continue to seek access to existing facilities, which may be available at costs that are higher than those incurred in the past, or which may be unavailable. If such access is unavailable, the System will store low-level waste on-site at the affected units. ANO has on-site storage that is estimated to be sufficient until 1999. Construction of on-site storage at the other nuclear units is being considered, along with other alternatives. A coordinated design concept that can be utilized at both Waterford 3 and River Bend is being evaluated. Grand Gulf 1 will have continued disposal access through December 1995; therefore, no immediate plans for on-site storage are needed for Grand Gulf 1. The estimated construction costs for storage sufficient for approximately five years at Grand Gulf 1, Waterford 3, and River Bend are in the range of $2.0 million to $5.0 million for each site. As an alternative to on-site storage, Entergy is working with other industry groups to influence the continued operation of the Barnwell disposal facility for out-of-region generators. Decommissioning. AP&L, GSU, LP&L, and System Energy are recovering portions of their estimated decommissioning costs for ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively. These amounts are being deposited in external trust funds that, together with the earnings thereon, can only be used for future decommissioning costs. Estimated decommissioning costs are regularly reviewed and updated to reflect inflation and changes in regulatory requirements and technology, and applications will be made to appropriate regulatory authorities to recover in rates any projected increase in decommissioning costs above that currently being recovered. (For additional information with respect to decommissioning costs for ANO, River Bend, Waterford 3, and Grand Gulf 1, respectively, see Note 8 of AP&L's, GSU's, and LP&L's and Note 7 of System Energy's Notes to Financial Statements, "Commitments and Contingencies - Spent Nuclear Fuel and Decommissioning Costs," incorporated herein by reference.) Uranium Enrichment Decontamination and Decommissioning Fees. The Energy Act requires all electric utilities (including AP&L, GSU, LP&L, and System Energy) that have purchased uranium enrichment services from the DOE to contribute up to a total of $150 million annually, adjusted for inflation, up to a total of $2.25 billion over approximately 15 years, for decommissioning and decontamination of enrichment facilities. AP&L's, GSU's, LP&L's, and System Energy's estimated annual contributions to this fund are $3.3 million, $0.6 million, $1.2 million, and $1.3 million, respectively, in 1993 dollars over approximately 15 years. Contributions to this fund are to be recovered through rates in the same manner as other fuel costs. Nuclear Insurance. The Price-Anderson Act provides for a limit of public liability for a single nuclear incident. As of December 31, 1993, the limit of public liability for such type of incident was approximately $9.4 billion. AP&L, GSU, LP&L, and System Energy have protection with respect to this liability through a combination of private insurance and an industry assessment program, and also have insurance for property damage, costs of replacement power, and other risks relating to nuclear generating units. (For a discussion of insurance applicable to nuclear programs of AP&L, GSU, LP&L, and System Energy, see Note 7 of System Energy's and Note 8 of AP&L's, GSU's, and LP&L's Notes to Financial Statements, and Note 8 of Entergy Corporation and Subsidiaries, Notes to Consolidated Financial Statements, "Commitments and Contingencies - Nuclear Insurance," incorporated herein by reference.) Nuclear Operations General. Entergy Operations operates ANO, River Bend, Waterford 3, and Grand Gulf 1, subject to the owner oversight of AP&L, GSU, LP&L, and System Energy, respectively. AP&L, GSU, LP&L, and System Energy, and the other Grand Gulf 1, Waterford 3, and River Bend co- owners, have retained their ownership interests in their respective nuclear generating units. AP&L, GSU, LP&L, and System Energy have also retained their associated capacity and energy entitlements, and pay directly or reimburse Entergy Operations at cost for its operation of the units. On June 24, 1992, the NRC issued a bulletin requiring all utilities using a certain fire barrier material in a nuclear power plant to take certain actions related to the material. This material may have been used in as many as 87 nuclear plants in the United States, including ANO, River Bend, Waterford 3, and Grand Gulf 1 (see "River Bend," below for additional information). ANO. In 1990, in response to a special diagnostic evaluation report by the NRC, AP&L implemented a comprehensive action plan for ANO designed to correct certain management, organizational, and technical problems, and to improve the long-term operational effectiveness and safety of the units. This action plan was largely completed in 1993. Leaks in certain steam generator tubes at ANO 2 were discovered and repaired during an outage in March 1992; and during a refueling outage in September 1992, a comprehensive inspection of all steam generator tubing was conducted and necessary repairs were made. During a mid-cycle outage in May 1993, a scheduled special inspection of certain steam generator tubing was conducted by Entergy Operations and additional repairs were made. Entergy Operations proposes to operate ANO 2 with no further steam generator inspections until the next refueling outage, which is scheduled for the spring of 1994, and the NRC has concurred with this proposal. The operations and power output of the unit have not been adversely affected to date by these repairs. River Bend. The Nuclear Information and Resource Service petitioned the NRC to shut down the River Bend plant in July 1992 because of alleged defects in a fire barrier material. GSU has used this material in its River Bend plant and is in compliance with the requirements of the bulletin. On August 19, 1992, the NRC denied the petitioner's request. In a December 1993 letter, the NRC requested additional technical information on the use of the material in the plant, and requested GSU's plans and schedules for resolving technical issues associated with the use of the material in certain configurations. GSU has provided the information requested in the NRC letter. On January 13, 1993, in connection with the Merger, GSU filed two applications with the NRC to amend the River Bend operating license. The applications sought the NRC's consent to the Merger and to a change in the licensed operator of the facility from GSU to Entergy Operations. On August 6, 1993, Cajun filed a petition to intervene and request for a hearing in the proceedings. On January 27, 1994, the presiding NRC Atomic Safety and Licensing Board (ASLB) issued an order granting Cajun's petition to intervene and ordered a hearing on one of Cajun's contentions. On February 15, 1994, GSU filed an appeal of the ASLB Order with the NRC. On December 16, 1993, prior to this ASLB ruling, the NRC Staff issued the two license amendments for River Bend, making them effective immediately upon consummation of the Merger. On February 16, 1994, Cajun filed with the D.C. Circuit petitions for review of the two license amendments issued by the NRC. These two amendments are in full force and effect, but are subject to the outcome of the two proceedings. A hearing on the proceeding before the ALSB is not expected to begin prior to the fall of 1994. In February 1993, GSU and the other affected utilities were served with a federal grand jury subpoena to produce documents and other information relating to the fire barrier material used in the plant. Nothing in the subpoena indicates that GSU or any employee is a target of the grand jury investigation. GSU is cooperating fully with the government in its investigation. The requested documentation and other information were produced in March 1993, and no additional requests have been received. On October 25, 1993, the NRC staff began an operational safety team inspection at River Bend that was concluded by mid-November 1993. The NRC held the inspection to verify that the plant is being operated safely and in conformance with regulatory requirements. The team's findings were discussed at a public meeting in November 1993, and a written inspection report was issued in January 1994. The inspection team found apparent violations in two categories: (1) procedure adequacy, and (2) concerns with the corrective action program. Due to the nature of these apparent violations, an enforcement conference was not warranted and no fine was proposed. State Regulation General. Each of the System operating companies is subject to regulation by its respective state and/or local regulatory authorities with jurisdiction over the service areas in which each company operates. Such regulation includes authority to set rates for electric and gas service provided at retail. (See "Rate Matters and Regulation - Rate Matters - Retail Rate Matters," above) AP&L is subject to regulation by the APSC and the Tennessee Public Service Commission (TPSC). APSC regulation includes the authority to set rates, determine reasonable and adequate service, fix the value of property used and useful, require proper accounting, control leasing, control the acquisition or sale of any public utility plant or property constituting an operating unit or system, set rates of depreciation, issue certificates of convenience and necessity and certificates of environmental compatibility and public need, and control the issuance and sale of securities. Regulation by the TPSC includes the authority to set standards of service and rates for service to customers in the state, require proper accounting, control the issuance and sale of securities, and issue certificates of convenience and necessity. GSU is subject to the jurisdiction of the municipal authorities of incorporated cities in Texas as to retail rates and services within their boundaries, with appellate jurisdiction over such matters residing in the PUCT. GSU is also subject to regulation by the PUCT as to retail rates and services in rural areas, certification of new generating plants, and extensions of service into new areas. GSU is subject to regulation by the LPSC as to electric and gas service, rates and charges, certification of generating facilities and power or capacity purchase contracts, and other matters. LP&L is subject to the jurisdiction of the LPSC as to rates and charges, standards of service, depreciation, accounting, and other matters, and is subject to the jurisdiction of the Council with respect to such matters within Algiers. MP&L is subject to regulation as to service, service areas, facilities, and retail rates by the MPSC. MP&L is also subject to regulation by the APSC as to the certificate of environmental compatibility and public need for the Independence Station. NOPSI is subject to regulation as to electric and gas service, rates and charges, standards of service, depreciation, accounting, issuance of certain securities, and other matters by the Council. Franchises. AP&L holds franchises to provide electric service in 301 incorporated cities and towns in Arkansas, all of which are unlimited in duration and terminable by either party. GSU holds non-exclusive franchises, permits, or certificates of convenience and necessity to provide electric and gas service in 55 incorporated villages, cities, and towns in Louisiana and 64 incorporated cities and towns in Texas. GSU ordinarily holds 50-year franchises in Texas towns and 60-year franchises in Louisiana towns. The present terms of GSU's electric franchises will expire in the years 2007-2036 in Texas and in the years 2015-2046 in Louisiana. The natural gas franchise in the City of Baton Rouge will expire in the year 2015. LP&L holds franchises to provide electric service in 116 incorporated villages, cities, and towns. Most of these franchises have 25-year terms expiring during the period 1995-2015. However, six of these municipalities have granted 60-year franchises, with the last one expiring in the year 2040. Of these franchises, none has expired to date, one is scheduled to expire as early as 1995, and 37 are scheduled to expire by year-end 2000. LP&L also supplies electric service in 353 unincorporated communities, all of which are located in parishes (counties) from which LP&L holds franchises to serve the areas in which the unincorporated communities are located. MP&L has received from the MPSC certificates of public convenience and necessity to provide electric service to the areas of Mississippi that MP&L serves, which include a number of municipalities. MP&L continues to serve in such municipalities upon payment of a statutory franchise fee, regardless of whether an original municipal franchise is still in existence. NOPSI provides electric and gas service in the City of New Orleans pursuant to city ordinances, which state, among other things, that the City has a continuing option to purchase NOPSI's electric and gas utility properties. System Energy has no franchises from any municipality or state. Its business is currently limited to wholesale sales of power. Environmental Regulation General. In the areas of air quality, water quality, control of toxic substances and hazardous and solid wastes, and other environmental matters, the System operating companies, System Energy, Entergy Power, and Entergy Operations are subject to regulation by various federal, state, and local authorities. Each of the Entergy companies considers itself to be in substantial compliance with those environmental regulations currently applicable to its business and operations. Entergy has incurred increased costs of construction and other increased costs in meeting environmental protection standards. Because environmental regulations are continually changing, the ultimate compliance costs to Entergy cannot be precisely estimated at any one time. However, Entergy currently estimates that its potential capital expenditures for environmental control purposes, including those discussed in "Clean Air Legislation," below, will not be material for the System as a whole. Clean Air Legislation. The Clean Air Act Amendments of 1990 (the Act) place limits on emissions of sulfur dioxide and nitrogen oxide from fossil-fueled generating plants. Entergy has evaluated the Act to determine the impact on the System's overall cost of emission control and monitoring equipment. Based upon such evaluation in connection with existing generating facilities, the System has determined that no additional control equipment will be required to control sulfur dioxide. In the area served by GSU, control equipment will be required for nitrogen oxide reductions due to the ozone nonattainment status of the Baton Rouge, Louisiana and Beaumont and Houston, Texas air quality control regions no later than May 1995. The cost of such control equipment is estimated at $16.0 million. The remainder of the System may be required to install nitrogen oxide emission controls on its coal units by the year 2000. The EPA is currently drafting rules that will determine the levels of nitrogen oxide emissions that will be allowed by affected units. Under the latest EPA-proposed regulations on nitrogen oxide, Entergy would not have to install additional controls. It is not possible to determine at this time if the final regulations promulgated by EPA would require the System's coal units to install nitrogen oxide emission controls. Should additional controls be required, the overall cost would vary depending on the eventual emission levels that are set. In addition, the System will be required to install additional continuous emission monitoring equipment at its coal units to comply with final EPA regulations. It is estimated that the continuous emission monitoring systems could cost as much as $1.0 million for all of the coal units. Final EPA regulations established the acceptable continuous monitoring methods, as well as alternative monitoring methods, that make it possible to determine the compliance of the units with respect to emission levels through fuel sampling and other estimation methods. Capital expenditures of approximately $11.0 million are estimated for continuous emission monitoring systems at the other fossil-fueled units. The authority to impose permit fees has been delegated to the states by EPA and, depending on the extent of the state program and the fees imposed by each state regulatory authority, permit fees for the System could range from $1.6 to $5.0 million annually. There are several other areas, such as air toxins and visibility, that will require regulatory study and rule promulgation to determine whether pollution control equipment is necessary. Regarding sulfur dioxide emissions, the Act provides "allowances" to most Entergy units based upon past emission levels and operating characteristics. Each unit of allowance is an entitlement to emit one ton of sulfur dioxide per year. Under the Act, utilities will be required to possess allowances for sulfur dioxide emissions from affected units. Based on Entergy's past operating history, it is considered a "clean" utility and as such will receive more allowances than are currently necessary for normal operations. The System believes that it will be able to operate its units efficiently without installing scrubbers or purchasing allowances from outside sources, and the System may have excess allowances available for sale to other utilities. Entergy currently estimates that total capital costs of approximately $39.4 million could be required to comply with the Act. These estimated costs for each legal entity are as follows: Nitrogen Continuous Company Oxide Emissions Control Monitors Total ---------------------- -------- ---------- ----- (In Thousands) AP&L $ 7,275 $ 3,300 $10,575 GSU 16,000 4,900 20,900 LP&L - 2,300 2,300 MP&L 2,500 1,500 4,000 NOPSI - - - System Energy - - - Entergy Power 1,575 - 1,575 ------- ------- ------- Total Entergy System $27,350 $12,000 $39,350 ======= ======= ======= Other Environmental Matters. The provisions of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (Superfund), among other things, authorize the EPA and, indirectly, the states to require the generators and certain transporters of certain hazardous substances released from or at a site, and the owners or operators of such site, to clean up the site or reimburse the costs therefor. This statute has been interpreted to impose joint and several liability on responsible parties. In compliance with applicable laws and regulations at the time, the System operating companies have sent waste materials to various disposal sites over the years. Also, past operating procedures and maintenance practices, which were not subject to regulation at that time, are now regulated by various environmental laws. Some of these sites have been the subject of governmental action, thereby causing one or more of the System operating companies to be involved with site cleanup activities. The System operating companies have participated to various degrees in accordance with their potential liability with these site cleanups and have, therefore, developed experience with cleanup costs. Their experience in these matters, and their judgments related thereto, are utilized by them in evaluating these sites. In addition, the System operating companies have established reserves for environmental clean-up/restoration activities. AP&L. AP&L has received notices from time to time between 1989 and 1993, from the EPA, the Arkansas Department of Pollution Control and Ecology (ADPC&E), and others that it (among numerous others, including various utilities, municipalities and other governmental units, and major corporations) may be a PRP for cleanup costs associated with various sites in Arkansas. Most of these sites are neither owned nor operated by any System company. Contaminants at the sites include principally polychlorinated biphenyls (PCB's), lead, and other hazardous wastes. These sites and others are described below. AP&L received notices from the EPA and ADPC&E in 1990 and 1991, identifying it as one of 30 PRP's (along with LP&L and GSU) at two Saline County sites in Arkansas. Both sites are believed to be contaminated with PCB's and lead. Cleanup costs for both sites are estimated at $6.0 million, with AP&L's total share of the costs being estimated at approximately $2.0 million. AP&L to date has expended approximately $1.0 million for remediation at one of these sites. The total liability cannot be precisely determined until remediation is complete at both sites. AP&L believes its potential liability for these sites will not be material. Reynolds Metals Company (RMC) and AP&L notified the EPA in 1989, of possible PCB contamination at two former RMC plant sites in Arkansas to which AP&L had supplied power. AP&L completed remediation at the substations serving the plant sites at a cost of $1.7 million. Additional PCB contamination was found in a portion of a drainage ditch that flows from the RMC's Patterson facility to the Ouachita River. RMC has demanded that AP&L participate in the remediation efforts with respect to the ditch. AP&L and independent contractors engaged by AP&L conducted an investigation of the ditch contamination and the potential migration of PCB's from the electrical equipment that AP&L maintained at the plant. The investigation concluded that little, if any, of the contamination was caused by AP&L. AP&L's expenditures thus far on the ditch have been approximately $150,000. It is AP&L's understanding that RMC has spent approximately $10.0 million to complete remediation of the ditch contamination. AP&L has not received a notice from the EPA that it may be a PRP with respect to remediation costs for this site. However, RMC is seeking reimbursement of $5.0 million (50% of expenditures) from AP&L. AP&L continues to deny responsibility for any of such remediation costs and believes that its potential liability, if any, for this site will not be material. AP&L entered into a Consent Administrative Order dated February 21, 1991, with the ADPC&E that named AP&L as a PRP for cleanup of contamination associated with the Utilities Services, Inc. state Superfund site located near Rison, Arkansas. Such site was found to have soil contaminated by PCB's and pentachlorophenol (a wood preservative chemical). Also, containers and drums that contained PCB's and other hazardous substances were found at the site. AP&L's share of total remediation costs are estimated to range between $3.0 million and $5.0 million. AP&L is attempting to identify and notify other PRP's. AP&L has received assurances from the ADPC&E that it will use its enforcement authority to allocate remediation expenses among AP&L and any other PRP's that can be identified (approximately 30 - 35 have been identified to date). AP&L has performed the activities necessary to stabilize the site, which to date has cost approximately $114,000. AP&L believes that its potential liability for this site will not be material. AP&L received Notice of Potential Liability and a Demand for Payment in November 1992 from the EPA in conjunction with a contaminated site in Union County, Arkansas. AP&L was identified as one of eleven PRP's, which also include LP&L. The EPA has already completed cleanup of the site. An agreement has been negotiated with the EPA which determined AP&L to be a de minimis party with total liability of approximately $47,000. As a result of an internal investigation, AP&L has discovered soil contamination at two AP&L-owned sites located in Blytheville, Arkansas and Pine Bluff, Arkansas. The contamination appears to be a result of past operating procedures that were performed prior to any applicable environmental regulation. AP&L is still investigating these sites to determine the full extent of the contamination. Until the investigations are complete, AP&L cannot estimate the liabilities associated with these sites. However, AP&L believes its potential liability for both of the sites should not be material. For all of these sites and for certain sites in which remediation has been completed, AP&L has expended approximately $3.2 million for cleanup costs since 1989. GSU. GSU has been notified by the EPA that it has been designated as a PRP for the cleanup of sites on which GSU and others have, or have been alleged to have, disposed of hazardous materials. GSU is currently negotiating with the EPA and various state authorities regarding the cleanup of some of these sites. Several class action and other suits have been filed seeking relief from GSU and others for damages caused by the disposal of hazardous waste and for asbestos-related disease that allegedly occurred from exposure on GSU premises or on premises on which GSU allegedly disposed of materials (see "Other Regulation and Litigation - GSU," below). While the amounts at issue in the cleanup efforts and suits may be very substantial sums, management believes that its financial condition and results of operations will not be materially affected by the outcome of the suits. These environmental liabilities are described below. In 1971, GSU purchased certain property near its Sabine generating station for possible cooling water capability expansion. Although it was not known to GSU at the time of the purchase, the property was utilized by area industries in the 1950's and 1960's as an industrial waste dump. GSU sold the property in 1984. In October 1984 the abandoned waste site on the property was included on the Superfund National Priorities List (NPL) by the EPA. The EPA has indicated that it believes GSU to be a PRP for cleanup of the site based on its past ownership. GSU has advised the EPA that it does not believe that it has such responsibility. GSU has pursued negotiations with the EPA and is a member of a task force made up of other PRP's for the voluntary cleanup of the waste site. A Consent Decree has been signed by all parties. Because additional wastes have been discovered at the site since the original cleanup costs were estimated, the total costs for the voluntary cleanup are unknown. However, it is estimated that cleanup will exceed $15.0 million. GSU has negotiated a responsible share of 2.26% of the estimated cleanup cost. Federal and state agencies are presently examining potential liabilities associated with natural resource damages. This matter is currently under negotiation with the other PRP's and the agencies. Remediation of the site is expected to be completed in 1996. In March 1993, GSU completed its cleanup activities at a site in Houston, Texas, which is included in the NPL. On September 20, 1993, GSU received formal notification from the EPA of its acceptance of the remedial activities conducted at the site. Currently, other parties are conducting cleanup activities at the site. However, these cleanup activities are unrelated to GSU's involvement at the site. Through 1993, GSU incurred cleanup costs of approximately $3.3 million. Pursuant to the Consent Decree, GSU is responsible for oversight costs incurred by the EPA. GSU has not received a reimbursement request for outstanding oversight costs, but anticipates these costs may total between $250,000 and $500,000. GSU is pursuing contribution for the cleanup costs at the site from other parties believed to be potentially responsible. GSU is currently involved in a multi-phased remedial investigation of an abandoned manufactured gas plant (MGP) site located in Lake Charles, Louisiana. The property was the site of an MGP that is believed to have operated during the period from approximately 1916 to 1931. Coal tar, a by-product of the distillation process, was apparently routed to a portion of the property for disposal. Since GSU purchased the property in 1926, the same area has been filled with soil and used as a landfill for miscellaneous items including electrical poles, electrical equipment, and other debris. Under an Order by the Louisiana Department of Environmental Quality (LDEQ), which is currently stayed, GSU was required to investigate and, if necessary, take remedial action at the site. The EPA has notified GSU that it is performing an independent review and ranking of the site to determine whether the site should be listed on the NPL. Another PRP has been identified and is believed to have had a role in the ownership and operation of the MGP. Negotiations with that company for joint participation and any remedial action are expected to continue. GSU currently is awaiting notification from the EPA before initiating additional cleanup negotiations or actions. While studies to determine the location of the coal tar have been conducted, the cleanup costs of the site are unknown. GSU does not presently believe that its ultimate responsibility with respect to this site will be material. GSU has also been advised that it has been named as a PRP, along with a number of other companies (including LP&L), for an abandoned waste oil recycling plant site in Livingston Parish, Louisiana, which is included on the NPL. Although significant remediation has been completed, additional studies are expected to continue in 1994. GSU and LP&L have been named as defendants in a class action lawsuit lodged against a group of PRP's associated with the site. (For information regarding litigation in connection with the Livingston Parish site, see "Other Regulation and Litigation - GSU," below.) GSU does not presently believe that its ultimate responsibility with respect to this site will be material. GSU received notification in 1992 from the EPA of potential liability at a site located in Iota, Louisiana. This site accepted a variety of wastes, including medical and chemical wastes. In addition to GSU, over 200 parties have been named as PRP's. The EPA is continuing its investigation of the site and has notified the PRP's of the possibility of this site being linked to another site. To date, GSU has not received notification of liability with regard to the other site. GSU does not presently believe its ultimate responsibility with respect to this site will be material. GSU has also been notified by the EPA of potential liability at two sites located in Saline County, Arkansas. It is believed that both sites served as a salvaging facility for transformers and batteries. In addition to GSU, 32 other parties (including AP&L and LP&L) have been named as PRP's. At this time, GSU's involvement with the site is unknown. GSU does not presently believe that its ultimate responsibility with respect to this site will be material. In November 1993, GSU received informal notification from the Rhode Island Department of Environmental Management regarding a site at which electrical capacitors had been located. The State traced several of these capacitors to GSU. GSU records indicate these capacitors were returned under warranty to the manufacturer in the 1960's due to defects. GSU does not presently believe it is responsible for any alleged activities occurring at this site. As of December 31, 1993, GSU had expended $7.0 million toward the cleanup of such sites. In 1990, GSU received an order from the LDEQ to reduce emissions of nitrogen oxides and reactive hydrocarbons at its Willow Glen and Louisiana Station plants located near Baton Rouge, Louisiana. GSU has requested an adjudicatory hearing on the matter, which the LDEQ secretary has deemed as staying the order. In the interim, GSU has joined several other Baton Rouge industries to develop and submit to LDEQ a comprehensive set of short- and long-range reduction plans. In 1993, LDEQ adopted regulations requiring permanent reductions in nitrogen oxides emissions at Willow Glen and Louisiana Station and is considering requirements for further reductions. The estimates for actions necessary to comply with these regulations are included in the discussion under "Clean Air Legislation," above. GSU believes these regulations implement the intent of the 1990 order, and actions beyond those required by the regulations will not be required. LP&L and NOPSI. LP&L and NOPSI have received notices from time to time between 1986 and 1993 from the EPA and/or the states of Louisiana and Mississippi that each or either of the companies may be a PRP for cleanup costs associated with disposal sites that are currently in various stages of remediation in Arkansas, Illinois, Louisiana, Mississippi, and Missouri that are neither owned nor operated by any System company. As to one Missouri site, LP&L's and NOPSI's aggregate liability is currently estimated not to exceed $558,000, and because of the type and the large number of PRP's (over 700, including many large utilities and national and international corporations), LP&L and NOPSI do not expect liabilities in excess of this amount. For the other Missouri site, LP&L and the other 64 PRP's (including several large, creditworthy utility companies) have received an EPA demand to pay approximately $1.2 million expended by the EPA. In June of 1993, LP&L paid $12,392 in full payment of its share of the cleanup costs. LP&L considers cleanup at this site to be complete. As to the two Saline County, Arkansas sites (involving AP&L, GSU, and LP&L), LP&L has been advised that current estimates for total cleanup are approximately $6.0 million. LP&L believes that, because of the number and nature of the PRP's, its exposure for these sites will not be material. Initial indications are that LP&L was involved in the Saline sites, but LP&L believes that because of the limited scope of its involvement and the number and nature of PRP's, its exposure for these sites will not be material. LP&L received notice from the EPA in November 1992, that it (along with AP&L) was involved in the Union County, Arkansas site. An agreement has been negotiated with the EPA that determined LP&L to be a de minimis party with a total liability of approximately $47,000 (see "AP&L," above.) As to the Mississippi site, LP&L (along with System Energy) understands that EPA has expended approximately $740,000 for this site (three separate locations being treated administratively as one). The State of Mississippi has indicated it intends to have PRP's conduct a cleanup of the site but has not yet taken formal action. LP&L has expended $22,300 to settle with the EPA for its costs for this site and, because there are 44 PRP's for this site (including a number of major oil companies), does not expect its share of future costs to be material. For a Livingston Parish, Louisiana site (involving at least 70 PRP's, including GSU and many other large and creditworthy corporations), LP&L has found in its records no evidence of its involvement. (For information regarding litigation in connection with the Livingston Parish site, see "Other Regulation and Litigation - LP&L," below.) At a second Louisiana site (also included on the NPL and involving 57 PRP's, including a number of major corporations), NOPSI believes it has no liability for the site because the material it sent to the site was not a hazardous substance. For the Illinois site, NOPSI, upon its review of the site documentation and of its own records, has asserted to the EPA that it has no involvement in this site. However, NOPSI is participating with other PRP's (including many large and creditworthy corporations) as a prudent means of resolving potential liability, if any. For all these sites, LP&L has expended approximately $349,000 and NOPSI has expended approximately $172,000 for cleanup costs (commencing in 1986) to date. During 1993, LP&L performed preliminary site assessments at the locations of two retired power plants previously owned and operated by two Louisiana municipalities. LP&L had purchased the power plants by agreement (as part of the municipal electric systems) after operating them for the last few years of their useful lives. The assessments indicated some subsurface contamination from fuel oil. LP&L and the LDEQ are now reviewing site remediation procedures that LP&L estimates will not exceed $650,000 in the aggregate. During 1993, the LDEQ issued new rules for solid waste regulation, including waste water impoundments. LP&L has determined that certain of its power plant waste water impoundments are affected by these regulations and has chosen to close them rather than retrofit and permit them. The aggregate cost of the impoundment closures, to be completed by 1996, is estimated to be $7.3 million. System Energy. In February 1990, System Energy received an EPA notice that it (among numerous other companies) may be a PRP for cleanup costs associated with the same site in Mississippi in which LP&L is involved. Potential liability is based on the alleged shipment of waste oil to the site from 1981 to 1985. System Energy does not expect its share of the total expenditures to be material because there are 44 PRP's for this site, including a number of major oil companies. Other Regulation and Litigation Entergy Corporation and GSU. In July and August 1992, Entergy Corporation and GSU filed applications with FERC, the LPSC, and the PUCT, and Entergy Corporation, Entergy Operations, and Entergy Services filed an application with the SEC under the Holding Company Act, seeking authorization of various aspects of the Merger. In January 1993, GSU filed two applications with the NRC seeking approval of the change in ownership of GSU and an amendment to the operating license for River Bend to reflect its operation by Entergy Operations. All regulatory approvals were obtained in 1993 and the Merger was consummated on December 31, 1993 (see "Business of Entergy - Entergy Corporation-GSU Merger," above, for further information). Requests for rehearing of certain aspects of the FERC order were filed on January 14, 1994, by 14 parties, including Entergy Corporation, the APSC, the Mississippi Attorney General, the LPSC, the MPSC, the Texas Office of Public Utility Counsel, and the PUCT. Entergy Corporation, the LPSC, the Texas Office of Public Utility Counsel, and the PUCT are requesting FERC to restore a 40% cap on the amount of fuel savings GSU may be required to transfer to other Entergy operating companies under a tracking mechanism designed to protect the other companies from certain unexpected increases in fuel costs. The other parties are seeking to overturn FERC's decision on various grounds. Requests for rehearing of the SEC order were filed with the SEC by Houston Industries Incorporated and Houston Lighting & Power Company on December 28, 1993, and petitions for review seeking to set aside the SEC order were filed with the D.C. Circuit by these parties on February 15, 1994 and by Cajun on February 14, 1994. See "Nuclear Operations - River Bend," above for information on challenges to the NRC's approval of GSU's applications. Appeals seeking to set aside the LPSC order related to the Merger were filed in the 19th Judicial District Court for the Parish of East Baton Rouge, Louisiana, by Houston Lighting & Power Company on August 13, 1993, and by the Alliance for Affordable Energy, Inc. on August 20, 1993. Subsequently, on February 9, 1994, Houston Lighting & Power Company filed a motion voluntarily dismissing its appeal. AP&L. Three lawsuits (which have been consolidated) were filed in the Arkansas District Court by numerous plaintiffs against AP&L and Entergy Services in connection with the operation of two dams during a period of heavy rainfall and flooding in May 1990. The consolidated lawsuits sought approximately $14.4 million in property losses and other compensatory damages, and $500 million in punitive damages. In their responses to these complaints, AP&L and Entergy Services asserted, among other things, that AP&L owns flowage easements giving it the permanent right to inundate the lands owned or occupied by the plaintiffs in connection with the operation of the dams. In June 1991, the Arkansas District Court granted summary judgment to AP&L with respect to the enforceability of its flowage easements. In November 1991, the Arkansas District Court ruled that Entergy Services was entitled to the benefit of AP&L's flowage easements, in effect, removing from consideration damages in the approximate amount of $13.5 million alleged to have occurred within the areas covered by the easements. As a result, over 300 plaintiffs claiming damage within the easements were dismissed from the consolidated case in December 1991. Certain plaintiffs appealed these orders to the Eighth Circuit, which appeal was denied in March 1992. Following the Eighth Circuit's denial of their interlocutory appeal from the Arkansas District Court's orders, certain of the plaintiffs, without prejudice to their right to refile, voluntarily dismissed their claims which had not been disposed of in the Arkansas District Court's orders, thus making the orders a final adjudication, and appealed these orders to the Eighth Circuit. The remaining plaintiffs obtained a stay and an administrative termination of their claims, pending the outcome of the appeal. In December 1993, a three-judge panel of the Eighth Circuit filed its opinion affirming the judgment of the Arkansas District Court and entered judgment accordingly. The plaintiffs appealing the Arkansas District Court's orders filed petitions with the Eighth Circuit for a rehearing by the entire Court sitting en banc, which petitions were denied. The plaintiffs may petition the U.S. Supreme Court to issue a writ of certiorari to permit its review of the Eighth Circuit's decisions. Neither AP&L nor Entergy Services can predict whether the U.S. Supreme Court will grant such a petition, if one is filed. GSU. Between 1986 and 1993, GSU and approximately 70 other defendants, including many national and international corporations, including LP&L, have been sued in 17 suits in the Livingston Parish, Louisiana District Court (State District Court) by a number of plaintiffs who allegedly suffered damage or injury, or are survivors of persons who allegedly died, as a result of exposure to "hazardous toxic waste" that emanated from a site in Livingston Parish. The plaintiffs alleged that the defendants generated, transported, or participated in the storage of such wastes at the facility, which was previously operated as a waste oil recycling facility. These State District Court suits, which seek damages in total amounts ranging from $1.0 million to $10.0 billion and are now consolidated in a class action, and three federal suits in three states other than Louisiana involving issues arising from the same facility, have been removed and transferred, respectively, to the U.S. District Court for the Middle District of Louisiana (Federal District Court). Motions to remand the class action to the State District Court have been filed, and procedural issues regarding the federal suits are being considered as well. It is not known what effect any action taken on these motions and issues, whenever taken by the Federal District Court, would have on the April 11, 1994 State District Court trial date that was established before the suits were removed to Federal District Court; but it is unlikely such trial date will be met. The matter is pending. In October 1989, an amended lawsuit petition was filed on behalf of 985 plaintiffs in the District Court of Jefferson County, Texas, 60th Judicial District in Beaumont, Texas, naming 55 defendants including GSU. In February 1990, another amended lawsuit petition was filed in a different state District Court in Jefferson County, Texas, on behalf of over 200 plaintiffs (subsequently amended to include a total of 660) naming 127 defendants including GSU. Possibly 300 to 400 or more of the plaintiffs in Texas may have worked at GSU's premises. At least five other individual suits have been filed in Beaumont against GSU and others, seeking damages for alleged asbestos exposure. All of the plaintiffs in such suits are also suing GSU and all other defendants on a conspiracy count. There are 25 asbestos- related law suits filed in the 14th Judicial District Court of Calcasieu Parish in Lake Charles, Louisiana, on behalf of an aggregate of 53 plaintiffs naming from 16 to 24 defendants including GSU, and GSU is aware of as many as 61 additional cases that may be filed. The suits allege that each plaintiff contracted an asbestos-related disease from exposure to asbestos insulation products on the premises of such defendants. Management believes that GSU has meritorious defenses, but there can be no assurance as to the outcome of these cases or that additional claims may not be asserted. In asbestos- related suits against the manufacturers, very substantial recoveries have been achieved by large groups of claimants. GSU does not presently believe that the ultimate resolution of these cases will materially adversely affect the financial position of GSU. On February 3, 1984, Dow Chemical Company filed a request with the LPSC for a hearing to consider issues related to the purchase of cogenerated power by GSU. Other industries subsequently filed similar requests and the matters were consolidated. In November 1984, the LPSC completed hearings on rules, policies, and pricing methodologies applicable to cogeneration. Key issues were whether or not (1) GSU should be required to pay the industries for avoided capacity costs, and (2) GSU should be required to wheel power to or from the industrial plants. While the matter is still pending before the LPSC, the LPSC did set interim rates, subject to refund by either Dow or GSU, which exclude capacity costs. GSU has significant business relationships with Cajun, primarily co-ownership of River Bend and Big Cajun 2 Unit 3. GSU and Cajun own 70% and 30% of River Bend, respectively, while Big Cajun 2 Unit 3 is owned 42% and 58% by GSU and Cajun, respectively. GSU operates River Bend and Cajun operates Big Cajun 2 Unit 3. GSU was requested by Cajun and Jefferson Davis Electric Cooperative, Inc., (Jefferson Davis) to provide transmission of power over GSU's system for delivery to the Industrial Road area near Lake Charles, Louisiana. GSU provides electric service to industrial and other customers in such area, and Cajun and Jefferson Davis do not. On October 10, 1989, Cajun filed a complaint at FERC contending that GSU wrongfully refused to provide Cajun certain transmission services so that its member, Jefferson Davis, could provide service to certain industrial customers, and it requested FERC to order GSU to provide the service. On October 26, 1989, FERC summarily dismissed Cajun's complaint, but the D.C. Circuit reversed FERC's summary determination and remanded the case to FERC for a hearing. On June 24, 1992, after a hearing, an ALJ issued an Initial Decision, again dismissing Cajun's complaint. The ALJ found that the parties' contract did not require GSU to provide the service and that Cajun's member, Jefferson Davis, had not sought permission from the LPSC to serve the end-use customers in question. If Jefferson Davis secured permission from the LPSC, the ALJ believed (but did not decide) that FERC would require GSU to provide the requested transmission service. Both Cajun and GSU have filed exceptions to the ALJ's decision, and the matter is pending before FERC. Cajun and Jefferson Davis also brought a related action in federal court in the Western District of Louisiana alleging that GSU breached its obligations under the parties' contract and violated the antitrust laws by refusing to provide the transmission service described above. Cajun and Jefferson Davis seek an injunction requiring GSU to provide the requested service and unspecified treble damages for GSU's refusal to provide the service. On November 9, 1989, the district court judge denied Cajun's and Jefferson Davis' motion for a preliminary injunction. On May 3, 1991, the judge stayed the proceeding pending final resolution of the matters still pending before FERC. GSU and Cajun are parties to FERC proceedings regarding certain long-standing disputes relating to transmission service charges. Cajun asserts that GSU has improperly applied the terms of a rate schedule, Service Schedule CTOC, to its billings to Cajun and it seeks an order from FERC directing GSU to recompute the bills. GSU asserts that Cajun underpaid its bills, and it seeks an order directing Cajun to pay surcharges to make up the underpayments. On April 10, 1992, FERC issued an order affirming in part and reversing in part an ALJ's recommendations. Both GSU and Cajun have requested rehearing, and the requests are still pending. In addition, on August 25, 1993, the United States Court of Appeals for the Fifth Circuit reversed portions of FERC's order previously decided adversely to GSU, and remanded the case to FERC for further proceedings. On January 13, 1994, FERC rejected GSU's proposal to collect an interim surcharge while FERC considers the court's remand. GSU interprets FERC's 1992 order and the Court of Appeals decision to mean that Cajun owes GSU approximately $85 million through December 31, 1993. If GSU also prevails on all of the issues raised in its pending request for rehearing of FERC's earlier orders, then GSU estimates that Cajun would owe GSU approximately $118 million through December 31, 1993. If GSU does not prevail on its rehearing request, and Cajun prevails on its rehearing request, and if FERC rejects the modifications GSU interprets the court of appeals to have directed, then GSU would owe Cajun an estimated $76 million through December 31, 1993. Pending FERC's ruling on the May 1992 motions for rehearing, GSU has continued to bill Cajun utilizing the historical billing methodology and has booked underpaid transmission charges, including interest, in the amount of $140.8 million as of December 31, 1993. This amount is reflected in long-term receivables and in other deferred credits, with no effect on net income. On December 7, 1993, Cajun filed a complaint in the Middle District of Louisiana alleging that GSU failed to provide Cajun an opportunity to construct certain facilities that allegedly would have reduced its rates under Service Schedule CTOC, and Cajun seeks an order compelling the conveyance of certain facilities and unspecified damages. GSU has moved to dismiss the complaint on the basis, among others, that FERC has already addressed the matter in the proceedings described above. In May 1990, GSU received a subpoena from the Office of Inspector General - Investigations, United States Department of Agriculture, seeking production of documents relating to the construction costs of River Bend. Such office is authorized to investigate matters relating to programs of the Department of Agriculture. GSU has been sued by Cajun with respect to its participation in River Bend with funds made available through Department programs administered by the REA. GSU has failed in its efforts to have the REA made a party to the Cajun litigation. GSU does not know the purpose of such Office's investigation, but presently assumes that it relates to the Cajun civil litigation since the production of documents sought by such Office is similar to that sought by Cajun in its action against GSU. However, there can be no assurance given by GSU as to the real purpose of such Office's investigation. Among other areas of responsibility, such office is authorized to investigate possible violations of law. GSU believes the subpoena proceeding has been administratively dismissed without prejudice to the parties. On December 2, 1991, Cajun filed a complaint seeking declaratory and injunctive relief from the U. S. District Court for the Middle District of Louisiana. The complaint concerns GSU's position that Cajun is in default with respect to paying its share of certain expenditures to repair corrosion damage in the service water system, to repair a feedwater nozzle crack, and to repair a turbine rotor. Cajun alleges that it has no obligation to pay its share of such costs and seeks a declaration that it may elect not to participate in the funding of such costs and enjoining GSU from demanding payment therefor or attempting to implement default provisions in the Operating Agreement with respect thereto. Cajun alleges that if it is required to pay its share of such costs it would be forced to default on other obligations and would be forced to seek relief in bankruptcy. GSU believes that Cajun is in default under the provisions of the Operating Agreement. No assurance can be given as to the outcome or timing of this action brought by Cajun. On November 25, 1992, Dixie Electric Membership Corporation and Southwest Louisiana Electric Membership Corporation, both members of Cajun, filed suit in the U.S. District Court for the Western District of Louisiana seeking a declaration that the River Bend Joint Ownership Agreement between GSU and Cajun is void because an allegedly required approval of the LPSC was not obtained. This suit has been transferred from the Western District to the Middle District, and is being processed in conjunction with the suit described in the following paragraph. GSU believes the suit is without merit. In June 1989, Cajun filed a civil action against GSU in the U. S. District Court for the Middle District of Louisiana. Cajun stated in its complaint that the object of the suit is to annul, rescind, terminate, and/or dissolve the Joint Ownership Participation and Operating Agreement entered into on August 28, 1979 (Operating Agreement), related to River Bend. Cajun alleges fraud and error by GSU, breach of its fiduciary duties owed to Cajun, and/or GSU's repudiation, renunciation, abandonment, or dissolution of its core obligations under the Operating Agreement, as well as the lack or failure of cause and/or consideration for Cajun's performance under the Operating Agreement. The suit seeks to recover Cajun's alleged $1.6 billion investment in the unit as damages, plus attorneys' fees, interest, and costs. In March 1992, the district court appointed a mediator to engage in settlement discussions and to schedule settlement conferences between the parties. Discussions with the mediator began in July 1992, however, GSU cannot predict what effect, if any, such discussions will have on the timing or outcome of the case. A trial without a jury is set for April 12, 1994, on the portion of the suit by Cajun to rescind the Operating Agreement. GSU believes the suits are without merit and is contesting them vigorously. No assurance can be given as to the outcome of this litigation. If GSU were ultimately unsuccessful in this litigation and were required to make substantial payments, GSU would probably be unable to make such payments and would probably have to seek relief from its creditors under the Bankruptcy Code. See Note 12 of GSU's Notes to Financial Statements, "Entergy Corporation-GSU Merger," for the accounting treatment of preacquisition contingencies, including a charge resulting from an adverse resolution of the litigation with Cajun related to River Bend. In July 1992, Cajun notified GSU that it would fund a limited amount of costs related to the fourth refueling outage at River Bend, completed in September 1992. Cajun has also not funded its share of the costs associated with certain additional repairs and improvements at River Bend completed during the refueling outage. GSU has paid the costs associated with such repairs and improvements without waiving any rights against Cajun. GSU believes that Cajun is obligated to pay its share of such costs under the terms of the applicable contract. Cajun has filed a suit seeking a declaration that it does not owe such funds and seeking injunctive relief against GSU. GSU is contesting such suit and is reviewing its available legal remedies. In September 1992, GSU received a letter from Cajun alleging that the operating and maintenance costs for River Bend are "far in excess of industry averages" and that "it would be imprudent for Cajun to fund these excessive costs." Cajun further stated that until it is satisfied it would fund a maximum of $700,000 per week under protest for the remainder of 1992. In a December 1992 letter, Cajun stated that it would also withhold costs associated with certain additional repairs, of which the majority will be incurred during the next refueling outage, currently scheduled for April 1994. GSU believes that Cajun's allegations are without merit and is considering its legal and other remedies available with respect to the underpayments by Cajun. The total resulting from Cajun's failure to fund repair projects, Cajun's funding limitation on the fourth refueling outage, and the weekly funding limitation by Cajun was $33.3 million as of December 31, 1993, compared with a $28.4 million unfunded balance as of December 31, 1992. During 1994, and for the next several years, it is expected that Cajun's share of River Bend-related costs will be in the range of $60 million to $70 million per year. Cajun's weak financial condition could have a material adverse effect on GSU, including a possible NRC action with respect to the operation of River Bend and a need to bear additional costs associated with the co-owned facilities. If GSU were required to fund Cajun's share of costs, there can be no assurance that such payments could be recovered. Cajun's weak financial condition could also affect the ultimate collectibility of amounts owed to GSU. Since 1986, GSU had been in litigation with the Southern Company regarding unit power and long-term power purchase contracts with the Southern Company. GSU entered into a settlement agreement dated December 21, 1990, which was consummated on November 7, 1991, and the settlement obligations were fully satisfied in 1993. In 1986, the PUCT and the LPSC disallowed the pass-through by GSU in its retail rates of the costs of the capacity purchases from the Southern Company, which were being incurred by GSU. GSU appealed the actions of the PUCT and the LPSC disallowing pass-through of Southern Company capacity charges to the appropriate state courts. The appeal from the LPSC is pending. As part of a settlement of a retail rate case in Texas during the fourth quarter of 1993, GSU has discontinued its appeal of the PUCT disallowance. Following the announcement of the execution of the Reorganization Agreement, a purported class action complaint was filed on June 9, 1992, in the District Court 60th Judicial District in Jefferson County, Texas (District Court) against GSU and its directors relating to the then proposed business combination with Entergy Corporation. On June 11, 1992, two additional purported class action complaints were filed against such defendants in the District Court. All three of the complaints (the Shareholder Actions) were filed by persons alleged to be shareholders of GSU and seeking declaration of a class action on behalf of all persons owning common stock of GSU. GSU has executed a Memorandum of Understanding with counsel for the plaintiffs in these suits agreeing in principle to settle such actions subject to execution of an appropriate stipulation of settlement, approval by the court, and certain other conditions. In the Memorandum, the defendants have denied any actionable acts or omissions and state that they have entered into the Memorandum solely to eliminate the burden and expense of further litigation and to facilitate the consummation of the business combination. The Memorandum memorialized certain agreements by GSU and Entergy Corporation for the benefit of shareholders principally in the event the business combination were not consummated, including a covenant to consider reinstitution of dividends on the common stock of GSU in such event. The business combination was consummated on December 31, 1993. Incident to the settlement, the defendants agreed not to oppose an application for attorneys' fees by plaintiffs' counsel that do not exceed $500,000 or for an award of expenses not to exceed $50,000. The individual directors named as defendants in these complaints are entitled to indemnification pursuant to GSU's Restated Articles of Incorporation, By-laws, and individual indemnity agreements, provided that the terms and conditions of the indemnities are satisfied. LP&L. For information regarding litigation in connection with an abandoned waste oil recycling plant site in Livingston Parish, Louisiana, in which LP&L and GSU are defendants, see "GSU," above. LP&L does not believe that it was a generator of any material delivered to this facility and is defending vigorously against the claims in these suits. Since the mid-1980's, LP&L and the tax authorities of St. Charles Parish, Louisiana (Parish), in which Parish Waterford 3 is located, have disputed use taxes paid on nuclear fuel ($4.9 million through 1989) under protest by LP&L. LP&L has been successful in a lawsuit in the Parish with regard to recovering these taxes, plus interest, and also with regard to Parish lease tax issues pertaining to fuel financing arrangements. On the grounds of the previous favorable court decisions, LP&L continues to challenge in the courts additional use tax assessments that it has paid to the Parish and to seek additional interest that LP&L claims it is due. Also, in early procedural stages are (1) suits by LP&L with regard to the state use tax on nuclear fuel, and (2) LP&L's defense (and indemnification, if necessary) of nuclear fuel lessors under LP&L's fuel financing arrangements in the suits filed by the Parish use tax authorities claiming approximately $64.0 million in lease and use taxes. These matters are pending. System Energy. In connection with an IRS audit of Entergy's 1988, 1989, and 1990 consolidated federal income tax returns, the IRS is proposing that adjustments be made to the Grand Gulf 2 abandonment loss deduction claimed on Entergy's 1989 consolidated federal income tax return. If any such adjustments are necessary, the effect on System Energy's net income should be immaterial. Entergy intends to contest the proposed adjustments if finalized by the IRS. The outcome of such proceedings cannot be predicted at this time. EARNINGS RATIOS OF SYSTEM OPERATING COMPANIES AND SYSTEM ENERGY The System operating companies and System Energy have calculated ratios of earnings to fixed charges and ratios of earnings to fixed charges and preferred dividends pursuant to Item 503 of Regulation S-K of the SEC as follows: ____________________ (a) "Earnings" as defined by SEC Regulation S-K represent the aggregate of (1) net income, (2) taxes based on income, (3) investment tax credit adjustments-net, and (4) fixed charges. "Fixed Charges" include interest (whether expensed or capitalized), related amortization, and interest applicable to rentals charged to operating expenses. (b) "Preferred Dividends" as defined by SEC Regulation S-K are computed by dividing the preferred dividend requirement by one hundred percent (100%) minus the income tax rate. (c) System Energy's Amended and Restated Articles of Incorporation do not currently provide for the issuance of preferred stock. (d) "Preferred Dividends" in the case of GSU also include dividends on preference stock. (e) Earnings for the year ended December 31, 1989, include the impact of the write-off of $60 million of deferred Grand Gulf 1-related costs pursuant to an agreement between MP&L and the MPSC. (f) Earnings for the year ended December 31, 1989, were inadequate to cover fixed charges due to System Energy's cancellation and write- off of its investment in Grand Gulf 2 in September 1989. The amount of the coverage deficiency for fixed charges was $745.2 million. (g) Earnings for the year ended December 31, 1991, include the $90 million effect of the 1991 NOPSI Settlement. (h) Earnings for the year ended December 31, 1993, include approximately $81 million, $52 million, and $18 million for AP&L, MP&L, and NOPSI, respectively, related to the change in accounting principle to provide for the accrual of estimated unbilled revenues. (i) Earnings for the year ended December 31, 1990, for GSU were not adequate to cover fixed charges by $60.6 million. Earnings for the years ended December 31, 1990 and 1989, were not adequate to cover fixed charges and preferred dividends by $165.1 million and $190.8 million, respectively. Earnings in 1990 include a $205 million charge for the settlement of a purchased power dispute. INDUSTRY SEGMENTS NOPSI Narrative Description of NOPSI Industry Segments Electric Service. NOPSI supplied electric service to 190,613 customers as of December 31, 1993. During 1993, 36% of electric operating revenues was derived from residential sales, 40% from commercial sales, 6% from industrial sales, 15% from sales to governmental and municipal customers, and 3% from sales to public utilities and other sources. Natural Gas Service. NOPSI supplied natural gas service to 154,251 customers as of December 31, 1993. During 1993, 56% of gas operating revenues was derived from residential sales, 18% from commercial sales, 9% from industrial sales, and 17% from sales to governmental and municipal customers. (See "Fuel Supply - Natural Gas Purchased for Resale," incorporated herein by reference.) Selected Financial Information Relating to Industry Segments For selected financial information relating to NOPSI's industry segments, see NOPSI's financial statements and Note 11 of NOPSI's Notes to Financial Statements, "Business Segment Information," incorporated herein by reference. Employees by Segment NOPSI's full-time employees by industry segment as of December 31, 1993, were as follows: Electric 568 Natural Gas 148 --- Total 716 (For further information with respect to NOPSI's segments, see "Property.") GSU For the year ended December 31, 1993, 96% of GSU's operating revenues were derived from the electric utility business. The remainder of operating revenues were derived 2% from the steam business and 2% from the natural gas business. Segment information for GSU is not provided. PROPERTY Generating Stations The total capability of Entergy 's owned and leased generating stations as of December 31, 1993, by company, is indicated below: _______________________ (1) "Owned and Leased Capability" is the dependable load carrying capability of the stations, as demonstrated under actual operating conditions based on the primary fuel (assuming no curtailments) that each station was designed to utilize. (2) Excludes the capacity of fossil-fueled generating stations placed on extended reserve as follows: AP&L - 506 MW; GSU - 405 MW; LP&L - 19 MW; MP&L - 73 MW; and NOPSI - 143 MW. Generating stations that are not expected to be utilized in the near-term to meet load requirements are placed in extended reserve shutdown in order to minimize operating expenses. (3) Excludes net capability of Entergy Power, which owns 809 MW of fossil-fueled capacity (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - Entergy Power," above). (4) Independence 2, a coal unit operated by AP&L and jointly owned 25% by MP&L (210 MW), 31.5% by Entergy Power (265 MW), and the balance by various municipalities and a cooperative. The unit was out of service, due to an explosion from August 11, 1993 to February 18, 1994. (5) GSU's nuclear capability represents its 70% ownership interest in River Bend; Cajun owns the remaining 30% undivided interest. (6) LP&L's nuclear capability represents its 90.7% ownership interest and 9.3% leasehold interest in Waterford 3. (7) System Energy's capability represents its 90% interest in Grand Gulf 1 (78.5% ownership interest and 11.5% leasehold interest). South Mississippi Electric Power Association has the remaining 10% undivided ownership interest in Grand Gulf 1. Entitlement to System Energy's capacity has been allocated to AP&L, LP&L, MP&L, and NOPSI pursuant to the Unit Power Sales Agreement. (8) Includes 188 MW of capacity leased by AP&L through 1999. Representatives of the System regularly review load and capacity projections in order to coordinate and recommend the location and time of installation of additional generating capacity and of interconnections in light of the availability of power, the location of new loads, and maximum economy to the System. Based on load and capability projections, the System has no need to install additional generating capacity until 1999. To delay the need for new capacity, the System is engaging in conservation and DSM programs, as discussed in "Business of Entergy - Competition - Least Cost Planning," above. When new generation resources are needed, the System plans to meet this need with a variety of sources other than construction of new base load generating capacity. In the meantime, the System will meet capacity needs by, among other things, removing generating stations from extended reserve shutdown. Generating stations brought out of extended reserve shutdown during 1993 added 248 MW to meet operating requirements. Under the terms of the System Agreement, some of the generating capacity and other power resources are shared among the System operating companies. Among other things, the System Agreement provides that parties having generating capacity greater than their load requirements sell such capacity to those parties having deficiencies in generating capacity and that the purchasers pay to the sellers a charge sufficient to cover certain of the sellers' ownership costs, including operating expenses, fixed charges on debt, dividend requirements on preferred and preference stock, and a fair rate of return on common equity investment. Under the System Agreement, these charges are based on costs associated with the sellers' steam electric generating units fueled by oil or gas. In addition, for all energy to be exchanged among the System operating companies under the System Agreement, the purchasers are required to pay the cost of fuel consumed in generating such energy plus a charge to cover other associated costs (see "Rate Matters and Regulation - Rate Matters - Wholesale Rate Matters - System Agreement," above, for a discussion of FERC proceedings relating to the System Agreement). The System's business is subject to seasonal fluctuations with the peak period occurring in the summer months. Excluding GSU, Entergy 's 1993 peak demand of 12,858 MW occurred on August 19, 1993. The net System capability at the time of peak was 14,029 MW, which reflects a reduction of the System's total 14,765 MW of owned and leased capability by net off-system firm sales of 736 MW. The capacity margin at the time of the peak was approximately 8.4%, not including units placed on extended reserve and capacity owned by Entergy Power. GSU's 1993 peak demand of 5,612 MW occurred on August 18, 1993. The net GSU capability at the time of peak was 6,704 MW, which reflects an increase of GSU's total 6,420 MW of owned and leased capability by net off-system purchases of 284 MW. The capacity margin at the time of the peak was approximately 18.2%, not including units placed on extended reserve. Interconnections The electric power supply facilities of Entergy consist principally of steam-electric production facilities strategically located with reference to availability of fuel, protection of local loads, and other controlling economic factors. These are interconnected by a transmission system operating at various voltages up to 500 KV. Generally, with the exception of Grand Gulf 1, Entergy Power's capacity and a small portion of MP&L's capacity, operating facilities or interests therein are owned by the System operating company serving the area in which the facilities are located. However, all of the System's generating facilities are centrally dispatched and operated with a view to realizing the greatest economy. This operation seeks, among other things, the lowest cost sources of energy from hour to hour. The minimum of investment and the most efficient use of plant are sought to be achieved, in part, through the coordinated scheduling of maintenance, inspection, and overhaul. The System operating companies have direct interconnections with neighboring utilities including, in individual cases, Mississippi Power Company, Southwestern Electric Power Company, Southwest Power Administration, Central Louisiana Electric Company, Inc., Oklahoma Gas and Electric Company, The Empire District Electric Company, Union Electric Company, Arkansas Electric Cooperative Corporation, Tennessee Valley Authority, Cajun, Sam Rayburn Dam Electric Cooperative, Inc., SRG&T, SRMPA, Associated Electric Cooperative, Inc., Municipal Energy Agency of Mississippi, Louisiana Energy and Power Authority, Farmers Electric Cooperative, South Mississippi Electric Power Authority, and the cities of Lafayette, Plaquemine, and New Roads, Louisiana. GSU also has an interconnection agreement with Houston Lighting and Power Company providing a minor amount of emergency service only. The System operating companies also have interchange agreements with Alabama Electric Cooperative, Big Rivers Electric Cooperative, Northeast Texas Electric Cooperative, Inc., Sam Rayburn G&T Electric Cooperative, Inc., Florida Power Corporation, Florida Power & Light Company, Jacksonville Electric Authority, Oglethorpe Power Cooperative, the City of Lafayette, Louisiana, the City of Springfield, Missouri, and East Kentucky Electric Cooperative. The System operating companies are members of the Southwest Power Pool, the primary purpose of which is to ensure the reliability and adequacy of the electric bulk power supply in the southwest region of the United States. The Southwest Power Pool is a member of the North American Electric Reliability Council. AP&L, LP&L, MP&L, and NOPSI are also members of the Western Systems Power Pool. Gas Property As of December 31, 1993, NOPSI distributed and transported natural gas for distribution solely within the limits of the City of New Orleans through a total of 1,422 miles of gas distribution mains and 32 miles of gas transmission lines. NOPSI receives deliveries of natural gas for distribution purposes at 14 separate locations, including deliveries from United Gas Pipe Line Company (United) at six of these locations. Of the remaining delivery points, two are principally served by interstate suppliers and the remaining are served by intrastate suppliers. As of December 31, 1993, the gas property of GSU was not material to GSU. Titles The System's generating stations are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the System operating companies has been constructed over lands of private owners pursuant to easements or on public highways and streets pursuant to appropriate permits. The rights of each company in the realty on which its properties are located are considered by it to be adequate for its use in the conduct of its business. Minor defects and irregularities customarily found in properties of like size and character exist, but such defects and irregularities do not materially impair the use of the properties affected thereby. The System operating companies generally have the right of eminent domain whereby they may, if necessary, perfect or secure titles to, or easements or servitudes on, privately-held lands used or to be used in their utility operations. Substantially all the physical properties owned by each System operating company and System Energy are subject to the lien of the mortgage and deed of trust securing the first mortgage bonds of such company. The Lewis Creek generating station is owned by GSG&T, Inc., and is not subject to the lien of the GSU mortgage securing the first mortgage bonds of GSU, but is leased and operated by GSU. In the case of LP&L, certain properties are subject to the liens of second mortgages securing other obligations of LP&L. In the case of MP&L and NOPSI, substantially all of their properties and assets are subject to the second mortgage lien of their respective general and refunding mortgage bond indentures. FUEL SUPPLY The following tabulation shows the percentages of natural gas, fuel oil, nuclear fuel, and coal used in generation, excluding that of Entergy Power, during the past three years. It also shows the average fuel cost per KWH generated by each type of fuel during that period. The balance of generation, which was immaterial, was provided by hydroelectric power. ENTERGY EXCLUDING GSU GSU The following tabulation shows the percentages of generation by fuel type used in generation, excluding that of Entergy Power, for 1993 (actual) and 1994 (projected). _______________________ (a) The System's 1993 actual generation by fuel type excludes GSU; 1994 estimated generation by fuel type includes GSU. (b) Capacity and energy from System Energy's interest in Grand Gulf 1 is allocated as follows: AP&L - 36%; LP&L - 14%; MP&L - 33%; and NOPSI - 17%. Natural Gas The System operating companies have various long-term gas contracts that will satisfy a significant percentage of each operating company's needs; however, such contracts typically require the operating companies to purchase less than half of their annual gas requirements under such contracts. Additional gas requirements are satisfied under less expensive short-term contracts and spot-market purchases. In November 1992, GSU entered into a transportation service agreement with a gas supplier that obligates such supplier to provide GSU with flexible natural gas swing service to certain generating stations by using such supplier's pipeline and salt dome gas storage facility. Many factors influence the availability and price of natural gas supplies for power plants including wellhead deliverability, storage and pipeline capacity, and the demand requirements of the end users. This demand is closely tied to the severity of the weather conditions in the region. Furthermore, pricing relative to other energy sources (i.e. fuel oil, coal, purchased power, etc.) will affect the demand for natural gas for power plants. Supplies of natural gas are expected to be adequate in 1994. Pursuant to FERC and state regulations, gas supplies may be interrupted to power plants during periods of shortage. To the extent natural gas supplies may be disrupted, the System operating companies will use alternate sources of energy such as fuel oil. Coal AP&L has long-term contracts for the supply of low-sulfur coal for the White Bluff Steam Electric Generating Station and the Independence Steam Electric Station (which is owned 25% by MP&L). Coal for the White Bluff Station is supplied under a contract from a mine in the State of Wyoming. The coal contract provides for the delivery of sufficient coal to operate the White Bluff Station through approximately 2002. Coal for the Independence Station is also supplied under a contract from a mine in the State of Wyoming. Coal supplied under this contract is expected to meet the requirements of the Independence Station through at least 2014. GSU has a contract for a supply of low-sulfur Wyoming coal for Nelson Unit 6, which should be sufficient to satisfy the fuel requirements at Nelson Unit 6 through 2004. Cajun has advised GSU that it has contracts that should provide an adequate supply of coal until 1997 for the operation of Big Cajun 2, Unit 3 (which is operated by Cajun and of which GSU owns 42%). Nuclear Fuel Generally, the supply of fuel for nuclear generating units involves the mining and milling of uranium ore to produce a concentrate, the conversion of uranium concentrate to uranium hexafluoride gas, enrichment of that gas, fabrication of the nuclear fuel assemblies, and disposal of the spent fuel. System Fuels is responsible for contracts to acquire nuclear fuel to be used in AP&L's, LP&L's, and System Energy's nuclear units and for maintaining inventories of such materials during the various stages of processing. Each of these companies is currently responsible for contracting for the fabrication of its own nuclear fuel and for purchasing the required enriched uranium hexafluoride from System Fuels. Currently, the requirements for GSU's River Bend plant are covered by contracts made by GSU. On October 3, 1989, System Fuels entered into a revolving credit agreement with banks permitting it to borrow up to $45 million to finance its nuclear materials and services inventory. AP&L, LP&L, and System Energy agreed to purchase from System Fuels the nuclear materials and services financed under the agreement if System Fuels should default in its obligations thereunder. Such purchases would be allocated based on percentages agreed upon among the parties. In the absence of such agreement, AP&L, LP&L, and System Energy would each be obligated to purchase one-third of the nuclear materials and services. Based upon the planned fuel cycles for the System's nuclear units, the following tabulation shows the years through which existing contracts and inventory will provide materials and services: Acquisition of or Conversion Spent Uranium to Uranium Enrich- Fabri- Fuel Concentrate Hexafluoride ment(3) cation Disposal ----------- ------------ ------- ------ -------- ANO 1 (1) (1) 1995 1997 (4) ANO 2 (1) (1) 1995 1994 (4) River Bend (2) (2) 2000 1995 (4) Waterford 3 (1) (1) 1995 1999 (4) Grand Gulf 1 (1) (1) 1995 1995 (4) __________________________ (1) Current contracts will provide these materials and services through termination dates ranging from 1994-1997. Additional materials and services required beyond these dates are estimated to be available for the foreseeable future. (2) Current GSU contracts will provide a significant percentage of these materials and services for River Bend through 1995. (3) Enrichment services for ANO 1, ANO 2, Waterford 3, and Grand Gulf 1 are provided by a System Fuels contract with the United States Enrichment Corporation (USEC). The contract has been terminated after 1995 to permit flexibility on future pricing and terms that could be obtained. Enrichment services for River Bend are provided by a GSU contract with USEC that may be partially terminated after 1998 and fully terminated after 2000. (See "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry - Decommissioning," above for information on annual contributions to a federal decontamination and decommissioning fund required by the Energy Act to be made by AP&L, GSU, LP&L, and System Energy as a result of their enrichment contracts with DOE.) (4) The Nuclear Waste Policy Act of 1982 provides for the disposal of spent nuclear fuel or high level waste by the DOE. Under this Act, the DOE was to begin accepting spent fuel in 1998 and to continue until the disposal of all spent fuel from reactor sites has been accomplished. In November 1989, the DOE indicated that the repository program will be delayed. Current on-site spent fuel storage capacity at ANO, River Bend, Waterford 3, and Grand Gulf 1 is estimated to be sufficient to store fuel from normal operations until 1995, 2003, 2000, and 2004, respectively. It is expected that any additional storage capacity required, due to delay of the DOE repository program, will have to be provided by the affected companies (see "Rate Matters and Regulation - Regulation - Regulation of the Nuclear Power Industry - Spent Fuel and Other High-Level Radioactive Waste," above). The System will require additional arrangements for segments of the nuclear fuel cycle beyond the dates shown above. Except as noted above, Entergy cannot predict the ultimate availability or cost of such arrangements at this time. AP&L, GSU, LP&L, and System Energy currently have nuclear fuel leasing arrangements that provide that AP&L, GSU, LP&L, and System Energy may lease up to $125 million, $105 million, $95 million, and $105 million of nuclear fuel, respectively. As of December 31, 1993, the unrecovered cost base of AP&L's, GSU's, LP&L's, and System Energy's nuclear fuel leases amounted to approximately $93.6 million, $96.5 million, $61.3 million, and $79.7 million, respectively. Each lessor finances its acquisition and ownership of nuclear fuel under a credit agreement and through the issuance of intermediate-term notes. The credit agreements, which were entered into by AP&L in 1988, by LP&L and System Energy in 1989, and GSU in 1993, had initial terms of five years, with the exception of GSU, which has an initial term of three years. These agreements are subject to annual renewal with, in LP&L's and GSU's case, the consent of the lenders. The credit agreements for AP&L, LP&L, and System Energy have all been extended and now have termination dates of December 1996, January 1997, and February 1997, respectively. The credit agreement for GSU was entered into in December 1993 and has a termination date of December 1996. The intermediate-term notes have varying maturities through January 31, 1999. It is expected that the credit agreements will be extended, or alternative financing will be secured by each lessor, based on the particular lessee's nuclear fuel requirements. If extensions or alternative financing cannot be arranged, the particular lessee must purchase sufficient nuclear fuel to allow the lessor to retire such borrowings. Natural Gas Purchased for Resale NOPSI has several suppliers of natural gas for resale. Its system is interconnected with three interstate and three intrastate pipelines. Presently, NOPSI's primary suppliers of natural gas for resale are United, an interstate pipeline, and Bridgeline and Pontchartrain, intrastate pipelines. NOPSI has a firm gas purchase contract with United and receives this service subject to FERC- approved rates pursuant to a certificate granted by FERC. NOPSI also has firm contracts with its two intrastate suppliers and also makes interruptible spot market purchases when economically attractive. In recent years, natural gas deliveries have been subject primarily to weather-related curtailments. However, NOPSI has experienced no such curtailments. In April 1992, FERC issued Order No. 636, which mandated interstate pipeline restructuring. The order requires interstate pipelines to cease selling gas to local distribution customers at the city-gate interconnection although transportation service can be provided in lieu of the former sale. As a result, in the future, NOPSI must substitute sources upstream of the United system for its current gas supply from United. NOPSI is considering purchases from independent intrastate or interstate supply aggregators and/or from intrastate pipeline sources in a manner consistent with its economic and supply reliability objectives. Prior to the effectiveness of Order No. 636, discussed above, in the event of a natural gas shortage on the United system, NOPSI would have received a portion of the available gas supply from United and its other suppliers. After Order No. 636 mandated restructuring (October 31, 1993), curtailments of supply could occur if NOPSI's suppliers failed to perform their obligations to deliver gas under their supply agreements with NOPSI. United could curtail transportation capacity only in the event of pipeline system constraints. Based on the current supply of natural gas, and absent extreme weather related curtailments, NOPSI does not anticipate that there will be any interruptions in natural gas deliveries to its customers. GSU purchases natural gas for resale from a single interstate supplier. Abandonment of service by the present supplier would be subject to abandonment proceedings by FERC. Research AP&L, GSU, LP&L, MP&L, and NOPSI are members of the Electric Power Research Institute (EPRI). EPRI conducts a broad range of research in major technical fields related to the electric utility industry. Entergy participates in various EPRI projects, based on its needs and available resources. During 1991, 1992, and 1993, the System, including GSU, contributed approximately $12 million, $16 million, and $17 million, respectively, for the various research programs in which Entergy was involved. Item 2. Item 2. Properties Refer to Item 1. "Business - Property," incorporated herein by reference, for information regarding the properties of the registrants. Item 3. Item 3. Legal Proceedings Refer to Item 1. "Business - Rate Matters and Regulation," incorporated herein by reference, for details of the registrants' material rate proceedings and other regulatory proceedings and litigation that are pending or that terminated in the fourth quarter of 1993. Item 4. Item 4. Submission of Matters to a Vote of Security Holders A consent in lieu of a special meeting of common stockholders of Entergy-GSU Holdings, Inc. (Holdings) was executed on December 30, 1993, pursuant to a Delaware statute that permits such a procedure. The consent was signed on behalf of Entergy Corporation and GSU, which at that time owned all of the outstanding common stock of Holdings. The common stockholders acted to: (1) increase the number of directors from 2 to 18 upon the occurrence of the combination of Entergy Corporation and GSU, such expanded board to consist of Edwin Lupberger and Joseph Donnelly, who continued as directors, and the following new directors: W. Frank Blount; John A. Cooper, Jr.; Brooke H. Duncan; Lucie J. Fjeldstad; Kaneaster Hodges, Jr.; Robert v.d. Luft; Adm. Kinnaird R. McKee; Paul W. Murrill; James R. Nichols; Eugene H. Owen; John N. Palmer, Sr.; Robert D. Pugh; H. Duke Shackelford; Wm. Clifford Smith; Bismark A. Steinhagen; and Dr. Walter Washington; (2) approve the terms and provisions of certain agreements related to such combination; (3) approve the actions of the officers in connection with those agreements and the transactions contemplated thereby; (4) approve the assumption and adoption by Holdings of certain benefit plans of Entergy Corporation; and (5) approve the taking of actions to issue stock with respect to such plans, including the listing of Holdings' common stock on the New York, Pacific, and Midwest Stock Exchanges and the filing of registration statements with the Securities and Exchange Commission. After the consummation of the transactions involved in the combination, the name of Holdings was changed to Entergy Corporation. On January 22, 1994, Mr. Donnelly resigned from the position of director of Entergy Corporation. PART II Item 5. Item 5. Market for Registrants' Common Equity and Related Stockholder Matters Entergy Corporation. The shares of Entergy Corporation's common stock are listed on the New York, Midwest, and Pacific Stock Exchanges. The high and low prices for each quarterly period in 1993 and 1992, were as follows: 1993 1992 --------------- ---------------- High Low High Low ------ ------ ------ ------ (In Dollars) First 36 1/2 32 1/2 29 5/8 27 1/8 Second 38 1/4 33 1/4 28 1/2 26 1/8 Third 39 7/8 36 1/4 31 7/8 28 1/4 Fourth 39 1/4 35 1/8 33 5/8 30 1/2 Four consecutive quarterly cash dividends on common stock were paid to stockholders of Entergy Corporation in each of 1993 and 1992. In 1993, dividends of 40 cents per share were paid in each of the first three quarters and dividends of 45 cents per share were paid in the last quarter. Dividends of 35 cents per share were paid in each of the first three quarters of 1992, and dividends of 40 cents per share were paid in the last quarter of 1992. As of February 24, 1994, there were 63,779 stockholders of record of Entergy Corporation. For information with respect to Entergy Corporation's future ability to pay dividends, refer to Note 7 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Dividend Restrictions," incorporated herein by reference. In addition to the restrictions described in Note 7, the Holding Company Act provides that, without approval of the SEC, the unrestricted, undistributed retained earnings of any Entergy Corporation subsidiary are not available for distribution to Entergy Corporation's common stockholders until such earnings are made available to Entergy Corporation through the declaration of dividends by such subsidiaries. AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy. There is no market for the common stock of System Energy and the System operating companies, all of which is owned by Entergy Corporation. Prior to December 31, 1993, GSU's common stock was publicly held. Effective with the Merger, all shares of GSU common stock were acquired by Entergy Corporation. No cash dividends on common stock were paid by GSU to its stockholders in 1992-1993. Cash dividends on common stock paid by AP&L, LP&L, MP&L, NOPSI, and System Energy to Entergy Corporation during 1993 and 1992, were as follows: 1993 1992 ------ ------ (In Millions) AP&L $156.3 $ 75.0 LP&L 167.6 174.6 MP&L 85.8 68.4 NOPSI 43.9 32.2 System Energy 233.1 137.7 For information with respect to restrictions that limit the ability of System Energy and the System operating companies to pay dividends, and for information with respect to dividends paid to Entergy Corporation by its subsidiaries subsequent to December 31, 1993, refer respectively, to Note 6 of System Energy's and Note 7 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's Notes to Financial Statements, "Dividend Restrictions," incorporated herein by reference. Item 6. Item 6. Selected Financial Data Entergy Corporation. Refer to information under the heading "Entergy Corporation and Subsidiaries Selected Financial Data - Five- Year Comparison," which information is incorporated herein by reference. AP&L. Refer to information under the heading "Arkansas Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. GSU. Refer to information under the heading "Gulf States Utilities Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. LP&L. Refer to information under the heading "Louisiana Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. MP&L. Refer to information under the heading "Mississippi Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. NOPSI. Refer to information under the heading "New Orleans Public Service Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. System Energy. Refer to information under the heading "System Energy Resources, Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. Item 7. Item 7 "Financial Statements and Exhibits". A current report on Form 8-K, dated January 18, 1994, was filed with the SEC on January 18, 1994, reporting information under Item 5 "Other Materially Important Events". A current report on Form 8-K, dated February 1, 1994, was filed with the SEC on February 8, 1994, reporting information under Items 2 and 7. Entergy Corporation, AP&L, GSU, LP&L, MP&L and NOPSI Current Reports on Form 8-K, dated December 31, 1993, were filed by these companies on January 3, 1994 reporting the consummation of the Entergy Corporation - GSU merger under Item 5 (in the case of AP&L, LP&L, MP&L and NOPSI), Items 2 and 7 (in the case of Entergy Corporation and GSU). EXPERTS All statements in Part I of this Annual Report on Form 10-K as to matters of law and legal conclusions, based on the belief or opinion of System Energy or any System operating company or otherwise, pertaining to the titles to properties, franchises and other operating rights of certain of the registrants filing this Annual Report on Form 10-K, and their subsidiaries, the regulations to which they are subject and any legal proceedings to which they are parties are made on the authority of Friday, Eldredge & Clark, 2000 First Commercial Building, 400 West Capitol, Little Rock, Arkansas, as to AP&L and as to Entergy Services in regards to flood litigation; Monroe & Lemann (A Professional Corporation), 201 St. Charles Avenue, Suite 3300, New Orleans, Louisiana, as to LP&L and NOPSI; and Wise Carter Child & Caraway, Professional Association, Heritage Building, Jackson, Mississippi, as to MP&L and System Energy. The statements attributed to Clark, Thomas & Winters, a professional corporation, as to legal conclusions with respect to GSU's rate regulation in Texas under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters," have been reviewed by such firm and are included herein upon the authority of such firm as experts. The statements attributed to Sandlin Associates regarding the analysis of River Bend Construction costs of GSU under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters", have been reviewed by such firm and are included herein upon the authority of such firm as experts. ENTERGY CORPORATION 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ENTERGY CORPORATION By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); W. Frank Blount, John A. Cooper, Jr., Brooke H. Duncan, Lucie J. Fjeldstad, Kaneaster Hodges, Jr., Robert v.d. Luft, Kinnaird R. McKee, Paul W. Murrill, James R. Nichols, Eugene H. Owen, John N. Palmer, Robert D. Pugh, H. Duke Shackelford, Wm. Clifford Smith, Bismark A. Steinhagen, and Walter Washington (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) ARKANSAS POWER & LIGHT COMPANY 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ARKANSAS POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John A. Cooper, Jr., Cathy Cunningham, Richard P. Herget, Jr., Tommy H. Hillman, Donald C. Hintz, Kaneaster Hodges, Jr., Jerry D. Jackson, R. Drake Keith, Jerry L. Maulden, Raymond P. Miller, Sr., Roy L. Murphy, William C. Nolan, Jr., Robert D. Pugh, Woodson D. Walker, Gus B. Walton, Jr., Michael E. Wilson (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) GULF STATES UTILITIES COMPANY 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GULF STATES UTILITIES COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Robert H. Barrow, Frank F. Gallaher, Frank W. Harrison, Jr., Donald C. Hintz, Jerry L. Maulden, Paul W. Murrill, Eugene H. Owen, M. Bookman Peters, Monroe J. Rathbone, Jr., Sam F. Segnar, Bismark A. Steinhagen, James E. Taussig, II. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) LOUISIANA POWER & LIGHT COMPANY 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. LOUISIANA POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John J. Cordaro, Donald C. Hintz, William K. Hood, Jerry D. Jackson, Tex R. Kilpatrick, Joseph J. Krebs, Jr., Jerry L. Maulden, H. Duke Shackelford, Wm. Clifford Smith (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) MISSISSIPPI POWER & LIGHT COMPANY 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MISSISSIPPI POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, Frank R. Day, John O. Emmerich, Jr., Norman B. Gillis, Jr., Donald C. Hintz, Jerry D. Jackson, Robert E. Kennington, II, Jerry L. Maulden, Donald E. Meiners, John N. Palmer, Sr., Clyda S. Rent, Walter Washington, Robert M. Williams, Jr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) NEW ORLEANS PUBLIC SERVICE INC. 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. NEW ORLEANS PUBLIC SERVICE INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, James M. Cain, John J. Cordaro, Brooke H. Duncan, Norman C. Francis, Donald C. Hintz, Jerry D. Jackson, Jerry L. Maulden, Anne M. Milling, John B. Smallpage, Charles C. Teamer, Sr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) SYSTEM ENERGY RESOURCES, INC. 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. SYSTEM ENERGY RESOURCES, INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Donald C. Hintz (President, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Edwin Lupberger (Chairman of the Board), Jerry D. Jackson, Jerry L. Maulden (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) EXHIBIT 23(a) INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Post-Effective Amendment Nos. 2, 3, 4A, and 5A on Form S-8 to Registration Statement No. 33-54298 of Entergy Corporation on Form S-4, and the related Prospectuses, of our reports dated February 11, 1994 (which express an unqualified opinion and include explanatory paragraphs as to uncertainties because of certain regulatory and litigation matters), appearing in this Annual Report on Form 10-K of Entergy Corporation for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-36149, 33-48356 and 33-50289 of Arkansas Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Arkansas Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-46085, 33-39221 and 33-50937 of Louisiana Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Louisiana Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-53004, 33-55826 and 33-50507 of Mississippi Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Mississippi Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-57926 of New Orleans Public Service Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of New Orleans Public Service Inc. for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-47662 of System Energy Resources, Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994 (which express an unqualified opinion and include an explanatory paragraph as to an uncertainty resulting from a regulatory proceeding), appearing in this Annual Report on Form 10-K of System Energy Resources, Inc. for the year ended December 31, 1993. /s/ Deloitte & Touche DELOITTE & TOUCHE New Orleans, Louisiana March 14, 1994 EXHIBIT 23(b) CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Gulf States Utilities Company on Form S-3 (File Numbers 33-49739 and 33-51181) and Form S-8 (File Numbers 2-76551 and 2-98011) of our reports, dated February 11, 1994, on our audits of the financial statements and financial statement schedules of Gulf States Utilities Company as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, which reports include explanatory paragraphs related to rate-related contingencies, legal proceedings and changes in accounting for income taxes, postretirement benefits, unbilled revenue and power plant materials and supplies and are included in this Annual Report on Form 10-K. /s/ Coopers & Lybrand Coopers & Lybrand Houston, Texas March 14, 1994 EXHIBIT 23(c) CONSENT OF EXPERTS We consent to the reference to our firm under the heading "Experts" in this Annual Report on Form 10-K. We further consent to the incorporation by reference of such reference to our firm into Arkansas Power & Light Company's ("AP&L") Registration Statements (Form S-3, File Nos. 33-36149, 33-48356 and 33-50289) and related Prospectuses, pertaining to AP&L's First Mortgage Bonds and Preferred Stock. Very truly yours, /s/ Friday, Eldredge & Clark FRIDAY, ELDREDGE & CLARK Date: March 14, 1994 EXHIBIT 23(d) CONSENT We consent to the reference to our firm under the heading "Experts", and to the inclusion in this Annual Report on Form 10-K of Gulf States Utilities Company ("GSU") of the statements of legal conclusions attributed to us herein (the Statements of Legal Conclusions) under Part I, Item 1. Business - "Rate Matters and Regulation" and in the discussion of Texas jurisdictional matters set forth in Note 2 to GSU's Financial Statements and Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements appearing as Item 8.

60751_1993.txt

60751_1993

1993

60751

ITEM 1. BUSINESS Lubrizol was organized under the laws of Ohio in 1928. The company began business as a compounder of special-purpose lubricants, and in the early 1930's was among the first to commence research in the field of lubricant additives. Today, the company is a full service supplier of performance chemicals to diverse markets worldwide. These specialty chemical products are created through the application of advanced chemical, mechanical and biological technologies to enhance the performance and quality of the customer products in which they are used. The company develops, produces and sells chemical additives for transportation and industrial lubricants and functional fluids, fuel additives and diversified specialty chemical products. Prior to December 1, 1992, the company also had a separately reportable Agribusiness segment. That segment included traditional operations which develop, produce and market planting seeds and specialty vegetable oils, and also included strategic biotechnology research and development. As described in Note 16 to the Financial Statements (included in the company's 1993 Annual Report to its shareholders and incorporated herein by reference) on December 1, 1992, the company transferred substantially all of its Agribusiness segment, other than the specialty vegetable oil operations, to Mycogen Corporation and a joint venture partnership formed with Mycogen. The transferred assets were related to the seed business activities of the company's former Agrigenetics Division. The Agribusiness assets and operations retained by the company are not reportable as a separate industry segment after 1992. Financial information for the industry segments, prior to December 1, 1992, is contained in Note 14 to the Financial Statements and in the table of Operating Results by Business Segment contained in Management's Discussion and Analysis on page 29 of the 1993 Annual Report to shareholders which are incorporated herein by reference. Specialty Chemicals PRINCIPAL PRODUCTS. The company's principal products are additive systems for gasoline and diesel engine oils, automatic transmission fluids, gear oils, industrial fluids, metalworking compounds and fuels. The company also offers other specialty chemical products. Additives for engine oils accounted for 50% of consolidated revenues in 1993, 48% in 1992, and 45% in 1991. Additives for driveline oils accounted for 19%, 18% and 19% of consolidated revenues for these respective periods. Additives improve the lubricants and fuels used in cars, trucks, buses, off-highway equipment, marine engines and industrial applications. In lubricants, additives enable oil to withstand a broader range of temperatures, limit the buildup of sludge and varnish deposits, reduce wear, inhibit the formation of foam, rust and corrosion, and retard oxidation. In fuels, additives help maintain efficient operation of the fuel delivery system, help control deposits and corrosion, improve combustion and assist in preventing decomposition during storage. Due to the variety in the properties and applications of oils, a number of different chemicals are used to formulate Lubrizol's products. Each additive combination is designed to fit the characteristics of the customer's base oil and the level of performance specified. Engine oils for passenger cars contain a combination of chemical additives which usually includes one or more detergents, dispersants, oxidation inhibitors and wear inhibitors, pour point depressants and viscosity improvers. Other chemical combinations are used in heavy duty engine oils for trucks and off-highway equipment and in formulations for gear oils, automatic transmission fluids, industrial oils, metalworking fluids, and gasoline, diesel and residual fuels. COMPETITION. The chemical additive field is highly competitive in terms of price, product performance and customer service. The company's principal competitors, both in the United States and overseas, are four major petroleum companies and one chemical company. The petroleum companies produce lubricant and fuel additives for their own use, and also sell additives to others. These competing companies are also customers of Lubrizol. Excluding viscosity improvers, management believes, based on volume sold, that it is the largest supplier to the petroleum industry of performance chemicals for lubricants. CUSTOMERS. In the United States, Lubrizol markets its additive products through its own sales organization. The company's additive customers consist primarily of oil refiners and independent oil blenders and are located in more than 100 countries. Approximately 60% of the company's sales are made to customers outside of North America. The company's ten largest customers, most of which are international oil companies and a number of which are groups of affiliated entities, accounted for approximately 44% of consolidated sales in 1993. Although the loss of any one of these customers could have a material adverse effect on the company's business, each is made up of a number of separate business units that the company believes make independent purchasing decisions with respect to chemical additives. Sales to Royal Dutch Petroleum Company (Shell) and its affiliates accounted for 9% of consolidated sales in 1993. RAW MATERIALS. Lubrizol utilizes a broad variety of chemical raw materials in the manufacture of its additives and uses oil in processing and blending additives. These materials are obtainable from several sources, and for the most part are derived from petroleum. Historically, the unstable conditions in the Middle East have caused the cost of raw materials to fluctuate significantly; however, it has not significantly affected the availability of raw materials to the company. The company expects raw materials to be available in adequate amounts in 1994. RESEARCH, TESTING AND DEVELOPMENT. Lubrizol has historically emphasized research and has developed a large percentage of the additives it manufactures and sells. Technological developments in the design of engines and other automotive equipment, combined with rising demands for environmental protection and fuel economy, require increasingly sophisticated chemical additives. Research and development expenditures were $88.5 million in 1993, $76.2 million for 1992 and $63.7 million for 1991. These amounts were equivalent to 5.8%, 5.3% and 4.7% of the respective revenues for such years. These amounts include expenditures for the performance evaluation of additive developments in engines and other types of mechanical equipment as well as expenditures for the development of specialty chemicals for industrial applications. In addition, $83.0 million, $63.6 million and $64.0 million was spent in 1993, 1992 and 1991, respectively, for technical service activities, principally for evaluation in mechanical equipment of specific lubricant formulations designed for the needs of petroleum industry customers throughout the world. The company has two research facilities at Wickliffe, Ohio, one of which is principally for lubricant additive research and the other for research in the field of other specialty chemicals. The company also maintains a mechanical testing laboratory at Wickliffe, equipped with a variety of gasoline and diesel engines and other mechanical equipment to evaluate the performance of additives for lubricants and fuels. Lubrizol has similar mechanical testing laboratories in England and Japan and, in addition, makes extensive use of independent contract research firms. Extensive field testing is also conducted through various arrangements with fleet operators and others. Liaison offices in Detroit, Michigan; Hazelwood, England; Hamburg, Germany; Tokyo, Japan; and Paris, France maintain close contact with the principal automotive and equipment manufacturers of the world and keep the company abreast of the performance requirements for Lubrizol products in the face of changing technologies. These liaison activities also serve as contacts for cooperative development and evaluation of products for future applications. Contacts with the automotive and equipment industry are important so the company may have the necessary direction and lead time to develop products for use in engines, transmissions, gear sets, and other areas of equipment that require lubricants of advanced design. PATENTS. Lubrizol owns certain United States patents relating to lubricant and fuel additives, lubricants, chemical compositions and processes, and protective coating materials and processes. It also owns similar patents in foreign countries. While such domestic and foreign patents expire from time to time, Lubrizol continues to apply for and obtain patent protection on an ongoing basis. Although the company believes that, in the aggregate, its patents constitute an important asset, it does not regard its business as being materially dependent upon any single patent or any group of related patents. The company has filed claims against Exxon Corporation and its affiliates ("Exxon") alleging infringements by Exxon of certain of the company's patents. These suits are pending in the United States and in Canada, France and the United Kingdom, and are at various stages. The international suits allege infringement of patents that correspond to a United States patent admitted as valid by Exxon in a settlement in 1988. In the suit in Canada, a determination of liability has been made by the courts against Exxon and in favor of the company, and the case has been returned to the trial court for an assessment of damages. In another patent infringement suit, instituted by Exxon in the United States, liability and damages determinations have been made (which are subject to appeal) against the company and in favor of Exxon. For further information regarding these cases, refer to Note 18 to the Financial Statements included in the company's 1993 Annual Report to its shareholders. ENVIRONMENTAL MATTERS. The company is subject to federal, state and local laws and regulations designed to protect the environment and limit manufacturing wastes and emissions. The company believes that as a general matter its policies, practices and procedures are properly designed to prevent unreasonable risk of environmental damage and the consequent financial liability to the company. Compliance with the environmental laws and regulations requires continuing management effort and expenditures by the company. Capital expenditures for environmental projects are anticipated to be $20 million in 1994, which is approximately the same as 1993. Management believes that the cost of complying with environmental laws and regulations will not have a material affect on the earnings, liquidity or competitive position of the company. The company is engaged in the handling, manufacture, use, transportation and disposal of substances that are classified as hazardous or toxic by one or more regulatory agencies. The company believes that its handling, manufacture, use, transportation and disposal of such substances generally have been in accord with environmental laws and regulations. Among other environmental laws, the company is subject to the federal "Superfund" law, under which the company has been designated as a "potentially responsible party" that may be liable for cleanup costs associated with various waste sites, some of which are on the U.S. Environmental Protection Agency Superfund priority list. The company's experience, consistent with what it believes to be the experience of others in similar cases, is that Superfund site liability tends to be apportioned among parties based upon contribution of materials to the Superfund site. Accordingly, the company measures its liability and carries out its financial reporting responsibilities with respect to Superfund sites based upon this standard, even though Superfund site liability is technically joint and several in nature. The company views the expense of remedial clean-up as a part of its product cost, and accrues for estimated environmental liabilities with regular charges to cost of sales. Management considers its environmental accrual to be adequate to provide for its portion of costs for all known environmental matters, including Superfund sites. Based upon consideration of currently available information, management does not believe liabilities for environmental matters will have a material adverse effect on the company's financial position, operating results or liquidity. AGRIBUSINESS As discussed in Note 16 to the Financial Statements, on December 1, 1992, the company transferred substantially all of the Agribusiness segment, other than the specialty vegetable oil operations, to Mycogen Corporation and a joint venture partnership (Agrigenetics, L.P.) formed with Mycogen. The company's 1993 consolidated revenues, costs and expenses include specialty vegetable oil operations, but do not include amounts related to the transferred assets. As also discussed in Note 16 to the Financial Statements, on December 31, 1993, the company exchanged another portion of its investment in the partnership for additional Mycogen common stock and cash. The company's investment in Mycogen, which includes Agrigenetics, Inc. (formerly Agrigenetics, L.P.), is accounted for by the equity method, under which the company recognizes its share of the earnings or losses of such entities. The specialty vegetable oil operation retained by the company sells specialty vegetable oils and operates an oilseed crushing and refining facility. Specialty vegetable oil sales consist primarily of high oleic sunflower oil in either crude or refined forms and safflower oil. Pursuant to contractual arrangements, the company has agreed to purchase planting seed for specialty vegetable oils from Agrigenetics, Inc., which in turn is to supervise production of oilseed for crushing. The company's ability to acquire high oleic oil seed is subject to governmental, agricultural and export policies as well as the weather. The discussion below is presented only for historical purposes except for any references to specialty vegetable oils. The transferred portion of the Agribusiness operations produced and marketed planting seeds for agricultural crops. The principal seed products were hybrid seed corn, hybrid sorghum, soybeans, hybrid sunflowers, alfalfa, and cotton. Revenues from planting seeds contributed approximately 75% of the Agribusiness sales in 1992 and 68% in 1991. Substantially all of the company's planting seed, and oilseed for crushing, was produced by an established network of growers under specified planting conditions on a short-term contract basis. The company furnished parental seed to its growers, primarily from stock developed, multiplied and maintained by the company. Company personnel supervised planting, growing and harvesting. The seed products were marketed through three regional groups representing eight Agrigenetics seed brands and through an international marketing group and three overseas subsidiaries, all of which sold planting seeds. The products were marketed primarily to dealers and distributors, most of whom were farmers with long-term relationships with the company. The company sold its seeds primarily in the major farm production areas in the United States. The company markets specialty vegetable oil through its own sales organization and commissioned agents. Sales to date have been principally to food processors. The United States seed industry is highly competitive and fragmented. Based on revenue figures from industry sources, management believes the transferred Agribusiness operations were the sixth largest seed company in the United States. The market for vegetable oils is very large and very competitive. The company's TRISUN(R) sunflower oil sells for a premium over regular sunflower oil. TRISUN(R) oil is very high in monounsaturates, and therefore more stable and resistant to oxidation than other vegetable oils. Agribusiness revenues from the sale of planting seeds were earned principally during the first half of the calendar year, and losses from these operations were incurred in the last half as a result of continuing operating expenses with low sales. Working capital needs were also seasonal. Expenditures for inventories were made during the last half of the year, while substantial collections on sales were not received until the second and third quarters of the following year. Strategic Agribusiness activities consisted principally of internal biotechnology research and development directed toward developing new products for the agriculture, food and chemical industries. Agribusiness' research and development consisted of traditional plant breeding and strategic research in advanced plant science. Plant breeding attempts to create desirable plants by crossing selected parent plants. The genetic combinations of the crosses are then tested under field conditions to determine if desired characteristics appear. Traditional research expense of the Agribusiness segment was $7.2 million in 1992 and $7.8 million in 1991. A major portion of Agribusiness' strategic research and development was conducted at the research laboratory in Madison, Wisconsin. Strategic research was focused on specialty chemicals and food products derived from oil seed crops and on genetic improvement of specific attributes of hybrid plant varieties. Total Agribusiness strategic research expense was $7.7 million in 1992 and $8.6 million in 1991. The company has United States utility patents covering its high oleic sunflower oil and seeds. The high oleic patents are being re-examined by the U.S. Patent and Trademark Office, and such re-examination has not been resolved. If the re-examination results in the cancellation of the patents, management believes that its business will not be materially affected. GENERAL EMPLOYEES. At December 31, 1993, the company and its wholly-owned subsidiaries had 4,613 employees of which approximately 60% were in the U.S. INTERNATIONAL OPERATIONS. Financial information with respect to domestic and foreign operations is contained in Note 12 to the Financial Statements that is included in the company's 1993 Annual Report to its shareholders and is incorporated herein by reference. The company supplies its additive customers abroad from overseas manufacturing plants and through export from the United States. Sales and technical service offices are maintained in more than 30 countries outside the United States. As a result, the company is subject to business risks inherent in non-U.S. activities, including political uncertainty, import and export limitations, exchange controls and currency fluctuations. The company believes risks related to its foreign operations are mitigated due to the political and economic stability of the countries in which its largest foreign operations are located. While changes in the dollar value of foreign currencies will affect earnings from time to time, the longer term economic effect of these changes should not be significant given the company's net asset exposure, currency mix and pricing flexibility. Generally, the income statement effect of changes in the dollar value of foreign currencies is partially or wholly offset by the company's ability to make corresponding price changes in local currency. The company's consolidated net income will generally benefit (decline) as foreign currencies increase (decrease) in value compared to the U.S. dollar. In 1993, European currencies weakened and the Japanese yen strengthened resulting in insignificant net earnings effect. ITEM 2. ITEM 2. PROPERTIES The general offices of the company are located in Wickliffe, Ohio. The company has various leases for general office space primarily located in Eastlake, Ohio; Houston, Texas; and London, England. The company owns three additive manufacturing plants in the United States; one located in the Cleveland, Ohio area, at Painesville, and two near Houston, Texas, at Deer Park and Bayport. Outside the United States, the company owns additive manufacturing plants in Australia, Brazil, Canada, England, France (three locations), Japan, South Africa and Singapore. All of these plants, other than Singapore, are owned in fee. In Singapore, Lubrizol owns the plant but leases the land on which the plant is located. The company owns in fee mechanical testing facilities in Wickliffe, Ohio; Hazelwood, England; and Atsugi, Japan. The company also owns an oilseed crushing and refining plant located in Culbertson, Montana. Finally, the company owns in fee a manufacturing plant in Germany that manufactures performance chemical additives for the coatings industry. Additive manufacturing plants in India, Mexico, Saudi Arabia and Venezuela are owned and operated by joint venture companies licensed by Lubrizol. Lubrizol's ownership of each of these companies ranges from 40% to 49%. Lubrizol has entered into long-term contracts for its exclusive use of major marine terminal facilities at the Port of Houston, Texas. In addition, Lubrizol has leases for storage facilities in Australia, Chile, Ecuador, Finland, France, Holland, Singapore, Spain, South Africa, Sweden, and Turkey; East Liverpool, Ohio; Los Angeles, California; St. Paul, Minnesota; Bayonne, New Jersey; and Tacoma, Washington. In some cases, the ownership or leasing of such facilities is through certain of its subsidiaries or affiliates. The company initiated a manufacturing rationalization plan during the third quarter of 1993. The plan will be implemented over the next several years and, through consolidation, is expected to result in a one-third reduction in the number of units used to produce intermediate products. See Note 17 to the Financial Statements included in the company's Annual Report to its shareholders. Although the company continues to maintain a capital expenditure program to support its operations, management of the company believes that its facilities are adequate for its present operations and for the foreseeable future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The company is a party in a case brought by Exxon Corporation and its affiliates, Exxon Chemical Patents, Inc. and Exxon Research & Engineering Company, in the Southern District of Texas, Houston Division on September 19, 1989. In December 1992, the trial jury rendered a verdict that the company willfully infringed an Exxon patent pertaining to an oil soluble copper additive component. In early 1993, the court prohibited the company from making or selling any additive packages in the United States that contained this component and awarded Exxon $18.1 million for attorneys' fees. On November 18, 1993, another jury in the same case awarded Exxon $48 million in damages. The findings of infringement and validity of the Exxon patent as well as the $18.1 million attorneys' fee award are on appeal to the United States Court of Appeals for the Federal Circuit in Washington, D.C., which has jurisdiction over all patent cases. Oral argument in this appeal was heard on December 6, 1993, and a decision may be forthcoming in 1994. On February 18, 1994, acting on a request from Exxon that the damages amount be tripled, the trial court judge doubled the damages amount and awarded prejudgment interest, court costs and additional attorneys' fees to Exxon. The total amount of the judgment, including the previously awarded attorneys' fees, is $129 million. The company has the right to appeal the February 1994 damages award to the same court in Washington, D.C., as is considering the appeal of the original verdict. The company's management continues to believe that it has not infringed the Exxon patent and that the patent is invalid. Based on the advice of legal counsel, management believes that the December 1992 trial court judgment will not be upheld on appeal. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to the vote of the security holders during the three months ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following sets forth the name, age, recent business experience and certain other information relative to each person who is an executive officer of Lubrizol as of March 1, 1994. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Common Shares of The Lubrizol Corporation are listed on the New York Stock Exchange under the symbol LZ. The number of shareholders of record of Common Shares was 6,576 as of February 10, 1994. All share and per share data have been restated to reflect the 2-for-1 stock split effected on August 31, 1992. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The summary of selected financial data for each of the last five years included in the Historical Summary contained on pages 44 and 45 of Lubrizol's 1993 Annual Report to its shareholders is incorporated herein by reference. Other income for 1993 includes $42.4 million for the gain on sale of Genentech (see Note 7) and a special charge of $86.3 million (see Note 17). Included in other income for 1990 is $101.9 million for the gain on sale of Genentech. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The Management's Discussion and Analysis of Financial Condition and Results of Operations contained on pages 25 through 29, inclusive, of Lubrizol's 1993 Annual Report to its shareholders is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of Lubrizol and its subsidiaries, together with the independent auditors' report relating thereto, contained on pages 30 through 42, inclusive, of Lubrizol's 1993 Annual Report to its shareholders, and the Quarterly Financial Data (Unaudited) contained on page 43 of such 1993 Annual Report are incorporated herein by reference. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information relating to directors of Lubrizol contained under the heading "Election of Directors" on pages 1 to 5, inclusive, of Lubrizol's Proxy Statement dated March 16, 1994, is incorporated herein by reference. Information relative to executive officers of Lubrizol is contained under Part I of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information relating to executive compensation contained under the headings "Committees and Compensation of the Board of Directors" on page 6, "Executive Compensation" on pages 8 through 11, inclusive, and under "Employee and Executive Officer Benefit Plans - Pension Plans" and "- Executive Agreements" on pages 15, 16, and 17 of Lubrizol's Proxy Statement dated March 16, 1994, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information relating to security ownership set forth under the heading "Security Ownership of Directors and Management" on page 7 of Lubrizol's Proxy Statement dated March 16, 1994, is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as part of this Annual Report: 1. The following consolidated financial statements of The Lubrizol Corporation and its subsidiaries, together with the independent auditors' report relating thereto, contained on pages 30 through 43, inclusive, of Lubrizol's 1993 Annual Report to its shareholders and incorporated herein by reference: Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets at December 31, 1993 and Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Independent Auditors' Report Quarterly Financial Data (Unaudited) 2. Schedules I Other Investments V Property, Plant and Equipment VI Accumulated Depreciation of Property, Plant and Equipment IX Short-Term Borrowings X Supplementary Income Statement Information Schedules other than those listed above are omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements and notes thereto. 3. Exhibits (3)(a) Amended Articles of Incorporation of The Lubrizol Corporation, as adopted September 23, 1991. (3)(b) Regulations of The Lubrizol Corporation, as amended effective April 27, 1992. (4)(a) Article Fourth of Amended Articles of Incorporation. (4)(b) The company agrees, upon request, to furnish to the Securities and Exchange Commission copies of financial documents evidencing long-term debt, which debt does not exceed 10% of the total assets of the company and its subsidiaries on a consolidated basis. (4)(c) Rights Agreement between The Lubrizol Corporation and National City Bank dated October 6, 1987. (4)(d) Amendment to Rights Agreement dated October 6, 1987, between The Lubrizol Corporation and National City Bank, effective October 24, 1988. (4)(e) Special Rights Agreement between The Lubrizol Corporation and National City Bank dated October 31, 1988. (4)(f) Amendment No. 2 to Rights Agreement dated October 6, 1987, as amended, between The Lubrizol Corporation and National City Bank, effective October 28, 1991. (4)(g) Amendment No. 1 to Special Rights Agreement dated October 31, 1988, between The Lubrizol Corporation and National City Bank, effective October 28, 1991. (10)(a)* The Lubrizol Corporation 1975 Employee Stock Option Plan, as amended. (10)(b)* The Lubrizol Corporation 1985 Employee Stock Option Plan, as amended. (10)(c)* The Lubrizol Corporation 1981 Key Employee Incentive Stock Option Plan. (10)(d)* The Lubrizol Corporation Deferred Compensation Plan for Directors. (10)(e)* Form of Employment Agreement between The Lubrizol Corporation and certain of its senior executive officers. (10)(f)* The Lubrizol Corporation Excess Defined Benefit Plan, as amended. (10)(g)* The Lubrizol Corporation Excess Defined Contribution Plan, as amended. (10)(h)* The Lubrizol Corporation Variable Award Plan. (10)(i)* The Lubrizol Corporation Executive Death Benefit Plan, as amended. (10)(j)* Amendment No. 1 to the Amended and Restated Severance Agreement between The Lubrizol Corporation and Dr. R.Y.K. Hsu. (Reference is made to Exhibit (10)(k) to The Lubrizol Corporation's Annual Report on Form 10-K for the year ended December 31, 1990, which Exhibit is incorporated herein by reference.) (10)(k)* Employment and Consulting Agreement dated February 23, 1987, between The Lubrizol Corporation and Dr. R.Y.K. Hsu with Amendment dated December 28, 1989. (Reference is made to Exhibit (10)(l) to The Lubrizol Corporation's Annual Report on Form 10-K for the year ended December 31, 1990, which Exhibit is incorporated herein by reference.) (10)(l)* The Lubrizol Corporation 1991 Stock Incentive Plan, as amended. (10)(m)* The Lubrizol Corporation Deferred Stock Compensation Plan for Outside Directors. (10)(n)* Amendment to Employment and Consulting Agreement dated October 1, 1992, between The Lubrizol Corporation and Dr. R.Y.K. Hsu. (Reference is made to Exhibit (10)(q) to The Lubrizol Corporation's Annual Report on Form 10-K for the year ended December 31, 1992, which Exhibit is incorporated herein by reference.) (10)(o)* Early Retirement and General Release Agreement dated April 14, 1993, between The Lubrizol Corporation and William D. Manning. (10)(p)* The Lubrizol Corporation Officers' Supplemental Retirement Plan (11) Statement setting forth computation of per share earnings. (12) Computation of Ratio of Earnings to Fixed Charges. (13) The following portions of The Lubrizol Corporation 1993 Annual Report to its shareholders: Pages 25-29 Management's Discussion and Analysis of Financial Condition and Results of Operations Page 30 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Page 31 Consolidated Balance Sheets at December 31, 1993 and 1992 Page 32 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Page 33 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and Pages 34-41 Notes to Financial Statements Page 42 Independent Auditors' Report Page 43 Quarterly Financial Data (Unaudited) Pages 44-45 Historical Summary (21) List of Subsidiaries of The Lubrizol Corporation. (23) Consent of Independent Auditors. *Indicates management contract or compensatory plan or arrangement. (b) The Lubrizol Corporation filed a Current Report on Form 8-K, reporting under "Item 5 - Other Events," a damage award granted to Exxon Corporation on November 18, 1993, against the company. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on March 28, 1994, on its behalf by the undersigned, thereunto duly authorized. THE LUBRIZOL CORPORATION BY /s/L. E. Coleman --------------------------------- L. E. Coleman, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below on March 28, 1994, by the following persons on behalf of the Registrant and in the capacities indicated. /s/L. E. Coleman Chairman of the Board and Chief - ------------------------------- Executive Officer and Director L. E. Coleman (Principal Executive Officer) /s/R. A. Andreas Vice President and Chief Financial - ------------------------------- Officer (Principal Financial Officer) R. A. Andreas /s/G. P. Lieb Controller, Accounting and Financial - ------------------------------- Reporting (Principal Accounting G. P. Lieb Officer) /s/W. G. Bares President, Chief Operating Officer - ------------------------------- and Director W. G. Bares /s/Edward F. Bell Director - ------------------------------- Edward F. Bell /s/Peggy G. Elliott Director - ------------------------------- Peggy G. Elliott /s/David H. Hoag Director - ------------------------------ David H. Hoag /s/Thomas C. MacAvoy Director - ------------------------------- Thomas C. MacAvoy /s/William P. Madar Director - ------------------------------- William P. Madar /s/Richard A. Miller Director - ------------------------------- Richard A. Miller /s/Ronald A. Mitsch Director - ------------------------------- Ronald A. Mitsch /s/Renold D. Thompson Director - ------------------------------- Renold D. Thompson /s/Karl E. Ware Director - ------------------------------- Karl E. Ware INDEPENDENT AUDITORS' REPORT To the Shareholders and Board of Directors of The Lubrizol Corporation: We have audited the consolidated financial statements of The Lubrizol Corporation as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 18, 1994; such consolidated financial statements and report are included in your 1993 Annual Report to shareholders and are incorporated herein by reference. Our audits also included the financial statement schedules of The Lubrizol Corporation, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/Deloitte & Touche - ---------------------------- DELOITTE & TOUCHE Cleveland, Ohio February 18, 1994 S-1 SCHEDULE I S-2 SCHEDULE V S-3 SCHEDULE VI S-4 SCHEDULE IX S-5 SCHEDULE X S-6 EXHIBIT INDEX (3)(a) Amended Articles of Incorporation of The Lubrizol Corporation, as adopted September 23, 1991. (3)(b) Regulations of The Lubrizol Corporation, as amended effective April 27, 1992. (4)(a) Article Fourth of Amended Articles of Incorporation. (4)(b) The company agrees, upon request, to furnish to the Securities and Exchange Commission copies of financial documents evidencing long-term debt, which debt does not exceed 10% of the total assets of the company and its subsidiaries on a consolidated basis. (4)(c) Rights Agreement between The Lubrizol Corporation and National City Bank dated October 6, 1987. (4)(d) Amendment to Rights Agreement dated October 6, 1987, between The Lubrizol Corporation and National City Bank, effective October 24, 1988. (4)(e) Special Rights Agreement between The Lubrizol Corporation and National City Bank dated October 31, 1988. (4)(f) Amendment No. 2 to Rights Agreement dated October 6, 1987, as amended, between The Lubrizol Corporation and National City Bank, effective October 28, 1991. (4)(g) Amendment No. 1 to Special Rights Agreement dated October 31, 1988, between The Lubrizol Corporation and National City Bank, effective October 28, 1991. (10)(a) The Lubrizol Corporation 1975 Employee Stock Option Plan, as amended. (10)(b) The Lubrizol Corporation 1985 Employee Stock Option Plan, as amended. (10)(c) The Lubrizol Corporation 1981 Key Employee Incentive Stock Option Plan. (10)(d) The Lubrizol Corporation Deferred Compensation Plan for Directors. (10)(e) Form of Employment Agreement between The Lubrizol Corporation and certain of its senior executive officers. (10)(f) The Lubrizol Corporation Excess Defined Benefit Plan, as amended. (10)(g) The Lubrizol Corporation Excess Defined Contribution Plan, as amended. (10)(h) The Lubrizol Corporation Variable Award Plan. (10)(i) The Lubrizol Corporation Executive Death Benefit Plan, as amended. (10)(j) Amendment No. 1 to the Amended and Restated Severance Agreement between The Lubrizol Corporation and Dr. R.Y.K. Hsu. (Reference is made to Exhibit (10)(k) to The Lubrizol Corporation's Annual Report on Form 10-K for the year ended December 31, 1990, which Exhibit is incorporated herein by reference.) (10)(k) Employment and Consulting Agreement dated February 23, 1987, between The Lubrizol Corporation and Dr. R.Y.K. Hsu with Amendment dated December 28, 1989. (Reference is made to Exhibit (10)(l) to The Lubrizol Corporation's Annual Report on Form 10-K for the year ended December 31, 1990, which Exhibit is incorporated herein by reference.) (10)(l) The Lubrizol Corporation 1991 Stock Incentive Plan, as amended. (10)(m) The Lubrizol Corporation Deferred Stock Compensation Plan for Outside Directors. (10)(n) Amendment to Employment and Consulting Agreement dated October 1, 1992, between The Lubrizol Corporation and Dr. R.Y.K. Hsu. (Reference is made to Exhibit (10)(q) to The Lubrizol Corporation's Annual Report on Form 10-K for the year ended December 31, 1992, which Exhibit is incorporated herein by reference.) (10)(o) Early Retirement and General Release Agreement dated April 14, 1993, between The Lubrizol Corporation and William D. Manning. (10)(p) The Lubrizol Corporation Officers' Supplemental Retirement Plan. (11) Statement setting forth computation of per share earnings. (12) Computation of Ratio of Earnings to Fixed Charges. (13) The following portions of The Lubrizol Corporation 1993 Annual Report to its shareholders: Pages 25-29 Management's Discussion and Analysis of Financial Condition and Results of Operations Page 30 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Page 31 Consolidated Balance Sheets at December 31, 1993 and 1992 Page 32 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Page 33 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Pages 34-41 Notes to Financial Statements Page 42 Independent Auditors' Report Page 43 Quarterly Financial Data (Unaudited) Pages 44-45 Historical Summary (21) List of Subsidiaries of The Lubrizol Corporation. (23) Consent of Independent Auditors.

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Item 3. Legal Proceedings. On September 3, 1993 Frenchmen's Reef Beach Resorts ("FRBA") filed for protection under chapter 11 of the Bankruptcy Code. FRBA is the owner of the Marriott Hotel, St. Thomas. U.S. Virgin Islands (the "Hotel"). The Company holds mortgages encumbering the Hotel which secure obligations of FRBA to the Company. In addition, the Company manages the Hotel for FRBA pursuant to a written agreement. FRBA has filed with the bankruptcy court a Disclosure Statement setting forth a Plan of Reorganization which, among other things, provides for the conveyance of the Hotel to the Company. The limited partners of FRBA have filed an objection to the Disclosure Statement. The Company has pending before the bankruptcy court a motion for permission to commence and pursue a foreclosure of its mortgages through the receipt of a judgement of foreclosure. In a proceeding captioned PMI Investment, Inc. vs. Allan V. Rose and Arthur Cohen et al. brought before the bankruptcy court the Company seeks to recover amounts owed by Rose and Cohen under a guaranty. In that same proceeding, the Company also seeks a determination that FSA has no claim to the proceeds of any recovery from Rose and Cohen. The Company has reached a settlement in that proceeding with Rose and Cohen. Under the settlement, the Company will receive $25.0 million in cash, which Rose has deposited in escrow, and the cash proceeds of the sale of approximately 1.1 million shares of the Company's stock owned by Rose under the Prime Motor Inns, Inc. Second Amended Plan of Reorganization. Disbursal of the settlement proceeds is subject to the bankruptcy court's approval of the settlement and the bankruptcy court's determination that FSA has no claim to the settlement proceeds. A trial was held in January, 1994 on both issues and the Company is awaiting the decision of the bankruptcy court. PMI has responded to informal requests for information by the United States Securities and Exchange Commission's Division of Enforcement relating to certain of PMI's significant transactions for the years 1985 through 1990. PMI has not submitted its Annual Report on Form 10-K for the fiscal year ended June 30, 1990 and Quarterly Reports on Form 10-Q during the pendency of its reorganization, except for its Quarterly Report on Form 10-Q for the quarter ended March 31, 1992. Contingent Claims As of March 1, 1994 unresolved bankruptcy claims of approximately $437,000,000 have been asserted against PMI. The Company has disputed substantially all of these unresolved bankruptcy claims and has filed objections to such claims. Management and its counsel believe that substantially all of these claims will be dismissed and disallowed. Any claims not disallowed will be satisfied by issuance of the Company's common stock. In accordance with SOP 90-7, the consolidated financial statements have given full effect to the issuance of the Company's common stock. The Company believes that the resolution of these claims will not have a material adverse effect on the Company's consolidated financial position or results of operations. In addition to the foregoing legal proceedings, the Company is involved in various other proceedings incidental to the normal course of its business. Management does not expect that any of such other proceedings will have a material adverse effect on the Company's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted during the fiscal quarter ended December 31, 1993 to a vote of the security holders of the Company. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Company's common stock, par value $.01 per share, commenced trading on the New York Stock Exchange (the "NYSE") on August 3, 1992 under the symbol "PDQ." As of March 10, 1994 there were 29,200,204 shares of common stock outstanding. The Company's Plan of Reorganization ("the Plan") provided for the issuance of 33,000,000 shares of common stock to holders of claims under the Plan. The number of shares ultimately distributed under the Plan could be less than 33,000,000 shares depending on the final outcome of disputed claims. In addition, the Company has issued warrants to purchase an aggregate of 2,106,000 shares of common stock. The warrants are not listed on any exchange. The following table sets forth the reported high and low closing sales prices of the common stock on the NYSE. As of March 10, 1994, the closing sales price of the common stock on the NYSE was $7 1/8. As of March 10, 1994, there were approximately 3,422 holders of record of common stock. Prime does not anticipate paying any dividends on the common stock in the foreseeable future. Covenants contained in certain of the Company's debt securities prohibit Prime from paying cash dividends. Item 6. Item 6. Selected Financial Data The Company is the successor in interest to PMI. The Company implemented "fresh start" reporting pursuant to the Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" of the American Institute of Certified Public Accountants, as of the Effective Date. Accordingly, the consolidated financial statements of the Company are not comparable in all material respects to any such financial statement as of any date or any period prior to the Effective Date. Subsequent to the Effective Date, the Company changed its fiscal year end from June 30 to December 31. The table below presents selected consolidated financial data derived from: (i) the Company's historical financial statements for the year ended December 31, 1993, (ii) the Company's historical financial statements as of and for the five month period ended December 31, 1992, (iii) the Company's "fresh start" balance sheet as of the Effective Date, and (iv) the historical consolidated financial statements of PMI for the one month ended July 31, 1992 and for each of the four years in the period ended June 30, 1992. This data should be read in conjunction with the Consolidated Financial Statements. - ---------------- (1) PMI filed for chapter 11 bankruptcy protection on September 18, 1990, at which time it owned or managed 141 hotels. During its approximately two-year reorganization, PMI restructured its assets, operations and capital structure. On the Effective Date, the Company emerged from chapter 11 reorganization with 75 owned or managed hotels (as compared to 141 owned or managed hotels prior to the chapter 11 reorganization) $135.6 million of stockholders' equity and $266.4 million of long-term debt. (2) PMI effectively discontinued the operations of its franchise segment on July 1, 1990, with the sales of the Howard Johnson, Ramada and Rodeway franchise businesses in July 1990. (3) Approximately $2.3 million, $28.0 million and $25.3 million of contractual interest expense during the one month ended July 31, 1992 and for the fiscal years ended June 30, 1992 and 1991, respectively, was not accrued and was not paid due to the chapter 11 proceeding. Item 6. (Continued) Selected Quarterly Financial Data (Unaudited) Quarterly financial data for the years ending December 31, 1993 and 1992 is presented as follows (in thousands, except per share amounts). (a) Gross profit is defined as net revenues less direct operating expenses, other operating and general expenses and depreciation and amortization expense. (b) Certain quarterly data has been reclassified to conform with the December 31, 1993 presentation. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations General The Company is the successor in interest to PMI, which emerged from chapter 11 reorganization on the Effective Date. During its approximately two-year reorganization, PMI restructured its assets, operations and capital structure. As a result, the Company (i) eliminated numerous unprofitable lease and management agreements, (ii) revalued its assets to reflect the then approximate current fair market value of such assets on its financial statements and (iii) reduced its liabilities by approximately $500 million. On the Effective Date, the Company emerged from chapter 11 reorganization with 75 owned or managed hotels (as compared to 141 hotels prior to the chapter 11 reorganization), $135.6 million of total equity and $266.4 million of long-term debt. Since the Effective Date, the Company has taken the following actions to further strengthen its operations and financial condition: - Reduced overhead costs, reconstituted its management team and recruited new senior management to the Company that is responsible to a new, independent board of directors; - Converted a portion of its notes, mortgages and other assets to cash or hotel operating assets that provided the Company with approximately $61.0 million in cash and six operating hotel properties obtained through settlements or lease expiration; - Repaid approximately $87.0 million of its long-term debt using the cash proceeds from conversions of other assets, tax refunds and income generated from Hotel operations; - Formulated and began implementing a hotel development and improvement plan pursuant to which the Company purchased one full- service hotel and built one new Wellesley Inn in 1993; and - Allocated more than 6.0% of its hotel revenues during this period to enhance the product quality and market position of its existing Hotels, including repositioning eight Hotels and changing the franchise affiliations of four of such Hotels. The following table sets forth certain operating data for the five year period ended December 31, 1993 with respect to the 41 Owned Hotels that were in the Company's portfolio on December 31, 1993 since the later of the year in which they were acquired or January 1, 1989. The data includes full year operating results for hotels that the Company previously managed and then acquired during the year. (1) Gross operating profit is defined as total hotel revenues less direct hotel operating expenses including room, food and beverage and selling and general expenses. - -------------- The Company's operating results for the five-year period from 1989 to 1993 were principally impacted by the overall trends in the U.S. lodging industry. In 1990 and 1991, occupancy and ADR declined due to the oversupply of hotel rooms and the weakness in demand due to the general slowdown in the U.S. economy. Beginning in 1992, the demand for hotel rooms increased primarily due to improved economic conditions in the United States. Coupled with the lack of new hotel supply, occupancy, ADR and REVPAR improved. In 1993, occupancy, ADR and REVPAR continued to rise due to improving industry fundamentals, the stabilization of the Company's Wellesley Inns and AmeriSuites and the positive effects of the capital investments made by the Company to improve product quality through repositionings of hotels. Over the five-year period ended December 31, 1993, gross operating profit was most affected by (i) the mix of the Company's limited- service hotels as compared to full-service hotels, (ii) labor and related costs and (iii) strategic marketing initiatives. The five Wellesley Inns added to the Company's portfolio generated high gross operating margins and allowed the Company to increase margins in 1990 despite a difficult economic environment. In 1991 and 1992, the positive impact on gross operating profits from the addition of the Wellesley Inns were offset by (i) above inflation rate increases in direct hotel labor and related expenses (including wages, health care benefits and workman's compensation), (ii) the Company's decision to increase advertising and promotions (including hiring additional sales staff, providing additional guest services such as enhanced continental breakfasts and increasing outdoor advertising and direct mail marketing campaigns) and (iii) the reallocation of previously centralized costs to specific hotels. In 1993, gross operating profit improved primarily due to the stabilization of labor and related costs and increased sales volumes. Given the current positive industry fundamentals and the Company's proposed new hotel development and acquisition refurbishment programs, the Company believes it will continue to benefit from operating leverage. Results of Operations for Year Ended December 31, 1993 Compared to Year Ended December 31, 1992 The Company implemented "fresh start" reporting in accordance with Statement of Position 90-7 of the American Institute of Certified Public Accountants upon its emergence from reorganization on the Effective Date. Under "fresh start" reporting, the purchase method of accounting was used and the assets and liabilities of the Company were restated to reflect their approximate fair value at the Effective Date. In addition, during the reorganization period (September 18, 1990 to the Effective Date), the Company's financial statements were prepared under accounting principles for entities in reorganization which includes reporting interest expense only to the extent paid and recording transactions and events directly associated with the reorganization proceedings. Accordingly, the consolidated financial statements of the Company are not comparable in all material respects to any such financial statement as of any date or for any period prior to the Effective Date. Subsequent to the Effective Date, the Company elected to change its fiscal year end from June 30 to December 31. For purposes of an analysis of the results of operations, comparisons of the Company's results of operations for the year ended December 31, 1993 to the prior year are made only when, in management's opinion, such comparisons are meaningful. Prior to the Effective Date, the Company did not employ "fresh start" reporting thereby making comparisons of certain financial statement data prior to such date less meaningful. The financial information set forth below presents the revenues and expenses which can be compared. The table excludes the items which were impacted by the changes in accounting such as interest expense, occupancy and other operating expense and depreciation expense for the years ended December 31, 1992 and 1993. The financial information should be read in conjunction with the consolidated financial statements of the Company included elsewhere in this report. Since the Company changed its fiscal year in 1992, management has compiled unaudited data for the calendar year ended December 31, 1992. The direct revenues and expenses of the Owned Hotels are classified into three categories: comparable hotels, new hotels and divested hotels. The following discussion focuses primarily on the 29 comparable hotel properties which were owned or leased by the Company during the entire two years presented. The 12 hotels classified as new hotels are composed of four new AmeriSuites hotels which were opened after December 31, 1991, a full-service Ramada Inn in Meriden, Connecticut which was purchased in July 1993, a newly constructed Wellesley Inn in Orlando, Florida which opened in November 1993 and six hotel properties which were added through settlements of mortgages and notes receivable and lease expirations. The hotels classified as divested hotels are composed of three hotel properties divested primarily as a result of property restructurings in 1992 and the Holiday Inn in Milford, Connecticut which was sold in September 1993. Room revenues increased by $7.1 million or 11.4% for the year ended December 31, 1993 over the prior year due to the impact of new hotels and improved occupancy and room rates at comparable hotels. The increase was partially offset by a decrease in room revenues as a result of the divestiture of hotels. Room revenues for comparable hotels increased by $3.5 million or 6.8% for the year ended December 31, 1993 compared to the prior year. The increase was primarily due to improved occupancy which increased 5.9% in 1993 reflecting improved economic conditions and the limited new construction of hotels. Average daily room rates were slightly higher in the year ended December 31, 1993 compared to the prior year, increasing by $1.30 or 2.4% over the prior year. The Company's comparable full-service hotels had an average occupancy of 69.3% for the year ended December 31, 1993 as compared to 65.2% in 1992. Average occupancy at the seven comparable Wellesley Inns in Florida remained relatively stable at approximately 90% while average occupancy at the three comparable Wellesley Inns in the Northeast increased to 73.4% for the year ended December 31, 1993 from 61.3% in 1992 primarily as a result of improved direct marketing efforts. Significant occupancy increases were also reported at the four comparable AmeriSuites hotels all of which were opened within the past four years. The average occupancy at the comparable AmeriSuites hotels increased to 67.7% for the year ended December 31, 1993 from 63.7% in 1992 reflecting stabilization of these hotels and their increased recognition in the market. Food and beverage revenues decreased by $792,000 or 6.1% for the year ended December 31, 1993 as compared to 1992 because all of the divested hotels contained food and beverage operations while many of the new hotels are limited-service hotels. Food and beverage revenues for comparable hotels increased by 5.3% for the year ended December 31, 1993 compared to the prior year primarily as a result of increased beverage revenues at the Company's sports lounges located in two Franchised Hotels. Management and other fees consist of base and incentive fees earned under management agreements, fees for additional services rendered to Managed Hotels and sales commissions earned by the Company's national sales group, MSI. The base and incentive fees comprise approximately 60% or $6.5 million of total management and other fees for the year ended December 31, 1993. Management and other fees decreased by $621,000 for the year ended December 31, 1993 as compared to the prior year primarily due to a decrease in charges for additional services. In addition, during the year ended December 31, 1993, the number of Managed Hotels declined by five due to property divestitures by independent owners, two of which were acquired by the Company. The decreases have been partially offset by increases in management fees attributable to increased hotel occupancies and higher incentive related performance fees. Interest income on mortgages and notes decreased by $5.3 million for the year ended December 31, 1993 as compared to the prior year primarily due to the Company's early collection of a note receivable with a face amount of $58.0 million in August 1992. Interest income for the year ended December 31, 1993 primarily related to mortgages secured by 12 Managed Hotels. Approximately $4.3 million or 28.8% of interest income is derived from the Company's $50 million note receivable secured by the Frenchman's Reef. For the year ended December 31, 1993, operating profits improved for the Frenchman's Reef over the prior year due to the stronger economy, the new affiliation with Marriott and product improvements and cost controls at the hotel. The Company's proposed mortgage restructuring is intended to provide the Company with ownership and control of the Frenchman's Reef. If consummated, the impact of this restructuring on operating income is expected to be minimal as direct revenues, expenses and depreciation would increase and interest income would decrease. In the year ended December 31, 1993, interest income also includes $976,000 recognized on subordinated mortgages which have been assigned no value on the Company's balance sheet due to substantial doubts as to their recoverability. These subordinated mortgages generated interest income primarily due to declines in interest rates on the variable rate mortgages senior to the Company's positions on these hotels. Direct room expenses increased by $1.6 million or 9.0% for the year ended December 31, 1993 over the prior year, as the increased occupancy of the comparable hotels combined with the new hotels more than offset the impact of the divested full-service hotels. Direct room expenses for comparable hotels increased by 6.0% for the year ended December 31, 1993 over the prior year primarily due to increased expenses associated with the higher occupancy levels including payroll costs, guest room supplies and reservation fees. In addition, the increase is also attributable to higher health benefits and worker's compensation expenses which have risen faster than the general inflation rate over the past three years. Direct room expenses as a percentage of room revenues decreased to 28.0% in 1993 as compared to 28.6% in 1992 primarily due to the impact of the divested hotels. Direct room expenses as a percentage of room revenues for comparable hotels were approximately 27% in 1993 and 1992 as the Company was able to increase room rates to offset the increases in costs. Direct food and beverage expenses decreased by $1.2 million or 10.3% primarily due to the impact of divested full-service hotels. Direct food and beverage expenses for comparable hotels increased by 2.4% for the year ended December 31, 1993 over the prior year. Direct food and beverage expenses as a percentage of food and beverage revenues for comparable hotels decreased to 84.3% for the year ended December 31, 1993 as compared to 86.7% for the year ended December 31, 1992. This improvement reflects the increase in beverage sales which have a lower cost of sales percentage versus food sales. Direct selling and general expenses consist primarily of hotel expenses which are not specifically allocated to rooms or food and beverage activities such as administration, selling and advertising, utilities and repairs and maintenance. Direct selling and general expenses decreased by $1.7 million or 7.6% as the divested hotels were all full-service operations which generally require increased overhead to support food and beverage operations. Direct selling and general expenses for comparable Hotels increased by only 1.2% for the year ended December 31, 1993 over the prior year primarily due to the restructuring of the Company's centralized operations which eliminated certain allocated central office charges. These cost savings were offset by higher utility charges as a result of the unusually warm summer in 1993. General and administrative expenses consist primarily of centralized management expenses such as operations management, sales and marketing, finance and hotel support services associated with operating both the Owned and Managed Hotels and general corporate expenses. For the year ended December 31, 1993, general and administrative expenses consisted of $11.7 million of centralized management expenses and $4.0 million in general corporate expenses. General and administrative expenses decreased by $1.5 million or 8.6% for the year ended December 31, 1993 as compared to the prior year primarily due to the restructuring of the Company's centralized management operations in February 1993 which eliminated approximately $2.5 million of annual costs. Other income consists primarily of a gain on the sale of a hotel of $1.0 million, settlement of closing adjustments of $625,000 related to the sale of a hotel in a prior year, interest of $1.2 million received as part of a federal tax refund and $500,000 received in settlement of prior year's fees on a Managed Hotel. The pre-tax extraordinary gains of $6.8 million in 1993 relate to the repurchase of debt. Pre-tax extraordinary gains of approximately $187,000 will be recognized in the first quarter of 1994 related to additional repurchases. See "Management's Discussion and Analysis of Financial Condition and Results of Operation- Liquidity and Capital Resources." Six Months Ended December 31, 1992 Compared to Six Months Ended December 31, The following discussion and analysis is based on the historical results of operations of the Company for the six-month periods ended December 31, 1992 and 1991. For purposes of the following discussion, comparisons of the Company's results of operations for the six-month period ended December 31, 1992 to the same period in the prior year are made only when, in management's opinion, such comparisons are meaningful. The financial information set forth below should be read in conjunction with the consolidated financial statements of the Company included elsewhere in this report. The following table presents the Company's condensed income statements for the six months ended December 31, 1992 and 1991 (in thousands): The Company's results of operations for the six months ended December 31, 1992 changed dramatically from the comparable period of the prior year. As a result of the Chapter 11, hotel properties were disposed of through lease rejection, lease expiration, contract termination or sale. The following table presents the direct revenues and expenses of the Company's owned and leased hotel properties for the six months ended December 31, 1992 and 1991. The hotel properties are classified into three categories: comparable hotels; new hotels; and divested hotels. The following discussion focuses on the 29 comparable hotel properties which were owned or leased by the Company during the two periods presented. At December 31, 1992, the Company owned or leased 34 hotel properties. Three new hotel properties which were opened after June 30, 1991 and two hotel properties which were added through note receivable settlements in 1992 are classified as "New Hotels". The hotel properties divested primarily as a result of the Chapter 11 are classified as "Divested Hotels". Owned and Leased Properties (In thousands, except for statistical information) Room revenues for comparable hotels increased by $1.1 million or 4.1% for the six months ended December 31, 1992 compared to the same period in the prior year. The increase was due to improved occupancy while average daily rate remained even with the prior year. The gain in occupancy was primarily attributable to the improved results at three AmeriSuites hotels, which were opened in the second half of 1990. In addition, occupancy increased at six Wellesley Inns located in Florida partially, as a result of Hurricane Andrew. The Company's inability to increase room rates was caused by the slowdown in the economy, particularly in the Northeast and increased competition. Food and beverage revenues for comparable hotels for the six months ended December 31, 1992 were relatively even with the same period in the prior year, as a result of the recession in the Northeast where the majority of the Company's food and beverage outlets are located. Room expenses as a percentage of room revenues for comparable hotels increased to 28.0% for the six months ended December 31, 1992 from 26.9% for the same period in the prior year. Food and beverage expenses as a percentage of food and beverage revenues for comparable hotels increased to 89.0% from 78.8% for the same period in the prior year. The increases in the percentage of expenses to revenues were primarily attributable to increased labor-related operating costs. In particular, health benefits and workers' compensation costs have increased at rates greater than inflation. Selling and general expenses for comparable hotels increased by 11.1% for the six months ended December 31, 1992 over the same period in the prior year primarily due to hiring of additional sales staff, sales training programs and increased advertising and sales promotion expenses. The following table presents the Company's other revenues and expenses for the six months ended December 31, 1992 and 1991 which are not considered direct operating revenues and expenses of the owned and leased hotels and which were not affected by accounting changes due to the reorganization and, therefore, can be compared. Other Revenues and Expenses (In thousands) The Company derived management fees from the hotel properties it managed based on a fixed percentage of gross revenues and charges for certain other services rendered. Under certain agreements, the Company was also eligible to receive performance-related incentive payments. The Company managed 28 of its 34 owned and leased hotel properties and managed 50 hotel properties for third party owners. Management fees increased by $0.4 million for the six months ended December 31, 1992 as compared to the same period of the prior year primarily due to incentive payments. The Company had a concentration of short-term management agreements with a limited number of related and third party owners. Fees derived from these agreements were approximately $3.3 million or 57% of the total management and other fees recognized during the six months ended December 31, 1992. Interest and dividend income decreased for the six months ended December 31, 1992 as compared to the same period of the prior year primarily due to a $58 million reduction in the principal amount of a note receivable arising from a note prepayment by New World Development Co., Ltd. in August 1992. General and administrative expenses decreased by 22.9% for the six months ended December 31, 1992 as compared to the same period of the prior year primarily due to staff reductions in administrative areas. Based on settlement negotiations and declines in cash flow generated by a hotel property, the Company recorded $13.0 million in valuation writedowns and reserves in July 1992 related to mortgages and notes receivable. Fiscal Year Ended June 30, 1992 Compared to Fiscal Year Ended June 30, 1991 PMI's results of operations for the years ended June 30, 1992 and 1991 changed dramatically from the prior years. On September 18, 1990 (the "Petition Date"), PMI and certain subsidiaries filed voluntary petitions in the Bankruptcy Court. Immediately after the Petition Date, the Company performed a detailed analysis of the operating performance of the 141 hotel properties that it operated either through ownership, lease or management. The 141 hotel properties were comprised of 81 owned or leased hotel properties and 60 hotel properties managed by PMI for third parties. As a result of the analysis 54 owned and leased hotel properties and 15 managed hotel properties were identified for disposal through lease rejection, lease expiration, contract termination or sale. The majority of the disposals occurred during the second and third quarters of fiscal 1991. In 1991, management segregated its hotel properties into Core Properties (those properties which PMI intended to retain) and Non-Core Properties (those properties intended for disposition). The following table presents the direct revenues and expenses of PMI's owned and leased Core and Non-Core Properties as shown in the accompanying consolidated statements of operations for the years ended June 30, 1992 and 1991. The discussion and analysis of direct revenues and expenses that follows the table focuses solely on the 30 owned and leased Core Properties that will continue to be owned or leased. Owned and Leased Properties (In thousands of dollars, except for statistical information) Room revenues for the 30 owned and leased Core Properties increased by $3.2 million in 1992 as compared to the prior year. Food and beverage revenues for such properties increased by $.4 million in 1992 as compared to the prior year. The increases were due to the opening of 3 new hotel properties in 1992 and the full year impact of 7 hotel properties opened in the first half of fiscal 1991. PMI experienced a decline in average daily rate which was offset by increased occupancy in 1992. The results were impacted by the slowdown in the economy, particularly in the Northeast, and increased competition resulting from the oversupply of hotels. Direct expenses as a percentage of revenues for rooms for the 30 owned and leased Core Properties increased to 26% in 1992 from 24% in 1991. Direct expenses as a percentage of revenues for food and beverage increased to 82% in 1992 from 80% in 1991. The increases were attributable to payroll and other fixed expenses which increased at inflation rates while revenues remained relatively stable. PMI derived management fees from the hotel properties it manages based on a fixed percentage of gross revenues and charges for services rendered. Under certain agreements, PMI was also eligible to receive performance-related incentive payments. PMI managed 24 of its 30 owned and leased Core Properties and managed 48 hotel properties for third parties as part of its core business. Management fees increased by $2.2 million in 1992, as compared to the prior year, primarily due to the increased level of services billed to third party owners. Interest income was derived primarily from PMI's portfolio of mortgage notes and other notes receivable. Certain of the notes held by PMI were received as part of the consideration for the sale of hotel properties, for services rendered or in connection with the development of hotel properties. PMI generally obtained contracts to manage the hotel properties securing the mortgages and notes and guaranteed that certain hotel properties would generate specific levels of cash flows which would enable the owners and investors to meet various obligations, including interest on the mortgage notes receivable. Other notes arose from loans to developers and operators of hotel properties and from transactions related to PMI's discontinued franchise operations. As a result of the oversupply of hotels and the slowdown of the economy, certain of the properties securing the notes experienced decreased operating cash flows and have been unable to pay some or all of the interest and principal due on the notes. Most of PMI's obligations to the owners and investors under financial guarantees were terminated as a result of PMI's bankruptcy filing. Accordingly, PMI suspended the accrual of interest on the related notes during September 1990 and began recognizing interest income only as cash was received. Interest and dividend income decreased by $7.0 million in 1992, versus the prior year, primarily as a result of the suspension of the accrual of interest in September 1990. Other operating and general expense decreased throughout 1992 primarily due to the elimination of expenses associated with properties disposed of as part of the Chapter 11. The most significant decrease is attributable to rent expense as properties operated under lease agreements with an annual rent expense of approximately $47 million were rejected as part of the Chapter 11 in 1991. Depreciation and amortization expense decreased in 1992 due to the impact of the disposition of hotel properties during 1991 and 1992. This was offset by the depreciation related to the new hotel properties. Interest expense declined in 1992, versus the prior year, as PMI discontinued accruing interest on certain debt obligations subject to compromise as of the Petition Date. Interest expense would have been higher by $28 million for the year ended June 30, 1992 had the Debtors' not filed for Chapter 11. If such interest expense had been recorded, the reported losses in 1992 would have increased. These debt obligations included $230 million aggregate principal amount of convertible subordinated debentures, the $110 million remaining balance under a bank credit agreement, and certain other notes to banks and others of approximately $58 million. Interest expense also decreased due to the reduction in interest rates throughout the year. Reorganization expenses consisted primarily of professional fees and other expenses of $19.3 million, estimated claims arising from bankruptcy of $6.0 million and losses on the disposal of assets of $2.3 million, offset by interest earned of $4.4 million on accumulated cash resulting from the Chapter 11. PMI also recorded $62.1 million in valuation writedowns and reserves in 1992 as part of the restructuring of its business. These items relate to mortgages and notes receivable of $49.5 million, land and buildings of $9.0 million, and other items of $3.6 million. The disproportionate tax rates in 1992 and 1991 resulted primarily from accounting losses for which deferred income tax credits cannot be recognized and state income taxes. Liquidity and Capital Resources The Company believes that it has sufficient financial resources to provide for its working capital needs, capital expenditures and debt service obligations in 1994. The Company anticipates meeting its future capital needs through a combination of existing cash balances, projected cash flow from operations, conversion of Other Assets to cash, and a portion of the proceeds from debt or equity offerings. Additionally, the Company may in the future incur mortgage financing on certain of its 15 unencumbered properties or enter into alliances with capital partners to provide additional funds for the development and acquisition of hotels to the extent such financing is available. At December 31, 1993, the Company had cash and cash equivalents of $41.6 million and restricted cash of $11.0 million, which was primarily collateral for various debt obligations. Cash flow from operations was approximately $19.7 million for the year ended December 31, 1993. Cash flow from operations exceeded income before extraordinary items of $8.2 million due to non-cash items such as depreciation and amortization of $7.1 million and the utilization of net operating loss carryforwards ("NOL's") of $4.5 million. At December 31, 1993, the Company has NOL's relating to its predecessor, PMI, of approximately $121.0 million which, subject to annual limitations, expire beginning in 2005 and continuing through 2008. The Company's other major sources of cash for the year ended December 31, 1993 were proceeds from asset settlements and scheduled collections of mortgages and notes receivable of $10.9 million and refunds of Federal income taxes of $17.7 million (of which approximately $1.2 million related to interest and was recorded as other income) related to PMI. The Company's major uses of cash for the year ended December 31, 1993 were debt repurchases and required principal payments of $30.9 million and capital expenditures of $14.3 million. During 1993, the Company repurchased $500,000 of its Senior Secured Notes, $16.5 million of its Junior Secured Notes and $8.8 million of its mortgage notes payable for an aggregate purchase price of $19.0 million. The repurchases were funded through internal sources of $17.5 million and additional borrowings of $1.5 million. As of March 15, 1994, the Company had repurchased during 1994 $7.2 million of its Senior Secured Notes and Junior Secured Notes for an aggregate purchase price of $7.0 million. During the first quarter of 1994, the Company also purchased through a third party agent approximately $5.2 million of its Senior Secured and Junior Secured Notes for aggregate consideration of $4.8 million. These notes are currently held by the third party agent and have not been retired due to certain restrictions under the note agreements. The purchases will be recorded as investments on the Company's balance sheet and no gain will be recorded on these transactions by the Company until the notes mature or are redeemed. The Company has a fully-secured demand credit agreement which permits borrowing of up to $5.0 million. This facility is supported by a certificate of deposit which is maintained by the lender. The Company currently has debt obligations of $19.3 million, $8.9 million and $42.8 million due in 1994, 1995, and 1996, respectively. Approximately $14.3 million, $5.0 million and $4.1 million of the debt due in 1994, 1995 and 1996, respectively, is owed by Suites of America. Of the approximately $14.3 million of Suites of America's debt due in 1994, approximately $9.2 is owed to ShoLodge and scheduled to mature in April 1994. The Company believes it will be able to refinance that debt with ShoLodge due to its relationship as a potential joint venture partner. Upon exercise of an option by either the Company or ShoLodge under a joint venture agreement, ShoLodge will hold a 50% equity interest in Suites of America and $9.1 million of its debt will be converted into equity of the joint venture. The remaining debt owed to ShoLodge will become debt of the joint venture with a five-year maturity. In addition, the Company has $34.0 million of debt obligations related to the Frenchman's Reef due in December 1996. The Company believes it will be required to seek an extension of the maturity of such debt or refinance it. The debt is secured by a first mortgage note receivable held by the Company with a book value of $50.0 million. See "Business--Lodging Operations--Franchised Hotels," "Business--Lodging Operations--AmeriSuites" and Note 9 to the Notes to the Consolidated Financial Statements. Capital Investments. The Company is implementing a hotel development and acquisition program, which focuses on its proprietary limited-service brands, Wellesley Inns and AmeriSuites, and on strategically positioned full-service hotels. In November 1993, the Company opened its newly constructed Wellesley Inn in Orlando, Florida. The Company is constructing a new Wellesley Inn in the Sawgrass section of Fort Lauderdale, Florida and has begun development of a Wellesley Inn site in Lakeland, Florida. The Company plans to acquire and convert two additional Wellesley Inns in 1994. The Company has also purchased a site in Tampa, Florida for planned construction of an AmeriSuites hotel. The Company plans to develop two additional AmeriSuites in 1994. The Company is also evaluating opportunities to acquire and rehabilitate existing full-service hotels either for its own portfolio or with investors. As part of the Company's full-service acquisition program, the Company acquired the Ramada Inn in Meriden, Connecticut in July 1993. The Company spent $7.8 million on its development and acquisition program in 1993. The Company anticipates capital spending for its hotel development and acquisition programs in 1994 will range between $35 and $40 million. No assurance can be given that the Company will locate suitable acquisitions and therefore will complete such capital expenditures in 1994. The Company is pursuing a program of refurbishing its Owned Hotels and repositioning them in order to meet the local market's demand characteristics. In some instances, this may involve a change in franchise affiliation. The refurbishment and repositioning program primarily involves Hotels which the Company has recently acquired through mortgage foreclosures or settlements, lease evictions/terminations or acquisitions. In 1993, the Company spent approximately $5.0 million on capital improvements at its Owned Hotels, of which $2.5 million related to refurbishments and repositionings on eight Owned Hotels. The Company intends to spend approximately $7.1 million on capital improvements related to its refurbishment and repositioning program at its Owned Hotels in 1994. Of this amount, $5.1 million relates to refurbishments and repositionings on eight Owned Hotels, which includes five hotels that were being refurbished in 1993 and will continue to be refurbished in 1994. Asset Realizations. The Company continues to negotiate settlements with mortgage and note obligors, from which it anticipates receiving cash or operating hotel assets. The Company intends to use the cash proceeds from asset conversions for debt repayments and general corporate purposes. In June 1993, the Company reached a settlement of an adversary proceeding regarding a note and promissory guarantee commenced by a subsidiary of PMI during PMI's bankruptcy case (the "Rose and Cohen Settlement") with Allan V. Rose ("Rose") and Arthur G. Cohen ("Cohen"). The settlement provided for Rose or his affiliate to pay the Company the sum of $25.0 million, all of which was paid into escrow on February 25, 1994, plus proceeds from approximately 1.1 million shares of the Company's common stock held by Rose which will be liquidated over a period of time. The Rose and Cohen Settlement is subject to a claim on the entire amount by Financial Security Assurance, Inc. ("FSA"). All proceeds from the Rose and Cohen Settlement must continue to be held in escrow until the Company receives an order of the U.S. Bankruptcy Court for the Southern District of Florida determining the Company's exclusive right to the settlement proceeds. A trial was held on such claim in such court in January 1994. The Company expects an order to be issued by that court in the near future, which order will be subject to appeal. Upon receipt of a favorable order, substantially all of the net proceeds will be used to repay the Senior Secured Notes and Junior Secured Notes. The Company has entered into a restructuring agreement relating to its mortgage notes receivable secured by the Frenchman's Reef with the general partner of Frenchman's Reef Beach Associates ("FRBA"), the owner of the hotel. In conjunction with the agreement, FRBA filed a pre-negotiated chapter 11 petition in September 1993. The plan of reorganization dated October 21, 1993 provides for the Company to receive ownership and control of the hotel through a 100% equity interest in the reorganized FRBA. The plan also provides for the existing equity holders and any other impaired claim holders to participate in excess cash flow above specified levels and all administrative and unsecured trade claims incurred in the ordinary course of business to be paid in full. There can be no assurance that the plan will become effective. A group purporting to represent a significant number of limited partners has filed an objection to the disclosure statement related to such plan and seeks to replace the Frenchman's Reef's general partner with a new general partner that may seek to redirect the bankruptcy proceedings in a way that may be materially adverse to the Company. In light of this uncertainty, the Company intends to pursue a foreclosure of its mortgages and has filed a motion with the bankruptcy court seeking to lift the stay of relief under the chapter 11 petition to permit a commencement of a foreclosure action. The motion is subject to approval by the Bankruptcy Court. Due to, among other factors, the contingent nature of bankruptcy proceedings, there can be no assurance of when and if any court approval will be obtained. Certain equity holders of the Frenchman's Reef have challenged the authority of the current general partner of the Frenchman's Reef and requested to replace it as general partner. If these equity holders were to become general partner, they have indicated through court filings that they would investigate the validity and priority of the Company's mortgages. In addition, the Company's management agreement with respect to the Frenchman's Reef could be rejected in connection with the bankruptcy case. The Company had, as of December 31, 1993, $39.6 million of debt secured by the Company's mortgage on the Frenchman's Reef. The Company does not intend to obtain ownership of the Frenchman's Reef unless the lender of such debt consents. The Company has entered into discussion with the lender regarding revising the terms of such debt. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations," "Business--Lodging Operations--Franchised Hotels" and Note 3 to Notes to Consolidated Financial Statements. During 1993, the Company also collected a $5.0 million installment obligation related to the Baltimore Marriott hotel and received $4.0 million in settlement of a mortgage note secured by the East Brunswick, New Jersey Sheraton hotel. During 1993, the Company received the fee interest in a Ramada hotel in Danbury, Connecticut in settlement of its mortgage note receivable. The Company also acquired three hotels through lease expiration or foreclosure, one of which it is presently converting to a Shoney's Inn in Orlando, Florida. In September 1993, the Company sold the Holiday Inn in Milford, Connecticut for a net sales price of $2.4 million. After retiring the property's debt of $1.4 million, the Company received net cash proceeds of $1.0 million from the transaction. Item 8. Item 8. Financial Statements and Supplementary Data. See Index to Financial Statements and Financial Statement Schedules included in Item 14. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Set forth below are the names, ages and positions of the directors and executive officers of the Company: The following is a biographical summary of the experience of the directors and executive officers of the Company: David A. Simon has been President, Chief Executive Officer and a Director since 1992 and Chairman of the Board of the Company since 1993. Mr. Simon was a director of PMI from 1988 to 1992. Mr. Simon was the Chief Operating Officer of PMI from 1988 to 1989 and Chief Executive Officer of PMI from 1989 to 1992 and was an executive officer in September 1990 when PMI filed for protection under Chapter 11 of the United States Bankruptcy Code. John M. Elwood has been a Director and Executive Vice President of the Company since 1992, Chief Financial Officer since 1993 and the Director of Reorganization of the Company during 1992. Mr. Elwood was the Director of Reorganization of PMI from 1990 to 1992. Mr. Elwood was the director of Reorganization of Allegheny International, Inc. from 1988 to 1990 and a Vice President of Mellon Bank, N.A. during 1988. Herbert Lust, II has been a Director since 1992 and Chairman of the Compensation and Audit Committee of the Company since 1993 and Chairman of the Compensation Committee and a member of the Audit Committee of the Company from 1992 to 1993. Mr. Lust was a member of the Committee of Unsecured Creditors of PMI from 1990 to 1992. Mr. Lust is a director of BRT Realty Trust. Leon Moore has been a Director of the Company since 1992 and a member of the Audit and Compensation Committee since 1993. From 1992 to 1993, Mr. Moore was a member of the Compensation Committee. Mr. Moore has been the President, Chief Executive Officer and Chairman of the Board of Directors of ShoLodge, Inc. for more than the past five years. Mr. Moore is a director of the Bank of Nashville. Allen J. Ostroff has been a Director since 1992. Mr. Ostroff was Chairman of the Board of the Company and a member of the Audit Committee from 1992 to 1993. Mr. Ostroff has been a Senior Vice President of the Prudential Realty Group, a subsidiary of the Prudential Insurance Company of America, for more than the last five years. A. F. Petrocelli has been a Director since 1992 and a member of the Compensation and Audit Committee of the Company since 1993 and of the Compensation Committee of the Company from 1992 to 1993. Mr. Petrocelli has been the Chairman of the Board of Directors and Chief Executive Officer of United Capital Corp. for more than the past five years. Paul H. Hower has been an Executive Vice President of the Company since 1993. Mr. Hower was President of Integrity Hospitality Services from 1992 to 1993 and Vice President and Hotel Division Manager of B. F. Saul Co. from 1988 to 1991. Denis W. Driscoll has been a Senior Vice President of the Company since 1993. Mr. Driscoll was President of Driscoll Associates, a human resources consulting organization from 1988 to 1993. John H. Leavitt has been a Senior Vice President of the Company since 1992. Mr. Leavitt was a Senior Vice President of PMI from 1991 to 1992 and a Senior Vice President of Medallion Hotel Corporation from 1988 to 1991. John E. Stetz has been a Senior Vice President of Development of the Company since 1993. Mr. Stetz was a Vice President - Development of Choice Hotels International from 1988 to 1992. Joseph Bernadino has been Senior Vice President, Secretary and General Counsel of the Company since 1993. Mr. Bernadino was an Assistant Secretary and Assistant General Counsel of PMI from 1988 to 1992. Richard T. Szymanski has been a Vice President and Corporate Controller of the Company since 1992. Mr. Szymanski was Corporate Controller of PMI from 1989 to 1992, and Division Controller from 1988 to 1989. Douglas W. Vicari has been a Vice President and Treasurer of the Company since 1992 and was Vice President and Treasurer of PMI during 1992. Mr. Vicari was the Director of Budget and Financial Analysis of PMI from 1989 to 1992, and Budget Manager from 1988 to 1989. Item 11. Item 11. Executive Compensation The following summary compensation table sets forth information concerning compensation for services in all capacities awarded to, earned by or paid to the persons who were, at December 31, 1993, the Company's Chief Executive Officer and the five other most highly compensated executive officers of the Company. The information shown reflects compensation for services in all capacities awarded to, earned by or paid to these persons for the fiscal year ending December 31, 1993. Stock option grants during fiscal year ended December 31, 1993 The following table sets forth information concerning individual grants of stock options made during the fiscal year ending December 31, 1993 to each of the officers listed below. The Company did not grant any stock appreciation rights during such period. (1) These stock options were granted to David A. Simon as a director of the Company in connection with a grant of options to the directors. These stock options vest with respect to 15,000 shares on each of August 4, 1993, 1994 and 1995 and will continue to be exercisable through August 4, 1999, subject to the provisions of the Company's 1992 Stock Option Plan. (2) These stock options were granted to John M. Elwood as a director of the Company in connection with a grant of options to the directors. These stock options vest with respect to 15,000 shares on each of August 4, 1993, 1994, and 1995 and will continue to be exercisable through August 4, 1999, subject to the provisions of the Company's 1992 Stock Option Plan. (3) These stock options vest with respect to one third of the grant on each of June 18, 1994, 1995, and 1996 and will continue to be exercisable through June 18, 1999, subject to the provisions of the Company's 1992 Stock Option Plan. (4) Joseph Bernadino received separate stock option grants of 5,000 shares and 3,000 shares each. One third of the 5,000 share grant vests on each of June 18, 1994, 1995 and 1996 and will continue to be exercisable through June 18, 1999. One third of the 3,000 share grant vests on each of September 1, 1994, 1995 and 1996 and will continue to be exercisable through September 1, 1999. Both grants are subject to the Company's 1992 Stock Option Plan. Aggregated option in fiscal year ended December 31, 1993 and year-end option values Employment Agreement Under the Plan As provided in the Plan, Mr. David A. Simon and the Company executed an employment agreement which provides for an initial term of three years, with automatic successive one-year extensions unless a prior election is made by either party not to extend the agreement. The employment agreement provides for an annual base salary of $300,000 (which will increase annually based upon increases in the consumer price index), a discretionary annual bonus based on attainment of performance objectives set by the Board of Directors, a life insurance policy in an amount not less than $1,000,000, an automobile and other customary welfare benefits, including medical and disability insurance. The agreement also provides that, to the extent payments made by the Company for disability insurance, life insurance and the use of the automobile are subject to federal, state or local income taxes, the Company will pay Mr. Simon the amount of such additional taxes plus such additional amount as will be reasonable to hold him harmless from the obligation to pay such taxes. Pursuant to this employment agreement, Mr. Simon was granted stock options on July 31, 1992 to purchase 330,000 shares of Common Stock. Such stock options are exercisable with respect to 110,000 shares at the end of each of the first, second and third years of his employment, provided his employment has not been terminated by such date. This employment agreement may be terminated by the Company at any time, with or without cause. If the agreement is terminated by the Company prior to the expiration of the initial three-year term without cause, or if Mr. Simon resigns because of circumstances amounting to constructive termination of employment, severance would be paid in a single lump sum equal to one-year's base salary or, if greater, the base salary that would have been payable over the remainder of the initial term. All stock options would become fully vested and remain exercisable for 90 days after termination or, if longer, until the expiration of the initial three year term. Any bonus awarded for the year of termination would be prorated. If the Company does not terminate the agreement prior to the expiration thereof, but elects not to extend the agreement beyond the initial term, severance would be payable in a single lump sum equal to one-year's base salary. If the agreement is terminated by the Company for cause (as such term is defined in the employment agreement), or if Mr. Simon resigns voluntarily under circumstances not amounting to a constructive termination of employment, no benefits are payable other than accrued but unpaid salary. Employment Agreements Subsequent to the Plan As of December 31, 1992, Mr. Elwood and the Company executed an employment agreement which has a term of one year. This employment agreement provides for an annual base salary of $240,000, a discretionary annual bonus based on attainment of performance objectives set by the Board of Directors, a life insurance policy in an amount not less than $480,000 (of which the Company will not pay premiums which exceed $5,000), moving expenses, an automobile, and other customary welfare benefits, including medical and disability insurance. Pursuant to the agreement, Mr. Elwood was granted stock options to purchase 20,000 shares of Common Stock which are now fully vested. The agreement expired on December 31, 1993 by its terms, but was extended on a day to day basis pending negotiation of a new contract. As of May 18, 1993, Mr. Paul H. Hower and the Company executed an employment agreement which has a term commencing June 23, 1993 and ending June 30, 1994. This employment agreement provides for an annual base salary of $180,000, a cash bonus of $10,000. a discretionary annual bonus based on attainment of performance objectives set by the Board of Directors, a life insurance policy in an amount not less than $360,000, moving expenses, an automobile, and other customary welfare benefits, including medical and disability insurance. Pursuant to the agreement, Mr. Hower was granted stock options as of June 23, 1993 to purchase 20,000 shares of Common Stock. Such stock options vest on June 30, 1994 provided his employment has not been terminated by such date. The agreement may be terminated by the Company at any time, with or without cause. If the agreement is terminated by the Company prior to the expiration of the one year term without cause, or if Mr. Hower resigns because of circumstances amounting to constructive termination of employment, severance would be paid in a single lump sum equal to six month's base salary or, if greater, the base salary that would have been payable over the remainder of the term. All other benefits, any bonus (subject to adjustment) and any non-vested stock options (subject to adjustment) will terminate. If the agreement is terminated by the Company for cause (as such term is defined in the agreement), or if Mr. Hower resigns voluntarily under circumstances not amounting to a constructive termination of employment, no benefits are payable other than accrued but unpaid salary. As of March 1, 1993, Mr. John Stetz and the Company executed an employment agreement which has a term of one year. This employment agreement provides for an annual base salary of $115,000, an annual bonus equal to 10% of the first year base management fee for each management agreement obtained, and other customary welfare benefits, including medical and disability insurance. The Agreement expired on February 28, 1994. Stock Option Plans 1992 Stock Option Plan As provided in the Plan, the Company adopted the 1992 Stock Option Plan (the "SOP"), providing for the grant of non-qualified stock options to key employees, officers and directors. The SOP (but not outstanding options) will terminate on July 31, 2002 and is administered by the Audit and Compensation Committee of the Board of Directors (the "Committee"). The Company has reserved 1,320,000 shares of common stock for issuance upon the exercise of stock options under the SOP. During the fiscal year ended December 31, 1993 options covering 728,000 shares of common stock were granted. Recipients of options under the SOP are selected by the Committee. The Committee determines the terms of each option grant including the purchase price of shares subject to options, the dates on which options become exercisable and the expiration date of each option (which may not exceed six years from the date of grant). Of the 728,000 shares covered by option grants under the SOP, 45,000 were granted to Mr. David A. Simon and 45,000 were granted to Mr. John M. Elwood. Options to purchase 152,000 shares of common stock were granted to all current executive officers as a group. The terms of these option grants are described above under the heading "Stock option grants during fiscal year ended December 31, 1993". Recipients of option grants under the SOP will have no voting, dividend or other rights as stockholders with respect to shares of common stock covered by stock options prior to becoming the holders of record of such stock. All stock option grants will permit the exercise price to be paid in cash, by tendering stock or by cashless exercise. The number of shares covered by stock options will be appropriately adjusted in the event of any merger, recapitalization or similar corporate event. The Board of Directors may at any time terminate the SOP or from time to time make such modifications or amendments to the SOP as it may deem advisable; provided that the Board may not, without the approval of stockholders, increase the maximum number of shares of common stock for which options may be granted under the SOP. 1992 Performance Incentive Plan As provided in the Plan, the Company adopted the 1992 Performance Incentive Plan (the "PIP") under which stock options covering an additional 330,000 shares of common stock were reserved for grants to one or more other executives, including those newly hired, at the discretion of Mr. David A. Simon. No options have been granted under the PIP. Mr. Simon will determine the terms of each option grant under the PIP including the purchase price of shares subject to options, the dates on which options become exercisable and the expiration date of each option (which may not exceed six years from the date of grant). Recipients of stock option grants under the PIP will have no voting, dividend or other rights as stockholders with respect to shares of Common Stock covered by stock options prior to becoming the holders of record of such stock. All stock option grants under the PIP will permit the exercise price to be paid in cash, by tendering stock or by cashless exercise. The number of shares covered by stock options under the PIP will be appropriately adjusted in the event of any merger, recapitalization or similar corporate event. The Board of Directors may at any time terminate the PIP or from time to time make such modifications or amendments to the PIP as it may deem advisable; provided that the Board may not, without the approval of stockholders, increase the maximum number of shares of Common Stock for which options may be granted under the PIP or change the class of persons eligible to receive options under the PIP. Audit and Compensation Committee Report on Executive Compensation All members of the Audit and Compensation Committee are independent, non-employee Directors. As provided in the Plan, Mr. Simon and the Company are parties to an employment agreement which provides for an initial term of three years, with automatic successive one-year extensions unless a prior election is made by either party not to extend the agreement. The agreement provides for an annual base salary of $300,000 (which will increase annually based upon increases in the consumer price index) and a discretionary annual bonus based on attainment of performance objectives to be set by the Board of Directors. Pursuant to the Plan and his employment agreement, Mr. Simon was granted options to purchase 330,000 shares of Common Stock. Mr. Simon's employment agreement and option grants were approved by the former directors of the Company. During 1993, no bonus was paid to Mr. Simon pursuant to his employment agreement. The Company's compensation policy is designed to help the Company achieve its business objectives by: - setting levels of compensation designed to attract and retain qualified executive in a highly competitive business environment; - providing incentive compensation that varies directly with both the Company's financial performance and individual initiative and achievement contributing to such performance; and - linking compensation to elements which effect the Company's annual and long-term share performance. The Company intends to compensate executives and to grant stock options pursuant to the SOP in order to provide executives with a competitive total compensation package and reward them for their contribution to the Company's annual and long-term share performance. Compensation Committee Interlocks and Insider Participation Mr. Moore and Mr. Petrocelli have certain business relationships with the Company, which are described under the heading "Certain Relationships and Related Transactions." AUDIT AND COMPENSATION COMMITTEE Herbert Lust, II (Chairman) Leon Moore A. F. Petrocelli Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The following table sets forth as of March 10, 1994, information with respect to the beneficial ownership of the Company's common stock by (i) each person known by the Company to own beneficially 5% or more of the Company's common stock, (ii) each director of the Company, (iii) the Company's Chief Executive Officer and each of the five remaining most highly compensated executive officers, and (iv) all executive officers and directors of the Company as a group. (a) Ingalls & Snyder filed a Schedule 13G, dated February 1, 1994, with the Securities and Exchange Commission (the "SEC") reporting ownership of 2,506,123 shares of common stock, with sole voting power with respect to 208,754 shares and sole dispositive power with respect to 2,506,123 shares. (b) Includes 101,726 shares owned by David A. Simon, 146 shares owned by his wife and 249 shares held by Mr. Simon as custodian for his children. Mr. Simon disclaims beneficial ownership of the shares owned by his wife and held as custodian for his children. Also includes warrants to purchase 6,774 shares with an exercise price of $2.71 a share, of which Mr. Simon disclaims beneficial ownership of 467 warrants owed by his wife and 697 warrants held as custodian for his children. (c) Includes warrants to purchase 12,122 shares with an exercise price of $2.71 a share. (d) Held by a trust under which Mr. Lust and his wife are co-trustees and beneficiaries. (e) These shares are owned by United Capital Corp. Mr. Petrocelli is Chairman of the Board of Directors and Chief Executive Officer of United Capital Corp. (f) Includes warrants to purchase 85 shares with an exercise price of $2.71. (g) The Directors and executive officers each own less than one percent of the outstanding common stock and own approximately one percent of the outstanding common stock as a group. Percentages were based on 29,200,204 shares outstanding as of March 10, 1994. Item 13. Item 13. Certain Relationships and Related Transactions. Leon Moore, a Director of the Company, is the President, Chief Executive Officer and Chairman of the Board of ShoLodge, Inc. ("ShoLodge"). Pursuant to an agreement with the Company and Suites of America, Inc. ("SOA"), a wholly owned subsidiary of the Company, ShoLodge was appointed the exclusive agent to develop certain AmeriSuites hotel properties. ShoLodge is entitled to receive fees for each hotel property developed. In addition, ShoLodge may receive, among other things, a profit sharing interest in certain sites. During the fiscal year ended December 31, 1993, ShoLodge earned development fees of $-0- and loan origination fees of $40,349. As of December 31, 1993, the Company and SOA have outstanding loans in the amount of $18,361,000 owed to ShoLodge and in the amount of $5,066,000 owed to the Bank of Nashville. Mr. Leon Moore is a director of The Bank of Nashville. The foregoing loans are secured by hotel properties owned by SOA. ShoLodge manages eight AmeriSuites hotel properties for the Company. During the fiscal year ended December 31, 1993, ShoLodge earned management fees and incentive fees totalling $468,000 from these AmeriSuites hotel properties. The Company and SOA are parties to agreements with ShoLodge which provide that, under certain circumstances, ShoLodge will contribute hotels to SOA, receive 50% ownership interest, and manage the AmeriSuites hotels owned by SOA pursuant to a new management agreement. In April 1993, the Company sold land located in Flagstaff, Arizona to an affiliate of Mr. Moore for the sum of $1.3 million. Upon its completion of the construction of an AmeriSuites hotel on the land in October 1993, Mr. Moore's affiliate sold the completed hotel to SOA for the sum of $5,875,000. ShoLodge financed a portion of the purchase price and received a mortgage on the hotel in the principal sum of $5,045,000. ShoLodge manages the hotel for SOA. In addition, in May 1993, the Company sold to an affiliate of Mr. Moore land located in Overland Park, Kansas on which the affiliate will build an AmeriSuites hotel for sum of $486,000. During 1993, the Company paid $2,376,000 in cash and cancelled its note receivable of $486,000 in full satisfaction of the profit participation of ShoLodge in four AmeriSuites hotel owned by SOA. An affiliate of Mr. Moore has entered into a contract to build a hotel for the Company in Tampa, Florida for $3,587,900. In April 1993, an affiliate of Mr. Moore completed construction of an AmeriSuites hotel located in Brentwood, Tennessee on land it leased from SOA and sold it to SOA for the sum of $4,035,000. ShoLodge financed the full purchase price and received a deed of trust on the hotel. The lease from SOA to the affiliate was terminated. ShoLodge manages the property for SOA. The Company uses the ShoLodge reservation system for its AmeriSuites and Wellesley Inn hotel properties. The total amount of reservation fees paid to ShoLodge for the fiscal year ended December 31, 1993 was approximately $222,000. A.F. Petrocelli, a Director of the Company, is the Chairman of the Board and Chief Executive Officer of United Capital Corp. In March 1994, the Company entered into management agreements with the corporate owners of two hotels who are affiliates of United Capital Corp. During 1993, the Company managed and held a nonrecourse junior note and mortgage on a hotel property owned partially by a partnership comprised of David A. Simon and certain former officers and directors of the Company. In connection with a settlement in lieu of foreclosure between the first mortgagee and the owners in which the hotel was conveyed to the first mortgagee, the Company discharged its junior mortgage. During 1989, a partnership in which Peter E. Simon, father of David A. Simon, is a partner acquired an interest in three hotels from PMI. In partial payment PMI received nonrecourse junior loans aggregating $21,590,000. As of December 31, 1993, the aggregate balance owed on these loans was $21,472,766. The Company is currently in the process of restructuring these loans. Due to the nonrecourse junior nature of these loans and the insufficient cash generated by the hotels, no debt payments were made on these loans during 1993. During 1989, this same partnership acquired PMI's interest in eight hotel properties. In partial payment PMI received a junior non- recourse mortgage note in the principal amount of $9,647,450. The Company restructured this transaction as of December 1, 1992 by (i) conveying to the partnership its interest in one hotel property, and (ii) amending the principal amount and interest rate of the note to $8,103,362 and 8.2% per annum, respectively. No debt payments were made on these loans during 1993. During February 1990, this same partnership purchased from PMI a note owing from a third party in the original principal amount of $3,255,380. This partnership paid PMI $488,318 in cash and granted PMI an 85% note participation. In partial settlement of its claim on the note, the Company acquired a hotel located in Miami, Florida in which the partnership has a 15% interest. In December 1993, the Company entered into a management agreement with the corporate owner of a hotel in which Peter E. Simon is a stockholder. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1. Financial Statements The Financial Statements listed in the accompanying index to financial statements are filed as part of this Annual Report. 2. Financial Statement Schedules The Financial Statement Schedules listed in the accompanying index to financial statements are filed as part of this Annual Report. 3. Exhibits (2) (a) Reference is made to the Disclosure Statement for Debtors' Second Amended Joint Plan of Reorganization dated January 16, 1992, which includes the Debtors' Second Amended Plan of Reorganization as an exhibit thereto filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (3) (a) Reference is made to the Restated Certificate of Incorporation of the Company dated June 5, 1992 filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (b) Reference is made to the Restated Bylaws of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (4) (a) Reference is made to the Form of 8.20% Fixed Rate Senior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (b) Reference is made to the Form of Adjustable Rate Senior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (c) Reference is made to the Form of 9.20% Junior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (d) Reference is made to the Form of 8.20% Tax Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (e) Reference is made to the Form of 10.20% Secured UND Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (f) Reference is made to the Form of 8% Secured UND Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (g) Reference is made to the Form of 9.20% OVR Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (h) Reference is made to the Collateral Agency Agreement among the Company, U.S. Trust and the Secured Parties, dated as of July 31, 1992 filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (i) Reference is made to the Security Agreement between the Company and U.S. Trust, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (j) Reference is made to the Subsidiary Guaranty from FR Delaware, Inc. to United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (k) Reference is made to the Security Agreement between FR Delaware, Inc. and United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (l) Reference is made to the Subsidiary Guaranty from Prime Note Collections Company, Inc. to United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (m) Reference is made to the Security Agreement between Prime Note Collections Company, Inc. and United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (n) Reference is made to a Form 8-A of the Company as filed on June 5, 1992 with the Securities and Exchange Commission, as amended by Amendment No. 1 and Amendment No. 2, which is incorporated herein by reference. (10) (a) Reference is made to the Agreement of Purchase and Sale between Flamboyant Investment Company, Ltd. and VMS Realty, Inc. dated June 3, 1985, and its related agreements, each of which was included as Exhibits to the Form 8-K dated August 14, 1985 of PMI, which are incorporated herein by reference. (b) Reference is made to PMI's Flexible Benefit Plan, filed as an Exhibit to the Form 10-Q dated February 12, 1988 of PMI, which is incorporated herein by reference. (c) Reference is made to the Employment Agreement dated as of July 31, 1992, between David A. Simon and the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (d) Reference is made to the 1992 Performance Incentive Stock Option Plan of the Company dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (e) Reference is made to the 1992 Stock Option Plan of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (f) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and David A. Simon filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (g) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and David L. Barsky filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (i) Reference is made to the Employment Agreement dated as of December 31, 1992 between John Elwood and the Company filed as an Exhibit to the Company's Form 10-K dated March 26, 1993, which is incorporated herein by reference. (j) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and John Elwood filed as an Exhibit to the Company's Form 10-K dated March 26, 1993, which is incorporated herein by reference. (k) Employment Agreement dated as of March 1, 1993 between John Stetz and the Company. (l) Employment Agreement dated as of May 18, 1993 between Paul Hower. (m) Consolidated and Amended Settlement Agreement dated as of October 12, between Allan V. Rose and the Company. (11) Computation of Earnings Per Common Share. (21) Subsidiaries of the Company. (23) (a) Consent of Arthur Andersen & Co. (b) Consent of J.H. Cohn & Co. (b) Reports on Form 8-K: None PRIME HOSPITALITY CORP. AND SUBSIDIARIES AND FINANCIAL STATEMENT SCHEDULES (ITEM 14 (A)) Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the consolidated financial statements or notes thereto. Separate financial statements of 50% or less owned entities accounted for by the equity method have been omitted because such entities considered in the aggregate as a single subsidiary would not constitute a significant subsidiary. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Prime Hospitality Corp.: We have audited the accompanying consolidated balance sheets of Prime Hospitality Corp. (a Delaware corporation) and subsidiaries ("the Company") as of December 31, 1993 and 1992 and the related consolidated statements of income, stockholders' equity and cash flows for the year ended December 31, 1993 and the five months ended December 31, 1992. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Prime Hospitality Corp. and subsidiaries as of December 31, 1993 and 1992 and the results of their operations and their cash flows for the year ended December 31, 1993 and the five months ended December 31, 1992 in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to financial statements and financial statement schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey March 17, 1994 PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS, EXCEPT SHARE DATA) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE DATA) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 NOTE 1 -- BUSINESS OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES Business Activities Prime Hospitality Corp. (the "Company") is a leading independent hotel operating company with ownership or management of full-service and limited-service hotels in the United States and one resort hotel in the U.S. Virgin Islands. The Company's hotels primarily provide moderately priced, quality accommodations in secondary or tertiary markets, and operate under franchise agreements with national hotel chains or under the Company's proprietary Wellesley Inns or AmeriSuites trade names. In addition to its hotel operations, the Company has a portfolio of financial assets including mortgages and notes receivable secured by hotel properties and owns real estate that is not part of its hotel operations. The Company emerged from the Chapter 11 reorganization case of its predecessor, Prime Motor Inns, Inc. and certain of its subsidiaries ("PMI"), which consummated its Plan of Reorganization ("the Plan") on July 31, 1992 (the "Effective Date"). PMI and certain of its subsidiaries had filed for protection under Chapter 11 of the United States Bankruptcy Code in September of 1990. During the reorganization, PMI renegotiated most of its leases, management agreements and debt commitments, resulting in the elimination of a substantial number of unprofitable contract relationships and excessive debt obligations. Basis of presentation Pursuant to the American Institute of Certified Public Accountant's Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"), the Company adopted fresh start reporting as of July 31, 1992. Under fresh start reporting, the reorganization value of the entity was allocated to the reorganized Company's assets on the basis of the purchase method of accounting. The reorganization value (the approximate fair value) of the assets of the emerging entity was determined by consideration of many factors and various valuation methods, including discounted cash flows and price/earnings and other applicable ratios believed by management to be representative of the Company's business and industry. Liabilities were recorded at face values, which approximate the present values of amounts to be paid determined at appropriate interest rates. Under fresh start reporting, the consolidated balance sheet as of July 31, 1992 became the opening consolidated balance sheet of the emerging Company. In accordance with SOP 90-7, financial statements covering periods prior to July 31, 1992 are not presented because such statements have been prepared on a different basis of accounting and are thus not comparable. Principles of consolidation The consolidated financial statements include the accounts of the Company and all of its majority-owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. Cash equivalents Cash equivalents are highly liquid unrestricted investments with a maturity of three months or less when acquired. Restricted cash Restricted cash consists primarily of highly liquid investments that serve as collateral for debt obligations due within one year. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) Mortgages and other notes receivable Mortgages and other notes receivable are reflected at their fair value as of July 31, 1992, adjusted for payments and other advances since that date. The amount of interest income recognized on mortgages and other notes receivable is generally based on the stated interest rate and the carrying value of the notes. The Company has a number of subordinated or junior mortgages which remit payment based on hotel cash flow. Because there is substantial doubt that the Company will recover their face value, these mortgages have not been valued in the Company's consolidated financial statements. Interest on cash flow mortgages and delinquent loans is only recognized when cash is received. Property, equipment and leasehold improvements Property, equipment and leasehold improvements that the Company intends to continue to operate are stated at their fair market value as of July 31, 1992 plus the cost of acquisitions subsequent to that date less accumulated depreciation and amortization from August 1, 1992. Provision is made for depreciation and amortization using the straight-line method over the estimated useful lives of the assets. Properties identified for disposal are stated at their estimated net realizable value. Income taxes The Company and its subsidiaries file a consolidated Federal income tax return. For financial reporting purposes, the Company follows Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109 ("FAS 109"). In accordance with FAS 109, as well as SOP 90-7, income taxes have been provided at statutory rates in effect during the period. Tax benefits associated with net operating loss carryforwards and other temporary differences that existed at the time fresh start reporting was adopted are reflected as a contribution to stockholders' equity in the period in which they are realized. Income per common share Net income per common share is computed based on the weighted average number of common shares and common share equivalents outstanding during each period. The weighted average number of common shares used in computing primary net income per share was 33,808,000 for the year ended December 31, 1993 and 33,000,000 for the five months ended December 31, 1992. The dilutive effect of stock warrants and options during the year ended December 31, 1993 and the five months ended December 31, 1992 was not material (see Note 10). Reclassifications Certain reclassifications have been made to the December 31, 1992 consolidated financial statements to conform them to the December 31, 1993 presentation. NOTE 2 -- CASH AND CASH EQUIVALENTS Cash and cash equivalents are comprised of the following (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 3 -- MORTGAGES AND OTHER NOTES RECEIVABLE Mortgages and other notes receivable are comprised of the following (in thousands): - --------------- (a) These mortgage notes are secured by the Marriott Frenchman's Reef resort hotel, which is managed by the Company, and consist of first and second mortgages with face values of $53,383,000 and $25,613,000, respectively, with final scheduled principal payments of $51,976,000 and $25,613,000 due on July 31, 1995. The notes bear interest at a stated rate of 13%. Interest and principal payments on the first mortgage are payable in monthly installments. Interest and scheduled principal payments on the second mortgage note are payable only to the extent of available cash flow, as defined, with any unpaid interest due at maturity. In connection with the adoption of fresh start reporting, the Company valued the notes at $50,000,000. During the year ended December 31, 1993 and five months ended December 31, 1992, the Company recognized $4,250,000 and $1,770,000 of interest income on these notes, respectively (an effective rate of approximately 8.5%), based on the current level of cash flows generated from the hotel property available to service the notes. During 1993, the Company entered into a restructuring agreement related to these notes with the general partner of Frenchman's Reef Beach Associates ("FRBA"), the owner of the hotel. In conjunction with the agreement, FRBA filed a pre-negotiated Chapter 11 petition in September 1993. The disclosure statement setting forth the plan of reorganization dated October 21, 1993 provided for the Company to receive ownership and control of the hotel through a 100% equity interest in the reorganized FRBA. The plan also provided for the existing equity holders and any other impaired claim holders to participate in excess cash flow above specified levels and all administrative and unsecured trade claims incurred in the ordinary course of business to be paid in full. A group purporting to represent a significant number of limited partners has filed an objection to the disclosure statement and has challenged the authority of the general partner. These holders have also indicated that they intend to challenge the validity of the Company's lien. In light of this uncertainty, the Company intends to defend its position and pursue a foreclosure of its mortgages and has filed a motion to lift the stay of relief under the Chapter 11 petition to permit a commencement of a foreclosure action. The motion is subject to approval by the Bankruptcy Court. In the event that the Company is successful in its foreclosure proceedings and obtains title to the property, the assets and liabilities of the Frenchman's Reef resort hotel will be included in the consolidated financial statements of the Company at an initial net carrying value equal to the carrying value of the notes. (b) From 1988 through 1990, PMI loaned entities controlled by Allan Rose and Arthur Cohen (the "Rose and Cohen entities"), an aggregate of $100,890,000 which was initially fully secured by property and/or PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) personal guarantees. PMI was committed to make additional loans, also on a fully secured basis, to the Rose and Cohen entities of up to an aggregate of $130,000,000 if values of, and/or revenues generated by, certain hotel properties controlled by the Rose and Cohen entities attained specified levels. PMI was to receive a minimum annual return of 10% on all loans made to the Rose and Cohen entities and a maximum return of 20%. All loans and unpaid interest are payable on December 31, 1997. In 1992, certain of the Rose and Cohen entities owning a portion of the collateral that secures the loans filed for Chapter 11 protection in the United States Bankruptcy Court, Southern District of New York. Also during 1992, PMI commenced an adversary proceeding against Rose and Cohen to recover jointly and severally on the personal guarantees of $50,000,000 given by Rose and Cohen as part of the loan agreement. The accrual of interest on the Rose and Cohen note was discontinued in fiscal 1990 and the notes were reflected at their estimated net realizable value. In June 1993, the Company reached a settlement with Allan Rose and Arthur Cohen. The settlement provided for an affiliate of Rose to purchase the notes for the sum of $25,000,000 in cash, which was fully funded into escrow by Rose on February 25, 1994. The Company is also to receive the cash proceeds from approximately 1,100,000 shares of the Company's common stock owned by Rose which will be liquidated over a period of time. In addition, pursuant to the settlement, certain bankruptcy claims against PMI have been withdrawn (see Note 7). The settlement is subject to a claim on the entire amount of the proceeds by Financial Security Assurance, Inc. ("FSA"). A trial was held in the United States Bankruptcy Court for the Southern District of Florida in January 1994 to approve the settlement agreement and resolve FSA's claim on the settlement proceeds. The Company expects an order to be issued by that court in the near future, which may be subject to appeal. All proceeds received pursuant to the settlement must be held in escrow until such order is received. The Company believes that FSA is unlikely to prevail on its claim, and as a result, does not believe it will have a material impact on the financial statements. Upon receipt of a favorable order from the court, substantially all of the net proceeds will be used to retire debt (see Note 6). (c) The Company is the holder of mortgage notes receivable with a book value of $50,670,000 secured primarily by 11 hotel properties operated by the Company under management agreements and $14,653,000 in mortgages secured primarily by 4 properties operated under lease agreements. These notes currently bear interest at rates ranging from 8.5% to 14.0% and mature through 2003. The mortgages were primarily derived from the sales of hotel properties. Many of the 11 managed properties were unable to pay in full the annual debt service required under the terms of the original mortgages. The Company has restructured approximately $36,500,000 of these loans to pay based upon available cash and a participation in the future excess cash flow of such hotel properties. The restructurings generally include a "senior portion" featuring defined payment terms, and a "junior portion" payable annually based on cash flow. The junior portion represents the difference between the original mortgage and the new senior portion and provides the Company the opportunity to recover that difference if the hotel's performance improves. In addition to the junior portions of the restructured mortgages, the Company holds junior or other cash flow mortgages and subordinated interests in 19 other hotel properties operated by the Company under management agreements. The Company's consolidated balance sheets do not reflect any value related to the junior portion of the restructured notes or the junior mortgages and subordinated interests on the 19 other hotels as there is substantial doubt that the Company will recover any of their face value. During 1993, the Company recognized $976,000 of interest income related to these mortgages due to excess cash flow on certain properties attributable to decreased interest expense on variable rate borrowings senior to the Company's positions on these hotels. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) (d) Other notes receivable currently bear interest at effective rates ranging from 4% to 11%, mature through 2011 and are secured primarily by hotel properties not currently managed by the Company. NOTE 4 -- PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS Property, equipment and leasehold improvements consist of the following (in thousands): At December 31, 1993, the Company was the lessor of land and certain restaurant facilities in Company-owned hotels with an approximate aggregate book value of $8,676,000 pursuant to noncancelable operating leases expiring on various dates through 2013. Minimum future rentals under such leases are $10,730,000, of which $3,939,000 is scheduled to be received in the aggregate during the five-year period ending December 31, 1998. Depreciation and amortization expense on property, equipment and leasehold improvements was $7,015,000 for the year ended December 31, 1993 and $2,784,000 for the five months ended December 31, 1992. NOTE 5 -- OTHER CURRENT LIABILITIES Other current liabilities consist of the following (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 6 -- DEBT Debt consists of the following (in thousands): - --------------- (a) Pursuant to the Plan, the Company issued two classes of Secured Notes which are identified as "Senior Secured Notes" and "Junior Secured Notes". Senior Secured Notes were issued in two series of notes which are identified as the "8.20% Fixed Rate Senior Secured Notes" and the "Adjustable Rate Senior Secured Notes". Each series is identical except that the interest rate on the Adjustable Rate Senior Secured Notes will be periodically adjusted to one-half of one percent over the prime rate, with a maximum interest rate of 10.0% per annum. The aggregate principal amount of Senior Secured Notes issued under the Plan was $91,300,000, comprised of $30,100,000 of 8.20% Fixed Rate Senior Secured Notes and $61,200,000 of Adjustable Rate Senior Secured Notes. On August 11, 1992, the Company prepaid $17,900,000 of the 8.20% Fixed Rate Senior Secured Notes and $36,400,000 of the Adjustable Rate Senior Secured Notes from the proceeds of collections of portions of the collateral for the Senior Secured Notes. The other class of Secured Notes issued to satisfy claims was comprised of Junior Secured Notes that bear interest at a rate of 9.20% per annum and will mature on July 31, 2000. The aggregate principal amount of Junior Secured Notes issued under the Plan was approximately $70,000,000. The collateral for the Secured Notes consists primarily of mortgages and other notes receivable and real property, net of related liabilities, (the "Secured Note Collateral") with a book value of $104,790,000 as of December 31, 1993. Interest on the Secured Notes is payable semi-annually commencing January 31, 1993. The Secured Notes require that 85% of the cash proceeds from the Secured Note Collateral be applied first to interest, second to prepayment of the Senior Secured Notes and third to prepayment of the Junior Secured Notes. Any remaining principal balance of the Senior Secured Notes is due July 31, 1997. Aggregate principal payments on the Junior Secured Notes are required in order that one-third of the principal balance outstanding on December 31, 1996 is paid by July 31, 1998; two-thirds of the balance is paid by July 31, 1999; and all of the balance is paid by July 31, 2000. To the extent the cash proceeds from the Secured Note Collateral are insufficient to pay interest or required principal payments on the Secured Notes, the Company will be obligated to pay any deficiency out of its general corporate funds. The Secured Notes contain covenants which, among other things, require the Company to maintain a net worth of at least $100,000,000, limit expenditures related to the development of hotel properties through December 31, 1996 and preclude cash distributions to stockholders, including dividends and redemptions, until the Secured Notes have been paid in full. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) During 1993, the Company repurchased $513,000 of its 8.2% Senior Secured Notes and $16,467,000 of its 9.2% Junior Secured Notes for an aggregate purchase price of $13,249,000. The Company recorded pre-tax extraordinary gains of $3,731,000 related to these repurchases. During the first quarter of 1994, the Company repurchased $6,527,000 of its Adjustable Rate Senior Secured Notes, $217,000 of its 8.20% Senior Secured Notes and $461,000 of its 9.20% Junior Secured Notes for an aggregate purchase price of $7,018,000. The repurchases resulted in pretax extraordinary gains of $187,000, which will be reflected in the Company's first quarter 1994 consolidated financial statements. These notes have been classified as long-term debt at December 31, 1993, in accordance with their terms, as repurchase was not contemplated at the balance sheet date. During the first quarter of 1994, the Company purchased through a third party agent approximately $5.2 million of its Senior Secured and Junior Secured Notes for aggregate consideration of $4.8 million. These notes are currently held by the third party agent and have not been retired due to certain restrictions under the note agreements. The purchases will be recorded as investments on the Company's balance sheet and no gain will be recorded on these transactions until the notes mature or are redeemed. (b) The Company has mortgage and other notes payable of approximately $66,039,000 that are secured by mortgage notes receivable and hotel properties with a book value of $104,324,000. Principal and interest on these mortgages and notes are generally paid monthly. At December 31, 1993 these notes bear interest at rates ranging from 4.68% to 10.5% and mature through 2008. At December 31, 1993, the Company has outstanding loans in the amount of $18,361,000 payable to ShoLodge, Inc. ("ShoLodge"), a company controlled by a director. The foregoing loans are secured by AmeriSuites hotel properties with an aggregate book value of $35,588,000. Interest is payable monthly at rates ranging from 8% (the prime rate plus 2%) to 9.5% (Note 9) and mature through April 1996. The Company has $11,665,000 of notes restructured under the Plan which bear interest at rates ranging from 8.00% to 9.50% per annum payable semi-annually. Prior to maturity, principal amounts outstanding will be paid semi-annually based on a thirty-year amortization schedule. Each note matures on July 31, 2002 and is secured by a lien on mortgage notes receivable and hotel properties with a book value of $11,074,000 at December 31, 1993. During 1993, the Company repurchased $8,828,000 of these notes for an aggregate purchase price of $5,799,000. The repurchase resulted in a pre-tax extraordinary gain of $3,030,000. The Company has other notes payable of $3,881,000, which bear interest at rates ranging from 8.0% to 8.2% and mature through 1999. (c) The Company has a fully-secured demand credit agreement which permits borrowing of up to $5,000,000 and bears interest at the prime rate plus 2%. This facility is supported by a certificate of deposit which is maintained by the bank. Maturities of long-term debt for the next five years ending December 31 are as follows (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 7 -- LEASE COMMITMENTS AND CONTINGENCIES Leases The Company leases various hotels under lease agreements with initial terms expiring at various dates from 1994 through 2015. The Company has options to renew certain of the leases for periods ranging from 1 to 94 years. Rental payments are based on minimum rentals plus a percentage of the hotel properties' revenues in excess of stipulated amounts. The following is a schedule, by year, of future minimum lease payments required under the remaining operating leases that have terms in excess of one year as of December 31, 1993 (in thousands): Rental expense for all operating leases, including those with terms of less than one year, consist of the following for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): Employee Benefits The Company does not provide any material post employment benefits to its current or former employees. Contingent Claims As of March 1, 1994, unresolved bankruptcy claims of approximately $437,000,000 have been asserted against PMI. The Company has disputed substantially all of these unresolved claims and has filed objections to such claims. The Company believes that substantially all of these claims will be dismissed and disallowed. Any claims not disallowed will be satisfied through the distribution of the Company's common stock. In accordance with SOP 90-7, the consolidated financial statements have given full effect to the maximum distribution, pursuant to the Plan of the Company's common stock (see Note 10). The Company has responded to informal requests for information by the Staff of the United States Securities and Exchange Commission's Division of Enforcement relating to a number of the significant transactions of PMI, for the years 1985 through 1991. However, no formal allegations have been made by the Staff. In addition to the foregoing legal proceedings, the Company is involved in various other proceedings incidental to the normal course of its business. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) The Company believes that the resolution of these contingencies will not have a material adverse effect on the Company's consolidated financial position or results of operations. Financial Instruments and Concentration of Credit Risk The Company's accounts receivable and mortgages and other notes receivable (see Note 3) are derived primarily from and are secured by hotel properties, which constitutes a concentration of credit risk. These notes are subject to many of the same risks as the Company's operating hotel assets. A significant portion of the collateral is located in the Northeastern and Southeastern United States. In addition to the hotel property related receivables referred to above, the Company's financial instruments include (i) assets; cash and cash equivalents and restricted cash investments and (ii) liabilities; trade and notes payable and long-term debt (see Note 6). As described in Note 1, in connection with the adoption of fresh start accounting as of July 31, 1992, the Company revalued its assets and liabilities at amounts approximating fair market value. Since there have been no substantive changes in market conditions since the date of the revaluation and on the basis of market quotes and experience on recent redemption offers for the Company's long-term debt, the Company believes that the carrying amount of these financial instruments approximated their fair market value as of December 31, 1993 and 1992. As a result of the reorganization proceedings and the rejection of certain leases, management contracts and other guarantees, the Company has no other material off-balance-sheet liabilities or credit risk as of December 31, 1993. NOTE 8 -- INCOME TAXES The provision for income taxes (including amounts applicable to extraordinary items) consisted of the following for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): Income taxes are provided at the applicable federal and state statutory rates. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) The tax effects of the temporary differences in the areas listed below resulted in deferred income tax provisions for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): At December 31, 1993, the Company had available federal net operating loss carryforwards of approximately $121,000,000 which will expire beginning in 2005 and continuing through 2008. Of this amount, $114,000,000 is subject to an annual limitation of $8,735,000 under the Internal Revenue Code due to a change in ownership of the Company upon consummation of the Plan. The Company also has potential state income tax benefits relating to net operating loss carryforwards of approximately $9,900,000 which will expire during various periods from 1995 to 2006. Certain of these potential benefits are subject to annual limitations similar to federal requirements due to a change in ownership. The utilization is further dependent on such factors as the level of business conducted in each state and the amount of income subject to tax within each state's carryforward period. In accordance with FAS 109, the Company has not recognized the future tax benefits associated with the net operating loss carryforwards or with other temporary differences. Accordingly, the Company has provided a valuation allowance of approximately $42,000,000 against the deferred tax asset as of December 31, 1993. To the extent any available carryforwards or other tax benefits are utilized, the amount of tax benefit realized will be treated as contribution to stockholders' equity and will have no effect on the income tax provision for financial reporting purposes. For the year ended December 31, 1993 and the five months ended December 31, 1992, the Company recognized $4,525,000 and $789,000, respectively, of such tax benefits as a contribution to stockholders' equity. The Company's federal income tax returns for the years 1987 through 1991 were examined by the Internal Revenue Service. The Company received a $17,700,000 federal income tax refund, including interest relating to its predecessor, PMI. In accordance with SOP 90-7, the Company recorded the tax refund and the interest related to its predecessor as a contribution to additional paid in capital ($16,462,000). The remaining amount of $1,238,000, which represents interest since July 31, 1992, is included in other income in the accompanying financial statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 9 -- RELATED PARTY TRANSACTIONS The following summarizes significant financial information with respect to transactions with present and former officers, directors, their relatives and certain entities they control or in which they have a beneficial interest for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): - ------------ (a) The Company manages 12 hotels for partnerships in which a related party owns various interests. The income amounts shown above primarily include transactions related to these hotel properties. (b) In 1991, PMI entered into an agreement (the "Development Agreement") with ShoLodge, whereby ShoLodge was appointed the exclusive agent to develop and manage certain hotel properties. The Company has loans payable to ShoLodge of $18,361,000 at December 31, 1993 related to the development of Hotels (see Note 6). In January 1993, the Company and its wholly-owned subsidiary, Suites of America, Inc. ("SOA") entered into agreements with ShoLodge designed to enhance the growth of its AmeriSuites hotel chain from the six hotels owned at that time by adding an additional six hotels to be built and financed by ShoLodge. ShoLodge has completed development of three hotels, two of which the Company has acquired subject to mortgages with ShoLodge. In addition, ShoLodge has three hotels currently under construction. Upon completion of the new hotels and the exercise of an option by either ShoLodge or the Company, ShoLodge will contribute its fee or mortgage interests on six hotels to SOA and will own a 50% interest in SOA. Upon exercise of this option, the Development Agreement will terminate and ShoLodge will manage all 12 hotels in SOA pursuant to a new management agreement. The Company will retain ownership of the AmeriSuites brand name and all rights to license and develop the name for its own account. In conjunction with the agreement, ShoLodge has also relinquished its profit sharing interests of $2,862,000 on the initial six hotels for cash and the cancellation of a note receivable. The Company uses the ShoLodge reservation system for its Wellesley and AmeriSuites hotel properties. NOTE 10 -- COMMON STOCK AND COMMON STOCK EQUIVALENTS Pursuant to the Plan, on July 31, 1992 the Company began distributing shares of common stock to certain claimants and holders of PMI stock. The Plan provided for issuance of 33,000,000 shares of common stock and as of March 10, 1994, 29,124,324 shares of common stock were distributed. The remaining shares are to be distributed semi-annually to holders of previously allowed claims and pending final resolution of disputed claims (see Note 7). The consolidated financial statements have given full effect to the issuance of the maximum amount of 33,000,000 shares under the Plan. The number of shares ultimately distributed under the Plan could be less than 33,000,000 depending on the final outcome of the disputed claims. In addition to the shares distributed under the Plan, warrants to purchase 2,100,000 shares of the Company's common stock were issued to former shareholders of the Company's predecessor, PMI, in partial settlement of their bankruptcy interests. The warrants became exercisable on August 31, 1993 at an exercise price of $2.71 per share. The exercise price was determined from the average per share daily closing price of the Company's PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) common stock during the year following its reorganization on July 31, 1992. As of December 31, 1993, 45,880 shares have been exercised. On July 31, 1992, the Company adopted various stock option and performance incentive plans under which options to purchase up to 1,320,000 shares of common stock may be granted to directors, officers or key employees under terms determined by the Board of Directors. During 1993 and 1992, options to purchase 20,000 and 350,000 shares, respectively, were granted to officers and directors, 130,000 of which are exercisable at December 31, 1993. In addition, options to purchase 330,000 shares were granted to a former officer in 1992. Such options are currently exercisable and expire on July 31, 1995. During 1993, 30,000 of these options were exercised. The exercise prices of the above options are based on the average market price one year from the date of grant and have been determined to be $2.71 per share. Based on this exercise price, the amount of compensation expense attributable to these options was $225,000 for the year ended December 31, 1993. In June 1993, options to purchase 393,000 shares of common stock were granted to employees under the Company's stock option plan. The options were granted at $3.625, which approximates the fair market value at the date of grant. Generally, options can be exercised during a participant's employment with the Company in equal annual installments over a three-year period and expire six years after the date of grant. In August 1993, options to purchase 315,000 shares of common stock were granted to the members of the Company's Board of Directors. The options were granted at $3.20, which approximates the fair market value at the date of grant. One-third of these options became exercisable at the date of grant and the remaining options can be exercised in equal annual installments over a two year period. The options expire six years after the date of grant. Summary of the stock option plans are as follows: PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 11 -- TRANSITION PERIOD FINANCIAL INFORMATION (UNAUDITED) Following the Effective Date, the Company elected to change its fiscal year end from June 30 to December 31. As described in Note 1, financial statements for periods prior to the Effective Date have been prepared on a different basis of accounting and are thus not comparable. Selected financial information for the six months ended December 31, 1992 and 1991, prepared on a pro-forma basis as if the Plan became effective on June 30, 1991, are as follows (in thousands, except per share amounts): NOTE 12 -- SUPPLEMENTAL CASH FLOW INFORMATION The following summarizes non-cash investing and financing activities for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): Cash paid for interest was $16,347,000 for the year ended December 31, 1993 and $2,981,000 for the five months ended December 31, 1992. Cash paid for income taxes was $2,697,000 for the year ended December 31, 1993 and $0 for the five months ended December 31, 1992. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Prime Hospitality Corp.: We have audited the accompanying consolidated balance sheet of Prime Hospitality Corp. (a Delaware corporation) and subsidiaries ("the Company") as of July 31, 1992 and the related consolidated statements of operations, stockholders' equity and cash flows for the one month then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Prime Hospitality Corp. and subsidiaries as of July 31, 1992 and the results of their operations and their cash flows for the one month then ended in conformity with generally accepted accounting principles. As discussed in Note 8, the Company held an investment in a mortgage note receivable from certain entities with a face value of $100,890,000 that is valued at $25,000,000 at July 31, 1992. The realization of this investment is dependent primarily on the ability of the Company to recover such amount pursuant to the personal guarantees provided by two individuals who control the entities that are the obligors under the mortgage note and own the hotel properties that serve as the underlying collateral for the note. The Company has commenced a legal action to recover pursuant to such guarantees; however, the financial statements do not include any adjustments that might result from the outcome of this matter. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to financial statements and financial statement schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey March 10, 1993 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Prime Motor Inns, Inc. (Debtor-in-Possession) We have audited the consolidated balance sheet of Prime Motor Inns, Inc. and Subsidiaries (Debtors-in-Possession) as of June 30, 1992, and the related consolidated statements of operations, stockholders' equity (deficiency) and cash flows for the years ended June 30, 1992 and 1991. In connection with our audits of the consolidated financial statements, we also have audited the accompanying financial statement schedules for the years ended June 30, 1992 and 1991. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Prime Motor Inns, Inc. and Subsidiaries (Debtors-in-Possession) as of June 30, 1992, and their results of operations and cash flows for the years ended June 30, 1992 and 1991, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein for the years ended June 30, 1992 and 1991. As discussed in Note 8, the Company held an investment in a mortgage note receivable from certain entities with a face value of $100,890,000 that had been written down to $30,000,000 at June 30, 1992. The realization of the carrying value is dependent primarily on the ability of the Company to recover such amount pursuant to the personal guarantees provided by the two individuals who control the entities that are the obligors under the mortgage note and the owners of the hotel properties that serve as the underlying collateral for the loan. The Company has commenced a legal action to recover pursuant to such guarantees; however, the outcome of this action is not presently determinable. As discussed in Note 12, the Company has reflected pre-petition and certain post-petition claims in the consolidated balance sheet as of June 30, 1992 as liabilities subject to compromise based on its estimate of the aggregate amount that will ultimately be allowable for settlement upon consummation of the plan of reorganization; however, the aggregate amount claimed by creditors is substantially in excess of the liability recorded by the Company. The actual aggregate amount of allowable pre and post-petition claims cannot presently be determined. As discussed in Note 15, the Company and certain of its present and former officers and directors are defendants in certain consolidated class action complaints alleging federal securities law violations and other claims. The ultimate outcome of such litigation cannot presently be determined. The eventual outcome of the matters discussed in the three preceding paragraphs is not presently determinable and the consolidated financial statements as of June 30, 1992 and for the years ended June 30, 1992 and 1991 do not include any adjustments relating to the resolution of those uncertainties. As discussed in Note 2, the Company's plan of reorganization became effective on July 31, 1992, and it will implement the guidance as to the accounting for entities emerging from Chapter 11 set forth in Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("Fresh Start Reporting") as of that date. The Company has not presently determined the amounts that will be recorded under Fresh Start Reporting. However, the implementation of Fresh Start Reporting as a result of the Company's emergence from Chapter 11 will materially change the amounts reported in consolidated financial statements as of and for periods ending subsequent to July 31, 1992. As a result of the reorganization and the implementation of Fresh Start Reporting, assets and liabilities will be recorded at fair values and outstanding obligations relating to the claims of creditors will be discharged primarily in exchange for cash, new indebtedness and equity. The accompanying consolidated financial statements as of June 30, 1992 and for the years ended June 30, 1992 and 1991 do not give effect to any adjustments that will be made as a result of the Company's reorganization and emergence from Chapter 11. J.H. COHN & CO. Roseland, New Jersey September 24, 1992 PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) FRESH START REPORTING WAS IMPLEMENTED AND THE PURCHASE METHOD OF ACCOUNTING WAS APPLIED TO RECORD THE FAIR VALUE OF ASSETS AND ASSUMED LIABILITIES OF THE REORGANIZED COMPANY AT JULY 31, 1992. ACCORDINGLY, THE ACCOMPANYING BALANCE SHEET AS OF JULY 31, 1992 IS NOT COMPARABLE IN ALL MATERIAL RESPECTS TO SUCH STATEMENT AS OF ANY DATE PRIOR TO JULY 31, 1992 SINCE THE BALANCE SHEET IS THAT OF A NEW ENTITY. See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY) (IN THOUSANDS, EXCEPT SHARE DATA) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 NOTE 1 -- REORGANIZATION AND EMERGENCE FROM CHAPTER 11 Prime Hospitality Corp. became the successor corporation to Prime Motor Inns, Inc. on July 31, 1992. As used herein, the "Company" refers to Prime Hospitality Corp. and subsidiaries, "PMI" refers to Prime Motor Inns, Inc. and subsidiaries and "Prime Motor Inns" refers to Prime Motor Inns, Inc., the parent company only. The accompanying consolidated financial statements and notes thereto reflect the activities of the Company as of and subsequent to July 31, 1992 and PMI prior to July 31, 1992. On September 18, 1990, Prime Motor Inns (predecessor to and former parent of the Company) and fifty of its subsidiaries (together with Prime Motor Inns, the "Debtors") filed voluntary petitions under title 11 of the United States Code ("Chapter 11") in the United States Bankruptcy Court, Southern District of Florida, Miami Division (the "Bankruptcy Court") and began operating as Debtors-In-Possession. On September 23, 1991, the Debtors filed their Joint Plan of Reorganization. The Debtors filed their Disclosure Statement for Debtors' Amended Joint Plan of Reorganization and their Amended Joint Plan of Reorganization on November 15, 1991. These plans and the disclosure statement were further amended and restated by the Disclosure Statement and the Second Amended Joint Plan of Reorganization of the Debtors dated January 16, 1992 (the "Plan"). The Plan was confirmed by the Bankruptcy Court on April 6, 1992. On July 31, 1992 (the "Effective Date"), the Debtors consummated the Plan and emerged from bankruptcy. On the Effective Date, Prime Motor Inns merged with and into the Company, which had been a wholly-owned subsidiary of Prime Motor Inns. The Company was the surviving corporation in the merger. In addition, certain of the Debtors and other subsidiaries of Prime Motor Inns that did not file petitions under Chapter 11 merged, consolidated or contributed substantially all of their assets to the Company or subsidiaries of the Company. On the Effective Date, the Company assumed the obligations of each combining Debtor under the Plan. The Company has distributed Secured Notes and Restructured Notes and is in the process of distributing cash, Tax Notes, Common Stock and Warrants in settlement of pre-petition claims and interests as such claims and interests are processed and settled. The American Institute of Certified Public Accountants has issued Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"), which provides guidance for financial reporting by Chapter 11 debtors during and following their Chapter 11 cases. The accompanying historical consolidated financial statements of PMI for the period from September 18, 1990 to the Effective Date have been prepared in accordance with SOP 90-7 on the following basis: - Liabilities subject to compromise are segregated. - Transactions and events directly associated with the reorganization proceedings are reported separately. - Interest expense is reported only to the extent it will be paid. Also pursuant to SOP 90-7, the Company implemented Fresh Start Reporting (hereinafter defined) upon the emergence of the Debtors from bankruptcy as of the Effective Date (see Note 2). NOTE 2 -- FRESH START REPORTING SOP 90-7 provides for the implementation of Fresh Start Reporting upon the emergence of debtors from bankruptcy if the reorganization value (the approximate fair value) of the assets of the emerging entity immediately prior to emergence is less than the total of all post-petition liabilities and allowed pre-petition claims, and if the holders of existing voting shares immediately before the emergence from bankruptcy receive less than 50% of the voting shares of the emerging entity. A Fresh Start balance sheet reflects assets at their PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) estimated fair value upon the emergence from bankruptcy and liabilities, other than deferred taxes, at the present value of amounts to be paid determined at appropriate current interest rates. The Company met the criteria for implementation of, and implemented Fresh Start Reporting as of the Effective Date. Under Fresh Start Reporting, the consolidated balance sheet as of July 31, 1992 became the opening consolidated balance sheet of the Company. Since Fresh Start Reporting has been reflected in the accompanying consolidated balance sheet as of July 31, 1992, this consolidated balance sheet is not comparable in all material respects to any such financial statements as of any prior date or for any period prior to July 31, 1992, since the consolidated balance sheet as of July 31, 1992 is that of a new entity. The estimated reorganization value (the approximate fair value) of the assets of the emerging entity was determined by consideration of many factors and various valuation methods, including discounted cash flows and price/earnings and other applicable ratios believed by management to be representative of the Company's business and industry. Reorganization liabilities, consisting of Tax Notes, Restructured and Reinstated Notes, Senior Secured Notes and Junior Secured Notes distributed as of the Effective Date, have been recorded based on face values, which approximate the present values of amounts to be paid determined at appropriate current interest rates. Common Stock has been valued at the excess of the fair value of identifiable assets of the Company over the present value of liabilities. Other current liabilities, consisting of those arising from post-petition operating and other expenses not paid as of the Effective Date and obligations arising from certain loans to finance construction, will be paid in full under their original terms and have been presented in the following balance sheet at their historical carrying values. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) The effects of consummating the Plan and implementing Fresh Start Reporting are set forth on PMI's historical consolidated balance sheet as of July 31, 1992 as follows: CONSOLIDATED FRESH START BALANCE SHEET AS OF JULY 31, 1992 (IN THOUSANDS, EXCEPT SHARE DATA) PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) CONSOLIDATED FRESH START BALANCE SHEET AS OF JULY 31, 1992 (IN THOUSANDS, EXCEPT SHARE DATA) PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTES TO CONSOLIDATED FRESH START BALANCE SHEET (a) Reflects cash payments of $38,800,000 to creditors on or after the Effective Date in accordance with the terms of the Plan. (b) Represents mortgage notes, other notes receivable and property, which are offset against creditor claims on the Effective Date in accordance with the terms of the Plan. (c) Represents long-term debt in the principal amount of $257,300,000 distributed to creditors on or after the Effective Date in accordance with the terms of the Plan and the recognition of $6,500,000 of related gain on discharge of indebtedness. As part of the Plan, the Company distributed approximately $1,400,000 of Tax Notes, approximately $94,600,000 of Restructured and Reinstated Notes, approximately $91,300,000 of Senior Secured Notes and approximately $70,000,000 of Junior Secured Notes. Additionally, approximately $15,000,000 of construction financing related to hotel property development outstanding prior to consummation will be paid based on original terms. (d) Represents 32,300,000 shares of Common Stock with an estimated fair value of $132,800,000, which will be distributed to creditors on or after the Effective Date in accordance with the terms of the Plan and the recognition of $249,600,000 of related gain on discharge of indebtedness. (e) Represents 700,000 shares of Common Stock with an estimated fair value of $2,800,000, which was exchanged for all of the shares of Prime's old common stock outstanding on the Effective Date. (f) Represents adjustments to: record at fair value operating property, equipment and leasehold improvements, certain mortgages and other notes receivable and certain other assets and related liabilities; eliminate deferred income; and eliminate accumulated deficit in accordance with the provisions of SOP 90-7 for Fresh Start Reporting. The gain on discharge of indebtedness of $249,600,000 has been presented as an "Extraordinary Item" in the accompanying consolidated statement of operations for the one month ended July 31, 1992. NOTE 3 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A summary of the significant accounting policies used by the Company and PMI in the preparation of the accompanying consolidated financial statements follows: Business activities The Company focuses on three types of business activities: operation of owned and leased hotel properties; management services provided to hotel properties owned by third parties; and management of its portfolio of mortgages, notes and other financial assets. The Company retains all the revenues and pays all the expenses with respect to the owned and leased hotel properties. The Company derives management fees from the hotel properties it manages based on a fixed percentage of gross revenues, fees for services rendered and performance-related incentive payments. The Company's portfolio of mortgages, notes and other assets primarily are associated with hotel properties currently managed or formerly owned by the Company and PMI. The majority of the Company's hotel properties are moderately priced hotels comprised of 100 to 150 rooms primarily located in the Northeast and Florida, which are designed to attract business and leisure travelers desiring quality accommodations at affordable prices. The Company operates or manages many of the restaurants and cocktail lounges at its full service hotels. Its limited service hotels, such as Wellesley Inns and AmeriSuite hotels, generally do not have restaurants or cocktail lounges. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) Most of the hotel properties are operated or managed by the Company in accordance with franchise agreements with national hotel chains, including Howard Johnson, Ramada, Marriott, Holiday Inn, Sheraton, Days Inn and Radisson. Additionally, the Company operates or manages the Wellesley hotel properties under its trademark "Wellesley Inns." The Company owns the trademark "AmeriSuites", and all of these hotel properties are managed for the Company by a related party. Principles of consolidation The consolidated financial statements include the accounts of the Company and PMI and all of their majority-owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. Cash equivalents Cash equivalents are highly liquid unrestricted investments with a maturity of three months or less when acquired. Restricted cash Restricted cash consists primarily of highly liquid investments that serve as collateral for debt obligations included in liabilities subject to compromise and is classified as either short-term or long-term depending on the date the obligation is due. Mortgages and other notes receivable Mortgages and other notes receivable are reflected at the lower of face or market value at July 31, 1992. Generally, the carrying amount of the portfolio of mortgages and other notes receivable is reduced through write-offs and by maintaining an aggregate loan valuation reserve at a level that, in the opinion of management, is adequate to absorb potential losses in the portfolio. To determine the appropriate level for the loan valuation reserve, management evaluates various factors including: general and regional economic conditions; the credit worthiness of the borrower; the nature and level of any delinquencies in the payment of principal or interest; and the adequacy of the collateral. Interest on delinquent loans (including impaired loans that have required writedowns or specific reserves) is only recognized when cash is received. The amount of interest income recognized on mortgages and other notes receivable is generally based on the loan's effective interest rate and adjusted carrying value of the note. Property, equipment and leasehold improvements Property, equipment and leasehold improvements that the Company intends to continue to operate are stated at cost less accumulated depreciation and amortization at June 30, 1992 and 1991 and at fair market value as of July 31, 1992. Provision is made for depreciation and amortization using the straightline method over the estimated useful lives of the assets. The Company intends to sell or otherwise dispose of those remaining operating and non-operating properties that have generated losses or insufficient returns on investment. Properties identified for disposal are stated at their estimated net realizable value through valuation reserves or writedowns. Income recognition on property sales and deferred income Income is generally recognized when properties used in the hotel business are sold. However, income is deferred and recognized under installment or other appropriate methods when collectibility of the sales price is PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) not reasonably assured or other criteria for immediate profit recognition under generally accepted accounting principles are not satisfied. Gains from sales of properties under sale and leaseback transactions that are generally deferred pursuant to applicable accounting rules are amortized over the lives of the related leases. Gains from sales of properties and certain other assets acquired through business combinations accounted for as purchases are generally offset against the carrying value of the remaining purchased assets if the sale takes place within the allocation period (generally a period of one year or less) following the purchase. Construction income recognition and deferred income Revenues under long-term construction contracts are generally recognized under the percentage-of-completion method and include a portion of the earnings expected to be realized on the contract in the ratio of costs incurred to estimated total costs. Under certain circumstances, the recognition of income is deferred until continuing involvement, in the form of operating guarantees made to the owners of the hotel property subject to the contract, has expired. Income taxes The Company and its subsidiaries file a consolidated Federal income tax return. PMI adopted Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109 ("FAS 109"), "Accounting for Income Taxes, "by applying FAS 109 to its consolidated financial statements commencing July 1, 1991. PMI used the "deferred method" of accounting for income taxes through June 30, 1991. Adoption of FAS 109 did not have a material effect on the consolidated financial statements. Deferred taxes have not been provided as of July 31, 1992 and June 30, 1992 due to the availability of significant net operating loss carryforwards and the uncertainty surrounding the ultimate realization of the future benefits, if any, to be derived from the temporary differences between the financial reporting basis and the tax basis of assets and liabilities. Income (loss) per common share Primary net income (loss) per common share is computed based on the weighted-average number of common shares and common share equivalents (stock options) outstanding during each year. The weighted-average number of common shares and common share equivalents used in computing primary net income (loss) per share was 33,028,000 for the month ended July 31, 1992 and the years ended June 30, 1992 and 1991. Fully diluted net income (loss) per common share includes, when dilutive, the effects of the elimination of interest expense and the issuance of additional common shares from the assumed conversion of the 6 5/8% convertible subordinated debentures due 2011 and the 7% convertible subordinated debentures due 2013 (collectively, the "Debentures"). The Debentures are included in the consolidated balance sheets as of June 30, 1992 and 1991 as liabilities subject to compromise. The effects of assuming the conversion of the Debentures were not dilutive in each of the two years in the period ended June 30, 1992, and for the one month ended July 31, 1992. Reclassifications Certain reclassifications have been made to the consolidated financial statements to conform them to the July 31, 1992 classifications. NOTE 4 -- ACQUISITIONS AND DISPOSITIONS In December 1989, PMI consummated its agreement with New World Development Co. Ltd. ("New World") to participate with and assist New World in its acquisition of the hotel business of Ramada, Inc. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) ("Ramada"). Under the agreement, PMI loaned approximately $58,000,000 to New World (see Note 8) and acquired certain real estate, notes receivable, the Rodeway International Franchise System ("Rodeway") and certain other assets, and assumed certain liabilities, for aggregate cash consideration of approximately $54,000,000 plus closing adjustments. Such assets were sold in fiscal 1991 (see Note 5). PMI entered into a license agreement to operate the domestic Ramada franchise system and agreed to indemnify New World for certain potential tax liabilities associated with the license. The potential tax liabilities to New World, and all other claims by New World and PMI against each other, were settled on August 4, 1992 (see Note 8). NOTE 5 -- DISCONTINUED OPERATIONS On July 2, 1990, PMI consummated the sale of its Howard Johnson and Ramada franchise businesses (the "franchise segment") to an affiliate of Blackstone Capital Partners, L.P. for $170,000,000 in cash. On July 5, 1990, PMI sold its Rodeway franchise business and two Rodeway hotel properties to Manor Care, Inc. for $14,900,000 in cash. As a result, PMI effectively discontinued the operations of its franchise segment as of July 1, 1990. The gain on sale of the discontinued segment has been shown separately in the accompanying 1991 consolidated statement of operations, net of the related state income tax provision. NOTE 6 -- CASH AND CASH EQUIVALENTS Cash and cash equivalents are comprised of the following (in thousands): NOTE 7 -- RESTRICTED CASH -- LONG TERM Restricted cash consists of cash in bank of $360,000 and commercial paper of $872,000 at July 31, 1992. At June 30, 1992, restricted cash consists primarily of commercial paper of $43,947,000. NOTE 8 -- MORTGAGES AND OTHER NOTES RECEIVABLE Mortgages and other notes receivable are comprised of the following and are stated at face value, net of writedowns and valuation reserves as of June 30, 1992. As of July 31, 1992, these assets have been valued at their fair market value (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) - --------------- (a) The mortgage notes are secured by the Frenchman's Reef resort hotel, which is managed by the Company, and consist of first and second mortgages with face values of $53,383,000 and $25,613,000, respectively, with final scheduled principal payments of $51,976,000 and $25,613,000 due on July 31, 1995. The notes bear interest at a stated rate of 13%. Interest and principal payments on the first mortgage are payable in monthly installments. Interest and scheduled principal payments on the second mortgage note are payable only to the extent of available cash flow, as defined, with any unpaid interest due at maturity. Based on a valuation of the property, PMI wrote down the second mortgage to $11,400,000 as of June 30, 1990 and discontinued the accrual of interest. As a result of the continuing decline in economic conditions and operating cash flows, the balance of the second mortgage was written off in fiscal 1992. In connection with the adoption of Fresh Start Reporting at July 31, 1992, the Company has valued these notes at $50,000,000. During the one month ended July 31, 1992, the Company recognized $345,000 of interest income on these notes (an effective rate of approximately 8.3%), based on the current levels of cash flows generated from the property available to service the notes. The Company is in the process of renegotiating the terms of these notes based on the current level of cash flow generated by the property. (b) From 1988 through 1990, PMI loaned entities controlled by Allan Rose and Arthur Cohen (the "Rose and Cohen entities"), who at such time were significant Howard Johnson franchisees, an aggregate of $100,890,000 fully secured initially by property and/or personal guarantees. PMI was committed to make additional loans, also on a fully secured basis, to the Rose and Cohen entities of up to an aggregate of $130,000,000 if values of, and/or revenues generated by, certain hotel properties controlled by the Rose and Cohen entities attained specified levels. PMI was to receive a minimum annual return of 10% on all loans made to the Rose and Cohen entities and a maximum return of 20%. All loans and unpaid interest are payable on December 31, 1997. Due to the decline in value of the hotel properties pledged as collateral for the loan and the continuing decline in the hotel real estate market, PMI discontinued funding additional loans in fiscal 1990. Further, based on PMI's estimate of the value of the collateral and the personal guarantees of Rose and Cohen and discussions related to the possible early payment of the loan, PMI wrote down the loan to $50,000,000 as of June 30, 1990 and discontinued the accrual of interest. In 1992, certain of the Rose and Cohen entities owning a portion of the collateral that secures the loans filed for Chapter 11 protection in the United States Bankruptcy Court, Southern District of New York. Also during 1992, the Company commenced an adversary proceeding against Rose and Cohen. The complaint seeks to recover jointly and severally on the personal guarantees of $50,000,000 given by Rose and Cohen as part of the loan agreement. As a result of further evaluation of the collateral and the personal guarantees, PMI wrote down the loan to $30,000,000 as of June 30, 1992 and $25,000,000 as of July 31, 1992. (c) In April 1989, PMI loaned FCD Hospitality, Inc. ("FCD"), an unaffiliated company, approximately $74,000,000 in cash for the purpose of financing FCD's acquisition of the outstanding common stock of Servico, Inc. ("Servico"), an operator of hotels. The loan was secured by the common stock of Servico, FCD and certain FCD affiliates, and was originally due prior to June 30, 1990. Interest was due at the prime rate plus 1%. PMI also entered into an agreement with FCD pursuant to which PMI would provide management consulting services for approximately $63,000,000 through June 1990. Additionally, in April 1989, PMI purchased approximately $80,000,000 of Servico's outstanding 12 1/4% subordinated notes due April 15, 1997 for approximately $64,000,000 (80% of par value). PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) Subsequent to April 1989, PMI entered into certain other transactions including working capital loans and the sale of certain hotels to Servico. Servico also pledged a substantial portion of its hotel properties and mortgage notes receivable on hotel properties as collateral and/or in satisfaction of its commitments on the loan to FCD and the consulting agreement. On September 18, 1990, Servico and certain of its subsidiaries filed for Chapter 11 protection. After an extensive valuation and recovery analysis performed by PMI and Servico, PMI agreed to settle all claims and disputes with Servico and FCD in June 1991. Under the terms of the agreement, which was approved by the Bankruptcy Court, the FCD loan, the subordinated notes, loans related to sales of properties and working capital and all accrued interest relating to these notes and loans with a face value of $166,210,000 were forgiven. As part of the settlement, PMI retained ownership of certain mortgage notes receivable with a face value of approximately $30,000,000 that are secured by three hotel properties. The entity that owns one of the properties filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in December 1990. Subsequent to July 31, 1992, the Company has restructured the note receivable to receive payments based on the property's available cash flow. Based on the valuation of the mortgage notes on the three properties, PMI wrote down the FCD Loan and Servico notes to $16,757,000 as of June 30, 1990 and discontinued the accrual of interest. In connection with the adoption of Fresh Start Reporting, the Company has valued the notes at $19,756,000 at July 31, 1992. (d) In connection with the Ramada acquisition in December 1989, PMI agreed to loan New World $58,000,000 (see Note 4). Interest was payable quarterly at a rate of 11%. Principal was to be paid in installments beginning in 1995 with a final scheduled payment of $55,499,000 due on March 31, 2005. On August 4, 1992, after extensive negotiation and approval of a settlement by the Bankruptcy Court, the Company collected net proceeds of $42,000,000 plus accrued interest in full satisfaction of the $58,000,000 loan balance offset by liabilities subject to compromise related to the Ramada acquisition with a net carrying value of $16,000,000. The net proceeds were used to prepay a portion of the Senior Secured Notes issued on the Effective Date. (e) At July 31, 1992, the Company held mortgages and other notes receivable secured by 33 hotel properties operated by the Company under management or lease agreements. These notes currently bear interest at rates ranging from 8.5% to 14% and mature through 2014. The mortgages were primarily derived from the sales of hotel properties. Many of these properties had been unable to pay in full the annual debt service required under the terms of the original mortgages. The Company has restructured $33,530,000 of these mortgages to receive the majority of available cash and to receive a participation in the future excess cash flow of such hotel properties. The Company is also in process of restructuring another $9,500,000 of these mortgages. (f) Other notes receivable bear interest at effective rates ranging from 8% to 12%, mature through 2001 and are secured primarily by hotel properties. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTE 9 -- PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS Property, equipment and leasehold improvements consist of the following and are stated at cost (other than properties held for sale) at June 30, 1992 and at fair market value as of July 31, 1992 (in thousands): At July 31, 1992, the Company was the lessor of land and certain restaurant facilities in Company-owned hotels with an approximate aggregate book value of $12,338,000 pursuant to noncancelable operating leases expiring on various dates through 2013. Minimum future rentals under such leases are $8,095,000, of which $3,449,000 is to be received during the five year period ending June 30, 1997. Depreciation and amortization expense on property, equipment and leasehold improvements was $569,000, $6,867,000 and $7,867,000, for the one month ended July 31, 1992 and for the years ended June 30, 1992 and 1991, respectively. Capitalized interest was $0, $139,000 and $1,000,000 for the one month ended July 31, 1992 and for the years ended June 30, 1992 and 1991, respectively. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTE 10 -- OTHER CURRENT LIABILITIES Other current liabilities consist of obligations for the following (in thousands): NOTE 11 -- NOTES PAYABLE Notes payable consist of the following (in thousands): - --------------- (a) Notes payable to related party are payable to ShoLodge, Inc. ("ShoLodge"), a company controlled by a director. The notes are secured by three hotel properties with a book value of $17,354,000 that were constructed in 1992 and 1991. Interest is payable monthly at variable rates ranging from the prime interest rate (6% at July 31, 1992) plus 1% to the prime rate plus 2%. One promissory note for $3,000,000 is due in May 1993 and the remainder is due on demand (see Note 22). (b) Other notes payable are secured by a hotel property. Interest is payable at the prime rate plus 2%. The notes are due in May 1993. NOTE 12 -- LIABILITIES SUBJECT TO COMPROMISE As a result of the Chapter 11 filing (see Note 1), enforcement of certain unsecured claims against the Debtors in existence prior to the petition date were stayed while the Debtors continued business operations as debtors-in-possession. These claims are reflected in the accompanying consolidated balance sheets as of June 30, 1992, as liabilities subject to compromise. Additional unsecured claims classified as liabilities subject to compromise arose subsequent to the Petition Date resulting from rejection of executory contracts, including lease, management and franchise agreements, and from the determination by the Bankruptcy Court (or agreements by the parties in interest) to allow claims for contingencies and other disputed amounts. Enforcement of claims secured against the Debtors' assets ("secured claims") were also stayed although the holders of such claims have the right to move the Court for relief from the stay. Secured claims are secured primarily by liens on the Debtors' property, equipment and leasehold improvements and certain mortgages and other notes receivable. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) Creditors have asserted pre-and post-petition claims against the Debtors alleging liabilities of approximately $9 billion plus unliquidated amounts. The Company projects that the claims asserted against the Debtors will be resolved and reduced to an amount that approximates PMI's estimate of $706,250,000 recognized as liabilities subject to compromise as of June 30, 1992. PMI has filed motions objecting to those claims that are: (a) duplicative; (b) superseded by amended claims; (c) erroneously asserted against multiple Debtors; (d) not obligations of any of the Debtors; or (e) filed after the Bar Date (as hereinafter defined). Additionally, PMI otherwise has disputed a substantial number of the claims asserted against the Debtors and has filed objections to such claims. The Bankruptcy Court established May 15, 1991 (the "Bar Date") as the deadline for filing proofs of claim, except certain specified claims, against the Debtors. A significant number of the bankruptcy claims have been resolved. As of March 1, 1993, unresolved bankruptcy claims of approximately $1 billion have been asserted against PMI. Approximately $767 million of these unresolved claims were filed by entities controlled by Allan Rose and Arthur Cohen (see Note 8). The Company has disputed a substantial number of these unresolved bankruptcy claims and has filed objections to such claims. In addition, a number of these claims have been resolved with the claimant and are awaiting approval by the Bankruptcy Court. The Company believes that substantially all of these claims will be dismissed, disallowed or deemed paid pursuant to the Plan and estimates that unresolved bankruptcy claims will be allowed in the amount of approximately $27 million. These claims will be settled as follows: claims of $18 million will be satisfied through the issuance of Secured Notes, Restructured Notes and Tax Notes; claims of $8 million will be satisfied through the distribution of the Company's Common Stock; and claims of $1 million will be satisfied through cash payments. In accordance with SOP 90-7, the July 31, 1992 consolidated financial statements have given full effect to the issuance of these Secured Notes, Restructured Notes and Tax Notes and the distribution of the Company's Common Stock. Liabilities have been provided for the anticipated cash payments. PMI's liabilities subject to compromise, stated at management's estimate of the total amount of allowed claims and not at the amounts for which claims will be settled, consist of the following (in thousands): The amounts listed above may be subject to future adjustments depending on further developments with respect to disputes or unresolved claims. Information as to the terms of the settlement of liabilities subject to compromise under the Plan as of or subsequent to the Effective Date through the distribution of cash, new indebtedness, new equity securities and/or offset against certain assets reflected in the accompanying consolidated balance sheets is set forth in Note 2. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) PMI discontinued accruing interest on certain debt obligations as of the date such obligations were determined to be subject to compromise. Contractual interest not accrued and not reflected as an expense in the consolidated statements of operations, as a result of the Debtors' Chapter 11 filing, amounted to approximately $2,300,000 for the one month ended July 31, 1992 and $28,000,000 and $25,300,000 for the years ended June 30, 1992 and 1991, respectively. Total contractual interest is disclosed in the accompanying consolidated statements of operations. NOTE 13 -- LONG-TERM DEBT As a result of the Chapter 11 filing (see Notes 1 and 12), all long-term obligations of the Debtors in existence prior to the Petition Date were stayed and have been classified as liabilities subject to compromise at June 30, 1992. Long-term debt consists of the following (in thousands): - --------------- (a) Pursuant to the Plan, the Company issued two classes of Secured Notes which are identified as "Senior Secured Notes" and "Junior Secured Notes". Senior Secured Notes were issued in two series of notes which are identified as the "8.20% Fixed Rate Senior Secured Notes" and the "Adjustable Rate Senior Secured Notes" (collectively the "Senior Secured Notes"). Each series is identical except that the interest rate on the Adjustable Rate Senior Secured Notes will be periodically adjusted to one-half of one percent over the daily "prime rate" reported by Chemical Bank, with a maximum interest rate of 10.0% per annum. The aggregate principal amount of Senior Secured Notes issued under the Plan was $91,300,000, comprised of $30,100,000 of 8.20% Fixed Rate Secured Notes and $61,200,000 of Adjustable Rate Senior Notes. On August 11, 1992, the Company prepaid $17,900,000 of the 8.20% Fixed Rate Senior Secured Notes and $36,400,000 of the Adjustable Rate Senior Secured Notes from the proceeds of collections of portions of the collateral for the Senior Secured Notes. The prepaid amounts of $54,300,000 have been classified as current at July 31, 1992. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) The other class of Secured Notes issued to satisfy claims was comprised of Junior Secured Notes that bear interest at a rate of 9.20% per annum and will mature on July 31, 2000. The aggregate principal amount of Junior Secured Notes issued under the Plan was $70,000,000. The collateral for the Secured Notes consists primarily of mortgages and other notes receivable and real property (the "Secured Note Collateral") with a book value of $143,191,000 as of July 31, 1992. Interest on the Secured Notes is payable semi-annually commencing January 31, 1993. The Secured Notes require that 85% of the cash proceeds from the Secured Note Collateral be applied first to interest, second to prepayment of the Senior Secured Notes and third to prepayment of the Junior Secured Notes. Any remaining principal balance of the Senior Secured Notes is due July 31, 1997. Aggregate principal payments on the Junior Secured Notes are required in order that one-third of the principal balance outstanding on December 31, 1996 is paid by July 31, 1998; two-thirds of that balance is paid by July 31, 1999; and all of that balance is paid by July 31, 2000. To the extent the cash proceeds from the Secured Note Collateral are insufficient to pay interest or required principal payments on the Secured Notes, the Company will be obligated to pay any deficiency out of its general corporate funds. The Secured Notes contain covenants which, among other things, require the Company to maintain a net worth of at least $100,000,000, limit expenditures related to the development of hotel properties through December 31, 1996 and preclude cash distributions to stockholders, including dividends and redemptions, until the Secured Notes have been paid in full. During March 1993, the Company repurchased $9,500,000 of the Junior Secured Notes for a purchase price of $7,400,000. The repurchase resulted in an extraordinary gain of $2,100,000, which will be reflected in the Company's first quarter 1993 consolidated financial statements. These notes have been classified as long-term debt at July 31, 1992 in accordance with their terms as repurchase was not contemplated at the balance sheet date. (b) Claims of taxing authorities were paid in Tax Notes or cash. Each Tax Note is in a face amount equal to the allowed claim and provides for annual payments of principal and interest until maturity on July 31, 1998. Such payments will be made in equal principal installments, plus simple interest from July 31, 1992 at the rate of 8.20% per annum, with payments to commence on July 31, 1993 and with additional payments to be made on each July 31 thereafter. (c) The Company has $20,734,000 of restructured notes issued to holders of oversecured and undersecured bankruptcy claims. Each restructured note matures on July 31, 2002 and is secured by a lien on the collateral which secured the underlying claim prior to bankruptcy. The notes are secured by mortgage notes receivable and hotel properties with a book value of $16,981,000 at July 31, 1992. The oversecured restructured notes bear interest at a rate of 9.20% per annum payable semi-annually in cash. Prior to maturity, principal amounts outstanding will be paid semi-annually based on a thirty-year amortization schedule. The Company has approximately $7,173,000 of these notes outstanding at July 31, 1992. During January 1993, the Company repurchased $1,700,000 of the oversecured restructured notes for a purchase price of $1,300,000. The repurchase resulted in an extraordinary gain of $400,000, which will be reflected in the Company's first quarter 1993 consolidated financial statements. These notes have been classified as current at July 31, 1992. The undersecured restructured notes bear interest at a rate of 8% per annum with interest payable semi-annually in cash. Semi-annual principal payments begin on July 31, 1996 based on a thirty-year PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) amortization schedule. The Company has approximately $13,561,000 of these notes outstanding at July 31, 1992. The Company has other mortgage notes and bonds payable of approximately $73,905,000 which are due through April 1, 2008 and bear interest at rates ranging from 4.68% to 10.5% at July 31, 1992. The notes are secured by mortgage notes receivable and hotel properties with a book value of $83,577,000 at July 31, 1992. (d) Construction financing obligations primarily consist of two loans payable to banks with an aggregate balance of $5,193,000 and a loan payable to ShoLodge of $3,570,000 at July 31, 1992. The loans payable to banks are secured by mortgages on two hotel properties with a book value of $13,963,000 at July 31, 1992. Principal is payable in monthly installments with the balances due by June 1994. Interest is payable monthly at the prime rate plus 2%. The loan payable to ShoLodge is secured by a hotel with a book value of $7,670,000 at July 31, 1992. Principal is payable in September 1993. Interest is payable monthly at the prime rate plus 2% (see Note 22). (e) At June 30, 1992, PMI's 6 5/8% convertible subordinated debentures due 2011 and 7% convertible subordinated debentures due 2013 were convertible at any time prior to maturity into common stock at $40.568 per share and $43.95 per share, respectively, and 5,451,342 shares of common stock were reserved for issuance upon such conversion. Sinking fund payments of $5,750,000 annually were required commencing April 1, 1997 for the 6 5/8% Debentures and June 1, 1999 for the 7% Debentures. All Debentures were subordinated to all existing and future senior indebtedness of PMI. (f) In April 1989, PMI borrowed approximately $140,000,000 from Morgan Bank pursuant to a demand note (the "Morgan Loan") with interest at the prime rate. The note was secured by the notes receivable from FCD and Servico and certain other assets. In September 1989, PMI entered into a $263,000,000 secured bank credit agreement (the "Credit Agreement"), expiring March 1991, in which borrowings (the "Bank Group Loan") were fully utilized by December 1989. Borrowings bear interest at the prime rate plus 1/2%. The borrowings were principally incurred to extinguish the Morgan Loan issued in connection with the Servico transaction ("Tranche A") and to finance PMI's portion of the Ramada acquisition ("Tranche B"). The Bank Group Loan was secured by the notes receivable from FCD and Servico, the net assets and common stock of subsidiaries acquired in the Ramada acquisition, the New World note, certain other mortgage notes receivable and certain other assets. In March 1990, PMI prepaid $1,000,000 of the Bank Group Loan with the proceeds of previously pledged mortgage notes receivable. In May 1990, PMI prepaid $40,000,000 of the Bank Group Loan from proceeds from the collection of a receivable related to the sale of a hotel property in fiscal 1989. In June 1990, PMI prepaid $1,000,000 of the Bank Group Loan with the proceeds of certain previously pledged mortgage notes receivable. In July 1990, PMI prepaid approximately $171,200,000 of the Bank Group Loan from the proceeds of the sale of the Howard Johnson, Ramada and Rodeway franchise businesses. In July 1990, the Credit Agreement was amended to convert $60,000,000 of $65,000,000 of unsecured demand loans then outstanding, which had been borrowed in fiscal 1990 to fund construction, into secured term loans ("Tranche C"). In addition, certain unsecured letter of credit reimbursement obligations were converted into Tranche C secured obligations. PMI also pledged additional collateral and certain then-existing defaults under the Bank Credit Agreement were waived. In July 1990, PMI paid the remaining $5,000,000 of unsecured demand notes then outstanding. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) (g) Other mortgage notes and bonds payable consist of debt secured by properties operated by PMI or notes receivable held by PMI. Principal is due in installments through 2009. Interest rates are generally variable ranging from 5% to 15% at June 30, 1992. (h) Other debt as of June 30, 1992 consists of an unsecured note bearing interest at the rate of 17%. At July 31, 1992, maturities of long-term debt for the next five years ending July 31 are as follows (in thousands): NOTE 14 -- LEASE COMMITMENTS The Company leases various hotels under lease agreements with initial terms expiring at various dates from 1998 through 2019. The Company has options to renew certain of the leases for periods ranging from 1 to 94 years. Rental payments are based on minimum rentals plus a percentage of the hotel's revenues in excess of stipulated amounts. As a result of the Chapter 11 filing, all lease contracts were reviewed during 1991 and a determination was made as to whether to accept or reject these contracts. The commitments shown below reflect those lease contracts which the Company has assumed. The following is a schedule by year of future minimum lease payments required under the remaining operating leases for core properties that have terms in excess of one year as of July 31, 1992 (in thousands): Rental expense for all operating leases, including those with terms of less than one year, is comprised as follows (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) - --------------- (a) Rentals include approximately $6,769,000 of rent recognized under the leases with related parties in 1991. NOTE 15 -- CONTINGENCIES PMI and certain of its present and former officers and directors were named as defendants in purported class action lawsuits on behalf of purchasers of PMI's common stock and debentures. The lawsuits allege that PMI made materially false and misleading statements and omissions regarding its financial condition in violation of Federal securities laws and other claims. A settlement was consummated in February 1993 which was funded through insurance proceeds. The Company has responded to informal requests for information by the Staff of the United States Securities and Exchange Commission's Division of Enforcement relating to a number of significant transactions of PMI for the years 1985 through 1991. However, no formal allegations have been made by the Staff. In addition to the foregoing legal proceedings, the Company is involved in various other proceedings incidental to the normal course of its business. The Company believes that the resolutions of these contingencies will not have a material adverse effect on the Company's consolidated financial position or results of operations. NOTE 16 -- REORGANIZATION EXPENSES The net expenses incurred as a result of the Debtors' Chapter 11 filing on September 18, 1990 and subsequent reorganization efforts have been segregated from normal operating expenses and presented as reorganization expenses in the accompanying consolidated statements of operations for the one month ended July 31, 1992 and for the years ended June 30, 1992 and 1991. Reorganization expenses are comprised of the following (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTE 17 -- VALUATION WRITEDOWNS AND RESERVES Valuation writedowns and reserves have been recorded in order to adjust the carrying value of assets and liabilities resulting from the restructuring of PMI's business and general economic conditions and primarily consist of the following (in thousands): The valuation writedowns and reserves for the year ended June 30, 1992 shown above were all recognized in the fourth quarter. In addition to the above, valuation writedowns and reserves of $-0-, $20,578,000 and $-0-were charged against deferred income for the one month ended July 31, 1992 and for the years ended June 30, 1992 and 1991, respectively. NOTE 18 -- INCOME TAXES Income taxes (credits) have been provided as follows (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) The difference between total income taxes (credits) and the amount computed by applying the Federal statutory income tax rate of 34% to income (loss) from continuing and discontinued operations before income taxes are as follows (in thousands): The tax effects of the temporary differences in the areas listed below resulted in deferred income tax provisions (credits) (in thousands): No Federal income tax was payable at July 31, 1992 due primarily to the utilization of net operating loss carryforwards. At July 31, 1992, the Company had net operating loss carryforwards of approximately $347,000,000 for Federal income tax purposes. Such tax net operating loss carryforwards, if not used as offsets to future taxable income, will expire beginning in 2005 and continuing through 2007. The amount of net operating loss carryforwards available for future utilization is limited to $130,500,000 during the carryforward period as a result of the change in ownership of the Company upon consummation of the Plan. In accordance with FAS 109, the Company has not recognized the future tax benefits associated with the net operating loss carryforwards or with other temporary differences. Accordingly, the Company has provided a valuation allowance of approximately $44,000,000 against the deferred tax assets as of July 31, 1992 and June 30, 1992. To the extent any available carryforwards or other benefits are utilized in periods subsequent to July 31, 1992, the tax benefit realized will be treated as a contribution to stockholders' equity and will have no effect on the income tax provision for financial reporting purposes. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) PMI's Federal income tax returns for the years 1987 through 1991 are currently under examination by the Internal Revenue Service. The Company does not believe there will be any material adverse effects on the consolidated financial statements as a result of this examination. NOTE 19 -- COMMON STOCK AND COMMON STOCK EQUIVALENTS Pursuant to the Plan, on July 31, 1992, the Company began distributing 33,000,000 shares of Common Stock to certain claimants and holders of PMI stock. At March 2, 1993, 22,623,100 shares of Common Stock were distributed. The remaining shares are to be distributed semi-annually to holders of previously allowed claims and pending final resolution of disputed claims (see Note 12). In addition, holders of PMI stock will receive Warrants to purchase Common Stock exercisable into an aggregate of approximately 2,100,000 shares at an exercise price equal to the average per share daily closing price during the year ending July 31, 1993. On July 31, 1992, the Company adopted a stock option plan under which options to purchase up to 1,320,000 shares of Common Stock may be granted to directors, officers or key employees under terms determined by the Board of Directors. During 1992, options to purchase 350,000 shares were granted to officers and directors none of which are exercisable at July 31, 1992. In addition, options to purchase 330,000 shares were granted to a former officer. Such options are currently exercisable and expire on July 31, 1995. The exercise prices of the above options are dependent on the average market price one year from the date of grant and are, therefore, currently undeterminable. On July 31, 1992, the Company adopted a performance incentive plan under which stock options covering an additional 330,000 shares of Common Stock were reserved for grants to key employees at the discretion of management. No options have been issued under this plan. PMI had an employee incentive stock option plan which provided for grants of stock options covering an aggregate of 3,520,000 shares of common stock to officers and key employees. Under the terms of the plan, which expired on November 23, 1991, options were granted at a price not less than 100% of fair market value on the date of grant. Options generally were exercisable in cumulative installments of 33 1/3% after the option has been outstanding 18, 32 and 46 months from the date of grant and expired five years after the date of grant. A summary of the transactions under this plan follows: PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTE 20 -- INTEREST AND DIVIDEND INCOME Included in interest and dividend income are the following (in thousands): NOTE 21 -- OTHER REVENUES Included in other revenues are the following (in thousands): NOTE 22 -- RELATED PARTY TRANSACTIONS The following summarizes significant financial information with respect to transactions with present and former officers, directors, their relatives and certain entities they control or in which they have a beneficial interest (in thousands): - --------------- (a) During 1990, PMI sold eight hotel properties to partnerships controlled by former officers and/or directors for aggregate consideration of $52,500,000 resulting in deferred gains of $4,000,000. The Company held mortgages and other notes receivable with a face value of $44,992,000 at July 31, 1992, which arose primarily from those hotel sales. The mortgages mature through 2005 and bear interest at rates ranging from 9.5% to 12.5%. At July 31, 1992, the carrying value of those mortgages was reduced to $6,081,000. The income amounts shown above primarily include transactions related to these properties. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) (b) In 1991, PMI entered into an agreement with ShoLodge, whereby Sholodge was appointed the exclusive agent to develop and manage certain hotel properties. Six hotels have been developed and opened to date. Development fees earned by ShoLodge of $-0-, $586,000 and $527,000 have been capitalized into property, equipment and leasehold improvements for the month ended July 1992, and the years ended June 1992 and June 1991, respectively. The Company has demand notes and loans payable to ShoLodge of $2,706,000 and $3,570,000, respectively, at July 31, 1992 concerning the development of hotels. Effective June 1992, the Company commenced using the ShoLodge reservation system for its Wellesley and AmeriSuite hotels. NOTE 23 -- SUPPLEMENTAL CASH FLOW INFORMATION PMI generally received mortgages and other notes as a portion of the total consideration paid by purchasers in connection with sales of hotel properties and as consideration for certain construction and development activities. Such noncash consideration is not reflected in the accompanying consolidated statements of cash flows. Investing activities involving such noncash proceeds are summarized below (in thousands): Noncash proceeds consisted of the following (in thousands): Cash paid for interest net of amounts capitalized, was $4,407,000 for the one month ended July 31, 1992 and $6,432,000 and $16,802,000 for the years ended June 30, 1992 and 1991, respectively. Cash paid for income taxes was $2,000 for the one month ended July 31, 1992 and $1,460,000 and $2,100,000 for the years ended June 30, 1992 and 1991, respectively. SCHEDULE II PRIME HOSPITALITY CORP. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) - --------------- (a) 11%; secured by real property; payable in monthly installments of $16,994 including interest. During 1993, the Company began foreclosure proceedings on this receivable. (b) 10%; secured by real property; due September 1, 1996. SCHEDULE II PAGE 1 OF 2 PRIME HOSPITALITY CORP. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) SCHEDULE II PAGE 2 OF 2 PRIME HOSPITALITY CORP. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) (CONTINUED) (a) 11%; secured by real property; payable in monthly installments of $16,994 including interest. (b) 10%; secured by real property; due September 1, 1996. (c) 10%; secured by real and personal property; due December 1, 1998; payable in monthly installments of $115,859 including interest. In January 1993, the Company restructured the note as follows: (i) a senior note of $5,000,000 at 8.5%; due January 1, 2003; payable in monthly installments of $38,446 and (ii) a junior note of $5,950,000 at 6.0% due January 1, 2008; payable to the extent of available cash flow. The notes are owed by a partnership in which a former director of PMI has a controlling interest. Subsequent to July 31, 1992, this note is no longer classified as a related party receivable. (d) 9.5% to 11%; secured by real and personal property; due from March 1, 1999 to December 1, 2019; payable in total monthly installments of $277,252 including interest. In December 1992, the Company restructured these notes to receive the majority of available cash flow. (e) 9.25%; secured by real property; payable in monthly installments of $590; due July 1, 2017. (f) Prime rate; unsecured; payable on demand. (g) 9%; secured by real property; due September 5, 2011. (h) Prime rate; unsecured; payable on demand. (i) 11%; secured by personal property; payable in quarterly installments of $2,307 including interest; due January 1, 1991. SCHEDULE V PRIME HOSPITALITY CORP. AND SUBSIDIARIES PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) - --------------- (a) Transfer from notes receivable to land, hotels and furniture, fixtures and autos. (b) Represents a hotel conveyed to a third party in return for the assumption of the related debt by the third party. (c) Represents a transfer in exchange for a note receivable. See Notes to Consolidated Financial Statements as to depreciation method and useful lives. SCHEDULE V PRIME HOSPITALITY CORP. AND SUBSIDIARIES PAGE 1 OF 2 PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) SCHEDULE V PAGE 2 OF 2 PRIME HOSPITALITY CORP. AND SUBSIDIARIES PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) (CONTINUED) (a) Fresh-start reporting adjustments. (b) Distributions under the Plan. (c) Transfer from construction in progress to hotels, leasehold improvements and furniture, fixtures and autos. (d) Writeoffs and/or writedowns to net realizable value. (e) Transfer from operating land, hotels, furniture, fixtures and autos and/or construction in progress to property held for sale. See Notes to Consolidated Financial Statements as to depreciation method and useful lives. SCHEDULE VI PRIME HOSPITALITY CORP. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) SCHEDULE VI PRIME HOSPITALITY CORP. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) - --------------- (a) Fresh start reporting adjustments. SCHEDULE IX PRIME HOSPITALITY CORP. AND SUBSIDIARIES SHORT-TERM BORROWINGS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) - --------------- (a) The average amount outstanding during the period was computed on the basis of the outstanding daily principal balances. (b) The weighted average interest rate was computed by dividing the total interest expense on these obligations by the average balance of short-term obligations outstanding. SCHEDULE X PRIME HOSPITALITY CORP. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) SCHEDULE X PRIME HOSPITALITY CORP. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) 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. PRIME HOSPITALITY CORP. DATE: March 24, 1994. By: /s/ David A. Simon ------------------------ David A. Simon, President 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 indicated on March 24, 1994. Exhibit Index (2) (a) Reference is made to the Disclosure Statement for Debtors' Second Amended Joint Plan of Reorganization dated January 16, 1992, which includes the Debtors' Second Amended Plan of Reorganization as an exhibit thereto filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (3) (a) Reference is made to the Restated Certificate of Incorporation of the Company dated June 5, 1992 filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (b) Reference is made to the Restated Bylaws of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (4) (a) Reference is made to the Form of 8.20% Fixed Rate Senior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (b) Reference is made to the Form of Adjustable Rate Senior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (c) Reference is made to the Form of 9.20% Junior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (d) Reference is made to the Form of 8.20% Tax Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (e) Reference is made to the Form of 10.20% Secured UND Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (f) Reference is made to the Form of 8% Secured UND Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (g) Reference is made to the Form of 9.20% OVR Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (h) Reference is made to the Collateral Agency Agreement among the Company, U.S. Trust and the Secured Parties, dated as of July 31, 1992 filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (i) Reference is made to the Security Agreement between the Company and U.S. Trust, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (j) Reference is made to the Subsidiary Guaranty from FR Delaware, Inc. to United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (k) Reference is made to the Security Agreement between FR Delaware, Inc. and United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (l) Reference is made to the Subsidiary Guaranty from Prime Note Collections Company, Inc. to United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (m) Reference is made to the Security Agreement between Prime Note Collections Company, Inc. and United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (n) Reference is made to a Form 8-A of the Company as filed on June 5, 1992 with the Securities and Exchange Commission, as amended by Amendment No. 1 and Amendment No. 2, which is incorporated herein by reference. (10) (a) Reference is made to the Agreement of Purchase and Sale between Flamboyant Investment Company, Ltd. and VMS Realty, Inc. dated June 3, 1985, and its related agreements, each of which was included as Exhibits to the Form 8-K dated August 14, 1985 of PMI, which are incorporated herein by reference. (b) Reference is made to PMI's Flexible Benefit Plan, filed as an Exhibit to the Form 10-Q dated February 12, 1988 of PMI, which is incorporated herein by reference. (c) Reference is made to the Employment Agreement dated as of July 31, 1992, between David A. Simon and the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (d) Reference is made to the 1992 Performance Incentive Stock Option Plan of the Company dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (e) Reference is made to the 1992 Stock Option Plan of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (f) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and David A. Simon filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (g) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and David L. Barsky filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (i) Reference is made to the Employment Agreement dated as of December 31, 1992 between John Elwood and the Company filed as an Exhibit to the Company's Form 10-K dated March 26, 1993, which is incorporated herein by reference. (j) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and John Elwood filed as an Exhibit to the Company's Form 10-K dated March 26, 1993, which is incorporated herein by reference. (k) Employment Agreement dated as of March 1, 1993 between John Stetz and the Company. (l) Employment Agreement dated as of May 18, 1993 between Paul Hower. (m) Consolidated and Amended Settlement Agreement dated as of October 12, between Allan V. Rose and the Company. (11) Computation of Earnings Per Common Share. (21) Subsidiaries of the Company are as follows: (23) (a) Consent of Arthur Andersen & Co. (b) Consent of J.H. Cohn & Co.

93397_1993.txt

93397_1993

1993

93397

Item 3. Legal Proceedings Eight proceedings instituted by governmental authorities are pending or known to be contemplated against Amoco and certain of its subsidiaries under federal, state and local environmental laws, each of which could result in monetary sanctions in excess of $100,000. No individual proceeding is, nor are the proceedings as a group, expected to have a material adverse effect on Amoco's consolidated cash flows, financial position or results of operations. Amoco estimates that in the aggregate the monetary sanctions reasonably likely to be imposed from these proceedings amount to approximately $4 million. The Internal Revenue Service ("IRS") has challenged the application of certain foreign income taxes as credits against the Corporation's U.S. taxes that otherwise would have been payable for the years 1980 through 1982. On June 18, 1992, the IRS issued a statutory Notice of Deficiency for additional taxes in the amount of $466 million, plus interest, relating to those years. The Corporation has filed a petition in the U.S. Tax Court contesting the IRS statutory Notice of Deficiency. A similar amount of additional taxes is expected to be claimed for years 1983 through 1985 based upon a subsequent IRS audit. Any claims for years subsequent to 1985 would not be as significant as those for prior years. The Corporation believes that the foreign income taxes have been reflected properly in its U.S. federal tax returns, and intends to contest the IRS claims. The Corporation is confident that it will prevail in the litigation. Consequently, this dispute is not expected to have a material adverse effect on the consolidated financial position of the Corporation. On January 21, 1994, a judgment was entered by the Superior Court of the State of California, County of Los Angeles, in favor of Amoco Chemical Company and Amoco Reinforced Plastics Company, subsidiaries of Amoco Corporation, against certain underwriters at Lloyd's of London and various other British and European insurance carriers, in AMOCO CHEMICAL COMPANY, et al, vs. CERTAIN UNDERWRITERS AT LLOYD'S OF LONDON, et al. In that case Amoco alleged that the defendant insurers wrongfully refused to pay for the defense and settlement of product liability lawsuits arising from Amoco Reinforced Plastics Company's manufacture of irrigation and sewer pipe in the 1970's. Judgment was entered for $36 million in compensatory damages and $377 million in punitive damages. The judgment is slightly lower than the jury verdicts that were previously reported by Amoco. The defendants have filed motions for a new trial and a judgment notwithstanding the verdict with respect to the actual and punitive damages, respectively. Amoco is making filings in opposition to those motions. In addition, the judgment is subject to appeal by the defendants. Accordingly, it is impossible at this time to predict the ultimate outcome of this case or its impact, if any, on the financial position, results of operations and cash flows of the Corporation. Reference is made to the first paragraph of Item 14(b). Rubicon and Amoco Production and the Corporation have agreed to settle the case. Final settlement papers are expected to be signed in the near future, after which the case will be dismissed. The terms of the settlement are confidential, but the settlement is not expected to have a material adverse effect on the financial position, results of operations or cash flows of the Corporation. Amoco has various other suits and claims pending against it among which are several class actions for substantial monetary damages which in Amoco's opinion are not meritorious. While it is impossible to estimate with certainty the ultimate legal and financial liability in respect to these other suits and claims, Amoco believes that the aggregate amount will not be material in relation to its consolidated financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the quarter ended December 31, 1993. __________________________ PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The principal public trading market for Amoco common stock is the New York Stock Exchange. Amoco common stock is also traded on the Chicago, Pacific, Toronto, and four Swiss stock exchanges. The following table sets forth the high and low share sales prices of Amoco common stock as reported on the New York Stock Exchange and cash dividends paid for the periods presented. On January 25, 1994, the board of directors declared a quarterly cash dividend rate of 55 cents per share. Amoco had 141,039 shareholders of record at December 31, 1993. Item 6. Item 6. Selected Financial Data The following selected financial data, as it relates to the years 1989 through 1993, have been derived from the consolidated financial statements of Amoco, including the consolidated statement of financial position at December 31, 1993 and 1992 and the related consolidated statement of income and consolidated statement of cash flows for the three years ended December 31, 1993, and the notes thereto, appearing elsewhere herein. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This discussion should be read in conjunction with the consolidated financial statements and accompanying notes and supplemental information. 1993 vs. 1992 Consolidated net income for 1993 amounted to $1,820 million, compared with a loss of $74 million incurred in 1992. Excluding the cumulative effects of adoption in 1992 of Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and SFAS No. 109, "Accounting for Income Taxes," 1992 earnings were $850 million. Net income in 1991 was $1,484 million, which included the cumulative benefit of $311 million associated with the adoption in 1991 of SFAS No. 96, "Accounting for Income Taxes." Year-to-year comparisons in net income were affected by various items, summarized in the table below: Favorably affecting 1993 net income were gains of $190 million associated with the disposition of certain Canadian properties and investments, and tax benefits of $113 million. Adversely affecting 1993 results were charges of $170 million associated with the writedown of Congo exploration and production operations to current recoverable value and additional deferred taxes of $53 million due to the effect of a tax rate change resulting from enactment of the Omnibus Budget Reconciliation Act of 1993. Included in 1992 results were charges of $805 million associated with a strategic reassessment of business operations. Partially offsetting were benefits of $90 million related to natural gas contract settlements and $90 million associated with revised estimates of tax obligations and retirement of debt. Excluding these items, 1993 earnings were 18 percent or $265 million above 1992 as a result of higher refined product margins in refining, marketing and transportation operations and improved chemical results. Also contributing to the improvement were higher U.S. natural gas prices and volumes and lower worldwide exploration and operating expenses. 1992 vs. 1991 Adjusting for special items, 1992 earnings were 10 percent or $137 million above the 1991 level. U.S. exploration and production operating results improved resulting from higher natural gas prices and volumes and lower expenses. Exploration and production earnings outside the United States were up slightly, mainly resulting from favorable currency effects. Chemical earnings were higher reflecting lower operating costs. Refining, marketing and transportation net income was lower, primarily attributable to lower refined product margins. Results on a segment basis, for the five years ended December 31, 1993, are presented below: 1993 vs. 1992 United States Exploration and Production U.S. exploration and production operations earned $811 million in 1993 compared with $778 million in 1992 and $595 million in 1991. Year- to-year comparisons of U.S. results were affected by various items, summarized in the table below. Adjusting the respective periods for the items shown, 1993 results were $27 million above the comparable 1992 period mainly as a result of higher prices and volumes for natural gas and lower exploration expenses. Offsetting were lower crude oil prices and production volumes. U.S. natural gas prices averaged $1.88 per thousand cubic feet ("mcf") for 1993, an increase of about $.23 per mcf over 1992, reflecting increased demand and a more favorable supply and demand balance. Amoco's crude oil prices averaged about $16 per barrel in 1993, down 10 percent or about $2 per barrel compared with 1992. Prices remained relatively constant through the first six months of 1993, but declined over the latter half of 1993 reflecting increased worldwide supply. As a result, the average price in December 1993 was about $5 per barrel below the corresponding December 1992 average. U.S. natural gas production averaged 2.4 billion cubic feet per day in 1993, 2 percent above 1992, reflecting increased deliverability, higher demand and increased marketing efforts. Crude oil and natural gas liquids ("NGL") production averaged 305,000 barrels per day in 1993, 5 percent below 1992, mainly due to normal field declines. Non-U.S. Exploration and Production Operations outside the U.S. were affected by various items, as shown below: Canadian exploration and production operations earned $338 million in 1993 compared with a loss of $81 million in 1992. In 1993, Amoco disposed of 65 percent of its equity investment in Crestar Energy Inc., resulting in a $120 million gain. Amoco also sold a significant portion of non-core properties, which resulted in a $70 million benefit and lowered production volumes by approximately 8 percent. Results in 1992 were affected by charges of $236 million related to restructuring, property dispositions and work force reductions. Excluding these items, 1993 earnings were $7 million below 1992's level as higher natural gas prices and volumes and a significant reduction in expenses were more than offset by declining crude oil prices and lower currency gains. Natural gas production averaged 916 million cubic feet per day in 1993, an increase of 13 percent over 1992, reflecting increased demand. Crude oil and NGL production averaged 84,000 barrels per day in 1993 and 89,000 barrels per day in 1992. Exploration and production activities in Europe incurred losses of $100 million in 1993 and $103 million in 1992. Excluding one-time Norwegian tax charges in 1992, losses increased by $36 million due to lower crude oil prices and higher expenses associated with increased activity in Eurasia. Natural gas production of 259 million cubic feet per day was 3 percent below 1992. Crude and NGL production averaged 51,000 barrels per day in 1993, compared with 55,000 barrels per day in 1992. Exploration and production operations in other areas incurred a loss of $54 million in 1993, compared with earnings of $277 million in 1992. Included in 1993 results were charges of $170 million related to the writedown of Congo operations to current recoverable value. Included in 1992 earnings were benefits of $90 million related to natural gas contract settlements. Exclusive of these items, results for 1993 of $116 million were $71 million below 1992 due to lower crude oil volumes and prices and lower currency gains. Partly offsetting was reduced exploration expense. Natural gas production averaged 530 million cubic feet per day in 1993, 6 percent higher than 1992, reflecting new production in Sharjah and Trinidad. Crude oil and NGL production averaged 238,000 barrels per day in 1993, 3 percent below the 1992 level. 1992 vs. 1991 U.S. exploration and production operations earned $778 million in 1992 compared with $595 million in 1991. The increase over 1991 earnings primarily resulted from higher natural gas prices and volumes and lower operating costs and exploration expenses. Partly offsetting were lower crude oil production and prices and charges related to restructuring of $94 million. In 1992, earnings outside the U.S. for exploration and production operations totaled $93 million, compared with $214 million in 1991. The decrease mainly resulted from restructuring charges of $258 million, charges of $39 million relating to the effects of Norwegian tax legislation, lower crude oil and NGL volumes and higher depreciation, depletion and amortization. Offsetting were favorable currency effects, lower operating expenses and the Sharjah natural gas settlement. Outlook Amoco and the oil industry will continue to be affected by the price volatility of crude oil and natural gas. Amoco's future performance is expected to be affected by ongoing efforts to reduce costs, the divestment of marginal operations and concentration of new investments in areas of competitive advantage. The Corporation will continue to focus on growth internationally and to pursue attractive new business opportunities worldwide. Refining, Marketing and Transportation 1993 vs. 1992 Worldwide refining, marketing and transportation operations earned $826 million for 1993, compared with earnings of $462 million for 1992 and $644 million for 1991. Results for 1993 included benefits of $59 million due to a reduction in previous estimates of future costs for environmental remediation. Operations also benefited $50 million from the drawdown of inventories valued under the last-in, first-out ("LIFO") method. Earnings for 1992 included charges of $51 million for anticipated losses on asset dispositions and work force reductions. Excluding these items, the earnings improvement of $204 million in 1993 reflected higher refined product margins. Operating costs also declined in 1993, resulting from continuing efforts to reduce expenses. Amoco's 1993 operating results outside the United States, consisting primarily of NGL supply and marketing activities in Canada and marine transportation, increased over 1992, partly reflecting restructuring efforts. U.S. refined product margins increased from 1992 levels as crude oil prices declined more than product prices. Refined product prices averaged 58 cents per gallon compared with 61 cents per gallon for 1992. U.S. refined product selling prices, excluding consumer excise taxes, and refinery utilization data for the past five years are shown below. Refined product sales volumes in the United States averaged 1,131,000 barrels per day in 1993 compared with 1,088,000 barrels per day in 1992. Gasoline sales volumes were up 3 percent in 1993 while distillate sales increased 5 percent. Canadian NGL sales volumes of 172,000 barrels per day in 1993 increased slightly over 1992 levels. Refining capacity utilization of 97 percent was up from 1992's utilization rate of 95 percent, reflecting continued operating efficiencies. 1992 vs. 1991 In 1992, earnings of $462 million compared with 1991 earnings of $644 million. Excluding special items, the decrease in earnings between the two years primarily resulted from lower refined product margins reflecting strong price competition, particularly for gasoline. Outlook Amoco's refining, marketing and transportation operations will continue to be affected by volatility in crude oil prices and the overall industry supply-demand balance for refined products. Environmental initiatives, including a commitment to provide a product slate that is responsive to environmental concerns and regulations, could require significant additional investments in refining and marketing facilities. Amoco continues its strong focus on controlling costs and implementing new technologies to further upgrade facilities and improve operating efficiencies. Chemicals 1993 vs. 1992 Chemical operations earned $240 million for 1993, compared with a loss of $94 million in 1992 and earnings of $68 million in 1991. Included in 1992 results were charges of $265 million primarily associated with restructuring. Adjusting for those charges, 1993 earnings improved $69 million over 1992 as benefits of cost-containment, restructuring and a strong purified terephthalic acid ("PTA") market favorably affected earnings. Weak margins for olefins and polypropylene partly offset these favorable effects. In 1993 overall chemical sales volumes improved slightly over 1992. Sales volumes for PTA were up 11 percent, as worldwide demand for PTA continued to grow. Polypropylene volumes also increased 11 percent, reflecting the full-year effect of operating the new unit added at the Chocolate Bayou plant, near Alvin, Texas, in mid-1992. Weak demand in the olefins industry caused olefins volumes to decline in 1993. The overall capacity utilization rates were 88 percent in both 1993 and 1992. Chemical margins for most product lines were down in 1993. Margins were lower for olefins and polypropylene due to overcapacity in their respective markets. However, PTA margins were higher resulting from the strong market demand mentioned above. 1992 vs. 1991 In 1992 chemical activities incurred a loss of $94 million compared with earnings of $68 million in 1991. Adjusting for $265 million in restructuring charges, 1992 earnings were up $103 million over 1991 resulting from expense reduction measures and the restructuring of selected plastics and specialty businesses. Outlook Chemical operations continue to be influenced by the worldwide economic environment and the chemical industry supply and demand balance. In anticipation of growth in worldwide demand for chemicals, Amoco will increase the emphasis placed on its attractive core commodity petrochemical strengths, while continuing to implement successful process- improvement and cost-control strategies. Amoco also will focus on broadening the current commodity chemical portfolio and diversifying into specialty chemical and polymer conversion businesses. Other Operations Other operations include investments in laser manufacturing, photovoltaics and biotechnology; investments in hazardous-waste incineration facilities; offshore contract drilling; interests in real estate development; and other corporate diversification activities. Other operations incurred a loss of $45 million in 1993, compared with losses of $179 million and $69 million, respectively, for 1992 and 1991. The higher losses for 1992 reflected charges of $99 million for anticipated losses on the disposition of non-strategic investments. Excluding these items, losses in other operations were mainly associated with technology activities. In 1993, the Corporation sold its 49 percent interest in a fertilizer manufacturing venture in Trinidad, and its interest in Ok Tedi Mining Ltd. in Papua, New Guinea. The Corporation is no longer involved in the mining business. Corporate Activities Corporate activities, including net interest and other corporate expenses, were net expenses of $196 million for 1993, compared with net expenses of $210 million for 1992 and $279 million in 1991. Included in the 1993 results were prior-year tax benefits of $101 million and losses associated with early retirement of higher interest-rate debt. Included in 1992 results were favorable effects of $70 million primarily related to revised estimates of tax obligations and early retirement of debt, and charges of $38 million for work force reductions. Net expenses in 1991 included charges of $47 million related to the AMOCO CADIZ judgment. Adjusting for these items over the years shown, net expense increased $11 million between 1992 and 1993 and $10 million between 1991 and 1992. Liquidity and Capital Resources In 1993, cash flow from operating activities amounted to $3.5 billion, compared with $3 billion in 1992 and $3.3 billion in 1991. Total debt was $5.1 billion at year-end 1993. Debt as a percent of debt-plus-equity was 27.1 percent at December 31, 1993, compared with 28.8 percent at year-end 1992. During 1993, Amoco retired approximately $1 billion of higher interest-rate debt and replaced it largely with the issuance of short-term commercial paper. Also, in 1992 and 1993, Amoco Canada Petroleum Company Ltd. ("Amoco Canada") debt was substantially refinanced. As part of the refinancing, Amoco and Amoco Company have guaranteed certain debt issues of Amoco Canada. See Notes 7 and 9 to the Consolidated Financial Statements. Working capital was $751 million at year-end 1993, compared with $810 million at year-end 1992. At year-end 1993, the Corporation's current ratio was 1.14 to 1 compared with the current ratio at December 31, 1992 of 1.16 to 1. As a matter of policy, Amoco practices asset and liability management techniques that are designed to minimize its investment in non- cash working capital. This does not impair operational capability or flexibility since the Corporation has ready access to both short-term and long-term debt markets. Amoco's short-term liquidity position is better than the reported figures indicate since the inventory component of working capital is valued in part under the LIFO method whereas other elements of working capital are reported at amounts more indicative of their current values. If inventories were valued at current replacement costs, it is estimated that inventories would have been $900 million higher at December 31, 1993. As a result, the level of working capital would rise and an increase in the current ratio would result. The Corporation believes its strong financial position will permit the financing of its business needs and opportunities in an orderly manner. It is anticipated that ongoing operations will be financed primarily by internally generated funds. Short-term obligations, such as commercial paper borrowings, give the Corporation the flexibility to meet short-term working capital and other temporary requirements. At December 31, 1993, bank lines of credit available to support commercial paper borrowings were $490 million, all of which were supported by commitment fees. To maintain flexibility, a $500 million shelf registration statement for debt securities remains on file with the Securities and Exchange Commission to permit ready access to capital markets. The Corporation has provided in its accounts for the reasonably estimable future costs of probable environmental remediation obligations. These amounts relate to various refining and marketing sites, chemical locations, and oil and gas operations, including multiparty sites at which Amoco has been identified as a potentially responsible party by the U.S. Environmental Protection Agency. Such estimated costs will be refined over time as remedial requirements and regulations become better defined. However, any additional costs cannot be reasonably estimated at this time due to uncertainty of timing, the magnitude of contamination, future technology, regulatory changes and other factors. Although future costs could be significant, they are not expected to be material in relation to Amoco's liquidity or consolidated financial position. In total, the accrued liability represents a reasonable best estimate of Amoco's remediation liability. See Notes 1 and 21 to the Consolidated Financial Statements. The Corporation and its subsidiaries maintain insurance coverage for environmental pollution resulting from the sudden or accidental release of pollutants. Amoco is self-insured for up to $35 million from the sudden or accidental release of pollutants per occurrence. Amoco currently does not carry insurance coverage with respect to other types of environmental obligations, except when required by regulation or contract. The financial statements do not reflect any significant recovery from claims under prior or current insurance coverage. At December 31, 1993, the Corporation's reserves for future environmental remediation costs totaled $683 million, of which $401 million related to refining and marketing sites. The Corporation also maintains reserves associated with dismantlement, restoration and abandonment of oil and gas properties, which totaled $590 million at December 31, 1993. Capital expenditures resulting from existing environmental regulations, primarily related to refining and marketing sites, totaled $360 million in 1993. Excluded from that total was $419 million for operating costs and amounts spent on research and development, and $104 million of mandated and voluntary spending charged against the remediation liability. Amoco's 1994 estimated capital spending for environmental cleanup and protection projects is expected to be approximately $250 million. Capital and exploration expenditures in 1993 totaled $3.3 billion, an increase of 12 percent from the $3 billion spent in 1992. A capital and exploration expenditure budget of $3 billion has been approved for 1994. Exploration and production spending for 1994 is forecast at $1.9 billion, the largest portion of which will be spent outside the United States. Capital outlays of approximately $1 billion are anticipated to be split equally between chemical operations and refining, marketing and transportation activities. It is anticipated that the 1994 capital and exploration expenditures budget will be financed primarily by funds generated internally. The planned expenditure level is subject to adjustment as changing economic conditions may indicate. In March 1994, management of the Corporation announced to its employees that the organizational structure of the Corporation will be changed in an effort to reduce costs and increase effectiveness. Management currently anticipates that the new structure will be finalized in the last half of 1994. Separate financial statements of subsidiary companies not consolidated, and of 50 percent or less owned companies accounted for by the equity method, have been omitted since, if considered in the aggregate, they would not constitute a significant subsidiary. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Amoco Corporation In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Amoco Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of Amoco Corporation's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 15 to the consolidated financial statements, Amoco Corporation changed its method of accounting for income taxes by adopting Statements of Financial Accounting Standards Nos. 109 and 96 in 1992 and 1991, respectively. Also in 1992, Amoco Corporation adopted Statement of Financial Accounting Standards No. 106, discussed in Note 19, and accordingly changed its method of accounting for postretirement benefits other than pensions. PRICE WATERHOUSE Chicago, Illinois February 22, 1994 AMOCO CORPORATION AND SUBSIDIARIES _________________________ CONSOLIDATED STATEMENT OF INCOME AMOCO CORPORATION AND SUBSIDIARIES _____________________ CONSOLIDATED STATEMENT OF FINANCIAL POSITION AMOCO CORPORATION AND SUBSIDIARIES ___________________________ CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY AMOCO CORPORATION AND SUBSIDIARIES _______________________ CONSOLIDATED STATEMENT OF CASH FLOWS AMOCO CORPORATION AND SUBSIDIARIES __________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Accounting Policies Principles of Consolidation The operations of all significant subsidiaries in which the Corporation directly or indirectly owns more than 50 percent of the voting stock are included in the consolidated financial statements. The Corporation also consolidates its proportionate share of assets, liabilities and results of operations of oil and gas joint ventures and undivided interest in pipeline companies. Investments in other companies in which less than a majority interest is held are generally accounted for by the equity method. Inventories Inventories are carried at the lower of current market value or cost. Cost is determined under the last-in, first-out ("LIFO") method for the majority of inventories of crude oil, petroleum products and chemical products. The costs of remaining inventories are determined on the first-in, first-out ("FIFO") or average cost methods. Costs Incurred in Oil and Gas Producing Activities The Corporation follows the successful efforts method of accounting. Costs of property acquisitions, successful exploratory wells, all development costs (including CO2 and certain other injected materials in enhanced recovery projects) and support equipment and facilities are capitalized. Unsuccessful exploratory wells are expensed when determined to be non-productive. Production costs, overhead and all exploration costs other than exploratory drilling are charged against income as incurred. Depreciation, Depletion and Amortization Generally, depreciation of plant and equipment, other than oil and gas facilities, is computed on a straight-line basis over the estimated economic lives of the facilities. Assets held under capital leases are generally amortized over the terms of the leases. Depletion of the cost of producing oil and gas properties, amortization of related intangible drilling and development costs and depreciation of tangible lease and well equipment are computed on the unit-of-production method. The portion of costs of unproved oil and gas properties estimated to be non-productive is amortized over projected holding periods. AMOCO CORPORATION AND SUBSIDIARIES __________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The estimated costs to dismantle, restore and abandon oil and gas properties are accrued over the properties' remaining productive lives on the unit-of-production method. Retirements Upon normal retirement or replacement of facilities, the gross book value less salvage is charged to accumulated depreciation. Gains or losses from abnormal retirements or sales are credited or charged to income. Maintenance and Repairs All maintenance and repair costs are charged against income, while significant improvements are capitalized. Income Taxes Provision is made in the Corporation's accounts to reflect the current and deferred tax consequences of transactions that have been recognized in the financial statements. Futures Contracts The Corporation periodically enters into futures and options contracts generally to hedge its exposure to price fluctuations on hydrocarbon transactions, and to hedge its exposure to fluctuations in currency exchange rates on borrowings in foreign currencies. Recognized gains and losses on hedge contracts are reported as a component of the related transaction. Translation of Foreign Currencies The U.S. dollar has been determined to be the appropriate functional currency for essentially all operations except foreign chemical operations. Environmental Liabilities The Corporation has provided in its accounts for the reasonably estimable future costs of probable environmental remediation obligations relating to current and past activities, including obligations for previously disposed assets or businesses. In the case of long-lived cleanup projects, the effects of inflation and other factors, such as improved application of known technologies and methodologies, are considered in determining the amount of estimated liabilities. The undiscounted accrued amount primarily consists of costs such as site assessment, monitoring, equipment, utilities and soil and ground water treatment and disposal. The estimated environmental remediation obligation has not been reduced for probable recoveries from third parties. AMOCO CORPORATION AND SUBSIDIARIES ___________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Net Income Per Share Net income per share of common stock is based on the monthly weighted average number of shares outstanding during the year. Note 2. Acquisitions, Dispositions and Special Items In 1993, new investments, advances and business acquisitions totaled $200 million, including the purchase of Phillips Fibers Corporation. Proceeds from dispositions of property and other assets and from sales of investments totaled $850 million, including certain non-strategic properties and investments in Canada for approximately $471 million. Earnings in 1993 included gains of $120 million relating to the Corporation's disposition of 65 percent of the equity investment in a Canadian company, Crestar Energy Inc., in connection with its initial public offering. Also included were gains of $70 million associated with the disposition of certain Canadian properties. Earnings in 1993 included after-tax charges of $170 million associated with the writedown of Congo exploration and production operations to current recoverable value. Earnings in 1992 were reduced by after-tax charges of $805 million, as part of a strategic reassessment of business operations. These charges included $473 million for costs of restructuring business units and related charges, including anticipated losses on the disposition of oil and gas properties and other non-strategic assets and investments; $181 million for charges related to work force reductions; and $151 million for other reserves and adjustments. Earnings were favorably affected by $90 million related to the settlement of natural gas contracts in Sharjah. Also favorably affecting earnings were benefits of $90 million associated with revised estimates of tax obligations and retirement of debt. In 1991, proceeds from dispositions of property and other assets totaled $747 million, including the sale of oil and gas properties in several states to Apache Corporation for approximately $500 million. Also, charges of $75 million were associated with the closing of the Casper, Wyo., refinery. Note 3. Cash Flow Information The Consolidated Statement of Cash Flows provides information about changes in cash and cash equivalents, including cash in excess of daily requirements that is invested in marketable securities, substantially all of which have a maturity of three months or less when acquired. The effect of foreign currency exchange rate fluctuations on total cash and marketable securities balances was not significant. AMOCO CORPORATION AND SUBSIDIARIES _________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Net cash provided by operating activities reflects cash payments for interest and income taxes as follows: Note 4. Inventories Inventories at December 31, 1993 and 1992, are shown in the following table: During the year ended December 31, 1993, the Corporation reduced certain inventory quantities which were valued at lower LIFO costs prevailing in prior years. The effect of this reduction was to increase net income by approximately $50 million. A smaller LIFO gain was included in 1992. Inventories carried under the LIFO method represented approximately 47 percent of total year-end inventory carrying values in 1993 and 48 percent in 1992. It is estimated that inventories would have been approximately $900 million higher than reported on December 31, 1993, and approximately $1.3 billion higher on December 31, 1992, if the quantities valued on the LIFO basis were instead valued on the FIFO basis. Note 5. Amoco Credit Corporation Amoco Credit Corporation ("Credit") is a wholly owned finance subsidiary of the Corporation. Credit is primarily engaged in the business of financing certain accounts and notes receivable of the Corporation through the issuance of commercial paper and other short-term borrowings. The financial information of Credit included in the consolidated financial statements is provided in the following table: AMOCO CORPORATION AND SUBSIDIARIES _________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 6. Property, Plant and Equipment Investment in properties at December 31, 1993 and 1992, detailed by industry segment, was as follows: Note 7. Short-Term Obligations Amoco's short-term obligations consist of notes payable and commercial paper. Notes payable as of December 31, 1993, totaled $71 million at an average annual interest rate of 3.2 percent, compared with $75 million at an average annual interest rate of 3.6 percent at year-end 1992. Commercial paper borrowings at December 31, 1993, were $936 million at an average annual interest rate of 3.4 percent compared with $143 million at an average annual interest rate of 3.5 percent as of December 31, 1992. The carrying value of short-term obligations as of December 31, 1993 and December 31, 1992, approximated estimated fair value. AMOCO CORPORATION AND SUBSIDIARIES _________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Bank lines of credit available to support commercial paper borrowings of the Corporation amounted to $490 million and $500 million at December 31, 1993 and 1992, respectively. All of these were supported by commitment fees. The Corporation also maintains compensating balances with a number of banks for various purposes. Such arrangements do not legally restrict withdrawal or usage of available cash funds. In the aggregate, they are not material in relation to total liquid assets. Note 8. Accounts Payable Accounts payable at December 31, 1993 and 1992, included liabilities in the amount of $304 million and $342 million, respectively, for checks issued in excess of related bank balances but not yet presented for collection. Note 9. Long-Term Debt Amoco's long-term debt resides principally with two Amoco subsidiaries--Amoco Company and Amoco Canada. Amoco Company functions as the principal holding company for all of Amoco's petroleum and chemical operations, except Canadian petroleum operations and selected other activities. AMOCO CORPORATION AND SUBSIDIARIES ________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The components of long-term debt and year-end rates are summarized as follows: During 1993, Amoco retired $305 million of debt through a tender offer program that was initiated in October. In addition, Amoco called for redemption a total of $646 million in other securities. The majority of these obligations were replaced with commercial paper. Early AMOCO CORPORATION AND SUBSIDIARIES _________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) retirement of these issues resulted in a loss of $44 million. Amoco Canada substantially completed refinancing its long-term debt with the issuance of $600 million in debentures. Proceeds from these issues were used to repay the bank loans and the commercial paper. Amoco Corporation guarantees the outstanding public debt obligations of Amoco Company. Amoco Corporation and Amoco Company guarantee the Notes and Debentures of Amoco Canada, except for the SEDs. AmProp Inc., a real estate subsidiary, had long-term debt secured by real estate assets, totaling $88 million at year-end 1993, and $104 million at year-end 1992, which is not guaranteed by Amoco Corporation or Amoco Company. Of Amoco's total debt outstanding at December 31, 1993, approximately $600 million was denominated in foreign currencies. The Corporation has entered into foreign currency forward and option contracts that have been designated as hedges of the currency exposure on substantially all of that debt. Unrealized losses on these hedge contracts totaled $14 million and $115 million for 1993 and 1992, respectively, and were offset by currency gains on long-term debt. The estimated fair values of long-term debt outstanding as of December 31, 1993 and 1992 were $4,264 million and $5,120 million, respectively, based on quoted market prices for the same or similar issues, or the current rates offered to the Corporation for debt of the same remaining maturities. Annual maturities of total long-term debt during the next five years, including the portion classified as current, are $44 million in 1994, $200 million in 1995, $249 million in 1996, $205 million in 1997 and $266 million in 1998. AMOCO CORPORATION AND SUBSIDIARIES _________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 10. Leases The Corporation leases various types of properties, including service stations, tankers, buildings, railcars and other facilities, some of which are subleased to others, through operating leases. Some of the leases and subleases provide for contingent rentals based on refined product throughput. Summarized below as of December 31, 1993, are future minimum rentals payable and related sublease rental income for non-cancelable capital and operating leases. Also shown is a reconciliation of minimum rentals payable with the amount of capitalized lease obligations included in the Consolidated Statement of Financial Position as of December 31, 1993. Rental expense and related rental income applicable to operating leases for the three years ended December 31, 1993, are summarized below: AMOCO CORPORATION AND SUBSIDIARIES _________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 11. Capital Stock There were 800,000,000 shares of common stock without par value authorized at December 31, 1993. Details concerning share transactions are shown below: In addition, there are 50 million shares of voting preferred stock and 50 million shares of non-voting preferred stock authorized. As of December 31, 1993, none of the preferred stock had been issued. Note 12. Foreign Currency A foreign currency gain of $47 million was reflected in income in 1993, compared with a gain of $129 million and a loss of $20 million for 1992 and 1991, respectively. In addition, net translation losses of $18 million and $27 million for 1993 and 1992, respectively, and a net translation gain of $1 million for 1991, were reflected in the foreign currency translation adjustment account in shareholders' equity. AMOCO CORPORATION AND SUBSIDIARIES ________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 13. Interest Expense The Corporation capitalizes interest cost related to the financing of major projects under development. All other interest is expensed as incurred. The components of interest expense are summarized in the following table: Note 14. Research and Development Expenses Research and development costs are expensed as incurred and amounted to $292 million in 1993, $300 million in 1992 and $330 million in 1991. Note 15. Taxes Effective January 1, 1992, the Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 109. The cumulative effect of the accounting change, relating to years prior to 1992, was to increase deferred income tax liabilities as of January 1, 1992, and reduce net income by $68 million ($.14 per share). In addition, 1992 net income before the cumulative effect was $215 million ($.43 per share) greater than it would have been under SFAS No. 96, the previous method. The Corporation had adopted SFAS No. 96, effective January 1, 1991. The cumulative effect of that accounting change was to decrease deferred income tax liabilities and increase 1991 net income by $311 million, or $.62 per share. AMOCO CORPORATION AND SUBSIDIARIES _________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The aggregate federal and foreign deferred income tax liability represents the tax effect of the following items at December 31: The decrease in the deferred tax asset valuation allowance primarily reflects recognition of tax benefits related to foreign operations and asset sales. The provision for income taxes is composed of: AMOCO CORPORATION AND SUBSIDIARIES _________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The following is a reconciliation between the provision for income taxes and income taxes determined by applying the federal statutory rate to income before income taxes: Taxes other than income taxes include: Undistributed earnings of certain foreign subsidiaries and joint-venture companies aggregated $341 million on December 31, 1993, which, under existing law, will not be subject to U.S. tax until AMOCO CORPORATION AND SUBSIDIARIES ________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) distributed as dividends. Since the earnings have been or are intended to be indefinitely reinvested in foreign operations, no provision has been made for any U.S. taxes that may be applicable thereto. Furthermore, any taxes paid to foreign governments on those earnings may be used in whole or in part, as credits against the U.S. tax on any dividends distributed from such earnings. It is not practicable to estimate the amount of unrecognized deferred U.S. taxes on these undistributed earnings. Note 16. Stock Option Plans The Corporation's stock option plans approved by shareholders provide for the granting of options with or without stock appreciation rights ("SARs") to key, managerial and other eligible employees to buy Corporation common stock at not less than 100 percent of the fair market value at the date of grant. Such options may be incentive stock options to the extent provided in the Internal Revenue Code. Options granted under the plans normally extend for 10 years and generally become exercisable two years after the date of the grant. Options with SARs permit holders to surrender exercisable options in exchange for payment determined by the amount by which the market value of the shares on the dates the rights are exercised exceeds the grant price. No options were granted with SARs in 1993. Such payments can be made in shares, cash or a combination at the discretion of the administering committee. Option plan transactions in 1993 are summarized in the following table: Of the total options outstanding on December 31, 1993, 692,492 were with SARs. Stock options for 6,396,005 shares were exercisable at year-end 1993. No options may be granted under the current plan after December 31, 2001. The Corporation's restricted stock grant plans provide for the awarding of shares of Corporation common stock to selected employees of Amoco and its participating subsidiaries, including officers and directors. Shares issued under the plans may not be sold or otherwise AMOCO CORPORATION AND SUBSIDIARIES ________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) transferred for a minimum period as established at the time of the grant. The shares generally are subject to forfeiture if the recipient's employment terminates during the specified period unless such termination is due to death, total disability or involuntary retirement. Shares issued have dividend and voting rights identical to other outstanding shares of the Corporation's common stock. During 1993, 58,535 shares were issued under the current plans. No restricted shares may be issued under the current plan after December 31, 2001. Note 17. Employee Compensation Programs Management incentive compensation plans approved by shareholders provide for the granting of awards to key, managerial and other eligible executives of the Corporation and certain subsidiaries. Amounts charged against earnings in anticipation of awards to be made later were $10 million in 1993, $8 million in 1992 and $6 million in 1991. Awards made in 1993, 1992 and 1991 amounted to $13 million, $16 million and $19 million, respectively. The Amoco Performance Share Plan, which became effective in 1992, allocates Amoco stock to employees when the Corporation's total return to shareholders meets or exceeds the average return achieved by a select group of competitors. No contributions were made on behalf of employees in 1993 as the return on Amoco common stock was below the competitor average. The return on Amoco stock was above the competitor average in 1992. As a result, employees earned stock equal to 4.4 percent of base compensation, and the amount charged to expense in 1992 was $77 million. Note 18. Retirement Plans The Corporation and its subsidiaries have a number of defined benefit pension plans covering most employees. Plan benefits are generally based on employees' years of service and average final compensation. Essentially all of the cost of these plans is borne by the Corporation. The Corporation makes contributions to the plans in amounts that are intended to provide for the cost of pension benefits over the service lives of employees. AMOCO CORPORATION AND SUBSIDIARIES _______________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The funded status of the plans as of December 31 for 1993 and 1992 was as follows: AMOCO CORPORATION AND SUBSIDIARIES _________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The actuarial assumptions used for the Corporation's principal pension plans for 1993 and 1992 were as follows: The components of net pension cost for the past three years were as follows: Most employees are also eligible to participate in defined contribution plans by contributing a portion of their compensation. The Corporation matches contributions up to specified percentages of each employee's compensation. Matching contributions charged to income were $96 million in 1993, $100 million in 1992 and $87 million in 1991. Note 19. Other Postretirement Benefits The Corporation and its subsidiaries provide certain health care and life insurance benefits for retired employees. Substantially all of the Corporation's domestic employees and employees in certain foreign countries are provided these benefits through insurance companies whose premiums are based on benefits paid during the year. Effective January 1, 1992, the Corporation adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires that the cost of such benefits be recognized during employees' years of active service. Prior to 1992, the cost of providing benefits to retirees was expensed as paid, and amounted to $47 million in 1991. AMOCO CORPORATION AND SUBSIDIARIES ________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The cumulative effect of the accounting change, relating to benefits attributable to years of service prior to 1992, was to reduce 1992 net income by $856 million ($1.72 per share). In addition, the effect of adopting SFAS No. 106 in 1992 was to reduce net income by $64 million ($.13 per share). During 1992, the Corporation approved plan amendments which reduced the accumulated obligation by $270 million. The reduced costs associated with these amendments will be amortized prospectively over the average remaining years of service to full retirement eligibility of active employees. The status of the Corporation's unfunded plans as of December 31 for 1993 and 1992 was as follows: The actuarial assumptions used for the Corporation's principal postretirement benefit plans for 1993 and 1992 were as follows: AMOCO CORPORATION AND SUBSIDIARIES ________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The components of net postretirement benefit costs for 1993 and 1992 were as follows: Note 20. Litigation The Internal Revenue Service ("IRS") has challenged the application of certain foreign income taxes as credits against the Corporation's U.S. taxes that otherwise would have been payable for the years 1980 through 1982. On June 18, 1992, the IRS issued a statutory Notice of Deficiency for additional taxes in the amount of $466 million, plus interest, relating to those years. The Corporation has filed a petition in the U.S. Tax Court contesting the IRS statutory Notice of Deficiency. A similar amount of additional taxes is expected to be claimed for years 1983 through 1985 based upon a subsequent IRS audit. Any claims for years subsequent to 1985 would not be as significant as those for prior years. The Corporation believes that the foreign income taxes have been reflected properly in its U.S. federal tax returns, and intends to contest the IRS claims. The Corporation is confident that it will prevail in the litigation. Consequently, this dispute is not expected to have a material adverse effect on the consolidated financial position of the Corporation. Note 21. Other Contingencies and Commitments At December 31, 1993, contingent liabilities of the Corporation included guarantees of $51 million on outstanding loans of others. The Corporation also has entered into various working capital maintenance agreements and pipeline throughput and deficiency contracts with affiliated companies. These agreements supported an estimated $15 million of affiliated company borrowings at December 31, 1993. The fair value of these guarantees and agreements is considered to be substantially less than the nominal amounts of the outstanding borrowings. In the normal course of business, the Corporation has entered into contracts for the purchase of transportation capacity, materials and services over terms of up to 16 years. The remaining minimum payments required under these contracts at December 31, 1993, totaled $487 million. AMOCO CORPORATION AND SUBSIDIARIES ________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) A significant portion of Amoco's receivables are from other oil and gas and chemical companies. Although collection of these receivables could be influenced by economic factors affecting these industries, the risk of significant loss is considered remote. Amoco is subject to federal, state and local environmental laws and regulations. Amoco is currently participating in the cleanup of numerous sites pursuant to such laws and regulations. The reasonably estimable future costs of probable environmental obligations, including Amoco's probable costs for obligations for which Amoco is jointly and severally liable, and for assets or businesses that were previously disposed, have been provided for in the Corporation's results of operations. These estimated costs represent the amount of expenditures expected to be incurred in the future to remediate sites with known environmental obligations. The accrued liability represents a reasonable best estimate of Amoco's remediation liability. As the scope of the obligations becomes better defined, there may be changes in the estimated future costs, which could result in charges against the company's future results of operations. The ultimate amount of any such future costs, and the range within which such costs can be expected to fall, cannot be determined. Although the costs could be significant, they are not expected to have a material effect on Amoco's liquidity or consolidated financial position. AMOCO CORPORATION AND SUBSIDIARIES ________________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Note 22. Summarized Financial Data--Amoco Company The Corporation's principal subsidiary, Amoco Company, is the holding company for all petroleum and chemical operating subsidiaries except Amoco Canada. Amoco guarantees the outstanding public debt obligations of Amoco Company. Summarized financial data for Amoco Company are presented as follows: Annual maturities of long-term debt during the next five years, including the portion classified as current, are $43 million in 1994, $135 million in 1995, $246 million in 1996, $202 million in 1997 and $263 million in 1998. Note 23. Segment and Geographic Data The Corporation operates in several industry segments. Petroleum operations include exploration and production ("E&P") and refining, marketing and transportation ("RM&T") segments. The E&P segment is engaged in exploring for, developing and producing crude oil and natural gas and extraction of natural gas liquids ("NGL"). The RM&T segment is responsible for petroleum refining operations, the marketing of all refined petroleum products and the transportation and wholesale marketing of NGL. This segment also encompasses transportation of crude oil to the refineries via marine vessels and pipelines and associated supply and trading activities. The chemical segment manufactures and sells various petroleum-based chemical products. Other operations include investments in technology companies, offshore contract drilling, real estate AMOCO CORPORATION AND SUBSIDIARIES _______________________ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) interests, hazardous-waste incineration facilities and other diversification activities. Intersegment and intergeographic sales are accounted for at prices that approximate arm's-length market prices. Operating profits include all revenues and expenses of the reportable segment, except for income taxes and equity in earnings of unconsolidated companies. Income taxes are generally assigned to the operations that give rise to the tax effects. Identifiable assets are those used in the operations of each segment or area, including intersegment or intergeographic receivables. Corporate assets consist primarily of cash, marketable securities and the unamortized cost of purchased tax benefits. Intersegment and intergeographic sales and receivables are eliminated in determining consolidated revenue and identifiable asset totals. Information by Industry Segment and Geographic Area is summarized in the tables on pages 60 to 63. AMOCO CORPORATION AND SUBSIDIARIES ________________________ SUPPLEMENTAL INFORMATION 1. Quarterly Results and Stock Market Data 2. Oil and Gas Exploration and Production Activities Supplemental information about oil and gas exploration and production activities is reported in compliance with SFAS No. 69, "Disclosures about Oil and Gas Producing Activities." Results of Operations for Oil and Gas Producing Activities Oil and gas production revenues reflect the market prices of net production sold or transferred, with appropriate adjustments for royalties, net profits interest and other contractual provisions. Other revenues in 1993 include Canadian gains on dispositions of properties and investments. Taxes other than income include production and severance taxes and property taxes. Other production costs are lifting costs incurred to operate and maintain productive wells and related equipment, including such costs as operating labor, repairs and maintenance, materials, supplies and fuel consumed. Also included are operating costs of field natural gas liquids plants, because the Corporation includes the operations of these plants in the exploration and production segment. Production costs include related administrative expenses and depreciation applicable to support equipment associated with production activities. Exploration expenses include the costs of geological and geophysical activity, carrying and retaining undeveloped properties and drilling exploratory wells determined to be non-productive. Depreciation, depletion and amortization expense relates to capitalized costs incurred in acquisition, exploration and development activities and does not include depreciation applicable to support equipment. Included in other related costs for 1993 are significant, non-recurring items and purchases of natural gas for field natural gas liquids plants. These items were classified as production costs in prior years; data for 1992 and 1991 were reclassified in the table above. Significant, non-recurring items include $210 million for the writedown of Congo operations to current recoverable value and U.S. environmental charges of $96 million in 1993, and restructuring charges of $566 million and $38 million in 1992 and 1991, respectively. Income taxes are generally assigned to the operations that give rise to the tax effects. Results of operations do not include interest expense and general corporate amounts nor their associated tax effects. Standardized Measure of Discounted Future Net Cash Flows Relating to Proved Oil and Gas Reserves The standardized measure of discounted future net cash flows relating to proved oil and gas reserves is prescribed by SFAS No. 69. The statement requires measurement of future net cash flows through assignment of a monetary value to proved reserve quantities and changes therein using a standardized formula. The amounts shown are based on prices and costs at the end of each period, legislated tax rates and a 10 percent annual discount factor. Because the calculation assumes static economic and political conditions and requires extensive judgment in estimating the timing of production, the resultant future net cash flows are not necessarily indicative of the fair market value of estimated proved reserves, but provide a reference point that may assist the user in projecting future cash flows. Summarized below is the standardized measure of discounted future net cash flows relating to proved oil and gas reserves at December 31, 1993, 1992 and 1991. Future cash inflows are computed by applying the year-end prices of oil and gas to proved reserve quantities as reported in the tables under the heading "Estimated Proved Reserves." Future price changes are considered only to the extent provided by contractual arrangements. Future development and production costs are estimated expenditures to develop and produce the proved reserves based on year-end costs and assuming continuation of existing economic conditions. Future income taxes are calculated by applying appropriate statutory tax rates to future pre-tax net cash flows from proved oil and gas reserves less recovery of the tax basis of proved properties, and adjustments for permanent differences. Statement of Changes in Standardized Measure of Discounted Future Net Cash Flows The following table details the changes in the standardized measure of discounted future net cash flows for the three years ended December 31, 1993: The price of crude oil has fluctuated over the past several years, and price changes have had significant effects on the computed future cash flows over the period shown. Because the price of crude oil is likely to remain volatile in the future, price changes can be expected to continue to significantly affect the standardized measure of future net cash flows. Estimated Proved Reserves Net proved reserves of crude oil (including condensate), natural gas liquids ("NGL") and natural gas at the beginning and end of 1993, 1992 and 1991, with the detail of changes during those years, are presented below. Reported quantities include reserves in which the Corporation holds an economic interest under production-sharing and other types of operating agreements with foreign governments. The estimates were prepared by Corporation engineers and are based on current technology and economic conditions. The Corporation considers such estimates to be reasonable and consistent with current knowledge of the characteristics and extent of proved production. These estimates include only those amounts considered to be proved reserves and do not include additional amounts that may result from extensions of currently proved areas, or amounts that may result from new discoveries in the future, or from application of secondary or tertiary recovery processes not yet determined to be commercial. Proved developed reserves are those reserves that are expected to be recovered through existing wells with existing equipment and operating methods. Capitalized Costs The following table summarizes capitalized costs for oil and gas exploration and production activities, and the related accumulated depreciation, depletion and amortization. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Part III Item 10. Item 10. Directors and Executive Officers of the Registrant The information required by this item with respect to directors is incorporated by reference to pages 3-10 of Amoco's Proxy Statement dated March 14, 1994. Also, see heading "Executive Officers of the Registrant" on page 17 of this Form 10-K. Item 11. Item 11. Executive Compensation The information required by this item is incorporated by reference to pages 11-17 of Amoco's Proxy Statement dated March 14, 1994. Information related to the Board Compensation and Organization Committee Report on Executive Compensation and the Cumulative Total Shareholder Return Five- Year Comparison graph are identified separately therein and are not incorporated herein. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item is incorporated by reference to pages 3, 10 and 12 of Amoco's Proxy Statement dated March 14, 1994. Item 13. Item 13. Certain Relationships and Related Transactions The information required by this item is incorporated by reference to page 10 of Amoco's Proxy Statement dated March 14, 1994. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. and 2. Financial Statements and Schedules See Index to Financial Statements and Supplemental Information on page 32. Schedules not included in this Form 10-K have been omitted because they are either not applicable or the required information is shown in the financial statements or notes thereto. 3. Exhibits See Index to Exhibits on page 83. (b) Reports on Form 8-K. A current report on Form 8-K dated December 1, 1993, was filed related to a jury verdict against Amoco Production Company, a subsidiary of Amoco Corporation, in RUBICON PETROLEUM INC. VS. AMOCO PRODUCTION COMPANY & AMOCO CORPORATION. In that case Rubicon alleged that in 1990 it entered into an oral contract with Amoco Production to purchase two Wyoming oil properties for $18 million. Rubicon sued for breach of contract, violation of the Texas Consumer Protection Statute and various other torts. The Matagorda County jury entered two alternative actual damage awards of $125 million and $45 million, respectively, a punitive damage award of $250 million, and attorneys' fees of one-third of Plaintiff's recovery. No judgment has yet been entered. See Item 3. Legal Proceedings. A current report on Form 8-K dated December 10, 1993, was filed related to jury verdicts in favor of Amoco Chemical Company, a subsidiary of Amoco Corporation, against certain underwriters at Lloyd's of London and various other British and European insurance carriers, in AMOCO CHEMICAL COMPANY et al, vs. CERTAIN UNDERWRITERS AT LLOYD'S OF LONDON, et al. A current report on Form 8-K dated February 8, 1994, was filed related to a judgment entered by the Superior Court of the State of California, County of Los Angeles, in favor of Amoco Chemical Company and Amoco Reinforced Plastics Company, subsidiaries of Amoco. See Item 3. Legal Proceedings. 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, in the City of Chicago, and State of Illinois, on the 22nd day of March, 1994. AMOCO CORPORATION (Registrant) H. L. FULLER H. L. Fuller Chairman of the Board 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 indicated on March 22, 1994. SCHEDULE V AMOCO CORPORATION PROPERTY, PLANT AND EQUIPMENT(1) For the Year Ended December 31, (millions of dollars) SCHEDULE VI AMOCO CORPORATION ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT SCHEDULE VIII AMOCO CORPORATION VALUATION AND QUALIFYING ACCOUNTS(1) SCHEDULE IX AMOCO CORPORATION SHORT-TERM OBLIGATIONS(1) For the Year Ended December 31, (millions of dollars, except interest rates) SCHEDULE X AMOCO CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION AMOCO CORPORATION _________________ INDEX TO EXHIBITS

30099_1993.txt

30099_1993

1993

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Item 1. Business of Dresser. - ------ ------------------- Dresser Industries, Inc., together with its subsidiaries (hereinafter "Dresser" or "Registrant" or the "Company") is a global supplier serving the total hydrocarbon energy stream, both upstream and downstream. Registrant's highly engineered and integrated products and technical services are primarily utilized in oil and gas drilling, production and transmission; gas distribution and power generation; gas processing; petroleum refining and marketing; and petrochemical production. Dresser was incorporated under the laws of Delaware in 1956 as a successor to a Pennsylvania corporation organized in 1938 by the consolidation of S. R. Dresser Manufacturing Company and Clark Bros. Company. Both were carrying on businesses founded in 1880. Dresser's executive offices are located at 2001 Ross Avenue, Dallas, Texas 75201 (telephone number 214/740- 6000). For the fiscal year ended October 31, 1993, consolidated sales and service revenues of Registrant amounted to $4,216 million. A majority of such revenues was derived from the sale of products and services to energy-oriented industries, including oil and gas exploration, drilling and production, gas transmission and distribution; petroleum and chemical processing; production of electricity; and marketing of petroleum products. Registrant's operations are divided into three industry segments: Oilfield Services; Hydrocarbon Processing Industry; and Engineering Services. Effective February 1, 1993, Registrant acquired the stock of Bredero Price Holding B.V. and its subsidiary companies ("Bredero Price"), a Netherlands based company that provides pipe coating for both onshore and offshore markets. These operations are included in the Oilfield Services segment. Effective April 1, 1993, Registrant acquired TK Valve & Manufacturing, Inc. ("TK Valve"), a Texas corporation that supplies ball valves for the oil and gas production and transmission industry. These operations are also included in the Oilfield Services segment. On December 8, 1993, Registrant announced an agreement to sell its 29.5% interest in Western Atlas International, Inc. to a wholly owned subsidiary of Litton Industries, Inc. The sale closed on January 28,1994. On January 19, 1994 shareholders of Registrant voted to approve the merger (the "Merger") of BCD Acquisition Corporation ("BCD"), a wholly owned subsidiary of Registrant, into Baroid Corporation ("Baroid"). The Merger was effective January 21, 1994 (the "Effective Date"), pursuant to an Agreement and Plan of Merger (the "Merger Agreement") dated September 7, 1993, among Registrant, BCD and Baroid. Shareholders of Baroid on the Effective Date will receive 37,286,662 million shares of Registrant's Common Stock in exchange for all of the issued and outstanding shares of Baroid. In addition, approximately 3.6 million shares of Registrant's Common Stock are reserved for issuance upon exercise of outstanding warrants to purchase Baroid common stock and for issuance pursuant to certain benefit plans assumed by Registrant. For financial reporting purposes, the Merger will be treated as a pooling of interests combination. Baroid operations include drilling fluids, drilling services and products and offshore services businesses. Further information concerning Baroid is included under the caption "Baroid" and Note R to the Consolidated Financial Statements. In connection with the Merger, Registrant and Baroid announced December 23, 1993, that they reached an agreement with the Antitrust Division of the Department of Justice (the "Antitrust Division") pursuant to which Registrant must dispose of either its 64% interest in M-I Drilling Fluids Company or Baroid Drilling Fluids Inc., a wholly-owned subsidiary of Baroid. In addition, Registrant must also dispose of the United States diamond drill bit business of DB Stratabit, Inc. ("DBS") and grant to the purchaser a non-exclusive license to manufacture steel-bodied diamond drill bits worldwide. Divestiture of the drilling fluids business must occur by June 1, 1994 and the diamond drill bit transaction must occur by July 1, 1994. On January 27, 1994, Registrant announced that it has agreed in principle to sell its interest in M-I Drilling Fluids Company to Smith International, Inc. The completion of the transaction is subject to the negotiation and execution of a definitive agreement, approval from both the Smith and Dresser Boards of Directors, the consent of minority partner Halliburton Company and certain regulatory approvals. Baroid operations are conducted principally through subsidiaries as follows: Drilling Fluids - --------------- Baroid Drilling Fluids Inc. provides specially formulated fluids used in the drilling process to lubricate and cool the drill bit, seal porous well formations, remove rock cuttings and control downhole pressure. Baroid Drilling Fluids Inc. is a worldwide integrated producer and distributor of drilling fluids. Drilling Services and Products - ------------------------------ Sperry-Sun Drilling Services Inc. ("Sperry-Sun") rents specialized steering and measurement-while-drilling ("MWD") tools and provides directional drilling services for oil and gas wells throughout the world. DBS provides diamond drill bits and coring products and services to the oil and gas industry worldwide. Offshore Services - ----------------- Sub Sea International Inc. ("Sub Sea") provides diving and underwater engineering services to the oil and gas industry to inspect, construct, maintain and repair offshore drilling rigs and platforms, underwater pipelines and other offshore oil and gas facilities. Unmanned, remotely operated vehicles ("ROVs") are often used to perform these services. Sub Sea designs, manufactures and deploys ROVs. Sub Sea also owns and operates marine equipment which performs pipeline installation, burial and inspection and maintenance and repair work on platforms in offshore oil and gas fields. The Information by Industry Segment is included in Note P to Consolidated Financial Statements on pages 50-52 and in Management's Discussion and Analysis on pages 12-20. This information includes sales and service revenues, operating profit or loss and identifiable assets attributable to each of Registrant's business segments for each of the past three fiscal years. This information should be read in conjunction with the consolidated financial statements, notes and accountant's report appearing in Item 8 of this report. OILFIELD SERVICES Registrant's oilfield services segment supplies products and services essential to oil and gas exploration, drilling and production. These products and services include drilling fluid systems, rock bits, production tools, pipe coating and resource exploration services. Drilling Fluid Systems and Related Services. M-I Drilling Fluids Company, a Texas general partnership in which Registrant has a 64% interest, provides a variety of drilling fluid systems and markets such fluids and related services for use in connection with drilling oil and gas wells. M-I markets drilling fluid systems and related services through its sales force to major domestic and international oil companies, independent drilling operators and contractors and foreign government-owned companies. Through its Swaco Geolograph operations, M-I designs, builds and markets a broad line of detection and control equipment used during drilling, often in conjunction with the above described fluid systems, and shakers, desilters, degassers and centrifuges used to remove solids and gas prior to re- use of the fluids. Total net revenues for M-I were $398.6 million in 1993, $384.1 million in 1992 and $443.5 million in 1991. Pipe Coating. Bredero Price, acquired in February 1993, provides pipe coating services for use both in on-shore and offshore pipelines, primarily in Europe and Asia. Rock Bits. Registrant produces a full line of oilfield and mining rock bits which are marketed under the Security trademark and are used in drilling oil and gas wells and in the mining industry. Production Tools. Registrant's Guiberson AVA Division produces and markets a broad line of tools which are sold to the completion, production and workover segments of the oil production industry. Drilling and well servicing contractors provide the primary market for bits and tools. Resource Exploration Services. Western Atlas International, Inc. ("Western Atlas"), an unconsolidated affiliate in which Registrant owns 29.5% of the outstanding shares, performs seismic services; integrated reservoir description services; data reduction and interpretation; core and fluids analysis; wireline logging; and provides specialized oilfield services equipment. Primary customers are the energy industry and governments worldwide. On December 8, 1993, Registrant announced it will sell its interest in Western Atlas to an affiliate of Litton Industries, Inc. for $558 million. HYDROCARBON PROCESSING INDUSTRY This segment designs, manufactures and markets highly engineered products and systems for energy producers, transporters, processors, distributors and users throughout the world. Products and systems of this segment include compressors, turbines, electrical generator systems, pumps, power systems, measurement and control devices, and gasoline dispensing systems. Compressors. Dresser-Rand Company, a New York general partnership in which Registrant has a 51% interest, manufactures industrial and aircraft derivative gas turbines, centrifugal compressors, axial compressors, reciprocating compressors, axial expanders, single and multi-stage steam turbines, and electric motors and generators. Gas turbines, motors, and steam turbines are used to drive compressors, generators and pumps with applications in many markets including: cogeneration, power generation, natural gas gathering, processing, transmission and distribution, natural gas injection, petrochemical plants, and refineries. An extensive line of centrifugal compressors is used in a multitude of services including: gas injection, gas lift, gas processing, transmission and distribution, urea and ammonia production, ethylene and liquified natural gas (LNG) production, coal gasification, refinery services and other petrochemical processes. Axial compressors are used in coal gasification, blast furnace, nitric acid and refinery services. Axial expanders are used in power recovery applications, nitric acid plants and refinery processes. Dresser-Rand also manufactures and supplies water cooled reciprocating compressors. Separate compressor lines are manufactured and marketed for the process, enhanced oil recovery, natural gas, and industrial air commercial markets and special shipboard air compressors for the Navy. Dresser-Rand's single and multi-stage mechanical drive steam turbines are used to power pumps, fans, blowers, reciprocating compressors and centrifugal compressors; steam turbine generator sets provide electric power for co- generation and alternate fuel markets; electric motors (synchronous and induction type); and electric generators are used with reciprocating engine, hydroturbine, steam turbine and gas turbine drivers. Dresser-Rand also manufactures and markets cryogenic expanders, combined with single stage compressors or generators, to recover energy from production of low temperature process gases used in air separation hydrocarbon facilities. The primary markets for such products are petroleum, petrochemical, chemical, paper and sugar industries, and engineering firms which design plants for such industries. The Consolidated statement of earnings for 1993 includes the $1,118.1 million of Dresser-Rand's sales revenues. Sales revenues for Dresser-Rand were not included in the consolidated statements of earnings for 1992 and 1991 while it was only 50% owned by Registrant. Pumps. Effective October 1, 1992, Registrant's Pump operations (excepting Mono Pump and Peabody) were combined with the Pump operations of Ingersoll-Rand Company into Ingersoll-Dresser Pump Company, a Delaware general partnership in which Registrant has a 49% interest. Ingersoll-Rand Company holds a 51% interest in Ingersoll-Dresser Pump Company. Ingersoll-Dresser Pump Company designs, develops, manufactures and markets centrifugal pumps which are used for critical applications in energy processing and petrochemical markets as well as in utility and municipal water and waste water markets. Ingersoll-Dresser Pump also manufactures heavy duty process pumps, submersible pumps, vertical turbine pumps, standard end-suction pumps, horizontal split-case and multistage pumps designed for general industrial, pipeline and high pressure services. Such pumps have a wide variety of applications in oil and gas production and refining, chemical and petrochemical processing, marine, sugar, agricultural, mining and mineral processing, utilities and general industry. Registrant's consolidated statements of earnings include net revenues for the Pump businesses transferred to Ingersoll-Dresser Pump Company of $517.5 million for eleven months for 1992 and $553.1 million for 1991. Registrant's Mono Pump operations produce progressing cavity pumps for handling viscous fluids. Power Systems. Registrant's Waukesha Engine Division produces heavy-duty reciprocating gas and diesel engines and packaged engine driven generator sets. Roots, the developer of the rotary lobe blower, offers a full line of low to medium pressure air and gas handling blowers along with vacuum pumps. These include rotary lobe and screw-type positive displacement products and several turbomachinery (centrifugal) lines. The primary markets served by Roots are waste water treatment, pneumatic conveying, paper, chemical and general industrial. Control Products. Control products encompass an assortment of sensing, indicating, transducing, transmitting and controlling devices. Instruments, valves and meters sold under registered trademarks - ASHCROFT, CONSOLIDATED, DEWRANCE, DURAGAUGE, DURATEMP, DURATRAN, EBRO, HANCOCK, HEISE, MASONEILAN and WILLY - measure and control pressure, temperature, level and flow of liquids and gases. These products are sold primarily to the process, power and gas distribution industries. Specialty products include gas meters, pipe fittings, couplings and repair devices for sale to the gas and water utilities and other industrial markets under the registered DRESSER trademark. Marketing Systems. Registrant manufactures and sells a variety of gasoline and diesel fuel dispensing systems and automated control systems under the Wayne trade name. ENGINEERING SERVICES Registrant's wholly owned subsidiary, The M. W. Kellogg Company, provides engineering, construction and related services, primarily to the hydrocarbon process industries. Sales and service revenues for The M.W. Kellogg Company were $1,209.3 million, $1,558.8 million, and $1,594.2 million for 1993, 1992 and 1991 respectively. BACKLOG The backlog of unfilled orders at October 31, 1993, 1992 and 1991 is included in Management's Discussion and Analysis on page 18. SALES AND DISTRIBUTION Registrant's products and services are marketed through various channels. In the United States, sales are generally made through a group or division sales organization or through independent distributors. Sales in Canada are usually effected through a division of a Canadian subsidiary. Sales in other countries are made directly by a United States division or subsidiary, through foreign subsidiaries or affiliates, and through distributor arrangements or with the assistance of independent sales agents. COMPETITION AND ECONOMIC CONDITIONS Dresser's products are sold in highly competitive markets, and its sales and earnings can be affected by changes in competitive prices, fluctuations in the level of activity in major markets, or general economic conditions. FOREIGN OPERATIONS Registrant maintains manufacturing, marketing or service facilities serving more than 75 foreign countries. Global distribution of products and services is accomplished through more than 290 subsidiary and affiliated companies engaged in various production, manufacturing, service, and marketing functions, and through foreign representatives serving the principal market areas of the world. The Information by Geographic Area is included in Note P to Consolidated Financial Statements on pages 50-52. Registrant's foreign operations are subject to the usual risks which may affect such operations. Such risks include unsettled political conditions in certain areas, exposure to possible expropriation or other governmental actions, operating in highly inflationary environments, and exchange control and currency problems. RESEARCH, DEVELOPMENT AND PATENTS Registrant's divisions, subsidiaries and affiliates conduct research and development activities in laboratories and test facilities within their particular fields for the purposes of improving existing products and developing new ones to meet the needs of their customers. In addition, research and development programs are directed toward development of new products and services for diversification or expansion. For the fiscal years ended October 31, 1993, 1992 and 1991, Registrant spent $81.5 million, $11 million and $9.4 million, respectively, for research and development activities. At December 1, 1993, Registrant and its subsidiaries and affiliates owned 1,536 patents and had pending 503 patent applications, covering various products and processes. They also were licensed under patents owned by others. Registrant does not consider that any patent or group of patents relating to a particular product or process is of material importance when judged from the standpoint of Registrant's total business. EMPLOYEES As of October 31, 1993, Registrant had approximately 15,700 employees in the United States (a decrease of approximately 12% from October 31, 1992), of whom approximately 5,500 were members of 10 unions represented by 21 bargaining units. As of the same date, Registrant had approximately 10,200 employees at foreign locations of whom approximately 4,500 were members of unions. During fiscal 1993, Registrant experienced one strike which lasted for 44 days. Relations between Registrant and its employees are generally considered to be satisfactory. EXECUTIVE OFFICERS OF REGISTRANT The names and ages of all executive officers of Registrant, all positions and offices with Registrant presently held by each person named and their business experience during the last five years are stated below: Principal Occupation During --------------------------- Name, Age and Position Past Five Years ---------------------- --------------- OFFICER EMPLOYED BY JOINT VENTURE COMPANY All officers are elected annually by the Board of Directors at a meeting following the Annual Meeting of Shareholders. The officers serve at the pleasure of the Board of Directors and can be removed at any time by the Board. Item 2. Item 2. Properties - ------ ---------- Registrant, together with its subsidiaries and affiliates, has more than 65 manufacturing plants, ranging in size from approximately 3,000 square feet to in excess of 980,000 square feet and totaling more than 10.8 million square feet, located in the United States, Canada, and various other foreign countries. The majority of the manufacturing sites are owned in fee. In addition, sales offices, warehouses, service centers and stock points are maintained, almost all in leased space, in the United States, Canada and certain other foreign countries. The properties are believed to be generally well maintained, adequate for the purposes for which they are used, and capable of supporting a higher level of market demand. During fiscal 1993 M-I Drilling Fluids Company also had 24 grinding and/or other facilities for beneficiating mineral ores, containing approximately 287 acres in plant site property. The following are the locations of the principal facilities of Registrant and its majority owned joint ventures for each industry segment as of October 31, 1993. - ---------------- (1) all or a portion of these facilities are leased. M-I Drilling Fluids Company, a partnership in which Registrant has a 64% interest, has mineral rights to proven and prospective reserves of barite, bentonite and lignite. Such rights included leaseholds and mining claims and property owned in fee. The principal deposit of barite is located in Nevada, with deposits also located in Ireland and Scotland. Reserves of bentonite are located in Wyoming and Greece. Based on the number of tons of each of the above minerals mined in fiscal 1993, M-I Drilling Fluids Company estimates its reserves, which it considers to be proven, to be sufficient for operation for a period of 15 years or more. Registrant has an undivided one-half interest in lead deposits located in Missouri. The lead ore is mined and concentrated under contract with Cominco American Incorporated, a U. S. subsidiary of Cominco Ltd., a Canadian company, as Operator. Based on recent assessment by the Operator, measured and indicative reserves total approximately 2.75 million tons grading 8.32% lead, 1.21% zinc and 0.27% copper. A reduced production, remnant mining phase began in 1993. Reduced grade of ore produced in recent months and the depressed price of lead and zinc have combined to limit projected mine life to the second half of 1994. Item 3. Item 3. Legal Proceedings. - ------ ----------------- The Company is involved in various legal proceedings. Information called for by this Item is included in Note L to the Consolidated Financial Statements on pages 41-44. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------ --------------------------------------------------- No matters were submitted to a vote of the Company's security holders during the quarter ended October 31, 1993. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder - ------ ----------------------------------------------------------------- Matters. ------- Registrant is listed on the New York and Pacific Stock Exchanges. The stock symbol is DI. The quarterly market prices for Registrant's Common Stock, traded principally on the New York Stock Exchange, were as follows for the two most recent fiscal years: Dividends on Registrant's Common Stock are declared by the Board of Directors and normally paid to shareholders as of the record date during the third week of March, June, September and December. The cash dividends paid per share of common stock for the first quarter of fiscal 1993 and for the 1993 and 1992 fiscal years were: As of January 25, 1994, there were approximately 25,700 shareholders of the Registrant's Common Stock. Item 6. Item 6. Selected Consolidated Financial Data - ------- ------------------------------------ The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and notes thereto included in this report. Item 7. Item 7. Management's Discussion and Analysis of Financial - ------- ------------------------------------------------- Condition and Results of Operations ----------------------------------- Results of Operations 1993 Compared to 1992 - ------------------------------------------- Earnings from continuing operations in 1993 increased $57 million to $127 million. The increase is attributable to the acquisition of Bredero Price, improved earnings in Oilfield Services and Engineering Services operations and changes implemented to reduce costs associated with retiree medical benefit plans. Revenues increased from $3.8 billion to $4.2 billion. The consolidation of Dresser-Rand's financial statements in 1993 was the primary reason for the increase. In 1992, Dresser-Rand was accounted for using the equity method. Earnings from operations were $219 million in 1993 compared to $126 million in 1992. Both 1993 ($74.1 million) and 1992 ($70.0 million) included Special Charges. The 1993 charge was primarily due to the settlement of the Parker & Parsley litigation ($65 million) while in 1992 the charges were mainly attributable to restructuring, particularly the Ingersoll-Dresser Pump joint venture. Excluding the Special Charges, Earnings from Operations were $293 million in 1993 and $196 million in 1992. In 1993, Earnings from Operations included 100% of Dresser-Rand's results, which added $46 million compared to 1992. In addition, the Company and its joint ventures amended retiree medical benefit plans, thereby reducing the related 1993 expense by some $26 million compared to 1992. Also during 1993, Ingersoll-Dresser Pump Company Results of Operations 1993 Compared to 1992 (Continued) - ------------------------------------------------------- sold the inventory the Company contributed to the joint venture, allowing the release of the associated LIFO inventory reserves of $21 million. This gain is reflected as a component of the earnings from the joint venture. See the Industry Segment Analysis beginning on page 15 for a discussion of the results for each segment. Other income increased from $18 million in 1992 to $32 million in 1993 because of a $13 million gain resulting from a plan change in retiree medical benefits for younger employees. Reduced interest expense resulting from the redemption of sinking fund debentures in 1992 was offset by interest on debt incurred to finance acquisitions. The effective tax rate declined to 33% in 1993 from 45% in 1992 as a result of reduced losses in foreign countries with no tax benefit, increased utilization of foreign tax credits and a $9 million benefit associated with a change in the tax rate from 34% to 35%. The consolidation of Dresser-Rand in 1993 resulted in an increase in minority interest representing our partner's 49% share of Dresser-Rand's earnings. Results of Operations 1992 Compared to 1991 - ------------------------------------------- Earnings from continuing operations were $70 million in 1992, down from $132 million in 1991. The decrease reflected the after-tax special charge of $50 million for restructuring and the increased expense for retiree medical benefits of $21 million net of tax. Revenues declined to $3.8 billion from $4.0 billion in 1991, with slightly lower revenues in each segment accounting for the reduction. Earnings from operations before Special Charges in 1992 of $196 million were $51 million lower than the $247 million recorded in 1991. The change in accounting for retiree medical benefits in 1992 accounted for $32 million of the reduction. See the Industry Segment Analysis beginning on page 15 for a discussion of the results for each segment. Other income amounted to $18 million in 1992 versus net expense of $2.3 million in 1991. The redemption of high rate sinking fund debentures reduced interest expense by $8 million. Also in 1992, the Company sold a partial interest in M. W. Kellogg's United Kingdom subsidiary resulting in a $15.5 million gain. The effective tax rate increased to 45% in 1992 from 38% in 1991. A reduction in utilization of foreign tax credits and increased foreign losses with no corresponding tax benefit caused the increase. Results of Operations 1992 Compared to 1991 (Continued) - ------------------------------------------------------- In 1992, the Company spun-off its industrial products operations (INDRESCO) and made the decision to dispose of its Environmental Products business. The results of these operations are reflected as Discontinued Operations in the 1992 and 1991 financial statements. In 1992, the Company adopted two new accounting standards relating to retiree medical benefits and income taxes. The combined net effect of these changes was a one time non-cash charge of $394 million or $2.91 per share, which is reflected as the Cumulative Effect of Accounting Changes in the 1992 Statement of Earnings. Legal and Environmental Matters - ------------------------------- During 1993, the Company settled litigation involving Parker & Parsley for a cash payment of $58 million. See Note L - Commitments and Contingencies for further discussion of this settlement and other pending legal matters. Note L also includes disclosure of environmental clean-up situations in which the Company is involved. Cash Flow and Financial Position - -------------------------------- Dresser's overall financial position remains strong at October 31, 1993. During 1993, the Company redeemed the last of its 11-3/4% debentures and issued $300 million of 6.25% Notes due 2000. The ratio of debt to total capitalization was 36%, which is consistent with the Company's objective of 35% debt and 65% equity. Available cash and short-term credit lines, combined with cash provided by operations, should be adequate to finance known requirements. Cash provided by operations before payments associated with the Parker & Parsley settlement of $58 million was adequate to cover capital expenditures of $140 million and dividends of $82 million. The proceeds from the $300 million of 6.25% Notes issued during the year, together with $200 million of commercial paper borrowings, was used to finance the acquisition of Bredero Price and TK Valve ($267 million), repay long-term debt ($80 million) and pay the settlement of the Parker & Parsley litigation ($58 million). Capital expenditures increased in 1993 by $51 million to $140 million. Most of the increase was due to the consolidation of Dresser-Rand in 1993. Dresser- Rand's capital expenditures amounted to $58 million in 1993 compared to the Pump Operations capital expenditures of $13 million in 1992. Capital expenditures planned for 1994 approximate $140 million. Industry Segment Analysis - ------------------------- See details of financial information by Industry Segment on pages 18 to 20. Oilfield Services Segment - ------------------------- Consolidated revenues in 1993 included $209 million from the operations of Bredero Price and TK Valve, which were acquired in early 1993. Excluding revenues of the acquired operations, segment revenues in 1993 were essentially unchanged from 1992. The favorable impact of higher North American drilling activity on the sales volume of M-I Drilling Fluids (owned 64% by Dresser), Guiberson AVA Division and Security Division was substantially offset by the impact of lower international drilling activity. Excluding the operating profit of Bredero Price and TK Valve, 1993 operating profit of consolidated operations increased $16 million or 93% over 1992. Higher M-I Drilling Fluids profit reflected higher domestic sales volume and the benefit of operating cost reductions for a full year. Operating profit improved in both the Security and Guiberson AVA divisions. Oilfield Services results in 1992 were significantly affected by lower U.S. drilling activity compared to 1991. Consolidated revenues were down 13% from 1991, resulting in operating profit $45 million under 1991. Operating expense reductions made during 1992 only partly offset the impact of lower sales volume in M-I Drilling Fluids, Security Division and Guiberson AVA Division. In 1992, special charges of $17 million were recorded for restructuring to reduce consolidated oilfield services operations to a size appropriate to the lower level of domestic exploration, drilling and production activity. Western Atlas International, owned 29.5% by Dresser, benefited from better North American activity and continuing expanded international markets in 1993. On 10% lower revenues, the Company's share of operating profit increased to $39 million or 11% from 1992, which showed a similar increase over 1991. The Company has agreed to sell its interest in Western Atlas International to the majority partner in early 1994 for $558 million. The merger of Dresser with Baroid, a worldwide supplier of oilfield services and equipment with sales of $850 million, will significantly expand the Company's range of products and services to Oilfield customers. See Note R to Consolidated Financial Statements for information which gives effect to the merger. Industry Segment Analysis (Continued) - ------------------------------------- Hydrocarbon Processing Industry Segment - --------------------------------------- Changes in ownership and the formation of a major joint venture have significantly affected the comparison of revenues and operating profit in the Hydrocarbon Processing Segment. Dresser increased its ownership in Dresser-Rand Company from 50% to 51% as of October 1, 1992. As a result, Dresser-Rand is included as a consolidated subsidiary in 1993 and as a major joint venture in 1992 and 1991. Ingersoll-Dresser Pump Company was formed as of October 1, 1992 with Dresser owning 49%. Ingersoll-Dresser Pump is included as a major joint venture in 1993. Dresser's Pump business, which was transferred to Ingersoll- Dresser Pump, is included as consolidated Pump Operations in 1992 and 1991. Revenues for 1993 of consolidated operations other than Dresser-Rand and Pump Operations decreased 4% from 1992. A 12% decrease in sales in the Valve and Controls Division was primarily due to depressed market conditions in key international markets and to the strength of the dollar compared to other currencies. Operating profit of the consolidated operations other than Dresser-Rand and Pump Operations of $128 million was 2% under 1992. A strong performance in 1993 by the Wayne Division with earnings up $15 million from 1992 offset a 23% decline for Valve and Controls. Earnings in international markets, principally Europe, were down in 1993 compared to the prior year. Also, inventory reductions in 1992, which resulted in a favorable LIFO impact of $9 million, did not recur in 1993. In 1992, consolidated sales excluding Dresser-Rand and Pump Operations were down slightly from 1991 with no significant changes in any one division. Earnings in 1992 increased $13 million compared to 1991. Strong earnings for the Wayne Division, improvements in the Instrument and Valve and Controls divisions and the LIFO benefit referred to above were the primary reasons for the increase. Dresser-Rand, reported as a consolidated operation in 1993, had sales of $1.1 billion, which were 13% lower than in 1992. In 1992, sales which were not included in Dresser's consolidated revenues increased from $1.2 billion in 1991 to $1.3 billion. Operating profit for each of the last three years was $90 million in 1993, $86 million in 1992 and $94 million in 1991. Expenses associated with the change in accounting for retiree medical costs reduced earnings by $14 million and $20 million in 1993 and 1992, respectively, compared to 1991. Industry Segment Analysis (Continued) - ------------------------------------- Hydrocarbon Processing Industry Segment (Continued) - --------------------------------------------------- Ingersoll-Dresser Pump Company operated at break-even in 1993, as the joint venture with Ingersoll-Rand rationalized the operations of the two former separate businesses. Also a significant portion of the joint venture's market is the European Community, which was in the midst of a recession in 1993. Operating profit for 1993 consists primarily of a $21 million release of LIFO inventory reserves related to inventory contributed to the joint venture by the Company, which was sold to third parties during the year. The Company's separate Pump Operations contributed earnings of $32 million and $36 million in 1992 and 1991, respectively. Special charges of $7 million were recorded in 1993 related to plant closing and other restructuring in the Wayne and Valve and Control operations, primarily in Europe, and similar actions at Dresser-Rand. In 1992, special charges related to the restructuring of Pump Operations ($35 million) and restructuring and special warranty claims in other Hydrocarbon Processing operations ($14 million). Engineering Services Segment - ---------------------------- Revenues in 1993 of $1.2 billion decreased 22% from 1992. In 1992, revenues were 2% under 1991. The decline in revenues reflected reduced hydrocarbon processing activity in certain international areas and slow growth and project delays in the U.S. In 1991, revenues included a $22 million payment received by The M. W. Kellogg Company for its retained interest in a foreign project. Engineering Services operating profit in 1993 increased $8 million from 1992; in 1992 operating profit was $15 million over 1991. In 1992, M. W. Kellogg realized a $15 million gain from the sale of a partial interest in its U.K. subsidiary. Operating profit in 1991 included the $22 million in revenue for the retained interest in a foreign project. Increased operating profit on lower revenues is due to enhanced gross margins on large international projects involving technologies in which M. W. Kellogg possesses expertise. Backlog of Unfilled Orders - -------------------------- INDUSTRY SEGMENT FINANCIAL INFORMATION - COVERED BY REPORT OF INDEPENDENT ACCOUNTANTS The following financial information by Industry Segment for the years ended October 31, 1993, 1992 and 1991 is an integral part of Note P to Consolidated Financial Statements. The Company increased its ownership in Dresser-Rand Company from 50% to 51% as of October 1, 1992. As a result, Dresser-Rand is included as a consolidated subsidiary in 1993 and as a major joint venture operation in 1992 and 1991. Ingersoll-Dresser Pump Company was formed as of October 1, 1992 with the Company owning 49%. Ingersoll-Dresser is included as a major joint venture investment in 1993. The Company's Pump business that was transferred to Ingersoll-Dresser is included as Pump Operations in 1992 and 1991. INDUSTRY SEGMENT FINANCIAL INFORMATION - COVERED BY REPORT OF INDEPENDENT ACCOUNTANTS (CONTINUED) INDUSTRY SEGMENT FINANCIAL INFORMATION - COVERED BY REPORT OF INDEPENDENT ACCOUNTANTS (CONTINUED) Item 8. Item 8. Financial Statements and Supplementary Data - ------- ------------------------------------------- Report of Management The consolidated financial statements of Dresser Industries, Inc. have been prepared by management and have been audited by independent accountants. The management of the Company is responsible for the financial information and representations contained in the financial statements and other sections of this Annual Report on Form 10-K. Management believes that the financial statements have been prepared in conformity with generally accepted accounting principles appropriate under the circumstances to reflect, in all material respects, the substance of events and transactions that should be included. In preparing the financial statements, it is necessary that management make informed estimates and judgments based on currently available information of the effects of certain events and transactions. In meeting its responsibility for the reliability of the financial statements, management depends on the Company's internal control structure. This internal control structure is designed to provide reasonable assurance that assets are safeguarded and transactions are executed in accordance with management's authorization and are properly recorded. In designing control procedures, management recognizes that errors or irregularities may occur. Also, estimates and judgments are required to assess and balance the relative cost and expected benefits of the controls. Management believes that the Company's internal control structure provides reasonable assurance that errors or irregularities that could be material to the financial statements are prevented or would be detected within a timely period by employees in the normal course of performing their assigned functions. The Board of Directors pursues its oversight role for the accompanying financial statements through its Audit and Finance Committee, which is composed solely of directors who are not officers or employees of the Company. The Committee meets with management and the internal auditors to review the work of each and to monitor the discharge by each of its responsibilities. The Committee also meets with the independent accountants and internal auditors, without management present, to discuss internal control structure, auditing and financial reporting matters. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Dresser Industries, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 14(A)(1) and (2) and 14(D) on page present fairly, in all material respects, the financial position of Dresser Industries, Inc. and its subsidiaries at October 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended October 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Notes A, G and M to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions, and Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, both effective as of November 1, 1991. /s/ Price Waterhouse PRICE WATERHOUSE Dallas, Texas December 9, 1993 CONSOLIDATED STATEMENTS OF EARNINGS (LOSS) See Accompanying Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEETS See Accompanying Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEETS See Accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' INVESTMENT See Accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF CASH FLOWS See Accompanying Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note A - Summary of Significant Accounting Policies - ------------------------------------------------------------------------------- Consolidation - ------------- All majority-owned subsidiaries are consolidated and all material intercompany accounts and transactions are eliminated. Investments in 20% to 50% owned partnerships and affiliates are reported at cost adjusted for the Company's equity in undistributed earnings. Revenue Recognition - ------------------- Revenues and earnings from long-term construction contracts are recognized on the percentage-of-completion method, measured generally on a cost incurred basis. Estimated contract costs include allowances for completion risks, process and schedule guarantees and warranties that generally are not finally determinable until the latter stages of a contract. Estimated contract earnings are reviewed and revised periodically as the work progresses. The cumulative effect of any estimated loss is charged against earnings in the period in which such losses are identified. Revenues from sale of products other than from long-term construction contracts are recorded when the products are shipped. Inventories - ----------- Inventories are valued at the lower of cost or market. The cost of most U.S. inventories produced by divisions of the Parent Company and wholly-owned subsidiaries is determined using the last-in, first-out (LIFO) method. The valuation of inventories not on LIFO, principally foreign inventories and inventories of consolidated joint venture companies, is determined using either the first-in, first-out (FIFO) or average cost method. Property, Plant and Equipment - ----------------------------- Fixed assets are depreciated over the estimated service life. Most assets are depreciated on a straight-line basis. Certain assets with service lives of more than 10 years are depreciated on accelerated methods. Accelerated depreciation methods are also used for tax purposes, wherever permitted. Due to the large number of asset classes, it is not practicable to state the rates used in computing the provisions for depreciation. Maintenance and repairs are expensed as incurred. Betterments are capitalized. Intangibles - ----------- The difference between purchase price and fair values at date of acquisition of net assets of businesses acquired is amortized on a straight-line basis over the estimated periods benefited, not exceeding 40 years. Note A - Summary of Significant Accounting Policies (Continued) - --------------------------------------------------- --------------------------- Postretirement Benefits - ----------------------- Effective November 1, 1991, postretirement benefits other than pensions are accounted for in accordance with Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other than Pensions (SFAS 106). Under SFAS 106, the Company accrues the estimated cost of these benefits during the employees' active service period. The Company previously expensed the cost of these benefits as claims and premiums were paid. See Note M for additional information. Income Taxes - ------------ Effective November 1, 1991, income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109). Under SFAS 109, the Company accounts for income taxes by the asset and liability method. Previously the Company deferred the tax effects of timing differences between financial reporting and taxable income. The asset and liability method requires the recognition of deferred tax assets and liabilities for the future tax consequences of temporary differences between the financial statement basis and the tax basis of assets and liabilities. Taxes on the minority interest's share of domestic partnership earnings of consolidated entities are provided at the Company's effective domestic tax rate. See Note G for additional information. Translation of Foreign Currencies - --------------------------------- For subsidiaries in countries which do not have highly inflationary economies, asset and liability accounts are translated at rates in effect at the balance sheet date, and revenue and expense accounts are translated at rates approximating the actual rates on the dates of the transactions. Translation adjustments are included as a separate component of shareholders' investment. For subsidiaries in countries with highly inflationary economies, inventories, cost of sales, property, plant and equipment and related depreciation are translated at historical rates. Other asset and liability accounts are translated at rates in effect at the balance sheet date, and revenues and expenses excluding cost of sales and depreciation are translated at rates approximating the actual rates on the dates of the transactions. Translation adjustments are reflected in the statement of earnings. Financial Instruments - Fair Value and Off-Balance-Sheet Risk - ------------------------------------------------------------- The carrying amounts of cash and cash equivalents, short-term investments and accounts and notes payable approximate fair value because of the short maturity of those instruments. The carrying amount of long-term debt is approximately equal to fair value based on market information. Note A - Summary of Significant Accounting Policies (Continued) - --------------------------------------------------- --------------------------- Financial Instruments - Fair Value and Off-Balance-Sheet Risk (Continued) - ------------------------------------------------------------------------- The Company has cash and cash equivalents held in currencies other than local currencies, and receivables and payables to be settled in currencies other than local currencies. These financial assets and liabilities create exposure to potential foreign exchange gains and losses arising on future changes in currency exchange rates. The Company protects against such risks by entering into forward exchange contracts. The Company does not engage in speculation, nor does the Company typically hedge nontransaction-related balance sheet exposure. At October 31, 1993, the Company had $237 million of forward exchange contracts outstanding, 98% of which were in European currencies. The fair value of foreign exchange contracts is based on year-end quoted rates for contracts with similar terms and maturity dates. However, such fair values are offset by gains and losses on the assets and liabilities hedged by such contracts, so that there is no significant difference between the recorded value and fair value of the Company's net foreign exchange position. Reclassification of Prior Years - ------------------------------- Prior years' financial statements have been reclassified to conform to 1993 presentations. Note B - Cash Flow Statement - ------------------------------------------------------------------------------- Cash and cash equivalents include cash on hand and investments with maturities of three months or less at time of original purchase. Supplemental information about cash payments and significant noncash investing and financing activities is as follows (in millions): Note C - Major Unconsolidated Joint Ventures - ------------------------------------------------------------------------------- Ingersoll-Dresser Pump Company Effective October 1, 1992, the Company and Ingersoll-Rand Company formed a joint venture comprised of the pump businesses of the two companies including all standard and engineered pump operations except the Company's Mono Pump subsidiaries. The new company, Ingersoll-Dresser Pump Company, is a general partnership owned 49% by the Company and 51% by Ingersoll-Rand Company. The Company contributed approximately $151 million of net assets, including reserves for restructuring and retiree benefits other than pensions, in exchange for its ownership interest. The operating results of the contributed Dresser Pump business prior to October 1, 1992 are fully consolidated in the Company's statement of earnings. The Company's share of operating results for the month of October, 1992 and all of 1993 are included in earnings from major joint ventures. Summarized financial information is as follows (in millions): The Company's share of pre-tax earnings includes $21.3 million from the release of LIFO inventory valuation reserves related to inventory contributed to the joint venture by the Company and sold by Ingersoll-Dresser Pump Company to third parties. Note C - Major Unconsolidated Joint Ventures (Continued) - ------------------------------------------------------------------------------- In connection with the Ingersoll-Dresser Pump Company joint venture agreement, the Company granted to Ingersoll-Rand Company an option to purchase 51% of the stock of Mono Group Limited for a price equal to 51% of its book value, including the unamortized goodwill, at the exercise date. The option period begins October 1, 1994, and expires April 30, 1995. If the option to purchase is exercised by Ingersoll-Rand Company, both Ingersoll-Rand and the Company have agreed to contribute their respective Mono Group Limited shares to the Ingersoll-Dresser Pump Company as a contribution of capital to the partnership. Western Atlas International, Inc. - --------------------------------- Western Atlas International, Inc. is a joint venture that was formed May 1, 1987 when the Company and Litton Industries combined their respective Atlas Wireline division and Western Geophysical division. On December 8, 1993, the Company announced an agreement to sell its 29.5% interest in Western Atlas International, Inc. to a wholly-owned subsidiary of Litton Industries. See Note R for additional information. Summarized financial information is as follows (in millions): Note C - Major Unconsolidated Joint Ventures (Continued) - ------------------------------------------------------------------------------- Dresser-Rand Company - -------------------- The Company owned 50% of Dresser-Rand from its inception on January 1, 1987 through September 30, 1992. Effective October 1, 1992, the Company acquired an additional 1% ownership interest. Since the Company now owns 51% of Dresser- Rand, it is included as a fully consolidated subsidiary with a 49% minority interest for 1993. Summarized financial information for the periods when equity accounting was applied is as follows (in millions): Note D - Business Combinations - ------------------------------------------------------------------------------- Effective February 1, 1993 the Company acquired all the outstanding stock of Bredero Price Holding B.V., a Netherlands corporation, from Koninklijke Begemann Groep N.V. for approximately $161.5 million in cash. Bredero Price is a multinational company that provides pipe coating for both onshore and offshore markets. Effective April 1, 1993, the Company acquired TK Valve & Manufacturing, Inc. from Sooner Pipe & Supply Corporation, Tulsa, Oklahoma for approximately $143.5 million in cash. TK Valve supplies ball valves for the oil and gas production and transmission industry. The purchase price exceeded the fair value of the net assets acquired by approximately $122 million for Bredero Price and approximately $92 million for TK Valve. Both acquisitions were accounted for as purchases. The resulting goodwill is being amortized on a straight-line basis over 40 years. The Consolidated Statement of Earnings includes the results of operations of Bredero Price from February 1, 1993 and TK Valve from April 1, 1993. Note D - Business Combinations (Continued) - ------------------------------------------------------------------------------- The following unaudited pro forma summary presents information as if the acquisitions had occurred at the beginning of each fiscal year. The pro forma information is provided for information purposes only. It is based on historical information and does not necessarily reflect the actual results that would have occurred nor is it necessarily indicative of future results of operations of the combined enterprises (in millions except per share amounts): In 1992, the Company acquired all of the shares of AVA International Corp. (AVA) in exchange for 1.9 million shares of the Company's common stock with a value of $43.3 million and $1.9 million cash. AVA produces well completion products that are sold primarily in foreign markets. The transaction, which was accounted for as a purchase, resulted in goodwill of $39.3 million which is being amortized on a straight-line basis over 40 years. The pro forma effect of the AVA acquisition was not significant. Note E - Long-Term Contracts - ------------------------------------------------------------------------------- Consistent with industry practice, service revenues and cost of services include the value of materials, equipment and labor contracts furnished by customers and for which the Company is responsible for the ultimate acceptability of performance of the project based on such material, equipment or labor. The value of such items was $112.4 million, $114.0 million and $471.7 million for the years ended October 31, 1993, 1992 and 1991, respectively. Amounts billed in excess of revenues recognized to date are included in current liabilities under advances from customers on contracts. Note F - Inventories - ------------------------------------------------------------------------- Inventories on the LIFO method were $77.9 million and $73.9 million at October 31, 1993 and 1992, respectively. Under the average cost method, inventories would have increased by $92.2 million and $98.8 million at October 31, 1993 and 1992, respectively. Note F - Inventories (Continued) - --------------------------------------------------------------------- During 1992, the Company experienced significant quantity reductions in LIFO inventories which were carried at lower costs that prevailed in prior years. Quantity reductions reduced the cost of sales by $14.6 million and increased earnings, net of tax, by $9.5 million or $.06 per share in 1992. Inventories are stated net of progress payments received on contracts of $175.7 million and $118.9 million at October 31, 1993 and 1992, respectively. Note G - Income Taxes - ------------------------------------------------------------------------------- The Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, as of November 1, 1991. The 1992 Statement of Earnings includes a charge of $40.8 million for the cumulative effect of the change. Prior year financial statements were not restated when SFAS 109 was adopted. The domestic and foreign components of earnings before income taxes of continuing operations consist of the following (in millions): The components of the provision for income taxes of continuing operations are as follows (in millions): Under the provisions of SFAS 109, the tax benefits of loss and credit carryforwards can be recognized in the period they arise if certain realization criteria are met. As a result of these provisions, the tax benefits attributable to approximately $40 million domestic carryforwards and $28 million of foreign carryforwards were reflected as a reduction in the 1992 cumulative effect charge referred to above. Note G - Income Taxes (Continued) - --------------------------------------------------------------------- The 1991 current taxes of $103.2 contain a charge of $5.6 million equivalent to income taxes which would have been incurred had net operating loss carryforwards not been available. The income tax benefits resulting from utilizing the operating loss carryforwards are presented as an extraordinary item in 1991. Since the Company plans to continue to finance foreign operations and expansion through reinvestment of undistributed earnings of its foreign subsidiaries (approximately $537 million at October 31, 1993), no provisions are generally made for U.S. or additional foreign taxes on such earnings. When the Company identifies exceptions to the general reinvestment policy, additional taxes are provided. The following is a reconciliation of income taxes at the U.S. Federal income tax rate (34.8% for 1993 and 34% for 1992 and 1991) to the provision for income taxes for continuing operations reflected in the Consolidated Statements of Earnings (in millions): Note G - Income Taxes (Continued) - ------------------------------------------------------------------- Deferred income tax benefits result from the recognition of temporary differences. Temporary differences are differences between the tax bases of assets and liabilities and their reported amounts in the financial statements that will result in differences between income for tax purposes and income for financial statement purposes in future years. The deferred income tax provisions (credits) related to the following (in millions): The components of the net deferred tax asset as of October 31, 1993, were as follows (in millions): At October 31, 1993, the Company had foreign operating loss carryforwards of approximately $54 million that had not been benefited. The tax benefit of these losses is recorded as a deferred tax asset and offset with a corresponding valuation allowance. These losses are available to reduce the future tax liabilities of their respective foreign entity. Approximately $42 million of these losses will carryforward indefinitely while the remaining amounts expire at various dates from 1994 to 2002. The net change of $4.2 million in the valuation allowance for deferred tax assets related all to changes in foreign loss carryforwards. Note H - Short-Term Debt - ------------------------------------------------------------------ Short-term debt at October 31, 1993 consisted of $216 million of domestic commercial paper maturing on December 31, 1993 and $13.5 million of primarily foreign bank loans. The Company has short-term committed bank lines of credit totalling $250 million of which $216.0 million support commercial paper. Such lines provide for borrowings at the prevailing interest rates. The lines of credit may be used by the Company and certain foreign subsidiaries, and include Eurodollars and foreign currencies. The lines of credit may be terminated at the option of the banks or the Company. Loan arrangements have been established with banks outside the United States, under which the Company's foreign subsidiaries may borrow on an overdraft and short-term note basis. At October 31, 1993, the amount available and unused under these arrangements aggregated $114.2 million. Note I - Long-Term Debt - ------------------------------------------------------------------ Long-term debt is summarized as follows (in millions): In June 1993, the Company made a public offering of debt securities in the form of $300.0 million of 6.25% Notes due 2000 from which the Company received $298.2 million in proceeds. The proceeds were used to retire short-term debt that was issued to acquire Bredero Price Holding B.V. and TK Valve & Manufacturing, Inc. (See Note D). The interest is payable semi-annually on May 15 and November 15. During 1992 the Company redeemed $133.1 million of Sinking Fund Debentures at redemption prices ranging from 100% to 106% of principal amount. On November 2, 1992, the Company redeemed the remaining $62.5 million in principal amounts of its 11 3/4% Sinking Fund Debentures due 2007 at a redemption price of 105.68%. The resulting loss was accrued as of October 31, 1992. The $9.8 million total losses on the debenture redemptions above are reported net of taxes of $3.5 million as an extraordinary loss in the 1992 Statement of Earnings. Note J - Employee Incentive Plans - ------------------------------------------------------------------------------- Stock Compensation Plan - ----------------------- The Company's shareholders have approved the 1992 Stock Compensation Plan which includes a Stock Option Program, a Restricted Incentive Stock Program and a Performance Stock Unit Program. The Stock Option Program provides for the granting of options to officers and key employees for purchase of the Company's common shares. The Plan is administered by the Executive Compensation Committee of the Board of Directors, whose members are not eligible for grants under the Plan. No option can be for a term of more than ten years from date of grant. The option price is recommended by the committee, but cannot be less than 100% of the average of the high and low prices of the shares on the New York Stock Exchange on the day the options are granted. The exercise price for options granted during 1993 increases on the annual anniversary dates of grant. Changes in outstanding options during the three years ended October 31, 1993 and options exercisable at October 31, 1993 are as follows: Shares reserved for granting of future options under the 1992 plan were 8,814,762 shares at October 31, 1993. Deferred Compensation Plan - -------------------------- Under the Deferred Compensation Plan, a portion of the incentive compensation for officers and key employees can be deferred in the form of common stock units or in cash for payment after retirement or termination of employment. Payments are made either in common shares of the Company or in cash at the equivalent market value of the common stock units at the option of the employee. Deferred compensation was $38.9 million at October 31, 1993 and $39.8 million at October 31, 1992. Note K - Capital Shares - ------------------------------------------------------------------------------- Changes in issued common shares during the three years ended October 31, 1993 are as follows: Changes in common shares held in treasury during the three years ended October 31, 1993 are as follows: Preferred Stock Purchase Rights - ------------------------------- In 1990, the Company issued one new Preferred Stock Purchase Right for each outstanding share of the Company's Common Stock. The Rights will expire in 2000 unless they are redeemed earlier. The Rights will generally not be exercisable until after 10 days (or such later time as the Board of Directors may determine) from the earlier of a public announcement that a person or group has, without Board approval, acquired beneficial ownership of 15% or more of the Company's Common Stock or the commencement of, or public announcement of an intent to commence, a tender or exchange offer which, if successful, would result in the offeror acquiring 30% or more of the Company's Common Stock. Once exercisable, each Right would entitle its holder to purchase 1/100 of a share of the Company's Series A Junior Preferred Stock at an exercise price of $90, subject to adjustment in certain circumstances. If the Company is acquired in a merger or other business combination not previously approved by the Company's Continuing Directors, each Right then exercisable would entitle its holder to purchase at the exercise price that number of shares of the surviving company's common stock which has a market value equal to twice the Right's exercise price. In addition, if any person or group (with certain exceptions) were to acquire beneficial ownership of 15% or more of the Company's Common Stock (unless pursuant to a transaction approved by the Company's Continuing Directors), each Right would entitle all rightholders, other than the 15% stockholder or group, to purchase that number of Series A Junior Preferred Stock having a market value equal to twice the Right's price. Note K - Capital Shares (Continued) - ------------------------------------------------------------------------------- Preferred Stock Purchase Rights (Continued) - ------------------------------------------- The Rights may be redeemed by the Company for $.01 per Right until the tenth day after a person or group has obtained beneficial ownership of 15% or more of the Company's Common Stock (or such later date as the Continuing Directors may determine). The Rights are not considered to be common stock equivalents because there is no indication that any event will occur which would cause them to become exercisable. Note L - Commitments and Contingencies - ------------------------------------------------------------------------------- Parker & Parsley Litigation - --------------------------- The Company was involved in litigation brought by Parker & Parsley Petroleum Company and related plaintiffs in 1989. On April 19, 1993, the Company entered into an agreement in principle to settle with the plaintiffs in the Parker & Parsley litigation, whereby the Company, without admitting any wrong doing, agreed to pay $57.5 million to settle all current and future claims brought forth by the plaintiffs. The settlement was paid on May 26, 1993. Legal actions arising from the same facts filed by Glyn Snell, et. al., and working interest owners who did not participate in the Parker & Parsley case (Texas Ten vs. Dresser et. al.) remain outstanding. The Company recorded a Special Charge of $65.0 million in 1993 to cover the Parker & Parsley settlement, legal fees and other expenses related to the Parker & Parsley litigation, the Glyn Snell, et. al. litigation, and the working interest owners litigation. The Company believes that it has insurance coverage for the amounts that it has paid or will pay pursuant to the above-described settlement of the litigation, and in fact $13.5 million has been received from certain insurance carriers. However, other insurance carriers have denied coverage, and the Company is engaged in litigation with these carriers seeking recovery of the costs and expenses incurred by the Company in the defense and settlement of the litigation. The Company's claim includes the $57.5 million settlement, as well as all unreimbursed costs and expenses incurred by the Company in defending the action. The insurance carriers had previously sued seeking a declaration that the claims asserted by the Company are not covered by the relevant insurance policies. The carrier's action has been abated in favor of the action brought by the Company. Discovery in the action is proceeding. Trial is currently scheduled for April, 1994. The Company also believes it has insurance coverage with respect to claims made in the suits brought by royalty owners and working interest owners. The amount and timing of any recoveries from the insurance carriers cannot be determined with certainty. Any recoveries will be recognized when amounts can be determined with certainty. Note L - Commitments and Contingencies (Continued) - ------------------------------------------------------------------------------- Asbestosis Litigation - --------------------- The Company has approximately 42,800 pending claims (approximately 12,000 filed in 1993) in which it is alleged that third parties sustained injuries and damages resulting from inhalation of asbestos fibers used in products manufactured by the Company and its predecessor companies. The Company has never been a miner or processor of asbestos but did produce a few refractory products that contained some asbestos. Approximately 50% of the pending claims allege injury as a result of exposure to such products, while the other 50% of the claimants allege injury as a result of exposure to asbestos gaskets and packings used in other products manufactured by the Company. Since 1976, the Company has tried, settled or summarily disposed of approximately 13,000 such claims for a total cost of $29 million including legal fees. The Company has entered into agreements with insurance carriers with respect to such claims. Management has no reason to believe the carriers will not be able to meet their obligations pursuant to the agreements. Under the agreements, insurance covers 60%-67% of legal fees and any settlements or awards. The net cost to the Company after recoveries from the carriers has been approximately $10 million. Of the 13,000 claims settled, approximately 80% relate to cases involving refractory products. Any future refractory product claims filed are the responsibility of INDRESCO Inc. pursuant to an agreement entered into at the time of the spin-off. The Company has provided for the estimated exposure, based on past experience, for the remaining open cases involving refractory products. The Company has also provided for estimated exposure relating to non-refractory product claims. However, the Company has less experience in settling such claims. Generally when settlements have been made, the amounts involved are substantially lower than the claims involving refractory products. In 1993, the Company did sustain an adverse judgment in cases filed by employees of Ingalls Shipyard in Pascagoula, Mississippi. The Company's share of damages awarded in six cases amounted to $3.8 million plus 10% add on for punitive damages. The judgment does not conform to the Company's past experience and was not in accord with the evidence. The court has entered judgment in the case and the Company has filed the appropriate post trial motions. The court has not ruled on the motions. If relief is denied, the Company will appeal the decision. Any ultimate loss would be covered by the agreement with the insurance carriers and would not result in a net loss exceeding approximately $1 million. Management recognizes the uncertainties of litigation and the possibility that a series of adverse rulings could materially impact operating results. However, based upon the Company's historical experience with similar claims, the time elapsed since the Company discontinued sale of products containing asbestos, and management's understanding of the facts and circumstances which gave rise to such claims, management believes that the pending asbestos claims will be resolved without material effect on the Company's financial position or results of operations. Note L - Commitments and Contingencies (Continued) - ------------------------------------------------------------------------------- Quantum Chemical Litigation - --------------------------- In October 1992, Quantum Chemical Corporation ("Quantum") brought suit against the Company's wholly owned subsidiary, The M. W. Kellogg Company ("Kellogg"), alleging that Kellogg negligently failed to provide an adequate design for an ethylene facility which Kellogg designed and constructed for Quantum and fraudulently misrepresented the state of development of its Millisecond Furnace technology to be used in the facility. Quantum is seeking $200 million in actual damages and punitive damages equal to twice the actual damages claimed. Kellogg has answered denying the claim and has filed a counterclaim against Quantum alleging libel, slander, breach of contract and fraud. Discovery in the action is proceeding, and trial is set for April 11, 1994. Management believes the Quantum lawsuit is totally without merit and will be resolved without material adverse effect on the Company's financial position or results of operations. Other Litigation - ---------------- The Company and its subsidiaries are involved in certain other legal actions and claims arising in the ordinary course of business. Management recognizes the uncertainties of litigation and the possibility that one or more adverse rulings could materially impact operating results. However, based upon the nature of and management's understanding of the facts and circumstances which gave rise to such actions and claims, management believes that such litigation and claims will be resolved without material effect on the Company's financial position or results of operations. Environmental Matters - --------------------- The Company is identified as a potentially responsible party in 67 Superfund sites. Primary responsibility for eight of these sites was assumed by INDRESCO Inc. at the time of the INDRESCO spin-off in 1992 (See Note O). At three of the 67 sites, Fisher-Calo, Bio-Ecology, and Operating Industries, the Company may be responsible for remediation costs ranging between $200,000 and $1 million. The Company previously has entered into de minimis settlements in respect of several other Superfund sites. Based upon the Company's historical experience with similar claims and management's understanding of the facts and circumstances relating to the sites other than Fisher-Calo, Bio-Ecology, and Operating Industries, management believes that the other situations will be resolved at nominal cost to the Company. Other - ----- The Company and certain subsidiaries are contingently liable as guarantors of obligations aggregating approximately $200 million at October 31, 1993, of which $170.0 million were guarantees of loans to Komatsu Dresser Company, a partnership in which INDRESCO Inc. (See Note O) has an ownership interest. Obligations to guarantee loans to Komatsu Dresser Company expired November 1, 1993. The Company has no further obligations regarding Komatsu Dresser Company. Note L - Commitments and Contingencies (Continued) - ------------------------------------------------------------------------------- Other (Continued) - ----------------- Total rental and lease expense charged to earnings was $74.7 million in 1993, $66.4 million in 1992 and $73.7 million in 1991. At October 31, 1993, the aggregate minimum annual obligations under noncancelable leases were: $36.4 million for 1994; $28.4 million for 1995; $20.7 million for 1996; $11.6 million for 1997; $9.1 million for 1998; and $49.8 million for all subsequent years. The lease obligations related primarily to general and sales office space and warehouses. Note M - Postretirement and Postemployment Benefits - ------------------------------------------------------------------------------- Benefits Other than Pensions - ---------------------------- The Company sponsors a number of plans providing health and life insurance benefits for retired U.S. bargaining and non-bargaining employees meeting eligibility requirements. Although certain plans are contributory, the Company has generally absorbed the majority of the costs. The Company funds the benefit plans as claims and premiums are paid. The Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefit Plans Other than Pensions (SFAS 106), for its U.S. benefit plans as of November 1, 1991. The Company elected to recognize this change in accounting on the immediate recognition basis. The cumulative effect as of November 1, 1991, reflected in the Statement of Earnings for the year ended October 31, 1992 as cumulative effect of an accounting change, was as follows (in millions, except per share amount): The effects of postretirement benefits for non-U.S. employees, which supplement foreign government plans, are not significant under SFAS 106. During fiscal 1993, the Company, Dresser-Rand and Ingersoll-Dresser Pump Company adopted amendments to certain postretirement medical benefit plans, primarily the non-union plans. The major amendments included the elimination of benefits for younger employees and the introduction of limits on the amount of future cost increases which will be absorbed by the companies. These amendments resulted in a curtailment gain of $12.8 million which was recognized in 1993 and unrecognized gains of $208.3 million which will be recognized as a reduction in benefit expense on a straight line basis over the periods ranging from 12 years to 18 years. Note M - Postretirement and Postemployment Benefits (Continued) - ------------------------------------------------------------------------------- Benefits Other than Pensions (Continued) - ---------------------------------------- The liability of the U.S. plans at October 31, 1993 and 1992 was as follows (in millions): Accrued compensation and benefits on the Balance Sheet include the current portion of the benefit liability. The net periodic postretirement benefit expense for the years ended October 31, 1993 and 1992 included the following components (in millions): *Includes $14.3 million in 1993 and $20 million in 1992 for Dresser-Rand Company which was not consolidated in 1992. Assumptions used to calculate the Accumulated Postretirement Benefit Obligation were as follows: Health care trend rate (weighted based on participant count) - October 31, 1993 - 13% for 1993 declining to 5.5% in 2003 and level thereafter. October 31, 1992 - 15% for 1992 declining to 6.0% in 2006 and level thereafter. The above changes in assumptions and changes in circumstances and experience resulted in an unrecognized net loss of $(28.2) million. Note M - Postretirement and Postemployment Benefits (Continued) - ------------------------------------------------------------------------------- Benefits Other than Pensions (Continued) - ---------------------------------------- A one percentage-point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of October 31, 1993 by approximately $44 million and would increase the net postretirement benefit cost for 1993 by approximately $5 million. Defined Benefit Pension Plans - ----------------------------- The Company has numerous defined benefit pension plans covering substantially all employees in the United States. The benefits for the U.S. plans covering the salaried employees are based primarily on years of service and employees' qualifying compensation during the final years of employment. The benefits for the U.S. plans covering the hourly employees are based primarily on years of service. The U.S. plans are funded in accordance with the requirements of applicable laws and regulations. The U.S. plan assets are invested in cash, short-term investments, equities, fixed-income instruments and real estate at October 31, 1993. The Company has additional defined benefit pension plans for employees outside the United States. The benefits under these plans are based primarily on years of service and compensation levels. The Company funds these plans in amounts sufficient to meet the minimum funding requirements under governmental regulations, plus such additional amounts as the Company may deem appropriate. The Company recognized a minimum pension liability for underfunded plans. The minimum liability is equal to the excess of the accumulated benefit obligation over plan assets. A corresponding amount is recognized as either an intangible asset or a reduction of shareholders' investment. The Company had recorded additional liabilities of $39.9 million and $19.5 million, intangible assets of $15.9 million and $12.6 million, and adjustments to shareholders' investment, net of income taxes, of $13.8 million and $4.0 million, as of October 31, 1993 and 1992, respectively. Pension expense includes the following (in millions): Cash contributions to the plans in 1993 were $38.7 million. Note M - Postretirement and Postemployment Benefits (Continued) - ------------------------------------------------------------------------------- Defined Benefit Pension Plans (Continued) - ----------------------------------------- The funded status of the plans on the August 1 measurement dates was as follows (in millions): On the Balance Sheet, other assets include prepaid pension costs and accrued compensation and benefits include the current portion of the pension liabilities. Note M - Postretirement and Postemployment Benefits (Continued) - ------------------------------------------------------------------------------- Defined Benefit Pension Plans (Continued) - ----------------------------------------- Contributions made in August and October 1993 to the trust for the pension plans decreased the liability for plans with accumulated benefits exceeding assets by $7.2 million. The actuarial assumptions used in determining funded status of the plans were as follows: The changes in assumptions in 1993 increased the projected benefit obligation by approximately $40 million. Defined Contribution Plans - -------------------------- The Company has defined contribution plans for most of its U.S. salaried employees. Under these plans, eligible employees may contribute amounts through payroll deductions supplemented by employer contributions for investment in various funds established by the plans. The cost of these plans was $12.5 million, $8.8 million and $7.1 million in 1993, 1992 and 1991, respectively. Postemployment Benefits - ----------------------- In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, Employers' Accounting for Postemployment Benefits (SFAS 112), which requires that accrual accounting be used for the cost of benefits provided to former or inactive employees who have not yet retired. Such benefits include salary continuation, disability, severance and health care. Under SFAS 112, the cost of benefits must be accrued either over the employee's service period or at the date of an event that gives rise to the benefits. SFAS 112 must be adopted by the Company no later than fiscal year 1995. The Company currently accrues the cost of some benefits covered by SFAS 112 but not all. SFAS 112 requires a cumulative catch-up charge to earnings upon adoption. The Company has not determined the amount of the cumulative adjustment. The Company expects to adopt SFAS 112 in the first quarter of fiscal 1995. Note N - Supplementary Earnings Statement Information and Special Charges - ------------------------------------------------------------------------------- Earnings per common share are based on the average number of common shares outstanding during each period. The average common shares outstanding were 137.3 million in 1993, 135.5 million in 1992 and 134.2 million in 1991. Common stock equivalents do not have a material effect on earnings per share. Depreciation of property, plant and equipment charged to earnings amounted to $141.5 million in 1993, $87.5 million in 1992 and $78.9 million in 1991. The increase in 1993 is primarily due to the consolidation of Dresser-Rand. Amortization of intangibles was $17.2 million in 1993, $11.1 million in 1992 and $10.6 million in 1991 and is included in selling, engineering, administrative and general expenses. Engineering, research and development costs were $152.9 million in 1993, and $94.0 million in 1992 and 1991. Research and development costs, as defined by Statement of Financial Accounting Standards No. 2, charged to earnings were $81.5 million in 1993, $11.0 million in 1992 and $9.4 million in 1991. The increases in 1993 costs are primarily due to the consolidation of Dresser-Rand. The components of other income (deductions), net on the Consolidated Statements of Earnings are as follows (in millions): Special Charges - --------------- The Company recorded special charges totalling $74.1 million in 1993. The charges included $65.0 million to cover settlement, legal fees and expenses of the Parker & Parsley and related litigation (See Note L) and $13.2 million for restructuring and termination costs partially offset by a $4.1 million gain from curtailment of retiree medical benefits. The curtailments resulted from employee terminations associated with plant closings. The special charges reduced segment operating profit by $6.9 million and the remaining $67.2 million was reflected as nonsegment expenses. In 1992, the Company recorded special charges totalling $70.0 million. The charges provided $35.0 million for the restructuring of the pump joint venture, $25.0 million for restructuring and termination costs in other operations, and $10.0 million primarily for the settlement of special warranty claims. The special charges reduced segment earnings of Oilfield Services by $17.1 million and Hydrocarbon Processing Industry by $49.3 million. The remaining $3.6 million was reflected as nonsegment expenses. Note O - Discontinued Operations - ------------------------------------------------------------------------------- In 1992, the Company decided to dispose of its Environmental Products business and recorded a $12.0 million charge for the estimated costs of disposal and future operating losses. Effective August 1, 1992, the Company divested its industrial products and equipment businesses including its 50% interest in Komatsu Dresser Company. The divestiture/spin-off was accomplished by a distribution of one INDRESCO share for every five shares of the Company's common stock. The results of operations net of income taxes for Environmental Products (including the $12 million charge in 1992) and for the INDRESCO businesses are reported as discontinued operations. Summarized information on the Discontinued Operations is as follows (in millions): Note P - Information by Industry Segment and Geographic Area - ------------------------------------------------------------------------------- The Company's industry segments are outlined below. See Notes C and O for information about changes in joint venture operations and discontinued operations. Oilfield Services ----------------- The Segment provides products and technical services utilized in the worldwide search for and development of crude oil and natural gas through exploration, drilling and production activities. Principal products and services of consolidated operations include drilling fluid systems, rock bits, downhole production tools, pipe coating and ball valves. The Western Atlas unconsolidated joint venture, which the Company has agreed to sell as discussed in Note R, provides integrated reservoir description services, seismic services, core analysis and wireline logging services. The Bredero Price and TK Valve & Manufacturing acquired operations are included in this segment (See Note D). Note P - Information by Industry Segment and Geographic Area (Continued) - ------------------------------------------------------------------------------- Hydrocarbon Processing Industry ------------------------------- The Segment provides highly engineered products, which are essential to the transportation and processing of various hydrocarbon raw materials, the conversion of the hydrocarbon raw materials into higher value-added energy forms and the marketing of refined products. Principal products, services and systems of consolidated operations include compressors, turbines, diesel engines, measurement and control devices, gas meters, piping specialties and gasoline dispensing systems along with related repair services. The Ingersoll-Dresser Pump unconsolidated joint venture provides pumps along with related repair services. Engineering Services -------------------- The Segment, which consists of the M. W. Kellogg Company, is involved in the design, engineering and construction of energy-related complexes throughout the world. Total revenues include sales and services to unaffiliated customers and either intersegment sales and services or intergeographic area sales and services. The intersegment and intergeographic area sales and services are accounted for at prices which approximate arm's length market prices. Operating profit consists of total revenues less total operating expenses and includes equity earnings or losses from unconsolidated affiliates. General corporate expenses, foreign exchange gains or losses, interest income and expense, and other income and expenses (including administrative and general expenses applicable to divested operations) not identifiable with a segment have been excluded in determining operating profit. Identifiable assets are those assets that are identified with particular segments. Corporate assets are principally cash and cash equivalents and deferred income tax benefits. Industry Segment Financial Information - -------------------------------------- The financial information by industry segment for the years ended October 31, 1993, 1992 and 1991 is included in Item 7., Management's Discussion and Analysis on pages 18 to 20 of this report, and is an integral part of this Note to Consolidated Financial Statements. Note P - Information by Industry Segment and Geographic Area (Continued) - ------------------------------------------------------------------------------- Geographic Area Financial Information - ------------------------------------- The financial information by Geographic Area for the years ended October 31, 1993, 1992 and 1991 is as follows (in millions): Note Q - Quarterly Financial Data (Unaudited) - ------------------------------------------------------------------------------- * Includes after-tax special charges for restructuring costs, termination costs and special warranty claims of $36.0 million. ** Includes $12.0 million for the estimated costs of disposal and future operating losses. Note R - Subsequent Events (Unaudited) - ------------------------------------------------------------------------------- Merger with Baroid Corporation - ------------------------------ On September 7, 1993, the Company and Baroid Corporation (Baroid) announced an agreement to merge the two companies. The agreement provides that, upon consummation of the merger, stockholders of Baroid will receive 0.40 shares of Dresser common stock for each share of issued and outstanding Baroid common stock and Baroid will become a wholly-owned subsidiary of Dresser. The merger will be accounted for as a pooling of interests. Supplemental unaudited earnings statement information assuming the merger had occurred on November 1, 1990, is as follows (in millions except earnings per share): Expenses associated with the merger of approximately $30.0 million less a tax benefit of $2.9 million, for a net special charge of $27.1 million or $0.16 per share, have been reflected in the combined results of operations for the year ended October 31, 1993 shown above. The above supplemental unaudited earnings statement information includes Baroid information for the twelve months ended October 31, 1993, December 31, 1992 and December 31, 1991. Following the merger, the Company is required by the United States Department of Justice to dispose of either its 64% general partnership interest in M-I Drilling Fluids Company or its 100% interest in Baroid Drilling Fluids Inc. prior to June 1, 1994. Dresser has not yet determined which drilling fluids company will be divested but is at present negotiating with interested parties. M-I Drilling Fluids Company revenues were $398 million and earnings before taxes were $25 million for the year ended October 31, 1993 and Baroid Drilling Fluids Inc. revenues were $372 million and earnings before taxes were $39 million for the same period. Note R - Subsequent Events (Unaudited) (Continued) - ------------------------------------------------------------------------------- Sale of Interest in Western Atlas International, Inc. - ----------------------------------------------------- On December 8, 1993, Dresser and Litton Industries, Inc. announced an agreement for the sale of Dresser's 29.5% interest in Western Atlas International, Inc. to a wholly-owned subsidiary of Litton for $358 million in cash and $200 million in 7 1/2% notes due over seven years. The sale is expected to close in January, 1994 and will result in an after-tax gain of approximately $150 million that Dresser will recognize in the first quarter of fiscal year 1994. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and - ------ --------------------------------------------------------------- Financial Disclosure. -------------------- None. PART III Item 10. Item 10. Directors and Executive Officers of Registrant. - ------- ---------------------------------------------- Certain information required by this Item is incorporated by reference to Dresser's definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this report (the "Dresser Proxy Statement"). Item 11. Item 11. Executive Compensation. - ------- ---------------------- The information required by this Item is incorporated by reference to the Dresser Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. - ------- -------------------------------------------------------------- The information required by this Item is incorporated by reference to the Dresser Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- The information required by this Item is incorporated by reference to the Dresser Proxy Statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. - ------- --------------------------------------------------------------- (a) List of Financial Statements, Financial Statement Schedules and Exhibits. (1) and (2) - Response to this portion of Item 14 is submitted as a separate section of this report. (3) Response to this portion of Item 14 is submitted as a separate section of this report. (b) Reports on Form 8-K. None. (c) Exhibits - Response to this portion of Item 14 is submitted as a separate section to this report. Management contracts or compensatory plans or arrangements in which Directors or executive officers participate are included in Exhibits 10.1 - 10.27. (d) Financial Statement Schedules - The response to this portion of Item 14 is submitted as a separate section of this report. Separate financial statements for the formerly unconsolidated Dresser-Rand Company are filed because under the Rules of the Securities and Exchange Commission it constituted a significant subsidiary as of October 31, 1991. The financial statements of Dresser-Rand Company, together with the report of Price Waterhouse dated November 12, 1992, appearing on pages 3 through 17 of the accompanying Consolidated Financial Statements of Dresser-Rand Company are incorporated by reference in this report. With the exception of the aforementioned information, the Consolidated Financial Statements of Dresser-Rand Company is not to be deemed filed as a part of this Form 10-K Annual Report. UNDERTAKINGS For the purpose of complying with the rules governing registration statements on Form S-8 under the Securities Act of 1933 (as amended effective July 31, 1990), the undersigned Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's registration statements on Form S-8 Nos. 2-76847 (filed April 5, 1982), 2-81536 (filed January 28, 1983), 33-26099 (filed December 21, 1988), 33-30821 (filed August 28, 1989), and 33-48165 (filed May 27, 1992): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of Registrant pursuant to the provisions of the Company's Restated Certificate of Incorporation, as amended, or otherwise, Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by Registrant of expenses incurred or paid by a director, officer or controlling person of Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. 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 on, January 28, 1994. DRESSER INDUSTRIES, INC. By: /s/ George H. Juetten --------------------- George H. Juetten, Vice President - Controller 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 indicated on January 28, 1994. FORM 10-K ITEM 14(A)(1) AND (2) AND ITEM 14(D) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES YEAR ENDED OCTOBER 31, 1993 DRESSER INDUSTRIES, INC. DALLAS, TEXAS LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements and report of independent accountants are included in Item 8: The following consolidated financial statement schedules of Dresser Industries, Inc. and report of independent accountants are included herein: Schedule II-- Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties Schedule VIII-- Valuation and Qualifying Accounts Schedule IX-- Short-Term Borrowings Schedule X-- Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (CONTINUED) Separate financial statements for the formerly unconsolidated Dresser-Rand Company are filed because it constituted a significant subsidiary as of October 31, 1991. Effective October 1, 1992, Dresser-Rand Company became a majority- owned consolidated subsidiary. The following consolidated financial statements of Dresser-Rand Company and report of independent accountants are included herein: Financial Highlights Operations Review Report of Independent Accountants Consolidated Statements of Operations-- Years ended September 30, 1992, 1991 and 1990 Consolidated Balance Sheets-- September 30, 1992 and 1991 Consolidated Statements of Partners' Equity-- Years ended September 30, 1992, 1991 and 1990 Consolidated Statements of Cash Flows-- Years ended September 30, 1992, 1991 and 1990 Notes to Consolidated Financial Statements Dresser-Rand Company Form 10-K Financial Schedules are included herein as follows: Report of Independent Accountants on Financial Statement Schedules Schedule V-- Property, Plant and Equipment Schedule VI-- Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment Schedule VIII-- Valuation and Qualifying Accounts Schedule IX-- Short-Term Borrowings Schedule X-- Supplementary Income Statement Information All other Dresser-Rand Company schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (CONTINUED) Separate financial statements are not presented for any of the other unconsolidated affiliates because none constitutes a significant subsidiary. Summarized financial statement information for Ingersoll-Dresser Pump Company (49% owned) and Western Atlas International, Inc. (29.5% owned) is presented in Note C to Consolidated Financial Statements included in Item 8. Other 20% to 50% owned unconsolidated affiliates are not material. Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties Dresser Industries, Inc. and Subsidiaries (Millions of Dollars) Note: Amounts receivable for purchases subject to the usual trade terms and other such items arising in the ordinary course of business are excluded. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS DRESSER INDUSTRIES, INC. AND SUBSIDIARIES (MILLIONS OF DOLLARS) Notes: (A) Primarily reclassification from other accrued liabilities, and addition of accounts due to acquisition. (B) Primarily addition of accounts due to acquisition of additional interest, partially offset by removal of companies accounts contributed to Ingersoll-Dresser Pump Company. (C) Primarily reclassification from other noncurrent liabilities, and reclassification to reserve for accounts receivable from unconsolidated affiliate. (D) Receivable write-offs and reclassifications, net of recoveries. SCHEDULE IX - SHORT-TERM BORROWINGS DRESSER INDUSTRIES, INC. AND SUBSIDIARIES (MILLIONS OF DOLLARS) Notes: (A) The rates do not include the hyperinflationary countries as those rates include factors to offset monetary devaluations which cannot be separated from the true interest rate. (B) The average borrowings are based on the amounts outstanding at each quarter-end. (C) The rates were computed by dividing actual interest expense for the year by the average debt outstanding during the year. Hyperinflationary country debt and interest rates were excluded as in (A). (D) Includes $300 million that was classified as long-term debt in April, 1993, since it was being refinanced. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION DRESSER INDUSTRIES, INC. AND SUBSIDIARIES (MILLIONS OF DOLLARS) *Amounts are not presented because such amounts are less than 1% of total net sales and service revenues. DRESSER-RAND COMPANY (A PARTNERSHIP) CONSOLIDATED FINANCIAL STATEMENTS * * * * * SEPTEMBER 30, 1992 AND 1991 DRESSER-RAND COMPANY DRESSER-RAND COMPANY FINANCIAL HIGHLIGHTS - ------------------------------------------------------------ Dollars in millions DRESSER-RAND ------------ OPERATIONS REVIEW Dresser-Rand reported revenues of $1.3 billion in 1992, up slightly from 1991. The 1992 earnings before taxes and extraordinary item of $93.5 million were essentially flat to the prior year. Earnings before tax reflect a 7.2% return on sales. Bookings in 1992 of $1.3 billion were the same as last year. The larger projects were received in Europe and the Middle East. Dresser-Rand also booked a large compression services contract in Venezuela with Maraven to be performed over 1993-94. Backlog at year-end was $1.1 billion. Turbo products bookings activity, while down from the record year in 1991, included orders for gas processing and transmission applications in Abu Dhabi, the North Sea and Czechoslovakia. Other applications involved the upgrading of refineries for reformulated gasoline requirements. Turbo was also successful on several oil production projects in the Americas. Turbo Division has enhanced its competitive position with Memorandums of Understanding with European Gas Turbines Ltd. for the joint marketing of gas turbine driven compressor packages, and with MAN/GHH for the manufacturing and marketing of axial flow compressors. The Engine Process Compressor Division benefitted from an overall increase in the worldwide market for motor driven process reciprocating compressors. The European markets were particularly strong, while the North American market softened in the last half of the year. Domestic gas price recovery has shown improvement in the compression services segments. In 1993, we see increased natural gas production as an opportunity for the reciprocating product and continued impact of environmentally driven projects in the North American refining market. Steam Turbine, Motor and Generator Division capitalized on the expansion of the power generation market in the pulp and paper industry through several major orders for turbine generators. The Electric Machinery operation also benefitted from higher demand by utilities, municipal projects, and offshore turbine activity. The petrochemical and refining markets were the major source of Steam Turbine business in the European markets. The worldwide petrochemical/refining markets require steam turbines to drive pumps and compressors, and provide a solid booking base in the future. We continue to register our worldwide manufacturing facilities under the ISO 9000 series, including those in the U.S. We received ISO registration at our Wellsville, New York, Steam Turbine facility in late 1992. All of our major units should achieve registration in 1993. Selective partnering and the practical application of employee quality training remain key parts of Dresser-Rand's focus of providing total customer satisfaction by being the best in product design, manufacture, and customer service. ------------------------------------- Ben R. Stuart President and Chief Executive Officer November, 1992 REPORT OF INDEPENDENT ACCOUNTANTS To the Partners and Management Committee of Dresser-Rand Company In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, partners' equity and cash flows present fairly, in all material respects, the financial position of Dresser-Rand Company (a Dresser Industries, Inc. and Ingersoll-Rand Company partnership) and its subsidiaries at September 30, 1992 and 1991, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 1992, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ Price Waterhouse PRICE WATERHOUSE Hackensack, New Jersey November 12, 1992 DRESSER-RAND COMPANY CONSOLIDATED STATEMENTS OF OPERATIONS See accompanying notes to consolidated financial statements. DRESSER-RAND COMPANY CONSOLIDATED BALANCE SHEETS See accompanying notes to consolidated financial statements. DRESSER-RAND COMPANY CONSOLIDATED STATEMENTS OF PARTNERS' EQUITY See accompanying notes to consolidated financial statements. DRESSER-RAND COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS Noncash financing activity: During 1991, amounts due from partners of $40,000,000 were reclassified as a return of Partners' capital. See accompanying notes to consolidated financial statements. DRESSER-RAND COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - FORMATION, OWNERSHIP AND OPERATIONS On December 31, 1986, Dresser Industries, Inc. and Ingersoll-Rand Company (the Partners) entered into a partnership agreement for the formation of Dresser-Rand Company (the Company), a New York general partnership (the partnership) owned equally by Dresser Industries, Inc. (Dresser) and Ingersoll-Rand Company (Ingersoll-Rand). The Partners contributed substantially all of the operating assets (excluding domestic cash and accounts receivable) and certain related liabilities which comprised their worldwide reciprocating compressor, steam turbine, and turbo-machinery businesses in exchange for an equal ownership interest. The net assets contributed by the Partners were recorded by the Company at amounts approximating their historical values. The Company commenced operations on January 1, 1987, and principally serves the petroleum, gas, petrochemical, chemical, and electric power industries on a worldwide basis. Effective October 1, 1992, Dresser contributed $8,035,000 to the Company and ownership interests became 51 percent Dresser and 49 percent Ingersoll-Rand. At the same time, the Company's fiscal year was changed to end on October 31. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Significant accounting policies used in the preparation of the accompanying consolidated financial statements are set forth below. Basis of Presentation The consolidated financial statements include the accounts of all wholly-owned and majority-owned subsidiaries. Investments in affiliates owned 50% or less are accounted for on the equity method. The Company's equity in the net earnings of these affiliates was not material. All material intercompany items have been eliminated in consolidation. Cash Equivalents Cash equivalents are stated at cost which approximates market. For purposes of the Consolidated Statements of Cash Flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Inventories Inventories are stated at cost, which is not in excess of net realizable value, and are valued principally using the first-in, first-out (FIFO) method. Property and Depreciation Property, plant and equipment is recorded at cost, and is depreciated over the estimated useful lives of the various classes NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) of assets. Depreciation is computed principally using accelerated methods, except for U.S. fixed assets with a service life of ten years or less, which are depreciated on a straight-line basis. Intangible Assets Costs in excess of values assigned to the underlying net assets of businesses acquired by the Partners which were contributed to the Company are being amortized on a straight-line basis over periods not exceeding 40 years. Such amortization amounted to $1,744,000 in 1992, 1991 and 1990. Income Taxes The Company is a partnership and generally does not provide for U.S. income taxes since all partnership income and losses are allocated to the Partners for inclusion in their respective income tax returns. Income taxes are provided on the taxable earnings of U.S. and foreign subsidiaries, including deferred taxes arising from timing differences between financial and tax reporting of income and expense items. Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" was issued in February 1992. The statement requires the Company to make changes in accounting for income taxes no later than fiscal year 1994. Based on a preliminary review of the provisions of this statement, the Company does not believe its implementation will have a material effect on income or retained earnings. Revenue Recognition and Warranties Revenue from the sale of products and estimated provisions for warranty costs are recorded for financial reporting purposes generally when the products are shipped. Service and equipment rental revenues are accrued as earned. Research, Engineering and Development Costs Expenses for research and development activities, including engineering costs, are expensed as incurred and amounted to $67,074,000 in 1992, $63,768,000 in 1991, and $55,583,000 in 1990. Foreign Currency Assets and liabilities of foreign entities operating in other than highly inflationary economies are translated at current exchange rates, and income and expenses are translated using average-for-the-year exchange rates. Adjustments resulting from translation are recorded in Partners' equity and will be included in net earnings only upon sale or liquidation of the underlying foreign investment. For foreign subsidiaries operating in highly inflationary economies, inventory and property balances and related income statement accounts are translated using historical exchange rates and resulting gains and losses are credited or charged to earnings. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The Company enters into forward foreign exchange contracts as a hedge against movements on the Company's assets and liabilities exposed to foreign exchange rate fluctuations. Gains and losses are recognized currently in income, and the resulting credit or debit offsets foreign exchange gains or losses on those assets and liabilities. Foreign currency translation and exchange gains (losses) recorded in other income (expense) in the accompanying Consolidated Statements of Operations amounted to $995,000 in 1992, $2,321,000 in 1991, and $(783,000) in 1990. NOTE 3 - INVENTORIES The components of inventory are as follows (in thousands): Finished products and work in process inventories are stated after deducting customer progress payments of $117,022,000 in 1992 and $162,910,000 in 1991. NOTE 4 - PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is summarized as follows (in thousands): Depreciation expense was $33,886,000 in 1992, $36,607,000 in 1991, and $35,233,000 in 1990. NOTE 5 - SHORT-TERM BORROWINGS Short-term borrowings consist primarily of foreign bank loans. At September 30, 1992, the Company had no U.S. bank loans or lines of credit for short-term borrowing facilities. Credit facilities have been arranged with banks outside the United States under which the Company's foreign operating units may borrow in the local currency or other currencies on an overdraft and short-term note basis. The amount of available lines of credit under these arrangements aggregated $55,355,000, of which $55,109,000 were unused at September 30, 1992. At September 30, 1992, the weighted average interest rate on outstanding borrowings was 11.75%. NOTE 5 - SHORT-TERM BORROWINGS (CONTINUED) Under the terms of the partnership agreement, the Company must obtain the consent of the Partners for any borrowing if, after giving effect to such borrowing, aggregate indebtedness equals or exceeds 33-1/3% of the sum of the Company's indebtedness and the Partners' capital accounts. NOTE 6 - TRANSACTIONS WITH AFFILIATES In the normal course of business, the Company engages in sales and purchases of manufactured products with the Partners and their affiliates. There are also various licensing, subcontracting, and servicing arrangements among the parties pursuant to the partnership and other agreements. Some of the agreements had planned expiration dates while others continue at the option of the Company or the Partners. Costs and charges under these arrangements are generally at normal and competitive market rates. In addition, certain administrative services of nominal value are provided at no cost to the Company. A summary of transactions with the Partners and their affiliates is as follows (in thousands): Amounts due from Partners consist of trade accounts and advances. The trade accounts represent the net balance arising from the sale or purchase of equipment and services to and from the Partners and do not accrue interest. Advances, which primarily represent cash in excess of the immediate working capital needs of the partnership, do not bear interest and have no repayment terms. Amounts due from (to) Partners are as follows (in thousands): One partner continues to operate a foreign manufacturing company on behalf of the Company. Net gains(losses) of $644,000 in 1992, $(383,000) in 1991, and $701,000 in 1990 relating to this operation are included in the accompanying Consolidated Statements of Operations. NOTE 7 - PENSION PLANS AND OTHER EMPLOYEE BENEFITS Pension Plans The Company has noncontributory pension plans covering substantially all U.S. and Canadian employees. In addition, pension or retirement indemnity coverage is provided for the majority of employees in other countries. The Company's U.S. salaried employees generally receive benefits based on years of service and qualifying compensation on a final average earnings formula. Benefit plans covering hourly employees generally have flat benefit formulas based primarily on years of service. These plans, with some modifications, have been adopted by the Company as a continuation of prior coverage under defined benefit and contribution plans sponsored by the Partners. The Company also maintained a defined contribution plan covering employees at one of its domestic facilities which was terminated in July 1990. Foreign plans provide benefits based on earnings and years of service. The Company's policy is to fund sufficient amounts to maintain the plans on a sound actuarial basis. Such amounts could be in excess of pension costs expensed, subject to the limitations imposed by current tax regulations. The components of pension costs are as follows (in thousands): A merit salary scale with a 5% inflation factor was used to project future compensation levels as a basis for 1992, 1991 and 1990 U.S. pension cost. For the foreign plans, rates of 6.2%, 6.4% and 6.6% were used to project future compensation levels for 1992, 1991 and 1990, respectively. NOTE 7 - PENSION PLANS AND OTHER EMPLOYEE BENEFITS (CONTINUED) The Company credited $1,556,000 in 1990 to operations for plan curtailments and termination benefits associated with the termination of employees at plant facilities closed. Plan assets are invested primarily in fixed income and equity securities. Plans where assets exceed accumulated benefits are immaterial. The funded status of employee pension benefit plans is as follows (in thousands): In addition to the above accrued pension cost, the Company has accrued $3,676,000 and $3,997,000 ($3,160,000 and $3,481,000 included in noncurrent liabilities) at September 30, 1992 and 1991, respectively, for pension costs relating to a plan maintained by a former employing partner. Pension expense for foreign operations, computed under Statement of Financial Accounting Standards No. 87 (SFAS 87), amounted to $1,920,000 in 1992, $2,380,000 in 1991 and $1,219,000 in 1990. In addition, the Company incurred a cost of $362,000 in 1992, $147,000 in 1991 and $145,000 in 1990 related to foreign defined contribution plans. The provisions of SFAS 87 require the recognition of a liability in the amount of the Company's unfunded accumulated benefit obligation with an equal amount recognized as an intangible asset or as a separate component (reduction) of equity; such amounts are adjusted each year based on actuarial valuations. As of September 30, 1992, the Company has recognized a noncurrent liability of $7,709,000, an intangible asset of $4,665,000 (included in other assets) and a charge to equity of $3,044,000. These amounts are $875,000, $5,000 and $870,000, respectively, lower than those reported as of September 30, 1991. Retiree Benefits In addition to providing pension benefits, the Company provides certain health care and life insurance benefits for retired employees. Most employees who retire are eligible for these benefits. The cost of retiree health care is recognized as an NOTE 7 - PENSION PLANS AND OTHER EMPLOYEE BENEFITS (CONTINUED) expense as claims are paid, and the cost of retiree life insurance is recognized by expensing the annual insurance premiums. These costs were $2,901,000 in 1992, $2,836,000 in 1991 and $1,840,000 in 1990. In December 1990 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106 "Employers Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106). Effective for fiscal years beginning after December 15, 1992, this new statement requires accrual of postretirement benefits (such as health care and life insurance) during the years an employee provides services. The Company expects to adopt SFAS 106 in the first quarter of 1993 and estimates the accumulated liability for postretirement benefits to be $160,000,000 on a pre-tax basis. Upon adoption, the Company will record this amount as a one time charge against earnings. The annual pre-tax postretirement benefit expense for fiscal 1993 is estimated to be $17,000,000. Savings and Investment Plans The Company also sponsors certain savings and investment plans. The cost for these plans amounted to $2,410,000 in 1992, $2,255,000 in 1991, and $2,039,000 in 1990. NOTE 8 - INCOME TAXES The components of income before income taxes and extraordinary item are as follows (in thousands): NOTE 8 - INCOME TAXES (CONTINUED) An analysis of the difference between the U.S. statutory rate and the effective rate is as follows: Current taxes of $17,910,000 in 1992, $10,972,000 in 1991, and $8,420,000 in 1990 do not include charges of $3,094,000, $8,907,000, and $4,197,000, respectively, equivalent to income taxes which would have been incurred had operating loss carryforwards not been available. The income tax benefit resulting from realization of the operating loss carryforwards is presented as an extraordinary item in the accompanying Consolidated Statements of Operations. For tax purposes the Company has net operating loss carryforwards of $22,014,000, of which $4,741,000 carryforward indefinitely, and the remaining amounts expire at various dates through 1998. NOTE 9 - INFORMATION BY GEOGRAPHIC AREA The Company operates in one industry segment consisting of the design, manufacture, and marketing of energy processing and conversion equipment. There are no significant concentrations of credit risk in trade receivables at September 30, 1992. Customers are not concentrated in any specific geographic region and no single customer accounted for 10 percent or more of net sales. Identifiable assets are those assets that are identified with particular geographic areas and operations. General corporate assets consist principally of property, plant and equipment. NOTE 9 - INFORMATION BY GEOGRAPHIC AREA (CONTINUED) The financial information by geographic area is as follows (in thousands): Foreign sales of U.S. manufactured products were $475,074,000 in 1992, $351,635,000 in 1991, and $231,621,000 in 1990. These sales represent the customer value of the transfers between geographic areas, primarily to Europe, and domestic exports sold directly to foreign customers of $299,824,000 in 1992, $170,677,000 in 1991, and $102,202,000 in 1990. NOTE 10 - COMMITMENTS AND CONTINGENCIES - --------------------------------------- All principal manufacturing facilities are owned by the Company. Certain office, warehouse and light manufacturing facilities, transportation vehicles, and data processing equipment are leased. Future minimum lease payments required under noncancellable operating leases with initial terms in excess of one year are as follows (in thousands): NOTE 10 - COMMITMENTS AND CONTINGENCIES (CONTINUED) - --------------------------------------------------- Total rental expense amounted to $16,312,000 in 1992, $13,305,000 in 1991, and $13,934,000 in 1990. Capital lease commitments of the Company are not significant. In the normal course of business, the Company issues direct and indirect guarantees, primarily contract performance bonds and letters of credit. Management believes these guarantees will not adversely affect the consolidated financial statements. The Company is involved in various litigation and claims arising in the normal course of business. Based on advice of counsel, management believes that recovery or liability with respect to these matters will not have a material effect on the consolidated financial position or results of operations of the Company. NOTE 11 - SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION - ----------------------------------------------------------- Cash paid during the year for interest and income taxes was as follows (in thousands): DRESSER-RAND COMPANY EXECUTIVE OFFICES 1 BARON STEUBEN PLACE CORNING, NY 14830 (607)937-6400 OFFICERS - ----------------------------------------------- BEN R. STUART President and Chief Executive Officer JOHN A. HELDMAN Vice President and Chief Financial Officer PAUL M. BRYANT Vice President, Human Resources EUGENE H. MOORE Vice President, General Counsel MANAGEMENT COMMITTEE - ----------------------------------------------- THEODORE H. BLACK Chairman of the Board and Chief Executive Officer Ingersoll-Rand Company WILLIAM E. BRADFORD President and Chief Operating Officer Dresser Industries, Inc. JOHN J. MURPHY Chairman of the Board and Chief Executive Officer Dresser Industries, Inc. JAMES E. PERRELLA President Ingersoll-Rand Company BEN R. STUART President and Chief Executive Officer of the Company AUDIT COMMITTEE - ----------------------------------------------- Consists of three (3) Directors each from Dresser Industries, Inc. and Ingersoll-Rand Company, for a total of six (6) Audit Committee members. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To The Partners of Dresser-Rand Company Our audits of the consolidated financial statements referred to in our report dated November 12, 1992, appearing on page 3 of the 1992 consolidated financial statements of Dresser-Rand Company, also included an audit of the financial statement schedules listed in item 14 (d) of this Form 10-K. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ Price Waterhouse PRICE WATERHOUSE Hackensack, NJ November 12, 1992 DRESSER-RAND COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED SEPTEMBER 30, 1992, 1991 AND 1990 (AMOUNTS IN THOUSANDS) (*) Other primarily represents reclassifications among categories and the effects of foreign currency translation. SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEARS ENDED SEPTEMBER 30, 1992, 1991 AND 1990 (AMOUNTS IN THOUSANDS) The average amounts outstanding were determined based on the sum of the month- end amounts outstanding divided by the number of months in the period. The weighted average interest rates were based on the sum of the quarter-end rates divided by the number of quarters in the period. DRESSER-RAND COMPANY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED SEPTEMBER 30, 1992, 1991 AND 1990 (AMOUNTS IN THOUSANDS) CHARGED TO COSTS AND EXPENSES 1992 1991 1990 ------------------------------- Maintenance and repairs....... $22,473 $22,691 $21,481 ======= ======= ======= Amounts for preoperating costs and similar deferrals, royalties, advertising costs, and taxes other than payroll and income taxes are not presented because such amounts are less than one percent of total net sales. INDEX TO EXHIBITS - ---------- * Filed Herewith INDEX TO EXHIBITS (CONT.) - ---------- * Filed Herewith INDEX TO EXHIBITS (CONT.) - ---------- * Filed Herewith

755497_1993.txt

755497_1993

1993

755497

Item 1. Business Balcor Pension Investors-VI (the "Registrant") is a limited partnership formed in 1984 under the laws of the State of Illinois. The Registrant raised $345,640,500 from sales of Limited Partnership Interests. The Registrant's operations consist of investment in first mortgage loans and, to a lesser extent, wrap-around mortgage loans and junior mortgage loans. The Registrant is also currently operating thirteen properties and holds minority joint venture interests with affiliates in one property acquired through foreclosure and in another property purchased from an unaffiliated party. All financial information in this report relates to this industry segment. The Registrant funded a total of thirty-one loans. Nine of these loans have been repaid, including three during 1993. A portion of the Mortgage Reductions generated by the loan prepayments has been distributed to Limited Partners, and the remainder has been retained while the Registrant analyzes future working capital requirements. During prior years, one loan was also written off. The Registrant acquired thirteen properties and a minority joint venture interest with an affiliate, and sold one property in 1992 and one in 1993. The Registrant also purchased a minority joint venture interest with an affiliate in the Sand Pebble Village II Apartments (formerly Sand Dune Apartments) during October 1993. In addition, during October 1993, an affiliate of the Registrant assumed management of the properties which collateralize the loans on the Northgate and Gatewood apartment complexes, and these investments have been classified as real estate held for sale at December 31, 1993. As of December 31, 1993, the Registrant has five outstanding loans in its investment portfolio and owns the properties described under Item 2. Item 2. Properties As of December 31, 1993, the Registrant acquired the thirteen properties and two minority joint venture interests described below: Location Description of Property Baton Rouge, Louisiana Hammond Aire Plaza Shopping Center: a regional shopping center containing approximately 276,000 square feet located on approximately 34 acres. DeKalb County, Georgia Park Central Office Building: a ten story office building containing approximately 210,000 square feet. Dallas, Texas * Brookhollow/Stemmons Center Office Complex: an 11 story office building containing approximately 221,000 square feet. Indianapolis, Indiana Hawthorne Heights Apartments: a 241 unit apartment complex located on approximately 15 acres. Pembroke Pines, Florida Flamingo Pines Shopping Center: a regional shopping center containing approximately 124,500 square feet located on approximately 16 acres. Fulton County, Georgia ** Perimeter 400 Center: a ten story office building and six story building connected at the first 3 levels which combined contain approximately 358,000 square feet. Columbia, Maryland Symphony Woods Office Center: a 6 story office building containing approximately 93,000 square feet. Lake Mary, Florida * Sun Lake Apartments: a 600 unit apartment complex located on approximately 46 acres. Chicago, Illinois 420 North Wabash Office Building: a 7-story office building containing approximately 120,000 square feet. Raleigh, North Carolina Woodscape Apartments: a 240-unit garden apartment complex located on approximately 27 acres. Birmingham, Alabama Shoal Run Apartments: a 276-unit garden apartment complex located on approximately 24 acres. Albuquerque, New Mexico Northgate Apartments: a 160-unit apartment complex located on approximately 4 acres. Albuquerque, New Mexico Gatewood Apartments: a 168-unit apartment complex located on approximately 4 acres. * Owned by the Registrant through a joint venture with an affiliated partnership. ** Owned by the Registrant through a joint venture with three affiliated partnerships. In addition, the Registrant also holds minority joint venture interests in the Sand Pebble Village and Sand Pebble Village II (formerly Sand Dune) apartment complexes, located in Riverside (Los Angeles), California. Certain of the above properties are held subject to various mortgages. In the opinion of the General Partner, the Registrant has provided for adequate insurance coverage for its real estate investment properties. See Notes to Financial Statements for other information regarding real property investments. Item 3. Item 3. Legal Proceedings (a) Williams proposed class action In February 1990, a proposed class-action complaint was filed, Paul Williams and Beverly Kennedy, et al. vs. Balcor Pension Investors, et al., Case No.: 90-C-0726 (U.S. District Court, Northern District of Illinois) against the Registrant, the General Partner, The Balcor Company, Shearson Lehman Hutton, Inc., American Express Company, other affiliates, and seven affiliated limited partnerships (the "Related Partnerships") as defendants. Several parties have since been joined as additional named plaintiffs. The complaint alleges that the defendants violated Federal securities laws with regard to the adequacy and accuracy of disclosure of information in respect of the offering of limited partnership interests of the Registrant and the Related Partnerships and also alleges breach of fiduciary duty, fraud, negligence and violations under the Racketeer Influenced and Corrupt Organizations Act. The complaint seeks compensatory and punitive damages. The defendants filed their answer, affirmative defenses and a counterclaim to the complaint. The defendants' counterclaim asserts claims of fraud and breach of warranty against plaintiffs, as well as a request for declaratory relief regarding certain defendants' rights under their partnership agreements to be indemnified for their expenses incurred in defending the litigation. The defendants seek to recover damages to their reputations and business as well as costs and attorneys' fees in defending against the claims brought by plaintiffs. In May 1993, the Court issued an opinion and order denying the plaintiffs' motion for class certification based in part on the inadequacy of the individual plaintiffs representing the proposed class. Further, the Court granted the defendants' motion for sanctions and ordered that plaintiffs' counsel pay the defendants' attorneys fees incurred with the class certification motion. The defendants have filed a petition for reimbursement of their fees and costs from plaintiffs' counsel, which remains pending. A motion filed by the plaintiffs is currently pending seeking to dismiss the defendants' counterclaim for fraud. In July 1993, the Court gave the plaintiffs leave to retain new counsel. In September 1993, the plaintiffs retained new counsel and filed a new amended complaint and motion for class certification which named three new class representatives. The defendants have conducted discovery with respect to the new representatives and, on February 16, 1994, filed a response to the plaintiffs' latest motion for class certification. The motion is expected to be briefed by March 30, 1994. The defendants intend to continue vigorously contesting this action. As of this time, no plaintiff class has been certified. Management of each of the defendants believes they have meritorious defenses to contest the claims. (b) Northgate Apartments and Gatewood Apartments Hall Elktree Associates Limited Partnership, a Texas limited partnership ("Hall"), which is the borrower of the loans collateralized by wrap-around mortgages on the Northgate and Gatewood apartment complexes, Albuquerque, New Mexico, previously commenced proceedings under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court, District of New Mexico, Case No. 11-92-11964 RA (In re Hall Elktree Associates Limited Partnership). These proceedings had stayed foreclosure proceedings relating to the properties filed by the Registrant (Balcor Pension Investors-VI vs. Hall Elktree Associates, Second Judicial District Court, Bernalillo County, New Mexico, Case No. CV-92- 04375). The plan of reorganization confirmed by the Bankruptcy Court in September 1993, as previously reported, was made effective as of December 14, 1993. As a result, the foreclosure proceedings were dismissed. Item 4. Item 4. Submission of Matters to a Vote of Security Holders (a, b, c & d) No matters were submitted to a vote of the Limited Partners of the Registrant during 1993. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters There has not been an established public market for Limited Partnership Interests and it is not anticipated that one will develop. For information regarding previous distributions, see Financial Statements, Statements of Partners' Capital, and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources", below. As of December 31, 1993, the number of record holders of Limited Partnership Interests of the Registrant was 67,413. Item 6. Item 6. Selected Financial Data Year ended December 31, 1993 1992 1991 1990 1989 Net interest income on loans $7,522,815 $9,526,285 $11,839,992 $17,751,930 $23,387,869 Income from operations of real estate held for sale 8,241,518 8,249,017 8,259,386 3,016,378 824,921 Interest on short- term investments 692,015 615,234 1,206,265 3,260,837 4,043,328 Provision for potential losses on loans, real estate and accrued interest receivable 7,065,000 18,500,000 16,086,000 9,000,000 12,500,000 Net income 11,817,474 730,590 3,860,085 14,044,732 14,075,407 Net income per Limited Partner- ship Interest 7.69 .48 2.51 9.14 9.16 Cash and cash equivalents 48,820,877 14,279,189 18,205,599 22,094,701 53,307,386 Net investment in loans receivable 34,470,940 62,471,935 70,010,108 101,907,116 185,601,593 Loans in substan- tive foreclosure 3,652,250 13,649,621 32,716,961 35,234,147 4,649,794 Real estate held for sale 139,802,469 138,512,995 135,610,614 97,021,713 30,821,352 Total assets 240,813,287 242,357,773 259,605,790 259,080,824 277,559,613 Distributions to Limited Partners 11,060,496 15,208,182 19,355,868 54,569,722 32,421,079 Distributions per Limited Partner- ship Interest 8.00 11.00 14.00 39.47 23.45 Number of loans outstanding 5 10 15 19 24 Properties owned 13 12 10 6 2 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Balcor Pension Investors - VI (the "Partnership") is a limited partnership formed in 1984 to invest in first mortgage loans and, to a lesser extent, wrap-around loans and junior mortgage loans. The Partnership raised $345,640,500 through the sale of Limited Partnership Interests and utilized these proceeds to fund a total of thirty-one loans. As of December 31, 1993, there were five loans outstanding in the Partnership's portfolio. In addition, the Partnership was operating eleven properties acquired through foreclosure and held minority joint venture interests with affiliates in two additional properties. In addition, the Northgate and Gatewood Apartments loans were classified as real estate held for sale in 1993. Operations Summary of Operations During 1993, the provision for potential losses on loans and real estate decreased significantly. This was the primary reason for the increase in net income during 1993 as compared to 1992. The Partnership acquired title to six properties in 1992 and the latter half of 1991, one of which was sold in 1992. The decrease in net interest income on loans receivable resulting from these acquisitions, along with an increase in the provision for potential losses on loans and real estate during 1992, were the primary reasons for the decrease in net income in 1992 compared to 1991. Further discussion of the Partnership's operations is summarized below. 1993 Compared to 1992 The following events resulted in a decrease in net interest income on loans receivable, and consequently mortgage servicing fees, during 1993 as compared to 1992: the acquisition through foreclosure of the Shoal Run Apartments during the first quarter of 1993, the 420 North Wabash Office Building and Woodscape Apartments during the latter half of 1992, and the Sand Pebble Village Apartments during July 1992, in which the Partnership holds a minority joint venture interest. This decrease was partially offset by additional income received on the 45 West 45th Street loan during 1993 as well as additional interest received in connection with the August 1993 prepayment of the Skyway, Mariwood and Hickory Knoll loan. The loan collateralized by the 45 West 45th Street Office Building located in New York, New York, is currently on non-accrual status and interest is recorded only as cash payments are received from the borrower. The funds advanced by the Partnership for the loan total approximately $9,500,000 representing approximately 3% of original funds advanced. During 1993, the Partnership received cash payments on the loan of approximately $748,000, while under the terms of the original loan agreement, the Partnership was entitled to receive approximately $903,000 of interest income during this period. The loan is classified as a loan in substantive foreclosure at December 31, 1993. Loans are classified in substantive foreclosure when a determination has been made that the borrower has little or no equity remaining in the collateral property in consideration of its current fair value, or the Partnership has taken certain actions which result in taking effective control of operations of the collateral property. The allowance for potential losses provides for potential loan losses and is based upon loan loss experience for similar loans and for the industry, upon prevailing economic conditions and the General Partner's analysis of specific loans in the Partnership's portfolio. While actual losses may vary from time to time because of changes in circumstances (such as occupancy rates, rental rates, and other economic factors), the General Partner believes that adequate recognition has been given to loss exposure in the loan portfolio at December 31, 1993. The Partnership recognized a provision for potential losses of $7,065,000 for its loans and real estate in 1993. In addition, an allowance of $4,065,000 was established related to the Partnership's real estate held for sale to provide for further declines in the fair value of certain properties in the Partnership's portfolio, and an allowance of $2,400,000 was established to provide for a further decline in the fair value of the 45 West 45th Street loan which is classified in substantive foreclosure. Allowances related to the Miami Free Zone loan in the amount of $2,106,906 were written off in connection with the prepayment of the loan at its net carrying value. Income from operations of real estate held for sale in 1993 represents the net property operations of the following properties: Occupancy Date of Percent at Property Acquisition* December 31, 1993 Hammond Aire Plaza Shopping Center December 1987 92% Park Central Office Building April 1988 95% Brookhollow/Stemmons Center Office Complex August 1990 94% Hawthorne Heights Apartments September 1990 97% Flamingo Pines Shopping Center October 1990 94% Perimeter 400 Center Office Complex December 1990 98% Symphony Woods Office Center September 1991 86% Sun Lake Apartments December 1991 97% 420 North Wabash Office Building October 1992 85% Woodscape Apartments December 1992 96% Shoal Run Apartments December 1992 99% Northgate Apartments October 1993 95% Gatewood Apartments October 1993 95% Winchester Mall (sold September 1993) * For financial statement purposes The properties owned by the Partnership at December 31, 1993 comprise approximately 53% of the Partnership's portfolio based on original funds advanced. Income from operations of real estate held for sale remained relatively unchanged during 1993 as compared to 1992. Rental income increased during 1993 at the Park Central Office Building due to leasing activity during the latter part of 1992 which resulted in increased average occupancy levels. Rental income also increased during 1993 at the Sun Lake Apartments due to increased occupancy levels and rental rates. Income was generated during 1993 from the acquisition through foreclosure of the 420 N. Wabash Office Building and Shoal Run Apartments which were acquired through foreclosure in the latter part of 1992. These increases were substantially offset by significant leasing costs incurred during 1993 to lease vacant space and renew existing leases at the Perimeter 400 Office Complex. See Liquidity and Capital Resources for additional information regarding these properties. The 1993 loan prepayments and the sale of Winchester Mall resulted in an increase in cash available for investment and correspondingly, an increase in interest income on short-term investments during 1993 as compared to 1992. Participation income is recognized from participations in cash flow from properties securing certain of the Partnership's loans. The Partnership's loans generally bear interest at contractually fixed interest rates. Some loans also provide for additional interest in the form of participations, usually consisting of either a share in the capital appreciation of the property securing the Partnership's loan and/or a share in the increase of gross income of the property above a certain level. The Partnership received substantial participation income in connection with the August 1993 prepayments of the Skyway, Mariwood and Hickory Knoll and Pinellas Cascade, Land of Lakes Pinellas Park loans. A prepayment premium of $210,000 was received in August 1993 in connection with the prepayment of the loan collateralized by the Pinellas Cascade, Land of Lakes Pinellas Park mobile home parks. The Partnership incurred higher legal fees during 1992 in connection with non- accrual loans, foreclosures and loan defaults, resulting in a decrease in administrative expenses during 1993 as compared to 1992. During 1993, the Partnership incurred leasing commissions in connection with leases signed at the Perimeter 400 Center and Brookhollow/Stemmons Center office complexes and the Park Central and 420 N. Wabash office buildings which resulted in an increase in amortization of deferred expenses during 1993 as compared to 1992. Investment in participation of joint venture with affiliate represents the Partnership's 44.63% share of the operations of the Sand Pebble Village and Sand Pebble Village II (formerly Sand Dune) apartment complexes. The Partnership recognized its share of a further decline in the fair value of Sand Pebble Village Apartments during 1993. As a result, the Partnership's participation in loss of joint venture with affiliate increased during 1993 as compared to 1992. The joint venture received title to Sand Pebble Village Apartments through foreclosure in July 1992 and purchased the Sand Pebble Village II Apartments in October 1993. Affiliates' participation in joint ventures represents the affiliates' shares of income or loss at the Sun Lake Apartments, Perimeter 400 Center Office Complex, and Brookhollow/Stemmons Center Office Complex. Participation in loss of joint ventures decreased during 1993 as compared to 1992 due to a provision for potential losses recognized for the Perimeter 400 Center during 1992. The Partnership recognized a gain on sale of property in 1993 in the amount of $3,471,731 in connection with the sale of Winchester Mall in September 1993. 1992 Compared to 1991 The acquisition of six properties through foreclosure during 1992 and the latter half of 1991, as well as decreased collections on non-accrual loans, resulted in a decrease in net interest income on loans receivable and mortgage servicing fees during 1992 as compared to 1991. The Partnership's three loans on non-accrual status as of December 31, 1992, were collateralized by the 45 West 45th Street Office Building and the Northgate and Gatewood apartment complexes. These loans were also classified in substantive foreclosure at December 31, 1992. During 1992, the Partnership received cash payments of net interest income totaling approximately $668,000 on these loans. Under the terms of the original loan agreements, the Partnership was entitled to receive approximately $1,749,000 of net interest income on the three non-accrual loans during 1992. In addition, in June 1992, the Partnership and an affiliated partnership negotiated a modification of the Jonathan's Landing Apartments loan. The Partnership recognized a provision for potential losses of $18,500,000 for its loans and real estate during 1992. In addition, the Partnership wrote-off its remaining investment in the Three Fountains Apartments loan in the amount of $1,056,761 after receiving a discounted payoff in October 1992, and wrote- off its investment in the Ansonia Mall in the amount of $7,852,747 after applying proceeds received from the sale of the property in December 1992. These losses had previously been reserved for in the Partnership's allowance for potential losses. Income from operations of real estate held for sale in 1992 represented the net property operations of the following properties: Occupancy Percent at Date of December 31, Property Acquisition* 1992 Hammond Aire Plaza Shopping Center December 1987 94% Park Central Office Building April 1988 97% Brookhollow/Stemmons Center Office Complex August 1990 85% Hawthorne Heights Apartments September 1990 97% Flamingo Pines Shopping Center October 1990 94% Perimeter 400 Center Office Complex December 1990 91% Ansonia Mall September 1991 Sold Symphony Woods Office Center September 1991 96% Sun Lake Apartments December 1991 99% Winchester Mall December 1991 66% 420 North Wabash Office Building October 1992 71% Woodscape Apartments December 1992 96% * For financial statement purposes The twelve properties shown above comprised approximately 54% of the Partnership's portfolio based on the original funds advanced during 1992. Income from property operations decreased slightly during 1992 as compared to 1991 due to decreased revenue at Park Central Office Building resulting from the loss of a major tenant in October 1991, and a loss from operations at Sun Lake Apartments due to improvements made at the property during the year. In addition, operating expenses increased at Perimeter 400 Center due to significant leasing activity in 1992. The decrease in income was substantially offset by income from operations at Symphony Woods and Winchester Mall and improved operations at Brookhollow/Stemmons Center resulting primarily from increased occupancy levels. Due to a decrease in the average cash balances available for investment in short-term interest-bearing instruments and a decrease in interest rates earned on these investments, interest income on short-term investments decreased during 1992 as compared to 1991. As a result of significant increases in legal, accounting and portfolio management fees incurred relating to non-accrual loans, loan defaults and foreclosure actions, administrative expenses increased during 1992 as compared to 1991. During 1992, participation in loss of joint venture with affiliate represented the Partnership's 44.63% share of the loss of the Sand Pebble Village Apartments. A joint venture consisting of the Partnership and an affiliate received title to the property through a non-judicial foreclosure in July 1992. Affiliates' participation in joint ventures represents the affiliates' share of income or loss at the Sun Lake Apartments, Perimeter 400 Center and Brookhollow/Stemmons Center office complexes. Affiliates' participation in loss of joint ventures increased significantly in 1992 as compared to 1991 primarily due to an increased provision for potential losses related to the Perimeter 400 Center Office Complex in 1992. The affiliate's share of this provision increased from $1,250,000 in 1991 to $3,819,000 in 1992. Liquidity and Capital Resources The cash or near cash position of the Partnership increased as of December 31, 1993 when compared to December 31, 1992. The Partnership's operating activities include cash flow from the operations of the Partnership's real estate held for sale, additional income from the loan prepayments and interest income from the Partnership's remaining loans. This cash, along with interest earned on short-term investments, was used to pay Partnership administrative expenses and mortgage servicing fees. The Partnership received funds from investing activities relating primarily to three loan prepayments in the latter half of 1993 and from the sale of Winchester Mall in September 1993 and used funds for improvements to certain properties. The Partnership also used approximately $1,933,000 to acquire its share of the Sand Pebble Village II Apartments in October 1993. The cash flow provided by operating and investing activities was used for financing activities which included regular quarterly distributions of Cash Flow to Partners, and, additionally, the repayment of the underlying mortgage loan on Miami Free Zone. As of December 31, 1993, the Partnership holds approximately $30,700,000 of Mortgage Reductions from loan prepayments and the sale of Winchester Mall. The Partnership made a special distribution of Mortgage Reductions of approximately $11,337,000 in January 1994. The remaining Mortgage Reductions have been retained while the Partnership analyzes future working capital requirements. The Partnership classifies the cash flow performance of its properties as either positive, a marginal deficit, or a significant deficit. A deficit is considered significant if it exceeds $250,000 annually or 20% of the property's rental and service income, each after consideration of debt service. During 1993 and 1992, ten of the Partnership's eleven remaining properties acquired prior to 1993 generated positive cash flow. Sun Lake Apartments, which has underlying debt, generated positive cash flow during 1993 as compared to a marginal deficit during 1992 primarily due to increased rental rates and occupancy levels. The Woodscape Apartments, which has underlying debt and was acquired in December 1992, generated a marginal deficit during 1993. Winchester Mall, which was sold in September 1993, generated positive cash flow during 1993 and 1992, and Shoal Run Apartments which was acquired in February 1993, generated positive cash flow during 1993. The Partnership assumed management of the Northgate and Gatewood Apartments in October 1993, and these properties generated positive cash flow during the fourth quarter of 1993. Significant leasing costs were incurred in 1993 at the Perimeter 400 Center and Brookhollow/Stemmons Center office complexes of approximately $2,063,000 and $1,744,000, respectively, to lease vacant space and renew existing tenant leases which were scheduled to expire during 1993. These non-recurring expenditures were not included in classifying the cash flow performance of the properties. Had these costs been included, these properties would have each been classified as generating significant deficits during 1993. Sand Pebble Village Apartments, a property in which the Partnership holds a minority joint venture interest, generated positive cash flow during 1993 and 1992. Sand Pebble Village II Apartments, a property in which the Partnership holds a minority joint venture interest, generated positive cash flow since it was purchased in October 1993. The General Partner is continuing its efforts to maintain high occupancy levels, while increasing rents where possible, and to monitor and control operating expenses and capital improvement requirements at the properties. The General Partner will also examine the terms of any mortgage loans collateralized by its properties, and may refinance or, in certain instances, use Partnership reserves to repay such loans. Because of the current weak real estate markets in certain cities and regions of the country, attributable to local and regional market conditions such as overbuilding and recessions in local economies and specific industry segments, certain borrowers have requested that the Partnership allow prepayment of mortgage loans. The Partnership has allowed some of these borrowers to prepay such loans, in some cases without assessing prepayment premiums, under circumstances where the General Partner believed that refusing to allow such prepayments would ultimately prove detrimental to the Partnership because of the likelihood that the properties would not generate sufficient revenues to keep loan payments current. In other cases, borrowers have requested prepayment in order to take advantage of lower available interest rates. In these cases, the Partnership has collected substantial prepayment premiums. In addition, certain borrowers have failed to make payments when due to the Partnership for more than ninety days and, accordingly, these loans have been placed on non-accrual status (income is recorded only as cash payments are received). The General Partner has negotiated with some of these borrowers regarding modifications of the loan terms and has instituted foreclosure proceedings under certain circumstances. Such foreclosure proceedings may be delayed by factors beyond the General Partner's control such as bankruptcy filings by borrowers and state law procedures regarding foreclosures. Further, certain loans made by the Partnership have been restructured to defer and/or reduce interest payments where the properties collateralizing the loans were generating insufficient cash flow to support property operations and debt service. In the case of most loan restructurings, the Partnership receives concessions, such as increased participations or additional interest accruals, in return for modifications, such as deferral or reduction of basic interest payments. There can be no assurance, however, that the Partnership will receive actual benefits from the concessions. The Partnership and three affiliated partnerships (together, the "Participants"), previously funded a $23,000,000 loan to 45 West 45th Street Office Building, New York, New York (the "Property"), of which the Partnership's share is $9,500,000 (approximately 41%). In September 1991, the loan was placed in default. Pursuant to a cash management agreement entered into between the Participants and the borrower, cash flow from property operations is received by the Participants and recognized as interest income. In May 1993, the Participants cashed a letter of credit which provided partial collateral for the loan, of which the Partnership's share was $199,800. The Participants intend to file foreclosure proceedings during 1994. In August 1993, the borrower of the loan collateralized by the Pinellas Cascade, Land of Lakes Pinellas Park mobile home parks located in Orange City, Florida prepaid the loan in full in the amount of $6,372,000, comprised of the original funds advanced on the loan ($6,000,000), additional interest ($144,000) participation income ($18,000) and a prepayment premium ($210,000). In August 1993, the borrower of the loan collateralized by the Skyway, Mariwood and Hickory Knoll mobile home parks located in Indianapolis, Indiana prepaid the loan in full in the amount of $7,333,400, comprised of the original funds advanced on the loan ($6,000,000), additional interest ($533,360) and participation income ($800,040). In December 1993, the borrower of the loan collateralized by the Miami Free Zone Warehouse Facility located in Miami, Florida prepaid the loan at its net carrying value in the amount of $14,513,339 consisting of the principal outstanding ($12,732,468), unpaid interest thereon ($60,504) and the amount representing the difference between the funds advanced by the Partnership and the outstanding principal balance on the underlying loan ($1,830,942), reduced by amounts held in escrow ($110,575). The underlying mortgage note payable which had a balance of $7,851,022 was also repaid. In February 1994, the borrower of the loan collateralized by the Breckenridge Apartments located in Richmond, Virginia prepaid the loan in full in the amount of $15,782,123, comprised of the original funds advanced on the loan ($13,737,000), unpaid interest thereon ($140,423), and additional interest ($1,904,700). In August 1993, the Partnership applied $263,000 which had been held in an operating reserve account against the principal balance of the loan. In February 1994, the borrower of the loan collateralized by the Highland Green Apartments located in Raleigh, North Carolina prepaid the loan in full in the amount of $9,023,389, comprised of the original funds advanced on the loan ($7,900,000), unpaid interest thereon ($28,089), and additional interest ($1,095,300). The Partnership funded a $7,750,000 loan collateralized by a first mortgage on Winchester Mall located in Rochester Hills, Michigan, and subsequently acquired the property through foreclosure in February 1992. In September 1993, the Partnership sold the property in an all-cash sale for $9,000,000. The carrying value of the property sold was $5,500,000 and the Partnership incurred selling expenses of $28,269. For financial statement purposes, the Partnership recognized a gain of $3,471,731 on the sale of the property. In March 1992, the loan collateralized by Shoal Run Apartments was placed in default and the borrower filed for bankruptcy protection. The Partnership was the successful bidder at a foreclosure sale and received title to the property in February 1993. During 1992, the Partnership commenced foreclosure proceedings against the borrower of the wrap-around mortgage loans collateralized by the Northgate and Gatewood apartment complexes. The borrower subsequently filed for protection under the U.S. Bankruptcy Code which stayed the foreclosure proceedings. A plan of reorganization was confirmed by the Bankruptcy Court in September 1993 and was made effective in December 1993. An affiliate of the General Partner was retained in October 1993 to manage the properties. See Item 3. Legal Proceedings for additional information. In July 1992, a joint venture consisting of the Partnership and an affiliated partnership foreclosed on the Sand Pebble Village Apartments. In March 1992, the Resolution Trust Company acquired the Sand Dune Apartments (now known as Sand Pebble Village II Apartments) through foreclosure, which is adjacent to Sand Pebble Village Apartments. The Sand Pebble and Sand Pebble II Apartments had been operated jointly prior to the respective foreclosures. The Partnership and the affiliated partnership concluded that it would be in their best interests to acquire the Sand Pebble Village II Apartments in order to obtain efficiencies in the management of this property and Sand Pebble Village and, consequently, to enhance the sale potential of Sand Pebble Village Apartments. In October 1993 a joint venture consisting of the Partnership and the affiliated partnership acquired the Sand Pebble Village II Apartments, for a purchase price of $9,300,000. The joint venture paid $4,300,000 in cash, of which the Partnership's share was $1,932,909. The remainder of the purchase price was paid with the proceeds of a $5,000,000 first mortgage loan. In February 1994, the Partnership entered into a contract for the sale of the Hammond Aire Plaza Shopping Center to an unaffiliated party for $16,300,000, the closing of which is expected to occur in 1994. See Item 1. Other Information. The loan collateralized by the Noland Fashion Square Shopping Center has been recorded by the Partnership as an investment in acquisition loan. The Partnership has recorded its share of the collateral property operations as equity in loss from investment in acquisition loan. The Partnership's share of the loss has no effect on the cash flow of the Partnership, and amounts representing contractually required debt service are recorded as interest income. Distributions to Limited Partners can be expected to fluctuate for various reasons. Generally, distributions are made from Cash Flow generated by interest and other payments made by borrowers under the Partnership's mortgage loans. Loan prepayments and repayments can initially cause Cash Flow to increase as prepayment premiums and participations are paid; however, thereafter prepayments and repayments will have the effect of reducing Cash Flow. If such proceeds are distributed, Limited Partners will have received a return of capital and the dollar amount of Cash Flow available for distribution thereafter can be expected to decrease. Distribution levels can also vary as loans are placed on non-accrual status, modified or restructured and, if the Partnership has taken title to properties through foreclosure or otherwise, as a result of property operations. The Partnership made four distributions totaling $8.00, $11.00 and $14.00 per Interest in 1993, 1992 and 1991, respectively. See Statement of Partners' Capital, for additional information. Distributions were comprised of $8.00 of Cash Flow in 1993, $10.25 of Cash Flow and $.75 of Mortgage Reductions in 1992 and $14.00 of Cash Flow in 1991. Cash Flow distributions decreased during 1993 as compared to 1992 and during 1992 as compared to 1991 primarily due to the reduction of Cash Flow resulting from loan defaults and the Partnership's need to maintain adequate reserves in light of continuing working capital requirements at the foreclosed properties. In January 1994, the Partnership paid a distribution of $16,867,256 ($12.20 per Interest) to the holders of Limited Partnership Interests for the fourth quarter of 1993. This distribution includes a regular quarterly distribution of $2.00 per Interest from Cash Flow and special distributions of $8.20 per Interest from Mortgage Reductions received from loan prepayments and $2.00 per Interest from Cash Flow received in connection with the Miami Free Zone loan prepayment. To date, Limited Partners have received cash distributions totaling $156.92. Of this amount, $111.92 represents cash flow from operations and $45.00 represents a return of original capital. During the quarter ended December 31, 1993 the Partnership also paid $460,854 to the General Partner as its distributive share of the Cash Flow distributed for the third quarter of 1993 and made a contribution to the Early Investment Incentive Fund in the amount of $153,618. During 1993 the General Partner used amounts placed in the Early Investment Incentive Fund to repurchase 4,335 Interests from Limited Partners for a total cost of $655,811. The Partnership expects to continue making cash distributions from the Cash Flow generated by the receipt of mortgage payments and property operations less payments on the underlying loans, fees to the General Partner and administrative expenses. The level of future distributions is dependent on cash flow from property operations and the receipt of interest income from mortgage loans. The General Partner, on behalf of the Partnership, has retained what it believes is an appropriate amount of working capital to meet current cash or liquidity requirements which may occur. In 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This statement addresses accounting by creditors for impairment of loans and also eliminates the classification of loans as "in substantive foreclosure." This statement has been adopted by the Partnership as of January 1, 1994, and will not have a material impact on the financial position or results of operations of the Partnership. Inflation has several types of potentially conflicting impacts on real estate investments. Short-term inflation can increase real estate operating costs which may or may not be recovered through increased rents and/or sales prices depending on general or local economic conditions. In the long-term, inflation can be expected to increase operating costs and replacement costs and may lead to increased rental revenues and real estate values. The Partnership's use of equity participations for loans receivable is intended to provide a hedge against the impact of inflation; sharing in cash flow or rental income and/or the capital appreciation of the properties collateralizing the loans should result in increases in the total yields on the loans as inflation rates rise. Item 8. Item 8. Financial Statements and Supplementary Data See Index to Financial Statements in this Form 10-K. The supplemental financial information specified by Item 302 of Regulation S-K is not applicable. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There have been no changes in or disagreements with accountants on any matter of accounting principles, practices or financial statement disclosure. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant (a) Neither the Registrant nor Balcor Mortgage Advisors-VI, its General Partner, has a Board of Directors. (b, c & e) The names, ages and business experience of the executive officers and significant employees of the General Partner of the Registrant are as follows: Name Title Chairman Marvin H. Chudnoff President and Chief Operating Officer Thomas E. Meador Executive Vice President, Chief Financial Officer and Chief Accounting Officer Allan Wood Senior Vice President Alexander J. Darragh Senior Vice President Robert H. Lutz, Jr. Senior Vice President Michael J. O'Hanlon First Vice President Gino A. Barra First Vice President Daniel A. Duhig First Vice President David S. Glasner First Vice President Josette V. Goldberg First Vice President G. Dennis Hartsough First Vice President Lawrence B. Klowden First Vice President Alan G. Lieberman First Vice President Lloyd E. O'Brien First Vice President Brian D. Parker First Vice President John K. Powell, Jr. First Vice President Jeffrey D. Rahn First Vice President Reid A. Reynolds Marvin H. Chudnoff (April 1941) joined Balcor in March 1990 as Chairman. He has responsibility for all strategic planning and implementation for Balcor, including management of all real estate projects in place and financing and sales for a varied national portfolio valued in excess of $6.5 billion. Mr. Chudnoff also holds the position of Vice Chairman of Edward S. Gordon Company Incorporated, New York, a major national commercial real estate firm, which he joined in 1983. He has also served on the Board of Directors of Skippers, Inc. and Acorn Inc., both publicly held companies, and of Waxman Laboratories of Mt. Sinai Hospital, New York. Mr. Chudnoff has been a guest lecturer at the Association of the New York Bar and at Yale and Columbia Universities. Thomas E. Meador (July 1947) joined Balcor in July 1979. He is President and Chief Operating Officer and has responsibility for all ongoing day-to-day activities at Balcor. He is a Director of The Balcor Company. Prior to joining Balcor, Mr. Meador was employed at the Harris Trust and Savings Bank in the commercial real estate division where he was involved in various lending activities. Mr. Meador received his M.B.A. degree from the Indiana University Graduate School of Business. Allan Wood (January 1949) joined Balcor in August 1983 and, as Balcor's Chief Financial Officer and Chief Accounting Officer, is responsible for all financial and administrative functions. He is directly responsible for all accounting, treasury, data processing, legal, risk management, tax and financial reporting activities. He is also a Director of The Balcor Company. Mr. Wood is a Certified Public Accountant. Prior to joining Balcor, he was employed by Price Waterhouse where he was involved in auditing public and private companies. Alexander J. Darragh (February 1955) joined Balcor in September 1988 and has primary responsibility for the Portfolio Advisory Group. He is responsible for due diligence analysis in support of asset management, institutional advisory and capital markets functions as well as for Balcor Consulting Group, Inc., which provides real estate advisory services to Balcor affiliated entities and third party clients. In addition, Mr. Darragh has supervisory responsibility of Balcor's Investor Services Department. Mr. Darragh received masters degrees in Urban Geography from Queens University and in Urban Planning from Northwestern University. Robert H. Lutz, Jr. (September 1949) joined Balcor in October 1991. He is President of Allegiance Realty Group, Inc., formerly known as Balcor Property Management, Inc. and, as such, has primary responsibility for all its management and operations. He is also a Director of The Balcor Company. From March 1991 until he joined Balcor, Mr. Lutz was Executive Vice President of Cousins Properties Incorporated. From March 1986 until January 1991, he was President and Chief Operating Officer of The Landmarks Group, a real estate development and management firm. Mr. Lutz received his M.B.A. from Georgia State University. Michael J. O'Hanlon (April 1951) joined Balcor in February 1992 as Senior Vice President in charge of Asset Management, Investment/Portfolio Management, Transaction Management and the Capital Markets Group which includes sales and refinances. From January 1989 until joining Balcor, Mr. O'Hanlon held executive positions at Citicorp in New York and Dallas, including Senior Credit Officer and Regional Director. He holds a B.S. degree in Accounting from Fordham University, and an M.B.A. in Finance from Columbia University. He is a full member of the Urban Land Institute. Gino A. Barra (December 1954) joined Balcor's Property Sales Group in September 1983. He is First Vice President of Balcor and assists with the supervision of Balcor's Asset Management Group, Transaction Management, Quality Control and Special Projects. Daniel A. Duhig (October 1956) joined Balcor in November 1986 and is responsible for various asset management matters relating to investments made by Balcor and its affiliated partnerships, including negotiations for modifications or refinancings of real estate mortgage investments and the disposition of real estate investments. David S. Glasner (December 1955) joined Balcor in September 1986 and has primary responsibility for special projects relating to investments made by Balcor and its affiliated partnerships and risk management functions. Mr. Glasner received his J.D. degree from DePaul University College of Law in June 1984. Josette V. Goldberg (April 1957) joined Balcor in January 1985 and has primary responsibility for all human resources matters relating to Balcor personnel, including training and development, employment, salary and benefit administration, corporate communications and the development, implementation and interpretation of personnel policy and procedures. Ms. Goldberg also supervises Balcor's payroll operations and Human Resources Information Systems (HRIS). In addition, she has supervisory responsibility for Balcor's Facilities, Corporate and Field Services and Telecommunications Departments. Ms. Goldberg has been designated as a Senior Human Resources Professional (SHRP). G. Dennis Hartsough (October 1942) joined Balcor in July 1991 and is responsible for asset management matters relating to all investments made by Balcor and its affiliated partnerships in office and industrial properties. From July 1989 until joining Balcor, Mr. Hartsough was Senior Vice President of First Office Management (Equity Group) where he directed the firm's property management operations in eastern and central United States. From June 1985 to July 1989, he was Vice President of the Angeles Corp., a real estate management firm, where his primary responsibility was that of overseeing the company's property management operations in eastern and central United States. Lawrence B. Klowden (March 1952) joined Balcor in November 1981 and is responsible for supervising the administration of the investment portfolios of Balcor and its loan and equity partnerships. Mr. Klowden is a Certified Public Accountant and received his M.B.A. degree from DePaul University's Graduate School of Business. Alan G. Lieberman (June 1959) joined Balcor in May 1983 and is responsible for the Property Sales and Capital Markets Groups. Mr. Lieberman is a Certified Public Accountant. Lloyd E. O'Brien (December 1945) joined Balcor in April 1987 and has responsibility for the operations and development of Balcor's Information and Communication systems. Mr. O'Brien received his M.B.A. degree from the University of Chicago in 1984. Brian D. Parker (June 1951) joined Balcor in March 1986 and is responsible for Balcor's corporate and property accounting, treasury, budget activities and corporate purchasing. Mr. Parker is a Certified Public Accountant and holds an M.S. degree in Accountancy from DePaul University and an M.A. degree in Social Service Administration from the University of Illinois. John K. Powell, Jr. (June 1950) joined Balcor in September 1985 and is responsible for Balcor Consulting Group, Inc. which provides real estate advisory services to Balcor affiliated entities and third party clients. Mr. Powell received a Master of Planning degree from the University of Virginia. Jeffrey D. Rahn (June 1954) joined Balcor in February 1983 and has primary responsibility for Balcor's Asset Management Department. He is responsible for the supervision of asset management matters relating to equity and loan investments held by Balcor and its affiliated partnerships. Mr. Rahn received his M.B.A. degree from DePaul University's Graduate School of Business. Reid A. Reynolds (April 1950) joined Balcor in March 1981 and is involved with the asset management of residential properties for Balcor. Mr. Reynolds is a licensed Real Estate Broker in the State of Illinois. (d) There is no family relationship between any of the foregoing officers. (f) None of the foregoing officers or employees are currently involved in any material legal proceedings nor were any such proceedings terminated during the fourth quarter of 1993. Item 11. Item 11. Executive Compensation (a, b, c, d & e) The Registrant has not paid and does not propose to pay any compensation, retirement or other termination of employment benefits to any of the five most highly compensated executive officers of the General Partner. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) No person owns of record or is known by the Registrant to own beneficially more than 5% of the outstanding Limited Partnership Interests of the Registrant. (b) Balcor Mortgage Advisors-VI and its officers and partners own as a group through the Early Investment Incentive Fund and otherwise the following Limited Partnership Interests of the Registrant: Amount Beneficially Title of Class Owned Percent of Class Limited Partnership Interests 30,546 Interests 2.2% Relatives and affiliates of the officers and partners of the General Partner do not own any additional interests. (c) The Registrant is not aware of any arrangements, the operation of which may result in a change of control of the Registrant. Item 13. Item 13. Certain Relationships and Related Transactions (a & b) See Note 10 of Notes to Financial Statements for additional information relating to transactions with affiliates. See Note 2 of Notes to Financial Statements for information relating to the Partnership Agreement and the allocation of distributions and profits and losses. (c) No management person is indebted to the Registrant. (d) The Registrant has no outstanding agreements with any promoters. PART IV Item 14. Item 14. Exhibits and Reports on Form 8-K (a) (1 & 2) See Index to Financial Statements and Schedules in this Form 10-K. (3) Exhibits: (3) The Amended and Restated Agreement and Certificate of Limited Partnership previously filed as Exhibit 3 to Amendment No. 1 to the Registrant's Registration Statement on Form S-11 dated January 14, 1985 (Registration No. 2-93840), is incorporated herein by reference. (4) Form of Subscription Agreement previously filed as Exhibit 4.1 to Amendment No. 1 to the Registrant's Registration Statement on Form S-11 dated January 14, 1985 (Registration No. 2-93840) and Form of Confirmation regarding Interests in the Registrant set forth as Exhibit 4.2 to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1992 (Commission File No. 0-14332) are incorporated herein by reference. (28) Copy of Agreement of Sale relating to the sale of Hammond Aire Plaza, Baton Rouge, Louisiana. (b) Reports on Form 8-K: No reports were filed on Form 8-K during the quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of l934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. BALCOR PENSION INVESTORS-VI By: /s/ Allan Wood Allan Wood Executive Vice President, and Chief Accounting and Financial Officer (Principal Accounting and Financial Officer) of Balcor Mortgage Advisors-VI, the General Partner Date: March 30, 1994 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. Signature Title Date President and Chief Executive Officer (Principal Executive Officer) of Balcor Mortgage /s/Thomas E. Meador Advisors-VI, the General Partner March 30, 1994 Thomas E. Meador Executive Vice President, and Chief Accounting and Financial Officer (Principal Accounting and Financial Officer) of Balcor Mortgage /s/ Allan Wood Advisors-VI, the General Partner March 30, 1994 Allan Wood INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Report of Independent Auditors Financial Statements: Balance Sheets, December 31, 1993 and 1992 Statements of Partners' Capital, for the years ended December 31, 1993, 1992 and 1991 Statements of Income and Expenses, for the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows, for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Schedules: I - Marketable Securities - Other Investments, as of December 31, 1993 X - Supplementary Income Statement Information for the years ended December 31, 1993, 1992 and 1991 Schedules, other than those listed, are omitted for the reason that they are inapplicable or equivalent information has been included elsewhere herein. REPORT OF INDEPENDENT AUDITORS To the Partners of Balcor Pension Investors-VI: We have audited the accompanying balance sheets of Balcor Pension Investors-VI (An Illinois Limited Partnership) as of December 31, 1993 and 1992, and the related statements of partners' capital, income and expenses and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Balcor Pension Investors-VI (An Illinois Limited Partnership) at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/Ernst & Young ERNST & YOUNG Chicago, Illinois March 15, 1994 BALCOR PENSION INVESTORS-VI (An Illinois Limited Partnership) BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 ------------- ------------- Cash and cash equivalents $ 48,820,877 $ 14,279,189 Restricted investment 700,000 700,000 Escrow deposits - restricted 238,983 829,534 Accounts and accrued interest receivable 1,798,891 1,476,653 Prepaid expenses 131,352 82,890 Deferred expenses, net of accumulated amortization of $516,617 in 1993 and $314,373 in 1992 1,194,206 910,056 ------------- ------------- 52,884,309 18,278,322 ------------- ------------- Investment in loans receivable: Loans receivable - first and wrap-around mortgages 31,272,000 68,579,125 Investment in acquisition loan 4,507,534 4,559,332 Less: Loans payable - underlying mortgage 7,851,022 Allowance for potential loan losses 1,308,594 2,815,500 ------------- ------------- Net investment in loans receivable 34,470,940 62,471,935 Loans in substantive foreclosure (net of allowance of $2,400,000 in 1993) 3,652,250 13,649,621 Real estate held for sale (net of allowance of $4,065,000 in 1993) 139,802,469 138,512,995 Investment in joint ventures with affiliate 10,003,319 9,444,900 ------------- ------------- 187,928,978 224,079,451 ------------- ------------- $ 240,813,287 $ 242,357,773 ============= ============= LIABILITIES AND PARTNERS' CAPITAL Accounts and accrued interest payable $ 428,576 $ 384,307 Due to affiliates 154,415 148,455 Other liabilities, principally escrow liabilities and accrued real estate taxes 1,090,697 2,066,939 Security deposits 666,823 612,120 Mortgage notes payable 21,257,668 21,572,650 ------------- ------------- Total liabilities 23,598,179 24,784,471 ------------- ------------- Affiliates' participation in joint ventures 19,636,325 19,522,553 Partners' capital (1,382,562 Limited Partnership Interests issued and outstanding) 197,578,783 198,050,749 ------------- ------------- $ 240,813,287 $ 242,357,773 ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-VI (An Illinois Limited Partnership) STATEMENTS OF PARTNERS' CAPITAL for the years ended December 31, 1993, 1992 and 1991 Partners' Capital Accounts ------------------------------------------ General Limited Total Partner Partners -------------- ------------- ------------- Balance at December 31, 1990 $ 231,749,359 $ (3,274,891)$ 235,024,250 Cash distributions to: Limited Partners (A) (19,355,868) (19,355,868) General Partner (2,150,652) (2,150,652) Net income for the year ended December 31, 1991 3,860,085 386,008 3,474,077 -------------- ------------- ------------- Balance at December 31, 1991 214,102,924 (5,039,535) 219,142,459 Cash distributions to: Limited Partners (A) (15,208,182) (15,208,182) General Partner (1,574,583) (1,574,583) Net income for the year ended December 31, 1992 730,590 73,059 657,531 -------------- ------------- ------------- Balance at December 31, 1992 198,050,749 (6,541,059) 204,591,808 Cash distributions to: Limited Partners (A) (11,060,496) (11,060,496) General Partner (1,228,944) (1,228,944) Net income for the year ended December 31, 1993 11,817,474 1,181,747 10,635,727 -------------- ------------- ------------- Balance at December 31, 1993 $ 197,578,783 $ (6,588,256)$ 204,167,039 ============== ============= ============= (A) Summary of cash distributions paid per Limited Partnership Interest: 1993 1992 1991 -------------- ------------- ------------- First Quarter $ 2.00 $ 3.50 $ 3.50 Second Quarter 2.00 2.75 3.50 Third Quarter 2.00 2.75 3.50 Fourth Quarter 2.00 2.00 3.50 The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-VI (An Illinois Limited Partnership) STATEMENTS OF INCOME AND EXPENSES for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 -------------- ------------- ------------- Income: Interest on loans receivable, loans in substantive foreclosure and from investment in acquisition loans $ 8,458,583 $ 10,951,092 $ 13,244,944 Less interest on loans payable - underlying mortgages 935,768 1,424,807 1,404,952 -------------- ------------- ------------- Net interest income on loans receivable 7,522,815 9,526,285 11,839,992 Income from operations of real estate held for sale 8,241,518 8,249,017 8,259,386 Interest on short-term investments 692,015 615,234 1,206,265 Participation income 932,553 47,631 34,464 Prepayment income 210,000 -------------- ------------- ------------- Total income 17,598,901 18,438,167 21,340,107 -------------- ------------- ------------- Expenses: Provision for potential losses on loans, real estate and accrued interest receivable 7,065,000 18,500,000 16,086,000 Administrative 1,511,351 1,710,994 1,396,278 Mortgage servicing fees 178,782 260,645 353,413 Amortization of deferred expenses 202,244 25,954 32,507 -------------- ------------- ------------- Total expenses 8,957,377 20,497,593 17,868,198 -------------- ------------- ------------- Income (loss) before joint venture participations, equity in loss from investment in acquisition loans and gain on sale of property 8,641,524 (2,059,426) 3,471,909 Participation in loss of joint ventures - affiliate (739,919) (30,386) Affiliates'participation in loss of joint ventures 495,936 2,856,402 424,206 Equity in loss from investment in acquisition loans (51,798) (36,000) (36,030) Gain on sale of property 3,471,731 -------------- ------------- ------------- Net income $ 11,817,474 $ 730,590 $ 3,860,085 ============== ============= ============= Net income allocated to General Partner $ 1,181,747 $ 73,059 $ 386,008 ============== ============= ============= Net income allocated to Limited Partners $ 10,635,727 $ 657,531 $ 3,474,077 ============== ============= ============= Net income per Limited Partnership Interest (1,382,562 issued and outstanding) $ 7.69 $ 0.48 $ 2.51 ============== ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-VI (An Illinois Limited Partnership) STATEMENTS OF CASH FLOWS for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 -------------- ------------- ------------- Operating activities: Net income $ 11,817,474 $ 730,590 $ 3,860,085 Adjustments to reconcile net income to net cash provided by operating activities: Gain on sale of property (3,471,731) Participation in loss of joint ventures - 739,919 30,386 affiliate Equity in loss from investment in acquisition loans 51,798 36,000 36,030 Affiliates'participation in loss of joint venture (495,936) (2,856,402) (424,206) Amortization of deferred expenses 202,244 68,800 32,507 Provision for potential losses on loans, real estate and accrued interest receivable 7,065,000 18,500,000 16,086,000 Net change in: Escrow deposits - restricted 590,551 178,671 490,468 Accounts and accrued interest receivable (322,238) 380,168 (698,293) Accounts and accrued interest payable 44,269 (237,057) 396,813 Prepaid expenses (48,462) (18,847) (64,043) Due to affiliates 5,960 20,141 9,419 Other liabilities (976,242) (526,673) 65,682 Security deposits 54,703 87,436 124,577 -------------- ------------- ------------- Net cash provided by operating activities 15,257,309 16,393,213 19,915,039 -------------- ------------- ------------- Investing activities: Purchase of restricted investment (700,000) Distribution from joint venture partner - affiliate 634,571 136,235 Payment of expenses on real estate held for sale (777,651) (1,553,823) Payment of expenses on loans in substantive foreclosure (35,044) Collection of principal payments on loans receivable and loans in substantive foreclosure 35,290,969 284,598 1,173,825 Collection of principal payment on investment in acquisition loan 202,552 Improvements to properties (3,347,853) (1,473,345) (552,771) Payment of deferred expenses (486,394) (898,040) Proceeds from property sale 9,000,000 714,450 Costs incurred in connection with the sale of real estate (28,269) Purchase of joint venture interest in property with affiliate (1,932,909) -------------- ------------- ------------- Net cash provided by or used in investing activities 39,130,115 (2,546,245) (932,769) -------------- ------------- ------------- Financing activities: Distributions to Limited Partners (11,060,496) (15,208,182) (19,355,868) Distributions to General Partner (1,228,944) (1,574,583) (2,150,652) Distributions to joint venture partners - affiliates (160,988) (1,182,789) (971,899) Capital contributions by joint venture partners - affiliates 770,696 670,948 Repayment of underlying loan payable (7,851,022) Principal payments on underlying loans and mortgage notes payable (314,982) (478,772) (392,953) -------------- ------------- ------------- Net cash used in financing activities (19,845,736) (17,773,378) (22,871,372) -------------- ------------- ------------- Net change in cash and cash equivalents 34,541,688 (3,926,410) (3,889,102) Cash and cash equivalents at beginning of year 14,279,189 18,205,599 22,094,701 -------------- ------------- ------------- Cash and cash equivalents at end of year $ 48,820,877 $ 14,279,189 $ 18,205,599 ============== ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-VI (An Illinois Limited Partnership) NOTES TO FINANCIAL STATEMENTS 1. Accounting Policies: (a) The Partnership records wrap-around mortgage loans at the face amount of the mortgage instrument which includes the outstanding indebtedness of the borrower under the terms of the underlying mortgage obligation(s). The underlying mortgage obligation(s) are recorded as a reduction of the wrap-around mortgage loan and the resulting balance represents the Partnership's net advance to the borrower. (b) Net interest income on the Partnership's wrap-around mortgage loans is primarily comprised of the difference between the interest portion of the monthly payment received from the borrower and the interest portion of the underlying debt service paid to the mortgage lender(s). This interest is recorded in the period that it is earned as determined by the terms of the mortgage loan agreements. Certain mortgage loans also contain provisions for specific amounts of interest to accrue on a periodic basis and to be paid to the Partnership upon maturity of the loans. Interest of this type is recognized only to the extent of the net present value of the total amount due to date. The accrual of interest is discontinued when payments become contractually delinquent for ninety days or more unless the loan is in the process of collection. Once a loan has been placed on non-accrual status, income is recorded only as cash payments are received from the borrower until such time as the borrower has demonstrated an ability to make payments under the terms of the original or renegotiated loan agreement. (c) The Partnership provides for potential loan losses based upon past loss experience for similar loans and prevailing economic conditions in the geographic area in which the collateral is located, delinquencies with respect to repayment terms, and the valuation of specific loans in the Partnership's portfolio. (d) Deferred expenses consist of mortgage brokerage fees which are amortized over the term of the loans and leasing commissions paid to outside brokers which are amortized over the term of the leases to which they apply. (e) Income from operating leases with significant abatements and/or scheduled rent increases is recognized on a straight-line basis over the respective lease terms. (f) Loans are classified in substantive foreclosure when a determination has been made that the borrower has little or no equity remaining in the collateral property in consideration of its current fair value, or the Partnership has taken certain actions which result in taking effective control of operations of the collateral property. These loans are on non-accrual status; therefore, income is recorded only as cash payments are received from the borrower. (g) Real estate held for sale and loans in substantive foreclosure are recorded at the lower of fair value less estimated costs to sell, or cost at the foreclosure date or the date of substantive foreclosure, respectively. Any future declines in fair value will be charged to income and recognized as a valuation allowance, while subsequent increases in value will reduce the valuation allowance, but not below zero. (h) In 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This statement addresses accounting by creditors for impairment of loans and also eliminates the classification of loans as "in substantive foreclosure." This statement has been adopted by the Partnership as of January 1, 1994, and will not have a material impact on the financial position or results of operations of the Partnership. (i) The Financial Accounting Standard Board's Statement No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information about financial instruments for which it is practicable to estimate that value. Since quoted market prices are not available for the Partnership's financial instruments, fair values have been based on estimates using present value techniques. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, may not be realized in immediate settlement of the instrument. Statement 107 excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Partnership. (j) Cash equivalents include all highly liquid investments with a maturity of three months or less when purchased. (k) The Partnership is not liable for Federal income taxes and each partner recognizes his proportionate share of the Partnership's income or loss in his tax return; therefore, no provision for income taxes is made in the financial statements of the Partnership. (l) Investment in acquisition loan represents a first mortgage loan which, because the loan agreement includes certain specified terms, must be accounted for under generally accepted accounting principles as an investment in a real estate joint venture. The investment is therefore reflected in the accompanying financial statements using the equity method of accounting. Under this method, the Partnership records its investment at cost (representing total loan funding) and subsequently adjusts its investment for its share of property income or loss. Amounts representing contractually-required debt service are recorded in the accompanying statements of income and expenses as interest income. Equity in investment in acquisition loan represents the Partnership's share of the collateral property's operations, including depreciation and interest expense. The Partnership's share of income (loss) has no effect on cash flow of the Partnership. (m) Investment in joint venture - affiliate represents the Partnership's 44.63% interest, under the equity method of accounting, in joint ventures with an affiliated partnership. Under the equity method of accounting, the Partnership records its initial investment at cost and adjusts its investment account for additional capital contributions, distributions and its share of joint venture income or loss. 2. Partnership Agreement: The Partnership was organized in October 1984. The Partnership Agreement provides for Balcor Mortgage Advisors-VI to be the General Partner and for the admission of Limited Partners through the sale of up to 1,450,000 Limited Partnership Interests at $250 per Interest, 1,382,562 of which were sold on or prior to October 31, 1985, the termination date of the offering. For financial statement purposes, the Partnership's results of operations are allocated 90% to Limited Partners and 10% to the General Partner, of which 2.5% relates to the Early Investment Incentive Fund. To the extent that Cash Flow is distributed, distributions will be made as follows: (i) 90% of such Cash Flow will be distributed to the Limited Partners, (ii) 7.5% of such Cash Flow will be distributed to the General Partner, and (iii) an additional 2.5% of such Cash Flow will be distributed to the General Partner and shall constitute the Early Investment Incentive Fund (the "Fund"). An amount not to exceed such 2.5% share originally allocated will be returned to the Partnership by the General Partner at the dissolution of the Partnership to the extent necessary to enable Early Investors to receive upon dissolution of the Partnership a return of their Original Capital plus a Cumulative Return of 15% for Interests purchased on or before June 30, 1985, and 14% for Interests purchased between July 1, 1985 and October 31, 1985. Amounts placed in the Fund are used to repurchase Interests from existing Limited Partners, at the sole discretion of the General Partner and subject to certain limitations. During 1993, the Fund repurchased 4,335 Interests at a total cost of $655,811. The amounts of the repurchases are as follows: Date Number of Repurchased Interests Cost First Quarter 1993 840 $125,941 Second Quarter 1993 861 129,262 Third Quarter 1993 1,762 265,012 Fourth Quarter 1993 872 135,596 All repurchases of Interests have been made at 90% of the current value of such Limited Partnership Interests at the previous quarter end. Distributions of Cash Flow and Mortgage Reductions pertaining to such repurchased Interests are paid to the Fund and are available to repurchase additional Interests. 3. Investment in Loans Receivable: Loans receivable at December 31, 1993 consisted of the following: Loans Receivable Current Current Original Due Mortgage Monthly Interest Funding Date Of Property Balances(A) Payment Rate % Date Loan Apartment Complexes: Breckenridge Richmond, VA (B)$13,737,000 Highland Green Raleigh, NC (C) 7,900,000 Jonathans Landing Kent, WA (D) 9,635,000 $71,603 8.75% 07-87 5-97 ----------- Total $31,272,000 =========== (A) All the loans are first mortgage loans. (B) In February 1994, the borrower prepaid this loan in full in the amount of $15,782,123, comprised of the original funds advanced on the loan ($13,737,000), unpaid interest thereon ($140,423) and additional interest ($1,904,700). In August 1993, the Partnership applied $263,000 which had been held in an operating reserve account against the principal balance of this loan. (C) In February 1994, the borrower prepaid this loan in full in the amount of $9,023,389, comprised of the original funds advanced on the loan ($7,900,000), unpaid interest thereon ($28,089) and additional interest ($1,095,300). (D) The Partnership and an affiliated partnership entered into a participation agreement to fund the first mortgage loan collateralized by this property. Interest rates will range from 8.75% to 10.25% through the maturity date of the loan. The Partnership participates ratably in 47% of the loan amount and related interest income. Allowances for potential loan losses related to the Miami Free Zone loan in the amount of $2,106,906 were written off during 1993 in connection with the repayment of the loan at its net carrying value. 4. Investment in Acquisition Loan: In January 1989, the Partnership and two affiliated partnerships (together the "Participants") entered into a participation agreement to fund a $23,300,000 first mortgage loan on the Noland Fashion Square, located in Independence, Missouri. The Partnership participates ratably in approximately 21% of the loan amount, interest income and participation income. At December 31, 1993, the loan had a balance of $4,507,534, and current monthly interest-only payments of $38,979 are due through maturity in December 1999. The loan provides for several types of additional interest which include, but are not limited to, a percentage of the adjusted gross cash flow of the underlying property, a percentage of the sale price over certain stated amounts and a percentage of the increase in the appraised value at maturity over the appraised value at funding. Additional interest amounts payable to the Partnership upon maturity of the loan or sale of the property are generally contingent upon certain conditions, as stated in the note and, therefore, no interest has been accrued. The loan balance includes the Partnership's share of the cumulative net loss of the property after the loan was funded. 5. Loan in Substantive Foreclosure: Loan in substantive foreclosure was collateralized by the 45 West 45th Street Office Building located in New York, New York and had a carrying value of $3,652,250 at December 31, 1993. The Partnership and three affiliated partnerships entered into a participation agreement to fund the first mortgage loan on this property. The Partnership participates ratably in approximately 41% of the original loan amount and related interest income. 6. Mortgage Notes Payable: Mortgage notes payable at December 31, 1993 and 1992 consisted of the following: Balance Balance Current Current Due Approx. at at Monthly Interest Date of Balloon Property 12/31/93 12/31/92 Payments Rate % Loan Payment Real estate held for sale Sun Lake Apts. (carrying value $24,685,000)(A) $15,700,000 $15,700,000 $101,788 7.625% 11-97 $15,700,000 Woodscape Apts. (carrying value $6,629,000) 3,416,256 3,497,106 35,572 10.00 4-95 3,311,000 Gatewood Apts. (carrying value $3,795,855)(B) 1,188,414 1,287,384 14,188 8.50 8-95 1,074,000 Northgate Apts. (carrying value $3,710,766)(B) 952,998 1,088,160 14,128 9.00 8-95 827,000 ----------- ----------- Grand Total $21,257,668 $21,572,650 =========== =========== (A) This mortgage loan is financed with underlying revenue bonds. Principal and interest payments due on the mortgage loan reflect payments due to the bondholders. The interest rate will remain constant until November 1, 1994, the next re-marketing date of the bonds. The bonds may be redeemed, at par plus accrued interest, on this date and on subsequent dates prior to maturity pursuant to the terms of the bond indenture. The bonds are secured by an irrevocable letter of credit in the amount of approximately $16,443,700 which expires on the re-marketing date. The Partnership will need to replace the letter of credit or find an alternate credit facility for the bonds as of such date. Unless there is a prior redemption of all or part of the bonds, the entire principal balance of the loan will be due on November 1, 1997. (B) See Note 7 of Notes to Financial Statements for additional information regarding these properties. Future maturities of the above mortgage notes payable are approximately as follows: 1994 $ 249,000 1995 5,309,000 1996 None 1997 15,700,000 During the years ended December 31, 1993, 1992 and 1991, the Partnership incurred interest expense on the mortgage notes payable of $1,855,630, $1,929,879 and $713,262, respectively, and paid interest expense of $1,855,630, $1,654,442 and $352,661, respectively. 7. Real Estate Held for Sale: During 1993, 1992 and 1991, the Partnership acquired the following properties through foreclosure: the Shoal Run Apartments in 1993, the Woodscape and Sun Lake apartment complexes, 420 North Wabash Office Building and Winchester Mall in 1992, and the Symphony Woods Office Center, Ansonia Mall and Perimeter 400 Center Office Building in 1991. In October 1993, an affiliate of the General Partner assumed management of the Northgate and Gatewood apartment complexes. These investments are classified as real estate held for sale at December 31, 1993. The Partnership recorded the cost of the properties at $7,506,621, $62,137,388, and $57,138,760 in 1993, 1992 and 1991, respectively, which was equal to the outstanding loan balance plus any accrued interest receivable. In addition, the Partnership increased (reduced) the bases of the properties by $1,209,857 and $(2,499,396) in 1992 and 1991, respectively, which represented certain other receivables, liabilities, escrows and costs recognized or incurred in connection with the foreclosures. 8. Affiliates' Participation in Joint Ventures: (a) The Brookhollow/Stemmons Center Office Complex is owned by a joint venture between the Partnership and an affiliated partnership. Profits and losses are allocated 72.5% to the Partnership and 27.5% to the affiliate. (b) The Perimeter 400 Center Office Building is owned by the Partnership and three affiliated partnerships. Profits and losses are allocated 50% to the Partnership and 50% to the three affiliates. (c) The Sun Lake Apartment Complex is owned by the Partnership and an affiliated partnership. Profits and losses are allocated 61.95% to the Partnership and 38.05% to the affiliate. All assets, liabilities, income and expenses of the joint ventures are included in the financial statements of the Partnership with the appropriate adjustment of profit or loss for each affiliate's participation. Net contributions (distributions) of $609,708, $(511,841), and $(971,899) were made to joint venture partners during 1993, 1992 and 1991, respectively. In addition, joint venture partners were allocated the appropriate percentage of the provision for potential losses in the amount of $1,020,000, $4,194,726 and $2,086,500 during 1993, 1992 and 1991, respectively. 9. Investment in Joint Venture with Affiliate: The Partnership and an affiliated partnership (together, the "Participants") acquired title to the Sand Pebble Village Apartments, located in Riverside, California at a foreclosure sale in July 1992. The Participants acquired the adjacent property, the Sand Dune Apartments (now known as the Sand Pebble Village II Apartments), for a purchase price of $9,300,000 in October 1993. The Participants paid $4,300,000 in cash, of which the Partnership's share was $1,932,909. The remainder of the purchase price was paid with the proceeds of a $5,000,000 first mortgage loan. The Partnership's investment in each of these properties has been classified as investment in joint ventures with affiliate. Profits and losses and all capital contributions and distributions are allocated 44.63% to the Partnership and 55.37% to the affiliate. 10. Transactions with Affiliates: Fees and expenses paid and payable by the Partnership to affiliates are: Year Ended Year Ended Year Ended 12/31/93 12/31/92 12/31/91 Paid Payable Paid Payable Paid Payable Mortgage servicing fees $186,190 $10,678 $268,928 $18,086 $361,626 $26,369 Property management fees1,053,447 84,481 971,875 86,437 455,591 49,693 Reimbursement of expenses to the General Partner, at cost: Accounting 119,308 9,444 103,592 8,191 76,045 13,975 Data processing 243,662 21,660 257,867 20,756 280,950 22,471 Investor communica- tions 21,334 1,688 41,188 3,257 23,339 4,289 Legal 37,335 2,955 29,267 2,314 17,162 3,154 Portfolio management 126,791 21,782 100,049 7,912 34,023 6,253 Other 21,812 1,727 19,000 1,502 11,483 2,110 11. Restricted Investment: In April 1992, the Partnership and an affiliated partnership (together, the "Participants") established a debt service reserve account of $700,000 as additional collateral for their obligations related to the mortgage loan on Sun Lake Apartments, pursuant to the settlement agreement reached in December 1991. The Partnership contributed $433,650 as its share of the account. The remaining portion is included in the affiliate's investment in the joint venture. The funds are invested in short-term interest bearing instruments and interest earned on the investments is payable to the Participants. The funds will be released to the Participants once certain terms and conditions of the agreement are met. 12. Property Sales: a) In September 1993, the Partnership sold the Winchester Mall located in Rochester Hills, Michigan in an all-cash sale for $9,000,000. The carrying value of the property sold was $5,500,000 and the Partnership incurred selling expenses of $28,269. For financial statement purposes, the Partnership recognized a gain of $3,471,731 on the sale of the property. b) In December 1992, the Partnership sold Ansonia Mall, located in Ansonia, Connecticut, for a sale price of $750,000. The basis of the property at the date of sale was $8,567,167. The Partnership received cash proceeds of $714,450, net of selling costs of $35,550. The Partnership recognized a loss on the sale of the property of $7,852,747, which was written-off against the Partnership's previously established allowance for potential losses. 13. Management Agreements: Twelve of the Partnership's properties are currently under management agreements with Allegiance Realty Group, Inc. (formerly Balcor Property Management, Inc.) an affiliate of the General Partner. These management agreements provide for annual fees of 5% of gross operating receipts for residential properties and a range of 3% to 6% of gross operating receipts for commercial properties. The 420 North Wabash Office Building is managed by an unaffiliated party for annual fees pursuant to the management agreement. 14. Fair Values of Financial Instruments: The following methods and assumptions were used by the Partnership in estimating its fair value disclosures for financial instruments. Cash and cash equivalents: the carrying amount of cash and cash equivalents reported in the balance sheet for cash and short-term investments approximates those assets' fair values. Net investment in loans receivable and mortgage notes payable: the fair values for the Partnership's net investment in loans receivable and mortgage notes payable are estimated using discounted cash flow analyses, using discount rates based upon rates of return currently received in the lending and real estate markets on instruments that are comparable to the Partnership's investments and similar debt instruments. The carrying amount of accrued interest approximates fair value. The carrying amounts and fair values of the Partnership's financial instruments at December 31, 1993 and December 31, 1992 are as follows: Carrying Fair Amount Value Cash and cash equivalents $ 48,820,877 $ 48,820,877 Restricted investment 700,000 700,000 Restricted escrow deposits 238,983 238,983 Accounts and accrued interest receivable 1,798,891 1,798,891 Net investment in loans receivable 34,470,940 36,044,540 Mortgage notes payable 21,257,668 19,843,109 Accounts and accrued interest payable 428,576 428,576 Carrying Fair Amount Value Cash and cash equivalents $ 14,279,189 $ 14,279,189 Restricted investment 700,000 700,000 Restricted escrow deposits 829,534 829,534 Accounts and accrued interest receivable 1,476,653 1,476,653 Net investment in loans receivable 62,471,935 63,385,002 Mortgage notes payable 21,572,650 19,887,482 Accounts and accrued interest payable 384,307 384,307 15. Contingencies: The Partnership is currently involved in a lawsuit whereby the Partnership and certain affiliates have been named as defendants alleging certain Federal securities law violations with regard to the adequacy and accuracy of disclosures of information concerning the offering of the Limited Partnership Interests of the Partnership. The defendants continue to vigorously contest this action. Although the outcome of these matters is not presently determinable, it is management's opinion that the ultimate outcome should not have a material adverse affect on the financial position of the Partnership. Management of the defendants believes they have meritorious defenses to contest the claims. 16. Subsequent Event: In January 1994, the Partnership paid a distribution of $16,867,256 ($12.20 per Interest) to the holders of Limited Partnership Interests for the fourth quarter of 1993. This distribution includes a regular quarterly distribution of $2.00 per Interest from Cash Flow and special distributions of $8.20 per Interest from Mortgage Reductions received from loan repayments during 1993 and $2.00 per Interest from Cash Flow received in connection with the Miami Free Zone loan prepayment. BALCOR PENSION INVESTORS - VI (An Illinois Limited Partnership) SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS as of December 31, 1993 Col. A Col. B Col. C Col. D Col. E Amount at Which Each Number Portfolio of of Shares Equity Security or Units - Market Issue and Each Principal Value of Other Security Name of Issuer and Amounts Cost Each Issue Issue Carried Title of Each Issue of Bonds of Each at Balance in the and Notes Issue Sheet Date Balance Sheet Marketable Securities(A) Commercial Paper: Canadian Wheat Board 3.30% due 01/05/1994$ 2,000,000 $1,991,383 $1,991,383 $1,991,383 Chevron Oil Finance Company 3.08% due 01/05/1994 3,000,000 2,987,680 2,987,680 2,987,680 Ameritech Corporation 3.37% due 01/06/1994 4,000,000 3,996,630 3,996,630 3,996,630 Paccar Financial Corporation 3.20% due 01/07/1994 4,000,000 3,991,466 3,991,466 3,991,466 Delaware Funding Corporation 3.28% due 01/12/1994 2,800,000 2,790,561 2,790,561 2,790,561 A I CR Corporation 3.25% due 01/14/1994 1,000,000 994,854 994,854 994,854 AIG Funding Incorporated 3.20% due 01/14/1994 4,000,000 3,986,844 3,986,844 3,986,844 Hewlett-Packard Company 3.18% due 01/18/1994 4,500,000 4,486,883 4,486,883 4,486,883 Kellogg Company 3.15% due 01/18/1994 10,000,000 9,971,125 9,971,125 9,971,125 Cincinnati Bell Incorporated 3.20% due 01/20/1994 4,000,000 3,989,689 3,989,689 3,989,689 Canadian Wheat Board 3.08% due 01/21/1994 1,000,000 997,006 997,006 997,006 Cargill Financial Service Corporation 3.17% due 01/21/1994 1,000,000 997,182 997,182 997,182 Delaware Funding Corporation 3.27% due 01/25/1994 2,862,000 2,849,262 2,849,262 2,849,262 AIG Funding Corporation 3.27% due 02/04/1994 2,000,000 1,989,282 1,989,282 1,989,282 Metropolitan Life Funding Corporation 3.30% due 02/07/1994 1,000,000 992,483 992,483 992,483 ----------- ----------- ----------- ----------- Total $47,162,000 $47,012,330 $47,012,330 $47,012,330 =========== =========== =========== =========== (a) Marketable securities are included in cash and cash equivalents on the balance sheet. Cash of $1,808,547 is also included in this category. BALCOR PENSION INVESTORS - VI (An Illinois Limited Partnership) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years ended December 31, 1993, 1992 and 1991 Col. A Col. B Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and Repairs $4,228,338 $1,919,318 $ 917,794 Real Estate Taxes 2,441,109 2,262,250 1,636,239

95395_1993.txt

95395_1993

1993

95395

Item 1. Business (a) General Development of Business Annual Report to Stockholders, information regarding the sale of Sundstrand Data Control Division to AlliedSignal, Inc. on pages 25, 27, 28, 36, 38 and 39, information on foreign operations and activity on pages 26-27, information regarding the restructuring of the aerospace segment on pages 26 and 36, information regarding the acquisition of the Electrical Systems Division of Westinghouse Electric Corporation on pages 26, 27, 28 and 36, information regarding the establishment of a joint venture with Labinal, Inc. on page 27, and information regarding date of incorporation on page 45. (b) Financial Information About Annual Report to Stockholders, Industry Segments information by business segment on pages 25-26, and pages 34-35. (c) Narrative Description of Business Annual Report to Stockholders, pages 6-29, information on foreign operations and activity on pages 26-27 and 34-35, information on unfilled orders on pages 27 and 46-47, information regarding the development of the auxiliary power unit products on page 27, information regarding environmental matters on pages 27 and 42-43, information regarding a significant customer on pages 27, 29 and 34, information regarding research and development expenditures on pages 29 and 42, information regarding contracts with or for the government on pages 29 and 43, information regarding materials and supplies, intellectual property rights and competition on page 45, and information regarding the number of employees on pages 46-47. (d) Financial Information About Annual Report to Stockholders, Foreign and Domestic Operations information on foreign operations and Export Sales and activity on pages 26-27 and 34-35, information regarding the acquisition of the Electrical Systems Division of Westinghouse Electric Corporation on page 27, information regarding foreign and domestic operations on pages 34- 35, and information regarding foreign earnings and assets on pages 35 and 40. Item 2. Item 2. Properties Annual Report to Stockholders, information regarding properties on page 45. FORM 10-K ITEM NO. INCORPORATED BY REFERENCE FROM: Item 3. Item 3. Legal Proceedings Annual Report to Stockholders, information regarding environmental matters on pages 27 and 42-43, information regarding certain government contracting matters on pages 29 and 43, and information regarding income tax matters on pages 29 and 40 except the sentence on page 40 which states "Jurisdiction of this matter now resides in the United States Court of Appeals for the Seventh Circuit" is deleted and replaced with "On February 22, 1994, the United States Court of Appeals for the Seventh Circuit affirmed the decision of the U.S. Tax Court. The Company intends to file a Motion for Rehearing challenging the correctness of the Court of Appeals' opinion." Item 4. Item 4. Submission of Matters to a Vote (Not Applicable). of Security Holders Executive officers of the Registrant Annual Report to Stockholders, information regarding officers on page 49. PART II. Item 5. Item 5. Market for the Registrant's Annual Report to Stockholders, Common Equity and Related information regarding restrictions Stockholder Matters on dividend payments on page 40, information regarding dividends on pages 43 and 46, information regarding Registrant's common stock price range on pages 43 and 46, information regarding the number of common stockholders on page 46, and information regarding exchange listings on page 50. Item 6. Item 6. Selected Financial Data Annual Report to Stockholders, pages 46-47, information regarding the sale of Sundstrand Data Control Division to AlliedSignal, Inc. on pages 25, 27, 28, 36, 38 and 39, information regarding the changes in accounting standards on pages 25, 26, 27, 28, 38 and 39, information regarding the restructuring of the aerospace segment on pages 26 and 36, information regarding the acquisition of the Electrical Systems Division of Westinghouse Electric Corporation on pages 26, 27, 28 and 36, and information regarding provisions for interest for asserted tax deficiencies on page 40. Item 7. Item 7. Management's Discussion and Annual Report to Stockholders, Analysis of Financial Condition pages 25-29. and Results of Operations Item 8. Item 8. Financial Statements and Annual Report to Stockholders, Supplementary Data pages 30-44 and 46-47. Item 9. Item 9. Changes in and Disagreements (Not Applicable). with Accountants on Accounting and Financial Disclosure FORM 10-K ITEM NO. INCORPORATED BY REFERENCE FROM: PART III. Item 10. Item 10. Directors and Executive Annual Report to Stockholders, Officers of the Registrant pages 48-49; Proxy Statement, pages 3-6. Item 11. Item 11. Executive Compensation Proxy Statement, information regarding Don R. O'Hare's consulting agreement with the Registrant on page 7, information under the caption "Compensation Committee Interlocks and Insider Participation" on page 10, and information under the captions "Summary Compensation Table," "Aggregated Option Exercises in Last Fiscal Year and Fiscal Year- End Option Values," "Retirement Plans" and "Employment Agreements" on pages 14-20. Item 12. Item 12. Security Ownership of Certain Proxy Statement, information under Beneficial Owners and Management the caption "Voting Securities" on pages 1-2, and information under the caption "Voting Securities Held by Nominees, Directors and Officers" on page 7. Item 13. Item 13. Certain Relationships and Proxy Statement, information under Related Transactions the caption "Loans" on page 20. PART IV. Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements Annual Report to Stockholders, the following Consolidated Financial Statements of Registrant and subsidiaries on pages 30 through 44. Consolidated Statement of Earnings for the years ended December 31, 1993, 1992, and 1991 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992, and Consolidated Balance Sheet as of December 31, 1993 and 1992 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992, and 1991 Information by Business Segment for the years ended December 31, 1993, 1992, and 1991 Quarterly Results (Unaudited) for 1993 and 1992 Notes to Consolidated Financial Statements Management's Report Independent Auditor's Report (a) 2. Financial Statement The schedules, other than the Schedules schedules relating to amounts receivable from related parties, property, plant and equipment, accumulated depreciation and short-term borrowings, have been omitted as the required information is not applicable, or not required, or because the required information is included in the Consolidated Financial Statements or Notes to Consolidated Financial Statements. PART IV. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements Report of Independent Auditors (Ernst & Young) on the financial statements and related schedules of Registrant for the years ended December 31, 1993, 1992, and 1991. (a) 2. Financial Statement Schedules Schedule II - Amounts Receivable From Related Parties, for the years ended December 31, 1993, 1992, and 1991. Schedule V - Property, Plant and Equipment, for the years ended December 31, 1993, 1992, and 1991. Schedule VI - Accumulated Depreciation of Property, Plant and Equipment, for the years ended December 31, 1993, 1992 and 1991. Schedule IX - Short-term Borrowings, for the years ended December 31, 1993, 1992, and 1991. (a) 3. Exhibits (3) Articles of Incorporation and By-Laws (a) Registrant's Restated Certificate of Incorporation as effective December 19, 1991 (filed as Exhibit (3)(a) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference). (b) Registrant's By-Laws, including all amendments, as effective April 21, 1992 (filed as Exhibit (19)(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, File No. 1-5358, and incorporated herein by reference). (4) Instruments Defining the Rights of Security Holders, including Indentures (a) Credit Agreement dated as of January 28, 1993, among Registrant and eight banking institutions including Morgan Guaranty Trust Company of New York, as Agent (filed as Exhibit (4)(a) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference). (b) Amended and Restated Rights Agreement dated December 4, 1987 and Amendment thereto dated March 5, 1990 (filed as Exhibit 4(a) and 4(b) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-5358, and incorporated herein by reference). (c) Lease dated as of December 14, 1987, between Registrant and Greyhound Real Estate Investment Six, Inc. (filed as Exhibit (4)(f) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, File No. 1- 5358, and incorporated herein by reference). (d) Note Agreement of Registrant dated May 15, 1991 (filed as Exhibit (19)(c) to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, File No. 1- 5358, and incorporated herein by reference). (e) Amendment effective December 31, 1991, to Registrant's Note Agreement dated as of May 15, 1991 (filed as Exhibit (19)(c) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-5358, and incorporated herein by reference). (f) Amendment and Restatement dated May 15, 1991, of Registrant's Note Agreement dated January 18, 1980 (filed as Exhibit (19)(d) to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, File No. 1-5358, and incorporated herein by reference). (g) Amendment effective December 31, 1991, to Registrant's May 15, 1991, Amended and Restated Note Agreement (filed as Exhibit (19)(d) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-5358, and incorporated herein by reference). (h) Note Agreement of Registrant dated October 31, 1991 (filed as Exhibit (4)(l) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference). (i) Note Agreement of Registrant dated December 2, 1991 (filed as Exhibit (4)(m) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference). (10) Material Contracts (a) Consulting Agreement dated October 1, 1989, between Registrant and Don R. O'Hare, a retired officer and a Director of Registrant (filed as Exhibit (10)(d) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* *Management contract or compensatory plan. (b) Amendments dated August 20, 1991, and November 1, 1991, to Consulting Agreement dated October 1, 1989, between Registrant and Don R. O'Hare, a retired officer and a Director of Registrant (filed as Exhibit (10)(c) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference).* (c) Amendment dated August 24, 1992, to Consulting Agreement dated October 1, 1989, between Registrant and Don R. O'Hare, a retired officer and a Director of Registrant (filed as Exhibit (19)(b) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-5358, and incorporated herein by reference).* (d) Amendment dated August 20, 1993, to Consulting Agreement dated October 1, 1989, between Registrant and Don R. O'Hare, a retired officer and a Director of Registrant.* (e) Amended and Restated Employment Agreement dated August 7, 1990, between Registrant and Harry C. Stonecipher, Registrant's Chairman of the Board, President and Chief Executive Officer (filed as Exhibit (19)(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, File No. 1-5358, and incorporated herein by reference).* (f) Agreement dated June 19, 1988, between Registrant and Paul Donovan, Registrant's Executive Vice President and Chief Financial Officer, regarding Registrant's repurchase of shares of restricted stock (filed as Exhibit (10)(h) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* (g) Amended and Restated Employment Agreement dated August 18, 1992, between Registrant and Robert J. Smuland, Registrant's Executive Vice President and Chief Operating Officer, Aerospace (filed as Exhibit (19)(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, File No. 1-5358, and incorporated herein by reference).* (h) Form of Employment Agreement, including amendment thereto, between Registrant and each of Paul Donovan, Registrant's Executive Vice President and Chief Financial Officer, Berger G. Wallin, Registrant's Executive Vice President and Chief Operating Officer, Industrial, Richard M. Schilling, Registrant's Vice President and General Counsel and Secretary, and DeWayne J. Fellows, Registrant's Vice President and Controller (filed as Exhibit (10)(g) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference).* (i) Employment Agreement dated March 14, 1991, between Registrant and Gary J. Hedges, Registrant's Vice President, Personnel and Public Relations (filed as Exhibit (10)(p) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1990, File No. 1-5358, and incorporated herein by reference).* (j) Agreement dated November 16, 1989, between Registrant and Labinal, Inc. establishing a jointly owned sales company to market, sell and support auxiliary power units for commercial aerospace applications (filed as Exhibit (10)(s) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference). (k) Letter of Intent dated January 22, 1993, by and between Registrant and Rockwell International Corporation setting forth Rockwell International Corporation's intent to purchase all of the assets, business and properties, subject to certain liabilities of Sundstrand Data Control Division (filed as Exhibit (10)(k) to Registrant's Annual Report for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference).* (l) Stock, Note and Real Property Purchase Agreement dated July 14, 1993, between Registrant and AlliedSignal Inc. providing for Registrant's sale to AlliedSignal Inc. of Registrant's Data Control division (filed as Exhibit (10)(a) to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, File No. 1-5358, and incorporated herein by reference). (m) Registrant's Stock Incentive Plan effective December 1, 1992 (filed as Exhibit (10)(l) to Registrant's Annual Report for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference).* (n) Closing Agreement dated November 20, 1992, by and between Registrant and subsidiaries of Registrant and the Internal Revenue Service, in connection with the resolution of the intercompany pricing dispute for the years 1979 through 1988 (filed as Exhibit (10)(m) to Registrant's Annual Report for the fiscal year ended December 31, 1992, File No. 1-5358, and incorporated herein by reference). *Management contract or compensatory plan. (o) Registrant's 1989 Restricted Stock Plan as adopted April 20, 1989, by the stockholders of Registrant (filed as Exhibit (10)(v) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* (p) Registrant's 1975 Restricted Stock Plan as adopted on April 19, 1975, by the stockholders of Registrant, including all amendments through April 16, 1986 (filed as Exhibit (10)(b) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1982, File No. 1-5358, and incorporated herein by reference).* (q) Registrant's 1982 Restricted Stock Plan as adopted on April 15, 1982, by the stockholders of Registrant, including all amendments through April 16, 1986 (filed as Exhibit (10)(c) to Registrant's Annual Report on Form 10- K for the fiscal year ended December 31, 1982, File No. 1-5358, and incorporated herein by reference).* (r) Text of resolution adopted by the Board of Directors of Registrant on April 17, 1986, amending Registrant's 1975 and 1982 Restricted Stock Plans (filed as Exhibit (10)(c) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986, File No. 1-5358, and incorporated herein by reference).* (s) Text of resolution adopted by the Board of Directors of Registrant on August 7, 1990, amending Registrant's 1975, 1982, and 1989 Restricted Stock Plans (filed as Exhibit (19)(f) to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1990, File No. 1-5358, and incorporated herein by reference).* (t) Text of resolution adopted by the Board of Directors of Registrant on November 30, 1989, and December 1, 1989, establishing an Officer Incentive Compensation Plan (filed as Exhibit (10)(cc) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* (u) Text of resolution adopted by the Board of Directors of Registrant on February 19, 1991, amending Registrant's Officer Incentive Compensation Plan (filed as Exhibit (10)(hh) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, File No. 1-5358, and incorporated herein by reference).* (v) Text of resolution adopted by the Board of Directors of Registrant on July 16, 1989, adopting a Director Emeritus Retirement Plan and copy of such plan as effective July 20, 1989 (filed as Exhibit (10)(dd) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, File No. 1-5358, and incorporated herein by reference).* (w) Text of resolution adopted by the Board of Directors of Registrant on October 17, 1984, establishing a 1984 Elected Officers' Loan Program (filed as Exhibit (10)(i) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1984, File No. 1-5358, and incorporated herein by reference).* (x) Text of resolution adopted by the Board of Directors of Registrant on October 15, 1991, amending the 1984 Elected Officers' Loan Program (filed as Exhibit (10)(ff) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, File No. 1-5358, and incorporated herein by reference).* (11) Computation of Fully Diluted Earnings Per Share (Unaudited) for the quarter ended December 31, 1993 and 1992, and for the year ended December 31, 1993 and 1992. (13) Annual Report to Stockholders for the year ended December 31, 1993. (21) Subsidiaries of Registrant (23) Consents of Experts and Counsel (a) Consent of Independent Auditors (Ernst & Young). (24) Powers of Attorney (99) Additional Exhibits (a) Undertakings (filed as Exhibit (28)(a) to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1982, File No. 1-5358, and incorporated herein by reference). (b) Reports on Form 8-K Form 8-K dated November 22, 1993, regarding Registrant's sale to AlliedSignal, Inc. of Registrant's Data Control division, and including pro forma financial statements and notes relating thereto. *Management contract or compensatory plan. 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 on this 2nd day of March, 1994. SUNDSTRAND CORPORATION (Registrant) By /s/ Harry C. Stonecipher ------------------------------------- HARRY C. STONECIPHER CHAIRMAN OF THE BOARD, PRESIDENT AND CHIEF EXECUTIVE OFFICER 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 date indicated. Harry C. Stonecipher ) Chairman of the Board, ) President and ) Chief Executive Officer ) ) Paul Donovan ) Executive Vice President ) and Chief Financial Officer ) ) DeWayne J. Fellows ) Vice President and Controller ) ) J. P. Bolduc ) Director ) ) Gerald Grinstein ) Director ) ) Charles Marshall ) March 2, 1994 Director ) ) Klaus H. Murmann ) Director ) ) Donald E. Nordlund ) Director ) ) Don R. O'Hare ) Director ) ) Thomas G. Pownall ) Director ) ) Ward Smith ) Director ) ) Robert J. Smuland ) Director ) By: /s/ Paul Donovan ---------------------------------------------------- PAUL DONOVAN, ATTORNEY-IN-FACT REPORT OF INDEPENDENT AUDITORS To the Shareholders and Board of Directors Sundstrand Corporation We have audited the consolidated balance sheets of Sundstrand Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sundstrand Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the notes to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions. /s/ ERNST & YOUNG Chicago, Illinois January 27, 1994 SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES YEAR ENDED DECEMBER 31, 1993 Dollar Amounts in Thousands SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES YEAR ENDED DECEMBER 31, 1992 Dollar Amounts in Thousands SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES YEAR ENDED DECEMBER 31, 1991 Dollar Amounts in Thousands SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (1) Dollar Amounts in Millions SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (1) Dollar Amounts in Millions SUNDSTRAND CORPORATION AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS Dollar Amounts in Millions

34903_1993.txt

34903_1993

1993

34903

Item 1. Business Federal Realty Investment Trust is an owner, operator and redeveloper of community and neighborhood shopping centers. The Trust is a self- administered real estate investment trust, founded in 1962. Since January 1989, the Trust has been managing, leasing, and supervising renovations of most of its properties. The Trust operates in a manner intended to enable it to qualify as a real estate investment trust (REIT) under Sections 856-860 of the Internal Revenue Code. Under those sections, a REIT which distributes at least 95% of its real estate investment trust taxable income to its shareholders each year and which meets certain other conditions will not be taxed on that portion of its taxable income which is distributed to its shareholders. The Trust intends to continue to qualify and to distribute substantially all of its taxable income to its shareholders. Therefore, no provision for Federal income taxes is required. The Trust's real estate portfolio has increased from 42 properties as of January 1989 to 49 properties as of December 31, 1993. During this five year period the Trust acquired 11 shopping centers, containing approximately 2.5 million square feet, at a cost of $196.0 million and sold four shopping centers containing 692,000 square feet. During this same period the Trust spent over $130 million to renovate, expand and improve its properties. Two of the 11 shopping centers acquired during the last five years were acquired under capital leases with an original recorded value of $34.0 million; one was acquired subject to a $2.5 million mortgage and the remainder were acquired with cash. This growth was financed primarily through borrowings and equity offerings, since each year the Trust has distributed all or the majority of its cash provided by operating activities to its shareholders. At December 31, 1993 the Trust owned or had a leasehold interest in 47 community and neighborhood shopping centers and one air-conditioned partially enclosed mall. These 48 shopping centers contain in the aggregate approximately 10.6 million net rentable square feet. The Trust's shopping centers usually feature supermarket, drug or discount department store chains. There are approximately 1,500 tenants providing a wide range of retail products and services. These tenants range from sole proprietorships to national retailers. Fourteen of the shopping centers are located in the Maryland and Virginia suburbs of Washington, D.C., eleven are in Pennsylvania, nine are in New Jersey, three are in Virginia, two are in the Baltimore, Maryland suburbs, two are in Illinois and the remainder are in North Carolina, Michigan, Georgia, New York, Tennessee, Louisiana and Massachusetts. The Trust also owns one apartment development located in Silver Spring, Maryland, containing 282 units. No single property or tenant accounts for more than 10% of the Trust's revenues. An important part of the Trust's investment strategy has been and is to acquire older, well-located shopping centers and enhance their revenue potential through a program of renovation, re-leasing and re-merchandising. In addition the Trust is currently seeking to acquire sites to develop new shopping centers. The Trust's policy is to execute tenant leases which provide for additional rent based upon tenant sales revenue and annual rent escalations. Tenants are typically required to pay their proportionate share of on-site operating expenses and real estate taxes. During the years ended December 31, 1993, 1992, and 1991, shopping centers have contributed 94%, 92% and 93%, respectively, of the Trust's total revenue. The Trust intends to continue to invest substantially all of its assets in shopping centers. The Trust is currently limited to investing east of the Mississippi River; to change this limitation requires Trustee approval. Investments are not required to be based on specific allocation by type of property. The extent to which the Trust may mortgage or otherwise finance investments varies with the investment involved and the economic climate. The success of the Trust depends upon, among other factors, the trends of the economy, construction costs, retailing trends, income tax laws, increases or decreases in operating expenses, governmental regulations, population trends, zoning laws, legislation and the ability of the Trust to keep its properties leased at profitable levels. The Trust competes for tenants with other real estate owners and the Trust's properties account for only a small fraction of the shopping centers available for lease. The Trust competes for investment opportunities and mortgage financing with individuals, partnerships, corporations, financial institutions, life insurance companies, pension funds and trust funds. The Trust engages in a continuing program to identify desirable properties on which offers to acquire are made from time to time. Similarly, the Trust regularly reviews its portfolio and from time to time considers the sale of certain of its properties. Investments in real property create a potential for environmental liability on the part of the current and previous owners of, or any mortgage lender on, such real property. If hazardous substances are discovered on or emanating from any properties, the owner or operator of the property may be held liable for costs and liabilities relating to such hazardous substances. The Trust's current policy is to obtain an environmental study on each property it seeks to acquire. On recent acquisitions, any substances identified prior to closing which present an immediate environmental hazard have been or are in the process of remediation. Costs related to the abatement of asbestos which increase the value of Trust properties are capitalized. Other costs are expensed. In 1993 approximately $1.5 million, of which $1.0 was capitalized abatement costs, was spent on environmental matters. The Trust has budgeted a range of $1.5 million to $2.7 million for 1994 for environmental matters, a majority of which is projected for asbestos abatement. (See Note 4 of Notes to Consolidated Financial Statements.) Current Developments The Trust believes that now is an opportune time to acquire shopping centers. The credit environment for real estate companies has improved and with the recent recession ended, the Trust expects an increased demand for retail space. During 1992 and 1993 in order to improve its capital structure and to finance the expansion its real estate portfolio, the Trust raised equity and debt. The Trust took advantage of the favorable interest rate environment in 1993 by replacing higher rate debt with lower rate debt and replaced near term maturing debt with longer term debt. As a result of these transactions, the Trust's debt to equity ratio has dropped to 1.28 to 1 as of December 31, 1993. In April 1993 the Trust sold 2.8 million shares of beneficial interest ("shares") in a public offering, raising net proceeds of $72.8 million. In December 1993 another 220,000 shares were issued for $5.4 million in a private placement in connection with the long term lease of a property. The Trust called its 8 3/4% convertible subordinated debentures and its 8.65% Senior Notes for redemption in 1993. The Trust redeemed $173,000 principal amount of the 8 3/4% debentures at a price of $1017.50 per debenture on March 15; the balance of the debentures that had been outstanding, or $2.2 million, were converted to shares. The Senior Notes were redeemed on May 14, 1993 at a price of $1010 per Note for a total redemption price of $50.5 million. During 1993 the Trust purchased $3.7 million of its 5 1/4% convertible subordinated debentures due 2002, so that at December 31, 1993 there was $40.2 million of the original $100.0 million outstanding. In October 1993 the Trust took advantage of favorable financing rates and issued in Europe $75.0 million of 5 1/4% convertible subordinated debentures, raising cash proceeds of approximately $73.0 million. The debentures, which mature in 2003, are convertible into shares at $36 per share. During 1993 the Trust prepaid $34.9 million of mortgage obligations whose interest rates were higher than current rates. The Trust acquired seven shopping centers in 1993. Pan Am Shopping Center in Fairfax, Virginia was acquired for $21.6 million in cash; Gaithersburg Square in Gaithersburg, Maryland was purchased for $11.0 million in cash and the assumption of a $2.0 million liability which is the estimated cost to remediate certain preexisting environmental issues; Quince Orchard Plaza in Gaithersburg, Maryland and its adjoining office building were purchased for $10.9 million in cash and the assumption of a liability of approximately $250,000; Crossroads Shopping Center in Highland Park, Illinois was purchased for $16.2 million in cash; Bala Cynwyd Shopping Center in suburban Philadelphia, Pennsylvania was purchased for $17.0 million in cash; Dedham Plaza in Dedham, Massachusetts was purchased for $25.0 million in cash and the assumption of a $250,000 liability to remediate existing environmental issues; and the leasehold interest in Bethesda Row in Bethesda, Maryland was acquired with $6.2 million in cash. The Trust continued its strategy of renovating, expanding and reconfiguring its centers in 1993, spending approximately $34.3 million. These improvements included $6.5 million to purchase and renovate a department store building at The Shops at Willow Lawn, $4.6 million to begin renovation and retenanting of Ellisburg Circle, $1.5 million for the first phase of the redevelopment at Huntington Shopping Center, and $2.3 million to begin the renovation and retenanting of Troy Shopping Center. At December 31, 1993 the Trust had 178 full-time employees. Item 3. Item 3. Legal Proceedings. None Item 4. Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Market Quotations Dividends Quarter ended High Low Paid December 31, 1993 $29 7/8 $24 1/8 $.39 September 30, 1993 30 1/4 25 1/2 .385 June 30, 1993 28 7/8 24 3/4 .385 March 31, 1993 29 23 7/8 .385 December 31, 1992 $25 1/4 $22 $.385 September 30, 1992 25 21 3/8 .38 June 30, 1992 21 3/4 20 .38 March 31, 1992 22 1/2 18 3/4 .38 The number of holders of record for Federal Realty's shares of beneficial interest at December 31, 1993 was 4,564. Dividends declared per quarter during the last two fiscal years were as follows: Quarter Ended 1993 1992 March 31 $.385 $.38 June 30 .385 $.38 September 30 .39 $.385 December 31 .39 $.385 The Trust's common shares of beneficial interest are listed on the New York Stock Exchange. Item 6. Item 6. Selected Financial Data. In thousands, except per share data Year ended December 31, 1993 1992 1991 1990 1989 ____________________________________________________________________________ Operating Data Rental Income $105,948 $89,971 $88,350 $80,698 $72,771 Income before gain on sale of real estate and extra- ordinary item 16,114 6,987 4,324 4,894 4,782 Gain on sale of real estate --- 2,501 61 947 7,215 Extraordinary item - gain (loss) on early extinguishment of debt 2,016 (58) 415 --- --- Net income 18,130 9,430 4,800 5,841 11,997 Funds from Operations 41,489 30,020 26,246 23,985 20,956 Dividends declared 42,021 36,306 25,771 24,048 20,440 Weighted average number of shares outstanding 27,009 22,767 17,304 16,695 14,672 Per share: Net income .67 .41 .28 .35 .82 Dividends declared 1.55 1.53 1.50 1.44 1.38 ____________________________________________________________________________ Balance Sheet Data Real estate at cost $758,088 $598,867 $566,056 $555,879 $514,552 Total assets 690,943 603,811 566,062 553,396 565,779 Mortgage and capital lease obligations 218,545 245,694 225,859 203,287 204,616 Notes payable 30,519 6,117 11,665 31,222 29,357 Senior notes --- 50,000 50,000 50,000 50,000 8 3/4% convertible subordinated debentures --- 2,371 4,338 4,576 5,630 5 1/4% convertible subordinated debentures due 2002 40,167 43,847 87,665 100,000 100,000 5 1/4% convertible subordinated debentures due 2003 75,000 --- --- --- --- Shareholders' equity 284,199 222,878 151,480 129,346 146,114 Number of shares outstanding 28,018 24,718 19,687 16,716 16,642 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources Federal Realty meets its liquidity requirements through net cash provided by operating activities, long-term borrowing through debt offerings and mortgages, medium and short-term borrowing under lines of credit, and equity offerings. Because all or a significant portion of the Trust's net cash provided by operating activities is distributed to shareholders, capital outlays for property acquisitions, renovation projects and debt repayments require funding from borrowing or equity offerings. In order to improve its capital structure and to finance and expand its real estate portfolio, the Trust raised equity and debt during 1992 and 1993. The Trust took advantage of the favorable interest rate environment by replacing higher rate debt with lower rate debt and replaced near term maturing debt with longer term debt. Equity has increased to $284.2 million at December 1993, while total debt was $364.2 million at December 31, 1993. The Trust's debt to equity ratio has consequently dropped from 2.5 to 1 at December 31, 1991 to 1.28 to 1 at December 31, 1993. In June 1992 the Trust sold 3.4 million common shares of beneficial interest ("shares") in a public offering, raising net proceeds of $66.5 million. In April 1993 another 2.8 million shares were issued in a public offering, netting proceeds of $72.8 million. In December 1993 another 220,000 shares were issued for $5.4 million in a private placement in connection with the long-term lease of a property. In March 1992 the Trust exchanged $22.6 million principal amount of its 5 1/4% convertible subordinated debentures due 2002 for 1.3 million shares. Another $21.2 million principal amount of these debentures were retired in 1992 when they were repurchased by the Trust with proceeds from the public offerings. The Trust purchased an additional $3.7 million of these debentures in 1993, so that at December 31, 1993 there was $40.2 million of the original $100.0 million outstanding. The Trust called its 8 3/4% convertible subordinated debentures and its 8.65% Senior Notes for redemption in 1993. The Trust redeemed $173,000 principal amount of the 8 3/4% debentures at a price of $1017.50 per debenture on March 15; the balance of the debentures that had been outstanding or $2.2 million were converted into shares. The Senior Notes were redeemed on May 14, at a price of $1010 per note for a total redemption price of $50.5 million. In October 1993 the Trust took advantage of favorable financing rates and issued in Europe $75.0 million of 5 1/4% convertible subordinated debentures, realizing cash proceeds of approximately $73.0 million. The debentures, which mature in 2003, are convertible into shares at $36 per share. The debentures are redeemable by the Trust, in whole, at any time after October 28, 1998 at 100% of the principal amount plus accrued interest. The Trust placed a $30.0 million mortgage on Federal Plaza in 1992; the mortgage bears interest beginning at 8 1/4%, resetting every three years, and matures in 2001. During 1992 the Trust prepaid $6.3 million of mortgage obligations and then in 1993 the Trust prepaid another $34.9 million of mortgage obligations; the interest rates on these mortgages were higher than current rates. At December 31, 1993 the Trust had $70.0 million of unsecured medium- term revolving credit facilities with three banks. All three facilities require fees and have covenants requiring a minimum shareholders' equity and a maximum ratio of debt to net worth. The Trust uses these facilities to fund acquisitions and other cash requirements until conditions are favorable for issuing equity or long term debt. The maximum drawn under these facilities during 1993 was $64.1 million; at December 31, 1993 the Trust had $24.4 million outstanding under these facilities. The average weighted interest rate on borrowings during 1993 on these facilities was 4.2%. These medium term facilities replace a $20.0 million unsecured line of credit which was available at December 1992. The increase in the Trust's revolving credit facilities are indicative of the improvement since 1991 in the credit environment. The Trust obtained an additional unsecured revolving credit facility of $15.0 million in February 1994, bringing its total availability to $85.0 million. In February 1994 the Trust borrowed $22.5 million, which was used to pay down the December 1993 balances on the revolving credit facilities. The loan, which is secured by the Northeast Plaza Shopping Center, bears interest at 150 basis points over LIBOR, the London Interbank Offered Rate, and is due on January 31, 1995. In June 1993 Standard and Poor's raised the ratings on the Trust's subordinated convertible debentures from BBB- to BBB, reflecting the successful results of the Trust's restructuring of its debt and increasing of its equity. In September 1993 Moody's Investors Service also upgraded the Trust's subordinated debt, from Ba1 to Baa2. The Trust's long term debt has varying maturity dates and in a number of instances includes balloon payments or other contractual provisions that could require significant repayments during a particular period. The earliest balloon repayment is in April 1994, when the holders of the Trust's 5 1/4% convertible subordinated debentures due 2002 may require the Trust to redeem the notes for $48.2 million (120% of the principal amount). The next balloon repayment is in 1998 when approximately $41.3 million of mortgages are due. Major expenditures of capital by the Trust during 1993 included the following: (1) $101.8 million to acquire six shopping centers; (2) $6.2 million incurred in connection with the long term lease of a seventh shopping center; (3) $32.5 million to prepay mortgages; (4) $50.5 million to redeem the Senior Notes; (5) $4.6 million to redeem portions of the convertible subordinated debt; and (6) $34.3 million in improvements to properties. These improvements included $6.5 million to purchase and renovate a department store building at The Shops at Willow Lawn, $4.6 million to begin renovation and retenanting of Ellisburg Circle Shopping Center, $1.5 million for the first phase of the redevelopment at Huntington Shopping Center, $2.3 million to begin the renovation and retenanting at Troy Shopping Center and $9.5 million in tenant work. Cash requirements for these expenditures were met by the net proceeds of the recent equity and debt offerings and from borrowings on the revolving credit facilities. Major expenditures of capital by the Trust during 1992 included the following: (1) $15.3 million to purchase Ellisburg Circle Shopping Center; (2) $9.1 million to purchase the land underlying Wildwood Shopping Center which had been subject to a long term ground lease; (3) $8.5 million to repay short term borrowings; (4) $23.6 million to repurchase 5 1/4% convertible subordinated debentures due 2002; (5) $8.0 million to prepay mortgages; and (6) $15.2 million in improvements to properties. Cash requirements for these expenditures were met by the net proceeds from the sale of Sargent Road and 25th Street Shopping Centers, the net proceeds from the mortgage on Federal Plaza and the proceeds of public offerings. The Trust has budgeted $49.0 million for capital improvements to its properties in 1994. These improvements include: (1) $14.0 million to begin the renovation and redevelopment of Congressional Plaza; (2) $4.0 million to begin renovation at Brick Plaza; (3) $6.0 million to begin renovation of Gaithersburg Square; and (4) approximately $9.0 million for tenant work. In addition the Trust has budgeted $48.2 million to redeem the 5 1/4% convertible subordinated debentures due 2002, which the noteholders may require the Trust to redeem in April 1994, and $4.1 million to exercise an option to purchase the land at Northeast Shopping Center in December 1994. These expenditures will be paid from proceeds from borrowings under its medium-term revolving credit facilities and from the issuance of long term debt or equity. In preparation for the future issuance of such long term debt or equity, the Trust filed a shelf registration statement with the Securities and Exchange Commission, which became effective in December 1993, under which up to $300 million of debt securities, preferred shares or common shares may be issued. The State of New Jersey Division of Taxation has assessed the Trust $364,000 in taxes, penalty and interest for the years 1985 through 1990, since the State has disallowed the dividends paid deduction in computing New Jersey taxable income. The Trust has filed a complaint in the Tax Court of New Jersey contesting the assessment since the Trust believes that it is entitled to the deduction. At this time, the outcome of this matter is unknown. The North Carolina Department of the Environment, Health and Natural Resources issued a Notice of Violation ("NOV") against a dry cleaner tenant at Eastgate Shopping Center in Chapel Hill, North Carolina concerning a spill at the shopping center. As owner of the shopping center, the Trust was named in and received a copy of the NOV. Estimates to remediate the spill range from $300,000 to $500,000. An agreement is being drawn with two previous owners of the shopping center to share the costs to remediate. The Trust has recorded a liability of $120,000 as its estimated share of the cleanup costs. Contaminants at levels in excess of New Jersey cleanup standards were identified at a shopping center in New Jersey. The Trust has retained an environmental consultant to investigate the contamination. The Trust is also evaluating whether it has insurance coverage for this matter. At this time, the Trust is unable to determine what the range of remediation costs might be. The Trust has also identified chlorinated solvent contamination at two other properties. In each case, the contamination appears to be linked to the current and/or previous dry cleaner. The Trust intends to look to the responsible parties for any remediation effort. Evaluation of these situations is preliminary and it is impossible to estimate the range of remediation costs, if any. The Trust reserved at closing $2.25 million for environmental issues principally associated with the recently acquired Gaithersburg Square. Pursuant to an indemnity agreement entered into with the seller at closing, the Trust agreed to take certain actions with respect to identified chlorinated solvent contamination. The seller indemnified the Trust for certain third party claims and government requirements related to contamination at adjacent properties. Management believes that the combination of cash available at December 31, 1993, the revolving credit facilities, and the unencumbered value of the Trust's properties provide the Trust with adequate capital resources and liquidity for operating purposes in the near future. The Trust, however, continues to renovate its existing centers and seeks to acquire more shopping centers. The Trust will need to raise equity or issue additional debt in order to fund its planned renovations in 1994 and to purchase any additional shopping centers. The Trust believes that it has the ability to raise this needed capital through the offering of equity and debt securities so that it may pursue its growth plans as well as to meet its longer term capital and debt financing needs, including scheduled loan payments and contractual repayment obligations. Results of Operations Funds from operations is defined as income before depreciation and amortization and extraordinary items less gains on sale of real estate. Management believes that funds from operations is an appropriate supplemental measure of the Trust's operating performance because it believes that reductions for depreciation and amortization charges are not meaningful in evaluating income-producing real estate, which have historically been appreciating assets. The Trust acquires, evaluates and sells income-producing properties based upon operating income without taking into account property depreciation and amortization charges and utilizes funds from operations, together with other factors in setting shareholder distribution levels. Gains on sale of real estate and extraordinary items are also excluded from this supplemental measure of performance because such amounts are not part of the ongoing operations of the Trust's portfolio. Funds from operations does not replace net income as a measure of performance or net cash provided by operating activities as a measure of liquidity. Funds from operations increased 38% in 1993 to $41.5 million from $30.0 million in 1992. Funds from operations increased 14% in 1992 to $30.0 million from $26.2 million in 1991. The Trust's shopping center leases generally provide for minimum rents, with periodic increases. Most shopping center tenants pay a majority of on- site operating expenses. Many leases also contain a percentage rent clause which calls for additional rents based on tenant sales, so that at a given sales volume if prices increase, so does rental income. These features in the Trust leases reduce the Trust's exposure to higher costs caused by inflation, although inflation has not been significant in recent years. Rental income, which consists of minimum rent, percentage rent, and cost recoveries, increased from $90.0 million in 1992 to $105.9 million in 1993. If centers acquired and sold in 1992 and 1993 are excluded, rental income increased 8.8% from $88.5 million in 1992 to $96.3 million in 1993. Perring Plaza, whose redevelopment was completed late in 1992, and Huntington Shopping Center, whose first phase of retenanting and redevelopment was completed in 1993, contributed 39% of this increase. Rental income increased from $88.4 million in 1991 to $90.0 million in 1992; if centers acquired and sold in 1992 and 1991 are excluded, rental income increased 3.5% from $85.5 million to $88.8 million. Minimum rents increased from $66.9 million in 1991 to $68.8 million in 1992 to $81.3 million in 1993. If centers acquired and sold during these years are excluded, minimum rents increased from $64.7 million in 1991 to $67.8 million in 1992 to $73.6 million in 1993. Forty-eight percent of the increase from 1992 to 1993 was contributed by Perring Plaza and Huntington Shopping Center. Of the 1992 increase, $400,000 was contributed by Perring Plaza and $1.2 million was contributed by Federal Plaza which was under redevelopment until May 1991. Cost reimbursements, which generally increase as expenses increase, rose from $14.7 million in 1991 to $14.9 million in 1992 to $18.2 million in 1993. Excluding centers acquired and sold during the three year period, cost reimbursements increased from $14.3 million in 1991 to $14.6 million in 1992 to $16.4 million in 1993. The increase in 1993 recoveries relates to a corresponding increase in expense in 1993 as discussed below, while the small increase in 1992 from 1991 relates to the corresponding slight increase in expense in 1992 as compared to 1991. Percentage rents are a fluctuating source of revenue based on tenant sales volume and lease rollovers. When leases are renewed the Trust seeks to set minimum rent at levels that include the past year's percentage rents. Percentage rents have decreased from $4.6 million in 1991 to $4.2 million in 1992 to $4.1 million in 1993. Excluding centers sold and acquired during the three year period, percentage rents have decreased from $4.3 million in 1991 to $4.0 million in 1992 to $3.9 million in 1993. The decreases result primarily from rolling percentage rent into minimum rents as leases renew and from the expiration of certain leases. Other property income, which includes items which tend to fluctuate from period to period, such as utility reimbursements, telephone income, merchant association dues, lease termination fees and temporary occupant income, has risen from $4.6 million in 1991 to $4.7 million in 1992 to $5.5 million in 1993. Excluding centers bought and sold during the three year period, other property income increased from $4.4 million in 1991 to $4.6 million in 1992 to $4.8 million in 1993. The increase in 1993 was due primarily to an increase in lease termination fees. Rental expenses have increased from year to year in dollar amount, especially in 1993 where $2.1 million of the increase is due to newly acquired centers. However, rental expenses have remained fairly stable as a percentage of property income (rental income plus other income); 21.9% in 1991, 22.1% in 1992 and 23.8% in 1993. Of the expenses included in rental expense, the greatest changes have been in repairs and maintenance and other operating expenses. Snow removal expense is the primary reason for the increase in repairs and maintenance. Other operating expenses have increased due to an increase in bad debt, environmental expense and marketing expenses for the centers. Real estate taxes have remained stable as a percentage of property income, at approximately 9.3%. Depreciation and amortization charges have increased from $21.9 million in 1991 to $23.0 million in 1992 to $25.4 million in 1993. The increase in 1993 is due to depreciation on the recent acquisitions and renovations, while in 1992 the increase was primarily due to increased depreciation on Federal Plaza, depreciation on renovations and increased amortization of lease costs. Interest income decreased from $5.5 million in 1992 to $3.9 million in 1993 due primarily to lower cash balances, as cash was used for acquisitions, renovations, and debt repayments. Interest income increased from $4.7 million in 1991 to $5.5 million in 1992, despite lower interest rates in 1992 since average cash balances were higher in 1992 due to the temporary investment of the proceeds of public offerings. Interest expense has decreased from $35.2 million in 1992 to $31.6 million in 1993, reflecting the redemption of the Senior Notes and the 8 3/4% convertible subordinated debentures, the reduction in the 5 1/4% convertible subordinated debentures due 2002 and the prepayment of various mortgages, partially offset by interest expense of the revolving credit facilities and interest on the 5 1/4% convertible subordinated debentures due 2003. Interest expense decreased from $38.1 million in 1991 to $35.2 million in 1992 due primarily to the exchange and repurchase of $56.2 million of the Trust's 5 1/4% convertible subordinated debentures due 2002 in 1991 and 1992. Administrative expenses have ranged from 3.6% of property income (rental income plus other income) in 1991 to 4.3% in 1992 to 4.2% in 1993. During the worst of the recession in 1991 the Trust reduced overhead expenses by reducing the number of employees and freezing or reducing many salaries. Employment practices have now returned to normal. Other charges of $682,000 in 1992 is comprised of two items. One is the $960,000 writedown of an investment in Olympia and York notes, partially offset by the recovery of $278,000 of a legal settlement. Income before gain on sale of real estate and extraordinary item increased $9.1 million from 1992 to 1993, primarily because of increased revenue from recent acquisitions and redevelopments and because of the decrease in interest expense. Income before gain on sale of real estate and extraordinary item increased $2.7 million in 1992 from 1991 due to an increase in revenue coupled with a decrease in interest expense partially offset by higher depreciation and amortization, administrative expense and net other charges. Gain on sale of real estate is dependent on the extent and timing of sales. The 1992 gain was primarily due to the sale of Sargent Road and 25th Street Shopping Centers. The 1991 gain was on the sale of Lawrence Village Shopping Center. In 1993 the Trust had a net gain of $2.0 million on the early extinguishment of debt, resulting from a $3.1 million gain on the extinguishment of the mortgage at Northeast Plaza, offset by losses on the redemption of the Senior Notes, convertible subordinated debentures and two mortgages. In 1992 the Trust had a net loss of $58,000 on the early extinguishment of debt, resulting from the prepayment of two mortgages and the exchange and repurchase of its 5 1/4% convertible subordinated debentures. In 1991 the Trust had a net gain of $415,000 on the early extinguishment of debt, consisting of a gain on the repurchase of the Trust's 5 1/4% convertible subordinated debentures due 2002 partially offset by $587,000 in prepayment fees on the early extinguishment of three mortgages. As a result of the foregoing items net income was $18.1 million in 1993, $9.4 million in 1992 and $5.8 million in 1991. Impact of New Accounting Standards In May 1993 the Financial Accounting Standards Board (FASB) issued FASB No. 115, "Accounting for Certain Investments in Debt and Equity Securities". This standard will be effective for 1994 financial statements and requires the classification of debt and equity investments into one of three categories: held-to-maturity, trading or available-for-sale. The Trust does not believe that the implementation of the standard in 1994 will have a material effect on the Trust's financial statements since the Trust's current accounting for debt and equity investments does not differ materially from the standard. Item 8. Item 8. Financial Statements and Supplementary Data. Included in Item 14. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure. None Part III Item 10. Item 10. Directors and Executive Officers of the Registrant. Executive Officers of the Registrant The Executive Officers are: Name Age Position with Trust Steven J. Guttman 47 President and Chief Executive Officer and Trustee Ron D. Kaplan 31 Vice President-Capital Markets Catherine R. Mack 49 Vice President-General Counsel and Secretary Mary Jane Morrow 41 Senior Vice President-Finance and Treasurer Hal A. Vasvari 50 Executive Vice President-Management Cecily A. Ward 47 Vice President-Controller Robert S. Wennett 33 Senior Vice President-Acquisitions Steven J. Guttman has been the Trust's President and Chief Executive Officer since April 1980. Mr. Guttman has been associated with the Trust since 1972, became Chief Operating Officer in 1975 and became a Managing Trustee in 1979. Ron D. Kaplan joined the Trust in November 1992 as Vice President- Capital Markets. Mr. Kaplan was formerly a Vice President of Salomon Brothers Inc where he was responsible for capital raising and financial advisory services for public and private real estate companies. While at Salomon Brothers, he participated in the offering of the Trust's 5 1/4% Euro-Convertible Debentures due 2002 and 8.65% Senior Notes. Catherine R. Mack came to the Trust in January 1985 as General Counsel and became a Vice President in February 1986. Before joining the Trust, Ms. Mack was an Assistant United States Attorney for the District of Columbia and, prior to that, an attorney with Fried, Frank, Harris, Shriver and Jacobson in Washington, D.C. where she represented several local real estate entities. She has practiced law since 1974. Mary Jane Morrow joined the Trust in January 1987 as Vice President- Finance and Treasurer. Before joining Federal Realty, Ms. Morrow was a Partner with Grant Thornton, the Trust's independent accountants. She was with Grant Thornton for over 10 years and has extensive experience in real estate and accounting. Hal A. Vasvari joined Federal Realty Management, Inc., the Trust's former managing agent, in August 1985 as Executive Vice President. In January 1989, Mr. Vasvari became Executive Vice President-Management of the Trust. Prior to August 1985, he was director of leasing for Kravco Co., a developer of shopping malls and shopping centers. Cecily A. Ward joined the Trust in April 1987 as Controller. Prior to joining the Trust, Ms. Ward, a certified public accountant, was with Grant Thornton, the Trust's independent accountants. Robert S. Wennett joined the Trust's acquisitions department in April 1986. Prior to joining the Trust, Mr. Wennett was an associate with Chemical Realty Corporation in New York where he was involved in real estate financing for corporate clients. The schedule identifying Trustees under the caption "Election of Trustees" of the 1994 Proxy Statement is incorporated herein by reference thereto. Item 11. Item 11. Executive Compensation. The sections entitled "Summary Compensation Table", "Option Grants in 1993", and "Aggregated Option Exercises in 1993 and Option Values as of December 31, 1993" of the 1994 Proxy Statement are incorporated herein by reference thereto. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The section entitled "Ownership of Shares By Certain Beneficial Owners" and the section entitled "Ownership of Shares by Trustees and Officers" of the 1994 Proxy Statement are incorporated herein by reference thereto. Item 13. Item 13. Certain Relationships and Related Transactions. The section entitled "Certain Transactions" of the 1994 Proxy Statement is incorporated herein by reference thereto. Part IV Item 14. Item 14. Exhibits, Financial Statement Page No. Schedules, and Reports on Form 8-K (a) 1. Financial Statements Report of Independent Certified Public Accountants Consolidated Balance Sheets- December 31, 1993 and 1992 Consolidated Statements of Operations - years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity - years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - years ended December 31, 1993, 1992 and Notes to Consolidated to Financial Statements (Including Selected Quarterly Data) (a) 2. Financial Statement Schedules Schedule I - Marketable Securities and other Investments................................F-19 Schedule II - Summary of Amounts Receivable from Related Parties and Underwriters, Promoters and Employees other than related parties.............F-20 to Schedule XI - Summary of Real Estate and Accumulated Depreciation.....................F-22 to Schedule XII - Mortgage Loans on Real Estate ..........................................F-25 to Report of Independent Certified Public Accountants...................................F-27 (a) 3. Exhibits (3) (i) The Trust's Third Amended and Restated Declaration of Trust dated May 24, 1984, filed with the Commission on July 5, 1984 as Exhibit 4 to the Trust's Registration Statement on Form S- 2 (file No. 2-92057) is incorporated herein by reference thereto. (ii) Bylaws of the Trust, filed with the Commission as an exhibit to the Trust's Current Report on Form 8-K dated February 20, 1985, is incorporated herein by reference thereto. (4) (i) Specimen Share of Beneficial Interest, filed with the Commission on November 23, 1982 as Exhibit 4 to the Trust's Registration Statement on Form S-2 (file No. 2-80524), is incorporated herein by reference thereto. (ii) Indenture dated March 15, 1985, relating to the Trust's 8 3/4 % Convertible Subordinated Debentures Due 2010, filed with the Commission on March 1, 1985 as Exhibit 4 (a) (2) to the Trust's Registration Statement on Form S-2 (File No. 2-96136) is incorporated herein by reference thereto. (iii) Indenture dated April 1, 1986, relating to the Trust's 8.65% Senior Notes due 1996, filed with the commission on March 27, 1986 as exhibit 4 (a) 1 to the Trust's Registration Statement on Form S-3, (File No. 33-3934) is incorporated herein by reference thereto. (iv) The 5 1/4% Convertible Subordinated Debenture due 2002 as described in Amendment No. 1 to Form S-3 (File No. 33-15264), filed with the Commission on August 4, 1987 is incorporated herein by reference thereto. (v) Shareholder Rights Plan, dated April 13, 1989, filed with the Commission as an exhibit to the Trust's Current Report on Form 8-K, dated April 13, 1989, is incorporated herein by reference thereto. (9) Voting Trust Agreement............................* (10) (i) Consultancy Agreement with Samuel J. Gorlitz, as amended, filed with the Commission as Exhibit 10 (v) to the Trust's Annual Report on Form 10-K for the year ended December 31, 1983, is incorporated herein by reference thereto. (ii) The Trust's 1983 Stock Option Plan adopted May 12, 1983, filed with the Commission as Exhibit 10 (vi) to the Trust's Annual Report on Form 10-K for the year ended December 31, 1983, is incorporated herein by reference. (iii) Deferred Compensation Agreement with Steven J. Guttman dated December 13, 1978, filed with the Commission as Exhibit 10 (iv) to the Trust's Annual Report on Form 10-K for the year ended December 31, 1980 is incorporated herein by reference thereto. The following documents, filed with the Commission as portions of Exhibit 10 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1985, are incorporated herein by reference thereto. (iv) The Trust's 1985 Non-Qualified Stock Option Plan, adopted on September 13, 1985 The following documents, filed with the Commission as portions of Exhibit 10, to the Trust's Annual Report on Form 10-K for the year ended December 31, 1980, have been modified as noted below, and are incorporated herein by reference thereto. (v) Consultancy Agreement with Daniel M. Lyons dated February 22, 1980, as amended (modified as of December l, 1983, to provide for an annual cost of living increase, not to exceed 10%). The following documents filed as portions of Exhibit 10 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1988 are incorporated herein by reference thereto: (vi) The 1988 Share Bonus Plan. (vii) Amendment No. 3 to Consultancy Agreement with Samuel J. Gorlitz. The following documents filed with the Commission as portions of Item 6 to the Trust's Quarterly Report on Form 10-Q for the quarter ended March 31, 1989 are incorporated herein by reference thereto; (viii) Executive Agreement between the Trust and Steven J. Guttman, dated April 13, 1989. (ix) Executive Agreement between the Trust and Catherine R. Mack, dated April 13, 1989. (x) Executive Agreement between the Trust and Mary Jane Morrow, dated April 13, 1989. (xi) Executive Agreement between the Trust and Hal A. Vasvari, dated April 13, 1989. (xii) Employment Agreement between the Trust and Steven J. Guttman, dated April 13, 1989. (xiii) Employment Agreement between the Trust and Catherine R. Mack, dated April 13, 1989. (xiv) Employment Agreement between the Trust and Mary Jane Morrow, dated April 13, 1989. (xv) Employment Agreement between the Trust and Hal A. Vasvari, dated April 13, 1989. (xvi) Executive Agreement between the Trust and Robert S. Wennett, dated April 13 ,1989, modified January 1, 1990, filed with the Commission as a portion of Exhibit 10 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1989 is incorporated herein by reference thereto. (xvii) The 1991 Share Purchase Plan, dated January 31, 1991, filed with the Commission as a portion of Exhibit 10 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1990 is incorporated herein by reference thereto. (xviii) Employment Agreement between the Trust and Robert S. Wennett, dated January 1, 1992, filed with the Commission as an exhibit to the Trust's Annual Report on Form 10-K for the year ended December 31, 1991 is incorporated herein by reference thereto. (xix) Amendment No. 4 to Consultancy Agreement with Samuel J. Gorlitz, filed with the Commission as an exhibit to the Trust's Annual Report on Form 10-K for the year ended December 31, 1992 is incorporated herein by reference thereto. (xx) Employment and Relocation Agreement between the Trust and Ron D. Kaplan, dated September 30, 1992, filed as an exhibit to the Trust's Annual Report on Form 10-K for the year ended December 31, 1992 is incorporated herein by reference thereto. (xxi) Employment Agreement between the Trust and Cecily A. Ward, dated January 1, 1993, filed as an exhibit to the Trust's Annual Report on Form 10-K for the year ended December 31, 1992 is incorporated herein by reference thereto. (xxii) Amendment dated October 1, 1992, to Voting Trust Agreement dated as of March 3, 1989 by and between I. Wolford Berman and Dennis L. Berman filed as an exhibit to the Trust's Annual Report on Form 10-K for the year ended December 31, 1992 is incorporated herein by reference thereto. (xxiii) 1993 Long-Term Incentive Plan and Certified Resolution Re: Amendment to 1993 Long-Term Incentive Plan, filed with the Commission as portions of Item 6 to the Trust's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, are incorporated herein by reference thereto. The following documents, filed with the Commission as portions of Item 6 to the Trust's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 are incorporated herein by reference thereto: (xxiv) Revolving Credit Agreement dated as of September 1, 1993 among Federal Realty Investment Trust and Corestates Bank. (xxv) Credit Agreement dated as of August 25, 1993 between Federal Realty Investment Trust and First Union National Bank of Virginia. (xxvi) Revolving Credit Agreement dated as of June 22, 1993 between Federal Realty Investment Trust and Signet Bank/Maryland. (xxvii) Consulting Agreement between Misner Development and Federal Realty Investment Trust. (xxviii) Fiscal Agency Agreement dated as of October 28, 1993 between Federal Realty Investment Trust and Citibank,N.A. (xxix) Credit Agreement dated as of February 11, 1994 between Federal Realty Investment Trust and Mellon Bank is filed herewith as an exhibit. (11) Statement regarding computation of per share earnings.........................................* (12) Statements regarding computation of ratios.......* (13) Annual Report to Shareholders, Form 10Q or quarterly report to shareholders...........................* (18) Letter regarding change in accounting principles.......................................* (19) Previously unfiled documents.....................* (22) Subsidiaries of the registrant...................* (23) Published report regarding matters submitted to vote of security holders.........................* (24) Consent of Grant Thornton........................ (25) Power of attorney................................* (28) Additional exhibits..............................* (b) Reports on Form 8-K Filed during the Last Quarter None _________ * Not applicable. 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. FEDERAL REALTY INVESTMENT TRUST Date: March 18, 1994 By:/s/ Steven J. Guttman _____________________________ Steven J. Guttman President 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. Signatures Title Date President and Trustee (Chief /s/Steven J. Guttman Executive Officer) March 18, 1994 Steven J. Guttman Senior Vice-President and Treasurer (Chief /s/ Mary Jane Morrow Financial Officer) March 18, 1994 Mary Jane Morrow Vice-President and /s/Cecily A. Ward Controller (Principal Cecily A. Ward Accounting Officer) March 18, 1994 /s/ Dennis L. Berman Trustee March 18, 1994 Dennis L. Berman Trustee March , 1994 A. Cornet de Ways Ruart /s/Samuel J. Gorlitz Trustee March 18, 1994 Samuel J. Gorlitz /s/Arnold M. Kronstadt Trustee March 18, 1994 Arnold M. Kronstadt /s/Morton S. Lerner Trustee March 18, 1994 Morton S. Lerner /s/Walter F. Loeb Trustee March 18, 1994 Walter F. Loeb /s/Donald H. Misner Trustee March 18, 1994 Donald H. Misner /s/George L. Perry Trustee March 18, 1994 George L. Perry SCHEDULES REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Trustees and Shareholders Federal Realty Investment Trust We have audited the accompanying consolidated balance sheets of Federal Realty Investment Trust as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Federal Realty Investment Trust as of December 31, 1993 and 1992 and the consolidated results of its operations and its consolidated cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Grant Thornton Washington, D.C. February 14, 1994 Federal Realty Investment Trust CONSOLIDATED BALANCE SHEETS Federal Realty Investment Trust CONSOLIDATED STATEMENTS OF OPERATIONS Federal Realty Investment Trust CONSOLIDATED STATEMENTS OF CASH FLOWS Federal Realty Investment Trust NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993, 1992, and 1991 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Federal Realty Investment Trust invests predominantly in income-producing real estate properties, primarily community and neighborhood shopping centers. The Trust uses the straight-line method in providing for depreciation. Estimated useful lives range from three to 25 years on apartment buildings and improvements, and from three to 35 years on shopping centers and improvements. Maintenance and repair costs are charged to operations as incurred. Major improvements are capitalized. The gain or loss resulting from the sale of properties is included in net income. The Trust capitalizes certain costs directly related to the acquisition, improvement and leasing of real estate including applicable salaries and other related costs. The capitalized costs associated with unsuccessful acquisitions are charged to operations when that determination is made. The capitalized costs associated with improvements and leasing are depreciated or amortized over the life of the improvement and lease, respectively. Costs related to the issuance of debt instruments are capitalized and are amortized over the life of the related issue using the interest method. Upon conversion or in the event of redemption, applicable unamortized costs are charged to shareholders' equity or to operations, respectively. The Trust operates in a manner intended to enable it to qualify as a real estate investment trust under Sections 856-860 of the Internal Revenue Code (the "Code"). Under those sections, a trust which distributes at least 95% of its real estate trust taxable income to its shareholders each year and which meets certain other conditions will not be taxed on that portion of its taxable income which is distributed to its shareholders. Therefore, no provision for Federal income taxes is required. The Trust consolidates the financial statements of nine partnerships and a joint venture which are controlled by the Trust. The equity interests of other investors are reflected as investors' interest in consolidated assets. All significant intercompany transactions and balances are eliminated. The Trust estimates the fair value of its financial instruments using the following methods and assumptions: (1) quoted market prices are used to estimate the fair value of investments in marketable debt and equity securities; (2) quoted market prices are used to estimate the fair value of the Trust's marketable senior notes and convertible subordinated debentures; (3) discounted cash flow analyses are used to estimate the fair value of long term notes and mortgage notes receivable and payable, using the Trust's estimate of current interest rates for similar notes; (4) carrying amounts in the balance sheet approximate fair value for cash and short term borrowings. Notes receivable from officers are excluded from fair value estimation since they have been issued in connection with employee stock ownership programs. The Trust defines cash as cash on hand, demand deposits with financial institutions and short term liquid investments with an initial maturity under three months. Cash balances may exceed insurable amounts. Earnings per share are computed using the weighted average number of shares outstanding during the respective periods, including options. NOTE 1: REAL ESTATE AND ENCUMBRANCES A summary of the Trust's properties at December 31, 1993 is as follows: Accumulated depreciation and Cost amortization Encumbrances (In thousands) Shopping centers $564,634 $93,923 $81,237 Shopping centers under capital leases 187,674 37,867 137,308 Apartments 5,780 3,255 - --------- --------- --------- $758,088 $135,045 $218,545 ========= ========= ========= The Trust's 48 shopping centers are located in twelve states, primarily along the East Coast between the New York metropolitan area and Richmond, Virginia. There are approximately 1,500 tenants providing a wide range of retail products and services. These tenants range from sole proprietorships to national retailers; no one tenant or corporate group of tenants accounts for 5% or more of revenue. The Trust acquired seven shopping centers and one office building in 1993. Pan Am Shopping Center in Fairfax, Virginia was acquired for $21.6 million in cash; Gaithersburg Square in Gaithersburg, Maryland was purchased for $11.0 million in cash and the assumption of a $2.0 million liability which is the estimated cost to remediate certain preexisting environmental issues; Quince Orchard Plaza in Gaithersburg, Maryland and its adjoining office building were purchased for $10.9 million in cash and the assumption of a liability of approximately $250,000 to remediate preexisting environmental issues; Crossroads Shopping Center in Highland Park, Illinois was purchased for $16.2 million in cash; Bala Cynwyd Shopping Center in suburban Philadelphia, Pennsylvania was purchased for $17.0 million in cash; Dedham Plaza in Dedham, Massachusetts, was purchased for $25.0 million in cash and the assumption of a $250,000 liability to remediate existing environmental issues; and the leasehold interest in Bethesda Row in Bethesda, Maryland was acquired with $6.2 million in cash. In 1992 the Trust purchased Ellisburg Circle Shopping Center in Cherry Hill, New Jersey for $15.3 million in cash. In June 1992 the Trust terminated a long term ground lease by purchasing the land underlying Wildwood Shopping Center, located in Bethesda, Maryland, for $9.1 million. In 1992 the Trust purchased an additional .3% interest in Barracks Road Shopping Center for $106,000, bringing the Trust's ownership percentage to over 99%. During 1992 the Trust sold two shopping centers, the Sargent Road Shopping Center in Hyattsville, Maryland for $1.9 million and the 25th Street Shopping Center in Easton, Pennsylvania for $9.7 million. The Trust received cash proceeds of $10.3 million on these transactions, realizing a gain of $2.7 million. Mortgage notes receivable consist of three notes collateralized by shopping centers. All three notes were issued in connection with either the acquisition or sale of Trust properties. The Trust estimates that the fair value of these notes at December 31, 1993 is $14.6 million compared to their book value of $13.9 million, since the stated interest rate on these notes is higher than current rates. The Trust estimated that the fair value of these notes at December 31, 1992 approximated their carrying value of $16.7 million. In 1992 the Trust placed a $30.0 million mortgage on Federal Plaza, located in Rockville, Maryland. The mortgage bears interest beginning at 8 1/4%, which resets every three years, with a final maturity on March 10, 2001. The Trust prepaid a number of mortgages in 1993 and 1992. In 1993 the Trust prepaid the mortgages on the Laurel, Northeast and Northeast Plaza shopping centers, resulting in a net gain of $2.9 million which has been recorded as a component of the net gain on early extinguishment of debt. In 1992 the Trust prepaid mortgages on the Eastgate and Town & Country (Louisiana) shopping centers; the prepayment fees on these transactions were recorded as a component of the net loss on early extinguishment of debt. Mortgages payable and capital lease obligations are due in installments over various terms extending to 2060 with actual or imputed interest rates ranging from 7.9% to 11.25%. Certain of the mortgage and capital lease obligations require additional interest payments based upon property performance. The fair value of mortgages payable at December 31, 1993 is $86.7 million compared to the carrying value of $81.2 million since the current estimated interest rate used to discount the cash flows is often less than the stated rate. The fair value of mortgages payable at December 31, 1992 was $124.3 million, compared to the carrying value of $120.0 million. Aggregate mortgage principal payments due during the next five years are $955,000, $1.0 million, $1.1 million, $1.3 million and $43.7 million, respectively. Future minimum lease payments and their present value for property under capital leases as of December 31, 1993 are as follows: Year ending December 31, (in thousands) 1994 $14,031 1995 17,051 1996 13,651 1997 13,666 1998 13,699 Thereafter 603,065 --------- 675,163 Less amount representing interest (537,855) --------- Present value $137,308 ========= Leasing Arrangements -------------------- The Trust's leases with shopping center and apartment tenants are classified as operating leases. Leases on apartments are generally for a period of one year, whereas shopping center leases generally range from three to 10 years and usually provide for contingent rentals based on sales and sharing of certain operating costs. The components of rental income are as follows: (in thousands) Year ended December 31, 1993 1992 1991 Shopping centers Minimum rents $81,291 $68,784 $66,901 Cost reimbursements 18,171 14,878 14,733 Percentage rents 4,147 4,171 4,580 Apartments - rents 2,339 2,138 2,136 --------- --------- --------- $105,948 $89,971 $88,350 ========= ========= ========= The components of rental expense are as follows: (in thousands) Year ended December 31, 1993 1992 1991 Management fees and costs $5,213 $3,957 $3,704 Repairs and maintenance 6,452 4,595 4,719 Utilities 3,944 3,595 3,752 Payroll - properties 3,205 2,567 2,298 Ground rent 375 362 937 Insurance 1,585 1,430 1,396 Other operating 5,745 4,413 3,580 --------- --------- --------- $26,519 $20,919 $20,386 ========= ========= ========= Minimum future shopping center rentals on noncancelable operating leases as of December 31, 1993 are as follows: Year ending December 31, (in thousands) 1994 $89,798 1994 80,695 1996 72,347 1997 62,508 1998 51,137 Thereafter 221,749 --------- $578,234 ========= NOTE 2. NOTES PAYABLE At December 31, 1993 the Trust had notes payable of $30.5 million. Of the $30.5 million, $6.1 million was issued in connection with renovations of certain Trust properties. Of the $6.1 million, $3.0 million, issued in connection with a lease at Perring Plaza, bears interest at 10% and is payable in equal monthly installments with a final maturity in January 2013. The majority of the rest of the $6.1 million, incurred primarily to fund the purchase and renovation of Federal Plaza, bears interest at 11% and matures in 1996. Due to decreases in interest rates since these notes were issued the fair value of these notes at December 31, 1993 is estimated to be $6.8 million compared to the carrying value of $6.1 million. At December 31, 1992 the fair value of these notes was $6.5 million compared to a carrying value of $6.1 million. At December 31, 1993 the Trust had $70.0 million of unsecured medium- term revolving credit facilities with three banks. All three facilities require fees and have covenants requiring a minimum shareholders' equity and a maximum ratio of debt to net worth. The maximum drawn under these facilities during 1993 was $64.1 million and at December 31, 1993 there was $24.4 million outstanding, bearing interest at rates from 4.2% to 5%. The average weighted interest rate on borrowings during 1993 was 4.2%, and the average amount outstanding was $6.6 million. The carrying value and fair value of these short term borrowings are the same. At December 31, 1992 the Trust had $20.0 million available under an unsecured line of credit; there were no amounts drawn under the line at December 31, 1992. The line, which was replaced by the medium-term revolving facilities, bore interest at prime plus 1/2% (6.5% at December 31, 1992), and replaced a secured $20.0 million line. The maximum drawn under the lines in 1992 was $8.5 million, the weighted average interest rate was 7.2%, and the average amount outstanding was $708,000. At December 31, 1991, notes payable included $8.5 million borrowed under the $20.0 million secured line of credit. The maximum drawn under this secured line during 1991 was $20.0 million, with a weighted average interest rate of 8.2% and an average amount outstanding of $19.6 million. NOTE 3. DIVIDENDS On November 18, 1993 the Trustees declared a quarterly cash dividend of $.39 per share, payable January 14, 1994 to shareholders of record January 3, 1994. For the years ended December 31, 1993, 1992 and 1991, $.45, $.915 and $.66 of dividends paid per share, respectively, represented a return of capital. NOTE 4. COMMITMENTS AND CONTINGENCIES Pursuant to the provisions of the Loehmann's Plaza Limited Partnership Agreement, on or after September 1, 1995 the Limited Partner may require the Trust to purchase his interest in the Partnership at its then fair market value. The Congressional Plaza Shopping Center Joint Venture Agreement provides that the Trust may be required to purchase its pro-rata share of one venturer's 22.5% or greater joint venture interest for a purchase price based on the appraised fair market value of the shopping center, but no less than the percentage of joint venture interest being sold multiplied by the difference between $17.5 million and the remaining principal balance of any liabilities of the Joint Venture. The State of New Jersey Division of Taxation has assessed the Trust $364,000 in taxes, penalty and interest for the years 1985 through 1990, since the State has disallowed the dividends paid deduction in computing New Jersey taxable income. The Trust has filed a complaint in the Tax Court of New Jersey contesting the assessment, since the Trust believes that it is entitled to the deduction. At this time, the outcome of this matter is unknown. The North Carolina Department of the Environment, Health and Natural Resources issued a Notice of Violation ("NOV") against a dry cleaner tenant at Eastgate Shopping Center in Chapel Hill, North Carolina concerning a spill at the shopping center. As owner of the shopping center, the Trust was named in and received a copy of the NOV. Estimates to remediate the spill range from $300,000 to $500,000. An agreement is being drawn with two previous owners of the shopping center to share the costs to remediate. The Trust has recorded a liability of $120,000 as its estimated share of the cleanup costs. Contaminants at levels in excess of New Jersey cleanup standards were identified at a shopping center in New Jersey. The Trust has retained an environmental consultant to investigate the contamination. The Trust is also evaluating whether it has insurance coverage for this matter. At this time, the Trust is unable to determine what the range of remediation costs might be. The Trust has also identified chlorinated solvent contamination at two other properties. In each case, the contamination appears to be linked to the current and/or previous dry cleaner. The Trust intends to look to the responsible parties for any remediation effort. Evaluation of these situations is preliminary and it is impossible to estimate the range of remediation costs, if any. The Trust reserved $2.25 million at closing for environmental issues principally associated with the recently acquired Gaithersburg Square. Pursuant to an indemnity agreement entered into with the seller at closing, the Trust agreed to take certain actions with respect to identified chlorinated solvent contamination. The seller indemnified the Trust for certain third party claims and government requirements related to contamination at adjacent properties. The Trust's non real estate investments consist of $524,000 in marketable equity securities and $3.5 million of Olympia and York Senior First Mortgage Notes. The marketable equity securities are stated at market. The Olympia and York notes were written down in 1992 to management's best estimate of the net realizable value. The writedown was recorded in the Consolidated Statements of Operations as a component of other charges, which also included an insurance recovery of $278,000 of a settlement of a personal injury lawsuit. The Trust has entered into agreements with certain key employees whereby if these employees voluntarily or involuntarily leave the employment of the Trust within six months after a "change of control" (defined as control of 35% or more of outstanding shares) of the Trust, they will be entitled to a lump sum cash payment equal to one to three times their annual salary as of the date of termination and have their health and welfare benefits and executive privileges continued for a period of one to three years. In the event of a change of control, the Trust also agreed that all restrictions on the exercise or receipt of any stock options and stock grants shall lapse upon termination of employment and that all shares owned at termination shall be redeemed by the Trust at a formula price. As of December 31, 1993 in connection with the renovation of certain shopping centers, the Trust has contractual obligations of $2.0 million. The Trust is also contractually obligated to provide up to $8.4 million for tenant improvements and $1.8 million to buy out tenant leases. The Trust is obligated under ground lease agreements on several shopping centers requiring minimum annual payments as follows: (in thousands) 1994 $ 2,758 1995 2,758 1996 2,758 1997 2,758 1998 2,758 Thereafter 157,502 --------- $171,292 ========= NOTE 5: SENIOR NOTES In April 1993 the Trust called its 8.65% Senior Notes for redemption on May 14, 1993 at a price of $1010 per note, for a total redemption price of $50.5 million. The redemption premium and unamortized loan costs have been recorded as a loss on the early extinguishment of debt. The market value of these notes at December 31, 1992 was $50.8 million. NOTE 6: 8 3/4% CONVERTIBLE SUBORDINATED DEBENTURES The Trust redeemed $173,000 principal amount of its 8 3/4% convertible subordinated debentures at a price of $1017.50 per debenture or a total price of $176,000 on March 15, 1993. The balance of the debentures that had been outstanding were converted into shares of beneficial interest at $16 per share. At December 31, 1992 $2.4 million of these debentures with a market value of $3.7 million were outstanding. NOTE 7: 5 1/4% CONVERTIBLE SUBORDINATED DEBENTURES DUE 2002 At December 31, 1993 and 1992 the Trust had outstanding $40.2 million and $43.8 million, respectively, of 5 1/4% convertible subordinated debentures due 2002. The debentures which are convertible into shares of beneficial interest at $30.625 per share were not registered under the Securities Act of 1933 and were not publicly distributed within the United States. During 1993 the Trust purchased $3.7 million of these debentures, resulting in a loss of $74,000 which has been recorded as a component of the net gain on early extinguishment of debt. In 1992, the Trust exchanged $22.6 million principal amount of the debentures for 1.3 million shares and purchased an additional $21.2 million principal amount. The debentures are redeemable at the option of the Trust; however, the debentures may not be redeemed prior to April 30, 1994, unless the closing market price per share has been at least 130% of the conversion price then in effect for a specified period prior to notice of redemption. The debentures are redeemable at the option of the holders on April 30, 1994 at a redemption price equal to 120% of their principal amount. Interest expense is accrued at 7.53% to record the premium put. The accretion of the premium was approximately $1.5 million in 1993 and $1.6 million in 1992. In 1993 and 1992, $671,000 and $5.6 million, respectively, of the accrued premium was retired upon the repurchase of the debentures. At December 31, 1993 the carrying value of the debentures plus the premium accrued to date is $47.7 million; the market value is $48.0 million. At December 31, 1992 the carrying value of debentures plus the premium accrued to that date was $50.6 million with a market value of $50.9 million. NOTE 8: 5 1/4% CONVERTIBLE SUBORDINATED DEBENTURES DUE 2003 In October 1993 the Trust issued $75.0 million of 5 1/4% convertible subordinated debentures, realizing cash proceeds of approximately $73.0 million. The debentures were not registered under the Securities Act of 1933, and were not publicly distributed within the United States. The debentures, which mature in 2003, are convertible into shares of beneficial interest at $36 per share. The debentures are redeemable by the Trust, in whole, at any time after October 28, 1998 at 100% of the principal amount plus accrued interest. The market value of the debentures at December 31, 1993 was $71.5 million. NOTE 9: SHAREHOLDERS' EQUITY In April 1993 the Trust sold 2.8 million shares of beneficial interest in a public offering, raising net proceeds of $72.8 million. In December 1993 the Trust sold 220,000 shares for $5.4 million in a private placement in connection with the long-term lease of a property. In June 1992 the Trust sold 3.4 million shares in a public offering, raising net proceeds of $66.5 million, and in 1991 the Trust sold 2.5 million shares in a public offering, receiving net proceeds of $42.2 million. The proceeds were used for debt retirement and property acquisitions and renovations. The Trust has a Dividend Reinvestment Plan, whereby shareholders may use their dividends to purchase shares; the plan was amended in 1991 so that shares purchased under the plan would be newly issued shares. In March 1993 the Trust registered an additional 500,000 shares with the Securities and Exchange Commission in connection with the plan. In January 1991 the Trustees adopted the Federal Realty Investment Trust Share Purchase Plan. Under the terms of this plan, officers and certain employees of the Trust purchased 446,000 common shares at $15.125 per share with the assistance of loans of $6.7 million from the Trust. One sixteenth of the loan is forgiven each year for eight years, as long as the officer or employee is still employed by the Trust. The Trust has loaned participants $506,000 to pay the taxes due in connection with the plan. The purchase loans and the tax loans bear interest at 9.39%. The shares purchased under the plan may not be sold, pledged or assigned until both the purchase and tax loans are satisfied and the eight year period has expired. Under the terms of the 1988 Share Bonus Plan, 78,000 shares and 30,000 shares were granted to officers and key employees in 1988 and 1989, respectively. During the years ended December 31, 1993, 1992 and 1991, 4,000 shares, 22,500 shares and 23,500 shares, respectively, were vested and charged to operations. In connection with these shares, the Trust has made loans to the participants to pay the taxes due in connection with the plan. The notes bear interest at the lesser of (i) the Trust's borrowing rate or (ii) the Trust's current indicated annual dividend rate divided by the purchase price of such shares. Notes issued under this plan are being forgiven over three years from issuance if the officer is still employed by the Trust. During the years ended December 31, 1993, 1992, and 1991, $80,000, $60,000 and $176,000, respectively, was forgiven. In connection with a restricted share grant, the Trust accepted from the President a non-interest bearing note for $210,000. One installment of $105,000 was paid on the note in 1992 and the second installment is due April 15, 1996. The Trust owns shares of other real estate investment trusts as a long- term investment. The Trust's cost of these shares was $887,000. Due to the price decline of certain of these investments, the Trust established an allowance for the unrealized loss which was $364,000 in 1993, $385,000 in 1992, and $465,000 in 1991. At December 31, 1993, 1992 and 1991, the Trust had 60,200 shares in treasury at a cost of $1.1 million. On April 13, 1989, the Trustees adopted a Shareholder Rights Plan (the Plan). Under the Plan, one right was issued for each outstanding share of common stock held as of April 24, 1989, and a right will be attached to each share issued in the future. The rights are exercisable into common shares upon the occurrence of certain events, including acquisition by a person or group of certain levels of beneficial ownership or a tender offer by such a person or group. The Rights are redeemable by the Trust for $.01 and expire on April 24, 1999. NOTE 10: STOCK OPTION PLAN The 1993 Long-Term Incentive Plan ("Plan") was approved by shareholders in May 1993. On the date of approval, 472,500 options were awarded to officers, employees and non-employee Trustees. Under the Plan, on each annual meeting date during the term of the plan, each non-employee Trustee will be awarded 2,500 options. On December 16, 1993, 69,000 options were awarded to employees. The option price to acquire shares under the 1993 Plan and previous plans is required to be a least the fair market value at the date of grant. As a result of the exercise of options, the Trust has outstanding from its officers and employees notes for $1.1 million. The notes bear interest at the lesser of (i) the Trust's borrowing rate or (ii) the current indicated annual dividend rate on the shares acquired pursuant to the option, divided by the purchase price of such shares. The notes are collateralized by the shares and are with recourse. Shares available Options Outstanding for future Price option grants Shares per share Balance December 31, 1990 374,537 194,796 Options granted (15,000) 15,000 $17.25 Options exercised --- (9,741) $14.83 to $15.33 Options expired 13,500 (20,250) $15.00 to $24.125 --------- --------- Balance December 31, 1991 373,037 179,805 Options granted (202,500) 202,500 $20.50 to $22.625 Options exercised --- (8,055) $17.25 to $18.00 Options expired 1,000 (1,000) $22.625 --------- --------- Balance December 31, 1992 171,537 373,250 Expiration of 1989 plan(171,537) ___ Adoption of 1993 plan 6,000,000 --- Options granted (541,500) 541,500 $25.75 to $26.00 Options exercised --- (53,384) $15.00 to $24.125 Options expired 2,500 (8,250) $20.875to $26.00 ---------- ---------- December 31, 1993 5,461,000 853,116 ========== ========== NOTE 11: SAVINGS AND RETIREMENT PLAN The Trust has a savings and retirement plan in accordance with the provisions of Section 401(k) of the Internal Revenue Code. Under the plan, the Trust out of its current net income, contributed 50% of each employee's contribution. Employees' contributions range, at the discretion of each employee, from 1% to 5% of compensation. In addition, the Trust may make discretionary contributions within the limits of deductibility set forth by the Code. All full-time employees of the Trust are eligible to become plan participants. The Trust's expense for the years ended December 31, 1993, 1992, and 1991 was $133,000, $100,000, and $82,000, respectively. NOTE 12: INTEREST EXPENSE The Trust incurred interest expense totalling $31.8 million, $35.4 million and $39.0 million in 1993, 1992 and 1991, respectively, of which $216,000, $237,000 and $892,000, respectively, was capitalized. Interest paid was $31.4 million, $36.9 million and $37.1 million, respectively. NOTE 13: SUBSEQUENT EVENTS In February 1994 the Trust borrowed $22.5 million from a bank; the loan, which is secured by Northeast Plaza, bears interest at 150 basis points over LIBOR (London Interbank Offered Rate) and is due on January 31, 1995. Proceeds from this borrowing were used to pay down the borrowings on the revolving credit facilities. In February 1994 the Trust obtained a fourth revolving credit facility. This facility, which is for $15.0 million and has terms substantially the same as the Trust's other revolving credit facilities, brings the Trust's total availability of revolving credit facilities to $85.0 million. NOTE 14: QUARTERLY DATA (UNAUDITED) The following summary represents the results of operations for each quarter in 1993 and 1992: Net Earnings Revenue income per share March 31 $26,644 $2,521 $.10 June 30 28,444 2,825 .10 September 30 28,898 4,538 .16 December 31 31,351 8,246 .31 March 31 $25,109 $1,703 $.08 June 30 24,114 2,244 .10 September 30 24,493 3,580 .15 December 31 26,481 1,903 .08 (a) Quarterly per share results are affected by the market price of common share equivalents in the calculation of earnings per share. The increases in revenue in 1993 over 1992 are primarily due to the acquisition of new properties in late 1992 and 1993 and due to the contributions of recently renovated centers. These increases in revenue as well as decreases in interest expense are the principal reasons for the increases in net income and earnings per share in 1993 as compared to 1992. The 1993 increases in net income and earnings per share in the second and third quarters would have been larger but for the fact that in 1992 there was a gain on sale of real estate of $642,000 ($.03 per share) in the second quarter and of $1.9 million ($.08 per share) in the third quarter. In addition during the fourth quarter of 1993, the Trust had a gain on the early retirement of debt of $3.0 million ($.11 per share). SCHEDULE II AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES Years ended December 31, 1993, 1992 and 1991 FEDERAL REALTY INVESTMENT TRUST FOOTNOTES (1) These notes receivable from Mr. Guttman and other officers were issued in connection with various stock grants and exercises of stock options. Certain notes are interest free and certain notes bear interest at the lesser of (i) the Trust's borrowing rate or (ii) the Trust's current indicated annual dividend rate divided by the purchase price of the shares. The notes, which are collateralized by common shares of the Trust, have maturity dates ranging from April 1994 through September 1998. The notes that were issued in connection with shares granted under the 1988 Share Bonus Plan are being forgiven over three years from issuance if the officer is still employed by the Trust. In 1991, 1992 and 1993, notes for $176,000, $60,000 and $80,000 respectively, were forgiven. (2) In 1991 the Share Purchase Plan was adopted by the Trustees; under the terms of this plan officers and certain employees of the Trust were offered the opportunity to purchase 446,000 common shares of the Trust with the assistance of loans of $6.7 million from the Trust. One sixteenth or $421,000, of the loans will be forgiven each year for eight years. The first sixteenth was forgiven upon purchase in January 1991, another 16th in January 1992 and the next 16th was accelerated to December 1992 from January 1993. These notes are reflected as subscriptions receivable in the consolidated balance sheet of the Trust as of December 31, 1993 and 1992. In connection with this plan, the Trust loaned the participants an additional $338,000 in 1992 and $169,000 in 1991 to pay the taxes due in connection with the plan. The purchase loans and the tax loans, which are collateralized by the common shares purchased, bear interest at 9.39% and are due approximately eight years from issuance. FEDERAL REALTY INVESTMENT TRUST SCHEDULE XI SUMMARY OF REAL ESTATE AND ACCUMULATED DEPRECIATION - CONTINUED Three Years Ended December 31, 1993 Reconciliation of Total Cost ---------------------------- Balance, January 1, 1991 $555,879,000 Additions during period Acquisitions 281,000 Improvements 20,725,000 Deduction during period - condemnation of land and miscellaneous retirements (10,829,000) ------------ Balance, December 31, 1991 566,056,000 Additions during period Acquisitions 24,591,000 Improvements 18,991,000 Deduction during period - disposition of property and miscellaneous retirements (10,771,000) ------------ Balance, December 31, 1992 598,867,000 Additions during period Acquisitions 123,083,000 Improvements 37,110,000 Deduction during period - disposition of property and miscellaneous retirements (972,000) ------------ Balance, December 31, 1993 $758,088,000 ============ (A) For Federal tax purposes, the aggregate cost basis is approximately $654,138,000 as of December 31, 1993. FEDERAL REALTY INVESTMENT TRUST SCHEDULE XI SUMMARY OF REAL ESTATE AND ACCUMULATED DEPRECIATION - CONTINUED Three Years Ended December 31, 1993 Reconciliation of Accumulated Depreciation and Amortization Balance, January 1, 1991 $78,596,000 Additions during period Depreciation and amortization expense 19,946,000 Deductions during period - disposition of property and miscellaneous retirements (2,853,000) ------------ Balance, December 31, 1991 95,689,000 Additions during period Depreciation and amortization expense 20,589,000 Deductions during period - disposition of property and miscellaneous retirements (3,096,000) ------------- Balance, December 31, 1992 113,182,000 Additions during period Depreciation and amortization expense 22,643,000 Deductions during period - miscellaneous retirements (780,000) ------------ Balance, December 31, 1993 $135,045,000 ============ FEDERAL REALTY INVESTMENT TRUST SCHEDULE XII MORTGAGE LOANS ON REAL ESTATE - CONTINUED Three Years Ended December 31, 1993 Reconciliation of Carrying Amount Balance, January 1, 1991 $16,676,000 Additions during period Increase in existing loan 135,000 Deductions during period Collections of principal (62,000) ------------ Balance, December 31, 1991 16,749,000 Additions during period Increase in existing loan 11,000 Deductions during period Collections of principal (67,000) ------------ Balance, December 31, 1992 16,693,000 Additions during period Increase in existing loan 47,000 Deductions during period First trust on wrap mortgage transferred to borrower (2,801,000) Collections of principal (68,000) ------------ Balance, December 31, 1993 $13,871,000 ============ Report of Independent Certified Public Accountants on Supplemental Information Trustees and Shareholders Federal Realty Investment Trust In connection with our audit of the consolidated financial statements of Federal Realty Investment Trust referred to in our report dated February 14, 1994 which is incorporated by reference in Part II of this form, we have also audited Schedule I as of December 31, 1993 and Schedules II, XI and XII as of December 31, 1993 and for each of the three years then ended. In our opinion, these schedules present fairly, in all material respects, the information required to be set forth therein. Grant Thornton Washington, D.C. February 14, 1994 CREDIT AGREEMENT dated as of February 11, 1994 between FEDERAL REALTY INVESTMENT TRUST and MELLON BANK, N.A. ___________________________________________________________________________ Page No. ARTICLE I DEFINITIONS . . . . . . . . . . . . . . . . 1 Section 1.1. Definitions . . . . . . . . . . . . . . . . . . . . . 1 Section 1.2. Accounting Term and Determinations. . . . . . . . . . 6 ARTICLE II THE ADVANCES . . . . . . . . . . . . . . . . 6 Section 2.1. The Advances . . . . . . . . . . . . . . . . . . . . . 6 Section 2.2. Method of Borrowing. . . . . . . . . . . . . . . . . . 6 Section 2.3. The Note. . . . . . . . . . . . . . . . . . . . . . . 7 Section 2.4. Interest Rates . . . . . . . . . . . . . . . . . . . . 7 Section 2.5. Method of Electing Interest Rates . . . . . . . . . . 7 Section 2.6. Prepayment of Advances . . . . . . . . . . . . . . . . 9 Section 2.7. Late Charges . . . . . . . . . . . . . . . . . . . . . 9 Section 2.8. Non-Usage Fee . . . . . . . . . . . . . . . . . . . . 10 Section 2.9. General Provisions as to Payments . . . . . . . . . . 10 Section 2.10. Extension of the Line of Credit Period . . . . . . . . 10 Section 2.11. Funding Losses . . . . . . . . . . . . . . . . . . . . 10 Section 2.12. Optional Termination or Reduction of the Line of Credit Commitment . . . . . . . . . . . . 11 Section 2.13. Incorporation by Reference . . . . . . . . . . . . . . 11 ARTICLE III CONDITIONS TO ADVANCES . . . . . . . . . . . 11 Section 3.1. Conditions to the First Advance . . . . . . . . . . . 11 Section 3.2. Conditions to Each Advance . . . . . . . . . . . . . . 13 ARTICLE IV Page No. REPRESENTATIONS AND WARRANTIES . . . . . . . 13 Section 4.1. Existence and Power . . . . . . . . . . . . . . . . . 13 Section 4.2. Authorization; Non-Contravention . . . . . . . . . . . 13 Section 4.3. Binding Effect . . . . . . . . . . . . . . . . . . . . 14 Section 4.4. Litigation . . . . . . . . . . . . . . . . . . . . . . 14 Section 4.5. Filings . . . . . . . . . . . . . . . . . . . . . . . 14 Section 4.6. Financial Information . . . . . . . . . . . . . . . . 14 Section 4.7. ERISA Compliance . . . . . . . . . . . . . . . . . . . 15 Section 4.8. Environmental Compliance . . . . . . . . . . . . . . . 15 Section 4.9. Regulation U . . . . . . . . . . . . . . . . . . . . . 16 ARTICLE V FINANCIAL COVENANTS . . . . . . . . . . . . 16 Section 5.1. Certain Definitions. . . . . . . . . . . . . . . . . . 16 Section 5.2. Minimum Shareholders' Equity . . . . . . . . . . . . . 17 Section 5.3. Total Liabilities to Shareholders' Equity Ratio . . . 17 Section 5.4. Minimum Funds From Operations . . . . . . . . . . . . 17 Section 5.5 Limitation on Dividends . . . . . . . . . . . . . . . 17 ARTICLE VI ADDITIONAL COVENANTS OF THE BORROWER . . . . 17 Section 6.1. Information . . . . . . . . . . . . . . . . . . . . . 17 Section 6.2 Payment of Obligations . . . . . . . . . . . . . . . . 19 Section 6.3. Maintenance of Property; Insurance . . . . . . . . . . 20 Section 6.4. Conduct of Business and Maintenance of Existence . . . 20 Section 6.5. Compliance with Laws . . . . . . . . . . . . . . . . . 20 Section 6.6. Accounting; Inspection of Property, Books and Records 20 Section 6.7. Restriction on Debt . . . . . . . . . . . . . . . . . 21 Section 6.9. Consolidations, Mergers and Sales of Assets . . . . . 21 Section 6.10 Transactions with Affiliates . . . . . . . . . . . . . 21 Section 6.11. Transactions with Other Persons . . . . . . . . . . . 22 Section 6.12 ERISA Matters . . . . . . . . . . . . . . . . . . . . 22 Page No. Section 6.13 Environmental Matters . . . . . . . . . . . . . . . . 22 Section 6.14 Pro-Rata Borrowing and Repayment . . . . . . . . . . . 23 Section 6.15 Confession of Judgment . . . . . . . . . . . . . . . . 23 Section 6.16 Use of Proceeds. . . . . . . . . . . . . . . . . . . . 23 Section 6.17 Independence of Covenants . . . . . . . . . . . . . . 23 ARTICLE VII DEFAULTS . . . . . . . . . . . . . . . . . . 23 Section 7.1 Events of Default . . . . . . . . . . . . . . . . . . 23 Section 7.2. Other Remedies . . . . . . . . . . . . . . . . . . . . 26 Section 7.3. Inspection of Properties . . . . . . . . . . . . . . . 26 ARTICLE VIII CHANGE IN CIRCUMSTANCES AFFECTING EURO-DOLLAR-BASED ADVANCES . . . . 27 Section 8.1. Basis for Determining Adjusted London Interbank Offered Rate Inadequate or Unfair . . . . . . . . . 27 Section 8.2. Illegality . . . . . . . . . . . . . . . . . . . . . . 27 Section 8.3. Increased Cost and Reduced Return . . . . . . . . . . 28 Section 8.4. Suspension of Advances . . . . . . . . . . . . . . . . 30 ARTICLE IX MISCELLANEOUS . . . . . . . . . . . . . . . 30 Section 9.1. Notices . . . . . . . . . . . . . . . . . . . . . . . 30 Section 9.2. No Waivers . . . . . . . . . . . . . . . . . . . . . . 30 Section 9.3. Expenses . . . . . . . . . . . . . . . . . . . . . . . 30 Section 9.4. Indemnification . . . . . . . . . . . . . . . . . . . 31 Section 9.5. Right of Set-Off . . . . . . . . . . . . . . . . . . . 32 Section 9.6. Amendments and Waivers . . . . . . . . . . . . . . . . 33 Section 9.7. Successors and Assigns . . . . . . . . . . . . . . . . 33 Section 9.8. Governing Law. . . . . . . . . . . . . . . . . . . . . 34 Page No. Section 9.9. Counterparts; Effectiveness . . . . . . . . . . . . . 34 Section 9.10. Waiver of Jury Trial; Submission to Jurisdiction . . . 34 Section 9.11. Waiver of Personal Liability . . . . . . . . . . . . . 35 Section 9.12. Entire Agreement . . . . . . . . . . . . . . . . . . . 35 SCHEDULE 1.1- AUTHORIZED PERSONS SCHEDULE 4.8- . . . . . . . . . EXHIBIT A-FORM OF NOTE EXHIBIT B-FORM OF BORROWER'S COUNSEL OPINION A6431.A(BF) CREDIT AGREEMENT This CREDIT AGREEMENT (as amended, supplemented or modified from time to time, this "Agreement") is dated as of February 11, 1994 and is between FEDERAL REALTY INVESTMENT TRUST, a District of Columbia unincorporated business trust (the "Borrower"), and MELLON BANK, N.A., a national banking association (the "Bank"). The parties hereto agree as follows: ARTICLE I DEFINITIONS Section 1.1. Definitions. The following terms, as used herein, have the following meanings: "Adjusted London Interbank Offered Rate" means, for any Interest Period, a rate per annum equal to the quotient obtained (rounded upwards, if necessary, to the next higher 1/100 of 1%) by dividing (i) the applicable London Interbank Offered Rate by (ii) 1.00 minus the applicable Euro-Dollar Reserve Percentage. "Advances" has the meaning set forth in Section 2.1. "Affiliate" means (i) any Person that directly, or indirectly through one or more intermediaries, controls the Borrower or (ii) any Person (other than the Borrower) that is controlled by or is under common control with such controlling Person (the term "control" meaning the possession, directly or indirectly, of the power to direct or cause the direction of the management or policies of a Person, whether through the ownership of voting securities, by contract or otherwise). "Authorized Person" means any of the officers of the Borrower identified on Schedule 1.1 or any other officer of the Borrower identified in a borrowing resolution delivered to and accepted by the Bank. "Available Amount" means, as of any date, $15,000,000 minus the aggregate unpaid principal amount of Advances outstanding on such date. "Business Day" means (i) when used with respect to Advances that bear or are to bear interest at the Prime-Based Rate, any day except a Saturday, Sunday or other day on which commercial banks in Pittsburgh, Pennsylvania are authorized by law to close and (ii) when used with respect to Advances that bear or are to bear interest at the Euro-Dollar-Based Rate, any day described in clause (i) above on which commercial banks are open for international business (including dealings in dollar deposits) in London. "CERCLA" means the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (42 U.S.C. Section 9601 et seq.), as amended by the Superfund Amendment and Reauthorization Act of 1986 and as otherwise amended from time to time. "Code" means the Internal Revenue Code of 1986, as amended. "Controlled Group" means all members of a controlled group of corporations and all trades or businesses (whether or not incorporated) under common control which, together with the Borrower, are treated as a single employer under Section 414(b) or 414(c) of the Code. "Debt" means, with respect to any Person at any date, without duplication, (i) all obligations of such Person for borrowed money, (ii) all obligations of such Person evidenced by bonds, debentures, notes or other similar instruments, (iii) all obligations of such Person to pay the deferred purchase price of property or services, (iv) all obligations of such Person as lessee under capital leases, (v) all obligations of such Person to purchase securities or other property which arise out of or in connection with the sale of the same or substantially similar securities or property, (vi) the stated amount of all letters of credit and similar instruments issued for the account of such Person (including all unreimbursed draws), (vii) all obligations of others secured by a Lien on any asset of such Person, whether or not such obligation is assumed by such Person, and (viii) all obligations of others guaranteed by such Person. "Default" means any condition or event which constitutes an Event of Default or which with the giving of notice or lapse of time or both would, unless cured or waived, become an Event of Default. "Effective Date" means the date on which this Agreement becomes effective in accordance with Section 9.9. "Environmental Requirements" means all federal, state and local environmental laws (including, without limitation, CERCLA), rules, regulations and orders regulating, relating to or imposing liability or standards of conduct concerning any Hazardous Materials. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended. "Euro-Dollar-Based Advance" means an Advance that bears interest at the Euro-Dollar-Based Rate. "Euro-Dollar-Based Rate" means a rate of interest based on the Adjusted London Interbank Offered Rate as provided in Section 2.4(b). "Euro-Dollar Reserve Percentage" for any day shall mean the percentage (expressed as a decimal, rounded upward to the nearest 1/100 of 1%), as determined in good faith by the Bank (which determination shall be conclusive), which is in effect on such day as prescribed by the Board of Governors of the Federal Reserve System (or any successor) representing the maximum reserve requirement (including, without imitation, supplemental, marginal and emergency reserve requirements) with respect to eurocurrency funding (currently referred to as "Eurocurrency liabilities") of a member bank in such System. The Adjusted London Interbank Offered Bank shall be adjusted automatically as of the effective date of each change in the Euro- Dollar Reserve Percentage. "Euro-Rate Interest Period" shall mean a period of one, two, three or six months for which maker has selected the Euro-Rate Option to apply to a Euro- Rate Segment. Each Euro-Rate Interest Period shall begin on a London Business Day, and the term "month", when used in connection with a Euro-Rate Interest Period shall be construed in accordance with prevailing practices in the Interest Period, as determined in good faith by Bank (which determination shall be conclusive). "Event of Default" has the meaning set forth in Section 7.1. "GAAP" means generally accepted accounting principles in the United States. "Hazardous Material" means (i) "hazardous wastes," as defined by the Resource Conservation and Recovery Act of 1976, as amended from time, (ii) "hazardous substances," as defined by CERCLA, (iii) "toxic substances," as defined by the Toxic Substances Control Act, as amended from time to time, (iv) "hazardous materials," as defined by the Hazardous Materials Transportation Act, as amended from time to time, (v) asbestos, oil or other petroleum products, radioactive materials, urea formaldehyde foam insulation, radon gas and transformers or other equipment that contains dielectric fluid containing polychlorinated biphenyls and (vi) any substance whose presence is detrimental or hazardous to health or the environment. "Interest Period" means, with respect to each election of the Euro- Dollar-Based Rate, the period commencing on the effective date of such borrowing and ending one, two, three or six months thereafter, as specified in the notice of such election; provided, however, that (i) any such period that would otherwise end on a day that is not a Business Day shall be extended to the next succeeding Business Day unless such Business Day falls in another calendar month (in which case such period shall end on the next preceding Business Day), (ii) any such period that begins on the last Business Day of a calendar month shall, subject to clause (iii) below, end on the last Business Day of a calendar month and (iii) no such period shall end after the Termination Date. "Lien" means, with respect to any asset, any mortgage, lien, pledge, charge, security interest or encumbrance of any kind in respect of such asset (including the interest of a vendor or lessor under any conditional sale agreement, capital lease or other title retention agreement relating to such asset). "Line of Credit Commitment" has the meaning set forth in Section 2.1. "Line of Credit Period" means the period from and including the Effective Date to but excluding the Termination Date. "London Interbank Offered Rate" means, for any Interest Period, the rate of interest designated as the British Banker's Association settlement rate that appears on the display on page 3750 (under the caption "USD" of the Telerate Services, Incorporated screen or on such other display as may replace such page) as of 11:00 A.M. (London Time) two Business Days before the first day of such Interest Period as the rate per annum for deposits in dollars in the London interbank market for a period of time comparable to such Interest Period; provided, however, that if no offered quotations appear on the Telerate Services, Incorporated screen or if quotations are not given on such screen for a period of time comparable to such Interest Period, then the London Interbank Offered Rate applicable to such Interest Period shall be the rate of interest determined by the Bank to be the prevailing rate per annum quoted to it at approximately 10:00 A.M. (Eastern Time) two Business Days before the first day of such Interest Period by two or more New York Euro-Dollar deposit dealers of recognized standing selected by the Bank for the offering of dollar deposits to the Bank by leading banks in the London interbank market for a period of time comparable to such Interest Period and in an amount approximately equal to the principal amount of the Advance to which such Interest Period is to apply. "Note" has the meaning set forth in Section 2.3. "PBGC" means the Pension Benefit Guaranty Corporation or any entity succeeding to any or all of its functions under ERISA. "Person" means an individual, a corporation, a partnership, an association, a trust, a limited liability company or any other entity or organization, including a government or political subdivision or an agency or instrumentality thereof. "Plan" means, at any time, an employee pension benefit plan that is covered by Title IV of ERISA or is subject to the minimum funding standards under Section 412 of the Code and is either (i) maintained by a member of the Controlled Group for employees of a member or members of the Controlled Group or (ii) maintained pursuant to a collective bargaining agreement or any other arrangement under which more than one employer makes contributions and to which a member of the Controlled Group is then making or accruing an obligation to make contributions or has within the preceding five plan years made contributions. "Prime-Based Advance" means an Advance that bears or is to bear interest at the Prime-Based Rate. "Prime-Based Rate" means a rate of interest based on the Prime Rate as provided in Section 2.4(a). "Prime Rate" means the interest rate per annum announced from time to time by the Bank as its prime rate. The prime rate may be greater or less than other interest rates charged by the Bank to other borrowers and is not solely based or dependent upon the interest rate which the Bank may charge any particular borrower or class of borrowers. "Release" means any disposing of, discharging, injecting, spilling, leaking, pumping, pouring, leaching, dumping, emitting, escaping, emptying, seeping, placing or the like onto or upon any land, water or air or otherwise entering the environment. "Revolving Credit Bank" has the meaning set forth in Section 6.8. "Termination Date" means the later of (i) three years from the Effective Date or (ii) the date to which the Line of Credit Period has been extended pursuant to Section 2.10. "Unfunded Vested Liabilities" means, with respect to any Plan at any time, the amount, if any, by which (i) the present value of all vested nonforfeitable benefits under such Plan exceeds (ii) the fair market value of all Plan assets allocable to such benefits, all determined as of the then most recent valuation date for such Plan, but only to the extent that such excess represents a potential liability of a member of the Controlled Group to the PBGC or the Plan under Title IV or ERISA. Section 1.2. Accounting Term and Determinations. Unless otherwise specified herein, all accounting terms used herein shall be interpreted, and all accounting determinations required hereunder shall be made and all financial statements delivered hereunder shall be prepared in accordance with GAAP as in effect from time to time, applied on a basis consistent (except for changes concurred in by the Borrower's independent public accountants) with the most recent financial statements of the Borrower delivered to the Bank. ARTICLE II THE ADVANCES Section 2.1. The Advances. The Bank agrees, on the terms and conditions set forth in this Agreement, from time to time on any Business Day during the Line of Credit Period, to make one or more loans to the Borrower in an aggregate principal amount not to exceed the Available Amount as of such Business Day (the "Line of Credit Commitment"). Each of the loans made to the Borrower pursuant to this Section 2.1 (the "Advances") shall be in an amount equal to $5,000 or an integral multiple thereof. The Borrower may, within the foregoing limits, borrow amounts under this Section 2.1, repay such amounts at maturity in accordance with Section 2.5, prepay such amounts in accordance with Section 2.6 and reborrow amounts under this Section 2.1. Section 2.2. Method of Borrowing. The Borrower may request loans pursuant to Section 2.1 by giving the Bank notice (which notice may be given by telephone by an Authorized Person if promptly confirmed in writing by an Authorized Person) not later than 10:00 A.M. (Eastern Time) at least two Business Days before the date of the proposed loan specifying (i) the date of the proposed loan (which must be a Business Day), (ii) the amount to be borrowed, (iii) whether the proposed loan is to bear interest at the Prime- Based Rate of the Euro-Dollar-Based Rate and (iv) in the case of a proposed loan that is to bear interest at the Euro-Dollar Based Rate, the Interest Period applicable thereto. The Bank shall (unless it determines that any applicable condition specified in this Agreement has not been satisfied) make the amount to be borrowed available to the Borrower not later than 2:00 P.M. (Eastern Time) on the date of the proposed loan by wire transfer of such funds to such account as the Borrower shall specify in its request for such Advance. Section 2.3. The Note. The Advances shall be evidenced by, and shall be repayable with interest in accordance with, a single note substantially in the form of Exhibit A hereto and appropriately completed (the "Note"). The Bank shall record on its books, and prior to any transfer of the Note shall make on the schedule forming a part thereof appropriate notations to evidence, the date and amount of each Advance and the date and amount of each payment of principal made by the Borrower with respect thereto; provided, however, that any failure of the Bank to make such a notation or any error therein shall not in any manner affect the obligation of the Borrower to repay the Advances in accordance with the terms of the Note. The Borrower hereby irrevocably authorizes the Bank to record such information and to make such notations. Section 2.4. Interest Rates. (a) If the Borrower elects, or this Agreement otherwise provides, that an Advance shall bear interest at the Prime-Based Rate, such Advance shall bear interest on the outstanding principal amount thereof, for each day from and including the date on which such Advance is made to but excluding the date on which such Advance is due, at a rate per annum equal to the Prime Rate for such day minus 1.00%. The Prime-Based Rate shall be adjusted automatically on and as of the effective date of any change in the Prime Rate. All such interest shall be payable on the first day of each month. (b) If the Borrower elects that an Advance shall bear interest at the Euro-Dollar-Based Rate, such Advance shall bear interest on the outstanding principal amount thereof, for each day during the applicable Interest Period, at a rate per annum equal to the sum of 1.00% plus the applicable Adjusted London Interback Offered Rate. All such interest shall be payable on the first day of each month. (c) At maturity (whether upon acceleration or otherwise), or upon the occurrence and during the continuation of an Event of default, the unpaid principal amount of and all accrued but unpaid interest on the Advances shall automatically bear interest for each day at a rate per annum equal to the sum of 4.75% plus the Adjusted London Interbank Offered Rate (assuming a one-month Interest Period) for such day. Section 2.5. Method of Electing Interest Rates. (a) Each Advance shall bear interest initially at the type of rate specified by the Borrower in the applicable notice delivered to the Bank pursuant to Section 2.2. Thereafter, the Borrower may from time to time elect to change or continue the type of interest rate applicable to such Advance (subject in each case to the provisions of Article VIII) as follows: (i) if such Advance is bearing interest at the Prime-Based Rate, the Borrower may elect to change the applicable rate to the Euro-Dollar-Based Rate as of any Business Day; (ii) if such Advance is bearing interest at the Euro-Dollar-Based Rate, the Borrower may elect to change the applicable rate to the Prime- Based Rate, or may elect to continue such Advance at the Euro-Dollar-Based Rate for an additional Interest Period, in each case beginning on the last day of the then applicable Interest Period; (iii) if such Advance is bearing interest at the Prime-Based Rate, the Borrower may elect to designate such Advance as any combination of Prime- Based Advances or Euro-Dollar-Based Advances as of any Business Day (subject to the definition of Interest Period); and (iv) if such Advance is bearing interest at the Euro-Dollar-Based Rate, the Borrower may elect to designate such Advance as any combination of Prime-Based Advances or Euro-Dollar-Based Advances as of the last day of the then applicable Interest Period (subject to the definition of Interest Period). The Borrower shall make each such election by delivering a notice to the Bank not later than 10:00 A.M. (Eastern Time) at least two Business Days before the new type of interest rate or the additional Interest Period selected in such notice is to begin. (b) Each notice of interest rate election delivered pursuant to subsection (a) above shall specify with respect to each outstanding Advance to which such notice applies: (i) the date on which the new type of interest rate or additional Interest Period selected in such notice is to begin, which shall comply with the applicable clauses of subsection (a) above; (ii) if the type of interest rate applicable to such Advance is to be changed, the new type of interest rate selected and, if the new rate is a Euro-Dollar-Based Rate, the duration of the initial Interest Period; (iii) if such Advance is currently bearing interest at the Euro- Dollar-Based Rate and such type of interest rate is to be continued for an additional Interest Period, the duration of such additional Interest Period; and (iv) if such Advance is to be designated as a combination of Prime- Based Advances and Euro-Dollar-Based Advances, the information specified in clauses (i) through (iii) above as to each such Prime-Based Advance and each such Euro-Dollar Based Advance. Each Interest Period specified in such notice of interest rate election shall comply with the provisions of the definition of Interest Period. (c) If the Borrower fails to deliver a timely notice of interest rate election pursuant to subsection (a) above selecting a new type of interest rate for an additional Interest Period for any Euro-Dollar-Based Advance, such Euro-Dollar-Based Advance shall bear interest at the Euro-Dollar-Based Rate (assuming a one-month Interest Period) commencing on the last day of the then current Interest Period (and continuing until the Borrower elects a different type of interest rate for such Euro-Dollar-Based Advance as provided in this Section 2.5). Section 2.6. Prepayment of Advances. (a) The Borrower may prepay the Prime-Based Advances in whole or in part at any time or from time to time by paying the principal amount to be prepaid plus accrued interest thereon to the date of prepayment. (b) The Borrower may prepay the Euro-Dollar-Based Advances in whole or in part at any time or from time by paying the principal amount to be prepaid plus accrued interest thereon to the date of prepayment; provided, however, that the Borrower shall reimburse the Bank on demand in accordance with Section 2.11 for any actual loss or reasonable expense incurred by the Bank as a result of the Borrower's repayment of a Euro-Dollar-Based Advance other than on the last day of the applicable Interest Period. (c) If on any date the aggregate unpaid principal amount of Advances outstanding on such date exceeds $15,000,000, the Borrower shall immediately prepay the Advances in an amount equal to such excess. Section 2.7. Late Charges. If the Borrower fails to make any payment of interest on the Advances, or fails to pay any fee or other amount due with respect to the Advances, within 10 Business Days after the date such payment was due, the Borrower shall pay to the Bank on demand a late charge equal to 5.00% of the amount of such payment. If the Borrower has not received, on or before the last day of any calendar month, a statement from the Bank setting forth the interest then due with respect to the Advances, the Borrower shall estimate the amount of such interest in good faith and shall pay such amount to the Bank (and the Borrower shall not incur a late charge if such amount is paid within 10 Business Days after the date such interest payment was due). If the Borrower thereafter receives a statement from the Bank setting forth the interest then due with respect to the Advances and the amount of such interest exceeds the estimated payment made by the Borrower, the Borrower shall, upon its receipt of such statement, pay an amount equal to such excess to the Bank. This charge shall be in addition to, and not in lieu of, any other remedy the Bank may have and is in addition to any reasonable fees and charges of any agents or attorneys which the Bank is entitled to employ on any default hereunder, whether authorized herein, or by law. Section 2.8. Non-Usage Fee. The Borrower shall pay to the Bank on the fifteenth day of January, April, July and October of each year, commencing April 15, 1994, a non-usage fee equal to 0.25% per annum of the average daily Available Amount during the preceding calendar quarter. Section 2.9. General Provisions as to Payments. The Borrower shall make each payment of principal of and interest on the Advances (and each payment of a non-usage fee or late charge) not later than 11:00 A.M. (Eastern Time) on the date when due, in federal or other immediately available funds, to the Bank at the Bank's address specified in Section 9.1. Whenever any payment of principal of or interest on the Advances (or any payment of a non-usage fee or late charge) is due on a day which is not a Business Day, the date for payment thereof shall be extended to the next succeeding Business Day. If the date for any payment of principal of the Advances (or the date for any payment of a non-usage fee or late charge) is extended by operation of law or otherwise, interest thereon shall be payable for such extended time. Section 2.10. Extension of the Line of Credit Period. The Bank shall review the Line of Credit Commitment on or before January 1 of each year, commencing January 1, 1995, and may, in its sole and absolute discretion, extend the Line of Credit Period from time to time for an additional one year period. The Bank shall have the unconditional right not to extend the Line of Credit Period, notwithstanding that no Event of Default exists. The Bank shall notify the Borrower on or before January 1 of each year, commencing January 1, 1995, whether the Bank has elected to extend the Line of Credit Period. Section 2.11. Funding Losses. If (i) the Borrower makes any principal payment with respect to the Euro-Dollar-Based Advances on any day other than the last day of the applicable Interest Period (pursuant to Article II or VIII or otherwise), (ii) the Borrower converts Euro-Dollar-Based Advances to Prime-Based Advances on any day other than the last day of the applicable Interest Period (pursuant to Article VIII or otherwise) or (iii) the Borrower fails to borrow a Euro-Dollar-Based Advance in accordance with any loan request delivered to the Bank in accordance with Section 2.2, the Borrower shall reimburse the Bank on demand for any actual loss or reasonable expense incurred by the Bank as a result of such event, including, without limitation, any loss incurred in obtaining, liquidating or employing deposits from third parties. The Bank shall deliver to the Borrower a certificate showing the calculation of the amount of such loss or reasonable expense, which certificate shall be conclusive in the absence of manifest error. The Bank may use any reasonable averaging and attribution methods in calculating such loss or reasonable expense. Section 2.12. Optional Termination or Reduction of the Line of Credit Commitment. The Borrower may, upon at least 45 days' notice to the Bank, (i) terminate the Line of Credit Commitment or (ii) reduce the unused portion of the Line of Credit Commitment from time to time by an aggregate amount of $3,000,000 or any integral multiple of $1,000,000 in excess thereof; provided, however, that the Borrower may not terminate or reduce the Line of Credit Commitment on or before January 1, 1995; and, provided, further, that the Borrower may not terminate the Line of Credit Commitment at any time that any Euro-Dollar-Based Advance is outstanding and may not reduce the Line of Credit Commitment on any date below an amount equal to the aggregate unpaid principal amount of Euro-Dollar-Based Advances outstanding on such date. Section 2.13. Incorporation by Reference. The terms and conditions of the Note are hereby incorporated by reference into this Agreement with the same force and effect as if fully set forth herein. ARTICLE III CONDITIONS TO ADVANCES Section 3.1. Conditions to the First Advance. The obligations of the Bank to make the first Advance is subject to the satisfaction of the following conditions: (i) receipt by the Bank of a duly executed Note, dated on or before the date of such Advance, complying with the provisions of Section 2.3; (ii) all legal matters incident to this Agreement, the Note and the transactions contemplated hereby and thereby shall be reasonably satisfactory to Ballard Spahr Andrews & Ingersoll; (iii) receipt by the Bank of a certificate of the Secretary of the Borrower dated the date of such Advance and certifying (A) that attached thereto is a true and complete copy of the declaration of trust of the Borrower as in effect on the date of such certification, (B) as to the absence of dissolution or liquidation proceedings by or against the Borrower, (C) that attached thereto is a true and complete copy of the bylaws of the Borrower as in effect on the date of such certification, (D) that attached thereto is a true and complete copy of resolutions adopted by the board of trustees of the Borrower authorizing the execution, delivery and performance of this Agreement and the Note and that such resolutions have not been amended and are in full force and effect on the date of such certification and (E) as to the incumbency and specimen signatures of each officer of the Borrower executing this Agreement, the Note or any other document delivered in connection herewith or therewith; (iv) receipt by the Bank of an opinion of counsel for the Borrower substantially in the form of Exhibit B hereto and covering such additional matters relating to the transactions contemplated hereby as the Bank may reasonably request; (v) receipt by the Bank of a certificate of an Authorized Person, dated the date of such Advance, certifying that, to the best of the Borrower's knowledge, no Default has occurred and is continuing or would result from such Advance and that the representations and warranties of the Borrower set forth in this Agreement are true and correct on and as of the date of such Advance; (vi) receipt by the Bank of such evidence as it may reasonably request confirming that the financial institutions described in Section 6.7(iii) do not have the right to confess judgment against the Borrower; (vii) receipt by the Bank of a charge fee in the amount of $37,500; and (viii) receipt by the Bank of all documents it may reasonably request relating to the existence of the Borrower and its authority to execute, deliver and perform this Agreement and the Note and the validity of this Agreement and the Note and any other matters relevant hereto or thereto, all in form and substance satisfactory to the Bank and its counsel. Section 3.2. Conditions to Each Advance. The obligation of the Bank to make such Advance is subject to the satisfaction of the following conditions: (i) the fact that no Default has occurred and is continuing or would result from such Advance; (ii) the fact that the representations and warranties of the Borrower set forth in this Agreement are true and correct on and as of the date of such Advance; and (iii) the fact that the amount of such Advance does not exceed the Available Amount. ARTICLE IV REPRESENTATIONS AND WARRANTIES The Borrower represents and warrants that: Section 4.1. Existence and Power. The Borrower is an unincorporated business trust, validly existing and in good standing under the laws of the District of Columbia, has all powers and all material governmental licenses, authorizations, consents and approvals required to carry on its business as now conducted and is not a "foreign person" within the meaning of sections 1445 and 7701 of the Code. The Borrower is duly qualified or licensed to do business in each jurisdiction where qualification or licensing is required by the nature of its business or the character and location of its property, business or customers and in which the failure to so qualify or be licensed, as the case may be, in the aggregate, could have a material adverse effect on the business, financial position, results of operations or properties of the Borrower. Section 4.2. Authorization; Non-Contravention. The execution, delivery and performance by the Borrower of this Agreement and the Note are within its power, have been duly authorized by all necessary action, require no action by or in respect of, or filing with, any governmental body, agency or official and do not contravene, or constitute (with or without the giving of notice or lapse of time or both) a default under, any provision of applicable law or of the declaration of trust or bylaws of the Borrower or of any agreement, judgment, injunction, order, decree or other instrument binding upon or affecting the Borrower or result in the creation or imposition of any Lien on any of its assets. Section 4.3. Binding Effect. This Agreement constitutes a valid and binding agreement of the Borrower and the Note, when executed and delivered in accordance with this Agreement, will constitute a valid and binding obligation of the Borrower, in each case enforceable against the Borrower in accordance with its terms, except as (i) the enforceability hereof and thereof may be limited by bankruptcy, insolvency or similar laws affecting creditors' rights generally and (ii) rights of acceleration and the availability of equitable remedies may be limited by equitable principles of general applicability. Section 4.4. Litigation. Except as disclosed in the Borrower's Form 10- Q for the quarter ended September 30, 1993 filed with the Securities and Exchange Commission, there is no action, suit or proceeding pending against, or to the knowledge of the Borrower threatened against or affecting, the Borrower or any of its subsidiaries before any federal, state or local government, authority, agency, court or other body, officer or entity, or before any arbitrator with authority to bind a party at law, in which there is a reasonable possibility of a decision which could materially adversely affect the business, financial position, results of operations or properties of the Borrower or which in any manner draws into question the validity of this Agreement or the Note, and there is no basis known to the Borrower for any such action, suit or proceeding. Section 4.5. Filings. All actions by or in respect of, and all filings with, any governmental body, agency or official required in connection with the execution, delivery and performance of this Agreement and the Note, or necessary for the validity or enforceability hereof and thereof or for the protection or perfection of the rights and interests of the Bank hereunder and thereunder, will, prior to the date of delivery hereof or thereof, have been duly taken or made, as the case may be, and will at all times thereafter remain in full force and effect. Section 4.6. Financial Information. (a) The audited balance sheet of the Borrower as of December 31, 1992 and the related audited statements of operations, cash flows and shareholders' equity for the fiscal year then ended, copies of which have been delivered to the Bank, fairly present, in conformity with GAAP, the financial position of the Borrower as of such date and its results of operations and cash flows for such fiscal year. As of the date of such financial statements, the Borrower did not have any material contingent obligation, contingent liability, liability for taxes, long-term lease or unusual forward or long-term commitment which is not reflected in any of such financial statements or in the notes thereto. (b) The unaudited balance sheet of the Borrower as of September 30, 1993 and the related unaudited statements of operations, cash flows and shareholders' equity for the calendar quarter then ended, copies of which have been delivered to the Bank, fairly present, in conformity with GAAP applied on a basis consistent with the financial statements referred to in subsection (a) above, the financial position of the Borrower as of such date and its results of operations and cash flows for each calendar quarter (subject to normal year-end adjustments). (c) Since September 30, 1993, there has been no material adverse change in the business, financial position, results of operations or properties of the Borrower. Section 4.7. ERISA Compliance. Each member of the Controlled Group has fulfilled its obligations under the minimum funding standards of ERISA and the Code with respect to each Plan and is in compliance in all material respects with the provisions of ERISA and the Code presently applicable to each Plan, and has not incurred or does not reasonably expect to incur any liability to the PBGC or a Plan under Title IV of ERISA. The execution and delivery of this Agreement and the issuance of the Note will not involve any transaction which is subject to the prohibitions of Section 406 of ERISA or in connection with which a tax would be imposed pursuant to section 4975 of the Code. No Lien has been attached, and no Person has threatened to attach a Lien, on any property of the Borrower as a result of the Borrower's failure to comply with ERISA. Section 4.8. Environmental Compliance. (a) Except as described in Schedule 4.8 or disclosed in the Borrower's Form 10-Q for the quarter ended September 30, 1993 filed with the Securities and Exchange Commission, neither the Borrower nor any of its subsidiaries is (i) in default with respect to any order, writ, injunction or decree of any court or (ii) in default in any respect under any Environmental Requirement, which default is likely to materially adversely affect the business, financial position, results of operations or properties of the Borrower and its subsidiaries. (b) Except as described in Schedule 4.8 or disclosed in the Borrower's Form 10-Q for the quarter ended September 30, 1993 filed with the Securities and Exchange Commission, (i) the Borrower and each of its subsidiaries is in compliance in all material respects with all applicable Environmental Requirements and state and federal health and safety statutes and regulations, other than violations that are unlikely to materially adversely affect the business, financial position, results of operations or properties of the Borrower and its subsidiaries, and (ii) to the best of the Borrower's knowledge, neither the Borrower nor any of its subsidiaries is the subject of any evaluation under any Environmental Requirement or any other federal, state or local investigation to evaluate whether any remedial action is needed to respond to a Release of Hazardous Material or any other environmental matter, other than investigations that are unlikely to materially adversely affect the business, financial position, results of operations or properties of the Borrower and its subsidiaries. Section 4.9. Regulation U. The Advances will not be used by the Borrower, directly or indirectly, for the purpose of purchasing or carrying any margin stock or for the purpose of reducing or retiring any indebtedness that was originally incurred to purchase or carry margin stock or for any other purpose that might constitute the Advances a "purpose credit" within the meaning of Regulation U or Regulation X of the Board of Governors of the Federal Reserve System. ARTICLE V FINANCIAL COVENANTS The Borrower agrees that so long as the Bank is committed to make Advances hereunder or any amount payable hereunder or under the Note remains unpaid: Section 5.1. Certain Definitions. As used in this Article V and elsewhere in this Agreement, the following terms have the following meanings: "Funds From Operations" means, for any calendar quarter, the Borrower's net income (or net loss) for such quarter before depreciation of real estate owned, amortization, gains on sales of investments and extraordinary items. "Shareholders' Equity" means, at any date, (i) shareholders' equity of the Borrower (as set forth in the Borrower's most recent statement of shareholders' equity) plus (ii) the sum as of such date of subscriptions receivable, deferred compensation, treasury stock (valued at cost) and changes in accumulated dividends in excess of the Borrower's net income (utilizing a base amount of $79,434,000 per the June 30, 1992 financial statements of the Borrower). "Total Liabilities" means, at any date, all obligations of the Borrower on such date in respect of capital leases, mortgages payable, notes payable, senior notes, convertible debentures and secured or unsecured bank debt. Section 5.2. Minimum Shareholders' Equity. The Borrower will not permit Shareholders' Equity to be less than $225,000,000 as of the last day of any calendar quarter. Section 5.3. Total Liabilities to Shareholders' Equity Ratio. The Borrower will not permit the ratio of (i) Total Liabilities to (ii) Shareholders' Equity to exceed 2.00 to 1.00 as of the last day of any calendar quarter. Section 5.4. Minimum Funds From Operations. The Borrower will not permit Funds From Operations to be less than (i) $7,000,000 for any calendar quarter or (ii) $30,000,000 in the aggregate for any period of four consecutive calendar quarters. Section 5.5 Limitation on Dividends. The Borrower will not (i) during any six consecutive calendar quarters pay dividends which exceed 135% of the Funds From Operations for such six quarter period or (ii) during any two consecutive calendar quarters pay dividends which exceed 175% of the Funds From Operation for such two quarter period. ARTICLE VI ADDITIONAL COVENANTS OF THE BORROWER The Borrower agrees that so long as the Bank is committed to make Advances hereunder or any amount payable hereunder or under the Note remains unpaid: Section 6.1. Information. The Borrower will deliver or cause to be delivered to the Bank: (i) within 120 days after the end of each fiscal year of the Borrower, copies of the Borrower's Annual Report to Shareholders and Annual Report on Form 10-K for such fiscal year, such reports to include a balance sheet of the Borrower as of the end of such fiscal year and the related statements of operations, cash flows and shareholders' equity for such fiscal year, setting forth in each case in comparative form the figures for the previous fiscal year, all in reasonable detail and accompanied by an opinion thereon by independent public accountants satisfactory to the Bank, which opinion shall state that such financial statements present fairly the financial position of the Borrower as of the date of such financial statements and the results of its operations and cash flows for the period covered by such financial statements in conformity with GAAP applied on a consistent basis (except for changes in the application of which such accountants concur) and shall not contain any "going concern" or like qualification or exception or qualifications arising out of the scope of the audit; (ii) within 60 days after the end of each of the first three quarters of each fiscal year of the Borrower, a copy of the Borrower's Quarterly Report on Form 10-Q for such quarter, such report to include all financial statements and financial information required by Rule 10-01 of Regulation S-X (which includes a balance sheet of the Borrower as of the end of such quarter and the related statements of operations, shareholders' equity and cash flows for such quarter and for the portion of such fiscal year ended at the end of such quarter, setting forth in each case in comparative form the figures for the corresponding quarter of the previous fiscal year and for the corresponding portion of the previous fiscal year), all certified (subject to normal year-end audit adjustments) as complete and correct by the chief financial officer or chief accounting officer of the Borrower; (iii) simultaneously with the delivery of each set of financial statements referred to in clauses (i) and (ii) above, a certificate of the chief financial officer or chief accounting officer of the Borrower (A) setting forth in reasonable detail the calculations necessary to confirm whether the Borrower is in compliance with the financial covenants set forth in Sections 5.2, 5.3, 5.4 and 5.5, (B) stating whether there exists on the date of such certificate any Default and, if any Default then exists, setting forth the details thereof and the action that the Borrower is taking or proposes to take with respect thereto and (C) stating whether, since the date of the most recent previous delivery of financial statements pursuant to clause (i) or (ii) above, there has been any material adverse change in the business, financial position, results of operations or properties of the Borrower, and, if so, the nature of such material adverse change; (iv) forthwith upon the occurrence of any Default, a certificate of the chief financial officer or chief accounting officer of the Borrower setting forth the details thereof and the action that the Borrower is taking or proposes to take with respect thereto; (v) promptly after obtaining actual knowledge of the commencement of, or of a material threat of the commencement of, any action, suit or proceeding against the Borrower or any of its subsidiaries before any federal, state or local government, authority, agency, court or other body, officer or entity, or before any arbitrator with authority to bind a party at law, in which there is a reasonable possibility of a decision which could materially adversely affect the business, financial position, results of operations or properties of the Borrower (or, in the case of a material threat of the commencement of any such action, suit or proceeding, in which a decision which could materially adversely affect the business, financial position, results of operations or properties of the Borrower is probable) or which in any manner draws into question the validity of this Agreement or the Note, a certificate of an officer of the Borrower setting forth the nature of such action, suit or proceeding and such additional information as may be reasonably requested by the Bank; (vi) within 60 days after the end of each fiscal quarter of the Borrower, a certificate of an officer of the Borrower setting forth the nature of each environmental problem affecting any of the properties of the Borrower or any of its subsidiaries as to which there is a reasonable possibility of a material adverse affect on the business, financial position, results of operations or properties of the Borrower, a summary of any remediation efforts or other actions taken or proposed to be taken with respect thereto and such additional information as may be reasonably requested by the Bank; (vii) promptly upon transmission thereof, copies of all press releases and other statements made available generally by the Borrower to the public concerning material developments in its business, financial position, results of operations or properties; and (viii) from time to time such additional information regarding the business, financial position, results of operations or properties of the Borrower as the Bank may reasonably request (including, without limitation, rent rolls on all of the properties of the Borrower (to be delivered no more frequently than twice during any calendar year) and a schedule of payments for all debt instruments of the Borrower). Section 6.2 Payment of Obligations. The Borrower will, and will cause each of its subsidiaries to, pay and discharge, as the same shall become due and payable, (i) all its obligations and liabilities, including all claims or demands of materialmen, mechanics, carriers, warehousemen, landlords and other like persons which, in any such case, if unpaid, might by law give rise to a Lien upon any of the Borrower's or any such subsidiary's property or assets, and (ii) all lawful taxes, assessments and charges or levies made upon it or its, or any such subsidiary or any such subsidiary's, properties or assets by any governmental body, agency or official (except where any of the items in clause (i) or (ii) of this Section 6.2 is being diligently contested in good faith and the Borrower has set aside on its books, if required under GAAP, appropriate reserves for the accrual of any such items). Section 6.3. Maintenance of Property; Insurance. The Borrower will, and will cause each of its subsidiaries to, keep all its properties in good working order and condition, subject to ordinary wear and tear, maintain with financially sound and reputable insurance companies insurance on all its properties in at least such amounts and against at least such risks (and with such risk retentions) as are usually insured against by companies engaged in the same or a similar business and furnish to the Bank upon request full information as to the insurance carried. Section 6.4. Conduct of Business and Maintenance of Existence. The Borrower will continue to engage in business of the same general type as now conducted by the Borrower and will preserve, renew and keep in full force and effect its existence as a real estate investment trust and its rights, privileges and franchises necessary or desirable in the normal conduct of its business. Section 6.5. Compliance with Laws. The Borrower will, and will cause each of its subsidiaries to, (i) comply in all material respects with all applicable laws, ordinances, rules, regulations, and requirements of governmental authorities (including, without limitation, ERISA and the rules and regulations thereunder and all Environmental Requirements (subject to Section 6.13)), except where the necessity of compliance therewith is contested in good faith by appropriate proceedings and (ii) at all times cause to be done those things necessary to maintain, preserve and renew its qualification as a real estate investment trust under the Code and all applicable regulations thereunder. Section 6.6. Accounting; Inspection of Property, Books and Records. The Borrower will keep proper books of record and account in which full, true and correct entries in conformity with GAAP shall be made of all dealings and transactions in relation to its business and activities, will maintain its fiscal reporting periods on the present basis and will permit representatives of the Bank, at the Borrower's expense (not to exceed $1,500 in the aggregate during any calendar year), to visit and inspect any of the Borrower's properties, to examine and make abstracts from any of the Borrower's books and records and to discuss the Borrower's affairs, finances and accounts with the Borrower's executive officers (who, on the Effective Date, are those officers identified in Section 7.1(xi) and independent public accountants, all at such reasonable times and as often as the Bank may reasonably request. Section 6.7. Restriction on Debt. The Borrower will not incur or at any time be liable with respect to any Debt except Debt which meets any one of the following criteria: (i) Debt outstanding under this Agreement and the Note; (ii) Debt having an original term in excess of three years; and (iii) unsecured Debt owing to financial institutions and having an aggregate unpaid principal balance of $100,000,000 or less. Section 6.8. Restrictions on Liens. The Borrower will not enter into any agreement, or permit any of its subsidiaries to enter into any agreement, with any third party which would prohibit the Borrower or any such subsidiary from creating a Lien on any of its properties in favor of the Bank to secure the Borrower's obligations to the Bank hereunder and under the Note. The Borrower will maintain or cause its subsidiaries to maintain free and clear of all Liens that portion of its and such subsidiaries' real property assets which at all times shall have a book value plus depreciation (each as determined in accordance with GAAP) equal to or greater than the aggregate amount of the commitments of all banks now or hereafter providing an unsecured revolving line of credit ("Revolving Credit Banks") to the Borrower from time to time. The Borrower further agrees that if at any time it creates a Lien in favor of any theretofore unsecured Revolving Credit Bank, that it will create such Lien in favor of all such Revolving Credit Banks, including the Bank, on a pari passu basis based on the commitments of such Revolving Credit Banks. Section 6.9. Consolidations, Mergers and Sales of Assets. The Borrower will not (i) consolidate or merge with or into any other Person or (ii) sell, lease or otherwise transfer all or any substantial part of its assets to any other Person; provided, however, that the Borrower may merge with another real estate investment trust or company if the Borrower is the surviving entity in such merger and no Default shall have occurred and be continuing immediately after giving effect to such merger. Section 6.10 Transactions with Affiliates. The Borrower will not directly or indirectly pay any funds to or to the account of, make any investment in, engage in any transaction with or effect any transaction in connection with any joint enterprise or other joint arrangement with any Affiliate except in the ordinary course of business pursuant to the reasonable requirements of the business of the Borrower and upon fair and reasonable terms no less favorable to the Borrower than would be obtained in a comparable arms-length transaction with a Person not an Affiliate. Section 6.11. Transactions with Other Persons. The Borrower will not enter into any agreement with any Person whereby any of them shall agree to any restriction on the Borrower's right to amend or waive any of the provisions of this Agreement. Section 6.12 ERISA Matters. The Borrower will not at any time permit any Plan to (i) engage in any "prohibited transaction" (as such term is defined in section 4975 of the Code or in Section 406 of ERISA), (ii) incur any "accumulated funding deficiency" (as such term is defined in Section 302 of ERISA), whether or not waived, or (iii) be terminated in a manner that could result in the imposition of a Lien on the property of the Borrower pursuant to Section 4068 of ERISA. The Borrower will deliver or cause to be delivered to the Bank if and when any member of the Controlled Group (i) gives or is required to give notice to the PBGC of any "reportable event" (as defined in Section 4043 of ERISA) with respect to any Plan which might constitute grounds for a termination of such Plan under Title IV of ERISA, or knows that the plan administrator of any Plan has given or is required to give notice of any such reportable event, a copy of the notice of such reportable event given or required to be given to the PBGC, (ii) receives notice of complete or partial withdrawal liability under Title IV of ERISA, a copy of such notice, or (iii) receives notice from the PBGC under Title IV of ERISA of an intent to terminate or appoint a trustee to administer any Plan, a copy of such notice. Section 6.13 Environmental Matters. (a) Except as set forth in subsection (b) below, the Borrower will, and will cause each of its subsidiaries to, (i) comply with all Environmental Requirements, (ii) obtain, maintain and comply with all permits, licenses, registrations and authorizations required under all Environmental Requirements and (iii) comply with all court orders, consent orders, settlement agreements or other settlement documents issued by, or entered into with, any administrative or governmental agency or entity concerning compliance with all Environmental Requirements. (b) The Borrower shall not be deemed to be in violation of subsection (a) above if (i) the Borrower, its subsidiaries and/or its tenants or other potentially responsible parties have initiated and are diligently pursuing in good faith appropriate measures satisfactory to the court or agency having jurisdiction over the matter to cure or eliminate the compliance failure, (ii) there has been set aside on the Borrower's consolidated financial statements a reserve deemed by the Borrower in its reasonable business judgment to be sufficient to cover the noncompliance liability or such greater amount as may be required by GAAP and (iii) such non-compliance will not materially adversely affect the business, financial position, results of operations or properties of the Borrower and its subsidiaries. Section 6.14 Pro-Rata Borrowing and Repayment. Borrower will use its best efforts (i) to borrow on an aggregate basis over the course of any consecutive twelve month period from all Revolving Credit Banks, including the Bank, on an approximately pro-rata basis based on the commitments of the Revolving Credit Banks and (ii) to make any principal repayment (which at any one time is equal to or greater than $10,000,000) of the amounts borrowed from the Revolving Credit Banks to all Revolving Credit Banks on an approximately pro-rata basis based on the outstanding principal balances of the loans to the Borrower from the Revolving Credit Banks. Section 6.15 Confession of Judgment. The Borrower will not grant any other Revolving Credit Bank the right to confess judgment against the Borrower. Section 6.16 Use of Proceeds. The Borrower will use the Advances to provide working capital for investment activities, for construction, renovation and tenant fit-up for the shopping centers and other properties acquired by the Borrower, for debt reduction, for the payment of dividends and for other similar purposes permissible for real estate investment trusts. Section 6.17 Independence of Covenants. All covenants contained herein shall be given independent effect. If a particular action or condition is not permitted by any of such covenants, the fact that such action or condition would be permitted by an exception to, or otherwise be within the limitations of, another covenant shall not avoid the occurrence of a Default if such action is taken or such condition exists. ARTICLE VII DEFAULTS Section 7.1 Events of Default. If one or more of the following events ("Events of Default") shall have occurred and be continuing: (i) the Borrower shall fail to pay when due or within 10 Business Days thereafter any principal of or interest on the Advances or any other amount payable hereunder or under the Note; (ii) the Borrower shall fail to observe or perform any covenant contained in Article V or Section 6.7, 6.8, 6.9, 6.10, 6.11, 6.12, 6.13, 6.14, 6.15 or 6.16 of this Agreement; (iii) the Borrower shall fail to observe or perform any covenant or agreement contained in this Agreement (other than those covered by clause (i) or (ii) above) for 10 Business Days after written notice thereof shall have been given to the Borrower by the Bank; provided, however, that the Borrower shall be entitled to a reasonable period of time (not to exceed 60 days following the Borrower's receipt of such written notice) to cure such failure if (A) the Bank reasonably determines that such failure cannot be remedied within such 10 Business Day period, (B) the Borrower initiates action to cure such failure within such 10 Business Day period, (C) the Borrower proceeds diligently and in good faith to cure such failure and (D) the Bank determines that such failure will not impair the ability of the Borrower to pay when due or within 10 Business Days thereafter any principal of or interest on the Advances or any other amount payable hereunder or under the Note; (iv) any representation, warranty, certification or statement made by the Borrower in this Agreement, or in any certificate, financial statement or other document delivered pursuant hereto or thereto, shall prove to have been incorrect in any material respect when made; (v) the Borrower shall fail to make any payment in respect of any Debt (other than the Note) owing to the Bank or any other recourse Debt when due or within any applicable grace period; (vi) any event or condition shall occur which results in the acceleration of the maturity of any Debt of the Borrower owing to the Bank or any other recourse Debt of the Borrower or enables the holder of such Debt or any Person acting on such holder's behalf to accelerate the maturity thereof; (vii) the Borrower shall commence a voluntary case or other proceeding seeking liquidation, reorganization or other relief with respect to itself or its debts under any bankruptcy, insolvency or other similar law now or hereafter in effect or seeking the appointment of a trustee, receiver, liquidator, custodian or other similar official of it or any substantial part of its property, or shall consent to any such relief or to the appointment of or taking possession by any such official in an involuntary case or other proceeding commenced against it, or shall make a general assignment for the benefit of creditors, or shall fail generally to pay its debts as they become due, or shall take any action to authorize any of the foregoing; (viii) an involuntary case or other proceeding shall be commenced against the Borrower seeking liquidation, reorganization or other relief with respect to it or its debts under an bankruptcy, insolvency or other similar law now or hereafter in effect or seeking the appointment of a trustee, receiver, liquidator, custodian or other similar official of it or any substantial part of its property, and such involuntary case or other proceeding shall remain undismissed and unstayed for a period of 30 days, or an order for relief shall be entered against the Borrower under the federal bankruptcy laws as now or hereafter in effect; (ix) one or more judgments or orders for the payment of money in excess of $1,000,000 individually or $2,500,000 in the aggregate shall be rendered against the Borrower and such judgment or order shall continue unsatisfied for a period of 30 days during which execution thereof shall not be effectively stayed; (x) the Internal Revenue Service shall make a final determination that the Borrower has failed to maintain its qualification as a real estate investment trust, the Internal Revenue Service shall make a preliminary determination that Borrower has failed to maintain its qualification as a real estate investment trust and the Borrower shall fail promptly to contest or remedy such determination by appropriate proceedings or the stock of the Borrower shall cease to be publicly traded; (xi) Steven J. Guttman and a majority of the vice presidents of Borrower as of the date hereof shall cease to participate actively as senior managers of the Borrower; or (xii) the Bank shall determine in good faith that a material adverse change has occurred in the financial condition of the Borrower since the date of this Agreement, and the Borrower shall fail to correct such change to the satisfaction of the Bank within 10 days after written notice thereof shall have been given to the Borrower by the Bank; then, and in every such event, the Bank may, at its option, by notice to the Borrower, terminate the Line of Credit Commitment and declare the Note (together with accrued but unpaid interest thereon) to be immediately due and payable (and the Note shall thereupon become immediately due and payable without presentment, demand, protest or other notice of any kind, all of which are hereby waived by the Borrower); provided, however, that upon the occurrence of any of the Events of Default specified in clause (vii) or (viii) above, without any notice to the Borrower or any other act by the Bank, the Line of Credit Commitment shall terminate and the Note (together with accrued but unpaid interest thereon) shall immediately become due and payable without presentment, demand, protest or other notice of any kind, all of which are hereby waived by the Borrower. Section 7.2. Other Remedies. If a Default or an Event of Default occur and be continuing, the Bank may proceed to protect and enforce its rights under this Agreement and the Note by exercising such remedies as are available to the Bank in respect thereof under applicable law, either by suit in equity or by action at law or both, for specific performance of any covenant or other agreement contained in this Agreement or in aid of the exercise of any power granted in this Agreement. No failure or delay by the Bank in exercising any right, power or privilege hereunder or under the Note shall operate as a waiver thereof nor shall any single or partial exercise thereof preclude any other or further exercise thereof or the exercise of any other right, power or privilege. The rights and remedies herein provided shall be cumulative and not exclusive of any rights or remedies provided by law. Section 7.3. Inspection of Properties. The Bank, upon obtaining any judgment against the Borrower, shall have the right to enter upon, and the Borrower hereby specifically grants to the Bank a license (effective only upon the entry of a judgment) to enter upon, any of the Borrower's properties that the Bank may seek to acquire in connection with the enforcement of such judgment for the purpose of inspecting, testing and assessing the properties for the presence of Hazardous Materials. The Borrower shall reimburse the Bank upon demand for all costs and expenses of any and all inspections, testing and assessing. If the Borrower fails to reimburse the Bank upon demand for such costs, then the Bank may pursue all its legal remedies to recover such costs. ARTICLE VIII CHANGE IN CIRCUMSTANCES AFFECTING EURO-DOLLAR-BASED ADVANCES Section 8.1. Basis for Determining Adjusted London Interbank Offered Rate Inadequate or Unfair. If on or prior to the first day of any Interest Period: (i) the Bank is advised that deposits in dollars (in the applicable amounts) are not being offered in the relevant market for such Interest Period; or (ii) the Bank determines that the Adjusted London Interbank Offered Rate will not adequately and fairly reflect the cost to the Bank of maintaining or funding the Euro-Dollar-Based Advances for such Interest Period (and such determination is also made with respect to all or substantially all other borrowers from the Bank that pay interest at a rate based on the Adjusted London Interbank Offered Rate); then the Bank shall promptly give notice thereof to the Borrower, whereupon, until such circumstances no longer exist, the right of the Borrower to elect to have the Advances bear interest at the Euro-Dollar-Based Rate shall be suspended and the Euro-Dollar-Based Advances then outstanding shall begin bearing interest at the Prime-Based Rate at the end of the Interest Period(s) applicable to such Euro-Dollar-Based Advances. Section 8.2. Illegality. If, after the date of this Agreement, the adoption of any applicable law, rule or regulation, or any change therein, or any change in the interpretation or administration thereof by any governmental authority, central bank or comparable agency charged with any interpretation or administration thereof, or compliance by the Bank with any request or directive (whether or not having the force of law) of any such authority, central bank or comparable agency shall make it unlawful or impossible for the Bank to make, maintain or fund the Euro-Dollar-Based Advances, the Bank shall promptly give notice thereof to the Borrower. Before giving any notice to the Borrower pursuant to this Section 8.2, the Bank shall designate a different lending office if such designation will avoid the need for giving such notice and will not, in the reasonable judgment of the Bank, be otherwise disadvantageous to the Bank. If such notice is given, the Euro-Dollar-Based Advances then outstanding shall begin bearing interest at the Prime-Based Rate either (i) on the last day of the applicable Interest Period if the Bank may lawfully continue to maintain and fund such Advances at the Euro-Dollar-Based Rate to such day or (ii) immediately if the Bank may not lawfully continue to maintain and fund such Advances at the Euro-Dollar-Based Rate to such day (in which case the Borrower shall reimburse the Bank on demand for any resulting loss or reasonable expense in accordance with Section 2.11). Section 8.3. Increased Cost and Reduced Return. (a) If, after the date of this Agreement, the adoption of any applicable law, rule or regulation, or any change therein, or any change in the interpretation or administration thereof by any governmental authority, central bank or comparable agency charged with any interpretation or administration thereof, or compliance by the Bank with any request or directive (whether or not having the force of law) of any such authority, central bank or comparable agency: (i) shall subject the Bank to any tax, duty or other charge with respect to the Euro-Dollar-Based Advances or the Bank's obligation to make the Euro-Dollar-Based Advances, or shall change the basis of taxation of payments to the Bank of the principal of or interest on the Euro-Dollar-Based Advances or any other amounts due under this Agreement or the Note in respect of the Euro-Dollar-Based Advances or the Bank's obligation to make the Euro- Dollar-Based Advances (except for changes in the rate of tax on the overall net income of the Bank imposed by the jurisdiction in which the Bank's principal executive office is located); or (ii) shall impose, modify or deem applicable any reserve, special deposit or similar requirement (including, without limitation, any such requirement imposed by the Board of Governors of the Federal Reserve System, but excluding any such requirement included in the applicable Euro-Dollar Reserve Percentage) against assets of, deposits with or for the account of, or credit extended by, the Bank, or shall impose on the Bank or on the London interbank market any other condition affecting the Euro-Dollar-Based Advances or the Bank's obligation to make the Euro-Dollar-Based Advances; and the result of any of the foregoing is to increase the cost to the Bank of making or maintaining the Euro-Dollar-Based Advances, or to reduce the amount of any sum received or receivable by the Bank under this Agreement or under the Note, then the Borrower shall pay to the Bank in accordance with subsection (c) below such additional amount or amounts as will compensate the Bank for such increased cost or reduction. (b) If the Bank shall determine that any applicable law, rule, regulation or guideline or the adoption after the date of this Agreement of any law, rule, regulation or guideline regarding capital adequacy, or any change in any of the foregoing or in the interpretation or administration of any of the foregoing by any governmental authority, central bank or comparable agency charged with the interpretation or administration thereof, or compliance by the Bank with any request or directive regarding capital adequacy (whether or not having the force of law) of any such authority, central bank or comparable agency, has or would have the effect of reducing the rate of return on the Bank's capital or the capital of any Person controlling the Bank as a consequence of the Bank's obligations under this Agreement to a level below that which the Bank or such controlling Person could have achieved but for such law, adoption, change or compliance (taking into consideration the Bank's policies with respect to capital adequacy) by an amount deemed by the Bank to be material, then from time to time the Borrower shall pay to the Bank in accordance with subsection (c) below such additional amount or amounts as will compensate the Bank for such reduction. (c) The Bank will promptly notify the Bank of any event of which it has knowledge, occurring after the date of this Agreement, which will entitle the Bank to compensation pursuant to this Section 8.3 and will deliver to the Borrower with each demand for payment a certificate, signed by an officer of the Bank, setting forth the amount or amounts to be paid to it hereunder, explaining in reasonable detail the calculation of such amount or amounts and setting forth in reasonable detail the method by which the Bank allocated any such amount or amounts to the Borrower. Any such certificate shall be conclusive in the absence of manifest error. In determining such amount, the Bank may use any reasonable averaging and attribution methods generally used by the Bank for the purpose of calculating increased costs and reduced returns and allocating increased costs and reduced returns to borrowers. The Bank will designate a different lending office if such designation will avoid the need for, or reduce the amount of, such compensation and will not, in the reasonable judgment of the Bank, be otherwise disadvantageous to it. (d) All payments required by this Section 8.3 shall be made by the Borrower within 30 days after demand by the Bank. All such payments not made on or before the tenth Business Day after such demand shall be accompanied by interest thereon for each day from and including such tenth Business Day to but excluding payment in full thereof at a rate equal to the Prime Rate minus 1.00% per annum. The Borrower shall not be obligated to reimburse the Bank for any increased cost or reduced return incurred more than 90 days after the date that the Bank receives actual notice of such increased cost or reduced return unless the Bank gives notice thereof to the Borrower in accordance with this Section 8.3 during such 90 day period. Section 8.4. Suspension of Advances. If notice has been given pursuant to Section 8.2 requiring that the Euro-Dollar-Based Advances cease to bear interest at the Euro-Dollar-Based Rate, then, unless and until the Bank notifies the Borrower that the circumstances giving rise to such notice no longer apply or that the Bank has elected to continue such Euro-Dollar-Based Advances at the Euro-Dollar-Based Rate through the end of the Interest Period(s) applicable to such Euro-Dollar-Based Advances, the Euro-Dollar- Based Advances then outstanding shall begin bearing interest at the Prime- Based Rate from and including the date of such notice (notwithstanding any prior election by the Borrower to the contrary). ARTICLE IX MISCELLANEOUS Section 9.1. Notices. All notices, requests and other communications to a party hereunder shall be in writing and shall be given to such party at its address set forth on the signature page hereof or such other address as such party may hereafter specify for that purpose by notice to the other. Each such notice, request or other communication shall be effective (i) if given by mail, two Business Days after such communication is deposited in the mails with first class postage prepaid, addressed as aforesaid or (ii) if given by any other means, when delivered at the address specified in this Section 9.1, provided that any notice given to the Bank pursuant to Section 2.2 shall only be effective upon receipt. Section 9.2. No Waivers. No failure or delay by the Bank in exercising any right, power or privilege hereunder (except as set forth in Section 8.3(d)) or under the Note shall operate as a waiver thereof, nor shall any single or partial exercise thereof preclude any other or further exercise thereof or the exercise of any other right, power or privilege. The rights and remedies herein provided shall be cumulative and not exclusive of any rights or remedies provided by law. Section 9.3. Expenses. The Borrower shall pay (i) all out-of-pocket expenses of the Bank, including the reasonable fees and disbursements of its counsel, in connection with the preparation of this Agreement, any waiver or consent hereunder, any amendment hereof or any Default hereunder and (ii) if an Event of Default occurs, all out-of-pocket expenses incurred by the Bank, including the reasonable fees and disbursements of its counsel, in connection with such Event of Default and any collection or other enforcement proceedings resulting therefrom. The Borrower shall indemnify the Bank against any transfer taxes, documentary taxes, assessments or charges made by any governmental authority by reason of the execution and delivery of this Agreement or the Note. Section 9.4. Indemnification. In consideration of the execution and delivery of this Agreement by the Bank, the Borrower hereby indemnifies, exonerates and holds the Bank and its Affiliates, officers, directors, employees and agents (collectively, the "Indemnified Parties") free and harmless from and against any and all actions, causes of action, suits, losses, costs, liabilities, obligations, penalties, fines, demands, defenses, damages, disbursements or expenses of any kind or nature whatsoever (including attorneys' fees and costs and experts' fees and disbursements and expenses incurred in investigating, settling, defending against or prosecuting any litigation, claim or proceeding) which may at any time be imposed upon, incurred by or asserted or awarded against any Indemnified Party (irrespective of whether any such Indemnified Party is a party to the action of which indemnification hereunder is sought), whether incurred in connection with actions between or among the parties hereto or the parties hereto and third parties (collectively, the "Indemnified Liabilities"), incurred by the Indemnified Parties or any of them as a result of, or arising out of, or relating to: (i) the actual or alleged presence of any Hazardous Material on, in, under or affecting, the transportation of any Hazardous Material to or from, or the Release of any Hazardous Material from or in connection with, all or any portion of any property, owned, leased or operated by the Borrower or any of its subsidiaries, the ground water or any surrounding areas (provided that there is a nexus to the Borrower's or such subsidiary's property); (ii) any misrepresentation, inaccuracy or breach of any warranty contained in or referred to in Section 4.7; (iii) the failure of the Borrower to comply with any Environmental Requirement during or after the term of this Agreement; (iv) the imposition of any Lien for damages caused by or the recovery of any costs for the clean-up, Release or threatened Release of Hazardous Material by the Borrower, or in connection with any property owned or formerly owned by the Borrower; or (v) any actual or alleged prohibited transaction or any actual or alleged sale of a prohibited loan under ERISA or under any state statute regulating investments of, and fiduciary obligations with respect to, governmental plans relating to Section 3(32) of ERISA, and in obtaining any individual prohibited transaction exemption under ERISA or any administrative exemption under any state statute that may be required (in the Bank's sole discretion) that the Bank or any of the Bank's affiliates or Indemnified Parties may incur, directly or indirectly, as a result of any misrepresentation, inaccuracy or breach of any warranty contained in or referred to in Section 4.7. The obligations of the Borrower in respect of Indemnified Liabilities shall survive repayment of the Note or any transfer of the Borrower's property by foreclosure or by a deed in lieu of foreclosure, regardless of whether caused by or within the control of the Borrower. Notwithstanding any of the foregoing, the Borrower shall not be responsible, or otherwise liable for, any Indemnified Liabilities arising for the account of a particular Indemnified Party by reason of the relevant Indemnified Party's gross negligence or wilful misconduct or breach of this Agreement. The Borrower and its successors and assigns hereby waive, release and agree not to make any claim or bring any cause or recovery action against the Bank or any other Indemnified Party in respect of claims arising under clauses (i) through (v) above. It is expressly understood and agreed that to the extent that any such Person is strictly liable in respect of any such claim, the Borrower's obligations to such Person under this Section 9.4 shall likewise be without regard to fault on the part of the Borrower with respect to the violation or condition which results in liability of such Person. If and to the extent that the foregoing undertaking may be unenforceable for any reason, the Borrower hereby agrees to make the maximum contribution to the payment and satisfaction of each of the Indemnified Liabilities which is permissible under applicable law. Section 9.5. Right of Set-Off. Upon the occurrence and during the continuance of any Event of Default, the Bank is hereby authorized at any time and from time to time, to the fullest extent permitted by law, to set off and apply any and all deposits (general or special, time or demand, provisional or final) at any time held and other indebtedness at any time owing by the Bank to or for the credit or the account of the Borrower against any and all of the obligations now or hereafter existing under this Agreement or the Note, irrespective of whether or not the Bank shall have made any demand hereunder or under the Note and although such obligation may be unmatured. The rights of the Bank under this Section 9.5 are in addition to other rights and remedies (including, without limitation, other rights of set-off) which the Bank may have. The Bank agrees to notify the Borrower promptly after it exercises any such right of set-off. Section 9.6. Amendments and Waivers. Any provision of this Agreement or the Note may be amended or waived if, but only if, such amendment or waiver is in writing and is signed by the Borrower and the Bank. Section 9.7. Successors and Assigns. (a) The provisions of this Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns, except that the Borrower may not assign or otherwise transfer any of its rights under this Agreement without the prior written consent of the Bank. (b) The Bank may at any time grant to one or more affiliates of the Bank (each, a "Participant") participating interests in the Line of Credit Commitment or in any or all of the Advances. In the event of any such grant by the Bank of a participating interest to a Participant, whether or not upon notice to the Borrower, the Bank shall remain responsible for the performance of its obligations hereunder, and the Bank shall continue to deal solely and directly with the Borrower in connection with the Bank's rights and obligations under this Agreement. Any agreement pursuant to which the Bank may grant such a participating interest shall provide that the Bank shall retain the sole right and responsibility to enforce the obligations of the Borrower under this Agreement including, without limitation, the right to approve any amendment, modification or waiver of any provision of this Agreement or the Note. (c) The Bank may at any time assign to one or more banks or other institutions (each, an "Assignee") all or part of its rights and obligations under this Agreement and the Note, and such Assignee shall assume such rights and obligations, pursuant to an instrument executed by such Assignee and the Bank with (and subject to) the consent of the Borrower (which may be withheld in the Borrower's sole discretion); provided, however, that any partial assignment shall be in the amount of at least $500,000 or integral multiples thereof. Upon execution and delivery of such an instrument and payment by such Assignee to the Bank of an amount equal to the purchase price agreed between such Assignee and the Bank, such Assignee shall become a party to this Agreement and shall have all the rights and obligations of a bank with a Line of Credit Commitment as set forth in such instrument of assumption, and the Bank shall be released from its obligations hereunder to a corresponding extent, and no further consent or action by any party shall be required. Upon the consummation of any assignment pursuant to this Section 9.7(c), the Bank and the Borrower shall make appropriate arrangements so that, if required, a new Note is issued to such Assignee. The cost of the preparation of such new Note shall be borne by the Bank. In the event that such Assignee is not incorporated under the laws of the United States of America or any jurisdiction thereof, such Assignee shall, prior to the first date on which interest or fees are payable hereunder for its account deliver to the Borrower certification as to exemption from deduction or withholding of any United States federal income taxes. (d) The Bank may furnish any information concerning the Borrower in its possession from time to time to Participants and Assignees (including prospective Participants and Assignees) and may, with the prior written consent of the Borrower, furnish such information in response to credit inquiries consistent with general banking practice. (e) No Participant, Assignee or other transferee of the Bank's rights shall be entitled to receive any greater payment under Section 8.3 than such transferee would have been entitled to receive with respect to the rights assigned or otherwise transferred, unless such assignment or transfer is made with the Borrower's prior written consent or by reason of the provisions of Section 8.2 or 8.3 requiring the Bank to designate a different lending office under certain circumstances or at a time when the circumstances giving rise to such greater payment did not exist. Section 9.8. Governing Law. This Agreement and the Note shall be deemed to be contracts made under seal and shall be governed by and construed in accordance with the laws of the Commonwealth of Pennsylvania, except as otherwise provided herein. Section 9.9. Counterparts; Effectiveness. This Agreement may be signed in counterparts, each of which shall be an original, with the same effect as if the signatures thereto and hereto were upon the same instrument. This Agreement shall become effective when the Bank shall have received counterparts hereof signed by both parties. Section 9.10. Waiver of Jury Trial; Submission to Jurisdiction. The Borrower and the Bank hereby irrevocably and unconditionally waive all right to trial by jury in any action, proceeding, or counterclaim arising out of or related to this Agreement or the Notes or any of the transactions contemplated hereby or thereby. Any legal action or proceeding with respect to this Agreement or the Notes or any document related hereto or thereto shall be brought in a federal court or Commonwealth of Pennsylvania state court sitting in Philadelphia, Pennsylvania, and by execution and delivery of this Agreement the Borrower and the Bank hereby accept for themselves and in respect of their property, generally and unconditionally, the jurisdiction of the aforesaid courts. The Borrower and the Bank hereby irrevocably and unconditionally waive any objection, including, without limitation, any objection to the laying of venue or based on the grounds of the forum non conveniens which they now or hereafter may have to the bringing of any action or proceeding in such respective jurisdictions. Section 9.11. Waiver of Personal Liability. The Borrower's Third Amended and Restated Declaration of Trust on file in the Office of the Recorder of Deeds of the District of Columbia provides that neither the shareholders nor the trustees of the Borrower, nor any officer, employee, representative or agent of the Borrower, shall be personally liable for the satisfaction of the obligations of the Borrower under this Agreement or the Note. The Bank hereby agrees to look solely to the Borrower and the property of the Borrower for the satisfaction of any claim arising from this Agreement, and shall not seek to impose personal liability on any shareholder, trustee, officer, employee, representative or agent of the Borrower in connection with any such claim. As used in this Section 9.11, the term "trustee" shall mean, collectively, the individuals currently serving as trustees of the Borrower, as long as they continue in office, and all other individuals then in office who have been duly elected or appointed as trustees of the Borrower. Section 9.12. Entire Agreement. This Agreement and the Note set forth the entire agreement of the parties with respect to the subject matter hereof and therefor and supersede all previous understandings, written or oral, in respect thereof. IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed by their respective authorized officers as of the day and year first above written. FEDERAL REALTY INVESTMENT TRUST By:/s/ Ron D. Kaplan -------------------------- Ron D. Kaplan Vice President - Capital Markets 4800 Hampden Lane Bethesda, Maryland 20814 Attention: Legal Department MELLON BANK, N.A. By:/s/ Frederick A. Felter --------------------------- Frederick A. Felter Vice President 1735 Market Street Philadelphia, Pennsylvania 19103 D15340.A(RE) Exhibit A - Note $15,000,000 Philadelphia, Pennsylvania February __, 1994 For Value Received, FEDERAL REALTY INVESTMENT TRUST, a District of Columbia unincorporated business trust (the "Borrower"), promises to pay to the order of MELLON BANK, N.A. (the "Bank"), the unpaid principal amount of each Advance made by the Bank to the Borrower pursuant to the Credit Agreement referred to below on the Termination Date provided, or as otherwise provided, in the Credit Agreement. The Borrower promises to pay interest on the unpaid principal amount of each such Advance on the dates and at the rate or rates provided for in the Credit Agreement. All such payments of principal and interest shall be made in lawful money of the United States in Federal or other immediately available funds at the office of the Bank, Philadelphia, Pennsylvania. All Advances made by the Bank, the respective types and maturities thereof and all repayments of the principal thereof shall be recorded by the Bank and, prior to any transfer hereof, appropriate notations to evidence the foregoing information with respect to each such Advance then outstanding shall be endorsed by the Bank on the schedule attached hereto, or on a continuation of such schedule attached to and made a part hereof; provided that the failure of the Bank to make any such recordation or endorsement shall not affect the obligations of the Borrower hereunder or under the Credit Agreement. This note is the Note referred to in the Credit Agreement dated as of January __, 1994 between the Borrower and the Bank (as the same may be amended from time to time, the "Credit Agreement"). Terms defined in the Credit Agreement are used herein with the same meanings. Reference is made to the Credit Agreement for provisions for the prepayment hereof, the accelerationof the maturityhereof and forthe rights and remediesof the Bank. FEDERAL REALTY INVESTMENT TRUST By:_____________________________ Name:___________________________ Title:__________________________ NOTE (cont'd) ADVANCES AND PAYMENTS OF PRINCIPAL ____________________________________________________________________________ Amount of Amount of Type of Principal Maturity Notation Date Advance Advance Repaid Date Made By ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ Exhibit 24 Consent of Independent Accountants We have issued our reports dated February 14, 1994 accompanying the consolidated financial statements and schedules included in the Annual Report of Federal Realty Investment Trust on Form 10K for the year ended December 31, 1993. We hereby consent to the incorporation by reference of said reports in the Registration Statement of Federal Realty Investment Trust on Form S-3 (File No. 33-51029, effective December 31, 1993). Grant Thornton Washington, D.C. March 16, 1994

73960_1993.txt

73960_1993

1993

73960

ITEM 1. BUSINESS The Company Ohio Edison Company (Company) was organized under the laws of the State of Ohio in 1930 and owns property and does business as an electric public utility in that state. The Company also has ownership interests in certain generating facilities located in the Commonwealth of Pennsylvania. The Company furnishes electric service to communities in a 7,500 square mile area of central and northeastern Ohio. It also provides transmission services and electric energy for resale to certain municipalities in the Company's service area and transmission services to certain rural cooperatives. The Company also engages in the sale, purchase and interchange of electric energy with other electric companies. The area it serves has a population of approximately 2,400,000. The Company owns all of the outstanding common stock of Pennsylvania Power Company (Penn Power), a Pennsylvania corporation, which furnishes electric service to communities in a 1,500 square mile area of western Pennsylvania. Penn Power also provides transmission services and electric energy for resale to certain municipalities in Pennsylvania. The area served by Penn Power has a population of approximately 360,000. Central Area Power Coordination Group (CAPCO) In September 1967, the CAPCO companies, consisting of the Company, Penn Power, The Cleveland Electric Illuminating Company (CEI), Duquesne Light Company (Duquesne) and The Toledo Edison Company (Toledo), announced a program for joint development of power generation and transmission facilities. Included in the program are Unit 7 at the W. H. Sammis Plant, Units 1, 2 and 3 at the Bruce Mansfield Plant, Units 1 and 2 at the Beaver Valley Power Station and Unit 1 at the Perry Nuclear Power Plant, each now in service. Perry Unit 2, a CAPCO nuclear generating unit whose construction had been previously suspended, has been abandoned by the CAPCO companies (see "Perry Unit 2"). Arrangements Among the CAPCO Companies The present CAPCO Basic Operating Agreement provides, among other things, for coordinated maintenance responsibilities among the CAPCO companies, a limited and qualified mutual backup arrangement in the event of outage of CAPCO units and certain capacity and energy transactions among the CAPCO companies. The agreements among the CAPCO companies generally treat the Company and Penn Power (Companies) as a single system as between them and the other three CAPCO companies, but, in agreements between the CAPCO companies and others, all five companies are treated as separate entities. Subject to any rights that might arise among the CAPCO companies as such, each member company, severally and not jointly, is obligated to pay only its proportionate share of the costs associated with the facilities and the cost of required fuel. The CAPCO companies have agreed that any modification of their arrangements or of their agreed-upon programs requires their unanimous consent. Should any member become unable to continue to pay its share of the costs associated with a CAPCO facility, each of the other CAPCO companies could be adversely affected in varying degrees because it may become necessary for the remaining members to assume such costs for the account of the defaulting member. Reliance on the CAPCO Companies Under the agreements governing the construction and operation of CAPCO generating units, the responsibility is assigned to a specific CAPCO company. CEI has such responsibilities for Perry Unit 1 and Duquesne is responsible for Beaver Valley Units 1 and 2. The Company monitors activities in connection with these units but must rely to a significant degree on the operating company for necessary information. The Company in its oversight role as a practical matter cannot be privy to every detail; it is the operating company that must directly supervise activities and then exercise its reporting responsibilities to the co-owners. The Company critically reviews the information given to it by the operating company, but it cannot be absolutely certain that things that it would have considered significant have been reported or that it would always have reached exactly the same conclusion about matters that are reported. In addition, the time that is necessarily part of the compiling and analyzing process creates a lag between the occurrence of events and the time the Company becomes aware of their significance. The Companies have similar responsibilities to the other CAPCO companies with respect to W.H. Sammis Unit 7 and Bruce Mansfield Units 1, 2 and 3. Perry Unit 2 In December 1993, the Companies announced that they will not participate in further construction of Perry Unit 2 and have abandoned Perry Unit 2 as a possible electric generating plant. The Company determined that recovery from customers of its Perry Unit 2 investment is not probable, resulting in a $366,377,000 write-off of its investment in 1993. Penn Power expects its Perry Unit 2 investment to be recoverable from its customers. However, due to the anticipated delay in commencement of recovery and taking into account the expected rate treatment, Penn Power recognized an impairment to its Perry Unit 2 investment of $24,458,000 in 1993. As a result, net income for the year ended December 31, 1993, was reduced by $248,743,000 ($1.63 per share of common stock). Financing and Construction The Companies access the capital markets from time to time to provide funds for their construction programs and to refinance existing securities. Future Financing The Companies' total construction costs, excluding nuclear fuel, amounted to approximately $239,000,000 in 1993. Such costs included expenditures for the betterment of existing facilities and for the construction of transmission lines, distribution lines, substations and other additions. For the years 1994-1998, such construction costs are estimated to be approximately $1,000,000,000, of which approximately $235,000,000 is applicable to 1994. See "Environmental Matters" below with regard to possible environment-related expenditures not included in this estimate. During the 1994-1998 period, maturities of, and sinking fund requirements for, long-term debt and preferred stock will require expenditures by the Companies of approximately $1,389,000,000, of which approximately $444,000,000 is applicable to 1994 (including $50,000,000 of preferred stock optionally redeemed in the first quarter of 1994). All or a major portion of maturing debt is expected to be refunded at or prior to maturity. Nuclear fuel purchases are financed through OES Fuel, Incorporated (a wholly owned subsidiary of the Company) commercial paper and loans, both of which are supported by a $325,000,000 long-term bank credit agreement. Investments for additional nuclear fuel during the 1994-1998 period are estimated to be approximately $204,000,000, of which approximately $45,000,000 applies to 1994. During the same periods, the Companies' nuclear fuel investments are expected to be reduced by approximately $261,000,000 and $64,000,000, respectively, as the nuclear fuel is consumed. Also, the Companies have operating lease commitments of approximately $547,000,000 for the 1994-1998 period, of which approximately $102,000,000 relates to 1994. The Companies recover the cost of nuclear fuel consumed and operating leases through their electric rates. Short-term borrowings of $104,126,000 at December 31, 1993 represented OES Capital, Incorporated (a wholly owned subsidiary of the Company) debt, which is secured by customer accounts receivable. OES Capital can borrow up to $120,000,000 under a receivables financing agreement at rates based on certain bank commercial paper. The Companies also had $85,000,000 of unused short-term bank lines of credit as of December 31, 1993. In addition, $132,000,000 of bank facilities that provide for borrowings on a short-term basis at the banks' discretion were available. OES Fuel had approximately $193,000,000 of unused borrowing capability at the end of 1993 which was available for reloan to the Company. Based on their present plans, the Companies may provide for their cash requirements in 1994 from: funds to be received from operations; available cash and temporary cash investments (approximately $160,000,000 as of December 31, 1993); the issuance of long-term debt and funds available under short-term bank credit arrangements. The Companies currently expect that, for the period 1994-1998, external financings may be necessary to provide a portion of their cash requirements. The extent and type of future financings will depend on the need for external funds as well as market conditions, the maintenance of an appropriate capital structure and the ability of the Companies to comply with coverage requirements in order to issue first mortgage bonds and preferred stock. The Companies will continue to monitor financial market conditions and, where appropriate, may take advantage of opportunities to refund outstanding high cost debt and preferred stock to the extent that their financial resources permit. Except as otherwise indicated, the foregoing statements with respect to construction expenditures are based on estimates made in February 1994 and are subject to change based upon the progress of and changes required in the construction program, including periodic reviews of costs, changing customer requirements for electric energy, the level of earnings and resulting changes in applicable coverage requirements, conditions in capital markets, changes in regulatory requirements and other relevant factors. Coverage Requirements The coverage requirements contained in the first mortgage indentures under which the Companies issue first mortgage bonds provide that, except for certain refunding purposes, the Companies may not issue first mortgage bonds unless applicable net earnings (before income taxes), calculated as provided in the indentures, for any period of twelve consecutive months within the fifteen calendar months preceding the month in which such additional bonds are issued, are at least twice annual interest requirements on outstanding first mortgage bonds, including those being issued. The Companies' respective articles of incorporation prohibit the sale of preferred stock unless applicable gross income, calculated as provided in the articles of incorporation, is equal to at least 1-1/2 times the aggregate of the annual interest requirements on indebtedness outstanding immediately thereafter plus the annual dividend requirements on all preferred stock which will be outstanding at that time. With respect to the issuance of first mortgage bonds under the Company's first mortgage indenture, the availability of property additions is more restrictive than the earnings test at the present time and would limit the amount of first mortgage bonds issuable against property additions to $404,000,000. The Company is currently able to issue $868,000,000 principal amount of first mortgage bonds against previously retired bonds without the need to meet the above restrictions. The Company could issue in excess of $1,000,000,000 of additional preferred stock before the end of the first quarter of 1994. For the remainder of 1994, however, the earnings coverage test contained in the Company's charter would preclude the issuance of additional preferred stock due to inclusion of the Perry Unit 2 write-off in the earnings test. Additional preferred stock capability is expected to be restored in January 1995. If the Company were to issue additional debt at or prior to the time it issued preferred stock, the amount of preferred stock which would be issuable would be reduced. To the extent that coverage requirements or market conditions restrict the Companies' abilities to issue desired amounts of first mortgage bonds or preferred stock, the Companies may seek other methods of financing. Such financings could include the sale of common stock and preference stock in amounts greater than otherwise planned, or of such other types of securities as might be authorized by applicable regulatory authorities which would not otherwise be sold and could result in annual interest charges and/or dividend requirements in excess of those that would otherwise be incurred. In addition, the Companies might, to the extent possible, reduce their expenditures for construction and other purposes. Utility Regulation The Companies are subject to broad regulation as to rates and other matters by the Public Utilities Commission of Ohio (PUCO) and the Pennsylvania Public Utility Commission (PPUC). With respect to their wholesale and interstate electric operations and rates, the Companies are subject to regulation, including regulation of their accounting policies and practices, by the Federal Energy Regulatory Commission (FERC). Under Ohio law, municipalities may regulate rates, subject to appeal to the PUCO if not acceptable to the utility. In 1986, a law was passed which extended the jurisdiction of the PUCO to nonutility affiliates of holding companies exempt under Section 3(a)(1) and 3(a)(2) of the Public Utility Holding Company Act of 1935 (1935 Act) to the extent that the activities of such affiliates affect or relate to the cost of providing electric utility service in Ohio. The law, among other things, requires PUCO approval of investments in, or the transfer of assets to, nonutility affiliates. Investments in such affiliates are limited to 15% of the aggregate capitalization of the holding company on a consolidated basis. The Company is an exempt holding company under Section 3(a)(2) of the 1935 Act, but the law has not had any effect on its operations as they are currently conducted. The Energy Policy Act of 1992 (1992 Act) amends portions of the 1935 Act, providing independent power producers and other nonregulated generating facilities easier entry into the electric generation markets. The 1992 Act also amends portions of the Federal Power Act, authorizing the FERC, under certain circumstances, to mandate access to utility-owned transmission facilities. The Companies are currently unable to predict the ultimate effects on their operations resulting from this legislation. In February 1994, a bill was introduced in the Ohio legislature which would amend Ohio law to require utilities to provide transmission access to enable others to serve retail customers located in the service territory of the transmitting utility. Access would not be required however, if the transmission access requested would impair the ability of the transmitting utility to provide physically adequate service to its existing customers unless the requesting party is willing to pay the cost of eliminating the problem in instances where such elimination is possible. The sponsor of the bill has indicated that he expects its introduction will encourage comments and debate in the months ahead on the policy considerations involved. The Company is unable to predict whether this legislation will be adopted and, if adopted, what form it will actually take. PUCO Rate Matters The Company's Rate Stabilization and Service Area Development Program provides for base electric rates to remain at 1990 levels until at least 1997, absent any significant changes in regulatory, environmental or tax requirements. Among other things, the program also provides for the adoption of demand side management programs and a tariff option for customer retention and service area stabilization. FERC Rate Matters Rates for the Companies' respective wholesale customers are regulated by the FERC. The Company's tariff for its customers was approved by the FERC in 1989. Penn Power sells power to its wholesale customers under agreements which were accepted by the FERC in 1984. These agreements provide that Penn Power's wholesale customers will be charged the applicable prevailing retail electric rates through August 1994, and that they will remain full requirements customers of Penn Power at least through that date. Negotiations are currently underway to extend these agreements. Fuel Adjustment Clauses Under the laws of the State of Ohio, an electric utility is required to have semiannual hearings before the PUCO with respect to its fuel and net purchased power policies and practices. At these hearings a utility is required to show that its electric fuel component (EFC) charges are "fair, just and reasonable". The law also requires additional auditing of, and additional reporting by, the utility with respect to its fuel costs and fuel procurement policies and practices. The law provides for the recovery of fuel costs, including any over or under collection of fuel costs applicable to a prior six month period, by adjusting an electric utility's EFC rate every six months. Penn Power uses a "levelized" energy cost rate (ECR) for the recovery of fuel and net purchased power costs from its customers. The ECR, which includes adjustment for any over or under collection from customers, is recalculated each year. Nuclear Regulation The construction and operation of nuclear generating units are subject to the regulatory jurisdiction of the Nuclear Regulatory Commission (NRC) including the issuance by it of construction permits and operating licenses. The NRC's procedures with respect to application for construction permits and operating licenses afford opportunities for interested parties to request public hearings on health, safety, environmental and antitrust issues. In this connection, the NRC may require substantial changes in operation or the installation of additional equipment to meet safety or environmental standards with resulting delay and added costs. The possibility also exists for modification, denial or revocation of licenses or permits. Full power operating licenses were issued for Beaver Valley Unit 1, Perry Unit 1 and Beaver Valley Unit 2 on July 1, 1976, November 13, 1986 and August 14, 1987, respectively. The construction permit and operating license issued by the NRC applicable to Perry Unit 1 is conditioned to require, among other things: (i) maintenance, emergency, economy and wholesale power and reserve sharing to be made available to, (ii) interconnections to be made with, and (iii) wheeling to be provided for, electric generating and/or distribution systems (or municipalities or cooperatives with the right to engage in such functions) if such entities so request and to permit such entities to become members of CAPCO (subject to certain prerequisites with respect to size), or to acquire a share of the capacity of Perry Unit 1 or any other future nuclear units, if they so desire. In September 1987, the Company asked the NRC to suspend these license conditions. In April 1991, the NRC Staff denied the Company's application; accordingly, the Company petitioned the NRC for a hearing. Pursuant to this request the matter was referred to the Atomic Safety and Licensing Board (ASLB). The ASLB ruled against the Company in November 1992. The Company petitioned the NRC to review the ASLB decision in December 1992. On August 3, 1993, the NRC ruled that the license conditions will not be suspended. On October 1, 1993, the Company appealed the NRC decision in the United States Court of Appeals for the District of Columbia Circuit. If these license conditions are not suspended, they could have a materially adverse but presently undeterminable effect on the Companies' future business operations. The NRC has promulgated and continues to promulgate additional regulations related to the safe operation of nuclear power plants. The Companies cannot predict what additional regulations will be promulgated or design changes required or the effect that any such regulations or design changes, or the consideration thereof, may have upon the Beaver Valley and Perry plants. Although the Companies have no reason to anticipate an accident at any nuclear plant in which they have an interest, if such an accident did happen, it could have a material but presently undeterminable adverse effect on the Company's consolidated financial position. In addition, such an accident at any operating nuclear plant, whether or not owned by the Companies, could result in regulations or requirements that could affect the operation or licensing of plants that the Companies do own with a consequent but presently undeterminable adverse impact, and could affect the Companies' abilities to raise funds in the capital markets. Nuclear Insurance The Price-Anderson Act limits the public liability which can be assessed with respect to a nuclear power plant to $9,396,000,000 (assuming 116 units licensed to operate) for a single nuclear incident, which amount is covered by: (i) private insurance amounting to $200,000,000; and (ii) $9,196,000,000 provided by an industry retrospective rating plan required by the NRC pursuant thereto. Under such retrospective rating plan, in the event of a nuclear incident at any unit in the United States resulting in losses in excess of private insurance, up to $75,500,000 (but not more than $10,000,000 per unit per year in the event of more than one incident) must be contributed for each nuclear unit licensed to operate in the country by the licensees thereof to cover liabilities arising out of the incident. Based on their present ownership and leasehold interests in Beaver Valley Units 1 and 2 and Perry Unit 1, the Companies' maximum potential assessment under these provisions (assuming the other CAPCO companies were to contribute their proportionate share of any assessments under the retrospective rating plan) would be $102,800,000 per incident but not more than $13,000,000 in any one year for each incident. In addition to the public liability insurance provided pursuant to the Price-Anderson Act, the Companies have also obtained insurance coverage in limited amounts for economic loss and property damage arising out of nuclear incidents. The Companies are members of Nuclear Electric Insurance Limited (NEIL) which provides coverage (NEIL I) for the extra expense of replacement power incurred due to prolonged accidental outages of nuclear units. Under NEIL I, the Companies have policies, renewable yearly, corresponding to their respective interests in Beaver Valley Units 1 and 2 and Perry Unit 1, which provide an aggregate indemnity of up to approximately $313,000,000 for replacement power costs incurred during an outage after an initial 21-week waiting period. Members of NEIL I pay annual premiums and are subject to assessments if losses exceed the accumulated funds available to the insurer. The Companies' present maximum aggregate assessment for incidents at any covered nuclear facility occurring during a policy year would be approximately $3,300,000. The Companies are insured as to their respective interests in the Beaver Valley Station and Perry Plant under property damage insurance provided by American Nuclear Insurers (ANI) and Mutual Atomic Energy Liability Underwriters (MAELU) to the operating company for each plant. Under the ANI/MAELU arrangements, $500,000,000 of primary coverage and $850,000,000 of excess coverage for decontamination costs, debris removal and repair and/or replacement of property is provided for the Beaver Valley Station and the Perry Plant. The Companies pay annual premiums for this coverage and are not liable for retrospective assessments. A secondary level of coverage for the Beaver Valley Station and Perry Plant over and above the ANI/MAELU policy is provided by a decontamination liability, excess property and decommissioning liability insurance policy issued to each operating company by NEIL (NEIL II). Under NEIL II a minimum of $1,400,000,000 of coverage is available to pay costs required for decontamination operations in excess of the $1,350,000,000 provided by the primary ANI/MAELU policy. Additionally, a maximum of $250,000,000, as provided by NEIL II, would cover decommissioning costs in excess of funds already collected for decommissioning. Any remaining portion of the NEIL II proceeds after payment of decontamination costs will be available to pay excess property damage losses. Members of NEIL II pay annual premiums and are subject to assessments if losses exceed the accumulated funds available to the insurer. The Companies' present maximum assessment for NEIL II coverage for accidents at any covered nuclear facility occurring during a policy year would be approximately $12,100,000. The NEIL II policy is renewable yearly. The Companies intend to maintain insurance against nuclear risks as described above as long as it is available. To the extent that replacement power, property damage, decontamination, decommissioning, repair and replacement costs and other such costs arising from a nuclear incident at any of the Companies' plants exceed the policy limits of the insurance from time to time in effect with respect to that plant, to the extent a nuclear incident is determined not to be covered by the Companies' insurance policies, or to the extent such insurance becomes unavailable in the future, the Companies would remain at risk for such costs. The NRC requires nuclear power plant licensees to obtain minimum property insurance coverage of $1,060,000,000 or the amount generally available from private sources, whichever is less. The proceeds of this insurance are required to be used first to ensure that the licensed reactor is in a safe and stable condition and can be maintained in that condition so as to prevent any significant risk to the public health and safety. Within 30 days of stabilization, the licensee is required to prepare and submit to the NRC a cleanup plan for approval. The plan is required to identify all cleanup operations necessary to decontaminate the reactor sufficiently to permit the resumption of operations or to commence decommissioning. Any property insurance proceeds not already expended to place the reactor in a safe and stable condition must be used first to complete those decontamination operations that are ordered by the NRC. The Companies are unable to predict what effect these requirements may have on the availability of insurance proceeds to the Companies for the Companies' bondholders. Environmental Matters Various federal, state and local authorities regulate the Companies with regard to air and water quality and other environmental matters. The Companies have estimated capital expenditures for environmental compliance of approximately $175,000,000, which is included in the construction estimate given under "Financing and Construction - Future Financing" for 1994 through 1998. Air Regulation Under the provisions of the Clean Air Act of 1970, both the State of Ohio and the Commonwealth of Pennsylvania adopted ambient air quality standards, and related emission limits, including limits for sulfur dioxide (SO2) and particulates. In addition, the U.S. Environmental Protection Agency (EPA) promulgated an SO2 regulatory plan for Ohio which became effective for the Company's plants in 1977. Generating plants to be constructed in the future and some future modifications of existing facilities will be covered not only by the applicable state standards but also by EPA emission performance standards for new sources. In both Ohio and Pennsylvania the construction or modification of emission sources requires approval from appropriate environmental authorities, and the facilities involved may not be operated unless a permit or variance to do so has been issued by those same authorities. The Clean Air Act Amendments of 1990 require significant reductions of SO2 and oxides of nitrogen from the Companies' coal-fired generating units by 1995 and additional emission reductions by 2000. Compliance options include, but are not limited to, installing additional pollution control equipment, burning less polluting fuel, purchasing emission allowances from others, operating existing facilities in a manner which minimizes pollution and retiring facilities. In compliance plans submitted to the PUCO and to the EPA, the Company stated that reductions for the years 1995 through 1999 are likely to be achieved by burning lower sulfur fuel, generating more electricity at its lower emitting plants and/or purchasing emission allowances. The Company continues to evaluate its compliance plans and other compliance options as they arise. Plans for complying with the year 2000 reductions are less certain at this time. The Companies are required to meet federally approved SO2 regulations, and the violations of such regulations can result in injunctive relief, including shutdown of the generating unit involved, and/or civil or criminal penalties of up to $25,000 per day of violation. The EPA has an interim enforcement policy for the SO2 regulations in Ohio which allows for compliance with the regulations based on a 30-day averaging period. The EPA has proposed regulations which could cause changes in the interim enforcement policy including a revision of methods of determining compliance with emission limits. The Companies cannot predict what action the EPA may take in the future with respect to the proposed regulations or the interim enforcement policy. Water Regulation Various water quality regulations, the majority of which are the result of the federal Clean Water Act and its amendments, apply to the Companies' plants. In addition, Ohio and Pennsylvania have water quality standards applicable to the Companies' operations. As provided in the Clean Water Act, authority to grant federal National Pollutant Discharge Elimination System (NPDES) water discharge permits can be assumed by a state. Ohio and Pennsylvania have assumed such authority. The Ohio Environmental Protection Agency (Ohio EPA) has issued NPDES Permits for the R.E. Burger, Edgewater, Niles, W.H. Sammis and West Lorain plants and has proposed a water discharge permit for the Mad River Plant. The West Lorain Plant is in compliance with all permit conditions. The other plants are in compliance with chemical limitations of the permits. The permit conditions would have required the addition of cooling towers at all of the above plants except West Lorain. However, the EPA and Ohio EPA have approved variance requests for the W.H. Sammis, R.E. Burger, Edgewater and Niles plants, eliminating the current need for cooling towers at those plants. Waste Disposal As a result of the Resource Conservation and Recovery Act of 1976, as amended, and the Toxic Substances Control Act of 1976, federal and state hazardous waste regulations have been promulgated. These regulations may result in significantly increased costs to dispose of waste materials. The ultimate effect of these requirements cannot presently be determined. The Pennsylvania Department of Environmental Resources has issued regulations dealing with the storage, treatment, transportation and disposal of residual waste such as coal ash and scrubber sludge. These regulations impose additional requirements relating to permitting, ground water monitoring, leachate collection systems, closure, liability insurance and operating matters. The Companies are developing and analyzing various compliance options and are currently unable to determine the ultimate increase in capital and operating costs at existing sites. Summary Environmental controls are still in the process of development and require, in many instances, balancing the needs for additional quantities of energy in future years and the need to protect the environment. As a result, the Companies cannot now estimate the precise effect of existing and potential regulations and legislation upon any of their existing and proposed facilities and operations or upon their ability to issue additional first mortgage bonds under their respective mortgages. These mortgages contain covenants by the Companies to observe and conform to all valid governmental requirements at the time applicable unless in course of contest, and provisions which, in effect, prevent the issuance of additional bonds if there is a completed default under the mortgage. The provisions of each of the mortgages, in effect, also require, in the opinion of counsel for the respective Companies, that certification of property additions as the basis for the issuance of bonds or other action under the mortgages be accompanied by an opinion of counsel that the company certifying such property additions has all governmental permissions at the time necessary for its then current ownership and operation of such property additions. The Companies intend to contest any requirements they deem unreasonable or impossible for compliance or otherwise contrary to the public interest. Developments in these and other areas of regulation may require the Companies to modify, supplement or replace equipment and facilities, and may delay or impede the construction and operation of new facilities, at costs which could be substantial. The Companies expect that the impact of any such costs would eventually be reflected in their rate schedules. Fuel Supply The Companies' sources of generation during 1993 were 81.9% coal and 18.1% nuclear. Over two-thirds of the Company's annual coal purchase requirements are supplied under long-term contracts. These contracts have minimum annual tonnage levels of approximately 5,900,000 tons (including the Company's portion of the coal purchase contract relating to the Bruce Mansfield Plant discussed below). This contract coal is produced primarily from mines located in Ohio, Pennsylvania, Kentucky and West Virginia; the contracts expire at various times through February 28, 2003. With the 1993 expiration of the long-term coal contract for the New Castle Plant, Penn Power's coal, other than that related to its interest in the Bruce Mansfield Plant and W. H. Sammis Unit 7, is currently supplied entirely through spot purchases of coal produced from nearby reserves. The Company and Penn Power estimate their 1994 coal requirements to be approximately 8,600,000 and 1,200,000 tons, respectively (including their respective shares of the coal requirements of CAPCO's W. H. Sammis Unit 7 and the Bruce Mansfield Plant). See "Environmental Matters" for factors pertaining to meeting environmental regulations affecting coal- fired generating units. The Companies, together with the other CAPCO companies, have each severally guaranteed (the Company's and Penn Power's composite percentages being approximately 46.7% and 6.7%, respectively) certain debt and lease obligations in connection with a coal supply contract for the Bruce Mansfield Plant (see Note 7 of Notes to Consolidated Financial Statements). As of December 31, 1993, the Companies' shares of the guarantees were $101,217,000. The price under the coal supply contract, which includes certain minimum payments, has been determined to be sufficient to satisfy the debt and lease obligations. This contract extends to December 31, 1999. The Companies' fuel costs (excluding disposal costs) for each of the five years ended December 31, 1993, were as follows: 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Cost of fuel consumed per million BTU's: Coal . . . . . . . . . . . . . . . . . . $1.37 $1.40 $1.40 $1.39 $1.34 Nuclear . . . . . . . . . . . . . . . . $ .76 $ .83 $ .87 $ .84 $ .90 Average fuel cost per kilowatt-hour generated (cents). . . . . . . . . . . . 1.31 1.31 1.34 1.34 1.34 Nuclear Fuel OES Fuel is the sole lessor for the Companies' nuclear fuel requirements (see "Financing and Construction - Future Financing" and Note 5E of Notes to Consolidated Financial Statements). The Companies and OES Fuel have contracts for the supply of uranium sufficient to meet projected needs through 2000 and conversion services sufficient to meet projected needs through 2001. Fabrication services for fuel assemblies have been contracted by the CAPCO companies for the next two reloads for Beaver Valley Unit 1, one reload for Beaver Valley Unit 2 (through approximately 1996 and 1995, respectively), and the next seven reloads for Perry Unit 1 (through approximately 2003). The CAPCO companies have a contract with the U.S. Enrichment Corporation for enrichment services for all CAPCO nuclear units through 2014. Prior to the expiration of existing commitments, the Companies intend to make additional arrangements for the supply of uranium and for the subsequent conversion, enrichment, fabrication, reprocessing and/or waste disposal services, the specific prices and availability of which are not known at this time. Due to the present lack of availability of domestic reprocessing services, to the continuing absence of any program to begin development of such reprocessing capability and questions as to the economics of reprocessing, the Companies are calculating nuclear fuel costs based on the assumption that spent fuel will not be reprocessed. On- site spent fuel storage facilities for the Perry Plant are expected to be adequate through 2010; facilities at Beaver Valley Units 1 and 2 are expected to be adequate through 2011 and 2005, respectively. After on-site storage capacity is exhausted, additional storage capacity will have to be obtained which could result in significant additional costs unless reprocessing services or permanent waste disposal facilities become available. The Federal Nuclear Waste Policy Act of 1982 provides for the construction of facilities for the disposal of high-level nuclear wastes, including spent fuel from nuclear power plants operated by electric utilities; however, the selection of a suitable site has become embroiled in the political process. Duquesne and CEI have each previously entered into contracts with the U.S. Department of Energy for the disposal of spent fuel from the Beaver Valley Power Station and the Perry Plant, respectively. System Capacity and Reserves The 1993 net maximum hourly demand on the Companies of 5,729,000 kW (including 450,000 kW of firm power sales which extend through 2005 as discussed under "Competition") occurred on July 28, 1993. The seasonal capability of the Companies on that day was 6,141,000 kW. Of that system capability, 6.6% was available to serve additional load, after giving effect to net firm purchases at that hour of 521,000 kW and term power sales to other utilities. Based on existing capacity, the load forecast made in November 1993 and anticipated term power sales to other utilities, the capacity margins during the 1994-1998 period are expected to range from about 5% to 9%. Regional Reliability The Company participates with 26 other electric companies operating in nine states in the East Central Area Reliability Coordination Agreement (ECAR), which was organized for the purpose of furthering the reliability of bulk power supply in the area through coordination of the planning and operation by the ECAR members of their bulk power supply facilities. The ECAR members have established principles and procedures regarding matters affecting the reliability of the bulk power supply within the ECAR region. Procedures have been adopted regarding: i) the evaluation and simulated testing of systems' performance; ii) the establishment of minimum levels of daily operating reserves; iii) the development of a program regarding emergency procedures during conditions of declining system frequency; and iv) the basis for uniform rating of generating equipment. Competition The Companies compete with other utilities for intersystem bulk power sales and for sales to municipalities and cooperatives. The Companies compete with suppliers of natural gas and other forms of energy in connection with their industrial and commercial sales and in the home climate control market, both with respect to new customers and conversions, and with all other suppliers of electricity. To date, there has been no substantial cogeneration by the Companies' customers. In an effort to more fully utilize their facilities and hold down rates to their other customers, the Companies have entered into a long- term power sales agreement with another utility. Currently, the Companies are selling 450,000 kW annually under this contract through December 31, 2005. The Companies have the option to reduce this commitment by 150,000 kW beginning June 1, 1996. Research and Development The Company participates in funding the Electric Power Research Institute (EPRI), which was formed for the purpose of expanding electric research and development under the voluntary sponsorship of the nation's utility industry - public, private and cooperative. Its goal is to mutually benefit utilities and their customers by promoting the development of new and improved technologies to help the utility industry meet present and future electric energy needs in environmentally and economically acceptable ways. EPRI conducts research on all aspects of electric power production and use, including fuels, generating, delivery, energy management and conservation, environmental effects and energy analysis. The major portion of EPRI research and development projects is directed toward practical solutions and their applications to problems currently facing the electric utility industry. In 1993, approximately 93% of the Company's research and development expenditures were related to EPRI. The Company also participates in various research and development efforts by sponsoring clean coal technology demonstration projects at Company-owned coal-fired units. These projects are designed to derive alternate ways of using coal that would otherwise be environmentally unacceptable. In addition to researching environmentally acceptable ways of burning coal, the Company is also researching technology which will produce ash waste with properties and characteristics different from present fly ash and bottom ash, with the initial goal of producing marketable products for use in agronomy applications. Executive Officers The executive officers are elected at the annual organization meeting of the Board of Directors, held immediately after the annual meeting of stockholders, and hold office until the next such organization meeting, unless the Board of Directors shall otherwise determine, or unless a resignation is submitted. Position Held During Name Age Past Five Years Dates ---- --- -------------------- ----- W. R. Holland 57 President and Chief Executive Officer 1993-present President and Chief Operating Officer 1991-1993 Senior Vice President of Detroit Edison Company *-1991 A. J. Alexander 42 Senior Vice President and General Counsel 1991-present Vice President and General Counsel 1989-1991 Associate General Counsel *-1989 Position Held During Name Age Past Five Years Dates ---- --- -------------------- ----- H. P. Burg 47 Senior Vice President and Chief Financial Officer 1989-present Vice President-Treasury and Budget *-1989 R. J. McWhorter 61 Senior Vice President- Generating Plant and Transmission Operations *-present A. R. Garfield 55 Vice President-System Operations 1991-present Manager, System Operations *-1991 J. A. Gill 56 Vice President- Administration *-present A. N. Gorant 63 Vice President-Division Operations and Customer Service *-present B. M. Miller 61 Vice President-Engineering and Construction *-present D. L. Yeager 59 Vice President-Special Projects *-present D. P. Zeno 63 Vice President-Governmental Affairs 1991-present Manager, Governmental Affairs *-1991 G. F. LaFlame 45 Secretary *-present R. H. Marsh 43 Treasurer 1991-present Manager, Assets Administration 1989-1991 Director, Benefits Investment Administration *-1989 H. L. Wagner 41 Comptroller 1990-present Assistant Comptroller *-1990 *Indicates position held at least since January 1, 1989. At December 31, 1993, the Company had 4,623 employees and Penn Power had 1,355 employees for a total of 5,978 employees for the Companies. ITEM 2. ITEM 2. PROPERTIES The Companies' respective first mortgage indentures constitute, in the opinion of the Companies' counsel, direct first liens on substantially all of the respective Companies' physical property, subject only to excepted encumbrances, as defined in the Indentures. See Notes 4 and 5 to the Consolidated Financial Statements for information concerning leases and financing encumbrances affecting certain of the Companies' properties. The Companies own, individually or, together with one or more of the other CAPCO companies as tenants in common, and/or lease, the generating units in service shown on the table below. Net Demonstrated Interest Capacity (kW) ----------------------- --------------------------- Penn Companies' Ohio Edison Power -------------- Plant-Location Unit Total Entitlement Owned Leased Owned - ---------------- ---- -------- ----------- ------ ------ ----- Coal-Fired Units R.E. Burger- 1-5 518,000 518,000 100.00% - - Shadyside, OH B. Mansfield- 1 780,000 501,000 60.00% - 4.20% Shippingport, PA 2 780,000 360,000 39.30% - 6.80% 3 800,000 335,000 35.60% - 6.28% New Castle- 3-5 333,000 333,000 - - 100.00% W. Pittsburg, PA Niles-Niles, OH 1-2 216,000 216,000 100.00% - - W.H. Sammis- 1-6 1,620,000 1,620,000 100.00% - - Stratton, OH 7 600,000 413,000 48.00% - 20.80% Nuclear Units Beaver Valley- 1 810,000 425,000 35.00% - 17.50% Shippingport, PA 2 820,000 343,000 20.22% 21.66% - Perry- 1 1,194,000 421,000 17.42% 12.58% 5.24% North Perry Village, OH Oil-Fired Units Various 164,000 164,000 84.82% - 15.18% --------- Total 5,649,000 ========= Prolonged outages of existing generating units might make it necessary for the Companies, depending upon the state of demand from time to time for electric service upon their system, to use to a greater extent than otherwise, less efficient and less economic generating units, or purchased power, and in some cases may require the reduction of load during peak periods under the Companies' interruptible programs, all to an extent not presently determinable. The Companies' generating plants and load centers are connected by a transmission system consisting of elements having various voltage ratings ranging from 23 kilovolts (kV) to 345 kV. The Companies' transmission lines aggregate 4,547 miles. The Companies' electric distribution systems include 25,173 miles of pole line carrying primary, secondary and street lighting circuits. They own, individually or, together with one or more of the other CAPCO companies as tenants in common, 436 substations with a total installed transformer capacity of 23,394,654 kilovolt-amperes, of which 64 are transmission substations, including 8 located at generating plants. The Company's transmission lines also interconnect with those of CEI, Columbus Southern Power Company, The Dayton Power and Light Company, Duquesne, Monongahela Power Company, Ohio Power Company and Toledo; Penn Power's interconnect with those of Duquesne and West Penn Power Company. These interconnections make possible utilization by the Company and Penn Power of generating capacity constructed as a part of the CAPCO program, as well as providing opportunities for the sale of power to other utilities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS See "Item 1 - Business - Nuclear Regulation" for information with respect to legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by Items 5 through 8 is incorporated herein by reference to the Common Stock Data, Classification of Holders of Common Stock as of December 31, 1993, Selected Financial Data, Management's Discussion and Analysis of Results of Operations and Financial Condition, and Consolidated Financial Statements included on pages 16 through 33 in the Company's 1993 Annual Report to Stockholders. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10, with respect to Identification of Directors and with respect to reports required to be filed under Section 16 of the Securities Exchange Act of 1934, is incorporated herein by reference to the Company's 1994 Proxy Statement filed with the Securities and Exchange Commission (SEC) pursuant to Regulation 14A and, with respect to Identification of Executive Officers, to "Part I, Item 1. Business- Executive Officers" herein. ITEM 11. ITEM 11.EXECUTIVE COMPENSATION ITEM 12. ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Items 11, 12 and 13 is incorporated herein by reference to the Company's 1994 Proxy Statement filed with the SEC pursuant to Regulation 14A. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements Included in Part II of this report and incorporated herein by reference to the Company's 1993 Annual Report to Stockholders (Exhibit 13 below) at the pages indicated. Page No. -------- Consolidated Statements of Income-Three Years Ended December 31, 1993 . . . . . . . . . . . . . . . . . . . . 20 Consolidated Balance Sheets-December 31, 1993 and 1992. . . . . 21 Consolidated Statements of Capitalization- December 31, 1993 and 1992. . . . . . . . . . . . . . . . . 22-23 Consolidated Statements of Retained Earnings-Three Years Ended December 31, 1993 . . . . . . . . . . . . . . . . . . 24 Consolidated Statements of Capital Stock and Other Paid-In Capital-Three Years Ended December 31, 1993 . . . . 24 Consolidated Statements of Cash Flows-Three Years Ended December 31, 1993 . . . . . . . . . . . . . . . . . . 25 Consolidated Statements of Taxes-Three Years Ended December 31, 1993 . . . . . . . . . . . . . . . . . . 26 Notes to Consolidated Financial Statements. . . . . . . . . . . 27-33 Report of Independent Public Accountants. . . . . . . . . . . . 33 2. Financial Statement Schedules Included in Part IV of this report: Page No. -------- Report of Independent Public Accountants on Schedules . . . . 35 Schedules - Three Years Ended December 31, 1993: V - Consolidated Property, Plant and Equipment. . . . 36-38 VI - Consolidated Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment . . . . . . . . . . . . . . 39-41 VIII - Consolidated Valuation and Qualifying Accounts and Reserves . . . . . . . . . . . . . 42 IX - Consolidated Short-Term Borrowings. . . . . . . . 43 X - Supplementary Consolidated Income Statement Information . . . . . . . . . . . . . . . . . . . 44 Schedules other than those listed above are omitted for the reason that they are not required or are not applicable, or the required information is shown in the financial statements or notes thereto. 3. Exhibits Exhibit Number - ------- 3-1- Amended Articles of Incorporation, Effective August 5, 1993, constituting the Company's Articles of Incorporation. (Registration No. 33-51139, Exhibit (3)(b).) 3-2- Code of Regulations of the Company as amended April 24, 1986. (Registration No. 33-5081, Exhibit (4)(d).) (B)4-1- Indenture dated as of August 1, 1930 between the Company and Bankers Trust Company, as Trustee, as amended and supplemented by Supplemental Indentures: Dated as of File Reference Exhibit No. ----------- -------------- ----------- March 3, 1931 2-1725 B-1,B-1(a),B-1(b) November 1, 1935 2-2721 B-4 January 1, 1937 2-3402 B-5 September 1, 1937 Form 8-A B-6 June 13, 1939 2-5462 7(a)-7 August 1, 1974 Form 8-A, August 28, 1974 2(b) July 1, 1976 Form 8-A, July 28, 1976 2(b) December 1, 1976 Form 8-A, December 15, 1976 2(b) June 15, 1977 Form 8-A, June 27, 1977 2(b) Supplemental Indentures: Dated as of File Reference Exhibit No. ----------- -------------- ----------- September 1, 1944 2-61146 2(b)(2) April 1, 1945 2-61146 2(b)(2) September 1, 1948 2-61146 2(b)(2) May 1, 1950 2-61146 2(b)(2) January 1, 1954 2-61146 2(b)(2) May 1, 1955 2-61146 2(b)(2) August 1, 1956 2-61146 2(b)(2) March 1, 1958 2-61146 2(b)(2) April 1, 1959 2-61146 2(b)(2) June 1, 1961 2-61146 2(b)(2) September 1, 1969 2-34351 2(b)(2) May 1, 1970 2-37146 2(b)(2) September 1, 1970 2-38172 2(b)(2) June 1, 1971 2-40379 2(b)(2) August 1, 1972 2-44803 2(b)(2) September 1, 1973 2-48867 2(b)(2) May 15, 1978 2-66957 2(b)(4) February 1, 1980 2-66957 2(b)(5) April 15, 1980 2-66957 2(b)(6) June 15, 1980 2-68023 (b)(4)(b)(5) October 1, 1981 2-74059 (4)(d) October 15, 1981 2-75917 (4)(e) February 15, 1982 2-75917 (4)(e) July 1, 1982 2-89360 (4)(d) March 1, 1983 2-89360 (4)(e) March 1, 1984 2-89360 (4)(f) September 15, 1984 2-92918 (4)(d) September 27, 1984 33-2576 (4)(d) November 8, 1984 33-2576 (4)(d) December 1, 1984 33-2576 (4)(d) December 5, 1984 33-2576 (4)(e) January 30, 1985 33-2576 (4)(e) February 25, 1985 33-2576 (4)(e) July 1, 1985 33-2576 (4)(e) October 1, 1985 33-2576 (4)(e) January 15, 1986 33-8791 (4)(d) May 20, 1986 33-8791 (4)(d) June 3, 1986 33-8791 (4)(e) October 1, 1986 33-29827 (4)(d) July 15, 1989 33-34663 (4)(d) August 25, 1989 33-34663 (4)(d) February 15, 1991 33-39713 (4)(d) May 1, 1991 33-45751 (4)(d) May 15, 1991 33-45751 (4)(d) Exhibit Number Supplemental Indentures: (Cont'd) - ------- Dated as of File Reference Exhibit No. ----------- -------------- ----------- September 15, 1991 33-45751 (4)(d) April 1, 1992 33-48931 (4)(d) June 15, 1992 33-48931 (4)(d) September 15, 1992 33-48931 (4)(e) April 1, 1993 33-51139 (4)(d) June 15, 1993 33-51139 (4)(d) September 15, 1993 33-51139 (4)(d) November 15, 1993 (A) 4-2 10-1- Administration Agreement between the CAPCO Group dated as of September 14, 1967. (Registration No. 2-43102, Exhibit 5(c)(2).) 10-2- Amendment No. 1 dated January 4, 1974 to Administration Agreement between the CAPCO Group dated as of September 14, 1967. (Registration No. 2-68906, Exhibit 5(c)(3).) 10-3- Transmission Facilities Agreement between the CAPCO Group dated as of September 14, 1967. (Registration No. 2-43102, Exhibit 5(c)(3).) (A)10-4- Amendment No. 1 dated as of January 1, 1993 to Transmission Facilities Agreement between the CAPCO Group dated as of September 14, 1967. 10-5- Agreement for the Termination or Construction of Certain Agreements effective September 1, 1980 among the CAPCO Group. (Registration No. 2-68906, Exhibit 10-4.) (A)10-6- Amendment dated as of December 23, 1993 to Agreement for the Termination or Construction of Certain Agreements effective September 1, 1980 among the CAPCO Group. 10-7- CAPCO Basic Operating Agreement, as amended September 1, 1980. (Registration No. 2-68906, Exhibit 10-5.) 10-8- Amendment No. 1 dated August 1, 1981, and Amendment No. 2 dated September 1, 1982 to CAPCO Basic Operating Agreement, as amended September 1, 1980. (September 30, 1981 Form 10-Q, Exhibit 20-1 and 1982 Form 10-K, Exhibit 19-3, respectively.) 10-9- Amendment No. 3 dated July 1, 1984 to CAPCO Basic Operating Agreement, as amended September 1, 1980. (1985 Form 10-K, Exhibit 10-7.) 10-10- Basic Operating Agreement between the CAPCO Companies as amended October 1, 1991. (1991 Form 10-K, Exhibit 10-8.) Exhibit Number - ------- (A)10-11- Basic Operating Agreement between the CAPCO Companies as amended January 1, 1993. 10-12- Memorandum of Agreement effective as of September 1, 1980 among the CAPCO Group. (1982 Form 10-K, Exhibit 19-2.) 10-13- Operating Agreement for Beaver Valley Power Station Units Nos. 1 and 2 as Amended and Restated September 15, 1987, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 10-15.) 10-14- Construction Agreement with respect to Perry Plant between the CAPCO Group dated as of July 22, 1974. (Registration No. 2- 52251 of Toledo Edison Company, Exhibit 5(yy).) 10-15- Participation Agreement No. 1 relating to the financing of the development of certain coal mines, dated as of October 1, 1973, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration No. 2-61146, Exhibit 5(e)(1).) 10-16- Amendment No. 1 dated as of September 15, 1978 to Participation Agreement No. 1 dated as of October 1, 1973 among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland as Owner Trustee, National City Bank as Loan Trustee and National City Bank as Bond Trustee. (Registration No. 2-68906 of Pennsylvania Power Company, Exhibit 5(e)(2).) 10-17- Participation Agreement No. 2 relating to the financing of the development of certain coal mines, dated as of August 1, 1974, among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland, as Owner Trustee, National City Bank, as Loan Trustee, and National City Bank, as Bond Trustee. (Registration No. 2-53059, Exhibit 5(h)(2).) 10-18- Amendment No. 1 dated as of September 15, 1978 to Participation Agreement No. 2 dated as of August 1, 1974 among Quarto Mining Company, the CAPCO Group, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland as Owner Trustee, National City Bank as Loan Trustee and National City Bank as Bond Trustee. (Registration No. 2-68906 of Pennsylvania Power Company, Exhibit 5(e)(4).) 10-19- Participation Agreement No. 3 dated as of September 15, 1978 among Quarto Mining Company, the CAPCO Companies, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants listed in Schedules A and B thereto, Central National Bank of Cleveland as Owner Trustee, and National City Bank as Loan Trustee and Bond Trustee. (Registration No. 2-68906 of Pennsylvania Power Company, Exhibit 5(e)(5).) Exhibit Number - ------- 10-20- Participation Agreement No. 4 dated as of October 31, 1980 among Quarto Mining Company, the CAPCO Group, the Loan Participants listed in Schedule A thereto and National City Bank as Bond Trustee. (Registration No. 2- 68906 of Pennsylvania Power Company, Exhibit 10-16.) 10-21- Participation Agreement dated as of May 1, 1986, among Quarto Mining Company, the CAPCO Companies, the Loan Participants thereto, and National City Bank as Bond Trustee. (1986 Form 10-K, Exhibit 10-22.) 10-22- Participation Agreement No. 6 dated as of December 1, 1991 among Quarto Mining Company, The Cleveland Electric Illuminating Company, Duquesne Light Company, Ohio Edison Company, Pennsylvania Power Company, the Toledo Edison Company, the Loan Participants listed in Schedule A thereto, National City Bank, as Mortgage Bond Trustee and National City Bank, as Refunding Bond Trustee. (1991 Form 10-K, Exhibit 10- 19.) 10-23- Agreement entered into as of October 20, 1981 among the CAPCO Companies regarding the use of Quarto coal at Mansfield Units 1, 2 and 3. (1981 Form 10-K, Exhibit 20-1.) 10-24- Restated Option Agreement dated as of May 1, 1983 by and between the North American Coal Corporation and the CAPCO Companies. (1983 Form 10-K, Exhibit 19-1.) 10-25- Trust Indenture and Mortgage dated as of October 1, 1973 between Quarto Mining Company and National City Bank, as Bond Trustee, together with Guaranty dated as of October 1, 1973 with respect thereto by the CAPCO Group. (Registration No. 2- 61146, Exhibit 5(e)(5).) 10-26- Amendment No. 1 dated August 1, 1974 to Trust Indenture and Mortgage dated as of October 1, 1973 between Quarto Mining Company and National City Bank, as Bond Trustee, together with Amendment No. 1 dated August 1, 1974 to Guaranty dated as of October 1, 1973 with respect thereto by the CAPCO Group. (Registration No. 2-53059, Exhibit 5(h)(2).) 10-27- Amendment No. 2 dated as of September 15, 1978 to the Trust Indenture and Mortgage dated as of October 1, 1973, as amended, between Quarto Mining Company and National City Bank, as Bond Trustee, together with Amendment No. 2 dated as of September 15, 1978 to Guaranty dated as of October 1, 1973 with respect to the CAPCO Group. (Registration No. 2-68906 of Pennsylvania Power Company, Exhibits 5(e)(11) and 5(e)(12).) 10-28- Amendment No. 3 dated as of October 31, 1980, to Trust Indenture and Mortgage dated as of October 1, 1973, as amended between Quarto Mining Company and National City Bank as Bond Trustee. (Registration No. 2-68906 of Pennsylvania Power Company, Exhibit 10-16.) Exhibit Number - ------- 10-29- Amendment No. 4 dated as of July 1, 1985 to the Trust Indenture and Mortgage dated as of October 1, 1973, as amended between Quarto Mining Company and National City Bank as Bond Trustee. (1985 Form 10-K, Exhibit 10-28.) 10-30- Amendment No. 5 dated as of May 1, 1986, to the Trust Indenture and Mortgage between Quarto and National City Bank as Bond Trustee. (1986 Form 10-K, Exhibit 10-30.) 10-31- Amendment No. 6 dated as of December 1, 1991, to the Trust Indenture and Mortgage dated as of October 1, 1973, between Quarto Mining Company and National City Bank, as Bond Trustee. (1991 Form 10-K, Exhibit 10-28.) 10-32- Trust Indenture dated as of December 1, 1991, between Quarto Mining Company and National City Bank, as Bond Trustee. (1991 Form 10-K, Exhibit 10-29.) 10-33- Amendment No. 3 dated as of October 31, 1980 to the Bond Guaranty dated as of October 1, 1973, as amended, with respect to the CAPCO Group. (Registration No. 2- 68906 of Pennsylvania Power Company, Exhibit 10-16.) 10-34- Amendment No. 4 dated as of July 1, 1985 to the Bond Guaranty dated as of October 1, 1973, as amended, by the CAPCO Companies to National City Bank as Bond Trustee. (1985 Form 10-K, Exhibit 10-30.) 10-35- Amendment No. 5 dated as of May 1, 1986, to the Bond Guaranty by the CAPCO Companies to National City Bank as Bond Trustee. (1986 Form 10-K, Exhibit 10-33.) 10-36- Amendment No. 6A dated as of December 1, 1991, to the Bond Guaranty dated as of October 1, 1973, by The Cleveland Electric Illuminating Company, Duquesne Light Company, Ohio Edison Company, Pennsylvania Power Company, the Toledo Edison Company to National City Bank, as Bond Trustee. (1991 Form 10- K, Exhibit 10-33.) 10-37- Amendment No. 6B dated as of December 30, 1991, to the Bond Guaranty dated as of October 1, 1973 by The Cleveland Electric Illuminating Company, Duquesne Light Company, Ohio Edison Company, Pennsylvania Power Company, the Toledo Edison Company to National City Bank, as Bond Trustee. (1991 Form 10-K, Exhibit 10-34.) 10-38- Bond Guaranty dated as of December 1, 1991, by The Cleveland Electric Illuminating Company, Duquesne Light Company, Ohio Edison Company, Pennsylvania Power Company, the Toledo Edison Company to National City Bank, as Bond Trustee. (1991 Form 10- K, Exhibit 10-35.) Exhibit Number - ------- 10-39- Open end Mortgage dated as of October 1, 1973 between Quarto Mining Company and the CAPCO Companies and Amendment No. 1 thereto, dated as of September 15, 1978. (Registration No. 2- 68906 of Pennsylvania Power Company, Exhibit 10-23.) 10-40- Repayment and Security Agreement and Assignment of Lease dated as of October 1, 1973 between Quarto Mining Company and Ohio Edison Company as Agent for the CAPCO Companies and Amendment No. 1 thereto, dated as of September 15, 1978. (1980 Form 10- K, Exhibit 20-2.) 10-41- Restructuring Agreement dated as of April 1, 1985 among Quarto Mining Company, the Company and the other CAPCO Companies, Energy Properties, Inc., General Electric Credit Corporation, the Loan Participants signatories thereto, Central National Bank of Cleveland, as Owner Trustee and National City Bank as Loan Trustee and Bond Trustee. (1985 Form 10-K, Exhibit 10- 33.) 10-42- Unsecured Note Guaranty dated as of July 1, 1985 by the CAPCO Companies to General Electric Credit Corporation. (1985 Form 10-K, Exhibit 10-34.) 10-43- Memorandum of Understanding dated March 31, 1985 among the CAPCO Companies. (1985 Form 10-K, Exhibit 10-35.) (C)10-44- Ohio Edison Company Executive Incentive Compensation Plan. (1984 Form 10-K, Exhibit 19-2.) (C)10-45- Ohio Edison Company Executive Incentive Compensation Plan as amended February 16, 1987. (1986 Form 10-K, Exhibit 10-40.) (C)10-46- Restated and Amended Executive Deferred Compensation Plan. (1989 Form 10-K, Exhibit 10-36.) (C)10-47- Restated and Amended Supplemental Executive Retirement Plan. (1989 Form 10-K, Exhibit 10-37). (D)10-48- Participation Agreement dated as of March 16, 1987 among Perry One Alpha Limited Partnership, as Owner Participant, the Original Loan Participants listed in Schedule 1 Hereto, as Original Loan Participants, PNPP Funding Corporation, as Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee and Ohio Edison Company, as Lessee. (1986 Form 10-K, Exhibit 28- 1.) (D)10-49- Amendment No. 1 dated as of September 1, 1987 to Participation Agreement dated as of March 16, 1987 among Perry One Alpha Limited Partnership, as Owner Participant, the Original Loan Participants listed in Schedule 1 thereto, as Original Loan Participants, PNPP Funding Corporation, as Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company (now The Bank of New York), as Indenture Trustee, and Ohio Edison Company, as Lessee. (1991 Form 10-K, Exhibit 10-46.) Exhibit Number - ------- (D)10-50- Amendment No. 3 dated as of May 16, 1988 to Participation Agreement dated as of March 16, 1987, as amended among Perry One Alpha Limited Partnership, as Owner Participant, PNPP Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee, and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10- 47.) (D)10-51- Amendment No. 4 dated as of November 1, 1991 to Participation Agreement dated as of March 16, 1987 among Perry One Alpha Limited Partnership, as Owner Participant, PNPP Funding Corporation, as Funding Corporation, PNPP II Funding Corporation, as New Funding Corporation, The First National Bank of Boston, as Owner Trustee, The Bank of New York, as Indenture Trustee and Ohio Edison Company, as Lessee. (1991 Form 10-K, Exhibit 10-47.) (D)10-52- Amendment No. 5 dated as of November 24, 1992 to Participation Agreement dated as of March 16, 1987, as amended, among Perry One Alpha Limited Partnership, as Owner Participant, PNPP Funding Corporation, as Funding Corporation, PNPPII Funding Corporation, as New Funding Corporation, The First National Bank of Boston, as Owner Trustee, The Bank of New York, as Indenture Trustee and Ohio Edison Company as Lessee. (1992 Form 10-K, Exhibit 10-49.) (D)10-53- Amendment No. 6 dated as of January 12, 1993 to Participation Agreement dated as of March 16, 1987 among Perry One Alpha Limited Partnership, as Owner Participant, PNPP Funding Corporation, as Funding Corporation, PNPP II Funding Corporation, as New Funding Corporation, The First National Bank of Boston, as Owner Trustee, The Bank of New York, as Indenture Trustee and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10-50.) (D)10-54- Facility Lease dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee, with Perry One Alpha Limited Partnership, Lessor, and Ohio Edison Company, Lessee. (1986 Form 10-K, Exhibit 28-2.) (D)10-55- Amendment No. 1 dated as of September 1, 1987 to Facility Lease dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee, Lessor and Ohio Edison Company, Lessee. (1991 Form 10-K, Exhibit 10-49.) (D)10-56- Amendment No. 2 dated as of November 1, 1991, to Facility Lease dated as of March 16, 1987, between The First National Bank of Boston, as Owner Trustee, Lessor and Ohio Edison Company, Lessee. (1991 Form 10-K, Exhibit 10-50.) (D)10-57- Amendment No. 3 dated as of November 24, 1992 to Facility Lease dated as of March 16, 1987, as amended, between The First National Bank of Boston, as Owner Trustee, with Perry One Alpha Limited Partnership, as Owner Participant and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10-54.) Exhibit Number - ------- (D)10-58- Letter Agreement dated as of March 19, 1987 between Ohio Edison Company, Lessee, and The First National Bank of Boston, as Owner Trustee under a Trust dated March 16, 1987 with Chase Manhattan Realty Leasing Corporation, required by Section 3(d) of the Facility Lease. (1986 Form 10-K, Exhibit 28-3.) (D)10-59- Ground Lease dated as of March 16, 1987 between Ohio Edison Company, Ground Lessor, and The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with the Owner Participant, Tenant. (1986 Form 10-K, Exhibit 28-4.) (D)10-60- Trust Agreement dated as of March 16, 1987 between Perry One Alpha Limited Partnership, as Owner Participant, and The First National Bank of Boston. (1986 Form 10-K, Exhibit 28-5.) (D)10-61- Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee under a Trust Agreement dated as of March 16, 1987 with Perry One Alpha Limited Partnership, and Irving Trust Company, as Indenture Trustee. (1986 Form 10-K, Exhibit 28-6.) (D)10-62- Supplemental Indenture No. 1 dated as of September 1, 1987 to Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of March 16, 1987 between The First National Bank of Boston as Owner Trustee and Irving Trust Company (now The Bank of New York), as Indenture Trustee. (1991 Form 10-K, Exhibit 10-55.) (D)10-63- Supplemental Indenture No. 2 dated as of November 1, 1991 to Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee and The Bank of New York, as Indenture Trustee. (1991 Form 10-K, Exhibit 10-56.) (D)10-64- Tax Indemnification Agreement dated as of March 16, 1987 between Perry One, Inc. and PARock Limited Partnership as General Partners and Ohio Edison Company, as Lessee. (1986 Form 10-K, Exhibit 28-7.) (D)10-65- Amendment No. 1 dated as of November 1, 1991 to Tax Indemnification Agreement dated as of March 16, 1987 between Perry One, Inc. and Parock Limited Partnership and Ohio Edison Company. (1991 Form 10-K, Exhibit 10-58.) (D)10-66- Partial Mortgage Release dated as of March 19, 1987 under the Indenture between Ohio Edison Company and Bankers Trust Company, as Trustee, dated as of the 1st day of August, 1930. (1986 Form 10-K, Exhibit 28-8.) (D)10-67- Assignment, Assumption and Further Agreement dated as of March 16, 1987 among The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Perry One Alpha Limited Partnership, The Cleveland Electric Illuminating Company, Duquesne Light Company, Ohio Edison Company, Pennsylvania Power Company and Toledo Edison Company. (1986 Form 10-K, Exhibit 28-9.) Exhibit Number - ------- (D)10-68- Additional Support Agreement dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Perry One Alpha Limited Partnership, and Ohio Edison Company. (1986 Form 10-K, Exhibit 28-10.) (D)10-69- Bill of Sale, Instrument of Transfer and Severance Agreement dated as of March 19, 1987 between Ohio Edison Company, Seller, and The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Perry One Alpha Limited Partnership. (1986 Form 10-K, Exhibit 28- 11.) (D)10-70- Easement dated as of March 16, 1987 from Ohio Edison Company, Grantor, to The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Perry One Alpha Limited Partnership, Grantee. (1986 Form 10-K, File Exhibit 28-12.) 10-71- Participation Agreement dated as of March 16, 1987 among Security Pacific Capital Leasing Corporation, as Owner Participant, the Original Loan Participants listed in Schedule 1 Hereto, as Original Loan Participants, PNPP Funding Corporation, as Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee and Ohio Edison Company, as Lessee. (1986 Form 10-K, as Exhibit 28-13.) 10-72- Amendment No. 1 dated as of September 1, 1987 to Participation Agreement dated as of March 16, 1987 among Security Pacific Capital Leasing Corporation, as Owner Participant, The Original Loan Participants Listed in Schedule 1 thereto, as Original Loan Participants, PNPP Funding Corporation, as Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee and Ohio Edison Company, as Lessee. (1991 Form 10-K, Exhibit 10- 65.) 10-73- Amendment No. 4 dated as of November 1, 1991, to Participation Agreement dated as of March 16, 1987 among Security Pacific Capital Leasing Corporation, as Owner Participant, PNPP Funding Corporation, as Funding Corporation, PNPP II Funding Corporation, as New Funding Corporation, The First National Bank of Boston, as Owner Trustee, The Bank of New York, as Indenture Trustee and Ohio Edison Company, as Lessee. (1991 Form 10-K, Exhibit 10-66.) 10-74- Amendment No. 5 dated as of November 24, 1992 to Participation Agreement dated as of March 16, 1987 as amended among Security Pacific Capital Leasing Corporation, as Owner Participant, PNPP Funding Corporation, as Funding Corporation, PNPP II Funding Corporation, as New Funding Corporation, The First National Bank of Boston, as Owner Trustee, The Bank of New York, as Indenture Trustee and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10-71.) Exhibit Number - ------- 10-75- Facility Lease dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee, with Security Pacific Capital Leasing Corporation, Lessor, and Ohio Edison Company, as Lessee. (1986 Form 10-K, Exhibit 28-14.) 10-76- Amendment No. 1 dated as of September 1, 1987 to Facility Lease dated as of March 16, 1987 between The First National Bank of Boston as Owner Trustee, Lessor and Ohio Edison Company, Lessee. (1991 Form 10-K, Exhibit 10-68.) 10-77- Amendment No. 2 dated as of November 1, 1991 to Facility Lease dated as of March 16, 1987 between The First National Bank of Boston as Owner Trustee, Lessor and Ohio Edison Company, Lessee. (1991 Form 10-K, Exhibit 10-69.) 10-78- Amendment No. 3 dated as of November 24, 1992 to Facility Lease dated as of March 16, 1987, as amended, between, The First National Bank of Boston, as Owner Trustee, with Security Pacific Capital Leasing Corporation, as Owner Participant and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10- 75.) 10-79- Amendment No. 4 dated as of January 12, 1993 to Facility Lease dated as of March 16, 1987 as amended between, The First National Bank of Boston, as Owner Trustee, with Security Pacific Capital Leasing Corporation, as Owner Participant, and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10- 76.) 10-80- Letter Agreement dated as of March 19, 1987 between Ohio Edison Company, as Lessee, and The First National Bank of Boston, as Owner Trustee under a Trust, dated as of March 16, 1987, with Security Pacific Capital Leasing Corporation, required by Section 3(d) of the Facility Lease. (1986 Form 10- K, Exhibit 28-15.) 10-81- Ground Lease dated as of March 16, 1987 between Ohio Edison Company, Ground Lessor, and The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Perry One Alpha Limited Partnership, Tenant. (1986 Form 10-K, Exhibit 28-16.) 10-82- Trust Agreement dated as of March 16, 1987 between Security Pacific Capital Leasing Corporation, as Owner Participant, and The First National Bank of Boston. (1986 Form 10-K, Exhibit 28-17.) 10-83- Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Security Pacific Capital Leasing Corporation, and Irving Trust Company, as Indenture Trustee. (1986 Form 10-K, Exhibit 28-18.) 10-84- Supplemental Indenture No. 1 dated as of September 1, 1987 to Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee and Irving Trust Company (now The Bank of New York), as Indenture Trustee. (1991 Form 10-K, Exhibit 10-74.) Exhibit Number - ------- 10-85- Supplemental Indenture No. 2 dated as of November 1, 1991 to Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee and The Bank of New York, as Indenture Trustee. (1991 Form 10-K, Exhibit 10-75.) 10-86- Tax Indemnification Agreement dated as of March 16, 1987 between Security Pacific Capital Leasing Corporation, as Owner Participant, and Ohio Edison Company, as Lessee. (1986 Form 10-K, Exhibit 28-19.) 10-87- Amendment No. 1 dated as of November 1, 1991 to Tax Indemnification Agreement dated as of March 16, 1987 between Security Pacific Capital Leasing Corporation and Ohio Edison Company. (1991 Form 10-K, Exhibit 10-77.) 10-88- Assignment, Assumption and Further Agreement dated as of March 16, 1987 among The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Security Pacific Capital Leasing Corporation, The Cleveland Electric Illuminating Company, Duquesne Light Company, Ohio Edison Company, Pennsylvania Power Company and Toledo Edison Company. (1986 Form 10-K, Exhibit 28-20.) 10-89- Additional Support Agreement dated as of March 16, 1987 between The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Security Pacific Capital Leasing Corporation, and Ohio Edison Company. (1986 Form 10-K, Exhibit 28-21.) 10-90- Bill of Sale, Instrument of Transfer and Severance Agreement dated as of March 19, 1987 between Ohio Edison Company, Seller, and The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Security Pacific Capital Leasing Corporation, Buyer. (1986 Form 10-K, Exhibit 28-22.) 10-91- Easement dated as of March 16, 1987 from Ohio Edison Company, Grantor, to The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of March 16, 1987, with Security Pacific Capital Leasing Corporation, Grantee. (1986 Form 10-K, Exhibit 28-23.) 10-92- Refinancing Agreement dated as of November 1, 1991 among Perry One Alpha Limited Partnership, as Owner Participant, PNPP Funding Corporation, as Funding Corporation, PNPP II Funding Corporation, as New Funding Corporation, The First National Bank of Boston, as Owner Trustee, The Bank of New York, as Indenture Trustee, The Bank of New York, as Collateral Trust Trustee, The Bank of New York, as New Collateral Trust Trustee and Ohio Edison Company, as Lessee. (1991 Form 10-K, Exhibit 10-82.) Exhibit Number - ------- 10-93- Refinancing Agreement dated as of November 1, 1991 among Security Pacific Leasing Corporation, as Owner Participant, PNPP Funding Corporation, as Funding Corporation, PNPP II Funding Corporation, as New Funding Corporation, The First National Bank of Boston, as Owner Trustee, The Bank of New York, as Indenture Trustee, The Bank of New York, as Collateral Trust Trustee, The Bank of New York, as New Collateral Trust Trustee and Ohio Edison Company, as Lessee. (1991 Form 10-K, Exhibit 10-83.) (A)10-94- Ohio Edison Company Master Decommissioning Trust Agreement for Perry Nuclear Power Plant Unit One, Perry Nuclear Power Plant Unit Two, Beaver Valley Power Station Unit One and Beaver Valley Power Station Unit Two dated July 1, 1993. 10-95- Nuclear Fuel Lease dated as of March 31, 1989, between OES Fuel, Incorporated, as Lessor, and Ohio Edison Company, as Lessee. (1989 Form 10-K, Exhibit 10-62.) 10-96- Receivables Purchase Agreement dated as of November 28, 1989 between Ohio Edison Company and OES Capital, Incorporated. (1989 Form 10-K, Exhibit 10-63.) 10-97- Guarantee Agreement entered into by Ohio Edison Company dated as of January 17, 1991. (1990 Form 10-K, Exhibit 10-64). 10-98- Transfer and Assignment Agreement among Ohio Edison Company and Chemical Bank, as trustee under the OE Power Contract Trust. (1990 Form 10-K, Exhibit 10-65). 10-99- Renunciation of Payments and Assignment among Ohio Edison Company, Monongahela Power Company, West Penn Power Company, and the Potomac Edison Company dated as of January 4, 1991. (1990 Form 10-K, Exhibit 10-66). (E)10-100- Participation Agreement dated as of September 15, 1987, among Beaver Valley Two Pi Limited Partnership, as Owner Participant, the Original Loan Participants listed in Schedule 1 Thereto, as Original Loan Participants, BVPS Funding Corporation, as Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee and Ohio Edison Company, as Lessee. (1987 Form 10-K, Exhibit 28-1.) (E)10-101- Amendment No. 1 dated as of February 1, 1988, to Participation Agreement dated as of September 15, 1987, among Beaver Valley Two Pi Limited Partnership, as Owner Participant, the Original Loan Participants listed in Schedule 1 Thereto, as Original Loan Participants, BVPS Funding Corporation, as Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee and Ohio Edison Company, as Lessee. (1987 Form 10-K, Exhibit 28-2.) (E)10-102- Amendment No. 3 dated as of March 16, 1988 to Participation Agreement dated as ofSeptember 15, 1987, as amended, among Beaver Valley Two Pi Limited Partnership, as Owner Participant, BVPS Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10-99.) Exhibit Number - ------- (E)10-103- Amendment No. 4 dated as of November 5, 1992 to Participation Agreement dated as of September 15, 1987, as amended, among Beaver Valley Two Pi Limited Partnership, as Owner Participant, BVPS Funding Corporation, BVPS II Funding Corporation, The First National Bank of Boston, as Owner Trustee, The Bank of New York, as Indenture Trustee and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10-100.) (E)10-104- Facility Lease dated as of September 15, 1987, between The First National Bank of Boston, as Owner Trustee, with Beaver Valley Two Pi Limited Partnership, Lessor, and Ohio Edison Company, Lessee. (1987 Form 10-K, Exhibit 28-3.) (E)10-105- Amendment No. 1 dated as of February 1, 1988, to Facility Lease dated as of September 15, 1987, between The First National Bank of Boston, as Owner Trustee, with Beaver Valley Two Pi Limited Partnership, Lessor, and Ohio Edison Company, Lessee. (1987 Form 10-K, Exhibit 28-4.) (E)10-106- Amendment No. 2 dated as of November 5, 1992 to Facility Lease dated as of September 15, 1987, as amended, between The First National Bank of Boston, as Owner Trustee, with Beaver Valley Two Pi Limited Partnership, as Owner Participant, and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10-103.) (E)10-107- Ground Lease and Easement Agreement dated as of September 15, 1987, between Ohio Edison Company, Ground Lessor, and The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of September 15, 1987, with Beaver Valley Two Pi Limited Partnership, Tenant. (1987 Form 10-K, Exhibit 28- 5.) (E)10-108- Trust Agreement dated as of September 15, 1987, between Beaver Valley Two Pi Limited Partnership, as Owner Participant, and The First National Bank of Boston. (1987 Form 10-K, Exhibit 28-6.) (E)10-109- Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of September 15, 1987, between The First National Bank of Boston, as Owner Trustee under a Trust Agreement dated as of September 15, 1987, with Beaver Valley Two Pi Limited Partnership, and Irving Trust Company, as Indenture Trustee. (1987 Form 10-K, Exhibit 28-7.) (E)10-110- Supplemental Indenture No. 1 dated as of February 1, 1988 to Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of September 15, 1987 between The First National Bank of Boston, as Owner Trustee under a Trust Agreement dated as of September 15, 1987 with Beaver Valley Two Pi Limited Partnership and Irving Trust Company, as Indenture Trustee. (1987 Form 10-K, Exhibit 28-8.) (E)10-111- Tax Indemnification Agreement dated as of September 15, 1987, between Beaver Valley Two Pi Inc. and PARock Limited Partnership as General Partners and Ohio Edison Company, as Lessee. (1987 Form 10-K, Exhibit 28-9.) Exhibit Number - ------- (E)10-112- Tax Indemnification Agreement dated as of September 15, 1987, between HG Power Plant, Inc., as Limited Partner and Ohio Edison Company, as Lessee. (1987 Form 10-K, Exhibit 28-10.) (E)10-113- Assignment, Assumption and Further Agreement dated as of September 15, 1987, among The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of September 15, 1987, with Beaver Valley Two Pi Limited Partnership, The Cleveland Electric Illuminating Company, Duquesne Light Company, Ohio Edison Company, Pennsylvania Power Company and Toledo Edison Company. (1987 Form 10-K, Exhibit 28-11.) (E)10-114- Additional Support Agreement dated as of September 15, 1987, between The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of September 15, 1987, with Beaver Valley Two Pi Limited Partnership, and Ohio Edison Company. (1987 Form 10-K, Exhibit 28-12.) (F)10-115- Participation Agreement dated as of September 15, 1987, among Chrysler Consortium Corporation, as Owner Participant, the Original Loan Participants listed in Schedule 1 Thereto, as Original Loan Participants, BVPS Funding Corporation, as Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee and Ohio Edison Company, as Lessee. (1987 Form 10-K, Exhibit 28- 13.) (F)10-116- Amendment No. 1 dated as of February 1, 1988, to Participation Agreement dated as of September 15, 1987, among Chrysler Consortium Corporation, as Owner Participant, the Original Loan Participants listed in Schedule I Thereto, as Original Loan Participants, BVPS Funding Corporation, as Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee, and Ohio Edison Company, as Lessee. (1987 Form 10-K, Exhibit 28-14.) (F)10-117- Amendment No. 3 dated as of March 16, 1988 to Participation Agreement dated as of September 15, 1987, as amended, among Chrysler Consortium Corporation, as Owner Participant, BVPS Funding Corporation, The First National Bank of Boston, as Owner Trustee, Irving Trust Company, as Indenture Trustee, and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10- 114.) (F)10-118- Amendment No. 4 dated as of November 5, 1992 to Participation Agreement dated as of September 15, 1987, as amended, among Chrysler Consortium Corporation, as Owner Participant, BVPS Funding Corporation, BVPS II Funding Corporation, The First National Bank of Boston, as Owner Trustee, The Bank of New York, as Indenture Trustee and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10-115.) (F)10-119- Facility Lease dated as of September 15, 1987, between The First National Bank of Boston, as Owner Trustee, with Chrysler Consortium Corporation, Lessor, and Ohio Edison Company, as Lessee. (1987 Form 10-K, Exhibit 28-15.) Exhibit Number - ------- (F)10-120- Amendment No. 1 dated as of February 1, 1988, to Facility Lease dated as of September 15, 1987, between The First National Bank of Boston, as Owner Trustee, with Chrysler Consortium Corporation, Lessor, and Ohio Edison Company, Lessee. (1987 Form 10-K, Exhibit 28-16.) (F)10-121- Amendment No. 2 dated as of November 5, 1992 to Facility Lease dated as of September 15, 1987, as amended, between The First National Bank of Boston, as Owner Trustee, with Chrysler Consortium Corporation, as Owner Participant and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 118.) (F)10-122- Amendment No. 3 dated as of January 12, 1993 to Facility Lease dated as of September 15, 1987, as amended, between The First National Bank of Boston, as Owner Trustee, with Chrysler Consortium Corporation, as Owner Participant, and Ohio Edison Company, as Lessee. (1992 Form 10-K, Exhibit 10-119.) (F)10-123- Ground Lease and Easement Agreement dated as of September 15, 1987, between Ohio Edison Company, Ground Lessor, and The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of September 15, 1987, with Chrysler Consortium Corporation, Tenant. (1987 Form 10-K, Exhibit 28- 17.) (F)10-124- Trust Agreement dated as of September 15, 1987, between Chrysler Consortium Corporation, as Owner Participant, and The First National Bank of Boston. (1987 Form 10-K, Exhibit 28-18.) (F)10-125- Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of September 15, 1987, between the First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of September 15, 1987, with Chrysler Consortium Corporation and Irving Trust Company, as Indenture Trustee. (1987 Form 10-K, Exhibit 28-19.) (F)10-126- Supplemental Indenture No. 1 dated as of February 1, 1988 to Trust Indenture, Mortgage, Security Agreement and Assignment of Facility Lease dated as of September 15, 1987 between The First National Bank of Boston, as Owner Trustee under a Trust Agreement dated as of September 15, 1987 with Chrysler Consortium Corporation and Irving Trust Company, as Indenture Trustee. (1987 Form 10-K, Exhibit 28-20.) (F)10-127- Tax Indemnification Agreement dated as of September 15, 1987, between Chrysler Consortium Corporation, as Owner Participant, and Ohio Edison Company, as Lessee. (1987 Form 10-K, Exhibit 28-21.) (F)10-128- Assignment, Assumption and Further Agreement dated as of September 15, 1987, among The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of September 15, 1987, with Chrysler Consortium Corporation, The Cleveland Electric Illuminating Company, Duquesne Light Company, Ohio Edison Company, Pennsylvania Power Company, and Toledo Edison Company. (1987 Form 10-K, Exhibit 28-22.) Exhibit Number - ------- (F)10-129- Additional Support Agreement dated as of September 15, 1987, between The First National Bank of Boston, as Owner Trustee under a Trust Agreement, dated as of September 15, 1987, with Chrysler Consortium Corporation, and Ohio Edison Company. (1987 Form 10-K, Exhibit 28-23.) 10-130- Operating Agreement dated March 10, 1987 with respect to Perry Unit No. 1 between the CAPCO Companies. (1987 Form 10-K, Exhibit 28-24.) 10-131- Operating Agreement for Bruce Mansfield Units Nos. 1, 2 and 3 dated as of June 1, 1976, and executed on September 15, 1987, by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 28-25.) 10-132- Operating Agreement for W. H. Sammis Unit No. 7 dated as of September 1, 1971 by and between the CAPCO Companies. (1987 Form 10-K, Exhibit 28-26.) 10-133- OE-APS Power Interchange Agreement dated March 18, 1987, by and among Ohio Edison Company and Pennsylvania Power Company, and Monongahela Power Company and West Penn Power Company and The Potomac Edison Company. (1987 Form 10-K, Exhibit 28-27.) 10-134- OE-PEPCO Power Supply Agreement dated March 18, 1987, by and among Ohio Edison Company and Pennsylvania Power Company and Potomac Electric Power Company. (1987 Form 10-K, Exhibit 28- 28.) 10-135- Supplement No. 1 dated as of April 28, 1987, to the OE-PEPCO Power Supply Agreement dated March 18, 1987, by and among Ohio Edison Company, Pennsylvania Power Company, and Potomac Electric Power Company. (1987 Form 10-K, Exhibit 28-29.) 10-136- APS-PEPCO Power Resale Agreement dated March 18, 1987, by and among Monongahela Power Company, West Penn Power Company, and The Potomac Edison Company and Potomac Electric Power Company. (1987 Form 10-K, Exhibit 28-30.) 11- Calculation of fully diluted earnings per common share. 12- Consolidated fixed charge ratios. (A) 13- 1993 Annual Report to Stockholders. (Only those portions expressly incorporated by reference in this Form 10-K are to be deemed "filed" with the SEC.) 18- Letter from Independent Public Accountants regarding a change in accounting. 21- List of Subsidiaries of the Registrant at December 31, 1993. 23- Consent of Independent Public Accountants. Exhibit Number - ------- (A) Provided herein in electronic format as an exhibit. (B) Pursuant to paragraph (b)(4)(iii)(A) of Item 601 of Regulation S- K, the Company has not filed as an exhibit to this Form 10-K any instrument with respect to long-term debt if the total amount of securities authorized thereunder does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis, but hereby agrees to furnish to the SEC on request any such instruments. (C) Management contract or compensatory plan contract or arrangement filed pursuant to Item 601 of Regulation S-K. (D) Substantially similar documents have been entered into relating to three additional Owner Participants. (E) Substantially similar documents have been entered into relating to five additional Owner Participants. (F) Substantially similar documents have been entered into relating to two additional Owner Participants. Note: Reports of the Company on Forms 10-Q and 10-K are on file with the SEC under number 1-2578. Pursuant to Rule 14a - 3 (10) of the Securities Exchange Act of 1934, the Company will furnish any exhibit in this Report upon the payment of the Company's expenses in furnishing such exhibit. (b) Reports on Form 8-K The Company filed one report on Form 8-K since September 30, 1993. A report dated December 13, 1993, reported the abandonment of Perry Unit 2 as a possible electric generating plant. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of Ohio Edison Company: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in Ohio Edison Company's annual report to stockholders incorporated by reference in this Form 10-K and have issued our report thereon dated February 1, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, N.Y. February 1, 1994 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. OHIO EDISON COMPANY BY /s/W. R. Holland ------------------------------------------- W. R. Holland President and Chief Executive Officer Date: March 23, 1994 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 date indicated: /s/W. R. Holland /s/H. P. Burg - --------------------------------- --------------------------------------------- W. R. Holland H. P. Burg President and Chief Senior Vice President and Director Executive Officer and Director (Principal Financial Officer and Principal (Principal Executive Officer) Accounting Officer) /s/Donald C. Blasius /s/Paul J. Powers - --------------------------------- -------------------------------------------- Donald C. Blasius Paul J. Powers Director Director /s/Robert H. Carlson /s/Charles W. Rainger - --------------------------------- -------------------------------------------- Robert H. Carlson Charles W. Rainger Director Director /s/Robert M. Carter - --------------------------------- -------------------------------------------- Robert M. Carter George M. Smart Director Director /s Carol A. Cartwright /s/Frank C. Watson - --------------------------------- -------------------------------------------- Carol A. Cartwright Frank C. Watson Director Director /s/R. L. Loughhead /s/Jesse T. Williams, Sr. - --------------------------------- -------------------------------------------- R. L. Loughhead Jesse T. Williams, Sr. Director Director /s/Glenn H. Meadows - --------------------------------- Glenn H. Meadows Director Date: March 23, 1994

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ITEM 1. BUSINESS First National Bancorp (Registrant) was incorporated as a Georgia business corporation in 1980. In July 1981, through a plan of reorganization, the Registrant acquired all of the issued and outstanding common stock of The First National Bank of Gainesville (FNBG), Gainesville, Georgia in exchange for Registrant's common stock. Because of its ownership of all the issued and outstanding shares of common stock of the following banks, Registrant is a "bank holding company" as that term is defined under Federal law in the Bank Holding Company Act of 1956, as amended, and under the bank holding company laws of the State of Georgia. As a bank holding company, the Registrant is subject to the applicable provisions of the Federal Reserve System and the Georgia State Department of Banking and Finance. The Registrant's primary business as a bank holding company is to manage the business and affairs of its banking subsidiaries. The Registrant's subsidiary banks provide a full range of banking and mortgage banking services to their customers. Since its formation in 1980 through December 31, 1993, the Registrant has acquired fourteen banks in addition to the founding bank, FNBG. Those banks which have been acquired and some information about each is presented in the "Acquisition Schedule, Properties, and Other Information" table below. The following table lists the Registrant and subsidiaries, disclosing information pertinent to Part I, Item 1 and properties information disclosure as required in Part I, Item 2 ITEM 2. PROPERTIES Registrant's fifteen subsidiary banks operate as autonomously as is possible under a holding company structure within their particular counties and maintain separate banking facilities, which each subsidiary bank owns or leases. In addition, Registrant owns a main office building, used as its corporate offices, and several other offices used to house banking support operations. See Item 1. Business for additional information concerning properties. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The nature of the business of Registrant and its subsidiaries ordinarily results in a certain amount of litigation. Accordingly, Registrant and its subsidiaries are parties (both as plaintiff and defendant) to a limited number of lawsuits incidental to their business and, in certain of such suits, claims or counterclaims have been asserted. In the opinion of management and counsel for Registrant, these lawsuits generally may be considered ordinary litigation incidental to the conduct of business and in none of these cases should the ultimate outcome have a material adverse effect on Registrant's financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The market, stock price, and dividend information which appears on page 35 of Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. The discussion of source of dividends and restrictions on dividends, which may be declared by the subsidiary banks, appearing on page 53, Note 14, of Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Selected Financial Data which appears as a part of Management's Discussion and Analysis of Financial Condition and Results of Operations on page 20 of Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations, which appears on pages 19 through 35 of Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and Notes to Consolidated Financial Statements, together with the report thereon of KPMG Peat Marwick, dated January 28, 1994, appearing on pages 37 through 56 of Registrant's 1993 Annual Report to shareholders, are incorporated by reference in this Form 10-K Annual Report. Consolidated quarterly financial information appearing on page 56 of the Registrant's 1993 Annual Report to shareholders, is incorporated by reference in this Form 10-K Annual Report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Within the twenty-four month period prior to the date of Registrant's most recent financial statements, and for the year ended December 31, 1993, Registrant did not change accountants and had no disagreements with its accountants on any matter of accounting principles, practices, or financial statement disclosure. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information concerning directors is presented on pages 2 through 6 of the Proxy Statement for Annual Meeting of Shareholders, to be held April 20, 1994, which information is incorporated by reference in this Form 10-K Annual Report. Information concerning executive officers of Registrant is set forth under the caption "Executive Officers of the Registrant" in Item 1. Business, hereof. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Executive Compensation is shown under Compensation of Executive Officers on pages 9 through 18 of the Proxy Statement for Annual Meeting of Shareholders, to be held April 20, 1994, which is incorporated by reference in this Form 10- K Annual Report. Compensation of Directors is shown under Compensation of Directors on page 18 of the Proxy Statement For Annual Meeting of Shareholders, to be held April 20, 1994, which is incorporated by reference in this Form 10-K Annual Report. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Principal Shareholders of Registrant which appears on page 9 of the Proxy Statement For Annual Meeting of Shareholders, to be held April 20, 1994, is incorporated by reference in this Form 10-K Annual Report. Security Ownership of Directors, Nominees, Executive Officers, and Directors and Executive Officers, as a group, which appears on pages 7 through 9 of the Proxy Statement For Annual Meeting of Shareholders, to be held April 20, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Transactions with Management which appears on page 19 of the Proxy Statement For Annual Meeting of Shareholders, to be held April 20, 1994, is incorporated by reference in this Form 10-K Annual Report. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)1.FINANCIAL STATEMENTS The following consolidated financial statements of Registrant and its subsidiaries and independent auditors' report, incorporated herein by reference from pages 37 through 56 of Registrant's 1993 Annual Report to shareholders, have been filed as Item 8 in Part II of this report: Independent Auditors' Report Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Income - Years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992, and 1991 Notes to Consolidated Financial Statements (a)2.FINANCIAL STATEMENT SCHEDULES Financial statement schedules are omitted as the required information is not applicable. (a)3.EXHIBITS LIST See Exhibit Index included as page 13 of this report, which is incorporated herein by reference. (b) REPORTS ON FORM 8-K Current Report on Form 8-K, dated December 28, 1993, was filed on December 31, 1993, pertaining to the issuance of 63,676, $1.00 par value common stock shares of Registrant, used in the acquisition of First Citizens Bancorp of Cherokee County, Inc., which was the parent company of Citizens Bank, Cherokee County. Current Report on Form 8-K, dated October 20, 1993, was filed on October 27, 1993, pertaining to the promotion of J. Reid Moore to the Controller's position with Registrant. Current Report on Form 8-K, dated October 14, 1993, was filed on October 14, 1993, pertaining to the signing of an Agreement of Reorganization and Plan of Merger, by Registrant and Metro, whereby Registrant will merge with Metro and acquire all of the outstanding shares of Metro's subsidiary bank, The Commercial Bank of Douglasville, Georgia. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, First National Bancorp has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST NATIONAL BANCORP By: /s/ Richard A. McNeece --------------------------------------------- Richard A. McNeece, Chairman and Chief Executive Officer By: /s/ Peter D. Miller --------------------------------------------- Peter D. Miller, President, Chief Administrative and Chief Financial Officer By: /s/ J. Reid Moore --------------------------------------------- J. Reid Moore Group Vice President and Controller Date: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of First National Bancorp and in the capacities and on the dates indicated. EXHIBITS INDEX

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ITEM 1. BUSINESS PACIFIC ENTERPRISES Pacific Enterprises is a Los Angeles-based utility holding company primarily engaged in supplying natural gas throughout most of Southern and portions of Central California. These operations are conducted through Southern California Gas Company, the nation's largest natural gas distribution utility, serving 4.7 million meters and 535 communities throughout a 23,000-square mile service territory with a population of approximately 16 million. Through other subsidiaries, Pacific Enterprises is also engaged in interstate and offshore natural gas transmission and in alternate energy development. STRATEGIC PLAN AND RECENT RESTRUCTURING Pacific Enterprises returned to profitability in 1993 and resumed dividends on its Common Stock. This was accomplished through the completion of a strategic restructuring and the continued strong performance of gas utility operations conducted through Southern California Gas Company, which has achieved or exceeded its authorized rate of return on rate base for the last 11 consecutive years. The restructuring was part of a new strategic plan to refocus on natural gas utility operations. It was adopted in 1992 in response to increasingly unsatisfactory financial performance and shareholder returns attributable to non-utility operations. Non-utility operations had been greatly expanded in 1986 with the initial acquisition of retailing operations and, to a lesser extent, again in 1988 with additional acquisitions in retailing and in oil and gas exploration and production. The profitability of gas utility operations could not offset declines in non-utility operations and earnings per share increasingly declined beginning in 1988 and substantial and increasing losses were incurred beginning in 1990. As a result, non-utility related indebtedness increased substantially and dividends on Common Stock were reduced in 1991 and suspended in 1992. During 1992 and early 1993, retailing and oil and gas exploration and production operations were sold with the sale proceeds applied to reduce non-utility related debt and the remaining debt was refinanced. Corporate staff and other expenses also were reduced. In addition, a quasi-reorganization for financial reporting purposes was effected on December 31, 1992 restating assets and liabilities to their fair value and eliminating an accumulated deficit in retained earnings. In mid-1993, Pacific Enterprises completed a public offering of 8 million shares of its Common Stock and applied a portion of the proceeds of the offering to the repayment of substantially all remaining non-utility debt. Cash dividends on Common Stock were then resumed at an initial annual rate of $1.20 per share. The restructuring was completed later in 1993 by establishing common membership for the Boards of Directors of Pacific Enterprises and Southern California Gas Company and electing several officers in common between the two companies. These include Willis B. Wood, Jr., Chairman and Chief Executive Officer of Pacific Enterprises, who was elected as Presiding Director of Southern California Gas Company and Richard D. Farman, Chief Executive Officer of Southern California Gas Company, who was elected as President of Pacific Enterprises. ------------------------------ Pacific Enterprises was incorporated in California in 1907 as the successor to a corporation organized in 1886. Its principal executive offices are located at 633 West Fifth Street, Los Angeles, California 90071-2006 and its telephone number is (213) 895-5000. SOUTHERN CALIFORNIA GAS COMPANY Pacific Enterprises' principal subsidiary is Southern California Gas Company ("SoCalGas"), a public utility owning and operating a natural gas transmission, storage and distribution system that supplies natural gas in 535 cities and communities throughout most of Southern California and parts of Central California. SoCalGas is the nation's largest natural gas distribution utility, providing gas service to approximately 16 million residential, commercial, industrial, utility electric generation and wholesale customers through approximately 4.7 million meters in a 23,000-square mile service area. SoCalGas is subject to regulation by the California Public Utilities Commission (CPUC) which, among other things, establishes rates SoCalGas may charge for gas service, including an authorized rate of return on investment. SoCalGas' future earnings and cash flow will be determined primarily by the allowed rate of return on common equity, growth in rate base, noncore pricing and the variance in gas volumes delivered to these noncore customers versus CPUC-adopted forecast deliveries, the recovery of gas and contract restructuring costs if the Comprehensive Settlement (see "Recent Developments - Comprehensive Settlement of Regulatory Issues") is not approved and the ability of management to control expenses and investment in line with the amounts authorized by the CPUC to be collected in rates. Also, SoCalGas' ability to earn revenues in excess of its authorized return from noncore customers due to volume increases will be substantially eliminated for the five years of the Comprehensive Settlement referenced above. This is because forecasted deliveries in excess of the 1991 throughput levels used to establish rates were contemplated in estimating the costs of the Comprehensive Settlement, and are reflected in current year liabilities. In addition, the impact of any future regulatory restructuring and increased competitiveness in the industry, including the continuing threat of customers bypassing SoCalGas' system and obtaining service directly from interstate pipelines, can affect SoCalGas' performance. For 1994, the CPUC has authorized SoCalGas to earn a rate of return on rate base of 9.22 percent and a 11.00 percent rate of return on common equity compared to 9.99 percent and 11.90 percent, respectively, in 1993. Growth in rate base for 1993 was approximately 1.8 percent and rate base is expected to increase by approximately 4 percent to 5 percent in 1994. SoCalGas has achieved or exceeded its authorized return on rate base for the last eleven consecutive years and its authorized rate of return on equity for the last nine consecutive years. RECENT DEVELOPMENTS REGULATORY ACTIVITY On December 17, 1993, the CPUC issued its decision in SoCalGas' 1994 general rate case which authorized a net $97 million rate reduction. SoCalGas plans to adjust its operations with the intention of operating within the amounts authorized in rates. Approximately $21 million of the rate reduction represents productivity improvements. Other items include non-operational issues, primarily reductions in marketing programs and income tax effects of the rate reduction. The decision also includes the effects of the reduction of SoCalGas' rate of return authorized in its 1994 cost of capital proceeding, which increased the total reduction in rates to $132 million. New rates emanating from the CPUC decision became effective January 1, 1994. RESTRUCTURING OF GAS SUPPLY CONTRACTS SoCalGas and the Company's gas supply subsidiaries have reached agreements with suppliers of California offshore and Canadian gas for a restructuring of long-term gas supply contracts. The cost of these supplies to SoCalGas has been substantially in excess of its average delivered cost of gas. During 1993, these excess costs totaled approximately $125 million. The new agreements substantially reduce the ongoing delivered costs of these gas supplies and provide lump sum settlement payments of $375 million to the suppliers. The expiration date for the Canadian gas supply contract has been shortened from 2012 to 2003, and the supplier of California offshore gas continues to have an option to purchase related gas treatment and pipeline facilities owned by the Company's gas supply subsidiary. The agreement with the suppliers of Canadian gas is subject to certain Canadian regulatory and other approvals. COMPREHENSIVE SETTLEMENT OF REGULATORY ISSUES SoCalGas and a number of interested parties, including the Division of Ratepayer Advocates ("DRA") of the CPUC, large noncore customers and ratepayer groups, have filed for CPUC approval a comprehensive settlement (the "Comprehensive Settlement") of a number of pending regulatory issues including partial rate recovery of restructuring costs associated with the gas supply contracts discussed above. The Comprehensive Settlement, if approved by the CPUC, would permit SoCalGas to recover in utility rates approximately 80 percent of its contract restructuring costs of $375 million and accelerated depreciation of related pipeline assets of its gas supply affiliates of approximately $130 million, together with interest, over a period of approximately five years. SoCalGas has filed a financing application with the CPUC primarily for the borrowing of $425 million to provide for funds needed under the Comprehensive Settlement. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Comprehensive Settlement of Regulatory Issues" for a discussion of the regulatory issues, in addition to the gas supply issues, addressed in the Comprehensive Settlement. OPERATING STATISTICS The following table sets forth certain operating statistics of SoCalGas from 1989 through 1993. OPERATING STATISTICS - 11 - SERVICE AREA SoCalGas distributes natural gas throughout a 23,000 - square mile service territory with a population of approximately 16 million people. As indicated by the following map, its service territory includes most of Southern California and portions of Central California. [MAP] Natural gas service is also provided on a wholesale basis to the distribution systems of the City of Long Beach, San Diego Gas & Electric Company and Southwest Gas Company. - 12 - UTILITY SERVICES SoCalGas' customers are divided, for regulatory purposes, into core and noncore customers. Core customers are primarily residential and small commercial and industrial customers, without alternative fuel capability. Noncore customers are primarily electric utilities, wholesale and large commercial and industrial customers, with alternative fuel capability. SoCalGas offers two basic utility services, sale of gas and transmission of gas. Residential customers and most other core customers purchase gas directly from SoCalGas. Noncore customers and large core customers have the option of purchasing gas either from SoCalGas or from other sources (such as brokers or producers) for delivery through SoCalGas' transmission and distribution system. Smaller customers are permitted to aggregate their gas requirements and also to purchase gas directly from brokers or producers, up to a limit of 10 percent of SoCalGas' core market. SoCalGas generally earns the same contribution to earnings whether a particular customer purchases gas from SoCalGas or utilizes SoCalGas' system for transportation of gas purchased from others. (See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Ratemaking Procedures.") SoCalGas continues to be obligated to purchase reliable supplies of natural gas to serve the requirements of its core customers. However, the only gas supplies that SoCalGas may offer for sale to noncore customers are the same supplies that it purchases to serve its core customers. Noncore customers that elect to purchase gas supplies from SoCalGas must for a two-year period agree to take-or-pay for 75 percent of the gas that they contract to purchase. SoCalGas also provides a gas storage service for noncore customers on a bid basis. The storage service program provides opportunities for customers to store gas on an "as available" basis during the summer to reduce winter purchases when gas costs are generally higher, or to reduce their level of winter curtailment in the event temperatures are unusually cold. During 1993, SoCalGas stored approximately 24 billion cubic feet of customer-owned gas. - 13 - DEMAND FOR GAS Natural gas is a principal energy source in SoCalGas' service area for residential, commercial and industrial uses as well as utility electric generation (UEG) requirements. Gas competes with electricity for residential and commercial cooking, water heating and space heating uses, and with other fuels for large industrial, commercial and UEG uses. Demand for natural gas in Southern California is expected to continue to increase but at a slower rate due primarily to a slowdown in housing starts, new energy efficient building construction and appliance standards and general recessionary business conditions. During 1993, 97 percent of residential energy customers in SoCalGas' service territory used natural gas for water heating and 94 percent for space heating. Approximately 78 percent of those customers used natural gas for cooking and over 72 percent for clothes drying. Demand for natural gas by large industrial and UEG customers is very sensitive to the price of alternative competitive fuels. These customers number only approximately 1,000; however, during 1993, accounted for approximately 19 percent of total revenues, 65 percent of total gas volumes delivered and 15 percent of the authorized gas margin. Changes in the cost of gas or alternative fuels, primarily fuel oil, can result in significant shifts in this market, subject to air quality regulations. Demand for gas for UEG use is also affected by the price and availability of electric power generated in other areas and purchased by SoCalGas' UEG customers. Since the completion of the Kern River/Mojave Interstate Pipeline (Mojave) in February 1992, SoCalGas' throughput to customers in the Kern County area who use natural gas to produce steam for enhanced oil recovery projects has decreased significantly because of the bypass of SoCalGas' system. Mojave now delivers to customers formerly served by SoCalGas 350 to 400 million cubic feet of gas per day. The decrease in revenues from enhanced oil recovery customers is subject to full balancing account treatment, except for a five percent incentive to SoCalGas for attaining certain throughput levels, and therefore, does not have a material impact on earnings. However, bypass of other Company markets also may occur as a result of plans by Mojave to extend its pipeline north to Sacramento through portions of SoCalGas' service territory. The effect of bypass is to increase SoCalGas' rates to other customers and thus make its natural gas service less competitive with that of competing pipelines and available alternate fuels. - 14 - In response to bypass, SoCalGas has received authorization from the CPUC for expedited review of price discounts proposed for long-term gas transportation contracts with some noncore customers. In addition, in December 1992, the CPUC approved changes in the methodology for allocating SoCalGas' costs between core and noncore customers to reduce the subsidization of core customer rates by noncore customers. Effective in June 1993, these new rate changes implemented the CPUC's policy known as "long-run marginal cost." The revised methodologies have resulted in a reduction of noncore rates and a corresponding increase in core rates that better reflect the cost of serving each customer class and, together with price discounting authority, has enabled SoCalGas to better compete with interstate pipelines for noncore customers. In addition, in August 1993 a capacity brokering program was implemented. Under the program, for a fee, SoCalGas provides to noncore customers, or others, a portion of its control of interstate pipeline capacity to allow more direct access to producers. Also, the Comprehensive Settlement (see "Recent Developments - Comprehensive Settlement of Regulatory Issues") will help SoCalGas' competitiveness by reducing the cost of transportation service to noncore customers. SUPPLIES OF GAS In 1993, SoCalGas delivered slightly less than 1 trillion cubic feet of natural gas through its system. Approximately 64 percent of these deliveries were customer-owned gas for which SoCalGas provided transportation services, compared to 65 percent in 1992. The balance of gas deliveries was gas purchased by SoCalGas and resold to customers. Most of the natural gas delivered by SoCalGas is produced outside of California. These supplies are delivered to the California border by interstate pipeline companies (primarily El Paso Natural Gas Company and Transwestern Natural Gas Company) that produce or purchase the supplies or provide transportation services for supplies purchased from other sources by SoCalGas or its transportation customers. These supplies enter SoCalGas' intrastate transmission system at the California border for delivery to customers. SoCalGas currently has paramount rights to daily deliveries of up to 2,200 million cubic feet of natural gas over the interstate pipeline systems of El Paso Natural Gas Company (up to 1,450 million cubic feet) and Transwestern Pipeline Company (up to 750 million cubic feet). The rates that interstate pipeline companies may charge for gas and transportation services and other terms of service are regulated by the Federal Energy Regulatory Commission (FERC). - 15 - The following table sets forth the sources of gas deliveries by SoCalGas from 1989 through 1993. - 16 - SOUTHERN CALIFORNIA GAS COMPANY SOURCES OF GAS Market sensitive gas supplies (supplies purchased on the spot market as well as under longer-term contracts and ranging from one month to ten years based on spot prices) accounted for approximately 66 percent of total gas volumes purchased by SoCalGas during 1993, as compared with 61 percent and 69 percent, respectively, during 1992 and 1991. These supplies were generally purchased at prices significantly below those for other long-term sources of supply. See "Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Comprehensive Settlement of Regulatory Issues" for a discussion of the contemplated gas cost incentive mechanism. On March 16, 1994, the CPUC issued its decision approving the gas cost incentive mechanism for implementation for a three year trial period beginning April 1, 1994. SoCalGas estimates that sufficient natural gas supplies will be available to meet the requirements of its customers into the next century. Because of the many variables upon which estimates of future service are based, however, actual levels of service may vary significantly from estimated levels. RATES AND REGULATION SoCalGas is regulated by the CPUC. The CPUC consists of five commissioners appointed by the Governor of California for staggered six-year terms. It is the responsibility of the CPUC to determine that utilities operate in the best interest of the ratepayer with a reasonable profit. The regulatory structure is complex and has a very substantial impact on the profitability of SoCalGas. The return that SoCalGas is authorized to earn is the product of the authorized rate of return on rate base and the amount of rate base. Rate base consists primarily of net investment in utility plant. Thus, SoCalGas' earnings are affected by changes in the authorized rate of return on rate base and the growth in rate base and by SoCalGas' ability to control expenses and investment in rate base within the amounts authorized by the CPUC in setting rates. SoCalGas' ability to achieve its authorized rate of return is affected by other regulatory and operating factors. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Ratemaking Procedures." SoCalGas' operating and fixed costs, including return on rate base, are allocated between core and noncore customers under a methodology that is based upon the costs incurred in serving these customer classes. For 1994, approximately 87 percent of the CPUC-authorized gas margin has been allocated to core customers and 13 percent to noncore customers, including wholesale customers. Under the current regulatory framework, costs may be reallocated between the core and the noncore markets once every other year in a biennial cost allocation proceeding (BCAP). PROPERTIES At December 31, 1993, SoCalGas owned approximately 3,280 miles of transmission and storage pipeline, 42,250 miles of distribution pipeline and 42,406 miles of service piping. It also owned twelve transmission compressor stations and six underground storage reservoirs (with a combined working storage capacity of approximately 116 billion cubic feet) and general office buildings, shops, service facilities, and certain other equipment necessary in the conduct of its business. Southern California Gas Tower, a wholly owned subsidiary of SoCalGas, has a 15% limited partnership interest in a 52-story office building in downtown Los Angeles. SoCalGas occupies about half of the building. See also "Item 2. ITEM 2. PROPERTIES Pacific Library Tower, a wholly-owned subsidiary of Pacific Enterprises, has a 25% ownership interest in a 72-story office building in downtown Los Angeles that was completed in late 1990. Pacific Enterprises and its subsidiaries occupy twelve floors of the building. Information with respect to the properties of other Pacific Enterprises' subsidiaries is set forth in Item 1 of this Annual Report. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Except for the matters referred to in the financial statements filed with or incorporated by reference in Item 8 or referred to elsewhere in this Annual Report, neither Pacific Enterprises nor any of its subsidiaries is a party to, nor is their property the subject of, any material pending legal proceedings other than routine litigation incidental to its businesses. Pacific Enterprises and certain of its directors and former directors are defendants in seven shareholder actions. Three of the actions are substantially identical shareholder derivative actions in which Pacific Enterprises is named only as a nominal defendant. The derivative actions seek recovery from the defendant directors on behalf of Pacific Enterprises for damages asserted to have been suffered by Pacific Enterprises by alleged breaches of fiduciary duties by the directors in connection with Pacific Enterprises' diversification program. The remaining four actions are shareholder class actions filed on behalf of shareholders who purchased shares of Pacific Enterprises between June 5, 1990 and February 4, 1992 and seek recovery from Pacific Enterprises and the defendant directors for damages asserted to have been suffered as a result of allegedly improper disclosures under the federal securities laws. In January 1994, Pacific Enterprises announced an agreement had been reached to settle the shareholder lawsuits which were originally filed in February 1992. The settlement, which is subject to court approval, totals $45 million. The settlement and related legal costs, after giving effect to amounts paid by other parties, had been fully provided in liabilities established in prior years. Pacific Enterprises is a defendant in various lawsuits arising in the normal course of business; however, management believes that the resolution of these pending claims and legal proceedings will not have a material adverse effect on Pacific Enterprises' financial statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 1993 to a vote of Pacific Enterprises' security holders. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Pacific Enterprises' Common Stock is traded on the New York and Pacific Stock Exchanges. Information as to the high and low sales prices for such stock as reported on the composite tape for stocks listed on the New York Stock Exchange and dividends paid for each quarterly period during the two years ended December 31, 1993 is set forth under the captions "Range of Market Prices of Capital Stock" and "Quarterly Financial Data" in Pacific Enterprises' 1993 Annual Report to Shareholders filed as Exhibit 13.01 to this Annual Report. Such information is incorporated herein by reference. At December 31, 1993, there were 45,414 holders of record of Pacific Enterprises' Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this Item is set forth under the caption "Financial Review - Selected Financial Data and Comparative Statistics 1983-1993" in Pacific Enterprises' 1993 Annual Report to Shareholders filed as Exhibit 13.01 to this Annual Report. Such information is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this Item is set forth under the caption "Financial Review - Management's Discussion and Analysis" in Pacific Enterprises' 1993 Annual Report to Shareholders filed as Exhibit 13.01 to this Annual Report. Such information is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pacific Enterprises' consolidated financial statements and schedules required by this Item are listed in Item 14(a)1 and 2 in Part IV of this Annual Report. The consolidated financial statements listed in Item 14(a)1 are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No change in the Company's accountants has taken place. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by this Item with respect to the Company's directors is set forth under the caption "Election of Directors" in the Company's Proxy Statement for its Annual Meeting of Shareholders scheduled to be held on May 5, 1994. Such information is incorporated herein by reference. Information required by this Item with respect to the Company's executive officers is set forth in Item 1 of this Annual Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information required by this Item is set forth under the caption "Election of Directors", "Executive Compensation" and "Employee Benefit Plans" in the Company's Proxy Statement for its Annual Meeting of Shareholders scheduled to be held on May 5, 1994. Such information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this Item is set forth under the caption "Election of Directors" in the Company's Proxy Statement for its Annual Meeting of Shareholders scheduled to be held on May 5, 1994. Such information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) DOCUMENTS FILED AS PART OF THIS REPORT: 1.01 Report of Deloitte & Touche, Independent Auditors (Contained in Exhibit 13.01). 1.02 Consolidated Balance Sheet at December 31, 1993 and 1992 (Contained in Exhibit 13.01). 1.03 Statement of Consolidated Income for the years ended December 31, 1993, 1992 and 1991 (Contained in Exhibit 13.01). 1.04 Statement of Consolidated Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 (Contained in Exhibit 13.01). 1.05 Statement of Consolidated Cash Flows for the years ended December 31, 1993, 1992 and 1991 (Contained in Exhibit 13.01). 1.06 Statement of Business Segment Information for the years ended December 31, 1993, 1992 and 1991 (Contained in Exhibit 13.01). 1.07 Notes to Consolidated Financial Statements (Contained in Exhibit 13.01). 2. SUPPLEMENTAL FINANCIAL STATEMENT SCHEDULES: 2.01 Report of Deloitte & Touche, Independent Auditors 2.02 Pacific Enterprises and Subsidiary Companies - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 - Schedule V 2.03 Pacific Enterprises and Subsidiary Companies - Accumulated Depreciation, and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992, and 1991 - Schedule VI 2.04 Pacific Enterprises and Subsidiary Companies - Short-Term Borrowings, December 31, 1993, 1992 and 1991 - Schedule IX 2.05 Pacific Enterprises and Subsidiary Companies - Supplementary Income Statement Information December 31, 1993, 1992 and 1991 - Schedule X 3. ARTICLES OF INCORPORATION AND BY-LAWS: 3.01 Articles of Incorporation of Pacific Enterprises (Note 22; Exhibit 4.1) 3.02 Bylaws of Pacific Enterprises (Note 21; Exhibit 3.02) 4. INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS: (Note: As permitted by Item 601(b)(4)(iii) of Regulation S-K, certain instruments defining the rights of holders of long-term debt for which the total amount of securities authorized thereunder does not exceed ten percent of the total assets of Southern California Gas Company and its subsidiaries on a consolidated basis are not filed as exhibits to this Annual Report. The Company agrees to furnish a copy of each such instrument to the Commission upon request.) 4.01 Specimen Common Stock Certificate of Pacific Enterprises (Note 16; Exhibit 4.01). 4.02 Specimen Preferred Stock Certificates of Pacific Enterprises (Note 8; Exhibit 4.02) 4.03 Specimen Remarketed Preferred Stock Certificate (Note 17; Exhibit 4.03) 4.04 First Mortgage Indenture of Southern California Gas Company to American Trust Company dated October 1, 1940 (Note 1; Exhibit B-4). 4.05 Supplemental Indenture of Southern California Gas Company to American Trust Company dated as of July 1, 1947 (Note 2; Exhibit B-5). 4.06 Supplemental Indenture of Southern California Gas Company to American Trust Company dated as of August 1, 1955 (Note 3; Exhibit 4.07). 4.07 Supplemental Indenture of Southern California Gas Company to American Trust Company dated as of June 1, 1956 (Note 4; Exhibit 2.08). 4.08 Supplemental Indenture of Southern California Gas Company to Wells Fargo Bank, National Association dated as of August 1, 1972 (Note 6; Exhibit 2.19). 4.09 Supplemental Indenture of Southern California Gas Company to Wells Fargo Bank, National Association dated as of May 1, 1976 (Note 5; Exhibit 2.20). 4.10 Supplemental Indenture of Southern California Gas Company to Wells Fargo Bank, National Association dated as of September 15, 1981 (Note 9; Exhibit 4.25). 4.11 Supplemental Indenture of Southern California Gas Company to Manufacturers Hanover Trust Company of California, successor to Wells Fargo Bank, National Association, and Crocker National Bank as Successor Trustee dated as of May 18, 1984 (Note 11; Exhibit 4.29). 4.12 Supplemental Indenture of Southern California Gas Company to Bankers Trust Company of California, N.A., successor to Wells Fargo Bank, National Association dated as of January 15, 1988 (Note 13; Exhibit 4.11). 4.13 Supplemental Indenture of Southern California Gas Company to First Trust of California, National Association, successor to Bankers Trust Company of California, N.A. (Note 18; Exhibit 4.37) 4.14 Rights Agreement dated as of March 7, 1990 between Pacific Enterprises and Security Pacific National Bank, as Rights Agent (Note 19; Exhibit 4). 10. MATERIAL CONTRACTS 10.01 Sale and Purchase Agreement, dated as of May 22, 1992, as amended between TCH Corporation and Pacific Enterprises (Note 19; Exhibit 1). 10.02 Sale and Purchase Agreement, dated as of May 22, 1992, as amended, among Big 5 Holdings, Inc., Pacific Enterprises and Thrifty Corporation (Note 19; Exhibit 2). 10.03 Sale and Purchase Agreement, dated as of October 11, 1992 by and between Hunt Oil Company and Pacific Enterprises Oil Company (USA) (Note 19; Exhibit 1). 10.04 Sale and Purchase Agreement, dated as of October 11, 1992 by and between Hunt Oil Company and Pacific Enterprises Mineral Company (Note 20; Exhibit 2). 10.05 Sale and Purchase Agreement, dated as of October 11, 1992 by and between Hunt Oil Company and Pacific Enterprises Oil Company (Western) (Note 20; Exhibit 3). 10.06 Sale and Purchase Agreement, dated as of October 11, 1992 by and between Hunt Oil Company and Pacific Gas Gathering Company (Note 6; Exhibit 4). 10.07 Form of Indemnification Agreement between Pacific Enterprises and each of its directors and officers (Note 21; Exhibit 10.07) 10.08 Credit Agreement dated as of March 4, 1993 among Pacific Enterprises, Morgan Guaranty Trust Company of New York and the other banks named therein. (Note 21; Exhibit 10.08) EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS 10.09 Restatement and Amendment of Pacific Enterprises 1979 Stock Option Plan (Note 7; Exhibit 1.1). 10.10 Pacific Enterprises Supplemental Medical Reimbursement Plan for Senior Officers (Note 8; Exhibit 10.24). 10.11 Pacific Enterprises Financial Services Program for Senior Officers (Note 8; Exhibit 10.25). 10.12 Pacific Enterprises Supplemental Retirement and Survivor Plan (Note 11; Exhibit 10.36). 10.13 Pacific Enterprises Stock Payment Plan (Note 11; Exhibit 10.37). 10.14 Pacific Enterprises Pension Restoration Plan (Note 8; Exhibit 10.28). 10.15 Southern California Gas Company Pension Restoration Plan For Certain Management Employees (Note 8; Exhibit 10.29). 10.16 Pacific Enterprises Executive Incentive Plan (Note 13; Exhibit 10.13). 10.17 Pacific Enterprises Deferred Compensation Plan for Key Management Employees (Note 12; Exhibit 10.41). 10.18 Pacific Enterprises Employee Stock Ownership Plan and Trust Agreement as amended in toto effective October 1, 1992. (Note 21; Exhibit 10.18). 10.19 Pacific Enterprises Stock Incentive Plan (Note 15; Exhibit 4.01). 10.20 Pacific Enterprises Retirement Plan for Directors (Note 21; Exhibit 10.20). 10.21 Pacific Enterprises Director's Deferred Compensation Plan (Note 21; Exhibit 10.21). 11. STATEMENT RE COMPUTATION OF EARNINGS PER SHARE 11.01 Pacific Enterprises Computation of Earnings per Share (see Statement of Consolidated Income contained in Exhibit 13.01). 13. ANNUAL REPORT TO SECURITY HOLDERS 13.01 Pacific Enterprises 1993 Annual Report to Shareholders. (Such report, except for the portions thereof which are expressly incorporated by reference in this Annual Report, is furnished for the information of the Securities and Exchange Commission and is not to be deemed "filed" as part of this Annual Report). 22. SUBSIDIARIES OF THE REGISTRANT 22.01 List of subsidiaries of Pacific Enterprises 24. CONSENTS OF EXPERTS AND COUNSEL 24.01 Consent of Deloitte & Touche, Independent Auditors. 25. POWER OF ATTORNEY 25.01 Power of Attorney of Certain Officers and Directors of Pacific Enterprises (contained on signature pages). (b) REPORTS ON FORM 8-K: The following reports on Form 8-K were filed during the last quarter of 1993. REPORT DATE ITEM REPORTED Nov. 3, 1993 Item 5 Dec. 9, 1993 Item 5 Dec. 17, 1993 Item 5 _________________________ NOTE: Exhibits referenced to the following notes were filed with the documents cited below under the exhibit or annex number following such reference. Such exhibits are incorporated herein by reference. Note Reference Document 1 Registration Statement No. 2-4504 filed by Southern California Gas Company on September 16, 1940. 2 Registration Statement No. 2-7072 filed by Southern California Gas Company on March 15, 1947. 3 Registration Statement No. 2-11997 filed by Pacific Lighting Corporation on October 26, 1955. 4 Registration Statement No. 2-12456 filed by Southern California Gas Company on April 23, 1956. 5 Registration Statement No. 2-56034 filed by Southern California Gas Company on April 14, 1976. 6 Registration Statement No. 2-59832 filed by Southern California Gas Company on September 6, 1977. 7 Registration Statement No. 2-66833 filed by Pacific Lighting Corporation on March 5, 1980. 8 Annual Report on Form 10-K for the year ended December 31, 1980, filed by Pacific Lighting Corporation. 9 Annual Report on Form 10-K for the year ended December 31, 1981, filed by Pacific Lighting Corporation. 10 Annual Report on Form 10-K for the year ended December 31, 1983 filed by Pacific Lighting Corporation. 11 Annual Report on Form 10-K for the year ended December 31, 1984 filed by Pacific Lighting Corporation. 12 Annual Report on Form 10-K for the year ended December 31, 1985 filed by Pacific Lighting Corporation. 13 Annual Report on Form 10-K for the year ended December 31, 1987, filed by Pacific Enterprises. 14 Current Report on Form 8-K dated March 7, 1990 filed by Pacific Enterprises. 15 Registration Statement No. 33-21908 filed by Pacific Enterprises on May 17, 1988. 16 Annual Report on Form 10-K for the year ended December 31, 1988 filed by Pacific Enterprises. 17 Annual Report on form 10-K for the year ended December 31, 1989 filed by Pacific Enterprises. 18 Registration Statement No. 33-50826 filed by Southern California Gas Company on August 13, 1992. 19 Current Report on Form 8-K dated September 25, 1992 filed by Pacific Enterprises. 20 Current Report on Form 8-K dated January 5, 1993 filed by Pacific Enterprises. 21 Annual Report on Form 10-K for the year ended December 31, 1992 filed by Pacific Enterprises. 22 Registration Statement No. 33-61278 filed by Pacific Enterprises on April 20, 1993. 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. PACIFIC ENTERPRISES By: /s/ WILLIS B. WOOD, JR. -------------------------------- Name: Willis B. Wood, Jr. Title: Chairman of the Board and Chief Executive Officer Dated: March 28, 1994 Each person whose signature appears below hereby authorizes Willis B. Wood, Jr. and Lloyd A. Levitin, and each of them, severally, as attorney-in-fact, to sign on his or her behalf, individually and in each capacity stated below, and file all amendments to this Annual Report. 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. SIGNATURE TITLE DATE /s/ WILLIS B. WOOD, JR. Chairman of the Board, March 28, 1994 - ----------------------------- Chief Executive (Willis B. Wood, Jr.) Officer and Director (Principal Executive Officer) /s/ LLOYD A. LEVITIN Executive Vice - March 28, 1994 - ----------------------------- President and Chief (Lloyd A. Levitin) Financial Officer (Principal Financial Officer) /s/ HYLA H. BERTEA Director March 28, 1994 - ---------------------------- (Hyla H. Bertea) /s/ HERBERT L. CARTER Director March 28, 1994 - ---------------------------- (Herbert L. Carter) /s/ JAMES F. DICKASON Director March 28, 1994 - ---------------------------- (James F. Dickason) /s/ RICHARD D. FARMAN Director March 28, 1994 - ---------------------------- (Richard D. Farman) /s/ WILFORD D. GODBOLD, JR. Director March 28, 1994 - ---------------------------- (Wilford D. Godbold, Jr.) /s/ IGNACIO E. LOZANO, JR. Director March 28, 1994 - ---------------------------- (Ignacio E. Lozano, Jr.) /s/ HAROLD M. MESSMER, JR. Director March 28, 1994 - ---------------------------- (Harold M. Messmer, Jr.) /s/ PAUL A. MILLER Director March 28, 1994 - ---------------------------- (Paul A. Miller) /s/ JOSEPH N. MITCHELL Director March 28, 1994 - ---------------------------- (Joseph N. Mitchell) /s/ JOSEPH R. RENSCH Director March 28, 1994 - ---------------------------- (Joseph R. Rensch) /s/ ROCCO C. SICILIANO Director March 28, 1994 - ---------------------------- (Rocco C. Siciliano) /s/ LEONARD H. STRAUS Director March 28, 1994 - ---------------------------- (Leonard H. Straus) /s/ DIANA L. WALKER Director March 28, 1994 - ---------------------------- (Diana L. Walker)

868016_1993.txt

868016_1993

1993

868016

Item 2. Properties. See Item 1. Item 3. Item 3. Legal Proceedings. None. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. (a) There is no market for the registrant's common stock. (b) There was one Common stockholder at September 30, 1993. (c) See "Item 6. Item 6. Selected Financial Data The financial data shown below as of and for the years ended September 30, 1993, 1992, 1991 and for the period July 25, 1990 (date of incorporation) through September 30, 1990 have been derived from, and should be read in conjunction with, the Company's financial statements and related notes appearing elsewhere herein. The financial statements as of and for the year ended September 30, 1993 have been audited by Coopers & Lybrand. The financial statements as of and for the years ended September 30, 1992 and 1991 and for the period July 25, 1990 (date of incorporation) through September 30, 1990 have been audited by BDO Seidman. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Revenues of the Company increased to $2.8 million in 1993 from $2.4 million in 1992 and $1.0 million in 1991. The growth from 1992 to 1993 is attributable primarily to increased investment earnings on additional outstanding Receivables and increased revenues associated with the sale of repossessed property. The growth from 1991 to 1992 was almost entirely attributable to increased investment earnings on additional outstanding Receivables. The Company has increased its investment in Receivables from $8.2 million at September 30, 1991 to $11.6 million at September 30, 1992 to $19.5 million at September 30, 1993. The Company continued to realize net income from operations during 1993. Net income for the fiscal year ended September 30, 1993 was $283,000 compared to $661,000 in 1992 and $238,000 in 1991. The 1993 decrease in net income is attributable to a reduced spread between interest sensitive income and interest sensitive expense along with increased operating expenses associated with the increased volume of Certificate sales, Receivable investments and real estate held for sale. The 1992 increase in net income is attributable to an increased spread between interest sensitive income and interest sensitive expense along with increased operating expenses associated with the increased volume of Certificate sales, Receivable investments and real estate held for sale. The Company, during 1993, experienced a slight increase in the loss from sale of real estate repossessions and also increased its provision for losses on Receivables. Since the date of its incorporation, the Company has benefitted from a declining interest rate environment with lower money costs and relatively consistent yields on Receivables acquired through Metropolitan. In addition, a declining rate environment has positively impacted earnings by increasing the value of the portfolio of predominantly fixed rate Receivables. Higher than normal prepayments in the Receivable portfolio were experienced during 1993 and 1992, allowing the Company to recognize unamortized discounts on Receivables at an accelerated rate. It is anticipated that Metropolitan may begin charging the Company underwriting fees associated with Receivables acquired from Metropolitan. Management anticipates that any such underwriting fee that may be charged by Metropolitan in the future will result in a slightly lower yield over the life of the Receivables. Management is unable to predict the specific impact of any such underwriting fee because no specific fee has been proposed or suggested to date. See "Business-Investment in Real Estate Receivables." Maintaining efficient collection procedures and minimizing delinquencies in the Company's Receivable portfolio are ongoing management goals. During 1993, the Company experienced a loss on sale of repossessed real estate of $18,400. Management believes that yields received on Receivables, which currently range from 12-15% (approximately 6-9% in excess of the Treasury, or risk-free, rate), will more than compensate the Company for such risk of loss. In April 1992, the Accounting Standards Division of the American Institute of Certified Public Accountants issued Statement of Position (SOP) No. 92-3, "Accounting for Foreclosed Assets," which provides guidance on determining the accounting treatment for foreclosed assets. SOP 92-3 requires that foreclosed assets be carried at the lower of (a) fair value minus estimated costs to sell, or (b) cost. The Company applied the provisions of SOP 92-3 effective October 1, 1992. The initial charge for its application is estimated to be approximately $10,000, before the application of related income taxes, and is included in continuing operations in 1993. Interest Sensitive Income and Expense Management continually monitors the interest sensitive income and expense of the Company. Interest sensitive expense is predominantly the interest costs of Investment Certificates, while interest sensitive income includes interest on Receivables, earned discount on Receivables, dividends and other investment income. The spread between interest sensitive income and interest sensitive expense was $362,300 in 1991, $925,300 in 1992 and $695,600 in 1993. The decrease from 1992 to 1993 of approximately $230,000 was the result of management's decision to accumulate cash to fund a contract purchase commitment in excess of $7 million from an affiliate in December 1992. Also, the Company recognized $366,935 of dividend income (13% dividend rate) from its preferred stock investment in its affiliate in 1992 and paid interest to its parent company at prime plus 1 1/2% on the borrowings used to finance the purchase of the preferred stock. In March 1992, the Company transferred the preferred stock to Metropolitan in full satisfaction of the $6 million payable. Therefore, there were no dividends received by the Company in fiscal 1993 on the preferred stock. See Note 7 to Financial Statements. Other Income Other income increased from approximately $500 in 1991 to $16,600 in 1992 to $42,700 in 1993. Other income is predominantly miscellaneous fees and charges related to Receivables, thus its growth is primarily due to the growth in Receivables. Other Expenses Operating expenses increased from approximately $100,600 in 1991 to $178,300 in 1992 to $244,600 in 1993 largely due to the increased volume of Investment Certificate sales and Receivable investments. Provision for Losses on Real Estate Receivables The provision for losses on Receivables has increased as the size of the portfolio of Receivables has grown. The following table summarizes the Company's allowance for losses on Receivables: Gain/Loss on Real Estate Sold During 1993, the Company experienced a loss on the sale of real estate of approximately $18,400. At the end of fiscal 1993, the Company had $61,000 in real estate held for sale, less than 1% of total real estate assets. Effect of Inflation During the three year period ended September 30, 1993, inflation has had a generally positive impact on the Company's operations. This impact has primarily been indirect in that the level of inflation tends to influence inflation expectations, which tends to impact interest rates on both Company assets and liabilities. Thus, with lower inflation rates over the past three years, interest rates have been generally declining during this period, which has reduced the Company's cost of funds. Interest rates on Receivables acquired, due to their nature, have not declined to the same extent as the cost of the Company's borrowings. In addition, inflation has not had a material effect on the Company's operating expenses. The main reason for the increase in operating expenses has been an increase in the number of Receivables acquired and serviced and increased sales of Investment Certificates. Revenues from real estate sold are influenced in part by inflation, as, historically, real estate values have fluctuated with the rate of inflation. However, the Company is unable to quantify the effect of inflation in this respect. Asset/Liability Management As most of the Company's assets and liabilities are financial in nature, the Company is subject to interest rate risk. Currently, the Company's financial assets (primarily Receivables and fixed income investments) reprice faster than its financial liabilities (primarily Investment Certificates). In a rising rate environment, this will tend to increase earnings, while in a falling rate environment, earnings will decrease. However, yields on Receivables have not been as sensitive to rate fluctuations as have Investment Certificate rates. During fiscal 1994, approximately $5.8 million of interest sensitive assets (cash and Receivables) are expected to reprice or mature. For liabilities, approximately $2.0 million of Investment Certificates will mature during fiscal 1994, along with about $5,000 of other debt payable. These estimates result in a one year interest rate mismatch (interest sensitive assets less interest sensitive liabilities) of approximately $3.8 million, or a ratio of interest sensitive assets to interest sensitive liabilities of approximately 290%. New Accounting Rules In the fourth quarter of fiscal 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), retroactive to October 1, 1992 and resulted in no significant affect on the Company's financial position. SFAS No. 109 requires a company to recognize deferred tax assets and liabilities for the expected future income tax consequences of events that have been recognized in a company's financial statements. Under this method, deferred tax liabilities and assets are determined based on the temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the temporary differences are expected to reverse. In 1992 and 1991, the Company accounted for income taxes as required by Accounting Principles Board Opinion No. 11. See Note 1 to Financial Statements. In May, 1993, Statement of Financial Accounting Standards No. 114 (SFAS No. 114) "Accounting by Creditors for Impairment of a Loan" was issued. SFAS No. 114 requires that certain impaired loans be measured based on the present value of expected future cash flows discounted at the loans' effective interest rate or the fair value of the collateral. The Company is required to adopt this new standard by October 1, 1995. The Company does not anticipate that the adoption of SFAS No. 114 will have a material effect on the financial statements. In December 1991, Statement of Financial Accounting Standards No. 107 (SFAS No. 107), "Disclosures about Fair Value of Financial Instruments," was issued. SFAS No. 107 requires disclosures of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. SFAS No. 107 is effective for financial statements issued for fiscal years ending after December 31, 1995 (Summit's fiscal year ending September 30, 1996) for entities with less than $150 million in total assets. This pronouncement does not change any requirements for recognition, measurement or classification of financial instruments in the Company's financial statements. Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS No. 112 "Employers' Accounting for Postretirement Benefits" are not applicable because the Company maintains no programs designed to provide employees with post-retirement or post-employment benefits. Liquidity and Capital Resources As a financial institution, the Company's liquidity is largely tied to its ability to renew, maintain or obtain additional sources of cash. The Company has successfully performed this task during the past three years and has continued to invest funds generated by operations and financing activities. The Company has continued to generate cash from operations with net cash provided of $1.4 million in 1993; $1.4 million in 1992; and $.5 million in 1991. Cash utilized by the Company in its investing activities increased to $9.2 million in 1993 from $2.6 million in 1992 and $14.1 million in 1991. Cash provided by the Company's financing activities was $5.8 million in 1993 compared to $5.0 million in 1992 and $13.4 million in 1991. These cash flows have resulted in year end cash and cash equivalent balances of $3.6 million in 1993; $5.6 million in 1992; and $1.8 million in 1991. Management considers the cash balance at September 30, 1993 of $3.6 million to be adequate to finance any required debt retirements or planned asset additions. During 1993, the $2.1 million decrease in cash and cash equivalents resulted from cash provided by operating activities of $1.4 million less cash used in investing activities of $9.2 million plus cash provided by financing activities of $5.7 million. Cash from operating activities resulted primarily from net income of $.3 million and the increase in compound and accrued interest on Investment Certificates of $1.0 million. Cash used in investing activities primarily included: (1) acquisition of real estate Receivables net of payments and sales, of $7.6 million; and (2) an advance to its parent company of $1.7 million for the purchase of Receivables. Cash provided by financing activities included: (1) issuance of Investment Certificates, net of repayments and related debt issue costs, of $7.0 million; less (2) repayment of amounts due its parent of $.4 million; and (3) repayment to banks and others of $.9 million. The Company's investing activities during 1993 were supported by cash from operations and external financing. The Company's increases in Receivables were primarily funded by sales of Investment Certificates. During 1992, the $3.9 million increase in cash and cash equivalents resulted from cash provided by operating activities of $1.4 million less cash used in investing activities of $2.5 million plus cash provided by financing activities of $5.0 million. Cash from operating activities resulted primarily from net income of $.7 million and the increase in compound and accrued interest on Investment Certificates of $.7 million. Cash used in investing activities primarily included the acquisition of real estate Receivables net of payments and sales, of $3.0 million less $.5 million advance repaid by its parent. Cash provided by financing activities included: (1) issuance of Investment Certificates, net of repayments and related debt issue costs, of $4.7 million; (2) borrowings from its parent of $.4 million; less (3) repayment to banks and others of $.1 million. Thus, during 1992, the Company's investing activities were supported by internal cash from operations and external cash from financing. The Company's increases in Receivables were primarily funded by sales of Investment Certificates. During 1991, the $.2 million decrease in cash and cash equivalents resulted from cash provided by operating activities of $.5 million less cash used in investing activities of $14.1 million plus cash provided by financing activities of $13.4 million. Cash from operating activities resulted primarily from net income of $.2 million and the increase in compound and accrued interest on Investment Certificates of $.2 million. Cash used in investing activities primarily included the acquisition of real estate Receivables net of payments, of $7.7 million, while the total advanced to or invested in affiliates was $6.5 million. Cash provided by financing activities included: (1) issuance of Investment Certificates, net of repayments and related debt issue costs, of $7.4 million; and (2) borrowings from parent of $6.0 million. Thus, during 1991 as in 1992 and 1993, the Company's investing activities were supported by internal cash from operations and external cash from financing. The Company's increases in Receivables were primarily funded by sales of Investment Certificates. Management believes that cash flow from operating activities and financing activities will be sufficient for the Company to conduct its business and meet its anticipated obligations as they mature during fiscal 1994. The Company has not defaulted on any of its obligations since its founding in 1990. Item 8. Item 8. Financial Statements and Supplementary Data YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991 Page Reports of Independent Certified Public Accountants................................... Balance Sheets.......................................... Statements of Income.................................... Statements of Stockholder's Equity...................... Statements of Cash Flows................................ Notes to Financial Statements........................... REPORT OF INDEPENDENT ACCOUNTANTS The Directors and Stockholder Summit Securities, Inc. We have audited the accompanying balance sheet of Summit Securities, Inc. (a wholly-owned subsidiary of Metropolitan Mortgage & Securities Co., Inc.) as of September 30, 1993, and the related statements of income, stockholder's equity and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Summit Securities, Inc. as of September 30, 1993 and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. As discussed in Note 1, the Company changed its methods of accounting for repossessed real property and income taxes in 1993. /S/ COOPERS & LYBRAND COOPERS & LYBRAND Spokane, Washington December 13, 1993 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors of Summit Securities, Inc. We have audited the accompanying balance sheet of Summit Securities, Inc. (a wholly-owned subsidiary of Metropolitan Mortgage & Securities Co., Inc.) as of September 30, 1992 and the related statements of income, stockholder's equity, and cash flows for each of the two years in the period ended September 30, 1992. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Summit Securities, Inc. at September 30, 1992, and the results of its operations and its cash flows for each of the two years in the period ended September 30, 1992, in conformity with generally accepted accounting principles. /s/ BDO Seidman BDO SEIDMAN Spokane, Washington December 7, 1992 SUMMIT SECURITIES, INC. BALANCE SHEETS September 30, 1993 and 1992 ____________ The accompanying notes are an integral part of the financial statements. SUMMIT SECURITIES, INC. STATEMENTS OF INCOME For the Years Ended September 30, 1993, 1992 and 1991 ____________ The accompanying notes are an integral part of the financial statements. SUMMIT SECURITIES, INC. STATEMENTS OF STOCKHOLDER'S EQUITY For the Years Ended September 30, 1993, 1992 and 1991 ____________ The accompanying notes are an integral part of the financial statements. SUMMIT SECURITIES, INC. STATEMENTS OF CASH FLOWS For the Years Ended September 30, 1993, 1992 and 1991 ____________ SUMMIT SECURITIES, INC. STATEMENTS OF CASH FLOWS, Continued For the Years Ended September 30, 1993, 1992 and 1991 ____________ The accompanying notes are an integral part of the financial statements. SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS ____________ 1. Summary of Accounting Policies Business Summit Securities, Inc., d/b/a National Summit Securities, Inc. in the states of New York and Ohio ("Summit" or "the Company"), a wholly-owned subsidiary of Metropolitan Mortgage & Securities Co., Inc. ("Metropolitan") was incorporated on July 25, 1990. Summit purchases contracts and mortgage notes collateralized by real estate, with funds generated from the public issuance of debt securities in the form of investment certificates, cash flow from receivables and sales of real estate. Cash and Cash Equivalents For purposes of balance sheet classification and the statement of cash flows, the Company considers all highly liquid debt instruments purchased with a remaining maturity of three months or less to be cash equivalents. Cash includes all balances on hand and on deposit in banks and financial institutions. The Company periodically evaluates the credit quality of its financial institutions. Substantially all cash and cash equivalents are on deposit with one financial institution and balances periodically exceed the FDIC insurance limit. Real Estate Contracts and Mortgage Notes Receivable Real estate contracts and mortgage notes held for investment purposes are carried at amortized cost. Discounts originating at the time of purchase net of capitalized acquisition costs are amortized using the level yield (interest) method. For contracts acquired after September 30, 1992, net purchase discounts are amortized on an individual contract basis using the level yield method over the remaining contractual term of the contract. For contracts acquired before October 1, 1992, the Company accounts for its portfolio of discounted loans using anticipated prepayment patterns to apply the level yield (interest) method of amortizing discounts. Discounted contracts are pooled by the fiscal year of purchase and by similar contract types. The amortization period, which is approximately 78 months, estimates a constant prepayment rate of 10-12 percent per year and scheduled payments, which is consistent with the Company's prior experience with similar loans and the Company's expectations. SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 1. Summary of Accounting Policies, Continued Real Estate Contracts and Mortgage Notes Receivable, Continued In May 1993, Statement of Financial Accounting Standards No. 114 (SFAS No. 114), "Accounting by Creditors for Impairment of a Loan," was issued. SFAS No. 114 requires that certain impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral. The Company is required to adopt this new standard by October 1, 1995. The Company does not anticipate that the adoption of SFAS No. 114 will have a material effect on the financial statements. Real Estate Held for Sale Real estate is valued at the lower of cost or market. The Company principally acquires real estate through foreclosure or forfeiture. Cost is determined by the purchase price of the real estate or, for real estate acquired by foreclosure, at the lower of (a) the fair value of the property at date of foreclosure less estimated selling costs, or (b) cost (unpaid contract carrying value). Profit on sales of real estate is recognized when the buyers' initial and continuing investment is adequate to demonstrate that (1) a commitment to fulfill the terms of the transaction exists, (2) collectibility of the remaining sales price due is reasonably assured, and (3) the Company maintains no continuing involvement or obligation in relation to the property sold and transfers all the risks and rewards of ownership to the buyer. In April 1992, the Accounting Standards Division of the American Institute of Certified Public Accountants issued Statement of Position (SOP) No. 92-3, "Accounting for Foreclosed Assets," which provides guidance on determining the accounting treatment of foreclosed assets. SOP 92-3 requires that foreclosed assets be carried at the lower of (a) fair value minus estimated costs to sell, or (b) cost. The Company applied the provisions of SOP 92-3 effective October 1, 1992. The application of SOP 92-3, estimated to be approximately $10,000 before the application of related income taxes, is included in continuing operations for the year ended September 30, 1993. SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 1. Summary of Accounting Policies, Continued Allowance for Losses on Real Estate Assets The established allowances for losses on real estate assets include amounts for estimated probable losses on both real estate held for sale and real estate contracts and mortgage notes receivable. Specific allowances are established for all delinquent contract receivables with net carrying values in excess of $100,000. Additionally, the Company establishes general allowances, based on prior actual delinquency and loss experience, for currently performing receivables and smaller delinquent receivables. Allowances for losses are determined on net carrying values of the contracts, including accrued interest. Accordingly, the Company continues interest accruals on delinquent loans until foreclosure, unless the principal and accrued interest on the loan exceed the fair value of the collateral, net of estimated selling costs. Deferred Costs Commission and other expenses incurred in connection with the registration and public offering of investment certificates are capitalized and amortized using the interest method over the estimated life of the related investment certificates, which range from 6 months to 5 years. Income Taxes The Company is included in the group of companies which file a consolidated income tax return with Metropolitan. The Company is allocated a current and deferred tax provision from Metropolitan as if the Company filed a separate tax return. Effective October 1, 1992, Metropolitan adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). Under this method, deferred tax liabilities and assets are determined on temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the temporary differences are expected to reverse. There was no effect on the Company's financial statements of adopting SFAS No. 109. In 1992 and 1991, Metropolitan and the Company accounted for income taxes as required by Accounting Principles Board Opinion No. 11. SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 1. Summary of Accounting Policies, Continued Financial Instruments In December 1991, Statement of Financial Accounting Standards No. 107 (SFAS No. 107), "Disclosures about Fair Value of Financial Instruments," was issued. SFAS No. 107 requires disclosures of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. SFAS No. 107 is effective for financial statements issued for fiscal years ending after December 31, 1995 (Summit's fiscal year ending September 30, 1996) for entities with less than $150 million in total assets. This pronouncement does not change any requirements for recognition, measurement or classification of financial instruments in the Company's financial statements. Reclassifications Certain amounts in the 1992 and 1991 financial statements have been reclassified to conform with the current year's presentation. These reclassifications had no effect on net income or retained earnings as previously reported. 2. Real Estate Contracts and Mortgage Notes Receivable Real estate contracts and mortgage notes receivable include mortgages collateralized by property located throughout the United States. At September 30, 1993, the Company held first position liens associated with contract and mortgage notes receivable with a face value of approximately $13,800,000 and second position liens of approximately $6,900,000. Approximately 21% of the face value of the Company's real estate contracts and mortgage notes receivable are collateralized by property located in the Pacific Northwest (Washington, Idaho, Montana and Oregon), approximately 9% by property located in California and approximately 27% by property located in Hawaii. SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 2. Real Estate Contracts and Mortgage Notes Receivable, Continued Contracts totaling approximately $6,000,000 which are collateralized by property in Hawaii were purchased from a Metropolitan affiliated company during fiscal 1993. At September 30, 1993, approximately $5,500,000 of these contracts were outstanding. These contracts relate to the sale of time share units in a condominium resort development which is owned by a Metropolitan affiliated company. The face value of the Company's real estate contracts and mortgage notes receivable as of September 30, 1993 and 1992 are grouped by the following dollar ranges: Contractual interest rates on the face value of the Company's real estate contracts and mortgage notes receivable as of September 30, 1993 and 1992 are as follows: The weighted average contractual interest rate on these receivables at September 30, 1993 is approximately 10.5%. Maturity dates range from 1993 to 2023. The constant effective yield on contracts purchased in fiscal 1993 and 1992 was approximately 12% and 15%, respectively. SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 2. Real Estate Contracts and Mortgage Notes Receivable, Continued The following is a reconciliation of the face value of the real estate contracts and mortgage notes receivable to the Company's carrying value: The principal amount of receivables with required principal or interest payments being in arrears for more than three months was approximately $1,662,000 and $529,000 at September 30, 1993 and 1992, respectively. Included in the amount for September 30, 1993 is approximately $680,000 of delinquent contracts purchased from an affiliate during 1993. The Company has a performance holdback of $600,000 to cover any losses related to certain timeshare unit contracts, including these delinquent contracts. Aggregate amounts of receivables (face amount) expected to be received, based upon prepayment patterns, are as follows: SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 3. Debt Payable At September 30, 1993 and 1992, debt payable consists of: SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 4. Investment Certificates At September 30, 1993 and 1992, investment certificates consist of: SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 5. Deferred Costs Unamortized commissions and other capitalized expenses incurred in connection with the sale of investment certificates aggregated $524,376 and $342,650 at September 30, 1993 and 1992, respectively, and are shown as deferred costs on the balance sheets. An analysis of such deferred costs is as follows: No valuation allowance has been established to reduce the deferred tax assets, as it is more likely than not that these assets will be realized due to the future reversals of existing taxable temporary differences. As of September 30, 1993, the Company's share of the consolidated group's net operating loss carryforwards was approximately $659,000, which expires in 2005. SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 6. Income Taxes, Continued The provision for income taxes is computed by applying the statutory federal income tax rate to income before income taxes as follows: SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 6. Income Taxes, Continued During the year ended December 31, 1992, the Company recognized an extraordinary credit of $49,772 by the utilization of net operating loss carryforwards of approximately $146,000. 7. Related Party Transactions Summit receives accounting, data processing, contract servicing and other administrative services from Metropolitan. Charges for these services were approximately $97,000 in fiscal 1993, $50,000 in fiscal 1992 and $0 in fiscal 1991 and were assessed based on the number of real estate contracts and mortgage notes receivable serviced by Metropolitan on Summit's behalf. Other indirect services provided by Metropolitan to Summit, such as management and regulatory compliance, are not directly charged to Summit. Management believes that this allocation is reasonable and results in the reimbursement to Metropolitan of all significant direct expenses incurred on behalf of Summit. Management does not believe that Summit could obtain these services from outside sources for less than the allocated costs, or that these costs would be significantly higher if Summit operated alone. SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 7. Related Party Transactions, Continued Summit had the following related party transactions with Metropolitan and affiliates during fiscal 1993 and 1992: Advances to parent of $1,710,743 at September 30, 1993 represent advances to Metropolitan for the purchase of Summit's investments in real estate contracts and mortgage notes receivable. Advances from parent of $400,365 at September 30, 1992 represent real estate contracts and mortgage notes and related costs advanced by Metropolitan on behalf of Summit. These advances to and from Metropolitan are non-interest bearing. On March 31, 1991, the Company borrowed $6,000,000 from Metropolitan, which was payable on demand and required monthly interest-only payments. The stated note rate was equal to the prime rate as quoted monthly by the Seattle-First National Bank plus 1.5%. Summit used the funds borrowed from Metropolitan to purchase preferred stock issued by Western United Life Assurance Company ("Western"), a full service life insurance company. Metropolitan also owns approximately 96% of the outstanding stock of Western. In March 1992, the Company repaid the $6,000,000 note payable to Metropolitan through the transfer of the Company's preferred stock investment in Western to Metropolitan. SUMMIT SECURITIES, INC. NOTES TO FINANCIAL STATEMENTS, Continued ____________ 8. Supplemental Disclosures for Statements of Cash Flows Supplemental information on interest and income taxes paid during the years ended September 30, 1993, 1992 and 1991 is as follows: Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. N/A. The Company reported a change in accountants in its Form 8-K dated June 25, 1993. PART III Item 10. Item 10. Directors and Executive Officers of Registrant. See "Management" under Item 1. Item 11. Item 11. Executive Compensation. See "Executive Compensation" under Item 1. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. See "Principal Shareholders" under Item 1. Item 13. Item 13. Certain Relationships and Related Transactions. See "Certain Transactions" under Item 1. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements Included in Part II, Item 8 of this report: Reports of Independent Certified Public Accountants Balance Sheets at September 30, 1993, and 1992 Statements of Income for the Years Ended September 30, 1993, 1992 and 1991. Statements of Stockholder's Equity for the years Ended September 30, 1993, 1992 and 1991 Statements of Cash Flows for the Years Ended September 30, 1993, 1992 and 1991 Notes to Financial Statements (b) 2. Financial Statements Schedules Included in Part IV of this report: Reports of Independent Certified Public Accountants on Financial Statement Schedules. Schedule I -- Summary of Investments other than Investments in Related Parties Schedule VIII -- Valuation and Qualifying Accounts and Reserves Schedule XII -- Loans on Real Estate Other Schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the financial statements or notes thereto. Columns may have been omitted from schedules filed because the information is not applicable. (c) 3. Exhibits 3(a). Articles of Incorporation of the Company. (Exhibit 3(a) to (Registration No. 33-36775). 3(b). Bylaws of the Company. (Exhibit 3(b) to Registration No. 33-36775). 4(a). Indenture dated as of November 15, 1990 between Summit and West One Bank, Idaho, N.A., Trustee. (Exhibit 4(a) to Registration No. 33-36775). 4(b). Amendment to Indenture dated as of November 15, 1990 between Summit and West One Bank, Idaho, N.A., Trustee. (Exhibit 4(b) to Registration No. 33-36775). *4(c). Form of Statement of Rights, Designations and Preferences of Variable Rate Cumulative Preferred Stock Series S-1. *4(d). Form of Variable Rate Cumulate Preferred Stock Certificate. *4(e). Form of Investment Certificate. 10(a). Receivable Purchase Option Agreement between Summit and Metropolitan Mortgage & Securities Co., Inc. dated November 15, 1990. (Exhibit 10(a) to Registration No. 33-36775). 10(b). Service Contract between Summit and Metropolitan Mortgage & Securities Co., Inc. dated November 15, 1990. (Exhibit 10(b) to Registration No. 33-36775). 10(c). Promissory Note dated March 31, 1991 between Summit and Metropolitan Mortgage & Securities Co., Inc. (Exhibit 10 to registrant's Annual Report on Form 10-K for the year ended September 30, 1991.) 11. Computation of Earnings Per Common Share. (See Financial Statements.) * Filed herewith REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES The Directors and Stockholder Summit Securities, Inc. In connection with our audit of the financial statements of Summit Securities, Inc. as of September 30, 1993 and for the year then ended, included herein, we have issued our report thereon, which includes an explanatory paragraph describing changes in the Company's methods of accounting for repossessed real property and income taxes, which financial statements are included in the Form 10-K. We have also audited the 1993 financial statement schedules listed in Item 16 herein. In our opinion, these 1993 financial statement schedules, when considered in relation to the basic 1993 financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/ COOPERS & LYBRAND Coopers & Lybrand Spokane, Washington December 13, 1993 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES The Directors and Stockholders Summit Securities, Inc. The audits referred to in our report dated December 7, 1992, relating to the financial statements of Summit Securities, Inc., as of September 30, 1992 and for the two years in the period then ended, which is contained in Item 8 of this Form 10-K included the audits of the financial statement schedules listed in the accompanying index for each of the two years in the period ended September 30, 1992. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based upon our audits. In our opinion, such financial statement schedules present fairly, in all material respects, the information set forth therein. /s/ BDO SEIDMAN BDO Seidman Spokane, Washington December 7, 1992 SCHEDULE I SUMMIT SECURITIES, INC. SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES SEPTEMBER 30, 1993 SCHEDULE VIII SUMMIT SECURITIES, INC. VALUATION AND QUALIFYING ACCOUNTS AND RESERVES YEARS ENDED SEPTEMBER 30, 1993, 1992 AND 1991 Schedule XII SUMMIT SECURITIES, INC. LOANS ON REAL ESTATE September 30, 1993 Schedule XII Continued SUMMIT SECURITIES, INC. LOANS ON REAL ESTATE September 30, 1993 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. SUMMIT SECURITIES, INC. /S/ C. PAUL SANDIFUR, JR. By_______________________________________________ C. Paul Sandifur, Jr., President, Director and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated: Signature Title Date /S/ C. PAUL SANDIFUR, SR. 1/13/94 _________________________ Chairman of the Board _________ C. Paul Sandifur, Sr. /S/ C. PAUL SANDIFUR, Jr. President, Director and 1/13/94 _________________________ Chief Executive Officer _________ C. Paul Sandifur, Jr. /S/ REUEL SWANSON Secretary and 1/13/94 _________________________ Director _________ Reuel Swanson /S/ MICHAEL BARCELO 1/13/94 ________________________ Treasurer _________ Michael Barcelo /S/ STEVEN CROOKS Controller and Principal 1/13/94 ________________________ Accounting Officer _________ Steven Crooks /S/ ALTON R. COGERT Chief Financial Officer 1/13/94 ________________________ and Assistant Vice President _________ Alton R. Cogert As filed with the Securities and Exchange Commission on January 13, 1994. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 __________________________________ FORM 10-K ANNUAL REPORT Under THE SECURITIES EXCHANGE ACT OF 1934 __________________________ (Exact name of registrant as specified in charter) __________________________ Idaho 6799 (State or other jurisdiction of (Primary Standard Industrial incorporation or organization Classification Code Number) West 929 Sprague Avenue Spokane, Washington 99204 82-0438135 (509) 838-3111 (I.R.S. Employer (Address, including zip code Identification No.) and telephone number, including area code, of registrant's principal executive offices) C. Paul Sandifur, Jr. President Summit Securities, Inc. W. 929 Sprague Avenue Spokane, WA 99204 Telephone No. (509) 838-3111 _____________________________________ (Name, address, including zip code, and telephone number, including area code, of agent for service) _____________________________________ EXHIBIT VOLUME EXHIBIT INDEX Page Number *4(c). Form of Statement of Rights, Designations and Preferences of Variable Rate Cumulative Preferred Stock Series S-1. *4(d). Form of Variable Rate Cumulate Preferred Stock Certificate. *4(e). Form of Investment Certificate. * Filed herewith Exhibit 4(c) FORM OF STATEMENT OF RIGHTS, DESIGNATIONS AND PREFERENCES OF VARIABLE RATE CUMULATIVE PREFERRED STOCK, SERIES S-1 PURSUANT TO 1.Name of Corporation: Summit Securities, Inc. 2. Copy of resolution establishing and designating Variable Rate Cumulative Preferred Stock, Series S-1, and determining the relative rights and preferences thereof: Attached hereto. 3. The undersigned does hereby certify that the attached resolution was duly adopted by the Board of Directors of the corporation on January , 1994. ______________________________________ Reuel Swanson, Secretary Exhibit 4(c) continued SUMMIT SECURITIES, INC. PREFERRED STOCK SERIES S-1 AUTHORIZING RESOLUTION Resolved, that pursuant to the authority expressly granted and vested in the Board of Directors (the "Board") of this Corporation by its Articles of Incorporation, as amended, a sub-series of Preferred Stock, Series S-1 of the Corporation be, and is hereby, established which will consist of 150,000 shares of the par value of $10.00 per share ($15,000,000), shall be designated "Variable Rate Cumulative Preferred Stock, Series S-1" (hereafter called "Preferred Stock"), shall be offered at $100.00 per share and which shall have rights, preferences, qualifications and restrictions as follows: 1. DIVIDENDS. a) Dividends (or other distributions deemed dividends for purposes of this resolution) on the issued and outstanding shares of Preferred Stock shall be declared and paid monthly at a percentage rate per annum of the liquidation preference of $100.00 per share equal to the "Applicable Rate," as hereinafter defined, or such greater rate as may be determined by the Board. Notwithstanding the foregoing, the Applicable Rate for any monthly dividend period shall, in no event, be less than 6% per annum or greater than 14% per annum. Such dividends shall be cumulative from the date of original issue of such shares and shall be payable, when and as declared by the Board, on such dates as the Board deems advisable, but at least once a year, commencing June 1, 1993. Each such dividend shall be paid to the holders of record of shares of Preferred Stock as they appear on the stock register of the Corporation on such record date as shall be fixed by the Board in advance of the payment date thereof. Dividends on account of arrears for any past Dividend Periods may be declared and paid at any time, without reference to any regular dividend payment date, to holders of record on such date as shall be fixed by the Board in advance of the payment date thereof. b) Except as provided below in this section, the Applicable Rate for any monthly dividend period shall be the highest of the Treasury Bill Rate, the Ten Year Constant Maturity Rate and the Twenty Year Constant Maturity Rate (each as defined in Exhibit A attached hereto and incorporated by reference herein) plus one half of one percentage point. In the event that the Board determines in good faith that for any reason one or more of such rates cannot be determined for any dividend period, than the Applicable Rate for such dividend period shall be the higher of whichever of such rates can be so determined. In the event that the Board determines in good faith that none of such rates can be determined for any dividend period, then the Applicable Rate in effect for the preceding dividend period shall be continued for such dividend period. The Treasury Bill Rate, the Ten Year Constant Maturity Rate and the Twenty Year Constant Maturity Rate shall each be rounded to the nearest five hundredths of a percentage point. c) No dividend shall be paid upon, or declared or set apart for, any share of Preferred Stock for any Dividend Period unless at the same time a like dividend shall be paid upon, or be declared and set apart for, all shares of Preferred Stock then issued and outstanding and all shares of all other series of preferred stock then issued and outstanding and entitled to receive dividends. Holders of Preferred Stock shall not be entitled to any dividend, whether payable in cash, property or stock, in excess of full cumulative dividends as herein provided. No interest, or sum of money in lieu of interest, shall be payable in respect of any dividend payment or payments which may be in arrears on Preferred Stock. d) Dividends payable for each full monthly Dividend Period shall be computed by dividing the Applicable Rate for such monthly Dividend Period by twelve and applying such rate against the liquidation preference of $100.00 per share. Dividends shall be rounded to the nearest whole cent. Dividends payable for any period less than a full monthly Dividend Period shall be computed on the basis of 30 day months and a 360 day year. The Applicable Rate with respect to each monthly Dividend Period shall be calculated as promptly as practicable by the Corporation according to the method provided herein. The Corporation will cause notice of such Applicable Rate to be enclosed with the dividend payment check next mailed to the holders of shares of Preferred Stock. e) So long as any shares of Preferred Stock are outstanding, (i) no dividend (other than a dividend in common stock or in any other stock ranking junior to Preferred Stock as to dividends and upon liquidation and other than as provided in the foregoing section 1(c)) shall be declared or paid or set aside for payment; (ii) no other distribution shall be declared or made upon common stock or upon any other stock ranking junior to or on a parity with Preferred Stock as to dividends or upon liquidation; and (iii) no common stock or any other stock of the Corporation ranking junior to or on a parity with Preferred Stock as to dividends or upon liquidation shall be redeemed, purchased or otherwise acquired by the Corporation for any consideration (or any monies paid to or made available for a sinking fund for the redemption of any shares of any such stock) except by conversion into or exchange for stock of the Corporation ranking junior to Preferred Stock as to dividends and upon liquidation unless, in each case, the full cumulative dividends on all outstanding shares of Preferred Stock shall have been paid or declared and set apart for all past dividend payment periods. f) The holders of Preferred Stock shall be entitled to receive, when and as declared by the Board, dividend distributions out of the funds of the Corporation legally available therefor. Any distribution made which may be deemed to have been made out of the capital surplus of Preferred Stock shall not reduce either the redemption process or the liquidation rights as hereafter specified. 2. REDEMPTION. a) The Corporation, at its option, may redeem shares of Preferred Stock, in whole or in part, at any time or from time to time, at redemption prices hereafter set forth plus accrued and unpaid dividends to the date fixed for redemption. i) In the event of a redemption of shares pursuant to this subsection prior to January 1, 1995, the redemption price shall be $102.00 per share; and the redemption price shall be $100.00 per share in the event of redemption anytime after December 31, 1994. ii) In the event that fewer than all of the outstanding shares of Preferred Stock are to be redeemed, the number of shares to be redeemed shall be determined by the Corporation and the shares to be redeemed shall be determined by lot, or pro rata, or by any other method, as may be determined by the Corporation in its sole discretion to be equitable. iii) In the event that the Corporation shall redeem shares hereunder, notice of such redemption shall be given by first class mail, postage prepaid, mailed not less than 30 days or more than 60 days prior to he redemption date, to each holder of record of the shares to be redeemed, at such holder's address as it appears on the stock register of the Corporation. Each such notice shall state: (i) the redemption date; (ii) the number of shares to be redeemed and, if fewer than all shares held by such holder are to be redeemed, the number of such shares to be redeemed from such holder; (iii) the redemption price; (iv) the place or places where certificates for such shares are to be surrendered for payment of the redemption price; and (v) that dividends on the shares to be redeemed will cease to accrue on such redemption date. iv) Notice having been mailed as aforesaid, from and after the redemption date (unless default shall be made by the Corporation in providing money for the payment of the redemption price), dividends on the shares so called for redemption shall no longer be deemed to be outstanding, and all rights of the holders thereof as stockholders of the Corporation (except the right to receive from the Corporation the redemption price) shall cease. Upon surrender in accordance with said notice of the certificates representing shares redeemed (properly endorsed or assigned for transfer, if the Board shall so require and the notice shall so state), such shares shall be redeemed by the Corporation at the redemption price aforesaid. In case fewer than all of the shares represented by any such certificate are redeemed, a new certificate shall be issued representing the unredeemed shares without cost to the holder thereof. b) Discretionary Redemption Upon Request of the Holder: The shares of Preferred Stock are not redeemable at the option of the holder. If, however, the Corporation receives an unsolicited written request for redemption of a block of shares from any holder, the Corporation may, in its sole discretion and subject to the limitations described below, accept such shares for redemption. Any shares so tendered, which the Corporation in its discretion, allows for redemption, shall be redeemed by the Corporation directly, and not from or through a broker or dealer, at a price equal to $97 per share, plus any declared but unpaid dividends to date if redeemed during the first year after the date of original issuance and $99 per share plus any declared but unpaid dividends if redeemed thereafter. The Corporation may change such optional redemption prices at any time with respect to unissued shares. For a period of three years from the date of initial sale of each share of Preferred Stock, any such optional redemption of such share shall occur only upon the death or major medical emergency of the holder or any joint holder of the share requested to be redeemed. Any optional redemption of a share in any calendar year after the third year from the date of sale of the share, not arising from the death or medical emergency of the holder or any joint holder shall occur only when the sum of all optional redemptions (including those arising out of the death or medical emergency of the holder or any joint holder) of shares of Preferred Stock during that calendar year shall not exceed 10% of the number of shares of Preferred Stock outstanding at the end of the preceding calendar year. In the event the 10% limit is reached in any calendar year, the only redemption which may thereafter occur during that calendar year shall be those arising from the death or medical emergency of the holder or any joint holder; provided, however, that to the extent that total optional redemptions in any calendar year do not reach the 10% limit, the amount by which such optional redemptions shall fall short of the 10% limit may be carried over into ensuing years; and provided further that to the extent that all redemptions, including those involving the death or medical emergency of the holder or any joint holder, exceed the 10% in any year, the amount by which such redemptions exceed the 10% limit shall reduce the limit in the succeeding year for limiting redemptions not involving the death or medical emergency of a holder or any joint holder. In no event shall such optional redemptions of all types in a single calendar year exceed 20% of the number of shares of Preferred Stock outstanding at the end of the preceding calendar year. The Corporation may not redeem any such shares tendered for redemption if to do so would be unsafe or unsound in light of the Corporation's financial condition (including its liquidity position); if payment of interest or principal on any outstanding instrument of indebtedness is in arrears or in default; or if payment of any dividend on Preferred Stock or share of any stock of the Company ranking at least on a parity therewith is in arrears as to dividends. c) Any shares of Preferred Stock which shall at any time have been redeemed shall, after such redemption, have the status of authorized but unissued shares of Preferred Stock, without designation as to series until such shares are designated as part of a particular series by the Board. d) Notwithstanding the foregoing provisions of this Section 2, if any dividends on Preferred Stock are in arrears, no shares of Preferred Stock shall be redeemed unless all outstanding shares of Preferred Stock are simultaneously redeemed, and the Corporation shall not purchase or otherwise acquire any shares of Preferred Stock; provided, however, that the foregoing shall not prevent the purchase or acquisition of shares of Preferred Stock pursuant to a purchase or exchange offer made on the same terms to holders of all of the outstanding shares of Preferred Stock. 3. CONVERSION OR EXCHANGE. The holders of shares of Preferred Stock shall not have any rights to convert such shares into or exchange such shares for shares of any other class or series of any class of securities of the Corporation. 4. VOTING. Except as required from time to time by law, the shares of Preferred Stock shall have no voting powers. Provided, however, not withstanding the foregoing, that whenever and as often as dividends payable on any shares of Preferred Stock shall be in arrears in an amount equal to twenty four full monthly dividends or more per share, the holders of Preferred Stock together with the holders of any other preferred stock hereafter authorized, voting separately and as a single class shall be entitled to elect a majority of the Board of Directors of the Corporation. Such right shall continue until all dividends in arrears on preferred stock have been paid in full. 5. LIQUIDATION RIGHTS. a) Upon the dissolution, liquidation or winding up of the Corporation, the holders of the shares of Preferred Stock shall be entitled to receive out of the assets of the Corporation, before any payment or distribution shall be made on the Common Stock, or on any other class of stock ranking junior to Preferred Stock, upon liquidation, the amount of $100.00 per share, plus a sum equal to all dividends (whether or not earned or declared) on such shares accrued and unpaid thereon to the date of final distribution. b) Neither the sale, lease or conveyance of all or substantially all the property or business of the Corporation, nor the merger or consolidation of the Corporation into or with any other corporation or the merger or consolidation of any other corporation into or with the Corporation, shall be deemed to be a dissolution, liquidation or winding up, voluntary or involuntary, for the purposes of this Section. c) After the payment to the holders of the shares of Preferred Stock of the full preferential amounts provided for in this Section, the holders of Preferred Stock as such shall have no right or claim to any of the remaining assets of the Corporation. d) In the event the assets of the Corporation available for distribution to the holders of shares of Preferred Stock upon any dissolution, liquidation or winding up of the Corporation, whether voluntary or involuntary, shall be insufficient to pay in full all amounts to which such holders are entitled pursuant to this Section, no such distribution shall be made on account of any shares or any other series of Preferred Stock or any other class of stock ranking on a parity with the shares of Preferred Stock upon such dissolution, liquidation or winding up, unless proportionate distributive amounts shall be paid on account of the shares of Preferred Stock, ratably in accordance with the sums which would be payable in such distribution if all sums payable in respect of the shares of all series of Preferred Stock and any such other class of stock as aforesaid were discharged in full. 6. PRIORITIES. For purposes of this Resolution, any stock of any class or classes of the Corporation shall be deemed to rank: a) Prior to the shares of Preferred Stock, either as to dividends or upon liquidation if the holders of such class or classes shall be entitled to the receipt of dividends or of amounts distributable upon dissolution, liquidation or winding up of the Corporation, as the case may be, in preference or priority to the holders of shares of Preferred Stock. b) On a parity with shares of Preferred Stock, either as to dividends or upon liquidation, whether or not the dividend rates, dividend payment dates or redemption or liquidation prices per share or sinking fund provisions, if any, are different from those of Preferred Stock, if the holder of such stock shall be entitled to the receipt of dividends or of amounts distributable upon dissolution, liquidation or winding up of the Corporation, as the case may be, in proportion to their respective dividend rates or liquidation prices, without preference or priority, one over the other, as between the holder of such stock and the holders of Preferred Stock; and c) Junior to shares of Preferred Stock, either as to dividends or upon liquidation, if the holders of shares of Preferred Stock shall be entitled to receipt of dividends or of amounts distributable upon dissolution, liquidation or winding up of the Corporation, as the case may be, in preference or priority to the holders of shares of such class or classes. 7. SHARES NON-ASSESSABLE. Any and all shares of Preferred Stock issued, and for which the full consideration has been paid or delivered, shall be deemed fully paid stock and the holder of such shares shall not be liable for any further call or assessment or any other payment thereon. 8. PRE-EMPTIVE RIGHTS. Holders of Preferred Stock shall have no pre-emptive rights to acquire additional shares of Preferred Stock. EXHIBIT A Treasury Bill Rate Except as provided below in this paragraph, the "Treasury Bill Rate" for each dividend period will be the arithmetic average of the two most recent weekly per annum market discount rates (or the one weekly per annum market discount rate, if only one such rate shall be published during the relevant Calendar Period (as defined below)) for three-month U.S. Treasury bills, as published weekly by the Federal Reserve Board during the Calendar Period immediately prior to the ten calendar days immediately preceding the first day of the dividend period for which the dividend rate on Preferred Stock Series E-5, is being determined. In the event that the Federal Reserve Board does not publish such a weekly per annum market discount rate during any such Calendar Period, then the Treasury Bill Rate for the related dividend period shall be the arithmetic average of the two most recent weekly per annum market discount rates (or the one weekly per annum market discount rate, if only one such rate shall be published during the relevant Calendar Period) for three-month U.S. Treasury bills, as published weekly during such Calendar Period by any Federal Reserve Bank or by any U.S. Government department or agency selected by the Company. In the event that a per annum market discount rate for three-month U.S Treasury bills shall not be published by the Federal Reserve Board or by any Federal Reserve Bank or by any U.S. Government department or agency during such Calendar Period, then the Treasury Bill Rate for such dividend period shall be the arithmetic average of the two most recent weekly per annum market discount rates (or the one weekly per annum market discount rate, if only one such rate shall be published during the relevant Calendar Period) for all of the U.S. Treasury bills then having maturities of not less than 80 nor more than 100 days, as published during such Calendar Period by the Federal Reserve Board or, if the Federal Reserve Board shall not publish such rates, by any Federal Reserve Bank or by any U.S. Government department or agency selected by the Company. In the event that the Company determines in good faith that for any reason no such U.S. Treasury bill rates are published as provided above during such Calendar Period, then the Treasury Bill Rate for such dividend period shall be the arithmetic average of the per annum market discount rates based upon bids during such Calendar Period for each of the issues of marketable non-interest bearing U.S. Treasury securities with a maturity of not less than 80 nor more than 100 days from the date of each such quotation, as quoted daily for each business day in New York City (or less frequently if daily quotations shall not be generally available) to the Company by at least three recognized primary U.S. Government securities dealers selected by the Company. In the event that the Company determines in good faith that for any reason the Company cannot determine the Treasury Bill Rate for any dividend period as provided above in this paragraph, the Treasury Bill Rate for such dividend period shall be the arithmetic average of the per annum market discount rates based upon the closing bids during such Calendar Period for each of the issues of marketable interest-bearing U.S. Treasury securities with a maturity of not less than 80 nor more than 100 days from the date of each such quotation, as quoted daily for each business day in New York City (or less frequently if daily quotations shall not be generally available) to the Company by at least three recognized primary U.S. Government securities dealers selected by the Company. Ten Year Constant Maturity Rate Except as provided below in this paragraph, the "Ten Year Constant Maturity Rate" for each dividend period shall be the arithmetic average of the two most recent weekly per annum Ten Year Average Yields (or the one weekly per annum Ten Year Average Yield, if only one such Yield shall be published during the relevant Calendar Period as provided below, as published weekly by the Federal Reserve Board during the Calendar Period immediately prior to the ten calendar days immediately preceding the first day of the dividend period for which the dividend rate on Preferred Stock, Series E-5 is being determined. In the event that the Federal Reserve Board does not publish such a weekly per annum Ten Year Average Yield during such Calendar Period, then the Ten Year Constant Maturity Rate for such dividend period shall be the arithmetic average of the two most recent weekly per annum Ten Year Average Yields (or the one weekly per annum Ten Year Average Yield, if only one such Yield shall be published during such Calendar Period), as published weekly during such Calendar Period by any Federal Reserve Bank or by any U.S. Government department or agency selected by the Company. In the event that a per annum Ten Year Average Yield shall not be published by the Federal Reserve Board or by any Federal Reserve Bank or by any U.S. Government department or agency during such Calendar Period, then the Ten Year Constant Maturity Rate for such dividend period shall be the arithmetic average of the two most recent weekly per annum average yields to maturity (or the one weekly average yield to maturity, if only one such yield shall be published during the relevant Calendar Period) for all of the actively traded marketable U.S. Treasury fixed interest rate securities (other than Special Securities (as defined below)) then having maturities of not less tan eight nor more than twelve years, as published during such Calendar Period by the Federal Reserve Board or, if the Federal Reserve Board shall not publish such yields, by any Federal Reserve Bank o by any U.S. Government department or agency selected by the Company. In the event that the Company determines in good faith that for any reason the Company cannot determine the Ten Year Constant Maturity Rate for any dividend period as provided above in this paragraph, then the Ten Year Constant Maturity Rate for such dividend period shall be the arithmetic average of the per annum average yields to maturity based upon the closing bids during such Calendar Period for each of the issues of actively traded marketable U.S. Treasury fixed interest rate securities (other than Special Securities) with a final maturity date not less than eight nor more than twelve years from the date of each such quotation, as quoted daily for each business day in New York City (or less frequently if daily quotations shall not be generally available) to the Company by at least three recognized primary U.S. Government securities dealers selected by the Company. Twenty Year Constant Maturity Rate Except as provided below in this paragraph, the "Twenty Year Constant Maturity Rate" for each dividend period shall be the arithmetic average of the two most recent weekly per annum Twenty Year Average Yields (or the one weekly per annum Twenty year Average Yield, if only one such Yield shall be published during the relevant Calendar Period), as published weekly by the Federal Reserve Board during the Calendar Period immediately prior to the ten calendar days immediately preceding the first day of the dividend period for which the dividend rate on Preferred Stock, Series E-5 is being determined. In the event that the Federal Reserve Board does not publish such a weekly per annum Twenty Year Average Yield during such Calendar Period, then the Twenty Year Constant Maturity Rate for such dividend period shall be the arithmetic average of the two most recent weekly per annum Twenty Year Average Yields (or the one weekly per annum Twenty Year Average Yield, if only one such Yield shall be published during such Calendar Period), as published weekly during such Calendar Period by any Federal Reserve Bank or by any U.S. Government department or agency selected by the Company. In the event that a per annum Twenty Year Average Yield shall not be published by the Federal Reserve Board or by any Federal Reserve Bank or by any U.S. Government department or agency during such Calendar Period, then the Twenty Year Constant Maturity Rate for such dividend period shall be the arithmetic average of the two most recent weekly per annum average yields to maturity (or the one weekly average yield to maturity, if only one such yield shall be published during such Calendar Period) for all of the actively traded marketable U.S. Treasury fixed interest rate securities (other than Special Securities) then having maturities of not less than eighteen nor more than twenty-two years, as published during such Calendar Period by the Federal Reserve Board or, if the Federal Reserve Board shall not publish such yields, by any Federal Reserve Bank or by any U.S. Government department or agency selected by the Company. In the event that the Company determines in good faith that for any reason the Company cannot determine the Twenty Year Constant Maturity Rate for any dividend period as provided above in this paragraph, then the Twenty Year Constant Maturity Rate for such dividend period shall be the arithmetic average of the per annum average yields to maturity based upon the closing bids during such Calendar Period for each of the issues of actively traded marketable U.S. Treasury fixed interest rate securities (other than Special Securities) with a final maturity date not less than eighteen nor more than twenty-two years from the date of each such quotation, as quoted daily for each business day in New York City (or less frequently if daily quotations shall not be generally available) to the Company by at least three recognized primary U.S. Government securities dealers selected by the Company. As used herein, the term "Calendar Period" means a period of 14 calendar days; the term "Special Securities" means securities which may, at the option of the holder, be surrendered at face value in payment of any federal estate tax or which provide tax benefits to the holder and are priced to reflect such tax benefits or which were originally issued at a deep or substantial discount; the term "Ten Year Average Yield" means the average yield to maturity for actively traded marketable U.S. Treasury fixed interest rate securities (adjusted to constant maturities of ten years); and the term "Twenty Year Average Yield" means the average yield to maturity for actively traded marketable U.S. Treasury fixed interest rate securities (adjusted to constant maturities of 20 years). Exhibit 4(d) (FORM OF VARIABLE RATE CUMULATIVE PREFERRED STOCK CERTIFICATE) Certificate No. Shares SUMMIT SECURITIES, INC. INCORPORATED UNDER THE LAWS OF THE STATE OF IDAHO VARIABLE RATE CUMULATIVE PREFERRED STOCK SERIES (Par Value: $10.00 per share; Liquidation Preference: $100.00 per share) This certifies that is the registered holder of shares of Variable Rate Cumulative Preferred Stock, Series of Summit Securities, Inc. transferable only on the books of the Corporation upon surrender of this certificate properly endorsed by the holder hereof in person or by attorney-in-fact. The Corporation will provide to any registered holder of stock of the Corporation, upon request and without charge, a full statement of the designations, preferences, limitations and relative rights of the shares of each class of stock authorized to be issued by the Corporation, the variations in the relative rights and preferences between the shares of each series of each class of stock so far as the same have been fixed and determined, and the authority of the Board of Directors to fix and determine the rights and preferences of subsequent series. In witness whereof the Corporation has caused this certificate to be signed by its duly authorized officers and the facsimile of its corporate seal imprinted hereon. Issue Date: ________________________________ ________________________________ Secretary or Assistant Secretary President or Vice President Exhibit 4(e) SUMMIT SECURITIES,INC. HARBOR CENTER, 1000 WEST HUBBARD, SUITE 140 COEUR D' ALENE, ID 83814-2276 INVESTMENT CERTIFICATE, SERIES A Principal Issue Maturity Interest Certificate Amount Date Date Rate Number Interest: Amortization Term: Months: Issued To: THE CERTIFICATE This is a duly authorized Certificate of Summit Securities, Inc. ("Summit"). This Certificate is issued under an Indenture dated July 25, 1990 ("Indenture") between Summit and West One Bank, Idaho, N.A. as Trustee ("Trustee"). The Indenture permits Summit to issue an unlimited amount of Certificates, the terms of which may vary according to series. This Certificate is of the series stated above; that series is not limited in aggregate principal amount as stated in the Indenture (or supplemental indentures). The Indenture (and supplemental indentures) contains statements of the rights of the Certificateholders, Summit and the Trustee and provision concerning authentication and delivery of the Certificates. Definitions of certain terms used in the Certificate are also found in the Indenture (and supplemental indentures). PAYMENT OF PRINCIPAL For value received, Summit promises to pay the principal amount of this Certificate at the maturity date stated above. Payment will be made to the Person to whom this Certificate is issued or registered assigns. PAYMENT OF INTEREST Summit promises to pay interest on the principal amount of this Certificate from the issue date until the principal amount is paid or made available for payment. Interest will be computed at the annual interest rate stated above. Interest will be payable or compounded as stated above or as otherwise elected by the Person entitled to payment of interest. Summit will pay interest to the Person in whose name this Certificate (or one or more Predecessor Certificates) is registered at the close of business on the Regular Record Date for the payment of interest. The Regular Record Date is the 15th date of the calendar month immediately preceding an Interest Payment Date. COMPOUNDING OF INTEREST If the Person entitled to payment of interest so elects, Summit will compound interest rather than pay interest in installments. Interest will be compounded on a semiannual basis at the interest rate stated above from the Interest Payment Date immediately preceding receipt by Summit of the compounding election. Interest will be compounded from the issue date of the Certificate if Summit receives the compounding election prior to the first Interest Payment Date. Interest will be compounded until the maturity date stated above and will be paid on such date. Prior to maturity, however, Summit will pay at the Certificateholder's request the interest accumulated in the last two semiannual compounding periods before Summit receives the request, together with the interest accrued from the end of the last such semiannual period. Interest compounded prior to the last two semiannual compounding periods is payable only onthe maturity date stated above. ALTERNATIVE INSTALLMENT PAYMENTS OF PRINCIPAL AND INTEREST If so elected by the Person to whom this Certificate is originally issued, Summit promises, in lieu of the foregoing provisions for payment of principal and interest, to pay equal monthly installments of principal and interest, commencing thirty days from the issue date, until the maturity date, at which time the remaining principal amount, if any, together with all unpaid accrued interest, shall be paid. The amount of each monthly installment shall be the amount necessary to amortize the principal amount at the specified interest rate during the specified amortization term. PREPAYMENT ON DEATH In the event of a Certificateholder's death, any person entitled to receive some or all of the proceeds of this Certificate may elect to have his or her share of the principal and any unpaid interest prepaid in full in five consecutive equal monthly installments. Interest on the declining principal balance of that share will continue to accrue at the interest rate stated above. Any request for prepayment must be made in writing to Summit. The request must be accompanied by the Certificate and evidence, satisfactory to Summit, of the Certificateholder's death. Before Summit prepays the Certificate, it may require additional documents or other material it considers necessary to establish the Persons entitled to receive some or all of the proceeds of the Certificate. Metropolitan may also require proof of other facts relevant to its obligation to prepay the Certificate in the event of death. MISCELLANEOUS The provisions on the reverse are part of this Certificate. This Certificate is not entitled to any benefit under the Indenture nor is this Certificate valid or obligatory for any purpose unless the certificate of authentication below has been executed by the Trustee by manual signature. This Certificate is not insured by the United States government, the State of Idaho nor any agency thereof. In witness whereof, Summit has caused this Certificate to be duly executed under its corporate seal. SUMMIT SECURITIES, INC. Attest:_________________________ By:_______________________________ Secretary or Assistant Secretary Chairman of the Board, President or Vice President CERTIFICATE OF AUTHENTICATION This is one of the Certificates referred to in the within-mentioned Indenture WEST ONE BANK, IDAHO, N.A. as Trustee By:_____________________________________ Authorized Signature (reverse of Certificate) TRANSFER AND EXCHANGE Transfer and exchange of this Certificate are conditioned by certain provisions in the Indenture. To effect a transfer, the Holder must surrender this Certificate at Summit's office or agency in Coeur d'Alene, Idaho or such other place as may be designated by Summit. This Certificate must be duly endorsed or accompanied by a written instrument of transfer satisfactory to Summit. Upon transfer, one or more new Certificates of the same series of authorized denominations and for the same aggregate principal amount will be issued to the designated transferee or transferrers. Prior to due presentment for registration of transfer, Summit, the Trustee or any of their agents may treat any Person in whose name this Certificate is registered as the owner of this Certificate, regardless of notice to the contrary or whether this Certificate might be overdue. This Certificate is issuable only as a registered Certificate; it does not bear coupons. As provided in the Indenture, this Certificate is exchangeable for the other Certificates of the same series of authorized denominations with the same aggregate principal amount. To effect an exchange, the Holder must surrender this Certificate at Summit's office or agency in Coeur d' Alene, Idaho or such other place as may be designated by Summit. The Certificate must be duly endorsed or accompanied by a written instrument of exchange satisfactory to Summit. No service charge will be made for a transfer or exchange, but Summit may require payment of a sum sufficient to cover any governmental charge in connection with such transaction. AMENDMENT OF THE INDENTURE; WAIVER OF RIGHTS With certain exceptions, the Indenture may be amended, the obligations and rights of Summit may be modified and the rights of the Certificateholders may be modified by Summit at any time with the consent of the Holders of 66-2/3% in aggregate principal amount of the Certificates at the time Outstanding. The Indenture allows the Holders of specified percentages in aggregate principal amount of the Certificates of a particular series to waive compliance by Summit with certain indenture provisions and to waive past defaults and their consequences on behalf of all the Holders of Certificates of that series. Any such consent or waiver by the Holder of this Certificate will be binding upon that Holder. The consent or waiver will also be binding upon all future Holders of this Certificate and of any Certificate issued upon the transfer of, or in exchange for or in lieu of this Certificate, whether or not that consent or waiver is noted upon the Certificate. FAILURE TO PAY INTEREST OR INSTALLMENTS; EVENTS OF DEFAULT If interest or any installment of principal and interest is not punctually paid or duly provided for, it shall cease to be payable to the registered Holder of this Certificate on the applicable Regular Record Date. Instead, the Trustee will fix a Special Record Date for payment of the Defaulted Interest or installments. The Trustee will give the Certificateholders notice of the Special Record Date at lease 10 days prior to the Special Record Date. The Person in whose name this Certificate (or one or more Predecessor Certificates) is registered at the close of business on the Special Record Date will be entitled to payment of the Defaulted Interest or installment. If the Certificates are listed on a securities exchange, however, the Defaulted Interest or installment may be paid at any time and in any lawful manner consistent with the requirements of the exchange. If an Event of Default occurs, the principal of all the Certificates may be declared due and payable as provided in the Indenture. FORM OF PAYMENT Payment of principal and interest will be made at the office or agency of Summit maintained for that purpose in Coeur d'Alene, Idaho or such other place as may be designated by Summit. Payment will be made in coin or currency of the United States of America that is legal tender for payment of public and private debts at the time of payment. At Summit's option, however, payment of interest may be made by check mailed to the Person entitled to the interest at that Person's address as it appears in the Certificate Register. BUSINESS DAYS Whenever any interest Payment Date, the Stated Maturity of this Certificate or any date on which any Defaulted Interest or installment is proposed to be paid is not a business day, the appropriate payment or compounding of interest or principal may be made on the next succeeding Business Day without accrual of additional interest. CERTAIN DEFINITIONS Summit is an Idaho corporation. The term "Summit" includes any successor corporation under the Indenture. The term "Trustee: includes any successor Trustee under the Indenture.

107203_1993.txt

107203_1993

1993

107203

ITEM 1. BUSINESS Willcox & Gibbs, Inc. (the "Company" or "W&G") is a New York corporation that was incorporated in 1866. It is the fifth largest distributor of electrical parts and supplies in the United States, based on 1993 pro forma sales. During the last several years, the Company has undertaken a major restructuring. On April 22, 1992, the Company, Rexel, S.A. (formerly known as Compagnie de Distribution de Materiel Electrique) ("Rexel"), International Technical Distributors, Inc. ("ITD"), a subsidiary of Rexel, and Southern Electric Supply Company, Inc. ("SES"), a subsidiary of ITD engaged in the distribution of electrical materials, entered into a Purchase Agreement (the "Purchase Agreement"). Pursuant to the Purchase Agreement, the Company issued to Rexel and ITD 6,284,301 shares of Company Common Stock in exchange for all of the stock of SES and approximately $10 million in cash. In addition, pursuant to the Purchase Agreement, the Company declared a dividend consisting of one share of common stock of the Company's subsidiary Worldtex, Inc. ("Worldtex") for each share of Company Common Stock outstanding on November 23, 1992 (the "Distribution"). In August 1992, the Company transferred to Worldtex all of the stock of the Company's subsidiaries engaged in the manufacture of covered elastic yarn. Also during 1992, the Company disposed of its data communications equipment distribution business, conducted by Data Net, Inc. and Dataspan Systems, Inc., and its Montrose Supply and Equipment Division, which distributed equipment to the knitting trade. In April 1993, the Company acquired Sacks Electrical Supply Co. ("Sacks"), a distributor of electrical supplies and components with three locations in Ohio, for $13,635,000. On December 17, 1993, the Company acquired Summers Group Inc. ("Summers") for $60,000,000 in cash and a $25,000,000 three year note issued to the seller, plus contingent consideration to be determined based on Summers' profits before interest and taxes for 1993 and 1994, subject to a maximum purchase price of $120,000,000. Summers is a distributor of electrical parts and supplies with locations principally in Texas, Oklahoma, Louisiana, California and Arkansas. The Company has also decided to sell its remaining apparel parts and supplies distribution business and has engaged an investment banking firm to seek a purchaser. Accordingly, this business is shown as a discontinued operation in the Company's Consolidated Financial Statements included elsewhere in this report. On March 1, 1994, the Company sold 3,491,280 newly-issued shares of Company Common Stock to Rexel for $31,421,520 in cash. In connection with that sale, the size of the Company's Board of Directors was reduced to nine and two additional nominees of Rexel became directors of the Company. As a result, five of the Company's nine current directors are nominees of Rexel. ELECTRICAL DISTRIBUTION OPERATIONS The Company operates 170 electrical distribution centers in 18 states, principally in the southern tier of the United States. The Company conducts its electrical distribution operations through four principal divisions: the Consolidated Electric Supply group ("Consolidated"), Sacks, SES and Summers. Consolidated, which was acquired by the Company in January 1984, has been engaged in the wholesale distribution of electrical materials since 1947. Headquartered in Miami, Consolidated operates 61 distribution centers, of which 33 are located in Florida, 11 in Ohio, three in Delaware, two in Maryland, one in Washington, D.C., four in the Atlanta, Georgia area, six in Southern California and one in Freeport, Grand Bahamas. Thirty-four of the distribution centers have been added during the time the Company has owned Consolidated. Sacks, acquired by the Company in April 1993, distributes electrical materials through three locations in Ohio. SES, acquired by the Company in November 1992, is engaged in the wholesale distribution of electrical materials through 29 distribution centers in six states, consisting of six distribution centers in Alabama, seven in Florida, four in Louisiana, nine in Mississippi, two in Tennessee and one in Oklahoma. Summers, acquired by the Company in December 1993, distributes electrical materials through 79 locations in 10 states, consisting of thirty-six in Texas, eleven in Louisiana, eight in Oklahoma, eight in California, seven in Arkansas, four in Missouri, two in Arizona, and one in each of Colorado, Illinois and New Mexico. Unless otherwise expressly stated below, the statistical information discussed below concerning the Company's electrical distribution business does not include Summers' operations. Each of the Company's electrical distribution centers serves an area with approximately a 50 mile radius and specializes in serving the needs of small-to medium-sized electrical contractors engaged in construction work on plants, schools, utilities, office buildings, hotels, condominiums, town houses and single family homes. In 1993, the Company's electrical distribution subsidiaries served over 23,000 customers with no single customer accounting for more than 1.9% of total annual sales. The Company's ten largest customers in 1993 represented less than 6% of sales. Management believes that approximately 60% of the sales of the Company's electrical distribution subsidiaries are from products used in new construction. The remainder are sold for maintenance and residential remodeling and to original equipment manufacturers. Management believes that the Company is the fifth largest distributor of electrical parts and supplies in the United States, although there are other companies which account for significantly greater national volume. The Company's subsidiaries compete with national chains (some of which are affiliated with manufacturing companies) and other independent distributors operating single or multiple outlets. Because the electrical supply business is fragmented and highly competitive, service and price are essential components of success. In order to achieve a competitive advantage in serving its customers, the Company's subsidiaries maintain an inventory of approximately 15,000 items at each distribution center, employ a sales staff that calls on customers and works with architects, engineers and manufacturers' representatives on major construction projects, provide next day and same day on-site delivery with its truck fleet and endeavor to obtain volume discounts to maintain profit margins while being competitive in price. The extensive product line of the Company's subsidiaries includes electrical supplies, including wire, cable, cords, boxes, covers, wiring devices, conduit, raceway duct, safety switches, motor controls, breakers, panels, lamps, fuses and related supplies and accessories, residential, commercial and industrial electrical fixtures and other special use fixtures, as well as materials and special cables for computers and advanced communications systems. The products sold by the Company's subsidiaries are purchased from over 5,000 manufacturers and other suppliers, the three largest of which accounted in the aggregate for approximately 13% of the total purchases by the Company's electrical distribution subsidiaries during 1993, with none of the remainder accounting for more than three percent. DISCONTINUED OPERATIONS APPAREL PARTS AND SUPPLIES DISTRIBUTION -- SUNBRAND The Company's Sunbrand Division markets to the apparel industry a wide range of sewing equipment parts, supplies and other equipment, including pressing and finishing equipment, fabric spreading machines and reconditioned equipment. Its product line includes needles, tools, electric and electronic devices and warehouse equipment. Sunbrand's executive offices are located in Atlanta and it catalogs over 140,000 items. Sunbrand has seven office/distribution centers located near major apparel manufacturing areas in Atlanta, El Paso, Fall River (Massachusetts), Miami, Mexico City, Nashville, and Santo Domingo (Dominican Republic). For over 20 years, Sunbrand has been a major distributor of a number of name brand ("genuine") parts to the apparel industry. It has agreements for the importation and sale of genuine sewing equipment parts manufactured by G.M. Pfaff AG of Germany ("Pfaff") and Pegasus Sewing Machine Mfg. Co., Ltd. of Japan ("Pegasus") for the United States and Puerto Rico which extend through 1998 and which are exclusive (with certain exceptions) through 1994. Sunbrand services over 13,000 customers, the largest of which accounted for approximately 5.4% of total 1993 sales. Its ten largest customers accounted, in the aggregate, for approximately 17.5% of Sunbrand's sales for 1993. Sunbrand is well known for its 1,200 page catalog, which serves as a reference standard for the industry. This catalog, which is published once every three years, is a valuable marketing tool that is used by many existing and potential buyers of parts and supplies. Products sold by Sunbrand are purchased from some 1,200 different companies, of which Pfaff and Pegasus account for the largest volume. In 1993, Pfaff accounted for 12.4% and Pegasus accounted for 10.0% of purchases from suppliers. The five largest suppliers accounted for 36.8% of total purchases in 1993. There is strong competition throughout the marketing areas served by Sunbrand. Most of its competitors are small regional distributors, though there are two national competitors. The principal competitive factors in Sunbrand's business are availability of parts and timely delivery. Customers rely on Sunbrand to supply parts that minimize downtime. Sunbrand's management believes that it is one of the largest distributors of its type in the United States. OTHER APPAREL PARTS AND SUPPLIES DISTRIBUTION In addition to Sunbrand, during 1993 the Company was engaged in three other operations involving distribution to the apparel and textile trades. The Company's Unity Sewing Supply Division ("Unity"), which the Company believes is one of the two largest importers and distributors of non-trademarked ("generic") parts for industrial sewing machines, is headquartered in New York with branch offices in Los Angeles and Miami. It sells to dealers, not to manufacturers or end users. Generic parts have become increasingly popular in the needle trades as a method to reduce manufacturing costs. In recent years, Unity has emphasized its export business to South and Central America and the Caribbean. The majority of Unity's parts are manufactured in Japan, Germany and the United States. Willcox & Gibbs, Ltd., a wholly-owned United Kingdom subsidiary, markets sewing equipment in certain Common Market countries and sells generic sewing equipment parts in the United Kingdom. The Company's subsidiary, Leadtec Systems, Inc. ("Leadtec"), distributes to the apparel industry a computer-based real-time production control system, marketed under the name "Satellite Plus", which utilizes hardware manufactured by others and proprietary software designed by Leadtec. In the markets in which Unity, Willcox & Gibbs, Ltd. and Leadtec operate, there is vigorous competition both in the United States and abroad. COVERED ELASTIC YARN Prior to 1993, the Company owned Worldtex and its subsidiaries, which engaged in the manufacture of covered elastic yarn. These operations were disposed of by the Company pursuant to the Distribution on November 12, 1992. While owned by the Company, Worldtex's principal product was nylon covered spandex used in the manufacture of women's pantyhose, which accounted for 58% of Worldtex's 1992 sales. Worldtex also sold covered spandex and covered latex rubber for use in the manufacture of men's, women's and children's socks. EMPLOYEES As of December 31, 1993, the Company had a total of approximately 3,100 employees, including approximately 2,800 who were employed by Consolidated, SES, Sacks and Summers, and approximately 300 who were employed by Sunbrand and the Company's other distribution divisions. Approximately 45 employees of Summers and Sacks are covered by collective bargaining agreements. The Company has experienced no significant labor problems during recent years and considers that its employee relations are good. ITEM 2. ITEM 2. PROPERTIES The Company's executive offices are located in leased office space at 530 Fifth Avenue, New York, New York. Consolidated's headquarters in Miami, Florida, and most of Consolidated's distribution centers are in facilities owned by subsidiaries of the Company. Leases of remaining premises, which are classified as operating leases, expire in various years through 2001. SES' headquarters in Meridian, Mississippi, and eleven of its locations are leased from Robert Merson, a Vice President of the Company and President of SES, and/or members of his or his wife's family, for terms extending through 2002 (except for one lease expiring in 1994). The Company believes that these leases are on terms at least as favorable as SES could have obtained from an unaffiliated third party. The remainder of SES' locations are leased for terms expiring in various years through 1999. Summers' headquarters in Dallas, Texas, is leased, as are 67 of its distribution centers. Summers owns 12 of its distribution centers. The Sunbrand Division's headquarters in Atlanta consists of approximately 110,000 square feet under a lease which runs through 1994. The other Sunbrand branches also occupy leased space. The Company's other parts and equipment distribution divisions operate from leased premises in London, England, Long Island, New York, Los Angeles and Miami. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings as of the date of this Report to which the Company or any of its subsidiaries is a party or to which any of their property is subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the last quarter of the Company's fiscal year, no matters were submitted to a vote of the Company's security holders. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT The officers of the Company are elected annually by the Board of Directors. Mr. Viry also serves as a director of the Company. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is listed on the New York Stock Exchange and the Pacific Stock Exchange. The following table sets forth the high and low per share sales prices for the Common Stock on the New York Stock Exchange as reported by the Dow Jones Historical Stock Quote Reporter Service for each quarter since December 31, 1991. The trading price of the Company's Common Stock was affected by the Distribution, which was declared on November 12, 1992. At March 25, 1994, there were approximately 1,448 holders of record of Common Stock. No dividends have been paid on the Company's Common Stock since the last quarter of 1991. Future payment of cash dividends by the Company will be dependent on such factors as business conditions, earnings and the financial condition of the Company. The Company's Note Agreement, dated as of April 2, 1991, as amended, restricts dividends and certain other payments with respect to the Company's capital stock if the sum thereof for the period since December 31, 1992, exceeds the sum of (i) 35% of net cash proceeds from the sale of stock and certain subordinated debt for such period, plus (ii) 35% of consolidated net income (as defined) for such period. In addition, the Note Agreement and the Company's Revolving Credit and Reimbursement Agreement, dated as of December 17, 1993, require that the Company meet certain financial tests that could have the effect of restricting the Company's ability to pay dividends. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA WILLCOX & GIBBS, INC. AND SUBSIDIARIES The following tables set forth certain consolidated financial data of the Company and its subsidiaries for the five fiscal years ended December 31, 1993, which has been derived from the Company's audited financial statements, and should be read in conjunction with the Consolidated Financial Statements and Notes thereto of the Company appearing elsewhere in this Report on Form 10-K. The selected financial data of the Company for the years set forth below are not directly comparable due to acquisitions and dispositions during such periods. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SIGNIFICANT TRANSACTIONS During the last several years, the Company has undertaken a major restructuring. On April 22, 1992, the Company, Rexel, S.A. (formerly known as Compagnie de Distribution de Materiel Electrique) ("Rexel"), International Technical Distributors, Inc. ("ITD"), a subsidiary of Rexel, and Southern Electric Supply Company, Inc. ("SES"), a subsidiary of ITD engaged in the distribution of electrical materials, entered into a Purchase Agreement (the "Purchase Agreement"). Pursuant to the Purchase Agreement, the Company issued to Rexel and ITD 6,284,301 shares of Company Common Stock in exchange for all of the stock of SES and approximately $10 million in cash. In addition, pursuant to the Purchase Agreement, the Company declared a dividend consisting of one share of common stock of the Company's subsidiary Worldtex, Inc. ("Worldtex") for each share of Company Common Stock outstanding on November 23, 1992 (the "Distribution" and, together with such transactions with Rexel, the "1992 Transactions"). In August 1992, the Company transferred to Worldtex all of the stock of the Company's subsidiaries engaged in the manufacture of covered elastic yarn. Accordingly, these businesses are reflected as discontinued operations in the Company's Consolidated Financial Statements. Also during 1992, the Company sold its data communications equipment distribution business and an apparel related unit. In April 1993, the Company acquired Sacks Electrical Supply Co. ("Sacks"), a distributor of electrical supplies and components with three locations in Ohio, for $13.6 million. On December 17, 1993, the Company acquired Summers Group Inc. ("Summers") for $60 million in cash and a $25 million three year note issued to seller, plus contingent consideration to be determined based on Summers' profits before interest and taxes for 1993 and 1994, subject to a maximum purchase price of $120 million. Summers is a distributor of electrical parts and supplies with locations principally in Texas, Louisiana, Oklahoma, California and Arkansas. The Company has also decided to sell its remaining apparel parts and supplies distribution businesses (the "Apparel Division") and has engaged an investment banking firm to seek a purchaser. Accordingly, the Apparel Division is shown as a discontinued operation in the Company's Consolidated Financial Statements. On March 1, 1994, the Company sold 3,491,280 newly-issued shares of Company Common Stock to Rexel for $31.4 million in cash, which the Company has used to reduce short-term debt. As a result of the aforementioned transactions and discontinuances, the Company is now engaged in only one business segment: the distribution of electrical parts and supplies, principally in the southern tier of the United States. If the above-mentioned acquisitions had occurred as of January 1, 1992, the Company's unaudited pro forma sales would have been $958.5 million and $907.3 million in 1993 and 1992, respectively. RESULTS OF CONTINUING OPERATIONS The following table sets forth the percentages which certain income and expense items bear to net sales: 1993 V. 1992 The Company's sales increased by $162.4 million in 1993, to $521.5 million. Excluding the impact of the acquisitions of SES, Sacks and Summers, full-year sales were up about 3.8%. The Company's Consolidated Electric Supply division ("CES") increase resulted primarily from the improving housing market, although commercial construction continues to lag. Full-year sales for SES, Sacks, and Summers as a group were up in 1993 compared with 1992, reflecting the continued market-share strength of these units in their respective geographic areas. Sales for these divisions totalled $601.3 million in 1993. Certain geographic regions showed an upturn in 1993. However, no assurance can be given that this trend will continue. Declining copper prices and strong competition for market share continue to put pressure on the Company's gross margin, which increased slightly in 1993, to 20.6%. Selling and administrative expenses increased $24.4 million in 1993, reflecting the additional operations added through the above-mentioned acquisitions. However, as a percentage of sales such expenses decreased to 17.3% in 1993 as compared to 18.3% in 1992, reflecting cost containment programs and a higher level of sales. Interest expense in 1993 was $5.9 million, compared with $5.4 million a year ago. Although the Company reduced its debt at the end of 1992 in connection with the 1992 Transactions, it increased its borrowings in 1993 to fund the acquisitions of Sacks and Summers. Other income-net in 1993 was $.7 million, compared to $0.1 million in 1992, reflecting principally earnings from short-term investments during the first half of 1993. Income from continuing operations increased $19.3 million to $6.9 million in 1993, reflecting principally the costs for 1992 Transactions and restructuring charges that were accrued in 1992. 1992 V. 1991 Sales in 1992 decreased $11.0 million, or 3.0%, to $359.1 million. The 1991 period includes results of two data communications units that the Company sold during 1992. 1992 sales included $14.9 million from SES from mid-November. Excluding sales of units sold, electrical supply sales, including SES, increased by $11.9 million, or 3.4%, to $359.1 million. Excluding SES, sales decreased by $3.0 million or 0.9%. The business continued to be impacted during the year by the softness in the housing market and the effect of tightened Company credit policies. Strong competition for market share continued to put pressure on profit margins, but margins held when compared to the prior period. SES sales for 1992 totalled $114.5 million. Selling and administrative expenses for the Company were 18.3% of sales for 1992 as compared with 19.1% for 1991, reflecting the absence of expenses related to units sold and cost containment programs instituted in 1991. Such expenses in 1992 decreased $4.5 million, or 6.4%, to $66.0 million. In connection with the 1992 Transactions, including the Worldtex spin-off, the Company incurred costs totalling $15.3 million, principally relating to certain investment advisor services, legal and accounting fees and executive incentive payments. Restructuring actions ($4.3 million and $5.5 million in 1992 and 1991, respectively) included principally the disposal of two data communications units which no longer related to the Company's core business. In 1992 and 1991, certain restructuring actions initiated in 1991 and 1990 required more costs to implement than originally expected. The additional costs, included in restructuring charges for these periods, changed based on the revised estimates and experience to date. The decrease in interest expense of $1.3 million for 1992 as compared to 1991 reflects the net effect of the sale of the $50 million 9.78% Senior Notes in April, 1991, the redemption of the $23 million 13% Senior Subordinated Notes in August, 1991 and changing levels of borrowing under the Company's prior revolving credit arrangement. Loss from continuing operations increased $8.0 million to $12.4 million in 1992, reflecting principally the impact of transaction costs relating to the 1992 Transactions, partially offset by the absence of operating losses from units sold, certain cost containment measures, and reduced restructuring charges and interest expense. DISCONTINUED OPERATIONS As discussed above, the results of the Apparel Division and Worldtex are included in the financial statements as discontinued operations. Summarized results are as follows (000's): Sales for the Apparel Division decreased $2.1 million for 1993 compared with 1992. Excluding units sold, sales increased 4.3%. 1992 sales (excluding the units sold) increased $9.6 million, or 13.9%, compared to 1991. These year over year increases resulted from increased market share, particularly in foreign markets such as Mexico, Central and South America and the Caribbean. Covered yarn sales increased $1.6 million in 1992 compared to 1991, reflecting growth in each of covered yarn's markets, offset somewhat by inclusion of such sales in the Company's results only through mid-November 1992. INCOME TAXES The Company had effective income tax rates of 43%, (6.3)% and 62.5% in 1993, 1992 and 1991. The 1993 rate reflects the impact of state and local taxes, non-deductible goodwill amortization and increase in the deferred tax asset valuation allowance, reduced by the impact of the utilization of federal capital loss carryforwards, the increase in the federal corporate income tax rate and the current deductibility of certain prior year transaction costs. The 1992 rate reflects the benefit of the Company's operating loss, reduced by the impact of state and local taxes, goodwill amortization, and certain transaction costs. Effective January 1, 1993, the Company changed its method of accounting from the deferred method to the liability method required by SFAS No. 109, "Accounting for Income Taxes" (see Note 10 of the Notes to the Consolidated Financial Statements). As permitted under Statement 109, prior years' financial statements have not been restated. The cumulative effect of adopting Statement 109 as of January 1, 1993 was to increase net income by $660 or $.03 per share. At December 31, 1993, the Company had state net operating loss carryforwards for tax purposes of approximately $16.5 million that expire between 1998 and 2008. Under Statement 109 the Company has recognized deferred tax assets of $11.3 million, arising primarily from basis differences between the recorded value for financial reporting purposes and tax basis of accounts receivable, inventory and various liabilities and reserves, including restructuring and transaction costs. Such deferred tax assets have been reduced by a valuation allowance of $1.1 million. In addition, the Company has recognized deferred tax liabilities totalling $7.8 million arising principally from a higher recorded value over tax basis of property, plant and equipment and certain acquisitions. It is management's belief that the net deferred tax asset as reflected on the consolidated financial statements will be realized based upon forecasted future pretax earnings and taxable income as well as utilization of certain carryback and/or carryforward opportunities. Such forecasts reflect the disposals of operations that do not relate to the Company's core business as well as the expected results of the Company's most recent acquisitions. NET INCOME (LOSS) The Company reported net income (loss) of $9.1 million, ($4.9) million, and $0.2 million in 1993, 1992, and 1991. Earnings per share was 43 cents in 1993 compared with a loss per share of 33 cents in 1992 and earnings per share of 2 cents in 1991. Results during this three-year period were significantly impacted by the 1992 Transactions and restructuring charges in 1992 and 1991. LIQUIDITY; CAPITAL RESOURCES At December 31, 1993, the Company had $19.1 million in cash and cash equivalents, compared to $15.6 million at December 31, 1992, and had $196.7 million of indebtedness for borrowed money (including current installments and short-term debt), compared to $109.6 million at December 31, 1992. Total assets increased $143.5 million at year end 1993 to $428.8 million, due almost entirely to the acquisitions as discussed below. During 1993, the Company generated $5.8 million in cash from its operating activities compared to $14.4 million in 1992, reflecting primarily changes in various working capital items. Net cash used in investing activities totalled $62.8 million and $17.6 million in 1993 and 1992, respectively. The increase in cash usage in 1993 reflected the Company's acquisitions of Sacks and Summers ($68.3 million), offset partially by proceeds from sales of short-term investments ($12.9 million). Capital expenditures decreased $5.8 million in 1993 to $5.4 million, reflecting primarily the absence of historical expenditures related to Worldtex. Net cash provided by financing activities in 1993 totalled $60.6 million compared to $10.7 million in 1992. The $49.9 million increase reflects borrowings under the Company's current credit arrangements to fund acquisitions. In April 1993, the Company acquired Sacks for $13.6 million in cash, and in December 1993 the Company acquired Summers for $60 million in cash and a $25 million three year note, plus contingent consideration, subject to a maximum purchase price of $120 million. The Company regularly reviews possible acquisitions of businesses, and may from time to time in the future acquire other businesses. The Company otherwise currently expects that its capital expenditures during 1994 will be consistent with historical requirements for the electrical distribution business. In connection with the acquisition of Summers, the Company terminated its $20 million line of credit and entered into the Revolving Credit and Reimbursement Agreement, dated as of December 17, 1993 (the "Credit Agreement"), with NationsBank of Florida, N.A., and Credit Lyonnais New York Branch. The Credit Agreement provides for borrowings from time to time through December 1997 of up to the lesser of (i) $70 million and (ii) the sum of 80% of eligible accounts receivable and 50% of eligible inventory. The Company borrowed $60 million under the Credit Agreement in December 1993 to fund the cash purchase price for Summers. On March 1, 1994, the Company sold 3,491,280 shares of newly issued Company Common Stock to Rexel for $31.4 million, which was applied to repay debt under the Credit Agreement. Borrowings under the Credit Agreement bear interest at NationsBank's prime rate or at a rate based on rates in the certificate of deposit market or LIBOR plus a margin, which margin varies depending on the Company's financial performance. The Credit Agreement includes various covenants, including restrictions on liens, debt and lease obligations and requirements that certain financial ratios be maintained. As of March 1, 1994, $26.8 million was outstanding under the Credit Agreement and $43.2 million was available for future borrowings. It is expected that any cash proceeds from the sale of the Apparel Division will be used to repay borrowings under the Credit Agreement. Upon the closing of such sale, the $70 million amount available for borrowings under the Credit Agreement must be reduced to $50 million. The Company's working capital requirements are generally met by internally generated funds and short-term borrowings. Management believes sufficient cash resources will be available to support its long-term growth strategies through internally generated funds, credit arrangements and the ability of the Company to obtain additional financing. However, no assurance can be given that financing will continue to be available on attractive terms. In addition, any issuance by the Company, of its capital stock or securities convertible into its capital stock prior to December 31, 1994 must be approved by Rexel. THREE-YEAR COMPARISONS The following financial data were impacted by the distribution of Worldtex and acquisitions of SES, Sacks and Summers, as discussed in Notes 2, 3 and 4 of the Notes to Consolidated Financial Statements. The Net assets of the Apparel Division are shown as "Net assets of discontinued operations" as of December 31, 1993. The balance sheet at December 31, 1992 has not been reclassified. Total long-term debt was $126.0 million, $109.2 million and $113.4 million, respectively, at December 31, 1993, 1992 and 1991. Working capital was $71.3 million, $122.3 million and $84.4 million, respectively, at December 31, 1993, 1992 and 1991, reflecting a decrease of $51.0 million and an increase of $37.9 million, respectively, in 1993 and 1992 and a current ratio of 1.34, 2.40 and 1.61 at the end of 1993, 1992 and 1991. Working capital is impacted by the fact that the net assets of the discontinued Apparel Division are included as noncurrent assets as of December 31, 1993, including $37.0 of net current assets. Any cash proceeds from the sale of the Apparel Division will be used to repay short-term debt. Net worth was $92.5 million, $84.2 million and $111.9 million, respectively, at December 31, 1993, 1992 and 1991, with the decrease in 1992 attributable to the charge to retained earnings for the distribution of Worldtex ($58.5 million), partially offset by adjustments to common stock and capital surplus in connection with the stock issuance to Rexel as discussed in Notes 2, 3 and 4 of the Notes to the Consolidated Financial Statements. (See the Consolidated Statement of Changes in Stockholders' Equity for additional information). The ratio of net worth to long-term debt was .73 to 1 at December 31, 1993, .77 to 1 at December 31, 1992 and .99 to 1 at December 31, 1991. On a pro forma basis, had the additional equity investment by Rexel been made as of December 31, 1993, the ratio of net worth to long-term debt would have been .98 to 1. The number of days sales represented by accounts receivable was 51.8, 59.1 and 59.1, respectively, at December 31, 1993, 1992 and 1991. Inventories, as a percentage of cost of sales, were 20.5%, 25.2% and 23.8%, at December 31, 1993, 1992 and 1991. These differences for 1993 as compared to prior years are principally due to the increase in the Company's receivables and inventories attributable to the electrical distribution business in 1993. The Company continually reviews the impact of inflation. Pricing policies are reviewed regularly and, to the extent permitted by competition, the Company passes increased costs on by increasing sales price. The Company will continue to monitor the impact of inflation and will consider these matters in setting its pricing policies. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements, supplementary financial information and schedules are filed as part of this Report: Report of Independent Accountants Financial Statements: Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Income, Years Ended December 31, 1993, 1992 and 1991 Consolidated Statement of Changes in Stockholders' Equity, Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Supplementary Financial Information Financial Statement Schedules: Schedule II -- Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees Other than Related Parties, Years Ended December 31, 1993, 1992 and 1991 Schedule VIII -- Valuation and Qualifying Accounts, Years Ended December 31, 1993, 1992 and 1991 Schedule IX -- Short-Term Borrowings, Years Ended December 31, 1993, 1992 and 1991 All schedules not mentioned above are omitted for the reason that they are not required or are not applicable, or the information is included in the Consolidated Financial Statements or the Notes thereto. The foregoing financial statements are incorporated by reference in certain registration statements on Form S-8 of the Company and the prospectuses relating thereto in reliance upon the report of Coopers & Lybrand pertaining to such financial statements given upon the authority of such firm as experts in accounting and auditing. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Willcox & Gibbs, Inc.: We have audited the accompanying consolidated balance sheets of Willcox & Gibbs, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for the years ended December 31, 1993, 1992 and 1991. We have also audited the financial statement schedules as noted in the accompanying index listed in Item 8 of this Form 10-K for the years ended December 31, 1993, 1992 and 1991. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Willcox & Gibbs, Inc. as of December 31, 1993 and 1992 and the consolidated results of its operations and cash flows for the years ended December 31, 1993, 1992 and 1991 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 10 of the consolidated financial statements, in 1993 the Company changed its method of accounting for income taxes. /s/ Coopers & Lybrand -------------------------------------- Coopers & Lybrand New York, New York March 4, 1994 except as to the information presented in the last paragraph of Note 11 for which the date is March 18, 1994. WILLCOX & GIBBS, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (DOLLARS IN THOUSANDS) ASSETS See accompanying notes to consolidated financial statements. WILLCOX & GIBBS, INC. CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) See accompanying notes to consolidated financial statements. WILLCOX & GIBBS, INC. CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) See accompanying notes to consolidated financial statements. WILLCOX & GIBBS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) CONSOLIDATION The consolidated financial statements include the accounts of the Company and all of its subsidiaries. All significant intercompany transactions and balances have been eliminated. (b) CASH EQUIVALENTS Highly liquid investments with a maturity of three months or less when purchased are generally considered to be cash equivalents. (c) SHORT-TERM INVESTMENTS Short-term investments are stated at cost plus accrued interest, which approximates market, and consist of direct obligations of the U.S. Government. (d) INVENTORIES Inventories are stated at the lower of cost (determined by LIFO for continuing operations or FIFO for discontinued operations) or market. The cost of inventories determined on a LIFO basis comprised 80.9% and 68.9% of total inventories at December 31, 1993 and 1992, respectively. Had the FIFO method been used to value all inventories, total inventories would have increased $5,884 and $6,569 at December 31, 1993 and 1992, respectively. (e) INVESTMENTS AND NONCURRENT RECEIVABLES Investments and noncurrent receivables are carried at cost, which approximates market, except for investments in companies over which the Company has significant influence, but not a controlling interest, which are carried under the equity method, and noncurrent marketable securities, which are carried at the lower of quoted market value or cost. Unrealized losses are accumulated in the marketable equity securities adjustment component of stockholders' equity. (f) DEPRECIATION AND AMORTIZATION Depreciation, computed by means of straight-line and accelerated methods, is based on the estimated useful lives of the related assets. Leasehold improvements are amortized over their respective lease terms or their estimated useful lives, if shorter. Cost in excess of net assets of acquired businesses ("goodwill") is amortized over 40 years. The Company periodically reviews the carrying value of goodwill in relation to current and expected operating results of the businesses which benefit therefrom in order to assess whether there has been a permanent impairment of goodwill. (g) FORWARD EXCHANGE CONTRACTS The Company enters into forward exchange contracts as a hedge against accounts payable denominated in foreign currency. These contracts are used by the Company to minimize exposure and reduce risk from exchange rate fluctuations in the regular course of its foreign business. Gains and losses on forward contracts are deferred and included in the measurement of the related foreign currency transaction. Cash provided and used for forward contracts is included in the cash flows resulting from changes in accounts and notes payable - trade. Contracts amounting to $128 were outstanding at December 31, 1993. WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (h) INCOME TAXES No provision is made for income taxes which may be payable if undistributed earnings of foreign subsidiaries were to be paid as dividends to the Company, since the Company intends that such earnings will continue to be invested in those countries. At December 31, 1993, the cumulative amount of foreign undistributed earnings amounted to approximately $6,312. Foreign tax credits may be available as a reduction of United States income taxes in the event of such distributions. (i) EARNINGS PER SHARE Primary earnings per share are based on the weighted average number of common and common equivalent shares outstanding during the year. (j) RECLASSIFICATIONS Certain prior year amounts have been reclassified to conform with the 1993 presentation. 2. SIGNIFICANT TRANSACTIONS On November 12, 1992, pursuant to a Purchase Agreement dated April 22, 1992 among the Company, Rexel, S.A. (formerly known as Compagnie de Distribution de Materiel Electrique) ("Rexel"), International Technical Distributors, Inc. ("ITD"), a subsidiary of Rexel, and Southern Electric Supply Company ("SES"), a subsidiary of ITD engaged in the distribution of electrical components and supplies, the Company issued to Rexel and ITD 6,284,301 shares of the Company's common stock. In exchange for such stock issuance, the Company received $9,885 in cash and all the capital stock of SES. The SES acquisition was accounted for by the purchase method (see Note 3). Common stock and capital surplus have been adjusted for the proceeds received from the common stock issuance less issue costs of $2,056. Pursuant to the Purchase Agreement (including an Investment Agreement), Rexel had agreed to certain limitations on its ownership of the outstanding common stock of the Company and to certain other restrictions during the five years after closing. However, the Company, Rexel and ITD executed an amendment to the Investment Agreement which, among other things, permits Rexel to increase its beneficial ownership of Company common stock to 45% and provides for termination of the Investment Agreement on December 31, 1994. On March 1, 1994, the Company sold to Rexel 3,491,280 newly issued shares of Company common stock for a total cash purchase price of $31,422 which was used to repay short-term debt (see Note 5). As a result, Rexel increased its beneficial ownership of the outstanding common stock of the Company from 30% to 40%. In connection with the November 12, 1992 transaction, the Company distributed Worldtex, Inc. ("Worldtex"), its covered yarn manufacturing segment, as a dividend to its stockholders during the fourth quarter of 1992. Worldtex owns the former subsidiaries of the Company engaged in the manufacture of covered yarn. Effective with the dividend, retained earnings was charged $58,547 for the book value of the net assets distributed, including assets of $152,407 and liabilities of $93,860. Liabilities included $32,000 of debt assumed by Worldtex which was previously outstanding under the Company's prior revolving credit arrangement. The results of the covered yarn operation for 1992 and 1991 are included in the Consolidated Statements of Income as discontinued operations (see Note 4). Results for 1992 include transaction-related costs of $15,344, including certain investment advisor services, legal and accounting fees and executive incentive payments, in connection with these transactions. WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 3. ACQUISITIONS On April 12, 1993 the Company acquired the common stock of Sacks Electrical Supply Co. ("Sacks"), a distributor of electrical supplies and components with three locations in Ohio, for $13.9 million (including $0.3 million of acquisition costs). On December 17, 1993, the Company acquired the common stock of Summers Group, Inc. ("Summers") for $60.7 million in cash (including $0.7 million of acquisition costs) and a $25 million three-year note issued to the seller, plus contingent consideration to be determined based on defined profits of Summers, subject to a maximum purchase price of $120 million. Summers is a distributor of electrical parts and supplies with locations principally in Texas, Oklahoma, Louisiana, California and Arkansas. Each of these 1993 acquisitions has been recorded as a purchase, and the excess of the total purchase price over the fair value of the net assets acquired ($6.9 million for Sacks and $11.5 million for Summers) is being amortized over 40 years. Sacks' and Summers' results of operations are included in the Company's financial statements from the respective dates of acquisition. As discussed in Note 2 of the Notes to Consolidated Financial Statements, the Company acquired all of the issued capital stock of SES in exchange for the issuance of 4,636,994 shares of the Company's common stock. The total purchase price was $21,370, representing market value of the shares and certain closing costs. The shares include 628,430 shares issued in 1993. SES' results of operations are included in the Company's financial statements from the date of acquisition. The acquisition has been recorded as a purchase and the excess of the total purchase price over the fair value of the net assets acquired ($10,475) is being amortized over 40 years. The following table summarizes the effect on consolidated sales and income (loss) from continuing operations of the Company, on an unaudited pro forma basis, assuming the Sacks and Summers acquisitions had been consummated as of January 1, 1992 and the SES acquisition had been consummated as of January 1, 1991. The pro forma results above are not necessarily indicative of what actually would have occurred if the acquisitions had been in effect at the beginning of each period or are they necessarily indicative of future consolidated results. 4. DISCONTINUED OPERATIONS The Company has decided to sell its apparel parts and supplies distribution business ("Apparel") and has engaged an investment banking firm, of which a director of the Company is president, to seek a purchaser. Accordingly, this business is included in the Consolidated Statements of Income as WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 4. DISCONTINUED OPERATIONS (CONTINUED) discontinued operations for all periods presented. As discussed in Note 2, the covered yarn operation is included as discontinued operations in 1992 and 1991. Summarized results of the discontinued operations are as follows: Interest expense of $3,927, $4,078 and $3,634 for the years ended December 31, 1993, 1992 and 1991, respectively, have been allocated to apparel operation results based upon net assets of the apparel operation. Interest expense of $1,148 and $1,162 for the years ended December 31, 1992 and 1991, respectively, has been allocated to covered yarn operation results determined by applying the Company weighted average borrowing rate during the respective periods to weighted average levels of the Company corporate debt to be assumed by Worldtex. The assets of the apparel operations at December 31, 1993 are included in the accompanying Consolidated Balance Sheet as "Net assets of discontinued operations." The assets and liabilities of the apparel operation included in the Consolidated Balance Sheets at December 31, 1993 and 1992 are as follows: The Company's continuing operations consist solely of the distribution of electrical parts and supplies, principally in the southern tier of the United States. 5. SHORT-TERM DEBT In connection with the acquisition of Summers, the Company terminated its $20 million line of credit and entered into the Revolving Credit and Reimbursement Agreement, dated as of December 17, 1993 (the "Credit Agreement"), with NationsBank of Florida, N.A., and Credit Lyonnais New York Branch. At December 31, 1993, $61.5 million was outstanding under this agreement at a weighted average interest rate of 4.57%. The $31.4 million cash received March 1, 1994 from the sale of common stock to Rexel was applied to repay debt under this agreement. The Credit Agreement provides for borrowings from time to time through December 1997 of up to the lesser of (i) $90 million WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 5. SHORT-TERM DEBT (CONTINUED) ($70 million as of March 1, 1994) and (ii) the sum of 80% of eligible accounts receivable and 50% of eligible inventory. Borrowings under the Credit Agreement bear interest at NationsBank's prime rate or at a rate based on rates in the certificate of deposit market or LIBOR plus a margin, which varies depending on the Company's financial performance. The Credit Agreement includes various covenants, including restrictions on liens, debt and lease obligations and requirements that certain financial ratios be maintained. The Company pays a fee of 1/4 of 1% of the total unused portion of the line of credit. Upon the sale of the apparel operation, the $70 million amount available for borrowings under the Credit Agreement must be reduced to $50 million. 6. LONG-TERM DEBT Long-term debt, less current installments, consists of: In April 1991, the Company sold $50,000 of Senior Notes in a private placement. The notes are payable ratably over a seven-year period commencing March 15, 1995 with interest payable semiannually at a rate of 9.78% per annum. Based on borrowing rates currently available to the Company for long-term debt with similar terms and average maturities, the fair value of the notes is approximately $54,055. Under the terms of the Senior Notes (as amended), the Company may pay dividends and make other restricted payments (as defined) to the extent of 35% of consolidated net income (as defined) plus certain other amounts and is subject to certain restrictions on the incurrence of additional debt and other transactions and to other covenants calling for minimum levels of working capital and certain financial ratios. The 7% Convertible Subordinated Debentures are due August 1, 2014 with interest payable semiannually on February 1 and August 1. The debentures are convertible into common stock of the Company at $9.57 per share, as adjusted in connection with the dividend of Worldtex, and are subject to a sinking fund, commencing August 1, 2000, calculated to retire 70% of the debentures prior to final maturity. The debentures are subordinated to present and future senior indebtedness (as defined) of the Company. In certain circumstances involving the occurrence of a Risk Event (as defined) prior to August 1, 1999, the Company will be required to offer to repurchase all or part of the debentures at 100% of their principal amount plus accrued interest. The Company has the option to pay the repurchase price in cash or shares of its common stock. At December 31, 1993, approximately 6,452,000 shares would have been necessary to repurchase the debentures. At December 31, 1993, the debentures, which trade on the New York Stock Exchange, had a fair market value of $49,000. WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 6. LONG-TERM DEBT (CONTINUED) The Senior Note due December 17, 1996 was issued to the seller in connection with the Summers acquisition and is payable in three annual installments commencing on December 17, 1994 with interest at 4.375% per annum. The mortgage notes payable are due in monthly installments of $59, including interest at 9.5% through December 31, 1996. The principal balance outstanding on December 31, 1996 is due in one payment on that date. The notes are collateralized by a mortgage and security agreement and a collateral assignment of rents and leases relative to various property located in Florida. Based on borrowing rates currently available to the Company for long-term debt with similar terms and average maturities, the fair value of the notes is approximately $7,036. Long-term debt maturities during the next five years are as follows: 7. STOCKHOLDERS' EQUITY The authorized capital stock of the Company is 37,600,000 shares, consisting of 600,000 shares of Preferred Stock with a par value of $12 per share, 2,000,000 shares of Preference Stock with a par value of $1 per share and 35,000,000 shares of Common Stock with a par value of $1 per share. The Board of Directors may issue the Preference Stock from time to time in one or more series and fix the dividend rates, voting rights and liquidation preferences and establish redemption, sinking fund, conversion, exchange and other relative rights, preferences and limitations of a particular series. On January 10, 1989, the Board of Directors declared a dividend distribution of one preference stock purchase right (the "Rights") for each share of common stock outstanding. Each right entitles the holder to purchase one one-hundredth of a share of newly created Junior Participating Preference Stock, par value $1.00 per share. The Rights Agreement was amended on November 12, 1992 pursuant to the agreement with Rexel and the dividend discussed in Note 2 of the Notes to Consolidated Financial Statements and was amended on March 1, 1994, in connection with the purchase by Rexel of additional shares of common stock of the Company. The Rights will become exercisable upon the occurrence of certain events at an exercise price of $15 for each one one-hundredth of a preference share. In the event a person or group acquires 20% or more of the Company's outstanding common stock, each right shall entitle the holder to purchase, by paying the $15 exercise price, stock of the Company with a value of twice the exercise price provided that ownership of the Company's stock by Rexel and its Affiliates (as such term is defined in the Rights Agreement) will not trigger such exercise right so long as Rexel and all its Affiliates do not own, in the aggregate, voting securities of the Company which, on a fully exercised basis, are in excess of 45% of the aggregate number of votes which may be cast by holders of outstanding voting securities of the Company. In addition, if the Company is acquired in a merger or other business combination, the rightholder shall be entitled to purchase, by paying the $15 exercise price, common stock of the acquiring company with a value of twice the exercise price, except as otherwise provided in the Rights Agreement. The Rights are redeemable by the Company at $.01 per Right under certain circumstances and will expire December 31, 1994. 500,000 shares of preference stock have been reserved for issuance upon exercise of the Rights. WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 7. STOCKHOLDERS' EQUITY (CONTINUED) Shares of common stock as at December 31, 1993 are reserved for: 8. STOCK OPTION PLANS, STOCK ACQUISITION PLAN AND EMPLOYEE STOCK OWNERSHIP PLAN Under the Company's 1988, 1985 and 1982 Stock Option Plans, options to purchase up to 1,266,667 shares, 829,630 shares and 379,259 shares of common stock, respectively, were available to be granted to key employees of the Company. The 1988 Plan also provides that each director of the Company, other than one who is an officer or employee, be granted a non-qualified stock option to purchase 10,000 shares of Company common stock. For each plan, the option period is either ten or eleven years from the date of grant, and no option may be exercised prior to the first anniversary of the date of grant. Information regarding the Company's stock option plans is summarized below: All options were granted at market value on the date of grant. As of December 31, 1993, options for the purchase of 218,753 shares and 15,262 shares were available for future grant under the 1988 and 1985 plans, respectively. The Company's Stock Acquisition Plan provides for the issuance of up to 237,037 shares of common stock to key employees over specified employment periods. As of December 31, 1993, 229,889 shares of common stock have been issued, and 7,148 shares are available for award. The Company's Employee Stock Ownership Plan, which became effective in 1981, provides eligible employees with an opportunity to purchase the Company's common stock through payroll deductions, which are matched by the Company, subject to certain limitations. Contributions to the plan are invested by an independent trustee in common stock of the Company. Stock attributable to Company contributions vests at the rate of 10% for each twelve months of contributions by the employee, with 100% vesting after five years of service. The Company's contributions to the plan, net of forfeitures, charged to income for 1993, 1992 and 1991 were $695, $758 and $393, respectively. WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 9. PENSION AND PROFIT-SHARING PLANS AND POSTRETIREMENT BENEFIT PLANS The Company has two qualified noncontributory defined benefit pension plans covering certain eligible domestic employees. The Company's funding policy is to contribute annually the maximum amount that can be deducted for Federal income tax purposes. The Company also has a non-qualified defined benefit supplemental retirement plan covering key employees, which is not funded. The benefits of both plans are based on years of service and defined levels of compensation. The Company also has a defined benefit plan maintained for eligible employees of certain United Kingdom subsidiaries included in the apparel operation. The plan is funded annually for the maximum amount permitted by statute. The benefits are based on years of service and defined levels of compensation. Under the collective bargaining agreement of the textile industry in France, employees of a subsidiary Worldtex are entitled to a lump-sum payment at retirement based on their length of service at retirement and final pay. All obligations under this plan were assumed by Worldtex in connection with the dividend. The following table sets forth the plans' funded status at December 31, 1993 and 1992: The qualified domestic plan assets include guaranteed investment contracts, mutual and money market funds, government securities, whole life insurance policies and common stock of the Company and Worldtex (such stock with a combined market value of $520 and $515 at December 31, 1993 and 1992, respectively). The United Kingdom plan assets are comprised of certain deferred annuity contracts. WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 9. PENSION AND PROFIT-SHARING PLANS AND POSTRETIREMENT BENEFIT PLANS (CONTINUED) Net periodic pension cost for 1993, 1992 and 1991 included the following components: For both the qualified domestic plans, the weighted average discount used in determining the actuarial present value of the projected benefit obligation was 7.25% at December 31, 1993 and the rates of increase in future compensation used were 4.5% and 4.0% at December 31, 1993. The weighted average discount rate and the rate of increase in future compensation levels used at December 31, 1992 and 1991 for the one plan were 8.25% and 6.0%, respectively. The expected long-term rates of return on assets were 8.0% and 8.5% for 1993 and 9.5% for all other years. For the non-qualified domestic plan, the weighted average discount rate used was 7.5% at December 31, 1993 and 9.5% for all other years. For 1993 and 1992, no salary increase was assumed as the Company has frozen salaries under the plan at current levels. The rate of increase in future compensation in 1991 was 5.0%. Liabilities under this plan attributable to Worldtex employees were assumed by Worldtex in connection with the dividend of Worldtex. For the United Kingdom plan, the assumed discount rate at December 31, 1993 was 9.0% and for all other years the rate was 10.0%. The rate of increase in future compensation levels was 9.0% for all years and the expected long-term rate of return on assets was 9.0% at December 31, 1993 and 10.0% for all other years. WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 9. PENSION AND PROFIT-SHARING PLANS AND POSTRETIREMENT BENEFIT PLANS (CONTINUED) For the French plan, the assumed discount rate and rate of increase in future compensation levels were 9.0% and 5.0%, respectively. Certain subsidiaries have noncontributory profit-sharing plans and defined contribution pension plans providing for minimum contributions based upon defined levels of subsidiary income or employee compensation. Pension and profit-sharing expense for the years ended December 31, 1993, 1992 and 1991 amounted to approximately $1,338, $2,141 and $1,234, respectively. A subsidiary of the Company, acquired in 1993 provides certain health care benefits for eligible retired employees. The status of the plan at December 31, 1993 is as follows: The postretirement benefit cost in 1993 consisted of interest cost of $39 on the accumulated postretirement benefit obligation ("APBO"). The plan is unfunded. The discount rate used in determining APBO was 7.25%. Increasing assumed health care trends one percentage point will increase the APBO by $66 as of December 31, 1993. 10. INCOME TAXES Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes." Under Statement 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Prior to the adoption of Statement 109, income tax expense was determined using the deferred method. Deferred tax expense was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. As permitted by Statement 109, the Company has elected not to restate the financial statements of any prior years. The effect of the change on pretax income from continuing operations for the year ended December 31, 1993 was not material; however, the cumulative effect of the change as of January 1, 1993 increased net income by $660 or $.03 per share. The Company and its U.S. subsidiaries file Federal income tax returns on a consolidated basis. The provision (benefit) for income taxes has been classified as follows in the consolidated statements of income: WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 10. INCOME TAXES (CONTINUED) The provision (benefit) for income taxes is comprised of the following: Deferred income taxes result from temporary differences in the recognition of revenue and expenses for financial statement and income tax reporting purposes. The tax effects of each as of December 31, 1993 are as follows: Income (loss) before income taxes is comprised of the following: WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 10. INCOME TAXES (CONTINUED) A reconciliation for 1993, 1992 and 1991 between the amount computed using the Federal income tax rate and the effective rate of tax on income (loss), including discontinued operations, but excluding extraordinary charge, is as follows: At December 31, 1993, the Company had state net operating loss carryforwards for tax purposes of approximately $16,500. These loss carryforwards will expire from years 1998 to 2008. 11. COMMITMENTS AND CONTINGENCIES At December 31, 1993, annual minimum rental commitments under noncancelable operating leases, primarily for real property, are summarized as follows: The minimum annual commitments include amounts payable to an officer of the Company and/or members of his and his wife's family and amounts payable to an officer of a subsidiary as follows: 1994 -- $841; 1995 -- $820; 1996 -- $710; 1997 -- $658; 1998 -- $630; thereafter -- $2,519. Total rent expense charged to operations for the years ended December 31, 1993, 1992 and 1991 amounted to approximately $6,589, $5,148 and $5,447, respectively. At December 31, 1993, the Company was contingently liable for outstanding letters of credit in the amount of $1,001. WILLCOX & GIBBS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 11. COMMITMENTS AND CONTINGENCIES (CONTINUED) In the normal course of business, the Company is sometimes named as a defendant in litigation. In the opinion of management, based upon the advice of counsel, any uninsured liability which may result from the resolution of any present litigation or asserted claim will not have a material effect on the Company's financial position or results of operations. In connection with the resignation of an executive of the Company on March 18, 1994, the Company has entered into an agreement with such executive which provides, among other things, certain payments and acceleration of certain other payments in connection with the executive's related employment agreement. As of December 31, 1993, the Company's remaining commitments under this agreement total approximately $1.1 million. 12. ACCOUNTS AND NOTES PAYABLE -- TRADE, AND OTHER LIABILITIES Accounts and notes payable -- trade and other liabilities consist of the following: 13. RESULTS OF OPERATIONS The Company has recorded charges to operations of $5,586 and $6,508 for the years ended December 31, 1992 and 1991, respectively, related to certain restructuring actions initiated by the Company ($1,248 and $959 for the years ended December 31, 1992 and 1991, respectively, are included in discontinued apparel operations.) In 1992, the Company sold its data communications equipment distribution business and an apparel-related unit in return for $3,350 in cash, $1,858 of short and long-term notes and a marketable equity security with a fair market value of $1,500. The disposal of these businesses relate to actions originally initiated in 1991. The Company also initiated other restructuring actions, including the disposal of other operations, that do not relate to the Company's core business. In 1991, the Company initiated certain restructuring actions, including the disposal of certain operations, that did not relate to the Company's core business. These operations included the above-mentioned data communications and apparel-related businesses. In 1992 and 1991, certain restructuring actions initiated in 1991 and 1990 required more costs to implement than originally expected. The additional costs, included in the restructuring charges for these periods, changed based on the revised estimates and experience to date. On August 16, 1991, the Company redeemed all of the outstanding 13% Senior Subordinated Notes due April 15, 1997 at a redemption price of 100% of the principal amount thereof ($23,000) together with accrued interest to the redemption date. An extraordinary charge of $1,436, net of a tax benefit of $794, was recorded to reflect the write-off of unamortized discount and expense. WILLCOX & GIBBS, INC. SUPPLEMENTARY FINANCIAL INFORMATION YEARS ENDED DECEMBER 31, 1993 AND 1992 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) SCHEDULE II WILLCOX & GIBBS, INC. AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) SCHEDULE VIII WILLCOX & GIBBS, INC. VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) SCHEDULE IX WILLCOX & GIBBS, INC. SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11. ITEM 11. EXECUTIVE COMPENSATION ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Reference is made to the information responsive to the Items comprising this Part III that is contained in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, which is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS AND SCHEDULES The financial statements and financial statement schedules included in this Report are listed in the introductory portion of Item 8. EXHIBITS The following exhibits are filed as part of this Report (for convenience of reference, exhibits are listed according to numbers assigned in the exhibit tables of Item 601 of Regulation S-K under the Securities Exchange Act of 1934 and management contracts and compensatory plans are indicated by an asterisk): 8-K REPORTS During the last quarter of the Company's 1993 fiscal year, the Company did not file a Current Report on Form 8-K. 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. Dated: March 30, 1994 WILLCOX & GIBBS, INC. By: /s/ Allan M. Gonopolsky ----------------------------------- Allan M. Gonopolsky VICE PRESIDENT, CHIEF FINANCIAL OFFICER AND CORPORATE CONTROLLER Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 30, 1994 by the following persons on behalf of the registrant and in the capacities indicated. INDEX TO EXHIBITS

61478_1993.txt

61478_1993

1993

61478

ITEM 1. BUSINESS ADC Telecommunications, Inc. designs, manufactures and markets a broad range of transmission and networking systems and physical connectivity products for broadband telecommunications networks utilizing copper and fiber optic transmission media. The Company markets its products worldwide through its own direct sales force, as well as through distributors, dealer organizations and original equipment manufacturers (OEMs). The Company's products are designed for use in the public telecommunications networks maintained by telephone operating companies, interexchange carriers, other telecommunications common carriers and broadcast and cable TV networks, and for use in private telecommunications networks maintained by large businesses, government agencies, and educational and other non-profit institutions. The Company was incorporated in 1953 as a Minnesota corporation under the name Magnetic Controls Company. In 1961, Magnetic Controls Company was merged with ADC Incorporated, a Minnesota corporation incorporated in 1935. In 1984, the Company sold substantially all of the assets of its magnetics operations. In 1985, Magnetic Controls Company changed its corporate name to ADC Telecommunications, Inc. in order to better reflect the Company's commitment to the telecommunications market and to identify the Company more closely with its ADC trademark. In July 1989, ADC acquired Kentrox Industries, Inc. (Kentrox), a manufacturer of public network service access equipment for private telecommunications networks, located in Portland, Oregon. In June 1990, the Company acquired technology and other assets of TELINQ Systems Incorporated, located in Richardson, Texas. The ADC TELINQ Development Center-SM- (TELINQ) is an advanced development center for ADC and is responsible for developing high speed digital transmission products. In July 1990, ADC acquired American Lightwave Systems, Inc. (ALS). ALS, located in Meriden, Connecticut, designs, manufactures and markets fiber optic video transmission equipment for the telephone, cable television, broadcast and government markets. In May 1991, the Company acquired Fibermux Corporation (Fibermux), located in Chatsworth, California. Fibermux designs, manufactures, markets, and installs enterprise-wide communication systems for the interconnection and transport of Local Area Network (LAN) and other voice, data and video traffic, primarily in private telecommunications networks. As used herein, the terms "Company" and "ADC" refer to ADC Telecommunications, Inc. and its wholly-owned subsidiaries unless the context requires otherwise. THE TELECOMMUNICATIONS MARKET The largest market for the Company's broad range of telecommunications products consists of companies providing service in the public telecommunications networks and the OEMs which supply such companies. The Company's transmission and physical connectivity products for the public network market are primarily located in central transmission facilities (i.e., in telephone company networks, central office and outside plant facilities which contain the equipment used in switching and transmitting incoming and outgoing telephone circuits to complete local and long distance telephone connections). Another market for the Company's products consists of rapidly growing private voice, data and video telecommunications networks maintained by businesses, government agencies, and educational and other non-profit institutions. The Company's customers in this market primarily include large businesses and government agencies with their own communications networks and the OEMs and Value Added Resellers (VARs) which supply such networks. The Company's products for private networks are located on the private network customers' premises and consist of enterprise-wide communication systems and public network service access equipment. The market for the Company's products has grown in large part due to the effects of three ongoing developments in the telecommunications industry. First, rapid technological change has created a demand for new products employing advanced technologies. Second, the shift to data and video network traffic has resulted in increasing demand for voice, data and video networking capabilities within private networks and, more recently, over the public networks as well. Third, the policy of deregulation being followed by the Federal Communications Commission and other similar regulatory agencies throughout the world has increased opportunities for independent companies to supply products and services within public telephone system markets and within private voice, data and video communications markets. The Company believes that for the foreseeable future technological change will be the most important development in the continuing evolution of the telecommunications market. One important technological change in the past decade has been the increasing replacement of analog technology with digital technology in transmission networks. In analog technology, information is converted to a voltage or current wave form for processing or transmission. In digital technology, information is converted to digital bits and then processed or transmitted using computer-based components. A second important change in transmission technology has been the introduction of fiber optic systems, which are based on a physical property of light that allows transmission of light pulses in a coded analog or digital format through a glass fiber approximately the size of a human hair. Fiber optic systems are increasingly replacing copper-based transmission systems because of their capacity to carry large volumes of information at high speeds, their small size and their insensitivity to electromagnetic interference. A third important technological change in the telecommunications marketplace is in the use of integrated circuits and miniaturization, which has facilitated the transfer of certain telecommunications functions from central switching and transmission locations to locations closer to the business or residential end-user. In addition, because of the increased use of integrated circuits in both public and private telecommunications, networks have become significantly more complex. Increasingly, high speed switching, network performance monitoring, information compression, and data translation functions are being performed by network equipment. The Company believes that over the long term, the majority of new equipment purchased by telephone operating companies and private network customers will employ digital technology and that a significant portion of such equipment will utilize the fiber optic transmission medium. PRODUCTS The Company categorizes its products into the following groups: TRANSMISSION PRODUCTS: Transmission products permit and enhance the generation of electronic and optical signals over a telecommunications circuit. Certain of the transmission products also provide access in order to monitor, test and reroute circuits within telecommunications transmission systems. ADC's transmission products are designed for use in copper-based and fiber optic transmission systems. NETWORKING PRODUCTS: Networking products provide interconnection and transportation of voice, data and video signals within a single customer building or campus as well as network access to the public network. The Company's networking products are designed for use in copper-based and fiber optic networks. BROADBAND CONNECTIVITY PRODUCTS: Broadband connectivity products provide the physical connectivity (contact points) for connecting different telecommunications system components and gaining access to telecommunications system circuits by electromechanical means for the purpose of testing, monitoring or reconfiguring such circuits. A majority of the Company's broadband connectivity products are designed for use in copper-based transmission systems, with the remainder designed for use in fiber optic transmission systems. Historically, most of the Company's products have been used in connection with copper-based telecommunications systems, reflecting the historical installed base of equipment utilizing copper cable in domestic and international telecommunications networks. As a direct result of this large installed base, the Company expects that, for the foreseeable future, a substantial portion of its existing and new products will be sold to maintain and improve the functionality of copper-based telecommunications systems. Although the Company expects to continue to allocate considerable resources to improving existing and developing new products for these systems, it will also devote significant resources to the development of fiber optic products because the Company believes that such products represent an increasing source of future growth of broadband connectivity product revenues. The percentages of total consolidated net sales attributable to each of the Company's product groups and to fiber optic products in total for the past three fiscal years are set forth in Part II, Item 7 hereof. As used herein, "copper products" refer to products used in copper-based telecommunications systems, and "fiber optic products" refer to products used in fiber optic telecommunications systems. TRANSMISSION PRODUCTS DIGITAL REPEATERS: The Company's copper-based digital repeaters regenerate digital signals that have degraded because of transmission over long distances, primarily in central office applications. Digital repeaters are sold primarily to telephone operating companies and other telecommunications common carriers. TEST AND MONITORING SYSTEMS: The Company manufactures three remote digital test and performance monitoring products. The T-Sentry-R- system and SENTRY 45-TM- system provide non-intrusive remote network performance monitoring and alarm surveillance on DS1 and DS3 signals. The Company's NetStar-R- system, a remotely operable, intrusive T1 test and monitoring system, is designed for high capacity T1 telephone central office testing and private network facility management. The Company has developed and recently released for commercial use its open systems-based FiberWatch-TM- remote fiber test and surveillance system. The FiberWatch system provides a database of installed fibers, performs scheduled and on-demand testing, and provides mapping and graphing capability for location of faults in networks. ADC also manufactures and sells the Logix control system, a software system which enables the user to network numerous test and monitoring systems and to interface with higher level network management systems. The Logix system has an open architecture that supports various standards and provides for the centralized management of all ADC test and monitoring systems. The Company's test and monitoring systems are sold to telephone operating companies, other telecommunications common carriers, OEMs, distributors, and users of private voice and data communication networks. COAXIAL MULTIPLEXER: Under contract with a large computer manufacturer, the Company manufactures a coaxial multiplexer device used to connect up to eight computer monitors by a single cable to a main computer. The device is sold exclusively to this customer under an agreement that is cancelable at its option. FIBER VIDEO DELIVERY EQUIPMENT: Through its ALS subsidiary, the Company manufacturers fiber optic based video transmission systems. The LiteAmp-R-, FN6000-TM-, LC6000-TM- and LX6000-TM- systems transmit a variety of analog signals over fiber in cable television (CATV) applications, broadcast applications and interactive systems for distance learning and campus interconnects. The DV6000-TM- system transmits a variety of signal types using a high speed, uncompressed digital format (2.4 billion bits per second) over fiber in broadcast, CATV and private network applications. With the recent addition of channel drop/add/pass capability, the DV6000 system can now be utilized in more complex network applications. The PixlNet-TM- DS1 compressed digital video system, which is expected to be commercially released by ALS during 1994, will be targeted for video teleconferencing and distance learning applications. The Company's fiber video delivery systems are sold directly to CATV companies, telephone operating companies, other telecommunications common carriers and users of private data and video communication networks. ALS also provides fiber optic subsystems for the video portion of the Homeworx product described below. CUSTOMER LOOP TRANSMISSION: The Company's fiber loop converter (FLC) products convert electrical signals to optical signals for transmission over fiber optic cables at T1 and T3 speeds and supply the power required to transmit such signals between floors within a building. FLCs deploying from one to four T1 circuits provide an alternative to multiplexing in high-capacity T1 applications. FLCs deploying T3 circuits provide full bandwidth T3 delivery and transport at OC-1 speed. The Company's Soneplex-TM- products perform the FLC functions as well as full multi-plexing, performance monitoring, alarming, remote provisioning/switching and other functions, all at speeds up to the OC-3 level. The Company is continuing to develop modules for upgrading the functionality of its Soneplex products. The Company's Soneplex system chassis can be configured for High bit rate Digital Subscriber Line (HDSL) transmission. This HDSL product, which the Company has acquired through a licensing and product development arrangement, transports electrical signals over copper wire without pre-conditioning of the circuit or regeneration of the signal. This product enhances existing copper networks and provides a migration path to fiber transmission. The Company's fiber loop converter and Soneplex product families are intended for large business customer loop transmission. The Company also has a customer loop transmission system under development for the small business and residential customer called the Homeworx system. The Company initiated customer field trials of the Homeworx access transport platform during 1993 and intends to perform additional customer field trials and commercially release two versions of this product in 1994. Customer loop transmission products are sold to telephone operating companies, other telecommunications common carriers and users of private voice and data communications networks. ATM SWITCH: Through a licensing and product development arrangement, the Company recently acquired an Asynchronous Transfer Mode (ATM) switching system that supports advanced high-speed data and video applications in the public telecommunications networks. The Company intends to perform a customer field trial and release this product commercially in 1994. The ATM switching system will primarily be sold to telephone operating companies, interexchange carriers and other telecommunications common carriers. CITYCELL-TM- SYSTEM: The Kentrox CityCell Digital Microcell System is a fiber-fed, radio frequency digital transmission microcell that extends cellular communications coverage, primarily in large urban areas. Kentrox sells its CityCell product primarily to public cellular communications providers and users of private voice and data communications networks. NETWORKING PRODUCTS PUBLIC NETWORK ACCESS EQUIPMENT: Through its Kentrox subsidiary, the Company manufactures digital public network service access equipment. These products, known as the T-SERV-R- Channel Service Unit, T-SMART-R- Intelligent Channel Service Unit, the DataSMART-TM- DSU/CSU, the D-Serv DSU/CSU, the DataSMART-TM- E1 SMDSU-TM-, the DataSMART-TM- T3E3 SMDSU-TM- and the DataSMART- TM- 45 SMDSU-TM- are used to interconnect digitally the common carrier network and the customer premises network. This equipment monitors circuits and provides system protection and other network management functions. The T-SMART product also enables the customer to test the performance of its voice network. The D-Serv and DataSMART product lines allow connection of both voice and data circuits. Kentrox has recently developed and introduced ATM DSUs, at both DS1 and DS3 transmission speeds, for the transport of voice, data and video signals. Kentrox intends to perform customer field trials and release these products commercially in 1994. The Kentrox public network service access equipment is sold through telephone operating companies, interexchange carriers, other telecommunications common carriers, OEMs and distributors, or directly to users of private voice and data communication networks. INTERNETWORKING PRODUCTS: Through its Fibermux subsidiary, the Company manufactures internetworking products. The Crossbow-TM- multi-LAN hub family of products interconnects workstations, personal computers and terminals, utilizing many different LAN protocols and cabling types. The LightWatch-R- network management system controls networks based on Crossbow hubs, from one location, utilizing the Simple Network Management Protocol (SNMP). The Magnum 100-R- family of products transports multiple voice, data and video signals simultaneously over a 100-megabit (million bits per second) speed fiber optic backbone. The Magnum 100 backbones link LANs, mainframes, minicomputers, personal computers, telephone systems and video equipment with diverse protocols using time-division multiplexing technology, within the enterprise network or over the public common carrier network. LightWatch network management software also controls Magnum 100 networks. The Company also sells LAN backbone products utilizing other technologies such as fiber distributed data interface (FDDI) and internetworking components such as routers, some of which have been acquired by the Company through licensing and product development arrangements. Fibermux sells internetworking products principally to users of private data communication networks. Fibermux currently has under development its ATMosphere-TM- ATM backbone wiring hub. The ATMosphere product, in its first phase, will provide a high speed, ATM-based backbone between Crossbow hubs and virtual networking management for users attached to Crossbow hubs. Fibermux intends to perform customer field trials and release this product commercially in 1994. PATCH/SWITCH SYSTEM AND PATCHMATE-TM- MODULE: The Company's Patch/Switch system is a data network management product that provides access to, monitors, tests and reconfigures digital data circuits and permits local or remote switching to alternate circuits or backup equipment. This system is fully modular, permitting the user to select and combine the particular functions desired in a system. The PatchMate Module is a manually operated electromechanical device used to gain access in order to monitor, test, and reconfigure digital data circuits. The Patch/Switch System and PatchMate Module are sold principally to users of private data communication networks. BROADBAND CONNECTIVITY PRODUCTS JACKS, PLUGS AND PATCH CORDS: Jacks and plugs are the basic components used to gain access to copper telecommunications circuits for testing and maintenance. A jack is a connecting device to which the wires of a circuit are attached and through which access to that circuit is obtained by the insertion of the plug. This access permits the circuit to be monitored, tested or re-routed (patched). Patch cords are wires or cables with a plug on each end. ADC offers a complete line of jacks and plugs in the longframe and smaller bantam formats. The bantam products are approximately half the size of the longframe products. The Company also manufactures a line of jacks in both of these formats which are designed to be mounted on printed circuit boards wherever access points are required, as well as a line of coaxial jacks and plugs used for gaining access to high frequency circuits. ADC incorporates its jacks, plugs and patch cords into its own products and also sells them in component form primarily to OEMs, whose products are used by telephone operating companies and other companies providing communication services. These components are generally manufactured to industry-recognized compatibility and reliability standards as off-the-shelf items. JACKFIELDS AND PATCH BAYS: A jackfield is a module containing an assembly of jacks wired to terminal blocks or connectors and used by telecommunications companies to gain access to copper communication circuits for testing or patching the circuits. ADC manufactures jackfields in both longframe and bantam formats, including prewired and connectorized models. When testing a large number of circuits, series of jackfields are combined in specialized rack assemblies, which often may include test modules. These assemblies are called patch bays. ADC manufactures a range of jackfields and patch bays in various configurations. The Company's analog jackfields and analog and digital patch bays are sold primarily to OEMs, telephone operating companies and other telecommunications common carriers. The Company also manufactures and sells specialized jackfields for use in audio and video transmission networks in the broadcast industry. DSX PRODUCTS: ADC manufactures digital signaling cross-connect (DSX) modules and bays which are jackfields and patch bays designed to gain access to and cross-connect digital copper circuits for both voice and data transmission. Since introduction of DSX products in 1977, the Company has continued to expand and refine its DSX product offerings, and has become a leading manufacturer of products for the mechanical termination and interconnection of digital circuits used in voice and data transmission. During 1993, ADC added the Mini-DSX-3 product, a double-density, double-capacity module, to its DSX product family. The Company's DSX products are sold primarily to telephone operating companies and other telecommunications common carriers. TERMINAL BLOCKS AND FRAME PRODUCTS: Terminal blocks are molded plastic blocks with contact points used to facilitate multiple wire interconnections. ADC manufactures a wide variety of terminal blocks. The Company's cross-connect frames are terminal block assemblies used to connect the external wiring of a telecommunications network to the internal wiring of a telephone operating company central office or to interconnect various pieces of equipment within a telephone company. ADC sells its terminal blocks and cross-connect frames primarily to OEMs and telephone operating companies. FIBER OPTIC PATCH CORDS: Fiber optic patch cords are functionally similar to copper patch cords and are the basic components used to gain access to fiber telecommunications circuits for testing, maintenance, cross-connection and configuration purposes. ADC manufactures its own FC, SC and ST-R-* connectors for use in the fiber optic patch cords. The Company's LightTracer -TM- fiber optic patch cord provides immediate identification of fiber optic connections. The Company incorporates its fiber optic patch cords into its own products and sells them in component form principally to OEMs, whose products are used by telephone operating companies and other companies providing communication services. FIBER DISTRIBUTION PANELS AND FRAMES: Fiber distribution panels and frames are functionally similar to copper panels and frames with the added feature of additional bend protection and provide interconnection points between fiber optic cables coming into a building and fiber optic cables connected to fiber optic equipment within the building. The Company sells fiber distribution products primarily to telephone operating companies and users of private voice and data communications networks. FIBERGUIDE-R- SYSTEMS: The FiberGuide system is a modular routing system which provides a segregated, protected method of storing and routing fiber patch cords and cables within buildings. ADC sells its FiberGuide systems to telephone operating companies and users of private telecommunication networks. ENGINEER, FURNISH AND INSTALL SERVICES: Engineer, furnish and install (EF&I) services consist of layout and installation of new telecommunications networks, modification of existing networks or the addition of equipment to existing networks. The Company sells its EF&I services to telephone operating companies, other common carriers and users of private telecommunications networks. PRODUCT DEVELOPMENT The Company is committed to an ongoing program of new product development which combines internal development efforts with acquisition, joint venture, licensing or marketing - --------------------- * (a registered trademark of American Telephone & Telegraph Co.) arrangements relating to new products and technologies from sources outside the Company. Development and product engineering expenses for fiscal 1993, 1992 and 1991 were $40,988,000, $36,063,000 and $32,315,000, respectively (approximately 11.2%, 11.4% and 11.0%, respectively, of consolidated net sales). The Company's product development program emphasizes the innovative application of existing technology in the design of new products rather than the research and development of new technology. The Company's product development group works closely with marketing personnel in an effort to determine emerging user needs in the telecommunications market and continually reviews and evaluates technological changes affecting this market. The Company is currently conducting development efforts with respect to technologies and products in each of its three product groups. Among other projects, the Company's development activities are directed at the integration of fiber optic technology into additional products and the incorporation of ATM technology into voice, data and video products for both public and private telecommunications networks. There is also emphasis on developing copper and fiber optic products for applications in the local loop. MARKETING AND DISTRIBUTION ADC sells its products to customers in three primary markets: (1) the United States public telecommunications network market, (2) the private and governmental voice, data and video network market in the United States, and (3) the international public and private network market. Major providers in the public telecommunications market in the United States include the Bell Operating Companies, other local telephone companies (such as GTE Corporation, United Telecommunications, Inc. and Centel Corporation), long-distance telephone companies (such as AT&T Communications/Information Systems, MCI Telecommunications Corp., Sprint and Williams Telecommunications Co.), CATV companies (such as Cox Enterprises, Inc. Liberty Cable Company, TCI, Inc.) other emerging telecommunication common carriers (such as MFS Communications Company and Teleport Communications Group, Inc.), and major OEMs which service these same customers (such as AT&T Technologies, Inc., Northern Telecom, Inc., Alcatel Alsthom Compagnie Generale D'Electricite, NEC America, Inc., Fujitsu Limited and Tellabs Operations, Inc.). The Company sells its products to most of the major providers and OEMs. The private network market includes predominantly large businesses and state and federal government agencies which own and operate their own voice and data networks for internal use. The major OEMs in this market include International Business Machines Corporation (IBM), AT&T Paradyne Corporation, Digital Equipment Corporation, Northern Telecom, Inc., Codex Corporation and Racal Corporation. The Company's products are sold in the United States by approximately 112 field sales representatives located in 24 sales offices throughout the country, and by several dealer organizations and distributors. The Company also has a customer service group, which supports field sales personnel and is responsible for application engineering, customer training, entering orders and supplying delivery status information, and a field service engineering group, which provides on-site service to customers. The foreign markets with the greatest potential for sales of the Company's products consist of the telephone operating companies in the public telecommunications networks of Canada, Western Europe, Australia, New Zealand, Mexico and the Asian region. The Company sells its products to foreign customers through 23 Company-employed field salespersons, eight foreign independent sales representatives and 81 foreign distributors. On October 31, 1993, the Company's foreign distribution network was selling products in 61 nations throughout the world. To date, the principal foreign market for the Company's products has been Canada. The Company has wholly-owned subsidiaries in Canada, the United Kingdom, Belgium, Australia, Mexico, Singapore and Venezuela. The Company's foreign sales offices are located in Toronto, Montreal, Ottawa, Vancouver, London, Brussels, Sydney, Mexico City, Singapore and Caracas. Consolidated export sales to unaffiliated customers for fiscal years 1993, 1992 and 1991 were $58,919,000, $49,347,000 and $37,960,000, respectively (approximately 16.1%, 15.6% and 12.9%, respectively, of consolidated net sales). The Company warrants most of its products against defects in materials and workmanship under normal use and service for periods of up to 15 years. To date, the Company's warranty experience has been favorable, with a low rate of product return. COMPETITION Competition in the telecommunications products market is intense. The Company manufactures, markets and sells products similar to those manufactured by numerous other companies, some of which, such as AT&T Technologies, Inc. and Switchcraft, Inc., a subsidiary of Raytheon Company, have greater resources than those available to the Company. The Company faces increasing competition from a number of other smaller competitors. The Company believes its success in competing with other manufacturers of telecommunications products depends primarily on its engineering, manufacturing and marketing skills, the price, quality and reliability of its products, and its delivery and service capabilities. The Company's Fibermux subsidiary competes with a number of other companies, none of which is dominant, and faces both strong price competition and pressure from alternative distribution strategies utilized by these other companies. The Company's Kentrox and ALS subsidiaries have various competitors, none of which is dominant. The Company believes that technological change, the shift in network traffic to data and video and continuing industry deregulation will continue to cause rapid evolution in the competitive environment of the telecommunications market, the full scope and nature of which is impossible to predict at this time. The Company believes the most significant competitive effect of continuing industry deregulation has been, and will continue for the immediate future to be, the creation of new opportunities for suppliers of telecommunications products like the Company. The Company expects, however, that such opportunities will attract increased competition from others as well. In addition, the Company expects that AT&T Technologies, Inc. will continue to be a major supplier to the Bell Operating Companies, and is competing more extensively outside the Bell system. The Company also believes that the rapid technological changes which characterize the telecommunications industry will continue to make the markets in which the Company competes attractive to new entrants. MANUFACTURING AND SUPPLIES The manufacturing process for the Company's electronic products consists primarily of assembly and test of electronic systems built from fabricated parts, printed circuit boards and electronic components. The manufacturing process for the Company's electromechanical products consists primarily of fabrication of jacks, plugs, and other basic components from raw materials, assembly of components and testing. The Company's sheet metal, plastic molding, stamping and machining capabilities permit the Company to configure components to customer demand. The Company purchases raw materials and component parts, consisting primarily of copper wire, optical fiber, steel, brass, nickel-steel alloys, gold, plastics, printed circuit boards, solid state components, discrete electronic components and similar items, from several suppliers. Although a number of components used by the Company are single sourced, the Company has experienced no significant difficulties to date in obtaining adequate quantities of these raw materials and component parts. The Company believes that alternative sources of supply exist, or can be developed without causing significant delays, for all of its raw materials and component parts. PROPRIETARY RIGHTS The Company owns a number of United States and foreign patents relating to its products. These patents, in the aggregate, constitute a valuable asset of the Company. The Company, however, believes that its business is not dependent upon any single patent or any group of related patents. The Company has registered the initials ADC alone and in conjunction with specific designs as trademarks in the United States and various foreign countries. EMPLOYEES As of October 31, 1993, there were 2,462 persons employed by the Company. The Company considers relations with its employees to be good. ITEM 2. ITEM 2. PROPERTIES The Company's corporate headquarters are currently located in two leased buildings in Minnetonka, Minnesota, comprising 144,700 square feet. A 57,000 square foot facility, also leased in Minnetonka, is occupied by the Company's Minnesota fiber optic operations. The Company also leases a 119,000 square foot facility in Minnetonka, Minnesota, in which the engineering, product management, manufacturing and manufacturing support operations for the Company's transmission products are located. The Company also owns two buildings comprising 132,800 square feet in Bloomington, Minnesota, which house manufacturing and manufacturing support operations. The Company owns a 76,000 square foot facility and a 20,000 square foot facility in LeSueur, Minnesota, which are used for electromechanical assembly and warehouse space. The Company leases additional warehouse space on a short term basis from time to time to meet its needs. The Company owns an 11,700 square foot facility in Bloomington, Minnesota, which is leased to an unaffiliated company. In addition, the Company owns approximately 38 acres of undeveloped land in Eden Prairie, Minnesota. The Company's Kentrox subsidiary owns a 105,000 square foot facility in Portland, Oregon, which serves as its office and manufacturing facility and leases approximately 4,000 square feet of space in Waseca, Minnesota, which serves as a research and development center. The Company leases approximately 15,000 square feet of space in Richardson, Texas, for the TELINQ Development Center. The Company's ALS subsidiary leases approximately 47,000 square feet of space in Meriden, Connecticut as its office and manufacturing facility. The Company's Fibermux subsidiary leases approximately 97,000 square feet in Chatsworth, California as it office and manufacturing facility. The Company also leases sales office facilities in the United States, Canada, the United Kingdom, Belgium, Australia, Mexico, Venezuela and Singapore. Leases for the Company's headquarters, sales offices and manufacturing facilities expire at different times through 2000 and are generally renewable on a fixed term or a month-to-month basis. The Company believes that the facilities used in its operations are very well maintained and in excellent condition. For information regarding encumbrances on the Company's properties, see Note 3 to the Consolidated Financial Statements included in Part II, Item 8, of this report. ITEM 3. ITEM 3. LEGAL PROCEEDINGS None. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company are as follows: Executive officers of the Company are elected by the Board of Directors. The Company's executive officers were last elected to their positions on February 23, 1993 except for Messrs. Brown and Switz. Messrs. Denny, Cadogan and Davis and Ms. Berg have served in various capacities with the Company for more than five years. Biographical information regarding the other named officers follows. Mr. Asten joined ADC in February 1992. Prior to such time, he was employed by Telco Systems, Inc., a manufacturer of fiber optic transmission products and customer premises network access equipment. At Telco Systems he served as Vice President, Worldwide Sales, beginning in 1987. Mr. Brown joined the Company in July 1993. He was employed by Ungermann-Bass, Inc. from 1990 to July 1993, most recently holding the position of Executive Vice President, Customer Operations. Prior to joining Ungermann-Bass, Mr. Brown was Senior Vice President, Marketing, Sales & Service for McData Corporation, a Colorado-based networking company. He was also elected a Vice President of ADC in July 1993. Mr. Mesiya joined the Company in 1990, following the acquisition of ALS. He has held the position of President of ALS since 1986, and was elected a Vice President of ADC in October 1992. Mr. Porter joined the Company in 1989, following the acquisition of Kentrox. He was named President of Kentrox in December 1991. Before that time he was Vice President, National Accounts, for ADC for one year. For three years prior to December 1990, he served as Vice President of Sales and Marketing of Kentrox. Mr. Switz joined the Company in January 1994. Prior to that time, he was employed at Burr-Brown Corporation, most recently as Vice President, Chief Financial Officer and Director, Ventures and Systems Business. Mr. Wetherell joined the Company in December 1991. Prior to that time, he was employed by Telex Communications, Inc., where he held various domestic and international positions beginning in 1984, and was the President and Chief Executive Officer from 1989 to 1991. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock, $.20 par value, is traded in the over-the-counter market and is quoted on the NASDAQ National Market System under the symbol "ADCT". The following table sets forth the high and low daily sale prices for each quarter during the fiscal years ended October 31, 1993 and 1992, as reported on the NASDAQ National Market System. In June 1993, the Company effected a two-for-one stock split in the form of a 100% stock dividend, and all sales prices are adjusted to reflect such stock split. No cash dividends have been declared or paid during the past two years and the Company has no present intention of declaring a cash dividend. The Company's revolving credit agreements permit cash dividends only to the extent of 25% of net income for the preceding four quarters. As of December 15, 1993, there were approximately 1,648 holders of record of the Company's Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following is a summary of certain consolidated statement of income and balance sheet information of ADC Telecommunications, Inc. and Subsidiaries for the five years ended October 31, 1993. This summary should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this report. All share and per share amounts have been restated for a two-for-one stock split effected in the form of a 100% stock dividend in June 1993, and all amounts except per share amounts are presented in thousands. No cash dividends have been declared or paid in any of the years presented. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The percentage relationships to net sales of certain income and expense items for the three years ended October 31, 1993 and the percentage changes in these income and expense items between years are contained in the following table: RESULTS OF OPERATIONS NET SALES: Net sales for the three years ended October 31, 1993 reflect the following volume increases (decreases) by product group and in total (dollars in thousands): The 1993 and 1992 increases in net sales of transmission products are primarily attributable to sales of new products and, in 1993, increased sales of fiber video delivery systems to public telecommunications network providers. The Company intends to continue introducing new transmission products in 1994. If such new products meet with reasonable market acceptance, the Company anticipates that net sales of all transmission products will grow as a percentage of the Company's total net sales. The 1993 increase in net sales of networking products primarily represents increased sales of public network access equipment to private network customers. The 1992 increase in net sales of networking products primarily reflects the acquisition of Fibermux in May 1991. Due to the timing of the acquisition, Fibermux product revenues were included in net sales of networking products for all of 1993 and 1992 and for six months in 1991. Although the Fibermux acquisition contributed to increased net sales and orders during all of 1992 and the last six months of 1991, net sales and orders for the Company as a whole were lower than anticipated during that 18-month period due to the effects of recession in the public network market. These effects are reflected in the 1992 decrease in net sales of broadband connectivity products. The Company began experiencing improvement in its public network market business during the second quarter of 1992 which continued throughout the remainder of 1992 and 1993. Within the broadband connectivity product group, net sales of ADC's copper products utilizing telephone jacks have declined as a percentage of total net sales during the last three years as shown in the following table: Although these products currently account for a substantial portion of the Company's revenues, management believes that future sales of copper products utilizing telephone jacks will continue gradually to decline as a percentage of total net sales primarily due to the ongoing evolution of technologies within the telecommunications marketplace (see Item 1 Business -- The Telecommunications Market) and the addition of new products to the ADC product portfolio. Net sales of fiber optic products represented 34.2%, 29.9% and 20.9% of total net sales in 1993, 1992 and 1991, respectively. These year-to-year increases reflect the Company's increasing emphasis on development and marketing of fiber optic products. Management anticipates increasing the Company's fiber optic product offerings which should expand total sales of such products. GROSS PROFIT: The 1993 and 1992 increases in gross profit percentage to 51.2% and 51.0% of net sales, respectively, from 49.4% of net sales in 1991 primarily reflect more favorable product sales mix, successful manufacturing cost reduction efforts and higher net sales volumes. OPERATING EXPENSES: Total operating expenses represented 36.7%, 38.8% and 36.3% of net sales in 1993, 1992 and 1991, respectively. The 1992 increase primarily reflects the first full year of Fibermux operating expenses, and a $3,800,000 personnel reduction charge ($.09 per share after taxes) recorded in the Company's first quarter 1992. This charge represented employee separation costs related to the elimination of positions during that quarter. The 14.8% and 14.5% increases in selling expenses in 1993 and 1992, respectively, also reflect increased marketing and selling activities associated with new product introductions and expansion of markets. The 13.7% and 11.6% increases in development and product engineering expenses in 1993 and 1992, respectively, also reflect significant investments in product development and introduction. The Company has been able to maintain its development and product engineering expenses as a relatively constant percentage of net sales during the 1991 to 1993 period by planning for and controlling such expenditures. The 5.7% and 4.1% increases in administration expenses in 1993 and 1992, respectively, primarily reflect the growth of the Company. Due to effective management of expenditures, the Company has decreased its ratio of administration expenses as a percentage of net sales over the three-year period. The major technological changes underway in the telecommunications industry (see Item 1 Business -- The Telecommunications Market) will require the Company to continue investing significantly in product development. Company management recognizes the need to balance the cost of product development with expense control and remains committed to minimizing the rate of increase of such expenses. OTHER INCOME (EXPENSE), NET: The interest income (expense) category reflected net interest income earned on cash balances during 1993 and the Company's first two quarters of 1991. In May 1991, the Company borrowed $40 million to acquire Fibermux, resulting in net interest expense from that date through 1992. (See "Liquidity and Capital Resources" below for a discussion of the Company's borrowings.) Other expense primarily represented amortization of the goodwill portions of the Fibermux, Kentrox and ALS acquisition prices, beginning at their respective acquisition dates. INCOME TAXES: See Note 6 to the Consolidated Financial Statements included in Part II, Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS (A) STATEMENT OF REGISTRANT No separate financial statements of the Company's subsidiaries are included herein because the Company is primarily an operating company and its subsidiaries are wholly-owned. (B) Consolidated Statements Report of Independent Public Accountants . . . . . . . . . . . . . . . . 28 Consolidated Balance Sheets as of October 31, 1993 and 1992. . . . . . . 29 Consolidated Statements of Income for the years ended October 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . 30 Consolidated Statements of Changes in Stockholders' Investment for the years ended October 31, 1993, 1992 and 1991 . . . . . . . . 31 Consolidated Statements of Cash Flows for the years ended October 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . 32 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . 33 Supplemental Schedules to Consolidated Financial Statements Schedules V and VI -- Property and Equipment and Accumulated Depreciation . . . . . . . . . . . . . . . . . . . 40 Schedule X -- Supplementary Income Statement Information. . . . . . 41 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted as not required, not applicable or the information required has been included elsewhere in the financial statements and related notes. (C) SUPPLEMENTAL FINANCIAL INFORMATION -- Unaudited . . . . . . . . . . . . 42 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To ADC Telecommunications, Inc.: We have audited the accompanying consolidated balance sheets of ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES as of October 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' investment and cash flows for each of the three years in the period ended October 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ADC Telecommunications, Inc. and Subsidiaries as of October 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended October 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental schedules to consolidated financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Minneapolis, Minnesota December 15, 1993 ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS - OCTOBER 31 (IN THOUSANDS) ASSETS The accompanying notes are an integral part of these consolidated balance sheets. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED OCTOBER 31 (IN THOUSANDS, EXCEPT PER SHARE STATISTICS) The accompanying notes are an integral part of these consolidated statements. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' INVESTMENT FOR THE YEARS ENDED OCTOBER 31 (IN THOUSANDS) The accompanying notes are an integral part of these consolidated statements. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED OCTOBER 31 (IN THOUSANDS) The accompanying notes are an integral part of these consolidated statements. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: BUSINESS AND OPERATIONS - The consolidated financial statements include the accounts of ADC Telecommunications, Inc. (a Minnesota corporation) and its wholly-owned subsidiaries, referred to collectively herein as the Company. All significant intercompany transactions and balances have been eliminated in consolidation. The Company designs, manufactures and markets products that serve a broad range of transmission, networking, and broadband connectivity functions in telecommunications networks utilizing copper and fiber optic transmission media. Revenue is recognized at the time of shipment. Export sales were $58,919,000, $49,347,000 and $37,960,000 in 1993, 1992 and 1991, respectively. CASH EQUIVALENTS - Cash equivalents primarily represent short-term investments in commercial paper with maturities of less than three months which yielded 3% and 4% at October 31, 1993 and 1992, respectively. These investments are reflected in the accompanying consolidated balance sheets at cost, which approximates market. INVENTORIES - Inventories include material, labor and overhead and are stated at the lower of first-in, first-out cost or market. Inventories at October 31 consisted of: PROPERTY AND EQUIPMENT - Property and equipment are recorded at cost. Additions and improvements to property and equipment are capitalized at cost while maintenance and repair expenditures are charged to operations as incurred. Depreciation charges are computed using the straight-line method for financial reporting purposes and both straight-line and accelerated methods for income tax purposes. For financial reporting purposes, depreciation is provided over the following estimated useful lives: GOODWILL AND OTHER INTANGIBLES - The excess of the cost over the net assets of acquired businesses (goodwill of $77,000,000 and $70,000,000 at October 31, 1993 and 1992, respectively) is being amortized on a straight-line basis over 25 years. Related accumulated amortization at October 31, 1993 and 1992 was $8,653,000 and $5,856,000, respectively. Other intangibles are being amortized on a straight-line basis over 5 years. RESEARCH AND DEVELOPMENT COSTS - The Company's policy is to expense all research and development costs in the period incurred. WARRANTY COSTS - The Company warrants most of its products against defects in materials and workmanship under normal use and service for periods extending to fifteen years. Historically, warranty costs have been insignificant. The Company maintains reserves for warranty costs based on this experience. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) ACQUISITIONS: Effective May 6, 1991, the Company acquired Fibermux Corporation (Fibermux). During the third quarter of 1990, the Company acquired technology and other assets of TELINQ Systems Incorporated and the stock of American Lightwave Systems, Inc. (ALS). Payments and accruals related to these acquisitions through October 31, 1993, totalled $74,463,000. These acquisitions have been accounted for as purchases, and, accordingly, the total purchase prices were allocated to the net assets acquired based on estimated fair values at the dates of the acquisitions. The excess of cost over the net assets has been recorded as goodwill. The results of operations have been included in the Consolidated Statements of Income from the respective acquisition dates. The inclusion of financial data for these acquisitions prior to the dates of acquisition would not have materially affected reported results. (3) DEBT: Under revolving credit agreements, the Company has credit arrangements which permit borrowing, on an unsecured basis, up to $40,000,000 through December 1996, principally at prevailing market rates of interest. The agreements require, among other matters, that the Company meet certain defined net worth, interest coverage and liability to equity ratios, and restrict cash dividends. The Company was in compliance with these covenants at October 31, 1993. The revolving credit borrowings can be repaid at any time prior to maturity without penalty. At maturity, the Company will have an option to convert any outstanding revolving credit loan balances to term loans bearing interest principally at the prime rate, payable in annual installments through December 2000. The Company is required to pay commitment fees based upon the average unused amounts of the commitments. There are no compensating balance requirements. In May 1991, the Company borrowed $40,000,000 under the revolving credit agreements to partially finance the acquisition of Fibermux. The debt outstanding under such agreements was repaid during 1993 and 1992. The weighted average annual interest rates during the period borrowings were outstanding were 4.9%, 5.3% and 6.6% for 1993, 1992 and 1991, respectively. At October 31, 1993 and 1992, the Company had a mortgage note payable of $1,100,000 and $1,434,000 respectively, collateralized by certain land, buildings and equipment. The note is payable in annual installments of approximately $300,000 through 1996 and bears interest at a rate of 7.55%. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) EMPLOYEE BENEFIT PLANS: PENSION PLAN - The Company maintains a defined benefit plan covering a majority of its employees. The Company funds the plan in accordance with the requirements of Federal laws and regulations. Plan assets consist of fixed income securities and a managed portfolio of equity securities. Pension expense included the following components: The rate of compensation used to measure the projected benefit obligation was 5% in 1993 and 6% in 1992 and 1991. The expected long-term rate of return on plan assets was 9%. The following table sets forth the funded status of the plan as of October 31: ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) EMPLOYEE BENEFIT PLANS (CONTINUED): The Company also maintains supplemental defined benefit retirement plans for members of the Board of Directors and for certain officers. The cost of these plans was $210,000, $257,000 and $494,000 for 1993, 1992 and 1991, respectively. RETIREMENT SAVINGS PLAN - The Company has a voluntary plan of investment available to any employee who has completed one year of service. The Company contributes 1% of wages to the Retirement Savings Plan on behalf of all employees covered under the plan. Based on Company performance, salary deferrals up to 6% of wages are partially matched by the Company. Employees are fully vested in salary deferrals and Company contributions at all times. The contributions to this plan totalled $3,210,000, $2,639,000 and $2,415,000 in 1993, 1992 and 1991, respectively. A portion of the cash contributions is invested in the Company's stock by the Plan's trustee. STOCK AWARD PLANS - The Company maintains a Stock Incentive Plan which provides for the granting of certain stock awards, including stock options at fair market value and restricted shares, to key employees of the Company. The Company also maintains a Non-Employee Director Stock Option Plan in order to enhance the ability to attract and retain the services of experienced and knowledgeable outside directors. The plan provides for granting of a maximum of 110,000 nonqualified stock options at the fair market value. During 1993, 1992, and 1991, the Company issued shares of common stock to certain employees which are restricted as to their transferability through October 31, 1996. The market value of such stock at the date of issuance is being amortized to income over the restricted period. The unamortized amount of the resulting deferred compensation is recorded as a reduction of shareholders' investment. In addition, the Company awarded stock retention bonuses which provide for cash payments to offset the personal income taxes incurred upon the lapsing of stock restrictions. The compensation expense associated with this plan was $1,938,000, $1,008,000 and $970,000 in 1993, 1992 and 1991, respectively. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) EMPLOYEE BENEFIT PLANS(CONTINUED): The following schedule summarizes activity in the plans: (5) CAPITAL STOCK: AUTHORIZED STOCK - The Company is authorized to issue 50,000,000 shares of common stock at 20 cents par value and 10,000,000 shares of preferred stock, no par value. The Board of Directors has the power to determine the dividend, voting, conversion and redemption rights of each series of preferred stock which they may create. There are no preferred shares issued. STOCK SPLIT - On May 26, 1993, the Company declared a two-for-one stock split effected in the form of a 100% stock dividend paid June 28, 1993 to shareholders of record as of June 15, 1993. The share and per share information in this report (except balance sheet data) have been adjusted to reflect the effect of the dividend. SHAREHOLDER RIGHTS PLAN - The Company has a Shareholder Rights Plan which provides that if any person or group acquires 20% or more of the Company's common stock, each Right not owned by such person or group will entitle its holder to purchase, at the Right's then-current purchase price ($16 2/3 at October 31, 1993), common stock of the Company having a value of twice the Right's purchase price. The Rights would not be triggered, however, if the acquisition of 20% or more of the Company's common stock is pursuant to a tender offer or exchange for all outstanding shares of the Company's common stock which is determined by the Board of Directors to be fair and in the best interests of the Company and its shareholders. If the Board of Directors determines that a 10% shareholder's interest is likely to have an adverse effect on the long-term interests of the Company and its shareholders, the Rights may also become exercisable. The Rights are redeemable at 1 2/3 cents any time prior to the time they become exercisable. The Rights will expire on October 6, 1996 if not previously redeemed or exercised. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (6) INCOME TAXES: The components of the provision for income taxes are as follows: The Company records a reduction in income taxes payable for qualifying tax credits in the year in which they occur. The benefit for deferred taxes is primarily due to timing differences in the tax deductibility of employee benefit plan costs, depreciation and certain accrued expenses and reserves which are not yet deductible for income tax purposes. The effective income tax rate differs from the Federal statutory rate as follows: In February 1992 the Financial Accounting Standards Board issued Statement No. 109, "Accounting for Income Taxes" (FASB 109), which the Company intends to implement in the first quarter of 1994. Management has determined that the impact of adopting FASB 109 will not be significant to the Company in fiscal 1994. The Company's United States income tax returns for the years 1990 and 1991 are currently under examination. Management believes that adequate provision for income taxes has been made for all years through 1993. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (7) COMMITMENTS AND CONTINGENCIES: OPERATING LEASES - A portion of the Company's operations are conducted using leased equipment and facilities. These leases are non-cancellable and renewable with expiration dates ranging through the year 2000. The rental expense included in the accompanying consolidated income statements was $5,347,000, $5,324,000 and $4,834,000 for 1993, 1992 and 1991, respectively. The following is a schedule of future minimum rental payments required under all non-cancellable operating leases as of October 31, 1993: CONTINGENCIES - The Company is exposed to a number of asserted and unasserted potential claims encountered in the normal course of business. In the opinion of management, the resolution of these matters will not have a material adverse effect on the Company's financial position or results of operations. CHANGE OF CONTROL - The Board of Directors has approved the extension of certain employee benefits, including salary continuation to key employees, in the event of a change of control of the Company. The Board has retained the flexibility to cancel such provisions under certain circumstances. (8) PERSONNEL REDUCTION: During the first quarter of 1992, the Company recorded a one-time charge associated with a workforce reduction program designed to reduce payroll costs. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES SUPPLEMENTAL SCHEDULES TO CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES V AND VI - PROPERTY AND EQUIPMENT AND ACCUMULATED DEPRECIATION: Transactions in property and equipment and accumulated depreciation accounts for the years ended October 31, 1993, 1992, and 1991 were as follows: * Includes $2,311,000 acquired in connection with the purchase of Fibermux in 1991 (see note 2 to the consolidated financial statements). ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES SUPPLEMENTAL SCHEDULES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION: The following amounts were charged to cost of products sold and operating expenses as follows: The amounts of royalties, taxes other than payroll and income taxes, and repairs and maintenance are not material in the aggregate. ADC TELECOMMUNICATIONS, INC. AND SUBSIDIARIES SUPPLEMENTAL FINANCIAL INFORMATION - UNAUDITED (IN THOUSANDS, EXCEPT EARNINGS PER SHARE) Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See Part I of this Report for information with respect to executive officers of the Company. Pursuant to General Instruction G(3), reference is made to the information contained under the captions "Election of Directors" and "Section 16(a) Reporting" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission on or before February 28, 1994, which information is incorporated herein. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G(3), reference is made to the information contained under the caption "Executive Compensation" (except for the information set forth under the subcaption "Compensation and Organization Committee Report on Executive Compensation," which is not incorporated herein) in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission on or before February 28, 1994, which information is incorporated herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to General Instruction G(3), reference is made to the information contained under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission on or before February 28, 1994, which information is incorporated herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G(3), reference is made to the information contained in the last paragraph under the caption "Election of Directors -- Compensation of Directors" in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission on or before February 28, 1994, which information is incorporated herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K(a) (a) 1. FINANCIAL STATEMENTS The following consolidated financial statements of the Company are included in Part II, Item 8 of this Annual Report on Form 10-K: Report of Independent Public Accountants. Consolidated Balance Sheets as of October 31, 1993 and 1992. Consolidated Statements of Income for the years ended October 31,1993, 1992 and 1991. Consolidated Statements of Changes in Stockholders' Investment for the years ended October 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows for the years ended October 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Supplemental Financial Information (Unaudited). 2. FINANCIAL STATEMENT SCHEDULES The following financial statement schedules are included in Part II, Item 8 of this Annual Report on Form 10-K: Schedules V --Property and Equipment and Accumulated and VI Depreciation. Schedule X --Supplementary Income Statement Information. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission have been omitted as not required or not applicable, or the information required has been included elsewhere in the financial statements and related notes. 3. LISTING OF EXHIBITS Exhibit Number Description --------- ----------- 3-a Restated Articles of Incorporation of ADC Telecommunications, Inc., as amended to date. (Incorporated by reference to Exhibit 3-a to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 3-b Composite Restated Bylaws of ADC Telecommunications, Inc., as amended to date (Incorporated by reference to Exhibit 3-b to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) 4-a Specimen certificate for shares of Common Stock of ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 4-a to the Company's Quarterly Report on Form 10-Q for the quarter ended July 31, 1989.) Exhibit Number Description --------- ----------- 4-b Restated Articles of Incorporation of ADC Telecommunications, Inc., as amended to date. (Incorporated by reference to Exhibit 4-b to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 4-c Composite Restated Bylaws of ADC Telecommunications, Inc., as amended to date (Incorporated by reference to Exhibit 3-b to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) 4-d Amended and Restated Rights Agreement, amended and restated as of August 16, 1989, between ADC Telecommunications, Inc. and Norwest Bank Minnesota, N.A., as Rights Agent. (Incorporated by reference to Exhibit 1 to Amendment No. 1 on Form 8 dated August 16, 1989, to the Company's Registration Statement on Form 8-A dated September 23, 1986.) 10-a* Stock Option and Restricted Stock Plan, restated as of January 26, 1988. (Incorporated by reference to Exhibit 19-a to the Company's Quarterly Report on Form 10-Q for the quarter ended April 30, 1988.) 10-b* Amendment to Stock Option and Restricted Stock Plan dated as of September 26, 1989. (Incorporated by reference to Exhibit 10-e to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) 10-c* The ADC Telecommunications, Inc. 1991 Stock Incentive Plan, as amended. (Incorporated by reference to Exhibit 10-a to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1993.) 10-d* Management Incentive Plan for the fiscal year ended October 31, 1991. (Incorporated by reference to Exhibit 10-e to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 10-e* Management Incentive Plan for the fiscal year ended October 31, 1992. (Incorporated by reference to Exhibit 10-e to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1992.) 10-f* Management Incentive Plan for the fiscal year ended October 31, 1993. 10-g* FITL Management Incentive Plan for the fiscal year ended October 31, 1993. 10-h* International Management Incentive Plan for the fiscal year ended October 31, 1993. 10-i* Transmission Market Development Management Incentive Plan for the fiscal year ended October 31, 1993. 10-j* Vice President of Sales and Customer Service Management Incentive Plan for the fiscal year ended October 31, 1993. 10-k* Fibermux Management Incentive Plan for the fiscal year ended October 31, 1993. 10-l* Kentrox Management Incentive Plan for the fiscal year ended October 31, 1993. 10-m* Agreement, dated as of November 1, 1991, between ADC Telecommunications, Inc. and Charles M. Denny, Jr., related to retirement and consulting arrangements. (Incorporated by reference to Exhibit 10-h to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 10-n* ADC Telecommunications, Inc. Change in Control Severance Pay Plan Statement and Summary Plan Description. (Incorporated by reference to Exhibit 10-q to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) Exhibit Number Description --------- ----------- 10-o* Compensation Plan for Directors of ADC Telecommunications, Inc., restated as of December 31, 1988. (Incorporated by reference to Exhibit 19-b to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1989.) 10-p* First Amendment of the Compensation Plan for Directors of ADC Telecommunications, Inc. restated as of December 31, 1988. (Incorporated by reference to Exhibit 10-s to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) 10-q* ADC Telecommunications, Inc. Directors' Supplemental Retirement Plan dated as of January 23, 1990. (Incorporated by reference to Exhibit 10-m to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.) 10-r* ADC Telecommunications, Inc. Nonemployee Director Stock Option Plan. (Incorporated by reference to Exhibit 19-b of the Company's Quarterly Report on Form 10-Q for the quarter ended April 30, 1991.) 10-s* ADC Telecommunications, Inc. Deferred Compensation Plan, dated as of November 1, 1978. (Incorporated by reference to Exhibit 10-n to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.) 10-t* ADC Telecommunications, Inc. Excess Benefits Plan, dated as of January 1, 1985. (Incorporated by reference to Exhibit 10-o to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.) 10-u* ADC Telecommunications, Inc. 401(k) Excess Plan, dated as of September 1, 1990. (Incorporated by reference to Exhibit 10-p to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.) 10-v Lease, dated February 25, 1991, between American Lightwave Systems, Inc. and 999 Research Parkway, Inc. (Incorporated by reference to Exhibit 10-t to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 10-w Lease, dated March 1, 1986, between ADC Telecommunications, Inc. and Metro International Ltd. as amended. (Incorporated by reference to Exhibit 10-w to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 10-x Lease Agreement, dated October 26, 1990, between Lutheran Brotherhood and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-w to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.) 10-y Lease Agreement, dated August 21, 1990, between Minnetonka Corporate Center I Limited Partnership and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-x to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.) 10-z Sublease Agreement, dated October 31, 1990, between Seagate Technology, Inc. and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-y to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.) Exhibit Number Description --------- ----------- 10-aa Renewal of Lease, dated July 9, 1990, between ADC Telecommunications, Inc. and Metro International General Partner Canada, Inc. (Incorporated by reference to Exhibit 10-z to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.) 10-bb Lease, dated September 30, 1993, between American Lightwave Systems, Inc. and 999 Research Parkway, Inc. 10-cc Lease, dated August 2, 1993, between ADC Telecommunications, Inc. and Engelsma Limited Partnership. 10-dd Lease, dated December 18, 1992, between Fibermux Corporation and Greenville Dallas Delaware, Inc. 10-ee* Supplemental Executive Retirement Plan Agreement for William J. Cadogan, dated as of November 1, 1990, between ADC Telecommunications, Inc. and William J. Cadogan. 21-a Subsidiaries of the Company. 23-a Consent of Independent Public Accountants to incorporation by reference of financial material included in this report into Company's Registration Statement on Form S-8 (File No. 2-83584), Registration Statement on Form S-8 (File No. 322654), Registration Statement on Form S-8 (File No. 33-40356) and Registration Statement on Form S-8 (File No. 33-40357.) 24-a Powers of attorney. There have been excluded from the exhibits filed with this report instruments defining the rights of holders of long-term debt of the Company where the total amount of the securities authorized under such instruments does not exceed 10% of the total assets of the Company. The Company hereby agrees to furnish a copy of any such instruments to the Commission upon request. (b) REPORTS ON FORM 8-K No reports on Form 8-K were filed by the Company during the quarter ended October 31, 1993. (c) See Exhibit Index and Exhibits attached to this report. (d) See Financial Statement Schedules included in Part II, Item 8 of this report. __________________ * Management contract or compensatory plan or arrangement required to be filed as an Exhibit to the Annual Report on Form 10-K. 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. ADC TELECOMMUNICATIONS, INC. Dated: January 11, 1994 By: /s/ Robert E. Switz ------------------------ Robert E. Switz Vice President, Chief Financial Officer 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. William J. Cadogan* President, Chief Executive Officer, Chief Operating Officer and Director (principal executive officer) By: /s/ Robert E. Switz Vice President, -------------------- Chief Financial Officer Robert E. Switz (principal financial officer) By: /s/ Joan K. Berg Vice President, By: /s/ Joan K. Berg ------------------- Controller ---------------- Joan K. Berg (principal accounting officer) Joan K. Berg Attorney-in-Fact* Dated: January 11, 1994 Charles M. Denny, Jr.* Director Thomas E. Holloran* Director B. Kristine Johnson* Director Charles W. Oswald* Director Jean-Pierre Rosso* Director Donald M. Sullivan* Director Warde F. Wheaton* Director John D. Wunsch* Director * By Power of Attorney filed with this report as Exhibit 24-a hereto. ADC TELECOMMUNICATIONS, INC. Annual Report on Form 10-K For the Fiscal Year Ended October 31, 1993 EXHIBIT INDEX Exhibit Number Description Page --------- ----------- ---- 3-a Restated Articles of Incorporation of N/A ADC Telecommunications, Inc., as amended to date. (Incorporated by reference to Exhibit 3-a to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 3-b Composite Restated Bylaws of ADC Telecommunications, N/A Inc., as amended to date (Incorporated by reference to Exhibit 3-b to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) 4-a Specimen certificate for shares of Common Stock N/A of ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 4-a to the Company's Quarterly Report on Form 10-Q for the quarter ended July 31, 1989.) 4-b Restated Articles of Incorporation of ADC N/A Telecommunications, Inc., as amended to date. (Incorporated by reference to Exhibit 4-b to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 4-c Composite Restated Bylaws of ADC Telecommunications, N/A Inc., as amended to date (Incorporated by reference to Exhibit 3-b to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) 4-d Amended and Restated Rights Agreement, amended N/A and restated as of August 16, 1989, between ADC Telecommunications, Inc. and Norwest Bank Minnesota, N.A., as Rights Agent. (Incorporated by reference to Exhibit 1 to Amendment No. 1 on Form 8 dated August 16, 1989, to the Company's Registration Statement on Form 8-A dated September 23, 1986.) 10-a Stock Option and Restricted Stock Plan, restated N/A as of January 26, 1988. (Incorporated by reference to Exhibit 19-a to the Company's Quarterly Report on Form 10-Q for the quarter ended April 30, 1988.) 10-b Amendment to Stock Option and Restricted Stock Plan N/A dated as of September 26, 1989. (Incorporated by reference to Exhibit 10-e to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) 10-c The ADC Telecommunications, Inc. 1991 Stock N/A Incentive Plan, as amended. (Incorporated by reference to Exhibit 10-a to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1993.) Exhibit Number Description Page -------- ----------- ---- 10-d Management Incentive Plan for the fiscal year N/A ended October 31, 1991. (Incorporated by reference to Exhibit 10-e to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 10-e Management Incentive Plan for the fiscal year N\A ended October 31, 1992. (Incorporated by reference to Exhibit 10-e to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1992.) 10-f Management Incentive Plan for the fiscal year xx ended October 31, 1993. 10-g FITL Management Incentive Plan for the fiscal xx year ended October 31, 1993. 10-h International Management Incentive Plan for the xx fiscal year ended October 31, 1993. 10-i Transmission Market Development Management Incentive xx Plan for the fiscal year ended October 31, 1993. 10-j Vice President of Sales and Customer Service xx Management Incentive Plan for the fiscal year ended October 31, 1993. 10-k Fibermux Management Incentive Plan for the fiscal xx year ended October 31, 1993. 10-l Kentrox Management Incentive Plan for the fiscal xx year ended October 31, 1993. 10-m Agreement, dated as of November 1, 1991, between ADC N/A Telecommunications, Inc. and Charles M. Denny, Jr., related to retirement and consulting arrangements. (Incorporated by reference to Exhibit 10-h to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991.) 10-n ADC Telecommunications, Inc. Change in Control N/A Severance Pay Plan Statement and Summary Plan Description. (Incorporated by reference to Exhibit 10-q to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) 10-o Compensation Plan for Directors of ADC N/A Telecommunications, Inc., restated as of December 31, 1988. (Incorporated by reference to Exhibit 19-b to the Company's Quarterly Report on Form 10-Q for the quarter ended January 31, 1989.) 10-p First Amendment of the Compensation Plan N/A for Directors of ADC Telecommunications, Inc. restated as of December 31, 1988. (Incorporated by reference to Exhibit 10-s to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1989.) 10-q ADC Telecommunications, Inc. Directors' N/A Supplemental Retirement Plan dated as of January 23, 1990. (Incorporated by reference to Exhibit 10-m to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990). 10-r ADC Telecommunications, Inc. Nonemployee N/A Director Stock Option Plan. (Incorporated by reference to Exhibit 19-b of the Company's Quarterly Report on Form 10-Q for the quarter ended April 30, 1991). Exhibit Number Description Page -------- ----------- ---- 10-s ADC Telecommunications, Inc. Deferred N/A Compensation Plan, dated as of November 1, 1978. (Incorporated by reference to Exhibit 10-n to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990.) 10-t ADC Telecommunications, Inc. Excess Benefits N/A Plan, dated as of January 1, 1985. (Incorporated by reference to Exhibit 10-o to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990). 10-u ADC Telecommunications, Inc. 401(k) Excess N/A Plan, dated as of September 1, 1990. (Incorporated by reference to Exhibit 10-p to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990). 10-v Lease, dated February 25, 1991, between N/A American Lightwave Systems, Inc. and 999 Research Parkway, Inc. (Incorporated by reference to Exhibit 10-t to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991). 10-w Lease, dated March 1, 1986, between ADC N/A Telecommunications, Inc. and Metro International Ltd. as amended. (Incorporated by reference to Exhibit 10-w to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1991). 10-x Lease Agreement, dated October 26, 1990, N/A between Lutheran Brotherhood and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-w to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990). 10-y Lease Agreement, dated August 21, 1990, N/A between Minnetonka Corporate Center I Limited Partnership and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-x to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990). 10-z Sublease Agreement, dated October 31, 1990, N/A between Seagate Technology, Inc. and ADC Telecommunications, Inc. (Incorporated by reference to Exhibit 10-y to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990). 10-aa Renewal of Lease, dated July 9, 1990, between N/A ADC Telecommunications, Inc. and Metro International General Partner Canada, Inc. (Incorporated by reference to Exhibit 10-z to the Company's Annual Report on Form 10-K for the fiscal year ended October 31, 1990). 10-bb Lease, dated September 30, 1993, between xx American Lightwave Systems, Inc. and 999 Research Parkway, Inc. 10-cc Lease, dated August 2, 1993, between ADC xx Telecommunications, Inc. and Engelsma Limited Partnership. 10-dd Lease, dated December 18, 1992, between xx Fibermux Corporation and Greenville Dallas Delaware, Inc. Exhibit Number Description Page --------- ----------- ---- 10-ee Supplemental Executive Retirement Plan xx Agreement for William J. Cadogan, dated as of November 1, 1990, between ADC Telecommunications, Inc. and William J. Cadogan. 21-a Subsidiaries of the Company. 23-a Consent of Independent Public Accountants xx to incorporation by reference of financial material included in this report into Company's Registration Statement on Form S-8 (File No. 2-83584), Registration Statement on Form S-8 (File No. 33-22654), Registration Statement on Form S-8 (File No. 33-40356) and Registration Statement on Form S-8 (File No. 33-40357.) 24-a Manually signed powers of attorney. xx

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797854_1993

1993

797854

Item 1. Business Acquisition of H Space Technologies Inc. H Space Technologies Inc. ("H Space") is in the business of designing and manufacturing point of sale, promotional and corporate display systems. A discussion with respect to H Space is set out hereafter. Management has conditionally agreed to merge the Corporation with H Space. The agreement is conditional on regulatory and shareholder approval. The Corporation intends to split its existing issued and outstanding shares on a 2:1 basis and thereafter issue 10,799.961 common treasury shares of the Corporation to the shareholders of H Space in exchange for all of the 3.599.987 common shares issued or optioned in H Space. As part of the merger, a private placement of up to 2,000,000 shares of the Corporation for a consideration of $1,000,000 is planned. Technology Profile Utilizing a knowledge base gained over the past 20 years in the field of fibre optics, the founders of H Space developed a unique Light Management System, "LMS" which will allow the company to launch into two commercial markets which are global in nature. This new "patent pending" technology facilitates the design and manufacture of animated point of sale and corporate identification display systems displacing aging neon signage. Low wattage, energy efficient light is transmitted through computer generated light/colour management system into any array of fibre optic cables which bring to the viewer an exciting array of every changing colours and message patterns. Prototype systems have been presented to major corporate end users. Engineering to prepare for multiple unit manufacturing is in process. The Company will focus its fiscal efforts on the commercialization of fibre optics "LMS" for the promotional, point of sale and corporate display market. The Company's sustainable competitive advantages rest in a combination of its technical depth in fibre optics and light transmission, its computer based design system and its seasoned management. Following completion of the commercialization of the above subject technology, the company will avail itself of Canadian government research grants to bring to market readiness equally existing fibre optic lighting systems for "holographic" display and interior design applications. Market Profile: Xzotec Inc. will initially focus on two defined markets: 1. Promotional signage; and Corporate display. The total market is estimated to be in the range of $3 billion (U.S.). The following is a brief overview. Promotional Signage: The utilization of illuminated promotion or "point of sale" signs and displays is a well established marketing tool. Advertising budgets are projected to increasingly focus on point of purchase where the majority of buying decisions are made. Currently, a portion of the point of purchase advertising budget of major corporations is committed to neon signs. Xzotec will be positioned to capture projected budget expenditure growth by offering major corporations enhanced, motion and colour rich sign age not previously available. The price point will be slightly higher than neon but this is not a barrier to entry. Test marketing and prototype work is already underway with a number of consumer product, Fortune 500 companies. Management believes that industries ranging from food and beverage to footwear, computers, clothing, financial services, tobacco, automotive and consumer electronics will be end user customers. Corporate Display: Most if not all Fortune 500 companies continue to invest in corporate imagery. This market sector will be attracted to the special ability of Xzotec Inc. to provide high profile corporate identification which is individually unique in design but utilizes the company's standard light management system and fibre optics. The marketplace for display systems will range from corporate name/logo signs to interior building designs and trade show exhibits. Strategic Relationship: Xzotec Inc. has benefited and will continue to derive assistance from its special relationship with Precision Camera Inc. Founded over 15 years ago by Mr. Gerd Kurz, an investor in and shareholder of H Space, Precision is Canada's premiere Company in the growing field of complex video applications. With in-house, state of the art design studios, precision machining, optical, electronic and video testing and repair facilities, Precision Camera has the technical capacity to design, engineer, manufacture and install complex integrated audio/video systems. The company is certified by Sony of Japan as a broadcast service facility for television and motion picture equipment. Precision has engineered systems from remote control cameras operating in nuclear reactors to the system in Toronto's Skydome Stadium retractable roof. This relationship has assisted management in their prototype development phase and will prove invaluable as the company moves into full commercial production. Management: Management of H Space has a considerable depth of knowledge in marketing, manufacturing, fibre optic and holographic technology. Both Michael Miville, the firm's President and Richard Howard, the Executive Vice- President, have previously built and sold successful companies. Other Business: Other than the acquisition of H Space, the Corporation has no business activities. Item 2. Item 2. Properties: N/A Item 3. Item 3. Legal Proceedings: None Item 4. Item 4. Security Ownership of Certian Beneficial Owners and Management: None PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Holder Matters: None Item 6. Item 6. Selected Financial Data: See attached information as Exhibit A. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: The Board of Directors and shareholders have agreed with H Space Technologies Inc. to approve the change of the name of the Corporation to Xzotec Inc. to increase the capital of the Corporation to 30 million common shares without par value to split the issued and outstanding common shares on a 2:1 basis prior to the acquisition of H Space Technologies Inc., to approve the acquisition of H Space Technologies Inc., to approve the stock option plan and to approve the private placement of 2 million treasury shares for a consideration of $1,000,000. Item 8. Item 8. Financial Statements and Supplementary Data: Attached are financial statements for the period ending August 31, 1993. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant: Name and Principal Present Shareholdings Shareholdings Occupation Shareholdings After Split After Acquisition Acquisition Michael Miville Nil Nil 2.430,000 President, Xzotec Inc. Richard Howard Exec. Vice-President Nil Nil 999,999 Xzotec Inc. Michael Mewha C.E.O., North American Nil Nil Nil Network Co. Inc. Barry Brawn Nil 956,463 1,114,797 (2) President, Assistco Inc. Anthony Swartz Nil Nil 3,324,960 (1) President, Sussex Investments Inc. Gerd Kurz President, Nil Nil 750,000 Precision Camera Inc. James T. Riley 956,463 956,463 956,463 Chairman Northquest Ventures Inc. (1) Assumes conversion of debenture in the principal amount of $150,000. (2) Assumes exercise of option in the amount of 158,334 shares at $1.00 per share. (3) The above directors have approved the acquisition of H Space Technologies Inc. Item 11. Item 11. Executive Compensation: None Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management: Mr. James T. Riley holds 936,463 shares directly. He also is the major shareholder of Northquest Ventures Inc. Item 13. Item 13. Certain Relationships and Related Transactions None PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K: See attached Financial Statements. The Corporation has no subsidiaries. See 8-K Report previously filed. 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. Date: October 7. 1993 CORNWALL TIN & MINING CORPORATION Date: October 7, 1993. "James T. Riley" CORNWALL TIN AND MINING CORPORATION (A Delaware Corporation) FINANCIAL STATEMENTS August 31, 1993 and 1992 (in U.S. dollars) Chartered Accountants BCE Place 181 Bay Street Suite 1400 Toronto, Ontario M5J 2V1 AUDITORS' REPORT To the Shareholders of Cornwall Tin and Mining Corporation Telephone: (416) 601-6150 Telecopier: (416) 601-6151 We have audited the balance sheets of Cornwall Tin and Mining Corporation (A Delaware Corporation) as at August 31, 1993 and 1992 and the statements of loss and deficit and of changes in financial position for each of the years then ended. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these financial statements present fairly, in all material respects, the financial position of the Corporation as at August 31, 1993 and 1992 and the results of its operations and the changes in its financial position for each of the years then ended in accordance with generally accepted accounting principles. "Deloitte & Touche" Chartered Accountants Toronto, Ontario September 16, 1993 COMMENTS BY AUDITOR FOR U.S. READERS ON CANADA-U.S. REPORTING CONFLICT In the United States, reporting standards for auditors require the addition of an explanatory paragraph when the financial statements are affected by significant uncertainties such as that referred to in the attached balance sheets as at August 31, 1993 and 1992 and as described in Note 1 to the financial statements. Our report to the shareholders dated September 16, 1993 is expressed in accordance with Canadian reporting standards which do not permit a reference to such an uncertainty in the auditor's report when the uncertainty is adequately disclosed in the financial statements. "Deloitte & Touche" Chartered Accountants Toronto, Ontario September 16, 1993 Deloitte Touche Tohmatsu International CORNWALL TIN AND MINING CORPORATION (A Delaware Corporation) BALANCE SHEETS August 31, 1993 and 1992 (in U.S. dollars) 1993 1992 ASSETS CURRENT $168 $204 Cash ADVANCE TO RELATED COMPANY - $43,573 (Note 3) LIABILITY CURRENT Accounts payable and $1,945 $23,525 accrued liabilities CAPITAL DEFICIENCY Share capital Authorized 4,000,000 common shares with a par value of $0.01 each Issued 2,710,800 common shares 27,108 27,108 Contributed surplus 3,039,388 3,039,388 Deficit (3,068,273) (3,046,244) 1,777 20,252 $168 $43,777 APPROVED BY THE BOARD "Jim Riley" Director "W Deschamps" Director CORNWALL TIN AND MINING CORPORATION (A Delaware Corporation) STATEMENTS OF LOSS AND DEFICIT Years ended August 31, 1993 and 1992 (in U.S. dollars) 1993 1992 EXPENSES Administrative services $18,114 - (Note 3) Net foreign exchange loss $1,900 $853 Legal and audit $1.895 $837 Franchise tax $100 $97 Bank charges $20 - Transfer agent - $170 LOSS FOR THE YEAR $22,029 $1957 DEFICIT, BEGINNING OF YEAR 3.046.244 3,044,287 DEFICIT, END OF YEAR $ 3,068,273 $3,046,244 LOSS PER SHARE $ 0.0081 $0.0007 CORNWALL TIN AND MINING CORPORATION (A Delaware Corporation) STATEMENTS OF CHANGES IN FINANCIAL POSITION Years ended August 31,1993 and 1992 (in U.S. dollars) 1993 1992 NET INFLOW (OUTFLOW) OF CASH RELATED TO THE FOLLOWING ACTIVITIES: OPERATING Loss for the year $(22,029) $(1,957) Change in non-cash operating working capital item Accounts payable and accrued (21,580) (389) liabilities (43,609) (2,346) FINANCING Advance to related company 43,573 2,353 NET CASH (OUTFLOW) INFLOW (36) 7 CASH, BEGINNING OF YEAR 204 197 CASH, END OF YEAR $168 $204 CORNWALL TIN AND MINING CORPORATION (A Delaware Corporation) NOTES TO THE FINANCIAL STATEMENTS August 31, 1993 and 1992 (in U.S. dollars) 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION OF FINANCIAL STATEMENTS The Corporation was incorporated under the laws of the State of Delaware on November 1, 1968. The Corporation has ceased its former operations of Mineral Exploration. Its charter was revived on June 2, 1992 for future undertakings. These financial statements have been prepared on the basis of accounting principles applicable to a going concern. Continuation of the business on this basis is dependent upon the Corporation achieving future profitable operations (see Note 3). There can be no assurance such operations will be successful. 2. SIGNIFICANT ACCOUNTING POLICY The accompanying financial statements are prepared in accordance with accounting principles generally accepted in Canada and conform in all material respects with accounting principles generally accepted in the United States. Foreign currency translation Monetary assets and liabilities are translated at the effective rate of exchange at the year end. Foreign currency transactions occurring during the year are translated at the effective rate of exchange on the transaction date. 3. ADVANCE TO RELATED COMPANY The Corporation has advanced funds to Northquest Ventures Inc. (formerly The Canadian Games Network Inc., a Canadian Company). The President of the Corporation is also the President of Northquest Ventures Inc. During fiscal 1993, Northquest Ventures Inc. agreed to assume the liabilities of the Corporation outstanding as at August 31, 1992 in exchange for an equal reduction in its advance. The remaining balance of the advance was charged to operations in exchange for services provided by Northquest Ventures Inc. up to August 31, 1993. 4. INCOME TAXES The Corporation has available net operating losses which may be carried forward to be applied against future income for income tax purposes until at least the year 2000. CORNWALL TIN AND MINING CORPORATION (A Delaware Corporation) NOTES TO THE FINANCIAL STATEMENTS August 31, 1993 and 1992 (in U.S. dollars) SUBSEQUENT EVENTS At the Annual Meeting of the Shareholders on September 8, 1993, the shareholders approved a resolution by the board of directors to acquire H Space Technologies Inc. ("H Space"), subject to regulatory approval. The acquisition would be facilitated by issuing 10,799,961 common shares of the Corporation in exchange for 3,599,987 common shares of H Space, being all the issued and outstanding shares of H Space. H Space Technologies Inc. is a corporation that has developed a unique "patent pending" technology which facilitates the design of and manufacture of animated point of sale and corporate identification display systems displacing aging neon signage. Resolutions were also approved: to change the name of the Corporation to "Xzotec Inc.," to increase the number of authorized common shares of the Corporation to 30,000,000; to split the issued and outstanding shares of the Corporation on the basis of two common shares of the new Corporation in exchange for one common share previously issued prior to closing the acquisition of H Space; and to create a stock option plan for the Corporation's senior directors, offices, affiliates as well as key employees and consultants to acquire shares at prices approved from time to time by the various regulatory bodies. Articles of Amendment have not been filed to effect these changes until the acquisition agreement with H Space has been executed.

910079_1993.txt

910079_1993

1993

910079

ITEM 1. BUSINESS Bedford Property Investors, Inc. (the "Company") was formerly known as ICM Property Investors Incorporated ("ICM"), a Delaware corporation, organized in November 1984. On July 1, 1993, ICM Property Investors Incorporated reincorporated from the state of Delaware to the state of Maryland under a new name, Bedford Property Investors, Inc. The Company is operated so as to qualify as a real estate investment trust ("REIT") under the applicable provisions of the Internal Revenue Code of 1986, as amended (the "Code"). To qualify, the Company must meet certain tests which, among other things, require that its assets consist primarily of real estate, its income be derived primarily from real estate, and at least 95% of its taxable income be distributed to its shareholders. Because the Company qualifies as a REIT, it is not generally subject to Federal income taxes. Business Plan The Company's business plan emphasizes asset and acquisition portfolio. The original business plan of ICM had been to invest in office buildings, via direct ownership or joint venture mortgage loan investment, dispersed throughout the United States. In 1993, the Board of Directors approved a new business plan under which the Company would move its investment focus to the western United States, make wholly-owned equity investments in suburban office and industrial properties, develop these property types and, subject to the Company's ability to raise additional capital and other factors, grow the asset base of the Company. As a result of this change in the Company's business plan, in 1993 the Company identified four non-strategic assets for disposition. During 1993, two of the four office building investments were sold (University Tower and Point West Place). In January 1994, the Company sold the third asset, its office building investment in Texas (Texas Bank North), and continues to offer for sale the office building investment located in Mississippi (IBM Building). During 1993, the Company purchased two suburban office buildings, Woodlands II in Utah and 1000 Town Center Drive in California. In January 1994, the Company purchased the Mariner Court office building, also in California. Real Estate Investments The Company's real estate portfolio consists of equity investments in completed, income- producing properties such as office buildings and industrial buildings located primarily in the western United States. As of December 31, 1993, the Company directly owned nine properties including four suburban office buildings and five industrial buildings located in five states. Two of these properties were classified as offered for sale, one of which has subsequently been sold. As of December 31, 1993, the Company's property portfolio had an overall occupancy level of 88%. The majority of the portfolio vacancy related to the 1000 Town Center Drive building acquired on December 30, 1993. The 1000 Town Center Drive building was 41% occupied as of December 31, 1993. Excluding the 1000 Town Center Drive building, the Company's property portfolio had an overall occupancy level of 98%. The favorable overall occupancy is the result of management's continuing focus on reducing the risk of vacant space and the costs associated with re-leasing by concentrating efforts on servicing those tenants with expiring leases, and wherever possible, extending their lease expiration dates. In addition, lease expirations for the next several years have been staggered so that the lease renewal risk is not significantly greater in any one year. Significant 1993 Events Sale of Edison Square Joint Venture: On May 31, 1993, the Company sold its partnership interest in the three Edison, New Jersey properties in exchange for a note receivable of $300,000 with an interest rate of 8%, payable quarterly in July, October, January and April until May 31, 1998, at which time the note matures. The sale of the Company's interest in the unconsolidated joint venture partnerships resulted in a gain of $2,686,000. Name Change and Reincorporation: On June 9, 1993, at the Company's Annual Meeting, the stockholders approved the Company's proposals to change the Company's name from ICM Property Investors Incorporated to Bedford Property Investors, Inc. (now traded on the New York Stock Exchange under the symbol "BED") And to reincorporate from Delaware to Maryland. Increase in Number of Authorized Shares: On June 9, 1993, at the Company's Annual Meeting, the stockholders approved the Company's proposals to increase the number of authorized shares of Common Stock from 10,000,000 shares to 30,000,000 million shares and to increase the number of authorized shares of Preferred Stock from 1,000,000 shares to 10,000,000 shares. Sale of University Tower, Irvine, California: On July 31, 1992, the Company entered into a contract to sell its investment in University Tower. The sale contract subsequently expired, but a lease was signed with the potential buyer for approximately 20% of the space, and as part of the lease, the lessee obtained a short-term option to purchase the building. On May 25, 1993, the option was exercised and, on August 18, 1993, the sale of University Tower was completed. The cash sale price, including the reimbursement of tenant relocation costs of $300,000, was $15,200,000, or $96 per square foot, and produced a gain of $407,000. Sale proceeds were used to pay off the Company's bank loan of $6,000,000 which was secured by the property, and to fund the Company's acquisition of Woodlands II. Purchase of Woodlands II, Salt Lake City, Utah: On August 25, 1993, the Company acquired the Woodlands II complex in Salt Lake City, Utah, for $6,750,000, or $59 per square foot. The property consists of a 106,084 square foot six-story Class "A" office building, a single story 8,268 square foot retail building and a 3.6 acre parcel available for future development. The complex was 96% occupied at the time of purchase. Sale of Point West Place, Framingham, Massachusetts: On October 1, 1993, the property was sold for a cash price of $7,180,000, or $66 per square foot, resulting in a gain of $497,000. A portion of the sale proceeds from Point West Place was used to retire $5,113,000 of mortgage debts secured by the five industrial properties. $20,000,000 Acquisition Line of Credit Secured: On December 29, 1993, the Company secured a $20,000,000 acquisition revolving line of credit from Bank of America. The credit facility has a term of three years and features a competitive interest rate and fee structure. At December 31, 1993, the outstanding balance was $3,621,000. Purchase of 1000 Town Center Drive, Oxnard, California: On December 30, 1993, the Company completed the acquisition of 1000 Town Center Drive, a 109,611 square foot six-story Class "A" suburban office building located in Oxnard, California for $5,100,000, or $47 per square foot. The seller received $3,600,000, or $33 per square foot, in cash, at closing with the balance of $1,500,000, or $14 per square foot, payable in December 1994. The $3,600,000 cash payment was financed using the Company's new $20 million revolving line of credit from Bank of America. The line of credit was subsequently paid off in January 1994 with the remaining sale proceeds from Point West Place. The building was 41% occupied at the time of purchase. It was acquired from NCEC Realty Incorporated, a wholly owned subsidiary of Citicorp which foreclosed on the property over two years ago. Subsequent Events Purchase of Mariner Court, Torrance, California: On January 5, 1994, the Company completed the acquisition of Mariner Court, a 105,673 square foot three-story suburban office building located in Torrance, California for $7,500,000 or $71 per square foot. The building was 91% occupied at the time of purchase. The Company borrowed $7,438,000 against the $20 million revolving line of credit with Bank of America to acquire the property. Sale of Texas Bank North, San Antonio, Texas: In July, 1993, the Company entered into a contract to sell the Texas Bank North building for a cash sale price of $8,500,000, or $56 per square foot. The sale was completed on January 14, 1994. The balance borrowed on the line of credit for the purchase of Mariner Court was paid off in January 1994 with the sale proceeds from the building. Investment Analysis Prospective real estate investments are carefully analyzed by the Company pursuant to several underwriting criteria, including expected initial cash returns on investment, competition and other market factors, and prospects for growth in income and market value. In determining the returns on investment, the Company takes into consideration any initial capital expenditures for leasing, deferred maintenance, and estimated costs associated with tenant turnover. In addition, the Company has formerly established a reserve policy in an attempt to normalize the cash flow from the Company's real estate investments. The reserve policy is a cash management technique designed to anticipate future expenditures associated with capital improvements and tenant turnover. These expenditures are converted to a monthly sinking fund payment that is subtracted from the net operating income of the real estate investment to determine net operating cash flow for cash management purposes. Dividends The Company made regular quarterly dividend distributions in the second, third and fourth quarters of 1993 of $0.05, $0.06 and $0.07 respectively per share following a nine quarter suspension. All dividend distributions made in 1993 were classified as a return of capital since no earnings and profits were reported for 1993. The disposition in 1993 of two of the Company's investments resulted in the Company incurring an ordinary loss for income tax purposes, in addition to capital losses. The ordinary loss carryforward is expected to exceed the Company's taxable income for several years. As a REIT, the Company is not required to make distributions when it incurs an ordinary federal income tax loss or applies unused ordinary tax loss carryforwards. Decisions on future distributions will be made on the basis of the Company's capital needs, cash flows, taxable income and other relevant factors. Tenants The Company's real estate investments are leased to tenants for terms ranging from month-to-month tenancies to 10 year leases. The Company leases space directly to 72 tenants, including 58 office tenants and 14 industrial tenants. Self-Management In the past, all of the Company's properties were managed by independent property management companies whose primary responsibilities included leasing, maintenance, and rent collection activities. Effective February 1, 1993, the Company began internally managing all of its industrial properties. The office properties are still contract managed. Effective July 1, 1993, the Company centralized recordkeeping for all properties, with the exception of Texas Bank North, at corporate headquarters. In-house property management and record keeping, which have not increased the number of employees, have resulted in savings of approximately $43,000 in 1993. Self-Administration On July 31, 1992, the Company terminated an Investment Management Agreement with an independent investment manager. The Board of Directors determined that as of August 1, 1992, the Company would be self-administered. By being self- administered the Company assumes direct responsibility for the administration of its day-to-day business affairs, including responsibility for retaining personnel, obtaining office space and arranging of other administrative functions. Financing The Company expects to sell one office building, offer additional equity securities and/or borrow under lines of credit to finance additional real estate acquisitions during 1994. Short-term borrowings are expected to be repaid with future offerings of shares of beneficial interest or long-term financing. As of December 31, 1993, the Company had $3,621,000 of debt outstanding against a revolving acquisition line of credit with Bank of America bearing interest at the rate of 6.75% (rate floats with prime). The balance on the line of credit was subsequently repaid in January, 1994. For additional information, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", and Note 9 to the Consolidated Financial Statements. Insurance The Company carries commercial general liability coverage on its properties with limits of $11,000,000 per occurrence and $12,000,000 in the aggregate. This coverage protects the Company against liability claims as well as the cost of defense. The Company carries property insurance on a replacement value basis covering both the cost of direct physical damage and the loss of rental income. Separate flood and earthquake insurance is provided with an annual aggregate limit of $10,000,000 for each peril. The Company also carries director and officer liability insurance with an aggregate limit of $10,000,000. This coverage protects the Company's directors and officers against liability claims as well as the cost of defense. Competition, Regulation, and Other Factors The success of the Company depends, among other factors, upon general economic conditions and trends, including real estate trends, interest rates, government regulations and legislation, income tax laws and zoning laws. The Company's real estate investments are located in markets in which they face significant competition for the rental revenues they generate. Many of the Company's investments, particularly the office buildings, are located in markets which have a significant supply of available space, resulting in intense competition for tenants and low rents. Government Regulations A number of jurisdictions have laws and regulations relating to the ownership of real estate, such as local building codes and similar regulations. From time to time, capital expenditures at properties owned by the Company may be required to comply with changes in these laws. No material expenditures are contemplated at this time in order to comply with any laws or regulations. Under various federal, state and local laws, ordinances and regulations, a current or previous owner or operator of real estate may be liable for the cost of removal or remediation of hazardous or toxic substances released on, under or in its property. The costs of such removal or remediation could be substantial. The Company's properties have been professionally inspected as a result of ongoing review, acquisition due diligence and financing requirements. Management believes that through these professional environmental inspections and testing for asbestos and other hazardous materials, the Company can minimize its exposure to potential liability associated with such environmental hazards. To the best of its knowledge, the Company is in compliance with all applicable environmental rules and regulations. Management is not aware of any material violation of applicable environmental requirements with respect to any of its real estate investments. To date, compliance with federal, state and local environmental protection regulations has not had a material effect upon the capital expenditures, earnings or competitive position of the Company. Other Information The Company's current business constitutes a single business segment. The Company is not dependent upon a single tenant or a limited number of tenants. The Company's operations are not impacted by seasonal changes. The Company's business is not subject to government contracts. The Company does not have any expenditures for research and development. The Company has no foreign operations or export sales. ITEM 2. ITEM 2. PROPERTIES The Company's real estate portfolio (net of accumulated depreciation) consists of the following: LOTUS FORMAT TABLE TO BE INCLUDED ON HARD COPY SUBMITTAL As of December 31, 1993, the Company's real estate investments (net of accumulated depreciation) were diversified by geographic region as follows: LOTUS FORMAT TABLE TO BE INCLUDED ON HARD COPY SUBMITTAL For additional information on the Company's real estate portfolio, see Note 2 to the Consolidated Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any material pending legal proceedings other than routine litigation incidental to its business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Company's security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Common Stock of Bedford Property Investors, Inc. is listed for trading on the New York Stock Exchange and the Pacific Stock Exchange under the symbol "BED". Prior to July 1, 1993, the Company's stock was traded on the same exchanges under the symbol "ICM". As of February 28, 1994, the Company had 475 stockholders of record. A significant number of these stockholders are also nominees holding stock in street name for individuals. The following tables show the high and low share prices as traded on the New York Stock Exchange for each quarter for the past two years. LOTUS FORMAT TABLE TO BE INCLUDED ON HARD COPY SUBMITTAL ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Following is a table (which should be read in conjunction with the discussion under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto contained herein) of selected financial data of the Company for the last five fiscal years: LOTUS FORMAT TABLE TO BE INCLUDED ON HARD COPY SUBMITTAL 1Includes rental income, interest income, equity in joint venture partnership operations and gains on sales of real estate investments and partnership interest in joint ventures. See "Consolidated Statements of Operations". 2Includes rental expenses consisting of: operating expenses, real estate taxes, depreciation and amortization, interest, general and administrative expenses, provision for possible loss on real estate investments and extraordinary item-extinguishment of debt. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto. Results of Operations - 1993 Compared to 1992 Income Rental income decreased by $1,849,000 from the prior year, primarily due to the Company ceasing to record the operations of Columbia Business Center as of March 31, 1992, the sales of University Tower and Point West Place in 1993, and the absence in 1993 of three additional months of rental income recorded for Texas Bank North Building in 1992, offset in part by the purchase of Woodlands II in August 1993. Correspondingly, rental expenses decreased by $2,012,000 from the prior year. As a result, 1993 income from property operations increased $163,000 over 1992. Interest income increased by $131,000, a result of investing the remaining cash proceeds from the sales of University Tower and Point West Place after acquiring Woodlands II and paying off bank and mortgage loans. Equity in joint venture partnership operations produced a loss of $153,000 for 1993, compared with a loss of $702,000 in 1992. The $549,000 reduction in the loss is attributable primarily to the sale of the joint venture partnership during the year. Only three months of joint venture partnership operations were recorded in 1993. Expenses Interest expense decreased by $420,000 from the prior year primarily attributable to the Company ceasing to record the operations of Columbia Business Center as of March 31, 1992 and paying off the $6,000,000 bank loan on August 18, 1993 and the $5,113,000 in mortgage loans on November 1, 1993. General and administrative expenses decreased by $1,320,000, the result of self administration and implemented cost reductions. In 1992, the Company recorded a provision for possible loss on real estate investments relating to University Tower, Columbia Business Center, Point West Place and Texas Bank North Building aggregating $18,921,000. Gains on Sales and Extraordinary Item On May 1, 1993, the Company sold its interest in the Edison Square joint venture partnerships for a note receivable of $300,000 which produced a gain of $2,686,000. In August 1993, the Company sold its investment in University Tower for $15,200,000, which produced a gain of $407,000. In October 1993, the Company sold its investment in Point West Place for $7,180,000, which produced a gain of $493,000. In 1992, the Company recorded an extraordinary item of $3,818,000 which represented the gain on extinguishment of debt as a result of the disposition of its investment in Columbia Business Center. Dividends Dividends declared for 1993 totaled $0.18 per share. They were paid approximately 30 days following the end of each quarter. Results of Operations - 1992 Compared to 1991 Income For 1992, the Company's operating results were mixed when compared to 1991. Rental income and rental expenses increased slightly over 1991 as a result of recording a full year of operations for University Tower (three months were recorded in 1991) and recording an additional three months of operations (fifteen months in total) for Texas Bank North, offset in part by recording only three months of operations for Columbia Business Center in 1992. Income from property operations declined slightly reflecting lower effective rents, offset in part by higher occupancies during the year. The decrease in interest income in 1992 reflects the absence of the interest income received in 1991 from the Company's mortgage loan to the partnership that owned University Tower during the first nine months of 1991. Equity in joint venture partnership operations produced a loss of $702,000 for 1992, compared with a loss of $1,108,000 for 1991. The $406,000 decline in the loss is attributable primarily to the absence in 1992 of the Company's equity in the operating losses of University Tower, which was consolidated as of September 30, 1991, and the reduction in the operating losses of Jefferson Plaza as a result of the Company ceasing to record its share of the partnership's operations as of March 31, 1992. Expenses Of the $1,241,000 decrease in interest expense, $1,176,000 was attributable to the Company ceasing to record the operations of Columbia Business Center as of March 31, 1992. The $651,000 increase in general and administrative expenses was attributable primarily to severance expense of two executive officers, a provision for state taxes for the years 1985 through 1989 and an increase in director and officer liability coverage, offset by lower professional and shareholder reporting costs. In 1992, the Company recorded a provision for possible loss on real estate investments relating to University Tower, Columbia Business Center, Point West Place and Texas Bank North Building aggregating $18,921,000. In 1991, the Company wrote down its investment in the IBM Building by $2,113,000. Extraordinary Item In 1992, the Company recorded an extraordinary item of $3,818,000 which represented the gain on extinguishment of debt as a result of the disposition of its investment in Columbia Business Center. Dividends No dividends were declared and paid in 1992. Financial Condition During fiscal year 1993, total assets of the Company decreased by $4,502,000 primarily as a result of a decrease in real estate investments of $9,591,000 and an increase in cash of $4,755,000. The decrease in real estate investments is due to the sale of University Tower and Point West Place (book value of $14,476,000 and $6,468,000, respectively) offset in part by $13,052,000 invested in Woodlands II, 1000 Town Center Drive and tenant improvements to existing real estate investments. The increase in cash consists of the remaining proceeds from the sales of University Tower and Point West Place after acquiring Woodlands II and 1000 Town Center Drive and paying off bank and mortgage loans. Total liabilities for the same period decreased by $6,573,000, of which $9,513,000 was attributable to the pay-off of the bank and mortgage loans, offset by the Company's borrowing of $3,621,000 on its revolving credit facility and recording a liability of $1,500,000 for the purchase of 1000 Town Center Drive. In addition, the Company accrued a dividend of $418,000 for the fourth quarter, payable on January 31, 1994 to shareholders of record on January 14, 1994. Liquidity and Capital Resources During the year ended December 31, 1993, the Company's operating activities and the sale of University Tower and Point West Place provided cash flow in the amount of $22,857,000. The Company funded $11,552,000 of real estate investments, paid off $9,513,000 of bank and mortgage loans and distributed dividends of $658,000. The Company secured a $20 million revolving credit facility with Bank of America, which was used in part to finance the acquisition of 1000 Town Center Drive (Note 9 to the Consolidated Financial Statements). At December 31, 1993, the Company was in compliance with covenants and requirements of its revolving credit facility with Bank of America. The Company anticipates that the cash flow generated by its real estate investments will be sufficient to meet its short-term liquidity requirements. The capital resources for long-term liquidity requirements, including the repayment of the revolving credit facility, may be provided by some or all of the following: (a) the cash flow generated by the Company's real estate investments, (b) other bank borrowings, (c) the financing of real estate investments, (d) the sale of real estate investments and (e) sale of new equity. The ability to obtain mortgage loans on income producing property is dependent upon the ability to attract and retain tenants and the economics of the various markets in which the properties are located, as well as the willingness of mortgage lending institutions to make loans secured by real property. The ability to sell real estate investments is partially dependent upon the ability of purchasers to obtain financing. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Financial Statements and Schedules Covered by Reports of Independent Public Accountants Report of Independent Public Accountants ............ 12 Consolidated Balance Sheets as of December 31, and 1992.......................................... . .... 13 For Years Ended December 31, 1993, 1992 and - -Consolidated Statements of Operations.................................... . ........... 14 - -Consolidated Statements of Changes in Stockholders' Equity................................. 15 - Consolidated Statements of Cash Flows......................................... . ........... 16 - Notes to Consolidated Financial Statements.................................... . .......... 17-22 Financial Statement Schedules: Schedule XI - Real Estate and Accumulated Depreciation . . 23-24 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III The information required by Items 10 through 13 of Part III is incorporated by reference from the Registrant's Proxy Statement, under the captions "Election of Directors", "Principal Stockholders", "Certain Transactions", and "Compensation of Directors and Executive Officers", which Proxy Statement will be mailed to stockholders in connection with the Registrant's annual meeting of stockholders which is scheduled to be held on May 18, 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements Report of independent public accountants. The following consolidated financial statements of the Company and its subsidiaries are included in Item 8 of this report: Consolidated Balance Sheets as of December 31, 1993 and 1992. Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. (a) 2. Financial Statement Schedules Schedule XI - Real Estate and Accumulated Depreciation All other schedules have been omitted as they are not applicable, or not required or because the information is given in the Consolidated Financial Statements or related Notes to Consolidated Financial Statements. (a) 3. Exhibits Exhibit No.List of Exhibits2.1Agreement and Plan of Merger dated July 1, 1993 between ICM Property Investors Incorporated, a Delaware corporation, and Bedford Property Investors, Inc., a Maryland corporation, is incorporated herein by reference to the Company's registration statement on Form 8-B/A filed March 6, 1994.3.1Articles of Incorporation of Bedford Property Investors, Inc. is incorporated herein by reference to the Company's registration statement on Form 8-B/A filed March 6, 1994.3.2Bylaws of Bedford Property Investors, Inc. are incorporated herein by reference to the Company's registration statement on Form 8-B/A filed March 6, 1994.4.1The Rights Agreement between ICM Property Investors Incorporated and the Chase Manhattan Bank, N.A., dated July 18, 1989, is incorporated herein by reference to Exhibit A, filed with the Company's Form 8-K dated July 19, 1989.4.2Amendment No. 1 to the Rights Agreement, dated March 20, 1990, between ICM Property Investors Incorporated and The Chase Manhattan Bank, N.A., is incorporated herein by reference to Exhibit B, filed with the Company's Form 8-K dated April 6, 1990.4.3The Registration Rights Agreement dated as of December 5, 1990, between ICM Property Investors Incorporated and Peter B. Bedford, is incorporated herein by reference to Exhibit D, filed with the Company's Form 8- K dated December 13, 1990. 10.1 (b)Termination Agreement, dated as of July 31, 1992, between Registrant and Kingswood Realty Advisors, Inc. is incorporated herein by reference to the Company's Form 10-K dated March 26, 1993.10.2The Company's Automatic Dividend Reinvestment and Share Purchase Plan, as adopted by the Company, is incorporated herein by reference to Exhibit 4.1 filed with Amendment No. 2 to the Registration Statement No. 2-94354, of ICM Property Investors Incorporated dated January 25, 1985.10.3Contract of Sale dated July 31, 1992 by and among ICMPI (Irvine) Inc. as Seller and In-N-Out Burger, Inc. and Rich Snyder, Revocable InterVivos Trust U/D/T 10/11/89, jointly and severally as Purchaser, for University Tower, is incorporated herein by reference to the Company's Form 10-Q filed for the quarter ended September 30, 1993.10.4Real Estate Purchase and Sale Agreement dated as of June 4, 1993 by and between Bay Street Number Two, Ltd., as Seller and ICM Property Investors Incorporated, as Purchaser, for Woodlands Tower II and Woodlands Commercial Center, Plan II and Related Properties, filed with the Company's Form 10-Q filed for the quarter ended September 30, 1993.10.5*1989 ICM Property Investors Incorporated Share Equivalent Plan (as Amended and Restated as of January 1, 1991), as adopted by the Company, incorporated herein by reference to Exhibit 10.6 to the Company's quarterly report on Form 10-Q filed for the quarter ended September 30, 1993.10.6*Bedford Property Investors, Inc. Employee Stock Option Plan, effective September 16, 1985, amended as of June 9, 1993, as adopted by the Company on September 27, 1993 and amended and restated as of February 7, 1994 incorporated herein by reference to the Company's registration statement on Form 8-B/A filed March 6, 1994.10.7*Bedford Property Investors, Inc. Directors' Stock Option Plan effective May 20, 1992, as adopted by the Company on September 27, 1993 and amended and restated as of February 7, 1994 incorporated herein by reference to the Company's registration statement on Form 8-B/A filed March 6, 1994.10.8Agreement to Purchase Real Property, dated July 23, 1993, by and between Bedford Property Investors, Inc., as Seller, and MGI Properties, as Purchaser, for Point West Place.10.9Sale-Purchase Agreement dated December 14, 1993, by and between NCEC Realty, Inc., as Seller and Bedford Property Investors, Inc., as Purchaser, for 1000 Town Center Drive, is incorporated herein by reference to the Company's Form 8-K filed January 13, 1994.10.10Purchase and Sale Agreement, dated December 20, 1993, by and between Mariner Court Associates, as Seller, and Bedford Property Investors, Inc., as Purchaser for Mariner Court, is incorporated herein by reference to the Company's Form 8-K filed January 13, 1994.10.11Agreement to Purchase Real Property, dated June 11, 1993, by and between Country Hollow Associates, as Seller, and A.S., Inc., as Purchaser, for Texas Bank North Building, is incorporated herein by reference to the Company's Form 8-K filed January 27, 1994.21Subsidiaries of Registrant.24.1Consent of KPMG Peat Marwick.*Compensatory plans required to be filed as an exhibit pursuant to item 14(c) of Form 10-K. (b) Reports on Form 8-KFor the quarter ended September 30, 1993, the Company filed a report on Form 8-K dated August 18, 1993, announcing the sale of the University Tower office building and the acquisition of the Woodlands II office building. During the quarter ended December 31, 1993, the Company filed a report on Form 8-K/A, which amended items reported on Form 8-K dated August 18, 1993. Also, the Company filed a report on Form 8-K dated October 1, 1993, announcing the sale of Point West Place. BEDFORD PROPERTY INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Summary of Significant Accounting Policies The Company On July 1, 1993, the Company (formerly known as ICM Property Investors Incorporated) reincorporated from the state of Delaware to the state of Maryland under a new name, Bedford Property Investors, Inc. As of July 1st, the Company's Common Stock traded under the symbol "BED" on both the New York and Pacific Stock Exchanges. Concurrent with the reincorporation, the number of authorized shares of Preferred Stock was increased from 1,000,000 shares to 10,000,000 shares and the number of authorized shares of Common Stock was increased from 10,000,000 to 30,000,000 shares. Also, the par value of both the Preferred and Common Stock was reduced from $1.00 to $0.01 per share and Treasury Stock was eliminated. For comparative purposes, stockholders' equity for the years ended December 31, 1992 and 1991 has been reclassified to reflect the above changes. Principles of Consolidation The consolidated financial statements include the accounts of Bedford Property Investors, Inc., its wholly-owned subsidiaries and its consolidated joint venture partnerships. As of June 30, 1992, the Company no longer had investments in joint venture partnerships which were consolidated. As of May 31, 1993, the Company no longer had investments in unconsolidated joint venture partnerships. All significant inter-entity balances have been eliminated in consolidation. Federal Income Taxes The Company has qualified as a real estate investment trust under Sections 856 to 860 of the Internal Revenue Code of 1986, as amended ("the Code"). A real estate investment trust is generally not subject to federal income tax on that portion of its real estate investment trust taxable income ("Taxable Income") which is distributed to its stockholders, provided that at least 95% of Taxable Income is distributed. No provision for federal income taxes has been made in the consolidated financial statements, as the Company believes it is in compliance with the Code. Taxable income differs from net income for financial reporting purposes primarily because of the different methods of accounting for joint venture partnerships and the difference in timing of the recognition of losses. As of December 31, 1993, for federal income tax purposes, the Company had an ordinary loss carryforward of approximately $31,227,000 and a capital loss carryforward of approximately $13,675,000. Real Estate Investments When the Company concludes that the recovery of the carrying value of a real estate investment is permanently impaired, it reduces such carrying value to the amount deemed recoverable. Investments which have been classified as offered for sale are written down to estimated net realizable value if net realizable value is less than the carrying amount of the investment. Depreciation and Amortization Buildings and improvements are carried at cost less accumulated depreciation. Buildings are depreciated on a straight-line basis over 45 years. Upon the acquisition of an investment by the Company, acquisition related costs are added to the carrying cost of that investment. These costs are being depreciated over the useful lives of the buildings. Leasing commissions and improvements to tenants' space are amortized over the terms of the respective leases. Expenditures for repairs and maintenance, which do not add to the value or prolong the useful life of a property, are expensed as incurred. Income Recognition Rental income from operating leases is recognized in income on a straight-line basis over the period of the related lease agreement. The Company records its proportionate share of joint venture operations on the basis of its obligation to fund or its right to receive cash flows in accordance with the partnership agreements, rather than on the Company's legal ownership percentage of the partnerships. Per Share Data Per share data are based on the weighted average number of shares outstanding during the year. Weighted average shares for computing per share data were 5,975,900 for 1993, 1992 and 1991. Outstanding warrants and stock options during the above periods have not been included in the calculation of shares outstanding because the effect of their assumed conversion would be immaterial. Reclassifications Certain reclassifications have been made to the 1992 and 1991 financial statements to conform to the 1993 presentation. Note 2 - Real Estate Investments The following table sets forth the Company's real estate investments as of December 31, 1993 (in thousands): LOTUS FORMAT TABLE TO BE SUBMITTED WITH HARD COPY University TowerOn July 31, 1992, the Company entered into a contract to sell its investment in University Tower for $15,350,000 in cash. In anticipation of the proposed sale, the Company provided a $3,200,000 provision for possible loss related to this investment. The contract of sale, which was scheduled to expire on November 13, 1992, was extended and expired on December 31, 1992. Subsequent to the expiration of the contract, the Company signed a tenant lease with the potential buyer for approximately 20% of the building's space and, as part of the lease, the lessee obtained a short-term option to purchase the building. On May 25, 1993, the option was exercised and the sale of University Tower was completed on August 18, 1993. The cash sale price, including the reimbursement of tenant relocation costs of $300,000, was $15,200,000 and produced a gain of $407,000. Point West Place During the fourth quarter of 1992, the Company decided to offer Point West Place for sale. In anticipation of such sale, the Company wrote down its investment in this property by $9,290,000 in 1992. On October 1, 1993, the property was sold for a cash price of $7,180,000, resulting in a gain of $493,000. A portion of the sale proceeds from Point West Place was used to retire $5,113,000 of mortgage debt secured by the five industrial properties. IBM Building The Company continues to offer the IBM Building for sale. Texas Bank North Building As of May 1, 1992, the Company's partner in the partnership that owns the Texas Bank North Building assigned its interest in the partnership to the Company. During the fourth quarter of 1992, the Company decided to offer the Texas Bank North Building for sale. In anticipation of such sale, the Company wrote down its investment in this property by $3,631,000. In December, 1993, the Company entered into a contract to sell the Texas Bank North Building for a cash sale price of $8,500,000. The sale was completed on January 14, 1994 and resulted in a gain of $1,193,000. Woodlands II The property, a suburban six-story office building located in Salt Lake City, Utah, was purchased for $6,750,000 on August 25, 1993. The Company also recorded acquisition costs of $101,000 paid to Peter B. Bedford, Chairman of the Board and Chief Executive Officer of the Company (see Note 5). 1000 Town Center Drive The property, a suburban six-story office building located in Oxnard, California, was purchased on December 30, 1993. The purchase price of $5,100,000 consisted of $3,600,000 in cash and $1,500,000 to be paid in December 1994. The Company also recorded acquisition costs of $77,000 paid to Peter B. Bedford, Chairman of the Board and Chief Executive Officer of the Company (see Note 5). The $3,600,000 cash payment was financed using the Company's new $20,000,000 revolving credit facility with Bank of America. The credit facility was subsequently paid off in January, 1994. Columbia Business Center In accordance with a Settlement Agreement dated June 3, 1992 between the Company and the first mortgagee, ownership of Columbia Business Center was transferred to the first mortgagee. As of June 30, 1992, the Company wrote off its investment in this property, resulting in the recognition of a net gain of $1,018,000 (comprised of an extraordinary gain of $3,818,000 attributable to the extinguishment of the first mortgage on the property and a $2,800,000 loss related to the write-off of the property's buildings and improvements). The property was managed by a company owned by Peter B. Bedford, then a Board member and significant stockholder in the Company. Industrial Buildings On December 5, 1990, the Company purchased five industrial properties from Peter B. Bedford. The aggregate purchase price of the properties to the Company was $9,050,000, plus closing and acquisition costs. The purchase price consisted of $3,938,000 in the form of 500,000 newly-issued shares of the Company's Common Stock and $5,113,000 in the form of interestonly first mortgage loans, scheduled to mature on December 4, 1995, bearing interest at rates of either 9% or 9.5%. Under a Registration Rights Agreement dated as of December 5, 1990 between the Company and Mr. Bedford, upon written request of Mr. Bedford after March 6, 1991, the Company will use its best efforts to effect the registration of the 500,000 shares of Common Stock. The Company and the seller entered into separate property management agreements under which an affiliate of the seller managed each of the properties on a dayto-day basis. Effective February 1, 1993, the Company began internally managing all of its industrial properties. The Company paid off the mortgage loans, including principal and accrued interest, on November 1, 1993. On-site maintenance of the suburban office buildings is managed by independent property managers. With the exception of Texas Bank North, the Company centralized financial recordkeeping of all its properties effective July 1, 1993. Note 3 - Unconsolidated Joint Venture Partnerships Edison Square Distributions to the Company exceeded its combined mortgage loan and equity investments in these joint venture partnerships and such amounts had been recorded as liabilities in the Company's financial statements. On May 31, 1993, the Company sold its partnership interests in the three Edison Square properties in exchange for a note receivable of $300,000 with an interest rate of 8% payable quarterly in July, October, January and April until May 31, 1998 at which time the note matures. The sale of the Company's interest in the three unconsolidated joint venture partnerships resulted in a gain of $2,686,000. Jefferson Plaza In May 1992, the Company paid $400,000 to settle a dispute with the partners in the partnership that owns Jefferson Plaza and transferred its interest in the property for a nominal sum, in exchange for general releases by the Company's partners. As of December 21, 1992, the investment in Jefferson Plaza was written off, resulting in a gain of $37,000. The combined balance sheets of the Company's unconsolidated joint venture partnerships in Edison Square reflected assets, liabilities and partners' deficit of $23,786,000, $31,599,000 and $7,813,000, respectively. The following table reflects the combined results of the operations of the Company's unconsolidated joint venture partnerships for each of the three years ended December 31, 1993, 1992 and 1991 (in thousands). LOTUS FORMAT TABLE TO BE INCLUDED ON HARD COPY SUBMITTAL 1 Includes the operations of Edison Square for the three months ended March 31, 1993. 2Includes the operations of Edison Square for the fifteen months ended December 31, 1992. 3Includes the operations of Edison Square for the year ended September 30, 1991, Jefferson Plaza for the year ended October 31, 1991 and University Tower for the eleven-month period ended September 30, 1991. Note 4 - Leases Minimum future rental receipts under occupancy leases outstanding at December 31, 1993 were as follows (in thousands): 1994 $6,640 1995 4,890 1996 4,053 1997 2,443 1998 1,341 Thereafter 2,106 The total minimum future rental payments shown above do not include tenants' obligations for reimbursement of operating expenses or taxes as provided by the terms of certain leases. Note 5 - Related Party Transactions Certain of the Company's properties were managed by Bedford Properties Holdings, Ltd., Inc., a wholly-owned company of Peter B. Bedford, Chairman of the Board and Chief Executive Officer of the Company. Fees of $2,000, $40,000 and $83,000 were earned during 1993, 1992 and 1991 respectively by Bedford Properties Holdings, Ltd., Inc. Effective February 1993, Bedford Properties Holdings, Ltd., Inc. ceased to render management services due to the Company's implementation of selfmanagement of the industrial buildings. In January 1993, the Company entered into an office lease with a company in which Peter B. Bedford is a 90% shareholder. The rental obligation for the two year term is $136,000 for 3,236 square feet. As of December 31, 1993, another company wholly-owned by Peter B. Bedford was leasing 2,400 square feet of space in one of the Company's industrial buildlings on a month-to-month basis at a rental rate of $1,248 per month, which the Company feels is market rent. The furniture and equipment currently being used by the staff of the Company is the property of Bedford Properties Holdings, Ltd., Inc. and will be transferred to the Company at a price based on an outside appraisal. In 1993, BPI Acquisitions was formed as a separate division of the Company to engage in the solicitation of equity capital, financing and the acquisition of properties. The salaries and costs associated with the division are funded by Mr. Bedford. To the extent capital is raised, financing is obtained or properties are acquired, the Company pays a fee to Mr. Bedford at a rate of one and one half (11/2) percent of such transactions up to the amount advanced. Such fees are capitalized as capital raising, financing or acquisition costs. The fundings by Mr. Bedford and any subsequent fees are subject to ongoing review and approval by the Company's independent directors. During 1993, the Company paid Mr. Bedford $478,000 in connection with the acquisition of two properties and the placement of a new revolving line of credit for property acquisitions. As of December 31, 1993, Mr. Bedford had funded $63,000 of costs related to BPI Acquisitions net of fees. Note 6 - Stock Option Plans The Employee Stock Option Plan provides for NonQualified Stock Options, Incentive Stock Options and Stock Appreciation Rights. On June 9, 1993, the Employee Stock Option Plan was amended whereby the aggregate number of shares which may be issued under the Plan was increased from 300,000 to 1,800,000. The amendment made consultants engaged in acquisition, financing and fund raising activities for the Company eligible under the Plan in addition to officers and key employees. The option price may not be less than 85% of the fair market value of the common stock at the time the option is granted, with the exception of incentive stock options, wherein the option price may not be less than 100% of the fair market value of the stock at the time the option is granted. On June 9, 1993, 39,000 stock options were granted to officers of the Company at an exercise price of $4.25 per share, which was the closing price at that date. These options vest at a rate of 25% per year of service. On May 20, 1992, the Board of Directors adopted the 1992 Directors' Stock Option Plan, which was subsequently amended by the Board and ratified by the shareholders on June 9, 1993. On May 20, 1992, each director was granted, subject to shareholder approval of the plan, options to purchase 50,000 shares of the Company's common stock at $2.875 per share, the closing price on that date. These options became exercisable on June 9, 1993. On June 9, 1993, each director was granted options to purchase an additional 10,000 shares at $4.25 per share, the closing price on that date. These options became exercisable on December 9, 1993. Pursuant to the reincorporation to the State of Maryland, the Board of Directors ratified the Employee and Directors' Plan on September 27, 1993, and on February 7, 1994 amended the Plan to reflect the Company's name change. Note 7 - Share Equivalent Incentive Plan The 1989 Share Equivalent Incentive Plan (the "Plan") provides for up to 300,000 "performance units" to be awarded to key employees of the Company over the eleven-year period ending December 31, 1999. Key employees selected to participate in the Plan will be paid a cash "performance award" measured by the appreciation, if any, in value of the Company's Common Stock over a three-year "performance cycle". In addition, a participating employee will be paid, at the end of the performance cycle, an amount equal to the cash distributions paid or credited by the Company during the three-year period on the number of shares of common stock equivalent to the number of units awarded. At December 31, 1993, there were no performance units outstanding. Note 8 - Stockholder Rights Plan On July 18, 1989, the Company's Board of Directors adopted a Stockholder Rights Plan and declared a dividend distribution of one right for each share of the Company's Common Stock outstanding on July 31, 1989. The Rights entitle the holders to purchase, under certain conditions, one-hundredth of a newly- issued share of Series A voting Preferred Stock at an exercise price of $30.00. The Rights may also, under certain conditions, entitle the holders to receive Common Stock or other consideration having a value equal to two times the exercise price of each Right. The Rights are redeemable by the Company at a price of $0.01 per Right. If not so redeemed, the Rights expire on July 18, 1999. Note 9 - Bank Loan Payable The Company's bank credit facility which matured on January 31, 1993 was not repaid and was extended through June 15, 1993. On April 26, 1993, a new credit facility with Bank of America, which consisted of a $6,000,000 threeyear term loan secured by a deed of trust on University Tower, was approved. On July 14, 1993, the new facility was funded and the previous bank credit facility was paid off. The new loan was paid off on August 18, 1993. In December 1993, the Company concluded an agreement with Bank of America for a $20 million revolving line of credit for real estate acquisitions. This facility, which matures on January 1, 1997, carries an interest rate option of either prime plus 0.75% or an offshore interest rate, similar to LIBOR, plus 3.00% and is secured by deeds of trust on the Woodlands II and IBM buildings. The outstanding amount on the facility of $3,621,000 at December 31, 1993 was used to finance the purchase of 1000 Town Center Drive. Borrowings under the facility were subsequently repaid in January 1994. The daily weighted average amount owing to the bank was $3,253,000 and $4,137,000 in 1993 and 1992 respectively. The weighted average interest rate in these periods was 6.7% and 5.7% respectively. Note 10 - Quarterly Financial Data-Unaudited The following is a summary of quarterly results of operations for 1993 and 1992: In thousands of dollars, except per share data) LOTUS FORMAT TABLE TO BE INCLUDED ON HARD COPY SUBMITTAL Company's investment in the Texas Bank North Building and Point West Place. 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. BEDFORD PROPERTY INVESTORS, INC. By: /s/Peter B. Bedford Peter B. Bedford Chairman of the Board and Chief Executive Officer Dated: March 25, 1994 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. By: /s/ Peter B. Bedford March 25, 1994 Peter B. Bedford, Chairman of the Board and Chief Executive Officer By: /s/Claude M. Ballard March 25, Claude M. Ballard, Director By: /s/ Anthony Downs March 25, Anthony Downs, Director By: /s/ Anthony M. Frank March 25, Anthony M. Frank, Director By: /s/ Martin I. Zankel, Esq. March 25, Martin I. Zankel, Esq., Director By:/s/ Jay Spangenberg March 25, Jay Spangenberg Chief Financial Officer By:\s\Hanh Kihara ________March 25, 1994 Hanh Kihara Controller

740868_1993.txt

740868_1993

1993

740868

ITEM 1. BUSINESS GENERAL The registrant, an Indiana corporation (hereinafter, the "Company"), is the leading independent designer, manufacturer and supplier of window systems to the combined automobile, light truck and van, bus, heavy truck and recreational vehicle markets in North America. The Company's window systems include various types of automotive windshields; rear, vent, quarter, push out and sliding windows; and window regulator systems, latches, door frames and related components. The Company also manufactures door systems for military and recreational vehicles and injection molded thermoplastic products and other products primarily for sale to the automotive industry. The Company's products are sold to major North American transportation original equipment manufacturers ("OEMs") including Ford, Chrysler, General Motors, AutoAlliance International, Inc. (a joint venture between Ford and Mazda), Mitsubishi, Nissan, Fleetwood, Winnebago, Navistar, Paccar (Peterbilt and Kenworth trucks) and the manufacturers of virtually all of the intra and intercity buses in the United States and Canada. BUSINESS STRATEGY The Company's business objective is to expand profitably its position as the leading independent supplier of window systems to the combined automotive, light truck and van, bus, heavy truck and recreational vehicle markets in North America. It also intends to broaden its product offerings to these markets, as well as expand its capabilities to complementary markets. Continued focus on achieving recognition as a world class manufacturer is a key component of this strategy. The Company continually strives for world class status through technical innovation, quality excellence, cost competitiveness and strategic alliances and acquisitions. Technical Innovation. The Company's most significant innovative achievement has been the development of reaction injection molded ("RIM") modular windows in the mid-1980's. This value-added product resulted from a long internal development effort and accounted for 35% of net sales in 1993. In recent years, as automotive OEMs increasingly shifted design, innovation, quality and product improvement responsibility to their suppliers, the Company increased its research, engineering and development expenditures (from $2.7 million in 1989 to $7.9 million in 1993), including the addition of an advanced design group and Company-wide computer-aided design capability. The Company has also added more sophisticated program management and complex manufacturing information systems. The Company's capabilities now include prototype and product development, specification testing and manufacturing engineering assistance. This has resulted in increased opportunities for the Company to participate earlier in the product planning process and to add value by furnishing engineering and design services and providing a broader range of parts required for vehicle assembly. Quality Excellence. The Company emphasizes a continuous improvement philosophy to its employees on all facets of operations including product quality. As a result of its commitment to quality, the Company has achieved Q1 and Pentastar quality ratings at its key manufacturing plants from Ford and Chrysler, respectively, and has received quality awards from Fleetwood (a recreational vehicle OEM), Nissan and other OEMs. At the corporate technical center, engineers examine the Company's and its competitors' products to evaluate alternative designs, suggest marketing opportunities and solve potential production problems, all of which serve to improve and maintain the Company's stringent quality standards. Competitive Cost. The Company strives to achieve a competitive cost to its customers through its emphasis on quality excellence and its involvement in the early stages of product development. The Company is a highly reliable and timely supplier able to meet its customers' demanding delivery requirements, while constantly focusing on reducing OEM inventory levels. Strategic Alliances. In 1986, Ford entered into a supply agreement (the "Supply Agreement") with the Company. Pursuant to the Supply Agreement, Ford agreed to purchase from the Company at least 70% of the requirements by dollar volume of Ford and Ford Canada for modular framed glass parts using RIM and polyvinyl chloride ("PVC") technology, commencing with the 1990 model year. Ford's purchase obligations are contingent upon the Company being competitive as to technology, quality, service, price and delivery. The Supply Agreement, which is currently scheduled to expire at the end of the 1998 model year, has been complemented by a supply agreement between Ford and the Company dated January 31, 1994 (the "1994 Supply Agreement"), which extends through the 1998 calendar year and which provides for Ford to purchase 100% of its requirements for those parts currently supplied by the Company (including parts other than modular windows), subject to specified annual price reductions. Since 1990, the Company has and is continuing to supply at least 70% of Ford's requirements for modular framed glass, which have predominately been modular windows using RIM technology. The Company works closely with Ford during the development and production by Ford of new products utilizing parts supplied by the Company, and net sales to Ford have increased from $26.7 million in 1985 to $373.1 million in 1993. The Company also benefits from an exclusive purchase and supply agreement with H.S. Die & Engineering of Grand Rapids, Michigan. H.S. Die supplies the molds (i.e., tooling) to the Company necessary to manufacture modular windows. Working closely with OEMs and H.S. Die, the Company is able to move rapidly from design to finished tooling for modular windows. As a result of this alliance, preproduction lead-times on new programs have been decreased by more than a year, which was demonstrated in Ford's development of the recently introduced Mustang model. Another strategic alliance links the Company with Schade KG, a modular and conventional window and door systems supplier located in Plettenberg, Germany. Pursuant to a Reciprocal Technology License and Cooperative Venture Agreement, both companies have cooperated in developing new business proposals. Schade helped the Company develop technical capabilities in PVC modular windows. The Company produces PVC windows for the Chrysler New Yorker at its Kentucky manufacturing facility and has been sourced to supply PVC windows for certain 1995 Mitsubishi and Nissan models. In addition, technology acquired from the Company's alliance with Schade has enabled the Company to supply door frames for General Motors's 1994 Saturn Coupe. In 1992, the Company formed a joint venture with Pollone S.A., a Brazilian automotive parts supplier, for the purpose of supplying encapsulated window assemblies to South American automakers. Located near Sao Paulo, Brazil, the joint venture, Pollexco, is owned 49% by the Company and 51% by Pollone, S.A. Production of products for Autolatina, a joint venture between Ford and Volkswagen, began in late 1993. Strategic Acquisitions. In acquisitions, the Company seeks processes, products or markets which complement the Company's existing businesses. The Company added high volume conventional window capacity to its product line as a result of a 1986 acquisition from Irvin Industries. In the mid-1980's, Ford--initially the Company's only RIM window customer--started its own subsidiary to manufacture RIM windows in Fulton, Kentucky. In 1986, the Company acquired Ford's RIM window subsidiary and manufacturing facility. In 1988, the Company acquired Nyloncraft, Inc., which manufactures injection molded thermoplastic products primarily for the automotive industry. Nyloncraft also supplies plastic components to six of the Company's manufacturing facilities. In 1990, the Company acquired the window regulator business operated by Hoover Universal, Inc., a subsidiary of Johnson Controls, Inc. The Company's technical capabilities, in particular the corporate technical center, have enabled it to redesign several products, reduce operating expenses and improve overall operations in the newly-acquired window regulator business. MARKET DESCRIPTION AND INDUSTRY FACTORS Automotive Market General. The overall market for new cars and light trucks in North America is large and cyclical, with average annual growth of 1% to 2%. However, considerable growth or decline routinely occurs within specific product segments or model lines. In particular, light truck sales have grown rapidly over the last 15 years as compared to the demand for cars. This growth in light truck demand primarily reflects the increased use of mini-vans and sport utility vehicles. The Company believes it will continue to be well-positioned as a supplier of window systems to OEMs in this higher growth market segment. Changing Supplier Policies. Several developments have substantially altered the competitive environment for automotive suppliers, including consolidation among suppliers and increased outsourcing of key components by OEMs. During the 1980s, Ford, Chrysler and General Motors began to reduce their supplier base, focusing on long-term sole-source contracts with more capable suppliers. Increasingly, the criteria for selection include not only cost, quality and responsiveness, but also certain full-service capabilities including design, engineering and project management support. OEMs now have rigorous programs for evaluating and rating suppliers which encompass quality, cost control, reliability of delivery, new technology implementation, engineering competence, continuous improvement programs and overall management. Under these programs, each facility operated by a supplier is evaluated independently. The suppliers who obtain superior ratings are favorably considered for new business; those who do not may continue their existing contracts, but normally do not receive additional business. As a result, these new supplier policies have sharply reduced the number of component suppliers. In the 1990's, OEM supply agreements have incorporated productivity provisions which specify annual price reductions which may be offset by product improvements, manufacturing improvements and/or various other mutually agreed upon methods. Transplants. Over the last ten years, Japanese manufactured vehicles have gained an increasing share of the North American market. In addition, a growing percentage of such vehicles are being made at North American operations of Japanese manufacturers ("Transplants"). Transplants receive component parts from a variety of sources including suppliers in Japan, Japanese suppliers who establish U.S. facilities and existing U.S. component suppliers. Because of the current market share of the Transplants, supplying them is an attractive opportunity. To date, the Company has been selected to supply window systems for certain Nissan, Mazda and Mitsubishi models manufactured in North America. The Company has also been selected to supply fixed vent windows for the new BMW model scheduled to be built in South Carolina in 1995. Non-Automotive Market The market for heavy trucks in North America is cyclical, and the Company believes it is well positioned to take advantage of supply opportunities which arise as aging fleets are replaced with new models. The availability of federally funded programs and the price of gasoline and diesel fuel are factors which affect the demand for intracity buses purchased for municipal mass transit systems. The market for recreational vehicles is influenced significantly by the strength of the economy and the level of consumer discretionary spending. Recent growth trends in the sale of recreational vehicles have been positive. PRODUCTS The Company designs, engineers, manufactures and supplies plastic and metal framed window assemblies, manual and power glass regulator systems and injection molded thermoplastic products principally for North American car, light truck and van, heavy truck, bus, military and recreational vehicle OEMs. The Company does not manufacture or sell primary glass. Modular Window Systems. The Company's modular, plastic framed windows are value-added parts because clips, weatherstripping and bright trim are attached during the molding process. The module-manufacturing processes used by the Company give the OEM designers great flexibility in window shape, sealing and aerodynamics. The module supplied to the OEM also lowers its parts inventory, reduces part weight and reduces assembly efforts. The Company produces modular windshields and rear windows, as well as fixed quarter, sliding and push out modular windows. The Company utilizes RIM technology and also PVC injection molding technology to manufacture modular windows. In RIM technology, liquids are mixed and fed into a mold that holds glass, framing and fastening components. The mixture polymerizes, and the completed module is removed, trimmed, cleaned, inspected and packed for shipment. In PVC injection molding, solid plastic subjected to high temperature and pressure flows in liquid form into the mold where it reverts without chemical reaction to a solid. Conventional Windows. The Company also produces conventionally framed window assemblies utilizing painted cold-rolled steel, stainless steel, rubber and/or aluminum. The glass or plastic glazed window assemblies supplied for mass transit systems have durable aluminum frames and non-leak weatherstripping. The Company supplies a wide variety of conventional windows to car, light truck and heavy truck OEMs, including pivoting wing ventilator windows, fixed and movable quarter windows and swing-out and sliding windows. The Company's flush-mount recreational vehicle windows seal tightly and feature independent sliding screens, removable storm windows and an anti-theft locking mechanism. Window Regulator Systems. The Company supplies manual and electrically powered versions of regulators (the mechanisms for lifting and lowering windows) for front and rear side windows and tailgate windows. The Company stresses safety, weight, glass stability, window system integration, parts reduction and enhanced vehicle design flexibility in its window regulators. Injection Molded Thermoplastic Products. The Company's Nyloncraft division manufactures injection molded inside and outside door handles, door latch components, fan shrouds, airspring pistons, window crank handles and a variety of other custom engineered products. The Company molds parts from nylons, polyesters, acetal and other engineered thermoplastic materials. Door Systems. The Company designs and manufactures preassembled doors for Class A motorhomes and ballistic door/window systems for the Hummer tactical military vehicle. The Company's preassembled door systems improve the OEMs' installation productivity and assist in design flexibility. CUSTOMERS AND MARKETING The Company supplies its products primarily to Ford, Chrysler and General Motors. Historical sales of the Company by customer group are set forth below. The loss of Ford, Chrysler or General Motors as a customer would have a material adverse effect on the Company. Sales of the Company's products to OEMs are made directly by the Company's sales and engineering personnel located at the Company's offices in the Detroit area and Elkhart, Indiana. Through these sales and engineering offices, the Company services its OEM customers and manages its continuing programs of product design improvement and development. The Company's customers award contracts that normally cover parts to be supplied for a particular vehicle model. Such contracts typically extend over the life of the model, which is generally four to seven years. The primary risk to the Company is that an OEM will produce fewer units of a model than anticipated. In addition, the Company competes for new business to supply parts for successor models and therefore runs the risk that the OEM will not select the Company to produce parts on a successor model. In order to reduce its reliance on any one model, the Company produces parts for a broad cross- section of both new and more mature models. The Company has been chosen as a supplier on a variety of generally successful car, light truck and van models. The following table presents a summary of the 1994 and 1995 models for which the Company is producing or will produce component parts. COMPANY 1994/1995 MODELS Ford Escort, Explorer, Taurus, Sable, Aerostar, Windstar, Ranger, Continental, Cougar, Mark VIII, Bronco, Thunderbird, Town Car, Econoline, Crown Victoria, Grand Marquis, Mustang, Probe, Villager, F-Series Truck Chrysler LHS, LeBaron, Fifth Avenue, Imperial, Cherokee, Wrangler, Comanche, Voyager, Avenger, Sebring, Concorde, Intrepid, Vision, New Yorker, Dakota, Ram Truck, Ram Van/Wagon, Talon General Motors Cavalier, Sunbird, Vandura Van, APV Mini-Van, S-10 Truck, Saturn Coupe, Saturn Station Wagon Nissan Quest, Sentra GS, Nissan Truck Mazda MX6 Mitsubishi Eclipse Based on its ability to service its OEM customers' needs effectively, the Company believes it will be able to maintain its position on most existing models, while also expanding into new models as further consolidation in the OEM supplier base occurs. The Company believes that the presence of Transplants represents an attractive growth opportunity over the next decade. The Company is currently supplying products for Mazda, Nissan and Mitsubishi models. The Company believes that it is favorably positioned to increase its business with the Transplants because of the Company's reputation for technical innovation, quality excellence, reliability and competitive cost. In the non-automotive markets, the Company sells various types of conventional window systems to North American OEMs of medium and heavy trucks, recreational vehicles and buses. The Company is the dominant supplier of wing ventilator windows for medium and heavy trucks manufactured in the United States and Canada. The Company's customers include Navistar, Freightliner, Volvo GM Heavy Truck Corp., Mack Truck, Paccar (Kenworth and Peterbilt models) and Ford. The Company supplies aluminum framed window systems to Fleetwood and Winnebago, the leading recreational vehicle OEMs in North America, as well as a number of other recreational vehicle manufacturers. The Company is the dominant supplier of metal framed window systems to intra and intercity bus OEMs. The Company also manufactures preassembled doors for certain recreational vehicle OEMs and door systems for the Hummer tactical military vehicle. The Company maintains separate sales and engineering groups at its corporate offices in Elkhart, Indiana to service these non-automotive markets. The Company has received "Supplier of the Year" and "Master of Quality" awards from Fleetwood and Freightliner, respectively, as well as recognition for quality and delivery accomplishments from other non-automotive OEMs. The Company believes that its cost competitiveness, quality excellence and design and engineering capabilities obtained in the automotive supply markets enable it to compete effectively in non-automotive markets as well. COMPETITION The Company operates in a highly competitive environment in each of its markets. The number of the Company's competitors in the automotive markets is expected to decrease due to the supplier consolidation resulting from changing OEM policies. The Company's major competitors include Donnelly Corporation, Libbey-Owens-Ford Co., Guardian Industries, Dura, Inc., Rockwell International, Hehr International, OEM internal operations and a large number of smaller operations. The Company principally competes for new business both at the beginning of the development of new models and upon the redesign of existing models by its major customers. New model development generally begins two to four years prior to the marketing of such models to the public. Once a producer has been designated to supply parts to a new program, an OEM will generally continue to purchase those parts from the designated producer for the life of the program. Competitive factors in the market for the Company's products include product quality, design and engineering competence, customer service, product mix, new product innovation, cost and timely delivery. The Company believes that its business strategy allows it to compete effectively in the markets for its products. The Company believes that it is well-positioned to succeed in this highly competitive supplier environment. The Company's size, emphasis on quality, customer service orientation, manufacturing expertise and technological leadership all contribute to the Company's success in the transportation supply industry. RESEARCH, ENGINEERING AND DEVELOPMENT The Company expended approximately $5.2 million, $5.5 million and $7.9 million on research, engineering and development during 1991, 1992 and 1993, respectively. These increased expenditures have improved significantly the Company's capacity to provide complete engineering and design services to support its product lines. The Company also has a corporate technical center in Elkhart, Indiana for basic research and development, as well as a large engineering and design staff in the Detroit area which works closely with automotive OEMs during all phases of new product development and production. FOREIGN OPERATIONS In addition to its domestic facilities described below, the Company owns a manufacturing facility in Aurora, Ontario, Canada and leases a manufacturing facility in Juarez, Mexico. The financial information concerning the Canadian operations of the Company is set forth in Notes 10 and 11 to the Company's Consolidated Financial Statements included elsewhere herein. EMPLOYEES The Company employs a total of approximately 3,500 persons, of whom approximately 20% are covered by collective bargaining agreements. The Company believes its relationship with its employees is good. ENVIRONMENTAL MATTERS The Company believes it is in substantial compliance with federal, state, local and foreign laws regarding discharge of materials into the environment and does not anticipate any material adverse effect on its future earnings, capital expenditures or competitive position as a result of compliance with such laws. For a discussion of potential environmental liabilities, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-- Liquidity and Capital Resources" and Note 8 to the Company's Consolidated Financial Statements included elsewhere herein. ITEM 2. ITEM 2. PROPERTIES The Company operates 11 manufacturing facilities, all of which are in good condition. The Company manufactures framed window assemblies at its Elkhart, Jacksonville, LaGrange, Aurora, Lawrenceburg, Fulton and Toledo manufacturing facilities. Injection molded thermoplastic parts are manufactured at the Bowling Green and Mishawaka facilities. Window regulator systems, latches and related components are manufactured at the Jacksonville, Pikeville and Juarez, Mexico facilities. Except as noted below, the Company owns all of these facilities. Approximate Building Size Location (in square feet) Elkhart 270,000 (1) Jacksonville, Florida 260,000 LaGrange, Indiana 140,000 Aurora, Ontario (Canada) 120,000 Lawrenceburg, Tennessee 150,000 Fulton, Kentucky 80,000 (2) Bowling Green, Kentucky 32,000 Mishawaka, Indiana 120,000 (3) Toledo, Ohio 61,000 (4) Pikeville, Tennessee 101,900 (5) Juarez, Mexico 15,000 (6) _________________________________ (1) Approximately 35,000 square feet of this facility houses the Company's executive offices and approximately 140,000 square feet of the facility are used in manufacturing. (2) The Company leases the Fulton, Kentucky facility pursuant to a lease which expires in 1994. The Company is entitled to extend the term of the lease for six (6) additional terms of three (3) years each and may, at its option, purchase the facility at any time during the lease. (3) The Company leases the Mishawaka, Indiana facility pursuant to a lease which expires in 1998. The Company is entitled to extend the term of such lease until 2003 and may, at its option, purchase such facility at any time during the term of the lease. (4) The Company leases the Toledo, Ohio facility pursuant to a lease which expires on May 31, 1998. (5) The Company leases the Pikeville, Tennessee facility pursuant to a Lease Purchase Contract entered into as part of agreements for the issuance of two series of industrial development bonds. Title to the facility will be transferred to the Company for Ten Dollars ($10.00) on completion of payment on the bond issues on July 1, 1999. Rent is payable semi- annually with respect to the Series A bonds and is equal to the principal and interest due on the bonds. Semi-annual principal payments on the Series A bonds currently are $75,000. Interest on the outstanding principal balance of the Series B bonds is payable quarterly, with an annual payment of principal in the amount of $200,000. (6) The Company leases the Juarez, Mexico facility pursuant to a month-to- month lease. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On February 22, 1993, the United States filed a lawsuit in the United States District Court for the Northern District of Indiana against the Company and certain other parties. On July 20, 1993, the Indiana Department of Environmental Management ("IDEM") joined the lawsuit. The lawsuit seeks recovery of the costs of enforcement, prejudgment interest and an amount in excess of $6.8 million, which represents costs incurred to date by the United States Environmental Protection Agency ("EPA") and IDEM in connection with the contamination of soil and groundwater on the Company's property in Elkhart, Indiana, and a well field of the City of Elkhart in close proximity to the Company's facility. The lawsuit also seeks a declaration that the Company and the other defendants are liable for any future costs incurred by the EPA and IDEM in connection with the site. For further information, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 8 to the Company's Consolidated Financial Statements included elsewhere herein. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS None Executive Officers of the Company The names and ages of all executive officers of the Company, all positions and offices held by each of them and the period during which each such person has served in these offices and positions is set forth below: Name Age Position and Offices James J. Lohman 52 Chairman of the Board and Chief Executive Officer James O. Futterknecht, Jr.47 President and Chief Operating Officer Joseph A. Robinson 55 Secretary, Treasurer and Chief Financial Officer James E. Crawford 47 Vice President-Product Development and Value Engineering Louis R. Csokasy 46 Vice President-Engineering and Quality Terrance L. Lindberg 51 Vice President-Specialty Products and General Manager-Nyloncraft Mr. Lohman has been the Chairman of the Board of Directors since 1985 and Chief Executive Officer since 1983. He joined the Company in 1964 and was Group Vice President from 1978 to 1981 and was President from 1981 to 1992. He has been a director of the Company since 1978. Mr. Futterknecht joined the Company in 1970, was Vice President - Corporate Sales from 1976 until 1984, was Vice President - Automotive Products from 1986 until 1987, was Vice President - Automotive Sales and engineering from 1987 to 1990, and was Executive Vice President from 1990 to 1992. He was elected as President and Chief Operating Officer and was appointed as a director in 1992. Mr. Robinson joined the Company as Secretary, Treasurer and Chief Financial Officer in December 1991 and was appointed as a director in 1992. Prior to that time, he was employed by the Standard Products Co., a manufacturer of automotive parts as Vice President from 1990 to 1991 and as Vice President - Finance from 1976 to 1990. Mr. Crawford joined the Company in 1978, was Product Engineering Manager from 1979 until 1984, was Vice President - Engineering/Research from 1984 until 1987, was Vice President - Modular Operations from 1987 to 1988, and was Vice President-Group Operations/Modular Products from 1988 to 1992. Mr. Crawford has been Vice President-Product Development and Value Engineering since 1992. Mr. Csokasy joined the Company in 1972. He was General Manager - Recreational Vehicles from 1985 to 1987, Manager of Corporate Engineering from 1987 to 1990, and was Vice President - Engineering from 1990 to 1992. He has been Vice President - Engineering and Quality since 1992. Mr. Lindberg joined the Company in 1983, was Manager of Mass Transit and Heavy Truck Products from 1984 to 1987, was Manager of Group Operations from 1987 until 1990, was Vice President - Group Operation from 1990 to 1992. Mr. Lindberg has been Vice President - Specialty Products and General Manager - Nyloncraft since 1992. PART II. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The Common Shares are traded on the American Stock Exchange under the symbol EXC. The following table sets forth for the fiscal periods indicated the high and low sale prices of the Common Shares, as reported by the American Stock Exchange, and dividends declared per share. As of February 15, 1994, there were 502 holders of record of the Common Shares. The Company has paid cash dividends every quarter since becoming a public company in April 1984. The Company intends to continue to pay quarterly cash dividends on its Common Shares, but the payment of dividends and the amount and timing of such dividends will depend upon the Company's earnings, capital requirements, financial condition and other factors deemed relevant by the Company's Board of Directors. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SELECTED CONSOLIDATED FINANCIAL INFORMATION (Amounts in thousands, except per share amounts) The following table presents selected consolidated financial data of the Company as of and for the five fiscal years ended December 31, 1993. The selected consolidated financial data have been derived from audited consolidated financial statements of the Company. Such selected consolidated financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements of the Company and the notes thereto included elsewhere herein. The comparability of the results for the periods presented is significantly affected by certain events, as described in "Management's Discussion and Analysis of Financial Condition and Results of Operations--General." EXCEL INDUSTRIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS Excel Industries, Inc. (Company) is engaged in the manufacture and sale of a broad line of window assemblies, manual and electric window regulators, upper door frames, and injection molded thermoplastic parts. The Company's products are used in the manufacture of automobiles, heavy and light trucks, buses and recreational vehicles. 2. SIGNIFICANT ACCOUNTING POLICIES Principles of consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions, profits and balances are eliminated. Net income per share Primary net income per share is computed using the weighted average number of shares outstanding during the period. Shares used to compute primary net income per share were 10,122,000 for 1993, 7,553,000 for 1992, and 6,488,000 for 1991. Fully diluted earnings per share assumes, when dilative, the conversion of the 10% convertible subordinated notes which were issued on January 2, 1990. Stock dividends and splits are given retroactive effect in computing the weighted average number of shares outstanding during the period. Short-term investments and marketable securities Short-term investments amounting to $5,771,000 at December 31, 1993 consist of investments generally in money market funds. Marketable securities consist of U.S. Government securities, tax- free municipal securities and municipal fund par value preferred shares with maturities generally longer than 90 days. Such investments are carried at cost which approximates market. Other income includes interest income of $1,916,000 in 1993, $1,010,000 in 1992, and $674,000 in 1991. Inventories Inventories are valued at the lower of cost or market. Cost is determined using the last-in, first-out (LIFO) method for domestic inventories and the first-in, first-out (FIFO) method for Canadian inventories. Properties Plant and equipment are carried at cost and include expenditures for new facilities and those which substantially increase the useful lives of existing plant and equipment. Depreciation The Company provides for depreciation of plant and equipment using methods and rates designed to amortize the cost of such equipment over its useful life. Depreciation is computed principally on accelerated methods for new plant and equipment and the straight-line method for used equipment. The estimated useful lives range from 10 to 40 years for buildings and improvements and 2 to 20 years for machinery and equipment. Goodwill The excess of purchase price over the fair value of net assets of acquired businesses (goodwill) is amortized on a straight-line basis over 20 to 40 years. Income taxes Deferred income taxes are provided using the liability method in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". 3. RESEARCH, ENGINEERING AND DEVELOPMENT Research, engineering and development expenditures charged to operations approximated $7,913,000 in 1993, $5,518,000 in 1992, and $5,200,000 in 1991. 4. RESTRUCTURING CHARGE In the fourth quarter of 1992, the Company provided a reserve of $4,500,000 for restructuring costs. The charge was equivalent to $2,900,000 or 34 cents per share after taxes. This charge represented estimated costs to downsize its Aurora, Ontario, Canada plant and relocate production of certain light truck and van windows to other manufacturing plants of the Company. A total of $1,010,000 was incurred in 1993 to transfer a portion of the planned production. 5. INVENTORIES Inventories consist of the following: December 31, 1993 1992 (000 Omitted) Raw materials $17,948 $15,302 Work in process and finished goods 12,378 11,699 LIFO reserve (459) (255) $29,867 $26,746 6. PENSION AND OTHER EMPLOYEE BENEFIT PLANS Pension and profit sharing plans The Company and its subsidiaries provide retirement benefits to substantially all employees through various pension, savings and profit sharing plans. Defined benefit plans provide pension benefits that are based on the employee's final average salary for salaried employees and stated amounts for each year of credited service for hourly employees. Contributions and costs for the Company's various other benefit plans are generally determined based on the employee's annual salary. Total expense relating to the Company's various retirement plans aggregated $2,199,000 in 1993, $2,102,000 in 1992, $1,712,000 in 1991. Components of net pension expense for all defined benefit pension plans are as follows: Year Ended December 31, 1993 1992 1991 (000 Omitted) Service cost $1,319 $1,312 $1,243 Interest cost 1,344 1,245 1,137 Actual return on assets (617) (1,242) (1,139) Net amortization and deferral (582) 190 222 Net defined benefit pension expense $1,464 $1,505 $1,463 The funded status of defined benefit pension plans is as follows: December 31, 1993 1992 (000 Omitted) Plan assets at fair value $15,844 $ 14,868 Projected benefit obligations 20,421 17,869 (4,577) (3,001) Unrecognized costs 1,862 472 Net accrued pension costs $(2,715) $(2,529) Actuarial present value of: Vested benefit obligations $15,644 $13,853 Accumulated benefit obligations $16,655 $14,815 Major assumptions: Discount rate 7.5% 8% Rate of increase in compensation 5% 5% to 8% Expected rate of return on plan assets 8 8% It is generally the Company's policy to fund the ERISA minimum contribution requirement. Plan assets are invested primarily in corporate equity securities and bonds and insurance annuity contracts. Supplemental and other postretirement benefits In addition to providing pension benefits, the Company provides certain health care benefits to substantially all active employees and postretirement health care benefits to management employees. The Company is primarily self-insured for such benefits and prior to 1992 followed the practice of expensing such benefits on a pay-as-you-go basis. In 1992, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Company elected to immediately recognize the Accumulated Postretirement Benefit Obligation (APBO) as January 1, 1992 in the amount of $6,447,000 (approximately $4,000,000 after-tax or 61 cents per share). Summary information on the Company's plan is as follows: December 31, 1993 1992 (000 Omitted) Retirees $1,504 $1,060 Retirement-eligible actives 968 1,245 Other active participants 6,077 5,402 Unrecognized gain 407 -- Accrued liability $8,956 $7,707 Accrued postretirement benefit cost The Company plans to continue the policy of funding these benefits on a pay-as-you-go basis. The components of net periodic postretirement benefit cost are as follows: Year Ended December 31, 1993 1992 (000 Omitted) Service costs, benefits attributed to employee service during the year $ 821 $ 750 Interest cost on accumulated postretirement benefit obligation 578 510 Net periodic postretirement benefit cost $1,399 $1,260 The discount rate used in determining the APBO was 7.75% in 1993 and 8% in 1992. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 10.25% declining by 1% per year to a rate of 6.25%. An increase of 1% in health care cost trend rate would increase the accrued postretirement benefit cost at December 31, 1993 by $2,066,000 and the 1993 annual expense by $384,000. 7. LONG-TERM DEBT Following is a summary of long-term debt of the Company: December 31, 1993 1992 (000 Omitted) 10% Convertible subordinated notes $30,000 $30,000 Industrial Revenue Bonds 5,383 4,533 Capital lease obligations 1,264 1,620 36,647 36,153 Current portion (1,553) (1,561) $35,094 $34,592 During 1992, the Company prepaid the balance owing on its guaranteed senior notes and was subject to a prepayment premium of approximately $1.3 million. Such amount is included in the accompanying income statement in interest expense. The convertible notes are due on December 1, 2000 and require aggregate prepayments of $8,000,000 in 1996, $7,000,000 in 1997, $6,000,000 in 1998, $5,000,000 in 1999 and $4,000,000 in 2000. The holders of the notes have the option to convert their notes at any time into common shares of the Company at a current conversion price of $13.214 per share. The Notes are subject to prepayment at the option of the Company if the market value of the Company's common shares equals or exceeds 150% of the conversion price for a specified period. The note agreements provide for maintaining a current ratio of 1.5 to 1, restrict the amount of additional borrowings and limit the amount of dividends that can be paid. Currently the Company has available for payment of dividends $19,615,000 of retained earnings. The Industrial Revenue Bonds bear interest at rates of interest tied to short-term Treasury rates. Certain plant and equipment purchased with the proceeds of the bonds collateralize these obligations. The Company had available unused lines of credit of approximately $6,300,000 at December 31, 1993. Long-term debt maturities are $1,553,000 in 1994, $1,358,000 in 1995, $9,557,000 in 1996, $8,072,000 in 1997, $6,580,000 in 1998, and $9,527,000 thereafter. 8. CONTINGENCIES A chemical cleaning compound, trichlorethylene (TCE), has been found in the soil and groundwater on the Company's property in Elkhart, Indiana, and in 1981, TCE was found in a well field of the City of Elkhart in close proximity to the Company's facility. The Company has been named as one of nine potentially responsible parties (PRPs) in the contamination of this site. The United States Environmental Protection Agency (EPA) and the Indiana Department of Environmental Management (IDEM) have conducted a preliminary investigation and evaluation of the site and have undertaken temporary remedial action in the nature of air-stripping towers. In early 1992, the EPA issued a Unilateral Order under Section 106 of the Comprehensive Environmental Response, Compensation and Liability Act which required the Company and other PRPs to undertake remedial work. The Company and the other PRPs have reached an agreement regarding the funding of groundwater monitoring and the operation of the air-strippers as required by the Unilateral Order. The Company was required to install and operate a soil vapor extraction system to remove TCE from the Company's property. As of February 1, 1994, the Company has installed and is operating the equipment pursuant to the Unilateral Order. In addition, the EPA and IDEM have asserted a claim for reimburesement of their investigatory costs and the costs of installing and operating the air-strippers on the munipal well field (the EPA Costs). On February 22, 1993, the United States filed a lawsuit in the United States District Court for the Northern District of Indiana against eight of the PRPs, including the Company. On July 20, 1993, IDEM joined in the lawsuit. The lawsuit seeks recovery of the costs of enforcement, prejudgment interest and an amount in excess of $6.8 million, which represents costs incurred to date by the EPA and IDEM, and a declaration that the eight defendant PRPs are liable for any future costs incurred by the EPA and IDEM in connection with the site. The Company does not believe the annual cost to the Company of monitoring groundwater and operating the soil vapor extraction system and the air-strippers will be material. Each of the PRPs, including the Company, is jointly and severally liable for the entire amount of the EPA Costs. Certain PRPs, including the Company, are currently attempting to negotiate an agreed upon allocation of such liability. The Company believes that adequate provisions have been recorded for its costs and its anticipated share of EPA Costs and that its cash on hand, unused lines of credit or cash from operations are sufficient to fund any required expenditures. The EPA has also named the Company as a PRP for costs at three other disposal sites. It has also asked the Company for information about contamination at other sites. The Company believes it either has no liability as a responsible party or that adequate provisions have been recorded for any costs to be incurred. There are claims and pending legal proceedings against the Company and its subsidiaries with respect to taxes, workers' compensation, warranties and other matters arising out of the ordinary conduct of the business. The ultimate result of these claims and proceedings at December 31, 1993 is not determinable, but, in the opinion of management, adequate provision for anticipated costs has been made or insurance coverage exists to cover such costs. 9. LEASES The Company leases certain of its manufacturing facilities, sales offices, transportation and other equipment. Total rental expense for all leases was approximately $3,416,000 in 1993, $2,998,000 in 1992, and $2,123,000 in 1991. Future minimum lease payments under noncancellable operating leases are $1,341,000 in 1994, $1,055,000 in 1995, $826,000 in 1996, $753,000 in 1997 and $143,000 in 1998. 10. INCOME TAXES Effective January 1, 1992, the Company adopted SFAS No. 109, "Accounting for Income Taxes". This statement mandates the liability approach for computing deferred income taxes similar to SFAS No. 96 previously followed by the Company. The cumulative effect of the change was to increase first quarter 1992 earnings by $800,000 (12 cents per share). The change had no impact on the 1992 income tax provision. Prior year financial statements have not been restated. Pre-tax income (loss) reported by U.S. and foreign subsidiaries was as follows: Year Ended December 31, 1993 1992 1991 (000 Omitted) United States $17,933 $8,688 $1,835 Foreign 2,292 (2,677) (1,562) $20,225 $6,011 $ 273 The provision (benefit) for income taxes is summarized below: Year Ended December 31, 1993 1992 1991 (000 Omitted) Current: US federal $ 6,049 $5,007 $1,615 Foreign 465 38 -- State 645 1,226 714 7,159 6,271 2,329 Deferred: US federal (317) (1,922) (1,388) Foreign 941 (1,256) (685) State 2 (659) (134) 626 (3,837) (2,207) $ 7,785 $2,434 $ 122 Deferred income taxes are provided for the temporary differences between the financial reporting basis and tax basis of the Company's assets and liabilities. At December 31, 1993, current deferred income tax assets of $2,886,000 are classified as prepaid expenses, long-term U.S. deferred income tax assets of $6,094,000 are classified as other assets, and $627,000 of long-term foreign deferred income tax liabilities are classified as other long-term liabilities. Deferred income taxes are comprised of the following at December 31: 1993 1992 (000 Omitted) Gross deferred tax liabilities Property, plant and equipment $ 2,257 $2,571 Inventories 436 308 Other 680 564 3,373 3,443 Gross deferred tax assets Postretirement benefit obligations 6,296 5,046 Restructuring reserve 1,103 1,655 Other accrued liabilities 3,708 4,210 Loss carryforwards 619 1,453 11,726 12,364 Net deferred tax assets $ 8,353 $ 8,921 The provision for income taxes computed by applying the Federal statutory rate to income before income taxes is reconciled to the recorded provision as follows: Year Ended December 31, 1993 1992 1991 (000 Omitted) Tax at United States statutory rate $7,079 $2,044 $ 93 State income taxes, net of federal benefit 421 374 383 Canadian rate differential on income/(losses) 344 (134) (154) Other (59) 150 (200) $7,785 $2,434 $ 122 Provision has been made for U.S. and Canadian taxes on undistributed earnings of the Company's Canadian subsidiary. The Company possesses approximately $10,570,000 of U.S. state income tax loss carryforwards. U.S. state loss carryforwards expire to the extent of $1,002,000 in the year 2005, $4,758,000 in 2006, and $4,810,000 in 2007. 11. SEGMENT INFORMATION AND MAJOR CUSTOMERS The Company operates in predominately one industry segment: the design, engineering and manufacture of certain components sold to manufacturers in the ground transportation industry. The Company, through its subsidiaries, operates primarily in two countries: the United States and Canada. The Company's Canadian subsidiary had net sales of $36,074,000 in 1993, $29,421,000 in 1992, and $21,735,000 in 1991. Total assets of the Canadian subsidiary were approximately $9,416,000 and $12,538,000 at December 31, 1993 and 1992, respectively. Intercompany sales were insignificant. Sales to three major customers, Ford Motor Company, Chrysler Corporation and General Motors Corporation, were approximately 72%, 11% and 4%, respectively, of the Company's net sales in 1993 as compared to 73%, 9% and 4% in 1992 and 69%, 8% and 8% in 1991. Accounts receivable from General Motors Corporation and Chrysler Corporation approximated 68% of trade accounts receivable at December 31, 1993 and 48% at December 31, 1992. Amounts due from Ford Motor Company are classified as "accounts receivable, related party" in the Company's balance sheet at December 31, 1993 and December 31, 1992. Sales to customers outside of the United States and Canada were not significant. 12. COMMON SHARES The Company has an incentive stock option plan covering key employees which was approved by shareholders in 1984. The plan provides that options may be granted at not less than fair market value and if not exercised, expire 10 years from the date of grant. At December 31, 1993, there were reserved 48,590 shares for the granting of options and options outstanding for 19,250 shares at an average exercise price of $6.59. During 1993, options for 7,875 shares were exercised at an average exercise price of $6.44. There were no options granted nor did any options expire during 1993. The Company has an employee stock purchase plan and has reserved 353,717 common shares for this purpose. The plan allows eligible employees to authorize payroll withholdings which are used to purchase common shares from the Company at ninety-percent (90%) of the closing price of the common shares on the date of purchase. Through December 31, 1993, 96,296 shares had been issued under the plan. The Company has reserved 2,270,319 common shares for possible future issuance in connection with its $30,000,000 convertible notes issued on January 2, 1990. 13. RELATED PARTY TRANSACTIONS Ford Motor Company owned 24% of the Company's common shares at December 31, 1993, 30% at December 31, 1992 and 40% at December 31, 1991. On January 11, 1994, Ford Motor Company donated 1,047,201 of the Company's common shares to the Ford Motor Company Fund. On January 13, 1994, Ford Motor Company and the Ford Motor Company Fund announced their intention to dispose of their combined 24% ownership in the Company through a secondary public offering. Ford officials stated that the disposition of common shares would not impact the customer-supplier relationship between Ford and the Company. Significant related party transactions are as follows: Year Ended December 31, 1993 1992 1991 (000 Omitted) Product sales $373,000 $311,000 $244,000 Product purchases 124,000 77,000 58,000 14. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following table sets forth in summary form the quarterly results of operations for the years ended December 31, 1993 and 1992. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth under the caption "ELECTION OF DIRECTORS" in the Company's proxy statement for the 1994 annual meeting of shareholders (the "Proxy Statement") is incorporated herein by reference. The Proxy Statement has previously been filed with the Securities and Exchange Commission. ITEM 11. EXECUTIVE COMPENSATION The information set forth under the captions "Compensation of Directors," "Compensation Committee Interlocks and Insider Participation," "Compensation of Executive Officers," "Summary Compensation Table," "Pension Plan," and "Deferred Compensation Plans" in the Proxy Statement is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the captions "Outstanding Shares," "Principal Shareholders," and "Security Ownership of Management" in the Proxy Statement is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Compensation Committee Interlocks and Insider Participation" in the Proxy Statement is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements The following consolidated financial statements of the Company and its subsidiaries are included in Item 8

8462_1993.txt

8462_1993

1993

8462

ITEM 1 - BUSINESS - ----------------- General - ------- Augat Inc. ("Augat") is a Massachusetts corporation organized in 1946. As used herein the term the "Company" means Augat and, unless the context indicates otherwise, its consolidated subsidiaries. Augat designs and manufactures a broad range of electromechanical components for the electronics industry. The Company's principal products are interconnection components, including integrated circuit sockets and accessories, coaxial cable network and fiber optic interconnection products, packaging panels and interconnection test probes and systems. The Company also makes terminals, custom connector assemblies, wiring harnesses and specialty wiring systems for the automotive, communications, information processing and business equipment markets. Industry Segments - ----------------- The Company operates within a single segment of the electronics industry defined as the electromechanical component and subsystem sector. Although the Company operates internally with several profit centers, the products of these centers all have similar purposes or end uses, i.e., interconnecting or controlling the flow of electricity among components or boards and other assemblies within electronic equipment or systems. These products are used by manufacturers of electronic equipment or systems. These products are used by manufacturers of electronic equipment in their products to obtain specified interconnections of components, subassemblies or subsystems. Each profit center is responsible for the manufacture of its own products within its own facilities. The manufacturing equipment and technology used by each profit center, while similar, are not interchangeable because they are customized for the particular product. However, Augat's manufacturing labor force, for the most part, is similar and interchangeable, as are the basic materials that make up the Company's products. Each profit center has comparable capital-to-labor ratios, as well as labor costs as a percentage of sales, with the exception of the Company's wire harness business, which consumes twice as much labor cost as a percentage of sales as the other profit centers. Products of the various profit centers, while sold to different market segments, principally the automotive, computer, dataprocessing, telecommunications and CATV markets, are sold across the same geographic areas and marketed via similar methods. Augat's customers are primarily companies that manufacture or install electronic equipment. Narrative Description of the Business - ------------------------------------- The Company designs, manufactures and markets electromechanical products used for the interconnection of circuits in electronic applications. Passive components used in electronic equipment, such as resistors and capacitors, and more complex active components, such as transistors, integrated circuits, hybrid circuits and microprocessors, must be attached and electrically interconnected to perform their specified functions. The Company's products principally relate to mounting and interconnecting components, testing or controlling the flow of electricity among components, boards and/or other assemblies within electronic equipment or systems. In general terms, the Company's products can be applied wherever computer logic is used, either in business or scientific systems or in the numerous products which incorporate computer functions. More specifically, the Company's products are used in computers, computer-aided engineering and manufacturing systems, industrial electronics, test equipment, medical electronics, business equipment, and additional applications in automotive, aerospace, telecommunications and broadband communications - including CATV - markets. Principal Products - ------------------ The Company's products include a broad range of integrated circuit sockets, miniature and subminiature switches, custom connector assemblies for the automotive and telecommunications industries, packaging panels, coaxial cable network and fiberoptic products and related hardware accessories and wire harness assemblies for the automotive industry. Integrated circuit sockets are mechanical devices into which integrated circuits are plugged to provide easy component replacement. The sockets are usually soldered to printed circuit boards by customers in order to connect integrated circuits, including microprocessors, large and very large scale integrated circuits and other dual-in-line packages, onto boards. Several thousand varieties of miniature and subminiature control switches of the toggle, slide, pushbutton and lighted types for use on printed circuit boards or elsewhere in electronic equipment are sold by the Company. Packaging panels are used to interconnect integrated circuits and other components. Each panel consists of a board with one or more copper etched and plated power and ground planes and incorporates sockets in particular patterns for placement of integrated circuits or other components on one side and wire-wrappable interconnections on the other. The Company also provides design and wiring services for purchasers of packaging panels and for the wiring of back planes and interconnection panels manufactured by others and provides spring loaded test probes and test fixtures for use in conjunction with functional board and device testers. The Company is a manufacturer of high density discrete connectors for both conventional board mounting and surface mounting. The Company also manufactures a wide range of interconnection hardware accessories generally used on or in connection with printed circuit boards, such as test jacks and jumpers, relay and crystal sockets, breadboards, racks and enclosures, adaptor plugs and cable assemblies as well as marketing flat cable and related components manufactured by others. The Company is also a major supplier of connectors and electronic packaging modules and wire harnesses to two major U.S. automotive manufacturers and is actively participating in the development of interconnection components for future automotive model years. Such automotive programs include a "mass air flow module", an "actuating assembly" that triggers automatic seatbelts and an "electronic search module" for a luxury car audio system. Products manufactured for the telecommunication industry include central office distribution, remote-switching and cross-connect applications. The Company also is a leading supplier of coaxial connector, fiber optic and broadband products for the cable television and local area network (LAN) markets. Specifically in the CATV market, the Company provides single-part assemblies and connectors as well as line amplifiers to cable system operators who, in turn, construct cable television systems that distribute signals from the head-end to a home. The Company is pursuing market opportunities for its coaxial, broadband and fiber optic products in the rapidly evolving communications technology marketplace. Sources and Availability of Raw Materials - ----------------------------------------- The Company's manufacturing operations utilize a wide variety of mechanical components, raw materials and other supplies. It has multiple commercial sources of supply for all materials which are important to its business. Patents and Licenses - -------------------- The Company owns a number of domestic and foreign patents and has filed a number of additional patent applications. The Company's general policy has been to seek patent protection for those inventions and improvements likely to be incorporated in its products. While the Company believes that its patents and patent applications have value, it considers that its competitive position in the marketplace is not materially dependent upon patent protection and no individual patent or patent application is considered material to future operations. Seasonality - ----------- The only seasonal effect experienced by the Company is in the third quarter of the calendar year and is principally due to vacation shutdowns at selected Company locations and by many of its customers, particularly in Europe. Working Capital - --------------- The Company manufactures and markets a full line of standard catalog items and also an extensive line of special products to meet specific customer needs. In order to maximize its market opportunities, the Company maintains a high level of inventory of both raw materials and finished products. Sales by the Company are generally made on credit and customers typically take 30 to 70 days to make payment; thus, the Company also has significant amounts of money invested in accounts receivable. Despite the high level of accounts receivable and inventory required, the Company has generally been able to finance these assets from current operations. When additional working capital in excess of that generated by the business has been required, the use of short-term borrowings, long-term debt and equity financing have been utilized. The Company's payment terms and the rights of return offered by it to customers and to it by manufacturers vary among such customers and manufacturers, but do not differ substantially from industry practice. The Company has generally allowed credits for returns by customers under appropriate circumstances. Marketing - --------- The Company sells to a broadly diversified group of customers located primarily in the United States, Western Europe, Far East and Canada. Sales are made to industrial and commercial customers within the computer, computer-aided engineering and manufacturing, industrial electronics, test equipment, telecommunications, aerospace, automotive and broadband communication markets. The Company's products are also widely used in both industrial and institutional research laboratories. During 1993 the Company's products and services were sold directly to approximately 5,600 customers and a substantial number of additional customers were served through a network of industrial electronic component distributors. Of total sales 20% was derived from sales through a number of distributors located throughout the world and no distributor accounted for as much as 2% of the Company's sales. One customer, Ford Motor Company, accounted for approximately 28% and another customer for 7% of the Company's sales in 1993; no other customer accounted for more than 4% of sales. The Company markets its products and services through independent sales representatives and direct Company sales personnel working throughout the United States and abroad, including wholly owned marketing subsidiaries in the United Kingdom, France, Germany, Switzerland, Sweden, Italy, Japan, Canada and Australia and sales offices in other areas. In 1993 the Company's international sales amounted to approximately 21% of total sales. Approximately 51% of these sales were derived from Western Europe. The overall net margins on international sales are somewhat less than those obtained on sales made in the United States. The Company's international business is subject to risks customarily encountered in foreign operations, including fluctuations in monetary exchange rates. Backlog - ------- The Company estimates that its backlog of unfilled orders at December 31, 1993 was $104 million compared with $90 million at December 31, 1992. Orders tend to fluctuate during the year according to customer requirements and business conditions, and the backlog level from quarter to quarter does not follow a consistent pattern. Although unfilled orders can be cancelled, the Company's experience has been that the dollar amount of cancelled orders is not material. Substantially all of the backlog is reasonably expected to be shipped within twelve months. Government Contracts - -------------------- The amount of the Company's business that may be subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government is insignificant. Competition - ----------- The Company encounters competition in all areas of its business activity from a number of competitors but does not compete with any one company in all areas. Competitors range from some of the country's largest diversified companies to small and highly specialized firms. The Company competes primarily on the basis of technology, innovation, performance and reliability. Price and company reputation are also important competitive factors. Although there are no precise statistics available, the Company believes it is a principal factor in the markets in which it competes. Research, Development and Engineering - ------------------------------------- The Company maintains a continuous program of design, development and engineering of new products and improvement of existing products to meet the changing needs of its customers. The Company provides engineering assistance to its customers, designing products to fill their individual requirements. The majority of new product development, manufacturing research, quality control development, new equipment development and related research and development expenditures take place in product management groups involving engineering, marketing, manufacturing, quality control and general management personnel. These expenses are included in the categories of marketing, manufacturing and general administrative expenses. In calendar year 1993, 1992 and 1991 expenditures for such research, development and engineering were approximately $19 million, $19 million, and $16 million, respectively. Environmental Affairs - --------------------- The Company's manufacturing facilities are subject to numerous laws and regulations designed to protect the environment. The Company has spent substantial amounts to purchase, install, and operate pollution control equipment and conduct appropriate environmental audits. The Company believes that its efforts in this regard places it in substantial compliance with existing environmental laws and regulations. In connection with the acquisition of National Industries, Inc. in 1991, the Company determined that possible contamination at certain National facilities in Alabama warranted additional study. The Company informed the State of Alabama about the possible contamination and its desire to voluntarily proceed with further study and, if necessary, remediation of the possible contamination. The Company has completed its investigation and provided this information to the State. The State has informed the Company that it believes further investigation is necessary. The Company, however, has considered and disagreed with the State's comments and is voluntarily proceeding to design and implement an appropriate remedy. The Company has included in its financial statements an allowance of $4.7 million for estimated environmental cleanup costs as of December 31, 1993. Employees - --------- The Company had approximately 4,300 employees as of December 31, 1993. None of the employees are covered by collective bargaining agreements and operations have never been interrupted by a work stoppage. The Company believes that relations with its employees are good. The Company also contracts for manufacturing labor and as of December 31, 1993 had approximately 2,000 contract laborers. Financial Information about Foreign and Domestic Operations and Export Sales - ---------------------------------------------------------------------------- Certain financial information concerning domestic and international operations and export sales can be found in Footnote number 10 to the accompanying financial statements of the Registrant which are included under Item 8 hereof. Balance of this page intentionally left blank. The Company believes that its existing facilities are adequate and suitable for the manufacture and sale of its products and have sufficient capacity to meet its current requirements. Machine capacity is adequate although additional machine capacity is currently being added in the business to meet increasing demands for the Company's new products and for ongoing cost reduction programs. The Company anticipates no difficulty in retaining occupancy of any of its manufacturing, office or sales facilities through lease renewals prior to expiration or through month-to-month occupancy, or in replacing them with equivalent facilities. In addition to the above listed properties, the Company leases a small amount of other office/warehouse space in the United States and foreign countries. The amount of such space is not significant. See Note 7 - "Commitments and Contingencies" to the accompanying financial statements of the Registrant which are included under Item 8 hereof for information concerning the Company's obligations under all leases. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS - -------------------------- On April 26, 1985, the Company and its subsidiary, Isotronics, Inc. ("Isotronics"), commenced an action in the Bristol County Superior Court of Massachusetts against Aegis, Inc. ("Aegis"), and a former employee of Isotronics (the "Employee"), seeking damages to be trebled under the Massachusetts statute relating to unfair trade practices (M.G.L. c. 93A) and injunctive relief. The complaint alleged wrongdoing by the defendants in connection with the organization and operation of Aegis, which competed with Isotronics in the manufacture and sale of microcircuit packages. On May 21, 1985, the defendants filed a counterclaim, and added the Chairman of the Board of the Company as an additional defendant. The counterclaim alleged improper interference with a contract of Aegis; the making of disparaging remarks about the Employee and another officer of Aegis; that the action is groundless; and that it was commenced because of personal animosity toward the Employee. The counterclaim seeks damages of $7,500,000 for abuse of process, damages of $50,000 for interference with the contract, and damages of $7,500,000, to be trebled, for violation of the Massachusetts statute relating to unfair trade practices (M.G.L. c 93A). A reply was filed which denied the material allegations of the counterclaim. On May 13, 1985, Aegis commenced an action in the U.S. District Court for the District of Massachusetts. The allegations of the amended complaint in the federal case generally are similar to those of the counterclaim in the Superior Court case, but include an additional claim that the Company and Isotronics had attempted to monopolize interstate commerce in violation of the Sherman Act. The allegations with respect to damages are similar to those of the Superior Court counterclaim. Assets of Isotronics were sold by the Company in May 1989, but all claims relating to the litigation were retained by the Company. On August 31, 1989 the Bristol County Superior Court ruled that Aegis and the Employee violated the Massachusetts statute relating to unfair trade practices. The court ruled further that Aegis and the Employee had failed to prove the counterclaims they had asserted against the Company, Isotronics and an officer of the Company. Aegis and the Employee appealed the decision and on October 1, 1990, the case was argued to the Massachusetts Supreme Judicial Court. The court rendered a decision on January 16, 1991, affirming the trial court's finding of a knowing and willful violation of the Massachusetts Unfair Trade Practices statute. A further trial to determine the amount of damages to be awarded against Aegis and the Employee took place in the Bristol County Superior Court from January 6, 1992 until February 20, 1992. On November 2, 1992, the Court issued a 173 page Memorandum of Decision and Order ("Order"). The Order concluded that the illegal conduct of defendants Aegis and Employee proximately caused the Company to suffer $14,140,000 in lost profits during the period January 1, 1985 until March 31, 1987. In 1987, a joint venture owned by Olin Corporation ("Olin") and Asahi Glass Co, Ltd. purchased the stock of Aegis. Because of alleged indemnity obligations which may run from Olin to the defendant Employee, the Company moved to amend its Complaint and add Olin as a defendant. On November 25, 1992 the court allowed the Company's motion. Olin moved to dismiss that complaint. The Court denied Olin's motion on December 14, 1992. At the same time the Court granted the Company a preliminary injunction restraining Olin from modifying any obligation it may have to defendant Employee. Olin has renewed its objections to the Company's complaint. On December 14, 1992, final judgment was entered entitling the Company to recover from the defendants jointly and severally, the sum of $14,140,000 in compensatory damages, plus costs of $376,632.98, interest of $10,744,460.47, and attorneys' fees of $1,216,188.06, for a total of $26,477,281.51. The judgment also awarded the Company noncompensatory damages of $14,140,000. The judgment also found in favor of the former Chairman of the Board on all counts of the defendants' counterclaims against him. The defendants have appealed the judgment, generally challenging the entire damages decision. The Company has filed a cross appeal limited to the question of whether a portion of the damages award should be assessed against each of the defendants jointly instead of jointly and severally. The appeal of the damages decision was argued before the Supreme Judicial Court in early October 1993, and the Court has not issued its decision. On September 4, 1992, the Company filed suit in the United States District Court for the District of Massachusetts against June M. Collier ("Collier"). This suit arises out of an Agreement of Merger which the Company entered into in August 1991, and through which an Alabama manufacturing company, National Industries, Inc. was merged into Augat National Inc., a wholly owned subsidiary of the Company. The Company alleges that the defendant, who was the sole stockholder of National Industries, breached certain warranties she made in connection with the merger and misrepresented the financial and operating conditions of National Industries. The suit also alleges a violation of Mass. Gen. Laws c. 93A. Collier has answered the company's complaint and asserted counterclaims for breach of contract, breach of the implied covenant of good faith and fair dealing, violation of section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, duress, misrepresentation and violations of Mass. Gen. Laws c. 93A. The Company has responded to Collier's counterclaims and has denied all of the substantive allegations. Management believes that Collier's counterclaims are without merit and will defend them vigorously. Discovery is scheduled to end on June 15, 1994. Trial has been set for August 1, 1994. There are no other material legal proceedings to which the Registrant is a party. Routine litigation incidental to its business is immaterial. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ Not Applicable. PART II ITEM 5 ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - -------------------------------------------------------------------------- The Company's Common Stock is currently traded on the New York Stock Exchange under the symbol "AUG". The Company, in December 1991, suspended its quarterly common stock dividend in order to maintain a strong balance sheet and to ensure Augat's financial long-term objectives. As discussed in Note 3 of the Notes to Consolidated Financial Statements which are included under Item 8 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ------------------------------------------------------------------------ Not Applicable. The balance of this page intentionally left blank. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item concerning directors is incorporated herein by reference pursuant to Rule 12b-23 to the Company's Proxy Statement dated March 24, 1994 with respect to the Annual Meeting of Shareholders to be held April 26, 1994. The executive officers of the Company are elected annually. * Effective, February, 1994 ITEMS 11 AND 12 - EXECUTIVE COMPENSATION AND SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------ The information required by these items is incorporated herein by reference pursuant to Rule 12b-23 to the Company's Proxy Statement dated March 24, 1994 for the Annual Meeting of Shareholders to be held April 26, 1994. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------------------------------------------------------- Not applicable. The balance of this page intentionally left blank. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - ---------------------------------------------------------------- (a) 1. Financial Statements The Financial Statements listed below appear in Part II, Item 8 hereof. Financial Statements: --------------------- Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements (a) 2. Financial Statement Schedules ----------------------------- The Financial Statement Schedules listed below appear in Part II, Item 8 hereof. Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation, and Amortization of Property, Plant and Equipment Schedule VIII- Valuation and Qualifying Accounts Schedule IX - Short-Term Borrowings Schedule X - Supplementary Income Statement Information Schedules not included with this additional financial data have been omitted because of the absence of conditions under which they are required or because the required financial information is included in the financial statements submitted. (a) 3. Exhibits -------- (3) Articles of Incorporation and By-Laws (a) Restated Articles of Organization, as amended. Incorporated by reference to Exhibit 3(a) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. (b) By-Laws, as amended. Incorporated by reference to Exhibit 3(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1987. (4) Instruments Defining the Rights of Security Holders, Including Indentures (a) Specimen certificate representing shares of the Registrant's $.10 par value common stock. Incorporated by reference to Exhibit 4(a) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. (b) Trust Indenture dated as of August 2, 1988 between Augat Inc. and The Chase Manhattan Bank, N.A. as Trustee. Incorporated by reference to Exhibit 2 of the Registrant's Registration Statement on Form 8-A dated August 2, 1988. (10) Material Contracts (a) 1994 Stock Plan (Exhibit 10(a)). (b) 1984 Stock Option and Appreciation Right Plan. Incorporated by reference to Exhibit A to the Proxy Statement dated March 12, 1984 for the Annual Meeting of the Registrant's Shareholders on April 24, 1984. (c) 1987 Stock Option and Appreciation Right Plan. Incorp- orated by reference to Exhibit A to the Registrant's Proxy Statement dated March 25, 1987 for the Annual Meeting of the Registrant's Shareholders held on April 28, 1987. (d) 1989 Stock Plan. Incorporated by reference to Exhibit 10(d) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. (e) Supplementary Employee Retirement Plan. Incorporated by reference to Exhibit 10(c) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1986. (f) Letter of Credit and Reimbursement Agreement among Chemical Bank as Letter of Credit Issuer, Altair International, Inc. as Borrower and Augat Inc. as Guarantor dated as of December 1, 1986. Incorporated by reference to Exhibit 10(f) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1986. (g) Employment Agreement dated January 3, 1991 between the Registrant and Marcel P. Joseph. Incorporated by reference to Exhibit 10(g) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. (h) Augat Inc. Savings and Retirement Plan. Incorporated by reference to Exhibit 10(h) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. (i) Rights Agreement dated as of August 2, 1988 between Augat Inc. and The Chase Manhattan Bank, N.A., Rights Agent. Incorporated by reference to Exhibit 1 of the Registrant's Registration Statement on Form 8-A dated August 2, 1988. (j) Severance Agreements. Incorporated by reference to Exhibit 10(k) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. (k) Deferred Compensation Plan. Incorporated by reference to Exhibit 10(1) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. (l) Supplemental Disability Income Plan. Incorporated by reference to Exhibit 10(m) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. (m) Supplemental Survivor Benefit Plan. Incorporated by reference to Exhibit 10(n) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. (n) Agreement of Merger among Augat Inc., National Industries, Inc. and June M. Collier dated August 30, 1991. Incorporated by reference to Exhibit 2 to the Registrants' Form 8-K filed September 16, 1991. (p) Note Agreement between Augat Inc., as Borrower and Principal Mutual Life Insurance Company and Allstate Life Insurance Company, as Lenders, dated as of February 1, 1992. Incorporated by reference to Exhibit 10(p) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991. (q) Revolving Credit Agreement among Augat Inc., Augat Wiring Systems Inc., Augat Automotive Inc., Augat Communications Group Inc., LRC Electronics Inc., Reed Devices Inc., The First National Bank of Boston, Shawmut Bank, N.A., Chemical Bank and The First National Bank of Boston, as agent, dated as of September 14, 1992. Incorporated by reference to the Exhibit (10.1) to the prospectus included in Registration Statement No. 33- 53600 dated December 2, 1992. (r) 1993 Employee Stock Purchase Plan. Incorporated by reference to Exhibit 10(r) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. (s) Amendment No. 3 to the Revolving Credit Agreement among Augat Inc., Augat Wiring Systems Inc., Augat Automotive Inc., Augat Communication Products Inc., LRC Electronics Inc., Reed Devices Inc., The First National Bank of Boston, Shawmut Bank, N.A., Chemical Bank and The First National Bank of Boston, as agent, dated as of July 9, 1993. (21) Subsidiaries of the Registrant. Exhibit 21. (23) Independent Auditors' Consent. Exhibit 23. (b) Reports on Form 8-K. -------------------- No reports on Form 8-K were filed with the Commission during the last quarter of calendar year 1993. SIGNATURES Pursuant to the requirement 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 of the undersigned thereunto duly authorized. (Registrant) AUGAT INC. --------------------------------------------------------- By /s/ MARCEL P. JOSEPH By /s/ ELLEN B. RICHSTONE --------------------------- --------------------------- Marcel P. Joseph Ellen B. Richstone Chairman of the Board, Vice President & Title Chief Executive Officer Title Chief Financial Officer ----------------------- ----------------------- & President ----------- Date March 24, 1994 -------------------- 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 date indicated.

101265_1993.txt

101265_1993

1993

101265

Item 1. Business - "Competition" and "Arrangements with Other Utilities". Shown below is a summary of the Company's sources and uses of electricity for 1993. TRANSMISSION AND DISTRIBUTION PLANT The transmission lines of the Company consist of approximately 95 circuit miles of overhead lines and approximately 17 circuit miles of underground lines, all operated at 345 KV or 115 KV and located within or immediately adjacent to the territory served by the Company. These transmission lines interconnect the Company's English, Bridgeport Harbor and New Haven Harbor generating stations and are part of the New England transmission grid through connections with the transmission lines of The Connecticut Light and Power Company. A major portion of the Company's transmission lines is constructed on a railroad right-of-way pursuant to a Transmission Line Agreement that expires in May 2000. The Company owns and operates 23 bulk electric supply substations with a capacity of 2,547,000 KVA and 50 distribution substations with a capacity of 288,750 KVA. The Company has 3,113 pole-line miles of overhead distribution lines and 130 conduit-bank miles of underground distribution lines. - 19 - See "Capital Expenditure Program" concerning the estimated cost of additions to the Company's transmission and distribution facilities. SEABROOK The Company has a 17.5% share in Seabrook Unit 1, a 1,150 megawatt nuclear generating unit located in Seabrook, New Hampshire. Eleven other New England electric utilities have ownership shares in Unit 1. After experiencing increasing financial stress beginning in May 1987, Public Service Company of New Hampshire (PSNH), which held the largest ownership share (35.6%) in Seabrook, commenced a proceeding under Chapter 11 of the Bankruptcy Code in January of 1988. Under this statute, PSNH continued its operations while seeking a financial reorganization. A reorganization plan proposed by Northeast Utilities (NU) was confirmed by the bankruptcy court in April of 1990 and, on May 16, 1991, PSNH completed the financing required for payment of its pre-bankruptcy secured and unsecured debt under the first stage of the reorganization plan and emerged from bankruptcy. On May 19, 1992, the NRC issued the final regulatory approval necessary for the second stage of the NU reorganization plan, under which PSNH would be acquired by NU; and on June 5, 1992, this acquisition was completed. As part of the transaction, PSNH's ownership share of Seabrook Unit 1 was transferred to a wholly-owned subsidiary of NU. Two previous regulatory approvals of the NU reorganization plan for PSNH, by the Federal Energy Regulatory Commission (FERC) and the Securities and Exchange Commission (SEC), continue to be challenged in court proceedings, and the Company is unable to predict the outcome of these proceedings. On February 28, 1991, EUA Power Corporation (EUA Power), the holder of a 12.1% ownership share in Seabrook, commenced a proceeding under Chapter 11 of the Bankruptcy Code. EUA Power, a wholly-owned subsidiary of Eastern Utilities Associates (EUA), was organized solely for the purpose of acquiring an ownership share in Seabrook and selling in the wholesale market its share of the electric power produced by Seabrook. EUA Power commenced this bankruptcy proceeding because the cash generated by its sales of power at current market prices was insufficient to pay its obligations on its outstanding debt. Subsequently, EUA Power's name was changed to Great Bay Power Corporation (Great Bay). The official committee of Great Bay's bondholders (Bondholders Committee) has proposed, and the bankruptcy court has confirmed, a reorganization plan for Great Bay, under which substantially all of the equity ownership of Great Bay would pass to its bondholders. On February 2, 1994, the Bondholders Committee accepted a financing proposal that would inject $35 million of new ownership equity into Great Bay. The bankruptcy court must approve this structure before the Great Bay reorganization plan becomes effective. Further approvals are also required from the NRC, FERC and the New Hampshire Public Utilities Commission. The bankruptcy court has approved an agreement among Great Bay, the Bondholders Committee, UI and The Connecticut Light and Power Company (CL&P), under which up to $20 million in advance payments against their respective future monthly Seabrook payment obligations will be made available between UI and CL&P as needed until the reorganization plan becomes effective. UI's share of funding obligations under this agreement totals $8 million. As of December 31, 1993, $5.5 million had been advanced by UI under this agreement. At January 31, 1994, $602,000 of the Company's advances remained outstanding. This agreement can be terminated by UI and CL&P upon thirty days notice or upon failure of the reorganization process to achieve certain milestones by specified dates. UI is unable to predict what impact, if any, failure of the reorganization plan to become effective will have on the operating license for Seabrook Unit 1, or what other actions UI and the other joint owners of the unit may be required to take in response to developments in this bankruptcy proceeding as it may affect Seabrook. Nuclear generating units are subject to the licensing requirements of the Nuclear Regulatory Commission (NRC) under the Atomic Energy Act of 1954, as amended, and a variety of other state and federal requirements. Although Seabrook Unit 1 has been issued a 40-year operating license, NRC proceedings and investigations prompted by inquiries from Congressmen and by NRC licensing board consideration of technical contentions may arise and continue for an indefinite period of time in the future. See "Nuclear Generation". - 20 - CAPITAL EXPENDITURE PROGRAM The Company's 1994-1998 capital expenditure program, excluding allowance for funds used during construction (AFUDC) and its effect on certain capital related items, is presently budgeted as follows: - 21 - NUCLEAR GENERATION General UI holds ownership and leasehold interests in Seabrook Unit 1 (17.5%) and Millstone Unit 3 (3.685%). UI also owns 9.5% of the common stock of Connecticut Yankee and is entitled to 9.5% of the generating capability of its nuclear generating unit. Each of these nuclear generating units is subject to the licensing requirements and jurisdiction of the NRC under the Atomic Energy Act of 1954, as amended, and to a variety of other state and federal requirements. The NRC regularly conducts generic reviews of numerous technical issues, ranging from seismic design to education and fitness for duty requirements for licensed plant operators. The outcome of reviews that are currently pending, and the ways in which the nuclear generating units in which UI has interests may be affected by these reviews, cannot be determined; and the cost of complying with any new requirements that might result from the reviews cannot be estimated. However, such costs could be substantial. Additional capital expenditures and increased operating costs for the nuclear generating units in which UI has interests may result from modifications of these facilities or their operating procedures required by the NRC, or from actions taken by other joint owners or companies having entitlements in the units. Some equipment modifications have required and may in the future require shutdowns or deratings of the generating units that would not otherwise be necessary and that result in additional costs for replacement power. The amounts of additional capital expenditures, increased operating costs and replacement power costs cannot now be predicted, but they have been and may in the future be substantial. Public controversy concerning nuclear power could also adversely affect the nuclear generating units in which UI has interests. Proposals to force the premature shutdown of nuclear plants in other New England states have received serious attention, and the licensing of Seabrook Unit 1 was a regional issue. The continuing controversy can be expected to increase the costs of operating the nuclear generating units in which UI has interests; and it is possible that one or more of the units could be shut down prematurely. Insurance Requirements The Price-Anderson Act, currently extended through August 1, 2002, limits public liability resulting from a single incident at a nuclear power plant. The first $200 million of liability coverage is provided by purchasing the maximum amount of commercially available insurance. Additional liability coverage will be provided by an assessment of up to $75.5 million per incident, levied on each of the nuclear units licensed to operate in the United States, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. In addition, if the sum of all public liability claims and legal costs resulting from any nuclear incident exceeds the maximum amount of financial protection, each reactor operator can be assessed an additional 5% of $75.5 million, or $3.775 million. The maximum assessment is adjusted at least every five years to reflect the impact of inflation. Based on its interests in nuclear generating units, the Company estimates its maximum liability would be $20.3 million per incident. However, assessment would be limited to $3.1 million per incident, per year. With respect to each of the operating nuclear generating units in which the Company has an interest, the Company will be obligated to pay its ownership and/or leasehold share of any statutory assessment resulting from a nuclear incident at any nuclear generating unit. The NRC requires nuclear generating units to obtain property insurance coverage in a minimum amount of $1.06 billion and to establish a system of prioritized use of the insurance proceeds in the event of a nuclear incident. The system requires that the first $1.06 billion of insurance proceeds be used to stabilize the nuclear reactor to prevent any significant risk to public health and safety and then for decontamination and cleanup operations. Only following completion of these tasks would the balance, if any, of the segregated insurance proceeds become available to the unit's owners. For each of the nuclear generating units in which the Company has an interest, the Company is required to pay its ownership and/or leasehold share of the cost of purchasing such insurance. - 22- Waste Disposal and Decommissioning Costs associated with nuclear plant operations include amounts for disposal of nuclear wastes, including spent fuel, and for the ultimate decommissioning of the plants. Under the Nuclear Waste Policy Act of 1982, the federal Department of Energy (DOE) is required to design, license, construct and operate a permanent repository for high level radioactive wastes and spent nuclear fuel. The Act requires the DOE to provide, beginning in 1998, for the disposal of spent nuclear fuel and high level radioactive waste from commercial nuclear plants through contracts with the owners and generators of such waste; and the DOE has established disposal fees that are being paid to the federal government by electric utilities owning or operating nuclear generating units. In return for payment of the prescribed fees, the federal government is to take title to and dispose of the utilities' high level wastes and spent nuclear fuel beginning no later than 1998. However, the DOE has announced that its first high level waste repository will not be in operation earlier than 2010, notwithstanding the DOE's statutory and contractual responsibility to begin disposal of high-level radioactive waste and spent fuel beginning not later than January 31, 1998. Until the federal government begins receiving such materials in accordance with the Nuclear Waste Policy Act, operating nuclear generating units will need to retain high level wastes and spent fuel on-site or make other provisions for their storage. Storage facilities for Millstone Unit 3 are expected to be adequate for the projected life of the unit. Storage facilities for the Connecticut Yankee unit are expected to be adequate through the mid-1990s. Storage facilities for Seabrook Unit 1 are expected to be adequate until at least 2010. Fuel consolidation and compaction technologies are being developed and are expected to provide adequate storage capability for the projected lives of the latter two units. In addition, other licensed technologies, such as dry storage casks, can accommodate spent fuel storage requirements. Disposal costs for low-level radioactive wastes (LLW) that result from normal operation of nuclear generating units have increased significantly in recent years and are expected to continue to rise. The cost increases are functions of increased packaging and transportation costs and higher fees and surcharges charged by the disposal facilities. Pursuant to the Low-Level Radioactive Waste Policy Act of 1980, each state was responsible for providing disposal facilities for LLW generated within the state and was authorized to join with other states into regional compacts to jointly fulfill their responsibilities. Pursuant to the Low-Level Radioactive Waste Policy Amendments Act of 1985, each state in which a currently operating disposal facility is located (South Carolina, Nevada and Washington) is allowed to impose volume limits and a surcharge on shipments of LLW from states that are not members of the compact in the region in which the facility is located. On June 19, 1992, the United States Supreme Court issued a decision upholding certain parts of the Low-Level Radioactive Waste Policy Amendments Act of 1985, but invalidating a key provision of that law requiring each state to take title to LLW generated within that state if the state fails to meet federally- mandated deadlines for siting LLW disposal facilities. The decision has resulted in uncertainty about states' continuing roles in siting LLW disposal facilities and may result in increased LLW disposal costs and the need for longer interim LLW storage before a permanent solution is developed. The Connecticut Hazardous Waste Management Service (the Service), a state quasi-public corporation, was charged with coordinating the establishment of a facility for disposal of LLW originating in Connecticut. In June 1991, the Service announced that it had selected three potential sites in north-central Connecticut for further study. The Service's announcement provoked intense controversy in the affected municipalities and resulted in legislative action to stop the selection process. On February 1, 1993, the Service presented the legislature with a new site selection plan under which communities are urged to volunteer a site for a facility in return for financial and other incentives. The volunteer process is being continued in 1994. The Service's activities in this regard are funded by assessments on Connecticut's LLW generators. Due to a change in the volunteer process, there was no assessment for the 1993-1994 fiscal year and the state projects no assessment for the 1994-1995 and 1995-1996 fiscal years. Additional LLW storage capacity has been or can be constructed or acquired at the Millstone and Connecticut Yankee sites to provide for temporary storage of LLW should that become necessary. Connecticut - 23 - LLW can be managed by volume reduction, storage or shipment at least through 1999. The Company cannot predict whether and when a disposal site will be designated in Connecticut. The State of New Hampshire has not met deadlines for compliance with the Low-Level Radioactive Waste Policy Act, and Seabrook Unit 1 has been denied access to existing disposal facilities. Therefore, LLW generated by Seabrook Unit 1 is being stored on- site. The Seabrook storage facility currently has capacity to store approximately five years' accumulation of waste generated by Seabrook, and the plant operator plans to expand its storage capacity as necessary. NRC licensing requirements and restrictions are also applicable to the decommissioning of nuclear generating units at the end of their service lives, and the NRC has adopted comprehensive regulations concerning decommissioning planning, timing, funding and environmental reviews. UI and the other owners of the nuclear generating units in which UI has interests estimate decommissioning costs for the units and attempt to recover sufficient amounts through their allowed electric rates to cover expected decommissioning costs. Changes in NRC requirements or technology can increase estimated decommissioning costs, and UI's customers in future years may experience higher electric rates to offset the effects of any insufficient rate recovery in prior years. New Hampshire has enacted a law requiring the creation of a government-managed fund to finance the decommissioning of nuclear generating units in that state. The New Hampshire Nuclear Decommissioning Financing Committee (NDFC) established $345 million (in 1993 dollars) as the decommissioning cost estimate for Seabrook Unit 1. This estimate premises the prompt removal and dismantling of the Unit at the end of its estimated 40-year energy producing life. Monthly decommissioning payments are being made to the state-managed decommissioning trust fund. UI's share of the decommissioning payments made during 1993 was $1.3 million. UI's share of the fund at December 31, 1993 was approximately $3.7 million. Connecticut has enacted a law requiring the operators of nuclear generating units to file periodically with the DPUC their plans for financing the decommissioning of the units in that state. Current decommissioning cost estimates for Millstone Unit 3 and Connecticut Yankee are $421 million (in 1994 dollars) and $324 million (in 1994 dollars), respectively. These estimates premise the prompt removal and dismantling of each unit at the end of its estimated 40-year energy producing life. Monthly decommissioning payments, based on these cost estimates, are being made to decommissioning trust funds managed by Northeast Utilities. UI's share of the Millstone Unit 3 decommissioning payments made during 1993 was $328,000. UI's share of the fund at December 31, 1993 was approximately $1.9 million. For the Company's 9.5% equity ownership in Connecticut Yankee, decommissioning costs of $1.3 million were funded by UI during 1993, and UI's share of the fund at December 31, 1993 was $9.5 million. Item 3. Legal Proceedings. See Item 2. Item 4. Submission of Matters to a Vote of Security Holders. There were no matters submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ended December 31, 1993. - 25 - EXECUTIVE OFFICERS OF THE COMPANY The names and ages of all executive officers of the Company and all such persons chosen to become executive officers, all positions and offices with the Company held by each such person, and the period during which he or she has served as an officer in the office indicated, are as follows: - 26 - There is no family relationship between any director, executive officer, or person nominated or chosen to become a director or executive officer of the Company. All executive officers of the Company hold office during the pleasure of the Company's Board of Directors and Messrs. Grossi, Fiscus and Crowe have each entered into an employment agreement with the Company. There is no arrangement or understanding between any executive officer of the Company and any other person pursuant to which such officer was selected as an officer. A brief account of the business experience during the past five years of each executive officer of the Company is as follows: Richard J. Grossi. Mr. Grossi served as President and Chief Operating Officer during the period January 1, 1989 to May 1, 1991. He has served as Chairman of the Board of Directors and Chief Executive Officer since May 1, 1991. Robert L. Fiscus. Mr. Fiscus served as Executive Vice President and Chief Financial Officer of the Company during the period January 1, 1989 to May 1, 1991. He has served as President and Chief Financial Officer since May 1, 1991. James F. Crowe. Mr. Crowe served as Senior Vice President-Marketing of the Company during the period January 1, 1989 to May 1, 1992, and as Executive Vice President from May 1, 1992 to January 1, 1994. He has served as Executive Vice President and Chief Customer Officer since January 1, 1994. Walter E. Barker. Mr. Barker served as Superintendent of Transmission and Distribution of the Company during the period January 1, 1989 to July 23, 1990, and as Vice President-Transmission and Distribution Engineering and Operations from July 23, 1990 to January 1, 1994. He has served as Vice President-Transmission and Distribution since January 1, 1994. Rita L. Bowlby. Ms. Bowlby has served as Vice President- Corporate Affairs since February 1, 1993. Prior to joining the Company, during the period from January 1, 1989 to February 1, 1993, she served as President of Bowlby & Associates, a business- to-business communications agency in Farmington, Connecticut. Stephen F. Goldschmidt. Mr. Goldschmidt served as Vice President-Planning from January 1, 1989 to January 1, 1994. He has served as Vice President-Information Resources since January 1, 1994. Albert N. Henricksen. Mr. Henricksen served as Vice President-Engineering of the Company during the period January 1, 1989 to July 23, 1990, and as Vice President-Human and Environmental Resources from July 23, 1990 to January 1, 1994. He has served as Vice President-Administration since January 1, 1994. David W. Hoskinson. Mr. Hoskinson served as Senior Vice President-Operations of the Company during the period January 1, 1989 to July 23, 1990, and as Senior Vice President-Generation Engineering and Operations from July 23, 1990 to January 1, 1994. He has served as Vice President-Generation since January 1, 1994. Robert H. Hyde. Mr. Hyde has served as Vice President-Customer Services of the Company since January 1, 1989. E. Jon Majkowski. Mr. Majkowski served as Vice President-Public Affairs of the Company during the period January 1, 1989 to May 1, 1992. He has served as Vice President since May 1, 1992. Anthony J. Vallillo. Mr. Vallillo served as Director of Sales and Market Development of the Company during the period January 1, 1989 to December 1, 1990, and as Director of Marketing from December 1, 1990 to June 1, 1992. He has served as Vice President-Marketing since June 1, 1992. James L. Benjamin. Mr. Benjamin has served as Controller of the Company since January 1, 1989. - 27 - Kurt D. Mohlman. Mr. Mohlman served as Director of Financial Planning during the period January 1, 1989 to September 1, 1990 and as Director of Financial Planning and Investor Relations from September 1, 1990 to January 1, 1994. He has served as Treasurer and Secretary of the Company since January 1, 1994. Charles J. Pepe. Mr. Pepe served as Director of Financing during the period January 1, 1989 to January 1, 1994. He has served as Assistant Treasurer and Assistant Secretary of the Company since January 1, 1994. - 28 - PART II Item 5. Item 5. Market for the Company's Common Equity and Related Stockholder Matters. UI's Common Stock is traded on the New York Stock Exchange, where the high and low sale prices during 1993 and 1992 were as follows: UI has paid quarterly dividends on its Common Stock since 1900. The quarterly dividends declared in 1992 and 1993 were at a rate of 64 cents per share and 66 1/2 cents per share, respectively. The indenture under which the Company's Medium-Term Notes and Notes are issued places limitations on the payment of cash dividends on common stock and on the purchase or redemption of common stock. Retained earnings in the amount of $82.6 million were free from such limitations at December 31, 1993. As of January 31, 1994, there were 21,919 Common Stock shareowners of record. - 29 - - 30 - - 31 - - 32 - - 33 - Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. MAJOR INFLUENCES ON FINANCIAL CONDITION The Company's financial condition should continue to improve as a result of the December 16, 1992 rate decision by the DPUC. The DPUC decision granted levelized rate increases of 2.66% ($15.8 million) in 1993 and 2.66% (an additional $17.3 million) in 1994. However, the Company's financial condition will continue to be dependent on the level of retail and wholesale sales. The two primary factors that affect sales volume are economic conditions and weather. The regional recession has restricted retail sales growth and been largely responsible for a weak wholesale sales market during the past two years. Sales increases due to economic recovery would help to increase the Company's earnings. Another major factor affecting the Company's financial condition will be the Company's ability to control expenses. A significant reduction in interest expense has been achieved since 1989, and additional savings of $10 million are expected in 1994 due to debt refinancing. Since 1990, annual growth in total operation and maintenance expense, excluding one-time items and cogeneration capacity purchases, has averaged approximately 2.7%, and the Company hopes to restrict future increases to less than the rate of inflation. LIQUIDITY AND CAPITAL RESOURCES The Company's capital requirements are presently projected as follows: The Company presently estimates that its cash on hand and temporary cash investments at the beginning of 1994, totaling $48.2 million, and its projected net cash provided by operations, less dividends, of $102 million, less capital expenditures of $73.4 million, will be insufficient to fund the Company's 1994 requirements for long-term debt maturities and mandatory redemptions and repayments, amounting to $113.3 million, by $36 million. The Company currently anticipates that its projected net cash provided by operations, less dividends and capital expenditures, for 1995 will be insufficient to fund the Company's 1995 requirements for long-term debt maturities and mandatory redemptions and repayments, by approximately $138 million. The Company currently anticipates that its projected net cash provided by operations, less dividends and capital expenditures, for 1996 through 1998 will be insufficient to fund the Company's requirements for long-term debt maturities and mandatory redemptions and repayments in the years 1996 through 1998, in amounts that cannot now be predicted accurately, but which may be substantial in the aggregate, depending on the levels of the Company's sales, wholesale and retail rates, operation and maintenance costs and taxes. All of the Company's capital requirements that exceed available net cash will have to be provided by external financing; and the Company has no commitment to provide such financing from any source of funds. The Company expects to be able to satisfy its external financing needs by issuing common stock and additional short-term and long-term debt, although the continued availability of these methods of financing will be dependent on many factors, including conditions in the securities markets, economic conditions, and the level of the Company's income and cash flow. - 34 - At December 31, 1993, the Company had $48.2 million of cash and temporary cash investments, an increase of $37.1 million from the balance at December 31, 1992. The components of this increase, which are detailed in the Consolidated Statement of Cash Flows, are summarized as follows: The Company has a revolving credit agreement with a group of banks, which currently extends to January 19, 1995. The borrowing limit of this facility is $75 million. The facility permits the Company to borrow funds at a fluctuating interest rate determined by the prime lending market in New York, and also permits the Company to borrow money for fixed periods of time specified by the Company at fixed interest rates determined by the Eurodollar interbank market in London, by the certificate of deposit market in New York, or by bidding, at the Company's option. If a material adverse change in the business, operations, affairs, assets or condition, financial or otherwise, or prospects of the Company and its subsidiaries, on a consolidated basis, should occur, the banks may decline to lend additional money to the Company under this revolving credit agreement, although borrowings outstanding at the time of such an occurrence would not then become due and payable. As of December 31, 1993, the Company had no short-term borrowings outstanding under this facility. The Company's long-term debt instruments do not limit the amount of short-term debt that the Company may issue. The Company's revolving credit agreement described in the previous paragraph requires it to maintain an available earnings/interest charges ratio of not less than 1.5:1.0 for each 12-month period ending on the last day of each calendar quarter. The Company had a $50 million term loan facility with a group of banks during 1993. Under this agreement, the Company chose an interest rate from among three alternatives: (i) a fluctuating interest rate determined by the prime lending market in New York; (ii) a fixed interest rate determined by the Eurodollar interbank market in London; and (iii) a fixed interest rate determined by the certificate of deposit market in New York. On February 1, 1993, the Company borrowed $50 million from this group of banks, using the proceeds to repay short-term borrowings and other current obligations. On December 3, 1993, the Company repaid the $50 million borrowing and terminated the agreement. The Company had a term loan agreement with PruLease, Inc. (PruLease) that expired on December 1, 1993. This agreement was executed on December 31, 1992, when the Company borrowed $49.1 million from PruLease and purchased all the nuclear fuel that was owned by PruLease and leased to the Company on that date. This - 35 - loan, which was collateralized by a first lien on the Company's ownership interest in the nuclear fuel for Seabrook Unit 1, was repaid in full at maturity. The Company has a Fossil Fuel Supply Agreement with a financial institution providing for financing up to $37.5 million in fossil fuel purchases. Under this agreement, the financing entity acquires and stores natural gas, coal and fuel oil for sale to the Company, and the Company purchases these fossil fuels from the financing entity at a price for each type of fuel that reimburses the financing entity for the direct costs it has incurred in purchasing and storing the fuel, plus a charge for maintaining an inventory of the fuel determined by reference to the fluctuating interest rate on thirty-day, dealer-placed commercial paper in New York. The Company is obligated to insure the fuel inventories and to indemnify the financing entity against all liabilities, taxes and other expenses incurred as a result of its ownership, storage and sale of fossil fuel to the Company. This agreement currently extends to February 1995. At December 31, 1993, approximately $10.1 million of fossil fuel purchases were being financed under this agreement. UI has four wholly-owned subsidiaries. Bridgeport Electric Company, a single-purpose corporation, owns and leases to UI a generating unit at Bridgeport Harbor Station. Research Center, Inc. (RCI) has been formed to participate in the development of one or more regulated power production ventures, including possible participation in arrangements for the future development of independent power production and cogeneration facilities. United Energy International, Inc. (UEI) has been formed to facilitate participation in a proposed joint venture relating to power production plants abroad. United Resources, Inc. (URI) serves as the parent corporation for several unregulated businesses, each of which is incorporated separately to participate in business ventures that will complement and enhance UI's electric utility business and serve the interests of the Company and its shareholders and customers. Four wholly-owned subsidiaries of URI have been incorporated. Souwestcon Properties, Inc. is participating as a 25% partner in the ownership of a medical hotel building in New Haven. A second wholly-owned subsidiary of URI is Thermal Energies, Inc., which is participating in the development of district heating and cooling water facilities in the downtown New Haven area, including the energy center for an office tower and participation as a 37% partner in the energy center for a new city hall and office tower complex. A third URI subsidiary, Precision Power, Inc., provides power-related equipment and services to the owners of commercial buildings and industrial facilities. A fourth URI subsidiary, American Payment Systems, Inc., manages agents and equipment for electronic data processing of bill payments made by customers of utilities, including UI, at neighborhood businesses. In addition to these subsidiaries, URI also has an 82% ownership interest in Ventana Corporation (Ventana), which offers energy conservation engineering and project management services to governmental and private institutions. In September 1993, URI recorded a $1.2 million after-tax write off of outstanding debt owed to URI by Ventana, which represented the difference between the amount owed to URI by Ventana and the value of an additional equity interest in Ventana received by URI in November 1993. This additional equity interest in Ventana was received in exchange for the forgiveness of debt owed to URI by Ventana. The Board of Directors of the Company has authorized the investment of a maximum of $13.5 million, in the aggregate, of the Company's assets in all of URI's ventures, UEI and RCI, and, at December 31, 1993, approximately $10.6 million had been so invested. RESULTS OF OPERATIONS 1993 vs. 1992 - ------------- Earnings for the year 1993 were $36.2 million, or $2.57 per share, down $16.3 million, or $1.19 per share, from 1992. This decrease reflects a one-time reorganizational charge of approximately $7.8 million after-tax, or $.56 per share, and the non-recurrence of one-time gains of $.59 per share in 1992. Earnings per share for 1993, excluding one-time items and accounting changes, decreased by $.04 per share, to $3.13 per share from $3.17 per share for 1992. - 36 - Sales margin increased by $10.3 million for the year. Retail revenues increased $36.6 million; $20.7 million from a recent rate decision ($12.1 million from rate changes and $13.2 million for the fold-in to base rates of the 1992 sales adjustment revenues, partly offset by the pass through to customers of expense credits of $4.6 million), and $15.9 million from increased retail sales. Retail sales increased by 2.7%, mostly due to a return to more normal summer weather. The retail revenue increases were offset by anticipated reductions of $21 million from the sales adjustment provision and $13.7 million in wholesale capacity revenues. Other operating revenues decreased by $0.3 million. Reductions in wholesale energy revenues of $15.8 million were directly offset by reductions in energy expense. Other factors affecting sales margin were lower retail fuel expense, increasing margin by $9.4 million, and higher revenue related taxes, decreasing margin by $0.6 million. Other operation and maintenance expenses, including purchased capacity charges, increased by $10.2 million, or 4.5%, in 1993 relative to 1992. Major generating station overhauls and unscheduled repairs accounted for $5.2 million of this increase. Employment costs increased by $4.0 million, most of which resulted from the adoption of a liability for postretirement benefits other than pensions that the implementation of Statement of Financial Accounting Standards (SFAS) No. 106 requires to be accrued over employees' careers. Purchased capacity charges (cogeneration and Connecticut Yankee power purchases) for 1993 increased by $4.0 million, transmission costs increased by $2.4 million; but other nuclear operation and maintenance expenses decreased by $4.0 million. Other operating expenses, including income taxes but excluding a 1993 fourth quarter one-time reorganization charge, decreased by $20.3 million in 1993 from 1992, as the effect of accounting treatments ordered in recent rate decisions for recovery of canceled plant, the flow-through to income of certain income tax benefits and lower property taxes more than offset increases in depreciation expense. Other income declined by $23 million in 1993 from 1992, $9.4 million of which was attributable to the absence of net one-time gains realized in 1992. The remainder was due primarily due to an expected decline in deferred revenue and income tax benefits associated with the DPUC's 1992 rate decision, offset, in part, by lower interest charges of $9.3 million. "Net" interest margin (interest income less interest expense) improved by $6.6 million in 1993 over 1992. 1992 vs. 1991 - ------------- Earnings for 1992 were $52.4 million, or $3.76 per share, up $1.4 million, or $.09 per share, over 1991. Earnings per share for 1992, excluding one-time items and accounting changes, increased by $.27, to $3.17 from $2.90 per share for 1991. Non-recurring earnings declined to a level of $.59 per share in 1992 from $.77 per share in 1991. Operating revenues in 1992, exclusive of retail and wholesale fuel recovery revenue, were up $4.3 million over 1991 levels, adding $.18 per share after taxes. Increased rates provided only $11 million of an expected annual $15 million revenue increase, because commercial and industrial customers shifted into lower priced time-of-use rates. An additional $6 million of revenue was accrued under the terms of the sales adjustment provisions of the Company's 1990 rate decision by the Department of Public Utility Control (DPUC). Retail sales volume declined 1.6% from the prior year, reducing retail revenues by $10.6 million and sales margin (revenue minus fuel expense and revenue-based taxes) by $7.4 million. Most of this decline reflected the cool, wet weather for the summer of 1992. On a weather-adjusted basis, retail sales were about even with 1991. Wholesale capacity sales declined by $2.1 million for the year, reflecting the end of a major contract in October 1992. Other sales margin improvements were derived from increased nuclear generation, which added $10.5 million to margin in 1992 over 1991. An overall capacity factor of 76% for the nuclear units was achieved in 1992, compared to 65% for 1991. Offsetting this gain, the Company experienced unusually low and intermittent demand by the New England Power Pool for the operation of the Company's fossil generating units, thus - 37 - degrading their efficiency, increasing fuel expense and decreasing sales margin by $2.5 million from 1991. These amounts are not recoverable through the fuel adjustment clause. Operation, maintenance and capacity expense for 1992 nuclear generation declined only $1.7 million from 1991 levels, compared to a savings of $4-5 million the Company originally expected to realize (principally from reduced Seabrook expenses). Other operation and maintenance expenses, excluding fuel and energy expenses, increased by $2.6 million for the year (excluding net non-recurring charges for 1992). Other taxes increased by $3.7 million (excluding a one-time charge in 1991), reflecting primarily the increased property tax placed on Seabrook by the State of New Hampshire. Depreciation increased by $2.5 million in 1992 over 1991. Net changes in interest income and expense added $2.9 million to pre-tax income in 1992, excluding one-time credits in 1991 and 1992. Reductions in plant balances not in rate base (Seabrook and other) led to reductions in deferred revenue of about $4 million after-tax. Non-recurring items decreased by $.18 per share compared to 1991 levels, to a net earnings figure of $.59 per share. In 1992, a net $2.7 million in income, or $.19 per share, was booked for Seabrook Unit 1 adjustments; $3.6 million, or $.26 per share, in non-operating income tax credits were realized; a net $3.0 million in income, or $.21 per share, from a gain on the sale of property was realized; and there were one-time charges to operating expenses of a net $1.0 million, for a loss of $.07 per share. OUTLOOK The Company's financial condition should continue to improve as a result of the December 16, 1992 retail rate decision by the DPUC. The DPUC decision granted levelized rate increases of 2.66% ($15.8 million) in 1993 and 2.66% (an additional $17.3 million) in 1994. However, the Company did not realize the full anticipated benefit of the 1993 rate increase, realizing about $4 million less than awarded due to differences between the sales realized in individual rate classes and the sales projections used for rate case purposes. The differences arose principally from rate class shifting by customers and differential growth in sales among rate classes. A similar shortfall may develop in 1994. The Company's financial condition will continue to be dependent on the level of retail and wholesale sales. The two primary factors that affect sales volume are economic conditions and weather. The regional recession has restricted retail sales growth and been largely responsible for a weak wholesale sales market during the past two years. Sales increases due to economic recovery would help to increase the Company's earnings. A 1% increase in sales would add about $6 million in revenue and about $5 million in sales margin (revenue minus fuel expense and revenue- based taxes). Wholesale capacity sales are expected to be approximately $6 million in 1994. Another major factor affecting the Company's financial condition will be the Company's ability to control expenses. Fuel expense, excluding wholesale fuel expense, is expected to decline by approximately $2.3 million in 1994 from the 1993 level, reflecting significantly lower nuclear fuel prices. Also, significant reductions in interest expense have been achieved since 1989, and additional savings of $10 million are expected in 1994 due to debt refinancing. For 1994, operation and maintenance expenses are expected to increase from normal inflationary pressures, but these increases should be substantially offset by savings from the phase-in of the Company's corporate structure reorganization. Since 1990, annual growth in total operation and maintenance expense, excluding one-time items and cogeneration capacity purchases, has averaged approximately 2.7%, and the Company hopes to restrict future increases to less than the rate of inflation. The final portion of the cost of Seabrook Unit 1 has been added to rate base (and retail revenues) for 1994. This will eliminate deferred revenues and reduce net income by $7.4 million after-tax in 1994 from 1993 levels. Although the Company believes that its financing outlook and plans are unlikely to be adversely affected by further developments with respect to the licensing and operation of Seabrook Unit 1, the Company's financial status and financing capability will continue to be sensitive to any such developments and to many other factors, including conditions in the securities markets, economic conditions, the level of the Company's income and cash - 38 - flow, and legislative and regulatory developments, including the cost of compliance with increasingly stringent environmental legislation and regulations and competition within the electric utility industry. INFLATION As a result of inflation and increased environmental and regulatory requirements, the estimated cost of replacing the Company's productive capacity today would substantially exceed the historical cost of such facilities reported in the financial statements. Since the Company's rates for service to its customers have been based in the past on the cost of providing such service and have been revised from time to time to reflect increased costs of service, the Company believes that any higher replacement costs it may experience in the future will be recovered through the normal regulatory process. - 39 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 40 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 41 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 42 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 43 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 44 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (A) STATEMENT OF ACCOUNTING POLICIES Accounting Records The accounting records are maintained in accordance with the uniform systems of accounts prescribed by the Federal Energy Regulatory Commission (FERC) and the Connecticut Department of Public Utility Control (DPUC). Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Bridgeport Electric Company (BEC), United Resources Inc., United Energy International, Inc. and Research Center, Inc. Intercompany accounts and transactions have been eliminated in consolidation. Reclassification of Previously Reported Amounts Certain amounts previously reported have been reclassified to conform with current year presentations. Utility Plant The cost of additions to utility plant and the cost of renewals and betterments are capitalized. Cost consists of labor, materials, services and certain indirect construction costs, including an allowance for funds used during construction (AFUDC). The cost of current repairs and minor replacements is charged to appropriate operating expense accounts. The original cost of utility plant retired or otherwise disposed of and the cost of removal, less salvage, are charged to the accumulated provision for depreciation. Allowance for Funds Used During Construction In accordance with the applicable regulatory systems of accounts, the Company capitalizes AFUDC, which represents the approximate cost of debt and equity capital devoted to plant under construction. In accordance with FERC prescribed accounting, the portion of the allowance applicable to borrowed funds is presented in the Consolidated Statement of Income as a reduction of interest charges, while the portion of the allowance applicable to equity funds is presented as other income. Although the allowance does not represent current cash income, it has historically been recoverable under the ratemaking process over the service lives of the related properties. The Company compounds semi-annually the allowance applicable to major construction projects. AFUDC rates in effect for 1993, 1992 and 1991 were 8.75%, 10.25% and 10.88%, respectively. Depreciation Provisions for depreciation on utility plant for book purposes, excluding costs associated with the 1984 reconversion of BEC's plant to a dual-fired capability, are computed on a straight-line basis, using estimated service lives determined by independent engineers. One-half year's depreciation is taken in the year of addition and disposition of utility plant, except in the case of major operating units on which depreciation commences in the month they are placed in service and ceases in the month they are removed from service. During the years 1985-1989, depreciation associated with BEC's reconversion costs was computed on an annuity basis over the original ten-year period that this plant was being leased to the Company by BEC. Commencing January 1, 1990, the reconversion costs are being depreciated on a straight-line basis over a period ending July 2000. The aggregate annual provisions for depreciation for the years 1993, 1992 and 1991 were equivalent to approximately 3.22%, 3.15% and 3.10%, respectively, of the original cost of depreciable property. - 45 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Income Taxes Effective January 1, 1993, the Company adopted SFAS 109, "Accounting for Income Taxes". In accordance with SFAS 109, the Company has provided deferred taxes for all temporary book-tax differences using the liability method. The liability method requires that deferred tax balances be adjusted to reflect enacted future tax rates that are anticipated to be in effect when the temporary differences reverse. In accordance with generally accepted accounting principles for regulated industries, the Company has established a net regulatory asset that reflects anticipated future recovery in rates of these deferred tax provisions. For ratemaking purposes, the Company practices full normalization for all investment tax credits (ITC) related to recoverable plant investments except for the ITC related to Seabrook Unit 1, which was taken into income in accordance with provisions of the 1989 Settlement Agreement. Accrued Utility Revenues The estimated amount of utility revenues (less related expenses and applicable taxes) for service rendered but not billed is accrued at the end of each accounting period. Cash and Cash Equivalents For cash flow purposes, the Company considers all highly liquid debt instruments with a maturity of three months or less at the date of purchase to be cash equivalents. The Company is required to maintain an operating deposit with the project disbursing agent related to its 17.5% ownership interest in Seabrook Unit 1. This operating deposit, which is the equivalent to one and one half months of the funding requirement for operating expenses, is restricted for use and amounted to $3.4 million, $2.9 million, and $1.8 million at December 31, 1993, 1992 and 1991, respectively. Investments The Company's investment in the Connecticut Yankee Atomic Power Company joint venture, a nuclear generating company in which the Company has a 9 1/2% stock interest, is accounted for on an equity basis. Fossil Fuel Costs The amount of fossil fuel costs that cannot be reflected currently in customers' bills pursuant to the FCA in the Company's rates is deferred at the end of each accounting period. Since adoption of the deferred accounting procedure in 1974, rate decisions by the DPUC and its predecessors have consistently made specific provision for amortization and rate-making treatment of the Company's existing deferred fossil fuel cost balances. Research and Development Costs Research and development costs, including environmental studies, are capitalized if related to specific construction projects and depreciated over the lives of the related assets. Other research and development costs are charged to expense as incurred. Pension and Other Post-Employment Benefits The Company accounts for normal pension plan costs in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 87, "Employers' Accounting for Pensions", and for supplemental - 46 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) retirement plan costs and supplemental early retirement plan costs in accordance with the provisions of SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits". Prior to January 1, 1993, the Company accounted for other post- employment benefits, consisting principally of health and life insurance, on a pay-as-you-go basis. Effective January 1, 1993, the Company commenced accounting for these costs under the provisions of SFAS No. 106, "Employers' Accounting for Post- Retirement Benefits Other than Pensions", which requires, among other things, that the liability for such benefits be accrued over the employment period that encompasses eligibility to receive such benefits. The annual incremental cost of this accounting change has been allowed in retail rates in accordance with a 1992 rate decision. Uranium Enrichment Obligation Under the Energy Policy Act of 1992 (Energy Act), the Company will be assessed for its proportionate share of the costs of the decontamination and decommissioning of uranium enrichment facilities operated by the Department of Energy. The Energy Act imposes an overall cap of $2.25 billion on the obligation assessed to the nuclear utility industry and limits the annual assessment to $150 million each year over a 15-year period. At December 31, 1993, the Company's unfunded share of the obligation, based on its ownership interest in Seabrook Unit 1 and Millstone Unit 3, was approximately $1.5 million. Effective January 1, 1993, the Company was allowed to recover these assessments in rates as a component of fuel expense. Accordingly, the Company has recognized these costs as a regulatory asset on its Consolidated Balance Sheet. Nuclear Decommissioning Trusts External trust funds are maintained to fund the estimated future decommissioning costs of the nuclear generating units in which the Company has an ownership interest. These costs are accrued as a charge to depreciation expense over the estimated service lives of the units and are recovered in rates on a current basis. The Company paid $1,616,000, $1,334,000 and $1,011,000 during 1993, 1992 and 1991 into the decommissioning trust funds for Seabrook Unit 1 and Millstone Unit 3. At December 31, 1993, the Company's share of the trust fund balances, which include accumulated earnings on the funds, were $3.7 million and $1.9 million for Seabrook Unit 1 and Millstone Unit 3, respectively. These fund balances are included in "Other Property and Investments" and the accrued decommissioning obligation is included in "Noncurrent Liabilities" on the Company's Consolidated Balance Sheet. - 47 - - 48 - - 49 - - 50 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (a) Common Stock The Company issued 46,000 shares of common stock in 1993, 100,800 shares of common stock in 1992 and 44,600 shares of common stock in 1991 pursuant to a stock option plan. During 1993, the Company also issued 4,143 shares of common stock pursuant to a long-term incentive program. Common stock, no par value, authorized at December 31, 1993, included 400,000 shares reserved for the Company's Employee Stock Ownership Plan (ESOP). There were no additions to ESOP in 1991, 1992 or 1993. The Company purchased on the open market, on behalf of shareholders participating in the common stock Dividend Reinvestment Plan, 148,362 shares of stock in 1991, 136,679 shares of stock in 1992 and 138,145 shares of stock in 1993. In 1990, the Company's Board of Directors and the shareowners approved a stock option plan for officers and key employees of the Company. The plan provides for the awarding of options to purchase up to 750,000 shares of the Company's common stock over periods of from one to ten years following the dates when the options are granted. On June 5, 1991, the DPUC approved the issuance of 500,000 shares of stock pursuant to this plan. The exercise price of each option cannot be less than the market value of the stock on the date of the grant. Options to purchase 214,000 shares of stock at an exercise price of $30.75 per share, 2,800 shares of stock at an exercise price of $28.3125 per share, 1,800 shares of stock at an exercise price of $31.1875 per share, 4,000 shares of stock at an exercise price of $35.625 per share, 36,200 shares of stock at an exercise price of $39.5625 per share and 5,000 shares of stock at an exercise price of $42.375 per share have been granted by the Board of Directors and remain outstanding at December 31, 1993. Options to purchase 44,600 shares of stock at an exercise price of $30.75 were exercised during 1991. Options to purchase 98,000 shares of stock at an exercise price of $30.75 and 2,800 shares of stock at an exercise price of $28.3125 were exercised during 1992. Options to purchase 42,400 shares of stock at an exercise price of $30.75 per share, 1,400 shares of stock at an exercise price of $28.3125 per share, 1,200 shares of stock at an exercise price of $31.1875 per share and 1,000 shares of stock at an exercise price of $35.625 per share were exercised during 1993. In addition, certain executive officers were eligible to earn shares of the Company's common stock, based upon the dividend and market performance of the stock compared to a peer group of electric utilities over a four-year period ending December 31, 1992, under the Company's long-term incentive program. The issuance of shares of stock pursuant to this program received DPUC approval on June 5, 1991. The total number of shares of common stock that could have been earned under the long-term incentive program was limited to 7,091. For the four-year period ending December 31, 1992, 6,027 shares of the Company's common stock were earned. Of this amount, a total of 4,143 shares were issued to the participants in 1993, and the remainder was distributed in an equivalent amount of cash based on the closing price of the Company's Common Stock on March 1, 1993, pursuant to the terms of the long-term incentive program. This program ended as of December 31, 1992. (b) Retained Earnings Restriction The indenture under which the Company's Medium-Term Notes and Notes are issued places limitations on the payment of cash dividends on common stock and on the purchase or redemption of common stock. Retained earnings in the amount of $82.6 million were free from such limitations at December 31, 1993. (c) Preferred and Preference Stock The par value of each of these issues was credited to the appropriate stock account and expenses related to these issues were charged to capital stock expense. - 51 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) In 1991, the Company purchased and cancelled shares of its $100 par value Preferred Stock, at a discount, resulting in a non-taxable addition to common equity of approximately $3,304,000. The 1991 purchases consisted of: 9,575 shares of 4.35% Preferred Stock, Series A 7,320 shares of 4.72% Preferred Stock, Series B 39,900 shares of 4.64% Preferred Stock, Series C 13,800 shares of 5 5/8% Preferred Stock, Series D In 1992, the Company purchased and cancelled 16,950 shares of its $100 par value 4.72% Preferred Stock, Series B, at a discount, resulting in a non-taxable addition to common equity of approximately $796,650. There was no redemption of preferred stock in 1993. Shares of preferred stock have preferential dividend and liquidation rights over shares of common stock. Preferred shareholders are not entitled to general voting rights. However, if any preferred dividends are in arrears for six or more quarters, or if some other event of default occurs, preferred shareholders are entitled to elect a majority of the Board of Directors until all preferred dividend arrears are paid and any event of default is terminated. Preference stock is a form of stock that is junior to preferred stock but senior to common stock. It is not subject to the earnings coverage requirements or minimum capital and surplus requirements governing the issuance of preferred stock. There were no shares of preference stock outstanding at December 31, 1993. (d) Long-Term Debt In January 1993, the net proceeds from the liquidation of an investment in tax-exempt municipal debt instruments were used to pay $60 million principal amount of maturing 10.32% First Mortgage Bonds of the Company's wholly-owned subsidiary, Bridgeport Electric Company; to repay a $7.5 million 13.1% term loan; to repay short- term borrowings incurred for the August 1, 1992 redemption of the Company's 12% Debentures, due August 1, 2017, and for repayment of a $7.5 million 12.9% term loan on September 30, 1992; and to repay short-term borrowings incurred for a $19.1 million rent payment on December 31, 1992 under the Company's facility sale and leaseback arrangement for a portion of its ownership interest in Seabrook Unit 1. On September 30, 1993, the Company repaid a $5 million 12.9% term loan with funds obtained through short-term borrowings. On September 17, 1993, the Company invited the owners of $68,400,000 aggregate principal amount of 14 1/2% Pollution Control Revenue Bonds, due October 1 and December 1, 2009, ("Bonds") to sell to the Company, for cash, any and all of the Bonds. The Bonds were issued in 1984 by The Industrial Development Authority of the State of New Hampshire ("NHIDA"), which loaned the issue proceeds to the Company to pay for the cost of installing pollution control facilities at the Seabrook nuclear generating plant in New Hampshire; and the Business Finance Authority of the State of New Hampshire ("NHBFA"), successor to the NHIDA, agreed to issue Pollution Control Refunding Revenue Bonds ("Refunding Bonds") in a principal amount equal to the aggregate principal amount of Bonds purchased by the Company and surrendered to the Bond trustee for cancellation, and to loan the issue proceeds of the Refunding Bonds to the Company to pay for part of the purchase price of the Bonds being purchased and cancelled. On October 15, 1993, the Company accepted offers from holders of $64,460,000 aggregate principal amount of the Bonds to sell them for an aggregate purchase price of $75,710,000. On October 26, 1993, the NHBFA issued and sold $64,460,000 principal amount of 5 7/8% Refunding Bonds, due October 1, 2033, and loaned the issue proceeds to the Company, which used them to pay - 52 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) a portion of the purchase price of the Bonds. The remainder of the purchase price was funded with the proceeds of short-term borrowings. On December 7, 1993, the Company issued and sold $100 million principal amount of five-year and one month Notes at a coupon rate of 6.20%. The net proceeds were used to repay $60 million principal amount of maturing 10.32% First Mortgage Bonds of the Company's wholly-owned subsidiary, Bridgeport Electric Company in January 1994; to repay a $5 million 13.1% term loan in January 1994 and for general corporate purposes, including repayment of short-term borrowings. Maturities and mandatory redemptions/repayments and annual interest expense on existing long-term debt are set forth below: (C) RATE-RELATED REGULATORY PROCEEDINGS On December 16, 1992, the DPUC approved levelized rate increases of 2.66% ($15.8 million) for 1993 and 2.66% (an additional $17.3 million) for 1994, including allowed conservation and load management revenue increases. The rate increases totaled $33.1 million, or 5.4%, over two years. In order to achieve levelized 2.66% rate increases for each of these two years, the DPUC determined that the recovery of $13.1 million of sales adjustment clause revenues would be deferred from 1993 to 1994. Utilities are entitled by Connecticut law to revenues sufficient to allow them to cover their operating and capital costs, to attract needed capital and maintain their financial integrity, while also protecting the public interest. Accordingly, the DPUC's 1992 rate decision authorized a return on equity of 12.4% for ratemaking purposes. However, the Company may earn up to 1% above this level before a mandatory review is required by the DPUC. - 53 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Since January 1971, UI has had a fossil fuel adjustment clause (FCA) in virtually all of its retail rates. The DPUC is required by law to convene an administrative proceeding prior to approving FCA charges or credits for each month. The law permits automatic implementation of the charges or credits if the DPUC fails to act within five days of the administrative proceeding, although all such charges and credits are also subject to further review and appropriate adjustment by the DPUC at public hearings required to be held at least every three months. The DPUC has made no material changes in UI's FCA charges and credits as the result of any of these proceedings or hearings. (D) ACCOUNTING FOR PHASE-IN PLAN The Company has been phasing into rate base its allowable investment in Seabrook Unit 1, amounting to $640 million, since January 1, 1990. In conjunction with this phase-in plan, the Company has been allowed to record a deferred return on the portion of allowable investment excluded from rate base during the phase-in period. The accumulated deferred return has been added to rate base each year since January 1, 1991 in the same proportion as the phase-in installment for that year has borne to the portion of the $640 million remaining to be phased-in. On January 1, 1994, the Company phased into rate base the remaining $74.5 million of allowable investment, plus the remaining $28.2 million of accumulated deferred return. The Company will be allowed to recover the accumulated deferred return, amounting to $62.9 million, over a five-year period commencing January 1, 1995. - 54 - - 55 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Total income taxes differ from the amounts computed by applying the federal statutory tax rate to income before taxes. The reasons for the differences are as follows: At December 31, 1993, the Company had deferred tax liabilities for taxable temporary differences of $574 million and deferred tax assets for deductible temporary differences of $149 million, resulting in a net deferred tax liability of $425 million. Significant components of deferred tax liabilities and assets were as follows: tax liabilities on book/tax plant basis differences, $229 million; tax liabilities on the cumulative amount of income taxes on temporary differences previously flowed through to ratepayers, $163 million; tax liabilities on normalization of book/tax depreciation timing differences, $89 million and tax assets on the disallowance of plant costs, $77 million. The Tax Reform Act of 1986 provides for a more comprehensive corporate alternative minimum tax (AMT) for years beginning after 1986. To the extent that the AMT exceeds the federal income tax computed at statutory rates, the excess must be paid in addition to the regular tax liability. For tax purposes, the excess paid in any year can be carried forward indefinitely and offset against any future year's regular tax liability in excess of that year's tentative AMT. The AMT carryforward at December 31, 1993, 1992 and 1991 was $11.4 million, $11.3 million and $9.9 million, respectively. (F) SHORT-TERM CREDIT ARRANGEMENTS The Company has a revolving credit agreement with a group of banks, which currently extends to January 19, 1995. The borrowing limit of this facility is $75 million. The facility permits the Company to borrow funds at a fluctuating interest rate determined by the prime lending market in New York, and also permits the Company to borrow money for fixed periods of time specified by the Company at fixed interest rates determined by the Eurodollar interbank market in London, by the certificate of deposit market in New York, or by bidding, at the - 56 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Company's option. If a material adverse change in the business, operations, affairs, assets or condition, financial or otherwise, or prospects of the Company and its subsidiaries, on a consolidated basis, should occur, the banks may decline to lend additional money to the Company under this revolving credit agreement, although borrowings outstanding at the time of such an occurrence would not then become due and payable. As of December 31, 1993, the Company had no short-term borrowings outstanding under this facility. The Company's long-term debt instruments do not limit the amount of short-term debt that the Company may issue. The Company's revolving credit agreement described in the previous paragraph requires it to maintain an available earnings/interest charges ratio of not less than 1.5:1.0 for each 12-month period ending on the last day of each calendar quarter. The Company had a $50 million term loan facility with a group of banks during 1993. Under this agreement, the Company chose an interest rate from among three alternatives: (i) a fluctuating interest rate determined by the prime lending market in New York; (ii) a fixed interest rate determined by the Eurodollar interbank market in London; and (iii) a fixed interest rate determined by the certificate of deposit market in New York. On February 1, 1993, the Company borrowed $50 million from this group of banks, using the proceeds to repay short-term borrowings and other current obligations. On December 3, 1993, the Company repaid the $50 million borrowing and terminated the agreement. The Company had a term loan agreement with PruLease, Inc. (PruLease) that expired on December 1, 1993. This agreement was executed on December 31, 1992, when the Company borrowed $49.1 million from PruLease and purchased all the nuclear fuel that was owned by PruLease and leased to the Company on that date. This loan, which was collateralized by a first lien on the Company's ownership interest in the nuclear fuel for Seabrook Unit 1, was repaid in full at maturity. The Company has a Fossil Fuel Supply Agreement with a financial institution providing for financing up to $37.5 million in fossil fuel purchases. Under this agreement, the financing entity acquires and stores natural gas, coal and fuel oil for sale to the Company, and the Company purchases these fossil fuels from the financing entity at a price for each type of fuel that reimburses the financing entity for the direct costs it has incurred in purchasing and storing the fuel, plus a charge for maintaining an inventory of the fuel determined by reference to the fluctuating interest rate on thirty-day, dealer-placed commercial paper in New York. The Company is obligated to insure the fuel inventories and to indemnify the financing entity against all liabilities, taxes and other expenses incurred as a result of its ownership, storage and sale of fossil fuel to the Company. This agreement currently extends to February 1995. At December 31, 1993, approximately $10.1 million of fossil fuel purchases were being financed under this agreement. - 57 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Information with respect to short-term borrowings is as follows: - 58 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) (G) SUPPLEMENTARY INFORMATION - 59 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (H) PENSION AND OTHER POST-EMPLOYMENT BENEFITS The Company's qualified pension plan, which is based on the highest three years of pay, covers substantially all of its employees, and its entire cost is borne by the Company. The Company also has a non-qualified supplemental plan for certain executives and a non-qualified retiree only plan for certain early retirement benefits. The net pension costs for these plans for 1993, 1992 and 1991 were $14,966,000, $5,749,000 and $2,054,000, respectively. The Company's funding policy for the qualified plan is to make annual contributions that satisfy the minimum funding requirements of ERISA but which do not exceed the maximum deductible limits of the Internal Revenue Code. These amounts are determined each year as a result of an actuarial valuation of the Plan. In accordance with this policy, the Company will be contributing $3.3 million in 1994 for 1993 funding requirements. Previously, due to the application of the full funding limitation under ERISA, the Company had not been required to make a contribution since 1985. The supplemental plan is unfunded. The qualified plan's irrevocable trust fund consists principally of equity and fixed-income securities and real estate investments in approximately the following percentages: - 60 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - 61 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) In addition to providing pension benefits, the Company also provides other postretirement benefits (OPEB), consisting principally of health care and life insurance benefits, for retired employees and their dependents. Employees with 25 years of service are eligible for full benefits, while employees with less than 25 years of service but greater than 15 years of service are entitled to partial benefits. Years of service prior to age 35 are not included in determining the number of years of service. Prior to January 1, 1993, the Company recognized the cost of providing OPEB on a pay-as-you-go basis by expensing the annual insurance premiums. These costs amounted to $1.3 million and $1.1 million for 1992 and 1991, respectively. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions", which requires, among other things, that OPEB costs be recognized over the employment period that encompasses eligibility to receive such benefits. In its December 16, 1992 decision on the Company's application for retail rate relief, the DPUC recognized the Company's obligation to adopt SFAS No. 106, effective January 1, 1993, and approved the Company's request for revenues to recover OPEB expenses on a SFAS No. 106 basis. A portion of these expenses represents the transition obligation, which will accrue over a 20-year period, representing the future liability for medical and life insurance benefits based on past service for retirees and active employees. For funding purposes, the Company has established two Voluntary Employees' Benefit Association Trusts (VEBA) to fund OPEB for employees who retire on or after January 1, 1994; one VEBA for union employees and one for non-union employees. Approximately 52% of the Company's employees are represented by Local 470-1, Utility Workers Union of America, AFL-CIO, for collective bargaining purposes. The funding policy assumes contributions to these trust funds to be the total OPEB expense under SFAS No. 106, excluding the amount that resulted from the reorganization minus pay-as-you- go benefit payments for pre-January 1, 1994 retirees, allocated in a manner that minimizes current income tax liability, without exceeding maximum tax deductible limits. In accordance with this policy, the Company contributed approximately $3 million to the union VEBA on December 30, 1993. The Company currently plans to fund the portion of the OPEB expense that is related to the reorganization during the years 1994-1996. The 1993 cost for OPEB includes the following components: A one percentage point increase in the assumed health care cost trend rate would have increased the service cost and interest cost components of the 1993 net cost of periodic postretirement benefit by approximately $445,000 and would increase the accumulated postretirement benefit obligation for health care benefits by approximately $2,421,000. - 62 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The following table reconciles the funded status of the plan with the amount recognized in the Consolidated Balance Sheet as of December 31, 1993: The weighted average discount rate used to measure the accumulated postretirement benefit obligation was 7.5%. During 1993, in conjunction with a in-depth organizational review, the Company offered a voluntary early retirement program to non-union employees who were eligible to receive pension benefits. This offer was accepted by 103 employees. The 1993 OPEB cost for this program was $1.267 million. These costs are recognized as a component of the reorganizational charge shown on the Company's Consolidated Statement of Income. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Post-Employment Benefits". This statement, which will be adopted during the first quarter of 1994, establishes accounting standards for employers who provide benefits, such as unemployment compensation, severance benefits and disability benefits, to former or inactive employees after employment but before retirement and requires recognition of the obligation for these benefits. The adoption of this new standard will result in a pre-tax charge against earnings amounting to approximately $2 million during the first quarter of 1994. Subsequent period costs are not expected to be material. - 63 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (I) JOINTLY OWNED PLANT At December 31, 1993, the Company had the following interests in jointly owned plants: The Company's share of the operating costs of jointly owned plants is included in the appropriate expense captions in the Consolidated Statement of Income. (J) UNAMORTIZED CANCELLED NUCLEAR PROJECT From December 1984 through December 1992, the Company had been recovering its investment in Seabrook Unit 2 over a regulatory approved ten-year period without a return on its unamortized investment. In the Company's 1992 rate decision, the DPUC adopted a proposal by the Company to write off its remaining investment in Seabrook Unit 2, beginning January 1, 1993, over a 24-year period, corresponding with the flowback of certain Connecticut Corporation Business Tax (CCBT) credits. Such decision will allow the Company to retain the Seabrook Unit 2/CCBT amounts for ratemaking purposes, with the accumulated CCBT credits not deducted from rate base during the 24-year period of amortization in recognition of a longer period of time for amortization of the Seabrook Unit 2 balance. (K) FUEL FINANCING OBLIGATIONS AND OTHER LEASE OBLIGATIONS The Company has a Fossil Fuel Supply Agreement with a financial institution providing for financing up to $37.5 million in fossil fuel purchases. Under this agreement, the financing entity acquires and stores natural gas, coal and fuel oil for sale to the Company, and the Company purchases these fossil fuels from the financing entity at a price for each type of fuel that reimburses the financing entity for the direct costs it has incurred in purchasing and storing the fuel, plus a charge for maintaining an inventory of the fuel determined by reference to the fluctuating interest rate on thirty-day, dealer-placed commercial paper in New York. The Company is obligated to insure the fuel inventories and to indemnify the financing entity against all liabilities, taxes and other expenses incurred as a result of its ownership, storage and sale of fossil fuel to the Company. This agreement currently extends to February 1995. At December 31, 1993, approximately $10.1 million of fossil fuel purchases were being financed under this agreement. The Company has leases (some of which are capital leases), including arrangements for data processing and office equipment, vehicles, office space and oil tanks. The gross amount of assets recorded under capital leases and the related obligations of those leases as of December 31, 1993 are recorded on the balance sheet. Future minimum lease payments under capital leases, excluding the Seabrook sale/leaseback transaction, which is being treated as a long-term financing, are estimated to be as follows: - 64 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Capitalization of leases has no impact on income, since the sum of the amortization of a leased asset and the interest on the lease obligation equals the rental expense allowed for ratemaking purposes. Rental payments charged to operating expenses in 1993, 1992 and 1991 amounted to $14.1 million, $14.8 million and $14.9 million, respectively. Operating leases, which are charged to operating expense, consist of a large number of small, relatively short-term, renewable agreements for a wide variety of equipment. (L) COMMITMENTS AND CONTINGENCIES Capital Expenditure Program The Company has entered into commitments in connection with its continuing capital expenditure program, which is presently estimated at approximately $366.5 million, excluding AFUDC, for 1994 through 1998. Seabrook After experiencing increasing financial stress beginning in May 1987, Public Service Company of New Hampshire (PSNH), which held the largest ownership share (35.6%) in Seabrook, commenced a proceeding under Chapter 11 of the Bankruptcy Code in January of 1988. Under this statute, PSNH continued its operations while seeking a financial reorganization. A reorganization plan proposed by Northeast Utilities (NU) was confirmed by the bankruptcy court in April of 1990 and, on May 16, 1991, PSNH completed the financing required for payment of its pre-bankruptcy secured and unsecured debt under the first stage of the reorganization plan and emerged from bankruptcy. On May 19, 1992, the NRC issued the final regulatory approval necessary for the second stage of the NU reorganization plan, under which PSNH would be acquired by NU; and on June 5, 1992, this acquisition was completed. As part of the transaction, PSNH's ownership share of Seabrook Unit 1 was transferred to a wholly-owned subsidiary of NU. Two previous regulatory approvals of the NU reorganization plan for PSNH, by the Federal Energy Regulatory Commission (FERC) and the Securities and Exchange Commission (SEC), continue to be challenged in court proceedings, and the Company is unable to predict the outcome of these proceedings. On February 28, 1991, EUA Power Corporation (EUA Power), the holder of a 12.1% ownership share in Seabrook, commenced a proceeding under Chapter 11 of the Bankruptcy Code. EUA Power, a wholly-owned subsidiary of Eastern Utilities Associates (EUA), was organized solely for the purpose of acquiring an ownership share in Seabrook and selling in the wholesale market its share of the electric power produced by Seabrook. EUA Power commenced this bankruptcy proceeding because the cash generated by its sales of power at current market prices was insufficient to pay its obligations on its outstanding debt. Subsequently, EUA Power's name - 65 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) was changed to Great Bay Power Corporation (Great Bay). The official committee of Great Bay's bondholders (Bondholders Committee) has proposed, and the bankruptcy court has confirmed, a reorganization plan for Great Bay, under which substantially all of the equity ownership of Great Bay would pass to its bondholders. On February 2, 1994, the Bondholders Committee accepted a financing proposal that would inject $35 million of new ownership equity into Great Bay. The bankruptcy court must approve this structure before the Great Bay reorganization plan becomes effective. Further approvals are also required from the NRC, FERC and the New Hampshire Public Utilities Commission. The bankruptcy court has approved an agreement among Great Bay, the Bondholders Committee, UI and The Connecticut Light and Power Company (CL&P), under which up to $20 million in advance payments against their respective future monthly Seabrook payment obligations will be made available between UI and CL&P as needed until the reorganization plan becomes effective. UI's share of funding obligations under this agreement totals $8 million. As of December 31, 1993, $5.5 million had been advanced by UI under this agreement. At January 31, 1994, $602,000 of the Company's advances remained outstanding. This agreement can be terminated by UI and CL&P upon thirty days notice or upon failure of the reorganization process to achieve certain milestones by specified dates. UI is unable to predict what impact, if any, failure of the reorganization plan to become effective will have on the operating license for Seabrook Unit 1, or what other actions UI and the other joint owners of the unit may be required to take in response to developments in this bankruptcy proceeding as it may affect Seabrook. Nuclear generating units are subject to the licensing requirements of the Nuclear Regulatory Commission (NRC) under the Atomic Energy Act of 1954, as amended, and a variety of other state and federal requirements. Although Seabrook Unit 1 has been issued a 40-year operating license, NRC proceedings and investigations prompted by inquiries from Congressmen and by NRC licensing board consideration of technical contentions may arise and continue for an indefinite period of time in the future. Nuclear Insurance Contingencies The Price-Anderson Act, currently extended through August 1, 2002, limits public liability resulting from a single incident at a nuclear power plant. The first $200 million of liability coverage is provided by purchasing the maximum amount of commercially available insurance. Additional liability coverage will be provided by an assessment of up to $75.5 million per incident, levied on each of the nuclear units licensed to operate in the United States, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. In addition, if the sum of all public liability claims and legal costs resulting from any nuclear incident exceeds the maximum amount of financial protection, each reactor operator can be assessed an additional 5% of $75.5 million, or $3.775 million. The maximum assessment is adjusted at least every five years to reflect the impact of inflation. Based on its interests in nuclear generating units, the Company estimates its maximum liability would be $20.3 million per incident. However, assessment would be limited to $3.1 million per incident, per year. With respect to each of the operating nuclear generating units in which the Company has an interest, the Company will be obligated to pay its ownership and/or leasehold share of any statutory assessment resulting from a nuclear incident at any nuclear generating unit. The NRC requires nuclear generating units to obtain property insurance coverage in a minimum amount of $1.06 billion and to establish a system of prioritized use of the insurance proceeds in the event of a nuclear incident. The system requires that the first $1.06 billion of insurance proceeds be used to stabilize the nuclear reactor to prevent any significant risk to public health and safety and then for decontamination and cleanup operations. Only following completion of these tasks would the balance, if any, of the segregated insurance proceeds become available to the unit's owners. For each of the nuclear generating units in which the Company has an interest, the Company is required to pay its ownership and/or leasehold share of the cost of purchasing such insurance. - 66 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Other Commitments and Contingencies Hydro-Quebec The Company is a participant in the Hydro-Quebec transmission intertie facility linking New England and Quebec, Canada. Phase II of this facility, in which UI has a 5.45% participating share, has increased the capacity value of the intertie from 690 megawatts to a maximum of 2000 megawatts. A ten-year Firm Energy Contract, which provides for the sale of 7 million megawatt-hours per year by Hydro-Quebec to the New England participants in the Phase II facility, became effective on July 1, 1991. The Company is obligated to furnish a guarantee for its participating share of the debt financing for the Phase II facility. Currently, the Company's guarantee liability for this debt amounts to approximately $9.8 million. Reorganization Charge During 1993, the Company undertook an in-depth organizational review with the primary objective of improving customer service. As a result of this review, the Company eliminated approximately 75 positions. In conjunction with this review, the Company offered a voluntary early retirement program to non-union employees who were eligible to receive pension benefits. The early retirement offer was accepted by 103 employees and the Company incurred a one-time charge to 1993 earnings of approximately $13.6 million ($7.8 million, after-tax). No decision has been made as to whether to offer a severance program to employees who may be affected by the organizational review when it is completed, but who were not eligible for, or did not accept, the early retirement offer. Site Remediation Costs The Company has estimated that the cost of environmental remediation of its decommissioned Steel Point Station property in Bridgeport will be approximately $10.3 million and has recorded a liability for this cost. Following remediation, the Company intends to sell the property for development for a value it estimates will not exceed $6 million. In the Company's last rate decision, the DPUC provided additional revenues to recover the $4.3 million difference during the period 1993-1996, subject to true-up in the Company's next retail rate proceeding, based on actual remediation costs and the actual gain on the sale of the property. Property Taxes In November 1993, the Company received "updated" personal property tax bills from the City of New Haven (the City) for the tax year 1991-1992, aggregating $6.6 million, based on an audit by the City's tax assessor. The Company anticipates receiving additional bills of this sort for the tax years 1992-1993 and 1993-1994, the amounts of which cannot be predicted at this time. The Company is contesting these tax bills vigorously and has commenced an action in the Superior Court to enjoin the City from any effort to collect these tax bills. Due to a lack of data, it is not possible, at this time, to assess accurately the Company's liability, if any. (M) NUCLEAR FUEL DISPOSAL AND NUCLEAR PLANT DECOMMISSIONING Costs associated with nuclear plant operations include amounts for disposal of nuclear wastes, including spent fuel, and for the ultimate decommissioning of the plants. Under the Nuclear Waste Policy Act of 1982, the federal Department of Energy (DOE) is required to design, license, construct and operate a permanent repository for high level radioactive wastes and spent nuclear fuel. The Act requires the DOE to provide, beginning in 1998, for the disposal of spent nuclear fuel and high level radioactive waste from commercial nuclear plants through contracts with the owners and generators of such waste; and the DOE has established disposal - 67 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) fees that are being paid to the federal government by electric utilities owning or operating nuclear generating units. In return for payment of the prescribed fees, the federal government is to take title to and dispose of the utilities' high level wastes and spent nuclear fuel beginning no later than 1998. However, the DOE has announced that its first high level waste repository will not be in operation earlier than 2010, notwithstanding the DOE's statutory and contractual responsibility to begin disposal of high-level radioactive waste and spent fuel beginning not later than January 31, 1998. Until the federal government begins receiving such materials in accordance with the Nuclear Waste Policy Act, operating nuclear generating units will need to retain high level wastes and spent fuel on-site or make other provisions for their storage. Storage facilities for Millstone Unit 3 are expected to be adequate for the projected life of the unit. Storage facilities for the Connecticut Yankee unit are expected to be adequate through the mid-1990s. Storage facilities for Seabrook Unit 1 are expected to be adequate until at least 2010. Fuel consolidation and compaction technologies are being developed and are expected to provide adequate storage capability for the projected lives of the latter two units. In addition, other licensed technologies, such as dry storage casks, can accommodate spent fuel storage requirements. Disposal costs for low-level radioactive wastes (LLW) that result from normal operation of nuclear generating units have increased significantly in recent years and are expected to continue to increase. The cost increases are functions of increased packaging and transportation costs and higher fees and surcharges charged by the disposal facilities. Pursuant to the Low-Level Radioactive Waste Policy Act of 1980, each state was responsible for providing disposal facilities for LLW generated within the state and was authorized to join with other states into regional compacts to jointly fulfill their responsibilities. Pursuant to the Low-Level Radioactive Waste Policy Amendments Act of 1985, each state in which a currently operating disposal facility is located (South Carolina, Nevada and Washington) is allowed to impose volume limits and a surcharge on shipments of LLW from states that are not members of the compact in the region in which the facility is located. On June 19, 1992, the United States Supreme Court issued a decision upholding certain parts of the Low-Level Radioactive Waste Policy Amendments Act of 1985, but invalidating a key provision of that law requiring each state to take title to LLW generated within that state if the state fails to meet federally-mandated deadlines for siting LLW disposal facilities. The decision has resulted in uncertainty about states' continuing roles in siting LLW disposal facilities and may result in increased LLW disposal costs and the need for longer interim LLW storage before a permanent solution is developed. The Connecticut Hazardous Waste Management Service (the Service), a state quasi-public corporation, was charged with coordinating the establishment of a facility for disposal of LLW originating in Connecticut. In June 1991, the Service announced that it had selected three potential sites in north-central Connecticut for further study. The Service's announcement provoked intense controversy in the affected municipalities and resulted in legislative action to stop the selection process. On February 1, 1993, the Service presented the legislature with a new site selection plan under which communities are urged to volunteer a site for a facility in return for financial and other incentives. The volunteer process is being continued in 1994. The Service's activities in this regard are funded by assessments on Connecticut's LLW generators. Due to a change in the volunteer process, there was no assessment for the 1993-1994 fiscal year and the state projects no assessment for the 1994-1995 and 1995-1996 fiscal years. Additional LLW storage capacity has been or can be constructed or acquired at the Millstone and Connecticut Yankee sites to provide for temporary storage of LLW should that become necessary. Connecticut LLW can be managed by volume reduction, storage or shipment at least through 1999. The Company cannot predict whether and when a disposal site will be designated in Connecticut. The State of New Hampshire has not met deadlines for compliance with the Low-Level Radioactive Waste Policy Act, and Seabrook Unit 1 has been denied access to existing disposal facilities. Therefore, LLW generated - 68 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) by Seabrook Unit 1 is being stored on-site. The Seabrook storage facility currently has capacity to store approximately five years' accumulation of waste generated by Seabrook, and the plant operator plans to expand its storage capacity as necessary. NRC licensing requirements and restrictions are also applicable to the decommissioning of nuclear generating units at the end of their service lives, and the NRC has adopted comprehensive regulations concerning decommissioning planning, timing, funding and environmental reviews. UI and the other owners of the nuclear generating units in which UI has interests estimate decommissioning costs for the units and attempt to recover sufficient amounts through their allowed electric rates to cover expected decommissioning costs. Changes in NRC requirements or technology can increase estimated decommissioning costs, and UI's customers in future years may experience higher electric rates to offset the effects of any insufficient rate recovery in prior years. New Hampshire has enacted a law requiring the creation of a government-managed fund to finance the decommissioning of nuclear generating units in that state. The New Hampshire Nuclear Decommissioning Financing Committee (NDFC) established $345 million (in 1993 dollars) as the decommissioning cost estimate for Seabrook Unit 1. This estimate premises the prompt removal and dismantling of the Unit at the end of its estimated 40-year energy producing life. Monthly decommissioning payments are being made to the state-managed decommissioning trust fund. UI's share of the decommissioning payments made during 1993 was $1.3 million. UI's share of the fund at December 31, 1993 was approximately $3.7 million. Connecticut has enacted a law requiring the operators of nuclear generating units to file periodically with the DPUC their plans for financing the decommissioning of the units in that state. Current decommissioning cost estimates for Millstone Unit 3 and Connecticut Yankee are $421 million (in 1994 dollars) and $324 million (in 1994 dollars), respectively. These estimates premise the prompt removal and dismantling of each unit at the end of its estimated 40-year energy producing life. Monthly decommissioning payments, based on these cost estimates, are being made to decommissioning trust funds managed by Northeast Utilities. UI's share of the Millstone Unit 3 decommissioning payments made during 1993 was $328,000. UI's share of the fund at December 31, 1993 was approximately $1.9 million. For the Company's 9.5% equity ownership in Connecticut Yankee, decommissioning costs of $1.3 million were funded by UI during 1993, and UI's share of the fund at December 31, 1993 was $9.5 million. Environmental Concerns In complying with existing environmental statutes and regulations and further developments in these and other areas of environmental concern, including legislation and studies in the fields of water and air quality (particularly "air toxics", "ozone non-attainment" and "global warming"), hazardous waste handling and disposal, toxic substances, and electric and magnetic fields, the Company may incur substantial capital expenditures for equipment modifications and additions, monitoring equipment and recording devices, and it may incur additional operating expenses. Litigation expenditures may also increase as a result of scientific investigations, and speculation and debate, concerning the possibility of harmful health effects of electric and magnetic fields. The Company believes that any additional costs incurred for these purposes will be recoverable through the ratemaking process. The total amount of these expenditures is not now determinable. (N) CHANGE IN METHOD OF ACCOUNTING FOR PROPERTY TAXES Effective January 1, 1991, the Company changed its method of accounting for property taxes from accrual over the twelve-month period following assessment date to accrual over the fiscal period of the applicable taxing authority. The effect of the change in accounting was to increase 1991 earnings for common stock by $7.9 million, of which $7.3 million represented the cumulative effect of the change at January 1, 1991, and $.6 million represented an increase in earnings for 1991. - 69 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (O) FAIR VALUE OF FINANCIAL INSTRUMENTS (1) The estimated fair values of the Company's financial instruments are as follows: - 70 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (P) QUARTERLY FINANCIAL DATA (UNAUDITED) Selected quarterly financial data for 1993 and 1992 are set forth below: - 71 - REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Shareowners and Directors of The United Illuminating Company: We have audited the accompanying consolidated balances sheets of The United Illuminating Company as of December 31, 1993, 1992 and 1991, and related consolidated statements of income, retained earnings and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The United Illuminating Company as of December 31, 1993, 1992, and 1991, and the consolidated results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles. /s/ COOPERS & LYBRAND Hartford, Connecticut January 24, 1994 - 72 - Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures. Not Applicable PART III Item 10. Directors and Executive Officers of the Company. The information appearing under the captions "NOMINEES FOR ELECTION AS DIRECTORS" AND "COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934" in the Company's definitive Proxy Statement, dated April 8, 1994, for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in partial answer to this item. See also "EXECUTIVE OFFICERS OF THE COMPANY", following Part I, Item 4 herein. Item 11. Executive Compensation. The information appearing under the captions "EXECUTIVE COMPENSATION," "STOCK OPTION PLAN," "RETIREMENT PLANS," "STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES," "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION" AND "DIRECTOR COMPENSATION" in the Company's definitive Proxy Statement, dated April 8, 1994, for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in answer to this item. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information appearing under the captions "PRINCIPAL SHAREHOLDERS" and "STOCK OWNERSHIP OF DIRECTORS AND OFFICERS" in the Company's definitive Proxy Statement, dated April 8, 1994 for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in answer to this item. Item 13. Certain Relationships and Related Transactions. The information appearing under the caption "NOMINEES FOR ELECTION AS DIRECTORS" in the Company's definitive Proxy Statement, dated April 8, 1994, for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in answer to this item. - 73 - PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as a part of this report: Financial Statements (see Item 8): Consolidated statement of income for the years ended December 31, 1993, 1992 and 1991 Consolidated statement of cash flows for the years ended December 31, 1993, 1992 and 1991 Consolidated balance sheet, December 31, 1993, 1992 and 1991 Consolidated statement of retained earnings for the years ended December 31, 1993, 1992 and 1991 Statement of accounting policies Notes to consolidated financial statements Report of independent accountants Financial Statement Schedules (see S-1 through S-5) Schedule V - Property, plant and equipment for the years ended December 31, 1993, 1992 and 1991. Schedule VI - Accumulated depreciation, depletion and amortization of property, plant and equipment for the years ended December 31, 1993, 1992 and 1991. Schedule VIII - Valuation and qualifying accounts for the years ended December 31, 1993, 1992 and 1991. - 74 - Exhibits: Pursuant to Rule 12b-32 under the Securities Exchange Act of 1934, certain of the following listed exhibits which are annexed as exhibits to previous statements and reports filed by the Company are hereby incorporated by reference as exhibits to this report. Such statements and reports are identified by reference numbers as follows: (1) Filed with Annual Report (Form 10-K) for fiscal year ended December 31, 1991. (2) Filed with Registration Statement No. 2-45434, effective September 25, 1972, and Registration Statement No. 2-45435, effective September 26, 1972. (3) Filed with Registration Statement No. 2-60849, effective July 24, 1978. (4) Filed with Registration Statement No. 2-66518, effective February 25, 1980. (5) Filed with Registration Statement No. 2-57275, effective October 19, 1976. (6) Filed with Registration Statement No. 2-67998, effective June 19, 1980. (7) Filed with Registration Statement No. 2-72907, effective July 16, 1981. (8) Filed with Post-Effective Amendment No. 1 to Registration Statement No. 2-78643, effective August 19, 1982. (9) Filed with Annual Report (Form 10-K) for fiscal year ended December 31, 1990. (10) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended September 30, 1991. (11) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended March 31, 1991. (12) Filed with Annual Report (Form 10-K) for fiscal year ended December 31, 1992. (13 Filed with Registration Statement No. 33-40169, effective August 12, 1991. (14) Filed with Registration Statement No. 33-35465, effective August 1, 1990. (15) Filed with Registration Statement No. 2-49669, effective December 11, 1973. (16) Filed with Registration Statement No. 2-54876, effective November 19, 1975. (17) Filed with Registration Statement No. 2-52657, effective February 6, 1975. (18) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended June 30, 1992. (19) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended September 30, 1990. - 75 - The exhibit number in the statement or report referenced is set forth in the parenthesis following the description of the exhibit. Those of the following exhibits not so identified are filed herewith. Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (3) 3.1 (1) Copy of Charter of The United Illuminating Company, dated December 15, 1965. (Exhibit 3.1) (3) 3.2 (2) Copy of a certificate concerning the creation of a class of Preferred Stock of The United Illuminating Company and the authority of the Board of Directors to issue said Preferred Stock, dated July 13, 1956, and filed with the Secretary of State of Connecticut July 13, 1956. (Exhibit 3.12) (3) 3.3 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated November 19, 1962, andfiled with the Secretary of State of Connecticut November 29, 1962. (Exhibit 3.3) (3) 3.4 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated October 25, 1965, and filed with the Secretary of State of Connecticut November 22, 1965. (Exhibit 3.4) (3) 3.5 (2) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated June 6, 1967, and filed with the Secretary of State of Connecticut June 6, 1967. (Exhibit 3.13) (3) 3.6 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated December 1, 1967, and filed with the Secretary of State of Connecticut December 7, 1967. (Exhibit 3.6) (3) 3.7 (3) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated April 27, 1971, and filed with the Secretary of State of Connecticut April 29, 1971. (Exhibit 2.2-14) (3) 3.8 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated March 29, 1972, and filed with the Secretary of State of Connecticut March 30, 1972. (Exhibit 3.8) (3) 3.9 (4) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated May 4 1973, and filed with the Secretary of State of Connecticut May 7, 1973. (Exhibit 2.2-17) (3) 3.10 Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated July 2, 1973, and filed with the Secretary of State of Connecticut July 2, 1973. (Exhibit 3.10) (3) 3.11 (5) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated April 26, 1976, and filed with the Secretary of State of Connecticut April 27, 1976. (Exhibit 2.2-18) (3) 3.12 (5) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated April 26, 1976, and filed with the Secretary of State of Connecticut April 27, 1976. (Exhibit 2.2-19) (3) 3.13 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated October 20, 1976, and filed with the Secretary of State of Connecticut October 21, 1976. (Exhibit 3.13) (3) 3.14 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated April 4, 1979, and filed with the Secretary of State of Connecticut April 5, 1979. (Exhibit 3.14) (3) 3.15 Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated April 29, 1980, and filed with the Secretary of State of Connecticut April 30, 1980. (Exhibit 3.15) - 76 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (3) 3.16 (6) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated May 20, 1980, and filed with the Secretary of State of Connecticut May 23, 1980. (Exhibit 2.2-20) (3) 3.17 (7) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated June 12, 1981, and filed with the Secretary of State of Connecticut June 16, 1981. (Exhibit 1.20) (3) 3.18 (12) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated July 13, 1981, and filed with the Secretary of State of Connecticut July 14, 1981. (3) 3.19 (8) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated June 1, 1983, and filed with the Secretary of State of Connecticut June 3, 1983. (Exhibit 4.31) (3) 3.20 (9) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated July 24, 1984, and filed with the Secretary of State of Connecticut July 24, 1984. (Exhibit 1) (3) 3.21 (9) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated August 8, 1984, and filed with the Secretary of State of Connecticut August 9, 1984. (Exhibit 2) (3) 3.22 (9) Copy of Certificate Amending or Restating Certificate of Incorporation, filed with the Secretary of State of Connecticut August 1, 1990. (Exhibit 3.22) (3) 3.23 (10) Copy of Certificate Amending or Restating Certificate of Incorporation, dated May 9, 1991, and filed with the Secretary of State of Connecticut August 27, 1991. (Exhibit 3.22a) (3) 3.24a (3) Copy of Bylaws of The United Illuminating Company. (Exhibit 2.3) (3) 3.24b (10) Copy of Article II, Section 2, of Bylaws of The United Illuminating Company, as amended March 26, 1990, amending Exhibit 3.24a. (Exhibit 3.23b) (3) 3.24c (11) Copy of Article V, Section 1, of Bylaws of The United Illuminating Company, as amended April 22, 1991, amending Exhibit 3.24a. (Exhibit 3.23c) (4) 4.1 (9) Copy of First Mortgage Indenture and Deed of Trust, dated as of December 1, 1984, between Bridgeport Electric Company and The First National Bank of Boston, Trustee. (Exhibit 4.12) (4) 4.2 (12) Copy of First Supplemental Mortgage Indenture, dated as of February 15, 1987, between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending and supplementing Exhibit 4.1. (Exhibit 4.2) (4) 4.3 (12) Copy of Second Supplemental Mortgage Indenture, dated as of January 14, 1988, between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending and supplementing Exhibit 4.1 and amending Exhibit 4.2. (Exhibit 4.3) (4) 4.4 Copy of Third Supplemental Mortgage Indenture, dated as of March 31, 1988 between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending Exhibit 4.1. (4) 4.5 (13) Copy of Indenture, dated as of August 1, 1991, from The United Illuminating Company to The Bank of New York, Trustee. (Exhibit 4) (4) 4.6 (14) Copy of Participation Agreement, dated as of (10) August 1, 1990, among Financial Leasing Corporation, Meridian Trust Company, The Bank of New York and The United Illuminating Company. (Exhibits 4(a) through 4(h), inclusive, Amendment Nos. 1 and 2). - 77 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (10) 10.1 (5) Copy of Stockholder Agreement, dated as of July 1, 1964, among the various stockholders of Connecticut Yankee Atomic Power Company, including The United Illuminating Company. (Exhibit 5.1-1) (10) 10.2a (5) Copy of Power Contract, dated as of July 1, 1964, between Connecticut Yankee Atomic Power Company and The United Illuminating Company. (Exhibit 5.1-2) (10) 10.2b (3) Copy of Supplementary Power Contract, dated as of March 1, 1978, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, supplementing Exhibit 10.2a. (Exhibit 5.1-6) (10) 10.2c (1) Copy of Agreement Amending Supplementary Power Contract, dated August 22, 1980, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, amending Exhibit 10.2b. (Exhibit 10.2b) (10) 10.2d (12) Copy of Second Amendment of the Supplementary Power Contract, dated as of October 15, 1982, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, amending Exhibit 10.2b. (Exhibit 10.2d) (10) 10.2e (9) Copy of Second Supplementary Power Contract, dated as of April 30, 1984, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, supplementing Exhibit 10.2a. (Exhibit 10.2e) (10) 10.2f (9) Copy of Additional Power Contract, dated as of April 30, 1984, between Connecticut Yankee Atomic Power Company and The United Illuminating Company. (Exhibit 10.2f) (10) 10.3 (5) Copy of Capital Funds Agreement, dated as of September 1, 1964, between Connecticut Yankee Atomic Power Company and The United Illuminating Company. (Exhibit 5.1-3) (10) 10.4a (5) Copy of Connecticut Yankee Transmission Agreement, dated as of October 1, 1964, among the various stockholders of Connecticut Yankee Atomic Power Company, including The United Illuminating Company. (Exhibit 5.1-4) (10) 10.4b (4) Copy of Agreement Amending and Revising Connecticut Yankee Transmission Agreement, dated as of July 1, 1979, amending Exhibit 10.4a. (Exhibit 5.1-7) (10) 10.5 (3) Copy of Capital Contributions Agreement, dated October 16, 1967, between The United Illuminating Company and Connecticut Yankee Atomic Power Company. (Exhibit 5.1-5) (10) 10.6a (1) Copy of NEPOOL Power Pool Agreement, dated as of September 1, 1971, as amended to November 1, 1988. (Exhibit 10.6a) (10) 10.6b (15) Copy of Agreement Setting Out Supplemental NEPOOL Understandings, dated as of April 2, 1973. (Exhibit 5.7-10) (10) 10.6c (1) Copy of Amendment to NEPOOL Power Pool Agreement, dated as of March 15, 1989, amending Exhibit 10.6a. (Exhibit 10.6c) (10) 10.6d (1) Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of October 1, 1990, amending Exhibit 10.6a. (Exhibit 10.6d) (10) 10.6e Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of September 15, 1992, amending Exhibit 10.6a. (10) 10.6f Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of June 1, 1993, amending Exhibit 10.6a. (10) 10.7a (1) Copy of Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units, dated May 1, 1973, as amended to February 1, 1990. (Exhibit 10.7a) (10) 10.7b (16) Copy of Transmission Support Agreement, dated as of May 1, 1973, among the Seabrook Companies. (Exhibit 5.9-2) - 78 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (10) 10.7c (10) Copy of Twenty-third Amendment to Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units, dated as of November 1, 1990, amending Exhibit 10.7a. (Exhibit 10.8ab) (10) 10.8a (4) Copy of Sharing Agreement - 1979 Connecticut Nuclear Unit, dated as of September 1, 1973, among The Connecticut Light and Power Company, The Hartford Electric Light Company, Western Massachusetts Electric Company, New England Power Company, The United Illuminating Company, Public Service Company of New Hampshire, Central Vermont Public Service Company, Montaup Electric Company and Fitchburg Gas and Electric Light Company, relating to a nuclear fueled generating unit in Connecticut. (Exhibit 5.8-1) (10) 10.8b (17) Copy of Amendment to Sharing Agreement - 1979 Connecticut Nuclear Unit, dated as of August 1, 1974, amending Exhibit 10.8a. (Exhibit 5.9-2) (10) 10.8c (5) Copy of Amendment to Sharing Agreement - 1979 Connecticut Nuclear Unit, dated as of December 15, 1975, amending Exhibit 10.8a. (Exhibit 5.8-4, Post-effective Amendment No. 2) (10) 10.9a (3) Copy of Transmission Line Agreement, dated January 13, 1966, between the Trustees of the Property of The New York, New Haven and Hartford Railroad Company and The United Illuminating Company. (Exhibit 5.4) (10) 10.9b (1) Notice, dated April 24, 1978, of The United Illuminating Company's intention to extend term of Transmission Line Agreement dated January 13, 1966, Exhibit 10.9a. (Exhibit 10.9b) (10) 10.9c (1) Copy of Letter Agreement, dated March 28, 1985, between The United Illuminating Company and National Railroad Passenger Corporation, supplementing and modifying Exhibit 10.9a. (Exhibit 10.9c) (10) 10.10 (12) Copy of Agreement, effective May 16, 1992, between The United Illuminating Company and Local 470-1, Utility Workers Union of America, AFL-CIO. (Exhibit 10.10) (10) 10.11 Copy of Fuel Oil Purchase and Sale Agreement, dated as of October 1, 1993, among Tosco Corporation, The United Illuminating Company and The Connecticut Light and Power Company. (Confidential treatment requested) (10) 10.12 (12) Copy of Coal Sales Agreement, dated as of August 1, 1992, between Pittston Coal Sales Corp. and The United Illuminating Company. (Confidential treatment requested) (Exhibit 10.13) (10) 10.13 (10) Copy of Fossil Fuel Supply Agreement between BLC Corporation and The United Illuminating Company, dated as of July 1, 1991. (Exhibit 10.31) (10) 10.14a (9) Copy of Lease, dated as of December 1, 1984, between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee. (Exhibit 10.22a) (10) 10.14b (12) Copy of Amendment, dated as of February 15, 1987, to Lease between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee, amending Exhibit 10.16a. (Exhibit 10.16b) (10) 10.14c (12) Copy of Second Amendment to Lease, dated as of December 9, 1987, between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee, amending Exhibit 10.16a. (Exhibit 10.16c) (10) 10.14d (12) Copy of Third Amendment to Lease, dated as of January 14, 1988, between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee, amending Exhibit 10.16a. (Exhibit 10.16d) - 79 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (10) 10.15a (12) Copy of Revolving Credit Agreement, dated as of January 25, 1993, among The United Illuminating Company, the Banks named therein, and Citibank, N.A., as Agent for the Banks. (Exhibit 10.19) (10) 10.15b Copy of letter, dated January 27, 1994, from Citibank, N.A., extending the expiration date of Exhibit 10.15a to January 19, 1995. (10) 10.16a* (12) Copy of Employment Agreement, dated as of January 1, 1988, between The United Illuminating Company and Richard J. Grossi. (Exhibit 10.22a) (10) 10.16b* (19) Copy of Amendment to Employment Agreement, dated as of July 23, 1990, between The United Illuminating Company and Richard J. Grossi, amending Exhibit 10.22a. (Exhibit 10.26a) (10) 10.17a* (12) Copy of Employment Agreement, dated as of January 1, 1988, between The United Illuminating Company and Robert L. Fiscus. (Exhibit 10.23a) (10) 10.17b* (19) Copy of Amendment to Employment Agreement, dated as of July 23, 1990, between The United Illuminating Company and Robert L. Fiscus, amending Exhibit 10.23a. (Exhibit 10.27a) (10) 10.18a* (12) Copy of Employment Agreement, dated as of January 1, 1988, between The United Illuminating Company and James F. Crowe. (Exhibit 10.24a) (10) 10.18b* (19) Copy of Amendment to Employment Agreement, dated as of July 23, 1990, between The United Illuminating Company and James F. Crowe, amending Exhibit 10.24a. (Exhibit 10.28a) (10) 10.19* (1) Copy of Executive Incentive Compensation Program of The United Illuminating Company. (Exhibit 10.24) (10) 10.21a* (19) Copy of The United Illuminating Company 1990 Stock Option Plan. (Exhibit 10.33) (10) 10.21b Amendments to The United Illuminating Company 1990 Stock Option Plan, adopted November 22, 1993 and January 24, 1994. (21) 21 List of subsidiaries of The United Illuminating Company. (28) 28.1 (12) Copies of significant rate schedules of The United Illuminating Company. (Exhibit 28.1) - ----------------------- *Management contract or compensatory plan or arrangement. The foregoing list of exhibits does not include instruments defining the rights of the holders of certain long-term debt of the Company and its subsidiaries where the total amount of securities authorized to be issued under the instrument does not exceed ten (10%) of the total assets of the Company and its subsidiaries on a consolidated basis; and the Company hereby agrees to furnish a copy of each such instrument to the Securities and Exchange Commission on request. (b) Reports on Form 8-K. Items Financial Statements Date of Reported Filed Report - -------- -------------------- ------- 5 None December 22, 1993 - 80 - CONSENT OF INDEPENDENT ACCOUNTANTS ---------------------------------- We consent to the incorporation by reference in the Registration Statement of The United Illuminating Company on Form S-3 (File No. 33-50221) and the Registration Statement on Form S-3 (File No. 33-50445) of our report, dated January 24, 1994, on our audits of the consolidated financial statements and financial statement schedules of The United Illuminating Company as of December 31, 1993, 1992 and 1991 and for the years then ended, which report is included in this Annual Report on Form 10-K. /s/ COOPERS & LYBRAND Hartford, Connecticut February 15, 1994 - 81 - SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE UNITED ILLUMINATING COMPANY By /s/ Richard J. Grossi ------------------------------ Richard J. Grossi Chairman of the Board of Directors and Chief Executive Officer Date: February 18, 1994 ----------------- 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. Signature Title Date --------- ----- ---- Director, Chairman of the Board of Directors and /s/ Richard J. Grossi Chief Executive Officer February 18, 1994 - --------------------- (Richard J. Grossi) (Principal Executive Officer) Director, President and /s/ Robert L. Fiscus Chief Financial Officer February 18, 1994 - --------------------- (Robert L. Fiscus) (Principal Financial and Accounting Officer) /s/ John D. Fassett Director February 18, 1994 - -------------------- (John D. Fassett) /s/ Leland W. Miles Director February 18, 1994 - -------------------- (Leland W. Miles) /s/ William S. Warner Director February 18, 1994 - ---------------------- (William S. Warner) /s/ John F. Croweak Director February 18, 1994 - -------------------- (John F. Croweak) /s/ F. Patrick McFadden, Jr. Director February 18, 1994 - ----------------------------- (F. Patrick McFadden, Jr.) /s/ J. Hugh Devlin Director February 18, 1994 - ------------------- (J. Hugh Devlin) /s/ Betsy Henley-Cohn Director February 18, 1994 - ---------------------- (Betsy Henley-Cohn) Director February , 1994 - ------------------------ (Frank R. O'Keefe, Jr.) /s/ James A. Thomas Director February 18, 1994 - ---------------------- (James A. Thomas) /s/ David E.A. Carson Director February 18, 1994 - ---------------------- (David E.A. Carson) - 82 - S-1 S-2 S-3 S-4 S-5 EXHIBIT INDEX (a) Exhibits Exhibit Table Item Exhibit Number Number Description Page No. ---------- ------- ----------- -------- (4) 4.4 Copy of Third Supplemental Mortgage Indenture, dated as of March 31, 1988 between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending Exhibit 4.1. (10) 10.6e Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of September 15, 1992, amending Exhibit 10.6a. (10) 10.6f Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of June 1, 1993, amending Exhibit 10.6a. (10) 10.11 Copy of Fuel Oil Purchase and Sale Agreement, dated as of October 1, 1993, among Tosco Corporation, The United Illuminating Company and The Connecticut Light and Power Company. (Confidential treatment requested) (10) 10.15b Copy of letter, dated January 27, 1994, from Citibank, N.A., extending the expiration date of Exhibit 10.15a to January 19, 1995. (10) 10.21b Amendments to The United Illuminating Company 1990 Stock Option Plan, adopted November 22,1993 and January 24, 1994. (21) 21 List of subsidiaries of The United Illuminating Company. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. MAJOR INFLUENCES ON FINANCIAL CONDITION The Company's financial condition should continue to improve as a result of the December 16, 1992 rate decision by the DPUC. The DPUC decision granted levelized rate increases of 2.66% ($15.8 million) in 1993 and 2.66% (an additional $17.3 million) in 1994. However, the Company's financial condition will continue to be dependent on the level of retail and wholesale sales. The two primary factors that affect sales volume are economic conditions and weather. The regional recession has restricted retail sales growth and been largely responsible for a weak wholesale sales market during the past two years. Sales increases due to economic recovery would help to increase the Company's earnings. Another major factor affecting the Company's financial condition will be the Company's ability to control expenses. A significant reduction in interest expense has been achieved since 1989, and additional savings of $10 million are expected in 1994 due to debt refinancing. Since 1990, annual growth in total operation and maintenance expense, excluding one-time items and cogeneration capacity purchases, has averaged approximately 2.7%, and the Company hopes to restrict future increases to less than the rate of inflation. LIQUIDITY AND CAPITAL RESOURCES The Company's capital requirements are presently projected as follows: The Company presently estimates that its cash on hand and temporary cash investments at the beginning of 1994, totaling $48.2 million, and its projected net cash provided by operations, less dividends, of $102 million, less capital expenditures of $73.4 million, will be insufficient to fund the Company's 1994 requirements for long-term debt maturities and mandatory redemptions and repayments, amounting to $113.3 million, by $36 million. The Company currently anticipates that its projected net cash provided by operations, less dividends and capital expenditures, for 1995 will be insufficient to fund the Company's 1995 requirements for long-term debt maturities and mandatory redemptions and repayments, by approximately $138 million. The Company currently anticipates that its projected net cash provided by operations, less dividends and capital expenditures, for 1996 through 1998 will be insufficient to fund the Company's requirements for long-term debt maturities and mandatory redemptions and repayments in the years 1996 through 1998, in amounts that cannot now be predicted accurately, but which may be substantial in the aggregate, depending on the levels of the Company's sales, wholesale and retail rates, operation and maintenance costs and taxes. All of the Company's capital requirements that exceed available net cash will have to be provided by external financing; and the Company has no commitment to provide such financing from any source of funds. The Company expects to be able to satisfy its external financing needs by issuing common stock and additional short-term and long-term debt, although the continued availability of these methods of financing will be dependent on many factors, including conditions in the securities markets, economic conditions, and the level of the Company's income and cash flow. - 34 - At December 31, 1993, the Company had $48.2 million of cash and temporary cash investments, an increase of $37.1 million from the balance at December 31, 1992. The components of this increase, which are detailed in the Consolidated Statement of Cash Flows, are summarized as follows: The Company has a revolving credit agreement with a group of banks, which currently extends to January 19, 1995. The borrowing limit of this facility is $75 million. The facility permits the Company to borrow funds at a fluctuating interest rate determined by the prime lending market in New York, and also permits the Company to borrow money for fixed periods of time specified by the Company at fixed interest rates determined by the Eurodollar interbank market in London, by the certificate of deposit market in New York, or by bidding, at the Company's option. If a material adverse change in the business, operations, affairs, assets or condition, financial or otherwise, or prospects of the Company and its subsidiaries, on a consolidated basis, should occur, the banks may decline to lend additional money to the Company under this revolving credit agreement, although borrowings outstanding at the time of such an occurrence would not then become due and payable. As of December 31, 1993, the Company had no short-term borrowings outstanding under this facility. The Company's long-term debt instruments do not limit the amount of short-term debt that the Company may issue. The Company's revolving credit agreement described in the previous paragraph requires it to maintain an available earnings/interest charges ratio of not less than 1.5:1.0 for each 12-month period ending on the last day of each calendar quarter. The Company had a $50 million term loan facility with a group of banks during 1993. Under this agreement, the Company chose an interest rate from among three alternatives: (i) a fluctuating interest rate determined by the prime lending market in New York; (ii) a fixed interest rate determined by the Eurodollar interbank market in London; and (iii) a fixed interest rate determined by the certificate of deposit market in New York. On February 1, 1993, the Company borrowed $50 million from this group of banks, using the proceeds to repay short-term borrowings and other current obligations. On December 3, 1993, the Company repaid the $50 million borrowing and terminated the agreement. The Company had a term loan agreement with PruLease, Inc. (PruLease) that expired on December 1, 1993. This agreement was executed on December 31, 1992, when the Company borrowed $49.1 million from PruLease and purchased all the nuclear fuel that was owned by PruLease and leased to the Company on that date. This - 35 - loan, which was collateralized by a first lien on the Company's ownership interest in the nuclear fuel for Seabrook Unit 1, was repaid in full at maturity. The Company has a Fossil Fuel Supply Agreement with a financial institution providing for financing up to $37.5 million in fossil fuel purchases. Under this agreement, the financing entity acquires and stores natural gas, coal and fuel oil for sale to the Company, and the Company purchases these fossil fuels from the financing entity at a price for each type of fuel that reimburses the financing entity for the direct costs it has incurred in purchasing and storing the fuel, plus a charge for maintaining an inventory of the fuel determined by reference to the fluctuating interest rate on thirty-day, dealer-placed commercial paper in New York. The Company is obligated to insure the fuel inventories and to indemnify the financing entity against all liabilities, taxes and other expenses incurred as a result of its ownership, storage and sale of fossil fuel to the Company. This agreement currently extends to February 1995. At December 31, 1993, approximately $10.1 million of fossil fuel purchases were being financed under this agreement. UI has four wholly-owned subsidiaries. Bridgeport Electric Company, a single-purpose corporation, owns and leases to UI a generating unit at Bridgeport Harbor Station. Research Center, Inc. (RCI) has been formed to participate in the development of one or more regulated power production ventures, including possible participation in arrangements for the future development of independent power production and cogeneration facilities. United Energy International, Inc. (UEI) has been formed to facilitate participation in a proposed joint venture relating to power production plants abroad. United Resources, Inc. (URI) serves as the parent corporation for several unregulated businesses, each of which is incorporated separately to participate in business ventures that will complement and enhance UI's electric utility business and serve the interests of the Company and its shareholders and customers. Four wholly-owned subsidiaries of URI have been incorporated. Souwestcon Properties, Inc. is participating as a 25% partner in the ownership of a medical hotel building in New Haven. A second wholly-owned subsidiary of URI is Thermal Energies, Inc., which is participating in the development of district heating and cooling water facilities in the downtown New Haven area, including the energy center for an office tower and participation as a 37% partner in the energy center for a new city hall and office tower complex. A third URI subsidiary, Precision Power, Inc., provides power-related equipment and services to the owners of commercial buildings and industrial facilities. A fourth URI subsidiary, American Payment Systems, Inc., manages agents and equipment for electronic data processing of bill payments made by customers of utilities, including UI, at neighborhood businesses. In addition to these subsidiaries, URI also has an 82% ownership interest in Ventana Corporation (Ventana), which offers energy conservation engineering and project management services to governmental and private institutions. In September 1993, URI recorded a $1.2 million after-tax write off of outstanding debt owed to URI by Ventana, which represented the difference between the amount owed to URI by Ventana and the value of an additional equity interest in Ventana received by URI in November 1993. This additional equity interest in Ventana was received in exchange for the forgiveness of debt owed to URI by Ventana. The Board of Directors of the Company has authorized the investment of a maximum of $13.5 million, in the aggregate, of the Company's assets in all of URI's ventures, UEI and RCI, and, at December 31, 1993, approximately $10.6 million had been so invested. RESULTS OF OPERATIONS 1993 vs. 1992 - ------------- Earnings for the year 1993 were $36.2 million, or $2.57 per share, down $16.3 million, or $1.19 per share, from 1992. This decrease reflects a one-time reorganizational charge of approximately $7.8 million after-tax, or $.56 per share, and the non-recurrence of one-time gains of $.59 per share in 1992. Earnings per share for 1993, excluding one-time items and accounting changes, decreased by $.04 per share, to $3.13 per share from $3.17 per share for 1992. - 36 - Sales margin increased by $10.3 million for the year. Retail revenues increased $36.6 million; $20.7 million from a recent rate decision ($12.1 million from rate changes and $13.2 million for the fold-in to base rates of the 1992 sales adjustment revenues, partly offset by the pass through to customers of expense credits of $4.6 million), and $15.9 million from increased retail sales. Retail sales increased by 2.7%, mostly due to a return to more normal summer weather. The retail revenue increases were offset by anticipated reductions of $21 million from the sales adjustment provision and $13.7 million in wholesale capacity revenues. Other operating revenues decreased by $0.3 million. Reductions in wholesale energy revenues of $15.8 million were directly offset by reductions in energy expense. Other factors affecting sales margin were lower retail fuel expense, increasing margin by $9.4 million, and higher revenue related taxes, decreasing margin by $0.6 million. Other operation and maintenance expenses, including purchased capacity charges, increased by $10.2 million, or 4.5%, in 1993 relative to 1992. Major generating station overhauls and unscheduled repairs accounted for $5.2 million of this increase. Employment costs increased by $4.0 million, most of which resulted from the adoption of a liability for postretirement benefits other than pensions that the implementation of Statement of Financial Accounting Standards (SFAS) No. 106 requires to be accrued over employees' careers. Purchased capacity charges (cogeneration and Connecticut Yankee power purchases) for 1993 increased by $4.0 million, transmission costs increased by $2.4 million; but other nuclear operation and maintenance expenses decreased by $4.0 million. Other operating expenses, including income taxes but excluding a 1993 fourth quarter one-time reorganization charge, decreased by $20.3 million in 1993 from 1992, as the effect of accounting treatments ordered in recent rate decisions for recovery of canceled plant, the flow-through to income of certain income tax benefits and lower property taxes more than offset increases in depreciation expense. Other income declined by $23 million in 1993 from 1992, $9.4 million of which was attributable to the absence of net one-time gains realized in 1992. The remainder was due primarily due to an expected decline in deferred revenue and income tax benefits associated with the DPUC's 1992 rate decision, offset, in part, by lower interest charges of $9.3 million. "Net" interest margin (interest income less interest expense) improved by $6.6 million in 1993 over 1992. 1992 vs. 1991 - ------------- Earnings for 1992 were $52.4 million, or $3.76 per share, up $1.4 million, or $.09 per share, over 1991. Earnings per share for 1992, excluding one-time items and accounting changes, increased by $.27, to $3.17 from $2.90 per share for 1991. Non-recurring earnings declined to a level of $.59 per share in 1992 from $.77 per share in 1991. Operating revenues in 1992, exclusive of retail and wholesale fuel recovery revenue, were up $4.3 million over 1991 levels, adding $.18 per share after taxes. Increased rates provided only $11 million of an expected annual $15 million revenue increase, because commercial and industrial customers shifted into lower priced time-of-use rates. An additional $6 million of revenue was accrued under the terms of the sales adjustment provisions of the Company's 1990 rate decision by the Department of Public Utility Control (DPUC). Retail sales volume declined 1.6% from the prior year, reducing retail revenues by $10.6 million and sales margin (revenue minus fuel expense and revenue-based taxes) by $7.4 million. Most of this decline reflected the cool, wet weather for the summer of 1992. On a weather-adjusted basis, retail sales were about even with 1991. Wholesale capacity sales declined by $2.1 million for the year, reflecting the end of a major contract in October 1992. Other sales margin improvements were derived from increased nuclear generation, which added $10.5 million to margin in 1992 over 1991. An overall capacity factor of 76% for the nuclear units was achieved in 1992, compared to 65% for 1991. Offsetting this gain, the Company experienced unusually low and intermittent demand by the New England Power Pool for the operation of the Company's fossil generating units, thus - 37 - degrading their efficiency, increasing fuel expense and decreasing sales margin by $2.5 million from 1991. These amounts are not recoverable through the fuel adjustment clause. Operation, maintenance and capacity expense for 1992 nuclear generation declined only $1.7 million from 1991 levels, compared to a savings of $4-5 million the Company originally expected to realize (principally from reduced Seabrook expenses). Other operation and maintenance expenses, excluding fuel and energy expenses, increased by $2.6 million for the year (excluding net non-recurring charges for 1992). Other taxes increased by $3.7 million (excluding a one-time charge in 1991), reflecting primarily the increased property tax placed on Seabrook by the State of New Hampshire. Depreciation increased by $2.5 million in 1992 over 1991. Net changes in interest income and expense added $2.9 million to pre-tax income in 1992, excluding one-time credits in 1991 and 1992. Reductions in plant balances not in rate base (Seabrook and other) led to reductions in deferred revenue of about $4 million after-tax. Non-recurring items decreased by $.18 per share compared to 1991 levels, to a net earnings figure of $.59 per share. In 1992, a net $2.7 million in income, or $.19 per share, was booked for Seabrook Unit 1 adjustments; $3.6 million, or $.26 per share, in non-operating income tax credits were realized; a net $3.0 million in income, or $.21 per share, from a gain on the sale of property was realized; and there were one-time charges to operating expenses of a net $1.0 million, for a loss of $.07 per share. OUTLOOK The Company's financial condition should continue to improve as a result of the December 16, 1992 retail rate decision by the DPUC. The DPUC decision granted levelized rate increases of 2.66% ($15.8 million) in 1993 and 2.66% (an additional $17.3 million) in 1994. However, the Company did not realize the full anticipated benefit of the 1993 rate increase, realizing about $4 million less than awarded due to differences between the sales realized in individual rate classes and the sales projections used for rate case purposes. The differences arose principally from rate class shifting by customers and differential growth in sales among rate classes. A similar shortfall may develop in 1994. The Company's financial condition will continue to be dependent on the level of retail and wholesale sales. The two primary factors that affect sales volume are economic conditions and weather. The regional recession has restricted retail sales growth and been largely responsible for a weak wholesale sales market during the past two years. Sales increases due to economic recovery would help to increase the Company's earnings. A 1% increase in sales would add about $6 million in revenue and about $5 million in sales margin (revenue minus fuel expense and revenue- based taxes). Wholesale capacity sales are expected to be approximately $6 million in 1994. Another major factor affecting the Company's financial condition will be the Company's ability to control expenses. Fuel expense, excluding wholesale fuel expense, is expected to decline by approximately $2.3 million in 1994 from the 1993 level, reflecting significantly lower nuclear fuel prices. Also, significant reductions in interest expense have been achieved since 1989, and additional savings of $10 million are expected in 1994 due to debt refinancing. For 1994, operation and maintenance expenses are expected to increase from normal inflationary pressures, but these increases should be substantially offset by savings from the phase-in of the Company's corporate structure reorganization. Since 1990, annual growth in total operation and maintenance expense, excluding one-time items and cogeneration capacity purchases, has averaged approximately 2.7%, and the Company hopes to restrict future increases to less than the rate of inflation. The final portion of the cost of Seabrook Unit 1 has been added to rate base (and retail revenues) for 1994. This will eliminate deferred revenues and reduce net income by $7.4 million after-tax in 1994 from 1993 levels. Although the Company believes that its financing outlook and plans are unlikely to be adversely affected by further developments with respect to the licensing and operation of Seabrook Unit 1, the Company's financial status and financing capability will continue to be sensitive to any such developments and to many other factors, including conditions in the securities markets, economic conditions, the level of the Company's income and cash - 38 - flow, and legislative and regulatory developments, including the cost of compliance with increasingly stringent environmental legislation and regulations and competition within the electric utility industry. INFLATION As a result of inflation and increased environmental and regulatory requirements, the estimated cost of replacing the Company's productive capacity today would substantially exceed the historical cost of such facilities reported in the financial statements. Since the Company's rates for service to its customers have been based in the past on the cost of providing such service and have been revised from time to time to reflect increased costs of service, the Company believes that any higher replacement costs it may experience in the future will be recovered through the normal regulatory process. - 39 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 40 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 41 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 42 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 43 - The accompanying Notes to Consolidated Financial Statements are an integral part of the financial statements. - 44 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (A) STATEMENT OF ACCOUNTING POLICIES Accounting Records The accounting records are maintained in accordance with the uniform systems of accounts prescribed by the Federal Energy Regulatory Commission (FERC) and the Connecticut Department of Public Utility Control (DPUC). Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Bridgeport Electric Company (BEC), United Resources Inc., United Energy International, Inc. and Research Center, Inc. Intercompany accounts and transactions have been eliminated in consolidation. Reclassification of Previously Reported Amounts Certain amounts previously reported have been reclassified to conform with current year presentations. Utility Plant The cost of additions to utility plant and the cost of renewals and betterments are capitalized. Cost consists of labor, materials, services and certain indirect construction costs, including an allowance for funds used during construction (AFUDC). The cost of current repairs and minor replacements is charged to appropriate operating expense accounts. The original cost of utility plant retired or otherwise disposed of and the cost of removal, less salvage, are charged to the accumulated provision for depreciation. Allowance for Funds Used During Construction In accordance with the applicable regulatory systems of accounts, the Company capitalizes AFUDC, which represents the approximate cost of debt and equity capital devoted to plant under construction. In accordance with FERC prescribed accounting, the portion of the allowance applicable to borrowed funds is presented in the Consolidated Statement of Income as a reduction of interest charges, while the portion of the allowance applicable to equity funds is presented as other income. Although the allowance does not represent current cash income, it has historically been recoverable under the ratemaking process over the service lives of the related properties. The Company compounds semi-annually the allowance applicable to major construction projects. AFUDC rates in effect for 1993, 1992 and 1991 were 8.75%, 10.25% and 10.88%, respectively. Depreciation Provisions for depreciation on utility plant for book purposes, excluding costs associated with the 1984 reconversion of BEC's plant to a dual-fired capability, are computed on a straight-line basis, using estimated service lives determined by independent engineers. One-half year's depreciation is taken in the year of addition and disposition of utility plant, except in the case of major operating units on which depreciation commences in the month they are placed in service and ceases in the month they are removed from service. During the years 1985-1989, depreciation associated with BEC's reconversion costs was computed on an annuity basis over the original ten-year period that this plant was being leased to the Company by BEC. Commencing January 1, 1990, the reconversion costs are being depreciated on a straight-line basis over a period ending July 2000. The aggregate annual provisions for depreciation for the years 1993, 1992 and 1991 were equivalent to approximately 3.22%, 3.15% and 3.10%, respectively, of the original cost of depreciable property. - 45 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Income Taxes Effective January 1, 1993, the Company adopted SFAS 109, "Accounting for Income Taxes". In accordance with SFAS 109, the Company has provided deferred taxes for all temporary book-tax differences using the liability method. The liability method requires that deferred tax balances be adjusted to reflect enacted future tax rates that are anticipated to be in effect when the temporary differences reverse. In accordance with generally accepted accounting principles for regulated industries, the Company has established a net regulatory asset that reflects anticipated future recovery in rates of these deferred tax provisions. For ratemaking purposes, the Company practices full normalization for all investment tax credits (ITC) related to recoverable plant investments except for the ITC related to Seabrook Unit 1, which was taken into income in accordance with provisions of the 1989 Settlement Agreement. Accrued Utility Revenues The estimated amount of utility revenues (less related expenses and applicable taxes) for service rendered but not billed is accrued at the end of each accounting period. Cash and Cash Equivalents For cash flow purposes, the Company considers all highly liquid debt instruments with a maturity of three months or less at the date of purchase to be cash equivalents. The Company is required to maintain an operating deposit with the project disbursing agent related to its 17.5% ownership interest in Seabrook Unit 1. This operating deposit, which is the equivalent to one and one half months of the funding requirement for operating expenses, is restricted for use and amounted to $3.4 million, $2.9 million, and $1.8 million at December 31, 1993, 1992 and 1991, respectively. Investments The Company's investment in the Connecticut Yankee Atomic Power Company joint venture, a nuclear generating company in which the Company has a 9 1/2% stock interest, is accounted for on an equity basis. Fossil Fuel Costs The amount of fossil fuel costs that cannot be reflected currently in customers' bills pursuant to the FCA in the Company's rates is deferred at the end of each accounting period. Since adoption of the deferred accounting procedure in 1974, rate decisions by the DPUC and its predecessors have consistently made specific provision for amortization and rate-making treatment of the Company's existing deferred fossil fuel cost balances. Research and Development Costs Research and development costs, including environmental studies, are capitalized if related to specific construction projects and depreciated over the lives of the related assets. Other research and development costs are charged to expense as incurred. Pension and Other Post-Employment Benefits The Company accounts for normal pension plan costs in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 87, "Employers' Accounting for Pensions", and for supplemental - 46 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) retirement plan costs and supplemental early retirement plan costs in accordance with the provisions of SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits". Prior to January 1, 1993, the Company accounted for other post- employment benefits, consisting principally of health and life insurance, on a pay-as-you-go basis. Effective January 1, 1993, the Company commenced accounting for these costs under the provisions of SFAS No. 106, "Employers' Accounting for Post- Retirement Benefits Other than Pensions", which requires, among other things, that the liability for such benefits be accrued over the employment period that encompasses eligibility to receive such benefits. The annual incremental cost of this accounting change has been allowed in retail rates in accordance with a 1992 rate decision. Uranium Enrichment Obligation Under the Energy Policy Act of 1992 (Energy Act), the Company will be assessed for its proportionate share of the costs of the decontamination and decommissioning of uranium enrichment facilities operated by the Department of Energy. The Energy Act imposes an overall cap of $2.25 billion on the obligation assessed to the nuclear utility industry and limits the annual assessment to $150 million each year over a 15-year period. At December 31, 1993, the Company's unfunded share of the obligation, based on its ownership interest in Seabrook Unit 1 and Millstone Unit 3, was approximately $1.5 million. Effective January 1, 1993, the Company was allowed to recover these assessments in rates as a component of fuel expense. Accordingly, the Company has recognized these costs as a regulatory asset on its Consolidated Balance Sheet. Nuclear Decommissioning Trusts External trust funds are maintained to fund the estimated future decommissioning costs of the nuclear generating units in which the Company has an ownership interest. These costs are accrued as a charge to depreciation expense over the estimated service lives of the units and are recovered in rates on a current basis. The Company paid $1,616,000, $1,334,000 and $1,011,000 during 1993, 1992 and 1991 into the decommissioning trust funds for Seabrook Unit 1 and Millstone Unit 3. At December 31, 1993, the Company's share of the trust fund balances, which include accumulated earnings on the funds, were $3.7 million and $1.9 million for Seabrook Unit 1 and Millstone Unit 3, respectively. These fund balances are included in "Other Property and Investments" and the accrued decommissioning obligation is included in "Noncurrent Liabilities" on the Company's Consolidated Balance Sheet. - 47 - - 48 - - 49 - - 50 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (a) Common Stock The Company issued 46,000 shares of common stock in 1993, 100,800 shares of common stock in 1992 and 44,600 shares of common stock in 1991 pursuant to a stock option plan. During 1993, the Company also issued 4,143 shares of common stock pursuant to a long-term incentive program. Common stock, no par value, authorized at December 31, 1993, included 400,000 shares reserved for the Company's Employee Stock Ownership Plan (ESOP). There were no additions to ESOP in 1991, 1992 or 1993. The Company purchased on the open market, on behalf of shareholders participating in the common stock Dividend Reinvestment Plan, 148,362 shares of stock in 1991, 136,679 shares of stock in 1992 and 138,145 shares of stock in 1993. In 1990, the Company's Board of Directors and the shareowners approved a stock option plan for officers and key employees of the Company. The plan provides for the awarding of options to purchase up to 750,000 shares of the Company's common stock over periods of from one to ten years following the dates when the options are granted. On June 5, 1991, the DPUC approved the issuance of 500,000 shares of stock pursuant to this plan. The exercise price of each option cannot be less than the market value of the stock on the date of the grant. Options to purchase 214,000 shares of stock at an exercise price of $30.75 per share, 2,800 shares of stock at an exercise price of $28.3125 per share, 1,800 shares of stock at an exercise price of $31.1875 per share, 4,000 shares of stock at an exercise price of $35.625 per share, 36,200 shares of stock at an exercise price of $39.5625 per share and 5,000 shares of stock at an exercise price of $42.375 per share have been granted by the Board of Directors and remain outstanding at December 31, 1993. Options to purchase 44,600 shares of stock at an exercise price of $30.75 were exercised during 1991. Options to purchase 98,000 shares of stock at an exercise price of $30.75 and 2,800 shares of stock at an exercise price of $28.3125 were exercised during 1992. Options to purchase 42,400 shares of stock at an exercise price of $30.75 per share, 1,400 shares of stock at an exercise price of $28.3125 per share, 1,200 shares of stock at an exercise price of $31.1875 per share and 1,000 shares of stock at an exercise price of $35.625 per share were exercised during 1993. In addition, certain executive officers were eligible to earn shares of the Company's common stock, based upon the dividend and market performance of the stock compared to a peer group of electric utilities over a four-year period ending December 31, 1992, under the Company's long-term incentive program. The issuance of shares of stock pursuant to this program received DPUC approval on June 5, 1991. The total number of shares of common stock that could have been earned under the long-term incentive program was limited to 7,091. For the four-year period ending December 31, 1992, 6,027 shares of the Company's common stock were earned. Of this amount, a total of 4,143 shares were issued to the participants in 1993, and the remainder was distributed in an equivalent amount of cash based on the closing price of the Company's Common Stock on March 1, 1993, pursuant to the terms of the long-term incentive program. This program ended as of December 31, 1992. (b) Retained Earnings Restriction The indenture under which the Company's Medium-Term Notes and Notes are issued places limitations on the payment of cash dividends on common stock and on the purchase or redemption of common stock. Retained earnings in the amount of $82.6 million were free from such limitations at December 31, 1993. (c) Preferred and Preference Stock The par value of each of these issues was credited to the appropriate stock account and expenses related to these issues were charged to capital stock expense. - 51 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) In 1991, the Company purchased and cancelled shares of its $100 par value Preferred Stock, at a discount, resulting in a non-taxable addition to common equity of approximately $3,304,000. The 1991 purchases consisted of: 9,575 shares of 4.35% Preferred Stock, Series A 7,320 shares of 4.72% Preferred Stock, Series B 39,900 shares of 4.64% Preferred Stock, Series C 13,800 shares of 5 5/8% Preferred Stock, Series D In 1992, the Company purchased and cancelled 16,950 shares of its $100 par value 4.72% Preferred Stock, Series B, at a discount, resulting in a non-taxable addition to common equity of approximately $796,650. There was no redemption of preferred stock in 1993. Shares of preferred stock have preferential dividend and liquidation rights over shares of common stock. Preferred shareholders are not entitled to general voting rights. However, if any preferred dividends are in arrears for six or more quarters, or if some other event of default occurs, preferred shareholders are entitled to elect a majority of the Board of Directors until all preferred dividend arrears are paid and any event of default is terminated. Preference stock is a form of stock that is junior to preferred stock but senior to common stock. It is not subject to the earnings coverage requirements or minimum capital and surplus requirements governing the issuance of preferred stock. There were no shares of preference stock outstanding at December 31, 1993. (d) Long-Term Debt In January 1993, the net proceeds from the liquidation of an investment in tax-exempt municipal debt instruments were used to pay $60 million principal amount of maturing 10.32% First Mortgage Bonds of the Company's wholly-owned subsidiary, Bridgeport Electric Company; to repay a $7.5 million 13.1% term loan; to repay short- term borrowings incurred for the August 1, 1992 redemption of the Company's 12% Debentures, due August 1, 2017, and for repayment of a $7.5 million 12.9% term loan on September 30, 1992; and to repay short-term borrowings incurred for a $19.1 million rent payment on December 31, 1992 under the Company's facility sale and leaseback arrangement for a portion of its ownership interest in Seabrook Unit 1. On September 30, 1993, the Company repaid a $5 million 12.9% term loan with funds obtained through short-term borrowings. On September 17, 1993, the Company invited the owners of $68,400,000 aggregate principal amount of 14 1/2% Pollution Control Revenue Bonds, due October 1 and December 1, 2009, ("Bonds") to sell to the Company, for cash, any and all of the Bonds. The Bonds were issued in 1984 by The Industrial Development Authority of the State of New Hampshire ("NHIDA"), which loaned the issue proceeds to the Company to pay for the cost of installing pollution control facilities at the Seabrook nuclear generating plant in New Hampshire; and the Business Finance Authority of the State of New Hampshire ("NHBFA"), successor to the NHIDA, agreed to issue Pollution Control Refunding Revenue Bonds ("Refunding Bonds") in a principal amount equal to the aggregate principal amount of Bonds purchased by the Company and surrendered to the Bond trustee for cancellation, and to loan the issue proceeds of the Refunding Bonds to the Company to pay for part of the purchase price of the Bonds being purchased and cancelled. On October 15, 1993, the Company accepted offers from holders of $64,460,000 aggregate principal amount of the Bonds to sell them for an aggregate purchase price of $75,710,000. On October 26, 1993, the NHBFA issued and sold $64,460,000 principal amount of 5 7/8% Refunding Bonds, due October 1, 2033, and loaned the issue proceeds to the Company, which used them to pay - 52 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) a portion of the purchase price of the Bonds. The remainder of the purchase price was funded with the proceeds of short-term borrowings. On December 7, 1993, the Company issued and sold $100 million principal amount of five-year and one month Notes at a coupon rate of 6.20%. The net proceeds were used to repay $60 million principal amount of maturing 10.32% First Mortgage Bonds of the Company's wholly-owned subsidiary, Bridgeport Electric Company in January 1994; to repay a $5 million 13.1% term loan in January 1994 and for general corporate purposes, including repayment of short-term borrowings. Maturities and mandatory redemptions/repayments and annual interest expense on existing long-term debt are set forth below: (C) RATE-RELATED REGULATORY PROCEEDINGS On December 16, 1992, the DPUC approved levelized rate increases of 2.66% ($15.8 million) for 1993 and 2.66% (an additional $17.3 million) for 1994, including allowed conservation and load management revenue increases. The rate increases totaled $33.1 million, or 5.4%, over two years. In order to achieve levelized 2.66% rate increases for each of these two years, the DPUC determined that the recovery of $13.1 million of sales adjustment clause revenues would be deferred from 1993 to 1994. Utilities are entitled by Connecticut law to revenues sufficient to allow them to cover their operating and capital costs, to attract needed capital and maintain their financial integrity, while also protecting the public interest. Accordingly, the DPUC's 1992 rate decision authorized a return on equity of 12.4% for ratemaking purposes. However, the Company may earn up to 1% above this level before a mandatory review is required by the DPUC. - 53 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Since January 1971, UI has had a fossil fuel adjustment clause (FCA) in virtually all of its retail rates. The DPUC is required by law to convene an administrative proceeding prior to approving FCA charges or credits for each month. The law permits automatic implementation of the charges or credits if the DPUC fails to act within five days of the administrative proceeding, although all such charges and credits are also subject to further review and appropriate adjustment by the DPUC at public hearings required to be held at least every three months. The DPUC has made no material changes in UI's FCA charges and credits as the result of any of these proceedings or hearings. (D) ACCOUNTING FOR PHASE-IN PLAN The Company has been phasing into rate base its allowable investment in Seabrook Unit 1, amounting to $640 million, since January 1, 1990. In conjunction with this phase-in plan, the Company has been allowed to record a deferred return on the portion of allowable investment excluded from rate base during the phase-in period. The accumulated deferred return has been added to rate base each year since January 1, 1991 in the same proportion as the phase-in installment for that year has borne to the portion of the $640 million remaining to be phased-in. On January 1, 1994, the Company phased into rate base the remaining $74.5 million of allowable investment, plus the remaining $28.2 million of accumulated deferred return. The Company will be allowed to recover the accumulated deferred return, amounting to $62.9 million, over a five-year period commencing January 1, 1995. - 54 - - 55 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Total income taxes differ from the amounts computed by applying the federal statutory tax rate to income before taxes. The reasons for the differences are as follows: At December 31, 1993, the Company had deferred tax liabilities for taxable temporary differences of $574 million and deferred tax assets for deductible temporary differences of $149 million, resulting in a net deferred tax liability of $425 million. Significant components of deferred tax liabilities and assets were as follows: tax liabilities on book/tax plant basis differences, $229 million; tax liabilities on the cumulative amount of income taxes on temporary differences previously flowed through to ratepayers, $163 million; tax liabilities on normalization of book/tax depreciation timing differences, $89 million and tax assets on the disallowance of plant costs, $77 million. The Tax Reform Act of 1986 provides for a more comprehensive corporate alternative minimum tax (AMT) for years beginning after 1986. To the extent that the AMT exceeds the federal income tax computed at statutory rates, the excess must be paid in addition to the regular tax liability. For tax purposes, the excess paid in any year can be carried forward indefinitely and offset against any future year's regular tax liability in excess of that year's tentative AMT. The AMT carryforward at December 31, 1993, 1992 and 1991 was $11.4 million, $11.3 million and $9.9 million, respectively. (F) SHORT-TERM CREDIT ARRANGEMENTS The Company has a revolving credit agreement with a group of banks, which currently extends to January 19, 1995. The borrowing limit of this facility is $75 million. The facility permits the Company to borrow funds at a fluctuating interest rate determined by the prime lending market in New York, and also permits the Company to borrow money for fixed periods of time specified by the Company at fixed interest rates determined by the Eurodollar interbank market in London, by the certificate of deposit market in New York, or by bidding, at the - 56 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Company's option. If a material adverse change in the business, operations, affairs, assets or condition, financial or otherwise, or prospects of the Company and its subsidiaries, on a consolidated basis, should occur, the banks may decline to lend additional money to the Company under this revolving credit agreement, although borrowings outstanding at the time of such an occurrence would not then become due and payable. As of December 31, 1993, the Company had no short-term borrowings outstanding under this facility. The Company's long-term debt instruments do not limit the amount of short-term debt that the Company may issue. The Company's revolving credit agreement described in the previous paragraph requires it to maintain an available earnings/interest charges ratio of not less than 1.5:1.0 for each 12-month period ending on the last day of each calendar quarter. The Company had a $50 million term loan facility with a group of banks during 1993. Under this agreement, the Company chose an interest rate from among three alternatives: (i) a fluctuating interest rate determined by the prime lending market in New York; (ii) a fixed interest rate determined by the Eurodollar interbank market in London; and (iii) a fixed interest rate determined by the certificate of deposit market in New York. On February 1, 1993, the Company borrowed $50 million from this group of banks, using the proceeds to repay short-term borrowings and other current obligations. On December 3, 1993, the Company repaid the $50 million borrowing and terminated the agreement. The Company had a term loan agreement with PruLease, Inc. (PruLease) that expired on December 1, 1993. This agreement was executed on December 31, 1992, when the Company borrowed $49.1 million from PruLease and purchased all the nuclear fuel that was owned by PruLease and leased to the Company on that date. This loan, which was collateralized by a first lien on the Company's ownership interest in the nuclear fuel for Seabrook Unit 1, was repaid in full at maturity. The Company has a Fossil Fuel Supply Agreement with a financial institution providing for financing up to $37.5 million in fossil fuel purchases. Under this agreement, the financing entity acquires and stores natural gas, coal and fuel oil for sale to the Company, and the Company purchases these fossil fuels from the financing entity at a price for each type of fuel that reimburses the financing entity for the direct costs it has incurred in purchasing and storing the fuel, plus a charge for maintaining an inventory of the fuel determined by reference to the fluctuating interest rate on thirty-day, dealer-placed commercial paper in New York. The Company is obligated to insure the fuel inventories and to indemnify the financing entity against all liabilities, taxes and other expenses incurred as a result of its ownership, storage and sale of fossil fuel to the Company. This agreement currently extends to February 1995. At December 31, 1993, approximately $10.1 million of fossil fuel purchases were being financed under this agreement. - 57 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Information with respect to short-term borrowings is as follows: - 58 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) (G) SUPPLEMENTARY INFORMATION - 59 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (H) PENSION AND OTHER POST-EMPLOYMENT BENEFITS The Company's qualified pension plan, which is based on the highest three years of pay, covers substantially all of its employees, and its entire cost is borne by the Company. The Company also has a non-qualified supplemental plan for certain executives and a non-qualified retiree only plan for certain early retirement benefits. The net pension costs for these plans for 1993, 1992 and 1991 were $14,966,000, $5,749,000 and $2,054,000, respectively. The Company's funding policy for the qualified plan is to make annual contributions that satisfy the minimum funding requirements of ERISA but which do not exceed the maximum deductible limits of the Internal Revenue Code. These amounts are determined each year as a result of an actuarial valuation of the Plan. In accordance with this policy, the Company will be contributing $3.3 million in 1994 for 1993 funding requirements. Previously, due to the application of the full funding limitation under ERISA, the Company had not been required to make a contribution since 1985. The supplemental plan is unfunded. The qualified plan's irrevocable trust fund consists principally of equity and fixed-income securities and real estate investments in approximately the following percentages: - 60 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) - 61 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) In addition to providing pension benefits, the Company also provides other postretirement benefits (OPEB), consisting principally of health care and life insurance benefits, for retired employees and their dependents. Employees with 25 years of service are eligible for full benefits, while employees with less than 25 years of service but greater than 15 years of service are entitled to partial benefits. Years of service prior to age 35 are not included in determining the number of years of service. Prior to January 1, 1993, the Company recognized the cost of providing OPEB on a pay-as-you-go basis by expensing the annual insurance premiums. These costs amounted to $1.3 million and $1.1 million for 1992 and 1991, respectively. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions", which requires, among other things, that OPEB costs be recognized over the employment period that encompasses eligibility to receive such benefits. In its December 16, 1992 decision on the Company's application for retail rate relief, the DPUC recognized the Company's obligation to adopt SFAS No. 106, effective January 1, 1993, and approved the Company's request for revenues to recover OPEB expenses on a SFAS No. 106 basis. A portion of these expenses represents the transition obligation, which will accrue over a 20-year period, representing the future liability for medical and life insurance benefits based on past service for retirees and active employees. For funding purposes, the Company has established two Voluntary Employees' Benefit Association Trusts (VEBA) to fund OPEB for employees who retire on or after January 1, 1994; one VEBA for union employees and one for non-union employees. Approximately 52% of the Company's employees are represented by Local 470-1, Utility Workers Union of America, AFL-CIO, for collective bargaining purposes. The funding policy assumes contributions to these trust funds to be the total OPEB expense under SFAS No. 106, excluding the amount that resulted from the reorganization minus pay-as-you- go benefit payments for pre-January 1, 1994 retirees, allocated in a manner that minimizes current income tax liability, without exceeding maximum tax deductible limits. In accordance with this policy, the Company contributed approximately $3 million to the union VEBA on December 30, 1993. The Company currently plans to fund the portion of the OPEB expense that is related to the reorganization during the years 1994-1996. The 1993 cost for OPEB includes the following components: A one percentage point increase in the assumed health care cost trend rate would have increased the service cost and interest cost components of the 1993 net cost of periodic postretirement benefit by approximately $445,000 and would increase the accumulated postretirement benefit obligation for health care benefits by approximately $2,421,000. - 62 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The following table reconciles the funded status of the plan with the amount recognized in the Consolidated Balance Sheet as of December 31, 1993: The weighted average discount rate used to measure the accumulated postretirement benefit obligation was 7.5%. During 1993, in conjunction with a in-depth organizational review, the Company offered a voluntary early retirement program to non-union employees who were eligible to receive pension benefits. This offer was accepted by 103 employees. The 1993 OPEB cost for this program was $1.267 million. These costs are recognized as a component of the reorganizational charge shown on the Company's Consolidated Statement of Income. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Post-Employment Benefits". This statement, which will be adopted during the first quarter of 1994, establishes accounting standards for employers who provide benefits, such as unemployment compensation, severance benefits and disability benefits, to former or inactive employees after employment but before retirement and requires recognition of the obligation for these benefits. The adoption of this new standard will result in a pre-tax charge against earnings amounting to approximately $2 million during the first quarter of 1994. Subsequent period costs are not expected to be material. - 63 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (I) JOINTLY OWNED PLANT At December 31, 1993, the Company had the following interests in jointly owned plants: The Company's share of the operating costs of jointly owned plants is included in the appropriate expense captions in the Consolidated Statement of Income. (J) UNAMORTIZED CANCELLED NUCLEAR PROJECT From December 1984 through December 1992, the Company had been recovering its investment in Seabrook Unit 2 over a regulatory approved ten-year period without a return on its unamortized investment. In the Company's 1992 rate decision, the DPUC adopted a proposal by the Company to write off its remaining investment in Seabrook Unit 2, beginning January 1, 1993, over a 24-year period, corresponding with the flowback of certain Connecticut Corporation Business Tax (CCBT) credits. Such decision will allow the Company to retain the Seabrook Unit 2/CCBT amounts for ratemaking purposes, with the accumulated CCBT credits not deducted from rate base during the 24-year period of amortization in recognition of a longer period of time for amortization of the Seabrook Unit 2 balance. (K) FUEL FINANCING OBLIGATIONS AND OTHER LEASE OBLIGATIONS The Company has a Fossil Fuel Supply Agreement with a financial institution providing for financing up to $37.5 million in fossil fuel purchases. Under this agreement, the financing entity acquires and stores natural gas, coal and fuel oil for sale to the Company, and the Company purchases these fossil fuels from the financing entity at a price for each type of fuel that reimburses the financing entity for the direct costs it has incurred in purchasing and storing the fuel, plus a charge for maintaining an inventory of the fuel determined by reference to the fluctuating interest rate on thirty-day, dealer-placed commercial paper in New York. The Company is obligated to insure the fuel inventories and to indemnify the financing entity against all liabilities, taxes and other expenses incurred as a result of its ownership, storage and sale of fossil fuel to the Company. This agreement currently extends to February 1995. At December 31, 1993, approximately $10.1 million of fossil fuel purchases were being financed under this agreement. The Company has leases (some of which are capital leases), including arrangements for data processing and office equipment, vehicles, office space and oil tanks. The gross amount of assets recorded under capital leases and the related obligations of those leases as of December 31, 1993 are recorded on the balance sheet. Future minimum lease payments under capital leases, excluding the Seabrook sale/leaseback transaction, which is being treated as a long-term financing, are estimated to be as follows: - 64 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Capitalization of leases has no impact on income, since the sum of the amortization of a leased asset and the interest on the lease obligation equals the rental expense allowed for ratemaking purposes. Rental payments charged to operating expenses in 1993, 1992 and 1991 amounted to $14.1 million, $14.8 million and $14.9 million, respectively. Operating leases, which are charged to operating expense, consist of a large number of small, relatively short-term, renewable agreements for a wide variety of equipment. (L) COMMITMENTS AND CONTINGENCIES Capital Expenditure Program The Company has entered into commitments in connection with its continuing capital expenditure program, which is presently estimated at approximately $366.5 million, excluding AFUDC, for 1994 through 1998. Seabrook After experiencing increasing financial stress beginning in May 1987, Public Service Company of New Hampshire (PSNH), which held the largest ownership share (35.6%) in Seabrook, commenced a proceeding under Chapter 11 of the Bankruptcy Code in January of 1988. Under this statute, PSNH continued its operations while seeking a financial reorganization. A reorganization plan proposed by Northeast Utilities (NU) was confirmed by the bankruptcy court in April of 1990 and, on May 16, 1991, PSNH completed the financing required for payment of its pre-bankruptcy secured and unsecured debt under the first stage of the reorganization plan and emerged from bankruptcy. On May 19, 1992, the NRC issued the final regulatory approval necessary for the second stage of the NU reorganization plan, under which PSNH would be acquired by NU; and on June 5, 1992, this acquisition was completed. As part of the transaction, PSNH's ownership share of Seabrook Unit 1 was transferred to a wholly-owned subsidiary of NU. Two previous regulatory approvals of the NU reorganization plan for PSNH, by the Federal Energy Regulatory Commission (FERC) and the Securities and Exchange Commission (SEC), continue to be challenged in court proceedings, and the Company is unable to predict the outcome of these proceedings. On February 28, 1991, EUA Power Corporation (EUA Power), the holder of a 12.1% ownership share in Seabrook, commenced a proceeding under Chapter 11 of the Bankruptcy Code. EUA Power, a wholly-owned subsidiary of Eastern Utilities Associates (EUA), was organized solely for the purpose of acquiring an ownership share in Seabrook and selling in the wholesale market its share of the electric power produced by Seabrook. EUA Power commenced this bankruptcy proceeding because the cash generated by its sales of power at current market prices was insufficient to pay its obligations on its outstanding debt. Subsequently, EUA Power's name - 65 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) was changed to Great Bay Power Corporation (Great Bay). The official committee of Great Bay's bondholders (Bondholders Committee) has proposed, and the bankruptcy court has confirmed, a reorganization plan for Great Bay, under which substantially all of the equity ownership of Great Bay would pass to its bondholders. On February 2, 1994, the Bondholders Committee accepted a financing proposal that would inject $35 million of new ownership equity into Great Bay. The bankruptcy court must approve this structure before the Great Bay reorganization plan becomes effective. Further approvals are also required from the NRC, FERC and the New Hampshire Public Utilities Commission. The bankruptcy court has approved an agreement among Great Bay, the Bondholders Committee, UI and The Connecticut Light and Power Company (CL&P), under which up to $20 million in advance payments against their respective future monthly Seabrook payment obligations will be made available between UI and CL&P as needed until the reorganization plan becomes effective. UI's share of funding obligations under this agreement totals $8 million. As of December 31, 1993, $5.5 million had been advanced by UI under this agreement. At January 31, 1994, $602,000 of the Company's advances remained outstanding. This agreement can be terminated by UI and CL&P upon thirty days notice or upon failure of the reorganization process to achieve certain milestones by specified dates. UI is unable to predict what impact, if any, failure of the reorganization plan to become effective will have on the operating license for Seabrook Unit 1, or what other actions UI and the other joint owners of the unit may be required to take in response to developments in this bankruptcy proceeding as it may affect Seabrook. Nuclear generating units are subject to the licensing requirements of the Nuclear Regulatory Commission (NRC) under the Atomic Energy Act of 1954, as amended, and a variety of other state and federal requirements. Although Seabrook Unit 1 has been issued a 40-year operating license, NRC proceedings and investigations prompted by inquiries from Congressmen and by NRC licensing board consideration of technical contentions may arise and continue for an indefinite period of time in the future. Nuclear Insurance Contingencies The Price-Anderson Act, currently extended through August 1, 2002, limits public liability resulting from a single incident at a nuclear power plant. The first $200 million of liability coverage is provided by purchasing the maximum amount of commercially available insurance. Additional liability coverage will be provided by an assessment of up to $75.5 million per incident, levied on each of the nuclear units licensed to operate in the United States, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. In addition, if the sum of all public liability claims and legal costs resulting from any nuclear incident exceeds the maximum amount of financial protection, each reactor operator can be assessed an additional 5% of $75.5 million, or $3.775 million. The maximum assessment is adjusted at least every five years to reflect the impact of inflation. Based on its interests in nuclear generating units, the Company estimates its maximum liability would be $20.3 million per incident. However, assessment would be limited to $3.1 million per incident, per year. With respect to each of the operating nuclear generating units in which the Company has an interest, the Company will be obligated to pay its ownership and/or leasehold share of any statutory assessment resulting from a nuclear incident at any nuclear generating unit. The NRC requires nuclear generating units to obtain property insurance coverage in a minimum amount of $1.06 billion and to establish a system of prioritized use of the insurance proceeds in the event of a nuclear incident. The system requires that the first $1.06 billion of insurance proceeds be used to stabilize the nuclear reactor to prevent any significant risk to public health and safety and then for decontamination and cleanup operations. Only following completion of these tasks would the balance, if any, of the segregated insurance proceeds become available to the unit's owners. For each of the nuclear generating units in which the Company has an interest, the Company is required to pay its ownership and/or leasehold share of the cost of purchasing such insurance. - 66 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Other Commitments and Contingencies Hydro-Quebec The Company is a participant in the Hydro-Quebec transmission intertie facility linking New England and Quebec, Canada. Phase II of this facility, in which UI has a 5.45% participating share, has increased the capacity value of the intertie from 690 megawatts to a maximum of 2000 megawatts. A ten-year Firm Energy Contract, which provides for the sale of 7 million megawatt-hours per year by Hydro-Quebec to the New England participants in the Phase II facility, became effective on July 1, 1991. The Company is obligated to furnish a guarantee for its participating share of the debt financing for the Phase II facility. Currently, the Company's guarantee liability for this debt amounts to approximately $9.8 million. Reorganization Charge During 1993, the Company undertook an in-depth organizational review with the primary objective of improving customer service. As a result of this review, the Company eliminated approximately 75 positions. In conjunction with this review, the Company offered a voluntary early retirement program to non-union employees who were eligible to receive pension benefits. The early retirement offer was accepted by 103 employees and the Company incurred a one-time charge to 1993 earnings of approximately $13.6 million ($7.8 million, after-tax). No decision has been made as to whether to offer a severance program to employees who may be affected by the organizational review when it is completed, but who were not eligible for, or did not accept, the early retirement offer. Site Remediation Costs The Company has estimated that the cost of environmental remediation of its decommissioned Steel Point Station property in Bridgeport will be approximately $10.3 million and has recorded a liability for this cost. Following remediation, the Company intends to sell the property for development for a value it estimates will not exceed $6 million. In the Company's last rate decision, the DPUC provided additional revenues to recover the $4.3 million difference during the period 1993-1996, subject to true-up in the Company's next retail rate proceeding, based on actual remediation costs and the actual gain on the sale of the property. Property Taxes In November 1993, the Company received "updated" personal property tax bills from the City of New Haven (the City) for the tax year 1991-1992, aggregating $6.6 million, based on an audit by the City's tax assessor. The Company anticipates receiving additional bills of this sort for the tax years 1992-1993 and 1993-1994, the amounts of which cannot be predicted at this time. The Company is contesting these tax bills vigorously and has commenced an action in the Superior Court to enjoin the City from any effort to collect these tax bills. Due to a lack of data, it is not possible, at this time, to assess accurately the Company's liability, if any. (M) NUCLEAR FUEL DISPOSAL AND NUCLEAR PLANT DECOMMISSIONING Costs associated with nuclear plant operations include amounts for disposal of nuclear wastes, including spent fuel, and for the ultimate decommissioning of the plants. Under the Nuclear Waste Policy Act of 1982, the federal Department of Energy (DOE) is required to design, license, construct and operate a permanent repository for high level radioactive wastes and spent nuclear fuel. The Act requires the DOE to provide, beginning in 1998, for the disposal of spent nuclear fuel and high level radioactive waste from commercial nuclear plants through contracts with the owners and generators of such waste; and the DOE has established disposal - 67 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) fees that are being paid to the federal government by electric utilities owning or operating nuclear generating units. In return for payment of the prescribed fees, the federal government is to take title to and dispose of the utilities' high level wastes and spent nuclear fuel beginning no later than 1998. However, the DOE has announced that its first high level waste repository will not be in operation earlier than 2010, notwithstanding the DOE's statutory and contractual responsibility to begin disposal of high-level radioactive waste and spent fuel beginning not later than January 31, 1998. Until the federal government begins receiving such materials in accordance with the Nuclear Waste Policy Act, operating nuclear generating units will need to retain high level wastes and spent fuel on-site or make other provisions for their storage. Storage facilities for Millstone Unit 3 are expected to be adequate for the projected life of the unit. Storage facilities for the Connecticut Yankee unit are expected to be adequate through the mid-1990s. Storage facilities for Seabrook Unit 1 are expected to be adequate until at least 2010. Fuel consolidation and compaction technologies are being developed and are expected to provide adequate storage capability for the projected lives of the latter two units. In addition, other licensed technologies, such as dry storage casks, can accommodate spent fuel storage requirements. Disposal costs for low-level radioactive wastes (LLW) that result from normal operation of nuclear generating units have increased significantly in recent years and are expected to continue to increase. The cost increases are functions of increased packaging and transportation costs and higher fees and surcharges charged by the disposal facilities. Pursuant to the Low-Level Radioactive Waste Policy Act of 1980, each state was responsible for providing disposal facilities for LLW generated within the state and was authorized to join with other states into regional compacts to jointly fulfill their responsibilities. Pursuant to the Low-Level Radioactive Waste Policy Amendments Act of 1985, each state in which a currently operating disposal facility is located (South Carolina, Nevada and Washington) is allowed to impose volume limits and a surcharge on shipments of LLW from states that are not members of the compact in the region in which the facility is located. On June 19, 1992, the United States Supreme Court issued a decision upholding certain parts of the Low-Level Radioactive Waste Policy Amendments Act of 1985, but invalidating a key provision of that law requiring each state to take title to LLW generated within that state if the state fails to meet federally-mandated deadlines for siting LLW disposal facilities. The decision has resulted in uncertainty about states' continuing roles in siting LLW disposal facilities and may result in increased LLW disposal costs and the need for longer interim LLW storage before a permanent solution is developed. The Connecticut Hazardous Waste Management Service (the Service), a state quasi-public corporation, was charged with coordinating the establishment of a facility for disposal of LLW originating in Connecticut. In June 1991, the Service announced that it had selected three potential sites in north-central Connecticut for further study. The Service's announcement provoked intense controversy in the affected municipalities and resulted in legislative action to stop the selection process. On February 1, 1993, the Service presented the legislature with a new site selection plan under which communities are urged to volunteer a site for a facility in return for financial and other incentives. The volunteer process is being continued in 1994. The Service's activities in this regard are funded by assessments on Connecticut's LLW generators. Due to a change in the volunteer process, there was no assessment for the 1993-1994 fiscal year and the state projects no assessment for the 1994-1995 and 1995-1996 fiscal years. Additional LLW storage capacity has been or can be constructed or acquired at the Millstone and Connecticut Yankee sites to provide for temporary storage of LLW should that become necessary. Connecticut LLW can be managed by volume reduction, storage or shipment at least through 1999. The Company cannot predict whether and when a disposal site will be designated in Connecticut. The State of New Hampshire has not met deadlines for compliance with the Low-Level Radioactive Waste Policy Act, and Seabrook Unit 1 has been denied access to existing disposal facilities. Therefore, LLW generated - 68 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) by Seabrook Unit 1 is being stored on-site. The Seabrook storage facility currently has capacity to store approximately five years' accumulation of waste generated by Seabrook, and the plant operator plans to expand its storage capacity as necessary. NRC licensing requirements and restrictions are also applicable to the decommissioning of nuclear generating units at the end of their service lives, and the NRC has adopted comprehensive regulations concerning decommissioning planning, timing, funding and environmental reviews. UI and the other owners of the nuclear generating units in which UI has interests estimate decommissioning costs for the units and attempt to recover sufficient amounts through their allowed electric rates to cover expected decommissioning costs. Changes in NRC requirements or technology can increase estimated decommissioning costs, and UI's customers in future years may experience higher electric rates to offset the effects of any insufficient rate recovery in prior years. New Hampshire has enacted a law requiring the creation of a government-managed fund to finance the decommissioning of nuclear generating units in that state. The New Hampshire Nuclear Decommissioning Financing Committee (NDFC) established $345 million (in 1993 dollars) as the decommissioning cost estimate for Seabrook Unit 1. This estimate premises the prompt removal and dismantling of the Unit at the end of its estimated 40-year energy producing life. Monthly decommissioning payments are being made to the state-managed decommissioning trust fund. UI's share of the decommissioning payments made during 1993 was $1.3 million. UI's share of the fund at December 31, 1993 was approximately $3.7 million. Connecticut has enacted a law requiring the operators of nuclear generating units to file periodically with the DPUC their plans for financing the decommissioning of the units in that state. Current decommissioning cost estimates for Millstone Unit 3 and Connecticut Yankee are $421 million (in 1994 dollars) and $324 million (in 1994 dollars), respectively. These estimates premise the prompt removal and dismantling of each unit at the end of its estimated 40-year energy producing life. Monthly decommissioning payments, based on these cost estimates, are being made to decommissioning trust funds managed by Northeast Utilities. UI's share of the Millstone Unit 3 decommissioning payments made during 1993 was $328,000. UI's share of the fund at December 31, 1993 was approximately $1.9 million. For the Company's 9.5% equity ownership in Connecticut Yankee, decommissioning costs of $1.3 million were funded by UI during 1993, and UI's share of the fund at December 31, 1993 was $9.5 million. Environmental Concerns In complying with existing environmental statutes and regulations and further developments in these and other areas of environmental concern, including legislation and studies in the fields of water and air quality (particularly "air toxics", "ozone non-attainment" and "global warming"), hazardous waste handling and disposal, toxic substances, and electric and magnetic fields, the Company may incur substantial capital expenditures for equipment modifications and additions, monitoring equipment and recording devices, and it may incur additional operating expenses. Litigation expenditures may also increase as a result of scientific investigations, and speculation and debate, concerning the possibility of harmful health effects of electric and magnetic fields. The Company believes that any additional costs incurred for these purposes will be recoverable through the ratemaking process. The total amount of these expenditures is not now determinable. (N) CHANGE IN METHOD OF ACCOUNTING FOR PROPERTY TAXES Effective January 1, 1991, the Company changed its method of accounting for property taxes from accrual over the twelve-month period following assessment date to accrual over the fiscal period of the applicable taxing authority. The effect of the change in accounting was to increase 1991 earnings for common stock by $7.9 million, of which $7.3 million represented the cumulative effect of the change at January 1, 1991, and $.6 million represented an increase in earnings for 1991. - 69 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (O) FAIR VALUE OF FINANCIAL INSTRUMENTS (1) The estimated fair values of the Company's financial instruments are as follows: - 70 - THE UNITED ILLUMINATING COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (P) QUARTERLY FINANCIAL DATA (UNAUDITED) Selected quarterly financial data for 1993 and 1992 are set forth below: - 71 - REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- To the Shareowners and Directors of The United Illuminating Company: We have audited the accompanying consolidated balances sheets of The United Illuminating Company as of December 31, 1993, 1992 and 1991, and related consolidated statements of income, retained earnings and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of The United Illuminating Company as of December 31, 1993, 1992, and 1991, and the consolidated results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles. /s/ COOPERS & LYBRAND Hartford, Connecticut January 24, 1994 - 72 - Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures. Not Applicable PART III Item 10. Directors and Executive Officers of the Company. The information appearing under the captions "NOMINEES FOR ELECTION AS DIRECTORS" AND "COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934" in the Company's definitive Proxy Statement, dated April 8, 1994, for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in partial answer to this item. See also "EXECUTIVE OFFICERS OF THE COMPANY", following Part I, Item 4 herein. Item 11. Executive Compensation. The information appearing under the captions "EXECUTIVE COMPENSATION," "STOCK OPTION PLAN," "RETIREMENT PLANS," "STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES," "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION" AND "DIRECTOR COMPENSATION" in the Company's definitive Proxy Statement, dated April 8, 1994, for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in answer to this item. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information appearing under the captions "PRINCIPAL SHAREHOLDERS" and "STOCK OWNERSHIP OF DIRECTORS AND OFFICERS" in the Company's definitive Proxy Statement, dated April 8, 1994 for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in answer to this item. Item 13. Certain Relationships and Related Transactions. The information appearing under the caption "NOMINEES FOR ELECTION AS DIRECTORS" in the Company's definitive Proxy Statement, dated April 8, 1994, for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in answer to this item. - 73 - PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as a part of this report: Financial Statements (see Item 8): Consolidated statement of income for the years ended December 31, 1993, 1992 and 1991 Consolidated statement of cash flows for the years ended December 31, 1993, 1992 and 1991 Consolidated balance sheet, December 31, 1993, 1992 and 1991 Consolidated statement of retained earnings for the years ended December 31, 1993, 1992 and 1991 Statement of accounting policies Notes to consolidated financial statements Report of independent accountants Financial Statement Schedules (see S-1 through S-5) Schedule V - Property, plant and equipment for the years ended December 31, 1993, 1992 and 1991. Schedule VI - Accumulated depreciation, depletion and amortization of property, plant and equipment for the years ended December 31, 1993, 1992 and 1991. Schedule VIII - Valuation and qualifying accounts for the years ended December 31, 1993, 1992 and 1991. - 74 - Exhibits: Pursuant to Rule 12b-32 under the Securities Exchange Act of 1934, certain of the following listed exhibits which are annexed as exhibits to previous statements and reports filed by the Company are hereby incorporated by reference as exhibits to this report. Such statements and reports are identified by reference numbers as follows: (1) Filed with Annual Report (Form 10-K) for fiscal year ended December 31, 1991. (2) Filed with Registration Statement No. 2-45434, effective September 25, 1972, and Registration Statement No. 2-45435, effective September 26, 1972. (3) Filed with Registration Statement No. 2-60849, effective July 24, 1978. (4) Filed with Registration Statement No. 2-66518, effective February 25, 1980. (5) Filed with Registration Statement No. 2-57275, effective October 19, 1976. (6) Filed with Registration Statement No. 2-67998, effective June 19, 1980. (7) Filed with Registration Statement No. 2-72907, effective July 16, 1981. (8) Filed with Post-Effective Amendment No. 1 to Registration Statement No. 2-78643, effective August 19, 1982. (9) Filed with Annual Report (Form 10-K) for fiscal year ended December 31, 1990. (10) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended September 30, 1991. (11) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended March 31, 1991. (12) Filed with Annual Report (Form 10-K) for fiscal year ended December 31, 1992. (13 Filed with Registration Statement No. 33-40169, effective August 12, 1991. (14) Filed with Registration Statement No. 33-35465, effective August 1, 1990. (15) Filed with Registration Statement No. 2-49669, effective December 11, 1973. (16) Filed with Registration Statement No. 2-54876, effective November 19, 1975. (17) Filed with Registration Statement No. 2-52657, effective February 6, 1975. (18) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended June 30, 1992. (19) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended September 30, 1990. - 75 - The exhibit number in the statement or report referenced is set forth in the parenthesis following the description of the exhibit. Those of the following exhibits not so identified are filed herewith. Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (3) 3.1 (1) Copy of Charter of The United Illuminating Company, dated December 15, 1965. (Exhibit 3.1) (3) 3.2 (2) Copy of a certificate concerning the creation of a class of Preferred Stock of The United Illuminating Company and the authority of the Board of Directors to issue said Preferred Stock, dated July 13, 1956, and filed with the Secretary of State of Connecticut July 13, 1956. (Exhibit 3.12) (3) 3.3 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated November 19, 1962, andfiled with the Secretary of State of Connecticut November 29, 1962. (Exhibit 3.3) (3) 3.4 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated October 25, 1965, and filed with the Secretary of State of Connecticut November 22, 1965. (Exhibit 3.4) (3) 3.5 (2) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated June 6, 1967, and filed with the Secretary of State of Connecticut June 6, 1967. (Exhibit 3.13) (3) 3.6 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated December 1, 1967, and filed with the Secretary of State of Connecticut December 7, 1967. (Exhibit 3.6) (3) 3.7 (3) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated April 27, 1971, and filed with the Secretary of State of Connecticut April 29, 1971. (Exhibit 2.2-14) (3) 3.8 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated March 29, 1972, and filed with the Secretary of State of Connecticut March 30, 1972. (Exhibit 3.8) (3) 3.9 (4) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated May 4 1973, and filed with the Secretary of State of Connecticut May 7, 1973. (Exhibit 2.2-17) (3) 3.10 Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated July 2, 1973, and filed with the Secretary of State of Connecticut July 2, 1973. (Exhibit 3.10) (3) 3.11 (5) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated April 26, 1976, and filed with the Secretary of State of Connecticut April 27, 1976. (Exhibit 2.2-18) (3) 3.12 (5) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated April 26, 1976, and filed with the Secretary of State of Connecticut April 27, 1976. (Exhibit 2.2-19) (3) 3.13 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated October 20, 1976, and filed with the Secretary of State of Connecticut October 21, 1976. (Exhibit 3.13) (3) 3.14 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated April 4, 1979, and filed with the Secretary of State of Connecticut April 5, 1979. (Exhibit 3.14) (3) 3.15 Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated April 29, 1980, and filed with the Secretary of State of Connecticut April 30, 1980. (Exhibit 3.15) - 76 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (3) 3.16 (6) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated May 20, 1980, and filed with the Secretary of State of Connecticut May 23, 1980. (Exhibit 2.2-20) (3) 3.17 (7) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated June 12, 1981, and filed with the Secretary of State of Connecticut June 16, 1981. (Exhibit 1.20) (3) 3.18 (12) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated July 13, 1981, and filed with the Secretary of State of Connecticut July 14, 1981. (3) 3.19 (8) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated June 1, 1983, and filed with the Secretary of State of Connecticut June 3, 1983. (Exhibit 4.31) (3) 3.20 (9) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated July 24, 1984, and filed with the Secretary of State of Connecticut July 24, 1984. (Exhibit 1) (3) 3.21 (9) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated August 8, 1984, and filed with the Secretary of State of Connecticut August 9, 1984. (Exhibit 2) (3) 3.22 (9) Copy of Certificate Amending or Restating Certificate of Incorporation, filed with the Secretary of State of Connecticut August 1, 1990. (Exhibit 3.22) (3) 3.23 (10) Copy of Certificate Amending or Restating Certificate of Incorporation, dated May 9, 1991, and filed with the Secretary of State of Connecticut August 27, 1991. (Exhibit 3.22a) (3) 3.24a (3) Copy of Bylaws of The United Illuminating Company. (Exhibit 2.3) (3) 3.24b (10) Copy of Article II, Section 2, of Bylaws of The United Illuminating Company, as amended March 26, 1990, amending Exhibit 3.24a. (Exhibit 3.23b) (3) 3.24c (11) Copy of Article V, Section 1, of Bylaws of The United Illuminating Company, as amended April 22, 1991, amending Exhibit 3.24a. (Exhibit 3.23c) (4) 4.1 (9) Copy of First Mortgage Indenture and Deed of Trust, dated as of December 1, 1984, between Bridgeport Electric Company and The First National Bank of Boston, Trustee. (Exhibit 4.12) (4) 4.2 (12) Copy of First Supplemental Mortgage Indenture, dated as of February 15, 1987, between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending and supplementing Exhibit 4.1. (Exhibit 4.2) (4) 4.3 (12) Copy of Second Supplemental Mortgage Indenture, dated as of January 14, 1988, between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending and supplementing Exhibit 4.1 and amending Exhibit 4.2. (Exhibit 4.3) (4) 4.4 Copy of Third Supplemental Mortgage Indenture, dated as of March 31, 1988 between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending Exhibit 4.1. (4) 4.5 (13) Copy of Indenture, dated as of August 1, 1991, from The United Illuminating Company to The Bank of New York, Trustee. (Exhibit 4) (4) 4.6 (14) Copy of Participation Agreement, dated as of (10) August 1, 1990, among Financial Leasing Corporation, Meridian Trust Company, The Bank of New York and The United Illuminating Company. (Exhibits 4(a) through 4(h), inclusive, Amendment Nos. 1 and 2). - 77 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (10) 10.1 (5) Copy of Stockholder Agreement, dated as of July 1, 1964, among the various stockholders of Connecticut Yankee Atomic Power Company, including The United Illuminating Company. (Exhibit 5.1-1) (10) 10.2a (5) Copy of Power Contract, dated as of July 1, 1964, between Connecticut Yankee Atomic Power Company and The United Illuminating Company. (Exhibit 5.1-2) (10) 10.2b (3) Copy of Supplementary Power Contract, dated as of March 1, 1978, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, supplementing Exhibit 10.2a. (Exhibit 5.1-6) (10) 10.2c (1) Copy of Agreement Amending Supplementary Power Contract, dated August 22, 1980, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, amending Exhibit 10.2b. (Exhibit 10.2b) (10) 10.2d (12) Copy of Second Amendment of the Supplementary Power Contract, dated as of October 15, 1982, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, amending Exhibit 10.2b. (Exhibit 10.2d) (10) 10.2e (9) Copy of Second Supplementary Power Contract, dated as of April 30, 1984, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, supplementing Exhibit 10.2a. (Exhibit 10.2e) (10) 10.2f (9) Copy of Additional Power Contract, dated as of April 30, 1984, between Connecticut Yankee Atomic Power Company and The United Illuminating Company. (Exhibit 10.2f) (10) 10.3 (5) Copy of Capital Funds Agreement, dated as of September 1, 1964, between Connecticut Yankee Atomic Power Company and The United Illuminating Company. (Exhibit 5.1-3) (10) 10.4a (5) Copy of Connecticut Yankee Transmission Agreement, dated as of October 1, 1964, among the various stockholders of Connecticut Yankee Atomic Power Company, including The United Illuminating Company. (Exhibit 5.1-4) (10) 10.4b (4) Copy of Agreement Amending and Revising Connecticut Yankee Transmission Agreement, dated as of July 1, 1979, amending Exhibit 10.4a. (Exhibit 5.1-7) (10) 10.5 (3) Copy of Capital Contributions Agreement, dated October 16, 1967, between The United Illuminating Company and Connecticut Yankee Atomic Power Company. (Exhibit 5.1-5) (10) 10.6a (1) Copy of NEPOOL Power Pool Agreement, dated as of September 1, 1971, as amended to November 1, 1988. (Exhibit 10.6a) (10) 10.6b (15) Copy of Agreement Setting Out Supplemental NEPOOL Understandings, dated as of April 2, 1973. (Exhibit 5.7-10) (10) 10.6c (1) Copy of Amendment to NEPOOL Power Pool Agreement, dated as of March 15, 1989, amending Exhibit 10.6a. (Exhibit 10.6c) (10) 10.6d (1) Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of October 1, 1990, amending Exhibit 10.6a. (Exhibit 10.6d) (10) 10.6e Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of September 15, 1992, amending Exhibit 10.6a. (10) 10.6f Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of June 1, 1993, amending Exhibit 10.6a. (10) 10.7a (1) Copy of Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units, dated May 1, 1973, as amended to February 1, 1990. (Exhibit 10.7a) (10) 10.7b (16) Copy of Transmission Support Agreement, dated as of May 1, 1973, among the Seabrook Companies. (Exhibit 5.9-2) - 78 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (10) 10.7c (10) Copy of Twenty-third Amendment to Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units, dated as of November 1, 1990, amending Exhibit 10.7a. (Exhibit 10.8ab) (10) 10.8a (4) Copy of Sharing Agreement - 1979 Connecticut Nuclear Unit, dated as of September 1, 1973, among The Connecticut Light and Power Company, The Hartford Electric Light Company, Western Massachusetts Electric Company, New England Power Company, The United Illuminating Company, Public Service Company of New Hampshire, Central Vermont Public Service Company, Montaup Electric Company and Fitchburg Gas and Electric Light Company, relating to a nuclear fueled generating unit in Connecticut. (Exhibit 5.8-1) (10) 10.8b (17) Copy of Amendment to Sharing Agreement - 1979 Connecticut Nuclear Unit, dated as of August 1, 1974, amending Exhibit 10.8a. (Exhibit 5.9-2) (10) 10.8c (5) Copy of Amendment to Sharing Agreement - 1979 Connecticut Nuclear Unit, dated as of December 15, 1975, amending Exhibit 10.8a. (Exhibit 5.8-4, Post-effective Amendment No. 2) (10) 10.9a (3) Copy of Transmission Line Agreement, dated January 13, 1966, between the Trustees of the Property of The New York, New Haven and Hartford Railroad Company and The United Illuminating Company. (Exhibit 5.4) (10) 10.9b (1) Notice, dated April 24, 1978, of The United Illuminating Company's intention to extend term of Transmission Line Agreement dated January 13, 1966, Exhibit 10.9a. (Exhibit 10.9b) (10) 10.9c (1) Copy of Letter Agreement, dated March 28, 1985, between The United Illuminating Company and National Railroad Passenger Corporation, supplementing and modifying Exhibit 10.9a. (Exhibit 10.9c) (10) 10.10 (12) Copy of Agreement, effective May 16, 1992, between The United Illuminating Company and Local 470-1, Utility Workers Union of America, AFL-CIO. (Exhibit 10.10) (10) 10.11 Copy of Fuel Oil Purchase and Sale Agreement, dated as of October 1, 1993, among Tosco Corporation, The United Illuminating Company and The Connecticut Light and Power Company. (Confidential treatment requested) (10) 10.12 (12) Copy of Coal Sales Agreement, dated as of August 1, 1992, between Pittston Coal Sales Corp. and The United Illuminating Company. (Confidential treatment requested) (Exhibit 10.13) (10) 10.13 (10) Copy of Fossil Fuel Supply Agreement between BLC Corporation and The United Illuminating Company, dated as of July 1, 1991. (Exhibit 10.31) (10) 10.14a (9) Copy of Lease, dated as of December 1, 1984, between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee. (Exhibit 10.22a) (10) 10.14b (12) Copy of Amendment, dated as of February 15, 1987, to Lease between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee, amending Exhibit 10.16a. (Exhibit 10.16b) (10) 10.14c (12) Copy of Second Amendment to Lease, dated as of December 9, 1987, between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee, amending Exhibit 10.16a. (Exhibit 10.16c) (10) 10.14d (12) Copy of Third Amendment to Lease, dated as of January 14, 1988, between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee, amending Exhibit 10.16a. (Exhibit 10.16d) - 79 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (10) 10.15a (12) Copy of Revolving Credit Agreement, dated as of January 25, 1993, among The United Illuminating Company, the Banks named therein, and Citibank, N.A., as Agent for the Banks. (Exhibit 10.19) (10) 10.15b Copy of letter, dated January 27, 1994, from Citibank, N.A., extending the expiration date of Exhibit 10.15a to January 19, 1995. (10) 10.16a* (12) Copy of Employment Agreement, dated as of January 1, 1988, between The United Illuminating Company and Richard J. Grossi. (Exhibit 10.22a) (10) 10.16b* (19) Copy of Amendment to Employment Agreement, dated as of July 23, 1990, between The United Illuminating Company and Richard J. Grossi, amending Exhibit 10.22a. (Exhibit 10.26a) (10) 10.17a* (12) Copy of Employment Agreement, dated as of January 1, 1988, between The United Illuminating Company and Robert L. Fiscus. (Exhibit 10.23a) (10) 10.17b* (19) Copy of Amendment to Employment Agreement, dated as of July 23, 1990, between The United Illuminating Company and Robert L. Fiscus, amending Exhibit 10.23a. (Exhibit 10.27a) (10) 10.18a* (12) Copy of Employment Agreement, dated as of January 1, 1988, between The United Illuminating Company and James F. Crowe. (Exhibit 10.24a) (10) 10.18b* (19) Copy of Amendment to Employment Agreement, dated as of July 23, 1990, between The United Illuminating Company and James F. Crowe, amending Exhibit 10.24a. (Exhibit 10.28a) (10) 10.19* (1) Copy of Executive Incentive Compensation Program of The United Illuminating Company. (Exhibit 10.24) (10) 10.21a* (19) Copy of The United Illuminating Company 1990 Stock Option Plan. (Exhibit 10.33) (10) 10.21b Amendments to The United Illuminating Company 1990 Stock Option Plan, adopted November 22, 1993 and January 24, 1994. (21) 21 List of subsidiaries of The United Illuminating Company. (28) 28.1 (12) Copies of significant rate schedules of The United Illuminating Company. (Exhibit 28.1) - ----------------------- *Management contract or compensatory plan or arrangement. The foregoing list of exhibits does not include instruments defining the rights of the holders of certain long-term debt of the Company and its subsidiaries where the total amount of securities authorized to be issued under the instrument does not exceed ten (10%) of the total assets of the Company and its subsidiaries on a consolidated basis; and the Company hereby agrees to furnish a copy of each such instrument to the Securities and Exchange Commission on request. (b) Reports on Form 8-K. Items Financial Statements Date of Reported Filed Report - -------- -------------------- ------- 5 None December 22, 1993 - 80 - CONSENT OF INDEPENDENT ACCOUNTANTS ---------------------------------- We consent to the incorporation by reference in the Registration Statement of The United Illuminating Company on Form S-3 (File No. 33-50221) and the Registration Statement on Form S-3 (File No. 33-50445) of our report, dated January 24, 1994, on our audits of the consolidated financial statements and financial statement schedules of The United Illuminating Company as of December 31, 1993, 1992 and 1991 and for the years then ended, which report is included in this Annual Report on Form 10-K. /s/ COOPERS & LYBRAND Hartford, Connecticut February 15, 1994 - 81 - SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE UNITED ILLUMINATING COMPANY By /s/ Richard J. Grossi ------------------------------ Richard J. Grossi Chairman of the Board of Directors and Chief Executive Officer Date: February 18, 1994 ----------------- 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. Signature Title Date --------- ----- ---- Director, Chairman of the Board of Directors and /s/ Richard J. Grossi Chief Executive Officer February 18, 1994 - --------------------- (Richard J. Grossi) (Principal Executive Officer) Director, President and /s/ Robert L. Fiscus Chief Financial Officer February 18, 1994 - --------------------- (Robert L. Fiscus) (Principal Financial and Accounting Officer) /s/ John D. Fassett Director February 18, 1994 - -------------------- (John D. Fassett) /s/ Leland W. Miles Director February 18, 1994 - -------------------- (Leland W. Miles) /s/ William S. Warner Director February 18, 1994 - ---------------------- (William S. Warner) /s/ John F. Croweak Director February 18, 1994 - -------------------- (John F. Croweak) /s/ F. Patrick McFadden, Jr. Director February 18, 1994 - ----------------------------- (F. Patrick McFadden, Jr.) /s/ J. Hugh Devlin Director February 18, 1994 - ------------------- (J. Hugh Devlin) /s/ Betsy Henley-Cohn Director February 18, 1994 - ---------------------- (Betsy Henley-Cohn) Director February , 1994 - ------------------------ (Frank R. O'Keefe, Jr.) /s/ James A. Thomas Director February 18, 1994 - ---------------------- (James A. Thomas) /s/ David E.A. Carson Director February 18, 1994 - ---------------------- (David E.A. Carson) - 82 - S-1 S-2 S-3 S-4 S-5 EXHIBIT INDEX (a) Exhibits Exhibit Table Item Exhibit Number Number Description Page No. ---------- ------- ----------- -------- (4) 4.4 Copy of Third Supplemental Mortgage Indenture, dated as of March 31, 1988 between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending Exhibit 4.1. (10) 10.6e Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of September 15, 1992, amending Exhibit 10.6a. (10) 10.6f Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of June 1, 1993, amending Exhibit 10.6a. (10) 10.11 Copy of Fuel Oil Purchase and Sale Agreement, dated as of October 1, 1993, among Tosco Corporation, The United Illuminating Company and The Connecticut Light and Power Company. (Confidential treatment requested) (10) 10.15b Copy of letter, dated January 27, 1994, from Citibank, N.A., extending the expiration date of Exhibit 10.15a to January 19, 1995. (10) 10.21b Amendments to The United Illuminating Company 1990 Stock Option Plan, adopted November 22,1993 and January 24, 1994. (21) 21 List of subsidiaries of The United Illuminating Company. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures. Not Applicable PART III Item 10. Item 10. Directors and Executive Officers of the Company. The information appearing under the captions "NOMINEES FOR ELECTION AS DIRECTORS" AND "COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934" in the Company's definitive Proxy Statement, dated April 8, 1994, for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in partial answer to this item. See also "EXECUTIVE OFFICERS OF THE COMPANY", following Part I, Item 4 herein. Item 11. Item 11. Executive Compensation. The information appearing under the captions "EXECUTIVE COMPENSATION," "STOCK OPTION PLAN," "RETIREMENT PLANS," "STOCK OPTION EXERCISES IN 1993 AND YEAR-END OPTION VALUES," "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION" AND "DIRECTOR COMPENSATION" in the Company's definitive Proxy Statement, dated April 8, 1994, for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in answer to this item. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The information appearing under the captions "PRINCIPAL SHAREHOLDERS" and "STOCK OWNERSHIP OF DIRECTORS AND OFFICERS" in the Company's definitive Proxy Statement, dated April 8, 1994 for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in answer to this item. Item 13. Item 13. Certain Relationships and Related Transactions. The information appearing under the caption "NOMINEES FOR ELECTION AS DIRECTORS" in the Company's definitive Proxy Statement, dated April 8, 1994, for the Annual Meeting of the Shareholders to be held on May 18, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission on or about April 8, 1994, is incorporated by reference in answer to this item. - 73 - PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as a part of this report: Financial Statements (see Item 8): Consolidated statement of income for the years ended December 31, 1993, 1992 and 1991 Consolidated statement of cash flows for the years ended December 31, 1993, 1992 and 1991 Consolidated balance sheet, December 31, 1993, 1992 and 1991 Consolidated statement of retained earnings for the years ended December 31, 1993, 1992 and 1991 Statement of accounting policies Notes to consolidated financial statements Report of independent accountants Financial Statement Schedules (see S-1 through S-5) Schedule V - Property, plant and equipment for the years ended December 31, 1993, 1992 and 1991. Schedule VI - Accumulated depreciation, depletion and amortization of property, plant and equipment for the years ended December 31, 1993, 1992 and 1991. Schedule VIII - Valuation and qualifying accounts for the years ended December 31, 1993, 1992 and 1991. - 74 - Exhibits: Pursuant to Rule 12b-32 under the Securities Exchange Act of 1934, certain of the following listed exhibits which are annexed as exhibits to previous statements and reports filed by the Company are hereby incorporated by reference as exhibits to this report. Such statements and reports are identified by reference numbers as follows: (1) Filed with Annual Report (Form 10-K) for fiscal year ended December 31, 1991. (2) Filed with Registration Statement No. 2-45434, effective September 25, 1972, and Registration Statement No. 2-45435, effective September 26, 1972. (3) Filed with Registration Statement No. 2-60849, effective July 24, 1978. (4) Filed with Registration Statement No. 2-66518, effective February 25, 1980. (5) Filed with Registration Statement No. 2-57275, effective October 19, 1976. (6) Filed with Registration Statement No. 2-67998, effective June 19, 1980. (7) Filed with Registration Statement No. 2-72907, effective July 16, 1981. (8) Filed with Post-Effective Amendment No. 1 to Registration Statement No. 2-78643, effective August 19, 1982. (9) Filed with Annual Report (Form 10-K) for fiscal year ended December 31, 1990. (10) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended September 30, 1991. (11) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended March 31, 1991. (12) Filed with Annual Report (Form 10-K) for fiscal year ended December 31, 1992. (13 Filed with Registration Statement No. 33-40169, effective August 12, 1991. (14) Filed with Registration Statement No. 33-35465, effective August 1, 1990. (15) Filed with Registration Statement No. 2-49669, effective December 11, 1973. (16) Filed with Registration Statement No. 2-54876, effective November 19, 1975. (17) Filed with Registration Statement No. 2-52657, effective February 6, 1975. (18) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended June 30, 1992. (19) Filed with Quarterly Report (Form 10-Q) for fiscal quarter ended September 30, 1990. - 75 - The exhibit number in the statement or report referenced is set forth in the parenthesis following the description of the exhibit. Those of the following exhibits not so identified are filed herewith. Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (3) 3.1 (1) Copy of Charter of The United Illuminating Company, dated December 15, 1965. (Exhibit 3.1) (3) 3.2 (2) Copy of a certificate concerning the creation of a class of Preferred Stock of The United Illuminating Company and the authority of the Board of Directors to issue said Preferred Stock, dated July 13, 1956, and filed with the Secretary of State of Connecticut July 13, 1956. (Exhibit 3.12) (3) 3.3 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated November 19, 1962, andfiled with the Secretary of State of Connecticut November 29, 1962. (Exhibit 3.3) (3) 3.4 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated October 25, 1965, and filed with the Secretary of State of Connecticut November 22, 1965. (Exhibit 3.4) (3) 3.5 (2) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated June 6, 1967, and filed with the Secretary of State of Connecticut June 6, 1967. (Exhibit 3.13) (3) 3.6 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated December 1, 1967, and filed with the Secretary of State of Connecticut December 7, 1967. (Exhibit 3.6) (3) 3.7 (3) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated April 27, 1971, and filed with the Secretary of State of Connecticut April 29, 1971. (Exhibit 2.2-14) (3) 3.8 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated March 29, 1972, and filed with the Secretary of State of Connecticut March 30, 1972. (Exhibit 3.8) (3) 3.9 (4) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated May 4 1973, and filed with the Secretary of State of Connecticut May 7, 1973. (Exhibit 2.2-17) (3) 3.10 Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated July 2, 1973, and filed with the Secretary of State of Connecticut July 2, 1973. (Exhibit 3.10) (3) 3.11 (5) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated April 26, 1976, and filed with the Secretary of State of Connecticut April 27, 1976. (Exhibit 2.2-18) (3) 3.12 (5) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated April 26, 1976, and filed with the Secretary of State of Connecticut April 27, 1976. (Exhibit 2.2-19) (3) 3.13 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated October 20, 1976, and filed with the Secretary of State of Connecticut October 21, 1976. (Exhibit 3.13) (3) 3.14 (1) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated April 4, 1979, and filed with the Secretary of State of Connecticut April 5, 1979. (Exhibit 3.14) (3) 3.15 Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated April 29, 1980, and filed with the Secretary of State of Connecticut April 30, 1980. (Exhibit 3.15) - 76 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (3) 3.16 (6) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated May 20, 1980, and filed with the Secretary of State of Connecticut May 23, 1980. (Exhibit 2.2-20) (3) 3.17 (7) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated June 12, 1981, and filed with the Secretary of State of Connecticut June 16, 1981. (Exhibit 1.20) (3) 3.18 (12) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated July 13, 1981, and filed with the Secretary of State of Connecticut July 14, 1981. (3) 3.19 (8) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors and Shareholders, dated June 1, 1983, and filed with the Secretary of State of Connecticut June 3, 1983. (Exhibit 4.31) (3) 3.20 (9) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated July 24, 1984, and filed with the Secretary of State of Connecticut July 24, 1984. (Exhibit 1) (3) 3.21 (9) Copy of Certificate Amending Certificate of Incorporation by Action of Board of Directors, dated August 8, 1984, and filed with the Secretary of State of Connecticut August 9, 1984. (Exhibit 2) (3) 3.22 (9) Copy of Certificate Amending or Restating Certificate of Incorporation, filed with the Secretary of State of Connecticut August 1, 1990. (Exhibit 3.22) (3) 3.23 (10) Copy of Certificate Amending or Restating Certificate of Incorporation, dated May 9, 1991, and filed with the Secretary of State of Connecticut August 27, 1991. (Exhibit 3.22a) (3) 3.24a (3) Copy of Bylaws of The United Illuminating Company. (Exhibit 2.3) (3) 3.24b (10) Copy of Article II, Section 2, of Bylaws of The United Illuminating Company, as amended March 26, 1990, amending Exhibit 3.24a. (Exhibit 3.23b) (3) 3.24c (11) Copy of Article V, Section 1, of Bylaws of The United Illuminating Company, as amended April 22, 1991, amending Exhibit 3.24a. (Exhibit 3.23c) (4) 4.1 (9) Copy of First Mortgage Indenture and Deed of Trust, dated as of December 1, 1984, between Bridgeport Electric Company and The First National Bank of Boston, Trustee. (Exhibit 4.12) (4) 4.2 (12) Copy of First Supplemental Mortgage Indenture, dated as of February 15, 1987, between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending and supplementing Exhibit 4.1. (Exhibit 4.2) (4) 4.3 (12) Copy of Second Supplemental Mortgage Indenture, dated as of January 14, 1988, between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending and supplementing Exhibit 4.1 and amending Exhibit 4.2. (Exhibit 4.3) (4) 4.4 Copy of Third Supplemental Mortgage Indenture, dated as of March 31, 1988 between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending Exhibit 4.1. (4) 4.5 (13) Copy of Indenture, dated as of August 1, 1991, from The United Illuminating Company to The Bank of New York, Trustee. (Exhibit 4) (4) 4.6 (14) Copy of Participation Agreement, dated as of (10) August 1, 1990, among Financial Leasing Corporation, Meridian Trust Company, The Bank of New York and The United Illuminating Company. (Exhibits 4(a) through 4(h), inclusive, Amendment Nos. 1 and 2). - 77 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (10) 10.1 (5) Copy of Stockholder Agreement, dated as of July 1, 1964, among the various stockholders of Connecticut Yankee Atomic Power Company, including The United Illuminating Company. (Exhibit 5.1-1) (10) 10.2a (5) Copy of Power Contract, dated as of July 1, 1964, between Connecticut Yankee Atomic Power Company and The United Illuminating Company. (Exhibit 5.1-2) (10) 10.2b (3) Copy of Supplementary Power Contract, dated as of March 1, 1978, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, supplementing Exhibit 10.2a. (Exhibit 5.1-6) (10) 10.2c (1) Copy of Agreement Amending Supplementary Power Contract, dated August 22, 1980, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, amending Exhibit 10.2b. (Exhibit 10.2b) (10) 10.2d (12) Copy of Second Amendment of the Supplementary Power Contract, dated as of October 15, 1982, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, amending Exhibit 10.2b. (Exhibit 10.2d) (10) 10.2e (9) Copy of Second Supplementary Power Contract, dated as of April 30, 1984, between Connecticut Yankee Atomic Power Company and The United Illuminating Company, supplementing Exhibit 10.2a. (Exhibit 10.2e) (10) 10.2f (9) Copy of Additional Power Contract, dated as of April 30, 1984, between Connecticut Yankee Atomic Power Company and The United Illuminating Company. (Exhibit 10.2f) (10) 10.3 (5) Copy of Capital Funds Agreement, dated as of September 1, 1964, between Connecticut Yankee Atomic Power Company and The United Illuminating Company. (Exhibit 5.1-3) (10) 10.4a (5) Copy of Connecticut Yankee Transmission Agreement, dated as of October 1, 1964, among the various stockholders of Connecticut Yankee Atomic Power Company, including The United Illuminating Company. (Exhibit 5.1-4) (10) 10.4b (4) Copy of Agreement Amending and Revising Connecticut Yankee Transmission Agreement, dated as of July 1, 1979, amending Exhibit 10.4a. (Exhibit 5.1-7) (10) 10.5 (3) Copy of Capital Contributions Agreement, dated October 16, 1967, between The United Illuminating Company and Connecticut Yankee Atomic Power Company. (Exhibit 5.1-5) (10) 10.6a (1) Copy of NEPOOL Power Pool Agreement, dated as of September 1, 1971, as amended to November 1, 1988. (Exhibit 10.6a) (10) 10.6b (15) Copy of Agreement Setting Out Supplemental NEPOOL Understandings, dated as of April 2, 1973. (Exhibit 5.7-10) (10) 10.6c (1) Copy of Amendment to NEPOOL Power Pool Agreement, dated as of March 15, 1989, amending Exhibit 10.6a. (Exhibit 10.6c) (10) 10.6d (1) Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of October 1, 1990, amending Exhibit 10.6a. (Exhibit 10.6d) (10) 10.6e Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of September 15, 1992, amending Exhibit 10.6a. (10) 10.6f Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of June 1, 1993, amending Exhibit 10.6a. (10) 10.7a (1) Copy of Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units, dated May 1, 1973, as amended to February 1, 1990. (Exhibit 10.7a) (10) 10.7b (16) Copy of Transmission Support Agreement, dated as of May 1, 1973, among the Seabrook Companies. (Exhibit 5.9-2) - 78 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (10) 10.7c (10) Copy of Twenty-third Amendment to Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units, dated as of November 1, 1990, amending Exhibit 10.7a. (Exhibit 10.8ab) (10) 10.8a (4) Copy of Sharing Agreement - 1979 Connecticut Nuclear Unit, dated as of September 1, 1973, among The Connecticut Light and Power Company, The Hartford Electric Light Company, Western Massachusetts Electric Company, New England Power Company, The United Illuminating Company, Public Service Company of New Hampshire, Central Vermont Public Service Company, Montaup Electric Company and Fitchburg Gas and Electric Light Company, relating to a nuclear fueled generating unit in Connecticut. (Exhibit 5.8-1) (10) 10.8b (17) Copy of Amendment to Sharing Agreement - 1979 Connecticut Nuclear Unit, dated as of August 1, 1974, amending Exhibit 10.8a. (Exhibit 5.9-2) (10) 10.8c (5) Copy of Amendment to Sharing Agreement - 1979 Connecticut Nuclear Unit, dated as of December 15, 1975, amending Exhibit 10.8a. (Exhibit 5.8-4, Post-effective Amendment No. 2) (10) 10.9a (3) Copy of Transmission Line Agreement, dated January 13, 1966, between the Trustees of the Property of The New York, New Haven and Hartford Railroad Company and The United Illuminating Company. (Exhibit 5.4) (10) 10.9b (1) Notice, dated April 24, 1978, of The United Illuminating Company's intention to extend term of Transmission Line Agreement dated January 13, 1966, Exhibit 10.9a. (Exhibit 10.9b) (10) 10.9c (1) Copy of Letter Agreement, dated March 28, 1985, between The United Illuminating Company and National Railroad Passenger Corporation, supplementing and modifying Exhibit 10.9a. (Exhibit 10.9c) (10) 10.10 (12) Copy of Agreement, effective May 16, 1992, between The United Illuminating Company and Local 470-1, Utility Workers Union of America, AFL-CIO. (Exhibit 10.10) (10) 10.11 Copy of Fuel Oil Purchase and Sale Agreement, dated as of October 1, 1993, among Tosco Corporation, The United Illuminating Company and The Connecticut Light and Power Company. (Confidential treatment requested) (10) 10.12 (12) Copy of Coal Sales Agreement, dated as of August 1, 1992, between Pittston Coal Sales Corp. and The United Illuminating Company. (Confidential treatment requested) (Exhibit 10.13) (10) 10.13 (10) Copy of Fossil Fuel Supply Agreement between BLC Corporation and The United Illuminating Company, dated as of July 1, 1991. (Exhibit 10.31) (10) 10.14a (9) Copy of Lease, dated as of December 1, 1984, between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee. (Exhibit 10.22a) (10) 10.14b (12) Copy of Amendment, dated as of February 15, 1987, to Lease between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee, amending Exhibit 10.16a. (Exhibit 10.16b) (10) 10.14c (12) Copy of Second Amendment to Lease, dated as of December 9, 1987, between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee, amending Exhibit 10.16a. (Exhibit 10.16c) (10) 10.14d (12) Copy of Third Amendment to Lease, dated as of January 14, 1988, between Bridgeport Electric Company as Lessor and The United Illuminating Company as Lessee, amending Exhibit 10.16a. (Exhibit 10.16d) - 79 - Exhibit Table Exhibit Reference Item No. No. No. Description - -------- ------- --------- ----------- (10) 10.15a (12) Copy of Revolving Credit Agreement, dated as of January 25, 1993, among The United Illuminating Company, the Banks named therein, and Citibank, N.A., as Agent for the Banks. (Exhibit 10.19) (10) 10.15b Copy of letter, dated January 27, 1994, from Citibank, N.A., extending the expiration date of Exhibit 10.15a to January 19, 1995. (10) 10.16a* (12) Copy of Employment Agreement, dated as of January 1, 1988, between The United Illuminating Company and Richard J. Grossi. (Exhibit 10.22a) (10) 10.16b* (19) Copy of Amendment to Employment Agreement, dated as of July 23, 1990, between The United Illuminating Company and Richard J. Grossi, amending Exhibit 10.22a. (Exhibit 10.26a) (10) 10.17a* (12) Copy of Employment Agreement, dated as of January 1, 1988, between The United Illuminating Company and Robert L. Fiscus. (Exhibit 10.23a) (10) 10.17b* (19) Copy of Amendment to Employment Agreement, dated as of July 23, 1990, between The United Illuminating Company and Robert L. Fiscus, amending Exhibit 10.23a. (Exhibit 10.27a) (10) 10.18a* (12) Copy of Employment Agreement, dated as of January 1, 1988, between The United Illuminating Company and James F. Crowe. (Exhibit 10.24a) (10) 10.18b* (19) Copy of Amendment to Employment Agreement, dated as of July 23, 1990, between The United Illuminating Company and James F. Crowe, amending Exhibit 10.24a. (Exhibit 10.28a) (10) 10.19* (1) Copy of Executive Incentive Compensation Program of The United Illuminating Company. (Exhibit 10.24) (10) 10.21a* (19) Copy of The United Illuminating Company 1990 Stock Option Plan. (Exhibit 10.33) (10) 10.21b Amendments to The United Illuminating Company 1990 Stock Option Plan, adopted November 22, 1993 and January 24, 1994. (21) 21 List of subsidiaries of The United Illuminating Company. (28) 28.1 (12) Copies of significant rate schedules of The United Illuminating Company. (Exhibit 28.1) - ----------------------- *Management contract or compensatory plan or arrangement. The foregoing list of exhibits does not include instruments defining the rights of the holders of certain long-term debt of the Company and its subsidiaries where the total amount of securities authorized to be issued under the instrument does not exceed ten (10%) of the total assets of the Company and its subsidiaries on a consolidated basis; and the Company hereby agrees to furnish a copy of each such instrument to the Securities and Exchange Commission on request. (b) Reports on Form 8-K. Items Financial Statements Date of Reported Filed Report - -------- -------------------- ------- 5 None December 22, 1993 - 80 - CONSENT OF INDEPENDENT ACCOUNTANTS ---------------------------------- We consent to the incorporation by reference in the Registration Statement of The United Illuminating Company on Form S-3 (File No. 33-50221) and the Registration Statement on Form S-3 (File No. 33-50445) of our report, dated January 24, 1994, on our audits of the consolidated financial statements and financial statement schedules of The United Illuminating Company as of December 31, 1993, 1992 and 1991 and for the years then ended, which report is included in this Annual Report on Form 10-K. /s/ COOPERS & LYBRAND Hartford, Connecticut February 15, 1994 - 81 - SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. THE UNITED ILLUMINATING COMPANY By /s/ Richard J. Grossi ------------------------------ Richard J. Grossi Chairman of the Board of Directors and Chief Executive Officer Date: February 18, 1994 ----------------- 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. Signature Title Date --------- ----- ---- Director, Chairman of the Board of Directors and /s/ Richard J. Grossi Chief Executive Officer February 18, 1994 - --------------------- (Richard J. Grossi) (Principal Executive Officer) Director, President and /s/ Robert L. Fiscus Chief Financial Officer February 18, 1994 - --------------------- (Robert L. Fiscus) (Principal Financial and Accounting Officer) /s/ John D. Fassett Director February 18, 1994 - -------------------- (John D. Fassett) /s/ Leland W. Miles Director February 18, 1994 - -------------------- (Leland W. Miles) /s/ William S. Warner Director February 18, 1994 - ---------------------- (William S. Warner) /s/ John F. Croweak Director February 18, 1994 - -------------------- (John F. Croweak) /s/ F. Patrick McFadden, Jr. Director February 18, 1994 - ----------------------------- (F. Patrick McFadden, Jr.) /s/ J. Hugh Devlin Director February 18, 1994 - ------------------- (J. Hugh Devlin) /s/ Betsy Henley-Cohn Director February 18, 1994 - ---------------------- (Betsy Henley-Cohn) Director February , 1994 - ------------------------ (Frank R. O'Keefe, Jr.) /s/ James A. Thomas Director February 18, 1994 - ---------------------- (James A. Thomas) /s/ David E.A. Carson Director February 18, 1994 - ---------------------- (David E.A. Carson) - 82 - S-1 S-2 S-3 S-4 S-5 EXHIBIT INDEX (a) Exhibits Exhibit Table Item Exhibit Number Number Description Page No. ---------- ------- ----------- -------- (4) 4.4 Copy of Third Supplemental Mortgage Indenture, dated as of March 31, 1988 between Bridgeport Electric Company and The First National Bank of Boston, Trustee, amending Exhibit 4.1. (10) 10.6e Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of September 15, 1992, amending Exhibit 10.6a. (10) 10.6f Copy of Agreement Amending NEPOOL Power Pool Agreement, dated as of June 1, 1993, amending Exhibit 10.6a. (10) 10.11 Copy of Fuel Oil Purchase and Sale Agreement, dated as of October 1, 1993, among Tosco Corporation, The United Illuminating Company and The Connecticut Light and Power Company. (Confidential treatment requested) (10) 10.15b Copy of letter, dated January 27, 1994, from Citibank, N.A., extending the expiration date of Exhibit 10.15a to January 19, 1995. (10) 10.21b Amendments to The United Illuminating Company 1990 Stock Option Plan, adopted November 22,1993 and January 24, 1994. (21) 21 List of subsidiaries of The United Illuminating Company.

732639_1993.txt

732639_1993

1993

732639

ITEM 3. LEGAL PROCEEDINGS Set forth below is a description of certain legal proceedings involving SFP and its subsidiaries. On January 30, 1987, New TC Holding Corporation ("New TC") and Ticor, Inc. ("Ticor") filed suit in the Superior Court of the State of California for the County of Los Angeles against SFP Properties, Inc. (formerly known as Southern Pacific Company), a wholly owned subsidiary of SFP (the "New TC Lawsuit"). In the complaint, New TC, which purchased all of the outstanding common stock of Ticor from SFP Properties, Inc. pursuant to a Share Purchase Agreement dated September 30, 1983, sought an order declaring that SFP Properties, Inc. is obligated by the terms of the Share Purchase Agreement to defend and hold harmless New TC and certain of its subsidiaries from losses which may exceed $100 million. On February 24, 1993, this case was dismissed by the court for lack of prosecution. SFP Properties, Inc. has reached an agreement in principle to pay New TC and Ticor $1.2 million in settlement of all claims made in the New TC Lawsuit and the third-party action filed in the Great American Lawsuit (described below). In another lawsuit, Great American Insurance Company ("Great American") seeks indemnity from Ticor for various claims and losses pursuant to the indemnity provisions of the 1977 Share Purchase Agreement in which Ticor purchased Constellation Reinsurance Company ("Con Re") from Great American (the "Great American Lawsuit"). Great American alleges that Con Re breached certain agreements with Great American, and that Ticor is required to indemnify and hold Great American harmless with respect to all losses incurred in connection therewith. In turn, Ticor seeks indemnity from SFP Properties, Inc. under the 1983 Share Purchase Agreement between New TC and SFP Properties, Inc. referred to above. Ticor's third-party complaint against SFP Properties, Inc., filed on December 22, 1989, alleges not only that SFP Properties, Inc. is responsible to indemnify Ticor under the 1983 Share Purchase Agreement between New TC and SFP Properties, Inc., but that SFP Properties, Inc.'s failure to infuse funds into Con Re and to implement less onerous tax allocation arrangements prior to Con Re's liquidation was the proximate cause of Con Re's failure to satisfy the claims now made against Great American. Ticor alleges that SFP Properties, Inc. had an implied contractual duty to Ticor to refrain from such conduct. On or about December 14, 1990, Ticor filed a petition for reorganization pursuant to Chapter 11 of the Bankruptcy Code, and both Great American's action against Ticor and Ticor's third-party action against against SFP Properties, Inc. were stayed. The Bankruptcy Court thereafter entered an order disallowing Great American's claim in its entirety, and the action brought by Great American against Ticor was dismissed, with prejudice. Subsequently, as described above, SFP Properties, Inc. reached an agreement in principle to pay New TC and Ticor $1.2 million in settlement of all claims made in the third- party action filed in the Great American Lawsuit and the New TC Lawsuit. On December 17, 1992, an amended complaint was filed in an action entitled David Rodriguez, derivatively on behalf of Santa Fe Pacific Corporation v. John S. Reed, Robert D. Krebs, W. John Swartz, John J. Schmidt, Joseph F. Alibrandi, Richard J. Flamson III, George B. Munroe, Jack S. Parker, Jean Head Sisco, Arthur W. Woelfle, Robert E. Gilmore, Michael A. Morphy, Edward F. Swift, Kathryn D. Wriston, John S. Runnells, II, Robert H. West, Alan C. Furth, Arjay Miller, and Benjamin F. Biaggini, Defendants, and Santa Fe Pacific Corporation, a Delaware corporation, Nominal Defendant, in the Circuit Court of Cook County, Illinois, County Department, Chancery Division, No. 92 CH 06618. The amended complaint asserts purported derivative claims on behalf of SFP against present and former directors of SFP and alleges that the defendant directors caused SFP to incur liability in connection with the action brought against SFP in 1985 by Energy Transportation Systems, Inc. and ETSI Pipeline Project (the "ETSI Litigation"). The four counts of the amended complaint allege breach of fiduciary duty and waste of corporate assets for intentional antitrust violations, negligent failure to stop antitrust violations, failure to timely settle the ETSI Litigation, and failure to take appropriate action against persons who committed antitrust violations. The amended complaint seeks damages from the individual defendants in an amount "not less than $342 million." On December 7, 1993, the Board appointed a Litigation Committee consisting of Directors Lindig and Roberts to consider and determine whether or not prosecution of such claims and action is in the best interest of SFP and its stockholders. In August 1991, the EPA issued an order to SFP Pipelines and nine additional parties regarding investigation and cleanup of contamination in the vicinity of the Partnership's storage facilities and truck loading terminal at Sparks, Nevada. The investigation and remediation at the Sparks terminal is also the subject of a lawsuit filed January 1, 1991, entitled Nevada Division of Environmental Protection v. Santa Fe Pacific Pipelines, Inc., Southern Pacific Transportation Company, Shell Oil Company, Time Oil Company, Berry-Hinkley Terminal, Inc., Chevron U.S.A., Inc., Texaco Refining and Marketing, Inc., Air BP, a division of BP Oil, Unocal Corporation, and Golden Gate Petroleum Company, Case No. CV91-546, in the Second Judicial District Court of the State of Nevada in and for the County of Washoe, seeking remediation of contamination allegedly due to operations of SFP Pipelines and other defendants and which involves potential monetary sanctions that could exceed $100,000. This lawsuit was subsequently joined by the County of Washoe Health District and the City of Sparks. Several lawsuits also have been brought against the ten respondents for alleged property value diminishment. Pursuant to the EPA order, a report on a detailed site investigation, along with a proposed remediation plan, was submitted to the EPA on March 6, 1992. In September 1992, the EPA approved the respondents' remediation plan and an estimate of remediation costs was made in accordance with that plan. During the quarter ended September 30, 1992, the Partnership recorded a $10 million provision for environmental remediation costs at Sparks, Nevada, and two sites in California. Effective December 10, 1993, Santa Fe Railway entered into an agreement with the South Coast Air Quality Management District ("District"), a political subdivision of the State of California, with respect to alleged violations of air emission regulations dating from January 1991. The agreement covers 48 Notices of Violation concerning smoke emissions from 71 locomotives operating in California's South Coast Air Basin. Under the agreement, Santa Fe Railway contributed $173,500 to the District to support its Locomotive Propulsion Systems Task Force Account or other locomotive emissions research or demonstration projects mutually agreed upon by the District and Santa Fe Railway, and contributed $4,000 to be used for certain audit expenses. In addition, Santa Fe Railway has agreed to purchase and install measuring meters and to implement a compliance reporting program to monitor locomotive emissions for an approximate total cost of $300,000. During the quarter ended June 30, 1993, the EPA issued a Notice of Violations to the Partnership associated with an oxygenate blending equipment malfunction at the Partnership's Phoenix terminal. It is possible that the Partnership will be required to pay in excess of $100,000 in fines arising from this Notice of Violations. SFP and its subsidiaries also are parties to a number of other legal actions arising in the ordinary course of business, including various governmental proceedings and private civil suits concerning environmental matters. While the final outcome of these and other legal actions cannot be predicted with certainty, considering the meritorious legal defenses available, it is the opinion of SFP management that none of these legal actions, when finally resolved, will have a material adverse effect on the consolidated financial position of SFP. Reference is made to Note 8 to the consolidated financial statements on page 26 of SFP's 1993 Annual Report to Shareholders for information concerning certain pending administrative appeals between SFP and the Internal Revenue Service. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted by SFP to a vote of its securities holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Listed below are the names, ages, and positions of all executive officers of SFP (excluding executive officers who are also directors of SFP) and their business experience during the past five years. Unless otherwise indicated, each executive officer listed below has served in his or her present occupation for at least five years. Executive officers hold office until their successors are elected or appointed, or until their earlier death, resignation, or removal. CAROL R. BEERBAUM, 50 Vice President--Human Resources since June 1992. Formerly, Senior Vice President, Human Resources, PHH Homequity, Inc. (relocation and real estate management services) from May 1990, and Vice President, Human Resources of PHH Homequity, Inc. from January 1987. JEROME F. DONOHOE, 55 Vice President--Law since July 1984. Also, partner with Mayer, Brown & Platt (law firm) since September 1990. RUSSELL E. HAGBERG, 43 Senior Vice President and Chief of Staff of Santa Fe Railway since January 1994. Prior to that, Vice President--Transportation of Santa Fe Railway from June 1991, Vice President--Human Resources of SFP from June 1990, and Vice President--Human Resources and Administration of Santa Fe Railway from March 1989. THOMAS N. HUND, 40 Vice President and Controller since July 1990. Formerly, Assistant Vice President and Controller of Santa Fe Railway from August 1989. Prior to that, Assistant Controller of SFP. STEVEN F. MARLIER, 48 Senior Vice President and Chief Marketing Officer of Santa Fe Railway since January 1994. Prior to that, Senior Vice President--Carload Business Unit of Santa Fe Railway since January 1992. Formerly, Regional Manager/General Manager, IBM Corporation (computers and data processing). DONALD G. MCINNES, 53 Senior Vice President and Chief Operating Officer of Santa Fe Railway since January 1994. Prior to that, Senior Vice President--Intermodal Business Unit of Santa Fe Railway since January 1992, Vice President--Intermodal of Santa Fe Railway from July 1989, Vice President--Administration of Santa Fe Railway from January 1989, and General Manager of Eastern Region of Santa Fe Railway from July 1987. JEFFREY R. MORELAND, 49 Vice President--Law and General Counsel of Santa Fe Railway since June 1989. Prior to that, General Counsel of SFP from April 1988. MARSHA K. MORGAN, 46 Corporate Secretary since December 1990. Prior to that, Treasurer from March 1988, and Assistant Treasurer from 1983. PATRICK J. OTTENSMEYER, 38 Vice President--Finance of SFP since September 1993. Previously, held a senior credit position with First Empire State Corporation (banking) from September 1992, was Senior Vice President of Security Pacific National Bank (banking) from October 1989 (which merged with Bank of America National Trust and Savings Association (banking) in April 1992), and held other positions with Security Pacific National Bank from 1984. DENIS E. SPRINGER, 48 Senior Vice President and Chief Financial Officer since October 1993. Prior to that, Senior Vice President, Treasurer and Chief Financial Officer from January 1992, Vice President, Treasurer and Chief Financial Officer from January 1991, Vice President--Finance from April 1988, and Assistant Vice President--Finance from October 1984. IRVIN TOOLE, JR., 52 Chairman, President and Chief Executive Officer, SFP Pipelines and SFP Pipeline Holdings, Inc. since September 1991. Formerly, Senior Vice President, Treasurer and Chief Financial Officer, SFP Pipelines from December 1988, and Vice President--Administration and Treasurer, SFP Pipelines from February 1986. DANIEL J. WESTERBECK, 50 Vice President and Tax Counsel since April 1988. Formerly, Assistant Vice President and Tax Counsel from October 1984. CATHERINE A. WESTPHAL, 45 Vice President--Corporate Communications since January 1994. Prior to that, Assistant Vice President--Public Relations from January 1992, Director--Public Relations from January 1991, and Manager--Public Affairs at Santa Fe Railway from January 1989. RICHARD T. ZITTING, 64 Chairman and Chief Executive Officer, SFP Gold, a subsidiary of SFP, since January 1994. Prior to that, President, SFP Gold or its predecessors from November 1978. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information as to the principal markets on which the Common Stock of SFP is traded, the high and low sales prices of such stock for the two years ending December 31, 1993, the frequency and amount of dividends declared on such stock during such period and the approximate number of record holders of the Common Stock is set forth below the heading "Common Stock Market Prices and Dividends" on page 18 of SFP's 1993 Annual Report to Shareholders and is hereby incorporated by reference. A statement regarding a limitation of dividends on SFP Common Stock is set forth in Note 11 to the consolidated financial statements on page 27 of SFP's 1993 Annual Report to Shareholders and is hereby incorporated by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA There is disclosed on page 1 of SFP's 1993 Annual Report to Shareholders selected financial data of SFP for each of the last five fiscal years. Such data with respect to the following topics are incorporated by reference: Revenues; Income (Loss) from Continuing Operations; Income (Loss) from Continuing Operations Per Common Share; Total Assets; Total Debt; and Cash Dividends Per Common Share. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITIONS Management's Discussion and Analysis of Results of Operations and Financial Condition appearing on pages 14 through 18 of SFP's 1993 Annual Report to Shareholders is hereby incorporated by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of SFP and subsidiary companies, together with the report thereon of Price Waterhouse dated February 4, 1994, appearing on pages 19 through 32 of SFP's 1993 Annual Report to Shareholders, are hereby incorporated by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the directors of SFP is provided on pages 2 through 4 and on pages 5 and 6 ("Legal Proceedings") of SFP's proxy statement dated March 9, 1994, and is hereby incorporated by reference. Pursuant to the retirement policy of the Board, one current director, Mr. George B. Munroe, age 72, will not stand for re-election at the 1994 Annual Meeting. Mr. Munroe, a director since 1972, retired in February 1987, from his position as Chairman of the Board and Chief Executive Officer of Phelps Dodge Corporation (copper mining, manufacturing, and specialty chemicals). He is a director of New York Life Insurance Company, The New York Times Company, and Phelps Dodge Corporation. Information concerning the executive officers of SFP (excluding one executive officer who is also a director of SFP) is included in Part I of this Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information concerning the compensation of directors and executive officers of SFP is provided on pages 4 through 5 ("Directors' Compensation") and pages 8 through 13 (excluding the portion of page 13 containing the "Compensation and Benefits Committee Report on Executive Compensation") of SFP's proxy statement dated March 9, 1994, and is hereby incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning the ownership of SFP equity securities by certain beneficial owners and management is provided on pages 2 through 4, and 6 through 7 of SFP's proxy statement dated March 9, 1994, and is hereby incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning certain relationships and related transactions is provided on page 4 ("Certain Relationships and Related Transactions") of SFP's proxy statement dated March 9, 1994, and is hereby incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) The following documents are filed as a part of this report: All other schedules have been omitted because they are not applicable or the required information is presented in the financial statements or the notes to the consolidated financial statements. 3. Exhibits: See Index to Exhibits on pages E-1-E-4 for a description of the exhibits filed as a part of this Report. (B) Reports on Form 8-K SFP filed no Reports on Form 8-K during the quarter ended December 31, 1993. - -------- * Incorporated by reference from the indicated pages of SFP's Annual Report to Shareholders for the fiscal year ended December 31, 1993. REPORT OF INDEPENDENT ACCOUNTANTS ON CONSOLIDATED FINANCIAL STATEMENT SCHEDULES To the Shareholders, Chairman and Board of Directors of Santa Fe Pacific Corporation Our audits of the consolidated financial statements referred to in our report dated February 4, 1994 appearing on page 19 of the 1993 Annual Report to Shareholders of Santa Fe Pacific Corporation and subsidiary companies (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Consolidated Financial Statement Schedules listed in Item 14(a)(2) of this Form 10-K. In our opinion, these Consolidated Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Kansas City, Missouri February 4, 1994 SANTA FE PACIFIC CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT FOR YEARS 1993, 1992 AND 1991 (IN MILLIONS) - -------- (1) Represents excess of fair value of gold assets received over coal and aggregate assets given up in exchange with Hanson Natural Resources Company ("HNRC"). See Note 3 to Financial Statements on page 24 in the 1993 Santa Fe Pacific Corporation Annual Report to Shareholders (Gain on Exchange of Mineral Assets). SANTA FE PACIFIC CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (CONTINUED) Rates used for computing annual depreciation and amortization provisions for properties are as follows (in percent): - -------- (1) See Note 1 to Financial Statements on page 24 in the 1993 Santa Fe Pacific Corporation Annual Report to Shareholders (Summary of Significant Accounting Policies: Properties, and Exploration and Development Costs). SANTA FE PACIFIC CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTIES FOR YEARS 1993, 1992 AND 1991 (IN MILLIONS) - -------- (1) Transfer of excess reserves from Other Road Properties to Track Structure as a result of depreciation studies filed with the Interstate Commerce Commission. (2) Represents accumulated depreciation on coal and aggregate assets acquired by HNRC in the asset exchange. See Note 3 to Financial Statements on page 24 in the 1993 Santa Fe Pacific Corporation Annual Report to Shareholders (Gain on Exchange of Mineral Assets). SANTA FE PACIFIC CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 - -------- (a) None of the securities were owned by the Registrant, none were held in the treasury of the issuer, and none were in default. (b) SFPP, L.P. is the operating partnership of Santa Fe Pacific Pipeline Partners, L.P. ("Pipeline Partnership"). A subsidiary of Santa Fe Pacific Corporation, the general partner of the Pipeline Partnership, is contingently liable for this amount. SANTA FE PACIFIC CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS 1993, 1992 AND 1991 SANTA FE PACIFIC CORPORATION AND SUBSIDIARY COMPANIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR YEARS 1993, 1992 AND 1991 The following amounts have been charged to operating expenses: Other supplementary income statement items have been omitted from this schedule either because the required information is disclosed elsewhere in the consolidated financial statements or the notes to consolidated financial statements or the amounts charged to operating expenses do not exceed one percent of total consolidated revenues. SIGNATURES SANTA FE PACIFIC CORPORATION, PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. SANTA FE PACIFIC CORPORATION /s/ Robert D. Krebs By: _________________________________ Robert D. Krebs Chairman, President and Chief Executive Officer Dated: March 30, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF SANTA FE PACIFIC CORPORATION AND IN THE CAPACITIES AND ON THE DATE INDICATED. S-1 /s/ Jeffrey R. Moreland *By__________________________________ Vice President--Law and General Counsel, The Atchison, Topeka and Santa Fe Railway Company Attorney in Fact Dated: March 30, 1994 S-2 SANTA FE PACIFIC CORPORATION INDEX OF EXHIBITS - -------- * Management contract or compensatory plan or arrangement. E-1 - -------- * Management contract or compensatory plan or arrangement. E-2 - -------- * Management contract or compensatory plan or arrangement. E-3 GRAPHICS APPENDIX Page 13 consists of a map depicting areas of minerals rights controlled by Santa Fe Pacific Gold Corporation in the western United States as well as the location of exploration offices, company mines, and company headquarters.

60195_1993.txt

60195_1993

1993

60195

71391_1993.txt

71391_1993

1993

71391

ITEM 1. BUSINESS The registrant was incorporated under the laws of the State of Idaho on February 27, 1930, for the primary purpose of exploring and the development of mining properties. Prior to 1993, the Company had owned fifteen unpatented lode mining claims in the Coeur d'Alene Mining District of Shoshone County, Idaho. Due to the increased fees from the Bureau of Land Management on unpatented mining claims, and the depressed prices for silver and lead, the Company decided to abandon these mining claims in 1993. The Company is now an inactive mining company. ITEM 2. ITEM 2. PROPERTIES The registrant abandoned all properties in 1993. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The registrant is not a party to any litigation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders during the fiscal year ended March 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The registrant's common stock is traded on the national over-the-counter market. ("On pink sheets") As of March 31, 1993, there were 1,676 registered holders of the Company's common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following data should be read in conjunction with the Company's financial statements and the notes thereto: ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company has ceased all exploratory mining activities and has abandoned all of its mining claims. The Company's only asset is 857,100 shares of common stock of United Mines, Inc., with a market value of $34,284. Total liabilities are $17,060, which are comprised of accounts payable of $1,919 and advances from officers of $15,141. The Company has no revenues. Any working capital needs are provided as loans or advances from the corporate officers. ITEM 8. ITEM 8. FINANCIAL STATEMENTS CONTENTS Page Statement of Financial Position as of March 31, 1993 and 1992 Statement of Operations for the Years Ended March 31, 1993, 1992 and 1991 Statement of Changes in Stockholders' Equity for the Years Ended March 31, 1993, 1992 and 1991 Statement of Cash Flows for the Years Ended March 31, 1993, 1992 and 1991 Notes to Financial Statements NEW HILARITY MINING COMPANY Statement of Financial Position as of (Unaudited) March 31, 1993 and 1992 - - --------------------------------------------------------------------------- ASSETS Prepared by management. The accompanying notes are an integral part of these financial statements. NEW HILARITY MINING COMPANY Statement of Operations for the Years (Unaudited) Ended March 31, 1993, 1992 and 1991 - - --------------------------------------------------------------------------- Prepared by management. The accompanying notes are an integral part of these financial statements. NEW HILARITY MINING COMPANY Statement of Changes in Stockholders' (Unaudited) Equity for the Years Ended March 31, 1993, 1992 and 1991 - - --------------------------------------------------------------------------- prepared by management. The accompanying notes are an integral part of these financial statements. NEW HILARITY MINING COMPANY Statement of Cash Flows for the Years (Unaudited) Ended March 31, 1993, 1992 and 1991 - - --------------------------------------------------------------------------- Prepared by management. The accompanying notes are an integral part of these financial statements. NEW HILARITY MINING COMPANY Notes to Financial Statements (Unaudited) - - --------------------------------------------------------------------------- NOTE 1 ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES The Company was originally incorporated as Lexington Mining Company on February 27, 1930 under the laws of the State of Idaho for the primary purpose of mining and exploring for nonferrous and precious metals, primarily silver, lead and zinc. On April 17, 1945, the Company was reorganized, and the name changed to New Hilarity Mining Company. For many years the Company explored for precious metal deposits, but no commercial ore bodies were discovered. In early 1993, the Company abandoned its fifteen unpatented lode mining claims located in the Coeur d'Alene Mining District of Shoshone County, Idaho. Earnings (losses) per share are computed on the weighted average number of shares outstanding. Marketable trading securities are carried at market value which is based on published over-the-counter market quotes. The preparation of financial statements in conformity with generally accepted accounting principles requires the use of the Company's management estimates for various accounts. NOTE 2 MARKETABLE SECURITIES The Company owns 857,100 shares of common stock of United Mines, Inc., which is quoted on the over-the-counter market. NOTE 3 RELATED PARTY TRANSACTIONS Former officers of the Company have periodically loaned the Company money for various working capital requirements. These loans are non-interest bearing and are due upon demand. NOTE 4 COMMON STOCK The Company was originally incorporated on February 27, 1930, with an authorized capital of 2,000,000 shares of assessable common stock with a par value of $.05 per share. On April 17, 1945, the shareholders increased the authorized common stock to 3,000,000 shares with a par value of $.10 per share and the common stock was changed from assessable to non-assessable. On August 18, 1982, the shareholders increased the authorized common stock to 15,000,000 shares with a par value of $.10 per share. NOTE 5 INCOME TAXES The Company has a net operating loss carryover of $401,793 to the fiscal year ended March 31, 1994. These loss carryovers will commence to expire in 2007. The Company has not recorded a deferred tax asset for the net operating loss carryover because it is highly uncertain if the Company will have future taxable income. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTS None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Terry Dunne, 48, is the president of the Company and a director. Mr. Dunne is a Certified Public Accountant with over 25 years of experience in public accounting. Mr. Dunne has a Master Degree in Business Administration and a Master Degree in Taxation. Robert O'Brien, 61, is the secretary of the Company and a director. Mr. O'Brien has recently served as an officer and director of Gold Securities Corporation and Inland Resources, Inc. From 1977 to 1985, Mr. O'Brien was self employed as a general contractor, and from 1958 to 1976, he was executive vice-president of Hamer's, Inc., a chain of high fashion men's clothing stores located in Spokane, Washington. Mr. O'Brien graduated from Gonzaga University with a degree in economics. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The officers and directors of the Company have served without compensation. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The officers and directors own no common stock of the Company. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K None, other than what is already shown in this 10-K report. SIGNATURES Pursuant to the requirements of Section 13 of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. New Hilarity Mining Company (Registrant) BY: /s/ Terrence J. Dunne, President Dated: November 27, 1996 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following person on behalf of the registrant and in the capacity and on the date indicated. BY: /s/ Terrence J. Dunne, President Dated: November 27, 1996

800575_1993.txt

800575_1993

1993

800575

Item 1. Business (a) General Development of Business Premark International, Inc. (the "Registrant") is a multinational consumer and commercial products company. The Registrant is a Delaware corporation which was organized on August 29, 1986 in connection with the corporate reorganization of Kraft, Inc. ("Kraft"). In the reorganization, the businesses of the Registrant and certain other assets and liabilities of Kraft and its subsidiaries were transferred to the Registrant. On October 31, 1986 the Registrant became a publicly held company through the pro-rata distribution by Kraft to its shareholders of all of the outstanding shares of common stock of the Registrant. The Registrant's principal operating subsidiaries are Dart Industries Inc. ("Dart"), which owns the operating subsidiaries comprising the Registrant's Tupperware business; Premark FEG Corporation, which owns the operating subsidiaries comprising the Registrant's Food Equipment Group; Ralph Wilson Plastics Company ("Ralph Wilson Plastics"); The West Bend Company ("West Bend"); Florida Tile Industries, Inc. ("Florida Tile"); Tibbals Flooring Co. ("Tibbals Flooring"); and Precor Incorporated ("Precor"). Dart was organized in Delaware in 1928 as a successor to a business originally established in 1902. Tupperware U.S., Inc. is a Delaware corporation formed in 1989 which operates the U.S. Tupperware business. In 1988, Ralph Wilson Plastics and West Bend were organized in Delaware as separate corporations owned directly by the Registrant, having previously been operating divisions of Dart. Premark FEG Corporation was organized in Delaware in 1984, a successor to a business originally incorporated in 1897. Florida Tile, a Florida corporation organized in 1954, was acquired in 1990. Tibbals Flooring, acquired in 1988, was organized in Tennessee in 1946. Precor, a Delaware corporation, was acquired in 1984. (b) Financial Information About Industry Segments For certain financial information concerning the Registrant's business segments, see Note 10 ("Segments of the Business") of the Notes to the Consolidated Financial Statements of Premark International, Inc., appearing on pages 38 and 39 of the Annual Report to Shareholders for the year ended December 25, 1993, which is incorporated by reference into this Report by Item 8 hereof. (c) Narrative Description of Business The Registrant conducts its business through its three business segments: Tupperware, Food Equipment Group, and Consumer and Decorative Products. A discussion of the three business segments follows. Words appearing in italics constitute trademarks and tradenames utilized by the Registrant's businesses. TUPPERWARE Principal Products, Markets and Distribution Tupperware manufactures and markets a broad line of highest- quality plastic consumer products for the kitchen, gifts and children's products. Important products include Bell tumblers, Modular Mates stackable storage containers, Wonderlier and Servalier bowls, Tuppertoys educational toys, One Touch canisters, and Tupperwave microwave cookware. The containers and canisters both feature highly successful Tupperware seals. During 1993, Tupperware continued to introduce new designs and colors in its products lines, and to extend existing products into new markets around the world. Tupperware also continued a major design upgrade program in its U.S. product line, which was launched in 1991. Beginning in 1989, a number of U.S. franchisees converted to the Tupperware Express product delivery system, under which Tupperware products are shipped directly from the plant to the ultimate consumer. Prior to Tupperware Express, all franchisees warehoused an inventory of Tupperware products for resale to their consultants, who in turn were responsible for coordinating delivery to the ultimate consumers. Under Tupperware Express, there are presently 95 franchisees who process the orders of their sales consultants for direct shipment and no longer are required to maintain an inventory of Tupperware products. High shipping and administrative costs have adversely affected Tupperware Express. Tupperware is continuing to test alternatives in the distribution network. In fiscal years 1993, 1992, and 1991, Tupperware contributed approximately 40%, 38% and 38%, respectively, of the sales of the Registrant's businesses. Tupperware products are sold in the United States and in 55 foreign countries. In 1993, sales in foreign countries represented approximately 81% of total Tupperware revenues. Although Tupperware's international distribution system is similar to that of its domestic operations, international product lines vary. Market penetration varies significantly throughout the world, with the highest levels occurring in Germany and Australia. Tupperware products are sold directly to the consumer through over 500,000 dealers (called "consultants" in the U.S.) worldwide, over 25% of which are considered active. Consultants are supported by over 32,000 unit managers and approximately 1,400 distributors or franchisees. All of such distributors and franchisees, and the vast majority of consultants, dealers and managers, are independent contractors. The dealer force continued to increase overall in 1993. Tupperware primarily relies on the "party plan" method of sales, which is designed to enable the purchaser to appreciate through demonstration the features and benefits of Tupperware products. Approximately 1.9 million parties and product demonstrations were held in 1993 in the United States, with millions more held in foreign countries. Parties are held in homes, offices, social clubs and other locations. Tupperware products are also being marketed through preview catalogs mailed to persons invited to attend parties and various other types of demonstrations. Sales of Tupperware products are supported through a program of sales promotions, sales and training aids and motivational conferences. Tupperware U.S. also utilizes catalogs and toll-free telephone ordering, which increases its success with hard-to-reach customers, in support of its sales force. Raw Materials and Facilities The manufacture of Tupperware products requires plastic resins meeting Tupperware's specifications. These resins are purchased from a number of large chemical companies, and Tupperware has experienced no difficulties in obtaining adequate supplies. Tupperware's headquarters are in Florida. Tupperware's domestic manufacturing plant (which is owned) is located in South Carolina. In 1993, Tupperware ceased manufacturing operations at its Halls, Tennessee facility, eliminating excess capacity in the United States. Fourteen additional manufacturing plants (one of which is leased) are located in 14 foreign countries. Tupperware conducts a continuing program of new product design and development at its research and development facilities in Florida, Hong Kong and Belgium. Research and development of resins used in Tupperware products are performed by its suppliers. Competition The Registrant believes that Tupperware holds approximately 65% of the U.S. market for plastic storage and serving containers. Tupperware products compete with a broad range of food preparation, cooking, storage and serving items made of various materials, which are sold primarily through retail outlets. Tupperware's competitive strategy is to provide high-quality products at premium prices through a direct-selling distribution system. Direct selling, featuring demonstration of its products prior to purchase, price, and new product development are significant factors affecting competition. Tupperware competes with other direct selling organizations for sales personnel and party dates. FOOD EQUIPMENT GROUP Principal Products, Markets and Distribution The Food Equipment Group, composed primarily of Premark FEG Corporation and its operating subsidiaries (the "Group"), is a leading manufacturer of commercial equipment relating to food preparation, cooking, storage and cleaning. Its core products include warewashing equipment; food preparation machines, such as mixers, slicers, cutters, meat saws and grinders; weighing and wrapping equipment and related systems; baking and cooking equipment, such as ovens, ranges, fryers, griddles and broilers; and refrigeration equipment. Products are marketed under the trademarks Hobart, Stero, Vulcan, Wolf, Tasselli, Adamatic, Still and Foster. Food equipment products are sold to the retail food industry, including supermarket chains, independent grocers, delicatessens, bakeries and convenience and other food stores, and to the foodservice industry, including independent restaurants, fast-food chains, hospitals, schools, hotels, resorts and airlines. Although historically the retail food market has grown at a faster pace than the larger foodservice industry, in 1993 this growth trend was reversed. Food equipment products are distributed in more than 100 countries, either through wholly-owned subsidiaries or through distributors, dealers or licensing arrangements covering virtually all areas of the world where a market for such products currently exists. The Group is the only major food equipment manufacturer in the U.S. with its own nationwide service network for the markets in which it sells, providing not only an important source of income but also an important source for developing new sales. The Group directly services its food machines, warewashers, weigh/wrap equipment and cooking equipment, while authorized independent agents service refrigeration units and some cooking equipment. For the fiscal years 1993, 1992, and 1991, sales by the Group contributed approximately 32%, 36%, and 36%, respectively, of the sales of the Registrant's businesses. Revenues from foreign operations constituted approximately 40% of the Group's 1993 sales. Major new products introduced by the Group in 1993 included a new undercounter warewasher, a new line of fryers and the Ultima 2000 weighing system in the U. S., as well as a new concept mixer, a new line of warewashers, a new refrigeration line and a new line of combi steam ovens in Europe. Raw Materials and Facilities The Group uses stainless and carbon steel, aluminum and plastics in the manufacture of its products. These materials are readily available from several sources, and no difficulties have been experienced with respect to their availability. In addition to manufacturing certain component parts, the Group also purchases many component parts, including electrical and electronic components, castings, hardware, fasteners and bearings, certain manufacturers of which utilize tooling provided by the Group. The Group owns its headquarters building and a major manufacturing complex consisting of four plants in Ohio. In addition, the Group operates 13 manufacturing plants in California, Georgia, Kansas, Maryland, New Jersey, Ohio, and Virginia, and nine manufacturing plants in Canada, France, Italy, the United Kingdom and Germany. Most of these plants are owned. Competition The Group competes in a slowly growing worldwide market which is highly fragmented. No single manufacturer competes with respect to all of the Group's products, and the degree of competition varies among different customer segments and products. The extensiveness of the Group's brand acceptance across a broad range of products is deemed by the Registrant to be a significant competitive advantage. Competition is also based on numerous other factors, including product quality, performance and reliability, labor savings and energy conservation. Miscellaneous The Group grants extended payment terms to end-user customers who meet its creditworthiness requirements. Currently, payment periods range from three to 36 months, with installments including finance charges. The Group also grants extended payment terms to dealers who meet specified creditworthiness and facility requirements, which allow its products to be on display at the dealerships or to be available for immediate delivery by the dealer to end-users. Payments to the Group by such dealers are generally without interest and are made at the earlier of the date of final sale or up to six months after delivery to the dealer. The Group had approximately $99 million and $102 million of backlog orders at the end of 1993 and 1992, respectively, after restatement for exchange rate effects. The Group considers such orders to be firm, though changes or cancellations of insignificant amounts may occur, and expects that the 1993 backlog orders will be filled in 1994. CONSUMER AND DECORATIVE PRODUCTS Consumer and Decorative Products is comprised of the Decorative Products Group and the Consumer Products Group, which contributed 28%, 26% and 26% of the sales of the Registrant's businesses for the fiscal years 1993, 1992 and 1991, respectively. Ralph Wilson Plastics, Florida Tile and Tibbals Flooring make up the Decorative Products Group, while the Consumer Products Group contains West Bend and Precor. DECORATIVE PRODUCTS GROUP Principal Products, Markets and Distribution Ralph Wilson Plastics manufactures decorative laminates through a production process utilizing heated high pressure presses. These laminates, sold principally under the Wilsonart trademark in more than 550 colors, designs and finishes, are used for numerous interior surfacing applications, including cabinetry, countertops, vanities, store fixtures and furniture. Approximately 50% of the Wilsonart brand decorative laminate sold is used in residential applications, primarily for surfacing kitchen and bathroom countertops and cabinetry. Decorative laminate applications in the commercial market include office furniture, retail store fixtures, restaurant and hotel furniture, and doors. Ralph Wilson Plastics also manufactures specialty- grade laminates, including chemical-resistant, wear-resistant, and fire-retardant types. Among the specialized applications for Wilsonart brand laminates are those in laboratory work surfaces, jetways and naval vessels. In addition to laminate products, Ralph Wilson Plastics manufactures a solid surface product which is marketed under the Gibraltar brand. In 1993, Ralph Wilson Plastics added approximately 17 new designs to its laminate product line and 16 new designs to its line of Gibraltar solid surfacing products. The company also produces and/or sells contact adhesives under the Lokweld trademark, metallic surfacings, and decorative edge molding for countertops and furniture. Wilsonart brand decorative products are sold throughout the United States through wholesale building material distributors and directly to original equipment manufacturers. Export sales are now made to Japan, Ireland, Canada, Mexico, Central and South America, the Caribbean, Australia, New Zealand, Hong Kong, Taiwan, Korea and Singapore. Florida Tile manufactures glazed ceramic wall and floor tile products in a wide variety of sizes, shapes, colors and finishes, which are suitable for residential and commercial uses. Tile products are marketed under the Florida Tile trademark through company-owned and independent distributors. Major product groups of Florida Tile are marketed under the trademarks Natura and Artura. Products are exported to Canada, the Caribbean Basin, Iceland, Ireland, the United Kingdom, Mexico, Saudi Arabia and Pacific Rim nations. Florida Tile also imports foreign-produced tile products to meet the growing demand for low to mid-priced products. Tibbals Flooring manufactures and distributes high-quality, prefinished oak flooring for residential and commercial applications. Its flooring products are pre-cut parquet panels and laminated two and three-ply oak plank lineal flooring products, each of which is sold in a variety of colors and finishes. Tibbals Flooring also manufactures wood moldings, installation adhesives and a full line of proprietary floor care products to complement its line of oak flooring products. These products are marketed under the Hartco trademark to a nationwide network of wholesale floor covering distributors. Raw Materials and Facilities The manufacture of decorative laminates requires various raw materials, including kraft and decorative paper, overlays, and melamine and phenolic resins. Each of these items is available from a limited number of manufacturers, but Ralph Wilson Plastics has not experienced difficulties in obtaining sufficient quantities. The principal raw materials used in Florida Tile products are talc, stains, frit (ground glass) and clay, all of which are available to Florida Tile in sufficient quantities. The principal raw materials used in Tibbals Flooring's hardwood flooring products are Appalachian red and white oak, steel wire, and various chemicals. All such raw materials are readily available from many sources in sufficient quantities, but lumber supplies are at a premium price compared to prior years. Ralph Wilson Plastics owns and operates three manufacturing facilities in Texas and North Carolina, giving it the largest decorative laminate production capacity in North America. Adhesives are produced at two plants located in Louisiana and Texas. Solid surfacing products are manufactured in one facility in Texas. Ralph Wilson Plastics has 14 regional distribution centers which are geographically dispersed throughout the United States. Stock items can be delivered in 24 hours, and non-stock items can be produced and delivered within 10 working days. Florida Tile manufactures products in three owned manufacturing plants located in Florida, Georgia, and Kentucky, and distributes its products through a network of company-owned and independent distribution outlets. Tibbals Flooring manufactures its products in an owned manufacturing facility in Tennessee and a leased facility in Kentucky. Competition Wilsonart brand products are sold in highly competitive markets in the United States. Ralph Wilson Plastics has approximately 47% of the U.S. market for decorative laminates. Ralph Wilson Plastics successfully competes with other companies by providing fast product delivery, offering a broad choice of colors, designs, and finishes, and emphasizing quality and service. Florida Tile competes with a number of other domestic and foreign tile manufacturers, and the Registrant believes Florida Tile is the third largest U.S. tile manufacturer. Foreign-manufactured products account for approximately 54% of the U.S. tile market. Important competitive factors in the tile market include price, style, quality, and service. Tibbals Flooring competes with a number of other domestic and foreign suppliers of prefinished wood flooring product, and estimates that it has a major share of this market. Important competitive factors include the fit, appearance and durability of the flooring products, the variety of finishes and colors, and the complementary molding, adhesive and floor care products. Miscellaneous The Decorative Products Group maintains a continuing program of product development. Its efforts emphasize product design, performance and durability, product enhancement, and new product applications, as well as manufacturing processes. Materials development for laminate products is generally performed by the companies providing those materials. CONSUMER PRODUCTS GROUP Principal Products, Markets and Distribution West Bend manufactures and sells small electric appliances (such as electric skillets, slow cookers, woks, corn poppers, beverage makers and electronic timers) primarily under the West Bend trademark, and high-quality, direct-to-the-home stainless steel cookware. Precor manufactures physical fitness equipment, such as treadmills, stationary bicycles, low-impact climbers and ski machines marketed under the Precor trademark. During 1993, West Bend introduced an automatic breadmaker, a line of hand mixers and a food steamer. In 1993 Precor extended to its treadmill lines its Ergo Logic fitness software, which records and recalls personal exercise information for up to four people, and introduced a line of commercial treadmills featuring a low- impact bed to minimize stress to ankles and knees. West Bend small appliances are sold primarily in the United States and Canada, directly to mass merchandisers, department stores, hardware stores, warehouse stores and catalog showrooms. West Bend's stainless steel cookware is sold to consumers through food preparation dinner parties and by other direct sales methods. Cookware is sold in 19 countries under 14 separate product lines. Precor equipment is sold primarily through specialty fitness equipment retail stores and high-end sporting goods and bicycle stores in the U.S. and Canada. In Asia, Europe, Latin America, and the Middle East, Precor products are sold through select distributors. Raw Materials and Facilities West Bend uses aluminum, stainless steel, plastic resins and other materials in the manufacture of its products. Precor uses steel, stainless steel, aluminum and other materials in the manufacture of its products. Generally, neither West Bend nor Precor has experienced any significant difficulties in obtaining any of these raw materials or products. West Bend owns and operates two manufacturing plants in Wisconsin and Mexico. Precor maintains three leased plants in Washington state. Competition Products sold by West Bend and Precor compete with products sold by numerous other companies of varying sizes in highly competitive markets. Important competitive factors include price, development of new products, product performance, warranties, and service. Miscellaneous West Bend's sales in the fourth quarter are significantly higher due to the gift-giving season. Precor's business is significantly higher in the first and fourth quarters, when winter weather forces more people to exercise indoors. The West Bend small appliance business is dependent upon two customers for approximately 33% of its revenues. OTHER INFORMATION RELATING TO THE BUSINESS Trademarks and Patents. The Registrant considers trademarks and patents to be of importance to its businesses. The Registrant's trademarks represent the leading brand names for most of its product lines. Its businesses have followed the practice of applying for patents with respect to most of the significant patentable developments and now own a number of patents relating to their products, including design patents covering Tupperware products. In certain cases the Registrant has elected common law trade secret protection in lieu of obtaining patent protection. In addition, exclusive and nonexclusive licenses under patents owned by others are utilized. No business is, however, dependent to any material extent upon any single patent or trade secret or group of patents or trade secrets. Research and Development. For fiscal years ended 1993, 1992 and 1991, the Registrant spent approximately $41 million, $41 million and $31 million, respectively, on research and development activities. Environmental Laws. Compliance by the Registrant's businesses with federal, state and local environmental protection laws has not in the past had, and is not expected to have in the future, a material effect upon its capital expenditures, liquidity, earnings or competitive position. The Registrant expects to expend approximately $1.1 million through 1995 on capital expenditures related to environmental facilities. In 1993, the Registrant had approximately $4 million of capital expenditures for environmental facilities, and approximately $3.7 million of remedial expenditures for environmental sites. See Item 3 for a further discussion of environmental matters. Employees. The Registrant and its subsidiaries employ approximately 24,000 people. Approximately 18% of such employees are affiliated with one of the several unions with which the Registrant's subsidiaries have collective bargaining agreements. In recent years there has been no major effort to organize additional persons working for the Registrant's businesses, and there have been no significant work stoppages. The Registrant considers its relations with its employees to be good. The independent consultants, dealers, managers, distributors and franchisees engaged in the direct sale of Tupperware products are not employees of the Registrant. Properties. The principal executive offices of the Registrant are located in Illinois and are leased. Most of the principal properties of the Registrant and its subsidiaries are owned, and none of the owned principal properties is subject to any encumbrance material to the consolidated operations of the Registrant. The Registrant considers the condition and extent of utilization of the plants, warehouses and other properties in its respective businesses to be generally good, and the capacity of its plants generally to be adequate for the needs of its businesses. Miscellaneous. Except as disclosed above in the narrative descriptions of the Registrant's business segments, none of the Registrant's businesses are seasonal, have working capital practices or backlog conditions which are material to an understanding of their businesses, are dependent on a small number of customers, or are subject to renegotiation of profits or termination of contracts or subcontracts at the election of the Federal Government. Executive Officers of the Registrant. Following is a list of the names and ages of all the Executive Officers of the Registrant, indicating all positions and offices with the Registrant held by each such person, and each such person's principal occupations or employment during the past five years. Each such person has been elected to serve until the next annual election of officers of the Registrant (expected to occur on May 4, 1994). Name and Age Positions and Offices Held and Principal Occupations or Employment During Past Five Years Warren L. Batts (61) Chairman of the Board and Chief Executive Officer. James M. Ringler (48) President and Chief Operating Officer since June 1992, after having served as Executive Vice President, Consumer and Commercial Products since January, 1990, and President, Food Equipment Group since August, 1990. Prior to January, 1990, Mr. Ringler served as President of White Consolidated Industries. E. V. Goings (48) Executive Vice President of Premark and President of Tupperware Worldwide since November 1992, after serving as a Senior Vice President of Sara Lee Corporation Prior thereto, Mr. Goings served in various executive positions with Avon Products, Inc. Joseph W. Deering(53) Group Vice President of Premark and President of Premark's Food Equipment Group since June 1992, after serving as President of Leucadia National's Manufacturing Group. Prior thereto, Mr. Deering served in various executive positions with Philips Industries, Inc. Bobby D. Dillon (64) Group Vice President and President of the Decorative Products Group since August 1989, after serving in various executive positions with Ralph Wilson Plastics. Thomas W. Kieckhafer(55) Corporate Vice President and President of West Bend since December 1989, after serving in various executive positions with West Bend. James C. Coleman(54) Senior Vice President, Human Resources since July 1991. Prior thereto, Mr. Coleman served as Staff Vice President, Personnel Relations for General Dynamics Corporation. John M. Costigan (51) Senior Vice President, General Counsel, and since December 1990, Secretary. Lawrence B. Skatoff (54) Senior Vice President and Chief Financial Officer since September 1991. Mr. Skatoff served as Vice President-Finance of Monsanto Company from October 1987 until joining the Registrant. L. John Fletcher(50) Vice President and Assistant General Counsel. Robert W. Hoaglund(55) Vice President, Control & Information Systems since December 1990, after serving as Vice President, Control & Administrative Services, Vice President, Internal Audit and Corporate Services, and Vice President, Auditing. Wendy R. Katz (36) Vice President, Internal Audit since May 1992. Prior thereto, Ms. Katz served in various financial positions at Tupperware. Thomas P. O'Neill,Jr.(40) Vice President and Treasurer since February 1992, after serving as Vice President, Auditing since April, 1989. Prior thereto, Mr. O'Neill served as Director, External Reporting and Accounting Standards. Lisa Kearns Richardson (41) Vice President, Planning and Analysis since February 1991. Prior thereto, Ms. Kearns Richardson served as Assistant Controller, a position assumed in October 1986. James E. Rose, Jr. (51) Vice President, Taxes. For information concerning foreign and domestic operations and export sales, see Note 7 ("Income Taxes") appearing on pages 33 and 34, and "Segments of Business by Geographical Areas" in Note 10 ("Segments of the Business") appearing on page 39 of the Annual Report to Shareholders for the year ended December 25, 1993, which are incorporated by reference into this Report by Item 8 hereof. Item 2. Item 2. Properties For information concerning material properties of the Registrant and its subsidiaries, see the information under the sub-captions "Narrative Description of Business" in Section (c) of Item 1 above and "Properties" under the caption "Other Information Relating To The Business" in Section (c) of Item 1 above. Item 3. Item 3. Legal Proceedings The Registrant and its subsidiaries are parties against which are pending a number of legal and administrative proceedings. Among such proceedings are those involving the discharge of materials into or otherwise relating to the protection of the environment. Certain of such proceedings involve Federal environmental laws such as the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as well as state and local laws. The Registrant establishes reserves with respect to certain of such sites. Because of the involvement of other parties and the uncertainty of potential environmental impacts, the eventual outcomes of such actions and the cost and timing of expenditures cannot be estimated with certainty. It is not expected that the outcome of such proceedings, either individually or in the aggregate, will have a materially adverse effect upon the Registrant's consolidated financial position or operations. Kraft has assumed any liabilities arising out of any legal proceedings in connection with certain divested or discontinued former Dart businesses, including matters alleging product liability, environmental liability and infringement of patents. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The stock price information set forth in Note 12 ("Quarterly Summary (unaudited)") appearing on page 40 of the Annual Report to Shareholders for the year ended December 25, 1993 is incorporated by reference into this Report. The information set forth in Note 13 ("Shareholders' Rights Plan") on page 40 of the Annual Report to Shareholders for the year ended December 25, 1993 is incorporated by reference into this Report. As of March 8, 1994, the Registrant had 26,442 shareholders of record. Item 6. Item 6. Selected Financial Data The information set forth under the caption "Selected Financial Data" on pages 24 and 25 of the Annual Report to Shareholders for the year ended December 25, 1993 is incorporated by reference into this Report. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information entitled "Financial Review" set forth on pages 19 through 23 of the Annual Report to Shareholders for the year ended December 25, 1993 constitutes "Management's Discussion and Analysis of Financial Condition and Results of Operations" and is incorporated by reference into this Report. Item 8. Item 8. Financial Statements and Supplementary Data (a) The following Consolidated Financial Statements of Premark International, Inc. and Report of Independent Accountants set forth on pages 26 through 40, and on page 41, respectively, of the Annual Report to Shareholders for the year ended December 25, 1993 are incorporated by reference into this Report: Consolidated Statements of Operations, Cash Flows and Shareholders' Equity--Years ended December 25, 1993, December 26, 1992 and December 28, 1991 Consolidated Balance Sheet--December 25, 1993 and December 26, 1992 Notes to the Consolidated Financial Statements Report of Independent Accountants dated February 11, 1994 (b) The supplementary data regarding quarterly results of operations contained in Note 12 ("Quarterly Summary (unaudited)") of the Notes to the Consolidated Financial Statements of Premark International, Inc. on page 40 of the Annual Report to Shareholders for the year ended December 25, 1993 is incorporated by reference into this Report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The information as to the Directors of the Registrant set forth under the sub-caption "Board of Directors" appearing under the caption "Election of Directors" on pages 1 through 3 of the Proxy Statement relating to the Annual Meeting of Shareholders to be held on May 4, 1994 is incorporated by reference into this Report. The information as to the Executive Officers of the Registrant is included in Part I hereof under the caption "Executive Officers of the Registrant" in reliance upon General Instruction G to Form 10-K and Instruction 3 to Item 401(b) of Regulation S-K. Item 11. Item 11. Executive Compensation The information set forth under the caption "Compensation of Directors" and beginning on page 14 of the Proxy Statement relating to the Annual Meeting of Shareholders to be held on May 4, 1994, and the information on pages 6 through 8, and beginning on page 10 of such Proxy Statement relating to executive officers' compensation, is incorporated by reference into this Report. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information set forth under the captions "Security Ownership of Certain Beneficial Owners" on page 5 and "Security Ownership of Management" on page 4 of the Proxy Statement relating to the Annual Meeting of Shareholders to be held on May 4, 1994 is incorporated by reference into this Report. Item 13. Item 13. Certain Relationships and Related Transactions None PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports On Form 8-K (a) (1) List of Financial Statements The following Consolidated Financial Statements of Premark International, Inc. and Report of Independent Accountants set forth on pages 26 through 40, and on page 41, respectively, of the Annual Report to Shareholders for the year ended December 25, 1993 are incorporated by reference into this Report by Item 8 hereof: Consolidated Statements of Operations, Cash Flows and Shareholders' Equity--Years ended December 25, 1993, December 26, 1992 and December 28, 1991 Consolidated Balance Sheet--December 25, 1993 and December 26, 1992 Notes to the Consolidated Financial Statements Report of Independent Accountants dated February 11, 1994 (a) (2) List of Financial Statement Schedules The following consolidated financial statement schedules (numbered in accordance with Regulation S-X) of Premark International, Inc. are included in this Report: Report of Independent Accountants on Financial Statement Schedules, page 21 of this Report Schedule V--Property, Plant and Equipment for the three years ended December 25, 1993, page 22 of this Report Schedule VI--Accumulated Depreciation of Property, Plant and Equipment for the three years ended December 25, 1993, page 24 of this Report Schedule VII--Guarantees of Securities of Other Issuers as of December 25, 1993, page 26 of this Report Schedule VIII--Valuation and Qualifying Accounts for the three years ended December 25, 1993, page 28 of this Report Schedule X--Supplementary Income Statement Information for the three years ended December 25, 1993, page 30 of this Report All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions, are inapplicable, or the information called for therein is included elsewhere in the financial statements or related notes thereto contained or incorporated by reference herein. (a) (3) List of Exhibits: (numbered in accordance with Item 601 of Regulation S-K) Exhibit Number Description * 3A Restated Certificate of Incorporation (Exhibit 3A to the Registrant's Annual Report on Form 10-K for the year ended December 28, 1991) * 3B Amended By-Laws (Exhibit 3B to the Registrant's Annual Report on Form 10-K for the year ended December 28, 1991) * 4A Form of Common Stock Certificate (Exhibit 3 to the Registrant's Current Report on Form 8-K dated March 20, 1989) * 4B Rights Agreement dated March 7, 1989 (Exhibit 1 to the Registrant's Current Report on Form 8-K dated March 20, 1989) * 4C Form of Right Certificate of Common Stock Purchase Right (Exhibit 1 to the Registrant's Current Report on Form 8-K dated March 20, 1989) * 4D Form of Indenture (Revised) in connection with the Registrant's Form S-3 Registration Statement No. 33-35137 (Exhibit (c)(3) to the Registrant's Current Report on Form 8-K dated September 17, 1990) *10A Reorganization and Distribution Agreement dated as of September 4, 1986 (Exhibit 2 to Registration of Securities on Form 10 dated September 8, 1986, File No. 1-9256) *10B Tax Sharing Agreement dated as of September 4, 1986 (Exhibit 10C to Registration of Securities on Form 10 dated September 8, 1986, File No. 1-9256) *10C Facilities and Guarantee Agreement, as amended, and Termination Agreement dated as of September 4, 1986 (Exhibit 10D to Registration of Securities on Form 10 dated September 8, 1986, File No. 1-9256) *10D $250,000,000 Credit Agreement dated as of May 12, 1992 (Exhibit (19)(10) to the Registrant's Quarterly Report on Form 10-Q for the 26 weeks ended June 27, 1992) COMPENSATORY PLANS OR ARRANGEMENTS *10E Premark International, Inc. Annual Incentive Plan (Exhibit 10H to the Registrant's Annual Report on Form 10-K for the year ended December 28, 1991) *10F Premark International, Inc. Restricted Stock Plan (Exhibit 10I to the Registrant's Annual Report on Form 10-K for the year ended December 28, 1991) *10G Premark International, Inc. Performance Unit Plan (Exhibit 10J to the Registrant's Annual Report on Form 10-K for the year ended December 28, 1991) 10H Premark International, Inc. Stock Option Plan, as amended *10I Premark International, Inc. Supplemental Benefits Plan (Exhibit 10L to the Registrant's Annual Report on Form 10-K for the year ended December 28, 1991) *10J Premark International, Inc. Change of Control Policy, as amended 1989 (Exhibit 4 to the Registrant's Current Report on Form 8-K dated March 20, 1989) *10K Employment Agreement entered into on July 11, 1991 between the Registrant and Lawrence B. Skatoff (Exhibit 10K to the Registrant's Annual Report on Form 10-K for the year ended December 26, 1992) *10L Form of Employment Agreement entered into on March 7, 1989 between the Registrant and certain executive officers (Exhibit 5 to the Registrant's Current Report on Form 8-K dated March 20, 1989) *10M Employment Agreement entered into on June 2, 1992 between the Registrant and Joseph W. Deering (Exhibit 10M to the Registrant's Annual Report on Form 10-K for the year ended December 26, 1992) 10N Employment Agreement dated November 9, 1992 between the Registrant and E. V. Goings 10O Premark International, Inc. Director Stock Plan, as amended 1993 11 A statement of computation of 1993 per share earnings 13 Pages 19 through 41 of the Annual Report to Shareholders of the Registrant for the year ended December 25, 1993 22 Subsidiaries of the Registrant as of March 8, 1994 24 Manually signed Consent of Independent Accountants to the incorporation of their report by reference into the prospectuses contained in specified registration statements on Form S-8 and Form S-3 25 Powers of Attorney *Document has heretofore been filed with the Commission and is incorporated by reference and made a part hereof. The Registrant agrees to furnish, upon request of the Commission, a copy of all constituent instruments defining the rights of holders of long-term debt of the Registrant and its consolidated subsidiaries. (b) Reports on Form 8-K No Current Reports on Form 8-K were filed by the Registrant for the quarter ended December 25, 1993. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Shareholders of Premark International, Inc. Our audits of the consolidated financial statements referred to in our report dated February 11, 1994, appearing on page 41 of the 1993 Annual Report to Shareholders of Premark International, Inc., (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a)(2) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ Price Waterhouse Chicago, Illinois February 11, 1994 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. Premark International, Inc. (Registrant) By /s/ WARREN L. BATTS Warren L. Batts Chairman of the Board and Chief Executive Officer March 14, 1994 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 date indicated. Signature Title /s/ Warren L. Batts Chairman of the Board of Directors, Warren L. Batts Chief Executive Officer and Director (Principal Executive Officer) /s/ Lawrence B. Skatoff Senior Vice President and Chief Lawrence B. Skatoff Financial Officer (Principal Financial Officer) /s/ Robert W. Hoaglund Vice President, Control and Robert W. Hoaglund Information Systems (Principal Accounting Officer) * Director William O. Bourke * Director Dr. Ruth M. Davis * Director Lloyd C. Elam, M.D. * Director Clifford J. Grum * Director Joseph E. Luecke * Director Bob Marbut * Director John B. McKinnon * Director David R. Parker * Director Robert M. Price /s/ James M. Ringler President, Chief Operating Officer and James M. Ringler Director * Director Janice D. Stoney *By /s/ John M. Costigan John M. Costigan Attorney-in-fact March 14, 1994 EXHIBIT INDEX Exhibit No. Description Page 10H Premark International, Inc. 34-44 Stock Option Plan, as amended 10N Employment Agreement dated 45-50 November 9, 1992 between Registrant and E. V. Goings 10O Premark International, Inc. 51-59 Director Stock Plan, as amended 1993 11 A statement of computation of 60-61 1993 per share earnings 13 Pages 19 through 41 of the Annual Report to Shareholders of the Registrant for the year ended December 25, 1993 62-96 22 Subsidiaries of the Registrant as of March 8, 1994 97-99 24 Manually signed Consent of Independent Accountants to the incorporation of their report by reference into the prospec- tuses contained in specified registration statements on Form S-8 and Form S-3 100 25 Powers of Attorney 101-102

75488_1993.txt

75488_1993

1993

75488

ITEM 1. BUSINESS. GENERAL CORPORATE STRUCTURE AND BUSINESS Pacific Gas and Electric Company (the Company) is an operating public utility engaged principally in the business of supplying electric and natural gas service throughout most of Northern and Central California, a territory with an estimated population of 12,800,000. As of December 31, 1993, the Company served approximately 4,400,000 electric customers and 3,600,000 gas customers. As of December 31, 1993, the Company (excluding subsidiaries) had approximately 23,000 employees. The Company was incorporated in California in 1905. Its principal executive office is located at 77 Beale Street, P.O. Box 770000, San Francisco, California 94177, and its telephone number is (415) 973-7000. The Company's service territory covers 94,000 square miles, and includes all or portions of 48 of California's 58 counties. The area's diverse economy includes aerospace, electronics, financial services, food processing, petroleum refining, agriculture and tourism. As of December 31, 1993, the Company had approximately $27 billion in assets. The Company generated approximately $10.6 billion in operating revenues for 1993. The Company's revenues come from three sources: traditional gas and electric utility operations, Diablo Canyon Nuclear Power Plant (Diablo Canyon) operations, and activities conducted through the Company's nonregulated subsidiary, PG&E Enterprises (Enterprises). The Company's traditional utility operations are generally regulated under the cost-based approach to ratemaking. Diablo Canyon operations are conducted under a performance based approach to alternative ratemaking, as a result of the Diablo Canyon rate case settlement, effective in 1988. Under this approach, revenues for the plant are based primarily on the amount of electricity generated, rather than on the costs associated with the plant's operations. Enterprises, a wholly owned subsidiary of the Company, is the parent company for the nonregulated portion of the Company's business, which includes non-utility electric generation facilities and natural gas and oil exploration and development. The Company serves its electric customers with power generated by eight primarily natural gas-fueled power plants, ten combustion turbines, one nuclear power plant, 70 hydroelectric powerhouses, one hydroelectric pumped storage plant and a geothermal energy complex of 14 units. The Company also purchases power produced by other generating entities that use a wide array of resources and technologies, including hydroelectric, wind, solar, biomass, geothermal and cogeneration. In addition, the Company is interconnected with electric power systems in 14 western states and British Columbia, Canada, for the purposes of buying, selling and transmitting power. To ensure a diverse and competitive mix of natural gas supplies, the Company has supply contracts of varying lengths with both Canadian and United States suppliers. In 1993, about 55% of the Company's gas supply came from fields in Canada, about 40% came from fields in other states (substantially all from the U.S. Southwest) and about 5% came from fields in California. In February 1993, the Company announced a corporate reorganization to consolidate certain business units, operating regions and operating divisions. As a result of the reorganization, the Company is organized into five business units: Customer Energy Services (formerly known as the Distribution business unit), Electric Supply, Gas Supply, Nuclear Power Generation and Enterprises. The former Engineering and Construction business unit has been disbanded, with its functions assumed by the remaining business units. The business units will continue to be supported by Corporate Services departments, which provide essential corporate services and management functions. COMPETITION Under traditional utility regulatory schemes, utilities have been accorded the exclusive right to serve customers within designated areas in return for their commitment to provide service to all who request it. Regulation was designed in part to take the place of competition to ensure that utility services were provided at fair prices. The Company is currently experiencing increasing competition in both the gas and electric energy markets. Recent restructuring in both the gas and electric industries has resulted in the separation of the energy supply function from the energy services function in both the gas and electric businesses. These changes have allowed competition to flourish in the gas supply and electric production segments of the energy business. As a result of regulatory changes in the gas industry, the Company no longer provides combined purchase and transportation services to many of its industrial and large commercial (noncore) gas customers. Instead, many noncore customers now purchase gas supplies directly from a gas shipper or producer, reserve interstate transportation capacity directly from an interstate pipeline, and then purchase intrastate transportation service from the Company once their gas arrives at the California border. In addition, an interstate pipeline company has proposed expanding its facilities into the Company's service territory. If approved, the expansion would allow that pipeline company to compete directly for intrastate transportation service to the Company's noncore customers. See "Gas Utility Operations -- Other Competitive Interstate Pipeline Projects" below. If, in the restructured gas industry, the Company's gas customers elect to serve their own gas supply needs, reserve their own interstate transportation capacity, or leave the Company's system altogether by moving to an alternative intrastate delivery system, the Company may find that it needs to spread the fixed costs of its gas supply and delivery system over fewer units of sales. Unless costs are reduced or imposed as transition charges on exiting customers, or other measures are taken, the price per unit would go up and remaining customers would be asked to pay higher prices, further exacerbating the competitive pressures. The restructuring of the natural gas industry has already had a significant impact on the Company's gas operations. In 1993, the Company terminated its long-term Canadian gas purchase contracts and entered into new, more flexible arrangements for the purchase of the Company's current lower gas supply requirements. In addition, the Company is continuing its efforts to permanently assign or broker its commitments for firm gas transportation capacity which it once held for its noncore customers. Changes in the electric utility industry are following the pattern of change in the natural gas industry. The Company continues to perform the functions of electricity production, transmission, distribution and customer service. However, the Company already obtains one-third of its electrical power supply from generation sources outside its service territory and from qualifying facilities, or QFs (small power producers or cogenerators who meet certain federal guidelines which qualify them to supply generating capacity and electric energy to utilities), owned and operated by independent power producers (IPPs). Future additions to satisfy electric supply needs in the Company's service territory will be determined largely through a competitive resource procurement process, a feature of the new competitive market for electric generation. It is expected that new power plant projects will be increasingly undertaken by IPPs rather than utilities, and indeed, the Company has indicated a willingness to forgo building new generation capacity in its service territory if the electric resource procurement process is appropriately reformed. In addition, federal regulators now have increased authority to order a utility to transport and deliver, or "wheel," energy for any wholesale purchaser or seller of power, and it is possible that the trend of increasing wholesale transmission access could lead to increased pressure for state regulators to mandate wheeling to retail customers. Whether states have authority to order retail wheeling is as yet undetermined. If future restructuring were to include retail wheeling whereby customers purchase energy directly from an IPP or other supplier and separately pay the Company to wheel the purchased power, the Company's power generation plants and resources would be subject to even greater competition from other available supply options. Under current regulation, customer prices are based on an allocation among customer classes of the Company's approved cost-of-service revenue requirements. Currently, large industrial and commercial customers are most likely to have lower cost competitive gas supply and electric generation alternatives. If a substantial number of these customers were to elect those alternatives and leave the Company's system, the Company's recovery of its investment in production sources and distribution facilities would be dependent on prices charged to remaining customers and the Company's ability to reduce costs. This could lead to lower shareholder returns. In addition, the continuing recession in California's economy has resulted in reduced growth in demand for the Company's products and services. California's current economic condition could also lead to increased regulatory resistance to, and reduced customer acceptance of, higher prices. Currently, the Company's average gas prices for residential, commercial and industrial customers are among the lowest utility gas prices in California. The Company's current electric prices are less competitive than its gas prices. Although the Company's residential electric bills are at the low end of the scale nationally, the Company's prices per kilowatt-hour (kWh) are high when compared with national averages. The Company's prices for industrial customers average approximately 7.3 cents per kWh, which is comparable to prices charged by the other major California utilities, but above the industrial electric prices in many other states. The Company's system average electric price, at 10.6 cents per kWh, is the highest in California and has increased slightly faster than inflation over the past five years. The Company's electric prices include the costs for generation, transmission, distribution and customer service. In an effort to improve its ability to succeed in the face of greater competition, the Company has taken steps to improve service to customers, reduce costs and lower the price of gas and electric service. To help reduce its costs and maintain competitive prices, the Company has: -- reduced its workforce by approximately 3,000 positions, which is expected to result in net revenue requirement savings of approximately $170 million during the three-year 1993 General Rate Case cycle and annual revenue requirement savings of at least $200 million beginning in 1996 (see "Current Rate Proceedings -- Workforce Reduction Rate Mechanism" below); -- reduced its cost of capital by taking advantage of significantly lower interest rates to refinance a significant portion of its long-term debt and a portion of its preferred stock; and -- obtained California Public Utilities Commission (CPUC) approval to freeze current electric rates through the end of 1994 and to reduce electric rates by $100 million for major businesses over an 18-month period beginning in July 1993 (see "Current Rate Proceedings -- Electric Rate Initiative" below). The Company has also taken specific steps which will assist it in remaining competitive in the restructured gas industry. -- In November 1993, the Company terminated its long-term Canadian gas purchase contracts and entered into new, more flexible arrangements for the purchase of the Company's current lower gas supply requirements. See "Gas Utility Operations -- Restructuring of Canadian Gas Supply Arrangements -- Decontracting Plan" below. -- The Company has implemented gas rate design modifications intended to more accurately reflect the cost to serve each customer class. Although implementation of the new rates did not result in an overall increase in the Company's authorized revenues, upon implementation the overall gas transportation rates for large industrial noncore customers decreased by approximately 31% and the overall transportation rate for utilities using gas to generate electricity decreased by approximately 20%, while residential and smaller commercial (core) customer rates for bundled gas service (procurement and transportation) increased by approximately 5% compared to rates previously in effect. -- The Company has entered into long-term gas transportation contracts providing discounted rates for certain major industrial customers. The CPUC has approved on an expedited basis eleven long-term contracts with existing customers, ten of those under the Expedited Application Docket (EAD) procedure. The eleven long-term contracts together represent approximately 7% of the Company's noncore transportation revenues and approximately 12% of the Company's transportation revenues from industrial and cogeneration customers. The Company is currently precluded from recovering in rates 25% of the revenue shortfalls resulting from discounts given in these contracts until the CPUC adopts final rules regarding noncore transportation pricing or approves recovery by the Company of such amounts as part of the Company's next gas ratemaking proceeding. See "California Ratemaking Mechanisms -- Gas Revenue Mechanisms" below. At that time, the CPUC is expected to make a further determination as to the rate recovery of revenue shortfalls attributable to EAD contracts. -- The Company has filed for approval new long-term gas transportation rates to be offered to its largest industrial and cogeneration customers. See "Long-Term Gas Transportation Rates" below. Approval of these rates will enable the Company to offer competitive long-term rates without the burden of the contract-by-contract approval required under the EAD procedure. In addition, the Company is currently seeking fundamental changes in the overall regulatory regime under which it must operate in order to allow the Company greater flexibility to compete in today's markets and still achieve its pricing and earnings goals. In March 1994, the Company filed an application with the CPUC requesting it adopt the Company's Regulatory Reform Initiative (RRI). The RRI has three components. The first, performance based ratemaking for determining base revenues, would replace several traditional rate cases with a framework which includes a base revenue index and financial incentives tied to performance standards. The Company would manage its non-fuel costs in accordance with revenue determined by an external index, instead of having its actual or forecast costs subject to detailed CPUC review. The performance standards would provide the Company with significant incentives to maintain its quality of service, as well as to provide that service while lowering residential customers' bills as much as possible. The PBR proposal provides for the sharing between ratepayers and shareholders of earnings above or below a target utility return on equity that would be computed annually. The second component of the RRI involves the creation of a Large Electric Manufacturing Class (LEMC) of customers. This proposal is intended to provide large manufacturing customers the price certainty and tariff options they need to be competitive, as well as the ability to negotiate customized contracts with the Company. The Company expects that the new tariff options will influence the LEMC customers' decisions to retain and/or expand their operations in California, and encourage other manufacturers to establish operations in the state. Also, the flexibility afforded by the LEMC proposal would allow a more prompt response to the LEMC customers' existing competitive alternatives, and thus help to avert the uneconomic bypass of the Company's electric system. The third component involves the use of market benchmarks to evaluate gas procurement costs. A specific proposal regarding the third component is not included in the Company's March 1994 filing but is expected to be filed at a later date. See "Regulatory Reform Initiative" for more details regarding the RRI. CALIFORNIA RATEMAKING MECHANISMS The ratemaking mechanisms currently applied by the CPUC in setting the Company's rates are discussed below. As noted above (see "Competition"), the Company has filed an application with the CPUC requesting adoption of the RRI as an alternative to the current regulatory approach to setting rates. If adopted, the RRI would significantly alter the ratemaking mechanisms described below. In addition, the Company implemented its electric rate initiative in 1993, which impacted the application of certain of these ratemaking mechanisms in current rate proceedings (see "Current Rate Proceedings" below). GENERAL RATE CASE AND ATTRITION MECHANISMS General Rate Case (GRC). Under the CPUC's Rate Case Plan, the CPUC sets the Company's base revenue requirements for both electric and gas operations in the GRC proceeding. Base revenue is revenue intended to recover the Company's fixed costs and non-fuel variable costs and to provide a return on invested capital. (Fuel revenue requirements, intended to offset the Company's fuel and fuel-related costs, are set as part of the Energy Cost Adjustment Clause proceeding for electric operations and the Biennial Cost Allocation Proceeding for gas operations, as discussed below.) The Company files a GRC application once every three years, with a decision issued approximately 13 months after the application is filed. In this proceeding, revenues and expenses are determined on a forecast or future test-year basis, rather than on a historic-year basis. A decision was issued in the Company's 1993 GRC in December 1992. In November 1993, the CPUC denied the petition filed in January 1993 by the CPUC's Division of Ratepayer Advocates (DRA) and various special interest groups to modify the decision in the Company's 1993 GRC so as to reduce the authorized revenue requirements. Under the current GRC mechanism, the Company's next GRC, based on a 1996 test year, would be filed in late 1994. Pending adoption of the RRI, the Company will proceed to make that filing in 1994. Attrition Rate Adjustment (ARA). The ARA adjusts base rates in the years between GRC decisions to partially offset attrition in earnings due to changes in operating expenses and capital costs. Labor expenses and nonlabor maintenance and operation expenses are indexed, and a prescribed amount is allowed for recovery of expenses related to changes in depreciation, income taxes, financing costs, rate base growth and other items. The cost of capital, including authorized return on equity, is determined separately by the CPUC in the annual Cost of Capital consolidated proceeding which reviews financing costs and adopts capital structures for all California energy utilities. Changes in fuel and fuel-related costs are addressed in the Energy Cost Adjustment Clause proceeding for electric operations and the Biennial Cost Allocation Proceeding for gas operations, both of which are discussed below. The ARA improves the Company's ability to earn its authorized rate of return for utility operations in the years between GRCs. In May 1993, the DRA and various special interest groups filed a joint petition with the CPUC requesting suspension, for an indefinite period, of the ARA mechanism currently in place for the Company. The petition requests that any future attrition rate increases be considered only upon application by the Company for such relief and only if the then current rate of inflation exceeds 6% on an annual basis. Under such circumstances, the petition recommends that the level of any attrition rate adjustment ultimately authorized by the CPUC be limited only to inflation above the 6% threshold level. In June 1993, the Company filed its response to the petition stating that the current ARA mechanism is a necessary feature of the three-year GRC cycle even during periods of low inflation. ELECTRIC REVENUE MECHANISMS Energy Cost Adjustment Clause (ECAC). Starting in 1994 with the reinstatement of the Annual Energy Rate (AER) mechanism described below, the ECAC provides for recovery of 91% of the cost of fuel and purchased energy, fuel oil inventory carrying costs up to an authorized level, facility charges and certain gains or losses from the sale of fuel oil, and for collection of performance-based Diablo Canyon revenues. The remaining 9% of the energy costs are recoverable through the AER procedure described below. Differences between total ECAC revenues and the sum of actual electric energy costs recoverable through the ECAC and Diablo Canyon revenues accumulate in a balancing account, usually with interest, and are recovered from or returned to customers through subsequent ECAC rates. Also included in the ECAC proceeding are revenue adjustments resulting from the Low Income Rate Assistance program and the Electric Revenue Adjustment Mechanism described below. Recovery of costs included in the ECAC is subject to a determination that such costs were incurred reasonably. (Diablo Canyon costs are not subject to reasonableness review, but are recovered pursuant to the Diablo Canyon rate case settlement. See "Diablo Canyon -- Diablo Canyon Settlement" below.) ECAC rates are set once a year, based on a January 1 revision date, to recover electric energy-related costs based on a forward-looking calendar test year. ECAC rates also are subject to adjustment effective May 1 if the required adjustment would be more than 5% of total annual electric revenues. The Company's next ECAC application is expected to be filed on April 1, 1994. Annual Energy Rate (AER). The AER mechanism, which had been suspended in August 1990, was reinstated by the CPUC in December 1993. The reinstatement of the AER mechanism places the Company at partial risk for variations between actual and forecasted energy expenses, since there is no specific balancing account associated with the AER. The AER provides for recovery of 9% of forecasted energy costs and the amounts collected under the AER will not be adjusted if actual costs differ from the amounts authorized. To minimize the revenue risk resulting from the potential for substantial swings in energy-related expenses, the allowable pre-tax earnings fluctuation (up or down) resulting from the AER procedure is limited by a 140 basis-point cap applied to earnings on the equity portion of total rate base. To the extent that AER-related energy expenses exceed the allowable range of fluctuation, such expenses outside the allowable range become subject to ECAC balancing account treatment. The AER mechanism is on the same time schedule as the ECAC mechanism. Electric Revenue Adjustment Mechanism (ERAM). The ERAM allows rate adjustments to offset the effect on base revenues of changes in electric sales from the level used to set rates in the last GRC or ARA proceeding. The ERAM eliminates the impact on earnings of sales fluctuations, including those resulting from conservation and weather conditions. Base revenue differences resulting from the disparity between actual and forecasted electric sales accumulate in a balancing account, with interest, and are recovered from or returned to customers through subsequent ERAM rate adjustments. ERAM rate adjustments are made as part of the ECAC process with a January 1 revision date. GAS REVENUE MECHANISMS Biennial Cost Allocation Proceeding (BCAP). The BCAP forecasts the cost of gas, allocates costs of providing gas service to various customer classes, including the base revenue amount approved in the GRC or ARA, and sets associated rates. Issues considered in the BCAP include: (i) the gas transportation forecast (throughput), purchased gas costs and transportation revenue requirement forecast for costs other than the base amount; (ii) the allocation of costs between core and noncore customer classes; and (iii) the rates for procurement services for core customers and for transportation and related services for each customer class. Core customers include all residential customers and commercial customers that do not exceed certain volume limitations. Noncore customers are industrial and larger commercial customers that exceed certain volume limitations. A filing is made on August 15 of every other year for rates to be effective on April 1 of the following year. The Company's next BCAP application is currently scheduled to be filed in August 1994. An interim filing, referred to as a trigger filing, is permitted to set new rates for the second year of the BCAP period if amortization of accumulated over-or under-collections in balancing accounts would change either bundled core rates or noncore transportation rates by more than 5%. In December 1992, the CPUC announced proposed rules which would (i) extend the gas ratemaking cycle from two to three years and (ii) reduce the amount of balancing account protection provided for noncore transportation revenues. Other than accepting comments from interested parties, the CPUC has taken no further action on the proposed rules. Purchased Gas Account (PGA). The PGA is a balancing account which accumulates differences between actual cost of gas procured for the core portfolio and revenues intended to cover those costs. Those differences accumulate with interest, and are recovered from or returned to procurement customers through subsequent BCAP rate adjustments. Gas Fixed Cost Accounts (GFCAs). The GFCAs include separate core and noncore accounts. The core GFCA is a balancing account that accumulates the differences between most of actual transportation revenues from core customers and the sum of the authorized core base revenue amount and core gas service costs. The difference accumulates with interest, and is recovered from or returned to customers through subsequent BCAP rate adjustments. The noncore GFCA tracks 75% of the difference between most of actual transportation revenues from noncore customers and the sum of the authorized noncore base revenues and noncore gas service costs. This amount accumulates with interest, and is recovered from or returned to customers through subsequent BCAP rate adjustments. Interstate Transition Cost Surcharge (ITCS) Account. The ITCS is a balancing account that accumulates unrecovered demand charges for interstate capacity acquired by a utility prior to the adoption of the CPUC's capacity brokering rules in November 1991. Demand charges that are not fully recovered because of the operation of the capacity brokering rules accumulate in the ITCS account and are recovered through subsequent BCAP rate adjustments as authorized by the CPUC. Unrecovered demand charges will be allocated to customers on an equal cents-per-therm-usage basis, subject to a limit on the amount that can be allocated to core customers. OTHER RATE ADJUSTMENT MECHANISMS Low Income Rate Assistance (LIRA). The LIRA program was established by the CPUC in 1989 to provide discount residential electric and gas rates for customers who qualify under low-income criteria. LIRA program administrative costs are recovered through base rate revenues and the direct cost of LIRA rate discounts are funded through LIRA rate adjustments made in the ECAC and BCAP proceedings. Customer Energy Efficiency (CEE). Under the CEE ratemaking mechanism adopted in 1990, the Company is authorized to recover in rates some of the energy savings resulting from and costs of certain of its CEE programs. Beginning in 1994, CEE rate adjustments resulting from shareholder incentives earned on CEE programs will be determined as part of the Annual Earnings Assessment Proceeding (AEAP), a new consolidated proceeding established by the CPUC to authorize shareholder earnings for the Company and the other California energy utilities arising out of the previous year's CEE program accomplishments. See "CEE/DSM Programs" below. Prior to 1994, these adjustments had been made in the ECAC proceeding. CATASTROPHIC EVENTS MEMORANDUM ACCOUNT (CEMA) The CEMA permits utilities to record for eventual recovery through rates the reasonable costs they incur in restoring service, repairing or replacing facilities and complying with government orders following a catastrophic event which is declared a disaster by the appropriate federal or state authorities. The utility must seek recovery of costs accumulated in the CEMA through a GRC or other formal rate-setting application, with recovery subject to a reasonableness review by the CPUC. REGULATORY REFORM INITIATIVE The Company has been engaged in discussions with the CPUC, customers and other interested parties concerning various reforms to the current regulatory approach to setting rates. On March 1, 1994, the Company filed an application with the CPUC requesting it adopt the Company's proposed RRI and approve 1995 electric and gas base revenue requirements. The RRI is, in part, a response to the report issued in February 1993 by the CPUC's Division of Strategic Planning on electric industry restructuring. That report concluded that the current regulatory approach is incompatible with the emerging industry structure resulting from technological change, competitive pressure and new market forces. The report indicated that the existing cost-of-service ratemaking does not provide sufficient incentives for efficient utility operations and disproportionately favors additions to rate base as opposed to energy efficiency or purchased power alternatives, and that the number and complexity of proceedings result in significant administrative costs and burdens which threaten the quality of public participation in CPUC proceedings. Although the report indicated the necessity for reform of the regulatory framework, it did not ultimately recommend a specific strategy. The Company's RRI has three components: (i) performance based ratemaking (PBR) for determining base revenues; (ii) establishment of the LEMC, consisting of large electric manufacturing customers; and (iii) use of market benchmarks to evaluate gas procurement costs. A specific proposal regarding the third component is not included in the Company's March 1, 1994 filing but is expected to be filed at a later date. In its filing, the Company proposes a schedule calling for technical workshops in April, public hearings beginning in June and a final CPUC decision by the end of 1994. The Company has requested that the RRI become effective on January 1, 1995. PBR Under the Company's PBR proposal, electric and natural gas base revenues would be determined annually by formula rather than through GRCs, ARAs and Cost of Capital proceedings. Base revenues are the revenues intended to recover the Company's operation and maintenance expenses (excluding costs for fuel or fuel-related items), depreciation expense, income and other taxes, and to provide a return on invested capital. Revenues to offset fuel and fuel-related costs would still be determined in the ECAC proceeding for electric operations and the BCAP for gas operations. The PBR mechanism will not apply to the base revenue associated with Diablo Canyon, including Diablo Canyon decommissioning costs, which will continue to be determined pursuant to the Diablo Canyon rate case settlement. See "Diablo Canyon -- Diablo Canyon Settlement" below. The Company's proposed PBR mechanism would determine the base revenues for a given calendar year by multiplying the base revenues authorized for the prior calendar year by an index consisting of inflation plus customer growth less a prescribed productivity factor. Those revenues would also be adjusted up or down depending on the Company's achievement relative to four performance standards: CEE programs, Energy Bills (i.e., a comparison of the Company's overall residential electric and gas bills relative to national averages), Customer Satisfaction and Electric Service Reliability. The positive or negative adjustments related to the Company's performance in these four areas would be one-time modifications to that year's base revenues as calculated under the PBR index formula. The adjustments for CEE incentives would be determined as they currently are under existing ratemaking procedures. The maximum adjustments that the Company could earn related to Energy Bills and Customer Satisfaction is $25 million per year for each, and the maximum for Electric Service Reliability is $19 million per year. Under PBR, the Company could also apply for an adjustment to base revenues due to the occurrence of certain extraordinary events outside the Company's control, including events that would currently qualify for ratemaking treatment through the existing CEMA (see "California Ratemaking Mechanisms -- Catastrophic Events Memorandum Account" above). The PBR proposal provides for the sharing between ratepayers and shareholders of earnings above or below a target utility return on equity (ROE) that would be computed annually. To the extent actual ROE exceeds more than 200 basis points above or below the target ROE, the difference would be shared equally with ratepayers through a reduction or increase in the next year's base revenue. If actual ROE was more than 500 basis points above or below the target ROE, then the Company and the CPUC would each have the option to initiate a proceeding to reexamine the PBR formula. The Company is proposing that base revenue indexing begin in 1995. However, the Company proposes to forgo any increase in the electric base revenue for 1995 determined under the PBR mechanism. Instead, 1995 electric base revenue would be held at the 1994 level. In its filing, the Company proposes that the RRI remain in place indefinitely. The Company recommends that after five years the CPUC review the PBR mechanism and make any necessary adjustments, but not return to the use of traditional rate cases to set rates. LEMC As proposed by the Company, the LEMC would consist of the Company's largest electric accounts (having an average hourly electricity usage over a 12-month period of at least 2,000 kilowatts) engaged in manufacturing. Currently, approximately 120 accounts would qualify for inclusion in the LEMC. LEMC customers would be removed from cost-of-service ratemaking. Standard LEMC tariff rates would be determined every calendar year by an index formula, similar to that used in the PBR mechanism, which is intended to reflect inflation less a productivity factor. In addition, several long-term tariff options designed to respond to these customers' competitive alternatives would be offered to the LEMC. The Company also seeks authorization to negotiate and enter into customized contracts with LEMC customers. In some cases, the customized contracts would become effective without prior approval or subsequent review by the CPUC of the contract terms. Generally, the Company proposes to separate the costs allocated to the LEMC and bear the risk of their recovery if sales to these customers decline over time. The Company's shareholders would bear the risk of LEMC costs that increase faster than the LEMC price index. ACCOUNTING IMPLICATIONS Based on the regulatory framework in which it operates, the Company currently accounts for the economic effects of regulation in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation." As a result, the Company defers recognition of costs which would otherwise be expensed when incurred because regulators have provided mechanisms that make it probable that the costs will be included in future rates. If the RRI is adopted, the mechanics of the rate setting process would change. However, the Company anticipates that rates derived from the RRI would remain based on cost-of-service, with the exception of rates for the LEMC customers and rates established under certain other regulatory mechanisms proposed to be discontinued upon adoption of the RRI. If the RRI is adopted as proposed, the Company anticipates that it will write-off certain regulatory assets, including an estimated $65 million related to the LEMC customers and potentially additional amounts which may be affected by the adoption of the RRI, the aggregate amount of which could have a significant adverse impact on the Company's financial position or results of operations. The estimated amount related to the LEMC is based on the base revenue allocation currently used in establishing rates; the actual amount could vary depending on the allocation method adopted by the CPUC. The final determination of the accounting impact will be dependent upon the form of the regulatory reform ultimately adopted. In the event that recovery of specific costs through rates becomes unlikely or uncertain for a portion or all of the Company's utility operations, whether resulting from the expanding effects of competition or specific regulatory actions which force the Company away from cost-of-service ratemaking, SFAS No. 71 would no longer apply. Discontinuation of SFAS No. 71 would cause the write-off of the applicable portion of regulatory assets, including regulatory balancing accounts receivable and those regulatory assets included in deferred charges, which could have a significant adverse impact on the Company's financial position or results of operations. LONG-TERM GAS TRANSPORTATION RATES On March 18, 1994, the Company filed an advice letter with the CPUC, requesting authorization to implement an optional long-term noncore gas transportation tariff. This tariff would be offered to the Company's largest industrial and cogeneration gas transport customers (having an annual usage greater than three million therms) under a standard ten-year service agreement. The proposed rates are intended to enable the Company to more effectively meet intensified competition by allowing it to offer a long-term competitive rate without having to obtain CPUC approval on a contract-by-contract basis as is currently required under the EAD procedure. The proposed rates are within the range of rates negotiated under existing EAD contracts and will exceed the marginal cost of serving the customers eligible for the new rates. The Company's shareholders will bear the risk of any revenue shortfalls attributable to any differences between the long-term rate option and the customer's otherwise applicable rate. The Company has requested that the requested tariff changes become effective no later than June 1, 1994. If approved, the rates would be offered to existing qualifying customers in a two-month open season commencing on that date. If its advice letter is approved, the Company anticipates that it will discontinue application of SFAS No. 71 for the customers accepting the long-term service agreement. This would cause a write-off of as much as approximately $25 million of regulatory assets related to those specific customers which elect to use the new tariff. This estimated amount is based on the base revenue allocation currently used in establishing rates; the actual amount could vary depending on the allocation method adopted by the CPUC. CURRENT RATE PROCEEDINGS ELECTRIC RATE INITIATIVE In April 1993, the Company proposed a comprehensive electric rate initiative to freeze current retail electric rates through the end of 1994 and to reduce electric rates by $100 million for major businesses as an economic stimulus for those customers. In June 1993, the CPUC approved the economic stimulus rate, effective for the period July 1993 through December 1994. In December 1993, the CPUC approved the electric rate freeze and issued its decisions in the Company's ARA and ECAC proceedings. As part of the ECAC decision, the CPUC approved the Company's request to defer beyond 1994 recovery of a portion of the undercollections in the ECAC balancing account. The total undercollection at December 31, 1993 was $427 million. Pursuant to the electric rate initiative, the effects of the CPUC decisions on the Company's various electric rate proceedings were consolidated resulting in a net change in electric rates of zero, effective January 1994 (see "1994 Revenue Changes" below). 1994 REVENUE CHANGES The following table summarizes the various rate case decisions that became effective on January 1, 1994. SUMMARY OF RATE CASE DECISIONS EFFECTIVE JANUARY 1, 1994 (IN MILLIONS) ARA Proceeding. In December 1993, the CPUC issued a resolution authorizing the Company to implement an adjustment to base rates pursuant to the ARA mechanism, effective January 1, 1994, which results in a net attrition increase of $41 million for electric base rates and $54 million for gas base rates. These adjustments incorporate the final decision in the Company's 1994 Cost of Capital proceeding described below. As part of the Company's electric rate initiative, the $41 million increase excludes approximately $20 million of increased taxes attributable to the higher corporate tax rate recently adopted for which the Company would otherwise have sought recovery through the ARA mechanism but instead will forgo. The CPUC's resolution also authorized the Company to reduce its 1994 electric and gas base revenues by approximately $143 million and $60 million, respectively, primarily as a result of the net savings from the Company's workforce reduction program and a plan change that will limit the amount the Company will contribute toward post-retirement medical benefits. These reductions in revenue requirements for electric operations were used to offset the $41 million attrition increase and to reduce undercollections in the ERAM balancing account by $102 million. Pursuant to the electric rate initiative, electric base revenues were held constant, resulting in a consolidated net change in electric rates of zero effective as of January 1, 1994. 1994 Cost of Capital Proceeding. As part of its ruling in the annual generic Cost of Capital proceeding for California's major energy utilities, the CPUC authorized the Company to set rates in 1994 designed to provide a utility return on common equity of 11.00%. The decision authorizes a utility capital structure of 47.50% common equity, 5.50% preferred stock and 47.00% long-term debt, which represents an increase from 46.75% in the equity component of the Company's capital structure. The decision states that the increase will bring the Company in line with other comparable utilities and will better reflect the increasingly competitive environment facing electric utilities. When combined with the authorized costs of debt and preferred stock, the 11.00% return on equity results in a 9.21% overall authorized utility rate of return for 1994 compared with the 10.13% authorized for 1993. The decision would decrease revenue requirements by approximately $116 million for electric rates and $36 million for gas rates effective January 1, 1994. As proposed by the Company, the reduction in the cost of capital was consolidated with other electric revenue changes such that there was no net increase in electric revenue requirements effective January 1, 1994. ECAC/AER/ERAM/LIRA/CEE. In December 1993, the CPUC issued a decision authorizing a net zero change in the Company's electric revenue requirement for the twelve-month forecast period beginning January 1, 1994. The decision also authorizes a gas revenue requirement increase of approximately $4 million relating to the Company's CEE programs for the same forecast period. The new rates are effective as of January 1, 1994. The net zero change in the Company's overall annual electric revenue requirement for 1994 is composed of a $112 million increase under the ECAC balancing account, a $7 million increase under the AER mechanism, a $129 million decrease under the ERAM, a $1 million decrease under the LIRA account and a $11 million increase for recovery of incentives earned on CEE programs. Consistent with its electric rate initiative, the Company had requested deferral beyond 1994 of a portion of undercollections in the ECAC balancing accounts. The total undercollection at December 31, 1993 was $427 million. In its decision, the CPUC approved the Company's request, but cautioned that the CPUC does not view its action as simply a deferral with payment due in 1995. Rather, the CPUC indicated that it expects the Company to take the necessary measures over the year to reduce its rates. With the stated objective of providing additional incentives for cost containment, the CPUC refused to allow the Company to collect interest on the revenue requirement deferral and ordered the reinstatement of the AER mechanism, which places the Company at risk for nine percent of the variations between actual and forecasted energy expenses. With respect to CEE, the decision authorizes the Company to recover in rates over three years an aggregate electric and gas revenue increase of approximately $41 million for shareholder incentives relating to CEE measures installed in 1992, a reduction from the $59 million initially requested by the Company. Those revenues will be recovered in equal annual amounts beginning in 1994. The electric and gas revenue increases of $11 million and $4 million, respectively, authorized in rates for 1994 relating to CEE include one third of the 1992 incentives as well as amounts earned in previous years. However, the decision also provides that the $41 million allowed as shareholder incentives shall be subject to refund pending completion of a CPUC audit of all the Company's 1990-1992 CEE expenses. The audit is required to be completed by the end of 1994. GAS COST ALLOCATION PROCEEDINGS In October 1992, the CPUC issued a decision in the Company's 1992 BCAP which resulted in a $434 million decrease in the core gas revenue requirement and a $3 million decrease in the noncore gas revenue requirement over a two-year period from then current rates. The decision allocated approximately $250 million in annual revenues to be collected from the noncore transportation customers other than the Company's electric department, with 75% balancing account treatment for transportation revenues from all noncore customers. In September 1993, the Company submitted an interim, or trigger, filing as permitted under the BCAP mechanism to set new rates. The Company's filing requests an increase of $136.7 million in the Company's core gas revenue requirement, which would result in a 7.7% increase in core rates over rates currently in effect. The Company requested that the proposed increase not be implemented until May 1, 1994. The CPUC has not acted yet on the Company's request. WORKFORCE REDUCTION RATE MECHANISM In February 1993, the Company announced a corporate reorganization and workforce reduction program. In conjunction with implementing the workforce reduction program, the Company filed an application with the CPUC to establish a balancing account through which the labor savings, net of the related costs, would be flowed back to the Company's customers in the form of reduced gas and electric rates. In March 1993, the CPUC authorized the establishment of a memorandum account to record all costs and savings incurred in connection with the workforce reduction program, subject to a reasonableness review. In October 1993, the Company filed a report with the CPUC to update the forecasted costs and savings associated with the workforce reduction program. In its filing with the CPUC, the Company proposed that the revenue requirement savings achieved during the balance of the 1993 GRC cycle through the workforce reduction program be passed on to ratepayers over a two-year period beginning January 1, 1994. As of December 31, 1993, the Company had recorded net workforce reduction program costs of $264 million. In April 1993, the Company announced a freeze on electric rates through 1994. As a result, the Company has expensed $190 million of such costs relating to electric operations. The remaining $74 million of such costs relating to gas operations has been deferred for future rate recovery. The amount deferred is currently being amortized as savings are realized. The Company is currently seeking rate recovery of all costs incurred in connection with the workforce reduction program relating to electric and gas operations. However, in its RRI filing (see "Regulatory Reform Initiative" above), the Company requests that if the CPUC's review of the costs and savings associated with the workforce reduction program is not completed and reflected in rates before PBR begins, such review not be conducted. Under the RRI, the memorandum account established for such costs and savings would be terminated as of January 1, 1995. During 1994 and 1995, the Company expects to benefit from the expense reduction attributable to the electric operations' workforce reduction. The Company currently estimates that the workforce reduction program will result in a net revenue requirement savings of approximately $170 million during the three-year 1993 GRC cycle, which ends December 31, 1995. Beginning in 1996, the workforce reduction program is expected to result in annual revenue requirement savings of at least $200 million. CEE/DSM PROGRAMS The Company has long been active in the implementation of CEE and other demand-side management (DSM) programs which provide incentives to customers to implement energy-efficient measures. These measures allow the Company to defer capital expenditures in connection with generating, transmission and distribution facilities, reduce operating costs, reduce the environmental impact of operations and provide service options to customers. In addition, these measures help to minimize the use of existing fossil fueled generation. Since the mid-1970s, the Company has expended over $1 billion on DSM programs, allowing the Company to avoid the need for approximately 1,600 megawatts (MW) of new generating capacity. In 1990, the CPUC issued a decision which implemented expanded CEE programs developed through collaborative efforts by the Company, other California utilities, regulatory agencies and environmental and consumer groups. The decision approved an incentive mechanism intended to encourage and sustain the Company's commitment to CEE. The mechanism adopted in 1990 provided that the Company can recover in rates the authorized costs of DSM programs plus shareholders incentives equal to 15% of the estimated net present value of energy savings from specified resource, or shared savings, programs that produce substantial net avoided capacity, transmission, distribution and energy costs savings, and 5% of the cost of certain service programs, including the Company's direct weatherization and energy efficiency education programs. Incentives earned on the implementation of CEE measures were originally authorized to be recovered in rates over the three-year period following the year in which the recovery of those incentives was authorized in the Company's annual ECAC proceeding. The CPUC subsequently initiated a rulemaking proceeding on CPUC policies related to DSM programs (DSM Proceeding), and in a February 1992 decision, concluded that, as an interim policy beginning in 1993, shareholders' return on DSM measures should be no greater than shareholders' return on equivalent investments in utility constructed plants. Accordingly, in the Company's 1993 GRC, the percentage of energy savings to be earned as shareholder incentives for 1993 resource program accomplishments was reduced to 5.1% from the 15% earned in 1990, 1991 and 1992. Pending determination of a permanent shareholder incentive mechanism in the DSM Proceeding, the percentage return applied in calculating the shared savings incentive will be recalculated each year based on the rate of return on utility constructed plants and the forecasted costs and benefits of DSM programs. In another 1993 decision, the CPUC determined that shareholder incentives earned on shared savings programs will be based on actual measured energy savings rather than forecasted savings, beginning with the 1994 DSM programs. The decision also concluded that, starting with the 1994 programs, shareholder incentives will be recovered in rates in four equal installments over a ten-year period, and the amount recoverable will be subject to the outcome of periodic measurement and evaluation studies. In addition, the decision provided that, beginning in 1994, the amount of shareholder incentives authorized for the Company and other California energy utilities will be determined annually in the AEAP. See "California Ratemaking Mechanisms -- Other Rate Adjustment Mechanisms" above. The CPUC held hearings in 1993 to determine whether shareholder incentives should be continued for DSM programs beyond 1994. In September 1993, the CPUC concluded that DSM shareholder incentives should be continued under the current regulatory framework. Hearings will be held in 1994 to determine the appropriate incentive mechanism and incentive level for DSM programs in 1995 and beyond. The Company estimates that it will earn approximately $7 million (after-tax) in shareholder incentives from the 1993 CEE programs. The Company plans to spend approximately $260 million on CEE programs in 1994, an increase over the $186 million spent in 1993. If the Company meets its 1994 energy savings goals, it could earn over a ten-year period approximately $11 million (after-tax) under the shareholder incentive mechanism. The Company is permitted to recover, through a balancing account, up to a maximum of 130% of the amount authorized for shared savings programs. As in the past, the Company is subject to a penalty if actual accomplishments under a shared savings program fall below the minimum performance standard established for the program. CAPITAL REQUIREMENTS AND FINANCING PROGRAMS The Company continues to require capital for additions to its facilities and to maintain and enhance the efficiency and reliability of existing generation, transmission and distribution facilities. Expenditures for these purposes, including the allowance for funds used during construction (AFUDC) were $1,883 million for 1993. New investments in nonregulated businesses totaled $234 million in 1993. The following table sets forth the forecasted total capital requirements, consisting of capital expenditures for the utility functions, the expansion of the gas pipeline from Canada to California, Diablo Canyon and the nonregulated investments of Enterprises and amounts for maturing debt and sinking funds for the years 1994 through 1998. CAPITAL REQUIREMENTS (IN MILLIONS) - ------------ (1) Utility expenditures are shown net of reimbursed capital and include California electric and gas operations and existing operations of the gas pipeline from Canada to California. Utility expenditures also include any amounts relating to the expansion of Pacific Gas Transmission Company's (PGT) pipeline system in 1994 through 1996 to provide additional deliveries in the Pacific Northwest. Capital expenditures relating to such further expansion total approximately $84 million. (2) Utility expenditures include AFUDC. Diablo Canyon expenditures include capitalized interest. (3) Enterprises' actual capital expenditures may vary significantly depending on the availability of attractive investment opportunities. (4) In January 1994, the Company approved a final plan for the disposition of PG&E Resources Company (Resources) in 1994, if market conditions remain favorable. In light of the planned disposition, the forecasted capital expenditures for Resources in 1994 was recently increased to the level indicated in the table above. If Resources is not divested in 1994, the Company's capital expenditures would be approximately $100 million per year in each of the years 1994 through 1998. (5) U.S. Generating Company's expenditures include commitments by the Company and/or Enterprises to make capital contributions for Enterprises' equity share of currently identified generating facility projects. These contributions, payable upon commercial operation of the projects, are estimated to be $95 million, $151 million and $27 million in 1994, 1995 and 1996, respectively. There are no current commitments to make contributions in 1997, 1998 or thereafter. Most of the utility capital expenditures for 1994 through 1998 are associated with short lead time, modest capital expenditure projects aimed at providing the facilities required by new customers and at the replacement and enhancement of existing generation, transmission, distribution and common utility facilities to improve their efficiency and reliability and to comply with environmental laws and regulations. One exception is the seismic retrofit of part of the Company's general office complex in downtown San Francisco. The Company estimates that, in addition to the capital expenditure objectives referred to above, its total capital requirements for the years 1994 through 1998 will include approximately $2,278 million for payment at maturity of outstanding long-term debt and for meeting sinking fund requirements for debt. In an effort to reduce financing costs, the Company redeemed or repurchased $3,536 million of high-cost first and refunding mortgage bonds and $267 million of redeemable preferred stock in 1993. In addition, in December 1993, the Board of Directors authorized the Company to redeem or repurchase up to $1.2 billion of first and refunding mortgage bonds, $125 million of medium-term notes and $175 million of redeemable preferred stock. Of those amounts, $80 million of bonds, $40 million of medium-term notes and $75 million of preferred stock were redeemed in February and March 1994. Redemptions and repurchases were financed in part by the issuance in 1993 of $2,950 million of first and refunding mortgage bonds (Series 93A through 93H), $750 million of medium-term notes and $200 million of redeemable preferred stock. In 1993, the Company also entered into loan agreements with the California Pollution Control Financing Authority to borrow proceeds of $260 million of tax-exempt pollution control bonds issued to finance sewage and solid waste disposal facilities. The funds necessary for the Company's 1994-1998 capital requirements will be obtained from (i) internal sources, principally net income before noncash charges for depreciation and deferred income taxes, and (ii) external sources, including short-term financing, such as bank loans and the sale of short-term notes, and long-term financing, such as sales of equity and long-term debt securities, when and as required. The Company conducts a continuing review of its capital expenditures and financing programs. These programs and the projections above are subject to revision based upon changes in assumptions as to system load growth, rates of inflation, receipt of adequate and timely rate relief, availability and timing of regulatory approvals, total cost of major projects, availability and cost of suitable nonregulated investments, and availability and cost of external sources of capital. ELECTRIC UTILITY OPERATIONS ELECTRIC OPERATING STATISTICS The following table shows the Company's operating statistics (excluding subsidiaries except where indicated) for electric energy, including the classification of sales and revenues by type of service. - ---------- (1) Includes energy supplied through the Company's system by the City and County of San Francisco for San Francisco's own use and for sale by San Francisco to its customers, by the Department of Energy for government use and sale to its customers, and by the State of California for California Water Project pumping, as well as energy supplied by QFs and purchases from other utilities. (2) Includes energy output from Modesto and Turlock Irrigation Districts' own resources. (3) Represents energy required for pumping operations. (4) Includes use by business units other than Electric Supply. - ------------ (1) Area net capability at time of annual peak, based on 1977 water conditions which are the most adverse of record to date. (2) Net control area peak demand includes demand served by Modesto and Turlock Irrigation Districts' own resources. ELECTRIC GENERATING AND TRANSMISSION CAPACITY As of December 31, 1993, the Company owned and operated the following generating plants, all located in California, listed by energy source: - ---------- (1) The following fossil fuel steam units (412 MW) were on long-term standby reserve during 1993. The units require a 12-18 month reactivation time, and are included as unavailable capacity in the Control Area Net Capacity table below. Contra Costa Unit 3 (116 MW) Kern Unit 1 (74 MW) Kern Unit 2 (106 MW) Moss Landing Unit 1 (116 MW) (2) Listed to show capability; subject to relocation within the system as required. (3) The Geysers net operating capacity is based on adequate geothermal steam supply conditions. Any decrease in capacity, at peak, is included as unavailable capacity in the Control Area Net Capacity table below. See "Geothermal Generation" below. To transport energy to load centers, the Company as of December 31, 1993, owned and operated approximately 18,450 circuit miles of interconnected transmission lines of 60 kilovolts (kV) to 500 kV and transmission substations having a capacity of approximately 33,130,000 kilovolt-amperes (kVa). Energy is distributed to customers through approximately 104,133 circuit miles of distribution system and distribution substations having a capacity of approximately 24,805,000 kVa. The following table sets forth the available capacity for the control area (the area served by the Company and various publicly-owned systems in Northern California) at the date of peak (including reduction for scheduled and forced outages and based on 1977 water conditions, which are the most adverse on record to date) by various sources of generation available to the control area and the total amount of generation provided by these sources during the year ended December 31, 1993. - ---------- (1) The maximum control area peak demand to date was 19,607,000 kW which occurred in August 1993. (2) The reserve capacity margin at the time of the 1993 control area peak, taking into account short-term firm capacity purchases from utilities located outside the Company's service area: spinning reserve (capability already connected to the system and ready to meet instantaneous changes in demand) to the control area peak was 9.9% and total reserve (spinning reserve and capability available within a short period of time) was 18.5%. (3) Represents actual year net generation from sources shown. ELECTRIC LOAD FORECAST AND RESOURCE PLANNING AND PROCUREMENT California's long-range electric resource planning is coordinated between the California Energy Commission (CEC) and the CPUC. Every two years, the CEC prepares an Electricity Report that includes load forecasts and resource assumptions for a 20-year period. The CPUC conducts a Biennial Resource Plan Update (BRPU) proceeding which is linked to a specific CEC Electricity Report. The purpose of the BRPU is to determine whether any cost-effective electric resources (either new generating resources or power purchases) should be added to the regulated utilities' electric systems based on a twelve-year planning horizon (as described below). In making this determination, the CPUC gives great weight to the load forecasts and resource assumptions included in the CEC's Electricity Report. The Company forecasts area electric peak demand (on a CEC area basis) to increase from approximately 16,100 MW in 1994 to approximately 23,000 MW in 2013, reflecting a compound annual growth rate of 1.9%. The Company forecasts area electric energy load to increase from approximately 87,500 gigawatthours (GWh) in 1994 to 120,900 GWh in 2013, reflecting a compound annual growth rate of 1.7%. The Company's energy and peak demand forecasts closely approximate the CEC staff's forecasts through 2005, and are somewhat higher than the CEC staff's forecasts for periods thereafter, primarily due to the Company's more optimistic economic and demographic assumptions. For the remainder of this decade, the Company anticipates adding between 600 and 750 MW of electric resources. These resources will be comprised of (i) up to 243.5 MW of new purchases or company-owned resources resulting from the BRPU solicitation, (ii) approximately 290 MW of new QF purchases to come on line by the end of 1996, (iii) between 49 and 200 MW of generation and DSM resources resulting from the integrated bid solicitation, (iv) improvements in its existing generating system, including 20 MW of upgrades of the hydroelectric system, and (v) further developments in regional operations efficiency from the Company's existing transmission lines from the Pacific Northwest. The Company also anticipates completing the 2,500 MW of CEE and load management improvements initiated in 1990. The Company currently plans no new major construction projects for electric supply before the year 2000, other than projects already under development. Future additions to satisfy electric supply needs in the Company's service territory will be determined largely through a competitive resource procurement process open to all potential suppliers. The Company has indicated its willingness to forgo competing in this process to build new generation resources if the CPUC grants the Company significant flexibility in conducting the planning and procurement process. The CPUC is exploring the use of an integrated bidding system in which both resource generation and DSM bidders would participate in the competitive procurement process. In October 1993, the CPUC issued a decision in the DSM Proceeding described above (see "General -- CEE/DSM Programs" above) which selected the Company to conduct an integrated bidding pilot program. The CPUC ordered the Company to conduct a pilot bid program for between 49 and 200 MW to test the feasibility of integrated bidding. The Company is granted significant flexibility in designing and implementing the bid program, in exchange for its agreement not to submit a bid in the pilot program. The Company expects to issue requests for bids in late 1994. The CEC committee conducting proceedings relating to the CEC's 1994 Electricity Report issued orders expanding the proceeding to include an extensive analysis of how changes in the structure of the electric industry may affect the achievement of California's energy policies. The orders direct comprehensive studies in a wide variety of areas, including wholesale wheeling and regional integration of transmission systems, performance based ratemaking and "maximum feasible" competitive choices for customers. Workshops and hearings related to these orders will take place during 1994, with the committee expected to report the results of its analysis to the CEC in early 1995. ELECTRIC TRANSMISSION POLICIES In September 1990, the CPUC issued an order instituting investigation into the development of transmission policies for (i) transmission access and allocation of transmission costs for a utility buying non-utility power; and (ii) transmission access, cost allocation and pricing issues for non-utility power producers who require transmission-only service from a utility. The CPUC explicitly stated that the investigation will not consider proposals for retail transmission service and should not be construed as a challenge to the franchise retail service territories of public utilities. The CPUC indicated that it believed the transmission investigation was necessary at this time in order to assure development of a competitive electricity generation sector in California. In September 1992, the CPUC issued a decision in the first phase of the investigation. The decision adopted certain policies and procedures on an interim basis which permit the Company to consider the expected transmission impacts of non-utility power purchases as it selects new QF resources through a competitive bidding process. Among other things, the decision provided that ratepayers, as opposed to utility shareholders, will bear prudently incurred costs of the most cost-effective transmission upgrades necessary to accommodate purchases from winning bidders. The second phase of the investigation could consider certain broader long-term transmission access and cost issues. In 1993, the assigned commissioner ruled that the scope of any future rulemaking in the second phase of the investigation would be limited to wholesale transmission issues which are not likely to be fully addressed by the Federal Energy Regulatory Commission (FERC). These issues include (i) coordinated regional transmission planning, (ii) unbundling of transmission service costs, (iii) determination of the best access form or vehicle, (iv) use of alternative dispute resolution mechanisms, (v) relative priority of transmission requests, and (vi) incentives for transmitting utilities. The assigned administrative law judge (ALJ) has been ordered to commence discussions regarding procedure and schedule in the second phase of the investigation. On the federal level, in 1993 the FERC began implementation of the National Energy Policy Act of 1992 (Energy Act). The Energy Act expanded the FERC's authority to order an electric utility to provide wholesale transmission service. The FERC may order any owner of transmission lines to provide transmission service, subject to a public interest finding, on application of any wholesale purchaser or seller of power. The FERC must allow the transmitting utility to recover its costs and may not order transmission service which will unreasonably impair system reliability. The Energy Act prohibits the FERC from ordering retail transmission service, or wheeling, directly to an ultimate consumer. In 1993, the FERC issued a final rule on the transmission access information utilities must file annually and policy statements concerning regional transmission groups and the necessary components of a good faith request and response for transmission access under the Energy Act. The FERC also opened an investigation on transmission pricing. QF GENERATION Under the Public Utility Regulatory Policies Act of 1978 (PURPA), the Company is required to purchase electric energy and capacity produced by QFs. The CPUC established a series of power purchase agreements which set the applicable terms, conditions and price options. A QF must meet certain performance obligations, depending on the contract, prior to receiving capacity payments. The total cost of both energy and capacity payments to QFs is recoverable in rates. Payments to QFs are expected to vary in future years. The amount of energy received from QFs and the total energy and capacity payments made under these agreements were: As of December 31, 1993, the Company had approximately 6,000 MW of QF capacity under CPUC-mandated power purchase agreements. Of the 6,000 MW, approximately 4,600 MW were operational. Development of the balance is uncertain but it is estimated that only 300 MW of the remaining contracts will become operational. The 6,000 MW of QF capacity consists of 3,400 MW from cogeneration projects, 1,500 MW from wind projects and 1,100 MW from other projects, including biomass, geothermal, solar and hydroelectric. ELECTRIC REASONABLENESS PROCEEDING Recovery of costs through the ECAC are subject to a CPUC determination that such costs were incurred reasonably. Under the current regulatory framework, annual reasonableness proceedings are conducted on a historic calendar year basis. In August 1993, the DRA filed a report on the Company's ECAC expenses for the 1991 record period, which questioned the Company's execution of amendments to three power purchase agreements with Texaco, Inc. for three QFs. In its report and in testimony filed in February 1994, the DRA asserted that the Company improperly agreed to extend the construction time under these agreements and recommended that the CPUC find these extensions unreasonable. Although no payments are at issue in the 1991 record period, the DRA argues that certain capacity payments under the contracts should be disallowed in subsequent year proceedings over the 15-year term of the contracts. The DRA indicated that it would recommend disallowances over the 15-year term of the contracts of approximately $80 million. In its report on ECAC expenses for the 1992 record period, the DRA recommended a disallowance of approximately $3.5 million for two of these agreements. The Company contested the DRA's assertions in its rebuttal testimony which was filed in November 1993. A decision is not expected from the CPUC until mid-1994. The Company is unable to predict the outcome of this matter, but believes the ultimate outcome will not have a significant adverse impact on its financial position or results of operation. HELMS PUMPED STORAGE PLANT (HELMS) Helms, a three-unit hydroelectric combined generating and pumped storage facility, completion of which was delayed due to a water conduit rupture in September 1982 and various start-up problems related to the plant's generators, became commercially operable in June 1984. As a result of the damage caused by the rupture and the delay in the operational date, the Company incurred additional costs which are not yet included in rate base and lost revenues during the period while the plant was under repair. Excluding the costs of the conduit rupture already reserved by the Company and the amount received in settlement of litigation with the supplier of the plant's generators, the remaining unrecovered costs of Helms (after adjustment for depreciation) and revenues discussed above totaled approximately $106 million at December 31, 1993. In August 1991, the Company filed an application with the CPUC to increase electric base rates to allow recovery of a portion of the remaining unrecovered costs associated with Helms. In addition to placing these costs in rate base, the Company seeks to recover the associated revenue requirement on such costs since 1984 and lost revenues during the time the generators were being repaired. In June 1993, the DRA issued its report on the Company's 1991 Helms application and recommended a disallowance of all requested costs and revenues. As a matter of policy, the DRA recommends that ratepayers should not be held responsible for plant costs or losses incurred by a utility due to contractor error whether or not the utility was prudent, and cites past CPUC action for this policy. In addition, the DRA contends that the Company acted imprudently in the management of the project and failed to adequately oversee the engineering and design of the generators. The DRA argues that the Company should not recover any revenue requirements associated with the generator costs for the period since 1984 since those revenues were not authorized previously by the CPUC and would constitute retroactive ratemaking. With respect to the lost revenues and related recorded interest during the time that Helms was out of service for the modification and repair of the generators, the DRA asserts that the Company has failed to establish that the outage was not caused by a problem first identified during the precommercial testing program. The Company filed its rebuttal testimony in January 1994 asserting it is unreasonable to hold a utility responsible for all costs arising out of contractor error in all instances without regard to the specific facts of the case. This testimony also asserts that the Company was prudent in managing and overseeing the project, and that various issues raised by the DRA were not based on facts or were irrelevant to the application. The Company has commenced discussions with the DRA in an attempt to expeditiously resolve the treatment of Helms costs through a settlement. The Company is uncertain whether, and to what extent, any of the remaining $106 million of costs and revenues will be recovered through the ratemaking process. GEOTHERMAL GENERATION Because of declining geothermal steam supplies, the Company's geothermal units at The Geysers Power Plant (The Geysers) are forecast to operate at reduced capacities. The consolidated Geysers capacity factor is forecast to be approximately 55.9% in 1994, which includes forced outages, scheduled overhauls, and projected steam shortage curtailments, as compared to the actual Geysers capacity factor of 61.8% in 1993. The Company expects steam supplies at The Geysers to continue to decline. The Company has entered into new steam sale agreements with several of its steam suppliers which allow the Company to alter the operation of its units to more economically utilize the existing installed capacity and partially offset the impact of the declining steam supplies at The Geysers. The new agreements permit the steam suppliers to furnish lower pressure steam and require that they make payments to the Company to compensate for the declining steam supply to the Company's units. WESTERN SYSTEMS POWER POOL (WSPP) In 1991, the FERC approved an agreement among 40 utilities operating in 22 states and British Columbia for a permanent WSPP. The entities participating in the WSPP may, on a voluntary basis, buy and sell surplus power and transmission capacity by posting quotes daily on a computer "bulletin board." The prices are negotiable but cannot exceed ceilings approved by the FERC. The permanent WSPP agreement approved by the FERC, among other things, imposes cost-based ceilings calculated from pool-wide average costs and allows QFs to participate in the pool if they waive their rights under PURPA to be paid avoided cost prices for transactions performed within the pool. The FERC order approving the permanent WSPP agreement was challenged in the U.S. Court of Appeals for the District of Columbia Circuit on the basis that the cost-based ceilings were improperly calculated and that the FERC exceeded its authority in conditioning QF participation in the pool. The Court of Appeals affirmed the FERC's authority to set cost-based ceilings and, at the request of the FERC, remanded the QF participation issues to the FERC for further consideration. In February 1994, the FERC ordered WSPP to permit QFs to participate on the same basis as other members without being required to waive their rights under PURPA. GAS UTILITY OPERATIONS GAS OPERATIONS As of December 31, 1993, the Company owned and operated approximately 5,700 miles of gas transmission lines and approximately 35,000 miles of gas distribution lines. The Company has three underground storage facilities. The Company's peak day send-out of gas during the year ended December 31, 1993, was 4,002 million cubic feet (MMcf). The total volume of gas throughput during that period was approximately 701,706 MMcf, of which 430,718 MMcf was sold to direct end-use or resale customers, 161,895 MMcf was used by the Company principally as fuel for fossil-fueled electric generating plants, and 109,093 MMcf was transported customer-owned gas. The California Gas Report, which presents the outlook for natural gas requirements and supplies for the State of California through the year 2010, is prepared annually by the California electric and gas utilities as a result of a CPUC order. The 1993 report forecasts the Company's gas demand from 1993 through 2010. The forecast growth rate for the Company's service territory of 1.8% per year from 1993 through 2010 is higher than the 1.3% annual forecasted growth rate shown in last year's report for the same period for two reasons. First, a more optimistic forecast of growth in the number of households leads to a higher forecasted growth rate of gas sales. Second, the expected success of the Company's natural gas vehicle program and the implementation of federal and state clean air regulations leads to a much higher forecast of natural gas vehicle use. The gas requirements forecast is subject to many uncertainties and there are many factors that can influence the demand for natural gas, including weather conditions, level of utility electric generation, fuel switching and new technology. In addition, some large customers, mostly in the industrial and enhanced oil recovery sectors, have the ability to purchase gas directly from gas producers, using unregulated private pipelines or interstate pipelines, bypassing the Company's system entirely. The report forecasts a total bypass volume of 108 billion cubic feet for 1993. The forecast assumes that bypass which began in 1991 will change little from the 1993 level and does not include any potential bypass from the proposed Mojave Pipeline Company expansion project. See "Other Competitive Interstate Pipeline Projects" below. GAS OPERATING STATISTICS The following table shows the Company's operating statistics (excluding subsidiaries except where indicated) for gas, including the classification of sales and revenues by type of service. - --------------- (1) Includes use by business units other than the Gas Supply business unit, principally as fuel for fossil-fueled generating plants. (2) In August 1991, the Company implemented its Customer Identified Gas (CIG) Program. Sales include approximately 105,000 MMcf, 130,000 MMcf and 50,000 MMcf in 1993, 1992 and 1991, respectively, of gas procured by the Company for CIG customers at prices negotiated directly between those customers and suppliers. The CIG Program was terminated on October 31, 1993 upon full implementation of the CPUC's capacity brokering program. (3) Over 100% indicates colder than normal. NATURAL GAS SUPPLIES The objective of the Company's gas supply planning is to maintain a balanced supply portfolio which provides supply reliability and contract flexibility, minimizes costs and fosters competition among suppliers. Under current CPUC regulations, the Company purchases natural gas from its various suppliers based on economic considerations, consistent with regulatory, contractual and operational constraints. During the year ended December 31, 1993, approximately 55% of the Company's total purchases of natural gas consisted of Canadian gas purchased from PGT, a wholly owned subsidiary of the Company, and, following implementation of the of the Decontracting Plan described below, from various Canadian producers and transported by PGT, approximately 5% was purchased from various California producers, and approximately 40% was purchased from other states (substantially all U.S. Southwest sources and transported by El Paso Natural Gas Company (El Paso) or Transwestern Pipeline Company (Transwestern)). The following table shows the volume and average price of gas in dollars per thousand cubic feet (Mcf) purchased by the Company from these sources during each of the last five years. - ---------- (1) The average prices for Canadian and U.S. Southwest gas include the commodity gas prices, interstate pipeline demand or fixed charges and other pipeline assessments, including direct bills allocated over the quantities received at the California border. The average prices for California gas include only commodity gas prices delivered to the Company's gas system. GAS REGULATORY FRAMEWORK Effective in May 1988, a new regulatory framework for natural gas service was established in California. This framework (i) segmented customers into core (all residential customers and commercial customers that do not exceed certain volume limitations) and noncore (industrial and commercial customers that exceed certain volume limitations) classes; (ii) unbundled utilities' gas transportation and procurement services; (iii) allows noncore customers to purchase gas directly from producers, aggregators or marketers and separately negotiate gas transportation with their utilities; and (iv) places the utilities at risk for collecting a portion of the transportation revenues associated with their noncore markets. In November 1991, the CPUC issued a decision adopting a statewide capacity brokering program, whereby noncore customers and other shippers can obtain rights to firm interstate pipeline transportation capacity held by the local gas distribution utilities. Under the capacity brokering program implemented August 1, 1993 for the Company's El Paso and Transwestern capacity, and November 1, 1993 for the Company's PGT capacity, the Company is required to make available for brokering all interstate pipeline capacity not reserved for its core customers and core subscription customers (noncore customers choosing bundled procurement and transportation service). Noncore customers, brokers and shippers, and the Company's electric department can bid for such capacity. In addition, in April 1992, the FERC issued its Order 636, which required interstate pipelines to unbundle sales services from transportation services, established various programs providing for reallocation of pipeline capacity and adopted various mechanisms by which pipelines may recover transition costs arising from the restructuring of their services. Under the Order 636 capacity allocation rules, firm capacity holders are permitted to exercise a one-time opportunity to "relinquish," i.e., permanently abandon, some or all of their transportation capacity, either by paying a negotiated exit fee or through a third party assuming the obligations of the existing transportation agreement. Thereafter, firm capacity holders may also "release" some or all of their capacity, i.e., give up capacity rights to third parties for a limited period of time. Releasing capacity holders remain liable on their existing contracts, but will receive a credit for the acquiring third parties' demand charge payments, the amounts of which will depend on the percentage of full rate paid by the acquiring third party. The Company's compliance with these regulatory changes has allowed many of the Company's noncore customers to arrange for the purchase and transportation of their own gas supplies. These changes have resulted in a decrease in the amount of gas required to be purchased by the Company and a related decrease in the Company's need for firm transportation capacity, and contributed to the need to restructure the Company's gas supply arrangements. RESTRUCTURING OF CANADIAN GAS SUPPLY ARRANGEMENTS FORMER CANADIAN GAS SUPPLY AND TRANSPORTATION ARRANGEMENTS Prior to implementation of the Decontracting Plan described below, the Company purchased Canadian natural gas under various long-term contracts. The gas was shipped to the U.S. border by Alberta and Southern Gas Co., Ltd. (A&S), a wholly owned subsidiary of the Company, over the NOVA Corporation of Alberta (NOVA) and Alberta Natural Gas Company Ltd (ANG) pipelines under an export license from the National Energy Board of Canada (NEB), a removal permit from the Alberta Energy Resources Conservation Board and an energy removal certificate from the province of British Columbia. PGT purchased this Canadian natural gas from A&S and transported it from Canada to the California border, under authorization from the Department of Energy (DOE) to import the gas. The gas was purchased at the California-Oregon border by the Company. A&S had been authorized to export up to 1,126 MMcf per day (MMcf/d) and 373,500 MMcf per year through October 31, 2005. DECONTRACTING PLAN The CPUC's gas procurement and capacity brokering programs and the FERC's new regulatory structure resulted in a decrease in the amount of gas required to be purchased by the Company. As a result, A&S was required to terminate its gas supply arrangements with Canadian producers. A&S had commitments to purchase minimum quantities of gas from Canadian producers under various contracts, most of which extended through 2005. A number of Canadian gas producers had filed lawsuits against the Company during 1991 and 1992 claiming damages of at least Cdn. $466 million resulting from the alleged failure of A&S to meet its minimum contractual gas purchase obligations for the 1989-1992 contract years and for the anticipated failure of A&S to meet those obligations through 2005. As a result of the regulatory changes discussed above, negotiations were conducted to terminate A&S's contracts with Canadian gas producers, restructure A&S's contracts with Canadian pipelines and gas processors and settle all litigation and claims arising from such contracts. Those negotiations resulted in the implementation of a Decontracting Plan, effective November 1, 1993. Gas producers representing more than 99.9% of the total volume of the gas supply of A&S participated in the Decontracting Plan. As a result, the Alberta provincial government and the NEB have ended restrictions imposed in 1992 on the shipment of gas to northern California and permitted the Decontracting Plan to be implemented. A&S also restructured its gas transportation and processing agreements. Under the Decontracting Plan, the Canadian producers' contracts with A&S, the sales agreement between A&S and PGT, and the Company's service agreement with PGT each were terminated, effective on November 1, 1993. The termination of the agreements relieved the parties of their obligations under those agreements and permitted producers to decontract their reserves from the A&S supply pool. As a result, the Company may contract on an individual basis for its requirements directly with any producer, aggregator or marketer, whether or not they were formerly in the A&S supply pool. Under the Decontracting Plan, participating producers released A&S, PGT and the Company from any claims they may have had that resulted from the termination of the former arrangements as well as any claims for losses which arose from alleged historical shortfalls in gas taken by A&S. The total amount of settlement payments paid to the producers is approximately $210 million. As part of the overall A&S decontracting process, A&S' operations have been significantly reduced, with Pan-Alberta Gas Ltd., a major aggregator of Canadian natural gas, acquiring A&S' restructured gas purchase contracts and its remaining Canadian sales contracts. A&S continues to hold gas transportation capacity on Canadian pipelines and is in the process of permanently assigning or brokering such capacity. As part of the Decontracting Plan, A&S permanently assigned substantial portions of its commitments for transportation capacity with NOVA through October 2001 and ANG through October 2005 to third parties. A&S also assigned approximately 600 MMcf/d of capacity on each of these pipelines to the Company for use in the servicing of the Company's core and core subscription customers. A&S currently holds remaining capacity of approximately 450 MMcf/d with annual demand charges of approximately $25 million for which it is continuing its efforts to assign or broker. There is uncertainty about the ability of A&S to assign or broker this remaining capacity. To the extent others do not take this capacity, A&S will remain obligated to pay for the related demand charges. In July 1993, FERC approved a transition cost recovery mechanism (TCRM) for PGT under which most costs which were incurred to restructure, reform or terminate the sales arrangements between A&S and PGT and underlying A&S gas supply contracts, or to resolve claims by gas suppliers related to past or future liabilities or obligations of PGT or A&S, are eligible for recovery in PGT's rates. The TCRM precludes most objections to the eligibility and prudence of such costs; prudence challenges may be made only on the grounds that the payment is unreasonably high in light of the damages claimed. Disposition of approved transition costs will be as follows: (1) 25% of such costs will be absorbed by PGT; (2) 25% will be recovered by PGT through direct bills (substantially all to the Company as PGT's principal customer); and (3) 50% will be recovered by PGT through volumetric surcharges over a three-year period. Costs associated with A&S's commitments for Canadian pipeline capacity do not qualify as transition costs recoverable under this mechanism. In October 1993, PGT filed an application at the FERC for recovery of payments made under settlement agreements with 140 producers, representing approximately 97% of the volumes dedicated to A&S. The application seeks recovery of $154 million under the TCRM, which is 75% of the $206 million paid to such producers as of the time of the filing. PGT intends to submit further applications with the FERC for recovery of transition costs incurred under settlement agreements entered into after October 15. In November 1993, the FERC issued an order accepting the filing, with rates effective on November 15, but subject to refund to the extent not ultimately approved by the FERC. In December 1993, the CPUC filed a limited challenge to the costs. In its filing the CPUC decided not to challenge the prudence of the transition costs filed by PGT, but did challenge the eligibility for recovery under the TCRM of PGT's settlement payment to BC Gas Utility of $2.4 million. The CPUC also requested a technical conference or hearing to determine if other payments made by PGT are consistent with the TCRM. In September 1993, the Company requested that the CPUC approve a memorandum account to track the direct bills charged to the Company by PGT for transition costs. In response, the DRA indicated that while it does not protest the Company's request to record the direct bills to a memorandum account, it does believe that these costs are unreasonable and that they should not be passed on to ratepayers. The DRA also urged that the CPUC investigate any gas supply restructuring costs that PGT attempts to pass on to the Company and to take into account these costs in its final decisions in the 1988-1990, 1991, 1992 and 1993 gas reasonableness proceedings. See "Gas Reasonableness Proceedings" below. In November 1993, the Company paid PGT approximately $51 million in payment of the direct bill charged by PGT for transition costs under the TCRM. The Company expects to seek recovery in its next BCAP application of this amount and volumetric surcharges to be billed to the Company. FINANCIAL IMPACT OF DECONTRACTING PLAN AND LITIGATION The Company incurred transition costs of $228 million, consisting of settlement payments made to producers in connection with the implementation of the Decontracting Plan and amounts incurred by A&S in reducing certain administrative and general functions resulting from the restructuring. Of these costs, the Company deferred $143 million for future rate recovery. In addition, the Company recorded a reserve of $31 million due to the uncertainty of A&S's ability to assign or broker its remaining commitments for Canadian transportation capacity. Accordingly, the Company expensed $93 million in 1993 and a total of $23 million in prior years. PGT and the Company are seeking recovery of all transition costs eligible for recovery under the TCRM other than the 25% of such costs to be absorbed by PGT. While such transition costs are still subject to challenges at the FERC level and the recovery of such costs paid by the Company as a shipper of gas on PGT will depend on the recovery mechanism adopted by the CPUC, the Company believes that it will ultimately recover the deferred transition costs. RESTRUCTURING OF INTERSTATE GAS SUPPLY ARRANGEMENTS NEW INTERSTATE GAS TRANSPORTATION AND PROCUREMENT ARRANGEMENTS The Company's contract for firm sales service from PGT had entitled the Company to purchase up to 1,066 MMcf/d from PGT at Malin, Oregon. Effective November 1, 1993, the Company converted its firm sales service contract to firm transportation service of up to 1,066 MMcf/d. The firm transportation agreement runs through October 31, 2005. The firm transportation demand charge associated with the Company's firm capacity on PGT is approximately $50 million per year. To procure Canadian gas, the Company may contract on an individual basis for gas supply directly with any Canadian producer, aggregator or marketer. The Company currently purchases substantially all of its Canadian gas under flexible, short-term arrangements. Following FERC approval of PGT's Order 636 compliance filing and pursuant to FERC rules on capacity relinquishment and release, the Company commenced capacity release on PGT's pipeline effective November 1, 1993. The Company retained approximately 610 MMcf/d on the PGT pipeline to support its service to core and core subscription customers. The Company made amounts not needed for core or core subscription service available for capacity release. The Company's release of its PGT capacity is also subject to the CPUC's capacity brokering program. The Company's contract for firm sales service from El Paso had entitled the Company to purchase up to 1,140 MMcf/d from El Paso at Topock, Arizona. On September 1, 1991, the Company converted its firm sales service contract to firm transportation service of up to 1,140 MMcf/d. The firm transportation agreement runs through 1997. The firm transportation reservation charge associated with the Company's firm capacity on El Paso is approximately $130 million per year. The Company may contract on an individual basis for gas supply directly with any producer, aggregator or marketer of Southwest gas and currently purchases substantially all of its Southwest gas under flexible, short-term arrangements. Pursuant to FERC rules on capacity relinquishment and release, the Company began brokering its capacity on the El Paso system effective August 1, 1993. The Company retained approximately 610 MMcf/d on the El Paso system to support its core and core subscription customers. The Company made amounts not needed for core or core subscription service available for capacity release. The Company's brokering of its El Paso capacity is also subject to the CPUC's capacity brokering program. During the period from August 1, 1993 to November 1, 1993, partial capacity brokering under the CPUC rules occurred. During this period, noncore customers who took assignment of the Company's brokered El Paso capacity received unbundled rates for intrastate service on the Company's system. The unbundled rates excluded the costs for the Company's El Paso and PGT capacity. In April 1992, the Company executed firm transportation agreements with Transwestern to transport 200 MMcf/d of San Juan basin gas supplies into the Company's southern gas system, of which 150 MMcf/d is to be used to meet the Company's gas demands and 50 MMcf/d is for use by the Company's electric department. The demand charges associated with the entire Transwestern capacity are currently approximately $30 million per year, effective November 1, 1993. RECOVERY OF INTERSTATE TRANSPORTATION DEMAND CHARGES Beginning November 1, 1993, when capacity release on both the PGT and El Paso systems was under way, full capacity brokering under the CPUC program went into effect. Under the full capacity brokering program, the Company's costs for interstate capacity on El Paso and PGT were unbundled from all the Company's rates for all noncore transportation service on its system. Noncore customers, or their gas suppliers, became responsible for the interstate transportation arrangements necessary to deliver gas at the Company's interconnections with the interstate pipelines. Under full capacity brokering, the Company continues to make its firm capacity on El Paso and PGT above the core and core subscription reservations, as well as capacity reserved for core and core subscription customers that is not being used to serve such customers' requirements at any given time, available for brokering to other potential shippers. Interstate transportation service which cannot be marketed at the full rates results in unrecovered demand charges. Under the CPUC brokering rules, the CPUC has authorized the use of the ITCS to account for unrecovered demand charges associated with interstate pipeline obligations in existence at the time the decision creating the ITCS was issued in November 1991. To the extent the Company is unable to broker its firm interstate capacity above core and core subscription reservations at the full as-billed rate, or to broker such capacity at all, the Company has been authorized to accumulate unrecovered demand charges for El Paso and PGT in the ITCS account for later review and allocation among customer classes. The Company has not succeeded in marketing its firm PGT or El Paso capacity above the core and core subscription reservations at the full cost of the capacity (the as-billed rate). The Company also has not been able to market all the El Paso and PGT capacity it has made available for brokering. Pursuant to the CPUC's ITCS mechanism, the Company has accumulated unrecovered demand charges for El Paso and PGT capacity in the ITCS. Ultimate recovery of unrecovered interstate pipeline demand charges accumulated in the ITCS will be subject to CPUC ratemaking mechanisms. There may be instances where the CPUC may not allow full recovery with respect to discounted rates, such as rates given to a customer in a negotiated discount gas transportation contract entered into pursuant to the Company's EAD procedure. The CPUC has indicated that if an EAD rate discount results in a shortfall in recovery of ITCS costs contained in the otherwise applicable tariff rate, the Company will not recover those ITCS costs from other customers. Also, as described above (see "General -- Long-Term Gas Transportation Rates"), the Company has requested authorization to implement an optional long-term noncore gas transportation tariff. Under the Company's proposal, shareholders will bear the risk of any revenue shortfalls attributable to any differences between the long-term rate option and the customer's otherwise applicable rate. Accordingly, shareholders may bear the costs of any shortfall in recovery of ITCS costs contained in the otherwise applicable rate. In July 1992, the CPUC issued a decision in its capacity brokering proceeding which denied the Company the authority to recover in gas rates at that time costs associated with 150 MMcf/d of Transwestern capacity prior to a prudence determination by the CPUC. Instead, those costs may be entered into a balancing account, subject to reasonableness review proceedings. The July 1992 decision did not address the Company's use of 50 MMcf/d on behalf of the electric department. The issue of the inclusion of the costs associated with the electric department's subscription to Transwestern capacity was raised in the Company's 1992 ECAC proceeding, but as a result of a settlement with the DRA, final resolution of the issue was deferred to a later reasonableness review proceeding. In the interim, the CPUC's decision in the ECAC case authorized the Company to record the demand charges incurred by the electric department in its ECAC balancing account, but such costs will not be recovered in electric rates until the CPUC makes a determination in a future reasonableness proceeding that the commitment to subscribe to the Transwestern capacity was prudent. Currently, the Company is not permitted to include any Transwestern firm capacity demand charges in the ITCS account. In January 1994, the DRA issued its report on the reasonableness of the Company's gas procurement and operating activities for the 1992 record period. In its report, the DRA argued that the Company imprudently entered into firm transportation agreements with Transwestern in 1992 and recommended a disallowance of the associated demand charges of approximately $18 million paid by the Company during the record period, of which $4.5 million related to capacity for the electric department. The DRA asserted that the incremental interstate capacity was unnecessary to meet the expected needs of the Company's core customers and that the Company should not have contracted for such capacity on account of noncore customers. The Company is continuing its efforts to broker or assign its remaining interstate transportation capacity that is not used. Since the latter half of 1993 when implementation of capacity brokering began on interstate pipelines, including El Paso, PGT and Transwestern, the Company has been able to broker a significant portion of the unused capacity, including limited amounts of the capacity held for its core and core subscription customers when such capacity was not being used to serve those customers. Amounts brokered have been on a short-term basis, most of which were at a discounted price. The average monthly demand charges associated with the Company's unused interstate capacity have been approximately $10 million, of which the Company has been able to recover approximately 40% through capacity brokering during the past few months. Because the success of the Company's brokering efforts will depend on market demand, the Company cannot predict the volume or the price of the capacity that will be brokered in the future. GAS REASONABLENESS PROCEEDINGS Recovery of gas costs through the Company's regulatory balancing account mechanisms is subject to a CPUC determination that such costs were incurred reasonably. Under the current regulatory framework, annual reasonableness proceedings are conducted by the CPUC on a historic calendar year basis. 1988-1990 RECORD PERIOD The CPUC has consolidated its review of the reasonableness of gas system costs for 1988 through 1990. In September 1991, the DRA issued its report on the Company's Canadian gas procurement activities during 1988 through 1990. The DRA recommended that the Company refund approximately $392 million for the approximately three-year period from February 1988 to December 1990, based on its contention that the Company should have purchased 50% of its Canadian supplies on the spot market instead of almost totally relying on long-term contracts. In addition to the recommendation on Canadian gas procurement, the DRA proposed a $37 million disallowance related to gas operations. The DRA contended that the Company should have withdrawn gas from storage in the winter of 1989-1990 and December 1990 instead of burning fuel oil, which was more expensive. On March 16, 1994, the CPUC issued a final decision on the Company's Canadian gas procurement activities during 1988 through 1990. The CPUC found that the Company could have saved its customers money if it had bargained more aggressively with its existing Canadian suppliers or bought cheaper gas from other Canadian sources. The CPUC concluded that it was appropriate for the Company to take about 70% of its daily customer demand for gas from its then-existing Canadian gas suppliers, but that the Company could have met the remainder of its daily demand with purchases from other available Canadian natural gas sources. The decision orders a disallowance of $90 million of gas costs, plus accrued interest estimated at approximately $25 million through December 31, 1993. The CPUC also issued a final decision on the Company's non-Canadian gas operations during 1988 through 1990. The decision finds that the Company should have withdrawn more gas from storage during December 1990 for the electric department's generation and orders a disallowance of $8 million. The Company intends to file requests for rehearing of this decision and the decision on the Canadian gas procurement activities described above. The decisions described above do not address an additional $18 million disallowance recommended by the DRA in connection with the Company's purchased power expenses for Pacific Northwest purchases during 1989 and 1990. In its September 1991 report on the Company's Canadian gas procurement activities during 1988 through 1990, the DRA noted that the Company purchased electric energy when it was cheaper than its incremental fossil fuel generation costs. However, the DRA argues that if cheaper Canadian gas supplies had been used then the Company's incremental fossil fuel generation costs would have been lower than the purchased power costs. The DRA has also sought permission to file additional testimony on the effects of any imprudently incurred Canadian gas costs on certain of the Company's electric operations costs during the 1988 through 1990 record periods. On March 7, 1994, the ALJ granted the DRA's motion requesting the right to file testimony concerning prices for energy purchased from QFs and geothermal steam prices. The ALJ's ruling combines these issues with the outstanding Pacific Northwest purchased power issues into a separate phase of the reasonableness proceeding. Hearings on these issues have not yet been scheduled. 1991 RECORD PERIOD In September 1992, the Company filed testimony to establish the reasonableness of its gas procurement and operating activities for 1991. In March 1993, the DRA issued its report on the reasonableness of those activities and recommended that the Company refund approximately $116 million in costs for that period. The major recommended disallowance relates to the DRA's contention that the Company failed to pursue least-cost purchasing alternatives in acquiring Canadian gas supplies during the 1991 record period. The DRA calculated that the Company would have saved $105 million in gas costs if it had purchased 50% of its Canadian gas supply at spot market prices, and accordingly recommended that amount be disallowed. The DRA also asserted that the Company's electric department's procurement policies and decisions were strongly influenced by the Company's Canadian gas affiliate arrangements. The DRA indicated that although the electric department's excess costs are subsumed in the $105 million recommended disallowance for Canadian gas procurement activities, it recommended a disallowance of $15.8 million in electric department gas costs even if the Canadian gas costs are not deemed unreasonable, given the electric department's alleged failure to pursue least-cost procurement alternatives. The DRA recommended an additional disallowance of approximately $2.4 million in connection with the Company's Southwest gas procurement activities during the 1991 record period. The DRA asserted that the Company imprudently incurred these additional costs by purchasing amounts in excess of minimum contract requirements at contract prices which were higher than spot market prices. In addition, the DRA recommended an $8.5 million disallowance related to the Company's gas inventory operations. The DRA contended that the Company's operating assumptions regarding the quantity of gas to be reserved in storage for potential needs of residential customers under extreme weather conditions resulted in the electric department incurring excess costs as it had to burn higher priced fuel oil to generate electricity during the record period. Hearings on the 1991 record period are scheduled for May 1994. 1992 RECORD PERIOD In January 1994, the DRA issued its report on the reasonableness of the Company's gas procurement and operating activities for 1992 and recommended a disallowance of approximately $92 million in costs for that period. The major recommended disallowance relates to the DRA's contention that the Company failed to pursue least-cost purchasing alternatives in acquiring Canadian gas supplies during the 1992 record period. The DRA calculated that the Company would have saved $60.5 million in gas costs if it had purchased 50% of its Canadian gas supply at spot market prices, and accordingly recommended that amount be disallowed. In addition, the DRA recommended a disallowance of approximately $5.1 million in connection with the Company's Southwest gas procurement activities during a three-month period in 1992 and a disallowance of $8.2 million related to the Company's gas inventory operations. In its report, the DRA also argued that the Company imprudently entered into firm transportation agreements with Transwestern in 1992 and recommended a disallowance of the associated demand charges of approximately $18 million paid by the Company during the record period, of which $4.5 million related to capacity for the electric department. The DRA asserted that the incremental interstate capacity was unnecessary to meet the expected needs of the Company's core customers and that the Company should not have contracted for such capacity on account of noncore customers. AFFILIATE AUDIT In addition to challenging the prudence of the gas costs incurred by the Company under its Canadian gas supply arrangements, in 1992 the DRA also initiated an audit of the non-gas costs incurred by the Company's present and former Canadian affiliates. In September 1993, the DRA distributed a report on its audit of A&S for the 1988 through 1991 period. The DRA report recommends that the CPUC impose a $50 million penalty on the Company and disallow approximately $6.2 million of primarily non-gas and administrative costs in 1991. The DRA has filed a motion asking that recommendations for the 1992 record period be made in a subsequent report. No action has been taken on this motion. In addition, the DRA has indicated that it will be filing in June 1994 a supplemental report addressing matters relating to the profitability of the Cochrane liquids extraction plant operated by the Company's former affiliate, ANG. The DRA has stated that the report will address the implications, if any, of ANG's status as an affiliate of the Company. In a previous report, the DRA had noted that a substantial portion of ANG's profits were derived from the operation of the Cochrane plant and that in part as a result of that profitability the Company had a pre-tax profit of $49 million from the sale of its ANG shares in 1992. The DRA's proposed $50 million penalty relates primarily to its contention that the Company has committed serious lapses in the oversight of A&S. In particular, the DRA alleges that the Company failed to prevent A&S from passing through allegedly excessive and improper transportation and non-gas and administrative costs in A&S' cost of service. Based on its calculations, the DRA alleges that A&S contracted for excessive Canadian pipeline capacity on the pipeline systems of NOVA and ANG relative to the capacity necessary to service the Company's ratepayers. The DRA further argues that A&S misallocated its cost of service between the Company and its other customers resulting in cross-subsidies of Canadian customers by the Company's ratepayers. The Company filed its rebuttal testimony in March 1994. Hearings are scheduled in May 1994. In December 1993, the ALJ denied a motion filed by the Company which had asked the CPUC to dismiss the penalty and disallowance because prior federal rulings approved such costs and thus preempt the issue. In January 1994, the DRA filed with the CPUC a report on alleged conflicts of interest which discusses the stock holdings of certain officers and directors of A&S in companies from which A&S contracted for gas supplies that eventually flowed to California. In its report, the DRA indicates that it did not discover specific transactions resulting from the stock ownership which caused identifiable harm to California ratepayers. However, the DRA concluded that the stock ownership created the appearance of impropriety and that the interests may have created a disincentive for those officers to aggressively seek opportunities to drive down the price for gas paid to producers. The DRA's report also criticizes the Company for not taking sufficient action to ensure that A&S's conflicts threshold was as stringent as that which the Company employed in evaluating possible conflicts of interest of its employees. The DRA's report does not request any specific disallowance associated with the conflicts of interest discussed in the report. Rather, the DRA argues that the Company's lack of oversight in this respect provides further evidence to support the $50 million penalty recommended in its September 1993 report on Canadian non-gas costs. FINANCIAL IMPACT OF GAS REASONABLENESS PROCEEDINGS The Company recorded reserves of $61 million in 1993 and will accrue approximately an additional $90 million in the first quarter of 1994 as a result of the CPUC's disallowance in the 1988-1990 gas reasonableness proceedings and the Company's assessment of gas procurement activities in the periods 1991 through 1993. The Company currently is unable to estimate the ultimate outcome of the gas reasonableness proceedings, including the affiliate audit, discussed above or predict whether such outcome will have a significant adverse impact on its financial position or results of operations. PGT/PG&E PIPELINE EXPANSION PROJECT In November 1993, PGT and the Company placed in service an expansion of their natural gas transmission systems from the Canadian border into California. The 840-mile combined pipeline will provide an additional 148 MMcf/d of firm capacity to the Pacific Northwest and an additional 755 MMcf/d of firm capacity to Northern and Southern California. At December 31, 1993, the Company's total investment in the project was approximately $1,587 million. The $1,587 million consisted of $767 million for the facilities within California (i.e., intrastate portion) and $820 million for the facilities outside California (i.e., interstate portion). The construction of facilities within the state of California has been certificated by the CPUC. The conditions of the certificate place the Company at risk for its decision to construct based on its assessment of market demand and for any potential underutilization of the facility. The certificate requires the application of a "cross-over" ban under which volumes delivered from the incremental interstate (PGT) expansion must be transported at an incremental intrastate expansion rate. Incremental rate design is based on the concept that expansion shippers, not existing ratepayers, bear the incremental costs of the expansion facilities. Capacity on the interstate portion is fully subscribed under long-term firm transportation contracts. However, to date, shippers have only executed long-term firm transportation contracts for approximately 40% of the intrastate capacity, and the Company continues negotiations for the remaining capacity. The CPUC has authorized the Company to provide as-available service on the expansion project, which can provide additional revenues to recover the incremental costs of the expansion. The CPUC certificate issued in December 1990 established a cost cap of $736 million for the California portion, which represented the maximum amount determined by the CPUC to be reasonable and prudent based on an estimate of the anticipated construction costs at that time. In October 1993, the CPUC issued a decision granting the Company's motion to put in place temporary interim rates based on the existing cost cap of $736 million. The decision authorized the temporary interim rates to become effective on the date of commercial operation, November 1, 1993, and remain in effect for five months or until interim rates are established by the CPUC. In February 1994, the CPUC announced a decision on the Company's request for an increase in the California portion of the expansion project's cost cap and its interim rate filing. The CPUC granted the Company's request to increase the cost cap to $849 million, but set interim rates based on the original cost cap of $736 million, subject to adjustment within the newly approved cost cap after the outcome of a reasonableness review of capital costs. The CPUC's decision finds that given market conditions at the time, the Company was reasonable in constructing the expansion project. In its decision, the CPUC also approved a one percentage point increase in the return on equity over the authorized return on utility operations in order to reflect the risk associated with the additional leverage of a capital structure of 70% debt and 30% equity for the California portion of the expansion project. The decision rejects assignment of unused capacity costs on other pipelines (or the Company's intrastate facilities) to the expansion project as previously proposed by an ALJ's proposed decision. The FERC issued an order in October 1991 approving the interstate portion of the expansion project. However, concluding that PGT had not sufficiently demonstrated that shippers would not be subject to discriminatory restraints on access into California or on the interstate portion of the project as a result of the "cross-over" ban imposed by the CPUC, the FERC reduced PGT's approved rate of return on equity to 10.13% (from the 12.5% return previously approved) until such time as PGT demonstrates that neither its rates or transportation policies nor those of the Company result in unduly discriminatory restraints. In March 1993, the FERC authorized an increase in the nominal return on equity to 12.75% from 12.5%, but reaffirmed the lower 10.13% return on equity it implemented as an incentive for PGT to seek removal of unduly discriminating restraints. Based upon the current status of the cost cap and interim rate case at the CPUC and market demand, the Company believes it will recover its investment in the expansion project. OTHER COMPETITIVE INTERSTATE PIPELINE PROJECTS In 1992, several new gas pipeline projects were completed to serve the enhanced oil recovery market in Southern California and other customers. In March 1992, projects sponsored by Kern and the Mojave Pipeline Company (Mojave) commenced commercial operations. The projects involved construction of Kern's 700 MMcf/d pipeline from Wyoming to California, Mojave's 400 MMcf/d pipeline from Arizona border interconnection points with the El Paso and Transwestern systems to a point of interconnection with the Kern project in California, and a pipeline, jointly owned by Kern and Mojave, from the point of interconnection to the Bakersfield area. Also in 1992, both Transwestern and El Paso put into service expanded pipeline facilities from the San Juan Basin in New Mexico to the California border. These projects provide additional capacity to some of the same markets served by the PGT/PG&E expansion project. Some of the gas available from the U.S. Southwest over these projects is priced equal to or lower than the current price of Canadian gas available over the PGT/PG&E expansion project, due in part to federal tax credits available for certain San Juan gas production. Altamont Gas Transmission Company (Altamont) has proposed to build a pipeline that would transport gas from Alberta, Canada, to Wyoming, where it would interconnect with the Kern project. However, in July 1992, Altamont announced a one-year delay (to late 1994) in the scheduled completion of its proposed pipeline project. In March 1993, Mojave filed a request seeking FERC authorization for construction of a 475 MMcf/d transportation-only pipeline expansion of its interstate natural gas pipeline. Mojave indicated that it intends to place the proposed expansion into service by January 1, 1996. The expansion would extend Mojave's system from its current terminus at Bakersfield, California, through California's Central Valley to Sacramento and the San Francisco Bay Area. Mojave's filing indicates that 433 MMcf/d of the firm service capacity provided by the proposed expansion will be provided to customers located in the Company's service territory, with approximately 257 MMcf/d of that amount to be used to provide gas service that currently is not provided by the Company. The remaining 176 MMcf/d represents service to customers currently served by the Company. In April 1993, the CPUC issued a resolution asserting jurisdiction over the rates and services of Mojave and the facilities used by Mojave to transport gas received by Mojave in California and ultimately consumed in California. The CPUC also filed with the FERC a protest and motion to dismiss Mojave's application. The Company also filed a protest and motion to dismiss Mojave's application, arguing that the FERC should dismiss Mojave's application because the CPUC, and not the FERC, has jurisdiction to review Mojave's proposed expansion. The Company indicated in its filing that Mojave's proposed expansion would bypass the Company's existing gas network, taking business from the Company and requiring the Company to spread costs over a smaller customer base. The Company contended that Mojave's project would cost over $330 million (net present value) more than if the Company served the targeted customers, while reducing the economic welfare of the Company's remaining customers by over $325 million in present value terms. In December 1993, the FERC held hearings in response to the Company's and the CPUC's requests to dismiss Mojave's pending pipeline expansion application. In February 1994, the FERC issued a decision asserting jurisdiction over Mojave's pending application. In March 1994, both the Company and the CPUC filed requests for a rehearing in this matter, arguing that the FERC erred in asserting jurisdiction. In addition, the Company requested that, if the FERC denies rehearing on the jurisdictional issues, the FERC hold a hearing to review the merits of Mojave's proposal and to establish a mechanism to reimburse the Company for costs arising from bypass associated with Mojave's proposed expansion. STORAGE SERVICE The Company has generally provided natural gas storage service only in conjunction with its procurement and transportation services. In an open season ending in January 1993, noncore customers indicated an interest in obtaining unbundled storage service. In February 1993, the CPUC adopted policies and rules for permanent unbundled gas storage programs for noncore customers, and ordered the Company to submit a storage proposal in compliance with those policies. The Company's proposal regarding an unbundled storage program was submitted to the CPUC in July 1993 and hearings on the proposal were held in October and November 1993. CPUC authorization of an unbundled storage program for the Company is expected in the second quarter of 1994. Following authorization, the Company will hold an open season offering noncore customers short-term storage services from existing facilities and long-term storage services from expanded facilities. DIABLO CANYON DIABLO CANYON OPERATIONS Diablo Canyon Units 1 and 2 began commercial operation in May 1985 and March 1986, respectively. As of December 31, 1993, Diablo Canyon Units 1 and 2 had achieved lifetime capacity factors of 78% and 80%, respectively. The table below outlines Diablo Canyon's refueling schedule for the next five years. This schedule assumes that a refueling outage for a unit will last approximately nine weeks, depending on the scope of the work required for a particular outage. The schedule is subject to change in the event of unscheduled plant outages or changes in the length of the fuel cycle. On July 9, 1992, the Company filed a license amendment request with the Nuclear Regulatory Commission (NRC) to change the operating license expiration dates for both units at Diablo Canyon. Diablo Canyon Units 1 and 2 are currently licensed to operate for 40 years commencing on the date the construction permit for the respective unit was issued, which occurred in 1968 and 1970, respectively. In 1982, the NRC determined that the 40-year term of operation for nuclear power plants may instead begin upon issuance of the first operating license. The Company's request seeks to utilize that policy change, and if granted, would extend the operating license expiration date for Unit 1's license from April 2008 to September 2021 and the expiration date for Unit 2's license from December 2010 to April 2025. In August 1992, a group intervened in opposition to the license amendment and requested hearings at the NRC. In October 1992, the intervenor group supplemented its petition with a request that eleven contentions be admitted for hearing. The Company and the NRC staff responded to the intervention petition and its supplement, asserting that the intervenors lack standing and none of the contentions are admissible. In January 1993, an NRC licensing board issued its order granting the intervenors standing and admitting for hearings two of the eleven contentions filed by the intervenors. The two admitted contentions relate to the Company's maintenance program for Diablo Canyon and the adequacy of the Company's implementation of certain compensatory measures approved by the NRC to address issues relating to a fire-barrier material known as Thermo-Lag pending NRC/industry resolution of those issues. Hearings were completed in August 1993. In February 1994, the intervenor group filed a motion to reopen the record in the proceeding in order to take evidence on an NRC inspection issue which the intervenor group alleges represents significant new information regarding deficiencies in the Company's maintenance of the plant's auxiliary saltwater system. Both the Company and the NRC staff have replied to the motion, urging it be rejected. A decision by the NRC licensing board on the motion to reopen is expected in the next few months, and a decision on the Company's license amendment request is expected in 1994. The Company is a member of Nuclear Mutual Limited (NML) and Nuclear Electric Insurance Limited (NEIL I and II). If the nuclear plant of a member utility is damaged or increased costs for business interruption are incurred due to a prolonged accidental outage, the Company may be subject to maximum assessments of $21 million (property damage) or $7 million (business interruption), in each case per policy period, if losses exceed premiums, reserves and other resources of NML, NEIL I or NEIL II. The federal government has enacted laws that require all utilities with nuclear generating facilities with a capacity of 100 MW or more to share in payment of claims resulting from a nuclear incident. The Price-Anderson Act limits industry liability for third-party claims resulting from any nuclear incident to $9.4 billion per incident. Coverage of the first $200 million is provided by a pool of commercial insurers. If a nuclear incident results in public liability claims in excess of $200 million, the Company may be assessed up to $159 million per incident with payments in each year limited to a maximum of $20 million per incident; payments in excess are deferred to the next calendar year. DIABLO CANYON SETTLEMENT The Diablo Canyon rate case settlement adopts alternative ratemaking for Diablo Canyon by basing revenues primarily on the amount of electricity generated by the plant, rather than on traditional cost-based ratemaking. Under this "performance based" approach, the Company assumes a significant portion of the operating risk of the plant because the extent and timing of the recovery of actual operating costs, depreciation and a return on the investment in the plant primarily depend on the amount of power produced and the level of costs incurred. The Company's earnings are affected directly by plant performance and costs incurred. Earnings relating to Diablo Canyon will fluctuate significantly as a result of refueling or other extended plant outages, plant expenses and the effects of a peak-period pricing mechanism. See "Diablo Canyon Operations" above for the plant refueling schedule. The settlement decision explicitly affirmed that Diablo Canyon costs and operations no longer should be subject to CPUC reasonableness reviews. The decision states that, to the extent permitted by law, the CPUC intends that this decision be binding upon future Commissions, based upon a determination that taken as a whole the settlement produces a just and reasonable result, and that the settlement has been approved based on the reasonable reliance of the parties and the CPUC that all of the terms and conditions will remain in effect for the full term of the settlement, ending 2016. However, the decision states that the CPUC cannot bind future Commissions in fixing just and reasonable rates for Diablo Canyon. Under the settlement, revenues are based on a pre-established price per kWh consisting of a fixed component (3.15 cents per kWh) and an escalating component for each kWh of electricity generated by the plant. Total prices for the years 1993 through 1994, effective January 1 of each year, are 11.16 cents and 11.89 cents per kWh, respectively. For 1995 through 2016, the escalating component will be adjusted by the change in the consumer price index plus 2.5%, divided by two. During the first 700 hours of full-power operation for each unit during the peak period (10 a.m. to 10 p.m. on weekdays in June through September), the price is 130% of the stated amount to encourage the Company to utilize the plant during the peak period. During the first 700 hours of full-power operation for each unit during the non-peak period of the year, the price is 70% of the stated amount. At all other times, the price is 100% of the stated amount. If power generation drops below specified capacity levels, the Company may trigger an annual revenue floor provision, or under certain conditions, seek abandonment of the plant (discussed below). Floor payments ensure that the Company will receive some revenue, even if the plant stops producing power. Floor payments are based on the prices set in the agreement at a 36% capacity factor from 1988 through 1997 (reduced by 3% each time the floor provision is exercised and not repaid) with the capacity factor decreasing in the future. Floor payments must be refunded to customers under specified circumstances. If actual operation falls below the floor capacity factor in three consecutive years, whether or not the floor payment provision has been triggered, the Company must file for abandonment or explain why continued application of the settlement is appropriate. In the event there is a prolonged plant outage and the Company files for abandonment, the Company may ask for recovery of the lesser of (a) floor payments allowed for ten years, less any years of floor payments already received and not repaid, or (b) $3 billion, reduced by $100 million per year of operation on January 1 of each year starting in 1989. The settlement provides that certain Diablo Canyon costs, including decommissioning costs, be recovered over the term of the settlement, including a full return on such costs through base rates. In March 1993, the CPUC denied a petition filed in September 1992 by a consumer advocacy group seeking to modify the CPUC's 1988 decision that adopted the Diablo Canyon rate case settlement. The petition contended that the Company has made unreasonably high profits because of the better-than-expected operating performance of Diablo Canyon. The petition did not propose any specific change to the Diablo Canyon rate provisions, but requested that the CPUC reopen the Diablo Canyon settlement to consider mechanisms for sharing with ratepayers additional benefits of Diablo Canyon's performance. The CPUC found that there had been no failure in the underlying assumptions of the settlement and that reopening the settlement would be contrary to the public policy in favor of settlements. Although all four CPUC Commissioners voted to deny the petition, CPUC President Fessler indicated in his concurring opinion that he was concerned about the high electricity rates paid by all classes of ratepayers and would consider reopening the settlement if the Company does not reduce its rates within a year. NUCLEAR FUEL SUPPLY AND DISPOSAL The Company has purchase contracts for, and an inventory of, uranium concentrates and contracts for conversion of uranium to uranium hexafluoride, uranium enrichment and fuel fabrication. Based on current operations forecasts, Diablo Canyon's requirements for uranium supply, enrichment services and conversion services will be satisfied through existing long-term contracts through 1994, 1996 and 1998, respectively. The Company is currently negotiating contracts for uranium supply and enrichment services through 2002. Fuel fabrication contracts for the two units will supply their requirements for the next five operating cycles for each unit. These contracts are intended to ensure long-term fuel supply, but permit the Company the flexibility to take advantage of short-term supply opportunities. In most cases, the Company's nuclear fuel contracts are requirements based, with the Company's obligations linked to the continued operation of Diablo Canyon. Under the Nuclear Waste Policy Act of 1982 (the Act), the DOE is responsible for the transportation and ultimate long-term disposal of spent nuclear fuel and high-level waste. The Act sets a national policy for the disposal of nuclear waste from commercial reactors, and establishes a timetable for the DOE to choose one or more sites for the deep underground burial of wastes from nuclear power plants. Under the Act, utilities are required to provide interim storage facilities until permanent storage facilities are provided by the federal government. The Act mandates that one or more such permanent disposal sites be in operation by 1998, although DOE has indicated that such sites may not be in operation until 2010. DOE is also considering providing interim storage in a monitored retrievable storage facility earlier than 2010. However, under DOE's current estimated acceptance schedule for spent fuel, Diablo Canyon's spent fuel is not likely to be accepted by DOE for interim or permanent storage before 2011, at the earliest. At the projected level of operation for Diablo Canyon, the Company's facilities are sufficient to store on-site all spent fuel produced through approximately 2006 while maintaining the capability for a full-core off-load. In the event an interim or permanent DOE storage facility is not available for Diablo Canyon's spent fuel by 2006, the Company will examine options for providing additional temporary spent fuel storage at Diablo Canyon or other facilities, pending disposal or storage at a DOE facility. Such additional temporary spent fuel storage may be necessary in order for the Company to continue operating Diablo Canyon beyond approximately 2006, and may require approval by the NRC and other regulatory agencies. In July 1988, the NRC gave final approval to the Company's plan to store radioactive waste from the Humboldt Bay Power Plant (Humboldt) at Humboldt for 20 to 30 years and, ultimately, to decommission the unit. The license amendment issued by the NRC allows storage of spent fuel rods at Humboldt until a federal repository is established. The Company has agreed to remove all nuclear waste as soon as possible after the federal disposal site is available. DECOMMISSIONING The estimated cost of decommissioning the Company's nuclear power facilities is recovered in base rates through an annual allowance. For the year ended December 31, 1993, the amount recovered in rates for decommissioning costs was $54 million. The estimated total obligation for decommissioning costs is approximately $1 billion in 1993 dollars; this obligation is being recognized ratably over the facilities' lives. This estimate considers the total costs of decommissioning and dismantling plant systems and structures and includes a contingency factor for possible changes in regulatory requirements and waste disposal cost increases. As of December 31, 1993, the Company had accrued $537 million in accumulated depreciation and decommissioning and had accumulated that amount in external trust funds, to be used for the decommissioning of the Company's nuclear facilities. Funds may not be released from the external trust funds until authorized by the CPUC. The CPUC reviews the funding levels for the Company's decommissioning trust in each GRC. Based upon the trust's then-current asset level, and revised earnings and decommissioning cost assumptions, the CPUC may revise the amount of decommissioning costs it has authorized in rates for contribution to the trust. To date the CPUC has not revised the funding levels initially established in 1987. However, to comply with tax law requirements, the Company anticipates that the CPUC will revise the funding levels no later than the 1997 tax year to reflect then-current earnings assumptions and decommissioning cost estimates. PG&E ENTERPRISES Enterprises is the parent company established to oversee the Company's principal non-utility unregulated business activities. Enterprises was established in 1988 and is a wholly owned subsidiary of the Company. Enterprises' activities are conducted through the entities described below. NON-UTILITY ELECTRIC GENERATION A wholly owned Enterprises subsidiary is a general partner in U.S. Generating Company (USGen), a California general partnership. A subsidiary of the Bechtel Group, Inc. is the other general partner of USGen. USGen develops and manages non-utility electric generation facilities which sell power to utilities other than the Company. Enterprises' ownership interest in projects developed by USGen varies by project. Profits and losses realized by USGen are distributed in proportion to the partners' relative interests in the project from which those profits or losses are derived. USGen is currently involved in seven operational plants and eight projects under construction or in advanced stages of development (with power sales agreements). Enterprises' share of capacity from those projects is approximately 1,515 MW. The projects are typically financed with a combination of equity commitments from the project sponsors and non-recourse debt. USGen also manages Enterprises' 39.9% limited partnership interest in Sycom Enterprises, which offers energy conservation services. GAS AND OIL EXPLORATION AND PRODUCTION Resources, a wholly owned indirect subsidiary of Enterprises, is engaged in natural gas and oil exploration and production primarily in the Gulf Coast, east Texas, Anadarko and Rocky Mountain regions of the U.S. In January 1994, the Company approved a final plan for the disposition of Resources in 1994 if market conditions remain favorable. The Company has retained Goldman, Sachs & Co. to advise it with respect to possible alternatives for the divestiture of Resources. In February 1994, Resources filed with the Securities and Exchange Commission a proposed S-1 registration statement with respect to one of these options. This option involves an initial public offering of all of the stock of Resources' parent holding company, PG&E Resources Holdings Company, which would be renamed Dalen Resources Corp. prior to the offering. Such an offering would be preceded by the transfer of Resources' non-strategic properties to a newly-formed subsidiary of Enterprises for disposition by sale. As of December 31, 1993, Resources had assets of approximately $680 million. POWER PLANT OPERATING SERVICES U.S. Operating Services Company (USOSC), a California general partnership, provides operations and maintenance services for power facilities managed by USGen and to third parties in the independent power production business. An Enterprises subsidiary and a subsidiary of Bechtel Group, Inc. are the general partners of USOSC. Enterprises' economic interest in USOSC projects varies by project. REAL ESTATE DEVELOPMENT PG&E Properties, Inc. (Properties) develops real estate in the Company's service territory, focusing on residential lot creation. It also develops offices, industrial buildings, retail outlets and apartments. Properties is wholly owned by Enterprises. ENVIRONMENTAL MATTERS AND OTHER REGULATION ENVIRONMENTAL MATTERS The Company is subject to a number of federal, state, and local laws and regulations designed to protect human health and the environment by imposing stringent controls with regard to planning and construction activities, land use, and air and water pollution, and, in recent years, by governing the use, treatment, storage and disposal of hazardous or toxic materials. These laws and regulations affect future planning and existing operations, including environmental protection and remediation activities. The Company has undertaken major compliance efforts with specific emphasis on its purchase, use and disposal of hazardous materials, the cleanup or mitigation of historic waste spill and disposal activities, and the upgrading or replacement of the Company's bulk waste handling and storage facilities. ENVIRONMENTAL PROTECTION MEASURES The Company's projected expenditures for environmental protection are subject to periodic review and revision to reflect changing technology and evolving regulatory requirements. Capital expenditures for environmental protection are currently estimated to be approximately $50 million, $50 million, $75 million, $95 million and $75 million for 1994, 1995, 1996, 1997 and 1998, respectively, and are included in the Company's five-year projection of capital requirements shown above in "General -- Capital Requirements and Financing Programs." Expenditures during these years will be primarily for oxides of nitrogen (NOx) emission reduction projects. Air Quality The Company's existing thermal electric generating plants are subject to numerous air pollution control laws, including the California Clean Air Act (CCAA) with respect to emissions. Pursuant to the CCAA and the Federal Clean Air Act, the three local air districts in which the Company operates fossil fuel fired generating plants have adopted final rules to reduce NOx emissions from these plants. The three agencies that have adopted utility boiler NOx rules are the Monterey Bay Unified Air Pollution Control District (Rule 431 adopted September 15, 1993), the San Luis Obispo County Air Pollution Control District (Rule 429 adopted November 16, 1993) and the Bay Area Air Quality Management District (Regulation 9, Rule 11 adopted February 16, 1994). These rules prescribe emission limitations for the Company's Contra Costa, Hunters Point, Moss Landing, Morro Bay, Pittsburg and Potrero power plants. In each district, other NOx rules have been or will be adopted to regulate other NOx sources. Because the Company's power plants operate as a system, the three agencies coordinated their NOx rulemakings. Together, the rules require a reduction in NOx emissions of approximately 90% from the power plants by 2004 (with numerous interim compliance deadlines). The first major retrofit is scheduled to begin in 1996. Certain retrofits will not be required if the smaller generating units are operated for emergency purposes only after 2000. Rule 431 also requires the Company to provide a total of $7 million to the Monterey Bay Unified Air Pollution Control District in 1994 and 1995 for emission reduction projects not related to Company sources. Rule 429 may require additional expenditures of up to $1.5 million in the San Luis Obispo County Air Pollution Control District, depending on air quality progress in that district. The Company currently estimates that compliance with these NOx rules could require capital expenditures of approximately $300 million to $500 million over 10 years, depending on assumptions about fuel use and unit retirement. Ongoing business and engineering studies could change this estimate. In the Company's 1993 GRC, the CPUC authorized NOx related plant additions of approximately $70 million for 1993, and established an Air Quality Adjustment (AQA) mechanism under which the Company may seek cost recovery in rates for NOx reduction projects beyond January 1, 1994. However, in its RRI filing (see "General -- Regulatory Reform Initiative" above) the Company has proposed that the AQA mechanism be terminated as of January 1, 1995. In the San Luis Obispo County Air Pollution Control District, the Company obtained permits to install the first phase of NOx emission reductions at the Morro Bay Power Plant, thereby commencing implementation of NOx reductions in that district. The Company spent $48 million for the first phase of this NOx reduction project, which has been completed. The Company operates both reciprocating engine and gas turbine drivers at its natural gas compressor stations. They are located in local air districts whose attainment plans call for reductions in emissions of exhaust pollutants over the next few years. On December 20, 1993, the Mojave Desert Air Quality Management District adopted a rule that will require a reduction in NOx emissions of approximately 90% from the Hinkley Compressor Station by January 1, 1998. The Topock Compressor Station is currently exempt from this rule. The San Joaquin Valley Unified Air Pollution Control District expects to adopt a similar rule during 1994 that would require a reduction in NOx emissions of approximately 90% from the Kettleman Compressor Station by January 1, 1999. The Company currently estimates that compliance with these NOx rules could require capital expenditures of approximately $55 million over five years. In 1990 Congress passed extensive amendments to the Federal Clean Air Act. The Environmental Protection Agency (EPA) has issued numerous regulations for the implementation of these amendments. The Company is currently assessing the impact of the regulations. Generally, existing or proposed state and local air quality requirements are more stringent than the new federal requirements, which should therefore have little impact on the Company. However, stringent federal air monitoring requirements, which must be met by January 1, 1995, are being incorporated in local air quality rules. The air monitoring rules will require the installation of monitoring equipment to measure emissions from the fossil fuel fired generating plants. The Company currently estimates that the cost of complying with the monitoring requirements will total approximately $29 million in 1994 and 1995. Water Quality The Company's existing power plants, including Diablo Canyon, are subject to federal and state water quality standards with respect to discharge constituents and thermal effluents. The Company's fossil fueled power plants comply in all material respects with the discharge constituents standards and either comply in all material respects with or are exempt from the thermal standards. A thermal effects study at Diablo Canyon was completed in May 1988, and has been reviewed by the Central Coast Regional Water Quality Control Board (Regional Board). The Regional Board has not yet made a final decision on the report and has requested that the Company continue the marine monitoring program. In the event that Diablo Canyon does not comply with the thermal limitations and in the unlikely event that major modifications are required (e.g., cooling towers), significant additional construction expenditures could be required. A thermal effects study of the Company's Pittsburg and Contra Costa Power Plants was submitted to the San Francisco and Central Valley Regional Water Quality Control Boards in December 1992. In general, the study found no significant adverse effects associated with the thermal discharge at either plant. Additionally, several fish species listed or proposed for listing as endangered species may be found in the waters near these plants. There are severe restrictions on the "taking" (e.g. harassing, wounding or killing) of such species. Therefore, significant modifications could be required to plant operations (e.g., cooling towers) if a plant intake structure or thermal discharge is found to "take" an endangered species. Pursuant to the federal Clean Water Act, the Company is required to demonstrate that the location, design, construction and capacity of power plant cooling water intake structures reflect the best technology available (BTA) for minimizing adverse environmental impacts at all existing water-cooled thermal plants. The Company submitted detailed studies of each power plant's intake structure to various governmental agencies. Each plant's existing water intake structure was found to meet the BTA requirements. However, if in the future there are changes in available technology, these findings are subject to further review by various agencies. Thus, construction expenditures or operational changes may be necessary to meet a more stringent future standard. Oil Spill Prevention The Company operates two offshore moorings, three docks, approximately 103 large aboveground fuel tanks with a capacity of approximately 16,000,000 barrels and approximately 45 miles of fuel pipelines. These facilities are used for the transport, handling and storage of residual fuel oil and diesel, both of which are used at the Company's power plants and facilities. Under the federal Clean Water Act Spill Prevention Control and Countermeasure (SPCC) regulations, many of the Company's power plants, substations and service centers must install and maintain facilities to prevent the release of oil and other hazardous materials to surface waters. Capitalized SPCC project costs for 1994 and 1995 are estimated to be approximately $4 million. In addition, activities associated with the transport, storage and handling of petroleum products are regulated by the federal Oil Pollution Act of 1990 (OPA) and the California Oil Spill Prevention and Response Act of 1990 (OSPRA). Under these laws, the Company is required to demonstrate $500 million of financial responsibility, which it demonstrates through a combination of insurance and self insurance. Regulations under OPA and OSPRA require development of Emergency Response Plans utilizing worst case planning scenarios. Plans must include contracting for response resources to respond to the worst case scenarios. The Company is a member of the Clean Bay, Clean Seas and Humboldt Bay oil spill co-ops and the Marine Preservation Association through which it can obtain the services of the Marine Spill Response Corporation, a national oil spill response organization. Company expenditures to comply with OPA and OSPRA requirements in 1994 and 1995 are estimated to total less than $2 million. HAZARDOUS MATERIALS AND HAZARDOUS WASTE COMPLIANCE AND REMEDIATION The Company assesses, on an ongoing basis, measures that may need to be taken to comply with laws and regulations related to hazardous materials and hazardous waste compliance and remediation activities. Generally, these compliance costs are recovered through the GRC process. However, as discussed below, the CPUC has established a separate mechanism for recovery of certain hazardous waste remediation costs. The EPA, the California Department of Toxic Substances Control (DTSC), and associated regional and local agencies have comprehensive rules which regulate the manufacture, distribution, use and disposal of polychlorinated biphenyls (PCBs). The Company has established programs and has committed resources to achieve compliance with these rules. In 1982, the EPA adopted new regulations greatly restricting the use of PCBs in electrical equipment. The regulations have resulted in the early retirement and replacement of certain equipment. Since Company operations generate PCB-contaminated waste which requires special handling, the Company has contracted with EPA-approved firms for the disposal or recycling of PCB waste. The Company estimates that PCB disposal will cost approximately $8 million in 1994 and 1995. The Company has a comprehensive program to comply with the many hazardous waste storage, handling and disposal requirements promulgated by the EPA under the Resource Conservation and Recovery Act and the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), along with California's hazardous waste laws and other environmental requirements. As part of this general compliance effort, the Company has initiated programs to address three specific environmental issues: (i) wastewater holding ponds, (ii) underground storage tanks, and (iii) historic hazardous waste sites, including former manufactured gas plant sites. Wastewater evaporation ponds contain materials such as compressor cooling water blowdown from gas compressor stations. The Company either is upgrading the existing ponds or closing the old ponds and building new evaporation ponds that meet new standards for leak monitoring, detection and containment. Capital expenditures for this work in the years 1994 and 1995 are estimated to be approximately $9.9 million. Closure and post-closure expenditures for these ponds, including remediation and cost contingencies, may approximate $20 million for a 30-year period. Underground storage tanks are the subject of federal and California regulatory programs directed at identifying and eliminating the possibility of leaks. The Company has approximately 270 underground tanks, some of which must be upgraded to meet new standards. The tanks contain hazardous materials such as gasoline, waste automotive crankcase oil, transformer fluid or oily wastewater. The Company has an ongoing program to improve leak monitoring, test each tank for leakage and, if necessary, sample soil and water from the surrounding area and remediate any contamination detected. Costs for testing, remediation and tank replacement in 1994 and 1995 are estimated to be approximately $4.8 million. A third program is aimed at assessing whether and to what extent remedial action may be necessary to mitigate potential hazards posed by lampblack and tar residues, byproducts of a process that the Company and other utilities used as early as the 1850s to manufacture gas from coal and oil. As natural gas became widely available (beginning about 1930), the Company's manufactured gas plants were removed from service. The residues which may remain at some sites contain chemical compounds which now are classified as hazardous. The Company has identified and reported to federal and California environmental agencies 96 manufactured gas plant sites which the Company operated in its service territory. The Company owns all or a portion of 30 of these manufactured gas plant sites. The Company has begun a program, in cooperation with environmental agencies, to evaluate and take appropriate action to mitigate any potential health or environmental hazards at sites which the Company owns. The Company currently estimates that this program may result in expenditures of approximately $15.5 million over the period 1994 through 1995. The full long-term costs cannot be determined accurately until a closer study of each site or facility has been completed. It is expected that expenses will increase as remedial actions related to these sites are approved by regulatory agencies or if the Company is found to be responsible for clean up at sites it does not currently own. The Company may be required to take remedial action at certain disposal sites and retired manufactured gas plant sites if they are determined to present a significant threat to human health or the environment because of an actual or potential release of hazardous substances. The Company has been designated as a potentially responsible party (PRP) under CERCLA, the federal Superfund law, with respect to the Purity Oil Sales site in Malaga, California; the Jibboom Junkyard site in Sacramento, California; the Industrial Waste Processing site near Fresno, California; and the Lorentz Barrel and Drum site in San Jose, California. The Company has been named as a PRP under the California Hazardous Substance Account Act (California Superfund law) with respect to the Martin Service Center former gas plant site and the Midway/Bayshore sites in Daly City, California; the Berman Steel site in Salinas, California; the Emeryville Service Center site in Emeryville, California; the GBF Land Fill at Pittsburg, California; the former Sacramento gas plant site in Sacramento, California; the former San Rafael gas plant site in San Rafael, California; and the former Monterey gas plant site in Monterey, California. Although the Company has not been formally designated a PRP with respect to the Geothermal, Incorporated site in Lake County, California, the Central Valley Regional Water Quality Control Board and the California Attorney General's office have directed the Company and other parties to initiate measures with respect to the study and remediation of that site. In addition, the Company has been named as a defendant in several civil lawsuits in which plaintiffs allege that the Company is responsible for performing or paying for remedial action at sites the Company no longer owns or never owned. The Company will perform a groundwater remedial action at its former Sacramento manufactured gas plant site during 1994, at a cost of up to $4 million. The DTSC must approve the groundwater remedial action design plan proposed for this site before it is implemented. The overall costs of the hazardous materials and hazardous waste compliance and remediation activities described above are difficult to estimate due to uncertainty concerning the extent of environmental risks and the Company's responsibility, the complexity of environmental laws and regulations and the selection of compliance alternatives. However, based on the information currently available, the Company has an accrued liability as of December 31, 1993, of $60 million for hazardous waste remediation costs. The ultimate amount of such costs may be significantly higher if, among other things, the Company is held responsible for cleanup at additional sites, other PRPs are not financially able to contribute to these costs, or further investigation indicates that the extent of contamination and affected natural resources is greater than anticipated at sites for which the Company is responsible. Potential Recovery of Hazardous Waste Compliance and Remediation Costs Generally, the Company seeks recovery of hazardous waste compliance costs in the GRC. However, as part of the Company's 1987 GRC, the CPUC established a separate procedure through which the Company may receive ratepayer recovery of reasonable hazardous waste remediation costs incurred at certain historic hazardous waste sites. The CPUC indicated that it was establishing this procedure because the amount and timing of certain hazardous waste remediation expenditures was difficult to forecast in the context of the GRC. This procedure entails obtaining CPUC approval by advice letter prior to incurring any costs, as well as filing an application periodically with the CPUC for recovery of the amounts expended, subject to a review of the reasonableness of the expenditures. The Company currently has received approval of advice letters totaling approximately $22.5 million, has filed two additional advice letters for approval, and expects to file additional requests for specific projects in 1994 and 1995. Amounts authorized by advice letters and subsequently spent by the Company may be collected from ratepayers only after a reasonableness review of the associated projects. In November 1992, the CPUC issued a decision in Southern California Gas Company's (SoCal Gas) environmental reasonableness proceeding deferring a decision on rate recovery of remediation costs incurred by SoCal Gas and instead requesting comments on incentive and/or cost sharing mechanisms for the ratemaking treatment of hazardous waste remediation costs as an alternative to the current reasonableness review of such expenses. In response to the CPUC's request and as a result of a collaborative effort, in November 1993, the Company and various interested parties, including the DRA and other California utilities, filed a report with the CPUC in connection with the SoCal proceeding, which proposes a cost sharing mechanism for the ratemaking treatment of hazardous waste remediation costs. The proposed mechanism would assign 90% of the includable hazardous substance cleanup costs to utility ratepayers and 10% to utility shareholders, without a reasonableness review of such costs or of underlying activities. However, under the proposed mechanism, utilities would have the opportunity to recover the shareholder portion of the cleanup costs from insurance carriers. The parties supporting the proposed mechanism, including the Company, also filed a settlement, requesting that the mechanism be adopted only in its entirety. A special interest group opposes the proposed mechanism. The CPUC has authority to adopt the proposed mechanism, reject it, suggest certain changes to the proposed mechanism, schedule hearings on the issues it considers relevant, or send the parties back for further negotiations until they reach a consensus. On March 10, 1994, the assigned ALJ issued a proposed decision adopting the settlement and proposed mechanism. A final CPUC decision is expected in 1994. The CPUC has put all parties on notice that the mechanism adopted for SoCal Gas may be applied to other utilities. Accordingly, a final decision in this proceeding is expected to establish the method by which the CPUC addresses similar issues in the Company's pending environmental reasonableness proceeding, which has been postponed indefinitely pending a decision in the SoCal Gas case. In the Company's environmental reasonableness proceeding, the Company seeks to recover approximately $10.2 million in costs for two environmental projects -- the Antioch Service Center site and the Sacramento Gas Plant site. However, in its RRI filing (see "General -- Regulatory Reform Initiative" above), the Company requests to withdraw its participation in the collaborative report and recommendation, the pending settlement and the Company's pending environmental reasonableness application if the CPUC approves the Company's RRI application. To the extent that hazardous waste compliance and remediation costs are not recovered through insurance or by other means, the Company may apply for recovery through ratemaking procedures established by the CPUC and, assuming continuation of these procedures, expects that most prudently incurred hazardous waste compliance and remediation costs will be recovered through rates. However, under the Company's proposed RRI, the specific rate mechanism for recovery of these costs would be discontinued at the end of 1994. As of December 31, 1993, the Company has a deferred charge of $61 million for most hazardous waste remediation costs, which represents the minimum amount of such costs expected to be recovered under the current ratemaking mechanisms. The Company believes that the ultimate outcome of these matters will not have a significant adverse impact on its financial position or results of operations. In December 1992, the Company filed a complaint in San Francisco County Superior Court against more than 100 of its domestic and foreign insurers, seeking damages and declaratory relief for remediation and other costs associated with hazardous waste mitigation. The Company had previously notified its insurance carriers that it seeks coverage under its Comprehensive General Liability Policies to recover costs incurred at certain specified sites. In the main, the Company's carriers neither admitted nor denied coverage, but requested additional information from the Company. The amount of recovery from insurance coverage, if any, cannot be quantified at this time. ELECTRIC AND MAGNETIC FIELDS In January 1991, the CPUC opened an investigation into potential interim policy actions to address increasing public concern, especially with respect to schools, regarding potential health risks which may be associated with electric and magnetic fields (EMF) from utility facilities. In its order instituting the investigation, the Commission acknowledged that the scientific community has not reached consensus on the nature of any health impacts from contact with EMF, but went on to state that a body of evidence has been compiled which raises the question of whether adverse health impacts might exist. The CPUC proceeding was subsequently bifurcated into two phases -- one focusing on EMF related to electric power and the other on EMF generated by cellular telephone transmitters. In the electric power phase, the CPUC created a 17-member EMF Consensus Group, with representatives from government, utilities (including a representative from the Company), organized labor and the public. The Consensus Group submitted to the CPUC its recommendations for a CPUC interim policy on EMF, which were considered during evidentiary hearings held in December 1992. In November 1993, the CPUC adopted an interim EMF policy for California energy utilities which, among other things, requires California energy utilities to take no-cost and low-cost steps to reduce EMF from new and upgraded utility facilities. California energy utilities will be required to fund a $1.5 million EMF education program and a $5.6 million EMF research program managed by the California Department of Health Services over the next four years. As part of its effort to educate the public about EMF, the Company provides interested customers with information regarding the EMF exposure issue. The Company also provides a free field measurement service to its customers which informs customers about EMF levels at different locations in and around their residences or commerical buildings. In the event that the scientific community reaches a consensus that EMF presents a health hazard and further determines that the impact of utility-related EMF exposures can be isolated from other exposures, the Company may be required to take mitigation measures at its facilities. The costs of such mitigation measures cannot be estimated with any certainty at this time. However, such costs could be significant depending on the particular mitigation measures undertaken. LOW EMISSION VEHICLE (LEV) PROGRAMS In October 1991, the CPUC issued an Order Instituting Investigation/Order Instituting Rulemaking on LEVs to investigate policy issues surrounding electric and natural gas utility involvement in the market associated with LEVs, specifically natural gas vehicles (NGVs) and electric vehicles (EVs). Hearings in the LEV proceeding were conducted in August 1991, and examined long-term utility involvement in LEV programs in relation to California's environmental, energy and transportation goals. The Company generally proposed that its long-term role in the LEV market be that of a fuel supplier, transporter and distributor. In July 1993, the CPUC issued a decision in the LEV proceeding. The decision recognized a significant role for the Company in the LEV market and directed the Company to file a request for funding for a six-year program (1995-2000). In November 1993, the Company filed an application for approximately $200 million in funding for the Company's fleet and market development activities for NGVs and EVs over the six-year period. However, in its RRI filing (see "General -- Regulatory Reform Initiative" above), the Company requests permission to withdraw the funding request portion of its LEV application if the CPUC approves the Company's RRI proposal. In July 1991, the CPUC approved the implementation of the Company's NGV market development program as proposed by the Company, and authorized initial funding for the program. The decision in the Company's 1993 GRC extended NGV funding of $8.5 million per year pending a final decision in the LEV proceeding described above, and authorized $1.8 million for EV programs. The Company is using the NGV funds to install additional natural gas refueling facilities, to purchase or convert additional NGVs for the Company's fleet, and to provide incentives and assistance in converting additional customer vehicles to NGVs. The Company and its customers currently operate nearly 2,000 NGVs. OTHER REGULATION CALIFORNIA PUBLIC UTILITIES COMMISSION In addition to its jurisdiction over rate matters, the CPUC has the authority, among other things, to establish rules and conditions of service, to authorize disposition of utility property, to establish rules and policies governing utility facilities, to regulate securities issues, to prescribe rates of depreciation and uniform systems of accounts and to regulate transactions between the Company and its subsidiaries and affiliates. CALIFORNIA ENERGY COMMISSION The Company also is subject to the jurisdiction of the CEC. The CEC has developed programs for forecasting peak demands and energy requirements, is encouraging and requiring certain types of energy conservation, has developed energy shortage and contingency plans, and is developing and coordinating a program of energy research and development. In addition, the CEC has statutory authority to certify future thermal-electric power plant sites and related facilities 50 MW and above within California. FEDERAL ENERGY REGULATORY COMMISSION The Company is subject to regulation by the FERC under the Federal Power Act as a "public utility" as defined in the Act. The FERC has authority, among other things, to regulate the Company's rates and terms and conditions for sales of electricity for resale and transmission of electricity in interstate commerce, and to prescribe rates of depreciation and uniform systems of accounts. The FERC also regulates the terms and conditions of interstate pipeline transportation service utilized by the Company to transport gas it purchases outside California. FERC-HYDROELECTRIC LICENSING Most of the Company's hydroelectric facilities are subject to licenses issued under Part I of the Federal Power Act, with various expiration dates to the year 2026 and involving a total normal operating capability of 2,684 MW. Helms adds an additional capacity of 1,212 MW. As the initial licenses for these projects expire, they become susceptible to competition for a new license. In the years prior to 1986, several governmentally-run utilities, claiming a statutory "preference" in their favor superior to the Company, had filed competing applications for three of the Company's projects. Federal legislation enacted in 1986 has eliminated any preference for governmentally-run utilities in the relicensing of hydroelectric projects. The 1986 law requires the Company to pay these challengers a "reasonable" settlement consisting of their costs incurred to pursue the licenses and a potential additional amount ranging from 0% to 100% of the Company's remaining net investment in the projects. In return, the challengers are required to withdraw their competing license applications. The FERC has approved the settlement agreement for one project. The challengers for the other two projects have filed with the FERC to assert claims amounting to approximately $100 million, including 100% of the Company's net investment in the projects of approximately $89 million. In October 1991, the FERC approved a partial settlement agreement between the Company and one of the challengers which, among other things, required the Company to provide additional load following services under a power sale agreement and pay approximately $2 million to settle the challenger's claims related to both projects of approximately $40 million. In October 1992, the FERC issued an order requiring the Company to pay compensation of $1.9 million to the remaining challengers for the two projects, representing the costs incurred preparing their applications. The FERC declined to award the remaining challengers any additional compensation. In December 1992, the challengers filed with FERC a request for rehearing of the compensation order. In February 1993, the FERC reaffirmed the award and rejected the challengers' request for additional compensation. The challengers have appealed FERC's order to the U.S. Court of Appeals. The Company expects to recover the costs of FERC-awarded compensation and the partial settlement through rates. NUCLEAR REGULATORY COMMISSION The Company also is subject to the jurisdiction of the NRC as to operation of its nuclear generating plants. ITEM 2. ITEM 2. PROPERTIES. Information concerning the Company's electric generation units, gas transmission facilities, and electric and gas distribution facilities is included in response to Item 1. All real properties and substantially all personal properties of the Company are subject to the lien of an indenture which provides security to the holders of the Company's First and Refunding Mortgage Bonds. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. See Item 1 - -Business, for other proceedings pending before governmental and administrative bodies. In addition to the following legal proceedings, the Company is subject to routine litigation incidental to its business. NATURAL GAS PURCHASE CONTRACTS LITIGATION In connection with the implementation of the Decontracting Plan described above (see "Gas Utility Operations -- Restructuring of Canadian Supply Arrangements -- Decontracting Plan") in November 1993, the Canadian gas producers party to the Decontracting Plan released A&S, PGT and the Company from any claims they may have had that resulted from the termination of A&S' former Canadian gas purchase arrangements as well as any claims for losses which arose from alleged historical shortfalls in gas taken by A&S. Accordingly, the lawsuits filed by Amoco Canada Petroleum Company Ltd. and Amoco Canada Resources Ltd. (Amoco), Shell Canada Limited (Shell), Chevron Canada Resources (Chevron), Gulf Canada Resources Limited and Gulf Canada Frontier Exploration Limited (Gulf), and Scurry-Rainbow Oil Limited, Opinac Exploration Limited, Norco Resources Limited and Hershey Oil Corporation (North Coleman Producers) were each discontinued under Canadian Law. QF TRANSMISSION CONSTRAINED AREA LITIGATION The Company was a defendant in three lawsuits concerning the existence, nature and extent of transmission constraints in the northern portion of the Company's service area, and whether the Company improperly used those transmission constraints and adopted policies and practices to defeat QF development. The plaintiffs all signed power purchase agreements with the Company for the sale of power from proposed projects that were to have been located in the northern portion of the Company's system. All of the power purchase agreements contained a provision stating that they would terminate if energy deliveries from the proposed projects did not begin within five years of the execution date of the agreement. None of the plaintiffs delivered power within those deadlines. The first case was filed in Fresno County Superior Court by Griswold Creek Joint Power Authority, Tranquility Irrigation District, Thermalito Irrigation District, Table Mountain Irrigation District and Concow Power Authority (collectively, Griswold Creek). The second and third cases were filed in San Francisco County Superior Court by Pacific Oroville Power, Inc. (POPI) and Robert F. Tamaro, doing business as Power Project Ventures (Tamaro), respectively. The three cases had been coordinated in the San Francisco County Superior Court by order of the California Judicial Council, at the Company's request, with trial set for September 1993. The September trial date was suspended while the parties pursued settlement discussion. The Griswold Creek and Tamaro cases were settled in October and November 1993, respectively. Trial of the POPI case, which commenced November 1, 1993, is expected to continue for at least six months. Plaintiff in the POPI case contends that: the Company misrepresented to the CPUC and to QFs its transmission capacity; the existence of transmission constraints extends the five-year deadline in the agreements; the Company was obligated to build transmission upgrades at utility (non-QF) expense which it failed to build; and the Company had a general goal of trying to stifle QF development. The POPI suit alleges breach of contract, negligent misrepresentation, misrepresentation, breach of the implied covenant of good faith and fair dealing, unfair business practices and negligent interference with prospective economic advantage, and seeks declaratory relief, damages, injunctive relief and relief from forfeiture. The POPI complaint seeks compensatory damages "according to proof," together with interest, attorneys' fees and costs of suit. While the complaint makes no mention of any dollar amount of compensatory damages, the plaintiff's damage expert has given a preliminary estimate of damages sought of $67 million. POPI also seeks an unspecified amount of punitive damages. If the trial of the POPI case results in an outcome adverse to the Company, there are other similarly-situated QFs which might choose to file similar complaints. How many such additional complaints might be filed will likely depend on the basis for any adverse decision in the POPI case. The Company believes that the matter has no merit and that the ultimate outcome of this matter will not have a significant adverse impact on its financial position or results of operations. AIR DISTRICT RULEMAKING PROCEEDINGS See "Environmental Matters and Other Regulations -- Environmental Matters -- Environmental Protection Measures" above for a description of proceedings pending before local air districts in California relating to NOx emission reduction requirements. ANTITRUST LITIGATION On December 3, 1993, the County of Stanislaus and Mary Grogan, a residential customer of the Company, filed a complaint in the U.S. District Court, Eastern District of California, against the Company and PGT, on behalf of themselves and purportedly as a class action on behalf of all natural gas customers of the Company during the period of February 1988 through October 1993. The complaint alleges that the purchase of natural gas in Canada was accomplished in violation of various antitrust laws which resulted in increased prices of natural gas for the Company's customers. The complaint alleges that the Company could have purchased as much as 50% of the Canadian gas on the spot market instead of relying on long-term contracts and that the damage to the class members is at least as much as the price differential multiplied by the replacement volume of gas, an amount estimated in the complaint as potentially exceeding $800 million. In addition, the complaint indicates that the damages to the class could include over $150 million paid by the Company to terminate the contracts with the Canadian gas producers in November 1993. The complaint seeks recovery of three times the amount of the actual damages pursuant to the antitrust laws. The Company believes the case is without merit and has filed a motion to dismiss the complaint. The Company believes that the ultimate outcome of the antitrust litigation will not have a significant adverse impact on its financial position. HINKLEY COMPRESSOR STATION LITIGATION In May 1993, a complaint was filed in San Bernardino County Superior Court on behalf of a number of individuals seeking recovery of an unspecified amount of damages for personal injuries and property damage allegedly suffered as a result of exposure to chromium near the Company's Hinkley Compressor Station, located along the Company's gas transmission system in San Bernardino County, as well as punitive damages. The original complaint has been amended, and additional complaints have been filed, to add additional individuals for a total of 178 plaintiffs. The complaints plead several causes of action, including negligence, negligent and intentional misrepresentation, fraudulent concealment, strict liability and violation of California's Safe Drinking Water and Toxic Enforcement Act of 1986 (Proposition 65). The plaintiffs contend that between 1951 and 1966 the Company discharged Chromium VI-contaminated wastewater into unlined ponds, which led to chromium percolating into the groundwater of surrounding property. The plaintiffs further allege that the Company disposed of the chromium in those ponds to avoid costly alternatives. In 1987, the Company undertook an extensive project to remediate potential groundwater chromium contamination. The Company has incurred substantially all of the costs it currently deems necessary to clean up the affected groundwater contamination. In accordance with the remediation plan approved by the regional water quality board, the Company will continue to monitor the affected area and periodically perform environmental assessments. In November 1993, the parties engaged in private mediation sessions. On December 20, 1993, the plaintiffs filed an offer to compromise and settle their claims against the Company for $250 million. The Company is unable to estimate the ultimate outcome of this matter, but such outcome could have a significant adverse impact on the Company's results of operations. The Company believes that the ultimate outcome of this matter will not have a significant adverse impact on its financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT "Executive officers," as defined by Rule 3b-7 of the General Rules and Regulations under the Securities and Exchange Act of 1934, of the Company are as follows: All officers serve at the pleasure of the Board of Directors. All executive officers have been employees of the Company for the past five years. In addition to their current positions, the executive officers had the following business experience during that period: PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information responding to Item 5 is set forth on page 47 under the heading "Quarterly Consolidated Financial Data" in the Company's 1993 Annual Report to Shareholders, which information is hereby incorporated by reference and filed as part of Exhibit 13 to this report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. A summary of selected financial information for the Company for each of the last five fiscal years is set forth on page 12 under the heading "Selected Financial Data" in the Company's 1993 Annual Report to Shareholders, which information is hereby incorporated by reference and filed as part of Exhibit 13 to this report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. A discussion of the Company's results of operations and liquidity and capital resources is set forth on pages 13 through 24 under the heading "Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Shareholders, which discussion is hereby incorporated by reference and filed as part of Exhibit 13 to this report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Information responding to Item 8 is contained in the Company's 1993 Annual Report to Shareholders on page 48 and pages 25 through 47 under the headings "Report of Independent Public Accountants," "Statement of Consolidated Income," "Consolidated Balance Sheet," "Statement of Consolidated Cash Flows," "Statement of Consolidated Common Stock Equity and Preferred Stock," "Statement of Consolidated Capitalization," "Schedule of Consolidated Segment Information," "Notes to Consolidated Financial Statements," and "Quarterly Consolidated Financial Data," which information is hereby incorporated by reference and filed as part of Exhibit 13 to this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information regarding executive officers of the Company is included in a separate item captioned "Executive Officers of the Registrant" contained on page 47 in Part I of this report. Other information responding to Item 10 is included on pages 3 through 5 under the heading "Nominees for Director" in the 1994 Proxy Statement relating to the 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information responding to Item 11 is included on page 7 under the heading "Compensation of Directors" and on pages 11 through 17 under the heading "Executive Compensation" in the 1994 Proxy Statement relating to the 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information responding to Item 12 is included on pages 8 and 18 under the headings "Security Ownership of Management" and "Principal Shareholders" in the 1994 Proxy Statement relating to the 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information responding to Item 13 is included on page 7 under the heading "Certain Relationships and Related Transactions" in the 1994 Proxy Statement relating to the 1994 Annual Meeting of Shareholders, which information is hereby incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) THE FOLLOWING DOCUMENTS ARE FILED AS A PART OF THIS REPORT: 1. The following consolidated financial statements, schedules of consolidated segment information, supplemental information and report of independent public accountants contained in the 1993 Annual Report to Shareholders, are incorporated by reference in this report: Statement of Consolidated Income for the Years Ended December 31, 1993, 1992 and 1991. Consolidated Balance Sheet as of December 31, 1993 and 1992. Statement of Consolidated Cash Flows for the Years Ended December 31, 1993, 1992 and 1991. Statement of Consolidated Common Stock Equity and Preferred Stock for the Years Ended December 31, 1993, 1992 and 1991. Statement of Consolidated Capitalization as of December 31, 1993 and 1992. Schedule of Consolidated Segment Information for the Years Ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Quarterly Consolidated Financial Data. Report of Independent Public Accountants. 2. Report of Independent Public Accountants. 3. Consolidated financial statement schedules: V -- Consolidated Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991. VI -- Accumulated Depreciation of Consolidated Plant in Service for the Years Ended December 31, 1993, 1992 and 1991. VIII -- Consolidated Valuation and Qualifying Accounts for the Years Ended December 31, 1993, 1992 and 1991. IX -- Consolidated Short-term Borrowings for the Years Ended December 31, 1993, 1992 and 1991. X -- Consolidated Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991. Schedules not included are omitted because of the absence of conditions under which they are required or because the required information is provided in the consolidated financial statements including the notes thereto. 4. Exhibits required to be filed by Item 601 of Regulation S-K: 3.1 Restated Articles of Incorporation effective as of November 18, 1992 (Form 8-K dated March 25, 1994 (File No. 1-2348), Exhibit 4.1). 3.2 Certificate of Determination of Preferences of 7.04% Redeemable First Preferred Stock (Form 8-K dated March 25, 1994 (File No. 1-2348), Exhibit 4.2). 3.3 Certificate of Determination of Preferences of 6 7/8% Redeemable First Preferred Stock (Form 8-K dated March 25, 1994 (File No. 1-2348), Exhibit 4.3). 3.4 Certificate of Decrease in Number of Shares of Certain Series of First Preferred Stock (Form 8-K dated March 25, 1994 (File No. 1-2348), Exhibit 4.4). 3.5 Certificate of Determination of Preferences of 6.30% Redeemable First Preferred Stock (Form 8-K dated March 25, 1994 (File No. 1-2348), Exhibit 4.5). 3.6 By-Laws dated October 1, 1993. 4. First and Refunding Mortgage dated December 1, 1920, and supplements thereto dated April 23, 1925, October 1, 1931, March 1, 1941, September 1, 1947, May 15, 1950, May 1, 1954, May 21, 1958, November 1, 1964, July 1, 1965, July 1, 1969, January 1, 1975, June 1, 1979, August 1, 1983, and December 1, 1988 (Registration No. 2-1324, Exhibits B-1, B-2, B-3; Registration No. 2-4676, Exhibit B-22; Registration No. 2-7203, Exhibit B-23; Registration No. 2-8475, Exhibit B-24; Registration No. 2-10874, Exhibit 4B; Registration No. 2-14144, Exhibit 4B; Registration No. 2-22910, Exhibit 2B; Registration No. 2-23759, Exhibit 2B; Registration No. 2-35106, Exhibit 2B; Registration No. 2-54302, Exhibit 2C; Registration No. 2-64313, Exhibit 2C; Registration No. 2-86849, Exhibit 4.3; Form 8-K dated January 18, 1989 (File No. 1-2348), Exhibit 4.2). 10.1 Master Agreement for the Assignment of Service between the Company and NOVA Corporation of Alberta dated September 1, 1993 and schedule A. 10.2 Service Agreement Rate Schedule FS between the Company and NOVA Corporation of Alberta dated October 1, 1993, rate schedule FS, and general terms and conditions. 10.3 Service Agreement Applicable to Firm Transportation Service Under Rate Schedule FS-1 between the Company and Alberta Natural Gas Company LTD dated September 22, 1993, statement of effective rates and charges effective November 1, 1993, service schedule FS-1, and general terms and conditions. 10.4 Firm Transportation Service Agreement between the Company and Pacific Gas Transmission Company dated October 26, 1993, rate schedule FTS-1, and general terms and conditions. 10.5 Transportation Service Agreement as Amended and Restated Between the Company and El Paso Natural Gas Company dated November 1, 1993, rate schedule T-3, and general terms and conditions. 10.6 Diablo Canyon Settlement Agreement dated June 24, 1988 (Form 8-K dated June 27, 1988) (File No. 1-2348), Exhibit 10.1), Implementing Agreement dated July 15, 1988 (Form 10-Q for the quarter ended June 30, 1988 (File No. 1-2348), Exhibit 10.1) and portions of the California Public Utilities Commission Decision No. 88-12-083, dated December 19, 1988, interpreting the Settlement Agreement (Form 10-K for fiscal year 1988 (File No. 1-2348), Exhibit 10.4). *10.7 Pacific Gas and Electric Company Deferred Compensation Plan for Directors (Form 10-K for fiscal year 1992 (File No. 1-2348), Exhibit 10.5). *10.8 Pacific Gas and Electric Company Deferred Compensation Plan for Officers (Form 10-K for fiscal year 1991 (File No. 1-2348), Exhibit 10.6). *10.9 Savings Fund Plan for Employees of Pacific Gas and Electric Company applicable to management employees, effective January 1, 1994. - --------------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this report pursuant to Item 14(c) of Form 10-K. *10.10 Performance Incentive Plan of Pacific Gas and Electric Company. *10.11 The Pacific Gas and Electric Company Retirement Plan applicable to management employees, effective January 1, 1994. *10.12 Pacific Gas and Electric Company Supplemental Executive Retirement Plan, as amended through October 16, 1991 (Form 10-K for fiscal year 1991 (File No. 1-2348), Exhibit 10.11). *10.13 Pacific Gas and Electric Company Stock Option Plan, as amended effective as of September 16, 1992. *10.14 Pacific Gas and Electric Company Performance Unit Plan (Form 10-K for fiscal year 1991 (File No. 1-2348), Exhibit 10.13). *10.15 Pacific Gas and Electric Company Relocation Assistance Program for Officers (Form 10-K for fiscal year 1989 (File No. 1-2348), Exhibit 10.16). *10.16 Pacific Gas and Electric Company Executive Flexible Perquisites Program. *10.17 Management Contract with Jerry R. McLeod (Form 10-K for fiscal year 1989 (File No. 1-2348), Exhibit 10.18). *10.18 PG&E Postretirement Life Insurance Plan (Form 10-K for fiscal year 1991 (File No. 1-2348), Exhibit 10.16). *10.19 Pacific Gas and Electric Company Retirement Plan for Non-Employee Directors (Form 10-K for fiscal year 1991 (File No. 1-2348), Exhibit 10.18). *10.20 Executive Compensation Insurance Indemnity in respect of Deferred Compensation Plan for Directors, Deferred Compensation Plan for Officers, Supplemental Executive Retirement Plan and Retirement Plan for Non-Employee Directors (Form 10-K for fiscal year 1991 (File No. 1-2348), Exhibit 10.19). *10.21 Contract For Performance of Work Between George A. Maneatis and Pacific Gas and Electric Company (Form 10-K for fiscal year 1991 (File No. 1-2348), Exhibit 10.20). *10.22 Pacific Gas and Electric Company Long-Term Incentive Program (Form 10-K for fiscal year 1991 (File No. 1-2348), Exhibit 10.21). 11. Computation of Earnings Per Common Share (Form 8-K dated March 2, 1994 (File No. 1-2348), Exhibit 11). 12.1 Computation of Ratios of Earnings to Fixed Charges (Form 8-K dated March 2, 1994 (File No. 1-2348), Exhibit 12.1). 12.2 Computation of Ratios of Earnings to Combined Fixed Charges and Preferred Stock Dividends (Form 8-K dated March 2, 1994 (File No. 1-2348), Exhibit 12.2). 13. 1993 Annual Report to Shareholders (portions of the 1993 Annual Report to Shareholders under the headings "Selected Financial Data," "Management's Discussion and Analysis of Consolidated Results of Operations and Financial Information," "Report of Independent Public Accountants," "Statement of Consolidated Income," "Consolidated Balance Sheet," "Statement of Consolidated Cash Flows," "Statement of Consolidated Common Stock Equity and Preferred Stock," "Statement of Consolidated Capitalization," "Schedule of Consolidated Segment Information," "Notes to Consolidated Financial Statements," and "Quarterly Consolidated Financial Data," included only) (except for those portions which are expressly incorporated herein by reference, such 1993 Annual Report to Shareholders is furnished for the information of the Commission and is not deemed to be "filed" herein). 21. Subsidiaries of the Company (not included because the Company's subsidiaries, considered in the aggregate as a single subsidiary, would not constitute a "significant subsidiary" under Rule 1-02(v) of Regulation S-X as of the end of the year covered by this report). 23. Consent of Arthur Andersen & Co. 24.1 Resolution of the Board of Directors authorizing the execution of the Form 10-K. 24.2 Powers of Attorney. 99. Information required by Form 11-K with respect to the Savings Fund Plan for Employees of Pacific Gas and Electric Company, as permitted by Rule 15d-21. - --------------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this report pursuant to Item 14(c) of Form 10-K. The exhibits filed herewith are attached hereto (except as noted) and those indicated above which are not filed herewith were previously filed with the Commission as indicated and are hereby incorporated by reference. Exhibits will be furnished to security holders of the Company upon written request and payment of a fee of $.30 per page, which fee covers only the Company's reasonable expenses in furnishing such exhibits. (B) REPORTS ON FORM 8-K Reports on Form 8-K during the quarter ended December 31, 1993 and through the date hereof: 1. October 14, 1993 Item 5. Other Events. -- Restructuring of Canadian Gas Purchase Obligations -- California Public Utilities Commission (CPUC) Proceedings Canadian Affiliates Audit Workforce Reduction Memorandum Account 1994 Attrition Rate Adjustment Electric Reasonableness Proceeding -- PGT/PG&E Pipeline Expansion Project 2. October 25, 1993 Item 5. Other Events. -- Performance Incentive Plan -- Year-to-Date Financial Results -- Regulatory Reform Initiative -- Medium-Term Note Program Item 7. Financial Statements, Pro Forma Financial Information and Exhibits. 3. November 4, 1993 Item 5. Other Events. -- Restructuring of Canadian Gas Purchase Obligations -- California Public Utilities Commission Proceedings 1994 Cost of Capital Proceeding CPUC Denial of Petition to Modify General Rate Case -- PGT/PG&E Pipeline Expansion Project 4. November 17, 1993 Item 5. Other Events. -- Performance Incentive Plan -- Year-to-Date Financial Results -- California Public Utilities Commission Proceeding -- 1988-1990 Reasonableness Proceeding -- QF Constrained Area Litigation 5. December 7, 1993 Item 5. Other Events. -- Antitrust Litigation -- California Public Utilities Commission Proceeding 1994 Cost of Capital Proceeding Hazardous Materials and Hazardous Waste Compliance and Remediation 6. December 23, 1993 Item 5. Other Events. -- Performance Incentive Plan -- Year-to-Date Financial Results 7. January 10, 1994 Item 5. Other Events. -- Performance Incentive Plan -- 1994 Target -- California Public Utilities Commission Proceedings Electric Fuel and Sales Balancing Accounts 1994 Attrition Rate Adjustment 8. January 24, 1994 Item 5. Other Events. -- Performance Incentive Plan -- 1993 Financial Results -- 1993 Consolidated Earnings (unaudited) -- Common Stock Dividend -- Potential Sale of PG&E Resources Company -- Hinkley Compressor Station Litigation 9. March 2, 1994 Item 5. Other Events. -- California Public Utilities Commission Proceedings PGT-PG&E Expansion Project 1992 Reasonableness Proceeding-DRA Recommendation 1988-1990 Reasonableness Proceeding -- Non-Canadian Gas Phase Item 7. Financial Statements, Pro Forma Information and Exhibits. -- 1993 Financial Statements -- Ratios of Earnings to Fixed Charges -- Ratios of Earnings to Combined Fixed Charges and Preferred Dividends -- Exhibits 10. March 11, 1994 Item 5. Other Events. -- Performance Incentive Plan -- Year-to-Date Financial Results -- California Public Utilities Commission Proceedings Regulatory Reform Initiative 1988-1990 Reasonableness Proceeding -- Canadian Issues 1988-1990 Reasonableness Proceeding -- Non-Canadian Issues 11. March 25, 1994 Item 5. Other Events. -- California Public Utilities Commission Proceedings -- Gas Reasonableness Proceedings -- Preferred Stock Offering Item 7. Financial Statements, Pro Forma Financial Information and Exhibits INDEMNIFICATION UNDERTAKING For purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into the registrant's Registration Statement on Form S-8 No. 33-23692 (filed August 12, 1988): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in a successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. 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, IN THE CITY AND COUNTY OF SAN FRANCISCO, ON THE 28TH DAY OF MARCH, 1994. PACIFIC GAS AND ELECTRIC COMPANY (Registrant) By BRUCE R. WORTHINGTON (Bruce R. Worthington, Attorney-in-Fact) 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. * By BRUCE R. WORTHINGTON (Bruce R. Worthington, Attorney-in-Fact) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and the Board of Directors of Pacific Gas and Electric Company: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements and the schedule of consolidated segment information included in the Pacific Gas and Electric Company Annual Report to Shareholders incorporated by reference in this Annual Report on Form 10-K and have issued our report thereon dated February 16, 1994. Our report on the 1993 consolidated financial statements includes explanatory paragraphs that describe the uncertainties regarding the ultimate outcome of the gas reasonableness proceedings, the recovery of certain Helms costs and revenues and the Hinkley litigation, as discussed in notes 2 and 11 to the consolidated financial statements. In addition, our report includes an explanatory paragraph indicating that, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits and income taxes as discussed in notes 1 and 7 to the consolidated financial statements. Our audits of the consolidated financial statements and the schedule of consolidated segment information were made for the purpose of forming an opinion on those statements taken as a whole. The supplemental schedules listed in Part IV, Item 14. (a)(3) of this Annual Report on Form 10-K are the responsibility of the Company's management and are presented for the purpose of complying with the Securities and Exchange Commission's rules and are not part of the consolidated financial statements. These supplemental schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and the schedule of consolidated segment information and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements and schedule of consolidated segment information taken as a whole. ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. San Francisco, California February 16, 1994 SCHEDULE V PACIFIC GAS AND ELECTRIC COMPANY SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 - ------------ SCHEDULE V PACIFIC GAS AND ELECTRIC COMPANY SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 - ------------ SCHEDULE V PACIFIC GAS AND ELECTRIC COMPANY SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 - --------------- (1) Electric tangible cost at December 31, 1991 includes approximately $5.9 billion related to the Diablo Canyon Nuclear Power Plant, substantially all in electric production. (2) Additions are net of transfers of property to plant in service. (4) Other changes consist of: SCHEDULE VI PACIFIC GAS AND ELECTRIC COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION OF CONSOLIDATED PLANT IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1993 - ------------ See Note 1 of Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders for the accounting policy with respect to plant in service and depreciation. SCHEDULE VI PACIFIC GAS AND ELECTRIC COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION OF CONSOLIDATED PLANT IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1992 - ------------ See Note 1 of Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders for the accounting policy with respect to plant in service and depreciation. SCHEDULE VI PACIFIC GAS AND ELECTRIC COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION OF CONSOLIDATED PLANT IN SERVICE FOR THE YEAR ENDED DECEMBER 31, 1991 - ------------ (1) Electric accumulated depreciation at December 31, 1991 includes approximately $1.2 billion related to the Diablo Canyon Nuclear Power Plant, substantially all in electric production. See Note 1 of the Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders for the accounting policy with respect to plant in service and depreciation. SCHEDULE VIII PACIFIC GAS AND ELECTRIC COMPANY SCHEDULE VIII -- CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - --------------- (1) Company disposed of its investment in Alaska Natural Gas Transportation System in January 1993. (2) Construction on the gas transportation system was discontinued in 1983. The Company accrued and reserved AFUDC through January 1993, at which time the Company's subsidiary that was a partner in the partnership organized to build and operate the gas transportation system withdrew from that partnership. (3) Deductions consist principally of write-offs of expired leaseholds on reserved property. (4) Primarily due to development cost for power projects. (5) Deductions consist principally of write-offs, net of collections of receivables considered uncollectible. SCHEDULE IX PACIFIC GAS AND ELECTRIC COMPANY SCHEDULE IX -- CONSOLIDATED SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (1) The general terms of aggregate short-term borrowings are described in Note 6 of Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders. (2) Calculated using a monthly average. SCHEDULE X PACIFIC GAS AND ELECTRIC COMPANY SCHEDULE X--CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ Amounts charged to expense for royalties, advertising costs, and miscellaneous taxes are not set forth inasmuch as such items do not exceed one percent of total revenues as shown in the related Statement of Consolidated Income. Amounts charged to expense for maintenance and repairs and depreciation and amortization of intangible assets, preoperating costs, and similar deferrals are not set forth inasmuch as the information is included in the Consolidated Financial Statements or Notes thereto. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 EXHIBITS TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1993 ------------------ PACIFIC GAS AND ELECTRIC COMPANY ------------------ - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- INDEX TO EXHIBITS - --------------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this report pursuant to Item 14(c) of Form 10-K. INDEX TO EXHIBITS--(CONTINUED) - --------------- *Management contract or compensatory plan or arrangement required to be filed as an exhibit to this report pursuant to Item 14(c) of Form 10-K.

28729_1993.txt

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28729

Item 1. Business GENERAL Bell Atlantic - Delaware, Inc. (formerly The Diamond State Telephone Company) (the "Company") is incorporated under the laws of the State of Delaware and has its principal offices at 901 Tatnall Street, Wilmington, Delaware 19801 (telephone number 302-576-5420). The Company is a wholly owned subsidiary of Bell Atlantic Corporation ("Bell Atlantic"), which is one of the seven regional holding companies ("RHCs") formed in connection with the court- approved divestiture (the "Divestiture"), effective January 1, 1984, of those assets of the American Telephone and Telegraph Company ("AT&T") related to exchange telecommunications, exchange access functions, printed directories and cellular mobile communications. The Company presently serves a territory consisting of a single Local Access and Transport Area ("LATA"). A LATA is generally centered on a city or based on some other identifiable common geography and, with certain limited exceptions, a LATA marks the boundary within which the Company may provide telephone service. The Company provides two basic types of telecommunications services. First, the Company transports telecommunications traffic between subscribers located within the same LATA ("intraLATA service"), including both local and toll services. Local service includes the provision of local exchange ("dial tone"), local private line and public telephone services (including dial tone service for pay telephones owned by the Company and other pay telephone providers). Among other local services provided are Centrex (telephone company central office-based switched telephone service enabling the subscriber to make both intercom and outside calls) and a variety of special and custom calling services. Toll service includes message toll service (calling service beyond the local calling area) within LATA boundaries, and intraLATA Wide Area Toll Service (WATS)/800 services (volume discount offerings for customers with highly concentrated demand). Second, the Company provides exchange access service, which links a subscriber's telephone or other equipment to the transmission facilities of interexchange carriers which, in turn, provide telecommunications service between LATAs ("interLATA service") to their customers. See "Line of Business Restrictions". The Company also provides exchange access service to interexchange carriers which provide intrastate intraLATA long distance telecommunications service. See "Competition - IntraLATA Toll Competition". The communications industry is currently undergoing fundamental changes driven by the accelerated pace of technological innovation, the convergence of the telecommunications, cable television, information services and entertainment businesses, and a regulatory environment in which many traditional regulatory barriers are being lowered and competition permitted or encouraged. Although no definitive prediction can be made of the market opportunities these changes will present or whether Bell Atlantic and its subsidiaries, including the Company, will be able successfully to take advantage of these opportunities, Bell Atlantic is positioning itself to be a leading communications, information services and entertainment company. OPERATIONS During 1993, Bell Atlantic reorganized certain functions formerly performed by each of the seven Bell System operating companies ("BOCs") transferred to it pursuant to the Divestiture, including the Company (collectively, the "Network Services Companies"), into nine lines of business ("LOBs") organized across the Network Services Companies around specific market segments. The Network Services Companies, however, remain responsible within their respective service areas for the provision of telephone services, for financial performance and for regulatory matters. The nine LOBs are: The Consumer Services LOB markets communications services to residential ----------------- customers within the service territories of the Network Services Companies, including the service territory of the Company, and plans in the future to market information services and entertainment programming. The Carrier Services LOB markets (i) switched and special access to the ---------------- Company's local exchange network, and (ii) billing and collection services, including recording, rating, bill processing and bill rendering. The principal customers of this LOB are interexchange carriers; AT&T is the largest single customer. Other customers include business customers and government agencies with their own special access network connections, wireless customers and other local exchange carriers ("LECs") which resell network connections to their own customers. The Small Business Services LOB markets communications and information ----------------------- services to small businesses (customers having up to 20 access lines or 100 Centrex lines). The Large Business Services LOB markets communications and information ----------------------- services to large businesses (customers having more than 20 access lines or more than 100 Centrex lines). These services include voice switching/processing services (e.g., dedicated private lines, custom Centrex, call management and voice messaging), end-user networking (e.g., credit and debit card transactions, and personal computer-based conferencing, including data and video), internetworking (establishing links between the geographically disparate networks of two or more companies or within the same company), network integration (integrating multiple geographically disparate networks into one system), network optimization (disaster avoidance, 911, intelligent vehicle highway systems), video services (distance learning, telemedicine, surveillance, videoconferencing) and integrated multi-media applications services. The Directory Services LOB manages the provision of (i) advertising and ------------------ marketing services to advertisers, and (ii) listing information (e.g., White Pages and Yellow Pages). These services are currently provided primarily through print media, but the Company expects that use of electronic formats will increase in the future. In addition, the Directory Services LOB manages the provision of photocomposition, database management and other related products and services to publishers. The Public and Operator Services LOB markets pay telephone and operator ---------------------------- services in the service territories of the Network Services Companies to meet consumer needs for accessing public networks, locating and identifying network subscribers, providing calling assistance and arranging billing alternatives (e.g., calling card, collect and third party calls). The Federal Systems LOB markets communications and information technology and --------------- services to departments, agencies and offices of the executive, judicial and legislative branches of the federal government. The Information Services LOB has been established to provide programming -------------------- services, including on-demand entertainment, transactions and interactive multimedia applications within the Territory and in selected other markets. See "FCC Regulation and Interstate Rates - Telephone Company Provision of Video Dial Tone and Video Programming". The Network LOB manages the technologies, services and systems platforms ------- required by the other eight LOBs and the Network Services Companies, including the Company, to meet the needs of their respective customers, including, without limitation, switching, feature development and on-premises installation and maintenance services. The Company has been making and expects to continue to make significant capital expenditures on its networks to meet the demand for communications services and to further improve such services. Capital expenditures of the Company were approximately $51 million in 1991, $45 million in 1992, and $48 million in 1993. The total investment of the Company in plant, property and equipment decreased from approximately $661 million at December 31, 1991 to approximately $626 million at December 31, 1992, and increased to approximately $656 million at December 31, 1993, in each case after giving effect to retirements, but before deducting accumulated depreciation at such date. The Company is projecting construction expenditures for 1994 at an amount similar to 1993. However, subject to regulatory approvals, the Network Services Companies, including the Company, plan to allocate capital resources to the deployment of broadband network platforms (technologies ultimately capable of providing a switched facility for access to and transport of high-speed data services, video-on-demand, and image and interactive multimedia applications). Most of the funds for these expenditures are expected to be generated internally. Some additional external financing may be necessary or desirable. LINE OF BUSINESS RESTRICTIONS The consent decree entitled "Modification of Final Judgment" ("MFJ") approved by the United States District Court for the District of Columbia (the "D.C. District Court") which, together with the Plan of Reorganization ("Plan") approved by the D.C. District Court, set forth the terms of Divestiture also established certain restrictions on the post-Divestiture activities of the RHCs, including Bell Atlantic. The MFJ's principal restrictions on post-Divestiture RHC activities included prohibitions on (i) providing interexchange telecommunications, (ii) providing information services, (iii) engaging in the manufacture of telecommunications equipment and customer premises equipment ("CPE"), and (iv) entering into any non-telecommunications businesses, in each case without the approval of the D.C. District Court. Since Divestiture, the D.C. District Court has retained jurisdiction over the construction, modification, implementation and enforcement of the MFJ. In September 1987, the D.C. District Court rendered a decision which eliminated the need for the RHCs to obtain its approval prior to entering into non-telecommunications businesses. However, the D.C. District Court refused to eliminate the restrictions relating to equipment manufacturing or providing interexchange services. With respect to information services, the Court issued a ruling in March 1988 which permitted the RHCs to engage in a number of information transport functions as well as voice storage and retrieval services, including voice messaging, electronic mail and certain information gateway services. However, the RHCs were generally prohibited from providing the content of the data they transmitted. As the result of an appeal of the D.C. District Court's September 1987 and March 1988 decisions by the RHCs and other parties, the United States Court of Appeals for the District of Columbia Circuit ordered the D.C. District Court to reconsider the RHCs' request to provide information content and determine whether removal of the restrictions thereon would be in the public interest. In July 1991, the D.C. District Court removed the remaining restrictions on RHC participation in information services, but imposed a stay pending appeal of that decision. In October 1991, the United States Court of Appeals for the District of Columbia Circuit vacated the stay, thereby permitting the RHCs to provide information services, and in May 1993 affirmed the D.C. District Court's July 1991 decision. The United States Supreme Court denied certiorari in November 1993. Several bills have been introduced in the current session of Congress pursuant to which the line of business restrictions established by the MFJ could be eliminated or modified. No definitive prediction can be made as to whether or when any such legislation will be enacted, the provisions thereof or their impact on the business or financial condition of the Company. FCC REGULATION AND INTERSTATE RATES The Company is subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to interstate services and certain related matters. The FCC prescribes a uniform system of accounts for telephone companies, interstate depreciation rates and the principles and standard procedures used to separate plant investment, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to intrastate services under the jurisdiction of the respective state regulatory authorities ("separations procedures"). The FCC also prescribes procedures for allocating costs and revenues between regulated and unregulated activities. Interstate Access Charges The Company provides intraLATA service and does not participate in the provision of interLATA service except through offerings of exchange access service. The FCC has prescribed structures for exchange access tariffs to specify the charges ("Access Charges") for use and availability of the Company's facilities for the origination and termination of interstate interLATA service. Access Charges are intended to recover the related costs of the Company which have been allocated to the interstate jurisdiction ("Interstate Costs") under the FCC's separations procedures. In general, the tariff structures prescribed by the FCC provide that Interstate Costs of the Company which do not vary based on usage ("non-traffic sensitive costs") are recovered from subscribers through flat monthly charges ("Subscriber Line Charges"), and from interexchange carriers through usage- sensitive Carrier Common Line ("CCL") charges. See "FCC Regulation and Interstate Rates - FCC Access Charge Pooling Arrangements". Traffic-sensitive Interstate Costs are recovered from carriers through variable access charges based on several factors, primarily usage. In May 1984, the FCC authorized the implementation of Access Charge tariffs for "switched access service" (access to the local exchange network) and of Subscriber Line Charges for multiple line business customers (up to $6.00 per month per line). In 1985, the FCC authorized Subscriber Line Charges for residential and single-line business customers at the rate of $1.00 per month per line, which increased in installments to $3.50 effective April 1, 1989. As a result of the phasing in of Subscriber Line Charges, a substantial portion of non-traffic sensitive Interstate Costs is now recovered directly from subscribers, thereby reducing the per-minute CCL charges to interexchange carriers. This significant reduction in CCL charges has tended to reduce the incentive for interexchange carriers and their high-volume customers to bypass the Company's switched network via special access lines or alternative communications systems. However, competition for this access business has increased in recent years. See "Competition - Alternative Access and Local Services". FCC Access Charge Pooling Arrangements The FCC previously required that all LECs, including the Company, pool revenues from CCL and Subscriber Line Charges that cover the non-traffic sensitive costs of the local exchange network, that is, the Interstate Costs associated with the lines from subscribers' premises to telephone company central offices. To administer such pooling arrangements, the FCC mandated the formation of the National Exchange Carrier Association, Inc. Some LECs received more revenue from the pool than they billed their interexchange carrier customers using the nationwide average CCL rate. Other companies, including the Company, received substantially less from the pool than the amount billed to their interexchange carrier customers. By an order adopted in 1987, the FCC changed its mandatory pooling requirements. These changes, which became effective April 1, 1989, permitted all of the Network Services Companies as a group to withdraw from the pool and to charge CCL rates which more closely reflect their non-traffic sensitive costs. The Network Services Companies, including the Company, are still obligated to make contributions of CCL revenues to companies who choose to continue to pool non-traffic sensitive costs so that the pooling companies can charge a CCL rate no greater than the nationwide average CCL rate. In addition to this continuing obligation, the Network Services Companies, including the Company, have a transitional support obligation to high cost companies who left the pool in 1989 and 1990. This transitional support obligation phases out over five years. These long-term and transitional support requirements will be recovered in the Network Services Companies' (including the Company's) CCL rates. Depreciation Depreciation rates provide for the recovery of the Company's investment in telephone plant and equipment, and are revised periodically to reflect more current estimates of remaining service lives and future net salvage values. In October 1993, the FCC issued an order simplifying the depreciation filing process by reducing the information required for certain categories of plant and equipment whose remaining service life, salvage estimates and depreciation rates fall within an approved range. Petitions for reconsideration of that order were filed in December 1993. In November 1993, the FCC issued a further order inviting comments on proposed ranges for an initial group of categories of plant and equipment. On March 3, 1994, the Company filed its triennial Depreciation Rate Study with the FCC, which presents proposed depreciation rates for all depreciable plant of the Company. The Company is requesting changes in rates retroactive to January 1, 1994 which will result in an increase of $12.5 million annually. Price Caps In September 1990, the FCC adopted "price cap" regulation to replace the traditional rate of return regulation of LECs. LEC price cap regulation became effective on January 1, 1991. The price cap system places a cap on overall prices for interstate services and requires that the cap decrease annually, in inflation-adjusted terms, by a fixed percentage which is intended to reflect expected increases in productivity. The price cap level can also be adjusted to reflect "exogenous" changes, such as changes in FCC separations procedures or accounting rules. LECs subject to price caps have somewhat increased flexibility to change the prices of existing services within certain groupings of interstate services, known as "baskets". Under price cap regulation, the FCC set an authorized rate of return of 11.25% for the years 1991 and beyond. To the extent that a company is able to earn a higher rate of return through improved efficiency, the FCC's price cap rules permit them to retain the full amount of this higher return up to 100 basis points above the authorized rate of return (currently, up to a 12.25% rate of return). If a company's rate of return is between 100 and 500 basis points above the authorized rate of return (that is, currently, between 12.25% and 16.25%), the company must share 50% of the earnings above the 100-basis-point level with customers by reducing rates prospectively. All earnings above the 500-basis-point level must be returned to customers in the form of prospective rate decreases. If, on the other hand, a company's rate of return is more than 100 basis points below the authorized rate of return (that is, currently, below 10.25%), the company is permitted to increase rates prospectively to make up the deficiency. Under FCC-approved tariffs, the Network Services Companies are charging uniform rates for interstate access services (with the exception of Subscriber Line Charges) throughout their service areas and are regarded as a single unit by the FCC for rate of return measurement. On February 16, 1994, the FCC initiated a rulemaking proceeding to determine the effectiveness of LEC price cap rules and decide what changes, if any, should be made to those rules. This rulemaking is expected to be concluded by the end of 1994. In January 1993, the FCC denied the Company exogenous treatment of the increased expense for postretirement benefits required under Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which the Company adopted effective January 1, 1991. The Company has appealed this decision. The appeal is likely to be decided during the second half of 1994. Computer Inquiry III In August 1985, the FCC initiated Computer Inquiry III to re-examine its regulations requiring that "enhanced services" (e.g., voice messaging services, electronic mail, videotext gateway, protocol conversion) be offered only through a structurally separated subsidiary. In 1986, the FCC eliminated this requirement, permitting the Company to offer enhanced services, subject to compliance with a series of nonstructural safeguards designed to promote an effectively competitive market. These safeguards include detailed cost accounting, protection of customer information and certain reporting requirements. In June 1990, the United States Court of Appeals for the Ninth Circuit vacated and remanded the Computer Inquiry III decisions to the FCC, finding that the FCC had not fully justified those decisions. In December 1991, the FCC adopted an order which reinstated relief from the separate subsidiary requirement upon a company's compliance with the FCC's Computer III Open Network Architecture ("ONA") requirements and strengthened some of the nonstructural safeguards. In the interim, the Network Services Companies, including the Company, had filed interstate tariffs implementing the ONA requirements. Those tariffs became effective in February 1992, subject to further investigation. That investigation was completed on December 15, 1993, when an order was released making minor changes to the Network Services Companies' ONA rates. In March 1992, the Company certified to the FCC that it had complied with all initial ONA obligations and therefore should be granted structural relief for enhanced services. The FCC granted the Company structural relief in June 1992. Other parties have appealed this decision, which remains in effect pending the outcome of the appeal. A decision on the appeal is likely by the end of 1994. The FCC's December 1991 order has been appealed to the United States Court of Appeals for the Ninth Circuit by several parties. Pending decision on those appeals, the FCC's decision remains in effect. If a court again reverses the FCC, the Company's right to offer enhanced services could be impaired. FCC Cost Allocation and Affiliate Transaction Rules In 1987, the FCC adopted rules governing (i) the allocation of costs between the regulated and unregulated activities of a communications common carrier and (ii) transactions between the regulated and unregulated affiliates of a communications common carrier. The cost allocation rules apply to certain unregulated activities: activities that have never been regulated as communications common carrier offerings and activities that have been preemptively deregulated by the FCC. The costs of these activities are removed prior to the separations procedures process and are allocated to unregulated activities in the aggregate, not to specific services for pricing purposes. Other activities must be accounted for as regulated activities, and their costs are subject to separations procedures. These activities include (i) those which have been deregulated by the FCC without preempting state regulation, (ii) those which have been deregulated by a state but not the FCC and (iii) "incidental activities," which cannot, in the aggregate, generate more than 1% of a company's revenues. Since the Network Services Companies, including the Company, engage in these types of activities, the Network Services Companies, including the Company, pursuant to the FCC's cost allocation rules, filed a cost allocation manual, which has been approved by the FCC. The affiliate transaction rules govern the pricing of assets transferred to and services provided by affiliates. These rules generally require that assets be transferred between affiliates at "market price", if such price can be established through a tariff or a prevailing price actually charged to third parties. In the absence of a tariff or prevailing price, "market price" cannot be established, in which case (i) asset transfers from a regulated to an unregulated affiliate must be valued at the higher of cost or fair market value, and (ii) asset transfers from an unregulated to a regulated affiliate must be valued at the lower of cost or fair market value. The affiliate transaction rules require that a service provided by one affiliate to another affiliate, which service is also provided to unaffiliated entities, must be valued at tariff rates or market prices. If the affiliate does not also provide the service to unaffiliated entities, the price must be determined in accordance with the FCC's cost allocation principles. In October 1993, the FCC proposed new affiliate transaction rules which would essentially eliminate the different rules for the provision of services and apply the asset transfer rules to all affiliate transactions. The Network Services Companies, including the Company, have filed comments opposing the proposed rules. The FCC has not attempted to make its cost allocation or affiliate transaction rules preemptive. State regulatory authorities are free to use different cost allocation methods and affiliate transaction rules for intrastate ratemaking and to require carriers to keep separate allocation records. Telephone Company Provision of Video Dial Tone and Video Programming In 1987, the FCC initiated an inquiry into whether developments in the cable and telephone industries warranted changes in the rules prohibiting telephone companies such as the Company from providing video programming in their respective service territories directly or indirectly through an affiliate. In November 1991, the FCC released a Further Notice of Proposed Rulemaking in these proceedings. In August 1992, the FCC issued an order permitting telephone companies such as the Company to provide "video dial tone" service. Video dial tone permits telephone companies to provide transport to multiple programmers on a non-discriminatory common carrier basis. The FCC has also ruled that neither telephone companies that provide video dial tone service, nor video programmers that use these services, are required to obtain local cable franchises. Other parties have appealed these orders, which remain in effect pending the outcome of the appeal. In December 1992, two Bell Atlantic Companies, Bell Atlantic - Virginia, Inc. and Bell Atlantic Video Services Company, filed a lawsuit against the federal government in the United States District Court for the Eastern District of Virginia seeking to overturn the prohibition in the Cable Communications Policy Act of 1984 against LECs providing video programming in their respective service areas. In a decision rendered in August 1993 and clarified in October 1993, the court struck down this prohibition as a violation of the First Amendment's freedom of speech protections and enjoined its enforcement against Bell Atlantic, the Network Services Companies, including the Company, and Bell Atlantic Video Services Company. This decision has been appealed to the United States Court of Appeals for the Fourth Circuit. In early 1993, the FCC granted Bell Atlantic authority to test a new technology known as Asynchronous Digital Subscriber Line ("ADSL") for use in delivering video entertainment and information over existing copper telephone lines. Beginning in March 1993, Bell Atlantic began a one-year technical trial of ADSL serving up to 400 Bell Atlantic employees in northern Virginia. In the Fall of 1993, Bell Atlantic petitioned the FCC for authorization to expand and convert this technical trial upon its completion into a six month market trial serving up to 2,000 customers. Bell Atlantic also requested authority to offer a commercial video dial tone service to customers served by 25 central offices in parts of northern Virginia and southern Maryland upon completion of the six month market trial. These applications are pending at the FCC. Interconnection and Collocation In October 1992, the FCC issued an order allowing third parties to collocate their equipment in telephone company offices to provide special access (private line) services to the public. The FCC's stated purpose was to encourage greater competition in the provision of interstate special access services. The order permits collocating parties to pay LECs an interconnection charge that is lower than the existing tariffed rates for similar non-collocated services; it allows LECs limited additional pricing flexibility for their own special access services when collocated interconnection is operational. In February 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for special access services. This tariff is currently effective. Bell Atlantic and certain other parties have appealed the FCC's special access collocation order. Bell Atlantic expects the appeal to be decided in 1994. On September 2, 1993, the FCC extended collocation to switched access services. The terms and conditions for switched access collocation are similar to those for special access collocation. On November 18, 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for switched access services. This tariff became effective on February 16, 1994. Bell Atlantic and certain other parties have appealed the FCC's switched access collocation order. Appeals of this order have been stayed pending a decision on the appeals of the special access collocation order. Increased competition through collocation will adversely affect the revenues of the Company, although some of the lost revenues could be offset by increased demand of the Company's own special access services as a result of the slightly increased pricing flexibility that the FCC has permitted. The Company does not expect the net revenue impact of special access collocation to be material. Revenue losses from switched access collocation, however, may be larger than from special access collocation. Intelligent Networks In December 1991, the FCC issued a Notice of Inquiry into the plans of the BOCs, including the Company, to deploy new "modular" network architectures, such as Advanced Intelligent Network ("AIN") technology. The Notice of Inquiry asks what, if any, regulatory action the FCC should take to assure that such architectures are deployed in a manner that is "open, responsive, and procompetitive". On August 31, 1993, the FCC issued a Notice of Proposed Rulemaking proposing a schedule for AIN deployment. The proposals in that Notice of Proposed Rulemaking generally follow those that Bell Atlantic proposed in its response to the Notice of Inquiry. The Company cannot estimate when the FCC will conclude this proceeding. The results of this proposed rulemaking could include a requirement that the Company offer individual components of its services, such as switching and transport, to competitors who will provide the remainder of such services through their own facilities. Such increased competition could divert revenues from the Company. However, deployment of AIN technology may also enable the Company to respond more quickly and efficiently to customer requests for new services. This could result in increased revenues from new services that could at least partially offset losses resulting from increased competition. STATE REGULATION AND INTRASTATE RATES The communications services of the Company are subject to regulation by the Delaware Public Service Commission (the "PSC") with respect to intrastate rates and services and other matters. In August 1992, the Company filed an intrastate rate case with the PSC to increase intrastate net revenues by $14.3 million annually. In November 1993, the PSC voted to award the Company a $3.8 million annual intrastate revenue increase based on the stipulated 10.58% overall rate of return. The Company then filed a petition for reargument of the decision, requesting that the PSC increase the Company's revenue award by an additional $6.3 million annually. On December 6, 1993, the Company entered into an agreement with the Office of Public Advocate of the Delaware state government which stipulated an increase in the Company's revenue award of $1.5 million annually. The PSC approved the stipulation and ordered a revised annual intrastate revenue increase of $5.3 million. The Company put final rates into effect on December 15, 1993. The Delaware Telecommunications Technology Investment Act of 1993 (the "Delaware Telecommunications Act") became effective on July 8, 1993. The Delaware Telecommunications Act modified telecommunications industry regulation for intrastate services and allows the Company to elect to be regulated under an alternative regulation plan instead of traditional rate of return regulation. The Delaware Telecommunications Act provides: -- that the prices of "Basic Telephone Services" (e.g., dial tone and local usage) will remain regulated and cannot change in any one year by more than the rate of inflation, less 3%; -- that the prices of "Discretionary Services" (e.g., Identa Ring(SM) and Calling Waiting) cannot increase more than 15% per year per service, after an initial one-year cap; -- that the prices of "Competitive Services" (e.g., directory advertising and message toll service) will not be subject to tariff; and -- that the Company develop a technology deployment plan with a commitment to invest a minimum of $250 million in Delaware's telecommunications network during the first five years of the plan. The Delaware Telecommunications Act also provides protections to ensure that competitors will not be unfairly disadvantaged, including a prohibition on cross-subsidization, imputation rules, services unbundling and resale service availability requirements, and a review by the PSC during the fifth year of the plan. On July 20, 1993, the PSC has initiated a rulemaking to develop regulations for the implementation of the Delaware Telecommunications Act. On March 24, 1994, the Company elected to be regulated under the alternative regulation provisions of the Delaware Telecommunications Act. On such date, the Company also filed a technology deployment plan consistent with such legislation pursuant to which it committed to (i) link public schools, major medical facilities and state government offices to the "information superhighway", (ii) digitize all of its telephone switches by 1998, and (iii) connect all of its central offices with fiber optic cable by 1998. Management does not believe that operating under the provisions of the Delaware Telecommunications Act will have a material impact on the financial condition or results of operations of the Company. NEW PRODUCTS AND SERVICES Bell Atlantic(R) IQ(SM) Services All of the Network Services Companies, including the Company, have introduced the Bell Atlantic(R) IQ(SM) Services family of calling features (although not all features are available in all states). These features include Identa Ring(SM), which allows a single line to have multiple telephone ----------- numbers, each with a distinctive ring; Repeat Call, which allows customers ----------- automatically to redial busy phone numbers; Return Call, which allows ----------- customers automatically to return the last incoming call, even without knowing the number; Ultra Forward(SM), which customers can use to program call- ------------- forwarding instructions; Home Intercom, which allows for phone-to-phone ------------- dialing within the home; and Caller ID, which displays the number of the --------- calling party. Information Services The Company offers various types of information services, such as message storage services, voice mail and electronic mail, including Answer Call, a telephone answering service aimed at residential and small - ----------- business customers. COMPETITION Regulatory proceedings, as well as new technology, are continuing to expand the types of available communications services and equipment and the number of competitors offering such services. An increasing amount of this competition is from large companies which have substantial capital, technological and marketing resources, many of which do not face the same regulatory constraints as the Company. Alternative Access and Local Services A substantial portion of the Company's revenues from business and government customers is derived from a relatively small number of large, multiple-line subscribers. The Company faces competition from alternative communications systems, constructed by large end users, interexchange carriers, and alternative access vendors which are capable of originating and/or terminating calls without the use of the local telephone company's plant. The ability of such alternative access providers to compete with the Company has been enhanced by the FCC's orders requiring the Company to offer collocated interconnection for special and switched access services. Other potential sources of competition are cable television systems, shared tenant services and other non-carrier systems which are capable of bypassing the Company's local plant, either partially or completely, through substitution of special access for switched access or through concentration of telecommunications traffic on fewer of the Company's lines. Well-financed competitors are seeking authority, or are likely soon to seek authority, to offer competing local exchange services, such as dial tone and local usage, in some of the most lucrative of the Company's local telephone service areas. The largest long-distance carrier is also positioning itself to begin to offer services that will compete with the Company's local exchange services. In November 1992, AT&T announced its intention to acquire a controlling interest in McCaw Cellular Communications Inc. ("McCaw"), the largest cellular company in the United States, and to integrate McCaw's wireless local service network with AT&T's long distance network. The entry of these and other local exchange service competitors will almost certainly reduce the local exchange service revenues of the Company, at least in the market segments and geographical areas in which the competitors operate. Depending on such competitors' success in marketing their services, and the conditions of interconnection established by the regulatory commissions, these reductions could be significant. These revenue reductions may be offset to some extent by revenues from interconnection charges to be paid to the Company by these competitors. The Company seeks to meet such competition by establishing and/or maintaining competitive cost-based prices for local exchange services (to the extent the FCC and state regulatory authorities permit the Company's prices to move toward costs), by keeping service quality high and by effectively implementing advances in technology. See "FCC Regulation and Interstate Rates - Interstate Access Charges" and "- FCC Access Charge Pooling Arrangements". Personal Communications Services Radio-based personal communications services ("PCS") also constitute potential sources of competition to the Company. PCS consists of wireless portable telephone services which would allow customers to make and receive telephone calls from any location using small handsets, and which could also be used for data transmission. The FCC has authorized trials of such services, using a variety of technologies, by numerous companies. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing PCS. Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States; five of the spectrum blocks would be auctioned by "basic trading area" and the remaining two would be auctioned by larger "major trading area" (as such trading areas are defined by Rand McNally). LECs and companies with LEC subsidiaries, such as Bell Atlantic, are eligible to bid for PCS licenses, except that cellular carriers, such as Bell Atlantic, are limited to obtaining only 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994 or in early 1995. If implemented, PCS and other similar services would compete with services currently offered by the Company, and could result in losses of revenues. Centrex The Company offers Centrex service, which is a telephone company central office-based communications system for business, government and other institutional customers consisting of a variety of integrated software-based features located in a centralized switch or switches and extended to the customer's premises primarily via local distribution facilities. In the provision of Centrex, the Company is subject to significant competition from the providers of CPE systems, such as private branch exchanges ("PBXs"), which perform similar functions with less use of the Company's switching facilities. Users of Centrex systems generally require more subscriber lines than users of PBX systems of similar capacity. The FCC increased the maximum Subscriber Line Charge on embedded Centrex lines to $6.00 per month per line effective April 1, 1989. Increases in Subscriber Line Charges result in Centrex users incurring higher charges than users of comparable PBX systems. IntraLATA Toll Competition The ability of interexchange carriers to engage in the provision of intrastate intraLATA toll service in competition with the Company is subject to state regulation. Such competition is permitted in Delaware. In addition, the PSC has initiated a proceeding to determine whether to require presubscription and dialing parity ("+1 dialing") for intraLATA toll competitors of the Company. Management believes that intraLATA presubscription, if implemented without adequate compensation and regulatory relief, could have a material effect on the Company's financial condition and results of operations. Directories The Company continues to face significant competition from other providers of directories as well as competition from other advertising media. In particular, the former sales representative of the Network Services Companies, including the Company, publishes directories in competition with those published by the Company in its service territory. Public Telephone Services The Company faces increasing competition in the provision of pay telephone services from other pay telephone service providers. In addition, the growth of wireless communications negatively impacts usage of public telephones. Operator Services Alternative operator services providers have entered into competition with the Company's operator services product line. CERTAIN CONTRACTS AND RELATIONSHIPS Certain planning, marketing, procurement, financial, legal, accounting, technical support and other management services are provided on behalf of the Company on a centralized basis by Bell Atlantic's wholly owned subsidiary, Bell Atlantic Network Services, Inc. ("NSI"). Bell Atlantic Network Funding Corporation provides short-term financing and cash management services to the Company. The seven RHCs each own (directly or through subsidiaries) a one-seventh interest in Bell Communications Research, Inc. ("Bellcore"). Pursuant to the Plan, Bellcore furnishes the RHCs and their BOC subsidiaries with technical assistance such as network planning, engineering and software development, as well as various other consulting services that can be provided more effectively on a centralized basis. Bellcore is the central point of contact for coordinating the efforts of the RHCs in meeting the national security and emergency preparedness requirements of the federal government. It also helps to mobilize the combined resources of the RHCs in times of natural disasters. EMPLOYEE RELATIONS As of December 31, 1993, the Company employed approximately 980 persons, including employees of the centralized staff at NSI. This represents approximately a 2% increase from the number of employees at December 31, 1992. The Company's workforce is augmented by members of the centralized staff of NSI, who perform services for the Company on a contract basis. Approximately 86% of the employees of the Company are represented by the Communications Workers of America, which is affiliated with the American Federation of Labor - Congress of Industrial Organizations. Under the terms of the three-year contracts ratified in October 1992 by unions representing associate employees of the Network Services Companies, including the Company, and NSI, represented associates received a base wage increase of 3.74% in August 1993. Under the same contracts, associates received a Corporate Profit Sharing payment of $495 per person in 1994 based upon Bell Atlantic's 1993 financial performance. Item 2. Item 2. Properties The principal properties of the Company do not lend themselves to simple description by character and location. At December 31, 1993, the Company's investment in plant, property and equipment consisted of the following: "Connecting lines" consists primarily of aerial cable, underground cable, poles, conduit and wiring. "Central office equipment" consists of switching equipment, transmission equipment and related facilities. "Land and buildings" consists of land owned in fee and improvements thereto, principally central office buildings. "Telephone instruments and related equipment" consists primarily of public telephone terminal equipment and other terminal equipment. "Other" property consists primarily of furniture, office equipment, vehicles and other work equipment, capital leases, leasehold improvements and plant under construction. The Company's central offices are served by various types of switching equipment. At December 31, 1993 and 1992, the number of local exchanges and the percent of subscriber lines served by each type of equipment were as follows: Item 3. Item 3. Legal Proceedings Pre-Divestiture Contingent Liabilities and Litigation The Plan provides for the recognition and payment by AT&T and the former BOCs (including the Company) of liabilities that are attributable to pre-Divestiture events but do not become certain until after Divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). Except to the extent that affected parties otherwise agree, contingent liabilities that are attributable to pre-Divestiture events are shared by AT&T and the BOCs in accordance with formulas prescribed by the Plan, whether or not an entity was a party to the proceeding and regardless of whether an entity was dismissed from the proceeding by virtue of settlement or otherwise. Each company's allocable share of liability under these formulas depends on several factors, including the type of contingent liability involved and each company's relative net investment as of the effective date of Divestiture. Under the formula generally applicable to most of the categories of these contingent liabilities, the Company's aggregate allocable share of liability is approximately 0.2%. AT&T and various of its subsidiaries and the BOCs (including, in some cases, the Company) have been and are parties to various types of litigation relating to pre-Divestiture events, including actions and proceedings involving environmental claims and allegations of violations of equal employment laws. Damages, if any, ultimately awarded in the remaining actions relating to pre- Divestiture events could have a financial impact on the Company whether or not the Company is a defendant since such damages will be treated as contingent liabilities and allocated in accordance with the allocation rules established by the Plan. While complete assurance cannot be given as to the outcome of any contingent liabilities or litigation, in the opinion of the Company's management, any monetary liability or financial impact to which the Company would be subject after final adjudication of all of the remaining potential or actual pre- Divestiture claims would not be material in amount to the financial position of the Company. PART I Item 4. Item 4. Submission of Matters to a Vote of Security Holders (Omitted pursuant to General Instruction J(2).) PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters (Inapplicable.) Item 6. Item 6. Selected Financial Data (Omitted pursuant to General Instruction J(2).) Item 7. Item 7. Management's Discussion and Analysis of Results of Operations (Abbreviated pursuant to General Instruction J(2).) This discussion should be read in conjunction with the Financial Statements and Notes to Financial Statements included in the index set forth on page. RESULTS OF OPERATIONS Net income for 1993 decreased $1,363,000 or 3.4% from the same period last year. Results in 1993 reflect an after-tax charge of $877,000 for the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112) and an extraordinary charge, net of tax, of $996,000 for the early extinguishment of debt. OPERATING REVENUES Operating revenues increased $11,909,000 or 5.1% in 1993. The increase in total operating revenues was comprised of the following: Local service revenues are earned from the provision of local exchange, local private line, and public telephone services. Local service revenues increased $6,564,000 or 6.5% in 1993. The increase was due from higher revenues resulting from a rate increase, net of refunds, as authorized by the Delaware Public Service Commission in Docket No. 92-47, growth in network access lines and higher demand for value-added central office services such as Custom Calling and Caller ID. The growth in access lines in service was 15,700 lines or a 3.5% increase in 1993. Network access revenues are received from interexchange carriers (IXCs) for their use of the Company's local exchange facilities in providing long-distance services to IXCs' customers and from end-user subscribers. Switched access revenues are derived from usage-based charges paid by IXCs for access to the Company's network. Special access revenues arise from access charges paid by customers who have private lines, and end-user access revenues are earned from local exchange carrier customers who pay for access to the network. Network access revenues increased $3,511,000 or 5.8% in 1993, primarily due to lower support payments to the National Exchange Carrier Association (NECA) interstate common line pool and an 8.9% growth in access minutes of use. Also contributing to this increase were higher end-user revenues, principally due to growth in network access lines in service. These increases were partially offset by the effect of interstate rate reductions filed by the Company with the Federal Communications Commission (FCC), which became effective on July 2, 1993 and July 1, 1992, and by related estimated price cap sharing liabilities. Toll service revenues are earned from interexchange usage services such as Message Toll Services (MTS) and Unidirectional Services (Wide Area Telecommunications Services (WATS) and 800 Services). Toll service revenues increased $676,000 or 1.9% in 1993. Total toll message volume growth was 4.5% in 1993. Volume-related message toll service revenue increases were partially offset in 1993 by declines in revenues from WATS and private line services, principally due to competitive pressures. Directory advertising, billing services and other revenues include amounts earned from directory advertising, billing and collection services provided to IXCs, premises services such as inside wire installation and maintenance, rent of Company facilities by affiliates and non-affiliates, and certain nonregulated enhanced network services. Directory advertising, billing services and other revenues increased $1,642,000 or 4.2% in 1993, primarily due to increased revenues from directory advertising due to higher rates and from growth in revenues from Answer Call, a nonregulated enhanced network service. Directory advertising revenue growth was adversely impacted by decreasing sales volume attributable primarily to competition. These revenue increases were offset in part by declines in billing and collection revenue resulting from reductions in services provided under long-term contracts with certain IXCs. The provision for uncollectibles, expressed as a percentage of total revenue, was 1.0% in 1993 and .8% in 1992. The increase was principally due to growth in revenues. OPERATING EXPENSES Operating expenses increased $413,000 or .2% in 1993. The increase in total operating expenses was comprised of the following: Employee costs consist of salaries, wages and other employee compensation, employee benefits and payroll taxes paid directly by the Company. Similar costs incurred by employees of Bell Atlantic Network Services, Inc. (NSI), who provide centralized services on a contract basis, are allocated to the Company and are included in other operating expenses. Employee costs increased $2,567,000 or 4.9% in 1993. Higher employee costs from salary and wage increases and overtime were offset in part by savings resulting from workforce reduction programs implemented in 1992. The Company continues to evaluate ways to streamline and restructure its operations and reduce its workforce requirements in an effort to improve its cost structure. Depreciation and amortization expense increased $1,883,000 or 4.8% in 1993. The increase was primarily a result of the effect of a one-time adjustment associated with the retirement of certain central office equipment, which reduced depreciation expense in 1992, and growth in the level of depreciable plant in 1993. On March 3, 1994, the Company filed its triennial Depreciation Rate Study with the FCC, which presents proposed depreciation rates for all depreciable plant of the Company. The Company is requesting changes in rates retroactive to January 1, 1994 which will result in an increase of $12,500,000 annually. Other operating expenses consist primarily of contracted services including centralized service expenses allocated from NSI, rent, network software costs, operating taxes other than income taxes, and other general and administrative expenses. Other operating expenses decreased $4,037,000 or 5.0% in 1993. The decrease in other operating expenses was principally due to the effect of the termination of billing agreements with certain affiliated companies and lower rent expense. These decreases were partially offset by higher costs for contracted services as a result of higher employee costs and taxes allocated from NSI. OPERATING INCOME TAXES The provision for income taxes increased $10,446,000 or 72.5% in 1993. The Company's effective income tax rate was 38.0% in 1993 compared to 26.7% in 1992. The increase in the 1993 effective tax rate is principally the result of federal tax legislation enacted in 1993, which increased the federal corporate tax rate from 34% to 35%, a decrease in the amortization of investment tax credits, and the effect of recording in 1992 an adjustment to deferred taxes associated with the retirement of certain plant investment. A reconciliation of the statutory federal income tax rate to the effective rate for each period is provided in Note 5 of Notes to Financial Statements. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). In connection with the adoption of Statement No. 109, the Company recorded a charge to income of $62,000 in the first quarter of 1993 (see Note 5 of Notes to Financial Statements). OTHER INCOME AND EXPENSE The change in other income and expense, net, was $380,000 in 1993. This change was primarily due to the effect of interest income recognized in 1992 in connection with the settlement of various federal income tax matters related to prior periods. INTEREST EXPENSE Interest expense increased $160,000 or 1.9% in 1993, principally as a result of an adjustment, related to Docket 84-800 for excess earnings refunds, which reduced interest expense in 1992. A higher level of short-term debt in 1993 also contributed to the increase. EXTRAORDINARY ITEM The Company called $40,000,000 in 1993 of long-term debentures which were refinanced at more favorable interest rates. As a result of these early retirements, the Company incurred an after-tax charge of $996,000 in 1993. These debt refinancings will reduce interest costs on the refinanced debt by approximately $800,000 annually. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE In connection with the adoption of Statement No. 112, effective January 1, 1993, the Company recorded a one-time, cumulative effect after-tax charge of $877,000 in 1993 (see Note 4 of Notes to Financial Statements). The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of expense in 1993 and is not expected to have a significant effect in future periods. COMPETITION AND REGULATORY ENVIRONMENT The telecommunications industry is currently undergoing fundamental changes which may have a significant impact on future financial performance of all telecommunications companies. These changes are driven by a number of factors, including the accelerated pace of technology change, customer requirements, a changing industry structure characterized by strategic alliances and the convergence of telecommunications and cable television, and a changing regulatory environment in which traditional regulatory barriers are being lowered and competition encouraged. The convergence of cable television, computer technology, and telecommunications can be expected to dramatically increase competition in the future. The Company is already subject to competition from numerous sources, including competitive access providers for network access services, competing cellular telephone companies and others. During 1993, a number of business alliances were announced that have the potential to significantly increase competition both within the industry and within the areas currently served by Bell Atlantic. Over the past several years, Bell Atlantic has taken a number of actions in anticipation of the increasingly competitive environment. Cost reductions have been achieved, giving greater pricing flexibility for services exposed to competition. A new lines of business organization structure was adopted. Subject to regulatory approval, the Company plans to allocate capital resources to the deployment of broadband network platforms. On the regulatory front, the Company is considering an alternative regulation plan, which has been signed into law, that allows the Company to elect to be regulated under a price regulation plan instead of traditional rate of return regulation. The Company conducts ongoing evaluations of its accounting practices, many of which have been prescribed by regulators. These evaluations include the assessment of whether costs that have been deferred as a result of actions of regulators and the cost of the Company's telephone plant will be recoverable in the future. In the event recoverability of costs becomes unlikely due to decisions by the Company to accelerate deployment of new technology, in response to specific regulatory actions or increasing levels of competition, the Company may no longer apply the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). The discontinued application of Statement No. 71 would require the Company to write off its regulatory assets and liabilities and may require the Company to adjust the carrying amount of its telephone plant should it determine that such amount is not recoverable. The Company believes that it continues to meet the criteria for continued financial reporting under Statement No. 71. A determination in the future that such criteria are no longer met may result in a significant one-time, non-cash, extraordinary charge, if the Company determines that a substantial portion of the carrying value of its telephone plant may not be recoverable. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing personal communications services (PCS). Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States. The geographical units by which the licenses would be allocated will be "basic trading areas" or larger "major trading areas." Five of the spectrum blocks are to be auctioned on a basic trading area basis, and the remaining two are to be auctioned by major trading area. Local exchange carriers such as the Company are eligible to bid for PCS licenses, except that cellular carriers are limited to obtaining 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994. In August 1993, the United States District Court for the Eastern District of Virginia ruled unconstitutional the 1984 Cable Act's limitation on in- territory provision of programming by local exchange carriers such as the Company. The Cable Act currently prohibits local exchange carriers from owning more than 5% of any company that provides cable programming in their local service area. In a case originally brought by two Bell Atlantic subsidiaries, the court ruled that this prohibition violates the First Amendment's freedom of speech protections, and enjoined enforcement of the prohibition against Bell Atlantic and its telephone subsidiaries. The ruling has been appealed. STATE REGULATORY ENVIRONMENT The communications services of the Company are subject to regulation by the Delaware Public Service Commission (the PSC) with respect to intrastate rates and services and other matters. In August 1992, the Company filed an intrastate rate case with the PSC to increase intrastate net revenues by $14.3 million annually. In November 1993, the PSC voted to award the Company a $3.8 million annual intrastate revenue increase based on the stipulated 10.58% overall rate of return. The Company then filed a petition for reargument of the decision, requesting that the PSC increase the Company's revenue award by an additional $6.3 million annually. On December 6, 1993, the Company entered into an agreement with the Office of Public Advocate of the Delaware state government which stipulated an increase in the Company's revenue award of $1.5 million annually. The PSC approved the stipulation and ordered a revised annual intrastate revenue increase of $5.3 million. The Company put final rates into effect on December 15, 1993. The Delaware Telecommunications Technology Investment Act of 1993 (the Delaware Telecommunications Act) became effective on July 8, 1993. The Delaware Telecommunications Act modified telecommunications industry regulation for intrastate services and allows the Company to elect to be regulated under an alternative regulation plan instead of traditional rate of return regulation. The Delaware Telecommunications Act provides: -- that the prices of "Basic Telephone Services" (e.g., dial tone and local usage) will remain regulated and cannot change in any one year by more than the rate of inflation, less 3%; -- that the prices of "Discretionary Services" (e.g., Identa Ring(SM) and Calling Waiting) cannot increase more than 15% per year per service, after an initial one-year cap; -- that the prices of "Competitive Services" (e.g., directory advertising and message toll service) will not be subject to tariff; and -- that the Company develop a technology deployment plan with a commitment to invest a minimum of $250 million in Delaware's telecommunications network during the first five years of the plan. The Delaware Telecommunications Act also provides protections to ensure that competitors will not be unfairly disadvantaged, including a prohibition on cross-subsidization, imputation rules, services unbundling and resale service availability requirements, and a review by the PSC during the fifth year of the plan. On July 20, 1993 the PSC initiated a rulemaking to develop regulations for the implementation of the Delaware Telecommunications Act. On March 24, 1994, the Company elected to be regulated under the alternative regulation provisions of the Delaware Telecommunications Act. On such date, the Company also filed a technology deployment plan consistent with such legislation pursuant to which it committed to (i) link public schools, major medical facilities and state government offices to the "information superhighway", (ii) digitize all of its telephone switches by 1998, and (iii) connect all of its central offices with fiber optic cable by 1998. Management does not believe that operating under the provisions of the Delaware Telecommunications Act will have a material impact on the financial condition or results of operations of the Company. The PSC has initiated a proceeding to determine whether to require presubscription and dialing parity ("+1 dialing") for intraLATA toll competitors of the Company. Management believes that intraLATA presubscription, if implemented without adequate compensation and regulatory relief, could have a material effect on the Company's financial condition and results of operations. OTHER MATTERS The Company has been designated as a potentially responsible party by the U.S. Environmental Protection Agency in connection with two Superfund sites. Designation as a potentially responsible party subjects the named company to potential liability for costs relating to cleanup of the affected sites. Management believes that the aggregate amount of any potential liability would not have a material effect on the Company's financial condition or results of operations. FINANCIAL CONDITION Management believes that the Company has adequate internal and external resources available to meet ongoing operating requirements including network expansion and modernization, and payment of dividends. Management expects that presently foreseeable capital requirements will be financed primarily through internally generated funds, although additional long-term debt may be needed to fund development activities and to maintain the Company's capital structure within management's guidelines. During 1993, as in prior years, the Company's primary source of funds continued to be cash generated from operations. Revenue growth, cost containment measures and savings on interest costs contributed to cash provided from operations of $79,177,000 for the year ended December 31, 1993. The primary use of capital resources continued to be capital expenditures. The Company invested $48,393,000 in 1993 in the network. This level of investment is expected to continue in 1994. The Company plans to allocate capital resources to the deployment of broadband network platforms, subject to regulatory approval. The Company's debt ratio was 37.4% as of December 31, 1993 compared to 36.7% at December 31, 1992. On December 16, 1993, the Company sold $20,000,000 of Thirty Year 7% Debentures, and $20,000,000 of Ten Year 6 1/8% Debentures, through a public offering. The thirty year debentures are not redeemable by the Company prior to December 1, 2013 and the ten year debentures are not redeemable prior to maturity. The net proceeds from these issuances were used to redeem $15,000,000 of Forty Year 8 3/4% Debentures, $15,000,000 of Forty Year 8 1/5% Debentures, and $10,000,000 of Forty Year 9% Debentures. These debt refinancings will reduce interest costs on the refinanced debt by approximately $800,000 annually. As of December 31, 1993, the Company had no amounts outstanding under a shelf registration statement filed with the Securities and Exchange Commission. PART II Item 8. Item 8. Financial Statements and Supplementary Data The information required by this Item is set forth on pages through . Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant (Omitted pursuant to General Instruction J(2).) Item 11. Item 11. Executive Compensation (Omitted pursuant to General Instruction J(2).) Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (Omitted pursuant to General Instruction J(2).) Item 13. Item 13. Certain Relationships and Related Transactions (Omitted pursuant to General Instruction J(2).) PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) The following documents are filed as part of this report: (1) Financial Statements See Index to Financial Statements and Financial Statement Schedules appearing on Page. (2) Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules appearing on Page. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (Continued) (3) Exhibits Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. Exhibit Number (Referenced to Item 601 of Regulation S-K) --------------------------------------------------------- 3a Certificate of Incorporation of the registrant, as amended and restated June 17, 1987 (Exhibit 3a to the registrant's Annual Report on Form 10-K for 1987, File No. 1-7757) 3a(i) Certificate of Amendment of Certificate of Incorporation dated August 14, 1992 (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-7757) 3a(ii) Certificate of Amendment of Certificate of Incorporation, dated January 10, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended through January 27, 1994. 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606) 10b Agreement Among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606) 24 Powers of attorney. (b) Reports on Form 8-K A Current Report on Form 8-K, dated December 1, 1993, was filed reporting on Item 7 (Financial Statements and Exhibits) in connection with the sale of debt securities. 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. Bell Atlantic - Delaware, Inc. By /s/ John J. Parker -------------------------------- John J. Parker Controller and Treasurer March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of this registrant and in the capacities and on the date indicated. Principal Executive } Officer: } Carolyn S. Burger President and } Chief Executive } Officer } Principal Financial } Officer: } } John J. Parker Controller } and Treasurer Directors: } By /s/ John J. Parker Harry Bonk } --------------------------- Carolyn S. Burger } John J. Parker Charles W. Crist } (individually and as Archie W. Dunham } attorney-in-fact) Joshua W. Martin, III } March 29, 1994 Robert F. Rider } David P. Roselle } } (constituting a majority of the registrant's Board of Directors) Index to Financial Statements and Financial Statement Schedules Financial statement schedules other than those listed above have been omitted either because the required information is contained in the financial statements and the notes thereto, or because such schedules are not required or applicable. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowner of Bell Atlantic - Delaware, Inc. We have audited the financial statements and financial statement schedules of Bell Atlantic - Delaware, Inc. as listed in the index on page of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Bell Atlantic - Delaware, Inc. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes 1, 4 and 5 to financial statements, the Company changed its method of accounting for income taxes and postemployment benefits in 1993 and postretirement benefits other than pensions in 1991. /s/ COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania February 7, 1994 STATEMENTS OF INCOME AND REINVESTED EARNINGS For the Years Ended December 31 (Dollars in Thousands) BALANCE SHEETS (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. BALANCE SHEETS (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. STATEMENTS OF CASH FLOWS For the Years Ended December 31 (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation Bell Atlantic - Delaware, Inc., (formerly The Diamond State Telephone Company) (the Company), a wholly owned subsidiary of Bell Atlantic Corporation (Bell Atlantic), maintains its accounts in accordance with the Uniform System of Accounts (USOA) prescribed by the Federal Communications Commission (FCC) and makes certain adjustments necessary to present the accompanying financial statements in accordance with generally accepted accounting principles applicable to regulated entities. Such principles differ in certain respects from those used by unregulated entities, but are required to appropriately reflect the financial and economic impacts of regulation and the ratemaking process. Significant differences resulting from the application of these principles are disclosed elsewhere in these Notes to Financial Statements where appropriate. Revenue Recognition Revenues are recognized as earned on the accrual basis, which is generally when services are rendered based on the usage of the Company's local exchange network and facilities. Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of 90 days or less when purchased to be cash equivalents. Cash equivalents are stated at cost, which approximates market value. Material and Supplies New and reusable materials are carried in inventory, principally at average original cost, except that specific costs are used in the case of large individual items. Nonreusable material is carried at estimated salvage value. Prepaid Directory Costs of directory production and advertising sales are deferred until the directory is published. Such costs are amortized to expense and the related advertising revenues are recognized over the average life of the directory, which is generally 12 months. Plant and Depreciation The Company's provision for depreciation is based principally on the remaining life method of depreciation and straight-line composite rates. The provision for depreciation is based on the following estimated remaining service lives: buildings, 25 to 35 years; central office equipment, 5 to 11 years; telephone instruments and related equipment, 5 to 8 years; poles, 22 years; cable and wiring, 11 to 18 years; conduit, 43 years; office equipment and furniture, 4 to 9 years; and vehicles and other work equipment, 3 to 9 years. This method provides for the recovery of the remaining net investment in telephone plant, less anticipated net salvage value, over the remaining service lives authorized by regulatory commissions. Depreciation expense also includes amortization of certain classes of telephone plant (and certain identified depreciation reserve deficiencies) over periods authorized by regulatory commissions. When depreciable plant is replaced or retired, the amounts at which such plant has been carried in plant, property and equipment are removed from the respective accounts and charged to accumulated depreciation, and any gains or losses on disposition are amortized over the remaining service lives of the remaining net investment in telephone plant. Maintenance and Repairs The cost of maintenance and repairs of plant, including the cost of replacing minor items not constituting substantial betterments, is charged to operating expenses. Allowance for Funds Used During Construction Regulatory commissions allow the Company to record an allowance for funds used during construction, which includes both interest and equity return components, as a cost of plant and as an item of other income. Such income is not recovered in cash currently, but will be recoverable over the service life of the plant through higher depreciation expense recognized for regulatory purposes. Employee Benefits Pension Plans Substantially all employees of the Company are covered under noncontributory multi-employer defined benefit pension plans sponsored by Bell Atlantic and its subsidiaries, including the Company. The Company uses the projected unit credit actuarial cost method for determining pension cost for financial reporting purposes. Amounts contributed to the Company's pension plans are actuarially determined, principally under the aggregate cost actuarial method, and are subject to applicable federal income tax regulations. Postretirement Benefits Other Than Pensions Substantially all employees of the Company are covered under postretirement health and life insurance benefit plans. Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. A portion of the postretirement accrued benefit obligation is contributed to 501 (c)(9) trusts and 401h accounts under applicable federal income tax regulations. The amounts contributed to these trusts and accounts are actuarially determined, principally under the aggregate cost actuarial method. Postemployment Benefits The Company provides employees with postemployment benefits such as disability benefits, workers' compensation, and severance pay. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. Prior to 1993, the cost of these benefits was charged to expense as the benefits were paid. Income Taxes Bell Atlantic and its domestic subsidiaries, including the Company, file a consolidated federal income tax return. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109), which requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. The consolidated amount of current and deferred tax expense is allocated by applying the provisions of Statement No. 109 to each subsidiary as if it were a separate taxpayer. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes" (APB No. 11). Under APB No. 11, deferred taxes were generally provided to reflect the effect of timing differences on the recognition of revenue and expense determined for financial and income tax reporting purposes. The Tax Reform Act of 1986 repealed the investment tax credit (ITC) as of January 1, 1986, subject to certain transitional rules. ITCs were deferred and are being amortized as a reduction to income tax expense over the estimated service lives of the related assets. Reclassifications Certain reclassifications of prior years' data have been made to conform to 1993 classifications. 2. DEBT Long-Term Long-term debt consists principally of debentures issued by the Company. Interest rates and maturities of the amounts outstanding at December 31 are as follows: Long-term debt outstanding at December 31, 1993 includes $32,000,000 that is callable by the Company. The call prices range from 103.1% to 100.9% of face value, depending upon the remaining term to maturity of the issue. In addition, long-term debt includes $15,000,000 that will become redeemable only on September 15, 1999, at the option of the holders. The redemption prices will be 100% of face value plus accrued interest. On December 16, 1993, the Company sold $20,000,000 of Thirty Year 7% Debentures, due December 1, 2023 and $20,000,000 of Ten Year 6 1/8% Debentures, due December 1, 2003, through a public offering. The Thirty Year 7% Debentures are not redeemable by the Company prior to December 1, 2013. The Ten Year 6 1/8% Debentures are not redeemable by the Company prior to maturity. The net proceeds from these issuances were used on December 31, 1993, to redeem the following debentures: $15,000,000 Forty Year 8 3/4% Debentures due in 2010, at a call price of 103.2% of the principal amount, plus accrued interest from July 1, 1993; $15,000,000 Forty Year 8 1/5% Debentures due in 2011, at a call price of 103.1% of the principal amount, plus accrued interest from August 1, 1993; and $10,000,000 Forty Year 9% Debentures due in 2018, at a call price of 104.5% of the principal amount, plus accrued interest from December 15, 1993. As a result of the early extinguishment of these debentures, the Company recorded a charge of $996,000, net of an income tax benefit of $685,000, in the fourth quarter of 1993. In 1992, the Company recorded a charge associated with the early extinguishment of debentures called by the Company. The financial impact of the early extinguishment of debt was not material. At December 31, 1993, the Company had no amounts outstanding under a shelf registration statement filed with the Securities and Exchange Commission. The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues. At December 31, 1993 and 1992, the fair value of the Company's long-term debt, excluding unamortized discount and premium and capital lease obligations, is estimated at $106,900,000 and $103,100,000, respectively. The Company has entered into an interest rate swap agreement expiring on April 1, 1994, which has the effect of fixing the rate of interest on $5,000,000 of debt at a rate of 3.65%. The fair value of the interest rate swap agreement is the estimated amount that the Company would receive or pay upon termination of the swap agreement at December 31, 1993 and 1992, taking into account current interest rates and the creditworthiness of the swap counterparties. The Company would pay $5,000 to terminate its interest rate swap agreement at December 31, 1993. The Company would have received $38,000 to terminate its interest rate swap agreement at December 31, 1992. Maturing Within One Year Debt maturing within one year consists of the following at December 31: * Amounts represent average daily face amount of the note. ** Weighted average interest rates are computed by dividing the average daily face amount of the note into the aggregate related interest expense. At December 31, 1993, the Company had an unused line of credit balance of $23,500,000 with an affiliate, Bell Atlantic Network Funding Corporation (BANFC) (Note 7). At December 31, 1993 and 1992, the carrying amount of debt maturing within one year, excluding capital lease obligations, approximates fair value. 3. LEASES The Company has entered into both capital and operating leases for facilities and equipment used in operations. Plant, property and equipment included capital leases of $125,000 and $125,000 and related accumulated amortization of $125,000 and $125,000 at December 31, 1993 and 1992, respectively. In 1993, 1992, and 1991, the Company did not incur any initial capital lease obligations. Total rent expense amounted to $3,521,000 in 1993, $7,743,000 in 1992, and $6,059,000 in 1991. Of these amounts, the Company incurred rent expense of $1,693,000, $5,607,000, and $4,167,000 in 1993, 1992, and 1991, respectively, from affiliated companies. At December 31, 1993, the aggregate minimum rental commitments under noncancelable leases for the periods shown are as follows: 4. EMPLOYEE BENEFITS Pension Plans - ------------- Substantially all of the Company's management and associate employees are covered under noncontributory multi-employer defined benefit pension plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The pension benefit formula is based on a flat dollar amount per year of service according to job classification under the associate plan and a stated percentage of adjusted career average earnings under the plans for management employees. The Company's objective in funding the plans is to accumulate funds at a relatively stable level over participants' working lives so that benefits are fully funded at retirement. Plan assets consist principally of investments in domestic and foreign corporate equity securities, U.S. and foreign Government and corporate debt securities, and real estate. Aggregate pension cost for the plans is as follows: The decrease in pension cost in 1993 is due to the net effect of the elimination of one-time charges associated with special termination benefits that were recognized in the preceding years, favorable investment experience, and changes in plan demographics due to retirement and severance programs. In 1992, the Company recognized $634,000 of special termination benefit costs related to the early retirement of associate employees. The special termination benefit costs and the net effect of changes in plan provisions, certain actuarial assumptions, and the amortization of actuarial gains and losses related to demographic and investment experience increased pension cost in 1992. A change in the expected long-term rate of return on plan assets resulted in a $1,017,000 reduction in pension cost (which reduced operating expenses by $915,000 after capitalization of amounts related to the construction program) and substantially offset the 1992 cost increase. Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" (Statement No. 87) requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic pension costs and a reconciliation of the funded status of the plans with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not allow for the determination of this information on an individual participating company basis. Significant actuarial assumptions are as follows: The Company has in the past entered into collective bargaining agreements with unions representing certain employees and expects to do so in the future. Pension benefits have been included in these agreements and improvements in benefits have been made from time to time. Additionally, the Company has amended the benefit formula under pension plans maintained for its management employees. Expectations with respect to future amendments to the Company's pension plans have been reflected in determining the Company's pension cost under Statement No. 87. Postretirement Benefits Other Than Pensions Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," (Statement No. 106). Statement No. 106 requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. In conjunction with the adoption of Statement No. 106, the Company elected, for financial reporting purposes, to recognize immediately the accumulated postretirement benefit obligation for current and future retirees, net of the fair value of plan assets and recognized accrued postretirement benefit cost (transition obligation), in the amount of $26,129,000, net of a deferred income tax benefit of $17,233,000. For purposes of measuring the interstate rate of return achieved by the Company, the FCC permits recognition of postretirement health and life insurance benefit costs, including amortization of the transition obligation, in accordance with the prescribed accrual method included in Statement No. 106. In January 1993, the FCC denied adjustments to the interstate price cap formula which would have permitted tariff increases to reflect the incremental postretirement benefit cost resulting from the adoption of Statement No.106. For intrastate ratemaking purposes, the Delaware Public Service Commission has authorized recognition of postretirement benefit cost on a pay-as-you-go basis. Pursuant to Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71), a regulatory asset associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery given the Company's assessment of its long-term competitive environment. Substantially all of the Company's management and associate employees are covered under multi-employer postretirement health and life insurance benefit plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The determination of benefit cost for postretirement health benefit plans is based on comprehensive hospital, medical, surgical and dental benefit plan provisions. The postretirement life insurance benefit formula used in the determination of postretirement benefit cost is primarily based on annual basic pay at retirement. The Company funds the postretirement health and life insurance benefits of current and future retirees. Plan assets consist principally of investments in domestic and foreign corporate equity securities, and U.S. Government and corporate debt securities. The aggregate postretirement benefit cost for the year ended December 31, 1993, 1992, and 1991 was $4,185,000, $3,743,000, and $3,470,000, respectively. As a result of the 1992 collective bargaining agreements, Bell Atlantic amended the postretirement medical benefit plan for associate employees and certain associate retirees of the Company. The increases in the postretirement benefit cost between 1993 and 1991 were primarily due to the change in benefit levels and claims experience. Also contributing to these increases were changes in actuarial assumptions and demographic experience. Statement No. 106 requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic postretirement benefit costs, and a reconciliation of the funded status of the plan with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not provide for the determination of this information on an individual participating company basis. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 8.25% for 1993 and 1992 and 7.5% for 1991. The medical cost trend rate in 1993 was approximately 13.0%, grading down to an ultimate rate in 2003 of approximately 5.0%. The dental cost trend rate in 1993 and thereafter is approximately 4.0%. Postretirement benefits other than pensions have been included in collective bargaining agreements and have been modified from time to time. The Company has periodically modified benefits under the plans maintained for its management employees. Expectations with respect to future amendments to the Company's postretirement plans have been reflected in determining the Company's postretirement benefit costs under Statement No. 106. Postemployment Benefits Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112). Statement No. 112 requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. This change principally affects the Company's accounting for disability and workers' compensation benefits, which previously were charged to expense as the benefits were paid. The cumulative effect at January 1, 1993 of adopting Statement No. 112 reduced net income by $877,000, net of a deferred income tax benefit of $578,000. The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of operating expense in 1993. 5. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). Statement No. 109 requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11. Statement No. 109 has been adopted on a prospective basis and amounts presented for prior years have not been restated. As of January 1, 1993, the Company recorded a charge to income of $62,000, representing the cumulative effect of adopting Statement No. 109, which has been reflected in Operating Income Taxes of the Statement of Income and Reinvested Earnings. Upon adoption of Statement No. 109, the effects of required adjustments to deferred tax balances were primarily deferred on the balance sheet as regulatory assets and liabilities in accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). At January 1, 1993, the Company recorded income tax-related regulatory assets totaling $15,111,000 in Other Assets. These regulatory assets represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) temporary differences for which deferred taxes had not been provided and (ii) the increase in the deferred state tax liability which resulted from increases in state income tax rates subsequent to the dates the deferred taxes were recorded. In addition, income tax-related regulatory liabilities totaling $23,155,000 were recorded in Deferred Credits and Other Liabilities - Other. These regulatory liabilities represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) a reduced deferred tax liability resulting from decreases in federal income tax rates subsequent to the dates the deferred taxes were recorded and (ii) a deferred tax benefit required to recognize the effects of the temporary differences attributable to the Company's policy of accounting for investment tax credits using the deferred method. These deferred taxes and regulatory assets and liabilities have been increased for the tax effect of future revenue requirements. These regulatory assets and liabilities are amortized at the time the related deferred taxes are recognized in the ratemaking process. Prior to the adoption of Statement No. 109, the Company had income tax timing differences for which deferred taxes had not been provided pursuant to the ratemaking process of $11,132,000 and $1,985,000 at December 31, 1992 and 1991, respectively. These timing differences principally related to the allowance for funds used during construction and certain taxes and payroll-related construction costs capitalized for financial statement purposes, but deducted currently for income tax purposes, net of applicable depreciation. At December 31, 1992 and 1991, deferred state taxes had not been provided on an additional $34,620,000 and $39,718,000, respectively, of income tax timing differences, principally related to accelerated tax depreciation. The Omnibus Budget Reconciliation Act of 1993, which was enacted in August 1993, increased the federal corporate income tax rate from 34% to 35%, effective January 1, 1993. In the third quarter of 1993, the Company recorded a net charge to the tax provision of $155,000, which included a $563,000 charge for the nine month effect of the 1% rate increase, largely offset by a one-time net benefit of $408,000 related to adjustments to deferred tax assets associated with the postretirement benefit obligation of the Company. Pursuant to Statement No. 71, the effect of the income tax rate increase on the deferred tax balances was primarily deferred through the establishment of regulatory assets of $478,000 and the reduction of regulatory liabilities of $1,725,000. The Company did not recognize regulatory assets and liabilities related to the postretirement benefit obligation or the associated deferred income tax asset. The components of income tax expense are as follows: Income tax expense (benefit) which relates to non-operating income and expense and is included in Miscellaneous-net was $(230,000), $41,000, and $(193,000) in 1993, 1992, and 1991, respectively. For the years ended December 31, 1992 and 1991, deferred income tax expense resulted from timing differences in the recognition of revenue and expense for financial and income tax accounting purposes. The sources of these timing differences and the tax effects of each were as follows: The provision for income taxes varies from the amount computed by applying the statutory federal income tax rate to income before provision for income taxes. The difference is attributable to the following factors: At December 31, 1993, the significant components of deferred tax assets and liabilities were as follows: Total deferred tax assets include approximately $20,000,000 related to postretirement benefit costs recognized in accordance with Statement No. 106. This deferred tax asset will gradually be realized over the estimated lives of current retirees and employees. 6. SUPPLEMENTAL CASH FLOW AND ADDITIONAL FINANCIAL INFORMATION For the years ended December 31, 1993, 1992, and 1991, revenues generated from services provided to AT&T, principally network access, billing and collection, and sharing of network facilities, were $25,842,000, $28,128,000, and $30,554,000, respectively. At December 31, 1993 and 1992, Accounts receivable, net, included $463,000 and $484,000, respectively, from AT&T. Financial instruments that potentially subject the Company to concentrations of credit risk consist of trade receivables with AT&T, as noted above. Credit risk with respect to other trade receivables is limited due to the large number of customers included in the Company's customer base. 7. TRANSACTIONS WITH AFFILIATES The Company has contractual arrangements with an affiliated company, Bell Atlantic Network Services, Inc. (NSI), for the provision of various centralized corporate, administrative, planning, financial and other services. These arrangements serve to fulfill the common needs of Bell Atlantic's telephone subsidiaries on a centralized basis. In connection with these services, the Company recognized $38,438,000, $36,905,000, and $34,285,000 in operating expenses for the years ended December 31, 1993, 1992, and 1991, respectively. Included in these expenses were $2,999,000 in 1993, $4,001,000 in 1992, and $3,269,000 in 1991 billed to NSI and allocated to the Company by Bell Communications Research, Inc., another affiliated company owned jointly by the seven regional holding companies. In 1991, these charges included $888,000 associated with NSI's adoption of Statement No. 106. In addition, in 1991, the Company recognized a charge of $8,973,000 representing the Company's proportionate share of NSI's accrued transition obligation under Statement No. 106. In connection with the adoption of Statement No. 112 in 1993, the cumulative effect included $161,000, net of a deferred income tax benefit of $106,000, representing the Company's proportionate share of NSI's accrued cost of postemployment benefits at January 1, 1993. The Company has a contractual agreement with an affiliated company, BANFC, for the provision of short-term financing and cash management services. BANFC issues commercial paper and secures bank loans to fund the working capital requirements of the telephone subsidiaries and NSI and invests funds in temporary investments on their behalf. In connection with this arrangement, the Company recognized interest expense of $109,000, $129,000, and $113,000 in 1993, 1992, and 1991, respectively, and $62,000, $45,000, and $85,000 in interest income in 1993, 1992, and 1991, respectively. In 1993, the Company received $561,000 in revenue from affiliates, principally, related to rent received for the use of Company facilities and equipment, and paid $4,284,000 in other operating expenses to affiliated companies. These amounts were $634,000 and $5,607,000, respectively, in 1992 and $754,000 and $4,167,000, respectively, in 1991. On February 1, 1994, the Company declared and paid a dividend in the amount of $10,060,000 to Bell Atlantic. 8. QUARTERLY FINANCIAL INFORMATION (unaudited) Net income for the first quarter of 1993 has been restated to include a charge of $877,000, net of a deferred income tax benefit of $578,000, related to the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Note 4). 9. REGULATORY MATTERS In November 1993, the Delaware Public Service Commission (PSC) issued its opinion and order on Docket No. 92-47 approving a $3,800,000 annual intrastate revenue increase based on a stipulated 10.58% overall rate of return. After petition for reargument of the PSC decision, the Company entered into an agreement with the Office of Public Advocate which stipulated: (i) an increase in the Company's revenue award of $1,500,000 over the originally awarded $3,800,000; (ii) no increase on residence dial tone line rates beyond the level specified in the stipulation until January 1, 1997; (iii) the Company would forgo its right to appeal the PSC decision in Docket No. 92-47. The PSC approved this stipulation on December 6, 1993. The Company put final rates into effect on December 15, 1993. Amounts which were previously collected from residence customers under temporary increases were refunded for the amount in excess of the final residence dial tone line rate. Refunds totaling approximately $5,800,000 were paid through a one-time credit on residence bills beginning February 1, 1994. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1993 (Dollars in Thousands) The notes on page are an integral part of this schedule. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1992 (Dollars in Thousands) The notes on page are an integral part of this schedule. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1991 (Dollars in Thousands) The notes on page are an integral part of this schedule. NOTES TO SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT - -------------- (a) These additions include (1) the original cost (estimated if not specifically determinable) of reused material, which is concurrently credited to material and supplies, and (2) allowance for funds used during construction. Transfers between Plant in Service, Plant Under Construction and Other are also included in Additions at Cost. (b) Items of plant, property and equipment are deducted from the property accounts when retired or sold at the amounts at which they are included therein, estimated if not specifically determinable. (c) The Company's provision for depreciation is principally based on the remaining life method and straight-line composite rates prescribed by regulatory authorities. The remaining life method provides for the full recovery of the remaining net investment in plant, property and equipment. In 1991, the Company implemented changes in depreciation rates approved by regulatory authorities. These changes reflect decreases in estimated service lives of the Company's plant, property and equipment in service. This ruling will allow a more rapid recovery of the Company's investment in plant, property and equipment through closer alignment with current estimates of its remaining economic useful life. For the years 1993, 1992, and 1991, depreciation expressed as a percentage of average depreciable plant was 6.5%, 6.4%, and 6.2%, respectively. (d) See Note 1 of Notes to Financial Statements for the Company's depreciation policies. SCHEDULE VI - ACCUMULATED DEPRECIATION For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) - ---------------------------------------- (a) Includes any gains or losses on disposition of plant, property and equipment. These gains and losses are amortized to depreciation expense over the remaining service lives of remaining net investment in plant, property and equipment. SCHEDULE VIII - VALUATION OF QUALIFYING ACCOUNTS For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) - ------------------------------------------- (a) (i) Amounts previously written off which were credited directly to this account when recovered; and (ii) accruals charged to accounts payable for anticipated uncollectible charges on purchases of accounts receivable from others which were billed by the Company. (b) Amounts written off as uncollectible. Bell Atlantic - Delaware, Inc. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) Advertising costs for 1993, 1992, and 1991 are not presented, as such amounts are less than 1 percent of total operating revenues. Amounts reported for 1992 and 1991 for maintenance and repairs have been revised to include certain additional costs. EXHIBITS FILED WITH ANNUAL REPORT FORM 10-K UNDER THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 Bell Atlantic - Delaware, Inc. COMMISSION FILE NUMBER 1-7757 Form 10-K for 1993 File No. 1-7757 Page 1 of 1 EXHIBIT INDEX Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. Exhibit Number (Referenced to Item 601 of Regulation S-K) - --------------------------------------------------------- 3a Certificate of Incorporation of the registrant, as amended and restated June 17, 1987 (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1987, File No. 1-7757) 3a(i) Certificate of Amendment of Certificate of Incorporation dated August 14, 1992 (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-7757) 3a(ii) Certificate of Amendment of Certificate of Incorporation, dated January 10, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended through January 27, 1994. 4 No instrument which defines the rights of holders of long and intermediate term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 10b Agreement Among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 24 Powers of attorney.

842461_1993.txt

842461_1993

1993

842461

ITEM 1. BUSINESS OF THE COMPANY. GENERAL Signal Capital Holdings Corporation ("SCHC" or herein together with its consolidated affiliates called the "Company") is engaged in (i) rail car leasing by Itel Rail Corporation and its subsidiaries and affiliates (collectively "Rail") (see discussion below of the 1992 rail car transaction for the limited nature of the Company's continuing interest in this business) and (ii) financing services. In 1993 and 1992, Rail sold substantially all of its other transportation services assets, except for one short-line railroad which is currently being held for sale. The financing services business has been held for sale as discussed below. For further information see Item 7 -- Financial Liquidity and Capital Resources -- Asset Sales and Note 4 of the Notes to the Consolidated Financial Statements. The Company is an indirect wholly-owned subsidiary of Itel Corporation ("Itel"). At December 31, 1993 the Company and its subsidiaries employed approximately 220 persons. RAIL CAR LEASING In June 1992, Itel and Rail completed a transaction with General Electric Capital Corporation and certain of its affiliates ("GECC") pursuant to which Rail contributed substantially all of its owned rail cars, subject to approximately $170 million of debt, to a trust (the "Trust") of which Rail, following the late 1993 distribution of 30% of its ownership to the parent company of SCHC, Rail Holdings Corporation ("RHC"), currently is a 69% beneficiary. The Trust contributed these rail cars, subject to the debt, along with other rail cars the Trust received as a contribution from its 1% beneficiary, to a partnership (the "Partnership") of which the Trust is a 99% partner. The Partnership assumed the Rail debt and leased all of the contributed rail cars along with the other rail cars it received as a contribution from its other partners to a subsidiary of GECC ("Lessee"). The leases (the "Leases") terminate in the year 2004 with fixed rentals of approximately $153 million annually. The Leases include the grant to the Lessee of an assignable fixed price purchase option at the end of the term of the Leases for all, but not less than all, of the rail cars for approximately $500 million. The Leases are net leases under which the Lessee will be responsible for maintenance and other expenses of the rail cars and all obligations of the Lessee are unconditionally guaranteed by GECC. Rail also assigned to GECC, for certain contingent consideration, substantially all of its contracts to lease rail cars from others. The Lessee has an annual obligation to make certain contingent payments to the Partnership in addition to basic rent ("Basic Rent") as defined in the Leases. Prior to the rail car transaction, most of Rail's cars other than boxcars were leased to major railroads and shippers under fixed-rate leases which were typically one to five years in length. The majority of these leases required Rail to maintain the cars and provide other administrative services. The utilization of grain hoppers was affected by, among other things, export demand, domestic trade policies and weather. Prior to the rail car transaction, most of Rail's boxcars were leased to small railroads and used primarily for transportation by the paper and forest product industries. A majority of these leases were long-term "per diem" leases. Per diem leases did not require fixed rental payments. Instead, the rental paid by the lessee was a percentage of the use charges ("car hire") earned by the lessee railroad for the use of the leased equipment on the tracks of other railroads. ASSETS HELD FOR SALE The principal assets held for sale at December 31, 1993 are the Company's financing services business ("Finance"). Itel acquired Finance in connection with the purchase of Pullman Leasing Company ("PLC") in 1988. Finance, which includes equipment leases, senior and subordinated loans and other related investments, has been classified as assets held for sale in the Company's consolidated financial statements since its acquisition. The finance business is being liquidated and no material amounts of new loans or investments are being made by Finance. Since the date of acquisition the portfolio has been reduced from $1.44 billion to $175 million at December 31, 1993, including reductions of $82 million, $82 million and $157 million in 1993, 1992 and 1991, respectively. All cash proceeds were used to repay indebtedness (see Note 4 of the Notes to the Consolidated Financial Statements). ITEM 2. ITEM 2. PROPERTIES. See Item 1 -- Business of the Company -- Rail Car Leasing and the Consolidated Financial Statements. The Company's rail cars have been leased to GECC under the Leases. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In the ordinary course of business, SCHC and its subsidiaries become involved as plaintiffs or defendants in various legal proceedings. The claims and counterclaims in such litigation, including those for punitive damages, individually in certain cases and in the aggregate, involve amounts which may be material. However, it is the opinion of the Company's management, based upon the advice of its counsel, that the ultimate disposition of pending litigation will not be material. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The common stock of SCHC is wholly-owned by an indirect wholly-owned subsidiary of Itel. Therefore, there is no trading market in SCHC's stock. SCHC has 1,000 shares of common stock outstanding, which is its only class of stock. Dividends declared on SCHC common stock were $148 million, $500 million and none for the years ended 1993, 1992 and 1991, respectively. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. BASIS OF PRESENTATION The Company intends to sell Finance, which includes senior, subordinated lending and specialized loans, and has classified it as assets held for sale in the Company's consolidated balance sheets since acquisition by Itel in 1988. The results of Finance have been classified as assets held for sale in the Company's consolidated statements of operations since acquisition. FINANCIAL LIQUIDITY AND CAPITAL RESOURCES Rail Car Transaction: In June 1992, Itel and Rail completed a transaction with GECC pursuant to which Rail contributed substantially all of its owned rail cars, subject to approximately $170 million of debt, to a Trust of which Rail, following the late 1993 distribution of 30% of its ownership to RHC, currently is a 69% beneficiary. The Trust contributed these rail cars, subject to the debt, along with other rail cars the Trust received as a contribution from its 1% beneficiary, to a Partnership of which the Trust is a 99% partner. The Partnership assumed the Rail debt and leased all of the contributed rail cars along with the other rail cars it received as a contribution from its other partners to the Lessee. The Leases terminate in the year 2004 with fixed rentals of approximately $153 million annually. The Leases include the grant to the Lessee of an assignable fixed price purchase option at the end of the term of the Leases for all, but not less than all, of the rail cars for approximately $500 million. The Leases are net leases under which the Lessee will be responsible for maintenance and other expenses of the rail cars and all obligations of the Lessee are unconditionally guaranteed by GECC. Rail also assigned to GECC, for certain contingent consideration, substantially all of its contracts to lease rail cars from others. The Lessee has an annual obligation to make certain contingent payments to the Partnership in addition to Basic Rent as defined in the Leases. In late 1993 the Company distributed 30% of its ownership in the Trust to RHC its parent. Since the Company's investment in the Trust is a net deficit, and because the transaction is between related parties, the Company did not recognize any gain in operations. The Company reflected directly in shareholder's equity an increase representing the distribution of the 30% negative investment offset by a decrease representing the minority interest receivable created at date of transfer. In addition, RHC has agreed to forgive or assume any additional income taxes of the Company due to the excess of fair market value over recorded value of the distributed investment in the Trust, and to defer the date for payment of previously recorded intercompany income taxes related to the distribution. Accordingly, such additional taxes were not charged against shareholder's equity. Liquidation of Finance: Finance has been classified as assets held for sale since acquisition in connection with the purchase of PLC in 1988. The finance business is being liquidated and no material amounts of new loans or investments are being made by Finance. Since the date of acquisition the portfolio has been reduced from $1.44 billion to $175 million at December 31, 1993, including reductions of $82 million, $82 million and $157 million in 1993, 1992 and 1991, respectively. Other Dispositions: In 1993 and 1992, the Company sold substantially all of its other transportation services assets, except for one of its short-line railroads which is currently being held for sale. Proceeds from the sales were used to reduce debt. Financings: In June 1992, the Trust issued $998 million of 7 3/4% Notes (the "Trust Notes"). The Trust Notes mature through 2004 and are secured by the Trust's ownership interest in the Partnership. The net proceeds from the Trust Notes were used to repay certain senior indebtedness of Rail, affiliated notes payable and to pay a dividend of $500 million. Debt Maturities and Repayments: Current maturities of long-term debt of $67.8 million at December 31, 1993 represent debt related to the Partnership and the Trust. With the completion of the rail car transaction in June 1992, the ongoing fixed cash flow of SCHC's rail car leasing business is available only to service interest and principal on the Trust and Partnership debt. CAPITAL EXPENDITURES Capital expenditures were zero, $9.0 million and $64.7 million for 1993, 1992 and 1991, respectively, primarily for rail cars. Due to the rail car transaction, future rail car leasing capital expenditures, if any, will be funded from the proceeds of any dispositions of the rail cars involved in that transaction. RESULTS OF OPERATIONS As a result of the rail car transaction with GECC in June 1992, the revenues and operating income of rail car leasing, though essentially fixed, are lower than such results prior to the rail car transaction. The ongoing fixed cash flow of rail car leasing is available only to service interest and principal on the Trust and Partnership debt. 1993 Compared to 1992. Total revenues for the Company decreased to $153.0 million in 1993 compared to $217.5 million in 1992 due to the effect of the rail car transaction. Operating income was $89.7 million in 1993 compared to $86.1 million in 1992. Results in 1992 include a $19.9 million non-recurring operating charge relating to the rail car transaction. Interest expense and other, net increased to $91.9 million in 1993 compared to $83.9 million in 1992 due primarily to the significant dividend payments in 1993 and 1992. Loss from continuing operations was ($18.9) million in 1993 in comparison to ($.6) million for 1992. In 1993, the Company wrote down miscellaneous investments and certain non-operating assets incurring a $17.6 million pre-tax non-recurring charge. Net loss was ($3.8) million and ($6.1) million for the years ended December 31, 1993 and 1992, respectively. Income (loss) from discontinued operations was $3.2 million and ($9.5) million in 1993 and 1992, respectively. Results in 1992 include a ($14.1) million net loss related to the sale of certain other transportation services assets. Income from assets held for sale was $12.0 million and $15.2 million in 1993 and 1992, respectively. The Company retired approximately $119 million of the face value of certain of its senior secured debt resulting in an extraordinary pre-tax loss of ($17.9) million in 1992. IMPACT OF INFLATION Due to the rail car transaction, inflation is currently not an important determinant of the Company's results of operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The response to this item is submitted as a separate section of this report starting on page. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL STATEMENT DISCLOSURE. Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) and (2) -- The response to this portion of Item 14 is submitted as a separate section of this report starting on page. (3) Listing of Exhibits. - --------------- * The Company or consolidated subsidiaries of the Company are also parties to other instruments defining the rights of holders of long-term debt of the Company or its consolidated subsidiaries where the total indebtedness authorized under each such agreement does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis. Pursuant to Item 601(b)(4)(iii) of Regulation S-K, the Company is not filing such instruments. The Company hereby undertakes to furnish to the Securities and Exchange Commission upon request copies of any or all such instruments. + Incorporated by reference to Signal Capital Holdings Corporation's Annual Report on Form 10-K, for the fiscal year ended December 31, 1988, as the same numbered exhibit. (b) Reports on Form 8-K. None. 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. SIGNAL CAPITAL HOLDINGS CORPORATION March 25, 1994 By: /s/ ROD F. DAMMEYER Rod F. Dammeyer President 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 DATE INDICATED. ITEM 14(A)(1) AND (2) AND ITEM 14(D) SIGNAL CAPITAL HOLDINGS CORPORATION ANNUAL REPORT ON FORM 10-K INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES All other schedules are omitted because they are not required or are not applicable, or the required information is included in the consolidated financial statements or notes thereto. REPORT OF INDEPENDENT AUDITORS The Board of Directors Signal Capital Holdings Corporation We have audited the accompanying consolidated balance sheets of Signal Capital Holdings Corporation as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholder's equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Signal Capital Holdings Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Chicago, Illinois February 8, 1994 SIGNAL CAPITAL HOLDINGS CORPORATION CONSOLIDATED BALANCE SHEETS ASSETS See accompanying Notes to the Consolidated Financial Statements. SIGNAL CAPITAL HOLDINGS CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS See accompanying Notes to the Consolidated Financial Statements. SIGNAL CAPITAL HOLDINGS CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying Notes to the Consolidated Financial Statements. SIGNAL CAPITAL HOLDINGS CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying Notes to the Consolidated Financial Statements. SIGNAL CAPITAL HOLDINGS CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION A. General Signal Capital Holdings Corporation ("SCHC" or herein together with its consolidated affiliates called the "Company") is engaged primarily in the leasing of railroad freight cars (see discussion below of the rail car transaction). The Company intends to sell its financing services business ("Finance"). Finance, which includes senior and subordinated loans, has been classified as assets held for sale in the Company's consolidated balance sheets since acquisition by Itel Corporation ("Itel") in 1988. The results of operations of Finance have been classified as assets held for sale in the Company's consolidated statements of operations since acquisition. The Company is an indirect wholly-owned subsidiary of Itel. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. Principles of Consolidation The consolidated financial statements include the accounts of SCHC, its wholly-owned subsidiaries and majority-owned affiliates after elimination of intercompany accounts and transactions. Minority interest primarily consists of GECC's ownership of the Partnership (see Note 3) and Railcar Services Corporation's, a Delaware special purpose corporation (the "SPC"), interest in the Trust (see Note 3). The SPC is owned by current and former officers and employees of Itel and Itel Rail Corporation and its subsidiaries (collectively "Rail"). B. Reclassifications The 1992 and 1991 consolidated financial statements and related notes have been reclassified to reflect the 1993 presentation. The Company adopted the Statements of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" and No. 115, "Accounting for Certain Investments in Debt and Equity Securities" at December 31, 1993. The effect on the Consolidated Financial Statements was immaterial. C. Revenue Recognition With the completion of the rail car transaction in June 1992, the revenues and operating income of the rail car leasing business, though essentially fixed, are lower than such results prior to the rail car transaction. The ongoing fixed cash flow of the rail car leasing business is available only to service interest and principal on the debt of the Trust and Partnership (see Note 3). Prior to the rail car transaction, fixed rate leases in the Company's rail car leasing business were accounted for either as operating leases or as finance leases. Rentals from fixed rate leases accounted for as operating leases were recognized as earned. Variable rate leases were treated as operating leases and earned revenues primarily from usage fees prescribed by the Interstate Commerce Commission. These fees consisted of per diem and mileage charges and were recognized as earned. Some variable rate all-mileage leases were based on tariff agreements between railroads and shippers. D. Cash and Equivalents and Restricted Cash The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Due to the short maturity of these instruments the carrying amount approximates fair value. Restricted cash consists primarily of cash to be used for interest and principal on the debt related to the Trust and the Partnership (see Note 3). SIGNAL CAPITAL HOLDINGS CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) E. Depreciation The Company provides for depreciation of property principally on the straight-line basis over the term of the Leases (see Note 3) for rental equipment -- rail cars and the term of the lease for leasehold improvements. Prior to the rail car transaction, rental equipment was depreciated on the straight-line basis over 12 to 35 years. F. Goodwill Goodwill relates to the purchase of Pullman Leasing Company ("PLC") in 1988. The Company at each balance sheet date evaluates, for recognition of potential impairment, its recorded goodwill against current and undiscounted expected future operating income before goodwill amortization expense. Such goodwill was initially amortized over 40 years using the straight-line method. Effective June 1, 1992 in connection with the rail car transaction, goodwill is being amortized over the term of the Leases (see Note 3). G. Investment in and Advances to Q-TEL S.A. de C.V. of Mexico ("Q-TEL") Investment in and advances to Q-TEL, formerly Quadrum, include a 19% equity interest in Q-TEL and at December 31, 1993 a $6 million loan. The 1993 non-recurring items include a write-down of the Company's investment in Q-TEL to net realizable value. H. Amounts due to (from) Affiliates The Company pays or receives interest on accounts with affiliates at market rates. Intercompany interest expense for continuing operations in 1993, 1992 and 1991 was zero, $6.9 million and $18.9 million, respectively. Itel charges the Company on a monthly basis for expenses identifiable to the Company's operations and management. Such charges were approximately $1.6 million, $2.3 million and $3.1 million in 1993, 1992 and 1991, respectively. I. Income Taxes The Company joins in the filing of a consolidated Federal income tax return with Itel. The Company and Itel entered into a tax-sharing agreement ("Tax Agreement"). Under the terms of the Tax Agreement, the Company, excluding Rail, and Rail each provide for and pay federal and certain state income taxes to Itel as though they are stand-alone taxpayers. Other state income and foreign taxes are expensed as incurred. Provisions for income taxes include deferred taxes resulting from temporary differences in income for financial and tax purposes using the liability method. Such temporary differences result primarily from differences in the carrying value of assets and liabilities. 3. RAIL CAR TRANSACTION On December 31, 1991, Rail and General Electric Capital Corporation and certain of its affiliates ("GECC"), an indirect wholly-owned subsidiary of General Electric Company ("GE"), agreed that Rail would transfer certain rail cars to a trust (the "Trust") subject to approximately $170 million of existing indebtedness ("Assumed Indebtedness"), together with certain contracts (including current end-user leases) relating to such rail cars and cash in an amount necessary to fund payments on such Assumed Indebtedness prior to the first rental payment date under the leases described below. On June 1, 1992, the Trust contributed all of the rail cars, subject to all of the aforementioned Assumed Indebtedness and together with all of the aforementioned contracts, to a partnership (the "Partnership"). In addition, the SPC contributed certain rail cars having a value equal to approximately 1% of the value of the rail cars to be contributed by Rail to the Trust. The SPC is owned by current and former officers and employees of Itel and Rail. GE Railcar Associates, Inc. ("Associates") and GE Railcar Leasing Associates, SIGNAL CAPITAL HOLDINGS CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Inc. ("GE Leasing"), each an indirect wholly-owned subsidiary of GE, also contributed certain rail cars, together with certain contracts relating to such rail cars, to the Partnership. The Trust is a 64.00% general partner and a 34.99% limited partner in the Partnership. Associates is a 1.00% general partner and the managing general partner for the Partnership. GE Leasing is a 0.01% limited partner in the Partnership. In connection with the transactions described above, the Partnership assumed the Assumed Indebtedness, which is secured by certain of the rail cars, and agreed to pay all amounts owing thereunder as they become due. The Assumed Indebtedness is being serviced out of rental receipts by the Partnership pursuant to the leases (the "Leases") between the Partnership and a subsidiary of GECC (the "Lessee"). The Leases between the Partnership and the Lessee were executed on June 1, 1992. The Leases expire in 2004, with fixed rentals of approximately $153 million annually. The Lessee shall not have the right to terminate the Leases, except in the limited circumstances specifically provided therein. The Leases include the grant to the Lessee of an assignable fixed price purchase option at the end of the term of the Leases for all, but not less than all, of the rail cars for approximately $500 million. The Leases are net leases under which the Lessee is responsible for maintenance, taxes, insurance and other expenses of the rail cars. Payments of basic rent ("Basic Rent") to the Partnership by the Lessee under the Leases are paid quarterly by the Lessee. The Lessee's obligations to pay Basic Rent and interest, if any, thereon are absolute and unconditional in all circumstances and shall generally not be subject to any reduction or setoff. All payments under the Leases, including Basic Rent, are unconditionally guaranteed by GECC. Rail also assigned to GECC, for certain contingent consideration, substantially all of its contracts to lease rail cars from others. The Lessee has an annual obligation to make certain contingent payments to the Partnership in addition to Basic Rent as defined in the Leases. No contingent payments were received in 1993 and 1992. In connection with the completion of the rail car transaction, the Trust issued $998 million of 7 3/4% Trust Notes (the "Trust Notes"). The Trust Notes mature through 2004 and are secured by the Trust's ownership interest in the Partnership. Results in 1992 include $19.9 million of pre-tax non-recurring operating costs relating to the rail car transaction. In late 1993 the Company distributed 30% of its ownership in the Trust to Rail Holdings Corporation ("RHC") its parent. Since the Company's investment in the Trust is a net deficit, and because the transaction is between related parties, the Company did not recognize any gain in operations. The Company reflected directly in shareholder's equity an increase representing the distribution of the 30% negative investment offset by a decrease representing the minority interest receivable created at date of transfer. In addition, RHC has agreed to forgive or assume any additional income taxes of the Company due to the excess of fair market value over recorded value of the distributed investment in the Trust, and to defer the date for payment of previously recorded intercompany income taxes related to the distribution. Accordingly, such additional taxes were not charged against shareholder's equity. 4. DISCONTINUED AND ASSETS HELD FOR SALE In 1993 and 1992, the Company sold substantially all of its other transportation services assets, except for one short-line railroad which is currently being held for sale, for aggregate net cash proceeds of $54 million. The Company recorded a $23 million pre-tax loss in 1992 in discontinued operations to reflect the disposal of this segment. SIGNAL CAPITAL HOLDINGS CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Finance has been included as assets held for sale since acquisition in connection with the purchase of PLC in 1988. The finance business is being liquidated and no material amounts of new loans or investments are being made by Finance. Since the date of acquisition the portfolio has been reduced from $1.44 billion to $175 million at December 31, 1993, including a reduction of $82 million, $82 million and $157 million in 1993, 1992 and 1991, respectively. Proceeds were used to repay indebtedness. Summarized financial results of discontinued operations and assets held for sale were as follows: The composition of remaining discontinued and assets held for sale, net consisted of the following: 5. NON-RECURRING ITEMS The non-recurring pre-tax loss in 1993 principally relates to the write-down of miscellaneous investments and certain non-operating assets to net realizable value. SIGNAL CAPITAL HOLDINGS CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 6. EXTRAORDINARY ITEMS The Company retired approximately $119 million of the face value of certain of its senior secured debt resulting in an extraordinary pre-tax loss of ($17.9) million in 1992. 7. ACCRUED EXPENSES AND ACCOUNTS PAYABLE Accrued expenses and accounts payable consisted of the following: 8. DEBT Debt consisted of the following: Trust Notes: In connection with the completion of the rail car transaction (see Note 3), the Trust issued $998 million of 7 3/4% Trust Notes. The Trust Notes are non-recourse to SCHC, mature through 2004 and are secured by the Trust's ownership interest in the Partnership, which holds substantially all of the rail cars formerly operated by Rail. The net proceeds from the Trust Notes were used to repay certain senior indebtedness of Rail, affiliated notes payable and to pay a dividend of $500 million. Equipment Trust Certificates ("ETCs") and Other Secured Indebtedness -- Rail has ETCs and other secured indebtedness outstanding with interest rates ranging from 9.5% to 11.1% which mature at various times through 2003. This debt has annual sinking fund requirements. With the completion of the rail car transaction in June 1992, the ongoing fixed cash flow of the Company's rail car leasing business is available only to service interest and principal on the debt of the Trust and Partnership. The aggregate annual maturities of long-term debt are as follows: 1994 -- $67.8 million; 1995 -- $73.7 million; 1996 -- $79.8 million; 1997 -- $84.8 million and 1998 -- $111.0 million. The Company's debt agreements are secured by assets with an aggregate net book value of approximately $1.1 billion. The fair value of the Company's debt is approximately $1.2 billion and is estimated based on quoted market prices. SIGNAL CAPITAL HOLDINGS CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 9. RECEIVABLES FROM AFFILIATES The receivables from affiliates at December 31, 1993 and 1992 are $139.4 million and $135.5 million, respectively, accrue interest at an annual rate equal to the prime rate and are due upon demand. 10. INCOME TAXES Deferred income taxes reflect the impact of temporary differences between amounts of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws. Deferred income taxes also result from differences between the fair value of assets acquired in business combinations accounted for as purchases and their tax bases. Significant components of the Company's deferred tax liabilities were as follows: Income tax (expense) benefit relating to operations was comprised of the following: SIGNAL CAPITAL HOLDINGS CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Reconciliations of income tax (expense) benefit in continuing operations to the statutory corporate Federal tax rate, 35% in 1993 and 34% in 1992 and 1991, were as follows: The income tax effects of items comprising the deferred income tax (expense) benefit were as follows: 11. CONTINGENCIES AND LITIGATION In the ordinary course of business, the Company becomes involved as plaintiffs or defendants in various legal proceedings. The claims and counterclaims in such litigation, including those for punitive damages, individually in certain cases and in the aggregate, involve amounts which may be material. However, it is the opinion of the Company's management, based upon the advice of its counsel, that the ultimate disposition of pending litigation will not be material. 12. PENSION PLAN AND POST-RETIREMENT BENEFITS The Company's employees are covered under Itel's pension plan which is noncontributory and covers substantially all full-time domestic employees except for certain employees who are covered by collective bargaining agreements. The pension plan assets are held in trust for the benefit of its participants. Itel's policy is to fund the plan as required by ERISA. Contributions, accrued pension expenses and the costs of 401(k) plans relating to the Company for 1993, 1992 and 1991 were insignificant. The Company's liability for post-retirement benefits is insignificant. SIGNAL CAPITAL HOLDINGS CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 13. SUMMARIZED FINANCIAL DATA SCHC has provided full and unconditional guarantees of certain Rail indebtedness registered with the Securities and Exchange Commission ("SEC"), which in 1992 was assumed by the Partnership. Pursuant to SEC regulations, summarized financial information for Rail is as follows: ITEL RAIL CORPORATION AND CONSOLIDATED AFFILIATES CONDENSED CONSOLIDATED BALANCE SHEETS ITEL RAIL CORPORATION AND CONSOLIDATED AFFILIATES CONDENSED CONSOLIDATED RESULTS OF OPERATIONS SIGNAL CAPITAL HOLDINGS CORPORATION SUMMARY QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The following tables summarize the Company's quarterly financial information. QUARTERLY INFORMATION: - --------------- (a) With the completion of the rail car transaction in June 1992, the revenues and operating income of the rail car leasing business, though essentially fixed are lower than such results prior to the rail car transaction. The ongoing fixed cash flow of the Company's rail car leasing business is available only to service interest and principal on the debt of the Trust and Partnership. (b) Operating income in the second quarter of 1992 includes a $19.9 million non-recurring operating charge relating to severance and transition costs due to the rail car transaction. (c) Continuing operations in 1993 include a $17.6 million non-recurring pre-tax loss principally relating to the write-down of miscellaneous investments and certain non-operating assets to net realizable value. (d) Income from discontinued operations and assets held for sale, net in 1992 include a $22.7 million pre-tax loss related to the sale of certain other transportation services assets. (e) The extraordinary items in 1992 reflect a pre-tax loss of $17.9 million on the retirement of the Company's senior secured debt. SIGNAL CAPITAL HOLDINGS CORPORATION SCHEDULE II AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) S-1 SIGNAL CAPITAL HOLDINGS CORPORATION SCHEDULE IV INDEBTEDNESS OF AND TO RELATED PARTIES -- NON CURRENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) S-2 SIGNAL CAPITAL HOLDINGS CORPORATION SCHEDULE V -- PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) S-3 SIGNAL CAPITAL HOLDINGS CORPORATION SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) S-4 SIGNAL CAPITAL HOLDINGS CORPORATION SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) S-5

725457_1993.txt

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ITEM 3. LEGAL PROCEEDINGS The company is a party to various pending legal proceedings, claims and assessments arising in the course of its business activities, including actions relating to trade practices, personal injury or property damage, alleged breaches of contracts, torts, labor matters, employment practices, tax matters and miscellaneous other matters. Some of these proceedings involve claims for punitive damages, in addition to other specific relief. Among these actions are approximately 710 cases pending against the company, together with numerous other ship owners and equipment manufacturers, involving injuries or illnesses allegedly caused by exposure to asbestos or other toxic substances on ships. In one case, Miller, Administrator of Estate of Moline vs. American Mail Line, et. al., U.S. District Court, Northern District of Ohio, C86-821, a judgment was entered in May 1991 awarding punitive damages of $50,000 per named defendant, along with compensatory damages aggregating $166,000. In March 1993, the U.S. Court of Appeals for the Sixth Circuit vacated the punitive damages award, holding that punitive damages are not available in a general maritime unseaworthiness action for wrongful death of a seaman, remanded the case for consideration of defendants' claims for indemnity and contribution, and otherwise affirmed the judgment of the District Court. The plaintiff filed a petition for certiorari with the U.S. Supreme Court in August 1993. The court refused review of the case without comment on October 12, 1993. The company insures its potential liability for bodily injury to seamen through mutual insurance associations. Industry-wide resolution of asbestos- related claims at significantly higher than expected amounts could result in additional contributions to those associations. In December 1989, the government of Guam filed a complaint with the Federal Maritime Commission ("FMC") alleging that American President Lines, Ltd. and an unrelated company charged excessive rates for carrying cargo between the U.S. and Guam, in violation of the Shipping Act, 1916 and the Intercoastal Shipping Act of 1933, and seeking an undetermined amount of reparations. Three private shippers are also complainants in this proceeding. Evidentiary hearings are continuing and a decision by the FMC is not expected until late 1994 or 1995. In March 1992, in connection with the same matter, the government of Guam and four private shippers filed a class action complaint in the United States District Court, District of Columbia, based on the same allegations, seeking an undetermined amount of damages on behalf of all shippers of cargo to and from Guam on the company's vessels and the vessels of the other named defendant. In January 1993, the class action complaint was dismissed. An appeal of the dismissal was filed in the U.S. Court of Appeals for the Circuit of the District of Columbia in February 1993. Based upon information presently available, and in light of legal and other defenses and insurance coverage and other sources of payment available to the company, management does not expect the legal proceedings described, individually or in the aggregate, to have a material adverse impact on the company's consolidated financial position or operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of the company's security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The company's Common Stock is traded on the New York and Pacific Stock Exchanges using the symbol APS. The reported high and low closing sales prices per share of the company's Common Stock and cash dividends declared for the preceding eight fiscal quarters are set forth in Note 12 to the consolidated financial statements, Part II, Item 8, on page 40. On March 1, 1994, the company had 3,880 common stockholders of record. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following selected financial data for the ten years ending December 31, 1993 are derived from the consolidated financial statements of the company, which have been examined and reported upon by the company's independent public accountants as set forth in their report included elsewhere herein. This information should be read in conjunction with the Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations. (1) The company's fiscal year ends on the last Friday in December. All years presented above were 52 weeks long, except for 1993 and 1988 which were 53- week years. (2) Earnings Per Common Share, Cash Dividends Per Common Share and Book Value Per Common Share have been computed for all periods retroactively reflecting the effect of a 3% stock dividend distributed on May 4, 1984, a 3-for-2 stock split effected on May 30, 1985, and a 2-for-1 stock split effected on December 31, 1993. Earnings Per Common Share also reflect the repurchase of 3.7 million, 7.8 million, 2.9 million, 1.0 million and 8.8 million shares of the company's common stock during 1992, 1991, 1990, 1989 and 1988, respectively, on a post-split basis. In 1989, 2.0 million shares of the company's Series B Preferred Stock were converted into common stock. (3) Redeemable Preferred Stock is included in Equity for the purpose of calculating these ratios. If Redeemable Preferred Stock were a component of Debt instead of Equity, Return on Equity would be 16.8%, 12.1%, 11.0%, (13.3%), (5.2%) and 12.8% in 1993, 1992, 1991, 1990, 1989 and 1988, respectively, and Total Debt to Equity would be 72.9%, 108.6%, 123.9%, 122.5%, 106.3% and 103.3% in 1993, 1992, 1991, 1990, 1989, and 1988, respectively. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The company's pretax income increased to $125 million in 1993 from $81 million in 1992, excluding the impact of $6 million and $41 million from the collection of Desert Storm container detention charges in 1993 and 1992, respectively. All detention claims with the U.S. government have been settled and a payment of $8 million was received and recorded as income by the company on January 31, 1994. Additional payments of up to $2 million are expected to be received in 1994. The improvements in the company's 1993 results compared with 1992 were due to higher freight volumes in all of the company's markets, higher operating margins in the company's North America stacktrain market, lower net interest expense and increased real estate income. Lower rates in the U.S. export and intra-Asia markets partially offset these improvements. Also contributing to the increase in earnings in 1993 were gains totaling $7 million from the sales of three of the company's older steamships and certain containers. Additionally, the company's 1993 income and volumes were positively impacted by the fact that its 1993 fiscal year was 53 weeks long, compared with 52 weeks in 1992 and 1991. (1) Volumes and revenue per FEU data are based upon shipments originating during the period, which differ from the percentage-of-completion method used for financial reporting purposes. (2)Excluding trans-Pacific Desert Storm volumes of 19.4 and average revenue per FEU of $5,309. The increase in the company's import volumes in 1993 compared with 1992 resulted primarily from expanded direct transportation of commercial dry cargo from the North and Central regions of the People's Republic of China. Also, volumes of textiles, footwear, auto parts and electronic goods in the company's import market improved in 1993 compared with 1992. The company's export volumes increased due to higher military volumes, particularly since June 1, 1993, when, as a result of its successful bid, the company became the preferred carrier of U.S. military cargo for a period of 12 months. The increase in volumes due to military shipments was partially offset by a decline in commercial refrigerated cargo. The company's intra-Asia volumes increased in 1993, due to expanded service to the People's Republic of China and the growing trade in Southeast and West Asia. In 1992, import volumes were slightly above those for 1991 due to increases in shipments of garments, electronic goods and refrigerated cargo, partially offset by a decline in shipments of auto parts from Japan. Export volumes declined in 1992 compared with 1991, primarily due to a decrease in non- Desert Storm military shipments and generally lower demand for U.S. goods, partially offset by an increase in volumes of refrigerated cargo. Volumes improved in the intra-Asia market in 1992 due to strong demand in the Middle East and India compared with 1991. Utilization of the company's containership capacity in 1993 was 89% and 92% for import and export shipments, respectively, compared with 89% and 90% in 1992, and 93% and 95% in 1991. Utilization includes the effects of shipments related to Operation Desert Storm in 1991. Transportation of Operation Desert Storm military cargo contributed $103 million to the company's international transportation revenues in 1991. Average revenue per forty foot equivalent unit ("FEU") for the company's import shipments increased in 1993 compared with 1992 due to higher rates and a higher proportion of textiles, auto parts and refrigerated cargo carried by the company. Increased volumes of higher-rated intermodal cargo also contributed to the increase in average revenue per FEU in the company's import market. Average revenue per FEU for the company's export shipments decreased in 1993 compared with 1992 due to strong competition in this market and a decrease in the proportion of higher-rated commercial refrigerated cargo carried by the company. The company's average revenue per FEU for its intra-Asia shipments declined in 1993 compared with 1992, resulting from competitive pressures in this market. Also, the company carried a higher proportion of lower-rated short-haul cargo in the intra-Asia trade during 1993 compared with 1992. Average revenue per FEU for the company's import shipments increased in 1992 from 1991 due to improved rates and a higher proportion of garments, refrigerated and intermodal cargo carried by the company in 1992. Average revenue per FEU for the company's export shipments increased in 1992 compared with 1991 due to a higher proportion of refrigerated cargo and intermodal shipments. In the company's intra-Asia market, average revenue per FEU was unchanged in 1992 compared with 1991, as a higher proportion of refrigerated cargo was offset by a lower proportion of longer distance shipments. Since 1991, the company and Orient Overseas Container Line, a Hong Kong shipping company ("OOCL"), have been parties to agreements enabling them to exchange vessel space and coordinate vessel sailings until 1996. The agreements permit both companies to offer faster transit times, more frequent sailings between key markets in Asia and the U.S. West Coast, and sharing of terminals and several feeder operations within Asia. In February 1994, the company and OOCL agreed to extend the term of the agreements through 2005 and to explore certain other opportunities, including the addition of an Asia-to- Europe service route. The new contracts are subject to certain conditions, including U.S. government approval. The company is party to an Operating-Differential Subsidy ("ODS") agreement with the U.S. government, expiring on December 31, 1997, which provides for payment by the U.S. government to partially compensate the company for the relatively greater expense of vessel operation under U.S. registry. ODS payments to the company, which were approximately $65 million in 1993, are expected to terminate at the end of 1997. The Clinton Administration and Congress are actively reviewing U.S. maritime policy. On November 4, 1993, the U.S. House of Representatives passed the "Maritime Security and Competitiveness Act of 1993," H.R. 2151, which would, among other things, extend the U.S. government's maritime support program for up to ten years, but would substantially reduce the amount of support payments per participating vessel from current levels. Similar legislation has not yet been addressed by the Senate. Accordingly, the company is unable to predict whether maritime reform legislation will be enacted, or whether enacted legislation, if any, will have terms similar to H.R. 2151. While the company continues to support efforts to enact new maritime support legislation, prospects for passage of a program acceptable to the company are unclear. Accordingly, on July 16, 1993, the company filed applications with the United States Maritime Administration ("MarAd") to operate under foreign flag its six C11-class containerships, which are now under construction and will be delivered to the company in 1995, and to transfer to foreign flag seven of the 15 U.S.-flag containerships currently operating in its trans-Pacific fleet. Enactment of maritime reform legislation, if any, may influence the company's decision whether to operate these ships under foreign flag, should its applications be approved. Management of the company believes that, in the absence of ODS or an equivalent government support program, it is generally no longer commercially viable to own or operate containerships in foreign trade under the U.S. flag because of the higher labor costs and the more restrictive design, maintenance and operating standards applicable to U.S.-flag liner carriers. The company continues to evaluate its strategic alternatives in light of the expiration of its ODS agreement and the uncertainties as to whether a new U.S. government maritime support program will be enacted or the company's application to flag its vessels under foreign registry will be approved. While no assurances can be given, management of the company believes that it will be able to structure its operations to enable it to continue to operate on a competitive basis without direct U.S. government support. (1)Volumes and revenue per FEU data are based upon shipments originating during the period, which differ from the percentage-of-completion method used for financial reporting purposes. (2) In addition to domestic third party business, the transportation of containers for the company's international customers is a significant component of the company's stacktrain operations. The effect of these shipments on domestic operations is eliminated in consolidation and therefore excluded above in Revenues and Stacktrain Average Revenue per FEU. Revenues and volumes from the company's North America stacktrain operations increased in 1993 from 1992 due to an increase in stacktrain services to Mexico and Canada and an overall improvement in demand for transportation services in the North America stacktrain market. Additionally, key competitors in this market were adversely affected by equipment shortages, which diverted some shipments to the company. Non-stacktrain volumes declined as the company converted its automotive shipments to its stacktrains. Stacktrain average revenue per FEU decreased in 1993 compared with 1992 due to the company's efforts to reduce stacktrain services that are less profitable. Overall revenues from the company's North America transportation operations declined in 1992 compared with 1991, due primarily to the continuing effects of the recession and the company's efforts to redirect its non-stacktrain business. Volumes in the company's North America stacktrain operations were down in 1992 compared with 1991 due to the continuing weak U.S. economy and the company's withdrawal from the Midwest-Texas lane, partially offset by improvements in stacktrain automotive volumes. Average revenue per FEU for the company's North America stacktrain business increased in 1992 compared with 1991 due to an improvement in cargo mix. For 1994, the company expects continued growth in the North America stacktrain markets and in intra-Asia shipping. Rate levels, especially in the U.S. export trade, ended 1993 at a depressed level and are not expected to improve significantly in the near term. The company's transportation operating expenses per FEU declined in 1993, compared with 1992, reflecting improvements in the North America stacktrain cost structure and the company's continued cost control efforts. Land transportation expenses were relatively unchanged in 1993 compared with 1992 despite a 9% increase in North America stacktrain volume, reflecting benefits realized from the renegotiation of rail contracts in 1992. Cargo handling expenses increased in 1993 compared with 1992 due to higher cargo volumes and contract rate increases at certain Asian and U.S. ports. In 1993, vessel expenses increased because of increased charter hire activity resulting from expanded service to China and the Philippines, partially offset by savings from four fewer ships in service during the year. In 1993, transportation equipment costs increased from the prior year primarily due to higher maintenance, repair and lease costs, partially offset by cost savings from changes in the company's rail cost structure. Other operating expenses increased in 1993 from 1992, primarily due to higher salary and fringe costs in North America and Asia operations, partially offset by gains of $7 million from the sale of three vessels and certain containers, and certain fixed cost savings in the North America stacktrain operations. Total transportation operating expenses increased only 3% in 1992 from 1991, despite the significant rise in operating costs in Asia. Land transportation costs decreased in 1992 compared with 1991 as a result of the company's renegotiated rail contracts and a decline in conventional rail costs due to lower non-stacktrain volumes. Cargo handling costs rose substantially in 1992, mainly due to contract rate increases at ports in Asia and the use of OOCL terminals on the West Coast and in Japan. Vessel expenses declined in 1992 compared with 1991, primarily due to lower fuel costs. The increase in transportation equipment costs in 1992 compared with 1991 reflects the increase in lease costs for refrigerated containers and dry containers related to OOCL activity, partially offset by equipment cost savings resulting from the renegotiated rail contracts. Information systems costs increased in 1992, due to increases in salaries and fringe benefits and costs for systems projects. Other operating expenses rose in 1992 from 1991 as a result of increased freight consolidation activities, OOCL start-up costs and increased agency fees. General and administrative expenses increased 9% in 1993 compared with 1992. In 1993, the company incurred approximately $9 million in costs related to certain corporate initiatives to improve company-wide systems and processes. Partially offsetting these costs in 1993 were cost savings at the corporate level. Expenditures on corporate initiatives are expected to be approximately $27 million during 1994. Anticipated cost savings resulting from these initiatives are expected to be realized in future years, but no assurances can be given as to the timing or amount of these savings. Depreciation and amortization expense increased 2% in 1993 from 1992 due to capital spending activity. General and administrative expense declined 2% in 1992 compared with 1991 as the company continued its cost savings efforts in this area. Depreciation and amortization expense increased 1% in 1992 from 1991 resulting from capital spending during the year. Net interest expense declined to $11 million in 1993 from $26 million in 1992. This decline was due to the company's restructuring of its long-term liabilities in late 1992 and early 1993, when the company retired certain capital lease obligations and redeemed its 11% Public Notes, and lower interest rates in 1993. Net interest expense in 1992 decreased $10 million from 1991, reflecting lower debt balances, lower interest rates on refinanced debt and higher cash balances. The effective tax rates applicable to the company were 39%, 35% and 38% in 1993, 1992 and 1991, respectively. The 1993 effective tax rate reflects a one percent federal corporate tax increase that was effective at the beginning of the year, and the related $2.7 million impact on the company's deferred tax balances. In 1992, the company changed its method of recognizing revenues and expenses to conform with new transportation industry guidelines established by the Financial Accounting Standards Board's Emerging Issues Task Force. Under the new method, the company recognizes revenues on a percentage-of-completion basis and expenses as incurred. The company previously recorded revenues and variable expenses at the time freight was loaded. In 1992, the company recorded a one-time charge of $22 million, after taxes of $13 million, for the effect of this change in accounting on prior years' results. In 1992, the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes"("SFAS 109"), the effects of which were applied retroactively to the beginning of fiscal 1989. SFAS 109 requires the company to compute deferred taxes based upon the amount of taxes payable in future years, after considering known changes in tax rates and other statutory provisions that will be in effect in those years. The company adopted SFAS 106 in 1991, which requires the company to recognize the cost of providing health care and other benefits to retirees over the term of employee service, as opposed to the company's previous method of recognizing those costs when incurred. The cumulative effect of this accounting change resulted in a one-time charge to earnings in 1991 of $10 million after income taxes. (1) Includes current and long-term portions. In November 1993, the company issued $150 million 10-year Senior Notes at an effective interest rate of 7.3%, and in January 1994, issued $150 million 30- year Senior Debentures at an effective interest rate of 8.2%. A portion of the proceeds from the issuance of this debt was used to repay $72 million of bank borrowings, and the remainder will be used to finance vessel purchases and other capital expenditures. In 1992 and early 1993, the company restructured its long-term liabilities to reduce its high-cost debt and eliminate restrictions on the use of subsidiary cash. In January 1993, the company purchased the remaining two vessels previously leased under leveraged leases and retired the related debt guaranteed by MarAd, eliminating MarAd's restrictions on the payment of dividends to the company by its wholly-owned subsidiary, American President Lines, Ltd. The purchase price of these vessels was $131 million, $110 million of which retired the related capital lease obligations. Also in January 1993, the company retired $95 million of 11% Public Notes. In 1993, the company began a fleet modernization program pursuant to which it has placed orders for the construction of six new C11-class containerships ("C11") and three new Kl0-class containerships ("K10") for an aggregate cost of approximately $730 million. The C11s are similar in design to the company's C10-class vessels, and each is designed to have a capacity of approximately 4,800 TEUs and a service speed of approximately 25 knots. Delivery of the C11s is scheduled for 1995. Each K10 is designed to have a capacity of approximately 3,600 TEUs and a service speed of approximately 24 knots. Delivery of the K10s is scheduled for 1996. The company presently expects the C11s to be deployed in its trans- Pacific service. OOCL is in the process of negotiating the purchase of six vessels similar in size and speed to the company's C11s. OOCL has agreed to deploy these new vessels in its coordinated trans-Pacific service with the company under the recent amendment to the slot-sharing agreement between the parties. The deployment of the 12 new C11-type vessels by the company and OOCL, replacing 16 older vessels, will increase the combined trans-Pacific capacity of the company and OOCL by approximately 15%. The company expects growth in demand in the trans-Pacific market and believes that the increase in combined capacity will be sufficient to permit the company and OOCL to maintain their combined relative market share in that market. However, no assurances can be given with respect to anticipated growth or the utilization or impact of capacity. The K10s, in combination with capacity from the six C11s, will replace four L9-class vessels chartered by the company and used in its West Asia/Middle East service. The charters of the L9s will expire in 1996. Deployment of the company's C11s and K10s is subject to U.S. government approval. The C11 vessels are being constructed by Howaldtswerke-Deutsche Werft AG, of Germany (three ships) and Daewoo Shipbuilding and Heavy Machinery, Ltd., of Korea ("Daewoo") (three ships). The total estimated project cost for constructing the vessels is $535 million. A payment of $52 million was made to the shipyards in 1993. The remaining payments are due in two 5% installments in 1994 and 80% upon delivery of the vessels. The company has obtained commitments from a group of European banks to finance approximately $400 million of the purchase price. Principal payments on any draw-downs would be due in semi- annual installments over a 12-year period commencing six months after the delivery of each vessel. Interest rates would be based upon various margins over LIBOR or the banks' cost of funds as elected by the company. The remaining cost of these vessels would be financed with the company's public debt and cash from operations. The K10s are being constructed by Daewoo. The total project cost for constructing these vessels is $195 million. A payment of $18 million was made to the shipyard in 1993. The remaining payments are due in two 10% installments in 1995 and 70% upon delivery of the vessels. Other than progress payments on the C11s and K10s, and the purchase of the previously leased ships, the company's 1993 capital expenditures were primarily for purchases of refrigerated containers. In 1992, the company's capital expenditures were primarily for purchases of refrigerated containers and the expansion of terminals and operating facilities. Capital expenditures in 1994 are expected to be approximately $200 million, including $52 million for vessel progress payments. The balance will be used primarily for refrigerated containers, chassis, terminal improvements in North America and Asia, and computer systems. At December 31, 1993, the company had outstanding purchase commitments to acquire facilities, equipment and services totaling $56 million. The company is in the process of expanding its two major West Coast ports' facilities and extending their lease terms. The company has entered into a contract with the Port of Los Angeles to lease a new 226-acre terminal facility for 30 years. Occupancy of the new facility is scheduled for 1997 upon completion of construction. The minimum annual rent expense under the new lease is estimated to be between $22 million and $26 million, depending upon the final scope of development. The annual rent for the company's current 129-acre terminal in Los Angeles was approximately $19 million in 1993. The company has agreed to purchase at least six gantry cranes and certain intermodal handling equipment for use at this terminal facility, the cost of which is not known at this time. The company also is negotiating with the Port of Seattle for the improvement and expansion of its existing terminal facility. Under the proposed plan, the facility would be expanded from 83 acres to approximately 160 acres by 1997 and the lease term would be 30 years from completion. The lease for the existing facility expires in 2015. In 1993, the company sold its remaining investment in the common stock of Amtech Corporation ("Amtech"), from which it realized a pretax gain of $9 million. In 1992, the company sold approximately one-half of its investment in Amtech, from which it realized a pretax gain of $8 million. Effective December 31, 1993, the company effected a two-for-one stock split in the form of a stock dividend. On a post-split basis, the company repurchased 3,715,928 and 7,774,344 of its outstanding common stock in 1992 and 1991, respectively. The average per share cost of these repurchases were $20.94 and $10.38 in 1992 and 1991, respectively. The company has a revolving credit agreement with a group of banks to provide an aggregate commitment of $100 million, which expires December 31, 1996. The revolving credit agreement contains various financial covenants which require the company to meet certain levels of fixed charge coverage, leverage and net worth. The agreement restricts the amount of increases in the company's cash dividends and restricts certain other corporate transactions. Borrowings under the agreement bear interest at rates based upon various indices as elected by the company. Any outstanding borrowings under this agreement are classified as long-term. The company borrowed under the revolving credit agreement during 1993 to partially finance the purchase of the leased vessels and for general corporate purposes. Also during 1993, the company borrowed under uncommitted lines of credit with certain banks for general corporate purposes. All outstanding bank borrowings were repaid with a portion of the proceeds from the issuance of $150 million 10-year Senior Notes in November 1993. The company is negotiating with a group of banks to replace its existing revolving credit agreement with a $200 million, five-year revolving credit agreement. While no assurances can be given, the company expects the new agreement to be finalized in the first fiscal quarter of 1994. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF MANAGEMENT To the Stockholders: The financial statements have been prepared by the company, and we are responsible for their content. They are prepared in accordance with generally accepted accounting principles, and in this regard we have undertaken to make informed judgments and estimates, where necessary, of the expected effect of future events and transactions. The other financial information in the annual report is consistent with that in the financial statements. The company maintains and depends upon a system of internal controls designed to provide reasonable assurance that our assets are safeguarded, that transactions are executed in accordance with management's intent and the law, and that the accounting records fairly and accurately reflect the transactions of the company. The company has an internal audit program which reviews the adequacy of the internal controls and compliance with them. The company engaged Arthur Andersen & Co. as independent public accountants to provide an objective, independent audit of our financial statements. There is an Audit Committee of the Board of Directors which is composed solely of outside directors. The committee meets whenever necessary to monitor and review with management, the internal auditors and the independent public accountants, the company's financial statements and accounting controls. Both the independent public accountants and the internal auditors have access to the Audit Committee, without management being present, to discuss internal controls, auditing and financial reporting matters. To help assure that its affairs are properly conducted, management has established policies regarding standards of corporate behavior. The company regularly reminds its key employees of significant policies and requires them to confirm their compliance. /s/ John M. Lillie John M. Lillie Chairman of the Board, President and Chief Executive Officer /s/ Will M. Storey Will M. Storey Executive Vice President and Chief Financial Officer /s/ William J. Stuebgen William J. Stuebgen Vice President, Controller and Chief Accounting Officer Oakland, California February 11, 1994 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of American President Companies, Ltd. We have audited the accompanying consolidated balance sheet of American President Companies, Ltd. (a Delaware corporation) and subsidiaries as of December 31, 1993 and December 25, 1992 and the related consolidated statements of income, cash flows and changes in stockholders' equity for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of American President Companies, Ltd. and subsidiaries as of December 31, 1993 and December 25, 1992 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 1 to the financial statements, the company has changed its method of recognizing revenues and expenses effective as of December 28, 1991. In addition, as explained in Note 7 to the financial statements, the company has changed its method of accounting for postretirement benefits effective December 29, 1990. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. This information has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Arthur Andersen & Co. San Francisco, California February 11, 1994 See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation and Fiscal Year The consolidated financial statements include the accounts of American President Companies, Ltd. and its majority-owned subsidiaries (the "company"), after eliminating intercompany accounts and transactions. The company's fiscal year ends on the last Friday in December. The company's 1993 fiscal year was 53 weeks, compared with 52 weeks for 1992 and 1991. Stock Split Effective December 31, 1993, the company effected a two-for-one stock split in the form of a stock dividend. All references to the number of common shares and per common share amounts for prior periods have been restated to reflect the split. Revenues and Expenses In 1992, the company changed its method of recognizing revenues and expenses to conform with new transportation industry guidelines established by the Financial Accounting Standards Board's Emerging Issues Task Force. Under the new method, the company recognizes revenues on a percentage-of-completion basis and expenses as incurred. The company previously recorded revenues and variable expenses at the time freight was loaded. As of the beginning of fiscal 1992, the company recorded a one-time charge of $21.6 million, after taxes of $13.2 million, for the effect of this change in accounting on prior years. If the change in accounting had not been implemented, net income for the year ended December 25, 1992 would have been $75.7 million, or $2.27 per share, fully diluted. Conversely, if the change had been applied retroactively to the year ended December 27, 1991, Income Before the Cumulative Effect of Accounting Change and related Earnings Per Share would have been $70.4 million, or $1.97 per share, fully diluted. Detention revenue is recognized when cash is received. Foreign Currency Transactions Foreign currency transactions and balances are translated to U.S. dollars. Included in Operating Income for 1993, 1992 and 1991 are net losses on foreign currency transactions and translations of $1.1 million, $2.0 million and $7.9 million, respectively. The 1991 loss includes the company's write-down of its assets in India due to the devaluation of the rupee. The company periodically enters into contracts to buy foreign currencies in the future to hedge the impact of foreign currency fluctuations on certain operating commitments. The gains or losses on these contracts are deferred and recognized when the related operating expenses are incurred, and are recorded as a decrease or increase in operating expenses in the accompanying Consolidated Statement of Income. In 1993, the company entered into foreign currency contracts to buy Deutsche marks in the future to lock in the U.S. dollar cost of constructing German-built vessels. These contracts are discussed in Note 10. Cash, Cash Equivalents and Short-Term Investments Cash and Cash Equivalents comprise cash balances and investments with maturities of three months or less at the time of purchase. Short-Term Investments are carried at cost, which approximates market. Property and Equipment Property and Equipment are recorded at historical cost. For assets financed under capital lease arrangements, an amount equal to the present value of the future minimum lease payments is recorded at the date of acquisition as Property and Equipment with a corresponding amount recorded as a capital lease obligation. Depreciation and Amortization are computed using the straight-line method based upon the following estimated useful lives: Maintenance and repair expenditures of $110.3 million, $101.6 million and $93.9 million have been charged to expense in 1993, 1992 and 1991, respectively, as they were incurred. Major periodic dry dockings and rail car overhauls totaling $18.2 million, $21.2 million and $19.7 million at December 31, 1993, December 25, 1992, and December 27, 1991, respectively, have been deferred and are being amortized over two to five years. Long-Term Investments The company has certain investments, long-term deposits and receivables, which are included in Investments and Other Assets. The fair value of these assets approximates their carrying value at December 31, 1993. For certain other investments, it was not practicable to determine fair value, as no quoted market prices were available. Software Costs Costs related to purchased and internally developed software are charged to expense as incurred. Capitalized Interest Interest costs of $1.5 million relating to cash paid for the construction of vessels were capitalized in 1993. No interest costs were capitalized in 1992 and 1991. Reclassifications Certain 1992 and 1991 amounts have been reclassified to conform to the 1993 presentation. NOTE 2. UNITED STATES MARITIME ADMINISTRATION AGREEMENTS The company and the United States Maritime Administration ("MarAd") are parties to an Operating-Differential Subsidy ("ODS") agreement expiring December 31, 1997, which provides for payment by the U.S. government to partially compensate the company for the relatively greater expense of vessel operation under United States registry and requires the company to replace the capacity of its existing vessels as they reach the end of their statutory lives if a construction differential subsidy, provided by the U.S. government, is made available. This subsidy has not been made available since 1981. The ODS amounts for 1993, 1992 and 1991 were $64.7 million, $69.7 million and $69.4 million, respectively, and have been included as a reduction of operating expenses. ODS payments to the company are expected to terminate at the end of 1997. The Clinton Administration and Congress are actively reviewing U.S. maritime policy. On November 4, 1993, the U.S. House of Representatives passed the "Maritime Security and Competitiveness Act of 1993," H.R. 2151, which would, among other things, extend the U.S. government's maritime support program for up to ten years, but would substantially reduce the amount of support payments per participating vessel from current levels. Similar legislation has not yet been addressed by the Senate. Accordingly, the company is not able to predict whether maritime reform legislation will be enacted or whether enacted legislation, if any, will have terms similar to H.R. 2151. While the company continues to support efforts to enact new maritime support legislation, prospects for passage of a program acceptable to the company are unclear. Accordingly, on July 16, 1993, the company filed applications with MarAd to operate under foreign flag its six C11-class containerships and to transfer to foreign flag seven of the 15 U.S.-flag containerships in its trans-Pacific fleet. Enactment of maritime reform legislation, if any, may influence the company's decision whether to operate these ships under foreign flag, should its applications be approved. Management of the company believes that, in the absence of ODS or an equivalent government support program, it is generally no longer commercially viable to own or operate containerships in foreign trade under the U.S. flag because of the higher labor costs and the more restrictive design, maintenance and operating standards applicable to U.S.-flag liner carriers. The company continues to evaluate its strategic alternatives in light of the expiration of its ODS agreement and the uncertainties as to whether a new U.S. government maritime support program acceptable to the company will be enacted or the company's application to flag its vessels under foreign registry will be approved. While no assurances can be given, management of the company believes that it will be able to structure its operations to enable it to continue to operate on a competitive basis without direct U.S. government support. The company also has a Capital Construction Fund ("CCF") agreement with MarAd which provides funding for the future acquisition of vessels and other assets and for the repayment of other vessel acquisition debt. The CCF is included in Investments and Other Assets on the accompanying Consolidated Balance Sheet, and there was no balance at December 31, 1993, and a balance of $2.7 million at December 25, 1992. The company receives a federal income tax deduction for deposits made to the CCF, subject to certain restrictions. Withdrawals from the CCF for investment in vessels or related assets do not give rise to a tax liability, but reduce the depreciable bases of the assets for income tax purposes. At December 31, 1993, the total tax basis of assets purchased with CCF funds was approximately $69.3 million less than net book value. Deferred income taxes have been provided for CCF amounts on deposit or invested in vessels or related equipment. NOTE 3. INCOME TAXES The company adopted Statement of Financial Accounting Standards, "Accounting for Income Taxes", ("SFAS 109") in 1992, the effects of which were applied retroactively to the beginning of fiscal 1989. SFAS 109 requires the company to compute deferred taxes based upon the amount of taxes payable in future years, after considering known changes in tax rates and other statutory provisions that will be in effect in those years. The reconciliation of the company's effective tax rate to the federal statutory tax rate is as follows: Effective January 1, 1993, the maximum corporate federal income tax rate increased to 35%. As a result, an adjustment of approximately $2.7 million was recorded to reflect the effect of the tax rate increase on deferred taxes provided in prior periods. The following is a summary of the company's provision for income taxes, net of $13.2 million and $6.4 million related to the cumulative effects of the accounting changes for revenue and expenses and postretirement benefits in 1992 and 1991, respectively, as restated: The following table shows the tax effect of the company's cumulative temporary differences and carryforwards included on the company's Consolidated Balance Sheet as of December 31, 1993 and December 25, 1992: The company used all federal alternative minimum tax credits in 1993 and has California alternative minimum tax credits of $0.8 million at December 31, 1993, which do not expire. The amount of deferred tax assets and liabilities as of December 31,1993 and December 25, 1992 were as follows: The net current deferred tax asset is included in Prepaid Expenses and Other on the accompanying Consolidated Balance Sheet. NOTE 4. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Accounts Payable and Accrued Liabilities at December 31, 1993 and December 25, 1992 were as follows: NOTE 5. LONG-TERM DEBT Long-term debt at December 31, 1993 and December 25, 1992 consisted of the following: (1) In November 1993, the company filed a shelf registration to issue up to $400 million of debt securities in varying terms and amounts. Also in November 1993, the company issued 7 1/8% Senior Notes with a face amount of $150 million and an unamortized discount of $2.1 million as of December 31, 1993. The effective interest rate of this debt is 7.325%. A portion of the proceeds from the issuance of this debt was used to repay $72 million of bank borrowings and the remainder will be used for financing capital expenditures, including progress payments for the construction of the new vessels. In January 1994, the company issued 8% Senior Debentures with a face amount of $150 million, due on January 15, 2024. The effective interest rate on this debt is 8.172%. Proceeds from the issuance of this debt were $147.1 million and will be used to finance capital expenditures, including vessel progress payments. (2) The Notes were redeemed by the company on January 15, 1993 using funds borrowed under the company's revolving credit agreement described below. (3) Principal payments are due in equal semiannual installments. The company has the option to issue Series II Bonds due sequentially in semiannual payments at the end of the term of the Series I Bonds in lieu of up to five cash payments, which it has not yet exercised. The bonds issued under this loan agreement are collateralized by the five C10-class vessels, which had a net book value of $185.9 million at December 31, 1993. Fair value of this debt is approximately $87 million at December 31, 1993 assuming a current interest rate of 5.23%. (4) The Bonds are redeemable on or after November 1, 1999 at a redemption price of 102% of the principal amount, reducing to 100% of the principal amount on or after November 1, 2001. (5) The interest rate at December 31, 1993 was 3.05%. The principal repayment is collateralized by a $6.6 million letter of credit. (6) The Note was used to finance the purchase of certain chassis and is collateralized by the chassis. At December 31, 1993, the net book value of these chassis was $4.3 million. Carrying value of significant issues of long-term debt, other than the Series I Bonds, approximates fair value because the interest rates on outstanding debt approximates current interest rates that would be offered to the company for similar debt. Principal payments scheduled on long-term debt during the next five years, on the basis that the company issues Series II Bonds totaling $23.8 million per year in lieu of the next five semiannual cash payments on the Series I Bonds, are as follows: (In thousands) 1994 $ 993 1995 1,085 1996 13,098 1997 24,137 1998 23,823 The company has a revolving credit agreement with a group of banks to provide for an aggregate commitment of up to $100 million which expires December 31, 1996. The revolving credit agreement contains various financial covenants which require the company to meet certain levels of fixed charge coverage, leverage and net worth. The agreement restricts the amount of increases in the company's cash dividends and restricts certain other corporate transactions. Borrowings under the agreement bear interest at rates based upon various indices as elected by the company. Any outstanding borrowings under this agreement are classified as long-term. The current annual commitment fee is three-eighths of one percent of the available amount. The company had no outstanding borrowings under this agreement at December 31, 1993. As an alternative to borrowing under its revolving credit agreement, the company has an option under that agreement to sell up to $150 million of certain accounts receivable to the banks. This alternative is subject to less restrictive financial covenants than the borrowing option. NOTE 6. LEASES The company leases equipment under capital leases expiring in three to seven years. Assets under capital lease included in Property and Equipment on the accompanying Consolidated Balance Sheet at December 31, 1993 and December 25, 1992 are as follows: The following is a schedule of future minimum lease payments required under the company's leases that have initial noncancelable terms in excess of one year as of December 31, 1993: In 1993, the company purchased two vessels which had been operated under capital lease agreements. The purchase price of these vessels totaled $130.8 million, of which $110.1 million retired the related capital lease obligation. The company financed this transaction with cash and borrowings under its revolving credit agreement. At December 25, 1992, the capital lease obligation for these vessels of $110.1 million was recorded as Current Portion of Capital Lease Obligation. The excess of the purchase price over the capital lease obligation was added to the net book value of the vessels and will be depreciated over their remaining useful lives. Total rental expense for operating leases and short-term rentals was $289.5 million, $260.4 million and $243.1 million in 1993, 1992 and 1991, respectively. NOTE 7. EMPLOYEE BENEFIT PLANS Pension Plans The company has defined benefit pension plans covering most of its employees, which generally call for benefits to be paid to eligible employees at retirement based on years of credited service and average monthly compensation during the five years of employment with the highest rate of pay. The company's general policy is to fund pension costs at no less than the statutory requirement. Certain plans are funded through a grantor trust. The investment in this trust at December 31, 1993 was $15.5 million and is included in Investments and Other Assets on the accompanying Consolidated Balance Sheet. The following table sets forth the pension plans' funded status and amounts recognized in the accompanying Consolidated Balance Sheet at December 31, 1993 and December 25, 1992: The following assumptions were made in determining the company's net pension liability: Net pension cost related to the company's pension plans included the following components: The company also participates in collectively bargained, multi-employer plans that provide pension and other benefits to certain union employees. The company contributed $5.2 million in 1993, $6.5 million in 1992 and $9.6 million in 1991 to such plans. These contributions are determined in accordance with the provisions of negotiated labor contracts and generally are based on the number of hours worked and are expensed as incurred. Postretirement Benefits Other than Pensions The company shares the cost of its health care benefits with the majority of its domestic shoreside retired employees. In 1991, the company adopted Statement of Financial Accounting Standard No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106") which requires the company to recognize the cost of providing health care and other benefits to retirees over the term of employee service, which is a change from the company's previous method of recognizing these costs when incurred. The company recognized a one-time charge of $10.5 million, after taxes of $6.4 million, for the effect of this change in accounting on prior years. Postretirement benefit costs recognized under SFAS 106 in the accompanying Consolidated Statement of Income for the years ended December 31, 1993 and December 25, 1992 were as follows: The following table sets forth the postretirement benefit obligation recognized in the accompanying Consolidated Balance Sheet at December 31, 1993 and December 25, 1992: The expected cost of the company's postretirement benefits is assumed to increase at an annual rate of 12% in 1994. This rate is assumed to decline approximately 1% per year to 5% in the year 1999 and remain level thereafter. The health care cost trend rate assumption has a significant impact on the amounts reported. An increase in the rate of 1% in each year would increase the accumulated postretirement benefit obligation at December 31, 1993 by $3.5 million and the aggregate of the service and interest cost for 1993 by $0.6 million. The weighted average discount rate used to determine the accumulated postretirement benefit obligation was 7%. The company has not funded the liability for these benefits. Profit-Sharing Plans The company has defined contribution profit-sharing plans covering certain non- union employees. Under the terms of these plans, the company has agreed to make matching contributions equal to those made by the participating employees up to a maximum of 6% of each employee's base salary. The company's total contributions to the plans for 1993, 1992 and 1991 were $6.0 million, $5.7 million and $5.1 million, respectively. NOTE 8. REDEEMABLE PREFERRED STOCK Shares of 9% Series C Cumulative Convertible Preferred Stock ("Series C Preferred Stock") are convertible into shares of the company's common stock at the rate of 2.641 shares of common stock for each share of Series C Preferred Stock, or a conversion price of $18.9325 per share of common stock. Holders of this stock have one vote for each share of common stock into which Series C Preferred Stock is convertible and have agreed to vote in accordance with the recommendations of the company's Board of Directors on certain matters. The holders of the Series C Preferred Stock also have a class vote with respect to mergers, recapitalizations, or other similar transactions which are not approved by a majority of the independent directors of the company. The Series C Preferred Stock is exchangeable at the option of the holder into shares of 9% Series D Convertible Preferred Stock, which have the same economic rights as the Series C Preferred Stock, but no voting rights except as required by law. The holders of the Series C Preferred Stock have agreed to certain transfer restrictions which do not apply to the Series D Preferred Stock. On or after July 31, 1995, the company may redeem shares of the Series C or Series D Preferred Stock outstanding, if any, and must redeem all such shares on January 31, 2001 at their stated value. The Series C Preferred Stock carries liquidation rights equal to the greater of 110% of the stated value per share, plus dividends accrued to the date of payment, or the current market value of the common stock into which the Series C Preferred Stock outstanding is convertible. NOTE 9. STOCKHOLDERS' EQUITY Common Stock On December 3, 1993 the Board of Directors of the company authorized a two-for- one stock split effected in the form of a stock dividend payable January 28, 1994 to stockholders of record on December 31, 1993. On January 28, 1994, the Board of Directors declared a cash dividend of $0.10 per common share payable on February 28, 1994 to stockholders of record on February 15, 1994. On a post-split basis, the company repurchased 3,715,928 and 7,774,344 of its outstanding common stock in 1992 and 1991, respectively. The average per share cost of these repurchases were $20.94 and $10.38 in 1992 and 1991, respectively. The excess of the purchase price of the common stock over its stated value has been reflected as a decrease in Additional Paid-In Capital. Earnings Per Common Share For the periods presented, primary earnings per common share were computed by dividing net income, reduced by the amount of preferred stock dividends, by the weighted average number of common shares and common equivalent shares outstanding during the year. Common equivalent shares consist of stock options granted. Fully diluted earnings per common share were computed based on the assumption that the Series C Preferred Stock was converted. The number of shares used in these computations was as follows: Stockholder Rights Plan The company's stockholder rights agreement provides that rights become exercisable when a person acquires 20% or more of the company's common stock or announces a tender offer which would result in the ownership of 20% or more of the company's common stock, or if a person who has been declared "adverse" by the independent directors of the company exceeds a threshold stock ownership established by the Board, which may not be less than 10%. The rights will be attached to all common stock, Series C Preferred Stock and Series D Preferred Stock certificates at the rate of one right per common share and one right for each common share into which Series C and Series D Preferred Stock is convertible. Once exercisable, each right entitles its holder to purchase two one-hundredths of a share ("unit") of Series A Junior Participating Preferred Stock at a purchase price of $130 per unit, subject to adjustment. Upon the occurrence of certain other events related to changes in the ownership of the company's outstanding common stock, each holder of a right would be entitled to purchase shares of the company's common stock or an acquiring corporation's common stock having a market value of two times the exercise value of the right. Rights that are, or were, beneficially owned by an acquiring or adverse person will be null and void. In addition, the Board of Directors may, in certain circumstances, require the exchange of each outstanding right for common stock or other consideration with a value equal to the exercise price of the rights. The company has reserved 500,000 shares of preferred stock for issuance pursuant to the exercise of the rights in the future. The rights expire November 29, 1998 and, subject to certain conditions, may be redeemed by the Board of Directors at any time at a price of $0.025 per right. Stock Incentive Plans On July 27, 1993, the Compensation Committee of the Board of Directors approved stock option grants under the company's 1989 Stock Incentive Plan (the "Plan") for 1,878,192 shares of the company's common stock to 384 key employees of the company. The options have an exercise price of $22.38 per share, a 10-year term and vest over a two- to nine-year period based upon the achievement of stock price appreciation targets. The percentage of the options that vest during specified time periods will depend on the amount of stock price appreciation in those time periods. After five years, the options will vest as to 60% of the covered shares if not otherwise vested, and after nine years, the options will vest as to the remaining 40% if not otherwise vested. These option grants are expected to be part of a two-part program replacing annual stock option grants for five years. To complete the program, the company intends to request stockholder approval at its 1994 Annual Meeting of Stockholders for an increase in the number of shares reserved under the Stock Incentive Plan to provide shares for a second grant of approximately 1,252,108 options with similar vesting conditions, and certain other grants. Previous stock option grants under the Plan become exercisable in three to four equal annual installments commencing one year after grant. The Plan also provides for awards of restricted shares of common stock and stock units to officers and other key employees. Recipients of restricted shares must pay the par value of $0.01 for each restricted share of common stock received. Restricted shares are not transferable until vested, but the recipient enjoys full voting and dividend rights. Vesting ordinarily occurs in five unequal annual installments increasing from 10 percent in the first year to 30 percent in the fifth year. The liability for these awards is based upon the market value of the shares at the date of award and is included in Stockholders' Equity. The 1992 Directors Stock Option Plan provides for the granting of options to purchase shares of common stock to non-employee members of the company's Board of Directors. The aggregate number of options which may be granted under this plan is 200,000. Options become exercisable in three equal installments on the first three anniversaries of the date of grant. The following is a summary of the transactions in the plans during 1993: At December 31, 1993, a total of 164,392 shares were available for future grants of stock options, restricted shares and stock units under these plans. NOTE 10. COMMITMENTS AND CONTINGENCIES Commitments In May 1993, the company entered into contracts for the construction and purchase of six new C11-class containerships from Howaldtswerke-Deutsche Werft AG, of Germany (three ships) and Daewoo Shipbuilding and Heavy Machinery, Ltd., of Korea ("Daewoo") (three ships). The total estimated project cost for the construction of these vessels is $535 million. A payment of $52 million was made to the shipyards in 1993. The remaining payments are due in two 5% installments in 1994 and 80% upon delivery of the vessels, which is scheduled for 1995. The company has obtained commitments from European banks to finance approximately $400 million of the purchase price of the six C11-class vessels. Principal payments on any draw-downs would be due in semi-annual installments over a 12 year period commencing six months after the delivery of each vessel. Interest rates would be based upon various margins over LIBOR or the banks' cost of funds as elected by the company. The remaining cost of these vessels would be financed with the company's public debt and cash from operations. In connection with the construction and purchase of the ships from Howaldtswerke-Deutsche Werft AG, the company entered into foreign currency contracts to buy Deutsche marks in the future to lock in the U.S. dollar cost of the Deutsche-mark denominated price of the German-built vessels. Any gains or losses on these contracts will be deferred and recognized as an adjustment to the cost basis of the ships when the related payments are made. At December 31, 1993, the company had contracts to purchase $241.5 million in Deutsche marks. At December 31, 1993, the carrying value of such contracts was an asset of $2.3 million and the fair market value, based on quoted market prices of comparable instruments, was a liability of $2.0 million. The value of the contracts upon ultimate settlement is dependent upon actual currency exchange rates at the various maturity dates in 1994 and 1995. In December 1993, the company entered into contracts with Daewoo for the construction and purchase of three diesel-powered K10-class containerships to be delivered in 1996. The total estimated project cost for construction of these vessels is $195 million. A payment of $18 million was made to the shipyard in 1993. The remaining payments are due in two 10% installments in 1995 and 70% upon delivery of the vessels. The project will be financed by funds from the recent debt offerings and internally generated cash flows. At December 31, 1993, the company had outstanding purchase commitments to acquire facilities, equipment and services totaling $56.4 million. In addition, the company had commitments to purchase terminal services for its major Asian operations. These commitments range from one to ten years and the amount of the commitments under these contracts is based upon the actual services performed. Also, the company had letters of credit totaling $10.4 million outstanding, which guarantee the company's performance under certain of its commitments. The company has entered into a contract with the Port of Los Angeles to lease a new 226-acre terminal facility for 30 years. Occupancy of the new facility is scheduled for 1997 upon completion of construction. The minimum annual rent expense under the new lease is estimated to be between $22 million and $26 million, depending upon the final scope of development. The annual rent for the company's current 129-acre terminal in Los Angeles was approximately $18.5 million in 1993. The company has agreed to purchase at least six gantry cranes and certain intermodal handling equipment for use at the new Los Angeles terminal, the cost of which is not known at this time. The company also is negotiating with the Port of Seattle for the improvement and expansion of its existing terminal facility. Under the proposed plan, the facility would be expanded from 83 acres to approximately 160 acres by 1997 and the lease term would be 30 years from completion. The lease for the existing facility expires in 2015. Since 1991, the company and Orient Overseas Container Line, a Hong Kong shipping company ("OOCL"), have been parties to agreements enabling them to exchange vessel space and coordinate vessel sailings until 1996. In February 1994, the company and OOCL reached agreements to extend the term of the agreements through 2005 and to explore certain other opportunities, including the addition of an Asia to Europe service route. The new contracts are subject to certain conditions, including U.S. government approval. Currently, each party is guaranteed vessel space and buys extra space as needed. Starting in December 1993, the company was required to increase the vessel space it purchases from OOCL and will compensate OOCL for this additional space at a rate currently calculated at $6.6 million per year. This commitment reduces as the company increases the capacity it can exchange with OOCL, which is expected to begin with the delivery of the C11s in 1995. The company has entered into employment agreements with certain of its executive officers. The agreements provide for certain payments to each officer upon termination of employment, other than as a result of death, disability in most cases, or justified cause, as defined. The aggregate estimated commitment under these agreements was $15 million at December 31, 1993. Contingencies The company is a party to various legal proceedings, claims and assessments arising in the course of its business activities, none of which in management's opinion is expected to have a material adverse impact on its consolidated financial position or operations. NOTE 11. BUSINESS SEGMENT INFORMATION The company provides container transportation services in North America, Asia and the Middle East through an intermodal system combining ocean, rail and truck transportation. In addition, the company has real estate holdings which are being developed and sold. Depreciation expense and capital expenditures were related only to transportation operations in 1993, 1992 and 1991. The following table shows the percentage of ocean transportation revenues by country: Operating income, net income and identifiable assets cannot be allocated on a geographic basis due to the nature of the company's business. 1) In 1992, the company changed its method of revenue and expense recognition to a percentage of completion method for revenue, and expenses as incurred from recording revenue and variable expenses when cargo was loaded. The cumulative effect of this change on prior years was recognized as a one-time charge at the beginning of the year. SCHEDULE II. AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES The company makes loans represented by promissory notes to certain employees primarily for the purpose of assisting in the employee's relocation. Generally, these notes are due in five annual installments. In 1990 and 1991 certain notes were amended to extend the payment of the unpaid current portion to one year after the end of the original term of the note. (1) Interest at 8.5%, unsecured. (2) Interest at 11%, unsecured, repaid in 1991. (3) Interest at 10%, unsecured, due through July 1994. (4) Interest at 11.5%, unsecured, written-off in 1991 after employment with the company was terminated. (5) Interest at 11%, unsecured, repaid in 1992 after employment with the company was terminated. SCHEDULE III. CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) SCHEDULE III. CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY), continued All material intercompany transactions and account balances are eliminated in consolidation. (1)The accounting change for Revenue and Expenses is described in Note 1 to the consolidated financial statements. (2)The accounting change for Postretirement Benefits is described in Note 7 to the consolidated financial statements. (3)For an analysis of Stockholders' Equity, see Consolidated Statement of Changes in Stockholders' Equity and Note 9 to the consolidated financial statements. SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI. ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT SCHEDULE IX. SHORT-TERM BORROWINGS (1) The average amount outstanding was calculated based on an average daily balance. (2) The weighted average interest rate during the period was computed by dividing the actual interest expense by the average short-term debt outstanding. (3) These borrowings were made from various banks at prevailing interest rates. (4) This borrowing was made under the company's previous $100 million revolving credit agreement. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information with respect to Directors and certain executive officers of the company appearing under the caption "Election of Directors - Information With Respect to Nominees and Directors" in the company's definitive proxy statement for the annual meeting of stockholders to be held on April 28, 1994 is hereby incorporated herein by reference. The following sets forth certain information with respect to the remaining executive officers of the company: Maryellen B. Cattani, age 50, elected Senior Vice President, General Counsel and Secretary of the company in July 1991. Prior to joining the company, she was a partner in the law firm of Morrison & Foerster from 1989 to 1991 and Senior Vice President, General Counsel and Secretary of Transamerica Corporation from 1983 to 1989. James S. Marston, age 60, elected Senior Vice President and Chief Information Officer of the company in September 1987, served as Vice President and then President of AMR Corporation-Technical Training Division from June 1982 to June 1986 and from June 1986 to September 1987, respectively. William J. Stuebgen, age 46, elected Vice President, Controller of the company in October 1990. Prior to that, he served as Vice President, Treasurer of the company from October 1988 to September 1990 and Vice President, Controller from April 1987 to March 1989. The executive officers of the company are elected by the Board of Directors. Each officer holds office until his or her successor has been duly elected and qualified, or until the earliest of his or her death, resignation, retirement or removal by the Board. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information appearing under the caption "Compensation of Executive Officers and Directors" and "Description of Plans" in the company's definitive proxy statement for the annual meeting of stockholders to be held on April 28, 1994, is hereby incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under the captions "Election of Directors- Stock Ownership of Directors and Officers" and "Certain Beneficial Ownership of Securities" in the company's definitive proxy statement for the annual meeting of stockholders to be held on April 28, 1994, is hereby incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing under the captions "Compensation of Executive Officers and Directors -- Employment Agreements and Certain Transactions" in the company's definitive proxy statement for the annual meeting of stockholders to be held on April 28, 1994, is hereby incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: 1. Financial Statements and Schedules The following report of independent public accountants, consolidated financial statements and notes to the consolidated financial statements of American President Companies, Ltd. and subsidiaries are contained in Part II, Item 8: a. Report of Independent Public Accountants b. Consolidated Statement of Income c. Consolidated Balance Sheet d. Consolidated Statement of Cash Flows e. Consolidated Statement of Changes in Stockholders' Equity f. Notes to Consolidated Financial Statements 2. The following schedules are contained in Part II, Item 8: a. Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties b. Schedule III - Condensed Financial Information of Registrant (Parent Company) c. Schedule V - Property, Plant and Equipment d. Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment e. Schedule IX - Short-Term Borrowings 3. Exhibits required by Item 601 of Regulation S-K The following documents are exhibits to this Form 10-K Exhibit No. Description of Document ______________________________________________________________________________ 3.1* Certificate of Incorporation, filed as Exhibit 3.1 to the company's Form SE (File No. 1-8544), dated May 14, 1985. 3.2* Certificate of Amendment of Certificate of Incorporation, filed as Exhibit 3.1 to the company's Form SE (File No. 1-8544), dated March 11, 1988. 3.3* By-Laws, as amended, filed as Exhibit 3.1 to the company's Form SE (File No. 1-8544), dated March 27, 1991 and electronically filed as Exhibit 3.1 to the company's Form 10Q (File No. 1-8544), dated August 3, 1993. 3.4* Amendment to the By-laws dated June 25, 1993 filed as Exhibit 3.2 to the company's Form 10Q (File No. 1-8544), dated August 3, 1993. 4.1* Amended and Restated Rights Agreement dated October 22, 1991, between the company and The First National Bank of Boston, as Rights Agent, filed as Exhibit 4.1 to the company's Form SE (File No. 1-8544), dated October 22, 1991. 4.2* Trust Indenture between American President Lines, Ltd., Issuer, and Security Pacific National Bank, Trustee, dated as of April 22, 1988, President Truman Issue, filed as Exhibit 4.1 to the company's Form SE (File No. 1-8544), dated July 26, 1988. 4.3* Forms of Series I and Series II Bonds, filed as part of Exhibit 4.1 to the company's Form SE (File No. 1-8544), dated July 26, 1988. 4.4* Certificate of Designation, Preferences, and Rights of the 9% Series C Cumulative Convertible Preferred Stock, filed with the Delaware Secretary of State on September 20, 1988, filed as Exhibit 4.1 to the company's Form SE (File No. 1-8544), dated September 21, 1988. 4.5* Specimen Certificate of the company's 9% Series C Cumulative Convertible Preferred Stock, par value $.01 per share, filed as Exhibit 4.1 to the company's Form SE (File No. 1-8544), dated August 1, 1989. 4.6* Preferred Stock Purchase Agreement among the company, Hellman & Friedman Capital Partners, Hellman & Friedman Capital Partners International (BVI), and APC Partners; dated as of August 3, 1988, and amendments 1 through 3, dated September, 1988 (without exhibits), filed as Exhibit 4.1 to the company's Form SE (File No. 1-8544), dated February 17, 1989. 4.7* Amendment of Preferred Stock Purchase Agreement among the company, Hellman & Friedman Capital Partners, Hellman & Friedman Capital Partners International (BVI), and APC Partners; dated March 15, 1989, filed as Exhibit 4.2 to the company's Form SE (File No. 1-8544), dated March 14, 1990. 4.8* Registration Rights Agreement, among the company, Hellman & Friedman Capital Partners, Hellman & Friedman Capital Partners International (BVI), and APC Partners; dated as of August 3, 1988, as amended (without exhibits), filed as Exhibit 4.2 to the company's Form SE (File No. 1-8544), dated February 17, 1989. 4.9* Refunding Revenue Bonds Loan Agreement, dated October 1, 1989, by and between American President Lines, Ltd. and Alaska Industrial Development and Export Authority, filed as Exhibit 4.1 to the company's Form SE (File No. 1-8544), dated May 8, 1991. 4.10* Trust Indenture between Alaska Industrial Development and Export Authority, Issuer, and Security Pacific National Bank, Trustee, dated October 1, 1989, to the Refunding Revenue Bonds, Series 1989, filed as Exhibit 4.2 to the company's Form SE (File No. 1-8544), dated May 8, 1991. 4.11* Refunding Revenue Bonds Guaranty Agreement by and between the company and Security Pacific National Bank and Alaska Industrial Development and Export Authority, filed as Exhibit 4.3 to the company's Form SE (File No. 1-8544), dated May 8, 1991. 4.12* Specimen Certificate of the company's Refunding Revenue Bonds, Series 1989, filed as Exhibit 4.4 to the company's Form SE (File No. 1-8544), dated May 8, 1991. 4.13* Refunding Revenue Bonds Loan Agreement between American President Lines, Ltd. and Alaska Industrial Development and Export Authority dated October 1, 1991, filed as Exhibit 4.1 to the company's Form SE (File No. 1-8544), dated March 17, 1992. 4.14* Trust Indenture between Alaska Industrial Development and Export Authority, Issuer, and Security Pacific National Bank, Trustee, dated October 1, 1991, to the Refunding Revenue Bonds Series 1991, filed as Exhibit 4.2 to the company's Form SE (File No. 1-8544), dated March 17, 1992. 4.15* Irrevocable Direct Pay Letter of Credit and Reimbursement Agreement between American President Lines, Ltd., American President Companies, Ltd. and The Industrial Bank of Japan, Limited, dated October 3, 1991, filed as Exhibit 4.3 to the company's Form SE (File No. 1-8544), dated March 17, 1992. 4.16* Certificate of Elimination with Respect to the $3.50 Series B Convertible Exchangeable Preferred Stock of American President Companies, Ltd., dated June 22, 1992, filed as Exhibit 4.1 to the company's Form 10Q (File No. 1-8544), dated August 3, 1993. 4.17* Certificate of Designation, Preferences and Rights of the 9% Series D Convertible Preferred Stock of American President Companies, Ltd., dated June 29, 1992, filed as Exhibit 4.2 to the company's Form 10Q (File No. 1-8544), dated August 3, 1993. 4.18* Indenture, dated as of November 1, 1993, between American President Companies, Ltd. and The First National Bank of Boston as Trustee, filed as Exhibit 4.1 to the company's Form 8K (File No. 1-8544) dated November 29, 1993. 4.19* Form of 7-1/8% Senior Note Due 2003 of American President Companies, Ltd., filed as Exhibit 4.2 to the company's Form 8K (File No. 1-8544) dated November 29, 1993. 4.20 Form of 8% Senior Debentures Due 2024 of American President Companies, Ltd. 10.1* Operating-Differential Subsidy Agreement (No. MA/MSB-417), effective as of January 1, 1978, between the United States and American President Lines, Ltd., and Addenda Nos. 1 through 79 thereto, excluding Nos. 16, 52, 56, 67, 72, 73, 76 and 77, filed as Exhibit 10.1 to the company's Form SE (File No. 1-8544), dated March 17, 1992. 10.2* Capital Construction Fund Agreement (No. MA/CCF-306), dated as of December 8, 1976, between the United States and American President Lines, Ltd., and Addenda Nos. 1 through 15 thereto, excluding No. 10, filed as Exhibit 10.2 to the company's Form SE (File No. 1-8544), dated March 17, 1992. 10.3* Sealift Readiness Agreement (No. SRP 10-83), dated January 1, 1991, between the Department of the Navy, Military Sealift Command, and American President Lines, Ltd., filed as Exhibit 10.4 to the company's Registration Statement on Form 10 (File No. 1-8544), which became effective on September 1, 1983. 10.4* Lease Agreement, dated June 1, 1988, between Monsanto Company and American President Intermodal Company, Ltd., filed as Exhibit 10.14 to the company's Form SE (File No. 1-8544), dated July 26, 1988. 10.5* Lease Agreement, dated June 1, 1988, between Consolidated Rail Corporation and American President Intermodal Company, Ltd., filed as Exhibit 10.2 to the company's Form SE (File No. 1-8544), dated March 14, 1990. 10.6* Lease and Preferential Assignment Agreement dated January 6, 1971, and First Supplemental Agreement dated February 24, 1971, between the City of Oakland and Seatrain Terminals of California, Inc., filed as Exhibit 10.32 to the company's Registration Statement on Form S-l, Registration No. 2-93718, which became effective on November 1, 1984. 10.7* Second Supplemental Agreement to Lease and Preferential Assignment Agreement, dated May 3, 1988, filed as Exhibit 10.3 to the company's Form SE (File No. 1-8544), dated March 14, 1990. 10.8* Preferential Assignment dated February 23, 1972, between the City of Oakland and Seatrain Terminals of California, Inc., filed as Exhibit 10.33 to the company's Registration Statement on Form S-l, Registration No. 2-93718, which became effective on November 1, 1984. 10.9* Assignment, Designation of Secondary Use and Consent, dated December 11, 1974, among Seatrain Terminals of California, Inc., American President Lines, Ltd., the City of Oakland and Seatrain Lines, Inc., filed as Exhibit 10.34 to the company's Registration Statement on Form S-l, Registration No. 2-93718, which became effective on November 1, 1984. 10.10* Acknowledgment of Termination of Consent to Secondary Use and Sublease and Assumption of Entire Combined Premises and Cranes dated December 18, 1981, between the City of Oakland and American President Lines, Ltd., filed as Exhibit 10.35 to the company's Registration Statement on Form S-l, Registration No. 2-93718, which became effective on November 1, 1984. 10.11* Supplemental Agreement dated July 6, 1982, between the City of Oakland and American President Lines, Ltd., filed as Exhibit 10.36 to the company's Registration Statement on Form S-l, Registration No. 2- 93718, which became effective on November 1, 1984. 10.12* Permit No. 441, dated November 26, 1980, Second Amendment to Permit No. 441, dated February 7, 1983, and Third Amendment to Permit No. 441, dated May 10, 1984, between the City of Los Angeles and American President Lines, Ltd., filed as Exhibit 10.37 to the company's Registration Statement on Form S-l, Registration No. 2-93718, which became effective on November 1, 1984. 10.13* Fourth Amendment to Permit No. 441, dated as of October 29, 1986 between the City of Los Angeles and American President Lines, Ltd., filed as Exhibit 10.4 to the company's Form SE (File No. 1-8544), dated March 23, 1987. 10.14* Financing and Security Agreement, dated March 27, 1984, between American President Lines, Ltd. and the City of Los Angeles, California, filed as Exhibit 10.38 to the company's Registration Statement on Form S-1, Registration No. 2-93718, which became effective on November 1, 1984. 10.15* Lease, dated July 31, 1972, Lease Agreement, dated September 1, 1980, Memorandum, dated September 1, 1980, and two letters dated July 3, 1981 and July 14, 1981, respectively, between Hanshin Port Development Authority and American President Lines, Ltd., filed as Exhibit 10.39 to the company's Registration Statement on Form S-1, Registration No. 2-93718, which became effective on November 1, 1984. 10.16* Pre-engagement Agreement for Lease dated March 17, 1983, Supplemental Agreement dated March 17, 1983 and form of Wharf Lease Agreement between Yokohama Port Terminal Corporation and American President Lines, Ltd., filed as Exhibit 10.41 to the company's Registration Statement on Form S-l, Registration No. 2-93718, which became effective on November 1, 1984. 10.17* Lease Contract of Wharfs Nos. 68 & 69 of Container Terminal No. 3 Kaohsiung Harbor, Taiwan, Republic of China, dated December 31, 1987 and Equipment Agreement between the Kaohsiung Harbor Bureau and APL, dated December 31, 1987, filed as Exhibit 10.4 to the company's Form SE (File No. 1-8544), dated March 11, 1988. 10.18* Lease dated April 28, 1978, Memorandum of Understanding, Addendum to Lease dated May 9, 1978, Addendum No. 2 to Lease dated July 28, 1978, and Addendum No. 3 to Lease dated March 27, 1984, between Sunset Cahuenga Building, a Joint Venture, and American President Lines, Ltd., filed as Exhibit 10.44 to the company's Registration Statement on Form S-l, Registration No. 2-93718, which became effective on November 1, 1984. 10.19* Addendum No. 4 dated April 19, 1985 to Lease dated April 28, 1978, between Sunset Cahuenga Building, a Joint Venture, and American President Lines, Ltd., filed as Exhibit 10.1 to the company's Form SE (File No. 1-8544), dated December 12, 1985. 10.20* Addendum No. 5 dated July 25, 1986 to Lease dated April 28, 1978, between Sunset Cahuenga Building, a Joint Venture, and American President Lines, Ltd., filed as Exhibit 10.5 to the company's Form SE (File No. 1-8544), dated March 11, 1988. 10.21* Addendum No. 6, dated May 1, 1988, to Lease dated April 28, 1978, between Sunset Cahuenga Building, a Joint Venture, and American President Lines, Ltd., filed as Exhibit 10.13 to the company's Form SE (File No. 1-8544), dated July 26, 1988. 10.22* Lease Agreement between Port of Seattle and American President Lines, Ltd. at Terminal 5 dated September 26, 1985, filed as Exhibit 10.5 to the company's Form SE (File No. 1-8544), dated December 12, 1985. 10.23* Lease Agreement between the company and Bramalea Pacific, Inc. dated April 18, 1988, and Amendments 1 through 5, filed as Exhibit 10.3 to the company's Form SE (File No. 1-8544), dated March 27, 1991. 10.24* Deferred Compensation Plan For Directors of the company, filed as Exhibit 10.49 to the company's Registration Statement on Form S-l, Registration No. 2-93718, which became effective on November 1, 1984. 10.25* Executive Survivors' Benefits Plan, dated November 29, 1988, filed as Exhibit 10.4 to the company's Form SE (File No. 1-8544), dated March 17, 1992. 10.26* 1989 Stock Incentive Plan of the company, filed as Exhibit 10.4 to the company's Form SE (File No. 1-8544), dated March 14, 1990. 10.27* Amendment to 1989 Stock Incentive Plan of the company, filed as Exhibit 10.4 to the company's Form SE (File No. 1-8544), dated October 31, 1990. 10.28* Credit agreements dated as of February 12, 1987, between American President Lines, Ltd. and Kreditanstalt Fuer Wiederaufbau, filed as Exhibit 10.9 to the company's Form SE (File No. 1-8544), dated March 23, 1987. 10.29* Guarantees dated as of February 12, 1987, by the company in favor of Kreditanstalt Fuer Wiederaufbau, filed as Exhibit 10.10 to the company's Form SE (File No. 1-8544), dated March 23, 1987. 10.30* 1988 Deferred Compensation Plan dated November 29, 1988, filed as Exhibit 10.5 to the company's Form SE (File No. 1-8544), dated February 17, 1989. 10.31* Grantor Trust Agreement with U.S. Trust Company of California, N.A., effective April 10, 1989, filed as Exhibit 10.1 to the company's Form SE (File No. 1-8544), dated August 1, 1989. 10.32* Employment Agreement as amended, dated January 29, 1991 between the company and John M. Lillie, filed as Exhibit 10.1 to the company's Form SE (File No. 1-8544), dated May 8, 1991. 10.33* Employment Agreement, dated March 4, 1991 between Will M. Storey and the company, filed as Exhibit 10.2 to the company's Form SE (File No. 1-8544), dated May 8, 1991. 10.34* Employment Agreement, dated July 30, 1991 between Joji Hayashi and the company, filed as Exhibit 10.1 to the company's Form SE (File No. 1- 8544), dated October 22, 1991. 10.35* Employment Agreement, dated July 30, 1991 between James S. Marston and the company, filed as Exhibit 10.2 to the company's Form SE (File No. 1-8544), dated October 22, 1991. 10.36* Employment Agreement, dated July 30, 1991 between Timothy J. Rhein and the company, filed as Exhibit 10.3 to the company's Form SE (File No. 1-8544), dated October 22, 1991. 10.37* Agreement dated May 6, 1991 between the company and Richard L. Tavrow, filed as Exhibit 10.3 to the company's Form SE (File No. 1-8544), dated March 17, 1992. 10.38* Form of Indemnity Agreement dated March 11, 1988 between the company and W. B. Seaton, Charles S. Arledge, John H. Barr, Calvin S. Hatch, J. Hayashi, Forrest N. Shumway and Barry L. Williams, filed as Exhibit 10.3 to the company's Form SE (File No. 1-8544), dated February 17, 1989. 10.39* Form of Indemnity Agreements dated April 25, 1991 between the company and F. Warren Hellman, John M. Lillie, Timothy J. Rhein, Will M. Storey, filed as Exhibits 10.3 through 10.6 to the company's Form SE (File No. 1-8544), dated May 8, 1991. 10.40* Trans-Pacific Stabilization Agreement, a Cooperative Working Agreement among Ocean Common Carriers, including American President Lines, Ltd., signed November 22, 1988, filed as Exhibit 10.2 to the company's Form SE (File No. 1-8544), dated August 1, 1989. 10.41* Assignment Agreement from United States Lines, Inc. to American President Lines, Ltd. with attached supplements, dated September 16, 1987, filed as Exhibit 10.8 to the company's Form SE (File No. 1- 8544), dated March 14, 1990. 10.42* Receivables Purchase Agreement, dated August 29, 1991 between American President Domestic Company, Ltd. and J.P. Morgan Delaware, Morgan Guaranty Trust Company of New York, Bank of America National Trust and Savings Association, Barclays Bank PLC, Citibank, N.A., The First National Bank of Boston, The First National Bank of Chicago, Security Pacific National Bank and Morgan Guaranty Trust Company of New York, as agent, filed as Exhibit 10.04 to the company's Form SE (File No. 1- 8544), dated October 22, 1991. 10.43* Receivables Purchase Agreement, dated August 29, 1991 between American President Lines, Ltd. and J.P. Morgan Delaware, Morgan Guaranty Trust Company of New York, Bank of America National Trust and Savings Association, Barclays Bank PLC, Citibank, N.A., The First National Bank of Boston, The First National Bank of Chicago, Security Pacific National Bank and Morgan Guaranty Trust Company of New York, as agent, filed as Exhibit 10.05 to the company's Form SE (File No. 1-8544), dated October 22, 1991. 10.44* Master Slot Charter Agreement between American President Lines, Ltd. and Orient Overseas Container Line Inc. dated July 24, 1991, filed as Exhibit 10.5 to the company's Form SE (File No. 1-8544), dated March 17, 1992. 10.45* Reciprocal Slot Exchange and Coordinated Sailing Agreement between American President Lines, Ltd. and Orient Overseas Container Line Inc. dated July 24, 1991, filed as Exhibit 10.6 to the company's Form SE (File No. 1-8544), dated March 17, 1992. 10.46* Agreement dated January 2, 1992 between the company and W.B. Seaton, filed as Exhibit 10.01 to the company's Form SE (File No. 1-8544), dated May 5, 1992. 10.47* Amendment No. 1, dated March 17, 1992, to the Receivables Purchase Agreement between APL Land Transport Services, Inc. and the Purchasers, J.P. Morgan Delaware and Morgan Guaranty Trust Company of New York, as agents, filed as Exhibit 10.02 to the company's Form SE (File No. 1-8544), dated May 5, 1992. 10.48* Amendment No. 1, dated March 17, 1992, to the Receivables Purchase Agreement, between American President Lines, Ltd. and the Purchasers, J.P. Morgan Delaware, Morgan Guaranty Trust Company of New York, as agent, filed as Exhibit 10.03 to the company's Form SE (File No. 1- 8544), dated May 5, 1992. 10.49* Amended and Restated Credit Agreement and APC Subordination Agreement, dated March 17, 1992 among American President Lines, Ltd., borrower, American President Companies, Ltd., guarantor, and J.P. Morgan Delaware, Morgan Guaranty Trust Company of New York, Bank of America National Trust and Savings Association, Barclays Bank PLC, Citibank, N.A., The First National Bank of Boston, The First National Bank of Chicago, Security Pacific National Bank and Morgan Guaranty Trust Company of New York, as agent, filed as Exhibit 10.05 to the company's Form SE (File No. 1-8544), dated May 5, 1992. 10.50* 1992 Directors' Stock Option Plan, dated March 17, 1992, filed as Exhibit 10.06 to the company's Form SE (File No. 1-8544), dated May 5, 1992. 10.51* Amendment No. 1 dated May 5, 1992 to the Amended and Restated Credit Agreement dated March 17, 1992 among American President Lines, Ltd., borrower, American President Companies, Ltd., guarantor, and Morgan Guaranty Trust Company of New York, as agent, filed as Exhibit 10.01 to the company's Form SE (File No. 1-8544), dated July 28, 1992. 10.52* Amended and Restated Retirement Plan for the Directors of American President Companies, Ltd., dated September 15, 1992, filed as Exhibit 10.01 to the company's Form SE (File No. 1-8544), dated October 20, 1992. 10.53* Amendment No. 1 dated July 28, 1992 to the Employment Agreement as amended, between the company and John M. Lillie, filed as Exhibit 10.1 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.54* Amendment No. 2 dated January 26, 1992 to the Employment Agreement as amended, between the company and John M. Lillie, filed as Exhibit 10.2 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.55* Amendment No. 1 to the 1988 Deferred Compensation Plan, effective January 1, 1992, filed as Exhibit 10.3 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.56* Addenda Nos. 16 and 17 to the Capital Construction Fund Agreement (No. MA/CCF-306), dated as of December 8, 1976, between the United States and American President Lines, Ltd., filed as Exhibit 10.4 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.57* Vessel Sale Agreement for the President Lincoln, dated October 30, 1992 among American President Lines, Ltd., the Purchaser, and Xerox Credit Corporation, Owner Participant, filed as Exhibit 10.5 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.58* Vessel Sale Agreement for the President Washington and President Monroe, dated November 17, 1992 among American President Lines, Ltd., the Purchaser, Bank of American National Trust and Savings Association, not in its individual capacity but solely as Owner Trustee under the related trust agreements for the benefit of the Trustors named and General Electric Credit Corporation of Georgia, Owner Participant, filed as Exhibit 10.6 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.59* Amendment No. 2 dated December 9, 1992 to the Amended and Restated Credit Agreement dated March 17, 1992 among American President Lines, Ltd., borrower, American President Companies, Ltd., guarantor, and Morgan Guaranty Trust Company of New York, as agent, filed as Exhibit 10.7 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.60* Amendment No. 2 dated December 9, 1992 to the APD Receivables Purchase Agreement dated August 29, 1991 among APL Land Transportation Services, Inc., seller, J.P. Morgan Delaware, as administrative agent, and Morgan Guaranty Trust Company of New York, as co-agent, filed as Exhibit 10.8 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.61* Amendment No. 2 dated December 9, 1992 to the APL Receivables Purchase Agreement dated August 29, 1991 among American President Companies, Ltd., seller, J.P. Morgan Delaware, as administrative agent, and Morgan Guaranty Trust Company of New York, as co-agent, filed as Exhibit 10.9 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.62* Amendment No. 1 to the Executive Survivors' Benefits Plan, effective December 4, 1992, filed as Exhibit 10.10 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.63* Excess-Benefit Plan of the company, amended and restated effective January 1, 1993, filed as Exhibit 10.11 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.64* American President Companies, Ltd. SMART Plan, amended and restated effective January 1, 1993, filed as Exhibit 10.12 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.65* American President Companies, Ltd. Retirement Plan, amended and restated effective January 1, 1993, filed as Exhibit 10.13 to the company's Form SE (File No. 1-8544), dated March 24, 1993. 10.66 Contract for the Purchase of Containership Vessels dated May 10, 1993, between Howaldtswerke-Deutsche Werft and Aktungesellschaft and American President Lines, Ltd. 10.67 Contract for the Purchase of Containership Vessels dated May 10, 1993, between Daewoo Shipbuilding and Heavy Machinery, Ltd. and American President Lines, Ltd. 10.68 Commitment Letter from Kreditanstalt fur Wiederaufbau to American President Companies, Ltd. 10.69* Amendment No. 1 to the Contract for the Purchase of Containership Vessels, dated June 3, 1993, between Daewoo Shipbuilding and Heavy Machinery, Ltd., filed as Exhibit 10.4 to the company's Form 10Q (File No. 1-8544, dated August 3, 1993.) 10.70* Addendum No. 17 to the Capital Construction Fund Agreement (No. MA/CCF- 306), dated April 22, 1993, between the United States and American President Lines, Ltd. filed as Exhibit 10.5 to the company's Form 10Q (File No. 1-8544), dated August 3, 1993. 10.71* Permit No. 733, dated September 10, 1993, between the City of Los Angeles and Eagle Marine Services, Ltd., and the Guaranty of Agreement made by American President Lines, Ltd., excluding exhibits, filed as Exhibit 10.1 to the company's Form 10Q (File No. 1-8544), dated November 18, 1993. 10.72 Addenda Nos. 87 and 89 dated August 16, 1991 and March 19, 1992, respectively to the Operating-Differential Subsidy Agreement (No. MA/MSB-417), effective as of January 1, 1978, between the United States and American President Lines, Ltd. 10.73 Amendments Nos. 3, 4 and 5 dated March 1, 1993, December 2, 1993 and February 1, 1994, respectively, to the Amended and Restated Credit Agreement dated March 17, 1992 among American President Lines, Ltd., as borrower, American President Companies, Ltd., as guarantor, and Morgan Guaranty Trust Company of New York, as agent, and the banks named therein. 10.74 Indemnity Agreement dated October 5, 1993 between the company and Toni Rembe. 10.75 Amendment No. 1 dated January 31, 1994 to the Reciprocal Slot Exchange and Coordinated Sailing Agreement between American President Lines, Ltd. and Orient Overseas Container Line Inc. dated July 24, 1991. 10.76* Indemnity Agreement dated March 17, 1992 between the company and John J. Hagenbuch, filed as Exhibit 10.04 to the company's Form SE (File No. 1-8544), dated May 5, 1992. 11.1 Computation of Earnings Per Share. 21.1 Subsidiaries of the company. 23.1 Consent of Independent Public Accountants. 24.1 Powers of Attorney *Incorporated by Reference Pursuant to Item 601(b) (4) (iii) (A) of Regulation S-K, the company agrees to furnish to the Securities and Exchange Commission upon its request copies of documents pertaining to United States Merchant Marine Bonds secured by mortgages on certain vessels owned by the company described in the Consolidated Financial Statements of American President Companies Ltd. and Subsidiaries. Documents pertaining to such bonds, other than United States Merchant Marine Bonds, are substantially identical to those set forth as Exhibit 4.2 and 4.3 hereto. Pursuant to Instruction 2 Item 601 of Regulation S-K, the company has omitted the Contract for the Purchase of Containership Vessels dated December 2, 1993, between Daewoo Shipbuilding and Heavy Machinery, Ltd. and American President Lines, Ltd. Such document is substantially identical to the Contract for the Purchase of Containership Vessels dated May 10, 1993, between Daewoo Shipbuilding and Heavy Machinery, Ltd. and American President Lines, Ltd., except with respect to prices and dates of delivery, set forth as Exhibit 10.67. (b) Reports on Form 8-K during the fourth quarter: On December 6, 1993, the company filed a Form 8K, dated November 29, 1993, for sale of $150 million aggregate principal amount of its 7-1/8% Senior Notes Due 2003. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AMERICAN PRESIDENT COMPANIES, LTD. (Registrant) By /s/ William J. Stuebgen William J. Stuebgen Vice President, Controller and Chief Accounting Officer March 9, 1994 Pursuant to the requirements of the Securities and 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. /s/ John M. Lillie* March 9, 1994 John M. Lillie Chairman of the Board of Directors, President and Chief Executive Officer /s/ Charles S. Arledge* March 9, 1994 Charles S. Arledge Director /s/ John H. Barr* March 9, 1994 John H. Barr Director /s/ John J. Hagenbuch* March 9, 1994 John J. Hagenbuch Director /s/ Joji Hayashi* March 9, 1994 Joji Hayashi Director /s/ F. Warren Hellman* March 9, 1994 F. Warren Hellman Director /s/ Toni Rembe* March 9, 1994 Toni Rembe Director /s/ Timothy J. Rhein* March 9, 1994 Timothy J. Rhein Director W. B. Seaton Director /s/ Forrest N. Shumway* March 9, 1994 Forrest N. Shumway Director /s/ Will M. Storey* March 9, 1994 Will M. Storey Executive Vice President, Chief Financial Officer and Director /s/ Barry L. Williams* March 9, 1994 Barry L. Williams Director *By: /s/ Maryellen B. Cattani March 9, 1994 Maryellen B. Cattani Attorney-in-fact